FINANCIAL ACCOUNTING

FINANCIAL ACCOUNTING

PART I

SECTION 1

CPA
CIFA

STUDY TEXT
KASNEB JULY 2018 SYLLABUS

Revised on: January 2019

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SYLLABUS

PAPER NO 1: FINANCIAL ACCOUNTING

GENERAL OBJECTIVE
This paper is intended to equip the candidate with knowledge, skills and attitudes that will enable
him/her to prepare financial statements for different entities
LEARNING OUTCOMES
A candidate who passes this paper should be able to:
• Prepare books of original entry and basic ledger accounts under double entry system
• Prepare basic financial statements of sole traders. partnerships, companies and manufacturing
entities and not for profit organisations
• Comply with the regulatory framework in the accounting field
• Account for assets and liabilities
• Analyse financial statements by use of ratios and statement of cash flows

CONTENT
1. Introduction to Accounting
- The nature and purpose of accounting
- Objectives of accounting
- Users of accounting information and their respective needs
- The accounting equation
- Reguratory framework of accounting (regulatory bodies such as ICPAK, IFAC, IASB,
IPSAB
- Accounting standards (IAS/IFRS), (Importance and limitations)
- Professional ethics
- Accounting concepts/principles
- Qualities of useful accounting information
2 Recording transactions
- Source documents (quotations_ purchases order, statement of account. remittance advice,
receipts, petty cash vouchers_ sales arid purchase invoices, credit notes and debit notes, bank
statements)
- Books of original entry: sales journal, purchases journal, returns inward, returns outward
journal, cashbook, petty cashbook and general journal
- Double entry and the ledger; general ledger, sales ledger, purchases ledger
- The trial balance
- Computerised accounting systems- Role of computers, application and accounting softwares
in the accounting process, benefits and challenges of operating computerised accounting
systems

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3. Accounting for assets and liabilities

3.1 Assets
- Property, plant and equipment — recognition, capital and revenue expenditure, measurement
(depreciation and revaluation), disposal and disclosures — property, plant and equipment
schedule
- Intangible assets — recognition, measurement (amortisation, impairment and revaluation),
disposals and disclosures
- Financial assets- examples and risks only
- Inventory - recognition, measurement and valuation using specific. cost method (FIFO and
weighted average cost)
- Trade receivables - bad debts and allowance for doubtful debts and receivables control
accounts
- Accrued income and prepaid expenses
- Cash at bank -- cashbook and bank reconciliation statement
- Cash in hand - cash book and petty cash book
3.2 Liabilities
- Bank overdraft - cash book and bank reconciliation
- Trade payables - payables control accounts
- Loans - accounting treatment of repayment of principal and interest
- Prepaid income and accrued expenses
4. Correction of errors and suspense account
5. Financial statements of a sole trader
- Income statement
- Statement of financial position
6. Financial statements of a partnership
- Partnership agreement
- Introduction to Partnership accounts
- Distinction between current and fixed capital
- Income statement
- Statement of financial position
- Changes in partnership – Admission of a new partner, retirement and change in profit sharing
ratio
7. Financial statements of a company
- Types of share capital - ordinary shares and preference shares
- Issue of shares (exclude issue by instalment and forfeiture)
- Types of reserves share premium, revaluation reserve, general reserves and retained profits
- Income tax -Accounting treatment and presentation (exclude computation)
- Financial statements - Income statement and statement of financial position
- Published financial statements (describe a complete set of published financial statements but
not preparation)
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8. Financial statements of a manufacturing entity

- Features of a manufacturing entity
- Classification and apportioning costs between manufacturing and selling and administration
- Financial statements - manufacturing account, income statement and statement of financial
position
9. Accounts from incomplete records
- Features
- Types of incomplete records (Pure single entry, simple single entry, quasi single entry)
- Ascertaining of profit by capital comparison
- Preparation of statement of affairs and profit determination
- Techniques of obtaining complete accounting information
9. Financial statements of a not-for-profit organisation
- Distinction between not for profit making organisation and profit making organisation
- Nature of receipts and payments accounts
- Accounting treatment of some special items
- Income and expenditure account
- Statement of financial position
10. Analysing financial statements
- Statement of cash flows (categories of cash, methods of preparing statement of cash flows
and the importance)
- Financial ratios — definition, categories, analysis and interpretation, application and
limitations
11. Introduction to public sector Accounting
- Features of public sector entities (as compared to private sector)
- Structure of the public sector (National and county governments: state corporations and other
agencies)
- Regulatory structures and oversight [IPSASB, PSASB (establishment, mandate and
functions), Director of Accounting Services, National Treasury, Parliamentary Committees.
Accounting Officers at national and county levels]
- Objectives of public sector financial statements
- Objectives of IFSAS
- Accounting techniques in public sector (budgeting, cash, accrual: commitment and fund)
(Preparation of financial statements should be excluded)
12. Emerging issues and trends

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CONTENT PAGE

Topic 1: Introduction to Accounting.....................................................................................6

Topic 2: Recording transactions..........................................................................................38
Topic 3: Accounting for assets and liabilities......................................................................88
Topic 4: Correction of errors and suspense account...........................................................153
Topic 5: Financial statements of a sole trader....................................................................166
Topic 6: Financial statements of a partnership...................................................................213
Topic 7: Financial statements of a company......................................................................254
Topic 8: Financial statements of a manufacturing entity ..................................................285
Topic 9: Accounts from Incomplete records......................................................................302
Topic 10: Financial statements of a not-for-profit organisation........................................322
Topic 11: Analysing financial statements...........................................................................341
Topic 12: Introduction to public sector Accounting...........................................................373

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TOPIC 1

INTRODUCTION TO ACCOUNTING

NATURE AND PURPOSE OF ACCOUNTING

Accounting is considered the language of business. It has evolved throughout the years as
information needs changed and became more complex. After finishing this article, the reader should
be able to have a general understanding about accounting, be acquainted with the different
definitions, know the different types of information found in accounting reports, and know the
different uses of accounting information.

Some say that accounting is a science because it is a body of knowledge which has been
systematically gathered, classified, and organized. It could be influenced by a lot of factors,
specifically by economic, social and political events. Some say that accounting is an art because it
requires creative skill and judgment. Furthermore, accounting is also considered as an information
system because it is used to identify and measure economic activities, process the information into
financial reports, and communicate these reports to the different users of accounting information.

To further understand what accounting is, we must take a look at the different definitions.

Accounting as an
Accounting as a Science Accounting as an Art
Information System
Accounting is the art of recording Accounting is a service
Accounting is the process of
(journalizing), classifying (posting to activity, which functions to
identifying, measuring, and
the ledger), summarizing in a provide quantitative
communicating economic
significant manner and in terms of information, primarily
information to permit
money, transactions and events which financial in nature, about
informed judgment and
are, in part, at least of a financial economic entities that is
decisions by users of
character, and interpreting the results intended to to be useful in
information.
thereof to interested users. making economic decisions.

The first definition emphasizes the following:

 Identifying - in accounting, this is the process of recognition or non-recognition of business

activities as accountable events. Stated differently, this is the process which determines if an
event has accounting relevance.
 Measuring - in accounting, this is the process of assigning monetary amounts to the
accountable events.
 Communicating - As we could notice with the above definitions, one main similarity
between the three is the impact of communication. In order to be useful, accounting
information should be communicated to the different decision makers. Communicating
accounting information is achieved by the presentation of different financial statements.

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The second definition emphasizes the following:

 Recording - The accounting term for recording is journalizing. All the accountable events are
recorded in a journal.
 Classifying - The accounting term for recording is posting. All accountable events that are
recorded in the journal are then classified or posted to a ledger.
 Summarizing - the items that are journalized and posted are summarized in the five basic
financial statements.

The third definition emphasizes that accounting is a service activity and that Information provided
by accounting could be classified into 3 types:

 Quantitative information - this is information that is expressed in numbers, quantities or

units
 Qualitative information - this is information that is expressed in words
 Financial information - this information is expressed in terms of money

Therefore, given the definitions, accounting is a service activity that is all about recording,
classifying and summarizing accountable events in order to communicate quantitative, qualitative,
and financial economic information, to different users in order to make relevant decisions.

OBJECTIVES OF ACCOUNTING

The objectives of accounting can be given as follows:

 Systematic recording of transactions - Basic objective of accounting is to systematically

record the financial aspects of business transactions i.e. book-keeping. These recorded
transactions are later on classified and summarized logically for the preparation of financial
statements and for their analysis and interpretation.

 Ascertainment of results of above recorded transactions - Accountant prepares profit and

loss account to know the results of business operations for a particular period of time. If
revenue exceeds expenses then it is said that business is running profitably but if expenses
exceed revenue then it can be said that business is running under loss. The profit and loss
account helps the management and different stakeholders in taking rational decisions. For
example, if business is not proved to be remunerative or profitable, the cause of such a state
of affair can be investigated by the management for taking remedial steps.

 Ascertainment of the financial position of the business - Businessman is not only

interested in knowing the results of the business in terms of profits or loss for a particular
period but is also anxious to know that what he owes (liability) to the outsiders and what he
owns (assets) on a certain date. To know this, accountant prepares a financial position
statement popularly known as Balance Sheet. The balance sheet is a statement of assets and
liabilities of the business at a particular point of time and helps in ascertaining the financial
health of the business.

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 Providing information to the users for rational decision-making - Accounting like a

language of commerce communes the monetary results of a venture to a variety of
stakeholders by means of financial reports. Accounting aims to meet the information needs of
the decision-makers and helps them in rational decision-making.

 To know the solvency position: By preparing the balance sheet, management not only
reveals what is owned and owed by the enterprise, but also it gives the information regarding
concern's ability to meet its liabilities in the short run (liquidity position) and also in the long-
run (solvency position) as and when they fall due.

USERS OF ACCOUNTING INFORMATION AND THEIR NEEDS

Users of accounting information could be divided

into 7 major groups which could be easily be remembered using the acronym GESCLIP. This
stands for Government, Employees, Suppliers (trade creditors), Customers/Clients/Consumers,
Lenders, Investors, and Public. Let us then discuss each user and find out why they need accounting
information.

1. Government – the government needs accounting information during its day-to-day

operations. The government needs accounting information to assess the amount of tax to be
paid by a business or an individual (like the Bureau of Internal Revenue or the Internal
Revenue Service when assessing income tax, estate tax, donor’s tax or other taxes);
accounting information is needed when determining the fees to be charged in acquiring a
business permit or a mayor’s permit; when the Securities and Exchange Commission
determines the legality of the amount of share capital subscribed, accounting information is
used; when the government deals with certain economic problems like inflation, still
accounting information is used. Of course, this list could go on and on.
2. Employees – if you are an employee working in the accounting, finance or sales department,
definitely, accounting information is essential. However, the use of accounting information is
not delimited to employee working under accounting related departments. Employees need
accounting information to know if the business could provide the necessary benefits that is
due to them. Through accounting information, employees would not be in the dark with
regards to the operations of the firm that they are working for.
3. Suppliers and Other Trade Creditors – suppliers and trade creditors are providers of
merchandise on account to different business establishments. Some examples of suppliers are
Coca-Cola and Pepsi. Coca-Cola and Pepsi products that are sold to different fast-food chains
and supermarkets but are not paid in cash immediately. Before extending credit to customers,
Coca-Cola and Pepsi should look into the accounting records of an entity to determine if they
would sell their products on account or not. Telecommunication providers like Smart
Telecom, Globe, and At&t, could also be considered as suppliers. Before getting a plan from
these telecommunication providers, they ask for different proofs of income from the clients
availing of a plan. This is because suppliers could determine from the accounting information
if a business or an individual has the ability to pay accounts on time.
4. Customers/Clients/Consumers - Customers need accounting information in order to
determine the continuity of a business, most especially when there is a long-term engagement
between the parties or if the customer is dependent on the enterprise. For instance, students
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have to go to a financially stable school that could continue to provide quality education until
they graduate. Through accounting information, customers could also check if prices that are
being charged
harged are reasonable. Students could look into the financial statements of a school
and determine if they are being charged the right tuition fees.
5. Lenders - Lenders have similar needs as suppliers wherein they interested in accounting
information that enable
able them to determine the ability of a client to pay their obligations and
the interest attached when the loan becomes due. However, in contrast to suppliers, lenders
are providers of money (like banks or lending institutions) while suppliers are provider
providers of
tangible goods.
6. Investors and Businessmen - Investors need accounting information in order to make
relevant decisions. Through accounting information, they could determine whether to
purchase stocks, sell stocks or hold the stock. Businessmen could determine
determine which operations
to continue or discontinue, which product line is profitable, and many more. They need to
know about the financial performance, position, and cash flows of a business.
7. Public - All of us need accounting information. We want to know the status of the economy,
we want to know what is happening with our favorite fast food chains, we want to know the
status of retirement plants, families need to budget their money, monitor receipts and
disbursements, and many more.

ACCOUNTING EQUATION

The accounting equation, also called the basic accounting equation, forms the foundation for all
accounting systems. In fact, the entire double entry accounting concept is based on the basic
accounting equation. This simple equation illustrates two facts about
about a company: what it owns and
what it owes.

The accounting equation equates a company's assets to its liabilities and equity. This shows all
company assets are acquired by either debt or equity financing. For example, when a company is
started, its assets
ts are first purchased with either cash the company received from loans or cash the
company received from investors. Thus, all of the company's assets stem from either creditors or
investors i.e. liabilities and equity.

Here is the basic accounting equation.

equatio

As you can see, assets equal the sum of liabilities and owner's equity(Capital)
equity(Capital). This makes sense
when you think about it because liabilities and equity are essentially just sources of funding for
companies to purchase assets.

The equation is generally

ly written with liabilities appearing before owner's equity because creditors
usually have to be repaid before investors in a bankruptcy. In this sense, the liabilities are considered

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more current than the equity. This is consistent with financial reporting where current assets and
liabilities are always reported before long-term assets and liabilities.

This equation holds true for all business activities and transactions. Assets will always equal
liabilities and owner's equity. If assets increase, either liabilities or owner's equity must increase to
balance out the equation. The opposite is true if liabilities or equity increase.

Now that we have a basic understanding of the equation, let's take a look at each accounting
equation component starting with the assets.

Assets

An asset is a resource that is owned or controlled by the company to be used for future benefits.
Some assets are tangible like cash while others are theoretical or intangible like goodwill or
copyrights.

Another common asset is a receivable. This is a promise to be paid from another party. Receivables
arise when a company provides a service or sells a product to someone on credit.

All of these assets are resources that a company can use for future benefits. Here are some common
examples of assets:
 Cash
 Accounts Receivable
 Prepaid Expenses
 Vehicles
 Buildings
 Goodwill
 Copyrights
 Patents

Liabilities

A liability, in its simplest terms, is an amount of money owed to another person or organization.
Said a different way, liabilities are creditors' claims on company assets because this is the amount of
assets creditors would own if the company liquidated.

A common form of liability is a payable. Payables are the opposite of receivables. When a company
purchases goods or services from other companies on credit, a payable is recorded to show that the
company promises to pay the other companies for their assets.

Here are some examples of some of the most common liabilities:

 Accounts payable
 Bank loans
 Lines of Credit
 Personal Loans
 Officer Loans
 Unearned income

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Equity (Capital)

Equity represents the portion of company assets that shareholders or partners own. In other words,
the shareholders or partners own the remainder of assets once all of the liabilities are paid off.

Owners can increase their ownership share by contributing money to the company or decrease equity
by withdrawing company funds. Likewise, revenues increase equity while expenses decrease equity.

Here are some common equity accounts:

 Owner's Capital
 Owner's Withdrawals
 Revenues
 Expenses
 Common stock
 Paid-In Capital

Example

Let's take a look at the formation of a company to illustrate how the accounting equation works in a
business situation.

Ted is an entrepreneur who wants to start a company selling speakers for car stereo systems. After
saving up money for a year, Ted decides it is time to officially start his business. He forms Speakers,
Inc. and contributes $100,000 to the company in exchange for all of its newly issued shares. This
business transaction increases company cash and increases equity by the same amount.

After the company formation, Speakers, Inc. needs to buy some equipment for installing speakers,
so it purchases $20,000 of installation equipment from a manufacturer for cash. In this case,
Speakers, Inc. uses
ses its cash to buy another asset, so the asset account is decreased from the
disbursement of cash and increased by the addition of installation equipment.

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After six months, Speakers, Inc. is growing rapidly and needs to find a new place of business. Ted
decides it makes the most financial sense for Speakers, Inc. to buy a building. Since Speakers, Inc.
doesn't have $500,000 in cash to pay for a building, it must take out a loan. Speakers, Inc. purchases
a $500,000 building by paying $100,000 in cash and taking out a $400,000 mortgage. This business
transaction decreases assets by the $100,000 of cash disbursed, increases assets by the new $500,000
building, and increases liabilities by the new $400,000 mortgage.

As you can see, all of these transactions

transactions always balance out the accounting equation. This is one of
the fundamental rules of accounting. The accounting equation can never be out of balance. Assets
will always equal liabilities and owner's equity.

Transactions that affect Assets and Equity of the th entity

These transactions result in the increase in Assets and Equity of the entity simultaneously.
Conversely, the transactions may cause a decrease in both Assets and Equity of the entity.

Any increase in the assets will be matched by an equal increase

increase in equity and vice versa causing the
Accounting Equation to balance after the transactions are incorporated.

Example 1

ABC LTD issues share capital for $2,500 in cash

.
Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000
After Transaction: Assets $12,500* - Liabilities $5,000 = Equity $7,500*
*Assets $12,500 = $10,000 Plus $2,500 (Cash)
*Equity $7,500 = $5,000 Plus $2,500 (Share Capital)
7 500=5 000+2 500

Example 2
ABC LTD pays dividend of $500 in cash.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

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After Transaction: Assets $9,500* - Liabilities $5,000 = Equity $4,500*

*Assets $9,500 = $10,000 Less $500 (Cash)
*Equity $4,500 = $5,000 Less $500 (Divident)

Transactions that affect Liabilities and Equity of the entity

These transactions result in the increase in Liabilities which is offset by an equal decrease in Equity
and vice versa.

Any increase in liability will be matched by an equal decrease in equity and vice versa causing the
Accounting Equation to balance after the transactions are incorporated.

Example 1
ABC LTD incurs utility expense of $500 which remains unpaid at the period end.

Before Transaction: Assets $10,000 - Liabilities $5,000 = Equity $5,000

After Transaction: Assets $10,000 - Liabilities $5,500* = Equity $4,500*
*Liability $5,500 = $5,000 Plus $500 (Accrued Liability)
*Equity $4,500 = $5,000 Less $500 (Accrued Expense)
4 500=5 000-500

Horizontal format

Name of business
Balance sheet as 31st December 20xx
Sh sh Sh
Non-Current Assets: Capital xxx
Land and buildings
xxx Non-current liabilities
Plant and machinery xxx Loan xxx
Fixtures, furniture and fittings xxx
Motor vehicle xxx

Current assets: Current liabilities

Stocks xxx Overdraft xxx
Debtors xxx Creditors xxx xxx
Cash at Bank xxx
Cash in hand xxx xxx ____
Total assets xxx xxx

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Vertical format

Name of business
Balance sheet as 31st December 20xx
Sh sh
Non-Current Assets:
Land and buildings xxx
Plant and machinery xxx
Fixtures, furniture and fittings xxx
Motor vehicle xxx

Current assets:
Stocks xxx
Debtors xxx
Cash at Bank xxx
Cash in hand xxx xxx
Total assets xxx

Capital xxx
Non-current liabilities
Loan xxx

Current liabilities
Overdraft xxx
Creditors xxx
xxx

Non-current assets are listed in order of performance as shown i.e. from land and buildings to motor
vehicles. The current assets are listed in order of liquidity i.e. which assets is far from being
converted into cash. Example, stock is not yet sold, (i.e. not yet realized 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 by creditors

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Illustration 1

Kamau has a business that has been trading for some time. You are given the following information
as 31.12.2014
Sh “000”
Building 22 000
Furniture 11 000
Motor vehicle 11 600
Stocks 17 000
Debtors 11 200
Cash at bank 3 000
Cash in hand 800
Creditors 5 000
Capital 61 600
Loan 10 000

You are required to prepare a balance sheet as at 31 December 2014

Solution

Kamau
Balance sheet as 31st December 2014

Sh “000” Sh “000”
Non-Current Assets:
Buildings 22 000
Furniture and fittings 11 000
Motor vehicles 11 600
44 600
Current assets:
Stocks
Debtors 17 000
Cash at Bank 11 200
Cash in hand 3 000
Total assets 800 32 000
76 600

Capital 61 600
Non-Current liabilities
Loan 10 000

Current liabilities
Creditors 5 000 15 000
76 600

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Illustration 2

D Mwangi has the following assets and liabilities as on 31 April 2012:

Sh.
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 2012 Mwangi:

a. Bought extra equipment on credit for Sh5,520.

b. Bought extra stock by cheque Sh 2,280.
c. Paid creditors by cheque Sh 3,160.
d. Debtors paid Sh 3,360 by cheque and Sh 240 by cash.
e. Mwangi put in extra Sh 1,000 cash as capital.

Required:
a) Determine the capital as at 1st May 2012.
b) Draw up a balance sheet after the above transactions have been completed.

Solution
Using the accounting equation of Assets = Liabilities + Capital, then assets and liabilities can be
listed as follows

Sh
Assets
Equipment 46,000
Motor Vehicle 25,160
Stock 24,600
Debtors 23,080
Cash at bank 29,120
Cash in hand _160
148 120
Liabilities
Creditors 15,800

Capital = Assets - Liabilities

= Sh 148,120 - Sh 15,800
= Sh 132,320

(i) To draw up the balance sheet, we consider the effect of the above transactions on the relevant
balances:

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a. Buying extra equipment means that the equipment balance will increase by Sh 5,520 and the
creditors will also increase by the same amount.
b. Buying extra stock by cheque means that the level of stock goes up by Sh 2,280 and the
balance at bank reduces by the same.
c. Paying creditors by cheque reduces the balance on the creditors account and also reduce the
amount at the bank.
d. Debtor paying the firm reduces the debtors balance by Sh 3,600 and increases the cash at
bank and cash in hand by Sh 3,360 and Sh 240 respectively.
e. Additional cash of Sh 1,000 increases the cash in hand balance by Sh 1,000 and the capital
balances.

This is also summarized as follows:

Assets/Liabilities Opening Balance Adjustment Increase / Closing Balance
Decrease
Equipment 46,000 5,520 51,520
Motor Vehicle 25,160 25,160
Stock 24,600 2,280 26,880
Debtors 23,080 -3,600 19,480
Cash at bank 29,120 (-2,280 - 3,160 + 3,360) 27,040
Cash in hand 160 (+240 + 1000) 1,400
Creditors 15,800 (+5,520 - 3,160) 18,160
Capital 132,320 1,000 133,320

The balance sheet will therefore be prepared as follows:

Mwangi
Balance sheet as at 1st May 2012

Sh Sh
Non-Current Assets
Equipment 51,520
Motor vehicle 25.160
76,680
Current Assets
Stock 26,880
Debtors 19,480
Cash at bank 27,040
Cash in hand 1,400 74 800
151,480
Current Liabilities
Creditors 18,160
Capital 133,320
151,480

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REGULATORY FRAMEWORK OF ACCOUNTING

INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANT (ICPAK)

The Institute of Certified Public Accountants of Kenya (ICPAK) was established in 1978. The
Institute is a member of the Pan-African Federation of Accountants (PAFA) and the International
Federation of Accountants (IFAC), the global umbrella body for the accountancy profession. The
Vision of the Institute is ‘A world class professional accountancy institute‘, while the Mission is
‘To develop and promote internationally recognised accountancy profession that upholds public
interest through effective regulation, research and innovation’.

The Institute is guided by the following core values: Credibility, Professionalism and
Accountability. The Institute draws its mandate from the Accountants Act (no 15 of 2008).

Its mandate includes:

The Accountants Act No 15, 2008 prescribes the following as the functions of the Institute:

 To promote standards of professional competence and practice amongst members of the

Institute
 To promote research into the subject of accountancy and finance and related matters, and the
publication of books, periodicals, journals and articles in connection therewith;
 To promote the international recognition of the Institute.
 To advise the Examination Board on matters relating to examinations standards and policies;
 To advise the Minister on matters relating to financial accountability in all sectors of the
economy;
 To carry out any other functions prescribed for it under any of the other provisions of this Act
or any other written law and
 To do anything incidental or conducive to the performance of any of the preceding functions.

The International Federation of Accountants (IFAC)

The International Federation of Accountants (IFAC) was founded on 7 October 1977, in

Munich, Germany, at the 11th World Congress of Accountants. IFAC comprises 179 member
and associate member organisations in 130 countries, representing more than 2.5 million
accountants in public practice, education, government service, industry, and commerce.

IFAC has established the following boards. We maintain separate pages for each board, with a
history of developments for each board:

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Body Function

International Public Sector Sets International Public Sector Accounting Standards (IPSAS) for
Accounting Standards Board use by the public sector
(IPSASB)

International Auditing and Sets International Standards on Auditing, Assurance Engagements

Assurance Standards Board and Related Services
(IAASB)

International Accounting Develops International Education Standards

Education Standards Board
(IAESB)

International Ethics Standards Develops the international Code of Ethics for Professional
Board for Accountants Accountants
(IESBA)

Public Interest Oversight Oversees IFAC's standard-setting activities, particularly with

Board (PIOB) respect to auditing, assurance, ethics, and independence. The
PIOB also oversees IFAC's compliance activities.

IFAC also supports the IASB with respect to setting accounting standards.

The International Accounting Standards Board (IASB)

The International Accounting Standards Board (IASB) is an independent, private-sector body
that develops and approves International Financial Reporting Standards (IFRSs). The IASB
operates under the oversight of the IFRS Foundation. The IASB was formed in 2001 to replace
the International Accounting Standards Committee. Currently, the IASB has 14 members.

The IASB's role

Under the IFRS Foundation Constitution, the IASB has complete responsibility for all technical
matters of the IFRS Foundation including:

- Full discretion in developing and pursuing its technical agenda, subject to certain
consultation requirements with the Trustees and the public
- The preparation and issuing of IFRSs (other than Interpretations) and exposure drafts,
following the due process stipulated in the Constitution
- The approval and issuing of Interpretations developed by the IFRS Interpretations
Committee

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ACCOUNTING STANDARDS (IMPORTANCE AND LIMITATION)

Accounting standards is a set of standards, guidelines and procedures that are used when accounting
for the affairs of most governmental and non-governmental bodies. The interpretation of numbers
and the wherewithal to place them in the proper context are at the heart of accounting. Standards
exist to ensure that accounting decisions are made in a unified and reasonable way.

The objective of setting standards is to bring about uniformity in financial reporting and to ensure
consistency in the data published by enterprises. For accounting standards, to be useful tool to
enhance the corporate governance and responsibility, two criteria must be satisfied, i.e.

i. A standard must provide a generally understood and accepted measure of the phenomena of
concern.
ii. A standard should significantly reduce the amount of manipulation of the reported numbers
and is likely to occur in the absence of the standards.

Accounting standards facilities uniform preparation and reporting of general purpose financial
statements published annually for the benefit of shareholders, creditors, employee and public at
large. They are very useful to the investors and other external groups in assessing the progress and
prospects of alternative investments in different companies in different countries.

Accounting standards can be seen as providing an important mechanism to help in the resolution of
potential financial conflicts of interest between the various important groups in society. It is essential
that accounting standards should command the greatest possible credibility among shareholders,
creditors, employee and public at large.

Their important can be summarized as follows:

Comparability

Paramount to the role of accounting standards is the universality that it brings to financial record
keeping. Governmental organizations must follow accounting procedures that are the same as their
counterparts, and non-governmental organizations must do the same. The result is that it is easy to
compare the financial standing of similar entities. All comparisons within groups are a matter of
comparing "apples to apples." This helps both external and internal observers weigh the state of an
entity in the context of other comparable entities. For instance, the financial standing of a town can
be measured against a neighboring town with the assumption that the pertinent numbers have been
reached in a similar fashion.

Transparency

Accounting standards are designed to enforce transparency in organizations. The principles,

procedures and standards that make up the generally accepted accounting principles were chosen
with the purpose of ensuring that organizations lean in the direction of openness when deciding how
to provide information to observers. This kind of transparency is especially important in the case of
public entities, such as governments or publicly traded companies. Standards limit the freedom and
flexibility of entities to use clever accounting to move items around or even to hide them.

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Relevance

Standards work to help entities provide the most relevant information in the most reasonable way
possible. In this way, an organization guided by accounting standards will generate the kind of
financial information that observers are most interested in examining. Entities ultimately should
provide information in a way that most fairly and clearly represents the current financial standing of
the operation. The standards make it more difficult for organizations to misdirect observers and to
fool them with data that does not have sufficient relevancy.

Audiences

Ultimately, the importance of accounting standards lies in the value that it brings to financial
documents for the various audiences that view and make critical decisions based on it. An absence
of accounting standards would make the work of investors, regulators, taxpayers, reporters and
others more difficult and more risky. For instance, without standards, an investor who has studied
the financial statements of a large publicly traded company would not know whether to trust the
findings on those statements. Standards mean that taxpayers can see how their tax dollars are being
spent, and regulators can ensure that laws are followed.

Limitations of accounting standards

i. Alternative solutions to certain accounting problems may each have arguments to recommend
them. Therefore, the choice between different alternative accounting treatments may become
difficult.
ii. There may be a trend towards rigidity and away from flexibility in applying the accounting
standards.
iii. Accounting standards cannot override the statute. The standards are required to be framed
within the ambit of prevailing statutes.

PROFESSIONAL ETHICS

A professional accountant is required to comply with the following fundamental principles:

a. Integrity
A professional accountant should be straight forward and honest in all professional and business
relationships.

b. Objectivity
A professional accountant should not allow bias, conflict of interest or undue influence of others to
override professional or business judgments.

c. Professional Competence and Due Care

A professional accountant has a continuing duty to maintain professional knowledge and skill at the
level required to ensure that a client or employer receives competent professional service based on
current developments in practice, legislation and techniques. A professional accountant should act

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diligently and in accordance with applicable technical and professional standards when providing
professional services.

d. Confidentiality
A professional accountant should respect the confidentiality of information acquired as a result of
professional and business relationships and should not disclose any such information to third parties
without proper and specific authority unless there is a legal or professional right or duty to disclose.

Confidential information acquired as a result of professional and business relationships should not
be used for the personal advantage of the profes-sional accountant or third parties.

e. Professional Behaviour
A professional accountant should comply with relevant laws and regulations and should
avoid any action that discredits the profession.

ACCOUNTING CONCEPT/PRINCIPLES

Accounting Concepts and Principles are a set of broad conventions that have been devised to
provide a basic framework for financial reporting. As financial reporting involves significant
professional judgments by accountants, these concepts and principles ensure that the users of
financial information are not mislead by the adoption of accounting policies and practices that go
against the spirit of the accountancy profession. Accountants must therefore actively consider
whether the accounting treatments adopted are consistent with the accounting concepts and
principles.

In order to ensure application of the accounting concepts and principles, major accounting standard-
setting bodies have incorporated them into their reporting frameworks such as the IASB Framework.

Following is a list of the major accounting concepts and principles:

 Relevance
 Reliability
 Matching Concept
 Timeliness
 Neutrality
 Faithful Representation
 Prudence
 Completeness
 Single Economic Entity Concept
 Money Measurement Concept
 Comparability/Consistency
 Understandability
 Materiality
 Going Concern
 Accruals
 Business Entity
 Substance over Form

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 Realization Concept
 Duality Concept

In case where application of one accounting concept or principle leads to a conflict with another
accounting concept or principle, accountants must consider what is best for the users of the financial
information. An example of such a case would be the trade off between relevance and reliability.
Information is more relevant if it is disclosed timely. However, it may take more time to gather
reliable information. Whether reliability of information may be compromised to ensure relevance of
information is a matter of judgment that ought to be considered in the interest of the users of the
financial information.

Relevance:
Information should be relevant to the decision making needs of the user. Information is relevant if it
helps users of the financial statements in predicting future trends of the business (Predictive Value)
or confirming or correcting any past predictions they have made (Confirmatory Value). Same piece
of information which assists users in confirming their past predictions may also be helpful in
forming future forecasts.

Example:
A company discloses an increase in Earnings Per Share (EPS) from $5 to $6 since the last reporting
period. The information is relevant to investors as it may assist them in confirming their past
predictions regarding the profitability of the company and will also help them in forecasting future
trend in the earnings of the company.

Relevance is affected by the materiality of information contained in the financial statements because
only material information influences the economic decisions of its users.

Reliability
Information is reliable if a user can depend upon it to be materially accurate and if it faithfully
represents the information that it purports to present. Significant misstatements or omissions in
financial statements reduce the reliability of information contained in them.

Example:

A company is being sued for damages by a rival firm, settlement of which could threaten the
financial stability of the company. Non-disclosure of this information would render the financial
statements unreliable for its users.

Reliability of financial information is enhanced by the use of following accounting concepts and
principles:
1. Neutrality
2. Faithful Representation
3. Prudence
4. Completeness
5. Single Economic Entity Concept

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Neutrality
Information contained in the financial st attempting to present them in a favored light. Information
may be deliberately biased or systematically biased.

Deliberate bias
Deliberate bias: Occurs where circumstances and conditions cause management to intentionally
misstate the financial statements.
Examples:
 Managers of a company are provided bonus on the basis of reported profit. This might tempt
management to adopt accounting policies that result in higher profits rather than those that
better reflect the company's performance inline with GAAP.
 A company is facing serious liquidity problems. Management may decide to window dress
the financial statements in a manner that improves the company's current ratios in order to
hide the gravity of the situation.
 A company is facing litigation. Although reasonable estimate of the amount of possible
settlement could be made, management decides to discloses its inability to measure the
potential liability with sufficient reliability.

Systematic bias
Systematic bias: Occurs where accounting systems have developed an inherent tendency of favoring
one outcome over the other over time.
Examples:
Accounting policies within an organization may be overly prudent because of cultural influence of
an over cautious leadership.

Faithful Representation
Information presented in the financial statements should faithfully represent the transaction and
events that occur during a period.

Faithfull representation requires that transactions and events should be accounted for in a manner
that represents their true economic substance rather than the mere legal form. This concept is known
as Substance Over Form.

Substance over form requires that if substance of transaction differs from its legal form than such
transaction should be accounted for in accordance with its substance and economic reality.

The rationale behind this is that financial information contained in the financial statements should
represent the business essence of transactions and events not merely their legal aspects in order to
present a true and fair view.

Example:
A machine is leased to Company A for the entire duration of its useful life. Although Company A is
not the legal owner of the machine, it may be recognized as an asset in its balance sheet since the
Company has control over the economic benefits that would be derived from the use of the asset.
This is an application of the accountancy concept of substance over legal form, where economic
substance of a transaction takes precedence over its legal aspects.

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Prudence
Preparation of financial statements requires the use of professional judgment in the adoption of
accountancy policies and estimates. Prudence requires that accountants should exercise a degree of
caution in the adoption of policies and significant estimates such that the assets and income of the
entity are not overstated whereas liability and expenses are not under stated.

The rationale behind prudence is that a company should not recognize an asset at a value that is
higher than the amount which is expected to be recovered from its sale or use. Conversely, liabilities
of an entity should not be presented below the amount that is likely to be paid in its respect in the
future.

Example:

Inventory is recorded at the lower of cost or net realizable value (NRV) rather than the expected
selling price. This ensures profit on the sale of inventory is only realized when the actual sale takes
place.

However, prudence does not require management to deliberately overstate its liabilities and
expenses or understate its assets and income. The application of prudence should eliminate bias from
financial statements but its application should not reduce the reliability of the information

Completeness

Reliability of information contained in the financial statements is achieved only if complete financial
information is provided relevant to the business and financial decision making needs of the users.
Therefore, information must be complete in all material respects.

Incomplete information reduces not only the relevance of the financial statements, it also decreases
its reliability since users will be basing their decisions on information which only presents a partial
view of the affairs of the entity.

Single Economic Entity Concept Consolidation Accounting

Consolidated financial statements of a group of companies are prepared on the basis of single
economic entity concept.

Single Economic Entity Concept suggests that companies associated with each other through the
virtue of common control operate as a single economic unit and therefore the consolidated financial
statements of a group of companies should reflect the essence of such arrangement.

Consolidated financial statements of a group of companies must be prepared as if the entire group
constitutes a single entity in order to avoid the misrepresentation of the scale of group's activities.

It is therefore necessary to eliminate the effects of any inter-company transactions and balances
during the consolidation of group accounts such as the following:

 Inter-company sales and purchases

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 Inter-company payables and receivables

 Inter-company payments such as dividends, royalties & head office charges

Inter-company transactions must be eliminated as if the transactions had not occurred in the first
place. Examples of adjustments that may be required to eliminate the effects of inter-company
transactions include:

 Elimination of unrealized profit or loss on the sale of assets member companies of a group
 Elimination of excess or deficit depreciation expense in respect of a fixed asset purchased
from a member company at a price that was higher or lower than the net book value of the
asset in the books of the seller.

Money Measurement Concept in Accounting

Definition
Money Measurement Concept in accounting, also known as Measurability Concept, means that only
transactions and events that are capable of being measured in monetary terms are recognized in the
financial statements.

Explanation
All transactions and events recorded in the financial statements must be reduced to a unit of
monetary currency. Where it is not possible to assign a reliable monetary value to a transaction or
event, it shall not be recorded in the financial statements.

However, any material transactions and events that are not recorded for failing to meet the
measurability criteria might need be disclosed in the supplementary notes of financial statements to
assist the users in gaining a better understanding of the financial performance and position of the
entity.

Recognition Criteria
The recognition criteria defined by IASB and FASB require that the elements of financial statements
(i.e. assets, liabilities, income and expense) must only be recognized in the financial statements if its
cost or value can be measured with sufficient reliability. Therefore, an entity shall not recognize an
element of financial statement unless a reliable value can be assigned to it.

Examples of Application
 Skills and competence of employees cannot be attributed an objective monetary value and
should therefore not be recognized as assets in the balance sheet. However, those transactions
related to employees that can be measured reliably such as salaries expense and pension
obligations are recognized in the financial statements.
 Where it is not possible to measure reliably the amount of settlement of a legal claim against
the company, no liability is recognized in the financial statements. Instead, the nature and
circumstances surrounding the lawsuit are disclosed in the supplementary notes to the
financial statements if considered material.
 IAS 38 Intangible Assets -require that internally generated goodwill shall not be recognized
as an asset in the balance sheet. This is due to the difficulty in identifying and measuring the
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cost of internally generated goodwill as distinct from the cost of running the day to day
operations of the business.

However, IFRS 3 Business Combinations permit purchased goodwill to be recognized as an

asset in the financial statements since the cost of purchased goodwill is usually determinable
objectively as the amount of consideration paid in excess of the value of other identifiable
assets of the acquired business.

Matching Principle & Concept

Matching Principle requires that expenses incurred by an organization must be charged to the
income statement in the accounting period in which the revenue, to which those expenses relate, is
earned.

Examples of the use of matching principle in IFRS and GAAP include the following:

 Deferred Taxation
IAS 12 Income Taxes and FAS 109 Accounting for Income Taxes require the accounting for
taxable and deductible temporary differences arising in the calculation of income tax in a
manner that results in the matching of tax expense with the accounting profit earned during a
period.
 Cost of Goods Sold
The cost incurred in the manufacture or procurement of inventory is charged to the income
statement of the accounting period in which the inventory is sold. Therefore, any inventory
remaining unsold at the end of an accounting period is excluded from the computation of cost
of goods sold.
 Government Grants
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires
the recognition of grants as income over the accounting periods in which the related costs
(that were intended to be compensated by the grant) are incurred by the entity.

Matching Vs Accruals Vs Cash Basis

In the accounting community, the expressions 'matching principle' and 'accruals basis of accounting'
are often used interchangeably. Accruals basis of accounting requires recognition of income and
expenses in the accounting periods to which they relate rather than on cash basis. Accruals basis of
accounting is therefore similar to the matching principle in that both tend to dissolve the use of cash
basis of accounting.

However, the matching principle is a further refinement of the accruals concept. For example,
accruals basis of accounting requires the recognition of the estimated tax expense in the current
accounting period even though the actual settlement of the provision may occur in the subsequent
period. However, matching principle would also necessitate the recognition of deferred tax in the
accounting periods in which the temporary differences arise so as to 'match' the accounting profits
with the tax charge recognized in the accounting period to the extent of the temporary differences

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Timeliness of Accounting Information

Timeliness principle in accounting refers to the need for accounting information to be presented to
the users in time to fulfill their decision making needs.

Timeliness of accounting information is highly desirable since information that is presented timely is
generally more relevant to users while conversely, delay in provision of information tends to render
it less relevant to the decision making needs of the users. Timeliness principle is therefore closely
related to the relevance principle.

Timeliness is important to protect the users of accounting information from basing their decisions on
outdated information. Imagine the problem that could arise if a company was to issue its financial
statements to the public after 12 months of the accounting period. The users of the financial
statements, such as potential investors, would probably find it hard to assess whether the present
financial circumstances of the company have changed drastically from those reflected in the
financial statements.

Examples

Users of accounting information must be provided financial statements on a timely basis to ensure
that their financial decisions are based on up to date information. This can be achieved by reporting
the financial performance of companies with sufficient regularity (e.g. quarterly, half yearly or
annual) depending on the size and complexity of the business operations. Unreasonable delay in
reporting accounting information to users must also be avoided.

In several jurisdictions, regulatory authorities (e.g. stock exchange commission) tend to impose
restrictions on the maximum number of days that companies may take to issue financial statements
to the public.

Timeliness of accounting information is also emphasized in IAS 10 Events After the Reporting
Period which requires entities to report all significant post balance sheet events that occur up to the
date when the financial statements are authorized for issue. This ensures that users are made aware
of any material transactions and events that occur after the reporting period when the financial
statements are being issued rather than having to wait for the next set of financial statements for
such information.

Timeliness Vs Reliability - A Conflict

Whereas timely presentation of accounting information is highly desirable, it may conflict with the
objective to present reliable information. This is because producing reliable and accurate
information may take more time but the delay in provision of accounting information may make it
less relevant to users. Therefore, it is necessary that an appropriate balance is achieved between the
timeliness and reliability of accounting information.

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Substance Over Legal Form

Substance over form is an accounting concept which means that the economic substance of
transactions and events must be recorded in the financial statements rather than just their legal form
in order to present a true and fair view of the affairs of the entity.

Substance over form concept entails the use of judgment on the part of the preparers of the financial
statements in order for them to derive the business sense from the transactions and events and to
present them in a manner that best reflects their true essence. Whereas legal aspects of transactions
and events are of great importance, they may have to be disregarded at times in order to provide
more useful and relevant information to the users of financial statements.

Example:

There is widespread use of substance over form concept in accounting. Following are examples of
the application of the concept in the International Financial Reporting Standards (IFRS).

 IAS 17 Leases requires the preparers of financial statements to consider the substance of lease
arrangements when determining the type of lease for accounting purposes.
For example, an asset may be leased to a lessee without the transfer of legal title at the end of
the lease term. Such a lease may, in substance, be considered as a finance lease if for instance
the lease term is substantially for entire useful life of the asset or the lease agreement entitles
the lessee to purchase the asset at the end of the lease term at a very nominal price and it is
very likely that such option will be exercised by the lessee in the given circumstances.
 IAS 18 Revenue requires accountants to consider the economic substance of the sale
agreements while determining whether a sale has occurred or not.
For example, an entity may agree to sell inventory to someone and buy back the same
inventory after a specified time at an inflated price that is planned to compensate the seller for
the time value of money. On paper, the sale and buy back may be deemed as two different
transactions which should be dealt with as such for accounting purposes i.e. recording the sale
and (subsequently) purchase. However, the economic reality of the transactions is that no sale
has in fact occurred. The sale and buy back, when considered in the context of both
transactions, is actually a financing arrangement in which the seller has obtained a loan which
is to be repaid with interest (via inflated price). Inventory acts as the security for the loan
which will be returned to the 'seller' upon repayment. So instead of recognizing sale, the
entity should recognize a liability for loan obtained which shall be reversed when the loan is
repaid. The excess of loan received and the amount that is to be paid (i.e. inflated price) is
recognized as finance cost in the income statement.

Importance

The principle of Substance over legal form is central to the faithful representation and reliability of
information contained in the financial statements. By placing the responsibility on the preparers of
the financial statements to actively consider the economic reality of transactions and events to be
reflected in the financial statements, it will be more difficult for the preparers to justify the
accounting of transactions in a manner that does fairly reflect the substance of the situation.
However, the principle of substance over form has so far not been recognized by IASB or FASB as a

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distinct principle in their respective frameworks due to the difficulty of defining it separately from
other accounting principles particularly reliability and faithful representation.

Comparability/Consistency

Financial statements of one accounting period must be comparable to another in order for the users
to derive meaningful conclusions about the trends in an entity's financial performance and position
over time. Comparability of financial statements over different accounting periods can be ensured by
the application of similar accountancy policies over a period of time.

A change in the accounting policies of an entity may be required in order to improve the reliability
and relevance of financial statements. A change in the accounting policy may also be imposed by
changes in accountancy standards. In these circumstances, the nature and circumstances leading to
the change must be disclosed in the financial statements.

Financial statements of one entity must also be consistent with other entities within the same line of
business. This should aid users in analyzing the performance and position of one company relative
to the industry standards. It is therefore necessary for entities to adopt accounting policies that best
reflect the existing industry practice.

Example:

If a company that retails leather jackets valued its inventory on the basis of FIFO method in the past,
it must continue to do so in the future to preserve consistency in the reported inventory balance. A
switch from FIFO to LIFO basis of inventory valuation may cause a shift in the value of inventory
between the accounting periods largely due to seasonal fluctuations in price

Comparability/Consistency

Financial statements of one accounting period must be comparable to another in order for the users
to derive meaningful conclusions about the trends in an entity's financial performance and position
over time. Comparability of financial statements over different accounting periods can be ensured by
the application of similar accountancy policies over a period of time.

A change in the accounting policies of an entity may be required in order to improve the reliability
and relevance of financial statements. A change in the accounting policy may also be imposed by
changes in accountancy standards. In these circumstances, the nature and circumstances leading to
the change must be disclosed in the financial statements.

Financial statements of one entity must also be consistent with other entities within the same line of
business. This should aid users in analyzing the performance and position of one company relative
to the industry standards. It is therefore necessary for entities to adopt accounting policies that best
reflect the existing industry practice.

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Example:

If a company that retails leather jackets valued its inventory on the basis of FIFO method in the past,
it must continue to do so in the future to preserve consistency in the reported inventory balance. A
switch from FIFO to LIFO basis of inventory valuation may cause a shift in the value of inventory
between the accounting periods largely due to seasonal fluctuations in price

Understandability

Transactions and events must be accounted for and presented in the financial statements in a manner
that is easily understandable by a user who possesses a reasonable level of knowledge of the
business, economic activities and accounting in general provided that such a user is willing to study
the information with reasonable diligence.

Understandability of the information contained in financial statements is essential for its relevance to
the users. If the accounting treatments involved and the associated disclosures and presentational
aspects are too complex for a user to understand despite having adequate knowledge of the entity
and accountancy in general, then this would undermine the reliability of the whole financial
statements because users will be forced to base their economic decisions on undependable
information.

Materiality
Information is material if its omission or misstatement could influence the economic decisions of
users taken on the basis of the financial statements (IASB Framework).

Materiality therefore relates to the significance of transactions, balances and errors contained in the
financial statements. Materiality defines the threshold or cutoff point after which financial
information becomes relevant to the decision making needs of the users. Information contained in
the financial statements must therefore be complete in all material respects in order for them to
present a true and fair view of the affairs of the entity.

Materiality is relative to the size and particular circumstances of individual companies.

Example - Size

A default by a customer who owes only $1000 to a company having net assets of worth $10 million
is immaterial to the financial statements of the company.

However, if the amount of default was, say, $2 million, the information would have been material to
the financial statements omission of which could cause users to make incorrect business decisions.

Example - Nature

If a company is planning to curtail its operations in a geographic segment which has traditionally
been a major source of revenue for the company in the past, then this information should be

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disclosed in the financial statements as it is by its nature material to understanding the entity's scope
of operations in the future.

Materiality is also linked closely to other accounting concepts and principles:

 Relevance: Material information influences the economic decisions of the users and is
therefore relevant to their needs.
 Reliability: Omission or mistatement of an important piece of information impairs users'
ability to make correct decisions taken on the basis of financial statements thereby affecting
the reliability of information.
 Completeness: Information contained in the financial statements must be complete in all
material respects in order to present a true and fair view of the affairs of the company.

What is a Going Concern?

Going concern is one the fundamental assumptions in accounting on the basis of which financial
statements are prepared. Financial statements are prepared assuming that a business entity will
continue to operate in the foreseeable future without the need or intention on the part of management
to liquidate the entity or to significantly curtail its operational activities. Therefore, it is assumed that
the entity will realize its assets and settle its obligations in the normal course of the business.

It is the responsibility of the management of a company to determine whether the going concern
assumption is appropriate in the preparation of financial statements. If the going concern assumption
is considered by the management to be invalid, the financial statements of the entity would need to
be prepared on break up basis. This means that assets will be recognized at amount which is
expected to be realized from its sale (net of selling costs) rather than from its continuing use in the
ordinary course of the business. Assets are valued for their individual worth rather than their value
as a combined unit. Liabilities shall be recognized at amounts that are likely to be settled.

What are possible indications of going concern problems?

 Deteriorating liquidity position of a company not backed by sufficient financing

arrangements.
 High financial risk arising from increased gearing level rendering the company vulnerable to
delays in payment of interest and loan principle.
 Significant trading losses being incurred for several years. Profitability of a company is
essential for its survival in the long term.
 Aggressive growth strategy not backed by sufficient finance which ultimately leads to over
trading.
 Increasing level of short term borrowing and overdraft not supported by increase in business.
 Inability of the company to maintain liquidity ratios as defined in the loan covenants.
 Serious litigations faced by a company which does not have the financial strength to pay the
possible settlement.
 Inability of a company to develop a new range of commercially successful products.
Innovation is often said to be the key to the long-term stability of any company.
 Bankruptcy of a major customer of the company.

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Accruals Concept

Financial statements are prepared under the Accruals Concept of accounting which requires that
income and expense must be recognized in the accounting periods to which they relate rather than on
cash basis. An exception to this general rule is the cash flow statement whose main purpose is to
present the cash flow effects of transaction during an accounting period.

Under Accruals basis of accounting, income must be recorded in the accounting period in which it is
earned. Therefore, accrued income must be recognized in the accounting period in which it arises
rather than in the subsequent period in which it will be received. Conversely, prepaid income must
be not be shown as income in the accounting period in which it is received but instead it must be
presented as such in the subsequent accounting periods in which the services or obligations in
respect of the prepaid income have been performed.

Expenses, on the other hand, must be recorded in the accounting period in which they are incurred.
Therefore, accrued expense must be recognized in the accounting period in which it occurs rather
than in the following period in which it will be paid. Conversely, prepaid expense must be not be
shown as expense in the accounting period in which it is paid but instead it must be presented as
such in the subsequent accounting periods in which the services in respect of the prepaid expense
have been performed.

Accruals basis of accounting ensures that expenses are "matched" with the revenue earned in an
accounting period. Accruals concept is therefore very similar to the matching principle.

Business Entity Concept

Financial accounting is based on the premise that the transactions and balances of a business entity
are to be accounted for separately from its owners. The business entity is therefore considered to be
distinct from its owners for the purpose of accounting.

Therefore, any personal expenses incurred by owners of a business will not appear in the income
statement of the entity. Similarly, if any personal expenses of owners are paid out of assets of the
entity, it would be considered to be drawings for the purpose of accounting much in the same way as
cash drawings.

The business entity concept also explains why owners' equity appears on the liability side of a
balance sheet (i.e. credit side). Share capital contributed by a sole trader to his business, for instance,
represents a form of liability (known as equity) of the 'business' that is owed to its owner which is
why it is presented on the credit side of the balance sheet.

Realization Concept (Revenue Recognition Principle)

In accounting, also known as revenue recognition principle, refers to the application of accruals
concept towards the recognition of revenue (income). Under this principle, revenue is recognized by
the seller when it is earned irrespective of whether cash from the transaction has been received or
not.

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In case of sale of goods, revenue must be recognized when the seller transfers the risks and rewards
associated with the ownership of the goods to the buyer. This is generally deemed to occur when the
goods are actually transferred to the buyer. Where goods are sold on credit terms, revenue is
recognized along with a corresponding receivable which is subsequently settled upon the receipt of
the due amount from the customer.

In case of the rendering of services, revenue is recognized on the basis of stage of completion of the
services specified in the contract. Any receipts from the customer in excess or short of the revenue
recognized in accordance with the stage of completion are accounted for as prepaid income or
accrued income as appropriate.

Example
Motors PLC is a car dealer. It receives orders from customers in advance against 20% down
payment. Motors PLC delivers the cars to the respective customers within 30 days upon which it
receives the remaining 80% of the list price.

In accordance with the revenue realization principle, Motors PLC must not recognize any revenue
until the cars are delivered to the respective customers as that is the point when the risks and rewards
incidental to the ownership of the cars are transferred to the buyers.

Importance

Application of the realization principle ensures that the reported performance of an entity, as
evidenced from the income statement, reflects the true extent of revenue earned during a period
rather than the cash inflows generated during a period which can otherwise be gauged from the cash
flow statement. Recognition of revenue on cash basis may not present a consistent basis for
evaluating the performance of a company over several accounting periods due to the potential
volatility in cash flows

Dual Aspect Concept | Duality Principle in Accounting

Dual Aspect Concept, also known as Duality Principle, is a fundamental convention of accounting
that necessitates the recognition of all aspects of an accounting transaction. Dual aspect concept is
the underlying basis for double entry accounting system.

Explanation

In a single entry system, only one aspect of a transaction is recognized. For instance, if a sale is
made to a customer, only sales revenue will be recorded. However, the other side of the transaction
relating to the receipt of cash or the grant of credit to the customer is not recognized.

Single entry accounting system has been superseded by double entry accounting. You may still find
limited use of single entry accounting system by individuals and small organizations that keep an
informal record of receipts and payments.

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Double entry accounting system is based on the duality principle and was devised to account for all
aspects of a transaction. Under the system, aspects of transactions are classified under two main
types:

1. Debit
2. Credit

Debit is the portion of transaction that accounts for the increase in assets and expenses, and the
decrease in liabilities, equity and income.

Credit is the portion of transaction that accounts for the increase in income, liabilities and equity,
and the decrease in assets and expenses.

The classification of debit and credit effects is structured in such a way that for each debit there is a
corresponding credit and vice versa. Hence, every transaction will have 'dual' effects (i.e. debit
effects and credit effects).

The application of duality principle therefore ensures that all aspects of a transaction are accounted
for in the financial statements.

Example

Mr. A, who owns and operates a bookstore, has identified the following transactions for the month
of January that need to be accounted for in the monthly financial statements:

$
1. Payment of salary to staff 2,000
2. Sale of books for cash 5,000
3. Sales of books on credit 15,000
4. Receipts from credit customers 10,000
5. Purchase of books for cash 20,000
6. Utility expenses - unpaid 3,000

Under double entry system, the above transactions will be accounted for as follows:

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Account Title Effect Debit Credit

$ $
1. Salary Expense Increase in expense 2,000
Cash at bank Decrease in assets 2,000
2. Cash in hand Increase in assets 5,000
Sales revenue Increase in income 5,000
3. Receivables Increase in assets 15,000
Sales revenue Decrease in income 15,000
4. Cash at bank Increase in asset 10,000
Receivables Decrease in asset 10,000
5. Purchases Increase in expense 20,000
Cash at bank Decrease in asset 20,000
6. Utility Expense Increase in expense 3,000
Accrued expenses Decrease in asset 3,000

QUALITIES OF USEFUL ACCOUNTING INFORMATION

In order for accounting information to be useful, it must contain certain qualities and meet certain
standards. These qualities include:

1. Relevance

Relevance in accounting information is necessary for predictive and feedback value. If investors
cannot review accounting information for a company and assess its financial worthiness, then the
information is not relevant and fails the relevance test. If management cannot review accounting
information and use it to make decisions concerning business operations, then the information fails
the feedback test.

2. Timeliness

Timeliness is a quality subset of relevance. If you do not present accounting information in a timely
manner, its usefulness to investors and managers is diminished or completely eliminated. The
quality of timeliness requires both recording the financial transaction in the appropriate accounting
period and generating accounting reports as soon as all data are posted so that issues with business
operations are discovered before the problem grows.

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3. Reliability

If accounting information is not reliable, it cannot be used to make quality business decisions. In
order to meet GAAP standards for reliability, accounting information must be verifiable, meaning
you should be able to prove the authenticity and show a paper trail for every income and expense
entry recorded to the accounting general ledger. In order for accounting information to be reliable, it
must also be neutral, meaning only GAAP standards were used when the accounting information
was recorded; that is, the information was not recorded to reflect better on the company’s financial
performance.

4. Consistency

In order for accounting information to be useful in decision making, it must be recorded

consistently, meaning the same accounting treatment must be applied at all times to a given type of
accounting data. Recording the same monthly expense in different expense accounts skews the
expense categories and makes it harder to determine the actual expense in any one category. Large-
scale accounting changes, such as changing inventory method, also affect consistency in accounting
data. You should make every attempt to limit large-scale changes altogether, and if they are
necessary, implement them at the beginning of a new accounting year.

5. Comparability

Comparability is a subset of consistency. If you cannot compare accounting information for one
period of time to another, then you cannot derive useful information in order to make operational
decisions. Without consistency, any comparison of accounting data is useless, as the data compared
will not have been created using the same methods or standards.

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TOPIC 2

RECORDING TRANSACTIONS

SOURCE DOCUMENTS

The details of financial transactions are usually described on various documents received by or
produced within an accounting system. These documents provide input into the system. The
purchase of supplies or materials will produce a purchase order (if used), an invoice and/or statement
and a voucher. Each of these documents provides input into various stages of the system either as a
control device or authorization of the transaction.

Some of source documents include;

1. Quotations
2. Purchase orders
3. Statement of account
4. Remittance advice
5. Receipts
6. Petty cash vouchers
7. Sales invoice
8. Purchase invoice
9. Credit notes
10. Debit notes
11. Bank statements

1. QUOTATIONS

A quotation is used to let a potential customer know the cost of goods or services before they decide
to purchase them. When a 'seller sends a quotation, it commits them to a certain price. This is why
quotations are mostly used when costs are relatively stable and the services/goods to be provided can
be accurately estimated (labor, cost of raw materials, etc.).

What to include in a quotation

There are a number of items that should be included and considered when preparing a quotation for
a customer.

First of all .a quotation should. include the price that you have decided to charge for the service or
goods you Will provide, In a quotation; you can include a breakdown of the components leading to
the settled price (such as labor costs, raw material costs, VAT etc.) You may also want to specify a
time schedule: i.e. how long the project will take you or how long it will _be until goods are

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delivered, A quotation may also indicate a specific time period for which it is valid, e.g. 30 days.
Also, a project or service quotation may include an explanation of how any requests for
modifications or changes will affect the price once the project is-underway

2. PURCHASE ORDERS

A purchase order (PO) is a commercial document issued by a buyer to .a seller, indicating types,
quantities and agreed prices for products or services the seller will provide to the buyer. Sending a
Purchase order to a supplier constitutes a legal offer to buy products or services. Acceptance of a
purchase order by a seller usually forms a contract between the buyer and seller, so no contract
exists until the purchase order is accepted.-It is used to control the purchasing of products and
services from external suppliers.

Companies use purchase orders for several reasons:

 Purchase orders allow-buyers to clearly and explicitly communicate their intentions to

sellers
 Sellers are protected in case of a buyer's refusal to pay for goods or services
 Purchase orders help a purchasing, agent to manage incoming orders and pending orders
 Purchase orders provide economies in that they streamline the purchasing process to a
standard procedure
 Commercial lenders or financial institutions may provide financial assistance on the basis
of purchase orders.

Electronic Purchase Orders

Many purchase orders are no longer paper-based, but rather transmitted electronically over the
Internet. It is common for electronic purchase orders to be used to buy goods or services online for
services or physical goods of any type.

3. STATEMENT OF ACCOUNT

Also known as an account-statement, a statement of account is a record of the transactions that have
occurred on a customer's account during a specified period of time. The line items on the account
will record information about purchases made by the customer, -any payments rendered by the
customer, and any other miscellaneous adjustments that have been made to the current balance due
on the account. Statements of this type are normally issued for each billing period specified in the
contract that established the customer account, and note balances on account at the beginning and
ending dates of the period. Customers can also sometimes request account statements that cover a
longer period of time than just the most current billing period.

The statement of account is associated with many different types of accounts. A statement for a
checking account at a bank is normally issued on a monthly basis, allowing the bank customer to see
which deposits have been posted to the account, as well as which cheques have cleared during the
period under consideration. The bank account statement will also include details about any other
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types of debits or credits that have had an impact on the account balance during the month, such as
purchases made using a debit card, funds transferred into the checking account from a savings
account, or even accrual of any interest, if the checking account carries that particular feature.

Most vendors will also issue a statement of account to each customer on a regular basis, usually
monthly. Like the checking account, vendor statements will show the balance owed at the beginning
of the statement period, any transactions that took place during the period, and the total balance on
the account as of the closing date of the statement. If the vendor has provided the customer with a
line of credit, the statement will also show the minimum payment due along with the total balance
on account.

In all its forms, a statement of account helps the account holder to manage the account more
efficiently. Various statements are also important when it comes to managing all financial resources
under the control of the account holder, since they provide important documentation of all types of
financial transactions associated with the account in question, In general, consumers are encouraged
to read the detail on each statement carefully, to make sure all line items on the document arc
accurate, and that the balance owed does match with the client's other financial records.

4. REMITTANCE ADVICE

A remittance advice is a letter sent by a customer to a supplier, to inform the supplier that their
invoice has been paid. If the customer is paying by cheque, the remittance advice often accompanies
the cheque.

Remittance advices are not mandatory; however they are seen as a courtesy because they help the
accounts-receivable department-16 match invoices with payments. The remittance advice should
therefore specify the invoice number(s) for which payment is tendered.

In countries where cheques are still used, most companies' invoices are designed so that customers
return a portion of the invoice, called a remittance advice, with their payment. In countries where
wire transfer is the predominant payment method, invoices are commonly accompanied by
standardized bank transfer order forms which include a field into which the invoice or client number
can be encoded, usually in a computer-readable way. The payer fills in his account details and hands
the form to a clerk at, or mails it to, his bank, which will then transfer the money.

The employee who opens the incoming mail should initially compare the amount of cash received
with the amount shown on the remittance advice. If the customer does not return a remittance
advice, an employee prepares one. Like the cash register tape, the remittance advice serves as a
record of cash initially received.

Modern systems will often scan a paper remittance advice into a computer system where data entry
will be performed. Modern remittance advices can include dozens, or hundreds of invoice numbers,
and other information. .

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5. RECEIPTS

A receipt is raised by the firm and-issued to customers or debtors when they make payments in the
form of cash or cheques.

It shows:

The name and address of the firm

i. The date of the receipt

ii. Amount received (cash or cheque or other means of payment)
iii. Receipt number.

6. PETTY CASH VOUCHERS

Petty cash is a small amount of discretionary funds in the form of cash used for expenditures where
it is riot sensible to make any disbursement by cheque, because of the inconvenience and costs of
writing, signing and then cashing the cheque.

A petty cash voucher is usually a small form that is used to document a disbursement (payment)
from a petty cash fund. Petty cash vouchers are also referred to as petty cash receipts and can be
purchased from office supply stores.

The petty cash voucher should provide space for the date, amount disbursed, naive of person
receiving the money, reason for the disbursement, general ledger account to be charged, and the
initials of the person disbursing the money from the petty cash fund. Sonic Petty cash vouchers are
pre-numbered and sometimes a number is assigned for reference and control. Receipts or other
documentation justifying the disbursement should be attached to the petty cash voucher.

When the petty cash fund is replenished, the completed petty cash vouchers provide the
documentation for the replenishment check.

7. SALES INVOICE

A sales invoice in financial accounting is a tool that a company uses to communicate to clients about
the sums that are due in exchange for goods that have been sold, A sales invoice should include
information about which items the customer has purchased, the quantities he has bought, discounts
he has received, and the total amount he owes. In addition, a sales invoice should contain a brief
summary of the terms of the transaction, such as the acceptable lag time between the sale and the
payment.

The sales invoice contains the following:

i) Name and address of the firm

ii) Name and address of the buying firm
iii) Date of making the sale — invoice date.
iv) Invoice number
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v) Amount due (net of trade discount)

vi) Description of goods sold
vii) Terms of' sale

8. PURCHASES INVOICE

A purchase invoice is raised by the creditor and sent to the firm when the firm makes a credit
purchase. It shows the following:

i. Name and the address of the creditor/seller

ii. Name and address of the firm
iii. Date of the purchase (invoice date)
iv. Invoice number
v. Amount due
vi. Description of goods sold
vii. Terms sale

9. CREDIT NOTES

A credit note is raised by the firm and issued to the debtor when the debtor returns some goods back
to the firm. Its contents include:

i. Name and address of the firm

ii. Name and address of the debtor
iii. Amount of credit
iv. Credit note number
v. Reason for credit e.g. if the goods sent but of the wrong type

The purpose of the credit note is to inform the debtor or customer that the debtor’s account with the
firm has been credited i.e. the amount due to the firm has been reduced or cancelled.

The credit note may also be issued when the firm gives an allowance of the amount due from the
debtors. From the context we can assume that all credit notes are issued when goods are returned

10. DEBTORS NOTE

This is raised by the creditor and issued to the firm when the firm returns some goods to the creditor.
It includes the following items:

i) Name and address of the firm

ii) Name and address of the creditor
iii) Amount of debit
iv) Debit Note number
v) Reason for the debit

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The purpose of the debit note is to inform the firm that the amount due to the creditor has been
reduced or cancelled.

11. BANK STATEMENT

A bank statement or account statement is a summary of financial transactions which have

occurred over a given period on a bank account held by a person or business with a financial
institution.

Bank statements have historically been and continue to be typically printed on one or several pieces
of paper and either mailed directly to the account holder, or kept at the financial institution's local
branch for pick-up. In recent years there has been a shift towards paperless, electronic statements,
and some financial institutions offer direct download into account holders accounting software.

Some ATMs offer the possibility to print, at any time, a condensed version of a bank statement,
commonly called a transaction history, or a transaction history may be viewed on the financial
institution's website or available via telephone banking.

Paper statements

Historically, bank statements were paper statements produced monthly, quarterly or even annually.
Since the introduction of computers in banks in the 1960s, bank statements have generally been
produced monthly. Bank statements for accounts with small transaction volumes, such as
investments or savings accounts, are usually produced less frequently. Depending on the financial
institution, bank statements may also include certain features such as the cancelled cheques (or their
images) that cleared through the account during the statement period.

Some financial institutions use the occasion of posting bank statements to include notices such as
changes in fees or interest rates or to include promotional material.

Today, the monthly mailing of bank statements is the norm in many countries. It is not customary in
some countries, such as Japan, where individual account holders are expected to keep track of
deposits, withdrawals, and balances using their own passbooks at ATMs.

Electronic statements

With the wider access to the Internet and online banking, bank statements (also known as electronic
statements or e-statements) can be viewed online, and downloaded or printed by the customer. To
reduce the cost of postage and the generation of paper bank statements, some financial institutions
encourage their customers to receive bank statements electronically, for example by charging a fee
for paper statements. This may be as attachments to emails or, as a security measure, as a reminder
that a new statement is available on the financial institution's website. Whether such statements are
transmitted as attachments or from the website, they are commonly generated in PDF format, to
reduce the ability of the recipient to electronically alter the statement.

Due to identity theft concerns, an electronic statement may not be seen as a dangerous alternative
against physical theft as it does not contain tangible personal information, and does not require extra

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safety measures of disposal such as shredding. However, an electronic statement can be easier to
obtain than a physical one through computer fraud, data interception and/or theft of storage media.

BOOKS OF ORIGINAL ENTRY

A Books of original entry (also referred to as Journal) is an accounting record that is used to record
the different types of transactions in chronological order or date order. The reason for being called
books of original entry is that this is the first place that business transactions are formally
recorded. You can think of a Journal as a Financial Diary.

Specialized Journals are journals used to initially record special types of transactions such as sales
and purchases. All these journals are designed to record special types of business transactions and
post the totals accumulated in these journals to the General Ledger periodically (usually once a
month).

Sales Journal
The Sales Journal is a special journal where Credit sales to customers are recorded. Another name
for this journal is the Sales Book or Sales Day Book.

Purchases Journal
The Purchases Journal is a special journal where Credit purchases from customers are recorded.
Another name for this journal is the Purchases Book or Purchases Day Book.

Returns Inwards Journal

The Returns Inwards Journal is a special journal that is used to record the returns from debtors and
allowances of goods sold on credit. Another name for this journal is the Sales Returns Book.

Returns Outwards Journal

The Returns Outwards Journal is a special journal that is used to record the returns to creditors and
allowances of goods purchased on credit. Another names for this journal is the Purchases Returns
Book.

The Cash Book

The Cash Book is used to record the receipt and payment of money by the business in the form of
cash, or through the business bank account. It contains the cash and bank accounts.

The Petty Cash Book

This is just a fancy name that describes a special fund that is set up and used for minor and
unanticipated cash expenses where a cheque can’t be written or the amount is so small that you don’t
want to write a cheque. The petty cash account is based on the Imprest System which is a system of
cash disbursement, cash expenditure and reimbursement of that expenditure.

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The General Journal

The Journal is a textual record of events (Debit and Credit) that is characterized by the fact that all
the records it contains are in a sequential chronological order. The General Journal is used to record
unusual or infrequent types of transactions. Type of entries normally made in the general journal
include depreciation entries, correcting entries, and adjusting and closing entries.

Recording Transactions from Source Documents

Journals use the information from the source documents to create a chronological listing of all
business transactions and detailed information about each transaction.

Journals are preliminary records where business transactions are first entered into the accounting
system. The journal is commonly referred to as the book of original entry. Specialized Journals-are
journals used to initially record special types of transactions such as sales and purchases in their own
journal

Why Use Special Journals

 Groups and records transactions of a like nature. A familiar example is recording all cash
received by a business in one place.
 Saves time with summary and less frequent postings to the General Ledger.
 Allows a business to have different individuals responsible for different journals thereby
increasing internal controls and allocating the record keeping workload.

SALES JOUNAL (DAY BOOK)

The sales day book records details of all credit sales by the business. The details are obtained from
copy sales invoices.

It is also called a sales day book. It records all the sales invoices issued by the firm during a
particular financial period

The format is as follows (with simple records of invoice).

Sales journal
Date Detail Folio Amount sh

Total
Each entry shows the date of the sale, name of the customer, the invoice number and the amount of
the transaction entered in the money column of the book.

At the end of the period, the last column is totaled and an entry made in the ledger

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The individual entries in the sales journal are posted to the debit side of the debtor's accounts in the
sales ledger and the total is posted on the credit side of the sales account in the general ledger,

As follows:
Dr. Debtors account
Cr, Sales account

Illustration
You are to enter up the sales journal from the following details.

2010
March I Credit sales to J. Omondi Sh.1,870
March 3 Credit sales to G. Achieng Sh. 1,660
March 6 Credit sales to V. Charles Sh 120
March 10 Credit sales to J. Njoroge Sh.550
March 17 Credit sales to F. Mwangi Sh. 2,890
March 19 Credit sales to U. Aketch Sh. 660
March 27 Credit sales to V, Sarah Sh. 280
March 31 Credit sales to L. Cate Sh. 780

Solution
Sales journal
Date 2010 Detail Folio Amount (sh)
1/3 1, Omondi 1,870.00
3/3 G. Achieng
6/3 V. Charles
10/3 J. Njoroge 550.00
17/3 F. Mwangi 2,890.00
19/3 U. Aketch
27/3 V. Sarah
31/3 L. Cate 780.00
Total 8,810.00

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PURCHASES JOURNAL

Purchases journal is also called a purchases day-book. It records all the purchase invokes received
by the firm during a particular financial period, it has the following format (including records of
voices)it is used to record credit purchases

Purchases journal
Date Detail Folio Amount sh

Total

The individual entries in the purchases journal are posted to the credit side of the creditor's accounts
in the purchases ledger and the total is posted to the debit side of purchases account of the general
ledger.

Dr. Creditors account

Cr. Purchases account

Illustration
You are to enter up the purchases journal from the following details;-

2010
March 1 Credit Purchases from J. James Sh.1,880
March 3 Credit Purchases from G. Njoroge Sh. 670
March 6 Credit Purchases from V. Viginia Sh. 200
March I0 Credit Purchases from J. James Sh.-350
March 7 Credit Purchases from F. Oluoch Sh. 3,890
March 19 Credit Purchases from U. Ouma Sh. 750
March 27 Credit Purchases from V. Agnes M Sh.390
March 31 Credit Purchases from L. Ken Sh. 980

Purchases journal
Date 2010 Detail Folio Amount (sh)
1/3 J. James 1,880
3/3 G. Njoroge 670
6/3 V. Viginia 200
10/3 J. James 350
17/3 F. Oluoch 3,890
19/3 U. Ourna 750
27/3 V. AgnesM 390
31/3 L. Ken 980
Total 9,110
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SALES RETURNS/RETURNS INWARDS DAYBOOK

It is also called the returns inwards day-book. it records all the credit notes raised by the firm and
sent to customers during a particular financial period.

Where, for some reason, a person who has purchased goods wishes to return them, and the seller
agrees to take them back, he (the seller) enters the purchases of the goods returned in his sales
returns book ( sometimes called sales returns journal inwards book).
The sales returns account is used to record the value of goods returned to a business by its
customers. When goods are returned, the debtor's account is credited in order to decrease the asset
and the sales returns account is debited.

We record in the sales returns day book details of all credit notes which we have sent to our
customers for goods which they returned to us.
A format of a sales returns book is shown below:

Return inwards journal

Date Credit note Description/Detail Folio Amount sh
No.

Total

Individual entries in a return inwards journal are posted to the credit of the debtors accounts in the
sales ledger and the total is posted to the debit side of the return-inwards account of the general
ledger
At the end of the period, the book will be totalled and an entry made in the ledger as follows:
Dr. Sales Returns account
Cr. Debtors account

PURCHASES RETURNS/RETURNS OUTWARDS JOURNAL.

The purchases returns day book is sometimes referred to as the returns outward book, or purchases
returns journal.

A purchases returns account is used to ''record 'the value of goods returned by a business to its
suppliers.

When goods are returned, the creditor's account is debited in order to decrease the liability to him
and the purchases returns account is credited.

We record in the purchases returns day book details from credit notes given to us by suppliers in
respect of goods which we have returned to them.

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The details recorded will be similar to those in the purchases day book. An example of purchases
return book is shown below.

Return outwards journal

Date Debit note Description/Detail Folio Amount sh
No.

Total

At the end of the period the book will be totaled and an entry made in the ledger as follows:
Dr. Creditors account
Cr. Purchases returns account.

Illustration
You are to enter the following items in the books 2011

July 1 Credit purchases from: K. Amos Sh.380; M. Ochieng Sh.500; N. Oluoch Sh.106.
July 3 Credit sales to: E. Ken S11.510; E. Rose Sh.246; F. Ton Sh.356.
July 5 Credit purchases from: R. Kyule Sh.200; J. Wanja Sh.180; D. Mwangi Sh.410; C. Kange
Sh.66,
July 8 Credit sales to: A. Ben Sh.307; H. Kim Sh.250; J. Tony Sh.185.
July 12 Returns outwards to: M. Ocheing Sh.30; N. Oluoch Sh.16.
July 14 Returns inwards from: E. Rose Sh.18; F. Tom Sh.22,
July 20 Credit sales to: E. Rose Sh.188; F. Paul Sh.310; E. Dan Sh.420.
July 24 Credit purchases from: J.Tony Sh.550; K. Musiu Sh.900.
July 31 Returns inwards from: E. Rose Sh.27; E. Ken Sh-.30.
July 31 Returns outwards to: J. Wanja Sh.13; C. Kange Sh.11.

Solution
Sales journal
Date Detail Amount sh
3 July E. Ken 510
3 July E. Rose 246
3 July F. Tom 356
8 July A. Ben 307
8 July H. Kim 250
8 July J. Tony 185
20 July E. Rose 188
20 July F. Paul 310
20 July E. Dan 420
Total 2,772

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Purchases journal
Date Detail Amount sh
1 July K. Amos 380
1 July M. Ochieng 500
1 July N. Oluoch 106
5 July R. Kyule 200
5 July J. Wanja 180
5 July D. Mwangi 410
5 July C. Kange 66
24 July C.Tony 550
24 July K.Musiti 900
Total 3,292

Return inwards journal

Date Description/Detail Amount sh
14 July E. Rose 18
14 July F. Torn 22
31 July E. Rose 27
31 July E. Ken 30
Total 97

Return outwards journal

Date Description/Detail Amount sh
12 July M. Ochieng 30
12 July N. Oluoch 16
31 July J. Wanja 13
31 July C. Kange 11
Total 70

THE CASH BOOK

The cash book is meant to record all cash transactions — whatever is their nature. It is divided into
two sides — one, the left hand side, for receipts of cash: and the-other, the right hand side, for
payments. Since in a modern business, transactions with or through bank are even more numerous
than strictly cash transactions, each side has two columns.— one to record cash transactions and the
other to record bank transactions payments into the bank being entered on the left hand side and
payments out of bank being entered on the right hand side.

(The left hand side is known as the debit side and the right hand side is called the credit side.)
Sometimes, cash is deposited in bank and sometimes, cash is withdrawn from the bank for use in
office. In this case, entries both for receipt and payment will appear in the cash book itself in
appropriate columns.

Such transactions are known as ‘contra’ transactions.

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There are two types of cashbooks:

i. Two-column cashbook
ii. Three-column cashbook

Two-column cashbook

The cash at bank cashbook and cash in hand cashbook are combined together to get a two-column
cashbook. The format is as follows:

Date Details Cash Bank Date Details Cash Bank

Sh. Sh. Sh. Sh.

Illustration
Write up a two-column cashbook from the following details, and balance off as of the end of the
month:

2003
May 1 Started business with capital in cash Sh 1,000
May 2 Paid rent by cash Sh 100.
May 3 F. Atieno lent us Sh 5,000; paid by cheque.
May 4 We paid B Omolo by cheque Sh 650.
May 5 Cash sales Sh 980.
May 7 N Mwangi paid us by cheque Sh 620.
May 9 We paid B. Musau in cash Sh 220.
May 11 Cash sales paid direct into the bank Sh 530.
May 15 G, Mugaka paid us in cash Sh 650.
May 16 We took Sh 500 out of the cash till and paid it into the bank account.
May 19 We repaid F. Atieno Sh 1,000 by cheque.
May 22 Cash sales paid direct into the bank Sh 660.
May 26 Paid motor expenses by cheque Sh 120.
May 30 Withdrew Sh 1,000 cash from the bank for business use.
May 31 Paid wages in cash Sh 970.

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Cash Book
Date Details Cash Bank Date Details Cash Bank
May Sh Sh May Sh Sh
1 Capital 1,000 - Rent 100 -
3 F. Atieno -loan- - 5,000 B Omolo - 650
5 Sales 980 - B Musau 220 -
7 N. Mwangi - 620 Bank C 500 -
11 Sales - 530 F Atieno (Loan) - 1,000
15 G. Mugaka 650 - Motor Expenses - 120
16 Cash C - 500 Cash C 970 1,000
22 Sales - 660 Wages 1,840 -
30 Bank C 1,000 - Balances c/d 3,630 4,540
3,630 7,310 3,630 7,310

Three-column cashbook

Additional columns for discounts allowed and discounts received can be included with the cash at
bank columns to get a 3 - column cashbook. The format is as follows:

Cash book
Date Details Discount Cash Bank Details Discount Cash Bank
Allowed Sh. Sh. Date Received Sh. Sh.

Illustration
A three-column cashbook is to be written up from the following details, balanced off, and the
relevant discount accounts in the general ledger shown.

19x8
Mar 1 Balances brought forward: Cash Sh 230; Bank. Sh 4,756.
2 The following paid their accounts by cheque, in each case deducting 5 percent discounts: R.
Ken Sh 140; E. Mwaura Sh 220; R. 1-laffen Sh 300.
4 Paid rent by cheque Sh 120.
6 J. Aluoch lent us Sh 1,000 paying by cheque.
8 We paid the following accounts by cheque in each case deducting 2'17 per cent cash
discount: N. White Sh 60; P. Paul Sh 480; C. Moses Sh 800.
10 Paid motor expenses in cash Sh 44.
12 H. Moraa pays his account of Sh 77, by cheque Sh 74, deducting Sh 3 cash discount.
15 Paid wages in cash Sh 160.
18 The following paid theiriaccounts by cheque, in each case deducting 5 per cent cash
discount: C. Mwangi Sh 260; R Wilson & Son Sh 340; H. Njoroge Sh 460.
21 Cash withdrawn from the bank Sh 350 fOr business use
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24 Cash Drawings Sh 120.

25 Paid T. Koech his account of Sh 140, by cash Sh 133, having deducted Sh 7 cash discount.
29 Bought fixtures paying by cheque Sh 650.
31 Received commission by cheque Sh 88.

Cash book
Date Details Disc Cash Bank Details Disc Cash Bank
All Sh. Sh. Date Rec Sh. Sh.
Mar Bal b/d 230 4756 4 Rent 120
2 R. Ken 7 133 8 N White 9 351
2 E. Mwaura 11 209 8 P Paul 12 468
2 R. Hatton J. 15 285 8 C Moses 20 780
6 Aluoch Loan 1000 l0 Motor exp. 44
12 H. Moraa C. 3 74 15 Wages 160
18 Mwangi R. 13 247 21 Cash 350
18 Wilson & Son 17 323 24 Drawings 120
18 H. Njoroge 23 437 25 T Koech 7 133 140
21 Bank 350 29 Fixtures 650
31 Commission __ ___ 88 31 Bal c/d __ 123 4,893
89 580 7552 48 580 7,552

Discount received
Sh. Sh.
Creditors 48

Discount Allowed
Sh. Sh.
Debtors 89

DISCOUNTS

Accounting for drawings, discounts allowed and discounts received

Drawings
The owner makes drawings from the firm in various ways:

i) Cash or bank withdrawals

When the owner withdraws money from the business we debit drawings and credit cashbook
'(cash in hand or cash at bank).

ii) Taking goods for own use and

When the owner takes out some of the goods for his own use, we debit drawings and credit
purchases.

iii) Personal expenses, paid by the business

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Here we debit the drawings and credit expense account

Taking some of the other assets from the business e.g. motor vehicles or using-part of the
premises.

Sometimes the owner may take over some of the assets of the business e.g. vehicle or, converting
business premises into living quarters or not paying into the business cash collected personally
from the customers. When this happens we debit drawings and credit the relevant asset e.g. motor
vehicles, premises or some building or even debtors.

Discounts Received

A discount received is an allowance by the creditors to the firm to encourage the firm to pay the
amount dues within the agreed time. It is an amount deducted from the invoice price.

When a discount is given by the supplier then we debit creditor’s account and credit discounts
received e.g. A. Ltd sells some goods on credit to B Ltd. Sh.1,000,000 under the terms of sale, B
Ltd, will receive s discount of 5% if they pay the amount due within one month. B decides to take
up the: offer and pays the amount within the given time. B will record the transaction as follows.

Debit: Creditor -A Ltd

Credit: Discounts Received

Creditor A Ltd a/c

Sh. Sh.
Bank 950 Purchases 1,000
Disc. Received 50 ____
1,000 1,000

Purchases a/c
Sh. Sh.
A ltd 1,000

Discount received a/c

Sh. Sh.
Balance 50 A ltd 50

Bank a/c
Sh. Sh.
A ltd 950

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Discount Allowed
These are the allowances made by a firm on the amounts receivable from the customers to
encourage prompt payment. The amounts deducted from the sales invoice. In the previous example
when A Ltd issued the discount and was taken up by B the entries in the books of A ltd will be;-
i. Debit- discount allowed
ii. Credit-debtors -B ltd

Debtors B Ltd a/c

Sh. Sh.
Sales 1,000 Bank 950
Discount 50
1,000 1,000

Sales a/c
Sh. Sh.
Debtors 1,000

Discount Allowed a/c

Sh. Sh.
Debtors B ltd 50 Bank 50

Bank a/c
Sh. Sh.
Debtors B ltd 950

PETTY-CASH BOOK

The petty cash book is used to record small payments of cash. As with the main cash book. it may or
not or not be part of the double-entry system.
Petty- Cash Book is a record of all the petty cash vouchers raised and kept by the cashier. The petty
cash vouchers will show summary- expenses paid by the cashier and this information is listed and
classified in the petty cash book under the headings of the relevant expenses such as:
 Postage and stationery
 Traveling
 Cleaning expenses.

Companies normally use cheque to pay their obligations because cheques provide a record of each
payment, Companies also maintain a petty cash fund to pay for-small, miscellaneous expenditures
such as stamps, Small delivery charges, or emergency supplies. The size of a petty cash fund varies
depending on the needs of the business. A petty cash book should be small enough so that it does not
unnecessarily tie up- Company assets or become a target for theft, but it should be large enough to
lessen the inconvenience associated with frequently replenishing the fund. For this reason,
companies typically establish a petty cash fund that needs to be replenished every two to four weeks.

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Companies assign responsibility for the Petty cash fund to a person called the petty cash custodian
or petty cashier. To establish a petty cash fund, someone must write a check to the petty cash
custodian, who cashes the check and keeps the money in a locked file or cash box.
Whenever someone in the company requests petty cash, the petty cash custodian prepares a voucher
that identifies the date, amount, recipient, and reason for the cash disbursement. For control
purposes, vouchers are sequentially pre-numbered and signed by both the person requesting the cash
and the custodian. After the cash is spent, receipts or other relevant documents should be returned to
the petty cash custodian, who attaches them to the voucher. All vouchers are kept with the petty cash
fund until the fund is replenished, so the total amount of the vouchers and ;the remaining cash in the
fund should always equal the amount assigned to the fund.
When the fund requires more cash or at the end of an accounting period, the petty cash custodian
requests a check for the difference between the cash on hand and the total assigned to the fund. At
this time, the person who provides cash to the custodian should examine the vouchers to verify their
legitimacy. The transaction that replenishes the petty cash fund is recorded with a compound entry
that debits all relevant asset or expense accounts and credits cash.

The petty cash account is debited or credited only when the fund is established or when the size of
the run' is increased or decreased, not when the fund is replenished.
If the voucher amounts do not equal the cash needed to replenish the fund, the difference is recorded
in an account named cash over and short. This account is debited when there is a cash shortage and
credited when there is a cash overage. Cash over and short appears on the income statement as a
miscellaneous expense if the account has a debit balance or as miscellaneous revenue if the account
has a credit balance.
The format for a petty cash book is as shown;-

PETTY CASH BOOK

Expenses The ledger
Receipts Date Detail Payment Postage Stationery Travelling
Amount

The balance c/d of the petty cash book will signify the balance of cash in hand or form part of cash
in hand. The totals of the expenses are posted to the debit side of the expense accounts. If a firm
operates another cashbook in addition to the petty cash book, then the totals of the expenses will also
be posted on the credit side of the cash in hand cashbook.

The Imprest system

This system of accounting operates on a simple principle that the cashier is refunded the exact
amount spent on the expenses during a particular financial period. At the beginning of each period, a
cash float is agreed upon and the cashier is given this amount to start with. Once the cashier makes
payments for the period lie will get a total of all the payments made against which he will claim a
reimbursement of the same amount that will bring back the amount to the cash float at the beginning
of the period.

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Illustration

The following is a summary of the petty cash transactions of Mmboga Ltd for May 2010

May Ksh
1 Received from cashier Ksh300,000 as petty float
2 Postage 18,000
3 Travelling 12,000
4 Cleaning 15,000
7 Petrol for delivery van 22.000
8 Travelling 25,000
9 Stationery 17,000
11 Cleaning 18,000
14 Postage 5,000
15 Travelling 8,000
18 Stationery 9,000
18 Cleaning 23,000
20 Postage 13,000
24 Delivery van 5,000 mile service 43,000
26 Petrol 18,000
27 Cleaning 21,000
29 Postage 5,000
30 Petrol 14,000

You are required to:

Rule up suitable petty cash book with analysis columns for expenditure on cleaning, motor
expenses, Postage, stationery, travelling.

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Solution
Mmboga Ltd
Petty Cash Book
Receipts Total Cleaning Motor Postage Stationery Travelling
Ksh Ksh'000' expenses Ksh'000' Ksh '000' Ksh '000'
'000' Ksh'000'
300 1. Bal b/d
2. Postage 18 - - 18 - -
3.Travelling 12 - - - - 12
4.Cleariing 15 15 - - - -
7. Petrol 22 - 22 - - -
8. Travelling 25 - - - - 25
9: Stationery 17 - - - 17 -
11. Cleaning 18 18 - - - -
14. Postage. 5 - - 5 - -
15. Travelling 8 - - - - 8
18. Stationery 9 - - - 9 -
18. Cleaning 23 23 - - - -
20. Postage 13 - - 13 - -
24. Motor serv. 43 - 43 - - -
26. Petrol 18 - 18 - - -
27. Cleaning 21 21 - - - -
29. Postage 5 - - 5 - -
30.Petrol 14 - 14 - - -
286 77 97 41 26 45
286 31. Cash
___ 31. Balance c/d 300
286 586

THE GENERAL JOURNAL / JOURNAL PROPER

It records information from other correspondence (information that is not recorded in books of prime
entry). It explains the type of entries that will be made in the ledger accounts giving a reason for
these entries.

The type of transactions recorded here are:

i. Writing off of assets from the accounts e.g. bad-debts.
ii. Purchase or sale of non-current assets on credit.
iii. Correction of errors

The word 'journal' means 'daily'. A journal is a 'day-to-day' record, showing for each transaction the
debit and credit entries in a-specific ledger.

It contains lists of individual transactions added as they occur. No amount is posted into the ledger
without also appearing in a journal.

Every money figure appearing in a journal that represents the amount of the transaction-must also
appear in some account in a ledger.
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In a journal referred to here we record all transaction which is not entered into one of the other day
books. This journal is also referred to as journal proper.

In the journal proper we record purchase and sales of fixed assets, transfers between accounts;
correction of errors; writing off bad debts; and opening entries needed to open a new set of books.

We keep the journal in order to have some control over entries in the ledger and also to make it
easier to locate any differences which we may discover as a result of taking out a trial balance.
Although the rulings of the lines is the same as the other journal (specific journals), the transactions
are recorded differently. In the journal proper we show the date, the .name of the account(s) to be
debited and the amount(s), the name of the account(s) to be debited and the, amount(s), the name of
the account(s) to be credited and the amount(s) and the description of the transaction.

A reference number (or folio number) should be given for the documents giving evidence of the
transaction.

For example, the form of the journal to record the purchase of a motor vehicle might be as follows:

Date Folio Dr.(Shs.) Cr.(Shs.)

Oct 3
Motor vehicles
Onze Motors
(Being purchase of van on credit from Onze Motors)

DOUBLE ENTRY AND THE LEDGER

A double-entry bookkeeping system is a set of rules for recording financial information in a

financial accounting system in which every transaction or event changes at least two different
nominal ledger accounts.

The name derives from the fact that financial information used to be recorded using pen and ink in
paper books -- hence "bookkeeping" (whereas rii5wjt is recorded mainly in computer systems) and
that these books were called journals and ledgers (hence nominal ledger, etc.) — and that each
transaction was entered twice (hence "double-entry"), with one side of the transaction being called a
debit and the other a credit.
It was first codified in the 15th century by the Franciscan Friar, Luca Pacioli. In deciding which
account has to be debited and which account has to be credited, the golden rules of accounting are
used. This is also accomplished using the accounting equation: Equity = Assets — Liabilities. The
accounting equation serves as an error detection tool. If at any point the sum of debits for all
accounts does not equal the corresponding sum of credits for all accounts, an error has occurred. It
follows that the sum of debits and the sum of the credits must be equal in value.
Double-entry bookkeeping is not a guarantee that no errors have been made — for example, the
wrong ledger account may have been debited or credited, or the entries completely reversed.

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ACCOUNTING ENTRIES
In the double-entry accounting system, each accounting entry records related pairs, of financial
transactions for asset, liability, income, expense, or capital accounts. Recording of a debit amount to
one or more accounts and an equal credit amount to one or more accounts results in total debits
being equal to total credits for all accounts in the general ledger. If the accounting entries are
recorded without error, the aggregate balance of all accounts having positive balances will be equal
to the aggregate balance of all accounts having negative balances. Accounting entries that debit and
credit related accounts typically include the same date and identifying code in both accounts, so that
in case of error, each debit and credit can be traced back to a journal and transaction source
document, thus preserving an audit trail. The rules for formulating accounting entries are known as
"Golden Rules of Accounting". The accounting entries are recorded in the "Books of Accounts".
Regardless of which accounts and how many are impacted by a given transaction, the fundamental
accounting equation A = L + OE will hold, i.e. assets equals liabilities plus owner's equity.

T- ACCOUNT
The simplest account structure is shaped like the letter T. The account title and account number
appear above the T. Debits (abbreviated Dr.) always go on the left side of the T and credits
(abbreviated Cr.) always go on the right.

Account title
Debit side (Dr) Credit side (Cr
Date Details Amount Date Details Amount
Sh. Sh.

Accountant's record increases in asset, expense, and owner's drawing accounts on the debit side, and
they record increases in liability, revenue, and owner's capital accounts on the credit side. An
account's assigned normal balance is on the side .where an increase goes because the increases in
any account are usually greater than the decreases. Therefore, asset, expense, and owner's drawing
accounts normally have debit balances. Liability, revenue, and owner's capital accounts normally
have credit balances. To determine the correct entry, identify the accounts affected by a transaction,
which category each account falls into, and whether the transaction increases or decreases the
account's balance.

THE DOUBLE ENTRY FOR ASSETS, LIABILITIES AND CAPITAL

As we mentioned earlier, every transaction affects two accounts. This is to mean that for every
transaction there is a debit entry and a corresponding credit entry. This is the bookkeeping stage of
accounting known as the double entry.

Transactions may increase or decrease assets, liabilities or capital.

- To increase an asset, we debit the asset account
- To decrease an asset, we credit the assets account.
- To increase a liability/capital account, we credit the liability/Capital account.
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- To decrease a liability /capital account, we debit the liability /capital account.

It should be noted from the above analysis that the double entry rules for liabilities and capital are
the same but they are the opposite of those of assets.

Dr Asset a/c Cr

When risking double entries, there are two important points to note;

i) Determine the accounts that are affected by each transaction.

ii) Figure out which account should be debited and which account should be credited

Illustration
1. A trader starts a business with Shs. 500,000 in cash on 1 January 2014.

Accounts affected Effect of transaction Debit or Creditor

Cash account Increase in asset Debit
Capital account Decrease in capital Credit

Dr Cash a/c Cr
2014 Sh.
January 1 capital 500,000

Dr Capital a/c Cr
2014 Sh.
January 1 cash 500,000

2. Furniture is bought For sh. 50,000 cash on 2 January 2014.

Accounts affected Effect of transaction Debit or Creditor

Furniture account Increase in asset Debit
Cash account Decrease in asset Credit

Dr Furniture a/c Cr
2014
Sh.9509
January 2 Cash 50,000

Dr Cash a/c Cr
2014 Sh.
January 2 Furniture 50,000
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 FINANCIAL ACCOUNTING

3. A motor vehicle is bought on credit from Tamim motor for Shs 200,000 on 3 January, 2014.

Accounts affected Effect of transaction Debit or Creditor

Motor vehicle Increase in asset Debit
Tamim motors Increase in liabilities Credit

Dr Motor vehicle account a/c Cr

2014 Sh.
January 3 Tamim 200,000

Dr Tamim motors a/c Cr

2014 Sh.
January 3 Motor vehicle 200,000

4. The trader paid the amount owing in cash to Tamim Motors on 20 January 2014.

Accounts affected Effect of transaction Debit or Creditor

Cash Decrease in asset Credit cash a/c
Tamim motors Decrease in liability Debit Tamim motors a/c

Dr Cash a/c Cr
2014 Sh.
January 20 Tamim Motors 200,000

Dr Tamim motors a/c Cr

2014 Sh.
January 20 Cash 200,000

5. On combining all the four transactions, the accounts will appear

Accounts affected Effect of transaction Debit or Creditor

Cash account Increase in asset Debit
Capital account Decrease in capital Credit

Dr Cash a/c Cr
2014 Sh. 2014 Sh.
January 1 Capital 500, 000 January 2 Furniture 50, 000
January 2 Tamim motors 200,000

Dr Capital a/c Cr
2014 Sh.
January 1 cash 500,000

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Dr Furniture a/c Cr
2014 Sh.
January 2 Cash 50,000
Dr Motor vehicle account a/c Cr
2014 Sh.
January 3 Tamim 200,000

Dr Tamim motors a/c Cr

2014 Sh. 2014 Sh.
January 20 Cash 200,000 January 3 Motor vehicle 200,000

DOUBLE ENTRIES FOR EXPENSES AND REVENUES

Expenses and revenues must be entered into appropriate accounts' in order to calculate profits and
losses.

You need to know which expense account should be debited or credited with the amounts involved.
As shown earlier, assets involve expenditure by the business hence shown as debit entries. Expenses
also involve expenditure by the business and should be shown as debit entries. The reason is that
both assets and expenses must .be paid for. When this payment is Made, the bank or cash account is
credited and therefore the original entry in the asset account or expense account must be a debit.

Revenues on the other hand are treated in the opposite way. When revenue is received, it is initially
debited in the bank account or cash account and the corresponding credit entry made in the revenue
account.

In summary

Debit expense account with increase in expense.

Credit expense account with decrease in expense.

Credit revenues account with increase in revenues.

Debit revenue account with decrease in revenues.

Illustrations
1. A stationer of Shs.10, 000 is paid in cash on 2 February, 2014.

Accounts affected Effect of transaction Debit or Creditor

Stationery a/c Increase in Expense Debit stationery a/c
Cash a/c Decrease in asset Credit Cash a/c

Dr Stationery a/c Cr
2014 Sh.
February 2 Cash 10,000
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 FINANCIAL ACCOUNTING

Dr Cash a/c Cr
2014 Sh.
February 2 Stationery 10,000

2. Shs 15,000 is received in cash for rent earned by the business in 10 February 2014

Accounts affected Effect of transaction Debit or Creditor

Rent received a/c Increase in rent received Credit
Cash a/c Decrease in asset Debit

Dr Rent received a/c Cr

2014 Sh.
February 10 Cash 15,000

Dr Cash a/c Cr
2014 Sh.
February 10 Rent received 15,000

3. On 28 February 6, salary amounting to Shs. 56,000 was paid by cheque

Accounts affected Effect of transaction Debit or Creditor

Salaries a/c Increase in Expense Debit
Bank a/c Decrease in asset Credit

Dr Salaries a/c Cr
2014 Sh.

February 28 Bank 56,000

Dr Bank a/c Cr
2014 Sh. 2014 Sh.
February 28 Salaries 56,000

THE LEDGER

The ledger, which is the most important and indeed the only essential book used in Bookkeeping, is
a classified record of transactions.

Items are grouped in various 'accounts according to their nature. The term "account" in Bookkeeping
means a record showing in Dr. and Cr.
It is usually shown in 'T' form.

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Thus an account headed with the name of James Rutto would contain a record of transactions with
him and with him only; an account in the name of Motor Vehicles would contain a record of
purchases and sales in motor vehicles only.

Types of ledger accounts

The accounts kept in a ledger fall into two categories, 'Personal' add 'Impersonal' accounts.

a) Personal accounts
Personal accounts are those opened by the trader with various persons with whom he transacts
business, the trader's own capital account and drawings accounts being included.

b) Impersonal accounts
They include two types:
i) Real accounts — These are accounts which record transactions in property. They relate to
tangible things, e.g. cash, investments. bills, stocks, furniture, motor vehicles, etc.
ii) Nominal accounts — These record revenues and gains and losses which have been taken
into account in computing the profit or loss which the business has made; e.g. discounts, bad
debts, salaries and wages, rent, commissions, etc.

Preparation of ledger accounts or posting

First of all, the opening entry should be posted, as it indicates the balances of assets and liabilities
with which the firm starts the new period. The way to post the opening entry is that on the debit side
of various assets (which have to be debited according to the opening entry) one writes "To Balance
brought down, or just "To Balance b/d"; and then the amount.

In the, case of liabilities and-the capital account, the entry is: By Balance b/d and then the amount on
the credit side. In the case of cash and balances, balances will be written in the Cash Book and no
separate accounts will be opened. –

SALES LEDGER AND PURCHASES LEDGER

SALES LEDGER

A sales ledger is an accounting tool used in business to keep track of sales made or invoices sent to
customers. A:sales ledger be very simple or complex, depending on the size and the nature of the
business. Sales ledgers were at one time handwritten in notebooks, with various columns, but now it
is much more common to keep track of expenses using an electronic spreadsheet or accounting
computer programs, which are easier to organize, sort, and change if needed. Generally, this type of
ledger will feature a number of different columns including the date, invoice number if applicable, a
description of the product or service, and the amount received for it.

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Keeping a thorough sales ledger is important for a business for a number of reasons. Not only does it
help. to keep track of profits and losses, but it can help to reveal purchasing trends, or other types of
sales data that may give clues to successful advertising campaigns or store displays, for example, In
addition, the ledger can be a helpful tool for preparing tax returns at the end of the year, and can also
be invaluable for detailing profits and expenses if the company is ever audited.

Illustration
You are to enter up the sales journal from the-following details. Post the items to the relevant
accounts in the sales ledger and then show the transfer to the sales account In the general ledger.

2010
March 1 Credit sales to J. Omondi Sh.1,870
March 3 Credit sales to G. Achieng Sh. 1,660
March 6 Credit sales to V. Charles Sh. 120
March 10 Credit sales to J. Omondi Sh. 550
March 17 Credit sales to F. Mwangi Sh. 2,890
March 19 Credit sales to U. Aketch Sh. 660
March 27 Credit sales to V. Sarah Sh.280
March 31 Credit sales to L. Cate Sh. 780

Solution

Sales Journal
Date 2010 Detail Folio Amount (sh)
1/3 J. Onlondi 1,870.00
3/3 G. Achieng 1,660.00
613 V. Charles 120.00
10/3 J. Omondi 550.00
17/3 F. Mwangi 2,890.00
19/3 U. Aketch 660.00
27/3 V. Sarah 280.00
3113 L. Cate 780.00
8,810.00

Sales ledger

Omondi a/c
2010 sh. 2010 sh.
1/3 sales 1,870
10/3 sales 550

Achieng a/c
2010 sh. 2010 sh.
3/3 sales 1,620
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Charles a/c
2010 sh. 2010 sh.
6/3 sales 120

Mwangi a/c
2010 sh. 2010 sh.
17/3 sales 2,890

Aketch a/c
2010 sh. 2010 sh.
19/3 sales 660

Cate a/c
2010 sh. 2010 sh.
31/3 sales 780

Sales a/c
Date 2010 Sh Date 2010 Sh
1/3 J. Omondi 1.870
3/3 G. Achieng 1,660
6/3 V. Charles 120
10/3 J. Omondi 550
17/3 F. Mwangi 2,890
19/3 U. Aketch 660
27/3 V. Sarah 280
31/3 L. Cate 780
8,810
Bal.b/d 8,810

PURCHASES LEDGER

A purchases ledger is a system in accountancy by which a business records and monitors its
creditors. The purchase ledger contains the individual accounts of suppliers from whom the business
has made purchases on credit. Information on invoices and credit notes received and payments
made. are recorded in the supplier's account using the debits and credits system, with the balance of
each account at a given moment representing the amount currently owed to that supplier.

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Historically, the purchase ledger was maintained in book form, hence the term ledger, but in modern
practice it is much more likely to be held on computer using accountancy software or a spreadsheet.
The purchase ledger will ordinarily hold a credit balance, unless credit notes or over-payments
exceed the credit balance. An example of a purchases ledger is shown below

Xyz Account
Date Details Amount Date Details Amount
2010 Shs 2010 Shs

1.8 Cash xx 3.8 Balance b/d xx

30.8 Balance c/d xx 1.9 Purchase xx
xx xx
Balance b/d xx

Illustration
You are to enter the following items in the books, post to personal accounts, and show transfers to
the general ledger.

2011
July 1 Credit purchases from: K. Amos Sh.380; M. Ochieng Sh.500; N: Oluoch Sh.106.
July 3 Credit sales to: E. Ken Sh.510; E. Rose Sh.246; F. Tom Sh.356.
July 5 Credit purchases from; R.Kyule Sh.200; J.Wanja Sh.l 80; D.Mwangi Sh.410;
C.Kange Sh.66.
July 8 Credit sales to: A. Ben Sh.307;11 Kim Sh.250; J. Tony Sh.185.
July 12 Returns outwards to: M. Ocheing Sh.30; N. Oluoch.Sh.16,
July 14 Returns inwards from: E. Rose Sh.18; F. Tom Sh.22.
July 20 Credit sales to: E. Rose Sh.188; F. Paul Sh.310; E. Dan Sh.420.
July 24 Credit purchases from: J.Tony Sh.550; K. Musiu 511.900
July 31 Returns inwards from: E. Rose Sh.27; E. Ken Sh.30.
July 31 Returns outwards to: J. Wanja Sh.13; C, Kange Sh.11.

Purchases ledger

N. Oluoch a/c
2011 Sh. 2011 Sh.
12/7 Returns out 16 1/7 Purchases 106

J. Wanja a/c
2011 Sh. 2011 Sh.
12/7 Returns out 13 5/7 Purchases 180

K. Amos a/c
2011 Sh. 2011 Sh.
1/7 Purchases 380
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D.Mwangi a/c
2011 Sh. 2011 Sh.
5/7 Purchases 410

K. Musiu a/c
2011 Sh. 2011 Sh.
24/7 Purchases 900

M. Ochieng a/c
2011 Sh. 2011 Sh.
30/7 Returns out 30 1/7 Purchases 500

C.Kange a/c
2011 Sh. 2011 Sh.
31/7 Returns out 11 5/7 Purchases 66
R. kyule
2011 Sh. 2011 Sh.
5/7 Purchases 200

J. Tony a/c
2011 Sh. 2011 Sh.
24/7 Purchases 550

Purchases a/c
2011 Sh. 2011 Sh.
1/7 K. Amos 380
1/7 M. Ochieng 500
1/7 N. Oluoch 106
5/7 R. Kyule 200
5/7 J. Wanja 180
5/7 D. Mwangi 410
5/7 C. Kange 66
24/7 J. Tony 24/7 550
24/7 K. Musiu 900 31/7 Balance c/d 3,292
3,292 3,292
Balance b/d 3,292

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THE TRIAL BALANCE

It has been seen how every amount that is placed on the debit side of an account has a corresponding
entry on the credit side of some other account.

This is the technical aspect of the principle of double entry system. This being the case. it is but
natural that the total of all the debit balances should agree with the total of all credit balances.

In fact, all businesses periodically tabulate the debit and credit balances separately in a statement to
see whether the total of debit balances agrees with the total of credit balances or not. Such a
statement is known as the Trial Balance.

The accountant heaves a sigh of relief, when the total of the debit balances agrees with the total of
credit balances, because it is quite a good proof that the ledger has been correctly written up.
However, it is not a conclusive proof of accuracy. Many mistakes may remain even if a trial balance
agrees.

After posting all transactions from an accounting period, accountants prepare a trial balance to verify
that the total of all accounts with debit balances equals the total of all accounts with credit balances.
The trial balance lists every open general ledger account by account number and provides separate
debit and credit columns for entering account balances.

The trial balance format is as follows,

Trial balance as at 31 December 2013

Rent — income xxx

Debtor — U Francis xxx -
Motor vehicle xxx -
Bank xxx -
Purchases xxx -
Wages xxx -
Capital - xxx
Creditor — M Anthony - xxx
Furniture & Fittings xxx -
Sales xxx
Cash in hand xxx -
Creditor - P James - xxx
Expenses — Rent xxx -
Expenses — Stationery xxx -
Returns Outwards - xxx
Drawings xxx -
xxx xxx
Illustration

Writ up the following transactions in the books of S Grace

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2003
March 1 Started business with cash Sh.1,500,000
March 2 Bought goods on credit from A. Agnes Sh296,000
March 3 Paid rent by cash Sh.28,000 - .
March 4 Paid Sh.1,000 of the cash of the firm into a bank
March 5 Sold goods on credit to 7. Sarah Sh.54,000
March 7 Bought stationery Sh15 paying by cheque
March 11 Cash sales Sh.49,000
March 14 Goods returned by S. Grace to A. Agnes Sh.17,000
March 17 Sold goods on credit to P. Lutz Sh.29,000
March 20 Paid for repairs to the building by cash Sh.18,000
March 22 3. Sarah returned goods to us Sh.14,000
March 27 Paid A. Agnes by cheque Sh.279,000
March 28 Cash purchases Sh.125,000 .
March 29 Bought a motor vehicle paying by cheque Sh395,000
March 30 Paid motor expenses in cash Sh.15,000
March 31 Bought fixtures Sh.120,000 on credit from R. Robert

Required;
a) Prepare ledger accounts
b) Extract trial balance from the ledger accounts

Solution:

Capital a/c
2003 sh. ‘000’ 2003 sh. ‘000’
31/3 Balance 1,500 1/3 Cash 1,500
Bal c/d 1,500

Cash in hand a/c

2003 sh. ‘000’ 2003 sh. ‘000’
1/3 Capital 1,500 3/3 Rent 28
11/3 Sales 49 4/3 Bank 1,000
28/3 Repairs 18
28/8 Purchases 125
30/3 Motor expenses 15
____ 31/3 Balance c/d 363
1,549 1,549
Balance b/d 363

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Purchases a/c
2003 sh. ‘000’ 2003 sh. ‘000’
2/3 A Agnes 296 31/3 Bal c/d 421
28/3 Cash 125 ___
421 421
Balance 421

Creditor- A Agnes a/c

2003 sh. ‘000’ 2003 sh. ‘000’
14/3 Return 17 2/3 Purchases 296
27/3 Bank 279 ___
296 296
Rent-Expenses a/c
2003 sh. ‘000’ 2003 sh. ‘000’
3/3 Cash 28 31/3 Bal c/d 28
Balance b/d 28

Bank a/c
2003 sh. ‘000’ 2003 sh. ‘000’
4/3 Cash 1,000 5/3 Stationery 15
27/3 A Agnes 279
30/3 Motor Van 395
____ 31/3 Balance c/d 311
1,000 1,000
Balance b/d 311

Debtor- J Sarah a/c

2003 sh. ‘000’ 2003 sh. ‘000’
3/3 Sales 54 22/3 Returns I/W 14
__ 31/3 Balance c/d 40
54 54

Sales a/c
2003 sh. ‘000’ 2003 sh. ‘000’
31/3 Balance c/d 132 5/3 J Sarah 54
11/3 Sales 49
17/3 P Lutz 29
132
Balance b/d 132

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Stationery a/c
2003 sh. ‘000’ 2003 sh. ‘000’
7/3 Bank 15 31/3 Balance c/d 15
Balance b/d 15
Return outwards a/c
2003 sh. ‘000’ 2003 sh. ‘000’
31/3 Balance c/d 17 14/3 Agnes 17
Balance c/d 17

P Lutz-Debtor a/c
2003 sh. ‘000’ 2003 sh. ‘000’
17/3 Sales 29 21/3 Balance c/d 29
Balance b/d 29

Building repairs - expenses a/c

2003 sh. ‘000’ 2003 sh. ‘000’
20/3 Cash 18 31/3 Balance c/d 18
Balance b/d 18

Return-Inwards a/c
2003 sh. ‘000’ 2003 sh. ‘000’
22/3 J Sarah 14 31/3 Balance c/d 14
Balance b/d 14

Motor vehicle a/c

2003 sh. ‘000’ 2003 sh. ‘000’
29/3 Bank 395 31/3 Balance c/d 395
Balance b/d 395

Robert- Creditor (others) a/c

2003 sh. ‘000’ 2003 sh. ‘000’
31/3 J Balance c/d 120 31/3 Fixtures 120
Balance c/d 120

Motor vehicle Expenses a/c

2003 sh. ‘000’ 2003 sh. ‘000’
30/3 Cash 15 31/3 Balance c/d 15
Balance b/d 15

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Fixtures a/c
2003 sh. ‘000’ 2003 sh. ‘000’
31/3 R Robert 120 31/3 Balance c/d 120
Balance b/d 120

S. Grace
Trial Balance As At March 2003
Debit (Sh) Credit (Sh)
Capital 1500
Purchases 421
Cash in hand 363
Bank 311
Rent expense 28
Sales - 132
Fixtures 120
Debtor -7 Sarah 40
Debtor- P Lutz 29
Motor vehicle 395
Creditors -
Motor expenses 15
Returns inwards 14
Creditors others — R - 120
Robert 15
Stationery - 17
Returns outwards 18 ____
Building repairs 1769 1769

COMPUTERISED ACCOUNTING

Role of Computers in Accounting:

The manual system of recording accounting transactions requires maintaining books of accounts
such as journal, cash book, special purpose books, and ledger and so on. From these books summary
of transactions and financial statements are prepared manually.

The advanced technology involves various machines, which can perform different accounting
functions, for example a billing machine. This machine is capable of computing discount, adding net
total and posting the requisite data to the relevant accounts.

With substantial increase in the number of transactions, a new machine was developed to store and
process accounting data with greater speed and accuracy. A computer, to which it was connected,
operated this machine.

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As a result, the maintenance of accounting data on a real-time basis became almost essential. Now
maintaining accounting records become more convenient with the computerized accounting.
Objects of Introduction of Computers in Accounting:

Labor Saving:
Labor saving is the main aim of introduction of computers in accounting. It refers to annual savings
in labor cost or increase in the volume of work handled by the existing staff.

Time Saving:
Savings in time is another object of computerization. Computers should be used whenever it is
important to save time. It is important that jobs should be completed in a specified time such as the
preparation of pay rolls and statement of accounts. Time so saved by using computers may be used
for other jobs.

Accuracy:
Accuracy in accounting statements and books of accounts is the most important in business. This
can be done without any errors or mistakes with the help of computers. It also helps to locate the
errors and frauds very easily.

Minimization of Frauds:
Computer is mainly installed to minimize the chances of frauds committed by the employees,
especially in maintaining the books of accounts and handling cash.

Effect on Personnel:
Computer relieves the manual drudgery, reduces the hardness of work and fatigue, and to that extent
improves the morale of the employees.

Need for Computerized Accounting:

The need for computerized accounting arises from advantages of speed, accuracy and lower cost of
handling the business transactions.

Numerous Transactions:
The computerized accounting system is capable of large number of transactions with speed and
accuracy.

Instant Reporting:
It is capable of offering quick and quality reporting because of its speed and accuracy.

Reduction in Paper Work:

Manual accounting system requires large storage space to keep accounting records/books, and
vouchers/documents. The requirement of books and stationery and books of accounts along with
vouchers and documents is directly dependent on the volume of transactions beyond certain point.

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There is a dire need to reduce the paper work and dispense with large volume of books of account.
This can be achieved with the help of computerized accounting system.

Flexible Reporting:
The reporting is flexible in computerized accounting system. It is capable of generating reports of
any balance as when required and for any duration which is within the accounting period.

Accounting Queries:
There are accounting queries, which are based on some external parameters. For example, a query
relating to overdue customers’ accounts can be easily answered by using the structured query
language [SQL] support of database technology in the computerized accounting system. Such an
exercise would be quite difficult and expensive in manual accounting system.

Online Facility:
Computerized accounting system offers online facility to store and process transaction data so as to
retrieve information to generate and view financial reports.

Accuracy:
The information and reports generated are accurate and quite reliable for decision-making. In
manual accounting system, as many people do the job and the volume of transactions is quite large,
such information and reports are likely to be distorted and unreliable and inaccurate.

Security:
This system is highly secured and the data and information can be kept confidential, when compared
to manual accounting system.

Scalability:
The system can cope easily with the increase in the volume of business. It requires only additional
data operators for storing additional vouchers.

Special Features of Computerized Accounting System:

1. It leads to quick preparation of accounts and makes available the accounting statements and
records on time.
2. It ensures control over accounting work and records.
3. Errors and mistakes would be at minimum in computerized accounting.
4. Maintenance of uniform accounting statements and records is possible.
5. Easy access and reference of accounting information is possible.
6. Flexibility in maintaining accounts is possible.
7. It involves less clerical work and is very neat and more accurate.
8. It adapts to the current and future needs of the business.
9. It generates real-time comprehensive MIS reports and ensures access to complete and critical
information instantly.

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Requirements of the Computerized Accounting System:

Accounting Framework:
A good accounting framework in terms of accounting principles, coding and grouping structure is a
pre-condition. It is the application environment of the computerized accounting system.
Operating Procedure:
A well-conceived and designed operating procedure blended with suitable operating environment is
necessary to work with the computerized accounting system. The computer accounting is one of the
database-oriented applications, wherein the transaction data is stored in well-organized database.

The user operates on such database using the required interface. And he takes the required reports by
suitable transformations of stored data into information. Hence, it includes all the basic requirements
of any database-oriented application in computers.

BENEFITS/ADVANTAGES OF COMPUTERIZED ACCOUNTING:

1. Better Quality Work:

The accounts prepared with the use of computers are usually uniform, neat, accurate, and more
legible than manual job.

2. Lower Operating Costs:

Computer is a labor and time saving devise. Hence, the volume of job handled with the help of
computers results in economy and lower operating costs.

3. Improved Efficiency:
Computer brings speed and accuracy in preparing the records and accounts and thus, increases the
efficiency of employees.

4. Facilitates Better Control:

From the management point of view, greater control is possible and more information may be
available with the use of computer in accounting. It ensures efficient performance in accounting
work.

5. Greater Accuracy:
Computerized accounting ensures accuracy in accounting records and statements. It prevents clerical
errors and omissions.

6. Relieve Monotony:
Computerized accounting reduces the monotony of doing repetitive accounting jobs, which are
tiresome and time consuming.

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7. Facilitates Standardization:
Computerized accounting facilitates standardization of accounting routines and procedures.
Therefore, standardization in accounting is ensured.

8. Minimizing Mathematical Errors:

While doing mathematics with computers, errors are virtually eliminated unless the data is entered
improperly in the first instance.

DISADVANTAGES OF COMPUTERIZED ACCOUNTING:

1. Reduction of Manpower:
The introduction of computers in accounting work reduces the number of employees in an
organization. Thus, it leads to greater amount of unemployment.

2. High Cost:
A small firm cannot install a computer accounting system because of its high installation and
maintenance cost. To be more economical there should be large volume of work. If the system is not
used to its full capacity, then it would be highly uneconomical.

3. Require Special Skills:

Computer system calls for highly specialized operators. The availability of such skilled personnel is
very scarce and very costly.

4. Other Problems:
Frequent repair and power failure may affect the accounting work very much. Computers are prone
to viruses. Often time’s people will assume the computer is doing things correctly and problems will
go unchecked for long period of time.

CHALLENGES/PROBLEMS FACED IN COMPUTERIZED ACCOUNTING SYSTEM:

1. User Training:
The user, for using computer accounting software, needs to understand the concepts of the software.
Hence, he should undergo proper training. A computer operator must learn the basics of computer,
concepts of software, working with the operating system software [such as Windows/DOS] and the
accounting software.

2. System Dependency:
Using a computer solution makes the user to depend fully on the computer system and necessitates
the availability of computer at all times. If the system is not available [due to hardware failure or
power cut], it would be difficult to verify the accounts.

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3. Hardware Requirements:
A full-fledged computer system with a printer is required to operate the computerized accounting
system. Most small organizations may not afford to have such facility with necessary software.

4. System Failure:
When there is a system crash [hard disk crash], there is high risk of losing the data available on the
hard disk drive at any point of time. It would be highly painful, if the problem occurs at end of the
financial year, when the financial statements should be ready.

5. Backups and Prints:

Backups of the data should be done regularly so that, when the data is lost, it can be restored from
floppies [backups]. Regular print outs of the system information would be useful as manual records.

6. Voucher Management:
Accounting software allows easy alteration of data. If a voucher is wrongly placed in a wrong head,
it would be very difficult to sort out and bring back the voucher. A good voucher management is
very essential.

7. Security:
Additional security has to be provided because improper handling of the system [hardware/software]
could be dangerous. Passwords, locks, etc., have to be set so that no unauthorized person can handle
the system.

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REVISION EXERCISE

QUESTION 1

a) The following transactions relate to Makinga Resort Club.

2007
May 1 Purchased goods on credit from Malewa Sh 120,000
May 4 Bought goods on credit from
D. Songa Sh 98,000
Simbuna Sh 114,000
Mateta Sh 100,000
May 10 Sold goods on credit to:
Mbaraka Sh 97,000
Ndigiri Sh 120,000

b) The following transactions relate to Moongo traders for the month of March 2005.
March 1 Bought goods for 5h 15,000 on credit from Kamau enterprises.
5 Returned goods Sh3,000 to Kamau Enterprises.
20 Sold goods to Beshir Sh20,000 on credit.
25 Bashiri returned goods Sh 1,500
28 Bought goods from Mbaka Sh30,000 and was allowed 20% trade discount.
3I Sold goods to Mukulima Sh 15,000 and was allowed a I 0% trade discount.

i) Record the above transactions in the books of original entry.

ii) Post the entries to the General ledger.

Solution:
a)
Purchases Daybook
Date 2007 Details Amount (sh)
May 1 Malewa 120,000
4 D. Songa 98,000
4 Simbuna 114,000
4 Mateta 100.000
432,000

Sales Daybook
Date 2007 Details Amount (sh)
May 10 Mbaraka 97,000
Ndigiri 120 000
217,000

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b)
Purchases Daybook
Date Details Amount (sh)
May Kamau enterprises 15,000
1 Mbaka 30,000
28 T. Discount (6,000) 24.000
39.000

Sales Daybook
Date Details Amount (sh)
May 20 Bashiri Ltd 20,000
31 Mukulima 15,000
T. Discount (1,500) 13,500
33,500

Purchases Daybook
Date Details Amount (sh)
May 5 Kamau enterprises 3,000
3,000

Sales Daybook
Date Details Amount (sh)
May 25 Bashiri Ltd 1,500
1,500

ii)
Purchases a/c
Shs.000 Shs.000
Kamau Ent. 15,000
Mbaka 24,000 Balance c/d 39,000
39,000 39,000

Sales a/c
Shs.000 Shs.000
Bashiri Ltd 20,000
Balance c/d 35,500 Mukulima 13,500
35,500 35,500

Purchases a/c
Shs.000 Shs.000
Kamau Ent. 3,000 Balance c/d 3,000
3,000 3,000

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Purchases a/c
Shs.000 Shs.000
Balance c/d 1,500 Bashiri Ltd 1,500
1,500 1,500

QUESTION 3
Nochad Hotels maintains a petty cash book on an imprest system with a monthly cash float of Sh
25,000. The float is reimbursed at the beginning of the month.
The balance brought forward as at I May, 2007 was Sh 1,200.
The following payments were made during the month of May, 2007. -
Sh
May 4 Airtime 2,000
9 Otieno-a creditor 8,000
17 Cooking gas 8,000
25 Bus fare 3,000

Prepare a petty cash book using the following analysis columns:

i. Telephone
ii. Travelling
iii. Cooking
iv. Ledger

Solution:
Receipts Date Particulars Total Expenses Travelling Cooking Ledger
Sh. 2006 Sh. Telephone Sh Sh. Sh.
May Sh.
1,200 1 Bal b/d
23,800 Bank
4 Air time 2,000 2,000
9 Creditor 8,000 8,000
16 C. gas 8,000 8,000
25 Bus fare 3,000 ____ 3,000 ____ ____
30 21,000 2,000 3,000 8,000 8,000
_____- Bal. c/d 4.000
25,000 25,000

QUESTION 3
a) Why do some businesses keep a petty cashbook as well as a cashbook?
b) Kathryn Rochford keeps her petty cashbook on the imprest system, the imprest being Sh.25.
For the month of April 20X9 her petty cash transactions were as follows:
Sh.000
Apr 1 Petty cash balance 113

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" 2 Petty cashier presented vouchers to cashier and obtained cash to

restore the imprest 2387
" 4 Bought postage stamps 850
" 9 Paid to Courtney Bishop, a creditor 235
" 11 Paid bus fares 172
" 17 Bought envelopes 70
" 23 Received cash for personal telephone call 68
" 26 Bought petrol 1000
i) Enter the above transactions in the petty cashbook and balance the petty cashbook at 30 April,
bringing down the balance on 1 May.
ii) On I May Kathryn Rochford received an amount of cash from the cashier to restore the
imprest. Enter this transaction in the petty cashbook.

Solution:
i)
 To keep detail out of cashbook
 To reduce postings to expense accounts.
 To enable petty cash to be kept by someone other than the main cashier.
ii)
Receipts Total Post and Travel Ledger
Sh. 000 Sh. 000 stationary expenses accounts
Sh. 000 Sh. 000 Sh. 000
113 (1) Balance b/d
2,387 (2) Cash
(4) Postages 850 850
(9) Courtney Bishop 235 235
(11) Bus fares 172 172
(17) Envelopes 70 70
68 (23) Telephone reimbursed
(26) 1000 - 1000 -
2,327 920 1,172 235
_____ (30) Balance c/d 241
2,568 2,568
241 (1) Balance b/d
2,259 (1) Cash

QUESTION 4
The following is a summary of the petty cash transactions of Sing'ornbe Ltd for May 2010
May Ksh
1 Received from cashier Ksh300,000 as petty float
2 Postage 18,000
3 Travelling 12,000
4 Cleaning 15,000
7 Petrol for delivery van 22,000
8 Travelling 25.000

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9 Stationery 17,000
11 Cleaning 18,000
14 Postage 5,000
15 Travelling 8,000
18 Stationery 9,000
18 Cleaning 23,000
20 Postage 13,000
24 Delivery van 5,000 mile service 43,000
26 Petrol 18,000
27 Cleaning 21,000
28 Postage 5,000
29 Petrol 14,000

You are required to:

(a) Rule up suitable petty cash book with analysis columns for expenditure on cleaning, motor
expenses. Postage, stationery, travelling.
(b) Enter the receipt of the amount necessary to restore the imprest and carry down the balance
for the commencement of the following month
Solution:
Receipts Total Cleaning Motor exp Postage Stationery Travelling
Ksh'000' Ksh'000' Ksh '000' Ksh'000' Ksh '000' Ksh '000'
300 1. Bal b/d
2. Postage 18 - 18 -
3.Travelling 12 - - - 12
4.Cleaning 15 15 - - -
7. Petrol 22 - 22 -
8. Travelling 25 - - - - 25
9. Stationery 17 - - - 17 -
11. Cleaning 18 18 - - -
14. Postage 5 - 5 -
13. Traveiiing 8 - - - 8
18. Stationery 9 - - - 9
IS. Cleaning 23 23 - - -
20. Postage 13 - - 13 - -
24. Motor serv. 43 - 43 -
26. Petrol 18 18 - - -
27. Cleaning 21 21 - - - -
29. Postage 5 - - 5 -
30. Petrol 14 -__ 14 -__ -__ -
286 77 97 41 26 45
286 31. Cash
___ 31. balance c/d 300
286 586

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QUESTION 5
Joseph Onyango opened a shop in Homa Bay on 1July 2005. The following transactions took place
during the month of July 2005:
July
I Introduced Sh.200,000 in cash into the business from his private hank account.
2 Opened a business bank account by transferring Sh. 1 80,000 0 the business cash into the
account
5 Paid Sh.5,000 in cash being rent for the month
6 Bought second-hand shop equipment at Sh.3,000 and paid by cheque.
9 Purchased goods or resale at Sh.10,000 paying them in cash.
11 Purchased goods for resale on credit worth Sh.20,000 from Selina Wambui.
20 Returned goods worth Sh.2,000 to Selina Wambui
23 Made cash sales of Sh. I 5,000.
25 Paid Selina Wabui Sh.16,200 by cheque.
26 Sold on credit goods worth Sh.l 0,000 to Frida Atieno.
27 Frida, Atieno returned goods worth Sh.5,000.
28 Received a cheque or Sh4,500 from Frida Atieno ill settlement of her account, the balance
being treated as a cash discount
30 Sold some of the second-hand office equipment at Sh.1,000 in cash. There was no profit or loss
on disposal.
30 Made a cash withdrawal Sh1,500 for his private use

Required:
a) Ledger accounts (including the three-column cash book) to record the above transactions.
b) Trial balance as at 3] July 200).

Solution:
Date Details Disc Cash Bank Date Details Disc Cash Bank
2005 Sh Sh Sh 2005 Sh Sh Sh
July1 Capital 200,000 July 2 Bank 180,000
2 Cash 180,000 5 Rent 5,000
23 Sales 15,000 6 Shop equip 3,000
28 F. Atieno 500 4,500 9 Purchases Selina 10,000
30 Office equip 1,000 25 Drawings 16,200
30 Bal. c/d 1,500
______ ______ 19 500 165,300
216,000 184,500 216,000 184,000
Bal. b/d 19,500 165,380

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Equipment a/c
Shs Shs
Balance c/d 200,000 Cash 200,000
200,000 200,000
Balance b/d 200,000

Rent a/c
Shs Shs
Cash 5,000 Balance c/d 5,000
5,000 5,000
Balance b/d 5,000

Shop a/c
Shs
Bank 3,000 Cash 1,000
____ Balance c/d 2,000
3,000 3,000
Balance b/d 3,000

Purchases a/c
Shs Shs
Cash 10,000 Balance c/d 30,000
Selina 20,000 30,000
30,000
Balance b/d 30,000

Selina a/c
Shs Shs
Ret 2,000 Purchases 20,000
Bank 16,200
Balance c/d 1,800 _____
20,000 20,000

Return outwards a/c

Shs Shs
Balance c/d 2,000 Selina 2,000
2,000 2,000
Balance b/d 2,000

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Sales a/c
Shs Shs
Cash 15,000
Balance b/d 25,000 F.ATieno 10,000
25,000 25,000
Balance b/d 25,000

F. Atieno a/c
Shs
Sales 10,000 Ret. Out 5,000
Bank 4,500
____ Discount 500
10,000 10,000

Return inwards a/c

Shs Shs
F.ATieno 5,000
5,000 Balance b/d 5,000
5,000 5,000
Balance b/d 5,000

Drawings a/c
Shs Shs
Cash 1,500 Balance c/d 1,500
1,500 1,500

Trial Balance
Shop Equipment Debit (Sh) Credit (Sh)
Bank 2,000
Cash 165,300
Rent 19,500
Purchases 5,000
Returns Inwards 30,000
Drawings 5,000
Discount Allowed 1,500
Capital 500
Creditors - 200,000
Returns Outwards - 1,800
Sales - 2,000
______ 25.000
228,000 228,800

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TOPIC 3

ACCOUNTING FOR ASSETS AND LIABILITIES

ASSETS

PROPERTY, PLANT AND EQUIPMENT - lAS 16,

The objective of this Standard is to prescribe the accounting treatment for property, plant and
equipment so that users of the financial statements can discern information about an ,entity's
investment in its property, plant and equipment and the changes in such investment. The principal
issues in accounting for property, plant and equipment are the recognition of the assets, the
determination of their carrying amounts and the depreciation charges and impairment losses to be
recognised in relation to them.

Property, plant and equipment are tangible items that:

(a) Are held for use in the production or supply of goods or services, for rental to others, or
for administrative purposes; and
(b) Are expected to be used during more than one period.
(c) The cost of an item of property, plant and equipment shall be recognised as an asset if,
and only if:
i) It is probable that future economic benefits associated with the item will flow to the
entity; and
ii) The cost of the item can be measured reliably.

Measurement at recognition: An item of property, plant and equipment that qualifies .for
recognition as an asset shall be measured at its cost. The cost of an item '.if property, plant and
equipment is the cash price equivalent at the recognition date. If payment is deferred beyond normal
credit terms, the difference between the cash price equivalent and the total payment is recognised as
interest over the period of credit unless such interest is recognised in the carrying amount of the item
in accordance with the allowed alternative treatment in lAS 23.

The cost of an item of property, plant and equipment comprises:

(a) Its purchase price, including import duties and non-refundable purchase taxes. After
deducting trade discounts and rebates
(b) Any costs directly attributable to bringing the asset to the location and condition necessary
for it to be capable of operating in the manner intended by management.
(c) The initial estimate of the costs of dismantling and removing the item, and restoring the
site on which it is located, the obligation for which an entity incurs either when the item is
acquired or as a consequence of having used the item during a particular period for
purposes other than In produce inventories during that period.

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Measurement after recognition: An entity shall choose either the cost model or the revaluation
model as its accounting policy and shall apply that policy to an entire class of property, plant and
equipment.

Cost model: After recognition as an asset, an item of property, plant and equipment shall be carried
at its cost less any accumulated depreciation and any accumulated impairment losses.

Revaluation Model: After recognition as an asset, an item of property, plant and equipment whose
fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the
date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated
impairment losses. Revaluations shall be made with sufficient regularity to ensure that the carrying
amount does not differ materially from that which would be determined using fair value at the
balance sheet date.
If an asset's carrying amount is increased as a result of a revaluation, the increase shall be credited
directly to equity tinder the heading of revaluation surplus. However, the increase shall be
recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset
previously recognised in profit or loss. If an asset's carrying amount is decreased as a result of a
revaluation, the decrease shall be recognised in profit or loss. However, the decrease shall be debited
directly to equity under the heading of revaluation surplus to the extent of any credit balance
existing in the revaluation surplus in respect of that asset.

Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.
Depreciable amount is the cost of an asset, 'or other amount substituted for cost, less its residual
value. Each part of an item of property, plant and equipment with a cost that is significant in relation
to the total cost of the item shall be depreciated separately. The depreciation charge for each period
shall be recognised in profit or loss unless it is included in the carrying amount of another asset. The
depreciation method- used shall reflect the pastern in which the asset's future economic benefits are
expected to be consumed by the entity.

The residual value of an asset is the estimated amount that an entity would currently obtain from
disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the
age and in the condition expected at the end of its useful life.

To determine whether an item of property, plant and equipment is impaired, an entity applies IAS 36
Impairment of Assets.

The carrying amount of an item of property, plant and equipment shall be derecognized:

(a) on disposal; or
(b) When no future economic benefits are expected from its use or disposal. ,

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MEANING OF DEPRECIATION

Depreciation is the diminution in the value of assets due to wear and tear or due to just passage of
time. In actual practice, both of these factors operate.

True profits of a business cannot be ascertained unless depreciation has been allowed for.

Depreciation means a fall in the quality or value of an asset. The net result of an asset's depreciation
is that sooner or later, the asset will become useless. The factors that cause depreciation are:

1. Wear and tear due to actual use

2. Efflux of time — mere passage of time will cause a fall in the value of an asset even if it is
not used,
3. Obsolescence — a new invention or a permanent change in demand may render the asset
useless.
4. Accidents
5. Fall in market prices.

The fact to remember is that except in a few cases (e.g. land and 'old paintings) all assets depreciate.
Though current assets may also lose value, the term depreciation is used only in resPect of fixed
assets and is usually confined to the fall in value caused by factors one and two mentioned above.

THE BASIC FACTORS IN DEPRECIATION

For calculating depreciation, the basic factors are:

i. The cost of the asset

ii. The estimated residual or scrap value at the end of its life
iii. The estimated number of years of its life (not the actual but the number of years it is likely to
be used by the firm). Machinery maybe capable of running for thirty years, but, say, due to new
inventions, it will be in use only for ten years, then the estimated life is ten years and • not
thirty years.

So much depreciation has to be provided as will reduce the value of the asset to its scrap value at the
end of its estimated life. The Companies Act requires companies to write off or provide for
depreciation in a specified manner.

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Objectives of Providing Depreciation

1. To ascertain true value of assets and financial position: The value of assets diminishes
over a period of time on account of various factors. In order to present a true state of affairs of
the business, the assets should be shown in the Balance Sheet, at their trite and fair values. If
the depreciation is not provided, the asset will appear in the Balance Sheet at the original
value. So, in order to show the true financial position of a business, it is imperative to charge
depreciation on the assets. If depreciation is not provided, the value of assets will be shown at
inflated value in the Balance Sheet. By this means, fixed assets will not represent true and
correct state of affairs of business.

2. To make provision for replacement of worn out assets: All the fixed assets used in the
business require replacement after the expiry of their useful life. The need for replacement
can be due to many reasons like change in technology, taste, fashion or demand, which makes
a particular asset useless causing permanent loss in its value. To provide requisite amount for
replacement of this depreciating asset, annual depreciation is charged to Profit & Loss
Account. The amount so provided may be retained in business by ploughing back or invested
in outside securities to make the funds available for replacement purposes. Practically, the
provisions so provided for depreciation help to recoup the expired cost of the assets used,
depleted or exhausted.

3. To calculate correct amount of profits or loss: Matching principles states that the expenses
or costs incurred to earn revenue must be charged to Profit & Loss Account for the purpose of
correct computation of profit. When an asset is purchased, it is nothing more than a payment
in advance for the use of asset. Depreciation is the cost of using a fixed asset. To determine
true and correct amount of profit or loss, depreciation must be treated as revenue expenses
and debited to Profit & Lass Account. Like any other operating expenses, if depreciation is°
not provided, the profits will be inflated and losses understated.

4. To compute cost of production: depreciation not only facilitates financial accounting in

computation of profits but it is also an important element of cast determination process. In the
absence of depreciation, it is very difficult to ascertain the actual cost of production, process,
batch, contract and order of a product. Although the method of charging depreciation is
entirely different, without depreciation, no costing system is complete.

5. To comply with legal provisions: Section 205 of the Companies Act 1956 provides that
depreciation on fixed assets must be charged and necessary provision should be made before
the company distributes dividends to its shareholders, Hence, depreciation is charged to
comply with the provisions of the Companies Act.

6. To avail of tax benefits; The income statement of Account will show more profits if
depreciation is not charged on assets. In this case, the business needs to pay more income tax
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to the government. Depreciation charges on assets save the amount of tax equivalent to tax
rate. Since it is shown as expense in the income statement of Account, it shrinks the amount
of profit.

METHODS FOR PROVIDING DEPRECIATION

The following are the various methods for providing depreciation —

(a) Fixed percentage on Original or Fixed Installment or Straight Line Method

(b) Fixed percentage on Diminishing Balance or Reducing Balance Method
(c) Sum of the Digits Method
(d) Annuity Method
(e) Depreciation Fund Method
(f) Insurance Policy Method
(g) Revaluation Method
(h) Depletion Method
(i) Machine Hour Rate Method
(j) Repairs Provision Method

(a) Fixed Percentage on Original Cost

Under this method, a suitable percentage of original, cost is written off the asset every year. Thus, if
an asset costs Shs.20, 000 and ten percent depreciation is thought proper, Shs.2, 000 would be
written off each year.

The amount to be written off every year is arrived at as under;

Cost minus − EstimatedScrap Value

In the case of companies, the scrap value is assumed to be five percent of the original cost of the
asset. In other words, ninety five percent of the cost-of an asset is to be written off over its life.

The tile oldie asset is to be reckoned by reference to the rate recognized by the Income-tax Rules.
The Rules lay down that depreciation is to be provided by applying the prescribed rate to the
reducing book figure or the asset as a result of the depreciation charge.

The period for which the asset is used in a particular year should also be taken into account, Thus, if
the asset is purchased on first April, and the books are closed on thirty first December, only nine
months' depreciation should be written off in the first year, though income tax authorities will permit
depreciation for a full year even if the asset is used only for a short while.

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This method is useful when the service rendered by the asset is uniform from year to year. It is
desirable, when this method is in use, to estimate the amount to be spent by way of repairs during
the whole life of the asset and provide for repairs each year at the average, actual repairs being
debited against the provision.

(b). Fixed Percentage on Diminishing Balance

Under this method, the rate or percentage of depreciation is fixed, but it applies to the Value at
which the asset stands in the books in the beginning of the year.

In the first year, depreciation is written off proportionate to the actual period in use. The depreciation
on Shs.20. 000 - the cost of the asset - at the rate of ten percent will be Shs.2, 000 in the first year.
This will reduce the book value of the asset to Shs.18, 000. Depreciation in the second year will be
Shs.1, 800, i.e, ten percent of Shs.18, 000.

In the third year it will be Shs.1, 620. It should be noted that, taking the life of the asset to be the
same, the rate of depreciation in the second method will be roughly three times the rate under the
first method.

Since the real cost of using an asset is the depreciation to be written off plus the amount spent on
repairs of the asset, the second method, viz., Fixed Percentage on Diminishing Balance gives .better
results.

In the first year of the life of an asset, repairs are light. They rise as the asset gets older: If one
follows the first method of depreciation, the total cost of using the asset, Vis a viz., depreciation
(which is constant every year) plus repairs, will rise.

Later years will show heavier expense. This is not proper because the asset gives the same service in
the later years, as in the earlier years.

The charge to Profit and Loss Account should be uniform. If one follows the second method,
depreciation in the earlier years will be heavy but will be lighter as the asset gets old.

Repairs, on the other hand, are light in the earlier years and heavier later. The total of the two -
depreciation and repairs - will be roughly constant. This method also recognizes on more fact.

As soon as an asset is put to use, its value, for sale purposes, falls heavily. Under this method, the
depreciation is heaviest in the first year. Thus, it reduces the book figure to its appropriate value.
Further, Income tax authorities recognize this method.

Both methods ignore interest. When an asset is used, one loses ultimately not only the money spent
on acquiring the asset but also the interest which could have been earned on it. The amount to he
charged by way of depreciation, therefore, should take into consideration not only the cost of the
asset but also the interest.

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(c). Sum of the Digits Method

Under this method, the amount of the depreciation to be written off each year is calculated by the
formula:

ℎ ( ℎ )
ℎ
ℎ ℎ

Suppose the He'd an asset costing Shs.50, 000 is ten years. The sum of all the digits one to ten is
fifty five. The depreciation to be provided in the first year will be:

10
50,000 = ℎ. 9,091
55
In the second year, it will be:

9
50,000 = ℎ. 8,181
55
It will be noticed that the method is similar to the Diminishing Value Method stated above.

(d). Annuity Method

As has been pointed out, the first two methods ignore interest. The annuity method takes into
account the interest lost on the acquisition of an asset.

Interest is calculated on the book value of the asset at the current rate and debited to the asset
account and credited to Interest Account.

The amount to be written off as depreciation is calculated from the annuity tables. The depreciation
will be different according to the rate of interest and according to the period, over which the asset is
to be written off.

(e). Revaluation Method

This method is used only in case of small items like cattle (livestock) or loose tools where it may be
too much to maintain an account of each single item. The amount of depreciation to be written off is
determined by comparing the value at the end of the year (valuation being done by someone having
knowledge of the asset) with the value in the beginning.

Suppose on first January, 2005 the value of loose tools was Shs. 1, 600 and during the year Shs.2.
000 worth of tools were purchased.

Now, if at the end of the year, the loose tools are considered to be worth only Shs.2, 400, the
depreciation comes to Shs.1, 200, i.e. Shs. 1,600 + 2,000 - 2,400

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(f). Depletion Method

This method is used in case of mines, quarries etc. where an estimate of total quantity of output
likely to be available should be available.

Depreciation is calculated per tonne of output. For example, if amine-is purchased for Shs.2, 00,000
and it is estimated that the total quantity of mineral in the mine is 5, 00,000 tonnes, the depreciation
per tonne output comes to 40%. i e.

200,000
100
500,000
If the output- in the first year is 30,000 tonnes, the depreciation to be written off in the first year will
be 30.000 x 0.40 or Sh. 12,000, in the second year, the output may be.50,000 tonnes; the
depreciation to be written off will be Shs.20, 000 i.e. 50,000 x 0.40

(g). Machine hour Rate Method

This is more or less like the .above. Instead of the usual method of estimating the, life of a machine
in years, it is estimated in hours. Then an accurate record is kept recording the number of hours each
machine is run and depreciation is calculated accordingly

For example, the effective life of a machine may be 30,000 hours. If the cost of the machine is
Shs.45,000, the hourly depreciation is Shs.1.50. The depreciation for a particular year during which
the machine runs for 2,500 hours will be 2,500 x1.50 or Sh. 3,750

(h).Repairs Provision Method

Institute of Cost and 'Management Accountants of England and Wales defines this method as
follows: " The -method of providing for the aggregate of depreciation and maintenance cost by
means of periodic charges each of which is a constant proportion of the aggregate of the cost of the
asset depreciated and the expected maintenance cost during its life." ,

It means that to the cost of the asset (less its estimated scrap value), the amount expected to be spent
on its repairs and maintenance throughout its life should be added and the sum then divided by its
estimated life.

Suppose an asset costs Shs.60, 000 and has an estimated scrap value of Shs.6, 000; it is expected that
its life is fifteen years during which period a sum of Shs.30, 000 is likely to be spent on its repairs
and maintenance

The total amount to be written off is Shs.'84,000 i.e. Shs.60, 000 — Shs.6, 000 + Shs.30, 000.
Dividend by 15 the amount is Shs.5, 600.

If it is debited to the Profit and Loss Account each year, both depreciation and repairs will be taken
care of. Of the amount, Shs.2, 000 should be credited to Repairs Provision Account, i.e. 30,000+15
and the balance Shs.3, 600 credited to Depreciation Provision Account:
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Actual repairs will have to be debited to the Repairs Provision Account and not to the Profit and
Loss Account. -

ACCOUNTING TREATMENT ON DEPRECIATION

When non-current assets are depreciated, a new account for each type of asset is opened; this
account is called a provision for depreciation whereby the following entries will be made;

Debit - P&L a/c

Credit — Provision for depreciation a/c
With the amount of depreciation charged for the period.

Illustration

A company starts a business on 1 January 1999, the financial year end being 31 December.

You are to show:

a) The plant account.

b) The provision for depreciation account.
c) The balance sheet extracts for each of the years 1999, 2000, 2001, 2002.

The machinery bought was:

1999 1 January 1 plant costing shs.8,000

2000 1 July 2 2 plant costing shs.5,000 each
1 October 1 plant costing shs.6,000
2002 1 April 1 plant costing shs.2,000

Depreciation is at the rate of 10 per cent per annum, using the straight-line method, plant being
depreciated for each proportion of a year.

Plant account

Date Sh. Date Sh,

1999
1/1 Cashbook 8,000 31/12 Balance c/d 8,000

2000
1/1 Balance b/d 8,000
Cashbook 10,000
Cashbook 6 ,000 31/12 Balance c/d 24,000
24,000 24,000
2001
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 FINANCIAL ACCOUNTING

1/1 Balance b/d 24,000 31/12 Balance c/d 24,000

2002 -
1/1 Balance b/d. 24,000
¼ Cashbook 2,000 31/12 Balance old 26,000
26,000 26,000

Calculation for depreciation

1999 Shs Accumulated Depreciation

8,000 x 10/100 x 12/12 800 800

2000
10,000 x 10/100 x 6/12 500
6,000 x10/100 x3/12 150
8,000 x 10/100x12/12 800 1450

2001
24,000 x 10/100 x12/12 2400 2400

2002
24,000 x 10/100 x 12/12 2400
2,000 x 101100 x 9/12 150 2550
7200

Provision for Depreciation

Date Details Amount Date Details Amount

Shs Shs
1999 1999
31/12 Balance c/d 800 31/12 Income statement 800

2000 2000
31/12 Balance c/d 2,250 1/1 Balance b/d 800
- 31/12 Income statement 1450
2.250 2250
2001 2001
31/12 Balance c/d 4,650 1/I Balance b/d 2,250
____ 31/12 Income statement 2,400
4,650 4,650
2002 2002
31/12 Balance c/d 7,200 1/I Balance b/d 4,650
____ 31/12 Income statement 2,550
7,200 7,200

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Balance Sheet (Extract) as at 31/12/99 - 31/12/02

Non-Current Cost Acc Depreciation NBV

Assets Sh. Sh. Sh,

1999
Plant 8,000 (800) 7.200
2000
Plant 24,000 (2,250) 21,750
2001
Plant 24,000 (4,650) 19,350
2002
Plant 26,00 (7,200) 18,800

DISPOSALS OF ASSETS

A firm may dispose off its non-current assets in the following 3 ways:

i) Selling the asset,

ii) Asset being written-off from damage/accident/theft.
iii) Asset is scrapped/not used anymore.

When an asset is disposed and is no longer used by the firm, the appropriate entries should be made
in the asset account and the total depreciation provided to date on the asset and the entries required
will depend on the type of disposal.

When the asset is sold, the following entries will be made:

(a) Debit - asset disposal a/c

Credit asset a/c
With the cost of the asset being disposed

(b) Debit - provision for depreciation of asset a/c.

Credit - asset disposal a/c
With the total depreciation provided to date on the asset.

(c) Debit - cashbook.

Credit asset disposal a/c
With the cash received on disposal.

When an asset is written off as a result of damage/accident/theft

If it was insured and the insurance company accept liability but by the end of the period the
insurance Company has not yet paid.
(a) Debit. - Asset disposal a/c
Credit - asset a/c
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With the cost of the asset damaged.

(b) Debit - provision for depreciation of asset a/c
Credit - asset disposal a/c
(c) Debit - insurance receivable a/c
Credit - asset disposal a/c

With the amount expected from the insurance.

If the insurance pays before the end of the financial period, it will not be necessary to create an
insurance debtor so the following entries will be made:

Debit cashbook.
Credit asset disposal a/c

If the asset is not used anymore or scrapped by the firm, the appropriate entries will be made in
the asset account and provision for depreciation a/c only.

Debit - asset disposal a/c

Credit - asset a/c
With the cost of the asset no longer in use

Debit - provision for depreciation for asset

Credit asset disposal a/c
With the total depreciation provided to date.

The balance in the disposal a/c after the above entries will either be a debit balance or a credit
balance. A Credit balance represents a profit on disposal, which is reported in the profit and loss a/c
together with other incomes. The entry will be:

Debit asset disposal ale

Credit - P&L a/c
With the balance in the account'

A debit balance in the asset disposal a/c is loss on disposal which is reported in the P&L a/c as an
expense and therefore the entry will be.

Illustration

A company depreciates its plant at the rate of 20 per cent per annum, straight line method, for each
month of ownership. From the following details draw up the plant account and the provision for
depreciation account for each of the years 2005, 2006, 2007 and 2008.

2005 Bought plant costing Sh. 900 on 1 January.

Bought plant costing' 511. 600 on 1 October.
2007 Bought plant costing Sh. 550 on 1 July
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2008 Sold plant which had been bought for Sh. 900 on 1 January 2005 for the sum of Sh. 275 on 30
September 2008
You are also required to draw up the plant disposal account and the extracts from the balance sheet
as at the end of each year.

Plant a/c
Date Sh. Date Sh,
2005 2005
1/1 Cashbook 900
1/10 Cashbook 600 31/12 Balance c/d 1,500
1,500 1,500

2006 2006
1/1 Balance b/d 1 ,500 31/12 Balance c/d 1,500

2007 2007
1/1 Balance b/d 1,500
1/7 Cashbook 550 31/12 Balance c/d 2,050
2,050 2,050

2008 2008
1/1 Balance b/d 2,050 30/9 Disposal 900
____ 31/12 Balance b/d 1,150
2,050 2,050

Plant Provision for Depreciation a/c

Date Sh. Date Sh,
2005 2005
31/12 Balance c/d 210 31/12 Income Statement 210

2006 2006
1/1 Balance b/d 210
31/12 Balance c/d 510 Income Statement 300
510 510

2007 2007
1/1 Balance b/d 510
31/12 Balance c/d 865 Income Statement 355
865 865

2008 2008
31/12 Disposal 675 30/9 Balance b/d 865
Balance b/d 555 31/12 Income Statement 365
1,230 1,230

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Calculation for Depreciation

Date Cost Months Depreciation charge Sh.
2005
1/1 900 12 20/100 x 900 x 12/12 180
1/10 600 3 20/100 x 600 x 3/12 30

2006
1/1 1,500 12 20/100 x 1,500 x 12/12 300

2007
1/1 1,500 12 20/100 x 1,500 x 12/12 300
1/2 550 6 20/100 x 550 x 6/12 55
355
2008
30/9 900 9 20/100 x 900 x 9/12 135
31/12 550 12 20/100 x 550 x 12/12 110
31/12 600 12 20/100 x 600 x 12/12 120
365

Plant Disposal a/c

2008 Sh. 2008 Sh.
Plant a/c 900 30/9 Provision for depreciation 675
P&L 50 30/9 Cashbook 275
950 950

Balance Sheet (Extract

Non-Current Assets Cost Total Depreciation NBV
2005 Plant 1,500 (210) 1,290
2006 Plant 1,500 (510) 990
2007 Plant 2,050 (865) 1,185
2008 Plant 1,150 (555) 595

REVALUATION OF NON-CURRENT ASSETS

In finance, a revaluation of non-current assets is a technique that may be required to accurately

describe the true value of the capital goods a business owns. This should be distinguished from
planned depreciation, where the recorded decline in value of an asset is tied to its age.

Non-current assets are held by an enterprise for the purpose of producing goods or rendering
services, as opposed to being held for resale in the normal course of business. For example,
machines, buildings, patents or licenses can be fixed assets of a business.

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The purpose of a revaluation is to bring into the books the fair market value of fixed assets. This
may be helpful in order to decide whether to invest in another business. If a company wants to sell
one of its assets, it is revalued in preparation for sales negotiations.

Reasons for revaluation

It is common to see companies revaluing their fixed assets. It is important to make the distinctions
between a 'private' revaluation to a 'public' revaluation which is carried out in the ftnancial reports.
The purposes are varied:

• To show the true rate of return on capital employed.

• To conserve adequate funds in the business for replacement of Fixed assets at the end of their
useful lives. Provision for depreciation based on historic cost will show inflated profits and
lead to payment of excessive dividends.
• To show the fair market value of assets which have considerably appreciated since their
purchase such as land and buildings.
• To negotiate fair price for the assets of.the company before merger with or acquisition by
another company.
• To enable proper internal reconstruction, and external reconstruction.
• To issue shares to existing shareholders (rights issue or follow-on offering).
• To get fair market value of assets, in case of sale and leaseback transaction.
• When the company intends to take a. loan from banks/financial institutions by mortgaging its
fixed assets. Proper revaluation of assets would enable the company to get a higher amount of
loan.
• Sale of an individual asset or group of assets.
• In financial firms revaluation reserves are required for regulatory reasons. They are included
when calculating a firm's funds to give a fairer view of resources. Only a portion of the firm's
total funds (usually about 20%) can be loaned or in the hands of any one counterparty at any
one time (large exposures restrictions).
• To decrease the leverage ratio (the ratio of debt to equity).

PROPERTY PLANT AND EQUIPMENT MOVEMENT SCHEDULE

The property, plant and equipment schedule is a summary report on the balances and transactions of
the asset and provision for depreciation account as per the requirements of LAS 16 to be reported in
the published accounts of companies.

The format is as follows:

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Cost Valuation Freehold Leasehold Plant and Fixture, Total

Property Property Machinery Furniture
& Fittings
Long Leases Short Leases
Bal. as at 1/1/01 xx xx Xx xx xx xx
Additions xx Xx Xx xx xx xx
Revaluations (gains) xx Xx Xx xx xx xx
Reclassifications - Xx Xx xx xx xx
Disposals xx Xx Xx xx xx xx
Ba1. as at 31/12/01 xx Xx Xx xx xx xx
Depreciation/
Amortization
Ba1. as at 1/1/10 - - Xx xx xx xx
Change for year xx - Xx xx xx xx
Revaluation xx - Xx xx xx xx
Eliminated on Disposal xx - Xx xx xx xx
Balance as at 31/12/01 xx - Xx xx xx xx
N.B. V as at 31/12/01 xx Xx Xx xx xx xx
NBV as at 31/12/01 xx Xx Xx xx xx xx

Additional information is in this schedule called reclassifications where some of the non-current
assets are transferred into a different class. (e.g.) some of the properties held under long leases (over
50 years) will be transferred to the short leases classes when their term becomes less than 50 years.
This is a reclassification from long lease to short lease and so is shown in the schedule at. the value
of transfer as a deduction in the long lease class and on addition in the short lease class

Illustration

Jaba Ltd. started its operations on 1 January 2008. The company acquired several items of plant fur
its use. The amounts for the plant acquisitions, disposals and depreciation far the years 2008. 2009
and 2010 are shown below.

The amounts for the year 2011 have not yet been computed.

Plant movement extracts for the years ended:

2008 2009 2010 2011

Sh ‘000’ Sh ‘000’ Sh ‘000’ Sh ‘000’
Plant at cost 80,000 80,000 90,000 ?
Accumulated depreciation (16,000) (28,800) (36,700) ?
Net book value 64,000 51,200 53,300 ?

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Additional information:

1. Disposals took place at the beginning of the financial years as follows:

Date of disposal Plant cost Sales proceeds

Sh ‘000’ Sh ‘000’
Disposal of plant A 2010 15,000 8,000
Disposal of plant B 2011 15,000 21,000

2. Plant A and plant B were sold and replaced on the same date when plant C and plant D were
acquired. Plant D cost Sh.50 million while the value of plant 'C is to be derived.
3. Depreciation is charged at 20% on reducing balance.

Required:

i. Extract of the plant movement schedule for the years ended 2008, 2009, 2010 and 2011
ii. Profit or loss arising on disposal of plant A and plant 13.

Solution
b) Movement schedule
Jaba limited
Schedule of movements of plant for the year ended 2008, 2009, 2010 and 2011
2008 2008 2008 2008
Sh ‘000’ Sh ‘000’ Sh ‘000’ Sh ‘000’
Asset cost
as at 1st January 80,000 80,000 80,000 90,000
Additions - - 25,000 (w1) 50,000
Disposals - - (15,000) (30,000)
Cost as at 31st December 80,000 80,000 90,000 110,000

Depreciation
At start - 16,000 28,800 36,700
Annual charge 16,000 12,800 15,220 (w1) 20,660 (w4)
On disposal - - (7,323) (17,712)
Cumulative for the year 16,000 28,800 36,700 39,648
NBV as at 31.12 64,000 51,200 53,300 70,352

W1

Plant 2010 account A

Sh ‘000’ Sh ‘000’
Balance b/d 80,000 Disposal 15,000
Bank 25,000 Balance c/d 90,000
105,000 105,000

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W2

Provision for depreciation on plant A

Sh ‘000’ Sh ‘000’
Disposal 7,320 Balance b/d 28,800
Bank 36,700 Depreciation 15,220
44,020 44,020

For 2008: 20% x 15,000 =3,000

For 2009: 20% x 12,000 = 2,400
For 2010: 20% x 9, 600 = 1,920
7,320
W3
Plant 2011 account B
Sh ‘000’ Sh ‘000’
Balance b/d 90,000 Disposal 30,000
Bank 50,000 Balance c/d 110,000
140,000 140,000

W4
Provision for depreciation on plant B
Sh ‘000’ Sh ‘000’
Disposal 17,712 Balance b/d 36,700
Bank 39,648 Depreciation 20,660
57,360 57,360

20% x 30,000 =6,000,000

20% x 24,000 =4,800,000
20% x 19,200 = 3,840,000
20% x 15, 360 = 3,072,000
17,712,000
Gain or loss on disposal of plant A and B

Plant A a/c
Sh ‘000’ Sh ‘000’
Balance c/d 15,000 Disposal 15,000
15,000 15,000
Disposal of plant A a/c
Sh ‘000’ Sh ‘000’
Plant A 15,000 Bank 8,000
Gain on disposal 320 Acc. Depreciation 7,320
15,320 15,320

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Plant B a/c
Sh ‘000’ Sh ‘000’
Balance c/d 30,000 Disposal 30,000
30,000 30,000

Disposal of plant B a/c

Sh ‘000’ Sh ‘000’
Plant B 30,000 Bank 21,000
Gain on disposal 7,712 Acc. Depreciation 17,712
37,712 37,712
Illustration

The chief accountant of Jivunie Ltd has encountered difficulties while accounting for fixed assets
and the related depreciation in the company's draft accounts for the year ended 30 April 2011.He has
decided to seek your professional advice and presented the following balances of fixed assets as at 1
May 2010:

Acquisition Accumulated Depreciation

Cost Depreciation Rates
Sh. Sh. %
Furniture 900,000 300,000 12.5
Trucks 3,525,000 1,470,000 25
Plant and machinery 7,387,500 4,462,500 10
Land 2,775,000 - Nil
Buildings 2,925,000 292,500 2.5

The following additional information was also available:

1. It is the company's policy to write off cost of the assets using above percentages on cost.
2. Depreciation is fully charged in the year of acquisition and none in the year of disposal.
3. A three year old machine acquired for sh.187,500 was sold for sh.15,750.
4. It has been decided to adju.st and charge depreciation on buildings at 4%. 5: A used delivery
truck purchased three years ago for sh.248,250 was traded in during the year at a value of
sh.157,500 in part exchange of the new delivery truck costing sh.450,000.
5. Land, buildings and machinery were acquired for sh.1,350,000 from a company that went out
of business. At the time of acquisition sh.90,000 was paid to have the assets revalued by a
professionally qualified valuer. The revaluation indicated the following market values.

Sh.
Land 900,000
Buildings 600,000
Machinery 300,000

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Required:
A schedule of movement of fixed assets as requested by the Chief Accountant for inclusion in the
company's accounts for the year ended 30 April 2011.
Cost/Valuation Land building Furniture Motor Total
& Machinery

Bal. as at 1/5/2010 13,087,500 900,000 3,525,000 17,512,500

Additions 1,350,000 - 450,000 1,800,000
Revaluations (gains) 450,000 - - 450,000
Disposals (187,500) - (248,250) (435,750)
Ba1. as at 30/04/2011 14,700,000 900,000 3,726,750 19,326,750
Depreciation
Ba1. as at 1/5/10 4,755,000 300,000 1,470,000 6,525.000
Charge for year 1,066,500 112,500 931,687.5 2,110,687.5
Eliminated on Disposal (37,500) - (124,125) (161.625)
Balance as at 30/4/2011 5,784,000 412,500 2.277,562.5 8,474,062.5
N.B. V as at 1/5/2010 8,332,500 600,000 2,055,000 10,987,500
NBV as at 30/4/2011 8,916,000 487,500 1,449,187.5 10852,687.8

Workings:

Depreciation on Furniture = 900,000 x 12.5% = 112,500

Depreciation on disposed delivery truck 25% x 248.250 x2 = sh.124, 125

Motor vehicle — 3,726,750 x25% = 931,587.5

Buildings - (2,925,500 + 600,000) x 4%— 141,000

At 4% = 2,925,500 x 4% x4 = 468,000
2.5% =2,925,000 x 2.5% x 4 =292,500
175,500
Machinery: = Cost + Additions —Disposals = Balance x 10%
7,387,500 +300,000 L. (187,500) = 7,500,000 x 10%
= A. 750,000

Depreciation on disposed machine 10% x 187,500 2 = 37,500

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 FINANCIAL ACCOUNTING

INTANGIBLE ASSETS

RECOGNITION, (AMORTIZATION, IMPAIRMENT AND DISPOSALS AND

DISCLOSURES

The objective of this Standard is to prescribe the accounting treatment for intangible assets that arc
not dealt with specifically in another Standard. This Standard requires an entity to recognise an
intangible asset if, and only if, specified criteria are met. The Standard also specifies how to meastfte
the carrying amount of intangible assets and requires specified disclosures about intangible assets.

An intangible asset is an identifiable non-monetary, asset without physical substance.

Recognition and measurement

The recognition of an item as an intangible asset requires an entity to demonstrate that the item
meets:

a) The definition of an intangible asset; and

b) The recognition criteria.

This requirement applies to costs incurred initially to acquire or internally generate an intangible
asset' and those incurred subsequently to add to, replace part of, or service it.

An asset meets the identifiability criterion in the definition of an intangible asset when it:

a) is separable, i.e. is capable of being separated or divided from the entity and sold, transferred,
licensed, rented or exchanged, either individually or together with a related contract, asset or
liability; or
b) Arises from contractual or other legal rights, regardless of whether those rights are transferable
or separable from the entity or from other rights and obligations.

An intangible asset shall be recognised if, and only if: -

a) It is probable that the expected future economic benefits that are attributable to thc asset will
flow to the entity; and
b) The cost of the asset can be measured reliably.

The probability recognition criterion is always considered to be satisfied for intangible assets that
arc acquired separately or in a business combination.

An intangible asset shall be measured initially at cost.

The cost of a separately acquired intangible asset comprises:

a) Its purchase price, including import duties .and non-refundable purchase taxes, after
deducting trade discounts and rebates; and
a. Any directly attributable cost of preparing the asset for its, intended use.

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In accordance with IFRS 3 Business Combinations, if an intangible asset is acquired in a business

combination, the cost of that intangible asset is its fair value at the acquisition date. The only
circumstances in which it might not be possible to measure' reliably the fair value of an intangible
asset acquired in a business combination are when the intangible asset arises from legal or other
contractual rights and either:

a) is not separable: or
b) is separable, but there is no history or evidence of exchange transactions for the same or similar
assets, and otherwise estimating fair value would be dependent on immeasurable variables.

Internally generated intangible assets

Internally generated goodwill shall not be recognised as an asset.

No intangible asset arising from research (or from the research phase of an internal project) shall be
recognised. Expenditure on research (or on the research phase of an internal project) shall be
recognised as an expense when it is incurred.

An intangible asset arising from development (or from the development phase of an internal project)
shall be recognised if and only if, an entity can demonstrate all of the following:

a) The technical feasibility of completing the intangible asset so that it will be available for use
or sale.
b) Its intention to complete the intangible asset and use or sell it.
c) Its ability to use or Sell the intangible asset.
d) How the intangible asset will generate probable future economic benefits. Among other
things, the entity can demonstrate the existence of a market for the output of the intangible
asset or the intangible asset itself or, if it is to be used internally, the usefulness of the
intangible asset.
e) The availability- of adequate technical, financial and other resources to complete the
development and to use or sell the intangible asset.
f) Its ability to measure reliably the expenditure attributable to the intangible asset during its
development

Internally generated brands, mastheads, publishing titles, customer lists and items similar in
substance shall not be recognised as intangible assets.

The cost of an internally generated intangible asset is the sum of expenditure incurred from the date
when the intangible asset first meets the recognition criteria. Reinstatement of expenditure
previously recognised as an expense is prohibited.

Expenditure on an intangible item shall be recognised as an expense when it is incurred unless:

(a) It forms part of the cost of an intangible asset that meets the recognition criteria; or

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(b) The item is acquired in a business combination and cannot be recognised as an intangible
asset. If this is the case, this expenditure (included in the cost of the business combination)
shall form part of the amount attributed to goodwill at the acquisition date (see IFRS 3
Business Combinations).

An active mallet is a market in which all the following conditions exist:

a) The items traded in the market are homogeneous;

b) Willing buyers and sellers can normally be found at any time; and
c) Prices are available to the public.

If an intangible asset's carrying amount is increased as a result of a revaluation, the increase shall be
credited directly to equity under the heading of revaluation surplus. However, the increase shall be
recognised in profit or loss to the extent that it reverses a revaluation decrease of the same asset
previously recognised in profit or loss. If an intangible asset's carrying amount is decreased as a
result of a revaluation, the decrease shall be recognised in profit or loss. However, the decrease shall
be debited directly to equity under the heading of revaluation surplus to the extent of any credit
balance in the revaluation surplus in respect of that asset.

Useful life

An entity shall assess whether the useful life of an intangible asset is finite or indefinite and, if finite,
the length of, or number of production or similar units constituting, that useful life. An intangible
asset shall be regarded by the entity as having an indefinite useful life when, based on an analysis of
all of the relevant factors, there is no foreseeable limit to the period over which the asset is expected
to generate net cash inflows for the entity.

Useful life is:

a) The period over which an asset is expected to be available for use by an entity; or
b) The number of production or similar units expected to be obtained from the asset by an entity.

The useful life of an intangible asset that arises from contractual or other legal rights shall not
exceed the period of the contractual or other legal rights, but may be shorter depending on the period
over which the entity expects to use the asset. If the contractual or other legal rights are conveyed for
a limited term that can be renewed, the useful life of the intangible asset shall include the renewal
period(s) only if there is evidence to support renewal by the entity without significant cost.

To determine whether an intangible asset is impaired; an entity applies TAS 36 Impairment of

Assets.

Intangible assets with finite useful lives

The depreciable amount of an intangible asset with a finite useful life shall be allocated on a
systematic basis over its useful life. Depreciable amount is the cost of an asset, or other amount
substituted for cost, less its residual value. Amortisation shall begin when the asset is available for
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use; i.e., when it is in the location and condition necessary for it to be capable of operating in the
manner intended by management. Amortisation shall cease at the earlier of the date that the- asset is
classified as held for sale (or included in a disposal group that is classified as held for sale) in
accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations and the date
that the asset is derecognised. The amortisation method used shall reflect the pattern in which the
asset's future economic benefits are expected to be consumed by the entity. If that pattern cannot he
determined reliably, the straight-line method shall be used. The amortisation charge for each period
shall be recognised in profit or loss unless this or another Standard permits or requires it to be
included in the carrying amount of another asset. •

The residual value of an intangible asset is the estimated amount that art entity would currently
obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were
already of the age and in the condition expected at the end of its useful life. The residual value of an
intangible asset with a finite useful life shall be assumed to be zero unless:

(a) There is a commitment by a third party to purchase the asset at the end of its useful life; or
(b) There is an active market for the asset and:
(i) Residual value can be determined by reference to that market; and
(ii) It is probable that such a market will exist at the end of the asset's useful life.

The amortisation period and the amortisation method for an intangible asset with a finite useful life
shall be reviewed at least at each financial year-end, If the expected useful life of the asset is
different from previous estimates, the amortisation period shall be changed accordingly. If there has
been a change in the expected pattern of consumption of the future economic benefits embodied in
the asset, the amortisation method shall be changed to reflect the changed pattern. Such changes
shall be accounted for as changes in accounting estimates in accordance with IAS 8.

Intangible assets with indefinite useful lives

An intangible asset with an indefinite useful life shall not be amortised.

In accordance with IAS 36 Impairment of Assets, an entity is required to test an intangible asset with
an indefinite useful life for impairment by comparing its recoverable amount with its carrying
amount
(a) Annually, and
(b) Whenever there is an indication that the intangible asset may be impaired,

The useful life of an intangible asset that is not being amortised shall be reviewed each period to
determine whether events and circumstances continue to support an indefinite useful life assessment
for that asset. If they do not, the change in the useful life assessment from indefinite to finite shall be
accounted for as a change in an accounting estimate in accordance with IAS 8 Accounting Policies,
Changes in Accounting Estimates and Errors.

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FINANCIAL ASSETS

A financial asset is an asset whose value comes from a contractual claim. These assets are frequently
traded. According to the International Financial Reporting Standards (IFRS), a financial asset can
be:

• Cash or cash equivalent,

• Equity instruments of another entity,
• Contractual right to receive cash or another financial asset from another entity or to exchange
financial assets or financial liabilities with another entity under conditions that are potentially
favourable to the entity,
• Contract that will or may be settled in the entity's own equity instruments and is either a non-
derivative for which the entity is or may be obliged to receive a variable number of the entity's
own equity instruments, or a derivative that will or may be settled other than by exchange of a
fixed amount of cash or another financial asset for a fixed number of the entity's own equity
instruments

Examples of financial assets are cash, investments in the bonds and equity issued by other entities,
receivables and derivative financial assets.

INVENTORY

Inventories In A Firm Include:

a) Finished goods (assets held for sale)

b) Work in progress (assets still in production for purposes of sale)
c) Raw -materials (to be used in production process).

The cost of inventories should include all costs of purchase. (Purchase price and other taxes like
import duties), costs of conversion (e.g. direct labour) and other costs incurred in bringing the
inventories into their present location and condition (carriage inwards).

Inventories or stock is a 'sensitive area, as it does not form part of the double entry. In most cases
either carrying out stocktaking or checking the stock records that the firm is kept determines the
value of stock at the end of the financial period. Stocktaking involves counting the number of units
of finished goods, work in progress or raw materials available or in the stores/warehouse/saleroom.

The value of stock to the final accounts is then derived by multiplying the cost per unit to the total
number of units available.

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Illustration

A firm has three products A, B and C whose costs are shs.200, shs.300 and shs.400 each
respectively. At the end of year 2002, stocktaking was carried out and the following units were
available:

Product A 200,000 units

Product B 20,000 units
Product C 30,000 units
Required
Compute the cost of stock to be included in the final accounts.

Solution

(200,000 x 200) + (20,000 x300) (30,000 x 400) = shs.58, 000,000

IAS 2 Inventories

The objective of this Standard is to prescribe the accounting treatment for inventories. A primary
issue in accounting for inventories is the amount of cost to be recognised as an asset and carried
forward until the related revenues are recognised. This Standard provides guidance on the
determination of cost and its subsequent recognition as an expense, including any write-down to net
realizable value. It. also provides guidance on the cost formulas that are used to assign costs to
inventories.

Inventories shall be measured at the lower of cost and net realizable value.

Net realizable value is the estimated selling price in the ordinary course of business less the
estimated costs of completion and the estimated costs necessary to make the sale.

The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs
incurred, in bringing the inventories to their present location and condition.

The cost of inventories shall be assigned by using the first-in, first-out (FIFO) or weighted average
cost formula. An-entity shall, use the same cost formula for all inventories having a similar nature
and use to the entity: For inventories with a different nature or use, 'different cost formulas may be
justified. However, the cost of inventories of items that are not ordinarily interchangeable and goods
or services produced and segregated for specific projects shall be assigned by using specific
identification of their individual costs.

When inventories are sold, the carrying amount of those inventories shall be recognised as an
expense in the period in which the related revenue is recognised. The amount of any write-down of
inventories to net realizable value and all losses of inventories shall be recognised as an expense in
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the period the write-down or loss occurs. The amount of any reversal of any write-down of
inventories, arising from all increase in net realizable value, shall be recognized as a reduction in the
amount of inventories recognised as an expense in the period in which the reversal occurs.

VALUATION USING SPECIFIC COST METHOD

The cost of the different units of stock that a firm has should be assigned to each unit as far as the
business can be able to identify each item.

For those units that the business cannot identify the specific cost, due to the number of transactions
and changes in the cost price, 1AS 2 on inventories recommends the use of the following estimates:

i. First in First Out (FIFO)

ii. Weighted Average Cost (AVCO)
iii. Last in First Out (LIFO)

FIRST IN FIRST OUT (FIFO)

The business assumes that items of stocks that were purchased first are sold first and therefore, items
left as part of closing stock were purchased recently.

With the FIR) (first-in, first-out) method for cost of goods sold, you charge out product costs to cast
of goods sold expense in the chronological order in which you acquired the goods. It's like the first
people in line to see a movie get in the theater first. The ticket-taker collects the tickets in the order
in which they were purchased.

Suppose that you acquire four units of a product during a period, one unit at a time, with unit costs
as follows (in the order in which you acquire the items): shs. 100, shs 102, shs104, and shs.106, By
the end of the period, you have sold three of these units. Using FIFO, you calculate the cost of goods
sold expense as follows:

Shs.100 + shs.102 + shs.104 = shs.306

In short, you use the first three units to calculate cost of goods sold expense. The cost of the ending
inventory asset, then, is shs.106, which is the cost of the most recent acquisition.

The shs.412 total cost of the four units is divided between shs.306 cost of goods sold expense for the
three units sold and the shs.106 cost of the one unit in ending inventory. The total cost has been
accounted for nothing has fallen between the cracks.

FIFO works well for two primary reasons:

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1. Products generally move into and out of inventory in a first-in, first-out sequence. The earlier
acquired products are delivered to customers before the later acquired products are delivered,
so the most recently purchased products are the ones still in ending inventory to be delivered
in the future.
Using FIFO, the inventory asset reported in the balance sheet at the end of the period reflects
recent purchase (or manufacturing) costs, which means the balance in the asset is close to the
current replacement costs of the products.
2. When product costs are steadily increasing, many businesses follow a first-in, first-out sales
price strategy and hold off raising sales prices as long as possible. They delay raising sales
prices until they have sold their lower-cost products. Only when they start selling from the
next batch of products, acquired at a higher cost, do they raise sales prices.

WEIGHTED AVERAGE COST

Under this method, the cost of each item -it determined from the weighted average of the cost or
similar items at the beginning of the period and the cost of similar items purchased during the
period. The average cost method takes the average of all units available for sale during the
accounting period. The average cost method uses the average cost to determine the value' of the, cost
of goods sold and ending inventory. .

LAST IN FIRST OUT (LIFO)

This method assumes that items of stock which were purchased last are sold first and therefore, the
closing stock shows items that were bought first.

LIFO is an inventory valuing method that assumes that the last items placed in inventory are the first
sold during an accounting year. Therefore, when the LIFO method is applied, the inventory at the
end of a year consists of the goods placed in inventory at the beginning of the year, rather than at the
end. During inflation, when prices are rising, the LIFO method yields a lower ending inventory. a
higher cost of goods sold, a lower gross profit, and a lower taxable income. The LIFO Method is
preferred by many companies because it has the effect of reducing a company's taxes and therefore
increasing cash flow.

Net Realizable Value (SP- Expenses)

This is the estimated selling price in the ordinary course of business less the estimated costs of
completion and the estimated costs necessary to make the sale.

In some cases, the value of stock may decline where below the cost price (either actual or estimated
under the different methods) and if the firm was to sell the stock, then it will fetch an amount below
this cost.

IAS 2 requires that closing stock should be stated at the lower of cost or net realizable value.

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 FINANCIAL ACCOUNTING

TRADE RECEIVABLES

BAD DEBTS AND ALLOWANCE FOR DOUBTFUL DEBTS AND RECEIVABLES

CONTROL ACCOUNTS

Accounts receivables

The term accounts receivables refer to the amounts due to a business following the sale of goods or
services to another company. It is a subcategory of Accounts Receivable. Trade receivables arc
considered a current asset on a company's balance sheet as they can be readily converted into cash.

Bad Debts

Some debtors may not pay up their accounts for various reasons e.g. a debtor may go out of
business. When a debtor is not able -to pay up his/her account this becomes a bad debt. Therefore
the business/firm should write it off from the 'accounts and thus it becomes an expense that should
be charged in the profit & loss account.

In practice a firm may also bee, unable to collect all the amounts due from debtors. This is because a
section of the debtors will not honor their obligations. The problem posed by this situation is that it
is difficult to identify the debtors who are unlikely to pay their accounts. Furthermore the amount
that will not be collected may also be difficult to ascertain. These debts that the firm may not collect
are called doubtful debts. A firm should therefore provide for such debts by charging the provision
in the income statement account. Provision for doubtful debts may be specific or general;Specific
relate to a debtor whom we can identify and we are doubtful that he may pay the debt (if one of our
debtor goes out of business).

Provision for Bad-Debts

A provision for doubtful debts can either be for a speCific or a general provision. A specific
provision is where a debtor is known and chances of recovering the debt are low.

The general provision is where a provision is made on the balance of the total debtors i.e. Debtors
less Bad debts and specific provision,

Accounting For Bad and Doubtful Debts

Bad debts
When a debt becomes bad the following entries will be made:
i. Debit bad debts account
Credit debtors account with the amount owing.
ii. Debit Profit and Loss Account.

Credit bad debts account to transfer the balance on the bad debts account to the income
statement account

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 FINANCIAL ACCOUNTING

Accounting treatment for provision of doubtful debts

The accounting treatment of provision for doubtful debts depends on the year of trading and the
entries will be as follows. If it is the 1st year of trading (1st year of making provision)

i. Debit P&L a/c.

ii. Credit provision for doubtful debts (with total amount of the provision).

In the subsequent periods, it will depend on whether if it is an increase or decrease required on the
provision.

If it is an increase:

iii. Debit P&L a/c.

iv. Credit provision for doubtful debts (with increase only).

If it is a decrease:

i. Debit provision for doubtful debts.

ii. Credit P&L a/c (with the decrease in provision only).

Illustration

Minim Ltd. started trading on 1 January 2013. It has been adjusting its doubtful debt provision at the
end of each year on percentage basis, but each year the percentage rate is adjusted in accordance
with the economic performance in the country.

The following details are available for the years ended 31 December 2013, 2014 and 2015.

Year Bad debts Witten Debtors at year end Provision for bad
off at year end and doubtful debts
2013 656,000 22,000,000 5%
2014 1,805,000 40,000,000 7%
2015 3,817,000 60,000,000 6%

Required;

i. Had debts account for the three years

ii. Provision for bad and doubtful debts for the years 2013, 2014 and 2015
iii. The balance sheet extracts for the years 2013, 2014 and 2015.

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Solution

i. Bad debts account for the three years

Bad debts account

Sh. Sh.
31.12.2013 Debtors 656,000 31.12.2013 Profit and loss 656,000

31.12.2014 Debtors 1,805,000 31.12.2014 Profit and loss 1,805,000

31.12.2015 Debtor 3,847,000 31.12.2015 Profit and loss 3,847,000

ii. Provision for bad and doubtful debts for the years 2013, 2014 and 2015

Year Debtors at year end Provision for bad and doubtful debts
2013 22,000,000 5%x22,000,000 =1,100,000
2014 40,000,000 7%x40,000,000=2,800,000
2015 60,000,000 6%x60,000,000=3,600,000

Bad debts account

Sh. Sh.
31.12.2013 balance c/d 1,100,000 31.12.2013 Profit and loss 1,100,000

31.12.2014 balance c/d 2,800,000 1.1.2014 balance b/d 1,100,000

- 31.12.2014 P&L (Bal. figu) 1,700,000
2,800,000 2,800,000

31.12.2015 balance c/d 3,847,000 1.12015 Balance b/d 2,800,000

- 31.12.2015 P&L (Bal. figu) 800,000
3,600,000 3,600,000

iii. The balance sheet extracts for the years 2013, 2014 and 2015.

Sh. Sh.
31.12.2013 Debtors 22,000,000
Less Provisions for doubtful debts (1,100,000) 20,900,000

31.12.2014 Debtors 40,000,000

Less Provisions for doubtful debts (2,800,000) 37,200,000

31.12.2014 Debtors 60,000,000

Less Provisions for doubtful debts (3,600,000) 56,400,000

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CONTROL ACCOUNTS

Control accounts are so called because they control a section of the ledgers. By control me mean that
the total on the control accounts should be the same as the totals on the ledger accounts. Control •
accounts are used in accounts debtors and creditors. Day books reduce the necessity of posting
several transactions in our ledger.

It is the problems associated with a large number of transactions in the ledger that control accounts
seek to resolve.

If we consider the problem with a business which has a large number of debtors, we need to have a
record of the amounts due from individual debtors in order that we can chase up unpaid debtors for
payment.

With regard to our final accounts — that is, the balance sheet we only need a total figure for debtors
and that is what control accounts will tell us, since they are nothing-more than accounts containing
totals.

In fact, an alternative name for them is 'total accounts'. The control account contains totals of posting
to the individual or personal accounts which it is controlling.

For example, a trade receivables control account or total debtors account contains entries for the
total of all items posted to the individual debtor's accounts.

Similarly, a creditors control account or total creditors account will contain entries for the total of all
items posted to the individual creditors accounts.

Trade receivables control Account — also called total debtors. The balance on the sales ledger
control account should be the same as the total of the balances in the sale ledger.

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FORMAT OF A SALES LEDGER CONTROL

Sh. Sh.
Balance b/d of the total debit xxx Total credit balances of the sales ledger xxx
balances from previous period brought forward
Final credit sales for the period (from xxx Total cash received from credit xxx
the sales journal) customers/debtors (from cash book)
Refunds to customers (from cashbook) xxx Total cheques received from credit xxx
customers/debtors (from cash book)
Dishonored cheques (from cashbook) xxx Total returns-inwards (returns-inwards xxx
journal)
Bad debts recovered (from general journal) xxx Total cash discount allowed to customers xxx
(froth cash book)
Total credit balances of the sales Ledger xxx Bad debtors written-off (from general xxx
carried forward journal)
Cash received from bad debtors recovered xxx
(cash book)
Purchases Ledger contra xxx
Allowances to customers (price reduction xxx
in excess to discounts allowed)
Total debit balance carried down to the xxx
next period — to be derived after posting
all those transactions
xxx xxx

Control accounts and double-entry

To give a simple example of control accounts, let us take the following transactions of a new
business for the month of January.

Shs.
Total Sales 105,000
Cash receipts from debtors 91,000

The debtors control account would appear as _follows:

Debtors control Account

Debtors control a/c

Date Details shs. Date Details shs.
Jan 31 sales 105,000 Jan 31 cash 91,000
- Jan 31 Balance c/d 14,000
105,000 105,000
Feb 1 Balance c/d 14,000

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Meanwhile the individual debtor's accounts will be debited with the separate sales transactions
which make up the Shs.105, 000, and individual accounts credited with cash receipts making up
Shs.91, 000. If this process is followed accurately, at any one time the balances on the individual
accounts will total the balance on the control account — in this case Shs. 14,000.

At first sight it may appear that we are contravening the rules of double-entry book-keeping, since
the transactions are being posted to the individual accounts and the control accounts.

That is to say, in the above example we credit sales with Shs.105, 000 and debit the control account
and the individual debtor's accounts with Shs.105, 000.

The answer to this apparent inconsistency is that only one of either the control accounts or the
individual accounts is part of the double- entry System.

Unfortunately for the student, it may be either of these which is part of the double-entry system, but
never both. You must read the examination question carefully to ascertain which system is in use

It may be that the control account is part of the double-entry system, in which case the individual
accounts will be a subsidiary record.

Alternatively, the individual accounts maybe part of the double-entry system and the control account
will be only a memorandum account.

Refunds to Customers

Sometimes a firm can refund some cash on the customer's account. This takes place when there is a
credit balance on the debtor's a/c and the customer is not a creditor too.

The entry will be:

Dr. Debtor's a/c

Cr. Cashbook

Contra against the purchases ledger balances:

Some debtors may also be creditors in the same firm and therefore, if the amount due to them as
creditors is less than what they owe as debtors, then the credit balance is transferred from their
creditors’ a/c to their debtors a/c as a contra entry.

NOTES:

The following notes should be taken into consideration:

1. Cash received from CASH SALES should NOT be included in sales ledger control a/c.
2. Only cash discounts (allowable & receivables) should be included. Trade discounts should
NOT be included.
3. Provision for doubtful debts is NOT included in the sales ledger control a/c, i.e. increase or
decrease in provisions for doubtful debts will not affect this account.
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Illustration
ABC Ltd. maintains control accounts in its business records. The balances and transactions relating
to the company's control accounts for the month of December 2014 are listed below:
Sh.
Balance at 1 December 2014:
Sales ledger 6,185,000 (debit)
52,500 (credit)
Purchases ledger 16,500 (debit)
4,285,000 (credit)
Transactions during December 2014:
Sales on credit 8,452,000
Purchases on credit 5,687,500
Returns inwards 203,500
Returns c utwards 284,000
Bills of Exchange payable 930,000
Bills of Exchange receivable 615,000
Cheques received from customers 7,985,000
Cheques paid to suppliers 4,732,000
Cash paid to suppliers 88,500
Bill payable dishonoured 400,000
Charges on bill payable dishonoured 10,000
Cash received from credit customers 153,000
Bad debts written-off 64.500
Cash discounts allowed 302,000
Bill receivable dishonoured 88,500
Balances at 31 December 2014:
Sales ledger 44,000 (credit)
Purchases ledger 23,500 (debit)

Required:
Post the trade receivables ledger control accounts for the month of December 2010 and derive the
respective debit and credit closing balances on 31 December 2014.

Solution
ABC
Trade receivable ledger control account
Sh ‘000’ Sh ‘000’
Balance b/d 6,185,000 Balance b/d 52,500
Credit sales 8,452,000 Returns inwards 203,500
Bills receivable dishonored 88,500 Bills receivable 615,000
Cheques received 7,985,000
Cash received 153,000
Bad debts written off 64,500
Discount allowed 302,000
_________ Balance c/d 5,394 000
14,769,500 14,769,500
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ACCRUED INCOME

Accrued income is an amount that has been

1. Earned,
2. There is a right to receive the amount, and
3. It has not yet been recorded in the general ledger accounts. One example of accrued income is
the interest earned on a bond investment.

To illustrate, let's assume that a company invested shs.100,000 on December l in a 6% shs. i 00, 000
bond that pays shs.3, 000 of interest on each Tune 1 and December 1. On December 31, the
company will have earned one month's interest amounting to shs.500 (shs.100,000 x 6% per year x
1/12 of a year, or 1/6 of the semiannual shs.3, 000). No interest will be received in December since it
will be part of the shs.3,000 to be received on June 1..

The shs.500 of interest earned during December, but not yet received or recorded as of December 31
is known as accrued income. -

Under the accrual basis of accounting, accrued income is recorded with an adjusting entry prior to
issuing the financial statements. In our example, there will need to be an adjusting .entry dated
December 31 that debits Interest Receivable (a balance Sheet account) for shs.500, and credits
Interest Income (an income statement account) for shs.500.

Accrued income will be presented in an income statement as follows;-

Income account
Date Details Amount Date Details Amount
1.1 Accrued at start xx 1.1 Prepaid at start xx
Balance to income statement xx Cash/bank xx
31.1 Prepaid at end(to statement of 31.1 Accrued at end (to statement of
financial position as a liability) xx financial position as an asset) xx
xx xx

PREPAID EXPENSES

Prepaid expenses are assets that become expenses as they expire or get used up. For example, office
supplies are considered an asset until they are used in the course of doing business, at which time
they become an expense. At the end of each accounting period, adjusting entries are necessary to
recognize the port ion of prepaid expenses that have become actual expenses through use or the
passage of time.

Prepaid expenses in one company's accounting records are often—but not always—unearned
revenues in another company's accounting records. Office supplies provide an example of a prepaid
expense that does not appear on another company's books as unearned revenue.

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Accounting records that do not include adjusting entries to show the expiration or consumption of
prepaid expenses overstate assets and net income and understate expenses.

Let us consider a situation where a business pays an annual insurance premium on April l of
Shs.10.000, If at December 31 we transferred the balance of Shs.10,000 to the profit and loss
account. it would not reflect the true expense of the accounting period, since Shs.2,500 (3/12 x
10,000) relates to the next accounting period.

In order that the profit and loss account show the true expense of Shs.7,500, we need to carry down
a debit balance on the account for the Shs.2,500 prepaid.

The insurance account would then appear as:

Insurance Account
2010 Details Sh. 2010 Details Sh.
April1 Bank 10,000 Dec.31 Profit &Loss a/c 7,500
- Dec.31 Balance c/d 2.500
2011 10000 10.000
Jan 1 Bal. b/d 2,500

The balance of Shs.2, 500 brought down into 2011 will then be transferred to the profit and loss
account at end of 2011 together with any further expense paid, and after adjusting for any accrual or
prepayment at December 31, 2011.

In the balance sheet at December 31, 20101the debit balance of Shs.2, 500 will appear under current
assets as a prepayment.

The reason for this is that it represents value due to the business at that date.

Prepaid expenses will be presented in an expense account statement as follows;-

Expenses account
Date Details Amount Date Details Amount
1.1 Prepaid at start xx 1.1 Accrued at start xx
Balance to income statement xx Cash/bank xx
31.1 Accrued at end(to statement of 31.1 Prepaid at end (to statement of
financial position as a liability) xx financial position as an asset) xx
xx xx

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CASH AT BANK

CASH BOOK AND BANK RECONCILIATION STATEMENT

The cashbook for cash at bank records all the transactions taking place at the bank i.e. the
movements of the account held with the bank. The bank will send information relating to this
account using a bank statement for the firm to compare.

Ideally, the records as per the bank and the cashbook should be the same and therefore the balance
carried down in the cashbook should be the same as the balance carried down by the bank in the
bank statement.

In practice however, this is not the case and the two (balance as per the bank and firm) are different.
A bank reconciliation statement explains the difference between the balance at the bank as per the
cashbook and balance at bank as per the bank statement.

Items Appearing In the Cashbook and Not Reflected In the Bank Statement

Unpresented Cheques: Cheques issued by the firm for payment to the creditors or to other supplies
but have not been presented to the firm's bank for payment.

Uncredited deposits/cheques: These are cheques received from customers and other sources for
which the firm has banked but the bank has not yet availed the funds by crediting the firm's account.

Errors made in the cashbook These include:

• Payments over/understated
• Deposits over/understated
• Deposits and payments misposted
• Overcasting and under casting the Balance c/d in the cashbook.

BANK RECONCILIATION

Banks usually send customers a monthly statement that shows the account's beginning balance (the
previous statement's ending balance), all transactions that affect the account's balance during the
month, and the account's ending balance.

The ending balance on a bank statement almost never agrees with the balance in a company's
corresponding general' ledger account. After receiving the bank statement, therefore, the company
prepares a. bank reconciliation statement, which identifies each difference between the company's
records and the bank's records. The normal differences identified in bank reconciliation will be
discussed separately. These differences are referred- to as reconciling items. Bank reconciliation

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begins by showing the bank statement's ending balance and the company's balance (book balance) in
the cash account on the same date:

Deposits in transit

Most companies make frequent cash deposits. Therefore, company records may show one or more
deposits, usually made on the last day included on the bank statement, which do not appear on the
bank statement. These deposits are called deposits in transit and cause the bank statement balance to
understate the company's actual cash balance. Since deposits in transit have already been recorded in
the company's books as cash receipts, they must be added to the bank statement balance.

Outstanding cheques

A check that a company mails to a creditor may take several days to pass through the mail, be
processed and deposited by the creditor, .and then clear the banking system. Therefore, company
records may include a number of cheques that do not appear on the bank-statement. These cheques
are called outstanding cheques and cause the bank statement balance to overstate the company's
actual cash balance. Since outstanding cheques have already been recorded in the company's books
as cash ' disbursements, they must be subtracted from the bank statement balance.

Automatic withdrawals and deposits

Companies may authorize a bank to automatically transfer funds into or out of their account.
Automatic withdrawals from the account are used to pay for loans (notes or mortgages payable),
monthly utility bills, or other liabilities. Automatic deposits occur when the company's checking
account receives automatic fund transfers from customers or other sources or when the bank collects
notes receivable payments on behalf of the company,

Banks use debit memoranda to notify companies about automatic withdrawals, and they use credit
memoranda to notify companies about automatic deposits. The names applied to these memoranda
may seem confusing at first glance because the company credits (decreases) its cash account upon
receiving debit memoranda from the bank, and the company debits (increases) its cash account upon
receiving credit memoranda from the bank. To the bank, however, a company's checking account
balance is a liability rather than an asset. Therefore, from .the bank's perspective, the terms debit and
-credit are correctly applied to the memoranda.

Unlike deposits in transit or outstanding cheques, which are already recorded in the company's
books, automatic withdrawals and deposits are often brought to the company's attention for the first
time when the bank statement is received. On the bank reconciliation, add unrecorded automatic
deposits to the company's book balance, and subtract unrecorded automatic withdrawals,

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Interest earned

Banks often pay interest on checking account balances. Interest income reported on the bank
statement has usually not been accrued, by the company and, therefore, must be added to the
company's book balance on the bank reconciliation,

Bank service charges

Banks often require customers to pay monthly, account fees, check printing fees, safe-deposit box
rental fees, and other fees. Unrecorded service charges Must be subtracted from the company's book
balance on the bank reconciliation.

NSF (not sufficient funds) cheques

A check previously recorded as part of a deposit may bounce because there are not sufficient funds
in the issuer's checking account. When this happens, the bank returns the check to the depositor and
deducts the check amount from the depositor's account .Therefore; NSF cheques must be subtracted
from the company's book balance on the bank reconciliation.

Errors

Companies and banks sometimes make errors. Therefore, each transaction on the bank statement
should be double-checked. If the bank incorrectly recorded a transaction, the bank must be
contacted, and the bank-balance must be adjusted on the bank reconciliation. If the company
incorrectly recorded a transaction, the book balance must be adjusted on the bank reconciliation and
a correcting entry must be journalized and posted to the general ledger.

When all differences between the ending bank statement balance and book balance have been
identified and entered on the bank reconciliation, the adjusted bank balance and adjusted book
balance are identical,

CAUSES FOR DIFFERENCE BETWEEN THE BALANCE AS PER CASH BOOK AND
THE BALANCE AS PER BANK STATEMENT

The balance shown by the bank statement should agree with the bank balance shown by the Cash
Book.

However, often there is a difference even if there is no mistake. The difference is due to the
following reasons:-

1. Cheques received are entered in the Cash Book as soon as they are received. .

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2. There may be a delay of a day or two in sending the cheque to the bank. Moreover, the bank
usually, does not credit the customer until the cheque is realized; if they are on other banks, it
means delay.
3. In the meantime, therefore, the Cash Book will show more balance than what the bank shows
in its Own books.
4. As soon as cheques are issued, they are entered in the Cash Book, but the bank, again, makes
no entry until the cheques are actually presented for payment and are paid.
5. This means that the bank shows a higher balance in favor of the client than what the Cash
Book of the client shows.
6. The bank often makes charges for services it renders; these are known as bank charges.
7. 'If there is an overdraft, the bank will also- charge interest. These bank charges and interest
are entered in the Pass Book and the entry is'-generally made in-the Cash Book only when,
the Pass Book is received. -
8. The bank is often entrusted with the task of collecting interest on securities or dividends on
shares or even the collection of amounts due on bills of exchange or promissory notes.
9. The bank will credit the customer as soon as the amounts are received but the entry by the
customer in the Cash Book must await receipt of information by the customer.
10. The bank may also make payments. According to the standing instructions of the client or in
respect of 'any special instruction such as on presentation of documents for supply of goods
for which a letter of credit has been opened previously.

Entries in the Cash Book in such cases are made on receipt of advice from the bank.

FORMAT 1

Bank Reconciliation Statement as at 31/12

Sh. Sh.
Balance at bank as per cashbook (updated) xx
Add: un presented cheques xx
Errors on bank Statement (see note 1) xx xx
xx
Less: Uncredited deposits xx
Errors on Bank Statement (see note 2) xx xx
Balance at bank as per Balance Sheet xx

Note 1: These types of errors will have an effect of increasing the balance at bank e.g. an overstated
deposit or an understated payment by the bank.
Note 2: These types of errors will have an effect of decreasing the balance at bank e.g. an
understated deposit ui an overstated payment by the bank, or making an unknown payment..

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FORMAT 2

Bank Reconciliation Statement as at 31/12

Sh. Sh.
Balance at bank as per bank statement xx
Add: Uncredited deposits xx
Errors on bank statement (note 2) xx xx
xx
Less: Unpresented cheques xx
Errors on bank statement (note I ) xx xx
Balance at bank as per cashbook (updated) xx

Illustration

On 10 January 2006, Joseph Kahiga, a sole trader, received his monthly bank statement for
December 2005.

The statement showed the following:

Date Particulars Debit Credit Balance

2005 Sh. Sh. Sh.
Dec 1 Balance 186,200
5 Cheque No.417864 (Electricity) 24,300 161,900
5 Dividend 2,600 164,500
5 Local cheque deposit (Solomon Otieno) 21,200 185,700
8 Cheque No.417866 (Jemima Nyarnbura) 17,400 16&,300
10 Cheque No.4 17867 (Young Traders) 1.700 166,600
13 Miscellaneous credit (Kevin Kagai) 18,500 185,100
14 Standing order 3,200 181,900
20 Cheque No.417865 (Janet Aoko) 30,700 151,200
20 Local cheque deposit (Donald Korir) 11,800 163,000
21 Cheque No.417868 (David Okoth) 9,500 153,500
21 Cheque No.417870 (Rent) 16,100 137,400
24 Bank charges 1,800 135,600
27 Local cheque deposit (Joy Nduta) 4,700 140,300
28 Direct debit 8,800 131,500
29 Cheque No.417873 (Daniel Wambua) 1,200 130,300
29 Local cheque deposit (Joseph Ondieki) 27,900 158,200
3 Cheque No.417871 (Moses Siringi) 2,500 155,700

Joseph Kahiga's cashbook for the month of December 2005 was as follows:

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CASH BOOK
2005 Sh. 2005 Cheque No. Sh.
Dec 1 Balance b/d 186,200 Dec 1 Electricity 417864 24,300
4 Solomon Otieno 21,200 2 Janet Aoko 417865 30,700
9 Kevin kagai 18,500 5 Jemimah Nyambura 417866 17,400
19 Donald Korir 11,800 6 Young Traders 417867 1,700
24 Joy Nduta 4,700 10 David Okoth 417868 9,500
27 Joseph Ondieki 27,900 14 Victor Karanja 417869 7,100
29 Owen Ndumbi 9,800 16 Rent 417870 16,100
30 Walter Oyugi 13,400 20 Moses Siringi 417871 2,500
21 Steve Maithya 417872 3,700
22 Daniel Wambua 417873 1,200
______ 31 Bal 179,300
293,500 293,500

Required:

i) Joseph Kahiga 's updated cash book. as at 31 December 2005.

ii) Joseph Kahiga's bank reconciliation statement as at 31 December 2005.

John Kahiga
Updated Cash Book as at 31 December 2005
Sh '000' Sh '000'
Balance b/d 179,300 Standing order 3,200
Dividend 2,600 Bank charges 1.800
______ Direct debit 8,800
181,900 Bal. c/d 168,100
181,900
Balance reconciliation statement as at 31 december 2005

Sh. Sh.
Balance as per cashbook (updated) 168,000
Add: un presented cheques:
Victor Karanja No.417869
7,100
Steve Maithya No.417872
3,700 10,800
178,900
Less: Uncredited cheques:
Owen Ndubi 9,800
Walter Oyugi 13,400 23,200
Balance at bank as per bank statement 155,700

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Illustration

Mwambi, a sole trader received his bank statement for the month of June 2001. At that ,date the
bank balance was. Sh.706,500 whereas his cash book balance was Sh.2,366,500. His accountant
investigated the matter and discovered the following discrepancies:

1. Bank charges of Sh.3, 000 had not been entered in the cashbook.
2. Cheques drawn by Mwambi totaling Sh.22,500 had not yet been presented to the bank
3. He had not entered receipts of Sh.26,500 in his cashbook.
4. The bank had not credited Mr. Mwambi with receipts of Sh.98, 500 paid into the bank on 30
June 2001.
5. Standing order payments amounting to Sh.62, 000 had not been entered into the cashbook,
6. In the cash book Mwambi had entered a payment' of Sh.74, 900 as Sh.79400.
7. A cheque for Sh. 15,000 from a debtor had been returned by the bank marked "refer to
drawer" but had not been written back into the cashbook.
8. Mwambi had brought forward the opening cash balance of Sh.329„250 as a debit balance
instead of a credit balance. . .
9. An old cheque payment amounting to S11.44, 000 had been written back in the cashbook but
the bank had already honoured it.
10. Some of Mwarphi's customers had agreed to settle their debts by paying directly into his bank
account. Unfortunately, the bank had credited some deposits amounting to Sh.832, 500 to
another customer's account. However, acting on information from his customers, Mwambi
had actually entered the expected receipts from the debtors in his cashbook.

Required:

i. A statement showing Mwambi's adjusted cash book balance as at 30 June 2001.

ii. A bank reconciliation statement as at 30 June 2001.

Solution

i.

Adjusted Cash book

Sh '000' Sh '000'
Balance b/d 2,366,500 Bank charges 3,000
Receipts 26,500 Standing order 62,000
Overcast in payment 4,500 Overcast in opening bal. 658,500
Dishonoured cheque 15,000
Cheque paid by bank 44,000
________ Balance c/d 1 615 000
2,397,500 2,397,500

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ii.

Bank reconciliation statement

Bank statement as at 30 June 2001
Sh.
Balance as per cashbook 1,615,000
Add:
Unpresented cheques 22.500
1,637,500
Less: Uncredited cheques (98,500)
Error (832,500)
Sal as per bank statement 706.500

CASH IN HAND - CASH BOOK AND PETTY CASH BOOKS

Cash in hand

These are funds that are immediately available to a business, and can be spent as needed, as opposed
to assets that must be sold to generate cash. The amount of cash on hand determines what projects a
company can undertake, or what financial hardships can be absorbed, without going into debt or
arranging other financing.

The cash in hand will be accounted for in the cash book and the petty cashbook.

LIABILITIES

BANK OVERDRAFT

CASH BOOK AND BANK RECONCILIATION STATEMENT

An overdraft occurs when money is withdrawn from a bank account and the available balance goes
below zero. In this situation the account is said to be "overdrawn". If there is a prior agreement with
the account provider for an overdraft, and the amount overdrawn is within the authorized overdraft
limit, then interest is normally charged at the agreed rate. If the negative balance exceeds the agreed
terms, then additional fees may be charged and higher interest rates may apply.

Reasons for overdraft

Overdrafts occur for a variety of reasons. These may include:

• Intentional short-term loan - The account holder may find. himself short of money and
knowingly makes an insufficient-funds debit. They accept the associated fees and Cover the
overdraft with their next deposit.

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• Failure to maintain an accurate account register - The account holder doesn't accurately
account for activity on their account and overspends through negligence.
• ATM overdraft - Banks or ATMs may allow cash withdrawals despite insufficient
availability of funds. The account holder may or may not be aware of this fact at the time of
the withdrawal. If the ATM is unable to communicate with the cardholder's hank, it may
automatically authorize a withdrawal based on limits preset by the authorizing network.
• Temporary Deposit Hold - A deposit made to the account can be placed on hold by the bank.
The funds may not be immediately available and lead to overdraft fees.
• Unexpected electronic withdrawals - At some point in the past the account holder may have
authorized electronic withdrawals by a business. This could occur in good faith of both parties
if the electronic withdrawal in question is made legally possible by terms of the contract, such
. as the initiation of a recurring service following a free trial period: The debit could also have
been made as a result of a wage garnishment, an offset claim for a taxing agency or a credit
account or overdraft with another account with the same bank, or a direct-deposit chargeback
in order to recover an overpayment.
• Authorization holds - When a customer makes a purchase using their debit card without
using their PIN, the transaction is treated as 'a credit transaction. The funds are placed on hold
in the customer's account reducing the customer's available balance. However the merchant
doesn't receive the funds until they procesS the transaction batch for the period during which
the customer's purchase was made. Banks do not hold these funds indefinitely, and so the bank
may release the hold before the merchant collects the funds thus making these funds available
again. if the customer spends these funds, then barring an interim deposit the account will
overdraw when the merchant collects for the original purchase.
• Bank fees - The bank charges a fee unexpected to the account holder, creating a negative
balance or leaving insufficient funds for a subsequent debit from the same account. .
• Playing the float - The account holder makes a debit while insufficient funds are present in
the account believing they will be able to deposit sufficient funds before the debit clears.
While many cases of playing the float are done with honest, intentions, the time involved in
cheques clearing and the difference in the processing of debits and credits are exploited by
those committing check kiting.
• Returned check deposit - The account holder deposits a check or money order and the
deposited item is returned due to non-sufficient funds, a closed account, or being discovered to
be counterfeit, stolen, altered, or forged: Asa result of the check chargeback and associated
fee, yin overdraft results or a subsequent debit which was reliant on such funds causes one.
This could he due to a deposited item that is known to be bad, or the customer could be a
victim of a had check or a counterfeit check scam. If the resulting overdraft is too large or
cannot be covered in a short period of time, the bank could sue or even press criminal charges.
• Intentional Fraud - An ATM deposit with misrepresented funds is made or a check or money
order known to be bad is deposited (see above) by the account holder, and enough money is
debited before the fraud is discovered to result in an. overdraft, once the chargeback is made.

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The fraud could be perpetrated against one's own account, another person's account, or an
account set up in another person's name by an identity thief.
• Bank Error - A check debit may post for an improper amount due to human or computer
error, so an amount much larger than the maker intended may be removed from the account.
Same bank errors can work to the account holder's detriment, but others could work to their
benefit.
• Victimization - The account may have been a target of identity theft. This could occur as the
result of demand-draft, ATM-card, or debit-card fraud, skimming, check forgery, an "account,
takeover," or phishing. The criminal act could cause an overdraft or cause a subsequent debit
to cause one. The money or cheques from an ATM-deposit could also have been stolen or the
envelope lost or stolen, in which case the victim is often denied a remedy.
• Intraday overdraft - A debit occurs in the customer's account resulting in an overdraft which
is then covered by a credit that posts to the account during the same business day. Whether
this actually results in overdraft fees depends on the deposit-account holder agreement of the
particular batik

Illustration

Lotus Ltd. operated two bank accounts with its banker, account number 1 and account number 2. As
at March 2004, the balances as per the bank statement and the cash book were as follows:

Account Balance as per bank Balance as per cash book

statement
Sh. Sh.
Number 1 323,600 (Cr) 34,000 (Dr)
Number 2 156,400 (Dr) 277,600 (Dr)

Investigations revealed the following:

1. Cheques lodged but not yet credited:

Sh
Account No. 1 80,000
Account No. 2 56,000

2. Cheque No.F30 I for .8,000 deposited into account No.2 was dishonored but it is has not been
reflected in the cash book.
3. A cheque No.M420 for Sh.8,800 paid direct into bank account No.1 has not been recorded in
the cash book
4. A cheque No.K341 for Sh.6,400 was deposited into account No.2 but ,this was wrongly
recorded in the cash book as Sh.8,000.

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5. A cheque No.A21 0 for Sh.29,200 paid out from account No.1 and recorded as such in the
cash book, was erroneously paid out 0 account NO.2 by the bank.
6. A cheque No.B308 for Sh.12,800 paid out from account NO.2 was erroneously entered in
account No.1 in the cash book.
7. A transfer of Sh.400,000 from account No.1 to account No.2 had been entered in the cash
book but the bank had not been instructed to effect the transfer.
8. A standing order payment of Sh.4.000 from account No.2 has not been recorded in the cash
book.
9. A cheque No.BJ48 for Sh.8,400 paid from account No.2 was incorrectly entered in the cash
book as Sh4,800.
10. Bank charges not yet entered in the cash book are Sh.1 ;200 for account No.1 and Sh.1 .600
for account No.2
11. A cheque No,D720 for Sh.80,000 received in respect of account No.2 and subsequently
credited to account N0,2 by the bank, was incorrectly entered in account No. 1 in the cash
book.
12. 18. A cheque No.H78J for Sh.7,200 received in respect of account No.2 was incorrectly
recorded in the cash book as Sh.6,800. •
13. There was an unpresented cheque of Sh2,400 in respect of account No.2.

Required:

i) Adjusted cash book for each of the two accounts

ii) Bank reconciliation statement for each of the IWO accounts, for the month of March 2004.

Solution
Updated Cash Book No. 1
Sh ‘000’ Sh ‘000’
Balance b/d 34,000 Bank 1,200
Direct credit 8,800 Cheque-error 80,000
Cheque No. B308 paid 12,800
Bal c/d 25.600 ______
81,200 81,200

Updated Cash Book No. 2

Sh ‘000’ Sh ‘000’
Balance b/d 277,600 Dishonoured cheque No. F301 8,000
Direct cheque No. D720 80,000 Cheque No. K341 overstated 1,600
Cheque No. H785 understated 400 Cheque No. B308 paid 12,800
Standing order 4,000
Cheque No. BJ48 understand 3,600
Bank charges 1,600
______ Balance c/d 326,400
358.000 358,000

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Bank Reconciliation statement No. 1

Sh. Sh.
Balance as per adjusted cashbook (25,600)
Add: Cheque No. A210 (error) 29,200
Transfer 400,000 429,200
403,600
Less: Uncredited cheques (80,000)
Balance as per bank statement 323,600

Bank Reconciliation statement No. 2

Sh. Sh.
Balance as per adjusted cashbook 326,400
Add: Unpresented cheque 2,400
328,800
Less: Cheque No. A210(error) 29,200
Transfer 400,000
Uncredited cheques 56,000 (485,200)
Balance as per bank statement 156,400

TRADE PAYABLES - CONTROL ACCOUNTS

Trade payables are also known as accounts payable and refers to money owed to creditors, lenders,
vendors or suppliers for products or services rendered. Payables are considered short-term if due
within 12 months whereas payables due longer than 12 months are considered long-term.

CONTROL ACCOUNTS

Control accounts are so called because they control a section of the ledgers. By control we mean that
the total on the control accounts should be the same as the totals on the ledger accounts.

Trade payables Control Account/ purchases ledger control accounts

The balance carried down (Balance c/d) on the purchases Ledger Control Account should be the
same as the total of the balances in the purchases ledger.

Purpose of Control Accounts

1. Provide for arithmetical check on the postings made in the individual accounts (either in the
sales ledger or purchases ledger.)

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2. To provide for a quick total of the balances to be shown in the trial balance as debtors and
creditors.
3. To detect and prevent errors and frauds in the customers and suppliers account.
4. To facilitate delegation of duties among the debtors and creditors clerks.

FORMAT OF A TRADE PAYABLES LEDGER CONTROL ACCOUNT

Sh. Sh.
Total debit balances from purchases ledger xxx Total credit balances of the purchases xxx
brought forward from previous period. ledger brought forward
Total cash paid to creditors ( from cash xxx Total credit purchases for the period (from xxx
book) purchases journal)
Total cheques paid to creditors (from cash xxx Refunds from suppliers (from cashbook) xxx
book)
Total cash discount received (froth cash xxx Total debit balances (of the of the xxx
book) purchases Ledger carried forward)
Allowances by suppliers xxx
Sales Ledger contra xxx
Total returns outwards (from returns- xxx
outwards journal)
Total credit balance (to be derived after xxx __
posting entries)
xxx xxx

Transferring accounts

Examination questions on control accounts often involve transfers between sales and purchases
ledgers.

If an account in the sales ledger has a debit balance and is to be transferred to purchase ledger. we
credit sales ledger control and debit the purchase ledger control. Conversely, a credit balance being
transferred from purchase ledger to sales ledger requires an entry debiting sales ledger and crediting
purchase ledger.

The important features to remember are that the control account is a general ledger account and that
all entries therein are made on the same side as in the personal account.

Debits in the personal accounts are debited to the control account and credits in personal accounts
arc credited to the control account.

Thus a customer is debited for goods sold to him, so that all sales are debited to a sales ledger
control account.

Cash received from a customer is credited to him so that the-control account is likewise credited.

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The effect is that the control account takes the place in the General Ledger of the various accounts in
the Sales Ledger.

Illustration

XML Ltd, maintains control accounts in its business records. The balances and transactions relating
to the company's control accounts for the month of December 2014 are listed below:

Sh.
Balance at 1 December 2014:
Sales ledger 6,185,000 (debit)
52,500 (credit)
Purchases ledger 16,500 (debit)
4,285,000 (credit)
Transactions during December 2014:
Sales on credit 8,452,000
Purchases on credit 5,687,500
Returns inwards 203,500
Returns outwards 284,000
kills of Exchange payable 930,000
Bills of Exchange receivable 615,000
Cheques received from customers 7,985,000
Cheques paid to suppliers 4,732,000
Cash paid to suppliers 88,500
Bill payable dishonoured 400,000
Charges on bill payable dishonoured 10,000
Cash received from credit customers 153,000
Bad debts written-off 64,500
Cash discounts allowed 302,000
Bill receivable dishonoured 88,500
Balances at 31 December 2014:
Sales ledger 44,000 (credit)
Purchases ledger 23,500 (debit)
Required:

Post the trade payables ledger control accounts for the month of December 2014 and deriVe the
respective: debit and credit closing balances on 31 December 2014.

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Solution

Trade payables Ledger Control Account

Trade payables Ledger Control Account

Sh '000' Sh '000'
Balance b/d 16,500 Balance b/d 4,285,000
Returns outwards 284,000 Credit purchases 5,687,500
Bills payable 930,000 Bills dishonoured 400,000
Cheques paid 4,732,000 Charges on bills dishonoured 10,000
Cash paid to supplier 88,500 Balance c/d 23,500
Bal c/d 4,355,000 _________
10.406.500 10.406.500

LOANS

ACCOUNTING TREATMENT OF REPAYMENT OF PRINCIPLE AND INTEREST

In finance, a loan is a debt evidenced by a note which specifies, among other things, the principal
amount, interest rate, and date of repayment. A loan entails the reallocation of the subject asset(s) for
a period or time, between the lender and the borrower. In a loan, the borrower initially receives or
borrows an amount of money, called the principal, from the lender, and is obligated to pay back or
repay an equal amount of money to the lender at a later time. Typically, the money is paid back in
regular instalments, or partial repayments; in an annuity, each instalment is the same amount.

The loan is generally provided at a cost, referred to as interest on the debt, which provides in
incentive for the lender to engage in the loan. In a legal loan, each of these obligations and
restrictions is enforced by contract, which can also place the borrower under additional restrictions
known as loan covenants. Although this article focuses on monetary loans, in practice any material
object might be lent.

Acting as a provider of loans is one of the principal tasks for financial institutions. For other
institutions, issuing of debt contracts such as bonds is a typical source of funding.

Accounting treatment for loans

Do not report loans as expenditures - regardless of the fund type used. Likewise, do not report the
repayment of loans as revenues. Instead, report both as balance sheet transactions. If an objective
was to present information on loans provided and principal recovered, a proprietary fund type is
desirable because of the cash flow statement. When reporting noncurrent loans receivable in the
general revenue fund, the noncurrent portion is reported as non-spendable fund balance. It is not
appropriate to classify the noncurrent portion to deferred revenues. In other governmental funds,
report noncurrent loans receivable as restricted, committed or assigned fund balance, as appropriate.

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PREPAID INCOMES AND ACCRUED EXPENSES

Prepaid income

Prepaid Income is an accounting concept that refers to a payment that has been received, but the
asset has not yet been fully delivered. The company receives a one-off payment for the asset, but
delivers its full value either in the future or over time. Prepaid Income is found on the statement of
financial position of a company as a liability (as it is something which is owed), either with its own
section or under Other Current Liabilities.

Illustration

A firm lets out part of its properties and receives rent of Sh. 2,000 per month, assuming that this is
the first year of renting and rent is received in arrears (rent for January is received early Feb). The
ledger accounts of the firm will be as follows:.

Cashbook
Year 1 Sh.
Feb (rent for January) 2,000
Mar (rent for February) 2,000
April (rent for March) 2,000
May (rent for April) 2,000
June (rent for May) 2,000
July (rent for June) 2,000
Aug (rent for July) 2,000
Sept (rent for August) 2,000
Oct (rent for September) 2,000
Nov (rent for October) 2,000
Dec (rent for November) 2,000
22,000

Rent – Income
Year 1 sh. Year 1 sh.
Jan Cash book 2,000
Feb Cash book 2,000
Mar Cash book 2,000
April Cash book 2,000
May Cash book 2,000
Jun Cash book 2,000
July Cash book 2,000
Aug Cash book 2,000
Sept Cash book 2,000
Oct Cash book 2,000
Nov Cash book 2,000
31/12 P&L 24,000 Dec Accrued c/d 2,000
24,000 24,000

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Although the cashbook is showing that rent received amounts Sh. 22,000, the full rental income of
Sh24, 000 will be reported in the Profit & Loss a/c as rent income and the accrued rent for Dec of
5h2, 000 will be reported in the balance sheet as a current asset.

Illustration

A firm receives rent income of Sh. 5,000 per month payable quarterly in advance. Assuming that the
firm's rental income began in 1st March and the financial year, end is on 31" Dec. The ledger
accounts will be:

Cash Book
Year 1 Sh ‘000’ Year 1 Sh ‘000’
1/3 Rent 15,000
1/6 Rent 15,000
1/9 Rent 15,000
1/12 Rent 15,000

Rent - Income
Year 1 sh. Year 1 sh.
1/3 Cash book 15,000
1/6 Cash book 15,000
P&L 50,000 1/9 Cash book 15,000
31/12 Bal c/d 10,000 1/12 Cash book 15,000
60,000 60,000

Rent for the four quarters of 12 months has been received as per the cashbook but because the end of
the financial year is at 31 Dec, rent for 2 months is pre-paid. This sh. 10,000 is not charged in the
P&L. but is carried forward as current liability in the balance sheet,

Accrued expenses

Money spent or cost incurred in an organization's efforts to generate revenue, representing the cost
of doing business.

Expenses may be in the form of actual cash payments (such as wages and salaries), a computed
expired portion (depreciation) of an asset, or an amount taken out of earnings (such as had debts). .
Expenses are summarized and charged in the income statement as deductions from the income
before assessing income tax. Whereas all expenses are costs, not all costs (such as those incurred in
acquisition of income generating assets) are expenses.

Most expenses are recorded during the accounting period at the time they are paid. However, when a
period ends there may be a few expenses that have been incurred but not paid and recorded becaus,
payment is not due.

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These unpaid and unrecorded expenses for which payment is not due are called accrued expenses.
Similar terms are amounts due, unpaid and outstanding. Examples of accrued expenses are accrued
wages and accrued rental expenses.

Illustration

a) The following cash book was extracted from the books of Fwamba Enterprises as at 31 December
2004.

Cash Book
Sh ‘000’ Sh ‘000’
Balance b/d 100,000 Purchases 300,000
Sales 500,000 Rent and rates 65,000
Commission 10,000 Insurance 32,000
Salaries and wages 150,000
______ Balance 63,000
610,000 610,000

The following additional information is available:

i. On July 1 2004 insurance amounting to Sh 15,000 had been paid for 12 months ending 30
June 2005.
ii. Commission earned but not yet received as at 31 December 2004 was Sh5.000.
iii. On 1 January 2004:
• Rent amounting to Sh13,000 was owing
• Rates totaling to Sh4,500 had been paid in advance.
iv. December 2003 salaries of Sh30,000 were paid on 5 January 2005 and wages amounting
to Sh35,000 had been paid
v. On 31 December 2004, rent outstanding amounted to Sh 16,000 and rates paid in advance
were Sh2,500

Required:
i) Insurance account.
ii) Rent and rates account.
iii) Salaries and wages account.

Insurance a/c
Sh ‘000’ Sh ‘000’
Bank 32,000 P&L 24,500
_____ Balance 7,500
32,000 32,000

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Rent and rates a/c

Sh ‘000’ Sh ‘000’
Balance 4,500 Balance b/d 13,000
Bank 65,000 P&L 70,000
Balance c/d 16,000 Balance c/d 2,500
85,500 85,500

Salaries and wages a/c

Sh ‘000’ Sh ‘000’
Bank 65,000 Balance b/d 30,000
P&L 85,000
______ Balance c/d 35,000
150,000 150,000

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REVISION EXERCISE

QUESTION 1

a) Citing an example in each case, briefly explain four types of bookkeeping errors which are not
disclosed by a trial balance
b) The trial balance extracted from the books of Benard Masita as at 30 September 2010 failed to
agree. The debit difference of Sh. 442,000 was posted to a suspense account. An income
statement was prepared which showed a gross profit and a net profit of Sh. 1,985,000 and Sh.
1,229,000 respectively. Upon investigations, the following errors were discovered:
1. A purchase of Sh 150,000 on credit was correctly posted to the suppliers account but was
completely omitted from the purchases day book.
2. Sales amounting to Sh. 250,000 to Samuel Njuguna were erroneously credited to his account.
The sales account had been correctly posted.
3. Salaries paid for the month of September 2010 amounting to Sh. 230,000 were recorded in
the salaries account as Sh 320,000.
4. Purchases of office stationery for Sh. 125,000 were erroneously debited to purchases account.
5. A payment of Sh. 45,000 to Daniel Olunya, a creditor, was erroneously debited to the account
of Alois Olunya, another creditor.
6. An entry of Sh. 21,000 for returns outwards was made in error in the sales day book instead
of in the purchases return day book.
7. A bad debt of Sh 22,500 is yet to be written off.
8. Goods valued at Sh .220,000 were taken for personal use but no entry had been made in the
books.
9. A discount received of Sh. 59,000 was correctly entered in the cashbook but posted to the
discounts allowed account.

Required:

i. A fully balanced suspense account.

ii. Statement of corrected gross profit.
iii. Statement of corrected net profit.

Solution:

a) A bank reconciliation explains the difference between balance at the bank as per cashbook and
balance at bank as per the bank statement.

The function is:

i. To update the cashbook with transactions that have gone through the bank e.g. bank charges.
ii. To check and correct any errors in the cashbook.
iii. To detect and prevent any frauds that relate to the cashbook and bank transactions.

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b)
Cashbook
Shs '000' Shs '000'
Balance b/d 2,366,500 Bank charges 3,000
Receipts 26,500 Standing order 62,000
Overcast in payment 4,500 Overcast in opening bal. 658,500
Dishonoured cheque 15,000
Cheque paid by bank 44,000
________ Balance c/d 1,615,000
2,397,500 2,397,500
Bank statement as at 30 June 2001

Shs
Balance as per cashbook 1,615,000
Add:
Unpresented cheques 22,500
1,637,500
Less: Uncredited cheques (98,500)
Error (832,500)
Bal as per bank statement 706,500

QUESTION 2
Ben Mogaka prepared the following draft balance sheet for BM Enterprises as at 31 December 2005:

Cost Accumulated Net book

depreciation value
Non-current assets Sh. Sh. Sh.
Equipment 450,000 220,000 230,000
Furniture 300,000 150,000 150,000
Motor vehicles 600.000 300.000 300,000
1.350.000 670.000 680,000
Current Assets:
Inventory 122,800
Accounts receivable 19,690
Deposit account 50,000
Suspense account 9 000 201.400
881,400
Financed by:
Capital 652,000
Net profit 153,200
Drawings (13,200) 792,000
Current liabilities:
Accounts payable 81,400
Bank overdraft 8,000 89,400
881,400

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Additional information:

On further investigation, the suspense account was discovered to have resulted from the following
errors:

1. The sales of goods on credit to Alex Otis amounting to Sh.19,000 had been recorded in
the sales journal as sh.9,000.
2. A receipt of Sh.20,000 from sale of an item of equipment had been credited to sales
account.
The equipment was shown in the books of account at costs of account of Sh.90,000 and
accumulated depreciation of Sh.72,000.
3. A credit note from a supplier, Simon Masound for Sh.15,000 had been omitted from the
books.
4. A bank overdraft for Sh.7,000 reflected in the cash book as at 31 December 2005 was
omitted In the trial balance.
5. A payment of Sh. 9,700 to Tom Wambugu, a creditor, was correctly entered in the cabs
book but posted to his personal account as Sh.7,900.
6. The debit side of rent expense account had been undercast by Sh.1,000.
7. A provision of Sh.2,000 for sundry expenses outstanding as at 31 December 2004 and
debited to sundry expenses at that dated had not been brought forward to the credit of the
account in the following period. No credit entry had been made in any other account in
respect to this account in respect to this item.
8. Discount received from the supplier of Sh.8,200 had been entered on the wrong side of
purchases ledger control account.
9. On 31 December, goods valued at Sh.9,600 (selling price) were returned by Jane Kerubo
(a debtor). No entry had been made in the books to reflect this transaction. These goods
were not included in the closing stock.
10. Discounts allowed were overcast by Sh.1,200.

Required:
a) Journal entries to correct the above errors (Narration not required)
b) Suspense account.
c) Statement of corrected net profit for the year ended 31 December 2005
d) Corrected balance sheet as 31 December 2005.

Solution:

i)
Insurance a/c
Shs.000 Shs.000
Bank 32,000 P&L 24,000
_____ Balance c/d 7,500
32,000 32,000

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ii)
Commission receivable a/c
Shs.000 Shs.000
P&L 15,000 Bank 10,000
______ Balance c/d 5,000
15,000 15,000
iii)
Rent and rates a/c
Shs.000 Shs.000
Bank 65,000 P&L 78,500
Balance c/d 16,000 Balance c/d 2,500
81,000 81,000
iv)
Salaries and wages a/c
Shs.000 Shs.000
Bank 150,000 Balance b/d 30,000
P&L 85,000
______ Balance c/d 35,000
150,000 150,000

QUESTION 3

On 1st January 2006 the following balances were extracted from the books of Nairobi Hotel.

Repairs Sh 27,700 Dr.

Insurance Sh 30,700 Dr
During the year ended 31st December 2006, the following transactions took place.
i. Paid for repairs Sh 100,000
ii. Paid insurance Sh 96,000 covering twelve months ending 30th April 2007.
iii. Received a refund of Sh 10,000 from insurance for the period ended 31stDecember 2005.

Prepare

i. Repairs account
ii. Insurance account

Solution:

i)
Repairs a/c
Shs.000 Shs.000
Balance b/d 27,700
Bank 100,000 P&L 127,000
127,700 127,700

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 FINANCIAL ACCOUNTING

ii)
Insurance a/c
Shs.000 Shs.000
Balance b/d 30,700 P&L 94,000
Bank 96,000 Balance c/c 32,000
126,700 126,700

QUESTION 4

In a new business during the year ended 31 December 2007 the following debts are found to be bad
written - off on the dates shown

31 May VidIa Ksh 340,000

30 September Vukulu Ksh 463,000
30 November Vihenda Ksh 156,000

On 31 December 2008 the schedule of remaining accounts receivable totaling Ksh.14,420,000 is

examined and it decided to make an allowance for doubtful debts of Ksh410,000

Your are required to show

a) The bad debts account and the Provision for doubtful debts account
b) The charge to the income statement
c) The relevant extracts from the balance sheet as at 31' December 2007

Solution:

Bad debts a/c

2007 Shs.000 2007 Shs.000
May 31 Vidija 340 Dec 31 P and L 959
Sept 30 Vukulu 463
Nov 30 Vihenda 156 ___
959 959
Allowance for doubtful debts a/c
2007 Shs.000 2007 Shs.000
Dec 31 P and L 410

Profit and loss a/c (Extracts)

Sh '000'
Bad debts 959
Allowance for doubtful debts 410

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Balance sheet as at 31 December 2007 (Extracts)

Sh '000'
Accounts Receivable 14,420
Less allowance for doubtful debts (410)
14,010

QUESTION 5

A business had always made an allowance for doubtful debts at the rate of 4 % of debtors. On 1
January 2008 the amount for this brought forward from the previous year was Ksh.320,000
During the year to 31 December 2008 the bad debts written -off amounted to Ksh.680,000.
On 31 December 2008 the accounts receivable balance was sh. 16,800,000 and the usual allowance
for doubtful debts is to be made
You are to show;
a. The bad debts account for the year ended 3 1 December 2008
b. The allowance for doubtful debts account for the year
c. Extract from the income statement for the year
d. The relevant extract from the balance sheet as at December 2008

Solution:
a)
Bad debts a/c
2008 Shs.000 2008 Shs.000
Dec 31 various 680 Dec 31 680

b)
Provision for doubtful debts a/c
2008 Shs.000 2008 Shs.000
Dec 31P and L 672 Jan 31 P and L 320
___ Dec 31P and L 352
672 672

c)
Profit and loss a/c (Extracts)
Sh '000'
Bad debts 680
Allowance for doubtful debts 352
d)

Balance sheet (Extracts)

Sh '000' Sh '000'
Accounts Receivable 16,800
Less allowance for doubtful debts 672 ______
14,010

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QUESTION 6

a) Outline the extent to which a trial balance is an indicator of correct book-keeping by an entity.
b) After preparation of the trial balance or Bakari Brothers Enterprises as at 31 September 2005,
the firm's accountant has been provided with the following additional information for the
purpose of preparation of the final accounts:
1. Due to an oversight, discount has been allowed to a credit customer on the gross invoiced
amount of Sh.80,000 at the rate 10%. The firm should have used a rate if 6%.
2. Electricity accrued amounts to Sh.36,710 while insurance premiums of Sh. 22,450 have been
prepaid.
3. In October 2005, the employees of the firm received a general salary increase, backdated to 1
July 2005. Amounts totalling Sh.126,550 in salary arrears are payable to former employees
who left shortly before the salary award was announced and who have not yet been traced. It
has been decided that the salary packets will be opened and the cash banked until the ex-
employees are traced.
4. Wages due to casuals amounting to Sh. 464,120 for services rendered in the last week of
December 2005 were paid in January 2006 together with the salaries for the month of
December 2005 which amounted to Sh.301,700.
5. During the year, the exterior of the warehouse was repaired and repainted at a cost of
Sh.500,000. This amount was erroneously debited to office premises account. It is policy of
Bakari Brothers Enterprises to provide for depreciation on the closing balances of non-current
assets and this has already been done: The annual rate of depreciation on office premises is
2% calculated on the straight-line basis.
6. In December 2005 2005, Bakari Brothers Enterprises had bought goods on credit from CB
Ltd. for Sh. 452,100 and has also sold goods on credit to the same company for Sh.163,040.
These amounts were correctly posted to their respective accounts. However, these accounts
are to be offset as at 31 December 2005 and the remaining balance settled by cheque in
January 2006.
7. The provision for discounts allowed to debtors, which at present has a balance of Sh.229,530
needs to be reduced to Sh. 157,400.
8. Debts totaling Sh.64,800 are irrecoverable and should be written off. However, amount of
Sh.21,440 written off as a bad debt in the previous year has now been recovered in full but
the cheque in settlement has not been banked or posted in the accounts.

Required:

Journal entries, including narrations, necessary to record the above transactions in the books of
Bakari Bothers Enterprises

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Solution:

a) A trial balance is a memoranda statement of credit and debit balances as they appear in the
ledges accounts. The double entry accounting method ensures that for every debit entry there is
a corresponding credit entry and vice versa. Therefore all items on the debit side of a trial
balance should be equal to the total items on the credit side. It therefore gives a prima facie
evidence that the process of bookkeeping has been correct.
b)

No Details Dr Cr
Sh Sh
1. Suspense a/c 2,000
Discount allowed a/c 2,000
(To correct discount allowed overstated)

2a). Electricity a/c 36,710

P&L a/c 36,710
(To record electricity due)

b) P & L a/c 22,450

Insurance a/c 22,450
(To record insurance prepaid)

3. Bank a/c 126,550

Cash a/c 126,550
(To record cash deposit)

4. Wages a/c 765,820

Bank a/c 765,820
(To record payment of wages)

5a). Repairs a/c 500,000

Office premises a/c 500,000

b) Provision for depreciation a/c 10,000

P & L a/c 10,000
(To correct depreciation overcharge)

6a) Creditors CB Ltd a/c 163,040

Debtor CB Ltd a/c 163,040
(To record offset accrual)

7. Provision discount allowed 72,130

P&L 72,130
(To record reduction in provision of discount allowed)

8a) Bad debts a/c 64,800

Debtors a/c 64,800
(To record bad debts)

bi) Debtors a/c 21,440

Bad debts recovered a/c 21,440
(To record creation of bad debts recovered)

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ii) Bank 21,440

Debtors 21,440
(To record cheque from debtor)

iii) Bad, debt recoverable 21,440

P&L 21,440
(To record bad debt recovered)

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TOPIC 4
CORRECTION OF ERRORS AND SUSPENSE ACCOUNT
TYPES OF ACCOUNTING ERRORS AND THEIR CORRECTION

A Trial Balance is said to be a statement of proof done arithmetically to prove that proper double
was observed in making accounting entries. The assumption is that the Trial balance totals will not
agree whenever there is an accounting error. There are several errors in fact which will not affect the
agreement of the trial balance totals. This means that there are two basic types of accounting errors:

 Errors which do not affect the Trial balance totals

 Errors which do affect the trial balance totals

The correction of all accounting errors must be journalized by way of the General Journal.

Errors which do not affect the Trial balance totals

1. Errors of Omission

This is an error that occurs when a transaction is completely omitted from the books of accounts. For
example if we bought a motor van Sh 90 000 cash and we neither debit the motor vehicle account
nor credit the cash account the trial balance would not be affected and it would still balance.

2. Errors of Principle

This occurs when we enter a transaction in the wrong class of account, but still observe double entry.
For example we purchase furniture (fixed asset) worth Sh 200 000 for cash. We debit purchases
account instead of debiting the furniture account and crediting the cash account. In such an instance
the trial balance would still balance.

3. Errors of Commission

These types of errors occur when the correct amount is entered but in the wrong persons personal
account though the account is in the same class of accounts. For example sales of Sh 20 000 sold to
D. Waithaka but posted to P. Waithaka‘s account in the sales ledger. The transaction would be as
follows.

Dr. P. Waithaka 20 000

Cr. Sales 20 000
The correct entry would have been

Dr. D Waithaka 20 000

Cr sales 20 000
To correct such an error, the following entry will be passed in the books.

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Dr. D. Waithaka 20 000

CR. D Waithaka 20 000

This is just a reversing transaction that transfers the amount from P. Waithaka to the correct account
of D Waithaka. You will note that the sales entry is no affected by the reversal and since both P.
Waithaka and D. Waithaka are in the sales ledger, the trial balance would still balance.

4. Compensating Errors

These are errors that cancel out each other e.g. an error that overstates booth the credits and the
debits or an error that understates both the debits and the credits by the same amount. E.g. if If the
purchases returns was overstated by shsSh2000 2000 and the sales return overstated by Sh 2000.
Since the purchases returns appear on the credit side and the sales returns appear on the debit side of
the trial balance, the two would cancel out each other.

To correct the above error

Dr. Purchases returns Sh 2 000
Cr. Sales returns Sh 2 000

Another example would be overstating purchases as well as sales by the same amount; overstating
both sides of a particular account by the same amount e.t.c.

5. Errors of Original Entry

These are errors that occur when the original figure is incorrect and yet double entry is still observed
using the incorrect figure. The figure could either be understated or overstated.

Example
Purchases worth shs20 000 recorded as Sh 200 000 in both the purchase account and the cash
account.

The incorrect entry would appear as follows

Dr. Purchases 200 000

Cr. Cash/ bank 200 000

The correct entry should have been

Dr. Purchases account 20 000
CR. Cash/bank 20 000
To correct the error, we make the following entries.
Dr. Cash at bank Sh 180 000
Cr. Purchases Sh 180 000
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6. Complete Reversal of Entries

This is an error that occurs when the correct amount is posted in the correct account but in the wrong
side of the account. For Example: if we sold goods on credit to D. Kameme worth Sh 100 000 the
wrong entry would appear as follows.

Dr. Sales 100 000

Cr. P. Kameme 100 000

The correct entry would have been

Dr P Kameme 200 000

Cr. Sales 200 000

Correcting the above error is done in two stages:

 Canceling the initial recording

 Recording the correct entry.

This is done as follows:

Dr P. Kameme 100 000

Cr. Sales 100 000

(To cancel the initial entry in the accounts)

Dr. P Kameme shsSh 100 000

Cr. Sales 100 000

(To Record the correct entry)

The accounts would appear as follows:

P. Kameme a/c

2016 Sh 2016 Sh
01/1 Sales (to cancel) 100000 01/1 Sales(to cancel) 100000
01/1 Sales (to enter correct entry) 100000

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Sales
Sh Sh
27/5 /5 P. Kameme a/c(to cancel) 100000
P. Kameme a/c(to enter 100000
correct entry)

7. Transposition errors
This is a special type of an error of original entry. It occurs when the wrong sequence of individual
characters in a figure is entered. Example For exampleentering, entering shsS870 h 870 as shsS h
780. itIt is an error that is very difficult to trace, however if it occurs only on one side of the entry
then the difference will be a number divisible by nine and hence easier to trace.

Illustration
Cash sales Sh 9 260 entered as Sh 6 290 on both cash book and sales ledger

The wrong entry would appear as follows.

Dr. Cash Sh 6 290
Cr. Sales Sh 6 290

The correct entry would have been

Dr. Cash Sh 9 260
Cr. Sales Sh 9 260
To correct the above entry
Dr. Cash (9260 - 6290) Sh 2 970
Cr. Sales (9260 - 6290) Sh 2 970

Exercise:
Show the journal entries required to correct the following errors. Entries; narratives must be shown.
1. Commissions received Sh 44 000 had been credited to rent receivable account
2. bank Bank charges Sh 3 850 had been debited to rent account
3. Completely omitted from the books of account is a payment of sundry expenses by cheque Sh
1 150
4. purchase Purchase of fixtures Sh 23 700 had been entered in purchases account
5. Return inwards of Sh 41 650 had been entered on the debit side of the return outwards
account
6. A loan from R. Simiyu shsSh 25 000 had 25 000 had been entered on the credit side of capital
account
7. Loan interest Sh 2 500 had been debited in the premises account

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8. Goods taken for own use shs1 250 had worth Sh 1 250 had been debited to purchases account
and credited to drawings account.

Suggested solution:
1) Dr Rent received account 44000
Cr. Commissions received 44000
(Correction of an error where commission received was credited to rent received)

2) Dr. bank charges a/c 3850

Cr. rent a/c 3850
(To correct wrong debit of bank charges in the rent account

3) Dr. Sundry expenses a/c 1150

Cr. Bank a/c 1150
(To record omitted payment of sundry expenses)

4) Dr. Fixtures 23700

Cr. Purchases a/c 23 700
(To correct error of principle where purchases of fixed assets is treated as purchase)

5) Dr. Return outwards 41 650

Cr. Return inwards 41 650
(To correct entry return inwards in the debit of return outwards a/c)

6) Dr Capital account 25 000

Cr. R. Simiyu a/c 25 000
(To correctly record loan received from R. Simiyu)

7) Dr. Loan interest a/c 2500

Cr. Premises a/c 2500
(To correctly record interest on loan)

8) Dr Drawings a/c (1250 x 2) 2500

Cr. Purchases a/c (1250x2) 2500
Note
We double the figures when correcting errors of complete reversal of entries like that in (8) above.
This is because if an amount was debited instead of being credited in the same account, a single
credit entry would just cancel the initial debit. However the second credit entry will now enter the
required credit entry. Instead of showing the two credit entries separately, the amount involved is
doubled and a single entry made but with a double value made.

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SUSPENSE ACCOUNT

Due to poor double entry or other errors not falling in the category described above, the trial balance
may fail to balance. In most cases the error causing this may take long to be identified. Before then
the accountant is allowed to open up an account known as the suspense account.
To this account, he assigns the balance equal to the difference between the credit and debit sides of
the trial balance to ensure that the trial balance balances. For example if the debit side exceeds the
credit side by Sh100 000, suspense account will be assigned a credit balance equal to Sh100 000
thus balancing the trial balance. Later on when the cause of the error is identified, journal entries are
passed against the suspense account till its balance is cleared thus eliminating it from the books.

Basically all errors affecting the balancing of the trial balance necessitate the creation of a suspense
account. A few of such are discussed below.

Failure to enter a corresponding entry for every debit or credit entry made

Making a wrong corresponding entry e.g. if cash sales of Sh 20 000 are made and a debit entry
correctly made in the cash book. However the sales account is credited with Sh2 000. This means
that the credit side of the trial balance will be understated by Sh 18 000. A suspense account will
thus be created and assigned accredit balance of Sh 18 000 to make the trial balance appear balanced
awaiting identification and correct of the error.
Once the error is identified then journal entries need to be passed to remove the suspense account as
follows:
Dr. Suspense account 18 000
Cr. Sales account 18 000
(To correct the error understating the credit balances of the trial balance)
Students are however cautioned that the suspense account should not be used to balance the trial
balance unless the examiner specifically asks the students to do so.

Illustration 1
Martin is an accountant at Zabiri Ltd. During the year ended 30 June 2014 he prepared a trial
balance which did not balance. He posted the difference to the suspense account. He then prepared
the financial statement for the year ended 30 June 2014. The net profit for the company was sh.
483,840.
Upon investigating the following errors were later discovered:
1. The total of purchases day book had been under cast by sh. 11,200,000
2. The total of the discount column on the debit side of the cash book amounting to sh.
2,240,000 had been posted to the credit of discount received amount.
3. Motor vehicles repairs amounting to sh. 8,512,000 had been posted to the motor vehicle
account.

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4. A cheque for sh. 4,368,000 received form Barnabas Bundi a debtor had been debited in the
cash book but no other entry had been made.
5. The returns outwards had been overcast by sh. 5,600,000.
Required:
(i) Journal entries to correct the errors
(ii) Suspense account
(iii) Statement of corrected net profit

Solution
a.
i. Journal entries
Journal Entries Dr. "000" Cr. "000"
Dr. Purchases 11,200
Cr. Suspense 11,200
(The total purchases had been understated error now
corrected).
Dr. Discount Received 2,240
Dr. Discount Allowed 2,240
Cr. Suspense 4,480
(Disc allowed posted in discount received, error now
corrected).
Dr. Motor Vehicle Repairs 8,512
Cr. Motor Vehicle 8,512
(Motor Vehicle repairs expense posted to Motor vehicle
account.
Dr. Suspense 4,368
Cr. Barnabas Debtor 4,368
(Receipt from debtor recorded in the ledge in error. Error of
omission now corrected).
Dr. Return outwards 5,600
Cr. Suspense 5,600
(To correct return outwards overcast).

ii. Suspense account

Suspense account
Shs '000' Shs '000'
Balance b/d 16,912 Purchases 11,200
Barnabas 4,368 Discount received 4,480
_____ Returns outwards 5,600
1,280 21,280

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iii. Statement of corrected profit

Statement of Corrected Net Profit

Shs '000'
Net profit before adjustment 483,840
Purchases under cast (11,200)
Discount received (2,240)
Discount allowed (2.240)
Motor vehicle expenses (8,512)
Return outwards (5,600)
454,048
Illustration 2
Ali Osman is a sole trader who operates a retail business. His balance sheet as at 30 April 2014 was
as follows:

Sh'000' Sh'000 Sh'000'

Capital and liabilities: Fixed assets:
Capital 420,000 Buildings 200,000
Add: Net profit for the year 105 000 Plant and machinery 150,000
Less: Drawings 525,000 350,000
(80,000) Current assets:
445,000 Stock 40,000
Current liabilities: Debtors 32,220
Sundry creditors Balance at bank 50,000
34,000 Cash in hand 4,540 126,760
______ Suspense account 2,249
479 000 479,900

Although the trial balance did not agree, the above balance sheet was prepared and a suspense
account opened to which the difference was posted. At a later date, an inspection of the books
revealed the following:
1. The salaries day book had been overcast by Sh.3,000,000.
2. A payment of Sh. 1,560,000 received from a debtor had been recorded in the cashbook but
had not been posted to the personal account.
3. A discount received Sh.150,000 had been posted to the wrong side of the personal account.
4. The stock book had been undercast by Sh.10,000,000 as at 30 April 2014.
5. Bank charges of Sh.850,000 had not been entered into the books.
6. A cash balance of Sh.500,000 had not been included in the trial balance.
7. An invoice for Sh.850,000 for private work commissioned by Ali Osman had been paid by
the business and posted to sundry expenses account.
Required:
a) Suspense account to clear the difference.
b) Statement showing the correct net profit or the year ended 30 April 2014

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a)
Suspense account
Sh. 000 Sh. 000
Bal b/d 2,240 Sales 3,000
Debtor 1,560 Cash 500
_____ Debtor 300
3,800 3.800

b) Statement showing the correct Net Profit

Sh.000 Sh.000
Profit as per the balance sheet 105,000
Add: Drawings 850
Stock undercast 10,000 10,850
Less: Sales overcast 3,000
Bank charges 850 (3,850)
Corrected Net Profit 112,090

Ali Osman
Adjusted Balance Sheet as at 30 April 2014
Sh.000 Sh.000
Non-Current assets
Buildings 200,000
Plant and machinery 150.000 350,000
Current assets
Stock (w I) 50,000
Debtors (w2) 30,660
Bank balance (w3) 49,150
Cash balance (w3) 5,040 134,850
484,850
Capital and Liabilities
Creditors (w4) 33,700
Capital account 420,000
Add adjusted profit 112,000
Drawings (w5) (80,850)
484,850

Workings:
1.
Adjusted a/c
Sh.000
Unadjusted balance 40 000
Add undercast 10 000
50 000

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2.
Debtor’s a/c
Shs '000' Shs '000'
Balance b/d 32,220 suspense 1,560
_____ Balance c/d 30,660
32,220 32,220

3.
Cash Book
Bank Cash Bank Cash
Sh '000' Sh '000' Sh '000' Sh '000'
Balance b/d 50,000 4,340 Bank charges 850 -
suspense ______ 500 Bal. c/d 49,150 5,040
50,000 5,0400 50,000 5,040

4.
Creditor’s a/c
Sh'000' Sh '000'
suspense 300 Balance b/d 34,000
Balance c/d 33,700 ______
34,000 34,000

5.
Drawings a/c
Sh.000
Cash 80 000
Expenses 850
80 850

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REVISION EXERCISE

QUESTION I
a. Citing an example in each case, briefly explain four types of bookkeeping errors which are not
disclosed by a trial balance
b. The trial balance extracted from the books of Benard Masita as at 30 September 2010 failed to
agree. The debit difference of Sh. 442,000 was posted to a suspense account. An income
statement was prepared which showed a gross profit and a net profit of Sh. 1,985,000 and Sh.
1,229,000 respectively. Upon investigations, the following errors were discovered:
1. A purchase of Sh 150,000 on credit was correctly posted to the suppliers account but was
completely omitted from the purchases day book.
2. Sales amounting to Sh. 250,000 to Samuel Njuguna were erroneously credited to his
account. The sales account had been correctly posted.
3. Salaries paid for the month of September 2010 amounting to Sh. 230,000 were recorded in
the salaries account as Sh 320,000.
4. Purchases of office stationery for Sh. 125,000 were erroneously debited to purchases
account.
5. A payment of Sh. 45,000 to Daniel Olunya, a creditor, was erroneously debited to the
account of Alois Ofunya, another creditor.
6. An entry of Sh. 21,000 for returns outwards was made in error in the sales day book
instead of in the purchases return day book.
7. A bad debt of Sh 22,500 is yet to be written off.
8. Goods valued at Sh '220,000 were taken for personal use but no entry had been made in the
books.
9. A discount received of Sh. 59,000 was correctly entered in the cashbook but posted to the
discounts allowed account.
Required:
i. A fully balanced suspense account.
ii. Statement of corrected gross profit.
iii. Statement of corrected net profit.

SOLUTION:

a) Four types of bookkeeping errors which are not disclosed by a trial balance

i) Error of Commission
This is an error in which the accountant records a transaction in the correct class of account, in the
correct side but in the wrong name of the account.
For example a gale of ponds on credit to Kenyani was recorded by debiting Kenyani's account.

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ii) Error of Principle

This is an error committed due to lack of accounting principles. That is, a transaction is recorded in
the wrong class of account, e.g. if a fixed asset such as motor van is debited to an expense account
such as motor vehicle expenses account.

iii) Error of Complete Reversal of Entries

This is where the correct accounts are used to record a transaction but each item is shown on the
wrong side of the account. For example, suppose we had paid a cheque to Ondieki for Shs 200, the
double entry of which is Cr. Bank Shs 200, Dr. Ondieki Shs 200, Dr. Bank Shs 200. The trial
balance totals will still agree.

iv) Compensating Errors

This is an error that occurs both on the debit side of an account and on the credit side of an account
and the figures are equal which cancel each other.
E.g Sales account was undercast by Shs 20,000 and Purchase ledger was undercast with Shs 20,000.
The net effect is neutral and the trial balance will still balance.

v) Error of original Entry

Where the original figure is incorrect, yet double entry is still observed using this incorrect figure.
An instance of this could be where there were sales of Shs 150 goods but an error is made in
calculating the sales invoice. If it were calculated as Shs 130 and Shs 130 and Shs 130 were credited
as sales and debited to the personal account of the customer, the trial balance would still "balance".

vi) Error of omission

Where a transaction is completely omitted from the books, the trial balance will still agree.

vii) Transposition Errors

Where the wrong sequence of the individual characters within a number was entered e.g. 385 instead
of 358 in the debit and credit entries, the trial balance would still agree.

b. Bernard Masita
i)
Suspense a/c
Sh. 000 Sh. 000
Bal b/d 442 000 Purchases 150 000
Salaries 90 000 Samuel Njuguna 500 000
Discount received 59 000
Discount allowed 59 000
_____ ______
650 000 650 000

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Statement of corrected gross Profit

Shs
Gross profit as per the books 1 985 000
Adjustments:
Drawings in form of goods 220 000
Purchases day book (150 000)
Purchases account 125 000
Returns outwards 21 000
Sales overturned by returns (21 000) 195 000
2 180 000

Statement of corrected net Profit

Shs
Net profit as per the accounts 1 229 000
Add:
Salaries account 90 000
Discount allowed (reversal) 59 000
Purchases reversed 59 000 208 000
Less:
Office stationery 125 000
Sales overturned by returns 22 500 (147 500)
1 289 500

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TOPIC 5
FINANCIAL STATEMENTS OF A SOLE TRADER

INTRODUCTION

A sole trader - also known as a sole proprietorship is a type of business entity which is owned and
run by one individual and where there' is no legal distinction between the owner and the business.

As a sole trader, your business is owned entirely by you, grown by you and ultimately succeeds or
fails by you. This also means you are entitled to all profit that the business makes.

Becoming a sole trader is simple. All you have to do is register your business name and you can start
trading.

There are huge incentives to becoming a sole trader but with them come terrifying or - depending on
your personality - gratifying, side effects.

Financial statements of a sole trader involve the following:-

 Income statement.
 Statement of financial position.

Trial balance provides the essential input for the preparation of these accounts or statements. These
accounts / statements provide necessary information to various interested groups e.g. shareholders,
investors, creditors, employees, management and government agencies etc. Therefore, these
financial statements are prepared to serve the information needs of these diverse groups to enable
them to make appropriate decisions.

THE INCOME STATEMENT

At the end of the year, every business must ascertain its net profit (or loss). This is done in two
stages:

1. Finding out the gross profit ( or gross loss)

2. Finding out the net profit ( or loss)

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DETERMINATION OF GROSS PROFIT (OR GROSS LOSS)

Gross profit is the difference between sale proceeds of a particular period and the cost of the goods
actually sold. Since gross profit means overall profit, no deduction of any sort, i.e. general,
administrative or selling and distribution expenses is made. Gross Profit is said to be made when the
Sale proceeds exceed the cost of goods sold. On the contrary, if the cost price of the goods is more
than the selling price, then we can say-that there is a loss.

The entries / items that will appear in an income statement to ascertain the gross profit or loss
will be;-

ITEMS TO BE DEBITED

I. Opening Stock:

It refers to the value of goods at hand at the end of the previous accounting year. Opening stock
means the stock of an item at the beginning of a new inventory-keeping period. It becomes the
opening stock for the current accounting year and contains the value of goods in which the business
deals.

2. Purchases:

It refers to the value of goods (in which the concern deals) which are purchased either on cash or on
credit for the purpose of resale. The balance of the purchase account, appearing in the Trial Balance,
reflects the total purchases made during the accounting period. While dealing with purchases, we
must bear in mind the following aspects:

a) Purchase of capital asset should not be added with the purchases. If it is already included in
purchases, it should be deducted immediately.
b) If goods are purchased for personal consumption and Lliey acc added with tne purchases,
they should be excluded. These types of purchases should be treated as drawings.
c) If some of the goods purchased are still in transit at the year-end, it is better to debit Stock-in-
transit Account and credit Cash or Supplier's Account.
d) If the amounts of purchases include goods received on consignment, on approval or on hire
purchase, these should be excluded from purchases.
e) Cost of goods sent on consignment must be deducted from the purchases in case of a trading
concern.

3. Purchases Returns/Returns Outwards:

It may come about that due to some reason; the goods are sent back to the supplier. In that case, the
supplier is debited in the book of accounts and purchases returns or returns outwards are credited. It
appears on the credit side in the Trial Balance. There are two ways of showing the purchases returns
in the income statement. It may be shown by way of deduction from purchases in the income

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statement. An alternative way is to show the purchases returns in the credit side of the income
statement.

4. Direct Expenses:

These types of expenses are incurred in connection with purchase, procurement or production of
goods. These expenses are directly related to the process of production. It also includes expenses
that bring the goods up to the point of sale.

ITEMS TO BE CREDITED

I. Sales

It refers to the sale of goods in which the business deals and includes both cash and credit sales. It
does not include sale of old, obsolete or depreciated assets, which were acquired for utilization in
business. However, goods sent to customers on approval basis, free samples and sales tax, if any,
included in the sales figure should be excluded.

2. Sales Returns / Returns Inward

When goods are returned by the buyers for some reason, it is called Sales Return or Returns Inward.
In the books of account, "Returns

Inwards Account" or "Sales Returns Account" is debited and buyer's account is credited.

It appears on the debit side of Trial Balance. We can show the sales returns in the Trading Account
in two ways. It may be shown by way of deduction from sales in the Trading Account. An
alternative way to show the sales returns is in the debit side of the Trading Account.

3. Abnormal Loss

It refers to the abnormal loss of stock due to fire, theft or accident. If any abnormal loss is there, it is
credited fully to the Trading Account because the Trading

Account is prepared under normal conditions of the business and has no place for abnormal
instances.

4. Closing Stock

It refers to the value of goods lying unsold at the end of any accounting year. This stock at the end is
called closing stock and is valued at either cost or market price, whichever is lower. The trial
balance generally does not include closing stock.

Therefore the following entry i ics-uidoti to ineuiporate the effect of closing stocx in the income
statement;

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To Closing Stock A/c Dr

To income statement A/c Cr
However, if closing stock forms a part of Trial Balance, it will not be transferred to

Income statement but taken only to the statement of financial position. In case of the goods that have
been dispatched to customers on approval basis, such goods should be included in the value of
closing stock.

Ascertaining the gross profit or loss

After recording the above items in the respective sides of the income statement, the balance is
calculated to ascertain Gross Profit or Gross Loss. If the total of, credit side is more than, that of the
debit side, the excess represents Gross Profit. Conversely, if the total of debit side is more than that
of the credit side, the excess represents Gross Loss.

TRADING ACCOUNT (HORIZONTAL FORMAT)

Sh Sh
Opening stock XX Sales XX
Purchases XX Less: Returns Inwards (XX)
Add: Carriage Inwards XX Net sales XX
XX
Less: Returns Outwards (XX)
Cost of stock available for sale XX
Less: Closing stock XX
Cost of sales XX
Gross Profit XX
XX XX

INTR TRADING ACCOUNT (VERTICAL FORMAT)

Sh Sh Sh
Sales XXX
Less: Returns Inwards (XX)
Net sales XX

Opening stock XX
Purchases XX
Add: Carriage Inwards XX
XX
Less: Returns Outwards XX
Cost of stock available for sale XX
Less: Closing stock (XX)
Cost of sales (XX)
Gross Profit XX

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Illustration

From the following details draw up the trading account of Mr.Karanja for the year ended 31

December 2010, which was his first year in business.

Sh. "000"
Carriage inwards 13,400
Returns outwards 9,900
Returns inwards 17,800
Sales 774,840
Purchases 666,660
Stock of goods: 31 December 2010 149,780

Mr.Karanja
Trading Account for the year ended 31 Dec 2010
Sh. "000" Sh. "000
Sales 774 840
Less: Returns Inwards 17 800
757 040
Less: Cost of sales
Purchases 666,660
Add: Carriage Inwards 13,400
Less: Returns Outwards (9,900)
Less: Closing stock (149,780)
Cost of sales (520,380)
Gross Profit 236 660

Illustration
The following details for the year ended 31 March 2010 arc available. Draw up the trading account
of B. Osongo for that year.
Sh. "000"
Stocks: 1 April 2009 16,523
Returns inwards 1,372
Returns 'outwards . 2,896
Purchases 53,397
Carriage inwards 1,122
Sal es 94,600
Stocks: 31 March 2010 14,323

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Solution
B. Osongo
Trading Account for the year ended 31 March 2010
Sh. "000" Sh. "000" $h. "000"
Sales 94,600
Less: Returns Inwards (1,372)
93,228
Less: Cost of sales
Opening Stock 16,523
Purchases 53,397
Add: Carriage Inwards 1 112
54,519
Less: Returns Outwards 2, 896 51.623
cost of goods available for sale 68, 146
Less: Closing stock (18,504) (49,642)
Gross Profit 43 586

DETERMINATION OF NET PROFIT (OR LOSS)

After ascertaining the gross profit, the subsequent step is to ascertain net profit or net loss during an
accounting period. Here the revenues and expenses of an accounting period are summarized to
reflect the alterations in various critical areas of the firm's operations. This step indicates how the
revenue (money received from the sale of products and services before expenses are withdrawn) is
transformed into the net income (the result after all revenues and expenses have been accounted for).
It displays the revenues recognised for a specific period and the cost and expenses charged against
these revenues, including write-offs (e.g. depreciation and amortization of various assets) and taxes.
The objective of the income statement is to explain to the managers and investors whether the
company made or lost money during the period being reported. As pointed out earlier, gross profit or
gross loss ascertained in first step, which becomes the starting point of the ascertainment of net
profit or loss. It takes into consideration all remaining indirect (normal and abnormal) expenses and
losses related to or incidental to business. These operating and non-operating expenses are charged
and shown to the debit side of the account. After transferring the Gross Profit or Gross Loss, the
sources of other incomes like commission or discount received are shown on the credit side. The
credit side also includes the non-trading income like interest on bank deposits or securities, dividend
on shares, rent of property let out, profit generated out of the sale of fixed assets, etc. On the debit
side will appear all other expenses that appear in the Trial Balance but cannot find a place in the
Trading Account. The debit side will also include the losses arising out of sale of assets and any
abnormal losses.

The net income is measured by matching revenues and expenses. Net income is the difference
between total revenues and total expenses.

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ITEMS TO BE DEBITED

 Management Expenses: These are the expenses incurred for carrying out the day-to-day
administration of a business. Expenses under this head include office salaries, office rent and
lighting, printing and stationery and telegrams, telephone charges etc.
 Selling and Distribution Expenses: These expenses are incurred for selling and distribution
of products and services, as the name indicates. They comprise of commissions and salaries
of salesmen, advertising expenses, packaging, bad debts etc.
 Maintenance Expenses: These expenses are incurred for maintaining the fixed assets of the
administrative office in a good condition. They include expenses towards repairs and
renewals.
 Financial Expenses: These expenses are incurred for arranging finances necessary for
running the business. These include interest on loans, discount on bills, brokerage and legal
expenses for raising loans etc.
 Abnormal Losses: Some abnormal losses may arise during the accounting period. All types
of abnormal losses are treated as unusual expenses and debited to Profit & Loss Account.
Examples are stock lost by fire but not covered by insurance, loss on sale of machinery, cash
defalcation etc.
 Wages and salaries earned by the worker- whether paid or otherwise- and rent, electricity,
telephone expenses are to be taken into consideration whether paid during the accounting
period or later.

To ascertain the amount of expenses to be debited to the income statement, four types of events are
essentially considered and then cash payment is made in connection with these events. They are as
under:

1. Expenses incurred and paid out in that year: If some particular expenditure is incurred in a
year and paid in the same year, the same will be debited to the income statement.
2. Expenses incurred but not paid out, partly or fully, during the current year: There are some
expenses, which are incurred in the current accounting period, but not paid for, partly or fully,
by the end of the period; they are called "Outstanding Expenses". These expenses become
liabilities of the business at the end of the accounting year. In fact, on the date of the final
accounts, outstanding expenses- in the form of both the expenses and a liability- exist without
having been recorded in the books of account. For recording it, the following entry is to be
passed:

Expenses A/c Dr. (will be shown in the income statement account A/c)

To Outstanding Expenses A /c (will appear in the liabilities side of statement of financial

position)

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3. Expenses paid for during the current year, but not incurred as yet, partly or fully: Sometimes,
it may happen that some expenses are paid during the current year, but are not incurred as yet,
partly or fully. Those expenses are known as "Prepaid Expenses".
Prepaid expense is an asset to the business and will be shown in the statement of financial
position. The adjustment entry to be passed is;-

Prepaid Expenses A/c Dr. (to be shown as asset in the statement of financial position)
To Expenses A/c (balance of this account to be debited to income statement A/c)
4. Expenses of the current year, likely to arise in subsequent period: Sometimes, an expenses or
a loss may arise in the future in connection with current years' business. In such a case, we
make a provision for the anticipated loss and a charge is created against the profit for the
current period. This provision is shown as either a liability or a contingent asset. i.e. it appears
in the statement of financial position as a deduction from some other asset. The best example
of this anticipated expense is Provision for bad debts.

ITEMS ON THE CREDIT SIDEOF THE INCOME STATEMENT

The Items that will appear in the credit side of income statement Account can be broadly classified
as under:

1. Gross Profit: This is the balance of the Trading Account transferred to the Profit & Loss
Account. If the Trading Account shows a gross loss, it will appear on the debit side.
2. Other Incomes: Sometimes a business might generate some profit, which is not due to the
sale of its goods or services, because the business may have some other source of financial
income. The examples are discount or commission received.
3. Non-trading Income: The business may have various transactions with the bank. At the end
of the year, the business may earn some amount of interest, which will find a place in the
Profit & Loss Account as non-trading income. The business may have some investment
outside the business in the form of shares, debentures or units. All sorts of gains obtained
from such kinds of investments are considered as non-trading income and are treated
accordingly.
4. Abnormal Gains: ['here may be capital gains arising during the course of the year, e.g. profit
arising out of sale of a fixed asset. The profit is shown as a separate income on the credit side
of the Profit & Loss Account. We must remember that all incomes from the abnormal gains
or other income should be credited to the Profit & Loss Account if they arise or accrue during
the period. Similarly, income received in advance should be deducted from the income.

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ASCERTAINING THE NET PROFIT & LOSS

Once the respective accounts are transferred from trial balance to income statement, gross
'profit/loss ascertained and all adjustments are taken care of, the income statement will now be
balanced. The totals of debit side and credit side are computed and the difference between these
totals is either a net profit or net loss. If the total of debit side exceeds the total of credit side, there is
a net loss, whereas when the total of credit side exceeds the total of debit side, there is a net profit.
Net Profit is the last item to be recorded on debit side; else, net loss is the last item on credit side.
After computing net profit/loss, the totals of two sides of income statement match.

The balance in the Profit and Loss Account represents the net profit or net loss. If the credit side is
more than the debit side, it shows the net profit. Alternatively, if the debit side is more than the
credit side, it shows net loss. When the Profit and Loss Account shows a net profit, we pass the
following entry:

Dr Profit & Loss A/c

Cr To Net Profit A/c
If the Profit and Loss Account shows a net loss, the entry will be reversed.

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 FINANCIAL ACCOUNTING

FORMAT

PROFIT AND LOSS ACCOUNT

It shows the net profit or net loss that the business has made from all the activities during a financial
period.

The net profit (or loss) is determined by deducting all the expenses from all the incomes of the same
financial period.

In practice, the trading account is combined together with the net profit and loss account into one
report so that the format is as shown below:

Name
Statement of financial position 31/Dec/2010
Sh. "000" Sh. "000" Sh. "000"
Sales XX
Less: Returns Inwards XX
XX
Less: Cost of sales
Opening stock XX
Purchases XX
Add: Carriage Inwards XX
XX
Less: Returns Outwards (XX)
Cost of goods available for sale XX
XX
Less: Closing stock (XX)
Cost of sales (XX)
Gross Profit XX
Discount received XX
Rent received XX
Interest received XX
Other incomes XX
Gross income XX
Less: Expenses
Carriage Outwards XX
Discounts allowed XX
Postage & stationary XX
Salaries & wages XX
Rent paid XX
Insurance & rates XX
Bank charges XX
Other expenses XX XX
Net profit/ (loss) XX

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Illustration

From the following trial balance of P Nyangweso draw up a trading , profit and loss account for the
year ended 30 September 2012, and a balance sheet as at that date.

Dr. Cr.
Sh. "000" Sh. "000"
Stock 1 October 19x8 23,680
Carriage outwards 2,000
Carriage inwards 3,100
Returns inwards 2,050
Returns outwards 3,220
Purchases 118,740
Sales 186.000
Salaries and wages 38,620
Rent 3,040
Insurance 780
Motor expenses 6,640
Office expenses 2,160
Lighting and heating expenses 1,660
General expenses 3,140
Premises 50,000
Motor vehicles 18,000
Fixtures and fittings 3,500
Debtors 38,960
Creditors 17,310
Cash at bank 4,820
Drawings 12,000
Capital 126,360
332 890 332 890

Solution

P. Nyangweso
Trading, Profit and Loss Account as at 30 September 2003
Sh. "000" Sh. "000" Sh. "000"
Sales 186,000
Less: Returns Inwards (2.050)
183,950
Less: Cost of sales
Opening stock 23,680
Purchases 118,740
Add: Carriage inwards 3,100
121,840
Less: Returns Outwards (3,220) 118,620
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Cost of goods available for sale 142,300.

Less: Closing stock (29,460) (112,840)
Gross Profit 71,110
Less Expenses
Salaries & wages 38,620
Carriage outwards 2,000
Rent 3,040
Insurance 780
Motor expenses 6,640
Office expenses 2,160
Lighting & heating 1,660
General expenses 3,140 (58,040)
Net Profit 13 070

ADJUSTMENTS MADE WHEN PREPARING THE INCOME STATEMENT

1. Bad Debts

In order to display high amount of sales figures, goods are frequently sold out to known customers
on credit. Some of these customers fail to pay their debts due to insolvency. These debts, which
cannot be recovered, are called Bad Debts. It is a loss to the business and an adjustment is needed.
The required entry will be:

Bad Debts A/c Dr

To sundry debtors A/c Cr
And then
Profit & Loss Account Dr
To Bad Debts A/c Cr
It should be noted here that no adjustment is required for any bad debt that already appears in the
Trial Balance. Bad debt appearing in the Trial Balance should be debited only to Profit & Loss
Account of the Period.

2. Provision for Bad Debts

Credit sales are recognised as income at the time of the sale without knowing the exact time of
collection. In the course of time, loss may result from unsuccessful attempts to protect the dues from
the customers. Every organisation creates a provision for this anticipated loss, from the reported
income of the credit sales in the current period.

There are different methods of creating provision for bad debts. However, we will discuss only one
method here. Accounting entry will depend upon the situation as to whether provision for bad debts
is or is not appearing in the Trial Balance.

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 FINANCIAL ACCOUNTING

Situation 1: When provision for Bad Debts not appearing in the Trial Balance: The accounting
entry will be:
Profit & Loss Account Dr.
To Provision for Bad Debts Account Cr
(To be shown in the Balance Sheet as a deduction for Debtors)

Situation 2: When provision for Bad Debts appearing in the Trial Balance:
At first, calculate the amount of provision to be created at the end of the period in the same way as
above. Now compare the provision with the provision appearing in the Trial Balance. There are two
resultant options:

a. If the new provision exceeds the provision appearing in the Trial Balance, pass the following
entry:
Profit & Loss Account Dr
To provision for Bad Debts Cr
b. If the new provision is less than the provision appearing in the Trial Balance, pass the following
entry:
Provision for Bad Debts Dr
To Profit & Loss Account Cr

Here, it should be noted that only new provision should be shown in the statement of financial
position as a deduction from Sundry Debtors.

3. Discount allowed on Debtors

Many business organizations offer to give a cash discount to all those debtors who arrange to make
their payment on or before the due date. It is clear that the real worth of debtors will be the gross
figure of debtors minus the cash discount that they would be given.

The figure of debtors should be accordingly adjusted.

The difficulty, however, is that nobody knows how many debtors will entertain cash discount and
what the amount will be. Therefore, all that is possible is to make a rough estimate. Usually, it is
made at a percentage of outstanding debtors who actually repay their obligation. Therefore, the
estimate amount of bad debt should be deducted from the total of debtors and provision for discount
on debtors should be made only on the balance.

Dr. Income statement Account

Cr To Provision for discount on Debtors Account
(To be shown in the statement of financial position by way of deduction from Sundry
debtors)
Example:

 Total Sundry Debtors as per Trial Balance shs. 40,600

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 Bad Debts after Trial Balance sh. 600

 Provision for debt to be created @ 5% on Sundry Debtors
 Provision for Discount on Sundry Debtors to be created @ 2%

Calculate the amount of Provision for Discount on Sundry Debtors.

Shs.
Debtors as per Trial Balance 40,600
Less: Bad debt written off (600)
40,000
Less: Provision for bad debt at 5% (2,000)
38 000

Provision for discount on Sundry Debtors will be: 2/100 x shs. 38,000= shs. 760.

4. Reserve for discount on Creditors

If goods are purchased on credit and cash is paid to creditors in time, creditors allow cash discount.
It is considered to be the income of the business. For this, following entries are passed:

(i) Creditors Account Dr.

To bank Account Cr
To Discount Account Cr
(ii)
Discount Received Account Dr.
To Profit & Loss Account Cr
At the end of the accounting year, we may expect certain discount out of such creditors. However,
that discount will be received in the next year though it is actually related to the current period. An
adjustment is requested for the expected discount from creditors that should be reflected in the
accounts at the year-end as follows:
Step 1

Calculate probable amount of discount to be received from creditors. Generally, it is calculated by

applying a percentage on outstanding creditors.

Step 2

Pass the following entry to record it:

Reserve for Discount on Creditors Account Dr. To income statement Account Cr

Step 3

Show this reserve for Discount on Creditors in the statement of financial position by way of
deduction from creditors.

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 FINANCIAL ACCOUNTING

In the next year, when the actual discount is received, the following entry is to be passed:

(i) Creditors Account Dr.

To Bank/ Cash Account

To Discount Received Account Cr.
(ii) Discount Received Account Dr. To Reserve for Discount on Creditors Account Cr.
Reserve for Discount on Creditors Account is bound to leave a balance. This should be adjusted
while creating similar reserve on creditors outstanding on the last date of the accounting year in
question. Note: In actual practice, no organisation makes any reserve for discount on creditors due to
the principle of conservatism.

5. Depreciation

According to Pickles, "Depreciation is the permanent and continuing diminution in the quality,
quantity or value of an asset". It is a measure of wearing out, consumption or other loss of values
Iota depreciable asset arising from use and passage of time. It is generally charged to such assets as
Plant & Machinery, Building, Furniture, Equipment, etc.

Initially, the cost of the assets including installation cost is debited to the particular assets. In each
accounting period, a portion of the cost expires and it needs adjustment for showing" correct profit
of the period and correct value of the assets.

Adjustment entries are:

(a) When assets account is maintained at written down value:

(i) Depreciation Account Dr.

To Assets Account Cr.
(Being depreciation charged)

(ii) Income statement Account Dr.

To Depreciation Account Cr.
(Being depreciation transferred to profit & Loss Account)

(b) When assets account is maintained at cost price:

(i) Depreciation Account Dr.

To Provision for Depreciation Account Cr
(Being depreciation Charged)

(ii) Profit & Loss Account Dr.

To Depreciation Account Cr
(Being depreciation transferred to profit & Loss Account)

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 FINANCIAL ACCOUNTING

Total accumulated depreciation is shown in the statement of financial position on the liabilities side.
Alternatively, it can be shown by way of deduction from the original cost of assets side.

Here, it should be noted that no adjustment is required for depreciation that already appears in the
Trial Balance. Depreciation that already appears in the Trial Balance should only be debited to
income statement Account.

6. Goods Distributed as Free samples:

This is one kind of advertisement. When goods are distributed to the prospective customers as free
samples, an expense is incurred (known as advertisement expense) and there is a usual reduction
from the stock of goods.

The following entry is passed:

Advertisement Account Dr.

To Purchase Account (For a trader) Cr
Or
To income statement Account (For a manufacturer)
At the year-end, transferring the entry to the income statement Account closes the
Advertisement Account:
Income statement Account Dr
To Advertisement Account Cr.

7. Income Tax
Income tax is not an expense to earn revenue. Therefore, when the profit is calculated, we cannot
deduct income tax from the profit and treat it as an expenditure of the business. For a sole proprietor,
income tax is payable by the owner and not by the business. Therefore, if income tax appears in the
Trial Balance, it should be treated as drawing and should be deducted from the capital. Following
are the entries to be passed:

(a) Income Tax Account Dr. (When Paid)

To Cash/ Bank Account Cr
(b) Drawing Account Dr.
To Income Tax Account Cr
However, for a registered partnership firm, income tax is payable by the business itself and not by
the owners. It generally appears as an appropriation of the net profits. The following entry is passed:
Profit and Loss Appropriation Account Dr.
To Income Tax Account Cr
8. Drawing Made by the Proprietors
Drawing made by the proprietor(s) may be in cash or in kind. Drawing relates to the resources of the
business and the capital of the owner(s).

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 FINANCIAL ACCOUNTING

Drawings made in Cash: In this case, following entries are passed:

(a) Drawings Account Dr.

To Cash/Bank Account Cr
(b) Capital Account Dr.
To Drawings Account Cr
Drawings made in kind: When some of the stocks are withdrawn from the business, the following
entries are passed:
(a) Drawings Account Dr.
To Purchases Account Cr.
(b) Capital Account Dr.
To Drawings Account Cr.
If the drawings made by the owner are incorporated in sales, we are to pass a reverse entry to cancel
the original entry. For the drawings, the above two entries are to be passed:

9. Mutual Indebtedness

Sometimes, a debtor may also be a creditor for the business. If finished goods are sold to X for
shs.100 and raw material is purchased from him for shs. 500', the name of X will appear both in the
debtors and creditors list. Generally, we set off these types of accounts.

We transfer the account that has a smaller balance to the account having a bigger balance and, in
effect, one account is closed. The following entry is passed (the amount will be the smaller of the
two figures):

Sundry Creditors Account Dr.shs .500

To Sundry Debtors Account shs . 500

10. Debtors arising out of Dishonour of Cheques or Bills

When a cheque previously received from a debtor is dishonoured, the old position of debtor and
creditor is restored between the buyer and the seller respectively. In this case, the Debtor Account is
debited and Bank Account is credited. In effect, the value of the sundry debtors increases and bank
balance decreases.

When a bill previously received from a debtor is dishonoured, the old position of debtor and creditor
is restored between the buyer and the seller respectively.

In this case, the Debtor Account is debited and Bank Account is credited. In effect, the value of the
sundry debtor's increases and one of the following is credited, depending on the manner in which it
has been previously dealt with:

Sundry Debtors Account Dr. (Dishonour of Bill)

To Bills Receivable Account (When the bill is retained)

To Bills for Collection Account (When the bill is sent to bank for collection)
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 FINANCIAL ACCOUNTING

To Bank Account (When the bill is discounted with banker)

To Endorsee Account (When the bill is endorsed)
If a provision for doubtful debts is to be created, it will be on the value of the sundry debtors after
making the above Adjustments.

11. Abnormal Loss of Stock by Accident e.g., by Fire

If a portion of the stock is lost, the value of such loss is first to be ascertained.
Therefore, Abnormal. Loss Account is to be debited and income statement Account is to be
credited.
Transferring balance to the •income statement Account closes abnormal loss account. Income
statement Account is to be debited and abnormal loss account is to be credited. if the above loss is
insured against risk, Insurance Claim. Account (or Insurance Company Account) is to be debited
and Abnormal Loss Account is to be credited. Until the money is received, Insurance Claim (or
Insurance Company Account) will find a place in the asset side of the Balance Sheet. When the
money is received, Bank Account is debited and the Insurance Claim

Account (Insurance Company Account) is credited. If the goods are partially insured, the portion not
covered by insurance is to be charged to income statement Account.

Journal entry to be passed is as follows:

(i) Accidental Loss Account Dr. (Actual loss of stock)

To Trading Account Cr
(ii) (a) Insurance Claim Account Dr. (Insurance claim admitted by the insurance Co)
Or

(b) Insurance Company Account Dr. (Insurance claim admitted by the insurance Co)

Income statement Account Dr. (Claim not admitted)

To Accidental Loss Account

12. Commission to the manager

Sometimes, the manager of a concern is given a percentage of the profit as commission. Since it is
an expense like salaries, we must account for it. The entry will be:

Income statement Account Dr

To Commission Account Cr.
If the amount is not paid within the accounting period, it will be shown in the liability side of the
Balance Sheet as commission payable.
A problem arises with the ascertainment of the amount payable as commission. The reason is that
commission may be paid at a certain percentage before or after charging such commission. If the
commission is paid before charging commission, calculation is very easy.

We simply multiply the rate with the profits.

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 FINANCIAL ACCOUNTING

13. Goods Sent on Approval Basis

When goods are sold to the customers on sale or return basis or on approval basis, it is not
considered as sale till the time it is not approved by the customer or till the expiry of a fixed period
as agreed by the parties. When goods are sold initially to a customer on approval basis, we pass the
entry for the sales. At the year-end, if the goods are still lying with the customers awaiting approval,
the following entries are to be passed:

i. To cancel previous entry

Sales Account Dr.
To Sundry Debtors Account Cr.
ii. To add the value of the closing stock (Cost of goods lying with the customer):

Stock Account Dr.

To income statement Cr

In the statement of financial position, it will be deducted from sundry debtors at sales price and the
closing stock will be increased by the cost of such sales.

14. Interest on Loan- Not yet Paid- Fully or partly

In the Trial Balance, the amount of the loan appears in the credit column. The amount of interest
paid appears on the debit column. However, if a portion of the interest is still outstanding at the year
end. We pass the following entry to make the adjustment:

Interest on Loan Account Dr

To Loan Account Cr
If nothing has been paid as interest, we are to find out the amount by applying the rate with the
amount of the loan and then pass the above entry. The total amount of unpaid interest will appear in
the Balance Sheet as liability.

Illustration
The following trial balance was extracted from the books of Masinzaji, a sole trader as at 31 August
2009
Sh. 000 Sh. 000
Plant machinery at cost 11,350 -
Provision for depreciation on plant and machinery - 4,150
Motor vehicles 13,290 7 -
Provision for depreciation on motor vehicles - 2,790
Goodwill 5,000 -
Quoted investments 6,470 -
Freehold premises at cost 32,000 -
Mortgage on premises - 10,000

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 FINANCIAL ACCOUNTING

Interest paid/received 1,000 460

Inventory 4,670 -
Bank and cash 2,850 -
Capital - 60,000
Drawings 5,600 -
Purchases/sales 34,260 58,640
Return inwards and outwards. 3260 2140
Carriage inwards 730 -
Carriage outwards 420
Discount allowed/received 1,480 1,970
Wages 7,180 -
Rates and rent 4,300 -
Allowance for bad debts - 530
Trade receivable/payable 8,070 4340
Electricity 2,640 -
Stationery 450 -
145,020 145,020

Required:
Additional information

1. Inventory as at 31 August was valued at sh. 3,690,000.

2. Allowance for bad debts is to be adjusted at 10% of debts.
3. Bad debts of sh. 370,000 had been posted to the ledger.
4. Goods which had cost sh. 300,000 had erroneously been invoiced to a customer for sh.
400,000 and had been accounted for as sales.
5. Electricity accrued as at 31 August 2009 was sh.130,000 and prepaid rates amounted to
sh.210,000
6. Stock of stationery as at 31" August 2009 was sh. 230,000.
7. Depreciation is to be provided on pro rata basis as follows.
i. Assets Rate per annum
ii. Motor vehicle 20% on reducing balance method
iii. Plant and machinery 25% on reducing balance method
8. A motor vehicle was sold on credit on 151 December 2008 for sh.458,000. The motor
vehicle had
a. Been bought on 1 June 2007 for sh. 1,000,000 the sale had not been recorded to the
ledger.
9. During the year Masinzaji took good worth 350,000 from the business for his own use.

Required:

Income statement for the year ended 31' August 2009

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Solution
a. Income statement
Masinzaji
Income statement for year ended 315' Aug. 2009
Sh.000 Sh.000
Sales 58,240
Return inwards (3,260)
Net sales 54,980
Cost of sales:
Opening inventory 4,670
Purchases 34,260
Return outwards (2,140)
Less: Drawings (350)
Goods available for sale 36,440
Carriage inwards 730
Closing inventory (3,690) (33480)
Gross profit 21,500
Incomes:
Discount received 1,970
Interest Received 460
Expenses
Stationery( w6) 220
Electricity (w4) 2,770
Loss on sale of vehicle (w3) 251
Increase in all of for doubtful debt (w1) 200
Rent and Rates (w5) 4,090
Wages 7,180
Discount allowed 1,480
Carriage outwards 420
Interest 1,000
Depreciation
Plant and machinery (w7) 1,800
Motor vehicle (w7) 1,958.2
Bad debt 370 (21,739.2)
2, 190.2

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 FINANCIAL ACCOUNTING

Workings:-

WI
Provision for bad and doubtful debts
10%x7,300,000=730,000
Provision for bad debts account
Sh.000 Sh.000
- Balance b/d 530
Balance c/d 730 Income statement 200
730 730
W2

Motor vehicle depreciation

First period of 3 months 20%x 1,000,000 x3/12) 50,000

Second period full year 20 %( 1,000,000-50,000) 190,000
Third period 20 %( 1,000,000-50,000-190,000) 51 000
Cumulative depreciation 291,000

W3
Disposal of motor vehicle account
Sh.000 Sh.000
Motor vehicle 1 000 Provision for depreciation 291
Bank 458
Income statement 251
1, 000 1, 000
W4
Electricity Account
Sh.000 Sh.000
Cash 2, 640 Income statement 2, 770
Balance c/d 130
2, 770 2, 770
W5
Rent and rates Account
Sh.000 Sh.000
Cash 4,300 Income statement 4,090
Balance c/d 210
4,300 4,300

W6
Sh”000”
Stationery 450
Closing stock (230)
220

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 FINANCIAL ACCOUNTING

W7
Depreciations
i. Plant and machineries
25% (11,35(400 — 4,150;000)2—,1,800,000
ii. Motor vehicle
20% (13,290,000 — (2,790, 000 -291,000)
=1,958,200

Illustration

The following trial balance was extracted from the books of Mr.Mugominyo, a sole trader.

Sh. Sh.
Capital 5,920,000
Drawings 1,200,000
Trade debtors 1,808,400
Trade creditors 2,168,000
Sales 8,892,600
Purchases 4,188,400
Stock – 1st January 2003 2,533,300
Sales returns 144,700
Purchases returns 218,800
Cash in hand 56,800
Balance at bank 1,056,400
Warehouse expenses 640,000
Discounts allowed 90,200
Discounts received 170,000
Office salaries 600,000
Office lighting 188,800
Rates 108,200
Motor vehicle (cost) 1,280,000
Freehold premises (cost) 2,600,000
Fixtures and fittings 576,000
General expenses 142,400
Insurance 28,000
Provision for bad debts 50,000
Motor vehicle expenses 150,400
Bad debts written off 28,800
37 420,800 17,420,800

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 FINANCIAL ACCOUNTING

Additional information:
1. Stock as at 31 December 2003 was valued at Sh. 1,760,000
2. Depreciation on fixtures and fittings and the motor vehicle is to be provided at the rate of 5%
and 10% per annum on cost respectively.
3. Rates prepaid as at 31 December 2003 amounted to Sh.25,600.
4. Unexpired insurance as at 31 December 2003 is to be made at 21/2 of the trade debtors,

Required:
a) Trading and profit and loss account for the year ended 31 December 2003.
b) Balances sheet as at 31 December 2003,

Solution
a)
Mr.Mugominyo
Statement of financial statement
For the year ended 31 December 2003
Shs '000' Shs '000' Shs '000'
Sales 8,892,600
Sales returns (144.700)
Net sales 8,747,900
Cost of sales
Opening stock 2,533,300
Purchases 4,188,400
Purchases returns (218,800) 3,969,600
Closing stock (1,760,000) (4,742,900)
Gross profit 4,005,000
Discount received 170,000
Provision for bad debts (w1) 4,790
4,180,790
Expenses
Warehouse expenses 640,000
Discount allowed 90,200
Office salaries 600,000
Office lighting 188,800
Rates: Paid 108,200
Prepaid (25,600) 82,600
Depreciation (w2) Motor Vehicle 128,000
Fixtures and Fittings 28,800
General expenses 142,400
Insurance: paid 28,000
Unexpired (4,000) 24,000
Motor vehicle expenses 150,000
Bad debts written off 28,800 (2.103, 600)
Net profit 2,076,190

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Mugominyo
Balance Sheet as at 31 December 2003
Cost Acc. Dep N.B.V
Sh. 000 Sh.000 Sh.000
Non-current assets
Freehold Premises 1,280,000 128,000 1,152,000
Motor Vehicles 2,600,000 - 2,600,000
Fixtures and fittings 576,000 28,800 547,200
4,456,000 4,299,200
Current Assets
Stock 1,760,000
Debtors 1,808,400
Provisionfor bad debts (45,210) 1,763,190
Cash at bank 1,056,400
Cash at hand 56,800
Prepayments 29,600 4,665,990
8,965,190
Liabilities
Creditors 2,169,000
Financed by:
Capital 5,920,000
Drawings (1,200,000)
Net profit 2,076,190 6 796,190
8,965,190
1. Provision for Bad debts
2.5% x1,808,400 = 45,210

Provision for bad debts account

Sh.000 Sh.000
P&L 4, 790 Balance b/d 50, 00
Balance c/d 45, 210
50,000 50,000
2. Depreciation
Fixtures and fittings 5%x576,000 = Sh 28,800
Motor vehicle 10% x 1,280,000 = Sh 128,000
3. Prepayments
Sh “000”
Rates 25 600
Unexpired insurance 4 000
29 600

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STATEMENT OF FINANCIAL POSITION

Statement of financial position is a summary of the financial balances of a sole proprietorship, a

business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific
date, such as the end of the financial year. It is a statement of assets and liabilities, which helps us to
establish the financial position of a business enterprise on a particular date, i.e. on a date when
financial statements or final accounts are prepared or books of accounts are closed. In fact, this
statement treats the balances of all those ledger accounts that have not yet been squared up. These
accounts relate to assets owned, expenses due but not paid, incomes accrues but not received or
certain receipts which are not due or accrued. In other words, it deals with all those real and personal
accounts, which have not been accounted for in the Manufacturing, Trading or Profit & Loss
Accounts. Besides, a statement of financial position also treats all those items given in the
adjustments, which affect real or Personal Accounts. The Nominal accounts are treated in the
income statement in the usual manner. A statement of financial position is often described as a
"snapshot of a company's financial condition". It aims to ascertain the nature and amount of different
assets and liabilities so that the financial position 'such as liquidity or solvency position could be
evident to all those interested. Therefore, an important feature of a statement of financial position is
to show the exact financial picture of a business concern on a particular date.

DIFFERENCE BETWEEN TRIAL BALANCE AND STATEMENT OF FINANCIAL

POSITION

The following are the points of difference between Trial Balance and statement of financial position;

Trial Balance Statement of financial position

The purpose of preparing a trial balance is to check A Statement of financial position is drafted to
the arithmetic accuracy of account books. reveal the financial position of the business.
A trial balance is prepared to document that the total A Statement of financial position shows that
amount of account balances with debit balances is the total of the asset amounts is equal to the
equal to the total amount of account balances with total of the amounts of liabilities and
credit balances. stockholders' equity.
It is prepared before the preparation of income It is prepared after the preparation of income
statement Account. statement Account.
It does not contain the value of the closing stock of It contains the value of the closing stock,
goods. which appears on the assets side.
Expenses due but not paid and incomes due but not Expenses due but not paid appear on the
received do not appear in the Trial Balance. liability side and income due but not received
appears on the asset side of the Statement of
financial position.
In case of Trial Balance, the columns are named as The two sides of Statement of financial
'debit' and 'credit' columns. position are called 'liabilities' and 'assets' sides
respectively.
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It is a list of balance extracted from the ledger It contains the balance of only those accounts,
accounts. which represent assets and liabilities.
It contains the balance of all accounts- real, nominal It contains the balance of only those accounts,
and personal. which represent assets and liabilities

PREPARATION AND PRESENTATION OF STATEMENT OF FINANCIAL POSITION

The Process of preparation and presentation of Statement of financial position involves two steps:

 Grouping
 Marshaling

Grouping

In the first step, the different items to be shown as assets and liabilities in the Statement of financial
position are grouped appropriately. For this purpose, items of similar nature are grouped under one
head so that the Balance Sheet could convey an honest and true message to its users. For example,
stock, debtors, bills receivables, Bank, Cash in Hand etc. are grouped under the heading Current
Assets and Land and Building, Plant and Machinery, Furniture and Fixtures, Tools and Equipment's
under Non-current Assets. Similarly Sundry creditors for goods must be shown separately and
distinguished from money owing, other than due to credit sales of goods.

Marshaling

The second step involves marshaling of assets and liabilities. This involves a sequential arrangement
of all the assets and liabilities in the Statement of financial position. There are two methods of
presentation:

 The order of liquidity

 The order of permanence

Under liquidity order, assets are shown on the basis of liquidity or reliability. These are rearranged
in an order of most liquid, more liquid, liquid, least liquid and not liquid (fixed) assets. Similarly,
liabilities are arranged in the order in which they are to be paid or discharged.

Under the "Order of performance", the assets are arranged on the basis of their useful life. The assets
predicted to be most fruitful for the business transaction for the longest duration will be shown first.
In other words, this method puts the first method in the reserve gear. Similarly, in case of liabilities,
after capital, the liabilities are arranged as long term, medium term, short term and current liabilities.
This is the commonly used method.

For a better understanding of how various items should be placed, it is important to know the type
and nature of assets and liabilities that are to be classified and arranged in either of two orderly
manner4 discussed earlier. For the purpose of presentation of assets in the statement of financial
position, assets are classified as under:

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1. Non-current assets
2. Intangible Assets
3. Current Assets
4. Fictitious Assets
5. Wasting Assets
6. Contingent Assets

Non-current assets

These are those assets, which are acquired for the purpose of producing Goods or rendering services.
These are not held for resale in the normal course of business. Fixed assets are used for the purpose
of earning revenue and hence these are held for a longer duration. These are also treated as 'Gross
Block' and 'Net Block' (Non-current assets after depreciation). Investment in these assets is known
as `Sunk Cost'. Examples of Non-current assets are Land & Building, Plant and Machinery,
Furniture and Fixtures, Tools and Equipment, Motor vehicles etc. All fixed assets are tangible by
nature.

Intangible assets

Intangible assets are those capital assets, which do not have any physical existence. Although these
assets cannot be seen or touched, they are long lasting and prove to be profitable to owner by virtue
of the right conferred upon them by mere possession. They also help the owner to generate income.
Goodwill trademarks, copyrights and patents are the examples of intangible assets.

Current assets

Current assets include cash and other assets, which are converted or realized into cash within a
normal operating cycle or say, within a year. These are acquired for resale, assisting and helping the
process of production, rendering service or supplying of goods. These assets constantly keep on
changing their form and contribute to routine transactions and operations of business. Examples are
Cash, Bank, Bills Receivables, Debtors, Stock, Prepaid expenses etc. Current assets are also known
as Floating Assets or Circulating Assets.

Liquid or quick assets

Those current assets, which can be converted into cash at a very short notice or immediately,
without incurring much loss or exposure to high risk, are quick assets. Quick assets can be worked
out by deducting Stock (raw materials, work-in progress or finished goods) and prepaid expenses out
of total current assets.

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Fictitious assets

These are the non-existent worthless items which represent unwritten-off losses or costs incurred in
the past, which cannot be recovered in future or realized in cash. Examples of such assets are
preliminary expenses (formation expenses), Advertisement suspense, Underwriting commission,
Discount on issue of shares and debentures, Loss on issue of debentures and Debit balance of
income statement Account. These fictitious assets are written off or wiped out by debiting them to
income statement Account.

Wasting assets

An asset that has a limited life and therefore dwindles in value over time is a wasting asset. This
type of asset has a limited useful life by nature and depletes over a limited duration. These assets
become worthless once their utility is over or exhausts fully. During the Iife of productive usage,
assets of this type produce revenue, but eventually reach a state where the worth of the assets begins
to diminish. Such assets are natural resources like timber and coal, oil, mineral deposits etc.

Contingent assets

Contingent assets are probable assets, which may or may not become assets, as that depends upon
occurrence or non-occurrence of a specified event or performance or non-performance of a specified
act. For example, a suit is pending in the court of law against ownership title of a disputed property.
Subsequently, if the verdict goes in favour of the business concern, it becomes the asset of the
concern. However, if the business firm does not win the lawsuit, it will not have ownership rights of
the property; it will be of no use to it. Thus, it remains a contingent asset as long as the judgment is
not pronounced by court. Such assets are shown by means of footnotes and hence do not form part
of assets shown in the Balance Sheet. Besides this, hire-purchase contract, uncalled share capital etc.
arc the other examples of contingent assets.

CLASSIFICATION OF LIABILITIES

Non-current liabilities/Long-term liabilities

These are the obligations that the business enterprise is expected to meet after a relatively long
period. Such liabilities do not become due for payment in the ordinary course of business operation
or within normal operating cycle.

Debentures, long-term loans from banks or financial institutions are the examples of long-term
liabilities.

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Current liabilities

Current liabilities are those liabilities that are payable within normal operating cycle, i.e. within a
given accounting year. These may arise out of realization from current assets or by creating fresh,
current liability (obligation). Trade creditors, Bills payable, Bank overdraft, outstanding expenses,
short—term loan (payable within twelve months or within the accounting year) are examples of
current liabilities.

Contingent liabilities

These liabilities may or may not be sustained by an entity depending on the outcome of a future
event such as a court case. These liabilities are recorded in a company's accounts and displayed in
the statement of financial position when both probable and reasonably estimable. It is not an actual
liability but an anticipated (probable) liability, which may or may not become payable. It depends
upon the occurrence of certain events or performance of certain acts. An element of uncertainty is
always attached to a contingent liability; it is a potential liability that may or may not become a sure
liability. Contingent liabilities are exemplified in the liability for bills discounted, liability for acting
as surety, liability arising on a suit for damages pending in the court of law, liability for calls on
partly paid shares etc. If a parent guarantees a daughter's first car loan, the parent has a contingent
liability. If the daughter makes her car payments and pays off the loan, the parent will have no
liability. If the daughter fails to make the payments, the parent will have a liability. Contingent
liabilities are shown as footnotes under the statement of financial position.

In accounting, a contingent liability and related contingent loss are recorded with a journal entry
only if the contingency is probable as well as estimable. If a contingent liability is only possible (not
probable) or if the amount cannot be estimated, a journal entry is not required. However, a
disclosure is required. When a contingent liability is remote (such as a nuisance suit), neither a
journal nor a disclosure is required.

PREPARING FINANCIAL STATEMENTS UNDER INCOMPLETE INFORMATION

An incomplete record situation is whereby, the accounting system falls short of the double entry.
This may be due to:

• Lack of records at all; or

• Insufficient records that will facilitate the preparation of final accounts

Reasons for incomplete records:

a) Managers or owners may not have the skills or expertise in preparing and maintaining an
accounting system (records and procedures).

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b) It may not be economical for the business to maintain accounting records due to the volume
or/and nature of transactions (small scale businesses)
c) Records are destroyed (e.g. through fire), stolen or misplaced.

There are 4 main approaches in preparing final accounts where there are insufficient records.

a) Estimating income from the net assets.

b) Estimating income from the use of ratios.
c) Use of a simple cashbook and bank statement.
d) Use of control accounts.

N/B: approach number c and d are normally used together

(a) Estimating Income from the Net Assets

Where the available records are so deficient (i.e. it is impossible to compile a reasonable complete
cash summary, the only method of estimating the profits or loss for the period, is to prepare
statement of affairs showing the net worth of the business at the beginning and at the end of the
period.

The profit/loss is estimated by use of the following formulas:

Profit or loss = Closing Capital — Opening Capital + Drawings Additional Capital

Or where there are no non-current liabilities then this optional formula can be used

Profit or loss = Closing Capital - Opening Capital + Drawings - Additional Capital

Illustration

A sole trader's capital position is as follows:

2002 2003
Sh. Sh.
Motor vehicle
Cost 7,500 7,540
Depreciation 3,000 4.500
4,500 3,000
Stock 2,960 3,450
Debtors 1,150 2,060
Bank 925 2,125
Cash 263 54
9,798 10,689
Creditors 2,860 3,340
Net assets 6,938 7.349
He has estimated his drawings for 2003 at Shs.12,500. Estimate his net profit for the year.

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Solution

Net profit = Closing Net Asset - Opening Net Asset + Drawings- Additional Net assets

= 7,349-6,938+12,500
=sh.12,911

b) Use of Ratios
There are three important ratios to be looked at:
1) Gross profit margin
2) Mark up
3) Stock turnover

If a firm has a uniform Gross Profit for all the items sold then any information available on sales or
purchases can be used to derive the total Gross Profit for the period and in case there is sufficient
information on expenses, then the Net Profit can also be derived.

The above ratios are computed as follows:

1) = 100
( )

E.g. If the selling price of a unit is Shs 100 and Gross Profit made per unit is Shs 25, the Gross Profit
Margin will be:

25
= 100
100
= 25%

If a firm sells 1,000 units in a financial period, then the Gross Profit will be:

= 25% ( ℎ . 100, 000)

= ℎ . 25, 000

2) Mark up

= 100
Cost of Sales (cost price per unit)

In the above example, the markup will be: 25x100

25
= 100
75
= 33.3%

NB: 75=100-25

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Cost = selling price — gross profit

3) Stock Turnover

Measures the rate at which a firm uses its stocks to make sales or turnover. The formula is:

=
Average Stocks

Opening Stock + Closing Stock

Average stock =
2
Example: A firm has the following data for the period:

Shs
Opening stock 20,000
Purchases 300,000
Closing stock 30,000

Required: The Stock Turnover Ratio

30,000 + 20,000
=
2
= 25,000

= ( 20,000 + 300,000) − 30,000

= 290,000
,
=
,

= 11.6

(c) Use of Cashbook and Bank Statement (in addition) Control Accounts.

If there is sufficient information relating to cash payments and receipts, then a simple cashbook for
both cash in hand and cash at bank can be prepared in confirmation of deposits and payments made
from the bank statement.

The information can then be posted to the relevant accounts e.g. any income received to the relevant
income accounts, expenses to relevant expense accounts and assets and liabilities to relevant
accounts. Information relating to amounts owed to suppliers/creditors and amounts due from debtors
can be posted in summary to the control accounts.

The preparation of the cashbook and control accounts will enable one to estimate any cash sales or
credit sales and cash purchases or credit purchases.

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Steps in Preparing the Final Accounts

1. Prepare a statement of affairs at the beginning of the period. (a list of all assets and liabilities)
to determine the beginning capital.
2. Open and post the balances and transactions to these 3 relevant accounts (i.e. the cashbook
(for both cash in hand and bank), sales ledger control account and purchases ledger control
account. Any other account can be. Opened where necessary.
3. Make adjustments for any accruals or prepayments.
4. Extract a list of the balances. (Trial balance)
5. Prepare the final accounts.

Illustration

Mr.Vidija is the proprietor of a grocery and general store. He has not previously engaged, an
accountant. He informs you that this year the inspector of Taxes refuses to accept the Accountant A
has supplied of his trading results for the year ended March 31 2006. That account is as follows:

Details Sh. Details Sh.

Payments for goods 9,495,000 Takings 10,930,000
Payments for expenses 1,130,000
Profits 305.000
10,931,000 l 0,930,000

He instructs you to examine his records and prepare accounts.

From your examination of the records and from interviews with your clients, you ascertain the
following information.
1. The takings are kept in a drawer under the counter; at the end of each day the cash is counted
and recorded on a scrap of paper; at irregular intervals Mrs. Vidija transcribes the figures into
a notebook; a batch of slips of papers was inadvertently destroyed before the figures had been
written into the notebook, but Mr. and Mrs. Vidija carefully estimated their takings for that
period, and the estimated figures included in the total of Sh. 10,390,000.
2. The following balances can be accepted:

March 31
2005 2006
Cash in hand Sh. Sh.
Balance at bank 45,000 87,000
Good debts 156,000 219,000
Creditors for purchases of stock 458,000 491,000
Stock at cost 279,000 243,000
1,950,000 1,900,000

3. Debts totaling Sh.356, 000 were abandoned during the year as bad; the takings included
Sh.25,000 recovered in respect of old debt abandoned in a previous year.
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4. Vidija rents the shop and living accommodation on a weekly tenancy for Sh. 3,000 per week
including rates; the rent is included in expenses Sh.1, 130,000. The living accommodation
may be regarded as one-third of the whole.
5. The expenses total also includes:
i. Sh. 35,000 running expenses of Vidija's private car;
ii. Sh. 60,000 for exterior decoration of the whole premises, the landlord having refused to
have this done
iii. Sh. 160,000 for alterations to the premises to enlarge the storage accommodation.
6. Vidija takes Sh.10,000 per week from the business and hands it over to his wife, who pays all
the household and personal expenses except those referred to below.
7. Vidija pays for his own cigarettes and beer from cash taken from the drawer; this is estimated
at Sh.l,500 per week.
8. Vidija competed in a football pool for 30 weeks of the year, staking Shl,000 each week,
buying a postal order with cash taken from drawer; his winnings totaled Sh.59,000.
9. During the year Vidija bought a second hand car (not used for business) from a friend; the
price agreed was Sh.350,000 but as the friend owed A Sh.67,000 for goods supplied from the
business the matter was settled by a cheque for the difference.
10. An assurance policy on Vidija's life matured and realized Sh. 641,000.
11. Vidija cashed a cheque for Sh.100,000 for a friend; the cheque was dishonored and the friend
is repaying the Sh.100,000 by installments. He had paid Sh.40,000 by March 31 2006;
12. Other private payments by cheque totaled Sh.96,000 plus a further sum of Sh. 110,000 for
income tax.
13. You are to provide Sh.42,000 for accountancy fees.

You are required to prepare:

a) A statement of financial position of the business as at March 31 2005

b) A income statement account for the year ended March 31 2006; and
c) A statement of financial position for the business as at March 31 2006

Solution
(a)
Mr.Vidija
Statement of financial position as at 31st march 2005
Current assets Sh.
Stock 1,950,000
Debtors 458,000
Cash at bank 156,000
Cash in hand 45,000.
2,609,000
Less: Creditors ( 279,000)
Capital account 2,330,000

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(b) Trading and profit and loss account.

Mr.Vidija
Income statement for year ended 31" march 2006
Sales 11,638,000
Opening stock 1,950,000
Purchases 9,459.000
11,409,000
Less: Closing stock ( 1,900 ,000)
Cost of sales (9,509.000)
Repairs(3 x 60,000) 2,129,000
Gross profit
Rent and rates(2/3 x 3,000 x 52weeks) 104,000
Sundry expenses 719,000
Cost of enlarging storage accommodation 160,000
Bad debts(356,000 — 25,000) 40,000
Accountancy fees 331,000
Net profit for the year 42.000 (1,396,000)
733,000

Note:

The cost of enlarging storage accommodation could be capitalized but it has been written siff in the
year in which incurred on prudent grounds.
a)
Mr.Vidija
Statement of financial position as at 31 March 2006
Current assets Sh. Sh.
Stock 1,900,000
Debtors 491,000
Cash at bank 219,000
Cash in hand 87,000
2,697,000
Less: Current liabilities
Trade creditors 243,000
Accountancy fees 42.000 (285,000)
2,412,000
Capital account of A
Balance as at 1 April 2005 2,330,000
Net profit 733,000
3,063,000
Less: Drawings ( 651,000)
2,412 000

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Workings

Cash Summary Account

Sh. Sh.
Balances 1/4/05 201,000 Expenses 1,130,000
(cash Sh.45,000+ bank Sh. 156,000)
Bad debt recovered 25,000 Purchases 9,495,000
Football pool winnings 59,000 Cash drawings 520,000
Insurance policy 641,000 Personal drawings 78,000
Repaid by friend 40,000 Football pools 30,000
Balance cash takings carried to total 11,182,000 Car(350,000-67,000) 283,000
debtors account
Loan to friend 100,000
Drawings by cheque 96,000
Income tax 110,000
Balance 31/3/06(cash Sh.
_________ 87,000 bank Sh.219,000) 306.000
12,148,000 12,148,000

Total debtors account

Sh. Cash takings 11,182,000
Debtors 1/4/05 458,000 Friend car 67,000
Balance=Sales 11,638,000 Bad debts w/o 356,000
_________ Debtors 31/3/06 491.000
12,096,000 12,096,000

Total Creditors Account

Sh. Sh.
Cash 9,495,000 Creditors 1/4/05 279,000
Creditors 31/3/06 243.000 Balances-Purchases 9,459,000
9,738,000 9,7,38,002

Sundry Expenses Account

Sh. Sh.
Cash 1,130,000 Rent 156,000
Car expenses 35,000
Alterations 60,000
Sundry expenses 719,000
________ Balance c/d 160,000
1,130,000 1,130,000

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Drawings Account
Sh. Sh.
Cash 520,000 Football pool winnings 59,000
Cheques 96,000 Life policy money 641,000
Rent(private element) 52,000 Repayment by friend 40,000
Private car expenses 35,000 Balance net drawings 651,000
Decorations(house)(one-third of Sh.60) 20,000
Purchase of car 350,000
Cash paid to friend 100,000
Cigarettes etc. 78,000
Football pools 30,000
Income tax 110.000 ________
1,391,000 1,391,000

LIMITATIONS OF FINANCIAL STATEMENTS

The income statement and the statement of financial position, it must have been gathered, are full of
information about the results of operations and the financial position of the firm concerned.

In fact, it would be unthinkable to appraise the performance and standing of a firm without the aid of
these two statements. A firm proclaims its efficiency, profit-ability and standing through them and it
is because of this that accounting is said to be the language of business.

However, the message conveyed by the statements is not infallible and often, one should not readily
accept the conclusions indicated by the financial statements. This is because by their very nature, the
statements suffer from a number of limitations,

These are given below but here we shall discuss only the impact of accounting policies.

The limitations briefly are the following:-

i. In spite of the great emphasis nowadays on accounting standards, the latest effort in respect of
which is being made by the IAS and the institute of certified public accountants of Kenya
(ICPAK), the management has a choice out of a number of accounting policies chiefly in
regard to valuation of inventory, depreciation, provision of gratuity, treatment of research and
development expenditure e t c.
ii. There are numerous parties which are interested in the financial statements. The proprietors or
shareholders, the workers, the investors, the creditors etc. are some of the obvious parties
which are interested in the firm and, therefore, in the financial statements concerned.
Financial analysts and academicians are also interested. Unfortunately, the information which
concerns these parties differs and it is difficult to draw up one set of financial statements that
will be equally useful to all the parties.
As matters stand, the statements concerning companies have to be drawn up in India in
accordance with Schedule VI of the Companies Act which is mostly from the point of view of
the shareholders. The statements as drawn up today merely perform the custodial function,
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 FINANCIAL ACCOUNTING

showing statements as drawn up today merely perform the custodial function, showing whether
or not the funds entrusted to the Management have been faithfully managed. The statements are
quite defective from the point of view of decision making. Whether a shareholder will be wise
to dispose off his holdings or to increase them will be difficult to decide on the basis of the
information contained in the financial statements.
iii. One of the important limitations from which financial statements suffer is the fact that
quantitative factors, translated in terms of money, are the only factors which can be revealed in
the statements.
The quantitative content of financial statements in Kenya has increased beyond recognition, for
example, quantities also must be given for sales, purchases, and stocks.
Even so, such information cannot throw adequate light on the qualitative factors, namely, the
attitudes of workers and consumers towards the company, research and development effort, the
quality and caliber of management etc. these are vital for the continued success of the
company.
iv. Great deal of effort these days is being directed towards evaluation of human resources at the
disposal of undertakings. However, these efforts have not yet been crowned with success and it
is a long way before a meaningful figure about this most important asset can be entered in the
financial statements.
Short of this, however, the directors' report can certainly describe fully, unless it is harmful to
disclose information to competitors, the problems faced by the company, the plans of the
company and the manner in which company is preparing to meet the future.
v. Last, but not the least, financial statements have now begun to suffer from a very serious
limitation which arises from the great fall in the value of money, in other words, inflation. Even
if a company is five years old, the values of the assets stated in the balance sheet will be
completely out of tune with the prevailing values. This means that profitability worked out on
the basis of the balance sheet figures will be misleading.
Further, it is to be recognized that good deal of profit reported in the profit and loss account of
a company today is due to inflation and, therefore, illusory. This is proved by the fact that a
large number of mills in India today are sick because, even though they reported good profits in
the past, they could not build up enough funds to replace their plant and machinery when it was
worn out.

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REVISION EXERCISE

QUESTION 1

The following balances were extracted from the books of Patel and Sons in respect of the year ended

31 December 2005:

Sh. Sh.
Sales 1,352,000
Purchases 990,000
Debtors 177,800
Creditors 83,400
Stock in trade (I January 2005) 80,000
Machinery (cost) 112,500
Furniture 17,000
Rent for building 19,200
Cash in hand 8,500
Cash at bank 34,738
Drawings 24,000
Capital 180.000
Salaries 37,820
Bad debts 2,400
Suspense account 6,000
Provision for bad debts 6,400
Printing expenses 4,600
Postage 3,000
Travelling expenses 15,800
Telephone expenses 3,200
Miscellaneous expenses 83,612
Insurance premiums 2,080 ________
1,621,800 1,621,800

Additional information:
1. Old furniture which stood in the books (as at I January 2005) at Sh.2,400,000 was disposed of
at Sh.1,160,000 during the year in part exchange for new furniture costing Sh.2,080,000. A net
invoice of Sh.920,000 in respect of this transaction was erroneously passed through the
Purchases Day Book.
2. The suspense account represented money advanced to a sales team detailed to undertake a sales
campaign in the Rift Valley Province. On returning, the sales team disclosed that Sh.2,400,000
was used for travelling, Sh.1,000,000 for legal fees and Sh.1,800,000 for miscellaneous
expenses. The balance was yet to be refunded by 31 December 2005.
3. The business is conducted in a rented building and 50% or the building is used for
accommodation of the business owner's family.

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4. Depreciation is to be provided on the straight line basis at 10%) per annum on machinery and
5% per annum on furniture. Depreciation is to be applied for the whole year regardless of date
of purchase of the asset.
5. Total bad debts for the year amounted to Sh.4,000,000. Provision for doubtful debts is to be
maintained at 5% of the outstanding debtors
6. 6_ Closing stock amounted to Sh100,000,000
7. Insurance premiums cover the one year period ended 31 January 2006.

Required:

a) Trading and profit and loss account for the year ended 31 December 2005.
b) Balance sheet as at 31 December 2005

Solution:

Patel and Sons

Trading and Profit and Loss Account for the Year Ended 31 December 2005
Shs '000' Shs '000' Shs '000'
Sales 1,352,000
Cost of sales
Opening stock 80,000.00
Purchases (wl) 989,080.00 1,069,080.00
Closing stock (100,000 00) (969,080.00)
Gross profit 382,920.00

Expenses
Rent (w2) 9,600.00
Salaries 37,820.00
Bad debts 4,000.00
Increase in provision for bad debts (w3) 2,410.00
Printing expenses 4,600.00
Postage 3,000.00
Travelling expenses (w4) 18,200.00
Telephone expenses (w5) 3,200.00
Miscellaneous 85,412.00
Insurance Premium (w6) 1,906.67
Legal fees 1,000.00
Depreciation (w7) - Furniture 834.00
- Machinery 11,200.00
Loss on disposal — Furniture (w8) 1,240.00 (184,422.67)
Net profit I98.497,33

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Patel and Sons

Balance sheet as at 31Dember 2005
Non-Current Assets Cost Accum. Depre Net Book Value
Sh.’000’ Sh. ’000’ Sh. ’000’
Machinery 112,00.00 11,200.00 100,800.00
Furniture (w9) 16,680.00 834.00 15,846.00
128.680.00 12,034.00 116,646.00
Current Assets
Stock 100,000.00
Debtors(w10) 167,390.00
Bank 34,780.00
Cash 8,500
prepayment 173,33 310,851.33
427,497.33
Capital and liabilities:
Liabilities
Creditors 83,400.00
Sundry creditors (800.00) 82,600.00

Capital 180,000.00
Net profit 198,497.33
Drawings (33,600.00)
427,497.33

Workings:
1. Purchases
Shs’000’ Shs’000’
Balance b/d 990,000.00 Furniture 920.00
_____ Balance c/d 989,080.00
990,000.00 990,000.00

2. Rent
Shs’000’ Shs’000’
Balance c/d 19,200.00 Drawings 9,600.00
_____ Balance c/d 9,600.00
19,200.00 19,200.00

3. Provision for bad debts a/c

Shs’000’ Shs’000’
Balance c/d 8,810.00 Balance b/d 6,400.00
_____ P & L 2,410.00
8,810.00 8,810.00

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4. Travelling a/c
Shs’000’ Shs’000’
Balance b/d 15,800.00 P & L 18,200.00
Suspense 2,400.00 ________
18,200.00 18,200.00

5. Miscellaneous a/c
Shs’000’ Shs’000’
Balance b/d 83,612.00 P & L 85,412.00
Suspense 1,800.00 ________
85,412.00 85,412.00

6. Insurance premium a/c

Shs’000’ Shs’000’
Balance b/d 2,080.00 Bank 173.33
_____ Balance c/d 1,906.67
2,080.00 2,080.00

7. Depreciation

Machinery: 10% x Shs 112, 000,000 = Shs 11,200,000

Furniture: 5% x 16,680,000 = Shs 834,000

8. Disposal a/c (furniture)

Shs’000’ Shs’000’
Furniture 2,400.00 Furniture 1,160.00
_____ Loss on depreciation 1,240.00
2,400.00 2,400.00

9. Furniture a/c
Shs’000’ Shs’000’
Balance b/d 17,000.00 Disposal 2,400.00
T-in-A 1,160.00
Purchases 920.00 Balance c/d 16,680.00
19,080.00 19,080.00

10. Debtors a/c

Shs’000’ Shs’000’
Balance b/d 177,800 Disposal 1,600
Prov. For bad debts 8,810
Balance c/d 167,390
177,800 177,800

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11. Suspense a/c

Shs’000’ Shs’000’
Balance b/d 6,000 Travelling 2,400
Legal fees 1,000
____ Miscellaneous 1,800
6,000 Sundry creditors 800
6,000
QUESTION 2

The following trial balance was extracted from the books of Hari Singh as at 31 December 2004:

Sh. Sh.
Drawings 1,600,000
Cash 676,000
Petty cash 100,000
Fixtures and fittings (cost) 2,000,000
Stock (1 January 2004) 5,000,000
Salaries and wages 5,200,000
Debtors and creditors 5,000,000 3,500,000
Bank balance 2,100,000
Rent 900,000
Electricity 600,000
Motor vehicle (written down value) 1,024,000
Advertising 900,000
Capital 3,400,000
Purchases 40,000,000
Sales 60,000,000
Postage and telephone 300,000
Discounts allowed 1,140,000
General expenses 400,000
Petty cash expenses 960,000
Suspense account 1,000,000
67,900,000 67,900,000

Additional information:
1. Closing stock as at 31 December 2004 was valued at Sh.7,500,000
2. Petty cash balance represents the month end imprest amount. As at 31 December 2004, the
petty cashier had vouchers amounting to 5h40,000 which had not been reimbursed by the
main cashier.
3. Discounts allowed amounting to Sh.100,000 had been posted to the debit of the debtors
account.
4. Sales had been undereast by Sh400,000.
5. The motor vehicle, which had been purchased on 1 January 2002, was being depreciated at
20% per annum on the reducing balance basis. The original cost of the motor vehicle was

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Sh.2,000,000. It has been decided that the motor vehicle be depreciated at 6% per annum on
the straight line basis and to make the change effective from the date of purchase.
6. Cash withdrawn from the bank for business use amounting to Sh400,000 had not been
entered in the bank column of the cash book. No entry bas been made for stock valued at
Sh1,000,000 taken by the proprietor for personal use.
7. Telephone bills amounting to Sh.100,000 were unpaid as at 31 December 2004.
8. Advertising expenses include the cost of a sales campaign conducted during the year of
Sh.600,000. It is expected that the benefits of this campaign will be enjoyed or the next three
years.
9. Fixtures and fittings are to be depreciated at 20% per annum on cost.

Required:

a) Trading, profit and loss account or the year ended 31 December 2004.
b) Balance sheet as at 31 December 2004.

Solution:

Hari Sigh
Trading profit and loss account
For the year ended 31 December 2004
Shs '000' Shs '000' Shs '000'
Sales (W1) 60,400
Cost of sales
Opening stock 5,000
Purchases 40,000 45,000
Closing stock (7,500) (37,500)
Gross profit 22,900
Depreciation (W2) 616
23,516
Expenses
Telephone and postages (W3) 400
Advertising 300
Depreciation 400
Salaries and wages 5,200
Rent 900
Discount allowed 1,140
General expenses 400
Petty cash expenses 960 (9,700)
13,816

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Hari Sigh
Balance sheet as at 31 December 2004
Non-current Assets Cost Accum. Depre Net Book Value
Sh. '000' Sh. '000' Sh. '000'
Fixtures and fittings 2,000 400 1,600
Motor vehicle 2,000 360 1.640
4.000 760 3,240
Current Assets
Stock 7,500
Debtors (w5) 4,900
Bank 1,700
Cash 676
Prepayments (w4) 600 15,476
Total assets 18,716

Capital and Current Liabilities

Current Liabilities
Creditors 3,500
Accruals 600 4,100

Capital 3,400
Drawings (2,600)
Net profit 13,816
18, 716

Workings:

1. Sales

Shs.’000’

Sales 60,000
sales undercast 400
Total assets 600,400

2. Adjusted Depreciation
Provision for Depreciation
Reducing balance basis: Accumulated depreciation for 3 years
Cost - N. B. V
Sh 2,000,000 - shs 1,024,000=Sh 976,000

Straight line method:

6% x 2,000,000 x 3 = Sh 360,000
Overcharged depreciation: Accumulated depreciation for 3 years
Sh 976,000 - Sh 360,000 -Sh 616,000
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3. Telephone and postage a/c

Shs’000’ Shs’000’
Bank 300 P&L 400
Balance b/d 100 ___
400 400

4. Advertising a/c
Shs’000’ Shs’000’
Bank 900 P&L 300
Balance b/d 600
900 900

5. Debtors a/c
Shs’000’ Shs’000’
Balance b/d 5,000 Discount allowed 100
____ Balance c/d 4,900
5,000 5,000

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TOPIC 6

FINANCIAL STATEMENTS OF A PARTNERSHIP

INTRODUCTION

There are a number of ways in which a partnership may be defined, but there are four key elements.

Two or more individuals

A partnership includes at least two individuals (partners). In certain jurisdictions, there may be an
upper limit to the number of partners.

Business arrangement

A partnership exists to carry on a business.

Profit motive

As it is a business, the partners seek to generate a profit.

Unincorporated business entity

A partnership is an unincorporated business entity. That means:

 The reporting entity (business entity) principle applies to a partnership, so for accounting
purposes, the partnership is a separate entity from the partners
 The partners have unlimited liability, and
 If the partnership is unable to pay its liabilities, the partners may be called upon to use their
personal assets to clear unpaid liabilities of the partnership.

Therefore A partnership is an unincorporated association of two or more individuals .,to carry on a

business for profit.

A partnership, by the Kenya Partnership Act of 1962 Chapter, is defined as the relationship which
exists between persons carrying on a business in common with a view of profit.

According to the definition there are the following essential elements:

a) There must be a business which would include trade, occupation or profession.

b) The business must be carried on for the purpose of making a profit
c) The business must be carried on by all or any one of them acting on behalf of all partners.
d) There must be an association of two or more persons

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e) Common property or part ownership does not create a partnership. Sharing returns, loans
offered, or debts do not create a partnership.

Types of partnerships

There are two main types of partnerships: General partnership and Limited Partnership.

General partnerships are governed by the Partnership Act of 1962 Cap 29. These are partnerships
which consist of persons whose liability for the debts and obligations are unlimited, because they
take part in management of the partnership business.

Limited partnerships are governed by the Limited Partnership Act of 1062 (Cap 30). They consist of
one or more general partners whose liability is unlimited and one or more limited partners whose
liability is limited to the amount of capital contributed by them to the firm.

He has no right to share in management of the firm and if he does so, his liability becomes unlimited
for the firm's debts.

The purpose of a limited partnership is to give limited liability to some partners who did not wish to
take an active part in the business.

However, the objective can be satisfied by forming a private company under the Companies Act.
Very few limited partnerships exist.

PARTNERSHIP AGREEMENT

A partnership can be formed without any legal formalities by any two or more people. The
maximum number of people who can form such a partnership under our laws is 20.

When two or more people decide to form a partnership, such an agreement, whether written or
verbal or even inferred from the conduct of the parties, constitutes a contract and a partnership is
automatically created.

However, it is generally strongly recommended that a partnership contract or agreement should be

written in order to lessen the chances of misunderstanding and future disagreement because it can be
easily referred to.

It is good practice to set out the terms agreed by the partners in a partnership agreement. While this
is not mandatory, it can reduce the possibility of expensive and acrimonious disputes in the future.
As a fonnal agreement is not mandatory, there is no definitive list of what it should contain. The
agreement should identify the partners; their respective business-related duties and responsibilities;
how income will be shared; the criteria for additional investments and withdrawals; and the
guidelines for adding partners, the withdrawal of a partner, and liquidation of the partnership. For
income tax purposes, the partnership files an information return only. Each partner shares in the net
income or loss of the partnership and includes this amount on his/her own tax return
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When a partnership agreement is in written form it should cover the following areas:

a. The names of the firm and the location of the business.

b. The nature of the business to be carried on by the firm.
c. The amount of capital to be contributed and left in the business by each partner.
d. The ratio in which profits are to be shared — one partner may entitled to a greater share of
the profits because he has more expenses or is doing a greater share of the work.
e. The rate of interest to be allowed on investment capital and the rate of interest to be charged
on drawings. Interest on capital may be appropriate where one or more partners are
contributing a materially greater sum than others. Interest on drawings is used to discourage
withdrawal.
f. Salaries to be allowed to partners and other benefits such as commissions or bonuses. Some
partners may be entitled to a salary because of the work they are performing.
g. Any variations in the usual rights of a partner
h. The method to be followed on admission or retirement of a partner
i. Method to be followed in the event of dispute among partners
j. Duration of partnership
k. Manner in which accounts are to be prepared and inspected.

Rights of Partners

a) Every partner has a right to take part in the conduct and management of business.
b) Every partner has a right to be consulted and heard in all matters affecting the business of the
partnership.
c) Every partner has a right of free access to all records, books and accounts of the business, and
also to examine and copy them.
d) Every partner is entitled to share in the profits equally.
e) A partner who has contributed more than the agreed share of capital is entitled to interest at
the rate of six percent per annum. But no interest can be claimed on capital.
f) A partner is entitled to be indemnified by the firm for all acts done by him in the course of the
partnership business, for all payments made by him in respect of partnership debts or
liabilities and for expenses and disbursements made in an emergency for protecting the firm
from loss provided he acted as a person of ordinary prudence would have acted in similar
circumstances for his own personal business.
g) Every partner is, as a rule, joint owner of the partnership property. He is entitled to have the
partnership property used exclusively for the purposes of the partnership.
h) A partner has power to act in an emergency for protecting the firm from loss, but he must act
reasonably.
i) Every partner is entitled to prevent the introduction of a new partner into the firm without his
consent

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j) Every partner has a right to retire according to the Deed or with the consent of the other
partners. If the partnership is at will, he can retire by giving notice to other partners.
k) Every partner has a right to continue in the partnership.
l) A retiring partner or the heirs of a deceased partner are entitled to share in the profits earned
with the aid of the proportion of assets belonging to such outgoing partner or interest at six
per cent per annum at the option. of the outgoing partner ( or his representative ) until the
accounts are finally settled.

Duties of partners

a) Every partner is bound to diligently carry on the business of the firm to the greatest common
advantage. Unless the agreement provides, there is no salary.
b) Every partner must be just and faithful to the other partners.
c) A partner is bound to keep and render true, proper, and correct accounts for the partnership
and must permit other partners to inspect and copy such accounts.
d) Every partner is bound to indemnify the firm for any loss caused by his willful neglect or
fraud in the conduct of the business.
e) e. A partner must not carry on a competing business, nor use the property of the firm for
his private purposes. In. both cases he must hand over to the firm any profit or gains made by
him but he must himself suffer any loss that might have occurred. •
f) Every partner is bound to share the losses equally with the others.
g) A partner is bound to act within the scope of his authority.
h) No partner can assign or transfer his partnership interest to any other person so as to make
him a partner in the business.

Powers of Partners

The above relates to relations among the partners themselves. When it comes to dealings with
outsiders or third parties, the partners are supposed to have the power to act in certain matters and
not to have such power in others.

In other words, unless a public notice has been given to the contrary, certain contracts entered into
by a partner on behalf of the partnership, even without consulting other partners, will be binding on
the firm.

In the case of a trading firm, the implied powers of the partners are as follows:

a) Buying and Selling goods

b) Receiving payments on behalf of the firm and giving valid receipts
c) Drawing cheques and drawing, accepting and endorsing hills of exchange and promissory
notes in the name of the firm
d) Borrowing moneys on behalf of the firm with or without pledging the stock in trade
e) Engaging servants for the business of the firm.

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In the following cases, a partner has no powers. This is to say, the third parties cannot bind the firm
unless the partners have agreed to be so bound.

a) Submitting a dispute relating to the firm to arbitration

b) Opening a bank account on behalf of the firm in the name of a partner
c) Compromise or relinquishment of any claim or portion of claim by the firm.
d) Withdrawal of a suit or proceedings filed on behalf of the firm.
e) Admission of any liability in a suit or proceedings against the firm
f) Acquisition of immovable property belonging to the firm
g) Transfer of immovable property belonging to the firm.
h) Entering into partnership on behalf of the firm

The rights, duties and powers of partners can be changed by mutual consent.

Types of Partners

Besides the usual partners who contribute to the capital of the firm and take part in its business, the
following special types of partners may be noted.

Sleeping or Dormant partner is one who is in reality a partner, but whose name does not appear in
any way as partner, and who is not known to outsiders as partner.

He is liable to those third parties who subsequently discover that he was or is a partner. He has no
duties to perform but he has the right of access to the books of account and of examining and
copying them.

Nominal partner is a person whose name is used as if he was a member of the firm, but who, in
reality, is not a partner. He is liable to those third parties who give credit to the firm on the strength
of his being a partner.

Partner in profit only is one who gets a share of the profits and does not share losses. He is liable to
outsiders. He does not take part in the management of the business.

Partner by estoppel or holding out is one, who without really being a partner, so conducts himself
as to lead others to believe him to be a partner. Similarly, if one is declared to be a partner and does
not disclaim the partnership, one will be treated as partner by holding out. Such persons are liable to
those third parties who extend credit to the firm on the belief that such persons are partners.

Sub-partner gets a share of profits of the firm from one of the partners. A sub-partner has no rights
against the firm and he is not liable for its debts.

An incoming partner is one who is newly admitted to the firm. He is not liable for the debts and
obligations of the firm incurred before his joining the firm unless he so agrees.

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A retiring or outgoing partner continues to be liable for obligations incurred before his retirement,
and will continue to be liable even for future obligations, if he does not give public notice of his
retirement.

Minor partner; A minor can be admitted to the benefits of an existing partnership with the consent
of all the partners. The minor is not personally liable for the debts of the firm but his share in the
partnership property and profits of the firm will be liable for the firm's debt and obligations. He can
bring a suit for accounts and for his distributive share when he wants to sever his connections with
the firm, but not otherwise.

But he was the right of access to the accounts of the firm including the right to examine and copy.
Within six months of his attaining majority or when he comes to know that he enjoys the benefits of
partnership ( whichever date is later ), he has to elect whether or not he wants to continue as partner.
He must give public notice of his decision not to continue as partner, otherwise he will be deemed to
have elected to be a full-fledged partner. On his election as a partner he will become liable for the
debts of the firm since he was admitted to the benefits of the firm.

If he repudiates his partnership, all his liabilities will cease from the date of the public notice to this
effect.

In the absence of any agreement to the contrary:-

1. No partner has the right to a salary

2. No interest is to be allowed on capital; if allowed, it is an appropriation of profit and a charge
against it.
If the profit is less than the interest to be allowed on capitals, the interest will be limited to the
profit. In case of losses, no interest will be allowed.
3. No interest is to be charged on drawings
4. Interest at the rate of six per cent is to be allowed on a partner's loan to the firm
5. Profits and losses are to be shared equally.

INTRODUCTION TO PARTNERSHIP ACCOUNTING

Except for the number of partners' equity accounts, accounting for a partnership is the same as
accounting for a sole proprietor. Each partner has a separate capital account for investments and
his/her share of net income or loss, and a separate withdrawal account. A withdrawal account is used
to track the amount taken from the business for personal use. The net income or loss is added to the
capital accounts in the closing process. The withdrawal account is also closed to the capital account
in the closing process.

Share of residual profit

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This is the amount of profit available to be shared between the partners in the profit and loss sharing
ratio; after all other appropriations have been made.

Interest on drawings

Charging interest on drawings is a means of discouraging partners from withdrawing excessive

amounts from the business. From this, it follows that interest on drawings is a debit entry in the
partners' current accounts and a credit entry in the Appropriation Account.

In an exam situation depending on what the question is testing, it will either provide the amounts of
interest on capital and drawings or give details of how to calculate the amounts.

Remember to deal with each of these appropriations before sharing the residual profit between the
partners.

A final point in this context is that, if the total of the appropriations is greater than the profit for the
year, the amount to be shared between the partners will be a loss. This will mean that the entries for
the share of the residual profit will be a credit in the

Appropriation Account (thus resulting in a nil balance) and debits in the partners' current accounts.

Therefore, it should be noted that there is a distinction to • (income minus expenses), which is
calculated in exactly the profit (the remaining profit after profit for the year has accordance with the
partnership agreement). be made between the profit for the year same way as for a sole trader and
residual been adjusted by the appropriations in

Appropriations of profit

Another point to remember is that the Appropriation Account is an additional accounting statement
that is required for a partnership. For a sole trader, the profit for the year is simply transferred to the
credit side of the proprietor's capital account (the double entry i. completed by a debit entry in the
income statement, resulting in a nil balance on that statement). In the case of a partnership, the
income statement will still be debited, but the profit will be credited to the appropriation account,
rather than the capital account. As each appropriation is dealt with, the double entry is completed
through entries in both the appropriation account and the partner's current account (if current
accounts are not maintained by the partnership, the entries will be made in the capital accounts).

Partners' salaries

To some extent the term 'salaries' is a misleading description. The salaries of employees are business
expenses that are written off to the income statement, thereby reducing profit for the year. However,
as partners are the owners of the business, any amounts that are paid to them under the partnership
agreement are part of their share of the profit. As the amount is guaranteed, it must be dealt with
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through a credit entry in the partner's account (usually the current account) before the residual profit
is shared.

The double entry is completed by a debit entry in the Appropriation Account.

Interest on capital

Almost always, interest on capital will be paid on partners' capital balances only — although the
balances on the current accounts are actually part of the total capital balance, it is normal to exclude
them from the value of capital on which interest is paid.

Paying interest on capital is a means of rewarding partners for investing funds in the partnership as
opposed to alternative investments. As such, it reduces the amount of profit available for sharing in
the profit and loss sharing ratio. This means that a debit entry is needed in the Appropriation
Account. The double entry is completed by a credit entry in the current account of the partner to
whom the salary is paid.

Interest on drawings

Charging interest on drawings is a means of discouraging partners from withdrawing excessive

amounts from the business. From this, it follows that interest on drawings is a debit entry in the
partners' current accounts and a credit entry in the Appropriation Account.

In an exam situation depending on what the question is testing, it will either provide the amounts of
interest on capital and drawings or give details of how to calculate the amounts.

Remember to deal with each of these appropriations before sharing the residual profit between the
partners.

A final point in this context is that, if the total of the appropriations is greater than the profit for the
year, the amount to be shared between the partners will be a loss. This will mean that the entries for
the share of the residual profit will be a credit in the

Appropriation Account (thus resulting in a nil balance) and debits in the partners' current accounts.

DISTINCTION BETWEEN CURRENT AND FIXED CAPITAL

In one sense, there is no difference. A partner's total capital is the sum of the balances on their
capital account and their current account.

In practice, however, it is convenient to separate the amount invested by the partner (the capital
account) from the amount they have earned through the trading activities of the partnership (the

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current account). Therefore, the capital account is usually fixed, while the current account is the
current total of appropriations and the share of residual profit/loss, less drawing.

Remember that a partner's drawings will be a debit entry in the partner's current account.

During the course of the year, a partner withdraws money for his private use; at the end of the year,
he is credited with interest on his capital, salary due to him and his share of profits and debited with
interest on drawings ( all depending upon the Partnership Deed).

If entries for all these transactions are passed through his capital account, the amount of his capital at
the end of the year will be different from what it was in the beginning. If, therefore, such entries are
passed through the capital account, the capital will be fluctuating.

In some firms, a separate account is opened to record all such entries as drawings, interest on
drawings and capital, salary, share of profit, etc.

The name given to such an account is Partners' Current Account or Drawings Account. If this is the
arrangement, the capital is fixed. Balances of both the Capital Account and the Curfent Account are
shown in statement of financial position. Strictly speaking, the amount of capital mentioned in the
Partnership Deed should remain fixed.

A capital account records the partner's equity investment at any point in time. It is credited initially
with the fair market value of the assets contributed by the partner at the time of formation of the
partnership; subsequent changes reflect the partner's share of net income earned, additional assets
invested, and assets withdrawn.

FORMAT'S

CURRENT ACCOUNT
Shs Shs Shs Shs Shs Shs
Balance b/d XX XX XX Balance b/d XX XX XX
Interest on drawings XX XX XX Interest on capital XX XX XX
Drawings XX XX XX Salaries XX XX XX
Balance c/d XX XX XX Share of profits XX XX XX
Loan interest XX XX XX
- - - Balance c/d XX XX XX
XX XX XX XX XX XX
Balance b/d XX XX XX

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FIXED CAPITAL ACCOUNT

Shs Shs Shs Shs Shs Shs
A B C A B C
Loss or revaluation XX XX XX Balance b/d XX XX XX
Goodwill written off XX XX XX Gains on revaluation XX XX XX
Additional capital
(c/book or asset) XX XX XX
Goodwill XX XX XX
- - - Balance c/d XX XX XX
XX XX XX XX XX XX
Balance b/d XX XX XX

How does goodwill arise, and how is it treated?

Goodwill is defined as the amount by which the fair value of the net assets of the business exceeds
the book value of the net assets. It arises due to factors such as the reputation, location, customer
base, and expertise or market position of the business. (In simple terms, 'fair value' can be thought of
as being the same as 'market value'.)

The first step is to create the asset of goodwill. This is a debit entry for the value of the goodwill in
the goodwill account. The double entry is completed with credit entries in the old partners' capital
accounts. The value of each entry is calculated by sharing the value of the goodwill between the
partners in the old profit and loss sharing ratio.

If goodwill is to be retained in the partnership (sometimes referred to as 'carried in the books') no

further entries are required.

If goodwill is not to be carried in the books, it is eliminated by a credit entry in the goodwill
account.

The double entry is completed with debit entries in the partners' capital accounts. The value of each
entry is calculated by sharing the value of the goodwill between the new partners in the new profit
and loss sharing ratio.

If a partner is contributing (or withdrawing) capital, the relevant amount will be recorded in both the
partner's capital account and the bank account. A contribution will be a credit entry in the capital
account and a debit entry in the bank account, and a withdrawal will be a debit entry in the capital
account and a credit entry in the bank account.

How loans from partners treated

A loan is not part of the partner's capital, and the loan is treated in the same way as a loan from a
third party. The liability of the partnership will be recorded by the creation of a liability, resulting in
a credit balance for the amount of the loan. The debit entry will depend on how the loan was made.
If the partner deposited cash in the bank account, the debit entry will be in the bank account. If the

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loan was created by converting a proportion of the partner's capital into a loan, the debit entry will
be in the capital account.

The interest on the loan will be a business expense and should therefore be debited to the income
statement.

INCOME STATEMENT

Partnership accounts do not present much difficulty unless there is an admission, retirement, death
or dissolution.

The income statement is prepared in the usual way as discussed in the chapter for financial
statements of a sole trader.

A new section called the Appropriation account is included and this account shows how the partners
share the Net Profit for the period. (In addition to other expenses in the profit and loss, an expense
for interest on loan given by one of the partners is included and the credit entry is made on the
partner's current account.)

The format for the Appropriation account is as follows:

Shs Shs
Net Profit for the year XXX
Add: Interest on drawings
A XXX
B XXX
C XXX XXX
Less: Interest on capital. XXX
A XXX
B XXX
C XXX XXX
Less: Salaries XXX
A XXX
B XXX
C XXX XXX
Balance of profit to be shared in percentage ratio XXX
A (ratio) XXX
B (ratio) XXX
C (ratio) XXX XXX
Nil

Illustration
Presidential Cleaning had the following profit sharing clauses in their partnership agreement.
1. 5% interest on capital based on average balance . a. Clinton Shs.40,000 (opening balance)
b. Bush Shs.60,000 (opening balance)

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c. Obama Shs.20,000 (opening balance)

2. 5% interest on current based on opening balance (except if they are overdrawn)
a. Clinton Shs.10,000 (opening balance)
b. Bush - Shs.l 5,000 (opening balance)
c. Obama Shs.5,000 (opening balance)
3. Interest on the advance from Clinton is paid. at 5% (treated as an expense)
a. Clinton loaned the partnership Shs.30,000 at the start of the year
4. 10% interest on the average level of drawings during the year (drawings made evenly throughout
the year)
a. Shs.20,000 Clinton
b. Shs.30,000 Bush
c. Shs.20,000 Obama
5. Residual profits or losses are share in the same ratio as the partners' capital contributions. Salaries
for partners
a. Shs.50,000 Clinton
b. Shs. 60,000 Bush
c. Shs.45,000 Obama
6. The partnership made a profit of Shs.250,000 during the year. Bush contributed a
Shs.10,000 van half way through the year.

Required;
An appropriation statement

Solution

Appropriation Statement
Presidential Cleaning
For year ending 31st March 2014
Shs. Shs.
Profit 250,000
Less; interest on loan to Clinton (1,500)
248,500
Add; Interest on drawings
Clinton 1,000
Bush 1,500
Obama 1,000 3,500
252,000
Less ; Interest on capital
Clinton 2,000
Bush 3,250
Obama 1,000 (6,250)
245,750
Less ; Interest on current
Clinton 500

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Obama 250 (750)

245,000
Less ; salaries
Clinton 50,000
Bush 60,000
Obama 45,000 (155,000)
90,000
Less ; Share of residue
Clinton 30,000
Bush 45,000
Obama 15,000
90,000
Loan made by partner Debit Bank account if funds were deposited in the partnership bank
account or

Credit Loan account Capital account if capital was converted into a loan

Profit for year Debit Income statement

Credit Appropriation account
Partners' salaries Debit Appropriation account
Credit Partners' Current Accounts
Interest on capital Debit Appropriation account
Credit Partners' current accounts
Interest on drawings Debit Partners' current accounts
Credit Appropriation account
Residual profit Debit Appropriation account
Credit Partners' current accounts
if profit is greater than total of
appropriations:
Debit Partners' current accounts
Credit Appropriation account
if profit is greater than total of
appropriations:
Interest on loan from Debit Income statement
partner Credit Bank account if the interest has
been paid to the partner or
Accrued expenses if the interest
remains unpaid
Loan made by partner Debit Bank account if funds were
deposited in the partnership bank
account or Capital account if
capital was converted into a loan

Credit Loan account

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Illustration

X and Y own a grocery shop. Their first financial year ended on 31 December 2002.

The following balances were taken from the books on that date:

Capital X- Sh.60, 000 Y— Sh.48, 000

Partnership salaries X.— Sh.9, 000 Y — Sh. 6,000.
Drawings X — Sh. 12,000 Y— Sh. 13,400

The firm's net profit for the year was Sh. 32,840.
Interest on capital is to be allowed at 10% per year.

Profits and losses are to be shared equally.

Required;

From the information above prepare the firm's appropriation account and the partners' current
accounts.

Solution

X and Y Profit and Loss Appropriation account for the year ended 31 Dec 2002

Shs. Shs.
Net for profit for the year 32,840

Less ; Interest on capital

X 6,000
Y 4,800 (10,800)
22,040

Less ; salaries
X 9,000
Y 6,000 (15,000)

Balance of profit to be shared in profit ratio

X 3,520

Y 3,520 (7,040)
Nil

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Current Accounts
X Y X Y
Sh. Sh. Sh. Sh.
Drawings 12,860 13,400 Interest on capital 6,000 4,800
Salaries 9,000 6,000
Bal c/d 5,660 920 Profit shared 3,520 3,520
18,520 14, 320 18,520 14, 320
Bal c/d 5,660 920
Illustration

Draw up a profit and loss appropriation account and current accounts for the year ended 31
December 2012
i. Net profits Sh.30, 350
ii. Interest to be charged on capitals: Wachira Sh.2, 000; P Sh.1, 500; Hamisi Sh. 900
iii. Interest to be charged on drawings; Wachira Sh.240; P Sh.180; Hamisi Sh.130
iv. Salaries to be credited: Phylis Sh.2,000; Hamisi Sh.3,500.
v. Profits to be shared: Wachira 50%; Phylis 30%; Hamisi20%.
vi. Current accounts: balances b/f Wachira Sh.1,860; Phylis Sh.946; Hamisi Sh.717
vii. Capital accounts: balances b/f Wachira Sh.40,000; Phylis Sh.30,000; Hamisi Sh.18,000
viii. Drawings: Wachirs Sh.9,200; Phylis Sh.7,100; Hamisi Sh.6,900.

Solution
Sh. Sh.
Net profit for the year 30,350
Add: Interest on drawings
Wachira 240
Phylis 180
Hamisi 130 550
30,900
Less: Interest on capital
Wachira 2,000
Phylis 1,500
Hamisi 900 (4,400)
26,500

Less: salaries;
Phylis 2,000
Hamisi 3,500 (5,500)
21,000
Balance of profit to be shared
Wachira 50% 10,500
Phylis 30% 6,300
Hamisi 20% 4,200 (21,000)
Nil

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Wachira Phylis Hamisi Wachira Phylis Hamisi

Sh. Sh. Sh. Sh. Sh. Sh.
Interest on drawings 240 180 130 Bal b/d 1860 946 717
Drawings 9200 7100 6900 Interest on capital 2000 1500 900
Salaries 2000 3500
Bal c/d 4920 3466 2287 Share of profits 10000 6300 4200
14360 10746 9317 14360 10746 9317

STATEMENT OF FINANCIAL POSITION

The statement of financial position also the same as that for a sole trader but the interest of each
partner in the business should be shown separately and any loan given by a partner to the firm is also
shown separately in the non-current liability section therefore, the format will be as follows.

Sh Sh Sh
Total assets. XXX
Capital:
A XXX
B XXX
C XXX
XXX
Current account
A XXX
B XXX
C (debit balance) (XXX) XXX
XXX
Non-current liabilities
10% loan B XXX
10% loan bank XXX XXX
XXX

Illustration
Fatuma, Ridhaa and Mashemba are partners running a firm under the name Fatima. The trial balance
for the partnership as at 31s` December2009 was as follows:

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Sh “000” Sh “000”
Capital accounts :Fatuma 320 000
Ridhaa 320 000
Mashemba 160 000
Current account: Fatuma 25 000
Ridhaa 30 000
Mashemba 10 500
Drawings : Fatuma 8 200
Ridhaa 12 100
Mashemba 3 600
Salaries and wages 766 000
Rent 96,000
Loan (Ridhaa) 74,500
Motor vehicle at cost 1,100,000
Office equipment and fittings at cost 300,000
Purchases 1,825,600
Opening inventory 36,940
Sales 3,594,470
Trade receivables 84,800
Trade payables 19,400
Cash in hand 3,450
Balance at bank 135,770
Motor insurance 25,000
Electricity 9,070
General expenses 126.340 ________
__4,543,370 4,543,370

Additional Information

I. Inventory as at 31 October 2010 was valued at sh. 3,200,000 2. Depreciation is to be provided as

follows:

Asset Rate per annum Method

Furniture and fittings 5% Straight-line
Motor vehicles 20% Reducing balance

3. Prepayment and accruals as at 31 October 2010 were as follows:

Prepayment Accruals
Sh. Sh.
Wages 100,000 -
Auditors fees - 120 000

Director's income - 20 000

Carriage income - 540 000
Carriage outwards 30 000 -

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4. Corporation tax for year ended 31 October was sh. 278,000

5. Allowance for doubtful debts as at 31 October 2010 was sh. 145,000
6. The board of directors has approved the following:
 Final dividend of sh. 0.50 per share
 Transfer of sh. 285,000 from the general reserve

Required:
a) Income statement for the year ended 31 October 2010
b) Statement of financial position as at 31 October 2010

Solution

1. Income statement and appropriation account

Fatuma, Ridliaa and Mashemba

Income statement and appropriation account for the year ended 31st December, 2009
Details Shs. Shs.
Sales 3,594,470
Cost of sales
Opening stock 36,940
Purchases 1,825,600
Cost of goods available for sale 1,862,540
Less: Closing stock (54,860) (1,807.680)
Gross profit 1,786,790
Less: Expense
Motor insurance (w2) 18,750
Depreciation: Motor Vehicle (w1) 275,000
Office equipment & fittings (w1) 60,000
Salaries and wages 766,000
Rent 96,000
Electricity 9,070
General expenses 126,340 (1,351,160)
Net profit 435,630
Share of profit: Fatuma 174,252
Ridha 174,252
Mashemba 87,126 (435,630)
nil

ii. Partners current accounts

Partner’s Current Accounts

Details Fatuma Ridha Mashemba Details Fatuma Ridha Mashemba
Balance b/d 10,500 Bal. b/d 25,000 30,000
Drawings 8,200 12,100 3,600 Profit share 174,252 174,252 87,126
Balance c/d 191,052 192,152 73,026
199,152 199,152 87,126 199,152 199,152 87,126
Balance b/d 191,052 192,152 73,026

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iii. Statement of financial position.

Fatuma, Ridhaa and Mashemba

Statement of financial position as at 31 December
Non-Current Assets Cost Accum. Depre Net Book Value
Sh. Sh. Sh.
Motor vehicle 1,100,000 (275,000) 825,000
Office equipment's & fittings 300,000 (60,000) 240.000
1.400.000 335 000 1,165,000
Current Assets
Stock 54,860
Advance insurance 6,250
Trade receivable 84,800
Bank 135,770
Cash 3,450 285,130
1 350 130
Financed By:
Capital accounts: Futuma 320,000
Ridhaa 320,000
Mashemba 160,000 800,000

Current accounts: Fatuma 191,052

Ridhaa 192,152
Mashemba 73,026 456,230
Loan 74,500

Current Liabilities
Trade payable 19, 400
1,350,130
WI

Provision for depreciation

Motor vehicle; 25% x 1,100,000 = 275,000

Office equipment and fittings 20% x 300,000 = 60,000

W2

Insurance account
Shs Shs
Cash 25,000 Income statement 18,750
_____ Balance c/d 6.250
25,000 25,000

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Motor vehicle account

Shs Shs
Balance b/d 1,100, 000 Depreciation 275,000
_____ Balance c/d 825.000
1,100,000 1,100,000

Equipment and furniture account

Shs Shs
Balance b/d 300, 000 Depreciation 60,000
_____ Balance c/d 240.000
300,000 300,000

CHANGES IN PARTNERSHIP

ADMISSION OF A NEW PARTNER

When a new partner is admitted into the firm, this marks the end of the old partnership and the
beginning of a new one.

The new partner will have to bring in the capital that is due from him as per the agreement and also
pay for a share of the goodwill.

Goodwill is credited to the partner's account (only the old) and is again written off by debiting the
partner's account (inclusive of the new one in the new Profit Sharing Ratio).

When a new person is admitted as partner, the two main problems to be tackled are regarding

a) Treatment of goodwill
b) Revaluation of assets and liabilities

Goodwill: Depending upon the share of profits to be given to the new partner, either a sum of
money will be paid by him to the old partners (through the firm or privately) or the old partners will
be credited with their share of the goodwill.

It is proper that it should be so. The new partner will take a share of profits which comes out of the
shares of other partners. The old partners must be compensated for such a loss,

The amount to be brought in by the new partner for goodwill is in addition to the amount to be
brought in as capital.

The various possibilities as regards goodwill are:

a. Premium method

i. The new partner brings goodwill in cash which is left in the business
ii. The new partner brings goodwill in cash but the cash is withdrawn by the old partners.
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iii. The amount of goodwill is paid by the new partner to the old partners privately.

b. Revaluation method

The new partner does not bring cash for goodwill which is raised in the books and is allowed to
remain in the books.

c. Memorandum Revaluation Method

Goodwill is raised in the books and then is immediately written off.

Before considering the entries to be made in the above cases, one must decide regarding the ratio in
which goodwill is to be credited to the old partners.

Traditionally, goodwill was credited to the old partners in the old profit-sharing ratio and, if the
amount was to be written off, it was written off to all the partners in the new profit-sharing ratio.
There would be no doubt that this should be the case when, on the admission of a new person as
partner, the ratio as among the old partners does not change.

But what if on the admission of a new partner the profit-sharing of old partners as among themselves
is also changed?

If one treats paying sums in respect of goodwill to old partners as compensation for their
surrendering to the new partner a part of their profits, then obviously the amount to be credited to
partners should be in the ratio of loss of profits.

Suppose, A and B, sharing in the ratio of 3:2, admit C as partner and it is agreed that the new profit-
sharing ratio is 2:2:1. It is obvious that B does not stiffer at all on C's admission.

He previously received two fifths of profits: he still receives two fifths of profits.

It is A alone who has suffered and, therefore, any amount brought in as goodwill by C should be
credited to only A.

Thus, it is proper to credit goodwill brought in by a new partner to the old partners in the ratio in
which they suffer on the admission of the new partner.

There would be no difficulty if the whole value of goodwill is raised in the books. This would then
mean revaluation of an asset and any profit arising out of such revaluation is naturally to be credited
to the old partners in the old ratio.

Hence, if goodwill is raised at its full value, it should be credited to the old partners in the old

Illustration

Amitu and Bosire have been in partnership, sharing profits and losses in the ratio 4:3.

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They agreed to admit Cheche to the partnership, with profits and losses being shared between
Amitu, Bosire and Cheche in the ratio 3:2:1, On the date of the change in partnership, the partners'
capital and current account balances were:

Capital Current
Amitu Shs 60,000 Cr Shs 12,800 Cr
Bosire Shs 40,000 Cr Shs 9,500 Cr

It was agreed that, at the date of Cheche's admission, the partnership was to be valued at Shs
164,300.

Step 1- Calculate goodwill .

The total book value of the partnership is equal to the combined value of the partners' capital and
current accounts, or Shs 122,300 (Shs 60,000 + Shs 12,800 + Shs 40,000 + Shs 9,500)

The partnership is valued at Shs 164,300,

Therefore, the goodwill is valued at Shs 42,000 (Shs 164,300 — Shs 122,300).

Step 2 — Create goodwill asset in books

The goodwill account is created by a debit entry of Shs 42,000.

This value is credited to the old partners in the old profit and loss sharing ratio — i.e. 4/7 (or Shs
24,000) to Amitu and 3/7 (or Shs 18,000) to Bosire.

Thus, the new capital balances are:

Amitu Shs 84.000 Cr (Sits 60,000 Cr and Shs 24,000 Cr)

Bosire Shs 58,000 Cr (Shs 40,000 Cr and Shs 18,000 Cr)

If goodwill is to be carried in the books, no further entries are needed, as the only change is that a
new asset of goodwill has been created, and the capital balances of the old partners have increased
by the same value.

Step 3 — Eliminate goodwill (if required by question)

If goodwill is not to be carried in the books, it is eliminated by a credit entry in the goodwill
account, and debit entries in the partners' capital accounts, based in the new profit and loss sharing
ratio:

Amitu Shs 21,000 (Shs 42,000 x 3/6)

Bosire Shs 14,000 (Shs 42,000 x 2/6)
Cheche Shs 7,000 (Shs 42,000x1/6)

As a result, the new capital balances are:

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Amitu Shs 63,000 Cr (Shs 84,000 Cr and Shs 21,000 Dr)

Bosire Shs 44,000 Cr (Shs 58,000 Cr and 14,000 Dr)
Cheche Shs 7,000 Dr (share of goodwill eliminated)

Step 4 Contribution of capital by new partner (if required by question)

If the question requires a contribution by any of the partners (or a repayment of capital) we simply
need to follow the normal principles of double-entry bookkeeping.

For example, the question may require the new partner to contribute cash so that the opening capital
balance is nil.

In this case, a credit of Shs 7,000 is needed in Cheche's capital account, so this is the amount of cash
that must he contributed.

The entries will therefore be:

Debit Bank Shs 7,000

Credit Capital — Cheche Shs 7,000

Illustration:

John and Joel were partners in a business sharing profits and losses in the ratio of 2:1. Interest on
fixed capital was allowed at the rate of 10% per annum. No interest was charged on current
accounts. On 30 September 2011 Joy was admitted as a partner and from that date profits and losses
were to be shared in the ratio of 2:2:1 for John, Joel and Joy respectively. Goodwill was not to be
retained in the books with adjusting entries being made in the current accounts.

The following trial balance was extracted from the partnership's books of account as at 31 March
2012:

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Sh “000” Sh “000”
Leasehold premises 15,000
Motor vehicles (at cost) 16,400
Furniture and fittings (at cost) 5,800
Accumulated depreciation as at 1 April 2011:
Motor vehicles 3,780
Furniture and fittings 970
Capital accounts: John 6,500
Joel 5,600
Cash introduced by Joy 9,000
Purchases 43,200
Sales 80,000
Bank balance 2,460
Receivable 6,440
Rent and rates 840
Inventory (1 April 2011) 9,600
Salaries 14,960
Selling and distribution costs 5,240
Current accounts: John 3,440
Joel 2,200
Payables ______ 8,450
119,940 119,940

Additional information:
1. No entries have been made to record the admission of Joy. Goodwill was agreed at Sh.10.5
million. Sh.6 million of the cash introduced by Joy was the fixed capital.
2. Salaries include the following partners' drawings:
Sh “000”

John 2,580
Joel 2.040
Joy 680
3. Depreciation is to be provided as follows:
Asset Rate per annum
Motor vehicles 20% on cost
Furniture and fittings 10% on cost
4. The sales during the six month period from 1 October 2011 to 31 March 2012 were 50%
more than the sales during the six month period from 1 April 2011 to 30 September 2011.
The selling and distribution expenses varied with the sales.
All other expenses accrued evenly.
5. Inventory as at 31 March 2012 was valued at Sh.11 million.
6. Allowance for doubtful debts was Sh.229,000 as at 30 September 2011 and Sh.309,000 as at
31 March 2012.
7. The leasehold premises is to be amortised over 30 years from 31 March 2011

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Required:
a) Income statement for the year ended 31 March 2012.
b) Statement of financial position as at 3 I March 2012.
c) Partners' current accounts.
Solution:
a) Income statement
Partners
Income statement for the year ended 31st march, 2012
Tota
30th September 2011 31st March 2012 l
Sh. ‘000’ Sh. ‘000’ Sh. ‘000’
Sales 32,000 48,000 80,000
Less cost of sales
Inventory 9,600 14,480 9,600
Purchases 21,600 21,600 43,200
Goods available for sale 31,200 36,080 52,800
Less closing inventory (14,480) (16,720) (11,000) (25,080) (11,000) (41,800)
Gross profit 15,280 22,920 38,200
Less expenses
Rent 420 420 840
Salaries 4,830 4,830 9,660
Selling & distribution 2,096 3,144 5,240
Depreciation on:
Motor vehicles 1,640 1,640 3,280
Furniture and fittings 290 290 580
Prov. for doubtful debts 229 (9,505) 309 (10,633) 538 (20,138)

Net profit 5,775 12,287 18,062

Interest on capital:
John 325 325 650
Joel 280 280 560
Joy - (605) 300 (905) 300 (1,510)
Profit to be shared 5,170 11,382 16,552
Share of profit
John 3,447 4,553 8,000
Joel 1,723 4,553 6,276
Joy - (5,170) 2,276 (11,382) 2,276 (16,552)
NIL NIL NIL

W1
Apportionment of sales 3/5 × 80,000,000 = 48,000,000
To 30th September 2011 100: 150 = 2 :3
To 31st March 2012 2/5 × 80,000,000 = 32,000,000

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W2
Interest on capital

To 30th September 2011 John: 10%×6,500,000× ½ = 325,000

Joel: 10% ×5,600,000× ½ = 280,000
Joy: = -
To 31st March 2012 John: 10% × 6,500,000× ½ = 325,000
Joel: 10% × 5,600,000× ½ = 280,000
Joy: 10% ×6,000,000×½ = 300,000
W3
Goodwill Account
Shs ‘000’ Shs ‘000’
Current Account: Current account:
John: 2/3 x 10500 7000 John: 2/5 x 10500 4200
Joel: 1/3 x 10500 3500 Joel: 2/5 x 10500 4200
_____ Joy 1/5 x 10500 2100
10,500 10,500

W4
Salaries expense for the business 14,960,000-5,300,000=9,660,000
b) Statement of financial position
John, Joel and Joy
Statement of financial position as at 31st march 2012
Non –current assets Cost Depreciation NBV
Sh. ‘000’ Sh. ‘000’ Sh. ‘000’
Non –current assets
Leasehold premises 15,000 15,000
Motor vehicle 16,400 7,060 9,340
Furniture and fittings 5,800 1,550 4,250
37,200 8,610 28,590
Current assets
Inventory 11,000
Trade receivables 6,440
Provision for doubtful debts (538) 5,902
Bank balance 2,460 19,362
Total assets 47,952
Equity and liabilities
Capital Account
John 6,500
Joel 5,600
Joy 6,000
Current Account
John 12,310
Joel 6,296
Joy 2,796
Owner’s Equity 39,502
Current liabilities
Trade payables 8,450
Total Equity and Liabilities 47,952

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c) Partners' current accounts.

Partners’ current accounts

For the year ended 31st march 2012
John Joel Joy John Joel Joy
Shs‘000’ Shs‘000’ Shs‘000’ Shs‘000’ Shs‘000’ Shs‘000’
Drawings 2,580 2,040 680 Balance b/d 3,440 2,200 3,000
Goodwill 4,200 4,200 2,100 Cash - - -
Bal. c/d 12,310 6,296 2,796 Goodwill 7,000 3,500 300
Int. on capital 650 560 2,796
_____ _____ ____ Share of profit 8,000 6,196 5,576
19,090 12,536 5,576 19,090 12,536 2,796
Balance b/d 12,810 6296

RETIREMENT OR WITHDRAWAL OF A PARTNER

If an existing partner wishes to retire or withdraw from the partnership, the partner may be bought
out by an existing partner or may receive assets from the partnership. If an existing partner
purchases the interest of the retiring partner, the partnership records an entry to close out the capital
account balance of the retiring partner and adds the amount to the capital account balance of the
partner who purchased the interest. If the partnership gives assets to the retiring partner in the
amount of the partner's capital account balance, an entry is made to reduce the assets and zero out
the retiring partner's capital account balance. If the retiring partner receives more assets or fewer
assets than the partner's capital account balance, the difference is taken from or added to the capital
accounts of the remaining partners according to how they share in gains or losses. -

Illustration:

Kanini, Lucy and Ndwiga are in partnership sharing profits and losses in the ratio 3:2:1
respectievly. Ndwiga decided to retire on 31 December 2012 and Gitonga was admitted as a
partner on that date.

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The following is the partnership trial balance as at 31december 2012

Sh. Sh.
Premises 1,800,000
Plant 740,000
Vehicles 300,000
Equipment 40,000
Inventory as at 31 December 2012 1,247,580
Accounts receivable 699,600
Cash 15,200
Accounts payable 380,720
Bank overdraft 84,000
Loan Ndwiga 560,000
Capital: Kanini 1,700,000
Lucy 1,300,000
Ndwiga 700,000
Current accounts :Kanini 74,280
Lucy 50,180
Ndwiga ________________ 93,560
4,892,560 4,892,560

Additional information
1. Revaluation premises Sh. 2,400,000 plant Sh. 700,000 and inventory Sh. 1,083,580
2. Allowance for doubtful debts amounting to sh. 60,000 is to be provided
3. Goodwill amounting to sh. 840,000 is to be recorded in the books on the day Ndwiga
retires. The partners in the new partnership do not wish to maintain goodwill.
4. Kanini and Lucy are to share profits in the same ratio as before. Gitonga will have the
same share of profits as Lucy.
5. Ndwiga is to take his car at book value of sh. 78,000 in part payment and the balance of
all he is owned by the firm in cash except sh. 400,000 which he is willing to leave as a
loan account.
6. The partners in the new firm are to start on equal footing so far as capital and current
accounts are concerned. Gitonga is to contribute cash to bring his capital and current
accounts to the same amount as the original partner from the old firm who has the lower
investment in the business
7. The original partner in the old firm who has the higher investment will draw cash so that
capital and current account balances equal those of his new partners

Required;-
a) Partners capital account
b) Partners current account
c) Statement of financial position for the partnership of Kanini, Lucy and Gitonga as at 31
December 2012

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Solution:

Kanini Lucy Ndwiga and Gitonga

Capital accounts for the year ended 31 December 2012
Kanini Lucy Ndwiga Gitonga Kanini Lucy Ndwiga Gitonga
Shs Shs Shs Shs Shs Shs Shs Shs
Goodwill 360,000 240,000 - 240,000 Bal b/d 1,700,000 1,300,000 700,000 1,712,000
Car loan - - 78,000 - Cash - - 66,000 -
cash - - 400,000 - Revaluation 198,000 132,000 140,000 -
Drawings 486,000 - 521,560 Goodwill 420,000 280,000 93,560- -
Bal c/d 1,472,000 1,472,000 ______ 1,472,000 Current a/c - - _____ _____
2,318,000 1,712,000 99,560 50,180 2,318,000 1,712,000 99,560 1,712,000
-

Kanini Lucy Ndwiga and Gitonga

Current accounts for the year ended 31 December 2012
Kanini Lucy Ndwiga Gitonga Kanini Lucy Ndwiga Gitonga
Shs Shs Shs Shs Shs Shs Shs Shs
Bal b/d - 50,180 - - Bal b/d 74,280 - 93,560 50,180
Capital a/c - - 93,560 - Cash - - - -
Drawings 24,100 - - - Bal c/d 50,180 - -
Bal c/d 50,180 -____ -____ 50,180 _____ _____ _____
74,280 50,180 93,560 50,180 74,280 50,180 93,560 50,180

c) Statement of financial position

Kanini Lucy and Gitonga

Statement of financial position as at 31 December 2012
Non Current assets Cost Acc. Dep NBV
Shs Shs Shs
Premises 2,400,000 2,400,000
Plant 700,000 700,000
Vehicle 222,000 222,000
Equipment 40,000 40,000
3,362,000
Current Assets
Inventory (W5) 1,083,580
Account receivables 639,600
Bank (W6) 646,520
Cash 15,200 2,444,900
5,806,900
Equity and liabilities
Capital A/c
Kanini 1,472,000
Lucy 1,472,000
Gitonga 1,472,000
Current a/c
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Kanini 50,180
Lucy (50,180)
Gitonga 50,180
4,466,180
Long term Liabilities
Loan from Ndwiga 960,000
Current Liabilities
Account payables 380,720
5,806,900

W1
Goodwill a/c
Sh. Sh.
Capital a/c Capital account
Kanini 3/6×840,000 420,000 Kanini 3/7 ×840,000 360,000
Lucy 2/6 × 840,000 280,000 Lucy 2/7 × 840,000 240,000
Ndwiga 1/6 × 840,000 140,000 Gitonga 2/7 ×840,000 240,000
840,000 840,000
W2
Revaluation a/c
Sh. Sh.
Plant 40,000 Premises 600,000
Inventory 164,000
Capital A/c
Kanini 3/6 ×396,000 198,000
Lucy: 2/6 × 396,000 132,000
Ndwiga 1/6×396000 66,000 ______
600,000 600,000

W3
Premises A/c
Sh. Sh.
Balance b/d 1,800,000 Balance c/d 2.400,000
Revaluation 600,000 ________
2,400,000 2,400,000

W4
Plant A/c
Sh. Sh.
Balance b/d 740,000 Revaluation 40,000
______ Balance c/d 700,000
740,000 740,000

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W5
Inventory A/c
Sh. Sh.
Balance b/d 1,247,580 Revaluation 164,000
______ Balance c/d 1,083,580
1,247,580 1,247,580
W6
Bank a/c
Sh. Sh.
Capital 1,712,000 Balances 84,000
Current 50,180 Drawings
Capital 486,000
Current 24,100
Capital 521,560
_____ Balance c/d 646,520
1,762,180 1,762,180

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REVISION EXERCISE

QUESTION 1

Aisha, Birdi and Wafula are partners. They share profits and losses in the ratio of 3:2:1. In the first
year of trading, ending 31 December 2004, the partnership earned a net profit of Shs.15,800,000.
They have agreed interest should be allowed don fixed capital balances at 10% per annum. Also, it
has been agreed that Birdi should receive a partnership salary of sh.4,500,000 per annum. Capital -
account balances are as follows: Aisha Shs.8,000,000, Birdi Shs.6000,000 and Wafula
Shs.6,000,000

You are required to draw up the appropriation account of the partnership for the year ended 31
December 2004.

Solution:

Aisha, Birdi & Wafula

Appropriation Account for year ended 31 December 2004
Shs.000 Shs.000 Shs.000
Net profit 15,800
Less: interest on capital
Hirst 800
Bright 600
Warhust 600 2,000
4,500 6,500
Salary: Bright 9,300

Balance of profits shared:

Hirst 4,650
Bright 3,100
Warhust 1,550 ____
9,300

QUESTION 2

Stewart and Armstrong are in partnership sharing profits and losses equally. The following balances
have been extracted from the books as at 31 December 2006.

Capital a/c: Current a/c: Salaries: Drawings:

Sh.000 Sh.000 Sh.000 Sh.000
Stewart,Shs.15,000 Stewart, Shs.3,200 Stewart, Shs. 6,000 Stewart, Shs. 8,000
Armstrong; Shs.20,000 Armstrong, Shs.800 Armstrong, Shs.4,000 Armstrong, Shs.5,000

The firm's net profit for the year to 31 December 2006 was Shs.26,750,000.
Interest is to be allowed on capital at 10% per year.
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Interest is to be charged on drawings based on 5% of total drawings for the year, irrespective of
when the drawings were taken.

Required;-
(a) An appropriation account for the year ended 31 December 2006
(b) The current accounts for both partners

Solution:

Steward and Armstrong

Appropriation Account for year ended 31 December 2004
Shs.000 Shs.000 Shs.000
Net profit 26,750
Less: interest on drawings
Steward 400
Armstrong 250 650
27,400
Less: interest on capital
Steward 1,500
Armstrong 2,000 3,500

Salary: Steward 6,000

Armstrong 4,000 10,000 _____
13,250
Balance of profits shared:
Steward 6,625
Armstrong 6,625 ____
13,250

Current Accounts
Details Steward Armstrong Details Steward Armstrong
Balance b/d 800 Bal. b/d 3,200
Interest on drawings 400 250 Interest on capital 1,500 2,000
Drawing 8,000 5,000 Salaries 6,000 4,000
Balance c/d 8,925 6,575 Profit share 6,625 6,625
17,325 12,625 17,325 12,625

QUESTION 3

Peter, Mark and Brian are partners. They share profits and losses equally. In the first year of trading,
ending 31 December 2007, the partnership earned a net profit of Shs 32,800,000. They have agreed
interest should be allowed on fixed capital balances at 10u/0 per annum. Also, it has been agreed

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that Mark should receive a partnership salary of Shs.7, 200,000 per annum. Capital account balances
are as follows; Peter Shs. I 8, 000,000, Mark Shs.12, 000,000 and Brian Shs.9, 000,000.

You are required to draw up the appropriation account of the partnership for the year ended 31
December 2007.

Solution:

Peter, Mark and Brian

Appropriation Account for year ended 31 December 2004
Shs.000 Shs.000 Shs.000
Net profit 32,800
Less: interest on capital
Peter 1,800
Mark 1,200
Brian 900 3,900
7,200 11,100
Salary: Mark 21,700

Balance of profits shared:

Peter 7,234
Mark 7,233
Brian 7,233 ____
21,700

QUESTION 4

Smith and Jones are in partnership. According to their partnership agreement, they share profits and
losses equally (1:1). Smith is entitled to a salary of shs. 1,000,000 p.a. and Jones is given a
commission of shs. 500,000. Smith and Jones contributed shs.4, 500,000 each as capital with an
interest on capital of 10% p.a.

During the year ending 31st December 2002 Smith and Jones mad drawings of Shs.2,000,000 each.
The rate of interest charged on such drawings being of 10% p.a.

The balances on the partners' current account on I January were: Smith Shs.550,000 (Cr) and Jones
Shs. 700,000 (Dr). The Net Profit registered for the year was Shs. 5,000,000.

You are required to prepare:

a) The Profit and Loss Appropriation Account;

b) The Partners' Current Account;
c) Statement of financial position (extract) showing the current account balances only.

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Solution:

Profit and Loss Appropriation Account for the year ending

31 December 2002
Shs.000 Shs.000 Sh.000
Net Profit 5,000
Add Interest on Drawings:
Smith (10% x2,000) 200
Jones (10% x2,000) 200 400
5,400
Less Interest on Capital:
Smith (10% x 4,500) 450
Jones (10% x 4,500) 450 900

Less Salary:
Smith 1000

Less Commission:
Jones 500 2,400
3,000
Share of Profits:
Smith (1/2 x3,000) 1,500 ____
Jones (1/2 x 3,000) 1,500 3,000

(b)
Partners’ Current Accounts
Details Shs.000 Shs.000 Details Shs.000 Shs.000
Balance b/d - 700 Interest on capital 450 450
Drawing 2,000 2,000 Salaries 1,000 -
Interest on drawings 200 200 Commissions - 500
Balance c/d 1,000 - Share of Profit 1,500 1,500
____- ____- Balance c/d ____-_ 450
3,500 2,900 3,500 2,900

The Balance in the Current Account may be either a credit or a debit balance.
A Credit Balance is that part of profit for the year, which the partner has not yet taken. Therefore the
partner is a creditor because the business owes money to the partner.
A Debit Balance represents an excess of money taken by the partner over profits earned. This leaves
the partner to be a debtor for the sum because the partner owes money to the business.

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(c)
Statement of financial position (Extract) as at 31 December 2002
Shs.000 Shs.000
Financed by:
Capital Account Balances:
Smith 4,500
Jones 4,500 9,000
Current Account Balances
Smith 1,300
Jones (450) 850
9,850

QUESTION 5
Jimmy and Billy are in partnership and according to their partnership agreement they share profits
and losses equally; interest is allowed on capital at 5% p.a.
Jimmy is entitled to a salary of Sh.500,000. The following Trial Balance is extracted from their
books on 31 December 2001.

Trial Balance as at 31 December 2001

Dr. Cr.
Shs.000 Shs.000
Premises 6,000
Carriage 100
Bad Debts 50
Purchases and Sales 16,000 28,000
Returns 80 60
Salaries 1,400
Rates and Taxes 400
Insurance 140
Cash in hand 700
Stock 1 January 2001 3,500
Fixtures and Fittings 4,500
Wages 2,600
Capital: Jimmy - 6,000
Billy - 6,000
Current: Jimmy 100 -
Billy 150
Drawings: Jimmy 800
Billy 900
Debtors and Creditors 8,000 5,000
Provision for Bad Debts - 250
Discounts 100 20
Office Expenses 110 -
45,480 45,480

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Additional information;-

1. Stock on 31 December 2001 was Shs 2,800,000.

2. Shs 60,000 of the carriage is for carriage in.
3. Depreciate Fixtures and Fittings by 10%.p.a.
4. Wages accrued Shs 400,000.
5. Provision for Bad Debts to equal 10% of Debtors.

You are required to prepare in vertical format:

a) A Trading, Profit and Loss and Appropriation Account for the year ending 31 December
2001;
b) A Current Account
c) Statement of financial position as at 31 December 2001.

Solution:

Jimmy and Billy

Trading and Profit and Loss Account for the Year Ended 31 December 2001
Shs '000' Shs '000' Shs '000'
Sales 28,000
Return Inwards (80)
Net sales 27,920
Cost of sales
Opening stock 1 Jan 2001 3,500
Purchases 16,000
Return outwards (60) 15,940
Net purchases 60
Carriage inwards 19,500
2,800 (16,700)
Closing stock 31 December 2001 11,220
Gross profit 20
Add Discount received 11,240

Expenses:

Discount allowed 100

Office expenses 110
Carriage outwards 40
Bad debts 50
Salaries 1,400
Rates 400
Wages 3,000
Insurance 140
Bad debts provision 550
Depreciation 450 (6,240)
Net profit 5,000
Interest on capital:
Jimmy 300

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Billy 300 600

Salary:
Jimmy 500 (1,100)
3,900
Share of profit
Jimmy (1/2x3900) 1,950
Billy (1/2x3900) 1,950 3,900

Current Accounts
Details Jimmy Billy Details Jimmy Billy
Shs.000 Shs.000 Shs.000 Shs.000
Balance b/d 100 - Balance b/d - 150
Drawing 800 900 Interest on capital 300 300
Balance c/d 1,850 1,500 Salaries 500 -
____- ____- Share of Profit 1,950 1,950
2,750 2,400 2,750 2,400
Balance c/d 1,850 1,500

Jimmy and Billy

Statement of financial position as at 31 December 2001
Fixed Assets Cost Accum. Depre Net Book Value
Sh.000 Sh.000 Sh.000
Premises 6,000 - 6,000
Fixtures and fittings 4,500 450 4.050
10,500 450 10,050
Current Assets
Stock 31 Dec 2001
Debtors 2,800
Less Bad debt provision 8,000
Cash in hand (800) 7,200
700 10,700
Financed By: 20,750
Capital Balances
Jimmy
Billy 6,000
6,000 12,000
Current Balances
Jimmy 1 ,850
Billy 1,500 15,350

Current Liabilities
Creditors 5,000
Wages Accrued 400 5,400
20,750

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QUESTION 6

Jack and Richard are in partnership as retail grocers. Their partnership agreement allows interest on
capital at 1 January 2001 at the rate of 8% p.a. Jack is allowed an annual salary of Sps.5,000,000 and
Richard, who works part-time a salary of sh.3,000,000. Profits or Losses are slcared equally. The
following Trial Balance was extracted from their books on 31 December 2001.

Trial Balance as at 31 December 2001

Dr. Cr.
Shs.000 Shs.000
Capital 1 January 2001: Jack 90,000
Richard 45,000
Current Account 1 January 2001 Jack 150
Richard 70
Sales 120,000
Stock- 1 January 2001 2,500
Purchases 104,780
Premises 100,000
Delivery Van 15,000
Rates 1,500
Van Expenses 950
Insurance 360
Cash at Bank 3,500
Cash in Hand 60
Creditors 1,170
Repairs to Premises 12,300
Drawings: John 10,000
Richard 5.000 _______
256,170 256,170

Taking into consideration the following:

1. Stock 31 December 2001 Shs.4, 600,000.

2. Insurance prepaid Shs 90,000.
3. Depreciation of delivery van 10% of book value.
4. An extension costing Shs 10,000,000 had been posted as repairs to premises.

You are required to prepare:

a) 'Trading and Profit and Loss Accounts, including the Appropriation section for the year
ending 31 December 2001.
b) Partners' Current Account for the year ending 31 December 2001.
c) Statement of financial position as at 31 May 2001.

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Solution:

Trading and Profit and Loss Account for the Year Ended 31 December 2001
Shs '000' Shs '000' Shs '000'
Sales 120,000
Cost of sales
Opening stock 1 Jan 2001 2,500
Purchases 104,780
107, 280
Closing stock 31 December 2001 (4,600)
Gross profit

Expenses:
Rates 1,500
van expenses 950
Insurance 270
Repairs to premises 1,500
Depreciation (10%x15,000) 1,500 (6,520)
Net profit 10,800
Less: Interest on capital:
Jack (8%x90,000) 7,200
Richard (8%x45,000) 3,600 10,800
Less Salary:
Jack 5,000
Richard 3,000 8000 (18,800)
(8,000)
Share of profit
Jack (1/2x8,000) 4,000
Richard (1/2x8,000) 4,000 (8,000)

Current Accounts
Details Jack Richard Details Jack Richard
Shs.000 Shs.000 Shs.000 Shs.000
Balance b/d 150 70 Interest on capital 7,200 3,600
Drawing 10,000 5,000 Salaries 5,000 3,000
Balance c/d 4,000 4,000 Share of Profit 1,950 2,470
14,150 9,070 14,150 9,070

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Statement of financial position as at 31 December 2001

Fixed Assets Cost Accum. Depre Net Book Value
Sh.000 Sh.000 Sh.000
Premises (+10,000) 110,000 - 110,000
Delivery van 15,000 1,500 13.500
125,000 1,500 123,500
Current Assets
Stock 31 Dec 2001 4,600
Cash at bank 3,500
Cash in hand 60
Insurance prepaid 90
10,700
Financed By: 20,750
Capital
Jack 90,000
Richard 45,000 135,000
Current
Jack (1,950)
Richard 2,470 (4,420)

Current Liabilities
Creditors 1,170
131,750

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TOPIC 7
FINANCIAL STATEMENTS OF A COMPANY

INTRODUCTION

Limited companies come into existence because of the growth in size of business and the need to
have many investors in the business.

Partnerships were not suitable for such businesses because the membership is limited to 20 persons.

Types of companies

There are 2 principle types of companies:

Private companies

These have the words limited at the end of the name. Being private, they cannot invite the members
of the public to invest in their ownership.

Public companies

There much larger in size as compared to private companies. They haVe the words public limited
company at the end of their name.

They can invite the members of the public to invest in their ownership and the companies may be
quoted on the stock exchange.

CAPITAL STRUCTURE OF A COMPANY INCLUDING INITIAL ISSUES OF SHARES

AT FULL PRICE, RIGHTS ISSUES AND BONUS

The term capital structure refers to the percentage of capital (money) at work in a business by type.
Broadly speaking, there are two forms of capita]: equity capital and debt capital. Each has its own
benefits and drawbacks and a substantial part of wise corporate stewardship and management is
attempting to find the perfect capital structure in terms of risk / reward payoff for shareholders. This
is true for companies and for small business owners trying to determine how much of their startup
money should come from a bank loan without endangering the business.

Equity Capital

This refers to money put up and owned by the shareholders (owners). Typically, equity capital
consists of two types:

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1. Contributed capital, which is the money that was originally invested in the business in
exchange for shares of stock or ownership and
2. Retained earnings, which represents profits from past years that have been kept by the
company and used to strengthen the fund growth, acquisitions, or expansion.
Many consider equity capital to be the most expensive type of capital a company can utilize because
it's "cost" is the return the firm must earn to attract investment. A speculative mining company that
is looking for silver in a remote region of Africa may require a much higher return on equity to get
investors to purchase the stock than a firm such as Procter & Gamble, which sells everything from
toothpaste and shampoo to detergent and beauty products.

Debt Capital

This type of capital is infused into a business with the understanding that it must be paid back at a
predetermined future date. In the meantime, the owner of the capital (typically a bank, bondholders,
or a wealthy individual), agree to accept interest in exchange for you using their money. Think of
interest expense as the cost of "renting" the capital to expand your business; it is often known as the
cost of capital. For many young businesses, debt can be the easiest way to expand because it is
relatively easy to access and is understood by the average American worker thanks to widespread
home ownership and the community-based nature of banks. The profits for the owners is the
difference between the return on capital and the cost of capital; for example, if you borrow
Shs.100,000 and pay 10% interest yet earn 15% after taxes, the profit of 5%, or Shs 5,000, would
not have existed without the debt capital infused into the business.

TYPES OF SHARE CAPITAL

ORDINARY SHARES

The terms "voting share" or "Common stock" are also used in other parts of the world; common
stock being primarily used in the United States.

It is called "common" to distinguish it from preferred stock. If both types of stock exist, ordinary
shareholders cannot be paid dividends until all preferred stock dividends (including payments in
arrears) are paid in full.

In the event of bankruptcy, ordinary share investors receive any remaining funds after bondholders,
creditors (including employees), and preferred stock holders are paid. As such, ordinary share
investors often receive nothing after a bankruptcy.

On the other hand, ordinary share on average perform better than preferred shares or bonds over
time. Ordinary share usually carries with it the right to vote on certain matters, such as electing the
board of directors. However, a company can have both a "voting" and "non-voting" class of ordinary
share.

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Holders of ordinary share are able to influence the corporation through votes on establishing
corporate objectives and policy, stock splits, and electing the company's board of directors. Some
holders of ordinary share also receive preemptive rights, which enable them to retain their
proportional ownership in a company should it issue another stock offering. There is no fixed
dividend paid out to ordinary shareholders and so their returns are uncertain, contingent on earnings,
company reinvestment, and efficiency of the market to value and sell stock.

Additional benefits from ordinary shares include earning dividends and capital appreciation.

PREFERENCE SHARES

Preferred stock (also called preferred shares, preference shares or simply preferreds) is an equity
security which may have any combination of features not possessed by ordinary share including
properties of both equity and a debt instruments, and is generally considered a hybrid instrument.
Preferred stock are senior (i.e. higher ranking) to common stock, but subordinate to bonds in terms
of claim (or rights to their share of the assets of the company).

Preferred stock usually carries no voting rights, but may carry-a dividend and may have, priority
over ordinary share in the payment of dividends and upon liquidation. Terms of the preferred stock
are stated in a "Certificate of Designation".

Similar to bonds, preferred stocks are rated by the major credit-rating companies. The rating for
preferred stock is generally lower, since preferred dividends do not carry the same guarantees as
interest payments from bonds and they are junior to all creditors.

ISSUE OF SHARES

Shares can be issued being payable for:

a) Immediately on application
b) By installments
Issue of shares take place on the following terms:
(Connected with the price of shares)

1) Shares issued at par value

In this case shares are issued at a price equal to the nominal value

2) Shares issued at a premium

Shares are issued at a price higher than the nominal value

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3) Shares issued at a discount

Shares are issued at a price lower than the nominal value —In Kenya it is illegal for a company to
issue shares at a discount

Accounting entries

To recognize the amount expected on issue:

DR- share application account at par value

CR- share capital at par value

Being the nominal value expected on application.

On receipt of amount

DR- bank account

CR- share application
Being the amount received on application

Issue at a premium

DR- share application

CR- share capital
CR- share premium

Being the amount expected on issue On receipt

DR- bank
CR-share application
Being the amount received on application

Issue at discount

DR- share application

CR- share application
Being the amount expected on application
DR- bank
DR- discount on share issue
CR- share application

Being the amount received on application and discount

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Over and under subscription

Often, when a company invites investors to apply or subscribe for its shares, the number of
applications will not equal the number of shares issued.

When more shares are applied for more than are actually available for issue, then the issue is said to
be oversubscribed.

When fewer shares are applied for than are available for issue, then the issue is said to be
undersubscribed.

When the issue is under subscribed, there is no problem since accounting entries will only be in
respect of the applied shares as the unapplied portion does not represent a transaction (there is no
transaction for the unapplied portion)

If however the shares are oversubscribed, the company must come up with a policy on how the
shares are to be allocated.

Any excess application money will be refunded by the company.

Rights Issue

A right issue is an option on the part of the shareholder given by the company to existing
shareholders at a price lower than the market price.

It involves selling ordinary shares to existing shareholders of the company on a prorata basis. When
the rights are issued the shareholders have 2 options available.

Buy the new shares and exercise their rights

Sell the rights in the market,

Ignore the rights.

A rights issue therefore gives the shareholder the right (but not an obligation) to buy the new shares
issued by the company.

Example
A Ltd has a share capital of Shs.200,000 trade up of 100,000 shares of Shs.2 each. The balance on
the share premium is Shs.60,000. Additional capital is raised by way of a right issue. The terms are
For every 5 shares held in the company, a shareholder can buy 2 shares at a price of Shs.2.5 per
share.

Required;
The journal entries to reflect the above transaction assuming that all the shareholders exercise their
rights and the relevant balance sheet extract.
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Shares to be issued

100 000
2 = 40,000 shares
5
Dr Cash book (40,000 x shs.2.5) shs 100,000
Cr Ordinary share capital (40,000 x shs.2) shs 80,000
Cr Share Premium [40,000 xshs.0.5] shs 20,000

Balance sheet (extract)

140,000 Ordinary shares 2 280,000

Reserves
Share premium 80,000

Bonus Shares

Shares issued to existing shareholders free of charge. They are paid out from either the share
premium, balance of retained profits of the General Reserves.

A scrip issue is similar to bonus issue only that a scrip issue gives the shareholder the choice of
receiving cash or stock dividends. In a bonus issue the shareholder has no choice but to take up the
shares.

Example

A Ltd has 100,000 shares at shs.1 each to form an ordinary share capital of shs.100,000 and a
balance on the share premium Alc of shs.50,000. It issues some bonus shares to existing
shareholders at a rate of 1 share for every 5shares held. This amount is to be financed by the share
premium. The entries will be as follows:

Shares to be issued:

100 000
1 = 20,000
5
Dr Share premium A/c [20,000 x shs.1] 20,000
Cr ordinary share capital 20,000
A bonus issue of 20,000 shares

Balance sheet (extract)

Ordinary shares 1,120,000

Reserves
Share premium 30,000

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TYPES OF RESERVES

Share Premium

Share premium is the amount received by a company over and above the face value of its shares.

Face value of a share is its value that is printed on the share certificate. For example, face value of a
Shs.1 share is one shilling. But just because the value of share is printed shs.l does not necessarily
mean that the share is worth only one shilling. If a company has a history of good financial
performance, it can sell its shares at a price higher than the face value of the shares. This difference
between the selling price and the face value of a share is known as share premium.

It is important to note that share premium arises only when the "company" sells the shares. It arises
only when a company issues new equity shares. It does not arise when the "investor" sells shares at a
price greater than face value. If a company sells a share whose face value is shs.1 at a price of shs.2,
the company earns a share premium of shs.l. But subsequently if the investor sells the same share to
someone else at a price of shs.4, no share premium will be gained by the company. The investor will
benefit from this gain.

Share premium is a non-distributable reserve. The company can use it only for the purposes that are
defined in the bylaws of that company. It cannot be used for purposes not defined in the company's
laws.

Usually the companies are not allowed to use the share premium for payment of dividends to the
shareholders and to set on the operating josses. Share premium can usually be used for paying equity
related expenses such as underwriter's fees. It can also be used to issue bonus shares to the
shareholders. The costs and expenses relating to issuance of new shares can also be paid from the
share premium.

The amount of share premium is presented in the balance sheet as part of the equity capital. It is
presented below the amount of issued share capital.

Example:

A Ltd wishes to raise capital by issuing 100,000 ordinary shares at sh.l each (per value) and the issue
price (selling price) is sh.1.5 each.

The following are the entries to be made in the A/C.

Dr Cashbook (100,000 x shs 1.5) 150,000

Cr Ordinary shares capital (100,000 x shs 1) 100,000
Cr Share Premium A/c (100,000 x shs 0.5) 50,000
Issue of shares at a premium of shs 0.5

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Revaluation Reserves

Any gain made on revaluation of non-current Assets especially for Land and buildings. When
company sills its property to realize the gain, the amount is transferred to the Profit and Loss
Account.

Capital redemption reserve

A reserve created after redemption or purchase of Preference shares without issuing new shares. The
transfer is made from either the share premium or the profit and loss account

Debenture Loans

The term debenture is used when a limited company receives money on loan, and certificates called
debenture certificates are issued to the lender:

They are also called loan stock or loan capital. Debehture interest has to be paid whether profits are
made or not. A debenture may either be redeemable of irredeemable. Redeemable is repayable at or
by a particular date and irredeemable is payable when the company is officially terminated.

Retained Profits

In accounting, retained earnings refer to the portion of net income whickis, retained by the company
rather than distributed to its owners as dividends. Similarly, if the corporation takes a loss, then that
loss is retained and called variously retained losses, accumulated losses or accumulated deficit.
Retained earnings and losses are cumulative from year to year with losses offsetting earnings.

Retained earnings are reported in the shareholders' equity section of the balance sheet. Companies
with net accumulated losses may refer to negative shareholders' equity as a shareholders' deficit. A
complete report of the retained earnings or retained losses is presented in the Statement of Retained
Earnings or Statement of Retained Losses.

INCOME TAX (ACCOUNTING TREATMENT, AND PRESENTATION)

In accounting for income tax the principle issue is how to account for the current tax liability and as
well as the future tax consequences (deferred tax)

Current and deferred tax

Deferred taxes is a tax that is payable in future.

Current tax

This is the corporation tax payable by companies based on trading results for given period. Tax is
mainly from profits but a company may have a taxable business which means a company doesn’t
have a tax liability in the current period, but carries the taxable loss to the subsequent period to be
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offset against future profits. Once the corporation tax has been estimated, IAS 12 requires the
following accounting treatment and presentation.

1) The total corporation tax liability for the period is shown as a separate item in the income
statement to be referred to as income tax expense.

2) If part of the total liability is unpaid by the end of the financial period then the unpaid
amount is to be presented as part of the current liabilities in the statement of financial
position (SOFP) and referred to as current tax.

3) Companies often use estimates to compute corporations before tax for a given financial
period. In the subsequent financial period, the tax initially estimated may either be more or
less than what is actually paid. This is referred to as under provision of the previous year’s
tax. If actual tax paid is more than what was provided then this is called overprovision.

> –

< –

IAS 12 recommends that an under provision of previous year’s tax should be added to the current
year tax expense while an overprovision should be deducted.

Deferred tax

This is the tax that is payable or that would be saved in future. If it is payable then it is called a
deferred tax liability and if it will be saved then it is called deferred tax asset. Deferred tax arises
because of the differences in the way traditions are treated in accounting and the way they are
treated after tax. Deferred tax is the basis of allocating tax charges to particular accounting periods.
The key to deferred taxation lies in two quite different concepts of;

1) Accounting profit (reported profit)

- This is the figure of profit before tax reported to the shareholders in the published accounts.

2) Taxable profits

- This is the figure of profit on which the taxation authorities base their calculation

The difference between accounting profit and taxable profit is caused by permanent differences and
temporary differences

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Permanent differences

i. One difference between accounting profit and taxable profit is caused by certain items not
being taxable/allowable

ii. Differences which only impact on tax computation of one period

iii. Differences which do not have deferred tax consequences whatsoever

Temporary differences

These are sometimes called timing differences. These are differences between the carrying amount
of an asset and for tax purposes

Examples:

i. Certain types of incomes and expenditures that are taxed on cash rather than on accrual basis
e.g. provisions which can be used by a company but which tax authorities don’t recognize.

ii. The difference between depreciation charged on a non current asset that qualifies for tax
allowances and the actual allowance tax depreciation) given.

A temporary difference arises when an expense is allowed for both tax and accounting purposes but
the timing of the allowance differs e.g. if relief for capital expenditure is given at a faster rate for tax
purposes than depreciation in the financial estimates, the tax charged will be lower in the first years
than it could have been if based on accounting profit but in the subsequent years the tax charge will
be higher.

Deferred tax liability

IAS 12 requires deferred tax liability to be recognized for all temporary differences with minor
expectations. A taxable temporary difference arises where the carrying value of an asset is greater
than its tax base.

Deferred tax asset

IAS 12 requires that;

i. Deferred tax asset should be recognized for all temporary differences

ii. A deductible temporary difference arises where the tax base of an asset exceeds its carrying
value.
iii. To the extent that it is probably taxable profit will be available against which deductible
temporary differences can be utilized than deferred tax asset can be recognized especially in
regard to tax losses carried forward.
iv. No discounting is allowed.

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Application scenario

a) Revaluation of non-current assets

- Deferred tax should be recognized on revaluation gain even when there is no intention to sell
the asset or roll over relief available on the gain.
- The revaluation of noncurrent assets results in taxable temporary differences and so its
liability. This is charged as a component of other comprehensive income (alongside the
revaluation gain reserve). It is therefore disclosed either in the statement of cash inflow
(SOCI) or in a statement showing other comprehensive incomes.

b) Tax loses-

- When used tax losses are carried forward a deferred tax asset can be recognized to the extent
taxable profit will be available in the future to offset the losses against.
- If an entity doesn’t expect to have taxable profits in future, it cannot recognize an asset in its
own account. If however the entity is part of a group and many surrender the tax losses to
other groups and companies, a deferred tax asset may be recognized in the consolidated
accounts.
- The asset is equal to the losses expected to be utilized multiplied by the tax rate.

Changes in tax rates

The corporation tax may change from one period to the next e.g. the tax rate for 2010 may be 33%
and 2011 35%. The question is which tax rate should be used in computing deferred tax for the
current year (assuming the current year is 2010) if a company uses the current year’s tax rate then it
is called the deferral method.

If a company uses the subsequent years tax rate i.e. 35%, in this case unless the subsequent tax rate
is not known in which case the firm can use the deferral method.

Further points on deferral tax

IAS 12 explains that there are two main types of temporary differences notably

- Taxable temporary difference (TTD)

- Deductible temporary difference (DDT)

Taxable temporary difference- These are differences that lead to a future payment of tax i.e.
deferred tax liability. They arise when the carrying amount of an asset is greater than the tax base.

Deductible temporary difference – These are temporary differences that lead to a future tax
saving, i.e. deferred tax asset. They arise when the carrying amount is less than the tax base. A

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deferred tax asset may also arise where the company has future taxable losses (tax losses carried
forward) or if the company has a tax refund or credit.

Disclosure requirements

The tax expense (income) should be presented on the face of income statement. The major
components of tax expense (income) should be disclosed separately in a note.

Current and deferred charged/credited directly to equity (taxes out of main event e.g. revaluation)
should be disclosed separately in a note.

Current and deferred tax charged/credited directly to equity should be disclosed. An explanation of
the relationship between tax expense (income) and accounts profit in either or both of the following
forms.

1. Reconciliation between tax expense and product of account profit multiplied by the
applicable rate, disclosing also the basis on which the applicable rates are computed
2. A numerical reconciliation between average effective tax rate and applicable tax rate,
disclosing also the basis on which applicable tax rate is computed.
3. Amount of deferred tax asset/liability and nature of evidence supporting its recognition.

FINANCIAL STATEMENTS

INCOME STATEMENTS AND STATEMENTS OF FINANCIAL POSITION

The income statement of a company is the same as that of a sole trader, but there are additional
expenses that are unique to the company and therefore, they should be included in the income
statement. (e.g.)
• Director's fees salaries and other expenses
• Audit fees
• Amortization e.g. goodwill
• Debenture interest
In addition to the income statement, just like a partnership has an appropriation account which
shows the allocation of the net profit for the period is to be shown. Therefore, the format will be as
shown:

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XYZ company income statement

For the year ended 31 December 2013
Shs Shs Shs
Sales xxx
Less Returns inwards xxx
xxx
Less Cost of Sales
Opening Stock xx
Purchases xx
Add Carriage inwards xx
Less purchase returns xx
Less Closing stock xx xx
Gross Profit xx
Add incomes
Discount received xx
Profit on disposal (sale of Assets) xx
Income from investment (can also be shown below) xx
Other incomes e.g. interest received from bank xx
Less Expenses
Directors salaries/fees/ xx
Audit fees xx
Debenture Interest xx
Amortization of good will xx
Operating profit for the period xx xx
Add investment income xx
Profit before tax
Taxation: Corporation tax
Transfer to deferred tax xx
Under or over provision xx
Profit after tax xx xx
Less transfer to the general reserve xx
xx
Less: Dividends (xx)
Preference dividend:
Interim paid xx
Final proposed xx
Ordinary dividend
Interim paid xx
Final proposed xx (xx)
Retained profit for the year xx
Retained profit b/d xx
Retained profit c/d Xx
xx

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Director's salaries

Salaries, fees and other expenses in relation to the directors are expenses as far as company accounts
are concerned.

This is different from that of Partnerships & Sole traders which are shown as appropriations —
expenses.

Audit fees

All companies are required to prepare the accounts which should be audited and therefore any fees
paid in relation to audit and accountancy is an expense.

Debenture interest

Loans taken up by companies are called debentures. The interest paid on these loans is charged as an
expenses and unpaid amount are shown as current liabilities in the business.

The debenture is classified under non-current liability.

Corporation tax

Companies pay corporation tax on the profits they earn. This is shown in the accounts because a
company is a separate legal entity unlike for sole traders and partnerships whose tax is shown as
drawings.

The tax is listed under those items as shown in the appropriation (under/over provision for previous
period, transfer to deferred tax corporation tax for the year).

The under provision and corporation tax relate to direct liability to the government and therefore is a
deduction from the net profit for the period.

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Transfer to deferred tax is to cater for future possible tax liability.

XYZ Company
Statement of financial position format
Shs Shs Shs
Non-current assets
Land & Building xx
Plant and Machinery xx
Fixtures, Furniture & Fittings xx
Motor vehicle xx
xx
Intangible Assets
Goodwill xx
Copyrights, patents xx

(Long-term) Investments (mkt value) xx

Current Assets
Stock xx
Debtors xx
Less provision for bad debts xx xx
Prepayments xx
(Short term) Investments xx
Cash at bank xx
Cash in hand xx xx
xx
Financed by
Authorized share capital
100,000 ordinary shares of shs 1 each xx
100,000 preference shares of shs 1 each xx
Issued and Fully paid
80,000 ordinary shares of shs 1 each xx
50,000 10% preference shares of shs 1 each xx
Capital Reserves xx
Share premium xx
Revaluation Reserve xx
Capital Redemption Reserve xx
Revenue Reserves xx
General Reserve xx
Profit and loss A/C xx
Deferred tax A/C xx
Non-Current Liabilities xx
10% debenture xx
Current liabilities
Bank overdraft xx
Creditors xx
Accruals xx
Interest payable(debenture interest) xx
Tax payable xx
Dividends payable xx xx
xx

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Illustration

The following balances were extracted from the books of Kasaya Limited as at 30 September 2010:

Sh. '000'
Land and buildings (net book value) 5,000
Plant and machinery (net book value) 8,600
Motor vehicles (net book value) 2,000
Inventory 6,000
Ordinary share capital (Sh.50 par value) 10,000
10% preference share capital (Sh.100 par value) 9,000
10% debentures 8,000
Corporation tax 500
Interim ordinary dividend paid 2,000
Other operating expenses 1,550
Distribution costs 6,000
Administrative expenses 13,000
Accounts payable 19, 000
Other operating income 4,000
Gross profit 25,000
Debenture interest paid 400
Preference dividend paid 450
Accounts receivable 20,000
Cash at bank 4,100
Capital redemption reserve 6,000
Share premium 4,000
Revenue reserves (1 October 2009) 3,000

Additional Information:
1. The balance on the corporation tax account represents an over provision of tax for the
previous year. Tax expense for the current year is estimated at Sh.3 million.
2. On 15 September 2010, the directors of the company proposed to pay the dividend due to the
preference shareholders and to also pay a final dividend of Sh.2 million to the ordinary
shareholders.
3. A building whose net book value is Sh.5 million is to be revalued to Sh.9 million.

Required:
a) Income statement for the year ended 30 September 2010.
b) Statement of financial position as at 30 September 2010.

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Solution
a. Income statement

Kasaya Ltd
Statement of Comprehensive Income for the year ended 30 September 2010
Sh.000 Sh.000
Gross profit 25,000
Other operating income 4,000
29,000
Expenses
Administrative expenses 13,000
Distribution costs 6,000
Other operating expenses 1,550
Debenture interest 800 (21,350)
Net profit before tax 7,650
Corporate tax (wl ) (2, 500)
Net profit after tax 5,150
Preference Dividends: Interim 450
Proposed 450 (900)
Earnings attributable to equity holders 4,250
Ordinary interim paid (2,000)
Ordinary dividend proposed (2,000)
Retained profits for the year 250
Revenue reserves b/d 3,000
Revenue Reserves c/d 3,250

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Kasaya Ltd
Statement of financial position for the year ended 30 September 2010
sh.000 Sh.000
Non-Current Assets
Land and buildings 29,000
Plant and machinery 8,000
Motor vehicles 2,000
39,000
Current Assets
Inventory 6,000
Accounts receivable 20,000
Cash at bank 4,100 30,100
69,100
Capital and Liabilities
Ordinary share capital 10,000
10% Preference share capital 9,000
Share premium 4,000
Revenue Reserves 3,250
Revaluation Reserve 4,000
Capital redemption Reserve 6,000
36,250
Current liabilities
Accounts payable 19,000
Debenture interest 400
Corporate tax 3,000
Proposed Dividends 2,450 24,850

Long term Liabilities

10% Debentures 8,000
69,100

Corporation tax a/c

Shs Shs
Balance c/d 3,000 Balance b/d 500
_____ Income statement 2.500
3,000 3,000

W2
Proposed: Preference Dividends: Sh. 4.50,000
Ordinary Dividends : Sh. 2,000,000

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Illustration
The following balances remained in the books of Elishama Ltd. as at 30 April 2003 after the
preparation of the trading account:

Share capital. authorized and issued: Sh.

2,400,000 Sh. 20 ordinary shares 48,000,000
800,000 8% Sh. 20 preference shares 16,000,000
Stock - 30 April 2003 33,540,000
Accounts receivable and prepayments 10,880,000
Accounts payable and accruals 5,488,800
Balance at bank 3,118,400
10% debentures 6,400,000
General reserve 11,200,000
Bad debts 136,000
Gross profit for the year 32,603,200
Salaries and wages 11,280,000
Rates and insurance. 564,000
Postage and telephone 248,000
Water and electricity 486,400
Debenture interest 320,000
Directors' fees 1,000,090
General expenses 1,243,200
Motor vehicles (Cost Sh. 11,640,000) 2,720,000
Office fittings and equipment (Cost Sh. 17,856,000) 10,976,000
Land and buildings at cost 52,880,000
Profit and loss account - 1 May 2002 9,700,800

Additional information:
1. A bill for Sh. 219,200 in respect of electricity for the period up to 30 April 2003 has not been
accrued.

2. The amount for insurance includes a premium of Sh. 120,000 paid in January 2003 to cover the
company for six months, February to July, 2003.

3. Office fittings and equipment are to be depreciated at 15% per annum on cost and motor vehicles
at 20% per annum on cost.

4. Provision is to be made for:

Directors' fees - Sh. 2,000,000

Audit fee - Sh. 480,000

The outstanding debenture interest

5. The directors have recommended that:

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 A sum of Sh. 4,800,000 be transferred to general reserve.

 The preference dividend be paid.
 A 10% ordinary dividend be paid.

Required:
a) Profit and loss and appropriation accounts for the year ended 30 April 2003.
b) Balance sheet as at 30 April 2003.
Solution

a)

Elishama Ltd Profit and loss and appropriation a/c

For the year ended 30th April 2003
Sh '000' Sh '000' Sh '000'
Gross profit 32,603.2
Expenses
Debenture interest: Paid 320
Due 320 640
Bad debts 136
Water and Electricity: Paid 486.4
Due 219.2 705.6
Rates and Insurance: Paid 564
Advance (60) 504
Depreciation: Office fittings and equipment 2,678.4
Motor vehicles 2,328
Salaries and wages 11,280
Postage and telephone 248
Directors fees: Paid 1,000
Provision 2,000 3,000
Audit fees 480
General expenses 1,243.2 (23,243.2)
Net profit 9,360
Add retained profit b/d 9.700.8
19,060.8
Less dividend: Preference 4,800
Ordinary 1,280 6,080
Transfer general reserve 4,800 (10,880)
8,180.8

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b)
Elishama Ltd
Balance Sheet as at 30th April 2003
Non-Current Assets Cost Accum. Net Book Value
Depre
Sh. '000' Sh. '000' Sh. '000'
Land and buildings 52,880 - 52,880
Office fittings & equipment's 17,856 9,558.4 8,297.6
Motor vehicle 11,640 11,248 392
82,376 20,806.4 61,569.6
Current Assets
Stock 33,540.8
Accounts receivable and prepayment (w1) 10,940
Bank 3,118.4 47,599.2
109,168.8
Current Liabilities
Account payment and accruals (w1) 8,508
Proposed dividends 6,080 14,588

Financed By:
2,400,000 Sh 20 Ordinary shares 48,000
800,000 8% sh 20 preference shares 16,000
10% debentures 6,400

Reserves
General reserves 16, 000
Profit and loss
8,180.8
109,168.8
W1

Accounts payable and accruals a/c

Shs’000’ Shs ‘000’
Balance b/d 5,488.8
Electricity accrued 219.2
Directors fee 2,320
Balance c/d 8,508 Auditors fee 480
8,508 8,508
W2

General reserve a/c

Shs’000’ Shs ‘000’
Balance b/d 11,200
Balance c/d 16,000 P&L 4,8000
16,000 16,000

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REVISION QUESTIONS

QUESTION 1

From the following trial balance of M Fry, you are asked to draw up an income statement for the
year ended 31 December 2007 and a statement of financial position as at that date

Shs.000 Shs.000
Profit and loss account 31 December 2006 23,000
Sales 52,000
Purchases 33,000
Stock in trade 31 December 2006 9,660
Premises 135,000
Equipment 25,000
Vehicles 16,000
Bank 9,600
Wages 14,500
Insurance 2,340
Preference share capital (shs 1 shares) 6% 50,000
Ordinary share capital (shs 1) 120,000
Provision for bad debts. 450
General reserve 7,800
Debtors 12,400
Creditors 7,000
Rent 3,250
260,750 260,750

Additional Information:

 Stock in trade at 31 December 2007 was shs 10,660,000

 Prepaid wages shs 320,000 ,
 Insurance owing shs 45,000
 The provision for debtors is to be maintained at 5%
 Corporation tax is to be provided for at shs 1,600,000
 The preference dividend is to be provided for and an ordinary dividend of 5% is also to be
provided for.

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Solution:

M Fry
Trading, profit & loss Appropriation Account
For year ended 31 December 2006
Shs.000 Shs.000
Sales 52,000
Less cost of goods sold
Opening stock 9,660
Purchases 33,000
42,660
Less Closing stock 10,660
32,000
Gross profit 20,000
Less expenses
Wages 14,180
Insurance 2,385
Rent 3,250
Vehicle depreciation 1,600
Equipment depreciation 5,000
Provision for doubtful debts 170
26,585
Profit for the year before tax (6,585)
Less corporation tax 1,600
Profit for the year after tax (8,185)
Add retained profit b/f 23,000
Less Appropriations: 14,815
Ordinary divindeds 6,000
Preference divindeds 3,000
Transfer to general reserves 4000
13,000
Retained profit c/f 1,815

M Fry
Statement of financial position as at 31 December 2007
Cost Dep. NBV
Fixed Assets Shs.000 Shs.000 Shs.000
Premises 135,000 135,000
Equipment 25,000 5,000 20,000
Vehicles 16,000 1,600 14,400
176,000 6,600 169,400
Current Assets
Stock 10,660
Debtors 12,400
Less provision 620 11,780
Prepayments 320
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Bank 9,600
32,360
Current liabilities
Creditors 7,500
Accruals 45
Tax owing 1,600
Ordinary dividends owing 6,000
Preference dividends owing 3,000
18,145
Net current assets 14,215
Total assets less current liabilities 183,615

Ordinary share capital 120,000

Preference share capital 50,000
General reserve 11,800
Profit and loss account 1,815
183,615

QUESTION 2

Johnston Ltd started trading on 1 January 2001. Its issued share capital was 450,000 ordinary shares
of shs.1 each and 6% preference shares of shs 1 each. The following information is available:

 Its net profits for the first three years of business were 2001 shs 56,784; 2002 shs 67,921 and
2003 shs 37, 609..
 Preference dividends were paid for each of these years, whilst ordinary dividends were
proposed as 2001 3%; 2002, 10% and 2003 5%.
 Corporation tax based on the-profits of each year was: 2001 shs 12,546; 2002 shs 16,711 and
2003 shs 9,878.
 Transfers to general reserve took place: 2002 shs 7,000 and 2003 shs 2,000.
Required;-

a) Draw up profit and loss appropriation accounts for each of the first three years of trading.
b) Produce statement of financial position extracts for each end of year date based on your
answer to question (a).

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Solution:

Johnston Ltd
Appropriation Account for year ended 31 December 2001
Shs.000 Shs.000
Profit for the year before tax 56,784
Less corporation tax 12,546
Profit for the year after tax 44,238
Less: Proposed dividends
Preference dividends 3,000
Ordinary dividends 13,500
16,500
Retained profit carried forward to next year 27,738

Johnston Ltd
Appropriation Account for year ended 31 December 2002
Shs.000 Shs.000
Profit for the year before tax 67,921
Less corporation tax 16,711
Profit for the year after tax 51,210
Add retained profit from last year 27,738
78,948
Less: Proposed dividends
Preference dividends 3,000
Ordinary dividends 45,000
Transfer to general reserves 7,000
55,000
Retained profit carried forward to next year 23,948

Johnston Ltd
Appropriation Account for year ended 31 December 2003
Shs.000 Shs.000
Profit for the year before tax 37,609
Less corporation tax 9,878
Profit for the year after tax 27,731
Add retained profit from last year 23,948
51,679
Less: Proposed dividends
Preference dividends 3,000
Ordinary dividends 22,500
Transfer to general reserves 2,000
27,500
Retained profit carried forward to next year 24,179

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b)
Johnston Ltd
Statement of financial position extract as at 31 December 2001
Capital & Reserves Shs.000
Ordinary share capital shs. 1 450,000
7% preference share capital shs. 1 50,000
Profit and loss account 27,738
527,738

Johnston Ltd
Statement of financial position extract as at 31 December 2002
Capital & Reserves Shs.000
Ordinary share capital shs. 1 450,000
Preference share capital shs. 1 7% 50,000
General reserve 7,000
Profit and loss account 23,948
530,948

Johnston Ltd
Statement of financial position extract as at 31 December 2002
Capital & Reserves Shs.000
Ordinary share capital shs. 1 450,000
Preference share capital shs. 1 7% 50,000
General reserve 9,000
Profit and loss account 24,179
533,179

QUESTION 3

Mashariki Enterprises provided the following details of assets and liabilities as at 1 June 2010. The
cost details were obtained from the invoices file while others were obtained verbally from the
managing director who was the proprietor.

Assets Cost/valuation Date of Depreciation

Sh. "000" acquisition
Equipment and furniture 2,300 1 September 2008 10% per annum
Building 26,000 1 January 2005 5% per annum
Land 3,400 1 January 2005 Nil
Motor vehicles 1,600 I May 2010 20% per annum
Bank Balance 1000
Trade receivables 1,380
Opening inventory 1,800
Prepaid insurance 450
Cash 120
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Trade payables 1,100

Bank loan 2,400
Accrued sundry expenses 2,600

The policy of the firm is to provide full depreciation in the year of purchase and none in the year of
disposal, using the straight line method.

The following is a summary of receipts and payments for the year ended 31 May 2011.

Bank Cash Bank Cash

Sh."000" Sh."000" Sh."000" Sh."000"
Sale of equipment 200 Rent 2,000
Receipts from debtors 4,150 Donations 250
Sales 13,000 Suppliers of goods 5,000
Furniture 900
Salary and wages 1,400
Stationery 300
Motor vehicle 400
Bank loan 600
Drawings 200
Sales comm. 150
Insurance 1200
Bank charges 120
Sundry expenses 2,800
Interest on loan 240

Additional information:

I. The following balances were available as at 31 May 2011:

 Prepaid insurance Sh.250, 000

 Accrued salary Sh.I50, 000
2. Equipment with a cost of Sh.300, 000 was disposed of during the year.

3. Closing inventory was valued at Sh. 1,200,000.

4. Trade receivables as at 31 May 2011 were Sh.l, 150,000 while trade payables were Sh.1, 250,000.

Required:

a) Income statement for the year ended 31 May 2011.

b) Statement of financial position as at 31 May 2011.

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Solution:

a) Income statement for the year

Mashariki Enterprises
Statement of Comprehensive Income for year ended 31 May 2011
Shs.000 Shs.000
Sales (w1) 16,920
cost of sales
Opening stock 1,800
Purchases (w2) 5,150
Closing stock (1,200) (5,750)
Gross profit 11,170
Expenses:
Insurance(w3) 1,400
Salaries and wages (w4) 1,550
Sundry expenses (w5) 200
Loss of disposal (w7) 40
Rent 2,000
Depreciation:
Equipment & Furniture(w6) 290
Motor (w6) 400
Donation 250
Stationery 300
Sales commission 150
Bank charges 120
Loan interest 240
Depreciation building (w6) 1,300 (8,240)
Net profit 2,930

b) Statement of financial position

Mashariki Enterprises
Statement of financial position as at 31 May 2011
Cost Acc. Dep. NBV
Non-current Assets Shs.000 Shs.000 Shs.000
Land 3,400 3,400
Building 26,000 9,100 16,900
Furniture and equipment 2,900 690 2,210
Motor vehicle 2,000 720 1,280
34,300 10,510 23,790
Current Assets
Inventory 1,200
Accounts receivable 1,150
Prepaid insurance 250
Bank (w8) 1,990

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Cash (w8) 920 5,510

Total assets 29,300
Financed by:
Capital (w8) 23,370
Net profit 2,930
Drawings (200)
26,100
Non-Current liabilities
Bank loan 1,800

Current liabilities 1,250

Accounts payable 150 1,400
Accrued salary 29,300

Workings

W1

Trade payable a/c

Shs.000 Shs.000
Balance b/d 1,380 Bank 13,000
Credit sales 12,770 Balance c/d 1,150
14,150 14,150

Total sales=cash sales=credit sales=1,150,000+12,770,000=16,920,000

W2

Trade receivables a/c

Shs.000 Shs.000
Bank 5,000 Balance b/d 1,100
Balance c/d 1,250 Credit purchases 5,150
6,250 6,250

Total Purchases=cash Purchases =credit Purchases =0+5,150,000=5,150,000

W3

Insurance expenses a/c

Shs.000 Shs.000
Balance b/d 450 Income statement 1,400
Bank 1,200 Balance c/d 250
1,650 1,650

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W4

Salaries and wages a/c

Shs.000 Shs.000
Bank 1,400
Balance c/d 150 Income statement 1,550
1,550 1,550
W5

Sundry expenses a/c

Shs.000 Shs.000
Cash 2,800 Balance b/d 2,600
_____ Income statement 200
2,800 2,800
W6

Depreciation
Equip & Furniture
10 %x( 2,300,000 - 300,000 + 900,000) = 290,000

Motor Vehicle
(20% x 1,600,000 + 20% x 400,000) = 400,000

Building = 5%x 26,000,000 = 1,300,000

W7

Loss on disposal of equipment

Disposal: Equipment a/c

Shs.000 Shs.000
Equipment 300 Cash proceeds 200
Accumulated derpreciation 60
_____ Profit and loss(balancing figure) 40
2,800 2,800

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Bank and cash balances

Cash Accounts
Details Bank Cash Details Bank Cash
Shs.000 Shs.000 Shs.000 Shs.000
Balance b/d 100 120 Rent 2,000
Sale of equipment 200 Donations 250
Receipts from debtors 13,000 Suppliers of goods 5,000
Sales 4,150 Furniture 900
Salaries and wages 1,400
Stationery 300
Motor vehicle 400
Bank loan 600
Drawings Sales 200
Commission 150
Insurance 1,200
Bank charges 120
Sundry Expenses 2,800
Interest on loan 240
____- ____- Bal e/d I, 990 920
14,000 4,470 14,000 4,470

W9
Shs.000
Assets
Equipment and furniture (2,300 - 460) 1,840
Building (26,000 - 7,800) 18,200
Land 3,400
Motor vehicle (1,600 -320) 1,280
Bank balance 1,000
Trade receivables 1,380
Inventory 1,800
Prepaid insurance 450
Cash 120
Total Assets 29,470
Less Liabilities
Trade payables (1,100)
Bank loan (2,400)
Accrued expenses (2,600)
Capital 23.310

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TOPIC 8

FINANCIAL STATEMENTS OF A MANUFACTURING ENTITY

FEATURES OF A MANUFACTURING ENTITY

it will be realized that the ordinary Trading Account is not capable of showing up the cost of
manufacturing goods, because:

1. It deals with stocks (both opening and closing) of finished goods

2. Some of the expenses connected with production, such as, depreciation and repairs of
machinery, are usually debited to the Profit and Loss Account.

Thus, for manufacturing organizations, manufacturing accounts will be needed in addition to a

trading and profit and loss accounts. This will be for internal purposes/ use in the company.

In place of purchases we will instead have the cost of manufacturing the goods. A separate
`Manufacturing Account' to which will be debited all expenses incurred in the factory on the
production of goods. This means that depreciation of and repairs to plant and machinery are also
debited to the Manufacturing Account and not to the Trading Account.

The total of such expenses adjusted for value of stocks of raw materials and of semi-finished goods
will show the total cost of the output during the financial period.

This figure is transferred to the debit of the Trading Account which will show the gross profit made
in the usual manner.

In a manufacturing concern, at any time there will be some unfinished or semi-finished work. This is
called work in process or work UN certified. It is an asset like stock of materials or finished goods.
The Value of work in progress in the beginning is debited to the Manufacturing Account as opening
stock. The value of work in process-is credited to this account, as closing stock, and then shown in
the Balance Sheet. -

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CLASSIFICATION OF COSTS

Classification and apportioning costs between manufacturing and selling and administration

For a manufacturing the manufacturing costs are did into the following types:

i) Direct material costs

Direct material costs are those materials used directly in the manufacture of products i.e. materials
that can be identified in the final products. E.g. in the manufacture of tables, direct materials consists
of timber, nails, glue etc.

ii) Direct labour costs

These are wages paid to those who are directly involved in the manufacture of a product e.g in the
manufacture of tables; direct labour consists of wage paid to those workers who saw. Shape of join
the piece of timber into table.

iii) Direct expenses

These are expenses that must be incurred in the manufacturing of a product. That is, they can be
directly allocated a particular unit of a product e.g. live changes for special equipment used in the
process of manufacture, royalties

NB: The sum of all the direct costs is known as Prime costs

iv) Indirect manufacturing costs / fact

These are any other expenses (apart from the direct costs) for items being manufactured: e.g cleaners
wages, factory rents, depreciation of plant and equipment, factory powder and lighting

NB: prime cost + indirect manufacturing costs=Production cost

v) Administrative Expenses

These are expenses that are administrative in nature, that is, expenses incurred in the process of
planning, controlling and directing the organization. E.g. office rents, office electricity, depreciation
of office machinery, secretarial salaries

vi) Selling and distribution expenses

These are expenses incurred in the process of selling, promoting and distributing the goods
manufactured, E.g. advertising expenses, carriage outwards, depreciation of motor van, salesmen
salaries etc.

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vii) Finance Costs

These are expenses such as bank charges, discount allowed.

FINANCIAL STATEMENTS

Manufacturing account, income statement and statement of financial position

Manufacturing account part

Manufacturing account is an account prepared by manufacturing concerns to ascertain cost of goods

manufactured during the period. All the expenses relating to manufacturing activity are debited.

The total represents cost of manufactures, which is transferred to trading account.

This is debited with the production cost of goods completed during the accounting period:

It consists of

• Direct materials
• Direct labour
• Direct expenses
• Indirect manufacturing costs.

It also includes adjustments for work in progress (goods that are partly completed at the end of a
period)

STEPS

1. Add opening stock of raw materials to purchases and subtract the stock of raw materials. This
is to get the cost of materials used during the period.
2. Add in all the direct costs to get the prime costs
3. Add all the indirect manufacturing costs.
4. Add the opening stock of WIP and subtract the closing stock WIP to get the production cost
of all goods completed in the period. This is because WIP cannot be sold and therefore should
not be included in the trading account.
5. The manufacturing account when completed shows the total that is available for sale during
the period
This will be used in trading account in place for purchases.

Final accounts of a manufacturer

1. Manufacturing accounts — used to determine the cost of production.

2. Income statement - Used to determine the gross profit on trading.
3. Statement of financial position

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Treatments of loose materials

The cost of loose tools consumed during the year is considered as a factory overhead in the
manufacturing account and is determined as follows:
shs

Opening stock of loose tools Xx

Add purchases of loose tools Xx
Xx
Less closing stock of loose tools Xx
Cost of loose tools consumed Xx

Manufacturing Accounts Format

XYZ Ltd
manufacturing account
for the year ended 20XX
Sh.
Opening stock raw materials xxx
Add: purchased raw materials xxx
Carriage inwards (raw materials) xxx
Less: return outwards (raw materials) (xxx)
Cost of materials available for production (xxx)
Less closing stock (R.M) x xx
Cost of raw materials used xxx
Add Direct labor xxx
Direct expenses xxx
Prime costs xxx
Indirect Manufacturing cost
Indirect labor xxx
Indirect expenses xxx
Heating expenses xxx
Lighting expenses xxx
Depreciation of factory equipment xxx
Depreciation of factory van xxx
Factory salaries/wages xxx
Factory rent xxx
Total indirect expense Xxx
Add opening work in progress Xxx
Less closing work in progress (xxx)
Total Cost of production for goods completed xxx
Manufacturing gross profit added xxx
Finished goods at transferred price xxx

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The statement of comprehensive income will be similar to that of a sole proprietorship except
for the following:

i. The purchases will be replaced by finished goods at transfer price. This is because finished
from manufacturing are now the ones being put up for sales.
ii. The opening sock to be used in the statement of comprehensive income is the opening stock
of finished goods
iii. After obtaining gross profit we add the element of factory profit if we had marked up
the goods before transferring them from the factory. If there was no transfer then this
need not be done. This arises because once we marked them up; the costs of goods
available for sale as well as cost of sales were increased by the element of profit and
consequently reducing our gross profit.

XYZ Income statement for the year ended 31 December XX

Sh. Sh.
Sales xxx
Less cost of goods sold
Opening stock of finished goods xxx
Add production cost of goods completed b/f xxx
xxx
Less closing stock of finished goods xxx
Cost of Sales xxx
Gross Profit xxx

Less Expenses
Office Rent xxx
Office Electricity xxx
Depreciation of office machinery xxx
Selling & distribution expenses xxx
Advertising xxx
Delivery Van expenses xxx
Carriage outwards xxx
Carriage Outwards xxx
Salesmen salaries xxx xxx
Net Profit /loss xxx

Note:
Expenses should be appointed as follows:
Indirect manufacturing costs - charged in manufacturing account
Administrative expenses - Charged in the profit & loss account
Selling and distribution expenses - Charged in the profit & loss account
Financial charges - Charged in the profit & loss account

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Treatment of manufacturing Profit

Manufacturing profit occur where goods manufactured are transferred from factory to the warehouse
at a higher value more than the cost of production i.e the market value.
The difference between the market value and the cost of production is the manufacturing profit.
Manufacturing profit should be added to the cost of production in the manufacturing account so as to
arrive at the market value of goods manufactured.

The market value of goods manufactured should take the place of purchases in the trading account.
The double entry for the manufacturing profit is:

DR Manufacturing Account
CR Profit and loss account.

Treatment of unrealized Profit

Unrealized Profit occurs where it is the policy of the firm to value stocks of finished goods at market
value rather than at cost.

The difference between the market value and the cost of the finished goods is the unrealized profit.
The difference between the unrealized profit on the opening stock of finished goods and the
unrealized profit on the closing stock of finished goods should be charged to the profit and account.

The provision for unrealized profit on the closing stock by the end of year should he subtracted from
the market value of the finished goods in the balance sheet. (1.e. closing stock is stated at production
cost on the statement of financial position)

Illustration:
Carol and Mary are in partnership sharing profits and losses equally. They make handbags under the
brand name ‘CARY’.

The partnership trial balance as at 31 December 2013 was as follows:

Sh. “000” Sh. “000”
Capital: Carol 24,000
Mary 24,000
Drawings: Carol 5,000
Mary 4,800
Land 15,200
Factory building at cost 20,400
Accumulated depreciation on factory building 15,370
Delivery vans at cost 8,100
Accumulated depreciation on delivery vans 1,912
Inventory (1 January 2013):
Raw materials 2,300
Work in progress 2,210
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Finished goods (10,250 handbags at Sh.2,000 each) 20,500

Sales 63,200
Returns inward 112
Purchase of raw materials 14,590
Tax 3,960
Factory wages 7,630
Office salaries 2,500
General expenses: Factory 7,730
Office 9,470
Plant at cost 17,220
Accumulated depreciation on plant 5,870
Provision for unrealised profit (I January 2013) 2,050
Allowance for doubtful debts 770
Trade receivables and payables 10,680 2,640
Bank overdraft ______ 4,670
148,442 148,442

Additional information:

1. During the year ended 31 December 2013. 16,727 handbags were transferred to the warehouse at
a price of sh.2, 400 each.
2. As at 31 December 2013, inventory was valued as follows:
 Raw materials - Sh.1, 900,000
 Work in progress - Sh.2, 880,000
 Finished goods - Sh.17, 428,800
3. All handbags are sold at Sh.3, 200 each.
4. The allowance for doubtful debts is to be maintained at 5% of the trade receivables.
5. Accrued general expenses as at 31 December 2013 were as follows:
 Factory - Sh.1,748,000
 Office - Sh.764, 000
6. As at 31 December 2013, rent and rates were prepaid as follows:
 Factory - Sh.104, 000
 Office - Sh.80, 000
7. Depreciation is to be provided on cost as follows:
Asset Rate per annum
Factory building 2%
Plant 10%
Delivery vans 20%
8. Carol is entitled to 25% of the manufacturing profit based on the transfer price to the warehouse,
while Mary is entitled to 10% of the trading gross profit.
9. No interest is credited or charged on capital accounts or drawings.

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Required:
(a) Manufacturing account for the year ended 31 December 2013.
(b) Income statement of the year ended 31 December 2013
(c) Statement of financial position as at 31 December 2013

Solution

a) Manufacturing account

Carol and Mary

Manufacturing Account for year ended 31st December 2013
Sh. “000” Sh. “000”
Direct materials
Opening inventory 2,300
Purchases of raw materials 14,590
Direct raw material for use 16,890
Less: Closing inventory (1,900)
Direct raw material used 14,990
Indirect factory costs
General expenses 9,478
Factory wages 7,630
Depreciation:
Factory building 408
Plant 1,722 19,238
Gross cost of production 34,228
Add: Work in progress at start 2,210
Less: Work in progress at end (2,880)
Cost of production 33,558
Add: Manufacturing profit 6,586.8
Cost of goods transferred to warehouse (16,727 × 2,400) 40,144.8

b) Income Statement for the year ended 31 December 2013

Carol and Mary

Income statement for the year ended 31st December 2013.
Sh. “000” Sh. “000”
Sales 63,200.00
Less: Return inwards 112.00
63,088.00
Less: Cost of sales
Opening inventory 20,500.00
Cost of finished goods 40,144.80
Goods available for sale 60,644.80
Less: Closing inventory (17,428.80) 43,216.00

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Gross profit 19,872.00

Other incomes
Decrease in provision for doubtful debt 236.00
20,108.00
Manufacturing profit 6,586.80
Less: Expenses
General expense 10,234.00
Depreciation: Delivery vans 1,620.00
Office salaries 2,500.00 (14,354.00)
12,340.80
Salary
Carol 25% x 6,586.80 1,646.70
Mary 10% x 19,872.00 1,987.20 (3,633.90)
8,706.90
Share of profit
Carol ½ x 8,706.90 4,353.45
Mary ½ x 8,706.90 4,353.45 8,706.90
Nil

c) Statement of Financial Position as at 31st December 2013

Carol and Mary

Statement of Financial Position as at 31st December 2013
Cost Acc. Dep. N.B.V
Non-Current Asset Sh. ‘000’ Sh. ‘000’ Sh. ‘000’
Fixed Assets
Land 15,200 - 15,200
Factory building 20,400 15,778.00 4,622
Delivery van 8,100 3,532.00 4,568
Plant 17,220 7,592.00 9,628
34,018
Current assets
Inventory
Raw materials 1,900.00
Work in progress 2,880.00
Finished goods 17,428.80
Less: Provision for unrealised profits 2,050.00 15,378.80
Trade receivables 10680.00
Less: Provision for doubtful debt (534.00) 10,146.00 30,304.80
Total assets 64,322.80
Capital and liabilities
Capital: Carol 25,000.15
Mary 25,540.65 50,540.80
Current Liabilities
Trade payables 2,640.00
Accruals 2,512.00
Tax 3,960.00
Bank Overdraft 4,670.00 13,782.00
64,322.80

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Workings

W1
Allowance for bad debts Account
Shs ‘000’ Shs ‘000’
Income statement 236 Balance b/d 770
Balance c/d (5%x15680) 534 ___
770 770
W2
General expenses Account (factory)
Shs ‘000’ Shs ‘000’
Bank 7,730 Income statement 9,478
Balance c/d 1,748 ___
9,478 9,478
W3
General expenses Account (office)
Shs ‘000’ Shs ‘000’
Bank 9,470 Income statement 10,234
Balance c/d 764 _____
10,234 10,234

W4
Sh ‘000’
1. Factory building 2% x 20,400 = 408
2. Plant 10% x 17,220 = 1,722
3. Delivery Vans 20% x 8,100 = 1,620
W4
Partners Capital Accounts
Details Carol Mary Details Carol Mary
Shs ‘000’ Shs ‘000’ Shs ‘000’ Shs ‘000’
Drawings 5,000 4,800 Balance b/d 24,000 24,000
Salary 1,646 1,987
Balance c/d 25,000 25,540 Share of profit 4,353 4,353
30,000 30,340 30,000 30,340

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REVISION EXERCISE

QUESTION 1
Mboyamak limited manufacturer’s farm implements. The following list of balances was extracted
from the books of account of the company as at 31 December 2012

Shs
Inventory as at 1 January 2012
Raw materials 1,270,000
Work in progress 1,555,000
Finished goods 1,163,000
Purchase of raw materials 4,576,750
Carriage of raw materials 98,000
Direct labour 4,210,400
office salaries 1,670,950
Rent 260,000
Electricity (office) 221,000
Depreciation expense Machinery 510,000
Equipment (office) 115,000
Sales 15,931,100
Electricity (factory) 406,000

Additional information;-
1. Inventory as at 31 December 2012 was given as follows:-
Shs
Raw materials 1,445,000
Work in progress 1,230,000
Finished goods 1,442,000
2. Rent is to be apportioned between the factory and office in the ratio of 3:1
3. Finished goods are transferred from factory to sales at mark up of 20%
4. The values of opening and closing inventory are given at the transfer price

Required;-
i) Manufacturing account for the year ended 31 December 2012
ii) Income statement for the year ended 31 December 2012

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Solution:

a) Manufacturing account

Mboyamak limited
Manufacturing account for the period / year ended 31 December 2012
Direct raw materials Sh. Sh.
Opening inventory 1,270,000
Purchase of raw materials 4,576,750
Carriage inwards 98,000
Raw materials available for use 5,944,750
Less: Closing inventory (1,445,000)
Direct raw materials used 4,499,750
Direct labour 4,210,400
Prime Cost 8,710,150
Indirect factory expenses
Depreciation on machinery 510,000
Electricity 406,000
Rent (¾ × 260,000) 195,000 1,111,000
Gross cost of production 9,821,150
Add work in progress at start 1,555,000
Less work in progress at end (1,230,000)
Cost of finished goods 10,146,150
Add profit mark up 20% 2,029,230
Cost of finished goods transferred to trading 12,175,380

b) Income statement

Mboyamak Limited
Income statement for the year ended 31 December 2012
Shs Shs
Sales 15,931,100
Less Cost of sales
Opening inventory 1,163,000
Cost of finished goods transferred 12,175,380
Cost of goods available for sale 13,338,380
Less: Closing inventory (1,442,000) (11,896,380)
Gross profit 4,034,720
Less expenses
Rent( ¼ × 260,000) 65,000
Depreciation on office equipment 115,000
Office salaries 1,670,950
Office Electricity 221,000 (2,070,950)
Net profit 2,962,770

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QUESTION 2
Kate and Robert are in partnership as manufacturers of plastic bottles. Kate is responsible for the
factory operations and Robert is responsible for sales.

The following trial balance was extracted from their books as at 30 September 2012:
Shs Shs
Capital accounts:
Kate 4,000,000
Robert 5,000,000
Drawings:
Kate 950,000
Robert 800,000
Land at cost 3,000,000
Factory building at cost 4,000,000
Plant at cost 3,000,000
Motor vehicles at cost 800,000
Provision for depreciation (1 October 2011):
Factory building 1,500,000
Plant 800,000
Motor vehicles 160.000
Inventory(1 October2011):
Raw materials 400,000
Work-in-progress 420,000
Finished goods 5,000,000
Sales 12,000,000
Returns inward 140,000
Purchase of raw materials 2,900,000
Factory wages 1,650,000
Office salaries 480,000
General expenses:
Factory 1,250,000
Administrative 1,400,000
Allowance for doubtful debts 190,000
Trade receivables and payables 2,170,000 550,000
Bank balance 500,000
Interest free loan ________ 4,660,000
28,860,000 28,860,000

Additional information:
1. Inventory as at 30 September 2012 was valued as follows:
Shs
Raw materials 340,000
Work-in-progress 530,000
Finished goods 4,600,000

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2. 370,000 plastic bottles were transferred at Sh.20 each from the factory to the warehouse during
the year.
3. Allowance for doubtful debts is to be adjusted to 10% of trade receivables as at 30 September
2012.
4. Accrued general expenses as at 30 September 2012 were as follows:

5. Pre-paid rates as at 30 September 2012 were as follows:

Sh.
Factory 20,000
Administrative 12,000
6. Depreciation for the year is to be provided on cost as follows:
Asset Rate per annum
Factory building 2%
Plant 10%
Motor vehicles 15%
7. Kate is credited with one-third of the manufacturing profit while Robert is credited with 10% of
the trading gross profit.
8. The net profit or loss is shared by Kate and Robert in the ratio 3:2 respectively.
9. No interest is credited or charged on capital accounts or drawings.

Required;
a) Manufacturing account for the year ended 30 September 2012.
b) Income statement for the year ended 30 September 2012.
c) Statement of financial position as at 30 September 2012.

Solution:

a) Manufacturing account
Kate and Robert
Manufacturing Account
For the year ended 30th September 2012
Prime Costs Shs Shs Shs
Cost of raw materials used
Opening stock of raw materials 400,000
Add: Purchases 2,900,000
Cost of raw materials available 3,300,000
Less: Closing stock of raw materials (340,000)
Cost of materials used 2,960,000
Direct Labour
Factory wages 1,650,000
Total Prime cost 4,610,000
Factory Overheads
General expenses 1,250,000

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Add: Accrued 300,000

Less: Prepaid (20,000) 1,530,000
Depreciation factory building 80,000
Depreciation Plant 300,000
Total factory overheads 1,910,000
Total production cost 6,520,000
Add: Work in progress (opening) 420,000
Less: Work in progress (closing) (530,000)
Cost of goods manufactured 6,410,000
Add: Factory profit 990,000
Transfer value of Goods manufactured 7,400,000

b) Income statement

Kate and Robert Income statement

For the year ended 30th September 2012
Shs Shs Shs
Sales 12,000,000
Less: Return inwards 140,000
Net sales 11,860,000
Less: cost of goods sold
Opening stock of finished goods 5,000,000
Add: Cost of goods manufactured goods 7,400,000
Less: Closing stock of finished goods (4,600,000)
Cost of goods (7,800,000)
Gross profit 4,060,000
Add: Other incomes
Factory profit 990,000
Increase in provision for bad debts(w1) (27,000)
Total Income 5,023,000
Less: Administration expenses
General administrative expenses 1,400,000
Add: Accrued 320,000
Less; Prepaid (12,000) 1,708,000
Office salaries 480,000
Depreciation on motor vehicles 120,000 (2,308,000)
Net profit for the year 2,715,000
Entitlements: Kate (1/3 × 990,000) 330,000
Robert (10% ×4,060,000) 406,000 (736,000)
Profit 1,979,000
Share of profit: Kate 3/5 × 1,979,000 1,187,400
Robert 2/5 × 1,979,000 791,600
1,979,000

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c) Statement of financial position

Kate and Robert Balance Sheet

As at 31st September 2012
Non-current Assets Sh. ‘000’ Sh. ‘000’ Sh. ‘000’
Cost Acc. Dep NBV
Land 3,000 - 3,000
Factory & buildings 4,000 1,580 2,420
Plant 3,000 1,100 1,900
Motor Vehicles 800 280 520
10,800 2,960 7,840
Current Assets
Stock:
Raw materials 340
Work in progress 530
Finished goods 4,600
Accounts receivable (w2) 1,953
Prepaid expenses 32
Bank 500 7,955
15,795
Financed by:-
Capital: (w3)
Kate 4,567.4
Robert 5,397.6 9,965
Non-current liabilities
Interest free loan 4,660
Current Liabilities 550
Creditors 620
Accrued expenses 1,170
15,795

Workings

W1

Provision for bad debts account 10%×2,170,000 = shs. 217,000

Allowance for doubtful debts Account

Shs Shs
- Balance b/d 190,000
Balance c/d 217,000 Income statement 27,000
217,000 217,000

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W2
Accounts receivable Account
Shs Shs
Balance c/d 2,170,000 Allowance for doubtful debts 217,000
_______ Income statement 1,953,000
2,170,000 2,170,000
W3
Partners Capital Accounts
Details Kate Robert Details Kate Robert
Shs ‘000’ Shs ‘000’ Shs ‘000’ Shs ‘000’
Drawings 950.00 800.00 Balance b/d 4,000.00 5,000.00
Salary 330.00 406.00
Balance c/d 4,567.40 5,397.60 Share of profit 1,187.40 791.60
5,517.40 6,197.60 5,517.40 6,197.60

W4
Depreciation
Factory building=2%×4,000,000= shs 80,000

Plant 10%×3,000,000= shs 300,000

Motor vehicles 15%×800,000=shs.120, 000

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TOPIC 9

ACCOUNTS FROM INCOMPLETE RECORDS

Introduction
Very often the small sole proprietorship and partnership businesses do not maintain double entry
book keeping system. Sometimes they keep record only of the cash transactions and credit
transactions. Sometimes they maintain no record of many transactions. But at the end of the
accounting period they want to know the performance and financial position of their businesses.
This creates some special problems to the accountants. This study discusses how to complete the
accounts from available incomplete records.

The term “Single Entry System” is popularly used to describe the problems of accounts from
incomplete records. In fact there is no such system as single entry system. In practice the quack
accountants follow some hybrid methods. For some transactions they complete double entries. For
some others they just maintain one entry. Still for some others, they even do not pass any entry. This
is no system of accounting. Briefly, this may be stated as incomplete records. The task of the
accountant is to establish linkage among the available information and to finalise the accounts.

FEATURES

 It is an inaccurate, unscientific and unsystematic method of recording business transactions.

 There is generally no record of real and personal accounts and, in most of the cases; a record
is kept for cash transactions and personal accounts.
 Cash book mixes up business and personal transactions of the owners.
 There is no uniformity in maintaining the records and the system may differ from fir m to
firm depending on the requirements and convenience of each firm.
 Profit under this system is only an estimate and therefore true and correct profits cannot be
determined. The same is the case with the financial position in t he absence of a proper
balance sheet.

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TYPES OF INCOMPLETE RECORDS

A scrutiny of many procedures
ures adopted in maintaining records under single entry system brings
forth the existence of following three types:

PURE SINGLE ENTRY

In this,, only personal accounts are maintained with the result that
that no information is available in
respect of cash and bankank balances, sale s and purchases,
purch etc. Inn view of its failure to pro
provide even the
basic information
tion regarding cash etc., this method exists only on paper and has no pracpractical
application.

SIMPLE SINGLE ENTRY:

In this, only: (a) personal
rsonal accounts, and (b) cash book are maintained. Althoughugh these accounts are
kept on the basis of double
ble entry system, postings from cash book are ma de only to personal
accounts and no other account
count is to be found in the ledger.
led Cash received from debtors or c ash paid
to creditors
reditors is simply noted on the bills
bills is sued or received as the case may be.

QUASI SINGLE ENTRY:

In this: (a) personal accounts,
unts, (b) cash book, and (c) some
s subsidiary books aare maintained. The
main subsidiary books kept under er this system are Sales book, Purchases book and Bills bobook. No
separate record is maintained d for discounts which are
ar entered
tered into the personal account
accounts. In addition,
some scattered information is also available in respect of few important items of expenses like
wages, rent, rates, etc. In fact, this is t he method which is generally
ly adopted as a substitut
substitute for
double entry system.

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ASCERTAINMENT OF PROFIT B Y CAPITAL COMPARISON

This method is also known as Net Worth method or Statement of Affairs Method.

– =

If detailed information regarding revenue and expenses is not known, it becomes difficult to prepare
profit and loss account. Instead by collecting information about assets and liabilities, it is easier to
prepare balance sheet at two different points of time. So, while preparing accounts from incomplete
records, if sufficient information is not available, it is better to follow the method of capital
comparison to arrive at the profit figure.

Methods of capital comparison

Capital is increased if there is profit, while capital is reduced if there is loss. However, if the
proprietor/partners made fresh investments in the business, capital is increased; if they make
withdrawal capital is reduced. So while determining the profit by capital comparison, the following
rules should be followed.

Capital at the end

Add: Drawings xxx
Less: Fresh capital introduced xxx
Capital in the beginning xxx
Profit xxx

It is clear from the above discussion that to follow the capital comparison method one should know
the opening capital and closing capital. This should be determined by preparing statement of affairs
at the two respective points of time. Capital always equals assets minus liabilities.

Thus preparation of statement of affairs will require listing up of assets and liabilities and their
amount. The accountant utilizes the following sources for the purpose of finding out the assets and
liabilities of a business enterprise:
i. Cash book for cash balance
ii. Bank pass book for bank balance
iii. Personal ledger for debtors and creditors
iv. Stock by actual counting and valuation.
v. As regards fixed assets, he prepares a list of them. The proprietor would help him by
disclosing the original cost and date of purchase. After deducting reasonable amount of
depreciation, the written down or depreciated value would be included in the Statement of
Affairs.

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After obtaining all necessary information about assets and liabilities, the next task of the accountants
is to prepare statement of affairs at two different points of time.
The design of the statement of affairs is just like balance sheet as given below:

Statement of affairs as on………………………….

Liabilities Sh. Assets Sh.
Capital (Bal. Fig.) xxx Building xxx
Loans, Bank overdraft xxx Machinery xxx
Sundry creditors xxx Furniture xxx
Bills payable xxx Stock xxx
Outstanding expenses xxx Sundry debtors xxx
Bills receivable xxx
Loans and advances xxx
Cash and bank xxx
xxx Prepaid expenses xxx
xxx xxx

Now from the statement of affairs prepared for two different dates, opening and closing capital
balances can be obtained.

Difference between Statement of Affairs and Balance Sheet

Basis Statement of affairs Balance sheet

Reliability It is prepared on the basis of It is based on transactions
transactions partly recorded on the recorded strictly on the basis of
basis of double entry book keeping and double entry book keeping;
partly on the basis of single basis. each item in the balance sheet
Most of the assets are recorded on the can be verified from the
basis of estimates, assumptions, subsidiary books and
information gathered from memory Hence the balance sheet is not
rather than records. Only reliable, but dependable.
Capital In this statement, capital is merely a Capital is derived from the
balancing figure being excess of assets capital account in the ledger
over capital. Hence assets need not be and therefore the total of
equal to liabilities. assets side will always be
equal to the total of liabilities
side.
Omission Since this statement is prepared on There is no possibility of
the basis of incomplete records, it omission of any item of asset
is very difficult, to locate the assets and liability since all items are
and liabilities, if they are omitted from properly recorded. Moreover, it
the books is easy to locate the missing
items since the balance sheet
will not agree.

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Basis of The valuation of assets is The valuation of assets is done

Valuation generally done in an arbitrary manner; on scientific basis that is
therefore no method of valuation is original cost in the case of new
disclosed. assets and depreciated amount
on the basis of cost minus
depreciation to date for used
assets. Any change in the
method of valuation is properly
disclosed.
Objects The object of preparing this The object of preparing the
statement in the calculation of balance sheet is to ascertain the
capital figures in the beginning and financial position on a
at the end of the accounting period particular date.
respectively.

Preparation of Statement of Affairs and Determination of Profit

Figures of assets and liabilities should be collected for preparation of statement of affairs. Given
below an example:

Illustration 1
Assets and Liabilities of Mr. SomeaKenya as on 31-12-2016 and 31-12-2017 are as follows:

31/12/2016 31/12/2017
Assets
Building 100,000 -
Furniture 50,000 -
Stock 120,000 270,000
Sundry debtors 40,000 90,000
Cash at bank 70.000 85,000
Cash in hand 1,200 3, 200
Liabilities
Loans 100,000 80,000
Sundry creditors 40,000 70, 000

Decided to depreciate building by 2.5% and furniture by 10% One life insurance policy of the
Proprietor was matured during the period and the amount sh.40,000 is retained in the business.
Proprietor took sh. 2,000 p.m. for meeting family expenses.

Prepare Statement of Affairs.

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Solution

Statement of Affairs as on 31-12-2016 and 31-12-2017

Liabilities 31/12/2016 31/12/2017 Assets 31/12/2016 31/12/2017
Capital 241,200 440,700 Building 100,000 97,500
(Bal. Fig.) Furniture 50,000 45,000
Loans 100,000 80,000 Stock 120,000 270,000
Sundry Creditors 40,000 70,000 Sundry Debtors 40,000 90,000
Cash at bank 70,000 85,000
_______ _______ Cash in hand 1,200 3,200
381,200 590,700 381,200 590,700

Illustration 2
Take figures in illustration1. Find out profit of Mr. SomeaKenya

Solution

Determination of Profit by applying the method of the Capital comparison

Sh.
Capital Balance as on 31-12-2017 440,700
Less : Fresh capital introduced (40,000)
400,700
Add : Drawings (2000 x12) 24,000
424,700
Less : Capital Balance as on 31-12-2016 (241.200)
Profit 183,500

Note:
• Closing capital is increased due to fresh capital introduction, so it is deducted.
• Closing capital was reduced due to withdrawal by proprietor; so it is added back.

Illustration 3
A and B are in Partnership having Profit sharing ratio 2:1. The following information is available
about their assets and liabilities:
31/3/2017 31/3/2018
Furniture 120,000
Advances 70,000 50,000
Creditors 32,000 30,000
Debtors 40,000 45,000
Stock 60,000 74,750
Loan 80,000
Cash at Bank 50,000 140,000

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The partners are entitled to salary @ sh.2,000 p.m. They contributed proportionate capital. Interest is
paid @ 6% on capital and charged @ 10% on drawings.

Drawings of A and B
A B
Sh. Sh.
April 30 2,000 -
May 31 - 2,000
June 30 4,000 -
Sept. 30 - 6,000
Dec. 31 2,000 -
Feb. 28 - 8,000

On 30th June, they took C as 1/3rd partner who contributed sh.75,000. C is entitled to share of 9
months' profit. The new profit ratio becomes 1:1:1. A withdrew his proportionate share. Depreciate
furniture @ 10% p.a., new purchases sh 10,000 may be depreciated for 1/4th of a year.

Current account as on 31/3/2017: A sh. 5.000 (Cr.), B fsh.2,000 (Dr.)

Prepare Statement of Profit, Current Accounts of partners and Statement of Affairs as on 31/3/2018.

Solution
Statement of Affairs
As on 31/3/2017 and 31/3/2018
Liabilities 31/3/2017 31/3/2018 Assets 31/3/2017 31/3/2018
Sh. Sh. Sh. Sh.
Capital A/c's Furniture 120,000 117,750
A 150,000 75,000 Advances 70,000 50,000
B 75,000 75,000 Stock 60,000 74,750
C - 75,000 Debtors 40,000 45,000
Loan 80,000 - Cash at bank 50,000 140,000
Creditors 32,000 30,000 Current A/c
B 2,000 -
Current A/c’s
A 5,000 74,036*
B - 48,322*
C ______ 50,142* _______ _______
342,000 427,500 342,000 427,500
*see current accounts

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Notes
(i) Depreciation on Furniiure 12,000
10% on sh 120,000 250
10% on sh 10,000 for 1/4 year 12,250

(ii) Furniture as on 31/3/2018 120,000

Balance as on 31/3/2017 10,000
Add: new purchase 130,000
(12,250)
Less: Depreciation 117,750

(iii) Total of Current Accounts as on 31/3/2018 427,500

Total of Assets (255,000)
Less : Fixed Capital + Liabilities 172,500

This is after adding salary, interest on capital and deducting drawings and interest on drawings.
(iv) Interest on Capital 2,250
A: on 50,000 @ 6% for 3 months 3,375
on 75,000 @ 6% for 9 months 5,625
4,500
B: on 75,000 @ 6% for 1 year 3,375
C: on 75,000 @ 6% for 9 months 7,875

(v) Interest on Drawings 183

A: on 2,000 @ 10% for 11 months 300
on 4,000 @ 10% for 9 months 50
on 2,000 @ 10% for 3 months 533
167
8: on 2,000 @ 10% for 10 months 300
on 6,000 @ 10% for 6 months 67
on 8,000 @ 10% for 1 month 534

Allocation of Profit 115,067

3 months Profit 28,767
9 months Profit 86,300
A : 2/3 x sh.28,767 + 1/3 x 86,300 47,944
B : 1 /3 x sh. 115,067 38,356
C: 1/3 x sh. 86,300 28,767
115,067

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Current Accounts

A B C A B C
To Balance b/d - 2,000 - By Balance b/d 5,000 - -
To Drawings 8,000 16,000 - By Salary 24,000 24,000 18,000
To Interest on - - By Interest on -
drawings capital 5,625 4,500 3,375
To Balance c/d 533 534 - By Share of -
74,036 48,322 50,142 Profit 47,944 38,356 28,767
82,569 66,856 50,142 82,569 66,856 50,142

Statement of Profit
Sh.
Current Account Balances as on 31/3/2018 172,500
Less: Salary A 2,000 x 12 = 24,000
B 2,000 x 12 = 24,000
C 2,000 x 9 = 18,000 (66,000)
Less: Interest on Capital A 5,625
B 4,500
C 3,375 (13,500)
Add: Drawings A 8,000
B 16.000 24,000
Add: Interest on Drawings A 533
B 534 1,067
118,067
Less: Current A/c Balances as on 31/3/2017 (5,000 - 2,000) (3,000)
115,067

TECHNIQUES OF OBTAINING COMPLETE ACCOUNTING INFORMATION

When books of accounts are incomplete, it is essential in the first instance to complete double entry
in respect of all transactions. The whole accounting process should be carefully followed and Trial
Balance should be drawn up.

The techniques to used are:-

 General techniques
 Derivation of information from cash book
 Analysis of sales and purchases ledger
 Distinction between Business expenses and drawings
 Identifying fresh investment by proprietors or partners
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General Techniques
Where the accounts of a business are incomplete, it is advisable to convert them first to the double
entry system and then to draw up the Profit and Loss Account the balance sheet, instead of
determining the amount of profit/loss by preparing the statement of affairs, As books of accounts of
different firms being incomplete in varying degrees, it is not possible to suggest a formula which
could uniformly be applied for preparing final accounts therefrom, As a general rule, it is essential
first to start the ledger accounts with the opening balances of assets, liabilities and the capital.
Afterwards, each book of original entry should be separately dealt with, so as to complete the double
entry by posting into the ledger such entries have not been posted. For example, If only personal
accounts have been posted from the cash Book, debits and credits pertaining to nominal accounts
and real accounts that are not posted should be posted into the ledger. If there are Discount Columns
in the Cash Book, the totals of discounts paid and received should be posted to Discounts Allowed
and Discounts Received Accounts respectively, for completing the double entry.

Afterwards, the other subsidiary books, i.e., Purchases Day Book, Sales Day Book, Return Book and
Bills Receivable and Payable, etc. should be totalled up and their totals posted into the ledger to the
debit or credit of the appropriate nominal or real accounts, the personal aspect of the transactions
having been posted already.

When an Accountant is engaged in posting the unposted items from the Cash Book and other
subsidiary books, he may be confronted with a number of problems. The manner in which some of
them may be dealt with is described below:

1. In the Cash Book, there might be entered several receipts which have no connection with the
business but which belong to the proprietor, e.g., interest collected on his private investment,
legacies received by him, amount contributed by the proprietor from his private resources,
etc. All those amounts should be credited to his capital account. Also the Cash Book may
contain entries in respect of payments for proprietor's purchases made by the business. All
such items should be debited to his capital account.
2. Amounts belonging to the business after collection may have been directly utilised for
acquiring business assets or for meeting certain expenses instead of being deposited into the
Cash Book. On the other hand, the proprietor may have met some of the business expenses
from his private resources. In that case, the appropriate asset or expense account should be
debited and the source which had provided funds credited.
3. If cash is short, because the proprietor had withdrawn amount without any entry having been
made in the cash book the proprietor’s capital account should be debited. In fact, it will be
necessary to debit or credit the proprietor's capital account in respect of all unidentified
amounts which cannot be adjusted otherwise.
4. Where the benefit of an item of an expense is received both by the proprietor and business,
then it should be allocated between them on some equitable basis e.g. rent of premises when

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the proprietor lives in the same premises, should be allocated on the basis of the area
occupied by him for residence.
5. The schedules of sundry debtors and creditors, extracted from respective ledgers maintained
for the purpose should be examined to find out if, by mistake, an item of revenue or expense
has found its way therein. Having done so and, if necessary after eliminating such amounts,
the schedules should be totalled and the total debited to Sundry Debtors Account in the
ledger. Similarly, the total of schedules of sundry creditors should be credited to Sundry
Creditors Account. One should note that since Sales Account, Purchase Account and other
nominal accounts having already been written up on the basis of Day Books, it is not
necessary to adjust them further. It is expected that the opening balances in these accounts
would have been adjusted by recovery or payment and the receipt from debtors and the
payment to creditors correctly posted to the accounts instead of having been recorded as Sales
or Purchases. If however, it has been done, these balances would require to be adjusted by
transfer to Sales or. Purchases Accounts or to Bad Debts or Discount Account, as the case
may be.

In the end, it will be possible to extract a Trial Balance. Students are advised always to do so as it
will disclose any mistakes committed in making adjustments.

Derivation of Information from Cash Book

The analysis of cash as well as bank receipts and payments, should be extensive but under
significant heads, so that various Items of income and expenditure can be posted therefrom into the
ledger. However before posting the information into the ledger the same should be collected in the
form of an account, the specimen whereof is shown below:

Cash and Bank Summary Account for the year ended

Cash Bank Cash Bank

Sh. Sh. Sh. Sh.
To Balance in hand 590 7,400 By Expenses 3,000
(opening) (Sundry payments)
To Sales 6,500 By Purchases 100 6,000
To Collection from By Sundry creditors - 5,000
debtors 10,000 By Drawings 1,500 -
By Petty expenses 800
By Rent - 1,000
By Electricity and water 350
By Repairs 350
By Wages 1,000
____ ______ By Balance in Hand 990 4,400
7,090 17,400 7,090 17,400

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The important point about incomplete records is that much of the information may not be readily
available and that the relevant information has to be ascertained. A good point is to prepare Cash
and Bank Summary (if not available in proper form with both sides tallied). The cash and bank
balance at the end should be reconciled with the cash and bank books. Having done so, the various
items detailed on the Summary Statements, should be posted into the ledger.

It is quite likely that some of the missing information will then be available. Consider the following
about a firm relating to 2012.

Sh.
Cash Balance on 1st Jan., 2012 250
Bank overdraft on 1st Jan.,2012 5,400
Cash purchases 3,000
Collection from Sundry debtors 45,600
Sale of old furniture 750
Purchase of Machinery 12,000
Payment of Sundry creditors 26,370
Expenses 8,450
Fresh Capital brought in 5,000
Drawings 3,230
Cash Balance on 31st Dec., 2012 310
Bank balance on 31st Dec., 2012 1,180

Now prepare the cash and Bank Summary.

Cash and Bank Summary

Dr. Cr.
Sh. Sh.
Cash Balance as on 1-1-2012 250 Bank overdraft 5,400
Collection from Sundry debtors 45,600 Cash purchases 3,000
Sale of old furniture 750 Purchase of Machinery 12,000
Fresh Capital brought in 5,000 Payment to Sundry creditors 26,370
Balancing figure 8,340 Expenses 8,450
Drawings 3,230
Cash balance on 31-12-2012 310
Bank balance on 31-12-2012 1,180
59,940 59,940
See that debit side is short by sh. 8,340. What may be the possible source of cash inflow?

May be cash sales.

Analysis of Sales Ledger and Purchase Ledger

Sales Ledger: It would disclose information pertaining to the opening balance of the debtors, the
goods sold to them on credit during the year, bills receivable dishonoured, if any; cash received from

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them in the accounting period, discount, rebate or any other concession allowed to them, receipts of
bills receivable, returns inwards, bad debts written off and transfers. Journal entries must be made by
debiting or crediting the impersonal accounts concerned with contra credit or debit given to total
debtors account.

Analysis of Sales Ledger of the year

Op. Sales Bills Total Cash Dis- Bills Sales Bad Total Balance

Customer Disho- Debits Reed. counts Reed. Returns Debts Credit (cl.)
Balance noured Alld.

From the aforementioned, it will be possible to build up information about sales and other accounts
which can then be posted in totals, if so desired. It would also be possible to prepare Total Debtors

Account in the following form:

Total Debtors Account (assumed figures)

Sh. Sh.
Opening balance 5,000 Cash/Bank 10,000
Sales 38,000 Discount 500
Bills dishonored 280 Bills receivable 20,000
Interest 100 Bad debts 280
_____ Closing balance 12,600
43,380 43,380

It is evident that any single amount comprised in the total Debtors Account can be ascertained if the
other figures are provided. For instance, if the information about sales is not available it could be
ascertained as a balancing figure, i.e., in the total Debtors Account given above, if all other figures
are given sales would be ? 38,000.

Purchases Ledger: Generally speaking, a Purchases Ledger is not as commonly in existence as the
Debtors Ledger for it is convenient to make entries in respect of outstanding liabilities at the time
they are paid rather than when they are incurred. The information is available in respect of opening
balance of the creditors, goods purchased on credit, bills payable dishonored; cash paid to the
creditors during the year, discount and other concessions obtained, returns outwards and transfers.
Here also, journal entries must be made by debiting or crediting the respective impersonal accounts.
Contra credit or debit being given to total creditor's account.

If a proper record of return to creditors, discount allowed by them etc., has not been kept, it will not
be possible to write up the Total Creditors A/c. In such a case, net credit purchase will be ascertained
as follows:

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Cash paid to Creditors including on account of Bills

Payable during the period xxx
Closing balance of Creditors and Bills Payable xxx
Total xxx
Less: Opening balance of Creditors and Bills Payable
Net credit purchase during the period

Alternatively
Cash paid to creditors during the period xxx
Add: Bills Payable issued to them xxx
Total xxx
Closing balance of Creditors
Less: Opening balance of creditors xxxx
Credit Purchases during the period xxx

The information may also be put in the form of an account, just like the Total Debtors Account.

Nominal Accounts: It is quite likely that the total expenditure shown by balance of nominal account
may contain items of expenditure which do not relate to the year for which accounts are being
prepared and, also, there may exist certain items of expenditure incurred but not paid, which have
not been included therein. On that account, each and every account should be adjusted in the manner
shown below (figures assumed):

Cash and Amount Paid out of Total Pre Expenses

Particulars Bank Accrued Private Payment for the
Payment Fund period
1 2 3 4 5 6 7
Rent & 2,200 300 100 2,600 150 2,450
Rates 4,500 500 1,000 6,000 250 5,750
Salaries

Total Private Fund

Only the amount entered as "expenses for the period” should be posted to the respective nominal
accounts. A similar adjustment of nominal accounts in respect of revenue receipt should be made.

Let us continue with the example given in derivation of Information from Cash Book. Given some
other information, how to compute credit purchase and credit sale is discussed below:

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Opening balance (1-1-2012) Sh.

Stock 20,000
Sundry creditors 12,300
Sundry debtors 15,000
Closing Balance (31-12-2012)
Stock 15,000
Sundry creditors 13,800
Sundry debtors 25,600
Discount received during 2012 1,130
Discount allowed 1,870

What are the purchases for 2012? Let us prepare the Sundry Creditors Account.

Sundry Creditors Account

Sh. Sh.
To Cash 26,370 By Balance b/d 12,300
To Discount 1,130 (opening)
To Balance c/d (closing) 13,800 By Purchases (balancing figure) 29,000
41,300 41,300

The credit purchases are Sh. 29,000; cash purchases are sh 3,000: hence total purchases are sh
32,000.

Likewise prepare the Sundry Debtors Account:

Sundry Debtors Account

To Balance b/d 15,000 By Cash By 45,600

(balancing figure) 58,070 Discount By 1,870
To Credit sales ______ Balance c/d 25,600
73,070 73,070
So total sales = credit sales + cash sales

= 58,070 + 8,340 = 66,410

Distinction between Business Expenses and Drawings

It has been already stated that often the distinction is not made between business expenses and
drawings. While completing accounts from incomplete records, it is necessary to scan the business
transactions carefully to identify the existence of drawings.

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The main items of drawings are:

• Rent of premises commonly used for residential as well as business purposes ;

• Common electricity and telephone bills;
• Life insurance premiums of proprietor/partners paid from business cash ;
• Household expenses met from business cash ;
• Private loan paid to friends and relatives out of business cash ;
• Personal gifts made to any friends and relatives out of business cash ;
• Goods or services taken from the business for personal consumption ;
• Cash withdrawals to meet family expenses.

So it is necessary to scan the summary of cash transactions, business resources and their utilisation
to assess the nature of drawings and its amount.

Fresh Investment by proprietors / partners

Like drawings, often fresh investments made by proprietors' partners are not readily identifiable. It
becomes necessary to scan the business transactions carefully. Apart from direct cash investment,
fresh investments may take the following shape:

• Money collected and put in the business on maturity of Life Insurance Policy of the proprietors;
• Interest and dividend of personal investment of the proprietors collected and put in the business;
• Income from non-business property collected and put in the business.

Unless these items are properly identified and segregated, business income will be inflated and
proper statement of affairs cannot be prepared.

Illustration

The following information relates to the business of Mr. Shiv Kumar, who requests you to prepare a
Trading and Profit & Loss Account for the year ended 31st March, 2013 and a Balance Sheet as on
that date:

(a)

Balance as on 31st Balance as on 31st

March, 2012 March, 2013
Building 320,000 360,000
Furniture 60,000 68,000
Motorcar 80,000 80,000
Stocks - 40,000
Bills payable 28,000 16,000
Cash and bank 180,000 104,000
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balances
Sundry debtors 160,000 -
Bills receivable 32,000 28,000
Sundry creditors 120,000 -

(b) Cash transactions during the year included the following besides certain other items:

sh sh
Sale of old papers and miscellaneous Cash purchases 48,000
income 20,000 Payment to creditors 184,000
Miscellaneous Trade expenses Cash sales 80,000
(including salaries etc.) 80,000
Collection from debtors 200,000

(c) Other information:

 Bills receivable drawn during the year amount to sh. 20,000 and Bills payable accepted sh.
16,000.
 Some items of old furniture, whose written down value on 31st March, 2012 was sh 20,000
was sold on 30th September, 2012 for sh 8,000. Depreciation is to be provided on Building and
Furniture @ 10% p.a. and on Motorcar @ 20% p.a. Depreciation on sale of furniture to be
provided for 6 months and for additions to Building for whole year.
 Of the Debtors, a sum of sh 8.000 should be written off as Bad Debt and a reserve for doubtful
debts is to be provided @ 2%.
 Mr. SomeaKenya has been maintaining a steady gross profit rate of 30% on turnover.
 Outstanding salary on 31st March, 2012 was sh 8,000 and on 31st March, 2013 was f 10,000
on 31st March, 2012. Profit and Loss Account had a credit balance of sh. 40,000.
 20% of total sales and total purchases are to be treated as for cash.
 Additions in Furniture Account took place in the beginning of the year and there was no
opening provision for doubtful debts.

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Solution

Trading and Profit and Loss Account of Mr. SomeaKenya

For the year ended 31st March, 2013

To Opening stock By Sales 400,000

(Balancing figure) 80,000 By Closing stock 40,000
To Purchases 240,000
To Gross profit c/d
@ 30% on sales 120,000 ______
440,000 440,000
To Miscellaneous expenses By Gross profit b/d 120,000
( 80,000 - 8,000 + 10,000) 82,000 By Miscellaneous receipts 20,000
By Net loss transferred to
To Depreciation: Capital A/c 25,840
Building 36,000
Furniture 7,800
(? 6,800+ 1,000)
Motor Car 16,000 59,800
To Loss on sale of furniture 11,000
To Bad debts 8,000 8,000
To Provision for doubtful debts 5,040 ______
165,840 165,840

Working Notes:

(i) Sundry Debtors Account

To Balance b/d 160,000 By Cash/Bank A/c 200,000

To Sales A/c 320,000 By Bills Receivable A/c 20,000
By Bad debts A/c 8,000
______ By Balance c/d (bal. fig.) 252,000
480,000 480,000

(ii) Sundry Creditors Account

Sh Sh
To Cash/Bank A/c 184,000 By Balance b/d 120,000
To Bills Payable A/c 16,000 By Purchases A/c 192,000
To Balance c/d (bal. fig.) 112,000 ______
312,000 312,000

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(ii) Bills Receivable Account

Sh. Sh.
To Balance b/d 32,000 By Cash/ Bank A/c (bal. 24,000
To Sundry Debtors A/c 20,000 fig.) 28,000
52,000 By Balance c/d 52,000

(iii) Bills Payable Account

Sh. sh
To Cash/Bank A/c (bal. fig.) 28,000 By Balance b/d 28,000
To Balance c/d 16,000 By Sundry Creditors A/c 16,000
44,000 44,000

(iv) Furniture Account

Sh. Sh.
To Balance b/d 60,000 By Bank/Cash A/c 8,000
To Bank A/c 28,000 By Depreciation A/c 1,000
By Profit and loss A/c (loss on sale) 11,000
By Depreciation A/c 6,800
_____ By Balance c/d 61,200
88,000 88,000

(iv) Cash/Bank Account

Sh. Sh.
To Balance b/d 180,000 By Misc. trade expenses A/c 80,000
To Miscellaneous receipts A/c 20,000 By Purchases A/c 48,000
To Sundry debtors A/c 200,000 By Furniture A/c (bal. fig.) 28,000
To Sales A/c 80,000 By Sundry creditors A/c 184,000
To Furniture A/c (sale) 8,000 By Bills payable A/c 28,000
To Bills receivable A/c 24,000 By Building A/c 40,000
______ By Balance c/d 104,000
512,000 512,000

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(iv)

Opening Balance Sheet of Mr. SomeaKenya

As on 1st March 2013
Liabilities Sh. Assets Sh.
Capital (balancing figure) 716,000 Building 320,000
Profit and loss A/c 40,000 Furniture 60,000
Sundry Creditors 120,000 Motor car 80,000
Bills Payable 28,000 Stock in trade 80,000
Outstanding salary 8,000 Sundry Debtors 160,000
Bills Receivable 32,000
______ Cash in hand and at bank 180,000
912,000 912,000

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TOPIC 10
FINANCIAL STATEMENTS OF A NOT FOR PROFIT MAKING
ORGANIZATION

INTRODUCTION

Non for profit organization or non-trading organization are those organizations which are
established not for earning profits but for promoting art, culture, sports, education etc. Medical
institution, Charitable trusts, welfare societies, educational institutions etc. are examples of non-
trading organizations

The final accounts of non-trading organizations include the following:

1. Receipts and payment account

2. Income and expenditure account
3. Statement of financial position
Their main not for profit organizations prepare financial statements is to know:

i. Whether their current incomes are sufficient to meet current expenses

ii. What their financial position is at the end of each period.
Therefore, they prepare an account each. year called Income and Expenditure Account, setting out
all incomes (or revenue receipts) on the credit side (Cr.) and all revenue expenses on the debit side
(Dr.).

DISTINCTION BETWEEN NOT FOR PROFIT MAKING ORGANISATION AND PROFIT

MAKING ORGANISATION

One of the major myth, regarding the non-profit organisation, which most of the people believe as true is that
it does not make the profit from business activity. However, in reality, the non-profit organisation too makes
the profit from various activities just like a for-profit organisation does, but only the way of handling profit is
different in the two organisations.

The basic aspect, which bifurcates business organisation is the purpose of their operation, i.e. not all
organisations work for the profit motive; rather there are some entities whose aim is to serve the society first.
This way, there are two major types of organisation, which are profit organisation and non-profit
organisation.

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Comparison Chart

Basis for
Profit Organization Non-Profit Organization
Comparison
A legal entity, which operates for earning A non-profit organization is a legal
Meaning profit for the owner, is known as For-profit or entity, which operates for serving the
Profit organization. society as a whole.
Motive Profit motive Service Motive
Form of Sole proprietorship, Partnership firm or Club, Trust, Public hospitals, society,
organization company etc.
Sole proprietor, partners or directors, as the Trustees, committees or governing
Management
case may be. bodies.
Donation, subscription, membership fee
Source of revenue Sale of goods and services.
etc.
Commenced Funds from donation, subscription,
Capital contributed by the owners.
through government grant and so on.
Financial Income statement, Balance Sheet and Cash Receipt & Payment A/c, Income &
Statement flow statement Expenditure A/c and Balance Sheet.
Money earned
Profit, is transferred to capital account. Surplus is transferred to capital fund.
over and above

TYPES OF FUNDS AND THEIR ACCOUNTING TREATMENT

1) Subscription

It is a recurring income for nonprofit organizations. This is one of the main sources of revenue. This
is shown on the credit side of income and expenditure account. Adjustment should be made to show
the correct income for the period.

Subscription received for certain specific purpose like subscription for tournament fund,
subscription for construction of pavilion etc. should be capitalized (that is shown on the liability side
of the balance sheet)

2) Donations

The amount received from a person, firm or company by way of gift is called a donation. Donations
may be specific donation or general donations.

a) Specific donations

If the donations are for a specific purpose, example donation for building, donation for library,
donation for furniture etc. it must be treated as capital receipts and should be shown on the liability
side of the balance sheet. The expenditure incurred on this account should be deducted and the
balance should be shown until it is completely used up.
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b) General donations

When the donations are given for a general purpose, it is the amount which will determine whether it
is a capital or revenue receipts. Donation of a comparatively small amount must be treated as
income, But if the amount of such donation is big, it must be treated as capital receipts and it should
be shown on the liability side of the balance sheet.

3) Grants

Grant received from central, state or local bodies for routine expenses are treated as income. Grant
for specific purpose such as constructions of buildings, purchase of x-ray equipment's Etc. is
capitalized

4) Legacy

It is the amount received by the nonprofit organizations as per the will of a deceased person. It is a
capital receipt and is shown on the liability side of the balance sheet, but if the amount is small it
may be treated as income and may be shown on the credit side income and expenditure account.

In the absence of any specific information legacy must be preferably be capitalized.

5) Endowment fund

The fund meant for permanent means of support is known as endowment fund. It is a capital receipt

6) Entrance fees

This is the amount of fee collected on the admission or members. Accountants differ on the
treatment of entrance fees. Many feel that since the amount is collected only once and as it is o I non
recurring in nature it should be capitalized and taken to the liability side of the balance sheet but
others argue Mai though it is paid is each members only once, the clerk or institution receives fairly
regularly every year because of regular entrance of members. So it should be shown as an income in
the credit side of income and expenditure account. In the absence of specific instruction in the
question, students may treat it any way but they must append a note justifying the choice made.

7) Sale of old assets

The amount realized from the sale of old assets should be treated as capital receipts and should be
credited to asset account. But loss or profit on its sales should be treated as revenue and is taken to
income and expenditure account:

8) Sale Of newspapers and periodicals etc.

The amount received on selling newspapers, periodicals, etc. should be treated as income and is
credited to income and expenditure account

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9) Expenditure stock items

Items like stationery sports, materials like bats balls etc. are called expenditure stock items the value
of that type Of items which remains Unused should be deducted from the total amount spent so that
only the amount 'actually used up is debited to income and expenditure account vrroat.ment is as
follows:

Stock of Stationery (opening) xxx

Add purchase during the year xxx
xxx (balance sheet (asset Side)
Less stock of stationery (closing) xxx
Stationery item used during the year xxx (debited in the I and E account)

10) Sale of scraps, grass etc.

These are treated as revenue receipts and shown on the income side

11) Life membership fee

.life membership may, sometime, be granted to members on their making a lump sum payment in
lieu of annual subscription. As the service has to be rendered for a long time without further
payment; it must he treated as capital receipts and should be capitalized.

12) Payment of honorarium

Amount paid to a person for the specific service rendered by him is called honorarium. For example
payment made to singers, dancers etc. is shown on the expenditure side

13) Special purpose fund

If there is any special purpose fund example tournament fund, charity fund, prize fund, endowment
fund etc. and there are certain items of-expenses and incomes relating to that fund. Then income and
expenses should not be shown in the income and expenditure account but income should be added to
Ike fund and expenses deducted from such fund on the liability side of the balance sheet

NATURE OF RECEIPT AND PAYMENT ACCOUNT:

"A receipt and payment account is a summarized cash book (cash and bank) for a given period".
or
"This is simply a summary of the cash transactions as in the cash book, analyzed and classified
under suitable headings, including the opening and closing balances".
Non-profit organizations (also called non-trading concerns) prepare a receipt and payment account at
the end of year. With the help of this account and some additional information, an income and

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expenditure account is prepared to disclose the true results of non-profit organizations. Receipt and
payment account cannot disclose the true result of non-trading concern.

All the information necessary for the preparation of this account is available from cash book.
Various cash receipts and cash payments during the whole year find place in this account in a
classified manner. Its closing balance indicates cash in hand and cash at bank at the year end.

Characteristics of Receipt and Payment Account:

Following are the features of receipt and payment account:

1. It is abridged addition of cash book - it is, in effect, a summary of cash book.

2. All cash receipts during the whole year are recorded on its left hand (i.e., debit) side. While
all the cash payments during the whole year written on its right hand (i.e., credit) side,
arranged in a classified form.
3. Cash receipts and cash payments of both capital and revenue nature are recorded here.
4. Only cash transactions are recorded in this account.
5. It generally shows a debit balance. In case of bank overdraft balance, however, its net balance
may be credit. Again, it may also show nil balance but such occasion is rare.
6. Its closing balance indicates closing cash in hand and closing cash at bank.
7. It is not an account within the double entry system - it is a statement only.
8. It is prepared on the last day of the accounting year.

Advantages:

The following are the advantages of receipt and payment account:

1. Total receipts and total payments under various heads are available at a glance.
2. The amount of cash in hand at the year end can be ascertained.
3. The correctness of cash book can be verified through it. The total of debit side of cash
book will agree with the total of receipt side of this account. On the other hand, the total
of credit side of cash book will agree with that of payment of this account.

Method of Preparation:

Receipts and payment account is prepared with all the cash receipts and cash payments of the whole
year. The net result of cash receipts and cash payments of a fixed time is determined through this
account. So it is its heading will be:

Receipt and Payment Account For the Year Ended 31.12.2005

Its left hand side is called "Receipts" and right hand side "payments". On the left hand side all cash
receipts are recorded, while on the right hand side all cash payments are recorded arranged in a
classified form. It starts with last year's closing cash in hand and cash at bank and closes with current
year's closing cash in hand and cash at bank. In other words, its opening balance indicates last year's

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closing cash in hand and cash at bank, while its closing balance means current year's closing cash in
hand and cash at bank.

Example:
From the following cash book prepare receipts and payments account for the year ended 31
December 2005.
Cash Book
Date References Amount Date References Amount
2005 2005
Jan. 1 Balance b/d 250 Jan. 5 Rent 200
Feb. 2 Subscription 600 Jan. 16 Traveling expenses 15
Mar. 10 Admission fee 25 Fed. 12 Salaries 250
Apr. 5 Subscription 950 Mar. 17 Entertainment expenses 50

May 20 Sale of old newspapers 10 Apr. 20 Electric charges 20

June 3 Subscription 880 May 5 Furniture 300

July 15 Admission fee 30 May 10 Postage 18

Aug. 20 Sale of old newspaper 15 June 3 Stationary 120

Sep. 5 Donation 100 July 12 Electric charges 30

Oct. 1 Sale of old furniture 150 Aug. 3 Newspaper 25

Nov. 15 Donation 50 Sep. 15 Salaries 320

Dec. 28 Subscription 250 Sep. 20 Newspaper 65

Oct. 3 Traveling expenses 25

Oct. 12 Postage 12

Nov. 5 Rent 300

Nov. 16 Entertainment expenses 80

Dec. 5 Books 450

Dec. 12 Salaries 350

Dec. 25 Rent 130

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Dec. 31 Balance c/d 550

3,310 3,310

2006
Jan. 1 550

Solution:
ABC Club
Receipt and Payment Account
For the year ended 31st December, 2005
Receipts $ Payments $
Balance b/d 250 Rent [200+300+130] 630
Subscription [600+950+880+250] 2,680 Traveling expenses [15+25] 40
Admission fee [25+30] 55 Salaries [250+320+350] 920
Sale of old newspaper [10+15] 25 Entertainment expenses [50+80] 130
Donation [100+50] 150 Electric charges [20+30] 50
Sale of old furniture 150 Furniture [200+300+130] 300
Postage [18+12] 30
Stationary 120
Newspaper [25+65] 90
Books 450
Balance c/d 550

3,310 3,310

Balance b/d 550

INCOME AND EXPENDITURE ACCOUNT

It is a revenue account prepared by a nonprofit organization to ascertain surplus or deficit for a

particular period. It is a nominal account. ]n this account only revenue receipts and revenue expenses
are recorded. All revenue expenses of the current year are recorded on the debit side and revenue
incomes of the current year are recorded on the credit side, the difference between incomes and
expenditure represents surplus or deficit.

The comparison of the two sides shows whether or not current expenses are being met out of current
income. The principles for preparing this account are exactly the same as for Trading and Profit and
Loss Account.

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That means that the matching principle is followed, meaning thereby that:
a) No item of capital nature is included in this account but all revenue items are entered.
b) Expenses and income should relate only to the year concerned (that is, items relating to the
past or, future will be excluded)
c) The whole of the incomes or expenses, even if some amounts are outstanding, should be
included.

STATEMENT OF FINANCIAL POSITION

Statement of financial position contains assets and liabilities. Assets or capital expenditure,
outstanding incomes prepaid expenses etc. are shown on the asset side. Capital receipts or liabilities.
capital fund, outstanding expenses, incomes received in advance are shown on the liability side of
the balance sheet; generally surplus is shown-by adding it to the capital fund.

Illustration:

The following is the summary of the cashbook of Mbedodo Football Club for the year ended 30 June
2011:
Receipts Sh. '000' Payments Sh. '000'
Bank balance (1 July 2010) 2,340 Casual wages 7,200
Members subscription 49,850 Bar supplies 42,300
Entrance fees 32,060 Rates 1,200
Bar sales 60,840 Rent 24,600
Competition receipts 25,820 Secretary's basic salary 18,000
Lighting and water 5,040
Competition prizes 14,400
Stationery and postage 3,840
Repairs to gymnasium 3,300
Ground upkeep 4,500
Bar manager's salary 5,400
Deposit with SACCO 35,000
______ Bank balance 6,130
170,910 170,910

Additional information:
1. The assets of the club on 1 July 2010 were as follows:
Sh. '000'
Land 650,00
Gymnasium and equipment 250,00
Bar inventory 10,800
Prizes in hand 4,800
2. Bar supplies owing amounted to Sh. 4,200,000 on 1 July 2010

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3. On 30 June 2011 the bar inventory was Sh. 9,600,000, prizes in hand - Sh. 2,400,00 and Sh.
5,640,000 was owing for bar supplies.
4. The secretary is to receive a leave allowance of 5% of his basic salary. It was also agreed that the
bar manager should receive a Sh. 500,000 bonus for increased sales during the year.
5. From the register of members, it appeared that unpaid subscriptions as at 30 June 2011 totaled
Sh. 5,100,000. Subscriptions received during the year included Sh. 2,550,000 in respect of the
previous year and Sh. 1,700,000 in respect of the year starting 1 July 2011.
6. Interest earned on the deposit with the SACCO for the year ended 30 June 2011 amounted to Sh.
1,750,000
7. The rent paid was for fifteen months up to 30th September 2011
8. The gymnasium and equipment are to be depreciated at the rate of 10% per annum on straight
line basis

Required;-
a) Income and expenditure account for the year ended 30 June 2011
b) Statement of financial position as at 30 June 2011

Solution:
a) Income and expenditure account

Mbedodo
Income and expenditure account for the year ended 30 June 2011
Incomes Sh ‘000’ Sh. ‘000
Profit from trading/ bar profit(w2) 10,000
Subscriptions(w3) 50,700
Interests earned 1,750
Entrance fees 32,060
Competition receipts 25,820
120,330
Expenses
Prizes given 2,400
Leave allowance 900
Basic salary 18,000
Competition prizes 14,400
Rent (W4) 19,680
Depreciation gym equipment 25,000
Casual wages 7,200
Rates 1,200
Lighting & water 5,040
Stationery & postage 3,840
Repairs to gym 3,300
Ground upkeep 4,500 (105,460)
Surplus 14,870

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b) Statement of financial position

Mbedodo
Statement of financial position as at 30 June 2011
Non-current assets Sh. '000'
Land 650,000
Gym & equipment (w7) 225,000
875,000
Current assets
Subscriptions Accrued 5,100
Bar inventory 9,600
Prices in land 2,400
SACCO 35,000
Bank 6,130
Prepaid rent 4,920
Interest receivable 1,750
Total assets 939,900
Financed by:
Accumulated fund (w6) 916,290
Surplus 14,870
Current liabilities
Leave allowance 900
Bar manager bonus 500
Bar surplus 5,640
Prepaid subscriptions 1,700
Total capital liabilities 939,900

Workings

W1 Depreciation gym equipment= (10%× 250,000) = Shs. 25,000

W2
Bar Trading Profit & Loss a/c
Shs. ‘000’ Shs. ‘000’
Bar sales 60,840
Cost of sales
Opening inventory 10,800
Bar purchases 43,740
Closing bar inventory (9,600) (44,940)
Gross profit 15,900
Bonus to manager 500
Bar manager’s salary 5,400 5,900
10,000

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W3
Subscription Account
Shs ‘000’ Shs ‘000’
Balance b/d 2,550 Cash 49,850
Income and expenditure 50,700 Accrued 5,100
Prepaid c/d 1,700 _____
54,950 54,950
W4
Prizes in land Account
Shs‘000’ Shs‘000’
Cashbook 24,600 Income statement 19,680
____ Prepaid c/d 4,920
24,600 24,600
W5
Rent Account
Shs‘000’ Shs‘000’
Balance b/d 4,800 Income statement 2,400
____ Prepaid c/d 2,400
4,800 4,800
W6
Statement of affairs
Dr. Cr.
Shs. ‘000’ Shs. ‘000’
Land 650,000
Property & equipment 250,000
Bar inv. 10,800
Prices in land 4,800
Subscriptions 2,550
Bank balance 2,340
Bar supplies accrued - 4,200
Accumulated fund - 916,290
920,490 920,490
W7
Gym Equipment Account
Shs ‘000’ Shs ‘000’
Balance b/d 250,000 Depreciation 25,000
______ Balance c/d 225,000
250,000 250,000

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REVISION EXERCISE

QUESTION 1
The following are the balances of assets and liabilities extracted from the books of Jenga Afya
Sports Club as at 30 June 2012 and 30 June 2013:

2012 2013
Shs’000’ Shs’000’
Sports pavilion at cost 10,000 10,000
Gym equipment at cost 6,000 ?
Furniture and fittings at cost 4,000 ?
Accumulated depreciation:
Gym equipment 1,400 ?
Furniture and fittings 1,200 ?
Subscriptions received in advance 600 1,800
Subscriptions in arrears 1,200 1,500
Coach's fees outstanding 400 500
Restaurant payables 500 600
Pre-paid electricity 125 150
Restaurant inventory 1,100 1,900

The club's receipts and payments for the year ended 30 June 2013 were as follows:
Sh. ‘000’
Receipts
Cash balance:
Cash in hand 2,400
Bank balance 1,650
Subscriptions 12,000
Restaurant sales 6,250
Gym services income 6,200
Sale of gym equipment 400
Payments
Restaurant purchases 4,250
Electricity bills 400
Restaurant wages 1,360
Coach's fees 3,100
Honoraria to secretary 4,600
Club maintenance expenses 200
Travelling expenses 420
Purchase of gym equipment 3,000
Purchase of furniture and fittings 1,100
Gym expenses 1,500
Salaries and wages 1,470
Purchase of office computers 1,000
Cash balance - Cash in hand 1,500
Bank balance 5,000
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Additional information:
1. Goods worth Sh.75, 000 from the restaurant were consumed by members of staff during the
year ended 30 June 2013, but were not paid for.
2. Depreciation is to be provided on cost of existing assets as follows:

Asset Rate per annum

Gym equipment 15%
Furniture and fittings 10%
Sports pavilion 5%
Office computers 20%

3. Depreciation on furniture and fittings is to be apportioned between restaurant and office at

40% and 60% respectively.
4. 10% of the subscriptions in arrears at the beginning of the year were not received by the end
of the financial year. The management decided to write them off.
5. Gym equipment sold during the year had a cost of Sh. 1,000,000 and had been used for 3
years.

Required:
a) The restaurant income statement for the year ended 30 June 2013,
b) The income and expenditure account for the year ended 30 June 2013.
c) Statement of financial position as at 30 June 2013.

Solution

a) Restaurant income statement

Restaurant trading account

Sh. ‘000’ Sh. ‘000’
Restaurant takings 6,250
Cost of sales
Opening stock 1,100
Purchases 4,275
Goods available for sale 5,375
Less closing stock 1,900 (3,475)
2,775
Less expenses
Restaurant wages 1,360
Depreciation on Furniture and fittings 204 (1,564)
Net profit 1,211

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b) Income and expenditure account

Jenga afya spors club
Income and expenditure account
For the year ended June 2013

Sh ‘000’ Sh ‘000’
Loss on sale of equipment 150 Profit from restaurant 1,211
Depreciation Subscriptions 11,220
Gym equipment 1,200 Gym service income 6,200
Furniture and fittings 306
Sports pavilion 500
Office computer 200
Bad debt written off 120
Electricity 375
Coach fees 3,200
Honoraria to secretary 4,600
Club maintenance expense 20
Gym expense 1,500
Travelling expenses 420
Salary and wages 1,470
Surplus 4,390 _____
18,631 18,631

c) Statement of financial position

Jenga afya spors club

Income and expenditure account
For the year ended June 2013
Cost Acc. Dep. NBV
Sh ‘000’ Sh ‘000’ Sh ‘000’
Non-current assets
Sports pavilion 10,000 500 9,500
Gym equipment 8,000 2,150 5,850
Furniture and fittings 5,100 1,710 3,390
Computers 1,000 200 800
24,100 4,560 19,540
Current assets
Inventory 1,900
Subscription in arrears 1,500
Prepaid electricity 150
Cash in hand 1,500
Cash at bank 5,000 10,050
29,590
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Capital and liabilities

Accumulated fund 22,375
Surplus 4,390
Less drawings (75)
26,690
Current liabilities
Payables 600
Subscription in advance 1,800
Accrued coach fee 500 2,900
29,590

Workings
W1
Accounts payable control Account
Shs’000’ Shs ‘000’
Restaurant payables 4,250 Balance b/d 500
Balance c/d 600 Credit purchases 4,350
4,850 4,850
W2
Subscription Account
Shs’000’ Shs ‘000’
Balance b/d 1,200 Balance b/d 500
Income and expenditure 11,220 Bank/Cash 12,000
Balance c/d 1,800 Bad debts w/off 120
____ Balance c/d 4,350
14,220 14,220
W3
Gym Equipment Account
Shs’000’ Shs ‘000’
Balance c/d 6,000 Disposal 1,000
Bank 3,000 Balance c/d 8,000
9,000 9,000

W4
Gym Equipment Disposal Account
Shs’000’ Shs ‘000’
Gym equipment 6,000 Cash 400
Depreciation 450
_____ Loss 150
1,000 1,000

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W5
Trial Balance as at 1 July 2012
Dr. Cr.
Shs’000’ Shs’000’
Sports pavilion 10,000 -
Gym equipment 6,000 -
Furniture and fittings 4,000 -
Accumulated depreciation
Gym equipment - 1,400
Furniture and fittings - 1,200
Subscriptions received in advance - 600
Subscriptions in arrears 1,200 -
Coaches fees outstanding - 400
Restaurant payables - 500
Prepaid electricity 125 -
Restaurant inventory 1,100 -
Cash in hand 2,400 -
Cash at bank 1,650 -
Accumulated fund - 22,375
26,475 26,475

W6
Electricity Account
Shs’000’ Shs ‘000’
Balance b/d 125 Income statement 375
Cash 400 Balance c/d 150
525 525

W7
Coach’s fee Account
Shs’000’ Shs ‘000’
Cash 3,100 Balance b/d 400
Balance b/d 500 Income statement 3,200
3,600 3,600

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QUESTION 2
The following is the income and expenditure account for Uzima Charitable Hospital for the year
ended 31 July 2012:

Expenditure Sh. Income Sh.

Medicine used 5,996,000 Subscriptions 11,200,000
Honoraria to doctors 2,400,000 Donations 1,900,000
Salaries 5,500,000 Income from annual walk 2,200,000
Electricity and water 95,000 Income from film show 2,290,000
Rent 1,200,000
Depreciation:
- Furniture and fixtures 420,000
- Equipment 650,000
Film show expenses 56,000
Annual walk expenses 100,000
Printing expenses 220,000
Surplus 953,000 _________
17,590,000 17,590,000

Additional information:

1 August 2011 31 July 2012

Subscriptions due 14,000 32,000
Subscription received in advance 12,800 20,000
Electricity and water bills 18,400 23,000
Furniture and fixtures at net book value 4,200,000 3,780,000
Equipment at net book value 2,320,000 2,780,000
Land - 2,000,000
Cash balance 68,000 32,000
Bank balance 1,800,000 ?
Stock of medicine 1,564,000 1,950,000

Required:
a) Subscriptions account for the year ended 31 July 2012.
b) Receipts and payments account for the year ended 31 July 2012.
c) Statement of financial position as at 31 July 2012.
Solution:

a) Subscriptions account for the year ended 31 July 2012

Subscription Account
Shs Shs
Balance b/d 24,000 Balance b/d 12,800
Subscription income 11,200,800 Cash received 11,200,000

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Balance c/d 20,000 Balance c/d 32,000

11,244,800 11,244,800

b) Receipts and payments account

Receipts and payment Account
For the year ended 31 July 2012
Sh. Sh.
Bank b/d 1,800,000 Medicine purchased 6,382,000
Cash b/d 68,000 Honoraria to doctor 2,400,000
Subscription received 11,199,200 Salaries 5,500,000
Donation 1,900,000 Electricity and water (w3) 90,400
Annual walk 2,200,000 Rent 1,200,000
Film show 2,290,000 Film show expenses 56,000
Annual walk expenses 100,000
Printing expenses 220,000
Land 2,000,000
Equipment(w2) 1,110,000
Cash c/d 32,000
_________ Bank 366,800
19,457,200 19,457,200

c) Statement of financial position as at 31 July 2012

Statement of financial position

As at 31 July 2012
Non-Current assets shs shs
Land 2,000,000
Equipment 2,780,000
Fixtures and fittings 3,780,000
8,560,000
Current Assets
Stock of medicine 1,950,000
Acc. Subscription 32,000
Bank 366,800
Cash 32,000 2,380,800
10,940,800
Financed by:-
Accumulated Fund b/d (w4) 9,944,800
Surplus 953,000 10,897,800
Current Liabilities
Accrued Electricity 23,000
Subsidiary in adv. 20,000 43,000
10,940,800

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Workings
W1
Medicine Account
Shs Shs
Balance b/d 1,564,000 Used medicine 5,996,000
Cash 6,382,000 Balance c/d 1,950,000
7,946,000 7,946,000
W2
Equipment Account
Shs Shs
Balance b/d 2,320,000 Depreciation 650,000
Cash 1,110,000 Balance c/d 2,780,000
3,430,000 3,430,000

W3
Electricity and water Account
Shs Shs
Receipts and payments 90,400 Balance b/d 18,400
Balance 23,000 Income and expenditure 95,000
113,400 113,400
W3
Accumulated fund working

Shs
Assets
Fixtures and fittings 4,200,000
Equipment 2,320,000
Cash 68,000
Bank 1,800,000
Stock 1,564,000
Accrued Subscriptions 24,000
9,976,000
Liabilities
Subscriptions in advance 12,800
Accrued Electricity 18,400
Accumulated fund 9,944,800
9,976,000

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TOPIC 11
ANALYZING FINANCIAL STATEMENTS

STATEMENT OF CASH FLOW

Definition

"A statement of changes in the financial position of a firm on cash basis is called a cash flow
statement."

The statement of cash flow describes the inflow (sources) & outflow (uses) of cash. It summarizes
the causes of changes in cash position of a business enterprise between two balance sheets.

CATEGORIES OF CASH

1. Cash flows from operating activities

2. Cash flows from investing activities
3. Cash flows from financing activities

Cash flows from Operating Activities

Operating activities are the basic revenue producing activities of the enterprise. The amount of cash
flows arising from operating activities is an indicator of a firm's operating capability to generate
sufficient funds to meet its operating needs, pay dividends, repay loans, etc. without depending on
external sources of finance.

Examples of cash flow from operating activities

1. Cash receipts from sale of goods & rendering of services

2. Cash receipts from royalties, fees, commissions, etc
3. Cash payment to suppliers of goods & services
4. Cash payment to & on behalf of employees
5. Cash receipts & payments of an insurance company for premiums, claims, annuities and other
policy benefits
6. Cash payments or refunds of income tax relating to operating activities
7. Cash receipts and payments from contracts held for dealing or trading purposes.

Cash flows from Investing Activities

Investing activities are the acquisition & disposal of long term assets & investments. A separate
disclosure of cash flows arising from investing activities is important because cash flows represent
the extent to which expenditure have been made for resources to generate future incomes.

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Examples of cash flow from investing activities

1. Cash payments to acquire fixed assets (including intangibles).

2. Cash receipts from disposal of fixed assets (including intangibles)
3. Cash receipts from disposal of shares, warrants, debt instruments, etc
4. Cash advances & loans made to third parties.
5. Cash receipts from the repayment of advances & loans made to third parties.

Cash flows from financing Activities

Financing activities are activities that result in changes in the size & composition of the owners'
capital (including preference share capital in the case of a company) & borrowings of the enterprise.

Examples of cash flows from financing activities

1) Cash proceeds from issuing shares or other similar instruments

2) Cash proceeds from issuing debentures, loans, bonds & other short or long term borrowings
3) Cash repayments of amounts borrowed such as redemption of debentures, bonds, preference
shares.

METHODS OF PREPARING STATEMENTS OF CASH FLOW

An enterprise should report cash flow from operating activities using either:

 The direct method, whereby major classes of gross cash payments are disclosed ;or
 The indirect method, whereby net profit or loss is adjusted for the effects of transactions of a
non-cash nature, any deferrals or accruals of post or future operating cash receipts or
payments, and items of income or expense associated with investing or financing cash flows.

DIRECT METHOD

Enterprises are encouraged to report cash flows from operating activities using the direct method.
Under the direct method information about major classes of gross cash receipts and gross cash
payments may be obtained either:

a. From the accounting records of the enterprise; or

b. By adjusting sales, cost of sales (interest and similar income and interest expense and similar
charges for a financial institution) and other items in the income statement for:

i. Changes during the period in inventories and operating receivables and payables
ii. Other non-cash items and
iii. Other items for which the cash effects are investing or financing cash flows.

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INDIRECT METHOD

Under the indirect method, the net cash flow from operating activities is determined by adjusting a
net profit or loss for the effects of:

a. Changes during the period in inventories and operating activities receivables and payables
b. Non-cash items such as depreciation, provisions, deferred taxes, unrealized minority interest
c. All other items for which the cash effects are investing or financing cash flows.
Alternatively, the net cash flow from operating activities may be presented under the indirect
method by showing the revenue and expenses disclosed in the income statement and the changes
during the period in inventories and operating receivables and payable.

REPORTING CASH FLOWS FROM INVESTING AND FINANCIAL ACTIVITIES

An enterprise should report separately major classes of gross cash receipts and gross cash payments
arising from investing and financing activities, except to the extent that cash flows described below
are reported on a net basis.

REPORTING CASH FLOWS ON NET BASIS

Cash flow arising from the following operating, investing or financing activities may be reported on
a net basis:

a. Cash receipts and payments on behalf of customers when the cash flow reflect the activities
of the customer rather than those of the enterprise; and
b. Cash receipts and payments for items, in which the turnover is quick, the amounts are large,
and the maturities are short.
Examples of cash receipts and payments referred to in (a) above are:

1. The acceptance and repayment of demand deposits of a bank

2. Funds held for customers by an investment enterprise
3. Rents collected on behalf of and paid over to the owners of properties. Examples of cash
receipts and payments referred to in (b) above are advances made for, and repayment of:
4. Principal amount relating to credit card customers
5. The purchase and sale of investments
6. Other short-term borrowing for example, those which have a maturity period of three months
or less
Cash flows arising each of the following activities of a financial institution may be reported on a net
basis:

a) Cash receipts and payments for the acceptance and repayment of deposits with fixed maturity
date.
b) The placement of deposits with and withdrawal of deposits from other financial institutions
c) Cash advances and loans made to customers and repayment of those advances and loans

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INTEREST AND DIVIDENDS

Cash flows from interest and dividends received and paid should each be disclosed separately. Each
should be classified in a consistent manner from period to period either as operating, investing or
financing activities

The total amount of interest paid during a period is disclosed in the cash flow statement whether it
has been recognized as an expense in the income statement or capitalized

Interest paid and interest and dividend received are usually classified as operating cash flows for a
financial institution. However, there is no consensus on the classification of these cash flows for
other enterprises. Interest paid and interest and dividends received may constitute operating cash
flow because they enter into the determination of net profit or loss alternatively, interest paid and
interest dividends received may be classified as financing cash flow and investing cash flows
respectively, because they are costs of obtaining financial resources or returns on investment.

Dividends paid may be classified as a financing cash flow because they are a cost of obtaining
financial resources. Alternatively, dividends paid may be classified as a component of cash flow
from operating activities in order to assist users to determine the ability of an enterprise to pay
dividends out of operating cash flows.

TAXES ON INCOME

Cash flows arising from taxes on income should be separately disclosed and should be classified as
cash flow from operating activities unless they can be specifically identified with financing and
investing activities

Taxes on income arises on transactions that give rise to cash flow that are classified as operating
,investing or financing activities in a cash flow statement. While tax expense may be readily
identifiable with investing or financing activities the relating tax cash flow are often impracticable to
identify and may arise in a different period from the cash flows of the underlying transaction.
Therefore, taxes paid are usually classified as cash flow from operating activities. However, when it
is practicable to identify the tax cash flows with an individual transaction that gives rise to cash
flows that are classified as investing or financing activities the tax cash flow is then classified as an
investing or financing activity as appropriate. When tax cash flows are allocated over more than one
class of activity, the total amount of taxes paid is disclosed.

NON-CASH TRANSACTIONS

Investing and financing transactions that do not require the use of cash or cash equivalents should be
excluded. From a cash flow statement, such transactions should be disclosed elsewhere in the
financial statements in a way that provides all the relevant information about these investing and
financing activities.

Many investing and financing activities do not have a direct impact on current cash flows although
they do affect the capital and asset structure of a company. The exclusion of non-cash transactions
from the cash flow statement is consistent with the objective of a cash flow statement as these items
do not involve cash flows in the current period. Examples of non-cash transactions are :
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i. The acquisition of asset or assets either by assuming directly related liabilities or by means of a
finance lease:
ii. The acquisition of a company by means of an equity issue; and
iii. The conversion of debt to equity.

COMPONENTS OF CASH AND CASH EQUIVALENTS

An enterprise should disclose the components of cash and cash equivalents and should present a
reconciliation of the amounts in its cash flow statement with the equivalent items reported in the
balance sheet.

OTHER DISCLOSURES

A company should disclose, together with a commentary by management, the amount of significant
cash and cash equivalent balances held by the company.

Additional information may be relevant to users in understanding the financial position and
liquidation of a company. Disclosure of this information, together with a commentary by
management, is encouraged and may include:

a. The amount of undrawn borrowing facilities that may be available for future operating
activities and to settle capital commitments, indicating any restrictions on the use of these
facilities.
b. The aggregate amounts of cash flows that represent increase in operating capacity separately
from those cash flows that are require maintaining operating capacity.

The separate disclosure of cash flows that represent increases in operating capacity and cash flows
are required to maintain operating capacity is useful in enabling the user to determine whether the
company is investing adequately in the maintenance of its operating capacity. A company that does
not invest adequately in the maintenance of its operating capacity may be prejudicing future
profitability for the use of current liquidity and distribution to owners.

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FORMAT OF CASH FLOW STATEMENT FOR NON-FINANCIAL INSTITUTION

ENTERPRISE

Direct method:
Sh sh
Cash flows from operating activities
Cash receipts from customers XX
Cash paid to suppliers (of goods and services) XX
Cash paid to and on behalf of employees XX
Cash generated from operations XX
Interest paid XX
Income tax paid XX
Cash flow before extraordinary item XX
Extraordinary item XX
Net cash from operating XX
Cash flow from investing activities
Purchase of property, plant and equipment XX
Proceeds from sale of equipment XX
Interest received XX
Dividends received XX
Net cash from or used in investing activities XX
Cash flow from financing activities
Proceeds from issuance of share capital XX
Proceeds from long term borrowing XX
Payment of finance lease liability XX
Dividends paid XX
Net cash from or used in financing activities XX
Net increase in cash and cash equivalent XX
Cash and cash equivalents at beginning of period XX
Cash and cash equivalent at end of period XX

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Indirect method:
sh Sh
Cash flows from operating activities
Net profit before taxation and extraordinary item XX
Adjustments for:
Depreciation XX
Amortization XX
Foreign exchange loss/gain XX
Investment income/loss XX
Interest expense XX
Operating profit before working capital XX
Increase/decrease in debtors XX
Increase/decrease inventories XX
Increase/decrease in trade creditors XX
Cash generated from operations XX
Interest paid XX
Income tax paid XX
Cash flow before extraordinary item XX
Extraordinary item (specify) XX
Net cash from operating activities XX
Cash flows from investing activities
Purchase of property, plant and equipment XX
Proceeds from sale of equipment XX
Interest received XX
Dividends received XX
Net cash from or used in investing activities XX
Cash flow from financing activities
Proceeds from issuance of share capital XX
Proceeds from long-term borrowing XX
Payment of finance lease liability XX
Dividends paid XX
Net cash from or used in financing activities XX
Net increase in cash and cash equivalents at the beginning of period XX
cash and cash equivalents at the beginning of period XX
Cash and cash equivalent at end of period XX

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FORMAT OF CASH FLOW STATEMENT FOR A FINANCIAL INSTITUTION

ENTERPRISE
sh Sh
Cash flows from operating activities
interest and commission receipts XX
interest payments XX
Recoveries on loans previously written off XX
Cash payments of employees and supplies XX
Operating profit before charges in operating assets XX
Increase or decrease in operating assets;
Short term funds XX
Extraordinary item XX
Deposits held for regulatory or monetary control purposes XX
Funds advanced to customers
Net increase in credit and receivables XX
Other short term negotiable securities XX
Increase or decrease in operating liabilities;
Deposit from customers XX
Negotiable certificates of deposit XX
Net cash from operating activities income tax XX
Income tax paid XX
Net cash from operating activities XX
Cash flow from investing activities
Disposal from subsidiary Y XX
Dividends received XX
Interest received XX
Proceeds from sale of non-dealing securities XX
Purchase of non-dealing securities XX
Purchase of property, plant and equipment XX
Net cash from investing activities XX
Cash flow from financing activities
Issue of loan capital XX
Issue of preference shares by subsidiary undertaking XX
Repayment of long-term borrowing XX
Net decrease in other borrowing XX
Net cash from financing activities XX
Effects of exchange rate changes on cash and cash equivalents XX
Net increase in cash and cash activities XX
Cash and cash equivalents at begging of period XX
Cash and cash equivalent at end of period XX

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Example:

The chief accountant of Gucci Ltd availed the following financial statement for the financial years
ended 30th April 2011 and 2010

Income statement for the year ended 30th April 2011

Sh. Sh.
Sales 4,395,000
Opening stock 190,000
purchases 2,980,000
3,170,000
Closing stock (240,000)
Cost of sales 2,930,000
Gross profit 1,465,000
Profit on sale of equipment 30,000
1,495,000
Expenses:
Wages and salaries 960,000
Depreciation 190,000
interest 25,000
(1,175,000)
Profit before tax 320,000
Tax (120,000)
Profit after tax 200,000
Dividends
Interim paid 20,000
Dividend proposed 50,000
(70,000)
Transfer to general reserve (120,000)
Retained profit for the year 80,000

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Statement of financial position as at 30th April 2010

2011 2010
Sh.”000” Sh.”000”
Non-current assets
Land 600,000 450,000
Motor vehicle 400,000 370,000
Equipment 200,000 300,000
Furniture 160,000 200,000
1,360,000 1,320,000
Current assets
Inventory 240,000 190,000
Trade receivables 210,000 230,000
Bank balance and cash in hand 90,000 60,000
540,000 480,000
Total assets 1,900,000 1,800,000

Equity and liabilities

Capital reserves:
ordinary share capital 600,000 500,000
share premium 150,000 100,000
general reserve 150,000 80,000
retained profits 320,000 240,000
1,220,000 920,000
Non-current liabilities
Debentures 200,000 300,000
Current liabilities
Trade payables 210,000 250,000
Taxation 90,000 70,000
Accrued wages and salaries 145,000 210,000
Accrued debenture interest 5,000 10,000
Proposed dividend 30,000 40,000
480,000 580,000
Total equity and liability 1,900,000 1,800,000

Additional information:
1. The purchase of land was financed by the issue of new ordinary shares at premium
2. An old piece of equipment was sold during the financial year ended 30th April 2011 at a profit sh.
30,000,000.
Depreciation was provided as follows in the year:
Sh”000”
Motor vehicle 100,000
Equipment 50,000
Furniture 40,000

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Required:
Statement of Cash flow in accordance with IAS 7 for the year ended 30th April 2011. Using direct
method.

Suggested solution:
Gucci statement of cash flows (workings)

Sh. ‘000’
1. Receipts from customers
Accounts receivable balance b/f 230,000
Sales for 2013 4,395,000 4,395,000
Accounts receivables balance c/f (210,000)
Cash collected from customers 4,415,000

2. cash paid to suppliers

Accounts payable b/f 250,000
Purchases 2,980,000
Accounts payable c/f (210,000)
Cash paid to customers 3,020,000

3. cash paid for wages and salaries

Wages and salaries accrued b/f 210,000
Expense for the year 960,000
Wages and salaries c/f (145,000)
Cash paid for wages and salaries 1,025,000

4. Cash paid on interest

Interest accrued b/f 10,000
Expense for the year 25,000
Interest accrued c/f (5,000)
Cash paid on interest 30,000

5. cash paid on tax

Tax payable bal b/f 70,000
Charge for the year 120,000
Tax payable c/f (90,000)
Cash paid on tax 100,000

6. cash paid for land purchases

Increase in share capital and premium
(600,000+150,000)-(500,000-100,000) 150,000

7.cash received from equipment sale

Balance b/f on equipment 300,000
Less depreciation (50,000)
250,000
Balance c/f on equipment 200,000
Disposal (carrying amount) 50,000
Add: profit on disposal 30,000
Cash received from disposal 80,000

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8.cash paid on purchase of motor vehicle

Bal b/f carrying amount of motor vehicle 370,000
Depreciation for the year (100,000)
Carrying amount suntotal 270,000
Bal c/f carrying amount of motor vehicle 400,000
Cash paid for addition on motor vehicle 130,000

9. cash from issue of shares 150,000

10. cash paid for dividends

Proposed b/f 40,000
Current year’s paid and proposed 50,000
Proposed c/f (30,000)
Cash paid for dividends 60,000

11. redemption of debentures(300,000-200,000) 100,000

Statement of cash flow for the year ended 30th April 2011
Sh sh
Cash flows from operating activities
Cash receipts from customers 4,415,000
Cash paid to suppliers (3,020,000)
Cash paid for wages and salaries (1,025,000)
Interest paid (30,000)
Tax paid (100,000)
Net cash from operating 240,000
Cash flow from investing activities
Purchase of land (150,000)
Proceeds from sale of equipment 80,000
Purchase of motor vehicle (130,000)
Net cash from or used in investing activities (200,000)
Cash flow from financing activities
issuance of shares at premium 150,000
Redemption of debentures (100,000)
Dividends paid (60,000)
Net cash from or used in financing activities (10,000)
Net cash generated during the year 30,000
Cash and cash equivalents at beginning of period 60,000
Cash and cash equivalent at end of period 90,000

Question:
a) In recent years, many financial analysts have commented on a growing disillusionment with
the usefulness and reliability of the information contained in some companies’ income
statements.
Required:
Discuss the extent to which a company’s statement of cashflows may be more useful and reliable
than its income statement. (6marks)
b) The following information has been extracted from the financial statements of Texco limited:

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Income statement for the year ended 30 September 2010

2010
Sh.”000”
Revenue 15,000
Cost of sales (9,000)
Gross profit 6,000
Other operating expenses (2,300)
3,700
Finance cost (124)
Profit before tax 3,576
Income tax expense (1,040)
Profit after tax 2,536
dividends (1,100)
1,436

Statement of financial position as at 30 September

2010 2009
Assets: Sh.”000” Sh.”000”
Non-current assets 18,160 14,500
Current assets:
Inventories 1,600 1,100
Trade receivables 1,500 800
Bank balance 150 3,250 1,200 3,100
Total assets 21,410
17,600

Equity and liabilities:

Capital and reserve:
Issued capital 10,834 7,815
Accumulated profits 5,836 4,400
16,670 12,215
Non-Current liabilities:
Interest bearing borrowings 1,700 2,900
Deferred tax 600 2,300 400 3,300

Current liabilities:
Trade payables 700 800
Proposed dividend 700 600
Tax 1,040 2,440 685
2,085
21,410
17,600

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Additional information:
1. Non-current assets:
Property Plant Total
Sh”000” Sh”000” Sh”000”
At 30 September2009
Cost 8,400 10,800 19,200
Depreciation 1,300 3,400 4,700
Net book value 7,100 7,400 14,500

At 30 September 2010
Cost 11,200 13,400 24,600
Depreciation 1,540 4,900 6,440
Net book value 9,660 8,500 18,160

2. Plant disposed of during the year ended 30 September 2010 had an original cost of
sh.2,600,000 and accumulated depreciation of sh.900,000. The cash received on disposal was
sh.730,000.
3. All additions to non-current assets during the year ended 30 September 2010 were purchased
for cash.
4. Dividends were declared before the balance sheet dates.

Required:
Statement of cash flows (in conformity with IAS 7, Statement of cash flows) and associated notes,
for the year ended 30 September 2010. (14
marks)

Suggested solution:
a) Preference of cash flow statement over income statement.
Cash flow statement explicitly indicates how a firm sources for funds and also how it is used.
Income statement on the other hand does not clearly indicate sources and application of
funds.

As opposed to income statement, statement of cash flow may guard against creative
accounting with income statement, especially using basis of accounting, companies may
overstate revenues e.g. By including gains on disposal as part of revenue when in fact this
forms part of other comprehensive income.

Some corporations fail due to poor working capital management. There is no deliberate effort
in income statement to indicate in working capital items. This is well covered in statement of
cash flows especially using the indirect method in presenting statement of cashflows.

Ordinarily, items not involving movement of cash e.g. depreciation; amortization and effect
of deferred tax would loosely part of sunk cost. Income statement takes into account
cognizance of such items before matching principle However, such items especially
depreciation and amortization may not have any bearing on future planning.

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b)

i. Gain/loss from disposal of NCA plant

Cash received 730
NBV (2600-900) 1 700
Loss on disposal 970

ii. Depreciation for the year.

Accumulated depreciation a/c

Disposal 900 Balance b/d 4 700
Balance c/d 6 440 Charge for period 2 640
7 340 7 340

iii. Additions to NCA

NCA (cost)
Balance b/d 19 200 Disposal 2 600
Addition 8 000 Balance c/d 2 4600
27 200 27 200

iv. tax paid for the year

Tax payable a/c

C/B (paid) 485 Balance b/d 685
Balance c/d 1 040 Expense I/c 840
1 525 1 525

*Expense I/c 1 040 Less: effect of deferred tax liability

(200) =840

v. dividends paid

Dividends payable a/c

Cash 1 000 Balance b/d 600
Balance c/d 700 Proposed 1 100
1 700 1 700

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Statement of cashflows

Cash flow from operating activities:

Sh”000” Sh”000” Sh”000”
Profit before tax 3 576
Adjustments:
Add:
Depreciation 2 640
Loss on disposal 970
Interest expense 124 3 734

Changes in working capital items:

Increase in debtors (700)
Increase in inventory (500)
Decrease in payables (100) (1 300)

Tax paid (485)

Interest paid (124) (609)
Net cash from Operating activities 5 401

Cash flow from investing activities:

Purchase of NCA (8 000)
Disposal of plant 730
Net cash flow from investing (7 270)
Cash flow from Financing activities:
Redemption of long term debt (1 200)
Issue of shares 3 019
Dividends paid (1 000)
Net cash flow from financing 819
(1 050)
Cash and cash equivalent at the start of the year 1 200
Cash and cash equivalent at the end of the year 150

IMPORTANCE OF CASH FLOW STATEMENT

Cash Flow Statement is of vital importance to the financial management & short term financial
planning. Its various uses are as follows:

1. Cash Flow Statement is prepared on cash basis hence it is useful in evaluating the cash
position of an enterprise.
2. A projected cash flow statement can be prepared so that it can enable the firm to plan & co –
ordinate its financial operations efficiently.
3. A comparison of historical & projected cash flow statements will reveal variations in the
performance so that the firm can take immediate effective action.
4. It indicates whether a firm's short term paying capacity is improving or deteriorating over a
period of time by preparing cash flow statements for a number of years.

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5. It helps in planning the repayment of loans, replacement of fixed assets etc. It is also
significant for making capital budgeting decisions.
6. It clearly indicates the causes for poor cash position in spite of substantial profits in a firm by
throwing light on various applications of cash made by the firm.
7. Cash Flow Statement provides information of all activities classified under operating,
investing & financing activities.

Limitations of Cash Flow Statement

Despite of a number of uses, cash flow statement also suffers from the following limitations:

i. As cash flow statement is based on cash basis of accounting, it ignores the basic accounting
concept of accrual basis.
ii. Cash Flow statement is not suitable for judging the profitability of a firm as non – cash charges
are ignored while calculating cash flows from operating activities.
iii. Funds flow statement presents a more complete picture than Cash flow statement.
iv. It is difficult to define the term "cash". There are no controversies over a number of items like
cheques, stamps, postal orders etc whether they are to be included in cash.

Note:

i. An increase in liability is a source of cash or cash inflow e.g. increase in creditors implies
purchase of goods on credit. Although no cash is received we can say that creditors have given
us loans which we have utilized to purchase goods from them.
ii. A decrease in liability is an application of cash or cash outflow e.g. sundry creditors are paid
off.
iii. An increase in asset is an outflow of cash e.g. goods sold on credit.
iv. A decrease in asset is an inflow or source of cash e.g. sale of stock, cash received from debtors.

Actual flow of cash

It is the movement of cash that results in actual inflow or outflow of from the firm e.g. When
shares are issued for cash or when loan is repaid or when assets are sold for cash.

Notional flow of cash

It refers to delayed receipts & payments. Increase in current liabilities like trade creditors, bills
payable, etc results in notional inflow of cash as here cash inflow is implied.

Usually increase in long term liabilities generate actual cash & increase in current liabilities generate
notional cash.

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RATIO ANALYSIS

Financial ratios are relationships determines from a firms financial information and used for
comparison purposes. There are basically 5 components of performance and measurements.

Ratios can be classified into:

a) Liquidity ratios.
b) Leverage or gearing ratios.
c) Activity ratios.
d) Profitability ratios.

USERS OF RATIOS
There are a vast number of parties interested in analyzing financial statements including
shareholders, lenders, customers, employees, government, and competitors. In many occasions, they
will be interested in different things therefore there is no any definite, all-encompassing list of points
for analysis that would be useful to all these stakeholders. However, it is possible to construct a
series of ratios that together will provide all of them with something that they find relevant and from
which they can investigate further if necessary.

Ratio category Examples of interested parties

Profitability Shareholders, management, employees,
creditors, potential investors
Liquidity Shareholders, suppliers, creditors, competitors
Efficiency Shareholders, potential purchasers, competitors
Shareholder Shareholders, potential investors
Capital structure Shareholders, lenders, creditors, potential
investors
UDYTEXT
1. Liquidity ratios

These measure firm’s ability to meet its short-term maturing obligations as and when they fall due.
The lower the ratio, the higher the liquidity risk and vice versa. Failure to meet short term liabilities
due to lack of liquidity may lead to poor credit worthiness, litigation by creditors and insolvency.

2. Leverage or gearing ratios

These measure extent to which a company uses its assets which have been financed by non owner
supplied funds. They measure financial risk of the company. The higher the ratio, the higher the
financial risk. Gearing refers to the amount of debt finance a company uses relative to its equity
finance.

3. Activity ratios
These measure the efficiency with which a firm uses its assets to generate sales. They are also called
turnover ratios as they indicate the rate at which assets are converted into sales.

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4. Profitability ratios
They measure the management’s effectiveness as shown by returns generated on sales and
investment. They indicate how successful management has been in generating profits of the
company.

5. Investment or equity ratios

These are used to evaluate the overall performance of a company. E.g. in determining company’s
dividend policy, determining theoretical value of company’s securities and predicting effects of
rights issue.

1. LIQUIDITY RATIOS

Current ratio

This is computed by dividing total current assets by total current liabilities:

Current ratio of more than one means that a company has more current assets than current liabilities.

Acid test or quick ratio

This is calculated by dividing total current liabilities excluding stock by current liabilities. A firm
with a satisfactory current ratio may actually be in a poor liquidity position when inventories form
most of the total current assets.

−
=
ATEMENT ANALYSISL ACCOUNTING
STUDYTEXT
2. GEARING OR LEVERAGE RATIOS
3.
Debt ratio or capital gearing ratio
This measures the proportion of debt finance to capital employed by a company. A company is
highly geared if the ratio is greater than 50%.

= 100
Debt equity ratio
This measures the proportion of non owner supplied funds to owner’s contribution to the company.
A company is highly geared if the debt equity ratio is greater than 100%.

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=
ℎ

Times interest cover

This shows number of times earnings by a company cover its current payments. The higher the ratio,
the lower the gearing position and thus the lower the financial risk.

Earnings before interest and tax + Depreciation

Times interest cover =
ℎ

3. PROFITABILITY RATIOS

Return on capital employed (ROCE)

This measures the efficiency with which a company uses long term funds or permanent assets to
generate returns to shareholders.

Pro it before interest and tax or operating pro it

ROCE =

Capital employed consists of shareholders funds (ordinary share capital, preference share capital,
share premium and retained earnings) and long term debts. Capital employed can also be calculated
as fixed assets plus net working capital.
221
STUDYTEXT
Gross profit margin
This ratio shows how well cost of production has been controlled in relation to distribution and
administration costs.
= 100

Net profit margin

This measures firm’s ability to control its production, operating and financing costs

= 100

Net assets turnover

This gives a guide to productive efficiency i.e. how well assets have been used in generating sales.
=
Operating profit/margin ratio
This indicates efficiency with which costs have been controlled in generating profit from sales.

= 100

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Operating expenses ratio

This indicates a firm’s ability to control production and operating costs to generate a given level of
sales.
= 100

Return on investment
These measures the efficiency with which a company uses its total funds in capital employed to
generate returns to owner’s funds.
Net pro it after tax
Return on investment = 100
Capital employed

Return on equity. (ROE)

This measures the efficiency with which a company other supplier’s funds to generate returns to
shareholders.
Earnings attributable to equity shareholders
Return on equity = 100
Equity

Equity comprises of ordinary share capital, share premium and reserves.CIAL ACCOUNTING
STUDYTEXT
4. ACTIVITY RATIOS
Fast forward - These measure the efficiency with which a firm uses its assets to generate sales
Debtor’s turnover
This shows the number of times debtors pay within the year. It indicates how efficient the firm is in
management of credit. The higher the ratio, the more efficient management is in managing its credit
policy.
’ =
Debtor’s days or ratio
This is also called the average collection period. It shows the average period of credit taken by
customers who buy on credit. It is compared the company’s allowed credit period by suppliers to
give an indication of credit administration efficiency.
’ =

=
’
Creditor’s turnover
This indicates the number of times creditors are paid by a company during a year.
ℎ
’ =

Creditor’s days or ratio

This is also called the average deferral period. It indicates the average time that suppliers allow a
company to settle its dues.

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 FINANCIAL ACCOUNTING

’ =
ℎ

=
’
Stock or inventory turnover
This indicates the efficiency of a firm in selling its products so as to generate sales. It shows the
times stock is turned over or converted into sales within a year. It shows how rapidly stock is being
turned into cash through sales.
Cost of sales
Stock or inventory turnover =
ST
UDYTEXT
Stock days/inventory conversion period
This indicates the number of days it takes to convert inventory into sales. The fewer the number of
days, the more efficient a company is in converting stock into sales.

S = .

Cash working cycle/Working capital cycle/Operating cycle

This is the period for which working capital financing is needed. The higher the working capital
cycle, the higher the investment in working capital. It is the period of time that elapses between the
point at which cash is spent on production or purchase of raw materials/stock to time stock is
converted into cash or cash is collected from a customer.

Average collection period xxx

Add inventory conversion period xxx
Less average deferral period (xxx)
Working capital cycle xxx

Calculation of Operating Cycle

The length of the operating cycle of a manufacturing firm is the sum of:
a. Inventory conversion period
b. Receivables/debtors’ conversion period
The inventory conversion period is the total time needed to produce and sell the product. It includes:
a. Raw material conversion period.
b. Work-in-Process conversion period.
c. Finished goods conversion period.
The debtors’ conversion period is the time required to collect the outstanding amount from
customers.

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A firm may acquire resources on credit and defer payments. Payables may thus arise. The payables
deferral period is the length of time the firm is able to defer payments on purchase of resources. The
difference between the payables deferral period and the sum of the inventory conversion period and
receivable conversion period is referred to as the operating/cash conversion cycle.

1. Inventory conversion period.

It is the sum of raw material conversion period, working in progress conversion period and finished
goods conversion period.
Raw material conversion period. - It is the average time period taken to convert raw material
into work in Process.

Raw material conversion period = Raw material inventory / (Raw material consumption/ 360)

Working in process conversion period. - It is the average time taken to complete the semi-
finished or work in process.

= /( /360)

Finished goods conversion period.- It is the time taken to sale the finished goods .

Finished goods conversion period = Finished goods inventory/ (cost of sales/ 360)

Debtors conversion period.

It is the time taken to convert the debtors to cash. It represents the average collection period.

= /( /360)

Payables deferral period.

It is the average time taken by the firm to pay its suppliers / creditors.

= /( ℎ / 360)

Summary

Inventory conversion period + Debtors conversion period – Creditors deferral period =Net
operating cycle
Example
The following information relates to Mutongoi Limited.
Sh.000
Purchase of raw material 6,700
Usage of raw material 6,500
Sale of finished goods (all on credit) 25,000
Cost of sales(Finished goods) 18,000
Average creditors 1,400
Average raw materials stock 1,200
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Average work in progress 1,000

Average finished goods stock 2,100
Average debtors 4,700

Assume a 365 days year.

Required:
The length of the operating cash cycle.

Solution.
Raw material conversion period = Raw material inventory / (Raw material consumption/ 360)

= (1,200/6,500) × 365
= 67days
Work in process conversion period = Working process inventory / (Cost of production /360)

= (1000/18000) × 365
=20 days

ℎ = ℎ /( / 360)

= (2100/18000) × 365

=43 days

= /( /360)

= (4700/25000) × 365

=69 days

= /( ℎ / 360)

= (1400/6700) × 365

= 76 days
Length of operating cycle.
Inventory conversion period.
Raw material conversion period 67
Work in process conversion
period 20
Finished goods conversion
period 43 130
Debtors conversion period 69
Gross working capital cycle 199

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Less: Creditor deferral period (76)

Net Cash Operating cycle 123

Cash turnover/Operating turnover

This shows number of times a company needs to replenish its working capital in a year.
Number of days in a year
ℎ =

Fixed assets turnover

This indicates level of sales generated by fixed asset base of a company. It shows the efficiency with
which a company utilizes its assets to generate sales.

Sales
Fixed assets turnover =
224 FINANCIACCOUNTING
STUDYTEXT
5. INVESTMENT OR EQUITY RATIOS
Fast forward - These are used to evaluate the overall performance of a company
Earnings Per Share (EPS)
This indicates the amount shareholders expect to generate in form of earnings for every share
invested. It shows profitability of a company on a per share basis.

Earnings attributable to equity shareholders

=
ℎ

Dividend per Share (DPS)

This represents the amount of cash dividend that shareholders expect to receive for every share
invested in the company.

Total ordinary dividends

Dividend Per Share =
ℎ
Dividend pay out ratio
This indicates proportion of earnings attributable to equity shareholders that are paid out to common
shareholders as dividends. It is used in analysis of dividend policy of the firm.

Total common dividends

= 100
ℎ ℎ

Dividend per share

= 100
ℎ

Dividend retention ratio

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 FINANCIAL ACCOUNTING

= 100
ℎ ℎ

Dividend cover
Earnings per share (EPS)
=
ℎ ( )

Earnings yield
This measures the potential return that shareholders expect to earn for every share invested in a
company. It evaluates the shareholders returns in relation to the market value of a share.
Earnings per share (EPS)
= 100
ℎ ( )
ST DYTEXT
Dividend yield
This ratio measures how much an investor expects to receive from cash dividends for every share
purchased or invested in a company.
Dividend per share (DPS)
= 100
ℎ ( )

Price earnings ratio

This indicates how much an investor is prepared to pay for a company’s share given its current
earnings per share. The higher the price earnings ratio, the more confident investors are that the
company will perform well in future.
ℎ ( )
=
ℎ ( )

1. Short term solvency or liquidity measure

Here the primary concern is the firm’s ability to pay its bills over the short term without undue
stress. Consequently this ratios focus on current assets and liabilities.

Illustration for business performance analysis

The following two financial statements will be used in calculation of ration to determine business
performance. The figures are in millions.

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BRIDGEVIEW COMPANY LTD

STATEMENT OF FINANCIAL POSITION AS AT 31st DECEMBER
2010 2011
Non-current Assets
Net plan and equipment 2731 2880
Current assets
Cash 84 98
Accounts receivables 165 188
Inventory 393 422
Total 642 708
Total assets 3373 3588
Liabilities and owners equity
Current liabilities
Accounts payable 312 344
Notes payable 231 196
Total 543 540
Long term debt 531 457
Owners equity
Common stock and paid-in surplus 500 550
Retained earnings 1799 2041
Total 2299 2591
Total liabilities and equity 3373 3588

Income statement for 2011

Sales 2311
Cost of goods sold 1344
Depreciation 276
Earnings before interest and Tax 691
Interest paid 141
Taxable income 550
Taxes (34%) 187
Net income 363
Dividends 121
Retained earnings 242

Assume also that 33 million shares were outstanding at the end of 2010 and 2011. Market price per
share is ksh 88.

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Required: calculate the key ratios the financial statements above and state the importance of the
ratios calculated.

Solution:
a) Current ratio.
=
708
= 1.31
540

The higher the current ratio, the better the company is in covering current liabilities. But at the same
time it may mean an inefficient use of assets such as having excess inventory.

b) Quick (acid test ratio)

Base inventory is the least record of current assets, the acid test ratio doesn’t take consideration of
inventory and therefore this ratio is written as
−

708 − 422
= 0.53
540
In this case the company has fewer current assets covering current liabilities.
c) Cash ratio
A very short term creditor may be interested in the cash inventory.
ℎ

98
= 0.18
540

d) Net working capital to total assets

708 − 540
× 100 = 4.7%
3588
Since net working capital is frequently viewed as a ratio of short term liquidity of a firm, it is
measured relative to total assets. A relatively low value may indicate relatively low liquidity levels.

e) Interval measure
This assumes operations were disrupted but the company is still compelled to pay some short-term
obligations. It tries to find out how much will current assets cover daily operating costs.
=

Average daily operating cost from our illustration assumed to be

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1344
= = 3.68
365 365
Therefore IM
708
= = 192
3.68

2. Long term solvency measures

This group of ratios is intended to measure the firm’s long run ability to meet its obligations or more
generally it’s financial. These are sometimes called financial leverage ratios or leverage ratios.

i. Total debt ratio

It takes into account all debts of all maturities to all creditors.
−
=
3588 − 2591
= 0.28
3588
ii. Debt-equity ratio
=
540 + 457
= 0.38
2591

iii. Equity multiplier

=
3588
= = 1.38
2591
iv. Long term debt ratio
This ratio takes into account only long term debt and not short term obligation. The formula is

=
+

457
= = 0.15
457 + 2591

The long term debt + equity is sometimes called firms capitalization.

v. Times interest earned
This ratio measures how well a company has its interest obligation covered.
=
691
= = 4.9
141

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vi. Cash coverage

The difference between cash coverage and times interest earned is that depreciation not being an
item involving movement of cash is added back to EBIT.

+
ℎ =
691 + 276
= = 6.9
141

3. Asset management/turnover ratio

Sometimes called asset neutralization ratios, the ratios in this category are intended to describe
how efficiently or intensely a firm uses its assets to generate sales.
a) Inventory turnover and Day sales in inventory
=
1344
= = 3.2
422
Inventory was turned 3.2 times. It may also be imperative to use average inventory figures if they
are available.
b) Day sales inventory
365
=
365
= = 114
32
It tells that on average inventory sits in store for 114 days before it is sold.
c) Receivables turn over
This measures how fast receivables are collected.

2311
= 12.3
188

This means that outstanding credit were collected and reloaded 12.3 times during the years.

d) Day sales and receivables/ average collection period

365
=
365
= = 29.67
12.3
On average credit sales were collected in 30 days.

e) Networking capital ratio or sales

Ratios measures how much would we get out of our working capital.

2311
= 13.8
(708 − 540)
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f) Fixed asset turnover

2311
= 0.80
2880
g) Total asset turnover

2311
= 0.64
3588
For every shilling invested in assets we generate sh.0.64 sales

4. Profitability measures
These measures are intended to measure how efficiently the firm uses its assets and how efficiently
the firm manages its operations. The focus in the group is on the bottom line i.e. income
a. Profit margin

363
= 15.7%
2311
b. Return on assets

363
= 10.12%
3588
c. Return on equity

363
= 14%
2591

5. Market value measures

These ratios are crucial when comparing the earning power of an organization and its distribution (of
dividend) policy with other organizations.
i. Price Earnings ratio
⁄ =
363
= = = 11
ℎ 33
88
⁄ =
11
=8
We can interprete this to mean that Bridgeview’s shares sell for 8 times to earning.
ii. Market-Book ratio
=

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88
= = 1.2
2591
33
Book value in this case is total equity, not just common stock divided by no. of shares outstanding.
The better if the ratio is more than one meaning share is doing well in the market.

iii. Dividend payout ratio

This measures amount of cash paid out to shareholders
ℎ
=
121
= = 0.33
363

iv. Retention/plough back ratio

=1−
Because everything paid is retained.

v. Capital intensity ratio

=
It’s the reciprocal of assets turnover ratio .

Limitations of financial ratios

1. Different companies use different accounting policies making comparisons is unrealistic.

2. Ratios do not take of inflation tendencies
3. Different companies use different calendar financial years therefore making comparison
difficult.
4. Unusual or transient events such as one time profit from sale of an asset may affect
performance and give misleading results.
5. Inaccuracies from financial statements would affect the ratios.

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TOPIC 12
INTRODUCTION TO PUBLIC SECTOR ACCOUNTING

DIDEFINITION OF TERMS

State Corporation is an entity incorporated under the Companies Act, which is solely or partly
owned by the national government for commercial purposes.

State agency is an entity howsoever incorporated by the government to undertake a specific strategic
government objective in delivering public service and includes any entity classified as;-

a) An executive agency;
b) An independent regulatory agency; or
c) A research institution, public university, tertiary education and training institution; County
Corporation is an entity howsoever incorporated, that is solely or partly owned by the county
government for commercial purposes:

Commercial purpose means a function;

(a) Whose dynamics are governed by a competitive profit making and market driven; or
(b) That can be performed commercially but serves a strategic socio-economic objective.

FEATURES OF PUBLIC SECTOR ENTITIES

AS COMPARED TO PRIVATE SECTOR)

There is an important difference between private sector accounting and governmental accounting.
The main reasons for this difference are the environment of the accounting system. In the
government environment, public sector entities have differing goals, as opposed to the private sector
entities' one main goal of gaining profit. Also, in government accounting, the entity has the
responsibility of fiscal accountability which is demonstration of compliance in the use of resources
in a budgetary context. In the private sector, the budget is a tool in financial planning and it isn't
mandatory to comply with it.

Government accounting refers to the field of accounting that specifically finds application in the
public sector ur government. It is a special field of accounting because; -

(a) The objectives to which accounting reports to differ significantly from that for which
generally accepted accounting practice has been developed for in the private (business)
sector; &

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(b) The usage of the results of accounting processes of government differs significantly from
the use thereof in the private sector.

An exception exists on the above-mentioned differences in the case of public utility businesses (for
example Electricity Services) that may be intended to produce a net income or profit, but a
significant debate exists over whether there should be such an exception. Nationalization includes,
amongst others, the argument that entities should be either private or public, and that the objectives
of public entities should differ significantly from that of private entities. In other words, is the
generation and reticulation of electricity with the objective to generate a profit in the pablic interest
or not? And if ii is the best way, shouldn't it then be completely private instead of having access to
putnie funds and monopolies? '

The unique objectives of government accounting do not preclude the use of the double entry
accounting system. There can, however, be other significant differences with private sector
accounting practices, especially those that are intended to arrive at a net income result. The
objectives for which government entities apply accountancy can be organized in two main
categories:

a. The accounting of activities for accountability purposes.

In other words, the representatives of the public, and officials appointed by them, must he
accountable to the public for powers and tasks delegated. The public, who have no other choice but
to delegate. arc in a position that differs significantly front that of shareholders and therefore need
financial information, to be supplied by accounting systems, that is applicable and relevant to them
and their purposes.

b. Decision;-making purpoSes.

The relevant mole-players, especially officials and representatives, need financial information that is
accounted; organized and presented for the objectives of their decision-making. These objectives
hear, in many instances, no relation to net income results but are rather about service delivery and
efficiency. The taxpayer, a very significant group, simply wants to pay as little as possible taxes for
the essential services for which money is being coerced by law.

Governmental accounting standards are currently being dominated by the accounting standards
(internationally sometimes referred to as IFRS) originally designed for the private sector. The so-
called Generally Recognised Accounting Practices (GRAP) that are being enforced in the punkt,.
Sector of countries such as South Africa, one of the front-runners in this regard is based nil the
Generally Accepted Accounting Practices originally developed for the private sector. The above and
common sense raises the question of whether this is the best solution. It is of course Cheaper and it
iti alleged that the history-Of separate development of accounting practices for government has not
beo successful. Even at the onset of the current fiscal crisis in Europe and other partS of the world it
was argued authoritatively that the sometimes inapplicable accounting practices of the private sector
being used, have contributed to the origination of, and belated reaction to, the fiscal crisis

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Examples of Entities in Public Sector

The following example of some of the entities in the public sector according to the Public Pittance
Management Act:-

a) the Government or any department of the Government;

b) the courts;
c) the commissions established under the Constitution;
d) a local authority uncle-r the Local Government Act
e) a state corporation within the meaning of the State Corporations Act
f) the Central Bank of Kenya established under the Central Bank of Kenya Act
g) a co-operative society established under the Co-operative Societies Act
h) a public school within the meaning of the Education Act-
i) a public university within the meaning of the Universities Act
j) a college or other educational institution maintained or assisted out of public funds',

STRUCTURE OF THE PUBLIC SECTOR

Most government organizations are classic examples of vertical structure. Vertical organizational
structures are characterized by few people at the top and increasing numbers of people in middle
management and lower level positions. In other words, a few people make policy and decisions, and
many people carry them out. Governments often lean toward them because. they create much
defined job scopes and powers--each person has a clear role to play. Vertical structure is the classic
bureaucracy and is epitomized and originated in one of the oldest government functions: military
command.

REGULATORY STRUCTURES AND OVERSIGHT IPSASB

The international Public Sector Accounting Standards Board (IPSASB)- formerly the Public Sector
Committee - of the International Federation of Accountants focuses on the accounting, auditing, and
financial reporting needs of national, regional, and local governments, related governmental
agencies, and the eonstituencies they serve. It addresses these needs by issuing and promoting
benchmark guidance, conducting educational and research programs, and facilitating the exchange
of information among accountants and those that work in the public sector or rely on its work.

The IPSASB's current activities are focused on the development of International Public Sector
Accounting Standards (IPSAS) for financial reporting by governments and other public sector
entities fthe Standards Project).

The IPSASB's Standards Project was established in late 1996. The objectives of the initial stage of
the project were to develop by the end of November 2001:

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 FINANCIAL ACCOUNTING

 A background paper identifying current practices and issues in public sector financial
reporting.
 A core set of IPSAS based (to the extent appropriate) on the International Accounting
Standards in place as at August 1997.
 An IPSAS on the cash basis of accounting,
 Guidance on the transition from the cash to the accrual basis of accounting.

The Preface to International Financial Reporting Standards issued by the International Accounting
Standards Board explains that international Financial Reporting Standards (IFRSs) are designed to
apply to the general purpose financial statements of all profit-oriented entities. Government Business
Enterprises (GBEs) as defined by the IPSASB are profit-oriented entities. Accordingly, they are
required to comply with IFRS.

(a) Present to the Senate, subject to the exceptions in the Constitution, the proposal for the basis
of allocating revenue among the Counties and consider any Bill dealing with county Financial
matters
(b) Introduce into the Senate a County Allocation of Revenue Bill and a Division of Revenue Bill
in accordance with Article 218(1)(b) of the Constitution at least two months before the end of
the financial year;
(c) Examine financial statements and other documents submitted to the Senate under Part 1V of
the Public Finance Management Act and make recommendations to the Senate for improving
the management of government's public finances;
(d) Monitor adherence by the Senate to the principles of public finance set out in the
Constitution, and to the fiscal responsibility principles of the Public finance Management Act.

In carrying out its functions in (a) and (b) the Committee shall consider recommendations frdm the
Commission on Revenue Allocation, County Executive Committee member responsible for finance,
the Intergovernmental Budget and Economic Council, the public and any other interested persons or
voups.

The Role of Auditor General

The Kenya Constitution defines the duties of the Office of the Controller and Auditor General in
broad terms, and more detailed responsibilities are provided in the Exchequer and Audit Act.
Specifically, the Controller and Auditor General, who is appointed by the President, are charged
with:

i. Reviewing proposed withdrawals from the Consolidated Fund and, if satisfied that they are
authorized by law, approving the withdrawals;
ii. Examining disbursements of monies appropriated by Parliament to ensure that they have been
applied to the purposes to which they were appropriated and that expenditures conform to the
authorities that govern them; and

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iii. Auditing and reporting on the public accounts of the Government of Kenya, the accounts of
all government officers and authorities, the accounts of all courts and commissions, and the
accounts of the Clerk of the National Assembly.
iv. Consider and approve the estimates for the Kenya National Audit Office; and
v. Determine the remuneration and other terms of appointment of the staff of the Kenya
National Audit O•lice.

The exchequer and Audit Act further require that the Controller and Auditor General audit and
report in all accounts of the local authorities.

The Role of Internal Audit

National government entity to maintain internal auditing arrangements

Every national government entity shall ensure that it complies with the Public Finance Management
Act and-

a) Has appropriate arrangements in place for• internal audit according to the guidelines of the
Accounting Standards Board; and
b) Where any regulations are in force, those regulations are complied with.

Regulations may prescribe requirements to be complied with in conducting internal audits.

A national government entity shall ensure that its arrangements for conducting internal audits
include;-

a) reviewing the governance mechanisms of the entity and mechanisms for transparency and
accountability with regard to the finances and assets of the entity;
b) conducting, risk-based, value-for-money and systems audits aimed at strengthening internal
control mechanisms that could have an impact on achievement of the strategic objectives of
the entity;
c) verifying the existence of assets administered by the entity and ensuring that there are proper
safeguards for their protection;
d) providing assurance that appropriate institutional policies and procedures and good business
practices are followed by the entity; and
e) Evaluating the adequacy and reliability of information available to management for making
decisions with regard to the entity and its operations.

A national government entity shall ensure that internal audits in respect of the entity are conducted
in accordance with international best practices.

Every national government entity shall establish an audit committee whose composition and
Functions shall be as prescribed by the regulations.

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Role of Controller of Budget

The Controller of Budget is nominated by the President and, with the approval of the National
Assembly, appointed by the President. To be qualified to be the Controller of budget, a person shall
have extensive knowledge of public finance or at least ten years' experience in auditing public
finance management.

The Controller should hold office for a term of eight years and shall not be eligible for
reappointment.

The Controller of Budget shall oversee the implementation of the budgets of the national and county
governments by authorizing withdrawals from public funds under Articles 204, 206 and 207of the
Kenyan Constitution.

The Controller shall not approve any withdrawal from a public fund unless satisfied that the
withdrawal is authorized by law. Every four months, the Controller shall submit to each !louse of
Parliament a report on the implementation of the budgets of the national and county governments.

In addition to this, the controller of budget and revenue allocation should ensure:

1. That all reasonable precautions have been taken to safeguard—

a) The collection of revenue; and -
b) The receipt, custody, issue and proper use of property;
2. that the applicable law has been complied with in relation to—
a) the collection of revenue; and
b) the receipt, custody, issue and proper use of property;
3. That all money,. other than money that has been appropriated by Parliament, has been dealt
with in :accordance with the proper authority.

OBJECTIVES OF PUBLIC SECTOR FINANCIAL STATEMENTS

The information needed to aid understanding and assessments of government financial operations
and to promote accountability extends beyond .reporting surpluses and deficits. A government's
financial statements must provide information that describes liabilities and financial assets, its non-
financial assets that are available for use in providing future services, the cost of using its economic
resources in the delivery of services, as well as information about investing and financing activities
and potential assets and liabilities. Further, this information needs to highlight measures (for
example, net debt and net economic resources) that help users assess whether the government's
financial position has improved or deteriorated and explain the changes in financial position. The
information reported in financial statements must also reflect the full nature and extent of the
government's resources, obligations and financial affairs.

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Financial statements should provide an accounting of the full nature and extent of the financial
affairs and resources which the government controls, including those related to the activities of its
agencies and enterprises

Financial statements should present information to describe the government's financial position at
the end of the accounting period. Such information should be useful in evaluating:

(a) The government's ability to finance its activities and to meet its liabilities and contractual
obligations; and
(b) the government's ability to provide future service

Financial statements should present information to describe the changes in a government's financial
position in the accounting period. Such information should be useful in evaluating:

(a) The sources, allocation and consumption of the government's recognized economic resources
in the accounting period;
(a) How the activities of the accounting period have affected the net debt of the government; and
(b) How the government financed its activities in the accounting period and how it met its cash
requirements

Financial statements should demonstrate the accountability of a government for the resources,
obligations and financial affairs for which it is responsible by providing information useful in:

(a) Evaluating the financial results of the government's management of its resources, obligations
and financial affairs in the accounting period; and
(b) Assessing whether resources were administered by the government in accordance with the
limits established by the appropriate legislative authorities

ACCOUNTING OFFICERS

According to Section 17 of the Government Financial Management Act the treasury appoints
persons, to be known as accounting officers, to be responsible for accounting for such services, as
the Treasury may specify. in respect of which money is appropriated by Parliament. In specifying
the services in respect of which an accounting officer is appointed, the Treasury shall ensure that all
the services for a ministry, department or commission are specified for the same accounting officer.

Responsibilities of Accounting Officers

An accounting officer is responsible to the Treasury to ensure that the resources of his ministry,
department or commission are used in a way that is

a) Lawful and authorised; and

(a) h) Effective, efficient, economical and transparent.

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In carrying out his responsibilities, an accounting officer shall do the following in relation to his
ministry, department or commission-

a) Ensure that no expenditure is made unless it is lawful, authorised, effective, efficient and
economical;
b) Ensure proper financial and accounting records are kept;
c) ensure that any financial or accounting records kept in electronic format are adequately
protected which shall include ensuring that such records are adequately backed-up and
adequately protected against computer viruses;
d) Prepare and submit accounts for each financial year under the Public Audit Act, 2003 for
audit by the Controller and Auditor-General;
e) Ensure that adequate arrangements are made for the management of liabilities:
f) Ensure that all contracts are complied with;
g) Ensure that all applicable procedures are followed in the acquisition or disposal of
property and that adequate arrangement are made for the custody, safeguarding and
maintenance of property:
h) Bring any concerns he has that a proposed decision or policy originating from his
ministry,department or commission may result in resources being used in a way that is
Unlawful. unauthorized, ineffective, inefficient, uneconomical or not transparent to the
attention of the Minister responsible for the ministry, department or commission of the
accounting officer and, if his concerns are not adequately addressed, bring them to the
attention of the Treasury: and perform such other duties as may be directed by the
Treasury

AUDITOR GENERAL

The Kenya Constitution defines the duties of the Office of the Controller and Auditor General in
broad terms, and more detailed responsibilities are provided in the Exchequer and Audit Act.
Specifically, the Controller and Auditor General, who is appointed by the President, is charged with:

i. Reviewing proposed withdrawals from the Consolidated Fund and. it' satisfied that they arc
authorized by law, approving the withdrawals;
ii. examining disbursements of monies appropriated by Parliament to ensure that they have
been applied to the purposes to which they were appropriated and that expenditures conform
to the authorities that govern them; and
iii. Auditing and reporting on the public accounts of the Government of Kenya, the accounts of
a) all government officers and authorities, the accounts of all courts and commissions. and the
ac-counts of the Clerk of the National Assembly.
iv. Consider and approve the estimates for the Kenya National Audit Office; and
v. Determine the remuneration and other terms of appointment of the staff of the Kenya
National Audit Office.

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The Exchequer and Audit Act further requires that the Controller and Auditor General audit and
report on all accounts of the local authorities.

ACCOUNTING TECHNIQUES IN THE PUBLIC SECTOR

(BUDGETING, CASE, ACCRUAL, COMMITMENT AND FUND)

Financial Accounting Techniques

Different public sector entities adopt different accounting techniques, some which arc;

Budgetary Accounting

This refers to the preparation of the operating accounts in a format of a budget. Under the budgetary
accounting, the concept is on forecasted cash flows and operations and this must be limited to the
budget estimates. Budgetary accounting aims at:

• ensuring efficiency of managers

• Communicates the entity goals to employees
• Provides control
• Provides a yardstick or it benchmark for measuring performance of employees

Cash Accounting

Only cash inflows and outflows are recognized and recorded. It does not recognize any revenue or
expenditure that has been received or paid. The resulting final accounts are just summarized cash
hooks.

Accrual Accounting

he accruals concept states that revenues and costs are recognized as they are earned or incurred. Lot
ities in the private sector and some in the public sector follow this system.

Commitment Accounting

This accounting technique recognizes transactions when the entity is committed to them. This means
that the transaction is not recognized when cash is received or paid, nor when invoices are received
or issued, but at an earlier stage when orders arc issued or received. Under this technique, the entity
recognizes the issue of an order as a commitment to incur expenditure and the accounts continuously
reed du. eminnitments. The main purpose of commitment accounting is budgetary control rather
than financial reporting. '

Fund Accounting

A fund is defined as a fiscal and accounting entity with a self-balancing set of accounts recording
cash and other financial resources, together with all related liabilities and residual equities or
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balances and changes therein, which are segregated for the purpose of carrying on specific activities
of attaining certain objectives in accordance with special regulations, restrictions or limitations.

In broad terms a single fund accounting entity is somewhat like a business accounting entity. Each
business accounting entity has a set of self-balancing set of accounts sufficient to capture all the
reported attributes for the whole business and all its transactions. Likewise each fund of the
government has a self-balancing set of accounts sufficient to capture all the reported attributes for
the government fund of this type, of the portion of government's activities and resources accounted
for in cacti particular fund. The key difference is that one accounting entity is used to account for all
activities and resources of a business, whereas each fund accounting entity is used to account for
only a subset of the government's activities and resources.

A general purpose unit of the government has dual nature. Some of its activities are general
government in nature, others are business type activities. The general type activities have unique
sources of financing such as taxes and grants. The allocation of resources to various purposes and
the control of general government activities focus heavily upon the sources and uses of the financial
resources. The business type activities function and may be controlled and evaluated much like their
business counterparts.

Government Funds; these are used to account fof the sources, uses and balances of a government's
expendable general governmental financial resources and the related current liabilities. In their
simplest form, governmental funds are in essence segregations of general government working
capital according to the purposes for which it is to be used.

Governmental fund accounting measures the financial position and changes in financial position,
sources, uses and balances of net fund financial resources rather than net income.

Type of Funds

Governmental Funds

The General Fund; it accounts for all financial resources except those required to be accounted Fur
in another fund.

Special Revenue Fund; accounts for the proceeds of specific revenue sources (other than
expendable trusts for major capital projects) that are legally restricted to expenditure for specified
sources.

Capital Project Fund; accounts for financial resources to be used for the acquisition or
construction of major capital facilities (other than those financed by proprietary funds or trust
funds).

Debt Service Fund/Sinking Fund; accounts for the accumulation of resources for and the payment
of general long- term debt, principal and interest.
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Revolving Fund; these funds provide financial resources for achieving some specified objectives.
The initial appropriation in these funds is made out of the Consolidated Fund. The receipts generated
in such funds are automatically used by the respective entities in accordance with the provisions of
the act.

Proprietary Funds

Enterprise Fund; accounts for:

a. Operations that are financed and operated in a manner similar to private business entities,
where the intent of the governing body is that casts of providing goods and services to the
general public on a continuing basis be financed or recovered primarily through user charges
or
b. Where the governing body has decided that periodic determination of revenues earned,
expenses incurred and/or net income is appropriate for capital maintenance, public policy,
management control accountability or Other purposes..

Internal Service Funds; accounts for the financing of goods and services provided by one department
or agency to other department or agencies of the • governmental unit on a cost reimbursement basis.

Fiduciary Funds

Trust and Agency Funds; accounts for assets held by a governmental unit in a trustee_ capacity or
as an agent for individuals, private organizations, other governmental units and/or other funds.
These include:

• Expendable trust funds

• Non expendable trust funds
• Pension trust funds
• Agency funds

Sources of Government Revenue These may be classified as;

• Internal Sources
• External Sources

Government Expenditure

These are the amounts which are spent by the government for different purposes. Government
expenditure may be classified as:

 Recurrent Expenditure
 Development Expenditure

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Recurrent Expenditure; this means revenue expenditure. It is incurred by the government on

normal activities. The main expenditure heads of recurrent expenditure are General Public
Administration. Defense, Education, Health, Social Welfare, Economic Services, and Other
Miscellaneous Services.

Development Expenditure; this is expenditure incurred for the establishment of new agricultural
and industrial projects, installation of new plant and machinery, construction of various projects, etc.
Development expenditure is shown in the capital budget. It is mainly financed from external loans
and grants. Internal loans are also another source of financing the development expenditure. The
major steps in Government accounting are as follows:

Annual Estimates

These estimates are prepared by the various ministries and these are submitted to the Treasury.
These estimates include revenue and expenditure figures for the next year.

Preparation of the Budget

The budget contains the estimates of government revenue and government expenditure for the
current year. The various proposals are debated in Parliament. After approval by Parliament, the
budget is implemented.

Government Spending

Specific amounts are appropriated by Parliament to different ministries. The ministries cannot spend
amounts in excess of their appropriations without the approval of parliament. In each ministry there
is a system of internal controls to ensure that the spending is according to appropriations and for
correct purposes.

Controller and Auditor General

The Controller and Auditor General is responsible to audit the accounts of various government
departments. The main purpose of this audit is to ensure that all moneys appropriated have been
spent for the correct purposes.

Public Accounts Committee

This committee consists of members of parliament. The committee basically deals with the audited
report of government accounts presented to it by the Controller and Auditor General.

Consolidated Fund

All revenues or other moneys raised or received by the government are paid in one fund known as
the consolidated fund. No money can be withdrawn from the consolidated fund without approval
from Parliament. From the consolidated fund, Parliament approves the annual budget of the
government. The Appropriation bill is introduced in Parliament after the approval of the budget. The

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main purpose of this bill is to issue from consolidated fund, the amounts necessary to meet expenses
of different ministries.

Therefore the consolidated fund is the main source from which funds are provided to different
departments of the government. This fund provides a limit within which the amounts can be spent
during a particular year. This fund helps to control the expenditure of the government.

Appropriations in Aid

These are particular classes of revenue which the treasury authorizes the accounting officer to use. in
addition to the amounts to be issued from the exchequer, to meet expenditure. The Appropriations in
Aid are scheduled in the annual Appropriations Act and any excess over the authorized sum for
Appropriations in Aid will be due to the exchequer unless the authorized turn is increased by
supplementary appropriation.

Paymaster General

The Paymaster General is the principal paying agent of the government and is considered as a
banker of all government departments. The Paymaster General makes the payments on the
government. For this purpose, the Paymaster General arranges with the treasury for the withdrawal
of cash frbm the Exchequer at regular intervals. The amounts withdrawn are transferred from the
exchequer account to the Paymaster General account, From these amounts, the payments are made
to the 'respective ministries. The Paymaster General maintains a separate account for each
accounting unit or branch so as to show the total receipts and payments in respect of these accounts.

Vote Book

The vote book is used by each fund in the government sector. The vote book is that book in which
various accounts are opened. The accounts relate to various expenditure heads arid sources or
revenue.

In a vote book, the vote number of any particular department or ministry is used. The amounts
appropriated to that department for different purposes are recorded into the respective accounts.
When expenditure is incurred for any specific purpose, it is recorded into the respective accounts,
The total funds allocated for a specific purpose and the amounts spent are compared from time to
time. This system helps to ensure that expenditure incurred does not exceed the amounts
appropriated for a specific purpose. For various expenses different code numbers are used,

CASH BASED ACCOUNTING

Traditionally the government has operated on an annual cash basis because appropriations are voted
by parliament on proposed expenditures for the forthcoming fiscal year. The Minister for Finance
presents these proposals — the Budget Estimates to parliament for discussion and approval. The

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proposed expenditures in the Budget Estimates include both the operating and capital expenditures
within that year.

Under cash-based accounting, cash receipts, payments and balances are recorded at the time of the
cash transactions, irrespective of when the related goods and services are produced or received. Cash
based accounting does not recognize noncurrent assets in the financial statements. All expenditures
are written off as expenses during the year they are incurred. Cash based accounting is not without
advantages. These include:

1. It is a widely used and traditionally accepted measure of government's shott term impact on
the economy
2. It is considered tangible, easily prepared and tracked
3. For a number of government transactions, such as grants and salaries, there is not likely to be
significant difference between cash and accrual

Cash-based accounting has its shortcomings too, which are cited as major reasons for many
governments now moving to full accrual accounting. It has been argued that the cash based
accounting provides incomplete or misleading information and perverse incentives:

1. It fails to recognize future costs associated with current government activities

2. It does not properly align costs with the provision of goods and services
3. Cash based accounting systems does not ensure sustainability of government activities as it
is:-
a) More concerned with the current rather than focusing on the future or long term
b) The financial statements do not provide details about the assets held by the government
and its agencies, the liabilities incurred by it are not clear and it is difficult to gauge the
total picture of the government's performance
4. The budgetary process that goes with it is not based on outputs and outcomes. There is no
relationship between inputs, outputs and outcomes:
a) The budgetary process is mainly focused on inputs which encourages which
encourages lavish spending towards the end of the financial year, sometimes merely to
avoid surrendering the unspent balance to the treasury
b) Departments have no justification whatsoever for their budget allocation except that
the amount requested is similar or increased from last year's allocations. Consequently,
there is no incentive for managers to justify what they have spent, leading to
government inefficiencies

These shortcomings provide a strong case for moving to accrual accounting

Accrual based accounting recognizes transactions in the period when the activity generating the
revenue or consuming the resources occurs, regardless of when the associated cash is actually paid
or received. All working capital items (in particular loans, accounts receivable) are carefully
adjusted at the end of each reporting period, to match the incurring of liabilities and the consumption
of assets.
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Another important feature of accrual accounting is its treatment of capital assets. The cost of a
capital asset is not added to the operating cost in the year iC is acquired. Instead, the capital assets
are depreciated over their useful lives such that only the annual amount of depreciation is added to
operating costs as the cost allocation for that year.

This treatment of capital assets improves the alignment of costs with consumption of assets and
more importantly, assets do not appear to be free goods after initial purchase.

There are compelling advantages for adopting the accrual based accounting, including

 Enhancing accountability
 Encouraging use of performance based measures in the government budgeting
 Ensuring fair distribution of government funds amongst competing interests

Enhancing Financial Information and Accountability

The ultimate benefit of adopting this change of accounting philosophy is to make governments ti Lot
e accountable to the taxpayer/public. The traditional cash based accounting focuses on control over
and accountability for cash spending. But the vision of public sector accountability has now changed
and there is increased need for robust information including financial information, on which to
assess performance and accountability.

Accrual accounting is a tool for decision makers that can help governments make better decisions
and improve the allocation of scarce government resources. It provides more complete information
out costs for use in analysis and decision making. It reports on all assets — both current and capital
—ensuring the entity now which resources are available for future use. It also reports on liabilities to
indicate potential demand on future resources to meet an entity's obligations.

Use of Performance Based Measures in Government Budgeting

The most important benefit of accrual accounting is the enhancement of performance based
measures through the adoption of Accrual Output Based Budgeting (Accrual 013B). It makes an
ideal means of shifting the emphasis of the budgetary process away from cash inputs, towards
outputs and outcomes. in the hope that this will resulting greater management efficiencies and hence
better outcomes for the governments and the-citizens.

The budget shift to outcomes will mean focus on outputs, prices, agreements, flexibility in suppliers
and performance benchmarking. The key benefits of Accrual OBB include:

1. 1 Funding departments/ministries for outputs (services and products) rather than inputs
(resources consumed in their production)

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2. Improving the government's management of its funding of services (purchaser interest) and
its resource base (ownership interest)
3. Improving the quality of performance information available to the government amid
departmental managers for strategic planning, resource allocation and operation control
4. Providing a sound basis, for internal resource allocation

Ensuring Fair Distribution of Government Funds among Competing Interests

Accrual based budgeting will ensure that government funds are distributed fairly among competing
interests. It is a process where 'all the actors set criteria and engage in discourse as a means of
resolving issues of allocating scarce resources.

This is possible with the provision of full information necessary to manage the financial position of
the government ministries and other agencies. information on assets and liabilities, income earned or
expenses incurred during the financial year but not resulting in a cash transaction in that year, cash
inflows and outflows, and consistent and streamlined reporting arrangements will ensure that there is
fair distribution of resources.

Challenges in implementing the accrual based accounting

The adoption of accrual accounting- by any government is a challenging process. It is not just a
technical process but a change in philosophy based on a broader view of public expenditure
management. Some of the challenges for the government include:

 Collection of information on capital assets, and properly identifying them

 Building capacity within the public service to ensure that those using the system have
sound knowledge of accrual accounting principles. This can be achieved through or
extensive training,
 Making entity changes to ensure wherever possible that the purchasing, asset management
and accounting functions are integrated under the new system
 Full accrual accounting should be the way forward for the government to ensure public
assets are
 -utilized properly in providing intended services to taxpayers. The adoption of full accrual
accounting
 Improve access to reliable financial information and internal control systems for decision
makers that can help the government to make better decisions and improve the allocation
of scarce government resources
 Provide a more comprehensive picture of the government entity's financial condition by
reporting on all assets so that governments know which resources are available for future
use
 and liabilities to indicate the potential demand on future resources to meet obligations
 Promote consistent and independently verified reporting practices and increase the
likelihood of a cultural change in government spending.

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Illustration

The approved estimates and actual expenditure details for the Ministry of Justice and Constitutional

Affairs for the year 2009/2010 were as follows:

Code Details Approved Estimates Actual Expenditure

000 Personnel Emoluments 123,280 97,520
050 House Allowance 19,550 14,260
080 Passage and Leave 41,040 667
100 Travelling and Accommodation 1,334 1,656
110 Transport expenses 16,100 13,593
120 Communication expenses 4,600 3,312
190 Miscellaneous expenses 17,480 16,882
196 Training expenses 5,980 4,738
230 Purchasing of Equipment 21,000 39,800
620 Appropriations-in-Aid 1,000 5,560

The Ministry made four equal withdrawals from the Exchequer in July 2009, October 2009, January
2010 and May 2010, totalling Sh.200, 000,000 by the year end.

Required:

(i) The general account of vote (GAV),

(ii) The exchequer account.
(iii) The Pay Master General (PMG) account.
(iv) Statement of assets and liabilities as at 30 June 2010.

Solution

General account of vote

Sh.000 Sh.000
A.I.A 4,560 Exchequer 240,364
Expenditure 192,428 Paymaster General Account 5,560
Balance c/d 57,936 ______
254,924 254,924

Exchequer Account
Sh.000 Sh.000
General Account of vote 249,364 Paymaster General Account 200,000
______ Balance c/d 49,364
249,364 249,364

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Paymaster General Account

Sh.000 Sh.000
Exchequer 200,000 Expenditure 192,428
General Account of vote 5,560 Balance c/d 13,132
205,560 205,560

Excess Appropriation in Aid Account

Sh.000 Sh.000
Balance c/d 4,560 GAV 4,560
4,560 4,560

Statement of assets and liabilities as at 30 June 2010

Sh.000 Sh.000
Assets
Exchequer a/c 49,364
Paymaster general a/c 13,132 62,496
Funded by:
General account of vote 57,936
Excess appropriation in Aid 4,560 62,496

Workings:-

Code Details Approved Estimates Actual Expenditure

0 Personnel Emoluments 123,280 97,520
50 House Allowance 19,550 14,260
80 Passage and Lease 41,040 667
100 Travelling and Accommodation 1,334 1,656
110 Transport expenses 16,100 13,593
120 Communication expenses 4,600 3,312
190 Miscellaneous expenses 17,480 16,882
196 Training expenses 5,980 4,738
230 Purchasing of Equipment 21,000 39,800
Appropriations-in-Aid (1,000) (5,560)
GAV 249,364 186,868

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REVISION EXERCISE:

QUESTION 1

(a) Highlight purposes of public sector accounting.

Solution:

i. To create a standard expectation of ethics and accountability for a nation’s financial

information.
ii. It assists in public sector budgeting.
iii. It helps in the establishment of a public governance system which enhances discipline
decision making by those in charge of state affairs.
iv. It enables the public assess whether there is value for money submitted as a result of the taxes
paid to the state.

QUESTION 2

The following were the approved estimates and actual expenditure for the Ministry of health for the
financial year ended 30 June 2013:

Item Details Approved Actual

estimate expenditure
Sh."000" Sh."000"
0300 Transport 76,500 73,100
0301 Travel and subsistence 88,400 86,700
0500 Personal emoluments Electricity 102,000 96,900
0700 expense 81,600 76,500
0240 Staff development 15,980 17,510
0900 Purchase of equipment 166,600 166,600
0400 Other allowances 116,960 113,390
1000 Appropriations- in-aid 133,960 125,800

Drawings from the Exchequer during the financial year ended 30 June 2013 amounted to Sh.127,
500,000.

Required:

i) General account of vote.

ii) Exchequer account.
iii) Paymaster general account.

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Solution:

ITEM DETAILS APPROVED ACTUAL

Estimate Expenditure
Sh '000' Sh '000'
0300 Transport 76,500 73,100
0301 Travel & subsistence 88,400 86,700
0500 Personal emoluments 102,000 96,900
0700 Electricity expenses 81,600 76,500
0900 Purchase of equipment 166,600 166,600
0400 Other allowances 116,960 113,390
G.A.V 632,060 613,190
A.I.A (133,960) (125,800)
Exchequer 498,100 487,390

i)
General account of vote a/c
Sh.000 Sh.000
Expenditure 613,190 Exchequer 127,500
Appropriation in Aid 133, 960
______ Balance c/d 351,730
254,924 254,924
ii)

Exchequer Account
Sh.000 Sh.000
General Account of vote 127,500 Paymaster General Account 127,500
127,500 127,500

iii)

Paymaster General Account

Sh.000 Sh.000
Exchequer 127,500 Expenditure 613,190
Appropriation in Aid 133, 960
Balance c/d 351,730 _______
613,190 613,190

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QUESTION 3

Uzuri County Council authorised the construction of a city hall on 1 July 2012. The hall was
expected to cost Sh. 160,000,000. The project was to be financed as follows:

Sh. 80,000,000 from a 6.5% bond issue

Sh. 64,000,000 from a government grant
Sh. l6,000,000 from the general fund

The following transactions and events took place during the year ended 30 June 2013:

1. The county council transferred Sh. 16,000,000 from the general fund to the city hall capital
fund. The capital project fund was for the purpose of construction of the city hall.
2. Planning and architects fees amounting to Sh.6,400,000 were paid.
3. The contract was awarded for Sh. 152, 000,000.
4. The 6.5% bonds were sold for Sh. 80,320,000 and the amount of the premium transferred to
the debt service fund.
5. The contract was certified 50% complete and an invoice for Sh.76,000,000 was received from
the contractor.

The contractor was paid the invoiced amount less 10% retention

Required:

i. Journal entries to record the above transactions.

ii. Statement of revenue and expenditure of the capital project fund for the year ended 30 June 2013.
iii. Statement of financial position of the capital project fund as at 30 June 2013.

Solution:
(i) Journal entries
Sh.000 Sh.000
General fund account 16,000
Capital project fund account 16,000
Being transfer from the general fund to capital fund account
Planning and architect fees account 6,400
Cash account 6,400
Being planning architect fees paid
City hall building account 152,000
Commitment/contractor account 152 000
Being contract award for city hall building
Cash account 80,320
6.5% bond account 80,000

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Debt service fund 320

Being sale of 6.5% bond and transfer to service fund
Commitment/contractor account 76,000
Cash book 68,400
Retentions 7,600
Being payment to the contractor

ii) Statement of revenue and expenditure

Uzuri County Council

Statement of revenue and expenditure for the construction of city hall for the year ended 30
June 2013

Sh.000 Sh.000
Revenue:
Bond issue 80,000
Government grant 64,000
General fund transfer 16,000
160,000
Other revenue:
Bond premium 320 160,320
Expenditure:
Planning and architects fees 6,400
Contractor 152,000 (158,400)
expenditure/commitment
Surplus 1,920

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 FINANCIAL ACCOUNTING

iii) Statement of financial position

Uzuri County Council

statement of financial position as at 30 June 2013 Building (city hall)

Sh.000
Assets
Building (city hall) 158,400
Cash (80,320 - 6,400 - 68,400) 5,520
163,920
Financed by:
65% bond issued 80,000
Government grant 64,000
Debt service fund 320
Retention 7,600
Capital project fund balance 12,000
163,920

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