CIMA CO2 Official Learning System - Fundamentals of Financial Accounting

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STUDY MATERIAL C2

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FURTHER ASPECTS OF LEDGER ACCOUNTING

5.4.3 Pension contributions

Many employees contribute to pension schemes by allocating a percentage of their gross

pay to the pension fund, for example 5 or 6 per cent. This amount is deducted from the

employee’s gross pay, and is payable to the pension-fund company.

Example 5.F

Lesley earns $200 gross in week 21. Pension contributions are 5 per cent. The ledger entries to record this are:

●

debit wages payable with $10;

●

credit pension company with $10.

Exercise 5.3

List the ledger entries required to record the following pay details, and the subsequent pay-

ment to the employee by cheque:

Gross pay $1,200

Social security tax – employee’s 9% of gross pay

Pension 6% of gross pay

Income tax $185

Social security tax – employer’s 10% of gross pay

Trade union subscription $5 per week

Solution

Debit wages expense account $1,200 (Gross wages)

Debit wages expense account $120 (Employer’s SS)

Credit income tax payable account $108 (Employee’s SS)

$120 (Employer’s SS)

$185 (Income tax)

Credit pension payable account $72

Credit trade union payable account $5

Credit wages payable account $830 (Net wages owing)

Debit wages payable account $830 (Net wages paid)

Credit bank $830

5.5 Accruals and prepayments

The most common application of accruals and prepayments is in accounting for expenses.

Accrued expenses . Charges that are brought into the ﬁ nancial statements at the end of a

period because, although goods and services have been provided, they have not yet been

charged for by the suppliers. For example, electricity, invoiced in arrears, generally requires

an accrual at the end of each accounting period.

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An accrued expense is a liability because it is owed to the relevant supplier of those goods

and services, irrespective of the fact that an invoice has not yet been received. If the business

were to close down at the end of the accounting period, the expense would still have to be paid.

The opposite of an accrual is a prepayment:

Prepayment . Expenditure on goods or services for future beneﬁ t, which is to be charged

to future operations, for example, rentals paid in advance. These amounts are included in

current assets.

A prepayment is an asset because the business has yet to enjoy or utilise the beneﬁ t from

it. Depending on the type of expense, if the business were to close down at the end of the

accounting period, the amount prepaid may well be refunded. As an example, local busi-

ness tax is often levied annually, for example the year to 31 March. A business with a year

end of 31 December may have already paid in full for its local business tax for the year to

31 March following. If it is closed down at 31 December, it would receive a refund of the

3 months ’ excess paid, for which it did not receive the services of the local government.

So far, you have dealt with entries in expense ledger accounts on the basis of payments

made during the period. It does happen, however, that some expenses that have been

incurred or consumed during a period do not require to be paid during that accounting

period, but are paid some time later. Hence, at the time that the trial balance is drawn up,

they have not been entered in the ledger accounts.

On the other hand, there are sometimes expenses that have been paid during the

accounting period that cover a future period, instead or as well as the period in which they

have been paid.

However, the income statement must be credited with all revenue earned during a

period (we credit all sales to the sales account, irrespective of whether or not the bills have

been paid), and it should be debited with all expenses incurred during the same period

(irrespective of whether or not the bills have been paid – or even received).

This is known as the convention of matching , that is, comparing the revenue earned

during a period with the expenditure incurred in earning that revenue . Thus, if a telephone

has been used to make calls during a period, to help earn revenue, the cost of those calls

should be included in the expenses of the period, even if the telephone bill has not yet

been received.

In addition, the organisation must make sure that its statement of ﬁ nancial position

reﬂ ects all assets and liabilities at that date, and thus prepaid expenses will be shown as

current assets, while accrued expenses will be shown as current liabilities.

In order to account for accrued expenses the organisation must make an estimate of

the cost incurred during the accounting period. This is usually based on past records or

in some cases may be calculated based on the consumption of a resource by metering the

resource concerned, for example, gas and electricity. The extent of any prepayment is usu-

ally calculated by reference to time. It is normally assumed that the expense is incurred

equally during the passage of time, thus the amount prepaid is simply a proportion of the

total invoiced amount.

While adjustment for accruals and prepayments is most common with regard to

expenses, it is also possible to have situations where revenue has been prepaid or should be

accrued. The principles are the same as those of expenses, the intention being to make the

adjustments necessary to ensure that the accounting statements produced show the extent

of the revenue and costs that have arisen during the period being reported.

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5.5.1 Recording accruals and prepayments in the

ledger accounts

So far you have learned how to record revenue and expenditure on the basis of invoices

issued and received, or payments made. However, there are a number of occasions when

this method does not fairly reﬂ ect the true revenue and expenditure that has arisen during

the period, and adjustments therefore need to be made.

Example 5.G

Draw up the heat and light account from the following information:

Owing at 1 Jan. 20X1 $125

Bills received and paid during 20X1:

28 Feb. $460

31 May $440

30 Aug. $390

30 Nov. $420

Bill received on 28 Feb. 20X2

$450 (for the period 1 Dec. 20X1 to 28 Feb. 20X2)

The year end is 31 December.

Solution

Heat and light

20X1 $ 20X1 $

28 Feb. Bank 460 1 Jan. Balance b/d 125

31 May Bank 440

30 Aug. Bank 390

30 Nov. Bank 420

31 Dec. Balance c/d

150 31 Dec. Income statement 1,735

1,860 1,860

20X2

1 Jan. Balance b/d 150

The credit balance of $150 represents one-third of the bill received on 28 February 20X2 (i.e. the amount appli-

cable to the month of December 20X1). This amount will appear on the statement of ﬁ nancial position under

current liabilities.

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Example 5.H

Draw up the rent payable account from the following information.

Rent is payable quarterly in advance on 1 March, June, September and December. The current annual rental

is $4,800.

Rent prepaid at 1 Jan. 20X1 800 (for January and February 20X1)

Rent paid during 20X1:

1 Mar. 1,200

1 Jun. 1,200

1 Sep. 1,200

1 Dec. 1,500

The annual rental is increased to $6,000 per annum with effect from 1 December 20X1, and the year end

is 31 December.

Solution

Rent payable

20X1 $ 20X1 $

1 Jan. Balance b/fwd 800

1 Mar. Bank 1,200

1 Jun. Bank 1,200

1 Sep. Bank 1,200 31 Dec. Income statement 4,900

1 Dec. Bank

1,500 31 Dec. Prepaid c/d 1,000

5,900 5,900

20X2

1 Jan. Balance b/d 1,000

The balance brought down represents the prepayment for January and February 20X2, which is at the new rate

of $500 per month. The charge to the income statement can be conﬁ rmed as being 11 months at the old rate of

$400 per month, and one month at the new rate of $500 per month, that is, $4,900.

5.6 Bad debts and allowance for receivables

When a business sells goods on credit, it assumes that the customer will pay up in full.

However, it sometimes happens that a customer does not pay in full, or even at all,

and thus it is incorrect to retain his balance as an asset, or to treat the sale as having

created proﬁ t.

There may also be occasions when an organisation feels that a proportion of receiva-

bles may fail to pay their debts, but is not certain who they are, or the amount that may

become unpaid.

Both of these situations need to be considered in preparing the ﬁ nancial statements.

STUDY MATERIAL C2

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FURTHER ASPECTS OF LEDGER ACCOUNTING

5.6.1 Accounting for bad debts

When it becomes known that a customer is unlikely to pay, the receivable balance must be

removed (since it is no longer an asset of the business) and transferred to the income state-

ment as an expense of the period in which the bad debt arises. This is done by debiting a

bad debts account and crediting the receivable’s account.

Example 5.I

X sold goods to Y on credit on 1 January 20X1 valued at $350. On 30 November 20X1, X was advised that Y

was unable to pay the debt.

Prior to X receiving this information Y’s account was as follows:

1 Jan. Sales 350

But now it is necessary to remove the asset and instead treat the outstanding balance as an expense. The entries

are shown below:

1 Jan. Sales 350 30 Nov. Bad debts 350

Bad debts

30 Nov. Y 350

There may be circumstances where only part of the debt needs to be written off as an expense. For example, if Y

had paid $200 on 30 June 20X1 and only the balance was to be written off, then the accounts would appear

as follows:

1 Jan. Sales 350 30 Jun. Bank 200

30 Nov. Bad debts 150

350 350

Bad debts

30 Nov. Y 150

One bad debts account is used to record all bad debts occurring during a year. At the end of the year the bal-

ance on the bad debts expense account is transferred to the income statement.

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5.6.2 Bad debts recovered

It is possible that debts that have previously been written off may later be paid. If this hap-

pens, then the entries made to write off the debt as an expense must be reversed before

recording the receipt of the payment from the customer.

Example 5.J

P sold goods to Q on credit valued at $500. Q did not pay and his debt was written off in 2X10. The original

ledger account entries were as follows:

2X10 $ 2X10 $

Balance b/d 500 Bad debts 500

Bad debts

2X10 $ 2X10 $

500 Income statement 500

On 31 December 2X11, Q paid the debt in full. The entries required to record this in the ledger accounts are

shown below:

2X10 $ 2X10 $

Balance b/d

500 Bad debts 500

2X11 2X11

Bad debts 500 Bank 500

Bad debts

2X11 $

Q 500

The credit balance on the bad debts expense account will be credited to the income statement at the end of

2X11.

Sometimes a part payment of a debt previously written off is made. If Q had paid $200 as full and ﬁ nal set-

tlement, then the entries made would have been:

Balance b/d

500 Bad debts 500

Bad debts 500 Bank 200

Bad debts 300

500 500

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FURTHER ASPECTS OF LEDGER ACCOUNTING

Bad debts

2X11 $ 2X11 $

300 Q (bad debt brought back) 500

The reason for reinstating the full amount of the original debt and then writing off the resulting $300 is so that

if P were to trade with Q again in the future it would be clear that a bad debt arose from their previous trading

activities. If only the part of the debt settled were reinstated it may appear that no bad debt occurred.

5.6.3 Allowance for receivables

While some debts are deﬁ nitely bad – it is known for certain that the customer will not

pay – others may be only doubtful . In this case it would not be appropriate to eliminate

the receivable balance because he/she may pay after all. But we have to recognise that the

value of the asset ‘ receivables ’ is probably less than it appears to be. The technique used is

to create an allowance for receivables .

Both writing off bad debts and allowances for receivables are in accordance with the

convention of prudence , which you will learn more about in Chapter 10. Adopting a pru-

dent approach is simply ensuring that proﬁ ts and assets are not overstated, by estimating

likely losses and decreases in assets as soon as they become apparent.

This estimate can be made using a number of different techniques. For example:

1. using experience and knowledge of customers and the economic climate;

2. listing all receivables and scrutinising them individually for their ability to pay;

3. calculating an overall percentage of the outstanding receivable balances;

4. preparing a schedule of receivables according to the length of time that their debt has

been outstanding, and using different percentages depending on the age of the debt.

This is known as an aged receivables schedule.

Example 5.K

Age of debt Amount ($) % Allowance ($)

Less than 1 month 8,000 1 80

1–2 months 3,000 2 60

2–3 months 700 5 35

More than 3 months 140 20 28

11,840 203

This technique is based on the belief that the older the debt the more likely it is to become a bad debt.

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When the allowance for receivables is ﬁ rst created, the ledger account entries are as shown below:

Bad debts

20X1 $

Allowance for receivables 203

Allowance for Receivables

20X1 $

Bad debts 203

The balance on the bad debts account is transferred to the income statement at the end of the period. Thus the

balance on this account will be reduced to nil.

The balance on the allowances account is used to decrease the value of receivables shown on the statement

of ﬁ nancial position at the end of the period. This balance will remain in the ledger accounts.

Note that no entries are made in the receivables accounts for the allowance.

Once the allowance has been created it must be reviewed and increased or decreased depending on the

circumstances of the business.

For example, if the above allowance were to be decreased to $130 in 20X2, then the entries would appear

as follows:

Bad debts

20X2 $

Allowance for receivables 73

Allowance for Receivables

20X2 $ 20X2 $

Bad debts 73 Balance b/d 203

Balance c/d

130

203 203

20X3

Balance b/d 130

Note that it is possible to avoid the use of the bad debts account if the entry is only being made once a year,

since the income statement can be debited directly, but most modern accounting systems provide monthly proﬁ t

statements for internal management use, and in these circumstances it is common to use the ledger accounts

shown.

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FURTHER ASPECTS OF LEDGER ACCOUNTING

Exercise 5.4

The following information is given regarding the allowance for receivables:

Receivables at 31 December 20X0 $30,000

Receivables at 31 December 20X1 $25,000

Receivables at 31 December 20X2 $35,000

Receivables at 31 December 20X3 $40,000

The allowance at each year end is to be 5 per cent of receivables, after writing off bad

debts. Bad debts to be written off are as follows:

31 December 20X1 $3,000

31 December 20X2 $2,000

Write up the allowance for receivables account for the years 20X0 to 20X3.

Solution

Allowance for Receivables account

20X0 $ 20X0 $

31 Dec. Balance c/d 1,500 31 Dec. Increase in allowance 1,500

20X1 20X1

31 Dec. Decrease in allowance 400 1 Jan. Balance b/d 1,500

Balance c/d 1,100

1,500 1,500

20X2 20X2

1 Jan. Balance b/d 1,100

31 Dec. Balance c/d 1,650 31 Dec. Increase in allowance 550

1,650 1,650

20X3 20X3

1 Jan. Balance b/d 1,650

31 Dec. Balance c/d 2,000 31 Dec. Increase in allowance 350

2,000 2,000

20X4

1 Jan. Balance b/d 2,000

Exercise 5.5

On 31 August 20X4, the sundry receivables of Henry Higgins stood at $10,000 and the

balance on the allowance for receivables account at that date was $200. Of the receivables

it was considered that $500 were irrecoverable and should be written off. It was decided

that the allowance for receivables should be made equal to 5 per cent of the outstanding

accounts.

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At 31 August 20X5, the receivables balances had fallen to $8,000, of which $100 were

considered to be irrecoverable and should be written off. The allowance for receivables was

to be at the same rate as in 20X4. You are required to:

1. show the bad debts account at 31 August 20X4 and 20X5;

2. show the allowance for receivables account at 31 August 20X4 and 20X5;

3. show the relevant ﬁ gures in the statements of ﬁ nancial position for the 2 years 20X4

and 20X5.

Solution

Bad debts

20X4 $ 20X4 $

31 Aug. Receivables 500 31 Aug. Income statement 775

Allowance for receivables 275

775 775

20X5 20X5

31 Aug. Receivables 100 31 Aug. Allowance for receivables 80

Income statement 20

100 100

Allowance for receivables

20X4 $ 20X4 $

31 Aug. Balance b/f 200

31 Aug. Balance c/f 475 Bad debts 275

475 475

20X5 20X5

31 Aug. Bad debts 80 1 Sep. Balance b/f 475

Balance c/f 395

475 475

20X6

1 Sep. Balance b/f 395

Balance sheet extracts

20X4 $

Receivables 9,500

Less : allowance 475

9,025

20X5 $

Receivables 7,900

Less : allowance 395

7,505

In this and the previous examples, both the bad debts and the change in the allowance for

receivables have been charged to a bad debts account in the income statement. In some