2 1 WHAT IS BOOKKEEPING? 1.1 Why do we prepare accounts? If you invest in a business (whether by buying shares in a company or by putting money into your own business), you need to know how well or badly that business is doing. In particular you need to be updated periodically with answers to two equally important questions: a) Is the business making a profit? b) Has it got enough funds to pay its debts? Accounts are the means by which these questions are answered. 1.2 Form of accounts A set of accounts consists of two principal statements, usually amplified by detailed notes. These statements are: (a) the statement of financial position: a statement of the financial position of a business at a given date; (b) the income statement: a summary of the results of a business’s transactions for a period ending on the date of the statement of financial position. The amount of detail in a set of accounts will vary according to the type of accounts and the people who will be using them. But the same principles will still apply. 1.3 Types of business There are 3 types of businesses which we will consider in Accounting and a brief description of these types of business is given below. What is important to remember is that regardless of the type of business we are looking at, all businesses will produce an Income Statement and a Statement of Financial Position periodically (usually annually). Sole Trader A sole trader is usually a small business, such as a plumber or plasterer, the owner and the ‘manager’ are the same person.
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Transcript
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1 WHAT IS BOOKKEEPING?
1.1 Why do we prepare accounts?
If you invest in a business (whether by buying shares in a company or by putting money into your own business), you need to know how well or badly that business is doing.
In particular you need to be updated periodically with answers to two equally important questions:
a) Is the business making a profit?
b) Has it got enough funds to pay its debts?
Accounts are the means by which these questions are answered.
1.2 Form of accounts
A set of accounts consists of two principal statements, usually amplified by detailed notes.
These statements are:
(a) the statement of financial position: a statement of the financial position of a business at a given date;
(b) the income statement: a summary of the results of a business’s transactions for a period ending on the date of the statement of financial position.
The amount of detail in a set of accounts will vary according to the type of accounts and the people who will be using them. But the same principles will still apply.
1.3 Types of business
There are 3 types of businesses which we will consider in Accounting and a brief description of these types of business is given below. What is important to remember is that regardless of the type of business we are looking at, all businesses will produce an Income Statement and a Statement of Financial Position periodically (usually annually).
Sole Trader
A sole trader is usually a small business, such as a plumber or plasterer, the owner and the ‘manager’ are the same person.
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The sole trader is legally responsible for all of the losses that their business makes.
Sole traders produce accounts which are not heavily regulated. The sole trader will usually employ a firm of accountants to prepare the business’s accounts.
Partnership
This is a business owned and managed by two or more people examples of such are Accountancy and Law firms. Each Partner in this business is a sole trader for accounting purposes and a Partnership is a collection of sole traders acting together in one business.
Partnerships produce special Partnership accounts.
Company
A company is not owned by the managers of the business (the directors) but instead is owned by Shareholders who buy shares in the company and who elect the Directors to run the company.
A company has limited liability which means that unlike a sole trader, the owners (i.e. the shareholders) are not responsible for the losses of the company. The company is its own legal entity.
Companies must produce company accounts and these are heavily regulated by Company Law and Accounting Standards.
1.4 The purpose of bookkeeping
If accounts are to be produced periodically, the transactions which are being accounted for (eg. purchases and sales of goods, expenses, receipt and payment of cash) must be recorded as and when they happen.
As we said in the Introduction, bookkeeping is the recording of a business’s commercial transactions. Its purpose is to enable those transactions to be summarised at the end of a period so that accounts can be produced.
1.5 Types of accounting records
The expression ‘books’ survives from the days before the invention of accounting machines and computers, when everything was written up in leather-bound books. You will see some handwritten records, but much of what we still call ‘books of account’ or ‘accounting records’ will take the form of computer print-outs. The same information is being given nonetheless.
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1.6 Revision questions
(a) What are the two basic questions which an investor in a business should ask?
(i) ……………………………………..……………………………………..
(ii) ……………………………………..……………………………………..
(b) What are the two principal statements in a set of accounts?
(i) ……………………………………..……………………………………..
(ii) ……………………………………..……………………………………..
(c) Fill in the missing words:
Bookkeeping is the _____________ of a business’s _____________
____________________ .
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1.7 Answers
(a) (i) Is the business making a profit?
(ii) Has the business got enough funds to pay its debts?
(b) (i) Statement of financial position
(ii) Income Statement
(c) Bookkeeping is the recording of a business’s commercial transactions
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2 THE STATEMENT OF FINANCIAL POSITION
2.1 Introduction
In Chapter 1 we saw that the Statement of Financial Position is one of the principal statements of our financial accounts.
Let’s consider what we mean by ‘position’: the SOFP considers what the business OWNS – which we refer to as ASSETS and what the business OWES – which we refer as LIABILITIES.
In this chapter we will look at Assets and Liabilities in the Statement of Financial Position (SOFP) in more detail.
2.2 Assets
As above, Assets are defined things which the business OWNS and can be broken down into two types:
Non-current assets, and
Current assets. Non-current assets Non-current assets can be defined as ‘assets acquired for use within a business over more than one year (usually several years) with a view to earning profits, but not for resale’. Without looking at the answer, try to think of some types of assets which a business would be likely to keep over several years which might help them to make profits.
Target about 10.
…………………………………………… ………………………………………….
…………………………………………… ………………………………………….
…………………………………………… ………………………………………….
…………………………………………… ………………………………………….
…………………………………………… ………………………………………….
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Answer:
Land, buildings, plant and machinery, patents, motor vehicles, tools, fixtures and fittings, office equipment, computers, long-term investments, ships, works of art, locomotives. Current assets Current assets are defined as ‘assets acquired for conversion into cash in the ordinary course of business’. These are any assets which are not non-current assets. In other words, non-current assets are those which a business keeps and uses in the long term (usually more than 12 months), and current assets are those which pass through the business as part of the normal trading process. Just as people or animals cannot live without blood constantly moving through their bodies, so a business cannot exist without the constant movement of current assets. a) Inventories b) Cash Receivables – these occur when we sell goods to our customers on credit (i.e they pay us later). When our customer will pay us depends on the credit terms we offer them but it will usually be within 3 – 6 months.
2.3 Liabilities
Above we defined a liability as an amount owed by the business. This means that the business has an obligation to pay money at some future date. As with assets, there are two types of Liability: Non-Current Liability and Current Liability. Non-current liabilities These are amounts owed by the business, payable in more than one year after the date of the statement of financial position. Long-term bank loans are much the common example. Current Liabilities
A current liability is simply a short-term liability i.e. an amount owed by the business, payable within one year.
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The commonest examples of current liabilities are:
(a) trade payables; - these occur when we buy goods on credit and owe our supplier money. When we will pay our supplier depends on how long they give us to pay but this will usually be less than 12 months.
(b) bank overdraft – we owe the bank the money back
2.4 The Business Entity Concept
We saw in Chapter 1 that a Sole Trader is a business which is owned and managed by the same person. However, from an accounting perspective, the Owner and the Manager are two different people. Therefore if the business owner puts anything into the business, the business OWES this back to the owner. This concept is known as the Business Entity Concept.
For Example, Joe the plumber has his own sole trader business. Joe uses his own money to buy a van for the business which costs £10,000. The plumbing business now has a Non Current Asset in their accounts (a Van). Per the Business Entity Concept, this plumbing business owes Joe £10,000 as the business and Jo are separate people. Anything which Joe puts into the business is owed back to him. The amount which the business owes back to the business owner is known as Capital.
2.5 Capital
The term ‘capital’ represents the total amount which the business owes to its owner, or proprietor. On our SOFP we need to show at that particular date how much capital there is in the business. How we calculate capital:
Opening capital
the amount which the proprietor has invested in the business to the start of the year
plus Capital injections
any money the proprietor put into the business during the year
plus Profits funds generated by the business (we will see how to calculate this in the next chapter).
(or) minus Losses funds lost by the business (we will see how to calculate this in the next chapter).
minus Drawings any amounts taken out of the business by the business owner e.g the sole trader takes £1,000 per month out of the business as his/her salary.
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So:
Opening capital
+ Capital injections
+ / – Profits / Losses
– Drawings
= Capital owed to proprietor
2.6 Layout of the statement of financial position
Below is an example of what a Statement of Financial Position (SOFP) looks like. Remember that the SOFP gives the position at a given date which in this example is 31 January 20X1. Therefore this SOFP shows what the sole trader P PILBEAM owns and owes at this date.
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P PILBEAM: Statement of financial position as at 31 January 20X1
£ £
ASSETS
Non-current assets
Motor vehicles 4,000
Current assets
Inventories 2,000
Trade receivables
Cash 6,300
8,300
Total assets 12,300
CAPITAL AND LIABILITIES
Capital
As at 1 January 10,000
Profit for the period 800
Less drawings (500)
At 31 January 10,300
Non-current liabilities
Current liabilities
Trade payables 2000
2000
Total capital and liabilities 12,300
As you can see from the illustration, when we prepare a SOFP we present Non-current assets separately from current assets and Non-current liabilities separately from current liabilities. If you look at the numbers in the SOFP you can see that Total Assets = Capital + Total Liabilities. The above equation is known as the Accounting Equation - we will look more closely at this in chapter 3.
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2.7 Revision questions
(1) Define non-current assets.
(2) Define current assets.
(3) Are the following non-current or current assets?
(a) Buildings
(b) Receivables
(c) Cash
(d) Fixtures & fittings
(e) Long-term investments
(4) Define a current liability?
(5) Name two types of current liability.
(a)
(b)
(6) How do we calculate capital?
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2.8 Answers
(1) Non-current assets are assets bought by the business for use over a number of years, with the aim of earning profits, but not for resale.
(2) Current assets are assets acquired for conversion into cash in the ordinary course of business.
(3) (a) non-current
(b) current
(c) current
(d) non-current
(e) non-current
(4) A current liability is an amount owed by the business which is payable within one year.
(5) (a) Trade payables
(b) Bank overdraft
(6) A opening capital + capital injections + profit – drawings.
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3. THE INCOME STATEMENT
3.1 Introduction
As mentioned in chapter 1, the Income Statement is ‘a summary of the results of a business’s transactions for a period ending on the date of the statement of financial position’.
The income statement summarises sales that a business has made and expenses a business has incurred over a period of time. This leads us to determine whether the business has made a profit (more sales than expenses) or if they have made a loss (more expenses than sales).
3.2 Income statement format
The pro forma Income Statement below shows you the items which most businesses are likely to have in their accounts.
Income Statement for the year ended 31 December 20X1
£ £ Revenue X Less cost of sales Opening inventories on 1 January 20X1 X X Purchases X Less closing inventories on 31 Dec 20X1 (X) ____ (X) ____ Gross profit X Less expenses Rent X Rates X Lighting and heating X Telephone X Postage X Insurance X Stationery X Office salaries X Accountancy and audit fees X Bank charges and interest X Delivery costs X Van running expenses X Advertising X ____ (X)
____ Net profit X ____
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3.3 Revenue
Revenue includes sales made for cash and sales made on credit.
3.4 Cost of sales
As the pro forma shows, the way to find the cost of the goods actually sold during a period is to take:
(a) the cost of goods in stock at the beginning of the period known as opening inventories
and add
(b) the cost of goods bought during the period ‘purchases’.
and then deduct
(c) the cost of goods in stock at the end of the period: closing inventories.
What this does is to take the cost of goods available for sale during the period (opening inventories plus purchases) and deduct the cost of the goods which weren’t sold during the period (closing inventories). This results in the cost of the goods which were actually sold.
The thing to remember here is that, whereas revenue should be a larger amount than cost of sales, the actual number of units of goods concerned will be the same. Cost of sales or ‘cost of goods sold’ means exactly that: the cost of the goods actually sold during the year or period. ‘Revenue’ thus means the selling price of the goods during the same period.
3.5 Gross Profit
The first part of the income statement (down as far as gross profit) is known in many businesses as the core profit, since it shows the results of the actual buying and selling operations of a business (sales we have made compared to how much it costs us to buy the things which we have sold i.e. the cost of sales).
As you can see from the pro forma, the gross profit arrived at is the result of subtracting cost of sales from revenue.
The resulting gross profit is a very useful figure, since it shows how successful the main activity of the business has been (i.e. the buying and selling of goods, as opposed to incidental expenses). You would have to be supremely incompetent to achieve a large loss.
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3.6 Net Profit
After arriving at gross profit, we must show other items of income and expenditure (mainly expenditure) which are relevant to the business but are incidental to it and not part of the buying, selling or manufacturing of the goods.
After we have taken off all other expenditure of the business the result is Net Profit as we can see in the Income Statement.
3.7 Relationship between Statement of Financial Position and the Income Statement
If you remember from the previous chapter, we included in the SOFP what the business owes back to the business owner, this being called Capital.
Capital is calculated as:
Capital at the start of the year + capital injections in the year + Profit or – loss – Drawings.
The net profit/loss from the Income Statement is therefore included in the calculation of capital in the SOFP.
If a business makes a profit (sales are higher than expenses) then capital will increase. If the business makes a loss (expenses are higher than sales) then capital will decrease.
We can therefore see that making sales or incurring expenses can have an effect on Capital.
We will explore this further in the next chapter.
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3.8 Revision questions
(1) (a) What is revenue less cost of sales?
(b) The final figure in the income statement is called what?
(2) A business’s sales for a year amount to £120,000. Only £100,000 of these have been paid for by customers. What will revenue be?
(3) How is cost of sales calculated?
(4) A business has opening inventories of £20,000 and closing inventories of £30,000. During the year it bought goods costing £70,000 of which £10,000 have not yet been paid for. What is the cost of sales for the year?
£…………………………………………………………………………………
(5) Using the numbers from (4), assuming sales of £100,000, calculate gross profit.
(6) Following on from (4) and (5), if the business has rental expenses of £5,000 and telephone expenses of £3000,
How much net profit have they made?
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3.9 Answers
(1) (a) Gross profit
(b) Net profit
(2) £120,000 (includes sales where customer has not yet paid).
(3)
Opening inventories X Add Purchases X Less Closing inventories (X) _____ Cost of sales X _____
We are determining the cost of goods sold in the period. Closing inventories will be sold next year.
(4)
£ Opening inventory 20,000 Add Purchases 70,000 Less Closing inventories (30,000) _____ Cost of sales 60,000 _____
£ Gross profit 40,000 Less Rent (5,000) Telephone (3,000) ______ Net profit 32,000 ______
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CALCULATIONS MADE EASY
Contents
1 Percentages the quick way
2 Rearranging equations – some simple rules using typical exam examples
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1. Percentages the quick way
First, you’ll save time if you don’t use the ‘%’ button on your calculator.
Just convert the % given in the question to a decimal, and put that decimal into your calculator directly.
Examples
5% = 0.05
15% = 0.15
One half of a percent
= 0.5% = 0.005
125% = 1.25
3.894% = 0.03894
Just remember to move the decimal point two places to the left
Second, don’t waste time by writing down separate numbers!
Example
A sales value of £150,000 will increase by 5% next year. What is next year’s value?
The slow way:
This year £150,000
5% of this is 0.05 x £150,000 = £7,500
Add together = £157,500
The quick way:
£150,000 x 1.05 = £157,500
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Examples to try
£40,000 with a 3% increase = ___________
£40,000 with a 23.75% increase = ___________
Example
A sales value of £150,000 will decrease by 10% next year. What is next year’s value?
The slow way:
This year £150,000
10% of this is 0.10 x £150,000 = £15,000
Subtract decrease = £135,000
A 10% decrease means that the new figure is 90% of the old value.
A 15% decrease would be 85%, a 3% decrease 97% and so on……..
The quick way:
£150,000 x 0.90 = £135,000
Examples to try
£40,000 with a 30% decrease = ___________
£40,000 with a 6.40% decrease = ___________
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2. Rearranging equations – some simple rules using typical exam examples
The rules:
You must do the same thing to both sides of an equation
When you move an item to the other side of the equation by adding or subtracting, it changes its sign [ positive (+ve) to negative (–ve) and vice versa].
When you move an item to the other side of the equation by multiplying or dividing, it changes from underneath a fraction to on top [and vice versa]
If you know any numbers, and they are separate from the unknown you’re trying to find; just write the numbers down – it can make life easier.
Proceed step by step, and leave a trail for a marker to follow
Example 1
Y = a + bx
If Y = £100,000; b = £4 per unit; and x = 2000 units: What is a?
Solution
100000 = a + 4 x 2000
100000 = a + 8000
100000 – 8000 = a
a = 920000
Example 2
D0 P0 =
Divi yield
If P0 = £20 million and D0 = £1 million; what is ‘Divi yield’?
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Solution
20m = 1m/divi yield
Divi yield x 20m = 1m
Divi yield = 1m/20m
Divi yield = 0.05m
Example 3
Assets = Liabilities + Capital
Cash = 3000, Inventory = 7000, Loans = 1000
What is capital?
Solution
Assets are cash + inventory = 3000 + 7000 = 10000
Loans are liabilities = 1000
10000 = 1000 + capital
Capital = 10000 - 1000
Capital = 9000
Example 4
Closing capital = opening capital + capital injected + profit – drawings
A sole trader business has closing capital of 30000, opening capital of 10000.
The sole trader took drawings out of the business of 5000.
How much profit did he make?
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Solution
30000 = 10000 + 0 + profit – 5000
30000 = 5000+ profit
Profit = 30000 - 5000
Profit = 25000
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Have a go
1. A business has Cash of 5000 and receivables of 6000, Payables of 4000 - what is capital?
2. A sole trader has capital of 100000, inventory of 60000, loans of 40000 - what is cash?
3. A sole trader has Assets of 50000, Liabilities of 20000, opening capital of 5000 - how much profit did the business make?
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Answers
1. Assets = liabilities + capital
Cash + receivables = loans + capital
5000 + 6000 = 4000 + Capital
11000 = 4000 + Capital
Capital = 11000 - 4000
Capital = 7000
2. Assets = Liabilities + Capital
Assets = 40000 + 100000
Assets = 140000
Inventory + cash = 140000
60000 + cash = 140000
Cash = 140000 - 60000
Cash = 80000
3. Assets = Liabilities + Capital
Assets = Liabilities + Capital
50000= 20000 + capital
Capital = 50000-20000
Capital = 30000
Capital = opening capital + capital injected + Profit – Drawings
30000 =5000 + 0+ Profit – 0
Profit = 30000 - 5000
Profit = 25000
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4 THE ACCOUNTING EQUATION
If you recall from chapter 2, the Accounting Equation is defined as:
Assets = Liabilities + Capital
This equation will always hold true and the assets of a business will always be equal to the liabilities of a business plus what the business owes back to the business owner (capital).
4.1 Dual Effect
A consequence of the Accounting Equation is that every transaction will have two effects (a dual effect).
Let’s think about how we can apply that to an example.
Suppose you are in business as a shopkeeper.
(a) You start up the business by putting £10,000 into the business. What are the two effects of this?
(i) The business’s cash goes up by £10,000. (Assets ↑)
(ii) The business’s capital goes up £10,000 (Capital ↑)
Expressed as an equation, this shows:
Total assets = Liabilities + Capital £ £ Cash 10,000 Capital 10,000
The business then has the following transactions:
(b) You buy goods from a wholesaler for £4,000 cash. What are the two effects of this?
(i) The business gains more inventories £4,000 (Assets ↑)
(ii) The business’s cash falls by £4,000. (Assets ↓)
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Accounting equation:
Assets = Liabilities + Capital £ £ Inventories 4,000 Capital 10,000 Cash 6,000 ________ ________ 10,000 10,000
________ ________
(c) You buy goods from another wholesaler for £2,000, who says he will send you a bill later. What are the two effects of this?
(i) The business gains more inventories of £2,000. (Assets ↑)
(ii) The business now has a payable to the wholesaler of £2,000 (Liabilities ↑)
There is nothing that a business can do which will not have this dual effect not even right at the beginning, when you first started up the business and put your money in as capital.
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4.2 Inventory
You will consider Inventory a lot in future studies but for now we need to be happy that Inventory is a current asset. However, when we are considering the Accounting Equation and the Dual Effect we do not need to consider whether Inventory has gone up or down.
This is because Inventory is something called a year end adjustment and therefore is only thought about at the end of the year when the accounts are being completed. You will see a lot of year end adjustments later in your studies.
When looking at the dual effect and Inventories are involved we consider buying Inventory to be a Purchase, which is an expense in the Income Statement and this will reduce profit. The sale of Inventories is regarded as Income in the Income Statement which will increase profits.
Remember that if we make a profit then Capital goes up and if we make a loss Capital goes down.
4.3 Impact on the Accounting Equation
Let us now consider the above example again
(a) You start up the business by putting £10,000 into the business. What are the two effects of this?
(i) The business’s cash goes up by £10,000. (Assets ↑)
(ii) The business’s capital goes up £10,000 (Capital ↑)
Expressed as an equation, this shows:
Assets = Liabilities + Capital
Cash 10000
0
Capital 10000
10000 = 10000
The business then has the following transactions:
(b) You buy goods from a wholesaler for £4,000 cash. What are the two effects of this?
(i) The business has a purchases expense of £4,000 (Expenses ↑, therefore Profit↓ hence Capital ↓)
(ii) The business’s cash falls by £4,000. (Assets ↓)
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Assets = Liabilities + Capital
Cash 6000
0
Capital
10000 – 4000 = 6000
6000 = 6000
(c) You buy goods from another wholesaler for £2,000, who says he will send you a bill later. What are the two effects of this?
(i) The business has a another purchase expense of £2,000 (Expenses ↑, therefore profit ↓ hence Capital ↓)
(ii) The business has a liability (a payable) of £2,000. (↑ Liabilities)
Accounting equation:
Assets = Liabilities + Capital
Cash 6000
Payable 2000 + Capital
6000 – 2000 = 4000
6000 = 6000
(d) You sell goods to a customer for £4000 and allow them to pay you at the end of the month. What are the two effects of this?
(i) The customer now owes the business money ( i.e. a receivable of £4,000). (Assets ↑)
(ii) The business has income from a sale (income ↑ therefore profit ↑, hence ↑Capital)
Assets = Liabilities + Capital
Cash 6000
Payable 2000 + Capital
4000 + 4000 = 8000
Receivables 4000
10000 = 10000
Test your understanding so far – Part 1
This was the activity that we asked you to complete. The answers are set out below.
Record the accounting equation for Dora’s business after each of the following transactions:
(1) Dora starts her business with £20,000 paid into a new business bank account.
(2) Goods for resale are bought on credit for £2,000.
(3) A new motor van is purchased for £5,000. Dora pays by cheque.
(4) Stock which had cost £2,000 is sold for £3,500 on credit.
(5) £1,800 is paid to a credit supplier.
(6) Dora borrows £5,000 from Explorer Bank plc.
(7) A cheque of £2,700 is received from a credit customer.
(8) Rent of £300 for the past month is paid by cheque.
(9) £250 wages are paid by cheque.
(10) Dora withdraws £200 from her business.
Answers (1) ↑ Cash £20,000
↑ Capital £20,000
Assets = Liabilities + Capital
Cash 20,000
Capital 20,000
–––––
–––––
20,000
20,000 –––––
–––––
(2) ↑ Purchases £2,000
↑ Trade Payables £2,000
Assets = Liabilities + Capital
Cash 20,000 Trade payables 2,000 Capital 20,000
Profit / (loss) (2,000)
––––– ––––– –––––
20,000
2,000 18,000
–––––
––––– –––––
(3) ↓ Cash £5,000
↑ Non-current assets £5,000
Assets = Liabilities + Capital Cash 15,000 Trade payables 2,000 Capital 20,000