Various Types of Transactions – Part 5, Disbursement or Release of Principal Sum of Loans or Borrowings from Third Parties

Business entities may apply for loans or borrow money from third parties (usually financial institutions; sometimes in the form of short term loans or advances from owners, directors & etc.). THIS IS NOT A SOURCE OF REVENUE OR OTHER INCOME. This is because the principal sum borrowed is a liability (resource – money that you get from others temporarily and you need to pay the price for this – interest). I include it together with the series of discussion of revenue and other income to follow the sequence of discussing various types of transactions appearing in the cash book. Upon fulfilling the terms and conditions set and agreement reached between the borrowers and the lenders, the principal sum of the loan will be realeased to the borrowers

The double entry involved in the recording of the realease of the loan is as follows:-

 

Balance Sheet

Income Statement

 

DR

CR

DR

CR

Cash at bank

24,000

     
Loan from XXX Bank

 

24,000

 

 

A decision need to be made as to whether the loan should be classified as current liability or non-current liability. This involves “splitting” the loan into the current portion and non-current portion in accordance with the repayment terms. Some business entities do not split the loan into current and non-current since it received the realease of the loan, nor during the financial year. The splitting of the loan into current and non-current portion is done ONLY as at the end of the financial year for proper financial statements presentation purposes. This is achieved by way of a reclassification journal entry once the current portion and non-current portion of the loan is calculated (this must be reflective of the position of the loan to the business entities as at the end of the financial year).

Assume the $24,000 loan received from XXX Bank is repayable over 5 years with monthly principal repayment of $500 (the interest on loan is purposely omitted), and as at the end of the financial year, the balance of the loan is $19,500 (This means 9 installments of $500 have been repaid). The portion of the loan to be classified as current liability is $6,000 (i.e. the amount expected to be repaid over the next 12 months from the end of the financial year, $500 x 12 months). The non-current portion of the loan is therefore $13,500 ($19,500 – $6,000). Assume the Loan from XXX Bank was originally classified as a current liabilities account, the reclassification journal entry is:-

 

Balance Sheet

Income Statement

 

DR

CR

DR

CR

Loan from XXX Bank (Current liabilities)

13,500

     
Loan from XXX Bank (Non-Current liabilities)

 

 

13,500

 

 

Further Example

The financial period of ABC Co. Ltd. is from 1 January to 31 December. On 1 January 2006, ABC Co. Ltd receive $100,000 loan from Northern Bank upon approval of its application submitted earlier. Interest is charged at 7% per annum calculated monthly. Based on these terms, the repayment schedule is tabulated as follows:-

Example Of Loan Repayment Schedule 

Assume ABC Co. Ltd. pays the installments on time

The double entries to record the transactions during the year ended 31 December 2006 are as follows:-

 

Balance Sheet

Income Statement

 

DR

CR

DR

CR

1 January 2006

 

     
 

 

     
Cash at bank

100,000

     
Loan from Northern  Bank

 

 

100,000

 

 

 

 

     
31 January 2006

 

     
 

 

     
Loan from Northern Bank

1,396.67

     
Interest expense

 

 

583.33

 
Cash at bank

 

1,980

   
(Please refer to instalment No. 1 of the repayment schedule)

 

     
 

 

     
28 February 2006

 

     
 

 

     
Loan from Northern Bank

1,404.81

     
Interest expense

 

 

575.19

 
Cash at bank

 

1,980

   
(Please refer to instalment No. 2 of the repayment schedule)

 

     
 

 

     
31 March 2006

 

     
 

 

     
Loan from Northern Bank

1,413.01

     
Interest expense

 

 

566.99

 
Cash at bank

 

1,980

   
(Please refer to instalment No. 3 of the repayment schedule)

 

     
 

 

     
30 April 2006

 

     
 

 

     
Loan from Northern Bank

1,421.25

     
Interest expense

 

 

558.75

 
Cash at bank

 

1,980

   
(Please refer to instalment No. 4 of the repayment schedule)

 

     
 

 

     
31 May 2006

 

     
 

 

     
Loan from Northern Bank

1,429.54

     
Interest expense

 

 

550.46

 
Cash at bank

 

1,980

   
(Please refer to instalment No. 5 of the repayment schedule)

 

     
 

 

     
30 June 2006

 

     
 

 

     
Loan from Northern Bank

1,437.88

     
Interest expense

 

 

542.12

 
Cash at bank

 

1,980

   
(Please refer to instalment No. 6 of the repayment schedule)

 

     
 

 

     
31 July 2006

 

     
 

 

     
Loan from Northern Bank

1,446.27

     
Interest expense

 

 

533.73

 
Cash at bank

 

1,980

   
(Please refer to instalment No. 7 of the repayment schedule)

 

     
 

 

     
31 August 2006

 

     
 

 

     
Loan from Northern Bank

1,454.71

     
Interest expense

 

 

525.29

 
Cash at bank

 

1,980

   
(Please refer to instalment No. 8 of the repayment schedule)

 

     
 

 

     
30 September 2006

 

     
 

 

     
Loan from Northern Bank

1,463.19

     
Interest expense

 

 

516.81

 
Cash at bank

 

1,980

   
(Please refer to instalment No. 9 of the repayment schedule)

 

     
 

 

     
31 October 2006

 

     
 

 

     
Loan from Northern Bank

1,471.73

     
Interest expense

 

 

508.27

 
Cash at bank

 

1,980

   
(Please refer to instalment No. 10 of the repayment schedule)

 

     
 

 

     
30 November 2006

 

     
 

 

     
Loan from Northern Bank

1,480.31

     
Interest expense

 

 

499.69

 
Cash at bank

 

1,980

   
(Please refer to instalment No. 11 of the repayment schedule)

 

     
 

 

     
31 December 2006

 

     
 

 

     
Loan from Northern Bank

1,488.95

     
Interest expense

 

 

491.05

 
Cash at bank

 

1,980

   
(Please refer to instalment No. 12 of the repayment schedule)

 

     

The relevant “T” accounts shown below provide a clearer picture of the figures involved in respect of the release of loan and the repayments recorded during the year ended 31 December 2006:-

ABC Co. Ltd

General Ledger

Loan From Northern Bank (Balance Sheet)

DEBIT

CREDIT

Date Descriptions Folio

 $

Date Descriptions Folio

 $

2006

     

2006

     

31-Jan

Cash at bank  

         1,396.67

01-Jan

Cash at bank  

   100,000.00

28-Feb

Cash at bank  

         1,404.81

     

 

31-Mar

Cash at bank  

         1,413.01

     

 

30-Apr

Cash at bank  

         1,421.25

       

31-May

Cash at bank  

         1,429.54

       

30-Jun

Cash at bank  

         1,437.88

       

31-Jul

Cash at bank  

         1,446.27

       

31-Aug

Cash at bank  

         1,454.71

       

30-Sep

Cash at bank  

         1,463.19

       

31-Oct

Cash at bank  

         1,471.73

       

30-Nov

Cash at bank  

         1,480.31

       

31-Dec

Cash at bank  

         1,488.95

       

31-Dec

Balance C/F  

       82,691.68

       
     

     100,000.00

     

   100,000.00

     

 

     

 

               

Cash at bank (Balance Sheet)

DEBIT

CREDIT

Date Descriptions Folio

 $

Date Descriptions Folio

 $

2006

   

 

2006

     

01-Jan

Balance B/F  

         5,467.98

31-Jan

Loan from Northern Bank  

       1,396.67

01-Jan

Cash at bank  

     100,000.00

31-Jan

Interest expense  

           583.33

     

 

28-Feb

Loan from Northern Bank  

       1,404.81

     

 

28-Feb

Interest expense  

           575.19

     

 

31-Mar

Loan from Northern Bank  

       1,413.01

     

 

31-Mar

Interest expense  

           566.99

     

 

30-Apr

Loan from Northern Bank  

       1,421.25

     

 

30-Apr

Interest expense  

           558.75

     

 

31-May

Loan from Northern Bank  

       1,429.54

     

 

31-May

Interest expense  

           550.46

     

 

30-Jun

Loan from Northern Bank  

       1,437.88

     

 

30-Jun

Interest expense  

           542.12

     

 

31-Jul

Loan from Northern Bank  

       1,446.27

     

 

31-Jul

Interest expense  

           533.73

     

 

31-Aug

Loan from Northern Bank  

       1,454.71

     

 

31-Aug

Interest expense  

           525.29

     

 

30-Sep

Loan from Northern Bank  

       1,463.19

     

 

30-Sep

Interest expense  

           516.81

     

 

31-Oct

Loan from Northern Bank  

       1,471.73

     

 

31-Oct

Interest expense  

           508.27

     

 

30-Nov

Loan from Northern Bank  

       1,480.31

     

 

30-Nov

Interest expense  

           499.69

     

 

31-Dec

Loan from Northern Bank  

       1,488.95

     

 

31-Dec

Interest expense  

           491.05

     

 

31-Dec

Balance C/F  

     81,707.98

     

     105,467.98

     

   105,467.98

     

 

     

 

               

Interest expense (income statement)

DEBIT

CREDIT

Date Descriptions Folio

 $

Date Descriptions Folio

 $

2006

     

2006

     

31-Jan

Interest expense  

             583.33

31-Dec

To income statement  

       6,451.68

28-Feb

Interest expense  

             575.19

     

 

31-Mar

Interest expense  

             566.99

     

 

30-Apr

Interest expense  

             558.75

     

 

31-May

Interest expense  

             550.46

     

 

30-Jun

Interest expense  

             542.12

     

 

31-Jul

Interest expense  

             533.73

     

 

31-Aug

Interest expense  

             525.29

     

 

30-Sep

Interest expense  

             516.81

     

 

31-Oct

Interest expense  

             508.27

     

 

30-Nov

Interest expense  

             499.69

     

 

31-Dec

Interest expense  

             491.05

     

 

     

         6,451.68

     

       6,451.68

     

 

     

 

Before the income statement and balance sheet of ABC Co. Ltd. are finalized, a reclassification journal entry is required to present correctly the current portion and non-current portion of the Loan from Northern Bank. From the “T” account shown above, the outstanding amount of Loan from Northern Bank as at 31 December 2006 was $82,691.68 (31-Dec Balance C/F). From the loan repayment schedule, the principal sum expected to be repaid in Year 2 is $18,559.53. This is the portion of the loan expected to be repaid within 12 months from the year end i.e. 31 December 2006 and therefore should be presented as a current liabilities item. The non-current portion of the loan is calculated as follows:-

Principal sum outstanding as at 31 December 2006

            82,691.68

Principal sum expected to be repaid in the next 12 months

            (18,559.53)

Principal sum expected to be repaid after the next 12 months

            64,132.15

Assume the Loan from Northern Bank was originally classified as a current liabilities account, the following reclassification journal entry is required to reflect correctly the current portion and the non-current portion of the loan on the balance sheet:-

 

Balance Sheet

Income Statement

 

DR

CR

DR

CR

Loan from Northern Bank (Current liabilities)

 

64,132.15

     
Loan from Northern Bank (Non-Current liabilities)

 

 

 

64,132.15

 

 

The income statement and balance sheet of ABC Co. Ltd. after the above transactions being recorded in the respective accounts and also the impact of the $64,132.15 reclassification journal entry are as follows: –

Income Statement and Balance Sheet of ABC Co. Ltd.
         
Income Statement for the year ended 31 December 2006
  BEFORE

 Adjustment

 AFTER
   

 DR

 CR

 
 

 $

   

 $

Sales

          109,270.00

   

             109,270.00

Cost of Sales

–          40,875.00

   

–              40,875.00

Gross profit

            68,395.00

   

               68,395.00

Other income: –        
Rental income

            12,000.00

   

               12,000.00

Operating expenses: –        
Accountancy fee

–                800.00

   

–                    800.00

Depreciation of property, plant and equipment

–             4,400.00

   

–                4,400.00

Donation

–                500.00

   

–                    500.00

Electricity & water

–             3,340.00

   

–                3,340.00

Interest expense

–   6,451.68

   

–                6,451.68

Printing & stationery

–             1,697.00

   

–                1,697.00

Rental of premises

–          12,000.00

   

–              12,000.00

Salaries

–          27,865.00

   

–              27,865.00

Upkeep of office

–             3,547.00

   

–                3,547.00

Telephone charges

–             1,285.00

   

–                1,285.00

Travelling, petrol & toll charges

–             2,648.00

   

–                2,648.00

 

–          64,533.68

   

–              64,533.68

Net profit for the year

            15,861.32

   

               15,861.32

Retained profits B/F

            27,654.00

   

               27,654.00

Retained profits C/F

            43,515.32

   

               43,515.32

         
Balance Sheet as at 31 December 2006        
 

 $

   

 $

Non-current assets        
Property, plant and equipment

            19,600.00

   

               19,600.00

         
Current assets        
Inventories

              5,000.00

   

                  5,000.00

Trade receivables

            32,807.00

   

               32,807.00

Other receivables, deposits & prepayments:

 

   

 

Rental receivable

              3,000.00

   

                  3,000.00

Rental deposit

              3,000.00

   

                  3,000.00

Utility deposit

                  500.00

   

                     500.00

Cash and bank balances

          105,467.98

   

             105,467.98

 

          149,774.98

   

             149,774.98

Current liabilities        
Trade payables

–             3,588.00

   

–                3,588.00

Other payables and accruals

–          24,579.98

   

–              24,579.98

Loan from Northern Bank

– 82,691.68

   64,132.15

 

–   18,559.53

 

–        110,859.66

   

–              43,139.51

Net current assets

            38,915.32

   

             106,635.47

 

            58,515.32

   

             126,235.47

Financed by: –        
Share capital

            15,000.00

   

               15,000.00

Retained profits

            43,515.32

   

               43,515.32

 

            58,515.32

   

               58,515.32

Non-current Liabilities        
Loan from Northern Bank

 

  64,132.15

     64,132.15

 

            58,515.32

   

             122,647.47

Various Types of Transactions – Collection from Sales or Services Rendered (Part 3)

For profit orientated entities, revenue is the “bloodline” of the businesses. The cash collected from invoicing or billing is vital in keeping the businesses up and running – meeting all sorts of daily expenses. Depending on the nature of the businesses, the sales invoices or bills issued to customers are for the sale of goods or services rendered. Generally the invoices or bills issued could be on cash term (pay on delivery of goods or services performed) or on credit term (e.g. 30 days, 60 days, 90 days etc). I have discussed in length the day book used in recording sales, the sales ledger and posting to the relevant accounts in the general ledger. The double entry for recording both the cash sales and credit sales are shown below:

Cash Sales

Balance Sheet

Income Statement

DR

CR

DR

CR

Petty cash/cash at bank

XXXX

Sales

XXXX

Credit Sales

a. Upon Recognition of Revenue

Balance Sheet

Income Statement

DR

CR

DR

CR

Trade debtors

XXXX

Sales

XXXX

b. Upon Receiving Payments from Trade Debtors

Balance Sheet

Income Statement

DR

CR

DR

CR

Petty cash/cash at bank

XXXX

Trade debtors

XXXX

The recording of collection from sales or services rendered usually is a straight forward matter. The “grey area” or issue involved usually is associated with when revenue should be recognised. This is because different industries have their own unique ways of conducting the businesses. As stated in the Objective Section of International Accounting Standard (IAS) 18: Revenue, revenue is recognised when it is probable that future economic benefits will flow to the entity and these benefits can be measure reliably.

For a typical business selling goods to its customers, the point of recognising revenue usually is at the point when the substantial risks and rewards associated with the goods have been transferred to its customers – usually when goods is delivered to and accepted by its customers. IAS 18 states the criteria of recognising revenue from sale of goods as follows: –

Revenue from the sale of goods shall be recognised when all the following conditions have been satisfied:

(a) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;

(b) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;

(c) the amount of revenue can be measured reliably;

(d) it is probable that the economic benefits associated with the transaction will flow to the entity; and

(e) the costs incurred or to be incurred in respect of the transaction can be measured reliably.

For a typical business rendering services to its customers, recognition of revenue is depending on the stage of completion of the services at the measurement point (at the balance sheet date – it could be the end of the month or the end of the year depending on the financial period determined by the entity). Stage of completion is referring to at the measurement point, the percentage of the services completed. For example, if the percentage of completion is 50% and $100,000 is to be invoiced to the customer when the job is completed, $50,000 would be recognised as revenue. Please take note that the cost associated with the revenue should also be recognised using the same percentage of completion method. IAS 18 states the criteria of recognising revenue from services rendered as follows: –

When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognised by reference to the stage of completion of the transaction at the balance sheet date. The outcome of a transaction can be estimated reliably when all the following conditions are satisfied:

(a) the amount of revenue can be measured reliably;

(b) it is probable that the economic benefits associated with the transaction will flow to the entity;

(c) the stage of completion of the transaction at the balance sheet date can be measured reliably; and

(d) the costs incurred for the transaction and the costs to complete the transaction can be measured reliably.

Many small businesses rendering services to their customers would find it very challenging to comply with the requirements of recognising revenue and the costs by way of percentage of completion method. This is because this requires a detailed tracking mechanism of the costs of each job and also the stage of completion throughout the life of each project/job. Some countries may have set their own requirement as to the application of accounting standards by giving exemption to “small entities” in respect of using percentage of completion method in recognising the revenue and costs. If this is the case, revenue and costs would usually be recognised using the completed contract method – i.e. the revenue and the relevant costs would be deferred from being recognised in the income statement until when the job is completed.

I will not discuss in detail the requirements of IAS 18 here as this article is just meant to be an introduction to the recording of revenue. If you are interested to know more about the issues involved regarding revenue, please refer to IAS 18. Appendix 1 of IAS 18 shows examples of different type of sales transactions including “Bill and Hold” sales, goods shipped subject to conditions, lay away sales under which the goods are delivered only when the buyer makes the final payment in a series of instalments, installation fees, servicing fees included in the price of the product, advertising commissions & etc. that are worth reading.

Various Types of Transactions – Contribution of Capital from Owners (Part 2)

When owners inject cash into businesses as capital, the double entry to record this type of transactions is: –

Balance Sheet

Income Statement

DR

CR

DR

CR

Petty cash/cash at bank

XXXX

Capital

XXXX

Cash injections could be done by way of contributing “hard cash”. If this is the case, the asset account debited is the Petty Cash account. Cash injections could also be done by way of the owners issue cheques. If this is the case, the asset account debited is the Cash at Bank account. Usually, if the amount involved is huge, cheques are issued instead of hard cash.

Following the rule of double entry recording system, whenever there is a debit entry made to an account (the Petty Cash of Cash at Bank account in this illustration), there must also be a credit entry made to an account (the Capital account in this illustration).

Please refer to Debits And Credits and The Accounting Equation if you need further explanations on double entry recording system and the accounting equation. If you need explanation on the difference between balance sheet and income statement, please refer to The Balance Sheet and The Income Statement .

For sole proprietorships and partnerships, the account to be credited whenever there are capital injections is called the “Capital Account”. Please take note that for many sole proprietorships and partnerships (especially for partnerships), there could be another account called “Current Account” maintained to record those transactions between the business and the partners such as profit attributable to each partner during the year, salary, interest on capital contributions, drawings OTHER THAN the capital transactions. Please refer to my post: Three Most Common Types of Small Businesses for an example of income statement and balance sheet of a partnership. Do not be confused with the current account opened with banking institutions. They are different. Capital Accounts and Current Accounts are maintained for each partner to show the capital position of each partner and their other dealings with the business.

For sole proprietorships, the importance of maintaining a separate Capital Account and Current account is not as apparent if compared to that of partnerships because all the transactions recorded in the Capital Account and the Current Account are attributable to only one person i.e. the owner. You may have come across many instances of the balance sheets prepared for sole proprietors with no separate Capital Account and Current Account maintained. In this case, all the transactions in the Capital Account and Current Account are recorded in one single account named “Capital Account”. Example of the equity section of the balance sheet of a sole proprietor using this method of recording is as follows: –

Capital:

$

Balance at beginning of year

5,178

Add: Additional capital injections during the year

15,000

Add: Profit for the year

3,152

Less: Net drawings during the year

(8,000)

Balance as at end of year

15,330

Some partnerships may choose this method of recording. However, the drawback is that there is no ready information available on how much is the accumulated capital amount that has been contributed by each partner. There could also be situations whereby the net drawings of some partners exceeded the capital amount that they have contributed and nobody realise this!

For private limited companies, whenever there are capital injections, the account to be credited is called “Share Capital Account”. Some call it “Paid-up Share Capital Account”. This is because there could be instances of unpaid capital by shareholders. I will explain this in another topic. The main difference if compared with the balance sheet of sole proprietorships or partnerships is no separate current account maintained. Any withdrawal or advance of money to private limited companies by shareholders are recorded separately in the balance sheet account called Amount due by Shareholder (current asset) or Amount due to Shareholder (current liability) depending on whether it is the Company who owe the shareholder money or the other way round. The amount owing usually is classified as current asset or current liability because the nature of the transactions is short term in nature. Even though there are instances where the amount due to or due by shareholders remained unpaid/unsettled for more than a year because there was no repayment fixed in the first place, it is deemed to be repayable on demand and is therefore classified as current asset or current liability.

Please take note that it may not be a straight forward matter for a company to give or obtain loan or advances from shareholders or in fact any other parties because it is the board of directors that has the power to manage the business of the company and make decisions on the company’s behalf – Not the shareholders. A shareholder may not sit on the board of directors and even though he or she does in fact sit on the board of directors, the decision making power lies with the board of directors, not on individual directors. Therefore, in making a decision whether the company should give or receive advance or loan from any party including shareholders, the board of directors has a duty to ensure that it is done on the basis that the company’s best interest is taken care of. It should also be noted that shareholders are not “powerless” entirely. They usually are given the power in the articles of association of the company such as to elect directors, set their remuneration in members’ annual general meetings and also on matters that would alter the capital of the company.

Various Types of Transactions – Introduction (Part 1)

It is easier to understand the basic principles and concepts of accounting once you are familiar with the types of transactions that a typical business entity has to deal with. There is no better place to start with knowing what kind of receipts a typical business receives and also the type of payments made. Even though numerous transactions nowadays are done on credit, eventually the amount owed is expected to be settled or paid.

Receipts

Generally, the receipt transactions of a typical business include the following:-

· Contribution of capital from owners

· Collection from sales or services rendered (cash sales or payments received from trade debtors). This is usually the major source of revenue or income of the business entity

· Collection from other source of revenue or income:-

o Interest income

This is earned through deposits placement with financial institutions. Sometimes, it is also earned through lending of money to third parties (Some countries have strict laws governing money lending activities) o Dividend income

This is earned through investment of shares in another company. It is a return on investment made.

o Rental income

This is earned through the letting of its assets (property, machinery, equipment & etc).

o Proceeds from disposal of assets

These are in respect of the money received as a result of the disposal of property, machinery, equipment & etc.

o Compensation received for loss of assets

Compensation received from insurance companies for stolen or damaged assets.

· Disbursement/Release of principal sum of loans or borrowings from third parties (usually financial institutions)

· Refund of deposits placed earlier with third parties

o E.g. The refund of rental and utility deposits upon termination of rental of premises.

Payments

Generally, they are for the following purposes: –

· For the inventories/stocks and related costs in which those inventories or stocks are meant for subsequent sale. (Generally all of these are called inventory costs)

· For capital expenditure.

· For revenue expenditure.

· For tax on the profits generated (due to income tax law requirements)

· For distribution of profits back to the owners in the form of dividends

· Sometimes as short term advance of money or loan to other entities ( it could be individuals including the owners, directors, employees or non-individuals such as companies who have business dealing with it)

· Of course on the other hand, it could be for repayment of loan or short term advance include interest for the money the business entities had borrowed earlier

· For refundable deposits of money paid to third parties or prepayment of capital and revenue expenditure

· Payment for investment in shares

· Deposit of money with financial institutions

· In less frequent instances, return of capital back to the owners

I will discuss the above one by one in my subsequent posts. However I am going to discuss briefly here on the double entries involved for the above transactions.

Receipts

For all receipt transactions above, if the transactions were in cash or cheques, the debit entry must be made to the petty cash or cash at bank account. The question here is – what should be the credit entry? Which account? Is it a credit to an income statement item account or to a balance sheet item account?

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank/Petty Cash

XXXX

?

?

?

Payments

On the other hand, if the transactions were in cash or cheques, the credit entry must be made to the petty cash or cash at bank account. The question is – what should be the debit entry? Which account? Is it a debit to an income statement item account or a debit to a balance sheet item account?

Balance Sheet

Income Statement

DR

CR

DR

CR

?

?

?

Cash at bank/Petty Cash

XXXX

Three Most Common Types of Small Businesses – Sole Proprietorships, Partnerships and Private Limited Companies

Sole Proprietorships

This is the type of business which legally the business entity is not separated from the owner. However, do not get yourself confused with the Separate Entity Concept in accounting. Usually the business is registered with government under a trade name (either with some association with the name of the owner or a different name altogether) and this trade name will represent the business entity in the conduct of its business activities.

Partnerships

This is the type of business with more than one owner. All the owners are called partners. In general all the partners contribute capital to the business and share common objectives of making the business successful and share the profits generated. Generally in law, the partners may have joint liability or joint and several liabilities. However, some countries may allow partnerships in which the liabilities of partners are limited. A partnership agreement could be used to set the terms and conditions among the partners.

Private Limited Companies

Some countries allow single member limited companies to be incorporated and some require minimum two members. The clear distinction of private limited companies from sole proprietorship and partnership is the liability of members is limited to the capital invested. Another distinct feature of limited private companies is that the governing body of the companies are the board of directors. The company incorporated carries its own identity under law and can sue and be sued by others. Of course when a company is found to have guilty legally, financial penalties are imposed because it is meaningless to impose jail terms on companies. In these circumstances, the relevant individuals behind the company (usually the directors) may be penalised financially, with jail terms or both. The relationship between the companies, the members/shareholders and the directors is unique and also can be a complex one whenever there are disputes between the company with third parties or disputes between members/shareholders or among the members of the board of directors. There are relevant sections in the Companies Act or Corporations Act of each country touching on this and of course there are common laws which have set down the legal principles since centuries ago.

You could find a lot of reading materials on the legal aspects of the above three types of business entities. Therefore, I only described them briefly in this post.

Example of Income Statement and Balance Sheet of a Sole Proprietor

Income Statement for the year ended 31 December 2006

$

Sales

159,270

Cost of Sales

– 90,875

Gross profit

68,395

Other income: –
Interest income

2,356

Operating expenses: –
Accountancy fee

– 800

Depreciation of property, plant and equipment

– 2,500

Donation

– 500

Electricity & water

– 3,340

Insurance premium

– 2,000

Printing & stationery

– 1,697

Rental of premises – 12,000
Salaries

– 35,579

Upkeep of office

– 3,547

Telephone charges

– 1,285

Travelling, petrol & toll charges

– 2,648

– 65,896

Net profit for the year

4,855

Retained profits B/F

27,654

Retained profits C/F

32,509

Balance Sheet as at 31 December 2006

$

Non-current assets
Property, plant and equipment

15,000

Current assets
Inventories

5,200

Trade receivables

6,000

Other receivables, deposits & prepayments

3,458

Cash and bank balances

10,639

25,297

Current liabilities
Trade payables

– 3,588

Other payables and accruals

– 2,575

– 6,163

Net current assets

19,134

34,134

Financed by: –
Capital

15,000

Retained profits

32,509

Net drawings

– 13,375

34,134

Example of Income Statement and Balance Sheet of a Partnership

Income Statement for the year ended 31 December 2006

$

Sales

159,270

Cost of Sales

– 90,875

Gross profit

68,395

Other income: –
Interest income

2,356

Operating expenses: –
Accountancy fee

– 800

Depreciation of property, plant and equipment

– 2,500

Donation

– 500

Electricity & water

– 3,340

Insurance premium

– 2,000

Printing & stationery

– 1,697

Rental of premises

– 12,000

Salaries

– 35,579

Upkeep of office

– 3,547

Telephone charges

– 1,285

Travelling, petrol & toll charges

– 2,648

– 65,896

Profit for the year

4,855

Add: –
Interest on partner’s drawings
Partner A 1,500
Partner B 2,000 3,500
Less: –
Partner’s salary
Partner A – 15,000
Partner B – 20,000 – 35,000
Partner’s commision
Partner A – 3,000
Partner B – 2,000 – 5,000
Interest charged on partner’s capital
Partner A – 2,500
Partner B – 3,500 – 6,000
Net loss for the year – 37,645
Shared as follows: –
Partner A – 60% – 22,587
Partner B – 40% – 15,058
– 37,645

Analysed as follows: –

Partner A

Partner B

Total

$

$

$

Shared net loss for the year

– 22,587

– 15,058

– 37,645

Less: –
Interest on partner’s drawings

– 1,500

– 2,000

– 3,500

Add: –
Partner’s salary

15,000

20,000

35,000

Partner’s commission

3,000

2,000

5,000

Interest charged on partner’s capital

2,500

3,500

6,000

Net profit for the year

– 3,587

8,442

4,855

Note 1

Note 1

Balance Sheet as at 31 December 2006

$

Non-current assets
Property, plant and equipment

15,000

Current assets
Inventories

5,200

Trade receivables

6,000

Other receivables, deposits & prepayments

3,458

Cash and bank balances

10,639

25,297

Current liabilities
Trade payables

– 3,588

Other payables and accruals

– 2,575

– 6,163

Net current assets

19,134

34,134

Financed by: –
Partner A Partner B

Total

$

$

$

Capital account

9,000

6,000

15,000

Current account
Balance B/F

45,874

24,280

70,154

Shared net loss for the year

– 22,587

– 15,058

– 37,645

Net drawings during the year

– 12,000

– 5,000

– 13,375

Balance C/F

11,287

4,222

19,134

20,287

10,222

34,134

Note 1: the net loss for the year for Partner A of $3,587 and net profit of Partner B of $8,422 were derived by calculating from the share of net loss for the year of $37,645, taken into account of the interest on capital, interest on drawings, salary and commission of each partner. You would not be able to know how much is each partner’s share of profit or loss directly from the net profit of $4,855.

Example of Income Statement and Balance Sheet of a Private Limited Company

Income Statement for the year ended 31 December 2006

$

Sales

159,270

Cost of Sales

– 90,875

Gross profit

68,395

Other income: –
Interest income

2,356

Operating expenses: –
Accountancy fee

– 800

Depreciation of property, plant and equipment

– 2,500

Donation

– 500

Electricity & water

– 3,340

Insurance premium

– 2,000

Printing & stationery

– 1,697

Rental of premises

– 12,000

Salaries

– 35,579

Upkeep of office

– 3,547

Telephone charges

– 1,285

Travelling, petrol & toll charges

– 2,648

– 65,896

Net profit for the year

4,855

Retained profits B/F

27,654

Retained profits C/F

32,509

Balance Sheet as at 31 December 2006

$

Non-current assets
Property, plant and equipment

15,000

Current assets
Inventories

5,200

Trade receivables

6,000

Other receivables, deposits & prepayments

3,458

Amount due by shareholders

13,375

Note 2
Cash and bank balances

10,639

38,672

Current liabilities
Trade payables

– 3,588

Other payables and accruals

– 2,575

– 6,163

Net current assets

32,509

47,509

Financed by: –
Share capital

15,000

Retained profits

32,509

47,509

Note 2: in this example, the net drawings of the owner in the example of a Sole Proprietor has been shown as amount due by shareholders for comparison purposes

Cash Basis Vs Accrual Basis of Accounting

Many small businesses use cash basis of accounting to record transactions, especially those who prepare the accounts once a year. Please refer to my post: Preparing Accounts of Small Businesses Once A Year – Tips and Pitfalls To Avoid for further illustrations.

Indications that cash basis of accounting is used includes the following:-

  • No books of original entry such as sales day book and purchases day book used to record sales and purchases.
  • No debtors ledger or creditors ledger maintained.
  • All receipts and payments are recorded directly in cash book.

Cash basis of recording transactions and presenting the financial statements produced has long been deemed an inappropriate basis to use. Accrual basis of accounting is the accepted basis and this is stated in International Accounting Standard (IAS) 1: Presentation of Financial Statements.

It is good if a business entity is aware of the difference between cash basis and accrual basis of accounting and records its transactions using accrual basis. However, for those businesses who have recorded the transactions using cash basis do not need to discard those set of accounts produced and record all past transactions using accrual basis of accounting all over again. What need to be done is re-examine all the account items that have been produced using cash basis of accounting to determine as to whether any adjustment is required to adjust those items should accrual basis of accounting is used. Some examples: –

  1. Sale of goods

    Under cash basis of accounting, all proceeds collected from sales are recorded in the accounting records upon receiving payments from customers. The balance sheets produced using cash basis of accounting do not show any trade debtor balances! Those sales figures shown in the income statements represent only cash sales. No credit sales are recorded.

    The solution is to identify all bills and invoices of those sales in which the transactions have occurred as at the end of the financial year, but still unpaid, i.e. those unpaid sales invoices or bills and put through a journal adjustment to recognise the credit sales and trade debtors as follows: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Trade debtors

    XXXX

    Sales

    XXXX

    A point to note on the criteria used to determine the occurrence of transactions (sales recognition in this case) is usually based on delivery and acceptance of goods by customers. You may have come across the solution because I have discussed this in Step 4a, The Worst Case Scenario of my post: Preparing Accounts of Small Businesses Once A Year – Tips and Pitfalls To Avoid.

  2. Purchase of goods

    This is the opposite of sales of goods discussed above. Similarly, the balance sheets produced under cash basis of accounting will not show any trade creditor balances. The purchases figures shown in the income statements represent only cash purchases. No credit purchases are recorded.

    The solution is the same as discussed in sale of goods above. You need to identify all unpaid bills and invoices in which the transactions have occurred as at the end of the financial year, but still unpaid, i.e. those unpaid purchase invoices or bills and put through a journal adjustment to recognise the credit purchases and trade creditors as follows: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Purchases

    XXXX

    Trade Creditors

    XXXX

  3. Prepayments
  4. Some expenses are paid now but part of them or the entire sums are meant for future period. This is the reason that they are called “Prepayments”. Under cash basis of accounting, prepayments are usually recorded as the respective expense accounts. What is required here is an adjustment to recognise the prepayments as current assets i.e. those portion of the payments that are meant for the next financial year.

    The original double entry recording the transactions when payments are made: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Expenses

    XXXX

    Cash at bank

    XXXX

    Adjustment for prepayments recognition:-

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Prepayments

    XXXX

    Expenses

    XXXX

    Example

    The financial period of ABC Co. Ltd. is from 1 January 2007 to 31 December 2007. On 1 November 2007, ABC Co. Ltd. paid the insurance premium for its fire policy covering the period from 1 December 2007 to 30 November 2008. The amount paid was $2,400. The prepayment for insurance is therefore $2,200 ($2,400/12 months x 11 months for the period from 1 January 2008 to 30 November 2008).

    The original double entry recording the transactions when payments are made: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Insurance premium

    2,400

    Cash at bank

    2,400

    Adjustment for prepayment recognition:-

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Prepayments

    2,200

    Insurance premium

    2,200

    The balance sheet and income statement of ABC Co. Ltd. before and after this adjustment for prepayment recognition are shown below to illustrate the impact of this adjustment: –

Example of Income Statement and Balance Sheet of ABC Co. Ltd.
Income Statement for the year ended 31 December 2007

BEFORE

Adjustment

AFTER

DR

CR

$

$

Sales

159,270

159,270
Cost of Sales

– 90,875

– 90,875
Gross profit

68,395

68,395
Other income: –
Interest income

2,356

2,356
Operating expenses: –
Accountancy fee

-800

– 800
Depreciation of property, plant and equipment

-2,500

– 2,500
Donation

-500

– 500
Electricity & water

-3,340

– 3,340
Insurance premium

-2,400

2,200 – 200
Printing & stationery

– 1,697

– 1,697
Rental of premises

-12,000

– 12,000
Salaries

-35,579

– 35,579
Upkeep of office

-3,547

– 3,547
Telephone charges

-1,285

– 1,285
Travelling, petrol & toll charges

-2,648

– 2,648

-66,296

– 64,096
Net profit for the year

4,455

6,655
Retained profits B/F

27,654

27,654
Retained profits C/F

32,109

34,309
Balance Sheet as at 31 December 2007

$

$

Non-current assets
Property, plant and equipment

15,000

15,000
Current assets
Inventories

5,200

5,200
Trade receivables

6,000

6,000
Other receivables, deposits & prepayments:
Sundry receivables

1,058

1,058
Deposits

2,000

2,000
Prepayments

2,200 2,200
Amount due by shareholders

13,375

13,375
Cash and bank balances

10,639

10,639

38,272

40,472
Current liabilities
Trade payables

-3,588

– 3,588
Other payables and accruals

-2,575

– 2,575

-6,163

– 6,163
Net current assets

32,109

34,309

47,109

49,309
Financed by: –
Share capital

15,000

15,000
Retained profits

32,109

34,309

47,109

49,309
  1. Interest income

    Business entities may place excess cash as term deposits with financial institutions to earn interest income. Under cash basis of accounting, there was no interest income recognised and recorded in the accounts until the business entities receive the interest upon maturity of the term deposits.

    However, under accrual basis of accounting, the amount of interest attributable to the relevant period of the deposits placement must be calculated and recognised accordingly. For examples, the financial period of ABC Co. Ltd. is from 1 January 2007 to 31 December 2007. On 1 July 2007, ABC Co. Ltd. placed $100,000 with its bank as term deposit for 1 year. The interest rate is 3.5% per annum. The interest earned from 1 July 2007 to 30 June 2008 is $350 ($100,000 x 3.5%). In respect for the accounts of ABC Co. Ltd. for the year ended 31 December 2007, the portion of the interest income to be recognised is $175 ($350 x 6months/12months for the period from 1 January 2007 to 31 December 2007).

    The journal adjustment to recognise this interest income is as follows: –

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Interest receivable

    175

    Interest income

    175

    The balance sheet and income statement of ABC Co. Ltd. before and after this adjustment for interest income recognition are shown below to illustrate the impact of this adjustment: –

Example of Income Statement and Balance Sheet of ABC Co. Ltd.
Income Statement for the year ended 31 December 2007

BEFORE

Adjustment

AFTER

DR

CR

$

$

Sales

159,270

159,270
Cost of Sales

-90,875

– 90,875
Gross profit

68,395

68,395
Other income: –
Interest income

175 175
Operating expenses: –
Accountancy fee

-800

– 800
Depreciation of property, plant and equipment

-2,500

– 2,500
Donation

-500

– 500
Electricity & water

-3,340

– 3,340
Insurance premium

-200

– 200
Printing & stationery

– 1,697

– 1,697
Rental of premises

-12,000

– 12,000
Salaries

-35,579

– 35,579
Upkeep of office

-3,547

– 3,547
Telephone charges

-1,285

– 1,285
Travelling, petrol & toll charges

-2,648

– 2,648

-64,096

– 64,096
Net profit for the year

4,299

4,474

Retained profits B/F

27,654

27,654
Retained profits C/F

31,953

32,128
Balance Sheet as at 31 December 2007

$

$

Non-current assets
Property, plant and equipment

15,000

15,000
Current assets
Inventories

5,200

5,200
Trade receivables

6,000

6,000
Other receivables, deposits & prepayments:
Interest receivable

175 175
Deposits

14,077

14,077
Prepayments

2,200

2,200
Fixed deposit with licensed bank

100,000

100,000
Cash and bank balances

10,639

10,639

138,116

138,291
Current liabilities
Trade payables

-3,588

– 3,588
Other payables and accruals

-102,575

– 102,575

– 106,163

– 106,163
Net current assets

31,953

32,128

46,953

47,128
Financed by: –
Share capital

15,000

15,000
Retained profits

31,953

32,128

46,953

47,128

On 30 June 2008, when the deposit matures and interest of $350 is received by ABC Co. Ltd., the double entry to record these transactions is as follows:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank

100,350

Fixed deposit with licensed bank

100,000

Interest receivable

175

Interest income

175

The balance sheet and income statement of ABC Co. Ltd. for the year ended 31 December 2008 before and after this adjustment are shown below to illustrate the impact of this adjustment: –

Example of Income Statement and Balance Sheet of ABC Co. Ltd.
Income Statement for the year ended 31 December 2008

BEFORE

Adjustment

AFTER

DR

CR

$

$

Sales

109,270

109,270
Cost of Sales

– 40,875

– 40,875
Gross profit

68,395

68,395
Other income: –
Interest income

175 175
Operating expenses: –
Accountancy fee

– 800

– 800
Depreciation of property, plant and equipment

– 2,500

– 2,500
Donation

– 500

– 500
Electricity & water

– 3,340

– 3,340
Insurance premium

– 200

– 200
Printing & stationery

– 1,697

– 1,697
Rental of premises

– 12,000

– 12,000
Salaries

– 27,865

– 27,865
Upkeep of office

– 3,547

– 3,547
Telephone charges

– 1,285

– 1,285
Travelling, petrol & toll charges

– 2,648

– 2,648

– 56,382

– 56,382
Net profit for the year

12,013

12,188
Retained profits B/F

27,654

27,654
Retained profits C/F

39,667

39,842
Balance Sheet as at 31 December 2007

$

$

Non-current assets
Property, plant and equipment

10,000

10,000
Current assets
Inventories

5,000

5,000
Trade receivables

17,030

17,030
Other receivables, deposits & prepayments:
Interest receivable

175

175

Deposits

14,077

14,077
Prepayments

2,200

2,200
Fixed deposit with licensed bank

100,000

100,000

Cash and bank balances

12,348

100,350 112,698

150,830

151,005
Current liabilities
Trade payables

-3,588

– 3,588
Other payables and accruals

-102,575

– 102,575

-106,163

– 106,163
Net current assets

44,667

44,842

54,667

54,842

Financed by: –
Share capital

15,000

15,000

Retained profits

39,667

39,842

54,667

54,842

Out of the $350 interest received, $175 was credited to the interest receivable account and $175 is credited to the interest income account for the year ended 31 December 2008 (for the interest earned for the period from 1 January 2008 to 31 December 2008.

The interest was calculated based on simple interest method. For illustrations on the difference between simple interest and compound interest, please refer to my post: Effective Interest? Simple Interest? Compound Interest? Nominal Interest?