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CHAPTER 1

INTRODUCTION TO FINANCIAL ACCOUNTING

1 WHAT IS ACCOUNTING?

1.1 Accounting is the process of identifying, measuring, recording,


summarizing economic information and finally communicating it
to interested parties (users)

1.2 ANALYSIS OF DEFINITION

(a) Process mean accounting has steps and procedures of


doing things.

(b) Identifying means accounting is only concerned with


activities or transactions relating to the business.

(c) Measuring means that all activities related to the business


should be stated in monetary terms.

(d) Recording is the aspect of writing down business


transactions in accounting books. This is called BOOK
KEEPING.

(e) Summarising means analyzing all recorded information in


categories and preparing financial statements.

Financial statements include:

(i) Income statement, which is a summary of trading


activities to establish profit or loss achieved during a
trading period.
(ii) Balance sheet which is a summary of what the
business owns or owes at a given time.

(f) Financial statements should be provided to any body


interested for assessment and decision making
(communication).

. Can you describe who an accountant is?


2. TYPES OF BUSINESSES

2.1 WHAT IS A BUSINESS?

A business is defined variously to suit one’s requirements. In our


studies we shall define a business as: “a person, firm, company
or other organisation which makes or produces some kind of
service usually for the purpose of making profits.”
- Profit is excess of Income over Expenditure
- Loss is excess of Expenditure over Income

Business can be organised at different levels with a major


limiting factor being resources (capital).

Businesses range from basic simple business to a more complex


one.

2.2 SOLE TRADER

This is the type of business owned and operated by one person.


However, the person running this business can have employees.

The sole trader, as an individual will provide the resources and


skills to operate the business.

Maintaining accounting records in a sole trader may vary from


basic to complex as some sole trader may grow very big.

2.3 PARTNERSHIP

This is a type of business where two or more persons put their


resources together to carry on business for the purpose of
making profits. There is a limit as to the number of partners
depending on the type of business to be carried on.

2.4 COMPANY

This is a formal association of persons for business purposes. A


company is legally incorporated under company law.

Members of a company are called shareholders.


Companies are usually limited (Ltd) meaning that if the company
goes into liquidation because of debts, each member will only
lose the cost of his shares i.e. amount contributed in the
business and no more.

2.5 TYPES OF LIMITED COMPANIES

(a) PRIVATE COMPANIES

They are private in the sense that membership is restricted


to well known individuals and members are few in
numbers.

Private companies usually have the word “LIMITED” at the


end of the name. Other countries use the word “PRIVATE”.

They do not invite members of the public to subscribe for


shares and members are not allowed to transfer their
shares without agreement of the other shareholders.

(b) PUBLIC COMPANIES

They offer shares to the public and there is no limit to


membership.

Shareholders can transfer shares without restrictions. Such


a company must include the words PUBLIC LIMITED
COMPANY (Abbr. PLC) after its name.

USERS OF ACCOUNTING INFORMATION

When financial statements are prepared they are passed on to interested


parties who might need them for various reasons.

The following might be interested in financial information.

(a) Managers of the organization:

Managers are people appointed by owners of the company to


supervise the daily activities of the company.

Managers need accounting information to make planning decisions.

(b) Shareholders and potential investors:


A shareholder is a member of limited company and therefore holds one
or more shares in that company. Potential investors are people with
resources but are yet to make a decision as to where to invest.

Shareholders are interested in profits and security of their investment.


They need to look at accounting information to access profitability of
the company and will make decisions such as retaining their
investment in the company or invest it somewhere else.

(c) Trade contacts:

Trade contacts are suppliers of goods and services to the company.


They also include customers.

Credit suppliers are interested in the ability of the company to pay its
debts should they supply to it.

Customers are interested in continuous supply with no danger of the


business closing.

Financial accounting information may just satisfy their concerns.

(d) Lenders

Lenders provide finance to companies in form of loans which could be


short or long term.

Their main concern is to whether a company will be able to pay


interest on loans and also eventually repay the loan itself.

This information may be provided by accounting information.

(e) Government agencies

Government needs to know how the economy is performing in order to


plan for
financial and industrial policies.

Tax authorities would also want to know the business profits in order
to assess
the tax payable by the company.

Financial statements could be used as a basis.

(f) Employees and trade union representatives


Employees are workers in a company. Their concern is job security and
better conditions of services.

They will need accounting information as a basis for negotiating for


improved salaries and conditions of services. Accounting information
may also disclose that the company is threatened with closure and
employees will have to make a decision of staying or not.

(g) The public:

People in general want accounting information because enterprises


affect them in many ways.

Companies are found where people live. Companies provide jobs for
the people and they also use local suppliers. Companies may also
affect the environment through pollution.

(h) Financial analyst and advisers:

These are specialists in economic trends. They need accounting


information in order to advise their clients on best investment options
and generally to inform the public on financial matters.

It is

4. QUALITIES OF GOOD ACCOUNTING INFORMATION

5 THE SCOPE OF FINANCIAL ACCOUNTING

5.1 Financial statements are prepared and presented in monetary


terms. But the success of the business does not entirely depend
on machinery and other items that can be measured in monetary
values.

A business could be successful because of:

(i) Good management


(ii) Dedicated workforce
(iii) Skill of staff

5.2 The above cannot be measured in monetary terms and therefore


do not appear in financial statements because they are non
financial matters in nature.

5.3 Financial accounting information is concerned with the following:


- Profits or losses in a period
- Assets and liabilities of the business
- Cash flows in the business

The list is non exhaustive.

5.4 Why keep accounts?

(a) An account is simply a record of activities taking place in a


business.

Example:

- Bought stamps and paid cash for them K2,000.


- Bought machinery on credit from XYZ Ltd
K15,000,000.

In the accounting books we need to keep a record of


stamps we bought and how much cash was paid thus
Stamps Account K2,000 and Cash Account K2,000 then
Machinery Account K15,000,000 and XYZ Ltd Account
K15,000,000 because XYZ Ltd is yet to be paid for the
machinery he supplied.

(b) It is important that accounting records are free from errors


(accurate) because users will need to make decisions from
them. Accounting records should also be updated all the
time.

Well maintained and updated records may help in the


followings:

(i) Help managers to control the business resources

(ii) Indicate how successfully managers are performing

(iii) Provide information about the resources and


activities of the business.

(iv) Help in calculating profits

(v) Provide information about what the business owns


(assets) and what the business owes (liabilities)

(vi) Help in answering audit queries.


CHAPTER 2

INTRODUCTION TO FINANCIAL STATEMENTS


1.0 CLASSIFICATION OF FINANCIAL STATEMENTS

Financial statements are sometimes called FINAL ACCOUNTS.

Financial statements are usually prepared at the end of the accounting


period i.e. on yearly basis.

They could also be prepared on quarterly basis called INTERIM


REPORTS.

3.2.1 WHAT ARE FINANCIAL STATEMENTS?

These are documents prepared showing financial performance


and the state of financial position of an organisation. They
usually list assets and liabilities including capital – The Balance
Sheet.
They also give account of the Profit and Loss – The Income
Statement.

3.2.2 THE BALANCE SHEET

The word balance in accounting could mean two things:

(i) Having two sides equal, or


(ii) Value of an item remaining

Therefore, a balance sheet is a statement prepared which has


two sides with equal values. These values are assets, liabilities
and capital.

In summary the accounting equation of the balance sheet is:-

Assets = Capital + Liabilities

On one side the balance sheet must have assets and on the
other side capital and liabilities and the two sides must be equal
as illustrated above.

3.2.3 ASSETS

An asset is anything owned by an organisation that has


monetary value. Value because the organisation will derive
economic benefit from its use.

3.2.4 TYPES OF ASSETS

Assets are classified as current assets and non current assets.

(a) Current assets

They are called current assets because they are temporal


in nature. They easily change in value with time and can
be turned into cash fairly soon. Examples of current assets
are:

 Inventory – stock of goods


 Receivables – amounts owing to the business by
credit customers (receivables)
 Prepayments – amounts paid in advance by the
business for which a service has not yet been
provided.
 Short term investments – this is the use of business
money in other activities to generate income or
profits within a short period of time e.g. within 1, 2, 3
months.
 Cash in hand – this is cash available for use in the
office.
 Cash at bank – this is money the business has with
the bank.

ACTIVITY 3.1

Give reasons why inventory, receivables, prepayments,


cash at bank and in hand are classified as current assets?

(b) Non current assets

Sometimes called fixed assets or capital assets.

These are possessions which do not change in value easily.


They are long lasting and help generate income for the
business on long term basis. They are acquired not for sale
as long as they are useful to the business. Examples of
non current assets includes:-

- Land
- Buildings Tangible non current assets
- Machinery
- Furniture and fittings
- Long term investments
- Goodwill, development costs and other intangible
assets.

ACTIVITY 3.2

Non Current assets are arranged in a certain order in the


balance sheet. Describe the arrangement.

3.2.5 LIABILITIES

These are amounts owed by the business (debts) to its trade


payables and to its owner(s). They represent the business’s
obligation to transfer economic benefits to a third party.
3.2.5.1 TYPES OF LIABILITIES

(a) Current liabilities

These are debts of the business that must be paid within a


fairly short period of time. A fairly short period of time
may be taken as one year.

In the accounts of limited companies, the Companies Act.


1994 requires the use of the term “Creditors: amounts
falling due within one year” rather than “current liabilities”.

Examples of current liabilities may include the


following:Trade creditors – suppliers to whom the business
owes money for goods supplied
on
credit.

- Accrued expenses - They represent bills for


expenses
for services which the business
been provided but has not yet
been
paid for at the time the balance
sheet
is being prepared.

- Bank overdraft - These are short term borrowings


repayable on demand. This
happens when a business over-
draws from its bank current
account e.g. a business
may have
K100 000 in its current account,
with
prior consent from the bank
manager, the business may be
allowed to withdraw K120 000
The
excess K20 000 withdrawn is
bank
overdraft, which must be shown
as current liability at the balance
sheet date as long as it is not
paid
at that date.
- Loans repayable within one year. Some loans maybe
obtained to be repaid over a period of more than 1
year, in the year of repayment they would be stated
as current liabilities.

- Taxation payable - These are tax amounts not yet


paid to tax authorities.
(b) Non current liabilities

They may also be called long term liabilities. These are


debts by arrangement with creditors concerned, have to be
paid over a long period of time, usually more than one year
e.g. 5 year loan.

This 5 year loan will be shown as non current liability for


the first 4 years. In the 5th year it would appear under
current liabilities.

Examples of non current liabilities may include:

- Loan - These could be bank loans as


long
as they are not repayable within
one year.

- Mortgage Loan - This is loan issued for capital


expenditure. It is usually
secured
against some property. Should
the business fail to pay the loan
the lender will have claim on the
property.

- Debenture loans - These are securities issued by a


limited company at a fixed rate
of
interest. They are repayable on
agreed terms.

ACTIVITY 3.3

What is the difference between tangible and intangible non current assets.

Capital (Sole trader)


This is other than money assets such as machinery, buildings, etc. put into
business to carry on business for profit purposes.

Capital put in by owners is also called EQUITY.

The capital of a business can be analysed as follows:

Capital at the beginning of period XX


Add: additional capital introduced
during the period XX

Add: Profit earned during period XX

Less: Drawings XX
___
Capital at end of period XX

For more details on above refer to the accounting equation.

3.2.7 Capital and business - relationship

Capital is a liability to the business because it belongs to the


owner. See business entity concept.

ACTIVITY 3.5

Categorise the following as tangible non current assets,


intangible non current assets, investments current assets,
current liabilities or non current liabilities.

(a) Shares in Chilanga Cement Plc, intended to be held on long


term.
(b) Machinery used in production
(c) Inventory – Goods for resale
(d) Bank overdraft
(e) A mortgage loan
(f) Trade payables
(g) Trade receivables
(h) Goodwill
(i) Rent paid in advance by the business
(j) Rent paid in advance to the business
(k) Accrued income to the business
(l) Accrued expenses by the business.
3.2.8 Format of the Balance Sheet (Sole trader)

The International Accounting Standard (1AS1) recommends the


following accounting equation when preparing the balance sheet:

Assets = Capital + Liabilities

In vertical format:

A detailed format is as follows:

Name of organisation:

Balance sheet as at (indicate date)

NON CURRENT ASSETS

Tangible non current assets


Land----------------------------------------XX
Buildings ----------------------------------XX
Machinery ---------------------------------XX
Fixtures & fittings ------------------------XX
Motor vehicles ----------------------------XX XX
Intangible non current assets
Goodwill ----------------------------------XX
Development costs ----------------------XX XX

Long term investments


Shares in another company. -----------------------------XX
XX

CURRENT ASSETS
Inventory ---------------------------------XX
Receivables ------------------------------XX
Prepayments ---------------------------- XX
Cash in Bank --------------------------- XX
Cash in Hand --------------------------- XX
XX
TOTAL ASSETS ------------------------------------------------- XX

FINANCED BY:

Capital and liabilities

Capital at start -----------------------------------XX


Add Net Profit/Less Net Loss -----------------XX (XX)
Less Drawings ----------------------------------(XX) XX

Non current liabilities


5 year loan -------------------------------------------------XX

Current Liabilities
Trade creditors -------------------------XX
Accrued expenses --------------------- XX
Bank overdraft ------------------------- XX
Taxation -------------------------------- XX
XX
TOTAL EQUITY & LIABILITY XX

N.B. non current assets plus current assets = Total assets

Total assets = Capital plus profit less drawing


Plus non current liabilities plus current liabilities.

The format given is not exhaustive neither is it inclusive.

Full Example – Preparation of balance sheet.


The following information is related to Kuku Hardware Stores, as
at 31 December 20X6. From it prepare a balance sheet.
K
Capital 1 January 20X6 47,600
Profit made during the year 8,000
Insurance prepaid 300
Rent accrued by Kuku 600
Receivables 500
Tax payable 3,500
Motor vehicles 9,000
Bank overdraft 2,000
Closing Inventory 31.12. 20X6 16,000
Fixtures and fittings 8,000
Cash in hand 100
Payables 1,200
Drawings 4,000
Premises 50,000
5 year loan 25,000

SOLUTION

KUKU HARDWARE & STORES

BALANCE SHEET AS AT 31 DECEMBER 20X6


ACTIVITY 3.5

Prepare a Balance Sheet for Freedom Enterprises as at 31


December 20X4 from the information below:

K
Land and buildings 80,000
Inventory 2,500
Payables 4,000
Profit for the year to 31.12. 20X4 6,600
Capital introduced during the year 5,000
Receivables 3,000
Fixtures and fittings 27,000
Expenses not yet paid by business 500

Drawings for the year 3,000


Amounts paid in advance by business 1,000
Motor vans 15,000
Cash at bank 4,600
Mortgage 70,000
Capital as at 1 January 20X4 50,000

3.2.9 The Income Statement

The income statement is a statement showing in detail how the


profit or loss of a period has been made. It is a summary of the
business trading activities over a period of time.

Thus: Income Less Expenditure = Profit.

3.2.10 The Matching or Accruals Concept


The income statement is prepared on the principle of matching
or accruals. When calculating profit, all income whether received
or not as long as they relate to the accounting period under-
review should be matched with expenditure whether paid or not
as long as expenditure relates to the same accounting period.

3.2.11 Difference between Cash and Profit

Because of the matching/accruals concept used in calculating


profits, profits and cash will always be different.

Remember that cash is an asset while profit is an income.

Example:

 The business started with capital in cash of K100.

Assets = Capital + Liabilities

Cash 100 = Capital 100 + 0

 The same K100 cash is used to buy goods

Assets = Capital + Liabilities

Cash 0 + Inventory 100 = Capital 100 + Liabilities 0

N.B. The asset of cash has been transformed into another


asset of inventory. The capital is no longer tied in cash but
in inventory.

 All the inventory is sold to customers on credit for K150


(refer to realization concept).

The asset of inventory has also been transformed another


asset receivables K150. Assets have increased because
goods have been sold at a profit of K50.

This means capital should also increase by the same


amount. (Refer to the accounting equation).
Assets = Capital + Liabilities

Receivables = capital + profit


150 = 100 + 50

N.B While it is agreed that the business has made profit of


K50, the business has no cash because the receivables are
not yet to pay.

 If the goods had been sold on cash basis, the profit will
remain at K50 but cash will be K150.

3.2.12 Division of the income statement

The income statement is divided into two parts. The gross profit
part and the net profit part.

3.2.13 The Gross Profit part

This part of the income statement is concerned with income


generated from sale of goods (sales) and the cost of goods sold
(purchases + direct expenses).

Thus: Sales – Cost of Goods Sold = Gross Profit.

Direct expenses are added to purchases because they are


incurred at the time of buying and bringing goods into premises.
These expenses could be avoided if one never went to buy
goods, so they increase cost of purchases.

Examples:

- Carriage inwards
- Customs duty

Gross profit is not final profits because there could be other


indirect expenses to be deducted.

The gross profit part answers questions such as “are you doing
fine in what you are buying and selling”. Is it a profitable
business?

3.2.14 The Net Profit Part

Net means final.


In carrying out a business there could be other expenses that
may be incurred which have no direct bearing on purchases.
These may be incurred whether you buy goods or not. They are
called indirect expenses. They may include:

- Salaries of workers
- Rentals
- Electricity etc.
- Carriage outwards.

Therefore Net Profit = Gross Profit less Indirect Expenses.

Please note that the business may have gross profit but end up
with Net loss.

The division of the income statement will help management


identify where the problem is i.e. is it on selling part or expenses
part.

3.2.15 Other Income

Sometimes a business may engage itself in other income


generating activities apart from the core business. Other income
is added to gross profit before deducting indirect expenses.

Examples of other Income:

- Dividend or interest received from investments


- Profit on sale of non current assets
- Income from Rentals
- Discount received from suppliers.

3.2.16 Simple example of Income Statement

- Bought goods costing K250


- When buying the goods transport costs of K20 were
incurred to bring the goods into the business premises
(carriage inwards)
- The same goods bought were all sold for K450.
- The business has an assistant who is paid a fixed salary of
K55.
Required:

Calculate:

(a) Gross profit


(b) Net profit

(a) Gross Profit


K000
Sales 450
Cost of sales:
Purchases 250
Add: Carriage inwards 20
(270)
Gross profit 180

(b)Net profit
K000
Gross profit 180
Less: Indirect Expenses
Salary (55)
Net profit 125

The full income statement would then be:

Sales 450
Cost of sales:
Purchases 250
Carriage Inwards 20
(270)
Gross profit 180
Less Indirect Expense
Salaries (55)
Net profit 125

ACTIVITY 3.6

On 1 June 20X5 Snow White commenced business dealing in ice cream.

(a) He rented a van at a cost of K1,000 for three months. Running


expenses for the van averaged K300 per month.
(b) He hired a part time helper at a cost of K100 per month.

(c) He borrowed K2,000 from his bank and the interest cost of the loan
was K25 per month.

(d) His main business was selling ice cream from the van, but he also did
some special catering supplying ice creams for office parties. Sales to
these customers were usually on credit.

(e) For the three months to 31 August 20X5, his total sales were K10,000
(K8,900, credit K1,100).

(f) He purchased his ice cream from a local manufacturer, Palmer Ltd.
The cost of purchases in the three months to 31 August 20X5 was
K6,200 and at 31 August he had sold every item of stock. He still owed
K700 to Palmer Ltd for purchases on credit.

(g) One of his credit sale customers has gone bankrupt, owing Snow White
K250. Snow White has decided to write off the debt in full.

(h) He used his own home for his office. Telephone and postage expenses
for the three months to 31 August were K150.

(i) During the period he paid himself K300 per month

Required:

Prepare an income settlement for the three months 1 June to 31 August 20X5

3.2.17 Relationship between the income statement and the Balance


Sheet

Balance sheets are pictures of the business at particular points in


time, while the income statements show the activities of the
business in between those balance sheet dates. Therefore the
linkage between the accounting statements can be seen as:

Balance sheet at start of


period

Plus profit or less loss


for the period
Cash in Movement of cash to or Cash out
from proprietors

Balance sheet at end of


period

Thus, the balance sheets are not merely isolated statements,


they are linked over time by the profit or loss. See also
accounting equation.

3.2.18 Inventory

When a business buys goods for resale, they are called inventory.

3.2.19 Closing Inventory

These are goods unsold at the end of the accounting period. Closing
inventory is determined by physical stock taking.

When calculating profit/loss, closing inventory is deducted from the total


inventory figures, because profit/loss is calculated on the cost of what has
been sold. Since the business is continuing the remaining inventory will be
carried forward to the next accounting period.

Example: in year 1 the following transactions took place


- Bought 10 shirts at K5 each
- Of the 10 shirts only 7 shirts were sold for K8 each.

Calculate profit

Solution:

Profit will only be calculated on the 7 shirts sold. The other 3


shirts will be carried forward and profit will be calculated when
they will be sold.

Thus: K K
Sales (7 x 8) 56
Cost of sales:
Purchases (10 x 5) 50
Less: closing inventory
(3 x 5) (15)
(35)
Profit 21

Closing inventory will appear as a current asset in the


balance sheet.

3.2.20 Opening inventory

What is considered closing inventory at the end of an accounting


period will be taken in the new accounting period as opening
inventory, and will be added to the cost of goods which will be
bought in the new year.

Example: Continuing from previous example:

In the following year 2 the following transactions took place.

- Bought 14 shirts at K5 each


- Sold 11 shirts at K10 each

Calculate profit?

Solution
Note that in year 1, 3 shirts at K5 each were not sold and so they
are brought to year 2 as opening inventory.
K K
Sales (11 x 10) 110

Cost of Sales
Opening stock (3 x 5) 15
Add: purchases (14 x 5)70
85
Less: Closing inventory
(6 x 5) (30)
(55)
Profit 55

3.2.21 Purchases Returns and Sales Returns


When calculating the figure of Net purchases, all goods returned
to supplies must be deducted.

Thus:

Purchases XX
Less: purchases
Returns (XX)

Net purchases XX

Net purchases represented the actual amount paid or to be paid


to suppliers for goods bought only. Purchases returns is also
called returns outwards.

Sales returns or returns inwards represents goods returned to the


business from cash or credit customers.

When computing revenue income from sales of goods, sales


returns is deducted because it no longer sales since goods which
were sold have been returned.

Thus income statement:

Sales XX
Less: Sales Returns (XX)

Turnover/Net sales XX

N.B. Turnover is sales less sales returns.

3.2.22 Format of Income Statement (sole trader)

Name of organization

Income Statement for the period end …………………………. (Date)

Sales XX
Less: Sales returns (XX)
Turnover XX

Cost of Sales
Opening inventory XX
Purchases XX
Less purchases returns (XX)
Net purchases XX +
Direct expenses
Carriage inwards XX +
Customs duty XX
XX
Cost of purchases XX
Total cost of inventory XX
Less closing inventory (XX)
(XX)
Gross profit/loss XX
Add other income
Discount received XX
Commission received XX
XX
Less Expenses:
Carriage outwards XX
Discount allowed XX
Salaries & wages XX
Rent XX __
Bad debts XX
Depreciation XX
Light & heat e.t.c XX
(XX)

Net Profit/Loss XX

N.B. Cost of purchases is:

Net purchases (actual value of goods bought)

Plus
Direct expenses

Full worked example on income statement:

On 31 December 20X3 Mungo, a wholesaler, had the following


details in his books.
K
Opening inventory 5,000
Sales 25,000
Purchases returns 2,000
Discount allowed 300
Returns inwards 500
Salaries and wages 8,000
Discount received 250
Rent 400
Electricity 100
Carriage inwards 50
Bad debts 75
Postage & stationery 80
Carriage outwards 95
Closing inventory 3,000
Purchases 12,000

From the above information prepare the income statement for


the year ended 31 December 20X3.

Solution:

MUNGO

Income Statement for the year ended 31 December 20X3


K K K
Sales 25,000
Less: Sales returns (500)

Turnover 24,500

Cost of sales:
Opening inventory 5,000
Purchases 12,000
Less purchases returns 2,000
Net purchases 10,000
Carriage Inwards 50
Cost of purchases 10,050
Total cost of inventory 15,050
Less closing inventory (3,000)
(12,050)
Gross profit 12,450
Add: Discount received 250
12,700
Less: Indirect Expenses
Discount allowed 300
Salaries and wages 8,000
Rent 400
Electricity 100
Bad debts 75
Postage and stationery 80
Carriage outwards 95
9,050

Net profit 3,650

ACTIVITY 3.7

Mr. Buju, has been in business for sometime now, as a timber


merchant. The information below has been extracted from his
books as at 30 June 20X4, the end of the accounting period.
K
Capital at start 1 July 20X3 121,900
Trade payables 19,000
Sales 280,000
Returns outwards 13,000
Discounts allowed 2,000
Discounts received 1,500
Fixtures and fittings @ cost 120,000
Depreciation fixtures & fittings 12,000
Trade receivables 24,000
Inventory 1 July 20X3 50,000
Purchases 135,000
Returns inwards 5,000
Carriage outwards 4,000
Drawings 18,000
Carriage inwards 11,000
Rent 7,000
Rates 8,000
Insurance 10,000
Heating & lighting 12,000
Postage 500
Stationery 700
Telephone 400
Advertising 5,000
Salaries & wages 35,000
Bad debts 1,500
Cash in bank 6,000
Cash in hand 300
5 year loan from Banda 20,000
Inventory at 30 June 20X4 17,000

Required:

Prepare income statement for the year end 30 June 20X3 and a
Balance Sheet as at that date.
3.2.23 Working capital

This is money needed by a business in order to keep operating


(trading). It is calculated as a difference between current assets
and current liabilities.

Thus: working Capital = Current Assets Less Current Liabilities

A deficiency in working capital may indicate liquidity problems in


a business.

EXERCISES

1. What is a balance sheet?

A. A list of all assets and liabilities of a business


B. A statement of the net worth of a business
C. A statement which shows how the net assets of a business have
changed over time.
D. A statement of the assets and liabilities of a business at a point
in time in financial terms.

2. Fill in the blanks

________________ and ________________ are examples long term liabilities.


3. Which of the following is not a current asset?

A. Machinery
B. Stock
C. Prepayments
D. Debtors

4 Working capital is another term for net assets. True or False?

5. Gross profit is best described as?

A. Sales less expenses


B. Invoiced sales less purchases of stock
C. Net profit less business overheads
D. Sales less cost of goods sold

6. Three sources of income other than the sale of goods which could
appear in the income statement are:

(i) ____________________________________
(ii) ____________________________________
(iii) ____________________________________

7. Four items which might be included in selling and distribution expenses


are:

(i) ____________________________________
(ii) ____________________________________
(iii) ____________________________________
(iv) ____________________________________
CHAPTER 3
REVENUE AND CAPITAL EXPENDITURE

CAPITAL AND REVENUE EXPENDITURE

Expenditure means spending money to acquire items. Items could be goods


or services.

The type of item acquired is what is called capital expenditure or revenue


expenditure.

4.1 Capital expenditure

When a business spends money to buy non current assets and


subsequently adding value to them is called capital expenditure. For
example, acquiring land, buildings, vehicles etc.

4.2 Adding Value

Adding value means spending money on an existing asset in order to


improve its performance or increase production capacity. E.g. carrying
out renovations on machinery in order to increase production capacity.

4.3 Other capital expenditure

Included in capital expenditure are amount spent on non current assets


to put them in a workable condition. Such amounts may include

- Transport costs to bring them into business premises


- Legal costs incurred in acquiring buildings
Any other costs incurred before non current assets could be put to use.

4.4 Revenue expenditure

This is expenditure incurred on the running of the business on a day to


day basis as the business is carrying on its trading activities. It is also
incurred in maintaining the non current assets.

Examples may include:

- Repairing machinery
- Replacing broken window panes to a building
- Electricity expenses in running machinery
- Petrol costs in running the vehicle
- Purchase of goods for resale

4.5 Warning

What is to be called capital or revenue expenditure will depend on


what the business is dealing in. If for example the business is buying
and selling vehicles to make profits, purchase of a vehicle will be
revenue expenditure. But if it buys a vehicle to be used in business,
that will be capital expenditure.

EXAMPLE

Baobab is in business as a general retailer. He bought a vehicle for use in his


business at a cost of K2,000. In bringing the vehicle to his premises he
incurred transport costs of K500, customs duty of K700. Before he could use
the vehicles, the vehicles had to be serviced and this costed K50.

When the vehicle was in use, he insured it against theft and fire and this cost
K100. In running the vehicle fuel costs amounted to K150, and replaced
tyres with new ones and this cost K70. He decided to put in a musical
system which cost K40. Insurance cover to bring the vehicle into business
premises amounted to K80.

Required:

(a) Identify items which are capital expenditure and what will be the cost
the vehicle in the books.

(b) Identify revenue expenditure


4.6 Joint expenditure

A builder was engaged to do some work on the business buildings. The


whole work was to cost K40,900 broken down as follows:

- K 30,000 to add an extension on building


- K 10,000 for wages of the builder for extension only
- K 900 to replace a few broken windows and some missing tiles.

The case above is an example of joint expenditure. In this case capital


expenditure should be separated from revenue expenditure. Thus

K 30,000 extension to building


K 10,000 wages
K 40,000 would be capital expenditure

4.7 Capital and revenue income

Income is proceeds coming into the business. Where income is coming


from is what would be identified as capital or revenue income.

(a) Capital income

Capital income are proceeds arising from the sale of non current
assets and long term investments. The profits or losses from the
sale of non current assets are included in the income statement
for the year in which the sale took place.

Example: suppose a machinery is bought for K10,000, and four


years later sold for K8,000. The K10,000 would be treated as
capital expenditure and K8,000 capital income. The loss K2,000
(10,000 – 8,000) would be shown in income statement.

(b) Revenue income


This is income generated in the normal cause of running the
business. Included are:

- revenue from ordinary trading (sales)


- interest received
- dividends received
- discount received
- commission received etc.

ACTIVITY 4.2

A business obtains a loan from the bank to finance the purchase of a non
current asset. The business would be paying interest annually.

How would you identify the loan and loan interest? Is it capital or revenue
income.

ACTIVITY 4.3

Classify each of the following items as ‘Capital’ or ‘Revenue’ expenditure or


income.

(a) Purchase of leasehold premises


(b) The annual depreciation of leasehold
(c) Solicitors fee in connection with the purchase of leasehold premises
(d) The costs of adding extra storage capacity to a mainframe computer
used in the business
(e) Computer repairs and maintenance costs
(f) Profit on the sale of an office building.
(g) Revenue from sales by credit card
(h) The cost of new machinery
(i) Customs duty charged on the machinery when imported into the
country
(j) Carriage costs of transporting the new machinery
(k) The cost of installing the machinery in the business premises
(l) The wages of machine operators

4.8 Treatment of “Capital” and “Revenue” expenditure and machines in


financial statements.

(a) Capital expenditure

Capital expenditure is shown in balance sheet under non current


assets.
(b) Revenue expenditure and income

This is stated in the income statement

(c) Capital income

Capital income does not include raising capital from the owner(s)
of the business, or raising and repaying loans. These
transactions add to the cash assets of the business, thereby
creating a corresponding increase in capital or loan. When the
loans is repaid, it reduces the liability (loan) and the asset of
cash.

4.9 Incorrect treatment

If capital expenditure is treated as revenue expenditure or revenue


expenditure is treated as capital expenditure, then:

- Both balance sheet figures and income statement figures will be


wrong
- Profit will be over stated if revenue expenditure is treated as
capital expenditure and non current assets will also be
overstated
- Profit will be understated if capital expenditure is treated as
revenue expenditure and non current assets in the balance sheet
will be understated.

EXERCISES

1. Which of the following explains the distinction between capital and


revenue expenditure?

A. Revenue expenditure is an expense in the income statement,


capital expenditure is an asset in the balance sheet.
B. Revenue expenditure is an expense in the income statement,
capital expenditure is a liability in the balance sheet.
C. Capital expenditure results in acquisition or improvement of non
current asset, revenue expenditure is incurred for the purpose of
trade or to maintain the earning capacity of non current assets.
D. Revenue expenditure results in the acquisition of or improvement
of non current assets, capital expenditure is incurred for the
purpose of trade or to maintain the earning capacity of non
current assets.

2. The data below relates to F Juma’s business, who is an engineer. This


is for the financial year ended 31 December 20X4.

(a) Purchase of extra milling machine (includes K50 for repairs of an


old machine) K1,700
(b) Rentals K250
(c) Electric expenses (includes new wiring K250, part of premises
improvement) K2,450
(d) Carriage inwards (includes K70 carriage on new cement mixer)
K780
(e) Purchase of extra milling machine K2,100

Required:

Allocate each or part of the items mentioned to either ‘capital’ or


‘revenue’ expenditure
CHAPTER 5

1.0 TWO PRIMARY CONCEPTS

1.1 The Entity Concept

This concept states that a business is a separate entity or person from its
owner. Like a biological person the business can exercise rights to own assets
and powers to borrow and incur liabilities. At law the business (applied to
limited liability companies) is a legal person. For accounting purposes even
an unincorporated entity is treated as a ‘person’ separate from the owner
who formed it

The implication of this concept is that assets and liabilities of the business
should be kept separate from those of its owner. The student is in the
position of the accountant for the business, not for the owner of the
business. He should view the owner as if he were an out side party or entity.

1.2 The Duality Concept

This concept states that there are two aspects to every transaction:
a) the giving aspect, which creates a liability, and
b) the receiving aspect, which creates an asset.

It is from this concept that the rule of double entry is derived.

The rule of double entry states that for every debit entry to an account there
is a corresponding credit entry in another account. ‘Corresponding’ means of
equal magnitude in value. Consequently to post transactions to the ledger,
you debit the receiving account and credit the giving account

What is given or received (the Flow) in a business transaction can be


analysed as follows:

1 Goods: Are given/received in a credit transaction


Can be trading goods (goods for re-sale)
Can be non current assets (for use in business)
The name of an outside entity is always given in a credit
transaction.

2 Cash: Is given/received in a cash transaction


Can be in the form of notes and coins
Can be in the form of cheques, electronic money transfers,
etc
Cash account is involved when notes and coins are
given/received
Bank account is involved when cheques, etc are involved

In all situations, the name of the second account affected by a transaction is


deduced from the name of the business activity that has been carried out,
for example, sales, purchases returns, rent, motor vehicles, etc.

The guidelines above can be presented in the form of a chart as follows:

THE
FLOW

GOODS CASH

For use in For Cash in the form Cheques, debit


business re-sale of notes & coins cards, EFTs,

The first account will be named after CASH BANK


the OUTSIDE ENTITY given in the ACCOUNT ACCOUNT
transaction

BUSINESS BUSINESS The second account will be named after


ACTIVITY ACTIVITY the ACTIVITY the business has carried
out
The chart above gives you a reliable guide to applying the rule of double
entry to all business transactions you will come across in career. Understand
it so that it can become second nature. Full application of the chart above
will be made when posting transactions from day books to the ledger in a
later chapter.

2.0 THE JOURNAL PROPER

This is a book of prime entry in which transactions that are infrequent are
recorded. Because of their infrequence, the transactions are not provided
with a separate day book. Such transactions include the purchase of non-
current assets, correction of errors and year end transfers and adjustments.
All these terms will be explained in subsequent chapters.

The mode of recording entries in the Journal, as it is loosely referred to, is to


indicate the account to debit and the account to credit plus a brief
description of the business activity that took place. The description of the
transaction is called the narration.

2.1 STARTING A BUSINESS

The first journal written is the one when a business just starts. For example:
Fix-it, a retired engineer, received interest on his fixed deposit account of K 8
000 000. He opened a business bank account.

The journal would be written as shown below:


Debit Credit
K 000 K 000
Bank account 8 000
Capital account 8 000

Being capital introduced in business by the proprietor.

The bank account represents the cash available to the business to finance
business activities. The capital account represents the amount the business
owes its owner. In case of cessation of trading activities, the business would
pay the owner the amount shown on the capital account.
The owner injects funds into the business as initial capital. The capital is
expected to grow (i.e increase by the amount of profits he later makes
through trading activities).

The journal above shows that bank account in the ledger will be debited, and
capital account will be credited.

2.1 A CONTINUING BUSINESS

The capital of a continuing business is derived from a given list of assets


and liabilities. Supposing a business had the following assets and
liabilities at the start of business: Furniture and fittings K5 245 000,
Inventory K8 692 000, Cash at bank K8 000 000, Trade Receivables:
Chibuye K235 000; Mambwe K390 000, Rent prepaid K332 000, Loan K5
000 000, Trade Payables: Chibale K160 000; Mwape K164 000, Electricity
due K221 000, Value Added Tax outstanding K2 375 000; the journal
would be written as follows:

DR CR
ASSETS: K 000 K 000
Furniture & Fittings 5 245
Inventory 8 692
Cash at Bank 8 000
Trade Receivables: Chibuye 235
Mambwe 390
625
Rent prepaid 332
LIABILITIES:
Loan 5 000
Trade Payables: Chibale 160
Mwape 164
324
Electricity due 221
Value Added Tax outstanding 2 375
Capital (Balancing figure) 14 974
TOTALS 22 894 22 894
The capital is obtained by deducting total liabilities from total assets.
Suffice to mention here that assets are debit balances and liabilities are
credit balances as shown above.

2.2 PURCHASE OF A NON CURRENT ASSET

Other examples of transactions that by their nature would first be recorded


in the journal are:
April 13. Received an invoice for the 10 ton truck bought on credit from L-
Stone Motors K 40 000 000 gross

April 29. Paid L-Stone Motors K 10 000 000 by cheque for the truck bought
earlier.

The entries in the journal for the above transactions would be:

Debit Credit
K 000 K 000
Motor Vehicles account 40 000
L-stone Motors account 40 000
Purchase on credit of a truck S/no. ……….
from L-Stone (Invoice No. ……….)

L-Stone Motors account 10 000


Bank account 10 000
Part payment for the truck S/no. ……….. which
was bought on credit.

EXERCISES

1 Calculate the value of premises from the following balances of


assets and liabilities:
K000
Premises ?
Trade Payables 5 600
Trade Receivables 8 250
Cash in Hand 4 520
Loan 9 000
Cash at Bank 6 440
Rates Prepaid 830
Salaries accrued 590
Machinery 7 250
Inventory at start 3 207
Capital 30 307

2 Write the journal entry for the following transactions:

Lily owns a truck which he wishes to use exclusively for business.


The truck is worth K 30 000 000. She obtains a loan from a bank of
K 20 000 000.
CHAPTER 6

PREPARING BOOKS OF PRIME ENTRY


INTRODUCTION

Business activities are called transactions. There are three types of


transactions:
(a) Cash transaction
(b) Credit transactions
(c) Account transfers
Cash transactions are those business activities in which cash is given or
received. Cash may be in the form of notes and coins or in the form of
cheques, credit card and electronic funds.

Credit transactions are those business activities in which one person gives
goods (or provides a service) to another without the immediate exchange of
cash.

Account transfers are transactions internal to the business and involve


transfers of funds from one account to another. They are usually handled at
the end of the year and when correcting errors that arise in the course of
preparing ledger accounts.

Numerous as they are, transactions have been grouped into:

1) those involving trading goods and cash, and take place frequently,

2) those that are infrequent. Transactions that occur regularly are recorded
in Day Books.

Those that rarely occur are recorded in the Journal Proper as their book of
prime entry (explained in the preceding chapter).

The structure of the day book is often determined by the type of information
required by the user (in this case, management). The information must be
comprehensive when it comes to reporting on business activities. In practice
the day books may have more columns than are illustrated below.
Nevertheless, we will include here all columns that are relevant for
accounting purposes.

In this and subsequent chapters we attempt to explain the preparation of


books of accounts in such a way that you will be able to develop the
necessary competence and work in industry with confidence.

BOOKS OF PRIME ENTRY – CREDIT TRANSACTIONS

In this chapter we will explain how books of prime entry (Day books) are
compiled for credit transactions. Credit transactions include those for sales of
goods on credit, purchases of goods on credit, and returns of goods either to
suppliers or by customers. In this type of transaction what is given or
received are goods (Refer to the chart in Chapter 2).
1.0 ANALYTICAL SALES DAY BOOK

The sales daybook is a book of prime entry in which transactions of sales of


goods on credit are recorded. The source document for the entries in the
sales daybook is sales invoice. The seller prepares it in duplicate (or triplicate
as is the practice in some organizations), issues the top copy (the original)
and retains the duplicate copy. The duplicate copy is used in the preparation
of the sales daybook.

1.1 ILLUSTRATION

The following transactions will be entered in the sales day book

April 1 Sold goods on credit to Chisakaila K 540 000 net. VAT is charged at
the rate of
17.5 %.

April 5 Sold goods on credit to Ngosa K 800 000 net. The customer is
entitled to
2% prompt discount if payment is made within 14 days.

April 13 Issued an invoice to Mulota K400 000 net.

April 15 Sold goods on credit to Mambwe K750 000 net.

SALES DAY BOOK


DATE CUSTOMERS FOLIO TOTAL VALUE ADDED TRADE OTHER
TAX RECEIVABLE RECEIVABLE
April K K K K
2005
1 Chisakaila 634 94 540
500.00 500.00 000.00
5 Ngosa 937 137 800
200.00 200.00 000.00
13 Mulota 470 70 400
000.00 000.00 000.00
15 Mambwe 881 131 750
250.00 250.00 000.00

TOTAL 2 922 432 2 490


950.00 950.00 000.00

 The transactions are entered in strict chronological order as they occur.


The names of businesses are entered in the particulars or customers
column. If the column were named ‘Customers’ then we would need a
column for account numbers. The account number column is not
shown here for convenience’s sake.
 Value Added Tax has been calculated as follow: On the net figure 0.175
x K 400 000 =
K70 000. The total amount is the sum of the net figure and the Value
Added Tax.
K 400 000 + 70 000 = K 470 000

 When the invoice carries an entitlement of cash discount, Value Added


Tax is calculated on the value after deducting the discount. The tax
authorities presume that the cash discount will be taken up. Thus,
value for Value Added Tax is K 800 000 x 0.98 = K784 000, and Value
Added Tax is 784 000x 0.175 = K137 200. The gross amount is the sum
of the Value Added Tax and the original invoice value (not the value for
Value Added Tax).

1.2 JOURNAL ENTRY

Posting the totals to the ledger will be explained in the next chapter. For now
it suffices to mention that the two accounts identifiable from entries in the
sales day book are:
DEBIT CREDIT
K K
Trade Receivable 2 922 950
Sales account 2 490 000
Value Added Tax account 432 950

1.3 FURTHER ANALYSES

The sales day book can further be analysed as:

a) Sales by product

b) Sales by geographical location. All these analyses are for management


information, not
necessarily for posting to accounts in the ledger.

2.0 ANAYTICAL SALES RETURNS DAY BOOK

Sales returns day book is a book of prime entry in which goods initially
sold on credit but are now returned are recorded. The source document
for goods returned is the credit note. The seller prepares the credit note in
duplicate and issues the top copy to the customer. The duplicate is the one
used to compile the sales returns day book.

2.1 ILLUSTRATION
April 7. Ngosa returned goods, K 200 000 net (He is entitled to prompt
discount of
2 %)
April 17. We sent a credit note to Mambwe, K 150 000, net

SALES RETURNS DAY BOOK


DATE CUSTOMER FOLIO TOTAL Value TRADE OTHER
Added
TAX RECEIVABLE RECEIVABLE
April K K K K
2005

7 Ngosa 234 300.00 34 300.00 200 000.00


17 Mambwe 176 250.00 26 250.00 150 000.00

TOTAL 410 550.00 60 550.00 350 000.00

 The commentary on Value Added Tax and prompt discount applies here
too. A separate section is included later on Value Added Tax. Value
Added Tax will further be discussed in much more detail in a later
chapter.

3.0 PURCHASES DAY BOOK

The purchases daybook is a book of prime entry in which transactions of


purchases of goods on credit are recorded. The source document for the
entries in the sales daybook is purchases invoice. The supplier prepares the
invoice in duplicate (or triplicate as is the practice in some organizations),
issues the top copy (the original) and retains the copy. The original top copy
is therefore used in the preparation of the purchases daybook.

3.1 ILLUSTRATION

April 12. Purchased goods on credit from Kunda K 282 000. The invoice
stated a tax inclusive amount.
April 13. Received an invoice for the 10 ton truck bought on credit from L-
Stone Motors K 40 000 000 gross
April 18. Purchased Goods on credit from Mwape K 270 000 gross value.
April 19. Received a bill for electricity from Zam Hydropower. The total of
the invoice was K 320 000

PURCHASES DAY BOOK


DATE SUPPLIER FOLIO TOTAL Value TRADE OTHER

Added
TAX PAYABLE PAYABLE
April K K K K
2005
12 Kunda 282 42 240
000.00 000.00 000.00
13 L-Stone Motors Ltd 40 000 40 000
000 .00 000.00
18 Mwape 270 40 229
000.00 212.76 787.24
19 Zam Hydropower 320 320
000.00 000.00

TOTAL 40 872 82 469 40 320


000.00 212.76 787.24 000.00

 The amounts above are all tax inclusive. The amount of Value Added
Tax is obtained as follows:
K 282 000 x 7/47 = K 42 000 The net amount is the difference
between the two figures, ie K 282 000 –K 42 000 = K 240 000

 The column for other payables can be sub-divided into: Other Payables
–Expenses,
K 272 340.43 and Other Payables –Non current Assets, K 40 000
000.00. In the
ledger these accounts have been referred to as L-Stone Motors and
Zamhydro Power
Company, more specifically.

 The Value Added Tax on the non-current asset is not claimable since
the business is taken as the final consumer of the motor vehicle that
has been bought for use in business. This is the reason why no tax is
recorded in the column for Value Added Tax in respect of the purchase
for the motor vehicle.

 When posting to the ledger, the payables accounts are credited with
the gross amounts ( i. e. tax inclusive figures). So there is need to
accurately identify the amounts involved and the specific names of
payables who will be paid.

3.2 JOURNAL ENTRY


Posting the totals to the ledger will be explained in more detail in the next
chapter. For now it suffices to mention that the accounts identifiable from
entries in the purchases day book are:

DEBIT CREDIT
K K
Purchases account 469 787.24
Value Added Tax account 82 212.76
Motor Vehicles 40 000 000.00
Electricity 320 000.00

Other Payables -Expenses 320 000.00


Other Payables –Non-current Assets 40 000
000.00
Trade Payable account 552 000.00

Note that when a journal has been prepared correctly the total of amounts in
the debit column will always be equal to the total in the credit column. This is
also a sign that you have understood the principle of double entry.

3.3 FURTHER ANALYSES

The Purchases day book can further be analysed as follows: -

a) purchases by product

b) purchases by geographical location. Such analyses are for management


information, not
necessarily for posting to ledger accounts in the ledger.

4.0 ANALYTICAL PURCHASES RETURNS DAY BOOK

Purchases returns day book is a book of prime entry in which goods


initially bought on credit but are taken back to the supplier are
recorded. The source document for goods returned is the credit note. The
supplier prepares the credit note in duplicate and issues the top copy to us.
The original copy of the credit note is the one we use to compile the
purchases returns daybook.

4.1 ILLUSTRATION
April 13 Returned goods worth K 42 600 to Kunda . This is a tax inclusive
figure.
April 19. Received a credit note from Mwape for K 35 700 (gross amount).

PURCHASES RETURNS DAY BOOK


DATE SUPPLIER FOLIO TOTAL Value TRADE OTHER
Added
TAX PAYABLE PAYABLE
April K K K K
2005

13 Kunda 42 600.00 6 344.68 36 255.32


19 Mwape 35 700.00 5 317.02 30 382.98

TOTAL 78 300.00 11 661.70 66 638.30

 The calculation of Value Added Tax is the same as explained for entries
in the purchases daybook.

 The day books are mere listings of transactions that took place in the
period. They are maintained as memorandum information for future
reference.

JOURNAL ENTRY

The amounts will be posted to the ledger as follows:


DEBIT CREDIT
K K
Trade Payables account 78 300.00
Purchases Returns account 66 638.30
Value Added Tax account 11 661.70

In the next section the cash book will be discussed as the day book for cash
transactions.

EXERCISES
1. Enter the following transactions in the appropriate day books. VAT is
charged at the
rate of 17.5%.

a)

March 2. Sold goods on credit to Akabondo K 845 000 net.

March 8. Sold goods on credit to Mubita K 780 000 net. The customer is
entitled to
2% prompt discount if payment is made within 14 days.

March 14. Issued an invoice to Mubiana K680 000 net.

March 16 Sold goods on credit to Mundia K750 000 net.

March 18. Akabondo returned goods, K 325 000 net (He is entitle to prompt
discount of 2%)

b)

March 7. Purchased goods on credit from Siwale K 424 000. The invoice
stated a tax inclusive amount.

March 12. Received an invoice for the 10 ton truck bought on credit from
Del Equipment K40 000 000 gross

March 15. Purchased Goods on credit from Simpasa K 380 000 gross
value.

March 19. Received a bill for electricity from Solarpower Co.The total of the
bill was K502000

March 22 Returned goods worth K 83 600 to Siwale . This is a tax inclusive


figure.

April 24. Received a credit note from Simpasa for K 42 500 (gross
amount).

2. Write the journals for the totals of the Day books you prepared in
Question 1.
CHAPTER 7

BOOKS OF PRIME ENTRY - CASH TRANSACTIONS

INTRODUCTION

In this chapter we will explain how to record cash transactions. Depending on


what is given or received, the first record can be in the Cash Account or in
the Bank Account.

TOPICS

1 Analytical cash book


2 Cash Account –Receipts and Payments
3 Bank Account –Receipts and Payments
4 Summary

LEARNING OBJECTIVES

After you have studied this chapter, you should be able to


 Explain the purpose of the cash book
 Prepare analytical cash book
 State the source document for entries in each day book.

1.0 ANALYTICAL CASHBOOK

The cash book is a book of prime entry in which cash transactions are
recorded. Cash transactions are those in which goods are exchanged for cash
in the form of notes and coins, or are paid for using the cheque system and
the debit cards (ATM Cards). Cash transactions involving the exchange of
notes and coins with goods are used to compile the cash account.
Transactions involving cheques are used to compile the bank account. A
section on the bank payment systems will be discussed in the chapter on
bank reconciliation.

2.0 CASH ACCOUNT

The entries in the cash book are analysed by type of receipts and type of
expenditure. Entries in the cash account would be analysed as follows:

ILLUSTRATION

Fix-it, a retired engineer, received interest from his fixed deposit account of
K8 000 000. He opened a business bank account withdrew K3 000 000 for
office use. The following are the transactions for the first month of trading:

April 2005

April 1. Sold goods for cash K 540 000 net. VAT is charged at the rate of
17.5 %
April 4. Borrowed K 12 000 000 from Credit Funds Bank, cheque
received same day
April 8. Paid wages in cash K 150 000
April 13. Cash sales K400 000 net.
April 13. Banked K200 000 from cash till.
April 14 Drew from bank for private use K 100 000
April 19. Paid cash for repairs to furniture K130 000
April 20. Cash purchases of stationery K150 000 (all tax-exempt).
April 22. Ngosa paid his account in full less 5% cash discount K 667 755.
April 25. Paid Salaries in by cheque K 300 000
April 26 Bought goods for re-sale in cash, K 246 750 gross.
April 28 Paid rent K 520 000 by cheque and received commission for
selling scratch cards K 270 000 by cash
April 29. Paid L-Stone Motors K 10 000 000 by cheque for the truck bought
earlier.
April 30 Settled Kunda’s account by cheque, less cash discount of 5%
K227 430.

Enter the transactions in the appropriate day books, post to the ledger and
extract a trial balance at the end of the month.

2.1 CASH BOOK ( CASH -RECEIPTS SIDE )

DATE PARTICULARS FOLIO TOTAL Value CASH TRADE OTHER LOANS


Added

TAX SALES RECEIVABLE RECEIVABLE


S S
APRIL K K K K K
1 Bank (c) 3 000
000
1 Sales 634 94 500 540
500 000
13 Sales 470 70 000 400
000 000
22 Ngosa 667 667 755
755
28 Commission 270 270 000
rec. 000

30 TOTAL 5 042 164 500 940 667 755 270 000


255 000

 The cashbook is the only book of prime entry that is also part of the
ledger. The ledger is the main book of account and will be discussed in
much more detail in the next chapter.

 The column for Other Receivables would further be analysed into,


commission received, rent received, etc. To be consistent if you use the
term ‘Other Receivables’ on the receipts side of the cash book, then
use ‘Other Payables’ on the payments side.

 The column for Trade Receivables capture amounts received from our
customers as payments on account. Value Added Tax is not calculated
on amounts from customers since it is already recorded in the sales
daybook. Value Added Tax is, however, calculated on cash sales and
recorded in the Value Added Tax column for posting the amount to the
ledger.

 The column headings are actually the names of accounts to which


totals for each column will be posted in the ledger. The accounts are
nominal in the case of income, and are real in the case of loans and
non-current assets.

 The cash book usually starts with a balance representing the cash that
remained in the till when the accounts for the preceding accounting
period were prepared. This is the K 8 000 000 you can see in the cash
book above. The balance at start is not a transaction and so it will not
be posted to any account in the ledger.

2.2 CASH BOOK ( CASH -PAYMENTS SIDE )

DATE PARTICULARS FOLI TOTAL Value CASH TRADE WAGES & REPAIRS STATIONERY
Added

TAX PURCH PAYABLES SALARIES


K K K K K
8 Wages 150 000 150 000
13 Bank 200 000
19 Repairs 130 000 130
000
20 Stationery 150 000 150 00
26 Purchases 246 750 36 210
750 000

30 Balance C/d 4 165 505


30 TOTAL 5 042 255 36 210 150 000 130 150 00
750 000 000

 The payments side of the cash book is analysed into amounts paid to
suppliers (Trade Payables), amounts paid for expenses (e.g repairs) and
amounts paid for non-current assets bought for cash. The term Other
payables would be used if payment was made as a settlement of an
outstanding amount owed to a supplier of a non-current asset, or to a
provider of a service on credit. The cash book would therefore have
more columns in practice than are illustrated above.

 The column headings are actually the names of accounts to which


totals for each column will be posted in the ledger. The accounts are
nominal in the case of expenses, and are real in the case of trade
payables and other payables.

 Amounts transferred from the cash account to the bank account and
vice versa are marked with ‘c’, meaning contra entry. Two accounts are
involved: the cash and bank accounts, and so the double entry
completes within the cash book. Such amounts are not posted to any
account in the ledger because the two accounts involved are already in
the cashbook
 Posting the totals to the ledger will be explained in the next chapter.
For now it suffices to mention that the two accounts identifiable from
entries in the cash book are: cash account (the Total Column),
purchases account, Value Added Tax account, repairs account, wages
and salaries, stationery and trade payables accounts.

3.0 BANK ACCOUNT

The Bank Account is also part of the cash book and entries in it are those for
receipt of cheques and payments by cheque or credit cards.The bank
account is analysed much the same way the cash account was done above.

3.1 CASH BOOK ( BANK -RECEIPTS SIDE )

DATE PARTICULARS FOLIO TOTAL Value CASH TRADE OTHER LOANS


Added

TAX SALE RECEIVABLE RECEIVABLE


S S S
APRIL K K K K K K
1 Capital 8 000
000
4 Loan 12 000 12 000 000
000
13 Cash 200
000

30 TOTAL 20 200 12 000 000


000

 The column for other receivables would further be analysed into rent
receivable, commission receivable, etc. In practice there would also be
columns for discount allowed, capital and contra entries;

3.2 CASH BOOK ( BANK -PAYMENTS SIDE )

DATE PARTICULARS FOLIO TOTAL Value CASH TRADE WAGES & RENT MOTOR
Added

TAX PURCH PAYABLES SALARIE PAYABLE VEHICLES


S
K K K K K K
1 Cash c 3 000
000
14 Drawings 100
000
25 Salaries 300 300 000
000
28 Rent 520 520 000
000
29 L-Stone 10 000 10 000 00
Motors 000
30 Kunda 227 227 430
430
30 Balance C/d 6 052
570
30 TOTAL 20 200 227 430 300 000 520 000 10 000 00
000

 Accounts that are similar can be combined (eg wages and salaries).
Rent payable and motor vehicles are examples of other payables. In
practice the payments side of the cashbook would also have columns
for drawings, discount received, and contra entries. Amounts in the
columns for contra entries are not posted to the ledger because double
entry is completed between the cash account and the bank account,
both of which are within the cash book itself.

 At the end of the month (or year as the period of account may be), a
balance is found separately for cash account and for bank account. The
total columns are used to find the balance on each account. The
balance represents the amount of cash remaining at the end of the
period of account and will be the opening balance for the cashbook of
the following period.

 Posting the totals to the ledger will be explained in the next chapter.
For now it suffices to mention that the accounts identifiable from
entries in the cash book above are: cash account (total columns), Trade
Receivables, sales account, other receivables account, and loan
account.

CHAPTER SUMMARY

You should now have learnt that: -

 The cash book is compiled for all cash transactions and preserved for
future reference
 The receipts and cash payment requests are the source documents for
preparing the Cash book

 The labels of analyses columns should be determined by the


accounting information needs of users within the organization.
The Cash Book is the only day book that is both a book of prime entry and a
part of the ledger, since it contains the Cash and Bank Accounts.

EXERCISES

1. Clatus

Clatus started business with K15 000 000 in his bank account and owned a
truck worth K30 000 000 which he intended to use exclusively for business
purposes. The following are his cash transactions for the month of March
2006:

March 1. 2006
March 2. Drew from bank for office use K 5 000 000
March 4. Paid rent in cash K 600 000
March 8. Bought furniture by cheque K 3 500 000
March 8. Drew cash for private use K 250 000
March 13. Cash sales K420 000 net. VAT is charged at the rate of 17.5 %
March 13. Bought stationery K350 000 for cash.
March 14 Sold goods for cash K 540 000 net. VAT is charged at the rate of
17.5 %
March 19. Paid cash for repairs to furniture K180 000
March 20. Paid delivery expenses in cash K630 000.
March 22. Mini-Finance Bank lent us K30 000 000 and paid Del Equipment
K25 000
000 for the truck we earlier bought on credit.
March 25. Paid Salaries in by cheque K 800 000
March 26 Bought goods for re-sale by cheque, K 720 550 gross.
March 27 Settled Simpasa’s account of K337500 by cheque, less 2%
discount
March 28 Paid rates K 330 000 by cheque
March 29. Paid in cash wages K 220 000, Solarpower for electricity K400
000
March 30 Akabondo paid K 400 000 on account.

Enter the transactions in the appropriate Cash book and find the closing
balance at the end of the month.

2. Refer to Question 1:

Prepare journal entries for the cash sale on March 13, the cash purchase
on March 26 and the
supplier payment on March 27

SOLUTIONS TO EXERCISES

QUESTION ONE
CASH BOOK (CASH-RECEIPTS SIDE)

DATE PARTICULARS FOLIO TOTAL Value CASH TRADE OTHER LOANS


Added

TAX SALES RECEVBL RECEVBLE


S S
Marc K K K K K
h
2 Bank (c) 5 000 000
13 Sales 493 500 73 420
500 000
14 Sales 634 500 94 540
500 000
30 Akabondo 400 000 400
000

31 TOTAL 6 528 000 168 960 400


000 000 000

CASH BOOK (CASH -PAYMENTS SIDE)


DATE PARTICULARS FOLI TOTAL Value CASH TRADE WAGES & RENT & STATIONERY
Added

TAX PURCH PAYABLES SALARIES REPAIRS


K K K K K
4 Rent 600 000 600
000
8 Drawings 250 000
13 Stationery 350 000 350 00
19 Furniture 180 000 180
repairs 000
20 Delivery 630 000
expnss
29 Wages 220 000 220 000
29 Solapwer 400 000
-Elect

31 Balance C/d 3 898 000


31 TOTAL 6 528 000 220 000 780 350 00
000

CASH BOOK (BANK -RECEIPTS SIDE)

DATE PARTICULARS FOLIO TOTAL Value CASH TRADE OTHER LOANS


Added

TAX SALE RECEIVABLE RECEIVABLE


S S S
Marc K K K K K K
h
1 Capital 15 000
00
22 Loan 30 30 000 000
000000

31 TOTAL 45 000 30 000 000


000

CASH BOOK (BANK -PAYMENTS SIDE)


DATE PARTICULARS FOLIO TOTAL Value CASH TRADE WAGES & RATES OTHER
Added

TAX PURCH PAYABLES SALARIE PAYABLE PAYABLS


S
K K K K K K
2 Cash c 5 000
000
8 Furniture 3 500 3 500 00
000
22 Del 25 000 25 000 00
Equipment 000
25 Salaries 800 800 000
000
26 Purchases 720 107 613
550 316 234
27 Simpasa 330 330 750
750
28 Rates 330 330
000 000

31 Balance C/d 9 318


700
31 TOTAL 45 000 107 613 330 750 800 000 330 28 500 00
000 316 234 000

Note: Some entries have not been extended in the analysis columns
because of computer field limitation.

QUESTION TWO

JOURNAL ENTRIES
K K
Bank 493 000
Sales 420 000
Value Added Tax 73 500
Cash sales with Value Added Tax at 17-1/2 %

Purchases 613 234


Value Added Tax 107 316
Bank 720 550
Cash purchases with Value Added Tax at 17.5%

Trade Payables (Simpasa) 337 500


Bank 330 750
Discount Received 6 750
Full settlement of a debt owed with 2% cash discount

CHAPTER 8
THE ANALYTICAL PETTY CASH BOOK
INTRODUCTION

Chapter 7 covered the three-column cashbook. The cashbook comprises a


cash account, a bank account and a cash discount column. This chapter
covers the other type of cashbook called the petty cash book. In this
chapter we will discuss the purpose of the petty cash book, the way entries
are made and posted to ledger and the source documents used in
preparation of the book. We will also explain the operation of the imprest
system and how it may differ with the operation of the three-column cash
book.

TOPICS

1) What is petty cash book


2) The purpose of petty cash book
3) What is to be paid out of petty cash
4) Personal security and control of petty cash
5) The petty cash voucher
6) The imprest system
7) Recording in petty cash book including Value Added Tax (VAT)
8) Balancing the petty cash book
9) Posting petty cash book to the ledger (double entry)

LEARNING OUTCOMES

After you have studied this chapter, you should be able to:

- Describe the petty cash book and its intended purpose.


- Identify what should be paid out of petty cash.
- Prepare a petty cash voucher as a source document for entries in the
petty cash book.
- Make appropriately entries in petty cash book, balance off at the end
and post to the ledger.
- Restore imprest in order to start a new period.

1. DEFINITION OF ANALYTICAL PETTY CASH BOOK

1.1 Analytical means the petty cash book is separated into columns
for different categories of expenses, for example,different columns for
expenses relating to postage, stationery, cleaning, and motor
expenses.

1.2 Petty means small items of expenditure the business may incur
in the course of its daily operations.

Therefore, the analytical petty cash book could be defined as:

A book used by a business to record payments of small amounts in cash.


The use of
cheques for such payments is considered to be uneconomical.

2. THE PURPOSE OF PETTY CASH

2.1 It is a common feature that almost in every business, there will be a


number of small expenses that have to be paid for cash, instead of
other methods. To make these payments, which could be on daily
bases, a certain amount of cash has to be kept within the business
offices.
3. WHAT ARE PETTY CASH ITEMS?

3.1 These are payments for small expenses required in cash. It is


important at this stage to be mindful that what is a petty item will
depend on nature and size of an organization, for example, a giant
mining company buying an office stapler would be petty item, but a
small school with may be 6 students a stapler would be a material
item.
3.2 Different business institutions have different rules about what is to be
paid out of petty cash. Because of its nature, cash is highly open to
abuse and requires responsible officers to handle it. Management of
the organization should specify who could receive money out of petty
cash.
3.3 The list of petty cash items should remain flexible for adjustment to
include other small items that may arise in due course.
3.4 If a list of petty items is not available, like in some businesses, the
responsible officer in charge of petty cash may rely on judgment, in
consultation with the supervisor.
3.5 Petty cash items may include the following:

o Travel expenses for employees and refunds of the same


o Other expenses such as printing, stationery, milk, tea, stamps
o Fuel expenses
o Cleaning, just to mention a few

4. PERSONNEL, SECURITY AND CONTROL OF PETTY CASH

4.1 PERSONNEL
Cash by nature is highly open to misappropriation. It is for his reason
that whatever amount is involved, it must be entrusted in the hands of
a responsible officer. For petty cash this responsibility is given to a
petty cashier. In the absence of petty cashier a deputy can takeover
the responsibility.

4.2 SECURITY
It is the responsibility of the petty cashier to ensure that:

(a) Petty cash is held in a safe place. It must be well secured in a


lockable box (petty cash box) with keys to it kept by the petty
cashier. No one should be allowed access to petty cash box apart
from the petty cashier and any other authorized officer.
(b)He or she should be the only one to make actual payments of petty
cash.
(c) All payments are fully and properly authorized and are being made
for valid reasons and intended purpose.

4.3 CONTROL

Petty cash should be used only for small items of expenditure and not
for large expenses, such as office furniture or airfares. Paying large
amounts from petty cash would be an obvious target for theft.

(a) To avoid such, it is important to monitor and control petty cash


spending by ensuring that all payments are properly authorized.

(b)There must be in place also a limit to petty cash payments. For


example management may decide that all petty cash payments
should be limited to
K100 000 amounts more than the limit should be paid by other
means, for
example by cheques.

(c ) Authorization for payments out of petty cash can be done by either


the petty
cashier or Supervisor. The petty cashier could be allowed to
authorize cash
payments up to a certain. Amount within the limit, say K40, 000
within the
K100, 000 limit. Amounts above that up to K100, 000 could be
authorized
by supervisor or appointed person.

5. PETTY CASH EXPENDITURE (PETTY CASH VOUCHER)

5.1 The initial payment of record of payment is the petty cash voucher.
The petty
cash voucher is prepared by the petty cashier whenever a payment
is requested. Petty cash vouchers are serially–numbered slips in a
padded booklet. The booklets are obtainable from stationery
suppliers. The following details are found on the petty cash
voucher:

o Description or details of payment i.e. item of expenditure, for


example, 4 realms A4 paper.
o The amount i.e. amount required for the item to be bought
o Name and signature of the one preparing the petty cash voucher
(usually petty cashier).
o Name and signature of the person authorizing payment (usually
petty cashier or supervisor depending on amount).
o Name and signature of the person to receive cash.
o The date when payment is made
o The voucher number

Example of petty cash voucher.

NO………………

PETTY CASH VOUCHER

DATE……………..

DESCRIPTION/DETAILS AMOUN
T

PREPARED BY:
AUTHORISED BY:
RECEIVED BY:
5.2 RECEIPTS

A receipt is a document prepared by a person receiving money


acknowledging that money has been received for goods or services
supplied.

A person buying items using petty cash must obtain a receipt from the
supplier. The receipt should be given to the petty cashier as evidence
of purchases. The petty cashier will then attach the receipt to the
petty cash voucher as supporting document for payment. The petty
cashier can then record in the book that payment has been made.

5.3 RECEIPTS NOT AVAILABLE.

There could be certain requested payments, which cannot be backed


up by a receipt, for example, Taxi fares, bus fares. In these cases
payment should be sanctioned by a supervisor and properly
authorized.

5.4 VALUE ADDED TAX RECEIPTS

If there’s an amount for Value Added Tax in a payment, and the tax can
be claimed from Zambia Revenue Authority (ZRA), the receipt must
show the following details:

o Total amount paid


o The tax paid
o The suppliers name, address and Value Added Tax registration
number.
o The date of the transaction.

6. THE IMPREST SYSTEM

6.1 The imprest system is where a petty cashier is reimbursed what has
been spent in order to restore the petty cash float.

6.2 Float is the sum of money the petty cashier must start with at the
beginning of every month. It’s decided by management and is usually
fixed but can be adjusted to suit current requirement.

Example of imprest system

The imprest amount (float) is K600, 000. During a particular month a


total of
K450 000 was paid out of petty cash.
In the above situation, the petty cashier is remaining with K150, 000
in cash box, therefore, in order to restore the imprest amount, the
petty cashier will need reimbursement or top up of K450 000 to restore
the imprest amount.

Imprest amount K600, 000


Cash payments K450, 000
Balance K150, 000 Imprest system
Reimbursement K450, 000
Imprest amount K600, 000

IOUs AND PETTY CASH. (I OWE YOU)

7.1 Some organizations allow individuals to borrow money from petty cash,
just for a short period of time, say a day or two.

In such cases the petty cashier must prepare an IOU slip, which shows
o Amount borrowed
o Name and signature of borrower
o The date the amount is borrowed.

7.2 Example of IOU.

I OWE PETTY CASH K20, 000

MARY BANDA
20/02/07

IOU is a good as cash, and the document should be placed in cash box
and be treated as cash. When counting cash in cash box IOU must be
added as cash equivalent.

Example cash and IOU.

The monthly petty cash float is K500, 000. During the month total
expenditure amounted to K285, 000 and an individual borrowed out of
petty cash K35, 000.

At the time of balancing the petty cash book, the individual had not
paid back the
K35, 000. How much cash is available at that time?
The following format will help you calculate the cash balance
remaining.

Physical cash available xx


Plus IOU xx
Plus total expenditure xx
Equals imprest amount xx

For the above example, the solution is;

Imprest amount (float) 500,000


Less expenditure (285,000)
Physical cash available 215,000
Plus IOU 35,000
Petty cash balance 250,000

7.3 When the borrowed money is paid back, the petty cashier will put back
the money in cash box and remove IOU slip, which is torn as if nothing
happened.

IOU should not be encouraged but if it happens, measures should be


put in place to control it. Employees who do not pay back are identified
and amounts recovered from their monthly salary through payroll.

8. RECORDING THE ANALYTICAL PETTY CASH BOOK

8.1 All payments before being recorded in petty cash book must be
supported with petty cash vouchers and receipts. It is highly
recommended that the petty cash book be updated (recorded) on daily
basis in order to have accurate information on petty cash expenditure.

Balancing the petty cash book will depend on the volume of


transactions for petty expenditure. In busy organizations it can be
every two weeks others on monthly basis.

Division of the petty cash book.

The petty cash book is divided into two parts, left and right hand sides.
o The left hand is the debit side. This side is used to record any
cash received by petty cashier.
o The right hand side is the credit side. This is where expenses in
the period are analysed.
o The analysis columns in petty cash book will vary depending on
the organization’s pattern and nature of expenditure.
Example: Analytical petty cash book.

RECEIPTS (DR) PAYMENTS (CR)


Total Dat Detai Vouch Tota Office Posta Cleani Travelin Motor Ledg
DR e ls er No. l Expen ge ng g expen er
CR se se

8.2 Example : Preparing the petty cash book

Lakefield Ltd make use of a petty cash book as part of their


bookkeeping system. The following is a summary of the petty cash
transactions for the month of time
20 X7.

June 1. Opening petty cash float received from K


Cashier…………………………………………… 700,000
2. Cleaning material………………………………….
30,000
3. Postage stamps……………………………………
25,000
4. Envelopes…………………………………………
10,000

June 8. Taxi fare…………………………………………… 65,000


10 Petrol for company car…………………….
100,000
14 Typing paper……………………………………… 80,000
15 Cleaning material………………………………… 29,000
16 Bus fare…………………………………………… 10,000
20 visitors lunches………………………………….. 45,000
21 Mops and bushes for cleaning…………………….
56,000
23 Postage stamps…………………………………. 15,000
27 Envelops………………………………………… 7,000
29 Visitors lunch……………………………………. 60,000
30 Photo copying paper……………………………… 95,000

You are required to draw up a petty cash book for the month using
analysis columns for stationery cleaning, entertainment, traveling and
postage.

Show clearly the receipt of the amount necessary to restore the float
and the balance brought forward for the start of the following month.

SOLUTION

The Analytical Petty Cash Book

Receipts Date Details V/n Total Stat Cleanin Entert Travel Postag
g t e
700,000 Jun 1 Cash
Jun 2 C/Mat 1 30,000 30,00
0
Jun 3 Stamps 2 25,000 25,000
Jun 6 Envelops 3 10,000 10,000
Jun 8 T/Fares 4 65,000 65,000
Jun Petrol 5 100,000 100,000
10
Jun T/Paper 6 80,000 80,000
14
Jun C/Mat 7 29,000 29,00
15 0
Jun B/Fares 8 10,000 10,000
16
Jun V/Lunch 9 45,000 45,0
20 00
Jun21 Mops/Brushe 10 56,000 56,00
s 0
Jun Stamps 11 15,000 15,000
23
Jun Envelops 12 7,000 7,000
27
Jun V/Lunch 13 60,000 60,0
29 00
Jun P/Paper 14 95,000 95,000
30
627,000 192,00 115,00 105,0 175,00 40,000
0 0 00 0
627,00 Jun Cash
0 30
Bal c/d 700,000
1,327,0 1,327,0
00 00
700,000 Jul 1 Bal b/d

DR (K) CR(K)

N.B

When petty cash is established and restored every month double entry
is:

Dr-petty cash
Cr- Bank A/C (when money is withdrawn from bank in the above
example:

Dr Bank A/C (Cash Book) Cr

June 1 Petty cash 700,000


June 30 petty cash 627,000

For expenses the petty cash book is used as on accumulative book for
small expenses, where each expense account is updated on monthly
basis after they have accumulated. As in example the double entry
would be;

Dr Stationery A/C Cr

June 30 Petty cash 192,000

Dr Cleaning A/C Cr
K K
June 30 Petty cash 115,000

Dr Entertainment A/C Cr
K K
June 30 Petty cash 105,000

Dr Traveling A/C Cr
K K
June 30 Petty cash 175,000

Dr Postage A/C Cr
K K
June 30 Petty cash 40,000

N.B

When balancing the petty cash book, balance c/d and b/d is the actual
imprest amount (or float). The amount remaining with the petty
cashier is not shown as part of balance. It therefore means that,
before balancing the petty cash book the cash spent should first be
reimbursed to the cashier, then put in petty cash box with the amount
that remained. This is restoring the imprest amount, which is the
balance.

8.3 Petty cash payments with Value Added Tax.

If a petty cash transactions (i.e. receipts and payment) involves Value


Added Tax,
Value Added Tax should be accounted for separately as long ass
there’s evidence of
Value Added Tax (i.e. Value Added Tax receipt).

Example: Value Added Tax receipt and petty cash record.

RECEIPTT S/No. RECEIPT S/No.


(04) (05)

Date: Date:
01.06.05 02.06.05

Amount Amount
K K
4 Reams A4 90,000 Repairs to computer
Paper 145,000
Value Added Tax 17.5% Add 17.5%
15.75 Value Added Tax
Total 105.75 25,375
170,375

The two Value Added Tax receipts will be recorded as follows in the
petty cash book

PAYMENTS SIDE

Date Details V. No. Total Statione Repairs Value


ry Added
Tax
02.06.0 4 Ream 04 105.75 90,00 15.75
5 of paper
Repairs 05 170.375 145,00 25,375
02.06.0 0
5

9. CHAPTER SUMMARY

You should have now learned that:

o Petty cash is used to make small payments.


o Petty cash must be kept safely in a lockable cash box.
o Because of its nature, for security reasons petty cash should be
in the hands of a responsible officer and that not every body in
an organization is eligible for petty cash.
o Petty cash is operated on an imprest system. This is where the
petty cashier is reimbursed what has been spent in order to
restore the imprest amount.

Thus: FLOAT xx
Less expenditure xx
Balance xx
Reimbursement xx
FLOAT xx

o All payments out of petty cash must be fully authorized by


signing on the
voucher.
o If there’s no receipt (document) to support the claim, the petty
cashier must consult the supervisor.
o Entries made (recorded) in petty cash book originate from a
document called petty cash voucher.
o The petty cash book is used as an accumulative book for small
expenses of which the totals for the period are transferred to
respective expense account in general ledger.
o Petty cash expenditure involving Value Added Tax, should be
recorded separately in petty cash book with separate amounts
in the Value Added Tax column.

EXERCISES

1. What is the purpose of the petty cash book?


2. Who is responsible for maintaining cashbook?
3. What is the imprest amount (petty cash float)?
4. The petty cash book is maintained on a system called imprest system.
What is imprest system?
5. What is the source document for entries in petty cash book?
6. What is the division of the petty cash book?

7. The following petty cash transactions were recorded during the month
of December
20x6.

1. Petty cash float was K400, 000 was obtained by withdrawal


of cash from the Bank.
2. Paid for stationary………………………………… 10,800
4. Paid for sundry expenses…………………………. 21,700
6. Cash sales………………………………………… 30,000
9. Repairs to vehicles……………………………….. 42,500
10. Cash received from staff telephone calls………… 18,000
12. Paid for stationery……………………………….. 90,000
14. Paid for sundry expenses………………………… 28,200
19. Cash sales…………………………………………. 33,000
25. Paid for stationary………………………………… 47,800

All expenses and income listed above are inclusive of Value Added Tax at
17.5%.
Required:

Record all the transactions in petty cash book and balance off as at 31
December 20x6 and restore the imprest amount.

SOLUTIONS TO EXERCISES

1. The purpose of petty cash book is to record small items of expenditure


2. The petty cashier.
3. This is a fixed amount a petty cashier requires at the beginning of every
period.
4. This is a system where the petty cashier is reimbursed what has been
spent in order to
restore the imprest amount.
5. The petty cash voucher with actual receipt of amount spent.
6. The petty cash book is divided into two sides.

Left side and right side


Left side to record receipts
Right side to record payments.

7 PETTY CASH BOOK


DR(K) CR(K)
Net Recpt SalesTa Total Date Details V/N Total Station Repairs S/Exps Value Ad
x Tax
400,0 Dec 1 Cash
00
Dec 2 Station 1 10,800 9,191.5 1,6
0
Dec 4 S/Exps 2 21,700 18,468. 3,2
09
25,531.92 4,468.0 30,00 Dec 6 C/Sales
8 0
Dec 9 Repairs 3 42,500 36,170. 6,3
21
15,319.15 2,680.8 18,00 Dec Recpt/Pho
5 0 10 ne
Dec Station 4 90,000 76,595. 13,4
12 75
Dec S/Exps 5 28,200 24,000. 4,2
14 00
28,085.11 4,914.8 33,00 Dec C/Sales
9 0 19
Dec Station 6 47,800 40,680. 71
25 85
241,00 126,46 36,170 42,468. 35,89
0 8.1 .21 09
160,0 Dec Cash
00 31
Dec Bal c/d 400,00
31 0
68,936.1 12,063. 641,0 641,00
8 82 00 0
400,0 Jan 1 Bal b/d
00
CHAPTER 9
PREPARING LEDGER ACCOUNTS – PART ONE
INTRODUCTION

In this chapter we will discuss how credit transactions recorded in the day
books are posted to the accounts in the ledger. The ledger is the main book
of account. It is in this book that the rule of double entry must be applied. At
the end of the exercise of posting entries to ledger accounts, the accounts
are closed and balances extracted in the form of a trial balance. The trial
balance is then used to prepare the Income Statement and Balance sheet.

TOPICS

1. Preparing ledger accounts


2. Summary

LEARNING OBJECTIVES

After you have studied this chapter, you should be able to:

 Understand how to apply the rule of double entry to transactions


 Post the entries in the day books to the ledger

1.0 PREPARING LEDGER ACCOUNT

With the guidelines in the preceding section we will use an exercise to


illustrate how the rule of double entry is applied to posting transactions to
the ledger. First we will handle trading activities and later on other
operational activities. For convenience sake we have reproduced the
transactions and the day books we prepared in the previous chapter.

1.1 ILLUSTRATION

Fix-it, a retired engineer, received interest on his fixed deposit account of K 8


000 000 and opened a business bank account. He immediately withdrew K 3
000 000 for office use. VAT is charged at the rate of 17.5 %. The following are
transactions for the first month of trading:

April 1. Sold goods on credit to Chisakaila K540 000 net.

April 5. Sold goods on credit to Ngosa K800 000 net. The customer is
entitled to less 2 % prompt discount if payment is made within
14 days.
April 7. Ngosa returned goods, K200 000 net (He is entitled to prompt
discount of
2%)
April 12. Purchased goods on credit from Kunda K282 000. The invoice
stated a tax inclusive amount.
April 13. Received an invoice for the 10 ton truck bought on credit from L-
Stone Motors K40 000 000 gross
April 13. Issued an invoice to Mulota K400 000 net.
April 13 Returned goods worth K42 600 to Kunda. This is a tax inclusive
figure.
April 15 Sold goods on credit to Mambwe K750 000 net.
April 17. We sent a credit note to Mambwe, K150 000, net
April 18. Purchased Goods on credit from Mwape K270 000 gross value.
April 19. Received a bill for electricity from Zam Hydropower. The total of
the invoice was K320 000
April 19. Received a credit note from Mwape for K35 700 (gross amount).

SALES DAY BOOK


DATE PARTICULARS FOLIO TOTAL VALUE ADDED TRADE OTHER
TAX RECEIVABLE RECEIVABLE
April K K K K
2005
1 Chisakaila 634 500.00 94 500.00 540 000.00
5 Ngosa 937 200.00 137 200.00 800 000.00
13 Mulota 470 000.00 70 000.00 400 000.00
15 Mambwe 881 250.00 131 250.00 750 000.00

TOTAL 2 922 950.00 432 950.00 2 490 000.00

SALES RETURNS DAY BOOK


DATE PARTICULARS FOLIO TOTAL VALUE TRADE OTHER
ADDED
TAX RECEIVABLE RECEIVABLE
April K K K K
2005

7 Ngosa 234 300.00 34 300.00 200 000.00


17 Mambwe 176 250.00 26 250.00 150 000.00

TOTAL 410 550.00 60 550.00 350 000.00

PURCHASES DAY BOOK


DATE PARTICULARS FOLIO TOTAL VALUE TRADE OTHER
ADDED
TAX PAYABLE PAYABLE
April K K K K
2005
12 Kunda 282 42 240 000.00
000.00 000.00
13 L-Stone Motors Ltd 40 000 000 . 40 000 000.00
00
18 Mwape 270 40 212.76 229 787.24
000.00
19 Zam Hydropower 320 320 000.00
000.00

TOTAL 40 872 82 212.76 469 787.24 40 320 000.00


000.00

PURCHASES RETURNS DAY BOOK


DATE PARTICULARS FOLIO TOTAL VALUE TRADE OTHER
ADDED
TAX PAYABLE PAYABLE
April K K K K
2005

13 Kunda 42 600.00 6 344.68 36 255.32


19 Mwape 35 700.00 5 317.02 30 382.98

TOTAL 78 300.00 11 661.70 66 638.30

1.2 LEDGERS
Explanatory notes follow after all the accounts have been written.

Note: All amounts on Debits and Credits are in Kwacha Currency.

TRADE RECEIVABLES

K
K
Sales 2 922 950.00 Sales Returns
410 550.00
SALES

Trade Receivables 2 490


000.00

SALES RETURNS

Trade Receivables 350 000.00

TRADE PAYABLE

Purchases Returns 78 300.00 Purchases 552


000.00

OTHER PAYABLE - (Non Current Asset)

Motor Vehicles 400


000.00

OTHER PAYABLE - (Electricity)

Electricity 320 000.00


PURCHASES

Trade Payable 469 787.24

MOTOR VEHICLES

Other Payable 40 000 000.00

ELECTRICITY

Other Payable 320 000.00

VALUE ADDED TAX


Payables 82 212.76 Payables 11
661.70
Trade Receivable 60 550.00 Trade Receivable 432
950.00

1.3 COMMENTS

In the accounts above credit transactions have been posted to the ledger.
What was given/received were goods. The names of the outside entities were
given (see the day books reproduced here also).

Sales on credit

The trade receivables account is debited with K 2 922 950.00 because it


represents customers who received the goods. The sales account represents
the business we are doing accounts for and it gave the goods. The credit is
split between sales account and Value Added Tax account. The Trade
receivables are debited with the gross amount because the customers are
expected to pay the total amount of both the net value of goods and the
Value Added Tax on them. The cash is eventually received the Value Added
Tax becomes payable to the Govt whereas the net amount is kept by the
business.

Sales Returns

The customers gave the goods they returned to us and so the trade
receivable account is credited with the gross amount of K 410 550.00. We
received the goods and the account representing our business, sales returns
account, has been debited with the net amount whereas the associated tax
is debited to the Value Added Tax account as amount not payable to the
govt.

Purchases on credit

The term ‘purchases’ conventionally refer to goods bought for re-sale and so
excludes purchases of non current assets.
The double entry can be represented in the following journal:
DR (K) CR(K)
Purchases 469 787.24
Value Added Tax 82 212.76
Electricity 320 000.00
Trade Payable (for goods) 552 000.00
Other Payable –(Electricity) 320 000.00
The amount in the other payables –electricity account is the gross amount
because Value Added Tax on this purchase has been ignored for simplicity’s
sake
The journal for the non current asset is : Debit the Motor Vehicles account
(representing the business, or the activity done) and credit the Other Payable
–Non Current asset account (representing the giver, L-Stone Motors). The
cost of the motor vehicle is gross because the Value Added Tax component is
not passed on to the customer. The vehicle is not for re-sale.

2.0 CHAPTER SUMMARY

By now you should have learnt that

 The implication of the entity concept is important if you are to apply


the rule of double entry correctly
 Proper accounting entries are made by applying the rule of double
entry to transactions without exception
 Closing accounts is dependent on whether something is continuing
about the fund in the account or not
 What can continue on an account is either the physical existence of an
asset or the future receipt/payment of cash.

EXERCISES

Refer to the Question bank at the end of Chapter 11.


CHAPTER 10

PREPARING LEDGER ACCOUNTS – PART TWO

INTRODUCTION

In this chapter we explain how the rule of double entry is applied when
posting entries from the cash account and from the bank account (the cash
book is part of the ledger also). It is important to refer to the page with
guidelines on identifying the flow, account to debit and account to credit
before you proceed.

TOPICS

1. Cash transactions
2. Posting entries in the cash book to the ledger
3. Summary

LEARNING OUTCOMES

After you have studied this chapter, you should be able to:

 Apply the rule of double entry to cash transactions


 Post the entries in the cash book to the appropriate ledger accounts
 Calculate Value Added Tax on cash purchases and cash sales

1.0 CASH TRANSACTIONS

With the guidelines in the preceding section we will use an exercise to


illustrate how the rule of double entry is applied to posting transactions to
the ledger. This time we will handle cash transactions. For convenience sake
we reproduce the cash transactions and the cash book compiled in chapter
5.

Fix-it, a retired engineer, received interest on his fixed deposit account of K8


000 000 and opened a business bank account. He immediately withdrew K3
000 000 for office use. The following are transactions for the first month of
trading:

April 2005
April 1. Sold goods for cash K540 000 net. VAT is charged at the rate of
17.5 %
April 4. Borrowed K12 000 000 from Credit Funds Bank, cheque
received same day
April 8. Paid wages in cash K150 000
April 13. Cash sales K400 000 net.
April 13. Banked K200 000 from cash till.
April 14 Drew from bank for private use K100 000
April 19. Paid cash for repairs to furniture K130 000
April 20. Cash purchases of stationery K150 000 (all tax-exempt).
April 22. Ngosa paid his account in full less 5% cash discount K667 766.
April 25. Paid Salaries by cheque K300 000
April 26 Bought goods for re-sale in cash, K246 750 gross.
April 28 Paid rent K520 000 by cheque and received commission for
selling scratch cards K270 000 by cash
April 29. Paid L-Stone K10 000 000 by cheque for the truck bought earlier.
April 30 Settled Kunda’s account by cheque, less 5% cash discount K227
430.

1.1 CASH BOOK (CASH -RECEIPTS SIDE)

DATE PARTICULARS FOLIO TOTAL VALUE ADDED CASH TRADE OTHER LOANS
TAX SALES RECEIVABLES RECEIVABLES
APRIL
1 Bank 3 000
000
1 Sales 634 94 500 540
500 000
13 Sales 470 70 000 400
000 000
22 Ngosa 667 667 755
755
28 Commission 270 270 000
rec. 000

30 TOTAL 5 042 164 500 940 667 755 270 000


255 000

1.2 CASH BOOK (CASH -PAYMENTS SIDE)

DATE PARTICULARS FOLIO TOTAL VALUE CASH TRADE WAGES & REPAIRS STATIONERY
ADDED
TAX PURCH PAYABLES SALARIES
APR
8 Wages 150 150
000 000
13 Bank 200
000
19 Repairs 130 130 000
000
20 Stationery 150 150 00
000
26 Purchases 246 36 210
750 750 000

30 Balance C/d 4 165


505
30 TOTAL 5 042 36 210 150 130 000 15000
255 750 000 000

1.3 CASH BOOK (BANK -RECEIPTS SIDE)


DATE PARTICULARS FOLIO TOTAL VALUE ADDED CASH TRADE OTHER LOANS
TAX SALE RECEIVABLES RECEIVABLES
S
APRIL
1 Capital 8 000
000
4 Loan 12 000 12 000
000 000
13 Cash 200
000

30 TOTAL 20 200 12 000


000 000

1.4 CASH BOOK (BANK -PAYMENTS SIDE)


DATE PARTICULARS FOLIO TOTAL VALUE CASH TRADE WAGES & RENT MOTOR
ADDED
TAX PURCH PAYABLES SALARIES PAYABLE VEHICLES
APR
1 Cash 3 000
000
14 Drawings 100
000
25 Salaries 300 300 000
000
28 Rent 520 520 000
000
29 L-Motors 10 000 10 000 00
000
30 Kunda 227 227 430
430
30 Balance C/d 6 052 570
30 TOTAL 11 272 227 430 300 000 520 000 10 000 00
000

2.0 POSTING TO THE LEDGER

Since the cash book is part of the ledger, the receipts are effectively on the
debit side of the cash/bank account, and payments are correspondingly on
the credit side of the cash/bank account. The ledger accounts which follow
below therefore will carry only the other entry of the double entry. Journal
entries would also be written for each of the transactions, for example:

Debit: Cash a/c (in the cash book) K 270 000


Credit: Commission a/c K 270 000

TRADE PAYABLE
Bank 227 430

TRADE RECEIVABLES

Cash 667 755

COMMISSION

Cash 270
000

SALES

Cash 940 000

PURCHASES

Cash 210 000

WAGES

Cash 150 000


Bank 300 000

REPAIRS

Cash 130 000

STATIONERY

Cash 150 000

RENT

Bank 520 000

VALUE ADDED TAX


Payables 82 212.76 Payables 11
661.70
Trade Receivables 60 550.00 Trade Receivables
432 950.00
Cash 36 750.00 Cash
164500.00

LOAN

Bank 12 000
000

L-STONE MOTORS

Bank 10 000 000

2.1 COMMENTS ON ENTRIES IN THE ACCOUNTS

 In the accounts above cash transactions have been posted to the


ledger. What was given/received was cash. The entries that would be in
the trade receivables account and trade payables account have not
been reproduced accordingly.

 The entries in the Value Added Tax account show that tax arise both
from credit transactions and cash transactions. The net of the credit
entries and the debit entries is the amount that becomes payable to
the tax authorities.

 The entry in the Lstone-Motors account is a part payment for the truck
we bought on credit from them (Refer to the entries in the Purchases
Day Book in the previous chapter)

 Note also that an account can capture both amounts from the cash and
the bank accounts, which are in the cash book.

In the next chapter we discuss how ledger accounts are closed for
preparation of the trial balance and eventually the financial statements.
3.0 SUMMARY

You should now have learnt that:

 When cash is paid the cash account is credited and the account
representing the activity is debited
 When cash is received the cash account is debited and the account
representing the activity is credited.
 Where the cash is paid / received by an outside entity, then the
account for that entity will also be updated with the transaction.
CHAPTER 11

CLOSING ACCOUNTS AND EXTRACTING A TRIAL


BALANCE

INTRODUCTION

In the previous chapters we applied the rule of double entry to post original
transactions to the ledger. In this chapter we will move a step further and
illustrate how accounts are closed and a trial balance extracted.

TOPICS

1. Transfers to Income Statement (Trading & Profit & Loss account)


2. Transfers to the following period( Balance sheet items)
3. Extracting a trial balance
4. Summary

LEARNING OBJECTIVES

After you have studied this chapter, you should be able to:

 Identify accounts whose balances are reported in the income


statement, and those whose balances are reported in the balance
sheet
 Close accounts in the correct way and extract a trial balance
accordingly

1.0 CLOSING LEDGER ACCOUNTS

Closing accounts is done prior to preparation of final accounts (Trading and


Profit & Loss account). Principally the income statement comprises these two
accounts. The purpose of the income statement is to provide a summary of
accounts and reveal if the business made any profit or loss on the activities
carried out during the year.

At this stage it is important to note that a different set of ‘transactions’ is


handled. The transactions are called transfers. Amounts are transferred
either to the income statement if there is nothing continuing on the account,
or to the following year if there is something continuing. What is said to
continue on an account can either be payment or receipt of cash, or physical
existence of what the account represents.

1.1 NOMINAL ACCOUNTS

When handling transfers you should first note where the funds are in an
account: debit or credit, and then introduce an entry on the opposite side.
Then complete double entry in one of the accounts in the income statement
or in the same account but of the following period of account.

Here is an example of how it is done (The ledger accounts have been


reproduced from the previous chapters and include both entries for cash and
credit transactions):

SALES

Trade Receivables 2 490


000.00
Trading 3 430 000.00 Cash 940 000.00

3 430 000.00 3 430 000.00

SALES RETURNS

Trade Receivable 350 000.00 Trading 350 000.00

350 000.00 350 000.00

The entry described ‘Trade Receivables’ completes double entry with the
Trade Receivables account. The entry described as ‘Trading’ completes
double entry with the trading account which is a segment of the Income
Statement. For example, the total of sales K3 430 000.00 is being transferred
to the Income Statement for reporting purposes. The transfer starts with a
debit entry in the Sales account and so it will end with a credit entry in the
trading account of the Income Statement.

1.2 REAL ACCOUNTS

Here is an example for transferring balances to the following period, and to


be reported in the balance sheet.

TRADE PAYABLE
Purchases Returns 78 300.00 Purchases
552 000.00
Bank 227 430.00
Discount Received 11 970.00
Balance c/d 234 300.00

552 000.00 552 000.00

Balance b/d 234 300.00

Closing books would literally mean that accounts with something continuing
on them are re-opened in the books of the following period of account. We
would have to transfer the unpaid amount on the Trade Payables above to a
Trade Payables account for the following month. The transfer would start with
a debit of K 234 300.00 described as Balance c/d above and end with a credit
entry in the Trade Payables account of the following period and described as
balance b/d. In the ledger we simply write the two entries on the same
account: one above the total lines and the other below the total lines but on
the opposite side as can be seen above.

1.3 OTHER ACCOUNTS BELOW


The other accounts are closed according to the principle highlighted in 1.1
and 1.2 above. Transfers to the Income statement can be either to trading
account or to profit and loss account, depending on whether the account has
to do with goods or with services consumed respectively. The account
balances that are summarized in the balance sheet are closed by ‘balance
c/d’ and balance b/d’ because on them there is some thing continuing to the
next period: payment or receipt of cash or physical existence of the asset
and future use.

L-STONE MOTORS -(Other Payables)

Bank 10 000 000.00 Motor Vehicles 40 000


000.00
Balance c/d 30 000 000.00

40 000 000.00 40 000 000.00

Balance b/d 30 000 000.00


ZAM HYDROPOWER CO. - (Other Payables)

Balance c/d 320 000.00 Electricity 320 000.00

320 000.00 320 000.00

Balance b/d 320 000.00

PURCHASES

Trade Payable 469 787.24


Cash 210 000.00 Trading 679
787.24

679 787.24 679


787.24

PURCHASES RETURNS

Trading c/d 66 638.30 Trade Payables 66 638.30

66 638.30 66 638.30

MOTOR VEHICLES

L-Stone Motors 40 000 000.00 Balance c/d 40 000 000.00

40 000 000.00 40 000 000.00

Balance b/d 40 000 000.00

ELECTRICITY

Zam Hydropower Co 320 000.00 Profit & Loss 320


000.00
320 000.00 320 000.00

DRAWINGS

Bank 100 000.00 Capital 100 000.00

100 000.00 100 000.00

TRADE RECEIVABLES

Sales 2 922 950.00 Sales Returns 410


550.00
Cash 667 755.00
Discount All 35 145.00
Balance c/d 1 809 500.00

2 922 950.00 2 922 950.00

Balance b/d 1 809 500.00

COMMISSION

Profit & Loss 270 000.00 Cash 270 000.00

270 000.00 270 000.00

WAGES & SALARIES

Cash 150 000


Bank 300 000 Profit & Loss c/d 450
000.00

450 000 450 000.00

REPAIRS

Cash 130 000.00 Profit & Loss c/d 130


000.00

130 000.00 130 000.00

STATIONERY
Cash 150 000.00 Profit & Loss c/d 150
000.00

150 000.00 150


000.00

RENT

Bank 520 000.00 Profit & Loss c/d 520 000.00

520 000.00 520 000.00

VALUE ADDED TAX

Payables 82 212.76 Payables 11


661.70
Trade Receivable 60 550.00 Trade Receivable 432
950.00
Cash 36 750.00 Cash
164 500.00
Balance c/d 429 598.94

609 111.70 609


111.70

Balance b/d 429 598.94

LOAN

Balance c/d 12 000 000.00 Bank 12 000


000.00

12 000 000.00 12 000


000.00

Balance c/d 12 000


000.00

CAPITAL

Balance c/d 8 000 000.00 Bank 8 000


000.00
8 000 000.00 8 000
000.00

Balance c/d 8 000


000.00

DISCOUNT ALLOWED

Trade Receivables 35 145.00 Profit & Loss


35 145.00

35 145.00 35 145.00

DISCOUNT RECEIVED

Profit & Loss 11 970.00 Trade Payables 11


970.00

11 970.00 11 970.00

The amounts in the cash and bank accounts below are a summary of the
entries in the cash book prepared in the preceding chapter. Drawings are
principally transferred to capital account because in the balance sheet the
amount of drawings is deducted from the balance on the capital account.

BANK ACCOUNT

Total Receipts 20 200 000 Total Payments 14 147 430


Balance c/d 6 052
570

20 200 000 20 200 000

Balance b/d 6 052 570

CASH
Total Receipts 5 042 255 Total Payments 876
750
Balance c/d 4 165
505

5 042 255 5 042


255

Balance b/d 4 165 505

2.0 EXTRACTING THE TRIAL BALANCE

The trial balance is a schedule of account balances that help in the


confirmation that the rule of double entry was correctly applied. It is NOT an
account to which amounts are posted to complete double entry. When the
Trial balance fails to balance it means that either the rule of double entry was
not applied accurately or errors have been made in the accounts. Correction
of errors is a subject of another topic. Only when the trial balance has
balanced can the next step of preparing the Income Statement and balance
sheet be carried out.

2.1 HOW IT IS DONE

Amounts are listed on the trial balance on the side they appear or would
appear below the total lines on the account. For example, Value Added Tax of
K429 598.94 is listed on the credit side in the trial balance because it is on
the credit side below total lines on the account in the ledger.

Purchases account balance of K679 787.24 is listed on the debit side of the
trial balance because the entry described as ‘trading’ on the account would
be on the debit side if it were written (by extension) below the total lines on
the ledger account itself. Alternatively, the transfer of funds to Trading
account will throw funds on the debit side of that account. It is that debit that
is effectively listed on the trial balance.

FIX-IT
TRIAL BALANCE AS AT 30 APRIL 2005
DR CR
Sales 3 430 000.00
Sales Returns 350 000.00
Trade Payables 234 300.00
L-Stone Motors 30 000 000.00
Zam Hydro Power Co. 320 000.00
Purchases 679 787.24
Purchases Returns 66 638.30
Motor Vehicles 40 000 000.00
Electricity 320 000.00
Drawings 100 000.00
Trade Receivables 1 809 500.00
Commissioned Received 270 000.00
Wages & Salaries 450 000.00
Repairs 130 000.00
Stationery 150 000.00
Rent 520 000.00
Value Added Tax 429 598.94
Loan 12 000 000.00
Capital 8 000 000.00
Discount Allowed 35 145.00
Discount Received 11 970.00
Bank 6 052 570.00
Cash 4 165 505.00
______________ ______________
54 762 507.24 54 762 507.24
______________ _____________

CHAPTER SUMMARY

You have seen that to prepare ledger accounts that lead to a balancing trial
balance you need to be thorough when recording entries in the books of
prime entry ( day books) and to apply the rule of double entry to every
transaction without exception. You also need to understand the logic of
account transfers to the income statement (profit and loss account), and
transfers to the same account but of the following period (balance c/d and
balance b/d). These balances are the amounts that are reported in the
balance sheet as a summary of ledger account balances. The challenge is all
yours to master the application of the rule of double entry. You will convince
yourself that you have developed the competence if you manage to balance
the illustrative question again and the question in the exercises section of
this chapter. Your progression will be steady and sure if you do this.

SELF-TEST QUESTIONS

1. Re-attempt the whole exercise and see whether you can do it up Trial
balance
2. What is the accounting treatment of discount allowed and discount
received?

EXERCISES

Question 1

Lambdar started business with K15 000 000 in his bank account and owned a
truck worth K30,000 000 which he intended to use exclusively for business
purposes. The following are his cash transactions for the month of March
2006:

March 2005
March 2. Drew from bank for office use K5 000 000
March 2. Sold goods on credit to Akabondo K845 000 net.
VAT is charged at the rate of 17.5 %
March 4. Paid rent in cash K 600 000
March 7. Purchased goods on credit from Siwale K424 000. The invoice
stated a tax inclusive amount.
March 8. Bought furniture by cheque K3 500 000
March 8. Sold goods on credit to Mubita K780 000 net. The customer is
entitled to
2 % prompt discount if payment is made within 14 days.
March 8. Drew cash for private use K250 000
March 12. Received an invoice for the forklift bought on credit from Del
Equipment
K30 000 000 gross
March 13. Cash sales K420 000 net. VAT is charged at the rate of 17.5 %
March 13. Bought stationery K350 000 for cash.
March 14 Sold goods for cash K540 000 net. VAT is charged at the rate of
17.5 %
March 14. Issued an invoice to Mubiana K680 000 net.
March 15. Purchased Goods on credit from Simpasa K 380 000 gross
value.
March 16 Sold goods on credit to Mundia K750 000 net.
March 18. Akabondo returned goods, K325 000 net (He is entitle to prompt
discount of 2 %)
March 19. Received a bill for electricity from Solarpower Co. The total of the
bill was
K502 000
March 19. Paid cash for repairs to furniture K180 000
March 20. Paid delivery expenses in cash K630 000.
March 21. We sent a credit note to Mundia, K300 000, net
March 22. Mini-Finance Bank lent us K30 000 000 and later the same day
paid Del Equipment K25 000 000 for the forklift we earlier
bought on credit.
March 22 Returned goods worth K83 600 to Siwale . This is a tax inclusive
figure.
March 24. Received a credit note from Simpasa for K42 500 (gross amount).
March 25. Paid Salaries in by cheque K800 000
March 26 Bought goods for re-sale by cheque, K 720 550 gross.
March 27 Paid Simpasa’s account in full by cheque, less 2% discount
March 28 Paid rates K330 000 by cheques.
March 29. Paid in cash wages K220 000, Solar power for electricity K400
000
March 30 Akabondo paid K400 000 on account.

Enter the transactions in the appropriate day books, post to the ledger and
extract a trial balance at the end of the month.
Question 2

Refer to Question 1: Prepare journal entries for the transactions on March 13,
March 26
and March 27.

Question 3

Winwell owns a fast-food store, which is Value Added Tax registered. During
the day’s
trading he entered into the following transactions:

A credit sale of K470 000


A cash sale of K200 000 net
A purchase for K700 000 list price net of Value Added Tax, less 20% trade
discount
A returns outward was made for K150 000 list price from the same supplier.

At the start of the day there was nil balance on the Value Added Tax account.
The rate of Value Added Tax is 17.5%

What is the closing balance on Winwell’s Value Added Tax account following
the above transactions?

Question 4

At the beginning of February 20x6 Vumbi owed K7 200 000 to ZRA A


summary of the transactions of Vumbi plc , which is registered for Value
Added Tax at 17.5%, shows the following for the month of February 20x6:

Outputs (inclusive of Value Added Tax) K 122 610 000


Inputs (exclusive of Value Added Tax) K 78 857 000

During February 20X6 Vumbi paid ZRA K6 800 000. Calculate the amount
owing to ZRA on 28 February 20x6.
SOLUTIONS TO EXERCISES

SOLUTION ONE
(Note: In this solution some words have been abbreviated to their
consonants only for convenience)

1. LAMBDAR - CALCULATION OF CAPITAL


K K
Assets:
Cash 15 000 000
Motor Vehicle 30 000 000
45 000 000
Liabilities:
None __________
Capital 45 000 000

==========

JOURNAL ENTRIES
DR CR
March 8 Furniture 3 500 000
Bank 3 500 000
Purchases of office desk by cheque

March 12 Motor Vehicle 30 000 000


Del Equipment 30 000 000
Purchases of a Truck S/No on credit

March 22 Bank 30 000 000


Loan (Mini Finance) 30 000 000
Loan obtained from Mini Finance

March 22 Del Equipment 25 000 000


Bank 25 000 000
Part payment for the motor vehicle
bought on credit on 12 March 2006
SALES DAY BOOK
DATE CUSTOMERS FOLIO TOTAL VALUE ADDED TRADE OTHER
TAX RECEIVABLE RECEIVABLE
March K K K K
2006
2 Akabindo 992 147 845
875.00 875.00 000.00
8 Mubita 913 113 780
770.00 770.00 000.00
14 Mubiana 799 119 680
000.00 000.00 000.00
16 Mundia 881 131 750
250.00 250.00 000.00

TOTAL 3 586 531 3 055


895.00 895.00 000.00

SALES RETURNS DAY BOOK


DATE CUSTOMER FOLIO TOTAL VALUE TRADE OTHER
ADDED
TAX RECEIVABLE RECEIVABLE
March K K K K
2006

18 Mubita 380 738.00 55 738.00 325 000.00


21 Mundia 352 500.00 52 500.00 300 000.00

TOTAL 733 238.00 108 625 000.00


238.00

PURCHASES DAY BOOK


DATE SUPPLIER FOLIO TOTAL VALUE TRADE OTHER
ADDED
TAX PAYABLE PAYABLE
March K K K K
2006
7 Siwale 424 63 360
000.00 149.00 851.00
12 Del Equipment 30 000 40 000
000 .00 000.00
15 Simpasa 380 56 323
000.00 596.00 404.00
19 Solarpower Co. 502 502
000.00 000.00
TOTAL 31 306 119 684 30 502
000.00 745.00 255.00 000.00

Workings

1 Trade Payable account K K


Siwale 424 000.00 360 851.00
Simpasa 380 000.00 323
804.00
Total 804 000.00 684
255.00

2 Other Payables
Solarpower Co. 502 000.00
Del Equipment 30 000 000.00
Total 30 502 000.00

PURCHASES RETURNS DAY BOOK


DATE SUPPLIER FOLIO TOTAL VALUE TRADE OTHER
ADDED
TAX PAYABLE PAYABLE
March K K K K
2006

22 Siwale 83 600.00 12 71 149.00


451.00
24 Simpasa 42 500.00 6 36 170.00
330.00

TOTAL 126 100.00 18 107 319.00


781.00

CASH BOOK (CASH-RECEIPTS SIDE)


DATE PARTICULARS FOLIO TOTAL VALUE CASH TRADE OTHER LOANS
ADDED
TAX SALES RECEVBL RECEVBLE
S S
Marc K K K K K
h
2 Bank (c) 5 000 000
13 Sales 493 500 73 420
500 000
14 Sales 634 500 94 540
500 000
30 Akabondo 400 000 400
000

31 TOTAL 6 528 000 168 960 400


000 000 000

2.2 CASH BOOK (CASH -PAYMENTS SIDE)


DATE PARTICULARS FOLI TOTAL VALUE CASH TRADE WAGES & REPAIRS STATIONERY
ADDED
TAX PURCH PAYABLES SALARIES
K K K K K
4 Rent 600 000
8 Drawings 250 000
13 Stationery 350 000 350 00
19 Furniture 180 000 180
repairs 000
20 Delivery 630 000
expnss
29 Wages 220 000 220 000
29 Solapwer 400 000
-Elect

31 Balance C/d 3 898 000


31 TOTAL 6 528 000 220 000 180 350 00
000

3.1 CASH BOOK (BANK -RECEIPTS SIDE)

DATE PARTICULAR FOLI TOTAL VALUE CASH TRADE OTHER LOANS


S O ADDED
TAX SALE RECEIVABLE RECEIVABLE
S S S
Marc K K K K K K
h
1 Capital 15 000
000
22 Loan 30 000 30 000 000
000

31 TOTAL 45 000 30 000 000


000

3.2 CASH BOOK (BANK -PAYMENTS SIDE)


DATE PARTICULARS FOLIO TOTAL VALUE CASH TRADE WAGES & RATES OTHER
ADDED
TAX PURCH PAYABLES SALARIE PAYABLE PAYABLS
S
K K K K K K
2 Cash c 5 000
000
8 Furniture 3 500 3 500 00
000
22 Del 25 000 25 000 00
Equipment 000
25 Salaries 800 800 000
000
26 Purchases 720 107 613
550 316 234
27 Simpasa 330 330 750
750
28 Rates 330 330
000 000

31 Balance C/d 9 318


700
31 TOTAL 45 000 107 613 330 750 800 000 330 28 500 00
000 316 234 000

SALES

Trade Receivables 3 055 000


Trading 4 015 000 Cash 960 000

4 015 000 4 015 000

SALES RETURNS

Trade Receivable 625 000 Trading 625 000

625 000 625 000

TRADE PAYABLE

Purchases Returns 126 100 Purchases 804


000
Bank 330 750
Discount Received 6 750
Balance c/d 340 400

804 000 804 000


-------------------
Balance b/d 340 400

DEL EQUIPMENT - (Other Payables)

Bank 25 000 000 Motor Vehicles 30 000 000


Balance c/d 5 000 000

30 000 000 30 000 000

Balance b/d 5 000 000

SOLARPOWER CO.-(Other Payables)

Cash 400 000 Electricity 502 000


Balance c/d 102 000
502 000 502 000

Balance b/d 102 000

PURCHASES

Trade Payable 684 255


Bank 613 234 Trading 1 297 489

1 297 489 1 297 489

PURCHASES RETURNS

Trade Payables 107 319


Trading c/d 107 319

107 319 107 319

MOTOR VEHICLES

Capital 30 000 000


L-Stone Motors 30 000 000 Balance c/d 60 000 000

60 000 000 60 000 000

Balance b/d 60 000 000

ELECTRICITY

Solarropower Co 502 000 Profit & Loss 502 000

502 000 502 000

DRAWINGS

Cash 250 000 Capital 250 000

250 000 250 000

TRADE RECEIVABLES

Sales 3 586 895 Sales Returns 733 238


Cash 400 000

Balance c/d 2 453 657


3 586 895 3 586 895
Balance b/d 2 453 657

FURNITURE

Bank 3 500 000


Balance c/d 3 500 000
3 500 000 3 500 000
Balance b/d 3 500 000

WAGES & SALARIES

Cash 220 000


Bank 800 000 Profit & Loss c/d 1 020
000

1 020 000 1 020 000

FURNITURE REPAIRS

Cash 180 000 Profit & Loss c/d 180 000

180 000 180 000

STATIONERY

Cash 350 000 Profit & Loss c/d 350 000

350 000 350 000

RATES

Cash 600 000


Bank 330 000 Profit & Loss c/d 930 000

930 000 930 000

VALUE ADDED TAX

Trade Payables 119 745 Trade Payables 18 781


Trade Receivable 108 238 Trade Receivable 531 895
Bank 107 316 Cash 168 000
Balance c/d 340 400

718 676 718 676


Balance b/d 340 400

LOAN

Balance c/d 30 000 000 Bank 30 000 000

30 000 000 30 000 000

Balance c/d 12 000 000.00

CAPITAL
Motor Vehicles 15 000 000

Balance c/d 45 000 000 Bank 30 000 000

45 000 000 45 000 000

Balance c/d 45 000 000

DELIVERY EXPENSES
Cash 630 000 Profit & Loss 630 000

630 000 630 000

DISCOUNT RECEIVED

Profit & Loss 6 750 Trade Payables 6 750

6 750 6 750

BANK ACCOUNT

Total Receipts 45 000 000 Total Payments 35 681 300


Balance c/d 9 318 700

45 000 000 45 000 000

Balance b/d 9 318 700

CASH

Total Receipts 6 528 500 Total Payments 2 630 000


Balance c/d 3 898 000

6 528 000 6 528 000

Balance b/d 3 898 000

LAMBDAR
TRIAL BALANCE AS AT 31 MARCH 2006

DR CR
K K
Sales 4 015 000
Sales Returns 625 000
Trade Payables 340 400
Del Equipment 5 000 000
Solarpower Co. 102 000
Purchases 1 297 489
Purchases Returns 107 319
Motor Vehicles 60 000 000
Electricity 502 000
Drawings 250 000
Trade Receivables 2 453 657
Furniture 3 500 000
Wages & Salaries 1 020 000
Repairs 1 80 000
Stationery 350 000
Rates 930 000
Value Added Tax 383 377
Loan 30 000 000
Capital 45 000 000
Delivery Expenses 630 000
Discount Received 6 750
Bank 9 318 700
Cash 3 898 000

84 954 846 84 954 846

SOLUTION 2
DR CR
Cash account 493 500
Sales 420 000
Value Added Tax 73 500
Cash sales with Value Added Tax

Purchases 613 234


Value Added Tax 107 316
Cash account 720 550
Cash purchases with Value Added Tax

Trade Payables -Cash 330 750


-Discount Rcvd 6 750
Cash 330 750
Discount Received 6 750
Settlement of amount owed to a supplier

SOLUTION 3

VALUE ADDED TAX

Trade Payables 98 000 Trade Payables 21 000


Trade Receivable 70 000
Cash 35 000
Balance c/d 28 000

126 000 126 000


Balance b/d 28 000

SOLUTION 4
VALUE ADDED TAX

Trade Payables 13 800 Balance b/d 7 200


Bank 6 800 Trade Receivable 18 261
Balance c/d 4 861

126 000 126 000


Balance b/d 4 861
CHAPTER 12

MORE ABOUT THE TRIAL BALANCE

INTRODUCTION

So far what has been covered in the previous chapters is the recording of
transactions in the books of original entry and posting to the ledger to
complete double entry. The trial balance is the next progression towards the
preparation financial statements.
Before financial statements are prepared, it is important to carry out a test
on the accuracy of records in the books of the prime entry and the ledger.

TOPICS

1 What a trial balance is


2 Its format and preparation
3 Analysis of trial balance
4 Errors not disclosed by trial balance
5 Errors disclosed by trial balance

LEARNING OBJECTIVES

At the end of this chapter, one should be able to:

- Prepare trial balance from the ledger accounts


- Explain the use and purpose of trial balance
- Describe and explain why the trial balance totals are equal
- Identify and describe errors not disclosed by trial balance and errors
disclosed by trial balance.

7.1 THE TRIAL BALANCE

The word trial is taken from the word try. Which is an attempt,
experiment or test to see whether work done is satisfactory.

Therefore, a trial balance could be defined as a means of checking the


correctness of a set of accounts from the ledger.

It is prepared to check that the total of debit balances and credit


balances are equal and offer reassurance that double entry in the
ledger is complete.

7.2 Trial Balance example

To understand clearly how the trial balance operates, let us do


examples.
The following transactions of Big Brown, a sole trader, took place from
1 January to 31 December 20X5.

- Started business with capital in cash K10 000


- Deposited K8,000 cash into the bank
- Paid for rentals by cheque K250
- Bought goods and paid by cheque K400
- Paid for stationery in cash K75
- Sold goods and received cash K600
- Bought goods on credit from suppliers K575
- Paid wages by cash K325
- Sold goods on credit to customers K780
- Withdrew K50 cash for personal use
- Paid electricity by cheque K25

Required:

Open the necessary accounts and prepare a trial balance as at 31


December 20X5.

Solution

Dr. Cash account Cr.

K K
Capital 10,000 Bank
8,000
Sales 600 Stationery 75
Wages 325
Drawings 50
Balance c/d 2,150
10,600 10,600

Balance b/d 2,150

Dr. Bank account Cr.

K K
Cash 8,000 Rent 250
Purchases 400
Electricity 25
Balance c/d 7,325
8,000 8,000
Balance b/d 7,325
Dr. Capital account Cr.
K K
Cash 10,000

Dr. Rent account Cr.


K K
Bank 250

Dr. Purchases account Cr.


K K
Bank 400
Payables 575

Dr. Stationery account Cr.


K K
Cash 75

Dr. Sales account Cr.


K K
Cash 600
Receivables 780

Dr. Payables (Suppliers) account Cr.


K K
Purchases 575

Dr. Wages account Cr.


K K
Cash 325

Dr. Receivables (customers) account Cr.


K K
Sales 780
Dr. Electricity account Cr.
K K
Bank 25

Dr. Drawings account Cr.


K K
Cash 50

N.B. For every transaction a debit entry was also represented by a


credit entry and vis
versa (double entry).

When preparing a trial balance, an account debited in the ledger will


also be shown as a debit in trial balance and an account credited in the
ledger will be shown as credit in trial balance.

A trial balance is not part if double entry. It is a memorandum


statement.

Using the accounts in the ledger we can now prepare a trial balance.
Thus:

Trial Balance as at 31 December 20X5

Dr. Cr.
K K
Cash in hand 2,150
Cash in bank 7,325
Capital 10,000
Rent 250
Purchases 975
Stationery 75
Sales 1,380
Payables 575
Wages 325
Receivables 780
Electricity 25
Drawings 50 ______
11,955 11,955

The order in which accounts appear in the trial balance does not
matter, because it is not mandatory that a business must prepare a
trial balance.

7.3 Analysis of trial balance


In our analysis of the trial we shall look at what to debit and credit in
trial balance using a table.
Dr. Cr.
1 All assets 1 All liabilities
2 All expenses 2 All losses
3 Purchases 3 Sales
4 Sales returns 4 Purchases
returns
5 Opening inventory 5 Capital
6 Drawings

Closing inventory does not appear in trial balance because it comes as


an adjustment after physical stock take. It is not a transaction, though
inventory account is opened and debited with value, because it is an
asset remaining and will be shown as current asset in balance sheet.

CHAPTER SUMMARY

- A trial balance provides reassurance that double entry book keeping


has been done correctly.
- A trial balance is just a memorandum statement; it is not part of
double entry
- A trial balance is the first step in the preparation of financial
statements, i.e. Income Statement & Balance Sheet.
- A trial balance may have equal totals on debit and credit side;
however, it does not reveal all possible errors.

EXERCISES

1. What is a trial balance?

2. What are the uses of a trial balance?

3. The following information is extracted from the books of B Stepson, a


sole trader, whose financial year ends on 31 October 20X5.

K
Capital 1 January 20X5 204,235
Opening inventory 46,000
Purchases 234,000
Sales 288,000
Light & heat 2,000
Advertising 3,000
Insurance 5,000
Bad debts 150
Rent 13,000
General 13,850
Drawings 8,000
Receivables 48,000
Payables 35,000
Bank overdraft 50,000
Returns inwards 1,000
Returns outwards 350
Carriage inwards 780
Carriage outwards 475
Machinery 132,000
Discounts allowed 880
Discount received 550

Required:

Prepare trial balance as at 31 December 20X5.

SOLUTION TO EXERCISES

1. A trial balance is listing of balances taken from the ledger.

2. The use of trial balance is to provide reassurance that double


entry is correct in the ledger. It is also used for the preparation
of financial statements.

3. B Stepson
Trial balance as at 31 December 20X5

Dr. Cr.
K K
Capital 1 January 20X5 204,235
Opening inventory 46,000
Purchases 234,000
Sales 288,000
Light & heat 2,000
Advertising 3,000
Insurance 5,000
Bad debts 150
Rent 13,000
General 13,850
Drawings 8,000
Receivables 48,000
Payables 35,000
Bank overdraft 50,000
Returns inwards 1,000
Returns outwards 350
Carriage inwards 780
Carriage outwards 475
Machinery 132,000
Discounts allowed 880
Discount received 550
543,135 543,135

CHAPTER 13

CONTROL ACCOUNTS

INTRODUCTION

In the chapters on posting to the ledger we discussed how to post entries to


the Trade Receivables and Trade Payables accounts. The amounts posted to
those accounts were totals from various day books. In this chapter we
discuss how individual personal accounts of suppliers and customers are
maintained.

TOPICS
1. Manual and computer accounting systems
2. Need for control accounts
3. Posting to personal accounts
4. Posting to Control accounts
5. Errors and their correction
6. Summary

LEARNING OBJECTIVES

After you have studied this chapter you should be able to

 Explain why control accounts are maintained by most large


organizations
 Post entries correctly to personal accounts in the Sales and
Purchases Ledgers
 Reconcile the control account balance with the sum of balances on
personal ledger accounts

1.0 ACCOUNTING SYSTEMS

A business can have a manual accounting system or a computerized


accounting system.

In a manual system records are kept in the form of books. First transactions
are recorded in ink in the books of prime entry. Then at another time the
entries in the day books are posted to the ledger. The exercise becomes
tedious when the organization grows big in size. Large numbers of
transactions would have to be posted to the personal accounts of suppliers
and customers. The need for computerizing the accounting system arises.

In a computerized accounting system the various stages of preparing


accounting records are electronically integrated. A transaction entered in a
daybook will automatically post the entry to the ledger accounts (assuming
perfect integration). In this case the need to have control accounts does not
arise. There are computer systems in which the sales ledger and purchases
ledger are maintained as sub systems in relation to the general ledger. The
balance on the trade receivable or trade payable should then be reconciled
with the sum of balances on personal accounts in the subsystems.

1.1 PURPOSE OF CONTROL ACCOUNTS


Personal accounts of customers and suppliers are maintained so that the
enterprise can send account statements at the end of the month. The
customers are provided with a way of verifying the transactions and
confirm the amounts due from them.

Similarly, at the end of the month we receive account statements from


suppliers. We have to verify the correctness of entries in the individual
personal accounts of each supplier. We will be able to identify payments
to them that are not yet processed in their accounting system.

Maintaining personal accounts of individual customers and suppliers is a


conventional practice that enable enterprises to identify errors that may
have been made and correct them. Ultimately they confirm amounts due
on account receivables and accounts payables, and report them in
financial statements without undue delay.

1.2 COMPILING PERSONAL ACCOUNTS

Given below is a set of transactions we handled in a preceding chapter. We


will this time post to the Sales Ledger and the Purchases ledger to illustrate
the use of control accounts. For conveniences sakes we have reproduced the
day books from which we will extract the entries to personal accounts of
customers and suppliers.

April 1. Sold goods on credit to Chisakaila K 540 000 net.


VAT is charged at the rate of 17.5 %
April 5. Sold goods on credit to Ngosa K 800 000 net. The customer is
entitled to less 2 % prompt discount if payment is made within
14 days.
April 7. Ngosa returned goods, K 200 000 net (He is entitled to prompt
discount of
2 %)
April 12. Purchased goods on credit from Kunda K 282 000. The invoice
stated a tax inclusive amount.
April 13. Received an invoice for the 10 ton truck bought on credit from L-
Stone Motors K 40 000 000 gross
April 13. Issued an invoice to Mulota K 400 000 net.
April 13 Returned goods worth K 42 600 to Kunda . This is a tax inclusive
figure.
April 15 Sold goods on credit to Mambwe K 750 000 net.
April 17. We sent a credit note to Mambwe, K 150 000, net
April 18. Purchased Goods on credit from Mwape K 270 000 gross value.
April 19. Received a bill for electricity from Zam Hydropower. The total of
the invoice was K 320 000
April 19. Received a credit note from Mwape for K 35 700 (gross amount).
April 22. Ngosa paid his account in full less 5% cash discount.
April 30 Settled Kunda’s account by cheque, less cash discount of 5%

SALES DAY BOOK


DATE PARTICULARS FOLIO TOTAL VALUE ADDED TRADE OTHER
TAX RECEIVABLE RECEIVABLE
April K K K K
2005
1 Chisakaila 634 500.00 94 500.00 540 000.00
5 Ngosa 937 200.00 137 200.00 800 000.00
13 Mulota 470 000.00 70 000.00 400 000.00
15 Mambwe 881 250.00 131 250.00 750 000.00

TOTAL 2 922 950.00 432 950.00 2 490 000.00

SALES RETURNS DAY BOOK


DATE PARTICULARS FOLIO TOTAL VALUE TRADE OTHER
ADDED
TAX RECEIVABLE RECEIVABLE
April K K K K
2005

7 Ngosa 234 300.00 34 300.00 200 000.00


17 Mambwe 176 250.00 26 250.00 150 000.00

TOTAL 410 550.00 60 550.00 350 000.00

PURCHASES DAY BOOK


DATE PARTICULARS FOLIO TOTAL VALUE TRADE OTHER
ADDED
TAX PAYABLE PAYABLE
April K K K K
2005
12 Kunda 282 42 240 000.00
000.00 000.00
13 L-Stone Motors Ltd 40 000 000 . 40 000 000.00
00
18 Mwape 270 40 212.76 229 787.24
000.00
19 Zam Hydropower 320 320 000.00
000.00

TOTAL 40 872 82 212.76 469 787.24 40 320 000.00


000.00

PURCHASES RETURNS DAY BOOK


DATE PARTICULARS FOLOI TOTAL VALUE TRADE OTHER
ADDED
TAX PAYABLE PAYABLE
April K K K K
2005

13 Kunda 42 600.00 6 344.68 36 255.32


19 Mwape 35 700.00 5 317.02 30 382.98

TOTAL 78 300.00 11 661.70 66 638.30

1.3 POSTING TO THE SALES LEDGER

Posting to any ledger must always be guided by the rule of double entry.
You have to trace the flow of goods: who is giving and who is receiving.
Even though you write one entry in the control account, you still have to
see the second entry in the other account mentally.

CHISAKAILA

Sales 634 500.00


Balance c/d 634 500.00
634 500.00 634 500.00
Balance b/d 634 500.00

NGOSA

Sales 937 200.00 Sales Returns 234300.00


Cash 667 755.00
Discount All 35 145.00
Balance c/d nil
937 200.00 937 200.00

MULOTA

Sales 470 00.00


Balance c/d 470 000.00
470 000.00 470 000.00
Balance b/d 470 000.00

MAMBWE

Sales 881 250.00 Sales Returns 176 250.00

Balance c/d 705 000.00


881 250.00 881 250.00
Balance b/d 705 000.00

TRADE RECEIVABLES ACCOUNT BALANCES LISTING:


K
Chisakaila 634 500.00
Mulota 470 000.00
Mambwe 705 000.00
TOTAL 1 809 500.00

POSTING TO THE PURCHASES LEDGER


KUNDA

Purchases Returns 42 600.00 Purchases 282 000.00


Bank 227 430.00
Discount Received 11 970.00

282 000.00 282 000.00

MWAPE

Purchases Returns 35 700.00 Purchases 270 000.00

Balance c/d 234 300.00

270 000.00 270 000.00

Balance b/d 234 300.00

TRADE PAYABLES ACCOUNT BALANCES LISTING:


K

Mwape 234 300.00


TOTAL 234 300.00

The listings made of account balances in the sales and purchases ledgers
agree with the total balance on the corresponding total (control account)
in the general ledger. The control accounts are shown below accordingly

TRADE RECEIVABLES

Sales 2 922 950.00 Sales Returns 410 550.00


Cash 667 755.00
Discount All 35 145.00
Balance c/d 1 809 500.00
2 922 950.00 2 922 950.00
Balance b/d 1 809 500.00

TRADE PAYABLE

Purchases Returns 78 300.00 Purchases 552 000.00


Bank 227 430.00
Discount Received 11 970.00
Balance c/d 234 300.00

552 000.00 552 000.00

Balance b/d 234 300.00

Let us suppose that the following errors were made in the account. We will
show what the balances would be on the accounts and the eventual
correction of the errors.

1. The Value Added Tax amount on sales returns from Ngosa did not take
into account the entitlement to cash discounts. The mistake was made
in the personal account only.

2. Discount allowed was not posted to the trade receivables account in


the general ledger.

The calculation of Value Added Tax on sales returns from Ngosa is


200 000 x 0175 = 34 000

The Trade Receivables accounts would be drafted as follows:

TRADE RECEIVABLES

Sales 2 922 950.00 Sales Returns 410 550.00


Cash 667 755.00

Balance c/d 1 844 645.00


2 922 950.00 2 922 950.00
Balance b/d 1 844 645.00

The account for Ngosa would be drafted as follows:


NGOSA

Sales 937 200.00 Sales Returns 234300.00


Cash 667 755.00
Discount All 34 000.00
Balance c/d 300.00
937 200.00 937 200.00
Balance b/d 300.00

The account listing of the sales ledger would be as follows:


K
Chisakaila 634 500
Ngosa 300
Mulota 470 000
Mambwe 705 000
Total 1 809 800

CORRECTION OF ERRORS

It is important to note that errors occurred in different parts of the


accounting records. The balance that is affected is the one to correct. You
should look at each error made and identify how it affected the accounts.
Correction may require reversing what was done or re-calculation or
amounts and posting the difference to the correct side of the ledger
account. Invariably you will be ill-equipped to correct errors if your grasp
of double entry is weak.

The Sales Ledger Control account balance will be corrected as follows:


K
Balance on TR account 1 844 645
Less: Discount Allowed 35 145
Adjusted balance 1 809 500

The Sales Ledger Listing total of balances will be corrected as follows:

SL Listing 1 809 800


Less: Undercast in Sales Returns 300
Adjusted total 1 809 500

A manufacturing business had trade payables of K 6 500 000 outstanding at


the beginning of the year. There were also amounts due from suppliers of K
45 000. During the year the following transactions took place:
$
Remittances to suppliers 34
000 000
Receipts for cash purchases 3 000 000
Contra agreements 70 000
Invoices from suppliers 42 000 000
Credit notes received 90 000
Debit notes from suppliers 20 000
Discounts for prompt payment 50 000

The amounts due from suppliers at the end of the year were K 63 000.
Write the trade payables account and determine the closing
balances on account at the end of the year?

2. Kenny trades with Cynthia with whom she both buys and sells goods on
credit. At the end of the financial year Kenny owes Cynthia K 150 000
and she owes him
K 130 000. They both agree to setting off the amounts outstanding.

What would be the contra entry in Kenny’s books?

a) Dr Trade Receivables with K 150 000


Cr Trade Payables with K 150 000
b) Dr Sales Account with K 150 000
Cr Purchases Account with K 150 000
c) Dr Purchases Account with K 130 000
Cr Sales Account with K 130 000
d) Dr Trade Payables Ledger with K 130 000
Cr Trade Receivables Ledger with K 130 000

3. For the month of October 20X5 Kawape’s purchases totaled 225 600
with Value Added Tax of K 33 840. The total of K 259 440 has been
credited to the trade payables control account as K254 940.

Which of the following adjustments is correct?

Control account List of trade payables


balances

a. K 4 500 Credit No adjustment


b. K 4 500 Credit Increase by K4 500
c. K 29 340 Debit No effect
d. K 33 840 Debit Increase by K4 500

4. Ignatius had the following balances on his trade receivables and trade
payables on 1 December 2006.
Customers owed K40 250 and he owed suppliers 26 423. Credit
balances in the trade receivables ledger amounted to K3 845 and debit
balances in the trade payables ledger amounted to K1 985.

During the month his daybooks showed the following totals:


Purchases 408 563
Sales 854 239
Returns inwards 44 271
Returns outwards 32 662
Payments to suppliers 300 912
Receipts from customers 675 843
Discounts received 9 027
Discounts allowed 20 275
Amounts written off to bad debts 13 173
Transfers between the receivables ledger and the payables
Ledgers 7 457
Rebates on customer invoices 3 244
Refunds of cash from suppliers 5 877

On 31 December 2006 amounts owed to customers were K2 119.


Suppliers who owed him amounts at start of the year had paid K1 525.

REQUIRED

Prepare a trade receivables control account and a trade payables


control account, showing the balances to carry forward to the following
month.

CHAPTER 14

BANK RECONCILIATION
INTRODUCTION
The receipts and payments we make in our cash book are also recoded by
the bank in there books. The cash book contains the cash account and the a
bank Account. The balance on the bank account must be exactly equal to the
amount the bank will show on the bank statement sent to us at the end of
the month. If the two balances are not the same then investigations should
be instituted to establish the causes of the difference. The cash book is
thereafter updated with entries that are on the bank statement but not in the
cash book, and a bank reconciliation statement is compiled for the entries
that are in the cash book but are not on the bank statement.

1.0 WHY PREPARE A BANK RECONCILIATION STATEMENT

 To provide a means of internal control which the auditors can rely


on.
 To reveal the volume of transactions that the bank have not
processed in their accounting system by the end of the period
under review, eg a month.
 To correct the errors that may have been made in the accounting
records.
 To provide a verifiable balance at the bank that is to be included
in the balance sheet without any undue delay to the preparation
of financial statements at the year-end.

2.0 TERMS IN FREQUENT USE

 Direct debits:

Amounts debited on the bank statement but are not on the


cashbook bank account. Consequently if we are to update our
cashbook the amounts should be recorded on the credit side as
they represent payments made directly by the bank on our
behalf.

 Direct credits:

Amounts credited on the bank statement but are not on the


cashbook bank account. When updating the cashbook the
amounts will have to be recorded on the debit side as they
represent receipt of cash directly through the bank.

 Standing order:
The name is derived from the activity that creates it. The
business issues a standing order to the bank by letter. The letter
contains an instruction to the bank to pay a specified fixed
amount on a stated date at regular interval (eg quarterly). When
the time is due for the matter the bank acts on the standing
order and pay the amount. The amount is shown on the debit
side of the bank statement and so it will be recorded on the
credit side of the updated cashbook.

 Deposits not yet credited by the bank:

Such deposits are usually made on the last day of the month or
year. The processing of the deposit slips by the bank takes place
the following day. So the bank statement for the month or year
under review does not show entries for such deposits, even
though they have already been recorded in the cash book.

 Unpresented cheques:

These are cheques we issued to pay for goods or services but the
cheques have not been taken to the bank for cashing by the
suppliers we paid. The cheques are already recorded in our cash
book but have not been reflected on the bank statement.

 Dishonoured cheques:

Cheques that once were received, recorded in the cash book but
the bank refuses to honour them for one reason or the other.
Such cheques are returned to the customer (trade receivable)
who paid the amount, and the earlier receipt is reversed.
3.0 PREPARING A BANK RECONCILIATION STATEMENT

The following exercise will illustrate how to prepare a bank


reconciliation statement.

EXERCISE

The bank columns in the cashbook for May 2005 and the bank
statement for that month for G Hoglah are as follows:

CASH BOOK
Debit side Credit side
K000 K000
May 1 Balance b/d 3 250 May 6 Kundananji 165
May 8 R Mbewe 720 May 13K Mwila 454
May 17B Jere 685 May 17P Muma 38
May 29F Banda 372 May 30Daka Bowling 44
May 31D Phiri 582 May 31Balance c/d 4 908
5 609 5 609
BANK STATEMENT

2005 DEBIT CREDIT


BALANCE
K000 K000 K000
May 1 Balance b/d 3 250
May 8 Cheque 720 3 970
May 9 Suwilanji 220 3 750
May 17 Cheque 685 4 435
May 18 K Mwila 454 3 981
May 19 P Muma 38 3 943
May 29 Cheque 372 4 315
May 30 GYM:Standing order 63 4 252
May 31 Akazipo: Trader’s credit 85 4 337
May 31 Bank charges 52 4 285

You are required to:


a) Write the cashbook up to date to take the above into account, and then
b) Draw up a bank reconciliation statement as at 31 May 2005

1. Identify entries appearing on both the cash book and the bank statement.
The matching field is either the date or the description. The amount
should be matched last. These entries represent transactions that have
been processed in both sets of accounts correctly.
2. Starting with the closing balance on the cash book, prepare an updated
cashbook by debiting amounts that appear in the credit column of the
bank statement, and vice versa.
3. Starting with the revised cashbook balance in step 2, prepare a bank
reconciliation statement. The amounts recorded in the cashbook but not
processed by the bank are reversed accordingly.

In practice more rigorous verification is done since a lump sum shown on the
bank statement may have to be broken down into several transactions and
matching entries identified separately. Extensive schedules of unmatched
entries are prepared, and totals used for preparation of bank reconciliation
statements.

SOLUTION

UPDATED CASHBOOK

K000 K000
May 31Balance b/d 4 908 May 31Suwilanji 220
May 31Akazipo 85 May 31GYM Club 63
May 31Bank Charges 52
May 31Balance c/d 4 658
5 609 5 609

June 1 Balance b/d 4 658

The rationale of how entries are treated in the bank reconciliation statement
is that cashbook entries not processed by the bank are reversed. Thus
payments made are added to the cashbook-revised balance as if they were
not made, and receipts are deducted accordingly:

BANK RECONCILIATION STATEMENT as at 31 May 2005


K000
Balance per updated Cashbook 4 658
Add: Unpresented cheques
Kundananji 165
Daka Bowling 44
209
4 867
Less: Deposits not yet credited
D Phiri 582
Balance per bank statement 4 285

The double entry for dishonoured cheques is similar to that done for bank
charges when updating the cashbook with entries that appeared on the bank
statement but not in the cashbook:

DR CR
K000 K000
Bank charges 52
Bank account (in CB) 52

GYN Club 63
Bank account (in CB) 63

Trade receivables (Dishonoured cheque) 337


Bank account (assumed fig) 337

EXERCISES

1. Your firm’s cash book shows a credit balance of K12 400 at 30 June
2005. Upon comparison with the bank statement you determine that
there are unpresented cheques totalling K4 500, and a receipt of K1
400 which has not been passed through the bank. The bank statement
shows bank charges of K740 which have not been entered in the cash
book.

What is the balance on the bank statement?

2. Your firm’s cash book at 30 September 2005 shows a balance at the


bank of K24 900. A comparison with the bank statement at the same
date reveals the following differences:

 Unpresented cheques 8 400


 Dishonoured cheques 1 400
 Receipts not credited 4 700
 Bank charges 500

Find the correct balance on the cash book at 30 September 2005


3. Trotters Grotto Ltd prepared the following summary of receipts and
payments account for the month of April 2006:
K000 K000
Receipts 1 478 Balance b/d 770
Balance c/d 662 Payments 1370
2140 2140

Trotters Grotto Ltd make all payments by cheques and all monies
received are banked immediately.

Before preparing bank reconciliation an investigation revealed the


following:

a) The balance brought forward from March 2006 in the cash book
should be
K750 000 and not K770 000
b) A cheque drawn for K128 000 for advertising had been incorrectly
entered in the cash book as K125 000.
c) Dividends received in the month of April of K89 000 were credited
by the bank but no entries were made in the cash book.
d) Business rates are paid directly by the bank under a standing order
arrangement. An amount of K120 000 was paid on 30 April 2006
and no entries have been made in the cash book.
e) A cheque received from Kebby for K207 000 had been returned by
the bank and marked ‘insuffficient funds’. No adjustment has been
made in the cashbook.
f) A cheque for K35 000 for miscellaneous consumables was entered
in the cashbook as a receipt instead of as a payment.
g) Cheques received totalling K807 000 had been entered in the
cashbook and paid into the bank, but had not been credited by the
bank until 3 May.
h) Cheques drawn amounting to K345 000 had not been presented to
the bank for payment.
i) Bank service charges of K67 000 appearing on the bank statement
have not been entered in the cashbook.

REQUIRED:

i) Calculate the closing balance that should appear on the cashbook,


taking into
account the appropriate information from the investigation.

ii) Prepare a bank reconciliation statement as at 30 April 2006.


CHAPTER 15: BAD DEBTS AND ALLOWANCES FOR
DOUBTFUL DEBTS

15.1 BAD DEBTS

As a business grows in size, some of its sales may be made on credit.


Customers will be able to access the goods from the business and
arrangement will be made when to settle the amount.

By doing so the business is taking a risk because some customers may fail to
pay for various reasons which may include:

 Restrictions by a country to transfer cash (foreign exchange) to


another country.
 The customers business may just close down (liquidated)
 Some customers may not be genuine and may just disappear without
paying.

When a business fails to recover its money from credit customers, after
making all efforts, the amount is written off as a bad debt.

Bad debts are a loss to the business.

When a business sells goods to a customer on credit, double entry is

DR. – Customers account


CR. – Sales account

The customers account will appear in the receivables ledger as an asset.


Example: Sale of goods on credit.

Beatle is in business as a wholesaler merchant.

During the year 2016, on 1 November it sold goods on credit to one of its
regular customer Mr. Fix, for $276,000.

In sales or receivable ledger.


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Mr. Fix owes the business K276,000 and therefore, he is an asset to the
business by virtual of the amount owed.

If at year end 31 December 20X6, Mr. Fix is still owing the amount, he will
appear together with others in balance sheet, under current assets as Trade
receivables.

- Mr. Fix account will be balanced as

Dr. Mr. Fix account Cr.

20X6 $ $
Nov. 1 Sales 276,000 Balance c/d
276,000
______ _______
276 000 276000

20X7
Jan. 1 Balance b/d 276,000

When the new year begins on 1 January 20X7, Mr. Fix is still a receivable
(debtor) with $276,000.
Assuming Mr. Fix’s credit period expires and the business fails to recover the
money, then the business has incurred bad debts.

15.2 ACCOUNTING FOR BAD DEBTS

Double entry:

DR. – Bad debts account (in general ledger)


CR. – Mr. Fix account (in sales ledger)

- Using the above example:

Dr. Mr. Fix account Cr.

20X7 K K
Jan. 1 Balance 276,000 Bad debts 276,000

_______ ______
276,000 276,000

Dr. Bad account Cr.

K K
Mr. Fix 276,000

- Mr. Fix is no longer a receivable (debtor) to the business, so his


account is closed to bad debts which is a loss. The bad debts
account will remain open throughout the accounting period.

- Should some more customers fail to pay, their accounts will be


closed off to the same bad debts account.

- At year end when preparing financial statements, the bad debts


account is transferred to income statement as a charge against
profits.

Double entry is:

Dr. – Income statement (with total amount of bad debts)


Cr. – Bad debts account

- Using Mr. Fix


Dr. Bad debts account Cr.

K K
Mr. Fix 276,000 Income Statement
276,000

_______ ______
276,000 276,000

NOTES:

- When adding receivables (debtors) in sales ledger Mr. Fix


will not be included as a receivable because his account
has been closed off to bad debts.

- When trial balance is extracted bad debts appear on debit


side as an expense.

15.3 BAD DEBTS DISCOVERED AT YEAR END

At the end of the accounting period, before financial statements are


prepared, all accounts in business books are reviewed for adjustment.

It may happen that after reviewing the receivables ledger and


preparation of aged receivables analysis, some receivables may be
discovered bad. An adjustment must be made for both receivables
total and bad debts.

- When preparing financial statements, bad debts discovered at


year should be added to bad debts in trial balance to show total
bad debts in income statement.

- In balance sheet, the receivables figure should be adjusted by


reducing with the bad debts just discovered.

15.4 BAD DEBTS RECOVERED

A debt previously written off may be recovered in full or partially.

Steps in recovery:

(a) The debt must first be reinstated to facilitate the recording of


cash coming in.
DR. – the receivable (Debtor) account
CR. – Bad debts recovered account.

(b) When payment is received:

DR. – Cash or Bank account


CR. – Receivables (Debtors) account with amount
received

Example: Bad debts recovered

A debt previously written off Mr. Fix K276,000 has now been fully
recovered with a payment by cheque.

Dr. Mr. Fix account Cr.

K K
Balance b/d 276,000 Bad debts 276,000

_______ _______
276,000 276,000

Bad debts recovered 276,000 Bank


276,000

276,000 276,000

Dr. Bad debts recovered account


Cr.

K K
Income statement 276,000 Mr. Fix
276,000

_______ _______
276,000 276,000

NOTES:
- The bad debts recovered account is closed off to income
statement as income. It will be added to gross profit.

- Sometimes cash may not be received immediately but


reasonable assurance is given that the amount will be paid.
The debt should still be reinstated but if at the balance
sheet the amount is not yet received, the debt must be
included in total receivables figure.

15.5 ALLOWANCE FOR BAD AND DOUBTFUL DEBTS

Because of past experiences where some debts become bad, some


organizations find it more prudent to provide for future bad debts.

- An allowance for doubtful debts is a general estimate of the


percentage of debts which are not expected to be repaid.
- An aged schedule of receivables may help in estimating the
allowance. It is well known that the longer a debt is owing, the
more likely that it will become bad debt.

Example of aged schedule of receivables

Period debt is Total Estimate Allowance


owing amount d% for doubtful
owing Doubtful debts
$ $
Less than 30 days 11,300,000 1% 113,000
30 days less than 7,400,000 4% 296,000
60 days
60 days less than 2,500,000 6% 150,000
90 days

Accounting for allowance for doubtful debts

(a) Upon creation:

Dr. – Income statement


Cr. – Allowance for doubtful debts account

NOTE: In income statement the provision is deducted from gross


profit as an expense.

Example:
The financial year of Mafuso ends on 31 December each year.
On 31 December 20X7 receivables accounts totaled K50 000. It
was decided to write off K5 000 as bad debts. It is also
estimated that 3% of the remaining receivables may eventually
prove to be bad and it is decided to make a provision for doubtful
debts.

In income statement

Dr. Income statement account (20X7) Cr.

K K
Expenses:
Allowance for doubtful Gross profit XX
debts 1,350

OR

Gross profit XX
Less: Expenses
Allowance for doubtful debts (1,350)

Dr. Allowance for doubtful debts account Cr.

K 31 Dec. 20X7 K
Balance c/d 1,350 Income statement 1,350
____ ____
1,350 1,350

1 Jan. 20X8 Bal. b/d 1,350

Balance sheet (extract) as at 31 December 20X7.

Current Assets
Receivables (50,000 – 5,000) 45 000
Less: Allowance for Bad Debts 1,350
43 650
NOTES:

- The allowance for bad debts account is closed off to


balance sheet or by bringing down the balance into the
next account period, awaiting to be used when bad debts
occur.

- In balance sheet, the allowance is deducted from the total


receivables figures, in order to show what is expected to be
received from the receivables.

The prudence concept is at play in this case.

- It is also important to remember that allowance for bad


debts are estimated from good receivables (debtors). If
receivables figure is inclusive of bad debts, bad debts must
be deducted before estimating for allowance for provision
for bad debts.

Using previous example:

Income statement K K
Gross profit XX
Less: Expenses
Bad debts 5,000
Allowance for bad debts 1,350
6,350

15.5.1 In subsequent years, adjustments may be made to the allowance


for doubtful debts. The allowance may increase or decrease due to
economic factors which may change from year to year.

(a) If increase in allowance for doubtful debts.

Compare the balance b/d in the allowance for doubtful debts


account with the newly calculated figure, the difference is the
increase which should be charged to income statement and
added to allowance b/d from previous year.

- The new balance is always the figure to be deducted in


balance sheet from year end receivables.

Double entry will be as follows:

Debit: Income Statement (as expense)


Credit: Allowance for Doubtful Debts (with the increase)
Example

In 20X8, receivables in Mafuso amounts to K54,000 after


deducting K3,000 bad debts. It is decided to maintain the
3% allowance for bad debts on receivables.

3% X K54,000 = K1,620

The increase from 20X7 is K270 (1,620 – 1,350).

In Income Statement:

Income statement (20X8) K K


Gross profit XXX
Less: Expenses:
Bad debts 3,000
Allowance for bad debts 270
3,270

Dr. Allowance for doubtful debts account Cr.

K K
Balance c/d 1,620 Balance b/d 1,350
____ Income statement 270
1,620 1,620

Balance b/d 1,620

Balance sheet (20X8)

Current assets K K

Receivables 54 000
Less: Bad Debts 1,620
52 380

(b) If decrease in allowance for doubtful debts

Assuming in 20X9, the economic environment is very conducive


for business and most of the receivables are paying, the
allowance for doubtful debts may be reduced.

Example:
The allowance for doubtful debts has been in existence for the
past two (2) years in the books of Mafuso. At 31 December
20X9, receivables were K30,000. After reviewing the receivables
ledger it is discovered that K1,500 will not be recovered and 3%
allowance for doubtful be maintained on remaining receivables.

K
Receivables 30,000
Less: Bad debts (1,500)
28,500

Remaining receivables: 28,500 x 3% allowance = K855

Double entry when the allowance is reduced will now be the


opposite.

Dr. – Allowance for doubtful debts account (to reduce)


Cr. – Income statement (add to gross profit)

NOTE:

The reduction is treated as income and is added to gross profit.

Where bad debts (expense) exist when the reduction takes place,
it is advisable to net off the two since they are related. Thus in
given example, instead of adding decrease to gross profit it will
be:

K
Bad debts (Expense) 1,500
Decrease in allowance for
Doubtful debts (income) 765
735 to be shown as bad debt in income
statement

- showing bad debts and allowance for bad debts separately.

Dr. Allowance for bad debts account Cr.

K K
Income statement 765 Balance b/d
1,620
Balance c/d 855
____ _____
1,620 1,620
Balance b/d 805

Income Statement (20X9) K K

Gross profit XX
Add: other income
Decrease in provision for doubtful debts 765
XX
Less: Expenses
Bad debts 1,500

15.5.2 When bad debts are incurred where allowance for doubtful debts
exists.

Remember the purpose of allowance for doubtful debts is to


accommodate future bad debts. So when bad debts are incurred when
an allowance for it exists. Double entry is:

DR. – Allowance for doubtful debts account (with amount of bad debt)
CR. – Bad debts account

Example: Transferring bad debts to allowance for doubtful debts


account.

Expert builders has total receivables amounting to K268,000 as at 31


December 20X7. It is discovered that of this amount K18,000 is not
recoverable and should be written off as bad debts. At 1 January 20X7,
a balance of K27,800 was brought forward from 20X6 in allowance for
doubtful debts.

It is believed that of the remaining receivables 10% may not pay.

Dr. Receivables account Cr.

K K
Balance 268,000 Bad debts 18,000
Balance c/d 250,000
______ _______
268,000 268,000

Balance b/d 250,000


Dr. Bad debts account Cr.

K K
Receivables 18,000 Allowance for doubtful
debts 18,000
_____ _____
18,000 18,000

Dr. Allowance for doubtful debts account Cr.

K K
Bad debts 18,000 Balance b/f
27,800
Income statement
15,200
Balance c/d 25,000 _____
43,000
43,000
Balance b/d 25,000

NOTES:
- Bad debts K18,000 is a charge against the allowance for
doubtful debts.
- The net charge is K15,200 (18,000 – 2,800) to income
statement.

If the amount of allowance is not enough for bad debts suffered,


the remainder will be charged against profits in that year.

15.6ALLOWANCE FOR CASH DISCOUNTS ON RECEIVABLES.

This is an allowance created to accommodate future cash discounts on


receivables. It is treated exactly like allowance for doubtful debts in
terms of how it is accounted for.

The estimate of discounts to be allowed should be based on the net


figure of receivables after deducting allowances for doubtful debts.

Example: Allowance for cash discounts

The following information is available in the books of Home Made


Furnishers Ltd as at 30 June, end of each financial year.
Year ended 30 Receivables Allowance for
Allowance for
June K doubtful debts cash
discounts
K %

20X6 20,000 1,000 3


20X7 25,000 1,250 3
20X8 23,000 1,200 3

20X6 K20,000 - 1,000 = 19,000 X 3% = 570


20X7 K25,000 - 1,250 = 23,750 X 3% = 713
20X8 K23,000 - 1,200 = 21,800 X 3% = 654

Dr. Allowance for cash discounts on receivables account


Cr.

K K
20x6
Balance c/d 570 Income statement
570 570
570
20x7
Balance c/d 713 Balance b/d 570
___ Income statement 143
713 713
20x8
Income statement 59 Balance b/d
713
Balance c/d 654 ___
713 713
Balance b/d 654

Income Statement
K K
Gross profit for (20X6, 20X7, 20X8) XX

Expenses:
20X6 Allowance for discounts allowed (570)
20X7 Increase in allowance for discounts allowed (143)
(20X8) Add decrease in allowanced for discounts 59

In Balance Sheet

Current Assets K
20X6 Receivables (20,000 – 1,000 - 570) 18,430

20X7 Receivables (25,000 – 1,250 – 713) 23,037

20X8 Receivables (23,000 – 1,200 – 654) 21,146


CHAPTER 16

PREPAYMENTS AND ACCRUALS

INTRODUCTION

The income statement of a business measures the profit by considering


revenues earned and expenses incurred in an accounting year.

Sales less cost of sales equals Gross Profit.

Gross profit less expenses equals net profit. The precise amount of net profit
is calculated on the accruals or matching concept.

TOPICS

1. What are accruals


2. Ledger accounting for accruals
3. ACCRUALS

The accruals concept states that income and expenses should be


included in the income statement of the period in which they are
earned or incurred and not paid or received.

Example

A business rents a shop for K1,200 per annum (K100 per month). If at
year end, the business has only paid K1000, a full years charge of
K1,200 will be expensed in income statement. The K200 though not
paid will be included because it relates to the same period.

Accruals or accrued expenses are expenses which are charged against


the profits of a particular period, even though they have not been paid,
because they were incurred in that period.

N.B. Accruals can be owing by the business or to the business.

Example 1: Owing by the business.

Using the above example the rent expense account would look like:
Dr. Rent Account Cr.

K K
Bank 1 000 Income Statement 1 200
Balance c/d 200
_____ ____
1 200 1 200
Balance b/d 200

By now one should know that a balance b/d on credit side of an


account could be interpreted as a liability or income depending on
what type of account one is looking at.

Therefore, the rent expense account with balance brought down on


credit is a liability (amount owing).

- But the amount to charge in income statement will be K1200


including K200 not paid because it relates to the same period.

- In balance sheet K200, will be shown under current liabilities as


accrued expenses.

Assuming in the following year K1 400 is paid for rent, the account will
be as follows:

Dr. Rent Account Cr.

K K
Bank 1 400 Opening balance from
previous year 200
Income Statement
Account 1 200
_____ ____
1 400 1 400

The K1 400 paid is first to pay the previous years balance of K200 and
the remainder K1 200 is what should be charged to the second year’s
income statement.

The K200 has now been paid and will not appear anywhere in financial
statements.

Example 2: Owing by the business


Genuine Motor Spares, is a dealer in motor spares. The financial year
for the business ends on 28 February each year. His telephone was
installed on 1 April 20x6 and receives his telephone account quarterly
at the end of each quarter. He pays it promptly as soon as it is
received. On the basis of the following data, calculate the telephone
expense to be charged to the income statement for the year ended 28
February 20x7.

The following payments were made.


K
30.6.20x6 23.50
30.9.20x6 27.20
31.12.20x6 33.40
31.3.20x7 36.00

Solution:

Dr. Telephone Account Cr.

K K
Bank 23.50 Income Statement 108.10
Bank 27.20
Bank 33.40
Balance c/d 24.00
_____ _____
108.10
108.10
Balance b/d 24.00

The K24 would be shown under current liabilities as an accrual. The


K24 represents two months arrears for January and February which
were still due by 28 February 20X7.

16.1 Amounts accrued to the business

While the business may owe others for expenses, the business may
also be owed for other amounts apart from trade among others:

- Rent receivables
- Commission receivable
- Unsettled claims for insurance etc.

Using the matching or accruals concepts, all income whether received


or not as long as it relates to the accounting period under review,
should be included as income in income statement for that period.
Since amounts are not yet received, they should be shown in balance
sheet under current assets as other receivables.

Example 1.

T.K. Furnishers Ltd sublets part of the buildings at an annual rent of


K1200 000 (K100 000 per month). During the year ended 31
December 20X8, T.K. discovers that the tenant had only paid K1 000
000.

Show rent receivable account and statement to be shown in income


statement and interpret the balance brought down.

Solution:

Dr. Rent Receivable Account Cr.

K K
Income Statement 1 200 000 Bank 1 000 000
Balance c/d 200 000

________ ________
1 200 000 1 200 000
Balance b/d 200 000

- The amount to be shown in income statement is not K1 000 000


paid, but will also include K200 000 not paid.

So the total to include in income statement is K1 200 000, to be


added to Gross profit.

- In balance sheet the K200 000 will be shown under current


assets as other receivables.

Example 2:

Using example 1, assuming in the following year 20X9, the


tenant pays K1 400 000 for rentals, the rent receivable account
will be:

Dr. Rent Account Cr.

K K
Balance b/f 200 000 Bank 1 400 000
Income Statement 1 200 000 ________
1 400 000 1 400 000

- In 20X9, the opening balance b/f of K200 000 is a debit


representing amounts not yet received (asset).

- When the tenant pays K1 400 000, the whole amount is not for
20X9. Part of it is to clear the debt K200 000 from 20X8 and the
remaining amount is the rent income for 20X9 to be added to
gross profit in income statement. In this example there’s nothing
owing at year end.

16.2 PREPAYMENTS

Prepayments are amount paid in advance before a service is provided.

It is important to note that payments in advance can be made by the


business or to the business.

Example 1: Payments in advance by the business.

A business has a fixed rate for electricity of K74 000 per month. It is
the business tendancy that when their liquidity position is favourable
they pay in advance for certain services including for electricity.

For the year ended 31.12.20X8 the business had paid for electricity
total of K1 036 000 to cover a period of 14 months to 28 February
20X9.

Show the electricity account, stating the amount to be included in


income statement and interpret the balance b/d.

DOUBLE ENTRY

1. Upon payment Dr – Electricity account


Cr – Bank account

2. Income statement Dr. Income statement with annual expense


Cr. Electricity account

In balance sheet. Dr. Electricity (Balance sheet) with balance b/d


(Dr.)

Therefore:
Dr. Electricity Account Cr.

K K
Bank (14 x 74) 1 036 000 Income statement 888 000
Balance c/d 148 000
________ ________
1 036 000 1 036 000
Balance b/d 148 000

Notes:

- Though K1 036 000 was paid during the year, the only expenses
is K888 000
(74 000 x 12 months). The other amount K148 000 is for the
year to come (prepayment) and it will be accounted for in that
year.

- Total charge to income statement is K888 000.

- The balance b/d will be shown in balance sheet under current


assets as prepayments.

Example 2:

Assuming the balance in example 1 of K148 000 is carried forward to


the next year and the business in the new year is only able to pay
K740 000.

Solution:

Dr. Electricity Account Cr.

K K
Balance b/f 148 000 Income statement 888 200
Bank 740 000
_______
888 000 888 000

Notes:

- Though only K740 000 has been paid for current year, i.e. for 10
months, the other amount of K148 000 paid in advance the
previous accommodates the first 2 months of the year making a
full payment for the year of K888 000 to be charged to income
statement.
- K148 000 is no longer an advance payment because it has now
been used in the year for which it was paid.

- In above case no amount will appear in balance sheet.

16.4 Prepayments to the business

Other persons or organizations make payments in advance to the


business for certain items e.g. for rent receivable and any other
income.

- Any amount receivable paid in advance would not be included in


income statement in the year it is received.

- It should be accounted for in the period the service will be


provided.

- In balance sheet it should be reflected under current liabilities as


other payables.

Example 1: Prepayments to the business.

Gas Pipe runs a service station and sales fuel among other services.

Some well established individuals make advanced payments to Gas


Pipe for fuel.

During the year ended 31.12.20X7, a payment of K3 000 000 was paid
in advance for fuel by a customer.

It now is discovered that the customer had actually withdrawn fuel


amounting to
K2 488 000 as at 31.12.20X7.

Show the necessary account to record the above information and state
the unused amount which will be shown in financial statements.

Solution:

Double entry

1. Upon receipt of amount

Dr. – Cash book with K3 000 000


Cr. – Fuel account (Income)
2. At year end, adjustments will be

Dr. – Fuel account with K512 000 balance c/d


Cr. – Prepayment (fuel) balance b/d to be shown in balance sheet
under current liabilities as other payables.

Dr. Fuel Account Cr.

K K
Income statement 2 488 000 Bank 3 000 000
Balance c/d 512 000
________ ________
3 000 000 3 000 000
Balance b/d 512 000
Notes:

The business is holding K512 000 cash for which fuel is yet to be
withdrawn. The fact that this amount could be claimed by customer
before fuel is withdrawn makes it become a liability to the business.

16.5 DIFFICULT SITUATIONS

Examples given so far for prepayments and accruals are straight


forward. This has been done to have basic knowledge on the subject
matter.

- In examination questions, however, one may be confronted with


complicated situations involving several receipts or payments
made in the year covering different periods.
- In such situations particular attention should be made on dates.

Example 1:

Fitwell Garage pays fire insurance annually in on 1 June each year.

From the following record of insurance payments, calculate the charge


to income statement for the financial year to 28 February 20X8.

1 June 20X6 insurance paid is K600 000


1 June 20X7 insurance paid is K700 000

Dr. Insurance Account Cr.

K K
Balance b/f 150 000 Income statement 675 000
Bank 700 000 Balance c/d 175 000
_______ ______
850 000 850 000
Balance b/d 175 000

Notes:
K
(a) The 3 months, 1 March – 31 May 20X7 ( /12 x 600 000)
3

150 000
(b) The 9 months, 1 June 20X7 – 20 February (20X8) 9/12 x 700 000
525 000
(c) Insurance cost for year charged to income statement
675 000

EXERCISES

1. If a business has paid rent of K1 000 000 for the year to 31 March
20X7, what is the prepayment in the accounts for the year to 31
December 20X6.

2. Define an accrual

3. What is the meaning of balances brought at year end in the following


accounts

- Debit balance in expense account


- Credit balance in expense account
- Debit balance in income receivable account
- Credit balance in income receivable account

4. A business maintains one account for rent and rates.

During the year ended 31 December 20X5, the following information


was made available for rent and rates.

- At 1 January 20X5, there was K250 000 rates which had been
paid in advance in 20X4, and K500 000 rent was owing on the
same date.
- The following payments were made during 20X5, rent K4 000
000 and rates
K3 6000 000.

- On 31 December 20X5, rent of K200 000 is owing and rates of


K150 000 are paid in advance.

Required:

Prepare the rent and rates account (combined and appropriately bring
down the balance).

CHAPTER 17

NON CURRENT ASSETS AND INTANGIBLE ASSETS

INTRODUCTION
This chapter deals with non current assets and depreciation. It looks at what
non currents are, depreciation and how it is provided and eventually leading
to disposal. The non current asset register is also discussed.

Additionally the chapter covers the basics of research and development costs
and goodwill

11.0 NON CURRENT ASSETS

11.1 DEFINITION

A non current asset is one bought by the business not for resale
but to be used in the business to help generate income over a
number of years.

- Non current assets are divided into tangible and intangible


assets.

- Tangible non current assets include:

 Land
 Buildings
 Fixtures and fittings
 Motor vehicles

- Intangible non current assets include:

 Goodwill
 Patents
 Trade marks

11.2 CURRENT ASSETS

These are assets that are temporal in nature. They change in


value with time, and examples includes:-

- Inventory
- Receivables
- Cash in bank and
- Cash in hand
Current assets are easily convertible into cash.

NOTE: What is non current asset will depend on the nature of


the business. If a business is dealing in motor vehicles and it
buys motor vehicles for resale, then motor vehicles will be
classified as inventory under current assets. Then motor
vehicles bought to be used in the business will be classified as
non – current assets.

11.3 DEPRECIATION

Definition: (IAS 16 Property, plant and equipment)

IAS 16 which deals with property, plant and equipment defines


depreciation as:

“the allocation of the depreciable amount of an asset over its


estimated useful life”.

Depreciation for the accounting period is charged to income


statement for the period either directly or indirectly.
Depreciation is an expense. No cash is involved.

11.4 KEY TERMS (IAS 16)

(a) Depreciable assets are assets which

- are expected to be used during more than one


accounting period.
- have a limited useful life and
- are held by an enterprise for use in the production or
supply of goods and services, for rental to others, or
for administrative purposes.

(b) Useful life is either:

- the period over which a depreciable asset is


expected to be used by the enterprise or
- the number of production or similar units expected to
be obtained from the asset by the enterprise.

(c) Depreciable amount of a depreciable asset is the historical


cost or other amount substituted for historical cost in the
financial statements, less the estimated residual value.

(d) Residual value


Sometimes called scrap value. This is the estimated value
of an asset at the end of its life. Residual value is not
depreciable. In most cases residual value is immaterial. It
is usually estimated at the time the asset is being
purchased. The estimation may be based on similar assets
in existence in the business.

Example 1: Equipment costing K80,000,000 which has an


expected life of five years and nil residual value will be
depreciated as:

Cost K80 000 000


Residual value NIL
K80 000 000 depreciable amount over 5
years

Example 2: Equipment costing K80 000 000 which has an


expected life of five years with K3 000 000 residual value
will be depreciated as:

Cost K80 000 000


Residual value (K3 000 000)
K77 000 000 is depreciable amount over
5 Years

11.5 CAUSES OF DEPRECIATION

(a) Wear and tear - This is when assets deteriorate because


of being used.

(b) Natural causes - This is when elements of nature take its


effect e.g. erosion of land, rust on machinery, rot and
decay in furniture.

(c) Obsolescence - This is where an asset becomes outdated


because of technological changes even when the asset is
new e.g. computers.

(d) Inadequacy - This arises when an asset is no longer used


because of the growth and changes in the size of the
business. For instance a business is operating a bicycle to
deliver oranges to its customers. When demand increases,
the business will need a van. The bicycle can be sold else
where.

(e) Depletion - Natural resources such as mines, quarries and


oil wells are wasting assets. As raw materials are
extracted they do not regenerate.

11.6 METHODS OF DEPRECIATION

There are many different methods of depreciation. The following


are selected for your study.
- Straight line
- Reducing balance method
- Sum of digits
- Revaluation method

11.7 THE STRAIGHT LINE METHOD

In this method the depreciable amount is charged equally from


one accounting period to the other over the expected useful life
of the asset. It is assumed that the business will enjoy equal
benefits from the use of the assets throughout its life.

N.B.V

TIME

In this way the net book value of an asset declines at a steady


rate, or in a straight line over time. The formula is:

Annual depreciation = Cost of an asset – residual value


Expected useful life of the asset

Example 1: Straight line method

A machine was bought on 1 January 20X4 at a cost of K800 000.


The machine is expected to be used over a period of 5 years with
no residual value.
Annual depreciation would be:

Depreciation = (K800 000 – 0)


5

= K160 000 P.A.

Example 2: Straight line method

A vehicle cost K500 000 will be in use in the business for 4 years
after which it will have residual value of K20 000. Annual
depreciation over 4 years will be:

(K500 000 – K20 000) = K480 000


4 4

= K120 000 P.A.

Sometimes the depreciation charge may be given as a


percentage on cost.

In example 1 above, the % on cost will be:

160 000
x 100 = 20%
800 000

Every year for 5 years 20% will be calculated on K800 000 to find
annual depreciation.

In example 2 above, the % will be calculated on depreciable


amount after deducting residual value.

Remember residual value is not depreciable.

120 000
x 100 = 25%
480 000

Every year for 4 years, 25% will be used on K480 000 which is
the depreciable amount.
11.8 The Reducing Balance Method

In this method depreciation is calculated as a fixed percentage of


the net book value of the asset, as at the end of previous
accounting period.

This method assumes that the business will benefit more from
the use of the asset in earlier years than later years.

Example: Reducing Balance Method

Machine was bought at a cost of K150 000. Depreciation is to be


charged at the rate of 20% per annum. Calculate depreciation
for the first 3 years.

K
Year 1 20% x 150 000
(30 000) Depreciation
Year 2 20% x 120 000 N.B.V
(24 000) Depreciation
Year 3 20% x 96 000 N.B.V
(19 200) Depreciation
76 800

11.9 Sum of digits method

This method is very similar to reducing balance method.


Depreciation is also charged more in earlier years than later year.
What makes it different from reducing balance method is the way
it is calculated.

What is referred to as sum of digits are the years the asset will
be in use i.e. estimated life.

If the life of an asset is 5 years then the sum of digits will be:

Year 1
+
Year 2
+
Year 3
+
Year 4
+
Year 5
15 is the sum of digits
Since depreciation is more in the first year than later years, each
year depreciation charge will be:

Year 1 5
/15 x depreciable amount

Year 2 4
/15 x depreciable amount

Year 3 3
/15 x depreciable amount

Year 4 2
/15 x depreciable amount

Year 5 1
/15 x depreciable amount
Example: Sum of digits method

Ever green purchased a non current asset for K600 000 on 1


January 20X4. The useful life of the asset is 5 years after which it
will have a residual value of K30,000. The depreciation charge
every year will be:

Depreciable amount is K600 000 – K30 000 = K570 000

K570 000 is depreciable amount over 5 years

Year 1 5
/15 x K570 000 = K190 000

Year 2 4
/15 x K570 000 = K152 000

Year 3 3
/15 x K570 000 = K114 000

Year 4 2
/15 x K570 000 = K 76 000

Year 5 1
/15 x K570 000 = K 38 000
K570 000
+
K 30 000 Residual value
K600 000

If the asset had no residual value, then the depreciable amount


would be the whole K600 000 spread over 5 years.

11.10 Revaluation method

- Fall in value of asset


When the market value of a non current asset falls below
its net book value, and the fall in value is expected to be
permanent, the asset should be written down to its new
market value. Revaluation means giving a new value to an
asset which could be gains or losses.

NOTE: Market value is value of asset it can currently fetch


on the market which is different from net book value which
is cost minus depreciation.

The charge in the income statement for the reduction in


the value of the asset during the accounting period is:
K
Net book value at start of year XX

Less: New value (XX)

Charge for impairment (Depreciation) XX

Example: Fall in value of an asset

A business purchased buildings on 1 January 20X3 at a cost


of K300 000. The buildings are expected to be used over a
period of 20 years. After 5 years in use on 1 January 20X8,
the land is now worth K200 000 and the reduction is
permanent.

Solution:

Annual depreciation: 300 000


= 15 000 x 5 years = K75 000
20
K75,000 depreciation has accumulated over 5 years.

N.B.V. after 5 years: 300 000 Cost


(75 000) Depreciation
225 000 N.B.V.
200 000 New value
25 000 Further loss (depreciation
due to revaluation)

As at 31 December 20X7 the total charge to income


statement would be:
K
Normal annual depreciation charge 15 000
Add loss through revaluation 25 000
40 000

The buildings will now be stated in the books @ K200 000


to be depreciated over 15 years remaining.

New annual depreciation from 20X8 on wards will be:

200 000
15

= K13 333

11.11 Increase in value of asset

Due to inflation, the market value of certain non current assets


go up, especially land and buildings. A business is not obliged to
revalue non current assets in its balance sheet. However in
order to give a ‘true and fair view’ the business may decide to
revalue the asset upwards. Depreciation would then be charged
on the new revalued amount.

Example: Increase in value of an asset

Musuku Ltd commenced business on 1 January 20X3, and bought


buildings costing K275 000. The buildings are to be depreciated
on a straight line basis over a period of 25 years with no residual
value.

After 4 years on 1 January 20X7, the buildings are revalued to


K260 000 with a life span of 21 years.

Solution:

Annual depreciation: K275 000


25 years
= K11 000 p.a.
Accumulated depreciation over 4 years: 4 x K11 000 = K44 000

K
Net book value at 31 December 20X6: 275 000 cost
44 000 accumulated
depreciation
231 000 N.B.V.

K
Gain in value: Net book value 231 000
Net value 260 000
29 000

The buildings would now be stated in the books at K260 000 and
will be depreciated over a period of 21 years.

As from 31 December 20X7 onwards annual depreciation would


be:

K260 000
21

= K12 381

NOTE: The increase as a result of revaluation of K29 000 will not


be shown as income in income statement because the gain is not
realized as the buildings are still being used in the business.
Instead the gain will be reflected in the revaluation reserve
account and added separately to capital in the balance sheet.
Remember the prudence concept.

11.12 Accounting for depreciation

Non current assets are maintained in the books at historical cost


i.e. the amount paid to acquire or produce it. An account for
depreciation in the general ledger is opened to record
accumulated depreciation to date. This account is called
Allowance for depreciation account.

- Allowance for depreciation account

Each accounting period a depreciation charge is made to


the income statement and another record will be made in
the allowance for depreciation account, which is
cumulative in nature.
- Double entry for depreciation

DR. – Income statement with depreciation expense


CR – Allowance for depreciation account

- In the Balance Sheet

The accumulated depreciation amount is shown as


deduction from cost of the non current asset to arrive at
net book value.

- There is an allowance for depreciation account for each


separate category of non current assets, e.g. for buildings,
machinery, furniture, motor vehicles etc. If a business has
20 vehicles there will be only one depreciation account for
all the vehicles even if they have been bought at different
times and years.

- Example: Recording allowance for depreciation. Fast


track company maintains non current assets at cost.
Separate allowance for depreciation accounts are kept for
each category of assets.

The following transactions took place:

20X1 1 January bought machinery for K60 000 and


fixtures
for K38 000.

20X2 1 July bought 3 machines at cost K40 000 each.

20X3 1 October bought another machine for K25 000

20X4 1 December bought fixtures for K18 000.

NOTES: Machinery is depreciated at the rate of 15% per


annum on cost and fixtures at the rate of 5% using the
reducing balance method.

Depreciation is to be charged fully for the whole


year
disregarding the purchase date.

Required: Show
(a)The machinery account
(b) The fixtures account
(c)The two separate allowance for depreciation
account
(d) Extracts of the income statement and
balance sheet
for each of the years 20X1, 20X2, 20X3 and
20X4.
Solution:

It may help to put up a table showing the build up of


depreciation for each category of non current assets

Category of asset 20X1 20X2 20X3 20X4 Total

Machinery 1 9 000 9 000 9 000 9


000 36 000

Machinery 2 - 18 000 18 000 18


000 54 000

Machinery 3 - - 3 750 3 750


7 500

Total 9 000 27 000 30 750 30 750


97 500

20X1 20X2 20X3 20X4 Total

Fixtures 1 1 900 1 805 1 715 1 629


7 049

Fixtures 2 - - - 900 900

Total 1 900 1 805 1 715 2 529


7 949

Machinery Account

20X1 Bank 60 000 Balance c/d 60


000
______ _______
60 000 60 000

20X2 Balance b/d 60 000 Balance c/d 180


000
Bank (3 x 40,000) 120 000 _______
180 000 180 000

20X3 Balance b/d 180 000 Balance c/d 205


000
Bank 25 000 ______
205 000 205 000

20X4 Balance b/d 205 000 Balance c/d 205


000

205 000 205 000

Dr Allowance for depreciation account (Machinery)Cr

20X1 K 20X1 K
Balance c/d 9 000 Income statement
9 000
_____ _____
9 000 9
000
20X2 20X2 Balance b/d 9
000
Balance c/d 36 000 Income statement
27 000
36 000 36
000
20X3 20X3 Balance b/d 36 000
Balance c/d 66 750 Income statement
30 750
66 750 66
750
20X4 20X4 Balance b/d 66
750
Balance c/d 97 500 Income statement
30 750
97 500 97
500

Fixtures Account

20X1 Bank 38,000 Balance c/d 38


000
______ ______
38 000 38 000

20X2 Balance b/d 38 000 Balance c/d 38


000
_____ ______
38 000 38 000

20X3 Balance b/d 38 000 Balance c/d 38


000
_____ _____
38 000 38 000

20X4 Balance b/d 38 000 Balance c/d 56


000
Bank 18 000 _____
56 000 56 000

Dr Allowance for depreciation account (Fixtures) Cr

K K
20X1 20X1
Balance c/d 1 900 Income statement
1 900
_____ _____
1 900 1
900
20X2 20X2 Balance b/d 1
900
Balance c/d 3 705 Income statement
1 805
3 705 3
705
20X3 20X3 Balance b/d 3 705
Balance c/d 5 420 Income statement
1 715
5 420 5
420
20X4 20X4 Balance b/d 5
420
Balance c/d 7 949 Income statement
2 529
7 949 7
949

Income statement (Extract)

K K
Gross profit XX
Less: Expenses

20X1 Depreciation: Machinery 9 000


Fixtures 1 900
(10 900)

XX
20X2 Depreciation: Machinery 27 000
Fixtures 1 805
(28 805)

XX
20X3 Depreciation: Machinery 30 750
Fixtures 1 715
(32 465)

20X4 Depreciation: Machinery 30 750


Fixtures 2 529
(33 279)

Balance Sheet (Extracts)

Non current assets Cost Depreciation N.B.V.

20X1 Machinery 60 000 9 000 51 000


Fixtures 38 000 1 900 36 100

20X2 Machinery 180 000 36 000 144 000


Fixtures 38 000 3 705 34 295

20X3 Machinery 205 000 66 750 138 250


Fixtures 38 000 5 420 32 580
20X4 Machinery 205 000 97 500 107 500
Fixtures 56 000 7 949 48 051

In the trial balance

Depreciation is an end of the year adjustment, therefore in the


year of acquisition of a non current asset depreciation will not be
reflected in the trial balance, but will start appearing in
subsequent years.

In previous exercise depreciation will only start appearing in


20X2, thus:

Trial Balance as at 31 December 20X2

Dr Cr
Machinery 180 000
Accumulated depreciation 9 000
Fixtures 38 000
Accumulated depreciation 1 900

Trial Balance as at 31 December 20X3


Dr Cr
Machinery 205 000
Accumulated depreciation 36 000
Fixtures 38 000
Accumulated depreciation 3 705

Any depreciation shown in the trial balance is what has


accumulated from previous years. For the year under review it
has to be calculated and shown in the income statement. The
figure shown in income statement will be added to the figure in
the trial balance and the accumulated total shown in the balance
sheet.

11.13 Choice Of Depreciation Method

Any method of depreciation can be used on a non current asset, but


the method chosen must be fair in allocating the charges between
different accounting periods.
CONSIDERATION WHEN SELECTING METHOD OF DEPRECIATION

(a) The method should allocate costs in proportion to the benefits


i.e.

(i) Use reducing balancing method if the business will benefit


more from the asset in earlier years than later years
(ii) Use the straight line if benefits will be spread equally over
the life of the asset

(b) Consistency must be observed. Same depreciation method must


be used for similar assets, and from one year to another.

(c) Choose a method which is easy to apply.

11.4 Asset Acquired During An Accounting Period

If a non current asset is purchased during an accounting period it


might be fair to charge depreciation according to the period the asset
has been used i.e. on monthly basis. However, this basis may apply
when straight line method is in use.

Examination questions will usually state the way depreciation is to be


applied.

Examples:

(a) Charge a full year’s depreciation in the year of acquisition or


nothing in the year of disposal. In this instruction dates of
purchase should be ignored even if the dates are given.
(b) Charge a full year’s depreciation on the value of asset available
at year end. (explanation same as in a)
(c) Depreciation should be charged on monthly basis.
(d) If instructions are silent and dates of purchase are given, then
the monthly basis should be adopted.

Example: Assets acquired during the year.

A business has an accounting period which runs from 1 January


to 31 December.
On 1 October 20X5 the business purchased furniture for K500
000 cost. The life span of the furniture is 10 years with no
residual value.

What is the depreciation charge for the year ended 31 December


20X5?

Solution

Annual depreciation is K500 000


= K50 000
10 years

The asset was acquired on 1 October 20X3 and will be


depreciated only for 3 months in 20X5.

K50 000 x 3 months


12 months

= K12 500

11.15 Change in estimated life

When the life span of an asset changes i.e. increased or reduced, the
net book value of the asset at the time of change is what will be spread
on the remaining life.

Example 1: Increase in life of an asset

A business purchased a motor vehicle at a cost of K400 000 with an


estimated life of 6 years. It is to be depreciated on straight line basis
over its life. However, after 2 years in use, it is discovered that the
asset life has 2 more years making a total of 8 years.

What will be the depreciation charge from year 3 on wards.

Solution:

Annual depreciation is K400 000


6 years = K66 667

K66 667 x 2 years = K133 334.

Net book value after 2 years K400 000


133 334
266 666 N.B.V.

Net book value to be spread over new life i.e. 6 years. From year 3
onwards annual depreciation will be:

K266 666
6 years = K44 444

Example 2: Decrease in life of asset

A business bought non current assets at a cost of K100 000. It is


estimated that the assets will be used in the business for a period of 7
years with K10 000 residual value. After one year in use, it was
reviewed that the assets life span be reduced to 3 years from the
remaining 6 years. What will be depreciation from year 2 onwards.

Solution

Annual depreciation (100 000 – 10 000)


7 years = K12 857

Net book value after 1 year 90 000 – 12 857 = K77 143.

N.B.V. of K77 143 will now be spread over 3 years.

From the second year onwards annual depreciation will be

K77 143
3 = K25 714

11.16 Change in Depreciation Method

It is allowed to change the depreciation method if it is discovered that


a wrong method was adopted initially, and is not true and fair, or if
there is a change in the pattern of consumption of economic benefits
from the non current asset. Every year end a business will normally
review its accounts and this is the time such a discovery may be
made. Changes should be necessary and not done at will otherwise
comparison will be difficult because of inconsistency.

Example: Change in depreciation method

A business bought furniture on 1 January 20X3 at a cost of K80 000.


The asset is to be depreciated using straight line method over a 5 year
period.
At 1 January 20X5, a review was conducted, and it was agreed to
change the method to reducing balance method at the rate of 20% per
annum.

Show the necessary entries to adjust to new method.

Solution:
Using straight line method

K80 000
5 years = K16 000 annual depreciation

Accumulated depreciation at time of change K16 000 x 2


K32 000

Net book value after 2 years K80 000 – K32 000 = K48 000

From year three onwards using reducing balance method, depreciation


will be:

Year 3 48 000 x 20%


(9 600) Depreciation
Year 4 38 400 x 20%
(7 680) Depreciation
30 720 x 20% etc.

11.17 The Disposal of Non Current Assets

When a business buys non current assets, they are meant to be used in
generating income for the business over a period time (more than 1
year). They are not meant for resale to make a profit.

However, the non current assets might be sold off at some stage
before even their useful life is over. Reasons for selling or disposal
may include:

- Inadequacy – where an asset fails to meet increased demand for


a product
- Obsolescence etc

(a) The Disposal Account

When non current assets are disposed of, a disposal account is


opened. This account will reveal whether a profit or loss has
been made on the asset sold. The profit or loss on disposal are
reported in the income statement.

- Ledger accounting on disposal of non current asset. The


profit or loss on disposal is the difference between net book
value of non current asset and the net sale price, which is
the price minus any costs of making the sale.
- A profit is made when sales price is more than net book
value
- A loss is made when sales price is less than net book value
of a non current asset.

Double entry when an asset is disposed of.

Step 1:

Debit – Disposal account with value of asset usually at


Credit – Asset account cost

Step 2:

Debit – Allowance for depreciation account with


accumulated
Credit – Disposal account depreciation at
the
time of sale

Note: The two steps in disposal account reveals the net


book value of the asset.

Step 3:

Debit – Receivable account (if sale is on credit) or


Debit – cash book (if sale is on cash or by cheque
Credit – Disposal account

with sale price of the asset

Step 4

The balancing figure in disposal account will be profit or


loss on disposal.

- If balancing figure is on debit of disposal account, a


profit has been achieved.
- If balancing figure on disposal account is on credit
side, then a loss is recorded.

Examples: Disposal of non current asset.

Green Grass purchased a van on 1 January 20X5 for K100


000. He estimated that its resale value on 31 December
20Y0 after six years use would be K40 000 and depreciated
it on a straight line basis. He sold it on 30 June 20X7 for
K55 000.

Solution:

The amount to be charged as depreciation each year is

Cost – residual value


Estimated economic life = (K100 000 – K40 000)
6 years

= K10 000

Green Grass owned the asset for two years and six months,
thus the total depreciation charged since acquisition is K10
000 x 21/2 years = K25 000.

This means that the net book value at the date of disposal
was K100 000 – K25 000 = K75 000.
Since the sale proceeds amounted to K55 000, a loss on
disposal of
K55 000 – K75 000 = K20 000 has been made.

Ledger accounting on disposal.

Dr Van account (at cost) Cr

20X5 K K
1 Jan. Bank 100 000 31 Dec. Balance c/d 100
000
_______ ______
100 000 100 000
20X6
1 Jan. Balance b/d100 000 31 Dec. Balance c/d 100
000
______ _______
100 000 100 000
20X7
1 Jan. Balance b/d100 000 June 30 Disposal 100
000
______ ______
100 000 100 000

Dr Allowance for depreciation Cr

K 20X5 K
31 Dec. Bal. c/d 10 000 31 Dec. Inc. statement
10 000
(Depreciation)
______ _____
10 000 10
000
20X6
31 Dec. Bal. c/d 20 000 1 Jan. Balance b/d
10 000
31 Dec. Inc. statement 10
000
(Depreciation)
______ ______
20 000 20
000
20X7
30 June Disposal 25 000 1 Jan. Balance b/d
20 000
30 June Inc. statement 5
000
(Depreciation) _____
25 000 25
000

Dr Disposal account Cr

20X7 K 20X7 K

30 June Van at cost 100 000 30 June Allow. For Dep.


25 000
30 June Bank 55
000
Loss (to inc. state.) 20
000
_______ ______
100 000 100 000

Example 2: Trading in or part exchange on disposal.

On 1 April 20X8, Quick Fix owned a motor vehicle which


was bought on 1 October 20X5 at a cost of K600 000. Its
estimated residual value after five years in use would be
K80 000.

Quick Fix’s policy is to provide depreciation on straight line


method on monthly basis.

During the financial year ended 31 March 20X9, the


following occurred:

On 30 June 20X8, the motor vehicle was traded in and


replaced with a new one. The trade in allowance was K255
000. The new vehicle cost K850 000. The balance after
deducting the trade in allowance was paid by cheque.

The new motor vehicle is expected to have a residual value


of K100 000 after its life of 8 years.

Required:

Show the necessary ledger accounts to record the above


information.

Solution:
Annual depreciation: K600 000 – K80 000
5 years = K104 000
For old vehicle

Accumulated depreciation = K104 000 x 2.75 = K286 000

Net book value = K600 000 – K286 000 = K314 000


Therefore a loss on disposal of K255 000 trade in allowance
minus Net book value of K314 000 = K59 000 was made.
This is because 2.75 is the period of 2 years 9 months that
the old motor vehicle was owned by Quick Fix.

Note: Trade in allowance is what should have been


realized if the asset was sold for cash.

Ledger accounting:

Dr Motor Vehicle account Cr

20X8 K K

30 June Balance 600 000 30 June Disposal 600


000
30 June New M/Veh.
(255 000 + 595 000) 850 000
31 March (20X9) Bal c/d 850
000
________
_______
1 450 000 1 450
000

1 April 20X0 Bal. b/d 850 000

Dr Disposal account Cr

20X8 K 20X8 K

30 June M/Vehicle 600 000 30 Acc. Dep.


286 000
Trade in All 255
000
Loss (P/L A/c) 59 000
_______ ______
600 000 600 000

Note: Double entry for new motor vehicle:

DR – Motor Vehicle account with


Trade in allowance (255 000)
Cash (595 000)
CR - Disposal account with Trade in allowance (255 000)
CR - Cash account with M/Vehicle (K595 000)

11.18 Controlling Tangible Non Current Assets.

Most organizations will own a number of non current assets and their
control is vital to the efficient running of the organization. A non
current asset register should be maintained for this purpose.

Non Current Asset Register.

This register will contain the following information for each non current
asset.

- the date of purchase


- the name and address of supplier
- the cost of the asset
- the estimated useful economic life of the asset
- the estimated residual or resale value of the asset at the end of
its useful life
- a description of the asset
- a code number for easy identification
- the method of accumulated depreciation to be used
- the accumulated depreciation of the asset
- details of disposal of the asset
- the location of the asset within the organization
- the extent to which it is being used
- the repairs carried out and how much they cost
- the expiry dates of any licences permitting the organization to
use it.

11.19.0 IAS 16 PROPERTY, PLANT AND EQUIPMENT

11.19.1 This standard covers all aspects of accounting for property,


plant and equipment.
This represents the bulk of items which tangible long term
asserts.

11.19.1 IAS 16 should be followed when accounting for property, plant


and
equipment unless another international accounting standard
requires a different
treatment.

11.19.2 IAS 16 does not apply to the following:

(a) Forests and other regenerative natural resources

(b) Mineral rights, exploration for and extraction of minerals, oil,


gas and other
regenerative resources.

Definitions

11.19.3 This standard gives a large number of definitions.

KEY TERMS

 Property, plant and equipment are tangible assets that:

Are held by an entity for use in the production or supply of goods or


services, for rental to others, or for administrative purposes; and

Are expected to be used during more than one period.

 Cost is the amount of cash equivalents paid or the fair value of the
other consideration given to acquire an asset at the time of its
acquisition or construction.

 Residual value is the estimated amount that an entity would


currently obtain from disposal of the asset after deducting the
estimated costs of disposal if the rest were already of the age and in
the condition expected at the end of its useful life.
 Fair value is the amount for which an asset could be exchanged
between knowledgeable, willing parties in an arms length transaction.

 Carrying amount is the amount for which an asset is recognized


after deducting any accumulated depreciation and impairment losses.

 Recoverable amount is the amount which the entity expects to


recover from the future use of an asset, including its residual value on
disposal.

Recognition

11.19.4 In this context, recognition simply means incorporation of the


item in the
Businesses accounts, in this case as a non current asset. The
recognition of
Property, plant and equipment depends on two criteria.

(a)It is probable that future economic benefits associated with the


asset will flow to
the entity.

(b) The cost of the asset to the entity can be measured reliably.

11.19.5 Property, plant and equipment can amount to substantial


amounts in financial
statement, affecting both the presentation of the company’s
financial position in
the balance sheet and the profitability of the entity as shown in
the income
statement. Smaller items such as tools are often written off as
expenses of the
period. Most companies have their own policy on this –items
below a certain value
are charged as expenses.

Initial measurement

11.19.6 Once an item of property, plant and equipment qualifies for


recognition as an
asset, it will initially be measured at cost.

Components of cost
11.19.7 The standard lists the components of the cost of an item of
property, plant and
equipment.
 Purchase price, less any trade discount or rebate
 Initial estimate of the costs of dismantling and removing
the item and restoring the site on which it is located
 Directly attributable costs of bringing the asset to working
condition for its intended use, eg:
o The cost of site preparation
o Initial delivery and handling costs
o Installation costs
o Professional fees (architects, engineers)

11.19.8 The following costs will not be part of the cost of property,
plant or equipment unless they can be attributed directly to the
asset’s acquisition, or bringing it into its working condition.

 Expenses of operations that are incidental to the


construction or development of the item
 Administration and other general overhead costs
 Start-up and similar pre-production costs
 Initial operating losses before the asset reaches planned
performances

All of these will be recognized as an expense rather than an


asset.

Exchange of assets
11.19.9 Exchange or part exchange of assets occurs frequently for items
of property, plant and equipment. IAS 16 states that the cost of
an item obtained through (part) exchange is the fair value of
the asset received (unless this cannot be measured reliably).

Subsequent expenditure

11.19.10 How should we treat any subsequent expenditure on long-term


assets, after their purchase and recognition? Subsequent
expenditure is added to the carrying amount of the asset,
but only when it is probable that future economic benefits, in
excess of the originally assessed standard of performance of the
existing asset, will flow to the enterprise. All other subsequent
expenditure is simply recognized as an expense in the period in
which it is incurred.
11.19.11 The important point here is whether any subsequent expenditure
on an asset improves the condition of the asset beyond the
previous performance. The standard gives the following
examples of such improvements.

(a) Modification of an item of plant to extend its useful


economic life, including increased capacity
(b) Upgrade of machine parts to improve the quality of output
(c) Adoption of a new production process leading to large
reductions in operating costs.

11.19.12 Normal repairs and maintenance on property, plant and


equipment items merely maintain or restore value, they do not
improve or increase it, so such costs are recognized as an
expense when incurred.

Measurement subsequent to initial recognition

11.19.13 The standard offers two possible treatments here, essentially a


choice between keeping an asset recorded at cost or revaluing it
to fair value.

(a) Cost model. Carry the asset at its cost less depreciation
and any accumulated impairment losses.
(b) Revaluation model. Carry the asset at a revalued
amount, being its fair value at the date of the revaluation
less any subsequent accumulated depreciation.
Revaluations should be made regularly enough so that the
carrying amount approximates to fair value at the balance
sheet date. The revaluation model is only available if the
item can be measured reliably.

Revaluations
11.19.14 The market value of land and buildings usually represents fair
value, assuming existing use and line of business. Such
valuations are usually carried out by professionally qualified
valuers.

11.19.15 In the case of plant and equipment, fair value can also be
taken as market value. Where a market value is not available,
however, depreciated replacement cost should be used. There
may be no market value where types of plant and equipment are
sold only rarely or because of their specialized nature (i.e. they
would normally only be sold as part of an ongoing business).

11.19.16 The frequency of valuation depends on the volatility of the fair


values of individual items of property, plant and equipment.
The more volatile the fair value, the more frequently revaluations
should be carried out. Where the current fair value is very
different from the carrying value then a revaluation should be
carried out.

11.19.17 Most importantly, when an item of property, plant and equipment


is revalued, the whole class of assets to which it belongs
should be revalued.

11.19.18 All the items within a class should be revalued at the same
time, to prevent selective revaluation of certain assets and to
avoid disclosing a mixture of costs and values from different
dates in the financial statements. A rolling basis of revaluation is
allowed if the revaluations are kept up to date and the
revaluation of the whole class is completed in a short period of
time.

11.19.19 How should any increase in value be treated when a


revaluation takes place? The debit will be the increase in value
in the balance sheet, but what about the credit? IAS 16 requires
the increase to be credited to a revaluation surplus (ie part of
owners’ equity), unless the increase is reversing a previous
decrease which was recognized as an expense. To the extent
that this offset is made, the increase is recognized as income;
any excess is then taken to the revaluation reserve.

11.19.20 IAS 16 makes further statements about revaluation, but these


are beyond the scope of your syllabus.

Depreciation

11.19.21 The standard reflects the following approach to depreciation.

 The depreciable amount of an item of property, plant


and equipment should be allocated on a systematic basis
over its useful life.
 The depreciation method used should reflect the pattern
in which the asset’s economic benefits are consumed by
the enterprise.
 The depreciation charge for each period would be
recognized as an expense unless it is included in the
carrying amount of another asset.

Most of the comments on depreciation in IAS 16 are dealt with in


Section 2.

11.19.22 Land and buildings are dealt with separately even when they
are acquired together because land normally has an unlimited
life and is therefore not depreciated. In contrast buildings do
have a limited life and must be depreciated. Any increase in the
value of land on which a building is standing will have no impact
on the determination of the building’s useful life.

11.19.23 Depreciation is usually treated as an expense, but not where it


is absorbed by the enterprise in the process of producing other
assets. For example, depreciation of plant and machinery is
incurred in the production of goods for sale (inventory items). In
such circumstances, the depreciation is included in the cost of
the new assets produced.

Review of useful life


11.19.24 A review of the useful life of property, plant and equipment
should be carried out at least annually and the depreciation
charge for the current and future periods should be adjusted if
expectations have changed significantly from previous estimates.

Review of depreciation method


11.19.25 The depreciation method should also be reviewed
periodically and, if there has been a significant change in the
expected pattern of economic benefits from those assets, the
method should be changed to suit this changed pattern. When
such a change in depreciation method takes place the change
should be accounted for as a change in accounting estimate
and the depreciation charge for the current and future period
should be adjusted.

Impairment of asset values


11.19.26 The carrying amount of an item or group of identical items of
property, plant and equipment should also be reviewed
periodically. This is to assess whether the recoverable amount
has declined below the carrying amount. When there has been
such a decline, the carrying amount should be reduced to the
recoverable amount.

11.19.27 Recoverable amounts should be considered on an individual


asset basis or for groups of identical assets.

Retirements and disposals

11.19.28 When an asset is permanently withdrawn from use, or sold or


scrapped, and no future economic benefits are expected from
its disposal, it should be withdrawn from the balance sheet.

11.19.29 Gains or losses are the difference between the estimated net
disposal
proceeds and the carrying amount of the asset. They should
be recognized as
income or expense in the income statement.

Disclosure

11.19.30 The standard has a long list of disclosure requirements, only


some of which are relevant to your syllabus.

 Measurement bases for determining the gross carrying


amount (if more than one, the gross carrying amount for
that basis in each category)
 Depreciation methods used
 Useful lives or depreciation rates used
 Gross carrying amount and accumulated depreciation at
the beginning and end of the period
 Reconciliation of the carrying amount at the beginning
and end of the period showing:

o Additions
o Disposals
o Increases/decreases from revaluations
o Reductions in carrying amount
o Depreciation
o Any other movements
11.19.31 The financial statements should also disclose the following:

 Existence and amounts of restrictions on title, and items


pledge as security for liabilities
 Accounting policy for restoration costs
 Amount of expenditures on account of items in the
course of construction
 Amount of commitments to acquisitions

11.19.32 Revalued assets require further disclosures

 Basis used to revalue the assets


 Effective date of the revaluation
 Whether an independent valuer was involved
 Nature of any indices used to determine replacement cost
 Carrying amount of each class of property, plant and
equipment that would have been included in the financial
statements had the assets been carried at cost less
depreciation.
 Revaluation surplus, indicating the movement for the
period and any restrictions on the distribution of the
balance to shareholders.

11.19.33 The standard also encourages disclosure of additional


information, which the users of financial statements may find
useful.

 The carrying amount of temporarily idle property, plant and


equipment
 The gross carrying amount of any fully depreciated
property, plant and equipment that is still in use
 The carrying amount of property, plant and equipment
retired from active use and held for disposal
 When the benchmark treatment is used, the fair value of
property, plant and equipment when this materially
different from the carrying amount.

CHAPTER 18

ACCOUNTING FOR INVENTORIES


INTRODUCTION

Profit is excess of income over expenditure. The purpose of this chapter is to


describe how inventory valuation affects gross profit and the impact it has on
current assets in the Balance Sheet.
TOPICS

the final accounts.

18.1 What is inventory

International Accounting Standard (IAS 2) defines inventory as:

- Assets held for sale in the ordinary course of business.


- Items in the process of production for sale
- Raw materials or supplies to be consumed in the production
process or in the rendering of services

Inventory is also called stock.

18.2 Cost of goods sold

The accruals concept requires that income should be matched with


expenses incurred in earning that income. Goods bought in an
accounting period may not all be sold at end of period. The unsold
goods will be held in the business warehouse as inventory. These
goods should not be included in the cost of sales for the period.

Profit is calculated on what has been sold.

Calculation of cost of goods sold

Opening inventory xx
Add: purchases xx
xx
Less: closing inventory (xx)
Cost of goods sold xx

Example

A trader is in business buying and selling radios. His financial year


ends on 31 March each year.

During the financial year ending 31 March 20x7, the following is a


summary of the transactions that took place.
- bought 30 radios at K40 000 each
- sold 21 radios at K55 000 each

During the year to 31 March 20x8 he continued with his business and
the following took place.

- bought some more radios 35 at K40 000 each


- sold 38 radios at K57 000 each

Required:

Calculate the gross profit for each of the two years?

Solution:
K K
Year to 31 March 20x7

Sales (21 x K55 000) 1 155 000

Cost of sales
Purchases (30 x K40 000) 1 200 000
Less: closing inventory
(9 x K40 000) (360 000)
(840 000)

Gross profit 315 000

NOTE: Though 30 radios were bought only 21 radios were sold. Profit
will be calculated on the 21 radios sold, thus 21 x K40 000 = K840 000
is cost of radios sold at (21 x K55 000 = K1 155 000). The 9 radios not
sold will be considered as closing inventory.

What is closing inventory in 20x7 will be opening inventory in 20x8.

Year to 31 March 20x8

Sales (38 x K57 000) K2 166 000

Cost of sales:
Opening inventory (9 x 40 000) K360 000
Add: Purchases (35 x K40 000) K1 400 000
K1 760 000

Less closing inventory


(6 x K40 000) (K240 000)
(K1 520 000)

Gross profit K646 000

NOTE: For the year to 31 March 20x8, the business had a total of 44
radios i.e. 9 from 20x7 plus 35 bought during the year. Out of 44
radios only 38 were sold leaving 6 unsold (closing inventory).
Therefore profit is calculated of the cost of the 38 radios sold. The
concept of going concern is in play for taking closing inventory to the
next accounting period.

Inventory stolen or destroyed or lost

If inventory bought is stolen or destroyed that is considered a loss to


the business. When calculating profit it will be part of cost of sales or
shown separately as an expense.

Example in inventory stolen or destroyed

Using example 12.4, assuming 2 radios were stolen, the situation will
now be as follows:

Sales (38 x K57 000) K2 166 000

Cost of sales:
Opening inventory (9 x 40,000) K360 000
Add purchases (35 x K40,000) K1 400 000
K1 760 000
Less closing inventory
(4 x K40 000) (K160 000)
(K1 600 000)

Gross profit K566 000

In the above example, since only 4 radios are remaining, the 2 radios
stolen will be included as part of cost of sales when calculating profit.

An alternative method will be to deduct the stolen radios from the total
inventory and show it as a separate expense as follows:

Sales (38 x K57 000) K2 166 000

Cost of sales:
Opening inventory (9 x K40 000) K360 000
Add: Purchases (35 x K40 000) K1 400 000
K1 760 000
Less: Inventory stolen (2 x 40,000) (K80,000)
K1 680 000
Less: Closing inventory (4 x 40 000) (K160,000)
K1 520 000
Gross profit K646 000
Expenses:
Inventory stolen (2 x 40 000) (K80
000)
K566 000

18.3 Inventory and cost of carriage inwards and carriage outwards.

Carriage refers to the cost of transporting purchased goods from the


supplier to the premises of the business which has bought them. This
cost is sometimes paid by customer or supplier.

- When the buyer (customer) pays the cost it is called carriage


inwards
- When the seller (supplier) pays the cost, the cost to the supplier
is called carriage outwards
- Carriage inwards is added to cost of purchases. It is a direct
expense and therefore included in cost of sales
- Carriage outwards is a selling and distribution expenses in the
income statement. It is an indirect expense.

Example Carriage inwards and outwards

The following amounts appear in the books of a trader at the end of


the financial year.
K
Opening inventory 55 000
Closing inventory 85 000
Carriage outwards 62 000
Purchases 75 000
Returns inwards 5 000
Carriage inwards 3 000

Required:

Calculate cost of sales.


Solution
K
Cost of sales:
Opening inventory 55 000
Purchases 75 000
Carriage inwards 3 000
133 000
Less: Closing inventory (85 000)
Cost of sales 48 000

18.4 Accounting or opening and closing inventories

In order to calculate gross profit, it is necessary to work out the cost of


goods sold, and in order to calculate the cost of goods sold, it is
necessary to have values for the opening inventory and closing
inventory.

Assuming the inventory value is given, double entry will be as follows:

- Transferring purchases to income statement

DR – Income Statement
CR – Purchases Account

- Value of inventory is arrived at after counting or conducting


physical stock take. This is usually done at year end to
determine closing inventory. When this is done, double entry is:

DR – Inventory Account (closing inventory value)


CR – Income Statement

When closing inventory is credited in income statement it means


it will be added to sales figure, but because of the format of the
income statement which is vertical presentation, closing
inventory is shown as a deduction from purchases in arriving at
cost of sales.

- Closing inventory (stock) at end of one period becomes opening


inventory at start of next period. The inventory account remains
the same until the end of the next period, when the value of
opening inventory is taken to the income statement. Any
purchase made in the period will be recorded in the purchases
account.

DR – Income Statement
CR – Inventory account (with value of opening inventory)

Example: Ledger accounting for inventory

Sky Ltd sets up business with capital in cash of K750 000. During the
first year trading to 31 December 20X8, recorded the transactions
below:

Bought goods on credit for resale K80 000


Bought goods and paid by cash K95 000
Sold goods for cash to different customers K150 000
Sold goods on credit also to different customers K105 000
Receipts from credit customers K70 000 cash
Payments to credit suppliers K60 000
Purchased motor van for use in the business K50 000 cash
Sundry expenses paid in cash K25 000
A physical stock take was conducted and closing inventory was valued
at K35 000.

Required:

Prepare ledger accounts for the above transactions and draft an


income statement for the year ended 31 December 20x8.

Solution:

Because this is the first year in business, there is no opening inventory.

Dr Cash account Cr

K’000 K’000
Capital 750 Purchases 95
Sales 150 Payables 60
Receivables 70 Motor van 50
Expenses 25
___ Balance c/d 740
970 970
Balance b/d740

Dr Capital account Cr

K’000 K’000
Cash
750

Dr Trade Payables Cr

K’000 K’000
Cash 60 Purchases 80
Balance c/d 20 __
80 80

Balance b/d 20
Dr Purchases account
Cr

K’000 K’000
Payables 80 Income Statement
175
Cash 95
___ ___
175
175

Dr Trade Receivables Cr

K’000 K’000
Sales 105 Cash 70
___ Balance c/d 35
105 105

Dr Sales account Cr

K’000 K’000
Income Statement 255 Cash
150
___ Receivables
105
255 255

Dr Motor van account Cr

K’000 K’000
Cash 50 Balance c/d
50
50 50

Dr Sundry Expenses account Cr

K’000 K’000
Cash 25 Income statement
25
25 25

Dr Inventory account Cr

K’000 K’000
Income statement 35 Balance c\d
35
====
====
Balance b/d 35

SKY LTD
Income statement for the year ended 31 December 20x8
(using vertical format)

K’000 K’000

Sales 255

Cost of sales:
Purchases 175
Less: Closing inventory 35
(140)
Gross profit 115
Less: Expenses
Sundry expenses (25)
Net profit 90

===
SKY LTD
Income statement for the year ended 31 December 20x8
Using T Format)

Dr Cr

K’000 K’000
Purchases 175 Sales 255
Gross profit c/d 115 Closing inventory 35
290 290

Sundry Expenses 25 Gross profit b/d 115


Net profit 90 ___
115 115

N.B. The balance on the inventory account is K35 000 which will
appear in balance sheet as a current asset.

As it is the K35 000 closing inventory is the only entry in the


inventory account. There’s no figure for opening inventory.

If opening inventory was there, it would have been eliminated by


transferring it as a debit balance to the income statement.

DR – Income statement (with value of opening inventory)


CR – Inventory account (with value of opening inventory)

18.5 Inventory Counting

- A business is regarded as a going concern unless it is otherwise it


is stated. As the business continues with its operations financial
statements must be drawn up at regular intervals, usually on
yearly basis. The time when financial statements are being
prepared, the activities of the business are frozen in order to
determine the assets and liabilities available at that date. This is
also the time that inventory quantities are established, and this
can be done by physical counting. The time taken will vary from
size of organization and inventory involved. If the organization is
large and involves different types of stock (inventory), it may be
necessary to:

(a) close down the business while stock take takes place
(b) maintain continuous inventory records manually or using a
computerized system where records are updated
immediately an entry is made for receipts and issues.
Inventory accruals

This is where goods have been received before the year end and
included in inventory, but no invoice has yet been received. Without
an invoice no record can be made in accounting books to show the
business indebtedness or liability to suppliers.

To determine the price of the uninvoiced goods a goods received note


(GRN), delivery notes or current order forms may be used for this
purpose.

- Double entry would then be effected as:

DR – Purchases account
CR – Payables (Liability)

18.6 Inventory Valuation


IAS 2 provides guidance and rules governing inventory valuation.
There are many methods in theory which may be used to value
inventory. The following are some of them.

(a) Selling price


(b) Net realizable value i.e. sales minus expenses
(c) Historical cost i.e. amount at which it was originally bought
(d) Current replacement cost i.e. how much it would cost to
replace.

- IAS 2 (inventories) states that inventory should be valued at the


lower of cost and net realizable value.

Therefore (a) and (d) above are eliminated.

(a) because selling price may include profit before goods are sold
thus going against the prudence and realization concepts.

(d) because replacement cost may over state inventory


especially where
prices are continuously rising.

Example 1: Net Realisable Value (N.R.V.)

An item is purchased for K45 000 (cost). Another K7 000 has to


be spent to get it ready for sale. After which the item will be sold
for K60 000.
N.R.V. = K60 000 – K7 000 = K53 000.

Therefore valuing it at K53 000 in balance sheet will be to


anticipate a profit of K53 000 – K45 000 = K8 000.

In this case the appropriate valuation will cost K45 000 because
it is lower of N.R.V. of K53 000.

Example 2: With different items of inventory

If a business has many inventory items on hand the comparison


of cost and N.R.V. should be carried out for each item separately.
Do not aggregate costs and N.R.V. for all items and compare the
two totals.

At the year end on 31 March 20x6, a business has three (3) items
of inventory remaining in warehouse, for which the cost and
N.R.V. is given below.

Inventory item Cost N.R.V. Lower of


cost/N.R.V. K K K
A 17 000 23 000 17
000
B 8 500 5 000 5
000
C 23 000 23 100 23
000

48 500 51 100
45 000
====== ======
======

K45 000 is the value that should appear in balance sheet as


value of inventory. Comparing K48 500 with K51 100 and valuing
inventory at K48 500 would be inappropriate because there
would be covering up.

Example 3:

The following figures relate to inventory held at the year end.

A B C
K K K
Cost 20 000 9 000 12 000
Selling price 30 000 12 000 22 000
Modification costs - 2 000 8 000
Marketing costs 7 000 2 000 2 000

Units held 200 000 150 000 300 000

Required:

Calculate the value of inventory held


Solution

Item Cost N.R.V. Valuation Qty Total Value


K K K Units K000
A 20 000 23 000 20 000 200 000
4 000 000
B 9 000 8 000 8 000 150 000
1 200 000
C 12 000 12 000 12 000 300 000
3 600 000

8 800 000

========
Note:
Net Realisable Value
Item
A: K300 000 – K7 000 = K23 000
B: K12 000 - K4 000 = K8 000
C: K22 000 - K10 000 = K12 000

18.7 Determining the purchase cost of inventory

Depending on the type of business, inventory could be

(i) raw materials i.e. if the business is producing its own goods
(ii) finished goods which could have been produced or bought
elsewhere for resale.
(iii) Work in progress (WIP) i.e. work yet to be completed.

The easiest way of valuation of inventory is to use historical cost i.e.


the amount paid at the time of buying the inventory.

However, actual cost may be applicable to businesses dealing in


specialized items of high value, and separately identifiable e.g. Toyota
cars may be identified separately as camry, vista, chaser, corsa, etc.
Certain items may not be identifiable separately. As items are bought
they may be stored in bins, shelves or pallets, where they are mixed
with other items bought previously. As these items are issued or sold,
they will be removed in their mixed state regardless of which came in
first or last.

When valuing inventory this may create problems especially when


items were bought at different prices.

There are many techniques which are used to value such items of
inventory. They include the following:

- First in first out (FIFO)


- Last in first out (LIFO)
- Average cost (AVCO)
- Replacement cost

12.16 (a) FIFO

In this method it is assumed that items are issued or sold in


order in which they were received. The oldest items are issued
or sold first.

(b) LIFO

This is the opposite of FIFO. Item of inventory are issued or sold


starting with the most recently received or bought, while the
earlier stock will be issued or sold last.

(c) AVCO

As purchase price change with each new consignment, the


average price of components in stock is constantly changed.
Each component of stock at any moment is assumed to have
been purchased at the average price of all components in stock
at that moment.

(d) Replacement cost

This method assumes that the cost at which inventory was


bought is the amount it would cost to replace it. This is often
(but not necessarily) the unit cost of inventories bought in the
next consignment following the issue of the component to
production. For this reason, a method which produces similar
results to replacement costs is called NIFO (Next in first out).

When preparing financial statements FIFO and AVCO are


preferred treatments. LIFO is not permitted as an alternative
treatment (IAS 2)

12.17 Example: Valuation methods

The following transactions took place during the month of June 20x8
QUANTITY UNIT COST
K’000’
1 June Opening inventory 200
12
6 June Purchases 400 17
9 June Sales 300 30
15 June Sales 250 32
17 June Purchases 100 18
21 June Sales 60 32

Required:

Show how continuous inventory records will be and how closing


inventory will be valued using each of the following:

(a) FIFO
(b) LIFO
(c) AVCO

Prepare income statements for each of the above methods.


Solution

(a) FIFO METHOD

Date Purchased Sales Inventory


Balance
After each
transaction
1 June - - 200 x K12 each K2 400

6 June 400 @ $17 each - K6 800


+
K6 800 K2 400 K$9
200

9 June - 300 @ K30 each (200 @ 12) (2 400)


K9000 (100 @ 17) (1 700)
300 @ 17 5 100

15 June - 250 @ 32 each 300 @ 17


5 100
K8 000 (250 @ 17) (4
250)
50 @ 17 850

17 June 100 @ $18 each - 1 800


2 650

21 June - 60 @ 32 each 50 @ 17
(850)
K1 920 10 @ 18 (180)
90 @ 18 1 620
K8 600 K18 920

Closing inventory using FIFI is 90 units remaining from the last cost of
100 @ K18 each thus 90 units @ K18 each = K1620.

(b) LIFO METHOD

Date Purchased Sales Inventory


Balance
After each
transaction
1 June - - 200 @ 12 each K2 400

6 June 400 @ K17 each - K6 800


+
K6 800 K2 400
K9 200

600
9 June - 300 @ K30 (300 @ 17)
K9000 100 @ 17 1 700
200 @ 12 2 400
300 4 100

15 June - 250 @ 32 300


(100 @ 17)
K 8 000 (150 @ 12)
50 @ 12 K600

17 June 100 @ K18 each - 50 @ 12 K600


K1 800 100 @ 18 K1
800
150 K2 400

21 June - 60 @ 32 150
K1 920 60 @ 18
40 @ 18 K720
50 @ 12 K600
K8 600 K18 920 90 1320

Closing inventory using LIFO is 90 units broken down as follows:

40 @ 18 = K720

50 @ 12 = K600

K1 320
(c) Using AVCO

Date Purchased Sales Inventory


Balance
After each
transaction

1 June - - 200 x K12 each K2 400

6 June 400 @ 17 each - K6 800


+
K6 800 K2 400
K9 200

9 June - 300 @ 30 600


K9000 (300)
300 @ 15 each K4
500

15 June - 250 @ 32 300


K8 000 (250)
50 @ 15 each
K750

17 June 100 @ 18 each - 50 @ 15


each K 750
K1 800 100 @ 18 each
K1 800
150 K2 550

21 June - 60 @ 32 each 150


K1 920 (60)
90 @ 17 K1 530

Using the AVCO method closing inventory is at 90 x K17 = K1 530.

Average cost takes place when purchases are made.


Average cost is taken to be: total cost
Number of units

The remaining units will be valued at K15 each thus;

300 units x K15 = K4 500

On 15 June 250 units are sold. The remaining 50 units will be valued
still at K15 each

Thus 50 units x K15 = K750.

On June 17, 100 units are purchased. The number of units are now 100
+ 50 units from 15 June making a total of 150 units.

Any remaining inventory will be valued at:

K2550
150 = K17 each

The closing inventory as at 31 June will be:

90 units x K17 = K1530.

(d) Inventory valuation and profit

Each method of inventory valuation produces different cost of


closing inventory and cost of sales, and this will produce different
profit figures.

Using the previous example, income statements using different


methods will be as follows:

(i) FIFO

Income Statement
K K
Sales 18 920
Purchases 8 600
Closing inventory (1 620)
(6 980)
Profit 11 940
(ii) LIFO

Income Statement
K K
Sales 18 920
Purchases 8 600
Closing inventory (1 320)
(7 280)
Profit 11 640

(iii) AVCO

Income Statement
K K
Sales 18 920
Purchases 8 600
Closing inventory (1 530)
(7 070)
Profit 11 850

CHAPTER 19

CORRECTION OF ERRORS AND THE SUSPENSE


ACCOUNT

8.1 Errors not disclosed by trial balance

These are errors where trial balance totals are equal but with mistakes.
It is not possible to draw up an exhaustive list of all the errors which
might be made. Below are some of the common ones which might
cover most of the errors.

- Errors of transposition
- Errors of Omission
- Errors of Principle
- Errors of Commission
- Compensating errors
- Errors of Original entry
- Complete reversal of entries

When errors are detected they should be corrected immediately. The


journal is the book of prime entry used for the correction of errors.

There is no rule regarding how errors should be corrected. One should


just first understand how the error was made and how it should be
corrected.

(a) Errors of transposition or errors of original entry

This occurs when a number of digits in an amount are


accidentally recorded the wrong way round. For example, a sales
invoice shows sales of K1478. When recorded in sales journal it
is shown as K1487. Double entry will be based on the wrong
figure in correct accounts, therefore, the trial balance will have
equal totals.

(b) Errors of Omission

This is where a transaction is not recorded in the accounting


books. Therefore, double entry will be based on recorded
transaction and the trial balance will have equal totals based on
processed activities.

Example

A business has sent a lot of sales invoices to different customers


one of them being K260 sent to customer. If it is omitted both
the Debit and Credit sides of trial balance will be down by K260.
The trial balance totals will be equal based on the other correctly
processed sales invoices.

(c) Errors of principle


These errors are a result of one’s failure to correctly apply the
principles of accounting or accounting concepts. The common
ones are failure to appreciate the distinction between capital and
revenue expenditure and capital income and revenue income.

Example 1

Bought non current asset (furniture) by cash K670.

Correct double entry in correct account

DR – Furniture account
CR – Cash account

Correct double entry but in wrong account

DR – Purchases account
error of principle
CR – Cash account

Please note that furniture has wrongly been debited in purchases


account instead of Furniture account. The fact that both have
debit entries, the trial balance totals will be equal but with wrong
figure of purchases and none in furniture. Record of furniture will
not be there since it is included in purchases.

(d) Errors of Commission

Commission in this context means failure to do work to ones best


ability.

Errors of commission are very common for customers or supplier


with similar names. Also common with mixing up expenses, e.g.
recording a debit entry or credit entry in the wrong account.

Example 1:

Sold goods on credit to J Bush of Northern region but was by


mistake recorded in J Bush of Eastern region.

N.B. Both are receivables are supposed to be debited.

Example 2:

Repairs expenses of K35 recorded in Insurance account.


N.B. Both are expenses and have debit entry for this example.

(e) Compensating errors

To compensate means to make up e.g. being paid some cash for


injury while on duty.

Compensating errors arise as a result of making mistakes in one


account which is compensated by another mistake in another
account (i.e, the errors cancel each other).

Example

Bought postage stamps by cash K5.


Paid for rent in cash K10.

Stamps account

Cash 10

Rent account

Cash 5

Cash account

Stamps 5
Rent 15

Trial Balance

Dr. Cr.
Stamps 10
Rent 5
Cash __ 15
15 15

Please note that figures in stamps and rent are switched. Error
made in stamps has been compensated by another error in rent.
Trial balance totals will be equal but with errors.
(f) Complete reversal of entries

This is when double entry for a transaction is reversed i.e.


Debiting an account which should be credited and crediting an
account which should be debited.

Example:

Paid for stationery in Cash K4


Correct double entry

Dr – Stationery account K4
Cr – Cash account K4

Reversed entry
Dr – Cash account K4
Cr – Stationery account K4

Trial balance will agree because correct amount and equal in


value is debited and credited in correct accounts but wrong
sides.

Activity 1

Identify the errors in the following situations.

(i) Recording motor repairs in motor account


(ii) Recording sale of non current asset in sales account
(iii) Translating purchases invoice figure of K505 into purchases
journal as K550.

8.2 Errors disclosed by trial balance

In some cases, the trial balance totals may not be the same. This may
mean a lot of things.

When the trial balance fails to agree sometimes it could just be a


simple additional error within the trial balance. It is advisable to sum
up the trial balance once or even twice again. If this produces same
results then it could be one of the following or combination of errors.

(i) Incomplete double entry. Recording only one account a


transaction. The trial balance will not agree.
(ii) Debiting one figure and crediting a different figure for same
transaction e.g. bought stamps for cash K5. Debit stamps with
K5 but credit cash with K4.
(iii) Transposition e.g. paid for stationery in cash K15. Debit
stationery with K15 but, credit cash with K51.

8.3 Correction of errors

When totals in trial balance are not equal, a temporal account is


opened called the suspense account.

8.4 Suspense account

The suspense account is opened for the difference in the trial balance
because it is not clear what caused the difference. However, it is not
encouraged to all the time open suspense account when trial balance
totals disagree, except under certain circumstances e.g. where it is
suspected that the difference may be as a result of many errors which
might take sometime to discover.

Also where the bookkeeper does not know where to post one side of a
transaction e.g. a cash payment is credited to cash, but the
bookkeeper does not know what the payment was for and so will not
know which account to debit.

8.5 Suspense account and Financial statement

Suspense account is always placed where there’s a deficit in trial


balance, which could be debit side or credit side, thus forcing
temporally the trial balances totals to be equal.

With the suspense in trial balance, the financial statements could now
be prepared.

- Suspense account will appear in balance sheet. If suspense


account is debit balance, it is shown separately under current
asset.
- If suspense balance is credit, it is shown separately as under
current liability.
- It is important to note that showing suspense account as such in
balance sheet does not mean that it is an asset or liability but
that is the only place it fits if balance sheet is to remain
balanced, while investigations are being carried out.
- When financial statements are prepared with suspense there
could be a possibility that the profit calculated is wrong and may
require adjustment when errors are detected and corrected.
8.6 The Journal and correction of errors

All errors once detected are corrected via the journal. When correcting
errors it is important that some will affect suspense account and others
not.

- Errors not causing imbalance in trial balance will not affect


suspense account.
- Errors causing imbalance in trial balance will be corrected via
suspense account.

Example 1: Suspense account not involved

Both T Flash light and T Flash bulb are our customers. On 1 January
20X5 sold goods to T Flash light but by mistake it was recorded in T
Flash bulb account K150.

Solution:
It is assumed that the sales account was correctly credited with K150
but instead of debiting T Flash light with K150, T Flash bulb was
debited instead. The trial balance is not affected by this error because
double entry in figure terms is correct. To correct this error it should
be:

Dr – T Flash light account


Cr – T Flash bulb account

Example 2: Suspense account involved

Paid rent in cash K170


Rent account is debited with K100
Cash account is credited with K170

Solution

The trial balance totals will not be equal. One side (Cr) will be greater
than debit side by K70. This error should be corrected via suspense
account.
Trial balance before error is corrected will be:

Dr Cr
Rent 100
Cash 170
Suspense 70
170 170

Suspense account will be opened with debit balance

Dr Suspense account Cr

Balance 70

- error corrected

Dr – Rent account with K70 i.e. to bring rent figure to K170


Cr – Suspense account with K70 i.e. to clear debit balance shown
in suspense account.

After correction the accounts will now be:

Dr Rent account Cr

Cash 100
Suspense account 70

Dr Suspense account Cr

Balance 70 Rent 70

70 70

Corrected trial balance


Dr Cr
Rent 170
Cash 170
170 170
N.B. Suspense account is now closed and rent adjusted by K70
to K170. The error has been corrected and trial balance will
agree with adjusted figure of rent. Cash was correctly recorded
and so is not affected by the error.

Example 3: With more than one error

C.H. Systems Ltd is a hardware business, whose financial year


ends on 31 December each year. At 31 December 20X5 a trial
balance was extracted which revealed a deficit of K1421 on the
debit side. This was resolved by opening a suspense account,
and financial statements where prepared and showed a profit of
K12,600.

In January 20X6 investigation revealed that:

(i) A page of sales day book totaling K576 had not been
posted to sales account.
(ii) An accrual of rates K371 had not been taken into account
(iii) A repayment part of the loan from the bank K300 had been
entered on the loan interest account
(iv) The petty cash balance had been included as K57 instead
of K75.
(v) A bad debt of K120 had been entered in the customers
account but not in the expense account.
(vi) Drawings K200 had been entered in the sundry expenses
account
(vii) An invoice for car repairs K380 had been entered in the
wages account.
(viii) The rent received account balance of K600 had been
entered on the wrong side of the trial balance and income
statement.
(ix) Advertising account with a balance of K2,759 had been
omitted altogether.
(x) Closing inventory had omitted some items valued at cost
K2,000.
(xi) Discount allowed of K150 had been credited to discounts
received.

Required:

(a) Show by means of journal to correct the above errors


(narratives are not required).
(b) Clear suspense account balance after the correction of
errors and
(c) Prepare a statement showing the corrected amount of the
profit.

Solution:

(a) The Journal

Dr Cr
(i) Suspense account 576
Sales account 576
Income Statement
371
(ii) Rates account 371

(iii) Bank loan account 300


Interest account 300

(iv) Petty cash account 18


Suspense account 18

(v) Bad debts account 120


Suspense account 120

(vi) Drawings account 200


Sundry expenses account 200

(vii) Car repairs account 380


Wages account 380
(viii) Suspense account (rent) 1,200
Rent 1,200

Advertising 2759
(ix) Suspense account (advertising) 2759

(x) Closing Inventory account 2,000


Income Statement 2,000

(xi) Discount allowed account 150


Discount received account 150
Suspense account 300
(b) Dr Suspense account Cr

Balance 1421
Sales 576 Petty cash 18
Rent 1200 Bad debts 120
Advertising 2759
Discount all. 150
____ Discount rec. 150
3197 3197

(c) Statement of profit adjustment:


K
Net profit before adjustments 12600
Add sales omitted 576
Less rates accrual (371)
Add loan repayment entered in loan interest
300
Less bad debts (120)
Add drawings entered in sundry expenses
200
Add rent received entered on wrong side 1200
Less advertising omitted (2759)
Add omitted inventory 2000
Less discount allowed (150 x 2) 300
Adjusted profit 13926

Notes

- Error (i) is an error of undercast in sales account. The trial


balance will not balance because the receivables figure will
be more by K576 on credit. The suspense account is
involved in correcting this error. Profits should adjust by
adding sales of K576.

- Error (ii) rates accruals comes as a year end adjustment.


The trial balance is not affected by this error but profits will
be over stated since accrued expenses are included as
expenses in the year to which they relate. Profits should
reduce by K371
- Error (iii) the trial balance is not affected because the loan
repayment should have been debited to loan account
instead of loan interest. Double entry was achieved but in
a wrong account. However, the loan interest account was
overstated by K300. therefore profits should be increased
by K300.

- Error (iv) this error will affect the trial balance and
suspense account is involved in correcting it. Petty cash is
an asset and was transposed. The debit side of trial
balance will be less by K18. However, profit is not affected
by this error because cash does not appear in Income
Statement but as a current asset in balance sheet.

- Error (v) this is incomplete double entry and the trial


balance will not balance thus the reason for the suspense
account. Since bad debt is an expense, its omission
increases profits. Therefore, after correcting the error the
profits should be reduced by the amount of the bad debts.

- Error (vi) this is an error of principle and the trial balance is


not affected. Drawings should have been debited but
instead sundry expenses were debited. Double entry was
correct but debited in wrong account.

- Error (vii) same as error (vi).

- Error (viii) The rent account in the ledger was correct with a
credit entry. On taking it to trial balance it was recorded on
the debit side instead of credit side. This made the debit
side of trial balance to be twice bigger the amount, and the
trial balance would not balance. The trial balance should
be credited with rent receivable by K1200 (600 x 2). The
first K600 to cancel the debit and the other K600 to
reinstate the rent receivable. Rent receivable is an income
and increases profit by crediting the income statement.
Now that it was debited in income statement, the profit
were understated by twice the amount, so add back twice
the amount.
- Error (ix) advertising account is the ledger but was not
transferred to trial balance. This will cause an imbalance in
trial balance. Therefore, it should just be included by
crediting suspense account with advertising. Its omission
from trial balance also means that it was omitted from
income statement thus overstating profits. This profits
should now be reduced by the amount.

- Error (x) closing inventory is a year end adjustment after


physical stock take. It does not appear in trial balance and
so the error is outside trial balance. However, profits were
understated because cost of sales were higher. Profits
should now be increased by the same amount.

- Error (ix) see error (viii).

EXERCISES

1. Identify four (4) errors not affecting trial balance

2. When is the suspense account used?

3. What does a credit balance on suspense account indicate?

4. The trial balance of John Black as at 31 March 20X9 did not agree,
there being a shortage of K 874 on the debit side. A suspense account
was opened for the difference. Subsequent investigation showed:

(i) Discount allowed K480 had been entered on the credit side of
discount allowed account.
(ii) The bank statement balance of K560 overdraft had been
included in trial balance instead of the cashbook balance of K63
debit.
(iii) The provision for bad debts account of K150 had been entered on
wrong side of trial balance
(iv) Rent receivable account was over cast by K20
(v) Drawings of K250 had been included in purchases account
(vi) The sale of furniture (non current asset) had been included in
sales account of K300
(vii) Payment for insurance of K45 was entered in insurance account
as K54
(viii) Discounts received was overstated by K100.
(ix) A cheque for K200 for car repairs had been posted to the building
repairs account
(x) Provision for depreciation account K270 was entered on wrong
side of trial balance
(xi) The scrapping of an old lorry with net book value of K375 was
omitted from the books.

Required:

(a) Correct the errors via the journal


(b) What was the balance on suspense account before the errors
were corrected.
CHAPTER 20

FINANCIAL STATEMENTS WITH ADJUSTMENTS

1 statement of Income Statement with adjustments


2 statement of financial position

- prepayments
- accruals
- bad debts and provision for depreciation
- opening and closing inventory
Exercise 1

Lord gwari, is a sole trader operating as a retailer. The following information


is extracted from his accounting books as at 31 December 20X7.

K’000 K’000
Distribution expenses 1460
10% Loan 1000
Trade payables 820
Cash at bank 140
Allowance for doubtful debts 18
Trade receivables 810
Motor vehicles at cost 1680
Accumulated depreciation motor vehicles 620
Warehouse at cost 1800
Accumulated depreciation warehouse 290
Buildings at cost 8300
Accumulated depreciation buildings 1020
Land at cost 1510
Interest on loan paid 50
Salaries and wages 1590
Discounts allowed and received 80
100
Returns inwards 400
Returns outwards 150
Carriage inwards 700
Carriage outwards 250
Inventory 1 January 20X7 1530
Purchases 8100
Sales 13600
Capital 1 January 20X7 10782

28400 28400

The following additional information is available:

(a) Closing inventory is K1,660,000


(b) Trade balances totaling K6,000 are to be written off and the allowance
for doubtful debts increased to K30,000.
(c) Salaries and wages owing K190,000 with K70,000 paid in advance.
(d) Distribution expenses of K60,000 were prepaid and K120,000 not paid
as at 31 December 20X7.
(e) Interest of K50,000 is owing
(f) In January 20X8, the business received invoices for credit purchases
totaling K18,000 for goods delivered before 31 December 20X7.
(g) It was also found that credit sales invoices totaling K7,000 for goods
delivered to customers before 31 December 20X7 had by mistake been
dated in January 20X8 and thus excluded from sales for the year and
from account receivables at the year end.

NOTE: The goods received had been included in the year end
inventory figures given at (a) above, and the goods sold had been
excluded from it.

No adjustment to the inventory figure is therefore required:

(h) Depreciation should be provided as follows:

- Land nil
- Buildings 2% on cost per annum
- Warehouse 15% on cost per annum
- Motor vehicles 25% on cost per annum

Required:

(a) Prepare income statement for the year ended 31 December 20X7 and

(b) Balance sheet as at 31 December 20X7.

Exercise 2

Mr. Bird Rock has been in business for some time trading in motor spares.
The list below has been taken from his books for the financial year ended 30
September 20X8.

K
Fixtures and fittings 910,000
Accumulated depreciation 136,500
Discounts received 15,400
Trade receivables 400,000
Carriage inwards 95,000
Postage and stationery 15,210
Telephone expenses 10,625
Bad debts 55,000
Returns inwards 110,300
Carriage outwards 5,266
Drawings 315,000
Rent & rates 88,000
Insurance 11,000
Heating and lighting 50,781
Advertising 16,000
Cash in hand 4,242
Cash at bank 112,000
Inventory 1 October 20X7 156,000
Purchases 1,200,400
Discounts allowed 14,000
Allowance for doubtful debts 40,000
Returns outwards 2,745
Trade payables 271,000
Capital 1 October 20X7 1,103,179
Sales 2,000,000

Additional Information at 30 September 20X8.

(i) Inventory is valued at K127,666.

(ii) Depreciation charge for the year is 10% on reducing balance method.

(iii) Rates prepaid K910

(iv) Telephone owing K1,000

(v) Heating & Lighting owing K4,616

(vi) Allowance for Bad debts to be adjusted so that it is 5% of trade


receivables.

Required:

Prepare income statement for Mr. Bird Rock for the year ended 30 September
20X8 and a balance sheet as at that date.
Solution

Mr. Bird Rock


Income statement for the year ended 30 September 20X8
K K
Sales 2,000,000
Less: Returns inwards (110,300)
Turnover 1,889,700

Cost of Sales:
Inventory 1/10/20X7 156,000
Purchases 1,200,400
Returns outwards (2,745)
Carriage inwards 95, 000
_________
1,448,685
Less: Closing inventory (127,666)
1,320,989
Gross Profit 568,711
Discount Received 15,400
584,111
Expenses:
Postage and stationery 15,210
Telephone expenses (10,625 + 1,000) 11,625
Bad debts (55,000 – 20,000) 35,000
Carriage outwards 5,266
Rent and rates (88,000 – 910) 87,090
Insurance 11,000
Heating and lighting (4,616 + 50,781) 55,397
Advertising 16,000
Discounts allowed 14,000
Depreciation: Fixtures and fittings 77,350
(327,938)
Net Profit 256,173

Mr. Bird Rock


Balance sheet as at 30 September 20X8

Non Current Assets Cost Depreciation N.B.V.


Fixtures and fittings 910,000 213,850 696,150
Current Assets
Inventory 30/09/20X8 127,666
Trade receivables (400,000 – 20,000) 380,000
Prepayments 910
Cash in Bank 112,000
Cash in hand 4,242
624,818
Total Assets 1,320,968

Financed by:

Capital 1/10/20X7 1,103,179


Net profit 256,173
1,359,352

Less: Drawings (315,000)


1,044,352

Current liabilities
Trade payables 271,000
Accruals (1,000 + 4,616) 5,616
276,616
1,320,968

22.1 FINANCIAL REPORTING UNDER THE CASH BASIS

a) Cash basis

This accounting system recognizes only cash inflows and cash


outflows. The resulting final accounts are summarized cash
books. There are no balance sheets under this system because
there are no other assets (apart from cash) and liabilities in the
books other than cash balances.

 Sales are recognized only when cash is recorded. So there are


no receivables.
 Purchases are only recognized when cash is paid. So there are
no payables.
 There is no inventory adjustment because the accounts are
not concerned with recording usage. There is no opening or
closing inventory except that cash has been paid for it.
 There are no non current assets.
 There are no current and non current liabilities

b) The cash accounting and accounting documents

Under this system the main book of accounting is the cash book.
Entered in the cash book are simply cash receipts and cash
expenditure using receipts and payments vouchers. This is where
the analysis cash book column cash book is used with columns
for cash receipts and expense columns. Double entry is
completed with the cash book.

Ledger accounting: Separate ledger cards are kept for all


receipts and payments on a cumulative basis.

Financial statements: Under this systems financial statements


may comprise:
i) Expenditure reports –which is a summary of expenditure on
activities carried out during a period, and
ii) A statement of cash position. This is a summary of sources
and expenditure and the resulting balance.

c) Advantages of cash basis accounting

Cash is clearly the livelihood of any organization. Through cash


basis accounting government would be able to assess from its
use.

i) how much tax to collect through budgets. If the government


spends less than the budget, then it is better off at the year-
end and can spend excess cash on other developmental
issues, pay back borrowings or reduce tax.

If it spends more than the budget, then it is worse off meaning


money will have to be borrowed or increase taxes

ii) Cash basis accounting is perceived to be easier to


prepare and understand
iii) Cash reporting instills confidence in an organization
from interested parties as it reflects the ability of an
organization to manage its finances.
iv) Organisations are forced to prioritise their activities
and live within their limits, as funding is not always
enough.
v) Cash basis accounting is not subjective as it
addresses actual activities.
d) Disadvantages of cash basis accounting

Cash basis accounting has also come under criticism because:


i) it focuses only on cash
ii) how much an organization is worth is not only cash but
also other assets and liabilities. Therefore financial
statements on cash basis
are incomplete and may be misleading about an
organisation’s position.

e) Accruals accounting
Revenue and costs are accrued (i.e recognized as they are
earned or incurred, and not as money is received or paid),
matched with one another so far as their relationship can be
established or justifiably assumed, and dealt with in the income
statement of the period to which they relate.

Meaning:
i) The earning of revenue is generally taken to mean that
invoices have been issued.
ii) Costs are incurred when services are received. Therefore
recognition of income and costs is not when cash is
received or paid.
There has been critical argument that the accruals accounting is
too
subjective and hide crucial information about an organisation’s
performance.

Advantages:

i) It provides measures of economic goods and services


consumed, transformed and earned.
ii) Accruals accounting yields an income figure. More profit
implies
more success.
iii) Accruals accounting yield a measure of capital. Income is
only recognized after capital has been maintained in real
terms.

Disadvantages:

i) Accruals accounting introduces subjectivity into the


accounts. It
brings in adjustments which are judgmental e.g. provision
for doubtful debts, which may distort accounting
information away from the ‘true and fair’ expectation.
ii) The relevance of accruals accounting, when it is linked with
historical costs, and during periods of rising prices, is
limited.
iii) In comparison with cash basis accounting, accruals
adjustments demand a higher administrative and
accounting cost.
iv) It provides an opportunity for manipulation that is a
problem associated with financial control. With cash based
accounting manipulation of accounting results could be
affected by postponing cash payments just to show that
the organization is financially sound.
In accruals postponement of cash payments in receipts has
no effect. Manipulation may come in by bringing in invoices
for goods supplied just to ensure that the accounts are
within budget.

CHAPTER 23

PARTNERSHIP ACCOUNTING
This chapter introduces a type of business called partnership. Partnership is
wide. At this stage emphasis is on the nature and principles on which
financial statements of partnerships are prepared.

- .

23.1 DEFINITION OF PARTNERSHIP

This is a form of business where two or more persons carry on business


together for the purpose of making profits.

A partnership usually is a progression from a sole trader

23.2 LEGAL STATUS OF PARTNERSHIP

In some countries a partnership is not a corporate entity. It does not


exist separately from its owners. In others it is a legal entity separate
from partners.
However, for accounting purposes the partnership will be treated as a
separate legal person from partners.

23.3 TYPES OF PARTNERS IN A PARTNERSHIP RELATIONSHIP

In a partnership one may find limited partners and general or unlimited


partner.

- Limited Partners

These are partners with limited liability. They are only liable or
limited to the amount of capital they have provided. Such
partners usually do not participate in management of the
business.

- General Partners

Sometimes called unlimited or ordinary partners. These have


unlimited liability. The debts of the business is beyond their
capital contribution in the business. As such they are responsible
for the day to day affairs of the business.

Therefore, in any partnership at least there must be a general


partner.

23.4 THE PARTNERSHIP ADMINISTRATION

Before a partnership can be operational, partners must agree on how


the business will be organized and run. The law does not state the
contents of the agreement but may contain the following.

- The capital contribution by each partner.


- How profits and losses will be shared i.e. profit sharing ratio.
- If capitals will attract interest. If yes, how much in percentage
terms.
- Are partners going to be allowed drawings and will the drawings
attract interest.
- If partners will be working in the business, are they going to be
entitled to a salary.
- Should a new partner be admitted or old an partner retires what
will be the arrangements and procedures to be followed.
- Name of firm, the type of business.
- Settling disputes
- Preparation and audit accounts.

Though not required by law the partnership agreement must be put in


writing, so that partners know their rights and responsibilities. This also
helps to reduce disputes.
In the absence of a formal agreement by partners The Partnership Act of
1890 will guide administration and management of a business owned by
partners. This is a UK Act which is also enforceable in Zambia because this
country is a former British colony. Some of the provisions of the Act are:

- Partners are to share profits or losses equally.


- Interest shall not be charged on partnership capital.
- Interest shall not be charged on drawings.
- (refer to a text book on business law for more information)

23.5 ADVANTAGES AND DISADVANTAGES OF PARTNERSHIP

Advantages:

Comparing a partnership to sole trading, the advantages of operating


as a partnership are as follows:

- Business risks are spread among more than one person.


- Partners will learn new skills from other partners
- A partner may take leave while others remain working. A sole
trader will have in most cases close business to take a rest.
- Capital resources could be larger because of so many persons
contributing.

Disadvantages could be:

- While risks are spread among many persons, some partners may
feel uncomfortable to share profits.
- Disputes may arise on management issues and this may lead to
partnership closure.
- A decision made by a partner in relation to business, is usually
binding to other partners. This means if a partner is being sued
in relation to the business, other partners are equally affected.

23.6 ACCOUNTING IN PARTNERSHIP


The accounting techniques in partnership are very similar to that of a
sole trader.

Partnerships also keep books of prime entry and ledgers, but there are
certain important differences as shown in the table.

Item Sole trader’s books Partnership books

Capital Capital account Partners fixed capitals


Introduced accounts
Drawings and Capital account Partners current
share of profits accounts
Division of Inapplicable – one Income statement –
profits proprietor only shared, appropriation
section

23.7 PREPARING PARTNERSHIP FINANCIAL STATEMENTS

(i) Income Statement

Income statement of sole trader and partnership are very much


the same. However, a partnership extends the income
statement by including the appropriation account.

The appropriation account of the income statement shows how


profits and entitlements to partnership are distributed.

N.B. Net profit in sole trader is all his and thus the whole amount
is added to capital in balance sheet.

For partnership profits there is need to show how profits are


shared between partners.

Expenses related to partners such as salaries, interest on capital


and drawings are treated as appropriations. However, similar
expenses which related to others such as employees will be
treated as operating expenses in income statement.
Example 1

Banda and Bwalya have been in partnership just for one year.

- They are sharing profits and losses equally.


- They are entitled to 10% on capitals per annum. Banda
and Bwalya have K100,000 and K200,000 as capitals
respectively
- Banda is entitled to a salary of K3,000, and Bwalya K5,000.
- Interest is charged on partners drawings. Banda is charged
K2,000 and Bwalya K1,500.
- Drawings during the year were Banda K6,000 and Bwalya
K5,000.
- The net profit before the distribution as at 31.12.20X4
amounted to K70,000 i.e. after preparing the income
statement which is same as sole trader.

Banda and Bwalya

Income Statement for the year ended 31.12.20X4

K K
Net profit 70,000
Add: Interest on drawings
Banda 2,000
Bwalya 1,500
73,500

Less: Appropriations:
Salaries: Banda 3,000
Bwalya 5,000
(8,000)
Interest on capitals:
Banda 10,000
Bwalya 20,000
(30,000)

35,500
Share of profits:
======
Banda ½ 17,750
Bwalya ½ 17,750
35,500

======
(ii) Capital accounts

When a partnership is being set at the beginning, partners have


to agree the amount of capital contribution to introduce. This
could be in form of cash or other assets. Double entry would be:

DR. Asset account (whatever asset)


CR. Capital account of each partner separately

The capital will usually remain fixed for the duration of the
business but could change under the following circumstances:

- When partners in the process of conducting business


introduce further capital.
- When a partner retires and capital is withdrawn.
- When assets are revalued.

Using example 1, the capital accounts presented in columnar


would be:

Capital accounts

Dr. Banda Bwalya Banda Bwalya Cr.

K K K K
Bal. 100,000 200,000

(iii) Current accounts

Current accounts are used to deal with regular transactions


between the partners and the firm.
These are matters that may not be dealt with in capital accounts.
These may include:

- Share of profits
- Interest on capital
- Drawings
- Interest on drawings
- Partners salaries

For entitlements such as salaries, interest on capital and share of


profits, Double entry is:

DR. Income Statement (Appropriation account)


CR. Current Accounts of partners

For drawings

DR. Current Accounts of partners


CR. Cash book or Purchases account

For interest on drawings

DR. Current accounts of Partners


CR. Income statement (appropriation account)

Using example 1, current accounts would be:

Current Accounts

Dr. Banda Bwalya Banda Bwalya Cr.

Drawings 6,000 5,000 Interest


Interest on capital 10,000 20,000
on drawings 2,000 1,500 Salaries 3,000 5,000
Balances c/d 22,750 36,250 Share of 17,750 17,750
Profits
30,750 42,750 30,750
42,750
Balances b/d 22,750 36,250

The balance of the current accounts at the end of each financial


year will then represent the amount of undrawn or withdrawn
profits.
- A credit balance like in example represents amounts to be
withdrawn by partners i.e. the partners are payables to the
firm.

- A debit balance will represent partners have withdrawn


more than their entitlements, so they are receivables to
the firm.

(iv) The balance sheet

Partnership balance sheet as far as non current and current


assets are concerned will be same as sole trader. The difference
is under capital part.

Using example 1

Balance Sheet as at 31.12.20X4 (extract)

Financed by:
Capitals: Banda 100,000
Bwalya 200,000
300,000
Current accounts: Banda 22,750
Bwalya 36,250
59,000
359,000

If one partner had finished with a debit balance in current


account, the balance will be shown in brackets in balance
meaning it should be deducted.

23.8 Most examination questions specify

Capital and current accounts should be shown separately. Occasionally


you may be faced with a question specifying only one account for each
partner. Such an account acts as a capital and current account
combined thus the term Fluctuating Capital.

In fluctuating capital, all entitlements are credited to capital accounts


and drawings and interest on drawing debited capital accounts. In this
situation current accounts are irrelevant. Therefore capital figures in
balance will be inclusive of current account items and will be changing
from year to year.

Using example 1: Fluctuating capitals


Capital accounts

Dr. Banda Bwalya Banda Bwalya Cr.

Balance 100,000 200,000


Drawings 6,000 5,000 Interest
Interest on capital 10,000 20,000
on drawings 2,000 1,500 Salaries 3,000
5,000
Balances c/d 122,750 236,250 Share of 17,750
17,750
Profits
130,750 242,750 130,750 242,750
Balances b/d 122,750 236,250

The balance sheet will then only show capital accounts as follows:

Balance sheet as at 31.12.20X4 (Extract)

Financed by:

Capital accounts: Banda 122,750


Bwalya 236,250
359,000
5. A and B are in partnership sharing profits and losses in the ratio 3:2.

Under the terms of the partnership agreement, the partners are


entitled to interest on capital at 5% per annum.

B is entitled to a salary of K4,500. Interest is charged on drawings at 5


percent per annum and the amounts of interest are A K400 and B
K300.

The net profit of the firm, before interests and salary for the year
ended 30 June 20X7 was K25,800.

The partners capital at 1 July 20X6 were A K30,000 and B K10,000.

At 1 July 20X6, there was a credit balance of K1,280 on B’s current


account while A’s current account balance was K500 debit.

Drawings for the year to 30 June 20X7 amounted to K12,000 and


K15,000 for A and B respectively.

Required:

Prepare, for the year to 30 June 20X7:

(a) The partnership appropriation account


(b) The partners current account.

6. X, Y and Z are in partnership business sharing profits and losses 4:1:3


respectively. The firms trial balance as at 31 December 20X1, was as
follows:

Dr. Cr.
K K
Sales 334,618
Returns Inwards 10,200
Purchases 196,239
Carriage Inwards 3,100
Inventory 1 Jan. 20X1 68,127
Discounts allowed 190
Salaries and wages 54,117
Bad debts 1,620
Provision for doubtful debts
1 January 20X1 950
General expenses 1,017
Business rates 2,900
Postage 845
Computers at cost 8,400
Office equipment at cost 5,700
Provision for depreciation at
1 January 20X1:
Computers 3,600
Office equipment 2,900
Payables 36,480
Receivables 51,320
Cash at bank 5,214
Drawings: X 39,000
Y 16,000
Z 28,000
Current accounts: X 5,940
Y 2,117
Z 9,618
Capital accounts: X 60,000
Y 10,000
Z 30,000
_______ _______
494,106 494,106
Additional information
(i) Inventory 31 December 20X1 K74,223
(ii) Business rates paid in advance K200
(iii) Stock of postage stamps K68
(iv) Increase provision for doubtful debts to K1,400
(v) Partners salaries: Y K18,000, Z K14,000
(vi) Interest on drawings: X K300, Y K200, Z K240
(vii) Interest on capital is at 8 percent per annum.
(viii) Depreciate computers by K2,800 and office equipment by
K1,100.
Required:

Draw up a set of financial statements for the year ended 31 December


20X1.

SOLUTIONS TO EXERCISES

1. The answer should include:

- The capital required is more than one person can provide.


- The experience or ability required to manage the business
cannot be found in one person alone
- Many people want to share management instead of doing
everything on their own.

2. In the absence of a partnership agreement, the Partnership Act


1890 governs the situation and states that:

(a) Profits and losses are to be shared equally


(b) No interest is allowed on capital
(c) No interest to be charged on drawings
(d) Salaries are not allowed
(e) Any loan by a partner or excess capital will attract interest
of 5% per annum.

3. A loan from a partner is shown separately as a non current


liability

4. False. Interest on a loan is an expense charged against profit in


income statement.

5. (a) Partnership appropriation account for the year ended 30


June
20X7.
K K
Net profit 30.06.20X7 25,800
Add: Interest on drawings A 400
B 300
700
26,500
Less: Appropriations:
Interest on capital A 1,500
B 500
(2,000)
Salary B 4,500
(4,500)
20,000
Share of profits A3/5 12,000
B 2/5 8,000
20,000

(b) Current Accounts

Dr. A B A B Cr.

Balance b/f - 500 Balances b/f 1,280


-
Drawings 12,000 15,000 Interest on
Interest on capital 1,500
500
Drawings 400 300 Salary -
4,500
Balances c/d 2,380 - Share of profits 12,000
8,000
____________ Balance c/d - 2,800
14,780 15,800 14,780
15,800

Balance b/d - 2,800 Balance b/d 2,380


-

6. XYZ Income statement for the year ended 31 December 20X1


K K
Sales 334,618
Less: Returns Inwards (10,200)
324,418
Cost of sales:
Opening inventory 68,127
Purchases 196,239
Carriage inwards 3,100
267,466
Less: closing inventory (74,223)
(193,243)
Gross profit 131,175
Less: Expenses
Discounts allowed 190
Salaries & wages 54,117
Bad debts (1620 + 450) 2,070
General expenses 1,017
Business rates (2,900 – 200) 2,700
Postage (845 – 68) 777
Depreciation: computers 2,800
Office equipment 1,100
(64,771)
Net profit 66,404
Interest on drawings: X 300
Y 200
Z 240
740
67,144
Less: appropriations:
Salaries Y 18,000
Z 14,000
(32,000)
Interest on capital: X 4,800
Y 800
Z 2,400
(8,000)
Share of profits: X 4/5 14,022
Y 1/8 3,506
Z 3/8 10,516
(27,144)
_
______

Current accounts
Dr. X Y Z X Y Z Cr.

Balance - 2,117 - Balances 5,940 -


9,618
Drawings 39,000 16,000 28,000 Salaries -
18,000 14,000
Interest on Interest on
Drawings 300 200 240 capital
4,800 800 2,400
Balances c/d 3,876 7,957 Share of profits 13,572
3,393 10,179
Balances c/d 14,988 -
-
39,300 22,193 36,197 39,300
22,193 36,197

Balance b/d 14,988 - - Balance b/d -


3,876 7,957

XYZ
Balance sheet as at 31 December 20X1

Non current assets Cost Dep.


N.B.V.
K K K
Computers 8,400 6,400
2,000
Office equipment 5,700 4,000
1,700
14,100 10,400
3,700

Current assets
Inventory 31.12.20X1 (74,223 + 68) 74,291
Receivables (51,320 – 1,400) 49,920
Prepayments 200
Cash at bank 5,214

129,625
Total assets 133,325
Financed by:
Capital accounts: X 60,000
Y 10,000
Z 30,000
100,000
Current accounts:X (14,988)
Y 3,876
Z 7,957
(3,155)
Current liabilities
Payables 36,480
133,325
CHAPTER 24
ACCOUNTING FOR NON-PROFIT MAKING
ORGANISATIONS
INTRODUCTION

This chapter is concerned with the preparation of financial statements of not


profit making organisations and whose objectives are to provide services to
their members or the pursuit of one or a number of activities rather than the
earning of profit.

Since running organisations involves cash and other assets and liabilities,
there’s need to also keep records of all activities (transactions).

22.2 NOT-FOR-PROFIT ORGANISATIONS

The main purpose of such organisations is to provide social amenities to its


members such as games of tennis, soccer, etc. They can also be charities to
help people. They exist not to make profits, thus the name not for profit
making organisations.

They may be engaged in profit making activities, but profits arising from
such is not shared by members but ploughed back in the organisation to
improve on services to members.

The accounting system can be basic to complex depending on size of the


organisation.

22.3 RECEIPTS AND PAYMENTS ACCOUNT

The receipts and payments account is effectively the cash book. It is a


summary of cash receipts and cash payments.

Smaller clubs and charities with no other assets (apart from cash) and
no liabilities will use the receipts and payments account as a financial
statement. No balance sheet is produced.

Example: receipts and payments account

ARMSTRONG Body Building Club

Receipts and payments account for the year ended


31 December 20X4
Receipts Payments
K K

Balance b/f 200 Bar purchases 160


Subscriptions 6,450 Rental 720
Bar Sales 240 Care takers wages 1,800
Donations 150 Printing & postage 22
Heat & light 60
Repairs 15
Balance c/d 4,263
_____ _____
7,040 7,040

Balance b/d 4,263

N.B. The receipts side is same as debit and payments side credit of
the cash
book.

Advantages and disadvantages of receipts and payments account:

Advantages

(a) Very easy to prepare


(b) Very easy to understand especially cash position
(c) It is used as a basis for the preparation of the income and
expenditure account

Disadvantages

(a) Only accounts for cash. There could be other assets in use.
(b) Does not account for any amounts paid in advance or owing.
(c) Does not distinguish between capital and revenue expenditure
(d) Does not account for depreciation of non current assets.

22.4 INCOME AND EXPENDITURE ACCOUNT

Organisations apart from cash asset may have other assets and
liabilities. Therefore, the receipts and payments account may be
inadequate to be used as a financial statement, because it does not
show the other assets and liabilities.

The receipts and payments account does not also show whether the
members contributions are being used effectively.
(a) To reveal a complete picture of assets and liabilities a Balance
Sheet must be prepared.
(b) To show any increase or decrease in capital the income and
expenditure account is prepared.

22.5 TERMS USED IN COMPARISON WITH TRADING ORGANISATIONS

Profit making organisations Not for profit making


organisations

(i) Cash book Receipts and payments account


(ii) Income statement Income and expenditure
account
(iii) Profit or loss Surplus or deficit
(iv) Capital Accumulated fund

Income and expenditure account is the same as income statement for


trading organisations.

The principals of matching or accruals concepts are applied to income


and expenditure accounts in the same way as for income statement in
trading organisations.

22.6 TRADING ACTIVITIES WITHIN THE NOT-FOR- PROFIT


ORGANISATION

The main source of income for non trading organisations is


subscriptions from members. However, they may engage in profit
ventures like owning a bar.

In such a case a separate bar income statement will be prepared to


determine profit or loss arising from it, and transferred to income and
expenditure account.

For other profit ventures such as dinner dance or fete income and
expenses are netted and the resultant profit or loss also transferred to
income and expenditure account.
Example: Bar income statement.

Armstrong Body Building Club


Bar Income Statement

K K
Bar Sales 240
Less cost of sales:
Bar opening inventory 30
Bar purchases 160
___
190
Less: Bar closing inventory (80)
(110)
130
Less: Bar man’s wages (70)
___
Net profit (transferred to income and
expenditure account) 60

22.7 Accumulated fund

In a trading organisation it is known as capital. In most cases it may


not be given. It should be calculated by identifying assets and
liabilities given at a particular time . Thus:

Accumulated fund = Assets – Liabilities

Example: accumulated fund

The North East Rotary Club had the following assets and liabilities as at
1 January 20X1, the beginning of the year.

Cash and Bank balances K210, Equipment at valuation K975,


Subscriptions in arrears K65, Subscriptions in advance K10, Owing to
suppliers of competition prizes K58 and Inventory of competition prizes
K38.

Required:
Calculate the accumulated fund as at 1 January 20X1, to be included in
balance sheet.

Solution:

Assets: K K
Cash and bank balance 210
Subscriptions in arrears 65
Equipment 975
Inventory of competition prizes 38
1288

Liabilities:
Subscriptions in advance 10
Owing to suppliers 58
68
Accumulated fund at 1 January 20X1 1220

22.8 Subscriptions

This may be the main source of income for not profit making
organisations.

Subscription is an agreed amount each member must pay at regular


intervals e.g. monthly or annually. Members will enjoy facilities of the
organisation at no cost, while non members will have to pay high fees
to use same facilities and sometimes may be denied access even if
they have money.

(a) Subscriptions account

A subscription account is always maintained to show the amount


collected, amount not collected and amounts paid in advance.
N.B. Members who have not paid the subscriptions and their
membership has not lapsed are considered as receivables
because they have not paid the institution and yet they have
been enjoying the services. This is called subscriptions in
arrears.

Subscriptions in arrears should be included as part of income


(subscriptions) in the year they are not paid and shown as
current asset in the balance sheet. Remember the matching or
accruals concept. When they are paid the following year, they
should not be included into subscriptions for that year and are no
longer assets.

Example: Subscriptions

The North East Rotary Club had the following details relating to
subscriptions for the year 1 January 20X1 to 31 December 20X1.

Cash received from members during the year to 31 December


20X1 K1987.

On 1 January 20X1, some members still owed the club K65 for
20X0, and some members had also not paid K85 for 20X1.

On 1 January 20X1, some members had paid in advance K10 in


20X0 for 20X1, and also at 31 December 20X1, some members
had paid K37 in advance for 20X2.

Required:

Show how the entries will be made in subscription account and


then show amount to be shown in income and expenditure
account as subscriptions for 20X1.

Solution:

Step 1: Open subscription account and show the opening


balances

Dr. Subscription account Cr.

K K
1 January 20X1 Bal. b/f 65 1 January 20X1 Balance b/f 10
The amount of K65 appearing on the debit side is an asset.
Money is for the club though not yet paid. K10 is liability. Money
is not yet for club though the club has it.

Step 2: Upon receiving cash as subscriptions from members.

Dr. Cash account


Cr. Subscription account

Dr. Subscription account Cr.

K K
1 January 20X1 Bal. b/f 65 1 January 20X1 Balance b/f 10
Cash 1987

Dr. Cash account Cr.

K K
Subscriptions 1987

Step 3: Put in the closing balances for accruals and


prepayments. The
balancing figure is subscription for 20X1.

Dr. Subscription account Cr.

K K
1 January 20X1 Bal. b/f 65 1 January 20X1 Balance b/f 10

Income and expenditure Cash 1987


account (balancing figure) 1980

31 December Balance c/d 37 31 December Balance c/d


85

2082 2082
Balance b/d 85 Balance b/d 37

K1980 will be credited to income and expenditure account.

The amount to be shown as income from subscriptions for 20X1


is K1980.

K85 will be shown in balance sheet under current assets as


subscriptions in arrears.

K37 will be shown in balance sheet under current liabilities as


subscriptions in advance.

In statement form it will be shown as:


K K
Subscriptions received (cash) 1987
Add: Subscription paid in advance 20X0 10
Subscription in arrears 20X1 85
95
2082
Less: Subscriptions paid in advance 20X2 37
Subscriptions in arrears 20X0 65
(102)
1980
Activity 1

The following information relates to a Tennis Club.

20X1 subscriptions owing to the club at the start of 20X2 was


K410

20X1 subscriptions received in cash by club during 20X2 was


K370

20X2 subscriptions received during 20X2 K6730

20X3 subscriptions received during 20X2 K1180

20X2 subscriptions unpaid at end of 20X2 K470.

The club takes credit for subscriptions when it becomes due, but takes
a prudent view
on overdue subscriptions. What amount is credited to the income and
expenditure
account for the year 20X2.

22.9 Life Membership


Life membership means members pay a substantial amount now and
enjoy the club facilities for the rest of their lives. This amount should
not be treated as subscription income in the year it is paid, but should
be spread over the life period of members.

A life membership account should be opened

Dr. Cash account


Cr. Life membership account

The balances on life membership will be shown in balance sheet as non


current liability.

Life period could be estimated by the organisations based on may be


age. In this way, life membership will be treated the same way non
current assets are treated with depreciation.

If a member outlives life membership contribution, the organisation will


decide whether the members will continue paying or be exempted
completely.

If a member dies before the life period, the remaining amount should
be transferred to accumulated fund (capital).

Some organisation may take advantage of life membership fund by


investing it to generate income in form of interest.

In this case the investment will remain fixed over a period of years and
will be shown as non current asset in balance sheet.

Annual interest generated on the investment will be considered as


annual subscription and credited to subscription account.

Example: Life membership

The old timers Bowling Club has introduced a life membership scheme
for its members. It is decided that life membership will be for five
years i.e. any amounts received for life membership will be spread
over a period of five (5) years from year of payment.

At the start of the year ended 31 December 20X3, the amount on life
membership account stood at K7,480. Of this amount K1,850 should
be treated as subscriptions for the year 20X3.
During the year ended 31 December 20X3, some members had paid
another K3,000 for life membership.

Required:

Show how entries will be made in the subscriptions account and the life
membership account.

Dr. Subscription account Cr.

K K
Life membership 2450

Dr. Life membership account Cr.

K K
Subscription 2450 Balance 7480
Balance c/d 8030 Cash 3000
____ _____
10,480
10,480 Balance b/d
8030

Workings: 3,000 ÷ 5
= K600 per annum for new life members
+
1850 per annum for old life members
____
2450 amount deducted from life membership
account and
credited to subscriptions account for 20X3.

K2450 will be added together with amounts received from


members who pay on annual basis. The total amount will then
be shown in income and expenditure account for 20X3.

The balance of K8030 in life membership account will be shown


as non current liability in balance sheet.

22.10 DONATIONS AND ENTRANCE FEES

(a) Donations are amounts other well wishers may give an


organisation
Donations in cash will be treated as income in the year the
donation is made. Double entry is:

Dr. - Cash account


Cr. - Donation account with cash

If donation is in form non current asset e.g. Van.

Dr. - Van account


Cr. - Accumulated fund

(b) Entrance fees are amounts members may be requested to pay


when they first join the club. This amount is also treated as
income in the year it is collected.

Dr. - Cash account with entrance fees


Cr. - Entrance fees with cash received.

The entrance fees account is at year end transferred to income


and expenditure account.

Dr. - Entrance fees account


Cr. - Income and expenditure account.

22.11 Accounting for the sale of investments and non current


assets.

Just like trading organizations, non profit making organizations also


sale non current assets and investments.

Accounting treatment is basically the same where the disposal account


is opened to determine profit or loss arising from the sale.

The difference is on the treatment of profit or loss on sale.

Remember profit could be:

(i) Sales – cost (if asset is maintained at cost) or


(ii) Sales – Net book value (if asset is depreciated)

If profit or loss is made using (i) above, the profit or loss will be directly
added or subtracted – to or from accumulated fund in balance sheet.

If (ii) is used then profit or loss is shown in income and expenditure


account.
Full worked example: Income and expenditure

The following is a summary of the receipts and payments of North East


Rotary Club during the year ended 31 December 20X1.

North East Rotary Club


Receipts and payments accounts for the year ended
31 December 20X1

Dr K K Cr.

Cash and bank balance 210 Secretarial expenses 163


Sales of competition tickets 437 Rent 1402
Members subscriptions 1987 Visiting speakers expenses 1275
Donations 177 Donations to charities 35
Refund of rent 500 Prizes for competitions 270
Balance c/d 13 Stationery & printing 179
____ ____
3,324 3,324
Balance b/d 13

The following valuations are also available:

As at 31 December 20X0 20X1


K K
Equipment (original cost K1,420) 975 780
Subscriptions in arrears 65 85
Subscriptions in advance 10 37
Owing to suppliers of competition prizes 58 68
Inventory of competition prizes 38 46

Required:

(a) Calculate the value of the accumulated fund of the club as at 1


January 20X1.
(b) Reconstruct the following accounts for the year ended 31
December 20X1.

(i) the subscription account


(ii) the competition prizes account
(c) Prepare an income and expenditure account for the club for the
year ended 31 December 20X1 and a balance sheet as at that
date.

EXERCISES

1. Identify three areas of difference between the accounts of a non


trading organization and that of a trading organization.

2. If a “not for profit” organization makes a surplus it will be?

(a) Credited to capital


(b) Credited to accumulated fund
(c) Shared among members
(d) Kept in the bank account

3. A club has 150 members who pay K10 each for membership. The
opening subscription receivable was K70 and 5 members had paid
subscriptions in advance at the year end. How much money was
collected from members?

(a) K1,500
(b) K1,740
(c) K1,620
(d) K1,520

4. The assets and liabilities of a social club on 31.12.20X1 were


equipment K1,500, premises K16,000, bar inventory K1,300, bar
payables K1,100, wages owing K250, subscriptions in arrears K500,
subscriptions prepaid K350, cash in hand K1,900. The accumulated
fund is:

(a) K21,200
(b) K19,650
(c) K19,500
(d) K200,000

5. The accounting records of Up Hill cricket club are given in the following
trial balance as at 31 December 20X4:

Dr. Cr.
K K
Clubhouse 140,000
Equipment 18,000
Profits from raffles 6,000
Accumulated fund 40,000
Bar inventory 1 January 20X4 9,000
General expenses 31,500
Wages of bar workers 30,000
Subscription received 190,000
Bar purchases 40,000
Caretakers wages 20,400
Bar sales 90,000
Cash in hand 900
Cricket professional’s salary 36,200

326,000 326,000

The following additional information is also available.

(i) The inventory in the bar at 31 December 20X4 was valued at


K5,600
(ii) Depreciation on equipment should be at 131/3%.
(iii) All sales and purchases for the bar were on cash basis.
(iv) As at 31 December 20X4 some members had paid subscriptions
in advance amounting to K1,800 and some members were owing
K700.

Required:

Prepare income and expenditure account for the year ended 31


December 20X4 and a balance sheet as at that date.
CHAPTER 25

INCOMPLETE RECORDS

INTRODUCTION

Sole traders do not often keep an elaborate set of books of accounts. The
books they keep comprise mainly a record of receipts and payments and file
of unpaid invoices in the correspondence file.

Even where an elaborate set of books is kept unexpected disasters such as


fires may occur. As a consequence the available books may contain
insufficient information for the preparation of the Income Statement and
balance sheet. The owner of the business will ask for these statements at the
end of the year.
The above sample situations pose a challenge on the accountant to prepare
the financial statements from whatever records that are available.

We will use the following question to illustrate the stages of compiling


financial statements from a set of limited records.

SINGLE ENTRY BOOKEEPING

Single entry is a generic term used to refer to a business situation in which


only a limited number of records are kept. Principally there is always a record
of receipts and payments and some documentary evidence of other
transactions. Accounts can be compiled from the information available by
completing double entry for all the transactions that took place. Day books
may not have been prepared because the administration of the business
does not yet have a defined complete accounting system as such.

ILLUSTRATION FOR INCOMPLETE RECORDS

Joel Mutale is a sole trader and provides you with the following summarized
data . He would like you to prepare appropriate statements to show
1. Capital on 1 July 2004
2. Profit for the year ended 30 July 2005
3. A list of assets and liabilities as at 30 June 2005

RECEIPTS AND PAYMENTS


K 000 K 000
Cash receipts
Commision received 3 700
Trade Receivable 12 500
Cash sales 4 200
20 400
Cash Payments
Electricity 1 580
Rent and Rates 3 640
Drawings 1 200
Cash banked 6 000
(12 420)
Excess of receipts over payments 7 980
Add: Opening Balance 3 000
Closing Balance 10 980
Summary of transactions through the bank
K 000 K 000
RECEIPTS

Cash banked 6 000


Trade Receivables 42 870
48 870
PAYMENTS
Equipment 5 520
Insurance 909
Trade Payable 34 000
Loan Interest 700
Wages & Salaries 8 300
Stationery 2 700
(52 129)
Excess of payments over receipts (3 259)
Add: Opening Balance (1 300)
Closing Balance 4 559

The following additional notes were extracted from Joel’s correspondence box
files:

As at As at
1 July 2004 30 June 2005
K 000 K 000
Equipment 8 200 12 500
Inventory 3 200 4 500
Bank loan 10 000 10 000
Rates due 420 -
Rent prepaid - 380
Electricity owing 300 320
Trade receivables 6 300 8 400
Trade payables 3 800 4 600

As you settle down to do work, Joel tell you that he pays loan interest at 12 %
and there is an amount that is not yet paid. He further say that during the
year he received cash discounts of K 800 000, issued credit notes for K 450
000 and cancelled irrecoverable debts of K 325 000

SOLUTION

The following steps will help you to be methodical in your approach:


Steps:

1. Calculate the amount of capital by preparing an opening journal, listing


assets and liabilities separately. The liabilities are credit balances and
so they are deducted from the total of assets that are debit balances.
2. Draw up the ledger accounts in T form and put the opening balances
in their right places: on the debit side of an asset account and on the
credit side of a liability account.
3. Leave space for current year entries (3 – 5 lines) and put in the closing
balances: above total lines on the debit side and below total lines on
the credit side for liability accounts, and on the credit side above total
lines and on the debit side below total lines for asset accounts.
4. The cashbook contains one entry of the double entry. Complete the
second entry in the ledger accounts by posting to the credit side if the
entry is on the debit side of the cash book account, or to the debit side
if the entry is on the credit side of the cash book account.
5. Care must be taken to open accounts for additional transfers of funds
and completing double entry for them. For example, amounts written
off as bad are credited to Trade Receivables account and debited to
Bad debt account. Amounts returned by customers are credited to
Trade Receivables account and debited to Sales returns account.
Amounts allowed receipts from customers are debited to Discount
allowed account and credited to Trade Receivables account.
6. The balancing figure on each account represents the amount to be
transferred to the Income Statement, whereas the closing balance is
the amount to report in the Balance sheet.

The ledger accounts follow then the Income Statement and Balance Sheet
finally. It is always better to draw up nominal accounts on separate pages
from the ones on which real and control accounts are. Doing so will facilitate
thoroughness in ensuring that no transfer to the Income Statement is
missed, and that work is properly organized.

TRADE RECEIVABLES

K 000 K 000
Balance b/d 6 300 Bank 42 870
Sales 59 045 Sales Returns 450
Cash 12 500
Discount All 800
Bad Debts 325
Balance c/d 8 400
65 345 65 345
Balance b/d 8 400

TRADE PAYABLES

K 000 K 000
Balance b/d 3 800
Purchases 34 800
Bank 34 000

Balance c/d 4 600


38 600 38 600
Balance b/d 4 600

EQUIPMENT

K 000 K 000
Balance b/d 8 200 P/L -Deprec 1 220
Bank 5 520
Balance c/d 12 500
13 720 13 720
Balance b/d 12 500

LOAN

K 000 K 000
Balance b/d 10 000
Balance c/d 10 000
10 000 10 000
Balance b/d 10 000

CAPITAL

K 000 K 000
Balance b/d 4 880
Balance c/d 4 880
4 880 4 880
Balance b/d 4 880

INVENTORY

K 000 K 000
Balance b/d 3 200
Trading c/d 3 200
3 200 3 200

PURCHASES

K 000 K 000
Trade Payables 34 800
Trading c/d 34 800
38 400 38 400

SALES RETURNS
K 000 K 000
Trade Receivable 450
Trading c/d 450
450 450

SALES

K 000 K 000
Cash 4 200
Trade Receivables 59 045
Trading c/d 63 245
63 245 63 245

BAD DEBTS

K 000 K 000
Balance b/d 325
P/L c/d 325
325 325

DISCOUNT ALLOWED

K 000 K 000
Trade Receivables 800
P/L c/d 800
800 800

DEPRECIATION

K 000 K 000
Equipment 1 220
P/L c/d 1 220
1 220 1 220

STATIONERY

K 000 K 000
Bank 2 700
P/L c/d 2 700
2 700 2 700

WAGES & SALARIES

K 000 K 000
Bank 8 300
P/L c/d 8 300
8 300 8 300

LOAN INTEREST

K 000 K 000
Bank 700 P/L c/d 1 200
Balance c/d 500
700 700
Balance b/d 500
INSURANCE

K 000 K 000
Bank 909
P/L c/d 909
909 909

RENT & RATES

K 000 K 000
Balance b/d 420
Bank 3 640 P/L c/d 2 840
Balance c/d 380
3 640 3 640
Balance b/d 380

ELECTRICITY

K 000 K 000
Balance b/d 300
Bank 1 580 P/L c/d 1 600
Balance c/d 320
1 900 1 900
Balance b/d 320

DRAWINGS

K 000 K 000
Bank 1 200
Capital c/d 1 200
1 200 1 200

COMMISSION

K 000 K 000
Bank 3 700
P/L c/d 3 700
3 700 3 700

The alternative to calculating cost of sales on the face of the Income


Statement is writing the following account:

COST OF SALES

K 000 K 000
Inventory b/d 3 200
Purchases 34 800 Trading (I/S) 33 500
Inventory c/d 4 500
38 000 38 000
Inventory b/d 4 500
COMMENTS

The full ledger accounts have been written here to illustrate how they would
be drawn up in practice. A student who has understood the principles of
double entry would list the amounts straight on the Income Statement,
depending on whether the amount is earned/incurred or not. For example,
the amounts to charge as expenses in respect of Electricity and Rent & Rates
are shown below:

ELECTRICITY
Amount paid 1 580
Add: Amount owing at end 320 Incurred but not yet paid for
1 900
Less: Amounts owing at start 300 settled now but incurred last year
Profit & Loss charge 1 600 Incurred for this year only

RENT & RATES


Cash paid 3 640
Less: Amount owing at start 420 settled now but incurred last
year 3 220
Less: Amounts prepaid at end 380 Not incurred but paid for
Profit & Loss charge 2 840 Incurred for this year only

The rationale flows because referring to the accounts, amounts on the same
side are added, whereas amounts on the opposite sides of an account are
netted. This logic can be applied to any account without exception. You only
need to understand double entry and the format of ledger accounts.

JOEL MUTALE
INCOME STATEMENT for the year ended 30 June 2005

K000 K000
Sales (less Sales Returns) 62 795
Less: Cost of Sales 33 500
Gross Profit 29 295

Add: Income
Commission received 3 700
32 995
Less: Expenses
Bad Debts 325
Discount Allowed 800
Depreciation 1 220
Electricity 1 600
Rent & Rates 2 840
Insurance 909
Loan Interest 1 200
Wages & Salaries 8 300
Stationery 2 700
19 894
Net Profit 13 101
Joel Mutale
BALANCE SHEET as at 30 June 2005

Km Km
Non current Assets:
Equipment 12 500

Current Assets:
Inventory 4 500
Trade receivables 8 400
Rent & Rates 380
Cash at bank & in hand 10 980
24 260
Total assets 36 760

Capital
Balance at start 4 880
Add: Net Profit 13 101

Less: Drawings 1 200


16 781

Non current Liabilities:


Loan 10 000

Current Liabilities:
Trade Payables 4 600
Loan Interest 500
Electricity 320
Bank Overdraft 4 559
9 979
36 760

Note also that depreciation has been deducted directly from Equipment
account because the closing balance given for this account imply that non
current assets are kept at their net book value (not at cost, in which case
there would be a separate account for Accumulated depreciation).

INCOMPLETE RECORDS

An incomplete records situation presents a greater challenge than merely


applying double entry to transactions. The owner of the business may have
not cared to keep any records and will rely on his memory and a few source
documents to provide figures for preparation of financial statements.
Sometimes the situation may be caused by an unexpected event such as fire
or a burglary.

To prepare financial statements from the limited information available you


will have to derive most figures either as balancing figures or as
complementary figure after applying some ratios.

EXERCISE

Mpomwa has been trading for the last five years. He has been using the front
half of the house he has rented as a shop, with the consent of the landlord.
Mpomwa maintains no formal accounting system for the purpose of
recording business transactions. He, however, needs to calculate the profit
earned during the year 2006 for tax purposes.

The following is a summary of Mpomwa’s business bank account:

RECEIPTS: K000
Cash from customers 48 120
Sales of private motor car 650
Total 48 770

PAYMENTS:
Cash paid to suppliers 32 890
Rent of entire premises 2 400
Wages of part-time staff 760
New counter and shelving 800
General expenses 3 650
Drawings 5 870
Total 46 370

The following additional information is obtained:

1. The landlord considers accommodation to be divided equally


between private and business use.
2. The fixtures and fittings in the shop were valued at K2 500 000 at
the beginning of the 2006. It is intended to depreciate fixed assets
at 10% on the year end balance.
3. It was discovered that not all the cash received was banked. Wages
for part-time staff and general expenses amounting to K350 000
and K110 000 respectively were paid direct from the till.
4. Inventory was valued at K2 560 000 at 31 December 2006 and
estimated at K1 950 000 at the beginning of the year.
5. From files of invoices it was discovered that K960 000 was owed to
suppliers at the beginning of the year and $1 270 000 at the end of
the year.
6. Cash at bank on 1 January amounted to K620 000.
7. There are just a few families to which Mpomwa allows credit. The
owed him K170 000 on 1 January 2006 and K 210 000 at 21
December 2006.
8. Mpomwa took goods from the shop costing K320 000 for personal
use during the year.

REQUIRED:

(a) A statement of affairs for the business at 1 January 2006


(b) The Income Statement for the year ended 31 December 2006
(c) The Balance Sheet as at 31 December 2006

CHAPTER 26

CASHFLOW STATEMENTS

INTRODUCTION

Financial statements are a means of informing the users of financial


information about performance in terms of profitability or otherwise, and of
the position in term of assets and liabilities. They comprise the Income
Statement, the Balance Sheet and the Cash flow Statement, at the minimum.
Other reports include a statement of accounting policies and the Operating
and Financial Review. Discussion of the last two statements is outside the
scope of this syllabus.

In this chapter we discuss the contents of IAS 7 and the essence of preparing
a cash flow statement.

TOPICS

This chapter will discuss the following topics:


1. Why prepare the cashflow statements
2. Contents of the cashflow statement
3. Methods of preparing cashflow statements
4. How to prepare the cashflow statements
5. Summary

LEARNING OBJECTIVES

After studying this chapter the student should be able to:


 Explain the importance of the cash flow statement
 repare the cash flow statement for a single entity

THE CASH FLOW STATEMENT

The cashflow statement provides information about the sources of cash and
the uses to which cash was put for a specified period. Some writers refer to
these as sources and applications of cash. Admittedly the information on
cash can be obtained from the cash and bank accounts in the Cashbook. In
practice the cash transactions are so numerous that it becomes tedious to
obtain cashflow information from the Cashbook. Consequently, the entries
for cashflows are obtained from individual ledger accounts where they are
already summarised.

Cashflow statements also serve the following purposes:

1. To explain the difference between the reported profit or loss in the


Income Statement and the cash and bank balances reported in the
balance sheet. The reported profit is calculated under the accruals
basis and so includes non cash items.
2. To communicate the solvency of the company: whether the entity has
sufficient cash resources to support continuity of business. Solvency is
much more critical than mere liquidity. Liquidity problems can be
solved by borrowing whereas an insolvent company cannot borrow
funds from anywhere, having exhausted all possible means.
3. To serve as a source of information for making cash flow forecasts.
Management can make projections of future cash receipts and
payments, having regard to proper timing of cash.
4. The following are the key definitions:

Cash: Amounts of money received or paid in the form of notes or


cheques in each transaction.

Cashfow: The volume of cash that comes into and goes out of the
business for a given period of time.

Cash equivalents: These are financial instruments (bank drafts, loan


notes, etc) that can be used to pay for goods or settle liabilities.
Operating activities: These are business transactions which include
trading activities (buying and selling) and administrative activities that
lead to either receipt or payment of cash.

Investing activities: These are transactions that result in acquisition


or disposal of non current assets and investments.

Financing activities: These are transactions by means of which the


business raises funds of a capital nature. Examples include loans,
finance leases, and issues of shares.

FORMATS OF CASHFLOW STATEMENTS

Cash flows are classified under three major headings in the cashflow
statements: operating activities, investing activities and financing activities.
The format below outline the contents of a cash flow statement as required
by IAS 7.

Under the direct method cashflow figures are obtained from the ledger
accounts for trade receivables, trade payables and expenses. Depending on
the information provided there might be need to adjust the cashflow figure
with amounts for non cash items such as depreciation and
increases/decreases in allowances for bad debts.

ABC Ltd
CASHFLOW STATEMENT (DIRECT METHOD)
for the year ended 31 December 2005
K000 K 000
Cashflow from Operating Activities:
Receipts from customers X
Payments to suppliers X
Payments for expenses X
X
Adjustments for Non-cash items:
Depreciation X
Loss on sale of non current assets X
Decrease in provisions for bad debts X
X
Net cashflow from Operating profit X

Interest paid X
Income tax X
Dividends paid X
Net cash from operating activities X

Cashflow from Investing Activities:


Purchase of non current assets X
Disposal of non current assets X
Interest received X
Dividend received X
Short term investments X
Net cash used in investing activities X
Cashflow before financing X

Cashflow from Financing Activities:


Issue of Share Capital X
Share Premium X
Issue of debentures (or Loan stock) X
Finance Leases X
Net cash used in financing X
Increase/decrease in cash and cash equivalents X

There are two methods of preparing cashflow statements: The direct method
and the indirect method. The difference between the two methods lies in the
way cashflow from operating activities is calculated.
ABC Ltd
CASHFLOW STATEMENT (INDIRECT METHOD)
for the year ended 31 December 2005
K000 K 000
Cashflow from Operating Activities:
Profit before tax X
Adjustments for Non-cash items:
Depreciation X
Loss on sale of non current assets X
Decrease in provisions for bad debts X
X
Changes in working capital:
Decrease in inventory X
Increase in debtors X
Increase in creditors X
X
Net cashflow from operating profit X
Interest paid X
Income tax paid X
Dividends paid X
Net cash from operating activities X

Cashflow from Investing Activities:


Purchase of non current assets X
Disposal of non current assets X
Short term investments X
Interest received X
Dividend received X
Net cash used in investing activities X
Cashflow before financing X

Cashflow from Financing Activities:


Issue of Share Capital X
Share Premium X
Issue of debentures (or Loan stock) X
Finance Leases X
Net cash used in financing X

Net increase/decrease in cash and cash equivalents X


Cash and cash equivalents b/f X
Cash and cash equivalents c/f X

Under the indirect method operating activities is adjusted from the accruals
figure to a pure cashflow amount with non-cash items and movements in
working capital. The rest of the cashflow statement is prepared as is done
under the direct method. You should be able to obtain cashflow figures from
the appropriate accounts by applying knowledge acquired in previous
chapters. The cashflow figure is the entry that goes to the account from
either the cash account of bank account.

We now use a question to illustrate how to prepare the cash flow statement.

ILLUSTRATION

The balance sheets of Prenodia Plc as at 30 June 2004 and 2005 and the
summary income Statement for the year ended 30 June 2005 were as
follows:

Balance sheet as at 30 June

2004 2005
Km Km Km Km
Non current Assets:
Premises 130 130
Less: Accumulated Depreciation 30 32
100 98
Plant & Machinery 70 80
Less: Accumulated Depreciation 17 23
53 57

Current Assets:
Inventory 25 24
Trade receivables 16 26
Short term investments - 12
Cash at bank & in hand - 7
41 69
Total assets 194 224

Share Capital 100 100


Profits & loss reserve 36 40
136 140

Non current Liabilities:


10% Debentures 20 40

Current Liabilities:
Trade Payables 19 22
Income Tax 7 8
Proposed dividend 12 14
38 44
194 224

Prenodia
Income Statement for the year ended 30 June 2005

Km Km
Sales 173
Less: Cost of Sales 96
Gross Profit 77
Less: Expenses
Sundry expenses 24
Interest payable 2
Loss on sale of non current assets 1
Depreciation –Premises 2
Depreciation –Plant 16
45
Operating profit 32
Interest receivable 2
Profit before tax 34
Income Tax (16)
Profit after tax 18
Proposed dividend (14)
Retained profit for the year 4

ADDITIONAL INFORMATION

During the year a machine costing K15 was sold for K 4m. Depreciation on
the machine had accumulated to K10m.

REQUIRED

Prepare a cashflow statement for Prenodia Plc for the year ended 30 June
2005
SOLUTION

The following part of the cashflow statement can be done as a working in the
notes to the statement or it can be included on the main Cashflow
Statement.

Direct method
Cash flow from Operating Activities:
Km Km
Receipts from customers 163
Payments to suppliers (92)
Payments for expenses (45)
26
Adjustments for Non-cash items:
Depreciation 18
Loss on sale of non current assets 1
Interest payable (Has its own entry ) 2
21
Net cash flow from Operating profit 47

Indirect method Km Km
Cash flow from Operating Activities:
Profit before tax 34
Interest payable (Has its own entry on the statement) 2
Interest receivable (Has its own entry on the statement) (2)
Adjustments for Non-cash items:
Depreciation (2 + 16) 18
Loss on sale of non current assets 1
Decrease in provisions for bad debts -
19
Movements in working capital:
Decrease in inventory 1
Increase in trade receivables (10)
Increase in trade payables 3
(6)
Net cash flow from operating profit 47

Net cash flow from operating profit has been calculated in different ways
under the two methods. Under the direct method the figure of expenses was
obtained straight from the Income Statement and so it is a figure after
deducting depreciation and loss on disposal. Consequently it was necessary
to adjust for these non-cash items. Otherwise they would not have been
added back to net profit.

Under the indirect method interest was adjusted for because it is dealt with
separately on the face of the Cash flow Statement. This reversal was not
necessary for interest receivable under the direct method because it was not
part of the expenses figure mentioned above.

The rest of the cashflow statement is completed in the same way under both
methods as follows:

CASHFLOW STATEMENT (INDIRECT METHOD)


for the year ended 31 December 2005
Km Km

Cash flow from Operating Activities:


Profit after tax 34
Interest payable 2
Interest receivable (2)
Adjustments for Non-cash items:
Depreciation (2 + 16) 18
Loss on sale of non current assets 1
Decrease in provisions for bad debts -
19
Movements in working capital:
Decrease in inventory 1
Increase in trade receivables (10)
Increase in trade payables 3
(6)
Net cash flow from operating profit 47
Interest received 2
Interest paid (2)
Income tax paid (15)
Dividends paid (12)
Net cash from operating activities 20

Cashflow from Investing Activities:


Purchase of machinery (25)
Disposal of machinery 4
Short term investments (12)
Net cash used in investing activities (33)
Cashflow before financing (13)

Cashflow from Financing Activities:


Issue of Share Capital -
Share Premium -
Issue of debentures (or Loan stock) 20
Net cash used in financing 20
Increase in cash and cash equivalents 7

The following are the steps to follow when obtaining cash flow figures from
ledger accounts:

1. Write the account and, using the information in the balance sheet as at
the end of the preceding year, put the opening balance on the side it
would appear depending on whether it is an asset or a liability.
2. Using information from the balance sheet as at the end of the current
year, insert the closing balances on the account on the side they would
be above total lines and below total lines depending on whether they
are assets or liabilities.
3. In between the two balances (enough space should have been left for
this depending on the expected number of entries) project ‘back
wards’ the figure from the income statement on the side it would be
when the entry for the transfer of funds to the trading, profit and loss
was made.
4. Complete the account, slotting in the missing figure on the side with a
smaller total. This figure is the amount of cash flow, the entry from
either the bank account or cash account.

The accounts are now shown below with the cashflow figure highlighted in
bolt type.

TRADE RECEIVABLES
Balance B/d 16 Bank 163
Sales 173 Balance c/d 26
189 189
Balance b/d 26

INVENTORY (Cost of Sales)

Balance B/d 25 Trading (IS) 96


Purchases 95 Balance c/d 24
120 120
Balance b/d 24

PURCHASES

Inventory 95
Trade Payables 95 Balance c/d 0
95 95

TRADE PAYABLES

Balance B/d 19
Bank 92 Purchases 95
Balance c/d 22
114 114
Balance b/d 22

DIVIDEND

Balance B/d 12
Bank 12 IS 14
Balance c/d 14
26 26
Balance b/d 14

TAXATION

Balance B/d 7
Bank 15 Income statement 16
Balance c/d 8
23 23
Balance b/d 8

PLANT & MACHINERY

Balance B/d 70 Disposal 15


Bank 25 Balance c/d 80
95 95
Balance b/d 80

ACCUMULATED DEPRECIATION

Disposal 10 Balance b/d 17


Balance B/d 23 IS- 16
33 33
Balance b/d 23
P & M DISPOSAL

Plant & Machinery 15 Accumul Depreciation 10


Bank 4
0 IS-Profit & Loss 1
15 15

OTHER OBSERVATIONS

The cash flow from debentures is simply the difference between the closing
balance and the opening balance. There being an increase of K20m then this
was a credit entry in the account implying that the debit was in the bank
account. The debit in the bank account represents a cash inflow.

Similarly, there was no balance at start of the period on the Short-term


investments. The account shows a closing balance of K12m representing new
investment. The balance is a debit on the account implying that the credit
was in the bank account. Therefore there was an outflow in K12m.

CHAPTER SUMMARY

You should now have learnt that


 Preparing a cashflow statement is important because the users of
financial statements need to know where cash resources came from
and what uses they were put to in the past year. This information
would enable them to make reasonable cashflow forecasts as well as
other economic decisions.
 The cashflow statement should be presented according to the format
recommended in the accounting standard (IAS7)

EXERCISES
QUESTION ONE
The balance sheet given below together with comparative figures are a for
Tokozile Ltd, a private company that has been operating for the last three
years.

TOKOZILE LTD
BALANCE SHEET AS AT 30 JUNE
2006 2005
K000 K000 K000 K000
Non current assets:
Property, plant & equip 2 800 2 100
Accumulated depreciation (650)
(490)
2 150 1 610

Current assets:
Inventory 1 100 850
Trade receivables 540 470

Bank 120 -
1 760 1 320
Total assets 3 910 2 930

Equity and liabilities:


Ordinary share capita l2 200 1 600
Share premium 260 -
Retained earnings 400 865

2 860 2 465
Non current liabilities:
Loan notes 340 140

Current liabilities:
Trade payables 430 110
Bank overdraft - 45
Taxation 280 170
710 325
3 910 2 930

Additional information:

a) During the year the company sold a piece of equipment with a net
book value of K 135,000 at a profit of K75,000.
b) Depreciation charged for the year ended 30 June 2006 was
K220,000.
c) Interest paid during the year ended 30 June 2006 was K37,000.
d) Income tax paid during the year amounted to K 230,000.
e) The company paid no dividend in the year under review.

REQUIRED:

(a) Calculate the operating profit of Tokozile Ltd for the year ended 30
June 2006
(b) Prepare a cashflow statement for Tokozile Ltd for the year ended
30 June 2006 in accordance with IAS 7 (revised).
QUESTION TWO

KONKOLA
INCOME STATEMENT for the year ended 31 March 2007
K000 K000
Revenue 2,150
Cost of sales (1,250)
Gross profit 900
Distribution cost 98
Administration expenses 122
(220)
Operating profit 680
Profit on disposal of non current assets 12
Dividend received 14
Interest paid (36)

(10)
Profit before tax 670
Taxation (132)
Profit after tax 538

STATEMENT OF CHANGES IN EQUITY


SHARE SHARE RETAINED
CAPITAL PREMIUM PROFIT
K000 K000 K000
Balances at start (31/03/06) 1,100 260
80
Issues of shares 300 60
Profit for year 538
Dividend (98)
Balance at end 31 March 2007 1,400 320
520
KONKOLA
BALANCE SHEET AS AT 31 JUNE
2006 2007
K000 K000 K000 K000
Non current assets:
Furniture & Fittings 750 930
Accumulated depreciation (210) (265)
540 665

Motor Vehicles at cost 780 885


Accumulated depreciation (305) (350)
475 535
Investments at cost 90 170
1,105 1,370
Current assets:
Inventory 615 456
Trade receivables 574 792
Bank (14) 452
1 175
1,700
Total assets 2,280 3,070

Equity and liabilities:


Ordinary share capital 1,100 1 400
Share premium 260 320
Retained earnings 80 520

1,440 2,240
Non current liabilities:
Loan notes 160 60
Current liabilities:
Trade payables 540 565
Proposed dividend 35 80
Taxation 105 125
680 770
2,280 3,070

Additional information for the year to 31 March 2007:

a) Vehicles which had cost K145 000 were sold during the year when
their net book value was K 55,000.
b) There were no accruals or prepaid expenses at the end of the year.

REQUIRED:

a. Prepare a cashflow statement for Konkola for the year ended


31 March 2007 using the DIRECT method. Show any additional
notes and reconciliation required.
b. Explain briefly the usefulness of cashflow statements to
external users

SOLUTION TO EXERCISES

SOLUTION ONE

CASHFLOW STATEMENT (INDIRECT METHOD)


for the year ended 30 June 2006
K000 K 000
Cash flow from Operating Activities:
Loss after tax (88)
Adjustments for Non-cash items:
Depreciation 220
Loss on sale of non current assets (75)
Decrease in provisions for bad debts -
145
Movements in working capital:
Increase in inventory (250)
Increase in trade receivables (70)
Increase in trade payables 320
(00)
Net cash flow from operating profit 57
Interest paid (37)
Income tax paid (230)
Net cash from operating activities (210)

Cash flow from Investing Activities:


Purchase of machinery (895)
Disposal of machinery 210
Interest received (00)
Net cash used in investing activities (685)
Cash flow before financing (895)

Cash flow from Financing Activities:


Issue of Share Capital 600
Share Premium 260
Loan notes 200
Net cash used in financing 1060
Increase in cash and cash equivalents
165

Proof: K000 K000


Balance of cash /bank at start (overdraft) (45)
Increase in cash (from cashflow statement) 165
Balance of cash/bank at end 30 June 2006 120

Workings:
Calculation of operating profit:
Retained profit at end –30 June 2006 400
Retained profit at end –30 June 2005 865
Loss for the year 2006 (465)
Add: Dividend -
Taxation 340
Interest charge 37
Operating loss (88)

Relevant Ledger accounts:

PROPERTY, PLANT & EQUIPMENT

Balance B/d 210 Disposal 195


Bank 895 Balance c/d 2800
2995 2995
Balance b/d 2800

ACCUMULATED DEPRECIATION

Disposal 60 Balance b/d 490


Balance B/d 650 IS-Depreciation 220
710 710
Balance b/d 650

P P & EQUIP DISPOSAL

Property, Plant, etc 195 Accumul. Depreciation 60


Bank 210
IS-Profit & Loss 75 000
270 270

TAXATION

Balance B/d 170


Bank 230 Income Statement 340
Balance c/d 280 000
510 510
Balance b/d 280

Note: Cost of plant sold is NBV + Depreciation, and the amount of


tax charged to the income statement of a balancing figure on the
Income tax account.

SOLUTION TWO

Direct method
Cash flow from Operating Activities:
K000 K000
Receipts from customers 1,932
Payments to suppliers (1066)
Payments for expenses (220)
646
Adjustments for Non-cash items:
Depreciation -Furniture 55
Depreciation –Motor Vehicles 135
190
Net cash flow from Operating profit 836

TRADE RECEIVABLES

Balance B/d 574 Bank 1,932


Sales 2,150 Balance c/d 792
2,724 2,724
Balance b/d 792

INVENTORY (Cost of Sales)

Balance B/d 615 Trading (IS) 1,250


Purchases 1,091 Balance c/d 456
1,701 1,701
Balance b/d 456

PURCHASES

Inventory 1,091
Trade Payables 1,091 0000
1,091 1,091

TRADE PAYABLES

Balance B/d 540


Bank 1,066 Purchases 1,091
Balance c/d 565 0000
1,631 1,631
Balance b/d 565

DIVIDEND

Balance B/d 35
Bank 53 IS 98
Balance c/d 80
133 133
Balance b/d 80

TAXATION

Balance B/d 105


Bank 112 Income statement 132
Balance c/d 125
237 237
Balance b/d 125

MOTOR VEHICLE

Balance B/d 780 Disposal 145


Bank 250 Balance c/d 885
1,030 1,030
Balance b/d 885

ACCUMULATED DEPRECIATION -MV


Disposal 90 Balance b/d 305
Balance B/d 350 IS- 135
440 440
Balance b/d 350

P & M DISPOSAL -MV

Plant & Machinery 145 Accumul Depreciation 90


Bank 67
IS-Profit 12 000
157 157

FURNITURE & FITTINGS

Balance B/d 750


Bank 180 Balance c/d 930
930 930
Balance b/d 930

ACCUMULATED DEPRECIATION -FF

Balance b/d 210


Balance B/d 265 IS- Depreciat 55
265 265
Balance b/d 350

KONKOLA
CASHFLOW STATEMENT For the year ended 31 March 2007

K000 K000
Cashflow from Operating Activities:
Net cash flow from operating profit(W1) 836
Interest paid (36)
Income tax paid (112)
Dividends paid (53)
Net cash from operating activities 635

Cashflow from Investing Activities:


Purchase of furniture (180)
Purchase of motor vehicle (250)
Disposal of motor vehicle 67
Purchase investments (80)
Net cash used in investing activities
(429)
Cashflow before financing 206

Cashflow from Financing Activities:


Issue of Share Capital 300
Share Premium 60
Loan notes (100)
Net cash from financing 260
Increase in cash and cash equivalents 466

Proof: K000 K000


Balance of cash /bank at start (overdraft) (14)
Increase in cash (from cashflow statement) 466
Balance of cash/bank at end 31 March 2007 452
CHAPTER 26

COMPANY ACCOUNTS

INTRODUCTION

A company can be defined as a business incorporated under company law by


a group of members known as shareholders. In this chapter we look at the
preparation of financial statements for internal use for Limited Companies.
Guidance on the structure and content of the financial statements is
provided for in IAS 1: Preparation of Financial Statements.

TOPICS

1. Company finance
2. Classes of shares
3. Debentures
4. Issue of shares
5. Share capital structure
6. Preparation of financial statements

LEARNING OUTCOMES

At the end of the chapter, the student should be able to:

 Explain sources of finance for companies.


 Explain the classes of shares.
 Explain debentures.
 Explain the process of issuing shares.
 Distinguish between a Bonus issue and a Rights issue.
 Record the issue of shares at par value and at a premium.
 Explain the following share capital structure terms: Authorised, Issued,
Called up, Paid up, Calls in arrears and Calls in advance.
 Prepare the Income Statement and Balance Sheet for a company.

26.1 Company finance


Generally, the finances of a company are raised from two main
sources: the
shareholders (through the share capital) and outside lenders of finance
(debentures
holders).

26.2 Classes of Share Capital


The ownership of a company is through shares. Share capital
represents part of the
capital invested in the company by its shareholders but may also
represent past
reserves of the company, which have been capitalised by an issue of
the shares.

A company may issue different classes of shares, the most common


are being the
following:

a) Ordinary shares
These are the normal shares issued by the company. The normal
rights of ordinary
shareholders are to vote at company meetings and to receive
dividends from the
remainder of profits.

b) Preference shares
These are shares carrying a fixed rate of dividend, the shareholders
of which have a
prior claim to any company profits for distribution. Preference shares
do not carry
a voting right. Preference shares could either be cumulative or non-
cumulative.

26.3 Debentures
This is a written acknowledgement of a loan to a company, given under
the
company's seal, which carries a fixed rate of interest. The conditions
and regulations
of the debenture are set out in a debenture trust deed.

Debentures are not part of the company's share capital - they are third
party liabilities.
Debenture interest is a charge against profit and must be paid whether
or not a company makes profit.

26.4 Issue of Shares


A company raises capital by issue of shares. The process of issuing
shares is the same
whether it is a newly formed company issuing shares for the first time
or an established
company asking for more capital to extend its operations.

Each share issued has a stated nominal value (also called a par value),
for example
20 000 shares of K1 each, the K1 per share is the nominal value.
Shares could be issued at par value or at a premium. The double entry
for recording the issue of shares is as follows:

a) Shares issued at nominal value

Dr - Cash book
Cr - Share capital account

For example, suppose 100 000 ordinary shares of K1 each are issued
at nominal value. The ledger accounts recording this issue will be as
shown below:

Bank account
___________________________________________________________________
K'000 K'000
Ordinary share capital 100

Ordinary share capital account


___________________________________________________________________
K'000 K'000
Bank 100

b) Shares issued at a premium

Dr - Cash book
Cr - Share capital account, with nominal value
Cr - Share premium account, with excess over the nominal value

For example 100 000 ordinary shares of K1 each are issued at a


price of K1.20 each.
The ledger accounts to record the issue will be:
Bank account
___________________________________________________________________
K'000 K'000
Ordinary share capital 120

Ordinary share capital account


___________________________________________________________________
K'000 K'000
Bank 100

Share premium account


___________________________________________________________________
K'000 K'000
Bank 20

26.4.1 Bonus issue


A bonus issue also called a Script or Capitalisation issue represents the
issue of shares to the existing shareholders in proportion to their
existing holding. No cash or other
consideration is passed from shareholders to the company. Any
reserve may be used to
finance the bonus issue.

The double entry for a bonus issue is:

Dr - Reserves
Cr - Share capital, with the amount of bonus issue

26.4.2 Rights issue


A rights issue represents the offer of shares to existing shareholders in
proportion to
their existing holdings at a stated price. Unlike the bonus issue, the
shareholders do not
have to take up their offer and have the alternative of selling their
rights on the stock
market.

The double entry for recording a rights issue is:


Dr - Cash book
Cr - Share capital, with nominal value
Cr - Share premium, with the premium (if any)

26.5 Share Capital Structure


The share capital structure is as follows:

i) Authorised share capital: - is the maximum share capital that a


company is allowed to issue. It is also known as the Nominal
capital.

ii) Issued share capital: - is the actual share capital issued to


shareholders at any point in time. It is the issued share capital that
appears on the company's balance sheet.

iii) Called up share capital: - is part of the nominal value payable on


each share that has been called for. However most capital is issued
on a fully paid up basis.

iv) Paid-up share capital: - is that part of the nominal value that is
paid at current date.

v) Calls in arrears: - is the amount requested for (called for) but not
yet received.

vi) Calls in advance: - is the amount received prior to payment being


requested.

ACTIVITY 1

Hightech Ltd was formed with the legal right to be able issue 100 000
shares of K100 each. The company has actually issued 80 000 shares.
None of these shares have been fully paid up. So far the company has
made calls of K60 per share. All the calls have been paid by shareholders
except for K200 000 unpaid by one shareholder.

Calculate the following:


a) Authorised share capital
b) Issued share capital
c) Called up share capital
d) Paid up share capital
e) Calls in arrears

26.6 Financial statements for companies


The Income Statement and the Balance Sheet for limited companies
are drawn in a
similar manner as to that of a sole trader and the partnership. The
main differences
in the financial statements of a company are:

i) The income statement


The income statement has an extra section called an Appropriation
Account that
shows how the profits are distributed or used by a company. The
following items are
found in this section:

a) Income tax: this is a tax levied as a percentage of the taxable


profits. Income tax is not an expense but an appropriation of profits
by the government. It is deducted separately immediately after net
profit. Income tax is an estimate of the tax liability and is normally
paid some months after the end of the accounting period. It is
therefore shown as a current liability in the balance sheet before it is
paid.

b) Dividends: A dividend is a return of part of the profits made by


a company to the
shareholders. Dividends can be stated as a percentage of the
nominal value of the
share or alternatively as an amount per share. For example: K100
000 dividends on
1 000 shares of K1 000 per share can be expressed as a dividend of
10% per share
or K100 per share.

The directors of the company as part of their responsibility can


declare an interim
dividend during the accounting period on the account of the total
dividend of the
year. The balance after an interim dividend is paid will be declared
at the general
meeting upon recommendation from the directors as a final
dividend.

The double entry bookkeeping for both the interim dividend and final
dividend is as
follows:

For the interim dividend


Dr - Dividend account
Cr - Cash book

For the final dividend


Dr - Profit and loss account
Cr - Proposed dividends account

The total of the interim dividend and the final dividend appear in the
income
statement but it is only the final proposed dividend that will appear
in the balance
sheet as a liability.

c) Transfers to reserves: A reserve is a profit set aside for a


particular purpose. For
example a fixed asset replacement reserve used to set aside profits
for replacing fixed
assets during a period of rising prices.

There are two types of reserves namely:

a) Capital reserve
b) Revenue reserve

Capital reserves (also known as statutory reserves) are


established by law. They include share premium, Capital Redemption
Reserve and Revaluation Reserve. Capital reserves can not be
distributed to shareholders as dividends. The share premium
account, which arises on issue of shares, as shown under issue of
shares above can be used for the following purposes:

- financing the issue of fully paid bonus shares


- writing off preliminary expenses on the formation of a
company
- writing off expenses, commission or discount on share or
debenture issue
- providing the premium on the redemption of debentures and
on redeemable of shares

Revenue reserves arise when a company makes profits and does


not pay out all the profits to the shareholders. There is no statutory
requirement for a company to have any amount in its revenue
reserve. Revenue reserves can be used for any purpose by the
company. However, where profits are transferred to a named
reserve, the directors are indicating that these amounts are not
available to support a dividend payment (although there is nothing in
law to prevent their distribution). Revenue reserves include, fixed
assets replacement reserve, general reserve, profit and loss account
(reserve) etc.

ii) The balance sheet


The main difference in the balance sheet of a limited company as
compared to that of sole traders and partnerships lies in the capital
section. The capital section of a company is made up of shareholders'
funds, which comprise, share capital and reserves.

Example:
You are provided with the following Trial Balance of Hightech Ltd at 31st
December
2006:
Dr Cr
K'000 K'000
Ordinary share capital (K1 000 shares) 400 000
10% preference share capital (K1 000 shares) 120 000
Freehold Premises at cost 920 000
Provision for depreciation - buildings 400 000
Plant and machinery (cost K300 million) 180 000
Sales 364 000
Purchases 196 000
Carriage inwards 4 000
Receivables and Payables 64 000 8 000

Cash at bank 60 000


Inventory at 1st January 2006 40 000
Discounts 1 600 800
Carriage outwards 3 200
10% debentures 2010 200 000
Debenture interest paid 20 000
Administrative expenses 16 000
Staff salaries (excluding directors) 16 000
Preference dividend paid 4 000
Profit and loss account b/d 32 000
1 524 800 1 524 800

Adjustments are required for:


1. Inventory at 31st December 2004, at cost K60 000 000.
2. Directors' salaries not yet paid K20 000 000.
3. Income tax for the year K8 600 000.
4. Proposed ordinary dividend K10 per share.
5. Depreciation on buildings for the year K18 400 000 and plant and
machinery is to be depreciated at 10% on cost.
6. Accrued audit fee K4 000 000.
7. Creation of a plant replacement reserve of K4 000 000.

You are required to prepare the Income Statement for the year ended 31st
December 2006 and a Balance Sheet as at that date.

SOLUTION
Hightech Ltd
Income statement for the year ended 31st December 2006
K’000 K’000
Sales revenue 364 000
Opening inventory 40 000
Purchases 196 000
Carriage inwards 4 000
240 000
Less: closing inventory 60 000
Cost of sales 180 000
Gross profit 184 000
Add Gains:
Discount received 800
Total income 184 800
Less Expenses:
Discount allowed 1 600
Carriage outwards 3 200
Administrative expenses 16 000
Staff salaries 16 000
Directors' salaries accrued 20 000
Audit fee accrued 4 000
Depreciation: - buildings 18 400
- Plant and machinery 30 000
Debenture interest 20 000
Total expenses 129 200
Net profit before tax 55 600
Less: Income tax 8 600
Net profit after tax 47 000
Transfer to plant replacement reserve 4 000
Dividends: - Preference (paid) 4 000
- Preference (proposed) 8 000
- Ordinary (proposed) 4 000
20 000
Retained profit for the year 27 000
Retained earnings b/d 32 000
Retained earnings c/d 59 000
Hightech Ltd
Balance sheet as at 31st December 2006
Cost Dep. Value
Non current assets: K’000 K’000
K’000
Freehold land and buildings 920 000 418 400
501 600
Plant and machinery 300 000 150 000
150 000
1 220 000 598 400 651
600
Current assets:
Inventory 60 000
Receivables 64 000
Cash at bank 60 000
184
000
Total assets 835
600

Capital and reserves:


Ordinary share capital 400 000
10% preference share capital 120 000
Plant replacement reserve 4 000
Accumulated profit 59 000

583 000
Non-current liabilities
10% debentures 2009 200
000

Current liabilities
Payables 8 000
Taxation 8 600
Dividends payable (4 000 + 8 000) 12 000
Accruals (20 000 + 4 000) 24 000
52 600
Total Equity and liabilities 835
600
CHAPTER SUMMARY

The chapter started by looking at the financing of limited companies which is


mainly by share capital and third party liabilities. It has also been noted that
dividends are a means of distributing profits to shareholders, while income
tax is an appropriation of profits by the government. Profits undistributed
are retained in the business by means of reserves.

The chapter has also looked at the preparation of financial statements for
internal use in a company.

EXERCISES

QUESTION ONE
You are presented with the following summarised Trial Balance of MK Ltd in
respect of the year ended 31st March 2007:
Dr Cr
K'000 K'000
Ordinary share capital (K500 shares) 200 000
Plant and machinery:
Cost 616 000
Depreciation (1 April 2006)
st
170 000
Receivables 104 000
Payables 76 000
Cash at bank 82 000
Inventory at 1st April 2006 180 000
Sales 2 000 000
Purchases 1 542 000
9% debentures 2010 150 000
Share premium account 40 000
Administrative costs 200 000
Provision for doubtful debts 4 000
Interim dividends paid 6 000
Profit and loss account balance 90 000
2 730 000 2 730 000
The following final adjustments are required:

1. The allowance for bad debts is to be adjusted to 5% of the receivables


figure.
2. Income tax on the current year profits is estimated at K62 400 000.
3. The directors propose a final dividend of K60 per share.
4. Depreciation at 10% of cost of plant and machinery is to be provided.
5. Debenture interest for the year ended 31st March 2007 was paid on 1st
April 2007. No accrual has been made.
6. Inventory at 31st March 2007 was valued at K122 000.

You are required to prepare the Income Statement account for the year
ended 31st March 2007 and a Balance Sheet as at that date.

QUESTION TWO
The following Trial Balance was extracted from the books of Hillside Plc at
31st March 2006:

K’000 K’000
K1 000 ordinary shares 200 000
8% K1 000 preference shares 70
000
7% debentures 100 000
Land and buildings: cost 130 000
Accumulated depreciation on buildings on 1 April 2005
st

30 000
Plant and machinery (K348 million cost) 262 500
Motor vans at cost 140 000
Accumulated depreciation on vans on 1 April 2005
st
56
800
Profit and loss account b/f 20 000
Share premium account 60
200
Inventory at 1st April 2005 35 000
Sales 344 600
Trade Receivables and Payables 45 000 27
000
Bank 5 800
Purchases 166 100
Distribution costs 18 000
General administration expenses 44 900
Debenture interest 7 000
Interim dividends:
Ordinary 10 000
Preference 2 800
Allowance for doubtful debts 1
500
890 100 890 100

Additional information available:

1. During the year the following transpired in relation to motor vans:

a) A new motor van was purchased on 1st January 2006 on credit for K24
million. The amount was still due to the supplier on 31st March 2006.
b) A motor van which had cost K16 million four years ago when new was
sold for
K6.6 million. The proceeds from the sale had not yet been received on
31 March
st

2006.

None of the above matters had been recorded in the books of the
company.

2. Depreciation on motor vans has been and is to be provided at the rate of


20% per annum on cost and is charged in full in the year of acquisition
and none in the year of disposal.

3. The cost of buildings is K100 million.

4. Depreciation on buildings, and plant and machinery is to be charged as


follows:
Buildings 2% on cost
Plant and machinery 10% on cost

5. On 31st March 2006 the company issued bonus shares to the ordinary
shareholders on a one (1) to ten (10) basis. No entry relating to this has
yet been made in the books.
6. Inventory at 31st March 2006 was valued at K51 million.

7. A bill for administrative expenses for K150 000 was unsettled as at 31st
March 2006.

8. Distribution costs include an insurance premium for delivery vans of K200


000 which relates to the period 1st July 2005 to 30th June 2006.

9. The allowance for doubtful debts is to be 21/2% of receivables outstanding


on 31st March 2006.

10. The directors wish to provide for:


a) A final ordinary dividend of 5%
b) A final preference dividend.

11. Income tax for the year is estimated at K18 million.

Required:

a) Using additional information (1) and (2), prepare the following ledger
accounts:

i) Motor van account


ii) Motor van accumulated depreciation account
iii) Motor van disposal account
(7 marks)
b) Prepare the company’s Income Statement for the year ended 31st March
2006.
(11 marks)
c) Prepare the company’s Balance Sheet as at 31 March 2006.
st

(14 marks)
(NATech: December 2006)
SOLUTIONS TO EXERCISES

SOLUTION ONE

MK Ltd
Income statement for the year ended 31st March 2007
K’000 K’000
Sales revenue 2 000 000
Opening inventory 180 000
Purchases 1 542 000
1 722 000
Less: closing inventory 122 000
Cost of sales 1 600 000
Gross profit 400 000
Less Expenses:
Administrative expenses 200 000
Increase in allowance for doubtful debts 1 200
Debenture interest accrued (9% x 150 000) 13 500
Depreciation on Plant and machinery 61 600
Total expenses 276 300
Net profit before tax 123 700
Less: Income tax 62 400
Net profit after tax 61 300
Dividends: - interim 6 000
- proposed 24 000
30 000
Retained profit for the year 31 300
Retained earnings b/d 90 000
Retained earnings c/d 121 300
MK Ltd
Balance sheet as at 31st March 2007
Cost Dep. Value
Non current assets: K’000 K’000
K’000
Plant and machinery 616 000 231 600
384 400

Current assets:
Inventory 122 000
Receivables (104 000 – 5 200) 98 800
Cash at bank 82 000
302
800
Total assets 687
200

Capital and reserves:


Ordinary share capital 200 000
Share premium account 4 000
Accumulated profit 121 300

361 300
Non-current liabilities
9% debentures 2009 150
000

Current liabilities
Payables 76 000
Taxation 62 400
Dividends payable 24 000
Accruals 13 500
175 900
Total Equity and liabilities 687
200

SOLUTION TWO

a) i) Motor Van Account


K’000 K’000
Balance b/d 140 000 Disposal 16 000
Payable 24 000 Balance c/d 148 000
164 000 164 000

ii) Motor Van Accumulated Depreciation Account


K’000 K’000
Disposal (16 000 x 20% x 4) 12 800 Balance b/d 56
800
Balance c/d 73 600 I. S. (148 000 x 20%)
29 600
86 400 86 400

iii) Motor Van Disposal Account


K’000 K’000
Motor van 16 000 Accumulated dep. 12
800
Income statement (bal. fig.) 3 400 Disposal proceeds
6 600
19 400 19 400
b) Hillside Plc
Income statement for the year ended 31st March 2006.
K’000 K’000
Sales revenue 344 600
Opening inventory 35 000
Purchases 166 100
201 100
Less: closing inventory 51 000
Cost of sales 150 100
Gross profit 194 500
Add: Gains:
Profit on disposal 3 400
Decrease in allowance for doubtful debts 300
3 700
Total income 198 200
Less: expenses:
Distribution costs (18 000 – 50) 17 950
General administration expenses (44 900 + 150) 45 050
Debenture interest 7 000
Depreciation: - Buildings 2 000
- Plant and machinery 34 800
- Motor van 29 600
136 400
Profit before taxation 61 800
Less: Income tax 18 000
Profit after taxation 43 800
Less: appropriations:
Dividends: interim – ordinary 10 000
- preference 2 800
Proposed – ordinary (5% x 220 000) 11 000
- preference 2 800
26 600
Retained profit for the year 17 200
Retained earnings brought forward (20 000)
Retained earnings carried forward (2 800)

c) Hillside Plc
Balance Sheet as at 31st March 2006.
COST DEP.
NBV
Non-current Assets: K’000 K’000
K’000
Land and buildings 130 000 32 000
98 000
Plant and machinery 348 000 120 300
227 700
Motor van 148 000 73 600 74
400
626 000 225 700
400 100
Current Assets:
Inventory 51 000
Trade receivables 48 000
Less: allowance for doubtful debts 1 200
46 800
Receivable for the motor van 6 600
Bank 5 800
Prepayment 50
110 250
Total assets
510 350

Capital and reserves:


Ordinary share capital (200 000 + 20 000) 220
000
8% preference share capital 70 000
Share premium account (60 200 – 20 000) 40
200
Accumulated profit (2 800)
327 400
Non-current liabilities:
7% debentures 100 000

Current liabilities:
Trade payables 10 000
Creditor for the motor van 24 000
Taxation 18 000
Dividends payable - preference 2 800
- ordinary 11 000
Accrual 150
82
950
Total Equity and liabilities 510
350
CHAPTER 27
ACCOUNTING CONCEPTS AND PRINCIPLES

INTRODUCTION

This chapter looks at the accounting concepts and principles which underlie
the preparation of financial statements. Some of these concepts have
already been explained in the previous chapters.

TOPICS

1. Nature and purpose of Accounting Concepts


2. Accounting concepts and conventions
3. International Accounting Standards (IAS)

LEARNING OUTCOMES

After studying this chapter, the student should be able to:

- explain the nature and purpose of accounting concepts


- Explain a number of Accounting Conventions and Concepts
- Explain International Accounting Standards (IAS)

27.1 Nature and Purpose of Accounting Conventions

Accounting conventions are principles or accepted practice which apply


generally to
transactions. Some conventions are of more relevance to some
transactions than to
others, but all have an influence in determining:

 Which assets and liabilities are recorded on a balance sheet


 How assets and liabilities are valued
 What income and expenditure is recorded in the income statement
 At what amount income and expenditure is recorded

27.2 ACCOUNTING CONCEPTS


Accounting concepts are the broad assumptions which underline the
periodic
financial accounts of business enterprises. Assumptions mean that:

- These concepts are not necessarily obvious, nor are the only
concepts which could
be used, but they the ones in use currently.

- These concepts look at why certain items are treated in specific ways
and

- Where there’s a choice of treatment, how to decide which treatment


to use.

- National legal requirements

- National accounting standards

27.3 THE CONCEPTS

The International Accounting Standards (IAS) 1 – Preparation of


Financial Statements lists a number of accounting principles and
conventions that must be followed when preparing financial
statements. The major accounting concepts that must be followed are:

a) Fair Presentation
b) Going Concern
c) Accruals
d) Consistency

a) Fair Presentation
Fair presentation requires the faithful representation of the effects
of transactions,
other events and conditions in accordance with the definitions and
recognition
criteria for assets, liabilities, income and expenses.

b) Going Concern Concept


This states that the business will continue in operational existence
for the
foreseeable future, and that there is no intention to put the
company into
liquidation, unless otherwise it is known.

c) The Accruals/Matching Concept


This states that, in computing profits, revenue earned must be
matched against the
expenditure or incurred in earning it.

d) The Consistency Concept


This states that in preparing accounts consistency should be
observed i.e. certain
items should be treated using different methods, the method
chosen should be used
consistently from one year to the next so that reasonable
conclusions can be made
on the performance of the business, for example Depreciation,
Stock Valuations.

OTHER CONCEPTS

e) Prudence Concept
This states that where alternative procedures or alternative
valuations, are possible,
the one selected should be the one which gives the most cautious
presentation of
the business financial position or results.

f) The Business Entity Concept


This concept states that a business and the owner should be treated
separately.

g) Money Measurement Concept


This states that accounts should deal only with items to which a
monetary value
can be attributed.

h) The Separate Valuation Principle


This states that in determining the amount to be attributed to an
asset or a liability
in the balance sheet, each component item of the asset or liability
must be valued
separately.

i) The Materiality Concept


This is judgemental depending on the nature and size of the
business.

A matter is material if its omission or misstatement would


reasonably influence the
decisions of a user of the accounts.
j) Substance Over Form
It can happen that the legal form of a transaction can differ from its
real substance,
where this happens accounting should show the transaction in
accordance with its
real substance e.g. goods bought on hire purchase.

k) Neutrality/Objective Concept
This states that accountants should be free from bias when
preparing financial
statements e.g. internally generated goodwill should not be
recorded in the books
because of its uncertainty as to its true value.

l) The Accounting Period Concept


This states that there must be a standard shorter period in which to
measure
performance of a business. Twelve months period is normally
adopted for this
purpose. This time interval is the accounting period.

m) The Realisation Concept


This states that profits are realized immediately goods or services
exchange hands
whether cash has been paid or not.

n) The Historical Cost Concept


This state that assets should be recorded in the accounting books
at cost i.e. price
paid to acquire it. These assets are systematically reduced by the
process called
depreciation.

27.4 INTERNATIONAL ACCOUNTING STANDARD (IAS)


These are standards which are used in preparing financial statements
in order to
provide users with an accurate picture of the profit and financial
position of the
enterprise.

CHAPTER SUMMARY
The chapter has looked at the accounting concepts and principles that
underlie the preparation of Financial Statements. Accounting concepts
influence the assets, liabilities, income and expenditure and the amounts at
which these are recorded in the balance sheet.

CHAPTER 28

INTERPRETATION OF FINAL ACCOUNTS

INTRODUCTION

Financial statements summarise the economic performance and situation of


a business. This information needs further analysis and interpretation to
deduce its meaning for the benefit of the users. Ratio Analysis is on of the
means by which financial statements are interpreted. Ratio analysis makes
uses of accounting ratios to draw relationships between sets of accounts.

TOPICS

1. Ratio analysis technique


2. Types of Ratios
3. Calculation of Ratios
4. Interpretation of statements
5. Limitation of Ratio analysis

LEARNING OUTCOMES

At the end of the chapter, the student should be able to:

- Explain the ratio analysis technique


- Calculate ratios
- interpret the ratios
- Explain the limitation of Ratio Analysis

28.1 Ratio analysis Technique


The key to obtaining meaningful information from ratio analysis is
comparison. This may involve comparing ratios over time within the same
business to establish whether things are improving or declining; and
comparing ratios between similar businesses to see whether the business
you are analysing is better or worse than average within its specific business
sector.

28.2 Types of Ratios

Interpretation of accounts makes use of five main categories of ratios, these


are:

1. Profitability ratios
2. Liquidity ratios
3. Efficiency ratios
4. Solvency ratios
5. Investors’ ratios

28.2.1 Profitability Ratios

These ratios tell us whether a business is making profits and if so whether at


an acceptable rate.

a) Return on capital employed (ROCE)


The ratio tells us what returns management has made on the resources
made available to
them before making any distributions of these returns. The higher the
return the better,
especially in high risk businesses. A very low return has a negative
impact on internal
growth sustenance of a company.

Formula:

ROCE = Profit before interest and tax x 100


Capital employed

The capital employed is taken to be the total assets less current liabilities
of the
business or share capital plus reserves plus long term liabilities. This
ratio is further
broken down into two ratios:

i) Operating profit margin on sales


Given a constant gross profit margin, the operating profit margin tells
us about the
company’s ability to control the level of its operating costs or
overheads. The higher the
operating profit margin, the better. An increasing operating profit
margin indicates
better control of costs, and a decreasing profit margin indicates worse
control of costs or
too low selling prices.

Formula:

Operating profit margin = Profit before interest and tax x 100


Sales
ii) Asset turnover
This measures the company’s ability to generate sales revenue in
relation to the size of the asset investment.

Formula:

Asset turnover = Sales


Capital employed

b) Gross profit margin


The ratio tells us about the ability of the company to consistently control
its production
costs or to manage the margin it makes on its products. The higher the
gross profit margin,
the better. An increasing gross profit margin indicates better control of
production costs or
management of margin, and a decreasing gross profit margin indicates
worse control of
production costs or too low selling prices.

Formula:
Gross profit margin = Gross profit x 100
Turnover

Where turnover = sales less sales returns


28.2.2 Liquidity Ratios

These ratios indicate how capable a business is in meeting its short term
obligations as they fall due.

a) Current ratio
The ratio, also referred to as the working capital ratio, measures
whether the business can
pay debts due within one year from assets that it expects to turn into
cash within that year.
A ratio of less than one (1) is often a course of concern, particularly if it
persists for any
length of time.

Formula:

Current ratio = Current assets


Current liabilities

b) Quick/Liquidity ratio (or Acid Test ratio)


This ratio shows the ability of the business to pay current liabilities out of
‘quick’
assets, i.e. assets which are either in cash or quickly convertible into
cash. Some assets
take time to convert into cash, for example, raw materials and other
inventory must first be
turned into final product, the product sold and then cash collected from
debtors. The quick
ratio therefore adjusts the current ratio to eliminate all assets that are not
already in cash or
near cash form. The higher the quick ratio, the better for a business. A
ratio of less than
one would start to send out danger signals on the liquidity of the
organisation.

Formula:

Quick ratio = Current assets – Inventory


Current liabilities

Note: Higher current and quick ratios are not always good indicators.
Sometimes, this may
indicate that working capital is inefficiently used. The efficiency
ratios below will
highlight this. In other words, such ratios should be within
acceptable range, i.e. not
too high and not too low.

28.2.3 Efficiency Ratios

These ratios tell us how efficiently the business is employing the resources
invested into fixed assets and working capital.

a) Inventory turnover ratio


This ratio shows on average how many times in a month the inventory is
turned over.
The higher the inventory turnover ratio, the quicker the inventory is being
turned over. It
helps us check whether we have got too much money tied up in
inventory. A decreasing
inventory turnover figure or one which is much lower than the average for
the industry may
indicate poor inventory management. On the other hand, a high turnover
ratio indicates a
good movement in inventory, thus reducing obsolescence.

Formula:

Inventory turnover = Cost of sales


Average inventory value

Alternatively the ratio can be expressed in inventory days. A higher


inventory days figure
or one which is much larger than the average for the industry may
indicate poor inventory
management.

Formula:

Inventory days = Average inventory x 365 days


Cost of sales

Note: If the average inventory cannot be calculated then the inventory at


the balance sheet
date should be used.

b) Receivables turnover
This ratio shows the average period taken by receivables to pay. It
indicates whether the
receivables are being allowed excessive credit. A decreasing trade
receivables turnover
figure or one less than the industry average may suggest general
problems with debt
collection (such as delays in invoicing or failure to screen the credit
worthiness of new
customers) or the financial position of major customers.

Formula:

Receivables turnover = Credit Sales


Trade receivables

Alternatively the ratio can be expressed in terms of Receivables


collection period. This
shows the average number of days it takes receivables to pay their
accounts. An increasing
higher figure or one more than the industry average may suggest
problems with debt
collection or the financial position of major customers.

Formula:

Receivables payment period = Trade receivables x 365 days


Credit Sales

d) Payables turnover

This ratio tells us whether a business is taking full advantage of full trade
credit available to
it. A decreasing trade payables turnover or one lower than the average
industry indicates
that you are taking longer to pay suppliers. This may not give any room
to the business to
be able to negotiate better credit terms from suppliers, cash discounts
lost and future supplies
being at risk.

Formula:
Trade payables turnover = Credit Purchases
Trade payables

Alternatively the ratio can be expressed in terms of Payables credit


period. This
shows the average number of days it takes the organisation to pay its
suppliers. An
increasing payables credit period indicates that you are taking longer to
pay your suppliers,
and a decreasing period indicates that you are paying quicker.

Formula:

Payables credit period = Trade payables x 365 days


Credit Purchases

Note: Where the purchases figure can not be calculated then the cost of
sales figure
may be used.

d) Non-current assets turnover


This ratio tells us about the non-current asset capacity. A reducing sales
value generated
from each Kwacha invested in non-current assets may indicate over
capacity or poor
performing equipment.

Formula:

Non-current assets turnover = Sales


Non-current assets

28.2.4 Solvency or Gearing Ratios

These ratios concentrate on the long-term health of a business, particularly


the effect of capital/finance structure on the business i.e. it establishes the
relationship between the proportion of Capital Employed that is borrowed
and the proportion that is provided by shareholders’ funds. The higher the
level of gearing (borrowing) the higher are the risks to a business since the
payment of interest and repayment of debts are not ‘optional’ in the same
way as dividends. However, gearing can be a financially sound part of a
business capital structure particularly if the business has strong, predictable
cash flows.
Capital gearing can be calculated in two ways:

a) Total gearing
This ratio shows the proportion of the company’s assets which are
financial by
borrowing and so gives an indication of the amount of further secured
borrowings that
might be undertaken.

Formula:

Total gearing = Preference share capital + interest bearing Loans


Assets employed (or Total capital)

b) Debt to equity ratio


This ratio shows a more pronounced change if either fixed return capital
or equity
capital changes. A ratio of 2 indicates that the debt is twice higher the
equity.

Formula:

Equity gearing = Preference share capital + interest bearing loans


Ordinary share capital + Reserves

Interest cover
This measures the ability of the business to service its debts. The ratio
answers the
question: Are the profits sufficient to be able to pay interest and other
finance obligations?
A high rate indicates that the company is in a strong position (security) as
regards payment
of interest. The measure should indicate the number of times the profits
can meet interest
obligations.

Formula:

Interest cover = Profit before interest and tax


Interest payable on loans

28.2.5 Investors’ ratios

These are the ratios used by investors to assess the performance of a


business as an investment. An investor is interested in the income earned
by the company for him/her and the return on his/her investment (i.e. the
income earned in relation to the market price of the investment).

a) Dividend per share


This measures the amount of dividend available per ordinary share. The
higher the
dividend per share, the better to the shareholder.

Formula:

Dividend per share = Dividends for ordinary shares


Number of ordinary shares

b) Dividend Cover
This ratio shows the proportion of profit on ordinary activities that is
available for
distribution to shareholders and what proportion will be retained in the
business to finance
future growth. A dividend cover of 2 times would indicate that the
company had paid 50%
of its distributable profits as dividends, and retained 50% in the business
to help finance
future operations. A decreasing dividend cover would indicate a fall in
profits but the
dividend level is maintained as in the previous years, so as to keep
shareholder expectations
satisfied.

Formula:

Dividend cover = Profit for the financial year or = Earnings per


share__
Ordinary dividend Net dividend per share

c) Dividend yield
Dividend yield is the return a shareholder is currently expecting on the
shares of a
company. On the stock market the dividend yield is normally stated gross
of tax. This
enables the yield on shares to be compared with yields on interest stocks
(company and
government stocks).

Formula:
Dividend yield = Dividend on the share for the year x 100
Current market value of the share

d) Earnings per share (EPS)


Earnings per share look at the theoretical profits that could be paid to
each ordinary
shareholder. Earnings are the net profits after tax, interest, minority
interest earnings and
dividends on other classes of shares.

Formula:

Earnings per share = Earnings


Issued ordinary shares

e) Price Earnings ratio (P/E ratio)


The price earnings ratio is the ratio of a company’s current share price to
the earnings
per share. A high P/E ratio indicates strong shareholder confidence in the
company
and its future, e.g. in profit growth, and a lower P/E ratio indicates lower
confidence.

Formula:

P/E = Current market value


Earnings per share

f) Earnings yield
Earnings yield is measured as earnings per share expressed as a
percentage of the
current share price. It indicates what the dividend yield would be if the
company paid
out all its profits as dividends and retained nothing in the business.

Formula:

Earnings yield = Earnings per share x 100


Current market value

28.3 Calculating Ratios


Calculating ratios is part of the process of ratio analysis. We shall illustrate
the calculation of the above ratios using the following example.
A public limited company quoted on the Lusaka Stock Exchange produced
the following results as at 31st December 2006:

Profit and loss account for the year ended 31st December 2006
K’000 K’000
Sales revenue 209 000
Opening inventory 37 000
Purchases 162 000
199 000
Closing inventory 42 000
157 000
Gross profit 52 000
Distribution costs 10 000
Administration expenses 13 000
Interest 2 000
25 000
Net profit 27 000
Taxation 10 000
Net profit after taxation 17 000
Dividends: Ordinary shares 6 000
Preference shares 2 000
8 000
Retained profit for the year 9 000

Balance sheet as at 31st December 2006


K’000 K’000
Non-current assets (net book value) 130
000
Current assets:
Inventory 42 000
Trade Receivables 29 000
Bank 3 000
74 000
Total assets 204 000
Capital and reserves:
Ordinary share capital (K500 shares) 35 000
8% Preference shares (K1 000 shares) 25 000
Share premium account 17 000
Revaluation reserve 10 000
Accumulated profit 31 000
118 000
Non-current liabilities
5% secured loan stock 40 000
Current liabilities
Trade payables 36 000
Taxation 10 000
46 000
204 000
The market value of each ordinary share is K2 040.

From the above details, you are required to calculate the following ratios:

a) Return on capital employed (ROCE)


b) Operating profit margin on sales
c) Gross profit Margin
d) Current ratio
e) Quick ratio
f) Inventory turnover
g) Inventory days
h) Receivables turnover ratio
i) Receivables collection period
j) Payables turnover ratio
k) Payables credit period
l) Non-current assets turnover ratio
m) Total gearing ratio
n) Debt to equity ratio
o) Interest Cover
p) Dividend per share
q) Dividend cover
r) Dividend yield
s) Earnings per share (EPS)
t) Price Earnings ratio (P/E ratio)
u) Earnings yield

SOLUTION

a) Return on capital employed

ROCE = Profit before interest and tax x 100


Capital employed

= 27 000 + 2 000 x 100 = 21.8%


133 000

b) Operating profit margin


Operating profit margin = Profit before interest and tax x 100
Sales

= 29 000 x 100 = 13.9%


209 000
c) Gross profit margin
Gross profit margin = Gross profit x 100
Turnover

= 52 000 x 100 = 24.9%


209 000

d) Current ratio
Current ratio = Current assets
Current liabilities

= 74 000 = 1.6 times


46 000

e) Quick ratio
Quick ratio = Current assets – Inventory
Current liabilities

= 74 000 – 42 000 = 0.7 times


46 000

f) Inventory turnover ratio


Inventory turnover = Cost of sales
Average inventory value

= 157 000 = 4.0 times


1
/2 (37 000 + 42 000)

g) Inventory days
Inventory days = Average inventory x 365 days
Cost of sales

= 39 500 x 365 = 92 days


157 000

h) Receivables turnover
Receivables turnover = Credit Sales
Trade receivables

= 209 000 = 7.2 times


29 000

i) Receivables collection period


Receivables collection period = Trade receivables x 365 days
Credit Sales
= 29 000 x 365 = 50.6 days
209 000

j) Payables turnover
Trade payables turnover = Credit Purchases
Trade payables

= 162 000 = 4.5 times


36 000

k) Payables credit period


Payables credit period = Trade payables x 365 days
Credit Purchases

= 36 000 x 365 = 81.1 days


162 000

l) Non-current assets turnover


Non-current assets turnover = Sales
Non-current assets

= 209 000 = 1.6 times


130 000

m) Total gearing
Total gearing = Preference share capital + interest bearing loans x 100
Assets employed (or Total capital)

= 25 000 + 40 000 x 100 = 41.1%


158 000
n) Debt to equity ratio
Equity gearing = Preference share capital + interest bearing loans x 100
Ordinary share capital + reserves

= 25 000 + 40 000 x 100 = 69 .9%


118 000 – 25 000

o) Interest cover
Interest cover = Profit before interest and tax
Interest payable on loans

= 29 000 = 14.5 times


2 000
p) Dividend per share
Dividend per share = Dividends for ordinary shares
Number of ordinary shares

= 6 000 = K86 per share


70 000

q) Dividend Cover
Dividend cover = Profit for the financial year or = Earnings per
share
Ordinary dividend Net dividend per share

= 17 000 – 2 000 = 2.5 times


6 000

r) Dividend yield
Dividend yield = Dividend on the share for the year x 100
Current market value of the share

= 86 x 100 = 4.2%
2 040

s) Earnings per share


Earnings per share = Earnings
Issued ordinary shares

= 15 000 = K214 per share


70 000

t) Price Earnings ratio


P/E = Current market value
Earnings per share

= 2 040 = 9.5
214
u) Earnings yield
Earnings yield = Earnings per share x 100
Current market value

= 214 x 100 = 10.5%


2 040
Interpretation of Financial Statements
The basis of interpretation is the ability to make use of the information
provided by the
ratios. Ratios are only a means to an end; they are not an end in
themselves. By comparing relationships between figures, ratios merely
highlight trends in the accounts and so one should be in position to comment
on the reported trends i.e. be able to define the reasons for the trends
disclosed. Do not hesitate to make obvious comments such as ‘the gross
profit percentage has increased from last year’ as this entails stating that the
business is more profitable.

Example:
The following information has been extracted from the published accounts of
Gideon Plc.

Extracts from the profit and loss accounts


2004 2003
K’000 K’000
Sales revenue 22 400 19 500
Cost of sales 16 920 13 650
Net profit before tax 930 640

This is after charging:


Depreciation 720 560
Debenture interest 160 120
Audit fees 24 20

Balance sheet as at 31st December


2004 2003
K’000 K’000
Non-current assets 3 700 2 860
Current assets:
Inventory 1 280 980
Trade receivables 2 460 2 160
Cash 160 240
3 900 3 380

Total assets 7 600 6 240

Capital and reserves:


Ordinary share capital 1 600 1 600
Reserves 2 490 1 750
4 090 3 350
Long-term liabilities:
10% debentures 1 600 1 200
Current liabilities:
Bank overdraft 220 160
Trade payables 1 500 1 380
Taxation 190 150
1 910 1 690

Total capital and liabilities 7 600 6 240

The latest industry average ratios are:

Current ratio 1.90


Quick ratio 1.27
Receivables turnover 52 days
Payables turnover 49 days
Inventory turnover 18.3 times

Required:

a) Calculate comparable ratios (to two decimal places where appropriate) for
Gideon Plc for the years 2003 and 2004.

b) Comment on the liquidity and efficiency ratios of Gideon Plc, comparing


the results
against the two years and against the industry.

SOLUTION

a)

i) Year 2003 2004

Current ratio 3 380 000


/1 690 000 3 900 000
/1 910
000
= 2.0 = 2.04

Quick ratio /1 690 000


3 380 000 – 980 000 3 900 000 – 1 280 000
/1 910
000
= 1.42 = 1.37

Debtors turnover /19 500 000 x 365


2 1600 000
/22 400 000 x
2 460 000

365

= 40 days = 40 days

Creditors turnover /13 650 000 x 365


1 380 000
/16 920
1 500 000

000 x 365

= 37 days = 32 days

Stock turnover /980 000


13 650 000 16 920 000
/1 280
000

= 13.9 times = 13.2


times

ii) Comments:

Liquidity ratios:

 The current ratio has improved slightly over the year and is
marginally higher than the industry average.

The ratio is in line with what is generally regarded as satisfactory


(2:1)

 The quick ratio has declined marginally but is still better than the
industry average.

This suggests that Austin Plc has no short term liquidity problems
and should have
no difficulty in paying its debts as they become due.

Efficiency ratios:

 Receivables turnover – receivables as a proportion of sales is


unchanged from 2003 and are considerably lower than the industry
average.
Consequently, there is probably little opportunity to reduce this
further and there
may be pressure in the future from customers to increase the
period of credit given.

 Payables turnover – the period of credit taken from suppliers has


fallen from 37 days’ purchases to 32 days’ and is much lower than
the industry average.

With this it may be possible to finance any additional receivables


by negotiating
better credit terms from suppliers.

 Inventory turnover has fallen slightly and is much lower than the
industry average.

This may partly reflect stocking up ahead of a significant increase


in sales.
Alternatively, there is some danger that the inventory could
contain certain
absolute items that may require writing off. The relative increase
in the level of
inventory has been financed by an increased overdraft which
may reduce if
inventory levels can be brought down.

Limitations of Ratio Analysis

The limitations of ratio analysis can be summarised as follows:

a) Companies use different accounting policies and so can be used to


manipulate company results
b) Availability of comparable information is quite difficult because no two
businesses are identical
c) Use of historical/out of date information may not be useful for future
decision making
d) Ratios are not definitive – they are only a guide
e) Interpretation needs careful analysis and should not be considered in
isolation. Some items in the financial statements are of vital importance
in assessing the position of a business.
f) It is a subjective exercise
g) A number of ratios are based on balance sheet figures as at a particular
point in time and so they may not be representative of the financial
position for the whole year.
CHAPTER SUMMARY

The chapter has looked at the Accounting Ratios used in interpreting the
financial performance and position of companies. The four main categories
of accounting ratios are: Profitability, Liquidity, Efficiency, Solvency and
Gearing. Calculating one ratio is not an end in itself, but should help one
draw conclusions about the company. You should also remember that ratio
analysis has its own draw backs such as being subjective and being based on
historical information.

Overall, ratios are very useful in interpreting the financial performance and
position of companies beyond the traditional income statement and balance
sheet. When used appropriately they are good tools in predicting the future
outcome of the company.

EXERCISES

QUESTION ONE
The following are the summarised financial statements for X Ltd for 2005 and
2006:

Summarised income statements


2005 2006
K’000 K’000
Turnover 243 150 291 950
Operating profit 8 619 10 335
Interest payable 992 992
Profit before taxation 7 627 9 343
Taxation 2 867 3 513
Profit after tax 4 760 5 830
Dividends 1 120 1 200
Retained profit for the year 3 640 4 630
Retained profit b/f 11 770 15 410
Retained profit c/f 15 410 20 040

Summarised balance sheets


2005 2006
K’000 K’000
Non current assets 2 498 6 350
Current assets:
Inventory 20 073 25 228
Receivables 20 105 21 685
Bank 6 046 2 895
Total assets 48 722 56 158

Capital and reserves:


Ordinary share capital of K250 per share 4 960 4 960
Retained earnings 15 410 20 040
Non current liabilities:
10% debentures 9 920 9 920
Current liabilities:
Trade payables 16 302 18 615
Taxation 1 237 1 630
Dividends payable 893 993
Total equity and liabilities 48 722 56 158

Required:

a) Calculate for each year the following ratios:


i) Return on capital employed
ii) Non current assets turnover
iii) Current ratio
iv) Quick ratio
v) Earning per share
vi) Dividend cover

b) Comment briefly on the changes in the ratios calculated in (a) above


between the two years.
QUESTION TWO

The following ratios were calculated from the financial statements of H Ltd
and G Ltd:

H Ltd G Ltd
Profitability
Return on capital employed 27.5% 15.5%
Gross profit margin 34% 28%
Net profit/sales ratio 19% 15%

Gearing
Total gearing 29.5% 13.5%
Interest cover 6 times 9 times

Liquidity
Current ratio 1.0 1.4
Quick ratio 0.6 1.0
Efficiency
Receivables collection period 63 days 250 days
Inventory turnover 4.5 times 3 times

Required: comment of the financial performance and position of H Ltd and G


Ltd.

SOLUTIONS TO EXERCISES

SOLUTION ONE

a)
2005 2006

i) ROCE = 8 619 x 100 10 335 x


100
30 290 34 920

= 28.5% 29.6%

ii) Non current assets turnover = 243 150 291 950


2 498 6 350

= 97.3 times 46 times

iii) Current ratio = 46 224 49 808


18 432 21 238

= 2.5 2.3

iv) Quick ratio = 46 224 – 20 073 49 808 – 25 228


18 432 21 238

= 1.4 1.2

v) Earnings per share = 4 760 5 830


19 840 19 840

= K239.9 per share K293.9


per share

vi) Dividends cover = 4 760 5 830


1 120 1 200

= 4.3 times 4.9 times

b) Return on capital employed has increased marginally by about 4%,


indicating that profits
have increased marginally. The Non current assets turnover has
drastically reduced. This
reduction could be as a result of the high investment in non current
assets. This investment
would in future help to increase profitability and turnover.
The current ratio has decreased though still at an acceptable level. The
quick ratio has also
decreased though also still above the desirable level of 1. The company
should however
observe this decline in the liquidity position to ensure that it does not
persist for a long time.

The earnings per share have increased by K54 per share. This is due to
the improved profits
in 2006. The dividends cover has improved. This is as a result of the
decrease in profits
paid out as dividends which is not proportional to the increase in profits.

SOLUTION TWO

Comments on the financial performance and position of H Ltd and G Ltd

Profitability
H Ltd has performed better than G Ltd both in terms of profitability to capital
employed and profitability to sales.

Gearing
H Ltd is highly geared in comparison to G Ltd. G Ltd has a better interest
cover that H Ltd. However, the interest cover for H Ltd of 6 times is quite
good despite the company having a high gearing ratio. This might indicate
that H Ltd used the funds borrowed to acquired profit generating assets.

Liquidity
G Ltd shows better current and quick ratios than H Ltd, indicating a better
liquidity position. A comparison with the industry average would help to
identify as to how poor or good the ratios of the two companies are.

Efficiency
H Ltd has better receivables collection period and inventory turnover than G
Ltd. The receivables collection period is too long for G Ltd which might
indicate that G Ltd has a poor credit control policy.

Conclusion
Provided that the two companies are in the same industry and are of the
same size, then it can be concluded that H Ltd’s finance performance and
position is better than that of G Ltd.
CHAPTER 29

MANUFACTURING ACCOUNTS

INTRODUCTION

In this chapter we shall look at the preparation of financial statements for


manufacturing organisations. A manufacturing organisation is one that
manufactures (produces) goods for sale. This could either be a sole trader, a
partnership or a company.

TOPICS

1. Manufacturing account
2. Work in progress
3. Transfers of goods at market value
4. Provision for unrealized profits

LEARNING OUTCOMES

At the end of the chapter, the student should be able to:

- Explain the purpose of a Manufacturing Account


- Explain the treatment of opening and closing Work In Progress in
Manufacturing Accounts
- Calculate the profit or loss on manufacturing
- Account for provision for unrealised profits on finished goods.
- Prepare Manufacturing Account, Income Statement and Balance Sheet for
sole traders, partnerships and companies.

30.1 Manufacturing Account


A Manufacturing Account is an account that collects together all the costs
involved in production to determine the production cost of goods completed.
To ascertain the production cost of the goods completed, charge all the
elements of production cost (i.e. direct materials, direct labour, direct
expenses and production overheads) to the Manufacturing Account.

Direct materials, labour, and expenses are all those costs involved in
production that are traceable to units of goods produced. The total of all
direct costs incurred in a year is called the prime cost. Production
overheads are all those costs incurred in a factory, but cannot be easily
traced to the units of goods produced.

At the end of the year, the cost of goods manufactured is then transferred,
as the figure equivalent to purchases, to the income statement.

30.2 Opening and closing work in progress


The goods partly completed at the start and end of the accounting period are
respectively known as opening work in progress and closing work in
progress. The value of the opening work in progress is added to the total
production cost for the period while the value of the closing work in progress
is deducted in arriving at the production cost of goods completed.

Example:
Joshua Muleya is a manufacturer. His Trial Balance as at 31st December 2006
is as follows:
Dr Cr
K’000 K’000
Capital 274 912
Drawings 17 120
Premises 80 000
Machinery 65 000
Office equipment 22 000
Delivery van expenses 5 000
Lighting and heating: Factory 5 718
Office 2 220
Manufacturing wages 90 940
General expenses: Office 7 632
Factory 11 280
Purchases of raw materials 78 108
Salesmen commission 15 720
Rent: Factory 9 600
Office 4 400
Office salaries 12 570
Receivables and Payables 56 740 38 900
Bank 26 674
Sales revenue 273 000
Inventory at 1st January 2006:
Raw materials 15 130
Finished goods 48 500
Work in progress 10 460 ______
586 812 586 812

Additional information:

1. Inventory at 31st December 2006 were:

Raw materials K18 100 000


Finished goods K49 560 000
Work in progress K12 840 000

2. Ignore depreciation of fixed assets.

Required: From the above details, prepare the Manufacturing Account, the
Income Statement for the year ended 31st December 2006 and a Balance
Sheet as at that date.

SOLUTION:

Joshua Muleya
Manufacturing account for the year ended 31st December 2006
K’000 K’000
Raw materials:
Opening inventory 17 130
Purchases 78 108
Total inventory available 95 238
Less: closing inventory 18 100
Cost of raw materials consumed 77 138
Direct labour:
Wages 90 940
Prime cost 168 078
Add: production overheads:
Lighting and heating 5 718
General expenses 11 280
Rent 9 600
26 598
194 676
Add: opening work in progress 10 460
205 136
Less: closing work in progress 12 840
Production cost 192 296

Joshua Muleya
Income Statement for the year ended 31st December 2006
K’000 K’000
Sales revenue 273 000
Opening inventory 48 500
Production cost 192 296
240 796
Less: closing inventory 49 560
Cost of sales 191 236
Gross profit 81 764
Less expenses:
Administrative expenses 5 000
Lighting and heating 2 220
General expenses 7 632
Rent 4 400
Office salaries 12 570
Salesmen's commission 15 720
Total expenses 47 542
Net profit 34 222

Joshua Muleya
Balance sheet as at 31st December 2006
Cost Dep. Value
Non-current assets: K’000 K’000
K’000
Premises 80 000 - 80
000
Machinery 65 000 - 65
000
Office equipment 22 000 - 22
000
167 000 - 167
000
Current assets:
Inventory: - Raw materials 18 100
- Work in progress 12 840
- Finished goods 49 560
Receivables 56 740
Cash at bank 26 674
163 914
Total assets 330
914

Capital and liabilities:


Capital 274 912
Add: net profit 34 222
309 134
Less: drawings 17 120

292 014
Current liabilities:
Payables 38 900
Total capital and liabilities 330
914

30.3 Transfer of goods at market value


In manufacturing organisations, it is usual to allocate the gross profit earned
by the business between the factory and the selling department so that the
actual profit earned from mere selling can be revealed. This split may also
allow the production manager to earn a commission. To achieve this, the
finished goods are transferred from the factory to the selling department
with a profit element (i.e. profit loading).

When goods are transferred at market value, there will be a balance in the
manufacturing account representing a profit or a loss arising from
manufacturing the goods instead of buying them as finished products. To
close the manufacturing account, the profit or loss should be transferred to
the income statement.
Example:

The following information has been extracted from the books of Meleki
manufacturing company for the year to 30th September 2006:
K'000
Deprecation for the year to 30th September 2006:
Factory equipment 21 000
Office equipment 12 000
Direct wages 120 000
Factory: insurance 3 000
Heat 45 000
Indirect materials 15 000
Power 60 000
Salaries 75 000
Finished goods at 1 October 2005
st
72 000
Office: electricity 55 000
General expenses 27 000
Postage and telephones 8 700
Salaries 210 000
Raw material purchases 600 000
Carriage inwards on raw materials 6 000
Raw material inventory at 1st October 2005 24 000
Advertising 6 000
Sales revenue 1 537 200
Work in progress at 1 October 2005
st
36 000

Notes:

1. At 30th September 2006, the following were on hand:


K'000
Raw materials 30 000
Work in progress 27 000
Finished goods 90 000

2. At 30th September 2006, there was an accrual for advertising of K3 000


000, and it was estimated that K4 500 000 had been paid in advance for
electricity. These items had not been included in the books of account for
the year to 30th September 2006.
3. Goods produced during the year are to be transferred to the Income
Statement at a market value of K978 000 000.

4. For the purpose of inventory valuation, finished goods have been valued
at cost.

Required: Prepare in the vertical columnar form, the company's


Manufacturing Account, Income Statement for the year to 30th September
2006.

SOLUTION:

Meleki Manufacturing Company


Manufacturing account for the year ended 30th September 2006
K’000 K’000 K’000
Raw materials:
Opening inventory 24 000
Purchases 600 000
Add: carriage inwards 6 000
606 000
Total inventory available 630 000
Less: closing inventory 30 000
Cost of raw materials consumed 600 000
Direct labour:
Wages 120 000
Prime cost 720 000
Add: production overheads:
Depreciation - factory equipment 21 000
Insurance 3 000
Heat 45 000
Indirect materials 15 000
Power 60 000
Salaries 75 000
219 000
939 000
Add: opening work in progress 36 000
975 000
Less: closing work in progress 27 000
Production cost 948 000

Market value 978 000


Less: production cost 948 000
Manufacturing profit 30 000

Meleki Manufacturing Company


Income Statement for the year ended 30th September 2006
K’000 K’000

Sales revenue 1 537 200


Opening inventory 72 000
Market value 978 000
1 050 000
Less: closing inventory 90 000
Cost of sales 960 000
Gross profit on trading 577 200
Add: profit on manufacturing 30 000
607 700
Less expenses:
Advertising 6 000
Add: accrual 3 000
9 000
Depreciation - office equipment 12 000
Electricity 45 000
Less: prepayment 4 500
40 500
General expenses 27 000
Postage and telephones 8 700
Salaries 210 000
Total expenses 307 200
Net profit 300 000
30.4 Allowance for unrealised profit
In cases where goods are transferred at market price to the selling
department, there may be some of these goods that remain unsold at the
end of the year. If the inventory of such goods is valued at the transfer price
or market price, then in order to arrive at the true profit, it is necessary to
provide in the accounts for unrealised profits included in the valuation of
inventories. The allowance for Unrealised Profit Account is opened to account
for such profits. This account is prepared in the same manner as the
Allowance for doubtful debts Account, i.e. an increase in the account balance
is treated as an expense, while a decrease is treated as a gain in the income
statement. The balance on the Provision for Unrealised Profit Account is at
the end of the year deducted from the closing inventory of finished goods in
the Balance Sheet.

Example:

The following balances as at 31st December 2006 have been extracted from
the books of Simon Choolwe, a manufacturer:
K'000
Inventory at 1 January 2006:
st

Raw materials 7 000


Work in progress 5 000
Finished goods 6 900
Purchase of raw materials 38 000
Direct labour 28 000
Factory overheads:
Variable 16 000
Fixed 9 000
Administrative expenses:
Rent and rates 19 000
Heat and light 6 000
Stationery and postage 2 000
Staff salaries 19 380
Sales revenue 192 000
Plant and machinery:
At cost 30 000
Provisions for depreciation 12 000
Motor vehicles (for sales deliveries):
At cost 16 000
Provisions for depreciation 4 000
Payables 5 500
Receivables 28 000
Drawings 11 500
Balance at bank (Dr) 16 600
Capital at 1st January 2006 48 000
Allowance for unrealised profit at 1st January 2006 1 380
Motor vehicles running costs 4 500

Additional information:

1. Inventories at 31st December 2006, were as follows:


K'000
Raw materials 9 000
Work in progress 8 000
Finished goods 10 350

2. The factory output is transferred to the income statement at factory cost


plus 25% for factory profit. The finished goods inventory is valued on the
basis of amounts transferred to the debit of the income statement.

3. Depreciation is provided annually at the following percentages of the


original costs of fixed assets held at the end of each financial year:
Plant and machinery 10%
Motor vehicles 25%

4. Amounts accrued due on 31st December 2006 for direct labour amounted
to K3 000 000 and rent and rates prepaid at 31st December 2006
amounted to K2 000 000.

Required:
Prepare the Manufacturing Account, Income Statement for the year ended
31st December 2006, and a Balance Sheet as at that date.

SOLUTION:
Simon Choolwe
Manufacturing account for the year ended 31st December 2006
K’000 K’000
Raw materials:
Opening inventory 7 000
Purchases 38 000
Total inventory available 45 000
Less: closing inventory 9 000
Cost of raw materials consumed 36 000
Direct labour:
Wages 28 000
Add: wages accrued 3 000
31 000
Prime cost 67 000
Add: factory overheads:
Variable 16 000
Fixed 9 000
Depreciation - plant and machinery 3 000
28 000
95 000
Add: opening work in progress 5 000
100 000
Less: closing work in progress 8 000
Factory cost 92 000

Market value 115 000


Less: factory cost 92 000
Manufacturing profit 23 000

Simon Choolwe
Income Statement for the year ended 31st December 2006
K’000 K’000 K’000
Sales revenue 192 000
Opening inventory 6 900
Market value 115 000
121 900
Less: closing inventory 10 350
Cost of sales 111 550
Gross profit on trading 80 450
Add: profit on manufacturing 23 000
103 450
Less expenses:
Rent and rates 19 000
Less: prepayment 2 000 17 000
Provision for unrealised profit (w1) 690
Heat and light 6 000
Stationery and postage 2 000
Staff salaries 19 380
Depreciation - motor vehicles 4 000
Motor vehicle running costs 4 500
Total expenses 53 570
Net profit 49 880

Balance sheet as at 31st December 2006


Cost Dep. Value
Non current assets: K’000 K’000
K’000
Plant and machinery 30 000 15 000 15
000
Motor vehicles 16 000 8 000 8
000
46 000 23 000
23 000
Current assets:
Inventories: - raw materials 9 000
- work in progress 8 000
- finished goods 10 350
less: allowance for unrealised profit 2 070
8 280
Receivables 28 000
Cash at bank 16 600
Rent and rates prepaid 2 000
71 880
94 880
Capital account
Balance on 1st January 2006 48 000
Add: net profit 49 880
97 880
Less: drawings 11 500

86 380
Current liabilities:
Payables 5 500
Direct labour accrued 3 000 8
500
94 880
Workings
1.
Allowance for Unrealised Profit Account
___________________________________________________________________
K'000 K'000
Balance c/d 2 070 Balance b/d 1
380
Income Statement
690
2 070 2 070

Note: Closing balance amount = K10 350 000 x /125 = K2 070 000
25
EXERCISES

QUESTION ONE
The following is a trial balance for J Mutinta as at 31st December 2006:
Dr Cr
K’000 K’000
Capital 59 360
Drawings 4 000
Productive machinery (cost K56m) 46 000
Accounting machinery (cost K4m) 2 400
Royalties 1 400
Carriage inwards on raw materials 700
Purchases of raw materials 74 000
Inventory at 1st January 2006:
Raw materials 4 200
Finished goods 7 780
Work in progress 2 700
Wages (direct K36m, factory K29m) 65 000
General factory expenses 6 200
Lighting 1 500
Factory power 2 740
Administrative salaries 8 800
Salesmen's salaries 6 000
Commission on sales 2 300
Rent 2 400
Insurance 840
General administrative expenses 2 680
Bank charges 460
Discount allowed 960
Carriage outwards 1 180
Receivables 28 460
Payables 25 000
Bank 11 360
Cash 300
Sales revenue 200 000
284 360 284 360

Notes at 31st December 2004:

1. Inventory of raw materials K4 800 000, Inventory of finished goods K8 000


000, Work In Progress K3 000 000.
2. Lighting, rent and insurance are to be apportioned: factory 5/6ths,
administration 1/6th.
3. Depreciation on productive machinery and accounting machinery at 10%
per annum on cost.

Required:
Prepare the Manufacturing Account, Income Statement for the year ended
31st December 2006 and a Balance sheet as at that date.

QUESTION TWO

The following trial balance was extracted from the books of Panuka Ltd after
completion of the manufacturing account for the year ended 31st March
2003.

Dr Cr
K’000 K’000
Ordinary share capital 40 000
7% preference share capital 20 000
Sales revenue 200 000
Production cost 106 400
Receivables 21 400
Payables 10 000
Inventory:
Finished goods (1st April 2002) 52 000
Raw materials (31st March 2003) 11 000
WIP (31st March 2003) 6 200
Premises at cost 35 000
Accumulated depreciation on buildings 2 000
Plant and machinery at cost 12 000
Depreciation on plant and machinery:
Accumulated provision 4 800
Charge for the year 1 200
Retained profit (1st April 2002) 27 080
Bank 8 528
Rent 3 500
General expenses 3 060
Distribution costs 21 316
Bad debts 400
Administrative salaries 21 615
Advertising expenses 5 590
Preference divided paid 700
Suspense 3 629
308 709 308 709
Additional information:

1. Closing inventory of finished goods on 31st March 2003 was valued at K46
600 000.

2. Depreciation on buildings is K400 000.

3. Included in rent paid is a 16 months rental of K1 680 000 payable as from


1st July 2002.
4. Provision for Income tax on profits for the year of K15 000 000 is to be
made.

5. The directors decided to provide for a 10% dividend on ordinary shares


and a final dividend on preference shares.

6. Investigations on the causes of the difference in books revealed the


following errors. These errors had no effect on the production cost:

i) A debit balance of K4 600 000 owing by a customer was omitted in


the trial
balance.

ii) The total of the discounts received column in the cash book, K120
000, had not
been posted to the nominal ledger.

iii) A payment for administrative salaries, K1 323 000, was posted to


the general
ledger as K1 332 000.

iv) A sales invoice for K8 000 000 had been omitted from the sales
account.

v) A cheque issued for general expenses for K50 000 had been
posted to the debit
of the bank account.

Required:
a) Show the journal entries to correct the errors in six (6) above. Narratives
are not
required.
(5 marks)
b) Open up the suspense account to clear the difference in books.
(3 marks)

c) Taking into account the corrected errors, you are to prepare:

i) Panuka Ltd’s Income Statement for the year ended 31st March
2003.
(12 marks)
ii) Panuka Ltd’s Balance Sheet as at 31st March 2003.
(11 marks)

(NATech June 2004)

SOLUTIONS TO EXERCISES

SOLUTION ONE

J Mutinta
Manufacturing account for the year ended 31st December 2006
K’000 K’000
Raw materials:
Opening inventory 4 200
Purchases 74 000
Carriage inwards 700
Total inventory available 78 900
Less: closing inventory 4 800
Cost of raw materials consumed 74 100
Direct labour:
Wages 36 000
Direct expenses:
Royalties 1 400
Prime cost 111 500
Add: factory overheads:
Indirect wages 29 000
General factory expenses 6 200
Lighting (5/6 x 1 500) 1 250
Factory power 2 740
Rent (5/6 x 2 400) 2 000
Insurance ( /6 x 840)
5
700
Depreciation on productive machinery (10% x 56) 5 600
47 490
158 990
Add: opening work in progress 2 700
161 690
Less: closing work in progress 3 000
Production cost 158 690

J Mutinta
Income Statement for the year ended 31st December 2006
K’000 K’000 K’000
Sales revenue 200 000
Opening inventory 7 780
Market value 158 690
166 470
Less: closing inventory 8 000
Cost of sales 158 470
Gross profit 41 530
Less expenses:
Lighting (1/6 x 1 500) 250
Administrative salaries 8 800
Salesmen’s salaries 6 000
Commission on sales 2 300
Rent (1/6 x 2 400) 400
Insurance ( /6 x 840)
1
140
General administrative expenses 2 680
Bank charges 460
Discount allowed 960
Carriage outwards 1 180
Depreciation on accounting machine (10% x 4m) 400
Total expenses 23 570
Net profit 17 960

J Mutinta
Balance sheet as at 31st December 2006
Cost Dep. Value
Non current assets: K’000 K’000
K’000
Productive machinery 56 000 15 600
40 400
Accounting machinery 4 000 2 000
2 000
60 000 17 600
42 400
Current assets:
Inventories: - raw materials 4 800
- work in progress 3 000
- finished goods 8 000 15 800
Receivables 28 460
Cash at bank 11 360
Cash in hand 300
55 920
Total assets 98
320
Capital account
Balance on 1st January 2006 59 360
Add: net profit 17 960
77 320
Less: drawings 4 000 73
320
Current liabilities:
Payables 25 000
Total capital and liabilities 98
320

SOLUTION TWO

a) Journal entries

K’000 K’000
i) Receivables in Trial balance 4 600
Suspense 4 600

ii) Suspense 120


Discount Received 120

iii) Suspense 9
Administrative salaries 9

iv) Suspense 8 000


Sales revenue 8 000

v) Suspense 100
Bank 100

b) Suspense Account

K’000
K’000
Discount Received 120 Balance b/d
3 629
Administrative salaries 9 Receivables in Trial balance
4 600
Sales revenue 8 000
Bank 100
8 229 8
229
c)

(i) Panuka Ltd Income Statement for the year ended 31st March
2003.

K’000 K’000
Sales revenue (200 000 + 8 000) 208 000
Opening inventory 52 000
Production cost 106 400
158 400
Less: closing inventory 46 600
Cost of sales 111 800
Gross profit 96 200
Add: Gains:
Discount received 120
Total income 96 320
Less: Expenses:
Rent [3 500 – (1680 ÷ 16 x 7 months)] 2 765
General expenses 3 060
Distribution costs 21 316
Bad debts 400
Administrative salaries (21 615 – 9) 21 606
Advertising expenses 5 590
Depreciation on Buildings 400
55 137
Profit before taxation 41 183
Less: Income tax 15 000
Profit after taxation 26 183
Dividends
Preference -paid 700
- proposed 700
Ordinary – proposed 4 000
5 400
Retained profit for the year 20 783
Add: Retained profit brought forward 17 080
Retained profit carried forward 37 863

(ii) Panuka Ltd Balance Sheet as at 31st March 2003.

COST DEP.
NBV
Non current Assets: K’000 K’000
K’000
Premises 35 000 2 400 32
600
Plant and machinery 12 000 6 000
6 000
47 000 8 400
38 600
Current Assets:
Inventory:
Finished goods 46 600
Raw materials 11 000
W-I-P 6 200
63 800
Receivables (21 400 + 4 600) 26 000
Bank (8 528 – 100) 8 428
Rent prepaid 735
98 963
Total assets 137
563

Capital and reserves:


Ordinary share capital 40 000
7% preference share capital 20
000
Accumulated profit 47
863
107 863
Current liabilities:
Payables 10 000
Taxation 15 000
Dividend payable: - preference 700
- ordinary 4 000
29 700
Total capital and liabilities 137
563

TERMINOLOGY
1. Assets: A resource or right under the entity’s control acquired as a result of a past
transaction or event, and the business expects to derive economic benefits as a result of
that control.
Items of possession and have value. The owner has a right of claim to the value of the
assets. An example would be inventory, trade receivables (debtors), cash, motor vehicles,
etc

2. Liability: A legal obligation to transfer out economic benefits as a result of a past


transaction or event.

A legal obligation to pay money or in kind to somebody else. An example would be a bank
loan, trade payables account balance, electricity bill still outstanding, etc.

3. A customer: someone we sell trading goods to on credit. Consequently he owes us


money. An account for a customer is called a trade receivables account.

4. A supplier: someone we buy trading goods from on credit. Consequently we owe him
money. An account for a supplier is called a trade payables account.

5. Cash transactions: business activities in which money is immediately given in


exchange for goods or services.

6. Credit transactions: Business trading activities in which goods or services are provided
without any immediate exchange of cash. The name of the outside entity is always
mentioned in a credit transaction because it is implied that actual cash will be paid or
received in future.

7. Cash can refer to amounts paid in notes and coins or by cheque, debit card (ATM access
card) and credit card.

8. An item of income is a source of revenue, which comes in the form of cash. An example
would be sales, rent receivable, commission received, etc.

9. An expense is an item of expenditure and cash is paid out as a result of it. An example
would be electricity paid, purchases of goods for resale, rent payable, carriage inwards,
carriage outwards, etc

10. A gain is a form of income. It is extra funds generated after undertaking some business
transaction. An example would be cash proceeds of a sale of a fixed asset above its book
value, discount received, etc.

11. A loss is an amount that reduces owner’s wealth and arises from operating activities. It
is an item of expenditure that could not generate a corresponding cash receipt. An
example would be discount received, bad debts, etc.

12. Non current assets: Items of value, which the business intends to use operationally for
more than one accounting period (usually 1 year). They are not intended to be re-sold.
E.g. Buildings, motor vehicles, machinery, etc

13. Current assets: Assets that are continuously changing, kept up-to-date, kept current.
E.g. stock, debtors, cash,etc

14. Long term liabilities: amounts that we owe and repayment will be in more that one
accounting period, e.g. bank loans, debentures, finance leases, etc

15. Current Liabilities: amounts we owe others and payment for them will be made within
the next 12 months (one accounting period).
16. Owners’ wealth: This is the amount the owner contributed from his private resources
into the business, plus any profits he has made. This is sometimes called owners’ equity
or capital

17. Drawings: Amounts the owner of the business withdraws from the business to go and
use in his private capacity at home. It is a reduction in the owners’ wealth.

18. Recognition: This term refers to inclusion in the statement totals of an element in one
of the financial statements. This is achieved by journalizing the entry either to add to or
deduct from the existing balance. For example, the value of a car just bought would be
added to the balance of motor vehicles in the balance sheet. Reducing a statement total
is referred to as de-recognition, e.g. When part of the loan is settled, the loan balance in
the balance sheet would be reduced.

19. Elements of financial statements: This term refers to the major classifications adopted
in the financial statements into which all transactions would fall. These are assets,
liabilities, contributions, distributions, gains, losses, income, expenses and owner’s
wealth.

20. Contributions: Refers to amounts the owner of the business inject into it as capital from
his private recourses, e.g. new share capital.

21. Distributions: Refers to amounts of resources the owner withdraws from the business
for private use, e.g. drawings, dividends.