Explain the role of special journals in the accounting process.
Special journals summarise similar transactions so that totals can be posted to the General Ledger, in the process reducing the number of ledger entries required and improving the efficiency of the recording system.
Explain the role of the General Journal.
The General Journal is used to record infrequent, non-cash transactions, which cannot be recorded in the special journals.
List seven types of transactions that will be recorded in the General Journal.
● commencing entries● non-cash transactions with the owner● bad debts● correcting entries● use of stock for advertising purposes● closing entries● balance day adjustments
Explain why there are no classification columns in the General Journal.
There are no classification columns because the General Journal is used to record a variety of transactions, unlike the special journals, which record similar and frequent transactions.
Explain how the rules of double-entry accounting apply to the General Journal.
In common with all transactions, the debits must equal the credits. Therefore, the entries in the General Journal must have corresponding debit and credit entries so that posting to the General Ledger will ensure it balances.
In relation to the General Journal, define the term ‘narration’.
A brief description of a transaction recorded in the General Journal, including a reference to the relevant source document.
Explain why narrations are necessary in the General Journal, but not in the special journals.
Transactions recorded in the special journals are all of a similar nature, thus a narration is not required. However, as the General Journal records a variety of transactions, it is necessary to provide a narration for each entry.
Define the term ‘commencing entry’.
A General Journal entry to establish double-entry records by entering existing asset, liability and owner’s equity balances in the ledger accounts.
State two reasons why a commencing entry may be necessary.
● when the business is just starting and the owner is contributing starting capital● when the business has been operating for some time already, and the owner decides to switch from single-entry accounting to double-entry accounting
In reference to a commencing entry, explain how the entry to the Capital account is determined.
The Capital amount is determined by using the accounting equation (Assets = Liabilities + Owner’s Equity) so that all debit entries match the credit entries.
Explain why drawings of stock must be recorded in the General Journal.
Drawings of stock is a non-cash transaction. Thus, it cannot be recorded in the Cash Payments Journal but rather must be recorded in the General Journal.
Define the term ‘bad debt’.
A bad debt is an expense incurred when a debt is written off because it is deemed to be irrecoverable.
Referring to one accounting principle, explain when a bad debt should be recognised.
According to the conservatism principle, a bad debt should be recognised as an expense when the loss is probable, so that assets (Debtors Control) are not overstated.
Explain why in some situations errors may be corrected in the appropriate special journal, but in others a General Journal entry is required.
When errors are detected before the journals are posted to the ledger, they can be corrected in the special journals. However, if the journals have already been posted to the ledger, errors must be corrected using a General Journal entry.
List three types of errors that may need to be corrected via the General Journal.
● recording a transaction in the wrong ledger account● omitting a transaction● recording an incorrect amount
List three types of errors that may need to be corrected via the General Journal.
● recording a transaction in the wrong ledger account● omitting a transaction● recording an incorrect amount
List the two basic steps for correcting an error involving the use of the wrong ledger account.
1) Undo the incorrect entry by reversing it; that is, record a debit entry to undo an incorrect credit, and vice versa.2) Enter the correct entry.
Define the term ‘trading firm’.
A trading firm is a firm that purchases goods in order to resell them at a profit.
Define the term ‘stock’.
Stock refers to goods purchased by a trading firm for the purpose of resale at a profit.
Explain how stock should be classified in the Balance Sheet.
Stock should be classified as a current asset because it is a resource controlled by the entity from which future economic benefit is expected to flow to the entity within the next 12 months.
State two reasons why stock is important to a trading firm.
● Stock is a firm’s main source of revenue, and thus the key to its ability to earn profit.● Stock is likely to be one of the most significant assets the firm controls.
State three reasons why stock is considered to be a vulnerable asset.
Stock is considered a vulnerable asset as it can be:● damage● spoilage● theft● changes in tastes and fashions.
Explain the role of the Stock Control account.
The Stock Control account summarises all movements of stock in a firm in the General Ledger.
Identify two transactions that would appear on the debit side of the Stock Control account.
● cash purchases● credit purchases● stock gain
Identify four transactions that would appear on the credit side of the Stock Control account.
● cash sales● credit sales● drawing of stock● advertising of stock● stock loss
Explain the relationship between the Stock Control account and the stock cards.
The Stock Control account is used to summarise all transactions affecting stock, with information relating to individual lines of stock, including details of stock transactions, recorded in stock cards.
Identify four details that will be provided in the top portion of a stock card but not in the Stock Control account.
● a description of the item● the stock code● the location of the item● the name of the supplier
Identify three details that are provided when transactions are recorded in the stock card but are not provided in the Stock Control account.
● the source document● the quantity of stock● the unit cost of stock
State how many stock cards a typical trading firm would require. Beware: This is a trick question!
A typical trading firm would require a stock card for every line of stock, including one for every different colour and for every different size. Therefore, the number of stock cards depends on how many lines of stock a trading firm possesses.
Explain why GST does not affect the valuation of a stock purchase.
GST does not affect the valuation of stock because it does not affect the economic benefit gain from the stock. Instead, the GST is an additional amount collected or paid on behalf of the ATO and will only affect the GST owed to the ATO.
State the effect on the balance of a transaction recorded in the:- in column- out column
● In column – increases the balance● Out column – decreases the balance.
Explain why the cost price is not shown on the source document that provides the evidence of a sale.
The cost price is not revealed as this protects the gross profit on the sale; customers who are aware of the mark-up have a tendency to haggle harder for price reductions.
Explain how the stock card is used to determine the Cost of Sales for each transaction.
The amount recorded in the ‘Out’ Cost Value column represents the cost of sales for the transaction. This is determined by applying the First In, First Out (FIFO) approach using the cost price of the units remaining in the Balance column of the previous transaction.
State three reasons why a small business might choose to value its stock using the FIFO (First In, First Out) assumption.
● It is not possible for some types of stock to label every item to identify its cost price; for example, petrol.● For other items of stock it may be possible, but not practical: a fruit shop would find it impractical to label each grape, for example.● Even where identifying the cost is both possible and practical, the owner may still decide it is not worth the time, effort and cost to label every item of stock.
Explain the FIFO assumption as it applies to stock cards.
Under this assumption, the business assumes that the stock that was purchased first will be sold first, even though the business may have no way of knowing for certain. Without marking stock, there is no way of knowing the cost price of the stock that has been sold, making FIFO an acceptable and necessary assumption.
Identify three transactions to which the FIFO assumption must be applied.
● sales● drawings (of stock)● advertising (of stock)● stock losses
Explain the importance of stock cards when sales are recorded in the special journals.
The amounts in the Value column of the Out section of the stock card represent the cost price of the sale. These amounts represent the Cost of Sales and they will be recorded in the Cost of Sales column in the special journals.
Explain the importance of stock cards when purchases are recorded in the special journals.
The amounts in the Value column of the In section of the stock card represent the cost price of the purchase. These amounts will be recorded in the special journals.
Identify two means of verifying the amounts recorded in the Cost of Sales account in the General Ledger.
● the Cost of Sales column of the Sales Journal (for credit sales)● the Cost of Sales column of the Cash Receipts Journal (for cash sales)
Define the term ‘stocktake’.
A physical count of the number of units of each line of stock on hand.
Explain the role of a stocktake.
The role of a stocktake is to verify the accuracy of the stock cards and, in the process, detect any stock losses and stock gains.
Explain why a stock loss is classified as an expense
Stock loss is an expense because it is an outflow of an economic benefit (Stock) in the form of a decrease in assets (Stock Control), leading to a decrease in owner’s equity.
Identify three reasons for a stock loss.
● theft● damages/breakages● undersupply from a supplier● oversupply to a customer
Explain how the cost price of a stock loss is determined.
The cost price of a stock loss is determined by comparing the stocktake figure of the units on hand with the stock card figure of the units on hand and establishing that there is stock missing. Multiply the number of units missing with the unit cost in the Balance column of the stock card (remembering to apply the FIFO assumption).
Explain why a stock gain is classified as a revenue.
Stock gain is a revenue because it is an inflow of an economic benefit (Stock) that increases assets (Stock Control), leading to an increase in owner’s equity.
Identify two reasons for a stock gain.
● oversupply from a supplier● undersupply to a customer
Explain how the cost price of a stock gain is determined.
The cost price of a stock gain is determined by comparing the stocktake figure of the units on hand with the stock card figure of the units on hand and determining that there is stock gained. Multiply the number of units gained with the lowest unit cost price still on hand in the Balance column of the stock card.
State two reasons why a small business may use stock for advertising purposes.
● to use as display purposes● to donate stock to local community organisations
Explain why stock used for advertising purposes is classified as an expense.
It is an expense because it is an outflow of an economic benefit (Stock) in the form of a decrease in assets (Stock Control), leading to a decrease in owner’s equity.
Explain how the cost of stock used for advertising purposes is determined.
It must be recorded in the Out column of the stock card and valued according to FIFO.
Define the term ‘Cost of Goods Sold’.
Cost of Goods Sold is used to describe all costs incurred in getting goods into a condition and location ready for sale.
State two reasons why Cost of Goods Sold may be greater than Cost of Sales.
● customs duty/import duties● freight in/delivery from suppliers● modifications● packaging● buying expenses
Explain why it is important to identify Gross Profit in the Income Statement.
It is important to identify Gross Profit to allow the owner to assess the adequacy of the firm’s mark-up, because Gross Profit expresses the relationship between selling prices and cost prices.
Explain why it is important to identify Adjusted Gross Profit in the Income Statement.
It is important to identify Adjusted Gross Profit to allow the owner to isolate the stock loss or gain and bring it to the attention of the owner, so that strategies may be developed to address any problems that are identified.
Explain the operation of the perpetual system of stock recording.
The perpetual system involves recording individual stock transactions in the stock cards as they occur, then conducting a physical stocktake at the end of the Reporting Period to verify the balances of those stock cards. In the process, any stock losses or gains will be detected.
Explain the benefits of the perpetual system of stock recording.
● Reordering of stock is assisted by maintaining a continuous record of the number of units of stock on hand, enabling the business to avoid lost sales.● Stock losses and gains can be detected by comparing the balances of the stock cards against the physical stocktake.● Fast and slow moving lines of stock can be identified so that stock can be rotated or the stock mix adjusted.
Explain the impact of FIFO on net profit in times of rising prices.
FIFO assumes that the older stock is sold first, and that the newer stock is still on hand: when prices are rising, this newer stock will be more expensive, overstating stock on hand. (It is possible some of the stock on hand is actuallythe older, cheaper stock.)
Define the following terms: - revenues - expenses- profit
- revenues – inflows of economic benefits (or savings in outflows), in the form of increases in assets or reductions in liabilities, that lead to an increase in owner’s equity- expenses – outflows or consumptions of economic benefits (or reductions in inflows), in the form of decreases in assets or increases in liabilities, that lead to a decrease in owner’s equity- profit – what is left over after expenses incurred are deducted from revenues earned.
Explain how the Reporting Period principle assists in the calculation of profit.
The Reporting Period allows businesses to divide the life of the business into arbitrary periods in order to determine profit.
Explain how the Reporting Period principle leads to Relevance in accounting reports.
Once the length of the Reporting Period is determined, it is important that the calculation of profit includes only revenues and expenses, and only those revenues and expenses that have occurred during the current Reporting Period. This ensures that the reports contain only information that is useful for decision-making and exclude information that is not useful for decision-making.
Explain the process of closing the ledger.
Closing the ledger involves transferring balances from revenue and expense ledger accounts to the Profit and Loss Summary account so that profit can be calculated.
Explain two reasons for closing the ledger.
● Transfer revenues and expenses to the Profit and Loss Summary account in order to calculate profit for the current Reporting Period.● Reset revenue and expense accounts to zero in preparation for the next Reporting Period.
Explain why asset and liability accounts are not closed.
Assets and liabilities will exist into the future. That is, the Balance Sheet items involve a future benefit or future sacrifice and so should not be reset to zero, but their balances should carry forward into the next Reporting Period.
Identify the three entries that will be recorded in the Profit and Loss Summary account.
● total revenues● total expenses● net profit/loss figure
Referring to revenues and expenses, explain why the cross-references in the Profit and Loss Summary account are not ledger account names.
Instead of listing every account names, the cross-reference is simplified to ‘revenues’ or ‘expenses’ to indicate that there are a number of revenue and expense accounts linked to these total figures.
Explain how the Profit and Loss Summary account would be classified in the Balance Sheet. (Beware!)
The Profit and Loss Summary account is a temporary account that opens (when the revenues and expenses are transferred in) and closes (when the profit or loss is transferred out) on the same day. It's function is simply to facilitate the calculation of profit and therefore is not entered in the Balance Sheet.
State one reason why transactions with the owner are recorded separately in the Drawings account (rather than directly in the Capital account).
It is recorded separately so that the owner’s transactions for a particular Reporting Period can be isolated. This is useful for decision-making so that the owner can assess the level of drawings.
State one reason why the Drawings account is closed to the Capital account.
The Drawings account is closed to the Capital account so that the Capital account can reflect the net effect of all transactions with the owner.
Referring to the definition of an expense, explain why the Drawings account is not closed to the Profit and Loss Summary account.
Although Drawings is an outflow of economic benefits in the form of a decrease in assets that reduces owner’s equity, it is expressly excluded from the definition of an expense, as it is a transaction with the owner.
Referring to one qualitative characteristic, explain why Drawings are not included in the calculation of profit.
Drawings is a transaction with the owner. Thus, to include drawings in the calculation of profit would be a direct breach of relevance. Relevance states that the accounting reports must contain all information that is useful for business decision-making; to include Drawings is to include information that is not useful for business decision-making.
Explain why it is necessary to prepare an Income Statement even when the profit figure is known.
The Income Statement details the revenues earned and expenses incurred during the Reporting Period and, in the process, shows both Gross Profit and Net Profit.It shows the reasons why that profit/loss occurred, giving the owner far more information on which to base his or her decisions.
Explain the relationship between the Profit and Loss Summary account and the Income Statement.
The Net Profit reported in the Income Statement should be the same figure determined in the Profit and Loss Summary account. This is because both will deduct expenses incurred from revenues earned for a particular Reporting Period.
Explain why the Income Statement is titled for the period rather than as at a particular date.
The information it reports is not confined to a single day, but covers a period of time.
Explain the difference between Cost of Sales and Cost of Goods Sold.
Cost of Goods Sold is a heading referring to all costs incurred in getting goods into a condition and location ready for sale, with Cost of Sales simply one of the items that may be reported under this heading.
Identify two revenues that would be classified as ‘Other Revenue’.
● Discount Revenue● Interest Revenue
Explain the purpose of preparing an Income Statement.
The purpose is to detail individual revenue and expense items, and to identify Gross Profit and Net Profit, thus making the report more useful as a decision-making tool.
Explain how the preparation of an Income Statement can assist decision-making.
It allows the owner to assess:● the firm’s ability to earn revenue so decisions can be made about the types of stock that are held for sale, the level and/or type of advertising, or the level of selling prices● the adequacy of the firm’s mark-up so decisions can be made about adjusting selling prices or controlling cost prices● the firm’s ability to control its expenses so decisions can be made about managing staff wages, protecting stock from stock loss, or operating more efficiently to control operating costs.
Explain how the preparation of an Income Statement can assist planning for the future.
By providing a basis for the next budget, the Income Statement will aid in the setting of targets for the future. This may include stock levels, staffing requirements or advertising expenditure.