CHAPTER TWELVE - PREPARATION OF SIMPLE FINAL ACCOUNTS

12.0 Learning Objectives………………………………………………………………
12.1 Introduction………………………………………………………………………
12.2 The Trial Balance…………………………………………………………………
12.3 The Statement of Comprehensive Income………………………………………..
12.3.1 The Movement of Inventories …………………………………………………
12.3.2 Carriage Inwards and Outwards…………………………………………………
12.3.3 Goods Taken By the Proprietor…………………………………………………
12.3.4 The Accounting Treatment of Inventories………………………………………
12.4 The Income Statement……………………………………................................
12.4.1 Adjustments in the Final Accounts……………………………………………
12.5 The Statement of Financial Position………………………………………………
12.5.1 Non-Current Assets………………………………………………………………
12.5.2 Current Assets…………………………………………………………………….
12.5.3 Liabilities………………………………………………………………………….
12.5.4 Capital Account…………………………………………………………………..
12.6 Manufacturing Account…………………………………………………………..
12.6.1 Prime Cost………………………………………………………………………..
12.6.2 Factory Overhead………………………………………………………………..
12.6.3 Production Cost………………………………………………………………….
12.6.4 Work-in-Progress…………………………………………………………………
12.6.5 Transfer Pricing…………………………………………………………………..
12.7 Summary………………………………………………………………………….







CHAPTER TWELVE

PREPARATION OF SIMPLE FINAL ACCOUNTS

12.0  Learning Objectives
After you have studied this chapter, you should be able to:
• define, explain and record returns inwards, returns outwards, carriage inwards and carriage outwards.
• identify items that will appear in the Comprehensive Income Statement, Income statement and statement of Financial Position  of a sole trader
• explain why carriage inwards is recorded in the Income Statement and also why carriage outwards is recorded in the Income statement
• prepare the inventories account and show how the opening and closing inventories are treated in the Comprehensive Income Statement
• prepare an Income statement and statement of Financial Position
• pass the necessary adjustment in respect of accruals, prepayments and provisions that affect the Income statement
• explain and calculate cost of goods sold taking into consideration the appropriate adjustments such as returns inwards and outwards, carriage inwards and outwards, and inventories
• prepare Manufacturing Account

12.1   Introduction
In this chapter, you are going to learn how to prepare a simple Comprehensive Income Statement and a statement of financial position   for a sole trader who deals in the buying and selling of goods. You will also learn how to prepare final accounts of a sole trader who is involved in the manufacturing process. New terminologies such as returns inwards, returns outwards, carriage inwards and carriage outwards will also be introduced. The chapter will also consider the treatment and recording of trading inventories that were purchased in the accounting period but the trader was not able sell all.

12.2  The Trial Balance
The first step in the preparation of the final accounts is the compilation of a Trial Balance, with a view to:
(a) confirms the arithmetical accuracy of the postings, and
(b) Providing in one statement a concise summary of the items, which are to be included in the Comprehensive Income Statement, Income Statement and the Statement of Financial Position.

Debit balances recorded in the Trial Balance normally represent either assets, or losses and expenses. The assets are entered in the Statement of Financial Position, while losses and expenses are debited to the Comprehensive Income Statement or to the Income statement.

Likewise, the credit balances represent liabilities, provisions, reserves, or revenues and gains. The liabilities are entered in the Statement of Financial Position  as deductions from assets of the firm, while income and gains are credited either to the Comprehensive Income Statement or to the Income statement.

Students must remember to carefully distinguish between balances, which appear in the Comprehensive Income Statement, Income statements, and those that appear in the Statement of Financial Position.  The trading and Income statement essentially closes off all the nominal account balances during a particular accounting period. Any account, which remains in the Trial Balance after the trading and Income statement have been prepared, represents either assets or liabilities that must be recorded in the Statement of Financial Position. The balance on the Income statement will finally be transferred to the capital account in the statement of Financial Position.

12.3  The Statement of Comprehensive Income
The main objective of this Statement is the determination or calculation of the gross profit for the period. It is also in this account that the cost of obtaining the goods, usually referred to as cost of goods sold or simply as cost of sales is calculated.

 Another important function of this Statement is that it enables the owner of a business to compare the gross and net profit of a current period with the results attained in previous periods. It is pertinent that, the component items in the Income Statement do not vary in any material effect from previous and subsequent accounts, as this will make it impossible for any analyst to make meaningful approximate comparison. This therefore means that the Income Statement should be standardized so that the same items should appear in similar form in the successive final accounts so that an effective comparison may be made of one trading period with another.

The actual items in the Income Statements of different classes of enterprises or businesses will necessarily vary depending on the nature of the nominal accounts in the respective business; for example, customs duty, licenses, and freight and insurance on inward shipments of raw materials will be essential items in the Statement of a cigarette manufacturer, but these particular items would not appear in the Comprehensive Income Statement of a retail tobacconist.

The following is the usual method of preparing the Statement of Comprehensive Income.

On the debit side are recorded:
(1) Inventories at commencement of the period, which is usually, called opening inventories.
(2) Purchases during the period (less returns outwards).
(3) All purchasing and expenses, such as wages, carriage inwards, and other items which are incurred in putting the product in a saleable condition or location.

The account is credited with-
1. Sales during the period (less returns inwards).
2. Inventories at end of period (it is the usual practice of deducting the closing inventories figure from the sum total of opening inventories and net purchases on the debit side of the Comprehensive Income Statement so as to show on the face of the account the cost of goods sold).

Where the balance remaining on the Statement is credit then the business has recorded a gain, which is referred to as gross profit and will be transferred to the Income statement as a credit entry by debiting the Comprehensive Income Statement.

Before we attempt to prepare the Statement of Comprehensive Incomes of a business in detail; we need to understand the following accounting terminologies:

12.3.1 The movement of inventories
Organisations usually maintain four different accounts for the inventories function.
The accounts involved are:
• Sales account
• Returns inwards account
• Purchases account and
• Returns outwards account

The sales and the returns inwards accounts are accounts in which are recorded the respective goods sold and goods returned by customers. The purchases account and the returns outwards account contain transactions involving goods bought for resale and goods returned to suppliers respectively.

The usual practice is to maintain the sales account separately and not to deduct directly any goods that have been returned by customers during the accounting period. The returns inwards account serves as a contra to the sales account by recording all sales that have been returned by customers. Being a contra account to the sales account means that it has a debit balance which when transferred to the sales account at the end of the accounting period will show the net sales or turnover of the organisation.

The accounting entries will be recorded as follows:
Dr. Bank or Receivables Account
            Cr. Sales Account
            With goods sold for cash or on credit

Dr. Returns inwards Account
            Cr. Bank or Receivables Account
            With goods sold but returned by customers

Dr. Sales Account
            Cr. Returns inwards Account
            With the balance on the return inwards account

Similarly the purchases account is maintained separately by recording all goods bought for the sole purpose of resale relating to the accounting period. The returns outwards account serves as a contra to the purchases account. In to this account is recorded all purchases that were returned to suppliers. Being a contra account to the purchases account means that it has a credit balance which when transferred to the purchases account at the end of the accounting period will show the net purchases of the organisation.

The accounting entries will be recorded as follows:
Dr. Purchases Account
             Cr. Bank or Payables Account
              With goods bought for cash or on credit

Dr. Bank or Payables Account
            CR. Returns outwards Account
            With goods bought but returned to suppliers

Dr. Returns outwards Account
            Cr. Purchases Account
            With the balance on the return outwards account

12.3.2  Carriage inwards and outwards
Carriage is an accounting terminology that refers to the cost of transport that a trading concern incurs in moving goods meant for resale into or out of a firm. Where the carriage is charged for delivering goods purchased, it is called carriage inwards.
Carriage of goods upon sale out of a firm is called carriage outwards.

Carriage inwards is a cost that is incurred in order to bring the goods into a condition that is necessary for its sale and as such should be charged to the Income Statement. This is done by adding the carriage inwards to the purchases figure in the Income Statement. This ensures that the true cost of buying goods for resale is taken into account in calculating the gross profit of a business.

 Carriage outwards, however, is not considered as a relevant cost the purpose of which is to put the asset into a saleable condition. It is therefore worthy to note that carriage outwards is an Income statement item and for that reason is not included in the calculation of gross profit. This is because carriage outwards is seen as expenses on sales and as a result is debited in the Income Statement.


12.3.3  Goods taken by the Proprietor
It is common in a one man business to find the proprietor making use of the products that he is selling for his own benefit. The use of products or goods by a proprietor is usually termed inventories drawings. The accounting effect of inventories drawings is that it reduces the amount of cost of goods available for sale since the total goods bought for resale have been reduced by the inventories drawings and as such the inventories drawings account must be debited and the purchases account credited.

  Illustration 12.1
  From the following Trial Balance of Jack Terror after his first year‟s trading, you are       required to prepare Income Statement for the year ended 30 June 2007.




 Solution to Illustration 12.1
The Income Statement will be compiled as follows:
Trading Account for the year ended 30 June 2007
¢'000 ¢'000
Purchases    20,000 Sales     28,000
Add carriage inwards         650 Less returns inwards         450
   20,650    27,550
Less returns outwards         745
Cost of sales    19,905
Gross Profit c/f      7,645
   27,550      27,550

Gross Profit c/f        7,645

12.3.4  The accounting treatment of inventories
From the above Income Statement one can deduce that the business is a new one and also was able to sell the goods that were purchased during the year. This means that the business had no opening and closing inventories during the accounting period ended 30 June 2007. The usual practice is for business organisations to hold certain minimum level of inventories to meet future demand.

If this practice is accepted to be normal, then it should be expected that in most situations a business would certainly have closing inventories that might have been bought in the current accounting period but have not been sold. Goods that were bought for the purpose of resale in an accounting period but have not been sold in that particular period and carried forward to the next accounting year constitute what is referred to in accounting terminology as closing inventories.

It must be noted that the closing inventories of an accounting period is brought forward as the opening inventories of the next accounting period. This is handled in the Income Statement by adding the opening inventories to the purchases figure which gives rise to cost of goods available for sale and deducting the closing inventories figure resulting in cost of goods sold.

Illustration 12.2
The following is the Trial Balance of Victorosky Trading Enterprise who has been in business for several years. You are required to draw up the Income Statement for the year ended 31 December 2006.


Solution to Illustration 12.2


12.4  The Income Statement
The main function of the Statement of Comprehensive Income is to ascertain the net Income statement resulting from the trading operations of the accounting period.

It is debited with the gross loss and with the General, Selling, Distribution and Administration expenses for the period, and is credited with the gross profit (if any)  and any miscellaneous gains made, such as interest and discounts received.

There is no established arrangement or order in which items should be set out in an Income Statement, but a sequence frequently adopted in practice and which is recommended for examination purposes is as follows:

Debits-
1. Gross loss from the Comprehensive Income Statement (if any).
2. Establishment charges, e.g., rent, rates, electricity. etc.
3. Administration expenses, e.g., clerical wages, salaries, director fees, etc.
4. Selling and Distribution expenses, e.g., advertising, travelling expenses; salaries and commission, carriage outwards, packing materials, etc.
5. Other expenses, e.g., loss by fire, loss by defalcations.
6. Finance Charges, e.g., loan interest and bank charges.
7. Personal Income tax
Credits-
1. Gross Profit (if any)
2. Investment income, e.g., interest earned on treasury bills and dividend receivable
3. Miscellaneous Income, e.g., rents received, discounts received.

In examination setting, students may be required to prepare the Income Statement and Statement of Financial Position, from a Trial Balance, which already contains the gross profit figure. The inventories that appear in the Trial Balance in this situation are the closing inventories, which must be recorded in the Statement of Financial Position as a current asset and should not be treated as an adjustment in the Income Statement. The opening inventories will not be recorded because it has already been accounted for in the inventories prior to the extraction of the Trial Balance.

The balance on the Income statement represents net profit or loss of the business or the firm. Where the resulting balance in the statement is a credit, a transfer will be made by debiting the Income statement and crediting the capital account of the proprietor. The effect of this entry is to close off the Income statement to the capital account.

12.4.1  Adjustments in the Final Accounts
The ultimate objective of preparing the Income statements and the Statement of Financial Position, is to enable the management of an organisation determine:

(a) The result of its operations during a given period; and (b) Its financial position at the end of that period.

It must also be noted that, in order to obtain these results accurately, it is necessary to make adjustments for:

(1) Expenses incurred but not paid and as a result have not been recorded in the books of account.
(2) Expenses paid in advance, a proportion of which relate to subsequent accounting period.
(3) Income earned in respect of the current accounting period but has not yet been received.
(4) Income received during the current accounting period but will affect the next accounting period.
(5) Provisions for possible losses, e.g., bad debts, and discounts on receivables.
(6) Necessary adjustments for depreciation in the values of the assets at the end of the trading period.

12.5  The Statement of Financial Position
This is a Statement that shows the Financial Position of a business as at the end of an accounting period. It is therefore a presentation of a concise summary of the assets and liabilities of an enterprise in a well-arranged form, so that the financial position of the firm or company on the date of the statement may be clearly ascertained.

  The arrangement of the Statement of Financial Position is nothing but the expression     of the accounting equation and as such must always agree or balance. This means the total book values of assets must be equal to the sum of the values of Capital and Liabilities. The assets of a business are usually arranged in order of their permanence and for this reason; they may conveniently be classified into non-current and current assets.

12.5.1  Non-current assets
These are assets which by their nature or the type of business in which they are employed, are held with the aim of earning revenue and not for the purpose of sale in the normal course of business. Non-current assets are generally valued at cost, less provisions for accumulated depreciation that is sufficient to reduce the carrying or book value of the asset to its salvage or scrap value by the end of its useful working life. Examples of non-current assets are land, buildings, motor vehicles and office equipment.

The amount at which non-current assets are shown in the Statement  does not reflect the amount that will be realised if sold or the cost that will be incurred when they are replaced, but rather is a historical record of their cost less amounts provided in respect of accumulated depreciation. Depreciation represents that part of the cost of a noncurrent asset to its owner, which is not recoverable when the asset is finally scrapped or sold. Provision against this loss of capital must be made before calculating the amount of profit or loss made by a business organisation.

12.5.2 Current assets
These are assets that are acquired and held for resale, and not as agents of production, but for the purpose of eventual conversion into cash. They are therefore not permanent in nature, but are continually changing in the ordinary course of business. Examples of current assets are cash, receivables, closing inventories and bills receivable. The professionally accepted basis of valuing inventories is “cost price or net realizable value, whichever is the lower.” The fundamental reason for this basis of valuation is that anticipated losses should always be provided for as far as possible, while anticipated profits should be ignored until actually realised.

Although examples of current and non-current assets have been mentioned above, it must be remembered that the dividing line between current and non- current assets is a thin one. This is due to the fact that what is considered as a non-current asset in one business may be a current asset in another, and any classification must depend upon the nature of the particular business carried on by the firm. For example a business that manufactures and sells furniture will certainly record a motor vehicle purchased as a non-current asset and furniture as a current asset but if he uses any of the furniture in the office such furniture will be classified as a non-current asset.

12.5.3 Liabilities
These are the obligations of a business enterprise to outsiders. The best method of arranging the liabilities in the case of a sole trader is in order of permanence. The usual groupings are as follows:
• Non-current liabilities.
• Current Liabilities

12.5.4 Capital Account
This represents the contribution of the proprietor of a business to the assets that the firm has acquired. It is made up of the following:
(1) The initial amount that the owner used in starting the business
(2) Any additional amount that he invested in the business during any accounting period
(3) The net profit from the Income statement, which has the effect of increasing the capital of the owner at the end of the accounting period
(4) The net loss from the Income statement that has the effect of reducing the capital account balance at the end of the period, and
(5) Drawings, which eventually results in the reduction of the capital balance.

12.6  Manufacturing Account
Though the Income statement is the acceptable means of determining the performance of a trading enterprise, it is not a sufficiently explanatory means of ascertaining the profit of a manufacturing concern.
Manufacturing firms usually prepare an additional account called Manufacturing Account, which shows the cost of goods produced or manufactured. The cost of goods manufactured, normally called the production costs is transferred from the Manufacturing Account into the Income Statement by crediting the Manufacturing Account and debiting the Income Statement. The production cost effectively replaces purchases found in the Income Statement of a retail enterprise. It must however be noted that where a manufacturing firm produces more than one product, a separate Manufacturing Account should be prepared for each product.

The sequence and grouping of items in a Manufacturing Account depends on the costing system of the firm and is usually designed to yield the maximum amount of information on the composition of the total cost of production. The classification, sequencing and grouping of the Manufacturing Account is as follows:
• Prime cost
• Factory overhead
• Production cost
• Work-in-progress

12.6.1 Prime cost
(1) Cost of raw materials consumed. These consist of the cost of direct materials that the firm purchased and used in the manufacturing process. It is calculated as follows:
               ¢
Opening inventories of raw materials  500,000
Add Purchases of raw materials  2,500,000

  3,000,000
Less returns outwards of raw materials  (200,000)

Cost of raw materials available  2,800,000
Less closing inventories of raw materials  (600,000)
Cost of raw materials consumed  2,200,000

(2) Direct labour costs. These consist of the cost of labour such as wages of operatives and workers (both casual and regular) whose efforts are traceable directly to the manufactured product.

(3) Direct Expenses. These consist of all direct costs other that direct materials and direct labour. Examples include royalties and cost of hiring machine.
The summation of the items above show the sub-total for prime cost.
12.6.2  Factory Overheads:
This sub-heading is shown immediately below the prime cost figure and consists of all indirect costs in respect of materials, labour and expenses. They may include rent, rates, electricity, depreciation of plant and equipment, insurance, the wages of foremen in the factory and research and development cost.
Certain expenses may be common to the manufacturing process as well as to the general administration of the business. Such expenses should be apportioned between the Factory and Administration, Selling and Distribution. The method or basis commonly used in apportioning these common expenses is usually given in an examination question.

12.6.3  Production Cost:
This is the summation of the prime costs and factory overhead figures. This represents the total cost that a manufacturing firm incurs in the production process and is transferred to the Comprehensive Income Statement for that accounting period.
Illustration 12.3
Kefir Enterprises is a manufacturing firm and has presented the following balances for the year ended 30 June 2006.



You are required to prepare the Manufacturing Account for the year ended 30 June 2006.

Solution to Illustration 12.3
The Manufacturing Account will be prepared as follows:
Kefir Enterprises

Manufacturing Account for the year ended 30 June 2006.
Raw materials: ¢ ¢
Opening inventories        30,000
Add Purchases        40,000
      70,000
Less Return outwards          2,000
Cost of raw materials available       68,000
Less closing inventories       26,000
Cost of raw materials consumed       42,000
Manufacturing wages       40,000
Prime cost
Factory Overheads:       82,000
Depreciation of Plant         5,600
Factory expenses       16,800
Rent and rates       12,800       35,200
Production cost     117,200




12.6.4  Work-in-progress

The time that manufacturing companies use to complete a unit or batch of production is not the same; it varies from company to company. It is therefore possible that by the time that the accounting period of a manufacturing firm ends there might be some product s that are not fully complete. Those products that have not been completed at the date of the statement of financial position date are called inventories of work-inprogress.
The cost of production must be adjusted for work-in-progress at the end and the beginning of the accounting period. This is due to the fact that the amount to be transferred to the Comprehensive Income Statement must contain the cost of only products that are fully complete. Any item or product that has not been fully processed cannot be sold; hence they must not appear in the Statement.
Illustration 12.4
Koki Enterprise is a manufacturing firm and has presented the following balances for the year ended 30 June 2007.



Required: Prepare the Manufacturing Account for the year ended 30 June 2007


Solution to Illustration 12.4
The cost of production taking into consideration work-in-progress would be prepared as follows:

Manufacturing Account for the year ended 30 June 2007.
Raw materials: ¢ ¢
Opening inventories          80,000
Add Purchases         240,000
         Carriage inwards          44,000
       364,000
Less Return outwards           35,000
Cost of raw materials available        329,000
Less closing inventories           48,000
Cost of raw materials consumed        281,000
Manufacturing wages     160,000
Royalties paid       72,000        232,000
Prime cost
Factory Overheads:        513,000
Depreciation of Plant       56,000
Insurance expenses -factory       28,000
Factory expenses
Work-in-progress:       66,000        150,000
       663,000
Add Opening inventories          58,000
       721,000
Less closing inventories           50,000
Cost of completed goods c/f        671,000



12.6.5 Transfer Pricing

The usual practice in the preparation of Manufacturing Account is to transfer the production cost to the Income Statement at historical cost. This means that the Manufacturing Account will not record any profit and for that matter one will not know whether the manufacturing process is profitable.

A technique is therefore devised with the purpose of ascertaining profit on the Manufacturing Account. This is done by transferring from the Manufacturing Account the market value of the goods produced for the period. The reason for the use of the market value as the transfer figure to the Income Statement is to ascertain the cost of the manufactured item had the firm decided to acquire those products in the open market instead of producing them.

In this situation, the Manufacturing Account will show a balance, which will reveal either a profit or loss on production. This will therefore inform management whether the production department is a profitable one. If the answer to this question is negative management may have to decide whether to close the production department or institute cost-cutting measures that will result in lower cost of production by means of strict supervision and economies to cheapen production.

Illustration 12.5
Given the same question in illustration 12.4 above, let us assume that the production department transfers the finished product from the factory to the marketing department at cost plus 25%.










The Manufacturing Account will be prepared in the horizontal format as follows:
Manufacturing Account for the year ended 30 June 2007.
Raw materials: ¢ ¢ ¢
Opening inventories      80,000 Market value of goods
Add Purchases     240,000 completed c/f    838,750
         Carriage inwards      44,000
   364,000
Less Return outwards       35,000
Cost of raw materials available    329,000
Less closing inventories      48,000
Cost of raw materials consumed    281,000
Manufacturing wages  160,000
Royalties paid    72,000    232,000
Prime cost
Factory Overheads:    513,000
Depreciation of Plant    56,000
Insurance expenses -factory    28,000
Factory expenses
Work-in-progress:    66,000    150,000
   663,000
Add Opening inventories      58,000
   721,000
Less closing inventories      50,000
Cost of completed goods c/f    671,000
Gross profit on manufacure c/f    167,750
   838,750    838,750




12.7  Summary
We have learned that the purpose of the Income statement of a sole proprietor is to determine his performance for the accounting period. The performance is determined by calculating the net profit or net loss as the case may be. Important terms such as carriage inward, carriage outward, returns inward and returns outward have also been explained. The statement of financial position was also mentioned and explained as a statement that shows the financial position of an enterprise as at a particular time or date.

We also saw that an enterprise that manufactures products for sale will need an additional account called Manufacturing Account to record the total cost incurred in producing the products

CHAPTER SIX - CONTROL OR TOTAL ACCOUNTS

6.0 Learning Objectives……………………………………………………………….
6.1 Introduction……………………………………………………………………….
6.2 The Nature and Functions of Control Accounts…………………………………..
6.2.1 Merits of Control Accounts………………………………………………………
6.2.2 Sources of Information for Control Accounts……………………………………
6.2.3 Receivables or Sales Ledger Control Accounts…………………………………..
6.2.4 Trade Payables or Purchases Ledger Control Accounts………………………….
6.2.5 Trade Receivables Statements or Statement of Account…………………………
6.3 Summary…………………………………………………………………………..




6.0  Learning Objectives
         At the end of this chapter candidates should be able to:
• Explain control accounts and know their usefulness
• Know the main types of control accounts
• Prepare control accounts from given information
• Describe trade receivable statement or statements of account
• Prepare trade receivables statement or statement of accounts.

6.1  Introduction
In a small organisation it may be possible for one person to maintain all the ledger accounts. Where a business maintains a large number of accounts it will become necessary to divide the ledger into sections and to assign the recording of each section to different persons. The main areas to which such ledgers can be divided are in the subsidiary ledger, trade ledger, trade receivables ledger, trade payables ledger and general ledger.
In very large organisations, the sub-division may further be divided among employees.
Where this type of divisions takes place, it will be necessary to institute controls on the accuracy of the postings made to each ledger. This is achieved by maintaining total accounts for trade receivables and payables in the general ledger. These total accounts are referred to as control accounts.

6.2  The Nature and Functions of Control Accounts
A control account is an account, the balance of which reflects the aggregate balances of many related subsidiary accounts which are part of the double entry system.

It is a memorandum record only, it does not form part of the double entry system but it is kept using double entry principle. Control accounts can be kept in respect of customers (sales ledger) accounts, suppliers (bought ledger) accounts and expenses.  Control accounts are maintained to facilitate easy detection of errors because they act as a check on the entries in the various ledgers. Where the Trial Balance totals are not equal, balances in each ledger can be added together and compared with the balance in the respective control accounts. Ordinarily the two should be equal, where there is a difference, such ledger that fails to reconcile with the control account will be investigated rather than all the ledger accounts.

Control accounts are also called self-balancing ledgers because the total trade receivables and total trade payables in the general ledger should be equal to the aggregate of the balances in the respective individual accounts in the subsidiary ledger.

6.2.1    Merits of Control Accounts
The merits of using control accounts can be summarized as follows:
• They can be used to locate errors more easily
• They make it difficult to commit fraud because they are normally under the control of responsible officers and their preparation is separate from the clerks who maintain the individual ledger accounts.
• They provide information about the total trade receivables and total trade payables thereby making management of the receivables and payables accounts easy.
They allow for account set-off

6.2.2 Sources of Information for Control Accounts
Information recorded in control accounts are obtained from:
• Receivables and Payables accounts
• Returns inwards and outwards accounts
• Bills payable and receivable accounts
• Dishonoured cheques
• Cash paid to payables and cash received from receivables (obtained from the cash book).
• Discount received and discount allowed accounts •  Sales day book and purchases day book.

6.2.3 Receivables or Sales Ledger Control Account
Sales ledger control account is the account containing the summary of all trade receivables or customers‟ accounts. What is posted to the debit side of this account is the aggregate of all the items recorded on the debit side of the receivables accounts.
The same thing applies to the credit side of the account.
Summary of Entries
(i)  Debit – (a)  Credit Sales from sales day book
(b) Dishonoured cheques from customers
(c) Debit notes issued
  Credits :( a)      Cash received from receivables as recorded in the cash book.
(b) Discount allowed as recorded in the cashbook
(c) Returns inwards as recorded in the sales return day book.
(d) Set off between sales ledger control and purchases ledger control accounts
(e) Bad debts written off

6.2.4 Trade payables or Purchases Ledger Control Account
This is the account containing the summary of all the accounts of the creditors or suppliers in the purchases ledger.

Summary of entries in the Purchases Ledger Control Accounts
Debit entries
(a) Payment to customers obtained from the cash book
(b) Returns outwards
(c) Cheques paid to suppliers from the cash book
(d) Discount received from the memorandum column on the credit side of the
(e) cash book
(f) Credit notes
(g) Transfer between sales ledger control and purchases ledger control accounts.

Credit entries
(a) Credit purchases obtained from the purchases day book
(b) Cash refund from suppliers (c)  Dishonoured bills payable

NOTE
Cash sales should not be debited to the sales ledger control account rather, cash sales should be debited to the cash book. Cash purchases should also not be credited to purchases ledger control account but should be credited to the cash book.
Illustration 6.1
Extracts from the books of JK Ltd. shows the following balances for the month of
June 20X6
                          N
Sales ledger balances – 1 June 20X6     4,702
Purchases ledger balances – 1 June 20X6      2,757
Sales journal balances – 30 June 20X6         37,437
Purchases journal balances – 30 June 20X6    40,800
Returns Inwards         910
Returns Outwards         749
Receipts from Customers – Cash    38,529
Discount allowed      1,345
Payment to Customers    35,415
Discount received          746
Bad debt written off         115
Sales ledger set off         209
Purchases ledger set off         110
On 30 June 20X6, it was discovered that a supplier was paid twice in error for N157.
The amount was refunded on that date.
You are required to determine the sales and purchases ledger balances at 1 July 20X6.
  (Adapted from ATS ICAN)


Solution to Illustration 6.1
JK Ltd.
Sales Ledger Control Account
20X6                 N     20X6                     N
June              June
1  Bal b/f  4,702  30              Cash                          38,529
30              Sales  37,437  30             Returns inwards           910
      30             Discounts allowed            1,345
      30             Bad debts                        115
      30              Set-off                           209
    ______  30              Bal c/d                        1,031
    42,139                                                    42,139
1 July   Bal b/d  1,031 

Purchases Ledger Control Account
20 x 6
June                                                 N         20X6                     N
                                                                                June
30   Returns outwards  749  1   Bal b/f                 2,757
30     Cash   35,415  30   Purchases            40,800
30    Discount received  746  30   Cash refund             157
30   Set-off  110 
30  Bal c/d  6,694                               _____
    43,714                                                 43,714
                                                                July 1    Balance b/d                                 6,694 Illustration 6.2
Aji Father Enterprises controls his Trade payables accounts by drawing up monthly, a Trade Payables Ledger Control Account in two parts A and B.
The following figures are available at January 31 2006 when there is a difference on the Trial Balance  of N2,000.

                                                     A                             B
                                          N                             N
Jan 1 Balances on Trade Payables (credit side)                      18,400              13,600
Jan 1 Balances on Trade Payables Ledger (debit side)                      150                    184
Jan 1 – 31 Purchases                                                                   114,512                        17,372
Jan 1 – 31 Returns                                                                      11,000                                  1,652
Jan 1 – 31 Sundry charges by suppliers                                   1,200              144
Jan 1 – 31 Cheques paid to suppliers                                              17,980         13,420
Jan 1 – 31 Discount received from suppliers                                    1,420           1,180
Jan 31       Balances carried down to debit side                                  150                          132
The book-keeper in charge of the A Ledger makes his accounts total N103,712 while the clerk in charge of the B Ledger makes his Ledger balances total N16,812.

Draw up the two Control Accounts and draw any conclusion you can from them.







Solution to Illustration 6.2
AJI Father Enterprises
 Ledger Control Account A
2006         N  2006               N
Jan  Balance b/d      150  Jan 1 Balance b/d                           18,400
1 – 31 Returns          11,000  1 – 31 Purchases                          114,512
1 – 31 Bank           17,980  1 – 31 Sundry charges                  1,200
1 – 31 Disc. Received           1,420        31 Balance c/d                                 150
      31 Balance c/d                  103,712                                                             _______
            134,262                                                134,262
Feb 1 Balance b/d               150  Feb 1 Balance b/d                            103,712

 Trade Payables Ledger Control Account B
2006               N            2006                  N
Jan            Balance b/d                   184  Jan 1  Balance b/d                13,600
1 – 31  Bank                         13,420  1 – 31  Purchases                 17,372
1 – 31  Disc Received            1,180  1 – 31  Sundry charges                   144
1 – 31  Returns                       1,652  31  Balance c/d                         132
1 – 31  Balance c/d              14,812                                            _____
                                                        31,248                                                       31,248
Feb 1             Balance b/d                    132   Feb 1 Balance b/d                       14,812

The Control Accounts reveal that there is a difference of N2,000 between the Control Account for the B Ledger (N16,812 – N14,812) which is the total discovered by the book keeper in charge of that Ledger. The A Ledger seems to be correct. The obvious solution is to check the Ledger entries in the B Ledger very carefully.

6.2.5 Trade Receivables Statements or Statements of Account
Trade receivables statements are documents sent periodically, usually once a month, by a seller to his customers showing the position of their accounts up to a certain date. Each statement gives the particulars of the invoices, debit notes and credit notes that the seller has sent to the customer during a month, payment made and how much the customer owes the seller and when the amount will be due for payment. The statement is often a copy of the customer’s account in the seller’s books.

The statement may be kept for reference purpose or returned to the seller with the customer’s cheque. In either case neither the customer nor the seller records the statement in his books.

Illustration 6.3
The following transactions took place between Sisi Eko Enterprises of 2, Balinga Street, Lagos and her customer Ambrose & Co of 10 Dennis Avenue, Ikeja in January 20X1.

2 Jan 20X1  Invoiced goods worth N23,120 on invoice number 426
9 Jan 20X1  Invoiced goods worth N16,240 on invoice number 489
16 Jan. 20X1 Ambrose & Co paid a sum of N25,140 with cheques
22 Jan. 20X1 Invoiced goods worth N52,910 on invoice number 563
25 Jan. 20X1 Credit note number 1326 for N6,000 was sent Required:
Prepare a Trade Receivables Statement to show these transactions
(ATS ICAN)

Solution to Illustration 6.3
SISI EKO Enterprises
2, Balinga Street, Lagos
Ambrose & Co              January 20X1
10, Dennis Avenue, Ikeja

Date of   Details Invoice/  Debits                    Credits                     Balances
Invoice  Credit       Note No
January                       N                             N                            N
2  Goods  426         23,120                       23,120
9  Goods  489        16,240                                          39,360
16  Payment  Cheque                                   25,140                     14,220
22  Goods  563        52,910                                                      67,130
25   Credit note  1326                                         6,000                     61,130
Amount due on January, 31                                              61,130 Cash discount terms: 5% for payment within 15 days

6.3  Summary
In this chapter we have explained the importance of control account in detection of error and in the management of the subsidiary accounts. We also showed, through illustration, how errors in a Trial Balance that does not “balance” can be detected easily through the control account. We also described the receivables statement and how they are prepared.

CHAPTER NINE- PAYROLL ACCOUNTING

9.0 Learning Objectives………………………………………………………………..
9.1 Introduction………………………………………………………………………..
9.2 Payroll……………………………………………………………………………...
9.3 Gross Pay…………………………………………………………………………..
9.4 Methods of Calculating Gross Pay ……………………………………………......
9.4.1 Time-Based System……………………………………………………………
9.4.2 Performance Related Systems…………………………………………………….
9.4.3 Straight Salary……………………………………………………………………..
9.4.4 Bonus Schemes…………………………………………………………………….
9.4.5 Types of Bonus Schemes…………………………………………………………..
9.4.5.1 Halsey Premium Plan……………………………………………………………
9.4.5.2 Rowan Plan………………………………………………………………………
9.4.5.3 Comparison of Halsey Plan and Rowan Plan……………………………………
9.5 Allowable Deductions and Reliefs…………………………………………………
9.6 Net Pay…………………………………………………………………………….
9.7 Accounting Entries………………………………………………………………...

CHAPTER NINE

PAYROLL ACCOUNTING

9.0   Learning Objectives

After you have studied this chapter, you should be able to:
• Define and explain payroll
• Explain the difference between gross salary, net salary and take-home pay
• Explain and calculate the difference between employee‟s and employer‟s social security contributions
• Calculate the net salary or pay of an employee where his or her gross pay, statutory and other deductions and personal income tax schedule are given
• State the control procedures required in the management of payroll
• Demonstrate ability to record payroll activities in the accounting records of a business organisation

9.1   Introduction
In this chapter you will learn how to calculate the salary or pay of employees and the various deductions that are made from the gross pay before calculating the income tax. You will also learn how to use the progressive personal income tax schedule to calculate the income tax of an employee. You will learn why statutory deductions like social security contributions are made and how they are calculated. Finally you will learn what types of reliefs are available to employees and how they are adjusted before the employees‟ net pay is calculated.

9.2   Payroll

Payroll may be defined as a record showing the names of employees, rates of pay, hours worked, bonuses, allowances, gross earning (salaries), statutory deductions and other contributions withheld during a given pay period.  In simple terms, payroll may be understood as a document showing for each worker his gross earning, any deductions (statutory and otherwise) made from his gross earning and the net amount payable to him in a particular pay period.

The objectives of payroll accounting are to process information such as; Hours Worked, Pay Rate, Gross Earning, Deduction and Net Pay (salary). Business organisations record information relating to employees‟ pay due to the following:

1) Payroll usually constitutes the most significant or material obligation or expense in most business establishments.

2) Business organisations are required by law to send returns on their payroll including the amount of income tax deducted at source to the tax authorities.

3) It is used for cost control purposes, usually in the form of variance analysis.
4) It is also the basis upon which most tax clearance certificates are prepared.

Employees are usually paid either a wage or a salary. Wages refer to the type of employee remuneration package that is time based. In this situation the rate of pay is given as a fixed amount per hour for number of hours actually worked or of those who reported for duty. Salary, though time based, is quoted on an annual basis.

In Ghana and Nigeria all employees are taxed under the PAYE (Pay-as-You Earn) system. This is a form of withholding tax system where the employer is legally required to deduct at source the income tax and social security contributions from the wages or salaries of employees and pay the same to the tax authorities. This therefore means that the employee will not have to wait till the end of the year for him to personally pay his tax liabilities to the state. The PAYE tax is a monthly phenomenon which is seen as an estimate and as such may result in overpayment or underpayment of an employee‟s income tax liability.  

9.3 Gross pay or earning is the total amount of wages or salaries that employees earn in a particular period before statutory deductions and others are made.  In Ghana, gross pay is the consolidated income of an individual earned from employment. The consolidated salary of an employee may consist of the following components:
• Basic Salary
• Leave allowance
• Responsibility allowance
• Transport allowance
• Overtime allowance
• Risk allowance
The two main remuneration methods often used are:  Time based system and Piecework system.  Others include:  Straight salary, bonuses, commission and allowances.
 
9.4.   Methods of calculating Gross pay
Methods of remuneration refer to the basis used in calculating wages of workers.  In the preparation of payroll, the organisation must initially determine the employee‟s Gross Salary or wages using the most appropriate remuneration plan adopted by the firm.

9.4.1  Time Based System
In this system of remuneration, employees are paid according to number of hours actually worked multiplied by a fixed amount or rate.  This simply means that the longer the period for which an employee works, the larger his or her gross pay will be. This method of remuneration is usually employed in the manufacturing industries.
The payment to the employees is based on this formula:

Earnings = Clock hours x Rate per hour

Advantages
• It is simple to understand and administer
• Wage negotiations (changes) can be easily affected
• It has stood the test of time
• It provides incentive for longer period of work
• It facilitates cost control Disadvantages
• There is no incentive to improve productivity and efficiency
• It is not a sound accounting practice to pay all employees in the grade the same rate irrespective of performance.
• Cost of supervision under this method is very high •  It is not a very good basis for cost control.
• It does not encourage innovation.

9.4.2   Performance related Systems
Under this system, the remuneration in terms of wages or salaries that is paid to each employee is dependent on his or her level of output, performance or services rendered.  Workers are normally given a fixed sum per unit of output so that the higher one‟s output the larger his gross pay or salary.  Casual labour, cooks, painters, contractors etc. are often paid by this method. The payment to the employee is based on the formula below:

Earnings = Number of units produced x rate per unit

Advantages
• It attracts higher grade worker (scholars and “macho” men).
• It provides direct incentive for innovations, efficiency and high productivity without any difficulty of individual piecework rates.
• It is simple to understand and administer.
• It facilitates cost control.
• It has stood the test of time.

Disadvantages
• Output may exceed target if proper supervision is not carried out.
It results in competition for higher grade workers thereby increasing the cost per output.
• Shoddy work or inferior goods will be made, if proper supervision is                                                      not put in place.
• It does not take into account individual disabilities.

9.4.3    Straight Salary
Under this method of remuneration, employees are paid a fixed amount annually with a constant increase per annum. This is usually referred to as the notch system and is usually stated as follows:
Gross Pay = ¢10,000,000 x¢ 2,000,000 – ¢18,000,000.
The above statement means that this employee will receive ¢10,000,000 for the first year of his engagement. Thereafter his gross pay will increase by ¢2,000,000 every subsequent year following the date of his employment. This increment will not continue when it gets to ¢18,000,000 until he or she is promoted to the next grade.  It must however be noted that the gross pay under this method does not depend on the number of hours worked or output produced.

9.4.4   Bonus Schemes
These are schemes which are used to reward exceptional employees by   paying bonuses on top of these normal earnings mentioned above. Such incentives vary from one company to the other. The main purpose of providing these incentives is to encourage workers to produce their best for the company.

9.4.5  Types of Bonus Schemes
9.4.5.1  Halsey Premium Plan

This plan was introduced by F. A. Halsey in 1891. The plan simply combines the time and piece rate systems. The main features of this plan are as follows:
a. Workers are paid at a rate per hour for the actual time taken to perform a task.
b. A standard time is set for each piece of work, job or operation.
c. If a worker takes standard time or more than the standard time to complete his work, he is paid wages for the actual time taken by him at the time rate.
d. If a worker takes less than the standard time, he is paid a bonus equal to 50 % of the time saved at the time rate fixed.
Under this system, total earnings of a worker are equal to wages for the actual time taken by him plus a bonus. The formula for calculating bonus and total earnings under this incentive plan is:
Bonus = 50% of [Time saved x Time rate]
Total earnings = Time rate x Time taken + 50% of [Time saved x Time rate]
    Illustration 9.1
            Standard time (or Allowed time) = 250 hours.
            Wages rate per hour                     = ¢15
Actual time taken                         = 220 hours

Thus time saved = 250hrs – 220hrs = 30hrs.
Bonus = 50% [30hrs x ¢15] = ¢225
Total earnings = ¢15 x 220hrs + 50% [30hrs x ¢15] = ¢3,525
 

Advantages of Halsey Plan.
1. It is easy to understand.
2. It guarantees a minimum time wages to all the workers. This means that slow or lazy and relatively inefficient workers have nothing to fear on the plan.
3. The benefits resulting from saving in time is equally divided between workers and the employer.
4. Bonus is separately calculated for each job. As a result any time saved by a worker on a particular job is not adjusted against excess time taken by him on another job.

Disadvantages of Halsey Plan
1. Workers do not like the employer to share the benefits of time saved by them.
2. It does not provide the employer with full protection against high rate setting.
3. Extra efficiency of a worker is not fully recognised and rewarded.

9.4.5.2 Rowan Plan

This plan is similar to the Halsey incentive plan mentioned above. The difference lies in the calculation of bonus. The main features of Rowan Plan are as follows:
a. Wages are paid on time basis for the actual time worked by the worker
b. A standard time is determined for each piece of work or job.
c. If a worker completes his work in standard time or in more than the standard    time, he is paid wages for the time actually taken by him.
d. If a worker completes his work in less than the standard time, he is entitled to a bonus.
e. The Bonus is calculated as the proportion of wages of actual time taken which     the time saved bears to the standard time.

The formula for calculating bonus and total earnings under this incentive plan is:

 Bonus =    Time saved      x Time taken x Time rate
Time allowed

Total earnings = (Time taken x Time rate) + Bonus

Illustration 9.2
            Standard time (or Allowed time) = 250 hours.
            Wages rate per hour                     = ¢15
Actual time taken                         = 220 hours

Bonus = 30 hrs    x 220 hrs x ¢15 = ¢396
250 hrs

Earnings = (220 hrs x ¢15) + ¢396 = ¢3,696


Advantages of Rowan Plan
1. Just like Halsey plan, it provides guaranteed minimum wages to workers.
2. It protects the employers against loose rate setting.
3. It pays a higher bonus than that under the Halsey plan up to 50% of the standard time saved.
4. The worker is not induced to rush through the work if time saved is more than 50% of the standard time, the bonus increases at a decreasing rate.
5. It provides good incentives for comparatively slow workers and beginners.

Disadvantage of Rowan Plan
1. The calculation of bonus is complicated and may not be easily understood by workers who may suspect the employers‟ motives.
2. In case of extra efficient workers, bonus is less than under Halsey Plan. This is true when the time saved is more than the time taken.

9.4.5.3  Comparison of Halsey Plan and Rowan Plan

1. Bonus. When time saved increases, bonus under Halsey Plan also keeps increasing. But under the Rowan Plan, when time saved increases, bonus increases only when time saved is up to 50% of the standard time allowed. Thereafter the amount of bonus begins to decline. Bonus under the two plans is the same when time saved is exactly 50%. Before 50% of standard time saved, bonus under Rowan Plan is higher than that of Halsey Plan and after 50% of the time saved, bonus under Rowan plan is lower than that of Halsey Plan. For example under Rowan plan, a person who has saved 60% of time allowed earns the same amount of bonus if he saves 40% of the time allowed.
2. Earnings per hour. Under both plans earnings per hour of workers keep on increasing. But the rates of earnings under the two plans differ. When time saved is less than 50% of time allowed , the rate of increase in per hour earnings is higher in Rowan Plan whereas when time saved is more than 50% of time allowed , the rate increase in per hour earnings is higher in Halsey Plan. At 50% time saved, earnings per hour under both schemes are the same.

3. Effect on labour cost. Labour cost per unit decreases as production increases up to the standard time allowed; thereafter, it continues to decrease but not at a faster rate.
Rowan plan cost per unit is higher than under Halsey Plan until time saved is 50% of time allowed .Thereafter it is lower and soon becomes significantly lower. At 50% time saved, labour cost per unit is the same under both plans.

9.5       Allowable deductions and reliefs
These are statutory deductions and others that are expected to be deducted from the gross salary of an employee at the end of a given period. In Ghana these deductions include the following:

a. Income Tax
b. 5% employee‟s Social Security Contributions
c. employees‟ provident fund
d. Any percentage contribution towards a Special retirement fund by an employee
e. Medical Insurance
f. Union/Senior Staff Dues or Welfare Fund Contributions
g. Repayment of Employees Advances or Loan from Employers
h. Hire Purchase Deductions
i. Others

The first two deductions (income tax and social security contribution) are compulsory in Ghana. However, the other deductions will depend on the regulations of the company in question and the employees own preferences.

9.6  Net Pay
This is the excess of the gross pay or salary over statutory deductions and income tax.
It is often called disposable income or “take home pay”.  It is the pay the worker actually takes home for a given period.

At the beginning of each Government fiscal year (1st January in the case of Ghana), the Minister of Finance presents the Budget to Parliament. In Nigeria, the President presents the Appropriation bill to the National assembly a few months before the commencement of a fiscal year (1st January). After due processes the bill is passed into law and becomes the Appropriation Act.

The budget statements contain the rates of income tax and any deductible reliefs for the following year. Due to the annual changes in rates and reliefs, the rates of income tax used in the computations in this book are for illustration purposes only. The calculation of income tax and net pay is as follows:
Income tax:
  ¢
Basic Salary  xxxxx
Add Other Cash allowances   xxxxx
Total Consolidated Salary  xxxxx
Less Statutory deductions and reliefs  xxxxx
Taxable Pay or Salary  xxxxx
Income Tax = (Taxable pay x rate of tax)
Net Pay:  xxxxx
Total Consolidated Salary  xxxxx
Less Statutory deductions  xxxxx
Taxable pay or salary  xxxxx
Income Tax  xxxxx
Net Pay or Salary  xxxxx

Illustration 9.3               
Mr Victor Kakapo has been in the employment of Pacheco Limited since January, 1 2005 on a salary scale of ¢50,000,000 per annum. For the year 2005 his entitlements were as follows:
  ¢
Inconvenience allowance  5,000,000
Leave allowance  3,000,000
Risk allowance  4,000,000

He is married with two children attending secondary schools in Ghana. He contributes to the social security scheme. He qualifies for the following reliefs:
  ¢
Marriage                                                        300,000
Child education         480,000
Aged dependent for two  400,000

You are required to calculate Mr. Victor Kakapo‟s Income tax and Net pay in 2005 using the income tax rates below.

 Income   Tax rate
 ¢
First      1,800,000 0 %
Next      1,800,000 5 %
Next      4,800,000 10 %
Next    27,600,000 15 %
Next    33,000,000 20 %
Exceeding    69,000,000
  28%
Computation of Mr. Victor Kakapo‟s Taxable Pay
¢ ¢
Basic Salary (2005)   50,000,000
Inconvenience allowance     5,000,000
Leave allowance     3,000,000
Risk allowance     4,000,000 Consolidated Salary  62,000,000
Less Statutory deductions & reliefs:
5% Social security    2,500,000
Marriage       300,000
Child education       480,000
Aged dependent        400,000     3,680,000
Taxable Pay   58,320,000




Computation of Mr. Victor Kakapo‟s Income Tax
 Income   Tax rate  Tax amount
 ¢   ¢
First      1,800,000 0%               -
Next      1,800,000 5%         90,000
Next      4,800,000 10%       480,000
Next    27,600,000 15%    4,140,000
Next    22,320,000 20%    4,464,000
Total    58,320,000    9,174,000
 


Therefore Victor Kakapo‟s Net Pay for 2005 is:

Basic Salary    50,000,000
Add Cash allowances   12,000,000 Total Consolidated Salary   62,000,000
Less:
5% Social security  2,500,000
Less Income tax
Net Pay or Salary


9.7  Accounting Entries

For the purpose of Accounting, the entries in the pay slips are passed in the general journal to record the payments made at the end of the given pay period.

1. When Liabilities/Expenses are due
• Debit Wages/Salaries Account with the Gross Salary.
• Credit Provident Fund Account.
• Credit Income Tax Account.
• Credit Medical Insurance Account
• Credit Union Dues Account
• Credit any Other Deduction Account
• Credit Payroll Payable Account with Net Salary or Wages.
• Credit 12.5% Employer‟s Social Security Fund Account
• Debit Employer‟s Social Security expenses Account (i.e. contribution)

2. When Expenses or Liabilities are Paid

• Debit provident fund account and credit Cash/Bank account with the amount paid • Debit Income tax account and credit cash/bank with the sum paid.
• Debit any other deduction account and credit cash/bank account with the amount paid.
• Debit payroll payable account and credit cash/bank account with the amount paid.
• Debit 12.5% Employer‟s Social Security Fund Account and credit cash or bank account with the amount paid.