Accounting Topic – Page 2 – accountingexplained

Introduction to Partnership Account

Businesses that are run by more than one owners are call partnership. Partnership account is a very hard topic, it is probably way harder than manufacturing account but I will try my very best to point out what you should be aware of and what are some of the usual mistakes that you will probably made!

Why is partnership account harder than sole-proprietorship account? The answer is because there are too many topics too be covered (and so many things to remember!) along in partnership and it will therefore easily messed up someone mind! So what are the special topics? In partnership, there exist a capital account (which is also in sole-proprietorship account) and a current account (which is not in sole-proprietorship account), calculation of goodwill (when a partner resigned or additional partner is admitted) and partnership dissolution (occurs when the business wants to cease (or stop) trading). In A level, this will probably be mind-blowing. 🙂

So as an introduction to this partnership account, you first need to know what is the advantages of having a partnership! (You could be tested with this kind of questions during exam.)

Advantages:

1) The ability to obtain more capital from various partners. Imagine you and your friends setting up a small business, pooling every friends cash (known as capital) will give you more money!

2) Contribution of skills, knowledge and experiences to the business by different partners. This is rather important because one person could be more knowledgeable in certain skills, say some partner is good with cooking, some is good with counting money (yeah, useless skills, maybe he/she is good with mathematics?) and some is good with communicating and even managing business.

I didn’t point out the need to memorize disadvantages but that doesn’t mean you need not to read it but I would say it has rarely been asked. But I will point it out anyway, 1) the liability of the business is still unlimited and that the partners are jointly responsible for all debts and 2) there is more room for disagreement between partners.

Let me re-explain the first point, if you invest $10,000 in a business, but your business went bankrupt with a debt of $12,000, you will have to pay the $12,000 regardless of how much you have originally invested. With partnership, lets say you invested the same amount of $10,000, and your 3 partners invested $10,000 each too, so you have a total of $40,000. Say the business suffers from major loss and the business is in a debt of $50,000, if one of your partners cannot afford to pay a total of $12,500, you and the other partner will have to pay out $16,667 each regardless of how much you have initially invested and regardless of whether every partner(s) could pay the debts or not.

SO, what is different in partnership account?

Well, there will be profit sharing ratio (which is also a loss sharing ratio). This is definitely easy. Let’s start with an example of profit sharing ratio of 3:2:1 between Allen, Ben and Catty and the net profit is $30,000.

Partnership Account - Profit Sharing Ratio

Other than Profit Sharing Ratio, you will also have interest on capitals. This works quite similar to the money you put in bank and received a % as interest. Interest on capital is decided by the partners itself and will be stated in the partnership agreements. The purpose of interest on capital is to motivate partners to invest more money to the business. To calculate interest on capital, simply used the formula below:

Interest on Capital = Contributed Capital x Interest Rate on Capital

If Allen has been contributing $10,000 into the business then his Interest on Capital will be $1,000 (i.e. $10,000 x 10%).

In partnership, you will also see Interest on Drawing. It works similarly with interest on capitals just that the purpose is to deter partners from drawing excessively. In order to stop your partner from taking cash from your business (i.e. drawing), interest on drawing is set up in partnership. The more you draw, the more you pay.

Interest on Drawing = Cash Withdraw x Interest Rate on Drawings

So say if Allen withdraw $1,000 and Ben withdraw $4,000 throughout the year, the interest on drawing (at 10%) will be:

Allen = $1,000 x 10% = $100

Ben = $4,000 x 10% = $400

As you can see from the above calculation, the more you withdraw, you will actually need to pay more in the interest.

How about salaries to partners? Occasionally, partners will be paid fixed salaries when they have direct involvement in the day-to-day operations of their business (and this is just as simple as it is.)

Now, putting everything back to perspective and this is what you will have to do during exam (to link what you have learned above into showing them in a partnership account!) The example below does not linked to the values as calculated above.

Partnership Appropriation Account

Note 1: Why add interest on drawing?

You just have to assume that cash is going in to the business (partners pay cash into the business). At such this is interest received and interest received is a gain to the company!

Note 2: Why subtract interest on capitals?

You just have to assume that cash is going out to the business (business pay cash to the partners). At such this is interest paid and interest paid is an expenses to the company!

This post is consider finished but might be review in the future.

Manufacturing Account

So far, all previous posts deal with businesses that either sell goods (or products) to customers or services to customers. We have not been dealing with manufacturing company. A manufacturing company not only manufactures products but also sells them to other company. So, the existing preparation of accounts are not enough to record everything (the trading and profit and loss account and the balance sheet statement.) In this case, you will need to have another account drawn up; the manufacturing account.

In manufacturing account, you will need to be aware of new terms;

1) Direct costs – Costs that can be directly traced to making the products. Direct costs are categorised into direct materials, direct labour and direct expenses.

2) Indirect costs – Costs that cannot be directly traced to making the products.

3) Prime costs – All direct costs.

4) Factory overhead – Costs which occur in the factory where the production is being done.

5) Production cost – prime costs + factory overhead (remember this but not that simple).

You will also need to know that there are three types of stock in manufacturing account; 1) raw materials, 2) finished goods and 3) work in progress. As the name implies, you will expect raw materials as the costs in direct materials so it will appear in the manufacturing account. As for finished goods (treat them as you normally do) in the trading account. Lastly, work in progress are products that are partially finished. You will be expected to include them in the manufacturing account to arrive at the Production Cost.

As for now, what is the format of manufacturing account? Manufacturing account has a purpose in arriving at the cost of production – you needed to know how much finished goods have been

Remember that Prime costs = Direct Materials + Direct Labour + Direct Expenses so now

Production cost = Direct Materials + Direct Labour + Direct Expenses + Factory Overhead (+Work In Progress – see below)

Now then that’s done but what else to watch out for?

1) It is important to know that examiners will have a list of expenses for you to categorize whether there are “factory overhead,” “administration expenses” and “selling and distribution expenses.” A general rule will be to treat factory expenses in manufacturing account and office expenses in profit and loss account. In some cases, you will need to further classified office expenses into “administrative” and “selling and distribution expenses”.

2) Production cost is transferred to trading account. You replaced the purchases from trading account. 3) Lastly, you must remember to post all closing balance of stocks into balance sheet (same treatment like the normal closing stock).

This post is finished.

Adjustments for Final Accounts – Accrual and Prepayments

This post has been re -updated on 7th June 2013.

This topic is easy if you understand what is accounting period and accrual concept.

Accrual concept is the consideration of income and expenses (also called charges) relating to the accounting period. You then need to know what is an accounting period. Accounting period is the time set by a company itself on its period of accounting, reporting date and year end closing. Most companies have an accounting period of one year and they usually ends at 31st December 20XX so you could expect most companies and exam questions’ accounting period starts at 1st January 20XX – 31st December 20XX.

Accrual means owing and prepayment means advanced payment. If you start a business on 15th August 2012 and you decide to rent a vacant lot for your business. So you will expect payment to be made in advance, say 3 months in advance worth of $3,000 (well, the tenant needed to ensure that you really wanted to rent the lot and perhaps also for security reason). So you made the following payments on 15th August 2012 and 15th November 2012. I have further explained the points below:Right now, you will need to know how to open up a Rent account (an expense account). The reason I emphasized on an expense account is the fact that you will need to apply the nature of transaction for an expenses – which is the debit side. You will also need to know how to post the rental account items to its relevant account and the overall format of how the adjusted accounts will look like. The above example uses rental account, which is an expense item, in this case, you will need to follow the general format for an expense account as proposed above. You will not see this in any textbook, you are expected to know where to put accrued and prepaid opening and closing entries, which is indeed confusing during the examination. In any case, you should also be able to tell whether it is an expense or an income. Remember that if you pay then it is an expense while if you receive then it is an income. Then use the relevant format to solve for the Profit and Loss amount.

In order to score well, you will need to know:

1) How to charge expense/income to the profit and loss account, for which you will need to refer back to the format above to solve.

(The trick that I used!) In order to remember,

I denote Expenses as [E], Revenues as [R], Accrual as [A], Bank as [B], Profit and Loss as [P] and Prepaid as [P].
For an Expense Account, the debit side will be PBA and the credit side will be APP.
So memorize only “E – PBA APP”
For an Income Account, the debit side will be APP and the credit side will be PBA.
So memorize only “R – APP PBA”

You can stick with any other method you like to as long as you can remember them.

2) How to post closing entry to the balance sheet.

Accrued at closing balance of Expenses = Current Liabilities
Prepaid at closing balance of Expenses = Current Assets
Accrued at closing balance of Revenues = Current Assets
Prepaid at closing balance of Revenues = Current Liabilities

Suspense Account

Suspense account is a little bit trickier than previous topic on Correction of Errors not affected by Trial Balance. There are more or less the same thing, involving correction of errors too. But obviously, it will get you from thinking, what will be the circumstances to use Suspense and what are the time to use Correction of Errors not affected by Trial Balance?

To make it a little bit clear, I throw out two circumstances,

1) You made a mistake of overlooking a transaction. (*overlooked means ignored or neglected) and

2) You made a mistake of entering a debit side of $100 and a credit side of $1,000 in the credit side.

The first instance will not affect the Trial Balance since both sides are ignored at the same time, thus giving you the same equal balances on debit and credit sides.

As for the second instance, you realized that there is a difference, a $900 differences in the debit side and the credit side. You can draw a conclusion that errors that do affect the Trial Balance will result in the need for suspense account. Suspense account is therefore any differences used to re-balance the trial balance. For the error in second instance, you will need to have a suspense account in the debit side of $900 in order to bring debit side to $1,000 (to equate them as the credit balance.)

Mistakes are commons in accounting. So real accountants will indeed be forced to use suspense account to re-balance their trial balance. However, suspense account consists of errors (multiple of them, you won’t be tested by correcting only one error, that will be too easy!) that must be corrected. –> the MAIN FOCUS of EXAM (I am not saying that Correction of Errors not Affecting Trial Balance is not important, they are equally important.)

Whatever the reasons of errors, you must realized that the combined correction of errors should be reduced back to zero. And one thing to bear in mind is that you only made one correction instead of two in Correction of Errors not Affecting Trial Balance. Essentially, one entry has been made correctly but not the subsequent entry –> which resulted in a difference in Trial Balance.

A comprehensive question involving suspense account could include testing on Trial Balance, Correction of Errors, Suspense Account, recalculation of adjusted profit and maybe reproducing a Profit and Loss or Balance Sheet statement.

Note that Profit and Loss is also called Income Statement and Balance Sheet is also called Statement of Financial Position (you must start to know them as most revised textbooks have started to use those names and you will probably see extinction in using Profit and Loss and Balance Sheet names in few years time.)

This post is still ongoing. 15th May 2013

Correction of Errors not affected by Trial Balance

Accounting is based on double-entry rule; a debit entry will result in another corresponding credit entry and a credit entry will result in another corresponding debit entry. So, a trial balance will tend to balance. But trial balance do not always give you the correct balances. And there are also circumstances where the trial balance is balanced but are incorrect. It’s getting pretty confused here, you just need to note that when trial balance balanced, it doesn’t necessary mean that the trial balance is correct.

If you think you need to revise back on Trial Balance, click here.

There are six of them:

1) Error of Omission – As the name implies, this means that a transaction or event has been completely left out from the books. Follow the Debit – PEDARI rule and the Credit SCROLG rule to re-correct the error.

2) Error of Commission – This error means that posting is done to the wrong account of the same category. Here, the category can be Debtors and Creditors. This error occur when you are supposed to post to a debtor name Carol, but due to a lot of debtors with similar names, say Caroline, then you could have posted in to Caroline account instead of Carol account.

3) Error of Principle – This error means that posting is done to a different category of account. So the PEDARI is consider to be different category, and so does SCROLG. So instead of posting to an expenses account, some could have mistakenly posted in assets account. In addition to debit side, when it comes to SCROLG, some could have mistakenly posted in revenues instead of gains. An emphasis here is that most often the mistakes apply to only “expenses and assets” and “gains and revenues.” The reason why I have made an emphasis here is that – the errors most likely come from mistakenly treated “expenses as assets” and “gains as revenues” or the reverse.

4) Error of Original Entry – This error means that a wrong amount has been initially recorded in the book of original entry and subsequently posted to the ledger accounts. This error is just as simple as the name implies.

5) Compensating Errors – This error means that the debit side of an account is compensated by another error of the same/equal amount on the credit side in another account.

6) Error of Complete Reversal Entry – As the name implies, this means that the debit and credit entry recorded for a particular transaction are reversed. The transactions are incorrect but because the amount is the same or equal at both sides, the trial balance still balanced.

1st JAN: This post is till ongoing.

Control Accounts

In real business operations, paying on cash may not be the only option of purchasing goods. Often, customers (debtors) purchased from you on credit. And you, as the owner, purchased goods from suppliers (creditors) on credit. So, recording numerous numbers of customers and suppliers on credit (throughout one year period) could create a lot of errors. One way to ensure arithmetic accuracy is to do control accounts by bringing multiple debtors/creditors in a year to the control accounts (like a summary throughout the year).

Control accounts are a type of accounting control which is used mainly in manual accounting systems. Control accounts are similar to trial ledger to check for arithmetical accuracy of the accounts, just that control accounts are more detailed in nature and only governs one activities at a time, such as the creditors and debtors amounts.

Please take note that “sales ledger control account‘ is also known as “debtors control account‘ and “purchases ledger control account” is the same as “creditors control account.” Both names should be familiarized because all the names are often used during examination. It is not hard to understand the meaning behind each name, you sale your products/services to a debtors and hence the name sales ledger control account and debtors control account. Likewise, you purchase your products from creditors and hence the name purchase ledger control account and creditors control account.

It should be noted that the following are not included in control accounts,

1) Bad debts recovered

2) Cash sales

3) Cash purchases

4) Increase in provision for doubtful debts

These four items do not affect debtors and creditors account.

Format for Debtors Control Account

Debtors Control Account

Not being able to memorize this format could put you in trouble. A simple way to understand this format is to assume the normal debtor account. A normal debtor account will have a debit entry, representing an increase in the debtor account. An a credit entry represents a decrease in the debtor account. A short summary is represented below.

Debtors Control Account - Summary.PNG

Format for Creditors Control Account

Creditors Control Account

So the same thing goes with understanding this format, anything that will increase the creditors account will have to be credited, and anything that will decrease the creditors account will have to be debited.

Contra Entry

If you recall that there is a contra entry for cash and bank account; this application is similar to control accounts. Contra entry occurs when you have a creditor that is a debtor at the same time. So, a supplier or (a creditor) will supply you with goods on credit and at the same time purchasing goods (now acting as a debtor) from you on credit. Contra amount is given most of the time.

(Optional): Useful for A-Level Students.

Note 1: A little bit complicated to explain but imagine this: Business A owes us money because they purchased goods on credit but Business A happens to sell something that our business requires (usually in lower quantity), so we purchased goods from Business A on credit. So we owe each other. For example, Business A owes us $20,000 and we owe Business A $1,000.

Note 2: Similar explanation as Note 1 but with different perspective this time. If our business owes Business A more than Business A owe us, then Business A becomes our creditors. In this context, we owe Business A $20,000 and Business A owes us $1,000.

Depreciation – Disposal Account

Disposal is generally simple to do, I have not seen students facing much difficulty in a straight forward question. Disposal account is opened upon the sale of an asset, because we have to delete the item from our accounts.

Some important points to take note in this topic:

1) The asset values at its original cost or historical cost.

2) Accumulated depreciation of the asset will have to be disposed of.

3) There is a cash transaction involved for the disposal of the asset (i.e. you sold your asset for cash or trade-in.)

4) There will be a profit or loss arising from such disposal. (No gain no loss could also be possible but rarely occurs.)

5) (*Optional) You will need to charge the profit or loss from disposal to the Profit & Loss Account.

The T-accounts and explanation are shown below:

As an example, if a motor vehicle was purchased at the start of the year at $50,000, and then disposed off at the end of the second year at a disposal value of $35,000. In this case, let’s assume that the depreciation was accumulated to $10,000 (straight line method, $5,000 per year).

Motor Vehicle A/C
1-Jan	Cash	50,000	31-Dec	Motor Vehicle disposals	50,000
			You are disposing of an asset worth
			$50,000

Here, students often confused why credit a $ 50,000 motor vehicle account. The reason was obvious, the vehicle that you will throw away is originally worth $50,000. Most students tend to write down the disposal value of $35,000… which is wrong –> Imagine that your motor vehicle was gone and that your motor vehicle account still has a balance carried down of $15,000 ($50,000-$35,000), this is unexplainable (a gone vehicle with a worthiness of $15,000?). Therefore, any assets sold should be reduced with its original cost.

Provision of Depreciation: Motor Vehicle
31-Dec	Motor Vehicle disposals	10,000	31-Dec	Balance c/d	10,000

Because we are supposed to close of all accounts related to the motor vehicle that we brought, all relevant accounts should be closed. If you note that the words Motor Vehicle disposals appear in the accounts of Motor Vehicle and Provision for depreciation. This signals another account that will be used to close all relevant accounts. (Take note that the account for provision of depreciation is kinda simplified, it only shows accumulated depreciation for second year.)

Important Information: In this example, the asset was purchased at 1st January and sold at the end of the year of the second year – 31st December, so it has to be fully depreciated for two years. For A Level students, most often, you will need to pay attention to the date and the month of the purchase and accounts for the depreciation accordingly to the months used during the financial year. However, you should also note if there is any additional information given on the company’s depreciation policy. The depreciation policy is to be given highest priority.

Motor Vehicle Disposals A/C
31-Dec	Motor Vehicle	50,000	31-Dec	Provision for depreciation	10,000
				Cash	35,000
				Loss on disposal	5,000

Motor Vehicle Disposals account will be the final account. Those that I have embolded means it were transferred from the first two accounts that we closed. The cash will be amount that we received or the amount that the motor vehicle was disposed off. Since every account has to be balanced, there will be shortage of amount in the credit side of the disposal account by $ 5,000. This is a loss on disposal. Can’t picture why? Here, the motor vehicle is worth $50k originally and at the end of the second year, the motor vehicle should worth $40k (after depreciation). And because you sold it for $35k, you are losing the $5,000.

You will also need to note that the reverse of loss on disposal will be on the debit side (profit on disposal).

If the question requires you to open up profit and loss account, then you should! If you are unsure, just note that Loss is an expense, it falls at debit entry in the profit and loss account. Profit is a gain, it falls at credit entry in the profit and loss account. Or you could use double entry rule, the loss on disposal is credit side, so it will falls on the debit side of profit and loss account, and vice versa.

Depreciation – Accounts Based

For depreciation, started opening accounts are the weakness for most students. I see through them! And I can’t emphasize enough how you will need a good basic (if you want to improve, read the first few topics of any accounting textbook) to be really able to grasp opening accounts easily! So the double entry rule is the most basic skill (for the fact that the trial balance and balance sheet will have to be balanced were all thanks to double entry rule!)

I will start explaining from the start (you can skip if you want to), I hope this explanation will implant a seed into your memory!

Example:

On 1 January 2012, a business brought a motor vehicle for $ 40,000. The motor vehicle was depreciated at $5,000 per annum using the Straight Line Method.

Cash or Bank account

Depreciation - Cash Account Fixed Assets account

Deciding the journal entries for Depreciation and Provision for Depreciation can be somewhat tricky.

If you could memorize the journal entries real hard, this will be it

Date	Particulars		Debit	Credit
1-Jan	Depreciation of Motor Vehicle		5,000
		Provision for Depreciation of Motor Vehicle		5,000

But if you think you can’t memorize, I will explain it more thoroughly.

First, if you remember that all expenses will falls in the debit side. Check the trial balance to confirm.

Second, the word depreciation means expense, and therefore, it lies in the debit entry. See the journal entry above and refer to the definition previously posted on depreciation.

Third, the double entry account. If you refer to the motor vehicle account earlier, you will know that depreciation will reduce the amount of your fixed assets, and this is opened in another account named Provision for Depreciation. The Motor Vehicle account is not to be reduced because you will need to show the original cost of the asset at the Balance Sheet, and a separate amount to show the total amount of depreciation charged towards the assets.

So the general format for depreciation account,

Depreciation A/C
Provision for Depreciation	XXX	Profit and Loss	XXX

and provision for depreciation account,

Provision for Depreciation A/C
First year depreciation.
Balance c/d	XXX	Depreciation	XXX

Second year depreciation.
Balance c/d	XXX	Balance b/d	XXX
		Depreciation	XXX
	XXX		XXX

Whilst in the final account, profit and loss account

Profit and Loss Account for the year ended … (vertical format)
Expenses:
Depreciation of fixed assets (FROM DEPRECIATION A/C)							XXX

and balance sheet,

Balance Sheet as at … (vertical format)
Fixed Assets:	Cost	Agg Depr	NBV
Motor Vehicle (FROM PROV of DEPRECIATION A/C)	XXX	(XXX)	XXX
			XXX

Next post will be on disposal account.

Depreciation – Calculation Based

Updated on 18th July 2012 on the meaning of depreciation and provision for depreciation.

This topic requires students to memorize the formula to calculate with each method of depreciation. It should be noted that depreciation only applies to assets (for business purposes only and not for resale) and anything purchased for resale should never be included for depreciation (most often used to trick A level students.)

1) Straight line method (also called fixed installment method)

(Cost – Estimated Disposal Value) / Number of Expected Years of Use

Example:

If a motor vehicle was purchased for $25,000 and the estimated disposal value is $5,000, and the number of useful life is 4 years, then,

Depreciation = (25,000 – 5,000) / 4 = $ 5,000 per year.

Therefore, this assets will have to be depreciated for 4 years at $ 5,000 per year (fixed) before this asset will be disposed off.

2) Reducing Balance Method (also called diminishing balance method)

The general formula is presumed to be = Net Book Value x Fixed Percentage Given

*Important terms have to be remembered, failure to understand this usually caused students proceeding to A level having the same difficulty.

Cost means Original Price of an Asset.

Provision for depreciation is the total depreciation used to reduce the amount of fixed assets in the balance sheet.

Depreciation is a one year expense which is brought forward to the profit and loss account.

Net Book Value means value after depreciation.

Example:

Assume the same motor vehicle at $25,000. The depreciation is to be charged at 10%.

1st year depreciation will be = $ 25,000 x 0.10 = $2,500

2nd year depreciation will be = $ (25,000 – 2,500) x 0.10 = $2,250

3rd year depreciation will be = $ (25,000 – 2,500 – 2,250) x 0.10 = $2,025

and so on… The first year uses Cost x Percentage only, while the second year and consecutive years use NBV x Percentage.

3) For A level student, Revaluation method (often used in manufacturing account to depreciate loose tools*)

Revaluation = Opening balance + Purchases – Closing balance

The most easiest depreciation method, but most students failed to recall the formula or are unknown of this method.

Example:

If the opening balance of a loose tools account amounted to $2,000 and during the year, the business purchased $500 worth of loose tools and at the end of the year, the loose tools accounted to $1,500.

Depreciation = OB + P – CB = $2,000 + $ 500 – $1,500 = $ 1,000.

*Loose tools are a part of machinery (spare parts) which can include things such as nails, tools and etc that is easily lost. There are considered to be a part of the fixed assets and so depreciation applies (to account for loose tools lost or stolen).

Depreciation – Theory Based

Depreciation means the systematic allocation of the cost of a depreciable asset to expense over the asset’s useful life.

Imagine a mobile phone that you have purchased a year ago. Your mobile phone during this one year period could have undergone wear and tear, outdated technology, physical damage and etc. So the next time when you are trying to sell this mobile phone, you need to lower the price because of the damages that your mobile phone has already undergone. Let’s say your original mobile phone costs you $600, after a year of using, you sell it for $400. Now, the $200 difference is the depreciation. Note that depreciation is an EXPENSES. This applies to most limited lifetime assets. People tend to be confused on what will depreciate. Strictly speaking, anything that you think will grow old will depreciate. But, there are circumstances when you don’t depreciate asset, asset such as land and investment are those that might not depreciate (you can think of those as something that last forever).

You should note that depreciation rationale lies in the concept of Matching Principle.

There are three ways of calculating depreciation:

1) Straight Line Method

2) Reducing Balance Method or Diminishing Method

3) Revaluation Method (Applicable for A Level students, usually appears in Manufacturing Account)