Intermediate Financial Accounting

(FA1 & FA2)

Student Hands’ on Handbook

By: Lecturer
Louis Kalusa, (PhD Candidate),
ACMA, CGMA, ZICALIC, MSC, MBA, BAC, DPSFM, ATD, CIA

2020

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INTERMEDIATE FINANCIAL ACCOUNTING
Learning outcomes

On successful completion of Intermediate Financial Accounting, students should be able to:

1. Describe the context and purpose of financial accounting

2. Apply double-entry bookkeeping techniques to record financial transactions and to maintain
accounting records
3. Identify and correct omissions and errors in accounting records
4. Make appropriate end of year adjustments to financial records
5. Prepare financial statements for sole traders, partnerships and limited companies and non-
profit making organisations
6. Describe features of public sector accounting
7. Describe the main accounting modules in a computerised accounting system
Topic Weighting
Context and purpose of financial accounting 5%
Financial transactions and accounting records 15%
Omissions and errors 15%
Year-end adjustments 15%
Financial statements 25%
Public Sector Accounting 15%
Computerised Accounting system 10%

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 TABLE OF CONTENTS
CHAPTER 1
INTRODUCTION TO FINANCIAL ACCOUNTING
1.1. What is financial accounting?
1.2. Types of business entities
1.3. Description of users of financial accounting information.
1.4. What makes accounting information to be useful?
1.5. The scope and objectives of financial accounting
CHAPTER 2
INTRODUCTION TO FINANCIAL STATEMENTS
2.1. Financial statements
2.2. Assets in the balance sheet
2.3. Liabilities in the balance sheet
2.4. Income and expenditure
CHAPTER 3
REVENUE AND CAPITAL EXPENDITURE
3.1. What is capital expenditure?
3.2. Examples of capital expenditure
3.3. What is Revenue expenditure?
3.4. Examples of revenue expenditure
3.5. Treatment of capital and revenue expenditure in financial statements
3.6. Capital income with examples
3.7. Revenue income with examples
3.8. Treatment of capital and revenue income in financial statements
3.9. Explain why some expenditure is part capital & part revenue.
CHAPTER 4
DOCUMENTATION
4.1. Recording of Business transactions
4.2. Importance of documentations

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4.3. Accounting use of Documents
4.4. Debit Note

CHAPTER 5
RULE OF DOUBLE ENTRY AND THE JOURNAL
5.1. Meaning of Double entry
5.2. Meaning of DEBIT and CREDIT
5.2. Accounting Concepts
5.3. Accounting for Journal
CHAPTER 6
PREPARING BOOKS OF PRIME ENTRY
6.1. Preparing Sales Day Book
6.2. Preparing Sales Returns Day Book
6.3. Preparing Purchases Day Book
6.4. Preparing Purchases Returns Day Book
CHAPTER 7
BOOKS OF PRIME ENTRY - CASH TRANSACTIONS
7.1. Analytical cash book
7.2. Cash Account –Receipts and Payments
7.3. Bank Account –Receipts and Payments
CHAPTER 8
THE ANALYTICAL PETTY CASH BOOK
8.1. What is petty cash book?
8.2. The purpose of petty cash book
8.3. What is to be paid out of petty cash?
8.4. Personal security and control of petty cash
8.5. The petty cash voucher
8.6. The imprest system
8.7. Recording in petty cash book including Value Added Tax (VAT)
8.8. Balancing the petty cash book
8.9. Posting petty cash book to the ledger (double entry)
CHAPTER 9
PREPARING LEDGER ACCOUNTS – PART ONE
9.1. What are ledger accounts?
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9.2. Format of the ledger Accounts
9.3. Preparing ledger accounts

CHAPTER 10
PREPARING LEDGER ACCOUNTS – PART TWO
10.1. Cash transactions
10.2. Posting entries in the cash book to the ledger
CHAPTER 11
CLOSING ACCOUNTS AND EXTRACTING A TRIAL BALANCE
11.1. Transfers to Income Statement (Trading & Profit & Loss account
11.2. Transfers to the following period (Balance sheet items)
11.3. Extracting a trial balance
CHAPTER 12
FURTHER TRIAL BALANCE
12.1. What a trial balance is
12.2. Its format and preparation
12.3. Analysis of trial balance
12.4. Errors not disclosed by trial balance
12.5. Errors disclosed by trial balance
CHAPTER 13
ACCOUNTING FOR CONTROL ACCOUNTS
13.1. What are control Accounts?
13.2. Main types of control Accounts
13.3. Need for control accounts
13.4. Posting to personal accounts
13.5. Posting to Control accounts
13.6. Errors and their correction
CHAPTER 14
BANK RECONCILIATION
14.1. Why prepare a bank reconciliation statement
14.2. Terms in frequent use
14.3. Preparing a bank reconciliation statement
CHAPTER 15
BAD DEBTS AND ALLOWANCES FOR DOUBTFUL DEBTS
15.1. What are bad debts and allowances for doubtful debts?
15.2. Accounting for bad debts
15.3. Treatment of bad debts in financial statements
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15.4. Bad debts recovered, accounting and treatment in final accounts
15.5. Allowances for doubtful debts
15.6. Accounting for allowance for doubtful debts
15.7. Treatment of allowance for doubtful debts in financial statements
15.8. Accounting and treatment for allowance for discounts allowed
CHAPTER 16
PREPAYMENTS AND ACCRUALS
16.1. What are accruals?
16.2. Ledger accounting for accruals
16.3. Treatment of accruals in financial statements
16.4. What are prepayments?
16.5. Ledger accounting for prepayments
16.6. Treatment of prepayments in financial statements
CHAPTER 17
NON CURRENT ASSETS AND INTANGIBLE ASSETS
17.1. IFRS 5-Non-current assets – what are they?
17.2. Depreciation
17.3. Methods of depreciation
17.4. Accounting for depreciation
17.5. The disposal of non-current assets
17.6. The non-current asset registers
17.7. IAS 38 - Intangible assets
CHAPTER 18
ACCOUNTING FOR INVENTORIES
18.1. What is inventory?
18.2. Cost of goods sold
18.3. Accounting for opening and closing inventories
18.4. Carriage costs
18.5. Inventory counting and inventory accruals
18.6. Valuing inventory and effect on profit
CHAPTER 19
CORRECTION OF ERRORS AND THE SUSPENSE ACCOUNT
19.1. Errors not disclosed by the trial balance
19.2. Errors disclosed by the trial balance
19.3. The journal, suspense account and the correction of errors.
CHAPTER 20
FINANCIAL STATEMENTS WITH ADJUSTMENTS
20.1. Income Statement with adjustments
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20.2. Balance sheet with adjustments

CHAPTER 21
DEPARTMENTAL ACCOUNTS
21.1. Why prepare departmental accounts
21.2. Expense apportionment
21.3. Departmental income statement
21.4. The balance sheet
21.5. Decision-making
CHAPTER 22
PUBLIC SECTOR ACCOUNTING REPORTING
22.1. Description of public sector
22.2. Users of public sector financial statements
22.3. International Federation of Accountants (Public Sector)
22.4. Financial reporting under cash basis and accruals basis
22.5. International public sector accounting standards
22.6. Reporting and the media
CHAPTER 23
ACCOUNTING FOR PARTNERSHIP
23.1. Definition of partnership as a form of business
23.2. Legal status of a partnership
23.3. Types of partners in partnership
23.4. Partnership agreement
23.5. Advantages and disadvantages of a partnership
23.6. Partnership current accounts
23.7. Partnership capital accounts
23.8. Profit and loss appropriation account
23.9. Financial statements of partnership
CHAPTER 24
ACCOUNTING FOR NON-PROFIT MAKING ORGANISATIONS
24.1. The receipts and payments account
24.2. Income and expenditure account
24.3. The balance sheet
CHAPTER 25
CASHFLOW STATEMENTS
25.1. Why prepare the cash flow statements
25.2. Contents of the cash flow statement
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25.3. Methods of preparing cash flow statements
25.4. How to prepare the cash flow statements

CHAPTER 26
COMPANY ACCOUNTS
26.1. Company finance
26.2. Classes of shares
26.3. Debentures
26.4. Issue of shares
26.5. Share capital structure
26.6. Preparation of financial statements
CHAPTER 27
ACCOUNTING CONCEPTS AND PRINCIPLES
27.1. Nature and purpose of Accounting Concepts
27.2. Accounting concepts and conventions
27.3. International Accounting Standards (IAS
CHAPTER 28
INTERPRETATION OF FINAL ACCOUNTS
28.1. Ratio analysis technique
28.2. Types of Ratios
28.3. Calculation of Ratios
28.4. Interpretation of statements
28.5. Limitation of Ratio analysis
CHAPTER 29
MANUFACTURING ACCOUNTS
29.1. Manufacturing account
29.2. Work in progress
29.2. Transfers of goods at market value
29.3. Provision for unrealized profits

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 CHAPTER 1
INTRODUCTION TO FINANCIAL ACCOUNTING
This chapter introduces the nature and objectives of financial accounting. Before you learn how to process
transactions and eventual preparation of financial statements, it is important that you understand why
accounting information is necessary and the assumptions on which it is based. This is because accounting
has limitations on the scope and use of accounting information. It is equally important to know the type of
business entities that operate in communities from which accounting information is derived.

TOPICS
1. What is financial accounting?
2. Types of business entities.
3. Description of users of financial accounting information.
4. What makes accounting information to be useful?
5. The scope and objectives of financial accounting

LEARNING OUTCOMES
At the end of this chapter you should be able to:
- Explain the need and objectives of financial accounting.
- Identify the users of financial accounting information as prepared by different types of business
units.
- Describe qualities of good accounting information.

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.
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 (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).

ACTIVITY 1.1

In communities we live in people work in different organizations. Some work as accountants. 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.

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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”.hey 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

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 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.

ACTIVITY 1.2

Distinguish the following terms: enterprise, business, company and firm.

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.
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 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.

ACTIVITY 1.3 It is easy for people working in an organization to have access to accounting information.
For people outside it may be difficult. How can external people access accounting information?

4. QUALITIES OF GOOD ACCOUNTING INFORMATION

For information to be of good quality, it must be able to satisfy the needs and requirements of those
looking at it. Here are some of them.
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(a) Relevance
Accounting information is relevant if it is connected with what the user wants. That is, it
must influence them to make a decision.

(b) Reliability
Accounting information provided should be depended upon when making decisions. For
accounting information to be reliable it must be audited .(Examined) by qualified and
experienced auditors so that accounts are free from error.

(c) Comparability
An exercise undertaken to judge to what extent accounting information is similar or not
similar.For reasonable conclusion to be made about the business it is important that its
accounting information is comparable.N.B. When comparing use similar businesses both
in size and nature, or use accounting information from the same business from previous
year. If business is starting for the first time a budget could also be used.

(d) Understandability
For anybody to make a meaningful decision they should have clear knowledge of what
they are looking at. Any difficulties arising from its interpretation must be dealt with by
those who understand it.

(e) Completeness
When financial statements are prepared they should have all its parts and should portray a
whole or rounded picture of the business activities.

(f) Objectivity
Financial statements should be free from opinions. They should not be prepared in order
to satisfy a particular group. They should be actual facts otherwise they would be
considered biased. The problem of bias is dealt with by external audit.

(g) Timeliness
For information to be meaningful, it should be provided at the time it is required so that
timely decisions could be made.Accounts are usually published soon after the year end.
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ACTIVITY 1.4 Looking at the qualities of accounting information, could you identify a problem that may
arise with each one of them?

ACTIVITY 1.5 Identify areas of conflict for qualities of good accounting information or are they all
compatible?

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

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 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 SUMMARY
- The chapter introduced what financial accounting is and its main users.
- Accounting is the process of collecting, recording, summarizing and communicating financial
information.
- Accounting information is essential to the efficient running of a business. It helps managers to
control the use of resources and plan effectively for the future.
- Accounting information is used by many interested parties both within and outside the business. It
is used as a basis for communicating information about business activities.
- Accounting information can only be useful if it satisfies the need and requirements of those using it.
- The scope of accounting is very wide, but it is limited to items which have a monetary value.

EXERCISES
1. Name five groups of people who might use accounting information of a business.
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2. What are the main elements of financial statements?
3. Accounting information is limited to items having monetary value. True or False.
4. List the characteristics of qualitative accounting information.

SOLUTIONS FOR ACTIVITY QUESTIONS

ACTIVITY 1.1
Accountants are employees found in both profit-making and non-profit making organizations. They are
custodians of finances. Their responsibility is to ensure that funds of an organization are used for intended
purpose by keeping records of where money came from and how it has been used.They prepare financial
statements which are communicated to users. They also advise management on financial matters such as
investment opportunities.

ACTIVITY 1.2
An enterprise is the most general term, referring to just about any organization with people having a
common goal. It can be a business or a club or local authority.A business is also a general term and is
used to describe any existing organization involved in trading to make profits.

A Company is an enterprise constituted by law usually involving limited liability for its members.
Companies need not be business e.g. charities could be constituted as companies.A firm is a much general
term. It is loosely used to describe a business or company. A firm could also be used to describe an
unincorporated business such as a partnership.

ACTIVITY 1.3
Limited companies are required by law to make certain accounting information public. They send copies of
accounting information to the registrar of companies. People can have access to the information from the
registrar of companies at a small fee.This does not apply to Sole Traders or Partnerships.

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ACTIVITY 1.4

Relevance - The problem is to identify the needs since there are many users.
Reliability - The problem is modern business has become so complex thus
making reliability difficult to achieve.
Comparability - The use of different methods by business in preparing financial statements has
made it difficult to compare. However, this has been reduced by accounting
standards.
Understandability -Not all users have a sound financial background. It may be difficulty to make
sense of accounting information if you have no knowledge.

Completeness - Completeness may be difficult to achieve because of the volume of work involve.
Objectivity -Though financial statements are prepared by management and bias removed an
audit, some people question the effectiveness of an audit.

Timelines -Due to volume of work financial statements may not be provided at the time they
are required. Accounts prepared quickly will be based on estimates and estimates
may reduce reliability.

SOLUTIONS TO EXERCISES

1. Any of the following

- Management - Lenders
- Shareholders - The Public
- Employees - Financial Analyst and advisers
- Trade contracts - The government

2. The main elements of financial statements are:

- Income statement prepared to find the Gross Profit and the Net profit.
- The Balance sheet prepared to show a summary of assets, liabilities and capital of an
enterprise.
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3. True – accounting information is limited to items having monetary value.

4. Relevance, Reliability, understandability, comparability, objectivity and timeliness.

CHAPTER 2
INTRODUCTION TO FINANCIAL STATEMENTS

In this chapter we introduce financial statements by explaining the terms used in classifying income,
expenditure, assets and liabilities. Before demonstrating how financial statements are prepared we explain
what the accounting equation is.

TOPIC LIST
1 Financial statements
2 Assets in the balance sheet
3 Liabilities in the balance sheet
4 Income and expenditure

LEARNING OBJECTIVES
At the end of this chapter you should be able to
- Define and give examples of assets and liabilities
- Explain what income is
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- Explain what expenditure is
- Prepare the income statement
- Prepare the balance sheet

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.

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 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
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 - 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.

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 - 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.
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 - 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.

3.2.6 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.

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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

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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

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 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.
27
 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

28
SOLUTION

KUKU HARDWARE & STORES

BALANCE SHEET AS AT 31 DECEMBER 20X6

Non current assets: K K

Premises 50,000
Fixtures and fittings 8,000
Motor vehicles 9,000
67,000
Current Assets:
Inventory 16,000
Receivables 500
Prepayment 300
Cash in hand 100
16,900
Total assets 83,900

Financed by:
Capital at start 47,600
Add: Net profit 8,000
55,600
29
Less: Drawings (4,000)
51, 600
Non-current liabilities:
5 year loan 25,000
Current Liabilities
Payables 1,200
Bank overdraft 2,000
Taxation payable 3,500
Accrued expenses 600
7,300
Total equity and liabilities 83,900

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
30
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.

31
  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.

32
 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

33
 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 Classification of Expenses

When preparing income statement, indirect expenses are classified as:
- Selling and distribution
- Administration
- Finance costs
3.2.17 Selling and Distribution expenses
These are expenses incurred in the process of selling goods: examples will include:
- Salaries of sales staff
- Commission to sales staff
- Travelling and entertainment expenses of sales staff.
- Marketing costs e.g. advertising and any sales promotion expenses

3.2.18 Administration expenses

These are expenses related to the day to day running of the business. Examples may
include:
- Salaries of general staff
- Rent & rates
- Insurance
34
 - Telephone
- Heating
3.2.19 Finance costs
These may be related to servicing borrowings. Examples:
- Interest on loan
- Interest on bank overdraft
3.2.20 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
35
 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 3.6On 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).

36
 (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

3.2.21 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

Movement of cash to or
Cash in 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.
37
3.2.22 Inventory
When a business buys goods for resale, they are called inventory.
3.2.23 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.

38
3.2.24 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

3.2.25 Purchases Returns and Sales Returns

39
 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.

3.2.26 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
40
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

41
 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
42
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
43
 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
44
 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.

3.2.27 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 LiabilitiesA deficiency in working capital may indicate liquidity
problems in a business.

CHAPTER SUMMARY
45
- Financial statements are classified into Income Statement and Balance Sheet.
- A balance sheet shows the financial position of a business.
- The income statement shows in detail how the profit or loss in an accounting period arises.
- A distinction is made in the balance sheet between non-current liabilities and current liabilities and
between non-current assets and current assets.
- Capital is what the business owes to the owner
- “Current” means within the coming one year from the balance sheet date. Current assets are
expected to be converted into cash within one year. Current liabilities are debts payable within one
year.
- The working capital of a business is the difference between its current assets and current liabilities.
- The income statement is divided between Gross profit and Net profit.

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?

46
 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) ____________________________________

SOLUTIONS TO ACTIVITY QUETIONS

ACTIVITY 3.6

47
MR BUJU
INCOME STATEMENT FOR THE YEAR ENDED 30 JUNE 20X4

K K K
Sales 280,000
Less returns inwards (5,000)
Turnover 275,000
COST OF SALES:
Opening inventory 50,000
Purchases 135,000
Less: returns outwards (13,000)
122,000
Carriage inwards 11,000
Cost of purchases 133,000
Total cost of inventory 183,000
Less: Closing inventory (17,000)
(166,000)
Gross profit 109,000
Discount received 1,500
110,500
EXPENSES:
Discount allowed 2,000
Depreciation: fixtures & fittings 12,000
Carriage outwards 4,000
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
48
 (98,100)
Net profit (transferred to Balance Sheet) 12,400

MR BUJU
BALANCE SHEET AS AT 30 JUNE 20 X4

Non Current Assets Cost Dep. N.B.V.

(K) (K) (K)
Fixtures & fittings 120,000 12,000 108,000

Current Assets
Inventory (closing) 17,000
Receivables 24,000
Cash in Bank 6,000
Cash in hand 300
47,300
Total Assets 155,300

Financed by:
Capital at start 121,900
Add: Net profit 12,400
134,300
Less Drawings (18,000)
116,300
Non current liabilities
5 year loan 20,000

Current liabilities
Payables 19,000
155,300

49
ACTIVITY 3.8

Snow White
Income Statement for the three months ended 31 August 20X5
K
Sales 10,000
Less cost of sales (6,200)
Gross Profit 3,800

Expenses:
Wages (3 x 100) 300
Van Rental 1,000
Van expenses (3 x 300) 900
Bad debts 250
Telephone and postage 150
Interest charges (3 x 25) 75
(2,675)
Net profit 1,125

SOLUTIOS TO EXERCISES

1. D, the balance sheet is only correct at a point in time

2. Loans, mortgages or debentures (any one of them).

3. A, machinery

4. False, working capital is another term for net current assets

5. D, cost includes direct expenses

50
6. Any of the following:

- Profit on sale of non current assets

- Discount received
- Rental income
- Interest or dividends received from investments.
7. Include
- Salaries of sales staff
- Commission to sales staff
- Travelling and entertainment of sales staff
Marketing costs

51
 CHAPTER 3
REVENUE AND CAPITAL EXPENDITURE

This chapter is very much linked to financial statements preparation. Certain items of expenditure are
shown in income statement and others in balance sheet and yet they are all expenditure. Explanation is
given so that users are not misled in their interpretation as they make decisions.

The distinction between the two is very important as far as financial statement preparation is concerned. In
addition distinction between capital income and revenue income is also covered.

TOPICS

1. What is capital expenditure?

2. Examples of capital expenditure
3. What is Revenue expenditure?
4. Examples of revenue expenditure
5. Treatment of capital and revenue expenditure in financial statements
6. Capital income with examples
7. Revenue income with examples
8. Treatment of capital and revenue income in financial statements
9. Explain why some expenditure is part capital & part revenue.

LEARNING OUTCOMES

At the end of this chapter you should be able to:

52
- Define capital and revenue expenditure giving examples
- Show how they are treated in financial statements
- Describe revenue and capital income and their treatment in financial statements.
- Describe why failure to distinguish the above may lead to distortion of financial statements

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.

53
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

54
SOLUTION
K K
Capital expenditure Revenue expenditure

Cost of vehicle 2,000 Insurance charges 100

Transport costs 500 fuel costs 150
Customs duty 700 new tyres 70
Service charges 50 ___
Music systems 40 320
Insurance cover 80
______
Cost of vehicle 3,370
in books

ACTIVITY 4.1

Give reasons why expenditure in activity 4.1 has been identified to be capital expenditure and 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

55
 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.

56
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,
57
 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.

CHAPTER SUMMARY
- Capital expenditure is money spent to acquire non current assets and adding value to them,
including expenditure incurred to bring the asset to the business premises.
- Revenue expenditure is related to running the business. For example, administration, selling
expenses etc. It is also expenditure on maintaining the earning capacity of non current assets e.g.
repairs.
Purchase of inventory and related expenses are also revenue expenditure
- Capital income arises from the sale of non current assets
- Revenue receipts is income generated in the process of trading
- Capital expenditure is shown in balance sheet and revenue expenditure in income statement.
- Failure to distinguish capital and revenue expenditure will distort financial statements.

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.

58
 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

SOLUTIONS TO ACTIVITY QUESTIONS

ACTIVITY 4.1
59
- All expenses under capital expenditure are directly attributable to the purchase of vehicle
before it could be used in the business. The purchase of music system is adding value.
- The other expenses are simply running expenses and are revenue expenditure.

ACTIVITY 4.2
It’s neither capital nor revenue expenditure (see notes).

ACTIVITY 4.3
(a) Capital expenditure
(b) Revenue expenditure
(c) Capital expenditure
(d) Capital expenditure
(e) Revenue expenditure
(f) Revenue income
(g) Revenue income
(h) Capital expenditure
(i) Capital expenditure
(j) Capital expenditure
(k) Capital expenditure
(l) Revenue expenditure

SOLUTION TO EXERCISES
1. C
2. (a) K1650 capital expenditure
K50 repairs of old machine is revenue expenditure
(b) Revenue expenditure K250
(c) K250 wiring of part of improvement of premises is capital expenditure
2,200 is revenue expenditure
(d) Carriage on new mixer is capital expenditure K70Carriage on goods for resale
K710 is revenue expenditure
(e) Capital expenditure K2,100

60
 CHAPTER 4
DOCUMENTATION

Business activities are called transactions. The first record of a transaction is made on source document
that will serve as evidence of what took place on the material day.

In this chapter you will learn the types of documents that are in business use and essential features of a
document. Special emphasis will be put on the documents that are referred to when making entries in
books of account.

Learning Objectives

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

 Distinguish between internal and external documents

 Mention the name of the document sent at each stage of business activities
 List the essential part of a document
 Explain the purpose of each accounting document: the Invoice, the credit Note and the Debit Note

PURPOSE OF DOCUMENTS

Documents serve to provide evidence of transactions that took place. In the event of a dispute the
document will be referred to. If the dispute is not resolved and the matter is taken to court, the document
will be presented as legal evidence of what took place. Documents are also used by auditors to verify the
transactions that took place previously.

DOCUMENTING BUSINESS TRANSACTIONS

Business transactions can be between departments within the same organization or between two
separately managed organizations.An external document is one that is sent between two or more
organizations. Examples of such documents are invoice, credit note and receipts. Documents may not
necessarily be accounting. Some documents are administrative in nature. Examples include Inquiry and
Acknowledgement.
61
An internal document is one that is sent between two departments within the same organization. The
following are examples of internal documents:

 Staff schedules
 Supplier Lists
 Inventory Lists
 Goods Received Notes
 Expense Claim Forms

The list above is not exhaustive. You should read more books to know more documents. It will also be
important to visit an organization to go and see samples of documents they handle in their business.

ESSENTIAL FEATURES OF A BUSINESS DOCUMENT

Most documents will contain the following:

 Name and address of the business
 Name and address of the other business
 Document serial number
 Date of business activity
 Description of the activity
 Quantity, unit price and total amount of goods
 Other details such as delivery address, references, Value Added Tax and discount terms.

It should be noted that the contents of a document will be determined by the purpose it will serve. For
example, an invoice will contain details of Value Added Tax whereas a delivery note may not.

CIRCULATION OF DOCUMENTS
In practice most documents are prepared in duplicate. There are circumstances in which a document
should be prepared in triplicate depending on who require a copy for use and the importance of keeping the
document safely for future reference. Technology has also introduced electronic documentation and it will
62
be in order for those organizations that can afford to acquire such systems, and comply with the relevant
legal provisions.

ACCOUNTING USE OF DOCUMENTS

The seller often issues documents. When a buyer has issued a document, it merely serves as a reminder
for the seller to issue the relevant document.

An invoice is sent when goods are sold on credit. The seller uses duplicate invoices to compile a record of
all sales in the Sales Day Book. The original sales invoice is what the buyer will call the Purchase Invoice.
Therefore the buyer uses the original invoices to compile a record of all purchases in the Purchases Day
Book.

When the customer returns goods, the seller of the goods will send a Credit Note to evidence the
transaction. The seller will use the duplicate Credit Note to prepare the Sales Returns Day Book. The buyer
will use the original Credit Note to prepare the Purchases Returns Day Book. Invoices are the source
documents for the credit transactions that are recorded in the Sales Day Book and the Purchases Day
Book
No. 979
Name of Organisation
INVOICE
Tel.
Fax.
P O Box

To……………………………………. Date: …………………..

……………………………………….
……………………………………….
Unit Price Total Amount
S/No. DESCRIPTION QTY K n K n

TOTAL
Amount in words: …………………………..
63
……………………………………………….
E& O E
Goods once delivered cannot be returned.
………………………………………………. ……………………………………………
Receiver's signature Organisation official

Credit Notes are the source documents for credit transactions that are recorded in the Sales Returns Day
Book and the Purchases Returns Day Book.

No. 917
Name of Organisation

CREDIT NOTE
Tel.
Fax.
P O Box

To……………………………………. Date: …………………..

……………………………………….
……………………………………….
Unit Price Total Amount
S/No. DESCRIPTION QTY K n K n

TOTAL
Amount in words: …………………………..
……………………………………………….
E& O E
Goods once delivered cannot be returned.

………………………………………………. ……………………………………………
Receiver's signature Organisation official

64
It can be seen from the specimen source documents on the preceding page that some documents have
certain details pre-printed as long as the details are standard to all situations. Other documents may only
have a structure and the details will be filled in according to the event. Source documents are serially
numbered and they always have to be signed by the person preparing it and by the person checking the
accuracy or authorizing the details on it.

More will be discussed on daybooks in the next chapter.

CHAPTER SUMMARY
You should now have learnt that:
 Business transactions should be evidenced by documentation.
 Documentation gives authority to account for the amounts involved in a transaction.
 Documents provide a useful record for future reference and are presented as evidence to auditors
and court officials when settling a dispute.
 A Debit Note is sent when there is an undercast in the original invoice. The buyer may send a debit
note together with the goods returned to remind the seller to send a credit note in turn.
EXERCISE
Research on the documents retention policies of three organizations of your choice.

65
 CHAPTER 5
RULE OF DOUBLE ENTRY AND THE JOURNAL

Preparing accounts depends wholly on the application of the rule of double entry. Topics at advanced
levels adopt varied formats but that does not water down the importance of the rule. In this chapter we will
explain the rule of double entry at so early the stage that you will be able to appreciate what it is and
competently apply it to transactions as they are introduced in subsequent chapters. Further, we also
explain the Journal, a book of prime entry in which transactions that do not have a regular day book are
recorded.

TOPICS

1. The two Primary Concepts: The business Entity Concept and the Duality Concept
2. The Journal

66
LEARNING OBJECTIVES

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

 Define and explain the implications of the business Entity Concept

 Define and explain the implications of the Duality Concept
 Trace the flow in each transaction and correctly debit the receiving account and credit the giving
account
 Prepare journals for transactions

Entries in the books of prime entry are then posted to the ledger. The ledger is the main book of account.
To illustrate how this is done we will introduce the first two concepts that guide the preparation of accounts:
the Entity Concept and the Duality Concept. Subsequent to this we will post entries that are trading in
nature first then later on post entries that are administration.

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
67
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,
68
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
69
 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
70
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.

71
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.

2.3 ACTIVITY

April 22. Fix-it buys on credit a compactor to be used in road works from Kabamba Construction for
42 000 000.
Write the journal for the above transaction.

Note: In practice the narration for the journal should be comprehensive enough to describe what business
transaction took place. All relevant reference documents should be quoted.
Journals will again be discussed in the chapter on correction of errors.

72
CHAPTER SUMMARY
You should now have learnt that:
 The journal proper contains journals for transactions that are infrequent.
Each journal indicates how the amounts involved will be posted to the ledger accounts.
 A journal should include a narration of the transaction, referring to relevant source documents.

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.

73
SOLUTIONS TO EXERCISES
Q1 The value of premises is K15 000 as shown in the working below
Working
DR CR
K 000 K 000
ASSETS:
Premises (balancing figure) 15 000
Machinery 7 250
Inventory 3 207
Trade Receivables 8 250
Cash at Bank 6 440
Cash at bank 4 520
Rates prepaid

LIABILITIES:
Salaries accrued 590
Trade Payables 5 600
Loan 9 000
Capital 30 307
TOTALS 45 497 45 497

Q2 The journals would be:

DR CR
K 000 K 000

Motor Vehicles 30 000

Capital 30 000
Capital introduced in the form of a vehicle

Bank 20 000
Loan 20 000
74
 Bank loan obtained on commencement of business.

CHAPTER 6
PREPARING BOOKS OF PRIME ENTRY

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).

75
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).

TOPICS
1. Preparing Sales Day Book
2. Preparing Sales Returns Day Book
3. Preparing Purchases Day Book
4. Preparing Purchases Returns Day Book

LEARNING OBJECTIVES
After you have studied this chapter, you should be able to
 Explain the purpose of each day book
 Prepare analytical day books
 Mention the ledgers to which entries in each day book are posted
 State the source document for entries in each day book.

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.

76
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 TRADE OTHER

ADDED
TAX RECEIVABL RECEIVABLE
E
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

77
  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
78
 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 o 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.
79
3.0 ANALYTICAL 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
80
 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

81
 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).
82
 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.

4.3 CHAPTER SUMMARY

83
You should now have learnt that: -
 Day books are records compiled and preserved for future reference
 The invoice is the source document for preparing the sales day book and the purchases day book
 The credit note is the source document for preparing the Sales Returns Day Book and the
Purchases Returns Day book
 The labels of analyses columns should be determined by the information needs of users within the
organization.

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).

84
2. Write the journals for the totals of the Day books you prepared in Question 1.
SOLUTIONS TO EXERCISES

Q1 Total of Sales Day Book columns:

Trade Receivable K 3 571 295
Value Added Tax K 516 295
Other Receivables K nil

Total of Sales Returns Day Book columns:

Trade Receivables K 726 738
Value Added Tax K 101 738
Other Receivables nil

Total of Purchases Day Book columns:

Trade Payables K 804 000
Sales Tax K 119 745
Other Payables –NCA K 40 000 000
Other Payables –Expenses K 502 000

Total of Purchases returns Day Book columns:

Trade Payables K 126 100
Value Added Tax K 18 781

Q2 The journals would be written as follows:

DEBIT CREDIT
K K
For the Sales Day Book totals:
Trade Receivables 3 571 295
Value Added Tax 516 295
Sales account 3 055 000
For the Sales Returns Day Book:
Trade Receivables 726 738
85
 Value Added Tax 101 738

Sales Returns Account 625 000

For the Purchases Day Book totals:
Trade Payables 805 000
Value Added Tax 119 745
Purchases 694 255

For the Purchases Returns Day Book:

Trade Payables 126 000
Value Added Tax 18 781
Purchases Returns Account 107 319

Non current assets (e.g Machinery) 40 000 000

Other Payables 40 000 000

Expense Account (e.g electricity) 502 000

Other Payables 502 000

86
 CHAPTER 7
BOOKS OF PRIME ENTRY - CASH TRANSACTIONS

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.

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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.

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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 REF TOTAL Value CASH TRADE OTHER LOANS
Added

TAX SALES RECEIVABL RECEIVAB

ES LES
APRIL K K K K K
1 Bank (c) 3 000 000
1 Sales 634 500 94 500 540 000
13 Sales 470 000 70 000 400 000
22 Ngosa 667 755 667 755
28 Commission 270 000 270 000
rec.
30 TOTAL 5 042 255 164 500 940 000 667 755 270 000

 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.
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  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 )

DAT PARTICUL FOL TOTAL Value CASH TRADE WAGES REPAIR STATIONER
E ARS I Adde & S Y
d

TAX PURC PAYABLE SALARIE

H S S

K’000 K’000 K’000 K’000 K’000 K’000 K’000

8 Wages 150 150
13 Bank 200
19 Repairs 130 130

20 Stationery 150 150

26 Purchases 246 .75 210
36.75

30 Balance C/d 4165 .51

30 TOTAL 5 042 .26 36.75 210 150 130 150

 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

90
 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 REF TOTAL Value CASH TRADE OTHER LOANS

Added

TAX SALES RECEIVABLES RECEIVABLES

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

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30 TOTAL 20 200 12 000

 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 PARTICULA FOLIO TOTAL Value CASH TRADE WAGES RENT MOTOR
RS Added &

TAX PURC PAYABLE SALARI PAYAB VEHICLES

H S ES LE

K”000 K”000 K”000 K”000 K”000 K”000

1 Cash c 3 000

14 Drawings 100

25 Salaries 300 300

28 Rent 520 520

000
29 L-Stone 10 000 10 000
Motors
30 Kunda 227.43 227.43
30 Balance C/d 6052 .57
30 TOTAL 20 200 227.43 300 520 10 000

 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

92
 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:

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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)

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DATE PARTICULARS FOLIO TOTAL Value CASH TRADE OTHER LOANS
Added

TAX SALES RECEVBLS RECEVBLES

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

31 TOTAL 6 528 000 168 000 960 000 400 000

CASH BOOK (CASH -PAYMENTS SIDE)

DATE PARTICULAR FOLI TOTAL Value CASH TRADE WAGES & RENT & STATIONERY
S Added

TAX PURCH PAYABLES SALARIES REPAIRS

K K K K K
4 Rent 600 000 600 000
8 Drawings 250 000
13 Stationery 350 000 350 000
19 Furniture 180 000 180 000
repairs
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 6 528 000 220 000 780 000 350 000

CASH BOOK (BANK -RECEIPTS SIDE)

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DATE PARTICULARS FOLIO TOTAL Value Added CASH TRADE OTHER LOANS

TAX SALES RECEIVABLES RECEIVABLES

March K K K K K K
1 Capital 15 000 00
22 Loan 30 000000 30 000 000

31 TOTAL 45 000 000 30 000 000

CASH BOOK (BANK -PAYMENTS SIDE)

DATE PARTICULAR FOLIO TOTAL Value CASH TRADE WAGES & RATES OTHER
S Added

TAX PURCH PAYABLES SALARIE PAYABLE PAYABLS

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

31 Balance C/d 9 318

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

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 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

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 CHAPTER 8
THE ANALYTICAL PETTY CASH BOOK

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

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 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
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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.

100
 (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.
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 NO………………

PETTY CASH VOUCHER

DATE……………..

DESCRIPTION/DETAILS AMOUNT

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

102
 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.
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 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

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 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.

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Example: Analytical petty cash book.

RECEIPTS (DR) PAYMENTS (CR)

Total Date Details Voucher Total Office Postage Cleaning Traveling Motor Ledger
DR No. CR Expense expense

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

106
 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

DR (K) CR(K)

Receipts Date Details V/n Total Stat Cleaning Entertt Travel Postage
700,000 Jun 1 Cash
Jun 2 C/Mat 1 30,000 30,000
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 29,000
15
Jun B/Fares 8 10,000 10,000
16
Jun V/Lunch 9 45,000
20 45,000
Jun21 Mops/Brushes 10 56,000 56,000
Jun Stamps 11 15,000 15,000
23
Jun Envelops 12 7,000 7,000
27
Jun V/Lunch 13 60,000
29 60,000
Jun P/Paper 14 95,000 95,000
30
627,000 192,000 115,000 105,00 175,000 40,000
0
627,000 Jun Cash
30
Bal c/d 700,000
1,327,000 1,327,000
700,000 Jul 1 Bal b/d

107
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

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 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).

109
 Example: Value Added Tax receipt and petty cash record.

RECEIPTT S/No. (04) RECEIPT S/No. (05)

Date: 01.06.05 Date: 02.06.05

Amount Amount
K K
4 Reams A4 90,000 Repairs to computer 145,000
Paper Add 17.5%
Value Added Tax 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 Stationery Repairs Value

Added Tax
02.06.05 4 Ream of 04 105.75 90,00 15.75
paper
02.06.05 Repairs 05 170.375 145,000 25,375

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.

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 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
111
 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 SalesTax Total Date Details V/N Total Station Repairs S/Exps Value
Added
Tax
400,000 Dec Cash
1
Dec Station 1 10,800 9,191.50 1,608.50
2

112
 Dec S/Exps 2 21,700 18,468.09 3,231.91
4
25,531.92 4,468.08 30,000 Dec C/Sales
6
Dec Repairs 3 42,500 36,170.21 6,329.79
9
15,319.15 2,680.85 18,000 Dec Recpt/Phone
10
Dec Station 4 90,000 76,595.75 13,404.25
12
Dec S/Exps 5 28,200 24,000.00 4,200.00
14
28,085.11 4,914.89 33,000 Dec C/Sales
19
Dec Station 6 47,800 40,680.85 7119.15
25
241,000 126,468.1 36,170.21 42,468.09 35,893.60
160,000 Dec Cash
31
Dec Bal c/d 400,000
31
68,936.18 12,063.82 641,000 641,000
400,000 Jan Bal b/d
1

113
 CHAPTER 9
PREPARING LEDGER ACCOUNTS – PART ONE
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%)

114
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 TRADE OTHER

ADDED
TAX RECEIVABL RECEIVABLE
E
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

115
 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
.00 000.00
18 Mwape 270 40 229 787.24
000.00 212.76
19 Zam Hydropower 320 320
000.00 000.00

TOTAL 40 872 82 469 787.24 40 320 000.00

000.00 212.76

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

116
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

117
 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).

118
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.

119
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.

120
 CHAPTER 10
PREPARING LEDGER ACCOUNTS – PART TWO
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.
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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 CASH TRADE OTHER LOANS
ADDED
TAX SALES RECEIVABLES RECEIVABLES
APRIL
1 Bank 3 000
000
1 Sales 634 94 540
500 500 000
13 Sales 470 70 400
000 000 000
22 Ngosa 667 667 755
755
28 Commission 270 270 000
rec. 000

30 TOTAL 5 042 164 940 667 755 270 000

255 500 000

1.2 CASH BOOK (CASH -PAYMENTS SIDE)

DATE PARTICUL FOLIO TOTA VALU CASH TRADE WAGES REPAIR STATIONERY
ARS L E & S
ADDE
D
TAX PURC PAYABLE SALARI
H S ES
APR

122
8 Wages 150 150
000 000
13 Bank 200
000
19 Repairs 130 130
000 000
20 Stationery 150 150 000
000
26 Purchases 246 36 210
750 750 000

30 Balance C/d 4 165

505
30 TOTAL 5 042 36 210 150 130 150000
255 750 000 000 000

1.3 CASH BOOK (BANK -RECEIPTS SIDE)

DATE PARTICULARS FOLIO TOTAL VALUE CASH TRADE OTHER LOANS

ADDED
TAX SALES RECEIVABLES RECEIVABLES
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

123
1.4 CASH BOOK (BANK -PAYMENTS SIDE)

DATE PARTICULA FOLI TOTAL VALU CASH TRADE WAGES RENT MOTOR
RS O E &
ADDE
D
TAX PURC PAYABLE SALARI PAYABL VEHICLES
H S ES E
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 10 000 000
000
30 Kunda 227 227 430
430
30 Balance C/d 6 052
570
30 TOTAL 11 272 227 430 300 520 10 000 000
000 000 000

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

124
 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

125
 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.

126
  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.

127
 CHAPTER 11
CLOSING ACCOUNTS AND EXTRACTING A TRIAL BALANCE

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
128
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

129
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)
130
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

131
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

132
 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

133
 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

134
 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.

135
 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.

136
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
137
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?

138
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.
139
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?

140
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
==========

141
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 TRADE OTHER

ADDED
TAX RECEIVABL RECEIVABLE
E
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
142
 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 733 238.00 108 238.00 625 000.00

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
143
 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 12 451.00 71 149.00
24 Simpasa 42 500.00 6 330.00 36 170.00

TOTAL 126 100.00 18 781.00 107 319.00

CASH BOOK (CASH-RECEIPTS SIDE)

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

31 TOTAL 6 528 000 168 960 000 400 000

000

2.2 CASH BOOK (CASH -PAYMENTS SIDE)

DATE PARTICULA FOLI TOTAL VALUE CASH TRADE WAGES & REPAIR STATIONERY
RS ADDE S
D
TAX PURC PAYABLE SALARIES
H S
K K K K K
4 Rent 600 000
8 Drawings 250 000
13 Stationery 350 000 350 000
19 Furniture 180 000 180
repairs 000
20 Delivery 630 000
expnss
29 Wages 220 000 220 000

144
29 Solapwer - 400 000
Elect

31 Balance C/d 3 898 000

31 TOTAL 6 528 000 220 000 180 350 000
000

3.1 CASH BOOK (BANK -RECEIPTS SIDE)

DATE PARTICULARS FOLIO TOTAL VALUE CASH TRADE OTHER LOANS
ADDED
TAX SALES RECEIVABLES RECEIVABLES
March K K K K K K
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 PARTICULA FOLIO TOTAL VALUE CASH TRADE WAGES RATES OTHER
RS ADDED &
TAX PURC PAYABLES SALARIE PAYABL PAYABLS
H S E
K K K K K K
2 Cash c 5 000
000
8 Furniture 3 500 3 500 000
000
22 Del 25 000 25 000 000
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 28 500 000
000 316 234 000

145
 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

146
 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

147
 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

148
 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

149
 FURNITURE REPAIRS

Cash 180 000 Profit & Loss c/d180 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

150
 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

151
 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

152
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

153
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

154
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

155
 CHAPTER 12
MORE ABOUT THE TRIAL BALANCE
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.
156
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

157
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

158
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:

159
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

160
 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
161
 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
162
Returns outwards 350
Carriage inwards 780
Carriage outwards 475
Machinery 132,000
Discounts allowed 880
Discount received 550
543,135 543,135

163
 CHAPTER 13
CONTROL ACCOUNTS

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
164
(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.

165
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 TRADE OTHER

ADDED
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

166
 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
167
 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

168
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

169
 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
170
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

171
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

The two balances have been reconciled. Few errors have been used here for the sake of simplicity so that
the principles involved can be clearly understood.

CHAPTER SUMMARY
You should now have learnt that control accounts are a useful tool for detecting errors that may have been
made in the accounts. They make ready an account balance that will be reported in the balance sheet
without undue delay. Work done on individual accounts
by staff in the Sales Ledger section can be verified and possible fraud can be discovered.
Correction of errors should be done to the amount that was affected by the error.

172
EXERCISES
1. 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:
K
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

173
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
174
 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.

SOLUTIONS TO EXERCISES

1.
TRADE PAYABLE

K000 K000
Balance b/d 45 Balance b/d 6 500
Purchases Returns 90 Purchases 42 000
Bank 34 000 Purchases 20
Trade Receivables 70
Discount Received 50
Balance c/d 14 328

48 583 48 583

Balance b/d 14 328

2 d
3 a

175
4

TRADE RECEIVABLES

K K
Balance b/d 40 250 Balance b/d 3 845
Sales 854 239 Retuens inwards 44 271
Bank 675 843
Discount All 20 275
Bad debts 13 173
Trade Payables 7 457
Returns inwards 3 244
Balance b/d 2 119 Balance c/d 128 400
896 608 896 608
Balance b/d 128 400 Balance b/d 2 119

TRADE PAYABLE

K K
Balance b/d 1 985 Balance b/d 26 423
Purchases Returns 32 662 Purchases 408 563
Bank 300 912
Trade Receivables 7 457
Discount Received 9 027
Balance c/d 83 403 Balance c/d 460

48 583 48 583

Balance b/d 460 Balance b/d 83 403

(1985 – 1525)

176
 CHAPTER 14
BANK RECONCILIATION
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.

LEARNING OBJECTIVES
By the end of this chapter you should be able to:
 Explain the terms used in describing transactions processed through the bank account
 To prepare a bank reconciliation statement

TOPICS
1. Why prepare a bank reconciliation statement
2. Terms in frequent use
3. Preparing a bank reconciliation statement
4. Summary

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.

177
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.

178
  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 13 K Mwila 454
May 17B Jere 685 May 17P Muma 38
May 29F Banda 372 May 30 Daka Bowling 44
May 31D Phiri 582 May 31 Balance 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
179
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
180
 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 reverse d. 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

181
ACTIVITY: Write the journal for the traders credit made by Akazipo in the exercise above. How would
treatment of the entries in the bank reconciliation statement change if you started with the balance as per
bank statement?

CHAPTER SUMMARY

You have now learnt that: -

 Bank reconciliation is mandatorily prepared because it is a form of internal control that

auditors will rely on to certify the verifiability of the bank balance shown in the balance
sheet.

 Errors and unprocessed transactions can be revealed in the course of the bank
reconciliation exercise. Financial information is more reliable when it is free from error.

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

182
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:

183
 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.

SOLUTIONS TO EXERCISES

Q1 K 10 040

Q2 K 23 100

Q3 UPDATED CASH BOOK

K000 K000
April 30Suspense 20 April 30 Bal b/d 662
April 30Dividend received 89 April 30 Suspense 3
April 30 Rates 120
April 30 Kebby 207
April 30 Suspense 70
April 30 Bank Charges 67
April 30 Balance c/d 1 020
5 609 5 609
May 1 Balance b/d 1 020

184
BANK RECONCILIATION STATEMENT
K 000
Balance per revised Cashbook (overdraft) 1 020
Add: Deposits not yet credited 807
1 827
Less: Unpresented cheques 345
Balance per Bank Statement 1 482

185
CHAPTER 15

BAD DEBTS AND ALLOWANCES FOR DOUBTFUL DEBTS

INTRODUCTION

This chapter covers how a business deals with bad debts and anticipated future discounts.

TOPICS

1 What are bad debts?

2 Accounting for bad debts
3 Treatment of bad debts in financial statements
4 Bad debts recovered, accounting and treatment in final accounts
5 Allowances for doubtful debts
6 Accounting for allowance for doubtful debts
7 Treatment of allowance for doubtful debts in financial statements
8 Accounting and treatment for allowance for discounts allowed

LEARNING OUTCOMES

When studying this chapter, one should be able to:

 Describe and account for bad debts and the treatment in financial statements
 Explain why allowance for doubtful debts are provided
 Account for allowance for doubtful debts and how they are calculated.

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.

186
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 20X6, on 1 November it sold goods on credit to one of its regular customer
Mr. Fix, for K276,000.

In sales or receivable ledger.

Dr. Mr. Fix account Cr.

K K
Nov. 1 Sales 276,000

In general ledger
187
 Dr. Sales account Cr.

K K
Nov. 1 Sales 276,000

- 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 K K
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
K276,000.

- 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

188
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.

189
 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.
190
 - 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
191
 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.

192
- 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 owing Total amount Estimated % Allowance for

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

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.

193
 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
194
 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.
195
- 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
196
 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)
197
 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
198
 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

199
 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.

15.6 ALLOWANCE 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.

200
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

201
 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 SUMMARY
- Bad debts are amounts a business fails to recover from receivables
- Bad debts are expenses and are charged to income statement
- Bad debts recovered are debts previously written off but have been recovered. They are a gain
and are added to gross profit in income statement.
- Allowance for doubtful debts are amounts set aside from profits to meet future bad debts.
- Allowance for doubtful debts balance is deducted from receivables figure in balance sheet.
- Specific allowance for doubtful debts must be deducted from the receivables figure before
calculating general allowance for doubtful debts. However, in balance sheet the total allowance
will be specific plus general.

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EXERCISES
1. What is double entry to write off bad debts?
2. What is double entry for bad debts recovered?
3. What is double entry for allowance for doubtful debts?
4. What is double entry for decrease in allowance for doubtful debts?
5. Bird Cage has total receivables balances outstanding at 31 December 20X6 of K28,000. She
believes that about 1% of these balances will not be paid and wishes to make an appropriate
allowance.
Before now, she has not made any allowance for doubtful debts at all.
On 31 December 20X7, her receivables balances amount to K40,000. Her experience during the
year has convinced her that an allowance of 5% should be made.
What accounting entries should she make on 31 December 20X6 and 20X7 and what figures for
receivables should appear in her balance sheets as at those dates.

SOLUTIONS TO EXERCISES

1. Dr. – Income Statement

Cr. – Bad debts account

2. Dr. – Receivables account

Cr. – Bad debts recovered account to reinstate the receivable
then
Dr. – Cash or Bank account
Cr. – Receivables account

3. On creation or increase in allowance for doubtful debts.

Dr. – Income statement
Cr. – Allowance for doubtful debts account

4. When allowance for doubtful debts reduces

Dr. – Allowance for doubtful debts account
Cr. – Income statement.

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5.

Dr. Allowance for doubtful debts account Cr.

K K
Balance c/d 280 20X6
Income statement 280
280 280
20X7
Balance b/d 280
Balance c/d 2,000 Income statement 1,720
2,000 2,000
Balance b/d 2,000

In balance sheet

20X6 Receivables (K28,000 – 280) K27,720

20X7 Receivables (40,000 – 2,000) K38,000

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 CHAPTER 16
PREPAYMENTS AND ACCRUALS

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. Treatment of accruals in financial statements
4. What are prepayments
5. Ledger accounting for prepayments
6. Treatment of prepayments in financial statements

LEARNING OUTCOMES
At the end of the Chapter, you should be able to:
 To prepare expense account and interpret balance brought down as an accrual or prepayment.
 To adjust expenses for accruals and prepayments in income statement
 To prepare income account with adjustment for amounts owing and prepaid
 To show accruals and prepayments appropriately in balance sheet.

16.1 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.
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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.

206
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
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 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.

16.2 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.

208
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

209
 - 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.

16.3 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

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 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
211
 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.

212
 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.
213
 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 (3/12 x 600 000) 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

CHAPTER SUMMARY
- Accruals are amounts the business has not yet paid or received for services provided.
- Accruals can be by the business or to the business.
- Prepayments are amounts paid in advance by the business or to the business.
- The matching or matching concept requires that income and expenses whether paid or not as long
as they relate to the accounting period under review, should be matched when computing profit for
that period.
- Accruals by the business are included as a charge in income statement, and shown under current
liabilities in balance sheet (accrued expenses).
- Accruals to the business (income) are also included in income statement added to amount
received, but stated as current asset in balance sheet (other receivables).

214
- Prepayments by business are excluded in income statement from total amount paid and reflected
as current asset in balance sheet (prepayments).
- Prepayments to the business are also deducted from total amount received in income statement
but shown as current liability in balance sheet (other payables).

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).

215
SOLUTIONS TO EXERCISES

1. K1 000 000 X 3 months = K250 000

12
2. An accrual is an amount not yet paid in received at end of accounting period.
3. - Asset (prepayment)
- Liability (amount owing)
- Asset (amount not yet received but to be received)
- Liability (amount receivable paid in advance to the business).

Dr. Rent and Rates Account Cr.

K K
Balance b/f 250 000 Balance b/f 500 000
Bank (rent) 4 000 000 Income statement
Bank (rates) 3 600 000 (Balancing figure) 7 400 000
Balance c/d 200 000 balance c/d 150 000
8 050 000 8 050 000
Balance b/d 150 000 Balance b/d 200 000

Note:
In balance sheet: Rent is current liability (K200 000)
Rates is current asset (150 000).

216
 CHAPTER 17
NON CURRENT ASSETS AND INTANGIBLE ASSETS
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

TOPICS
1 Non-current assets – what are they?
2 Depreciation
3 Methods of depreciation
4 Accounting for depreciation
5 The disposal of non current assets
6 The non current asset register
7 ISA 38 - Intangible assets

LEARNING OUTCOMES
After studying this chapter, the student should be able to:
 Define non current assets giving examples
 Distinguish clearly between non current assets and current assets
 Define depreciation and explain why it is provided
 Identify causes of depreciation
 Calculate and account for depreciation using different methods
 Identify the steps in disposal of non current asset
 Describe the importance of maintaining a non current asset register
 Define research
 Distiguish between pure or basic research and applied research
 Define development costs and explain how they are treated in financial statements
 Define goodwill
 Distiguish between purchased and inherent goodwill
 Explain and apply the accounting treatment for both types of goodwill

217
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.

218
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.

219
 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.
220
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.

221
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.

222
 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.

223
 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

224
 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:

225
 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
226
 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.
227
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.
228
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:

229
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

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 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

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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

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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)
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 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

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 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

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 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)
236
 (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

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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)

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 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
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 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.

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- 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.

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- 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.
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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/d 100 000 31 Dec. Balance c/d 100 000
______ _______
100 000 100 000
20X7
1 Jan. Balance b/d 100 000 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
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 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.
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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
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 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)

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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.
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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.

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  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
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  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

250
 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

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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.

252
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
253
 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
254
  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.

255
  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.

11.19 RESEARCH AND DEVELOPMENT COSTS (IAS 38)

IAS 38 – INTANGIBLE ASSETS

An intangible asset is an identifiable non monetary asset without physical substance. The asset must be:

(a) Controlled by the entity as a result of event in the past.

(b) Something from which the entity expects future economic benefits to them.

Examples:

- Goodwill
- Development costs

RESEARCH AND DEVELOPMENT COSTS

RESEARCH - This is an investigation undertaken in order to discover new facts

or get additional information.

Research could be used for new or improved products, processes and methods.

Research is a cost to an entity.

256
DIVISION OF RESEARCH

Research costs can be divided as follows:

1. PURE OR BASIC RESEARCH

This is research carried out to advance knowledge without specific objectives.

2. APPLIED RESEARCH

This utilizes pure research to attain specific objectives. Research used to extend knowledge of
problems in industry, health, education, etc.

3. DEVELOPMENT

This is making use of the results of research to produce or develop new or existing products or
services.

Examples:

- Designing tools involving new technology

- Design, construction and operation of pilot project not for commercial production.

COMPONENTS OF RESEARCH AND DEVELOPMENT COSTS

Research and development costs will include all costs that are directly attributable to research and
development activities, or that can be allocated on a reasonable basis.

Selling costs are not included in research and development.

Examples of Research & Development Costs

- Salaries and wages and other related employment costs of personnel engaged in research and
development activities.
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- Costs of materials and services used in research and development activities.
- Depreciation of property, plant and equipment used for research/development activities.
- Overhead costs which may be allocated because they relate to research and development.

ACCOUNTING FOR RESEARCH AND DEVELOPMENT COSTS

THE ACCOUNTING PROBLEM

The costs of Research and Development can run into millions of kwachas. However, it may take many
years before the new technology or product is commercialized.

Following the accruals concept, the cost of research and development should be capitalized when incurred,
and then amortised when the product is eventually marketed. This would then match the costs with the
benefits.

However, prudence would say that the eventual profits are so uncertain and so it would be better to write
off research and development costs in income statement when they arise.
THE SOLUTION

IAS 38 has found a compromise between accruals and prudence.

- All research costs must be charged to the income statement as it is incurred. This is because
there is a long time gap between research commencing and a profitable product being launched.

- Development costs should be capitalized if it meets certain conditions.

CONDITIONS FOR CAPITALISATION

(i) The project is technically feasible.

(ii) The enterprise intends to complete the project and use or market the product.
(iii) The enterprise has the ability to use or sell the asset.
(iv) There is either an external market for the asset or an internal use for it.
(v) The company has the financial resources to complete the project.
(vi) The related costs can be measured reliably.
258
AMORTISATION

Capitalised development costs can be carried forward until the product being developed is ready for
production. At this point it must be amortised over the expected commercial life of the product.

CHAPTER SUMMARY

- Non current assets are acquired not for resale but to be used in organization to help
generate income over a period of more than one year.

- Non current assets are depreciated over a period of their estimated life span

- Depreciation is the allocation of the cost of the asset over its economic life

- Depreciation is a non cash expense and it is charged to income statement.

- The straight line method of depreciation assumes that the asset will be used evenly
through out its life and therefore some amount is charged to income statement from one
year to the next.

- Reducing balance method assumes that the asset will be used more in its earlier years
than later years, thus the depreciation amount will be reducing with time.

- Non current assets may be sold off before their life span expires. A disposal account is
opened to determine whether a profit or loss has been made on disposal.

- It is also important that an organization keeps a non current asset register for control
purposes.

EXERCISES

1. Fill in the blanks.

259
 Net book value is ………………………… less…………………………

2. Two common methods of depreciation are:

(a) ……………………………………………..

(b) …………………………………………….

3. A non current asset (cost K10 000, depreciation K7 500) is given in part exchange for an
new asset costing K20 500. The agreed trade in allowance is K3 500. Calculate profit or
loss on disposal.

4. The details about a non current asset that would be included in a non current asset
register are:

SOLUTIONS TO EXERCISES

1. Net book value is cost less accumulated depreciation

2. (a) Straight line

(b) reducing balance

3. Net book value (K10 000 – K7 500) = K2 500

Trade in allowance = K3 500
Profit on disposal K1 000

4. (a) Date of purchase

(b) Description and location
(c) Original cost
(d) Depreciation method and rate
(e) Accumulated depreciation to date
260
261
 CHAPTER 18
ACCOUNTING FOR INVENTORIES

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
1 What is inventory?
2 Cost of goods sold
3 Accounting for opening and closing inventories
4 Carriage costs
5 Inventory counting and inventory accruals
6 Valuing inventory and effect on profit

Learning Outcomes
At the end of this chapter, students should be able to:
- Describe inventory
- Explain the application of accounting concepts to the valuation of inventory
- Explain the methods of valuing inventory when items have been purchased at different prices.
- Explain the impact of inventory valuation methods on profit and net assets
- Explain the effect of carriage inwards on goods purchased
- Calculate the value of closing inventory
- Report closing inventory in 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.
262
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

263
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

264
 (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.

265
 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.
266
 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.

267
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:

268
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/d 740

Dr Capital account Cr

K’000 K’000
269
 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
270
 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
271
 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.

272
 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

273
 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

274
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

275
 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.
276
 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.
277
 (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:

278
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

279
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
280
 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

281
(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)
282
 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.

283
(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)
284
 (7 070)
Profit 11 850

CHAPTER SUMMARY

- Profit is calculated on inventory sold. Unsold inventory at year end (closing inventory) is carried
forward to the next accounting period as opening inventory.

- Cost of sales is calculated as:

Opening inventory XX
Purchases XX
XX
Less: Closing inventory (XX)
XX

- Carriage inwards is included as part of cost of inventory because the expense is directly
attributable to purchases.

- Inventory account is opened at year end as an adjusting item. This takes place after physical stock
count or continuous inventory count. The value is based on lower of cost and net realizable value
for each separate item or group (separate valuation concept).

- Cost is purchase cost plus direct expenses.

285
- N.R.V. is selling price minus completion and selling costs.

- Valuation methods for inventory includes the following

FIFO
LIFO
AVCO

- Closing inventory is created in income statement and shown as current asset in balance sheet.

EXERCISES

1. What is the formula for calculating cost of goods sold?

2. What is the difference between carriage inwards and carriage outwards and how are they treated
in financial statements.

3. How is inventory determined and how is it incorporated in financial statements.

4. Distinguish between cost and net realizable value in relation to inventory.

5. Identify three methods of pricing inventory.

SOLUTION TO EXERCISES

1. Opening inventory XX
Purchases XX
Less: closing inventory (XX)
XX

286
2. They are all transport expenses. Carriage inwards is a direct expense incurred at the time of
buying the goods and therefore is added to purchases as part of cost.

Carriage outwards is selling expense and appears under indirect expenses in income statement.

3. Inventory is arrived at by conducting physical stock count or continuous count. Closing inventory is
credited to income statement and shown as current asset in balance sheet.

4. Cost includes amount spent to buy goods plus direct expenses.

Net realisable value (N.R.V.) is value of inventory calculated as follows:

Selling Price - expenses incurred in putting the item in a saleable

condition

Inventory is valued at lower of cost and net realisable value.

5. FIFO, LIFO, AVCO

287
CHAPTER 19

CORRECTION OF ERRORS AND THE SUSPENSE ACCOUNT

INTRODUCTION

In Chapters 11 and 12 on Trial balance it was clearly stated that when trial balance totals are equal, does
not mean that the information is free from errors.

This chapter will discuss errors that the trial may disclose and those that may not be disclosed, and how
they are corrected.

TOPICS

1 Errors not disclosed by the trial balance

2 Errors disclosed by the trial balance
3 The journal, suspense account and the correction of errors.

LEARNING OBJECTIVES

288
At the end of the chapter, the student should be able to:

- Identify different types of errors and how to correct them

- Distinguish between errors affecting trial balance and those not
- Adjust profit figure after correcting errors
- Show correctly suspense account in balance sheet before errors are corrected

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.
289
(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
290
 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).
291
 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

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 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.
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 (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.
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 - 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

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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

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 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.

297
(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 K2759 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

298
 (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

299
(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

300
- 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.

301
 - 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).

CHAPTER SUMMARY
The trial balance totals may not be equal because of errors which may include:
(i) Additional errors
(ii) Incomplete double entry
(iii) Transposition errors

When the trial balance does not balance a temporal account called suspense account is opened.
Suspense does not appear in Income Statement but in balance sheet.
- If suspense account balance is debit, it is shown separately under current assets
- If suspense account balance is credit, it is shown as current liability
Only errors that cause the trial balance not to balance are corrected via suspense account.
Errors not affecting trial balance include:
(i) errors of omission
(ii) errors of principle
(iii) errors of commission
(iv) complete reversal of entries
(v) compensating errors

302
All errors are corrected through the journal.

- When all errors are corrected the trial balance totals will be equal with adjusted figures.

- If after correction of errors a balance remains in suspense account, it may indicate errors in
correcting them or not all errors have been identified. A good question will mention the outcome.

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.
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SOLUTIONS TO EXERCISES

1. Errors of omission, errors of principle, errors of commission and compensating errors.

2. When the trial balance totals are not equal.
3. It indicates a shortage on credit side of trial balance.
4.

The Journal

K K
(i) Discount allowed account (480 x 2) 960
Suspense account 960

(ii) Trial balance (Bank account) 560

Bank account 63
Trial balance (Bank account) 623
304
(iii) Suspense account 300
Trial balance (with provision for bad
debts) 300

(iv) Rent receivable account 20

Suspense account 20

(v) Drawings account 250

Purchases account 250

(vi) Sales account 300

Disposal account 300

(vii) Suspense account 9

Insurance account 9

(viii) Discount received account 100

Suspense account 100

(ix) Car repairs account 200

Building repairs account 200

(x) Suspense account 540

Trial balance (with provision for
depreciation account) 540

(xi) Income Statement account 375

Lorry account 375

Dr Suspense account Cr
305
Provision for bad debts 300 Discount allowed 960
Insurance 9 Bank account 623
Provision for depreciation 540 Rent receivable 40
Balance 874 Discount received 100
1723 1723

306
CHAPTER 20

FINANCIAL STATEMENTS WITH ADJUSTMENTS

INTRODUCTION

This chapter summarises all the adjustments so far discussed in previous chapters in order to prepare
financial year end statements. This chapter contains exercises for practice, thus consolidating the

307
knowledge in the previous chapters. The student is advised to attempt the questions before seeing the
solutions.

TOPICS

1 Income Statement with adjustments

2 Balance sheet with adjustments.

LEARNING OBJECTIVES

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

Prepare income statement and balance sheet with correct treatment of:

- prepayments
- accruals
- bad debts and provision for depreciation
- opening and closing inventory

308
Exercise 1

Shoe Black, 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

309
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.

310
Solution:
Workings:
1. K’000 4. Distribution expenses
Sales 13,600 K’000
Sales excluded 7 1,460
13,607 add owing 120
Less prepaid (60)
1,520

2. Purchases 8,100 5. Interest on loan K’000

Purchases for 50
Invoices not add accrued 50
Received 18 ___
8,118 1,00

N.B. 10% x 1000 = 100

3. Salaries and wages only K50,000 has been paid the
K’000 other K50,000 is still owing
1,590
Add owing 190
Less prepaid (70)
1,710

6. (i) Bad debts and allowance for bad debts

K’000
Receivables 810
Less: Bad debts (6)
Remaining receivables 804

K’000
(ii) Allowance for bad debts is 18
New balance 30
311
 Increase in allowance is 12

(iii) Bad debts and allowance for bad debts in

Income statement will be
K’000
Bad debts written off 6
Increase in allowance 12
18

(iv) Receivables in balance sheet will be:

K’000
Remaining receivables 804
Add omission 7
Allowance for bad debts (30)
781

7. Depreciation:
K’000
(i) Buildings: Balance as per trial balance 1,020
charge to income statement
(2% x 8,300) 166
1,186

K’000
(ii) Warehouse: Balance as per trial balance 290
charge to income statement
(15% x 1,800) 270
560

K’000
(iii) Motor vehicles: Balance as per trial balance 620
Charge to income statement
(25% x 1650) 420
312
 1,040

Shoe Black
Income statement for the year ended 31 December 20X7

K’000 K’000
Sales (1) 13,607
Less: Returns inwards (400)
Turnover 13,207
Cost of sales:
Opening inventory 1,530
Purchases (2) 8,118
Less: Returns outwards (150)
Add: Carriage inwards 700
Less: Closing inventory (1,660)
Gross profit (8,538)
4,669
Add: Discount received 100
4,769

Less: Expenses

Loan interest 100

Bad debts & allowance (6) (iii) 18
Salaries and wages (3) 1,710
Discounts allowed 80
Distribution Expenses 1,520
Carriage outwards 250
Depreciation: Buildings (7 (i)) 166
Warehouse (7 (ii)) 270
Motor vehicles (7 (iii)) 420
(4,534)
Net profit 235

313
Shoe Black

Balance Sheet as at 31 December 20X7

Non Current Assets Cost Depreciation N.B.V.

K’000 K’000 K’000

Land 1510 - 1510

Buildings 8300 1186 7114
Warehouse 1800 560 1240
Motor Vehicles 1680 1040 640
10504

Current Assets
Inventory (closing) 1660
Receivables (6 (iv)) 781
Prepayments (60 + 70) 130
Cash at Bank 140
2711

Total Assets 13215

Financed by:

Capital at start 10782

Add Net Profit 235

Non current Liabilities

10% Loan 1000

Current liabilities
Trade payables (820 + 18) 838
Accrued expenses (120 + 190 + 50) 360 1198
314
 13215

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
315
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
_________
316
 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

317
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

CHAPTER SUMMARY

318
1. Income statements are prepared on matching and accruals concepts. That is matching income
with expenses, whether received or not and whether paid or not, as long as they relate to a
particular period under review.

2. Prepayments made in one period are not a charge in that period. In income statement they are
deducted from the appropriate expenses charge and shown in balance sheet as current asset.
Prepayments will be a charge to the period for which they have been paid.

3. Amounts not paid by the business at the balance sheet date, should be accounted for as expenses
in that period in income statement and shown as current liabilities in balance sheet.

4. Any increase in Allowance for bad debts should be charged to income statement and any decrease
treated as income (gain) and netted off with bad debts because they are related.

5. The closing balances in Allowance for bad debts is the amount to be deducted from Trade
receivables in balance sheet.

CHAPTER 21

DEPARTMENTAL ACCOUNTS

INTRODUCTION

A business dealing in unrelated range of products under one roof, might wish to know the performance of
each product and make decisions such as to continue or withdraw.

The range of products will be divided into departments such as drappery, hardware, kitchen, etc, and each
department will be a cost centre and prepare its own income statement. This chapter shows how to
prepare departmental accounts and their usefulness.

TOPICS

1 Why prepare departmental accounts

2 Expense apportionment
319
3 Departmental income statement
4 The balance sheet
5 Decision-making

LEARNING OBJECTIVES

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

- Identify reasons why dividing a business into departments could be helpful

- Apportion expenses between departments using appropriate basis
- Prepare departmental income statements using the gross profit and contribution basis.

21.1 PREPARING DEPARTMENTAL ACCOUNTS

Departmental accounts are prepared to assess the performance of each department. The layout of
departmental accounts is not different from what has been covered in earlier chapters. The
primary difficulty in preparing departmental accounts is that many expenses are shared. Common
expenses shared may include:

- Rent and rates

- Electricity
- Insurance
- Transport
- Telephone

A business with separate departments for drappery, kitchenware and toiletries may prepare departmental
accounts as follows:

Drappery Kitchen Toiletries Total

320
 Ware
K K K K
Sales 120,000 200,000 50,000 370,000
Cost of sales (75,000) (150,000) (80,000) (305,000)
Gross profit 45,000 50,000 (30,000) 65,000

The above information shows that Toiletries is a loss department. Without it gross profit would
have been K95,000. A decision has to be made on how to improve the operations of the toiletry
department, or replace it with another which is profitable.

LOSS LEADER

It is important to be mindful that certain business have a deliberate policy of reducing prices in one
department to increase customer flow and hoping that customers will also buy from other
departments. Thus loss in one department to be offset by profits in other departments. This policy
should be reviewed and be done away with if it is not yielding profitable results for the whole
business.

In the above example the end result is gross profit. This is because at this stage it is
relatively easy to keep separate records for sales, purchases and inventories of each
department.

21.2 EXPENSES

Some expenses in a departmentalized business could be considered as direct and others shared
expenses.

- Examples of direct expenses include salaries or wages of personnel identified with each
department where they work.
- Most of the expenses are shared and should therefore be divided between the
departments using the most fair basis, because they cannot be traced to a particular
department.
- Examples of shared costs include electricity, transport, rentals, telephone, insurance,
advertising, etc.
321
21.3 CONTRIBUTION AND NET PROFIT

- Contribution is the difference between sales and direct expenses attributable to each
department i.e. expenses which would not be paid if the department was closed.
- When calculating net profit, expenses not traceable to the department and which will still
be paid even if the department was closed, are considered.

Therefore the best way of assessing departmental performance could be through

contribution.

Example: Complete departmental income statement.

The business of Opani has two departments, hardware and electrical. The information
below was taken from his books as at 31 December 20x7, the end of the financial year.

Hardware Electrical Unspecified

K K K
Sales 198,000 264,700
Purchases 75,000 137,000
Opening inventory 25,000 43,600
Wages 35,000 34,000
Other expenses 24,700 20,100
Building at cost 146,000
Motor vehicles at cost 145,000
Rates 15,000
Accumulated depreciation:
Buildings 37,000
Motor vehicles 60,300
Electricity 20,000
322
Notes:

(a) Depreciation policy is 20% straight line on buildings and 40% on motor vehivles
using reducing balance method.

(b) Buildings are used 4/5 hardware and 1/5 electrical

(c) Motor vehicles are used equally between the two departments.

(d) Electricity and Rates are apportioned on floor area occupied 2/3 hardware and 1/3
electrical.

(e) Closing inventory is K15,000 and K17,000 respectively for hardware and electrical.

Required:

(a) Prepare income statement for the year ended 31.12.20x7

(b) Assess the impact of closing down either department.

Solution:

(a) Opani,

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Departmental income statement for the year ended 31.12.20x7.

Hardware Electrical Total

K K K K K
Sales 198,000 264,700
462,700
Cost of sales:
Opening inventory 25,000 43,600
Purchases 75,000 137,000
100,000 180,600
Less: closing inventory (15,000) (17,000)
(85,000 (163,600)
(248,600)
Gross profit 113,000 101,100
214,100
Direct expenses:
Wages 35,000 34,000
Other expenses 24,700 20,100
(59,700 (54,100) (113,800)
Contribution 53,300 47,000 100,300

Shared expenses:
Depreciation:
Buildings 23,360 5,840
Motor vehicles 16,940 16,940
Rates 10,000 5,000
Electricity 13,333 6,667
(63,633) (34,447) (97,080)
Net profit (10,333) 12,553 3,220

(b) - Some costs are fixed e.g. rates, depreciation, electricity and
these would not be saved even if Hardware department is closed.

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 - Contribution by hardware department is very good though it has made a
net loss. The problem could be on the apportionment of indirect
expenses.

- Some customers might not use the business if the other department is
closed down.

21.4 THE BALANCE SHEET

The balance sheet is prepared as a single entity. It does not show separate assets and liabilities
for each department.

21.5 DECISION MAKING

Apart from deciding whether to close a department or not which is not easy, departmentalizing a
business may provide vital information such as:

(a) Profitability of each department for the purpose of may be expanding a profitable
department.
(b) Payment of bonuses or commission to employees may be based on departmental profits.
(c) Promotion of departmental managers could also be based on departmental profits.

CHAPTER SUMMARY

- Depending on the nature and size of the business it may be more convenient to divide the
business into departments.
- By departmentalizing a business, profitability of each department would be assessed and decisions
made.
- Separate gross profit and contribution is shown with direct departmental expenses and shared
expenses.
- Decisions about growth and trimming, closing down can be made.

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EXERCISES

1. Yugo owns a super market which is divided into three departments namely butchery, grocery and
beverages.

For the year ended 30 June 20x5, the following details were taken from his books.

Butchery Grocery Beverages Unspecified

K K K K
Sales 854,000 605,000 936,500
Purchases 600,000 350,000 740,000 -
Sales Returns - 20,000 - -
Salaries & wages 88,000 90,000 75,000
Opening inventory 36,000 50,000 44,000 -
Rentals - - - 45,000
Equipment at cost 55,000 47,000 30,000 -
Administrative expenses - - - 75,000

Additional information:

(i) Closing inventory is valued as follows:

- Butchery K25,000
- Grocery K33,200
- Beverages K41,750

(ii) Equipment is depreciated at 10% p.a. on cost.

(iii) Rent is to be divided equally between the three departments

(iv) Administrative expenses 2:1:3 respectively between butchery, grocery and beverages.

(v) Departmental managers are entitled to 10% commission on sales

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Required:

(i) Prepare departmental income statement for the year ended 30 June 20x5.

2. Papa is in business running a pharmacy, which is divided into drugs, perfumes and toiletries.

The balances below have been taken from his books as at 31 December 20x9.

K
Sales: drugs 675,000
Perfumes 500,000
Toiletries 300,000
Purchases: Drugs 900,000
Perfumes 350,000
Toiletries 225,000
Opening inventory: Drugs 75,000
Perfumes 60,000
Toiletries 45,000
Salaries and wages: Drugs 80,000
Perfumes 35,000
Toiletries 20,000
Lighting and heating 25,000
Telephone expenses 33,000
Motor expenses 66,000
Insurance 15,000
Fixtures and fittings 66,000
Office expenses 19,000
Buildings at cost 200,000
Additional information:

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 (i) Depreciation is: fixtures and fittings 10% and building 15% and is to be apportioned equally
for the three departments.
(ii) All other expenses to be apportioned 0.5 drugs, 0.25 perfumes and 0.25 toiletries.
(iii) Closing inventory is valued as follows:
Drugs K60,000
Perfumes K35,000
Toiletries K21,000

Required:

Prepare Papa’s departmental income statements for the year ended 31 December 20x9.

SOLUTIONS TO EXERCISES

1. Yugo

Departmental income statement for the year ended 30 June 20x5

Butchery Grocery Beverages Total

K K K K K K K
Sales 854,000 605,000 936,500 2,395,500
Sales returns - (20,000) - (20, 000)
______ _______ ______
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 854,000 585,000 936,500 2,375,500
Cost of sales:
Opening inv. 36,000 50,000 44,000
Purchases 600,000 350,000 740,000
636,000 400,000 784,000
Closing invent. (25,000) (33,200) (41,750)
(611,000) (366,800) (742,250) (1,720,050)
________ _______ _______ ________
Gross profit 243,000 218,200 194,250 655,450

Direct expenses:
Salaries/wages 88,000 90,000 75,000
Depreciation 5,500 4,700 3,000
Commission 85,400 58,500 93,650
______ _____ ______
(178,900) (153,200) (171,650) (503,750)
________ ________ ________ ________
CONTRIBUTION 64,100 65,000 22,600
151,700
OTHER EXPENSES:
Rent 15,000 15,000 15,000
Admin. Expenses 25,000 12,500 37,500
______ ______ ______
(40,000) (27,500) (52,500) (120,000)
Net profit 24,100 37,500 (29,900) 31,700

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2. Papa

Departmental income statement for the year ended 30 June 20x5

Drugs Perfumes Toiletries Total

K K K K K K
Sales 675,000 500,000 300,000 1,475,000
Cost of sales:
Opening inv. 75,000 60,000 45,000
Purchases 900,000 350,000 225,000
______ ______ ______
975,000 410,000 270,000
Closing inv. (60,000) (35,000) (21,000)
______ _______ _______
(915,000) (375,000) 249,000 (1,539,000)
Gross profit (240,000) 125,000 51,000 (64,000)

Direct expenses:
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 Salaries/wages (80,000) (35,000) (20,000) (135,000)
Contribution (320,000) 90,000 31,000 (199,000)
OTHER EXPENSES:
Depreciation:
Fixtures/fittings 2,200 2,200 2,200
Buildings 10,000 10,000 10,000
Lighting & heat 12,500 6,250 6,250
Telephone 16,500 8,250 8,250
Motor expenses 33,000 16,500 16,500
Insurance 7,500 3,750 3,750
Office expenses 9,500 4,750 4,750
(91,200) (51,700) (51,700) (194,600)
_________ ______ _______ ________
311,200 38,300 20,700 (
393,600)
======= ======= =======

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CHAPTER 22

PUBLIC SECTOR ACCOUNTING REPORTING

INTRODUCTION

This chapter is designed to set in context the discussion of public sector accounting at an introductory level.
Its purpose is to set out briefly the description of the public sector accounting and reporting in conformity to
the international public sector accounting standards.

TOPICS
1 Description of public sector
2 Users of public sector financial statements
3 International Federation of Accountants (Public Sector)
4 Financial reporting under cash basis and accruals basis
5 International public sector accounting standards
6 Reporting and the media

LEARNING OBJECTIVES

After studying this chapter, the student should be able to:

1. Describe what a public sector is.

2. Identify the users of public sector financial reports and the decisions they can make.
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 3. Explain the role of the International Federation of Accountants in public sector accounting.
4. Distinguish between the cash basis reporting and accruals basis reporting.
5. Identify international accounting standards on public sector accounting
6. Differentiate between above the line and below the line accounting.

22.1 PUBLIC SECTOR

There is a range of meanings given to the phrase ‘public sector’ but for our studies we shall adopt
the following:

‘In a mixed economy, public sector is that part of the economy that is owned and operated by
government authorities and public corporations.’

Public sector includes the following:

a) State owned enterprises

Also called public enterprises. This is a publicly owned commercial or industrial

organization that performs some essential service such as ZESCO and ZNBC, or
produces some essential commodity such a lime.

b) Local government or local authorities

This is an elected local government organization and employees who have legal
power and duty to provide and administer many local services for which rates are paid
to run it. The rates are a form of revenue to the government. Areas falling in this
category of revenue source are markets, schools, roads and public health centers.

Public sector organizations are funded mainly by the central government and also raise funds on
their own through taxes, rates, borrowing etc, and as such they keep records of sources and
application of funds.

Financial reports are prepared for accountability purposes and communicated to users who in turn
will make decisions affecting the community at large.
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 It should be made clear that public sectors exhibit a variety of social, economic, political and legal
characteristics. They have different powers and responsibilities and they display varied patterns of
accountability. They have different objectives and are financed in different ways. They also have
different organization structures.

Recent years has seen public sectors being exposed to competition and market mechanisms from
the private sector. Certain ranges of services provided are required to be awarded on the basis of
competitive tenders, with private sector contractors competing with public sector organizations e.g.
waste management services, road maintenance, cleaning, etc.

22.2 PUBLIC SECTORS POWERS AND RESPONSIBILTIES

As far as powers and responsibilities are concerned all public sector bodies have one feature in
common: There specific powers are derived ultimately from parliament and are ultimately
responsible to parliament.

Local authorities are partially accountable to parliament and more immediately answerable to a
local electorate.

22.3 PUBLIC SECTOR FINANCIAL REPORTS

By law and accounting standards, companies are required to produce annual reports and financial
statements. These include income statements, balance sheet and cash flow statement together
with accompanying notes. They are audited before they are published.

In public sector the same reports have been introduced, though some details are different. These
are forwarded to interested partied.

22.4 USERS OF FINANCIAL REPORTS

Users of public sector financial reports include the following:

a) Authorities –this could be the central government.

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 Government generally is interested in assessing how these organizations have utilized the
funding allocated to them for control and planning purposes.

b) Mangers –these are officials who are trustees and ensure that the daily activities of their
organizations are running smoothly. They have a keen interest and ensure that all
activities are being carried out as per budgetary plan and justification made for
extraordinary activities.

c) Tax payers . They are interested in how government are using money they pay as tax, and
also to assist in predicting future tax levels.

d) Public. The public generally includes workers (those who pay tax) and non workers. Is the
government providing good education, health, etc? If not then where is the money they
need to assess performance of their elected representatives.

e) International funding organizations. These are organizations such as International

Monetary Fund (IMF) World Bank, etc. who provide developmental funding to government.
They would want to know if the funds have been used for the intended purpose.

22.5 INTERNATIONAL FEDERATION OF ACCOUNTANTS (Public Sector) (IFAC)

The International Federation of Accountants is an organization of national professional

accountancy organization that represents accountants employed in public practice, business and
industry, the public sector and education.

IFAC has a Public Sector Committee (PSC). The PSC focuses on the accounting, auditing and
reporting needs of national, regional and local governments, related governmental entities and the
constituencies they serve. It addresses these needs by issuing and promoting benchmark
guidance, conducting research and educational programs, and facilitating the exchange of
information among accountants and all those who work within the public sector.

22.6 FINANCIAL REPORTING UNDER THE CASH BASIS

a) Cash basis
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 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.
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 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.
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 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.

22.7 INTERNATIONAL PUBLIC SECTOR ACCOUNTING STANDARDS (IPSAS)

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 The public sector committee (PSC) of the International Federation of Accountants (IFAC) issues
these accounting standards. These standards apply to national, regional and local governments
and their related government entities. The approach taken is to base IPSAS on the International
Accounting Standards (IASs) of the International Accounting Standards Committee. Subsequently
issues related to the public sector but which have not been dealt with by IASs will be addressed.

23 REPORTING AND MEDIA

Above-the-line: This term refers to revues and expenses that relate to normal on-going operations
of an organization and which when netted produces the reported operating profit.
Below-the-line: This term refers to exceptional and extraordinary items which are not included in
the calculation of profit (above the line). The items relate to capital income and expenditure.
Virement: This deals with the transfer of items from one financial account to another.

24 CHAPTER SUMMARY

 Public sector accounting deals with accounting which applies to national, regional and
local government and their related government entities

 Users of public sector financial reports include:

i) Authorities (including parliament)
ii) Heads of government departments
iii) Tax payers
iv) The public (the electorate)
v) Donors & International financiers such as the World Bank

 The cash basis of accounting recognizes transactions and events only when cash is
received or paid. Notes to the financial statements may provide additional information
about liabilities and other non cash assets (payables and receivables)

 Accruals based accounting recognizes income and expenditure when it accrues and not
when cash is received or paid.

339
340
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.

TOPICS

1. Definition of partnership as a form of business

2. Legal status of a partnership
3. Types of partners in partnership
4. Partnership agreement
5. Advantages and disadvantages of a partnership
6. Partnership current accounts
7. Partnership capital accounts
8. Profit and loss appropriation account
9. Financial statements of partnership

LEARNING OBJECTIVES

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

- Explain what a partnership is and how it differs from a sole trader.

- Explain the features of a partnership agreement.
- Distinguish the treatment of profit and loss of a partnership and sole trader.
- Prepare partnership financial statements.

23.1 DEFINITION OF PARTNERSHIP

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 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.

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 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)

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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 Introduced Capital account Partners fixed capitals

accounts

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 Drawings and share Capital account Partners current accounts
of profits
Division of profits Inapplicable – one proprietor Income statement – shared,
only 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

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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
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 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:

347
 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

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 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

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 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
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 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

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CHAPTER SUMMARRY

Accounting for partnership is similar to that of sole trader in many respects, except that any profit or loss
needs to be allocated between partners.

Partners need to prepare a partnership agreement that will outline the roles and responsibilities of each
partner

EXERCISES

1. Why do people want to form a Partnership?

2. Some partnerships don’t bother drawing up a partnership agreement. How do the partners in
those partnerships know what rights and responsibilities they have?

3. In the balance sheet of a partnership, how is a loan from a partner disclosed?

4. Interest on a loan made by a partner is shown as appropriation of profit, not as an expense. True
or false?

5. A and B are in partnership sharing profits and losses in the ratio 3:2.

352
 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
353
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
354
 (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

355
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.

356
 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)
357
 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

358
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

359
360
 CHAPTER 24
ACCOUNTING FOR NON-PROFIT MAKING ORGANISATIONS

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).

TOPICS

1 The receipts and payments account

2 Income and expenditure account
3 The balance sheet

LEARNING OBJECTIVES

After studying this chapter, the student should be able to:

- explain the difference between receipts and payments accounts and the cash book and how they
are prepared.
- prepare income and expenditure accounts
- make appropriate entries relating to subscriptions, life membership and donation
- calculate profit or loss on other activities and incorporate them into financial
statements.
- differentiate the financial statements of an incorporated organization with the profit making
organisations.

361
24.1 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 a profit 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.
24.2 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

362
 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.

24.3 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.

24.4 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

363
 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.
24.5 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

364
24.6 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

365
24.7 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.

366
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

367
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.

368
 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.

369
24.8 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.

370
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
371
 = 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.

24.9 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.

372
 The entrance fees account is at year end transferred to income and expenditure account.

Dr. - Entrance fees account

Cr. - Income and expenditure account.

24.10 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

373
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.

374
Solution:
(a) Accumulated fund
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

(b) (i) Subscription account

Dr. K K Cr.

Balance b/d 65 Balance b/d 10

Income & exp. Cash 1987
account 1980

Balance c/d 37 Balance c/d 85

2082 2082

375
 Competition prizes account

(ii) Dr. K K Cr.

Balance b/d 38 Balance b/d 58

Bank 270 Cost of prizes given to
income and expenditure
account (Bal. Fig) 272
Balance c/d 68 Balances c/d 46

376 376

Balance b/d 46 Balance b/d 68

North East Rotary Club

Income and Expenditure account for the year
ended 31 December 20X1

Income K K
Subscriptions 1980
Ticket sales 437
Less cost of prizes (272)
Profit on competition 165
Donations 177
2322

Expenditure
Secretarial expenses 163
Rent (1402 – 500) 902
Speakers expenses 1275
Donations to charities 35
376
 Stationery and printing 179
Depreciation 195
(2749)
Deficit (427)

North East Rotary Club

Balance sheet as at 31 December 20X1

Non current assets Cost Dep. N.B.V.

Equipment 1420 640 780

Current assets
Inventory of prizes 46
Subscriptions in arrears 85
131

Total assets 911

Financed by:
K
Accumulated fund at 1 January 20X1 1220
Less deficit (427)
793
Current liabilities
Payables for prizes 68
Subscriptions paid in advance 37
Bank overdraft 13
118
911

377
CHAPTER SUMMARY

- The receipts and payments accounts only shows the cash position of the organization. It is just a
summary of cash receipts and payments. It may be the source of information for the income and
expenditure account.

- The income and expenditure account is prepared to determine surplus (profit) or deficit (loss). It is
prepared on matching or accruals concept.

- The main source of income for clubs is subscription. Subscription should be adjusted for arrears
and prepayments.

- Accumulated fund is same as capital in trading organizations and is calculated thus Assets –
liabilities.

- Any trading activities should be shown separately and profit or loss is what is shown in income and
expenditure or netting off within the income and expenditure account.

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

378
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
379
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.

380
 SOLUTIONS TO ACTIVITY QUESTIONS

Activity 1
Subscriptions account
Dr. Cr.

K K
Balance b/f 410 Bank (370 + 6730 + 1180) 8,280

Income & Expenditure Subscriptions written off 40

Account (balancing figure) 7,200

Balance c/d 1,180 Balance c/d 470

8,790 8,790

Balance b/d 470 Balance b/d 1,180

Note:
Subscriptions written off amounting to K40 is the difference between the subscriptions owing at the start of
the period amounting to K410 and the amounts received during the year in relation to these subscriptions
amounting to K370.

SOLUTIONS TO EXERCISES

1. (i) The capital account is the accumulated fund

(ii) The profit/loss is the surplus/deficit
(iii) The Income Statement is the income and expenditure account

381
2. The correct answer is B.

3. The correct answer is C.

Subscriptions account
Dr. Cr.

K K
Balance b/f 70 Bank 1,620

Subscriptions to (Income
& Expenditure) (150 x 10) 1,500
Balance c/d 50 ____
1,620 1,620
Balance b/d 50

4. The correct answer is C.

Assets K K
Equipment 1,500
Premises 16,000
Bar inventory 1,300
Subscriptions in arrears 500
Cash 1,900 21,200

Liabilities
Bar payables 1,100
Wages owing 250
Prepaid subscriptions 350
(1,700)
Accumulated fund 19,500

382
5. Bar income statement for the year ended 31 December 20X4.

K K
Bar sales 90,000
Cost of sales:
Bar opening inventory 9,000
Bar purchases 40,000
49,000

Less: bar closing inventory 5,600

(43,400)
Gross profit on bar 46,600
Less: wages of bar workers (30,000)

Net profit 16,600

Up Hill Cricket Club

Income and Expenditure account for the year ended
31 December 20X4

Income K K
Subscriptions 190,000
Less subscriptions prepaid (1,800)
Add subscriptions owing 700
188,900
Bar profits 16,600
Raffle profits 6,000
211,500
Expenditure
General expenses 31,500
Care takers wages 20,400
383
 Salary for professionals 36,200
Depreciation: equipment 2,400
(90,500)
Surplus 121,000

Up Hill Cricket Club

Balance sheet as at 31 December 20X4

K K K
Non Current Assets Cost Dep. N.B.V.
Club house 140,000 140,000
Equipment 18,000 2,400 15,600
158,000 2,400 155,600

Current Assets
Bar inventory 5,600
Subscriptions in arrears 700
Cash in hand 900
7,200
162,800

Financed by:

Accumulated fund @ start 40,000

Add: Surplus 121,000
161,000

Current liabilities
Subscriptions in advance 1,800
162,800

384
 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.
TOPICS
1. Single entry bookkeeping
2. Incomplete records
3. Preparing Financial statements

LEARNING OBJECTIVES
After studying this chapter the student should be able to:

 Explain the difference between single entry and incomplete records

 Prepare a set of financial statements from a limited set of records
 Prepare a set of records for an incomplete records situation
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
385
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

386
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
387
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.

388
 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

389
 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

390
 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

391
 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

392
 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

393
 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

394
 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

395
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
396
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

397
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
398
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.

CHAPTER SUMMARY
You should by now have learnt that:
1. Understanding double entry is very important. You cannot correctly handle a question on single entry
without it.
2. The skill of writing ledger accounts should be perfected, otherwise the figure you derive for transfer to
the income statement will be incorrect
3. You should understand what a debit balance on an accounts represents and what a credit balance on
an account means, otherwise you will not list balances under the correct heading on the balance sheet.
4. An incomplete records situation can be more involving than a single entry situation.

399
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.
400
 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

SOLUTION TO EXERCISE

MPOMWA
Statement of affairs as at 1 January 2006
K000
Assets:
Fixtures 2 500
Inventory 1 950
Trade receivable 170
Bank 620
5 240

Liabilities:
Trade payables 960
Capital 4 280

401
 CAPITAL

K 000 K 000
Balance b/d 4 280
Bank 650
Balance c/d 4 930
4 930 4 930
Balance b/d 4 930

CASH

K 000 K 000
Wages 350
Trade receivable 48 580 General Expenses 110
Bank 48 120
Balance c/d
48 580 48 580
Balance b/d

TRADE RECEIVABLES

K 000 K 000
Balance b/d 170 Cash 48 580
Sales 48 620
Balance c/d 210
48 580 48 580
Balance b/d 210

402
 TRADE PAYABLES

K 000 K 000
Balance b/d 960
Purchases 33 200
Bank 32 890

Balance c/d 1 270

34 160 34 160
Balance b/d 1 270

FIXTURE S

K 000 K 000
Balance b/d 2 500
Bank 800
Balance c/d 3 300
3 300 3 300
Balance b/d 3 300

GENERAL EXPENSES

K 000 K 000
Bank 3 650
Cash 110 P/L c/d 3 760
3 760 3 760

403
 RENT

K 000 K 000
Drawings 1 200
Bank 2 400 P/L c/d 1 200

3 640 3 640

WAGES

K 000 K 000
Bank 760 P/L c/d 1 110
Cash 350
1 110 1 110

DRAWINGS

K 000 K 000
Bank 5 870
Rent 1 200
Inventory 320
Capital c/d 7 390
7 390 7 390

MPOMWA
INCOME STATEMENT for the year ended 31 December 2006

404
 K000 K000
Sales (less Sales Returns) 48 620
Less: Cost of Sales 32 270
Gross Profit 16 350
Less: Expenses
Rent 1 200
Wages 1 110
General expenses 3 760
Depreciation 330
6 400
Net Profit 9 950

MPOMWA
BALANCE SHEET as at 31 December 2006
K000 K000
Non current Assets:
Fixtures 3 300
Less: Accumulated depreciation 330
3 970
Current Assets:
Inventory 2 560
Trade receivables 210
Bank(620+48 770-46 370) 3 020
5 790
Total assets 8 760
Capital
Balance at start 4 930
405
 Add: Net Profit 9 950
14 880
Less: Drawings 7 390
7 490
Non current Liabilities:
None

Current Liabilities:
Trade Payable 210
210
8 760

Working:

Cost of sales is calculated as follows:

Inventory at start 1 950
Purchases 33 200
35 150
Less: Inventory at end 2 560
Drawings 320
2 880
32 270

406
 CHAPTER 26
CASHFLOW STATEMENTS
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

407
LEARNING OBJECTIVES

After studying this chapter the student should be able to:

 Explain the importance of the cash flow statement
 Prepare 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.

408
 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
409
 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
410
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

411
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
412
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
413
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
414
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
415
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
416
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

417
 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
418
 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

419
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)

420
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 l 2 200 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

421
 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)
422
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

423
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

424
 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)
425
 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

426
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

427
 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:

428
 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

429
 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

430
 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
431
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:

432
 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

433
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.

434
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.

435
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

436
 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
437
 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.
438
 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:

439
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
440
 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 31 st December
2006:
Dr Cr
441
 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 31 st December 2006 and a Balance
Sheet as at that date.
442
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
443
 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
444
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 (1st April 2006) 170 000
Receivables 104 000
Payables 76 000
Cash at bank 82 000
445
 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 31 st March 2007 and a
Balance Sheet as at that date.

446
QUESTION TWO
The following Trial Balance was extracted from the books of Hillside Plc at 31 st 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 1st April 2005 30 000
Plant and machinery (K348 million cost) 262 500
Motor vans at cost 140 000
Accumulated depreciation on vans on 1st April 2005 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:

447
 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 st March
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.

448
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 31 st March 2006.
(11 marks)
c) Prepare the company’s Balance Sheet as at 31st March 2006.
(14 marks)
(NATech: December 2006)

449
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

450
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
451
 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
452
 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
453
 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
454
 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

455
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
456
 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.

457
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.
458
 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

459
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.

460
 CHAPTER 28
INTERPRETATION OF FINAL ACCOUNTS
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
461
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.

462
 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:
a
463
 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.
464
 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

465
 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:

466
 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:
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 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.
468
 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
469
 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.

470
A public limited company quoted on the Lusaka Stock Exchange produced the following results as at 31 st
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:
471
 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
472
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
473
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

474
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

475
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

476
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

477
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
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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

479
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 3 380 000 – 980 000/1 690 000 3 900 000 – 1 280 000/1 910 000

= 1.42 = 1.37

Debtors turnover 2 1600 000/19 500 000 x 365 2 460 000/22 400 000 x 365

= 40 days = 40 days

Creditors turnover 1 380 000/13 650 000 x 365 1 500 000/16 920 000 x 365

= 37 days = 32 days

480
 Stock turnover 13 650 000/980 000 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.

481
  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.

482
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
483
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
484
 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.

485
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

486
 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.

487
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.

488
 CHAPTER 30

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

489
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
490
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.

491
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

492
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
493
 - 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.

494
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 1st October 2005 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 1st October 2005 36 000

Notes:

1. At 30th September 2006, the following were on hand:

K'000
Raw materials 30 000
Work in progress 27 000
495
 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
496
 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
497
 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 1st January 2006:
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
498
 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%

499
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

500
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
501
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 25/125 = K2 070 000

502
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
503
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
504
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 1 st 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:

505
 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 31 st March 2003.
(12 marks)
ii) Panuka Ltd’s Balance Sheet as at 31st March 2003.
(11 marks)

(NATech June 2004)

506
B 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 (5/6 x 840) 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

507
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 (1/6 x 840) 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
508
 - 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

509
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

510
(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 86
511
(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

512
FINANCIAL ACCOUNTING 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.

513
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.
514
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.

515
516