Accounting

‘the art of recording, classifying, and summarizing in a significant manner and in terms of money,
transactions and events which are, in part at least of financial character, and interpreting the results
thereof”

Bookkeeping

Book-keeping is a process of accounting concerned with recording transactions and keeping records. Book-keeping is a
small and simple part of accounting.

Difference between Bookkeeping and Accounting

Book-keeping: It is concerned with systematic recording of transaction in the books of original entry and
their posting into the ledgers. It involves.

• Journalizing

• Posting into ledger

• Totaling of different accounts in the ledger

• Balancing

• Preparing Trial Balance

Accountancy: Accounting begins where Book-keeping ends. “It means that an accountant comes into the
picture only when the book-keeper has done his job. The functions of accountant can be classified as
under:

• Inspecting the work of book keeper

• Preparation of Income Statement

• Preparation of Balance Sheet

• Passing Entries for rectification of errors and making adjustments

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Heads of Accounts

Assets are the resources controlled by the enterprise as a result of past events and from which future
economic benefits are expected to flow to the enterprise. It is simply what a company owns.
Liabilities are the present obligations of an enterprise arising from past events, the settlement of which is
expected to result in an outflow of resources embodying economic benefits. Liability is what a company
owes.
Capital is the source of fund provided by owner.
Revenue is an inflow of assets in return of services performed or good delivered in accounting period.
Expenses are the cost of producing revenue in a particular accounting period.

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Accounting Process

Transaction Occurs

Source Documents is prepared

Entry recorded in Books of Prime Entry

Entry posted to ledger

Trial Balance

Financial Statements

Source Documents
A source document is a proof or evidence of a transaction that is carried out in a business

Sales Invoice Credit Sales

Purchase Invoice Credit Purchase
Credit Note Issued Returned by Customer A credit note may be issued by a supplier to
reduce an invoice for returns/overcharge
Credit Note Received Returned by Business (purchase
return)
Wages Sheet/Payroll Register Payment of wages
Receipt For cash received / Cash payments
counterfoil For cash deposited in bank
Cheque/Deposit Slip For Amount received through Bank
Cheque Counterfoil/Stub For Payment by Bank
Petty cash Voucher / Cash For Petty Cash Transaction
Memo
Bank Statement For Online / Credit Transfer

Other Documents are

Debit Note: A debit note may be issued by a customer to request a reduction in an invoice
Statement of Account: The Statement of account is a document, issued by a supplier to its customer, listing transactions
over a given period, normally monthly. It will include details of invoices, payments received and any credits approved
with a resultant balance payable by the customer.
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Books of Prime Entry

These are also known as book of original entry/ preliminary entry/first entry. Transaction are at first recorded in Book of
Prime Entry then in ledger.

Benefits of maintaining Books of Prime Entry

• Reduces the number of entries in the ledger

• Act as an aid for posting to the ledger
• Helps to gather and summaries accounting information
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 • Facilitate preparation of control accounts
• Allows work to be divided between several people

Sales Journal Transaction related to credit Sales of goods

Purchase Journal Transaction related to credit purchases of goods
Sales Return Journal Transaction related to Sales Return
Purchase Return Journal Transaction related to Purchase Return
Cash Book Transaction related to Cash and Bank
General Journal / Journal It Contains

• Opening entries,
• Closing entries
• purchases/sale of fixed asset on credit,
• correction of errors,
• writing off bad debt,
• year-end adjustments,
• items which cannot be entered in other books of prime
entry,

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Ledger

A ledger is a book in which all accounts are maintained.

Benefits of Division Of ledger

• easier for reference as accounts of the same type are kept together
• helps to locate errors
• deters fraud and reduces the possibility of fraud due to segregation of duties
• allows checking process to be introduced

Sales Ledger (Receivable Ledger) Contains accounts of Receivables

Purchase Ledger (Payable Ledger) Contains accounts of payables
General Ledger (Nominal Ledger) Contain all accounts except cash bank, receivables and payables
Cash Book Contains accounts of cash and bank

Accounts
Account is an individual record of an asset, a liability, an expense, a revenue or capital in summarized nature. Account is
an individual record which contain summary of same nature of transaction.

Real Account These are the accounts relating to all assets and
properties.
Personal Account Receivables and payables accounts
Nominal Account These are accounts related to loses, expense , Income and
gains

CASH BOOK
Cash book is the only book of original entry which is given ruling in such a way that it could act at the same time as a
book of original entry and as a ledger account.

TRADE DISCOUNT
It is an allowance or deduction given by the supplier to the retailer on the catalogue price or list price.

§ It is given to encourage him to buy in bulk.

§ It is given so that retailer could make some profit.

Note: It is not recorded in the books either by the seller or the buyer.

CASH DISCOUNT
It is an allowance or deduction given by the receiver of cash to the payer of cash for prompt payment.

It is of two types discount allowed and discount received.

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CONTRA ENTRY: WHEN A TRANSACTION EFFECTS BOTH CASH AND BANK ACCOUNTS AT THE SAME TIME, SUCH ENTRIES
ARE CALLED AS CONTRA ENTRIES.

Trial balance may be defined as a statement or a list of all ledger account balances taken from various ledger books on a
particular date to check the arithmetical accuracy. It is not a part of the double entry system of book keeping.

Objectives or Advantages Of Trial Balance

1. It checks the arithmetical accuracy of ledger accounts.

2. It is useful in preparing financial statements.
3. To have a proof that the double entry of each transaction is made.
•

Income statement shows the financial performance of the business for an accounting year. It consists of two sections:

Trading Account: In this gross profit is calculated.

Profit and loss Account: In this profit for the year is calculated.

It shows the financial position of the business at a certain date. It is based upon accounting equation. It is not a part of
the double entry system. It shows the assets, liabilities and capital of a business.

ADVANTAGES OF MAINTAINING ACCOUNTING RECORDS USING THE DOUBLE ENTRY

METHOD.

• Less risk of errors

• Less risk of fraud
• Easier to refer to previous transactions
• Financial position can be ascertained
• Easier to prepare financial statements
• Easier to make business decisions
• Easier to calculate accounting ratios

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Explain the meanings of ‘asset’
Asset is something which the business owns or something which is owed to the business

Define a non-current asset.

Assets which are purchased for use not for resale
Assets whose values do not fluctuate frequently
Asses which will be kept by the business for more than 12 months
Assets which are acquired to aid the business earn revenue

State the difference between a non-current asset and a current asset.

Non-current asset-any reasonable definition e.g. an item held for more than 12 months, an item which is not for
resale.
Current asset- any reasonable definition e.g. short term, an item which can be turned into cash quickly.

State what is meant by a liability. Give one example of a liability.

Liability is something which a business owes to a third party

Define a non-current liability.

Liabilities which are not due for repayment within 12 months

Explain the two ways of preparing an account.

A ledger is a book of accounts to maintain a classified record of all the financial (monetary) transactions of a
business. In the ledger one page or sometimes more than one page, contain a record of transactions relating to a
particular item or person. This record is known as an account. Ledger is therefore a book to keep all accounts at a
single place.

Name an alternative format to ‘T’ accounts.

Running balance format

State one benefit of this format compared with ‘T’ accounts.

Balance \of account always available.
Format used in computerized accounting.

Define a trial balance.

A trial balance is a list of balances on the accounts in the books/ledgers/records at a particular date used to check
the accuracy of accounts. Allow “check accuracy” if linked with “list of balances”.

State reasons why a trial balance is prepared.

• Confirms arithmetical accuracy of the double –entry

• Assists in the preparation of financial statements
• Can trace or identify errors

State what is meant by the term book-keeping.

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The recording of all financial transactions in the books of account

Explain the difference between book – keeping and accounting.

Bookkeeping involves preparing accounts from source documents or prime entry records, Accounting involves
identifying, measuring and communicating financial information

Bookkeeping is the process of recording data whereas Accounting provides information for decision making

Book-keeping refers to the maintaining of all double entry records/recording transactions Accounting refers to the
preparation (and interpretation) of financial statements

State two reasons why book- keeping records are maintained

• A record of all transactions

• Detailed record if each customer, supplier, expense or income.
• Reference can easily be made to the detail in each account.
• Financial statement can be prepared at regular intervals.
• Aid management and decisions can be made.

Explain the difference between ledger and an account

A ledger is a book of accounts to maintain a classified record of all the financial (monetary) transactions of a
business.in the ledger one page or sometimes more than one page, contain a record of transactions relating to a
particular item or person. This record is known as an account. Ledger is therefore a book to keep all accounts at a
single place.

BOOKS OF ORIGINAL ENTRY

Name of the books of prime (original) entry which a business may maintain.

Book of prime (original) entry Source document

Cash book Cheque counterfoil/bank statement/ Receipt
Petty cash book Receipt/voucher
Sales journal Sales invoice
Sales returns journal Credit note issued
Purchases journal Purchase invoice
Purchases returns journal Credit note received
General journal Invoice for non-current asset, purchased on credit or other
or suitable document

Write down advantages of maintaining books of original entry (prime entry).

Þ Reduces the number of entries in the ledger

Þ Acts as an aid for posting to the ledger
Þ Helps to gather and summaries accounting information
Þ Facilitate preparation of control accounts
Þ Groups together similar types of transactions
Þ Allows work to be divided between several people

State why it is useful for a business to maintain a sales journal.

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 Þ To reduce number of entries/detail in sales account
Þ Allows work to be shared between several people
Þ Provides list of credit sales

Give two uses of the general journal.

Þ Correction of errors
Þ Year-end transfers/from expenses account to income statement
Þ Items which cannot be recorded in other journals
Þ Bad debts written off
Þ Depreciation of the year
Þ Record drawings for inventory

State the purpose of each of the invoice, debit note, credit note and statement of account.
Invoice
A document from the supplies when goods are sold
Debit Note
A document from a customer asking for a reduction in the value of an invoice received by them.
Credit Note
A document sent to the customer showing the reduction of an invoice.
Statement of Account
To notify the customer of the amount outstanding at the end of the month.
To provide the customer with a summary of the month’s transactions.

State the purpose of the three documents.

1. Invoice
2. Cheque counterfoil
3. Credit note

1. The invoice is an official demand for payment,

It details the goods or services delivered
It Will be sent to customers for sales or services or from trade payables for purchases
It Will be recorded in the sales journal or purchases journal
It Details the terms of payment

2. A Cheque will be raised to pay payables and the counterfoil will be completed as a record of the
payment.

3. A credit note is an advice that the trade receivable account will be credited.
It is used when sales have been made but the goods are returned as incorrect or defective
It is recorded in the sales returns journal or purchase returns journal

State why a narrative should be shown as part of a journal entry.

A narrative explains the reasons for the entries which are to be recorded in the ledger.

Explain how the cash book is both a book of prime entry and a ledger account.

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 Þ The cash book is the book of original entry for cash and bank transactions, recorded from source
documents like cheques and receipts.
Þ It contains ledger account for cash and bank.

Name the two accounts which are posted with the totals from a three-column cash book.

Þ Discount allowed
Þ Discount received

State what is meant by a bank overdraft.

Paying more from the band account then there is in it. This means that the business owes the bank money (the
bank is a current liability).

Explain why there could be a credit balance on a bank account but on the cash account.

Businesses can withdraw more from bank then put in/can have overdraft however they cannot take more cash than is
physical present

State one advantage of dividing the ledger into sales ledger, a purchase ledger and a nominal (general) ledger.

Explain why dividing the ledger into sections makes it easier to use.

Þ Easier for reference as accounts of the same type are kept together
Þ Helps to locate errors
Þ Allows tasks to be divided between different people
Þ Deters fraud and reduces the possibility of fraud
Þ Allows checking procedures to be introduced

State two reasons for maintaining a petty cash book in addition to main cash book.

Þ To record small cash payments

Þ To remove small cash payments from the main cash book.
Þ To reduce the number of entries in the main cash book and the expenses in the ledger.
Þ To allow the chief cashier to delegate some of the work.
Þ To provides trading for any junior staff members

Explain the imprest system of petty cash.

The petty cashier starts each month with the same amount of money.At the end of the period the amount spent is
reimbursed the amount of the actual expenses so the cash remaining is equal to the imprest amount.

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State one advantage of the imprest system of petty cash.

Þ The chief cashier is aware of exactly how much is spent in each period.
Þ The chief cashier can control expenditure of petty cash
Þ The cash remaining and the total of the vouchers received should always be equal to the imprest amount.
Þ Can help to reduce fraud
Þ Control/limit/keep track of petty cash expenditure

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Bad debts and Provision for doubtful debts

Bad debts

A bad debt is an amount written off in respect of a debt that has become bad, that is, money will
not be received from the customer in respect of the amount owed by him. A debt should be written off
only when the business is certain that the customer will not pay. In cases where the business only has
doubt (not sure) when a provision for doubtful debts should be made.

Accounting entries for bad debts

Debit Credit

Bad Debts xx

Customer (ABC) xx

Note: the balance of the bad debts account is transferred to income statement at the end of the
financial year where it is shown as an expense.

1. Obtain reference from new credit customers

2. Fix a credit limit for each customer
3. Issue invoices and statements promptly
4. Follow up overdue accounts promptly
5. Supply goods on a cash basis only
6. Refuse further supplies until outstanding account is paid

Þ It is important to monitor debtors to ensure that they pay the amount owed on the due date.
Þ To ensure that the debtors do not have overdue debts.
Þ To ensure that they do not exceed their credit limits.
Þ To improve the cash flow of the business.
Þ Because business has to comply with accounting standards eg prudence.

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Provision for doubtful debts (PFDD)

Provision for doubtful debts is in amount set aside to provide for a reduction in the value of trade
receivables in anticipation of debts that may prove to become bad in the future. It should be noted that
provision for doubtful debts is completely different from bad debts.

Prudence concept - that the business should be pessimistic while recording its debtor’s balances and should make
account of all the probable losses on the amount due by his debtors to ensure profits and debtors are not overstated.

Prudence concept states that profits should be understated, rather than overstated. Creating a provision for doubtful
debts increases the expenses and reduces the profit. Assets should be understated rather than overstated . Provision is
subtracted from debtors thereby reducing assets.

Matching / accrual concept – it emphasis that all expenses incurred should be matched with the income of the relevant
period. So, doubtful debts relating to the current year sales which are likely to be confirmed in next year are matched
against current year’s income.

Matching/Accruals concept states that expenses should be matched to the time period in which that expense was
incurred. Bad debts frequently occur outside the year of sale. The provision matches the likely bad debts to the year in
which the sale of that stock was made so that profit and debtors are not overstated.

In the Statement of financial position, trade receivables should be recorded at their expected net collectible amount
(amounts the business reasonably expects to receive from customers)

• Rates of bad debts in previous years.

• Specific information about customer in financial difficulties.
• Actual state of economy
• How long each debt is outstanding

Methods of calculating Provision for doubtful debts:

1. By taking a percentage of the total amount owing by customers at end of year. This is known as a
general provision.
Provision for doubtful debts = Rate x Trade receivable at end of year
(trade receivable end of year should be after deducting any bad debts)

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 2. By analyzing each individual debt and aggregating those debts that may prove to be bad (specific
provision).

Bad debts recovered

A bad debt recovered refers to a situation whereby money is being received in respect of a debt that had
previously been written off as bad. A series of entries have to be made when a bad debt is recovered
these are listed below.
1. Recreate the debt
Debit Credit

Customer(ABC) xx

Bad Debt Recovered xx

2. Record the money received

Debit Credit

Bank xx

Customer (ABC) xx

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Capital And Revenue Transactions

Capital Receipt Revenue Receipt

Capital receipts arise from selling non-current assets revenue receipts arise from day-to-day business
activities
Capital receipts arise from owners/lenders providing Revenue receipts from the sale of goods
additional capital
Capital receipts are recorded in the Statement of revenue receipts are recorded in the income
Financial Position. statement
Loan From bank, sale of non-current asset Commission received, discount received

Capital Expenditure Revenue Expenditure

Expenditure incurred on the purchase, alteration or Expenditure incurred on the day-to-day running
improvement of non-current assets expenses of the business
Purchase of non-current asset Rent, insurance

If Revenue Expenditure treated as Capital Exp.

Then G.P. → No Change

N.P. → Overstated
Capital → Overstated
Fixed Assets → Overstated

If Capital Expenditure Treated as Revenue

G.P. → No Change
N.P. → Understated
Fixed Assets → Understated
Capital → Understated

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Bank Reconciliation Statement

It is a statement prepared by the trader to explain why the balance on the bank column in the cash book
differs from the balance on the bank statement

STATE WHY THE BANK STATEMENT BALANCE IS ON THE OPPOSITE SIDE TO THAT SHOWN IN
THE CASH BOOK

The bank statement is a copy of the account of the business as it appears in the books of the bank the
bank statement is prepared from the viewpoint of the bank the bank account in the cash book is
prepared from the viewpoint of the business

PURPOSE OF PREPARING BANK RECONCILIATION STATEMENTS

Þ Ascertain the true bank balance at a certain date

Þ Assist in detecting fraud and embezzlement
Þ Identify any “stale” cheques
Þ Demonstrate that any differences between the cash book balance and that on the
statement are due to genuine reasons (unpresented cheques, uncredited deposits)

Reason why the bank account and bank statement may differ
Difference arises due

1. The different times at which same items are recorded.

Þ Uncredited/Uncleared cheques/ Bank Lodgments.
Þ Unpresented/outstanding cheques.
2. The business not recording certain items in cash book.
Þ Bank charges and bank interest.
Þ Dishonored cheques.
Þ Amount paid directly paid into the bank.
Þ Amount paid directly paid by the bank to others.

Adjusted Control Account (Bank)

Balance b/d xx Balance b/d xx
Credit transfer xx Bank Charges xx
Interest On deposit xx Direct Debits xx

Errors in cash book xx Standing Order xx

Dishonored Cheques xx
Errors in Cash Book xx
c/d (corrected) xx c/d (corrected) xx
xx xx
balance b/d xx balance b/d xx

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 Bank Reconciliation Statement

As at 31 Dec……..

Balance as per bank Statement xxx

Add: Uncredited Deposits xxx

Less: Unpresented Cheque (xxx)

Add or less any error in bank Xxx/(xxx)

Balance as per updated cashbook (bank column) xxx

Bank Reconciliation Statement

As at 31 Dec……..

Balance as per updated cashbook (bank column) xxx

less: Uncredited Deposits (xxx)

Add: Unpresented Cheque xxx

Add or less any error in bank Xxx/(xxx)

Balance as per bank Statement xxx

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Accrual and Prepayments
Accrual Principle
Only items relating to that particular time period should be included in the statement: the timing of the actual receipts
and payments is not relevant.

Accrued Expense : Expense incurred but not paid for (Current Liability)
Accrued Income : Income earned but not received yet (Current Asset)
Prepaid Expense : Expense paid for but not incurred yet (Current Asset)
Pre-Received Income : Income (cash) received but not earned yet (Current Liability)

Expense Payable
Balance b/d(Prepaid) xxx Balance b/d(owing) xxx
Bank/Cash/creditor xxx Bank (Refund) xxx
Income Statement xxx
(Expense of the year)
Balance c/d(owing) xxx Balance c/d(prepaid) xxx
xxx xxx

Income Receivable
Balance b/d(Due) xxx Balance b/d(advance/perceived) xxx
Income Statement xxx Bank/Cash/Debtor xxx
(income of the year)
Bank (Refund) Income written off xxx
Balance c/d(advance/perceived) xxx Balance c/d(due) xxx
xxx xxx

If accrual prepayment adjustment were not done then business would be producing the accounts in contravention of the
accounting standards and good accounting practice if she did not make adjustments for accruals and prepayments.

Businesses must apply the accruals/matching concept which states that revenue and expenditure must be matched to
the time period in which they were incurred not to the time period when they were received or paid.

The net profit figure would be unreliable in the profit and loss account. If all the relevant expenditure for the period had
not been matched with revenue.

The balance sheet would also not show a true and fair view of the business as accruals and prepayments outstanding at
the year-end would not appear under current assets and current liabilities.

Applying the accruals/matching concept each year permits a valid comparison of net profit both year on year and with
other businesses. This also links to the consistency concept.

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It can also be argued that accounting for accruals and prepayments is to some extent an application of the prudence
concept as failure to accrue expenses at the year-end would result in profit and working capital values being overstated.

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Depreciation Of Non Current Assets
IAS 16 defines depreciation as the systematic allocation of the depreciable amount of an asset over its useful life.

In simple terms depreciation is an expense for using the economic benefits of non-current assets. It can also be defined
as the reduction in the book value of an asset.

Matching/Accrual Concept – Matching concept requires that all costs incurred in a period should be deducted against
revenue earned during that period in arriving at profit. Therefore, depreciation being an expense must be charged
against revenue when calculating profits.

Prudence Concept – According to the prudence concept, profits should not be anticipated or overstated but provision
should be made for all possible losses. If depreciation is not charged against revenue for the period, profits as well as
assets would be overstated. Hence this would be against the principle of prudence.

Calculation of Net Book Value (Going concern Concept) – Non-Current assets should be shown in the statement of
financial at their net book value (NBV) and not their expected sales value. Net book value is the difference between the
cost of the asset and its accumulated depreciation. Hence to be able to calculate the net book value, depreciation has to
be proved. This treatment is also in line with going concern concept.

Once a depreciation method is chosen, it should not be changed. This is in accordance with the
consistency concept. Under this concept different accounting methods are used the same way from
period to period this way accounting user may have more useful comparisons of financial statements
from year to year

1. Physical deterioration
2. Economic reasons
3. Passage of time (time factor) (Lease Hold land)
4. Depletion

Þ Cost of non-current asset

Þ Residual value / Scrap value
Þ Useful life
Þ Repair & Maintenance

STRAIGHT LINE DEPRECIATION METHOD / FIXED INSTALLMENT METHOD

It assures that the asset is used evenly every year throughout its expected life. It is calculated or the amount that is
calculated remains the same throughout each year.

Depreciation= Cost - Scrap value / Estimated useful life (years)

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Depreciation= Cost – Scrap value* percentage % ( but mostly in CAIE Qs Scrap value is not given)

This is useful for those assets which provide equal benefits to the business for each year of their lives.

ü simple to understand and easy to calculate the amount of depreciation.

ü provides the same amount of depreciation throughout the life of the asset.
ü helps to estimate the amount of depreciation in advance.
•
û does not take into consideration the seasonal fluctuations in the use of fixed assets. Depreciation
amount per month will remain the same irrespective of the use of machine.
û Equal amount of Depreciation is charged even though the capacity of the machine declines every year.

DECLINING/REDUCING/DIMINISHING BALANCE DEPRECIATION METHOD

This method assures that the asset is used up more in the first years of its life than the next year and so on. It is
calculated by applying a fixed percentage to the reduced value of the asset i.e. (NBV) Net Book Value at the start of the
year.

Depreciation = Book value x Depreciation rate

Book value = Cost - Accumulated depreciation

ü Equalizes the yearly burden on statement in respect of both depreciation and repairs. The amount of
depreciation goes on decreasing while the expenses on repairs goes on increasing, so that the total
charge against revenue over different years remains more or less the same.
ü is acceptable for income tax purposes
ü matches the cost and revenue of the business. The greater amount of depreciation provided in initial
years is matched against the higher amount of revenue generated by increased production by the use of
new asset.

û charges heavy amount of depreciation in earlier years.

û Difficult to compute and asset value is not fully depreciated i.e. book value never become zero.

Revaluation Method

This method is used where it is not practical, or is difficult, to keep detailed records of certain types of
non-current assets.
Examples: loose tools, packing cases, equipment used in offices and laboratories
Depreciation of Loose tools = Loose tools at the start of the year + Purchases of loose tools during the
year – Disposed of Loose tools - Closing stock of Loose tools.

Recording of Depreciation
Income Statement xxx
Provision for Depreciation xxx

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RECORDING OF DISPOSAL

Debit Credit
Removal of Cost
Disposal xx
Non Current Asset xx
Removal of Accumulated Depreciation
Provision for Depreciation xx
Disposal xx
Recording of Receipt

Bank/Cash/ABC xx
Disposal xx
Recording of Closing Entry(Loss)

Income Statement xx
Disposal xx
Recording of Closing Entry(Profit)

Disposal xx
Income Statement xx

SIMPLE FORMULA TO CALCULATE PROFIT/LOSS ON DISPOSAL

Sale Proceeds – Book Value = Profit (if Positive) / loss (if negative)

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24
Why would a company choose one method over another?

A method of depreciation is chosen by a company because of its policy on depreciation and ensuring that
the consistency concept is applied when preparing accounts.

Why SLM is used for leasehold assets and buildings.

The straight-line method is where the same amount of the cost of the asset is written off each year. It is
appropriate in the case of an asset that remains in the business over a long period of time and loses value
slowly, for example assets such as buildings that generate profit over many years.

The straight-line method involves spreading the depreciable amount evenly over the estimated useful life
of the asset. Using this method, the depreciation is the same figure each year, which suggests that the
asset is being used up at an even rate.

Why RBM is used for computer equipment’s and vehicles.

The reducing balance applies a constant percentage to the gradually carrying amount balance so that the
amount of depreciation expense diminishes over the useful life of the asset. The amount written off is
high in early years and reduces each year until written off. This method is appropriate in the case of an
asset which loses most of its value in the years immediately after purchase e.g. vehicles, computer,
equipment etc., (assets that become obsolete quickly because of changes in technology).

It should be noted that relatively few businesses use the reducing balance method and, where it is used,
the percentage figure is often an approximation.

The general principle of providing depreciation is based on the matching concept.

This may increase profit and assets in short term but this change would not help profit in long term as lower
depreciation charge means higher losses on disposal. Business should not go for reduction in rates specially in order to
increase profit as it is not accordance with Consistency and Prudence concept.

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Control Account
A control account acts as a check on the purchases ledger/sales ledger. If there is an error in the purchases ledger/sales
ledger it will not be revealed by a control account prepared from the individual accounts in that ledger.

1. Control accounts can be used to provide totals of debtors and creditors readily. (It is less time
consuming than adding together all the debtors or creditors balances from the sales and purchases
ledgers.)

2. Control accounts can be used to identify errors. It identifies the ledger or ledgers in which errors
have been made when there is a difference in trial balance.

3. Control accounts acts as a deterrent against fraud. Segregation of duties helps in the prevention
of fraud because members of staff who complete the control accounts are not involved in
completing the sales ledger.

Sales Ledger Control Account

Bal B/d xx Bal b/d xx
Credit Balance
Credit Sales xx Receipts (Cash / Cheques received) xx
Dishonored Cheques xx Sales Returns xx
Interest Charged xx Bad Debt xx
Bad Debt Recovered xx Discount Allowed xx
(receipt are recorded as well)
Refund to customers Contra (set off) xx
Bal c/d xx Bal c/d xx
Credit Balance
xx xx
Bal b/d xx Bal b/d xx

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 Purchase Ledger Control Account
Bal B/d xx Bal b/d xx
(Debit balance)
Purchase Return xx Credit Purchases xx
Payments (Cheques/cash paid) xx Interest charged xx
Discount Received xx Refund by suppliers xx
Contra (Set Off) xx xx
xx
Bal c/d xx Bal c/d xx
(Debit Balance)
xx xx
Bal b/d xx Bal b/d xx

1. Overpayment of amount due

2. Cash discount not deducted before payment made
3. Returned goods after payment of amount due
4. Payment made to creditor in advance

1. Overpayment of amount due by a debtor

2. Cash discount not deducted by debtor before payment made
3. Goods returned by debtor after payment of amount due
4. Payment made in advance by debtor

27
Correction of Errors

While recording transactions in subsidiary books or the ledgers, errors can be made. Such errors will
normally be discovered when preparing a trial balance, However, it should be noted that the trial balance
has a serious limitation in that it does not detect all errors. Hence, we can say that there are two
categories of errors:

1. Errors not affecting trial balance

2. Errors affecting trial balance

Errors not affecting the trial balance

These are errors that will not be detected by the trial balance since the total of both columns will be the
same.

Below is a list of such errors:

Errors Definition and examples

The error arises when a transaction has not been recorded at all
1. Error of omission in the books, that is, no entries have been made. It has been
completely omitted from both accounts.
Drawings of goods $15 has been completely omitted.
This is where an entry has been made in a wrong account which
2. Error of Commission belongs to the same category of the account where the entry
should have been made. It usually arises with personal and real
accounts.
Repair of $15 paid in cash has been recorded in Rent account
This error occurs when a transaction has been recorded in a
3. Error of principle wrong account. However, the wrong account and the correct
account where the entry should have been recorded must be
different categories.
For example instead of recording in a real account, the entry has
been made in a nominal account.
Motor vehicle expenses of $15 paid in cash has been recorded in
the vehicle account.
This error occurs when a wrong amount has been used for
4. Error if original entry recording a transaction. The amount of the corresponding entries
refer to the two entries of the same transaction.
Cash sale of $156 has been recorded as $165 in both accounts.
It arises when the account which should have been debited, has
5. Error of reversal of actually been credited and the other account which should have
entries been credited, has been debited. This means that both entries are
on the wrong side.
Received commission in cash $20 has been debited to
commission receivable account and credited to cash account.
The error arises where there are at least two errors. One error on
6. Compensating error the debit side cancels out another error of the same amount on
the credit side or two errors of the same amount on the same
side cancels out each other.
Sales and purchases account are both overcast by $100.
28
Errors affecting the trial balance:

These are errors that will be detected by the trial balance since the total of both columns will not be the
same.

Below is a list of such errors:

1. Error of Single Entry The error occurs when only one of the two entries of a
transaction has been recorded, either the debit entry or the
credit entry has been made.
Rent of $43 paid in cash has been recorded in the cash account
only.
This errors occurs when the two entries of a transaction have
2. Error of two debits or been recorded on the same side instead of one entry on the debit
two credits side and the second corresponding entry on the credit side.
29
 Furniture of $650 bought by cheque has been debited to
furniture account and bank account.
This error occurs when three entries have been made for a single
3. Error of three entries transaction. All the entries can be on the same side or two of
them may be on the debit side and one on the credit side or vide
versa.
Goods bought from Paul $75 for cash has been credited to both
Paul’s account and cash account and debited to purchase
account.
This error occurs when the amount of a debit entry differs from
4. Error of different the amount of its corresponding credit entry.
amount for Cash received from Jack $45 has been correctly recorded in cash
corresponding entries account but entered in Jack account as $54.

This error occurs when an amount has been wrongly calculated. It

5. Arithmetical error usually occurs when computing the totals of subsidiary books or
when balancing of accounts.
The Sales Journal has been overcast by $90.
Listing error is an error arising when transferring a ledger balance
6. Listing error to the trial balance, it does not arise when recording a
transaction. It occurs when an item has been incorrectly
listed/entered on the trial balance, For example, a wrong amount
may have been listed on the correct side or the correct amount
written on the wrong side. Listing error may also arise in the
ledger where the correct balance has been brought forward on
the wrong side or a wrong amount brought forward on the
correct side.
Drawings has been wrongly listed on the trial balance as $10 200
instead of $10 000.

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Suspense account

The suspense account is a temporary account which is created when the trial balance disagree and must
be closed upon the correction of all errors affecting the trial balance. Quite often the importance and
uses of the suspense account is not properly understood. The following issues are important aspects
relating the suspense account.

1. When the totals of the trial balance disagree, the difference has to be calculated and entered on
the trial balance. The difference is listed in the column where there is a shortage by writing
suspense next to it. This means that the difference is posted to a suspense account and will
appear in the suspense account as balance b/d or we can also write “Difference in trial balance”.

31
 2. The balance b/d in the suspense account may either be on the debit side or credit side. It will be
on the debit side it the total on the credit side is lower (shortage on credit side).

3. The suspense account must contain entries for only those errors that affect the trial balance.
Errors not affecting trial balance must not be recorded (corrected) in the suspense account.

Guidelines for correction of errors

1. All errors are corrected by means of a journal. This is because it would provide an explanation of
the error corrected.
2. Most questions on errors starts by providing the transaction followed by the error made and/or
entries recorded in a sentence. Therefore identity the transaction and write the correct double
entry.
3. Next compare the correct entry with the error made or entries recorded. This will allow you to
identify which one of the twelve errors it is. Here you have to bear in mind that whenever no
information is provided about one of the two corresponding entries which have been made, it
means that the entry has been made correctly. This is a general principle which stems from the
fact that if something is wrong the examiner has to inform us about the mistake otherwise we
have to assume it is correct. In any case we cannot assume that something is wrong since this will
give rise to different assumptions from different students!
4. Once you have identified the type of error made, this will let you know whether an entry in the
suspense account is required or not.
5. To start the correction, locate in which account or accounts the error has occurred. It may be that
a wrong entry has been made or the amount recorded is overstated or understand, hence cancel
that wrong entry or increase/decrease the amount straight away. To cancel an entry or decrease
the amount recorded in an account always record the correction on the opposite side of the
entry/amount. For example if the wrong entry appears on the debit side, then to cancel it, record
on the credit side. If an amount is overstated on the credit side then to decrease it record on the
excess on the debit side. However if the amount is understated then to correct it you have to
record on the same side. For example if the amount recorded on the credit side is understand,
then record the shortage on the credit side itself.
6. After cancelling the wrong entry, next you may be required to record the correct entry which
should have been made.
7. Finally make any entries in suspense account if it is error affecting trial balance

Guidelines for correction of figures in trial balance or Statement of financial position

Items with Correcting entry on Journal Effect on Amount

Debit Balance Entry on debit side Increase

Debit Balance Entry on credit side Decrease

Credit balance Entry on debit side Decrease

Credit balance Entry on credit side Increase

32
As an example, assume that the item corrected is capital. Capital account has a credit balance. If a
correcting entry has been recorded on the credit side of the capital account, this would increase the
balance of capital whereas if the correcting entry is on the debit side, this would decrease the balance
of capital.

Guidelines for correction of profit

1. Ascertain whether the error corrected has an impact on profit or not by checking if the item being
corrected appears in income statement. Profit is affected and must be corrected only if it is an
item appearing in income statement such as sales, purchases return inwards, return outwards,
inventory, discount received and expenses. Items which do not appear in income statement will
not affect profit such as trade receivables trade payables, bank etc.
2. A correction on the DEBIT SIDE of any item appearing in the income statement will DECREASE
profit except closing inventory which will result is an increase in profit.
3. A correction on the CREDIT SIDE of any item appearing in the income statement will INCREASE
profit except closing inventory whereby profit will decrease.

33
Inventory Valuation

Inventories include assets held for sale in the ordinary course of business (finished goods), assets in the
production process for sale in the ordinary course of business (work in process), and materials and
supplies that are consumed in production (raw material).

Measurement/Valuation of Inventories

According to IAS 2, inventories are required to be stated/valued at the lower of cost and net realizable
value (NRV).

Cost should include all:

• Costs of purchase (including taxes, transport, and handling) net of trade discounts received
• Costs of conversion (including fixed and variable manufacturing overheads) and
• Other costs incurred in bringing the inventories to their present location and condition (e.g packaging cost)

Net Realizable Value is the estimated selling price in the ordinary courses of business, less the estimated
cost of completion (any additional processing cost to be incurred on the product so that it can be sold)
and the estimated costs necessary to make the sale.

Example 1

At 31 December 2011, a business has goods costing $600 in its inventory. These goods have a sales value
of $625. To sell these goods the business will have to incur $30 a selling expenses. State the value at
which these goods should be included in inventory valuation.

Answer

Cost of the goods = $600

Net realizable value = $595 (625-30)

Value of inclusion in inventory = $595 (lower of cost and NRV)

Example 2

The normal selling price of an inventory item is $22 per unit. The item originally cost $15, but can only be
sold at a normal selling price after modifications costing $14 per unit. The scrap value of the item is $7
per unit According to IAS, at how much should the item be valued?

Answer

Cost of the item = $15

Net realizable value 1 = $8 (22-14)

Net realizable value 2 = $7 Note there are two net realizable values

Value for inclusion in inventory = $8 Compare the cost with the higher of net realizable values)

34
Closing Inventory Adjustments

Income Statement Statement Of Financial Position

Recorded in Cost of Sales Recorded in Current Assets

Some Special Cases

1. If Cost and NRV is given then value inventory at lower of cost or NRV
2. If post inventory (after year end) is given then do adjust it.
3. If value of inventory has to be find then use Markup / Margin or inventory turnover

Accrual Prepayment Adjustments

1. Accrued Expense

Income Statement Statement Of Financial Position

Add in Relevant Expense Account Recorded as other Payable in Current Liability

2. Prepaid Expense

Income Statement Statement Of Financial Position

less in Relevant Expense Account Recorded as other receivable in Current Asset

1. Accrued/outstanding Income

Income Statement Statement Of Financial Position

Add in Relevant Income Account Recorded as other receivable in Current Asstes

1. Pre received Income / Advance Income

Income Statement Statement Of Financial Position

Add in Relevant income Account Recorded as other Payable in Current Liability

35
 Trial Balance
Advertisement 2000
insurance 4000
Commission received (income) 3500
Rent Received (income) 5000

Additional Information

1. Prepaid advertisement is 500 and insurance accrued is 400

2. Commission outstanding is 300 and Rent received in advance is 600

Income Statement Statement Of Financial Position

Other income Other Receivable
Commission Received (3500 +300) 3800 Commission receivable 300
Rent Received (5000-600) 4400 Advertisement receivable 500
Expenses Other Payable
Advertisement (2000-500) 1500 Insurance Payable 400
Insurance (4000 + 400) 4400 Rent Payable 600

Special Cases

1. Sometimes accrued or prepaid amount might not be given but time period would be given by which
number of month prepaid or accrued can be find.
• Then use formula
• Amount Accrued/Prepaid = Expense Paid / Total Period(months) * Accured/ Prepaid month

Provision for Doubtful Debts Adjustments

Income Statement Statement Of Financial Position

Difference of Current year provision less Previous Only current year provision is deducted from
year provision (trial balance) trade receivables
If difference is positive it is expense and if
negative it is income

36
 Trial Balance
Trade receivables 20000
Provision For Doubtful Debts 1000

Additional information

1. Provide provision for doubtful debts at 10%

Income Statement Statement Of Financial Position

Expenses Current Assets
Increase in P4DD 1000 Trade Receivables 20000
(20000*10% - 1000)
(2000 – 1000)
Less:P4DD (2000)

Trial Balance
Trade receivables 30000
Provision For Doubtful Debts 2000

Additional information

1. Provide provision for doubtful debts at 5%

Income Statement Statement Of Financial Position

Other Income Current Assets
Decrease in P4DD 500 Trade Receivables 30000
(30000*5% - 2000)
(1500 – 2000)
Less:P4DD (1500)

Trial Balance
Trade receivables 30000
Provision For Doubtful Debts 2000

37
Additional information

1. Provide provision for doubtful debts at 5% on debtors 3 months old and 10% on debtors 6 month old.one
quarter debtors are 3 month old.

Income Statement Statement Of Financial Position

Expenses Current Assets
Increase in P4DD 500 Trade Receivables 30000
(1/4 *30000 *5% + ¾ * 30000 * 10%) -
2000)
(7500*5% +22500*10%) -2000
(375 + 2250) – 2000
2625 - 2000
Less:P4DD (2625)

Special Cases

1 P4DD should be applied in last i.e. if any bad debt is given in adjustments(not in trial balnce) it should be
deducted from trade receivables.
2 If P4DD is to be applied on aging of trade receivables then do accordingly.
3 If Specific Provision is given then current year provision would be Total provision i.e. general provision +
specific provison

Provision for Depreciation Adjustments

Income Statement Statement Of Financial Position

Current year depreciation is recorded Current year depreciation would be added to
Provision for depreciation

Trial Balance
Equipment 20000
Provision For Depreciation Equipment 4000
Motor Vehicle 12000
Provision for Depreciation Motor Vehicle 2000

Additional information

1. Provide provision for depreciation on equipment as 10% on cost.

2. Provide provision for depreciation on motor vehicle as 5% on book value.

38
 • Income Statement •Statement of Financial Position
• Expenses • • • Cost • Accumulated • Book
• Depreciation • Value
• Dep Equipment • 2000 • Equipment • 20000 • 6000 • 14000
• (10%*20000) • (4000+2000)
• Dep Motor • 500 • Motor Vehicle• 12000 • 2500 • 9500
Vehicle • (2000+500)
• (5%*12000-
2000)

Trial Balance as at 31st December, 2017

Land and Building 100000
Provision For Depreciation (Land and building) 4000
Motor Vehicle 12000
Provision for Depreciation Motor Vehicle 2000

Additional information

1. Provide provision for depreciation on building as 10% on cost. Land and building contain land costing
80000.
2. Provide provision for depreciation on motor vehicle as 5% on cost on month to month basis. Motor Vehicle
costing 9000 were bought 5 years before whereas Motor Vehicle costing 3000 were bought at 1 July 2017.

• Income Statement •Statement of Financial Position

• Expenses • • • Cost • Accumulated • Book
• Depreciation • Value
• Dep building • 2000 • Equipment • 100000 • 6000 • 14000
• (10%*20000) • (4000+2000)
• Dep Motor • 525 • Motor Vehicle• 12000 • 2500 • 9500
Vehicle • (2000+525)
• (5%*9000 +
5%*3000*6/12)
• (450+75)

Trial Balance
Leasehold land (25 years) 25000
Provision For Depreciation Leasehold Land 2000

• Income Statement • Statement of Financial Position

• Expenses • • • Cost • Accumulated • Book

39
 • Depreciation • Value
• Dep Leasehold• 1000 • Leasehold • 25000 • 3000 • 22000
land Land • (2000+1000)
• (25000/25)

Interest on Loan
Income Statement Statement Of Financial Position
Calculated Interest would be recorded in Income Difference of Interest charged (I/S) – Interest Paid
Statement (TB) would be recorded in Current liability as
(%*Loan) Other Payable
OR
(Interest Paid (TB) + Accrued Interest)

Trial Balance
10% Loan 50000
Interest on loan 2000

Income Statement Statement Of Financial Position

Expenses Current Liability
Interest on loan 5000 Other Payable:
(10% * 50000) Interest Payable(5000-2000) 3000

Trial Balance as at 31 Dec 2017

10% Loan 50000
Interest on loan 2000

Additional Information

Loan is taken at 1 July 2017.

40
 Income Statement Statement Of Financial Position
Expenses Current Liability
Interest on loan 2500 Other Payable:
(10% * 50000* 6/12) Interest Payable(2500-2000) 500

Trial Balance as at 31 Dec 2017

10% Loan 50000
Interest on loan 2500

Additional Information

Three-month loan interest is accrued.

Income Statement Statement Of Financial Position

Expenses Current Liability
Interest on loan 2500 Other Payable:
(Interest Paid (TB)+ Accrued) Interest Payable 1250
(2500 + 50000*10%*3/12)
(2500 + 1250)

Disposal

If Disposal balance is given in trial balance and no adjustment is mentioned then treat it income if it is credit balance and
treat it expense if it is debit balance.

If Disposal balance is given and some adjustments are there like any error or some transactions unrecorded then do
record all transaction and update the relevant accounts.

Suspense

If suspense account is given and no adjustment is given then treat debit balance as current asset and credit balance as
current liability.

If suspense account is given and some adjustment are given then make entries of all adjustments. Then close suspense
account and update the relevant account.

41
 A partnership is a business organization consisting of a minimum of two and a maximum of twenty
owners known as partner.

Partnership Deed

When a group of person is about to start a partnership, it is advisable that they prepare a partnership deed.
The partnership deed is an agreement containing the rules and regulations that will govern the business. It can
be a verbal or written agreement, but it is preferable to have it on paper so as to avoid any misunderstanding
between partners. The following would normally be included in a partnership deed:

1. Any interest payable on partner’s capital.

2. Any interest to be charged on partners’ drawings.
3. Any salary, bonus or commission payable to the partners.
4. Any interest payable on any loan by a partner to the partnership.
5. The profit and loss sharing ratio.
6. Rules for the admission and retirement of partners

In the absence of a partnership deed, Section 24 of Partnership Act 1890 will govern the situation and contains
the following provisions:

1. No interest in payable on partners’ capital.

2. No interest is to be changed on partners’ drawings.
3. No salary is payable to partners.
4. Any loan by a partner to the partnership will carry interest at the rate of 5% per annum.
5. Profits and losses are to be shared equally.

Types of Capital Account

1. Fixed capital and Current account

2. Floating/Fluctuating capital account

The fixed capital account is used to record only the initial capital invested and any additional capital
introduced by partners. When we have a fixed capital account, we need to have a current account which will
contain all the other items related to the partners as shown below.

42
Reasons for keeping separate accounts for current and capital accounts

Þ To keep capital invested separate from profit and drawings

Þ To help avoid the possibility of partners overdrawing
Þ To reward the partner who has invested more capital with interest on the amount invested
Þ To identify partners drawings in order to calculate interest on drawings

Partners may want separate capital accounts to

Þ Show the permanent investment.

Þ Show the impact of any changes in capital (e.g. goodwill, capital introduced, revaluations).
Þ Facilitate the calculation of interest on capital.
Partners may want separate current accounts to

Þ Show the ongoing transactions between the partners and the partnership.
Þ Show the amount of drawings compared with the share of profit.
Þ Facilitate the calculation of interest on drawings.

Reasons for charging interest on drawing

Þ To ensure cash is retained and reinvested within the business

Þ To restrict partners drawing
Þ To reward partner with lower drawings

Reasons for charging interest on capital

Þ To reward the partner for business investment

Þ To encourage partners to introduce more capital
Þ To reward partners for the lost opportunity cost of capital invested.
Current account

A ($) B ($) A ($) B ($)

Jan 1 Bal b/d xx - Jan 1 Bal b/d - xx

Drawings xx xx Interest on capital xx xx

Interest on drawings x x Salary x

Salary paid x x Share of profit* xx xx

Share of loss* x x Interest on partner’ x

loan
Bal c/d
Bal c/d
Dec 31 xx x

xxx xxx xxx xxx

43
Note: Interest on loan from a partner is debited to income statement and credited to the partner’s current
account.

Format of the Appropriation Account

Profit and loss appropriation account for the year ended ………

$ $

Profit for the year xx

Add Interest on drawings: Mr.A xx

Mr.B xx xx

Less Appropriations

Interest on capital: Mr.A xx

Mr.B xx

Salary for Alex xx xx

Residual Profits to be shared xx

Share of residual profits: Mr.A x

Mr.B x xx

Extract of Balance Sheet showing the capital structure of a partnership, that is, the section “Financed by” only.

Financed by $ $ $

Capital: Mr.A XXX

Mr.B XXX

Current account: Mr.A (Dr balance - minus) (X)

Mr.B (Cr balance - add) X XXXX

44
 These are costs that are directly identifiable to the unit or batch of units produced. The amount
of direct costs attributed to each unit or batch of units can easily be calculated. Such costs
include direct materials, direct labour and other direct expenses.
Direct costs, therefore, vary directly with number of units produced.
Sum of direct costs is called prime cost.

These are costs incurred in the factory for production but cannot be identified to any particular
unit or batch of units produced. They are usually period costs. They are paid on a time basis
(weekly, monthly or yearly) irrespective of quantity produced.

Indirect costs are termed as factory overheads. They include indirect labour (like salaries of
supervisors, storekeepers and drivers), indirect materials and other indirect expenses (like rent of
factory, rates, insurance, depreciation of plant and machinery, repairs and maintenance etc).

EXAMPLES OF DIRECT COST

DIRECT
The use of such materials is directly related to quantity produced. For example, in making a chair,
MATERIALS the amount of wood and metal are easily identified and remains the same for each unit of chair
being produced. For example, 2 square feet of wood and 15 feet of metal tubes at their
respective costs.

These are wages paid to factory workers whose amount of work depends on the number of units
DIRECT produced. For example, a worker is paid $10 per chair for cutting and welding the metal frame.
LABOUR Another worker is paid $7 for cutting wood and fixing on the chair

These are other expenses that vary directly with quantity produced. One very common direct
OTHER DIRECT expense is royalties. This is a fixed sum of money per unit produced payable to the owner of a
EXPENSES trademark for making and selling the product under that trademark.

These are partly finished goods. Materials have been used and labour paid but the product is not yet completed for sale.
Inventory of work in progress exists all the time.

Opening inventory of work in progress is added to manufacturing costs while closing inventory of work in progress is
deducted.

45
Manufacturing account for the year ended

Raw Materials $
Opening inventory of raw materials xx
Add Raw material purchased xx
Add carriage on raw materials xx
Less return outwards of raw materials xx
Cost of raw material used xx
Direct labour\direct wages\manufacturing wages\factory wages xx
Direct expenses xx
Royalties xx
Prime cost xx
Add Indirect Cost
Factory indirect wages\wages of factory supervisor xx
Factory indirect expenses xx
Factory rent, rates, insurance, heat, light and power xx
Depreciation of factory Plant, Machinery and Equipment xx xx
Gross cost of production xx
Add Opening inventory of word in progress xx
Less Closing inventory of word in progress (xx) xx
Cost of production xx

46
Income Statement for the year ended.

$ $

Revenue xx
Less: Return inward\sales returns (x)
Net revenue xx
Opening inventory of finished goods xx
Cost of production xx
Ordinary (finished) goods purchased xx
Add carriage inwards on finished goods xx
Less Return outwards on finished goods (xx)
Less closing inventory of finished goods (xx)
Cost of Sales (xx)
Gross profit xx
Add Other Income
Add: Discount received\Rent received xx
Profit on disposal xx
Decrease in Provision for doubtful debts xx xx
Less Expenses
Rent and rates for office and administration xx
Advertising and Selling and distribution cost xx
Carriage outwards xx

Office salaries xx
Depreciation of office furniture and delivery vehicles xx (xx)
Profit for the year xx

47
GROSS PROFIT MARGIN
• This measures the success in selling goods
• The ratio shows the gross profit earned per $100 of sales

WAYS TO INCREASE GROSS PROFIT

• Selling goods at higher prices
• Reducing the rate of trade discount to customers
• Buying goods at cheaper prices
• Using different sales mix i.e. selling some new items at higher prices (price skimming)

Reasons of low gross profit margin

• Business may be selling some products at lower prices

• Some products may be outdated obsolete so business might be selling them at lower price.
• Business may be buying goods at higher prices
• Business may not be able to pass increase in cost price to customer
• Business may be selling some new items at lower margin (penetration pricing)

48
PROFIT MARGIN
• This measures the overall success of the business
• The ratio shows the net profit earned per $100 of sales
• The ratio indicates how well the business controls its expenses

WAYS TO INCREASE PROFIT

• Reduce expenses e.g. reduce staffing levels, reduce advertising etc.
• Increase gross profit e.g. reduce purchase price ,increase selling prices etc.
• Increase other income e.g. rent out part of premises, earn more discount etc.
• Increase sales volume by more seasonal sales promotions.
•

RETURN ON CAPITAL EMPLOYED (ROCE)

• The ratio shows the profit earned per $100 employed in the business
• The ratio measures the profitability of the investment in the business
• The ratio shows how efficiently the capital is being employed

REASONS OF INCREASE OF ROCE

• Reduction of capital employed i.e. payback of loan, decrease in drawings
• Controlling expenses to increase profit

CURRENT RATIO
A business needs sufficient working capital for the day-to-day running of the business to pay expenses, liabilities, etc. as
they fall due so to measure liquidity we use current ratio.

It shows whether the business has sufficient current assets to meet its current liabilities.

Its benchmark is 2:1

QUICK RATIO/ LIQUID RATIO

The quick ratio shows whether the business would have any surplus liquid funds if all the current liabilities were paid
immediately from the liquid assets.

Its benchmark is 1:1

49
Stock is not included in calculation because stock is not regarded as a liquid asset – a buyer has to be found and then the
money collected.

WAYS TO IMPROVE LIQUIDITY OF BUSINESS

• Introduce more capital (issue shares if limited company)
• Sell non-current assets
• Get loan
• Reduce inventory
• Extend trade payables
• Reduce trade receivables
• delaying drawings
• Sell of bonus share instead of paying dividend (For Limited Company)

DISADVANTAGES TO A BUSINESS OF HAVING INSUFFICIENT WORKING CAPITAL.

• May have problems paying debts as they fall due
• May not be able to take advantage of cash discounts
• Cannot make the most of opportunities as they occur
• Difficulties in obtaining further supplies

It shows how frequently business is covering the amount from trade receivables. Early recovery is desirable.

WAYS TO REDUCE TRADE RECEIVABLES TURNOVER

4. Refuse credit terms to late payers
5. Offer cash discount for prompt payment
6. Charge interest on overdue accounts
7. Ask for cash with order / increase cash sales

50
It shows how frequently business is paying its trade payables. Late payment in line with industry average is desirable.

IMPACT OF INCREASING TRADE PAYABLES TURNOVER

8. Loss of cash discounts which would have impact on profits.
9. Cause some suppliers to refuse credit terms which would have an adverse effect on liquidity.
10. May create a bad relationship with supplier
11. May incur interest charges
12. Force the business to find alternative suppliers who are unable to supply goods on the same
quality.

Comment on trade receivable and trade payable turnover (Understand

it)

• For good condition Trade Receivable turnover should be greater than trade payable turnover. If Trade
payable would be greater than it means business is paying earlier than recovering the amount so it might
create liquidity issues.
• If previous year data is given then do comparison , for good condition business needs to be recovering the
amount earlier than previous years as well as industry average and paying the trade payables according to
industry average.
• If business is recovering the amount later than previous year or industry average then this shows poor
credit control and it might lead to liquidity issues and bad debts.
• If business is paying trade payables earlier than previous year or industry average than it might be good for
supplier but for business it is not desirable as it shows some idle cash which can be utilized elsewhere to
earn more return.

It shows how frequently business is able to convert its inventory into sales.

WAYS TO INCREASE RATE OF INVENTORY TURNOVER

• Reduce inventory level (just in time method of inventory).
• Reduce mark up to be more competitive
• Promotions such as advertise products
• Offer cash discounts to encourage sales.

DISADVANTAGES OF HOLDING TOO MUCH STOCK

• Deterioration of inventory
• Obsolescence
• Space required for storage
• Risk of theft
• Cost of storage

51
Uses of Ratio Analysis
1. Helps to compare with competitors.
2. Helps to compare with industry averages.
3. Allow managers to measure their performance by setting targets/benchmark.
4. Helps to compare with previous year.
5. Provides information to users/potential investors.
6. Aids decision making by measuring profitability, liquidity, efficiency.

Limitation of Ratio Analysis

1. A ratio on its own is isolated (We need to compare it with some figures)
2. Depends upon the reliability of the information from which ratios are calculated.
3. Different industries will have different ideal ratios.
4. Different companies have different accounting policies. E.g. Method of depreciation used.
5. Ratios do not take inflation into account.
6. Ratios only consider the financial data it do not consider outside influences and qualitative factors e.g. world
economy, trade cycles.
7. Ratios do not explain the cause so after calculating ratios we still have to analyze them in order to derive a
conclusion.
8. Ratios are based on historical data i.e. market value might differ
1. analysis does not explain the cause business has to do further investigation for this purpose.

BANK MANAGER
• Assessment of prospects of any requested loan/overdraft repaid when due
• Assessment of prospects of any interest on loan/overdraft being paid when due
• Assessment of the security available to cover any loan/overdraft

LENDERS
• Assessment of prospects of any requested loan when due
• Assessment of prospects of any interest on loan being paid when due
• Assessment of the security available to cover any loan

CREDITOR FOR GOODS

• Assessment of the liquidity position
• Identifying how long the business takes to pay creditors
• Identifying future prospects of the business
• Identifying what credit limit is reasonable

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A company is a business organization which is owned by shareholders but managed by a board of
directors. Unlike soletraders and partnerships, a company is an incorporated business, that is, it has a
legal identity of its own; hence the shareholders have limited liability. The capital of a company is divided
into units of small denomination. One of the units into which the capital of a company is divided is called
a share. A share is an amount of investment in a company evidenced by a share certificate.

Authorized share capital

Authorized capital is the maximum amount of share capital a company is allowed to issue

Issued Capital
The amount of capital actually required be issued to shareholders and this is known as the issued share capital.

Called up capital
Called-up capital is the total amount of capital a company has requested from its shareholders.

Paid up Capital
Paid-up capital is that part of the called up capital for which a company has actually received the money
from its shareholders.

Shareholders fund/Shareholder Equity

The total of issued share capital and the reserves is known as the shareholders fund/Shareholder Equity.

Debenture
Debenture is a medium to long-term debt instrument used by large companies to borrow money, at a
fixed rate of interest.

Characteristics of debentures
1. Debenture holders are entitled to a fixed rate of interest (not dividend) Debenture interest must
be paid even if the company is making losses.
2. The debenture holders have priority for being reimbursed on liquidation of the company.
3. The debenture holders are not entitled to voting rights.

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Calculation of Ordinary share dividend

Interim Ordinary share dividend

Rate (%) of interim Ordinary dividend x Total nominal value of paid-up /issued Ordinary share capital
OR
Dollar of interim Ordinary dividend per share x Number of paid-up/issued Ordinary share capital

Final Ordinary share dividend

Rate (%) of final Ordinary dividend x Total nominal value of paid-up /issued Ordinary share capital
OR
Dollar of final Ordinary dividend per share x Number of paid-up/issued Ordinary share capital

Advantages of preference shares

• Preference shares will give a cash injection and increase the financing of the company.
• Control of the company will not be changed because the preference shareholders do not possess voting
rights in the company.
• The dividends that are paid to the preference shareholders are fixed unlike the ordinary shareholders.
• Preference share are an alternative to borrowing from a bank because the assets of the company will not
be required for security unlike a bank loan.
• By issuing preference shares the company is attracting a wider range of investors especially those who
want lower risks because
• the preference share pays a fixed rate of interest and is paid before the equity holders dividends.
Disadvantages of preference shares
• The Company may have to pay higher rates of dividends to the preference shareholders as compared to
the equity shareholders.
• Preference shares are debt capital and will increase the gearing ratio of the company.
• Preference shareholders have preferential rights over the company assets in case of winding up of the
company unlike the equity. shareholders.
• If the preference shares are cumulative this could place a financial burden on the company because the
dividends would have to be paid when profits are available unlike dividends to the equity holders.
• If the company issued redeemable preference shares then the company would have to repay the share
capital to the shareholders at a given time which could cause a cash flow problem.

Difference Between ordinary and preference shares

Preference Shares Ordinary shares

Receive a fixed rate of dividend Dividend may vary according to profits
They do not usually carry voting rights They usually carry voting rights
Capital is returned before the ordinary share capital in a Ordinary shares are the last to be repaid in a winding up.
winding up.

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Differences between preference shares and debentures

Preference shares receive a fixed rate of dividend Debentures receive a fixed rate of interest.
Preference shareholders are members of the company Debenture holders are not members of the company.
Preference shares are part of the capital of the company Debentures are long term loans.
Preference shareholders are repaid after the debenture debenture holders are paid before the preference
holders in the event of the company being wound up. shareholders in the event of the company being wound up.

Reserve

Reserves are one of the most notable appropriations of profits. Companies create reserves so they can be
ready to face any contingencies in near future.

Reserves in a company can be divided into two broad categories – one is capital reserve and another is
revenue reserve.

Revenue Reserve
Revenue reserve is created from the net profit companies make out of their own operations. Companies
create revenue reserve to quickly expand the business. And revenue reserve also helps the companies to
source their capital from their own internal profits. As an example, we can talk about retained earnings
and general reserve.

General Reserve
General Reserve is amount set aside from the retained profit to assist in expansion and other purposes of
the company.

Purpose of General Reserve

• A general reserve is retained profit for a non-specific purpose
• Used to fund the general growth of the business and its assets
• Can be used to cover future shareholders dividend
• To conserve cash and working capital

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Guidelines and techniques to obtain missing information

1. Calculation or profit or loss for the year without preparation of income statement
Statement to calculate profit/loss for the year
$
Capital at end (net assets at end) xxx
Add Drawings xxx
Less capital introduced (xxx)
Less capital at start (net assets at start) (xxx)
• Profit for the year xxx

Note: Capital = Total Net book value of assets – Total liabilities

2. Calculation of Sales revenue

Revenue (sales.Takings) = Cash sales + Credit sales

= Cost of sales + Gross profit
= Gross profit ÷ Margin

3. Calculation of cost of sales

Cost of sales = Opening inventory + Net cost of purchase ---- Closing inventory
= Sales --- Gross profit
= Rate of inventory turn x Average inventory
= Gross profit ÷ Mark-up

4. Calculation of gross profit

Gross profit = Net revenue --- Cost of sales
= Mark-up x Cost of sales
= Margin x Net revenue
= Profit for the year + Total Expenses

5. Prepare a cash account to obtain a missing information as balancing figure

A cash account contains enormous information. Most soletraders keeps only a cash account which
serves as the basis for preparing their financial statements. Certain questions on incomplete records
require preparation of a cash account to obtain a missing item as balancing figure. Below is summary
of a cash account highlighting the various information that can be derived as balancing figure.

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 Cash Account
$ $
Balance b/d xxx Expenses xxx
Cash sales* xxx Bank (cash deposited at bank)* xxx
Receipts from customers* xxx Drawings* xxx
Cash stolen* xxx
Balance c/d* xxx
xxx xxx
* Any one of these items can be the missing information.

Prepare a bank account to obtain a missing information as balancing figure

The bank account also highlights massive information. Soletraders usually relies on the bank statement to
prepare their bank account. As with a cash account, the bank account also can reveal missing items as
balancing figure. Below is summary of a bank account highlighting the range of information that can be
derived as a balancing figure.

Bank Account
$ $
Balance b/d xxx Expenses xxx
Cash (cash deposited at bank)* xxx Drawings xxx
xxx Balance c/d* xxx

(xxx) (xxx)

Reconstruct a sales ledger control account to obtain a missing information as balancing figure
In question on incomplete records, very often a receivables control account has to be reconstructed to
obtain credit sales. However of credit sales is provided then the balancing figure may represent receipts

Sales Ledger Control Account

$ Receipt from customers* $

Balance b/d xxx Discount allowed xxx
Credit sales * xxx Bad debts xxx
Return inwards xxx
Balance c/d* xxx

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Reconstruct a purchase ledger control account to obtain a missing information as balancing figure
Purchase Ledger Control Account
$ $
Payment to suppliers* xxx Balance b/d xxx
Discount received xxx Credit purchases* xxx
Return outwards xxx
Balance c/d* xxx

(xxx) (xxx)

Reconstruct a non current asset account at net book value to obtained depreciation.
Equipment Account at NBV
$ $
Balance b/d (Net Book Value) xxx Disposal at Net Book Value xxx
Acquisition (cost price) xxx Income statement (depreciation)* xxx
Balance c/d
xxx

(xxx) (xxx)

WHAT ARE THE BENEFITS OF KEEPING FULL DOUBLE ENTRY RECORDS FOR THE BUSINESS?
1. Helps in preparation of Trial Balance
2. Helps in preparation of Financial Statements
3. Less Chances of Errors
4. Less Chances of Frauds
5. Improves the Accuracy of Accounting Records

If a sole trader does not keep adequate records then the business may not have records of the transactions, then the
business will be unaware of the total sales and purchases in a period. This may result in it not having records of its
stockholdings which could result in it and running out of certain lines of stock. Therefore, being unable to meet customer
demand, this could result in the loss of future business.

The business may not have a record of debtors and therefore it will not be able to send out invoices and reminders of
amounts owing from debtors. This may lead to debtors not paying their accounts, which could lead to bad debts and
hence less profit and cash flow difficulties.

The business may not have a record of creditors, which could lead to the business not paying the amounts owed to its
suppliers. This could lead to suppliers refusing to supply further goods and this could eventually lead to the failure of the
business.
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The business may not have records of expenses that have been paid or those which are owed; therefore it will not have
any control of these, which may lead to overspending on expenses and, therefore, cash flow difficulties.

The business will be unable to prepare a trial balance and final accounts and, therefore, be unable to calculate how
much profit or loss it has made in a period.

If the business cannot provide details of its profits banks will be reluctant to loan it money, as there is no adequate
record of its ability to repay the money. It will also not have adequate records for HMRC to calculate the taxation due,
which could lead to fines.

The risk of errors and fraud will increase if transactions are not recorded and this could be difficult to trace

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