KNEC

NOTES

FINANCIAL ACCOUNTING

BY MASOMO MSINGI
PUBLISHERS
DIPLOMA IN SUPPLY CHAIN MANAGEMENT

FINANCIAL ACCOUNTING ( MODULE I)

Course outline

Introduction to accounting:
 Definition of terms used in accounting
 Users of accounting information
 Information needs
 Qualities of good accounting information
 Nature of accounting equation
 Effects of business transactions
The ledger and the trial balance
 Definition of a ledger and an account
 Importance of a ledger
 Relationship between a ledger and an account
 Classifications of ledgers
 Nature of double- entry system
 Definition of a trial balance
 Importance of a trial balance
 Balancing off of accounts
 Definition of a trial balance
 Importance of a trial balance
Types of errors and their correction
 Types of errors that do not affect the agreement of a trial balance
 Types of errors that do not affect the agreement of a trial balance
 Types of errors that affect the agreement of a trial balance
 Functions of suspense account
 Corrections of errors using a
Source documents
 Meaning of source documents
 Types of source documents
 Uses of source documents
 Relationship between source documents and books of account
Books of original entry
 Definition of books of original entry
 Classifications of books of original entries
 Preparation of books of original entry
 Posting transactions from the books of original entry to the ledger
The cashbook
 Definition of cashbook
 Types of cashbook
 Types of discounts
 Recording transactions in a cashbook
Petty cashbook
 Definition of petty cashbook
  Imprest system
 Purpose of petty cash
 Preparation of petty cashbook
Bank reconciliation statements
 Definition of bank reconciliation statements
 Purpose of preparing bank reconciliation statements
 Causes of the differences between bank statements and the cashbook balance
 Steps/procedure in preparing bank reconciliation statement
Control accounts
 Definition of control accounts
 Uses of control accounts
 Preparation of control account
Accounting concepts, conventions and bases
 Definition of accounting concepts, conventions and bases
 Types of accounting concepts, conventions and bases
Capital and revenue expenditure
 Definition of capital and revenue expenditure
 Double entry system for revenue and capital expenditure
 Classification of expenditure
Adjustments to final accounts
 Meaning of final accounts
 Purpose of final accounts adjustment
 Procedure of making adjustments in final accounts
Accounting for fixed assets
 Definition of depreciation
 Causes of depreciation
 Reasons for providing for depreciation
 Methods for providing for depreciation
 Double entry for depreciation.
 Accounting for disposal of fixed assets
 The fixed asset movement schedule
Final Accounts for sole-proprietorship
 Definition of final accounts
 Types of final accounts
 Preparation of final accounts
Non-Profit Making Organizations
 Definition of Non-profit making Organization
 Differences between Receipts and payment accounts
 Relationship between Income and Expenditure accounts
 Preparation of final accounts of Non-profit making Organizations
Emerging Trends and Issues in Financial Accounting
 Emerging trends and issues in financial accounting
 Challenges posed by emerging trends and issues in financial accounting
  Coping with the challenges posed by emerging trends and issues in financial
accounting to managing emerging financial issues

TABLE OF CONTENTS

INTRODUTION TO ACCOUNTING ........................................................................................... 1

TYPES OF ERRORS AND THEIR CORRECTION

SORCE DOCUMENTS

BOOKS OF ORIGINAL ENTRY

THE CASH BOOK

PETTY CASHBOOK

BANK RECONCILIATION STATEMENTS

CONTROL ACCOUNTS

ACCOUNTING CONCEPTS,CONVENTIONS AND BASES

CAPITAL AND REVENUE EXPENDITURE

ADJUSTMENTS TO FINAL ACCOUNTS

ACCOUNTING FOR FIXED ASSETS

FINAL ACCOUNTS FOR SOLE-PROPRIETORSHIPS

NON-PROFIT MAKING ORGANISATIONS

EMERGING TRENDS AND ISSUES IN FINANCIAL ACCOUNTING

FINANCIAL ACCOUNTING

1.0 INTRODUCTION TO ACCOUNTING

 Definition of terms used in accounting.
 Users of accounting information.
 Information needs
 Qualities of good accounting information
 Nature of accounting equation
 Effects of business transaction

INTRODUTION TO ACCOUNTING

1. NATURE OF ACCOUNTING
Accounting is defined as the process of identifying, measuring and reporting economic
information to the users of this information to permit informed judgment

Many businesses carry out transactions. Some of these transactions have a financial
implication i.e. either cash is received or paid out. Examples of these transactions include
selling goods, buying goods, paying employees and so many others.
Accounting is involved with identifying these transactions measuring (attaching a value) and
reporting on these transactions. If a firm employs a new staff member then this may not be an
accounting transaction. However when the firm pays the employee salary, then this is related
to accounting as cash involved. This has an economic impact on the organization and will be
recorded for accounting purposes. A process is put in place to collect and record this
information; it is then classified and summarized so that it can be reported to the interested
parties.

2. USERS OF ACCOUNTING INFORMATION

Accounting information is produced in form of financial statement. These financial
statements provide information about an entity financial position, performance and changes
in financial position.
Financial position of a firm is what the resources the business has and how much belongs to
the owners and others.
The financial performance reflects how the business has performed, whether it has made
profits or losses. Changes in financial positions determine whether the resources have
increased or reduced.
The users of accounting information have an interest in the existence of the firm. Therefore
the information contained in the financial statements will affect the decision making process.

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 The following are the users of accounting information:

Owners:
They have invested in the business and examples of such owners include sole traders,
partners (partnerships) and shareholders (company). They would like to have information
on the financial performance, financial position and changes in financial position.
This information will enable them to assess how the managers of the business are
performing whether the business is profitable or not and whether to make drawings or put
in additional capital.

Customers
Customers rely on the business for goods and services. They would like to know how the
business is performing and its financial position.
This information would enable them to assess whether they can rely on the firm for future
supplies.

Suppliers
They supply goods or services to the firm. The supplies are either for cash or credit. The
suppliers would like to have information on the financial performance and position so as to
assess whether the business would be able to pay up for the goods and services provided as and
when the payments falls due.

Managers
The managers are involved in the day-to-day activities of the business. They would like
to have information on the financial position, performance and changes in financial
position so as to determine whether the business is operating as per the plans.
In case the plan is not achieved then the managers come up with appropriate measures
(controls) to ensure that the set plans are met.

The Lenders
They have provided loans and others sources of capital to the business. Such lenders include
banks and other financial institutions. They would like to have information on the financial
performance and position of the business to assess whether the business is profitable enough
to pay the interest on loans and whether it has enough resources to pay back the principal
amount when it is due.

1. The Government and its agencies

The Government is interested in the financial performance of the business to be able to
assess the tax to be collected in the case there are any profits made by the business.
The other government agencies are interested with the financial position and performance
of the business to be able to come with National Statistics. This statistics measure the
average performance of the economy.

2. The Financial Analyst and Advisors

 Financial analyst and advisors interpret the financial information. Examples include
stockbrokers who advise investors on shares to buy in the stock market and other
professional consultants like accountants. They are interested with the financial position
and performance of the firm so that they can advise their clients on how much is the
value their investment i.e. whether it is profitable or not and what is the value.
Others advisors would include the press who will then pass the information to other
relevant users.

3. The Employees
They work for the business/entity. They would like to have information on the financial
position and performance so as to make decisions on their terms of employment. This
information would be important as they can use it to negotiate for better terms including
salaries, training and other benefits.
They can also use it to assess whether the firm is financially sound and therefore their
jobs are secure.

4. The Public
Institutions and other welfare associations and groups represent the public. They are
interested with the financial performance of the firm. This information will be important
for them to assess how socially responsible is the firm.
This responsibility is in form the employment opportunities the firm offers, charitable
activities and the effect of firm’s activities on the environment.

5. THE ACCOUNTING EQUATION

A business owns properties. These properties are called assets. The assets are the business
resources that enable it to trade and carry out trading. They are financed or funded by the
owners of the business who put in funds.
These funds, including assets that the owner may put is called capital. Other persons who are
not owners of the firm may also finance assets. Funds from these sources are called liabilities.
The total assets must be equal to the total funding i.e. both from owners and non-owners. This
is expressed inform of accounting equation which is stated as follows:

ASSETS = LIABILITIES + CAPITAL

Each item in this equation is briefly explained below.

Assets:
An asset is a resource controlled by a business entity/firm as a result of past events for which
economic benefits are expected to flow to the firm.
 An example is if a business sells goods on credit then it has an asset called a debtor. The past
event is the sale on credit and the resource is a debtor. This debtor is expected to pay so that
economic benefits will flow towards the firm i.e. in form of cash once the customers pays.

Assets are classified into two main types:

i) Non- current assets (formerly called fixed assets).
ii) Current assets.

Non- current assets are acquired by the business to assist in earning revenues and not for resale.
They are normally expected to be in business for a period of more than one year.
Major examples include:
 Land and buildings
 Plant and machinery
 Fixtures, furniture, fittings and equipment
 Motor vehicles
Current assets are not expected to last for more than one year. They are in most cases directly
related to the trading activities of the firm. Examples include:
 Stock of goods – for purpose of selling.
 Trade debtors/accounts receivables – owe the business amounts as a resort of trading.
 Other debtors – owe the firm amounts other than for trading.
 Cash at bank.
 Cash in hand.

Liabilities:
These are obligations of a business as a result of past events settlement of which is expected to
result to an economic outflow of amounts from the firm. An example is when a business buys
goods on credit, then the firm has a liability called creditor. The past event is the credit
purchase and the liability being the creditor the firm will pay cash to the creditor and therefore
there is an out flow of cash from the business.

Liabilities are also classified into two main classes.

i) Non-current liabilities (or long term liabilities)

ii) Current liabilities.

Non-current liabilities are expected to last or be paid after one year. This includes long-term
loans from banks or other financial institutions. Current liabilities last for a period of less than
one year and therefore will be paid within one year. Major examples:

 Trade creditors/
or accounts payable – owed amounts as a result of
business buying goods on credit.
 Other creditors - owed amounts for services supplied to the firm
other than goods.
 Bank overdraft - amounts advanced by the bank for a short-term
period.
 Capital:
This is the residual amount on the owner’s interest in the firm after deducting liabilities
from the assets.
The Accounting equation can be expressed in a simple report called the Balance Sheet.
The basic format is as follows:

Name
Balance sheet as at 31.12.
Sh Sh Sh Sh
Capital xx Non Current Assets
Land & Buildings xx
Non Current Liabilities Plant & Machinery xx
Loan xx Fixtures, furniture & fittings xx
Motor vehicles xx
Current liabilities xx
Overdraft xx Current Assets
Creditors xx xx Stocks xx
Debtor’s xx
Capital and Liabilities Cash at bank xx
Cash in hand xx xx
xx Total assets xx
The above format of the balance sheet is the horizontal format however currently the practice
is to present the Balance Sheet using the vertical format which is shown below.

Name
Balance sheet as at 31.12.

Non Current Assets Sh Sh Sh

Land & Buildings xx
Plant & Machinery xx
Fixtures, furniture & fittings xx
Motors vehicles xx
xx
Current Assets
Stocks/inventories xx
Debtors/ trade receivables xx
Cash at bank xx
Cash in hand xx

Current Liabilities
Bank Overdraft xx
Creditors/trade payables xx (xx)
Net Current Assets xx
Net assets xx

Capital xx
Non Current Liabilities
Loan (from bank or other sources) xx
xx

Please pay attention to the format. The Non Current assets are listed in order of permanence as
shown i.e. from Land and Buildings to motor vehicles. The Current Assets are listed in order
of liquidity i.e. which asset is far from being converted into cash. Example ,stock is not yet
sold, (i.e. not yet realised yet) then when it is sold we either get cash or a debtor (if sold on
credit). When the debtor pays then the debtor may pay by cheque (cash has to be banked) or
cash.
The Current Liabilities are listed in order of payment i.e. which is due for payment first. Bank
overdraft is payable on demand by the bank, then followed by creditors.
Note that in the vertical format, current liabilities are deducted from current assets to give net
current assets. This is added to Non Current assets, which give us net assets.
Net assets should be the same as the total of Capital and Non Current Liabilities.
Example 1.1
B Kelly has a business that has been trading for some time. You are given the following
information as at 31.12.2002
£
Buildings 11,000
Furniture & Fittings 5,500
Motor Vehicles 5,800
Stocks 8,500
Debtor 5,600
Cash a bank 1,500
Cash in hand 400
Creditors 2,500
Capital 30,800
Loan 5,000

You are required to prepare a Balance Sheet as at 31 December 2001

B Kelly
Balance Sheet as at 31 December 2001

Non Current Assets £ £ £

Buildings 11,000
Furniture & Fittings 5,500
Motor Vehicles 5,800
22,300

Current Liabilities
Stock 8,500
Debtors 5,600
Cash at bank 1,500
Cash in hand 400
16,000
Creditors (2,500)
Net Current Assets 13,500
Net Assets 35,800

Capital 30,800
Non-Current Liabilities
Loan 5,000
35,800

Example 1.2
 L Stokes sets up a new business. Before he actually sells anything he has bought motor
vehicles of ₤3,000, premises of ₤7,000, stock of goods ₤2,000. He still owes ₤800 in respect
of them. He had borrowed ₤4,000 from D Evans. After the events just described and before
trading starts, he had ₤300 cash in hand and ₤600 cash at bank.

You are required to calculate the amount of his capital.

Solution:
Assets: ₤ ₤
Motor Vehicle 3,000
Premises 7,000
Stock 2,000
Cash at bank 600
Cash in hand 300
12,900

Liabilities:
Creditors 800
Loan - D Evans 4,000 (4,800)
8,100

Capital 8,100

Remember the Accounting equation:

Assets = Liabilities + Capital.

To get capital we rearrange the equation as follows:

Capital = Assets - Liabilities

Total Assets = ₤12,900

Total Liabilities = ₤4,800
Capital = ₤ 12,900 - 4,800
= ₤ 8,100

Example 1.3
C Kings has the following items in his balance sheet as on 30 June 2002.
Capital £41,800, Creditors £3,200, Fixtures £7,000, Motor Vehicles £8,400, Stock of goods
£9,900, Debtors £6,500, Cash at bank £12,900 and Cash in hand £240.

During the first week of July 2002:

a. He bought extra stock of goods £1,540 on credit.
b. One of the debtors paid him £560 in cash.
c. He bought extra fixture by cheque £2,000.
 You are to draw up a balance sheet as on 7 July 2002 after the above transactions have been
completed.

First we need to look at the effect of the above transactions on the assets and liabilities of C
Kings.
For
(a) Buying extra stock increases the level of stock by £1,540 and because this is bought
on credit the creditors increase by £1,540 also.
(b) Amount received from the debtor means that the level of debtors reduces and cash
increases by £560.
(c) Extra fixtures bought by cheque, will increase the fixtures and reduce the cash at
bank by £2,000.

This can be summarized as follows:

Opening Increase/(Decrease) Closing

Balances Balances
£ £
Capital 41,800 - 41,800
Creditors 3,200 1,540 4,740
Fixtures 7,000 2,000 9,000
Motor Vehicles 8,400 - 8,400
Stock 9,900 1,540 11,440
Debtors 6,560 (560) 6,000
Cash at bank 12,900 (2000) 10,900
Cash in hand 240 560 800

Given these closing balances then the balance sheet can be drawn as follows:

C Kings
Balance sheet as at 7 July 2002.

Non Current Assets £ £

Fixtures 9,000
Motor Vehicles 8,400
17,400

Current Assets
Stock 11,440
Debtors 6,000
Cash at bank 10,900
Cash at hand 800
29,140
Current Liabilities
Creditors (4,740)
Net Current Assets 24,400
Net Assets 41,800

Capital 41,800

From the illustration remember that any change in the items of the balance sheet will have a
double effect on the accounting equation has a double effect and therefore the equation will
always balance.

Example 1.4
D Moody has the following assets and liabilities as on 31 April 2002:
£
Creditors 15,800
Equipment 46,000
Motor Vehicle 25,160
Stock 24,600
Debtors 23,080
Cash at bank 29,120
Cash in hand 160

During the first week of May 2002 Moody:

a. Bought extra equipment on credit for £5,520.
b. Bought extra stock by cheque £2,280.
c. Paid creditors by cheque £3,160.
d. Debtors paid £3,360 by cheque and £240 by cash.
e. Moody put in extra £1,000 cash as capital.

Required:
a. Determine the capital as at 1st May 2002.
b. Draw up a balance sheet after the above transactions have been completed.

Solution:
(i) Using the accounting equation of Assets = Liabilities + Capital, then assets and liabilities
can be listed as follows.
Assets £ Liabilities £
Equipment 46,000 Creditors 15,800
Motor Vehicle 25,160
Stock 24,600
Debtors 23,080
Cash at bank 29,120
Cash in hand 160
148,120

Capital = Assets – Liabilities