Intro to Financial Accounting Chapter

CHAPTER 1
INTRODUCTION TO FINANCIAL ACCOUNTING

This chapter introduces the nature and objectives of financial accounting.
Before you learn how to process transactions and eventual preparation of financial statements, it
is important that you understand why accounting information is necessary and the assumptions
on which it is based. This is because accounting has limitations on the scope and use of
accounting information. It is equally important to know the type of business entities that operate
in communities from which accounting information is derived.
TOPICS
1. What is financial accounting?
2. Types of business entities.
3. Description of users of financial accounting information.
4. What makes accounting information to be useful?
5. The scope and objectives of financial accounting
LEARNING OUTCOMES
At the end of this chapter you should be able to:
- Explain the need and objectives of financial accounting.
- Identify the users of financial accounting information as prepared by different types of
business units.
- Describe qualities of good accounting information.
1 WHAT IS ACCOUNTING?
1.1 Accounting is the process of identifying, measuring, recording, summarizing

economic information and finally communicating it to interested parties (users)
1.2 ANALYSIS OF DEFINITION
(a) Process mean accounting has steps and procedures of doing things.
(b) Identifying means accounting is only concerned with activities or

transactions relating to the business.
(c) Measuring means that all activities related to the business should be stated
in monetary terms.
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(d) Recording is the aspect of writing down business transactions in
accounting books. This is called BOOK KEEPING.
(e) Summarising means analyzing all recorded information in categories and

preparing financial statements.
Financial statements include:
(i) Income statement, which is a summary of trading activities to

establish profit or loss achieved during a trading period.
(ii) Balance sheet which is a summary of what the business owns or
owes at a given time.
(f) Financial statements should be provided to any body interested for

assessment and decision making (communication).
ACTIVITY 1.1
In communities we live in people work in different organizations. Some work as accountants.

Can you describe who an accountant is?
2. TYPES OF BUSINESSES
2.1 WHAT IS A BUSINESS?
A business is defined variously to suit ones requirements. In our studies we shall

define a business as: a person, firm, company or other organisation which makes
or produces some kind of service usually for the purpose of making profits.
- Profit is excess of Income over Expenditure
- Loss is excess of Expenditure over Income
Business can be organised at different levels with a major limiting factor being
resources (capital).
Businesses range from basic simple business to a more complex one.
2.2 SOLE TRADER
This is the type of business owned and operated by one person. However, the
person running this business can have employees.
The sole trader, as an individual will provide the resources and skills to operate
the business.
Maintaining accounting records in a sole trader may vary from basic to complex
as some sole trader may grow very big.
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2.3 PARTNERSHIP
This is a type of business where two or more persons put their resources together
to carry on business for the purpose of making profits. There is a limit as to the
number of partners depending on the type of business to be carried on.
2.4 COMPANY
This is a formal association of persons for business purposes. A company is

legally incorporated under company law.
Members of a company are called shareholders.
Companies are usually limited (Ltd) meaning that if the company goes into
liquidation because of debts, each member will only lose the cost of his shares i.e.
amount contributed in the business and no more.
2.5 TYPES OF LIMITED COMPANIES
(a) PRIVATE COMPANIES
They are private in the sense that membership is restricted to well known
individuals and members are few in numbers.
Private companies usually have the word LIMITED at the end of the
name. Other countries use the word PRIVATE.
They do not invite members of the public to subscribe for shares and
members are not allowed to transfer their shares without agreement of the
other shareholders.
(b) PUBLIC COMPANIES
They offer shares to the public and there is no limit to membership.
Shareholders can transfer shares without restrictions. Such a company

must include the words PUBLIC LIMITED COMPANY (Abbr. PLC)
after its name.
ACTIVITY 1.2
Distinguish the following terms: enterprise, business, company and firm.
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USERS OF ACCOUNTING INFORMATION
When financial statements are prepared they are passed on to interested parties who might need
them for various reasons.
The following might be interested in financial information.
(a) Managers of the organization:
Managers are people appointed by owners of the company to supervise the daily
activities of the company.
Managers need accounting information to make planning decisions.
(b) Shareholders and potential investors:
A shareholder is a member of limited company and therefore holds one or more shares in
that company. Potential investors are people with resources but are yet to make a
decision as to where to invest.
Shareholders are interested in profits and security of their investment. They need to look
at accounting information to access profitability of the company and will make decisions
such as retaining their investment in the company or invest it somewhere else.
(c) Trade contacts:
Trade contacts are suppliers of goods and services to the company. They also include
customers.
Credit suppliers are interested in the ability of the company to pay its debts should they
supply to it.
Customers are interested in continuous supply with no danger of the business closing.
Financial accounting information may just satisfy their concerns.
(d) Lenders
Lenders provide finance to companies in form of loans which could be short or long term.
Their main concern is to whether a company will be able to pay interest on loans and also
eventually repay the loan itself.
This information may be provided by accounting information.
(e) Government agencies
Government needs to know how the economy is performing in order to plan for
financial and industrial policies.
Tax authorities would also want to know the business profits in order to assess
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the tax payable by the company.
Financial statements could be used as a basis.
(f) Employees and trade union representatives
Employees are workers in a company. Their concern is job security and better conditions
of services.
They will need accounting information as a basis for negotiating for improved salaries
and conditions of services. Accounting information may also disclose that the company
is threatened with closure and employees will have to make a decision of staying or not.
(g) The public:
People in general want accounting information because enterprises affect them in many
ways.
Companies are found where people live. Companies provide jobs for the people and they
also use local suppliers. Companies may also affect the environment through pollution.
(h) Financial analyst and advisers:
These are specialists in economic trends. They need accounting information in order to
advise their clients on best investment options and generally to inform the public on
financial matters.
ACTIVITY 1.3
It is easy for people working in an organization to have access to accounting information. For
people outside it may be difficult. How can external people access accounting information?
4. QUALITIES OF GOOD ACCOUNTING INFORMATION
For information to be of good quality, it must be able to satisfy the needs and
requirements of those looking at it. Here are some of them.
(a) Relevance
Accounting information is relevant if it is connected with what the user wants.

That is, it must influence them to make a decision.
(b) Reliability
Accounting information provided should be depended upon when making

decisions. For accounting information to be reliable it must be audited
(Examined) by qualified and experienced auditors so that accounts are free from
error.
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(c) Comparability
An exercise undertaken to judge to what extent accounting information is similar

or not similar.
For reasonable conclusion to be made about the business it is important that its
accounting information is comparable.
N.B. When comparing use similar businesses both in size and nature, or use
accounting information from the same business from previous year. If business is
starting for the first time a budget could also be used.
(d) Understandability
For anybody to make a meaningful decision they should have clear knowledge of
what they are looking at. Any difficulties arising from its interpretation must be
dealt with by those who understand it.
(e) Completeness
When financial statements are prepared they should have all its parts and should
portray a whole or rounded picture of the business activities.
(f) Objectivity
Financial statements should be free from opinions. They should not be prepared
in order to satisfy a particular group. They should be actual facts otherwise they
would be considered biased. The problem of bias is dealt with by external audit.
(g) Timeliness
For information to be meaningful, it should be provided at the time it is required

so that timely decisions could be made.
Accounts are usually published soon after the year end.
ACTIVITY 1.4
Looking at the qualities of accounting information, could you identify a problem

that may arise with each one of them?
ACTIVITY 1.5
Identify areas of conflict for qualities of good accounting information or are they
all compatible?
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5 THE SCOPE OF FINANCIAL ACCOUNTING
5.1 Financial statements are prepared and presented in monetary terms. But the
success of the business does not entirely depend on machinery and other items
that can be measured in monetary values.
A business could be successful because of:
(i) Good management

(ii) Dedicated workforce
(iii) Skill of staff
5.2 The above cannot be measured in monetary terms and therefore do not appear in
financial statements because they are non financial matters in nature.
5.3 Financial accounting information is concerned with the following:
- Profits or losses in a period

- Assets and liabilities of the business
- Cash flows in the business
The list is non exhaustive.
5.4 Why keep accounts?
(a) An account is simply a record of activities taking place in a business.
Example:
- Bought stamps and paid cash for them K2,000.

- Bought machinery on credit from XYZ Ltd K15,000,000.
In the accounting books we need to keep a record of stamps we bought

and how much cash was paid thus Stamps Account K2,000 and Cash
Account K2,000 then Machinery Account K15,000,000 and XYZ Ltd
Account K15,000,000 because XYZ Ltd is yet to be paid for the
machinery he supplied.
(b) It is important that accounting records are free from errors (accurate)
because users will need to make decisions from them. Accounting records
should also be updated all the time.
Well maintained and updated records may help in the followings:
(i) Help managers to control the business resources
(ii) Indicate how successfully managers are performing
(iii) Provide information about the resources and activities of the

business.
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(iv) Help in calculating profits
(v) Provide information about what the business owns (assets) and
what the business owes (liabilities)
(vi) Help in answering audit queries.
CHAPTER SUMMARY
- The chapter introduced what financial accounting is and its main users.
- Accounting is the process of collecting, recording, summarizing and communicating

financial information.
- Accounting information is essential to the efficient running of a business. It helps

managers to control the use of resources and plan effectively for the future.
- Accounting information is used by many interested parties both within and outside the
business. It is used as a basis for communicating information about business activities.
- Accounting information can only be useful if it satisfies the need and requirements of
those using it.
- The scope of accounting is very wide, but it is limited to items which have a monetary
value.
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EXERCISES
1. Name five groups of people who might use accounting information of a business.
2. What are the main elements of financial statements?
3. Accounting information is limited to items having monetary value. True or False.
4. List the characteristics of qualitative accounting information.
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SOLUTIONS FOR ACTIVITY QUESTIONS
ACTIVITY 1.1
Accountants are employees found in both profit-making and non-profit making organizations.
They are custodians of finances. Their responsibility is to ensure that funds of an organization
are used for intended purpose by keeping records of where money came from and how it has
been used.
They prepare financial statements which are communicated to users. They also advise
management on financial matters such as investment opportunities.
ACTIVITY 1.2
An enterprise is the most general term, referring to just about any organization with people
having a common goal. It can be a business or a club or local authority.
A business is also a general term and is used to describe any existing organization involved in
trading to make profits.
A Company is an enterprise constituted by law usually involving limited liability for its
members.
Companies need not be business e.g. charities could be constituted as companies.
A firm is a much general term. It is loosely used to describe a business or company. A firm could
also be used to describe an unincorporated business such as a partnership.
ACTIVITY 1.3
Limited companies are required by law to make certain accounting information public. They
send copies of accounting information to the registrar of companies. People can have access to
the information from the registrar of companies at a small fee.
This does not apply to Sole Traders or Partnerships.
ACTIVITY 1.4
Relevance - The problem is to identify the needs since there are many users.
Reliability - The problem is modern business has become so complex thus

making reliability difficult to achieve.
Comparability - The use of different methods by business in preparing
financial statements has made it difficult to compare.

However, this has been reduced by Accounting standards.
Understandability - Not all users have a sound financial background. It may be

difficulty to make sense of accounting information if you have no
knowledge.
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Completeness - Completeness may be difficult to achieve because of the
volume of work involve.
Objectivity - Though financial statements are prepared by management

and bias removed an audit, some people question the
effectiveness of an audit.
Timelines - Due to volume of work financial statements may not be

provided at the time they are required. Accounts prepared quickly
will be based on estimates and estimates may reduce reliability.
SOLUTIONS TO EXERCISES
1. Any of the following
- Management - Lenders
- Shareholders - The Public
- Employees - Financial Analyst and advisers
- Trade contracts - The government
2. The main elements of financial statements are:
- Income statement prepared to find the Gross Profit and the Net profit.
- The Balance sheet prepared to show a summary of assets, liabilities and capital of
an enterprise.
3. True accounting information is limited to items having monetary value.
4. Relevance, Reliability, understandability, comparability, objectivity and timeliness.
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CHAPTER 2
INTRODUCTION TO FINANCIAL STATEMENTS
INTRODUCTION
In this chapter we introduce financial statements by explaining the terms used in classifying
income, expenditure, assets and liabilities. Before demonstrating how financial statements are
prepared we explain what the accounting equation is.
TOPIC LIST
1 Financial statements
2 Assets in the balance sheet
3 Liabilities in the balance sheet
4 Income and expenditure
LEARNING OBJECTIVES
At the end of this chapter you should be able to

- Define and give examples of assets and liabilities
- Explain what income is
- Explain what expenditure is
- Prepare the income statement
- Prepare the balance sheet
1.0 CLASSIFICATION OF FINANCIAL STATEMENTS
Financial statements are sometimes called FINAL ACCOUNTS.
Financial statements are usually prepared at the end of the accounting period i.e. on
yearly basis.
They could also be prepared on quarterly basis called INTERIM REPORTS.
3.2.1 WHAT ARE FINANCIAL STATEMENTS?
These are documents prepared showing financial performance and the state of
financial position of an organisation. They usually list assets and liabilities
including capital The Balance Sheet.
They also give account of the Profit and Loss The Income Statement.
3.2.2 THE BALANCE SHEET
The word balance in accounting could mean two things:
(i) Having two sides equal, or

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(ii) Value of an item remaining
Therefore, a balance sheet is a statement prepared which has two sides with equal
values. These values are assets, liabilities and capital.
In summary the accounting equation of the balance sheet is:-
Assets = Capital + Liabilities
On one side the balance sheet must have assets and on the other side capital and
liabilities and the two sides must be equal as illustrated above.
3.2.3 ASSETS
An asset is anything owned by an organisation that has monetary value. Value

because the organisation will derive economic benefit from its use.
3.2.4 TYPES OF ASSETS
Assets are classified as current assets and non current assets.
(a) Current assets
They are called current assets because they are temporal in nature. They
easily change in value with time and can be turned into cash fairly soon.
Examples of current assets are:
Inventory stock of goods

Receivables amounts owing to the business by credit customers
(receivables)
Prepayments amounts paid in advance by the business for which
a service has not yet been provided.
Short term investments this is the use of business money in other
activities to generate income or profits within a short period of
time e.g. within 1, 2, 3 months.
Cash in hand this is cash available for use in the office.
Cash at bank this is money the business has with the bank.
ACTIVITY 3.1
Give reasons why inventory, receivables, prepayments, cash at bank and

in hand are classified as current assets?
(b) Non current assets
Sometimes called fixed assets or capital assets.
These are possessions which do not change in value easily. They are long
lasting and help generate income for the business on long term basis.
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They are acquired not for sale as long as they are useful to the business.
Examples of non current assets includes:-
- Land
- Buildings Tangible non current assets
- Machinery
- Furniture and fittings
- Long term investments
- Goodwill, development costs and other intangible assets.
ACTIVITY 3.2
Non Current assets are arranged in a certain order in the balance sheet.
Describe the arrangement.
3.2.5 LIABILITIES
These are amounts owed by the business (debts) to its trade payables and to its
owner(s). They represent the businesss obligation to transfer economic benefits
to a third party.
3.2.5.1 TYPES OF LIABILITIES
(a) Current liabilities
These are debts of the business that must be paid within a fairly short
period of time. A fairly short period of time may be taken as one year.
In the accounts of limited companies, the Companies Act. 1994 requires

the use of the term Creditors: amounts falling due within one year rather
than current liabilities.
Examples of current liabilities may include the following:
- Trade creditors suppliers to whom the business

owes money for goods supplied on
credit.
- Accrued expenses - They represent bills for expenses

for services which the business
been provided but has not yet been
paid for at the time the balance sheet
is being prepared.
- Bank overdraft - These are short term borrowings

repayable on demand. This
happens when a business over-
draws from its bank current
account e.g. a business may have
$100 000 in its current account, with
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prior consent from the bank
manager, the business may be
allowed to withdraw K120 000 The
excess K20 000 withdrawn is bank
overdraft, which must be shown
as current liability at the balance
sheet date as long as it is not paid
at that date.
- Loans repayable within one year. Some loans maybe obtained to

be repaid over a period of more than 1 year, in the year of
repayment they would be stated as current liabilities.
- Taxation payable - These are tax amounts not yet

paid to tax authorities.
(b) Non current liabilities
They may also be called long term liabilities. These are debts by
arrangement with creditors concerned, have to be paid over a long period
of time, usually more than one year e.g. 5 year loan.
This 5 year loan will be shown as non current liability for the first 4 years.
In the 5th year it would appear under current liabilities.
Examples of non current liabilities may include:
- Loan - These could be bank loans as long

as they are not repayable within
one year.
- Mortgage Loan - This is loan issued for capital

expenditure. It is usually secured
against some property. Should
the business fail to pay the loan
the lender will have claim on the
property.
- Debenture loans - These are securities issued by a

limited company at a fixed rate of
interest. They are repayable on
agreed terms.
ACTIVITY 3.3
What is the difference between tangible and intangible non current assets.
3.2.6 Capital (Sole trader)
This is other than money assets such as machinery, buildings, etc. put into
business to carry on business for profit purposes.
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Capital put in by owners is also called EQUITY.
The capital of a business can be analysed as follows:
Capital at the beginning of period XX

Add: additional capital introduced
during the period XX
Add: Profit earned during period XX
Less: Drawings XX
___
Capital at end of period XX
For more details on above refer to the accounting equation.
3.2.7 Capital and business - relationship
Capital is a liability to the business because it belongs to the owner. See business
entity concept.
ACTIVITY 3.5
Categorise the following as tangible non current assets, intangible non current
assets, investments current assets, current liabilities or non current liabilities.
(a) Shares in Chilanga Cement Plc, intended to be held on long term.

(b) Machinery used in production
(c) Inventory Goods for resale
(d) Bank overdraft
(e) A mortgage loan
(f) Trade payables
(g) Trade receivables
(h) Goodwill
(i) Rent paid in advance by the business
(j) Rent paid in advance to the business
(k) Accrued income to the business
(l) Accrued expenses by the business.
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3.2.8 Format of the Balance Sheet (Sole trader)
The International Accounting Standard (1AS1) recommends the following

accounting equation when preparing the balance sheet:
In vertical format:
A detailed format is as follows:
Name of organisation:
Balance sheet as at (indicate date)
NON CURRENT ASSETS
Tangible non current assets

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

Goodwill ----------------------------------XX
Development costs ----------------------XX XX
Long term investments

Shares in another company. -----------------------------XX
XX
CURRENT ASSETS
Inventory ---------------------------------XX
Receivables ------------------------------XX
Prepayments ---------------------------- XX
Cash in Bank --------------------------- XX
Cash in Hand --------------------------- XX
XX
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TOTAL ASSETS ------------------------------------------------- XX
FINANCED BY:
Capital and liabilities
Capital at start -----------------------------------XX

Add Net Profit/Less Net Loss -----------------XX (XX)
Less Drawings ----------------------------------(XX) XX
Non current liabilities

5 year loan -------------------------------------------------XX
Current Liabilities
Trade creditors -------------------------XX
Accrued expenses --------------------- XX
Bank overdraft ------------------------- XX
Taxation -------------------------------- XX
XX
TOTAL EQUITY & LIABILITY XX
N.B. non current assets plus current assets = Total assets
Total assets = Capital plus profit less drawing

Plus non current liabilities plus current liabilities.
The format given is not exhaustive neither is it inclusive.
Full Example Preparation of balance sheet.
The following information is related to Kuku Hardware Stores, as at 31 December

20X6. From it prepare a balance sheet.
K
Capital 1 January 20X6 47,600
Profit made during the year 8,000
Insurance prepaid 300
Rent accrued by Kuku 600
Receivables 500
Tax payable 3,500
Motor vehicles 9,000
Bank overdraft 2,000
Closing Inventory 31.12. 20X6 16,000
Fixtures and fittings 8,000
Cash in hand 100
Payables 1,200
Drawings 4,000
Premises 50,000
5 year loan 25,000
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SOLUTION
KUKU HARDWARE & STORES
BALANCE SHEET AS AT 31 DECEMBER 20X6
Non current assets: K K

Premises 50,000
67,000
Current Assets:
Inventory 16,000
Receivables 500
Prepayment 300
Cash in hand 100
16,900
Total assets 83,900
Financed by:
Capital at start 47,600

Add: Net profit 8,000
55,600
Less: Drawings (4,000)
51, 600
Non current liabilities:

5 year loan 25,000
Current Liabilities
Payables 1,200
Taxation payable 3,500
Accrued expenses 600
7,300
Total equity and liabilities 83,900
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ACTIVITY 3.5
Prepare a Balance Sheet for Freedom Enterprises as at 31 December 20X4 from

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

Amounts paid in advance by business 1,000
Motor vans 15,000
Cash at bank 4,600
Mortgage 70,000
Capital as at 1 January 20X4 50,000
3.2.9 The Income Statement
The income statement is a statement showing in detail how the profit or loss of a
period has been made. It is a summary of the business trading activities over a
period of time.
Thus: Income Less Expenditure = Profit.
3.2.10 The Matching or Accruals Concept
The income statement is prepared on the principle of matching or accruals. When

calculating profit, all income whether received or not as long as they relate to the
accounting period under-review should be matched with expenditure whether paid
or not as long as expenditure relates to the same accounting period.
3.2.11 Difference between Cash and Profit
Because of the matching/accruals concept used in calculating profits, profits and

cash will always be different.
Remember that cash is an asset while profit is an income.
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Example:
The business started with capital in cash of K100.
Cash 100 = Capital 100 + 0
The same K100 cash is used to buy goods
Cash 0 + Inventory 100 = Capital 100 + Liabilities 0
N.B. The asset of cash has been transformed into another asset of
inventory. The capital is no longer tied in cash but in inventory.
All the inventory is sold to customers on credit for K150 (refer to

realization concept).
The asset of inventory has also been transformed another asset receivables
K150. Assets have increased because goods have been sold at a profit of
K50.
This means capital should also increase by the same amount. (Refer to the
accounting equation).
Receivables = capital + profit

150 = 100 + 50
N.B While it is agreed that the business has made profit of K50, the
business has no cash because the receivables are not yet to pay.
If the goods had been sold on cash basis, the profit will remain at K50 but
cash will be K150.
3.2.12 Division of the income statement
The income statement is divided into two parts. The gross profit part and the net
profit part.
3.2.13 The Gross Profit part
This part of the income statement is concerned with income generated from sale
of goods (sales) and the cost of goods sold (purchases + direct expenses).
Thus: Sales Cost of Goods Sold = Gross Profit.

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Direct expenses are added to purchases because they are incurred at the time of
buying and bringing goods into premises. These expenses could be avoided if one
never went to buy goods, so they increase cost of purchases.
Examples:
- Carriage inwards
- Customs duty
Gross profit is not final profits because there could be other indirect expenses to
be deducted.
The gross profit part answers questions such as are you doing fine in what you
are buying and selling. Is it a profitable business?
3.2.14 The Net Profit Part
Net means final.
In carrying out a business there could be other expenses that may be incurred
which have no direct bearing on purchases. These may be incurred whether you
buy goods or not. They are called indirect expenses. They may include:
- Salaries of workers
- Rentals
- Electricity etc.
- Carriage outwards.
Therefore Net Profit = Gross Profit less Indirect Expenses.
Please note that the business may have gross profit but end up with Net loss.
The division of the income statement will help management identify where the
problem is i.e. is it on selling part or expenses part.
3.2.15 Other Income
Sometimes a business may engage itself in other income generating activities

apart from the core business. Other income is added to gross profit before
deducting indirect expenses.
Examples of other Income:
- Dividend or interest received from investments

- Profit on sale of non current assets
- Income from Rentals
- Discount received from suppliers.
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3.2.16 Classification of Expenses
When preparing income statement, indirect expenses are classified as:
- Selling and distribution

- Administration
- Finance costs
3.2.17 Selling and Distribution expenses
These are expenses incurred in the process of selling goods: examples will
include:
- Salaries of sales staff

- Commission to sales staff
- Travelling and entertainment expenses of sales staff.
- Marketing costs e.g. advertising and any sales promotion expenses
3.2.18 Administration expenses
These are expenses related to the day to day running of the business. Examples
may include:
- Salaries of general staff

- Rent & rates
- Insurance
- Telephone
- Heating
3.2.19 Finance costs
These may be related to servicing borrowings. Examples:
- Interest on loan
- Interest on bank overdraft
3.2.20 Simple example of Income Statement
- Bought goods costing K250

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

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

K000
Gross profit 180
Less: Indirect Expenses
Salary (55)
Net profit 125
The full income statement would then be:
Sales 450
Cost of sales:
Purchases 250
Carriage Inwards 20
(270)
Gross profit 180
Less Indirect Expense
Salaries (55)
Net profit 125
ACTIVITY 3.6
On 1 June 20X5 Snow White commenced business dealing in ice cream.
(a) He rented a van at a cost of K1,000 for three months. Running

expenses for the van averaged K300 per month.
(b) He hired a part time helper at a cost of K100 per month.
(c) He borrowed K2,000 from his bank and the interest cost of the
loan was K25 per month.
(d) His main business was selling ice cream from the van, but he also
did some special catering supplying ice creams for office parties.
Sales to these customers were usually on credit.
(e) For the three months to 31 August 20X5, his total sales were
K10,000 (K8,900, credit K1,100).
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(f) He purchased his ice cream from a local manufacturer, Palmer Ltd.
The cost of purchases in the three months to 31 August 20X5 was
K6,200 and at 31 August he had sold every item of stock. He still
owed K700 to Palmer Ltd for purchases on credit.
(g) One of his credit sale customers has gone bankrupt, owing Snow
White K250. Snow White has decided to write off the debt in full.
(h) He used his own home for his office. Telephone and postage
expenses for the three months to 31 August were K150.
(i) During the period he paid himself K300 per month
Required:
Prepare an income settlement for the three months 1 June to 31

August 20X5
3.2.21 Relationship between the income statement and the Balance Sheet
Balance sheets are pictures of the business at particular points in time, while the
income statements show the activities of the business in between those balance
sheet dates. Therefore the linkage between the accounting statements can be seen
as:
Balance sheet at start of

period
Plus profit or less loss

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

from proprietors
Balance sheet at end of

period
Thus, the balance sheets are not merely isolated statements, they are linked over
time by the profit or loss. See also accounting equation.
25
3.2.22 Inventory
When a business buys goods for resale, they are called inventory.
3.2.23 Closing Inventory
These are goods unsold at the end of the accounting period. Closing inventory is
determined by physical stock taking.
When calculating profit/loss, closing inventory is deducted from the total

inventory figures, because profit/loss is calculated on the cost of what has been
sold. Since the business is continuing the remaining inventory will be carried
forward to the next accounting period.
Example: in year 1 the following transactions took place

- Bought 10 shirts at K5 each
- Of the 10 shirts only 7 shirts were sold for K8 each.
Calculate profit
Solution:
Profit will only be calculated on the 7 shirts sold. The other 3 shirts will be
carried forward and profit will be calculated when they will be sold.
Thus: K K
Sales (7 x 8) 56
Cost of sales:
Purchases (10 x 5) 50
Less: closing inventory
(3 x 5) (15)
(35)
Profit 21
Closing inventory will appear as a current asset in the balance sheet.
3.2.24 Opening inventory
What is considered closing inventory at the end of an accounting period will be

taken in the new accounting period as opening inventory, and will be added to the
cost of goods which will be bought in the new year.
Example: Continuing from previous example:
In the following year 2 the following transactions took place.
- Bought 14 shirts at K5 each

- Sold 11 shirts at K10 each
26
Calculate profit?
Solution
Note that in year 1, 3 shirts at K5 each were not sold and so they are brought to
year 2 as opening inventory.
K K
Sales (11 x 10) 110
Cost of Sales
Opening stock (3 x 5) 15
Add: purchases (14 x 5) 70
85
Less: Closing inventory
(6 x 5) (30)
(55)
Profit 55
3.2.25 Purchases Returns and Sales Returns
When calculating the figure of Net purchases, all goods returned to supplies must
be deducted.
Thus:
Purchases XX
Less: purchases
Returns (XX)
Net purchases XX
Net purchases represented the actual amount paid or to be paid to suppliers for
goods bought only. Purchases returns is also called returns outwards.
Sales returns or returns inwards represents goods returned to the business from
cash or credit customers.
When computing revenue income from sales of goods, sales returns is deducted
because it no longer sales since goods which were sold have been returned.
Thus income statement:
Sales XX
Less: Sales Returns (XX)
Turnover/Net sales XX
N.B. Turnover is sales less sales returns.
27
3.2.26 Format of Income Statement (sole trader)
Name of organization
Income Statement for the period end . (Date)
Sales XX
Less: Sales returns (XX)
Turnover XX
Cost of Sales
Opening inventory XX
Purchases XX
Less purchases returns (XX)
Net purchases XX +
Direct expenses
Carriage inwards XX +
Customs duty XX
XX
Cost of purchases XX
Total cost of inventory XX
Less closing inventory (XX)
(XX)
Gross profit/loss XX
Add other income
Discount received XX
Commission received XX
XX
Less Expenses:
Carriage outwards XX
Discount allowed XX
Salaries & wages XX
Rent XX __
Bad debts XX
Depreciation XX
Light & heat e.t.c XX
(XX)
Net Profit/Loss XX
N.B. Cost of purchases is:
Net purchases (actual value of goods bought)
Plus
Direct expenses
Full worked example on income statement:
28
On 31 December 20X3 Mungo, a wholesaler, had the following details in his
books.
K
Opening inventory 5,000
Sales 25,000
Purchases returns 2,000
Discount allowed 300
Returns inwards 500
Salaries and wages 8,000
Discount received 250
Rent 400
Electricity 100
Carriage inwards 50
Bad debts 75
Postage & stationery 80
Carriage outwards 95
Closing inventory 3,000
Purchases 12,000
From the above information prepare the income statement for the year ended 31
December 20X3.
Solution:
MUNGO
Income Statement for the year ended 31 December 20X3

K K K
Sales 25,000
Less: Sales returns (500)
Turnover 24,500
Cost of sales:
Purchases 12,000
Less purchases returns 2,000
Net purchases 10,000
Carriage Inwards 50
Cost of purchases 10,050
Total cost of inventory 15,050
Less closing inventory (3,000)
(12,050)
Gross profit 12,450
Add: Discount received 250
12,700
Less: Indirect Expenses
Rent 400
Electricity 100
29
Bad debts 75
Postage and stationery 80
9,050
Net profit 3,650
ACTIVITY 3.7
Mr. Buju, has been in business for sometime now, as a timber merchant. The
information below has been extracted from his books as at 30 June 20X4, the end
of the accounting period.
K
Capital at start 1 July 20X3 121,900
Trade payables 19,000
Sales 280,000
Returns outwards 13,000
Discounts allowed 2,000
Discounts received 1,500
Fixtures and fittings @ cost 120,000
Depreciation fixtures & fittings 12,000
Trade receivables 24,000
Inventory 1 July 20X3 50,000
Purchases 135,000
Returns inwards 5,000
Carriage outwards 4,000
Drawings 18,000
Carriage inwards 11,000
Rent 7,000
Rates 8,000
Insurance 10,000
Heating & lighting 12,000
Postage 500
Stationery 700
Telephone 400
Advertising 5,000
Salaries & wages 35,000
Bad debts 1,500
Cash in bank 6,000
Cash in hand 300
5 year loan from Banda 20,000
Inventory at 30 June 20X4 17,000
Required:
Prepare income statement for the year end 30 June 20X3 and a Balance Sheet as
at that date.
30
3.2.27 Working capital
This is money needed by a business in order to keep operating (trading). It is

calculated as a difference between current assets and current liabilities.
Thus: working Capital = Current Assets Less Current Liabilities
A deficiency in working capital may indicate liquidity problems in a business.
CHAPTER SUMMARY
- Financial statements are classified into Income Statement and Balance Sheet.
- A balance sheet shows the financial position of a business.
- The income statement shows in detail how the profit or loss in an accounting period
arises.
- A distinction is made in the balance sheet between non current liabilities and current
liabilities and between non current assets and current assets.
- Capital is what the business owes to the owner
- Current means within the coming one year from the balance sheet date. Current assets
are expected to be converted into cash within one year. Current liabilities are debts
payable within one year.
- The working capital of a business is the difference between its current assets and current
liabilities.
- The income statement is divided between Gross profit and Net profit.
31
EXERCISES
1. What is a balance sheet?
A. A list of all assets and liabilities of a business

B. A statement of the net worth of a business
C. A statement which shows how the net assets of a business have changed over
time.
D. A statement of the assets and liabilities of a business at a point in time in financial
terms.
2. Fill in the blanks
________________ and ________________ are examples long term liabilities.
3. Which of the following is not a current asset?
A. Machinery
B. Stock
C. Prepayments
D. Debtors
4 Working capital is another term for net assets. True or False?
5. Gross profit is best described as?
A. Sales less expenses

B. Invoiced sales less purchases of stock
C. Net profit less business overheads
D. Sales less cost of goods sold
6. Three sources of income other than the sale of goods which could appear in the income
statement are:
(i) ____________________________________
(ii) ____________________________________
(iii) ____________________________________
7. Four items which might be included in selling and distribution expenses are:
(i) ____________________________________
(ii) ____________________________________
(iii) ____________________________________
(iv) ____________________________________
32
SOLUTIONS TO ACTIVITY QUETIONS
ACTIVITY 3.6
MR BUJU
INCOME STATEMENT FOR THE YEAR ENDED 30 JUNE 20X4
K K K
Sales 280,000
Less returns inwards (5,000)
Turnover 275,000
COST OF SALES:
Purchases 135,000
Less: returns outwards (13,000)
122,000
Cost of purchases 133,000
Total cost of inventory 183,000
Less: Closing inventory (17,000)
(166,000)
Gross profit 109,000
Discount received 1,500
110,500
EXPENSES:
Discount allowed 2,000
Depreciation: fixtures & fittings 12,000
Rent 7,000
Rates 8,000
Insurance 10,000
Heating & lighting 12,000
Postage 500
Stationery 700
Telephone 400
Advertising 5,000
Bad debts 1,500
(98,100)
Net profit (transferred to Balance Sheet) 12,400
33
MR BUJU
BALANCE SHEET AS AT 30 JUNE 20 X4
Non Current Assets Cost Dep. N.B.V.

(K) (K) (K)
Fixtures & fittings 120,000 12,000 108,000
Current Assets
Inventory (closing) 17,000
Receivables 24,000
Cash in Bank 6,000
Cash in hand 300
47,300
Total Assets 155,300
Financed by:
Capital at start 121,900
Add: Net profit 12,400
134,300
Less Drawings (18,000)
116,300
Non current liabilities
5 year loan 20,000
Current liabilities
Payables 19,000
155,300
ACTIVITY 3.8
Snow White
Income Statement for the three months ended 31 August 20X5
K
Sales 10,000
Less cost of sales (6,200)
Gross Profit 3,800
Expenses:
Wages (3 x 100) 300
Van Rental 1,000
Van expenses (3 x 300) 900
Bad debts 250
Telephone and postage 150
Interest charges (3 x 25) 75
(2,675)
Net profit 1,125
34
SOLUTIOS TO EXERCISES
1. D, the balance sheet is only correct at a point in time
2. Loans, mortgages or debentures (any one of them).
3. A, machinery
4. False, working capital is another term for net current assets
5. D, cost includes direct expenses
6. Any of the following:
- Profit on sale of non current assets

- Discount received
- Rental income
- Interest or dividends received from investments.
7. Include
- Salaries of sales staff
- Commission to sales staff
- Travelling and entertainment of sales staff
Marketing costs
35
CHAPTER 3
REVENUE AND CAPITAL EXPENDITURE
INTRODUCTION
This chapter is very much linked to financial statements preparation. Certain items of
expenditure are shown in income statement and others in balance sheet and yet they are all
expenditure. Explanation is given so that users are not misled in their interpretation as they
make decisions.
The distinction between the two is very important as far as financial statement preparation is
concerned.
In addition distinction between capital income and revenue income is also covered.
TOPICS
1. What is capital expenditure?
2. Examples of capital expenditure
3. What is Revenue expenditure?
4. Examples of revenue expenditure
5. Treatment of capital and revenue expenditure in financial statements
6. Capital income with examples
7. Revenue income with examples
8. Treatment of capital and revenue income in financial statements
9. Explain why some expenditure is part capital & part revenue.
LEARNING OUTCOMES
At the end of this chapter you should be able to:
- Define capital and revenue expenditure giving examples

- Show how they are treated in financial statements
- Describe revenue and capital income and their treatment in financial statements.
- Describe why failure to distinguish the above may lead to distortion of financial
statements
36
CAPITAL AND REVENUE EXPENDITURE
Expenditure means spending money to acquire items. Items could be goods or services.
The type of item acquired is what is called capital expenditure or revenue expenditure.
4.1 Capital expenditure
When a business spends money to buy non current assets and subsequently adding value
to them is called capital expenditure. For example, acquiring land, buildings, vehicles
etc.
4.2 Adding Value
Adding value means spending money on an existing asset in order to improve its
performance or increase production capacity. E.g. carrying out renovations on machinery
in order to increase production capacity.
4.3 Other capital expenditure
Included in capital expenditure are amount spent on non current assets to put them in a
workable condition. Such amounts may include
- Transport costs to bring them into business premises

- Legal costs incurred in acquiring buildings
Any other costs incurred before non current assets could be put to use.
4.4 Revenue expenditure
This is expenditure incurred on the running of the business on a day to day basis as the
business is carrying on its trading activities. It is also incurred in maintaining the non
current assets.
Examples may include:
- Repairing machinery
- Replacing broken window panes to a building
- Electricity expenses in running machinery
- Petrol costs in running the vehicle
- Purchase of goods for resale
4.5 Warning
What is to be called capital or revenue expenditure will depend on what the business is
dealing in. If for example the business is buying and selling vehicles to make profits,
purchase of a vehicle will be revenue expenditure. But if it buys a vehicle to be used in
business, that will be capital expenditure.
37
EXAMPLE
Baobab is in business as a general retailer. He bought a vehicle for use in his business at a cost
of K2,000. In bringing the vehicle to his premises he incurred transport costs of K500, customs
duty of K700. Before he could use the vehicles, the vehicles had to be serviced and this costed
K50.
When the vehicle was in use, he insured it against theft and fire and this cost K100. In running
the vehicle fuel costs amounted to K150, and replaced tyres with new ones and this cost K70.
He decided to put in a musical system which cost K40. Insurance cover to bring the vehicle into
business premises amounted to K80.
Required:
(a) Identify items which are capital expenditure and what will be the cost the vehicle in the
books.
(b) Identify revenue expenditure
SOLUTION
K K
Capital expenditure Revenue expenditure
Cost of vehicle 2,000 Insurance charges 100

Transport costs 500 fuel costs 150
Customs duty 700 new tyres 70
Service charges 50 ___
Music systems 40 320
Insurance cover 80
______
Cost of vehicle 3,370
in books
ACTIVITY 4.1
Give reasons why expenditure in activity 4.1 has been identified to be capital expenditure and
revenue expenditure.
38
4.6 Joint expenditure
A builder was engaged to do some work on the business buildings. The whole work was
to cost K40,900 broken down as follows:
- K 30,000 to add an extension on building

- K 10,000 for wages of the builder for extension only
- K 900 to replace a few broken windows and some missing tiles.
The case above is an example of joint expenditure. In this case capital expenditure
should be separated from revenue expenditure. Thus
K 30,000 extension to building

K 10,000 wages
K 40,000 would be capital expenditure
4.7 Capital and revenue income
Income is proceeds coming into the business. Where income is coming from is what
would be identified as capital or revenue income.
(a) Capital income
Capital income are proceeds arising from the sale of non current assets and long
term investments. The profits or losses from the sale of non current assets are
included in the income statement for the year in which the sale took place.
Example: suppose a machinery is bought for K10,000, and four years later sold
for K8,000. The K10,000 would be treated as capital expenditure and K8,000
capital income. The loss K2,000 (10,000 8,000) would be shown in income
statement.
(b) Revenue income
This is income generated in the normal cause of running the business. Included
are:
- revenue from ordinary trading (sales)

- interest received
- dividends received
- discount received
- commission received etc.
ACTIVITY 4.2
A business obtains a loan from the bank to finance the purchase of a non current asset. The
business would be paying interest annually.
How would you identify the loan and loan interest? Is it capital or revenue income.
39
ACTIVITY 4.3
Classify each of the following items as Capital or Revenue expenditure or income.
(a) Purchase of leasehold premises

(b) The annual depreciation of leasehold
(c) Solicitors fee in connection with the purchase of leasehold premises
(d) The costs of adding extra storage capacity to a mainframe computer used in the business
(e) Computer repairs and maintenance costs
(f) Profit on the sale of an office building.
(g) Revenue from sales by credit card
(h) The cost of new machinery
(i) Customs duty charged on the machinery when imported into the country
(j) Carriage costs of transporting the new machinery
(k) The cost of installing the machinery in the business premises
(l) The wages of machine operators
4.8 Treatment of Capital and Revenue expenditure and machines in financial statements.
(a) Capital expenditure
Capital expenditure is shown in balance sheet under non current assets.
(b) Revenue expenditure and income
This is stated in the income statement
(c) Capital income
Capital income does not include raising capital from the owner(s) of the business,
or raising and repaying loans. These transactions add to the cash assets of the
business, thereby creating a corresponding increase in capital or loan. When the
loans is repaid, it reduces the liability (loan) and the asset of cash.
4.9 Incorrect treatment
If capital expenditure is treated as revenue expenditure or revenue expenditure is treated

as capital expenditure, then:
- Both balance sheet figures and income statement figures will be wrong
- Profit will be over stated if revenue expenditure is treated as capital expenditure
and non current assets will also be overstated
- Profit will be understated if capital expenditure is treated as revenue expenditure
and non current assets in the balance sheet will be understated.
40
CHAPTER SUMMARY
- Capital expenditure is money spent to acquire non current assets and adding value to
them, including expenditure incurred to bring the asset to the business premises.
- Revenue expenditure is related to running the business. For example, administration,

selling expenses etc. It is also expenditure on maintaining the earning capacity of non
current assets e.g. repairs.
Purchase of inventory and related expenses are also revenue expenditure
- Capital income arises from the sale of non current assets
- Revenue receipts is income generated in the process of trading
- Capital expenditure is shown in balance sheet and revenue expenditure in income

statement.
- Failure to distinguish capital and revenue expenditure will distort financial statements.
41
EXERCISES
1. Which of the following explains the distinction between capital and revenue expenditure?
A. Revenue expenditure is an expense in the income statement, capital expenditure is

an asset in the balance sheet.
B. Revenue expenditure is an expense in the income statement, capital expenditure is
a liability in the balance sheet.
C. Capital expenditure results in acquisition or improvement of non current asset,
revenue expenditure is incurred for the purpose of trade or to maintain the earning
capacity of non current assets.
D. Revenue expenditure results in the acquisition of or improvement of non current
assets, capital expenditure is incurred for the purpose of trade or to maintain the
earning capacity of non current assets.
2. The data below relates to F Jumas business, who is an engineer. This is for the financial
year ended 31 December 20X4.
(a) Purchase of extra milling machine (includes K50 for repairs of an old machine)
K1,700
(b) Rentals K250
(c) Electric expenses (includes new wiring K250, part of premises improvement)
K2,450
(d) Carriage inwards (includes K70 carriage on new cement mixer) K780
(e) Purchase of extra milling machine K2,100
Required:
Allocate each or part of the items mentioned to either capital or revenue expenditure
42
SOLUTIONS TO ACTIVITY QUESTIONS
ACTIVITY 4.1
- All expenses under capital expenditure are directly attributable to the purchase of
vehicle before it could be used in the business. The purchase of music system is
adding value.
- The other expenses are simply running expenses and are revenue expenditure.
ACTIVITY 4.2
Its neither capital nor revenue expenditure (see notes).
ACTIVITY 4.3
(a) Capital expenditure

(b) Revenue expenditure
(c) Capital expenditure
(d) Capital expenditure
(e) Revenue expenditure
(f) Revenue income
(g) Revenue income
(h) Capital expenditure
(i) Capital expenditure
(j) Capital expenditure
(k) Capital expenditure
(l) Revenue expenditure
SOLUTION TO EXERCISES
1. C
2. (a) K1650 capital expenditure

K50 repairs of old machine is revenue expenditure
(b) Revenue expenditure K250
(c) K250 wiring of part of improvement of premises is capital expenditure

2,200 is revenue expenditure
(d) Carriage on new mixer is capital expenditure K70
Carriage on goods for resale K710 is revenue expenditure
(e) Capital expenditure K2,100
43
CHAPTER 4
DOCUMENTATION
INTRODUCTION
Business activities are called transactions. The first record of a transaction is made on source
document that will serve as evidence of what took place on the material day.
In this chapter you will learn the types of documents that are in business use and essential
features of a document. Special emphasis will be put on the documents that are referred to when
making entries in books of account.
Learning Objectives
After you have studied this chapter, you should be able to:
Distinguish between internal and external documents

Mention the name of the document sent at each stage of business activities
List the essential part of a document
Explain the purpose of each accounting document: the Invoice, the credit Note and the
Debit Note
PURPOSE OF DOCUMENTS
Documents serve to provide evidence of transactions that took place. In the event of a dispute the
document will be referred to. If the dispute is not resolved and the matter is taken to court, the
document will be presented as legal evidence of what took place. Documents are also used by
auditors to verify the transactions that took place previously.
DOCUMENTING BUSINESS TRANSACTIONS
Business transactions can be between departments within the same organization or between two
separately managed organizations.
An external document is one that is sent between two or more organizations. Examples of such
documents are invoice, credit note and receipts. Documents may not necessarily be accounting.
Some documents are administrative in nature. Examples include Inquiry and Acknowledgement.
An internal document is one that is sent between two departments within the same organization.
The following are examples of internal documents:
Staff schedules
Supplier Lists
Inventory Lists
Goods Received Notes
Expense Claim Forms
The list above is not exhaustive. You should read more books to know more documents. It will
also be important to visit an organization to go and see samples of documents they handle in
their business.
44
ESSENTIAL FEATURES OF A BUSINESS DOCUMENT
Most documents will contain the following:

Name and address of the business
Name and address of the other business
Document serial number
Date of business activity
Description of the activity
Quantity, unit price and total amount of goods
Other details such as delivery address, references, Value Added Tax and discount terms.
It should be noted that the contents of a document will be determined by the purpose it will
serve. For example, an invoice will contain details of Value Added Tax whereas a delivery note
may not.
CIRCULATION OF DOCUMENTS
In practice most documents are prepared in duplicate. There are circumstances in which a
document should be prepared in triplicate depending on who require a copy for use and the
importance of keeping the document safely for future reference. Technology has also introduced
electronic documentation and it will be in order for those organizations that can afford to acquire
such systems, and comply with the relevant legal provisions.
ACCOUNTING USE OF DOCUMENTS
The seller often issues documents. When a buyer has issued a document, it merely serves as a
reminder for the seller to issue the relevant document.
An invoice is sent when goods are sold on credit. The seller uses duplicate invoices to compile a
record of all sales in the Sales Day Book. The original sales invoice is what the buyer will call
the Purchase Invoice. Therefore the buyer uses the original invoices to compile a record of all
purchases in the Purchases Day Book.
When the customer returns goods, the seller of the goods will send a Credit Note to evidence the
transaction. The seller will use the duplicate Credit Note to prepare the Sales Returns Day Book.
The buyer will use the original Credit Note to prepare the Purchases Returns Day Book.
Invoices are the source documents for the credit transactions that are recorded in the Sales Day
Book and the Purchases Day Book.
45
No. 979
Name of Organisation
INVOICE
Tel.
Fax.
P O Box
To. Date: ..
.
.
Unit Price Total Amount
S/No. DESCRIPTION QTY K n K n
TOTAL
Amount in words: ..
.
E& O E
Goods once delivered cannot be returned.
.
Receiver's signature Organisation official
46
Credit Notes are the source documents for credit transactions that are recorded in the Sales
Returns Day Book and the Purchases Returns Day Book.
No. 917
Name of Organisation
CREDIT NOTE
Tel.
Fax.
P O Box
To. Date: ..
.
.
Unit Price Total Amount
S/No. DESCRIPTION QTY K n K n
TOTAL
Amount in words: ..
.
E& O E
Goods once delivered cannot be returned.
.
Receiver's signature Organisation official
It can be seen from the specimen source documents on the preceding page that some documents
have certain details pre-printed as long as the details are standard to all situations. Other
documents may only have a structure and the details will be filled in according to the event.
Source documents are serially numbered and they always have to be signed by the person
preparing it and by the person checking the accuracy or authorizing the details on it.
More will be discussed on daybooks in the next chapter.
47
CHAPTER SUMMARY
You should now have learnt that:

Business transactions should be evidenced by documentation.
Documentation gives authority to account for the amounts involved in a transaction.
Documents provide a useful record for future reference and are presented as evidence to
auditors and court officials when settling a dispute.
A Debit Note is sent when there is an undercast in the original invoice. The buyer may
send a debit note together with the goods returned to remind the seller to send a credit
note in turn.
EXERCISE
Research on the documents retention policies of three organizations of your choice.
48
CHAPTER 5
RULE OF DOUBLE ENTRY AND THE JOURNAL

INTRODUCTION
Preparing accounts depends wholly on the application of the rule of double entry. Topics at
advanced levels adopt varied formats but that does not water down the importance of the rule. In
this chapter we will explain the rule of double entry at so early the stage that you will be able to
appreciate what it is and competently apply it to transactions as they are introduced in
subsequent chapters. Further, we also explain the Journal, a book of prime entry in which
transactions that do not have a regular day book are recorded.
TOPICS
1. The two Primary Concepts: The business Entity Concept and the Duality Concept
2. The Journal
LEARNING OBJECTIVES
Define and explain the implications of the business Entity Concept

Define and explain the implications of the Duality Concept
Trace the flow in each transaction and correctly debit the receiving account and credit the
giving account
Prepare journals for transactions
Entries in the books of prime entry are then posted to the ledger. The ledger is the main book of
account. To illustrate how this is done we will introduce the first two concepts that guide the
preparation of accounts: the Entity Concept and the Duality Concept. Subsequent to this we will
post entries that are trading in nature first then later on post entries that are administration.
1.0 TWO PRIMARY CONCEPTS
1.1 The Entity Concept
This concept states that a business is a separate entity or person from its owner. Like a biological
person the business can exercise rights to own assets and powers to borrow and incur liabilities.
At law the business (applied to limited liability companies) is a legal person. For accounting
purposes even an unincorporated entity is treated as a person separate from the owner who
formed it
The implication of this concept is that assets and liabilities of the business should be kept
separate from those of its owner. The student is in the position of the accountant for the business,
not for the owner of the business. He should view the owner as if he were an out side party or
entity.
49
1.2 The Duality Concept
This concept states that there are two aspects to every transaction:
a) the giving aspect, which creates a liability, and
b) the receiving aspect, which creates an asset.
It is from this concept that the rule of double entry is derived.
The rule of double entry states that for every debit entry to an account there is a corresponding
credit entry in another account. Corresponding means of equal magnitude in value.
Consequently to post transactions to the ledger, you debit the receiving account and credit the
giving account
What is given or received (the Flow) in a business transaction can be analysed as follows:
1 Goods: Are given/received in a credit transaction

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

Can be in the form of notes and coins
Can be in the form of cheques, electronic money transfers, etc
Cash account is involved when notes and coins are given/received
Bank account is involved when cheques, etc are involved
In all situations, the name of the second account affected by a transaction is deduced from the
name of the business activity that has been carried out, for example, sales, purchases returns,
rent, motor vehicles, etc.
50
The guidelines above can be presented in the form of a chart as follows:
THE
FLOW
GOODS CASH
For use in For Cash in the form Cheques, debit

business re-sale of notes & coins cards, EFTs,
The first account will be named after CASH BANK

the OUTSIDE ENTITY given in the ACCOUNT ACCOUNT
transaction
BUSINESS BUSINESS The second account will be named after

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

This is a book of prime entry in which transactions that are infrequent are recorded. Because of
their infrequence, the transactions are not provided with a separate day book. Such transactions
include the purchase of non-current assets, correction of errors and year end transfers and
adjustments. All these terms will be explained in subsequent chapters.
The mode of recording entries in the Journal, as it is loosely referred to, is to indicate the account
to debit and the account to credit plus a brief description of the business activity that took place.
The description of the transaction is called the narration.
51
2.1 STARTING A BUSINESS
The first journal written is the one when a business just starts. For example: Fix-it, a retired
engineer, received interest on his fixed deposit account of K 8 000 000. He opened a business
bank account.
The journal would be written as shown below:

Debit Credit
K 000 K 000
Bank account 8 000
Capital account 8 000
Being capital introduced in business by the proprietor.
The bank account represents the cash available to the business to finance business activities. The
capital account represents the amount the business owes its owner. In case of cessation of trading
activities, the business would pay the owner the amount shown on the capital account.
The owner injects funds into the business as initial capital. The capital is expected to grow (i.e
increase by the amount of profits he later makes through trading activities).
The journal above shows that bank account in the ledger will be debited, and capital account will
be credited.
2.1 A CONTINUING BUSINESS
The capital of a continuing business is derived from a given list of assets and liabilities.
Supposing a business had the following assets and liabilities at the start of business: Furniture
and fittings K5 245 000, Inventory K8 692 000, Cash at bank K8 000 000, Trade
Receivables: Chibuye K235 000; Mambwe K390 000, Rent prepaid K332 000, Loan K5 000
000, Trade Payables: Chibale K160 000; Mwape K164 000, Electricity due K221 000, Value
Added Tax outstanding K2 375 000; the journal would be written as follows:
DR CR
ASSETS: K 000 K 000
Furniture & Fittings 5 245
Inventory 8 692
Cash at Bank 8 000
Trade Receivables: Chibuye 235
Mambwe 390
625
Rent prepaid 332
LIABILITIES:
Loan 5 000
Trade Payables: Chibale 160
Mwape 164
324
Electricity due 221
Value Added Tax outstanding 2 375
52
Capital (Balancing figure) 14 974
TOTALS 22 894 22 894
The capital is obtained by deducting total liabilities from total assets. Suffice to mention here
that assets are debit balances and liabilities are credit balances as shown above.
2.2 PURCHASE OF A NON CURRENT ASSET
Other examples of transactions that by their nature would first be recorded in the journal are:
April 13. Received an invoice for the 10 ton truck bought on credit from L-Stone Motors K
40 000 000 gross
April 29. Paid L-Stone Motors K 10 000 000 by cheque for the truck bought earlier.
The entries in the journal for the above transactions would be:
Debit Credit
K 000 K 000
Motor Vehicles account 40 000
L-stone Motors account 40 000
Purchase on credit of a truck S/no. .
from L-Stone (Invoice No. .)
L-Stone Motors account 10 000

Bank account 10 000
Part payment for the truck S/no. .. which
was bought on credit.
2.3 ACTIVITY
April 22. Fix-it buys on credit a compactor to be used in road works from Kabamba
Construction for 42 000 000.
Write the journal for the above transaction.
Note: In practice the narration for the journal should be comprehensive enough to describe what
business transaction took place. All relevant reference documents should be quoted.
Journals will again be discussed in the chapter on correction of errors.
CHAPTER SUMMARY
The journal proper contains journals for transactions that are infrequent.
Each journal indicates how the amounts involved will be posted to the ledger accounts.
53
A journal should include a narration of the transaction, referring to relevant source
documents.
EXERCISES
1 Calculate the value of premises from the following balances of assets and liabilities:
K000
Premises ?
Trade Payables 5 600
Trade Receivables 8 250
Cash in Hand 4 520
Loan 9 000
Cash at Bank 6 440
Rates Prepaid 830
Salaries accrued 590
Machinery 7 250
Inventory at start 3 207
Capital 30 307
2 Write the journal entry for the following transactions:
Lily owns a truck which he wishes to use exclusively for business. The truck is worth
K 30 000 000. She obtains a loan from a bank of K 20 000 000.
54
Q1 The value of premises is K15 000 as shown in the working below
Working
DR CR
K 000 K 000
ASSETS:
Premises (balancing figure) 15 000
Machinery 7 250
Inventory 3 207
Cash at Bank 6 440
Cash at bank 4 520
Rates prepaid
LIABILITIES:
Salaries accrued 590
Loan 9 000
Capital 30 307
TOTALS 45 497 45 497
Q2 The journals would be:

DR CR
K 000 K 000
Motor Vehicles 30 000

Capital 30 000
Capital introduced in the form of a vehicle
Bank 20 000
Loan 20 000
Bank loan obtained on commencement of business.
55
CHAPTER 6
PREPARING BOOKS OF PRIME ENTRY
INTRODUCTION
Business activities are called transactions. There are three types of transactions:
(a) Cash transaction
(b) Credit transactions
(c) Account transfers
Cash transactions are those business activities in which cash is given or received. Cash may be
in the form of notes and coins or in the form of cheques, credit card and electronic funds.
Credit transactions are those business activities in which one person gives goods (or provides a
service) to another without the immediate exchange of cash.
Account transfers are transactions internal to the business and involve transfers of funds from
one account to another. They are usually handled at the end of the year and when correcting
errors that arise in the course of preparing ledger accounts.
Numerous as they are, transactions have been grouped into:
1) those involving trading goods and cash, and take place frequently,
2) those that are infrequent. Transactions that occur regularly are recorded in Day Books.
Those that rarely occur are recorded in the Journal Proper as their book of prime entry
(explained in the preceding chapter).
The structure of the day book is often determined by the type of information required by the user
(in this case, management). The information must be comprehensive when it comes to reporting
on business activities. In practice the day books may have more columns than are illustrated
below. Nevertheless, we will include here all columns that are relevant for accounting purposes.
In this and subsequent chapters we attempt to explain the preparation of books of accounts in
such a way that you will be able to develop the necessary competence and work in industry with
confidence.
BOOKS OF PRIME ENTRY CREDIT TRANSACTIONS
In this chapter we will explain how books of prime entry (Day books) are compiled for credit
transactions. Credit transactions include those for sales of goods on credit, purchases of goods on
credit, and returns of goods either to suppliers or by customers. In this type of transaction what is
given or received are goods (Refer to the chart in Chapter 2).
56
TOPICS
1. Preparing Sales Day Book

2. Preparing Sales Returns Day Book
3. Preparing Purchases Day Book
4. Preparing Purchases Returns Day Book
LEARNING OBJECTIVES
After you have studied this chapter, you should be able to

Explain the purpose of each day book
Prepare analytical day books
Mention the ledgers to which entries in each day book are posted
State the source document for entries in each day book.
1.0 ANALYTICAL SALES DAY BOOK
The sales daybook is a book of prime entry in which transactions of sales of goods on credit are
recorded. The source document for the entries in the sales daybook is sales invoice. The seller
prepares it in duplicate (or triplicate as is the practice in some organizations), issues the top copy
(the original) and retains the duplicate copy. The duplicate copy is used in the preparation of the
sales daybook.
1.1 ILLUSTRATION
The following transactions will be entered in the sales day book
April 1 Sold goods on credit to Chisakaila K 540 000 net. VAT is charged at the rate of
17.5 %.
April 5 Sold goods on credit to Ngosa K 800 000 net. The customer is entitled to
2% prompt discount if payment is made within 14 days.
April 13 Issued an invoice to Mulota K400 000 net.
April 15 Sold goods on credit to Mambwe K750 000 net.
SALES DAY BOOK

DATE CUSTOMERS FOLIO TOTAL VALUE ADDED TRADE OTHER
TAX RECEIVABLE RECEIVABLE
April K K K K
2005
1 Chisakaila 634 500.00 94 500.00 540 000.00
5 Ngosa 937 200.00 137 200.00 800 000.00
13 Mulota 470 000.00 70 000.00 400 000.00
15 Mambwe 881 250.00 131 250.00 750 000.00
TOTAL 2 922 950.00 432 950.00 2 490 000.00
57
The transactions are entered in strict chronological order as they occur. The names of
businesses are entered in the particulars or customers column. If the column were named
Customers then we would need a column for account numbers. The account number
column is not shown here for conveniences sake.
Value Added Tax has been calculated as follow: On the net figure 0.175 x K 400 000 =
K70 000. The total amount is the sum of the net figure and the Value Added Tax.
K 400 000 + 70 000 = K 470 000
When the invoice carries an entitlement of cash discount, Value Added Tax is calculated
on the value after deducting the discount. The tax authorities presume that the cash
discount will be taken up. Thus, value for Value Added Tax is K 800 000 x 0.98 = K784
000, and Value Added Tax is 784 000x 0.175 = K137 200. The gross amount is the sum
of the Value Added Tax and the original invoice value (not the value for Value Added
Tax).
1.2 JOURNAL ENTRY
Posting the totals to the ledger will be explained in the next chapter. For now it suffices to
mention that the two accounts identifiable from entries in the sales day book are:
DEBIT CREDIT
K K
Trade Receivable 2 922 950
Sales account 2 490 000
Value Added Tax account 432 950
1.3 FURTHER ANALYSES
The sales day book can further be analysed as:
a) Sales by product
b) Sales by geographical location. All these analyses are for management information, not
necessarily for posting to accounts in the ledger.
2.0 ANAYTICAL SALES RETURNS DAY BOOK
Sales returns day book is a book of prime entry in which goods initially sold on credit but are
now returned are recorded. The source document for goods returned is the credit note. The seller
prepares the credit note in duplicate and issues the top copy to the customer. The duplicate is the
one used to compile the sales returns day book.
2.1 ILLUSTRATION
April 7. Ngosa returned goods, K 200 000 net (He is entitled to prompt discount of
2 %)
April 17. We sent a credit note to Mambwe, K 150 000, net
58
SALES RETURNS DAY BOOK
DATE CUSTOMER FOLIO TOTAL Value TRADE OTHER
Added
April K K K K
2005
7 Ngosa 234 300.00 34 300.00 200 000.00

17 Mambwe 176 250.00 26 250.00 150 000.00
TOTAL 410 550.00 60 550.00 350 000.00
The commentary on Value Added Tax and prompt discount applies here too. A separate
section is included later on Value Added Tax. Value Added Tax will further be discussed
in much more detail in a later chapter.
3.0 ANALYTICAL PURCHASES DAY BOOK
The purchases daybook is a book of prime entry in which transactions of purchases of goods on
credit are recorded. The source document for the entries in the sales daybook is purchases
invoice. The supplier prepares the invoice in duplicate (or triplicate as is the practice in some
organizations), issues the top copy (the original) and retains the copy. The original top copy is
therefore used in the preparation of the purchases daybook.
3.1 ILLUSTRATION
April 12. Purchased goods on credit from Kunda K 282 000. The invoice stated a tax
inclusive amount.
40 000 000 gross
April 18. Purchased Goods on credit from Mwape K 270 000 gross value.
April 19. Received a bill for electricity from Zam Hydropower. The total of the invoice was
K 320 000
PURCHASES DAY BOOK

DATE SUPPLIER FOLIO TOTAL Value TRADE OTHER
Added
TAX PAYABLE PAYABLE
April K K K K
2005
12 Kunda 282 000.00 42 000.00 240 000.00
13 L-Stone Motors Ltd 40 000 000 .00 40 000 000.00
18 Mwape 270 000.00 40 212.76 229 787.24
19 Zam Hydropower 320 000.00 320 000.00
TOTAL 40 872 000.00 82 212.76 469 787.24 40 320 000.00
59
The amounts above are all tax inclusive. The amount of Value Added Tax is obtained as
follows:
K 282 000 x 7/47 = K 42 000 The net amount is the difference between the two figures,
ie K 282 000 K 42 000 = K 240 000
The column for other payables can be sub-divided into: Other Payables Expenses,
K 272 340.43 and Other Payables Non current Assets, K 40 000 000.00. In the
ledger these accounts have been referred to as L-Stone Motors and Zamhydro Power
Company, more specifically.
The Value Added Tax on the non-current asset is not claimable since the business is
taken as the final consumer of the motor vehicle that has been bought for use in business.
This is the reason why no tax is recorded in the column for Value Added Tax in respect
of the purchase for the motor vehicle.
When posting to the ledger, the payables accounts are credited with the gross amounts ( i.
e. tax inclusive figures). So there is need to accurately identify the amounts involved and
the specific names of payables who will be paid.
3.2 JOURNAL ENTRY
Posting the totals to the ledger will be explained in more detail in the next chapter. For now it
suffices to mention that the accounts identifiable from entries in the purchases day book are:
DEBIT CREDIT
K K
Purchases account 469 787.24
Value Added Tax account 82 212.76
Motor Vehicles 40 000 000.00
Electricity 320 000.00
Other Payables -Expenses 320 000.00

Other Payables Non-current Assets 40 000 000.00
Trade Payable account 552 000.00
Note that when a journal has been prepared correctly the total of amounts in the debit column
will always be equal to the total in the credit column. This is also a sign that you have understood
the principle of double entry.
3.3 FURTHER ANALYSES
The Purchases day book can further be analysed as follows: -
a) purchases by product
b) purchases by geographical location. Such analyses are for management information, not
necessarily for posting to ledger accounts in the ledger.
60
4.0 ANALYTICAL PURCHASES RETURNS DAY BOOK
Purchases returns day book is a book of prime entry in which goods initially bought on credit
but are taken back to the supplier are recorded. The source document for goods returned is the
credit note. The supplier prepares the credit note in duplicate and issues the top copy to us. The
original copy of the credit note is the one we use to compile the purchases returns daybook.
4.1 ILLUSTRATION
April 13 Returned goods worth K 42 600 to Kunda . This is a tax inclusive figure.
April 19. Received a credit note from Mwape for K 35 700 (gross amount).
PURCHASES RETURNS DAY BOOK

DATE SUPPLIER FOLIO TOTAL Value TRADE OTHER
Added
TAX PAYABLE PAYABLE
April K K K K
2005
13 Kunda 42 600.00 6 344.68 36 255.32

19 Mwape 35 700.00 5 317.02 30 382.98
TOTAL 78 300.00 11 661.70 66 638.30
The calculation of Value Added Tax is the same as explained for entries in the purchases
daybook.
The day books are mere listings of transactions that took place in the period. They are
maintained as memorandum information for future reference.
4.2 JOURNAL ENTRY
The amounts will be posted to the ledger as follows:

DEBIT CREDIT
K K
Trade Payables account 78 300.00
Purchases Returns account 66 638.30
Value Added Tax account 11 661.70
In the next section the cash book will be discussed as the day book for cash transactions.
61
4.3 CHAPTER SUMMARY
You should now have learnt that: -
Day books are records compiled and preserved for future reference
The invoice is the source document for preparing the sales day book and the purchases
day book
The credit note is the source document for preparing the Sales Returns Day Book and the
Purchases Returns Day book
The labels of analyses columns should be determined by the information needs of users
within the organization.
EXERCISES
1. Enter the following transactions in the appropriate day books. VAT is charged at the
rate of 17.5%.
a)
March 2. Sold goods on credit to Akabondo K 845 000 net.
March 8. Sold goods on credit to Mubita K 780 000 net. The customer is entitled to
2% prompt discount if payment is made within 14 days.
March 14. Issued an invoice to Mubiana K680 000 net.
March 16 Sold goods on credit to Mundia K750 000 net.
March 18. Akabondo returned goods, K 325 000 net (He is entitle to prompt discount of 2%)
b)
March 7. Purchased goods on credit from Siwale K 424 000. The invoice stated a tax
inclusive amount.
March 12. Received an invoice for the 10 ton truck bought on credit from Del Equipment
K40 000 000 gross
March 15. Purchased Goods on credit from Simpasa K 380 000 gross value.
March 19. Received a bill for electricity from Solarpower Co.The total of the bill was
K502000
March 22 Returned goods worth K 83 600 to Siwale . This is a tax inclusive figure.
April 24. Received a credit note from Simpasa for K 42 500 (gross amount).
2. Write the journals for the totals of the Day books you prepared in Question 1.
62
Q1 Total of Sales Day Book columns:

Trade Receivable K 3 571 295
Value Added Tax K 516 295
Other Receivables K nil
Total of Sales Returns Day Book columns:

Trade Receivables K 726 738
Other Receivables nil
Total of Purchases Day Book columns:

Trade Payables K 804 000
Sales Tax K 119 745
Other Payables NCA K 40 000 000
Other Payables Expenses K 502 000
Total of Purchases returns Day Book columns:

Trade Payables K 126 100
Q2 The journals would be written as follows:

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

Sales Returns Account 625 000
For the Purchases Day Book totals:

Purchases 694 255
For the Purchases Returns Day Book:

Purchases Returns Account 107 319
63
Non current assets (e.g Machinery) 40 000 000
Other Payables 40 000 000
Expense Account (e.g electricity) 502 000

Other Payables 502 000
64
CHAPTER 7
BOOKS OF PRIME ENTRY - CASH TRANSACTIONS
INTRODUCTION
In this chapter we will explain how to record cash transactions. Depending on what is given or
received, the first record can be in the Cash Account or in the Bank Account.
TOPICS
1 Analytical cash book

2 Cash Account Receipts and Payments
3 Bank Account Receipts and Payments
4 Summary
LEARNING OBJECTIVES
After you have studied this chapter, you should be able to

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

The cash book is a book of prime entry in which cash transactions are recorded. Cash
transactions are those in which goods are exchanged for cash in the form of notes and coins, or
are paid for using the cheque system and the debit cards (ATM Cards). Cash transactions
involving the exchange of notes and coins with goods are used to compile the cash account.
Transactions involving cheques are used to compile the bank account. A section on the bank
payment systems will be discussed in the chapter on bank reconciliation.
2.0 CASH ACCOUNT
The entries in the cash book are analysed by type of receipts and type of expenditure. Entries in
the cash account would be analysed as follows:
65
ILLUSTRATION
Fix-it, a retired engineer, received interest from his fixed deposit account of
K8 000 000. He opened a business bank account withdrew K3 000 000 for office use. The
following are the transactions for the first month of trading:
April 2005
April 1. Sold goods for cash K 540 000 net. VAT is charged at the rate of 17.5 %
April 4. Borrowed K 12 000 000 from Credit Funds Bank, cheque received same day
April 8. Paid wages in cash K 150 000
April 13. Cash sales K400 000 net.
April 13. Banked K200 000 from cash till.
April 14 Drew from bank for private use K 100 000
April 19. Paid cash for repairs to furniture K130 000
April 20. Cash purchases of stationery K150 000 (all tax-exempt).
April 22. Ngosa paid his account in full less 5% cash discount K 667 755.
April 25. Paid Salaries in by cheque K 300 000
April 26 Bought goods for re-sale in cash, K 246 750 gross.
April 28 Paid rent K 520 000 by cheque and received commission for selling scratch cards
K 270 000 by cash
April 29. Paid L-Stone Motors K 10 000 000 by cheque for the truck bought earlier.
April 30 Settled Kundas account by cheque, less cash discount of 5% K227 430.
Enter the transactions in the appropriate day books, post to the ledger and extract a trial balance
at the end of the month.
2.1 CASH BOOK ( CASH -RECEIPTS SIDE )
DATE PARTICULARS FOLIO TOTAL Value Added CASH TRADE OTHER LOANS
TAX SALES RECEIVABLES RECEIVABLES

APRIL K K K K K
1 Bank (c) 3 000 000
1 Sales 634 500 94 500 540 000
13 Sales 470 000 70 000 400 000
22 Ngosa 667 755 667 755
28 Commission rec. 270 000 270 000
30 TOTAL 5 042 255 164 500 940 000 667 755 270 000
The cashbook is the only book of prime entry that is also part of the ledger. The ledger is
the main book of account and will be discussed in much more detail in the next chapter.
The column for Other Receivables would further be analysed into, commission received,
rent received, etc. To be consistent if you use the term Other Receivables on the
receipts side of the cash book, then use Other Payables on the payments side.
The column for Trade Receivables capture amounts received from our customers as
payments on account. Value Added Tax is not calculated on amounts from customers
since it is already recorded in the sales daybook. Value Added Tax is, however,
66
calculated on cash sales and recorded in the Value Added Tax column for posting the
amount to the ledger.
The column headings are actually the names of accounts to which totals for each column
will be posted in the ledger. The accounts are nominal in the case of income, and are real
in the case of loans and non-current assets.
The cash book usually starts with a balance representing the cash that remained in the till
when the accounts for the preceding accounting period were prepared. This is the K 8 000
000 you can see in the cash book above. The balance at start is not a transaction and so it
will not be posted to any account in the ledger.
2.2 CASH BOOK ( CASH -PAYMENTS SIDE )
DATE PARTICULARS FOLI TOTAL Value CASH TRADE WAGES & REPAIRS STATIONERY
Added
TAX PURCH PAYABLES SALARIES

K K K K K
8 Wages 150 000 150 000
13 Bank 200 000
19 Repairs 130 000 130 000
20 Stationery 150 000 150 00
26 Purchases 246 750 36 750 210 000
30 Balance C/d 4 165 505

30 TOTAL 5 042 255 36 750 210 000 150 000 130 000 150 00
The payments side of the cash book is analysed into amounts paid to suppliers (Trade
Payables), amounts paid for expenses (e.g repairs) and amounts paid for non-current
assets bought for cash. The term Other payables would be used if payment was made as a
settlement of an outstanding amount owed to a supplier of a non-current asset, or to a
provider of a service on credit. The cash book would therefore have more columns in
practice than are illustrated above.
The column headings are actually the names of accounts to which totals for each column
will be posted in the ledger. The accounts are nominal in the case of expenses, and are
real in the case of trade payables and other payables.
Amounts transferred from the cash account to the bank account and vice versa are
marked with c, meaning contra entry. Two accounts are involved: the cash and bank
accounts, and so the double entry completes within the cash book. Such amounts are not
posted to any account in the ledger because the two accounts involved are already in the
cashbook
mention that the two accounts identifiable from entries in the cash book are: cash account
(the Total Column), purchases account, Value Added Tax account, repairs account,
wages and salaries, stationery and trade payables accounts.
67
3.0 BANK ACCOUNT
The Bank Account is also part of the cash book and entries in it are those for receipt of cheques
and payments by cheque or credit cards.The bank account is analysed much the same way the
cash account was done above.
3.1 CASH BOOK ( BANK -RECEIPTS SIDE )

APRIL K K K K K K
1 Capital 8 000 000
4 Loan 12 000 000 12 000 000
13 Cash 200 000
30 TOTAL 20 200 000 12 000 000
The column for other receivables would further be analysed into rent receivable,
commission receivable, etc. In practice there would also be columns for discount
allowed, capital and contra entries;
3.2 CASH BOOK ( BANK -PAYMENTS SIDE )
DATE PARTICULARS FOLIO TOTAL Value CASH TRADE WAGES & RENT MOTOR
Added
TAX PURCH PAYABLES SALARIES PAYABLE VEHICLES

K K K K K K
1 Cash c 3 000 000
14 Drawings 100 000
25 Salaries 300 000 300 000
28 Rent 520 000 520 000
29 L-Stone Motors 10 000 000 10 000 00
30 Kunda 227 430 227 430
30 Balance C/d 6 052 570
30 TOTAL 20 200 000 227 430 300 000 520 000 10 000 00
Accounts that are similar can be combined (eg wages and salaries). Rent payable and
motor vehicles are examples of other payables. In practice the payments side of the
cashbook would also have columns for drawings, discount received, and contra entries.
Amounts in the columns for contra entries are not posted to the ledger because double
entry is completed between the cash account and the bank account, both of which are
within the cash book itself.
At the end of the month (or year as the period of account may be), a balance is found
separately for cash account and for bank account. The total columns are used to find the
balance on each account. The balance represents the amount of cash remaining at the end
68
of the period of account and will be the opening balance for the cashbook of the
following period.
mention that the accounts identifiable from entries in the cash book above are: cash
account (total columns), Trade Receivables, sales account, other receivables account, and
loan account.
CHAPTER SUMMARY
You should now have learnt that: -
The cash book is compiled for all cash transactions and preserved for future reference
The receipts and cash payment requests are the source documents for preparing the Cash
book
The labels of analyses columns should be determined by the accounting information

needs of users within the organization.
The Cash Book is the only day book that is both a book of prime entry and a part of the ledger,
since it contains the Cash and Bank Accounts.
69
EXERCISES
1. Clatus
Clatus started business with K15 000 000 in his bank account and owned a truck worth
K30 000 000 which he intended to use exclusively for business purposes. The following
are his cash transactions for the month of March 2006:
March 1. 2006
March 2. Drew from bank for office use K 5 000 000
March 4. Paid rent in cash K 600 000
March 8. Bought furniture by cheque K 3 500 000
March 8. Drew cash for private use K 250 000
March 13. Cash sales K420 000 net. VAT is charged at the rate of 17.5 %
March 13. Bought stationery K350 000 for cash.
March 14 Sold goods for cash K 540 000 net. VAT is charged at the rate of 17.5 %
March 19. Paid cash for repairs to furniture K180 000
March 20. Paid delivery expenses in cash K630 000.
March 22. Mini-Finance Bank lent us K30 000 000 and paid Del Equipment K25 000
000 for the truck we earlier bought on credit.
March 25. Paid Salaries in by cheque K 800 000
March 26 Bought goods for re-sale by cheque, K 720 550 gross.
March 27 Settled Simpasas account of K337500 by cheque, less 2% discount
March 28 Paid rates K 330 000 by cheque
March 29. Paid in cash wages K 220 000, Solarpower for electricity K400 000
March 30 Akabondo paid K 400 000 on account.
Enter the transactions in the appropriate Cash book and find the closing balance at the end of the
month.
2. Refer to Question 1:
Prepare journal entries for the cash sale on March 13, the cash purchase on March 26 and the
supplier payment on March 27
70
QUESTION ONE
CASH BOOK (CASH-RECEIPTS SIDE)
DATE PARTICULARS FOLIO TOTAL Value CASH TRADE OTHER LOANS

Added
TAX SALES RECEVBLS RECEVBLES

March K K K K K
2 Bank (c) 5 000 000
13 Sales 493 500 73 500 420 000
14 Sales 634 500 94 500 540 000
30 Akabondo 400 000 400 000
31 TOTAL 6 528 000 168 000 960 000 400 000
CASH BOOK (CASH -PAYMENTS SIDE)

DATE PARTICULARS FOLI TOTAL Value CASH TRADE WAGES & RENT & STATIONERY
Added
TAX PURCH PAYABLES SALARIES REPAIRS

K K K K K
4 Rent 600 000 600 000
8 Drawings 250 000
13 Stationery 350 000 350 00
19 Furniture repairs 180 000 180 000
20 Delivery expnss 630 000
29 Wages 220 000 220 000
29 Solapwer -Elect 400 000
31 Balance C/d 3 898 000

31 TOTAL 6 528 000 220 000 780 000 350 00
CASH BOOK (BANK -RECEIPTS SIDE)

March K K K K K K
1 Capital 15 000 00
22 Loan 30 000000 30 000 000
31 TOTAL 45 000 000 30 000 000
71
CASH BOOK (BANK -PAYMENTS SIDE)
DATE PARTICULARS FOLIO TOTAL Value CASH TRADE WAGES & RATES OTHER
Added
TAX PURCH PAYABLES SALARIES PAYABLE PAYABLS

K K K K K K
2 Cash c 5 000 000
8 Furniture 3 500 000 3 500 00
22 Del Equipment 25 000 000 25 000 00
25 Salaries 800 000 800 000
26 Purchases 720 550 107 316 613 234
27 Simpasa 330 750 330 750
28 Rates 330 000 330 000
31 Balance C/d 9 318 700

31 TOTAL 45 000 000 107 316 613 234 330 750 800 000 330 000 28 500 00
Note: Some entries have not been extended in the analysis columns because of computer
field limitation.
QUESTION TWO
JOURNAL ENTRIES
K K
Bank 493 000
Sales 420 000
Cash sales with Value Added Tax at 17-1/2 %
Purchases 613 234

Bank 720 550
Cash purchases with Value Added Tax at 17.5%
Trade Payables (Simpasa) 337 500

Bank 330 750
Discount Received 6 750
Full settlement of a debt owed with 2% cash discount
72
CHAPTER 8
THE ANALYTICAL PETTY CASH BOOK
INTRODUCTION
Chapter 7 covered the three-column cashbook. The cashbook comprises a cash account, a bank
account and a cash discount column. This chapter covers the other type of cashbook called the
petty cash book. In this chapter we will discuss the purpose of the petty cash book, the way
entries are made and posted to ledger and the source documents used in preparation of the book.
We will also explain the operation of the imprest system and how it may differ with the
operation of the three-column cash book.
TOPICS
1) What is petty cash book

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

- Identify what should be paid out of petty cash.
- Prepare a petty cash voucher as a source document for entries in the petty cash book.
- Make appropriately entries in petty cash book, balance off at the end and post to the
ledger.
- Restore imprest in order to start a new period.
1. DEFINITION OF ANALYTICAL PETTY CASH BOOK
1.1 Analytical means the petty cash book is separated into columns for different categories of
expenses, for example,different columns for expenses relating to postage, stationery,
cleaning, and motor expenses.
1.2 Petty means small items of expenditure the business may incur in the course of its daily
operations.
Therefore, the analytical petty cash book could be defined as:
A book used by a business to record payments of small amounts in cash. The use of
cheques for such payments is considered to be uneconomical.
73
2. THE PURPOSE OF PETTY CASH
2.1 It is a common feature that almost in every business, there will be a number of small
expenses that have to be paid for cash, instead of other methods. To make these
payments, which could be on daily bases, a certain amount of cash has to be kept within
the business offices.
3. WHAT ARE PETTY CASH ITEMS?
3.1 These are payments for small expenses required in cash. It is important at this stage to be
mindful that what is a petty item will depend on nature and size of an organization, for
example, a giant mining company buying an office stapler would be petty item, but a
small school with may be 6 students a stapler would be a material item.
3.2 Different business institutions have different rules about what is to be paid out of petty
cash. Because of its nature, cash is highly open to abuse and requires responsible officers
to handle it. Management of the organization should specify who could receive money
out of petty cash.
3.3 The list of petty cash items should remain flexible for adjustment to include other small
items that may arise in due course.
3.4 If a list of petty items is not available, like in some businesses, the responsible officer in
charge of petty cash may rely on judgment, in consultation with the supervisor.
3.5 Petty cash items may include the following:
o Travel expenses for employees and refunds of the same

o Other expenses such as printing, stationery, milk, tea, stamps
o Fuel expenses
o Cleaning, just to mention a few
4. PERSONNEL, SECURITY AND CONTROL OF PETTY CASH
4.1 PERSONNEL
Cash by nature is highly open to misappropriation. It is for his reason that whatever
amount is involved, it must be entrusted in the hands of a responsible officer. For petty
cash this responsibility is given to a petty cashier. In the absence of petty cashier a
deputy can takeover the responsibility.
4.2 SECURITY
It is the responsibility of the petty cashier to ensure that:
(a) Petty cash is held in a safe place. It must be well secured in a lockable box (petty
cash box) with keys to it kept by the petty cashier. No one should be allowed access
to petty cash box apart from the petty cashier and any other authorized officer.
(b) He or she should be the only one to make actual payments of petty cash.
(c) All payments are fully and properly authorized and are being made for valid reasons
and intended purpose.
74
4.3 CONTROL
Petty cash should be used only for small items of expenditure and not for large expenses,
such as office furniture or airfares. Paying large amounts from petty cash would be an
obvious target for theft.
(a) To avoid such, it is important to monitor and control petty cash spending by ensuring
that all payments are properly authorized.
(b) There must be in place also a limit to petty cash payments. For example management
may decide that all petty cash payments should be limited to
K100 000 amounts more than the limit should be paid by other means, for
example by cheques.
(c ) Authorization for payments out of petty cash can be done by either the petty
cashier or Supervisor. The petty cashier could be allowed to authorize cash
payments up to a certain. Amount within the limit, say K40, 000 within the
K100, 000 limit. Amounts above that up to K100, 000 could be authorized
by supervisor or appointed person.
5. PETTY CASH EXPENDITURE (PETTY CASH VOUCHER)
5.1 The initial payment of record of payment is the petty cash voucher. The petty
cash voucher is prepared by the petty cashier whenever a payment is requested.
Petty cash vouchers are seriallynumbered slips in a padded booklet. The booklets
are obtainable from stationery suppliers. The following details are found on the petty
cash voucher:
o Description or details of payment i.e. item of expenditure, for example, 4 realms

A4 paper.
o The amount i.e. amount required for the item to be bought
o Name and signature of the one preparing the petty cash voucher (usually petty
cashier).
o Name and signature of the person authorizing payment (usually petty cashier or
supervisor depending on amount).
o Name and signature of the person to receive cash.
o The date when payment is made
o The voucher number
75
Example of petty cash voucher.
NO
PETTY CASH VOUCHER
DATE..
DESCRIPTION/DETAILS AMOUNT
PREPARED BY:
AUTHORISED BY:
RECEIVED BY:
5.2 RECEIPTS
A receipt is a document prepared by a person receiving money acknowledging that

money has been received for goods or services supplied.
A person buying items using petty cash must obtain a receipt from the supplier. The
receipt should be given to the petty cashier as evidence of purchases. The petty cashier
will then attach the receipt to the petty cash voucher as supporting document for
payment. The petty cashier can then record in the book that payment has been made.
5.3 RECEIPTS NOT AVAILABLE.
There could be certain requested payments, which cannot be backed up by a receipt, for
example, Taxi fares, bus fares. In these cases payment should be sanctioned by a
supervisor and properly authorized.
5.4 VALUE ADDED TAX RECEIPTS
If theres an amount for Value Added Tax in a payment, and the tax can be claimed from
Zambia Revenue Authority (ZRA), the receipt must show the following details:
o Total amount paid

o The tax paid
o The suppliers name, address and Value Added Tax registration number.
o The date of the transaction.
76
6. THE IMPREST SYSTEM
6.1 The imprest system is where a petty cashier is reimbursed what has been spent in order to
restore the petty cash float.
6.2 Float is the sum of money the petty cashier must start with at the beginning of every
month. Its decided by management and is usually fixed but can be adjusted to suit
current requirement.
Example of imprest system
The imprest amount (float) is K600, 000. During a particular month a total of
K450 000 was paid out of petty cash.
In the above situation, the petty cashier is remaining with K150, 000 in cash box,
therefore, in order to restore the imprest amount, the petty cashier will need
reimbursement or top up of K450 000 to restore the imprest amount.
Imprest amount K600, 000

Cash payments K450, 000
Balance K150, 000 Imprest system
Reimbursement K450, 000
Imprest amount K600, 000
IOUs AND PETTY CASH. (I OWE YOU)
7.1 Some organizations allow individuals to borrow money from petty cash, just for a short
period of time, say a day or two.
In such cases the petty cashier must prepare an IOU slip, which shows
o Amount borrowed
o Name and signature of borrower
o The date the amount is borrowed.
7.2 Example of IOU.
I OWE PETTY CASH K20, 000
MARY BANDA
20/02/07
IOU is a good as cash, and the document should be placed in cash box and be treated as
cash. When counting cash in cash box IOU must be added as cash equivalent.
Example cash and IOU.
The monthly petty cash float is K500, 000. During the month total expenditure amounted
to K285, 000 and an individual borrowed out of petty cash K35, 000.
77
At the time of balancing the petty cash book, the individual had not paid back the
K35, 000. How much cash is available at that time?
The following format will help you calculate the cash balance remaining.
Physical cash available xx

Plus IOU xx
Plus total expenditure xx
Equals imprest amount xx
For the above example, the solution is;
Imprest amount (float) 500,000

Less expenditure (285,000)
Physical cash available 215,000
Plus IOU 35,000
Petty cash balance 250,000
7.3 When the borrowed money is paid back, the petty cashier will put back the money in cash
box and remove IOU slip, which is torn as if nothing happened.
IOU should not be encouraged but if it happens, measures should be put in place to
control it. Employees who do not pay back are identified and amounts recovered from
their monthly salary through payroll.
8. RECORDING THE ANALYTICAL PETTY CASH BOOK
8.1 All payments before being recorded in petty cash book must be supported with petty cash
vouchers and receipts. It is highly recommended that the petty cash book be updated
(recorded) on daily basis in order to have accurate information on petty cash expenditure.
Balancing the petty cash book will depend on the volume of transactions for petty
expenditure. In busy organizations it can be every two weeks others on monthly basis.
Division of the petty cash book.
The petty cash book is divided into two parts, left and right hand sides.
o The left hand is the debit side. This side is used to record any cash received by
petty cashier.
o The right hand side is the credit side. This is where expenses in the period are
analysed.
o The analysis columns in petty cash book will vary depending on the
organizations pattern and nature of expenditure.
78
Example: Analytical petty cash book.
RECEIPTS (DR) PAYMENTS (CR)

Total Date Details Voucher Total Office Postage Cleaning Traveling Motor Ledger
DR No. CR Expense expense
8.2 Example : Preparing the petty cash book
Lakefield Ltd make use of a petty cash book as part of their bookkeeping system. The
following is a summary of the petty cash transactions for the month of time
20 X7.
June 1. Opening petty cash float received from K

Cashier 700,000
2. Cleaning material. 30,000
3. Postage stamps 25,000
4. Envelopes 10,000
June 8. Taxi fare 65,000

10 Petrol for company car. 100,000
14 Typing paper 80,000
15 Cleaning material 29,000
16 Bus fare 10,000
20 visitors lunches.. 45,000
21 Mops and bushes for cleaning. 56,000
23 Postage stamps. 15,000
27 Envelops 7,000
29 Visitors lunch. 60,000
30 Photo copying paper 95,000
You are required to draw up a petty cash book for the month using analysis columns for
stationery cleaning, entertainment, traveling and postage.
Show clearly the receipt of the amount necessary to restore the float and the balance
brought forward for the start of the following month.
79
SOLUTION
The Analytical Petty Cash Book
DR (K) CR(K)
Receipts Date Details V/n Total Stat Cleaning Entertt Travel Postage
700,000 Jun 1 Cash
Jun 2 C/Mat 1 30,000 30,000
Jun 3 Stamps 2 25,000 25,000
Jun 6 Envelops 3 10,000 10,000
Jun 8 T/Fares 4 65,000 65,000
Jun 10 Petrol 5 100,000 100,000
Jun 14 T/Paper 6 80,000 80,000
Jun 15 C/Mat 7 29,000 29,000
Jun 16 B/Fares 8 10,000 10,000
Jun 20 V/Lunch 9 45,000 45,000
Jun21 Mops/Brushes 10 56,000 56,000
Jun 23 Stamps 11 15,000 15,000
Jun 27 Envelops 12 7,000 7,000
Jun 29 V/Lunch 13 60,000 60,000
Jun 30 P/Paper 14 95,000 95,000
627,000 192,000 115,000 105,000 175,000 40,000
627,000 Jun 30 Cash
Bal c/d 700,000
1,327,000 1,327,000
700,000 Jul 1 Bal b/d
N.B
When petty cash is established and restored every month double entry is:
Dr-petty cash
Cr- Bank A/C (when money is withdrawn from bank in the above example:
Dr Bank A/C (Cash Book) Cr
June 1 Petty cash 700,000

June 30 petty cash 627,000
For expenses the petty cash book is used as on accumulative book for small expenses,
where each expense account is updated on monthly basis after they have accumulated.
As in example the double entry would be;
Dr Stationery A/C Cr
Dr Cleaning A/C Cr
K K
80
Dr Entertainment A/C Cr
K K
Dr Traveling A/C Cr
K K
Dr Postage A/C Cr
K K
N.B
When balancing the petty cash book, balance c/d and b/d is the actual imprest amount (or
float). The amount remaining with the petty cashier is not shown as part of balance. It
therefore means that, before balancing the petty cash book the cash spent should first be
reimbursed to the cashier, then put in petty cash box with the amount that remained. This
is restoring the imprest amount, which is the balance.
8.3 Petty cash payments with Value Added Tax.
If a petty cash transactions (i.e. receipts and payment) involves Value Added Tax,
Value Added Tax should be accounted for separately as long ass theres evidence of
Value Added Tax (i.e. Value Added Tax receipt).
Example: Value Added Tax receipt and petty cash record.
RECEIPTT S/No. (04) RECEIPT S/No. (05)
Date: 01.06.05 Date: 02.06.05
Amount Amount
K K
4 Reams A4 90,000 Repairs to computer
Paper 145,000
Value Added Tax 17.5% Add 17.5%
15.75 Value Added Tax
Total 105.75 25,375
170,375
The two Value Added Tax receipts will be recorded as follows in the petty cash book
81
PAYMENTS SIDE
Date Details V. No. Total Stationery Repairs Value

Added
Tax
02.06.05 4 Ream of 04 105.75 90,00 15.75
paper
02.06.05 Repairs 05 170.375 145,000 25,375
9. CHAPTER SUMMARY
You should have now learned that:
o Petty cash is used to make small payments.

o Petty cash must be kept safely in a lockable cash box.
o Because of its nature, for security reasons petty cash should be in the hands of a
responsible officer and that not every body in an organization is eligible for petty
cash.
o Petty cash is operated on an imprest system. This is where the petty cashier is
reimbursed what has been spent in order to restore the imprest amount.
Thus: FLOAT xx
Less expenditure xx
Balance xx
Reimbursement xx
FLOAT xx
o All payments out of petty cash must be fully authorized by signing on the
voucher.
o If theres no receipt (document) to support the claim, the petty cashier must
consult the supervisor.
o Entries made (recorded) in petty cash book originate from a document called
petty cash voucher.
o The petty cash book is used as an accumulative book for small expenses of
which the totals for the period are transferred to respective expense account in
general ledger.
o Petty cash expenditure involving Value Added Tax, should be recorded
separately in petty cash book with separate amounts in the Value Added Tax
column.
82
EXERCISES
1. What is the purpose of the petty cash book?

2. Who is responsible for maintaining cashbook?
3. What is the imprest amount (petty cash float)?
4. The petty cash book is maintained on a system called imprest system. What is imprest
system?
5. What is the source document for entries in petty cash book?
6. What is the division of the petty cash book?
7. The following petty cash transactions were recorded during the month of December
20x6.
1. Petty cash float was K400, 000 was obtained by withdrawal

of cash from the Bank.
2. Paid for stationary 10,800
4. Paid for sundry expenses. 21,700
6. Cash sales 30,000
9. Repairs to vehicles.. 42,500
10. Cash received from staff telephone calls 18,000
12. Paid for stationery.. 90,000
14. Paid for sundry expenses 28,200
19. Cash sales. 33,000
25. Paid for stationary 47,800
All expenses and income listed above are inclusive of Value Added Tax at 17.5%.
Required:
Record all the transactions in petty cash book and balance off as at 31 December 20x6 and
restore the imprest amount.
83
1. The purpose of petty cash book is to record small items of expenditure

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

Left side to record receipts
Right side to record payments.
7 PETTY CASH BOOK

DR(K) CR(K)
Net Recpt SalesTax Total Date Details V/N Total Station Repairs S/Exps Value Add
Tax
400,000 Dec 1 Cash
Dec 2 Station 1 10,800 9,191.50 1,
Dec 4 S/Exps 2 21,700 18,468.09 3,
25,531.92 4,468.08 30,000 Dec 6 C/Sales
Dec 9 Repairs 3 42,500 36,170.21 6,
15,319.15 2,680.85 18,000 Dec 10 Recpt/Phone
Dec 12 Station 4 90,000 76,595.75 13,
Dec 14 S/Exps 5 28,200 24,000.00 4,
28,085.11 4,914.89 33,000 Dec 19 C/Sales
Dec 25 Station 6 47,800 40,680.85 7
241,000 126,468.1 36,170.21 42,468.09 35,
160,000 Dec 31 Cash
Dec 31 Bal c/d 400,000
68,936.18 12,063.82 641,000 641,000
400,000 Jan 1 Bal b/d
84
CHAPTER 9
PREPARING LEDGER ACCOUNTS PART ONE
INTRODUCTION
In this chapter we will discuss how credit transactions recorded in the day books are posted to
the accounts in the ledger. The ledger is the main book of account. It is in this book that the rule
of double entry must be applied. At the end of the exercise of posting entries to ledger accounts,
the accounts are closed and balances extracted in the form of a trial balance. The trial balance is
then used to prepare the Income Statement and Balance sheet.
TOPICS
1. Preparing ledger accounts

2. Summary
LEARNING OBJECTIVES
Understand how to apply the rule of double entry to transactions

Post the entries in the day books to the ledger
1.0 PREPARING LEDGER ACCOUNT
With the guidelines in the preceding section we will use an exercise to illustrate how the rule of
double entry is applied to posting transactions to the ledger. First we will handle trading
activities and later on other operational activities. For convenience sake we have reproduced the
transactions and the day books we prepared in the previous chapter.
1.1 ILLUSTRATION
Fix-it, a retired engineer, received interest on his fixed deposit account of K 8 000 000 and
opened a business bank account. He immediately withdrew K 3 000 000 for office use. VAT is
charged at the rate of 17.5 %. The following are transactions for the first month of trading:
April 1. Sold goods on credit to Chisakaila K540 000 net.
April 5. Sold goods on credit to Ngosa K800 000 net. The customer is entitled to less 2 %
prompt discount if payment is made within 14 days.
April 7. Ngosa returned goods, K200 000 net (He is entitled to prompt discount of
2%)
April 12. Purchased goods on credit from Kunda K282 000. The invoice stated a tax
inclusive amount.
April 13. Received an invoice for the 10 ton truck bought on credit from L-Stone Motors
K40 000 000 gross
April 13. Issued an invoice to Mulota K400 000 net.
April 13 Returned goods worth K42 600 to Kunda. This is a tax inclusive figure.
April 15 Sold goods on credit to Mambwe K750 000 net.
85
April 17. We sent a credit note to Mambwe, K150 000, net
April 18. Purchased Goods on credit from Mwape K270 000 gross value.
April 19. Received a bill for electricity from Zam Hydropower. The total of the invoice
was K320 000
April 19. Received a credit note from Mwape for K35 700 (gross amount).
SALES DAY BOOK

DATE PARTICULARS FOLIO TOTAL VALUE ADDED TRADE OTHER
April K K K K
2005
1 Chisakaila 634 500.00 94 500.00 540 000.00
5 Ngosa 937 200.00 137 200.00 800 000.00
13 Mulota 470 000.00 70 000.00 400 000.00
15 Mambwe 881 250.00 131 250.00 750 000.00
TOTAL 2 922 950.00 432 950.00 2 490 000.00

April K K K K
2005
7 Ngosa 234 300.00 34 300.00 200 000.00

17 Mambwe 176 250.00 26 250.00 150 000.00
TOTAL 410 550.00 60 550.00 350 000.00
PURCHASES DAY BOOK

TAX PAYABLE PAYABLE
April K K K K
2005
12 Kunda 282 000.00 42 000.00 240 000.00
18 Mwape 270 000.00 40 212.76 229 787.24
19 Zam Hydropower 320 000.00 320 000.00
TOTAL 40 872 000.00 82 212.76 469 787.24 40 320 000.00
86
TAX PAYABLE PAYABLE
April K K K K
2005
13 Kunda 42 600.00 6 344.68 36 255.32

19 Mwape 35 700.00 5 317.02 30 382.98
TOTAL 78 300.00 11 661.70 66 638.30
1.2 LEDGERS
Explanatory notes follow after all the accounts have been written.
Note: All amounts on Debits and Credits are in Kwacha Currency.
TRADE RECEIVABLES
K K
Sales 2 922 950.00 Sales Returns 410 550.00
SALES
Trade Receivables 2 490 000.00
SALES RETURNS
Trade Receivables 350 000.00
TRADE PAYABLE
Purchases Returns 78 300.00 Purchases 552 000.00
OTHER PAYABLE - (Non Current Asset)
Motor Vehicles 400 000.00
OTHER PAYABLE - (Electricity)
87
PURCHASES
Trade Payable 469 787.24
MOTOR VEHICLES
Other Payable 40 000 000.00
ELECTRICITY
Other Payable 320 000.00
VALUE ADDED TAX
Payables 82 212.76 Payables 11 661.70

Trade Receivable 60 550.00 Trade Receivable 432 950.00
1.3 COMMENTS
In the accounts above credit transactions have been posted to the ledger. What was
given/received were goods. The names of the outside entities were given (see the day books
reproduced here also).
Sales on credit
The trade receivables account is debited with K 2 922 950.00 because it represents customers
who received the goods. The sales account represents the business we are doing accounts for and
it gave the goods. The credit is split between sales account and Value Added Tax account. The
Trade receivables are debited with the gross amount because the customers are expected to pay
the total amount of both the net value of goods and the Value Added Tax on them. The cash is
eventually received the Value Added Tax becomes payable to the Govt whereas the net amount
is kept by the business.
Sales Returns
The customers gave the goods they returned to us and so the trade receivable account is credited
with the gross amount of K 410 550.00. We received the goods and the account representing our
business, sales returns account, has been debited with the net amount whereas the associated tax
is debited to the Value Added Tax account as amount not payable to the govt.
Purchases on credit
The term purchases conventionally refer to goods bought for re-sale and so excludes purchases
of non current assets.
88
The double entry can be represented in the following journal:
DR (K) CR(K)
Purchases 469 787.24
Value Added Tax 82 212.76
Trade Payable (for goods) 552 000.00
Other Payable (Electricity) 320 000.00
The amount in the other payables electricity account is the gross amount because Value Added
Tax on this purchase has been ignored for simplicitys sake
The journal for the non current asset is : Debit the Motor Vehicles account (representing the
business, or the activity done) and credit the Other Payable Non Current asset account
(representing the giver, L-Stone Motors). The cost of the motor vehicle is gross because the
Value Added Tax component is not passed on to the customer. The vehicle is not for re-sale.
2.0 CHAPTER SUMMARY
By now you should have learnt that
The implication of the entity concept is important if you are to apply the rule of double
entry correctly
Proper accounting entries are made by applying the rule of double entry to transactions
without exception
Closing accounts is dependent on whether something is continuing about the fund in the
account or not
What can continue on an account is either the physical existence of an asset or the future
receipt/payment of cash.
EXERCISES
Refer to the Question bank at the end of Chapter 11.
89
CHAPTER 10
PREPARING LEDGER ACCOUNTS PART TWO
INTRODUCTION
In this chapter we explain how the rule of double entry is applied when posting entries from the
cash account and from the bank account (the cash book is part of the ledger also). It is important
to refer to the page with guidelines on identifying the flow, account to debit and account to credit
before you proceed.
TOPICS
1. Cash transactions
2. Posting entries in the cash book to the ledger
3. Summary
LEARNING OUTCOMES
Apply the rule of double entry to cash transactions

Post the entries in the cash book to the appropriate ledger accounts
Calculate Value Added Tax on cash purchases and cash sales
1.0 CASH TRANSACTIONS
With the guidelines in the preceding section we will use an exercise to illustrate how the rule of
double entry is applied to posting transactions to the ledger. This time we will handle cash
transactions. For convenience sake we reproduce the cash transactions and the cash book
compiled in chapter 5.
Fix-it, a retired engineer, received interest on his fixed deposit account of K8 000 000 and
opened a business bank account. He immediately withdrew K3 000 000 for office use. The
following are transactions for the first month of trading:
April 2005
April 1. Sold goods for cash K540 000 net. VAT is charged at the rate of 17.5 %
April 4. Borrowed K12 000 000 from Credit Funds Bank, cheque received same day
April 8. Paid wages in cash K150 000
April 13. Cash sales K400 000 net.
April 13. Banked K200 000 from cash till.
April 14 Drew from bank for private use K100 000
April 19. Paid cash for repairs to furniture K130 000
April 20. Cash purchases of stationery K150 000 (all tax-exempt).
April 22. Ngosa paid his account in full less 5% cash discount K667 766.
April 25. Paid Salaries by cheque K300 000
April 26 Bought goods for re-sale in cash, K246 750 gross.
April 28 Paid rent K520 000 by cheque and received commission for selling scratch cards
K270 000 by cash
90
April 29. Paid L-Stone K10 000 000 by cheque for the truck bought earlier.
April 30 Settled Kundas account by cheque, less 5% cash discount K227 430.
1.1 CASH BOOK (CASH -RECEIPTS SIDE)
DATE PARTICULARS FOLIO TOTAL VALUE ADDED CASH TRADE OTHER LOANS
APRIL
1 Bank 3 000 000
1 Sales 634 500 94 500 540 000
13 Sales 470 000 70 000 400 000
22 Ngosa 667 755 667 755
28 Commission rec. 270 000 270 000
30 TOTAL 5 042 255 164 500 940 000 667 755 270 000
1.2 CASH BOOK (CASH -PAYMENTS SIDE)
DATE PARTICULARS FOLIO TOTAL VALUE CASH TRADE WAGES & REPAIRS STATIONERY
ADDED
APR
8 Wages 150 000 150 000
13 Bank 200 000
19 Repairs 130 000 130 000
20 Stationery 150 000 150 00
26 Purchases 246 750 36 750 210 000
30 Balance C/d 4 165 505

30 TOTAL 5 042 255 36 750 210 000 150 000 130 000 15000
1.3 CASH BOOK (BANK -RECEIPTS SIDE)

APRIL
1 Capital 8 000 000
4 Loan 12 000 000 12 000 000
13 Cash 200 000
30 TOTAL 20 200 000 12 000 000
1.4 CASH BOOK (BANK -PAYMENTS SIDE)

DATE PARTICULARS FOLIO TOTAL VALUE CASH TRADE WAGES & RENT MOTOR
ADDED
TAX PURCH PAYABLES SALARIES PAYABLE VEHICLES
APR
1 Cash 3 000 000
14 Drawings 100 000
25 Salaries 300 000 300 000
28 Rent 520 000 520 000
29 L-Motors 10 000 000 10 000 0
30 Kunda 227 430 227 430
30 Balance C/d 6 052 570
30 TOTAL 11 272 000 227 430 300 000 520 000 10 000 0
91
2.0 POSTING TO THE LEDGER
Since the cash book is part of the ledger, the receipts are effectively on the debit side of the
cash/bank account, and payments are correspondingly on the credit side of the cash/bank
account. The ledger accounts which follow below therefore will carry only the other entry of the
double entry. Journal entries would also be written for each of the transactions, for example:
Debit: Cash a/c (in the cash book) K 270 000

Credit: Commission a/c K 270 000
TRADE PAYABLE
Bank 227 430
TRADE RECEIVABLES
Cash 667 755
COMMISSION
Cash 270 000
SALES
Cash 940 000
PURCHASES
Cash 210 000
WAGES
Cash 150 000

Bank 300 000
REPAIRS
Cash 130 000
STATIONERY
92
Cash 150 000
RENT
Bank 520 000
VALUE ADDED TAX

Trade Receivables 60 550.00 Trade Receivables 432 950.00
Cash 36 750.00 Cash 164500.00
LOAN
Bank 12 000 000
L-STONE MOTORS
Bank 10 000 000
2.1 COMMENTS ON ENTRIES IN THE ACCOUNTS
In the accounts above cash transactions have been posted to the ledger. What was
given/received was cash. The entries that would be in the trade receivables account and
trade payables account have not been reproduced accordingly.
The entries in the Value Added Tax account show that tax arise both from credit
transactions and cash transactions. The net of the credit entries and the debit entries is the
amount that becomes payable to the tax authorities.
The entry in the Lstone-Motors account is a part payment for the truck we bought on
credit from them (Refer to the entries in the Purchases Day Book in the previous chapter)
Note also that an account can capture both amounts from the cash and the bank accounts,
which are in the cash book.
In the next chapter we discuss how ledger accounts are closed for preparation of the trial balance
and eventually the financial statements.
93
3.0 SUMMARY
When cash is paid the cash account is credited and the account representing the activity is
debited
When cash is received the cash account is debited and the account representing the
activity is credited.
Where the cash is paid / received by an outside entity, then the account for that entity will
also be updated with the transaction.
94
CHAPTER 11
CLOSING ACCOUNTS AND EXTRACTING A TRIAL

BALANCE
INTRODUCTION
In the previous chapters we applied the rule of double entry to post original transactions to the
ledger. In this chapter we will move a step further and illustrate how accounts are closed and a
trial balance extracted.
TOPICS
1. Transfers to Income Statement (Trading & Profit & Loss account)

2. Transfers to the following period( Balance sheet items)
3. Extracting a trial balance
4. Summary
LEARNING OBJECTIVES
Identify accounts whose balances are reported in the income statement, and those whose
balances are reported in the balance sheet
Close accounts in the correct way and extract a trial balance accordingly
1.0 CLOSING LEDGER ACCOUNTS
Closing accounts is done prior to preparation of final accounts (Trading and Profit & Loss
account). Principally the income statement comprises these two accounts. The purpose of the
income statement is to provide a summary of accounts and reveal if the business made any profit
or loss on the activities carried out during the year.
At this stage it is important to note that a different set of transactions is handled. The
transactions are called transfers. Amounts are transferred either to the income statement if there
is nothing continuing on the account, or to the following year if there is something continuing.
What is said to continue on an account can either be payment or receipt of cash, or physical
existence of what the account represents.
1.1 NOMINAL ACCOUNTS
When handling transfers you should first note where the funds are in an account: debit or credit,
and then introduce an entry on the opposite side. Then complete double entry in one of the
accounts in the income statement or in the same account but of the following period of account.
Here is an example of how it is done (The ledger accounts have been reproduced from the
previous chapters and include both entries for cash and credit transactions):
95
SALES

Trading 3 430 000.00 Cash 940 000.00
3 430 000.00 3 430 000.00
SALES RETURNS
Trade Receivable 350 000.00 Trading 350 000.00
350 000.00 350 000.00
The entry described Trade Receivables completes double entry with the Trade Receivables
account. The entry described as Trading completes double entry with the trading account which
is a segment of the Income Statement. For example, the total of sales K3 430 000.00 is being
transferred to the Income Statement for reporting purposes. The transfer starts with a debit entry
in the Sales account and so it will end with a credit entry in the trading account of the Income
Statement.
1.2 REAL ACCOUNTS
Here is an example for transferring balances to the following period, and to be reported in the
balance sheet.
TRADE PAYABLE

Bank 227 430.00
Discount Received 11 970.00
Balance c/d 234 300.00
552 000.00 552 000.00
Balance b/d 234 300.00
Closing books would literally mean that accounts with something continuing on them are re-
opened in the books of the following period of account. We would have to transfer the unpaid
amount on the Trade Payables above to a Trade Payables account for the following month. The
transfer would start with a debit of K 234 300.00 described as Balance c/d above and end with a
credit entry in the Trade Payables account of the following period and described as balance b/d.
In the ledger we simply write the two entries on the same account: one above the total lines and
the other below the total lines but on the opposite side as can be seen above.
96
1.3 OTHER ACCOUNTS BELOW
The other accounts are closed according to the principle highlighted in 1.1 and 1.2 above.
Transfers to the Income statement can be either to trading account or to profit and loss account,
depending on whether the account has to do with goods or with services consumed respectively.
The account balances that are summarized in the balance sheet are closed by balance c/d and
balance b/d because on them there is some thing continuing to the next period: payment or
receipt of cash or physical existence of the asset and future use.
L-STONE MOTORS -(Other Payables)
Bank 10 000 000.00 Motor Vehicles 40 000 000.00

Balance c/d 30 000 000.00
40 000 000.00 40 000 000.00
Balance b/d 30 000 000.00
ZAM HYDROPOWER CO. - (Other Payables)
Balance c/d 320 000.00 Electricity 320 000.00
320 000.00 320 000.00
PURCHASES
Trade Payable 469 787.24

Cash 210 000.00 Trading 679 787.24
679 787.24 679 787.24
PURCHASES RETURNS
Trading c/d 66 638.30 Trade Payables 66 638.30
66 638.30 66 638.30
97
MOTOR VEHICLES
L-Stone Motors 40 000 000.00 Balance c/d 40 000 000.00
40 000 000.00 40 000 000.00
Balance b/d 40 000 000.00
ELECTRICITY
Zam Hydropower Co 320 000.00 Profit & Loss 320 000.00
320 000.00 320 000.00
DRAWINGS
Bank 100 000.00 Capital 100 000.00
100 000.00 100 000.00
TRADE RECEIVABLES

Cash 667 755.00
Discount All 35 145.00
Balance c/d 1 809 500.00
2 922 950.00 2 922 950.00
Balance b/d 1 809 500.00
COMMISSION
Profit & Loss 270 000.00 Cash 270 000.00
270 000.00 270 000.00
WAGES & SALARIES
Cash 150 000

Bank 300 000 Profit & Loss c/d 450 000.00
450 000 450 000.00
98
REPAIRS
Cash 130 000.00 Profit & Loss c/d 130 000.00
130 000.00 130 000.00
STATIONERY
Cash 150 000.00 Profit & Loss c/d 150 000.00
150 000.00 150 000.00
RENT
Bank 520 000.00 Profit & Loss c/d 520 000.00
520 000.00 520 000.00
VALUE ADDED TAX

Trade Receivable 60 550.00 Trade Receivable 432 950.00
Cash 36 750.00 Cash 164 500.00
609 111.70 609 111.70
LOAN
Balance c/d 12 000 000.00 Bank 12 000 000.00
12 000 000.00 12 000 000.00
Balance c/d 12 000 000.00
CAPITAL
Balance c/d 8 000 000.00 Bank 8 000 000.00
8 000 000.00 8 000 000.00
Balance c/d 8 000 000.00

99
DISCOUNT ALLOWED
Trade Receivables 35 145.00 Profit & Loss 35 145.00
35 145.00 35 145.00
DISCOUNT RECEIVED
Profit & Loss 11 970.00 Trade Payables 11 970.00
11 970.00 11 970.00
The amounts in the cash and bank accounts below are a summary of the entries in the cash book
prepared in the preceding chapter. Drawings are principally transferred to capital account
because in the balance sheet the amount of drawings is deducted from the balance on the capital
account.
BANK ACCOUNT
Total Receipts 20 200 000 Total Payments 14 147 430

Balance c/d 6 052 570
20 200 000 20 200 000
Balance b/d 6 052 570
CASH
Total Receipts 5 042 255 Total Payments 876 750

5 042 255 5 042 255
100
2.0 EXTRACTING THE TRIAL BALANCE
The trial balance is a schedule of account balances that help in the confirmation that the rule of
double entry was correctly applied. It is NOT an account to which amounts are posted to
complete double entry. When the Trial balance fails to balance it means that either the rule of
double entry was not applied accurately or errors have been made in the accounts. Correction of
errors is a subject of another topic. Only when the trial balance has balanced can the next step of
preparing the Income Statement and balance sheet be carried out.
2.1 HOW IT IS DONE
Amounts are listed on the trial balance on the side they appear or would appear below the total
lines on the account. For example, Value Added Tax of K429 598.94 is listed on the credit side
in the trial balance because it is on the credit side below total lines on the account in the ledger.
Purchases account balance of K679 787.24 is listed on the debit side of the trial balance because
the entry described as trading on the account would be on the debit side if it were written (by
extension) below the total lines on the ledger account itself. Alternatively, the transfer of funds to
Trading account will throw funds on the debit side of that account. It is that debit that is
effectively listed on the trial balance.
FIX-IT
TRIAL BALANCE AS AT 30 APRIL 2005
DR CR
Sales 3 430 000.00
Sales Returns 350 000.00
Trade Payables 234 300.00
L-Stone Motors 30 000 000.00
Zam Hydro Power Co. 320 000.00
Purchases 679 787.24
Purchases Returns 66 638.30
Motor Vehicles 40 000 000.00
Drawings 100 000.00
Commissioned Received 270 000.00
Wages & Salaries 450 000.00
Repairs 130 000.00
Stationery 150 000.00
Rent 520 000.00
Value Added Tax 429 598.94
Loan 12 000 000.00
Capital 8 000 000.00
Discount Allowed 35 145.00
Bank 6 052 570.00
Cash 4 165 505.00
______________ ______________
54 762 507.24 54 762 507.24
______________ _____________
101
CHAPTER SUMMARY
You have seen that to prepare ledger accounts that lead to a balancing trial balance you need to
be thorough when recording entries in the books of prime entry ( day books) and to apply the
rule of double entry to every transaction without exception. You also need to understand the
logic of account transfers to the income statement (profit and loss account), and transfers to the
same account but of the following period (balance c/d and balance b/d). These balances are the
amounts that are reported in the balance sheet as a summary of ledger account balances. The
challenge is all yours to master the application of the rule of double entry. You will convince
yourself that you have developed the competence if you manage to balance the illustrative
question again and the question in the exercises section of this chapter. Your progression will be
steady and sure if you do this.
SELF-TEST QUESTIONS
1. Re-attempt the whole exercise and see whether you can do it up Trial balance
2. What is the accounting treatment of discount allowed and discount received?
102
EXERCISES
Question 1
Lambdar started business with K15 000 000 in his bank account and owned a truck worth
K30,000 000 which he intended to use exclusively for business purposes. The following are his
cash transactions for the month of March 2006:
March 2005
March 2. Drew from bank for office use K5 000 000
March 2. Sold goods on credit to Akabondo K845 000 net.
VAT is charged at the rate of 17.5 %
March 4. Paid rent in cash K 600 000
March 7. Purchased goods on credit from Siwale K424 000. The invoice stated a tax
inclusive amount.
March 8. Bought furniture by cheque K3 500 000
March 8. Sold goods on credit to Mubita K780 000 net. The customer is entitled to
2 % prompt discount if payment is made within 14 days.
March 8. Drew cash for private use K250 000
March 12. Received an invoice for the forklift bought on credit from Del Equipment
K30 000 000 gross
March 13. Cash sales K420 000 net. VAT is charged at the rate of 17.5 %
March 13. Bought stationery K350 000 for cash.
March 14 Sold goods for cash K540 000 net. VAT is charged at the rate of 17.5 %
March 14. Issued an invoice to Mubiana K680 000 net.
March 15. Purchased Goods on credit from Simpasa K 380 000 gross value.
March 16 Sold goods on credit to Mundia K750 000 net.
March 18. Akabondo returned goods, K325 000 net (He is entitle to prompt discount of 2 %)
March 19. Received a bill for electricity from Solarpower Co. The total of the bill was
K502 000
March 19. Paid cash for repairs to furniture K180 000
March 20. Paid delivery expenses in cash K630 000.
March 21. We sent a credit note to Mundia, K300 000, net
March 22. Mini-Finance Bank lent us K30 000 000 and later the same day paid Del
Equipment K25 000 000 for the forklift we earlier bought on credit.
March 22 Returned goods worth K83 600 to Siwale . This is a tax inclusive figure.
March 24. Received a credit note from Simpasa for K42 500 (gross amount).
March 25. Paid Salaries in by cheque K800 000
March 26 Bought goods for re-sale by cheque, K 720 550 gross.
March 27 Paid Simpasas account in full by cheque, less 2% discount
March 28 Paid rates K330 000 by cheques.
March 29. Paid in cash wages K220 000, Solar power for electricity K400 000
March 30 Akabondo paid K400 000 on account.
Enter the transactions in the appropriate day books, post to the ledger and extract a trial balance
at the end of the month.
103
Question 2
Refer to Question 1: Prepare journal entries for the transactions on March 13, March 26
and March 27.
Question 3
Winwell owns a fast-food store, which is Value Added Tax registered. During the days
trading he entered into the following transactions:
A credit sale of K470 000

A cash sale of K200 000 net
A purchase for K700 000 list price net of Value Added Tax, less 20% trade discount
A returns outward was made for K150 000 list price from the same supplier.
At the start of the day there was nil balance on the Value Added Tax account. The rate of Value
Added Tax is 17.5%
What is the closing balance on Winwells Value Added Tax account following the above
transactions?
Question 4
At the beginning of February 20x6 Vumbi owed K7 200 000 to ZRA A summary of the
transactions of Vumbi plc , which is registered for Value Added Tax at 17.5%, shows the
following for the month of February 20x6:
Outputs (inclusive of Value Added Tax) K 122 610 000

Inputs (exclusive of Value Added Tax) K 78 857 000
During February 20X6 Vumbi paid ZRA K6 800 000. Calculate the amount owing to ZRA on 28
February 20x6.
104
SOLUTION ONE
(Note: In this solution some words have been abbreviated to their consonants only for
convenience)
1. LAMBDAR - CALCULATION OF CAPITAL

K K
Assets:
Cash 15 000 000
Motor Vehicle 30 000 000
45 000 000
Liabilities:
None __________
Capital 45 000 000
==========
JOURNAL ENTRIES
DR CR
March 8 Furniture 3 500 000
Bank 3 500 000
Purchases of office desk by cheque
March 12 Motor Vehicle 30 000 000

Del Equipment 30 000 000
Purchases of a Truck S/No on credit
March 22 Bank 30 000 000

Loan (Mini Finance) 30 000 000
Loan obtained from Mini Finance
March 22 Del Equipment 25 000 000

Bank 25 000 000
Part payment for the motor vehicle
bought on credit on 12 March 2006
SALES DAY BOOK

DATE CUSTOMERS FOLIO TOTAL VALUE ADDED TRADE OTHER
March K K K K
2006
2 Akabindo 992 875.00 147 875.00 845 000.00
8 Mubita 913 770.00 113 770.00 780 000.00
14 Mubiana 799 000.00 119 000.00 680 000.00
16 Mundia 881 250.00 131 250.00 750 000.00
TOTAL 3 586 895.00 531 895.00 3 055 000.00
105
DATE CUSTOMER FOLIO TOTAL VALUE ADDED TRADE OTHER
March K K K K
2006
18 Mubita 380 738.00 55 738.00 325 000.00

21 Mundia 352 500.00 52 500.00 300 000.00
TOTAL 733 238.00 108 238.00 625 000.00
PURCHASES DAY BOOK

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

Siwale 424 000.00 360 851.00
Simpasa 380 000.00 323 804.00
Total 804 000.00 684 255.00
2 Other Payables
Solarpower Co. 502 000.00
Del Equipment 30 000 000.00
Total 30 502 000.00

DATE SUPPLIER FOLIO TOTAL VALUE ADDED TRADE OTHER
TAX PAYABLE PAYABLE
March K K K K
2006
22 Siwale 83 600.00 12 451.00 71 149.00

24 Simpasa 42 500.00 6 330.00 36 170.00
TOTAL 126 100.00 18 781.00 107 319.00
106
CASH BOOK (CASH-RECEIPTS SIDE)
DATE PARTICULARS FOLIO TOTAL VALUE CASH TRADE OTHER LOANS
ADDED
TAX SALES RECEVBLS RECEVBLES
March K K K K K
2 Bank (c) 5 000 000
13 Sales 493 500 73 500 420 000
14 Sales 634 500 94 500 540 000
30 Akabondo 400 000 400 000
31 TOTAL 6 528 000 168 000 960 000 400 000
2.2 CASH BOOK (CASH -PAYMENTS SIDE)

DATE PARTICULARS FOLI TOTAL VALUE CASH TRADE WAGES & REPAIRS STATIONERY
ADDED
K K K K K
4 Rent 600 000
8 Drawings 250 000
13 Stationery 350 000 350 00
19 Furniture repairs 180 000 180 000
20 Delivery expnss 630 000
29 Wages 220 000 220 000
29 Solapwer -Elect 400 000
31 Balance C/d 3 898 000

31 TOTAL 6 528 000 220 000 180 000 350 00
3.1 CASH BOOK (BANK -RECEIPTS SIDE)
March K K K K K K
1 Capital 15 000 000
22 Loan 30 000 000 30 000 000
31 TOTAL 45 000 000 30 000 000
3.2 CASH BOOK (BANK -PAYMENTS SIDE)

DATE PARTICULARS FOLIO TOTAL VALUE CASH TRADE WAGES & RATES OTHER
ADDED
TAX PURCH PAYABLES SALARIES PAYABLE PAYABLS
K K K K K K
2 Cash c 5 000 000
8 Furniture 3 500 000 3 500 00
22 Del Equipment 25 000 000 25 000 00
25 Salaries 800 000 800 000
26 Purchases 720 550 107 316 613 234
27 Simpasa 330 750 330 750
28 Rates 330 000 330 000
31 Balance C/d 9 318 700

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

Trading 4 015 000 Cash 960 000
4 015 000 4 015 000
SALES RETURNS
Trade Receivable 625 000 Trading 625 000
625 000 625 000
TRADE PAYABLE
Purchases Returns 126 100 Purchases 804 000

Bank 330 750
Balance c/d 340 400
804 000 804 000

-------------------
Balance b/d 340 400
DEL EQUIPMENT - (Other Payables)
Bank 25 000 000 Motor Vehicles 30 000 000

30 000 000 30 000 000
SOLARPOWER CO.-(Other Payables)
Cash 400 000 Electricity 502 000

Balance c/d 102 000
502 000 502 000
Balance b/d 102 000
PURCHASES
Trade Payable 684 255

Bank 613 234 Trading 1 297 489
1 297 489 1 297 489
PURCHASES RETURNS

Trading c/d 107 319
107 319 107 319
108
MOTOR VEHICLES
Capital 30 000 000

L-Stone Motors 30 000 000 Balance c/d 60 000 000
60 000 000 60 000 000
ELECTRICITY
Solarropower Co 502 000 Profit & Loss 502 000
502 000 502 000
DRAWINGS
Cash 250 000 Capital 250 000
250 000 250 000
TRADE RECEIVABLES
Sales 3 586 895 Sales Returns 733 238

Cash 400 000

3 586 895 3 586 895
FURNITURE
Bank 3 500 000

3 500 000 3 500 000

WAGES & SALARIES
Cash 220 000

Bank 800 000 Profit & Loss c/d 1 020 000
1 020 000 1 020 000
FURNITURE REPAIRS
Cash 180 000 Profit & Loss c/d 180 000
180 000 180 000
STATIONERY
Cash 350 000 Profit & Loss c/d 350 000
350 000 350 000
109
RATES
Cash 600 000

Bank 330 000 Profit & Loss c/d 930 000
930 000 930 000
VALUE ADDED TAX
Trade Payables 119 745 Trade Payables 18 781

Trade Receivable 108 238 Trade Receivable 531 895
Bank 107 316 Cash 168 000
Balance c/d 340 400
718 676 718 676

Balance b/d 340 400
LOAN
Balance c/d 30 000 000 Bank 30 000 000
30 000 000 30 000 000
Balance c/d 12 000 000.00
CAPITAL
Motor Vehicles 15 000 000
Balance c/d 45 000 000 Bank 30 000 000
45 000 000 45 000 000
DELIVERY EXPENSES
Cash 630 000 Profit & Loss 630 000
630 000 630 000
DISCOUNT RECEIVED
Profit & Loss 6 750 Trade Payables 6 750
6 750 6 750
BANK ACCOUNT

45 000 000 45 000 000
CASH

6 528 000 6 528 000
110
LAMBDAR
TRIAL BALANCE AS AT 31 MARCH 2006
DR CR
K K
Sales 4 015 000
Sales Returns 625 000
Del Equipment 5 000 000
Solarpower Co. 102 000
Purchases 1 297 489
Purchases Returns 107 319
Electricity 502 000
Drawings 250 000
Furniture 3 500 000
Wages & Salaries 1 020 000
Repairs 1 80 000
Stationery 350 000
Rates 930 000
Loan 30 000 000
Capital 45 000 000
Delivery Expenses 630 000
Bank 9 318 700
Cash 3 898 000
84 954 846 84 954 846
SOLUTION 2
DR CR
Cash account 493 500
Sales 420 000
Cash sales with Value Added Tax
Purchases 613 234

Cash account 720 550
Cash purchases with Value Added Tax
Trade Payables -Cash 330 750

-Discount Rcvd 6 750
Cash 330 750
Settlement of amount owed to a supplier
111
SOLUTION 3
VALUE ADDED TAX
Trade Payables 98 000 Trade Payables 21 000

Trade Receivable 70 000
Cash 35 000
Balance c/d 28 000
126 000 126 000

Balance b/d 28 000
SOLUTION 4
VALUE ADDED TAX
Trade Payables 13 800 Balance b/d 7 200

Bank 6 800 Trade Receivable 18 261
Balance c/d 4 861
126 000 126 000

Balance b/d 4 861
112
CHAPTER 12
MORE ABOUT THE TRIAL BALANCE
INTRODUCTION
So far what has been covered in the previous chapters is the recording of transactions in the
books of original entry and posting to the ledger to complete double entry. The trial balance is
the next progression towards the preparation financial statements.
Before financial statements are prepared, it is important to carry out a test on the accuracy of
records in the books of the prime entry and the ledger.
TOPICS
1 What a trial balance is

2 Its format and preparation
3 Analysis of trial balance
4 Errors not disclosed by trial balance
5 Errors disclosed by trial balance
LEARNING OBJECTIVES
At the end of this chapter, one should be able to:
- Prepare trial balance from the ledger accounts

- Explain the use and purpose of trial balance
- Describe and explain why the trial balance totals are equal
- Identify and describe errors not disclosed by trial balance and errors disclosed by trial
balance.
7.1 THE TRIAL BALANCE
The word trial is taken from the word try. Which is an attempt, experiment or test to see
whether work done is satisfactory.
Therefore, a trial balance could be defined as a means of checking the correctness of a set
of accounts from the ledger.
It is prepared to check that the total of debit balances and credit balances are equal and
offer reassurance that double entry in the ledger is complete.
113
7.2 Trial Balance example
To understand clearly how the trial balance operates, let us do examples.
The following transactions of Big Brown, a sole trader, took place from 1 January to 31
December 20X5.
- Started business with capital in cash K10 000

- Deposited K8,000 cash into the bank
- Paid for rentals by cheque K250
- Bought goods and paid by cheque K400
- Paid for stationery in cash K75
- Sold goods and received cash K600
- Bought goods on credit from suppliers K575
- Paid wages by cash K325
- Sold goods on credit to customers K780
- Withdrew K50 cash for personal use
- Paid electricity by cheque K25
Required:
Open the necessary accounts and prepare a trial balance as at 31 December 20X5.
Solution
Dr. Cash account Cr.
K K
Capital 10,000 Bank 8,000
Sales 600 Stationery 75
Wages 325
Drawings 50
Balance c/d 2,150
10,600 10,600
Balance b/d 2,150
Dr. Bank account Cr.
K K
Cash 8,000 Rent 250
Purchases 400
Electricity 25
Balance c/d 7,325
8,000 8,000
Balance b/d 7,325
114
Dr. Capital account Cr.
K K
Cash 10,000
Dr. Rent account Cr.

K K
Bank 250
Dr. Purchases account Cr.

K K
Bank 400
Payables 575
Dr. Stationery account Cr.

K K
Cash 75
Dr. Sales account Cr.

K K
Cash 600
Receivables 780
Dr. Payables (Suppliers) account Cr.

K K
Purchases 575
Dr. Wages account Cr.

K K
Cash 325
Dr. Receivables (customers) account Cr.

K K
Sales 780
Dr. Electricity account Cr.

K K
Bank 25
Dr. Drawings account Cr.

K K
Cash 50
115
N.B. For every transaction a debit entry was also represented by a credit entry and vis
versa (double entry).
When preparing a trial balance, an account debited in the ledger will also be shown as a
debit in trial balance and an account credited in the ledger will be shown as credit in trial
balance.
A trial balance is not part if double entry. It is a memorandum statement.
Using the accounts in the ledger we can now prepare a trial balance. Thus:
Trial Balance as at 31 December 20X5
Dr. Cr.
K K
Cash in hand 2,150
Cash in bank 7,325
Capital 10,000
Rent 250
Purchases 975
Stationery 75
Sales 1,380
Payables 575
Wages 325
Receivables 780
Electricity 25
Drawings 50 ______
11,955 11,955
The order in which accounts appear in the trial balance does not matter, because it is not
mandatory that a business must prepare a trial balance.
7.3 Analysis of trial balance
In our analysis of the trial we shall look at what to debit and credit in trial balance using a
table.
Dr. Cr.
1 All assets 1 All liabilities
2 All expenses 2 All losses
3 Purchases 3 Sales
4 Sales returns 4 Purchases returns
5 Opening inventory 5 Capital
6 Drawings
Closing inventory does not appear in trial balance because it comes as an adjustment after
physical stock take. It is not a transaction, though inventory account is opened and
debited with value, because it is an asset remaining and will be shown as current asset in
balance sheet.
116
CHAPTER SUMMARY
- A trial balance provides reassurance that double entry book keeping has been done
correctly.
- A trial balance is just a memorandum statement; it is not part of double entry
- A trial balance is the first step in the preparation of financial statements, i.e. Income
Statement & Balance Sheet.
- A trial balance may have equal totals on debit and credit side; however, it does not reveal
all possible errors.
EXERCISES
1. What is a trial balance?
2. What are the uses of a trial balance?
3. The following information is extracted from the books of B Stepson, a sole trader, whose
financial year ends on 31 October 20X5.
K
Purchases 234,000
Sales 288,000
Light & heat 2,000
Advertising 3,000
Insurance 5,000
Bad debts 150
Rent 13,000
General 13,850
Drawings 8,000
Receivables 48,000
Payables 35,000
Returns outwards 350
Carriage inwards 780
Machinery 132,000
Discounts allowed 880
Required:
Prepare trial balance as at 31 December 20X5.
117
1. A trial balance is listing of balances taken from the ledger.
2. The use of trial balance is to provide reassurance that double entry is correct in
the ledger. It is also used for the preparation of financial statements.
3. B Stepson
Trial balance as at 31 December 20X5
Dr. Cr.
K K
Purchases 234,000
Sales 288,000
Light & heat 2,000
Advertising 3,000
Insurance 5,000
Bad debts 150
Rent 13,000
General 13,850
Drawings 8,000
Receivables 48,000
Payables 35,000
Machinery 132,000
543,135 543,135
118
CHAPTER 13
CONTROL ACCOUNTS
INTRODUCTION
In the chapters on posting to the ledger we discussed how to post entries to the Trade
Receivables and Trade Payables accounts. The amounts posted to those accounts were totals
from various day books. In this chapter we discuss how individual personal accounts of suppliers
and customers are maintained.
TOPICS
1. Manual and computer accounting systems

2. Need for control accounts
3. Posting to personal accounts
4. Posting to Control accounts
5. Errors and their correction
6. Summary
LEARNING OBJECTIVES
After you have studied this chapter you should be able to
Explain why control accounts are maintained by most large organizations

Post entries correctly to personal accounts in the Sales and Purchases Ledgers
Reconcile the control account balance with the sum of balances on personal ledger
accounts
1.0 ACCOUNTING SYSTEMS
A business can have a manual accounting system or a computerized accounting system.
In a manual system records are kept in the form of books. First transactions are recorded in ink in
the books of prime entry. Then at another time the entries in the day books are posted to the
ledger. The exercise becomes tedious when the organization grows big in size. Large numbers of
transactions would have to be posted to the personal accounts of suppliers and customers. The
need for computerizing the accounting system arises.
In a computerized accounting system the various stages of preparing accounting records are
electronically integrated. A transaction entered in a daybook will automatically post the entry to
the ledger accounts (assuming perfect integration). In this case the need to have control accounts
does not arise. There are computer systems in which the sales ledger and purchases ledger are
maintained as sub systems in relation to the general ledger. The balance on the trade receivable
or trade payable should then be reconciled with the sum of balances on personal accounts in the
subsystems.
119
1.1 PURPOSE OF CONTROL ACCOUNTS
Personal accounts of customers and suppliers are maintained so that the enterprise can send
account statements at the end of the month. The customers are provided with a way of
verifying the transactions and confirm the amounts due from them.
Similarly, at the end of the month we receive account statements from suppliers. We have to
verify the correctness of entries in the individual personal accounts of each supplier. We
will be able to identify payments to them that are not yet processed in their accounting
system.
Maintaining personal accounts of individual customers and suppliers is a conventional

practice that enable enterprises to identify errors that may have been made and correct them.
Ultimately they confirm amounts due on account receivables and accounts payables, and
report them in financial statements without undue delay.
1.2 COMPILING PERSONAL ACCOUNTS
Given below is a set of transactions we handled in a preceding chapter. We will this time post to
the Sales Ledger and the Purchases ledger to illustrate the use of control accounts. For
conveniences sakes we have reproduced the day books from which we will extract the entries to
personal accounts of customers and suppliers.
April 1. Sold goods on credit to Chisakaila K 540 000 net.

VAT is charged at the rate of 17.5 %
April 5. Sold goods on credit to Ngosa K 800 000 net. The customer is entitled to less 2
% prompt discount if payment is made within 14 days.
April 7. Ngosa returned goods, K 200 000 net (He is entitled to prompt discount of
2 %)
April 12. Purchased goods on credit from Kunda K 282 000. The invoice stated a tax
inclusive amount.
40 000 000 gross
April 13. Issued an invoice to Mulota K 400 000 net.
April 13 Returned goods worth K 42 600 to Kunda . This is a tax inclusive figure.
April 15 Sold goods on credit to Mambwe K 750 000 net.
April 17. We sent a credit note to Mambwe, K 150 000, net
April 18. Purchased Goods on credit from Mwape K 270 000 gross value.
April 19. Received a bill for electricity from Zam Hydropower. The total of the invoice
was K 320 000
April 19. Received a credit note from Mwape for K 35 700 (gross amount).
April 22. Ngosa paid his account in full less 5% cash discount.
April 30 Settled Kundas account by cheque, less cash discount of 5%
120
SALES DAY BOOK
April K K K K
2005
1 Chisakaila 634 500.00 94 500.00 540 000.00
5 Ngosa 937 200.00 137 200.00 800 000.00
13 Mulota 470 000.00 70 000.00 400 000.00
15 Mambwe 881 250.00 131 250.00 750 000.00
TOTAL 2 922 950.00 432 950.00 2 490 000.00

April K K K K
2005
7 Ngosa 234 300.00 34 300.00 200 000.00

17 Mambwe 176 250.00 26 250.00 150 000.00
TOTAL 410 550.00 60 550.00 350 000.00
PURCHASES DAY BOOK

TAX PAYABLE PAYABLE
April K K K K
2005
12 Kunda 282 000.00 42 000.00 240 000.00
18 Mwape 270 000.00 40 212.76 229 787.24
19 Zam Hydropower 320 000.00 320 000.00
TOTAL 40 872 000.00 82 212.76 469 787.24 40 320 000.00
DATE PARTICULARS FOLOI TOTAL VALUE ADDED TRADE OTHER

TAX PAYABLE PAYABLE
April K K K K
2005
13 Kunda 42 600.00 6 344.68 36 255.32

19 Mwape 35 700.00 5 317.02 30 382.98
TOTAL 78 300.00 11 661.70 66 638.30
121
1.3 POSTING TO THE SALES LEDGER
Posting to any ledger must always be guided by the rule of double entry. You have to trace
the flow of goods: who is giving and who is receiving. Even though you write one entry in
the control account, you still have to see the second entry in the other account mentally.
CHISAKAILA
Sales 634 500.00

634 500.00 634 500.00
NGOSA
Sales 937 200.00 Sales Returns 234300.00

Cash 667 755.00
Balance c/d nil
937 200.00 937 200.00
MULOTA
Sales 470 00.00

470 000.00 470 000.00
MAMBWE
Sales 881 250.00 Sales Returns 176 250.00

881 250.00 881 250.00
TRADE RECEIVABLES ACCOUNT BALANCES LISTING:

K
Chisakaila 634 500.00
Mulota 470 000.00
Mambwe 705 000.00
TOTAL 1 809 500.00
POSTING TO THE PURCHASES LEDGER

KUNDA

Bank 227 430.00
282 000.00 282 000.00
122
MWAPE
270 000.00 270 000.00
TRADE PAYABLES ACCOUNT BALANCES LISTING:

K
Mwape 234 300.00

TOTAL 234 300.00
The listings made of account balances in the sales and purchases ledgers agree with the total
balance on the corresponding total (control account) in the general ledger. The control
accounts are shown below accordingly
TRADE RECEIVABLES

Cash 667 755.00
Balance c/d 1 809 500.00
2 922 950.00 2 922 950.00
Balance b/d 1 809 500.00
TRADE PAYABLE

Bank 227 430.00
552 000.00 552 000.00
Let us suppose that the following errors were made in the account. We will show what the
balances would be on the accounts and the eventual correction of the errors.
1. The Value Added Tax amount on sales returns from Ngosa did not take into account the
entitlement to cash discounts. The mistake was made in the personal account only.
2. Discount allowed was not posted to the trade receivables account in the general ledger.
The calculation of Value Added Tax on sales returns from Ngosa is

200 000 x 0175 = 34 000
The Trade Receivables accounts would be drafted as follows:
123
TRADE RECEIVABLES

Cash 667 755.00
Balance c/d 1 844 645.00

2 922 950.00 2 922 950.00
Balance b/d 1 844 645.00
The account for Ngosa would be drafted as follows:

NGOSA
Sales 937 200.00 Sales Returns 234300.00

Cash 667 755.00
Balance c/d 300.00
937 200.00 937 200.00
Balance b/d 300.00
The account listing of the sales ledger would be as follows:

K
Chisakaila 634 500
Ngosa 300
Mulota 470 000
Mambwe 705 000
Total 1 809 800
CORRECTION OF ERRORS
It is important to note that errors occurred in different parts of the accounting records. The
balance that is affected is the one to correct. You should look at each error made and identify
how it affected the accounts. Correction may require reversing what was done or re-
calculation or amounts and posting the difference to the correct side of the ledger account.
Invariably you will be ill-equipped to correct errors if your grasp of double entry is weak.
The Sales Ledger Control account balance will be corrected as follows:

K
Balance on TR account 1 844 645
Less: Discount Allowed 35 145
Adjusted balance 1 809 500
The Sales Ledger Listing total of balances will be corrected as follows:
SL Listing 1 809 800

Less: Undercast in Sales Returns 300
Adjusted total 1 809 500
The two balances have been reconciled. Few errors have been used here for the sake of
simplicity so that the principles involved can be clearly understood.
124
CHAPTER SUMMARY
You should now have learnt that control accounts are a useful tool for detecting errors that may
have been made in the accounts. They make ready an account balance that will be reported in the
balance sheet without undue delay. Work done on individual accounts
by staff in the Sales Ledger section can be verified and possible fraud can be discovered.
Correction of errors should be done to the amount that was affected by the error.
EXERCISES
1. A manufacturing business had trade payables of K 6 500 000 outstanding at the

beginning of the year. There were also amounts due from suppliers of K 45 000. During
the year the following transactions took place:
K
Remittances to suppliers 34 000 000
Receipts for cash purchases 3 000 000
Contra agreements 70 000
Invoices from suppliers 42 000 000
Credit notes received 90 000
Debit notes from suppliers 20 000
Discounts for prompt payment 50 000
The amounts due from suppliers at the end of the year were K 63 000.
Write the trade payables account and determine the closing balances on account at
the end of the year?
2. Kenny trades with Cynthia with whom she both buys and sells goods on credit. At the
end of the financial year Kenny owes Cynthia K 150 000 and she owes him
K 130 000. They both agree to setting off the amounts outstanding.
What would be the contra entry in Kennys books?
a) Dr Trade Receivables with K 150 000

Cr Trade Payables with K 150 000
b) Dr Sales Account with K 150 000
Cr Purchases Account with K 150 000
c) Dr Purchases Account with K 130 000
Cr Sales Account with K 130 000
d) Dr Trade Payables Ledger with K 130 000
Cr Trade Receivables Ledger with K 130 000
125
3. For the month of October 20X5 Kawapes purchases totaled 225 600 with Value Added
Tax of K 33 840. The total of K 259 440 has been credited to the trade payables control
account as K254 940.
Which of the following adjustments is correct?
Control account List of trade payables balances
a. K 4 500 Credit No adjustment

b. K 4 500 Credit Increase by K4 500
c. K 29 340 Debit No effect
d. K 33 840 Debit Increase by K4 500
4. Ignatius had the following balances on his trade receivables and trade payables on 1
December 2006.
Customers owed K40 250 and he owed suppliers 26 423. Credit balances in the trade
receivables ledger amounted to K3 845 and debit balances in the trade payables ledger
amounted to K1 985.
During the month his daybooks showed the following totals:
Purchases 408 563

Sales 854 239
Returns inwards 44 271
Returns outwards 32 662
Payments to suppliers 300 912
Receipts from customers 675 843
Discounts received 9 027
Discounts allowed 20 275
Amounts written off to bad debts 13 173
Transfers between the receivables ledger and the payables
Ledgers 7 457
Rebates on customer invoices 3 244
Refunds of cash from suppliers 5 877
On 31 December 2006 amounts owed to customers were K2 119. Suppliers who owed
him amounts at start of the year had paid K1 525.
REQUIRED
Prepare a trade receivables control account and a trade payables control account,
showing the balances to carry forward to the following month.
126
1.
TRADE PAYABLE
K000 K000
Balance b/d 45 Balance b/d 6 500
Purchases Returns 90 Purchases 42 000
Bank 34 000 Purchases 20
Trade Receivables 70
Discount Received 50
Balance c/d 14 328
48 583 48 583
Balance b/d 14 328
2 d
3 a
4
TRADE RECEIVABLES
K K
Balance b/d 40 250 Balance b/d 3 845
Sales 854 239 Retuens inwards 44 271
Bank 675 843
Discount All 20 275
Bad debts 13 173
Balance b/d 2 119 Balance c/d 128 400
896 608 896 608
TRADE PAYABLE
K K
Purchases Returns 32 662 Purchases 408 563
Bank 300 912
Balance c/d 83 403 Balance c/d 460
48 583 48 583
Balance b/d 460 Balance b/d 83 403

(1985 1525)
127
CHAPTER 14
BANK RECONCILIATION
INTRODUCTION
The receipts and payments we make in our cash book are also recoded by the bank in there
books. The cash book contains the cash account and the a bank Account. The balance on the
bank account must be exactly equal to the amount the bank will show on the bank statement sent
to us at the end of the month. If the two balances are not the same then investigations should be
instituted to establish the causes of the difference. The cash book is thereafter updated with
entries that are on the bank statement but not in the cash book, and a bank reconciliation
statement is compiled for the entries that are in the cash book but are not on the bank statement.
LEARNING OBJECTIVES
By the end of this chapter you should be able to:
Explain the terms used in describing transactions processed through the bank account
To prepare a bank reconciliation statement
TOPICS
1. Why prepare a bank reconciliation statement

2. Terms in frequent use
3. Preparing a bank reconciliation statement
4. Summary
1.0 WHY PREPARE A BANK RECONCILIATION STATEMENT
To provide a means of internal control which the auditors can rely on.
To reveal the volume of transactions that the bank have not processed in their
accounting system by the end of the period under review, eg a month.
To correct the errors that may have been made in the accounting records.
To provide a verifiable balance at the bank that is to be included in the balance
sheet without any undue delay to the preparation of financial statements at the
year-end.
2.0 TERMS IN FREQUENT USE
Direct debits:
Amounts debited on the bank statement but are not on the cashbook bank account.
Consequently if we are to update our cashbook the amounts should be recorded
on the credit side as they represent payments made directly by the bank on our
behalf.
128
Direct credits:
Amounts credited on the bank statement but are not on the cashbook bank
account. When updating the cashbook the amounts will have to be recorded on the
debit side as they represent receipt of cash directly through the bank.
Standing order:
The name is derived from the activity that creates it. The business issues a
standing order to the bank by letter. The letter contains an instruction to the bank
to pay a specified fixed amount on a stated date at regular interval (eg quarterly).
When the time is due for the matter the bank acts on the standing order and pay
the amount. The amount is shown on the debit side of the bank statement and so
it will be recorded on the credit side of the updated cashbook.
Deposits not yet credited by the bank:
Such deposits are usually made on the last day of the month or year. The
processing of the deposit slips by the bank takes place the following day. So the
bank statement for the month or year under review does not show entries for such
deposits, even though they have already been recorded in the cash book.
Unpresented cheques:
These are cheques we issued to pay for goods or services but the cheques have not
been taken to the bank for cashing by the suppliers we paid. The cheques are
already recorded in our cash book but have not been reflected on the bank
statement.
Dishonoured cheques:
Cheques that once were received, recorded in the cash book but the bank refuses
to honour them for one reason or the other. Such cheques are returned to the
customer (trade receivable) who paid the amount, and the earlier receipt is
reversed.
129
3.0 PREPARING A BANK RECONCILIATION STATEMENT
The following exercise will illustrate how to prepare a bank reconciliation statement.
EXERCISE
The bank columns in the cashbook for May 2005 and the bank statement for that month
for G Hoglah are as follows:
CASH BOOK
Debit side Credit side
K000 K000
May 1 Balance b/d 3 250 May 6 Kundananji 165
May 8 R Mbewe 720 May 13K Mwila 454
May 17B Jere 685 May 17P Muma 38
May 29F Banda 372 May 30Daka Bowling 44
May 31D Phiri 582 May 31Balance c/d 4 908
5 609 5 609
BANK STATEMENT
2005 DEBIT CREDIT BALANCE

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

a) Write the cashbook up to date to take the above into account, and
then
b) Draw up a bank reconciliation statement as at 31 May 2005
1. Identify entries appearing on both the cash book and the bank
statement. The matching field is either the date or the description.
The amount should be matched last. These entries represent
transactions that have been processed in both sets of accounts
correctly.
2. Starting with the closing balance on the cash book, prepare an
updated cashbook by debiting amounts that appear in the credit
column of the bank statement, and vice versa.
3. Starting with the revised cashbook balance in step 2, prepare a
bank reconciliation statement. The amounts recorded in the
cashbook but not processed by the bank are reversed accordingly.
130
In practice more rigorous verification is done since a lump sum shown on the bank statement
may have to be broken down into several transactions and matching entries identified separately.
Extensive schedules of unmatched entries are prepared, and totals used for preparation of bank
reconciliation statements.
SOLUTION
UPDATED CASHBOOK
K000 K000
May 31Balance b/d 4 908 May 31Suwilanji 220
May 31Akazipo 85 May 31GYM Club 63
May 31Bank Charges 52
May 31Balance c/d 4 658
5 609 5 609
June 1 Balance b/d 4 658
The rationale of how entries are treated in the bank reconciliation statement is that cashbook
entries not processed by the bank are reversed. Thus payments made are added to the cashbook-
revised balance as if they were not made, and receipts are deducted accordingly:
BANK RECONCILIATION STATEMENT as at 31 May 2005

K000
Balance per updated Cashbook 4 658
Add: Unpresented cheques
Kundananji 165
Daka Bowling 44
209
4 867
Less: Deposits not yet credited
D Phiri 582
Balance per bank statement 4 285
The double entry for dishonoured cheques is similar to that done for bank charges when updating
the cashbook with entries that appeared on the bank statement but not in the cashbook:
DR CR
K000 K000
Bank charges 52
Bank account (in CB) 52
GYN Club 63
Bank account (in CB) 63
Trade receivables (Dishonoured cheque) 337

Bank account (assumed fig) 337
ACTIVITY: Write the journal for the traders credit made by Akazipo in the exercise above.
How would treatment of the entries in the bank reconciliation statement change if you started
with the balance as per bank statement?
131
CHAPTER SUMMARY
You have now learnt that: -
Bank reconciliation is mandatorily prepared because it is a form of internal

control that auditors will rely on to certify the verifiability of the bank balance
shown in the balance sheet.
Errors and unprocessed transactions can be revealed in the course of the bank
reconciliation exercise. Financial information is more reliable when it is free from
error.
EXERCISES
1. Your firms cash book shows a credit balance of K12 400 at 30 June 2005. Upon
comparison with the bank statement you determine that there are unpresented cheques
totalling K4 500, and a receipt of K1 400 which has not been passed through the bank.
The bank statement shows bank charges of K740 which have not been entered in the cash
book.
What is the balance on the bank statement?
2. Your firms cash book at 30 September 2005 shows a balance at the bank of K24 900. A
comparison with the bank statement at the same date reveals the following differences:
Unpresented cheques 8 400

Dishonoured cheques 1 400
Receipts not credited 4 700
Bank charges 500
Find the correct balance on the cash book at 30 September 2005
132
3. Trotters Grotto Ltd prepared the following summary of receipts and payments account for
the month of April 2006:
K000 K000
Receipts 1 478 Balance b/d 770
Balance c/d 662 Payments 1370
2140 2140
Trotters Grotto Ltd make all payments by cheques and all monies received are banked
immediately.
Before preparing bank reconciliation an investigation revealed the following:
a) The balance brought forward from March 2006 in the cash book should be
K750 000 and not K770 000
b) A cheque drawn for K128 000 for advertising had been incorrectly entered in the cash
book as K125 000.
c) Dividends received in the month of April of K89 000 were credited by the bank but
no entries were made in the cash book.
d) Business rates are paid directly by the bank under a standing order arrangement. An
amount of K120 000 was paid on 30 April 2006 and no entries have been made in the
cash book.
e) A cheque received from Kebby for K207 000 had been returned by the bank and
marked insuffficient funds. No adjustment has been made in the cashbook.
f) A cheque for K35 000 for miscellaneous consumables was entered in the cashbook as
a receipt instead of as a payment.
g) Cheques received totalling K807 000 had been entered in the cashbook and paid into
the bank, but had not been credited by the bank until 3 May.
h) Cheques drawn amounting to K345 000 had not been presented to the bank for
payment.
i) Bank service charges of K67 000 appearing on the bank statement have not been
entered in the cashbook.
REQUIRED:
i) Calculate the closing balance that should appear on the cashbook, taking into
account the appropriate information from the investigation.
ii) Prepare a bank reconciliation statement as at 30 April 2006.
133
Q1 K 10 040
Q2 K 23 100
Q3 UPDATED CASH BOOK
K000 K000
April 30Suspense 20 April 30 Bal b/d 662
April 30Dividend received 89 April 30 Suspense 3
April 30 Rates 120
April 30 Kebby 207
April 30 Suspense 70
April 30 Bank Charges 67
April 30 Balance c/d 1 020
5 609 5 609
May 1 Balance b/d 1 020
BANK RECONCILIATION STATEMENT

K 000
Balance per revised Cashbook (overdraft) 1 020
Add: Deposits not yet credited 807
1 827
Less: Unpresented cheques 345
Balance per Bank Statement 1 482
134
CHAPTER 15
BAD DEBTS AND ALLOWANCES FOR DOUBTFUL DEBTS
INTRODUCTION
This chapter covers how a business deals with bad debts and anticipated future discounts.
TOPICS
1 What are bad debts?

2 Accounting for bad debts
3 Treatment of bad debts in financial statements
4 Bad debts recovered, accounting and treatment in final accounts
5 Allowances for doubtful debts
6 Accounting for allowance for doubtful debts
7 Treatment of allowance for doubtful debts in financial statements
8 Accounting and treatment for allowance for discounts allowed
LEARNING OUTCOMES
When studying this chapter, one should be able to:
Describe and account for bad debts and the treatment in financial statements
Explain why allowance for doubtful debts are provided
Account for allowance for doubtful debts and how they are calculated.
15.1 BAD DEBTS
As a business grows in size, some of its sales may be made on credit. Customers will be
able to access the goods from the business and arrangement will be made when to settle
the amount.
By doing so the business is taking a risk because some customers may fail to pay for
various reasons which may include:
- Restrictions by a country to transfer cash (foreign exchange) to another country.

- The customers business may just close down (liquidated)
- Some customers may not be genuine and may just disappear without paying.
When a business fails to recover its money from credit customers, after making all
efforts, the amount is written off as a bad debt.
- Bad debts are a loss to the business.
When a business sells goods to a customer on credit, double entry is
DR. Customers account

CR. Sales account
135
The customers account will appear in the receivables ledger as an asset.
Example: Sale of goods on credit.
Beatle is in business as a wholesaler merchant.
During the year 20X6, on 1 November it sold goods on credit to one of its regular
customer Mr. Fix, for K276,000.
In sales or receivable ledger.
Dr. Mr. Fix account Cr.
K K
Nov. 1 Sales 276,000
In general ledger
Dr. Sales account Cr.
K K
Nov. 1 Sales 276,000
- Mr. Fix owes the business K276,000 and therefore, he is an asset to the
business by virtual of the amount owed.
- If at year end 31 December 20X6, Mr. Fix is still owing the amount, he
will appear together with others in balance sheet, under current assets as
Trade receivables.
- Mr. Fix account will be balanced as
20X6 K K
Nov. 1 Sales 276,000 Balance c/d 276,000
______ _______
276 000 276000
20X7
Jan. 1 Balance b/d 276,000
When the new year begins on 1 January 20X7, Mr. Fix is still a receivable
(debtor) with K276,000.
- Assuming Mr. Fixs credit period expires and the business fails to recover
the money, then the business has incurred bad debts.
136
15.2 ACCOUNTING FOR BAD DEBTS
Double entry:
DR. Bad debts account (in general ledger)

CR. Mr. Fix account (in sales ledger)
- Using the above example:
20X7 K K
Jan. 1 Balance 276,000 Bad debts 276,000
_______ ______
276,000 276,000
Dr. Bad account Cr.
K K
Mr. Fix 276,000
- Mr. Fix is no longer a receivable (debtor) to the business, so his account is closed
to bad debts which is a loss. The bad debts account will remain open throughout
the accounting period.
- Should some more customers fail to pay, their accounts will be closed off to the
same bad debts account.
- At year end when preparing financial statements, the bad debts account is
transferred to income statement as a charge against profits.
Double entry is:
Dr. Income statement (with total amount of bad debts)

Cr. Bad debts account
- Using Mr. Fix
Dr. Bad debts account Cr.
K K
Mr. Fix 276,000 Income Statement 276,000
_______ ______
276,000 276,000
137
NOTES:
- When adding receivables (debtors) in sales ledger Mr. Fix will not be
included as a receivable because his account has been closed off to bad
debts.
- When trial balance is extracted bad debts appear on debit side as an

expense.
15.3 BAD DEBTS DISCOVERED AT YEAR END
At the end of the accounting period, before financial statements are prepared, all accounts
in business books are reviewed for adjustment.
It may happen that after reviewing the receivables ledger and preparation of aged
receivables analysis, some receivables may be discovered bad. An adjustment must be
made for both receivables total and bad debts.
- When preparing financial statements, bad debts discovered at year should be

added to bad debts in trial balance to show total bad debts in income statement.
- In balance sheet, the receivables figure should be adjusted by reducing with the
bad debts just discovered.
15.4 BAD DEBTS RECOVERED
A debt previously written off may be recovered in full or partially.
Steps in recovery:
(a) The debt must first be reinstated to facilitate the recording of cash coming in.
DR. the receivable (Debtor) account

CR. Bad debts recovered account.
(b) When payment is received:
DR. Cash or Bank account

CR. Receivables (Debtors) account with amount received
Example: Bad debts recovered
A debt previously written off Mr. Fix K276,000 has now been fully recovered
with a payment by cheque.
138
K K
Balance b/d 276,000 Bad debts 276,000
_______ _______
276,000 276,000
Bad debts recovered 276,000 Bank 276,000
276,000 276,000
Dr. Bad debts recovered account Cr.
K K
Income statement 276,000 Mr. Fix 276,000
_______ _______
276,000 276,000
NOTES:
- The bad debts recovered account is closed off to income statement as

income. It will be added to gross profit.
- Sometimes cash may not be received immediately but reasonable

assurance is given that the amount will be paid. The debt should still be
reinstated but if at the balance sheet the amount is not yet received, the
debt must be included in total receivables figure.
15.5 ALLOWANCE FOR BAD AND DOUBTFUL DEBTS
Because of past experiences where some debts become bad, some organizations find it
more prudent to provide for future bad debts.
- An allowance for doubtful debts is a general estimate of the percentage of debts

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

owing % Doubtful doubtful debts
K K
Less than 30 days 11,300,000 1% 113,000
30 days less than 60 days 7,400,000 4% 296,000
60 days less than 90 days 2,500,000 6% 150,000
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Accounting for allowance for doubtful debts
(a) Upon creation:
Dr. Income statement

Cr. Allowance for doubtful debts account
NOTE: In income statement the provision is deducted from gross profit as an

expense.
Example:
The financial year of Mafuso ends on 31 December each year. On 31 December

20X7 receivables accounts totaled K50 000. It was decided to write off K5 000 as
bad debts. It is also estimated that 3% of the remaining receivables may
eventually prove to be bad and it is decided to make a provision for doubtful
debts.
In income statement
Dr. Income statement account (20X7) Cr.
K K
Expenses:
Allowance for doubtful Gross profit XX
debts 1,350
OR
Gross profit XX
Less: Expenses
Allowance for doubtful debts (1,350)
Dr. Allowance for doubtful debts account Cr.
K 31 Dec. 20X7 K
Balance c/d 1,350 Income statement 1,350
____ ____
1,350 1,350
1 Jan. 20X8 Bal. b/d 1,350
140
Balance sheet (extract) as at 31 December 20X7.
Current Assets
Receivables (50,000 5,000) 45 000
Less: Allowance for Bad Debts 1,350
43 650
NOTES:
- The allowance for bad debts account is closed off to balance sheet or by
bringing down the balance into the next account period, awaiting to be
used when bad debts occur.
- In balance sheet, the allowance is deducted from the total receivables

figures, in order to show what is expected to be received from the
receivables.
The prudence concept is at play in this case.
- It is also important to remember that allowance for bad debts are estimated
from good receivables (debtors). If receivables figure is inclusive of bad
debts, bad debts must be deducted before estimating for allowance for
provision for bad debts.
Using previous example:
Income statement K K
Gross profit XX
Less: Expenses
Bad debts 5,000
Allowance for bad debts 1,350
6,350
15.5.1 In subsequent years, adjustments may be made to the allowance for doubtful debts. The
allowance may increase or decrease due to economic factors which may change from
year to year.
(a) If increase in allowance for doubtful debts.
Compare the balance b/d in the allowance for doubtful debts account with the
newly calculated figure, the difference is the increase which should be charged to
income statement and added to allowance b/d from previous year.
- The new balance is always the figure to be deducted in balance sheet from
year end receivables.
Double entry will be as follows:
Debit: Income Statement (as expense)

Credit: Allowance for Doubtful Debts (with the increase)
141
Example
In 20X8, receivables in Mafuso amounts to K54,000 after deducting

K3,000 bad debts. It is decided to maintain the 3% allowance for bad
debts on receivables.
3% X K54,000 = K1,620
The increase from 20X7 is K270 (1,620 1,350).
In Income Statement:
Income statement (20X8) K K

Gross profit XXX
Less: Expenses:
Bad debts 3,000
Allowance for bad debts 270
3,270
K K
Balance c/d 1,620 Balance b/d 1,350
____ Income statement 270
1,620 1,620
Balance b/d 1,620
Balance sheet (20X8)
Current assets K K
Receivables 54 000
Less: Bad Debts 1,620
52 380
(b) If decrease in allowance for doubtful debts
Assuming in 20X9, the economic environment is very conducive for business and
most of the receivables are paying, the allowance for doubtful debts may be
reduced.
Example:
The allowance for doubtful debts has been in existence for the past two (2) years
in the books of Mafuso. At 31 December 20X9, receivables were K30,000. After
reviewing the receivables ledger it is discovered that K1,500 will not be recovered
and 3% allowance for doubtful be maintained on remaining receivables.
142
Receivables 30,000
Less: Bad debts (1,500)
28,500
Remaining receivables: 28,500 x 3% allowance = K855
Double entry when the allowance is reduced will now be the opposite.
Dr. Allowance for doubtful debts account (to reduce)

Cr. Income statement (add to gross profit)
NOTE:
The reduction is treated as income and is added to gross profit.
Where bad debts (expense) exist when the reduction takes place, it is advisable to
net off the two since they are related. Thus in given example, instead of adding
decrease to gross profit it will be:
K
Bad debts (Expense) 1,500
Decrease in allowance for
Doubtful debts (income) 765
735 to be shown as bad debt in income
statement
- showing bad debts and allowance for bad debts separately.
Dr. Allowance for bad debts account Cr.
K K
Income statement 765 Balance b/d 1,620
Balance c/d 855
____ _____
1,620 1,620
Balance b/d 805
Income Statement (20X9) K K
Gross profit XX
Add: other income
Decrease in provision for doubtful debts 765
XX
Less: Expenses
Bad debts 1,500
143
15.5.2 When bad debts are incurred where allowance for doubtful debts exists.
Remember the purpose of allowance for doubtful debts is to accommodate future bad
debts. So when bad debts are incurred when an allowance for it exists. Double entry is:
DR. Allowance for doubtful debts account (with amount of bad debt)
CR. Bad debts account
Example: Transferring bad debts to allowance for doubtful debts account.
Expert builders has total receivables amounting to K268,000 as at 31 December 20X7. It

is discovered that of this amount K18,000 is not recoverable and should be written off as
bad debts. At 1 January 20X7, a balance of K27,800 was brought forward from 20X6 in
allowance for doubtful debts.
It is believed that of the remaining receivables 10% may not pay.
Dr. Receivables account Cr.
K K
Balance 268,000 Bad debts 18,000
Balance c/d 250,000
______ _______
268,000 268,000
Balance b/d 250,000
Dr. Bad debts account Cr.
K K
Receivables 18,000 Allowance for doubtful
debts 18,000
_____ _____
18,000 18,000
K K
Bad debts 18,000 Balance b/f 27,800
Income statement 15,200
Balance c/d 25,000 _____
43,000 43,000
Balance b/d 25,000
NOTES:
- Bad debts K18,000 is a charge against the allowance for doubtful debts.
- The net charge is K15,200 (18,000 2,800) to income statement.
144
If the amount of allowance is not enough for bad debts suffered, the remainder
will be charged against profits in that year.
15.6 ALLOWANCE FOR CASH DISCOUNTS ON RECEIVABLES.
This is an allowance created to accommodate future cash discounts on receivables. It is

treated exactly like allowance for doubtful debts in terms of how it is accounted for.
The estimate of discounts to be allowed should be based on the net figure of receivables
after deducting allowances for doubtful debts.
Example: Allowance for cash discounts
The following information is available in the books of Home Made Furnishers Ltd as at
30 June, end of each financial year.
Year ended 30 Receivables Allowance for Allowance for

June K doubtful debts cash discounts
K %
20X6 20,000 1,000 3

20X7 25,000 1,250 3
20X8 23,000 1,200 3
20X6 K20,000 - 1,000 = 19,000 X 3% = 570

20X7 K25,000 - 1,250 = 23,750 X 3% = 713
20X8 K23,000 - 1,200 = 21,800 X 3% = 654
Dr. Allowance for cash discounts on receivables account Cr.
K K
20x6
Balance c/d 570 Income statement 570
570 570
20x7
Balance c/d 713 Balance b/d 570
___ Income statement 143
713 713
20x8
Income statement 59 Balance b/d 713
Balance c/d 654 ___
713 713
Balance b/d 654
145
Income Statement
K K
Gross profit for (20X6, 20X7, 20X8) XX
Expenses:
20X6 Allowance for discounts allowed (570)

20X7 Increase in allowance for discounts allowed (143)
(20X8) Add decrease in allowanced for discounts 59
In Balance Sheet
Current Assets K
20X6 Receivables (20,000 1,000 - 570) 18,430
20X7 Receivables (25,000 1,250 713) 23,037
20X8 Receivables (23,000 1,200 654) 21,146
146
CHAPTER SUMMARY
- Bad debts are amounts a business fails to recover from receivables
- Bad debts are expenses and are charged to income statement
- Bad debts recovered are debts previously written off but have been recovered. They are a
gain and are added to gross profit in income statement.
- Allowance for doubtful debts are amounts set aside from profits to meet future bad debts.
- Allowance for doubtful debts balance is deducted from receivables figure in balance
sheet.
- Specific allowance for doubtful debts must be deducted from the receivables figure
before calculating general allowance for doubtful debts. However, in balance sheet the
total allowance will be specific plus general.
EXERCISES
1. What is double entry to write off bad debts?
2. What is double entry for bad debts recovered?
3. What is double entry for allowance for doubtful debts?
4. What is double entry for decrease in allowance for doubtful debts?
5. Bird Cage has total receivables balances outstanding at 31 December 20X6 of K28,000.
She believes that about 1% of these balances will not be paid and wishes to make an
appropriate allowance.
Before now, she has not made any allowance for doubtful debts at all.
On 31 December 20X7, her receivables balances amount to K40,000. Her experience

during the year has convinced her that an allowance of 5% should be made.
What accounting entries should she make on 31 December 20X6 and 20X7 and what
figures for receivables should appear in her balance sheets as at those dates.
147
1. Dr. Income Statement

Cr. Bad debts account
2. Dr. Receivables account

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

Cr. Receivables account
3. On creation or increase in allowance for doubtful debts.
Dr. Income statement

Cr. Allowance for doubtful debts account
4. When allowance for doubtful debts reduces
Dr. Allowance for doubtful debts account

Cr. Income statement.
5.
K K
Balance c/d 280 20X6
Income statement 280
280 280
20X7
Balance b/d 280
Balance c/d 2,000 Income statement 1,720
2,000 2,000
Balance b/d 2,000
In balance sheet
20X6 Receivables (K28,000 280) K27,720

20X7 Receivables (40,000 2,000) K38,000
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CHAPTER 16
PREPAYMENTS AND ACCRUALS
INTRODUCTION
The income statement of a business measures the profit by considering revenues earned and
expenses incurred in an accounting year.
Sales less cost of sales equals Gross Profit.
Gross profit less expenses equals net profit. The precise amount of net profit is calculated on the
accruals or matching concept.
TOPICS
1. What are accruals

2. Ledger accounting for accruals
3. Treatment of accruals in financial statements
4. What are prepayments
5. Ledger accounting for prepayments
6. Treatment of prepayments in financial statements
LEARNING OUTCOMES
At the end of the Chapter, you should be able to:
To prepare expense account and interpret balance brought down as an accrual or

prepayment.
To adjust expenses for accruals and prepayments in income statement
To prepare income account with adjustment for amounts owing and prepaid
To show accruals and prepayments appropriately in balance sheet.
16.1 ACCRUALS
The accruals concept states that income and expenses should be included in the income
statement of the period in which they are earned or incurred and not paid or received.
Example
A business rents a shop for K1,200 per annum (K100 per month). If at year end, the
business has only paid K1000, a full years charge of K1,200 will be expensed in income
statement. The K200 though not paid will be included because it relates to the same
period.
Accruals or accrued expenses are expenses which are charged against the profits of a
particular period, even though they have not been paid, because they were incurred in that
period.
N.B. Accruals can be owing by the business or to the business.
149
Example 1: Owing by the business.
Using the above example the rent expense account would look like:
Dr. Rent Account Cr.
K K
Bank 1 000 Income Statement 1 200
Balance c/d 200
_____ ____
1 200 1 200
Balance b/d 200
By now one should know that a balance b/d on credit side of an account could be
interpreted as a liability or income depending on what type of account one is looking at.
Therefore, the rent expense account with balance brought down on credit is a liability
(amount owing).
- But the amount to charge in income statement will be K1200 including K200 not
paid because it relates to the same period.
- In balance sheet K200, will be shown under current liabilities as accrued

expenses.
Assuming in the following year K1 400 is paid for rent, the account will be as follows:
K K
Bank 1 400 Opening balance from
previous year 200
Income Statement
Account 1 200
_____ ____
1 400 1 400
The K1 400 paid is first to pay the previous years balance of K200 and the remainder K1
200 is what should be charged to the second years income statement.
The K200 has now been paid and will not appear anywhere in financial statements.
Example 2: Owing by the business
Genuine Motor Spares, is a dealer in motor spares. The financial year for the business
ends on 28 February each year. His telephone was installed on 1 April 20x6 and receives
his telephone account quarterly at the end of each quarter. He pays it promptly as soon as
it is received. On the basis of the following data, calculate the telephone expense to be
charged to the income statement for the year ended 28 February 20x7.
150
The following payments were made.
K
30.6.20x6 23.50
30.9.20x6 27.20
31.12.20x6 33.40
31.3.20x7 36.00
Solution:
Dr. Telephone Account Cr.
K K
Bank 23.50 Income Statement 108.10
Bank 27.20
Bank 33.40
Balance c/d 24.00
_____ _____
108.10 108.10
Balance b/d 24.00
The K24 would be shown under current liabilities as an accrual. The K24 represents two
months arrears for January and February which were still due by 28 February 20X7.
16.2 Amounts accrued to the business
While the business may owe others for expenses, the business may also be owed for other
amounts apart from trade among others:
- Rent receivables
- Commission receivable
- Unsettled claims for insurance etc.
Using the matching or accruals concepts, all income whether received or not as long as it
relates to the accounting period under review, should be included as income in income
statement for that period.
Since amounts are not yet received, they should be shown in balance sheet under current
assets as other receivables.
Example 1.
T.K. Furnishers Ltd sublets part of the buildings at an annual rent of K1200 000 (K100
000 per month). During the year ended 31 December 20X8, T.K. discovers that the
tenant had only paid K1 000 000.
Show rent receivable account and statement to be shown in income statement and
interpret the balance brought down.
Solution:
151
Dr. Rent Receivable Account Cr.
K K
Income Statement 1 200 000 Bank 1 000 000
Balance c/d 200 000
________ ________
1 200 000 1 200 000
Balance b/d 200 000
- The amount to be shown in income statement is not K1 000 000 paid, but will
also include K200 000 not paid.
So the total to include in income statement is K1 200 000, to be added to Gross

profit.
- In balance sheet the K200 000 will be shown under current assets as other
receivables.
Example 2:
Using example 1, assuming in the following year 20X9, the tenant pays K1 400
000 for rentals, the rent receivable account will be:
K K
Balance b/f 200 000 Bank 1 400 000
Income Statement 1 200 000 ________
1 400 000 1 400 000
- In 20X9, the opening balance b/f of K200 000 is a debit representing amounts not
yet received (asset).
- When the tenant pays K1 400 000, the whole amount is not for 20X9. Part of it is
to clear the debt K200 000 from 20X8 and the remaining amount is the rent
income for 20X9 to be added to gross profit in income statement. In this example
theres nothing owing at year end.
152
16.3 PREPAYMENTS
Prepayments are amount paid in advance before a service is provided.
It is important to note that payments in advance can be made by the business or to the
business.
Example 1: Payments in advance by the business.
A business has a fixed rate for electricity of K74 000 per month. It is the business
tendancy that when their liquidity position is favourable they pay in advance for certain
services including for electricity.
For the year ended 31.12.20X8 the business had paid for electricity total of K1 036 000 to
cover a period of 14 months to 28 February 20X9.
Show the electricity account, stating the amount to be included in income statement and
interpret the balance b/d.
DOUBLE ENTRY
1. Upon payment Dr Electricity account

Cr Bank account
2. Income statement Dr. Income statement with annual expense

Cr. Electricity account
In balance sheet. Dr. Electricity (Balance sheet) with balance b/d (Dr.)
Therefore:
Dr. Electricity Account Cr.
K K
Bank (14 x 74) 1 036 000 Income statement 888 000
Balance c/d 148 000
________ ________
1 036 000 1 036 000
Balance b/d 148 000
Notes:
- Though K1 036 000 was paid during the year, the only expenses is K888 000
(74 000 x 12 months). The other amount K148 000 is for the year to come
(prepayment) and it will be accounted for in that year.
- Total charge to income statement is K888 000.
153
- The balance b/d will be shown in balance sheet under current assets as
prepayments.
Example 2:
Assuming the balance in example 1 of K148 000 is carried forward to the next year and
the business in the new year is only able to pay K740 000.
Solution:
Dr. Electricity Account Cr.
K K
Balance b/f 148 000 Income statement 888 200
Bank 740 000
_______
888 000 888 000
Notes:
- Though only K740 000 has been paid for current year, i.e. for 10 months, the
other amount of K148 000 paid in advance the previous accommodates the first 2
months of the year making a full payment for the year of K888 000 to be charged
to income statement.
- K148 000 is no longer an advance payment because it has now been used in the
year for which it was paid.
- In above case no amount will appear in balance sheet.
16.4 Prepayments to the business
Other persons or organizations make payments in advance to the business for certain
items e.g. for rent receivable and any other income.
- Any amount receivable paid in advance would not be included in income

statement in the year it is received.
- It should be accounted for in the period the service will be provided.
- In balance sheet it should be reflected under current liabilities as other payables.
Example 1: Prepayments to the business.
Gas Pipe runs a service station and sales fuel among other services.
Some well established individuals make advanced payments to Gas Pipe for fuel.
154
During the year ended 31.12.20X7, a payment of K3 000 000 was paid in advance for
fuel by a customer.
It now is discovered that the customer had actually withdrawn fuel amounting to
K2 488 000 as at 31.12.20X7.
Show the necessary account to record the above information and state the unused amount
which will be shown in financial statements.
Solution:
Double entry
1. Upon receipt of amount
Dr. Cash book with K3 000 000

Cr. Fuel account (Income)
2. At year end, adjustments will be
Dr. Fuel account with K512 000 balance c/d

Cr. Prepayment (fuel) balance b/d to be shown in balance sheet under current
liabilities as other payables.
Dr. Fuel Account Cr.
K K
Income statement 2 488 000 Bank 3 000 000
Balance c/d 512 000
________ ________
3 000 000 3 000 000
Balance b/d 512 000
Notes:
The business is holding K512 000 cash for which fuel is yet to be withdrawn. The fact
that this amount could be claimed by customer before fuel is withdrawn makes it become
a liability to the business.
16.5 DIFFICULT SITUATIONS
Examples given so far for prepayments and accruals are straight forward. This has been
done to have basic knowledge on the subject matter.
- In examination questions, however, one may be confronted with complicated

situations involving several receipts or payments made in the year covering
different periods.
- In such situations particular attention should be made on dates.
Example 1:
Fitwell Garage pays fire insurance annually in on 1 June each year.
155
From the following record of insurance payments, calculate the charge to income
statement for the financial year to 28 February 20X8.
1 June 20X6 insurance paid is K600 000

1 June 20X7 insurance paid is K700 000
Dr. Insurance Account Cr.
K K
Balance b/f 150 000 Income statement 675 000
Bank 700 000 Balance c/d 175 000
_______ ______
850 000 850 000
Balance b/d 175 000
Notes:
K
(a) The 3 months, 1 March 31 May 20X7 (3/12 x 600 000) 150 000
(b) The 9 months, 1 June 20X7 20 February (20X8) 9/12 x 700 000 525 000
(c) Insurance cost for year charged to income statement 675 000
CHAPTER SUMMARY
- Accruals are amounts the business has not yet paid or received for services provided.
- Accruals can be by the business or to the business.
- Prepayments are amounts paid in advance by the business or to the business.
- The matching or matching concept requires that income and expenses whether paid or not
as long as they relate to the accounting period under review, should be matched when
computing profit for that period.
- Accruals by the business are included as a charge in income statement, and shown under
current liabilities in balance sheet (accrued expenses).
- Accruals to the business (income) are also included in income statement added to amount
received, but stated as current asset in balance sheet (other receivables).
- Prepayments by business are excluded in income statement from total amount paid and
reflected as current asset in balance sheet (prepayments).
- Prepayments to the business are also deducted from total amount received in income
statement but shown as current liability in balance sheet (other payables).
156
EXERCISES
1. If a business has paid rent of K1 000 000 for the year to 31 March 20X7, what is the
prepayment in the accounts for the year to 31 December 20X6.
2. Define an accrual
3. What is the meaning of balances brought at year end in the following accounts
- Debit balance in expense account

- Credit balance in expense account
- Debit balance in income receivable account
- Credit balance in income receivable account
4. A business maintains one account for rent and rates.
During the year ended 31 December 20X5, the following information was made available
for rent and rates.
- At 1 January 20X5, there was K250 000 rates which had been paid in advance in
20X4, and K500 000 rent was owing on the same date.
- The following payments were made during 20X5, rent K4 000 000 and rates
K3 6000 000.
- On 31 December 20X5, rent of K200 000 is owing and rates of K150 000 are paid
in advance.
Required:
Prepare the rent and rates account (combined and appropriately bring down the balance).
157
1. K1 000 000 X 3 months = K250 000

12
2. An accrual is an amount not yet paid in received at end of accounting period.
3. - Asset (prepayment)
- Liability (amount owing)
- Asset (amount not yet received but to be received)
- Liability (amount receivable paid in advance to the business).
Dr. Rent and Rates Account Cr.
K K
Balance b/f 250 000 Balance b/f 500 000
Bank (rent) 4 000 000 Income statement
Bank (rates) 3 600 000 (Balancing figure) 7 400 000
Balance c/d 200 000 balance c/d 150 000
8 050 000 8 050 000
Note:
In balance sheet: Rent is current liability (K200 000)

Rates is current asset (150 000).
158
CHAPTER 17
NON CURRENT ASSETS AND INTANGIBLE ASSETS
INTRODUCTION
This chapter deals with non current assets and depreciation. It looks at what non currents are,
depreciation and how it is provided and eventually leading to disposal. The non current asset
register is also discussed.
Additionally the chapter covers the basics of research and development costs and goodwill
TOPICS
1 Non current assets what are they?

2 Depreciation
3 Methods of depreciation
4 Accounting for depreciation
5 The disposal of non current assets
6 The non current asset register
7 ISA 38 - Intangible assets
LEARNING OUTCOMES
After studying this chapter, the student should be able to:
Define non current assets giving examples

Distinguish clearly between non current assets and current assets
Define depreciation and explain why it is provided
Identify causes of depreciation
Calculate and account for depreciation using different methods
Identify the steps in disposal of non current asset
Describe the importance of maintaining a non current asset register
Define research
Distiguish between pure or basic research and applied research
Define development costs and explain how they are treated in financial statements
Define goodwill
Distiguish between purchased and inherent goodwill
Explain and apply the accounting treatment for both types of goodwill
159
11.0 NON CURRENT ASSETS
11.1 DEFINITION
A non current asset is one bought by the business not for resale but to be used in
the business to help generate income over a number of years.
- Non current assets are divided into tangible and intangible assets.
- Tangible non current assets include:
Land
Buildings
Fixtures and fittings
Motor vehicles
- Intangible non current assets include:
Goodwill
Patents
Trade marks
11.2 CURRENT ASSETS
These are assets that are temporal in nature. They change in value with time, and
examples includes:-
- Inventory
- Receivables
- Cash in bank and
- Cash in hand
Current assets are easily convertible into cash.
NOTE: What is non current asset will depend on the nature of the business. If a
business is dealing in motor vehicles and it buys motor vehicles for resale, then
motor vehicles will be classified as inventory under current assets. Then motor
vehicles bought to be used in the business will be classified as non current
assets.
11.3 DEPRECIATION
Definition: (IAS 16 Property, plant and equipment)
IAS 16 which deals with property, plant and equipment defines depreciation as:
160
the allocation of the depreciable amount of an asset over its estimated useful
life.
Depreciation for the accounting period is charged to income statement for the
period either directly or indirectly. Depreciation is an expense. No cash is
involved.
11.4 KEY TERMS (IAS 16)
(a) Depreciable assets are assets which
- are expected to be used during more than one accounting period.

- have a limited useful life and
- are held by an enterprise for use in the production or supply of
goods and services, for rental to others, or for administrative
purposes.
(b) Useful life is either:
- the period over which a depreciable asset is expected to be used by

the enterprise or
- the number of production or similar units expected to be obtained
from the asset by the enterprise.
(c) Depreciable amount of a depreciable asset is the historical cost or other

amount substituted for historical cost in the financial statements, less the
estimated residual value.
(d) Residual value
Sometimes called scrap value. This is the estimated value of an asset at

the end of its life. Residual value is not depreciable. In most cases
residual value is immaterial. It is usually estimated at the time the asset is
being purchased. The estimation may be based on similar assets in
existence in the business.
Example 1: Equipment costing K80,000,000 which has an expected life

of five years and nil residual value will be depreciated as:
Cost K80 000 000

Residual value NIL
K80 000 000 depreciable amount over 5 years
Example 2: Equipment costing K80 000 000 which has an expected life of
five years with K3 000 000 residual value will be depreciated as:
Cost K80 000 000

Residual value (K3 000 000)
K77 000 000 is depreciable amount over 5 Years
161
11.5 CAUSES OF DEPRECIATION
(a) Wear and tear - This is when assets deteriorate because of being used.
(b) Natural causes - This is when elements of nature take its effect e.g.
erosion of land, rust on machinery, rot and decay in furniture.
(c) Obsolescence - This is where an asset becomes outdated because of

technological changes even when the asset is new e.g. computers.
(d) Inadequacy - This arises when an asset is no longer used because of the
growth and changes in the size of the business. For instance a business is
operating a bicycle to deliver oranges to its customers. When demand
increases, the business will need a van. The bicycle can be sold else
where.
(e) Depletion - Natural resources such as mines, quarries and oil wells are
wasting assets. As raw materials are extracted they do not regenerate.
11.6 METHODS OF DEPRECIATION
There are many different methods of depreciation. The following are selected for
your study.
- Straight line
- Reducing balance method
- Sum of digits
- Revaluation method
11.7 THE STRAIGHT LINE METHOD
In this method the depreciable amount is charged equally from one accounting
period to the other over the expected useful life of the asset. It is assumed that the
business will enjoy equal benefits from the use of the assets throughout its life.
N.B.V
TIME
In this way the net book value of an asset declines at a steady rate, or in a straight
line over time. The formula is:
Annual depreciation = Cost of an asset residual value

Expected useful life of the asset
162
Example 1: Straight line method
A machine was bought on 1 January 20X4 at a cost of K800 000. The machine is
expected to be used over a period of 5 years with no residual value.
Annual depreciation would be:
Depreciation = (K800 000 0)

5
= K160 000 P.A.
Example 2: Straight line method
A vehicle cost K500 000 will be in use in the business for 4 years after which it
will have residual value of K20 000. Annual depreciation over 4 years will be:
(K500 000 K20 000) = K480 000

4 4
= K120 000 P.A.
Sometimes the depreciation charge may be given as a percentage on cost.
In example 1 above, the % on cost will be:
160 000
x 100 = 20%
800 000
Every year for 5 years 20% will be calculated on K800 000 to find annual
depreciation.
In example 2 above, the % will be calculated on depreciable amount after

deducting residual value.
Remember residual value is not depreciable.
120 000
x 100 = 25%
480 000
Every year for 4 years, 25% will be used on K480 000 which is the depreciable
amount.
163
11.8 The Reducing Balance Method
In this method depreciation is calculated as a fixed percentage of the net book

value of the asset, as at the end of previous accounting period.
This method assumes that the business will benefit more from the use of the asset
in earlier years than later years.
Example: Reducing Balance Method
Machine was bought at a cost of K150 000. Depreciation is to be charged at the

rate of 20% per annum. Calculate depreciation for the first 3 years.
K
Year 1 20% x 150 000
(30 000) Depreciation
Year 2 20% x 120 000 N.B.V
Year 3 20% x 96 000 N.B.V
76 800
11.9 Sum of digits method
This method is very similar to reducing balance method. Depreciation is also

charged more in earlier years than later year. What makes it different from
reducing balance method is the way it is calculated.
What is referred to as sum of digits are the years the asset will be in use i.e.
estimated life.
If the life of an asset is 5 years then the sum of digits will be:
Year 1
+
Year 2
+
Year 3
+
Year 4
+
Year 5
15 is the sum of digits
Since depreciation is more in the first year than later years, each year depreciation
charge will be:
5
Year 1 /15 x depreciable amount
4
164
3
2
1
Example: Sum of digits method
Ever green purchased a non current asset for K600 000 on 1 January 20X4. The
useful life of the asset is 5 years after which it will have a residual value of
K30,000. The depreciation charge every year will be:
Depreciable amount is K600 000 K30 000 = K570 000
K570 000 is depreciable amount over 5 years

5
Year 1 /15 x K570 000 = K190 000
4
Year 2 /15 x K570 000 = K152 000
3
Year 3 /15 x K570 000 = K114 000
2
Year 4 /15 x K570 000 = K 76 000
1
Year 5 /15 x K570 000 = K 38 000
K570 000
+
K 30 000 Residual value
K600 000
If the asset had no residual value, then the depreciable amount would be the
whole K600 000 spread over 5 years.
11.10 Revaluation method
- Fall in value of asset
When the market value of a non current asset falls below its net book
value, and the fall in value is expected to be permanent, the asset should
be written down to its new market value. Revaluation means giving a new
value to an asset which could be gains or losses.
NOTE: Market value is value of asset it can currently fetch on the market
which is different from net book value which is cost minus depreciation.
The charge in the income statement for the reduction in the value of the
asset during the accounting period is:
K
Net book value at start of year XX
Less: New value (XX)
165
Charge for impairment (Depreciation) XX
Example: Fall in value of an asset
A business purchased buildings on 1 January 20X3 at a cost of K300 000.

The buildings are expected to be used over a period of 20 years. After 5
years in use on 1 January 20X8, the land is now worth K200 000 and the
reduction is permanent.
Solution:
Annual depreciation: 300 000

= 15 000 x 5 years = K75 000
20
K75,000 depreciation has accumulated over 5 years.
N.B.V. after 5 years: 300 000 Cost

225 000 N.B.V.
200 000 New value
25 000 Further loss (depreciation
due to revaluation)
As at 31 December 20X7 the total charge to income statement would be:

K
Normal annual depreciation charge 15 000
Add loss through revaluation 25 000
40 000
The buildings will now be stated in the books @ K200 000 to be

depreciated over 15 years remaining.
New annual depreciation from 20X8 on wards will be:
200 000
15
= K13 333
11.11 Increase in value of asset
Due to inflation, the market value of certain non current assets go up, especially
land and buildings. A business is not obliged to revalue non current assets in its
balance sheet. However in order to give a true and fair view the business may
decide to revalue the asset upwards. Depreciation would then be charged on the
new revalued amount.
166
Example: Increase in value of an asset
Musuku Ltd commenced business on 1 January 20X3, and bought buildings

costing K275 000. The buildings are to be depreciated on a straight line basis
over a period of 25 years with no residual value.
After 4 years on 1 January 20X7, the buildings are revalued to K260 000 with a
life span of 21 years.
Solution:
Annual depreciation: K275 000

25 years
= K11 000 p.a.
Accumulated depreciation over 4 years: 4 x K11 000 = K44 000
K
Net book value at 31 December 20X6: 275 000 cost
44 000 accumulated depreciation
231 000 N.B.V.
K
Gain in value: Net book value 231 000
Net value 260 000
29 000
The buildings would now be stated in the books at K260 000 and will be
depreciated over a period of 21 years.
As from 31 December 20X7 onwards annual depreciation would be:
K260 000
21
= K12 381
NOTE: The increase as a result of revaluation of K29 000 will not be shown as
income in income statement because the gain is not realized as the buildings are
still being used in the business. Instead the gain will be reflected in the
revaluation reserve account and added separately to capital in the balance sheet.
Remember the prudence concept.
11.12 Accounting for depreciation
167
Non current assets are maintained in the books at historical cost i.e. the amount
paid to acquire or produce it. An account for depreciation in the general ledger is
opened to record accumulated depreciation to date. This account is called
Allowance for depreciation account.
- Allowance for depreciation account
Each accounting period a depreciation charge is made to the income

statement and another record will be made in the allowance for
depreciation account, which is cumulative in nature.
- Double entry for depreciation
DR. Income statement with depreciation expense

CR Allowance for depreciation account
- In the Balance Sheet
The accumulated depreciation amount is shown as deduction from cost of

the non current asset to arrive at net book value.
- There is an allowance for depreciation account for each separate category

of non current assets, e.g. for buildings, machinery, furniture, motor
vehicles etc. If a business has 20 vehicles there will be only one
depreciation account for all the vehicles even if they have been bought at
different times and years.
- Example: Recording allowance for depreciation. Fast track company

maintains non current assets at cost. Separate allowance for depreciation
accounts are kept for each category of assets.
The following transactions took place:
20X1 1 January bought machinery for K60 000 and fixtures

for K38 000.
20X2 1 July bought 3 machines at cost K40 000 each.
20X3 1 October bought another machine for K25 000
20X4 1 December bought fixtures for K18 000.
NOTES: Machinery is depreciated at the rate of 15% per annum on cost

and fixtures at the rate of 5% using the reducing balance method.
Depreciation is to be charged fully for the whole year

disregarding the purchase date.
Required: Show
168
(a) The machinery account
(b) The fixtures account
(c) The two separate allowance for depreciation
account
(d) Extracts of the income statement and balance sheet
for each of the years 20X1, 20X2, 20X3 and 20X4.
Solution:
It may help to put up a table showing the build up of depreciation for each
category of non current assets
Category of asset 20X1 20X2 20X3 20X4 Total
Machinery 1 9 000 9 000 9 000 9 000 36 000
Machinery 2 - 18 000 18 000 18 000 54 000
Machinery 3 - - 3 750 3 750 7 500
Total 9 000 27 000 30 750 30 750 97 500
20X1 20X2 20X3 20X4 Total
Fixtures 1 1 900 1 805 1 715 1 629 7 049
Fixtures 2 - - - 900 900
Total 1 900 1 805 1 715 2 529 7 949
Machinery Account
20X1 Bank 60 000 Balance c/d 60 000

______ _______
60 000 60 000
20X2 Balance b/d 60 000 Balance c/d 180 000

Bank (3 x 40,000) 120 000 _______
180 000 180 000

Bank 25 000 ______
205 000 205 000
205 000 205 000
169
Dr Allowance for depreciation account (Machinery) Cr
20X1 K 20X1 K
Balance c/d 9 000 Income statement 9 000
_____ _____
9 000 9 000
20X2 20X2 Balance b/d 9 000
36 000 36 000
20X3 20X3 Balance b/d 36 000
66 750 66 750
20X4 20X4 Balance b/d 66 750
97 500 97 500
Fixtures Account
20X1 Bank 38,000 Balance c/d 38 000

______ ______
38 000 38 000

_____ ______
38 000 38 000

_____ _____
38 000 38 000

Bank 18 000 _____
56 000 56 000
Dr Allowance for depreciation account (Fixtures) Cr
K K
20X1 20X1
_____ _____
1 900 1 900
3 705 3 705
170
5 420 5 420
7 949 7 949
Income statement (Extract)
K K
Gross profit XX
Less: Expenses
20X1 Depreciation: Machinery 9 000

Fixtures 1 900
(10 900)
XX
Fixtures 1 805
(28 805)
XX
Fixtures 1 715
(32 465)

Fixtures 2 529
(33 279)
Balance Sheet (Extracts)
Non current assets Cost Depreciation N.B.V.
20X1 Machinery 60 000 9 000 51 000

Fixtures 38 000 1 900 36 100
20X2 Machinery 180 000 36 000 144 000

Fixtures 38 000 3 705 34 295
20X3 Machinery 205 000 66 750 138 250

Fixtures 38 000 5 420 32 580
20X4 Machinery 205 000 97 500 107 500

Fixtures 56 000 7 949 48 051
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In the trial balance
Depreciation is an end of the year adjustment, therefore in the year of acquisition

of a non current asset depreciation will not be reflected in the trial balance, but
will start appearing in subsequent years.
In previous exercise depreciation will only start appearing in 20X2, thus:
Dr Cr
Machinery 180 000
Accumulated depreciation 9 000
Fixtures 38 000

Dr Cr
Machinery 205 000
Fixtures 38 000
Any depreciation shown in the trial balance is what has accumulated from
previous years. For the year under review it has to be calculated and shown in the
income statement. The figure shown in income statement will be added to the
figure in the trial balance and the accumulated total shown in the balance sheet.
11.13 Choice Of Depreciation Method
Any method of depreciation can be used on a non current asset, but the method chosen
must be fair in allocating the charges between different accounting periods.
CONSIDERATION WHEN SELECTING METHOD OF DEPRECIATION
(a) The method should allocate costs in proportion to the benefits i.e.
(i) Use reducing balancing method if the business will benefit more from the
asset in earlier years than later years
(ii) Use the straight line if benefits will be spread equally over the life of the
asset
(b) Consistency must be observed. Same depreciation method must be used for
similar assets, and from one year to another.
(c) Choose a method which is easy to apply.
172
11.4 Asset Acquired During An Accounting Period
If a non current asset is purchased during an accounting period it might be fair to charge
depreciation according to the period the asset has been used i.e. on monthly basis.
However, this basis may apply when straight line method is in use.
Examination questions will usually state the way depreciation is to be applied.
Examples:
(a) Charge a full years depreciation in the year of acquisition or nothing in the year
of disposal. In this instruction dates of purchase should be ignored even if the
dates are given.
(b) Charge a full years depreciation on the value of asset available at year end.
(explanation same as in a)
(c) Depreciation should be charged on monthly basis.
(d) If instructions are silent and dates of purchase are given, then the monthly basis
should be adopted.
Example: Assets acquired during the year.
A business has an accounting period which runs from 1 January to 31 December.
On 1 October 20X5 the business purchased furniture for K500 000 cost. The life
span of the furniture is 10 years with no residual value.
What is the depreciation charge for the year ended 31 December 20X5?
Solution
Annual depreciation is K500 000

= K50 000
10 years
The asset was acquired on 1 October 20X3 and will be depreciated only for 3
months in 20X5.
K50 000 x 3 months

12 months
= K12 500
11.15 Change in estimated life
When the life span of an asset changes i.e. increased or reduced, the net book value of the
asset at the time of change is what will be spread on the remaining life.
Example 1: Increase in life of an asset
173
A business purchased a motor vehicle at a cost of K400 000 with an estimated life of 6
years. It is to be depreciated on straight line basis over its life. However, after 2 years in
use, it is discovered that the asset life has 2 more years making a total of 8 years.
What will be the depreciation charge from year 3 on wards.
Solution:
Annual depreciation is K400 000

6 years = K66 667
K66 667 x 2 years = K133 334.
Net book value after 2 years K400 000

133 334
266 666 N.B.V.
Net book value to be spread over new life i.e. 6 years. From year 3 onwards annual
depreciation will be:
K266 666
6 years = K44 444
Example 2: Decrease in life of asset
A business bought non current assets at a cost of K100 000. It is estimated that the assets
will be used in the business for a period of 7 years with K10 000 residual value. After
one year in use, it was reviewed that the assets life span be reduced to 3 years from the
remaining 6 years. What will be depreciation from year 2 onwards.
Solution
Annual depreciation (100 000 10 000)

7 years = K12 857
Net book value after 1 year 90 000 12 857 = K77 143.
N.B.V. of K77 143 will now be spread over 3 years.
From the second year onwards annual depreciation will be
K77 143
3 = K25 714
11.16 Change in Depreciation Method
It is allowed to change the depreciation method if it is discovered that a wrong method

was adopted initially, and is not true and fair, or if there is a change in the pattern of
consumption of economic benefits from the non current asset. Every year end a business
174
will normally review its accounts and this is the time such a discovery may be made.
Changes should be necessary and not done at will otherwise comparison will be difficult
because of inconsistency.
Example: Change in depreciation method
A business bought furniture on 1 January 20X3 at a cost of K80 000. The asset is to be
depreciated using straight line method over a 5 year period.
At 1 January 20X5, a review was conducted, and it was agreed to change the method to
reducing balance method at the rate of 20% per annum.
Show the necessary entries to adjust to new method.
Solution:
Using straight line method
K80 000
5 years = K16 000 annual depreciation
Accumulated depreciation at time of change K16 000 x 2

K32 000
Net book value after 2 years K80 000 K32 000 = K48 000
From year three onwards using reducing balance method, depreciation will be:
Year 3 48 000 x 20%

Year 4 38 400 x 20%
30 720 x 20% etc.
11.17 The Disposal of Non Current Assets
When a business buys non current assets, they are meant to be used in generating income
for the business over a period time (more than 1 year). They are not meant for resale to
make a profit.
However, the non current assets might be sold off at some stage before even their useful
life is over. Reasons for selling or disposal may include:
- Inadequacy where an asset fails to meet increased demand for a product

- Obsolescence etc
(a) The Disposal Account
When non current assets are disposed of, a disposal account is opened. This
account will reveal whether a profit or loss has been made on the asset sold. The
profit or loss on disposal are reported in the income statement.
175
- Ledger accounting on disposal of non current asset. The profit or loss on
disposal is the difference between net book value of non current asset and
the net sale price, which is the price minus any costs of making the sale.
- A profit is made when sales price is more than net book value
- A loss is made when sales price is less than net book value of a non
current asset.
Double entry when an asset is disposed of.
Step 1:
Debit Disposal account with value of asset usually at

Credit Asset account cost
Step 2:
Debit Allowance for depreciation account with accumulated

Credit Disposal account depreciation at the
time of sale
Note: The two steps in disposal account reveals the net book value of the
asset.
Step 3:
Debit Receivable account (if sale is on credit) or

Debit cash book (if sale is on cash or by cheque
Credit Disposal account
with sale price of the asset
Step 4
The balancing figure in disposal account will be profit or loss on disposal.
- If balancing figure is on debit of disposal account, a profit has been

achieved.
- If balancing figure on disposal account is on credit side, then a loss
is recorded.
Examples: Disposal of non current asset.
Green Grass purchased a van on 1 January 20X5 for K100 000. He

estimated that its resale value on 31 December 20Y0 after six years use
would be K40 000 and depreciated it on a straight line basis. He sold it on
30 June 20X7 for K55 000.
176
Solution:
The amount to be charged as depreciation each year is
Cost residual value

Estimated economic life = (K100 000 K40 000)
6 years
= K10 000
Green Grass owned the asset for two years and six months, thus the total
depreciation charged since acquisition is K10 000 x 21/2 years = K25 000.
This means that the net book value at the date of disposal was K100 000
K25 000 = K75 000.
Since the sale proceeds amounted to K55 000, a loss on disposal of
K55 000 K75 000 = K20 000 has been made.
Ledger accounting on disposal.
Dr Van account (at cost) Cr
20X5 K K
1 Jan. Bank 100 000 31 Dec. Balance c/d 100 000
_______ ______
100 000 100 000
20X6
1 Jan. Balance b/d 100 000 31 Dec. Balance c/d 100 000
______ _______
100 000 100 000
20X7
1 Jan. Balance b/d 100 000 June 30 Disposal 100 000
______ ______
100 000 100 000
Dr Allowance for depreciation Cr
K 20X5 K
31 Dec. Bal. c/d 10 000 31 Dec. Inc. statement 10 000
(Depreciation)
______ _____
10 000 10 000
20X6
31 Dec. Bal. c/d 20 000 1 Jan. Balance b/d 10 000
31 Dec. Inc. statement 10 000
(Depreciation)
______ ______
20 000 20 000
20X7
30 June Disposal 25 000 1 Jan. Balance b/d 20 000
177
30 June Inc. statement 5 000
(Depreciation) _____
25 000 25 000
Dr Disposal account Cr
20X7 K 20X7 K
30 June Van at cost 100 000 30 June Allow. For Dep. 25 000
30 June Bank 55 000
Loss (to inc. state.) 20 000
_______ ______
100 000 100 000
Example 2: Trading in or part exchange on disposal.
On 1 April 20X8, Quick Fix owned a motor vehicle which was bought on
1 October 20X5 at a cost of K600 000. Its estimated residual value after
five years in use would be K80 000.
Quick Fixs policy is to provide depreciation on straight line method on

monthly basis.
During the financial year ended 31 March 20X9, the following occurred:
On 30 June 20X8, the motor vehicle was traded in and replaced with a
new one. The trade in allowance was K255 000. The new vehicle cost
K850 000. The balance after deducting the trade in allowance was paid by
cheque.
The new motor vehicle is expected to have a residual value of K100 000
after its life of 8 years.
Required:
Show the necessary ledger accounts to record the above information.
Solution:
Annual depreciation: K600 000 K80 000
5 years = K104 000
For old vehicle
Accumulated depreciation = K104 000 x 2.75 = K286 000
Net book value = K600 000 K286 000 = K314 000
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Therefore a loss on disposal of K255 000 trade in allowance minus Net
book value of K314 000 = K59 000 was made. This is because 2.75 is the
period of 2 years 9 months that the old motor vehicle was owned by Quick
Fix.
Note: Trade in allowance is what should have been realized if the asset
was sold for cash.
Ledger accounting:
Dr Motor Vehicle account Cr
20X8 K K
30 June Balance 600 000 30 June Disposal 600 000

30 June New M/Veh.
(255 000 + 595 000) 850 000
31 March (20X9) Bal c/d 850 000
________ _______
1 450 000 1 450 000
1 April 20X0 Bal. b/d 850 000
Dr Disposal account Cr
20X8 K 20X8 K
30 June M/Vehicle 600 000 30 Acc. Dep. 286 000

Trade in All 255 000
Loss (P/L A/c) 59 000
_______ ______
600 000 600 000
Note: Double entry for new motor vehicle:
DR Motor Vehicle account with

Trade in allowance (255 000)
Cash (595 000)
CR - Disposal account with Trade in allowance (255 000)

CR - Cash account with M/Vehicle (K595 000)
179
11.18 Controlling Tangible Non Current Assets.
Most organizations will own a number of non current assets and their control is vital to
the efficient running of the organization. A non current asset register should be
maintained for this purpose.
Non Current Asset Register.
This register will contain the following information for each non current asset.
- the date of purchase

- the name and address of supplier
- the cost of the asset
- the estimated useful economic life of the asset
- the estimated residual or resale value of the asset at the end of its useful life
- a description of the asset
- a code number for easy identification
- the method of accumulated depreciation to be used
- the accumulated depreciation of the asset
- details of disposal of the asset
- the location of the asset within the organization
- the extent to which it is being used
- the repairs carried out and how much they cost
- the expiry dates of any licences permitting the organization to use it.
11.19.0 IAS 16 PROPERTY, PLANT AND EQUIPMENT
11.19.1 This standard covers all aspects of accounting for property, plant and equipment.
This represents the bulk of items which tangible long term asserts.
11.19.1 IAS 16 should be followed when accounting for property, plant and
equipment unless another international accounting standard requires a different
treatment.
11.19.2 IAS 16 does not apply to the following:
(a) Forests and other regenerative natural resources
(b) Mineral rights, exploration for and extraction of minerals, oil, gas and other
regenerative resources.
Definitions
11.19.3 This standard gives a large number of definitions.
180
KEY TERMS
Property, plant and equipment are tangible assets that:

Are held by an entity for use in the production or supply of goods or services, for rental
to others, or for administrative purposes; and
Are expected to be used during more than one period.
Cost is the amount of cash equivalents paid or the fair value of the other consideration
given to acquire an asset at the time of its acquisition or construction.
Residual value is the estimated amount that an entity would currently obtain from
disposal of the asset after deducting the estimated costs of disposal if the rest were
already of the age and in the condition expected at the end of its useful life.
Fair value is the amount for which an asset could be exchanged between
knowledgeable, willing parties in an arms length transaction.
Carrying amount is the amount for which an asset is recognized after deducting any
accumulated depreciation and impairment losses.
Recoverable amount is the amount which the entity expects to recover from the
future use of an asset, including its residual value on disposal.
Recognition
11.19.4 In this context, recognition simply means incorporation of the item in the
Businesses accounts, in this case as a non current asset. The recognition of
Property, plant and equipment depends on two criteria.
(a) It is probable that future economic benefits associated with the asset will flow to
the entity.
(b) The cost of the asset to the entity can be measured reliably.
11.19.5 Property, plant and equipment can amount to substantial amounts in financial
statement, affecting both the presentation of the companys financial position in
the balance sheet and the profitability of the entity as shown in the income
statement. Smaller items such as tools are often written off as expenses of the
period. Most companies have their own policy on this items below a certain value
are charged as expenses.
Initial measurement
11.19.6 Once an item of property, plant and equipment qualifies for recognition as an
asset, it will initially be measured at cost.
181
Components of cost
11.19.7 The standard lists the components of the cost of an item of property, plant and
equipment.
Purchase price, less any trade discount or rebate
Initial estimate of the costs of dismantling and removing the item and
restoring the site on which it is located
Directly attributable costs of bringing the asset to working condition for its
intended use, eg:
o The cost of site preparation
o Initial delivery and handling costs
o Installation costs
o Professional fees (architects, engineers)
11.19.8 The following costs will not be part of the cost of property, plant or equipment
unless they can be attributed directly to the assets acquisition, or bringing it into
its working condition.
Expenses of operations that are incidental to the construction or

development of the item
Administration and other general overhead costs
Start-up and similar pre-production costs
Initial operating losses before the asset reaches planned performances
All of these will be recognized as an expense rather than an asset.
Exchange of assets
11.19.9 Exchange or part exchange of assets occurs frequently for items of property, plant
and equipment. IAS 16 states that the cost of an item obtained through (part)
exchange is the fair value of the asset received (unless this cannot be measured
reliably).
Subsequent expenditure
11.19.10 How should we treat any subsequent expenditure on long-term assets, after their
purchase and recognition? Subsequent expenditure is added to the carrying
amount of the asset, but only when it is probable that future economic benefits, in
excess of the originally assessed standard of performance of the existing asset,
will flow to the enterprise. All other subsequent expenditure is simply recognized
as an expense in the period in which it is incurred.
11.19.11 The important point here is whether any subsequent expenditure on an asset
improves the condition of the asset beyond the previous performance. The
standard gives the following examples of such improvements.
(a) Modification of an item of plant to extend its useful economic life,

including increased capacity
(b) Upgrade of machine parts to improve the quality of output
182
(c) Adoption of a new production process leading to large reductions in
operating costs.
11.19.12 Normal repairs and maintenance on property, plant and equipment items merely
maintain or restore value, they do not improve or increase it, so such costs are
recognized as an expense when incurred.
Measurement subsequent to initial recognition
11.19.13 The standard offers two possible treatments here, essentially a choice between
keeping an asset recorded at cost or revaluing it to fair value.
(a) Cost model. Carry the asset at its cost less depreciation and any
accumulated impairment losses.
(b) Revaluation model. Carry the asset at a revalued amount, being its fair
value at the date of the revaluation less any subsequent accumulated
depreciation. Revaluations should be made regularly enough so that the
carrying amount approximates to fair value at the balance sheet date. The
revaluation model is only available if the item can be measured reliably.
Revaluations
11.19.14 The market value of land and buildings usually represents fair value, assuming
existing use and line of business. Such valuations are usually carried out by
professionally qualified valuers.
11.19.15 In the case of plant and equipment, fair value can also be taken as market value.
Where a market value is not available, however, depreciated replacement cost
should be used. There may be no market value where types of plant and
equipment are sold only rarely or because of their specialized nature (i.e. they
would normally only be sold as part of an ongoing business).
11.19.16 The frequency of valuation depends on the volatility of the fair values of
individual items of property, plant and equipment. The more volatile the fair
value, the more frequently revaluations should be carried out. Where the current
fair value is very different from the carrying value then a revaluation should be
carried out.
11.19.17 Most importantly, when an item of property, plant and equipment is revalued, the
whole class of assets to which it belongs should be revalued.
11.19.18 All the items within a class should be revalued at the same time, to prevent
selective revaluation of certain assets and to avoid disclosing a mixture of costs
and values from different dates in the financial statements. A rolling basis of
revaluation is allowed if the revaluations are kept up to date and the revaluation of
the whole class is completed in a short period of time.
11.19.19 How should any increase in value be treated when a revaluation takes place?
The debit will be the increase in value in the balance sheet, but what about the
credit? IAS 16 requires the increase to be credited to a revaluation surplus (ie
183
part of owners equity), unless the increase is reversing a previous decrease which
was recognized as an expense. To the extent that this offset is made, the increase
is recognized as income; any excess is then taken to the revaluation reserve.
11.19.20 IAS 16 makes further statements about revaluation, but these are beyond the
scope of your syllabus.
Depreciation
11.19.21 The standard reflects the following approach to depreciation.
The depreciable amount of an item of property, plant and equipment

should be allocated on a systematic basis over its useful life.
The depreciation method used should reflect the pattern in which the
assets economic benefits are consumed by the enterprise.
The depreciation charge for each period would be recognized as an
expense unless it is included in the carrying amount of another asset.
Most of the comments on depreciation in IAS 16 are dealt with in Section 2.
11.19.22 Land and buildings are dealt with separately even when they are acquired
together because land normally has an unlimited life and is therefore not
depreciated. In contrast buildings do have a limited life and must be depreciated.
Any increase in the value of land on which a building is standing will have no
impact on the determination of the buildings useful life.
11.19.23 Depreciation is usually treated as an expense, but not where it is absorbed by the
enterprise in the process of producing other assets. For example, depreciation of
plant and machinery is incurred in the production of goods for sale (inventory
items). In such circumstances, the depreciation is included in the cost of the new
assets produced.
Review of useful life

11.19.24 A review of the useful life of property, plant and equipment should be carried out
at least annually and the depreciation charge for the current and future periods
should be adjusted if expectations have changed significantly from previous
estimates.
Review of depreciation method

11.19.25 The depreciation method should also be reviewed periodically and, if there has
been a significant change in the expected pattern of economic benefits from those
assets, the method should be changed to suit this changed pattern. When such a
change in depreciation method takes place the change should be accounted for as
a change in accounting estimate and the depreciation charge for the current and
future period should be adjusted.
184
Impairment of asset values
11.19.26 The carrying amount of an item or group of identical items of property, plant
and equipment should also be reviewed periodically. This is to assess whether the
recoverable amount has declined below the carrying amount. When there has
been such a decline, the carrying amount should be reduced to the recoverable
amount.
11.19.27 Recoverable amounts should be considered on an individual asset basis or for

groups of identical assets.
Retirements and disposals
11.19.28 When an asset is permanently withdrawn from use, or sold or scrapped, and no
future economic benefits are expected from its disposal, it should be withdrawn
from the balance sheet.
11.19.29 Gains or losses are the difference between the estimated net disposal
proceeds and the carrying amount of the asset. They should be recognized as
income or expense in the income statement.
Disclosure
11.19.30 The standard has a long list of disclosure requirements, only some of which are
relevant to your syllabus.
Measurement bases for determining the gross carrying amount (if more
than one, the gross carrying amount for that basis in each category)
Depreciation methods used
Useful lives or depreciation rates used
Gross carrying amount and accumulated depreciation at the beginning
and end of the period
Reconciliation of the carrying amount at the beginning and end of the
period showing:
o Additions
o Disposals
o Increases/decreases from revaluations
o Reductions in carrying amount
o Depreciation
o Any other movements
11.19.31 The financial statements should also disclose the following:
Existence and amounts of restrictions on title, and items pledge as

security for liabilities
Accounting policy for restoration costs
Amount of expenditures on account of items in the course of
construction
Amount of commitments to acquisitions
185
11.19.32 Revalued assets require further disclosures
Basis used to revalue the assets

Effective date of the revaluation
Whether an independent valuer was involved
Nature of any indices used to determine replacement cost
Carrying amount of each class of property, plant and equipment that
would have been included in the financial statements had the assets been
carried at cost less depreciation.
Revaluation surplus, indicating the movement for the period and any
restrictions on the distribution of the balance to shareholders.
11.19.33 The standard also encourages disclosure of additional information, which the
users of financial statements may find useful.
The carrying amount of temporarily idle property, plant and equipment

The gross carrying amount of any fully depreciated property, plant and
equipment that is still in use
The carrying amount of property, plant and equipment retired from active
use and held for disposal
When the benchmark treatment is used, the fair value of property, plant
and equipment when this materially different from the carrying amount.
11.19 RESEARCH AND DEVELOPMENT COSTS (IAS 38)
IAS 38 INTANGIBLE ASSETS

An intangible asset is an identifiable non monetary asset without physical substance. The asset
must be:
(a) Controlled by the entity as a result of event in the past.
(b) Something from which the entity expects future economic benefits to them.
Examples:
- Goodwill
- Development costs
RESEARCH AND DEVELOPMENT COSTS
RESEARCH - This is an investigation undertaken in order to discover new facts

or get additional information.
Research could be used for new or improved products, processes and methods.
Research is a cost to an entity.
186
DIVISION OF RESEARCH
Research costs can be divided as follows:
1. PURE OR BASIC RESEARCH
This is research carried out to advance knowledge without specific objectives.
2. APPLIED RESEARCH
This utilizes pure research to attain specific objectives. Research used to extend
knowledge of problems in industry, health, education, etc.
3. DEVELOPMENT
This is making use of the results of research to produce or develop new or existing
products or services.
Examples:
- Designing tools involving new technology

- Design, construction and operation of pilot project not for commercial production.
COMPONENTS OF RESEARCH AND DEVELOPMENT COSTS
Research and development costs will include all costs that are directly attributable to research
and development activities, or that can be allocated on a reasonable basis.
Selling costs are not included in research and development.
Examples of Research & Development Costs
- Salaries and wages and other related employment costs of personnel engaged in research
and development activities.
- Costs of materials and services used in research and development activities.
- Depreciation of property, plant and equipment used for research/development activities.
- Overhead costs which may be allocated because they relate to research and development.
ACCOUNTING FOR RESEARCH AND DEVELOPMENT COSTS
THE ACCOUNTING PROBLEM
The costs of Research and Development can run into millions of kwachas. However, it may take
many years before the new technology or product is commercialized.
Following the accruals concept, the cost of research and development should be capitalized when
incurred, and then amortised when the product is eventually marketed. This would then match
the costs with the benefits.
However, prudence would say that the eventual profits are so uncertain and so it would be better
to write off research and development costs in income statement when they arise.
187
THE SOLUTION
IAS 38 has found a compromise between accruals and prudence.
- All research costs must be charged to the income statement as it is incurred. This is
because there is a long time gap between research commencing and a profitable product
being launched.
- Development costs should be capitalized if it meets certain conditions.
CONDITIONS FOR CAPITALISATION
(i) The project is technically feasible.

(ii) The enterprise intends to complete the project and use or market the product.
(iii) The enterprise has the ability to use or sell the asset.
(iv) There is either an external market for the asset or an internal use for it.
(v) The company has the financial resources to complete the project.
(vi) The related costs can be measured reliably.
AMORTISATION
Capitalised development costs can be carried forward until the product being developed is ready
for production. At this point it must be amortised over the expected commercial life of the
product.
CHAPTER SUMMARY
- Non current assets are acquired not for resale but to be used in organization to
help generate income over a period of more than one year.
- Non current assets are depreciated over a period of their estimated life span
- Depreciation is the allocation of the cost of the asset over its economic life
- Depreciation is a non cash expense and it is charged to income statement.
- The straight line method of depreciation assumes that the asset will be used
evenly through out its life and therefore some amount is charged to income
statement from one year to the next.
- Reducing balance method assumes that the asset will be used more in its earlier
years than later years, thus the depreciation amount will be reducing with time.
- Non current assets may be sold off before their life span expires. A disposal
account is opened to determine whether a profit or loss has been made on
disposal.
- It is also important that an organization keeps a non current asset register for
control purposes.
188
EXERCISES
1. Fill in the blanks.
Net book value is less
2. Two common methods of depreciation are:
(a) ..
(b) .
3. A non current asset (cost K10 000, depreciation K7 500) is given in part exchange
for an new asset costing K20 500. The agreed trade in allowance is K3 500.
Calculate profit or loss on disposal.
4. The details about a non current asset that would be included in a non current asset
register are:
1. Net book value is cost less accumulated depreciation
2. (a) Straight line
(b) reducing balance
3. Net book value (K10 000 K7 500) = K2 500

Trade in allowance = K3 500
Profit on disposal K1 000
4. (a) Date of purchase

(b) Description and location
(c) Original cost
(d) Depreciation method and rate
(e) Accumulated depreciation to date
189
CHAPTER 18
ACCOUNTING FOR INVENTORIES
INTRODUCTION
Profit is excess of income over expenditure. The purpose of this chapter is to describe how
inventory valuation affects gross profit and the impact it has on current assets in the Balance
Sheet.
TOPICS
1 What is inventory?
2 Cost of goods sold
3 Accounting for opening and closing inventories
4 Carriage costs
5 Inventory counting and inventory accruals
6 Valuing inventory and effect on profit
Learning Outcomes
At the end of this chapter, students should be able to:
- Describe inventory
- Explain the application of accounting concepts to the valuation of inventory
- Explain the methods of valuing inventory when items have been purchased at different
prices.
- Explain the impact of inventory valuation methods on profit and net assets
- Explain the effect of carriage inwards on goods purchased
- Calculate the value of closing inventory
- Report closing inventory in the final accounts.
18.1 What is inventory
International Accounting Standard (IAS 2) defines inventory as:
- Assets held for sale in the ordinary course of business.

- Items in the process of production for sale
- Raw materials or supplies to be consumed in the production process or in the
rendering of services
Inventory is also called stock.
190
18.2 Cost of goods sold
The accruals concept requires that income should be matched with expenses incurred in
earning that income. Goods bought in an accounting period may not all be sold at end of
period. The unsold goods will be held in the business warehouse as inventory. These
goods should not be included in the cost of sales for the period.
Profit is calculated on what has been sold.
Calculation of cost of goods sold
Opening inventory xx
Add: purchases xx
xx
Less: closing inventory (xx)
Cost of goods sold xx
Example
A trader is in business buying and selling radios. His financial year ends on 31 March
each year.
During the financial year ending 31 March 20x7, the following is a summary of the
transactions that took place.
- bought 30 radios at K40 000 each

- sold 21 radios at K55 000 each
During the year to 31 March 20x8 he continued with his business and the following took
place.
- bought some more radios 35 at K40 000 each

- sold 38 radios at K57 000 each
Required:
Calculate the gross profit for each of the two years?
Solution:
K K
Year to 31 March 20x7
Sales (21 x K55 000) 1 155 000
Cost of sales
Purchases (30 x K40 000) 1 200 000
Less: closing inventory
(9 x K40 000) (360 000)
(840 000)
Gross profit 315 000
191
NOTE: Though 30 radios were bought only 21 radios were sold. Profit will be
calculated on the 21 radios sold, thus 21 x K40 000 = K840 000 is cost of radios sold at
(21 x K55 000 = K1 155 000). The 9 radios not sold will be considered as closing
inventory.
What is closing inventory in 20x7 will be opening inventory in 20x8.
Year to 31 March 20x8
Sales (38 x K57 000) K2 166 000
Cost of sales:
Opening inventory (9 x 40 000) K360 000
Add: Purchases (35 x K40 000) K1 400 000
K1 760 000
Less closing inventory

(6 x K40 000) (K240 000)
(K1 520 000)
Gross profit K646 000
NOTE: For the year to 31 March 20x8, the business had a total of 44 radios i.e. 9 from
20x7 plus 35 bought during the year. Out of 44 radios only 38 were sold leaving 6
unsold (closing inventory). Therefore profit is calculated of the cost of the 38 radios
sold. The concept of going concern is in play for taking closing inventory to the next
accounting period.
Inventory stolen or destroyed or lost
If inventory bought is stolen or destroyed that is considered a loss to the business. When
calculating profit it will be part of cost of sales or shown separately as an expense.
Example in inventory stolen or destroyed
Using example 12.4, assuming 2 radios were stolen, the situation will now be as follows:
Sales (38 x K57 000) K2 166 000
Cost of sales:
Opening inventory (9 x 40,000) K360 000
Add purchases (35 x K40,000) K1 400 000
K1 760 000
Less closing inventory
(4 x K40 000) (K160 000)
(K1 600 000)
192
In the above example, since only 4 radios are remaining, the 2 radios stolen will be
included as part of cost of sales when calculating profit.
An alternative method will be to deduct the stolen radios from the total inventory and
show it as a separate expense as follows:
Sales (38 x K57 000) K2 166 000
Cost of sales:
Opening inventory (9 x K40 000) K360 000
Add: Purchases (35 x K40 000) K1 400 000
K1 760 000
Less: Inventory stolen (2 x 40,000) (K80,000)
K1 680 000
Less: Closing inventory (4 x 40 000) (K160,000)
K1 520 000
Expenses:
Inventory stolen (2 x 40 000) (K80 000)
K566 000
18.3 Inventory and cost of carriage inwards and carriage outwards.
Carriage refers to the cost of transporting purchased goods from the supplier to the
premises of the business which has bought them. This cost is sometimes paid by
customer or supplier.
- When the buyer (customer) pays the cost it is called carriage inwards
- When the seller (supplier) pays the cost, the cost to the supplier is called carriage
outwards
- Carriage inwards is added to cost of purchases. It is a direct expense and
therefore included in cost of sales
- Carriage outwards is a selling and distribution expenses in the income statement.
It is an indirect expense.
Example Carriage inwards and outwards
The following amounts appear in the books of a trader at the end of the financial year.
K
Opening inventory 55 000
Closing inventory 85 000
Carriage outwards 62 000
Purchases 75 000
Carriage inwards 3 000
193
Required:
Calculate cost of sales.
Solution
K
Cost of sales:
Purchases 75 000
133 000
Less: Closing inventory (85 000)
Cost of sales 48 000
18.4 Accounting or opening and closing inventories
In order to calculate gross profit, it is necessary to work out the cost of goods sold, and in
order to calculate the cost of goods sold, it is necessary to have values for the opening
inventory and closing inventory.
Assuming the inventory value is given, double entry will be as follows:
- Transferring purchases to income statement
DR Income Statement
CR Purchases Account
- Value of inventory is arrived at after counting or conducting physical stock take.

This is usually done at year end to determine closing inventory. When this is
done, double entry is:
DR Inventory Account (closing inventory value)

CR Income Statement
When closing inventory is credited in income statement it means it will be added

to sales figure, but because of the format of the income statement which is vertical
presentation, closing inventory is shown as a deduction from purchases in arriving
at cost of sales.
- Closing inventory (stock) at end of one period becomes opening inventory at start
of next period. The inventory account remains the same until the end of the next
period, when the value of opening inventory is taken to the income statement.
Any purchase made in the period will be recorded in the purchases account.
DR Income Statement
CR Inventory account (with value of opening inventory)
194
Example: Ledger accounting for inventory
Sky Ltd sets up business with capital in cash of K750 000. During the first year trading
to 31 December 20X8, recorded the transactions below:
Bought goods on credit for resale K80 000

Bought goods and paid by cash K95 000
Sold goods for cash to different customers K150 000
Sold goods on credit also to different customers K105 000
Receipts from credit customers K70 000 cash
Payments to credit suppliers K60 000
Purchased motor van for use in the business K50 000 cash
Sundry expenses paid in cash K25 000
A physical stock take was conducted and closing inventory was valued at K35 000.
Required:
Prepare ledger accounts for the above transactions and draft an income statement for the
year ended 31 December 20x8.
Solution:
Because this is the first year in business, there is no opening inventory.
Dr Cash account Cr
K000 K000
Capital 750 Purchases 95
Sales 150 Payables 60
Receivables 70 Motor van 50
Expenses 25
___ Balance c/d 740
970 970
Balance b/d 740
Dr Capital account Cr
K000 K000
Cash 750
Dr Trade Payables Cr
K000 K000
Cash 60 Purchases 80
Balance c/d 20 __
80 80
Balance b/d 20
Dr Purchases account Cr
195
K000 K000
Payables 80 Income Statement 175
Cash 95
___ ___
175 175
Dr Trade Receivables Cr
K000 K000
Sales 105 Cash 70
___ Balance c/d 35
105 105
Dr Sales account Cr
K000 K000
Income Statement 255 Cash 150
___ Receivables 105
255 255
Dr Motor van account Cr
K000 K000
Cash 50 Balance c/d 50
50 50
Dr Sundry Expenses account Cr
K000 K000
Cash 25 Income statement 25
25 25
Dr Inventory account Cr
K000 K000
Income statement 35 Balance c\d 35
==== ====
Balance b/d 35
196
SKY LTD
Income statement for the year ended 31 December 20x8
(using vertical format)
K000 K000
Sales 255
Cost of sales:
Purchases 175
Less: Closing inventory 35
(140)
Gross profit 115
Less: Expenses
Sundry expenses (25)
Net profit 90
===
SKY LTD
Income statement for the year ended 31 December 20x8
Using T Format)
Dr Cr
K000 K000
Purchases 175 Sales 255
Gross profit c/d 115 Closing inventory 35
290 290
Sundry Expenses 25 Gross profit b/d 115

Net profit 90 ___
115 115
N.B. The balance on the inventory account is K35 000 which will appear in balance
sheet as a current asset.
As it is the K35 000 closing inventory is the only entry in the inventory account.
Theres no figure for opening inventory.
If opening inventory was there, it would have been eliminated by transferring it as

a debit balance to the income statement.
DR Income statement (with value of opening inventory)

CR Inventory account (with value of opening inventory)
197
18.5 Inventory Counting
- A business is regarded as a going concern unless it is otherwise it is stated. As the

business continues with its operations financial statements must be drawn up at
regular intervals, usually on yearly basis. The time when financial statements are
being prepared, the activities of the business are frozen in order to determine the
assets and liabilities available at that date. This is also the time that inventory
quantities are established, and this can be done by physical counting. The time
taken will vary from size of organization and inventory involved. If the
organization is large and involves different types of stock (inventory), it may be
necessary to:
(a) close down the business while stock take takes place
(b) maintain continuous inventory records manually or using a computerized
system where records are updated immediately an entry is made for
receipts and issues.
Inventory accruals
This is where goods have been received before the year end and included in inventory,
but no invoice has yet been received. Without an invoice no record can be made in
accounting books to show the business indebtedness or liability to suppliers.
To determine the price of the uninvoiced goods a goods received note (GRN), delivery
notes or current order forms may be used for this purpose.
- Double entry would then be effected as:
DR Purchases account
CR Payables (Liability)
18.6 Inventory Valuation

IAS 2 provides guidance and rules governing inventory valuation. There are
many methods in theory which may be used to value inventory. The following
are some of them.
(a) Selling price

(b) Net realizable value i.e. sales minus expenses
(c) Historical cost i.e. amount at which it was originally bought
(d) Current replacement cost i.e. how much it would cost to replace.
- IAS 2 (inventories) states that inventory should be valued at the lower of cost and
net realizable value.
Therefore (a) and (d) above are eliminated.
(a) because selling price may include profit before goods are sold thus going
against the prudence and realization concepts.
198
(d) because replacement cost may over state inventory especially where
prices are continuously rising.
Example 1: Net Realisable Value (N.R.V.)
An item is purchased for K45 000 (cost). Another K7 000 has to be spent to get it
ready for sale. After which the item will be sold for K60 000.
N.R.V. = K60 000 K7 000 = K53 000.
Therefore valuing it at K53 000 in balance sheet will be to anticipate a profit of

K53 000 K45 000 = K8 000.
In this case the appropriate valuation will cost K45 000 because it is lower of
N.R.V. of K53 000.
Example 2: With different items of inventory
If a business has many inventory items on hand the comparison of cost and
N.R.V. should be carried out for each item separately. Do not aggregate costs and
N.R.V. for all items and compare the two totals.
At the year end on 31 March 20x6, a business has three (3) items of inventory
remaining in warehouse, for which the cost and N.R.V. is given below.
Inventory item Cost N.R.V. Lower of cost/N.R.V.

K K K
A 17 000 23 000 17 000
B 8 500 5 000 5 000
C 23 000 23 100 23 000
48 500 51 100 45 000

====== ====== ======
K45 000 is the value that should appear in balance sheet as value of inventory.
Comparing K48 500 with K51 100 and valuing inventory at K48 500 would be
inappropriate because there would be covering up.
Example 3:
The following figures relate to inventory held at the year end.
A B C
K K K
Cost 20 000 9 000 12 000
Selling price 30 000 12 000 22 000
Modification costs - 2 000 8 000
Marketing costs 7 000 2 000 2 000
Units held 200 000 150 000 300 000
199
Required:
Calculate the value of inventory held

Solution
Item Cost N.R.V. Valuation Qty Total Value

K K K Units K000
A 20 000 23 000 20 000 200 000 4 000 000
B 9 000 8 000 8 000 150 000 1 200 000
C 12 000 12 000 12 000 300 000 3 600 000
8 800 000
========
Note:
Net Realisable Value
Item
A: K300 000 K7 000 = K23 000
B: K12 000 - K4 000 = K8 000
C: K22 000 - K10 000 = K12 000
18.7 Determining the purchase cost of inventory
Depending on the type of business, inventory could be
(i) raw materials i.e. if the business is producing its own goods
(ii) finished goods which could have been produced or bought elsewhere for resale.
(iii) Work in progress (WIP) i.e. work yet to be completed.
The easiest way of valuation of inventory is to use historical cost i.e. the amount paid at
the time of buying the inventory.
However, actual cost may be applicable to businesses dealing in specialized items of high
value, and separately identifiable e.g. Toyota cars may be identified separately as camry,
vista, chaser, corsa, etc.
Certain items may not be identifiable separately. As items are bought they may be stored
in bins, shelves or pallets, where they are mixed with other items bought previously. As
these items are issued or sold, they will be removed in their mixed state regardless of
which came in first or last.
When valuing inventory this may create problems especially when items were bought at
different prices.
There are many techniques which are used to value such items of inventory. They
include the following:
- First in first out (FIFO)

- Last in first out (LIFO)
- Average cost (AVCO)
- Replacement cost
200
12.16 (a) FIFO
In this method it is assumed that items are issued or sold in order in which they
were received. The oldest items are issued or sold first.
(b) LIFO
This is the opposite of FIFO. Item of inventory are issued or sold starting with
the most recently received or bought, while the earlier stock will be issued or sold
last.
(c) AVCO
As purchase price change with each new consignment, the average price of
components in stock is constantly changed. Each component of stock at any
moment is assumed to have been purchased at the average price of all components
in stock at that moment.
(d) Replacement cost
This method assumes that the cost at which inventory was bought is the amount it
would cost to replace it. This is often (but not necessarily) the unit cost of
inventories bought in the next consignment following the issue of the component
to production. For this reason, a method which produces similar results to
replacement costs is called NIFO (Next in first out).
When preparing financial statements FIFO and AVCO are preferred treatments.
LIFO is not permitted as an alternative treatment (IAS 2)
12.17 Example: Valuation methods
The following transactions took place during the month of June 20x8
QUANTITY UNIT COST
K000
1 June Opening inventory 200 12
6 June Purchases 400 17
9 June Sales 300 30
15 June Sales 250 32
17 June Purchases 100 18
21 June Sales 60 32
201
Required:
Show how continuous inventory records will be and how closing inventory will be valued
using each of the following:
(a) FIFO
(b) LIFO
(c) AVCO
Prepare income statements for each of the above methods.

Solution
(a) FIFO METHOD
Date Purchased Sales Inventory Balance

After each transaction
1 June - - 200 x K12 each K2 400
6 June 400 @ $17 each - K6 800

+
K6 800 K2 400 K$9 200
9 June - 300 @ K30 each (200 @ 12) (2 400)

K9000 (100 @ 17) (1 700)
300 @ 17 5 100
15 June - 250 @ 32 each 300 @ 17 5 100

K8 000 (250 @ 17) (4 250)
50 @ 17 850
17 June 100 @ $18 each - 1 800 2 650
21 June - 60 @ 32 each 50 @ 17 (850)

K1 920 10 @ 18 (180)
90 @ 18 1 620
K8 600 K18 920
Closing inventory using FIFI is 90 units remaining from the last cost of 100 @ K18 each
thus 90 units @ K18 each = K1620.
202
(b) LIFO METHOD

1 June - - 200 @ 12 each K2 400
6 June 400 @ K17 each - K6 800

+
K6 800 K2 400 K9 200
600
9 June - 300 @ K30 (300 @ 17)
K9000 100 @ 17 1 700
200 @ 12 2 400
300 4 100
15 June - 250 @ 32 300

(100 @ 17)
K 8 000 (150 @ 12)
50 @ 12 K600
17 June 100 @ K18 each - 50 @ 12 K600

K1 800 100 @ 18 K1 800
150 K2 400
21 June - 60 @ 32 150
K1 920 60 @ 18
40 @ 18 K720
50 @ 12 K600
K8 600 K18 920 90 1320
Closing inventory using LIFO is 90 units broken down as follows:
40 @ 18 = K720
50 @ 12 = K600
K1 320
203
(c) Using AVCO

1 June - - 200 x K12 each K2 400
6 June 400 @ 17 each - K6 800

+
K6 800 K2 400 K9 200
9 June - 300 @ 30 600

K9000 (300)
300 @ 15 each K4 500
15 June - 250 @ 32 300

K8 000 (250)
50 @ 15 each K750
17 June 100 @ 18 each - 50 @ 15 each K 750

K1 800 100 @ 18 each K1 800
150 K2 550
21 June - 60 @ 32 each 150

K1 920 (60)
90 @ 17 K1 530
Using the AVCO method closing inventory is at 90 x K17 = K1 530.
Average cost takes place when purchases are made.
Average cost is taken to be: total cost

Number of units
The remaining units will be valued at K15 each thus;
300 units x K15 = K4 500
On 15 June 250 units are sold. The remaining 50 units will be valued still at K15 each
Thus 50 units x K15 = K750.
On June 17, 100 units are purchased. The number of units are now 100 + 50 units from
15 June making a total of 150 units.
204
Any remaining inventory will be valued at:
K2550
150 = K17 each
The closing inventory as at 31 June will be:
90 units x K17 = K1530.
(d) Inventory valuation and profit
Each method of inventory valuation produces different cost of closing inventory

and cost of sales, and this will produce different profit figures.
Using the previous example, income statements using different methods will be as
follows:
(i) FIFO
Income Statement
K K
Sales 18 920
Purchases 8 600
Closing inventory (1 620)
(6 980)
Profit 11 940
(ii) LIFO
Income Statement
K K
Sales 18 920
Purchases 8 600
(7 280)
Profit 11 640
(iii) AVCO
Income Statement
K K
Sales 18 920
Purchases 8 600
(7 070)
Profit 11 850
205
CHAPTER SUMMARY
- Profit is calculated on inventory sold. Unsold inventory at year end (closing inventory) is
carried forward to the next accounting period as opening inventory.
- Cost of sales is calculated as:
Opening inventory XX
Purchases XX
XX
Less: Closing inventory (XX)
XX
- Carriage inwards is included as part of cost of inventory because the expense is directly
attributable to purchases.
- Inventory account is opened at year end as an adjusting item. This takes place after
physical stock count or continuous inventory count. The value is based on lower of cost
and net realizable value for each separate item or group (separate valuation concept).
- Cost is purchase cost plus direct expenses.
- N.R.V. is selling price minus completion and selling costs.
- Valuation methods for inventory includes the following
FIFO
LIFO
AVCO
- Closing inventory is created in income statement and shown as current asset in balance
sheet.
EXERCISES
1. What is the formula for calculating cost of goods sold?
2. What is the difference between carriage inwards and carriage outwards and how are they
treated in financial statements.
3. How is inventory determined and how is it incorporated in financial statements.
4. Distinguish between cost and net realizable value in relation to inventory.
206
5. Identify three methods of pricing inventory.
1. Opening inventory XX
Purchases XX
Less: closing inventory (XX)
XX
2. They are all transport expenses. Carriage inwards is a direct expense incurred at the time
of buying the goods and therefore is added to purchases as part of cost.
Carriage outwards is selling expense and appears under indirect expenses in income
statement.
3. Inventory is arrived at by conducting physical stock count or continuous count. Closing

inventory is credited to income statement and shown as current asset in balance sheet.
4. Cost includes amount spent to buy goods plus direct expenses.
Net realisable value (N.R.V.) is value of inventory calculated as follows:
Selling Price - expenses incurred in putting the item in a saleable

condition
Inventory is valued at lower of cost and net realisable value.
5. FIFO, LIFO, AVCO
207
CHAPTER 19
CORRECTION OF ERRORS AND THE SUSPENSE

ACCOUNT
INTRODUCTION
In Chapters 11 and 12 on Trial balance it was clearly stated that when trial balance totals are
equal, does not mean that the information is free from errors.
This chapter will discuss errors that the trial may disclose and those that may not be disclosed,
and how they are corrected.
TOPICS
1 Errors not disclosed by the trial balance

2 Errors disclosed by the trial balance
3 The journal, suspense account and the correction of errors.
LEARNING OBJECTIVES
At the end of the chapter, the student should be able to:
- Identify different types of errors and how to correct them

- Distinguish between errors affecting trial balance and those not
- Adjust profit figure after correcting errors
- Show correctly suspense account in balance sheet before errors are corrected
8.1 Errors not disclosed by trial balance
These are errors where trial balance totals are equal but with mistakes.
It is not possible to draw up an exhaustive list of all the errors which might be made.
Below are some of the common ones which might cover most of the errors.
- Errors of transposition
- Errors of Omission
- Errors of Principle
- Errors of Commission
- Compensating errors
- Errors of Original entry
- Complete reversal of entries
208
When errors are detected they should be corrected immediately. The journal is the book
of prime entry used for the correction of errors.
There is no rule regarding how errors should be corrected. One should just first
understand how the error was made and how it should be corrected.
(a) Errors of transposition or errors of original entry
This occurs when a number of digits in an amount are accidentally recorded the
wrong way round. For example, a sales invoice shows sales of K1478. When
recorded in sales journal it is shown as K1487. Double entry will be based on the
wrong figure in correct accounts, therefore, the trial balance will have equal
totals.
(b) Errors of Omission
This is where a transaction is not recorded in the accounting books. Therefore,

double entry will be based on recorded transaction and the trial balance will have
equal totals based on processed activities.
Example
A business has sent a lot of sales invoices to different customers one of them
being K260 sent to customer. If it is omitted both the Debit and Credit sides of
trial balance will be down by K260. The trial balance totals will be equal based
on the other correctly processed sales invoices.
(c) Errors of principle
These errors are a result of ones failure to correctly apply the principles of
accounting or accounting concepts. The common ones are failure to appreciate
the distinction between capital and revenue expenditure and capital income and
revenue income.
Example 1
Bought non current asset (furniture) by cash K670.
Correct double entry in correct account
DR Furniture account
CR Cash account
Correct double entry but in wrong account
DR Purchases account
error of principle
CR Cash account
Please note that furniture has wrongly been debited in purchases account instead
of Furniture account. The fact that both have debit entries, the trial balance totals
209
will be equal but with wrong figure of purchases and none in furniture. Record of
furniture will not be there since it is included in purchases.
(d) Errors of Commission
Commission in this context means failure to do work to ones best ability.
Errors of commission are very common for customers or supplier with similar
names. Also common with mixing up expenses, e.g. recording a debit entry or
credit entry in the wrong account.
Example 1:
Sold goods on credit to J Bush of Northern region but was by mistake recorded in
J Bush of Eastern region.
N.B. Both are receivables are supposed to be debited.
Example 2:
Repairs expenses of K35 recorded in Insurance account.
N.B. Both are expenses and have debit entry for this example.
(e) Compensating errors
To compensate means to make up e.g. being paid some cash for injury while on
duty.
Compensating errors arise as a result of making mistakes in one account which is

compensated by another mistake in another account (i.e, the errors cancel each
other).
Example
Bought postage stamps by cash K5.

Paid for rent in cash K10.
Stamps account
Cash 10
Rent account
Cash 5
210
Cash account
Stamps 5
Rent 15
Trial Balance
Dr. Cr.
Stamps 10
Rent 5
Cash __ 15
15 15
Please note that figures in stamps and rent are switched. Error made in stamps
has been compensated by another error in rent. Trial balance totals will be equal
but with errors.
(f) Complete reversal of entries
This is when double entry for a transaction is reversed i.e. Debiting an account
which should be credited and crediting an account which should be debited.
Example:
Paid for stationery in Cash K4

Correct double entry
Dr Stationery account K4
Cr Cash account K4
Reversed entry
Dr Cash account K4
Cr Stationery account K4
Trial balance will agree because correct amount and equal in value is debited and
credited in correct accounts but wrong sides.
Activity 1
Identify the errors in the following situations.
(i) Recording motor repairs in motor account

(ii) Recording sale of non current asset in sales account
(iii) Translating purchases invoice figure of K505 into purchases journal as
K550.
8.2 Errors disclosed by trial balance
In some cases, the trial balance totals may not be the same. This may mean a lot of
things.
211
When the trial balance fails to agree sometimes it could just be a simple additional error
within the trial balance. It is advisable to sum up the trial balance once or even twice
again. If this produces same results then it could be one of the following or combination
of errors.
(i) Incomplete double entry. Recording only one account a transaction. The trial
balance will not agree.
(ii) Debiting one figure and crediting a different figure for same transaction e.g.
bought stamps for cash K5. Debit stamps with K5 but credit cash with K4.
(iii) Transposition e.g. paid for stationery in cash K15. Debit stationery with K15 but,
credit cash with K51.
8.3 Correction of errors
When totals in trial balance are not equal, a temporal account is opened called the
suspense account.
8.4 Suspense account
The suspense account is opened for the difference in the trial balance because it is not
clear what caused the difference. However, it is not encouraged to all the time open
suspense account when trial balance totals disagree, except under certain circumstances
e.g. where it is suspected that the difference may be as a result of many errors which
might take sometime to discover.
Also where the bookkeeper does not know where to post one side of a transaction e.g. a
cash payment is credited to cash, but the bookkeeper does not know what the payment
was for and so will not know which account to debit.
8.5 Suspense account and Financial statement
Suspense account is always placed where theres a deficit in trial balance, which could be
debit side or credit side, thus forcing temporally the trial balances totals to be equal.
With the suspense in trial balance, the financial statements could now be prepared.
- Suspense account will appear in balance sheet. If suspense account is debit

balance, it is shown separately under current asset.
- If suspense balance is credit, it is shown separately as under current liability.
- It is important to note that showing suspense account as such in balance sheet
does not mean that it is an asset or liability but that is the only place it fits if
balance sheet is to remain balanced, while investigations are being carried out.
- When financial statements are prepared with suspense there could be a possibility
that the profit calculated is wrong and may require adjustment when errors are
detected and corrected.
212
8.6 The Journal and correction of errors
All errors once detected are corrected via the journal. When correcting errors it is
important that some will affect suspense account and others not.
- Errors not causing imbalance in trial balance will not affect suspense account.
- Errors causing imbalance in trial balance will be corrected via suspense account.
Example 1: Suspense account not involved
Both T Flash light and T Flash bulb are our customers. On 1 January 20X5 sold goods to
T Flash light but by mistake it was recorded in T Flash bulb account K150.
Solution:
It is assumed that the sales account was correctly credited with K150 but instead of
debiting T Flash light with K150, T Flash bulb was debited instead. The trial balance is
not affected by this error because double entry in figure terms is correct. To correct this
error it should be:
Dr T Flash light account

Cr T Flash bulb account
Example 2: Suspense account involved
Paid rent in cash K170

Rent account is debited with K100
Cash account is credited with K170
Solution
The trial balance totals will not be equal. One side (Cr) will be greater than debit side by
K70. This error should be corrected via suspense account.
Trial balance before error is corrected will be:
Dr Cr
Rent 100
Cash 170
Suspense 70
170 170
Suspense account will be opened with debit balance
Dr Suspense account Cr
Balance 70
- error corrected
213
Dr Rent account with K70 i.e. to bring rent figure to K170
Cr Suspense account with K70 i.e. to clear debit balance shown in suspense
account.
After correction the accounts will now be:
Dr Rent account Cr
Cash 100
Suspense account 70
Balance 70 Rent 70
70 70
Corrected trial balance

Dr Cr
Rent 170
Cash 170
170 170
N.B. Suspense account is now closed and rent adjusted by K70 to K170. The
error has been corrected and trial balance will agree with adjusted figure of rent.
Cash was correctly recorded and so is not affected by the error.
Example 3: With more than one error
C.H. Systems Ltd is a hardware business, whose financial year ends on 31

December each year. At 31 December 20X5 a trial balance was extracted which
revealed a deficit of K1421 on the debit side. This was resolved by opening a
suspense account, and financial statements where prepared and showed a profit of
K12,600.
In January 20X6 investigation revealed that:
(i) A page of sales day book totaling K576 had not been posted to sales
account.
(ii) An accrual of rates K371 had not been taken into account
(iii) A repayment part of the loan from the bank K300 had been entered on the
loan interest account
(iv) The petty cash balance had been included as K57 instead of K75.
(v) A bad debt of K120 had been entered in the customers account but not in
the expense account.
(vi) Drawings K200 had been entered in the sundry expenses account
214
(vii) An invoice for car repairs K380 had been entered in the wages account.
(viii) The rent received account balance of K600 had been entered on the wrong
side of the trial balance and income statement.
(ix) Advertising account with a balance of K2,759 had been omitted
altogether.
(x) Closing inventory had omitted some items valued at cost K2,000.
(xi) Discount allowed of K150 had been credited to discounts received.
Required:
(a) Show by means of journal to correct the above errors (narratives are not
required).
(b) Clear suspense account balance after the correction of errors and
(c) Prepare a statement showing the corrected amount of the profit.
Solution:
(a) The Journal
Dr Cr
(i) Suspense account 576
Sales account 576
Income Statement 371
(ii) Rates account 371
(iii) Bank loan account 300

Interest account 300
(iv) Petty cash account 18

Suspense account 18
(v) Bad debts account 120

Suspense account 120
(vi) Drawings account 200

Sundry expenses account 200
(vii) Car repairs account 380

Wages account 380
(viii) Suspense account (rent) 1,200
Rent 1,200
Advertising 2759
(ix) Suspense account (advertising) 2759
(x) Closing Inventory account 2,000

Income Statement 2,000
215
(xi) Discount allowed account 150
Discount received account 150
(b) Dr Suspense account Cr
Balance 1421
Sales 576 Petty cash 18
Rent 1200 Bad debts 120
Advertising 2759
Discount all. 150
____ Discount rec. 150
3197 3197
(c) Statement of profit adjustment:

K
Net profit before adjustments 12600
Add sales omitted 576
Less rates accrual (371)
Add loan repayment entered in loan interest 300
Less bad debts (120)
Add drawings entered in sundry expenses 200
Add rent received entered on wrong side 1200
Less advertising omitted (2759)
Add omitted inventory 2000
Less discount allowed (150 x 2) 300
Adjusted profit 13926
Notes
- Error (i) is an error of undercast in sales account. The trial balance will
not balance because the receivables figure will be more by K576 on credit.
The suspense account is involved in correcting this error. Profits should
adjust by adding sales of K576.
- Error (ii) rates accruals comes as a year end adjustment. The trial balance
is not affected by this error but profits will be over stated since accrued
expenses are included as expenses in the year to which they relate. Profits
should reduce by K371
216
- Error (iii) the trial balance is not affected because the loan repayment
should have been debited to loan account instead of loan interest. Double
entry was achieved but in a wrong account. However, the loan interest
account was overstated by K300. therefore profits should be increased by
K300.
- Error (iv) this error will affect the trial balance and suspense account is
involved in correcting it. Petty cash is an asset and was transposed. The
debit side of trial balance will be less by K18. However, profit is not
affected by this error because cash does not appear in Income Statement
but as a current asset in balance sheet.
- Error (v) this is incomplete double entry and the trial balance will not
balance thus the reason for the suspense account. Since bad debt is an
expense, its omission increases profits. Therefore, after correcting the
error the profits should be reduced by the amount of the bad debts.
- Error (vi) this is an error of principle and the trial balance is not affected.
Drawings should have been debited but instead sundry expenses were
debited. Double entry was correct but debited in wrong account.
- Error (vii) same as error (vi).
- Error (viii) The rent account in the ledger was correct with a credit entry.
On taking it to trial balance it was recorded on the debit side instead of
credit side. This made the debit side of trial balance to be twice bigger the
amount, and the trial balance would not balance. The trial balance should
be credited with rent receivable by K1200 (600 x 2). The first K600 to
cancel the debit and the other K600 to reinstate the rent receivable. Rent
receivable is an income and increases profit by crediting the income
statement. Now that it was debited in income statement, the profit were
understated by twice the amount, so add back twice the amount.
- Error (ix) advertising account is the ledger but was not transferred to trial
balance. This will cause an imbalance in trial balance. Therefore, it
should just be included by crediting suspense account with advertising. Its
omission from trial balance also means that it was omitted from income
statement thus overstating profits. This profits should now be reduced by
the amount.
- Error (x) closing inventory is a year end adjustment after physical stock
take. It does not appear in trial balance and so the error is outside trial
balance. However, profits were understated because cost of sales were
higher. Profits should now be increased by the same amount.
- Error (ix) see error (viii).
217
CHAPTER SUMMARY
The trial balance totals may not be equal because of errors which may include:
(i) Additional errors

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

(ii) errors of principle
(iii) errors of commission
(iv) complete reversal of entries
(v) compensating errors
All errors are corrected through the journal.
- When all errors are corrected the trial balance totals will be equal with adjusted figures.
- If after correction of errors a balance remains in suspense account, it may indicate errors
in correcting them or not all errors have been identified. A good question will mention
the outcome.
218
EXERCISES
1. Identify four (4) errors not affecting trial balance
2. When is the suspense account used?
3. What does a credit balance on suspense account indicate?
4. The trial balance of John Black as at 31 March 20X9 did not agree, there being a shortage
of K 874 on the debit side. A suspense account was opened for the difference.
Subsequent investigation showed:
(i) Discount allowed K480 had been entered on the credit side of discount allowed
account.
(ii) The bank statement balance of K560 overdraft had been included in trial balance
instead of the cashbook balance of K63 debit.
(iii) The provision for bad debts account of K150 had been entered on wrong side of
trial balance
(iv) Rent receivable account was over cast by K20
(v) Drawings of K250 had been included in purchases account
(vi) The sale of furniture (non current asset) had been included in sales account of
K300
(vii) Payment for insurance of K45 was entered in insurance account as K54
(viii) Discounts received was overstated by K100.
(ix) A cheque for K200 for car repairs had been posted to the building repairs account
(x) Provision for depreciation account K270 was entered on wrong side of trial
balance
(xi) The scrapping of an old lorry with net book value of K375 was omitted from the
books.
Required:
(a) Correct the errors via the journal

(b) What was the balance on suspense account before the errors were corrected.
219
1. Errors of omission, errors of principle, errors of commission and compensating

errors.
2. When the trial balance totals are not equal.
3. It indicates a shortage on credit side of trial balance.
4.
The Journal
K K
(i) Discount allowed account (480 x 2) 960
(ii) Trial balance (Bank account) 560

Bank account 63
Trial balance (Bank account) 623
(iii) Suspense account 300

Trial balance (with provision for bad
debts) 300
(iv) Rent receivable account 20

Suspense account 20
(v) Drawings account 250

Purchases account 250
(vi) Sales account 300

Disposal account 300
(vii) Suspense account 9

Insurance account 9
(viii) Discount received account 100

(ix) Car repairs account 200

Building repairs account 200
(x) Suspense account 540

Trial balance (with provision for
depreciation account) 540
(xi) Income Statement account 375

Lorry account 375
220
Provision for bad debts 300 Discount allowed 960

Insurance 9 Bank account 623
Provision for depreciation 540 Rent receivable 40
Balance 874 Discount received 100
1723 1723
221
CHAPTER 20
FINANCIAL STATEMENTS WITH ADJUSTMENTS

INTRODUCTION
This chapter summarises all the adjustments so far discussed in previous chapters in order to
prepare financial year end statements. This chapter contains exercises for practice, thus
consolidating the knowledge in the previous chapters. The student is advised to attempt the
questions before seeing the solutions.
TOPICS
1 Income Statement with adjustments

2 Balance sheet with adjustments.
LEARNING OBJECTIVES
At the end of this chapter, the student should be able to:
Prepare income statement and balance sheet with correct treatment of:
- prepayments
- accruals
- bad debts and provision for depreciation
- opening and closing inventory
222
Exercise 1
Shoe Black, is a sole trader operating as a retailer. The following information is extracted from
his accounting books as at 31 December 20X7.
K000 K000
Distribution expenses 1460
10% Loan 1000
Trade payables 820
Cash at bank 140
Allowance for doubtful debts 18
Trade receivables 810
Motor vehicles at cost 1680
Accumulated depreciation motor vehicles 620
Warehouse at cost 1800
Accumulated depreciation warehouse 290
Buildings at cost 8300
Accumulated depreciation buildings 1020
Land at cost 1510
Interest on loan paid 50
Salaries and wages 1590
Discounts allowed and received 80 100
Returns inwards 400
Inventory 1 January 20X7 1530
Purchases 8100
Sales 13600
Capital 1 January 20X7 10782
28400 28400
The following additional information is available:
(a) Closing inventory is K1,660,000

(b) Trade balances totaling K6,000 are to be written off and the allowance for doubtful debts
increased to K30,000.
(c) Salaries and wages owing K190,000 with K70,000 paid in advance.
(d) Distribution expenses of K60,000 were prepaid and K120,000 not paid as at 31
December 20X7.
(e) Interest of K50,000 is owing
(f) In January 20X8, the business received invoices for credit purchases totaling K18,000 for
goods delivered before 31 December 20X7.
(g) It was also found that credit sales invoices totaling K7,000 for goods delivered to
customers before 31 December 20X7 had by mistake been dated in January 20X8 and
thus excluded from sales for the year and from account receivables at the year end.
NOTE: The goods received had been included in the year end inventory figures given at
(a) above, and the goods sold had been excluded from it.
223
No adjustment to the inventory figure is therefore required:
(h) Depreciation should be provided as follows:
- Land nil
- Buildings 2% on cost per annum
- Warehouse 15% on cost per annum
- Motor vehicles 25% on cost per annum
Required:
(a) Prepare income statement for the year ended 31 December 20X7 and
(b) Balance sheet as at 31 December 20X7.
Solution:
Workings:
1. K000 4. Distribution expenses

Sales 13,600 K000
Sales excluded 7 1,460
13,607 add owing 120
Less prepaid (60)
1,520
2. Purchases 8,100 5. Interest on loan K000

Purchases for 50
Invoices not add accrued 50
Received 18 ___
8,118 1,00
N.B. 10% x 1000 = 100

3. Salaries and wages only K50,000 has been paid the
K000 other K50,000 is still owing
1,590
Add owing 190
Less prepaid (70)
1,710
6. (i) Bad debts and allowance for bad debts

K000
Receivables 810
Less: Bad debts (6)
Remaining receivables 804
K000
(ii) Allowance for bad debts is 18
New balance 30
Increase in allowance is 12
224
(iii) Bad debts and allowance for bad debts in
Income statement will be
K000
Bad debts written off 6
Increase in allowance 12
18
(iv) Receivables in balance sheet will be:
K000
Remaining receivables 804
Add omission 7
Allowance for bad debts (30)
781
7. Depreciation:
K000
(i) Buildings: Balance as per trial balance 1,020
charge to income statement
(2% x 8,300) 166
1,186
K000
(ii) Warehouse: Balance as per trial balance 290
charge to income statement
(15% x 1,800) 270
560
K000
(iii) Motor vehicles: Balance as per trial balance 620
Charge to income statement
(25% x 1650) 420
1,040
Shoe Black
Income statement for the year ended 31 December 20X7
K000 K000
Sales (1) 13,607
Less: Returns inwards (400)
Turnover 13,207
Cost of sales:
Purchases (2) 8,118
Less: Returns outwards (150)
Add: Carriage inwards 700
Gross profit (8,538)
4,669
Add: Discount received 100
225
4,769
Less: Expenses
Loan interest 100

Bad debts & allowance (6) (iii) 18
Salaries and wages (3) 1,710
Distribution Expenses 1,520
Depreciation: Buildings (7 (i)) 166
Warehouse (7 (ii)) 270
Motor vehicles (7 (iii)) 420
(4,534)
Net profit 235
Shoe Black
Balance Sheet as at 31 December 20X7
Non Current Assets Cost Depreciation N.B.V.

K000 K000 K000
Land 1510 - 1510

Buildings 8300 1186 7114
Warehouse 1800 560 1240
10504
Current Assets
Inventory (closing) 1660
Receivables (6 (iv)) 781
Prepayments (60 + 70) 130
Cash at Bank 140
2711
Total Assets 13215
Financed by:
Capital at start 10782

Add Net Profit 235
Non current Liabilities

10% Loan 1000
Current liabilities
Trade payables (820 + 18) 838
Accrued expenses (120 + 190 + 50) 360 1198
13215
226
Exercise 2
Mr. Bird Rock has been in business for some time trading in motor spares. The list below has
been taken from his books for the financial year ended 30 September 20X8.
K
Accumulated depreciation 136,500
Discounts received 15,400
Trade receivables 400,000
Postage and stationery 15,210
Telephone expenses 10,625
Bad debts 55,000
Drawings 315,000
Rent & rates 88,000
Insurance 11,000
Heating and lighting 50,781
Advertising 16,000
Cash in hand 4,242
Cash at bank 112,000
Inventory 1 October 20X7 156,000
Purchases 1,200,400
Allowance for doubtful debts 40,000
Returns outwards 2,745
Capital 1 October 20X7 1,103,179
Sales 2,000,000
Additional Information at 30 September 20X8.
(i) Inventory is valued at K127,666.
(ii) Depreciation charge for the year is 10% on reducing balance method.
(iii) Rates prepaid K910
(iv) Telephone owing K1,000
(v) Heating & Lighting owing K4,616
(vi) Allowance for Bad debts to be adjusted so that it is 5% of trade receivables.
Required:
Prepare income statement for Mr. Bird Rock for the year ended 30 September 20X8 and a
balance sheet as at that date.
227
Solution
Mr. Bird Rock

Income statement for the year ended 30 September 20X8
K K
Sales 2,000,000
Less: Returns inwards (110,300)
Turnover 1,889,700
Cost of Sales:
Inventory 1/10/20X7 156,000
Purchases 1,200,400
Returns outwards (2,745)
Carriage inwards 95, 000
_________
1,448,685
1,320,989
Gross Profit 568,711
Discount Received 15,400
584,111
Expenses:
Postage and stationery 15,210
Telephone expenses (10,625 + 1,000) 11,625
Bad debts (55,000 20,000) 35,000
Rent and rates (88,000 910) 87,090
Insurance 11,000
Heating and lighting (4,616 + 50,781) 55,397
Advertising 16,000
Depreciation: Fixtures and fittings 77,350
(327,938)
Net Profit 256,173
228
Mr. Bird Rock
Balance sheet as at 30 September 20X8
Non Current Assets Cost Depreciation N.B.V.

Fixtures and fittings 910,000 213,850 696,150
Current Assets
Inventory 30/09/20X8 127,666
Trade receivables (400,000 20,000) 380,000
Prepayments 910
Cash in Bank 112,000
Cash in hand 4,242
624,818
Total Assets 1,320,968
Financed by:
Capital 1/10/20X7 1,103,179

Net profit 256,173
1,359,352
Less: Drawings (315,000)

1,044,352
Current liabilities
Accruals (1,000 + 4,616) 5,616
276,616
1,320,968
CHAPTER SUMMARY
1. Income statements are prepared on matching and accruals concepts. That is matching
income with expenses, whether received or not and whether paid or not, as long as they
relate to a particular period under review.
2. Prepayments made in one period are not a charge in that period. In income statement
they are deducted from the appropriate expenses charge and shown in balance sheet as
current asset. Prepayments will be a charge to the period for which they have been paid.
3. Amounts not paid by the business at the balance sheet date, should be accounted for as
expenses in that period in income statement and shown as current liabilities in balance
sheet.
4. Any increase in Allowance for bad debts should be charged to income statement and any
decrease treated as income (gain) and netted off with bad debts because they are related.
5. The closing balances in Allowance for bad debts is the amount to be deducted from Trade
receivables in balance sheet.
229
CHAPTER 21
DEPARTMENTAL ACCOUNTS
INTRODUCTION
A business dealing in unrelated range of products under one roof, might wish to know the
performance of each product and make decisions such as to continue or withdraw.
The range of products will be divided into departments such as drappery, hardware, kitchen, etc,
and each department will be a cost centre and prepare its own income statement. This chapter
shows how to prepare departmental accounts and their usefulness.
TOPICS
1 Why prepare departmental accounts

2 Expense apportionment
3 Departmental income statement
4 The balance sheet
5 Decision-making
LEARNING OBJECTIVES
- Identify reasons why dividing a business into departments could be helpful

- Apportion expenses between departments using appropriate basis
- Prepare departmental income statements using the gross profit and contribution basis.
21.1 PREPARING DEPARTMENTAL ACCOUNTS
Departmental accounts are prepared to assess the performance of each department. The
layout of departmental accounts is not different from what has been covered in earlier
chapters. The primary difficulty in preparing departmental accounts is that many
expenses are shared. Common expenses shared may include:
- Rent and rates

- Electricity
- Insurance
- Transport
- Telephone
A business with separate departments for drappery, kitchenware and toiletries may prepare
departmental accounts as follows:
230
Drappery Kitchen Toiletries Total
Ware
K K K K
Sales 120,000 200,000 50,000 370,000
Cost of sales (75,000) (150,000) (80,000) (305,000)
Gross profit 45,000 50,000 (30,000) 65,000
The above information shows that Toiletries is a loss department. Without it gross profit
would have been K95,000. A decision has to be made on how to improve the operations
of the toiletry department, or replace it with another which is profitable.
LOSS LEADER
It is important to be mindful that certain business have a deliberate policy of reducing

prices in one department to increase customer flow and hoping that customers will also
buy from other departments. Thus loss in one department to be offset by profits in other
departments. This policy should be reviewed and be done away with if it is not yielding
profitable results for the whole business.
In the above example the end result is gross profit. This is because at this stage it is
relatively easy to keep separate records for sales, purchases and inventories of each
department.
21.2 EXPENSES
Some expenses in a departmentalized business could be considered as direct and others

shared expenses.
- Examples of direct expenses include salaries or wages of personnel identified

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

each department i.e. expenses which would not be paid if the department was
closed.
- When calculating net profit, expenses not traceable to the department and which
will still be paid even if the department was closed, are considered.
Therefore the best way of assessing departmental performance could be through

contribution.
231
Example: Complete departmental income statement.
The business of Opani has two departments, hardware and electrical. The
information below was taken from his books as at 31 December 20x7, the end of
the financial year.
Hardware Electrical Unspecified

K K K
Sales 198,000 264,700
Purchases 75,000 137,000
Opening inventory 25,000 43,600
Wages 35,000 34,000
Other expenses 24,700 20,100
Building at cost 146,000
Motor vehicles at cost 145,000
Rates 15,000
Accumulated depreciation:
Buildings 37,000
Electricity 20,000
Notes:
(a) Depreciation policy is 20% straight line on buildings and 40% on motor
vehivles using reducing balance method.
(b) Buildings are used 4/5 hardware and 1/5 electrical
(c) Motor vehicles are used equally between the two departments.
(d) Electricity and Rates are apportioned on floor area occupied 2/3 hardware
and 1/3 electrical.
(e) Closing inventory is K15,000 and K17,000 respectively for hardware and
electrical.
Required:
(a) Prepare income statement for the year ended 31.12.20x7

(b) Assess the impact of closing down either department.
232
Solution:
(a) Opani,
Departmental income statement for the year ended 31.12.20x7.
Hardware Electrical Total

K K K K K
Sales 198,000 264,700 462,700
Cost of sales:
Opening inventory 25,000 43,600
Purchases 75,000 137,000
100,000 180,600
Less: closing inventory (15,000) (17,000)
(85,000 (163,600) (248,600)
Gross profit 113,000 101,100 214,100
Direct expenses:
Wages 35,000 34,000
Other expenses 24,700 20,100
(59,700 (54,100) (113,800)
Contribution 53,300 47,000 100,300
Shared expenses:
Depreciation:
Buildings 23,360 5,840
Motor vehicles 16,940 16,940
Rates 10,000 5,000
Electricity 13,333 6,667
(63,633) (34,447) (97,080)
Net profit (10,333) 12,553 3,220
(b) - Some costs are fixed e.g. rates, depreciation, electricity and
these would not be saved even if Hardware department is closed.
- Contribution by hardware department is very good though it has

made a net loss. The problem could be on the apportionment of
indirect expenses.
- Some customers might not use the business if the other department
is closed down.
21.4 THE BALANCE SHEET
The balance sheet is prepared as a single entity. It does not show separate assets and
liabilities for each department.
21.5 DECISION MAKING
Apart from deciding whether to close a department or not which is not easy,
departmentalizing a business may provide vital information such as:
(a) Profitability of each department for the purpose of may be expanding a profitable
department.
233
(b) Payment of bonuses or commission to employees may be based on departmental
profits.
(c) Promotion of departmental managers could also be based on departmental profits.
CHAPTER SUMMARY
- Depending on the nature and size of the business it may be more convenient to divide the
business into departments.
- By departmentalizing a business, profitability of each department would be assessed and
decisions made.
- Separate gross profit and contribution is shown with direct departmental expenses and
shared expenses.
- Decisions about growth and trimming, closing down can be made.
EXERCISES
1. Yugo owns a super market which is divided into three departments namely butchery,
grocery and beverages.
For the year ended 30 June 20x5, the following details were taken from his books.
Butchery Grocery Beverages Unspecified

K K K K
Sales 854,000 605,000 936,500
Purchases 600,000 350,000 740,000 -
Sales Returns - 20,000 - -
Salaries & wages 88,000 90,000 75,000
Opening inventory 36,000 50,000 44,000 -
Rentals - - - 45,000
Equipment at cost 55,000 47,000 30,000 -
Administrative expenses - - - 75,000
Additional information:
(i) Closing inventory is valued as follows:
- Butchery K25,000
- Grocery K33,200
- Beverages K41,750
(ii) Equipment is depreciated at 10% p.a. on cost.
(iii) Rent is to be divided equally between the three departments
(iv) Administrative expenses 2:1:3 respectively between butchery, grocery and beverages.
(v) Departmental managers are entitled to 10% commission on sales
234
Required:
(i) Prepare departmental income statement for the year ended 30 June 20x5.
2. Papa is in business running a pharmacy, which is divided into drugs, perfumes and
toiletries.
The balances below have been taken from his books as at 31 December 20x9.
K
Sales: drugs 675,000
Perfumes 500,000
Toiletries 300,000
Purchases: Drugs 900,000
Perfumes 350,000
Toiletries 225,000
Opening inventory: Drugs 75,000
Perfumes 60,000
Toiletries 45,000
Salaries and wages: Drugs 80,000
Perfumes 35,000
Toiletries 20,000
Lighting and heating 25,000
Telephone expenses 33,000
Motor expenses 66,000
Insurance 15,000
Office expenses 19,000
Buildings at cost 200,000
(i) Depreciation is: fixtures and fittings 10% and building 15% and is to be
apportioned equally for the three departments.
(ii) All other expenses to be apportioned 0.5 drugs, 0.25 perfumes and 0.25 toiletries.
(iii) Closing inventory is valued as follows:
Drugs K60,000
Perfumes K35,000
Toiletries K21,000
235
Required:
Prepare Papas departmental income statements for the year ended 31 December 20x9.
1. Yugo
Departmental income statement for the year ended 30 June 20x5
Butchery Grocery Beverages Total

K K K K K K K
Sales 854,000 605,000 936,500 2,395,500
Sales returns - (20,000) - (20, 000)
______ _______ ______
854,000 585,000 936,500 2,375,500
Cost of sales:
Opening inv. 36,000 50,000 44,000
Purchases 600,000 350,000 740,000
636,000 400,000 784,000
Closing invent. (25,000) (33,200) (41,750)
(611,000) (366,800) (742,250) (1,720,050)
________ _______ _______ ________
Gross profit 243,000 218,200 194,250 655,450
Direct expenses:
Salaries/wages 88,000 90,000 75,000
Depreciation 5,500 4,700 3,000
Commission 85,400 58,500 93,650
______ _____ ______
(178,900) (153,200) (171,650) (503,750)
________ ________ ________ ________
CONTRIBUTION 64,100 65,000 22,600 151,700
OTHER EXPENSES:
Rent 15,000 15,000 15,000
Admin. Expenses 25,000 12,500 37,500
______ ______ ______
(40,000) (27,500) (52,500) (120,000)
Net profit 24,100 37,500 (29,900) 31,700
236
2. Papa
Departmental income statement for the year ended 30 June 20x5

Drugs Perfumes Toiletries Total
K K K K K K
Sales 675,000 500,000 300,000 1,475,000
Cost of sales:
Opening inv. 75,000 60,000 45,000
Purchases 900,000 350,000 225,000
______ ______ ______
975,000 410,000 270,000
Closing inv. (60,000) (35,000) (21,000)
______ _______ _______
(915,000) (375,000) 249,000 (1,539,000)
Gross profit (240,000) 125,000 51,000 (64,000)
Direct expenses:
Salaries/wages (80,000) (35,000) (20,000) (135,000)
Contribution (320,000) 90,000 31,000 (199,000)
OTHER EXPENSES:
Depreciation:
Fixtures/fittings 2,200 2,200 2,200
Buildings 10,000 10,000 10,000
Lighting & heat 12,500 6,250 6,250
Telephone 16,500 8,250 8,250
Motor expenses 33,000 16,500 16,500
Insurance 7,500 3,750 3,750
Office expenses 9,500 4,750 4,750
(91,200) (51,700) (51,700) (194,600)
_________ ______ _______ ________
311,200 38,300 20,700 ( 393,600)
======= ======= =======
237
CHAPTER 22
PUBLIC SECTOR ACCOUNTING REPORTING
INTRODUCTION
This chapter is designed to set in context the discussion of public sector accounting at an
introductory level. Its purpose is to set out briefly the description of the public sector accounting
and reporting in conformity to the international public sector accounting standards.
TOPICS
1 Description of public sector
2 Users of public sector financial statements
3 International Federation of Accountants (Public Sector)
4 Financial reporting under cash basis and accruals basis
5 International public sector accounting standards
6 Reporting and the media
LEARNING OBJECTIVES
1. Describe what a public sector is.

2. Identify the users of public sector financial reports and the decisions they can make.
3. Explain the role of the International Federation of Accountants in public sector
accounting.
4. Distinguish between the cash basis reporting and accruals basis reporting.
5. Identify international accounting standards on public sector accounting
6. Differentiate between above the line and below the line accounting.
22.1 PUBLIC SECTOR
There is a range of meanings given to the phrase public sector but for our studies we
shall adopt the following:
In a mixed economy, public sector is that part of the economy that is owned and
operated by government authorities and public corporations.
Public sector includes the following:
a) State owned enterprises
Also called public enterprises. This is a publicly owned commercial or

industrial organization that performs some essential service such as ZESCO
and ZNBC, or produces some essential commodity such a lime.
238
b) Local government or local authorities
This is an elected local government organization and employees who have

legal power and duty to provide and administer many local services for which
rates are paid to run it. The rates are a form of revenue to the government.
Areas falling in this category of revenue source are markets, schools, roads
and public health centers.
Public sector organizations are funded mainly by the central government and also raise
funds on their own through taxes, rates, borrowing etc, and as such they keep records of
sources and application of funds.
Financial reports are prepared for accountability purposes and communicated to users
who in turn will make decisions affecting the community at large.
It should be made clear that public sectors exhibit a variety of social, economic, political
and legal characteristics. They have different powers and responsibilities and they display
varied patterns of accountability. They have different objectives and are financed in
different ways. They also have different organization structures.
Recent years has seen public sectors being exposed to competition and market
mechanisms from the private sector. Certain ranges of services provided are required to
be awarded on the basis of competitive tenders, with private sector contractors competing
with public sector organizations e.g. waste management services, road maintenance,
cleaning, etc.
22.2 PUBLIC SECTORS POWERS AND RESPONSIBILTIES
As far as powers and responsibilities are concerned all public sector bodies have one
feature in common: There specific powers are derived ultimately from parliament and are
ultimately responsible to parliament.
Local authorities are partially accountable to parliament and more immediately

answerable to a local electorate.
22.3 PUBLIC SECTOR FINANCIAL REPORTS

By law and accounting standards, companies are required to produce annual reports and
financial statements. These include income statements, balance sheet and cash flow
statement together with accompanying notes. They are audited before they are published.
In public sector the same reports have been introduced, though some details are different.
These are forwarded to interested partied.
22.4 USERS OF FINANCIAL REPORTS
Users of public sector financial reports include the following:
a) Authorities this could be the central government.
Government generally is interested in assessing how these organizations have

utilized the funding allocated to them for control and planning purposes.
239
b) Mangers these are officials who are trustees and ensure that the daily activities
of their organizations are running smoothly. They have a keen interest and ensure
that all activities are being carried out as per budgetary plan and justification
made for extraordinary activities.
c) Tax payers . They are interested in how government are using money they pay as
tax, and also to assist in predicting future tax levels.
d) Public. The public generally includes workers (those who pay tax) and non
workers. Is the government providing good education, health, etc? If not then
where is the money they need to assess performance of their elected
representatives.
e) International funding organizations. These are organizations such as International

Monetary Fund (IMF) World Bank, etc. who provide developmental funding to
government. They would want to know if the funds have been used for the
intended purpose.
22.5 INTERNATIONAL FEDERATION OF ACCOUNTANTS (Public Sector) (IFAC)
The International Federation of Accountants is an organization of national professional

accountancy organization that represents accountants employed in public practice,
business and industry, the public sector and education.
IFAC has a Public Sector Committee (PSC). The PSC focuses on the accounting,
auditing and reporting needs of national, regional and local governments, related
governmental entities and the constituencies they serve. It addresses these needs by
issuing and promoting benchmark guidance, conducting research and educational
programs, and facilitating the exchange of information among accountants and all those
who work within the public sector.
22.6 FINANCIAL REPORTING UNDER THE CASH BASIS
a) Cash basis
This accounting system recognizes only cash inflows and cash outflows. The
resulting final accounts are summarized cash books. There are no balance sheets
under this system because there are no other assets (apart from cash) and
liabilities in the books other than cash balances.
Sales are recognized only when cash is recorded. So there are no receivables.
Purchases are only recognized when cash is paid. So there are no payables.
There is no inventory adjustment because the accounts are not concerned with
recording usage. There is no opening or closing inventory except that cash has
been paid for it.
There are no non current assets.
There are no current and non current liabilities
b) The cash accounting and accounting documents
240
Under this system the main book of accounting is the cash book. Entered in the
cash book are simply cash receipts and cash expenditure using receipts and
payments vouchers. This is where the analysis cash book column cash book is
used with columns for cash receipts and expense columns. Double entry is
completed with the cash book.
Ledger accounting: Separate ledger cards are kept for all receipts and payments
on a cumulative basis.
Financial statements: Under this systems financial statements may comprise:

i) Expenditure reports which is a summary of expenditure on activities
carried out during a period, and
ii) A statement of cash position. This is a summary of sources and
expenditure and the resulting balance.
c) Advantages of cash basis accounting
Cash is clearly the livelihood of any organization. Through cash basis accounting
government would be able to assess from its use.
i) how much tax to collect through budgets. If the government spends less than
the budget, then it is better off at the year-end and can spend excess cash on
other developmental issues, pay back borrowings or reduce tax.
If it spends more than the budget, then it is worse off meaning money will
have to be borrowed or increase taxes
ii) Cash basis accounting is perceived to be easier to prepare and

understand
iii) Cash reporting instills confidence in an organization from
interested parties as it reflects the ability of an organization to
manage its finances.
iv) Organisations are forced to prioritise their activities and live within
their limits, as funding is not always enough.
v) Cash basis accounting is not subjective as it addresses actual
activities.
d) Disadvantages of cash basis accounting
Cash basis accounting has also come under criticism because:

i) it focuses only on cash
ii) how much an organization is worth is not only cash but also other assets
and liabilities. Therefore financial statements on cash basis
are incomplete and may be misleading about an organisations position.
e) Accruals accounting
Revenue and costs are accrued (i.e recognized as they are earned or incurred, and
not as money is received or paid), matched with one another so far as their
relationship can be established or justifiably assumed, and dealt with in the
income statement of the period to which they relate.
241
Meaning:
i) The earning of revenue is generally taken to mean that invoices have been
issued.
ii) Costs are incurred when services are received. Therefore recognition of
income and costs is not when cash is received or paid.
There has been critical argument that the accruals accounting is too
subjective and hide crucial information about an organisations
performance.
Advantages:
i) It provides measures of economic goods and services consumed, transformed

and earned.
ii) Accruals accounting yields an income figure. More profit implies
more success.
iii) Accruals accounting yield a measure of capital. Income is only recognized
after capital has been maintained in real terms.
Disadvantages:
i) Accruals accounting introduces subjectivity into the accounts. It

brings in adjustments which are judgmental e.g. provision for doubtful
debts, which may distort accounting information away from the true and
fair expectation.
ii) The relevance of accruals accounting, when it is linked with
historical costs, and during periods of rising prices, is limited.
iii) In comparison with cash basis accounting, accruals adjustments demand a
higher administrative and accounting cost.
iv) It provides an opportunity for manipulation that is a problem associated
with financial control. With cash based accounting manipulation of
accounting results could be affected by postponing cash payments just to
show that the organization is financially sound.
In accruals postponement of cash payments in receipts has no effect.
Manipulation may come in by bringing in invoices for goods supplied just
to ensure that the accounts are within budget.
22.7 INTERNATIONAL PUBLIC SECTOR ACCOUNTING STANDARDS (IPSAS)
The public sector committee (PSC) of the International Federation of Accountants

(IFAC) issues these accounting standards. These standards apply to national, regional and
local governments and their related government entities. The approach taken is to base
IPSAS on the International Accounting Standards (IASs) of the International Accounting
Standards Committee. Subsequently issues related to the public sector but which have not
been dealt with by IASs will be addressed.
23 REPORTING AND MEDIA
Above-the-line: This term refers to revues and expenses that relate to normal on-going
operations of an organization and which when netted produces the reported operating
profit.
242
Below-the-line: This term refers to exceptional and extraordinary items which are not
included in the calculation of profit (above the line). The items relate to capital income
and expenditure.
Virement: This deals with the transfer of items from one financial account to another.
24 CHAPTER SUMMARY
Public sector accounting deals with accounting which applies to national, regional
and local government and their related government entities
Users of public sector financial reports include:

i) Authorities (including parliament)
ii) Heads of government departments
iii) Tax payers
iv) The public (the electorate)
v) Donors & International financiers such as the World Bank
The cash basis of accounting recognizes transactions and events only when cash is
received or paid. Notes to the financial statements may provide additional
information about liabilities and other non cash assets (payables and receivables)
Accruals based accounting recognizes income and expenditure when it accrues

and not when cash is received or paid.
243
CHAPTER 23
PARTNERSHIP ACCOUNTING
This chapter introduces a type of business called partnership. Partnership is wide. At this stage
emphasis is on the nature and principles on which financial statements of partnerships are
prepared.
TOPICS
1. Definition of partnership as a form of business

2. Legal status of a partnership
3. Types of partners in partnership
4. Partnership agreement
5. Advantages and disadvantages of a partnership
6. Partnership current accounts
7. Partnership capital accounts
8. Profit and loss appropriation account
9. Financial statements of partnership
LEARNING OBJECTIVES
- Explain what a partnership is and how it differs from a sole trader.

- Explain the features of a partnership agreement.
- Distinguish the treatment of profit and loss of a partnership and sole trader.
- Prepare partnership financial statements.
23.1 DEFINITION OF PARTNERSHIP
This is a form of business where two or more persons carry on business together for the
purpose of making profits.
A partnership usually is a progression from a sole trader
23.2 LEGAL STATUS OF PARTNERSHIP
In some countries a partnership is not a corporate entity. It does not exist separately from
its owners. In others it is a legal entity separate from partners.
However, for accounting purposes the partnership will be treated as a separate legal
person from partners.
244
23.3 TYPES OF PARTNERS IN A PARTNERSHIP RELATIONSHIP
In a partnership one may find limited partners and general or unlimited partner.
- Limited Partners
These are partners with limited liability. They are only liable or limited to the
amount of capital they have provided. Such partners usually do not participate in
management of the business.
- General Partners
Sometimes called unlimited or ordinary partners. These have unlimited liability.

The debts of the business is beyond their capital contribution in the business. As
such they are responsible for the day to day affairs of the business.
Therefore, in any partnership at least there must be a general partner.
23.4 THE PARTNERSHIP ADMINISTRATION
Before a partnership can be operational, partners must agree on how the business will be
organized and run. The law does not state the contents of the agreement but may contain
the following.
- The capital contribution by each partner.

- How profits and losses will be shared i.e. profit sharing ratio.
- If capitals will attract interest. If yes, how much in percentage terms.
- Are partners going to be allowed drawings and will the drawings attract interest.
- If partners will be working in the business, are they going to be entitled to a
salary.
- Should a new partner be admitted or old an partner retires what will be the
arrangements and procedures to be followed.
- Name of firm, the type of business.
- Settling disputes
- Preparation and audit accounts.
Though not required by law the partnership agreement must be put in writing, so that partners
know their rights and responsibilities. This also helps to reduce disputes.
In the absence of a formal agreement by partners The Partnership Act of 1890 will guide
administration and management of a business owned by partners. This is a UK Act which is
also enforceable in Zambia because this country is a former British colony. Some of the
provisions of the Act are:
- Partners are to share profits or losses equally.

- Interest shall not be charged on partnership capital.
- Interest shall not be charged on drawings.
- (refer to a text book on business law for more information)
245
23.5 ADVANTAGES AND DISADVANTAGES OF PARTNERSHIP
Advantages:
Comparing a partnership to sole trading, the advantages of operating as a partnership are

as follows:
- Business risks are spread among more than one person.

- Partners will learn new skills from other partners
- A partner may take leave while others remain working. A sole trader will have in
most cases close business to take a rest.
- Capital resources could be larger because of so many persons contributing.
Disadvantages could be:
- While risks are spread among many persons, some partners may feel
uncomfortable to share profits.
- Disputes may arise on management issues and this may lead to partnership
closure.
- A decision made by a partner in relation to business, is usually binding to other
partners. This means if a partner is being sued in relation to the business, other
partners are equally affected.
23.6 ACCOUNTING IN PARTNERSHIP
The accounting techniques in partnership are very similar to that of a sole trader.
Partnerships also keep books of prime entry and ledgers, but there are certain important
differences as shown in the table.
Item Sole traders books Partnership books
Capital Introduced Capital account Partners fixed capitals

accounts
Drawings and share Capital account Partners current accounts
of profits
Division of profits Inapplicable one Income statement shared,
proprietor only appropriation section
246
23.7 PREPARING PARTNERSHIP FINANCIAL STATEMENTS
(i) Income Statement
Income statement of sole trader and partnership are very much the same.
However, a partnership extends the income statement by including the
appropriation account.
The appropriation account of the income statement shows how profits and
entitlements to partnership are distributed.
N.B. Net profit in sole trader is all his and thus the whole amount is added to
capital in balance sheet.
For partnership profits there is need to show how profits are shared between
partners.
Expenses related to partners such as salaries, interest on capital and drawings are
treated as appropriations. However, similar expenses which related to others such
as employees will be treated as operating expenses in income statement.
Example 1
Banda and Bwalya have been in partnership just for one year.
- They are sharing profits and losses equally.

- They are entitled to 10% on capitals per annum. Banda and Bwalya have
K100,000 and K200,000 as capitals respectively
- Banda is entitled to a salary of K3,000, and Bwalya K5,000.
- Interest is charged on partners drawings. Banda is charged K2,000 and
Bwalya K1,500.
- Drawings during the year were Banda K6,000 and Bwalya K5,000.
- The net profit before the distribution as at 31.12.20X4 amounted to
K70,000 i.e. after preparing the income statement which is same as sole
trader.
247
Banda and Bwalya
Income Statement for the year ended 31.12.20X4
K K
Net profit 70,000
Add: Interest on drawings
Banda 2,000
Bwalya 1,500
73,500
Less: Appropriations:
Salaries: Banda 3,000
Bwalya 5,000
(8,000)
Interest on capitals:
Banda 10,000
Bwalya 20,000
(30,000)
35,500
Share of profits: ======
Banda 17,750
Bwalya 17,750
35,500
======
(ii) Capital accounts
When a partnership is being set at the beginning, partners have to agree the
amount of capital contribution to introduce. This could be in form of cash or
other assets. Double entry would be:
DR. Asset account (whatever asset)

CR. Capital account of each partner separately
The capital will usually remain fixed for the duration of the business but could
change under the following circumstances:
248
- When partners in the process of conducting business introduce further
capital.
- When a partner retires and capital is withdrawn.
- When assets are revalued.
Using example 1, the capital accounts presented in columnar would be:
Capital accounts
Dr. Banda Bwalya Banda Bwalya Cr.
K K K K
Bal. 100,000 200,000
(iii) Current accounts
Current accounts are used to deal with regular transactions between the partners
and the firm.
These are matters that may not be dealt with in capital accounts. These may
include:
- Share of profits
- Interest on capital
- Drawings
- Interest on drawings
- Partners salaries
For entitlements such as salaries, interest on capital and share of profits, Double
entry is:
DR. Income Statement (Appropriation account)

CR. Current Accounts of partners
For drawings
DR. Current Accounts of partners

CR. Cash book or Purchases account
For interest on drawings
DR. Current accounts of Partners

CR. Income statement (appropriation account)
Using example 1, current accounts would be:
Current Accounts
249
Drawings 6,000 5,000 Interest

Interest on capital 10,000 20,000
on drawings 2,000 1,500 Salaries 3,000 5,000
Balances c/d 22,750 36,250 Share of 17,750 17,750
Profits
30,750 42,750 30,750 42,750
Balances b/d 22,750 36,250
The balance of the current accounts at the end of each financial year will then
represent the amount of undrawn or withdrawn profits.
- A credit balance like in example represents amounts to be withdrawn by

partners i.e. the partners are payables to the firm.
- A debit balance will represent partners have withdrawn more than their
entitlements, so they are receivables to the firm.
(iv) The balance sheet
Partnership balance sheet as far as non current and current assets are concerned
will be same as sole trader. The difference is under capital part.
Using example 1
Balance Sheet as at 31.12.20X4 (extract)
Financed by:
Capitals: Banda 100,000
Bwalya 200,000
300,000
Current accounts: Banda 22,750
Bwalya 36,250
59,000
359,000
If one partner had finished with a debit balance in current account, the balance
will be shown in brackets in balance meaning it should be deducted.
23.8 Most examination questions specify
Capital and current accounts should be shown separately. Occasionally you may be faced
with a question specifying only one account for each partner. Such an account acts as a
capital and current account combined thus the term Fluctuating Capital.
In fluctuating capital, all entitlements are credited to capital accounts and drawings and
interest on drawing debited capital accounts. In this situation current accounts are
irrelevant. Therefore capital figures in balance will be inclusive of current account items
and will be changing from year to year.
250
Using example 1: Fluctuating capitals
Capital accounts
Balance 100,000 200,000

Drawings 6,000 5,000 Interest
Interest on capital 10,000 20,000
on drawings 2,000 1,500 Salaries 3,000 5,000
Balances c/d 122,750 236,250 Share of 17,750 17,750
Profits
130,750 242,750 130,750 242,750
Balances b/d 122,750 236,250
The balance sheet will then only show capital accounts as follows:
Balance sheet as at 31.12.20X4 (Extract)
Financed by:
Capital accounts: Banda 122,750

Bwalya 236,250
359,000
251
CHAPTER SUMMARRY
Accounting for partnership is similar to that of sole trader in many respects, except that any
profit or loss needs to be allocated between partners.
Partners need to prepare a partnership agreement that will outline the roles and responsibilities of
each partner
EXERCISES
1. Why do people want to form a Partnership?
2. Some partnerships dont bother drawing up a partnership agreement. How do the

partners in those partnerships know what rights and responsibilities they have?
3. In the balance sheet of a partnership, how is a loan from a partner disclosed?
4. Interest on a loan made by a partner is shown as appropriation of profit, not as an

expense. True or false?
5. A and B are in partnership sharing profits and losses in the ratio 3:2.
Under the terms of the partnership agreement, the partners are entitled to interest on
capital at 5% per annum.
B is entitled to a salary of K4,500. Interest is charged on drawings at 5 percent per

annum and the amounts of interest are A K400 and B K300.
The net profit of the firm, before interests and salary for the year ended 30 June 20X7
was K25,800.
The partners capital at 1 July 20X6 were A K30,000 and B K10,000.
At 1 July 20X6, there was a credit balance of K1,280 on Bs current account while As
current account balance was K500 debit.
Drawings for the year to 30 June 20X7 amounted to K12,000 and K15,000 for A and B
respectively.
Required:
Prepare, for the year to 30 June 20X7:
(a) The partnership appropriation account

(b) The partners current account.
252
6. X, Y and Z are in partnership business sharing profits and losses 4:1:3 respectively. The
firms trial balance as at 31 December 20X1, was as follows:
Dr. Cr.
K K
Sales 334,618
Returns Inwards 10,200
Purchases 196,239
Carriage Inwards 3,100
Inventory 1 Jan. 20X1 68,127
Bad debts 1,620
Provision for doubtful debts
1 January 20X1 950
General expenses 1,017
Business rates 2,900
Postage 845
Computers at cost 8,400
Office equipment at cost 5,700
Provision for depreciation at
1 January 20X1:
Computers 3,600
Office equipment 2,900
Payables 36,480
Receivables 51,320
Cash at bank 5,214
Drawings: X 39,000
Y 16,000
Z 28,000
Current accounts: X 5,940
Y 2,117
Z 9,618
Capital accounts: X 60,000
Y 10,000
Z 30,000
_______ _______
494,106 494,106
Additional information
(i) Inventory 31 December 20X1 K74,223
(ii) Business rates paid in advance K200
(iii) Stock of postage stamps K68
(iv) Increase provision for doubtful debts to K1,400
(v) Partners salaries: Y K18,000, Z K14,000
(vi) Interest on drawings: X K300, Y K200, Z K240
(vii) Interest on capital is at 8 percent per annum.
(viii) Depreciate computers by K2,800 and office equipment by K1,100.
253
Required:
Draw up a set of financial statements for the year ended 31 December 20X1.
1. The answer should include:
- The capital required is more than one person can provide.

- The experience or ability required to manage the business cannot be found
in one person alone
- Many people want to share management instead of doing everything on
their own.
2. In the absence of a partnership agreement, the Partnership Act 1890 governs the
situation and states that:
(a) Profits and losses are to be shared equally

(b) No interest is allowed on capital
(c) No interest to be charged on drawings
(d) Salaries are not allowed
(e) Any loan by a partner or excess capital will attract interest of 5% per
annum.
3. A loan from a partner is shown separately as a non current liability
4. False. Interest on a loan is an expense charged against profit in income statement.
5. (a) Partnership appropriation account for the year ended 30 June

20X7.
K K
Net profit 30.06.20X7 25,800
Add: Interest on drawings A 400
B 300
700
26,500
Less: Appropriations:
Interest on capital A 1,500
B 500
(2,000)
Salary B 4,500
(4,500)
20,000
Share of profits A3/5 12,000
B 2/5 8,000
20,000
254
(b) Current Accounts
Dr. A B A B Cr.
Balance b/f - 500 Balances b/f 1,280 -

Drawings 12,000 15,000 Interest on
Interest on capital 1,500 500
Drawings 400 300 Salary - 4,500
Balances c/d 2,380 - Share of profits 12,000 8,000
____________ Balance c/d - 2,800
14,780 15,800 14,780 15,800
Balance b/d - 2,800 Balance b/d 2,380 -
6. XYZ Income statement for the year ended 31 December 20X1

K K
Sales 334,618
Less: Returns Inwards (10,200)
324,418
Cost of sales:
Purchases 196,239
267,466
Less: closing inventory (74,223)
(193,243)
Gross profit 131,175
Less: Expenses
Bad debts (1620 + 450) 2,070
Business rates (2,900 200) 2,700
Postage (845 68) 777
Depreciation: computers 2,800
Office equipment 1,100
(64,771)
Net profit 66,404
Interest on drawings: X 300
Y 200
Z 240
740
67,144
Less: appropriations:
Salaries Y 18,000
255
Z 14,000
(32,000)
Interest on capital: X 4,800
Y 800
Z 2,400
(8,000)
Share of profits: X 4/5 14,022
Y 1/8 3,506
Z 3/8 10,516
(27,144)
_
______
Current accounts
Dr. X Y Z X Y Z Cr.
Balance - 2,117 - Balances 5,940 - 9,618

Drawings 39,000 16,000 28,000 Salaries - 18,000 14,000
Interest on Interest on
Drawings 300 200 240 capital 4,800 800 2,400
Balances c/d 3,876 7,957 Share of profits 13,572 3,393 10,179
Balances c/d 14,988 - -
39,300 22,193 36,197 39,300 22,193 36,197
Balance b/d 14,988 - - Balance b/d - 3,876 7,957
XYZ
Balance sheet as at 31 December 20X1
Non current assets Cost Dep. N.B.V.

K K K
Computers 8,400 6,400 2,000
Office equipment 5,700 4,000 1,700
14,100 10,400 3,700
Current assets
Inventory 31.12.20X1 (74,223 + 68) 74,291
Receivables (51,320 1,400) 49,920
Prepayments 200
Cash at bank 5,214
129,625
Total assets 133,325
Financed by:
Capital accounts: X 60,000
Y 10,000
Z 30,000
100,000
Current accounts: X (14,988)
Y 3,876
256
Z 7,957
(3,155)
Current liabilities
Payables 36,480
133,325
257
CHAPTER 24
ACCOUNTING FOR NON-PROFIT MAKING ORGANISATIONS

INTRODUCTION
This chapter is concerned with the preparation of financial statements of not profit making
organisations and whose objectives are to provide services to their members or the pursuit of one
or a number of activities rather than the earning of profit.
Since running organisations involves cash and other assets and liabilities, theres need to also
keep records of all activities (transactions).
TOPICS
1 The receipts and payments account

2 Income and expenditure account
3 The balance sheet
LEARNING OBJECTIVES
- explain the difference between receipts and payments accounts and the cash book and
how they are prepared.
- prepare income and expenditure accounts
- make appropriate entries relating to subscriptions, life membership and donation
- calculate profit or loss on other activities and incorporate them into financial
statements.
- differentiate the financial statements of an incorporated organization with the profit
making organisations.
24.1 NOT-FOR-PROFIT ORGANISATIONS
The main purpose of such organisations is to provide social amenities to its members
such as games of tennis, soccer, etc. They can also be charities to help people. They
exist not to make profits, thus the name not for profit making organisations.
They may be engaged in profit making activities, but profits arising from such is not
shared by members but ploughed back in the organisation to improve on services to
members.
The accounting system can be basic to complex depending on size of the organisation.
258
24.2 RECEIPTS AND PAYMENTS ACCOUNT
The receipts and payments account is effectively the cash book. It is a summary of cash
receipts and cash payments.
Smaller clubs and charities with no other assets (apart from cash) and no liabilities will
use the receipts and payments account as a financial statement. No balance sheet is
produced.
Example: receipts and payments account
ARMSTRONG Body Building Club
Receipts and payments account for the year ended

31 December 20X4
Receipts Payments
K K
Balance b/f 200 Bar purchases 160

Subscriptions 6,450 Rental 720
Bar Sales 240 Care takers wages 1,800
Donations 150 Printing & postage 22
Heat & light 60
Repairs 15
Balance c/d 4,263
_____ _____
7,040 7,040
Balance b/d 4,263
N.B. The receipts side is same as debit and payments side credit of the cash
book.
Advantages and disadvantages of receipts and payments account:
Advantages
(a) Very easy to prepare

(b) Very easy to understand especially cash position
(c) It is used as a basis for the preparation of the income and expenditure account
Disadvantages
(a) Only accounts for cash. There could be other assets in use.
(b) Does not account for any amounts paid in advance or owing.
(c) Does not distinguish between capital and revenue expenditure
(d) Does not account for depreciation of non current assets.
259
24.3 INCOME AND EXPENDITURE ACCOUNT
Organisations apart from cash asset may have other assets and liabilities. Therefore, the
receipts and payments account may be inadequate to be used as a financial statement,
because it does not show the other assets and liabilities.
The receipts and payments account does not also show whether the members
contributions are being used effectively.
(a) To reveal a complete picture of assets and liabilities a Balance Sheet must be
prepared.
(b) To show any increase or decrease in capital the income and expenditure account
is prepared.
24.4 TERMS USED IN COMPARISON WITH TRADING ORGANISATIONS
Profit making organisations Not for profit making organisations
(i) Cash book Receipts and payments account

(ii) Income statement Income and expenditure account
(iii) Profit or loss Surplus or deficit
(iv) Capital Accumulated fund
Income and expenditure account is the same as income statement for trading
organisations.
The principals of matching or accruals concepts are applied to income and expenditure
accounts in the same way as for income statement in trading organisations.
24.5 TRADING ACTIVITIES WITHIN THE NOT-FOR- PROFIT ORGANISATION
The main source of income for non trading organisations is subscriptions from members.
However, they may engage in profit ventures like owning a bar.
In such a case a separate bar income statement will be prepared to determine profit or loss
arising from it, and transferred to income and expenditure account.
For other profit ventures such as dinner dance or fete income and expenses are netted and
the resultant profit or loss also transferred to income and expenditure account.
260
Example: Bar income statement.
Armstrong Body Building Club

Bar Income Statement
K K
Bar Sales 240
Less cost of sales:
Bar opening inventory 30
Bar purchases 160
___
190
Less: Bar closing inventory (80)
(110)
130
Less: Bar mans wages (70)
___
Net profit (transferred to income and
expenditure account) 60
24.6 Accumulated fund
In a trading organisation it is known as capital. In most cases it may not be given. It

should be calculated by identifying assets and liabilities given at a particular time . Thus:
Accumulated fund = Assets Liabilities
Example: accumulated fund
The North East Rotary Club had the following assets and liabilities as at 1 January 20X1,
the beginning of the year.
Cash and Bank balances K210, Equipment at valuation K975, Subscriptions in arrears
K65, Subscriptions in advance K10, Owing to suppliers of competition prizes K58 and
Inventory of competition prizes K38.
Required:
Calculate the accumulated fund as at 1 January 20X1, to be included in balance sheet.
261
Solution:
Assets: K K
Cash and bank balance 210
Subscriptions in arrears 65
Equipment 975
Inventory of competition prizes 38
1288
Liabilities:
Subscriptions in advance 10
Owing to suppliers 58
68
Accumulated fund at 1 January 20X1 1220
24.7 Subscriptions
This may be the main source of income for not profit making organisations.
Subscription is an agreed amount each member must pay at regular intervals e.g. monthly
or annually. Members will enjoy facilities of the organisation at no cost, while non
members will have to pay high fees to use same facilities and sometimes may be denied
access even if they have money.
(a) Subscriptions account
A subscription account is always maintained to show the amount collected,

amount not collected and amounts paid in advance.
N.B. Members who have not paid the subscriptions and their membership has
not lapsed are considered as receivables because they have not paid the institution
and yet they have been enjoying the services. This is called subscriptions in
arrears.
Subscriptions in arrears should be included as part of income (subscriptions) in

the year they are not paid and shown as current asset in the balance sheet.
Remember the matching or accruals concept. When they are paid the following
year, they should not be included into subscriptions for that year and are no longer
assets.
Example: Subscriptions
The North East Rotary Club had the following details relating to subscriptions for
the year 1 January 20X1 to 31 December 20X1.
Cash received from members during the year to 31 December 20X1 K1987.
On 1 January 20X1, some members still owed the club K65 for 20X0, and some
members had also not paid K85 for 20X1.
262
On 1 January 20X1, some members had paid in advance K10 in 20X0 for 20X1,
and also at 31 December 20X1, some members had paid K37 in advance for
20X2.
Required:
Show how the entries will be made in subscription account and then show amount
to be shown in income and expenditure account as subscriptions for 20X1.
Solution:
Step 1:Open subscription account and show the opening balances
Dr. Subscription account Cr.
K K
1 January 20X1 Bal. b/f 65 1 January 20X1 Balance b/f 10
The amount of K65 appearing on the debit side is an asset. Money is for the club
though not yet paid. K10 is liability. Money is not yet for club though the club
has it.
Step 2: Upon receiving cash as subscriptions from members.
Dr. Cash account

Cr. Subscription account
K K
Cash 1987
Dr. Cash account Cr.
K K
Subscriptions 1987
Step 3: Put in the closing balances for accruals and prepayments. The
balancing figure is subscription for 20X1.
263
K K
Income and expenditure Cash 1987

account (balancing figure) 1980
31 December Balance c/d 37 31 December Balance c/d 85
2082 2082
Balance b/d 85 Balance b/d 37
K1980 will be credited to income and expenditure account.
The amount to be shown as income from subscriptions for 20X1 is K1980.
K85 will be shown in balance sheet under current assets as subscriptions in

arrears.
K37 will be shown in balance sheet under current liabilities as subscriptions in

advance.
In statement form it will be shown as:

K K
Subscriptions received (cash) 1987
Add: Subscription paid in advance 20X0 10
Subscription in arrears 20X1 85
95
2082
Less: Subscriptions paid in advance 20X2 37
Subscriptions in arrears 20X0 65
(102)
1980
Activity 1
The following information relates to a Tennis Club.
20X1 subscriptions owing to the club at the start of 20X2 was K410
20X1 subscriptions received in cash by club during 20X2 was K370
20X2 subscriptions received during 20X2 K6730
20X3 subscriptions received during 20X2 K1180
20X2 subscriptions unpaid at end of 20X2 K470.
264
The club takes credit for subscriptions when it becomes due, but takes a prudent view
on overdue subscriptions. What amount is credited to the income and expenditure
account for the year 20X2.
24.8 Life Membership

Life membership means members pay a substantial amount now and enjoy the club
facilities for the rest of their lives. This amount should not be treated as subscription
income in the year it is paid, but should be spread over the life period of members.
A life membership account should be opened
Dr. Cash account

Cr. Life membership account
The balances on life membership will be shown in balance sheet as non current liability.
Life period could be estimated by the organisations based on may be age. In this way,
life membership will be treated the same way non current assets are treated with
depreciation.
If a member outlives life membership contribution, the organisation will decide whether
the members will continue paying or be exempted completely.
If a member dies before the life period, the remaining amount should be transferred to
accumulated fund (capital).
Some organisation may take advantage of life membership fund by investing it to

generate income in form of interest.
In this case the investment will remain fixed over a period of years and will be shown as
non current asset in balance sheet.
Annual interest generated on the investment will be considered as annual subscription

and credited to subscription account.
Example: Life membership
The old timers Bowling Club has introduced a life membership scheme for its members.
It is decided that life membership will be for five years i.e. any amounts received for life
membership will be spread over a period of five (5) years from year of payment.
At the start of the year ended 31 December 20X3, the amount on life membership
account stood at K7,480. Of this amount K1,850 should be treated as subscriptions for
the year 20X3.
During the year ended 31 December 20X3, some members had paid another K3,000 for
life membership.
Required:
Show how entries will be made in the subscriptions account and the life membership
account.
265
K K
Life membership 2450
Dr. Life membership account Cr.
K K
Subscription 2450 Balance 7480
Balance c/d 8030 Cash 3000
____ _____
10,480 10,480
Balance b/d 8030
Workings: 3,000 5
= K600 per annum for new life members
+
1850 per annum for old life members
____
2450 amount deducted from life membership account and
credited to subscriptions account for 20X3.
K2450 will be added together with amounts received from members who pay on
annual basis. The total amount will then be shown in income and expenditure
account for 20X3.
The balance of K8030 in life membership account will be shown as non current
liability in balance sheet.
24.9 DONATIONS AND ENTRANCE FEES
(a) Donations are amounts other well wishers may give an organisation
Donations in cash will be treated as income in the year the donation is made.
Double entry is:
Dr. - Cash account

Cr. - Donation account with cash
If donation is in form non current asset e.g. Van.
Dr. - Van account

Cr. - Accumulated fund
(b) Entrance fees are amounts members may be requested to pay when they first join
the club. This amount is also treated as income in the year it is collected.
Dr. - Cash account with entrance fees

Cr. - Entrance fees with cash received.
266
The entrance fees account is at year end transferred to income and expenditure
account.
Dr. - Entrance fees account

Cr. - Income and expenditure account.
24.10 Accounting for the sale of investments and non current assets.
Just like trading organizations, non profit making organizations also sale non current
assets and investments.
Accounting treatment is basically the same where the disposal account is opened to
determine profit or loss arising from the sale.
The difference is on the treatment of profit or loss on sale.
Remember profit could be:
(i) Sales cost (if asset is maintained at cost) or

(ii) Sales Net book value (if asset is depreciated)
If profit or loss is made using (i) above, the profit or loss will be directly added or
subtracted to or from accumulated fund in balance sheet.
If (ii) is used then profit or loss is shown in income and expenditure account.
Full worked example: Income and expenditure
The following is a summary of the receipts and payments of North East Rotary Club
during the year ended 31 December 20X1.
North East Rotary Club

Receipts and payments accounts for the year ended
31 December 20X1
Dr K K Cr.
Cash and bank balance 210 Secretarial expenses 163

Sales of competition tickets 437 Rent 1402
Members subscriptions 1987 Visiting speakers expenses 1275
Donations 177 Donations to charities 35
Refund of rent 500 Prizes for competitions 270
Balance c/d 13 Stationery & printing 179
____ ____
3,324 3,324
Balance b/d 13
267
The following valuations are also available:
As at 31 December 20X0 20X1

K K
Equipment (original cost K1,420) 975 780
Subscriptions in arrears 65 85
Subscriptions in advance 10 37
Owing to suppliers of competition prizes 58 68
Inventory of competition prizes 38 46
Required:
(a) Calculate the value of the accumulated fund of the club as at 1 January 20X1.
(b) Reconstruct the following accounts for the year ended 31 December 20X1.
(i) the subscription account

(ii) the competition prizes account
(c) Prepare an income and expenditure account for the club for the year ended 31
December 20X1 and a balance sheet as at that date.
Solution:
(a) Accumulated fund

Assets: K K
Cash and bank balance 210
Equipment 975
Inventory of competition prizes 38
1288
Liabilities:
Subscriptions in advance 10
Owing to suppliers 58
68
(b) (i) Subscription account
Dr. K K Cr.

Income & exp. Cash 1987
account 1980
Balance c/d 37 Balance c/d 85

2082 2082
268
Competition prizes account
(ii) Dr. K K Cr.

Bank 270 Cost of prizes given to
income and expenditure
account (Bal. Fig) 272
Balance c/d 68 Balances c/d 46
376 376

Income and Expenditure account for the year
ended 31 December 20X1
Income K K
Subscriptions 1980
Ticket sales 437
Less cost of prizes (272)
Profit on competition 165
Donations 177
2322
Expenditure
Secretarial expenses 163
Rent (1402 500) 902
Speakers expenses 1275
Donations to charities 35
Stationery and printing 179
Depreciation 195
(2749)
Deficit (427)
269
Non current assets Cost Dep. N.B.V.

Equipment 1420 640 780
Current assets
Inventory of prizes 46
131
Total assets 911
Financed by:
K
Less deficit (427)
793
Current liabilities
Payables for prizes 68
Subscriptions paid in advance 37
Bank overdraft 13
118
911
CHAPTER SUMMARY
- The receipts and payments accounts only shows the cash position of the organization. It
is just a summary of cash receipts and payments. It may be the source of information for
the income and expenditure account.
- The income and expenditure account is prepared to determine surplus (profit) or deficit
(loss). It is prepared on matching or accruals concept.
- The main source of income for clubs is subscription. Subscription should be adjusted for
arrears and prepayments.
- Accumulated fund is same as capital in trading organizations and is calculated thus

Assets liabilities.
- Any trading activities should be shown separately and profit or loss is what is shown in
income and expenditure or netting off within the income and expenditure account.
270
EXERCISES
1. Identify three areas of difference between the accounts of a non trading organization and
that of a trading organization.
2. If a not for profit organization makes a surplus it will be?
(a) Credited to capital

(b) Credited to accumulated fund
(c) Shared among members
(d) Kept in the bank account
3. A club has 150 members who pay K10 each for membership. The opening subscription
receivable was K70 and 5 members had paid subscriptions in advance at the year end.
How much money was collected from members?
(a) K1,500
(b) K1,740
(c) K1,620
(d) K1,520
4. The assets and liabilities of a social club on 31.12.20X1 were equipment K1,500,
premises K16,000, bar inventory K1,300, bar payables K1,100, wages owing K250,
subscriptions in arrears K500, subscriptions prepaid K350, cash in hand K1,900. The
accumulated fund is:
(a) K21,200
(b) K19,650
(c) K19,500
(d) K200,000
5. The accounting records of Up Hill cricket club are given in the following trial balance as
at 31 December 20X4:
Dr. Cr.
K K
Clubhouse 140,000
Equipment 18,000
Profits from raffles 6,000
Accumulated fund 40,000
Bar inventory 1 January 20X4 9,000
Wages of bar workers 30,000
Subscription received 190,000
Bar purchases 40,000
Caretakers wages 20,400
Bar sales 90,000
Cash in hand 900
Cricket professionals salary 36,200
326,000 326,000
271
The following additional information is also available.
(i) The inventory in the bar at 31 December 20X4 was valued at K5,600
(ii) Depreciation on equipment should be at 131/3%.
(iii) All sales and purchases for the bar were on cash basis.
(iv) As at 31 December 20X4 some members had paid subscriptions in advance
amounting to K1,800 and some members were owing K700.
Required:
Prepare income and expenditure account for the year ended 31 December 20X4 and a
balance sheet as at that date.
272
SOLUTIONS TO ACTIVITY QUESTIONS
Activity 1
Subscriptions account
Dr. Cr.
K K
Balance b/f 410 Bank (370 + 6730 + 1180) 8,280
Income & Expenditure Subscriptions written off 40

Account (balancing figure) 7,200
Balance c/d 1,180 Balance c/d 470
8,790 8,790
Balance b/d 470 Balance b/d 1,180
Note:
Subscriptions written off amounting to K40 is the difference between the subscriptions owing at
the start of the period amounting to K410 and the amounts received during the year in relation to
these subscriptions amounting to K370.
1. (i) The capital account is the accumulated fund

(ii) The profit/loss is the surplus/deficit
(iii) The Income Statement is the income and expenditure account
2. The correct answer is B.
3. The correct answer is C.

Subscriptions account
Dr. Cr.
K K
Balance b/f 70 Bank 1,620
Subscriptions to (Income
& Expenditure) (150 x 10) 1,500
Balance c/d 50 ____
1,620 1,620
Balance b/d 50
273
4. The correct answer is C.
Assets K K
Equipment 1,500
Premises 16,000
Bar inventory 1,300
Cash 1,900 21,200
Liabilities
Bar payables 1,100
Wages owing 250
Prepaid subscriptions 350
(1,700)
Accumulated fund 19,500
5. Bar income statement for the year ended 31 December 20X4.
K K
Bar sales 90,000
Cost of sales:
Bar opening inventory 9,000
Bar purchases 40,000
49,000
Less: bar closing inventory 5,600

(43,400)
Gross profit on bar 46,600
Less: wages of bar workers (30,000)
Net profit 16,600
Up Hill Cricket Club

Income and Expenditure account for the year ended
31 December 20X4
Income K K
Subscriptions 190,000
Less subscriptions prepaid (1,800)
Add subscriptions owing 700
188,900
Bar profits 16,600
Raffle profits 6,000
211,500
Expenditure
Care takers wages 20,400
Salary for professionals 36,200
Depreciation: equipment 2,400
(90,500)
Surplus 121,000
274
Up Hill Cricket Club
K K K
Non Current Assets Cost Dep. N.B.V.
Club house 140,000 140,000
Equipment 18,000 2,400 15,600
158,000 2,400 155,600
Current Assets
Bar inventory 5,600
Cash in hand 900
7,200
162,800
Financed by:
Accumulated fund @ start 40,000

Add: Surplus 121,000
161,000
Current liabilities
Subscriptions in advance 1,800
162,800
275
CHAPTER 25
INCOMPLETE RECORDS
INTRODUCTION
Sole traders do not often keep an elaborate set of books of accounts. The books they keep
comprise mainly a record of receipts and payments and file of unpaid invoices in the
correspondence file.
Even where an elaborate set of books is kept unexpected disasters such as fires may occur. As a
consequence the available books may contain insufficient information for the preparation of the
Income Statement and balance sheet. The owner of the business will ask for these statements at
the end of the year.
The above sample situations pose a challenge on the accountant to prepare the financial
statements from whatever records that are available.
TOPICS
1. Single entry bookkeeping

2. Incomplete records
3. Preparing Financial statements
LEARNING OBJECTIVES
After studying this chapter the student should be able to:
Explain the difference between single entry and incomplete records

Prepare a set of financial statements from a limited set of records
Prepare a set of records for an incomplete records situation
We will use the following question to illustrate the stages of compiling financial statements from
a set of limited records.
SINGLE ENTRY BOOKEEPING
Single entry is a generic term used to refer to a business situation in which only a limited number
of records are kept. Principally there is always a record of receipts and payments and some
documentary evidence of other transactions. Accounts can be compiled from the information
available by completing double entry for all the transactions that took place. Day books may not
have been prepared because the administration of the business does not yet have a defined
complete accounting system as such.
276
ILLUSTRATION FOR INCOMPLETE RECORDS
Joel Mutale is a sole trader and provides you with the following summarized data . He would like
you to prepare appropriate statements to show
1. Capital on 1 July 2004
2. Profit for the year ended 30 July 2005
3. A list of assets and liabilities as at 30 June 2005
RECEIPTS AND PAYMENTS

K 000 K 000
Cash receipts
Commision received 3 700
Trade Receivable 12 500
Cash sales 4 200
20 400
Cash Payments
Electricity 1 580
Rent and Rates 3 640
Drawings 1 200
Cash banked 6 000
(12 420)
Excess of receipts over payments 7 980
Add: Opening Balance 3 000
Closing Balance 10 980
Summary of transactions through the bank

K 000 K 000
RECEIPTS
Cash banked 6 000

48 870
PAYMENTS
Equipment 5 520
Insurance 909
Trade Payable 34 000
Loan Interest 700
Wages & Salaries 8 300
Stationery 2 700
(52 129)
Excess of payments over receipts (3 259)
Add: Opening Balance (1 300)
Closing Balance 4 559
277
The following additional notes were extracted from Joels correspondence box files:
As at As at
1 July 2004 30 June 2005
K 000 K 000
Equipment 8 200 12 500
Inventory 3 200 4 500
Bank loan 10 000 10 000
Rates due 420 -
Rent prepaid - 380
Electricity owing 300 320
Trade receivables 6 300 8 400
Trade payables 3 800 4 600
As you settle down to do work, Joel tell you that he pays loan interest at 12 % and there is an
amount that is not yet paid. He further say that during the year he received cash discounts of K
800 000, issued credit notes for K 450 000 and cancelled irrecoverable debts of K 325 000
SOLUTION
The following steps will help you to be methodical in your approach:

Steps:
1. Calculate the amount of capital by preparing an opening journal, listing assets and
liabilities separately. The liabilities are credit balances and so they are deducted from the
total of assets that are debit balances.
2. Draw up the ledger accounts in T form and put the opening balances in their right places:
on the debit side of an asset account and on the credit side of a liability account.
3. Leave space for current year entries (3 5 lines) and put in the closing balances: above
total lines on the debit side and below total lines on the credit side for liability accounts,
and on the credit side above total lines and on the debit side below total lines for asset
accounts.
4. The cashbook contains one entry of the double entry. Complete the second entry in the
ledger accounts by posting to the credit side if the entry is on the debit side of the cash
book account, or to the debit side if the entry is on the credit side of the cash book
account.
5. Care must be taken to open accounts for additional transfers of funds and completing
double entry for them. For example, amounts written off as bad are credited to Trade
Receivables account and debited to Bad debt account. Amounts returned by customers
are credited to Trade Receivables account and debited to Sales returns account. Amounts
allowed receipts from customers are debited to Discount allowed account and credited to
Trade Receivables account.
6. The balancing figure on each account represents the amount to be transferred to the
Income Statement, whereas the closing balance is the amount to report in the Balance
sheet.
The ledger accounts follow then the Income Statement and Balance Sheet finally. It is always
better to draw up nominal accounts on separate pages from the ones on which real and control
278
accounts are. Doing so will facilitate thoroughness in ensuring that no transfer to the Income
Statement is missed, and that work is properly organized.
TRADE RECEIVABLES
K 000 K 000
Balance b/d 6 300 Bank 42 870
Sales 59 045 Sales Returns 450
Cash 12 500
Discount All 800
Bad Debts 325
Balance c/d 8 400
65 345 65 345
Balance b/d 8 400
TRADE PAYABLES
K 000 K 000
Balance b/d 3 800
Purchases 34 800
Bank 34 000
Balance c/d 4 600

38 600 38 600
Balance b/d 4 600
EQUIPMENT
K 000 K 000
Balance b/d 8 200 P/L -Deprec 1 220
Bank 5 520
Balance c/d 12 500
13 720 13 720
Balance b/d 12 500
LOAN
K 000 K 000
Balance b/d 10 000
Balance c/d 10 000
10 000 10 000
Balance b/d 10 000
CAPITAL
K 000 K 000
Balance b/d 4 880
Balance c/d 4 880
4 880 4 880
Balance b/d 4 880
INVENTORY
K 000 K 000
Balance b/d 3 200
Trading c/d 3 200
3 200 3 200
279
PURCHASES
K 000 K 000
Trading c/d 34 800
38 400 38 400
SALES RETURNS
K 000 K 000
Trade Receivable 450
Trading c/d 450
450 450
SALES
K 000 K 000
Cash 4 200
Trading c/d 63 245
63 245 63 245
BAD DEBTS
K 000 K 000
Balance b/d 325
P/L c/d 325
325 325
DISCOUNT ALLOWED
K 000 K 000
Trade Receivables 800
P/L c/d 800
800 800
DEPRECIATION
K 000 K 000
Equipment 1 220
P/L c/d 1 220
1 220 1 220
STATIONERY
K 000 K 000
Bank 2 700
P/L c/d 2 700
2 700 2 700
WAGES & SALARIES
K 000 K 000
Bank 8 300
P/L c/d 8 300
8 300 8 300
280
LOAN INTEREST
K 000 K 000
Bank 700 P/L c/d 1 200
Balance c/d 500
700 700
Balance b/d 500
INSURANCE
K 000 K 000
Bank 909
P/L c/d 909
909 909
RENT & RATES
K 000 K 000
Balance b/d 420
Bank 3 640 P/L c/d 2 840
Balance c/d 380
3 640 3 640
Balance b/d 380
ELECTRICITY
K 000 K 000
Balance b/d 300
Bank 1 580 P/L c/d 1 600
Balance c/d 320
1 900 1 900
Balance b/d 320
DRAWINGS
K 000 K 000
Bank 1 200
Capital c/d 1 200
1 200 1 200
COMMISSION
K 000 K 000
Bank 3 700
P/L c/d 3 700
3 700 3 700
The alternative to calculating cost of sales on the face of the Income Statement is writing the
following account:
COST OF SALES
K 000 K 000
Inventory b/d 3 200
Purchases 34 800 Trading (I/S) 33 500
Inventory c/d 4 500
38 000 38 000
Inventory b/d 4 500
281
COMMENTS
The full ledger accounts have been written here to illustrate how they would be drawn up in
practice. A student who has understood the principles of double entry would list the amounts
straight on the Income Statement, depending on whether the amount is earned/incurred or not.
For example, the amounts to charge as expenses in respect of Electricity and Rent & Rates are
shown below:
ELECTRICITY
Amount paid 1 580
Add: Amount owing at end 320 Incurred but not yet paid for
1 900
Less: Amounts owing at start 300 settled now but incurred last year
Profit & Loss charge 1 600 Incurred for this year only
RENT & RATES

Cash paid 3 640
Less: Amount owing at start 420 settled now but incurred last year
3 220
Less: Amounts prepaid at end 380 Not incurred but paid for
Profit & Loss charge 2 840 Incurred for this year only
The rationale flows because referring to the accounts, amounts on the same side are added,
whereas amounts on the opposite sides of an account are netted. This logic can be applied to any
account without exception. You only need to understand double entry and the format of ledger
accounts.
JOEL MUTALE
INCOME STATEMENT for the year ended 30 June 2005
K000 K000
Sales (less Sales Returns) 62 795
Less: Cost of Sales 33 500
Gross Profit 29 295
Add: Income
Commission received 3 700
32 995
Less: Expenses
Bad Debts 325
Discount Allowed 800
Depreciation 1 220
Electricity 1 600
Rent & Rates 2 840
Insurance 909
Loan Interest 1 200
Wages & Salaries 8 300
Stationery 2 700
19 894
Net Profit 13 101
282
Joel Mutale
BALANCE SHEET as at 30 June 2005
Km Km
Non current Assets:
Equipment 12 500
Current Assets:
Inventory 4 500
Trade receivables 8 400
Rent & Rates 380
Cash at bank & in hand 10 980
24 260
Total assets 36 760
Capital
Balance at start 4 880
Add: Net Profit 13 101
Less: Drawings 1 200

16 781
Non current Liabilities:

Loan 10 000
Current Liabilities:
Loan Interest 500
Electricity 320
Bank Overdraft 4 559
9 979
36 760
Note also that depreciation has been deducted directly from Equipment account because the
closing balance given for this account imply that non current assets are kept at their net book
value (not at cost, in which case there would be a separate account for Accumulated
depreciation).
INCOMPLETE RECORDS
An incomplete records situation presents a greater challenge than merely applying double entry
to transactions. The owner of the business may have not cared to keep any records and will rely
on his memory and a few source documents to provide figures for preparation of financial
statements. Sometimes the situation may be caused by an unexpected event such as fire or a
burglary.
To prepare financial statements from the limited information available you will have to derive
most figures either as balancing figures or as complementary figure after applying some ratios.
283
CHAPTER SUMMARY
You should by now have learnt that:
1. Understanding double entry is very important. You cannot correctly handle a question on
single entry without it.
2. The skill of writing ledger accounts should be perfected, otherwise the figure you derive for
transfer to the income statement will be incorrect
3. You should understand what a debit balance on an accounts represents and what a credit
balance on an account means, otherwise you will not list balances under the correct heading
on the balance sheet.
4. An incomplete records situation can be more involving than a single entry situation.
284
EXERCISE
Mpomwa has been trading for the last five years. He has been using the front half of the house he
has rented as a shop, with the consent of the landlord. Mpomwa maintains no formal accounting
system for the purpose of recording business transactions. He, however, needs to calculate the
profit earned during the year 2006 for tax purposes.
The following is a summary of Mpomwas business bank account:
RECEIPTS: K000
Cash from customers 48 120
Sales of private motor car 650
Total 48 770
PAYMENTS:
Cash paid to suppliers 32 890
Rent of entire premises 2 400
Wages of part-time staff 760
New counter and shelving 800
General expenses 3 650
Drawings 5 870
Total 46 370
The following additional information is obtained:
1. The landlord considers accommodation to be divided equally between private and

business use.
2. The fixtures and fittings in the shop were valued at K2 500 000 at the beginning of
the 2006. It is intended to depreciate fixed assets at 10% on the year end balance.
3. It was discovered that not all the cash received was banked. Wages for part-time staff
and general expenses amounting to K350 000 and K110 000 respectively were paid
direct from the till.
4. Inventory was valued at K2 560 000 at 31 December 2006 and estimated at K1 950
000 at the beginning of the year.
5. From files of invoices it was discovered that K960 000 was owed to suppliers at the
beginning of the year and $1 270 000 at the end of the year.
6. Cash at bank on 1 January amounted to K620 000.
7. There are just a few families to which Mpomwa allows credit. The owed him K170
000 on 1 January 2006 and K 210 000 at 21 December 2006.
8. Mpomwa took goods from the shop costing K320 000 for personal use during the
year.
REQUIRED:
(a) A statement of affairs for the business at 1 January 2006

(b) The Income Statement for the year ended 31 December 2006
(c) The Balance Sheet as at 31 December 2006
285
SOLUTION TO EXERCISE
MPOMWA
Statement of affairs as at 1 January 2006
K000
Assets:
Fixtures 2 500
Inventory 1 950
Trade receivable 170
Bank 620
5 240
Liabilities:
Trade payables 960
Capital 4 280
CAPITAL
K 000 K 000
Balance b/d 4 280
Bank 650
Balance c/d 4 930
4 930 4 930
Balance b/d 4 930
CASH
K 000 K 000
Wages 350
Trade receivable 48 580 General Expenses 110
Bank 48 120
Balance c/d
48 580 48 580
Balance b/d
TRADE RECEIVABLES
K 000 K 000
Balance b/d 170 Cash 48 580
Sales 48 620
Balance c/d 210
48 580 48 580
Balance b/d 210
TRADE PAYABLES
K 000 K 000
Balance b/d 960
Purchases 33 200
Bank 32 890
Balance c/d 1 270

34 160 34 160
Balance b/d 1 270
286
FIXTURE S
K 000 K 000
Balance b/d 2 500
Bank 800
Balance c/d 3 300
3 300 3 300
Balance b/d 3 300
GENERAL EXPENSES
K 000 K 000
Bank 3 650
Cash 110 P/L c/d 3 760
3 760 3 760
RENT
K 000 K 000
Drawings 1 200
Bank 2 400 P/L c/d 1 200
3 640 3 640
WAGES
K 000 K 000
Bank 760 P/L c/d 1 110
Cash 350
1 110 1 110
DRAWINGS
K 000 K 000
Bank 5 870
Rent 1 200
Inventory 320
Capital c/d 7 390
7 390 7 390
MPOMWA
INCOME STATEMENT for the year ended 31 December 2006
K000 K000
Sales (less Sales Returns) 48 620
Less: Cost of Sales 32 270
Gross Profit 16 350
Less: Expenses
Rent 1 200
Wages 1 110
Depreciation 330
6 400
Net Profit 9 950
287
MPOMWA
BALANCE SHEET as at 31 December 2006
K000 K000
Non current Assets:
Fixtures 3 300
Less: Accumulated depreciation 330
3 970
Current Assets:
Inventory 2 560
Trade receivables 210
Bank(620+48 770-46 370) 3 020
5 790
Total assets 8 760
Capital
Balance at start 4 930
Add: Net Profit 9 950
14 880
Less: Drawings 7 390
7 490
None
Trade Payable 210
210
8 760
Working:
Cost of sales is calculated as follows:

Inventory at start 1 950
Purchases 33 200
35 150
Less: Inventory at end 2 560
Drawings 320
2 880
32 270
288
CHAPTER 26
CASHFLOW STATEMENTS
INTRODUCTION
Financial statements are a means of informing the users of financial information about
performance in terms of profitability or otherwise, and of the position in term of assets and
liabilities. They comprise the Income Statement, the Balance Sheet and the Cash flow Statement,
at the minimum. Other reports include a statement of accounting policies and the Operating and
Financial Review. Discussion of the last two statements is outside the scope of this syllabus.
In this chapter we discuss the contents of IAS 7 and the essence of preparing a cash flow
statement.
TOPICS
This chapter will discuss the following topics:

1. Why prepare the cashflow statements
2. Contents of the cashflow statement
3. Methods of preparing cashflow statements
4. How to prepare the cashflow statements
5. Summary
LEARNING OBJECTIVES
After studying this chapter the student should be able to:

Explain the importance of the cash flow statement
Prepare the cash flow statement for a single entity
THE CASH FLOW STATEMENT
The cashflow statement provides information about the sources of cash and the uses to which
cash was put for a specified period. Some writers refer to these as sources and applications of
cash. Admittedly the information on cash can be obtained from the cash and bank accounts in the
Cashbook. In practice the cash transactions are so numerous that it becomes tedious to obtain
cashflow information from the Cashbook. Consequently, the entries for cashflows are obtained
from individual ledger accounts where they are already summarised.
Cashflow statements also serve the following purposes:
1. To explain the difference between the reported profit or loss in the Income Statement
and the cash and bank balances reported in the balance sheet. The reported profit is
calculated under the accruals basis and so includes non cash items.
2. To communicate the solvency of the company: whether the entity has sufficient cash
resources to support continuity of business. Solvency is much more critical than mere
liquidity. Liquidity problems can be solved by borrowing whereas an insolvent company
cannot borrow funds from anywhere, having exhausted all possible means.
289
3. To serve as a source of information for making cash flow forecasts. Management can
make projections of future cash receipts and payments, having regard to proper timing of
cash.
4. The following are the key definitions:
Cash: Amounts of money received or paid in the form of notes or cheques in each
transaction.
Cashfow: The volume of cash that comes into and goes out of the business for a given
period of time.
Cash equivalents: These are financial instruments (bank drafts, loan notes, etc) that can
be used to pay for goods or settle liabilities.
Operating activities: These are business transactions which include trading activities
(buying and selling) and administrative activities that lead to either receipt or payment of
cash.
Investing activities: These are transactions that result in acquisition or disposal of non
current assets and investments.
Financing activities: These are transactions by means of which the business raises funds
of a capital nature. Examples include loans, finance leases, and issues of shares.
FORMATS OF CASHFLOW STATEMENTS
Cash flows are classified under three major headings in the cashflow statements: operating
activities, investing activities and financing activities. The format below outline the contents of a
cash flow statement as required by IAS 7.
Under the direct method cashflow figures are obtained from the ledger accounts for trade
receivables, trade payables and expenses. Depending on the information provided there might be
need to adjust the cashflow figure with amounts for non cash items such as depreciation and
increases/decreases in allowances for bad debts.
290
ABC Ltd
CASHFLOW STATEMENT (DIRECT METHOD)
for the year ended 31 December 2005
K000 K 000
Cashflow from Operating Activities:
Receipts from customers X

Payments to suppliers X
Payments for expenses X
X
Adjustments for Non-cash items:
Depreciation X
Loss on sale of non current assets X
Decrease in provisions for bad debts X
X
Net cashflow from Operating profit X
Interest paid X
Income tax X
Dividends paid X
Net cash from operating activities X
Cashflow from Investing Activities:

Purchase of non current assets X
Disposal of non current assets X
Interest received X
Dividend received X
Short term investments X
Net cash used in investing activities X
Cashflow before financing X
Cashflow from Financing Activities:

Issue of Share Capital X
Share Premium X
Issue of debentures (or Loan stock) X
Finance Leases X
Net cash used in financing X
Increase/decrease in cash and cash equivalents X
There are two methods of preparing cashflow statements: The direct method and the indirect
method. The difference between the two methods lies in the way cashflow from operating
activities is calculated.
291
ABC Ltd
CASHFLOW STATEMENT (INDIRECT METHOD)
K000 K 000
Profit before tax X
Depreciation X
Loss on sale of non current assets X
Decrease in provisions for bad debts X
X
Changes in working capital:
Decrease in inventory X
Increase in debtors X
Increase in creditors X
X
Net cashflow from operating profit X
Interest paid X
Income tax paid X
Dividends paid X
Net cash from operating activities X

Purchase of non current assets X
Disposal of non current assets X
Short term investments X
Interest received X
Dividend received X
Net cash used in investing activities X
Cashflow before financing X

Issue of Share Capital X
Share Premium X
Issue of debentures (or Loan stock) X
Finance Leases X
Net cash used in financing X
Net increase/decrease in cash and cash equivalents X

Cash and cash equivalents b/f X
Cash and cash equivalents c/f X
Under the indirect method operating activities is adjusted from the accruals figure to a pure
cashflow amount with non-cash items and movements in working capital. The rest of the
cashflow statement is prepared as is done under the direct method. You should be able to obtain
cashflow figures from the appropriate accounts by applying knowledge acquired in previous
chapters. The cashflow figure is the entry that goes to the account from either the cash account of
bank account.
We now use a question to illustrate how to prepare the cash flow statement.
292
ILLUSTRATION
The balance sheets of Prenodia Plc as at 30 June 2004 and 2005 and the summary income
Statement for the year ended 30 June 2005 were as follows:
Balance sheet as at 30 June
2004 2005
Km Km Km Km
Non current Assets:
Premises 130 130
Less: Accumulated Depreciation 30 32
100 98
Plant & Machinery 70 80
Less: Accumulated Depreciation 17 23
53 57
Current Assets:
Inventory 25 24
Short term investments - 12
Cash at bank & in hand - 7
41 69
Total assets 194 224
Share Capital 100 100

Profits & loss reserve 36 40
136 140

10% Debentures 20 40
Income Tax 7 8
Proposed dividend 12 14
38 44
194 224
293
Prenodia
Income Statement for the year ended 30 June 2005
Km Km
Sales 173
Less: Cost of Sales 96
Gross Profit 77
Less: Expenses
Sundry expenses 24
Interest payable 2
Loss on sale of non current assets 1
Depreciation Premises 2
Depreciation Plant 16
45
Operating profit 32
Interest receivable 2
Profit before tax 34
Income Tax (16)
Profit after tax 18
Proposed dividend (14)
Retained profit for the year 4
ADDITIONAL INFORMATION
During the year a machine costing K15 was sold for K 4m. Depreciation on the machine had
accumulated to K10m.
REQUIRED
Prepare a cashflow statement for Prenodia Plc for the year ended 30 June 2005
294
SOLUTION
The following part of the cashflow statement can be done as a working in the notes to the
statement or it can be included on the main Cashflow Statement.
Direct method
Cash flow from Operating Activities:
Km Km
Receipts from customers 163
Payments to suppliers (92)
Payments for expenses (45)
26
Depreciation 18
Interest payable (Has its own entry ) 2
21
Net cash flow from Operating profit 47
Indirect method Km Km
Interest payable (Has its own entry on the statement) 2
Interest receivable (Has its own entry on the statement) (2)
Depreciation (2 + 16) 18
Decrease in provisions for bad debts -
19
Movements in working capital:
Decrease in inventory 1
Increase in trade receivables (10)
Increase in trade payables 3
(6)
Net cash flow from operating profit 47
Net cash flow from operating profit has been calculated in different ways under the two methods.
Under the direct method the figure of expenses was obtained straight from the Income Statement
and so it is a figure after deducting depreciation and loss on disposal. Consequently it was
necessary to adjust for these non-cash items. Otherwise they would not have been added back to
net profit.
Under the indirect method interest was adjusted for because it is dealt with separately on the face
of the Cash flow Statement. This reversal was not necessary for interest receivable under the
direct method because it was not part of the expenses figure mentioned above.
The rest of the cashflow statement is completed in the same way under both methods as follows:
295
Km Km

Profit after tax 34
Interest payable 2
Interest receivable (2)
Depreciation (2 + 16) 18
19
Decrease in inventory 1
(6)
Interest received 2
Interest paid (2)
Income tax paid (15)
Dividends paid (12)
Net cash from operating activities 20

Purchase of machinery (25)
Disposal of machinery 4
Short term investments (12)
Net cash used in investing activities (33)
Cashflow before financing (13)

Issue of Share Capital -
Share Premium -
Issue of debentures (or Loan stock) 20
Net cash used in financing 20
Increase in cash and cash equivalents 7
The following are the steps to follow when obtaining cash flow figures from ledger accounts:
1. Write the account and, using the information in the balance sheet as at the end of the
preceding year, put the opening balance on the side it would appear depending on
whether it is an asset or a liability.
2. Using information from the balance sheet as at the end of the current year, insert the
closing balances on the account on the side they would be above total lines and below
total lines depending on whether they are assets or liabilities.
3. In between the two balances (enough space should have been left for this depending on
the expected number of entries) project back wards the figure from the income
296
statement on the side it would be when the entry for the transfer of funds to the trading,
profit and loss was made.
4. Complete the account, slotting in the missing figure on the side with a smaller total. This
figure is the amount of cash flow, the entry from either the bank account or cash account.
The accounts are now shown below with the cashflow figure highlighted in bolt type.
TRADE RECEIVABLES
Balance B/d 16 Bank 163

Sales 173 Balance c/d 26
189 189
Balance b/d 26
INVENTORY (Cost of Sales)
Balance B/d 25 Trading (IS) 96

Purchases 95 Balance c/d 24
120 120
Balance b/d 24
PURCHASES
Inventory 95
Trade Payables 95 Balance c/d 0
95 95
TRADE PAYABLES
Balance B/d 19
Bank 92 Purchases 95
Balance c/d 22
114 114
Balance b/d 22
DIVIDEND
Balance B/d 12
Bank 12 IS 14
Balance c/d 14
26 26
Balance b/d 14
TAXATION
Balance B/d 7
Bank 15 Income statement 16
Balance c/d 8
23 23
Balance b/d 8
PLANT & MACHINERY
Balance B/d 70 Disposal 15

Bank 25 Balance c/d 80
95 95
Balance b/d 80
297
ACCUMULATED DEPRECIATION
Disposal 10 Balance b/d 17

Balance B/d 23 IS- 16
33 33
Balance b/d 23
P & M DISPOSAL
Plant & Machinery 15 Accumul Depreciation 10

Bank 4
0 IS-Profit & Loss 1
15 15
OTHER OBSERVATIONS
The cash flow from debentures is simply the difference between the closing balance and the
opening balance. There being an increase of K20m then this was a credit entry in the account
implying that the debit was in the bank account. The debit in the bank account represents a cash
inflow.
Similarly, there was no balance at start of the period on the Short-term investments. The account
shows a closing balance of K12m representing new investment. The balance is a debit on the
account implying that the credit was in the bank account. Therefore there was an outflow in
K12m.
CHAPTER SUMMARY
You should now have learnt that

Preparing a cashflow statement is important because the users of financial statements
need to know where cash resources came from and what uses they were put to in the past
year. This information would enable them to make reasonable cashflow forecasts as well
as other economic decisions.
The cashflow statement should be presented according to the format recommended in the
accounting standard (IAS7)
298
EXERCISES
QUESTION ONE
The balance sheet given below together with comparative figures are a for Tokozile Ltd, a
private company that has been operating for the last three years.
TOKOZILE LTD
BALANCE SHEET AS AT 30 JUNE
2006 2005
K000 K000 K000 K000
Non current assets:
Property, plant & equip 2 800 2 100
Accumulated depreciation (650) (490)
2 150 1 610
Current assets:
Inventory 1 100 850
Bank 120 -
1 760 1 320
Total assets 3 910 2 930
Equity and liabilities:

Ordinary share capita l 2 200 1 600
Share premium 260 -
Retained earnings 400 865
2 860 2 465
Loan notes 340 140
Current liabilities:
Trade payables 430 110
Bank overdraft - 45
Taxation 280 170
710 325
3 910 2 930
a) During the year the company sold a piece of equipment with a net book value of K
135,000 at a profit of K75,000.
b) Depreciation charged for the year ended 30 June 2006 was K220,000.
c) Interest paid during the year ended 30 June 2006 was K37,000.
d) Income tax paid during the year amounted to K 230,000.
e) The company paid no dividend in the year under review.
REQUIRED:
(a) Calculate the operating profit of Tokozile Ltd for the year ended 30 June 2006
(b) Prepare a cashflow statement for Tokozile Ltd for the year ended 30 June 2006 in
accordance with IAS 7 (revised).
299
QUESTION TWO
KONKOLA
INCOME STATEMENT for the year ended 31 March 2007
K000 K000
Revenue 2,150
Cost of sales (1,250)
Gross profit 900
Distribution cost 98
Administration expenses 122
(220)
Operating profit 680
Profit on disposal of non current assets 12
Dividend received 14
Interest paid (36)
(10)
Taxation (132)
Profit after tax 538
STATEMENT OF CHANGES IN EQUITY

SHARE SHARE RETAINED
CAPITAL PREMIUM PROFIT
K000 K000 K000
Balances at start (31/03/06) 1,100 260 80
Issues of shares 300 60
Profit for year 538
Dividend (98)
Balance at end 31 March 2007 1,400 320 520
300
KONKOLA
BALANCE SHEET AS AT 31 JUNE
2006 2007
K000 K000 K000 K000
Non current assets:
Furniture & Fittings 750 930
540 665
Motor Vehicles at cost 780 885

475 535
Investments at cost 90 170
1,105 1,370
Current assets:
Inventory 615 456
Bank (14) 452
1 175 1,700
Total assets 2,280 3,070
Equity and liabilities:

Ordinary share capital 1,100 1 400
Share premium 260 320
Retained earnings 80 520
1,440 2,240
Loan notes 160 60
Proposed dividend 35 80
Taxation 105 125
680 770
2,280 3,070
Additional information for the year to 31 March 2007:
a) Vehicles which had cost K145 000 were sold during the year when their net book
value was K 55,000.
b) There were no accruals or prepaid expenses at the end of the year.
REQUIRED:
a. Prepare a cashflow statement for Konkola for the year ended 31 March 2007
using the DIRECT method. Show any additional notes and reconciliation
required.
b. Explain briefly the usefulness of cashflow statements to external users
301
SOLUTION ONE

for the year ended 30 June 2006
K000 K 000
Loss after tax (88)
Depreciation 220
Loss on sale of non current assets (75)
145
Increase in inventory (250)
(00)
Interest paid (37)
Net cash from operating activities (210)
Cash flow from Investing Activities:

Purchase of machinery (895)
Disposal of machinery 210
Interest received (00)
Cash flow before financing (895)
Cash flow from Financing Activities:

Issue of Share Capital 600
Share Premium 260
Loan notes 200
Net cash used in financing 1060
Proof: K000 K000

Balance of cash /bank at start (overdraft) (45)
Increase in cash (from cashflow statement) 165
Balance of cash/bank at end 30 June 2006 120
302
Workings:
Calculation of operating profit:
Retained profit at end 30 June 2006 400
Retained profit at end 30 June 2005 865
Loss for the year 2006 (465)
Add: Dividend -
Taxation 340
Interest charge 37
Operating loss (88)
Relevant Ledger accounts:
PROPERTY, PLANT & EQUIPMENT

2995 2995
Balance b/d 2800
ACCUMULATED DEPRECIATION

Balance B/d 650 IS-Depreciation 220
710 710
Balance b/d 650
P P & EQUIP DISPOSAL
Property, Plant, etc 195 Accumul. Depreciation 60

Bank 210
IS-Profit & Loss 75 000
270 270
TAXATION
Balance B/d 170

Bank 230 Income Statement 340
Balance c/d 280 000
510 510
Balance b/d 280
Note: Cost of plant sold is NBV + Depreciation, and the amount of tax charged to the
income statement of a balancing figure on the Income tax account.
303
SOLUTION TWO
Direct method
K000 K000
Receipts from customers 1,932
Payments to suppliers (1066)
Payments for expenses (220)
646
Depreciation -Furniture 55
Depreciation Motor Vehicles 135
190
Net cash flow from Operating profit 836
TRADE RECEIVABLES
Balance B/d 574 Bank 1,932

Sales 2,150 Balance c/d 792
2,724 2,724
Balance b/d 792
INVENTORY (Cost of Sales)
Balance B/d 615 Trading (IS) 1,250

Purchases 1,091 Balance c/d 456
1,701 1,701
Balance b/d 456
PURCHASES
Inventory 1,091
Trade Payables 1,091 0000
1,091 1,091
TRADE PAYABLES
Balance B/d 540

Bank 1,066 Purchases 1,091
Balance c/d 565 0000
1,631 1,631
Balance b/d 565
DIVIDEND
Balance B/d 35
Bank 53 IS 98
Balance c/d 80
133 133
Balance b/d 80
TAXATION
Balance B/d 105

Bank 112 Income statement 132
Balance c/d 125
237 237
Balance b/d 125
304
MOTOR VEHICLE

1,030 1,030
Balance b/d 885
ACCUMULATED DEPRECIATION -MV

Balance B/d 350 IS- 135
440 440
Balance b/d 350
P & M DISPOSAL -MV
Plant & Machinery 145 Accumul Depreciation 90

Bank 67
IS-Profit 12 000
157 157
FURNITURE & FITTINGS
Balance B/d 750

930 930
Balance b/d 930
ACCUMULATED DEPRECIATION -FF
Balance b/d 210

Balance B/d 265 IS- Depreciat 55
265 265
Balance b/d 350
305
KONKOLA
CASHFLOW STATEMENT For the year ended 31 March 2007
K000 K000
Net cash flow from operating profit(W1) 836
Interest paid (36)
Dividends paid (53)
Net cash from operating activities 635

Purchase of furniture (180)
Purchase of motor vehicle (250)
Disposal of motor vehicle 67
Purchase investments (80)
Cashflow before financing 206

Issue of Share Capital 300
Share Premium 60
Loan notes (100)
Net cash from financing 260
Proof: K000 K000

Balance of cash /bank at start (overdraft) (14)
Increase in cash (from cashflow statement) 466
Balance of cash/bank at end 31 March 2007 452
306
CHAPTER 26
COMPANY ACCOUNTS
INTRODUCTION
A company can be defined as a business incorporated under company law by a group of

members known as shareholders. In this chapter we look at the preparation of financial
statements for internal use for Limited Companies. Guidance on the structure and content of the
financial statements is provided for in IAS 1: Preparation of Financial Statements.
TOPICS
1. Company finance
2. Classes of shares
3. Debentures
4. Issue of shares
5. Share capital structure
6. Preparation of financial statements
LEARNING OUTCOMES
Explain sources of finance for companies.

Explain the classes of shares.
Explain debentures.
Explain the process of issuing shares.
Distinguish between a Bonus issue and a Rights issue.
Record the issue of shares at par value and at a premium.
Explain the following share capital structure terms: Authorised, Issued, Called up, Paid up,
Calls in arrears and Calls in advance.
Prepare the Income Statement and Balance Sheet for a company.
26.1 Company finance

Generally, the finances of a company are raised from two main sources: the
shareholders (through the share capital) and outside lenders of finance (debentures
holders).
26.2 Classes of Share Capital

The ownership of a company is through shares. Share capital represents part of the
capital invested in the company by its shareholders but may also represent past
reserves of the company, which have been capitalised by an issue of the shares.
A company may issue different classes of shares, the most common are being the
following:
307
a) Ordinary shares
These are the normal shares issued by the company. The normal rights of ordinary
shareholders are to vote at company meetings and to receive dividends from the
remainder of profits.
b) Preference shares
These are shares carrying a fixed rate of dividend, the shareholders of which have a
prior claim to any company profits for distribution. Preference shares do not carry
a voting right. Preference shares could either be cumulative or non-cumulative.
26.3 Debentures
This is a written acknowledgement of a loan to a company, given under the
company's seal, which carries a fixed rate of interest. The conditions and regulations
of the debenture are set out in a debenture trust deed.
Debentures are not part of the company's share capital - they are third party liabilities.
Debenture interest is a charge against profit and must be paid whether or not a company
makes profit.
26.4 Issue of Shares

A company raises capital by issue of shares. The process of issuing shares is the same
whether it is a newly formed company issuing shares for the first time or an established
company asking for more capital to extend its operations.
Each share issued has a stated nominal value (also called a par value), for example
20 000 shares of K1 each, the K1 per share is the nominal value. Shares could be issued
at par value or at a premium. The double entry for recording the issue of shares is as
follows:
a) Shares issued at nominal value
Dr - Cash book
Cr - Share capital account
For example, suppose 100 000 ordinary shares of K1 each are issued at nominal value.
The ledger accounts recording this issue will be as shown below:
Bank account
___________________________________________________________________
K'000 K'000
Ordinary share capital 100
Ordinary share capital account

___________________________________________________________________
K'000 K'000
Bank 100
308
b) Shares issued at a premium
Dr - Cash book
Cr - Share capital account, with nominal value
Cr - Share premium account, with excess over the nominal value
For example 100 000 ordinary shares of K1 each are issued at a price of K1.20 each.
The ledger accounts to record the issue will be:
Bank account
___________________________________________________________________
K'000 K'000
Ordinary share capital 120
Ordinary share capital account

___________________________________________________________________
K'000 K'000
Bank 100
Share premium account

___________________________________________________________________
K'000 K'000
Bank 20
26.4.1 Bonus issue

A bonus issue also called a Script or Capitalisation issue represents the issue of shares to
the existing shareholders in proportion to their existing holding. No cash or other
consideration is passed from shareholders to the company. Any reserve may be used to
finance the bonus issue.
The double entry for a bonus issue is:
Dr - Reserves
Cr - Share capital, with the amount of bonus issue
26.4.2 Rights issue

A rights issue represents the offer of shares to existing shareholders in proportion to
their existing holdings at a stated price. Unlike the bonus issue, the shareholders do not
have to take up their offer and have the alternative of selling their rights on the stock
market.
309
The double entry for recording a rights issue is:
Dr - Cash book
Cr - Share capital, with nominal value
Cr - Share premium, with the premium (if any)
26.5 Share Capital Structure

The share capital structure is as follows:
i) Authorised share capital: - is the maximum share capital that a company is allowed
to issue. It is also known as the Nominal capital.
ii) Issued share capital: - is the actual share capital issued to shareholders at any point in
time. It is the issued share capital that appears on the company's balance sheet.
iii) Called up share capital: - is part of the nominal value payable on each share that has
been called for. However most capital is issued on a fully paid up basis.
iv) Paid-up share capital: - is that part of the nominal value that is paid at current date.
v) Calls in arrears: - is the amount requested for (called for) but not yet received.
vi) Calls in advance: - is the amount received prior to payment being requested.
ACTIVITY 1
Hightech Ltd was formed with the legal right to be able issue 100 000 shares of K100 each.
The company has actually issued 80 000 shares. None of these shares have been fully paid up.
So far the company has made calls of K60 per share. All the calls have been paid by
shareholders except for K200 000 unpaid by one shareholder.
Calculate the following:
a) Authorised share capital

b) Issued share capital
c) Called up share capital
d) Paid up share capital
e) Calls in arrears
310
26.6 Financial statements for companies
The Income Statement and the Balance Sheet for limited companies are drawn in a
similar manner as to that of a sole trader and the partnership. The main differences
in the financial statements of a company are:
i) The income statement

The income statement has an extra section called an Appropriation Account that
shows how the profits are distributed or used by a company. The following items are
found in this section:
a) Income tax: this is a tax levied as a percentage of the taxable profits. Income tax is
not an expense but an appropriation of profits by the government. It is deducted
separately immediately after net profit. Income tax is an estimate of the tax liability
and is normally paid some months after the end of the accounting period. It is
therefore shown as a current liability in the balance sheet before it is paid.
b) Dividends: A dividend is a return of part of the profits made by a company to the

shareholders. Dividends can be stated as a percentage of the nominal value of the
share or alternatively as an amount per share. For example: K100 000 dividends on
1 000 shares of K1 000 per share can be expressed as a dividend of 10% per share
or K100 per share.
The directors of the company as part of their responsibility can declare an interim
dividend during the accounting period on the account of the total dividend of the
year. The balance after an interim dividend is paid will be declared at the general
meeting upon recommendation from the directors as a final dividend.
The double entry bookkeeping for both the interim dividend and final dividend is as
follows:
For the interim dividend

Dr - Dividend account
Cr - Cash book
For the final dividend

Dr - Profit and loss account
Cr - Proposed dividends account
The total of the interim dividend and the final dividend appear in the income
statement but it is only the final proposed dividend that will appear in the balance
sheet as a liability.
c) Transfers to reserves: A reserve is a profit set aside for a particular purpose. For
example a fixed asset replacement reserve used to set aside profits for replacing fixed
assets during a period of rising prices.
There are two types of reserves namely:
a) Capital reserve
b) Revenue reserve
311
Capital reserves (also known as statutory reserves) are established by law. They
include share premium, Capital Redemption Reserve and Revaluation Reserve. Capital
reserves can not be distributed to shareholders as dividends. The share premium
account, which arises on issue of shares, as shown under issue of shares above can be
used for the following purposes:
- financing the issue of fully paid bonus shares

- writing off preliminary expenses on the formation of a company
- writing off expenses, commission or discount on share or debenture issue
- providing the premium on the redemption of debentures and on redeemable of
shares
Revenue reserves arise when a company makes profits and does not pay out all the
profits to the shareholders. There is no statutory requirement for a company to have
any amount in its revenue reserve. Revenue reserves can be used for any purpose by
the company. However, where profits are transferred to a named reserve, the directors
are indicating that these amounts are not available to support a dividend payment
(although there is nothing in law to prevent their distribution). Revenue reserves
include, fixed assets replacement reserve, general reserve, profit and loss account
(reserve) etc.
ii) The balance sheet

The main difference in the balance sheet of a limited company as compared to that of sole
traders and partnerships lies in the capital section. The capital section of a company is
made up of shareholders' funds, which comprise, share capital and reserves.
Example:
You are provided with the following Trial Balance of Hightech Ltd at 31st December
2006:
Dr Cr
K'000 K'000
Ordinary share capital (K1 000 shares) 400 000
10% preference share capital (K1 000 shares) 120 000
Freehold Premises at cost 920 000
Provision for depreciation - buildings 400 000
Plant and machinery (cost K300 million) 180 000
Sales 364 000
Purchases 196 000
Receivables and Payables 64 000 8 000
Cash at bank 60 000
Inventory at 1st January 2006 40 000
Discounts 1 600 800
10% debentures 2010 200 000
Debenture interest paid 20 000
Administrative expenses 16 000
Staff salaries (excluding directors) 16 000
Preference dividend paid 4 000
Profit and loss account b/d 32 000
1 524 800 1 524 800
312
Adjustments are required for:
1. Inventory at 31st December 2004, at cost K60 000 000.
2. Directors' salaries not yet paid K20 000 000.
3. Income tax for the year K8 600 000.
4. Proposed ordinary dividend K10 per share.
5. Depreciation on buildings for the year K18 400 000 and plant and machinery is to be
depreciated at 10% on cost.
6. Accrued audit fee K4 000 000.
7. Creation of a plant replacement reserve of K4 000 000.
You are required to prepare the Income Statement for the year ended 31st December 2006 and a
Balance Sheet as at that date.
SOLUTION
Hightech Ltd
Income statement for the year ended 31st December 2006
K000 K000
Sales revenue 364 000
Purchases 196 000
240 000
Less: closing inventory 60 000
Add Gains:
Total income 184 800
Less Expenses:
Discount allowed 1 600
Staff salaries 16 000
Directors' salaries accrued 20 000
Audit fee accrued 4 000
Depreciation: - buildings 18 400
- Plant and machinery 30 000
Debenture interest 20 000
Total expenses 129 200
Net profit before tax 55 600
Less: Income tax 8 600
Net profit after tax 47 000
Transfer to plant replacement reserve 4 000
Dividends: - Preference (paid) 4 000
- Preference (proposed) 8 000
- Ordinary (proposed) 4 000
20 000
Retained profit for the year 27 000
Retained earnings b/d 32 000
Retained earnings c/d 59 000
313
Hightech Ltd
Balance sheet as at 31st December 2006
Cost Dep. Value
Non current assets: K000 K000 K000
Freehold land and buildings 920 000 418 400 501 600
Plant and machinery 300 000 150 000 150 000
1 220 000 598 400 651 600
Current assets:
Inventory 60 000
Receivables 64 000
Cash at bank 60 000
184 000
Capital and reserves:

Ordinary share capital 400 000
10% preference share capital 120 000
Plant replacement reserve 4 000
Accumulated profit 59 000
583 000
Non-current liabilities
10% debentures 2009 200 000
Current liabilities
Payables 8 000
Taxation 8 600
Dividends payable (4 000 + 8 000) 12 000
Accruals (20 000 + 4 000) 24 000
52 600
Total Equity and liabilities 835 600
CHAPTER SUMMARY
The chapter started by looking at the financing of limited companies which is mainly by share
capital and third party liabilities. It has also been noted that dividends are a means of distributing
profits to shareholders, while income tax is an appropriation of profits by the government.
Profits undistributed are retained in the business by means of reserves.
The chapter has also looked at the preparation of financial statements for internal use in a
company.
314
EXERCISES
QUESTION ONE
You are presented with the following summarised Trial Balance of MK Ltd in respect of the
year ended 31st March 2007:
Dr Cr
K'000 K'000
Ordinary share capital (K500 shares) 200 000
Plant and machinery:
Cost 616 000
Depreciation (1st April 2006) 170 000
Receivables 104 000
Payables 76 000
Cash at bank 82 000
Inventory at 1st April 2006 180 000
Sales 2 000 000
Purchases 1 542 000
9% debentures 2010 150 000
Share premium account 40 000
Administrative costs 200 000
Provision for doubtful debts 4 000
Interim dividends paid 6 000
Profit and loss account balance 90 000
2 730 000 2 730 000
The following final adjustments are required:
1. The allowance for bad debts is to be adjusted to 5% of the receivables figure.

2. Income tax on the current year profits is estimated at K62 400 000.
3. The directors propose a final dividend of K60 per share.
4. Depreciation at 10% of cost of plant and machinery is to be provided.
5. Debenture interest for the year ended 31st March 2007 was paid on 1st April 2007. No
accrual has been made.
6. Inventory at 31st March 2007 was valued at K122 000.
You are required to prepare the Income Statement account for the year ended 31st March 2007
and a Balance Sheet as at that date.
315
QUESTION TWO
The following Trial Balance was extracted from the books of Hillside Plc at 31st March 2006:
K000 K000
K1 000 ordinary shares 200 000
8% K1 000 preference shares 70 000
7% debentures 100 000
Land and buildings: cost 130 000
Accumulated depreciation on buildings on 1st April 2005 30 000
Plant and machinery (K348 million cost) 262 500
Motor vans at cost 140 000
Accumulated depreciation on vans on 1st April 2005 56 800
Profit and loss account b/f 20 000
Inventory at 1st April 2005 35 000
Sales 344 600
Trade Receivables and Payables 45 000 27 000
Bank 5 800
Purchases 166 100
Distribution costs 18 000
General administration expenses 44 900
Interim dividends:
Ordinary 10 000
Preference 2 800
Allowance for doubtful debts 1 500
890 100 890 100
Additional information available:
1. During the year the following transpired in relation to motor vans:
a) A new motor van was purchased on 1st January 2006 on credit for K24 million. The
amount was still due to the supplier on 31st March 2006.
b) A motor van which had cost K16 million four years ago when new was sold for
K6.6 million. The proceeds from the sale had not yet been received on 31st March
2006.
None of the above matters had been recorded in the books of the company.
2. Depreciation on motor vans has been and is to be provided at the rate of 20% per annum on
cost and is charged in full in the year of acquisition and none in the year of disposal.
3. The cost of buildings is K100 million.
4. Depreciation on buildings, and plant and machinery is to be charged as follows:

Buildings 2% on cost
Plant and machinery 10% on cost
5. On 31st March 2006 the company issued bonus shares to the ordinary shareholders on a one
(1) to ten (10) basis. No entry relating to this has yet been made in the books.
316
6. Inventory at 31st March 2006 was valued at K51 million.
7. A bill for administrative expenses for K150 000 was unsettled as at 31st March 2006.
8. Distribution costs include an insurance premium for delivery vans of K200 000 which relates
to the period 1st July 2005 to 30th June 2006.
9. The allowance for doubtful debts is to be 21/2% of receivables outstanding on 31st March
2006.
10. The directors wish to provide for:

a) A final ordinary dividend of 5%
b) A final preference dividend.
11. Income tax for the year is estimated at K18 million.
Required:
a) Using additional information (1) and (2), prepare the following ledger accounts:
i) Motor van account

ii) Motor van accumulated depreciation account
iii) Motor van disposal account
(7 marks)
b) Prepare the companys Income Statement for the year ended 31st March 2006.
(11 marks)
c) Prepare the companys Balance Sheet as at 31st March 2006.
(14 marks)
(NATech: December 2006)
317
SOLUTION ONE
MK Ltd
Income statement for the year ended 31st March 2007
K000 K000
Sales revenue 2 000 000
Purchases 1 542 000
1 722 000
Cost of sales 1 600 000
Less Expenses:
Increase in allowance for doubtful debts 1 200
Debenture interest accrued (9% x 150 000) 13 500
Depreciation on Plant and machinery 61 600
Net profit after tax 61 300
Dividends: - interim 6 000
- proposed 24 000
30 000
Retained earnings b/d 90 000
Retained earnings c/d 121 300
318
MK Ltd
Balance sheet as at 31st March 2007
Cost Dep. Value
Current assets:
Inventory 122 000
Receivables (104 000 5 200) 98 800
Cash at bank 82 000
302 800

361 300
9% debentures 2009 150 000
Current liabilities
Payables 76 000
Taxation 62 400
Dividends payable 24 000
Accruals 13 500
175 900
SOLUTION TWO
a) i) Motor Van Account

K000 K000
Balance b/d 140 000 Disposal 16 000
Payable 24 000 Balance c/d 148 000
164 000 164 000
ii) Motor Van Accumulated Depreciation Account

K000 K000
Disposal (16 000 x 20% x 4) 12 800 Balance b/d 56 800
Balance c/d 73 600 I. S. (148 000 x 20%) 29 600
86 400 86 400
iii) Motor Van Disposal Account

K000 K000
Motor van 16 000 Accumulated dep. 12 800
Income statement (bal. fig.) 3 400 Disposal proceeds 6 600
19 400 19 400
319
b) Hillside Plc
Income statement for the year ended 31st March 2006.
K000 K000
Purchases 166 100
201 100
Add: Gains:
Profit on disposal 3 400
Decrease in allowance for doubtful debts 300
3 700
Total income 198 200
Less: expenses:
Distribution costs (18 000 50) 17 950
General administration expenses (44 900 + 150) 45 050
Depreciation: - Buildings 2 000
- Plant and machinery 34 800
- Motor van 29 600
136 400
Profit before taxation 61 800
Profit after taxation 43 800
Less: appropriations:
Dividends: interim ordinary 10 000
- preference 2 800
Proposed ordinary (5% x 220 000) 11 000
- preference 2 800
26 600
Retained earnings brought forward (20 000)
Retained earnings carried forward (2 800)
320
c) Hillside Plc
Balance Sheet as at 31st March 2006.
COST DEP. NBV
Non-current Assets: K000 K000 K000
Land and buildings 130 000 32 000 98 000
Motor van 148 000 73 600 74 400
626 000 225 700 400 100
Current Assets:
Inventory 51 000
Less: allowance for doubtful debts 1 200
46 800
Receivable for the motor van 6 600
Bank 5 800
Prepayment 50
110 250

Ordinary share capital (200 000 + 20 000) 220 000
Share premium account (60 200 20 000) 40 200
Accumulated profit (2 800)
327 400
Non-current liabilities:
7% debentures 100 000
Creditor for the motor van 24 000
Taxation 18 000
Dividends payable - preference 2 800
- ordinary 11 000
Accrual 150
82 950
321
CHAPTER 27
ACCOUNTING CONCEPTS AND PRINCIPLES
INTRODUCTION
This chapter looks at the accounting concepts and principles which underlie the preparation of
financial statements. Some of these concepts have already been explained in the previous
chapters.
TOPICS
1. Nature and purpose of Accounting Concepts

2. Accounting concepts and conventions
3. International Accounting Standards (IAS)
LEARNING OUTCOMES
- explain the nature and purpose of accounting concepts

- Explain a number of Accounting Conventions and Concepts
- Explain International Accounting Standards (IAS)
27.1 Nature and Purpose of Accounting Conventions
Accounting conventions are principles or accepted practice which apply generally to

transactions. Some conventions are of more relevance to some transactions than to
others, but all have an influence in determining:
Which assets and liabilities are recorded on a balance sheet

How assets and liabilities are valued
What income and expenditure is recorded in the income statement
At what amount income and expenditure is recorded
27.2 ACCOUNTING CONCEPTS
Accounting concepts are the broad assumptions which underline the periodic
financial accounts of business enterprises. Assumptions mean that:
- These concepts are not necessarily obvious, nor are the only concepts which could
be used, but they the ones in use currently.
- These concepts look at why certain items are treated in specific ways and
- Where theres a choice of treatment, how to decide which treatment to use.
- National legal requirements
- National accounting standards
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27.3 THE CONCEPTS
The International Accounting Standards (IAS) 1 Preparation of Financial Statements

lists a number of accounting principles and conventions that must be followed when
preparing financial statements. The major accounting concepts that must be followed
are:
a) Fair Presentation
b) Going Concern
c) Accruals
d) Consistency
a) Fair Presentation
Fair presentation requires the faithful representation of the effects of transactions,
other events and conditions in accordance with the definitions and recognition
criteria for assets, liabilities, income and expenses.
b) Going Concern Concept

This states that the business will continue in operational existence for the
foreseeable future, and that there is no intention to put the company into
liquidation, unless otherwise it is known.
c) The Accruals/Matching Concept

This states that, in computing profits, revenue earned must be matched against the
expenditure or incurred in earning it.
d) The Consistency Concept

This states that in preparing accounts consistency should be observed i.e. certain
items should be treated using different methods, the method chosen should be used
consistently from one year to the next so that reasonable conclusions can be made
on the performance of the business, for example Depreciation, Stock Valuations.
OTHER CONCEPTS
e) Prudence Concept
This states that where alternative procedures or alternative valuations, are possible,
the one selected should be the one which gives the most cautious presentation of
the business financial position or results.
f) The Business Entity Concept

This concept states that a business and the owner should be treated separately.
g) Money Measurement Concept

This states that accounts should deal only with items to which a monetary value
can be attributed.
h) The Separate Valuation Principle

This states that in determining the amount to be attributed to an asset or a liability
in the balance sheet, each component item of the asset or liability must be valued
separately.
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i) The Materiality Concept
This is judgemental depending on the nature and size of the business.
A matter is material if its omission or misstatement would reasonably influence the

decisions of a user of the accounts.
j) Substance Over Form

It can happen that the legal form of a transaction can differ from its real substance,
where this happens accounting should show the transaction in accordance with its
real substance e.g. goods bought on hire purchase.
k) Neutrality/Objective Concept
This states that accountants should be free from bias when preparing financial
statements e.g. internally generated goodwill should not be recorded in the books
because of its uncertainty as to its true value.
l) The Accounting Period Concept

This states that there must be a standard shorter period in which to measure
performance of a business. Twelve months period is normally adopted for this
purpose. This time interval is the accounting period.
m) The Realisation Concept

This states that profits are realized immediately goods or services exchange hands
whether cash has been paid or not.
n) The Historical Cost Concept

This state that assets should be recorded in the accounting books at cost i.e. price
paid to acquire it. These assets are systematically reduced by the process called
depreciation.
27.4 INTERNATIONAL ACCOUNTING STANDARD (IAS)

These are standards which are used in preparing financial statements in order to
provide users with an accurate picture of the profit and financial position of the
enterprise.
CHAPTER SUMMARY
The chapter has looked at the accounting concepts and principles that underlie the preparation of
Financial Statements. Accounting concepts influence the assets, liabilities, income and
expenditure and the amounts at which these are recorded in the balance sheet.
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CHAPTER 28
INTERPRETATION OF FINAL ACCOUNTS

INTRODUCTION
Financial statements summarise the economic performance and situation of a business. This
information needs further analysis and interpretation to deduce its meaning for the benefit of the
users. Ratio Analysis is on of the means by which financial statements are interpreted. Ratio
analysis makes uses of accounting ratios to draw relationships between sets of accounts.
TOPICS
1. Ratio analysis technique

2. Types of Ratios
3. Calculation of Ratios
4. Interpretation of statements
5. Limitation of Ratio analysis
LEARNING OUTCOMES
- Explain the ratio analysis technique

- Calculate ratios
- interpret the ratios
- Explain the limitation of Ratio Analysis
28.1 Ratio analysis Technique
The key to obtaining meaningful information from ratio analysis is comparison. This may
involve comparing ratios over time within the same business to establish whether things are
improving or declining; and comparing ratios between similar businesses to see whether the
business you are analysing is better or worse than average within its specific business sector.
28.2 Types of Ratios
Interpretation of accounts makes use of five main categories of ratios, these are:
1. Profitability ratios
2. Liquidity ratios
3. Efficiency ratios
4. Solvency ratios
5. Investors ratios
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28.2.1 Profitability Ratios
These ratios tell us whether a business is making profits and if so whether at an acceptable rate.
a) Return on capital employed (ROCE)

The ratio tells us what returns management has made on the resources made available to
them before making any distributions of these returns. The higher the return the better,
especially in high risk businesses. A very low return has a negative impact on internal
growth sustenance of a company.
Formula:
ROCE = Profit before interest and tax x 100

Capital employed
The capital employed is taken to be the total assets less current liabilities of the
business or share capital plus reserves plus long term liabilities. This ratio is further
broken down into two ratios:
i) Operating profit margin on sales

Given a constant gross profit margin, the operating profit margin tells us about the
companys ability to control the level of its operating costs or overheads. The higher the
operating profit margin, the better. An increasing operating profit margin indicates
better control of costs, and a decreasing profit margin indicates worse control of costs or
too low selling prices.
Formula:
Operating profit margin = Profit before interest and tax x 100

Sales
ii) Asset turnover
This measures the companys ability to generate sales revenue in relation to the size of
the asset investment.
Formula:
Asset turnover = Sales

Capital employed
b) Gross profit margin

The ratio tells us about the ability of the company to consistently control its production
costs or to manage the margin it makes on its products. The higher the gross profit margin,
the better. An increasing gross profit margin indicates better control of production costs or
management of margin, and a decreasing gross profit margin indicates worse control of
production costs or too low selling prices.
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Formula:
Gross profit margin = Gross profit x 100
Turnover
Where turnover = sales less sales returns
28.2.2 Liquidity Ratios
These ratios indicate how capable a business is in meeting its short term obligations as they fall
due.
a) Current ratio
The ratio, also referred to as the working capital ratio, measures whether the business can
pay debts due within one year from assets that it expects to turn into cash within that year.
A ratio of less than one (1) is often a course of concern, particularly if it persists for any
length of time.
Formula:
Current ratio = Current assets

Current liabilities
b) Quick/Liquidity ratio (or Acid Test ratio)

This ratio shows the ability of the business to pay current liabilities out of quick
assets, i.e. assets which are either in cash or quickly convertible into cash. Some assets
take time to convert into cash, for example, raw materials and other inventory must first be
turned into final product, the product sold and then cash collected from debtors. The quick
ratio therefore adjusts the current ratio to eliminate all assets that are not already in cash or
near cash form. The higher the quick ratio, the better for a business. A ratio of less than
one would start to send out danger signals on the liquidity of the organisation.
Formula:
Quick ratio = Current assets Inventory

Current liabilities
Note: Higher current and quick ratios are not always good indicators. Sometimes, this may
indicate that working capital is inefficiently used. The efficiency ratios below will
highlight this. In other words, such ratios should be within acceptable range, i.e. not
too high and not too low.
28.2.3 Efficiency Ratios
These ratios tell us how efficiently the business is employing the resources invested into fixed
assets and working capital.
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a) Inventory turnover ratio
This ratio shows on average how many times in a month the inventory is turned over.
The higher the inventory turnover ratio, the quicker the inventory is being turned over. It
helps us check whether we have got too much money tied up in inventory. A decreasing
inventory turnover figure or one which is much lower than the average for the industry may
indicate poor inventory management. On the other hand, a high turnover ratio indicates a
good movement in inventory, thus reducing obsolescence.
Formula:
Inventory turnover = Cost of sales

Average inventory value
Alternatively the ratio can be expressed in inventory days. A higher inventory days figure
or one which is much larger than the average for the industry may indicate poor inventory
management.
Formula:
Inventory days = Average inventory x 365 days

Cost of sales
Note: If the average inventory cannot be calculated then the inventory at the balance sheet
date should be used.
b) Receivables turnover
This ratio shows the average period taken by receivables to pay. It indicates whether the
receivables are being allowed excessive credit. A decreasing trade receivables turnover
figure or one less than the industry average may suggest general problems with debt
collection (such as delays in invoicing or failure to screen the credit worthiness of new
customers) or the financial position of major customers.
Formula:
Receivables turnover = Credit Sales

Trade receivables
Alternatively the ratio can be expressed in terms of Receivables collection period. This
shows the average number of days it takes receivables to pay their accounts. An increasing
higher figure or one more than the industry average may suggest problems with debt
collection or the financial position of major customers.
Formula:
Receivables payment period = Trade receivables x 365 days

Credit Sales
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d) Payables turnover
This ratio tells us whether a business is taking full advantage of full trade credit available to
it. A decreasing trade payables turnover or one lower than the average industry indicates
that you are taking longer to pay suppliers. This may not give any room to the business to
be able to negotiate better credit terms from suppliers, cash discounts lost and future supplies
being at risk.
Formula:
Trade payables turnover = Credit Purchases

Trade payables
Alternatively the ratio can be expressed in terms of Payables credit period. This
shows the average number of days it takes the organisation to pay its suppliers. An
increasing payables credit period indicates that you are taking longer to pay your suppliers,
and a decreasing period indicates that you are paying quicker.
Formula:
Payables credit period = Trade payables x 365 days

Credit Purchases
Note: Where the purchases figure can not be calculated then the cost of sales figure
may be used.
d) Non-current assets turnover

This ratio tells us about the non-current asset capacity. A reducing sales value generated
from each Kwacha invested in non-current assets may indicate over capacity or poor
performing equipment.
Formula:
Non-current assets turnover = Sales

Non-current assets
28.2.4 Solvency or Gearing Ratios
These ratios concentrate on the long-term health of a business, particularly the effect of
capital/finance structure on the business i.e. it establishes the relationship between the proportion
of Capital Employed that is borrowed and the proportion that is provided by shareholders funds.
The higher the level of gearing (borrowing) the higher are the risks to a business since the
payment of interest and repayment of debts are not optional in the same way as dividends.
However, gearing can be a financially sound part of a business capital structure particularly if the
business has strong, predictable cash flows.
Capital gearing can be calculated in two ways:
a) Total gearing
This ratio shows the proportion of the companys assets which are financial by
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borrowing and so gives an indication of the amount of further secured borrowings that
might be undertaken.
Formula:
Total gearing = Preference share capital + interest bearing Loans

Assets employed (or Total capital)
b) Debt to equity ratio

This ratio shows a more pronounced change if either fixed return capital or equity
capital changes. A ratio of 2 indicates that the debt is twice higher the equity.
Formula:
Equity gearing = Preference share capital + interest bearing loans

Ordinary share capital + Reserves
Interest cover
This measures the ability of the business to service its debts. The ratio answers the
question: Are the profits sufficient to be able to pay interest and other finance obligations?
A high rate indicates that the company is in a strong position (security) as regards payment
of interest. The measure should indicate the number of times the profits can meet interest
obligations.
Formula:
Interest cover = Profit before interest and tax

Interest payable on loans
28.2.5 Investors ratios
These are the ratios used by investors to assess the performance of a business as an investment.
An investor is interested in the income earned by the company for him/her and the return on
his/her investment (i.e. the income earned in relation to the market price of the investment).
a) Dividend per share

This measures the amount of dividend available per ordinary share. The higher the
dividend per share, the better to the shareholder.
Formula:
Dividend per share = Dividends for ordinary shares

Number of ordinary shares
b) Dividend Cover
This ratio shows the proportion of profit on ordinary activities that is available for
distribution to shareholders and what proportion will be retained in the business to finance
future growth. A dividend cover of 2 times would indicate that the company had paid 50%
of its distributable profits as dividends, and retained 50% in the business to help finance
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future operations. A decreasing dividend cover would indicate a fall in profits but the
dividend level is maintained as in the previous years, so as to keep shareholder expectations
satisfied.
Formula:
Dividend cover = Profit for the financial year or = Earnings per share__
Ordinary dividend Net dividend per share
c) Dividend yield
Dividend yield is the return a shareholder is currently expecting on the shares of a
company. On the stock market the dividend yield is normally stated gross of tax. This
enables the yield on shares to be compared with yields on interest stocks (company and
government stocks).
Formula:
Dividend yield = Dividend on the share for the year x 100

Current market value of the share
d) Earnings per share (EPS)

Earnings per share look at the theoretical profits that could be paid to each ordinary
shareholder. Earnings are the net profits after tax, interest, minority interest earnings and
dividends on other classes of shares.
Formula:
Earnings per share = Earnings

Issued ordinary shares
e) Price Earnings ratio (P/E ratio)

The price earnings ratio is the ratio of a companys current share price to the earnings
per share. A high P/E ratio indicates strong shareholder confidence in the company
and its future, e.g. in profit growth, and a lower P/E ratio indicates lower confidence.
Formula:
P/E = Current market value

Earnings per share
f) Earnings yield
Earnings yield is measured as earnings per share expressed as a percentage of the
current share price. It indicates what the dividend yield would be if the company paid
out all its profits as dividends and retained nothing in the business.
Formula:
Earnings yield = Earnings per share x 100

Current market value
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28.3 Calculating Ratios
Calculating ratios is part of the process of ratio analysis. We shall illustrate the calculation of the
above ratios using the following example.
A public limited company quoted on the Lusaka Stock Exchange produced the following results
as at 31st December 2006:
Profit and loss account for the year ended 31st December 2006
K000 K000
Purchases 162 000
199 000
Closing inventory 42 000
157 000
Gross profit 52 000
Administration expenses 13 000
Interest 2 000
25 000
Net profit 27 000
Taxation 10 000
Net profit after taxation 17 000
Dividends: Ordinary shares 6 000
Preference shares 2 000
8 000

K000 K000
Non-current assets (net book value) 130 000
Current assets:
Inventory 42 000
Bank 3 000
74 000
Ordinary share capital (K500 shares) 35 000
8% Preference shares (K1 000 shares) 25 000
Revaluation reserve 10 000
118 000
5% secured loan stock 40 000
Current liabilities
Taxation 10 000
46 000
204 000
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The market value of each ordinary share is K2 040.
From the above details, you are required to calculate the following ratios:
a) Return on capital employed (ROCE)

b) Operating profit margin on sales
c) Gross profit Margin
d) Current ratio
e) Quick ratio
f) Inventory turnover
g) Inventory days
h) Receivables turnover ratio
i) Receivables collection period
j) Payables turnover ratio
k) Payables credit period
l) Non-current assets turnover ratio
m) Total gearing ratio
n) Debt to equity ratio
o) Interest Cover
p) Dividend per share
q) Dividend cover
r) Dividend yield
s) Earnings per share (EPS)
t) Price Earnings ratio (P/E ratio)
u) Earnings yield
SOLUTION
a) Return on capital employed
ROCE = Profit before interest and tax x 100

Capital employed
= 27 000 + 2 000 x 100 = 21.8%

133 000
b) Operating profit margin

Operating profit margin = Profit before interest and tax x 100
Sales
= 29 000 x 100 = 13.9%

209 000
c) Gross profit margin

Gross profit margin = Gross profit x 100
Turnover
= 52 000 x 100 = 24.9%

209 000
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d) Current ratio
Current ratio = Current assets
Current liabilities
= 74 000 = 1.6 times

46 000
e) Quick ratio
Quick ratio = Current assets Inventory
Current liabilities
= 74 000 42 000 = 0.7 times

46 000
f) Inventory turnover ratio

Inventory turnover = Cost of sales
Average inventory value
= 157 000 = 4.0 times

1
/2 (37 000 + 42 000)
g) Inventory days
Inventory days = Average inventory x 365 days
Cost of sales
= 39 500 x 365 = 92 days

157 000
h) Receivables turnover
Receivables turnover = Credit Sales
Trade receivables
= 209 000 = 7.2 times

29 000
i) Receivables collection period

Receivables collection period = Trade receivables x 365 days
Credit Sales
= 29 000 x 365 = 50.6 days

209 000
j) Payables turnover
Trade payables turnover = Credit Purchases
Trade payables
= 162 000 = 4.5 times

36 000
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k) Payables credit period
Payables credit period = Trade payables x 365 days
Credit Purchases
= 36 000 x 365 = 81.1 days

162 000
l) Non-current assets turnover

Non-current assets turnover = Sales
Non-current assets
= 209 000 = 1.6 times

130 000
m) Total gearing
Total gearing = Preference share capital + interest bearing loans x 100
Assets employed (or Total capital)
= 25 000 + 40 000 x 100 = 41.1%

158 000
n) Debt to equity ratio
Equity gearing = Preference share capital + interest bearing loans x 100
Ordinary share capital + reserves
= 25 000 + 40 000 x 100 = 69 .9%

118 000 25 000
o) Interest cover
Interest cover = Profit before interest and tax
Interest payable on loans
= 29 000 = 14.5 times

2 000
p) Dividend per share

Dividend per share = Dividends for ordinary shares
Number of ordinary shares
= 6 000 = K86 per share

70 000
q) Dividend Cover
Dividend cover = Profit for the financial year or = Earnings per share
Ordinary dividend Net dividend per share
= 17 000 2 000 = 2.5 times

6 000
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r) Dividend yield
Dividend yield = Dividend on the share for the year x 100
Current market value of the share
= 86 x 100 = 4.2%
2 040
s) Earnings per share

Earnings per share = Earnings
Issued ordinary shares
= 15 000 = K214 per share

70 000
t) Price Earnings ratio

P/E = Current market value
Earnings per share
= 2 040 = 9.5
214
u) Earnings yield
Earnings yield = Earnings per share x 100
Current market value
= 214 x 100 = 10.5%

2 040
Interpretation of Financial Statements

The basis of interpretation is the ability to make use of the information provided by the
ratios. Ratios are only a means to an end; they are not an end in themselves. By comparing
relationships between figures, ratios merely highlight trends in the accounts and so one should be
in position to comment on the reported trends i.e. be able to define the reasons for the trends
disclosed. Do not hesitate to make obvious comments such as the gross profit percentage has
increased from last year as this entails stating that the business is more profitable.
Example:
The following information has been extracted from the published accounts of Gideon Plc.
Extracts from the profit and loss accounts

2004 2003
K000 K000
Sales revenue 22 400 19 500
Cost of sales 16 920 13 650
This is after charging:

Depreciation 720 560
Audit fees 24 20
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Balance sheet as at 31st December
2004 2003
K000 K000
Non-current assets 3 700 2 860
Current assets:
Inventory 1 280 980
Trade receivables 2 460 2 160
Cash 160 240
3 900 3 380

Ordinary share capital 1 600 1 600
Reserves 2 490 1 750
4 090 3 350
Long-term liabilities:
10% debentures 1 600 1 200
Bank overdraft 220 160
Taxation 190 150
1 910 1 690
Total capital and liabilities 7 600 6 240
The latest industry average ratios are:
Current ratio 1.90

Quick ratio 1.27
Receivables turnover 52 days
Payables turnover 49 days
Inventory turnover 18.3 times
Required:
a) Calculate comparable ratios (to two decimal places where appropriate) for Gideon Plc for the
years 2003 and 2004.
b) Comment on the liquidity and efficiency ratios of Gideon Plc, comparing the results
against the two years and against the industry.
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SOLUTION
a)
i) Year 2003 2004

3 380 000 3 900 000
Current ratio /1 690 000 /1 910 000
= 2.0 = 2.04
3 380 000 980 000 3 900 000 1 280 000

Quick ratio /1 690 000 /1 910 000
= 1.42 = 1.37
2 1600 000 2 460 000

Debtors turnover /19 500 000 x 365 /22 400 000 x 365
= 40 days = 40 days
1 380 000 1 500 000
Creditors turnover /13 650 000 x 365 /16 920 000 x 365
= 37 days = 32 days
13 650 000 16 920 000

Stock turnover /980 000 /1 280 000
= 13.9 times = 13.2 times
ii) Comments:
Liquidity ratios:
The current ratio has improved slightly over the year and is marginally higher than
the industry average.
The ratio is in line with what is generally regarded as satisfactory (2:1)
The quick ratio has declined marginally but is still better than the industry average.
This suggests that Austin Plc has no short term liquidity problems and should have
no difficulty in paying its debts as they become due.
Efficiency ratios:
Receivables turnover receivables as a proportion of sales is unchanged from 2003

and are considerably lower than the industry average.
Consequently, there is probably little opportunity to reduce this further and there
may be pressure in the future from customers to increase the period of credit given.
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Payables turnover the period of credit taken from suppliers has fallen from 37
days purchases to 32 days and is much lower than the industry average.
With this it may be possible to finance any additional receivables by negotiating

better credit terms from suppliers.
Inventory turnover has fallen slightly and is much lower than the industry average.
This may partly reflect stocking up ahead of a significant increase in sales.

Alternatively, there is some danger that the inventory could contain certain
absolute items that may require writing off. The relative increase in the level of
inventory has been financed by an increased overdraft which may reduce if
inventory levels can be brought down.
Limitations of Ratio Analysis
The limitations of ratio analysis can be summarised as follows:
a) Companies use different accounting policies and so can be used to manipulate company
results
b) Availability of comparable information is quite difficult because no two businesses are
identical
c) Use of historical/out of date information may not be useful for future decision making
d) Ratios are not definitive they are only a guide
e) Interpretation needs careful analysis and should not be considered in isolation. Some items in
the financial statements are of vital importance in assessing the position of a business.
f) It is a subjective exercise
g) A number of ratios are based on balance sheet figures as at a particular point in time and so
they may not be representative of the financial position for the whole year.
CHAPTER SUMMARY
The chapter has looked at the Accounting Ratios used in interpreting the financial performance
and position of companies. The four main categories of accounting ratios are: Profitability,
Liquidity, Efficiency, Solvency and Gearing. Calculating one ratio is not an end in itself, but
should help one draw conclusions about the company. You should also remember that ratio
analysis has its own draw backs such as being subjective and being based on historical
information.
Overall, ratios are very useful in interpreting the financial performance and position of
companies beyond the traditional income statement and balance sheet. When used appropriately
they are good tools in predicting the future outcome of the company.
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EXERCISES
QUESTION ONE
The following are the summarised financial statements for X Ltd for 2005 and 2006:
Summarised income statements

2005 2006
K000 K000
Turnover 243 150 291 950
Operating profit 8 619 10 335
Interest payable 992 992
Profit before taxation 7 627 9 343
Taxation 2 867 3 513
Profit after tax 4 760 5 830
Dividends 1 120 1 200
Retained profit for the year 3 640 4 630
Retained profit b/f 11 770 15 410
Retained profit c/f 15 410 20 040
Summarised balance sheets

2005 2006
K000 K000
Non current assets 2 498 6 350
Current assets:
Inventory 20 073 25 228
Receivables 20 105 21 685
Bank 6 046 2 895

Ordinary share capital of K250 per share 4 960 4 960
Retained earnings 15 410 20 040
10% debentures 9 920 9 920
Taxation 1 237 1 630
Dividends payable 893 993
Total equity and liabilities 48 722 56 158
Required:
a) Calculate for each year the following ratios:

i) Return on capital employed
ii) Non current assets turnover
iii) Current ratio
iv) Quick ratio
v) Earning per share
vi) Dividend cover
b) Comment briefly on the changes in the ratios calculated in (a) above between the two years.
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QUESTION TWO
The following ratios were calculated from the financial statements of H Ltd and G Ltd:
H Ltd G Ltd
Profitability
Return on capital employed 27.5% 15.5%
Gross profit margin 34% 28%
Net profit/sales ratio 19% 15%
Gearing
Total gearing 29.5% 13.5%
Interest cover 6 times 9 times
Liquidity
Current ratio 1.0 1.4
Quick ratio 0.6 1.0
Efficiency
Receivables collection period 63 days 250 days
Inventory turnover 4.5 times 3 times
Required: comment of the financial performance and position of H Ltd and G Ltd.
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SOLUTION ONE
a)
2005 2006
i) ROCE = 8 619 x 100 10 335 x 100

30 290 34 920
= 28.5% 29.6%
ii) Non current assets turnover = 243 150 291 950

2 498 6 350
= 97.3 times 46 times
iii) Current ratio = 46 224 49 808

18 432 21 238
= 2.5 2.3
iv) Quick ratio = 46 224 20 073 49 808 25 228

18 432 21 238
= 1.4 1.2
v) Earnings per share = 4 760 5 830

19 840 19 840
= K239.9 per share K293.9 per share
vi) Dividends cover = 4 760 5 830

1 120 1 200
= 4.3 times 4.9 times
b) Return on capital employed has increased marginally by about 4%, indicating that profits
have increased marginally. The Non current assets turnover has drastically reduced. This
reduction could be as a result of the high investment in non current assets. This investment
would in future help to increase profitability and turnover.
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The current ratio has decreased though still at an acceptable level. The quick ratio has also
decreased though also still above the desirable level of 1. The company should however
observe this decline in the liquidity position to ensure that it does not persist for a long time.
The earnings per share have increased by K54 per share. This is due to the improved profits
in 2006. The dividends cover has improved. This is as a result of the decrease in profits
paid out as dividends which is not proportional to the increase in profits.
SOLUTION TWO
Comments on the financial performance and position of H Ltd and G Ltd
Profitability
H Ltd has performed better than G Ltd both in terms of profitability to capital employed and
profitability to sales.
Gearing
H Ltd is highly geared in comparison to G Ltd. G Ltd has a better interest cover that H Ltd.
However, the interest cover for H Ltd of 6 times is quite good despite the company having a high
gearing ratio. This might indicate that H Ltd used the funds borrowed to acquired profit
generating assets.
Liquidity
G Ltd shows better current and quick ratios than H Ltd, indicating a better liquidity position. A
comparison with the industry average would help to identify as to how poor or good the ratios of
the two companies are.
Efficiency
H Ltd has better receivables collection period and inventory turnover than G Ltd. The
receivables collection period is too long for G Ltd which might indicate that G Ltd has a poor
credit control policy.
Conclusion
Provided that the two companies are in the same industry and are of the same size, then it can be
concluded that H Ltds finance performance and position is better than that of G Ltd.
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CHAPTER 29
MANUFACTURING ACCOUNTS
INTRODUCTION
In this chapter we shall look at the preparation of financial statements for manufacturing
organisations. A manufacturing organisation is one that manufactures (produces) goods for sale.
This could either be a sole trader, a partnership or a company.
TOPICS
1. Manufacturing account
2. Work in progress
3. Transfers of goods at market value
4. Provision for unrealized profits
LEARNING OUTCOMES
- Explain the purpose of a Manufacturing Account

- Explain the treatment of opening and closing Work In Progress in Manufacturing Accounts
- Calculate the profit or loss on manufacturing
- Account for provision for unrealised profits on finished goods.
- Prepare Manufacturing Account, Income Statement and Balance Sheet for sole traders,
partnerships and companies.
30.1 Manufacturing Account

A Manufacturing Account is an account that collects together all the costs involved in production
to determine the production cost of goods completed. To ascertain the production cost of the
goods completed, charge all the elements of production cost (i.e. direct materials, direct labour,
direct expenses and production overheads) to the Manufacturing Account.
Direct materials, labour, and expenses are all those costs involved in production that are
traceable to units of goods produced. The total of all direct costs incurred in a year is called the
prime cost. Production overheads are all those costs incurred in a factory, but cannot be easily
traced to the units of goods produced.
At the end of the year, the cost of goods manufactured is then transferred, as the figure
equivalent to purchases, to the income statement.
30.2 Opening and closing work in progress

The goods partly completed at the start and end of the accounting period are respectively known
as opening work in progress and closing work in progress. The value of the opening work in
progress is added to the total production cost for the period while the value of the closing work in
progress is deducted in arriving at the production cost of goods completed.
344
Example:
Joshua Muleya is a manufacturer. His Trial Balance as at 31st December 2006 is as follows:
Dr Cr
K000 K000
Capital 274 912
Drawings 17 120
Premises 80 000
Machinery 65 000
Office equipment 22 000
Delivery van expenses 5 000
Lighting and heating: Factory 5 718
Office 2 220
Manufacturing wages 90 940
General expenses: Office 7 632
Factory 11 280
Purchases of raw materials 78 108
Salesmen commission 15 720
Rent: Factory 9 600
Office 4 400
Office salaries 12 570
Receivables and Payables 56 740 38 900
Bank 26 674
Inventory at 1st January 2006:
Raw materials 15 130
Finished goods 48 500
Work in progress 10 460 ______
586 812 586 812
1. Inventory at 31st December 2006 were:
Raw materials K18 100 000

Finished goods K49 560 000
Work in progress K12 840 000
2. Ignore depreciation of fixed assets.
Required: From the above details, prepare the Manufacturing Account, the Income Statement
for the year ended 31st December 2006 and a Balance Sheet as at that date.
345
SOLUTION:
Joshua Muleya
Manufacturing account for the year ended 31st December 2006
K000 K000
Raw materials:
Purchases 78 108
Total inventory available 95 238
Cost of raw materials consumed 77 138
Direct labour:
Wages 90 940
Prime cost 168 078
Add: production overheads:
Lighting and heating 5 718
Rent 9 600
26 598
194 676
Add: opening work in progress 10 460
205 136
Less: closing work in progress 12 840
Production cost 192 296
Joshua Muleya
Income Statement for the year ended 31st December 2006
K000 K000
240 796
Gross profit 81 764
Less expenses:
Lighting and heating 2 220
Rent 4 400
Office salaries 12 570
Salesmen's commission 15 720
Net profit 34 222
346
Joshua Muleya
Cost Dep. Value
Non-current assets: K000 K000 K000
Premises 80 000 - 80 000
Machinery 65 000 - 65 000
Office equipment 22 000 - 22 000
167 000 - 167 000
Current assets:
Inventory: - Raw materials 18 100
- Work in progress 12 840
- Finished goods 49 560
Receivables 56 740
Cash at bank 26 674
163 914
Capital and liabilities:

Capital 274 912
Add: net profit 34 222
309 134
Less: drawings 17 120
292 014
Payables 38 900
Total capital and liabilities 330 914
30.3 Transfer of goods at market value

In manufacturing organisations, it is usual to allocate the gross profit earned by the business
between the factory and the selling department so that the actual profit earned from mere selling
can be revealed. This split may also allow the production manager to earn a commission. To
achieve this, the finished goods are transferred from the factory to the selling department with a
profit element (i.e. profit loading).
When goods are transferred at market value, there will be a balance in the manufacturing account
representing a profit or a loss arising from manufacturing the goods instead of buying them as
finished products. To close the manufacturing account, the profit or loss should be transferred to
the income statement.
347
Example:
The following information has been extracted from the books of Meleki manufacturing company
for the year to 30th September 2006:
K'000
th
Deprecation for the year to 30 September 2006:
Factory equipment 21 000
Office equipment 12 000
Direct wages 120 000
Factory: insurance 3 000
Heat 45 000
Indirect materials 15 000
Power 60 000
Salaries 75 000
st
Finished goods at 1 October 2005 72 000
Office: electricity 55 000
Postage and telephones 8 700
Salaries 210 000
Raw material purchases 600 000
Carriage inwards on raw materials 6 000
st
Raw material inventory at 1 October 2005 24 000
Advertising 6 000
Work in progress at 1st October 2005 36 000
Notes:
1. At 30th September 2006, the following were on hand:

K'000
Work in progress 27 000
2. At 30th September 2006, there was an accrual for advertising of K3 000 000, and it was
estimated that K4 500 000 had been paid in advance for electricity. These items had not been
included in the books of account for the year to 30th September 2006.
3. Goods produced during the year are to be transferred to the Income Statement at a market
value of K978 000 000.
4. For the purpose of inventory valuation, finished goods have been valued at cost.
Required: Prepare in the vertical columnar form, the company's Manufacturing Account,
Income Statement for the year to 30th September 2006.
348
SOLUTION:
Meleki Manufacturing Company

Manufacturing account for the year ended 30th September 2006
K000 K000 K000
Raw materials:
Purchases 600 000
Add: carriage inwards 6 000
606 000
Direct labour:
Wages 120 000
Prime cost 720 000
Add: production overheads:
Depreciation - factory equipment 21 000
Insurance 3 000
Heat 45 000
Indirect materials 15 000
Power 60 000
Salaries 75 000
219 000
939 000
975 000
Market value 978 000

Less: production cost 948 000
Manufacturing profit 30 000
349
Meleki Manufacturing Company
Income Statement for the year ended 30th September 2006
K000 K000

1 050 000
Gross profit on trading 577 200
Add: profit on manufacturing 30 000
607 700
Less expenses:
Advertising 6 000
Add: accrual 3 000
9 000
Depreciation - office equipment 12 000
Electricity 45 000
Less: prepayment 4 500
40 500
Postage and telephones 8 700
Salaries 210 000
Net profit 300 000
30.4 Allowance for unrealised profit

In cases where goods are transferred at market price to the selling department, there may be
some of these goods that remain unsold at the end of the year. If the inventory of such goods is
valued at the transfer price or market price, then in order to arrive at the true profit, it is
necessary to provide in the accounts for unrealised profits included in the valuation of
inventories. The allowance for Unrealised Profit Account is opened to account for such profits.
This account is prepared in the same manner as the Allowance for doubtful debts Account, i.e. an
increase in the account balance is treated as an expense, while a decrease is treated as a gain in
the income statement. The balance on the Provision for Unrealised Profit Account is at the end of
the year deducted from the closing inventory of finished goods in the Balance Sheet.
350
Example:
The following balances as at 31st December 2006 have been extracted from the books of Simon
Choolwe, a manufacturer:
K'000
st
Inventory at 1 January 2006:
Raw materials 7 000
Purchase of raw materials 38 000
Direct labour 28 000
Factory overheads:
Variable 16 000
Fixed 9 000
Administrative expenses:
Rent and rates 19 000
Heat and light 6 000
Stationery and postage 2 000
Plant and machinery:
At cost 30 000
Provisions for depreciation 12 000
Motor vehicles (for sales deliveries):
At cost 16 000
Provisions for depreciation 4 000
Payables 5 500
Receivables 28 000
Drawings 11 500
Balance at bank (Dr) 16 600
st
Capital at 1 January 2006 48 000
Allowance for unrealised profit at 1st January 2006 1 380
Motor vehicles running costs 4 500
1. Inventories at 31st December 2006, were as follows:

K'000
Raw materials 9 000
2. The factory output is transferred to the income statement at factory cost plus 25% for factory
profit. The finished goods inventory is valued on the basis of amounts transferred to the
debit of the income statement.
3. Depreciation is provided annually at the following percentages of the original costs of fixed
assets held at the end of each financial year:
351
Plant and machinery 10%
Motor vehicles 25%
4. Amounts accrued due on 31st December 2006 for direct labour amounted to K3 000 000 and
rent and rates prepaid at 31st December 2006 amounted to K2 000 000.
Required:
Prepare the Manufacturing Account, Income Statement for the year ended 31st December 2006,
and a Balance Sheet as at that date.
SOLUTION:
Simon Choolwe
K000 K000
Raw materials:
Purchases 38 000
Direct labour:
Wages 28 000
Add: wages accrued 3 000
31 000
Prime cost 67 000
Add: factory overheads:
Variable 16 000
Fixed 9 000
Depreciation - plant and machinery 3 000
28 000
95 000
100 000
Factory cost 92 000

Less: factory cost 92 000
Manufacturing profit 23 000
352
Simon Choolwe
K000 K000 K000
121 900
Gross profit on trading 80 450
Add: profit on manufacturing 23 000
103 450
Less expenses:
Rent and rates 19 000
Less: prepayment 2 000 17 000
Provision for unrealised profit (w1) 690
Heat and light 6 000
Stationery and postage 2 000
Depreciation - motor vehicles 4 000
Motor vehicle running costs 4 500
Net profit 49 880

Cost Dep. Value
Motor vehicles 16 000 8 000 8 000
46 000 23 000 23 000
Current assets:
Inventories: - raw materials 9 000
- work in progress 8 000
- finished goods 10 350
less: allowance for unrealised profit 2 070
8 280
Receivables 28 000
Cash at bank 16 600
Rent and rates prepaid 2 000
71 880
94 880
Capital account
Balance on 1st January 2006 48 000
97 880
Less: drawings 11 500
86 380
353
Payables 5 500
Direct labour accrued 3 000 8 500
94 880
Workings
1.
Allowance for Unrealised Profit Account
___________________________________________________________________
K'000 K'000
Balance c/d 2 070 Balance b/d 1 380
Income Statement 690
2 070 2 070
Note: Closing balance amount = K10 350 000 x 25/125 = K2 070 000
354
EXERCISES
QUESTION ONE
The following is a trial balance for J Mutinta as at 31st December 2006:
Dr Cr
K000 K000
Capital 59 360
Drawings 4 000
Productive machinery (cost K56m) 46 000
Accounting machinery (cost K4m) 2 400
Royalties 1 400
Carriage inwards on raw materials 700
Purchases of raw materials 74 000
Inventory at 1st January 2006:
Raw materials 4 200
Wages (direct K36m, factory K29m) 65 000
General factory expenses 6 200
Lighting 1 500
Factory power 2 740
Administrative salaries 8 800
Salesmen's salaries 6 000
Commission on sales 2 300
Rent 2 400
Insurance 840
General administrative expenses 2 680
Bank charges 460
Receivables 28 460
Payables 25 000
Bank 11 360
Cash 300
284 360 284 360
Notes at 31st December 2004:
1. Inventory of raw materials K4 800 000, Inventory of finished goods K8 000 000, Work In
Progress K3 000 000.
2. Lighting, rent and insurance are to be apportioned: factory 5/6ths, administration 1/6th.
3. Depreciation on productive machinery and accounting machinery at 10% per annum on cost.
Required:
Prepare the Manufacturing Account, Income Statement for the year ended 31st December 2006
and a Balance sheet as at that date.
355
QUESTION TWO
The following trial balance was extracted from the books of Panuka Ltd after completion of the
manufacturing account for the year ended 31st March 2003.
Dr Cr
K000 K000
Receivables 21 400
Payables 10 000
Inventory:
Finished goods (1st April 2002) 52 000
Raw materials (31st March 2003) 11 000
WIP (31st March 2003) 6 200
Premises at cost 35 000
Accumulated depreciation on buildings 2 000
Plant and machinery at cost 12 000
Depreciation on plant and machinery:
Accumulated provision 4 800
Charge for the year 1 200
Retained profit (1st April 2002) 27 080
Bank 8 528
Rent 3 500
Bad debts 400
Advertising expenses 5 590
Preference divided paid 700
Suspense 3 629
308 709 308 709
1. Closing inventory of finished goods on 31st March 2003 was valued at K46 600 000.
2. Depreciation on buildings is K400 000.
3. Included in rent paid is a 16 months rental of K1 680 000 payable as from 1st July 2002.
4. Provision for Income tax on profits for the year of K15 000 000 is to be made.
5. The directors decided to provide for a 10% dividend on ordinary shares and a final dividend
on preference shares.
6. Investigations on the causes of the difference in books revealed the following errors. These
errors had no effect on the production cost:
356
i) A debit balance of K4 600 000 owing by a customer was omitted in the trial
balance.
ii) The total of the discounts received column in the cash book, K120 000, had not
been posted to the nominal ledger.
iii) A payment for administrative salaries, K1 323 000, was posted to the general
ledger as K1 332 000.
iv) A sales invoice for K8 000 000 had been omitted from the sales account.
v) A cheque issued for general expenses for K50 000 had been posted to the debit
of the bank account.
Required:
a) Show the journal entries to correct the errors in six (6) above. Narratives are not
required.
(5 marks)
b) Open up the suspense account to clear the difference in books. (3 marks)
c) Taking into account the corrected errors, you are to prepare:
i) Panuka Ltds Income Statement for the year ended 31st March 2003.
(12 marks)
ii) Panuka Ltds Balance Sheet as at 31 March 2003.
st
(11 marks)
(NATech June 2004)
357
SOLUTION ONE
J Mutinta
K000 K000
Raw materials:
Purchases 74 000
Direct labour:
Wages 36 000
Direct expenses:
Royalties 1 400
Prime cost 111 500
Add: factory overheads:
Indirect wages 29 000
General factory expenses 6 200
Lighting (5/6 x 1 500) 1 250
Factory power 2 740
Rent (5/6 x 2 400) 2 000
5
Insurance ( /6 x 840) 700
Depreciation on productive machinery (10% x 56) 5 600
47 490
158 990
161 690
358
J Mutinta
K000 K000 K000
166 470
Gross profit 41 530
Less expenses:
Lighting (1/6 x 1 500) 250
Salesmens salaries 6 000
Commission on sales 2 300
Rent (1/6 x 2 400) 400
1
Insurance ( /6 x 840) 140
General administrative expenses 2 680
Bank charges 460
Depreciation on accounting machine (10% x 4m) 400
Net profit 17 960
J Mutinta
Cost Dep. Value
Productive machinery 56 000 15 600 40 400
Accounting machinery 4 000 2 000 2 000
60 000 17 600 42 400
Current assets:
Inventories: - raw materials 4 800
- work in progress 3 000
- finished goods 8 000 15 800
Receivables 28 460
Cash at bank 11 360
Cash in hand 300
55 920
Total assets 98 320
Capital account
Balance on 1st January 2006 59 360
77 320
Less: drawings 4 000 73 320
359
Payables 25 000
SOLUTION TWO
a) Journal entries
K000 K000
i) Receivables in Trial balance 4 600
Suspense 4 600
ii) Suspense 120

Discount Received 120
iii) Suspense 9
Administrative salaries 9
iv) Suspense 8 000

Sales revenue 8 000
v) Suspense 100
Bank 100
b) Suspense Account
K000 K000
Discount Received 120 Balance b/d 3 629
Administrative salaries 9 Receivables in Trial balance 4 600
Sales revenue 8 000
Bank 100
8 229 8 229
360
c)
(i) Panuka Ltd Income Statement for the year ended 31st March 2003.
K000 K000
Sales revenue (200 000 + 8 000) 208 000
158 400
Gross profit 96 200
Add: Gains:
Total income 96 320
Less: Expenses:
Rent [3 500 (1680 16 x 7 months)] 2 765
Bad debts 400
Administrative salaries (21 615 9) 21 606
Advertising expenses 5 590
Depreciation on Buildings 400
55 137
Profit before taxation 41 183
Profit after taxation 26 183
Dividends
Preference -paid 700
- proposed 700
Ordinary proposed 4 000
5 400
Add: Retained profit brought forward 17 080
Retained profit carried forward 37 863
361
(ii) Panuka Ltd Balance Sheet as at 31st March 2003.
COST DEP. NBV

Non current Assets: $
Premises 35 000 2 400 32 600
47 000 8 400 38 600
Current Assets:
Inventory:
W-I-P 6 200
63 800
Receivables (21 400 + 4 600) 26 000
Bank (8 528 100) 8 428
Rent prepaid 735
98 963

107 863
Payables 10 000
Taxation 15 000
Dividend payable: - preference 700
- ordinary 4 000
29 700
362
TERMINOLOGY
1. Assets: A resource or right under the entitys control acquired as a result of a past transaction or
event, and the business expects to derive economic benefits as a result of that control.
Items of possession and have value. The owner has a right of claim to the value of the assets. An
example would be inventory, trade receivables (debtors), cash, motor vehicles, etc
2. Liability: A legal obligation to transfer out economic benefits as a result of a past transaction or
event.
A legal obligation to pay money or in kind to somebody else. An example would be a bank loan,
trade payables account balance, electricity bill still outstanding, etc.
3. A customer: someone we sell trading goods to on credit. Consequently he owes us money. An

account for a customer is called a trade receivables account.
4. A supplier: someone we buy trading goods from on credit. Consequently we owe him money. An
account for a supplier is called a trade payables account.
5. Cash transactions: business activities in which money is immediately given in exchange for
goods or services.
6. Credit transactions: Business trading activities in which goods or services are provided without
any immediate exchange of cash. The name of the outside entity is always mentioned in a credit
transaction because it is implied that actual cash will be paid or received in future.
7. Cash can refer to amounts paid in notes and coins or by cheque, debit card (ATM access card) and
credit card.
8. An item of income is a source of revenue, which comes in the form of cash. An example would be
sales, rent receivable, commission received, etc.
9. An expense is an item of expenditure and cash is paid out as a result of it. An example would be
electricity paid, purchases of goods for resale, rent payable, carriage inwards, carriage outwards,
etc
10. A gain is a form of income. It is extra funds generated after undertaking some business
transaction. An example would be cash proceeds of a sale of a fixed asset above its book value,
discount received, etc.
11. A loss is an amount that reduces owners wealth and arises from operating activities. It is an item
of expenditure that could not generate a corresponding cash receipt. An example would be
discount received, bad debts, etc.
12. Non current assets: Items of value, which the business intends to use operationally for more than
one accounting period (usually 1 year). They are not intended to be re-sold. E.g. Buildings, motor
vehicles, machinery, etc
13. Current assets: Assets that are continuously changing, kept up-to-date, kept current. E.g. stock,
debtors, cash,etc
14. Long term liabilities: amounts that we owe and repayment will be in more that one accounting
period, e.g. bank loans, debentures, finance leases, etc
15. Current Liabilities: amounts we owe others and payment for them will be made within the next
12 months (one accounting period).
363
16. Owners wealth: This is the amount the owner contributed from his private resources into the
business, plus any profits he has made. This is sometimes called owners equity or capital
17. Drawings: Amounts the owner of the business withdraws from the business to go and use in his
private capacity at home. It is a reduction in the owners wealth.
18. Recognition: This term refers to inclusion in the statement totals of an element in one of the
financial statements. This is achieved by journalizing the entry either to add to or deduct from the
existing balance. For example, the value of a car just bought would be added to the balance of
motor vehicles in the balance sheet. Reducing a statement total is referred to as de-recognition,
e.g. When part of the loan is settled, the loan balance in the balance sheet would be reduced.
19. Elements of financial statements: This term refers to the major classifications adopted in the
financial statements into which all transactions would fall. These are assets, liabilities,
contributions, distributions, gains, losses, income, expenses and owners wealth.
20. Contributions: Refers to amounts the owner of the business inject into it as capital from his
private recourses, e.g. new share capital.
21. Distributions: Refers to amounts of resources the owner withdraws from the business for
private use, e.g. drawings, dividends.
364
Completeness, 11
Consistency concept, 323
Contra entries, 68
Credit notes - Debt notes, 44, 45
Current accounts, 244, 249
A Current assets, 13, 250
Current liabilities, 14
Account transfers, 56, 95
Accounting concepts, 190
Accounting conventions, 322 D
accounting for prepayments, 153 Debenture, 291
Accounting information, 5, 8 Depreciation, 159, 160, 162, 163, 164, 165,
Accruals concept, 20, 166, 167, 168
Administration expenses, 23 Development costs, 193
Allowance for cash discounts, 144, 145, 146 Direct credits, 129
Analytical cash book, 65 Direct debits, 128
Asset, 13 Direct labour, 344,
Authorised share capital, 309 Direct materials, 344
Average cost, 200, 201 Discounts, 125
Dishonoured cheques, 129
B Dividend, 35
Doubtful debts, 134
Bad debts, 135, 222
Duality concept, 49
Balance sheet, 12, 13
Bank Account, 68
Bank reconciliation, 128 E
Bank reconciliation statement, 128 Errors not disclosed by trial balance, 208,
Below-the-line, 249 209, 210
Books of original entry, 112 Exchange of assets, 182
Business, 2 Expenditure, 37,
Expense, 182,
C Expense claim forms, 44
Capital, 2, 15, 16
Capital accounts, 249 F
Capital and revenue expenditure, 36 Fair value, 181
Capital expenditure, 36 FIFO, 200, 201, 202, 205, 206, 207
Capital income, 39 Final accounts, 12
Capital reserves, 312 Finance costs, 23
Capi talisation , 188 Financial accounting, 7
Carriage inwards, 23, 193 Financial reporting, 238, 239, 240
Carriage outards, 23, 193 Financial statements, 241,
Cash basis, 240
Cash book, 66, 67,
Cash at bank, 13
G
Cash in hand, 13 General reserve, 312
Cash transaction, 50 Going concern concept, 323
Cashflow statements, 289, 290
Change in estimated life, 173 H
Company, 3
Company law, 3, Historical cost, 161
Comparability, 5, 12
365
I Preference shares, 308
Prepayments, 13
IAS 16, 180 Prime cost, 344
Imprest system, 73, 74, 75, 76 Private companies, 3
Incomplete, 217 Profit and loss account, 102
Interest on drawings, 249 Property, plant and equipment, 160
International accounting standards, 322 Prudence concept, 323
Issued share capital, 310 Public companies, 3
Purchases day book, 45, 59, 86, 106
J
Journal, 53, 54
R
Ratios, 325, 326, 327, 328, 329,
L Realisation concept 324
Recognition, 181
Ledger accounting, 56, 178, 149 Recoverable amount, 181
Lenders, 4 Reducing balance method, 188
Liability, 10 Relevance, 5
Life membership, 265 Reliability, 5, 10
LIFO, 199, 200, 201, 202 Replacement cost, 183
Limited partners, 244 Research, 186
Local authorities, 238 Revaluation, 183,
Revenue expenditure, 36
M Revenue income, 39
Revenue reserves, 312
Managers, 4
Rule of double entry, 49
Manufacturing account, 344
Market value, 183
Matching concept, 21 S
Materiality, 324 Sales day book, 57
Money measurement, 323 Sales ledger, 121
Mortgage, 16 Selling and distribution, 32, 193
Separate valuation principle, 323
N Shareholders, 3, 4
Statutory reserves, 312
Net book value, 174
Straight line method, 162
Non current assets, 14, 180
Subscriptions, 261, 262, 263, 264, 265
Not for profit, 258
Substance over form, 324
Sum of digits, 162, 164
O Supplier lists, 44
Objectivity, 6 Suspense account, 208
Obsolescence, 162
Operating activities, 290 T
Operating as a partnership, 246
Tax, 240
Ordinary shares, 308
Timeliness, 6
Overheads, 326
Trade contacts, 4
Trade creditors, 15
P Trade payables, 67, 96, 119
Partnership, 3 Trade receivables, 66, 123
Partnership current accounts, 251 Transfers, 97
Petty cash book, 73, 74, 75 Trial balance, 66, 95, 101,
366
True and fair, 166, 174 V
U Virement, 243
Understandability, 6 W
Unpresented cheques, 129
Work in progress, 343
Working capital, 31
367

Intro to Financial Accounting Chapter

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CHAPTER 1

INTRODUCTION TO FINANCIAL ACCOUNTING

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

1.2 ANALYSIS OF DEFINITION

(b) Identifying means accounting is only concerned with activities or

(e) Summarising means analyzing all recorded information in categories and

Financial statements include:

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

(f) Financial statements should be provided to any body interested for

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

2.1 WHAT IS A BUSINESS?

A business is defined variously to suit ones requirements. In our studies we shall

Businesses range from basic simple business to a more complex one.

2.2 SOLE TRADER

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

Members of a company are called shareholders.

2.5 TYPES OF LIMITED COMPANIES

(a) PRIVATE COMPANIES

(b) PUBLIC COMPANIES

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

Shareholders can transfer shares without restrictions. Such a company

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

The following might be interested in financial information.

(a) Managers of the organization:

Managers need accounting information to make planning decisions.

(b) Shareholders and potential investors:

(c) Trade contacts:

Financial accounting information may just satisfy their concerns.

This information may be provided by accounting information.

(e) Government agencies

Financial statements could be used as a basis.

(f) Employees and trade union representatives

(g) The public:

(h) Financial analyst and advisers:

4. QUALITIES OF GOOD ACCOUNTING INFORMATION

Accounting information is relevant if it is connected with what the user wants.

Accounting information provided should be depended upon when making

An exercise undertaken to judge to what extent accounting information is similar

For information to be meaningful, it should be provided at the time it is required

Accounts are usually published soon after the year end.

Looking at the qualities of accounting information, could you identify a problem

A business could be successful because of:

(i) Good management

5.3 Financial accounting information is concerned with the following:

- Profits or losses in a period

The list is non exhaustive.

5.4 Why keep accounts?

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

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

In the accounting books we need to keep a record of stamps we bought

Well maintained and updated records may help in the followings:

(i) Help managers to control the business resources

(ii) Indicate how successfully managers are performing

(iii) Provide information about the resources and activities of the

(vi) Help in answering audit queries.

- Accounting is the process of collecting, recording, summarizing and communicating

- Accounting information is essential to the efficient running of a business. It helps

2. What are the main elements of financial statements?

3. Accounting information is limited to items having monetary value. True or False.

4. List the characteristics of qualitative accounting information.

Companies need not be business e.g. charities could be constituted as companies.

This does not apply to Sole Traders or Partnerships.