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