ZICA T1 - Financial Accounting

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 one’s requirements. In our studies we shall define a business as: “a person, firm, company or other organisation which makes or produces some kind of service usually for the purpose of making profits.”

- Profit is excess of Income over Expenditure- Loss is excess of Expenditure over Income

Business can be organised at different levels with a major limiting factor being resources (capital).

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

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 statements2 Assets in the balance sheet3 Liabilities in the balance sheet4 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 liabilitiesincluding 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:

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(i) Having two sides equal, or(ii) Value of an item remaining

Therefore, a balance sheet is a statement prepared which has two sides with equal values. These values are assets, liabilities and capital.

In summary the accounting equation of the balance sheet is:-

Assets = Capital + Liabilities

On one side the balance sheet must have assets and on the other side capital and liabilities and the two sides must be equal as illustrated above.

3.2.3 ASSETS

An asset is anything owned by an organisation that has monetary value. Value because the organisation will derive economic benefit from its use.

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.

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These are possessions which do not change in value easily. They are long lasting and help generate income for the business on long term basis. They are acquired not for sale as long as they are useful to the business. Examples of non current assets includes:-

- Land- Buildings Tangible non current assets- Machinery- Furniture and fittings- Long term investments- Goodwill, development costs and other intangible assets.

ACTIVITY 3.2

Non Current assets are arranged in a certain order in the balance sheet. Describe the arrangement.

3.2.5 LIABILITIES

These are amounts owed by the business (debts) to its trade payables and to its owner(s). They represent the business’s obligation to transfer economic benefits to a third party.

3.2.5.1 TYPES OF LIABILITIES

(a) Current liabilities

These are debts of the business that must be paid within a fairly short period of time. A fairly short period of time may be taken as one year.

In the accounts of limited companies, the Companies Act. 1994 requires the use of the term “Creditors: amounts falling due within one year” rather than “current liabilities”.

Examples of current liabilities may include the following:

- Trade creditors – suppliers to whom the businessowes 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

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account e.g. a business may have K100 000 in its current account, with prior consent from the bank manager, the business may be allowed to withdraw K120 000 The excess K20 000 withdrawn is bank overdraft, which must be shown as current liability at the balance sheet date as long as it is not paid at that date.

- Loans repayable within one year. Some loans maybe obtained to be repaid over a period of more than 1 year, in the year of repayment they would be stated as current liabilities.

- Taxation payable - These are tax amounts not yet paid to tax authorities.

(b) Non current liabilities

They may also be called long term liabilities. These are debts by arrangement with creditors concerned, have to be paid over a long period of time, usually more than one year e.g. 5 year loan.

This 5 year loan will be shown as non current liability for the first 4 years. In the 5th year it would appear under current liabilities.

Examples of non current liabilities may include:

- Loan - These could be bank loans as long as they are not repayable within one year.

- 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)

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This is other than money assets such as machinery, buildings, etc. put into business to carry on business for profit purposes.

Capital put in by owners is also called EQUITY.

The capital of a business can be analysed as follows:

Capital at the beginning of period XXAdd: 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

=

C

+

L

A detailed format is as follows:

Name of organisation:

Balance sheet as at (indicate date)

NON CURRENT ASSETS

Tangible non current assetsLand----------------------------------------XXBuildings ----------------------------------XXMachinery ---------------------------------XXFixtures & fittings ------------------------XXMotor vehicles ----------------------------XX XX

Intangible non current assetsGoodwill ----------------------------------XXDevelopment costs ----------------------XX XX

Long term investmentsShares in another company. -----------------------------XX

XX

CURRENT ASSETSInventory ---------------------------------XXReceivables ------------------------------XXPrepayments ---------------------------- XX

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Cash in Bank --------------------------- XXCash in Hand --------------------------- XX

XXTOTAL ASSETS ------------------------------------------------- XX

FINANCED BY:

Capital and liabilities

Capital at start -----------------------------------XXAdd Net Profit/Less Net Loss -----------------XX (XX)Less Drawings ----------------------------------(XX) XX

Non current liabilities5 year loan -------------------------------------------------XX

Current LiabilitiesTrade creditors -------------------------XXAccrued expenses --------------------- XXBank overdraft ------------------------- XXTaxation -------------------------------- XX

XXTOTAL EQUITY & LIABILITY XX

N.B. non current assets plus current assets = Total assets

Total assets = Capital plus profit less drawingPlus 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.

KCapital 1 January 20X6 47,600Profit made during the year 8,000Insurance prepaid 300Rent accrued by Kuku 600

Receivables 500Tax payable 3,500Motor vehicles 9,000

Bank overdraft 2,000Closing Inventory 31.12. 20X6 16,000Fixtures and fittings 8,000Cash in hand 100Payables 1,200Drawings 4,000Premises 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 KPremises 50,000Fixtures and fittings 8,000Motor vehicles 9,000

67,000Current Assets:

Inventory 16,000Receivables 500Prepayment 300Cash in hand 100

16,900Total assets 83,900

Financed by:

Capital at start 47,600Add: Net profit 8,000

55,600Less: Drawings (4,000)

51, 600

Non current liabilities:5 year loan 25,000

Current LiabilitiesPayables 1,200Bank overdraft 2,000Taxation payable 3,500Accrued expenses 600

7,300Total 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:

KLand and buildings 80,000Inventory 2,500Payables 4,000Profit for the year to 31.12. 20X4 6,600Capital introduced during the year 5,000Receivables 3,000Fixtures and fittings 27,000Expenses not yet paid by business 500

Drawings for the year 3,000Amounts paid in advance by business 1,000Motor vans 15,000Cash at bank 4,600Mortgage 70,000Capital 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 + profit150 = 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

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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.

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

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- Income from Rentals- Discount received from suppliers.

3.2.16 Classification of Expenses

When preparing income statement, indirect expenses are classified as:

- Selling and distribution- Administration- Finance costs

3.2.17 Selling and Distribution expenses

These are expenses incurred in the process of selling goods: examples will include:

- Salaries of sales staff- Commission to sales staff- Travelling and entertainment expenses of sales staff.- Marketing costs e.g. advertising and any sales promotion expenses

3.2.18 Administration expenses

These are expenses related to the day to day running of the business. Examples may include:

- Salaries of general staff- Rent & rates- Insurance- 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:

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Calculate:

(a) Gross profit(b) Net profit

(a) Gross Profit K000Sales 450Cost of sales: Purchases 250 Add: Carriage inwards 20

(270) Gross profit 180

(b) Net profitK000

Gross profit 180Less: Indirect Expenses Salary (55) Net profit 125

The full income statement would then be:

Sales 450Cost of sales:Purchases 250Carriage Inwards 20

(270)Gross profit 180Less Indirect ExpenseSalaries (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.

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(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).

(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:

Cash in Cash out

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Balance sheet at start of period

Plus profit or less loss for the period

Movement of cash to or 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.

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 KSales (7 x 8) 56Cost of sales:Purchases (10 x 5) 50Less: 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:

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In the following year 2 the following transactions took place.

- Bought 14 shirts at K5 each- Sold 11 shirts at K10 each

Calculate profit?

Solution

Note that in year 1, 3 shirts at K5 each were not sold and so they are brought to year 2 as opening inventory.

K KSales (11 x 10) 110

Cost of SalesOpening stock (3 x 5) 15Add: purchases (14 x 5) 70

85Less: 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 XXLess: 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 XXLess: Sales Returns (XX)

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Turnover/Net sales XX

N.B. Turnover is sales less sales returns.

3.2.26 Format of Income Statement (sole trader)

Name of organization

Income Statement for the period end …………………………. (Date)

Sales XXLess: Sales returns (XX)Turnover XX

Cost of SalesOpening inventory XXPurchases XXLess purchases returns (XX)Net purchases XX +Direct expenses Carriage inwards XX + Customs duty XX

XXCost of purchases XXTotal cost of inventory XXLess closing inventory (XX)

(XX)Gross profit/loss XXAdd other income Discount received XX Commission received XX

XXLess 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)

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PlusDirect expenses

Full worked example on income statement:

On 31 December 20X3 Mungo, a wholesaler, had the following details in his books.

KOpening inventory 5,000Sales 25,000Purchases returns 2,000Discount allowed 300Returns inwards 500Salaries and wages 8,000Discount received 250Rent 400Electricity 100Carriage inwards 50Bad debts 75Postage & stationery 80Carriage outwards 95Closing inventory 3,000Purchases 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 20X3K K K

Sales 25,000 Less: Sales returns (500)

Turnover 24,500

Cost of sales:Opening inventory 5,000Purchases 12,000Less purchases returns 2,000Net purchases 10,000Carriage Inwards 50Cost of purchases 10,050Total cost of inventory 15,050Less closing inventory (3,000)

(12,050)Gross profit 12,450Add: Discount received 250

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12,700Less: Indirect Expenses

Discount allowed 300Salaries and wages 8,000Rent 400Electricity 100Bad debts 75Postage and stationery 80Carriage outwards 95

9,050

Net profit 3,650

ACTIVITY 3.7

Mr. Buju, has been in business for sometime now, as a timber merchant. The information below has been extracted from his books as at 30 June 20X4, the end of the accounting period.

KCapital at start 1 July 20X3 121,900Trade payables 19,000Sales 280,000Returns outwards 13,000Discounts allowed 2,000Discounts received 1,500Fixtures and fittings @ cost 120,000Depreciation fixtures & fittings 12,000Trade receivables 24,000Inventory 1 July 20X3 50,000Purchases 135,000Returns inwards 5,000Carriage outwards 4,000Drawings 18,000Carriage inwards 11,000Rent 7,000Rates 8,000Insurance 10,000Heating & lighting 12,000Postage 500Stationery 700Telephone 400Advertising 5,000Salaries & wages 35,000Bad debts 1,500Cash in bank 6,000Cash in hand 3005 year loan from Banda 20,000Inventory at 30 June 20X4 17,000

Required:

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Prepare income statement for the year end 30 June 20X3 and a Balance Sheet as at that date.

3.2.27 Working capital

This is money needed by a business in order to keep operating (trading). It is calculated as a difference between current assets and current liabilities.

Thus: working Capital = Current Assets Less Current 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.

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EXERCISES

1. What is a balance sheet?

A. A list of all assets and liabilities of a businessB. A statement of the net worth of a businessC. 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. MachineryB. StockC. PrepaymentsD. Debtors

4 Working capital is another term for net assets. True or False?

5. Gross profit is best described as?

A. Sales less expensesB. Invoiced sales less purchases of stockC. Net profit less business overheadsD. 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) ____________________________________

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(iii) ____________________________________(iv) ____________________________________

SOLUTIONS TO ACTIVITY QUETIONS

ACTIVITY 3.6

MR BUJUINCOME STATEMENT FOR THE YEAR ENDED 30 JUNE 20X4

K K KSales 280,000 Less returns inwards (5,000)Turnover 275,000COST OF SALES: Opening inventory 50,000 Purchases 135,000 Less: returns outwards (13,000)

122,000 Carriage inwards 11,000 Cost of purchases 133,000 Total cost of inventory 183,000 Less: Closing inventory (17,000)

(166,000)Gross profit 109,000Discount received 1,500

110,500EXPENSES:Discount allowed 2,000Depreciation: fixtures & fittings 12,000Carriage outwards 4,000Rent 7,000Rates 8,000Insurance 10,000Heating & lighting 12,000Postage 500Stationery 700Telephone 400Advertising 5,000Salaries & wages 35,000Bad debts 1,500

(98,100)Net profit (transferred to Balance Sheet) 12,400

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MR BUJUBALANCE 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 AssetsInventory (closing) 17,000Receivables 24,000Cash in Bank 6,000Cash in hand 300

47,300Total Assets 155,300

Financed by:Capital at start 121,900Add: Net profit 12,400

134,300Less Drawings (18,000)

116,300Non current liabilities 5 year loan 20,000

Current liabilities Payables 19,000

155,300

ACTIVITY 3.8

Snow WhiteIncome Statement for the three months ended 31 August 20X5

KSales 10,000Less cost of sales (6,200)Gross Profit 3,800

Expenses:Wages (3 x 100) 300Van Rental 1,000Van expenses (3 x 300) 900Bad debts 250Telephone and postage 150

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Interest charges (3 x 25) 75(2,675)

Net profit 1,125

SOLUTIOS TO EXERCISES

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

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

3. A, machinery

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

5. D, cost includes direct expenses

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

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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.

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- Describe why failure to distinguish the above may lead to distortion of financial statements

CAPITAL AND REVENUE EXPENDITURE

Expenditure means spending money to acquire items. Items could be goods or services.

The type of item acquired is what is called capital expenditure or revenue expenditure.

4.1 Capital expenditure

When a business spends money to buy non current assets and subsequently adding value to them is called capital expenditure. For example, acquiring land, buildings, vehicles etc.

4.2 Adding Value

Adding value means spending money on an existing asset in order to improve its performance or increase production capacity. E.g. carrying out renovations on machinery in order to increase production capacity.

4.3 Other capital expenditure

Included in capital expenditure are amount spent on non current assets to put them in a workable condition. Such amounts may include

- Transport costs to bring them into business premises- Legal costs incurred in acquiring buildings

Any other costs incurred before non current assets could be put to use.

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

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What is to be called capital or revenue expenditure will depend on what the business is dealing in. If for example the business is buying and selling vehicles to make profits, purchase of a vehicle will be revenue expenditure. But if it buys a vehicle to be used in business, that will be capital expenditure.

EXAMPLE

Baobab is in business as a general retailer. He bought a vehicle for use in his business at a cost of K2,000. In bringing the vehicle to his premises he incurred transport costs of K500, customs duty of K700. Before he could use the vehicles, the vehicles had to be serviced and this costed K50. When the vehicle was in use, he insured it against theft and fire and this cost K100. In running the vehicle fuel costs amounted to K150, and replaced tyres with new ones and this cost K70. He decided to put in a musical system which cost K40. Insurance cover to bring the vehicle into business premises amounted to K80.

Required:

(a) Identify items which are capital expenditure and what will be the cost the vehicle in the books.

(b) Identify revenue expenditure

SOLUTION

K KCapital expenditure Revenue expenditure

Cost of vehicle 2,000 Insurance charges 100Transport costs 500 fuel costs 150Customs duty 700 new tyres 70Service charges 50 ___Music systems 40 320Insurance cover 80

______Cost of vehicle 3,370in books

ACTIVITY 4.1

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

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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 wagesK 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.

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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.

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

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- Profit will be understated if capital expenditure is treated as revenue expenditure and non current assets in the balance sheet will be understated.

CHAPTER SUMMARY

- Capital expenditure is money spent to acquire non current assets and adding value to them, including expenditure incurred to bring the asset to the business premises.

- Revenue expenditure is related to running the business. For example, administration, selling expenses etc. It is also expenditure on maintaining the earning capacity of non current assets e.g. repairs.

Purchase of inventory and related expenses are also revenue expenditure

- Capital income arises from the sale of non current assets

- Revenue receipts is income generated in the process of trading

- Capital expenditure is shown in balance sheet and revenue expenditure in income statement.

- Failure to distinguish capital and revenue expenditure will distort financial statements.

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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 Juma’s business, who is an engineer. This is for the financial

year ended 31 December 20X4.

(a) Purchase of extra milling machine (includes K50 for repairs of an old machine) K1,700

(b) Rentals K250(c) Electric expenses (includes new wiring K250, part of premises improvement)

K2,450(d) Carriage inwards (includes K70 carriage on new cement mixer) K780(e) Purchase of extra milling machine K2,100

Required:

Allocate each or part of the items mentioned to either ‘capital’ or ‘revenue’ expenditure

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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

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

ACTIVITY 4.3

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

SOLUTION TO EXERCISES

1. C

2. (a) K1650 capital expenditureK50 repairs of old machine is revenue expenditure

(b) Revenue expenditure K250

(c) K250 wiring of part of improvement of premises is capital expenditure2,200 is revenue expenditure

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(d) Carriage on new mixer is capital expenditure K70

Carriage on goods for resale K710 is revenue expenditure

(e) Capital expenditure K2,100

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

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Supplier Lists Inventory Lists Goods Received Notes Expense Claim Forms

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

ESSENTIAL FEATURES OF A BUSINESS DOCUMENT

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

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

CIRCULATION OF DOCUMENTS

In practice most documents are prepared in duplicate. There are circumstances in which a document should be prepared in triplicate depending on who require a copy for use and the importance of keeping the document safely for future reference. Technology has also introduced electronic documentation and it will 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.

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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 EGoods once delivered cannot be returned.

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

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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 EGoods 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.

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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.

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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 Concept2. 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,

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not for the owner of the business. He should view the owner as if he were an out side party or entity.

1.2 The Duality Concept

This concept states that there are two aspects to every transaction:a) the giving aspect, which creates a liability, and 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 transactionCan 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 transactionCan be in the form of notes and coinsCan be in the form of cheques, electronic money transfers, etcCash account is involved when notes and coins are given/receivedBank 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.

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The guidelines above can be presented in the form of a chart as follows:

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.

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THEFLOW

GOODS CASH

For use in business

For re-sale

Cash in the form of notes & coins

Cheques, debit cards, EFTs,

The first account will be named after the OUTSIDE ENTITY given in the transaction

BUSINESS ACTIVITY

BUSINESS ACTIVITY

CASH ACCOUNT

BANK ACCOUNT

The second account will be named after the ACTIVITY the business has carriedout

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 CreditK 000 K 000

Bank account 8 000Capital 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 CRASSETS: K 000 K 000Furniture & Fittings 5 245Inventory 8 692Cash at Bank 8 000Trade Receivables: Chibuye 235

Mambwe 390 625

Rent prepaid 332LIABILITIES:Loan 5 000

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Trade Payables: Chibale 160 Mwape 164

324Electricity due 221Value Added Tax outstanding 2 375Capital (Balancing figure) 14 974TOTALS 22 894 22 894The 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 000Bank 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

You should now have learnt that:

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The journal proper contains journals for transactions that are infrequent.

Each journal indicates how the amounts involved will be posted to the ledger accounts.

A journal should include a narration of the transaction, referring to relevant source documents.

EXERCISES

1 Calculate the value of premises from the following balances of assets and liabilities:K000

Premises ?Trade Payables 5 600 Trade Receivables 8 250Cash in Hand 4 520Loan 9 000Cash at Bank 6 440Rates Prepaid 830Salaries accrued 590Machinery 7 250Inventory at start 3 207Capital 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.

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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 207Trade Receivables 8 250Cash at Bank 6 440Cash at bank 4 520Rates prepaid

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

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TOTALS 45 497 45 497

Q2 The journals would be:DR CRK 000 K 000

Motor Vehicles 30 000Capital 30 000Capital introduced in the form of a vehicle

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

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.

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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).

TOPICS

1. Preparing Sales Day Book2. Preparing Sales Returns Day Book3. Preparing Purchases Day Book4. 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.

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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 BOOKDATE CUSTOMERS FOLIO TOTAL VALUE ADDED TRADE OTHER

TAX RECEIVABLE RECEIVABLEApril K K K K2005

1 Chisakaila 634 500.00 94 500.00 540 000.005 Ngosa 937 200.00 137 200.00 800 000.00

13 Mulota 470 000.00 70 000.00 400 000.0015 Mambwe 881 250.00 131 250.00 750 000.00

TOTAL 2 922 950.00 432 950.00 2 490 000.00

The transactions are entered in strict chronological order as they occur. The names of businesses are entered in the particulars or customers column. If the column were named ‘Customers’ then we would need a column for account numbers. The account number column is not shown here for convenience’s sake.

Value Added Tax has been calculated as follow: On the net figure 0.175 x K 400 000 = K70 000. The total amount is the sum of the net figure and the Value Added Tax. K 400 000 + 70 000 = K 470 000

When the invoice carries an entitlement of cash discount, Value Added Tax is calculated on the value after deducting the discount. The tax authorities presume that the cash discount will be taken up. Thus, value for Value Added Tax is K 800 000 x 0.98 = K784 000, and Value Added Tax is 784 000x 0.175 = K137 200. The gross amount is the sum of the Value Added Tax and the original invoice value (not the value for Value Added Tax).

1.2 JOURNAL ENTRY

Posting the totals to the ledger will be explained in the next chapter. For now it suffices to mention that the two accounts identifiable from entries in the sales day book are:

DEBIT CREDIT K K

Trade Receivable 2 922 950Sales account 2 490 000Value Added Tax account 432 950

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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

SALES RETURNS DAY BOOKDATE CUSTOMER FOLIO TOTAL Value

AddedTRADE OTHER


7 Ngosa 234 300.00 34 300.00 200 000.0017 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

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organizations), issues the top copy (the original) and retains the copy. The original top copy is therefore used in the preparation of the purchases daybook.

3.1 ILLUSTRATION

April 12. Purchased goods on credit from Kunda K 282 000. The invoice stated a tax inclusive amount.

April 13. Received an invoice for the 10 ton truck bought on credit from L-Stone Motors K 40 000 000 gross

April 18. Purchased Goods on credit from Mwape K 270 000 gross value.April 19. Received a bill for electricity from Zam Hydropower. The total of the invoice was

K 320 000

PURCHASES DAY BOOKDATE SUPPLIER FOLIO TOTAL Value

Added

TRADE OTHER

TAX PAYABLE PAYABLEApril K K K K2005

12 Kunda 282 000.00 42 000.00 240 000.0013 L-Stone Motors Ltd 40 000 000 .00 40 000 000.0018 Mwape 270 000.00 40 212.76 229 787.2419 Zam Hydropower 320 000.00 320 000.00

TOTAL 40 872 000.00 82 212.76 469 787.24 40 320 000.00

The amounts above are all tax inclusive. The amount of Value Added Tax is obtained as follows: K 282 000 x 7/47 = K 42 000 The net amount is the difference between the two figures, ie K 282 000 –K 42 000 = K 240 000

The column for other payables can be sub-divided into: Other Payables –Expenses, K 272 340.43 and Other Payables –Non current Assets, K 40 000 000.00. In the ledger these accounts have been referred to as L-Stone Motors and Zamhydro Power Company, more specifically.

The Value Added Tax on the non-current asset is not claimable since the business is taken as the final consumer of the motor vehicle that has been bought for use in business. This is the reason why no tax is recorded in the column for Value Added Tax in respect of the purchase for the motor vehicle.

When posting to the ledger, the payables accounts are credited with the gross amounts ( i. e. tax inclusive figures). So there is need to accurately identify the amounts involved and the specific names of payables who will be paid.

3.2 JOURNAL ENTRY

Posting the totals to the ledger will be explained in more detail in the next chapter. For now it suffices to mention that the accounts identifiable from entries in the purchases day book are:

DEBIT CREDIT K K

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Purchases account 469 787.24Value Added Tax account 82 212.76Motor Vehicles 40 000 000.00Electricity 320 000.00

Other Payables -Expenses 320 000.00Other Payables –Non-current Assets 40 000 000.00Trade Payable account 552 000.00

Note that when a journal has been prepared correctly the total of amounts in the debit column will always be equal to the total in the credit column. This is also a sign that you have understood the principle of double entry.

3.3 FURTHER ANALYSES

The Purchases day book can further be analysed as follows: -

a) purchases by product

b) purchases by geographical location. Such analyses are for management information, not necessarily for posting to ledger accounts in the ledger.

4.0 ANALYTICAL PURCHASES RETURNS DAY BOOK

Purchases returns day book is a book of prime entry in which goods initially bought on credit but are taken back to the supplier are recorded. The source document for goods returned is the credit note. The supplier prepares the credit note in duplicate and issues the top copy to us. The original copy of the credit note is the one we use to compile the purchases returns daybook.

4.1 ILLUSTRATION

April 13 Returned goods worth K 42 600 to Kunda . This is a tax inclusive figure.April 19. Received a credit note from Mwape for K 35 700 (gross amount).

PURCHASES RETURNS DAY BOOKDATE SUPPLIER FOLIO TOTAL Value

AddedTRADE OTHER


13 Kunda 42 600.00 6 344.68 36 255.3219 Mwape 35 700.00 5 317.02 30 382.98

TOTAL 78 300.00 11 661.70 66 638.30

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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 78 300.00Purchases Returns account 66 638.30Value Added Tax account 11 661.70

In the next section the cash book will be discussed as the day book for cash transactions.

4.3 CHAPTER SUMMARY

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.

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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.SOLUTIONS TO EXERCISES

Q1 Total of Sales Day Book columns:Trade Receivable K 3 571 295Value Added Tax K 516 295Other Receivables K nil

Total of Sales Returns Day Book columns:Trade Receivables K 726 738Value Added Tax K 101 738Other Receivables nil

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

Total of Purchases returns Day Book columns:Trade Payables K 126 100Value Added Tax K 18 781

Q2 The journals would be written as follows: DEBIT CREDIT

K KFor the Sales Day Book totals: Trade Receivables 3 571 295

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Value Added Tax 516 295Sales account 3 055 000

For the Sales Returns Day Book:Trade Receivables 726 738Value Added Tax 101 738Sales Returns Account 625 000

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

For the Purchases Returns Day Book:Trade Payables 126 000Value Added Tax 18 781Purchases Returns Account 107 319

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

Expense Account (e.g electricity) 502 000Other Payables 502 000

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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 book2 Cash Account –Receipts and Payments3 Bank Account –Receipts and Payments4 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

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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:

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 dayApril 8. Paid wages in cash K 150 000April 13. Cash sales K400 000 net.April 13. Banked K200 000 from cash till.April 14 Drew from bank for private use K 100 000April 19. Paid cash for repairs to furniture K130 000April 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 000April 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 cashApril 29. Paid L-Stone Motors K 10 000 000 by cheque for the truck bought earlier.April 30 Settled Kunda’s account by cheque, less cash discount of 5% K227 430.

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 )

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DATE PARTICULARS FOLIO TOTAL Value Added CASH TRADE OTHER LOANS

TAX SALES RECEIVABLES

RECEIVABLES

APRIL K K K K K1 Bank (c) 3 000 0001 Sales 634 500 94 500 540 000

13 Sales 470 000 70 000 400 00022 Ngosa 667 755 667 75528 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, 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 Added

CASH TRADE WAGES & REPAIRS STATIONERY

TAX PURCH PAYABLES SALARIES K K K K K

8 Wages 150 000 150 00013 Bank 200 00019 Repairs 130 000 130 00020 Stationery 150 000 150 00026 Purchases 246 750 36 750 210 000

30 Balance C/d 4 165 50530 TOTAL 5 042 255 36 750 210 000 150 000 130 000 150 000

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

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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

Posting the totals to the ledger will be explained in the next chapter. For now it suffices to mention that the two accounts identifiable from entries in the cash book are: cash account (the Total Column), purchases account, Value Added Tax account, repairs account, wages and salaries, stationery and trade payables accounts.

3.0 BANK ACCOUNT

The Bank Account is also part of the cash book and entries in it are those for receipt of cheques and payments by cheque or credit cards.The bank account is analysed much the same way the cash account was done above.

3.1 CASH BOOK ( BANK -RECEIPTS SIDE )

DATE PARTICULARS

FOLIO TOTAL Value Added CASH TRADE OTHER LOANS

TAX SALES

RECEIVABLES

RECEIVABLES

APRIL K K K K K K1 Capital 8 000 0004 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 Added

CASH TRADE WAGES &

RENT MOTOR

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TAX PURCH PAYABLES SALARIES

PAYABLE VEHICLES

K K K K K K1 Cash c 3 000 000

14 Drawings 100 00025 Salaries 300 000 300 00028 Rent 520 000 520 00029 L-Stone Motors 10 000 000 10 000 00030 Kunda 227 430 227 43030 Balance C/d 6 052 57030 TOTAL 20 200 000 227 430 300 000 520 000 10 000 000

Accounts that are similar can be combined (eg wages and salaries). Rent payable and motor vehicles are examples of other payables. In practice the payments side of the cashbook would also have columns for drawings, discount received, and contra entries. Amounts in the columns for contra entries are not posted to the ledger because double entry is completed between the cash account and the bank account, both of which are within the cash book itself.

At the end of the month (or year as the period of account may be), a balance is found separately for cash account and for bank account. The total columns are used to find the balance on each account. The balance represents the amount of cash remaining at the end of the period of account and will be the opening balance for the cashbook of the following period.

Posting the totals to the ledger will be explained in the next chapter. For now it suffices to mention that the accounts identifiable from entries in the cash book above are: cash account (total columns), Trade Receivables, sales account, other receivables account, and loan account.

CHAPTER SUMMARY

You should now have learnt that: -

The cash book is compiled for all cash transactions and preserved for future reference The receipts and cash payment requests are the source documents for preparing the Cash

book

The labels of analyses columns should be determined by the accounting information needs of users within the organization.

The Cash Book is the only day book that is both a book of prime entry and a part of the ledger, since it contains the Cash and Bank Accounts.

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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. 2006March 2. Drew from bank for office use K 5 000 000March 4. Paid rent in cash K 600 000March 8. Bought furniture by cheque K 3 500 000March 8. Drew cash for private use K 250 000March 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 000March 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 000March 26 Bought goods for re-sale by cheque, K 720 550 gross. March 27 Settled Simpasa’s account of K337500 by cheque, less 2% discountMarch 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.

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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


QUESTION ONE

CASH BOOK (CASH-RECEIPTS SIDE)

DATE PARTICULARS FOLIO TOTAL Value Added

CASH TRADE OTHER LOANS

TAX SALES RECEVBLS

RECEVBLES

March K K K K K2 Bank (c) 5 000 000

13 Sales 493 500 73 500 420 00014 Sales 634 500 94 500 540 00030 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 Added

CASH TRADE WAGES & RENT & STATIONERY

TAX PURCH PAYABLES SALARIES REPAIRS K K K K K

4 Rent 600 000 600 0008 Drawings 250 00013 Stationery 350 000 350 00019 Furniture repairs 180 000 180 00020 Delivery expnss 630 00029 Wages 220 000 220 00029 Solapwer -Elect 400 000

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31 Balance C/d 3 898 00031 TOTAL 6 528 000 220 000 780 000 350 000

CASH BOOK (BANK -RECEIPTS SIDE)

DATE PARTICULARS FOLIO TOTAL Value Added CASH TRADE OTHER LOANS

TAX SALES

RECEIVABLES

RECEIVABLES

March K K K K K K1 Capital 15 000 00

22 Loan 30 000000 30 000 000

31 TOTAL 45 000 000 30 000 000

CASH BOOK (BANK -PAYMENTS SIDE)

DATE PARTICULARS

FOLIO TOTAL Value Added

CASH TRADE WAGES &

RATES OTHER


PAYABLE PAYABLS

K K K K K K2 Cash c 5 000 0008 Furniture 3 500 000 3 500 000

22 Del Equipment 25 000 000 25 000 00025 Salaries 800 000 800 00026 Purchases 720 550 107 316 613 23427 Simpasa 330 750 330 75028 Rates 330 000 330 000

31 Balance C/d 9 318 70031 TOTAL 45 000 000 107 316 613 234 330 750 800 000 330 000 28 500 000

Note: Some entries have not been extended in the analysis columns because of computer field limitation.

QUESTION TWO

JOURNAL ENTRIES K K

Bank 493 000Sales 420 000Value Added Tax 73 500

Cash sales with Value Added Tax at 17-1/2 %

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Purchases 613 234Value Added Tax 107 316

Bank 720 550Cash purchases with Value Added Tax at 17.5%

Trade Payables (Simpasa) 337 500Bank 330 750Discount Received 6 750

Full settlement of a debt owed with 2% cash discount

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 book2) The purpose of petty cash book3) What is to be paid out of petty cash4) Personal security and control of petty cash5) The petty cash voucher6) The imprest system7) Recording in petty cash book including Value Added Tax (VAT)8) Balancing the petty cash book9) Posting petty cash book to the ledger (double entry)

LEARNING OUTCOMES

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- 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.

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 sameo Other expenses such as printing, stationery, milk, tea, stampso Fuel expenses

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o Cleaning, just to mention a few 4. PERSONNEL, SECURITY AND CONTROL OF PETTY CASH

4.1 PERSONNELCash 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 SECURITYIt is the responsibility of the petty cashier to ensure that:

(a) Petty cash is held in a safe place. It must be well secured in a lockable box (petty cash box) with keys to it kept by the petty cashier. No one should be allowed access to petty cash box apart from the petty cashier and any other authorized officer.

(b) He or she should be the only one to make actual payments of petty cash.

(c) All payments are fully and properly authorized and are being made for valid reasons and intended purpose.

4.3 CONTROL

Petty cash should be used only for small items of expenditure and not for large expenses, such as office furniture or airfares. Paying large amounts from petty cash would be an obvious target for theft.

(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 pettycash voucher is prepared by the petty cashier whenever a payment is requested. Petty cash vouchers are serially–numbered slips in a padded booklet. The booklets

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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 boughto 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 madeo The voucher number

Example of petty cash voucher.

NO………………

PETTY CASH VOUCHER

DATE……………..

DESCRIPTION/DETAILS AMOUNT

PREPARED BY:AUTHORISED BY:RECEIVED BY:

76

5.2 RECEIPTS

A receipt is a document prepared by a person receiving money acknowledging that money has been received for goods or services supplied.

A person buying items using petty cash must obtain a receipt from the supplier. The receipt should be given to the petty cashier as evidence of purchases. The petty cashier will then attach the receipt to the petty cash voucher as supporting document for payment. The petty cashier can then record in the book that payment has been made.

5.3 RECEIPTS NOT AVAILABLE.

There could be certain requested payments, which cannot be backed up by a receipt, for example, Taxi fares, bus fares. In these cases payment should be sanctioned by a supervisor and properly authorized.

5.4 VALUE ADDED TAX RECEIPTS

If there’s an amount for Value Added Tax in a payment, and the tax can be claimed from Zambia Revenue Authority (ZRA), the receipt must show the following details:

o Total amount paido The tax paido The suppliers name, address and Value Added Tax registration number.o The date of the transaction.

6. THE IMPREST SYSTEM

6.1 The imprest system is where a petty cashier is reimbursed what has been spent in order to restore the petty cash float.

6.2 Float is the sum of money the petty cashier must start with at the beginning of every month. It’s decided by management and is usually fixed but can be adjusted to suit current requirement.

Example of imprest system

The imprest amount (float) is K600, 000. During a particular month a total of K450 000 was paid out of petty cash. In the above situation, the petty cashier is remaining with K150, 000 in cash box, therefore, in order to restore the imprest amount, the petty cashier will need reimbursement or top up of K450 000 to restore the imprest amount.

Imprest amount K600, 000Cash payments K450, 000Balance K150, 000 Imprest systemReimbursement K450, 000Imprest amount K600, 000

IOUs AND PETTY CASH. (I OWE YOU)

77

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 showso Amount borrowedo Name and signature of borrowero The date the amount is borrowed.

7.2 Example of IOU.

I OWE PETTY CASH K20, 000

MARY BANDA20/02/07

IOU is a good as cash, and the document should be placed in cash box and be treated as cash. When counting cash in cash box IOU must be added as cash equivalent.

Example cash and IOU.

The monthly petty cash float is K500, 000. During the month total expenditure amounted to K285, 000 and an individual borrowed out of petty cash K35, 000.

At the time of balancing the petty cash book, the individual had not paid back the K35, 000. How much cash is available at that time?

The following format will help you calculate the cash balance remaining.

Physical cash available xxPlus IOU xxPlus total expenditure xxEquals imprest amount xx

For the above example, the solution is;

Imprest amount (float) 500,000Less expenditure (285,000)Physical cash available 215,000Plus IOU 35,000Petty 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.

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8. RECORDING THE ANALYTICAL PETTY CASH BOOK

8.1 All payments before being recorded in petty cash book must be supported with petty cash vouchers and receipts. It is highly recommended that the petty cash book be updated (recorded) on daily basis in order to have accurate information on petty cash expenditure.

Balancing the petty cash book will depend on the volume of transactions for petty expenditure. In busy organizations it can be every two weeks others on monthly basis.

Division of the petty cash book.

The petty cash book is divided into two parts, left and right hand sides.o The left hand is the debit side. This side is used to record any cash received by

petty cashier.o The right hand side is the credit side. This is where expenses in the period are

analysed. o The analysis columns in petty cash book will vary depending on the

organization’s pattern and nature of expenditure.

Example: Analytical petty cash book.

RECEIPTS (DR) PAYMENTS (CR)TotalDR

Date Details Voucher No.

TotalCR

Office Expense

Postage Cleaning Traveling Motor expense

Ledger

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 KCashier…………………………………………… 700,000

2. Cleaning material…………………………………. 30,000 3. Postage stamps…………………………………… 25,000 4. Envelopes………………………………………… 10,000

June 8. Taxi fare…………………………………………… 65,000

79

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.

SOLUTION

The Analytical Petty Cash Book

Receipts Date Details V/n Total Stat Cleaning Entertt Travel Postage700,000 Jun 1 Cash

Jun 2 C/Mat 1 30,000 30,000Jun 3 Stamps 2 25,000 25,000Jun 6 Envelops 3 10,000 10,000Jun 8 T/Fares 4 65,000 65,000Jun 10 Petrol 5 100,000 100,000Jun 14 T/Paper 6 80,000 80,000Jun 15 C/Mat 7 29,000 29,000Jun 16 B/Fares 8 10,000 10,000Jun 20 V/Lunch 9 45,000 45,000Jun21 Mops/Brushes 10 56,000 56,000Jun 23 Stamps 11 15,000 15,000Jun 27 Envelops 12 7,000 7,000Jun 29 V/Lunch 13 60,000 60,000Jun 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 700,0001,327,000 1,327,000

700,000 Jul 1 Bal b/d

DR (K) CR(K)

80

N.B

When petty cash is established and restored every month double entry is:

Dr-petty cashCr- Bank A/C (when money is withdrawn from bank in the above example:

Dr Bank A/C (Cash Book) Cr

June 1 Petty cash 700,000 June 30 petty cash 627,000

For expenses the petty cash book is used as on accumulative book for small expenses, where each expense account is updated on monthly basis after they have accumulated. As in example the double entry would be;

Dr Stationery A/C Cr

June 30 Petty cash 192,000

Dr Cleaning A/C CrK K


Dr Entertainment A/C CrK K


Dr Traveling A/C Cr

K KJune 30 Petty cash 175,000

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,81

Value Added Tax should be accounted for separately as long ass there’s evidence of Value Added Tax (i.e. Value Added Tax receipt).

Example: Value Added Tax receipt and petty cash record.

RECEIPTT S/No. (04)

Date: 01.06.05

Amount K4 Reams A4 90,000PaperValue Added Tax 17.5% 15.75Total 105.75

RECEIPT S/No. (05)

Date: 02.06.05

Amount KRepairs to computer 145,000Add 17.5%Value Added Tax 25,375 170,375

The two Value Added Tax receipts will be recorded as follows in the petty cash book

PAYMENTS SIDE

Date Details V. No. Total Stationery Repairs Value Added Tax

02.06.05

02.06.05

4 Ream of paperRepairs

04

05

105.75

170.375

90,00

145,000

15.75

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 xxLess expenditure xx

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Balance xxReimbursement xxFLOAT xx

o All payments out of petty cash must be fully authorized by signing on the voucher.

o If there’s no receipt (document) to support the claim, the petty cashier must consult the supervisor.

o Entries made (recorded) in petty cash book originate from a document called petty cash voucher.

o The petty cash book is used as an accumulative book for small expenses of which the totals for the period are transferred to respective expense account in general ledger.

o Petty cash expenditure involving Value Added Tax, should be recorded separately in petty cash book with separate amounts in the Value Added Tax column.

EXERCISES

1. What is the purpose of the petty cash book?2. Who is responsible for maintaining cashbook?3. What is the imprest amount (petty cash float)?4. The petty cash book is maintained on a system called imprest system. What is imprest

system?5. What is the source document for entries in petty cash book?6. What is the division of the petty cash book?

7. The following petty cash transactions were recorded during the month of December 20x6.

1. Petty cash float was K400, 000 was obtained by withdrawalof cash from the Bank.

2. Paid for stationary………………………………… 10,8004. Paid for sundry expenses…………………………. 21,7006. Cash sales………………………………………… 30,0009. Repairs to vehicles……………………………….. 42,50010. Cash received from staff telephone calls………… 18,00012. Paid for stationery……………………………….. 90,00014. Paid for sundry expenses………………………… 28,20019. Cash sales…………………………………………. 33,00025. Paid for stationary………………………………… 47,800

All expenses and income listed above are inclusive of Value Added Tax at 17.5%.

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Required:

Record all the transactions in petty cash book and balance off as at 31 December 20x6 and restore the imprest amount.


1. The purpose of petty cash book is to record small items of expenditure2. 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 sideLeft side to record receiptsRight side to record payments.

7 PETTY CASH BOOKDR(K) CR(K)

Net Recpt SalesTax Total Date Details V/N Total Station Repairs S/Exps Value Added Tax

400,000 Dec 1 CashDec 2 Station 1 10,800 9,191.50 1,608.50Dec 4 S/Exps 2 21,700 18,468.09 3,231.91

25,531.92 4,468.08 30,000 Dec 6 C/SalesDec 9 Repairs 3 42,500 36,170.21 6,329.79

15,319.15 2,680.85 18,000 Dec 10 Recpt/PhoneDec 12 Station 4 90,000 76,595.75 13,404.25Dec 14 S/Exps 5 28,200 24,000.00 4,200.00

28,085.11 4,914.89 33,000 Dec 19 C/SalesDec 25 Station 6 47,800 40,680.85 7119.15

241,000 126,468.1 36,170.21 42,468.09 35,893.60160,000 Dec 31 Cash

Dec 31 Bal c/d 400,000

84

68,936.18 12,063.82 641,000 641,000400,000 Jan 1 Bal b/d

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 accounts2. 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

85

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 grossApril 13. Issued an invoice to Mulota K400 000 net.April 13 Returned goods worth K42 600 to Kunda. This is a tax inclusive figure.April 15 Sold goods on credit to Mambwe K750 000 net.April 17. We sent a credit note to Mambwe, K150 000, netApril 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 BOOKDATE PARTICULARS FOLIO TOTAL VALUE ADDED TRADE OTHER



13 Mulota 470 000.00 70 000.00 400 000.0015 Mambwe 881 250.00 131 250.00 750 000.00

TOTAL 2 922 950.00 432 950.00 2 490 000.00

SALES RETURNS DAY BOOKDATE PARTICULARS FOLIO TOTAL VALUE ADDED TRADE OTHER


7 Ngosa 234 300.00 34 300.00 200 000.0017 Mambwe 176 250.00 26 250.00 150 000.00

TOTAL 410 550.00 60 550.00 350 000.00

86

PURCHASES DAY BOOKDATE PARTICULARS FOLIO TOTAL VALUE ADDED TRADE OTHER


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

PURCHASES RETURNS DAY BOOKDATE PARTICULARS FOLIO TOTAL VALUE ADDED TRADE OTHER


13 Kunda 42 600.00 6 344.68 36 255.3219 Mwape 35 700.00 5 317.02 30 382.98

TOTAL 78 300.00 11 661.70 66 638.30

1.2 LEDGERSExplanatory notes follow after all the accounts have been written.

Note: All amounts on Debits and Credits are in Kwacha Currency.

TRADE RECEIVABLES K

KSales 2 922 950.00 Sales Returns 410 550.00

SALES

87

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)

Electricity 320 000.00PURCHASES

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

88

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. The double entry can be represented in the following journal:

DR (K) CR(K)Purchases 469 787.24Value Added Tax 82 212.76Electricity 320 000.00Trade Payable (for goods) 552 000.00Other Payable –(Electricity) 320 000.00

The amount in the other payables –electricity account is the gross amount because Value Added Tax on this purchase has been ignored for simplicity’s sake The journal for the non current asset is : Debit the Motor Vehicles account (representing the business, or the activity done) and credit the Other Payable –Non Current asset account (representing the giver, L-Stone Motors). The cost of the motor vehicle is gross because the Value Added Tax component is not passed on to the customer. The vehicle is not for re-sale.

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

89

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.

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 transactions2. Posting entries in the cash book to the ledger3. Summary

LEARNING OUTCOMES


Apply the rule of double entry to cash transactions

90

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 2005April 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 dayApril 8. Paid wages in cash K150 000April 13. Cash sales K400 000 net.April 13. Banked K200 000 from cash till.April 14 Drew from bank for private use K100 000April 19. Paid cash for repairs to furniture K130 000April 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 000April 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 cashApril 29. Paid L-Stone K10 000 000 by cheque for the truck bought earlier.April 30 Settled Kunda’s account by cheque, less 5% cash discount K227 430.

1.1 CASH BOOK (CASH -RECEIPTS SIDE)

DATE PARTICULARS FOLIO TOTAL VALUE ADDED CASH TRADE OTHER LOANSTAX SALES RECEIVABLES RECEIVABLES

APRIL1 Bank 3 000

0001 Sales 634

500 94 500 540

00013 Sales 470

000 70 000 400

00022 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 ADDED



91

APR8 Wages 150

000 150

00013 Bank 200

00019 Repairs 130

000 130 000

20 Stationery 150 000

150 000

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 150000

1.3 CASH BOOK (BANK -RECEIPTS SIDE)

DATE PARTICULARS FOLIO TOTAL VALUE ADDED CASH TRADE OTHER LOANSTAX SALES RECEIVABLES RECEIVABLES

APRIL1 Capital 8 000

0004 Loan 12 000

00012 000

00013 Cash 200

000

30 TOTAL 20 200 000

12 000 000

1.4 CASH BOOK (BANK -PAYMENTS SIDE)


CASH TRADE WAGES & RENT MOTOR

TAX PURCH PAYABLES SALARIES PAYABLE VEHICLESAPR

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

10 000 000

30 Kunda 227 430

227 430

30 Balance C/d 6 052 57030 TOTAL 11 272

000 227 430 300 000 520 000 10 000 000

2.0 POSTING TO THE LEDGER

Since the cash book is part of the ledger, the receipts are effectively on the debit side of the cash/bank account, and payments are correspondingly on the credit side of the cash/bank account. The ledger accounts which follow below therefore will carry only the other entry of the double entry. Journal entries would also be written for each of the transactions, for example:

Debit: Cash a/c (in the cash book) K 270 000Credit: Commission a/c K 270 000

92

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 000Bank 300 000

REPAIRS

Cash 130 000

STATIONERY

Cash 150 000

RENT

Bank 520 000

VALUE ADDED TAX

93

Payables 82 212.76Payables 11 661.70

Trade Receivables 60 550.00Trade 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.

3.0 SUMMARY

You should now have learnt that:

When cash is paid the cash account is credited and the account representing the activity is debited

When cash is received the cash account is debited and the account representing the activity is credited.

94

Where the cash is paid / received by an outside entity, then the account for that entity will also be updated with the transaction.

CHAPTER 11

CLOSING ACCOUNTS AND EXTRACTING A TRIAL BALANCE

INTRODUCTION

95

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):

SALES

Trade Receivables 2 490 000.00

Trading 3 430 000.00 Cash 940 000.00

3 430 000.00 3 430 000.00

SALES RETURNS

96

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 227 430.00Discount Received 11 970.00Balance c/d 234 300.00

552 000.00 552 000.00

Balance b/d 234 300.00

Closing books would literally mean that accounts with something continuing on them are re-opened in the books of the following period of account. We would have to transfer the unpaid amount on the Trade Payables above to a Trade Payables account for the following month. The transfer would start with a debit of K 234 300.00 described as Balance c/d above and end with a credit entry in the Trade Payables account of the following period and described as balance b/d. In the ledger we simply write the two entries on the same account: one above the total lines and the other below the total lines but on the opposite side as can be seen above.

1.3 OTHER ACCOUNTS BELOW

The other accounts are closed according to the principle highlighted in 1.1 and 1.2 above. Transfers to the Income statement can be either to trading account or to profit and loss account, depending on whether the account has to do with goods or with services consumed respectively. The account balances that are summarized in the balance sheet are closed by ‘balance c/d’ and balance b/d’ because on them there is some thing continuing to the next period: payment or receipt of cash or physical existence of the asset and future use.

97

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 469 787.24Cash 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

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

98

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

Sales 2 922 950.00 Sales Returns 410 550.00

Cash 667 755.00Discount All 35 145.00Balance 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 000Bank 300 000 Profit & Loss c/d 450

000.00

450 000 450 000.00

REPAIRS

Cash 130 000.00 Profit & Loss c/d 130 000.00

130 000.00 130 000.00

STATIONERY99

Cash 150 000.00 Profit & Loss c/d 150 000.00

150 000.00 150 000.00

RENT

Bank 520 000.00 Profit & Loss c/d 520 000.00

520 000.00 520 000.00

VALUE ADDED TAX

Payables 82 212.76 Payables 11 661.70

Trade Receivable 60 550.00 Trade Receivable 432 950.00

Cash 36 750.00 Cash 164 500.00

Balance c/d 429 598.94

609 111.70 609 111.70


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 8 000 000.00Bank 8 000 000.00

8 000 000.00 8 000 000.00

100

Balance c/d 8 000 000.00

DISCOUNT ALLOWED

Trade Receivables 35 145.00 Profit & Loss 35 145.00

35 145.00 35 145.00

DISCOUNT RECEIVED

Profit & Loss 11 970.00 Trade Payables 11 970.00

11 970.00 11 970.00

The amounts in the cash and bank accounts below are a summary of the entries in the cash book prepared in the preceding chapter. Drawings are principally transferred to capital account because in the balance sheet the amount of drawings is deducted from the balance on the capital account.

BANK ACCOUNT

Total Receipts 20 200 000 Total Payments 14 147 430Balance c/d 6 052

570

20 200 000 20 200 000

Balance b/d 6 052 570

CASH

Total Receipts 5 042 255 Total Payments 876 750

Balance c/d 4 165 505

5 042 255 5 042 255


101

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 CRSales 3 430 000.00Sales Returns 350 000.00Trade Payables 234 300.00L-Stone Motors 30 000 000.00Zam Hydro Power Co. 320 000.00Purchases 679 787.24Purchases Returns 66 638.30Motor Vehicles 40 000 000.00Electricity 320 000.00Drawings 100 000.00Trade Receivables 1 809 500.00Commissioned Received 270 000.00Wages & Salaries 450 000.00Repairs 130 000.00Stationery 150 000.00Rent 520 000.00 Value Added Tax 429 598.94Loan 12 000 000.00Capital 8 000 000.00Discount Allowed 35 145.00Discount Received 11 970.00

102

Bank 6 052 570.00Cash 4 165 505.00 ______________ ______________

54 762 507.24 54 762 507.24 ______________ _____________

CHAPTER SUMMARY

You have seen that to prepare ledger accounts that lead to a balancing trial balance you need to be thorough when recording entries in the books of prime entry ( day books) and to apply the rule of double entry to every transaction without exception. You also need to understand the logic of account transfers to the income statement (profit and loss account), and transfers to the same account but of the following period (balance c/d and balance b/d). These balances are the amounts that are reported in the balance sheet as a summary of ledger account balances. The challenge is all yours to master the application of the rule of double entry. You will convince yourself that you have developed the competence if you manage to balance the illustrative question again and the question in the exercises section of this chapter. Your progression will be steady and sure if you do this.

SELF-TEST QUESTIONS

1. Re-attempt the whole exercise and see whether you can do it up Trial balance2. What is the accounting treatment of discount allowed and discount received?

103

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 2005March 2. Drew from bank for office use K5 000 000March 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 000March 7. Purchased goods on credit from Siwale K424 000. The invoice stated a tax

inclusive amount.March 8. Bought furniture by cheque K3 500 000March 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 000March 12. Received an invoice for the forklift bought on credit from Del Equipment K30 000 000 grossMarch 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 000March 20. Paid delivery expenses in cash K630 000.March 21. We sent a credit note to Mundia, K300 000, netMarch 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 000March 26 Bought goods for re-sale by cheque, K 720 550 gross.March 27 Paid Simpasa’s account in full by cheque, less 2% discountMarch 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.

104

Question 2

Refer to Question 1: Prepare journal entries for the transactions on March 13, March 26 and March 27.

Question 3

Winwell owns a fast-food store, which is Value Added Tax registered. During the day’s trading he entered into the following transactions:

A credit sale of K470 000A cash sale of K200 000 netA purchase for K700 000 list price net of Value Added Tax, less 20% trade discountA returns outward was made for K150 000 list price from the same supplier.

At the start of the day there was nil balance on the Value Added Tax account. The rate of Value Added Tax is 17.5%

What is the closing balance on Winwell’s Value Added Tax account following the above transactions?

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.

105


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 000Motor Vehicle 30 000 000

45 000 000Liabilities:None __________Capital 45 000 000

========== JOURNAL ENTRIES

DR CRMarch 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 BOOKDATE CUSTOMERS FOLIO TOTAL VALUE ADDED TRADE OTHER

TAX RECEIVABLE RECEIVABLEMarch K K K K2006

2 Akabindo 992 875.00 147 875.00 845 000.008 Mubita 913 770.00 113 770.00 780 000.0014 Mubiana 799 000.00 119 000.00 680 000.0016 Mundia 881 250.00 131 250.00 750 000.00

TOTAL 3 586 895.00 531 895.00 3 055 000.00

106

SALES RETURNS DAY BOOKDATE CUSTOMER FOLIO TOTAL VALUE ADDED TRADE OTHER

TAX RECEIVABLE RECEIVABLEMarch K K K K2006

18 Mubita 380 738.00 55 738.00 325 000.0021 Mundia 352 500.00 52 500.00 300 000.00

TOTAL 733 238.00 108 238.00 625 000.00

PURCHASES DAY BOOKDATE SUPPLIER FOLIO TOTAL VALUE ADDED TRADE OTHER

TAX PAYABLE PAYABLEMarch K K K K2006

7 Siwale 424 000.00 63 149.00 360 851.0012 Del Equipment 30 000 000 .00 40 000 000.0015 Simpasa 380 000.00 56 596.00 323 404.0019 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

PURCHASES RETURNS DAY BOOKDATE SUPPLIER FOLIO TOTAL VALUE ADDED TRADE OTHER

TAX PAYABLE PAYABLEMarch K K K K2006

22 Siwale 83 600.00 12 451.00 71 149.0024 Simpasa 42 500.00 6 330.00 36 170.00

TOTAL 126 100.00 18 781.00 107 319.00

107

CASH BOOK (CASH-RECEIPTS SIDE)


CASH TRADE OTHER LOANS

TAX SALES RECEVBLS

RECEVBLES

March K K K K K2 Bank (c) 5 000 00013 Sales 493 500 73 500 420 00014 Sales 634 500 94 500 540 00030 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 ADDED


TAX PURCH PAYABLES SALARIESK K K K K

4 Rent 600 0008 Drawings 250 00013 Stationery 350 000 350 00019 Furniture repairs 180 000 180 00020 Delivery expnss 630 00029 Wages 220 000 220 00029 Solapwer -Elect 400 000

31 Balance C/d 3 898 00031 TOTAL 6 528 000 220 000 180 000 350 000

3.1 CASH BOOK (BANK -RECEIPTS SIDE)

DATE PARTICULARS FOLIO TOTAL VALUE ADDED CASH TRADE OTHER LOANSTAX SALE

SRECEIVABLES

RECEIVABLES

March K K K K K K1 Capital 15 000 00022 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 ADDED

CASH TRADE WAGES &

RATES OTHER


PAYABLE PAYABLS

K K K K K K2 Cash c 5 000 0008 Furniture 3 500 000 3 500 00022 Del Equipment 25 000 000 25 000 00025 Salaries 800 000 800 00026 Purchases 720 550 107 316 613 23427 Simpasa 330 750 330 75028 Rates 330 000 330 000

31 Balance C/d 9 318 700

108

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

SALES

Trade Receivables 3 055 000Trading 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 750Discount Received 6 750Balance 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 000Balance c/d 5 000 000

30 000 000 30 000 000


SOLARPOWER CO.-(Other Payables)

Cash 400 000 Electricity 502 000Balance c/d 102 000

502 000 502 000

Balance b/d 102 000

PURCHASES

Trade Payable 684 255Bank 613 234 Trading 1 297 489

1 297 489 1 297 489

PURCHASES RETURNS

Trade Payables 107 319Trading c/d 107 319

107 319 107 319

109

MOTOR VEHICLES

Capital 30 000 000L-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 238Cash 400 000


3 586 895 3 586 895Balance b/d 2 453 657

FURNITURE

Bank 3 500 000Balance c/d 3 500 000

3 500 000 3 500 000Balance b/d 3 500 000

WAGES & SALARIES

Cash 220 000Bank 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

RATES

110

Cash 600 000Bank 330 000 Profit & Loss c/d 930 000

930 000 930 000

VALUE ADDED TAX

Trade Payables 119 745 Trade Payables 18 781Trade Receivable 108 238 Trade Receivable 531 895Bank 107 316 Cash 168 000Balance 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

CAPITALMotor 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

Total Receipts 45 000 000 Total Payments 35 681 300Balance c/d 9 318 700

45 000 000 45 000 000


CASH

Total Receipts 6 528 500 Total Payments 2 630 000Balance c/d 3 898 000

6 528 000 6 528 000


LAMBDARTRIAL BALANCE AS AT 31 MARCH 2006

DR CR

111

K KSales 4 015 000Sales Returns 625 000Trade Payables 340 400Del Equipment 5 000 000Solarpower Co. 102 000Purchases 1 297 489Purchases Returns 107 319Motor Vehicles 60 000 000Electricity 502 000Drawings 250 000Trade Receivables 2 453 657Furniture 3 500 000Wages & Salaries 1 020 000Repairs 1 80 000Stationery 350 000Rates 930 000Value Added Tax 383 377Loan 30 000 000Capital 45 000 000Delivery Expenses 630 000Discount Received 6 750Bank 9 318 700Cash 3 898 000

84 954 846 84 954 846

SOLUTION 2 DR CR

Cash account 493 500Sales 420 000Value Added Tax 73 500

Cash sales with Value Added Tax

Purchases 613 234Value Added Tax 107 316Cash account 720 550

Cash purchases with Value Added Tax

Trade Payables -Cash 330 750 -Discount Rcvd 6 750

Cash 330 750Discount Received 6 750

Settlement of amount owed to a supplier

SOLUTION 3

VALUE ADDED TAX

Trade Payables 98 000 Trade Payables 21 000

112

Trade Receivable 70 000Cash 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 200Bank 6 800 Trade Receivable 18 261Balance c/d 4 861

126 000 126 000

Balance b/d 4 861

CHAPTER 12

113

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 is2 Its format and preparation3 Analysis of trial balance4 Errors not disclosed by trial balance5 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.

7.2 Trial Balance example

To understand clearly how the trial balance operates, let us do examples.114

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 KCapital 10,000 Bank 8,000Sales 600 Stationery 75

Wages 325 Drawings 50

Balance c/d 2,15010,600 10,600

Balance b/d 2,150

Dr. Bank account Cr.

K KCash 8,000 Rent 250

Purchases 400 Electricity 25

Balance c/d 7,3258,000 8,000

Balance b/d 7,325

Dr. Capital account Cr. K K

Cash 10,000

115

Dr. Rent account Cr. K K

Bank 250

Dr. Purchases account Cr. K K

Bank 400 Payables 575

Dr. Stationery account Cr.

K KCash 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

N.B. For every transaction a debit entry was also represented by a credit entry and vis versa (double entry).

116

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 2,150Cash in bank 7,325Capital 10,000Rent 250Purchases 975Stationery 75Sales 1,380Payables 575Wages 325Receivables 780Electricity 25Drawings 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 liabilities2 All expenses 2 All losses3 Purchases 3 Sales4 Sales returns 4 Purchases returns5 Opening inventory 5 Capital6 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.

CHAPTER SUMMARY

- A trial balance provides reassurance that double entry book keeping has been done correctly.

117

- 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.

KCapital 1 January 20X5 204,235Opening inventory 46,000Purchases 234,000Sales 288,000Light & heat 2,000Advertising 3,000Insurance 5,000Bad debts 150Rent 13,000General 13,850Drawings 8,000Receivables 48,000Payables 35,000Bank overdraft 50,000Returns inwards 1,000Returns outwards 350Carriage inwards 780Carriage outwards 475Machinery 132,000Discounts allowed 880Discount received 550

Required:

Prepare trial balance as at 31 December 20X5.


1. A trial balance is listing of balances taken from the ledger.

118

2. The use of trial balance is to provide reassurance that double entry is correct in the ledger. It is also used for the preparation of financial statements.

3. B Stepson Trial balance as at 31 December 20X5

Dr. Cr.K K

Capital 1 January 20X5 204,235Opening inventory 46,000Purchases 234,000

Sales 288,000Light & heat 2,000Advertising 3,000Insurance 5,000Bad debts 150Rent 13,000General 13,850Drawings 8,000Receivables 48,000Payables 35,000Bank overdraft 50,000Returns inwards 1,000Returns outwards 350Carriage inwards 780Carriage outwards 475Machinery 132,000Discounts allowed 880Discount received 550

543,135 543,135

119

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 systems2. Need for control accounts3. Posting to personal accounts4. Posting to Control accounts5. Errors and their correction6. 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.

120

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.April 13. Received an invoice for the 10 ton truck bought on credit from L-Stone Motors K

40 000 000 grossApril 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, netApril 18. Purchased Goods on credit from Mwape K 270 000 gross value.April 19. Received a bill for electricity from Zam Hydropower. The total of the invoice

was K 320 000 April 19. Received a credit note from Mwape for K 35 700 (gross amount).April 22. Ngosa paid his account in full less 5% cash discount.April 30 Settled Kunda’s account by cheque, less cash discount of 5%

121

SALES DAY BOOKDATE PARTICULARS FOLIO TOTAL VALUE ADDED TRADE OTHER



13 Mulota 470 000.00 70 000.00 400 000.0015 Mambwe 881 250.00 131 250.00 750 000.00

TOTAL 2 922 950.00 432 950.00 2 490 000.00

SALES RETURNS DAY BOOKDATE PARTICULARS FOLIO TOTAL VALUE ADDED TRADE OTHER


7 Ngosa 234 300.00 34 300.00 200 000.0017 Mambwe 176 250.00 26 250.00 150 000.00

TOTAL 410 550.00 60 550.00 350 000.00

PURCHASES DAY BOOKDATE PARTICULARS FOLIO TOTAL VALUE ADDED TRADE OTHER

TAX PAYABLE PAYABLEApril K K K K200512 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

PURCHASES RETURNS DAY BOOKDATE PARTICULARS FOLOI TOTAL VALUE ADDED TRADE OTHER


13 Kunda 42 600.00 6 344.68 36 255.3219 Mwape 35 700.00 5 317.02 30 382.98

TOTAL 78 300.00 11 661.70 66 638.30

122

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 634 500.00Balance c/d 634 500.00

634 500.00 634 500.00Balance b/d 634 500.00

NGOSA

Sales 937 200.00 Sales Returns 234300.00Cash 667 755.00Discount All 35 145.00Balance c/d nil

937 200.00 937 200.00

MULOTA

Sales 470 00.00 Balance c/d 470 000.00

470 000.00 470 000.00Balance b/d 470 000.00

MAMBWE

Sales 881 250.00 Sales Returns 176 250.00

Balance c/d 705 000.00881 250.00 881 250.00


TRADE RECEIVABLES ACCOUNT BALANCES LISTING: K

Chisakaila 634 500.00Mulota 470 000.00Mambwe 705 000.00TOTAL 1 809 500.00

POSTING TO THE PURCHASES LEDGER

KUNDA

Purchases Returns 42 600.00 Purchases 282 000.00Bank 227 430.00Discount Received 11 970.00

282 000.00 282 000.00

123

MWAPE


Balance c/d 234 300.00

270 000.00 270 000.00


TRADE PAYABLES ACCOUNT BALANCES LISTING: K

Mwape 234 300.00TOTAL 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

Sales 2 922 950.00 Sales Returns 410 550.00Cash 667 755.00Discount All 35 145.00Balance c/d 1 809 500.00

2 922 950.00 2 922 950.00Balance b/d 1 809 500.00

TRADE PAYABLE

Purchases Returns 78 300.00 Purchases 552 000.00Bank 227 430.00Discount Received 11 970.00Balance c/d 234 300.00

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:

TRADE RECEIVABLES

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Sales 2 922 950.00 Sales Returns 410 550.00Cash 667 755.00 Balance c/d 1 844 645.00

2 922 950.00 2 922 950.00Balance b/d 1 844 645.00

The account for Ngosa would be drafted as follows:

NGOSA

Sales 937 200.00 Sales Returns 234300.00Cash 667 755.00Discount All 34 000.00 Balance c/d 300.00

937 200.00 937 200.00Balance b/d 300.00

The account listing of the sales ledger would be as follows: K

Chisakaila 634 500Ngosa 300Mulota 470 000Mambwe 705 000Total 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: KBalance on TR account 1 844 645Less: Discount Allowed 35 145Adjusted balance 1 809 500

The Sales Ledger Listing total of balances will be corrected as follows:

SL Listing 1 809 800Less: Undercast in Sales Returns 300Adjusted total 1 809 500

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

CHAPTER SUMMARY

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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:

KRemittances to suppliers 34 000 000Receipts for cash purchases 3 000 000Contra agreements 70 000Invoices from suppliers 42 000 000Credit notes received 90 000Debit notes from suppliers 20 000Discounts for prompt payment 50 000

The amounts due from suppliers at the end of the year were K 63 000.

Write the trade payables account and determine the closing balances on account at the end of the year?

2. Kenny trades with Cynthia with whom she both buys and sells goods on credit. At the

end of the financial year Kenny owes Cynthia K 150 000 and she owes him K 130 000. They both agree to setting off the amounts outstanding.

What would be the contra entry in Kenny’s books?

a) Dr Trade Receivables with K 150 000Cr Trade Payables with K 150 000

b) Dr Sales Account with K 150 000Cr Purchases Account with K 150 000

c) Dr Purchases Account with K 130 000Cr Sales Account with K 130 000

d) Dr Trade Payables Ledger with K 130 000 Cr Trade Receivables Ledger with K 130 000

3. For the month of October 20X5 Kawape’s purchases totaled 225 600 with Value Added Tax of K 33 840. The total of K 259 440 has been credited to the trade payables control account as K254 940.

Which of the following adjustments is correct?

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Control account List of trade payables balances

a. K 4 500 Credit No adjustmentb. K 4 500 Credit Increase by K4 500c. K 29 340 Debit No effectd. 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 563Sales 854 239Returns inwards 44 271Returns outwards 32 662Payments to suppliers 300 912Receipts from customers 675 843Discounts received 9 027Discounts allowed 20 275Amounts written off to bad debts 13 173Transfers between the receivables ledger and the payables Ledgers 7 457Rebates on customer invoices 3 244Refunds 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.


1.

TRADE PAYABLE

K000 K000

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Balance b/d 45 Balance b/d 6 500Purchases Returns 90 Purchases 42 000Bank 34 000 Purchases 20

Trade Receivables 70Discount Received 50Balance c/d 14 328

48 583 48 583

Balance b/d 14 328

2 d3 a

4

TRADE RECEIVABLES

K KBalance b/d 40 250 Balance b/d 3 845Sales 854 239 Retuens inwards 44 271

Bank 675 843Discount All 20 275Bad debts 13 173Trade Payables 7 457Returns inwards 3 244

Balance b/d 2 119 Balance c/d 128 400896 608 896 608

Balance b/d 128 400 Balance b/d 2 119

TRADE PAYABLE

K KBalance b/d 1 985 Balance b/d 26 423Purchases Returns 32 662 Purchases 408

563Bank 300 912 Trade Receivables 7 457Discount Received 9 027Balance c/d 83 403 Balance c/d 460

48 583 48 583

Balance b/d 460 Balance b/d 83 403(1985 – 1525)

CHAPTER 14

BANK RECONCILIATION

INTRODUCTION

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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 statement2. Terms in frequent use3. Preparing a bank reconciliation statement4. 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.

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.

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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.

3.0 PREPARING A BANK RECONCILIATION STATEMENT

The following exercise will illustrate how to prepare a bank reconciliation statement.

EXERCISE

130

The bank columns in the cashbook for May 2005 and the bank statement for that month for G Hoglah are as follows:

CASH BOOKDebit side Credit side

K000 K000May 1 Balance b/d 3 250 May 6 Kundananji 165May 8 R Mbewe 720 May 13K Mwila 454May 17B Jere 685 May 17P Muma 38May 29F Banda 372 May 30Daka Bowling 44May 31D Phiri 582 May 31Balance c/d 4 908

5 609 5 609BANK STATEMENT

2005 DEBIT CREDIT BALANCEK000 K000 K000

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

You are required to:a) Write the cashbook up to date to take the above into account, and

thenb) Draw up a bank reconciliation statement as at 31 May 2005

1. Identify entries appearing on both the cash book and the bank statement. The matching field is either the date or the description. The amount should be matched last. These entries represent transactions that have been processed in both sets of accounts correctly.

2. Starting with the closing balance on the cash book, prepare an updated cashbook by debiting amounts that appear in the credit column of the bank statement, and vice versa.

3. Starting with the revised cashbook balance in step 2, prepare a bank reconciliation statement. The amounts recorded in the cashbook but not processed by the bank are reversed accordingly.

In practice more rigorous verification is done since a lump sum shown on the bank statement may have to be broken down into several transactions and matching entries identified separately. Extensive schedules of unmatched entries are prepared, and totals used for preparation of bank reconciliation statements.

SOLUTION

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UPDATED CASHBOOK

K000 K000May 31Balance b/d 4 908 May 31Suwilanji 220May 31Akazipo 85 May 31GYM Club 63

May 31Bank Charges 52 May 31Balance c/d 4 6585 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 2005K000

Balance per updated Cashbook 4 658Add: Unpresented cheques

Kundananji 165Daka Bowling 44

2094 867

Less: Deposits not yet creditedD 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 CRK000 K000

Bank charges 52Bank account (in CB) 52

GYN Club 63Bank account (in CB) 63

Trade receivables (Dishonoured cheque) 337Bank 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?

CHAPTER SUMMARY

You have now learnt that: -

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Bank reconciliation is mandatorily prepared because it is a form of internal control that auditors will rely on to certify the verifiability of the bank balance shown in the balance sheet.

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

EXERCISES

1. Your firm’s cash book shows a credit balance of K12 400 at 30 June 2005. Upon comparison with the bank statement you determine that there are unpresented cheques totalling K4 500, and a receipt of K1 400 which has not been passed through the bank. The bank statement shows bank charges of K740 which have not been entered in the cash book.

What is the balance on the bank statement?

2. Your firm’s cash book at 30 September 2005 shows a balance at the bank of K24 900. A comparison with the bank statement at the same date reveals the following differences:

Unpresented cheques 8 400 Dishonoured cheques 1 400 Receipts not credited 4 700 Bank charges 500

Find the correct balance on the cash book at 30 September 2005

3. Trotters Grotto Ltd prepared the following summary of receipts and payments account for the month of April 2006:

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K000 K000Receipts 1 478 Balance b/d 770Balance 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 000b) 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.


Q1 K 10 040

Q2 K 23 100

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Q3 UPDATED CASH BOOK

K000 K000April 30Suspense 20 April 30 Bal b/d 662April 30Dividend received 89 April 30 Suspense 3

April 30 Rates 120April 30 Kebby 207April 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 STATEMENTK 000

Balance per revised Cashbook (overdraft) 1 020Add: Deposits not yet credited 807

1 827Less: Unpresented cheques 345Balance per Bank Statement 1 482

CHAPTER 15

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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 debts3 Treatment of bad debts in financial statements4 Bad debts recovered, accounting and treatment in final accounts5 Allowances for doubtful debts 6 Accounting for allowance for doubtful debts7 Treatment of allowance for doubtful debts in financial statements8 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 accountCR. – Sales account

The customers account will appear in the receivables ledger as an asset.

Example: Sale of goods on credit.136

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 KNov. 1 Sales 276,000

In general ledger

Dr. Sales account Cr.

K KNov. 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 KNov. 1 Sales 276,000 Balance c/d 276,000

______ _______276 000 276000

20X7 Jan. 1 Balance b/d 276,000

When the new year begins on 1 January 20X7, Mr. Fix is still a receivable (debtor) with K276,000.

- Assuming Mr. Fix’s credit period expires and the business fails to recover the money, then the business has incurred bad debts.

15.2 ACCOUNTING FOR BAD DEBTS

Double entry:

137

DR. – Bad debts account (in general ledger)CR. – Mr. Fix account (in sales ledger)

- Using the above example:


20X7 K KJan. 1 Balance 276,000 Bad debts 276,000

_______ ______276,000 276,000

Dr. Bad account Cr.

K KMr. 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 KMr. Fix 276,000 Income Statement 276,000

_______ ______276,000 276,000

NOTES:

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- 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) accountCR. – Bad debts recovered account.

(b) When payment is received:

DR. – Cash or Bank accountCR. – 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.


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K KBalance 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 KIncome 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 owing K

Estimated % Doubtful

Allowance for doubtful debts K

Less than 30 days 11,300,000 1% 113,00030 days less than 60 days 7,400,000 4% 296,00060 days less than 90 days 2,500,000 6% 150,000

Accounting for allowance for doubtful debts

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(a) Upon creation:

Dr. – Income statementCr. – 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 KExpenses:Allowance for doubtful Gross profit XXdebts 1,350

OR

Gross profit XXLess: Expenses

Allowance for doubtful debts (1,350)

Dr. Allowance for doubtful debts account Cr.

K 31 Dec. 20X7 KBalance c/d 1,350 Income statement 1,350

____ ____ 1,350 1,350

1 Jan. 20X8 Bal. b/d 1,350

Balance sheet (extract) as at 31 December 20X7.

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Current AssetsReceivables (50,000 – 5,000) 45 000Less: 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 KGross 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)

Example

142

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 KGross profit XXXLess: Expenses: Bad debts 3,000 Allowance for bad debts 270

3,270


K KBalance 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 000Less: Bad Debts 1,620

52 380

(b) If decrease in allowance for doubtful debts

Assuming in 20X9, the economic environment is very conducive for business and most of the receivables are paying, the allowance for doubtful debts may be reduced.

Example:

The allowance for doubtful debts has been in existence for the past two (2) years in the books of Mafuso. At 31 December 20X9, receivables were K30,000. After reviewing the receivables ledger it is discovered that K1,500 will not be recovered and 3% allowance for doubtful be maintained on remaining receivables.

K

Receivables 30,000Less: Bad debts (1,500)

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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:

KBad debts (Expense) 1,500Decrease in allowance forDoubtful 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 KIncome statement 765 Balance b/d 1,620Balance c/d 855

____ _____ 1,620 1,620

Balance b/d 805

Income Statement (20X9) K K

Gross profit XXAdd: other income

Decrease in provision for doubtful debts 765 XX

Less: ExpensesBad debts 1,500

15.5.2 When bad debts are incurred where allowance for doubtful debts exists.

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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 KBalance 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 KReceivables 18,000 Allowance for doubtful

debts 18,000 _____ _____ 18,000 18,000


K KBad debts 18,000 Balance b/f 27,800

Income statement 15,200Balance c/d 25,000 _____

43,000 43,000Balance b/d 25,000

NOTES:- Bad debts K18,000 is a charge against the allowance for doubtful debts.- The net charge is K15,200 (18,000 – 2,800) to income statement.

If the amount of allowance is not enough for bad debts suffered, the remainder will be charged against profits in that year.

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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 forJune K doubtful debts cash discounts

K %

20X6 20,000 1,000 320X7 25,000 1,250 320X8 23,000 1,200 3

20X6 K20,000 - 1,000 = 19,000 X 3% = 57020X7 K25,000 - 1,250 = 23,750 X 3% = 71320X8 K23,000 - 1,200 = 21,800 X 3% = 654

Dr. Allowance for cash discounts on receivables account Cr.

K K20x6Balance c/d 570 Income statement 570

570 57020x7Balance c/d 713 Balance b/d 570

___ Income statement 143713 713

20x8Income statement 59 Balance b/d 713Balance c/d 654 ___

713 713Balance b/d 654

Income StatementK K

Gross profit for (20X6, 20X7, 20X8) XX

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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 K20X6 Receivables (20,000 – 1,000 - 570) 18,430

20X7 Receivables (25,000 – 1,250 – 713) 23,037

20X8 Receivables (23,000 – 1,200 – 654) 21,146

CHAPTER SUMMARY

- Bad debts are amounts a business fails to recover from receivables

147

- 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.


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1. Dr. – Income StatementCr. – Bad debts account

2. Dr. – Receivables accountCr. – Bad debts recovered account to reinstate the receivable

then

Dr. – Cash or Bank accountCr. – Receivables account

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

Dr. – Income statementCr. – Allowance for doubtful debts account

4. When allowance for doubtful debts reduces

Dr. – Allowance for doubtful debts accountCr. – Income statement.

5.


K KBalance c/d 280 20X6

Income statement 280 280 280

20X7Balance 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) K27,72020X7 Receivables (40,000 – 2,000) K38,000

CHAPTER 16

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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 accruals2. Ledger accounting for accruals3. Treatment of accruals in financial statements4. What are prepayments5. Ledger accounting for prepayments6. 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.

Example 1: Owing by the business.

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Using the above example the rent expense account would look like:

Dr. Rent Account Cr.

K KBank 1 000 Income Statement 1 200Balance 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 KBank 1 400 Opening balance from

previous year 200Income StatementAccount 1 200

_____ ____1 400 1 400

The K1 400 paid is first to pay the previous years balance of K200 and the remainder K1 200 is what should be charged to the second year’s income statement.

The K200 has now been paid and will not appear anywhere in financial statements.

Example 2: Owing by the business

Genuine Motor Spares, is a dealer in motor spares. The financial year for the business ends on 28 February each year. His telephone was installed on 1 April 20x6 and receives his telephone account quarterly at the end of each quarter. He pays it promptly as soon as it is received. On the basis of the following data, calculate the telephone expense to be charged to the income statement for the year ended 28 February 20x7.

The following payments were made.K

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30.6.20x6 23.5030.9.20x6 27.2031.12.20x6 33.4031.3.20x7 36.00

Solution:

Dr. Telephone Account Cr.

K KBank 23.50 Income Statement 108.10Bank 27.20Bank 33.40Balance 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:

Dr. Rent Receivable Account Cr.

K K

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Income Statement 1 200 000 Bank 1 000 000Balance 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 KBalance b/f 200 000 Bank 1 400 000Income 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 there’s nothing owing at year end.

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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 accountCr – 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 KBank (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.

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- 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 KBalance b/f 148 000 Income statement 888 200Bank 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.

During the year ended 31.12.20X7, a payment of K3 000 000 was paid in advance for fuel by a customer.

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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 000Cr. – Fuel account (Income)

2. At year end, adjustments will be

Dr. – Fuel account with K512 000 balance c/dCr. – Prepayment (fuel) balance b/d to be shown in balance sheet under current liabilities as other payables.

Dr. Fuel Account Cr.

K KIncome statement 2 488 000 Bank 3 000 000Balance c/d 512 000

________ ________3 000 000 3 000 000

Balance b/d 512 000Notes:

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.

From the following record of insurance payments, calculate the charge to income statement for the financial year to 28 February 20X8.

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1 June 20X6 insurance paid is K600 0001 June 20X7 insurance paid is K700 000

Dr. Insurance Account Cr.

K KBalance b/f 150 000 Income statement 675 000Bank 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).

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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).

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

8 050 000 8 050 000Balance b/d 150 000 Balance b/d 200 000

Note:

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

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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 Depreciation3 Methods of depreciation4 Accounting for depreciation5 The disposal of non current assets6 The non current asset register7 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

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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:

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“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 000Residual 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 000Residual value (K3 000 000)

K77 000 000 is depreciable amount over 5 Years

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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

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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.

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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.

KYear 1 20% x 150 000

(30 000) DepreciationYear 2 20% x 120 000 N.B.V

(24 000) DepreciationYear 3 20% x 96 000 N.B.V

(19 200) Depreciation 76 800

11.9 Sum of digits method

This method is very similar to reducing balance method. Depreciation is also charged more in earlier years than later year. What makes it different from reducing balance method is the way it is calculated.

What is referred to as sum of digits are the years the asset will be in use i.e. estimated life.

If the life of an asset is 5 years then the sum of digits will be:

Year 1 +Year 2 +Year 3 +Year 4 +Year 5 15 is the sum of digits

Since depreciation is more in the first year than later years, each year depreciation charge will be:

Year 1 5/15 x depreciable amount


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Year 5 1/15 x depreciable amountExample: 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

Year 1 5/15 x K570 000 = K190 000

Year 2 4/15 x K570 000 = K152 000

Year 3 3/15 x K570 000 = K114 000

Year 4 2/15 x K570 000 = K 76 000

Year 5 1/15 x K570 000 = K 38 000 K570 000

+ K 30 000 Residual value K600 000

If the asset had no residual value, then the depreciable amount would be the whole K600 000 spread over 5 years.

11.10 Revaluation method

- Fall in value of asset

When the market value of a non current asset falls below its net book value, and the fall in value is expected to be permanent, the asset should be written down to its new market value. Revaluation means giving a new value to an asset which could be gains or losses.

NOTE: Market value is value of asset it can currently fetch on the market which is different from net book value which is cost minus depreciation.

The charge in the income statement for the reduction in the value of the asset during the accounting period is:

KNet book value at start of year XX

Less: New value (XX)

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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

20K75,000 depreciation has accumulated over 5 years.

N.B.V. after 5 years: 300 000 Cost(75 000) Depreciation225 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 000Add 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.

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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

KNet book value at 31 December 20X6: 275 000 cost

44 000 accumulated depreciation 231 000 N.B.V.

KGain 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

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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 expenseCR – 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

(a) The machinery account

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

180 000 180 000

20X3 Balance b/d 180 000 Balance c/d 205 000Bank 25 000 ______

205 000 205 000

20X4 Balance b/d 205 000 Balance c/d 205 000

205 000 205 000

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Dr Allowance for depreciation account (Machinery) Cr

20X1 K 20X1 KBalance c/d 9 000 Income statement 9 000

_____ _____ 9 000 9 000

20X2 20X2 Balance b/d 9 000Balance c/d 36 000 Income statement 27 000

36 000 36 00020X3 20X3 Balance b/d 36 000Balance c/d 66 750 Income statement 30 750

66 750 66 75020X4 20X4 Balance b/d 66 750Balance c/d 97 500 Income statement 30 750

97 500 97 500

Fixtures Account

20X1 Bank 38,000 Balance c/d 38 000 ______ ______ 38 000 38 000

20X2 Balance b/d 38 000 Balance c/d 38 000 _____ ______ 38 000 38 000

20X3 Balance b/d 38 000 Balance c/d 38 000 _____ _____ 38 000 38 000

20X4 Balance b/d 38 000 Balance c/d 56 000Bank 18 000 _____

56 000 56 000

Dr Allowance for depreciation account (Fixtures) Cr

K K 20X1 20X1

Balance c/d 1 900 Income statement 1 900 _____ _____ 1 900 1 900


3 705 3 70520X3 20X3 Balance b/d 3 705

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Balance c/d 5 420 Income statement 1 715 5 420 5 420


7 949 7 949

Income statement (Extract)

K KGross profit XXLess: Expenses

20X1 Depreciation: Machinery 9 000 Fixtures 1 900

(10 900)

XX20X2 Depreciation: Machinery 27 000

Fixtures 1 805(28 805)

XX20X3 Depreciation: Machinery 30 750

Fixtures 1 715(32 465)

20X4 Depreciation: Machinery 30 750Fixtures 2 529

(33 279)

Balance Sheet (Extracts)

Non current assets Cost Depreciation N.B.V.

20X1 Machinery 60 000 9 000 51 000Fixtures 38 000 1 900 36 100




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In the trial balance

Depreciation is an end of the year adjustment, therefore in the year of acquisition of a non current asset depreciation will not be reflected in the trial balance, but will start appearing in subsequent years.

In previous exercise depreciation will only start appearing in 20X2, thus:

Trial Balance as at 31 December 20X2

Dr CrMachinery 180 000Accumulated depreciation 9 000Fixtures 38 000Accumulated depreciation 1 900

Trial Balance as at 31 December 20X3 Dr Cr

Machinery 205 000Accumulated depreciation 36 000Fixtures 38 000Accumulated depreciation 3 705

Any depreciation shown in the trial balance is what has accumulated from previous years. For the year under review it has to be calculated and shown in the income statement. The figure shown in income statement will be added to the figure in the trial balance and the accumulated total shown in the balance sheet.

11.13 Choice Of Depreciation Method

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.

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11.4 Asset Acquired During An Accounting Period

If a non current asset is purchased during an accounting period it might be fair to charge depreciation according to the period the asset has been used i.e. on monthly basis. However, this basis may apply when straight line method is in use.

Examination questions will usually state the way depreciation is to be applied.

Examples:

(a) Charge a full year’s depreciation in the year of acquisition or nothing in the year of disposal. In this instruction dates of purchase should be ignored even if the dates are given.

(b) Charge a full year’s depreciation on the value of asset available at year end. (explanation same as in a)

(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 months12 months

= K12 500

11.15 Change in estimated life

When the life span of an asset changes i.e. increased or reduced, the net book value of the asset at the time of change is what will be spread on the remaining life.

Example 1: Increase in life of an asset

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A business purchased a motor vehicle at a cost of K400 000 with an estimated life of 6 years. It is to be depreciated on straight line basis over its life. However, after 2 years in use, it is discovered that the asset life has 2 more years making a total of 8 years.

What will be the depreciation charge from year 3 on wards.

Solution:

Annual depreciation is K400 000 6 years = K66 667

K66 667 x 2 years = K133 334.

Net book value after 2 years K400 000 133 334 266 666 N.B.V.

Net book value to be spread over new life i.e. 6 years. From year 3 onwards annual depreciation will be:

K266 666 6 years = K44 444

Example 2: Decrease in life of asset

A business bought non current assets at a cost of K100 000. It is estimated that the assets will be used in the business for a period of 7 years with K10 000 residual value. After one year in use, it was reviewed that the assets life span be reduced to 3 years from the remaining 6 years. What will be depreciation from year 2 onwards.

Solution

Annual depreciation (100 000 – 10 000) 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

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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 0005 years = K16 000 annual depreciation

Accumulated depreciation at time of change K16 000 x 2K32 000

Net book value after 2 years K80 000 – K32 000 = K48 000

From year three onwards using reducing balance method, depreciation will be:

Year 3 48 000 x 20%(9 600) Depreciation

Year 4 38 400 x 20%(7 680) Depreciation30 720 x 20% etc.

11.17 The Disposal of Non Current Assets

When a business buys non current assets, they are meant to be used in generating income for the business over a period time (more than 1 year). They are not meant for resale to make a profit.

However, the non current assets might be sold off at some stage before even their useful life is over. Reasons for selling or disposal may include:

- Inadequacy – where an asset fails to meet increased demand for a product- Obsolescence etc

(a) The Disposal Account

When non current assets are disposed of, a disposal account is opened. This account will reveal whether a profit or loss has been made on the asset sold. The profit or loss on disposal are reported in the income statement.

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- Ledger accounting on disposal of non current asset. The profit or loss on disposal is the difference between net book value of non current asset and the net sale price, which is the price minus any costs of making the sale.

- A profit is made when sales price is more than net book value- A loss is made when sales price is less than net book value of a non

current asset.

Double entry when an asset is disposed of.

Step 1:

Debit – Disposal account with value of asset usually atCredit – Asset account cost

Step 2:

Debit – Allowance for depreciation account with accumulatedCredit – 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) orDebit – cash book (if sale is on cash or by chequeCredit – 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.

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Solution:

The amount to be charged as depreciation each year is

Cost – residual valueEstimated 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 K1 Jan. Bank 100 000 31 Dec. Balance c/d 100 000

_______ ______100 000 100 000

20X61 Jan. Balance b/d 100 000 31 Dec. Balance c/d 100 000

______ _______100 000 100 000

20X71 Jan. Balance b/d 100 000 June 30 Disposal 100 000

______ ______100 000 100 000

Dr Allowance for depreciation Cr

K 20X5 K31 Dec. Bal. c/d 10 000 31 Dec. Inc. statement 10 000

(Depreciation)______ _____10 000 10 000

20X631 Dec. Bal. c/d 20 000 1 Jan. Balance b/d 10 000

31 Dec. Inc. statement 10 000 (Depreciation)

______ ______20 000 20 000

20X730 June Disposal 25 000 1 Jan. Balance b/d 20 000

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30 June Inc. statement 5 000 (Depreciation) _____25 000 25 000

Dr Disposal account Cr

20X7 K 20X7 K

30 June Van at cost 100 000 30 June Allow. For Dep. 25 000 30 June Bank 55 000

Loss (to inc. state.) 20 000_______ ______100 000 100 000

Example 2: Trading in or part exchange on disposal.

On 1 April 20X8, Quick Fix owned a motor vehicle which was bought on 1 October 20X5 at a cost of K600 000. Its estimated residual value after five years in use would be K80 000.

Quick Fix’s policy is to provide depreciation on straight line method on monthly basis.

During the financial year ended 31 March 20X9, the following occurred:

On 30 June 20X8, the motor vehicle was traded in and replaced with a new one. The trade in allowance was K255 000. The new vehicle cost K850 000. The balance after deducting the trade in allowance was paid by cheque.

The new motor vehicle is expected to have a residual value of K100 000 after its life of 8 years.

Required:

Show the necessary ledger accounts to record the above information.

Solution:Annual depreciation: K600 000 – K80 000

5 years = K104 000For 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 00030 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)

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11.18 Controlling Tangible Non Current Assets.

Most organizations will own a number of non current assets and their control is vital to the efficient running of the organization. A non current asset register should be maintained for this purpose.

Non Current Asset Register.

This register will contain the following information for each non current asset.

- the date of purchase- the name and address of supplier- the cost of the asset- the estimated useful economic life of the asset- the estimated residual or resale value of the asset at the end of its useful life- a description of the asset- a code number for easy identification- the method of accumulated depreciation to be used- the accumulated depreciation of the asset- details of disposal of the asset- the location of the asset within the organization- the extent to which it is being used- the repairs carried out and how much they cost- the expiry dates of any licences permitting the organization to use it.

11.19.0 IAS 16 PROPERTY, PLANT AND EQUIPMENT

11.19.1 This standard covers all aspects of accounting for property, plant and equipment. This represents the bulk of items which tangible long term asserts.

11.19.1 IAS 16 should be followed when accounting for property, plant and equipment unless another international accounting standard requires a different treatment.

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.

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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 company’s financial position in the balance sheet and the profitability of the entity as shown in the income statement. Smaller items such as tools are often written off as expenses of the period. Most companies have their own policy on this –items below a certain value are charged as expenses.

Initial measurement

11.19.6 Once an item of property, plant and equipment qualifies for recognition as an asset, it will initially be measured at cost.

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Components of cost

11.19.7 The standard lists the components of the cost of an item of property, plant andequipment.

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 preparationo Initial delivery and handling costso Installation costso Professional fees (architects, engineers)

11.19.8 The following costs will not be part of the cost of property, plant or equipment unless they can be attributed directly to the asset’s acquisition, or bringing it into its working condition.

Expenses of operations that are incidental to the construction or development of the item

Administration and other general overhead costs Start-up and similar pre-production costs Initial operating losses before the asset reaches planned performances

All of these will be recognized as an expense rather than an asset.

Exchange of assets

11.19.9 Exchange or part exchange of assets occurs frequently for items of property, plant and equipment. IAS 16 states that the cost of an item obtained through (part) exchange is the fair value of the asset received (unless this cannot be measured reliably).

Subsequent expenditure

11.19.10 How should we treat any subsequent expenditure on long-term assets, after their purchase and recognition? Subsequent expenditure is added to the carrying amount of the asset, but only when it is probable that future economic benefits, in excess of the originally assessed standard of performance of the existing asset, will flow to the enterprise. All 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

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(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

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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 asset’s economic benefits are consumed by the enterprise.

The depreciation charge for each period would be recognized as an expense unless it is included in the carrying amount of another asset.

Most of the comments on depreciation in IAS 16 are dealt with in Section 2.

11.19.22 Land and buildings are dealt with separately even when they are acquired together because land normally has an unlimited life and is therefore not depreciated. In contrast buildings do have a limited life and must be depreciated. Any increase in the value of land on which a building is standing will have no impact on the determination of the building’s useful life.

11.19.23 Depreciation is usually treated as an expense, but not where it is absorbed by the enterprise in the process of producing other assets. For example, depreciation of plant and machinery is incurred in the production of goods for sale (inventory items). In such circumstances, the depreciation is included in the cost of the new assets produced.

Review of useful life

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

Review of depreciation method

11.19.25 The depreciation method should also be reviewed periodically and, if there has been a significant change in the expected pattern of economic benefits from those assets, the 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.

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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 Additionso Disposalso Increases/decreases from revaluationso Reductions in carrying amounto Depreciationo 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

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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.

DIVISION OF RESEARCH

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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.THE SOLUTION

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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.

EXERCISES

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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 500Trade in allowance = K3 500Profit 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

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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 sold3 Accounting for opening and closing inventories4 Carriage costs5 Inventory counting and inventory accruals6 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.

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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 xxAdd: purchases xx

xxLess: 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 salesPurchases (30 x K40 000) 1 200 000Less: closing inventory (9 x K40 000) (360 000)

(840 000)

Gross profit 315 000

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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 000Add: 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 000Add purchases (35 x K40,000) K1 400 000

K1 760 000Less closing inventory (4 x K40 000) (K160 000)

(K1 600 000)

Gross profit K566 000

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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 000Add: Purchases (35 x K40 000) K1 400 000

K1 760 000Less: Inventory stolen (2 x 40,000) (K80,000)

K1 680 000Less: Closing inventory (4 x 40 000) (K160,000)

K1 520 000Gross profit K646 000Expenses: 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 000Closing inventory 85 000Carriage outwards 62 000Purchases 75 000Returns inwards 5 000Carriage inwards 3 000

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Required:

Calculate cost of sales.

Solution K

Cost of sales:Opening inventory 55 000Purchases 75 000Carriage inwards 3 000

133 000Less: 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 StatementCR – 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 StatementCR – Inventory account (with value of opening inventory)

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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 000Bought goods and paid by cash K95 000Sold goods for cash to different customers K150 000Sold goods on credit also to different customers K105 000Receipts from credit customers K70 000 cashPayments to credit suppliers K60 000Purchased motor van for use in the business K50 000 cashSundry expenses paid in cash K25 000A physical stock take was conducted and closing inventory was valued at K35 000.

Required:

Prepare ledger accounts for the above transactions and draft an income statement for the year ended 31 December 20x8.

Solution:

Because this is the first year in business, there is no opening inventory.

Dr Cash account Cr

K’000 K’000Capital 750 Purchases 95Sales 150 Payables 60Receivables 70 Motor van 50

Expenses 25___ Balance c/d 740970 970

Balance b/d 740

Dr Capital account Cr

K’000 K’000 Cash 750

Dr Trade Payables Cr

K’000 K’000Cash 60 Purchases 80Balance c/d 20 __

80 80

Balance b/d 20Dr Purchases account Cr

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K’000 K’000Payables 80 Income Statement 175Cash 95

___ ___175 175

Dr Trade Receivables Cr

K’000 K’000Sales 105 Cash 70

___ Balance c/d 35105 105

Dr Sales account Cr

K’000 K’000Income Statement 255 Cash 150

___ Receivables 105255 255

Dr Motor van account Cr

K’000 K’000Cash 50 Balance c/d 50

50 50

Dr Sundry Expenses account Cr

K’000 K’000Cash 25 Income statement 25

25 25

Dr Inventory account Cr

K’000 K’000Income statement 35 Balance c\d 35

==== ==== Balance b/d 35

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SKY LTDIncome statement for the year ended 31 December 20x8

(using vertical format)

K’000 K’000

Sales 255

Cost of sales:Purchases 175Less: Closing inventory 35

(140)Gross profit 115Less: ExpensesSundry expenses (25)Net profit 90 ===

SKY LTDIncome statement for the year ended 31 December 20x8

Using T Format)

Dr Cr

K’000 K’000Purchases 175 Sales 255Gross profit c/d 115 Closing inventory 35

290 290

Sundry Expenses 25 Gross profit b/d 115Net profit 90 ___

115 115

N.B. The balance on the inventory account is K35 000 which will appear in balance sheet as a current asset.

As it is the K35 000 closing inventory is the only entry in the inventory account. There’s no figure for opening inventory.

If opening inventory was there, it would have been eliminated by transferring it as a debit balance to the income statement.

DR – Income statement (with value of opening inventory)CR – Inventory account (with value of opening inventory)

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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 accountCR – Payables (Liability)

18.6 Inventory ValuationIAS 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.

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(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 000B 8 500 5 000 5 000C 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 000Selling price 30 000 12 000 22 000Modification costs - 2 000 8 000Marketing costs 7 000 2 000 2 000

Units held 200 000 150 000 300 000

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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 000B 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 ValueItem A: K300 000 – K7 000 = K23 000B: K12 000 - K4 000 = K8 000C: 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

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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 20x8QUANTITY UNIT COST

K’000’1 June Opening inventory 200 126 June Purchases 400 179 June Sales 300 3015 June Sales 250 3217 June Purchases 100 1821 June Sales 60 32

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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 BalanceAfter 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 100K8 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 620K8 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.

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(b) LIFO METHOD


1 June - - 200 @ 12 each K2 400

6 June 400 @ K17 each - K6 800 +

K6 800 K2 400 K9 200

6009 June - 300 @ K30 (300 @ 17)

K9000 100 @ 17 1 700200 @ 12 2 400300 4 100

15 June - 250 @ 32 300(100 @ 17)

K 8 000 (150 @ 12) 50 @ 12 K600

17 June 100 @ K18 each - 50 @ 12 K600K1 800 100 @ 18 K1 800

150 K2 400

21 June - 60 @ 32 150K1 920 60 @ 18

40 @ 18 K72050 @ 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

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(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 600K9000 (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 750K1 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 costNumber 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.

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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 StatementK K

Sales 18 920Purchases 8 600Closing inventory (1 620)

(6 980)Profit 11 940

(ii) LIFO

Income StatementK K


(7 280)Profit 11 640

(iii) AVCO

Income StatementK K


(7 070)Profit 11 850

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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 XXPurchases XX

XXLess: 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

FIFOLIFOAVCO

- 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.

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5. Identify three methods of pricing inventory.


1. Opening inventory XXPurchases XXLess: 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

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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 balance2 Errors disclosed by the trial balance3 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

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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 one’s failure to correctly apply the principles of accounting or accounting concepts. The common ones are failure to appreciate the distinction between capital and revenue expenditure and capital income and revenue income.

Example 1

Bought non current asset (furniture) by cash K670.

Correct double entry in correct account

DR – Furniture accountCR – Cash account

Correct double entry but in wrong account

DR – Purchases accounterror 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

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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

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Cash account

Stamps 5Rent 15

Trial Balance

Dr. Cr.Stamps 10Rent 5Cash __ 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 K4Correct double entry

Dr – Stationery account K4Cr – Cash account K4

Reversed entryDr – Cash account K4Cr – 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.

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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 there’s a deficit in trial balance, which could be debit side or credit side, thus forcing temporally the trial balances totals to be equal.

With the suspense in trial balance, the financial statements could now be prepared.

- Suspense account will appear in balance sheet. If suspense account is debit balance, it is shown separately under current asset.

- If suspense balance is credit, it is shown separately as under current liability.- 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.

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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 accountCr – T Flash bulb account

Example 2: Suspense account involved

Paid rent in cash K170 Rent account is debited with K100Cash 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 CrRent 100Cash 170Suspense 70

170 170

Suspense account will be opened with debit balance

Dr Suspense account Cr

Balance 70

- error corrected

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Dr – Rent account with K70 i.e. to bring rent figure to K170Cr – 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 100Suspense account 70


Balance 70 Rent 70

70 70

Corrected trial balanceDr Cr

Rent 170Cash 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

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(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 300Interest account 300

(iv) Petty cash account 18Suspense account 18

(v) Bad debts account 120Suspense account 120

(vi) Drawings account 200Sundry expenses account 200

(vii) Car repairs account 380Wages account 380

(viii) Suspense account (rent) 1,200Rent 1,200

Advertising 2759 (ix) Suspense account (advertising) 2759

(x) Closing Inventory account 2,000Income Statement 2,000

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(xi) Discount allowed account 150Discount received account 150 Suspense account 300

(b) Dr Suspense account Cr

Balance 1421Sales 576 Petty cash 18Rent 1200 Bad debts 120

Advertising 2759Discount all. 150

____ Discount rec. 1503197 3197

(c) Statement of profit adjustment: K

Net profit before adjustments 12600Add sales omitted 576Less rates accrual (371)Add loan repayment entered in loan interest 300Less bad debts (120)Add drawings entered in sundry expenses 200Add rent received entered on wrong side 1200Less advertising omitted (2759)Add omitted inventory 2000Less discount allowed (150 x 2) 300Adjusted 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

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- 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).

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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.

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EXERCISES

1. Identify four (4) errors not affecting trial balance

2. When is the suspense account used?

3. What does a credit balance on suspense account indicate?

4. The trial balance of John Black as at 31 March 20X9 did not agree, there being a shortage of K 874 on the debit side. A suspense account was opened for the difference. Subsequent investigation showed:

(i) Discount allowed K480 had been entered on the credit side of discount allowed account.

(ii) The bank statement balance of K560 overdraft had been included in trial balance instead of the cashbook balance of K63 debit.

(iii) The provision for bad debts account of K150 had been entered on wrong side of trial balance

(iv) Rent receivable account was over cast by K20(v) Drawings of K250 had been included in purchases account(vi) The sale of furniture (non current asset) had been included in sales account of

K300(vii) Payment for insurance of K45 was entered in insurance account as K54(viii) Discounts received was overstated by K100.(ix) A cheque for K200 for car repairs had been posted to the building repairs account(x) Provision for depreciation account K270 was entered on wrong side of trial

balance(xi) The scrapping of an old lorry with net book value of K375 was omitted from the

books.

Required:

(a) Correct the errors via the journal(b) What was the balance on suspense account before the errors were corrected.

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

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

The Journal

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

Suspense account 960

(ii) Trial balance (Bank account) 560Bank account 63Trial balance (Bank account) 623

(iii) Suspense account 300Trial balance (with provision for baddebts) 300

(iv) Rent receivable account 20Suspense account 20

(v) Drawings account 250Purchases account 250

(vi) Sales account 300Disposal account 300

(vii) Suspense account 9Insurance account 9

(viii) Discount received account 100Suspense account 100

(ix) Car repairs account 200Building repairs account 200

(x) Suspense account 540Trial balance (with provision fordepreciation account) 540

(xi) Income Statement account 375Lorry account 375

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

1723 1723

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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 adjustments2 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

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Exercise 1

Shoe Black, is a sole trader operating as a retailer. The following information is extracted from his accounting books as at 31 December 20X7.

K’000 K’000Distribution expenses 146010% Loan 1000Trade payables 820Cash at bank 140Allowance for doubtful debts 18Trade receivables 810Motor vehicles at cost 1680Accumulated depreciation motor vehicles 620Warehouse at cost 1800Accumulated depreciation warehouse 290Buildings at cost 8300Accumulated depreciation buildings 1020Land at cost 1510Interest on loan paid 50Salaries and wages 1590Discounts allowed and received 80 100Returns inwards 400Returns outwards 150Carriage inwards 700Carriage outwards 250Inventory 1 January 20X7 1530Purchases 8100Sales 13600Capital 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.

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NOTE:The goods received had been included in the year end inventory figures given at (a) above, and the goods sold had been excluded from it.

No adjustment to the inventory figure is therefore required:

(h) Depreciation should be provided as follows:

- Land nil- Buildings 2% on cost per annum- Warehouse 15% on cost per annum- Motor vehicles 25% on cost per annum

Required:

(a) Prepare income statement for the year ended 31 December 20X7 and

(b) Balance sheet as at 31 December 20X7.

Solution:

Workings:

1. K’000 4. Distribution expensesSales 13,600 K’000Sales excluded 7 1,460

13,607 add owing 120Less prepaid (60)

1,520

2. Purchases 8,100 5. Interest on loan K’000Purchases for 50Invoices not add accrued 50Received 18 ___

8,118 1,00

N.B. 10% x 1000 = 1003. Salaries and wages only K50,000 has been paid the

K’000 other K50,000 is still owing 1,590

Add owing 190Less prepaid (70)

1,710

6. (i) Bad debts and allowance for bad debtsK’000

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

K’000(ii) Allowance for bad debts is 18

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New balance 30Increase in allowance is 12

(iii) Bad debts and allowance for bad debts inIncome statement will be

K’000Bad debts written off 6Increase in allowance 12

18

(iv) Receivables in balance sheet will be:

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

781

7. Depreciation:K’000

(i) Buildings: Balance as per trial balance 1,020charge to income statement(2% x 8,300) 166

1,186

K’000(ii) Warehouse: Balance as per trial balance 290

charge to income statement(15% x 1,800) 270

560

K’000(iii) Motor vehicles: Balance as per trial balance 620

Charge to income statement (25% x 1650) 420

1,040

Shoe BlackIncome statement for the year ended 31 December 20X7

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

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4,669Add: Discount received 100

4,769

Less: Expenses

Loan interest 100Bad debts & allowance (6) (iii) 18Salaries and wages (3) 1,710Discounts allowed 80Distribution Expenses 1,520Carriage outwards 250Depreciation: 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.K’000 K’000 K’000

Land 1510 - 1510Buildings 8300 1186 7114Warehouse 1800 560 1240Motor Vehicles 1680 1040 640

10504

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

2711

Total Assets 13215

Financed by:

Capital at start 10782Add Net Profit 235

Non current Liabilities10% Loan 1000

Current liabilitiesTrade payables (820 + 18) 838Accrued expenses (120 + 190 + 50) 360 1198

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13215

Exercise 2

Mr. Bird Rock has been in business for some time trading in motor spares. The list below has been taken from his books for the financial year ended 30 September 20X8.

KFixtures and fittings 910,000Accumulated depreciation 136,500Discounts received 15,400Trade receivables 400,000Carriage inwards 95,000Postage and stationery 15,210Telephone expenses 10,625Bad debts 55,000Returns inwards 110,300Carriage outwards 5,266Drawings 315,000Rent & rates 88,000Insurance 11,000Heating and lighting 50,781Advertising 16,000Cash in hand 4,242Cash at bank 112,000Inventory 1 October 20X7 156,000Purchases 1,200,400Discounts allowed 14,000Allowance for doubtful debts 40,000Returns outwards 2,745Trade payables 271,000Capital 1 October 20X7 1,103,179Sales 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:

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Prepare income statement for Mr. Bird Rock for the year ended 30 September 20X8 and a balance sheet as at that date.Solution

Mr. Bird RockIncome statement for the year ended 30 September 20X8

K KSales 2,000,000Less: Returns inwards (110,300)Turnover 1,889,700

Cost of Sales:Inventory 1/10/20X7 156,000Purchases 1,200,400Returns outwards (2,745)Carriage inwards 95, 000

_________1,448,685

Less: Closing inventory (127,666)1,320,989

Gross Profit 568,711Discount Received 15,400

584,111Expenses:Postage and stationery 15,210Telephone expenses (10,625 + 1,000) 11,625Bad debts (55,000 – 20,000) 35,000Carriage outwards 5,266Rent and rates (88,000 – 910) 87,090Insurance 11,000Heating and lighting (4,616 + 50,781) 55,397Advertising 16,000Discounts allowed 14,000Depreciation: Fixtures and fittings 77,350

(327,938)Net Profit 256,173

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Mr. Bird RockBalance sheet as at 30 September 20X8

Non Current Assets Cost Depreciation N.B.V.Fixtures and fittings 910,000 213,850 696,150Current AssetsInventory 30/09/20X8 127,666Trade receivables (400,000 – 20,000) 380,000Prepayments 910Cash in Bank 112,000Cash in hand 4,242

624,818Total Assets 1,320,968

Financed by:

Capital 1/10/20X7 1,103,179Net profit 256,173

1,359,352

Less: Drawings (315,000)1,044,352

Current liabilitiesTrade payables 271,000Accruals (1,000 + 4,616) 5,616

276,6161,320,968

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.

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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 accounts2 Expense apportionment3 Departmental income statement4 The balance sheet5 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:

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Drappery Kitchen Toiletries TotalWare

K K K KSales 120,000 200,000 50,000 370,000Cost 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.

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

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Solution:

(a) Opani,

Departmental income statement for the year ended 31.12.20x7.

Hardware Electrical TotalK K K K K

Sales 198,000 264,700 462,700Cost of sales: Opening inventory 25,000 43,600 Purchases 75,000 137,000

100,000 180,600Less: closing inventory (15,000) (17,000)

(85,000 (163,600) (248,600)Gross profit 113,000 101,100 214,100Direct expenses:Wages 35,000 34,000Other 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 16,940Rates 10,000 5,000Electricity 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.

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

Additional information:

(i) Closing inventory is valued as follows:

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

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

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

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

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

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Required:

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

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

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

KSales: drugs 675,000

Perfumes 500,000Toiletries 300,000

Purchases: Drugs 900,000Perfumes 350,000Toiletries 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 25,000Telephone expenses 33,000Motor expenses 66,000Insurance 15,000Fixtures and fittings 66,000Office expenses 19,000Buildings at cost 200,000Additional information:

(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 K60,000Perfumes K35,000Toiletries K21,000

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Required:

Prepare Papa’s 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 TotalK K K K K K K

Sales 854,000 605,000 936,500 2,395,500Sales returns - (20,000) - (20, 000)

______ _______ ______854,000 585,000 936,500 2,375,500

Cost of sales:Opening inv. 36,000 50,000 44,000Purchases 600,000 350,000 740,000

636,000 400,000 784,000Closing 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 75,000Depreciation 5,500 4,700 3,000Commission 85,400 58,500 93,650

______ _____ ______(178,900) (153,200) (171,650) (503,750)________ ________ ________ ________

CONTRIBUTION 64,100 65,000 22,600 151,700OTHER EXPENSES:Rent 15,000 15,000 15,000Admin. Expenses 25,000 12,500 37,500

______ ______ ______ (40,000) (27,500) (52,500) (120,000)

Net profit 24,100 37,500 (29,900) 31,700

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2. Papa

Departmental income statement for the year ended 30 June 20x5

Drugs Perfumes Toiletries Total K K K K K K

Sales 675,000 500,000 300,000 1,475,000Cost of sales:Opening inv. 75,000 60,000 45,000Purchases 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 2,200Buildings 10,000 10,000 10,000Lighting & heat 12,500 6,250 6,250Telephone 16,500 8,250 8,250Motor expenses 33,000 16,500 16,500Insurance 7,500 3,750 3,750Office expenses 9,500 4,750 4,750

(91,200) (51,700) (51,700) (194,600)_________ ______ _______ ________

311,200 38,300 20,700 ( 393,600) ======= ======= =======

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CHAPTER 22

PUBLIC SECTOR ACCOUNTING REPORTING

INTRODUCTION

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

TOPICS 1 Description of public sector2 Users of public sector financial statements3 International Federation of Accountants (Public Sector)4 Financial reporting under cash basis and accruals basis5 International public sector accounting standards6 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 accounting6. 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

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Also called public enterprises. This is a publicly owned commercial or industrial organization that performs some essential service such as ZESCO and ZNBC, or produces some essential commodity such a lime.

b) Local government or local authorities

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

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

Financial reports are prepared for accountability purposes and communicated to users who in turn will make decisions affecting the community at large.

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 REPORTSBy 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:

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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.

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.

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There are no current and non current liabilities

b) The cash accounting and accounting documents

Under this system the main book of accounting is the cash book. Entered in the cash book are simply cash receipts and cash expenditure using receipts and payments vouchers. This is where the analysis cash book column cash book is used with columns for cash receipts and expense columns. Double entry is completed with the cash book.

Ledger accounting: Separate ledger cards are kept for all receipts and payments on a cumulative basis.

Financial statements: Under this systems financial statements may comprise:i) Expenditure reports –which is a summary of expenditure on activities

carried out during a period, andii) 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 cashii) how much an organization is worth is not only cash but also other assets

and liabilities. Therefore financial statements on cash basis are incomplete and may be misleading about an organisation’s position.

e) Accruals accounting

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Revenue and costs are accrued (i.e recognized as they are earned or incurred, and not as money is received or paid), matched with one another so far as their relationship can be established or justifiably assumed, and dealt with in the income statement of the period to which they relate.

Meaning: i) The earning of revenue is generally taken to mean that invoices have been

issued.ii) Costs are incurred when services are received. Therefore recognition of

income and costs is not when cash is received or paid.There has been critical argument that the accruals accounting is too subjective and hide crucial information about an organisation’s performance.

Advantages:

i) It provides measures of economic goods and services consumed, transformed and earned.

ii) Accruals accounting yields an income figure. More profit implies more success.

iii) Accruals accounting yield a measure of capital. Income is only recognized after capital has been maintained in real terms.

Disadvantages:

i) Accruals accounting introduces subjectivity into the accounts. It brings in adjustments which are judgmental e.g. provision for doubtful debts, which may distort accounting information away from the ‘true and fair’ expectation.

ii) The relevance of accruals accounting, when it is linked with historical costs, and during periods of rising prices, is limited.

iii) In comparison with cash basis accounting, accruals adjustments demand a higher administrative and accounting cost.

iv) It provides an opportunity for manipulation that is a problem associated with financial control. With cash based accounting manipulation of accounting results could be affected by postponing cash payments just to show that the organization is financially sound.In accruals postponement of cash payments in receipts has no effect. Manipulation may come in by bringing in invoices for goods supplied just to ensure that the accounts are within budget.

22.7 INTERNATIONAL PUBLIC SECTOR ACCOUNTING STANDARDS (IPSAS)

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.

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23 REPORTING AND MEDIA

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

24 CHAPTER SUMMARY

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

Users of public sector financial reports include:i) Authorities (including parliament)ii) Heads of government departmentsiii) Tax payersiv) 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.

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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 business2. Legal status of a partnership 3. Types of partners in partnership4. Partnership agreement5. Advantages and disadvantages of a partnership6. Partnership current accounts7. Partnership capital accounts8. Profit and loss appropriation account9. 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.

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However, for accounting purposes the partnership will be treated as a separate legal person from partners.

23.3 TYPES OF PARTNERS IN A PARTNERSHIP RELATIONSHIP

In a partnership one may find limited partners and general or unlimited partner.

- Limited Partners

These are partners with limited liability. They are only liable or limited to the amount of capital they have provided. Such partners usually do not participate in management of the business.

- General Partners

Sometimes called unlimited or ordinary partners. These have unlimited liability. The debts of the business is beyond their capital contribution in the business. As such they are responsible for the day to day affairs of the business.

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:

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- 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)

23.5 ADVANTAGES AND DISADVANTAGES OF PARTNERSHIP

Advantages:

Comparing a partnership to sole trading, the advantages of operating as a partnership are as follows:

- Business risks are spread among more than one person.- Partners will learn new skills from other partners- A partner may take leave while others remain working. A sole trader will have in

most cases close business to take a rest.- Capital resources could be larger because of so many persons contributing.

Disadvantages could be:

- While risks are spread among many persons, some partners may feel uncomfortable to share profits.

- Disputes may arise on management issues and this may lead to partnership closure.

- A decision made by a partner in relation to business, is usually binding to other partners. This means if a partner is being sued in relation to the business, other partners are equally affected.

23.6 ACCOUNTING IN PARTNERSHIP

The accounting techniques in partnership are very similar to that of a sole trader.

Partnerships also keep books of prime entry and ledgers, but there are certain important differences as shown in the table.

Item Sole trader’s books Partnership books

Capital Introduced Capital account Partners fixed capitals accounts

Drawings and share of profits

Capital account Partners current accounts

Division of profits Inapplicable – one proprietor only

Income statement – shared, appropriation section

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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.

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Banda and Bwalya

Income Statement for the year ended 31.12.20X4

K KNet profit 70,000Add: 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 10,000Bwalya 20,000

(30,000) 35,500

Share of profits: ====== Banda ½ 17,750

Bwalya ½ 17,750 35,500

======(ii) Capital accounts

When a partnership is being set at the beginning, partners have to agree the amount of capital contribution to introduce. This could be in form of cash or other assets. Double entry would be:

DR. Asset account (whatever asset)CR. Capital account of each partner separately

The capital will usually remain fixed for the duration of the business but could change under the following circumstances:

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- 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 KBal. 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 partnersCR. Cash book or Purchases account

For interest on drawings

DR. Current accounts of PartnersCR. Income statement (appropriation account)

Using example 1, current accounts would be:

Current Accounts

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Drawings 6,000 5,000 InterestInterest on capital 10,000 20,000on drawings 2,000 1,500 Salaries 3,000 5,000Balances 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 200,000300,000

Current accounts: Banda 22,750 Bwalya 36,250

59,000359,000

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.

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Using example 1: Fluctuating capitals

Capital accounts


Balance 100,000 200,000Drawings 6,000 5,000 InterestInterest on capital 10,000 20,000on drawings 2,000 1,500 Salaries 3,000 5,000Balances 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 122,750Bwalya 236,250

359,000

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CHAPTER SUMMARRY

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

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

EXERCISES

1. Why do people want to form a Partnership?

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

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

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

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

Under the terms of the partnership agreement, the partners are entitled to interest on capital at 5% per annum.

B is entitled to a salary of K4,500. Interest is charged on drawings at 5 percent per annum and the amounts of interest are A K400 and B K300.

The net profit of the firm, before interests and salary for the year ended 30 June 20X7 was K25,800.

The partners capital at 1 July 20X6 were A K30,000 and B K10,000.

At 1 July 20X6, there was a credit balance of K1,280 on B’s current account while A’s current account balance was K500 debit.

Drawings for the year to 30 June 20X7 amounted to K12,000 and K15,000 for A and B respectively.

Required:

Prepare, for the year to 30 June 20X7:

(a) The partnership appropriation account(b) The partners current account.

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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 334,618Returns Inwards 10,200Purchases 196,239Carriage Inwards 3,100Inventory 1 Jan. 20X1 68,127Discounts allowed 190Salaries and wages 54,117Bad debts 1,620Provision for doubtful debts 1 January 20X1 950General expenses 1,017Business rates 2,900Postage 845Computers at cost 8,400Office equipment at cost 5,700Provision for depreciation at 1 January 20X1: Computers 3,600 Office equipment 2,900Payables 36,480Receivables 51,320Cash at bank 5,214Drawings: X 39,000

Y 16,000Z 28,000

Current accounts: X 5,940Y 2,117Z 9,618

Capital accounts: X 60,000Y 10,000Z 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.

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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 KNet profit 30.06.20X7 25,800Add: 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 12,000B 2/5 8,000

20,000

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(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 500Drawings 400 300 Salary - 4,500Balances 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 334,618Less: Returns Inwards (10,200)

324,418Cost of sales: Opening inventory 68,127 Purchases 196,239 Carriage inwards 3,100

267,466Less: closing inventory (74,223)

(193,243)Gross profit 131,175Less: Expenses Discounts allowed 190 Salaries & wages 54,117 Bad debts (1620 + 450) 2,070 General expenses 1,017 Business rates (2,900 – 200) 2,700 Postage (845 – 68) 777 Depreciation: computers 2,800

Office equipment 1,100 (64,771)

Net profit 66,404Interest on drawings: X 300

Y 200Z 240

740 67,144

Less: appropriations: Salaries Y 18,000

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Z 14,000(32,000)

Interest on capital: X 4,800Y 800Z 2,400

(8,000)Share of profits: X 4/5 14,022

Y 1/8 3,506Z 3/8 10,516

(27,144) _______

Current accountsDr. X Y Z X Y Z Cr.

Balance - 2,117 - Balances 5,940 - 9,618Drawings 39,000 16,000 28,000 Salaries - 18,000 14,000Interest on Interest onDrawings 300 200 240 capital 4,800 800 2,400Balances c/d 3,876 7,957 Share of profits13,572 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

XYZBalance sheet as at 31 December 20X1

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

K K KComputers 8,400 6,400 2,000Office equipment 5,700 4,000 1,700

14,100 10,400 3,700

Current assetsInventory 31.12.20X1 (74,223 + 68) 74,291Receivables (51,320 – 1,400) 49,920Prepayments 200Cash at bank 5,214

129,625Total assets 133,325Financed by:Capital accounts: X 60,000

Y 10,000Z 30,000

100,000Current accounts: X (14,988)

Y 3,876

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Z 7,957 (3,155)

Current liabilities Payables 36,480

133,325

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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, there’s need to also keep records of all activities (transactions).

TOPICS

1 The receipts and payments account2 Income and expenditure account3 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.

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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 ended31 December 20X4

Receipts PaymentsK K

Balance b/f 200 Bar purchases 160Subscriptions 6,450 Rental 720Bar Sales 240 Care takers wages 1,800Donations 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.

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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.

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Example: Bar income statement.

Armstrong Body Building Club Bar Income Statement

K KBar Sales 240Less cost of sales: Bar opening inventory 30 Bar purchases 160

___190

Less: Bar closing inventory (80)(110) 130

Less: Bar man’s wages (70)___

Net profit (transferred to income and expenditure account) 60

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.

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Solution:

Assets: K KCash and bank balance 210Subscriptions in arrears 65Equipment 975Inventory of competition prizes 38

1288

Liabilities:Subscriptions in advance 10Owing to suppliers 58

68Accumulated 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.

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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 accountCr. Subscription account



Cash 1987

Dr. Cash account Cr.

K K Subscriptions 1987

Step 3: Put in the closing balances for accruals and prepayments. Thebalancing figure is subscription for 20X1.

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Income and expenditure Cash 1987account (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) 1987Add: Subscription paid in advance 20X0 10 Subscription in arrears 20X1 85

952082

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.

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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 MembershipLife 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 accountCr. 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:

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Show how entries will be made in the subscriptions account and the life membership account.


K K Life membership 2450

Dr. Life membership account Cr.

K K Subscription 2450 Balance 7480Balance 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 accountCr. - Donation account with cash

If donation is in form non current asset e.g. Van.

Dr. - Van accountCr. - 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.

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Dr. - Cash account with entrance feesCr. - Entrance fees with cash received.

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

Dr. - Entrance fees accountCr. - 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 ClubReceipts and payments accounts for the year ended

31 December 20X1

Dr K K Cr.

Cash and bank balance 210 Secretarial expenses 163Sales of competition tickets 437 Rent 1402Members subscriptions 1987 Visiting speakers expenses 1275Donations 177 Donations to charities 35Refund of rent 500 Prizes for competitions 270Balance c/d 13 Stationery & printing 179

____ ____3,324 3,324

Balance b/d 13

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The following valuations are also available:

As at 31 December 20X0 20X1 K K

Equipment (original cost K1,420) 975 780Subscriptions in arrears 65 85Subscriptions in advance 10 37Owing to suppliers of competition prizes 58 68Inventory 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 fundAssets: K KCash and bank balance 210Subscriptions in arrears 65Equipment 975Inventory of competition prizes 38

1288Liabilities:Subscriptions in advance 10Owing to suppliers 58

68Accumulated fund at 1 January 20X1 1220

(b) (i) Subscription account

Dr. K K Cr.

Balance b/d 65 Balance b/d 10Income & exp. Cash 1987account 1980

Balance c/d 37 Balance c/d 852082 2082

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

Balance b/d 38 Balance b/d 58Bank 270 Cost of prizes given to

income and expenditureaccount (Bal. Fig) 272

Balance c/d 68 Balances c/d 46

376 376

Balance b/d 46 Balance b/d 68

North East Rotary ClubIncome 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)

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North East Rotary ClubBalance sheet as at 31 December 20X1

Non current assets Cost Dep. N.B.V.Equipment 1420 640 780

Current assetsInventory of prizes 46Subscriptions in arrears 85

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Total assets 911

Financed by: K

Accumulated fund at 1 January 20X1 1220Less deficit (427)

793Current liabilitiesPayables for prizes 68Subscriptions paid in advance 37Bank 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.

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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 140,000Equipment 18,000Profits from raffles 6,000Accumulated fund 40,000Bar inventory 1 January 20X4 9,000General expenses 31,500Wages of bar workers 30,000Subscription received 190,000Bar purchases 40,000Caretakers wages 20,400Bar sales 90,000Cash in hand 900Cricket professional’s salary 36,200

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326,000 326,000

The following additional information is also available.

(i) The inventory in the bar at 31 December 20X4 was valued at K5,600(ii) Depreciation on equipment should be at 131/3%.(iii) All sales and purchases for the bar were on cash basis.(iv) As at 31 December 20X4 some members had paid subscriptions in advance

amounting to K1,800 and some members were owing K700.

Required:

Prepare income and expenditure account for the year ended 31 December 20X4 and a balance sheet as at that date.

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SOLUTIONS TO ACTIVITY QUESTIONS

Activity 1Subscriptions account

Dr. Cr.

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

Income & Expenditure Subscriptions written off 40Account (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 KBalance b/f 70 Bank 1,620

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

1,620 1,620Balance b/d 50

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4. The correct answer is C.

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

LiabilitiesBar payables 1,100Wages owing 250Prepaid subscriptions 350

(1,700)Accumulated fund 19,500

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

K KBar sales 90,000Cost 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 46,600Less: wages of bar workers (30,000)

Net profit 16,600

Up Hill Cricket ClubIncome 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 6,000 211,500Expenditure General expenses 31,500 Care takers wages 20,400 Salary for professionals 36,200 Depreciation: equipment 2,400

(90,500)

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Surplus 121,000

Up Hill Cricket ClubBalance sheet as at 31 December 20X4

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

158,000 2,400 155,600

Current AssetsBar inventory 5,600Subscriptions in arrears 700Cash in hand 900

7,200 162,800

Financed by:

Accumulated fund @ start 40,000Add: Surplus 121,000

161,000

Current liabilitiesSubscriptions in advance 1,800

162,800

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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 bookkeeping2. Incomplete records3. 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.

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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 20042. Profit for the year ended 30 July 20053. A list of assets and liabilities as at 30 June 2005

RECEIPTS AND PAYMENTSK 000 K 000

Cash receiptsCommision received 3 700Trade Receivable 12 500Cash sales 4 200

20 400Cash Payments

Electricity 1 580Rent and Rates 3 640Drawings 1 200Cash banked 6 000

(12 420)Excess of receipts over payments 7 980Add: Opening Balance 3 000Closing Balance 10 980

Summary of transactions through the bankK 000 K 000

RECEIPTS

Cash banked 6 000Trade Receivables 42 870

48 870PAYMENTS

Equipment 5 520Insurance 909Trade Payable 34 000Loan Interest 700Wages & Salaries 8 300Stationery 2 700

(52 129)Excess of payments over receipts (3 259)Add: Opening Balance (1 300)Closing Balance 4 559

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The following additional notes were extracted from Joel’s correspondence box files:

As at As at 1 July 2004 30 June 2005 K 000 K 000

Equipment 8 200 12 500Inventory 3 200 4 500Bank loan 10 000 10 000Rates due 420 -Rent prepaid - 380Electricity owing 300 320Trade receivables 6 300 8 400Trade 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

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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 000Balance b/d 6 300 Bank 42 870Sales 59 045 Sales Returns 450

Cash 12 500Discount All 800Bad Debts 325Balance c/d 8 400

65 345 65 345Balance b/d 8 400

TRADE PAYABLES

K 000 K 000Balance b/d 3 800Purchases 34 800

Bank 34 000

Balance c/d 4 600 38 600 38 600

Balance b/d 4 600

EQUIPMENT

K 000 K 000Balance b/d 8 200 P/L -Deprec 1 220Bank 5 520

Balance c/d 12 500 13 720 13 720

Balance b/d 12 500

LOAN

K 000 K 000Balance b/d 10 000

Balance c/d 10 000 10 000 10 000

Balance b/d 10 000

CAPITAL

K 000 K 000Balance b/d 4 880

Balance c/d 4 880 4 880 4 880

Balance b/d 4 880

INVENTORY

K 000 K 000Balance b/d 3 200

Trading c/d 3 200 3 200 3 200

PURCHASES

K 000 K 000Trade Payables 34 800

Trading c/d 34 800

280

38 400 38 400

SALES RETURNS

K 000 K 000Trade Receivable 450

Trading c/d 450 450 450

SALES

K 000 K 000Cash 4 200Trade Receivables 59 045

Trading c/d 63 245 63 245 63 245

BAD DEBTS

K 000 K 000Balance b/d 325

P/L c/d 325 325 325

DISCOUNT ALLOWED

K 000 K 000Trade Receivables 800

P/L c/d 800 800 800

DEPRECIATION

K 000 K 000Equipment 1 220

P/L c/d 1 220 1 220 1 220

STATIONERY

K 000 K 000Bank 2 700

P/L c/d 2 700 2 700 2 700

WAGES & SALARIES

K 000 K 000Bank 8 300

P/L c/d 8 300 8 300 8 300

LOAN INTEREST

K 000 K 000Bank 700 P/L c/d 1 200Balance c/d 500


INSURANCE

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K 000 K 000Bank 909

P/L c/d 909 909 909

RENT & RATES


Bank 3 640 P/L c/d 2 840Balance c/d 380

3 640 3 640Balance b/d 380

ELECTRICITY


Bank 1 580 P/L c/d 1 600Balance c/d 320

1 900 1 900Balance b/d 320

DRAWINGS

K 000 K 000Bank 1 200

Capital c/d 1 200 1 200 1 200

COMMISSION

K 000 K 000Bank 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 000Inventory b/d 3 200Purchases 34 800 Trading (I/S) 33 500

Inventory c/d 4 500 38 000 38 000

Inventory b/d 4 500COMMENTS

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:

ELECTRICITYAmount paid 1 580Add: Amount owing at end 320 Incurred but not yet paid for

1 900Less: Amounts owing at start 300 settled now but incurred last yearProfit & Loss charge 1 600 Incurred for this year only

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RENT & RATESCash paid 3 640Less: Amount owing at start 420 settled now but incurred last year

3 220Less: Amounts prepaid at end 380 Not incurred but paid forProfit & 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 MUTALEINCOME STATEMENT for the year ended 30 June 2005

K000 K000Sales (less Sales Returns) 62 795Less: Cost of Sales 33 500Gross Profit 29 295

Add: IncomeCommission received 3 700

32 995Less: Expenses

Bad Debts 325Discount Allowed 800Depreciation 1 220Electricity 1 600Rent & Rates 2 840Insurance 909Loan Interest 1 200Wages & Salaries 8 300Stationery 2 700

19 894Net Profit 13 101

Joel MutaleBALANCE SHEET as at 30 June 2005

Km Km

Non current Assets:Equipment 12 500

Current Assets:Inventory 4 500Trade receivables 8 400Rent & Rates 380Cash at bank & in hand 10 980

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24 260Total assets 36 760

Capital Balance at start 4 880Add: Net Profit 13 101

Less: Drawings 1 20016 781

Non current Liabilities:Loan 10 000

Current Liabilities:Trade Payables 4 600Loan Interest 500Electricity 320Bank Overdraft 4 559

9 97936 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.

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.

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EXERCISE

Mpomwa has been trading for the last five years. He has been using the front half of the house he has rented as a shop, with the consent of the landlord. Mpomwa maintains no formal accounting system for the purpose of recording business transactions. He, however, needs to calculate the profit earned during the year 2006 for tax purposes.

The following is a summary of Mpomwa’s business bank account:

RECEIPTS: K000Cash from customers 48 120Sales of private motor car 650Total 48 770

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PAYMENTS:Cash paid to suppliers 32 890Rent of entire premises 2 400Wages of part-time staff 760New counter and shelving 800General expenses 3 650Drawings 5 870Total 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

SOLUTION TO EXERCISE

MPOMWAStatement of affairs as at 1 January 2006

K000Assets: Fixtures 2 500 Inventory 1 950 Trade receivable 170 Bank 620

5 240 Liabilities: Trade payables 960Capital 4 280

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CAPITAL

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

Balance c/d 4 930 4 930 4 930

Balance b/d 4 930

CASH

K 000 K 000Wages 350

Trade receivable 48 580 General Expenses 110Bank 48 120Balance c/d

48 580 48 580Balance b/d

TRADE RECEIVABLES

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

Balance c/d 210 48 580 48 580

Balance b/d 210

TRADE PAYABLES

K 000 K 000Balance b/d 960Purchases 33 200

Bank 32 890

Balance c/d 1 270 34 160 34 160

Balance b/d 1 270

FIXTURE S

K 000 K 000Balance b/d 2 500Bank 800

Balance c/d 3 300 3 300 3 300

Balance b/d 3 300

GENERAL EXPENSES

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

3 760 3 760

RENT

K 000 K 000Drawings 1 200

Bank 2 400 P/L c/d 1 200

3 640 3 640

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WAGES

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

1 110 1 110

DRAWINGS

K 000 K 000Bank 5 870Rent 1 200Inventory 320

Capital c/d 7 390 7 390 7 390

MPOMWAINCOME STATEMENT for the year ended 31 December 2006

K000 K000Sales (less Sales Returns) 48 620Less: Cost of Sales 32 270Gross Profit 16 350Less: Expenses

Rent 1 200Wages 1 110General expenses 3 760Depreciation 330

6 400Net Profit 9 950

MPOMWABALANCE SHEET as at 31 December 2006

K000 K000

Non current Assets: Fixtures 3 300 Less: Accumulated depreciation 330

3 970Current Assets:Inventory 2 560Trade receivables 210Bank(620+48 770-46 370) 3 020


Capital Balance at start 4 930Add: Net Profit 9 950

14 880Less: Drawings 7 390

7 490Non current Liabilities:None

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Current Liabilities:Trade Payable 210

210 8 760

Working:

Cost of sales is calculated as follows:Inventory at start 1 950Purchases 33 200

35 150Less: Inventory at end 2 560

Drawings 320 2 88032 270

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 statements2. Contents of the cashflow statement

289

3. Methods of preparing cashflow statements4. How to prepare the cashflow statements5. 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.

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.

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FORMATS OF CASHFLOW STATEMENTS

Cash flows are classified under three major headings in the cashflow statements: operating activities, investing activities and financing activities. The format below outline the contents of a cash flow statement as required by IAS 7.

Under the direct method cashflow figures are obtained from the ledger accounts for trade receivables, trade payables and expenses. Depending on the information provided there might be need to adjust the cashflow figure with amounts for non cash items such as depreciation and increases/decreases in allowances for bad debts.

ABC LtdCASHFLOW STATEMENT (DIRECT METHOD)for the year ended 31 December 2005

K000 K 000Cashflow from Operating Activities:

Receipts from customers XPayments to suppliers XPayments for expenses X

XAdjustments for Non-cash items:

Depreciation XLoss on sale of non current assets XDecrease in provisions for bad debts X

XNet cashflow from Operating profit X

Interest paid XIncome tax XDividends paid XNet cash from operating activities X

Cashflow from Investing Activities:Purchase of non current assets X

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Disposal of non current assets XInterest received XDividend received XShort term investments XNet cash used in investing activities XCashflow before financing X

Cashflow from Financing Activities:Issue of Share Capital XShare Premium XIssue of debentures (or Loan stock) XFinance Leases XNet cash used in financing X

Increase/decrease in cash and cash equivalents X

There are two methods of preparing cashflow statements: The direct method and the indirect method. The difference between the two methods lies in the way cashflow from operating activities is calculated.

ABC LtdCASHFLOW STATEMENT (INDIRECT METHOD)for the year ended 31 December 2005

K000 K 000Cashflow from Operating Activities:

Profit before tax XAdjustments for Non-cash items:

Depreciation XLoss on sale of non current assets XDecrease in provisions for bad debts X

XChanges in working capital:

Decrease in inventory XIncrease in debtors XIncrease in creditors X

XNet cashflow from operating profit XInterest paid XIncome tax paid XDividends paid XNet cash from operating activities X

Cashflow from Investing Activities:Purchase of non current assets X

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Disposal of non current assets XShort term investments XInterest received XDividend received XNet cash used in investing activities XCashflow before financing X

Cashflow from Financing Activities:Issue of Share Capital XShare Premium XIssue of debentures (or Loan stock) XFinance Leases XNet cash used in financing X

Net increase/decrease in cash and cash equivalents XCash and cash equivalents b/f XCash and cash equivalents c/f X

Under the indirect method operating activities is adjusted from the accruals figure to a pure cashflow amount with non-cash items and movements in working capital. The rest of the cashflow statement is prepared as is done under the direct method. You should be able to obtain cashflow figures from the appropriate accounts by applying knowledge acquired in previous chapters. The cashflow figure is the entry that goes to the account from either the cash account of bank account.

We now use a question to illustrate how to prepare the cash flow statement.

ILLUSTRATION

The balance sheets of Prenodia Plc as at 30 June 2004 and 2005 and the summary income Statement for the year ended 30 June 2005 were as follows:

Balance sheet as at 30 June

2004 2005Km Km Km Km

Non current Assets:Premises 130 130Less: Accumulated Depreciation 30 32

100 98Plant & Machinery 70 80Less: Accumulated Depreciation 17 23

53 57

Current Assets:Inventory 25 24Trade receivables 16 26Short term investments - 12Cash at bank & in hand - 7

41 69

293

Total assets 194 224

Share Capital 100 100Profits & loss reserve 36 40

136 140

Non current Liabilities:10% Debentures 20 40

Current Liabilities:Trade Payables 19 22Income Tax 7 8Proposed dividend 12 14

38 44 194 224

PrenodiaIncome Statement for the year ended 30 June 2005

Km Km

Sales 173Less: Cost of Sales 96Gross Profit 77Less: Expenses

Sundry expenses 24Interest payable 2Loss on sale of non current assets 1Depreciation –Premises 2Depreciation –Plant 16

45Operating profit 32Interest receivable 2Profit before tax 34Income Tax (16)Profit after tax 18Proposed dividend (14)Retained profit for the year 4

ADDITIONAL INFORMATION

294

During the year a machine costing K15 was sold for K 4m. Depreciation on the machine had accumulated to K10m.

REQUIRED

Prepare a cashflow statement for Prenodia Plc for the year ended 30 June 2005

SOLUTION

The following part of the cashflow statement can be done as a working in the notes to the statement or it can be included on the main Cashflow Statement.

Direct methodCash flow from Operating Activities:

Km KmReceipts from customers 163Payments to suppliers (92)Payments for expenses (45)

26Adjustments for Non-cash items:

Depreciation 18Loss on sale of non current assets 1Interest payable (Has its own entry ) 2

21Net cash flow from Operating profit 47

Indirect method Km KmCash flow from Operating Activities:

Profit before tax 34Interest payable (Has its own entry on the statement) 2

295

Interest receivable (Has its own entry on the statement) (2)Adjustments for Non-cash items:

Depreciation (2 + 16) 18Loss on sale of non current assets 1Decrease in provisions for bad debts -

19Movements in working capital:

Decrease in inventory 1Increase in trade receivables (10)Increase in trade payables 3

(6)Net cash flow from operating profit 47

Net cash flow from operating profit has been calculated in different ways under the two methods. Under the direct method the figure of expenses was obtained straight from the Income Statement and so it is a figure after deducting depreciation and loss on disposal. Consequently it was necessary to adjust for these non-cash items. Otherwise they would not have been added back to net profit.

Under the indirect method interest was adjusted for because it is dealt with separately on the face of the Cash flow Statement. This reversal was not necessary for interest receivable under the direct method because it was not part of the expenses figure mentioned above.

The rest of the cashflow statement is completed in the same way under both methods as follows:

CASHFLOW STATEMENT (INDIRECT METHOD)for the year ended 31 December 2005

Km K m

Cash flow from Operating Activities:Profit after tax 34Interest payable 2Interest receivable (2)Adjustments for Non-cash items:

Depreciation (2 + 16) 18Loss on sale of non current assets 1Decrease in provisions for bad debts -


Decrease in inventory 1Increase in trade receivables (10)Increase in trade payables 3

(6)Net cash flow from operating profit 47Interest received 2Interest paid (2)Income tax paid (15)Dividends paid (12)Net cash from operating activities 20

296

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

Cashflow from Financing Activities:Issue of Share Capital -Share Premium -Issue of debentures (or Loan stock) 20Net 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 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 163Sales 173 Balance c/d 26

189 189 Balance b/d 26

INVENTORY (Cost of Sales)

Balance B/d 25 Trading (IS) 96Purchases 95 Balance c/d 24


PURCHASES

Inventory 95Trade Payables 95 Balance c/d 0

95 95

TRADE PAYABLES

297

Balance B/d 19Bank 92 Purchases 95Balance c/d 22

114 114 Balance b/d 22

DIVIDEND

Balance B/d 12Bank 12 IS 14Balance c/d 14

26 26Balance b/d 14

TAXATION

Balance B/d 7Bank 15 Income statement 16Balance c/d 8

23 23Balance b/d 8

PLANT & MACHINERY

Balance B/d 70 Disposal 15Bank 25 Balance c/d 80

95 95Balance b/d 80

ACCUMULATED DEPRECIATION

Disposal 10 Balance b/d 17Balance B/d 23 IS- 16

33 33Balance b/d 23

P & M DISPOSAL

Plant & Machinery 15 Accumul Depreciation 10Bank 4

0 IS-Profit & Loss 115 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.

298

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)

EXERCISES

QUESTION ONEThe 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 LTDBALANCE SHEET AS AT 30 JUNE

2006 2005K000 K000 K000 K000

Non current assets: Property, plant & equip 2 800 2 100 Accumulated depreciation (650) (490)

2 150 1 610

Current assets: Inventory 1 100 850 Trade receivables 540 470

Bank 120 -1 760 1 320

Total assets 3 910 2 930

Equity and liabilities:Ordinary share capita l 2 200 1 600Share premium 260 -Retained earnings 400 865

2 860 2 465

299

Non current liabilities: Loan notes 340 140

Current liabilities: Trade payables 430 110 Bank overdraft - 45 Taxation 280 170

710 3253 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).

QUESTION TWO

KONKOLAINCOME STATEMENT for the year ended 31 March 2007

K000 K000Revenue 2,150Cost of sales (1,250)Gross profit 900Distribution cost 98Administration expenses 122

(220)Operating profit 680Profit on disposal of non current assets 12Dividend received 14Interest paid (36)

(10)Profit before tax 670Taxation (132)Profit after tax 538

STATEMENT OF CHANGES IN EQUITYSHARE SHARE RETAINEDCAPITAL PREMIUM PROFIT K000 K000 K000

Balances at start (31/03/06) 1,100 260 80

300

Issues of shares 300 60Profit for year 538Dividend (98)Balance at end 31 March 2007 1,400 320 520

KONKOLABALANCE SHEET AS AT 31 JUNE

2006 2007K000 K000 K000 K000

Non current assets: Furniture & Fittings 750 930 Accumulated depreciation (210) (265)

540 665

Motor Vehicles at cost 780 885 Accumulated depreciation (305) (350)

475 535Investments at cost 90 170

1,105 1,370Current assets: Inventory 615 456 Trade receivables 574 792

Bank (14) 4521 175 1,700

Total assets 2,280 3,070

Equity and liabilities:Ordinary share capital 1,100 1 400Share premium 260 320Retained earnings 80 520

301

1,440 2,240Non current liabilities: Loan notes 160 60Current liabilities: Trade payables 540 565 Proposed dividend 35 80 Taxation 105 125

680 7702,280 3,070

Additional information for the year to 31 March 2007:

a) Vehicles which had cost K145 000 were sold during the year when their net book value was K 55,000.

b) There were no accruals or prepaid expenses at the end of the year.

REQUIRED:

a. Prepare a cashflow statement for Konkola for the year ended 31 March 2007 using the DIRECT method. Show any additional notes and reconciliation required.

b. Explain briefly the usefulness of cashflow statements to external users


SOLUTION ONE

CASHFLOW STATEMENT (INDIRECT METHOD)for the year ended 30 June 2006

K000 K 000Cash flow from Operating Activities:

Loss after tax (88)Adjustments for Non-cash items:

Depreciation 220Loss on sale of non current assets (75)Decrease in provisions for bad debts -


Increase in inventory (250)Increase in trade receivables (70)Increase in trade payables 320

(00)Net cash flow from operating profit 57Interest paid (37)Income tax paid (230)Net cash from operating activities (210)

Cash flow from Investing Activities:Purchase of machinery (895)

302

Disposal of machinery 210Interest received (00)Net cash used in investing activities (685)Cash flow before financing (895)

Cash flow from Financing Activities:Issue of Share Capital 600Share Premium 260Loan notes 200Net cash used in financing 1060


Proof: K000 K000Balance of cash /bank at start (overdraft) (45)Increase in cash (from cashflow statement) 165Balance of cash/bank at end 30 June 2006 120

Workings:Calculation of operating profit:Retained profit at end –30 June 2006 400Retained profit at end –30 June 2005 865Loss for the year 2006 (465)Add: Dividend -

Taxation 340Interest charge 37

Operating loss (88)

Relevant Ledger accounts:

PROPERTY, PLANT & EQUIPMENT


2995 2995Balance b/d 2800

ACCUMULATED DEPRECIATION

Disposal 60 Balance b/d 490Balance B/d 650 IS-Depreciation 220


P P & EQUIP DISPOSAL

303

Property, Plant, etc 195 Accumul. Depreciation 60Bank 210

IS-Profit & Loss 75 000270 270

TAXATION

Balance B/d 170Bank 230 Income Statement 340Balance c/d 280 000


Note: Cost of plant sold is NBV + Depreciation, and the amount of tax charged to the income statement of a balancing figure on the Income tax account.

SOLUTION TWO

Direct method

Cash flow from Operating Activities:K000 K000

Receipts from customers 1,932Payments to suppliers (1066)Payments for expenses (220)

646Adjustments for Non-cash items:

Depreciation -Furniture 55Depreciation –Motor Vehicles 135

190Net cash flow from Operating profit 836

TRADE RECEIVABLES

Balance B/d 574 Bank 1,932Sales 2,150 Balance c/d 792

2,724 2,724Balance b/d 792

INVENTORY (Cost of Sales)

Balance B/d 615 Trading (IS) 1,250Purchases 1,091 Balance c/d 456

1,701 1,701Balance b/d 456

304

PURCHASES

Inventory 1,091Trade Payables 1,091 0000

1,091 1,091

TRADE PAYABLES

Balance B/d 540Bank 1,066 Purchases 1,091Balance c/d 565 0000

1,631 1,631Balance b/d 565

DIVIDEND

Balance B/d 35Bank 53 IS 98Balance c/d 80


TAXATION

Balance B/d 105Bank 112 Income statement 132Balance c/d 125


MOTOR VEHICLE


1,030 1,030Balance b/d 885

ACCUMULATED DEPRECIATION -MV

Disposal 90 Balance b/d 305Balance B/d 350 IS- 135


P & M DISPOSAL -MV

Plant & Machinery 145 Accumul Depreciation 90Bank 67

IS-Profit 12 000 157 157

FURNITURE & FITTINGS

Balance B/d 750Bank 180 Balance c/d 930


ACCUMULATED DEPRECIATION -FF

Balance b/d 210Balance B/d 265 IS- Depreciat 55


305

KONKOLACASHFLOW STATEMENT For the year ended 31 March 2007

K000 K000Cashflow from Operating Activities:

Net cash flow from operating profit(W1) 836Interest paid (36)Income tax paid (112)Dividends paid (53)Net cash from operating activities 635

Cashflow from Investing Activities:Purchase of furniture (180)Purchase of motor vehicle (250)Disposal of motor vehicle 67Purchase investments (80)Net cash used in investing activities (429)Cashflow before financing 206

Cashflow from Financing Activities:Issue of Share Capital 300Share Premium 60Loan notes (100)Net cash from financing 260


Proof: K000 K000Balance of cash /bank at start (overdraft) (14)Increase in cash (from cashflow statement) 466Balance of cash/bank at end 31 March 2007 452

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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 finance2. Classes of shares3. Debentures4. Issue of shares5. Share capital structure6. 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.

307

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 financeGenerally, 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 CapitalThe ownership of a company is through shares. Share capital represents part of the capital invested in the company by its shareholders but may also represent past reserves of the company, which have been capitalised by an issue of the shares.

A company may issue different classes of shares, the most common are being the following:

a) Ordinary sharesThese 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 sharesThese 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 SharesA 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

308

Dr - Cash book Cr - Share capital account

For example, suppose 100 000 ordinary shares of K1 each are issued at nominal value. The ledger accounts recording this issue will be as shown below:

Bank account ___________________________________________________________________

K'000 K'000 Ordinary share capital 100

Ordinary share capital account ___________________________________________________________________

K'000 K'000 Bank 100

b) Shares issued at a premium

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

309

26.4.1 Bonus issueA 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 - ReservesCr - Share capital, with the amount of bonus issue

26.4.2 Rights issueA rights issue represents the offer of shares to existing shareholders in proportion to their existing holdings at a stated price. Unlike the bonus issue, the shareholders do not have to take up their offer and have the alternative of selling their rights on the stock market.

The double entry for recording a rights issue is:

Dr - Cash bookCr - Share capital, with nominal valueCr - 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.

310

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 capitalb) Issued share capital c) Called up share capitald) Paid up share capitale) Calls in arrears

26.6 Financial statements for companiesThe 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 statementThe 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:

311

For the interim dividendDr - Dividend accountCr - Cash book

For the final dividendDr - Profit and loss accountCr - 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 reserveb) Revenue reserve

Capital reserves (also known as statutory reserves) are established by law. They include share premium, Capital Redemption Reserve and Revaluation Reserve. Capital reserves can not be distributed to shareholders as dividends. The share premium account, which arises on issue of shares, as shown under issue of shares above can be used for the following purposes:

- financing the issue of fully paid bonus shares- writing off preliminary expenses on the formation of a company- writing off expenses, commission or discount on share or debenture issue- providing the premium on the redemption of debentures and on redeemable of

shares

Revenue reserves arise when a company makes profits and does not pay out all the profits to the shareholders. There is no statutory requirement for a company to have any amount in its revenue reserve. Revenue reserves can be used for any purpose by the company. However, where profits are transferred to a named reserve, the directors are indicating that these amounts are not available to support a dividend payment (although there is nothing in law to prevent their distribution). Revenue reserves include, fixed assets replacement reserve, general reserve, profit and loss account (reserve) etc.

ii) The balance sheetThe 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

312

K'000 K'000 Ordinary share capital (K1 000 shares) 400 000

10% preference share capital (K1 000 shares) 120 000Freehold Premises at cost 920 000

Provision for depreciation - buildings 400 000Plant and machinery (cost K300 million) 180 000Sales 364 000Purchases 196 000

Carriage inwards 4 000Receivables and Payables 64 000 8 000

Cash at bank 60 000 Inventory at 1st January 2006 40 000 Discounts 1 600 800

Carriage outwards 3 200 10% debentures 2010 200 000

Debenture interest paid 20 000 Administrative expenses 16 000 Staff salaries (excluding directors) 16 000 Preference dividend paid 4 000 Profit and loss account b/d 32 000

1 524 800 1 524 800

Adjustments are required for:1. Inventory at 31st December 2004, at cost K60 000 000.2. Directors' salaries not yet paid K20 000 000.3. Income tax for the year K8 600 000.4. Proposed ordinary dividend K10 per share.5. Depreciation on buildings for the year K18 400 000 and plant and machinery is to be

depreciated at 10% on cost.6. Accrued audit fee K4 000 000.7. Creation of a plant replacement reserve of K4 000 000.

You are required to prepare the Income Statement for the year ended 31st December 2006 and a Balance Sheet as at that date.

SOLUTIONHightech LtdIncome statement for the year ended 31st December 2006

K’000 K’000Sales revenue 364 000Opening inventory 40 000Purchases 196 000Carriage inwards 4 000

240 000Less: closing inventory 60 000Cost of sales 180 000Gross profit 184 000Add Gains:Discount received 800 Total income 184 800

313

Less Expenses: Discount allowed 1 600 Carriage outwards 3 200 Administrative expenses 16 000 Staff salaries 16 000 Directors' salaries accrued 20 000 Audit fee accrued 4 000 Depreciation: - buildings 18 400

- Plant and machinery 30 000 Debenture interest 20 000 Total expenses 129 200Net profit before tax 55 600Less: Income tax 8 600Net profit after tax 47 000Transfer to plant replacement reserve 4 000Dividends: - Preference (paid) 4 000

- Preference (proposed) 8 000 - Ordinary (proposed) 4 000

20 000Retained profit for the year 27 000Retained earnings b/d 32 000Retained earnings c/d 59 000Hightech LtdBalance sheet as at 31st December 2006

Cost Dep. ValueNon current assets: K’000 K’000 K’000 Freehold land and buildings 920 000 418 400 501 600 Plant and machinery 300 000 150 000 150 000

1 220 000 598 400 651 600Current assets: Inventory 60 000 Receivables 64 000 Cash at bank 60 000 184 000Total assets 835 600

Capital and reserves: Ordinary share capital 400 000 10% preference share capital 120 000 Plant replacement reserve 4 000 Accumulated profit 59 000

583 000Non-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

314

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.

EXERCISES

QUESTION ONEYou 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 000Plant 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 000Administrative 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.

315

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.

QUESTION TWOThe following Trial Balance was extracted from the books of Hillside Plc at 31st March 2006:

K’000 K’000K1 000 ordinary shares 200 0008% K1 000 preference shares 70 0007% debentures 100 000Land and buildings: cost 130 000Accumulated depreciation on buildings on 1st April 2005 30 000Plant and machinery (K348 million cost) 262 500Motor vans at cost 140 000Accumulated depreciation on vans on 1st April 2005 56 800Profit and loss account b/f 20 000Share premium account 60 200Inventory at 1st April 2005 35 000Sales 344 600Trade Receivables and Payables 45 000 27 000Bank 5 800Purchases 166 100Distribution costs 18 000General administration expenses 44 900Debenture interest 7 000Interim dividends: Ordinary 10 000 Preference 2 800Allowance for doubtful debts 1 500

890 100 890 100

Additional information available:

316

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 costPlant and machinery 10% on cost

5. On 31st March 2006 the company issued bonus shares to the ordinary shareholders on a one (1) to ten (10) basis. No entry relating to this has yet been made in the books.

6. Inventory at 31st March 2006 was valued at K51 million.

7. A bill for administrative expenses for K150 000 was unsettled as at 31st March 2006.

8. Distribution costs include an insurance premium for delivery vans of K200 000 which relates to the period 1st July 2005 to 30th June 2006.

9. The allowance for doubtful debts is to be 21/2% of receivables outstanding on 31st March 2006.

10. The directors wish to provide for:a) A final ordinary dividend of 5%b) A final preference dividend.

11. Income tax for the year is estimated at K18 million.

Required:

a) Using additional information (1) and (2), prepare the following ledger accounts:

i) Motor van account ii) Motor van accumulated depreciation account iii) Motor van disposal account

(7 marks)b) Prepare the company’s Income Statement for the year ended 31st March 2006.

(11 marks)c) Prepare the company’s Balance Sheet as at 31st March 2006.

(14 marks)

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(NATech: December 2006)


SOLUTION ONE

MK LtdIncome statement for the year ended 31st March 2007

K’000 K’000Sales revenue 2 000 000Opening inventory 180 000Purchases 1 542 000

1 722 000Less: closing inventory 122 000Cost of sales 1 600 000Gross profit 400 000Less Expenses: Administrative expenses 200 000 Increase in allowance for doubtful debts 1 200 Debenture interest accrued (9% x 150 000) 13 500 Depreciation on Plant and machinery 61 600 Total expenses 276 300Net profit before tax 123 700Less: Income tax 62 400Net profit after tax 61 300Dividends: - interim 6 000

- proposed 24 000 30 000

Retained profit for the year 31 300Retained earnings b/d 90 000Retained earnings c/d 121 300

318

MK LtdBalance sheet as at 31st March 2007

Cost Dep. ValueNon current assets: K’000 K’000 K’000 Plant and machinery 616 000 231 600 384 400

Current assets: Inventory 122 000 Receivables (104 000 – 5 200) 98 800 Cash at bank 82 000 302 800Total assets 687 200

Capital and reserves: Ordinary share capital 200 000 Share premium account 4 000 Accumulated profit 121 300

361 300Non-current liabilities 9% debentures 2009 150 000

Current liabilities Payables 76 000 Taxation 62 400 Dividends payable 24 000 Accruals 13 500

175 900Total Equity and liabilities 687 200

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SOLUTION TWO

a) i) Motor Van AccountK’000 K’000

Balance b/d 140 000 Disposal 16 000Payable 24 000 Balance c/d 148 000

164 000 164 000

ii) Motor Van Accumulated Depreciation AccountK’000 K’000

Disposal (16 000 x 20% x 4) 12 800 Balance b/d 56 800Balance c/d 73 600 I. S. (148 000 x 20%) 29 600

86 400 86 400

iii) Motor Van Disposal AccountK’000 K’000

Motor van 16 000 Accumulated dep. 12 800Income statement (bal. fig.) 3 400 Disposal proceeds 6 600

19 400 19 400b) Hillside Plc

Income statement for the year ended 31st March 2006. K’000 K’000

Sales revenue 344 600Opening inventory 35 000Purchases 166 100

201 100Less: closing inventory 51 000Cost of sales 150 100Gross profit 194 500Add: Gains:Profit on disposal 3 400Decrease in allowance for doubtful debts 300

3 700Total income 198 200Less: expenses: Distribution costs (18 000 – 50) 17 950 General administration expenses (44 900 + 150) 45 050 Debenture interest 7 000 Depreciation: - Buildings 2 000

- Plant and machinery 34 800 - Motor van 29 600

136 400Profit before taxation 61 800Less: Income tax 18 000Profit after taxation 43 800Less: appropriations:Dividends: interim – ordinary 10 000

- preference 2 800

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Proposed – ordinary (5% x 220 000) 11 000 - preference 2 800

26 600Retained profit for the year 17 200Retained earnings brought forward (20 000)Retained earnings carried forward (2 800)

c) Hillside Plc Balance Sheet as at 31st March 2006.

COST DEP. NBVNon-current Assets: K’000 K’000 K’000Land and buildings 130 000 32 000 98 000Plant and machinery 348 000 120 300 227 700Motor van 148 000 73 600 74 400

626 000 225 700 400 100Current Assets:Inventory 51 000Trade receivables 48 000Less: allowance for doubtful debts 1 200

46 800Receivable for the motor van 6 600Bank 5 800Prepayment 50


Capital and reserves:Ordinary share capital (200 000 + 20 000) 220 0008% preference share capital 70 000Share premium account (60 200 – 20 000) 40 200Accumulated profit (2 800)

327 400Non-current liabilities:7% debentures 100 000

Current liabilities:

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Trade payables 10 000Creditor for the motor van 24 000Taxation 18 000Dividends payable - preference 2 800

- ordinary 11 000Accrual 150

82 950Total Equity and liabilities 510 350

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 Concepts2. Accounting concepts and conventions3. 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

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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 there’s a choice of treatment, how to decide which treatment to use.

- National legal requirements

- National accounting standards

27.3 THE CONCEPTS

The International Accounting Standards (IAS) 1 – Preparation of Financial Statements lists a number of accounting principles and conventions that must be followed when preparing financial statements. The major accounting concepts that must be followed are:

a) Fair Presentationb) Going Concernc) Accrualsd) 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

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items should be treated using different methods, the method chosen should be used consistently from one year to the next so that reasonable conclusions can be made on the performance of the business, for example Depreciation, Stock Valuations.

OTHER CONCEPTS

e) Prudence Concept This states that where alternative procedures or alternative valuations, are possible, the one selected should be the one which gives the most cautious presentation of the business financial position or results.

f) The Business Entity Concept This concept states that a business and the owner should be treated separately.

g) Money Measurement Concept This states that accounts should deal only with items to which a monetary value can be attributed.

h) The Separate Valuation Principle This states that in determining the amount to be attributed to an asset or a liability in the balance sheet, each component item of the asset or liability must be valued separately.

i) The Materiality Concept This is judgemental depending on the nature and size of the business.

A matter is material if its omission or misstatement would reasonably influence the decisions of a user of the accounts.

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

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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 SUMMARYThe 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.

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 technique2. Types of Ratios3. Calculation of Ratios4. Interpretation of statements5. Limitation of Ratio analysis

LEARNING OUTCOMES


- Explain the ratio analysis technique- Calculate ratios- interpret the ratios

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- 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 ratios2. Liquidity ratios3. Efficiency ratios4. Solvency ratios5. Investors’ ratios

28.2.1 Profitability Ratios

These ratios tell us whether a business is making profits and if so whether at an acceptable rate.

a) Return on capital employed (ROCE) The ratio tells us what returns management has made on the resources made available to them before making any distributions of these returns. The higher the return the better, especially in high risk businesses. A very low return has a negative impact on internal growth sustenance of a company.

Formula:

ROCE = Profit before interest and tax x 100 Capital employed

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

Given a constant gross profit margin, the operating profit margin tells us about the company’s ability to control the level of its operating costs or overheads. The higher the

operating profit margin, the better. An increasing operating profit margin indicates better control of costs, and a decreasing profit margin indicates worse control of costs or too low selling prices.

Formula:

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Operating profit margin = Profit before interest and tax x 100Sales

ii) Asset turnoverThis measures the company’s 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.

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

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near cash form. The higher the quick ratio, the better for a business. A ratio of less than one would start to send out danger signals on the liquidity of the organisation.

Formula:

Quick ratio = Current assets – Inventory Current liabilities

Note: Higher current and quick ratios are not always good indicators. Sometimes, this may indicate that working capital is inefficiently used. The efficiency ratios below will

highlight this. In other words, such ratios should be within acceptable range, i.e. not too high and not too low.

28.2.3 Efficiency Ratios

These ratios tell us how efficiently the business is employing the resources invested into fixed assets and working capital.

a) Inventory turnover ratio This ratio shows on average how many times in a month the inventory is turned over. 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

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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

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

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performing equipment.

Formula:

Non-current assets turnover = Sales Non-current assets

28.2.4 Solvency or Gearing Ratios

These ratios concentrate on the long-term health of a business, particularly the effect of capital/finance structure on the business i.e. it establishes the relationship between the proportion of Capital Employed that is borrowed and the proportion that is provided by shareholders’ funds. The higher the level of gearing (borrowing) the higher are the risks to a business since the payment of interest and repayment of debts are not ‘optional’ in the same way as dividends. However, gearing can be a financially sound part of a business capital structure particularly if the business has strong, predictable cash flows.

Capital gearing can be calculated in two ways:

a) Total gearing This ratio shows the proportion of the company’s assets which are financial by borrowing and so gives an indication of the amount of further secured borrowings that might be undertaken.

Formula:

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

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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 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

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e) Price Earnings ratio (P/E ratio) The price earnings ratio is the ratio of a company’s current share price to the earnings per share. A high P/E ratio indicates strong shareholder confidence in the company and its future, e.g. in profit growth, and a lower P/E ratio indicates lower confidence.

Formula:

P/E = Current market value Earnings per share

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

Formula:

Earnings yield = Earnings per share x 100 Current market value

28.3 Calculating RatiosCalculating 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 K’000 K’000

Sales revenue 209 000Opening inventory 37 000Purchases 162 000

199 000Closing inventory 42 000

157 000Gross profit 52 000Distribution costs 10 000Administration expenses 13 000Interest 2 000

25 000Net profit 27 000Taxation 10 000Net profit after taxation 17 000Dividends: Ordinary shares 6 000

Preference shares 2 000 8 000

Retained profit for the year 9 000

Balance sheet as at 31st December 2006

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K’000 K’000Non-current assets (net book value) 130 000Current assets: Inventory 42 000 Trade Receivables 29 000 Bank 3 000

74 000Total assets 204 000Capital and reserves: Ordinary share capital (K500 shares) 35 000 8% Preference shares (K1 000 shares) 25 000 Share premium account 17 000 Revaluation reserve 10 000 Accumulated profit 31 000

118 000Non-current liabilities 5% secured loan stock 40 000Current liabilities Trade payables 36 000 Taxation 10 000

46 000204 000

The market value of each ordinary share is K2 040.

From the above details, you are required to calculate the following ratios:

a) Return on capital employed (ROCE)b) Operating profit margin on sales c) Gross profit Margin d) Current ratioe) Quick ratiof) Inventory turnover g) Inventory daysh) Receivables turnover ratioi) Receivables collection periodj) Payables turnover ratiok) Payables credit periodl) Non-current assets turnover ratiom) Total gearing ration) Debt to equity ratioo) Interest Cover p) Dividend per shareq) Dividend coverr) Dividend yields) Earnings per share (EPS)t) Price Earnings ratio (P/E ratio)u) Earnings yield

SOLUTION

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a) Return on capital employed ROCE = Profit before interest and tax x 100

Capital employed

= 27 000 + 2 000 x 100 = 21.8% 133 000

b) Operating profit margin Operating profit margin = Profit before interest and tax x 100

Sales

= 29 000 x 100 = 13.9%209 000

c) Gross profit margin Gross profit margin = Gross profit x 100

Turnover

= 52 000 x 100 = 24.9% 209 000

d) Current ratio Current ratio = Current assets

Current liabilities

= 74 000 = 1.6 times 46 000

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

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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

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

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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

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

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

Example:The following information has been extracted from the published accounts of Gideon Plc.

Extracts from the profit and loss accounts 2004 2003 K’000 K’000

Sales revenue 22 400 19 500Cost of sales 16 920 13 650Net profit before tax 930 640

This is after charging: Depreciation 720 560 Debenture interest 160 120 Audit fees 24 20

Balance sheet as at 31st December 2004 2003 K’000 K’000

Non-current assets 3 700 2 860Current assets: Inventory 1 280 980 Trade receivables 2 460 2 160 Cash 160 240

3 900 3 380

Total assets 7 600 6 240

Capital and reserves: Ordinary share capital 1 600 1 600 Reserves 2 490 1 750

4 090 3 350Long-term liabilities: 10% debentures 1 600 1 200Current liabilities: Bank overdraft 220 160 Trade payables 1 500 1 380 Taxation 190 150

1 910 1 690

Total capital and liabilities 7 600 6 240

The latest industry average ratios are:

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Current ratio 1.90Quick ratio 1.27Receivables turnover 52 days Payables turnover 49 daysInventory 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.

SOLUTION

a)

i) Year 2003 2004

Current ratio 3 380 000/1 690 000 3 900 000/1 910 000

= 2.0 = 2.04

Quick ratio 3 380 000 – 980 000/1 690 0003 900 000 – 1 280 000/1 910 000

= 1.42 = 1.37

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

= 40 days = 40 days

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

= 37 days = 32 days

Stock turnover 13 650 000/980 00016 920 000/1 280 000

= 13.9 times = 13.2 times

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ii) Comments:

Liquidity ratios:

The current ratio has improved slightly over the year and is marginally higher than the industry average.

The ratio is in line with what is generally regarded as satisfactory (2:1)

The quick ratio has declined marginally but is still better than the industry average.

This suggests that Austin Plc has no short term liquidity problems and should have no difficulty in paying its debts as they become due.

Efficiency ratios:

Receivables turnover – receivables as a proportion of sales is unchanged from 2003 and are considerably lower than the industry average.

Consequently, there is probably little opportunity to reduce this further and there may be pressure in the future from customers to increase the period of credit given.

Payables turnover – the period of credit taken from suppliers has fallen from 37 days’ purchases to 32 days’ and is much lower than the industry average.

With this it may be possible to finance any additional receivables by negotiating better credit terms from suppliers.

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 makingd) Ratios are not definitive – they are only a guidee) 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

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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.

EXERCISES

QUESTION ONEThe following are the summarised financial statements for X Ltd for 2005 and 2006:

Summarised income statements 2005 2006 K’000 K’000

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

Summarised balance sheets 2005 2006 K’000 K’000

Non current assets 2 498 6 350Current assets: Inventory 20 073 25 228 Receivables 20 105 21 685 Bank 6 046 2 895Total assets 48 722 56 158

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Capital and reserves: Ordinary share capital of K250 per share 4 960 4 960 Retained earnings 15 410 20 040Non current liabilities: 10% debentures 9 920 9 920Current liabilities: Trade payables 16 302 18 615 Taxation 1 237 1 630 Dividends payable 893 993Total 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 ratioiv) Quick ratiov) Earning per share

vi) Dividend cover

b) Comment briefly on the changes in the ratios calculated in (a) above between the two years.QUESTION TWO

The following ratios were calculated from the financial statements of H Ltd and G Ltd:

H Ltd G LtdProfitability 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

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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. 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

ProfitabilityH 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.

LiquidityG 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.

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EfficiencyH 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.

ConclusionProvided that the two companies are in the same industry and are of the same size, then it can be concluded that H Ltd’s finance performance and position is better than that of G Ltd.

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 account2. Work in progress3. Transfers of goods at market value4. 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.

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- Prepare Manufacturing Account, Income Statement and Balance Sheet for sole traders, partnerships and companies.

30.1 Manufacturing AccountA 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 progressThe goods partly completed at the start and end of the accounting period are respectively known as opening work in progress and closing work in progress. The value of the opening work in progress is added to the total production cost for the period while the value of the closing work in progress is deducted in arriving at the production cost of goods completed.

Example:Joshua Muleya is a manufacturer. His Trial Balance as at 31st December 2006 is as follows:

Dr Cr K’000 K’000

Capital 274 912Drawings 17 120Premises 80 000Machinery 65 000Office equipment 22 000Delivery van expenses 5 000Lighting and heating: Factory 5 718

Office 2 220Manufacturing wages 90 940General expenses: Office 7 632

Factory 11 280Purchases of raw materials 78 108Salesmen commission 15 720Rent: Factory 9 600 Office 4 400Office salaries 12 570Receivables and Payables 56 740 38 900Bank 26 674Sales revenue 273 000Inventory at 1st January 2006: Raw materials 15 130 Finished goods 48 500 Work in progress 10 460 ______

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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.

SOLUTION:

Joshua MuleyaManufacturing account for the year ended 31st December 2006

K’000 K’000Raw materials: Opening inventory 17 130 Purchases 78 108 Total inventory available 95 238 Less: closing inventory 18 100 Cost of raw materials consumed 77 138Direct labour: Wages 90 940Prime cost 168 078Add: production overheads: Lighting and heating 5 718 General expenses 11 280 Rent 9 600 26 598

194 676Add: opening work in progress 10 460

205 136Less: closing work in progress 12 840Production cost 192 296

Joshua Muleya

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Income Statement for the year ended 31st December 2006 K’000 K’000

Sales revenue 273 000Opening inventory 48 500Production cost 192 296

240 796Less: closing inventory 49 560Cost of sales 191 236Gross profit 81 764Less expenses: Administrative expenses 5 000 Lighting and heating 2 220 General expenses 7 632 Rent 4 400 Office salaries 12 570 Salesmen's commission 15 720 Total expenses 47 542Net profit 34 222

Joshua MuleyaBalance sheet as at 31st December 2006

Cost Dep. ValueNon-current assets: K’000 K’000 K’000 Premises 80 000 - 80 000 Machinery 65 000 - 65 000 Office equipment 22 000 - 22 000

167 000 - 167 000Current assets: Inventory: - Raw materials 18 100

- Work in progress 12 840 - Finished goods 49 560

Receivables 56 740 Cash at bank 26 674 163 914Total assets 330 914

Capital and liabilities: Capital 274 912 Add: net profit 34 222 309 134 Less: drawings 17 120

292 014Current liabilities: Payables 38 900Total capital and liabilities 330 914

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30.3 Transfer of goods at market valueIn 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.

Example:

The following information has been extracted from the books of Meleki manufacturing company for the year to 30th September 2006:

K'000Deprecation for the year to 30th September 2006:

Factory equipment 21 000Office equipment 12 000

Direct wages 120 000Factory: insurance 3 000

Heat 45 000 Indirect materials 15 000 Power 60 000 Salaries 75 000

Finished goods at 1st October 2005 72 000Office: electricity 55 000 General expenses 27 000

Postage and telephones 8 700Salaries 210 000

Raw material purchases 600 000Carriage inwards on raw materials 6 000Raw material inventory at 1st October 2005 24 000Advertising 6 000Sales revenue 1 537 200

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Work in progress at 1st October 2005 36 000

Notes:

1. At 30th September 2006, the following were on hand: K'000

Raw materials 30 000Work in progress 27 000Finished goods 90 000

2. At 30th September 2006, there was an accrual for advertising of K3 000 000, and it was estimated that K4 500 000 had been paid in advance for electricity. These items had not been included in the books of account for the year to 30th September 2006.

3. Goods produced during the year are to be transferred to the Income Statement at a market value of K978 000 000.

4. For the purpose of inventory valuation, finished goods have been valued at cost.

Required: Prepare in the vertical columnar form, the company's Manufacturing Account, Income Statement for the year to 30th September 2006.

SOLUTION:

Meleki Manufacturing CompanyManufacturing account for the year ended 30th September 2006

K’000 K’000 K’000Raw materials: Opening inventory 24 000 Purchases 600 000 Add: carriage inwards 6 000 606 000 Total inventory available 630 000 Less: closing inventory 30 000 Cost of raw materials consumed 600 000Direct labour: Wages 120 000Prime cost 720 000Add: 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

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Market value 978 000Less: production cost 948 000Manufacturing profit 30 000

Meleki Manufacturing CompanyIncome Statement for the year ended 30th September 2006

K’000 K’000

Sales revenue 1 537 200Opening inventory 72 000Market value 978 000

1 050 000Less: closing inventory 90 000Cost of sales 960 000Gross profit on trading 577 200Add: profit on manufacturing 30 000

607 700Less expenses: Advertising 6 000 Add: accrual 3 000

9 000 Depreciation - office equipment 12 000 Electricity 45 000 Less: prepayment 4 500

40 500 General expenses 27 000 Postage and telephones 8 700 Salaries 210 000

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Total expenses 307 200Net profit 300 000

30.4 Allowance for unrealised profitIn cases where goods are transferred at market price to the selling department, there may be some of these goods that remain unsold at the end of the year. If the inventory of such goods is valued at the transfer price or market price, then in order to arrive at the true profit, it is necessary to provide in the accounts for unrealised profits included in the valuation of inventories. The allowance for Unrealised Profit Account is opened to account for such profits. This account is prepared in the same manner as the Allowance for doubtful debts Account, i.e. an increase in the account balance is treated as an expense, while a decrease is treated as a gain in the income statement. The balance on the Provision for Unrealised Profit Account is at the end of the year deducted from the closing inventory of finished goods in the Balance Sheet.

Example:

The following balances as at 31st December 2006 have been extracted from the books of Simon Choolwe, a manufacturer:

K'000Inventory at 1st January 2006:


Purchase of raw materials 38 000Direct labour 28 000Factory overheads:

Variable 16 000Fixed 9 000

Administrative expenses:Rent and rates 19 000Heat and light 6 000Stationery and postage 2 000Staff salaries 19 380

Sales revenue 192 000Plant and machinery:

At cost 30 000Provisions for depreciation 12 000

Motor vehicles (for sales deliveries):

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At cost 16 000Provisions for depreciation 4 000

Payables 5 500Receivables 28 000Drawings 11 500Balance at bank (Dr) 16 600Capital at 1st January 2006 48 000Allowance for unrealised profit at 1st January 2006 1 380Motor vehicles running costs 4 500


1. Inventories at 31st December 2006, were as follows: K'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:

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 ChoolweManufacturing account for the year ended 31st December 2006

K’000 K’000Raw materials: Opening inventory 7 000 Purchases 38 000 Total inventory available 45 000 Less: closing inventory 9 000 Cost of raw materials consumed 36 000Direct labour: Wages 28 000 Add: wages accrued 3 000

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31 000Prime cost 67 000Add: factory overheads: Variable 16 000 Fixed 9 000 Depreciation - plant and machinery 3 000 28 000


100 000Less: closing work in progress 8 000Factory cost 92 000

Market value 115 000Less: factory cost 92 000Manufacturing profit 23 000

Simon ChoolweIncome Statement for the year ended 31st December 2006

K’000 K’000 K’000Sales revenue 192 000Opening inventory 6 900Market value 115 000

121 900Less: closing inventory 10 350Cost of sales 111 550Gross profit on trading 80 450Add: profit on manufacturing 23 000

103 450Less expenses: Rent and rates 19 000 Less: prepayment 2 000 17 000 Provision for unrealised profit (w1) 690 Heat and light 6 000 Stationery and postage 2 000 Staff salaries 19 380 Depreciation - motor vehicles 4 000 Motor vehicle running costs 4 500Total expenses 53 570Net profit 49 880

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Balance sheet as at 31st December 2006 Cost Dep. Value

Non current assets: K’000 K’000 K’000 Plant and machinery 30 000 15 000 15 000 Motor vehicles 16 000 8 000 8 000

46 000 23 000 23 000Current 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 880Capital account Balance on 1st January 2006 48 000 Add: net profit 49 880 97 880 Less: drawings 11 500

86 380Current liabilities: Payables 5 500 Direct labour accrued 3 000 8 500

94 880Workings1.

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

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EXERCISES

QUESTION ONEThe following is a trial balance for J Mutinta as at 31st December 2006:

Dr Cr K’000 K’000

Capital 59 360Drawings 4 000Productive machinery (cost K56m) 46 000Accounting machinery (cost K4m) 2 400Royalties 1 400Carriage inwards on raw materials 700Purchases of raw materials 74 000Inventory at 1st January 2006: Raw materials 4 200 Finished goods 7 780 Work in progress 2 700Wages (direct K36m, factory K29m) 65 000General factory expenses 6 200Lighting 1 500Factory power 2 740Administrative salaries 8 800Salesmen's salaries 6 000Commission on sales 2 300

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Rent 2 400Insurance 840General administrative expenses 2 680Bank charges 460Discount allowed 960Carriage outwards 1 180Receivables 28 460Payables 25 000Bank 11 360Cash 300Sales revenue 200 000

284 360 284 360

Notes at 31st December 2004:

1. Inventory of raw materials K4 800 000, Inventory of finished goods K8 000 000, Work In Progress K3 000 000.

2. Lighting, rent and insurance are to be apportioned: factory 5/6ths, administration 1/6th.

3. Depreciation on productive machinery and accounting machinery at 10% per annum on cost.

Required:Prepare the Manufacturing Account, Income Statement for the year ended 31st December 2006 and a Balance sheet as at that date.

QUESTION TWO

The following trial balance was extracted from the books of Panuka Ltd after completion of the manufacturing account for the year ended 31st March 2003.

Dr Cr K’000 K’000

Ordinary share capital 40 0007% preference share capital 20 000Sales revenue 200 000Production cost 106 400Receivables 21 400Payables 10 000Inventory:

Finished goods (1st April 2002) 52 000Raw materials (31st March 2003) 11 000WIP (31st March 2003) 6 200

Premises at cost 35 000Accumulated depreciation on buildings 2 000Plant and machinery at cost 12 000Depreciation on plant and machinery:

Accumulated provision 4 800Charge for the year 1 200

Retained profit (1st April 2002) 27 080

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Bank 8 528Rent 3 500General expenses 3 060Distribution costs 21 316Bad debts 400Administrative salaries 21 615Advertising expenses 5 590Preference divided paid 700Suspense 3 629

308 709 308 709Additional information:

1. Closing inventory of finished goods on 31st March 2003 was valued at K46 600 000.

2. Depreciation on buildings is K400 000.

3. Included in rent paid is a 16 months rental of K1 680 000 payable as from 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:

i) A debit balance of K4 600 000 owing by a customer was omitted in the trial balance.

ii) The total of the discounts received column in the cash book, K120 000, had not been posted to the nominal ledger.

iii) A payment for administrative salaries, K1 323 000, was posted to the general ledger as K1 332 000.

iv) A sales invoice for K8 000 000 had been omitted from the sales account.

v) A cheque issued for general expenses for K50 000 had been posted to the debit of the bank account.

Required:

a) Show the journal entries to correct the errors in six (6) above. Narratives are not required.

(5 marks)b) Open up the suspense account to clear the difference in books. (3 marks)

c) Taking into account the corrected errors, you are to prepare:

i) Panuka Ltd’s Income Statement for the year ended 31st March 2003.(12 marks)

ii) Panuka Ltd’s Balance Sheet as at 31st March 2003.

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(11 marks)

(NATech June 2004)


SOLUTION ONE

J MutintaManufacturing account for the year ended 31st December 2006

K’000 K’000Raw materials: Opening inventory 4 200 Purchases 74 000 Carriage inwards 700 Total inventory available 78 900 Less: closing inventory 4 800 Cost of raw materials consumed 74 100Direct labour: Wages 36 000Direct expenses: Royalties 1 400 Prime cost 111 500Add: factory overheads: Indirect wages 29 000 General factory expenses 6 200 Lighting (5/6 x 1 500) 1 250 Factory power 2 740

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Rent (5/6 x 2 400) 2 000 Insurance (5/6 x 840) 700 Depreciation on productive machinery (10% x 56) 5 600 47 490



J MutintaIncome Statement for the year ended 31st December 2006

K’000 K’000 K’000Sales revenue 200 000Opening inventory 7 780Market value 158 690

166 470Less: closing inventory 8 000Cost of sales 158 470Gross profit 41 530Less expenses: Lighting (1/6 x 1 500) 250 Administrative salaries 8 800 Salesmen’s salaries 6 000 Commission on sales 2 300 Rent (1/6 x 2 400) 400 Insurance (1/6 x 840) 140 General administrative expenses 2 680 Bank charges 460 Discount allowed 960 Carriage outwards 1 180 Depreciation on accounting machine (10% x 4m) 400Total expenses 23 570Net profit 17 960

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J MutintaBalance sheet as at 31st December 2006

Cost Dep. ValueNon current assets: K’000 K’000 K’000 Productive machinery 56 000 15 600 40 400 Accounting machinery 4 000 2 000 2 000

60 000 17 600 42 400Current 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 920Total assets 98 320

Capital account Balance on 1st January 2006 59 360 Add: net profit 17 960 77 320 Less: drawings 4 000 73 320Current liabilities: Payables 25 000Total capital and liabilities 98 320

SOLUTION TWO

a) Journal entries

K’000 K’000 i) Receivables in Trial balance 4 600

Suspense 4 600

ii) Suspense 120 Discount Received 120

iii) Suspense 9 Administrative salaries 9

iv) Suspense 8 000 Sales revenue 8 000

v) Suspense 100 Bank 100

b) Suspense Account

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K’000 K’000Discount Received 120 Balance b/d 3 629Administrative salaries 9 Receivables in Trial balance 4 600Sales revenue 8 000Bank 100

8 229 8 229

c)

(i) Panuka Ltd Income Statement for the year ended 31st March 2003.

K’000 K’000Sales revenue (200 000 + 8 000) 208 000Opening inventory 52 000Production cost 106 400

158 400Less: closing inventory 46 600Cost of sales 111 800Gross profit 96 200

Add: Gains:Discount received 120Total income 96 320Less: Expenses:Rent [3 500 – (1680 ÷ 16 x 7 months)] 2 765General expenses 3 060Distribution costs 21 316Bad debts 400Administrative salaries (21 615 – 9) 21 606Advertising expenses 5 590Depreciation on Buildings 400

55 137

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Profit before taxation 41 183Less: Income tax 15 000Profit after taxation 26 183Dividends Preference -paid 700 - proposed 700 Ordinary – proposed 4 000

5 400Retained profit for the year 20 783Add: Retained profit brought forward 17 080Retained profit carried forward 37 863

(ii) Panuka Ltd Balance Sheet as at 31st March 2003.

COST DEP. NBVNon current Assets: K’000 K’000 K’000Premises 35 000 2 400 32 600Plant and machinery 12 000 6 000 6 000

47 000 8 400 38 600Current Assets:Inventory: Finished goods 46 600 Raw materials 11 000 W-I-P 6 200

63 800Receivables (21 400 + 4 600) 26 000Bank (8 528 – 100) 8 428Rent prepaid 735


Capital and reserves:Ordinary share capital 40 0007% preference share capital 20 000Accumulated profit 47 863

107 863

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Current liabilities:Payables 10 000Taxation 15 000Dividend payable: - preference 700

- ordinary 4 000 29 700

Total capital and liabilities 137 563

TERMINOLOGY

1. Assets : A resource or right under the entity’s control acquired as a result of a past transaction or event, and the business expects to derive economic benefits as a result of that control.

Items of possession and have value. The owner has a right of claim to the value of the assets. An example would be inventory, trade receivables (debtors), cash, motor vehicles, etc

2. Liability : A legal obligation to transfer out economic benefits as a result of a past transaction or event.

A legal obligation to pay money or in kind to somebody else. An example would be a bank loan, trade payables account balance, electricity bill still outstanding, etc.

3. A customer : someone we sell trading goods to on credit. Consequently he owes us money. An account for a customer is called a trade receivables account.

4. A supplier : someone we buy trading goods from on credit. Consequently we owe him money. An account for a supplier is called a trade payables account.

5. Cash transactions : business activities in which money is immediately given in exchange for goods or services.

6. Credit transactions : Business trading activities in which goods or services are provided without any immediate exchange of cash. The name of the outside entity is always mentioned in a credit transaction because it is implied that actual cash will be paid or received in future.

7. Cash can refer to amounts paid in notes and coins or by cheque, debit card (ATM access card) and credit card.

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8. An item of income is a source of revenue, which comes in the form of cash. An example would be sales, rent receivable, commission received, etc.

9. An expense is an item of expenditure and cash is paid out as a result of it. An example would be electricity paid, purchases of goods for resale, rent payable, carriage inwards, carriage outwards, etc

10. A gain is a form of income. It is extra funds generated after undertaking some business transaction. An example would be cash proceeds of a sale of a fixed asset above its book value, discount received, etc.

11. A loss is an amount that reduces owner’s wealth and arises from operating activities. It is an item of expenditure that could not generate a corresponding cash receipt. An example would be discount received, bad debts, etc.

12. Non current assets : Items of value, which the business intends to use operationally for more than one accounting period (usually 1 year). They are not intended to be re-sold. E.g. Buildings, motor vehicles, machinery, etc

13. Current assets : Assets that are continuously changing, kept up-to-date, kept current. E.g. stock, debtors, cash,etc

14. Long term liabilities : amounts that we owe and repayment will be in more that one accounting period, e.g. bank loans, debentures, finance leases, etc

15. Current Liabilities : amounts we owe others and payment for them will be made within the next 12 months (one accounting period).

16. Owners’ wealth : This is the amount the owner contributed from his private resources into the business, plus any profits he has made. This is sometimes called owners’ equity or capital

17. Drawings: Amounts the owner of the business withdraws from the business to go and use in his private capacity at home. It is a reduction in the owners’ wealth.

18. Recognition : This term refers to inclusion in the statement totals of an element in one of the financial statements. This is achieved by journalizing the entry either to add to or deduct from the existing balance. For example, the value of a car just bought would be added to the balance of motor vehicles in the balance sheet. Reducing a statement total is referred to as de-recognition, e.g. When part of the loan is settled, the loan balance in the balance sheet would be reduced.

19. Elements of financial statements: This term refers to the major classifications adopted in the financial statements into which all transactions would fall. These are assets, liabilities, contributions, distributions, gains, losses, income, expenses and owner’s wealth.

20. Contributions : Refers to amounts the owner of the business inject into it as capital from his private recourses, e.g. new share capital.

21. Distributions : Refers to amounts of resources the owner withdraws from the business for private use, e.g. drawings, dividends.

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AAccount transfers, 56, 95Accounting concepts, 190Accounting conventions, 322accounting for prepayments, 153Accounting information, 5, 8Accruals concept, 20, Administration expenses, 23Allowance for cash discounts, 144, 145, 146Analytical cash book, 65Asset, 13Authorised share capital, 309Average cost, 200, 201

BBad debts, 135, 222Balance sheet, 12, 13Bank Account, 68Bank reconciliation, 128Bank reconciliation statement, 128Below-the-line, 249Books of original entry, 112Business, 2

CCapital, 2, 15, 16Capital accounts, 249Capital and revenue expenditure, 36Capital expenditure, 36Capital income, 39Capital reserves, 312Capi talisation , 188Carriage inwards, 23, 193Carriage outards, 23, 193Cash basis, 240Cash book, 66, 67, Cash at bank, 13Cash in hand, 13Cash transaction, 50Cashflow statements, 289, 290Change in estimated life, 173Company, 3Company law, 3, Comparability, 5, 12Completeness, 11Consistency concept, 323Contra entries, 68Credit notes - Debt notes, 44, 45Current accounts, 244, 249Current assets, 13, 250Current liabilities, 14

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DDebenture, 291Depreciation, 159, 160, 162, 163, 164, 165,

166, 167, 168Development costs, 193Direct credits, 129Direct debits, 128Direct labour, 344, Direct materials, 344Discounts, 125Dishonoured cheques, 129Dividend, 35Doubtful debts, 134Duality concept, 49

EErrors not disclosed by trial balance, 208,

209, 210Exchange of assets, 182Expenditure, 37, Expense, 182, Expense claim forms, 44

FFair value, 181FIFO, 200, 201, 202, 205, 206, 207Final accounts, 12Finance costs, 23Financial accounting, 7Financial reporting, 238, 239, 240Financial statements, 241,

GGeneral reserve, 312Going concern concept, 323

HHistorical cost, 161

IIAS 16, 180Imprest system, 73, 74, 75, 76Incomplete, 217Interest on drawings, 249International accounting standards, 322Issued share capital, 310

JJournal, 53, 54

LLedger accounting, 56, 178, 149Lenders, 4Liability, 10Life membership, 265LIFO, 199, 200, 201, 202Limited partners, 244Local authorities, 238

MManagers, 4Manufacturing account, 344Market value, 183Matching concept, 21Materiality, 324Money measurement, 323Mortgage, 16

NNet book value, 174Non current assets, 14, 180Not for profit, 258

OObjectivity, 6Obsolescence, 162Operating activities, 290Operating as a partnership, 246Ordinary shares, 308Overheads, 326

PPartnership, 3Partnership current accounts, 251Petty cash book, 73, 74, 75Preference shares, 308Prepayments, 13Prime cost, 344Private companies, 3Profit and loss account, 102Property, plant and equipment, 160Prudence concept, 323Public companies, 3

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Purchases day book, 45, 59, 86, 106

RRatios, 325, 326, 327, 328, 329, Realisation concept 324Recognition, 181Recoverable amount, 181Reducing balance method, 188Relevance, 5Reliability, 5, 10Replacement cost, 183Research, 186Revaluation, 183, Revenue expenditure, 36Revenue income, 39Revenue reserves, 312Rule of double entry, 49

SSales day book, 57Sales ledger, 121Selling and distribution, 32, 193Separate valuation principle, 323Shareholders, 3, 4Statutory reserves, 312Straight line method, 162Subscriptions, 261, 262, 263, 264, 265

Substance over form, 324Sum of digits, 162, 164Supplier lists, 44Suspense account, 208

TTax, 240Timeliness, 6Trade contacts, 4Trade creditors, 15Trade payables, 67, 96, 119Trade receivables, 66, 123Transfers, 97Trial balance, 66, 95, 101, True and fair, 166, 174

UUnderstandability, 6Unpresented cheques, 129

VVirement, 243

WWork in progress, 343Working capital, 31

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ZICA T1 - Financial Accounting

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Transcript of ZICA T1 - Financial Accounting