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FINANCIAL ACCOUNTING
STUDY TEXT
CPA SECTION 1 & ATC
i i FINANCIAL ACCOUNTING
S T U D Y T E X T

i v FINANCIAL ACCOUNTING
S T U D Y T E X T
v
S T U D Y T E X T
TABLE OF CONTENTS......................................................................................................... v
ACKNOWLEDGMENT ......................................................................................................... iii
CHAPTER ONE .................................................................................................................... 1
INTRODUCTION TO ACCOUNTING .................................................................................... 3
CHAPTER TWO .................................................................................................................. 17
ACCOUNTING PROCEDURES AND TECHNIQUES ........................................................ 19
CHAPTER THREE .............................................................................................................. 79
PREPARATION OF FINANCIAL STATEMENTS ................................................................ 81
CHAPTER FOUR .............................................................................................................. 129
SOLE PROPRIETORsHIP ................................................................................................ 131
CHAPTER FIVE ................................................................................................................ 139
PARTNERSHIP ACCOUNTS ............................................................................................ 141
CHAPTER SIX .................................................................................................................. 185
NON PROFIT MAKING ORGANIZATION ........................................................................ 187
CHAPTER SEVEN ............................................................................................................ 199
MANUFACTURING ACCOUNTS ..................................................................................... 201
CHAPTER EIGHT ............................................................................................................. 215
FINANCIAL STATEMENT ANALYSIS .............................................................................. 217
CHAPTER NINE ................................................................................................................ 231
COMPANY ACCOUNTS ................................................................................................... 233
CHAPTER TEN ................................................................................................................. 267
INCOMPLETE RECORDS ................................................................................................ 269
CHAPTER ELEVEN .......................................................................................................... 285
COMPUTERISED ACCOUNTING .................................................................................... 287
CHAPTER TWELVE ......................................................................................................... 297
PUBLIC SECTOR ACCOUNTING .................................................................................... 299
ANSWERS TO EXAM TYPE QUESTIONS ...................................................................... 309
REVISION TEST PAPERS ................................................................................................ 349
ANSWERS TO TEST PAPERS ........................................................................................ 369
GLOSSARY ...................................................................................................................... 395
INDEX ............................................................................................................................... 399
TABLE OF CONTENTS

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CHAPTER ONE
INTRODUCTION TO
ACCOUNTING
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S T U D Y T E X T
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CHAPTER ONE
INTRODUCTION TO ACCOUNTING
OBJECTIVES
After studying this chapter, you should be able to:
• Define accounting and explain the phases of accounting
• Explain the branches of accounting
• Identify the users of financial information
• Understand the basic financial accounting equations and define assets, liabilities and
capital
• Prepare an account in the T form
• Identify the characteristics of good information
• List and explain the principles, concepts and conventions underlying the accounting
reports
• Understand the regulation of accounting profession
INTRODUCTION
This chapter forms the basis of all accounting work.
The first part deals with the nature of accounting and the phases of the accounting process.
The basic accounting equation will be introduced and the regulations of accounting profession
introduced.
DEFINITION OF KEY TERMS
1. Accounting: Accounting may be defined as the process of identifying, measuring,
recording and communicating financial information in order to permit users to make
informed decisions.
2. Accounting equation: This is a mathematical description of the relationship between
assets, liabilities and capital.
3. Accounting policies are the specific principles, bases, conventions, rules and practices
applied by an entity in preparing and presenting financial statements.
4. Assets: Items of value to an organization.
5. Liabilities: Obligations by the organization to other parties.
6. Capital: Resources put into the business by its owners
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EXAM CONTEXT
This is a very important chapter, which set the basis of accounting ideas and conventions. Expect
questions on all aspects, including the framework.
INDUSTRY CONTEXT
All professions require that one understands the basics. Accounts and its braches such as
auditing are not an exception. Most accounting fundamentals are contained in this chapter. A
clear understanding of this chapter’s content will not only help one pass the exam but also in
application of accounts in the industry.
1.1 NATURE AND PURPOSE OF ACCOUNTING
Accounting, as a preamble, could be termed the language of business. It is the common media
through which people of all walks can effectively communicate business matters and understand
one another equally.
It is the language accountants use to communicate i.e. record business transactions and
summarize results of business operations. Accounting can be defined as the art of recording,
classifying and summarizing in a significant manner, and in terms of money, transactions and
events which are of a financial character, and interpreting the results thereof.
It encompasses the recording of information of economic value to a business. The information
then forms the basis for judgment by the users.
PHASES OF THE ACCOUNTING PROCESS
From the above definition, we can clearly see that accounting is a process that can be divided
into four phases;
1. Recording phase: involves the routine and mechanical process of writing business
transactions and events in the books of accounts – also called books of original entry
or simply journals - in a chronological order in accordance with the entity’s and other
established accounting rules and procedures.
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2. Classifying phase: involves sorting and grouping of similar transactions into their
respective classes by posting them into a ledger.
A ledger is a group of accounts of a similar nature
An account is the basic record of accounting which measures increases or decreases
in a particular asset, liability, income or expense account.
3. Summarizing phase: this involves the preparation of financial statements or reports. It
is usually done periodically e.g. monthly, annually etc.
4. Interpretation: this refers to the analysis of the accounting information. It involves
communication of financial information to help users in making economic decisions.
This is the reason why accounting is called the language of business.
BRANCHES OF ACCOUNTING
Accounting, in all its broadness, can be sub-divided into areas of specialization;
a. Financial accounting; concerns itself with the collection and processing of accounting
data and reporting to interested parties inside and outside the firm.
b. Tax accounting; deals with the determination of the firm’s tax liability which could be,
Value added tax (VAT), customs duty, Pay as you earn (PAYE), corporation tax etc.
c. Cost accounting; helps establish costs relating to the production of a good or service
and allocating it to the various factors that contributed to the cost of production.
d. Managerial accounting; deals with the generation of accounting information to be used
categorically by the firm’s internal management in their day-to-day decision making.
e. Auditing; concerns itself with the vouching and verification of transactions from the
financial accounting to determine that they are a true representation of the business’
activity i.e. the true and fair view of the company’s state of affairs.
USERS OF FINANCIAL INFORMATION
1) Management – management of business entities need accounting information to assist
for planning and decision making. They will need the information to prepare budgets
and compare with the actual results of operations. They will also be interested in the
cost consequences of a particular course of action to assist them in making decisions
2) Present and potential investors – they need accounting information to assess the
risk inherent in, and the return provided by their investments. They need information
to decide whether they should maintain, increase, decrease of dispose altogether their
investments.
3) Employees are interested about the stability and profitability of their employer. It is
a source of stability for them and they need to know whether to start searching for
employment elsewhere or keep their current postings. They are also concerned about
the ability to provide remuneration, retirement benefits and employment opportunities.
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4) Lenders. They are the givers of some part of the company’s capital. They need to know
if the loans and the corresponding interests will be paid when due.
5) Customers. They require financial data in order to anticipate price changes and to
seek alternative sources of supplies when necessary.
6) The government. Governments and their agencies require information to regulate the
activities of the enterprises. They also need the financial information to determine level
of taxation and also in preparation of national statistics.
The general purpose of accounting can therefore be summarized into five purposes;
i. Helps in decision making
ii. Ascertain the value of the business
iii. Know the profit and or loss position
iv. Ascertain the assets and liabilities of the firm
v. Know the cash and wealth of the business
1.2 THE BASIC ACCOUNTING EQUATION
Fast forward Capital = Assets - liabilities
FINANCIAL STATEMENTS AND ELEMENTS OF FINANCIAL
STATEMENTS
there are two main financial statements available to users; the statement of financial position
and the income statement.
Balance sheet
It shows the financial position of the entity at a given point in time.
The accounting equation is reflected in the balance sheet. The equation, normally called the
book keeping equation is:
Assets – liabilities = capital
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The equation shows that for a firm to operate, it needs resources (assets) which have to be
supplied by external parties including creditors (liabilities) and from the owner (capital).
Business transactions will always affect two items of the accounting system.
Assets and liabilities are valued according to accounting conventions.
Assets could be defined as being resources controlled by an enterprise as a result of past events
and from which future economic benefits are expected to flow to the enterprise.
Current assets are those assets whose benefits are expected to flow within a period of less than
six months. They form part of the enterprise’s operating cycle or are held for trading purposes
e.g. inventory, accounts receivable (debtors), cash in hand and cash at bank.
Non-current assets have their benefits expected to flow for a period of more than 12 months.
They are tangible and intangible assets acquired for retention by an entity for the purpose of
providing a service to the business.
Examples of tangible non-current assets include buildings, equipment, and machinery.
Intangible non-current assets include goodwill, copyrights, patents, royalties.
A liability is defined as a present obligation of the enterprise arising from past events, the
settlement of which is expected to result in an outflow of resources embodying economic benefits
from the enterprise.
They represent claims on the business by the outsiders.
Current liabilities are expected to be settled in the normal course of the entity’ operating cycle
and within 12 months.
Equity is the residual interest in the assets of the enterprise after deducing all the liabilities.
THE ACCOUNTING EQUATION AND THE STATEMENT OF
FINANCIAL POSITION
The accounting equation is the basis of financial accounting.
Transactions are recorded using the double entry system of book keeping showing the two-fold
effect that is done to maintain equality of the equation. The double entry system requires the use
of an account.
An Account is the most basic accounting record. It summarizes the increases and decreases in
a particular asset, liability, revenue, expense or a capital item.
An account is divided into two sides; the left being the debit and the other the credit side. To debit
therefore will mean to enter an amount on the left hand side of an account and vice-versa.
The double entry concept states that “for every debit entry, there is a corresponding credit
entry”.
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The basic double entry rules for accounts are:
Accounts To record Entry in the account
Assets An increase Debit
A decrease Credit
Liabilities An increase Credit
A decrease Debit
Capital An increase Credit
A decrease Debit
Revenue An increase Credit
Expenses An increase Debit
QUALITIES OF GOOD ACCOUNTING INFORMATION
For accounting information to be able to effect the purpose for which it was meant, there are
certain attributes that it must fulfill. These include:
(a) Understandability. For accounting information to be considered useful, it must be well
understood by the parties for which it was prepared for. The parties must be able to
derive satisfaction from the financial data represented by accounting.
(b) Relevance. The accounting information should be able to influence the important
decisions in the company. The information should be verifiable, neutral and truthful.
(c) Reliability. Reliability means that the accounting information should have differing
methods or ways of doing it and yet arrive at the same or similar conclusions.
(d) Comparability. The accounting information should be able to be compared with
other information from different organizations or of the same organization at differing
periods.
(e) Timely. If the accounting information is not availed to the deserving user at the time of
need, then it may as well be useless. For accounting information to be useful, it must
be presented to the party in need at the time of the need.
LIMITATIONS OF ACCOUNTING INFORMATION
o Historical
Accounting information is prepared based from past period monetary transactions. It
is hardly feasible that what happened in the past will hold on in the future and so the
accounting information may be considered irrelevant on that basis alone.
o Too quantitative rather than qualitative
Accounting information consists of too many figures and less of explanations. For
any system to be useful, it must strike a balance between quantitative and qualitative
measures.
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o Only comparable to similar businesses
Accounting information makes it only comparable to businesses of similar nature. It is
difficult to compare a service oriented organization to a manufacturing based firm.
1.3 THE PRINCIPLES, CONCEPTS AND CONVENTIONS
UNDERLYING THE ACCOUNTING REPORTS
Fast forward – Prudence, substance over form and materiality should govern the selection and
application of accounting policies.
After defining what accounting is all about, we now need to know the environment that accounting
operates. Just like any other field of study, accounting has developed its own concepts that
govern its application. These concepts form the fundamental accounting assumptions underlying
the preparation of financial statements.
THE CONCEPTS
There are four main concepts:
Going concern
It is assumed that the operation will continue in operational existence into the foreseeable future.
This implies that the management should view all the available information in the light of the
foreseeable future, but not only for the current period.
Accounting period convention
Also known as the time concept. It is assumed that the continuous lifetime of the entity is divided
into small equal periods to ease the burden of reporting. These subdivisions are called the
financial year.
Business entity concept
The assumption is that the business is a separate legal entity; distinct from the owners and the
management. The financial affairs of the business entity are recorded and reported separately
from those of the owners of the capital or the managers
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Monetary principle
It is assumed that the financial impact of the business entity is broken down into transactions that
are assessed and quantified in some unit of measure. The underlying assumption is that, for the
sake of commonness, the unit of measure is a monetary one.
THE ACCOUNTING PRINCIPLES
Historical cost
Postulates that assets should be recorded at cost, at the purchase price or at the acquisition
price. This ignores the effects of inflation on cost as the assets are kept by the business over the
years.
It recognizes that for example a building purchased 40 years ago for Sh 29,000 would be reported
today in the statement of financial position at that historical price even though its actual worth
today may be Sh 2.9 million.
However, this problem has been overcome by asset revaluation as an alternative to the historical
cost of accounting.
Monetary principle
This principle holds that accounting will only endeavor to deal with those items to which a
monetary value can be attached. As such, financial statements reflect only the items that can be
measured in monetary terms. Goodwill for example is never shown in the statements because it
has no monetary measurement.
Accrual concept
The accruals concept is also known as matching concept.
In the principle, revenues and costs are recognized when earned or incurred and not as the
monetary attachment is received or paid. What this means is that the time when the revenue
is received or the expense is incurred is completely disregarded. This leads into two scenarios;
prepayments and accruals
Prepayments occur when money is received for a period that it has yet to be earned, or an
expense is paid for but has not yet been incurred.
Accruals occur when the expense for the money is being paid for has already been incurred
i.e. the expense belongs to a past period, or when an income is received way after the period of
earning has expired.
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Revenue realization concept
It states that a sale should be recognized when the event from which it arises has taken place
and the receipt of cash from the transaction is reasonably certain. Revenue can be recognized
at different levels of selling such as when the inquiry is made, during delivery, at issue of invoice
or when payment is made.
Revenue realization demands that only when the money receivable is reasonably certain of
reception should accountants recognize it as income. For instance, it may not be prudent to
recognize a sale when a customer makes an inquiry because the requisition may be revoked well
before the goods are even ordered or delivered.
Prudence
Prudence states that where alternatives exist, the one selected should be one that gives the most
cautious presentation of the financial position of the business. Assets and profits should not be
overstated, but a balance must be achieved to prevent the material overstatement of liabilities
and losses.
Where a losses foreseen, it should be anticipated and taken immediately into account. In other
words, accountants should never anticipate for gains but must always provide for losses.
Consistency
The items in the financial statement should be presented and classified in the same manner from
one period to the next unless there is a significant change in the nature of the operations of the
business, or a review of its financial statement presentation demonstrates that relevance is better
achieved by presenting items in a different way, or a change is required by a new international
standard.
For instance, an entity is not allowed to change form LIFO to FIFO or otherwise unless:
- there is a significant change in the business
- there is a new accounting order
- It helps present the information better.
Materiality
Information is material if its non-disclosure could influence the decisions of users. Materiality
depends on the size and the nature of the item being judged. Strict adherence to accounting
rules is not necessary in accounting for trivial items such as loose tools, e.g. a stapler should not
be capitalized, and a bribe cannot be itemized under expenses.
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Duality
Duality principle emphasizes the double entry book-keeping entry that every transaction has two
effects, for every debit there is a corresponding, equal and opposite credit entry. As such it forms
the basis of the double entry system of book keeping.
Substance over form
Some transactions have a real nature that differs from their legal form. This principle states that
whenever it is legally possible, the real substance prevails over the legal form.
1.4 THE REGULATION OF ACCOUNTING PROFESSION
THE INTERNATIONAL ACCOUNTING STANDARDS BOARD (IASB)
The IASB is an independent, privately funded accounting standard setter based in London.
The 14 members of the IASB come from nine countries and have a variety of backgrounds with a
mix of auditors, preparers of financial statements, users of financial statements and an academic.
The board consists of 12 fulltime members and two part-time members.
In March 2001 the International Accounting Standards committee (IASC) was formed as a notfor-
profit corporation incorporated in the USA. The IASC foundation is the parent entity of the
IASB.
From April 2001 the IASB assumed accounting standards setting responsibilities from its
predecessor body, IASC. This restructuring was based upon the recommendations on shaping
IASC for the future.
Objectives of the International Accounting Standards Board
1. To develop, in the public interest, a single set of high quality, understandable and
enforceable global accounting standards that require high quality, transparent and
comparable information in general purpose financial statements.
2. To provide the use and vigorous application of those standards.
3. To work actively with the national accounting standard setters to bring about convergence
of national accounting standards and IFRS to high quality solutions.
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THE INTERNATIONAL FEDERATION OF ACCOUNTANTS (IFAC)
The IFAC is a private sector body established in 1977 and which now consists of over 100
professional accounting bodies from around 80 different countries. The IFAC’s main objective
is to co-ordinate the accounting profession on a global scale by issuing and establishing
international standards on auditing, management accounting, ethics, education and training. The
IFAC has separate committees working on these topics and also organizes the world congress of
accountants, which is held every five years. The IASB is affiliated with the IFAC.
INTERNATIONAL PUBLIC SECTOR ACCOUNTING STANDARDS
BOARD (IPSAB)
Regulation of public not-for-profit entities, principally local and national governments and
governmental agencies, is by the IPSAB, which comes under the IFAC.
Fast forward – ICPAK, RAB and KASNEB jointly form the framework of regulation of the
accounting profession in Kenya.
It is important to put accounting into practical perspective. This will be made possible by looking
at the institutions that regulate the climate within which the accounting profession is practiced.
The Accounting Act was enacted by the parliament into chapter 531, Laws of Kenya in1977.
The Act then established the Institute of Certified accountants of Kenya (ICPAK), the Registration
of Accountants Board (RAB) and the Kenya Accountants and Secretaries National Examinations
Board (KASNEB).
The three jointly form the framework of regulation of the accounting profession in Kenya.
Role of ICPAK
1. To provide standards of professional competence and practice among its members.
2. To promote research into the subjects of accountancy, finance and related matters, and
the publication of books, periodicals, articles and journals in that connection.
3. To promote the international recognition of the institute.
4. Advise the examinations board on matters relating to examination standards and
policies.
5. Carry out any other functions prescribed for it under any other provision or under other
written law
6. Do anything incidental or conducive to the performance of any of the preceding
functions
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Role of KASNEB
1. Prepare syllabuses for accountants and secretaries examinations
2. Make rules in relation to the examinations
3. Issue certificates to candidates who have satisfied the examination requirements.
Role of RAB
1. Register the accountants that have been certified by the examination body to have
fulfilled the examination requirement.
2. Issuance of practicing certificates to those wishing to render the accounting services to
the public
CHAPTER SUMMARY
Accounting may be defined as the process of identifying, measuring, recording and communicating
financial information in order to permit users to make informed decisions.
More simply, accounting could be explained as keeping records about the transactions a business,
or other organisation, takes part in so as to be able to gauge how well the organisation is doing.
Accounting may be split into four main categories:
a) Financial accounting
b) Auditing
c) Cost accounting
d) Management accounting
The reason why the accounting process is carried out by organisations is to enable users of
financial information such as the government and investors to take profitable courses of action
on the basis of the financial information provided.
The accounting equation may be presented as follows:
Assets = Liabilities + Capital
Accounting information should be:
a) Comprehensible
b) Complete
c) Reliable
d) Relevant
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CHAPTER QUIZ
1. What is financial reporting?
2. What are the two main financial statements drawn by accountants?
3. List 5 general purposes of accounting?
4. Assets – Capital =………….?
5. List 5 qualities of good accounting information?
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ANSWERS TO CHAPTER QUIZ
1. A way of recording, analyzing and summarizing financial data.
2. The statement of comprehensive income and the statement of financial position (also
known as the balance sheet).
3. - Helps in decision making.
- Ascertain the value of the business.
- Know the profit and loss position.
- Ascertain the assets and liabilities of the firm.
- Know the cash and wealth of the business.
4. Liabilities.
5. - Understandability.
- Relevance.
- Reliability.
- Comparability.
- Timely.
PAST PAPER ANALYSIS
12/07, 6/07, 12/06, 6/06, 12/05, 6/05, 12/04, 6/04
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CHAPTER ONE
ACCOUNTING PROCEDURES
AND TECHNIQUES
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CHAPTER TWO
ACCOUNTING PROCEDURES AND TECHNIQUES
OBJECTIVES
After studying this chapter, you should be able to:
• Define bookkeeping and distinguish it from accounting
• Explain the accounting cycle
• Prepare book of original entry and the various ledgers
• Distinguish between real, nominal and personal accounts
• Understand and prepare two column, three column and petty cashbook
• Prepare a bank reconciliation statement
• Prepare initial accounts
• Record transactions with regard to assets, liabilities, capital, income and expenses
• Balance off accounts and extract a trial balance
• Identify the different types of errors and pass journal entries to correct them
INTRODUCTION
In this chapter we will introduce bookkeeping, books of original entry and take you through the
accounting cycle. We will finally explain how to extract the trial balance and use it to detect errors
and how to correct them.
DEFINITION OF KEY TERMS
Assets: an asset can be defined as resources present in a business organization that have
probable future economic benefit. They include cash, land and buildings stock e.t.c.
Assets can either be defined as current, non-current or intangible.
Current Assets: these are assets consumed in one year or are expected to benefit the firm
within a period of not more than one financial year e.g. stock, cash at hand, cash at bank,
debtors, prepayments e.t.c
Non-current Assets: these are assets whose economic benefits to the organization are achieved
for a period exceeding one financial year. Examples would be land and buildings, motor vehicles,
plant and machinery, computers e.t.c
Intangible Assets: these are assets of economic value to the business enterprise but cannot be
physically felt or seen e.g. goodwill, patents, copyrights e.t.c
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Liabilities
These are obligations that a business is expected to meet within a certain duration. They can
also be defined as total funds owed for assets supplied to a business or expense incurred but
not paid yet.
Liabilities can either be short term or long term. Short term liabilities are those that are expected
to be met within duration of one financial year. Payment for accrued expense, creditors, dividends
to share holders e.t.c. on the other hand long term liabilities are those payable within a period
exceeding one financial year e.g. long term loan, re-payment of debentures e.t.c
Capital: this is defined as the total of all resources invested and left in business by its owner.
Revenue/Income: this can be defined as the monetary value of all goods and services sold to
customers by a business enterprise
Expenses: This can be defined as the monetary equivalent of all resources/assets that have
been consumed during a given period to generate the revenues for the business organization in
a given accounting period.
EXAM CONTEXT
Most question set will require a thorough understanding of this chapter since it forms the basis
of most accounting work.
INDUSTRY CONTEXT
This chapter also acts as a foundation to more complex accounting. This chapter details simple
accounting, books of original entry and bank reconciliation. These are accounting activities done
on a daily basis by accounts assistant and act as source document for final financial statements.
Auditor will always assess these to be able to approve final financial statements.
2.1 BOOK KEEPING
Fast forward - Book keeping is intended to record all the accounting data in such a way that one
can make a deduction based on it.
Book keeping defined as the process of recording business transactions (data) in a systematic
manner. It can also be defined as that part of accounting that is concerned with recording data.
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Book keeping is intended to record all the accounting data in such a way that one can make a
deduction based on it. The deductions could be such as:
• How much sales has been achieved over a given period of time, be it a day, a month,
or a year.
• How much is owed to the creditors.
• How much is available in the bank, among others.
The whole process of book keeping is in the form of a cycle i.e. the accounting cycle.
2.2 THE ACCOUNTING CYCLE
The accounting process can be perceived as a cycle which starts with the occurrence of a
transaction, recording of the transaction and finally the preparation of the financial statements.
Financial statements are reports on results of all the transactions that occur during the year
and the position of the business as at the last date of the accounting period. A transaction is an
activity which involves the exchange of goods and services for another thing of value e.g. when
the business purchases goods for sale, sells goods to customers on credit, pays for services e.g.
telephone.
A transaction is first recorded in the source documents e.g. the cash sale receipt, the invoices
received from creditors, debit and credit notes issued and received etc
The daybooks as the name suggests they are filled daily showing all the transactions that occurred
during the day. Such information is obtained from the source documents.
The data in the day books is then filled in the ledger accounts and a trial balance extracted as
the end of the accounting period. Adjustments e.g. for prepayments and accruals are then made
and an adjusted trial balance is drawn reflecting these changes.
From this trial balance, the final statements are prepared i.e. the statement of comprehensive
income which reveals whether the company made a profit or loss from the transactions carried
out in the year, and the statement of financial position which tells of the financial position of the
business in terms of its assets and liabilities as at that closing date.
After these, the closing entries are made to prepare the accounts to receive the data for the
following financial period and a closing trial balance extracted.
This marks the end of journals
For every transaction entered into the business enterprise, there is the primary book where it will
be initially recorded. This is known as books of original entry.
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2.3 BOOKS OF ORIGINAL ENTRY
Fast forward - Accounts can be divided into personal accounts and impersonal accounts.
Books of original entry can be defined as the books in which we first record a transaction. These
books essentially record the following details of a transaction:
• date of the transaction
• the name of the person/ firm with whom the transaction took place
• the details of an item bought or sold e.g. a motor vehicle stock e.t.c
• details for cross referencing
• the amount (shown in monetary terms) of the transaction
Books of original entry are known as journals or daybooks. Both terms are used interchangeably.
The commonly used books of original entry are:
i. PURCHASES JOURNAL
This journal is used to record all purchases made on credit only.
Example
PURCHASES JOURNAL
Date Details Folio Amount (Sh)
1/12/2006 J. Chege PL 009 4,200
1/12/2006 A. Mbole PL 011 6,700
4/12/2006 J. Chege PL 009 9,200
5/12/2006 B. Gummo PL 010 2,100
8/12/2006 H. Njeri PL 014 4,100
8/12/2006 A. Mbole PL 011 10,400
9/12/2006 J. Chege PL 009 8,500
10/12/2006 A. Mbole PL 011 6,100
51,300
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S T U D Y T E X T
ii. SALES JOURNAL
A sales journal records credit sales only.
>>> Example
SALES JOURNAL
Date Details Folio Amount
(Sh)
1/4/2006 J. Kamau SL 001 5,000
1/4/2006 P. Otieno SL 002 4,000
2/4/2006 E. Muteti SL 003 3,200
3/4/2006 P. Otieno SL 002 4,700
4/4/2006 J. Kamau SL 001 4,200
5/4/2006 A. Kioko SL 005 6,700
6/4/2006 J. Kamau SL 001 2,800
30,600
iii. RETURN OUTWARDS JOURNAL
It records goods returned by the business to the suppliers for the reason that they are either
tampered with, are not of the kind ordered for, are damaged, or are in excess of the amount
ordered.
>>> Example
RETURN OUTWARDS JOURNAL
Date Details Folio Amount (Sh)
9/12/2006 A. Mbole PL 011 1,100
ACCOUNTING PROCEDURES AND TECHNIQUES
2 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
iv. RETURN INWARDS JOURNAL
This journal is used to record all the goods that are returned to the business by the customers
because they were not the kind ordered for or were in excess e.t.c
>>> Example
RETURN INWARDS JOURNAL
Date Details Folio Amount (Sh)
8/4/2006 J. Kamau SL 001 800
9/4/2006 A. Akiko SL 005 500
1,300
v. CASH BOOK
This is a book of original entry that is used to record all cash received or paid out by the business
via the cash till or via the business’ bank account. A cash book is a unique journal since it acts
both as a book of original entry as well as a ledger account where all transactions affecting cash
are recorded. It shall be dealt with in detail later on in this chapter.
vi. GENERAL JOURNAL: (ALSO REFERRED TO AS THE
JOURNAL PROPER)
All other transactions not falling into any of the above journals are recorded in this journal.
In the general journal the following details relating to the transaction are included; date, the name
of the account to be debited, the name of the account to be credited and a brief narration or
description of the transaction as illustrated below.
GENERAL JOURNAL
Date Details Debit(Dr) Credit(Cr)
_/_/_ Account to be debited *****
account to be credited *****
(a brief narrative to describe the above transaction)
25
S T U D Y T E X T
A general journal has the following uses:
• Recording the purchase or sale of fixed assets on credit
• Correction of errors in the ledger accounts
• Adjustment of ledger entries
• Writing off of bad debts
POSTING
When all transactions have been entered into the specific journals, they are then entered into
their respective accounts in the ledger in a process referred to as posting. An account is a place
where all details relating to a particular asset, liability or capital, is recorded. There could be an
account for motor vehicles, another for buildings, another one for a specific creditor and yet other
separate accounts for each debtor e.t.c.
Accounts can be divided into two:
• Personal accounts
• Impersonal accounts.
Personal accounts are accounts dealing with customers and suppliers i.e. debtors and creditors.
Impersonal accounts on the other hand can further be divided into:
Real account used for recording possessions like land, motor vehicles, buildings, furniture and
fittings.
Nominal account used for recording capital, income and expenses.
All accounts are prepared in a ‘T’ format and thus generally referred to as T- accounts. The Taccounts
have two sides; the debit side on the left and the credit side on the right of the account
as shown below.
<Name of the account>
Dr Cr
DATE PARTICULARS AMOUNT (Sh) DATE PARTICULARS AMOUNT (Sh)
Every transaction in a business affects two accounts. One of the accounts is debited while the
other is credited by the same amount giving rise to double entry book keeping i.e. for each entry
recorded in the journals there will be a debit and a credit entry in two separate accounts in the
ledger.
ACCOUNTING PROCEDURES AND TECHNIQUES
2 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
A brief example would be when we buy a motor vehicle for cash. Two items will be
affected:
• We will have a new asset; known as a car (a motor vehicle)
• On the other hand, the asset cash will have reduced by the amount we pay for the
car.
Generally a transaction either increases or decreases an asset, liability or capital. This is reflected
in the accounts as follows:
(i) When we increase an asset we make a debit entry to the asset account
(ii) When we decrease an asset we make a credit entry to that account
(iii) When we increase our liabilities or capital, we make a credit entry
(iv) When we decrease our liability or capital we make a debit entry to that account.
Uses of special journal
• They facilitate grouping transactions which are alike together, recording them to provide
relevant transaction details.
• It facilitates easier mechanization of the recording process
• It makes the posting work easier because numerous ledger accounts take the totals.
• They minimize possible errors.
2.4 THE LEDGER
Fast forward - All accounts that do not fall under either the sales or purchases ledger are
held under the general ledger.
The ledger is a book in which various accounts are kept. There are three main types of ledgers:
i. Sales ledger
ii. Purchases ledger
iii. General ledger
(i) SALES LEDGER
After all transactions have been recorded in the sales journal, the next step is to post these
transactions using double-entry book keeping into the various ledgers. The sales ledger is made
up of individual accounts of the debtors i.e. customers who have purchased from us on credit.
27
S T U D Y T E X T
To maintain double entry, the sales ledger is posted as follows:
i. For all the customers in the sales journal, debit their individual accounts in the sales
ledger.
ii. Make the corresponding credit entry in the sales account which is in the general
ledger.
To avoid having too many entries in the sales account, we sum up all the individual debtors
account and post the total to the credit side of the sales account in the general ledger. This total
should equal to the total as reported in the sales journal i.e. the first book in which the all the
credit sales were initially recorded before being posted to the ledger accounts. The two totals will
however be equal if and only if double entry concept was adhered to in the posting process.
Recall the sales journal illustrated earlier. The transaction recorded in this journal can be posted
as follows in the sale ledger:
Recall the sales journal illustrated earlier. The transaction recorded in this journal can be
posted as follows in the sale ledger:
J. Kamau
Dr Cr
DATE PARTICULARS AMOUNT
(Sh)
DATE PARTICULARS AMOUNT
1/4/2006 sales 5000 ( Sh)
4/4/2006 sales 4200
6/4/2006 sales 2800
E. MUTETI
Dr Cr
DATE PARTICULARS AMOUNT
(Sh)
DATE PARTICULARS AMOUNT
2/4/2006 Sales 3200 ( Sh)
P. OTIENO
Dr Cr
DATE PARTICULARS AMOUNT
(Sh)
DATE PARTICULARS AMOUNT
1/4/2006 Sales 4000 ( Sh)
3/4/2006 Sales 4700
A. KIOKO
Dr Cr
DATE PARTICULARS AMOUNT
(Sh)
DATE PARTICULARS AMOUNT
5/4/2006 sales 6700 ( Sh)
Recall the sales journal illustrated earlier. The transaction recorded in this journal can be
posted as follows in the sale ledger:
J. Kamau
Dr Cr
DATE PARTICULARS AMOUNT
(Sh)
DATE PARTICULARS AMOUNT
1/4/2006 sales 5000 ( Sh)
4/4/2006 sales 4200
6/4/2006 sales 2800
E. MUTETI
Dr Cr
DATE PARTICULARS AMOUNT
(Sh)
DATE PARTICULARS AMOUNT
2/4/2006 Sales 3200 ( Sh)
P. OTIENO
Dr Cr
DATE PARTICULARS AMOUNT
(Sh)
DATE PARTICULARS AMOUNT
1/4/2006 Sales 4000 ( Sh)
3/4/2006 Sales 4700
A. KIOKO
Dr Cr
DATE PARTICULARS AMOUNT
(Sh)
DATE PARTICULARS AMOUNT
5/4/2006 sales 6700 ( Sh)
Purchases ledger
ACCOUNTING PROCEDURES AND TECHNIQUES
2 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
(ii) PURCHASES LEDGER
After all the transactions have been entered on the purchases journal, the entries are then posted
in the purchases ledger. The purchases ledger is made up of individual creditors’ account. Every
credit purchase made by customers is recorded on the credit side of their individual account in
the purchases ledger. The totals of this ledger are then posted to the debit side of the purchases
account in the general ledger, again to avoid having too many individual creditors’ entries in
the purchases account. This total should equal the total of the purchases journal, if the posting
process was done correctly.
Recall the purchases journal illustrated earlier. The transaction recorded in this journal can be
posted as follows in the purchases ledger:
After all the transactions have been entered on the purchases journal, the entries are
then posted in the purchases ledger. The purchases ledger is made up of individual
creditors’ account. Every credit purchase made by customers is recorded on the credit
side of their individual account in the purchases ledger. The totals of this ledger are then
posted to the debit side of the purchases account in the general ledger, again to avoid
having too many individual creditors’ entries in the purchases account. This total should
equal the total of the purchases journal, if the posting process was done correctly.
Recall the purchases journal illustrated earlier. The transaction recorded in this journal
can be posted as follows in the purchases ledger:
J. CHEGE
Dr Cr
DATE PARTICULARS AMOUNT
(Sh)
DATE PARTICULARS AMOUNT
1/12/2006 purchases (4S2h0)0
4/12/2006 purchases 8500
9/12/2006 purchases 9200
B. GUMMO
Dr Cr
DATE PARTICULARS
AMOUNT
(Sh) DATE PARTICULARS
AMOUNT
(Sh)
5/12/2006 purchases 2100
A. MBOLE
Dr Cr
DATE PARTICULARS
AMOUNT
(Sh) DATE PARTICULARS
AMOUNT
(Sh)
1/12/2006 Purchases 6700
8/12/2006 Purchases 6100
10/12/2006 Purchases 10400
29
S T U D Y T E X T
(iii) GENERAL LEDGER
All other accounts that do not fall under either the sales or purchases ledger are held under the
general ledger. Such accounts would include:
(i) Fixed assets accounts e.g. furniture and fittings account, plant and equipment account
(ii) Expenses accounts e.g. electricity account insurance, expense account e.t.c
(iii) Return inwards account
(iv) Return outwards account
>>> Example 1
Given the following details; enter them in the sales journal, purchases journal, general journal,
and then post them to the relevant ledger accounts.
Year 2006
May 2 Credit sales to E. Kamau Sh 12,800
“2 Credit purchases to H Opati Sh 9,600
“4 Credit sales to J Omondi Sh 11,700
“7 Credit sales to N.Kimanzi Sh 20,700
“8 Credit sales to P.Amino Sh. 4,900
“12 credit Credit purchases from M. Kibaki Sh 7,200
“13 Credit sales to E. Kamau Sh 42,000
“13 Credit Credit purchases from G.Njenga Sh. 9,700
“15 return Return inwards from J Hadija Sh. 200
“16 return Return outwards to K Nyongesa Sh.1, 200
H. NJERI
Dr Cr
Date Particulars
Amount
(Sh) Date Particulars Amount (Sh)
8/12/2006 purchases 4100
GENERAL LEDGER
All other accounts that do not fall under either the sales or purchases ledger are held
under the general ledger. Such accounts would include:
ACCOUNTING PROCEDURES AND TECHNIQUES
3 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
“20 credit Credit purchases from H. Opati Sh. 11,200
“21 credit Credit purchases from E. Joe Sh 4,900
“23 credit Credit purchases from O. Mbiyu Sh. 4,500
“27 bought Bought motor vehicle cash Sh 20,000
“30 Sales to E Williams Sh. 10,600
Suggested solution:
Entries in the sales ledger
“27 Bought motor vehicle cash Sh 20,000
“30 Sales to E Williams Sh. 10,600
E. Kamau
2006 Sh 2006 Sh
2/5 sales 12800
13/5 sales 42000
J. Omondi
2006 Sh 2006 Sh
4/5 sales 11700
N.kimanzi
2006 Sh 2006 Sh
7/5 sales 20700
P. Amimo
2006 Sh 2006 Sh
8/5 sales 4900
31
S T U D Y T E X T
E. Williams
2006 Sh 2006 Sh
30/5 sales 10600
J. Hadija
2006 Sh 2006 Sh
15/5 Return inwards 200
Entries in the Purchases ledger
H. Opati
2006 Sh 2006 Sh
2/5 Purchases 9600
20 /5 Purchases 11200
M. Kibaki
2006 Sh 2006 Sh
12/5 Purchases 7200
G. Njenga
2006 Sh 2006 Sh
13/5 Purchases 9700
E. Joe
2006 Sh 2006 Sh
ACCOUNTING PROCEDURES AND TECHNIQUES
3 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
13/5 Purchases 9700
E. Joe
2006 Sh 2006 Sh
21/5 Purchases 4900
O. Mbiyu
2006 Sh 2006 Sh
23/5 Purchases 4500
K. Nyongesa
2006 Sh 2006 Sh
16/5 Return outwards 1200
Entries in the General ledger
Purchases control a/c
2006 Sh 2006 Sh
31/5 Credit purchases 47100
Sales ledger control a/c
2006 Sh 2006 Sh
31/5 Credit sales 102700
Return inwards a/c
2006 Sh 2006 Sh
31/5 Debtor Hadija 200
Return outwards
E. Joe
2006 Sh 2006 Sh
21/5 Purchases 4900
O. Mbiyu
2006 Sh 2006 Sh
23/5 Purchases 4500
K. Nyongesa
2006 Sh 2006 Sh
16/5 Return outwards 1200
Entries in the General ledger
Purchases control a/c
2006 Sh 2006 Sh
31/5 Credit purchases 47100
33
S T U D Y T E X T
2.5 CASH BOOKS
A cash book is a document or a record of all transactions involving cash in business organization.
It keeps track of all incoming and outgoing cash i.e. cash receipts and payments.
TWO COLUMN CASH BOOK
Usually a business maintains two cash books; cash-in-hand cash book and cash-at-bank cash
book. A cash-in-hand cash book records all transactions relating to cash paid out or received
through the cash till. The cash at bank cash book handles transactions relating to cash that goes
through the bank e.g. payments by cheque. Normally these two cash books are combined to
form a two column cash book, the two columns being the cash and bank column.
A contra entry, for cash book items, is where both the debit and the credit entries are shown in
the cash book, such when cash is paid into bank or withdrawn.
A withdrawal of cash from bank would appear in the cash book as a debit for cash and a credit
for bank of the same amount and vice versa for a deposit. Both the debit and credit entries are in
the same book. When this happens it is known as a contra item.
31/5 Debtor Hadija 200
Return outwards
2006 Sh 2006 Sh
315 Creditor K. Nyongesa 1200
Motor vehicle
2006 Sh 2006 Sh
27/5 Cash 20000
CASH BOOKS:
A cash book is a document or a record of all transactions involving cash in business
organization. It keeps track of all incoming and outgoing cash i.e. cash receipts and
payments.
ACCOUNTING PROCEDURES AND TECHNIQUES
3 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
Format of a two column cash book
>>> Example
Mr. Tamaa started a business on 1st January 2007.during the first month of trading the following
transactions took place.
Wrote a personal cheque and deposited into the business bank account Sh800,000
Withdrew Sh200, 000 from the bank and put it into the cash till.
2nd Jan, Purchased goods by cheque Sh70,000
3rd Jan, Bought furniture for cash Sh25,000
3rd Jan, Bought equipment on credit Sh75,000
4th Jan, Sold goods for cash Sh100,000
5th Jan, Bought goods and paid by cheque Sh.200,000
6th Jan, Bought a motor van paying by cheque Sh.210,000
10th Jan, Obtain loan from the bank Sh.500,000
12th Jan, Sold goods on credit Sh75,000
16th Jan, Sold goods payment made by cheque Sh.100,000
16th Jan, Received a cheque from a debtor Sh.60,000
30th Jan, Took Sh10,000 from the cash till personal use.
Using the given details write up a two column cash book for Mr. Tamaa for the month of
January 2007
A contra entry, for cash book items, is where both the debit and the credit entries are
shown in the cash book, such when cash is paid into bank or withdrawn.
A withdrawal of cash from bank would appear in the cash book as a debit for cash and a
credit for bank of the same amount and vice versa for a deposit. Both the debit and
credit entries are in the same book. When this happens it is known as a contra item.
Format of a two column cash book:
Dr. TWO COLUMN CASH BOOK Cr.
Date Particulars Folio Cash Bank Date Particulars Folio Cash Bank
Example
Mr. Tamaa started a business on 1st January 2007.during the first month of trading the
following transactions took place.
Wrote a personal cheque and deposited into the business bank account Sh800,000
Withdrew Sh200, 000 from the bank and put it into the cash till.
35
S T U D Y T E X T
Mr.Tamaa
TWO COLLUMN CASH BOOK
FOR THE MONTH OF JANUARY 2007
Dr. Cr.
DATE PARTICULARS CASH BANK DATE PARTICULARS CASH BANK
2005
Jan
2005
Jan
1 Capital 200,000 02 Cash © 200,000
2 Bank © 200,000 02 purchases 70,000
4 Sales 100,000 03 furniture 25,000
10 Loan 500,000 05 Purchases 200,000
16 Sales 100,000 06 Motor van 210,000
16 Debtors 60,000 30 Drawings 10,000
31 Balance c/d 265,000 780,000
300,000 1,460,000 300,000 1,460,000
Feb 1 Balance b/d 265,000 780,000
Notes
(i) It is important to note that only transactions involving cash are entered into
the cash book. Credit sales and credit purchases are not entered until the
customer pays or the supplier is paid.
(ii) When cash is withdrawn from bank and put in the cash till the entry made to
capture this transaction is referred to as a contra entry. A contra entry
affects both sides of the cashbook; the bank column on one side and a cash
column on the other. A contra entry may also arise if cash from the cash till is
deposited into the bank account. It’s denoted by a ‘c’ indicated in the folio
column.
Mr.Tamaa
TWO COLUMN CASH BOOK
FOR THE MONTH OF JANUARY 2007
Notes
(i) It is important to note that only transactions involving cash are entered into the cash
book. Credit sales and credit purchases are not entered until the customer pays or the
supplier is paid.
(ii) When cash is withdrawn from bank and put in the cash till the entry made to capture
this transaction is referred to as a contra entry. A contra entry affects both sides of the
cashbook; the bank column on one side and a cash column on the other. A contra entry
may also arise if cash from the cash till is deposited into the bank account. It’s denoted
by a ‘c’ indicated in the folio column.
(iii) When all transactions have been entered into the cash book we then balance it off.
Normally the cashbook will have debit balance in both the cash and bank columns.
However, a bank overdraft will result into a credit balance in the bank column. A bank
overdraft is a facility offered by the bank where the account holder is allowed to withdraw
more cash than the remaining balance in his account.
(iv) The debit side of the cash book generally records cash/bank receipts while the credit
side records cash/bank payments.
ACCOUNTING PROCEDURES AND TECHNIQUES
3 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
THREE COLUMN CASH BOOKS
Sometimes businesses maintain a three column cash book. The additional column is the discounts
column, i.e. discount received on the credit side and the discount allowed on debit side.
Format of a three column cash book:
Example:
Enter the following transactions in a three column cash book.
(i) Balance brought forward cash Sh 4700 bank Sh 17000
(ii) Cash sales Sh 20000 (discount 8%)
(iii) Cash sales Sh 42000
(iv) Cash purchases Sh 18000 (discount 10%)
(v) Sales paid for by cheque of Sh 40000 after deducting a 20% discount
(vi) Paid Sh 50000 by cheque after deducting 20% cash discount.
(vii) Purchases by cheque Sh 12000
THREE COLUMN CASH BOOKS
Sometimes businesses maintain a three column cash book. The additional column is the
discounts column, i.e. discount received on the credit side and the discount allowed on
debit side.
Format of a three column cash book:
Example:
Enter the following transactions in a three column cash book.
(i) Balance brought forward cash Sh 4700 bank Sh 17000
(ii) Cash sales Sh 20000 (discount 8%)
(iii) Cash sales Sh 42000
(iv) Cash purchases Sh 18000 (discount 10%)
(v) Sales paid for by cheque of Sh 40000 after deducting a 20% discount
(vi) Paid Sh 50000 by cheque after deducting 20% cash discount.
(vii) Purchases by cheque Sh 12000
THREE COLUMN CASH BOOK
Dr. Cr.
Date Particulars Cash
Disc.
Allowed Bank Date Particulars Cash
Disc
received Bank
37
S T U D Y T E X T
Notes
(i) It is important to check whether the amounts of sales or purchases are shown as gross
or net of discount.
From (v) above, the amount is shown as net and for the purposes of knowing the
discount, we work backwards so as to ascertain the discount amount as follows:
Net amount = Sh 40,000
Discount allowed = 20%
Therefore the net amount = Gross amount (n) x (100-20) %
n = 40000 = Shs.50000
0.8
Therefore discount allowed = Sh 50,000 – 40,000 = Sh 10,000
(ii) The amounts of both discounts allowed column and discounts received are treated as
follows:
Discount allowed
The totals will be posted to the debit side of the discount allowed account in the general ledger.
Notes
(i) It is important to check whether the amounts of sales or purchases are shown as
gross or net of discount.
From (v) above, the amount is shown as net and for the purposes of knowing the
discount, we work backwards so as to ascertain the discount amount as follows:
Net amount = Sh 40,000
Discount allowed = 20%
Therefore the net amount = Gross amount (n) x (100-20) %
40000 = n x 0.8
shs 50000
0.8
40000
n = =
Dr. THREE COLUMN CASH BOOK Cr.
Date Particulars
Disc.
Allowed
Cash
Bank Date Particulars
Disc.
Received
Cash
Bank
2006
April
2006
April
1 Balance b/f - 4700 17000 4 Purchases 1800 16200 -
2 Sales 1600 18400 - 5 purchases 12500 - 50000
2 Sales
-
42000 - 6 Purchases -
-
12000
5 Sales 10000
-
40000 30
Balance
c/d -
48900
-
30 Balance c/d - - 5000
11600 65100 62000 14300 65100 62000
ACCOUNTING PROCEDURES AND TECHNIQUES
3 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
Discount received
The totals of the discounts received column will be posted to the credit side of the discounts
received account in the general ledger.
2.6 BANK AND CASH BOOK RECONCILIATION
Fast forward – Differences between the cash and the bank statement arise for three reasons;
errors, usually in the cash book, omissions, such as bank charges not posted in the cash book
and timing differences, such as un-presented cheques.
At the end of a particular period (mostly one month) the balances of the cash book should be
extracted and in many instances, the cash at bank balance in the cash book does not agree
with the bank statement over the same period though theoretically it should. This is a normal
occurrence and the two needs to be reconciled so that any material errors can be identified as
early as possible. The causes of the disagreement may be as a result of:
(i) Items that appear on the cash book but not on the bank statement.
(ii) Items that appear on the bank statement but not on the cashbook
(iii) Errors when entering amounts in the cash book
(iv) Errors by the bank while posting transactions
follows:
Discount allowed
The totals will be posted to the debit side of the discount allowed account in the general
ledger.
Discounts allowed
2006 Sh 2006 Sh
30/4 Debtors 11600 /5
Discount received
The totals of the discounts received column will be posted to the credit side of the
discounts received account in the general ledger.
Discounts received
2006 Sh 2006 Sh
30/4 Sundry creditors 14300
BANK AND CASH BOOK RECONCILIATION
Fast forward – Differences between the cash and the bank statement arise for three
reasons; errors, usually in the cash book, omissions, such as bank charges not posted in
the cash book and timing differences, such as un-presented cheques.
At the end of a particular period (mostly one month) the balances of the cash book
should be extracted and in many instances, the cash at bank balance in the cash follows:
Discount allowed
The totals will be posted to the debit side of the discount allowed account in the general
ledger.
Discounts allowed
2006 Sh 2006 Sh
30/4 Debtors 11600 /5
Discount received
The totals of the discounts received column will be posted to the credit side of the
discounts received account in the general ledger.
Discounts received
2006 Sh 2006 Sh
30/4 Sundry creditors 14300
BANK AND CASH BOOK RECONCILIATION
Fast forward – Differences between the cash and the bank statement arise for three
reasons; errors, usually in the cash book, omissions, such as bank charges not posted in
the cash book and timing differences, such as un-presented cheques.
At the end of a particular period (mostly one month) the balances of the cash book
should be extracted and in many instances, the cash at bank balance in the cash book
39
S T U D Y T E X T
Items that appear on the cash and not on the bank statement
(i) Un-credited amounts (cheques/deposits)
This item mainly affects the cheques. Due to the nature of the cheque clearing process, a firm
may deposit a cheque and thus debit the cashbook, but by the time the bank statement is being
prepared, the amounts are not yet available. The cheque could also bounce and before the bank
can communicate to the account holder, the balances in the bank statement and in the cash book
will not tally.
(ii) Un-presented cheques
These are the cheques issued to the suppliers by the firm and shown as payments in the cash
book. The suppliers may hold the cheque for a number of days before presenting it to the bank
for payment and thus the bank will not have recorded such a payment in the bank statement
hence will reflect a different balance from that in the cash book.
Items appearing in the bank statement and missing in the cash book
i) Direct Credits: when a customer deposits either cash or a cheque directly into the
business’ bank account without informing the business.
ii) Bank Charges: when the bank debits (decreases) the account of the business with
charges e.g. cheque book charges, ledger fees, commissions on electronic funds
transfer both incoming and out going e.t.c.
iii) Direct Debits; when the bank pays/ honors a standing order, deducts loan payment
from the account e.t.c
iv) Interest Income; when the bank credits (increases) with the amount of interest earned
on the account.
v) Dishonored Cheques; when a cheque earlier deposited is dishonored
vi) Interest charges with regard to bank facilities e.g. overdraft, credit card e.t.c.
Errors while entering the amounts in the cashbook would include
• Overstatement/understatement of receipts and payments in the cash book
• Mis-posting of deposits or payments in the cash book.
Bank reconciliation is used to bring the two balances into agreement i.e. the back balance in the
cash book and the bank balance in the bank statement.
The first thing to do while reconciling a bank statement is to update the cashbook. This is done by
entering all the transactions that ought to be in the cashbook but were missing, as well as correct
all errors in the cash book.
ACCOUNTING PROCEDURES AND TECHNIQUES
4 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
Such entries would include
• Bank charges
• Direct credits and debits
• Dishonored cheques
• Overstatement/understatement of receipts in the cashbook
• Over/understatement of payments in the cash book
• Misposting of deposits or payments in the cash book
The second step is to prepare a bank reconciliation statement which expected to make adjustments
on the balance in the bank statement to agree with the new balance obtained from the adjusted
cashbook.
The following items will now be shown under the bank reconciliation statement
• Un-presented cheques
• Un-credited deposits
• Errors in the bank statement
• The updated cash book balance
The Format of a bank reconciliation statement
Format 1
<Name of business>
BANK RECONCILIATION STATEMENT AS AT
Sh Sh
Balance as per bank statement xxx
Add:
Un-credited cheques xxx
Errors that reduce bank balance xxx xxx
xxx
Less:
Un-presented cheques xxx
Errors that increase bank balance xxx (xxx)
Balance as per updated cash book xxx
41
S T U D Y T E X T
Format 2
<Name of business>
BANK RECONCILIATION STATEMENT
Sh Sh
Balance as per updated cash book xxx
Add:
Un-presented cheques xxx
Errors in the bank statement that increase bank balance xxx xxx
xxx
Less:
Uncredited cheques xxx
Errors on bank statement that reduce bank balance xxx (xxx)
Balance as per bank statement xxx
Note:
Errors in the bank statement that reduce bank balance
Understatement of deposits into the bank account
Overstatement of payments from the bank account
Errors that increase bank balance
Overstatement of deposits
Understatement of payments
>>> Example:
On 31st December 2006 the cash book of H. Njeri showed a balance at the bank of Sh Sh8, 100.
The bank statement however showed a balance of Sh 6,700. Going through the bank statement
she found out that:
(i) A cheque received from Taifa Ltd on 1st December for Sh 600 and entered into the
cash book did not appear on the bank statement
(ii) A cheque paid to E. Kamara Sh 700on 25th December had not been presented
(iii) A cheque received from N Njiru on 24th December Sh 600 and entered into the cash
book was returned dishonored. No entry in this regard was recorded I the cash book
(iv) Bank charges amounting to Sh 100 had not been entered into the cash book
(v) The bank received directly Sh 1000from E.A.B.L as dividends on 18th December on
behalf of H. Njeri
(vi) A cheque payment of Sh 2000 to Olivia had been entered in error Sh200 in the
cashbook
Required
(a) Make the necessary entries to update the cash book
(b) Prepare a bank reconciliation statement for H. Njeri for the month of December 2006
ACCOUNTING PROCEDURES AND TECHNIQUES
4 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Suggested solution
BANK RECONCILIATION STATEMENT
H. NJERI
BANK RECONCILIATION STATEMENT AS AT 31ST DECEMBER 2006
Balance as per updated cash book 6,600
Add:
Un-presented cheques; E. Kamara 700
Errors that increase bank balance xxx 700
7,300
Less: uncredited cheques; Taifa 600
Errors that reduce bank balance xx (600)
Balance as per bank statement as at 31st December 2006 6,700
November 1992 Q
A trainee accountant working for a sole trader, Juma Mambo Leo had prepared the following
summary of the cash book for the month of March 1999
Cash book Sh Sh
Opening balance b/d 561000 Payments 4,189,000
Receipts 3748000 Closing balance c/d 120,000
4309000 4309000
Suggested solution
Corrected Cash Book
2006 Sh 2006 Sh
/5 Balance b/f 8,100 /5 N. Njiru (dishonored) 600
Direct credit 1,000 Bank charges 100
Error in cheque to Olivia 1,800
Balance as per cash book 6,600
9,100 9,100
BANK RECONCILIATION STATEMENT
H. NJERI
BANK RECONCILIATION STATEMENT AS AT 31ST DECEMBER 2006
Balance as per updated cash book 6,600
Add:
Un-presented cheques; E. Kamara 700
Errors that increase bank balance xxx 700
7,300
Less: uncredited cheques; Taifa 600
Errors that reduce bank balance xx (600)
Balance as per bank statement as at 31st December 2006 6,700
November1992Q
A trainee accountant working for a sole trader, Juma Mambo Leo had prepared the
following summary of the cash book for the month of March 1999
Cash book Sh Sh
Opening balance b/d 561000 Payments 4,189,000
Receipts 3748000 Closing balance c/d120,000
43
S T U D Y T E X T
Whilst checking the cash book against t the bank statement you find the following
discrepancies;
(i) Bank charges of Sh 8000 shown in the bank statement have not been entered in the
cash book
(ii) The bank has debited a cheque of Sh 37000 in error in the account of Juma Mambo
Leo
(iii) Cheques totaling Sh 96000 have not been presented to the bank for payment.
(iv) Dividends received for Sh 4200 have been credited on the bank statement but not yet
recorded on Juma Mambo Leo’s cash book
(v) There were cheques received of Sh 484000 which were entered in the cash book but
not yet credited by the bank.
(vi) A cheque of Sh 17000 has been returned by the bank marked as ‘refer to drawer’ but
no entry relating to this has been made in the books.
(vii) The opening balance in the cash book should have been Sh 651000 and not Sh
561000
(viii) The bank statement shows that there is n overdraft at 31st march 1999 of Sh 198000
Required
(i) State and briefly explain two purposes of a bank reconciliation statement.
(ii) Entries necessary to correct the cash book
(iii) A bank reconciliation statement as at 31st march 1999
(KASNEB)
Suggested solution
(i) Purposes of a bank reconciliation statement
Bank reconciliation is an attempt to explain the differences between the cash
book’s cash at bank balance and the balance shown in the bank statement
It is prepared for the following reasons;
• To update the cash book with some relevant entries appearing in the bank
statement e.g. bank charges, direct debit and credit dishonoureddishonored
cheques e.t.c
• To detect or prevent errors or frauds that relate to the cash book
• To prevent or prevent errors or frauds that relate to the bank
(ii) The first step will be to update the cash book as follows:
It is prepared for the following reasons:
• To update the cash book with some relevant entries appearing in the bank
statement e.g. bank charges, direct debit and credit dishonored cheques e.t.c
• To detect or prevent errors or frauds that relate to the cash book
• To prevent or prevent errors or frauds that relate to the bank
(ii) The first step will be to update the cash book as follows:
Corrected Cash Book
2006 Sh 2006 Sh
Balance b/d 120000 Bank charges 8000
Dividend received 42000 Returned cheque 17000
Error in opening balance 90000 Balance as per cash book 227000
252000 252000
Bank reconciliation statement
ACCOUNTING PROCEDURES AND TECHNIQUES
4 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
Bank reconciliation statement
As at 31st march 1999
Sh Sh
Balance as per updated cash book 227000
Add:
Un-presented cheques 96000
Errors that increase bank balance ---
96000
Less:
Uncredited cheques 484000
Errors that reduce bank balance 37000
(521000)
Balance as per bank statement (overdraft) (198000)
Reinforcement question may 2003 q2 (solution at the back)
2.7 THE PETTY CASH BOOK
Fast forward – Most businesses keep petty cash on the premises, which is topped up from the
main account.
Majority of business payments are made by cheque. However for some amounts, the cashier
need not write a cheque for each.
Examples of such payments includes when a staff member is given some bus fare from office to
town on official duty, when stationery is bought e.g. pens e,t,ce.t.c. Such transactions involve fairly
small amount s which does not warrant the writing of a cheque. For this reason most businesses
maintain a petty cash usually handled by the petty cashier. The petty cashier is usually given a
certain amount to use in the payments, called a cash float. The petty cashier maintains records
of all the expenses paid out (either by keeping receipts or preparing petty cash vouchers which
are signed against). After some time the petty cashier will request to be reimbursed for all the
amounts paid out of the cash float given to him. This system of reimbursing some amount to the
petty cashier after a certain period of time to maintain the cash float is known as the imprest
system.
45
S T U D Y T E X T
The petty cash book maintains columns relating to specific expenses e.g. traveling entertainment,
stationery, general office expenditure, postage e.t.c. it is upon a business enterprise to determine
the number of expenses account to maintain under the petty cash system.
Format of a petty cash book
The ledger column is used to record the amount paid by petty cash to a person/ business with
whom we have an account. A good example is when we pay creditors the amount owed using
the petty cash.
>>> Illustration
Given the information below write up a petty cash book with the following columns; :
i. Postage and telegram
ii. Stationery
iii. Traveling
iv. Office expenses
v. The ledger
i) January 1 received petty cash Sh 20000
ii) January 1 paid for sugar Sh 700
iii) January 2 bought pencils and pens Sh 800
iv) January 4 bus fare Sh 400
v) January 5 telegram Sh 1500-
vi) January 8envelops Sh 900
vii) January 9paid David (trade creditor) Sh 6000
viii) January 9 coffee Sh 200
ix) January 15 cleaning Sh14000
payments, called a cash float. The petty cashier maintains records of all the expenses
paid out (either by keeping receipts or preparing petty cash vouchers which are signed
against). After some time the petty cashier will request to be reimbursed for all the
amounts paid out of the cash float given to him. This system of reimbursing some
amount to the petty cashier after a certain period of time to maintain the cash float is
known as the imprest system.
The petty cash book maintains columns relating to specific expenses e.g. traveling
entertainment, stationery, general office expenditure, postage e.t.c. it is upon a business
enterprise to determine the number of expenses account to maintain under the petty
cash system.
Format of a petty cash book:
Expenses
Receipts Date Detail Payment
amount
Postage Stationery General
expense
s
Travel Entertainment The
ledger
ACCOUNTING PROCEDURES AND TECHNIQUES
4 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
The ledger column is used to record any payments made to supplier with whom we have an
account. inIn the illustration above David is one such supplier.
At the end of a certain period of time the respective expenses columns are summed up and
posted to specific expenses accounts in the general ledger. The petty cashier is also given a
cheque/ cash as reimbursement for the amount expensed (in this case shsSh13100 Sh 13100
will be reimbursed to the cashier to make the original float of shsSh20000Sh 20000)
Further exercises:
Q1 K.A.S.N.E.B. ADOPTED
(a) Differentiate between a petty cash book and a three column cash book.
(b) Explain why it is important for a bank to prepare a bank reconciliation statement.
(c) You have recently been employed in a medium sized company and deployed in the
accounts department. Your section head has given you the following extracts form the
cashbook for the month of April 2003.
The head of section further informs you that all receipts are banked intact and all payment s are
made by cheque. On investigation you discover the following:
(i) Bank commissions and charges amounting to shsSh272000 Sh 272000 entered on the
bank statement had not been entered in the cash book.
(ii) Cheques drew\an amounting to shsSh534000 Sh 534000 had not been presented to
the bank for payment.
(iii) Cheques amounting to shsSh Sh 1524000 had been entered in the cash book as paid
to the bank but had not been credited by the bank till may 2003
(iv) A cheque of shsSh44000 Sh 44000 had been entered in the cash book as receipt
instead of a payment
(v) A cheque of shsSh Sh 50000 had been debited by the bank by mistake
vi) January 8envelops Sh 900
vii) January 9paid David (trade creditor) Sh 6000
viii) January 9 coffee Sh 200
ix) January 15 cleaning Sh14000
Expenses
Receipts Date Detail Payment
amount
Telegram
Postage
Stationery Travel Office General The
ledger
20000 Jan
1
Petty cash
1 Sugar 700.00 700.00
2 Stamps 1200.00 1200
3 Pencils
and pens
800.00 800.00
4 Bus fare 400.00 400.00
5 Telegram 1500.00 1500.00
8 Envelopes 900.00 900.00
9 David 6000.00 6000.00
9 Coffee 200.00 200.00
15 Cleaning 14000.00 14000.00
Total 13100 2700.00 800.00 400.00 2300.00 900.00 6000.00
ledger column is used to record any payments made to supplier with whom we have an account. In the illustration above David
one such supplier.
47
S T U D Y T E X T
(vi) A cheque received for shsSh Sh 160000had been returned unpaid. No adjustment has
been made in the cashbook
(vii) All dividends receivable are credited directly into the bank account. During the month
of April 2003 divindedsdividends totaling shsSh142000were Sh 142000 were credited
into the bank account. No entries have been made in the cash book.
(viii) A cheque drawn for shsSh12000has Sh 12000 has been incorrectly entered into the
cash book as Sh 132000
(ix) The balance brought forward in the cash book should have been
(x) Sh (Confirm this) The bank statement as at 30th April showed an overdraft of
ShSh2,324,000
2.8 INTRODUCTION TO INITIAL ACCOUNTS
So far we have looked at books of original entry. After the initial recording, the transactions
are then entered into individual accounts in the ledger. The accounts are either personal or
impersonal.
Personal accounts deal with individuals (debtors and creditors)
Impersonal accounts are either real or nominal. Real accounts record assets (things of value)
while nominal accounts record revenues, expenses and capital.
RECORDING TRANSACTIONS WITH REGARD TO LIABILITIES
When we increase our liabilities it means we have obligations to fulfill in the future. On the other
hand for all these obligations we have an asset to be exchanged for the liability that we take up.
All increase in liabilities:
Dr. Asset account
Cr. Liability account
>>> Illustration (i)
On 3rd June 2004 Ramani stores bought stock on credit from Jitegemea stores. The stock was
worth shsSh200000Sh 200000
Dr. Purchase account 200000
Cr. Jitegemea Stores (creditor) shsSh200000Sh200000
(To record purchase of stock on credit)
For most businesses expenses, the services are first offered and then paid for later.
ACCOUNTING PROCEDURES AND TECHNIQUES
4 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
Illustration (ii)
Electricity for June 2005 was Sh.40000 it was paid for at a later date.
Dr. Electricity account Sh.40000
Cr. Accrued expenses shsSh.40000
RECORDING TRANSACTIONS WITH REGARD TO CAPITAL
When the owner injects more capital into the business
Dr. Cash/bank
Cr. Capital account
Sometimes however the capital may not be in the form cash but he may introduce his own asset
to be used in the business. In that case the particular asset account will be debited instead of
cash.
Illustration iii
On 1st January 2005 Mr. Makhoha started a business. He decided to make a building which he
previously rented out to be his operating premises. In addition, he deposited Shs1000000 Sh
1000000 into the business’ bank account. The building was worth Sh 400000.
The entry will be as follows.
Dr. bank Sh 1000000
Dr. Building Sh 400000
Cr. Capital SH 1400000
The entries will appear as follows in the specific accounts.
The entries will appear as follows in the specific accounts.
Bank a/c
Sh Sh
27/5 Capital 1000000 /5
Building a/c
Sh Sh
27/5 Capital 1400000 /5
49
S T U D Y T E X T
RECORDING TRANSACTIONS WITH REGARD TO INCOME
When we make sales the following is possible:
• The customer to pay in cash
• The customer to purchase on credit
>>> Illustration
Lenana store sold goods worth shs Sh 90000 to Batian stores on 25th November 2006
Batian stores immediately paid for the goods worth Sh 20000 a cheque. The transaction will be
recorded as follows:
Bank a/c
Sh Sh
27/5 Capital 1000000 /5
Building a/c
Sh Sh
27/5 Capital 1400000 /5
Sh Sh
27/5 Capital 1000000 /5
Building a/c
Sh Sh
27/5 Capital 1400000 /5
Capital a/c
Sh Sh
27/5 /5 Bank 1000000
Building 400000
RECORDING TRANSACTIONS WITH REGARD TO INCOME
When we make sales the following is possible:
• The customer to pay in cash
• The customer to purchase on credit
Illustration
Lenana store sold goods worth Sh 90000 to Batian stores on 25th November 2006
Batian stores immediately paid for the goods worth Sh 20000 a cheque. The transaction will be recorded as follows:
Dr. Bank Sh 90000
Cr sales90000
Bank a/c
Sh Sh
sales 90000 Cash 20000
Sales
Sh Sh
bank 90000
ACCOUNTING PROCEDURES AND TECHNIQUES
5 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
>>> Illustration II
If Batian stores did not pay immediately, the entries made by Lenana stores would have been as
follows.
Dr. Batian stores a/c debtor Sh 90000
Cr. Sales account Sh 90000
On the day that Batian stores will pay, the following g entries will be made.
Dr. Cash/ bank Sh 90000
Cr. Batian stores a/c debtor Sh 90000
Batian Stores debtor a/c
Sh Sh
27/5 sales 90000 /5 Cash 90000
Sales a/c
Sh Sh
27/5 /5 Batian stores a/c debtor 90000
Bank a/c
Sh Sh
27/5 batian stores a/c debtor 90000 /5
RECORDING TRANSACTIONS WITH REGARD TO EXPENSES
51
S T U D Y T E X T
RECORDING TRANSACTIONS WITH REGARD TO EXPENSES
All expenses have debit entries.
If we incur a business expense and pay for it in cash,
Dr. Expenses account
Cr. Bank account
>>> Illustration
Kimuchu wholesalers’ motor vehicle was repaired at a cost of shsSh12000 which 12000 which
was paid immediately in cash.
The entries to record the above transactions would be as follows
Dr. Motor vehicle repairs Account Sh120000
Cr. Cash account Sh 120000
If we incur one expense and pay for it later the entries made will be as follows.
Dr. Expenses account
Cr. Creditors account
>>> Illustration
If Dubai wholesalers took their motor vehicle for repair to Toyota E.A for repairs. The entries
would be as follows:
Dr. motor vehicle repairs account
Cr. Toyota E.A account (creditor)
When Dubai wholesalers later pay for the repairs, the following entries will be made.
Dr. Toyota E.A account (creditor)
CR cash account
This will eliminate the balance in the Toyota E.A account provided they pay for the repairs in
full.
However it is important to note that not all business expenses involve movement in cash. Some
do not involve movement of cash and are recognized in the book as provisions. An example
would be depreciation and doubtful debts provision. The entries in such accounts will be:
ACCOUNTING PROCEDURES AND TECHNIQUES
5 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Dr. Expenses account
Cr. Provision for (specific expense)
>>> Illustration
For the month of May 2006 XYZ Co. Ltd incurred depreciation expense on motor vehicles
Sh.400000.
The entries will be as follows
Dr. Motor vehicle depreciation account Sh 40000
Cr. Provision for depreciation on motor vehicle account Sh 40000
The provision for depreciation and for doubtful debts will be covered more comprehensively later
on in this course.
Motor vehicle depreciation account
Sh Sh
27/5 Provision for depreciation on
motor vehicle account
40000 /5 Bank 90000
Provision for depreciation on motor vehicle account
Sh Sh
27/5 /5 Motor vehicle depreciation
account
40000
The provision for depreciation and for doubtful debts will be covered more comprehensively later on in this course.
Cash account
2006 Sh 2006 Sh
1/5 Balance b/f 2000 7/5 Expenses 4500
4/5 Sales 10000 11/5 Purchases 9700
8/5 Debtor 2500 31/5 Balance c/d 300
14500 14500
1/6 Balance b/f 300
53
S T U D Y T E X T
2.9 BALANCING OFF ACCOUNTS
When balancing off accounts we add up the debit side of each account and compare it with the
sum of the credit side of the same account. The difference is put as the balance carried down
(Balance c/d) on the side that is less such that the two sides now balance.
On the opposite side of the balance c/d and below the balancing totals, the opening balance for
the next accounting period is indicated as balance brought forward (balance b/f)
>>> Example I
Enter the following transactions in a cash account and then balance it off showing clearly the
balances c/d and balances b/f
i) Balance brought forward in the cash till at 2000 1 May 2006
ii) Cash sales of 10000 4 May 2006
iii) Cash received from debtors 2500 11May 2006
iv) Expenses paid 4500 7 May 2006
v) Cash purchases 9700 11May 2006
When balancing off accounts:
i) The totals should appear on the same line on the credit and the debit side
ii) A single line should be drawn above the totals and a double line below the totals on both
the credit and debit sides.
iii) The balance C/D can be on either side depending on which side has the higher
amount.
Motor vehicle depreciation account
Sh Sh
27/5 Provision for depreciation on
motor vehicle account
40000 /5 Bank 90000
Provision for depreciation on motor vehicle account
Sh Sh
27/5 /5 Motor vehicle depreciation
account
40000
The provision for depreciation and for doubtful debts will be covered more comprehensively later on in this course.
Cash account
2006 Sh 2006 Sh
1/5 Balance b/f 2000 7/5 Expenses 4500
4/5 Sales 10000 11/5 Purchases 9700
8/5 Debtor 2500 31/5 Balance c/d 300
14500 14500
1/6 Balance b/f 300
ACCOUNTING PROCEDURES AND TECHNIQUES
5 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
However in common practice the following can be deduced concerning the balance b/d of various
accounts:
• All assets have debit balances
• All liabilities Have credit balances
• Capital always has credit balance
• Income accounts have credit balances
• Expenses accounts have debit balances.
A credit balance means that the totals on the credit side as higher than those on the debit side
hence the balancing figure (balance c/d) goes to the debit side. A debit balance occurs when
the debit side is higher than the credit side hence the balancing figure (balance c/d) goes to the
credit side.
The purposes of balancing off accounts would be
• Identify how much is outstanding in a particular account. Ee.g. how much credit sales
are yet to be paid for?
• Determine the expenses that have been incurred
• To determine how much the business owes to the suppliers
• To identify transactions that may have been omitted for debtors.
In balancing off accounts you will realize that not all accounts have a balance at the end of a
particular period. An example would be when a particular customer purchased goods on credit
worth Shs.400000and later paid the entire amount of Shs400000 before the accounts were
balanced off. His account will have no balance to carry forward to the next period and would not
be included in the balances appearing in the sales ledger.
>>> Example II
Mr. John Kimuto bought goods worth Sh 50000 from Katune Electronics on 1st January 2007. He
paid the amount on 15th January 2007.
On 18th and 20th of the same month he bought other goods on credit worth Sh 14000 and 40000
respectively, and paid shs Sh 54000 by cheque on 28th. Prepare John kimuto’s account in the
books of Katune Electronics as at 30th January 2007
Mr. John Kimuto a/c
2007 Sh Sh
1/1 Sales 50000 15/1 bank 50000
18/1 Sales 14000 28/01 Bank 54000
20/1 sales
40000
104000 104000
However assuming the same transactions only that he was able to pay Sh14000 instead of Sh54000 his
55
S T U D Y T E X T
However assuming the same transactions only that he was able to pay shsSh14000 instead of
shsSh54000 his account would appear as follows:
This balance of shs Sh.40000 will be included in the sales ledger at the end of the month. It will
be shown under John Katune. At the end of the period the total amount of the sales ledger will
represent the amount owed to the business by customers. i.e. debtors.
RECORDING TRANSACTIONS WITH REGARD TO ASSETS
All accounting in the business organization will fall under the defined terms.
Increase in an asset can be due to any of the following:.
i) Buying a new asset either in cash/bank
ii) Revaluing existing assets
iii) Buying a new asset on credit
For all the above entries we make a debit to the assets account and credit to the respective
account as follows.
Cash purchase:
i) Dr. Motor vehicle account
Cr. Cash/bank
ii) Dr. Motor vehicle a/c` (with increase in value)
Cr. revaluation
iii) Dr. Motor vehicle a/c
Cr. Creditor a/c
When we increase an asset, we make a debit entry into the account.
For example; on 7th June 2006, Mr. Matatu bought a motor vehicle for cashssh Sh hs50000. The
following will be the entry
20/1 sales
40000
104000 104000
However assuming the same transactions only that he was able to pay Sh14000 instead of Sh54000 his account follows:
Mr. John Kimuto
2007 Sh Sh
1/1 Sales 50000 15/1 bank 50000
18/1 Sales 14000 28/01 Bank 14000
20/1 sales
40000 30/1 Balance c/d 40000
104000 104000
01/2 balance b/d 40000
ACCOUNTING PROCEDURES AND TECHNIQUES
5 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
. Dr. assetsAssets account (motor vehicle) 50000
Cr. Cash at bank account 50000
When we decrease an asset, we make a credit entry into the account.
Decrease in an asset can be as a result of of:
• Selling an existing asset for cash
• Selling an existing asset on credit
• Revaluation of an asset below its net book value
• Writing off an existing asset for no value.
The transaction is recorded as follows:
Selling an existing asset on cash:
Dr. Cash/bank account (with cash received)
Cr. Asset account
Selling an existing asset on credit:
Dr. Debtor account (with the sales value)
Cr. Asset account
Revaluation of existing assets:
Dr. Asset revaluation account
Cr. Asset account
Sometimes the current assets may be disposed at a value higher than their book value. This
results into a gain on disposal. The same asset can be disposed at a lower value than its book
value resulting to a loss on disposal.
57
S T U D Y T E X T
In this case transactions are recorded as follows:
Gain on disposal:
Dr. Cash/ bank/ debtor account (selling price of the asset)
Cr. Asset account (with the book value of the asset)
Cr. Gain on disposal account (with the amount of the selling price above the
book value)
Loss on disposal:
Dr. Cash /bank/ debtor account (with the selling price of the asset)
Dr. Loss on disposal account (with the amount of selling price below the book value)
Cr. Asset account (with the book value of the asset)
>>> Illustration 1
Doe Co. LTD sold on e of the existing machinery for Sh 200000. The machinery was received in
cash. The entry will be as follows:
Dr. cash 200000
Cr. Machinery 200000
Dr. cash 200000
Cr. Machinery 200000
Machinery a/c
Sh Sh
27/5 /5 Cash 200000
Cash account
Sh Sh
Machinery 200000
Illustration 2
When preparing the financial statements for the year 2005, Doe Co. Ltd hired the services of a professional ACCOUNTING PROCEDURES AND TECHNIQUES
5 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
>>> Illustration 2
When preparing the financial statements for the year 2005, Doe Co. Ltd hired the services of a
professional valuer, to revalue an existing motor vehicle which they thought had a book value
of less than what was shown as the net book value due to the bad state of the roads. The
professional valuer valued it for Sh 50000 while us the net book value was Sh 80000.
The recording will be as follows:
Dr. Revaluation account Sh (80000 - 50000) Sh 30000
Cr. Motor vehicle account ShsSh30000
2.10 EXTRACTION OF THE TRIAL BALANCE
At the end of a given period, all the accounts are balanced off and the balances brought forward
are then extracted and used to prepare what is known as a trial balance.
A trial balance can be defined as a list of account tittles and their balances in the ledger on a
specific date shown in debit and credit columns.
If the double entry in the respective was done correctly then the trial balance should balance i.ei.
e. the debit and the credit balances should equal.
However strange, as it may seem, a balanced trial balance is no guarantee that posting was
done correctly since there are some errors that could pass unnoticed and the trial balance still
balances. These will be discussed later on this chapter.
Cr.Motor vehicle account Sh30000
Machinery a/c
Sh Sh
27/5 /5 revaluation account 30000
Revaluation account
Sh Sh
27/5 /5 Cash 200000
EXTRACTION OF THE TRIAL BALANCE
59
S T U D Y T E X T
A trial balance should have the exact date in which it was extracted. This is because, a trial
balance is a “snap-shot” of a particular day and any other day would have a trial balance with
totally different figures.
>>> Illustration
Record the following transaction s for the month of November for M.S Suppliers. Balance off all
the accounts and extract a trial balance as at 30th November 2006
Year 2006
November 1 Started Started business with Sh.175000 in cash
November 2 Put Put Sh140000 of the cash into the bank account
November 3 Bought goods for cash worth Sh.7500
November 4 Bought Bought stationery on credit Sh.17000 from Nzomo
November 5 Bought goods on credit from Isaac Sh 18000, Philips Sh.24500, Timothy Sh.5500
Mathew Sh17000
November 6 Paid rent by cheque Sh.2750
November 7 Sold goods on credit to Njeri Sh 4500, Onyango Sh7500 Muiru Sh 9500
Tinga Sh 8000
November 8 Bought Bought furniture from Irungu Suppliers on credit Sh 24000
November 12 Paid Paid salaries and wages Sh 6000 cash
November 14 Returned goods to Timothy Sh 3000, Philip Sh 2000
November 15 bought Bought an old motor van by cheque Sh 35000
November 16 received Received loan from Henry by cheque Sh 30000
November 17 Goods returned to us by Njeri Sh1000 Sh1000 Muiru Sh 2000
November 18 Cash sales Sh 450
November 21 Sold goods on credit to Pauline Sh5750, Onyango Sh 50100 Tinga Sh 4500
November 24 We paid the following by cheque Philips Sh 2250 Timothy Sh2500
November 25 Received a cheque from Pauline Sh 5750, onyango Sh 12500
November 28 Received a further loan from Henry Sh 10000 cash
November 30 Received Sh 25000 Received Sh 25000 from Tinga in cash.
ACCOUNTING PROCEDURES AND TECHNIQUES
6 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
SSuuggggeesstteedd ssoolulutitoino n
Cash a/c
2006 Sh 2006 Sh
1/11 Capita 175000 2/11 bank 140000
18/11 Sales 4500 3/11 Purchases 7500
28/11 Henry 10000 12/11 Salaries and wages 6000
30/11 Tinga 25000 30/11 Balance c/d 61000
214500 214500
1/12/ Balance b/d 61000
Capital a/c
2006 Sh 2006 Sh
30/11 Balance c/d 175000 1/11 Cash 175000
1/12 Balance b/d 175000
Bank account a/c
2006 Sh 2006 Sh
2/11 Cash 140000 6/11 Rent 2750
16/11 Loan Henry 30000 15/11 Motor van 35000
25/11 Pauline 5750 24/11 Philips 22500
25/11 Onyango 12500 24/11 Timothy 2500
30/11 Balance c/d 125500
188250 188250
30/11 Balance b/d 125500
61
S T U D Y T E X T
Sales returns a/c
2006 Sh 2006 Sh
17/11 Njeri 1000 30/11 Balance c/d 3000
17/11 Muiru 2000
3000 3000
30/11 Balance b/d 3000
Purchases a/c
2006 Sh 2006 Sh
3/11 Cash a/c 7500 30/11 Balance c/d 72500
5/11 Isaac 18000
Philips 24500
Timothy 5500
Mathew 17000
72500 72500
1/12 Balance b/d 72500
Sales a/c
2006 Sh 2006 Sh
30/11 Balance c/d 61750 7/11 Njeri 4500
7/11 Onyango 7500
7/11 Muiru 9500
7/11 Tinga 8000
18/11/
c
cash 4500
21/11 Pauline 5750
21/11 Onyango 5000
21/11 Tinga 17000
102250 61750
1/12 Balance b/d 61750
ACCOUNTING PROCEDURES AND TECHNIQUES
6 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Purchases returns a/c
2006 Sh 2006 Sh
31/11 Balance b/d 5000 14/11 Timothy 3000
14/11 Philip 2000
5000 5000
1/12 Balance b/d 5000
Furniture a/c
2006 Sh 2006 Sh
8/11 Irungu suppliers 24000 31/11 Balance c/d 24000
1/12 Balance b/d 24000
Motor van a/c
2006 Sh 2006 Sh
15/11 bank 35000 31/11 Balance c/d 35000
1/12 Balance b/d 35000
Rent a/c
2006 Sh 2006 Sh
6/11 bank 2750 31/11 Balance c/d 2750
1/12 Balance b/d 2750
Salaries and wages a/c
2006 Sh 2006 Sh
12/11 cash 6000 31/11 Balance c/d 6000
1/12 Balance b/d 6000
Stationery a/c
2006 Sh 2006 Sh
4/11 Nzomo 8500 31/11 Balance c/d 8500
1/12 Balance b/d 8500
Njeri a/c
2006 Sh 2006 Sh
63
S T U D Y T E X T
2006 Sh 2006 Sh
4/11 Nzomo 8500 31/11 Balance c/d 8500
1/12 Balance b/d 8500
Njeri a/c
2006 Sh 2006 Sh
7/11 sales 4500 17/11 Sales returns 1000
31/11 Balance c/d 3500
4500 4500
1/12 Balance b/d 3500
Onyango a/c
2006 Sh 2006 Sh
7/11 sales 7500 25/11 bank 12500
21/11 sales 5000
12500 12500
Tinga a/c
2006 Sh 2006 Sh
7/11 sales 8000 30/11 Cash 25000
21/11 sales 17000
25000 25000
Muiru a/c
2006 Sh 2006 Sh
7/11 Sales 9500 17/11 Sales returns 2000
31/11 Balance c/d 7500
9500 9500
1/12 Balance b/d 7500
Nzomo a/c
2006 Sh 2006 Sh
31/11 Balance c/d 8500 4/11 Stationery 8500
1/12 Balance b/d 8500
Isaac a/c
2006 Sh 2006 Sh
31/11 Balance c/d 18000 5/11 Purchases 18000
1/12 Balance b/d 18000
Philip a/c
ACCOUNTING PROCEDURES AND TECHNIQUES
6 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
2006 Sh 2006 Sh
31/11 Balance c/d 18000 5/11 Purchases 18000
1/12 Balance b/d 18000
Philip a/c
2006 Sh 2006 Sh
14/11 Purchase returns 2000 5/11 Purchases 24500
24/11 Bank 22500
24500 24500
Timothy a/c
2006 Sh 2006 Sh
14/11 Purchase returns 3000 5/11 Purchases 5500
24/11 bank 2500
5500 5500
Mathew a/c
2006 Sh 2006 Sh
31/11 Balance b/d 17000 5/11 Purchases 17000
1/12 Balance b/d 17000
Irungu supplies a/c
2006 Sh 2006 Sh
31/11 Balance c/d 24000 8/11 furniture 24000
1/12 Balance b/d 24000
Pauline a/c
2006 Sh 2006 Sh
21/11 Sales 5750 25/11 bank 5750
Loan Henry a/c
2006 Sh 2006 Sh
31/11 Balance b/d 40000 16/11 bank 30000
28/11 Cash 10000
40000 40000
1/12 Balance b/d 40000
65
S T U D Y T E X T
M.S SUPPLIES
TRIAL BALANCE AS AT 30TH NOVEMBER 2006
Dr. Cr.
Cash 61000
Bank 125500
Capital 175000
Sales returns 3000
Purchases 72500
Sales 61750
Purchases returns 5000
Furniture 24000
Motor van 35000
Rent 2750
Salaries and wages 6000
Henry loan account 40000
Stationery account 3500
Njeri(SL) 8500
Tinga (SL) -
Muiru (SL) 7500
Nzomo (PL) 8500
Isaac (PL) 18000
Mathew(PL) 17000
Irungu(PL) 24000
349250 349250
Note:
So many businesses have a large number of suppliers and customers and hence instead of
bringing each individual debtor/ creditor balance in the trial balance, we bring total of the accounts
obtained form the sales ledger and the purchase ledger. These two show the figures of debtors
and creditors respectively.
ACCOUNTING PROCEDURES AND TECHNIQUES
6 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
2.11 ERRORS NOT AFFECTING THE TRIAL BALANCE
If double entry is followed when recording all transactions into the books of accounts, then the
trial balance would balance. However there are some errors that would occur while entering the
transactions but this would not affect the balancing of the trial balance.
The following are the errors that do not affect the balancing of the trial balance
(i) Errors of Omission
This is an error that occurs when a transaction is completely omitted from the books of accounts.
For example if we bought a motor van shs Sh 90000 cash and we neither debit the motor vehicle
account nor credit the cash account the trial balance would not be affected and it would still
balance.
(ii) Errors of Principle
This occurs when we enter a transaction in the wrong class of account, but still observe double
entry. For example we purchase furniture (fixed asset) worth shs Sh 200000 for cash. We debit
purchases account instead of debiting the furniture account and crediting the cash account. In
such an instance the trial balance would still balance.
iii) Errors of Commission
These types of errors occur when the correct amount is entered but in the wrong persns personal
account though the account is in the same class of accounts. For example sales of shs Sh 20000
sold to D. Waithaka but posted to P. Waithaka’s account in the sales ledger. The transaction
would be as follows.
Dr. P. Waithaka 20000
Cr. Sales 20000
The correct entry would have been
Dr. D Waithaka 20000
Cr sales 20000
67
S T U D Y T E X T
To correct such an error, the following entry will be passed in the books.
Dr. D. Waithaka 20000
CR. D Waithaka 20000
This is just a reversing transaction that transfers the amount from P. Waithaka to the correct
account of D Waithaka. You will note that the sales entry is no affected by the reversal and since
both P. Waithaka and D. Waithaka are in the sales ledger, the trial balance would still balance.
iv) Compensating Errors
These are errors that cancel out each other e.g. an error that overstates booth the credits and
the debits or an error that understates both the debits and the credits by the same amount. E.g.
if If the purchases returns was overstated by shsSh2000 2000 and the sales return overstated
by Sh 2000. Since the purchases returns appear on the credit side and the sales returns appear
on the debit side of the trial balance, the two would cancel out each other.
To correct the above error
Dr. Purchases returns Sh 2000
Cr. Sales returns Sh 2000
Another example would be overstating purchases as well as sales by the same amount;
overstating both sides of a particular account by the same amount e.t.c.
v) Errors of Original Entry
These are errors that occur when the original figure is incorrect and yet double entry is still observed
using the incorrect figure. The figure cold eithercould either be understated or overstated.
>>> Example
Purchases worth shs20000 Sh 20000 recorded as Sh 200000 in both the purchase account and
the cash account.
The incorrect entry would appear as follows
Dr. Purchases 200000
Cr. Cash/ bank200000
ACCOUNTING PROCEDURES AND TECHNIQUES
6 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
The correct entry should have been
Dr. Purchases account 20000
CR. Cash/bank 20000
To correct the error, we make the following entries.
Dr. Cash at bank Sh 180000
Cr. Sh180000
vi) Complete Reversal of Entries
This is an error that occurs when the correct amount is posted in the correct account but in the
wrong side of the account. For Example: if we sold goods on credit to D. Kameme worth shsSh
100000 the wrong entry would appear as follows.
Dr. Sales 100000
Cr. P. Kameme 100000
The correct entry would have been
Dr P Kameme 200000
Cr. Sales 200000
Correcting the above error is done in two stages:
• Canceling the initial recording
• Recording the correct entry.
This is done as follows:
Dr P. Kameme 100000
Cr. Sales 100000
(To cancel the initial entry in the accounts)
Dr. P Kameme shsSh 100000
Cr. Sales 100000
(To Record the correct entry)
69
S T U D Y T E X T
The accounts would appear as follows:
Vi) Transposition errors
This is a special type of an error of original entry. It occurs when the wrong sequence of individual
characters in a figure is entered. Example For exampleentering, entering shsS870 h 870 as shsS
h 780. itIt is an error that is very difficult to trace, however if it occurs only on one side of the entry
then the difference will be a number divisible by nine and hence easier to trace.
>>> Illustration
Cash sales Sh 9260 entered as Sh 6290 on both cash book and sales ledger
The wrong entry would appear as follows.
Dr. Cash Sh 6290
Cr. Sales Sh 6290
The correct entry would have been
Dr. Cash Sh 9260
Cr. Sales Sh 9260
The accounts would appear as follows:
P. Kameme a/c
2006 Sh 2006 Sh
01/1 Sales (to cancel) 100000 01/1 Sales(to cancel) 100000
01/1 Sales (to enter correct entry) 100000
Sales
Sh Sh
27/5 /5 P. Kameme a/c(to cancel) 100000
P. Kameme a/c(to enter
correct entry)
100000
Vi) Transposition errors
ACCOUNTING PROCEDURES AND TECHNIQUES
7 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
To correct the above entry
Dr. Cash (9260 - 6290) Sh 2970
Cr. Sales (9260 - 6290) Sh 2970
>>> Exercise: 1
Show the journal entries required to correct the following errors. Entries; narratives must
be shown.
1) Ccommissions received shs Sh 44000 had been credited to rent receivable account
2) bank Bank charges shsSh 3850 had been debited to rent account
3) Ccompletely omitted from the books of account is a payment of sundry expenses by
cheque shsSh 1150
4) purchase Purchase of fixtures Sh 23700 had been entered in purchases account
5) Rreturn inwards of shs Sh 41650 had been entered on the debit side of the return
outwards account
6) aA loan from R. Simiyu shsSh25000 had 25000 had been entered on the credit side
of capital account
7) Loan interest shs Sh 2500 had been debited in the premises account
8) Goods taken for own use shs1250had worth Sh 1250 had been debited to purchases
account and credited to drawings account.
Suggested solution:
1) Dr Rent received account 44000
Cr. Commissions received 44000
(Correction of an error where commission received was credited to rent received)
2) Dr. bank charges a/c 3850
Cr. rent a/c 3850
(To correct wrong debit of bank charges in the rent account
3) Dr. Sundry expenses a/c 1150
Cr. Bank a/c 1150
(To record omitted payment of sundry expenses)
4) Dr. Fixtures 23700
Cr. Purchases a/c 23700
(To correct error of principle where purchases of fixed assets is treated as purchase)
71
S T U D Y T E X T
5) Dr. Return outwards 41650
Cr. Return inwards 41650
(To correct entry return inwards in the debit of return outwards a/c)
6) Dr Capital account 25000
Cr. R. Simiyu a/c 25000
(To correctly record loan received from R. Simiyu)
7) Dr Loan interest a/c 2500
Cr. Premises a/c 2500
(To correctly record interest on loan)
8) Dr drawingsDrawings a/c (1250 x 2) 2500
Cr. Purchases a/c (1250x2) 2500
Note
We double the figures when correcting errors of complete reversal of entries like that in (8)
above. This is because if an amount was debited instead of being credited in the same account,
a single credit entry would just cancel the initial debit. However the second credit entry will now
enter the required credit entry. Instead of showing the two credit entries separately, the amount
involved is doubled and a single entry made but with a double value made.
2.12 SUSPENSE ACCOUNT
Due to poor double entry or other errors not falling in the category described above, the trial
balance may fail to balance. In most cases the error causing this may take long to be identified.
Before then the accountant is allowed to open up an account known as the suspense account.
To this account, he assigns the balance equal to the difference between the credit and debit
sides of the trial balance to ensure that the trial balance balances. For example if the debit side
exceeds the credit side by Sh100000, suspense account will be assigned a credit balance equal
to Sh100000 thus balancing the trial balance. Later on when the cause of the error is identified,
journal entries are passed against the suspense account till its balance is cleared thus eliminating
it from the books.
Basically all errors affecting the balancing of the trial balance necessitate the creation of a
suspense account. A few of such are discussed below.
ACCOUNTING PROCEDURES AND TECHNIQUES
7 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Failure to enter a corresponding entry for every debit or credit entry made
Making a wrong corresponding entry e.g. if cash sales of shs Sh 20000 are made and a debit
entry correctly made in the cash book. However the sales account is credited with Sh Sh2000.
This means that the credit side of the trial balance will be understated by Sh 18000. A suspense
account will thus be created and assigned accredit balance of Sh 18000 to make the trial balance
“appear’ balanced awaiting identification and correct of the error.
Once the error is identified then journal entries need to be passed topassed to remove the
suspense account as follows:
Dr. Suspense account 18000
Cr. Sales account 18000
(To correct the error understating the credit balances of the trial balance)
Students are however cautioned that the suspense account should not be used to balance the
trial balance unless the examiner specifically asks the students to do so.
2.13 VALUATION OF INVENTORY
There are three basis approaches to valuing inventory that are allowed by GAAP –
(a) First-in, First-out (FIFO):
Under FIFO, the cost of goods sold is based upon the cost of material bought earliest in the
period, while the cost of inventory is based upon the cost of material bought later in the year. This
results in inventory being valued close to current replacement cost. During periods of inflation, the
use of FIFO will result in the lowest estimate of cost of goods sold among the three approaches,
and the highest net income.
(b) Last-in, First-out (LIFO):
Under LIFO, the cost of goods sold is based upon the cost of material bought towards the end
of the period, resulting in costs that closely approximate current costs. The inventory, however,
is valued on the basis of the cost of materials bought earlier in the year. During periods of
inflation, the use of LIFO will result in the highest estimate of cost of goods sold among the three
approaches, and the lowest net income.
73
S T U D Y T E X T
(c) Weighted Average:
Under the weighted average approach, both inventory and the cost of goods sold are based
upon the average cost of all units bought during the period. When inventory turns over rapidly
this approach will more closely resemble FIFO than LIFO.
Firms often adopt the LIFO approach for the tax benefits during periods of high inflation, and
studies indicate that firms with the following characteristics are more likely to adopt LIFO - rising
prices for raw materials and labor, more variable inventory growth, an absence of other tax loss
carry forwards, and large size. When firms switch from FIFO to LIFO in valuing inventory, there
is likely to be a drop in net income and a concurrent increase in cash flows (because of the tax
savings). The reverse will apply when firms switch from LIFO to FIFO.
Given the income and cash flow effects of inventory valuation methods, it is often difficult to
compare firms that use different methods. There is, however, one way of adjusting for these
differences. Firms that choose to use the LIFO approach to value inventories have to specify in
a footnote the difference in inventory valuation between FIFO and LIFO, and this difference is
termed the LIFO reserve. This can be used to adjust the beginning and ending inventories, and
consequently the cost of goods sold, and to restate income based upon FIFO valuation.
ACCOUNTING PROCEDURES AND TECHNIQUES
7 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
CHAPTER SUMMARY
Book keeping defined as the process of recording business transactions (data) in a systematic
manner. It can also be defined as that part of accounting that is concerned with recording data.
The accounting process can be perceived as a cycle which starts with the occurrence of a
transaction recording of the transaction and finally the preparation of the final statements which
report on results of all the transactions that occur during the year and the position of the business
as at the last date of the accounting period.
The commonly used books of original entry are:-
• Purchases Journal.
• Sales journal.
• Return outwards journal.
• Return inwards journal.
• Cashbook.
• General journal.
When all transactions have been entered into the specific journals, they are then entered into
their respective accounts in the ledger in a process referred to as posting.
75
S T U D Y T E X T
CHAPTER QUIZ
1. What is the difference between the cash book and the petty cash book?
2. Which is the source document for petty cash book?
3. Name the reason for making a journal entry?
4. Which ledger is used to keep individual customer accounts?
5. What is the purpose of the trial balance?
ACCOUNTING PROCEDURES AND TECHNIQUES
7 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
ANSWERS TO CHAPTER QUIZ
1. The cash book records amounts paid into out of the bank account. The petty cash book
records payment of small amounts of cash.
2. Receipt and claim forms.
3. Most commonly to correct an error.
4. Receivables ledger.
5. To test the accuracy of the double entry bookkeeping.
PAST PAPER ANALYSIS
12/06, 6/06, 12/04, 6/04, 6/03, 12/02
EXAM TYPE QUESTIONS
QUESTION 1
Skates drew up the following trial balance as at 30 September 2002. You are to draft the trading
and statement of comprehensive income for the year to end 30 September 2002 and a statement
of financial position as at that date.
77
S T U D Y T E X T
Dr Cr
Capital
Drawings
Cash at bank
Cash in hand
Debtors
Creditors
Stock 30 September 2001
Motor van
Office equipment
Sales
Purchases
Returns inwards
Carriage inwards
Returns outwards
Carriage outwards
Motor expenses
Rent
Telephone charges
Wages and salaries
Insurance
Office expenses
Sundry expenses
Sh
842,000
311,500
29,500
1,230,000
2,391,000
410,000
625,000
9,210,000
55,000
21,500
30,900
163,000
297,000
40,500
1,281,000
49,200
137,700
28,400
17,153,200
Sh
3,095,500
937,000
1,309,000
30,700
17,153,200
ACCOUNTING PROCEDURES AND TECHNIQUES
7 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
QUESTION 2
A three-column cashbook is to be written up from the following details, balanced off, and the
relevant discount accounts in the general ledger shown.
19x8
Mar 1 Balances brought forward: Cash Sh .230; Bank Sh .4,756.
“ 2 The following paid their accounts by cheque, in each case deducting 5 percent
3 Discounts: R Burton Sh 140; E Taylor Sh. 220; R Harris Sh 800.
“ 4 Paid rent by cheque Sh.120.
“ 6 J Cotton lent us Sh 1,000 paying by cheque.
“ 8 We paid the following accounts by cheque in each case deducting a 21⁄2 per
cent cash discount: N Black Sh 360; P Towers Sh 480; C Rowse Sh 300.
“ 10 Paid motor expenses in cash Sh 44.
“ 12 H Hankins pays his account of Sh. 77, by cheque Sh 74, deducting Sh 3
cash discount.
“ 15 Paid wages in cash Sh. 160.
“ 18 The following paid their accounts by cheque, in each case deducting 5 per cent
cash discount: C Winston Sh 260; R Wilson & Son Sh 340; H Winter Sh 460.
“ 21 Cash withdrawn from the bank Sh 350 for business use.
“ 24 Cash Drawings Sh 120.
“ 25 Paid T Briers his account of Sh 140, by cash Sh 133, having deducted
Sh 7 cash discount.
“ 29 Bought fixtures paying by cheque Sh 650.
“ 31 Received commission by cheque Sh 88.
79
S T U D Y T E X T
CHAPTER THREE
PREPARATION OF FINANCIAL
STATEMENTS
S TSUTDUYD YT ETXETX T
8 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
81
S T U D Y T E X T
CHAPTER THREE
PREPARATION OF FINANCIAL STATEMENTS
OBJECTIVES
After studying the following chapter you should be able to:
• Understand and prepare statement of comprehensive income (income statement) and
statement of financial position using the various formats
• Make accounts’ adjustments for prepayments and accruals, discounts and account for
bad debts
• Calculate depreciation chargeable using straight-line method, reducing balance method,
sum of years digit method, Depletion units method and units of output method and
account for it
• Prepare a property, plant and equipment schedule
• Define the various statement of financial position items; assets, liabilities and capital
INTRODUCTION
Fast forward - A statement of comprehensive income is the sales (revenue) for the business
less all the expenses incurred to generate the sales. The end product is ether profit or loss.
The main objective of every business organization is to make profit. However, in some instances,
businesses end up make losses. It is important to measure the performance of a business
organization in certain predefined periods to asses whether the business organization is making
profits or losses.
DEFINITION OF KEY TERMS
• Statement of comprehensive income- formerly known as the income statement
basically represents the performance of a business. It is the sales (revenue) for the
business less all the expenses incurred to generate the sales. The end product is ether
profit or loss.
• Statement of financial position- formerly known as the balance sheet is a statement
which shows the assets of a business at a given point in time and the claim thereof
against the assets, the claims can either by the capital injected or liabilities to third
parties
8 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
EXAM CONTEXT
This is a very important chapter and as you will see in past paper analysis at the end of this
chapter, it has been tested in every seating since June 2003.
INDUSTRY CONTEXT
All stakeholders of any entity will be very keen on the financial statements because of the
simple fact that they shows to what extent the company made or lost money and its asset base.
Stakeholders will assess entity abilities by how much profit is reported in comparison to previous
years and rival entities to make mainly investment Decisions.
The main reasons for preparing the statement of comprehensive
income are:
i) To compare the actual profit to the expected profits
ii) For planning purposes i.e. to identify areas that need attention in future
iii) To obtain funds from lenders based on one’s profitability
iv) To inform prospective owners on the performance
v) In computation of taxes to ensure that the correct amount is remitted to the tax
authorities.
83
S T U D Y T E X T
3.1 FORMAT OF THE STATEMENT OF COMPREHENSIVE
INCOME
A statement of comprehensive income basically represents the performance of a business. It is
the sales (revenue) for the business less all the expenses incurred to generate the sales. The
end product is ether profit or loss.
A statement of comprehensive income can be prepared in two formats; the vertical or horizontal
format. The horizontal format is however the most common one.
HORIZONTAL FORMAT
Xyz Statement of comprehensive income
For the period ended xxxxxx
Sh Sh
Sales xx
less return inwards (xx)
net sales Xxx
less cost of sales
opening stock xx
add purchases xx
carriage inwards xx
xx
less return outwards (xx)
net purchases xx
goods available for sale xxx
less closing stock (xx)
cost of sales Xxx
gross profit Xxx
add other incomes
discount received Xxx
profit on disposal of assets Xxx
income from investments Xxx
other incomes e.g. interest received from bank Xxx
Xxx
less expenses
administrative expenses xx
operating expenses xx
selling and distribution expenses xx
total expenses (xxx)
net profit for the period Xxx
PREPARATION OF FINANCIAL STATEMENTS
8 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
Notes
(i) Carriage inwards forms part of the cost of sales. It represents the amount paid for the
transportation of goods into the business premises before they are sold.
(ii) Carriage outwards is a business expense. It represents the amount paid to transport
goods to the customer’s premises.
(iii) All costs incurred to put the goods into saleable condition form part of the cost of sales
e.g. cost of transportation to the warehouse, insurance while goods are on transit to the
warehouse, warehouse expenses.
(iv) Incase the net sales are less than cost of sales the difference is referred to as gross
loss.
(v) If the expenses are more than the gross profit the difference is referred to as net loss
(vi) Other incomes represent that portion of revenues not directly related to the main
business e.g. commissions, rent receivable e.tc
>>> Illustration 1
Given the following trial balance for BCD Ltd draw up a statement of comprehensive income
BCD Ltd for the year ended 31 December 2007
Sh Sh
Sales 205,500
Purchases 129,000
Opening stock 16,000
Rent 42,000
Lighting expenses 8,000
General expenses 17,000
Fixture and fittings 4,800
Debtors 148,000
Creditors 37,000
Bank 14,300
Cash 2,800
Drawings 14,000
Capital 128,000
Commissions 24,000
Returns inwards 4,600
Return outwards 6,000
400,500 400,500
The closing stock as at 31st march 2007 was Sh 9000
85
S T U D Y T E X T
Suggested solution
BCD Company Ltd
Statement of comprehensive income
For the year ended 31 December 2007.
Sh Sh
Sales 205500
Less: return inwards (4600)
Net sales 200900
Cost of sales
Opening stock 16000
Add: purchases 129000
Less: return outwards (6000)
Cost of goods available for sale 139000
Less: closing stock (9000)
(130000)
Gross profit 61900
Other incomes
Commission received 24000
Total income 85900
Expenses
Rent 42000
Lighting expenses 8000
General expenses 17000
(67000)
Net profits 18900
Notes
• Closing stock is not found in the trial balance since there is no double entry in the stock.
The closing balance of the stock is obtained by actual counting of the stock at hand at
the end o the accounting period.
• Opening businesses will have no opening stock, however for the subsequent periods
there may be opening stock. The closing stock at the end of one period becomes the
opening stock for the next period.
Sometimes items of income and expenses will not be expressly stated as income or expense. For
instance the commissions, rents e.t.c may not be indicated whether they are incomes expenses.
It will be upon you to identify whether it’s an income or an expense identifying the column under
which it falls. All income accounts have credit balances while the expenses have debit balances
in the trial balance. The same case applies to the returns inwards and outwards. Return inwards
which represent an increase in stock have a debit balance while return outwards have a credit
balance.
PREPARATION OF FINANCIAL STATEMENTS
8 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
3.2 ACCOUNTS ADJUSTMENTS
Before preparing a statement of comprehensive income for a particular period, there are
adjustments that are made to particular accounts to ensure the profit and loss statement shows
accurate results of profits and losses. These accounts include:
i) Prepayments accounts
ii) Accruals accounts
iii) Bad and doubtful debts accounts
iv) Depreciation account
v) Discounts allowed accounts
vi) Discounts received accounts
vii) Commissions received accounts
viii) Commissions paid account
PREPAYMENTS AND ACCRUAL ACCOUNTS
(I) PREPAYMENTS ACCOUNTS
These could either be prepaid incomes or prepaid expenses.
Prepaid expenses
For some businesses expenses may tend to be prepaid in nature. An example would be insurance
premiums or, rent and rates. This are usually paid for one year upfront. However the period for
which the expenses relate may not match with the accounting year. Take for instance a business
that commences operations on 1st January 2006. Beginning 1st April 2006 they pay for insurance
for one year. The premiums would thus cover the period 1st April2006 to 31st march2007. On the
other hand the business accounting period would cover from 1st January 2006 to 31st December
2006. Therefore by the end of the accounting period, premiums with respect to three months
would not have been expensed, yet they have already been paid for. This is what results to a
prepayment which is an asset to the business at the end of the accounting period.
Example:
Jumba Agro vet started business on 1st January 2005. On 1st May 2006 they acquired a go down
next to BOC Gas Suppliers. They immediately insured it against fire paying insurance premiums
Sh1200000 to cover the go down for the next one year.
Show the entries as they would appear in the accounts on 31st December2006.
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S T U D Y T E X T
The prepaid amount is arrived at as follows:
May – Dec = 8 months
Jan – April = 4 months
8 x 1200000 = Sh 800000 ……………..expenses for the year
12
4 x 1200000 = Sh 400000 ………………prepaid amount
12
The prepaid amount shown in the prepaid insurance account represents an asset that will be
under the current assets in the balance sheet. It represents the amount of money (current asset)
that could still be lying in the bank had the company opted to pay for 8 months only to the close
of the year i.e. May – December
(i) prepaid income
Prepaid income on the other hand represents income already received yet the services or the
goods have not been delivered e.g. for a business dealing in renting out houses and they receive
rent for consequent periods then a certain portion of this rent at the end of the accounting period
will relate to the next accounting period. Such incomes received in advance form a liability to the
business since they remain indebted to deliver the service already paid for. It appears as under
the current liabilities section of the balance sheet.
go down next to BOC Gas Suppliers. They immediately insured it against fire paying
insurance premiums Sh1200000 to cover the go down for the next one year.
Show the entries as they would appear in the accounts on 31st December2006.
Bank a/c
2005 Sh 2005 Sh
1/5 insurance 1200000
Insurance a/c
2005 Sh 2005 Sh
1/5 Bank 1200000 31/12 Prepaid insurance 400000
31/12 P&L a/c 800000
Pre paid insurance
Sh Sh
31/12 Insurance a/c 400000
The prepaid amount is arrived at as follows:
May – Dec = 8 months
PREPARATION OF FINANCIAL STATEMENTS
8 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
Example
On 1st April 2006 Josmumo enterprise received rent for 12 months amounting to Sh 144000 for
a part of a building they had rented out since it was not being used. The rent money received
covered the period beginning 1st April 2006 and ending 31st March 2007. Show this transaction in
the books of Josmumo as at 31st December 2006 i.e. of financial year
Solution:
On receiving cash
Dr. Cash/Bank Sh 144000
Cr. Rent income Sh 144000
At close of accounting period
Dr. rent income a/c 36000
Cr. Rent received in advance a/c 36000
The balance in the rent received in advance account is posted in the statement of financial
position as a short-term liability. This is simply because the money for the period 30th March has
been paid yet the services have not been delivered. This is in line with the revenue recognition
principle. The balance of Sh 36000would thereby be in the incoming years of income
Cr. Rent income Sh ShSh 144000
At close of accounting period
Dr. rent income a/c 36000
Cr. Rent received in advance a/c 36000
Cash/bank
2006 Sh Sh
1/4 Rent income 144000
Rent income
2007 Sh Sh
30/5 Rent in advance 36000 /5 Bank/ cash 144000
Rent received in advance a/c
Sh Sh
/5 Rent income 36000
The balance in the rent received in advance account is posted in the statement of
financial position as a short-term liability. This is simply because the money for the
period 30th March has been paid yet the services have not been delivered. This is in line
89
S T U D Y T E X T
In the subsequent accounting period:
Dr. Rent received I advance a/c
Cr. Rent receivable (income) account
II) ACCRUAL ACCOUNTS
Accrual accounts affect both the incomes and expenses.
Accrued expenses
Accrued expenses represent that portion of expenses that has been used but has not been paid
for. It is common for established businesses to consume services first and pay for them later, say
after 30 days e.g. motor vehicle repairs. On the other hand there are expenses that cannot be
determined in advance until they have been consumed e.g. electricity telephone e.t.c. A common
occurrence with such accounts is that by the time the final statements are being prepared, a
portion of the expenses will not have been paid most likely because the bills have not been
received. These expenses need to be recognized in the period in which they were incurred.
This will be in line with the matching concept which states that expenses should matched with
income.
>>> Illustration
JKT Enterprises prepares its financial statements for periods ending 31st December. On 31 st
December 2005 a bill for electricity amounting to Sh 27000 had been received by the accountant.
Other bills received for the period amounted to Sh 210000. These had been paid for as at 31st
December 2005.
Required:
Show the necessary entries with regard to electricity:
i) Dr. Electricity expense a/c 210000
Cr. Cash/ bank 210000
(To record electricity expense for the year paid for)
ii) Dr. Electricity expense 27000
Cr. Accrued electricity for the period
(To record accrued electricity expense for the period.)
You will note that there are two debits to the electricity expense account. This represents the total
of electricity expense incurred in the year. The entries will appear as follows in their respective
accounts:
PREPARATION OF FINANCIAL STATEMENTS
9 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
The total of Sh 237,000 will be taken to the expenses account in the statement of comprehensive
income
The balance b/d in the accrued expenses account is taken as a current liability to the balance
sheet. Once the payment is made in the following period
Dr. accrued expenses a/c 27000
Cr. Cash/ bank 27000
This would then eliminate the accrued account (the liability will then have been paid off)
(To record accrued electricity expense for the period.)
You will note that there are two debits to the electricity expense account. This represents
the total of electricity expense incurred in the year. The entries will appear as follows in
their respective accounts:.
Electricity expense a/c
Sh Sh
Cash/bank/ 210000 /5 P & L 237000
Accrued electricity 27000
Cash/bank
Sh Sh
Electricity expense 210000
Accrued electricity expense
Sh Sh
Balance c/d 27000 /5 Electricity expense 27000
Balance b/d 27000
The total of ShSh 237,000 will be taken to the expenses account in the statement of
comprehensive income
The balance b/d in the accrued expenses account is taken as a current liability to the
balance sheet. Once the payment is made in the following period
Dr. accrued expenses a/c 27000
Cr. Cash/ bank 27000
This would then eliminate the accrued account (the liability will then have been paid off)
Accrued expense a/c
2006 Sh 2006 Sh
05/01 Cash/bank 27000 01/01 Balance b/d 27000
Cash/bank
Sh 2006 Sh
05/01 Accrued expenses 27000
91
S T U D Y T E X T
Accrued income
It is usual phenomenon for business enterprises to sell goods on credit. This would then mean
that at the close of the financial period, there are some amounts yet to be cleared by the customer.
For the main line of business this income is captured in the books of original entry i.e. general
ledger sales ledger. Therefore revenue owing for direct sales is already in the books (in the sales
account in the general ledger and the debtors account in the sales ledger) and no further entries
are needed.
However, there may be other types of revenues for the business all of which have not been
received at the end of the financial period. Such would include rent and commission receivable
e.t.c. Since they do not form major part of the sales they are usually not systematically recorded
as the other business sales. There is need therefore at the end of the period to recognize them.
>>> Example
Due to empty spaces in the warehouse XYZ Ltd Decided to sublet it at a monthly fee of Sh20000.
The payments were supposed to be made at the end of every month on 31st December when
XYZ was preparing its financial statements. The rent for December was still outstanding. Adjust
for it in the books.
Cr. Rent income A/c 20000
The credit on the rent income account will increase other income for the year. The debit
on the rent receivable account will represent an asset to the business to be posted in the
statement of financial position under the current asset section.
Assuming all other monthly rentals from January to November had been received the
entries would appear as follows.
Rent received (income)
2006 Sh 2006 Sh
bank 220000
Rent receivable 20000
Bank/cash
Sh Sh
Rent received 220000
Rent receivable
Sh Sh
Rent income 20000
PREPARATION OF FINANCIAL STATEMENTS
9 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
3.3 DISCOUNT RECEIVED AND ALLOWED
Fast forward - Discounts given to encourage bulk purchasing are referred to as trade discounts
DISCOUNT ALLOWED
Represent an amount allowed to a customer on his sales amount usually given as an incentive
for bulk purchasing or for prompt payment.
Discount given to encourage bulk purchasing are referred to as trade discounts. Usually they do
not feature in the books of account since the invoiced amount is usually net of such discount and
the invoice itself is the source document for sales.
The discount given to encourage prompt payment is referred to as the cash discount. After a
credit purchase the customer is offered a discount at a certain rate if he /she pays within given
period e.g. a 2% discount if payment is made 10 days from the invoice date otherwise the credit
period may be 30days.
Such terms will be indicated as 2/10 net 30
The sale is recorded at the invoice value and if the customer qualifies for the discount it is
recognized in such a way as to reduce the customer’s account by the amount of the discount.
Discount allowed is deducted from the sales to get a net figure of sales in the trading account.
The conventional way of treating discounts in the P& L is to view them as finance charges. This
then makes discount allowed fall under operating expense and discount received as income.
The entries for discount allowed as follows:
Dr. Discount allowed
Cr. Debtors account
>>> Illustration
Mr. Jomens bought goods from us worth Sh100000. The terms were 5/15 net 30 days. Seven
days later he settled his account fully. Show the following entries in the ledger accounts.
93
S T U D Y T E X T
Solution:
The terms 5/15 net 30 days will be interpreted as follows:
Jomenes qualifies for a 5% cash discount if he pays within 15 days. The maximum credit period
is 30 days.
The discount then would be
5/100 x 100000 = Sh 5000 if he pays within 15 days
Since he paid d within 7 days he qualifies for the cash discount.
The entries for the discount allowed would be as follows:
Dr, discounts allowed a/c 5000
Cr. Jomenes a/c 5000
If he paid on the 16th day he would have to settle the whole amounted Sh 100000 and would not
qualify for the discount.
The journal entries for the transaction as a whole would be:
Dr. Jomenes account Sh 100000
Cr. Sales account Sh 100000
When he pays on the 7th day:
Dr. cash/Bank Sh 95000
Cr. Discounts allowed 5000
Cr. Jomenes account100000
The ledger account would appear as follows.
Sales a/c
Sh Sh
Balance b/d 100000 Jomenes 100000
Cash a/c
Sh Sh
Jomenes a/c 100000 Balance c/d 95000
Discount allowed a/c
Sh Sh
PREPARATION OF FINANCIAL STATEMENTS
9 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
The balance in the discount allowed account is transferred to the statement of comprehensive
income as an expense.
Discounts received
The discount received represents cash discount received by a business when it pays its suppliers
for the amounts outstanding. They are given as incentive to encourage prompt payment of the
amounts owing to the suppliers. It is important to note that discount received do not represent a
Decrease in the purchase price of goods but rather as an income to the business. This is the most
conventional way of treating discount received. Some scholars however argue that discounts
received and allowed are a reduction to the purchase price and the selling price respectively.
The entries in the books of accounts are as follows:
Dr. Creditor accounts
Cr. Discounts received
>>> Illustration
Mabati enterprises ole Mlango suppliers Sh200000. it pays on time to qualify for a 10% cash
discount. Show how the entries would appear in the books of Mabati enterprises.
Amount of Discount = 200000 x 10/100 = Sh20000
The entry would appear as follows:
Dr. Mlango Enterprises 20,000
Cr. Discount received 20,000.
For a deeper understanding of the double-entry, all the entries since we bought the supplies to
the time full settlement was made on purchases would be:
Dr. Purchase’s a/c 200000
Cr. Mlango enterprises 200000
Sh Sh
Jomenes 5000 Balance c/d 5000
Jomenes a/c
Sh Sh
Sales 100000 Discount allowed 5000
Cash 95000
100000 100000
The balance in the discount allowed account is transferred to the statement of
comprehensive income as an expense.
Discounts received
The discount received represents cash discount received by a business when it pays its
suppliers for the amounts outstanding. They are given as incentive to encourage prompt
payment of the amounts owing to the suppliers. It is important to note that discount
received do not represent a Decrease in the purchase price of goods but rather as an
95
S T U D Y T E X T
On payment:
Dr. Mlango enterprises 200000
Cr. Cash/bank 180000
Cr. Discount received 20000
The accounts would appear as follows.
The balance in the discounts received account is taken to the statement of comprehensive income
as an income under other incomes.
Purchases a/c
Sh Sh
Mlango enterprises 200000 Balance c/d 200000
Mlango enterprises a/c
Sh Sh
Cas/bank 180000 Purchases 200000
Discount received 20000
200000 200000
Cash/bank
Sh Sh
Rent income 20000 Mlango enterprises 180000
Discount received
Sh Sh
Rent income 20000 Mlango enterprises 20000
The balance in the discounts received account is taken to the statement of
comprehensive income s as an income under other incomes.
PREPARATION OF FINANCIAL STATEMENTS
9 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
PROVISION FOR BAD AND DOUBTFUL DEBTS
A large portion of sales for most of the business organizations are made on credit. The business
thus undertakes the risk that some of the sales may not end up being paid. Indeed some of the
sales are not paid for and such are referred to as bad debts.
They are a common business expense as long as credit sales exist. Usually they occur in the
following situations:
(i) Bankruptcy of a business enterprise
(ii) Debtor refusing to pay a particular invoice
(iii) Debtor refusing to pay part of the invoice.
(iv) After they have been outstanding for a long period of time as learnt from experience.
When it occurs a bad debt is treated as follows:
Dr. bad debts expense (to recognize an expense)
Cr. Debtors account (to clear the asset; debtor)
PROVISION FOR BAD DEBT
When it is certain that some amounts will not be collected, it is prudent to clear the debt from
the books and charge as an expense in the P& L account. However it’s hard to tell before hand
that a certain debt will not be paid. For this reason most business make an estimation of the
amount of debts that will not be paid in a given accounting period, and charge it as an expense
in the statement of comprehensive income of that accounting period This amount will usually be
very subjective sometimes based only on past experiences which might not necessarily recur
in future. The amount set aside to cater for future debts that might never be paid for in future is
referred to as the provision for bad debts. It’s also known as provision for doubtful debts.
Provision for bad debts should be recognized while preparing the financial statements. It serves
two main purposes:
(i) To match expenses and revenues by recognizing the part of a debt that will never be
paid for
(ii) To recognize a figure of debtors that is close to the realizable amount of debtors as
possible.
97
S T U D Y T E X T
Decrease in provisions
As indicated earlier, the provision for bad debts is a very subjective estimate. As such it’s prone
to constant adjustments due changing circumstances under which it is made. For example:
Assume from the books of Mali Raha Stores the total amount of debtors for the previous period
was Sh 400000. Assume further that Mali Raha had estimated that out of this amount 50000 i.e.
(12.5%of the debtor’s balance) would not be bad debt. However after a careful consideration
they discover that this figure was overestimated. It’s agreed that a figure 10% of the balance of
debtors is what should be maintained as provision for bad debts. In the current period the balance
of debtors is Sh 450000.
The entries as they would appear in the books. Maintain a rate of 10% for provision of bad debts
would be:
Provision for bad debts = 450000x 10/100 = Sh 45000
This would be the amount of the provision for the year. However in the previous year, Sh 50000had
already been provided for. Therefore instead of increase in the provision this time w reduce it
to Sh45000 as this is the balance that should appear in the closing balance of the provision
account.
The reduction in provision for is treated as income in under “other incomes” in the statement of
comprehensive income
The entries would be:
Dr. Provision for doubtful debts (50000 - 45000) 5000
Cr. Profit & loss account/statement of comprehensive income. 5000
To record reduction in provision for doubtful debts.
The accounts would appear as follows:
As indicated earlier, the provision for bad debts is a very subjective estimate. As such it’s
prone to constant adjustments due changing circumstances under which it is made. For
example:
Assume from the books of Mali Raha Stores the total amount of debtors for the previous
period was Sh 400000. Assume further that Mali Raha had estimated that out of this
amount 50000 i.e. (12.5%of the debtor’s balance) would not be bad debt. However after
a careful consideration they discover that this figure was overestimated. It’s agreed that
a figure 10% of the balance of debtors is what should be maintained as provision for bad
debts. In the current period the balance of debtors is Sh 450000.
The entries as they would appear in the books. Maintain a rate of 10% for provision of
bad debts would be:
Provision for bad debts = 450000x 10/100 = Sh 45000
This would be the amount of the provision for the year. However in the previous year,
Sh 50000had already been provided for. Therefore instead of increase in the provision
this time w reduce it to Sh45000 as this is the balance that should appear in the closing
balance of the provision account.
The reduction in provision for is treated as income in under “other incomes” in the
statement of comprehensive income
The entries would be:
Dr. Provision for doubtful debts (50000-45000) 5000
Cr. Profit & loss account/statement of comprehensive income. 5000
To record reduction in provision for doubtful debts.
The accounts would appear as follows:
Provision for bad debts account
Sh Sh
Statement of comprehensive
income
Balance c/d
5000
45000
______
50000
Balance b/d 50000
______
50000
Extract of the Statement of comprehensive income for the current period
PREPARATION OF FINANCIAL STATEMENTS
9 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
Extract of the Statement of comprehensive income for the current period
Sales xxx
Less: cost of sales (xx)
Gross profit xxx
Other incomes:
Reduction in provision for depreciation 5000
Less
Expenses xxx
Net profit xxx
In the balance sheet, the balance of debtors should be net of provision of doubtful debts carried
forward.
For the example earlier given:
Statement of financial position Extract As At ending date of the current period
Non current assets xxx
Current assets:
Debtors 450000
Less Provision for bad debts (45000)
(ii) During the following accounting period the statement of financial position would be as
follows (assume the case of increase in provision).
Increase in provision for bad debts
A company may find it necessary to increase the amount asset aside for bad debts to a figure
higher than that provided for in the previous period. In such a case the amount by which the
provision is increased is treated as an expense in the statement of comprehensive income for
the period in which the increase is made.
The accounting entries would be:
Dr. Expense (an expense account in the P&L)
Cr. Provision for bad debts
99
S T U D Y T E X T
From the example of Mali Raha Store above, if the provision for bad debts was to be increased
from 50000 for the previous period to 55000 for the current period the increase of 5000 would be
accounted for as follows:
Dr. P&L account 5000
Cr. Provision for bad debts account 5000.
(To record the increase in the provision for bad debts by 5000)
Extract of the Statement of comprehensive income for the current period
Sales xxx
Less: cost of sales (xx)
Gross profit xxx
Less expense:
Increase in provision for bad debts (5000)
Net profit xxx
The balance of debtors in the statement of financial position would now be reported net of 55000
i.e. the new provision for bad debts. This is as shown in the following statement of financial
position extract:
Statement of financial position Extract As At ending date of the current period
Non current assets xxx
Current assets:
Debtors 450000
Less Provision for bad debts (55000)
From the example of Mali Raha Store above, if the provision for bad debts was to be
increased from 50000 for the previous period to 55000 for the current period the
increase of 5000 would be accounted for as follows:
Dr. P&L account 5000
Cr. Provision for bad debts account 5000.
(To record the increase in the provision for bad debts by 5000)
Provision for a/c
Sh Sh
Balance c/d 55000
______
55000
Balance b/d
Profit and loss a/c
50000
5000
______
55000
Extract of the Statement of comprehensive income for the current period
Sales xxx
Less: cost of sales (xx)
Gross profit xxx
Less expense:
Increase in provision for bad debts (5000)
Net profit xxx
The balance of debtors in the statement of financial position would now be reported net
of 55000 i.e. the new provision for bad debts. This is as shown in the following statement
of financial position extract:
Statement of financial position Extract As At ending date of the current period
Non current assets xxx
Current assets:
Debtors 450000
PREPARATION OF FINANCIAL STATEMENTS
1 0 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
Points to note
(i) The statement of financial position figure for debtors is given as:
Gross figure less provision C/F or
Gross figure less doubtful debts as a percentage of debtors.
(ii) The figure of provision of bad debts in the P&L should be balance of doubtful debts
carried forward less provision provided for in the previous year. i.e. the increase or
Decrease in the provision .
(iii) Incase during the year there were some bad debts written-off then the provision for bad
debts should be provided for after deducting such bad debts.
(iv) In cases of examination questions, if bad debts appear on the trial balance then the
figure of debtors in the statement of financial position is net of such debts and should
not be adjusted further. This is so because of the rule of double entry. For bad debts to
appear in the trial balance the entries that have been passed are as follows:
Dr. bad debts a/c xxx
Cr. Debtors a/c xxxx
If however the bad debts appear in the additional information, then the following entries
need to be passed in the books to adjust the debtors figure:
Dr. bad debts
Cr. Debtors
After these the provision for bad debts is adjusted as usual.
3.4 DEPRECIATION
Fast forward - There are two major methods of charging depreciation:
• straight line method
• reducing balance method
Depreciation can be defined as that part of the original cost of fixed assets that are consumed
during its period of use in the business.
Depreciation can also be defined as the loss in the value due to of usage of an asset. Almost all
business assets have a given time duration for their existence and as they are used/ consumed
their value keeps on Declining.
101
S T U D Y T E X T
CAUSES OF DEPRECIATION
Depreciation caused by the factors discussed below;
i) Physical deterioration
ii) Economic factors
iii) Time
iv) Depletion
i) Physical deterioration
Almost all assets are affected by wear and tear. Example motor vehicle, furniture used
in the office, e.t.c.
ii) Economic factors
These are factors that are not related to the physical condition of an asset but are
largely due to economic conditions e.g.
a) Obsolescence: this is when an asset becomes out of date. For example, the
typewriters are fast becoming obsolete and being replaced with computers. Thus
even if it were new, it would be overtaken by events. Technological advancements
are the largest contributors to the obsolescence.
b) Inadequacy: this happens when an asset can no longer be used mainly due to
growth of size of a business. For example a start up business in the transportation
industry is using a small pick-up and as it grows it may find large tracks more
economical and convenient.
iii) Time
Time is also a key contributor to depreciation in the sense that even if an asset was left
unused; its value would fall considerably with passage of time.
iv) Depletion
This is the case of exhaustion of natural resources with time. As extraction of such
assets continues they become of lesser value e.g. mines oil fields, quarries, e.t.c
DEPRECIATION AS AN EXPENSE
Depreciation is an operating expense in the business that reflects the loss in value of an asset
during a given accounting period. Depreciation is recognized in line with such concepts as
matching concept whereby we match revenues of a particular period with the expenses incurred
in the same period.
Methods of charging depreciation
There are two major methods of charging depreciation;
i) Straight line method ii) Reducing balance method
PREPARATION OF FINANCIAL STATEMENTS
1 0 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Other methods are:
• Revaluation method
• Depletion unit method
• Machine hours method
• Sum of years digit method
Depreciation is arrived at by simply taking the total cost of the assets less any amounts received
during its disposal. The resulting figure ids known as the residue value.
The depreciation will be the difference between the cost and the amount received. The problem
arises when an asset is used for more than one accounting period. We therefore can only estimate
how much to allocate to each accounting period. The methods used are:
Straight line method
This method assumes that an asset is depreciated uniformly over its useful life.
Useful life in this case is taken in form of years.
Depreciation is calculated as follows:
Depreciation = Cost estimated disposal value (residue value)
number of expected years of usage
The depreciation could also be calculated as a percentage of total cost. The percentage is
calculated as follows.
1 x 100
No. of expected years of usage
For example if the number of useful years is five years, we can calculate the percentage of
depreciation each year as
1 x 100 = 20%
5
Therefore each year our calculation would be as follows:
(Cost-estimated residue value) x 20%
103
S T U D Y T E X T
>>> Example 1
X ltd bought furniture worth Sh 200000. The furniture was expected to last 8 years and would be
disposed off for Sh 40000 at the end of the eighth year. Show how depreciation to be allocated in
each of the accounting period for the 8 years using the straight line method of depreciation.
Depreciation = 200000 - 40000 = Sh 20000
8
Each year the depreciation charge would be Sh 20,000
If an asset is estimated not to have any residue value at the end of its life time, depreciation
equals to the total cost of the asset divided by its life time.
>>> Example 2
If the furniture in example 1 had a nil residue value, depreciation allocated each year would be:
Depreciation = 200000 - 0 = Sh 25000
8
Reducing balance method
In this method, the depreciation is charged at a fixed percentage over the remaining cost of an
asset. It’s a method conveniently for assets that are assumed to have a higher depreciation
rate over their first few years of use. More so, advocates of this method argue that the cost of
running an asset is not depreciation only but also costs to do with maintenance and repairs.
They argue that during the first year, costs of repairs and maintenance will be minimal and hence
charge minimal depreciation during the first years to match the low repairs and maintenance
cost. During later years, depreciation charge will be minimal whereas repairs and maintenance
will have increased significantly. This will therefore tend to give a uniform cost of running an
asset. However this is not always the case.
PREPARATION OF FINANCIAL STATEMENTS
1 0 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
>>> Example 3
An equipment is bought for Sh300000 and depreciation is to be charged at 25% on the reducing
balance method show the calculation of depreciation charge for the first years of use.
1st year 300000 x 25% = 75000
2nd year (300000 - 75000)*25% = 56250
3rd year (225000 - 56250)*25% = 42187.5
You will realize that:
During the first year depreciation was higher then becoming smaller and smaller as the years go
by.
To obtain the percentage for reducing balance we use the following formulae:
r = 1 - n s
c
Where:
r Is the rate of depreciation to be applied
n is the number of useful life
s is the net residue value (this must be a significant figure or else the answer will be
absurd)
c s the cost of the asset
Machine-hour method
Under this method, the asset is depreciated on the basis of the number of hours operated during
a specific accounting period. Compared to the number of hours expected to run during its life
time.
>>> Example 4
XYZ Co. Ltd bought a machine for Sh 120000. The machine is expected to run for Sh 20000
during its life time and have a scrap value (residue value) of Sh 20000. During its first year of
operation it was run for 5000 hours. Calculate the depreciation charge for that year.
105
S T U D Y T E X T
Depreciable amount = cost – scrap (residue value)
= 120000 - 20000 = Sh 100000
100000 25000
20000
50000
depreciation = × = shs
Alternatively we can get the depreciation amount per hour run and then multiply by the number of
running hours during accounting period.
total expected no. of running hours
amount per hour
depreciable amount
depreciation =
5 per hour
20000
100000
= = shs
Total during the accounting period will be
Charge per hour X no of hours
= 5 X 5000
= Sh 25000
Sum of all years digit method
Under this method, a higher amount of depreciation is charged during the initial year of service
and a lower amount as the asset becomes old. The depreciation charge is calculated by taking
the sum of years the asset is expected to last and then comparing it with the number of years the
asset is expected to last during an accounting period as follows. For an asset expected to last 3
years it will be:
1st year expected to last 3 years
2nd year expected to last 2 years
3rd year expected to last 1 year
Sum 6 years
depreciable amount
no
during
sum fo all years expected tolast
. fo years expected to last as at this year
first year : 􀀀
depreciable amount
6
3
: 􀀀
amount 25000
(during its life time)
total expected running hours
. of hours run during the year
depreciable shs
no
depreciation = × =
PREPARATION OF FINANCIAL STATEMENTS
during first year: no. of years expected to last as at this year x depreciable amount
sum of all years expected to last
: 3 x depreciable amount
6
1 0 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
>>> Illustration
Calculate the depreciation amount per year for a machine costing Sh225000
And expected to last for five years with no residue value
Depreciable amount = cost – residue value
= 225000- 0
=225000
Sum of years 1st = 5yrs
2nd = 4yrs
3rd = 3yrs
4th = 2yrs
5th = 1yrs
Sum 5yrs
1st = 5 x 225000 = 75000
15
2nd = 4 x 225000 = 60000
15
3rd = 3 x 225000 = 45000
15
4th = 2 x 225000 = 30000
15
5th = 1 x 225000 = 15000
15 225000
Depletion unit method
This is a method mainly used in the extraction of minerals e.g. quarry, oil fields e.t.c.
Depreciation is calculated as:
Cost of the asset x no. of units taken in the period
expected total content in units
107
S T U D Y T E X T
>>> Illustration
An oil field is acquired for $1000000 and expected to produce 100000 litres of crude oil .during
the first year a total of 20000 litres were extracted. Calculate the depreciation charge during the
year using the depletion unit method.
Depreciation = $1000000 x 20000 = $200000
10000
Units of output method
Under this method, depreciation is measured in terms of expected output of an asset during its
lifetime compared to the output during a particular accounting period.
Depreciation = No. of units during a particular period x depreciable amount
total no. of units expected during life time
>>> Illustration
A machine is expected to produce 100,000 toys. During a particular accounting
Period ended 31st December 2007, a total of 10000 units were produced. The machine had cost
Sh180000 and was expected to have a salvage value of Sh 30000
Calculate depreciation as at 31st December 2007
(180,000 30,000) 15,000
100,000
10,000
depreciation= × − = shs
Revaluation method
This is a method used to calculate depreciation on small parts of equipment and tools in an
organization. An organization will find it appropriate to group the tools together and have a single
figure and then revalue them at the end of the accounting period. For example, in the construction
industry, one would group together screw drivers, hammers mattocks, spades and all other small
equipments and then revalue after a certain period of time to arrive at the depreciation during a
specific accounting period.
PREPARATION OF FINANCIAL STATEMENTS
1 0 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
Depreciation will be
Cost/valuation as at the beginning of the year xxx
Add
Purchases during the year xxx
Less
Valuation as at the end of the year (xxx)
Depreciation for the year xxxx
3.5 ACCOUNTING FOR DEPRECIATION
So far we have looked at ways of calculating depreciation for assets. Of more importance is to
know how to account for this depreciation so as to give a figure that reflects the true and fair view
of the state of affairs of a given company as to its P&L and balance sheet.
As earlier mentioned, depreciation is a business expense, and it’s accounted for in the same way
as all the expenses.
The two most commonly used methods of depreciation are straight line method (also known as
the cost approach) and the reducing balance method.
Once we have computed he depreciation amount, we account for it as follows in the books of
account:
Dr. Deprecation expense account xxxx
Cr. Provision for/accumulated depreciation account
We could also directly debit the P&L account while the credit is made in the provisions/accumulated
depreciation account.
Depreciation can be calculated pro-rata. This means with regard to the time of acquisition.
However it’s upon an enterprise to setup a policy that best fits them e.g. charge a depreciation
pro-rata to time charge a full depreciation for the year on the year of acquisition, charge no
depreciation during the year of disposal.
>>> Example
XYZ Company bought equipment for Sh500000 on 1st April 2002. The company’s policy is to
charge depreciation using the straight line method pro-rata to time, what would be the depreciation
charged for the three consecutive years ending 31st December. Enter the above in the books of
accounts.
109
S T U D Y T E X T
(Depreciation rate 20, nil residue value)
1st year 31st Dec 2002 = 75000
100
20
500000
12
9
× × =
2nd year 31st Dec 2003 500000 100000
100
20
= × =
3rd year 31st Dec 2004 500000 100000
100
20
= × =
2002: Dr. Equipment depreciation account 75000
Cr. Accumulated depreciation account 75000
2003: Dr. Equipment depreciation account 100000
Cr. Accumulated depreciation account 100000
2004: Dr. Equipment depreciation account 100000
Cr. Accumulated depreciation account 100000
Depreciation expense a/c
2002 Sh 2002 Sh
Accumulated
depreciation
75000 P &L account 75000
2003 2003
Accumulated
depreciation
100000 P &L account 100000
2004 2004
Accumulated
depreciation
100000 P &L account 100000
Accumulated depreciation a/c
2002 Sh 2002 Sh
Balance c/d 75000 Depreciation for the
year
75000
2003 2003
Balance c/d 175000 Balance b/d 75000
Depreciation for the
100000
PREPARATION OF FINANCIAL STATEMENTS
11 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
Assuming the depreciation rate is reducing balance at rate of 2005
1st year 31st Dec 2002 = 9 x 500000 x 20 = 75000
12 100
2nd year 31st Dec 2003 = 20 x (500000 - 75000) = 85000
100
3rd year 31st Dec 2004 = 20 x (425000 - 85000) = 68000
100
Entries:
2002: Dr. Equipment depreciation account 75000
Cr. Accumulated depreciation account 75000
2003: Dr. Equipment depreciation account 85000
Cr. Accumulated depreciation account 85000
2004: Dr. Equipment depreciation account 68000
Cr. Accumulated depreciation account 68000
depreciation
Accumulated depreciation a/c
2002 Sh 2002 Sh
Balance c/d 75000 Depreciation for the
year
75000
2003 2003
Balance c/d 175000 Balance b/d 75000
Depreciation for the
year
100000
175000 175000
2004 2004
Balance c/d 275000 Balance b/d 175000
Depreciation for the
year
100000
275000 275000
111
S T U D Y T E X T
At the end of the period, the amount of the equipment to be shown in the balance sheet net of
accumulated depreciation as at that time.
The extracts would be as follows:
2002 (straight line)
Equipment at cost 500000
Less: accumulated depreciation 75000 425000
2003
Equipment at cost 500000
Less: accumulated depreciation 175000 325000
2004
Equipment at cost 500000
Less: accumulated depreciation 275000 225000
Depreciation expense a/c
2002 Sh 2002 Sh
Accumulated depreciation 75000 P &L account 75000
2003 2003
Accumulated depreciation 85000 P &L account 85000
2004 2004
Accumulated depreciation 68000 P &L account 68000
Accumulated depreciation a/c
2002 Sh 2002 Sh
Balance c/d 75000 Depreciation for the year 75000
2003 2003
Balance c/d 160000 Balance b/d 75000
Depreciation for the year 85000
160000 160000
2004 2004
Balance c/d 228000 Balance b/d 160000
Depreciation for the year 68000
228000 228000
At the end of the period, the amount of the equipment to be shown in the balance sheet
net of accumulated depreciation as at that time.
The extracts would be as follows:
2002(straight line)
Equipment at cost 500000
Less: accumulated depreciation 75000 425000
2003
Equipment at cost 500000
PREPARATION OF FINANCIAL STATEMENTS
11 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Using Reducing balance method
2002
Equipment at cost 500000
Less: accumulated depreciation 75000 425000
2003
Equipment at cost 500000
Less: accumulated depreciation 160000 340000
2004
Equipment at cost 500000
Less: accumulated depreciation 228000 272000
For each asset bought by a business enterprise, an account for depreciation is opened. This is
because different assets are depreciated with different accounting policies as well as different
rates.
3.6 ACQUISITION OF AN ASSET
When we acquire a new asset in the business, there are various entries to be recorded. We first
open an asset account by the following entry:
Dr. Assets account
Cr. cash/bank/creditor depending on purchases xxxx
At the end of an accounting period we will need to account for the deprecation so that we match
revenues against expenditure. We therefore open a depreciation account for the assets as
follows:
Dr. Asset depreciation account xxx
Cr. Accumulated depreciation account xxxx
If an assets is to be depreciated pro-rata to time, then we take the proportion of time the asset
was in existence and calculate depreciation with the predetermined policy (straight line/reducing
balance e.t.c) and at the pre determined rate.
113
S T U D Y T E X T
3.7 DISPOSAL OF AN ASSET
Disposal of assets in a business is a common occurrence. Assets could be disposed by a business
due to any of the following reasons:
i) The asset is no longer required
ii) The asset has been scrapped off
iii) The asset capacity is no longer sufficient and needs to be replaced
iv) The asset’s useful life has come to an end.
When we dispose an asset the following will be of interest:
i) To remove the cost of the assets from the books of accounts since its no longer an
asset to the business.
ii) Remove all the accumulated depreciation earlier provided for the asset.
iii) Determine whether the asset was disposed at a gain or a loss.
The following entries will be entered:
i) Transfer the cost of the asset from the asset cost account to the asset disposal account
i.e.
Dr. Disposal account
Cr. Asset cost account
ii) Transfer the accumulated depreciation from the accumulated depreciation account to
the asset disposal account
Dr. accumulated depreciation account
Cr. Asset disposal account
iii) Record the amount of sale of the asset in the books of accounts
Dr. cash/bank (if sold on cash)
Dr. Debtor (if sold on credit)
Cr. Disposal account
iv) Transfer the balancing amount of the disposal account to the P&L account as either
gainer loss
If the disposal account has a credit balance, this is a gain on disposal.
If the asset disposal account has a debit balance then this is a loss. in other words if the “benefits”
from the assets(accumulated depreciation and disposal value) exceed the initial cost of the asset
being disposed then the asset is said to be disposed at a gain. The opposite of this results in a
loss on disposal.
PREPARATION OF FINANCIAL STATEMENTS
11 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
The asset disposal account will be as follows:
>>> Example
JJ traders bought a van in Jan 2003 for Sh 200,000. The policy of the company is to depreciate
motor vehicles at a rate of 25% using straight line method. The motor van was sold in March
2006 at a cash price of Sh 60,000 (full depreciation is charged on the year of acquisition and non
on the year of disposal)
Show the entries of depreciation expense, accumulated depreciation since 2003 as well as the
entries at the time of disposal in 2003.
If the disposal account has a credit balance, this is a gain on disposal.
If the asset disposal account has a debit balance then this is a loss. in other words if the
“benefits” from the assets(accumulated depreciation and disposal value) exceed the
initial cost of the asset being disposed then the asset is said to be disposed at a gain.
The opposite of this results in a loss on disposal.
The asset disposal account will be as follows:
Disposal of asset a/c
Sh Sh
Assets (cost value) Xxx Accumulated depreciation Xxx
Gain on disposal(balance) Xxx Cash/debtor Xxx
Loss on disposal(balance) Xxx
xxxx Xxxx
Example
JJ traders bought a van in Jan 2003 for Sh 200,000. The policy of the company is to
depreciate motor vehicles at a rate of 25% using straight line method. The motor van
was sold in March 2006 at a cash price of Sh 60,000 (full depreciation is charged on the
year of acquisition and non on the year of disposal)
Show the entries of depreciation expense, accumulated depreciation since 2003 as well
as the entries at the time of disposal in 2003.
Solution
Motor vehicle depreciation a/c
2003 Sh 2003 Sh
Accumulated depreciation 50000 P &L account 50000
2004 2004
Accumulated depreciation 50000 P &L account 50000
2005 2005
Accumulated depreciation 50000 P &L account 50000
2006
Accumulated depreciation
0
2006
P &L account
0
Accumulated depreciation a/c
2003 Sh 2003 Sh
Balance c/d 50000 Depreciation for the year 50000
2004 2004
Balance c/d 100000 Balance b/d 50000
Depreciation for the year 50000
115
S T U D Y T E X T
A special case where accounting for depreciation change in estimate
If we change the rate at which we were charging depreciation for an asset then we’ll need to
adjust for depreciation as follows.:
i) Calculate for depreciation so far provided for
ii) Cost of asset less this provided depreciation so far
iii) The balance be provided for uniformly at the new rate
Accumulated depreciation a/c
2003 Sh 2003 Sh
Balance c/d 50000 Depreciation for the year 50000
2004 2004
Balance c/d 100000 Balance b/d 50000
Depreciation for the year 50000
100000 100000
2005 2005
Balance c/d 150000 Balance b/d 100000
Depreciation for the year 50000
150000 150000
2006 2006
Balance c/d 150000 Balance b/d 150000
Depreciation for the year 0
150000 150000
Disposal of asset a/c
Sh Sh
Motor van (cost value) 200000 Accumulated depreciation 150000
Gain on disposal 10000 Cash 60000
210000 210000
A special case where accounting for depreciation change in estimate
If we change the rate at which we were charging depreciation for an asset then we’ll
need to adjust for depreciation as follows.:
i) Calculate for depreciation so far provided for
ii) Cost of asset less this provided depreciation so far
iii) The balance be provided for uniformly at the new rate
e.g.
If an asset is bought for Sh 100000, expected to be depreciated at a rate of 20% with no
residue value, and after being in use for 3 years the rate is changed to 10%, we would
make the following adjustments:
3 60000
100
20
deprecaition so far = 100000! ! =
PREPARATION OF FINANCIAL STATEMENTS
11 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
>>> Example
If an asset is bought for Sh 100000, expected to be depreciated at a rate of 20% with no residue
value, and after being in use for 3 years the rate is changed to 10%, we would make the following
adjustments:
Depreciation so far = 100000 x 20 x 3 = 60000
100
Balance not depreciated = 100000 - 60000 = 40000
Depreciation over the remaining useful life = 10 x 40000 = 4000
100
3.8 CHANGE IN DEPRECIATION POLICY
When we change the depreciation policy, we need to adjust for the over/under charge previously
shown in the books of account (P&L and balance sheet) supposing it was an undercharge.
We calculate the correct amount of depreciation for the previous periods and then deduct the
difference in the retained earnings (profits) account. The other entry is passed in the credit of the
accumulated depreciation account as follows:
Dr. Retained profits (earnings)
Cr. Accumulated depreciation account
(With the amount of the under charge)
However if it was an overcharge, the entry would be:
Dr. accumulated deprecation account
Cr retained earnings account
(With the amount of the over charge)
>>> Illustration
Mkulima processing plant has a piece of equipment bought in 2003 at a cost Sh 200000.
Previously the equipment was being depreciated at a rate of 20% per annum on cost. However
in 2005 the management decided to change the policy after discovering that the appropriate rate
would have been reducing balance. Show the entries for adjustment that would appear in the
books of Mkulima processing plant in 2005.
117
S T U D Y T E X T
Notes
There will be entries:
i) Recognize depreciation for the year
ii) Adjusting for the amount of the under/over charge
Determination of the amount of under (over charge)
Year Amount (cost)
Straight line
method
Reducing
balance method
Under
(overcharge)
2003 2000000 400000 400000 0
2004 2000000 400000 320000 (80000)
2005 2000000 400000 256000 (148000)
However in advanced accounting levels you will realize that not all undercharge is to be deducted
from the profits. An element of tax should be recognized. This is because during the year of
undercharge, the company was being taxed on the “excess profits” and hence we should have
a pre paid tax asset.
The entries would be:
Dr. retained earnings
Dr. prepaid tax
Cr. accumulated depreciation
i.e. in the case of an under charge.
3.9 REASONS FOR PROVIDING FOR DEPRECIATION
i) Matching: depreciation is an ordinary expense resulting from use of an asset to generate
revenue during a given period. Matching this expense against the revenue helps to
determine the real profit.
ii) To determine financial position
Depreciation should be deducted to present the present economic value so that a fair
financial position of the firm is reached at.
iii) Asset replacement
Providing for depreciation helps to check cash outflows in the form of drawings, taxes,
dividends, e.t.c which lead to accumulation of resources required later for replacement
of the asset. This is because the expense is provided for yet the cash does not flow out
of the business allowing for cash to be used later.
iii) Reservation of equity if we do not provide for depreciation there would be a risk of
distributing non-distributable funds and hence consuming our capital due to overstated
profits.
PREPARATION OF FINANCIAL STATEMENTS
11 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
3.10 PROPERTY, PLANT, AND EQUIPMENT SCHEDULE
This was formerly referred to as the fixed asset movement schedule. It is a tabular representation
of the movement of tangible assets cost within a given accounting period the schedule also
shows movement of depreciation for all tangible assets within the given accounting period IAS
16 property plant and equipment requires that the schedule be shown in the published account
of companies.
The format is as shown below:
Property plant and equipment schedule Property plant and equipment schedule
Cost/valuation Freehold
property
Leasehold
property
Plant and
machinery
Fixture
furniture
and
fittings
total
Long
lease
Short
lease
Sh Sh Sh Sh Sh Sh
1. Balance as at1/1/01 Xx Xx Xx Xx Xx Xx
2. Additions Xx Xx Xx Xx Xx Xx
3. Revaluation gains Xx - - - - Xx
4. Reclassifications - (xx) Xx - - -
5. Disposal (xx) (xx) (xx) (xx) (xx) (xx)
6. Balance as at 31/12/01 xx xx Xx xx xx xx
7. Depreciation/amortization
8. Balance at 1/1/01 Xx - Xx Xx Xx Xx
9. Change for the year Xx - Xx Xx Xx Xx
10. Revaluation (xx) - (xx) (xx) (xx) (xx)
11. Eliminated on disposal (xx) - (xx) (xx) (xx) (xx)
12. Balance as at 31/12/01 (xx) - (xx) (xx) (xx) (xx)
13. N.B.V as at 1/1/01(1-8) Xx Xx Xx Xx Xx Xx
14. N.B.V as at 31/12/01(6-12) Xx Xx Xx Xx Xx Xx
119
S T U D Y T E X T
>>> Example
KASNEB adopted May 2000 question 3
a) Briefly explain the nature and the purpose of accounting for depreciation (5 marks)
b) The chief accountant of Jitegemea Ltd has encountered difficulties while accounting
for fixed assets and the related depreciation in the company’s draft accounts for the
year ended 30th April 2000. He has decDecided to seek your professional advice and
presented the following balances of fixed assets as at 1 st may1999.
Acquisition cost Accumulated depreciation Depreciation rate
Furniture 900000 300000 12.5
Trucks 3525000 1470000 25
Plant and machinery 7387500 4462500 10
Land 2775000 - Nil
Buildings 2925000 292500 2.5
The following additional information was available:
1. It is the company’s policy to write off costs of the assets using the above percentage on
cost.
2. Depreciation is fully charged on the year of acquisition and non in the year of disposal.
3. A three year old machine acquired for Sh 187500 was sold for Sh 15750.
4. It has been decided to adjust and charge depreciation on buildings at 4 %
5. A used delivery van purchased three years ago for Sh 248250 was traded in during the
year at the value of 157500 in part exchange of the new delivery truck costing
Sh 450000
6. Land, buildings and machinery were acquired for Sh 1350000 from a company that went
out of business. At the time of acquisition Sh. 90000 was paid to have the assets by a
professional qualified valuer. The revaluation indicated the following market value:
Sh
Land 900000
Buildings 600000
Machinery 300000
Required:
Reschedule of movement of fixed assets as requested by the chief accountant for inclusion in the
company’s accounts for the year ended 30 April 2000. (10 marks)
PREPARATION OF FINANCIAL STATEMENTS
1 2 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
Solution:
a) Covered in the text
b)
Workings:
Depreciation on furniture = 900000 x 12.5% = 112500
Motor vehicle = cost 3525000
Add 450000
3726750 x 25 % = 931 687.5
Buildings = (292500 + 600000) x 4% = 141000
At 2.5 % = 2925000 x 2.5 % x 4 = 292500
4% = 292500 x 4% x 4 = 468000
175500
Cost/valuation Land
buildings
and
machinery
Plant and
machinery
Fixture
furniture and
fittings
Total
Sh Sh Sh Sh
15. Balance as at1/5/99 13087500 900000 3225000 17512500
16. Additions 1350000 - 450000 1800000
17. Revaluation gains 450000 - - 450000
18. Disposal (187500) - (248250) (435750)
19. Balance as at 30/4/2000 14700000 900000 3726750 19326750
20. Depreciation/amortization
21. Balance at 1/5/99 4755000 300000 1470000 6525000
22. Change for the year 1066500 112500 931687.5 2110687.5
23. Eliminated on disposal (37500) - (124125) (161625)
24. Balance as at 30/4/2000 5784000 412500 2277562.5 8474062.5
25. N.B.V as at 1/5/99 8332500 600000 2055000 10987500
26. N.B.V as at 30/4/2000 8916000 487500 1449187.5 10852687.8
Workings:
Depreciation on furniture = 900000 x 12.5% = 112500
Motor vehicle = cost 3525000
Add 450000
121
S T U D Y T E X T
Machinery cost C/F + additions – disposals = balance x 10%
73787500 + 300000 - (187500) = 7500000x 10% = 750000
3.11 THE STATEMENT OF FINANCIAL POSITION
Fast forward - a statement of financial position is based on the fundamental business equation
i.e. Assets = Capital + Liabilities A = C + L
So far we have covered a majority of the expense items that are typical of any business
organization. We have also come across a trial balance and realized that all the entries in the
trial balance are used in one of two places i.e. the statement of comprehensive income and the
statement of financial position.
The statement of financial position can be defined as a statement which shows the assets of a
business at a given point in time and the claim thereof against the assets .The claims can either
be by the capital injected or liabilities to third parties.
If all double entry rules have been followed the statement of financial position should balance
.A statement of financial position is based on the fundamental business equation i.e. Assets
=capital + liabilities A=C+L
A statement of financial position is divided into two:
The debit side and the credit side .the debit side represent the business assets while the credit
side represents liabilities and capital.
The main categories in balance sheet will be as follows
1. ASSETS
Fast forward - Assets can be classified as current, non-current or fictitious assets.
These are economic resources created by past activities and are capable of bringing economic
benefits to the firm in future .assets can be identified by:
i) Have economic value i.e. can be measured in money terms
ii) Ability to generate income, goods and services in the future
iii) Generated by past activities but not dependent on future activities.
PREPARATION OF FINANCIAL STATEMENTS
1 2 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Assets can be classified as either:
a) Non-Current (Long Term) Assets
These are assets expected to bring economic benefits to the firm in more than one
accounting period. They can either be tangible or intangible. Tangible non-current
assets include land motor vehicles, equipment, and computers e.t.c
Intangible assets include goodwill, patents, copy rights, trademark. Intangible assets
have the ability to make revenues for a business. If someone owns exclusive copyrights
over a given music item then the copy right ownership is an asset to such a business
even though not touchable.
b) Current Assets
These are assets that are expected to be consumed by an organization within a period
not exceeding one accounting period. The benefits from such assets is felt within one
accounting period e.g. stock, cash at bank or cash in hand, prepayments, debtors,
short-term investments e.t.c.
Current assets are also referred to as floating assets
c) Fictitious Assets: discounts on issue of shares, formation expense of a company.
2. LIABILITIES
These are financial obligations arising from past agreements activity which is expected to be paid
or redeemed in future accounting periods
Liabilities can either be
a) Current Liabilities
These are debts arising from ordinary trade activities and expected to be settled within
the next accounting period out current assets. Examples would include trade creditors,
accrued expenses, bank overdraft, and bills of exchange payable, unpaid
b) Non-Current Liabilities
These are financial obligations the firm has undertaken to redeem or settle over a
period exceeding one accounting period. These liabilities arise from events outside the
ordinary trading activities. Non-current liabilities include bank loans, debentures, longterm
bonds payable, long-term leases.
c) Contingent liabilities
These are liabilities whose timing and amount depend on the occurrence of an event in
the future. Examples include damages that could be suffered due to law suits in future
or pending in the courts. These liabilities are not recorded in the books unless the
amount and timing are clearly certain.
3. CAPITAL/EQUITY
This represents the amount contributed by owners of the business. Capital is usually a residue
after all other claims. For different business organizations capital could be referring to the
following:
• Preference share capital
• Ordinary share capital
123
S T U D Y T E X T
The format of the statement of financial position
Xyz company Ltd
Statement of financial position as at xxxxx
Sh Sh Sh
Non-current assets Cost
Accumulated
Depreciation
NBV
land and buildings xxx
plant and equipment xx
less accumulated depreciation (xx)
xx
fixtures, furniture and fittings xx
less accumulated depreciation (xx)
xx
motor vehicles xx
less accumulated depreciation (xx)
xx
Total non-current assets xxx
Current Assets
stock xx
debtors xxx
less provision for doubtful debts (xxx)
xxx
prepayments xxx
short term investments xxx
cash at bank xxx
cash in hand xxx
total current assets xxx
less Current Liabilities
bank overdraft xxx
creditors xxx
accruals xxx
(xxx)
net current assets xxx
total assets yyyyy
Capital
Add: net profit
Less: drawings
Non-current liabilities
loans
Xx
Xx_____
xx
(xx)____
xxx
xx
yyyy
PREPARATION OF FINANCIAL STATEMENTS
1 2 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
Notes:
A statement of financial position should present in an ordinary way so that users can make
deductions they would want to without taking too much time. Therefore statements of financial
position of similar organization are prepared in the same way so as to enhance understandability
and compatibility.
Most organizations present their statements of financial position with increasing order of liquidity
(also known as permanency). This means that for assets we start with those assets that are
less likely to be converted into cash in the near future and ending with those that are readily
convertible into cash e.g. for current assets:
Ø Stock
Ø Debtors
Ø Cash at bank
Ø Cash in hand
CHAPTER SUMMARY
Statement of comprehensive income- formerly known as the income statement basically
represents the performance of a business. It is the sales (revenue) for the business less all the
expenses incurred to generate the sales. The end product is ether profit or loss.
The main reasons for preparing the statement of comprehensive income are:
i) To compare the actual profit to the expected profits
ii) For planning purposes i.e. to identify areas that need attention in future
iii) To obtain funds from lenders based on one’s profitability
iv) To inform prospective owners on the performance
v) In computation of taxes to ensure that the correct amount is remitted to the tax
authorities.
Statement of financial position - formerly known as the balance sheet is a statement which
shows the assets of a business at a given point in time and the claim thereof against the assets,
the claims can either by the capital injected or liabilities to third parties
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CHAPTER QUIZ
1. What are the main reasons for preparing the statement of comprehensive income?
2. How is the cost of goods sold calculated?
3. What expense (accrual or prepayment) is charged against profit for a period even
though it has not yet been paid or invoiced?
4. If a receivable allowance is increased, what is the effect on the income statement?
5. What are the causes of depreciation?
6. What are the two major methods of charging depreciation?
PREPARATION OF FINANCIAL STATEMENTS
1 2 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
ANSWERS TO CHAPTER QUIZ
1. - To compare the actual profit to the expected profits
- For planning purposes i.e. to identify areas that need attention in future
- To obtain funds from lenders based on one’s profitability
- To inform prospective owners on the performance
- In computation of taxes to ensure that the correct amount is remitted to the tax
authorities.
2. Opening inventory + purchases – closing inventory.
3. Accrued expenses.
4. Increase in expenses.
5. - Physical deterioration.
- Economic factors.
- Time.
- Depletion.
6. - Straight line method.
- Reducing balance method
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EXAM TYPE QUESTION
Question 1
Mary
Statement of financial position as at 31 December 2000
Non Current Assets Sh. Sh.
Premises 25,000.00
Plant 12,000.00
37,000.00
Current Assets:
Stock 11,000.00
Debtors 10,000.00
Cash at bank 5,000.00
Cash in hand 3,000.00
29,000.00
Current liabilities:
Creditors (12,000.00) 17,000.00
54,000.00
Capital 34,000.00
Non Current Liabilities:
Loan from bank 20,000.00
54,000.00
During the year to 31 December 2001 the following total transactions occurred:
a) Mary withdrew a total of Sh.10,000.00 in cash
b) Stock in trade was bought, all on credit, for Sh.34,000.00
c) Sales were made totaling 60,000.00 of stock in trade which had cost Sh.37,000.00. Of
these sales Sh.51,000.00 were on credit and Sh.9,000.00 for cash.
d) A total of Sh.16,000.00 was drawn from the bank in cash to the cash till.
e) Electricity for the year paid by cheque totaled Sh.2,000.00
f) Rates for the year paid by cheque totaled Sh.1,000.00
g) Wages for the year all paid cash totaled KSh.10,000.00
h) Sundry expenses all paid in cash totaled Sh.2,000.00
i) Creditors were paid a total of Sh.36,000.00 all by cheque
j) Debtors paid a total of Sh.54,000.00 all in cheques.
k) The bank charged interest on the loan deducting Sh.3,000.00.
Required:
Prepare a revised statement of financial position. (20 marks)
PREPARATION OF FINANCIAL STATEMENTS
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S T U D Y T E X T
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CHAPTER FOUR
SOLE PROPRIETORSHIP
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CHAPTER FOUR
SOLE PROPRIETORsHIP
OBJECTIVES
After studying this chapter, you should be able to:
• Define a sole trader and explain the advantages and disadvantages of sole proprietorship
form of business
• Prepare financial statements for sole proprietor form of business
• Understand the operation of nonprofit making organizations and operate
INTRODUCTION
Fast forward - The only unique account in the statement of financial position of a sole proprietorship
would be the drawings account.
Sole traders can be said to be business people who start their own enterprises and run them for
themselves with the aim of making a profit. Sole proprietorship could be run family members or
even the owner and one or two employees. They are the most common businesses that you will
come across in any economic set-up. They include butcheries, kiosks, some wholesale shops
and supermarkets, e.t.c the main reasons why they are so common include:
i) They are easy to set up (e.g. you only need a trading license)
ii) They require less capital to put up
iii) They are easy to manage
Advantages
i) They is ease in Decision making since only one party makes the Decision
ii) There is a personal touch with the customers
iii) It is easy to manage
iv) No sharing of profits
v) Easy to start since minimal capital is required
Disadvantages
i) Incase of incapacitation of the sole proprietor the business can easily collapse
ii) It is hard to raise capital
1 3 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
iii) There is no limited liability i.e. the private property of the proprietor can be sold to cover
the debts incurred by the business.
iv) The sole proprietor suffers losses alone
DEFINITION OF KEY TERMS
Drawings are either cash or goods withdrawn from the business by the sole proprietor for his
own use.
A Sole proprietorship is a business run by a single individual with an aim of making profit.
EXAM CONTEXT
This is a very important chapter bearing in mind sole proprietorships are the most common type
of business in the country. Expect questions from this chapter.
INDUSTRY CONTEXT
Sole proprietorships are the most common types of businesses in Kenya, in the form of kiosks,
farms and other family run businesses. This is a sector that that has largely gone without
maintaining financial statements. Sole traders have however seen the need of maintaining
financial statements with Kenya Revenue Authority (KRA) requiring them to file tax returns. This
has resulted in high demand for bookkeeping.
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S T U D Y T E X T
4.1 FINANCIAL STATEMENTS OF A SOLE
PROPRIET0RSHIP
The main objective of most business enterprises is to make profit. However, sometimes the
business ends up making losses. For a sole proprietorship, most important financial statements
are:
a) The statement of comprehensive income
b) The statement of financial position.
Refer to the general format of the Statement of comprehensive income and the statement
of financial position.
DRAWINGS
Fast forward - The total of the drawings account is deducted from capital to know how much is
left thereafter.
The only unique account in the statement of financial position of a sole proprietorship would be
the drawings account. A drawings account is used to record both cash and goods withdrawn
from the business by the sole proprietor for his/her own use. For example a shopkeeper will take
consumables from his shop and if it is not accounted for properly, one would end up deducing
the that the business is not making profits while us the truth is that the business is profitable only
that the profits are taken away from the business in the form of the goods or cash.
When one makes a withdrawal of cash the entries will be:
Dr. Drawings account
Cr. Cash/bank account
The drawings account is shown in the statement of financial position on the credit side. The total
of the drawings account is deducted from capital to know how much is left thereafter.
When we make a withdrawal of goods the entries are as follows:
Dr. Drawing account
Cr. purchases account
This amount of goods should be shown at cost to avoid bringing in the element of unrealized
profits in the business.
SOLE PROPRIETORSHIP
1 3 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
The drawings are then deducted from the net profit in the statement of financial position as
shown in the statement of financial position extract shown below;
Statement of financial position Extract
Capital
Add: net profit
Less: drawings
Non-current liabilities
loans
Xx
Xx
xx
(xx)
xxx
xx
yyyy
CHAPTER SUMMARY
The main reasons why sole proprietorships are so common include:
• They are easy to set up (e.g. you only need a trading license)
• They require less capital to put up
• They are easy to manage
CASE STUDY
Most businesses in Kenya are sole proprietorships. These range from small scale farmers to
jua kali trader to kiosk owners. These small businesses have been responsible for the current
boom in the country of microfinance, informal banking like M-pesa and the increased attention by
established banks like Equity bank to target small bankers (commonly known as the unbaked).
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S T U D Y T E X T
CHAPTER QUIZ
1. Why are sole traders common?
2. What are the advantages of sole trading?
3. If an owner takes goods out of inventory for his personal use, how is this dealt
with?
SOLE PROPRIETORSHIP
1 3 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
ANSWERS TO CHAPTER QUIZ
1. - They are easy to set up.
- They require less capital to put up.
- They are easy to manage.
2. - There is ease in decision making since only one party makes the decision
- There is a personal touch with the customers
- It is easy to manage
- No sharing of profits
- Easy to start since minimal capital is required
3. The amount is debited to drawings at cost.
PAST PAPER ANALYSIS
12/06, 6/04, 12/03, 6/02, 6/01, 12/00, 6/00
EXAM TYPE QUESTIONS
QUESTION 1 (December, 2006 Q 1)
Mr. Hassan Baraka retired from employment on 1 October 2005 and was paid terminal benefits
of Sh 3,000,000 He utilized Sh 2,500,000 in purchasing business premises and deposited the
balance in a new business account at Faida Bank Ltd.”
Mr. Baraka did not maintain proper books of account. However, he kept files of statements from
suppliers, cheque counter foils and unpaid invoices for purchases made. He also maintained
a note book in which he recorded sales to customers who had credit accounts and settled their
accounts by cheque. Cash collected from sales was banked at the end of each week after payment
of certain expenses. Mr. Baraka also maintained some petty cash for office use. Mr. Baraka
estimates to have paid the following business expenses from his personal bank account.
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S T U D Y T E X T
Sh ‘000’
Rent and rates for additional apace 100
Lighting expenses 50
Stationery and postage expenses 26
An analysis of the bank statements for the year ended 30 September 2006 was as
follows:
Receipts Sh.’000’ Payments Sh.’000’
Account opening 500 Petty cash withdrawn 20
Weekly bankings 3,769 Fixtures and fittings 300
Cheques from customers 382 Suppliers for goods 3,728
Cash refunded by a supplier 10 Insurance for inventory 40
Bank charges
110
______
Balance carried down 463
4,661 4,661
Additional information:
1. Baraka estimates that during the year ended 30 September 2006, he utilized cash
collected from sales for the following purposes:
Sh.’000’
Wages payment 400
Sundry expenses payment 50
Drawings 600
2 Cheques received from credit customers amounting to Sh 30, 000 had not been credited
by the bank as at 30 September 2006.
3 Insurance paid for inventory during the year includes Sh 20,000 relating to premium for
the year ending 30 September 2007.
4 Petty cash balance as at 30 September 2006 was Sh 15,000 which included a post
dated cheque of Sh 5,000 drawn by Mr. Baraka’s friend in exchange for cash advanced
from petty cash.
5 Credit customers owed Sh 172,000 as at 30 September 2006.
6 As at 30 September 2006, the following were due on accounts payable:
Sh ‘000’
Suppliers 403
Wages 10
Sundry expenses 6
SOLE PROPRIETORSHIP
1 3 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
7 Depreciation is to be provided on a straight-line basis at the following rates:
Business premises 2%
Fixtures and fittings 10%
8 The value of inventory as at 30 September 2006 was Sh 360,000.
Required:
(a) Statement of comprehensive income for the year ended 30 September 2006.
(12 Marks)
(b) Statement of financial position as at 30 September 2006.
(8 Marks)
(Total: 20 Marks)
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S T U D Y T E X T
CHAPTER FIVE
PARTNERSHIP ACCOUNTS
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S T U D Y T E X T
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S T U D Y T E X T
CHAPTER FIVE
PARTNERSHIP ACCOUNTS
OBJECTIVES
After studying the following chapter, you should be able to:
• Define partnership and highlight the advantages and disadvantages of partnership form
of business
• Prepare current account and capital accounts for partnership form of business and
distribute profits to partners through the preparation of appropriation account
• Account for change in partnership agreement
• Understand the concept of goodwill; characteristics and Calculation of goodwill
• Account for goodwill and revaluation profit or loss
• Account for asset revaluation for assets taken over by a retiring partner
INTRODUCTION
A partnership is defined as the relationship which exists between persons carrying on a business
in common with a view of making profits.
Advantages of partnerships
Advantages over sole traders
i. Risks are distributed over a larger number of people
ii. There is access to addition capital
iii. Expertise; partners bring in experience from individual fields
iv. Easier to raise funds from external sources
Advantages over limited liability companies
i. Easier to establish and manage because there is no compliance to the Companies Act
Rules
1 4 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Disadvantages
Against sole traders
i. Possibility of dispute among partners
ii. Less control in the management as many people are involved
iii. Less amount of profits distributed
Against limited liability companies
i. Liability of partners is unlimited. They can be called to contribute personal assets incase
the business cannot meet its obligations
ii. Comparatively difficult to raise capital
iii. Retirement or death of a partner leads to dissolution and reformation of the firm
DEFINITION OF KEY TERMS
Relationship - a partnership has more than one person, a differentiating factor from sole
proprietorship.
Business in common - all members to a partnership have a common purpose. This means they
cannot run parallel businesses.
Profits - key to every business undertaking, partnerships aim to make profits.
EXAM CONTEXT
As emphasized in every chapter, all chapters equally important. This chapter has been frequently
examined as seen in the past paper analysis the latest being June and December sitting for 2006
and 2007.
INDUSTRY CONTEXT
Unlike sole proprietorships where most traders don’t maintain proper or any accounts in
partnerships this is very crucial. Not all partner may be part of the day to day running of the
business, they will for this reason require true and fair financial statements prepared and audited
for the purposes of profit sharing.
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S T U D Y T E X T
5.1 PARTNERSHIP AGREEMENTS
Fast forward – In the absence of the partners’ agreement, it is presumed that:
• Profits will be shared equally
• There are no partners’ salaries
• No interest on capital is paid
• Partners are entitled to interest of 4% per annum on any loans advanced to the firm
A partnership is usually established through a partnership agreement in which the terms of the
partnership are set out. The agreement covers the following items:
• Amount of capital invested by each partner in the business
• The profit sharing ratio
• The interest on capital
• Salaries to partners
• Limits to drawings
• Interest on drawings, etc.
• Some partnership agreements may also guarantee minimum share of profits for one or
more partners. What this means is that if the amount allocated by the profit sharing ratio
is lower than that stipulated, the partner would receive the guaranteed minimum share
and the remainder of the profits would be share by the other partners according to the
agreement.
In the absence of the partners’ agreement, it is presumed that:
• Profits will be shared equally
• There are no partners’ salaries
• No interest on capital is paid
• Partners are entitled to interest of 4% per annum on any loans advanced to the firm
5.2 ACCOUNTING FOR PARTNERSHIPS
Fast forward – There are two very important accounts used in partnership accounting
a) Partners current account
b) Capital accounts
PARTNERSHIP ACCOUNTS
1 4 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
Four main transactions are recorded in these important accounts. They are; division of profits,
capital investments by partners, drawings, interest on capital and interest on drawings.
CAPITAL ACCOUNT
Partners’ capital account records the initial and additional investments made by the partners into
the business. In other words it records items of long-term nature. Each partner’s contribution is
shown separately i.e. each partner has a capital account.
Capital accounts have credit balances normally
Let’s take an initial example of two partners; Abdi and Jillo, the format of capital account would
be as follows:
Capital account
Abdi Jillo Abdi Jillo
Goodwill written off XX XX Balance b/f XX XX
Revaluation Loss XX XX Additional capital XX XX
Gains on Revaluation XX XX
Balance c/d XX XX Goodwill XX XX
This is called a fixed capital account
>>> Example
Abdi and Jillo intend to start a business of selling cattle. Abdi contributes Sh 100,000 and Jillo
Sh 150,000. Record these initial investments in the relevant accounts.
Solution
Just like sole proprietorship, capital contribution is recorded thus;
Dr. Cash
Cr. Capital account (with each partner’s contribution)
Capital, Abdi Cash account
Cash 100,000 Capital; Abdi 100,000
Capital; Jillo 150,000
Capital, Jillo
Cash 150,000
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S T U D Y T E X T
CURRENT ACCOUNTS
The current accounts records movements in partners’ earnings. Items that increase earnings to
the partners are credited and those that decrease are debited.
They normally have a credit balance, just like the capital accounts.
The format of Current accounts is as follows
Current Account
Abdi Jillo Abdi Jillo
Balance b/d xx Balance b/d xx
interest on drawings xx xx Interest on Capital xx xx
Drawings xx Salaries xx xx
Profit share xx xx
Balance c/d xx Loan Interest xx xx
Balance c/d xx
Note that the opening and closing balances are both on the credit and debit sides. The normal
balances should be on the credit side. It is therefore not normal to have debit balances on the
partners’ current account. It may arise when a partner has overdrawn in his/her account.
Salaries
Some partners could render services to the partnership in areas that they are competently
qualified. For example accountancy services, legal etc. They are thus remunerated for those
services in the form of salaries.
Salaries paid to partners increase their accounts. Therefore to record salaries paid to a partner,
we:
Dr. Salary account
Cr. Partner current account
Interest on capital
This is a form of ‘reward’ to the partners for contributing capital to the business. It therefore
increases partners’ incomes.
The entry is therefore as follows:
Dr. Profit and loss appropriation account
Cr. Current account.
PARTNERSHIP ACCOUNTS
1 4 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
Drawings
Drawings are goods meant for the business that owners take for personal use. They are therefore
not sold nor are they reflected in the closing stock. They are normally removed at cost from the
trading account into a drawings account. At the end of the year, they are transferred into the
current account by the following entry;
Dr. Current account
Cr. Drawings account
Interest on drawings
Fast forward – Drawings are like advancement to the partners in form of goods.
Interest is normally charged on Drawings. This reflects an amount over and above the value of
the goods called the interest on drawings recorded thus:
Dr. Current account
Cr. Profit and loss appropriation account
Division on partnership profit
Profit from a partnership is divided among the partners in accordance with the partnership deed.
In case of no such deed, profits are shared equally as noted above.
To record partnership profits, we need to introduce a profit and loss appropriation account or
simply appropriation account.
To record profit share:
Dr. Profit and loss appropriation account
Cr. current account
Note
The capital account could either be fixed or fluctuating. A fixed capital account is one that records
the long-term items alone. As the name suggests, the amounts do not change unless additional
capital is introduced by partners.
Fluctuating capital account is one where both the long-term and short-term (current account
items) items are recorded on the same account. Where fluctuating capital accounts are kept,
current accounts do not exist; their items are passed onto the capital account.
The amount of the ending balance keeps on changing due to the inclusion of short-term items
hence the name fluctuating account.
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S T U D Y T E X T
Note that the fixed format is highly preferred by examiners and unless told to use the fluctuating
capital account, stick to the fixed capital account(s i.e. separate capital and current accounts).
The format of the fluctuating capital account is as follows:
Fluctuating Capital Account
Abdi Jillo Abdi Jillo
Drawings xx xx Balance b/d xx xx
interest on drawings xx xx Additional capital xx xx
interest on Capital xx xx
salaries xx xx
loan interest xx xx
Balance c/d xx xx profit share xx xx
The end balances in a fluctuating capital account keep changing even without injection of
additional capital due to the inclusion of current account items.
In fluctuating capital account, the current account does not exist.
5.3 FINAL ACCOUNTS
In sole proprietorship, we learnt the two conventional final accounts i.e. trading, statement of
comprehensive income and the balance sheet. The financed by side of the statement of financial
position records the partners’ capital and current accounts separately. We normally introduce
the profit and loss appropriation account or simply the appropriation account. The rest does not
change in partnerships.
APPROPRIATION ACCOUNT
Appropriation account is an extension of the statement of comprehensive income showing how
the partnership profit was shared. In arriving at the amount to be shared among the partners,
we include the four basic items discussed above; salaries to partners, interest on drawings and
interest on capital, the fourth item being the profit share.
The basic format of an appropriation account is as follows:
Let us use Abdi and Jillo again;
PARTNERSHIP ACCOUNTS
1 4 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
Abdi and Jillo Partnership
Profit and Loss Appropriation Account
For the period ended…
Sh. Sh.
Net Profit for the year XX
Add; Interest on Drawings; Abdi XX
Jillo XX
XX
XX
Less; Interest on Capital; Abdi XX
Jillo XX
(XX)
Less; Salaries; Abdi XX
Jillo XX
(XX)
Balance to be shared in ratio; XX
Abdi XX
Jillo XX
(XX)
NIL
Note: The final figure should be zero because the balance is fully shared among/between
the partners.
>>> Worked examples
You now know all you need to about partnership accounting.
Let us now look at some short examples:
>>> Example 1
Mogire, Waituka and Kipkorir are in partnership. Mogire does the accounting work while Waituka
offers legal services and for each earns a salary of Sh 10,000 per month. The profit or loss is
shared equally. The profit for the month was Sh 110,000.
Show the relevant accounts for the partnership:
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S T U D Y T E X T
Current Account
Mogire Waituka Kipkorir Mogire Waituka Kipkorir
Salary 10,000 10,000
Balance
c/d
40,000 40,000 30,000
Profit
Share
30,000 30,000 30,000
40,000 40,000 30,000 40,000 40,000 30,000
balance
b/d
40,000 40,000 30,000
The appropriation account will be
MOGIRE, WAITUKA AND KIPKORIR PARTNERSHIP
PROFIT AND LOSS APPROPRIATION ACCOUNT
FOR THE MONTH ENDED…
Net profit for the month 110,000
less salaries Mogire 10,000
Waituka 10,000
(20,000)
profit to be shared 90,000
Profit share Mogire 30,000
Waituka 30,000
Kipkorir 30,000
(90,000)
NIL
>>> Example 2
Assume in the above example that a clause in the partnership deed guaranteed a minimum profit
to Mogire of Sh 35,000, show the new set of accounts.
Solution
In our discussion above, we noted that some partnership agreements could guarantee one or
more of the partners a minimum profit share beyond which his/hers share cant fall. In this example,
Mogire’s share can’t go below Sh 35,000. The remaining will be shared equally between Waituka
and Kipkorir as follows:
PARTNERSHIP ACCOUNTS
1 5 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
Current Account
Mogire Waituka Kipkorir Mogire Waituka Kipkorir
Salary
10,000
10,000
Balance c/d 45,000 37,500 27,500 Profit Share 35,000 27,500 27,500
45,000 37,500 27,500 45,000 37,500 27,500
balance b/d 45,000 37,500 27,500
MOGIRE, WAITUKA AND KIPKORIR PARTNERSHIP
PROFIT AND LOSS APPROPRIATION ACCOUNT
FOR THE MONTH ENDED…
Net profit for the month 110,000
less salaries Mogire 10,000
Waituka 10,000
(20,000)
profit to be shared 90,000
Profit share Mogire 35,000
Waituka 27,500
Kipkorir 27,500
(90,000)
NIL
Let us now have a comprehensive example capturing all aspects up to final accounts
>>> Example 3
Ochieng and Otieno are in partnership sharing profits and losses equally. The following is their
trial balance as at 30th June 2006:
Dr, Sh. Cr. Sh
Buildings (cost Sh. 80,000) 55,000
Fixture at 16,000
Provision for depreciation on fixtures 8,300
Debtors 21,243
Creditors 16,150
Cash at bank 5,677
Stock at 30th June 2005 46,979
Sales 128,650
Purchases 90,416
Carriage outwards 6,288
Discounts allowed 5,115
Loan from Oloo 129,100
Office expenses 7,416
Salaries 23,917
Bad debts 5,503
Provision for bad debts 5,400
Loan interest – Oloo 9,000
Capital – Ochieng 45,000
Capital – Otieno 39,500
Current account – Ochieng 13,106
Current account – Otieno 9,298
Drawings by Ochieng 12,400
Drawings by Otieno 8,650 _______
TOTAL
394604 394604
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S T U D Y T E X T
Prepare a trading, profit and loss and appropriation account for the year ended 30th June 2006
and a statement of financial position as at that date incorporating the following information:
a. Stock at 30th June 2006 was Sh 61,341
b. Office expenses and Wages of Sh 2596 and Sh 5717 respectively are for next year.
c. Depreciation is to be charged at 10% on reducing balance method on fixtures and Sh
750 on buildings.
d. Provision for bad debts is to be reduced to Sh 4000
e. Not yet entered in the books is salary of Sh 1,000 to Ochieng
f. Interest on drawings: Ochieng, Sh 5,180 and Otieno Sh 5,120
g. Interest on capital account balances is at 10%
h. Freehold land was purchased during the year at Sh 80,900 vide a cheque. While the
entry was passed in the cash at bank account, no other entry was made.
Solution
Workings:
From your previous chapters, prepayments and accruals are treated as balance carry downs
So that they appear in balance sheet. Note that the figure to the statement of comprehensive income is
the balancing figure.
Office expenses account Salaries and wages
Balance b/d 7,416 Profit and loss 4,820
Balance
b/d 23917 Profit and loss 18200
Balance c/d 2,596 Balance c/d 5717
7,416 7,416 23917 23917
Balance b/d 2,596
Balance
b/d 5717
Provision for bad debts Freehold land account
Profit & loss 1,400 Balance b/d 5,400 Bank 80900 Balance c/d 80900
Balance c/d 4,000
Balance
b/d 80900
5,400 5,400
Balance b/d 4,000
From your previous chapters, prepayments and accruals are treated as balance carry downs
So that they appear in balance sheet. Note that the figure to the statement of comprehensive income
is the balancing figure.
Depreciation on fixtures= 10% of NBV
NBV= cost - Accumulated depreciation
Depreciation on fixtures= 10%(16000 - 8300)
=770
PARTNERSHIP ACCOUNTS
1 5 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Depreciation on fixtures= 10% of NBV
NBV= Cost - Accumulated depreciation
Depreciation on fixtures = 10% (16000 - 8300)
= 770
Interest on capital; Ochieng, 10%X 45,000 = 4,500
Otieno, 10%X 39500 = 3950
Note that the statement of financial performance includes the appropriation account. The title
should use the correct wording because we are presenting three accounts in continuation.
OCHIENG AND OTIENO PARTNERSHIP
STATEMENT OF FINANCIAL PERFORMANCE AND APPROPRIATION ACCOUNT
FOR THE YEAR ENDED 30TH JUNE 2006
Sh Sh.
Opening stock 46,979 Sales 128,650
add purchases 90,416
cost of goods available 137,395
less closing stock 61,341
Cost of goods sold 76,054
Gross profit c/d 52,596
128,650 128,650
Office expenses 4,820 Gross profit b/d 52,596
Wages and salaries 18,200 Provision for bad debts 1,400
Depreciation on fixtures 770
Depreciation on Buildings 750
Carriage outwards 6,288
Discount allowed 5,115
Loan interest; Oloo 9,000
Bad debts 5,503
Net profit c/d 3,550
53,996 53,996
interest on Capital Net profit b/d 3,550
Ochieng 4,500 Interest on Drawings;
Otieno 3,950 Ochieng 5,180
Salary; Ochieng 1,000 Otieno 5,120
Profit share
Ochieng 2,200
Otieno 2,200
13,850 13,850
153
S T U D Y T E X T
Note that in partnership final accounts, even when not asked to draw the capital and (especially
the) current account, they are almost being asked indirectly because you will need them to draw
your balance sheet.
Partnership Current account
Ochieng Otieno Ochieng Otieno
Drawings 12,400 8,650 Balance b/d 13,106 9,298
Interest on Drawings 5,180 5,120 Salary 1,000
Interest on Capital 4,500 3,950
Balance c/d 3,226 1,678 Profit share 2,200 2,200
20,806 15,448 20,806 15,448
Balance b/d 3,226 1,678
OCHIENG AND OTIENO PARTNERSHIP
STATEMENT OF FINANCIAL POSITION
AS AT 30TH JUNE 2006
Non Current assets
Cost Dep. Net Capital Sh
Sh Sh Sh Ochieng 45,000
Freehold land
80,900
80,900 Otieno 39,500
Buildings
80,000
25,750
54,250 add current accounts;
Fixtures
16,000
9,070 6,930 Ochieng 3,226
142,080 Otieno 1,678
Current Assets Long term liabilities
Debtors
21,243
Loan from Oloo 129,100
less provision for BD
(4,000)
Current liabilities
Net debtors 17,243 Creditors 16,150
Bank 5,677
Stock 61,341
Prepaid office expenses 2,596
Prepaid wages 5,717
92,574
234,654 234,654
PARTNERSHIP ACCOUNTS
1 5 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
5.4 ACCOUNTING FOR CHANGE IN PARTNERSHIP
AGREEMENT
Fast forward – Changes in the partnership agreement will affect both the statement of
comprehensive income/statement of financial performance and the statement of financial
position.
Change they say is inescapable. Partners being as they can be may effect changes in their
partnership deed. A change may occur in three areas:
a) Profit and loss sharing ratio
b) Entry of a new partner
c) Exit of an existing partner either through death or retirement
In any case a change will affect both the statement of comprehensive income and the statement
of financial position.
Statement of Comprehensive Income
The statement of comprehensive income is separated up to the point of change and after the
point of change. Profits are then distributed according to the agreements before the change and
after the change.
The statement of financial position
The capital accounts will have to be adjusted for goodwill and effects of revaluation.
>>> Example 1
Jane and John are in partnership sharing profits and losses equally. The partnership agreement
charges Sh 2000 per month to Jane.
In mid year, they agree to change the partnership deed to charge a higher salary of Sh 6000 to
Jane and also change the profit and loss sharing ratio into 3:2.
You are required to show the relevant accounts at the year end if the profit amounted to
Sh. 120,000.
155
S T U D Y T E X T
The distribution of profits before change was as follows:
JANE AND JOHN PARTNERSHIP
PROFIT AND LOSS APPROPRIATION ACCOUNT
FOR THE PERIOD SIX MONTHS BEFORE CHANGE
Net Profit (120,000/2) 60,000
Less salary to Jane (2,000X6) (12,000)
Balance to be shared 48,000
Profit Share Jane 24,000
John 24,000
(48,000)
NIL
Distribution of profits after change
JANE AND JOHN PARTNERSHIP
PROFIT AND LOSS APPROPRIATION ACCOUNT
FOR THE PERIOD SIX MONTHS AFTER CHANGE
Net Profit 60,000
Less salary to Jane (6000X6) (36,000)
Balance to be shared 24000
Profit Share Jane (3/5X24,000) 14,400
John (2/5X24,000) 9,600
(24,000)
NIL
>>> Example 2
Wanyika and Wathara are in partnership sharing profits and losses equally. Their year ends on
31st December. On September 30th 2007, Wawinja joined the partnership. Henceforth, the profit
and loss sharing ratio became 3:2:1 in Wanyika, Wathara and Wawinja respectively. No salaries
were payable to any partner. The profit as at 31st December 2007 was Sh 360,000.
Assuming that the profit accrues evenly over the year, show the appropriation account and the
partners’ current accounts.
PARTNERSHIP ACCOUNTS
1 5 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
Profit distribution before change will be:
WANYIKA AND WATHARA PARTNERSHIP
PROFIT AND LOSS APPROPRIATION ACCOUNT
FOR THE NINE MONTHS ENDED SEPTEMBER 30TH 2007
Net profit ( 360,000x9/12) 270,000
profit share Wanyika 135,000
Wathara 135,000
(270,000)
NIL
Distribution after change will be:
WANYIKA AND WATHARA PARTNERSHIP
PROFIT AND LOSS APPROPRIATION ACCOUNT
FOR THE THREE MONTHS ENDED DECEMBER 31ST 2007
Net profit ( 360,000x3/12) 90,000
profit share Wanyika (90,000X3/9) 30,000
Wathara (2/9X90,000) 20,000
Wawinja (1/9X90,000) 10,000
(90,000)
NIL
Let us now have a typical exam question on what we have already learnt.
>>> Example 3 (KASNEB Adapted)
Aloo and Bara are partners in the business of selling motor vehicle spare parts and accessories.
The trial balance given below was extracted from the books of the partnership on 30th June
1996.
157
S T U D Y T E X T
Dr., Sh ‘000 Cr., Sh ‘000
Capital – Aloo 1,500
Capital – Bara (admitted as partner on 1.4.1996 200
Sales 6,000
Creditors 800
Drawings – Aloo 600
Furniture and fittings at cost 800
Land and buildings at cost 1,500
Provision for depreciation – furniture and fittings 100
Provision for depreciation – land and buildings 200
Debtors 480
Provision for bad and doubtful debts(1.7.1995) 35
Purchases 3,390
Returns inwards 120
Returns outwards 90
Stock as at 1.7.1995 450
Salaries and wages – selling 640
Salaries and wages – administrative 650
Salesmen commission 50
Cash at bank 100
Insurance 45
Rent and rates 20
General administrative expenses 80 ____
TOTALS 8,925 8,925
Prior to his admission as a partner on 1st April 1996, Bara was the general manager of the firm
and was earning a salary of Sh 31250 per month. This salary has not been included in the
accounts. He brought in capital of Sh 200000 in cash and was thereafter entitled to one-fifth of
the firm’s profits. The partnership agreement provides for interest to be charged on drawings
made after the commencing of partnership at the rate of 10% per annum.
The following additional information is provided:
1. The sales for the 9 months to 31stmarch 1996, including returns of Sh 96000 were Sh
4,800,000 whereas the purchases over the same period amounted to Sh 2,690,000.
there were no purchase returns the last three months of the period
PARTNERSHIP ACCOUNTS
1 5 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
2. Depreciation is to be provided on written down value of the building at 5% per annum
and on furniture at 20%per annum. Although the cost of the land on 30th June 1996 was
Sh 700,000 no depreciation is to be provided.
3. A debt of Sh 20,000 is to be written off, and the provision for bad and doubtful debts is
to be maintained at 5% of the remaining debtors.
4. The drawings by Aloo after the formation of the partnership are Sh 200,000 made on 1st
April 1996.
5. Expenses are to be apportioned between the two periods as follows;
Base
Selling expenses net sales value
Administrative expenses time basis
Depreciation time basis
Other expenses time basis
6. Insurance paid in advance and rates outstanding at 30th June 1996 are Sh 5,000 and
Sh 10,000 respectively
7. Stock in trade was Sh 600,000 at 31st March 1996 and Sh 750,000at 30th June 1996
Required:
Prepare the statement of comprehensive income for the 9 months ended 31st March 1996 and for
the 3 months ended 30th June 1996, and a statement of financial position as at that date.
Solution
Does it look like rocket science, may be yes, but wait till we are through, just follow the steps we
have been using.
You should never forget your workings, they always start.
Look at what you are given in the additional information.
1. The fact that those differentiations are given makes it easy for us, just post them.
2. Depreciation
a). Buildings; 5% of written down value
Buildings at cost = 1500,000 – 700,000
= 800,000
Written down value = cost – accumulated dep.
= 800,000 – 200,000
= 600,000
Therefore, dep = 5% X 600,000
= 30,000
b) Furniture; 20% (800,000 – 100,000)
= 140,000
159
S T U D Y T E X T
3. We can do this without drawing the T accounts now,
We write off a bad debt by, Dr. Bad debts Sh 20,000
Cr. Trade debtors Sh 20,000
Provision for bad debts; 5 %( 480,000 – 20,000)
= 23,000
The difference (this time a decrease) goes to the statement of comprehensive income
= 35,000 – 23,000
= 12,000
4. Apportioning of expenses;
Selling expenses are on basis of net sales value
Net sales = 5,880,000
For nine months, 4707, 000/5880,000 X 640,000 = 512,000
For 3 months, 1176, 000/5880,000 X 640,000 = 128,000
5.
Insurance account Rent and rates account
Balance
b/d
45,000
Profit and
loss
40,000
Balance
b/d
20,000
Profit and
loss
30,000
balance c/d
5,000
Balance
c/d
10,000
45,000
45,000
30,000
30,000
Balance
b/d
5,000 Balance b/d
10,000
ALOO AND BARA PARTNERSHIP
STATEMENT OF COMPREHENSIVE INCOME FOR
9 Months to 01.04.2006
3 Months to
30.06.2006
Sh Sh Sh Sh
Sales
4,800,000
1,200,000
less returns inwards 96,000
24,000
Net sales
4,704,000
1,176,000
less cost of sales
Opening stock
450,000 600,000
add purchases
2,690,000 700,000
PARTNERSHIP ACCOUNTS
1 6 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
ALOO AND BARA PARTNERSHIP
STATEMENT OF COMPREHENSIVE INCOME FOR
9 Months to 01.04.2006 3 Months to 30.06.2006
Sh. Sh. Sh. Sh.
Sales
4,800,000
1,200,000
less returns inwards 96,000 24,000
Net sales
4,704,000
1,176,000
less cost of sales
Opening stock
450,000
600,000
add purchases
2,690,000
700,000
less returns outwards
(90,000)
cost of goods available
3,050,000
1,300,000
less closing stock
(600,000)
(750,000)
cost of sales
(2,450,000)
(550,000)
Gross profit
2,254,000
626,000
add Decrease in provision for BD 9,000 3,000
less expenses
Depreciation on furniture
105,000
35,000
Depreciation on buildings
22,500
7,500
Bad debts
15,000
5,000
Salaries – Selling
512,000
128,000
Salaries- Administrative expenses
487,500
162,500
Salesmen commission
40,000
10,000
Insurance
30,000
10,000
Rates
22,500
7,500
General administrative expenses
60,000
20,000
Salary to Bara
281,250
Total expenses
1,575,750
385,500
Net Profit
687,250
243,500
add interest on drawings; Aloo 5,000
Profit to be shared 248,500
Profit share 198,800
Aloo 49,700
Bara (248,500)
NIL
161
S T U D Y T E X T
Notes:
a. Bara will not get salary in the last three months because he is now a partner. If he was
still entitled to the same amount of salary even after becoming a partner, the amount
would appear in his current account but not the statement of comprehensive income
b. The appropriation account will only be for the last three months; the effective period of
partnership.
Partners’ Current account
Aloo Bara Aloo Bara
Interest on drawings 5,000 Profit for 9 months 687,250
Drawings
600,000
Profit for 3 months 198,800
49,700
Balance c/d
281,050
49,700
886,050
49,700 886,050
49,700
ALOO AND BARA PARTNERSHIP
STATEMENT OF FINANCIAL POSITION
AS AT 30TH JUNE 1996
Non-Current Assets Cost Dep. Net
Sh. Sh. Sh.
Furniture 800,000 240,000 560,000
Land and Buildings
1,500,000
230,000 1,270,000
1,830,000
Add working Capital
Current Assets
Debtors 460,000
Less provision for bad debts
(23,000)
Net debtors 437,000
Bank 100,000
Stock 750,000
Prepaid insurance 5,000
1,292,000
less current liabilities
Creditors 800,000
Accrued rates 10,000
Accrued salary to Bara 281,250
(1,091,250)
Working capital 200,750
2,030,750
Financed by;
Capital Aloo 1,500,000
Bara 200,000
1,700,000
Current Accounts Aloo 281,050
Bara 49,700
330,750
2,030,750
PARTNERSHIP ACCOUNTS
1 6 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
5.5 ADJUSTMENTS FOR GOODWILL AND REVALUATION
PROFIT OR LOSS
Fast forward – Purchased goodwill is the amount paid for a business in excess of its net
assets
Goodwill could be defined as any excess of the cost of acquisition over the acquirer’s interest
in the fair value of the identifiable assets and liabilities acquired as at the date of the exchange
transaction.
In layman terms, goodwill can be viewed as that amount over and above the value of assets
being purchased.
Goodwill should not be recognized in the books because it has no objective value and it keeps
on changing in value constantly.
Goodwill could either be purchased or non-purchased, purchased goodwill is recognized in the
books while non-purchased is not.
Purchased goodwill is the amount paid for a business in excess of its net assets. It arises when
a business is sold as a going concern.
Non purchased goodwill could be termed as the goodwill inherent in a business. It may not be
objectively measures. Some of its measures include:
• Good reputation
• Hospitable reception and staff attitude
• High profitability
• Good management
• Strategic location
• Promptness in response
It therefore becomes difficult to value.
In accounting for goodwill, we deal more with the purchased goodwill because of its ease to value
numerically (remember accounting is the science of numbers).
If a business K has net assets worth Sh 900, 000 and it is purchased at one million shillings, then
goodwill could be calculated as:
Goodwill = Sh 1,000,000 - 900,000=Sh 100,000. This captures our definition of goodwill given
above.
163
S T U D Y T E X T
METHODS OF CALCULATING GOODWILL
In calculating goodwill, the method varies according to the type of business whose goodwill is
being measured.
For retail businesses for instance, goodwill is customarily calculated at average weekly sales for
the previous year multiplied by a given figure.
For professional firms, the custom is to value goodwill at the gross annual fees multiplied by a
given figure.
It can also be valued by getting the average net annual profit for a specified past number of years
multiplied by a given number.
In case of sole traders, goodwill is valued based on the super profits method. The net profit figure
is adjusted for a normal salary figure given to the proprietor and notional interest for capital.
CHARACTERISTICS OF GOODWILL
i. It is incapable of realization separately from the business as a whole
ii. Its value has no reliable or predictable relationship to any costs which may have been
incurred
iii. Its value arises from various intangible factors which cannot be valued
iv. Its value can fluctuate widely according to internal and external circumstances over
relatively short periods of time.
v. The assessment of the value of goodwill is highly subjective.
Accounting entries
As we have mentioned above, only purchased goodwill is passed into the accounts. Specific to
partnerships, adjustments for goodwill in the accounts of the partners whenever a change in
the partnership takes place:-
a. Change in profit and loss sharing ratios
b. Admission of a new partner
c. Retirement or death of a partner
The change may involve cash being paid by one partner to another, or an adjustment in the
books is made so that the changes in the partnership does not lead to partner losing his/her
ownership share without being compensated adequately.
While accounting for goodwill,
a) It could be shown in the books; or
b) It could be written off i.e. not shown the books
PARTNERSHIP ACCOUNTS
1 6 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
a) Where goodwill is shown in the books, the double entry is:
Dr. Goodwill
Cr. partners capital account (using the old profit sharing ratio)
>>> Example 1
Mutie, Mutua and Mutinda have always shared profits in the ratio of 4:2:2 respectively. They now
decide to alter that ratio to 5:2:1. Accompanying the change is a Sh 80,000 goodwill. The net
assets without the goodwill are Sh 100,000. The capital accounts are as follows:
Sh
Mutie 50,000
Mutua 30,000
Mutinda 20,000
If the partners decide to show goodwill in the accounts, show the statement of financial position
as at 31st December 2006.
Old ratio 4:2:2
New Ratio 5:1:1
Share goodwill in the old ratio of Sh 80,000
Dr. Goodwill 80,000
Cr. Capital accounts; Mutie (4/8X80,000) 40,000
Mutua (2/8X80,000) 20,000
Mutinda (2/8X80,000) 20,000
Mutie, Mutua and Mutinda Partnership
Statement of financial position as at 31st December 2006
Assets 100,000 Capital; Mutie 90,000
Goodwill 80,000 Mutua 50,000
Mutinda 40,000
180,000 180,000
>>> Example 1b
Suppose that after some days they decide to sell the business and receive Sh 180,000 in cash
show how the cash would be shared.
165
S T U D Y T E X T
Solution
Each partner will receive an amount equal to their statement of financial position balances
above:
Dr. Capital Accounts; Mutie 90,000
Mutua 50,000
Mutinda 40,000
Cr. Cash 180,000
b) If goodwill is to be written off or is not to be shown in the accounts, the entries are made
in two steps:
b1) Dr. goodwill
Cr. partners’ Capital accounts
Using the old profit sharing ratio
b2) Dr. Partners’ capital accounts using the new ratio
Cr. goodwill
To write off goodwill from the books, you will note that goodwill will appear nowhere in
the books of account.
>>> Example 2
Using the example 1 above, show the partners’ capital accounts and the statement of financial
position if they decide to write off the goodwill account.
Solution
Step 1; use the old sharing ratio
Dr. Goodwill 80000
Cr. Capital accounts; Mutie(4/8X80,000) 40,000
Mutua(2/8X80,000) 20,000
Mutinda(2/8X80,000) 20,000
Step 2; write off goodwill using the new sharing ratio
Dr. Capital accounts: Mutie (5/8) 50,000
Mutua (2/8) 20,000
Mutinda (1/8) 10,000
Cr. Goodwill 80,000
This way goodwill will not appear in the books at all, let’s see it from the accounts
PARTNERSHIP ACCOUNTS
1 6 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
Goodwill account
Capital
accounts( in Mutie 40,000
Capital
accounts(in Mutie 50,000
old sharing ratio) Mutua 20,000
new sharing
ratio) Mutua 20,000
Mutinda 20,000 Mutinda 10,000
80,000 80,000
Capital accounts
Mutie Mutua Mutinda Mutie Mutua Mutinda
Go o d w i l l ( n e w
ratio)
50,000 20,000 10,000 Balance b/d 50,000 30,000 20,000
Balance c/d 40,000 30,000 30,000
Goodwi l l (ol d
ratio)
40,000 20,000 20,000
90,000 50,000 40,000 90,000 50,000 40,000
Balance b/d 40,000 30,000 30,000
MUTIE, MUTUA AND MUTINDA PARTNERSHIP
STATEMENT OF FINANCIAL POSITIONAT 31ST DECDECEMBER 2006
Assets 100,000 Capital
Mutie 40,000
Mutua 30,000
Mutinda 30,000
100,000 100,000
>>> Example 2b
If the business is sold on 1st January 2007 for Sh 100,000 cash show how the proceedings would
be shared among the partners.
Solution
Sh.
Mutie 40,000
Mutua 30,000
Mutinda 30,000
100,000
167
S T U D Y T E X T
5.6 REVALUATION OF PARTNERSHIP ASSETS
Like goodwill, revaluation of partnership assets takes place under the similar conditions
of:
i. A change in the profit and loss sharing ratio
ii. Admission of a new partner
iii. Exit of an existing partner
It is necessary to revalue partnership assets to ensure fairness. For instance when a new partner
is and the assets are not revalued, he/she may end up gaining unfairly from efforts of the other
existing partners. Similarly, when a partner exits the partnership and no revaluation is done, he
may forego benefits he helped plough into the partnership which is not fair.
Revaluation therefore becomes necessary in order to compensate the old partners for their
efforts.
Adjustments are then made to the old partners’ capital accounts in their old profit and loss sharing
ratio.
When revalued, asset values may increase or Decrease.
Accounting entries
a. when asset values increase,
i. dr. Asset account
ii. Cr Revaluation account (with the amount of increase)
b. when asset value Decreases,
i. Dr, Revaluation account
ii. Cr. Asset account (with the amount of Decrease)
c. After all the entries are made, revaluation account is balanced. The balance could
either be a gain or a loss which is then passed o to the partners’ capital accounts in
the existing/old profit and loss sharing ratio. A profit is credited to the partners’ capital
account while a loss is debited.
>>> Example 1
Victor and Mary are in partnership sharing profits and losses in the ratio 2:1. Their statement of
financial position as at 31st December 2005 was as follows:
Plant at cost 12,000 Capitals;
Fixtures 8,460 Victor 19,820
Stock 5,500 Mary 9,920
Debtors 1,530
Bank 2,250
29,740 29740
PARTNERSHIP ACCOUNTS
1 6 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
From January 1st, they decided to change their profit and loss into the ratio of their capitals.
Accompanying the change was a revaluation on the partnership assets as follows: Plant Sh18,000,
fixtures Sh. 8,000 and stock Sh. 5,000.
You are required to show the revaluation account and the statement of financial position as at
January 1st 2006.
Solution
Plant account Fixtures account
Balance b/d 12,000
B a l a n c e
b/d
8,460
Revaluation 460
Revaluation 6,000 Balance c/d 18,000 Balance c/d 8,000
18,000 18,000 8,640 8,460
Stock account
B a l a n c e
b/d
5,500 Revaluation 500
Balance c/d 5,000
5,500 5,500
Note that the being revalued is taken down as the closing balance. Revaluation gain or loss is
the difference between the book value and the revalued amount.
Let us now prepare the Revaluation account. We only take the gains or the losses to this account
in order to get the net revaluation gain or loss.
Revaluation account
Fixtures 460 Plant
6,000
Stock 500
(Rev. Gain = 5040)
Capital a/c Victor 3,360
Capital a/c Mary 1,680
6,000
6,000
The gain (or loss) on revaluation is never shown on the face of the revaluation account. It is
shared directly between/among the partners in their OLD profit sharing ratio. In this example, it
is shown in parentheses just to emphasize on its calculation.
169
S T U D Y T E X T
Capital account
Victor Mary Victor Mary
Balance b/d 19,820 9,920
Balance b/d 23,180 11,600 Revaluation gain 3,360 1,680
23,180 11,600 23,180 11,600
Victor and Mary Partnership
Statement of financial position as at 1st January 2006
Assets Capitals
Plant 18,000 Victor 23,180
Fixture 8,000 Mary 11,600
Stock 5,000
Debtors 1,530
Bank 2,250
34,780 34,780
We now know almost everything we need to know about partnership accounting. Let us work out
a typical full examination question covering all we have learnt so far.
5.7 REVALUATION OF ASSETS TAKEN OVER BY A
RETIRING PARTNER
On retirement of a partner, his/her investment in the partnership is given back to him/her
together with balances due to him from his current account and any loan payable to him by the
partnership.
The payment is normally effected in cash. Sometimes the retiring partner may have so much to
be paid that a full settlement may not be possible or it could plunge the partnership into financial
difficulties thereafter. In such a case, the partnership pays part of all the dues and the remainder
is held in the partnership as a loan to the partnership.
Some of this part payment may be in the form of the retiring partner taking over an asset or
assets from the partnership. Any such assets are deducted from the retiring partner’s amount
payable to him.
PARTNERSHIP ACCOUNTS
1 7 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
Accounting entries
The asset being taken over is first revalued and any revaluation gain or loss accounted for.
Then:
Dr. Capital account of the retiring partner (with the revalued amount)
Cr. Asset account
EXAMPLE 1 (KASNEB ADAPTED)
Kyamba, Onyango and Wakil were partners in a manufacturing and retail business sharing profits
and losses in the ratio of 2:2:1 respectively
Given below is the statement of financial position of the partnership as at 31st March 2001.
Statement of financial position as at 31st March 2001
Assets
Non-current assets
Fixed assets 465,000
Current assets
Stocks 294,000
Debtors 209,000
503,000
968,000
Capital and liabilities
Capital accounts
Kyamba 160,000
Onyango 140,000
Wakil 200,000
500,000
Current accounts
Kyamba 65,300
Onyango 49,000
Wakil 53,000
167,300
667,300
Current liabilities
Bank overdraft 48,700
Trade creditors 252,000
300,700
968,000
171
S T U D Y T E X T
Additional information:
1. On April 1st, Wakil retired from the partnership and was to start a business as a sole
trader while Kyamba and Onyango continued with the partnership.
On retirement of Wakil, the manufacturing business was transferred to him while
Kyamba and Otieno continued with the retail business.
2. The assets and liabilities transferred to Wakil were as follows:
Net book value Transfer Value
Sh Sh
Fixed Assets 260,000 306,000
Stocks 166,000 157,000
Debtors 172,000 165,000
Creditors 156,000 156,000
Wakil obtained a loan from a commercial bank and paid into the partnership the net due to him.
Fixed assets ac
Balance b/d 465,000 Wakil 306,000
Revaluation acc. 46,000 Balance c/d 205,000
511,000 511,000
Stock account
Balance b/d 294,000 Revaluation 9,000
Wakil 157,000
Balance c/d 128,000
294,000 294,000
Debtors account
Balance b/d 209,000 Revaluation 7,000
Wakil 165,000
Balance c/d 37,000
209,000 209,000
Creditors
Wakil 156,000 252,000
Balance c/d 96,000
252,000 252,000
Revaluation account
Stock 9,000 Fixed assets 46,000
Debtors 7,000
Capital,
Kyamba 12,000
Onyango 12,000
Wakil 6,000
46,000 46,000
PARTNERSHIP ACCOUNTS
1 7 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
3. O3. On retirement of Wakil from the partnership, goodwill was valued at Sh. 200,000
but was not to be maintained in the books of partnership of Kyamba and Onyango
4. After retirement of Wakil on 1st April 2001, Kyamba and Onyango agreed on the following
terms and details of the new partnership:
• Kyamba and Onyango to introduce additional capital of Sh 48,000 and Sh 68,000
respectively
• Each partner was entitled to interest on capital at10% per annum w.e.f 1st April
2001 and the balance of the profits was to be shared equally after allowing for
annual salaries of Sh 72,000 to Kyamba and Sh 60,000 to Onyango.
5. The profit of the new partnership before interest on capitals and partners’ salaries was
Sh 240,000 at the year ended 31st March 2002.
6. The profits made by the new partnership increased stocks by Sh 100,000. Debtors by
Sh 90,000 and bank balance by Sh 50,000.
7. Drawings by the partners in the year were Kyamba Sh 85,000 and Onyango Sh
70,000.
Required:
a. Profit and loss appropriation account for the year ended 31st March 2002
b. Capital accounts for the year ended 31st March 2002
c. Current accounts for the year ended 31st March 2002
d. Statement of financial position of the new partnership as at 31st March 2002
Solution
Never forget your workings, however complicated the question might seem.
Before we prepare the current final accounts, we need to close the books unto the point of
Wakil’s retirement. So, we close the current account of Wakil into his capital account
Wakil, Current account
Capital
account
53,000
Balance
b/d
53,000
Capital accounts
Kyamba Onyango Wakil Kyamba Onyango Wakil
Goodwill 100,000 100,000 Balance b/d 160,000 140,000 200,000
Fixed
assets
306,000 Revaluation 12,000 12,000 6,000
Stock 157,000 Goodwill 80,000 80,000 40,000
Debtors 165,000 Wakil’s Current acc. 53,000
Balance
c/d
152,000 132,000 Liabilities 156,000
Bank (balancing figure) 173,000
252,000 232,000 628,000 252,000 232,000 628,000
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S T U D Y T E X T
Notice how Wakil’s current account has been closed into the capital account.
The balancing figure of represents the amount Wakil will have to pay the partnership because
he’s got more than he should have gotten. It could be looked at this way:
Capital acc 402,000
Current acc 53,000
455,000
Wakil should have got Sh 455,000, but from his capital account, he is to get Sh 628,000. The
balance therefore represents the amount he will have to pay the partnership of Sh 173,000.
We can now prepare the statement of financial position immediately after the retirement of Wakil
using the capital accounts above.
KYAMBA AND ONYANGO PARTNERSHIP
STATEMENT OF FINANCIAL POSITION AS AT 1ST APRIL 2001
Fixed assets
205,000
Current assets
Stock 128,000
Debtors 37,000
Bank(173000 - 48700) 124,300
289,300
Less current liabilities
Creditors 96,000
193,300
393,300
Capital accounts(from Capital acc. Above)
Kyamba 152,000
Onyango 132,000
284,000
Current accounts
Kyamba 65,300
Onyango 49,000
114,300
393,300
We could now go ahead with the profit and loss appropriation account.
PARTNERSHIP ACCOUNTS
1 7 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
KYAMBA AND ONYANGO PARTNERSHIP
PROFIT AND LOSS APPROPRIATION ACCOUNT
FOR THE YEAR ENDED 31ST MARCH 2002.
Net profit 240,000
less salaries
Kyamba
72,000
Onyango
60,000
(132,000)
108,000
less interest on capital
Kyamba
20,000
Onyango
20,000
(40,000)
Balance to be shared 68,000
Kyamba
34,000
Onyango
34,000
(68,000)
NIL
At the end of the year, the capital accounts will be similar to those drawn above but with the
exclusion of Wakil’s column because he has since left and then the additional contributions of
capital by the remaining partners.
Capital accounts
Kyamba Onyango Kyamba Onyango
Goodwill 100,000 100,000 Balance b/d 160,000 140,000
Revaluation 12,000 12,000
Goodwill 80,000 80,000
Balance
c/d
200,000 200,000 Cash(more capital) 48,000 68,000
300,000 300,000 300,000 300,000
Current accounts
Kyamba Onyango Kyamba Onyango
Drawings 85,000 70,000 Balance b/d 65,300 49,000
Salary 72,000 60,000
Interest on capital 20,000 20,000
Balance
c/d
106,300 93,000 Profit share 34,000 34,000
191,300 163,000 191,300 163,000
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S T U D Y T E X T
And finally the statement of financial position of the existing partnership
KYAMBA AND ONYANGO PARTNERSHIP
STATEMENT OF FINANCIAL POSITION AS AT 31ST MARCH 2002
Fixed assets 205,000
Current assets
Stock 228,000
Debtors 127,000
Bank 135,300
490,300
Less current liabilities
Creditors 96,000
393,300
599,300
Capital accounts
Kyamba 200,000
Onyango 200,000
400,000
Current accounts
Kyamba 106,300
Onyango 93,000
199,300
599,300
PARTNERSHIP ACCOUNTS
1 7 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
Chapter summary
A partnership is usually established through a partnership agreement in which the terms of the
partnership are set out. The agreement covers the following items:
• Amount of capital invested by each partner in the business
• The profit sharing ratio
• The interest on capital
• Salaries to partners
• Limits to drawings
• Interest on drawings
In the absence of the partners’ agreement, it is presumed that,
• Profits will be shared equally
• There are no partners’ salaries
• No interest on capital is paid
• Partners are entitled to interest of 4% per annum on any loans advanced to the firm
CASE STUDY
The most prominent forms of partnerships in the country are service based. These include audit
firms and law firms.
Examples of the big audit firms include Price water house Coopers (PWC), Deloitte, Ernst and
Young and KPMG in Kenya.
With the growing partnership between indigenous mid-level firms and leading global networks,
a shift in market structure is unfolding as the smaller companies continue to win contracts from
the top four. Though the top four multinationals control about 85 per cent of the market in terms
of deal value, the mid tier firms that have sought international affiliation have been growing their
client base at a faster rate than the multinationals.
Estimates from the Institute of Certified Public Accountants of Kenya (ICPAK) show that the
mid-tier firms now control between 60-70 per cent of the industry’s client base up from about 40
per cent in 2000. In recent years, seven of the top 15 firms, excluding the big four, have formed
partnerships with local accounting firms as they seek to spread their foothold across the globe
with the emerging markets like Kenya being their focus. (Source, The Business Daily, 2008).
177
S T U D Y T E X T
CHAPTER QUIZ
1. What is a partnership?
2. What is a partner’s salary, an expense or an appropriation of profit?
3. How is profit shared between partners?
4. How is profit shared in the absence of the partnership agreement?
PARTNERSHIP ACCOUNTS
1 7 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
ANSWER TO CHAPTER QUIZ
1. An agreement between two or more individuals to carry on the risk and rewards of a
business together.
2. An appropriation of profit.
3. According to the terms of the partnership agreement.
4. It is presumed that:-
- Profits will be shared equally
- There are no partners’ salaries.
- No interest on capital is paid.
- Partners are entitled to interest of 4% per annum on any loans advanced to the firm.
PAST PAPER ANALYSIS
12/07, 6/07, 12/06, 6/06, 12/05, 6/05, 6/04, 6/03
exam type questions
Question 1 (June 2006 Question 4)
(a) Briefly explain why goodwill should be paid under the following circumstances:
i. By a partner on admission to a partnership. (2 marks)
ii. To a partner on retirement from a partnership. (2 marks)
179
S T U D Y T E X T
(b) Akili, Busara and Chema are in partnership sharing profits sharing profits and losses
equally after allowing for interest on capital at 5% per annum to the partners and a
salary to Busara of Sh 20,000 per month.
The trial balance of the partnership as at 30 April 2006 was as follows:
Sh.’000’ Sh.’000’
Capital accounts: Akili 2,500
Busara 2,000
Chema 1,000
Current accounts: Akili 200
Busara 300
Chema 200
Drawings: Akili 300
Busara 400
Chema 200
Sales 20,000
Inventory as at 1 May 2005 3,000
Purchases 10,300
Operating expenses 6,400
Loan: Busara (Interest at 10% per annum) 1,000
Chema (Interest at 10% per annum) 2,000
Land 1,000
Buildings 5,000
Plant and machinery: Cost 7,000
Accumulated depreciation 4,000
(30 April 2006)
Accounts receivable/accounts payable 4,000 3,300
Cash at Bank 1,100
37,600 37,600
Additional Information
1. Closing inventory as at 30 April was valued at Sh 2,400,000.
2. Interest on loans had not been paid.
3. Sales include credit sales of Sh 600,000 in respect of two items sold on the basis of
confirmation by the customers. The items had cost Sh 100,000 each. As at 30 April
2006, the customers had not confirmed whether they would buy the goods.
PARTNERSHIP ACCOUNTS
1 8 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
4. On 1 November 2005, the terms of the partnership agreement were changed. The new
terms provided for:
• Profit sharing ratio of 5:3:2 for Akili, Busara and Chema respectively.
• Interest on capital at 5% per annum.
• Salaries of Sh 10,000 per month to Busara and Chema.
For the purpose of the change, goodwill was valued at Sh 1,200,000 and was to be written
off immediately while the land buildings were valued at Sh 2,000,000 and Sh 6,400,000
respectively.
Required:
a) Trading, Profit and loss and appropriation accounts for the year ended 30 April 2006
(6 marks)
b) Partners’ capital and current accounts (6 marks)
c) Statement of financial position as at 30 April 2006 (4 marks)
(Total: 20 marks)
Question 2 (December 2006 Question 3)
Grace and Beatrice were operating a retail business sharing profits and losses in the ratio of 2:1
respectively up to 31 March 2006 when they admitted Catherine to the partnership. The partners
allowed payment of interest on partners’ fixed capital accounts but did not allow for interest on
partners’ current accounts.
The following balances on the opposite page were extracted from the partnership’s book of
account as at 30 September 2006:
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S T U D Y T E X T
Sh.’000’ Sh.’000’
Leasehold premises (purchased 1 October 2005) 6,000
Purchases 16,400
Sales (Sh 14,000,000 to 31 March 2006)” 35,000
Motor vehicles at cost 3,400
Salaries 5,200
Provision for depreciation as at 1 October 2005:
Motor vehicles 1,200
Shop fittings 400 1,600
Stocks (1 October 2005) 4,800
Shop fitting at cost at cost 1,200
Accounts receivable 900
Balance at bank 9,280
Fixed capital accounts: Grace 3,000
Beatrice 2,000
Catherine 1,500 6,500
Current accounts: Grace 1,600
Beatrice 1,200
Catherine 3,500 6,300
Professional charges 420
Rent, rates and electricity” 1,240
General expenses (Sh 1,410,000 for six months to 31 March 2006)” 2,640
Accounts payable 4,280
Shop wages 2,200
Additional information:
1 On 31 March 2006 when Catherine was admitted as a partner, the profit sharing ratio
changed to Grace 2/5, Beatrice 2/5 and Catherine 1/5. For the purpose of admission,
goodwill was valued at Sh 12,000,000 and was written off the books immediately. On
1 April 2006, Catherine paid Sh 5,000,000 which comprised her fixed capital of Sh
1,500,000 and her current account contribution of Sh 3,500,000.”
2 The partners also agreed that any apportionment of gross profit was to be made on the
basis of sales. The apportionment of expenses, unless otherwise indicated, was to be
on time basis.
PARTNERSHIP ACCOUNTS
1 8 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
3 On 30September 2006, stock was valued at Sh 5,100,000.
4 Provision was to be made for depreciation on motor vehicles and shop fittings at the
rate of 20% and 5% per annum respectively, based on cost.
5 Salaries included the following partner’s drawings during the year:
Grace - Sh 600,000
Beatrice - Sh 480,000
Catherine - Sh 250,000”
6 At 30 September 2006, rates paid in advance amounted to Sh 260,000 while electricity
accrued amounted to Sh 60,000.
7 A difference in the books of Sh 120,000 that had been written off to general expenses
as at 30 September 2006 was later found to have been due to the following errors:
• Sales returns of Sh 180,000 had been debited to sales but were omitted from the
customers account.
• The purchase journal had been under cast by Sh 200,000.
8 Doubtful debts (for which full provision was required) as at 31 March 2006 amounted to
Sh120,000 and Sh 160,000 as at 30 September 2006.
9 Professional charges included Sh 200,000 paid in respect to the acquisition of leasehold
premises. These fees are to be capitalized as part of the lease, the total cost of which
was to be depreciated in 25 equal annual installments. Other premises owned by
Beatrice were leased to the partnership at Sh 600,000 per annum but no rent had been
paid or credited to her for the year to 30 September 2006.
Required:
(a) Statement of comprehensive income for the year ended 30 September 2006.
(10 Marks)
(b) Statement of financial position as at 30 September 2006.
(6 Marks)
(c ) Partners’ current accounts. (4 Marks)
(Total: 20 marks)
Question 3 (June 2007 Question 2)
Ali and Bakari were in partnership sharing profits and losses in the ratio of 3:2 respectively. The
terms of the partnership entitled to the partners to interest on their capital balances at 5% per
annum. Bakari was also entitle to an annual salary of Sh,4 million.
The statement of financial position extracted from the books of account of the partnership as at
1 January 2006 was as follows.
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S T U D Y T E X T
Sh. ‘000’ Sh. ‘000’
Non-current assets:
Business premises 20.800
Equipment at cost 8.000
Provision for depreciation-equipment 4.800 3.200
24.000
Current assets:
Inventory 5.600
Accounts receivable 2.200
Cash at bank 400 8.200
Total assets 32.200
Capital and liabilities:
Capital accounts: Ali 16.000
Bakari 10.000 26.000
Current accounts: Ali 3.200
Bakari (300) 2.900
Current liabilities:
Accounts payable 3.000
Accruals 300
3.300
Total capital and liabilities 32.200
On 1 April 2006 Chando was admitted as a partner. He has been a salaried employee of
the partnership and earned Sh 8 million per year. The terms of Chando’s admission were as
follows:
• Chando was to pay Sh 12 million to the partnership as his capital contribution. Goodwill
was valued at Sh 14 million and was to be written off the partners capital accounts
immediately.
• The profit sharing ratio was to be 4/7 to Ali, 2/7 to Bakari and 1\7 to Chando. The partners’
interest on capital was to be raised from 5% per annum.
• Bakari’s salary per annum was to be raised to Sh 6 million and Chando was to receive a
salary of Sh 6 million per annum.
• The necessary transactions to effect the admission are to be made in the capital
accounts.
PARTNERSHIP ACCOUNTS
1 8 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
Additional information:
1. The following balances were extracted from the partnership’s draft financial statements
for the year ended 31 December 2006:
Sh. ‘000’ Sh. ‘000’
Net profit for the year 55.155
Inventory 12.555
Accounts receivable 3.500
Cash at bank 8.800
Accounts payable 3.080
Accruals 400
Drawings by partners
Ali 23.705
Bakari 19.525
Chando 8.250 15.480
2. The closing inventory (Sh 12,555,000) included some stock items which had cost
Sh 750,000 but could only realize Sh 280.000.
3. A provision for doubtful debts is to be made at 3% of the accounts receivable
4. During the year depreciation on equipment was wrongly computed at the rate of 10%
based on cost instead of correct rate of 15% using the reducing balance method. I
addition, depreciation amounting to Sh 200.000 had not been provided on business
premises.
5. The partners had taken goods for personal use as follows:
Sh. ‘000’
Ali 1.000
Bakari 900
Chando 600
6. Accrued electricity as at 31 December 2006 amounted to Sh 120.000. This amount had
not been provided in the accounts.
Required:
a) A schedule showing the corrected net profit and appropriation account for the year
ended 31 December 2006.
Hint: Start with the net profit of Sh 55,155,000 as per draft accounts to compute the
corrected net profit) (8 marks)
b) Partners’ current accounts. (4 marks)
c) Partners capital accounts (2 marks)
d) Statement of financial position as at 31 December 2006
(6 marks)
185
S T U D Y T E X T
CHAPTER SIX
NON PROFIT MAKING
ORGANIZATIONS
S TSUTDUYD YT ETXETX T
1 8 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
187
S T U D Y T E X T
CHAPTER SIX
NON PROFIT MAKING ORGANIZATIONS
OBJECTIVES
After studying this chapter, you should be able to:
• Prepare financial statements for nonprofit making organizations
• Understand and explain the terminologies used in the financial statements of nonprofit
making organizations different from sole proprietorship
• Understand the format of the financial statement for a nonprofit making organization
• Understand the operation of nonprofit making organizations such as clubs and explain
the sources of revenue to these form of business organizations
INTRODUCTION
Fast forward - Since the non profit making organizations are not owned by a group of people,
they do not maintain a capital account.
These are some form of business organization that is set up to promote or to cater for the welfare
of the members involved and not to make profit. They include clubs, e.g. sports clubs, welfare
associations and charitable institutions e.t.c.
Since these organizations are not formed for purposes of trade they maintain different types of
accounts from the trading organizations.
Instead of preparing cash book the non profit making organizations prepare a receipts and
payments account whose entries however are similar to those made in the cash book.
The excess of income over expenditure is referred to as a surplus; the equivalent of a profit in
the P & L account. If expenditure exceeds income then a deficit results; the equivalent of a loss
in the P & L account.
Since the non profit making organizations are not owned by a group of people, they do not
maintain a capital account. Instead the member’s contributions, donations, investments e.t.c are
maintained as accumulated fund instead of capital.
1 8 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
The non profit making activities may however carry some trading activities in small scale to
finance some of the clubs activities e.g. a golf club may also be operating a bar. In such cases
then, in addition to the statement of comprehensive income the organization may also maintain a
trading account for such trading activities e.g. a bar’s trading account which will be similar to the
trading account of profit-making organizations.
DEFINITION OF KEY TERMS
Non profit making organizations are some form of business organization that is set up to
promote or to cater for the welfare of the members involved and not to make profit.
EXAM CONTEXT
As you can see in the past paper analysis at the end of this chapter, this is a frequently examined
chapter. Clear understanding of its content will be an obvious edge.
INDUSTRY CONTEXT
Examples of non-profit making organizations are the Kenya Red Cross, Strathmore University,
Muthaiga Country Club and many other entities that do not exists to make a profit and distribute
to share holders. Nonprofit corporations exist solely to provide programs and services that are
of public benefit. While they are able to earn a profit, more accurately called a surplus; such
earnings must be retained by the organization for its future provision of programs and services.
Earnings may not benefit individuals or stake-holders.
189
S T U D Y T E X T
THE FORMAT OF THE STATEMENT OF COMPREHENSIVE INCOME
<NAME OF ORGANISATION>
STATEMENT OF COMPREHENSIVE INCOME
FOR THE YEAR ENDED <DATE>
Incomes Sh Sh
Profit from trading activities Xx
Subscriptions Xx
Income from investments Xx
Donations Xx
Income from other activities(e.g. dinner dance, raffles
e.t.c)
Xx
xxx
Expenditure
Depreciation Xx
Salaries and wages Xx
Expenses on other activities e.g. prizes Xx
Loss from trading activities Xx
All other expenses xx
(xxx)
SURPLUS/ (DEFICIT) xxxx
NON PROFIT MAKING ORGANIZATIONS
1 9 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
FORMAT OF THE STATEMENT OF FINANCIAL POSITION
XYZ COMPANY LTD
STATEMENT OF FINANCIAL POSITION AS AT XXXXX
Sh Sh Sh
Non-current assets Cost
Accumulated
Depreciation NBV
land and buildings xxx
plant and equipment xx (xx) xx
fixtures, furniture and fittings xx (xx) xx
motor vehicles xx (xx) xx
total non-current assets Xx Xx xxx
Current Assets
stock xx
Debtors xxx
less provision for doubtful debts (xxx)
xxx
Prepayments Xxx
short term investments Xxx
cash in hand(receipts and payments) xxx
total current assets xxx
less Current Liabilities
bank overdraft xxx
Creditors xxx
Accruals xxx
(xxx)
net current assets xxx
total assets yyyyy
Accumulated fund b/f
Add/(less):surplus(deficit)
Less: drawings
Other funds
Life membership fund
Building education fund
Xx
Xx
Xx
Xx_____
xx
(xx)____
xxx
xx
yyyy
191
S T U D Y T E X T
NOTES TO THE FORMAT ON THE OPPOSITE PAGE
1 SUBSCRIPTION
Fast forward - Any subscriptions prepaid are shown as creditors since the club is the one left with
a liability of providing the service already paid for.
These are the amounts received by the club from the members to renew their membership. It is
often paid on an annual basis. Usually this is income for the club and is therefore reported in the
statement of comprehensive income. Depending on the policy of a club, any subscriptions due
but not received are shown as accrued income (debtors for subscriptions) in the balance sheet.
Any subscriptions prepaid are shown as creditors since the club is the one left with a liability
of providing the service already paid for. Some clubs however will not report subscriptions as
income until it is received in form of cash.
2. INCOME FROM INVESTMENT
Fast forward – If investment income is for a specific purpose and relates to a specific fund it will
not be reported in the statement of comprehensive income, but credited directly to the fund.
Some clubs invest excess cash in the bank (fixed deposit account), shares of limited companies,
treasury bills and any other investment that may be available.
If the club is investing with no specific intention (i.e. a general investment) then the income from
this investment should be reported in the statement of comprehensive income. However if the
investment is for a specific purposed and relates to a specific fund (e.g. building fund) it will not
be reported in the statement of comprehensive income but credited directly to the fund.
3. OTHER FUNDS
These are fund set up for a specific purpose. They will be shown together with the accumulated
fund. Any incomes relating to these funds will be credited directly to the funds net of any expenses
incurred in generating the funds. Such funds include building funds, educational funds e.t.c
NON PROFIT MAKING ORGANIZATIONS
1 9 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
LIFE MEMBERSHIP FUND
Some members may pay some amount to become full life members of the club and if this happens,
there may be a need to spread out these amounts over the expected life of the members in the
club. Depending on the policy of the club, the following accounting treatment may be allowed:
i) The full amount is reported in the statement of comprehensive income in the year it is
receive and therefore no balance is retained in the life membership account.
ii) The amount is shown separately in the life membership fund with no transfer in the
statement of comprehensive income and hence no balance in the life membership
account.
iii) Some amount is transferred to the income and expenditure from the life membership
fund over the expected life of the members in the club.
CHAPTER SUMMARY
Non profit making organizations are organizations which do not exist primarily to make profit
but to fulfil some other purpose such as the general welfare of society, or to promote sports,
religion or some other lawful activity.
They may carry out some trading activity, but this would be strictly to assist them in achieving
their objectives.
They maintain two main accounts: the receipts and payments account and the income and
expenditure account.
CASE STUDY
The K-Rep Company is a holding company, whose primary function is to own the K-Rep NGO
and hold majority shares in the K-Rep Bank. It is a non-profit company registered as a company
limited by guarantee. Its income mostly constitutes dividends and income on fee notes from the
K-Rep Bank. This income is channeled to the NGO for product development and experimentation
in keeping with the mission of K-Rep.
193
S T U D Y T E X T
CHAPTER QUIZ
1. Why do non- profit making organizations exist?
2. Why don’t non- profit making organizations maintain a capital account?
NON PROFIT MAKING ORGANIZATIONS
1 9 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
ANSWERS TO CHAPTER QUIZ
1. To promote or to carter for the welfare of the members involved and not to make profit.
2. They are not owned by individuals or groups for profit generation. They instead have
accumulated funds from members.
PAST PAPER ANALYSIS
6/07, 6/06, 6/05, 12/03, 12/02
195
S T U D Y T E X T
EXAM TYPE QUESTIONS
Question 1 (June 2006 Question2)
Umoja Women’s Welfare Society sells water tanks at subsidized prices to its members and the
general public. The members’ contributions are used to meet the cost of manufacturing the water
tanks.
The trial balance extracted from the books of account of the society as at 30 April 2006 was as
follows:
Sh.’000’ Sh.’000’
DR CR
Accumulated fund as at 1 may 2005 25,000
Annual subscriptions received 10,000
Stock of raw materials as at 30 April 2006 20,000
Motor vehicle: Cost 10,000
Accumulated depreciation 4,000
Machinery: Cost 22,000
Accumulated depreciation 5,000
Donations from members 2,500
Raw materials used in production of water tanks 35,000
Sale of water tanks 45,000
Selling expenses 2,000
Factory wages 600
Factory overheads 1,000
Creditors for raw materials 2,800
Cash at bank and in hand 500
Society’s office expenses 4,100
Membership fees fund 7,500
Sale of Raffle tickets 2,800
Raffle prizes paid 1,200
Cost of raffle tickets 300
Suspense account 7,900
104,600 104,600
NON PROFIT MAKING ORGANIZATIONS
1 9 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
Additional information:
1 An investigation carried out on the suspense account revealed that it comprised:
Sh.’000’
Subscriptions in arrears as at 30 April 2005 3,500
Bonus paid to factory staff during the year 1,500
Rent for factory building 1,000
Rent for the society’s offices 4,000
Subscriptions in advance as at 30 April 2005 2,100
7,900
2 Annual subscriptions in arrears as at 30 April 2006 amounted to Sh 2,000,000 while
subscriptions received in advance as at 30 April 2006 amounted to Sh 1,500,000.
3 The membership fee is levied every ten years. The membership fees attributable to the
year ended 30 April 2006 amounted to Sh 800,000
4 Accrued society’s office expenses as at 30 April 2006 amounted to Sh 400,000.
5 The motor vehicle usage should be apportioned to the factory and society’s offices at
80% and 20% respectively. Depreciation should be provided on cost at 5% per annum
on machinery and 10% per annum on motor vehicles.
Required:
(a) Water tanks trading and statement of comprehensive income for the year ended 30
April 2006 (6 marks)
(b) Income and expenditure account for the year ended 30 April 2006 (8 marks)
(c ) Statement of financial position as at 30 April 2006. (6 marks)
(Total: 20 marks)
Question 2 (June 2007 Question 3)
Bahari Sailors Club is an association for sailors. It provides the following services to the members
and the public:
• A club house with a bar for drinks and other social functions
• Yacht racing competitions
• Hire of boats
• A sailing training school for all age groups.
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The following financial information relates to the club as at 1 June 2006:
Sh ‘000’
Fixed assets (Net book value):
Repairs workshop 5000
Freehold premises 40000
Boatyard and launch facilities 8000
Fixtures and fittings 3000
Club-owned boats and yachts 35000
Current assets and liabilities:
Members’ subscriptions:
Outstanding 400
Prepaid 560
Bank balance 11.070
Bar stocks 3.100
Creditors for bar purchases 500
The club’s receipts and payments for the year ended 31 May 2007 were as follows:
Sh ‘000’ Payments Sh ‘000’
Receipts
Receipt from training school 2.050 Purchase of two new club yachts 5.000
Boat hire charges: Repairs to yachts and boats 1.920
For members 900 Purchase of bar stocks
5.010
For non-members 1.960 Prizes paid on yacht racing
Members’ subscriptions 20.090 competitions 1.870
Bar and social functions’ takings Wages to barmen 1.260
(Cash collections) 8.000 salary to training school staff and
Fees and charges from yacht racing bar attendants 1.500
Competitions 3.080 General expenses 2.200
Salvage proceeds from sunk boat 200
Additional information:
1) During the year, a club boat whose net book value was Sh 2,000,000 was involved in a
collision while sea. The boat sunk and the salvage was disposed of for Sh 200,000.
NON PROFIT MAKING ORGANIZATIONS
1 9 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
2) Depreciation is provided on reducing balance basis at the following annual rates:
Asset: Rate
Freehold premises 5%
Boatyard and launch facilities 5%
Club boats and yachts 5%
Fixtures and fittings 10%
Repairs workshop 10%
3) Full years’ depreciation is provided in the year of acquisition but none in the year of
disposal. Bar stocks as at 31 May 2007 were valued at Sh 2850000.
4) Outstanding creditors as at 31 May 2007 were as follows:
Sh. ‘000’
Bar purchases 610
Bar wages 35
Repairs to boats 320
5) Non-members are allowed to hire boats at an extra charge of 20%. During the year,
25% of the 20% extra charge received from hire of boats to non-members was donated
to a local charity. This donation had not yet been paid to the local charity.
6) A retired club member died recently and bequeathed (left by his will) two boats to the
club. The boats were valued at Sh 3000000 and were formally acquired on 1 May
2007.
7) As at 31 May 2007 outstanding and prepaid member’s subscripts amounted to Sh
350000 and Sh 790000 respectively.
Required:
a) Income and expenditure account for the year ended 31 May 2007.
(12 Marks)
b) Statement of financial position as at 31 May 2007.
(8 marks)
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CHAPTER SEVEN
MANUFACTURING ACCOUNT
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CHAPTER SEVEN
MANUFACTURING ACCOUNTS
OBJECTIVES
After studying this chapter, you should be able to:
Identify the various types of costs and their classification for purposes of preparing the
manufacturing account
Distinguish between production and non production costs, prime cost and overhead costs
Prepare manufacturing, trading and statement of comprehensive income for a manufacturing
firm
Understand the concept of unrealized profit and pass journal entries to account for the
provision
INTRODUCTION
Earlier we dealt with sole proprietors; most sole proprietors are merchandising entities since
they buy goods in a form when they are ready for sale. They resale the goods and hence a
majority of them are distributive agents. Another form of business enterprise is manufacturing
business. These are businesses that manufacture the goods themselves and later distribute
them. Such enterprises in Kenya include Unilever (K) Ltd, Bidco Oil Refineries e.t.c. for such
business enterprises an account known as a manufacturing account is prepared in addition to
the statement of comprehensive income
A manufacturing enterprise will utilize a manufacturing account to determine production cost. In
the trading, statement of financial performance will be used instead of a purchases account.
DEFINITION OF KEY TERMS
Prime cost: These are costs that can be directly related attributed to a unit of product. The sum
of direct costs is referred to as prime costs.
EXAM CONTEXT
This is a very important chapter. Though not tested very frequently, examiners have repeatedly
stressed that students must know the whole syllabus. If you miss out a syllabus area, you will
severely limit your chances of passing the exam.
2 0 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
INDUSTRY CONTEXT
This is a very important chapter bearing in mind the number of manufacturing industries in the
country. All the concepts that will be discussed in this chapter are very important.
7.1 PRODUCTION COSTS
In manufacturing enterprises the total costs of production is divided into two:
i) Prime cost/ direct cost
ii) Indirect cost
I) DIRECT MANUFACTURING COST
Fast forward – Direct costs are costs that are easily traced into a unit of a product.
Direct costs are also known as prime costs. These are costs that can be directly related attributed
to a unit of product. The sum of direct costs is referred to as prime costs. The costs are easily
traced into a unit of a product.
They include:
a) Direct materials
b) Direct labor
c) Direct expenses
Other direct costs include: hire purchase of special machinery for production, carriage inwards
on raw materials.
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S T U D Y T E X T
II) INDIRECT MANUFACTURING COSTS.
These are incurred during the production process but cannot be easily traced to unit of a product
made. This cost must be incurred for production to be complete. They include:
a) Factory lighting and heating
b) Rent of factory
c) Deprecation on plant and equipment
d) Factory power
e) Wages for factory casuals
f) Maintenance of factory forklifts
III) OTHER EXPENSES
Other expenses incurred by a manufacturing enterprise include:
i) Administration Expense
Ø Salaries and wages for staff (administration staff)
Ø Legal expenses
Ø Accountancy expenses
Ø Depreciation of office equipment
ii) Selling and Administration Expense
Ø Salaries and wages for the sales and marketing team
Ø Depreciation for distribution vehicles
Ø Advertising expense
Ø Carriage outwards,
Ø Commissions paid out on sales
iii) Finance charges
Ø Discount allowed
Ø Bank charges
Ø Bank interest on loan
Ø Debenture interest
MANUFACTURING ACCOUNT
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S T U D Y T E X T
7.2 THE MANUFACTURING STATEMENT OF
COMPREHENSIVE INCOME
Fast forward – The statement of comprehensive income will be similar to that of a sole
proprietorship except for a few areas that are covered below.
The manufacturing statement of comprehensive income will be divided into three:
• Manufacturing section
• Trading account
• Profit and loss account
These sections are clearly shown in the format below:
Format of a manufacturing account:
XYZ LTD
MANUFACTURING ACCOUNT
FOR THE PERIOD ENDED XX XX XX
Production cost for the period: Sh Sh
Direct material xxx
Direct labor xxx
Direct expenses xxx
Prime costs xxx
Indirect manufacturing costs
Indirect labor xxx
Indirect materials xxx
Factory rent xxx
Depreciation for factory machinery and plant xxx
Salary for factory manager xxx
Heating and lighting expenses xxx
xxx
Total cost of production during the period xxx
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S T U D Y T E X T
Sometimes we may have the balances of raw materials from previous year’s production. These
could also be Work In Progress (WIP) brought in at the beginning of the period as well as some
work in progress at the end of the period. In this case the format would appear as follows:
XYZ LTD
MANUFUCTURING ACCOUNT
FOR THE PERIOD ENDED XXXXXX
Opening stock raw materials xxx
Add: purchased raw materials xxx
Carriage inwards (raw materials) xxx
Less: return outwards (raw materials) (xxx)
Cost of materials available for production xxx
Less closing stock (R.M) (xxx)
Cost of raw materials used xxx
Add direct labor xxx
Direct expenses xxx
Prime costs xxx
Indirect Expenses
Indirect labor xxx
Indirect expenses xxx
Heating expenses xxx
Lighting expenses xxx
Depreciation of factory equipment xxx
Depreciation of factory van xxx
Factory salaries/wages xxx
Factory rent xxx
Total indirect expense xxx
Add opening work in progress xxx
Less closing work in progress (xxx)
Total Cost of production xxx
Manufacturing gross profit added xxx
Finished goods at transferred price xxx
The statement of comprehensive income will be similar to that of a sole proprietorship
except for the following:
i) The purchases will be replaced by finished goods at transfer price. This is because
finished from manufacturing are now the ones being put up for sales.
ii) The opening sock to be used in the statement of comprehensive income is the opening
stock of finished goods.
MANUFACTURING ACCOUNT
2 0 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
iii) After obtaining gross profit we add the element of factory profit if we had marked up
the goods before transferring them from the factory. If there was no transfer then this
need not be done. This arises because once we marked them up; the costs of goods
available for sale as well as cost of sales were increased by the element of profit and
consequently reducing our gross profit.
>>> Illustration I:
Given the following:
Sales = 200000
Cost of production
Opening stock of finished goods = 20000
Closing stock of finished goods = 25000
i) Determine the gross profit, assuming the goods were transferred at cost:
Sales 200000
Cost of sales
Opening stock 20000
Add cost of production 100000
Goods available for sale 120000
Less closing stock (25000)
Cost of sales (95000)
Gross profit 105000
ii) Calculate the gross profit, assuming the cost of production was marked up by 25%
before transfer from manufacturing.
Cost of production = 100000
Transfer mark up = 100000x 20/100 = 20000
Transfer price = 100000 + 20000 = 120000
Sh
Sales 200000
Cost of sales
Opening stock 20000
Add: transfer price of finished goods 120000
Cost of goods available for sale 140000
Less; closing stock (25000)
Cost of sales (115000)
Gross profit 85000
Add: manufacturing gross profit 20000
Total gross profit 115000
You will realize that if we mark up the cost of goods manufactured, we end up understating the
gross profit by the amount of mark up and hence the need to mark back the manufacturing gross
profit to normal sales gross profit.
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7.3 PROVISION FOR UNREALIZED PROFIT
Fast forward – a high value of closing stock will lead to a lesser value of cost of goods and
consequently higher profits (overstated profits).
For firms that take up the policy of marking up goods during manufacturing, there will be an
element of unrealized profit in the value of the closing stock for finished goods. This needs to
be adjusted for so that we can reflect statements that are reliable and accurate. If the element
of unrealized profit is not deducted from closing stock of finished goods we end up overstating
closing stock which in effect overstates our gross profit. This is because a high value of closing
stock will lead to a lesser value of cost of goods and consequently higher profits (overstated
profits)
The adjustment is done as follows:
Dr. P&L account xxx
Cr. Finished goods account xxx
(With amount of unrealized profit)
>>> Illustration
ABC Co. LTD manufactures food products for the local market. The factory applies \ mark up of
25% on goods transferred to the selling department. For the year just ended, the closing stock of
finished goods was found to be Sh 1000000. Calculate and show the adjustments necessary:
200000
125
25
amount of unrealised profit = =
Dr. P&L account (unrealized profit) 200000
Cr. Finished goods account 200000
If during the previous year a provision for unrealized profit had been made at Sh 50000, then this
year we would only require making an extra Sh 150000. The account would appear as follows:
MANUFACTURING ACCOUNT
Unrealized profits a/c
Sh Sh
P&L account 150000 Provision for unrealized profits
a/c
150000
2 0 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
The statement of financial position of manufacturing enterprises is similar to that of other
organizations. The only difference is that may arise is that there will be there will be three classes
of stock under current assets. These are:
i) Closing stock of finished goods
ii) Closing stock of raw materials
iii) Closing stock of work in progress
CHAPTER SUMMARY
In manufacturing enterprises the total costs of production is divided into two:
i) Prime cost/ direct cost
ii) Indirect cost
If the element of unrealized profit is not deducted from closing stock of finished goods we end
up overstating closing stock which in effect overstates our gross profit. This is because a high
value of closing stock will lead to a lesser value of cost of goods and consequently higher profits
(overstated profits).
a/c
Provision for unrealized profits
Sh Sh
Balance c/d 200000
______
200000
Profit for the year
Balance c/d
150000
50000
______
200000
The statement of financial position of manufacturing enterprises is similar to that of
other organizations. The only difference is that may arise is that there will be there
will be three classes of stock under current assets. These are:
i) Closing stock of finished goods
ii) Closing stock of raw materials
iii) Closing stock of work in progress
Chapter summary
In manufacturing enterprises the total costs of production is divided into two:
iii) Prime cost/ direct cost
iv) Indirect cost
If the element of unrealized profit is not deducted from closing stock of finished goods
we end up overstating closing stock which in effect overstates our gross profit. This is
because a high value of closing stock will lead to a lesser value of cost of goods and
consequently higher profits (overstated profits).
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CASE STUDY
The Chandaria Group of Industries is a family-owned manufacturing company (with the three key
players being Maganlal and his two sons, Dinesh and Mahesh) that relies on a strong professional
team being involved in every sector of specialization. A committed team of senior, middle and
junior managers ensure a drive of excellence in all the departments such as global research,
production, sales and marketing and finance.
One of the main reasons why Chandaria Group of Industries is successful is its ability to account
for all its investments and processes.
CHAPTER QUIZ
1. How is the total cost of production divided in manufacturing enterprises?
2. What are prime/ direct costs?
MANUFACTURING ACCOUNT
2 1 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
ANSWERS TO CHAPTER QUIZ
1. - Prime/ direct costs
- Indirect costs.
2. These are costs that can be directly related to a unit of production.
PAST PAPER ANALYSIS
12/07, 12/06, 6/06, 6/04, 6/03
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EXAM TYPE QUESTION
Question 1 (December 2007 Question2)
The following balances were extracted from the books of Taba Ltd., a manufacturing and trading
company, as at 31 October 2007:
Sh “000”
Business premises at cost 20.000
Plant and equipment at cost 18.000
Motor vehicles at cost 6.400
Accumulated depreciation as at 1 November 2006:
Business premises 3.200
Plant and equipment 10.000
Motor vehicles 2.400
Ordinary shares (Sh.10 each) 15.000
Share premium 5.000
Retained earnings (1 November 2006) 28.300
Inventory as at 1 November 2006:
Direct materials 1.200
Work in progress 800
Finished goods 1.600
Purchases of direct materials sales 16.400
Production overhead 67.100
Administration overhead 10.400
Trade receivables 4.900
Trade payables 4.600
Other payables: PAYE 1.300
VAT 2.800
Cash in hand 300
Bank balance 32.900
Direct manufacturing wages 18.000
Selling overhead 200
MANUFACTURING ACCOUNT
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S T U D Y T E X T
Additional information:
1. On 1 November 2006, the company sold an item of plant for Sh 600.000. The item of
plant had cost the company Sh 2.000.000 on 1 November 2003. The proceeds from the
sale were recorded as a credit to the sales account and a debit to the bank account.
2. Depreciation for the year ended 31 October 2007 is to be provided using the following
annual rates:
Asset Rate
Business premises 4% based on cost
Plant and equipment 20% based on cost
Motor vehicles 25% on reducing balance basis
3. Depreciation on motor vehicles is to be apportioned as follows:
Rate
Production overhead 50%
Selling overhead 25%
Administration overhead 25%
Depreciation on other assets is to be allocated to production overhead.
4. Inventory of raw materials as at 31 October 2007 was valued at Sh 1400000. This
inventory included raw material which cost Sh 300000 and could only realized a scrap
value of Sh 100000.
5. Closing work-in progress as at 31 October 2007 was valued as follows:
Sh.
Direct labour 500000
Direct material 125000
Production overhead 200000
Total 1700000
6. The year end stock taking for finished goods was done on 3 November 2007. These
goods were valued at Sh 1300000 being the cost production.
7. The following transactions took place between 1 November 2007 before the stock
taking of the finished goods was carried out.
Sh.
• Sales to customers at selling price 500,000
• Returns by customers at selling price 125,000
• Completed work-in progress at total production cost 200,000
The goods sold to customers during the period 1 November 2oo7 to 3 November 2007 were at a
uniform mark-up of 25% on the production cost.
Required:
a) Manufacturing, trading and statement of comprehensive income for the year ended 31
October 2007. (12 marks)
b) Statement of financial position as at 31 October 2007. (8 marks)
(Total 20 marks)
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S T U D Y T E X T
Question 1 (June 2003 Question 1)
The following balances have been extracted from the books of Limuru Manufacturers, a small
scale manufacturing enterprise, as at 31 December 2002:
Sh.
‘000’
Stocks as at 1 January 2002: Raw materials 7,000
Work in progress 5,000
Finished goods 6,900
Purchases of raw materials 38,000
Direct labour 28,000
Factory overheads: Variable 16,000
Fixed 9,000
Administrative expenses: Rent and rates 19,000
Lighting 6,000
Stationery and postage 2,000
Staff salaries 19,380
Sales 192,000
Plant and machinery: At cost 30,000
Provision for depreciation 12,000
Motor vehicles (for sales deliveries): At cost 16,000
Provision for depreciation 4,000
Creditors 5,500
Debtors 28,000
Drawings 11,500
Balance at bank 16,600
Capital at 1 January 2002 48,000
Provision for unrealized profit at 1 January
2002
1,380
Motor Vehicle running costs 4,500
Additional information:
1. Stocks at 31 December 2002 were as follows:
Sh.
‘000’
Raw materials 9,000
Work in progress 8,000
Finished goods 10,350
2. The factory output is transferred to the trading account at factory cost plus 25% of
factory profit.
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2 1 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
3. Depreciation is provided at the rates shown below on the original cost of fixed assets
held at the end of each financial year.
Plant and machinery - 10% per annum
Motor vehicles - 25% per annum
4. Amounts accrued at 31 December 2002 for direct labour amounted to Sh 3,000,000
and rent and rates prepaid at 31 December 2002 amounted to Sh 2,000,000.
Required:
(a) Manufacturing, trading and profit and loss account for the year ended
31 December 2002. (12 marks)
(b) Statement of financial position as at 31 December 2002.
(8 marks)
(Total: 20 marks)
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CHAPTER EIGHT
FINANCIAL STATEMENT
ANALYSIS
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Chapter eight
FINANCIAL STATEMENT ANALYSIS
OBJECTIVES
After you have studied this chapter, you should be able to:
• Explain how the use of ratios can help to analyze the profitability, liquidity, efficiency and
capital structure of a firm.
• Calculate the main accounting ratios.
• Interpret the results of calculating accounting ratios
• Explain the advantages and disadvantages of the gearing of an organization being high
or low.
• Explain how the proportion of costs that are fixed and variable impacts profit at different
levels of activity.
INTRODUCTION RATIO ANALYSIS
Fast forward - A financial ratio is a relationship between financial variables and helps ascertain
financial condition of the firm.
Ratio analysis is a means of comparing and quantifying relationships between financial variables
in the statement of comprehensive income and the Statement of financial position. A financial
ratio is a relationship between financial variables and helps ascertain financial condition of the
firm. With ratios, financial statements can be interpreted and usefully applied to satisfy the needs
of the users of financial statements.
EXAM CONTEXT
This like all chapters is a very important chapter. It has been examined frequently and can be
tested in any sitting.
INDUSTRY CONTEXT
Financial statements analysis reports give a frank financial account into the current state of the
business, regarding stock turnover and the ability to meet short and long term debts. Managers,
Shareholders, Creditors etc all take an interest in Ratio Analysis. For example, managers can
use the information to see if the company’s liquidity is struggling and they may have to take out
short term finance such as an overdraft to overcome this.
2 1 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
However its drawbacks include that it purely only covers the financial aspects of how a business
is performing and therefore managers should take into account the current state of the market. Is
it in a period of recession? This may reflect depressing ratios - depressing ratios may also mean
that the company is growing and investing heavily into marketing or research and development
which means it will have very small amounts of working capital. It should also be used as part of
a trend of data for example - Gearing over a number of years, is it decreasing or increasing - and
why and what is the result of this?
CLASSIFICATION OF RATIOS
Ratios can be classified into:
a) Liquidity ratios.
b) Leverage or gearing ratios.
c) Activity ratios.
d) Profitability ratios.
USERS OF RATIOS
There are a vast number of parties interested in analyzing financial statements including
shareholders, lenders, customers, employees, government, and competitors. In many occasions,
they will be interested in different things therefore there is no any definite, all-encompassing list
of points for analysis that would be useful to all these stakeholders. However, it is possible to
construct a series of ratios that together will provide all of them with something that they find
relevant and from which they can investigate further if necessary.
Ratio category Examples of interested parties
Profitability Shareholders, management, employees, creditors, potential investors
Liquidity Shareholders, suppliers, creditors, competitors
Efficiency Shareholders, potential purchasers, competitors
Shareholder Shareholders, potential investors
Capital structure Shareholders, lenders, creditors, potential investors
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S T U D Y T E X T
1. Liquidity ratios
These measure firm’s ability to meet its short-term maturing obligations as and when
they fall due. The lower the ratio, the higher the liquidity risk and vice versa. Failure to
meet short term liabilities due to lack of liquidity may lead to poor credit worthiness,
litigation by creditors and insolvency.
2. Leverage or gearing ratios
These measure extent to which a company uses its assets which have been financed
by non owner supplied funds. They measure financial risk of the company. The higher
the ratio, the higher the financial risk. Gearing refers to the amount of debt finance a
company uses relative to its equity finance.
3. Activity ratios
These measure the efficiency with which a firm uses its assets to generate sales. They
are also called turnover ratios as they indicate the rate at which assets are converted
into sales.
4. Profitability ratios
They measure the management’s effectiveness as shown by returns generated on sales
and investment. They indicate how successful management has been in generating
profits of the company.
5. Investment or equity ratios
These are used to evaluate the overall performance of a company. E.g. in determining
company’s dividend policy, determining theoretical value of company’s securities and
predicting effects of rights issue.
1. LIQUIDITY RATIOS
Fast forward – These measure firm’s ability to meet its short term maturing obligations as and
when they fall due.
§ Current ratio. This is computed by dividing total current assets by total current
liabilities:
Current ratio = Current assets
Current liabilities
Current ratio of more than one means that a company has more current assets than
current liabilities.
§ Acid test or quick ratio. This is calculated by dividing total current liabilities excluding
stock by current liabilities. A firm with a satisfactory current ratio may actually be in a
poor liquidity position when inventories form most of the total current assets.
Acid test ratio = Current assets less stock
Current liabilities
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2 2 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
2. GEARING OR LEVERAGE RATIOS
Fast forward - These measure extent to which a company uses its assets which have been
financed by non-owner supplied funds.
§ Debt ratio or capital gearing ratio. This measure the proportion of debt finance to
capital employed by a company. A company is highly geared if the ratio is greater than
50%.
Debt ratio = Total long term debt x 100%
Capital employed
§ Debt equity ratio. This measures the proportion of non owner supplied funds to
owner’s contribution to the company. A company is highly geared if the debt equity ratio
is greater than 100%.
Debt equity ratio = Long term debt
Equity or Net worth
§ Times interest cover. This shows number of times earnings by a company cover its
current payments. The higher the ratio, the lower the gearing position and thus the
lower the financial risk.
Times interest cover = Earnings before interest and tax + Depreciation
Interest charged
3. PROFITABILITY RATIOS
Fast forward - These measure management’s effectiveness as shown by returns generated on
sales and investment.
§ Return on capital employed (ROCE). This measures the efficiency with which a company
uses long term funds or permanent assets to generate returns to shareholders.
ROCE = Profit before interest and tax or operating profit
Total capital employed
Capital employed consists of shareholders funds (ordinary share capital, preference
share capital, share premium and retained earnings) and long term debts. Capital
employed can also be calculated as fixed assets plus net working capital.
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S T U D Y T E X T
§ Gross profit margin. This ratio shows how well cost of production has been controlled
in relation to distribution and administration costs.
Gross profit margin = Gross profit X 100%
Sales
§ Net profit margin. This measures firm’s ability to control its production, operating and
financing costs.
Net profit margin = Net profit X 100%
Sales
§ Net assets turnover. This gives a guide to productive efficiency i.e. how well assets
have been used in generating sales.
Net assets turnover = Sales
Capital employed
§ Operating profit/margin ratio. This indicates efficiency with which costs have been
controlled in generating profit from sales.
Operating profit ratio = Profit before interest and tax or operating profit X 100%
Sales
§ Operating expenses ratio. This indicates a firm’s ability to control production and
operating costs to generate a given level of sales.
Operating expenses ratio = Operating expenses X 100%
Sales
§ Return on investment. This measures the efficiency with which a company uses its
total funds in capital employed to generate returns to owner’s funds.
Return on investment = Net profit after tax X 100%
Capital employed
§ Return on equity. (ROE) This measures the efficiency with which a company other
supplier’s funds to generate returns to shareholders.
Return on equity = Earnings attributable to equity shareholders X 100%
Equity
Equity comprises of ordinary share capital, share premium and reserves.
FINANCIAL STATEMENT ANALYSIS
2 2 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
4. ACTIVITY RATIOS
Fast forward - These measure the efficiency with which a firm uses its assets to generate sales
§ Debtor’s turnover. This shows the number of times debtors pay within the year. It
indicates how efficient the firm is in management of credit. The higher the ratio, the
more efficient management is in managing its credit policy.
Debtor’s turnover = Credit sales
Average debtors
§ Debtor’s days or ratio. This is also called the average collection period. It shows
the average period of credit taken by customers who buy on credit. It is compared the
company’s allowed credit period by suppliers to give an indication of credit administration
efficiency.
Debtor’s days or ratio = Average debtors X Number of days in a year.
Credit sales
= Number of days in a year
Debtor’s turnover
§ Creditor’s turnover. This indicates the number of times creditors are paid by a company
during a year.
Creditor’s turnover = Credit Purchases
Average creditors
§ Creditor’s days or ratio. This is also called the average deferral period. It indicates the
average time that suppliers allow a company to settle its dues.
Creditor’s days or ratio = Average creditors X Number of days in a year.
Credit purchases
= Number of days in a year
Creditor’s turnover
§ Stock or inventory turnover. This indicates the efficiency of a firm in selling its products
so as to generate sales. It shows the times stock is turned over or converted into sales
within a year. It shows how rapidly stock is being turned into cash through sales.
Stock or inventory turnover = Cost of sales
Average stock
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S T U D Y T E X T
§ Stock days/inventory conversion period. This indicates the number of days it takes
to convert inventory into sales. The fewer the number of days, the more efficient a
company is in converting stock into sales.
Stock days/inventory conversion period = Average stock X Number of days in a year.
Cost of sales
= Number of days in a year
Inventory turnover
§ Cash working cycle/Working capital cycle/Operating cycle. This is the period for
which working capital financing is needed. The higher the working capital cycle, the
higher the investment in working capital. It is the period of time that elapses between
the point at which cash is spent on production or purchase of raw materials/stock to
time stock is converted into cash or cash is collected from a customer.
Average collection period xxx
Add inventory conversion period xxx
Less average deferral period (xxx)
Working capital cycle xxx
§ Cash turnover/Operating turnover. This shows number of times a company needs to
replenish its working capital in a year.
Cash turnover/Operating turnover = Number of days in a year
Working capital cycle
§ Fixed assets turnover. This indicates level of sales generated by fixed asset base of
a company. It shows the efficiency with which a company utilizes its assets to generate
sales.
Fixed assets turnover = Sales
Total fixed assets
FINANCIAL STATEMENT ANALYSIS
2 2 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
5. INVESTMENT OR EQUITY RATIOS
Fast forward - These are used to evaluate the overall performance of a company
§ Earnings Per Share (EPS). This indicates the amount shareholders expect to generate
in form of earnings for every share invested. It shows profitability of a company on a per
share basis.
EPS = Earnings attributable to equity shareholders
Number of ordinary shares
§ Dividend Per Share (DPS) This represents the amount of cash dividend that
shareholders expect to receive for every share invested in the company.
Dividend Per Share = Total ordinary dividends
Number of ordinary shares
§ Dividend pay out ratio. This indicates proportion of earnings attributable to equity
shareholders that are paid out to common shareholders as dividends. It is used in
analysis of dividend policy of the firm.
Dividend pay out ratio = Total common dividends X 100
Earnings attributable to equity shareholders
= Dividend per share X 100
Earnings per share
§ Dividend retention ratio.
Dividend retention ratio = Retained earnings X 100
Earnings attributable to equity shareholders
§ Dividend cover.
Dividend cover = Earnings per share
Dividend per share
§ Earnings yield. This measures the potential return that shareholders expect to earn for
every share invested in a company. It evaluates the shareholders returns in relation to
the market value of a share.
Earnings yield = Earnings per share X 100
Market price per share
225
S T U D Y T E X T
§ Dividend yield. This ratio measures how much an investor expects to receive from
cash dividends for every share purchased or invested in a company.
Dividend yield = Dividend per share X 100
Market price per share
§ Price earnings ratio. This indicates how much an investor is prepared to pay for a
company’s share given its current earnings per share. The higher the price earnings
ratio, the more confident investors are that the company will perform well in future.
Price earnings ratio = Market price per share
Earnings per share
LIMITATIONS OF RATIOS
o Subjectivity. Ratios are subjective to accounting information that depends on the
accounting policies adopted by a particular organization hence making it impossible for
cross sectional analysis if a company uses different accounting policies. It is difficult to
categorize firms due to diversifications i.e. some companies have more than one line of
business and thus will fall into several industries thus difficult in ratio comparison.
o Irrelevance. Ratios are historical figures which may irrelevant in making future
decisions.
o Qualitative aspects are ignored. Qualitative aspects such competent management,
experience and motivation of employees are not captured in computation of ratios.
o Ambiguity. Different people will use different stances to describe financial information
e.g. including preference share capital in equity or return on capital being referred to as
gross capital employed.
o Usefulness. Ratios are computed at a specific point in time. By the time they are
analyzed for decision making, circumstances may have changed thus ratios are only
useful in the short term
o Monopoly. For a company without competitor, it may not be .possible to analyze its
performance with other companies in the same industry.
FINANCIAL STATEMENT ANALYSIS
2 2 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
CHAPTER SUMMARY
Ratios can be classified into:
• Liquidity ratios.
• Leverage or gearing ratios.
• Activity ratios.
• Profitability ratios.
Ratio category Examples of interested parties
Profitability Shareholders, management, employees, creditors, potential investors
Liquidity Shareholders, suppliers, creditors, competitors
Efficiency Shareholders, potential purchasers, competitors
Shareholder Shareholders, potential investors
Capital structure Shareholders, lenders, creditors, potential investors
CASE STUDY
Comparative Analysis of Barclays, KCB & Stanchart (2008)
Profitability
Barclays recorded the highest Profit Before Tax (PBT) of Sh7.1 billion followed by Standard
chartered with Sh 4.9 billion and KCB with Sh 4.2 billion. KCB and Standard Chartered
registered impressive growth levels of 33% and 29% in PBT compared to Barclays 9%.
Reason for profitability difference
KCB’s impressive growth was attributed to a 42% increase in loans and advances to it
customers given their wide branch network and aggressive marketing. Its operational expenses
rose by 20% as the bank opened 11 branches across Kenya and a new subsidiary in Kampala
Uganda.
Standard Chartered Bank’s remarkable growth is attributed to a 49% rise in foreign exchange
income. However the bank had a rise of 23% in operational expenses as it opened 2 new branches
and increased its number of employees.
Barclays’ dismal growth in PBT is attributed to a 43% rise in operational expenses. The bank
increased its network by 95 new Automatic Teller Machine (ATM), 47 branches and 3,003
employees.
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S T U D Y T E X T
Balance sheet reviews
Standard Chartered has a healthy balance sheet and recorded the lowest cost to income ratio
of 46% followed by Barclays at 59% and KCB at 65%.This means that Standard Chartered is
able to generate more income at a lower cost.
Lending Capacity
Standard Chartered is able to lend more as its gross loans and advances to deposits ratio stood
at 56% compared to Barclays whooping 99% and KCBs 77%.In essence Barclays has lend out
most of the customer deposits.
Barclays Standard chartered KCB
Sh. Sh Sh
Earnings Per Share 3.6 12.14 1.49
Dividend Per Share 1.65 10 0.7
Price/Earning Ratio 20.28 17.3 20.13
Yield Curve 2.26 4.76 2.67
Average stock price 73 210 30
(Source, http://markets.nairobist.com/)
CHAPTER QUIZ
1. What do the profitability ratios measure?
2. What are the limitations of ratios?
3. How is dividend cover calculated?
FINANCIAL STATEMENT ANALYSIS
2 2 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
ANSWERS TO CHAPTER QUIZ
1. Profitability ratios measure management’s effectiveness as shown by returns generated
on sales and investment. They indicate how successful management has been in
generating profits of the company.
2.
- Irrelevance
- Qualitative aspects are ignored.
- Ambiguity.
- Can’t be used by monopolies for comparison.
- Subjectivity.
3.
Dividend cover = Earnings per share
Dividend per share
PAST PAPER ANALYSIS
12/06, 6/05, 6/05, 12/04, 12/03
EXAM TYPE QUESTIONS
Question 1 (June 2005 Question 5)
a) Explain the importance of ratio analysis to a business enterprise. (2 marks)
b) Identify with reasons, one party who may be interested in each of the following ratios:
(i) Current ratio (2 marks)
(ii) Net profit margin (2 marks)
(iii) Stock turnover (2 marks)
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S T U D Y T E X T
c) Citing suitable examples, briefly explain of the following terms:
(i) Accounting concepts (2 marks)
(ii) Accounting policies (2 marks)
(iii) Accounting standards (2 marks)
d) Explain the accounting treatment that would be applicable in dealing with the following
transactions relating to the accounts of Mlachake Ltd. for the year ended 31 December
2004:
(i) A debtor who owed the company Sh 200,000 was declared bankrupt on
1 February 2005. 25% of the debt had been recovered when the accounts were
approved by the directors on 15 March 2005. (2 marks)
(ii) Some items of inventory purchased for Sh 300,000 were damaged in the
warehouse during the year. These items were repaired at Sh 50,000 and sold to a
customer on 2 February 2005 at 75% of the normal selling price of Sh.400,000
(2 marks)
(iii) On 10 December 2004, the company secured an order worth Sh 1.2 million from a
foreign based company. The goods were shipped on 10 January 2005 and
included in sales for December 2004. (2 marks)
(Total: 20 marks)
Question 2 (December 2005 Question 3)
(a) State four purposes of ratio analysis
(b) The following information was extracted from the financial statements of Sunrise Ltd.
and Sunset Ltd. in respect of the year ended 30 September 2005:
Statement of comprehensive income extracts for the year
ended 30 September 2005:
Sunrise Ltd. Sunset Ltd.
Sh. ‘000’ Sh. ‘000’
Sales 497,000 371,000
Cost of sales 258,000 153,000
Operating profit 138,000 79,000
Interest expense 19,000 -
FINANCIAL STATEMENT ANALYSIS
2 3 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
Statement of financial position extracts
as at 30 September 2005:
Sunrise Ltd. Sunset Ltd.
Sh. ‘000’ Sh. ‘000’
Non-current assets 142,000 92,000
Current assets:
Inventory 100,000 87,000
Debtors 46,000 42,000
Cash at bank 40,000 44,000
Current liabilities 98,000 108,000
Long-term loan 33,000 -
Shareholders funds 197,000 157,000
Required:
For each company, compute the following ratios:
(i) Acid test ratio (2 marks)
(ii) Inventory turnover (2 marks)
(iii) Average collection period (2 marks)
(iv) Return on capital employed (2 marks)
(v) Debt equity ratio (2 marks)
(c) (i) On the basis of the ratios computed in (b) above, comment on the overall
performance of Sunrise Ltd. and Sunset Ltd. and advise which of the two
companies would provide better investment. (3 marks)
(ii) Explain the possible shortcomings of relying on your analysis in (b) above.
(3 marks)
(Total: 20 marks)
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S T U D Y T E X T
CHAPTER NINE
COMPANY ACCOUNTS
S TSUTDUYD YT ETXETX T
2 3 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
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S T U D Y T E X T
CHAPTER NINE
COMPANY ACCOUNTS
OBJECTIVES
After you study this chapter, you should be able to:
• Define a company and understand the capital structure of a company and issuance of
share capital by a company
• Compare and contrast a Company and other forms of business
• Prepare financial statements for a limited liability company and understand the true and
fair view requirements
• Account for forfeiture of shares and reissue of forfeited shares
• Calculate rights and determine number of shares issuable give in specific number
INTRODUCTION
A company form of business formed by a group people called the promoters. Once formed,
the law recognizes the company as a legal person separate from the owners by all means.
This means that it can sue or be sued in its own name; it can borrow funds in its own name or
even enter into contract in its own name. This concept is sometimes referred to as the veil of
incorporation.
A company is greater in size and complexity than either the sole proprietorship or the partnership
discussed earlier. It’s also a more recent form of business. It actually came into existence after
the partnership in an effort to cover the shortfalls of a partnership form of business.
Partnership’s draw back
• Partnership membership is limited
to 20 hence thus limiting the capital
raising capability
Solution offered by a Company
• There is no limit to the number of
members for a public company hence
more capital can be raised
• The liabilities of the members are
unlimited.
• The liability of the members is limited to
the capital contributed
• The death of partner may cause the
dissolution of a partnership
• A company’s life is not pegged on the
life of the members and can only be
terminated through a legal winding up
procedure.
Have difficulties in securing loans and
contracts since the law doesn’t recognize
it as a separate entity with contractual
capacity.
Can easily secure loans and contracts since
the law recognizes it as an artificial person with
contractual capacity
Limited growth due to limited capital
available
Can expand rapidly since capital is readily
available from the large number of members
2 3 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
DEFINITION OF KEY TERMS
Capital is the amount of money or other assets introduced by the owner of the business
A Company is an organization that is a legal entity and has limited liability
EXAM CONTEXT
This chapter is very important for this papers preparation for exams and forms a basis for more
in-depth company accounting that we will look into in other financial accounting papers that
we shall tackle. This include consolidating accounts for subsidiaries and associates to parent
companies
INDUSTRY CONTEXT
Most private and public companies in Kenya will require that financial statements be prepared and
audited by independent auditors. All companies listed in the Nairobi Stock Exchange are required
to prepare true and fair financial statements and have them audited by independent auditors.
This stresses the need to understand very well this chapter not just for audit and accounting
careers, but also to be able to interpret company financial statements as shareholders.
235
S T U D Y T E X T
9.1 PUBLIC AND PRIVATE COMPANIES
Fast forward - Companies can be classified as either public company or private company.
The major differences between the two are:
Public company Private company
They have no maximum limit for membership Has a maximum limit of 50 members
Their membership is open to the public
Membership open only for relatives or
close associates of the existing members
Can raise capital through the issue of shares to
the public
Cannot raise capital from the general
public
There is free transfer of shares amongst
shareholders
Transfer of shares is restricted and must
be authorized.
9.2 THE BOARD OF DIRECTORS
Fast forward – Company owners delegate the running of their business to a group of people
referred to as the directors who together form the board of directors.
In the sole proprietorship and partnerships, the owners of the business i.e. the sole proprietor
and the partners respectively, oversee the day to day running of the business
In the case of a company, such an arrangement is impossible to maintain due to the large number
of owners (shareholders) and the complexity of the activities undertaken by the company. For
this reason the owners delegate the running of their business to a group of people referred to
as the directors who together form the board of directors. They may be shareholders as well
but not necessarily. They combine their expertise to manage the affairs of the company on the
shareholders behalf.
COMPANY ACCOUNTS
2 3 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
9.3 THE COMPANY’S CAPITAL
The major types of capitals that a company has are:
Loan capital (debentures)
This is capital borrowed from creditors which will be repaid later at an interest. It’s actually a
liability to the company. This will be discussed later in this topic.
SHARE CAPITAL
To become an owner of any company a person must have contributed to its capital. To facilitate
this there total capital required by the company is divided into small units or shares. One becomes
a member of a company (shareholder) by purchasing one or more of the shares. Share capital is
thus the capital raised from members of the company. As expected shareholders expect return
on their investment. Thus the profi ts made by the company are distributed to the shareholders in
proportion to the number of shares held. The profi t distributed to the shareholders is referred to
as a divided. This amount is determined and proposed to the share holders for approval by the
directors. The shareholders; however, are only allowed to review the proposal downwards. The
accounting for and distribution of profi ts shall be covered comprehensively later on.
Share capital can be divided into two types of shares:
i) Preference shares
ii) Ordinary shares
Preference shares; holders of these shares receive their dividend at an agreed rate before the
ordinary shareholders receive anything.
Ordinary shares the ordinary shareholders receive their dividends after the preference
shareholders, if there is any profi t left.
The preference shares are further divided into:
Cumulative preference shares: these are preference shares whose agreed percentage of
dividend accumulates over the period they are fully paid.
237
S T U D Y T E X T
Non-cumulative preference shares : these are preference shares which if not paid the
percentage of divided agreed upon in a given period lose the right to claim such dividends ever
again in future periods.
Participating preference shares: these are shares that receive an agreed percentage of
dividends before the ordinary shareholders and still receive a portion of the remaining profi ts
being distributed to the ordinary shareholders.
Non participating preference shares these are the preference shares that receive only the
agreed percentage of dividend, no more.
SHARE CAPITAL
Fast forward – Share capital can be;
a) Authorized share capital
b) Issued share capital
c) Called up capital
d) Calls in arrears
e) Paid up capital.
In this section we shall consider the process of obtaining share capital and the accounting entries
involved. However, for better understanding, it’s important to defi ne the following terms fi rst:
i) Authorized/registered/normal share capital: this is the amount of capital that the
company is allowed to issue as indicated in its Articles of Association. A company may
issue only a portion of the authorized share capital to shareholders. The remaining
capital not issued remains as security to the company incase more capital is needed in
future, and only then shall it be issued. However, no company is allowed to issue more
shares than the amount authorized. The authorized share capital is normally shown in
the statement of fi nancial position under the equities section but its value is not summed
up together with the rest of the equity items.
ii) Issued share capital: this is the part of the share capital that has already been issued
to the shareholders.
iii) Called up share capital: once the company issues the capital to the shareholders it
may not require them to pay for the whole amount for the shares purchased. Instead
it may prescribe that certain amounts be paid fi rst and the rest to be paid when the
company requires. The total amount that a company has already requested to be paid
on the shares, up to a specifi ed date is referred to as the called up share capital. The
part remaining unpaid on the shares is referred to as the uncalled share capital.
iv) Paid up share capital: It’s that part of the issued share capital for which calls have
been made and payments of the calls actually received by the company.
COMPANY ACCOUNTS
2 3 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
v) Calls in arrears: out of the called up capital, not all of it is paid for. The balance of
called up capital that remains unpaid is referred to as calls in arrears.
vi) Calls in advance; some shareholders may pay for the outstanding amount on their
shares even before makes the calls for it. Such payments are referred to as the calls in
advance.
The following example will help illustrate the above terms.
Intel Solutions Ltd was formed with the legal right to be able to issue 400000 shares of Sh 4 each.
However they actually issued 300000 of which none was fully paid.
So far Intel Solutions Ltd has made calls of Sh 3 per share. All shares have been paid by the
shareholders except for Sh 150000 shares whose shareholders have only paid Sh 1 per share.
Required:
Determine
a) Authorized share capital
b) Issued share capital
c) Called up capital
d) Calls in arrears
e) Paid up capital.
Solution:
Authorized share capital:
400,000 x 4 = 1,600,000
Issued share capital
300000 x 4 = 1200000
Called up capital
300000 x 3 = 900000
Calls in arrears
150000 x (3 – 1) = 300000
Paid capital
900000 (obtained from d above) – 300000 = 600000
239
S T U D Y T E X T
RESERVES
These are funds that the business sets aside for purposes of future financial obligations and
appear in the financed-by section of the Statement of financial position.
They are categorized into two:
Capital reserves
Revenue reserves
Revenue reserves: these are the reserves which can be distributed to the shareholders if need
be in a form such as bonus shares. They are generally used for the expansion or purchase of
non-current assets. They include:
§ Retained profits – the balance after appropriation
§ General reserves
Capital reserves: capital reserves on the other hand cannot be distributed to the share holders.
They include:
• Share premium –representing the amount paid on the issued shares above their par
value.
• Revaluation reserve – representing the amounts by which assets appreciate after a
revaluation is done.
• Capital redemption reserve fund – representing the amount transferred from the retained
earnings to finance the redemption of preference shares. If the amount is transferred to
cater for the redemption of debentures, the reserve created for that purpose is referred
to as the Debenture redemption fund. These shall be explained further in later section
of the topic.
9.4 FINANCIAL STATEMENTS OF A LIMITED COMPANY
STATEMENT OF COMPREHENSIVE INCOME
Like any other business entity, the company is formed with the intention of making profit. This profit
is reported in the company’s statement of comprehensive income just like in sole proprietorship
or partnership form of business. However some expense items are unique to the company’s
profit and loss statement e.g. director’s remuneration, audit fee. Companies are also required to
pay tax on the profits earned in the form of a corporation tax which currently stands at 30% of the
net profit earned in one trading period.
Unlike in sole proprietorship and partnership, a company’s statement of comprehensive income
statement also includes an extra section which shows how the profits made by the company are
distributed or appropriated. This section is referred to as the appropriation account.
COMPANY ACCOUNTS
2 4 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
Generally the Trading and Statement of comprehensive income will have the following format:
XYZ STATEMENT OF COMPREHENSIVE INCOME
FOR THE PERIOD ENDED XXXXXX
Sh Sh
Sales xx
less return inwards (xx)
net sales Xxx
less cost of sales
opening stock xx
add purchases xx
carriage inwards xx
xx
less return outwards (xx)
net purchases xx
goods available for sale xxx
less closing stock (xx)
cost of sales Xxx
gross profit Xxx
add other incomes
discount received Xxx
profit on disposal of assets Xxx
income from investments Xxx
other incomes e.g. interest received from bank Xxx
Xxx
less expenses
administrative expenses xx
operating expenses xx
selling and distribution expenses xx
debenture interest xx
audit fees xx
directors remuneration xx
amortization of goodwill xx
total expenses (xxx)
net profit for the period before tax Xxx
corporation tax (xxx)
net profit for the period after tax Xxx
appropriation section:
net profit for the period after tax Xxx
add retained profit b/f Xxx
Xxx
less transfers to general reserves xxx
preference dividend
interim paid xx
final proposed xx
xxx
ordinary dividend
interim paid xx
final proposed xx
xxx
(xxx)
retained profit c/d Xxx
241
S T U D Y T E X T
THE STATEMENT OF FINANCIAL POSITION
The Statement of financial position of a company is also similar to that of a partnership except for
the capital section of the Statement of financial position. For company the capital section is also
referred to as the ‘financed by’ section. Just as the name suggests, this section shows the funds
used to finance the net assets. This stems from the basic accounting equation where:
Capital = assets – liabilities = net assets
Therefore the figure obtained for net assets must necessarily tally with that in the financed by
section i.e. all other factors e.g. errors held constant, the statement of financial position should
balance.
The general format of a statement of financial position is as follows:
XYZ COMPANY LTD
STATEMENT OF FINANCIAL POSITION AS AT XXXXX
Sh Sh Sh
Non-current assets
land and buildings xxx
plant and equipment xx
less accumulated depreciation (xx)
xx
fixtures, furniture and fittings xx
less accumulated depreciation (xx)
xx
motor vehicles xx
less accumulated depreciation (xx)
xx
total non-current assets xxx
Current Assets
stock xx
Debtors xxx
less provision for doubtful debts (xxx)
xxx
Prepayments xxx
short term investments xxx
cash at bank xxx
cash in hand xxx
total current assets xxx
less Current Liabilities
bank overdraft xxx
Creditors xxx
Accruals xxx
interest payable (debenture interest) xxx
tax payable xxx
dividends payable xxx
(xxx)
net current assets xxx
total assets yyyyy
COMPANY ACCOUNTS
2 4 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Financed By
authorized share capital
1,000,000 ordinary shares of Sh 1 each
1,000,000 preference shares of Sh 1
each
issued and fully paid
800,000 ordinary shares of Sh 1 each xxx
500,000 10% preference shares of Sh 1
each
xxx
xxx
capital reserves
share premium xxx
revaluation reserve xxx
capital redemption reserve xxx
xxx
revenue reserves
general reserve xxx
profit and loss account xxx
xxx
xxx
non current liabilities
10% debentures xxx
yyyy
9.5 TRUE AND FAIR VIEW
Fast forward - A basic requirement for the financial statements of the company is that they must
portray a true and fair view of the company.
It is expected that the Trading and Statement of comprehensive income will portray a true and
fair view of the results of trading activities over a given accounting period. The statement of
financial position is also expected to give a true and fair view of status of the company’s assets
vis-à-vis the company’s liabilities as at the statement of financial position date. Actually this forms
part of the major objectives of an audit of a company’s financial statements. The auditor states
in his report whether or not in his opinion the financial statements are a true and fair reflection of
the company’s results and state of affairs.
243
S T U D Y T E X T
Examples on preparation of financial statements
The following is the trial balance of Transit Ltd as at March 19x8
Sh Sh
Ordinary share capital (Sh 1 each) 42,000
Leasehold property at cost 75,000
Motor vans at cost(used for distribution) 2,500
Provision for depreciation motor van to 31 march 19x7 1,000
Administration expenses 7,650
Distribution expenses 10,000
Stock 31 march 19x7 12,000
Purchases 138,750
Sales 206,500
Director’s remuneration 25,000
Rent receivables 3,600
Investment at cost 6,750
Investment income 340
7% debentures 15,000
Debenture interest 1,050
Bank interests 162
Bank overdraft 730
Debtors and creditors 31,000 24,100
Interim dividend paid 1,260
Profit and loss account 17,852
311,122 311,122
You ascertain the following:
All the motor vans were purchased on 1 April 19x5. Depreciation has been and is to be provided
at the rate of 20% per annum on cost from the date of purchase to the date of sale. On 31 march
19x8 one van, which had cost £ 900 was sold for £550,as part settlement of the price of £ 800 of
a new van, but no entry with regard to this transactions were made in the cashbooks.
The estimated corporation tax liability for the year to March 10x8 is £12700
It is proposed to pay a final dividend of 10% for the year to 31 march 19x8
Stock at the lower of cost or net realizable value on 31 March 19x8 is £16700
Required:
Prepare without taking into account the relevant statutory provisions:
a) Profit and loss statement for the year ended 31 march 19x8.
b) A statement of financial position as at that date.
COMPANY ACCOUNTS
2 4 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
Transit Ltd
Profit and loss statement for the year ended 31st March 19x8
£ £
Gross profit 72,450
Profit on disposal of van 190
Rent receivable 3,600
76,240
Less: expenses
Depreciation on motor van 500
Administration expense 32,650
Distribution expense 10,000
Debenture interest 1,050
Bank interest 162
(44,362)
Trading profit for the year 31,878
Add: investment income 340
Profit before tax 32,218
Taxation 12,700
Profit after tax 19,518
Less: dividends
Interim paid 1,260
Final proposed 4,200
(5,460)
Retained profit for the year 14,058
Retained profit b/f 17,852
Retained profit c/f 31,910
Transit Ltd
Statement of financial position as at 31.3.19x8
£ £ £
non-current assets
Leasehold property 75,000 - 75,000
Motor vans 2,400 960 1,440
77,400 960 76,440
Investments 6,750
83,190
Current assets
Stock 16,700
Debtors 31,000
47,700
Current liabilities
Bank overdraft 980
Creditors 24,100
Tax payable 12,700
Proposed dividend 4,200
(41,980)
5,720
88,910
Financed by :
Authorized issued and fully paid
4200 ordinary shares of £ 1 42,000
Revenue reserves
Statement of comprehensive income c/f 31,910
73,910
Non current liabilities
7% debentures 15,000
88,910
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S T U D Y T E X T
Workings:
Sales 206,500
Less: cost of sales
Opening stock 12,000
Purchases 138,750
150,750
Less: closing stock (16,700)
134,050
Gross profit 72,450
Motor vehicle depreciation
Disposal 540 Bal b/d 1,000
Bal c/d 960 P & L 500
1,500 1,500
Motor vehicle
Bal b/f 2,500 Disposal 900
Disposal 550 Bal c/d 2,400
Cash book 250
3,300 3,300
Motor vehicle disposal
Disposal 900 motor vehicle 550
P & L 960 depreciation 540
1,090 1,090
COMPANY ACCOUNTS
2 4 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
9.6 ISSUANCE OF SHARES
Profit to a company is earned by using the resources at its disposal in the most efficient manner.
These resources are contributed by the shareholders in the form share capital and from creditors
in the form of loan capital also called debentures.
The shareholder provides the share capital buying shares issued by a company. For public limited
companies such shares are offered through the stock exchange.
The share issuing process
The process of issuing shares to the public starts with the company issuing a prospectus. This
is a document that invites the public to purchase shares from the company. It contains details of
the companies operations and the benefits that shall accrue from investing in the company.
Once the prospectus is issued, applications follow. Shareholders respond to the prospectus by
applying to purchase the shares. In most cases more shares are applied for than the company
had initially offered for sale i.e. there is an over-subscription. If the shares applied for are less
than what the company had offered this will be referred to as under-subscription.
Allotment
At this stage successful applicants are awarded the shares for in a process called allotment. In
the event of an over subscription the issuing company allots to the share holders only a proportion
of the shares applied for in the most equitable manner to cater for all the successful applicants.
Refund to unsuccessful applicants
For the unsuccessful applicants any fees paid on application is refunded. For the applicants
allotted fewer shares than applied for, they may as well be refunded their application fee or
the same could be used to offset future payments on the shares if they were issued payable in
installments.
The call stage
If shares are issued payable in installments, only a certain portion of the shares issue price is
payable on application. The rest becomes payable as and when the company feels the need to
request for the payment. The placement of a request for the payment of the amount due on the
shares by a company to its shareholders is referred to as a call. The company may make several
calls e.g. first, second, third calls.
247
S T U D Y T E X T
Forfeiture of shares
If share holder fails to respond to the calls made within the stipulated time, the company may
decide to cancel the shares allotted to such a share holder. This is what is referred to as forfeiture
of shares. A shareholder whose shares are forfeited foregoes any amounts previously paid to the
company on the shares.
Reissue of forfeited shares
The company may decide to offer the shares forfeited to any other willing buyer at a price which
should be at least equal to the called up amount.
ACCOUNTING ENTRIES TO RECORD ISSUE OF SHARES
Before handling the accounting entries it is important to note the following:
§ Share can be issued at a premium or a discount (at a price higher or lower than the par
value respectively)
§ The shares may not necessarily be payable in full on application they may be issued on
installment basis each installment carrying a given proportion of the issue price of the
share e.g. 20% on application 25% on allotment, 30% on first call and 15% on second
and final call.
§ When shares are issued at a premium and on installment basis, the share premium
may be attached uniformly throughout the installments or may be attached to certain
installment, say on allotment.
I. Accounting for shares payable fully on application
a) Issued at par:
i) Dr Bank account xxx
Cr. Share applications account xxx
(To record cash received on application)
ii) Dr Share applications account xxx
Cr. Bank account xxx
(To record refunds to unsuccessful applicants)
iii) Dr. Share applications account xxx
Cr. Ordinary share capital account xxx
(To transfer application fees to the ordinary share capital account)
COMPANY ACCOUNTS
2 4 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
b) Issued at a premium
i) Dr Bank account xxx
Cr. Share applications account xxx
(To record cash received on application)
ii) Dr Share applications account xxx
Cr. Bank account xxx
(To record refunds to unsuccessful applicants)
iii) Dr. Share applications account xxx
Cr. Ordinary share capital account (par value) xxx
Cr. Share premium account (share premium) xxx
(To transfer application fees to the ordinary share capital account and recognize
share premium)
II accounting for shares issued on installment basis with only two calls
made
a) At par
On application:
i) Dr Bank account xxx
Cr. Share applications account xxx
(To record cash received on application)
ii) Dr Share applications account xxx
Cr. Bank account xxx
(To record refunds to unsuccessful applicants)
iii) Dr. Share applications account xxx
Cr. Ordinary share capital account xxx
(To transfer application fees to the ordinary share capital account)
On Allotment:
iv) Dr. Bank account xxx
Cr. Allotment account xxx
(To record amount payable on allotment)
Note if some of the excess cash paid on application is used to offset amounts
payable on allotment instead of being refunded the entry would have been:
Dr. Bank account xxx
Dr. Applications account (excess amount on application) xxx
Cr. Allotment account xxx
249
S T U D Y T E X T
v) Dr. Allotment account xxx
Cr. Ordinary share capital account xxx
(To transfer amount paid on allotment to the ordinary share capital account)
On First call:
vi) Dr. Bank xxx
Cr. First call account xxx
(To record cash received on first call)
vii) Dr. first call account xxx
Cr. Ordinary share capital account xxx
(To transfer first call to the ordinary share capital account)
On second and final call:
vi) Dr. Bank xxx
Cr. Second and final call account xxx
(To record cash received on first call)
vii) Dr. second and final call account xxx
Cr. Ordinary share capital account xxx
(To transfer second and final call to the ordinary share capital account)
b) At a premium payable on allotment
All other entries for the application, first call, and second and final call would remain as above.
However the entries on allotment would be:
On Allotment:
iv) Dr. Bank account xxx
Cr. Allotment account xxx
(To record amount payable on allotment)
Dr. Allotment account xxx
Cr. Ordinary share capital account xxx
Cr. Share premium account (share premium) xxx
(To transfer amount paid on allotment to the ordinary share capital account as
Well as recognize the premium paid together with the allotment money)
>>> Illustration 1
Markers Ltd issued 1000 shares to the public at Sh 10 each payable as to sh. 2.5 on application,
Sh 5 on allotment and Sh 2.5 on first and final call. They received applications for 2000 shares of
which they returned one half and then proceeded to allot the rest.
Required:
i) Show the journal entries to record the issue
ii) Show the accounts as they would appear in Markers Ltd’s books.
COMPANY ACCOUNTS
2 5 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
Suggested Solution:
a) Journal entries;
On application:
Sh. Sh.
i) Dr Bank account 5,000
Cr. Share applications account 5,000
(To record cash received on application)
ii) Dr Share applications account 2,500
Cr. Bank account 2,500
(To record refunds to unsuccessful applicants)
iii) Dr. Share applications account 2,500
Cr. Ordinary share capital account 2,500
(To transfer application fees to the ordinary share capital account)
On Allotment:
iv) Dr. Bank account 5,000
Cr. Allotment account 5,000
(To record amount payable on allotment)
v) Dr. Allotment account 5,000
Cr. Ordinary share capital account 5,000
(To transfer amount paid on allotment to the ordinary share capital account)
On First and final call:
vi) Dr. Bank 2,500
Cr. First call account 2,500
(To record cash received on first call)
vii) Dr. first call account 2,500
Cr. Ordinary share capital account 2,500
(To transfer first call to the ordinary share capital account)
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S T U D Y T E X T
COMPANY ACCOUNTS
vii) Dr. first call account 2500
Cr. Ordinary share capital account 2500
(To transfer first call to the ordinary share capital account)
Dr Bank account Cr
Sh Sh
Application a/c 5000 Application a/c 2500
Allotment a/c 5000 Balance c/d 10000
First and final call 2500
12500 12500
Dr Share application account Cr
Bank a/c
Sh
2500 Bank a/c
Sh
5000
Ordinary share capital
a/c 2500
5000 5000
Dr Allotment account Cr
Ordinary share capital a/c
Sh
5000 Bank a/c
Sh
5000
Dr First and final call Cr
Ordinary share capital a/c
Sh
12500 Bank a/c 12500
Dr Ordinary share capital account Cr
Sh Sh
2 5 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
>>> Illustration 2
Chakaza Ltd issued 1000 shares to the public at Sh 25 each payable as to Sh 5 on application,
Sh 15 on allotment and Sh 5 on first and final call. They received applications for 4000 shares
of which they rejected 1000 half and then proceeded to allot the rest of the applicants one share
for every three held.
Required:
Show the journal entries to record the issue
Suggested solution:
a) Journal entries;
On application:
Sh. Sh.
i) Dr Bank account 20,000
Cr. Share applications account 20,000
(To record cash received on application)
ii) Dr Share applications account 5,000
Cr. Bank account 5,000
(To record refunds to unsuccessful applicants)
iii) Dr. applications account (excess amount on application) 10,000
Cr. Allotment account 10,000
(To record excess amount paid on application used to
off-set amount due on allotment)
iv) Dr. Share applications account 5,000
Cr. Ordinary share capital account 5,000
(To transfer application fees to the ordinary share capital account)
Dr Ordinary share capital account Cr
Sh Sh
Balance c/d 10000 Application a/c 2500
Allotment a/c 5000
First and final call 2500
10000 10000
Illustration 2
253
S T U D Y T E X T
On Allotment:
iv) Dr. Bank account 5,000
Dr. Applications account (excess amount on application) 10,000
Cr. Allotment account 15,000
(To record amount payable on allotment)
v) Dr. Allotment account 15,000
Cr. Ordinary share capital account 15,000
(To transfer amount paid on allotment to the ordinary share capital account)
On First and final call:
vi) Dr. Bank 5,000
Cr. First call account 5,000
(To record cash received on first call)
vii) Dr. first call account 5,000
Cr. Ordinary share capital account 5,000
(To transfer first call to the ordinary share capital account)
9.7 FORFEITURE OF SHARES
So far we have assumed that the share holders were very cooperative and paid all the due
calls as and when required to do so. Sometimes; however, a shareholder may fail to pay the
calls requested from him within the stipulated time in which case the shares will be forfeited.
Any amounts already paid will be lost to him. Between the time of call and the forfeiture time the
amounts due will be in a debtor’s account; the calls in arrears account from where they will be
transferred to the forfeiture account.
The journal entries for forfeiture are as follows:
Dr. Calls in arrears a/c
Cr. (the call not paid for) for the amount owing
(To record the accrual of calls made but not paid for)
Dr. Forfeiture account
Cr. Calls in arrears a/c
(To record forfeiture of shares whose calls have remained in arrears for a period
exceeding the allowed limit.)
Dr. Ordinary capital share capital
Cr. Forfeiture account
(To record the cancellation of the shares from the issued share capital)
COMPANY ACCOUNTS
2 5 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
Note: any balance in the forfeiture account id transferred to the share premium account.
>>> Illustration 3
Assume that 100 Sh 10 shares were allotted to member who paid Sh 7.5 on application and
allotment but who failed the first and final call of Sh 2.5. How would such forfeiture be shown in
the books of account?
Suggested solution
Dr. Calls in arrears a/c 250
Cr. First and final call 250
(To record the accrual of calls made but not paid for)
Dr. Forfeiture account 250
Cr. Calls in arrears a/c 250
(To record forfeiture of shares whose calls have remained in arrears for a period
exceeding the allowed limit.)
Dr. Ordinary capital share capital a/c 1,000
Cr. Forfeiture account 1,000
(To record the cancellation of the shares from the issued share capital)
Reissue of forfeited shares
If the forfeited shares are reissued to another shareholder, the following entries will be made:
Dr. Bank a/c
Cr. Reissue of forfeited shares a/c
(To record the amount paid for the shares by the new shareholders)
Dr. Reissue of forfeited shares a/c
Cr. Ordinary share capital a/c
(To record the reissue of shares)
Dr. Forfeiture a/c
Cr. Reissue of forfeited shares a/c
(To transfer the balance in the Reissue of forfeited shares a/c to the forfeiture account)
Dr. Forfeiture account
Cr. Share premium account
(To transfer the balance in the forfeiture a/c to the share premium account)
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S T U D Y T E X T
>>> Illustration 3 - continued
Assume that the shares forfeited were reissued at Sh 5. The entities would follow as thus.
Dr. Bank a/c 500
Cr. Reissue of forfeited shares a/c 500
(To record the amount paid for the shares by the new shareholders)
Dr. Reissue of forfeited shares a/c 1000
Cr. Ordinary share capital a/c 1000
(To record the reissue of shares)
Dr. Forfeiture a/c500
Cr. Reissue of forfeited shares a/c 500
(To transfer the balance in the Reissue of forfeited shares a/cTo the forfeiture account)
Dr. Forfeiture account 250
Cr. Share premium account 250
(To transfer the balance in the forfeiture a/c to the share Premium account)
The accounts showing the forfeiture and re issue of the shares would appear as follows:
COMPANY ACCOUNTS
Calls in arrears a/c
First and final call
Sh
250
Forfeiture account
Sh.
250
First and final call
Sh
Calls in arrears a/c
Sh.
250
Forfeiture account
Calls in arrears a/c
Reissue of forfeited shares a/c
Share premium account
Sh
250
500
250
Ordinary capital share capital a/c
Sh.
1000
1000 1000
Ordinary capital share capital a/c
Sh
Sh.
2 5 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
9.8 RIGHTS ISSUE
Fast forward – rights are normally given on pro-rata basis.
A rights issue is an option on the side of the shareholder given by the company given to existing
shareholders to purchase the company’s shares at a price lower than the prevailing market value
of the share. The option is normally given on pro-rata basis.
In response to the rights issue the shareholder may:
§ Buy the shares and exercise the rights
§ Sell the rights to a third party in the market or
§ Ignore the rights, in which case the directors may decide to issue the shares in any
other way.
§ The rights issue is beneficial to a company since it provides a cheap means to raise
new long term capital via the issue of shares.
Reissue of forfeited shares a/c
Share premium account
500
250
1000 1000
Ordinary capital share capital a/c
Forfeiture account
Sh
1000
Reissue of forfeited shares a/c
Sh.
1000
Bank a/c
Reissue of forfeited shares a/c
Sh
500
Sh.
Reissue of forfeited shares a/c
ordinary capital share capital a/c
Sh
1000
Bank a/c
Sh.
500
Forfeiture account 500
1000 1000
RIGHTS ISSUE
Fast forward – rights are normally given on pro-rata basis.
A rights issue is an option on the side of the shareholder given by the company given to
existing shareholders to purchase the company’s shares at a price lower than the
prevailing market value of the share. The option is normally given on pro-rata basis.
In response to the rights issue the shareholder may:
 Buy the shares and exercise the rights
 Sell the rights to a third party in the market or
 Ignore the rights, in which case the directors may decide to issue the shares in
any other way. The rights issue is beneficial to a company since it provides a
cheap means to raise new long term capital via the issue of shares.
Issue of debentures
As explained earlier, a debenture is a loan capital to the business. The entries for issue
of debentures are similar to those for the shares. Actually if the word debenture was to
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S T U D Y T E X T
ISSUE OF DEBENTURES
As explained earlier, a debenture is a loan capital to the business. The entries for issue of
debentures are similar to those for the shares. Actually if the word debenture was to replace the
word share capital, the entries in the accounts would be identical.
Redemption of Redeemable Preference Shares and Redeemable
Debentures
Redeemable preference shares
Redeemable preference shares are shares that can be redeemed (bought back by the company
from the shareholders) at later date as stipulated in the terms laid down.
The redemption is necessitated by the fact that the company might have been in need of large
amounts of capital initially but not indefinitely since accumulated profits will take its place.
Preference shares are not a cheap source of capital considering that fixed dividends have to be
paid to them in each period dividend is declared. Redemption of preference shares is thus a relief
to the company.
During redemption the following should be observed:
1. The preference shares being redeemed must be fully paid
2. There must be funds to cater for the redemption provided from:
§ New issue of shares
§ Profit reserves
§ Partly from the issue of new shares and partly from the profit reserves.
If funds are obtained from the profit reserves, they are first transferred to a capital
redemption reserve fund. This account replaces the redeemed preference shares in
the Financed-by section of the Statement of financial position.
3. If the shares are redeemed at a premium e.g. Sh 10 preference shares being redeemed
at Sh 15, the funds to cater for the premium on redemption should be obtained from:
§ Share premium account if one exists
§ In the absence or insufficiency of share premium then use the profit reserves
In the section following, we shall consider the journal entries necessary to record the
redemption as well as statement of financial position extracts showing the effect of the
redemption of the preference shares. Actually, most examiners will require students to
prepare journal entries showing the redemption of the shares.
COMPANY ACCOUNTS
2 5 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
>>> Illustration I
During the year ended 31 December 2007 ABC company ltd redeemed 1000 Sh 5 preference
shares at par.
As at 31 December 2006 the statement of financial position revealed:
Sh
Other assets 13000
Bank 7000
Ordinary share capital 5000
Redeemable preference share capital 5000
Statement of comprehensive income 7000
Creditors 3000
Required:
a) make journal entries to record the above information
b) prepare the statement of financial position as at 31 December 2007
Assuming that:
1. To cater for this Abc company issued 1000 Sh 5 new ordinary shares.
2. No new shares are issued to cater for the redemption
3. 500 Sh 5 ordinary shares are issued
Suggested solution:
1. a)
Journal entries
Dr. bank 5000
Cr ordinary share capital 5000
(To record issue of ordinary shares at par)
Dr. redeemable preference shares 5000
Cr. Bank 5000
(To record redemption at par)
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S T U D Y T E X T
1 b)
Statement of financial position extract:
Abc company ltd
Statement of financial position as at 31st December 2007
Other assets 13,000
Bank 7,000
20,000
Financed by
Ordinary share capital 10,000
Statement of comprehensive
income
7,000
Creditors 3,000
20,000
Solution
2 a)
Dr. Profit and loss account 5,000
Cr. Capital redemption reserve fund 5,000
(To record transfer of funds to the capital redemption reserve fund)
Dr redeemable preference shares 5,000
Cr. Bank 5,000
(To record redemption at par)
2 b)
Statement of financial position extract:
Abc company ltd
Statement of financial position as at 31 December 2007
Other assets 13,000
Bank 2,000
15,000
Financed by
Ordinary share capital 5,000
Statement of comprehensive
income
2,000
Capital redemption reserve
fund
5,000
Creditors 3,000
15,000
COMPANY ACCOUNTS
2 6 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
Solution
3 a)
Dr. bank 2,500
Cr ordinary share capital 2,500
(To record issue of ordinary shares at par)
Dr. Profit and loss account 2,500
Cr. Capital redemption reserve fund 2,500
(To record transfer of funds to the capital redemption reserve fund)
Dr redeemable preference shares 5,000
Cr. Bank 5,000
(To record redemption at par)
3 b)
Statement of financial position extract:
Abc company ltd
Statement of financial position as at 31 December 2007
Other assets 13,000
Bank 4,500
17,500
Financed by
Ordinary share capital 7,500
Statement of comprehensive
income
4,500
Capital redemption reserve
fund
2,500
Creditors 3,000
17,500
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S T U D Y T E X T
CHAPTER SUMMARY
The major types of capital that a company has are:-
• Share capital – Both preference and ordinary share holdings.
• Loan capital.
The major differences between the public and private companies are:
Public company Private company
They have no maximum limit for membership Has a maximum limit of 50 members
Their membership is open to the public
Membership open only for relatives or close
associates of the existing members
Can raise capital through the issue of shares to
the public
Cannot raise capital from the general
public
There is free transfer of shares amongst
shareholders
Transfer of shares is restricted and must be
authorized.
CASE STUDY
The announcement by Equity Bank that their shares will trade on the NSE beginning 7th August,
2006 surprised many, mostly because they had refused to sell new shares to an expecting public.
The bank may have been motivated to take this path for several reasons:-
• Fear to dilute the stake of anchor shareholders.
The bank’s ownership structure now stands as: IFC & AFRICAP 18%, BRITAK 12%
OTHERS 75%.
If the bank was to float new shares, they would have to reduce the stakes of these
three. This must have been a scaring prospect for these shareholders as they would
like to maintain the control they now have over the bank
• CMA, NSE & brokers' fees.
By avoiding to list new shares, the bank have deftly avoided a substantial chunk of the
fees payable to these institutions while at the same getting to trade at the NSE. They
have also managed to escape to pay fees to a myriad of market operatives including
brokers, lawyers, and agents (read banks). In the Scanad IPO which is much smaller,
this is a hefty Sh 70m. Equity’s would have hit nearly Sh 200m in fees alone.
(Source, http://gathinga.blogspot.com)
CHAPTER QUIZ
1. Which share holders received dividend first?
2. What is the difference between Participating and non participating preference shares?
COMPANY ACCOUNTS
2 6 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
ANSWERS TO CHAPTER QUIZ
1. Preference shares are the shareholders who receive their dividend at an agreed rate
before the ordinary shareholders receive anything.
2. Participating preference shares are shares that receive an agreed percentage of
dividends before the ordinary shareholders and still receive a portion of the remaining
profits being distributed to the ordinary shareholders, while Non participating
preference shares only receive the agreed percentage of dividend, no more.
PAST PAPER ANALYSIS
6/07, 6/06, 12/05, 6/05, 12/04, 6/04, 6/03, 12/02
EXAM TYPE QUESTION
Question 1 (June 2007 Question 1)
a) (I) distinguish between share premium and revaluation reserves. (2 marks)
(ii) Briefly explain how a company can utilize its share premium (2 marks)
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S T U D Y T E X T
b) The following trial balance was extracted from the books of pata Ltd., as at 31 December
2006:
Sh. ‘000’ Sh. ‘000’
Ordinary shares of Sh 10 each 150.000
8% preference shares of Sh 10 each 50.000
7% debentures 100.000
Share premium 20.000
General reserves 65.000
Retained earnings (1 January 2006) 35.000
Land at cost 111.000
Plant and machinery at cost 382.000
Provision for depreciation – plant and machinery 85.500
Sales 290.000
Discounts allowed/received 3.200 4.600
Accounts receivable/payable 48.000 27.000
Inventory (1 January 2006) 35.000
Cash at bank 7.500
Carriage inwards 1.000
Purchases 165.000
Salaries and wages 32.100
Electricity 2.900
Interest on debentures 7.000
Directors fees 12.000
Provision for bad and doubtful debts 1.500
General expenses 11.900
Interim dividends paid Ordinary 7.500
Preference 2.000
Suspense account _____ 400
829.000 829.000
Additional information:
1. During the year, land was revalued to Sh 180 million by the directors, the revaluation
reserve arising from land revaluation was partly utilized to finance the issue of Sh 1
bonus share for every 10 ordinary shares held
The bonus shares were issued to the existing ordinary shareholders on 29 December
2006 although no entry had been recorded in the books of Pata Ltd.
COMPANY ACCOUNTS
2 6 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
2. Inventory as at 31 December 2006 was valued at Sh 41 million.
3. Corporation tax is estimated at Sh 3 million while unpaid wages as at 31 December
200t amounted to Sh 150 000.
4. General expenses include an insurance premium amounting to Sh 200.000 for the
period 1 April 200t to 31 March 2006.
5. A machine which had cost Sh 2 million was disposed of on 1 January 2006. The
accumulated depreciation on disposal of the machine was Sh 1.5 million. The cash
received in respect of the sale was Sh 400.000 which was recorded in a suspense
account.
6. A provision is to be made for bad and doubtful debts at the rate of 2 ½ % of the accounts
receivable.
7. The company depreciates its plant and machinery on straight line basis at the rate of
10% per annum.
8. The directors propose to pay a final ordinary dividend of 5% and also transfer Sh 5
million to general reserves.
Required:
i. Trading, statement of comprehensive income for the year ended 31 December 2006.
(8 marks)
ii. Statement of financial position as at 31 December 2006.
(8 marks)
(Total: 20marks)
Question 2 (December 2005 Question1)
Araka Ltd., a company dealing in retail products, extracted from the following trial balance as at
30 September 2005:
Sh. ‘000’ Sh. ‘000’
Freehold land: Cost 121,500
Buildings: Cost 431,000
Accumulate depreciation 68,960
Plant and machinery: Cost 64,172
Accumulated depreciation 16,074
Sales 1,312,567
Purchases 839,004
Cash in hand 1,268
Creditors ledger control account 21,172
Electricity 6,917
Ordinary share capital 50,000
Cash at bank 1,210
Debtors ledger control account 61,074
Suspense account 4,300
Inventory as at 1 October 2004 41,912
Retained profits 296,057
Motor vehicle expenses 4,174
Sundry expenses 2,002
Salaries and wages 121,600
Directors remuneration 48,999
Bank charges 1,621
Motor vehicles: Cost 28,900
Accumulated depreciation ________ 14,712
1,779,542 1,779,542
265
S T U D Y T E X T
Additional information:
1. Provision for doubtful debts should be made at 2% of the debtors ledger balances after
writing of bad debts amounting to Sh 1,370,000.
2. The suspense account was analyzed as follows:
Sh. ‘000’ Sh. ‘000’
Bad debts written off during the year 512
Motor vehicle purchased on 1 April 2005 7,400
7,912
Less: motor vehicle sold on 1 April 2005 3,000
Amounts received in respect of a bad debt recovered 612 (3,612)
4,300
3. The motor vehicle sold during the year had been purchased on 1 February 2002 for Sh
6,500,000.
4. Bank statement as at 30 September 2005 showed bank charges of Sh 533,000. This
had not been recorded in the cash book.
5. The debtors’ ledger control account did not agree with the list of balances in personal
accounts. You ascertain that some invoices for October 2005 had been posted in the
personal accounts as at September 2005. The list of balances was overstated by Sh
4,300,000.
6. Estimated corporation tax for the year ended 30 September 2005 was Sh131,700,000.
7. The value of inventory as at 30 September 2005 was amounted to Sh 62,047,000.
8. The directors proposed to pay ordinary dividend of 10%.
9. The following petty cash expenditure had not been recorded:
Sh. ‘000’
Motor vehicle expenses 412
Sundry expenses 91
Casual workers wages 36
10. Depreciation is provided at the following rates:
Buildings – 2% per annum on cost
Plant and machinery – 20% per annum on reducing balance basis.
Motor vehicle – 25% per annum on cost
Full year’s depreciation is provided in the year of purchase and none in the year of
disposal.
Required:
a) Statement of comprehensive income for the year ended 30 September 2005.
(12 marks)
b) Statement of financial position as at 30 September 2005
(8 marks)
(Total: 20 marks)
COMPANY ACCOUNTS
2 6 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
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S T U D Y T E X T
CHAPTER TEN
INCOMPLETE RECORDS
S TSUTDUYD YT ETXETX T
2 6 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
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S T U D Y T E X T
CHAPTER TEN
INCOMPLETE RECORDS
OBJECTIVES
After you study this chapter, you should be able to:
• To calculate figures of cost revenue and profit for a business that is not maintained
through double entry using the various methods.
• Use control accounts to check the accuracy of posting in the ledgers.
• Explain why we maintain control accounts.
INTRODUCTION
As we discussed previously, recording of business transactions in the company’s books is a
systematic process. Information is transferred from one stage to the next for further processing
and analysis. In some cases however we may not be able to identify the process from its start to
its end. This may be as a result of the business having incomplete records due to failure to keep
proper accounting records or the records being destroyed accidentally
With incomplete records however, we may still be able to compute values for revenues, costs
and profits. This will usually be done by adopting a backward approach.
EXAM CONTEXT
Incomplete records can be tested in all forms of accounts; manufacturing accounts, partnership
accounts and company accounts are just example of other chapters that can be examined
together with this chapter.
INDUSTRY CONTEXT
Buildings do burn and all or part of the records lost. In such a case we still have with the limited
records available have to provide financial statements for all stakeholders.
Incomplete records are therefore very crucial. They could be used by insurance companies to
back up claims on damages.
2 7 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
10.1 WORKING WITH INCOMPLETE RECORDS
Fast forward – incomplete records can be used to prepare financial statements by adopting a
backward approach
To arrive at the figures of cost revenue and profit for a business that is not maintaining double
entry, the following methods can be used:
• Use of control accounts
• Use of ratios
• Estimating income from net assets
• Use of simple cashbook and bank statement
Most business enterprises use a blend of methods i) and iv) to arrive at the figure of financial
statement presentation. Control accounts are largely divided into two:
a) Debtors ledger control account
b) Creditors ledger control account
The two accounts help one to arrive at the figure of both sales and purchases respectively.
The cashbook and the bank statement help one to account for transactions involving cash receipts
and cash payments. This include expenses paid in cash, cash purchases, cash sales etc
Method (iii) is usually a simper method. It is based on the fundamental accounting equation.
A = C + L
This would mean that for a business that does not generate profits in a given period the assets
at the beginning should be equivalent to assets as to the end.
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S T U D Y T E X T
Assuming there is no new capital injected into a business enterprise, then any increase in the net
assets will be brought about by profits and if net assets decrease it could be as a result of either
losses or drawings or both.
Profit /loss = Closing Capital – Opening Capital – Drawing – Capital injected during period.
>>> Examples:
Rongai traders had the following opening balances as at the beginning of the year 2005
Sh
Land and buildings(N.B.V) 200,000
Furniture and fittings(N.B.V) 75,000
Motor vehicles(N.B.V) 120,000
Cash in hand 7,000
Debtors 42,000
Creditors 64,000
Bank overdraft 78,000
Long-term loan 50,000
Stock 28,000
The closing balances at the end of the year were as follows:
Sh
land and buildings (N.B.V) 180,000
furniture and fittings (N.B.V) 70,000
motor vehicles (N.B.V) 100,000
cash in hand 21,000
Cash at bank 87,000
Debtors 96,000
Creditors 72,000
long-term loan 40,000
Stock 18,000
Drawings made during the year amounted to Sh 14200
Compute the profit for the year 2005.
Solution:
We know that,
Profit/loss = closing capital – opening capital – drawings – capital injected
To get the opening capital, we use the equation
A = C + L
Hence C = A – L
INCOMPLETE RECORDS
2 7 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Computation of opening capital
Assets Sh
land and buildings(N.B.V) 200,000
furniture and fittings(N.B.V) 75,000
motor vehicles(N.B.V) 120,000
cash in hand 7,000
Debtors 42,000
Stock 28,000
472,000
less liabilities
Creditors 64,000
bank overdraft 78,000
long-term loan 50,000
-192,000
beginning capital 280,000
Closing capital balance:
Assets Sh
land and buildings(N.B.V) 180,000
furniture and fittings(N.B.V) 70,000
motor vehicles(N.B.V) 100,000
cash in hand 21,000
Cash at bank 87,000
Debtors 96,000
Stock 18,000
572,000
long term loan 40,000
Creditors 72,000
-112,000
460,000
From the above:
Profit = 460000 – 280000 – 14200
= Sh 165800
To estimate the beginning or ending balance, we can use a Statement of affairs. As the name
suggests a statement of affairs is a statement from which the capital of an owner can be found by
estimating assets and liabilities as at a given time. A statement of affairs adopts the same format
as that of a statement of financial position only that the objective of this statement is to obtain the
figure for the capital balance.
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XYZ Limited
Statement of affairs as at xx xx xx
Sh Sh Sh
Non-current assets Cost
Accumulate
depreciation
NBV
land and buildings xxx
plant and equipment xx
less accumulated
depreciation
(xx)
xx
fixtures, furniture and fittings xx
less accumulated
depreciation
(xx)
xx
motor vehicles xx
less accumulated
depreciation
(xx)
xx
total non-current assets xxx
Current Assets
stock xx
debtors xxx
less provision for doubtful
debts
(xxx)
xxx
prepayments xxx
short term investments xxx
cash at bank xxx
cash in hand xxx
total current assets xxx
less Current Liabilities
bank overdraft xxx
creditors xxx
accruals xxx
interest payable (debenture
interest)
xxx
tax payable xxx
dividends payable xxx
(xxx)
net current assets xxx
total assets yyyyy
Financed By
long term liabilities xxx
6% long term loan xxx
10% debenture xxx
(xxxx)
Capital difference xxxx
INCOMPLETE RECORDS
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S T U D Y T E X T
10.2 DRAWING FINANCIAL STATEMENTS
From the preceding example you will realize that we only obtain profits as the difference between
the opening and the closing capital balances (net of drawings)
However, you will also realize that the figures only give the profit for the period. There is no other
information that can be deducted from it.
Financial statements are meant to give a true and fair view of the results of the operations. This
enables the management to make informed decisions. Apart from the profitability for a given
period, an organization will be interested in knowing the following:
i) Total sales during the period
ii) Total cost of sales during the period
iii) Total operating expenses on an item to item basis
iv) The profit mark-up margin
This therefore raises the need for more comprehensive/detailed financial statements and more
so a detailed P & L account.
To achieve this objective when dealing with incomplete records, we make use of control
accounts.
10.3 CONTROL ACCOUNTS
Fast forward – Control accounts are basically used to check the accuracy of posting in the
ledgers.
TYPES OF CONTROL ACCOUNTS
We are going to cover two control accounts:
i) Sales ledger control account
ii) Purchases ledger control account
Control accounts operate on the principle that if the opening balance of an account is known,
additions and deductions are known, and then the closing balance can be calculated. Put in
another way, when we have the opening balance of a control account, we know some of the
items affecting both the credit and the debit side of the account as well as the closing balance,
and then we can obtain the missing balances.
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S T U D Y T E X T
i) Sales Ledger Control Account
This also referred to as the debtors control account. A sales ledger control account is similar to
the account of an individual debtor only that the items that will be reflected in the account will be
for all the debtors and the transactions affecting them during a specific period of time.
This account comprises the following entries:
• opening balances of debtors • dishonored cheque
• closing balance of debtors • bad debts recovered
• credit sales during the period • bad debts written off
• returns by debtors
• cash received from bad debts
recovered
• set-off’s • purchases ledger contra
• cash received from debtors(both cash
and cheque)
• allowances to customer
• discounts allowed
• refund to customers
In most cases, all the figures will be available from the information given apart from the total
credit sales. It is for this reason that we prepare the sales ledger control account to help us obtain
the figure for credit sales that will assist us in obtaining total sales to be used in the statement of
comprehensive income
Format for the sales ledger control account
Dr Cr
balance b/d (debit balance) xx balance b/d (credit balance) xx
credit sales during the period xx cash received from debtors xx
refund to customers xx cheques received from debtors xx
bad debts recovered xx total returns by debtors xx
dishonored cheque xx discounts allowed xx
allowances to customer xx
cash received from bad debts
recovered
xx
bad debts written off xx
purchases ledger contra xx
total credit balance c/d (balancing
figure)
xx
total debit balance c/d (balancing
figure)
xxx
xxx xxx
INCOMPLETE RECORDS
2 7 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
Notes:
i) It is possible to have balances brought forward in the sales ledger control account as
both a debit and a credit balance.
Debit balance is the normal total of the account. A credit balance will arise when one or
more debtor accounts have a credit balance i.e. the company owes them refund. This
is most common when there is overpayment by a debtor.
ii) Purchases ledger contra;
This is also termed as set-off. It occurs when companies/individuals trade with each
other in such a way that both companies sell products to each other and also buy from
each other. E.g. assume a hardware that sells timber to a carpenter. One day, it orders
for a set of tables to be made by the carpenter. They could enter into an agreement
whereby the carpenter will take the timber and make the table then net off what is to be
paid to the hardware.
iii) Allowances
These are price reductions in excess of discounts allowed to customers.
iv) Refund to customers
This happens when a customer has a credit balance in his account. This could happen
when goods have been returned to us or there had been an overpayment.
v) Cash sales are not included in the sales ledger control account. Only credit sales and
cash received from credit sales is included.
vi) Provision for doubtful debts is not including in the sales ledger control account.
vii) Only cash discounts allowed are entered in the sales ledger control, trade discounts are
not included.
ii) Purchases ledger control account
This account is also known as total creditors control account. This account is similar to an
individual; creditors account only that it will include details and transactions entered into by all
the creditors, hence the name ‘total creditors account’.
The account comprises the following entries:
total credit balance brought forward
total debit balance brought forward
total cheques paid to creditors (for credit purchases)
total cash paid to creditors (for credit purchases)
total discounts received
allowances by suppliers
sales ledger control
total return outwards
total credit purchases from the journal
refund from suppliers
total credit balance and total debit balances
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Format of a purchases ledger control account
Dr Cr
total debit balance brought forward xx
total credit balance brought
forward
xx
total cheques paid to creditors
(for credit purchases)
xx
total credit purchases from the
journal
xx
total cash paid to creditors (for credit
purchases)
xx refund from suppliers xx
total cash discounts received xx
allowances by suppliers xx
sales ledger xx
total return outwards xx
total credit balance c/d(balancing figure) xx
total debit balance c/d(balancing
figure)
xxx
xxx xxx
Notes
i) It is possible as was the case with the sales ledger to have both a debit and credit
balance brought forward in the total creditors account. This is because we could have
over paid our suppliers and thus has a debit balance in our account. We could also
have returned goods for which we had paid.
ii) For cash paid and cheques paid to creditors, we only consider the amount paid for the
credit sales. Cash sales are not part of the creditors control account since this account
only records purchase on credit. Cash purchases are accounted for differently to arrive
at the total purchases figure for the period.
iii) Refund from suppliers: This happens incase we overpaid the suppliers or we returned
goods we had paid for among other reasons.
iv) Allowance by suppliers this reduction in price in excess of cash discounts received.
v) We only consider the cash discount received. Trade and other discounts are not
considered in the purchases ledger control.
INCOMPLETE RECORDS
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S T U D Y T E X T
10.4 REASONS FOR MAINTAINING CONTROL ACCOUNTS
- Ensures arithmetic check on the accounting record
- Incases of incomplete records
- Provides a quick figure for total balances as at a given time to be reflected in the
statement of financial position as debtors and debtors respectively
- Detect and prevent fraud In the suppliers and the customers accounts
- Facilitate allocation of duties among the debtors and creditors-handling staff.
The same principle of preparing the purchases ledger control account and the sales ledger
control account applies when preparing financial statements. However, in the case of incomplete
records, of utmost importance is to obtain the figure for credit purchases and credit sales. In
most cases, we can trace in some way the other balance and hence our balancing figures would
be credit sales in the sales ledger control account and credit purchases in the purchases ledger
control account.
Having obtained the above figure, the next step would be to obtain the following:
i) Expenses for the period
ii) Cash sales for the period
iii) Credit sales for the period
When there is no accrual or prepayment of expenses, the amount shown in the cashbook as paid
for the period will amount to total expenses for the period. However, incase there are accruals, or
prepayments, we would need to prepare the specific expenses accounts that would help us get
the actual expenses for the period.
10.5 STOCK LOSS
Fast forward – to estimate stock loss we would have to use a gross profit percentage where
there are no stock record documents.
Sometimes stock could be lost, or even destroyed through fire. We would need to establish the
amount of stock loss for our purpose of establishing profits. Possible scenarios are that:
i) We could be keeping perpetual stock taking records and hence it would be easy to
extract the figure of stock stolen, lost or destroyed.
ii) We would have had a stock count before the loss
However in most business organizations and especially the small business organizations there
are no stock record documents. Therefore to identify the amount of stock loss, we would have to
use a gross profit percentage.
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S T U D Y T E X T
>>> Example
On 29th November 2005 there was a fire out break at the premises of Wajibu enterprises. The
whole of his stock, purchases and sales journal all got burnt in the fire except for stock worth Sh
24600 that was in the loading bay even though cleared in by the supplier. However the sales
ledger and the purchases ledger were salvaged.
The following figures were available on 30th November 2005:
a) Stock at the last statement of financial position date 31st December 2004
was Sh 249000
b) Receipts from debtors during the period to 29th November was Sh 634900
Debtors were Sh 285560 on 31st December 2004 and Sh 246660 on 29th November
2005
c) Payments to creditors during the period 1st January 05 – 29th November 05 was Sh
345400. Creditors were Sh 152000on 31st December 04 and 125780 on
29th November 2005
d) The gross profit margin on all sales has been constant at 25%
All sales were made on credit and all purchases made on credit
Required
Compute the amount of stock destroyed by fire on 29th November 2005
Solutions:
First compute the amount of credit sales and credit purchases
Sales ledger control account
Dr Cr
balance b/f 285,560 Bank 634,900
credit sales 596,000
balance c/d 246,660
881,560 881,560
Purchases ledger control account
Dr Cr
bank 345,400 balance b/f 152,660
credit purchases 318,520
balance c/d 125,780
471,180 471,180
INCOMPLETE RECORDS
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S T U D Y T E X T
WAJIBU ENTERPRISES
TRADING ACCOUNT FOR THE PERIOD ENDED 30TH NOVEMBER 2005
Sh Sh
sales 596,000
less cost of sales
opening stock 249,600
add purchases 318,520
goods available for sale 568,120
less closing stock x
cost of sales xx
gross profit at 25% 149,000
G.P - 25 x 596000 = 149,000
100
596,000 – (Cost of sales) = 149,000 (gross profit)
Cost of sales = 596,000 – 149,000 = 447,000
Goods available for sale - closing stock = cost of sales
Closing stock = goods available for sale – cost of sales
Closing stock = 568,120 – 447,000 = 121,120
Stock destroyed = closing stock – salvaged stock
= 121,120 – 24,620
= Sh 96,500
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S T U D Y T E X T
CHAPTER SUMMARY
To arrive at the figures of cost revenue and profit for a business that is not maintaining double
entry, the following methods can be used.
i) Use of control accounts
ii) Use of ratios
iii) Estimating income from net assets
iv) Use of simple cashbook and bank statement
Control accounts are basically used to check the accuracy of posting in the ledgers. The major
types of control accounts used are:
i) Sales ledger control account
ii) Purchases ledger control account
CASE STUDY
A good example closer home would be the Nakumatt Downtown Store that burned down in
February, 2009. Most of the records for the day must have burned down; stocks worth millions
were lost in the furnace. The stock had to be accounted for so that all stakeholders could be given
a figure on how much was lost. These stakeholders include owners, bankers and the insurance
company that would need good backing before compensating any damages.
Incomplete records accounting had to come into play to give correct information on the losses for
inclusion into the chains financial statements.
CHAPTER QUIZ
1. In the absence of a sale account or sales day book, how can a figure of sales
for the year be computed?
2. What methods can be used to arrive at the figure of cost revenue and profit
for a business that is not maintaining double entry?
3. A business has opening payables of Sh 75 million and closing payable of
Sh 65 million and discounts received of Sh 3 million. What is the figure for
purchases?
INCOMPLETE RECORDS
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S T U D Y T E X T
ANSWERS TO CHAPTER QUIZ
1. By using the trade accounts receivable control account to calculate sales as a balancing
figure.
2. - Use of control accounts
- Use of ratios.
- Estimating income from net assets.
- Use of simple cash book and bank statement.
3.
Payables control
Sh (millions) Sh Millions
Bank 65 Opening payables 75
Discounts received 3 Purchases 58
Closing payables 65
133 133
PAST PAPER ANALYSIS
6/07, 12/06, 12/04, 12/03
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EXAM TYPE QUESTIONS
QUESTION 1
Crown Garments Wholesalers Ltd., was burgled on the night of 14 December 2006. The burglars
stole all the cash takings for the day together with the petty cash and some of the expensive
clothing.
On 30 November 2006, the owner had taken a physical stock count which established the value
of stock at Sh 32540000. The stock of clothing left after the burglary amounted to sh11300000
at cost. Deliveries of additional stock items from suppliers between 1 December 2006 and 14
December 2006 were invoiced at Sh 5784000 after deducting trade discounts of sh 732000.
Sales to retail customers (at selling prices) were as follows:
Period Cash sales Credit sales
Sh. Sh
1 December 2006 to 6 December 2006 1429710 6.250.290
7 December 2006 to 13 December 2006 1644500 8.079.500
14 December 2006 259320 1200680
Additional information:
1) The cash takings from 1 December 2006 to 13 December 2006 (inclusive) had been
banked intact.
2) Cheques for Sh.168.920 and Sh 192670 had been drawn to pay staff wages.
3) Credit customer had paid cheques amounting to Sh 15867110 (all of which had been
banked) in full settlement of accounts totaling Sh 16102830.
4) The company had paid credit suppliers a total of Sh 17118360 (all of which had been
presented to bank) in full settlement of accounts totaling Sh 17532800.
5) The petty cash imprest account had been replenished to its established level of
sh.25.000 on 1 December 2006 by withdrawal from the bank of Sh 9740. Subsequent
disbursements to 14 December 2006 had amounted to Sh 13690.
6) The cash book balances in the firms records on 30 November 2006 were as follows:
Sh.
Balance at bank 6.625.080 (debit)
Cash in hand 129.600
Petty cash 15.260
7) The gross profit margin had been at the rate of 30% throughout the year 2006. However,
from 7 December 2006 the company reduced the mark-up on cost to 331/3% as a
strategy to boost sales.
Required:
a) The amount of cash stolen. (6 marks)
b) The value of stock (at cost) stolen. (8marks)
c) The balance at bank close of business on 14 December 2006. (6 marks)
INCOMPLETE RECORDS
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CHAPTER ELEVEN
COMPUTERIZED
ACCOUNTING
S TSUTDUYD YT ETXETX T
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CHAPTER ELEVEN
COMPUTERISED ACCOUNTING
OBJECTIVES
After studying this chapter, you should be able to:
• Identify the different accounting packages.
• Explain the rationale for computerized accounting system.
• List the components of a computerized accounting system.
• Select a good computerized accounting system.
• Explain the challenges of a computerized system.
• Explain current trends in computerized accounting software.
INTRODUCTION
Keeping accurate accounting records is a vital part of managing an organization. Apart from
helping to keep it afloat financially and legally, it is also a requirement of funding bodies. Smaller
groups can usually manage with simple book-keeping procedures but bigger groups juggling with
larger sums of money and more complex financial transactions may find their workload eased
by using a computerized accounting system. The good news is that there are easy to use and
reasonably priced computerized accounting package are available on the market.
DEFINITION OF KEY TERMS
1. Portfolio - In finance, a portfolio is an appropriate mix of collection of investments held
by institutions or a private individual.
2. Configuration - In communications or computer systems, a configuration is an
arrangement of functional units according to their nature, number, and chief characteristics.
Often, configuration pertains to the choice of hardware, software, firmware, and
documentation. The configuration affects system function and performance.
EXAM CONTEXT
This is a new chapter. It has not been examined in the past and could be examined considering
the fact that most entities have moved to computerized accounting and this is what accountants
and auditor are using.
2 8 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
INDUSTRY CONTEXT
Most entities have moved to computerized accounting owing to its advantages (notably high
speed and accuracy). It’s therefore increasingly become a requirement that accountants and
auditors be conversant with computerized accounting.
11.1 CLASSIFICATIONS OF COMPUTERISED ACCOUNTING
Fast forward - Accounting software that is designed for home use is often referred to as personal
accounting software.
There are many types of accounting software applications on the market today. Some applications
are intended to perform accounting functions for large corporate organizations. Others are meant
for personal use. Still other applications fall somewhere in between, performing functions suited
to small businesses, as well as those suited to the average person. Available software ranges
from the very simple to the very complex, with much variation in price as well.
Accounting software can be useful in such functions as recording and processing accounts
receivable and accounts payable transactions. Some software applications can be used in
payroll processing, the documentation of tax transactions, and the creation of related reports.
Accounting software can also be used in billing clients and customers and debt collection. Some
accounting programs even provide for timesheet record keeping, useful for professionals who
need to keep track of the hours they work.
Accounting software that is designed for home use is often referred to as personal accounting
software. This type of software is used mostly in managing household budgets and expenses.
Some personal accounting software makes it possible to download bank account information
directly from the Internet for use with the software.
Low-end accounting software is generally used by smaller businesses and can typically be
found for sale by a variety of retailers. Usually, software in this class is not highly specific and can
be used for a wide range of businesses. This type of accounting program is usually adequate for
such uses as generating invoices, reconciling accounts, and handling payroll.
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S T U D Y T E X T
COMPUTERIZED ACCOUNTING
The next step up in the realm of accounting software consists of applications capable of
performing a variety of functions important to business accounting. Referred to as mid-market
software, accounting applications in this class perform general business accounting functions
and frequently include integrated management information systems. Many software applications
at this level are capable of providing for accounting in several different currencies. Mid-market
accounting software is usually purchased from a dealer.
Higher-end accounting software is more expensive than other types and is usually much more
complex. Generally designed for use by large businesses with millions of dollars in transactions,
high-end accounting programs usually have very sophisticated features and options. Software
in this class also allows for a high level of customization. Typically, higher-end software is sold
through a dealer.
Some companies choose to develop their own accounting software, gearing it completely towards
their unique needs. Other companies choose to purchase ready-made software packages.
Many organizations employ a combination of the two, purchasing software and applying local
modifications to make it more efficient.
11.2 TYPES OF ACCOUNTING PACKAGES
1. QuickBooks
QuickBooks is a line of business accounting software developed and marketed by Intuit. Small
businesses use QuickBooks for most financially-related business processes, from entering sales
receipts, tracking expenses, preparing and sending invoices, sales tax tracking and payment,
preparation of basic financial statements and reports, and inventory management. The program
does not include MICR line printing, but does include check printing and options for employee
payroll and time tracking. For most tasks, QuickBooks doesn’t require users to understand
standard accounting procedures, including double-entry bookkeeping. Most transactions are
recorded using on-line screens that closely resemble paper based forms such as invoices or
checks.
Options now include versions for manufacturers, wholesalers, professional service firms,
contractors, non-profit entities and retailers, in addition to one specifically designed for
professional accounting firms who service multiple small business clients. In May 2002 Intuit
launched QuickBooks Enterprise Solutions for medium-sized businesses.
2. Sage Pastel
Sage Pastel is a leading developer of accounting, payroll, ERP and business management
software for the small, medium and large enterprise market. Founded in 1989, Sage Pastel has
developed an in-depth knowledge and understanding of the industry, establishing itself as the
market leader.
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S T U D Y T E X T
Sage pastel has been developed to provide comprehensive accounting and business solutions
for start-up, small, medium and larger sized companies. Sage Pastel Accounting also offers a
range of add-on modules that can assist your business with CRM, Business Intelligence, legal
and auditing solutions.
4. CreditQuest
CreditQuest is an end-to-end commercial Credit Management System that brings origination,
financial analysis, underwriting, documentation and executive reporting together in a collaborative,
streamlined workflow. It combines a unified, relationship-centric view of the customer’s financial
data and supporting documents with portfolio management capability. Data from CreditQuest
passes seamlessly to LaserPro Harland Financial Solutions’ industry-leading documentation
solution.
CreditQuest is composed of four key functional areas, supported by a robust Report Manager
and over 40 standard reports.
• Credit Manager
• Decision Manager
• Financial Analyzer
• Project Analyzer
• Report Manager
• Portfolio Manager
CreditQuest is mainly used by banks for credit and financial analyses.
11.3 FEATURES OF A GOOD COMPUTERIZED SYSTEM
1. Scalability
It is always very important to remember that as the company business expands, the business
accounting software should also change accordingly. This is particularly true pertaining to the
increase in products and services offered and the number of employees.
Wherever possible, when we choose our accounting package we should try to visualize our
business in 3 or 5 years time and how different it will be. Use this information to guide the
purchase decision. It may well be better to pay a little more now for the software knowing that it
can be easily upgraded when needed with minimum disruption and cost to our business
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S T U D Y T E X T
2. Support
It is important that any software has great support for when something goes wrong (and it always
does).
Secondly, we should ensure that the support should be local or as close as possible to us.
Imagine that things need done with the software by someone trying to help you over the phone.
Wherever possible, make some enquiries with other businesses about the package they use and
who helps them.
3. Accountant Interface
It’s most unlikely we will handle every aspect of our businesses accounting. The accountant is
an important factor in making the right decision. What software are they used to working with and
what do they prefer?
Can we easily supply them data and reports from our accounting package without the need for
any extra work (which we will have to pay for)?
We should interface with them when we are thinking of buying the accounting software.
4. Best Value for Money
Once we have selected the right package for your business the most logical step is to shop for
the best value for money.
Shop around as the price can vary greatly and the product is exactly the same unless the price
differential is with good support or installation assistance.
5. Major Brands
Wherever possible, we should choose the most popular and major brand to avoid the hustle of
dealing with some unknown accounting software house.
Furthermore by choosing a major brand we can get regular updates and also know that the
company will be around as long as your business needs them.
6. Ease of Use
Ease of use is a personal thing but it is worth trying the software before you buy it if you can.
Remember to get the person who will be the main user to test the software as well.
COMPUTERIZED ACCOUNTING
2 9 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Also consider how well the package can interact with other software we are using.
Nowadays, the modern accounting software should come with the import and export data function
where the import and export of data to spreadsheet or vice versa are easily done. With these
capabilities, just in case, there can be more detailed analysis to be done.
7. Features Needed
Most accounting software packages come in several different versions.
If we don’t need certain features now and can’t see a need for them in the future then we need
not buy them.
The major differences are usually - number of users allowed, number of reports available and
others.
11.4 Comparison Of The Steps Of An Accounting Cycle Under The
Manual System and Under The Computerized System
Fast forward – All accounting processes in manual systems are manual.
Steps In Accounting Cycle Manual System Computerized System
1. Analyze source documents Manual Manual
2. Record transactions in journal Manual
Manual data entry
includes manual electronic
coding
3. Post to Ledger accounts Manual Automatic
4. Prepare Unadjusted Trial Balance Manual Automatic
5. Journalize adjusting entries Manual Manual
6. Post adjusting entries Manual Automatic
7. Prepare adjusted Trial Balance Manual Automatic
8. Journalize closing entries Manual Automatic
9. Post closing entries Manual Automatic
10. Prepare post-closing Trial Balance Manual Automatic
11. Prepare financial statements Manual Automatic
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Advantages of a computerized accounting system
a) Faster and efficient in processing of information.
b) Automatic generation of accounting documents like invoices, cheques and statement of
account.
c) With the larger reductions in the cost of hardware and software and availability of userfriendly
accounting software package, it is relatively cheaper like maintaining a manual
accounting system.
d) More timely information can be produced.
e) No more manual processing of the data- all automatically been posted to the various
ledgers/accounts.
f) Many types of useful reports can be generated for management to use in decision
making.
Disadvantages/ Challenges of a computerized accounting system
a) Power failure, computer viruses and hackers are the inherent problems of using
computerized systems.
b) Once data been input into the system, automatically the output are obtained hence the
data being input needs to be validated for accuracy and completeness, we should not
forget concept of GIGO (Garbage In (Input) Garbage out (Output).
c) Accounting system not properly set up to meet the requirement of the business due to
badly programmed or inappropriate software or hardware or personnel problems can
cause more havoc.
d) Danger of computer fraud if proper level of control and security whether internal and
external are not properly been instituted.
Fast forward – like manual accounting, computerized accounting also has controls.
11.5 CONTROLS IN COMPUTERIZED ACCOUNTING
SYSTEM
a) Proper transaction authorization. Input control needs to be instituted like input data
needs to be verified for accuracy and completeness by a person different from the one
who is keying in the data.
b) Besides the above input control, there should be processing and output controls to
ensure integrity of the transaction data is intact.
c) No unauthorized access to computer files, data, etc. All kept under lock and key and
proper log is maintained.
d) Uses of password control to access data.
COMPUTERIZED ACCOUNTING
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S T U D Y T E X T
CHAPTER SUMMARY
The fact that this is a new chapter and the trend in the industry it is a very important chapter both
for your exams and industrial use.
Most companies have moved to computerized accounting, even the small companies have their
computerized need catered for by affordable off the shelf software as mentioned earlier.
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CHAPTER QUIZ
1. Analyzing source documents in both manual and automated accounting
systems is done manually. True or false?
2. Preparation of post-closing trial balance is done automatically in both manual
and computerized accounting systems. True or False?
COMPUTERIZED ACCOUNTING
2 9 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
CHAPTER QUIZ ANSWERS
1. True.
2. False, like all other processes in the manual system it’s done manually.
EXAM TYPE QUESTION
You started work in ABC Company Ltd. The management is asking you to implement a
computerized accounting system. The following questions were posed to you:-
(a) What benefits will a computerized accounting system bring your company? State up to
five possible benefits. (5 marks)
(b) There are so many different packages on the market. What should I be looking for when
selecting a computerized package? List seven factors. (7marks)
(c) If we get a Sales Ledger package what kind of reports should we expect? List six types
of report you would expect. (6marks)
(d) What’s the difference between a stand-alone package and an integrated package?
What are the advantages and disadvantages of each? State the difference and give
two advantages and two disadvantages of an integrated package. (10 marks)
(d) Our computer support staff says that we’ll have to configure the package before we can
use it. What do they mean by that? Explain what configuration involves. (5 marks)
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CHAPTER TWELVE
PUBLIC SECTOR
ACCOUNTING
S TSUTDUYD YT ETXETX T
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S T U D Y T E X T
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CHAPTER TWELVE
PUBLIC SECTOR ACCOUNTING
OBJECTIVES
After studying this chapter, you should be able to:
• List and explain the features of public sector accounting.
• Explain the relevance of accounting concepts, basis and policies to public sector
accounting.
• Explain what fund accounting is and its relationship with entity theory.
• Explain the different ways of income measurement and valuation in the public sector.
• Prepare, analyze and interpret financial statements of government units.
• Deal with accounts of state corporations and similar organizations.
INTRODUCTION
There is increasing demand for public accountability and transparency by all stakeholders in the
Public Sector in Kenya. Revelations during the Public Accounts Committee (PAC) hearings and
in the Auditor-General’s reports raise issues of financial accountability and transparency.
In the past, financial reporting by the Government has largely been seen as inadequate,
government ministries/bodies do not provide understandable financial reports. The reports have
been complex, confusing, and voluminous.
The preparation of transparent and understandable financial statements is an important way
for Government departments/other agencies to demonstrate their accountability to citizens who
fund them through taxes, as well as development partners.
DEFINITION OF KEY TERMS
1. Stewardship - is personal responsibility for taking care of another person’s property or
financial affairs or in religious orders taking care of finances.
2. Transparency - is a management approach in which (ideally) all decision making is
carried out publicly.
3 0 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
EXAM CONTEXT
This is a new chapter. It has not been examined in the past and could be examined considering
the fact that most public sector accounting has increasingly become important with donors and
taxpayers demanding transparency.
INDUSTRY CONTEXT
The number of qualified accountants in Kenya has increased tremendously over the years.
However, the IPSAS is a new concept which is not understood by many. The Government, as the
leading user of these standards, will therefore require undertaking massive training to enlighten
its accountants on IPSAS.
There has been an increasing need for transparent and understandable financial statements by
both taxpayers and donors. This has created the demand for public sector accounting hence the
need for all accountants to understand, be able to prepare and interpret public sector accounts.
12.1 FEATURES OF PUBLIC SECTOR ACCOUNTING
Fast forward – The International Public Sector Accounting Standard Board (IPSASB) is the
global organization for the accounting profession founded in 1977.
International Public Sector Accounting Standards (IPSAS) are a set of high quality,
independently developed, accounting standards aimed at meeting financial reporting needs of
the public sector.
IPSAS are developed by the International Public Sector Accounting Standard Board (IPSASB),
which is an arm of the International Federation of Accountants (IFAC); the global organization
for the accounting profession founded in 1977.
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S T U D Y T E X T
IFAC has 157 member bodies drawn from 122 countries. It represents 2.5 million accountants
around the world. Transition to IPSAS as an accounting framework is designed to improve
the quality and consistency of financial reporting, enhance transparency and accountability;
facilitate better decision making, financial management and good governance in our entire
public sector.
The above reform in financial reporting will mean that the Government will now be able to
produce a consolidated set of general purpose financial statements — it will be interesting and
encouraging seeing the Government’s consolidated financial statements just like those that
companies listed on the Nairobi Stock Exchange prepare.
The International Public Sector Accounting Standards Board (IPSASB) focuses on the accounting
and financial reporting needs of national, regional and local governments, related governmental
agencies, and the constituencies they serve. It addresses these needs by issuing and promoting
benchmark guidance and facilitating the exchange of information among accountants and those
who work in the public sector or rely on its work. A key part of the IPSASB’s strategy is to
converge the IPSASs with the International Financial Reporting Standards (IFRSs) issued by the
IASB. To facilitate this strategy, the IPSASB has developed guidelines or “rules of the road” for
modifying IFRSs for application by public sector entities.
Members of the IPSASB are nominated by IFAC member bodies (like ICPAK) and, for public
members, through nominations from member bodies, other organizations, and the general
public.
Anne Owuor is Kenya nominee to the IPSASB; she became a member of the International Public
Sector Accounting Standards Board in January 2008. She was nominated by the Institute of
Certified Public Accountants of Kenya (ICPAK).
The IPSASB’s objective, scope of activities and membership are set out in its Terms of Reference.
They are also summarized in a fact sheet. The IPSASB’s Strategic and Operational Plan, 2007-
2009 sets out the direction for the board in fulfilling these objectives.
Adoption and implementation of IPSAS is not a requirement for the Government or any of its
entities, it is a best practice issue, IPSASB or even IFAC cannot enforce compliance.
PUBLIC SECTOR ACCOUNTING
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S T U D Y T E X T
12.2 FUND ACCOUNTING AND ITS RELATIONSHIP WITH
ENTITY THEORY
Fast forward – in the fund theory accountability is measured instead of profitability.
FUND ACCOUNTING
Fund accounting serves any non-profit organization or the public sector. These organizations
have a need for special reporting to financial statements users that show how money is spent,
rather than how much profit was earned.
System used by nonprofit organizations, particularly governments. Because there is no profit
motive, Accountability is measured instead of profitability. The main purpose is stewardship of
financial resources received and expended in compliance with legal requirements. Financial
reporting is directed at the public rather than investors.
The accounting equation is Assets = Restrictions on Assets.
Funds are established to ensure accountability and expenditure for designated purposes.
Revenues must be raised and expended in accordance with special regulations and restrictions.
Budgets are adopted and recorded in the accounts of the related fund. Contractual obligations
are given effect in some funds.
ENTITY THEORY
View in which a business or other organization has a separate accountability of its own.
It is based on the equation:
Assets = Liabilities + Stockholders’ Equity
The entity theory considers liabilities as equities with different rights and legal standing in the
business. Under the theory, assets, obligations, revenues, and expenses and other financial
aspects of the business entity are accounted for separately from its owners. In other words, the
company has an identity distinct from its owners or managers. The firm is viewed as an economic
and legal unit.
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S T U D Y T E X T
Relationship Between entity and fund theory
Both the fund theory will focus on ensuring that assets availed to the entity in question are used
appropriately (according to restriction). In the case of fund theory according restriction on assets
(without having to make a profit), this will also be the case for entity theory only that in this theory
it has to be for maximum profits within the restrictions.
12.3 FINANCIAL ACCOUNTING TECHIQUES
Public sector organizations may adopt different accounting techniques; the most important
being:-
1. BUDGETARY ACCOUNTING
Budgetary accounting is the preparation of operating accounts in form of budgets. A budget is a
management plan that has been transformed into figures necessary to evaluate the achievement
of the organization’s objectives.
Under budgetary accounting, the concept is based on the forecasted cash flows; ad operations
must be limited to the budget estimates. The organization cannot spend above budget restrictions
without parliamentary approval.
The executive branch of the government unit proposes the budget, the legislature branch reviews,
modifies and enacts the budget and finally the executive branch implements the budget.
Budget accounting therefore aims to achieve the following:
a. Ensure efficiency of managers.
b. Communicate the objectives of the organization to the employees.
c. Provide controls.
d. Provide a yardstick for measuring performance of employees.
2. CASH ACCOUNTING
Under this system only cash inflows and outflows are recognized and recorded. The system does
not recognize any revenue or expenditure that has not been received or paid (i.e. accrued).
PUBLIC SECTOR ACCOUNTING
3 0 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
3. ACCRUALS ACCOUNTING
The accruals concept states that revenues and costs are recognized as they are earned and
incurred. Most of the organizations in the private sector prefer this method. However, under
public sector accounting, both cash and accruals accounting can be used by different entities or
kinds of organizations e.g. if part of an organization is charged with the responsibility of running
activities on the same basis as commercial organization s, such an entity may adopt accrual
accounting irrespective of the accounting techniques adopted by the main organization.
4. COMMITMENT ACCOUNTING
This accounting system recognizes transactions when the organization is committed to them. It
means the transaction is not recognized when cash is paid or received, nor when an invoice is
received or issued, but at an early stage where orders are received and placed. This accounting
method is meant to ensure that government units do not overspend because transactions will
only be entered into after checking committed balances.
5. FUND ACCOUNTING
An organization may be composed of various entity funds; each fund will have its own books of
account as if it was completely independent from the whole organization.
12.4 ANNUAL ACCOUNTS FOR GOVERNMENT
Every government unit will prepare financial statements to account for the money allocated to
them. The financial statements differ according to the nature of the activities undertaken by
the government unit. However the following types of accounts are common among government
units:
1. INCOME AND EXPENDITURE ACCOUNTS
This is similar to income and expenditure accounts for nonprofit making organizations. It’s
however prepared by government units, which provide commercial services e.g. a staff canteen
or student’s welfare
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S T U D Y T E X T
2. STATEMENT OF ASSETS AND LIABILITIES
Just shows the assets and liabilities in the organization.
3. GENERAL ACCOUNTS OF VOTE (GAV)
During a budget speech, the Minister for Finance will give detailed appropriation (allocations)
of funds to different governmental units. Through an appropriation bill, Parliament will approve
different estimates to individual governmental units. The amount approved to each governmental
unit by parliament is then recorded into a particular account known as “General Account of vote”
(GAV). This account therefore records funds allocated to various governmental units.
4. THE EXCHEQUER ACCOUNT
All incomes of the government are received and recorded into an account called the “Exchequer
account”. The total amount available in the exchequer represents the consolidated fund, i.e. the
consolidated fund operates an account called exchequer.
5. PAYMASTER GENERAL ACCOUNT (PMG)
The Paymaster General Account (PMG) is the cash account operated by the individual
governmental units. It records amounts so far withdrawn from the exchequer.
6. APPROPRIATION- IN- AID (AIA)
AIA is the amount to be generated by the governmental unit from its internal activities. It is
subtracted from the gross estimate (gross vote) to arrive at net estimate of (net vote) which
is approved by parliament to be released from the consolidated fund. An AIA account may be
maintained,
Where: when AIA is received from own operations:
DR PMG account
CR AIA account
At the end of the year:
DR AIA account
CR GAV account
PUBLIC SECTOR ACCOUNTING
3 0 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
7. APPROPRIATION ACCOUNT
Shows the following in tabular form:
• Approved estimates
• Actual expenditure
• Amounts under-spent
• Amounts over-spent
8. REVENUE ACCOUNT
A revenue account records only the estimated revenue and actual revenue from each particular
revenue source for the governmental unit. The difference between the two, if significant must be
explained by the accounting officer. Alternatively the significant difference between two can be
used to correct future estimations by the governmental unit. It could also represent new factors
emerging during the year which were not taken into account during the previous budget.
CHAPTER SUMMARY
IPSAS 1, Presentation of Financial Statements, sets out the overall considerations for the
presentation of financial statements, guidance for the structure of those statements and minimum
requirements for their content under the accrual basis of accounting.
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S T U D Y T E X T
CHAPTER QUIZ
1. Which accounting equation is used in the fund theory?
2. Which accounting equation is used in the entity theory?
PUBLIC SECTOR ACCOUNTING
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S T U D Y T E X T
CHAPTER QUIZ ANSWERS
1. The accounting equation is Assets = Restrictions on Assets
2. Assets = Liabilities + Stockholders’ Equity
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CHAPTER THIRTEEN
ANSWERS TO EXAM TYPE
QUESTIONS
S TSUTDUYD YT ETXETX T
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S T U D Y T E X T
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S T U D Y T E X T
ANSWERS TO EXAM TYPE
QUESTIONS
CHAPTER ONE
Question One
Mary
Statement of financial position as at
31.12.2003
Non current assets Sh. Sh.
Freehold premises 25,000
Plant 12,000
37,000
Current assets W1
Stock 8,000
Debtors 7,000
Cash at Bank 1,000
Cash in hand 6,000
22,000
59,000
Capital [34,000 + 5,000 – 10,000] W2 29,000
Non current liabilities
Loan from bank 20,000
Current liabilities
Creditors W4 10,000
59,000
Workings
W1
Stock: 11,000 + 34,000 – 37,000 = 8,000
Debtors: 10,000 + 51,000 – 54,000 = 7,000
Cash at bank: 5,000 – 16,000 – 2,000 – 1,000 – 36,000 + 54,000 – 3,000 = 1,000
Cash hand: 3,000 – 10,000 + 9,000 + 16,000 – 10,000 – 2,000 = 6,000
3 1 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
W2
Capital Sh.
Balance b/f 34,000
Add profit W3 5,000
39,000
Less drawings (10,000)
29,000
W3
Profit:
Sales 60,000
Cost of sales (37,000)
Electricity (2,000)
Rates (1,000)
Wages (10,000)
Sundry expenses (2,000)
Bank interest (3,000)
Net profit 5,000
W4
Creditors = 12,000 + 34,000 – 36,000 = 10,000
Question Two
Accounting is defined as the process of identifying, measuring and reporting economic information
to the users of this information to permit informed judgment
Many businesses carry out transactions. Some of these transactions have a financial implication
i.e. either cash is received or paid out. Examples of these transactions include selling goods,
buying goods, paying employees and so many others.
Accounting is involved with identifying these transactions measuring (attaching a value) and
reporting on these transactions. If a firm employs a new staff member then this may not be an
accounting transaction. However when the firm pays the employee salary, then this is related
to accounting as cash involved. This has an economic impact on the organization and will be
recorded for accounting purposes. A process is put in place to collect and record this information;
it is then classified and summarized so that it can be reported to the interested parties.
Accounting equation
A business owns properties. These properties are called assets. The assets are the business
resources that enable it to trade and carry out trading. They are financed or funded by the owners
of the business who put in funds.
These funds, including assets that the owner may put is called capital. Other persons who are
not owners of the firm may also finance assets. Funds from these other sources are called
liabilities.
The total assets must be equal to the total funding i.e. both from owners and non-owners. This is
expressed in form of accounting equation, which is stated as follows:
ASSETS = LIABILITIES + CAPITAL
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S T U D Y T E X T
ANSWERS TO EXAM TYPE QUESTIONS
Profit is determined by redrafting the second section of the Statement of financial position.
Remember that net assets will be the same as capital.
Opening and closing capital are determined as follows:
01.01.2003 31.12.2003
Non –Current Assets Sh. Non – Current Assets Sh.
Property 20,000 Property 20,000
Machinery 6,000 Machinery 9,000
26,000 29,000
Current Assets: Current Assets:
Debtors 4,000 Debtors 8,000
Cash 1,000 Cash 1,500
5,000 9,500
Total assets 31,000 Total assets 38,500
Current Liabilities: Current Liabilities:
Creditors 5,000 Creditors 3,000
Overdraft 6,000 Overdraft 9,000
11,000 12,000
Net assets 20,000 Net assets 26,500
Opening capital 20,000 Closing capital 26,500
Sh
Opening Capital 20,000
Add additional capital 5,000
Add net profit (Missing figure) 6,000
31,000
Less drawings (4,500)
Closing Capital 26,500
Profit may be also computed as follows:
Using the extended accounting equation
Net profit = closing capital (net assets) – opening capital + drawings – additional capital
= 26,500 – 20,000 + 4,500 – 5,000
= Sh 6,000
3 1 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
CHAPTER 2
Question 1
Skates
Trading, Statement of comprehensive income for the year ended 31 September 2002
Sh. Sh. Sh.
Sales 13,090,000
Less: returns outwards __(55,000)
13,035,000
Cost of sales:
Opening stock 2,391,000
Purchases 9,210,000
Add carriage inwards ___21,500
9,231,500
Less returns outwards __(30,700) 9,200,800
11,591,800
Less closing stock (2,747,500) (8,844,300)
4,190,700
Less expenses
Wages and salaries 1,282,000
Carriage outwards 30,900
Motor expenses 163,000
Rent and rates 297,000
Telephone 40,500
Insurance 49,200
Office expenses 137,700
Sundries 28,400 (2,027,700)
Net profit _2,163,000
Skates
Statement of financial position as at 30 September 2002
Non current assets Sh. Sh. Sh.
Office equipment 625,000
Motor van 410,000
1,035,000
Current assets
Stocks 2,747,500
Debtors 1,239,000
Bank 311,500
Cash __29,500
4,318,500
Current liabilities
Creditors (937,000) 3,381,500
4,416,500
Capital 3,095,500
Add net profit 2,163,000
5,258,500
Less drawings (842,000)
4,416,500
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S T U D Y T E X T
Question 2
Cash Book
Disct Cash Bank Disct Cash Bank
Bank
Bal b/d 230 4756 Rent 120
R Burton 7 133 N Black 9 351
E Taylor 11 209 P Towers 12 468
R Harris 15 285 C Rowse 20 780
J Cotton: loan 1000 Motor expenses 44
H Hankins 3 74 Wages 160
C Winston 13 247 Cash 350
R Wison & Son 17 323 Drawings 120
H Winter 23 437 T Briers 7 133
Bank 350 Fixtures 650
Commission 88 Balances c/d 123 4833
89 580 7,552 48 580 7,552
Discounts Received
3/1 Sundry Creditors 48
Discounts Allowed
3/1 Sundry
Debtors
89
ANSWERS TO EXAM TYPE QUESTIONS
3 1 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
CHAPTER 3
Question 1
Mary Carter
Statement of financial position as at 31.12.2001
Non current assets Sh. Sh. Sh.
Freehold premises 25,000
Plant 12,000
37,000
Current assets
Stock 8,000
Debtors 7,000
Cash at Bank 1,000
Cash in hand 6,000
22,000
Current liabilities
Creditors (10,000) 12,000
49,000
Capital [34,000 + 5,000 –
10,000]
29,000
Non current liabilities
Loan from bank 20,000
49,000
Workings
Stock: 11,000 + 34,000 – 37,000 = 8,000
Debtors: 10,000 + 51,000 – 54,000 = 7,000
Cash at bank: 5,000 – 16,000 – 2,000 – 1,000 – 36,000 + 54,000 – 3,000 = 1,000
Cash hand: 3,000 – 10,000 + 9,000 + 16,000 – 10,000 – 2,000 = 6,000
Capital
Bal b/f 34,000
Add profit _5,000
39,000
Less drawings (10,000)
29,000
Profit:
Sales 60,000
Cost of sales (37,000)
Electricity (2,000)
Rates (1,000)
Wages (10,000)
Sundry expenses (2,000)
Bank interest (3,000)
Net profit 5,000
Creditors
= 12,000 + 34,000 – 36,000 = 10,000
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S T U D Y T E X T
CHAPTER 4
QUESTION 1 (December, 2006 Q 1)
(a) Baraka
Statement of comprehensive income for year to 30 September 2006
Sh “.000”
Sh“.000”
Sales: Cash 4,814
Credit 584 5,398
Cost of sales:
Purchases 4,121
Less: Closing inventory (360) (3,761)
Gross profit 1,637
Expenses
Wages 410
Rent and rates 100
Lighting expenses 50
Insurance 20
Stationery and postage 26
Sundry expenses 56
Bank charges 110
Depreciation: Premises 50
Fixtures and fittings 30 (852)
Net profit 785
(b) Baraka
Statement of financial position as at 30 September 2006
Non Current assets Sh. “000” Sh “.000” Sh. “000”
Premises 2,500 (50) 2,450
Fixtures and fittings 300 (30) 270
2,800 80 2,720
Current assets
Inventory 360
Receivables 177
Prepayments 20
Cash at bank 493
Cash in hand 10
1,060
Current liabilities
Payables 403
Accrued expenses 16 (419) 641
3,361
Capital 3,176
Net profit for year 785
3361
Less: Drawings (600)
3,361
ANSWERS TO EXAM TYPE QUESTIONS
3 1 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
Workings
1. Cash and Bank
Cash Bank Cash Bank
Sh.000 Sh.000 Sh.000 Sh.000
Capital 500 Cash Contra 20
Bank contra 20 Fixtures and fittings 300
Suppliers 10 Suppliers – purchases 3,728
Customers 382 Insurance of inventory 40
Banking-contra 3,769 Bank charges 110
Customers Wages 400
Uncredited
amount
30 Lighting expenses 50
Cash sales 4,814 Drawings 600
Bank contra 3,769
Bal. c/d (inclusive-5000) 15 493
4,834 4,691 4,834 4,691
2.
Receivables
Sh.000 Sh.000
Sales 584 Cash 382
Cash 30
Balance c/d 172
584 584
3.
Sh.000 Sh.000
Cash 3,728 Cash 10
Balance c/d 403 Purchases 4,121
4,131 4,131
4.
Sh.000 Sh.000
Premises 2,500
Cash at bank 500
Rent and rates 100
Lighting expenses 50
Balance c/d 3,176 Stationery and postage 26
3,176 3,176
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S T U D Y T E X T
CHAPTER 5
Question 1 (June 2006 Question2)
(a)
Umoja Women’s Welfare Society
Water tank statement of comprehensive income for the year ended 30 April 2006
Sh. ‘000’
Sales 45,000
Cost of sales (41,000)
Gross profit 4,000
Selling expenses (2,000)
Net profit 2,000
(b)
Umoja Women’s Welfare Society
Income and expenditure account for the year ended 30 April 2006
Income Sh .’000’ Sh .’000’
Net profit from water tank 2,000
Subscriptions 9,100
Raffle tickets 2,800
Donations from members 2,500
Membership fees 800
17,200
Expenditure
Office expenses (4,100+400) 4,500
Rent - Office 4,000
Depreciation of Motor vehicle 200
Raffle prizes paid 1,200
Cost of raffle tickets 300 (10,200)
Surplus for the year 7,000
ANSWERS TO EXAM TYPE QUESTIONS
3 2 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
(c)
Umoja Women’s Welfare Society
Statement of financial position as at 30 April 2006
Non current assets Sh ‘000’ Sh .‘000’ Sh .‘000’
Machinery 22,000 (6,100) 15,900
Motor Vehicles 10,000 (5,000) 5,000
32,000 11,100 20,900
Current assets
Raw materials 20,000
Subscriptions receivable 2,000
Cash at bank 500
22,500
Current liabilities
Payables 2,800
Subscriptions paid in advance 1,500
Accrued office expenses 400 (4,700) 17,800
38,700
Accumulated fund b/f 25,000
Surplus for the year 7,000
32,000
Membership fees fund (see
note)
6,700
38,700
Note on Membership fees fund
Note number 3 on the membership fee fund is ambiguous. The examiner does not indicate clearly
the source of the fund (whether it is from the surplus from the period, whether there are donations
made or whether it is funded by the members of the society). Therefore we have ignored the
note, but other alternatives may apply and this will depend on the assumption. For example if we
assume that the members are meant to fund the amount of Sh 800,000 , then we can increase
the fund to Sh 7,500,000 and have a receivable of Sh 800,000 as part of the current assets.
Other workings
(i) Cost of sales
Sh.’000’
Raw materials used 35,000
Factory wages 600
Factory overheads 1,000
Factory rent 1,000
Factory staff bonus 1,500
Depreciation – Machinery (5%X22m) 1,100
- Motor vehicles (80% X1m) 800
41,000
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(ii) Subscriptions
Sh.‘000’ Sh.‘000’
Balance b/d 3,500 Balance b/d 2,100
Income & Expenditure
(bal)
9,100 Cash 10,000
Balance c/d 1,500 Balance c/d 2,000
14,100 14,100
Question 2
Workings
Wk 1
Statement of affairs
Bakari Sailors club
As at 1st June 2006
Assets Sh.‘000’ Sh .‘000’
Repairs workshop 5,000
Freehold premises 40,000
Boatyard and lunch facility 8,000
Fixtures and fittings 3,000
Club-owned boats and yachts 35,000 91,000
Members subscription accrued 400
Bank balance 11,070
Bar stocks 3,100
105,570
Liabilities
Members subscription prepaid 560
Creditors for bar 500
Accumulated fund (bal.. fig) 104,510
105,570
Wk 2
Disposal of boat
Net book value 2,000,000
Cash (200,000)
Less to income and expenditure a/c 1,800,000
Wk 3
Depreciation (reducing balance) ‘000’
Free hold premises 40,000 x 5% 2,000
Boatyard and Lunch facility 8,000 x 5% 400
Fixtures and fittings 300 x 10% 300
Repairs Workshop 5,000 x 10% 500
ANSWERS TO EXAM TYPE QUESTIONS
3 2 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Wk 4
Bar trading account for the year ended 31st May 07
Sh ‘000’ Sh. ‘000’
Bar sales 8,000
Opening inventory 3,100
Purchases (5,010 + 610) 5,620
Closing inventory (2,850) (5,870)
Bar gross profit 2,130
Less bar wages (35 + 1,260) (1,295)
Bar Net profit 835
Wk 5
Repair of boats 320
Receipts and payments 1,920
2,240
Wk 6
120% - 1,960
100% - ?
20% - ?
(20 x 1960)/ 120 = 81.75 = 82
Wk 7
Club owned boats and yachts
Balance b/d 35,000 Disposal 2,000
Receipts and payments
5,000
Depreciation 2,050
Fixtures & fittings 3,000
Bal c/ld
38,950
323
S T U D Y T E X T
Bahari Sailors club
Income and expenditure a/c
For year 31st May 2007
Sh ‘000’ Sh ‘000’
Incomes
Subscription W7 20,370
Bar profits W3 835
Receipts from training school 2,050
Boat hire charges M. 900
W.M 1,960
Yacht racing 3,080 29,195
Expenses
Repairs of boats Wk 4 2,240
Donations Wk 5 82
Depreciation Club owned Wk 6 2, 050
Premises 2,000
Boat yard and lunch facility 400
I and F 300
Repairs workshop 500
Loss on disposal 1,800
Yacht racing competition 1,870
Salaries 1,500
General expenses 2,200 (14,942)
14,303
ANSWERS TO EXAM TYPE QUESTIONS
3 2 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
Bahari Sailors club
Statement of financial position
As at 31st May 2007
Sh ‘000’ Sh ‘000’
Non-current assets (N B V)
Repairs workshop 5,000
Depreciation (500) 4500
Free hold Premises 40,000
Depreciation (2,000) 38000
Boat facility L.F 8,000
Depreciation (400) 7600
F & F 3,000
Depreciation (300) 2700
N.B.V. (W6) 38,950
91,750
Current Assets
Bar stocks 2,850
Accrued subscription 350
Bank balance 28,590
Current Liabilities
Donations (82)
Creditors (610+35+320) (965)
Prepaid subscription (790) 29,953
121,703
Accumulated fund 104,510
Surplus 14,313
Donated boat 3,000 121,703
325
S T U D Y T E X T
CHAPTER 6
Question 1 (December 2007 Question2)
Taba Ltd
Manufacturing Trading and loss a/c for the year ended 31 October 2006
Raw materials Sh’000’ Sh’000’
Opening stock of R .M 1,200
Purchases of R.M 16,400
Cost of R.M available for use 17,600
Less: closing stock of R.M (1,400)
Raw materials consumed 16,200
Direct manufacturing wages 18,000
PRIME COST 34,200
Factory overheads
Production overheads 10,400
Depreciation plant 3,200 -
Depreciation Business premises 800 -
Depreciation M. Vehicle 500 14,900
Total cost of production 19,100
Add: Opening W.I.P 800
Less: Closing W.I.P (1,700)
Cost of finished goods 48,200
Sales 67,100
Less: Proceeds from sale of plant (600)
66,500
Less: cost of sales
Opening stock 1,600
Add: Cost of finished goods 48,200
19,800
Less: Closing stock of finished goods (1,300) 48,500
Gross profit 18,000
Less: Expenses: Loss on disposal 200
Administration o/heads (4,900 + 250) 5,150
Selling O/heads (2,600 + 250) 2,850 (8,200)
Net profit 9,800
ANSWERS TO EXAM TYPE QUESTIONS
3 2 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
Taba Ltd
Statement of financial position as at 31 October 2006
Non-current assets Cost Acc. Depreciation NBV
Business premises 20,000 4,000 16,000
Plant and equipment 18,000 12,200 5,800
Motor vehicle 6,400 3,400 3,000
24,800
Current assets
Trade receivables 4,600
Cash in hand 300
Bank Balance 32,900
Stock: Raw materials 1,400
Work in progress 1,700
Finished goods 1,200
40,000
Current liabilities
Trade payables 2,800
Other payables: PAYE 1,300
VAT 2,800 (6,900) 33,300
58,100
Ordinary share capital 15,000
Share premium 5,000
Retained earnings b/f 28,300
Profit for the year 9,800
Retained earnings c/f 38,100
58,100
327
S T U D Y T E X T
Question 2 (June 2003 Question 1)
LIMURU MANUFACTURERS
MANUFACTURING ACCOUNT FOR THE YEAR ENDED 31ST DEC 2002
Sh’000 Sh’000
Opening stock of raw materials 7,000
Add: Purchases of raw materials 38,000
Less Closing stock of raw materials (9,000)
Cost of raw materials consumed 36,000
Direct labour 31,000
PRIME COST 67,000
Add: Factory overheads
Variable & fixed 25,000
Depreciation of plant & machinery _3,000 28,000
95,000
Add: Opening WIP 5,000
Less: Closing WIP _(8,000)
Production cost 92,000
Add: Manufacturing profit (25% Production cost) _23,000
Market value of manufactured goods 115,000
LIMURU
STATEMENT OF COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31 DEC 2002
Sh’000 Sh’000
Sales 192,000
Less Cost of sales
Opening stock finished goods 6,900
Market value of goods produced 115,000
Less Closing stock of finished goods (10,350) (111,550)
Gross profit 80,450
Add: Manufacturing profit _23,000
103,450
Less: Expenses
Rent & rates 17,000
Lighting 6,000
Stationery & postage 2,000
Staff salaries 19,380
Depreciation of motor vehicles 4,000
Motor vehicle running costs 4,500 (52,880)
50,570
Add: Opening stock figure - unrealized profit 1,380
Less: Closing stock figure – unrealized profit (2,070)
Net profit 49,880
ANSWERS TO EXAM TYPE QUESTIONS
3 2 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
LIMURU MANUFACTURERS
BALANCE SHEET
AS AT 31ST DECEMBER 2002
Sh’000 Sh’000 Sh’000
NON CURRENT ASSETS
Plant and machinery 30,000 15,000 15,000
Motor vehicles 16,000 8,000 _8,000
23,000
CURRENT ASSETS
Stock : Raw materials 9,000
WIP 8,000
Finished goods 10,350
Less; provision for unrealized profit (2,070) 8,280
Debtors 28,000
Prepayments 2,000
Bank 16,600 71,880
TOTAL ASSETS 94,880
EQUITY & LIABILITIES
Capital
Opening balance 48,000
Add: Net profit 49,880
Less: Drawings (11,500)
86,380
CURRENT LIABILITIES
Creditors 5,500
Accruals 3,000 _8,500
TOTAL EQUITY & LIABILITIES 94,880
CHAPTER 7
Question 1 (June 2006 Question 4)
(a) Goodwill is that advantage that an existing business may have over a newly established
business. The advantage is in the form of the ability to generate revenue and profits as
a result for example customer loyalty, location and marketing.
(i) On admission of a new partner, the new partner will start enjoying the benefits of the
existing partnership as a result of the goodwill created by the previous partners. The
newly admitted partner should therefore pay for his share of the goodwill.
(ii) On retirement of one of the partners, the remaining partners will continue enjoying the
benefits that the retired partner helped create. Therefore it will be important for the
retiring partner to be paid his share of the goodwill.
329
S T U D Y T E X T
(b)
Akili, Busara and Chema
Trading, profit, loss and appropriation account for the year ended 30April 2006
Sh’000’ Sh’000’
Sales (20-0.6) 19,400
Cost of sales
Opening Inventory 3,000
Purchases 10,300
13,300
Closing Inventory (2,600) (10,700)
Gross profit 8,700
Expenses
Interest(10% X 3m) 300
Operating 6,400 (6,700)
Net profit 2,000
1st six Months 2nd six Months
1000 1000 2000
Int. on cap.
A 62.5 71.5 140
B 50 71 121
C 25 (137.5) 49 (197.5) 74 (335)
862.5 802.5 1,665
Salaries
A 0 0 0
B 120 60 180
C 0 (120) 60 (120) 60 (240)
Balance 742.5 682.5 1,425
A 247.5 341.25 588.75
B 247.5 204.75 453.25
C 247.5 (742.5) 136.5 (682.5) 384 (1,425)
0 0 0
(b)
Capital account
A B C A B C
Sh.’000’ Sh.’000’ Sh.’000’ Sh.’000’ Sh.’000’ Sh.’000’
Goodwill 600 360 240 Bal.b/d 2,500 2,000 1,000
Goodwill 400 400 400
Bal.c/d 3,100 2,840 1,960 Rev.gain 800 800 800
3,700 3,200 2,200 3,700 3,200 2,200
Current account
A B C A B C
Sh.’000’ Sh.’000’ Sh.’000’ Sh.’000’ Sh.’000’ Sh.’000’
Drawings 300 400 200 Bal.b/d 200 3,00 200
Int. –cap 140 121 74
Salaries 0 180 60
Profits 588.75 452.25 384
Bal.c/d 628.75 753.25 718 Int.Loan 0 100 200
3,700 3,200 2,200 3,700 3,200 2,200
ANSWERS TO EXAM TYPE QUESTIONS
3 3 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
(c)
Akili, Busara and Chema
Statement of financial position as at 30 April 2006
Non Current assets Sh.’000’ Sh.’000’ Sh.’000’
Land and buildings 8,000 0 8,400
Plant and Machinery 7,000 (4,000) 3,000
15,000 (4,000) 11,400
Current assets
Inventory (2,400+200) 2,600
Receivables 3,400
6,000
Current liabilities
Bank Overdraft 1,100
Payables 3,300 (4,400) 1,600
13,000
Capital Accounts
Akili 3,100
Busara 2,840
Chema 1,960
7,900
Current account
Akili 628.75
Busara 753.25
Chema 718 2,100
10,000
Non current liabilities
10% Loan : Busara 1,000
: Chema 2,000 3,000
13,000
331
S T U D Y T E X T
Question 2 (December 2006 Question 3)
a) Statement of comprehensive income for the year ended 30 September 2006
Sh “.000” Sh “.000”
Sales:
1 October 2005 to 31 March 2006 14,000
1 April 2006 to September 2006 21,000
35,000
Opening Inventory 4,800
Purchases (16,400 + 200) 16,600
21,400
Closing inventory (5,100) (16,300)
Gross profit 18,700
Six months 1.10.2005
to 31.3.2006)
Six months (1.4.2005
to 30.9. 2006)
Gross profit ( ratio of 14:21) (7,480) (11,220)
Expenses:
Salaries (5,200 – 1,330) (1,935) (1,935)
Rent, rates and electricity
1,240 + 600 +60 – 260)
(820) (820)
Shop wages (1,100) (1,100)
Professional charges (420-210) (110) (110)
General expenses (2,640 – 120) (1,410) (1,110)
Depreciation: Motor vehicles 680 (340) (340)
Shop fittings 60 (30) (30)
Amortization of lease
(1/25 x (6,000 +200) (124) (124)
Provision for doubtful debts (120) (40)
Net profit (Shared in PSR) 1,491 5,611
Grace 2 : 2 994 2,244.4
Beatrice 1: 2 497 2,244.4
Catherine 0: 1 0 1,122.2
ANSWERS TO EXAM TYPE QUESTIONS
3 3 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
b) Statement of financial position as at 30 September 2006
Cost Depreciation Net book value
Sh ‘.000’ Sh ‘.000’ Sh ‘.000’
Non-Current Assets:
Leasehold premises 6,200 248 5,952
Motor vehicles 3,400 1,880 1,520
Shop fittings 1,200 460 740
10,800 2,588 8,212
Current Assets:
Stocks 5100
Accounts receivable
(900 – 180) 760
Provision for bad debts 160 560
Prepayments 260
Cash at bank 9.280 15,300
Suspense 100 23,512
Capital:
Fixed capital
Grace 3,000
Beatrice 2,000
Catherine 1,500
6,500
Current account
Grace 7,438.4
Beatrice 3,261.4
Catherine 1,972.2
12,672
Accounts payable (4,280+60 4, 340
23,512
c) Current accounts
G B C G B C
Sh ‘.000’ Sh ‘.000’ Sh ‘.000’ Sh ‘.000’ Sh ‘.000’ Sh ‘.000’
Goodwill 4,800 4,800 2,400 Bal. b/d 1,600 1,200
Drawings 600 480 250 Profit 3,238.4 2,741.4 1,122.2
Bal. c/f 7,438.4 3,261.4 1,972.2 Goodwill 8,000 4,000
Rent 600
Cash 3,500
12,838.4 8,541.4 4,622.2 12,838.4 8,541.4 4,622.2
333
S T U D Y T E X T
Question 3 (June 2007 Question 2)
(a)
Ali, Bakari, Chando Partnership
Profit and loss and appropriation a/c
As at 31st December 2006
Sh ‘000’ Sh ‘000’ Sh ‘000’
Profit as per draft a/c 55,155
Add
Reduction in provision for depreciation 320
55,475
Less
Salary to Chando 2,000
Less loss in stock realization 470
Provision for bad debts 105
Drawing of stock 2500
Depreciation of business premises 200
Telephone expenses 120 5,395
50,080
Less
Interest on capital
Ali 938
Bakari 647
Chando 450 (2,035)
48,045
Less:
Salaries
Bakari 5,500
Chomba 4,500 10,000
38,045
Residue profit shared
Ali (4/7) 21,740
Bakari (2/7) 10,870
Chando (1/7) 5,435 38,045
ANSWERS TO EXAM TYPE QUESTIONS
3 3 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
Ali, Bakari, Chando Partnership
Statement of financial position
As at 31st December 2006
Sh ‘000’ Sh ‘000’ Sh. ‘000’
Non-current assets
Business premises 20,800 200 20,600
Equipment 8,000 5,280 2,720
23,320
Current assets
Inventory 12,085
Account receivable 3,500
Less provision for bad debts (105) 3,395
Cash at bank 8,800
24,280
Current liabilities
Accounts payable 3,080
Accruals 2,250 (5,600) 18,800
42,000
Financed by:
Capital: Ali 16,400
Bakari 11,600
Chando 10,000 38,000
Current accounts
Ali 1,173
Bakari (3,708)
Chando 1,535 (1,000)
37,000
(b) Current a/c
Ali Bakari Chando Ali Bakari Chando
Sh
.‘000’
Sh
.‘000’
Sh
.‘000’
Sh .‘000’
Sh
.‘000’
Sh
.‘000’
Bal b/d 300 Balance 3,200
Drawings
23,705 19,525 8,250
Interest
on capital
938 647 450
Stock
Drawing
1,000 900 600 Salaries 5,500 4,500
Balance c/d 1,173
Profit
share
21,740 10,870 5,435
Bal c/d 3,708
25,878 20,725 10,385 25,878 20,725 10,385
335
S T U D Y T E X T
CHAPTER 8
Question 1 (June 2005 Question 5)
a) The importance of Ratio analysis
I.) Evaluation of performance
By use of ratio analysis, a company is able to compare its present and past performance
(vertical analysis) or even with other companies falling in the same industry (horizontal
analysis)
II.) Acts as control
Ratios are at times used as controls by companies. The employees of a company
are given goals which they need to attain. At the end of the accounting period their
performance is reviewed with an aim of finding what the problem might have been.
b) Parties interested in the following Ratios
I) Current Ratio
The current ratio measures the liquidity position of a business. The creditors would be
interested in it so as to know the probability of their debt being paid.
II) Net Profit Margin
This measures the profitability of a company. Almost all parties are interested in this ratio
from the company itself to the government, employers, creditor, the general public at
large, potential investors etc.,. It helps to know whether to invest in the company i.e. the
investors and public; future prospects for the employees etc.
III) Stock Turnover
This represents how fast the company is able to turn stocks to sales. The company
management and even potential investors are interested in this. Further the suppliers
would like to know this so as to know how frequently they ought to supply goods.
c) Brief explanation of the following:
I) Accounting concepts
These are broad assumptions which underlie preparation of financial statements of a
company.
Examples of accounting concepts include the Historical Concept, Prudence, Accrual
Basis etc.
II) Accounting standards
They are authoritative statements of how particular types of transactions and events
should be reflected in financial statements. They are developed to achieve comparability
of financial information between and among different organizations.
III) Accounting policies
These are the principles, bases, conventions, rules and practices applied by an entity
that specify how the effects of transactions and other events are to be reflected in its
financial statements though:
i) Recognizing
ii) Selecting measurement basis for a/c
iii) Presenting assets, liabilities, gains, losses and charges to shareholders funds.
ANSWERS TO EXAM TYPE QUESTIONS
3 3 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
d) Explanation of Accounting Treatments
I) The debtor declared bankrupt
In the books of Mlachake ltd by 31 December 2004, the statement of financial position
shows debtor’s figure of Sh. 200,000. This was on assumption that such debtors
would be recoverable. The declaration of the debtor bankrupt reduced the chances of
realization of the debt. However this declaration is done after the statement of financial
position date. In accordance to International Financial Reporting Standards, this is an
event after the statement of financial position and it provides additional evidence of the
conditions as they existed at the statement of financial position date. This therefore is
an adjusting event and therefore the following adjustments should be made:
(I) 75% of the debt (Sh 200,000) should be written off in the statement of
comprehensive income as a bad debt
(II) Bad debts recovered of 25% of Sh 200,000 should be recognized.
However, if the financial statements had been finalized to the point that the reports
had been sent to stakeholders and shareholders, then it should be disclosed by way of
note.
II) The inventory which got damaged
Such inventory which has been damaged should be valued at the lower of cost and net
realizable value. Further the cost of repairing the inventory should be incorporated in
the cost of the inventory. As such, this would be consistent with Accounting Standard
No.2 which deals with inventories.
III) The secured order of Sh 12 million
In accordance to the Prudence concept, revenue/gains are recognized if their realization
can be determined with reasonable certainty. In this case, the fact that a foreign based
company secured an order for goods to be later demonstrates commitment of the
customer to buy the goods. However the commitment is not enough to warrant the
recognition of the sale in our books of account.
Therefore it was not proper for the sale to be recognized in December as it was since
as at December 19th the Sale was still uncertain.
Those goods should only have been recognized for the month of January which is when
their sale became certain.
Question 2 (December 2005 Question3)
a) Purposes of ratio analysis
• Assessing the company’s financial performance
• To evaluate financial stability of a company
• To predict future performance and stability of a business entity
• To compare performance of the firm with past performance and within the
industry.
• To detect and investigate inconsistencies due to errors and fraud.
337
S T U D Y T E X T
b)
Ratio Formula Sunrise Ltd. Sunset Ltd.
i) Acid test ratio
Current asset – Inventory
Current Liability
186 – 100
98
= 0.88:1
173 – 87
108
= 0.80:1
ii) Inventory turnover
Cost of sales
Average stock
258
100
= 2.58
153
87
= 1.76
iii) Average collection period
365 x Average debtors
Credit sales
365 x 46
497
= 34 days
365 x 42
371
= 41 days
iv) Return on capital employed
(ROCE)
Profit before interest & tax x 100
Capital employed
157* x 100
230
= 68.2%
79 x 100
157
= 50.3%
*Note that the operating profit is net of interest expense an this to be arrived at profits before
interest. The interest expense must be added back. 19 + 138 = 157*
v) Debt equity ratio
Debt Capital
Equity Capital
33 x100
197
= 17%
0 x 100
197
= 0%
(c)
(i) Comments on Performance
• Sunrise Ltd. has a better performance gauging by the return on capital employed.
• Sunset Ltd. has a low gearing and thus less risky with high access to capital market.
• Sunrise Ltd. has better management of inventory.
• Sunrise Ltd. has a better credit policy.
• Overall sunrise has a better performance but a higher risk and thus for risk takers
sunrise is the best and for risk averse investors sunset would be the firm, to invest in.•
(ii) Shortcomings of relying on analysis in (b) above
• Ratios are historical since they use past data.
• Comparison of ratios for companies maybe misleading due to different bases adopted
e.g. in valuation of stock or depreciation.
• Ratios alone do not provide all the information required by users
• Ratios computed from inaccurate information will be misleading.
ANSWERS TO EXAM TYPE QUESTIONS
3 3 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
CHAPTER 9
Question 1 (June 2007 Question 1)
a)
i) Share Premium
This arises when a company issues shares at a price that is more than the par value.
Revaluation reserve
The unrealized gain when the amount at which non-current assets are carried is
increased above last.
ii) How a company can utilize share premium
(i) Finance a fully paid bonus issue
(ii) Write off preliminary expenses
(iii) Write off expenses or commission paid or discount allowed on any issue of share
or debentures.
(iv) Provide for premium payable on redemption of redeemable preference shares or
debentures.
b) Workings
(W1)
Dr. hand 69,000,000
Cr. Re-evaluation reserve 69,000,000
W2
Dr. Re evaluation reserve 150,000,000
Cr. Ordinary share 150,000,000
No. of Shares = 150,000,000
10
Total no of share = 165,000,000
WK3
Salaries & wages 32,100,000
Add Accrued 150,000
32,250,000
WK 4
General Expenses 11,900,000
Insurance premium 200,000
11,700,000
Insurance premium 200,000 X 9 = 150,000
12
Prepayment of insurance premium = 50,000
339
S T U D Y T E X T
WK5
Disposal a/c
Machine A/c 2,000,000 Provision for Depreciation 1,500,000
Cash 400,000
Loss on disposal(P&L) 100,000
2,000,000 2,000,000
Cash at bank = 7,500,000
Cash in hand = 400,000
WK6
Correction of error
Dr. cash 400,000
Cr. Suspense 400,000
Dr. Suspense 400,000
Cr. Cash 400,000
WK7
Provision for bad debts
Debtors = 48,000,000
Provision = 2 ½ % X 48,000,000 = 1,200,000
Provision for Bad debts & doubtful debts
Sh ‘000’ Sh ‘000’
P&C 300,000 Balance b/d 1,500,000
Balance c/d 1,200,000
2,000,000 2,000,000
WK 8
Depreciation – Plant & Machinery
10% X 380,000,000
= 38,000,000
Machine a/c
Sh ‘000’ Sh ‘000’
Disposal 2,000
Balance c/d 382,000 Balance c/d 380,000
382,000 382,000
Provision for Depreciation
Sh ‘000’ Sh ‘000’
Disposal 1,500 Balance b/d 85,500
Balance c/d 122,000 Depreciation 38,000
123,500 123,500
W9
Dividends = 5% 􀀀 16,500,000 pne = 8% x 50,000 = 4,000
= 825,000 int = 7% x 100,000,000
700,000
ANSWERS TO EXAM TYPE QUESTIONS
3 4 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
a)
PATA LTD
STATEMENT OF COMPREHENSIVE INCOME A/C
FOR THE YEAR ENDEND 31ST DECEMBER 2006
Sh ‘000’ Sh ‘000’ Sh ‘000’
Sales 290,000
Less cost of sales
Opening stock 35,000
Purchases 165,000
Add carriage in 1,100 166,100
201,100
Less closing stock (41,000)
(160,100)
Gross profit 129,900
Add incomes
Discount received 4,600
Decrease in provision for doubtful debts 300
4,900
134,800
Less expenses
General expenses 11,700
Insurance premium 150
Loss and disposal 100
Depreciation of plant and machinery 38,000
Discount allowed 3,200
Salaries and wages 32,250
Electricity 2,900
Debenture interest 7,000
Directors fees 12,800 108,000
Profit before tax 26,700
Taxation (corporation tax) 3,000
Profit after tax 23,700
Less transfer to general reserve (5,000)
18,700
Less: Dividends.
Preference Dividends: Interim paid 2,000
Final proposed 2000
Ordinary dividends: Interim paid 7,500
Final proposed 8,250 19,750
Retained Profit for the year (1,050)
Retained earnings b/d 35,000
Retained earnings c/d 33,950
341
S T U D Y T E X T
b)
Pata Ltd
Statement of financial position
As at 31st December 2006
Sh ‘000’ Sh ‘000’ Sh ‘000’
Non –Current assets
Land 180,000 - 180,000
Plant and machinery 380,000 122,000 258,000
438,000
Current assets
Stock 41,000
Account receivable 48,000
Less provision for bad debts (1200) 46,800
Prepaid insurance premium 50
Cash at bank 7,500
95,350
Current liabilities
Account payable 27,000
Proposed dividends: ordinary 8,250
Preference 2,000
Tax payable 3,000
Accrued wages 150 (40,400) 54,950
492,950
Financed by:
Authorized share capital issued
Ordinary share capital of Sh.10 each 165,000
8% preference share capital of Sh.10 each 50,000
215,000
Capital reserve
Share premium 20,000
Revaluation reserve 54,000 74,000
Capital Redemption reserve
General reserve 70,000
Statement of comprehensive income 33,950 103,950
Non currents liabilities
7% Debenture interest 100,000
492,950
ANSWERS TO EXAM TYPE QUESTIONS
3 4 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
2) Workings
Wk 1
Interest on capital
Ali = 5% x 16,000,000 x 3/12 = 200,000
= 6% x 16,400,000 x 9/12 = 738,000
938,000
Bakari = 5% x 10,000,000 x 3/12 = 125,000
= 6% x 11,600,000 x 9/12= 522,000
647,000
Chando = 6% x 10,000,000 x 9/12 = 450,000
Wk 2
Goodwill a/c
Sh.
‘000’
Sh.
‘000’
Capital a/c: Ali 8,400 Capital: Ali 8,000
Bakari 5,600 Bakari 4000
Chando 2,000
14,000 14,000
Capital a/c
Sh
‘000’
Sh
.‘000’
Sh
‘000’
Sh
.‘000’
Sh
.‘000’
Sh
.‘000’
Ali Bakari Chando Ali Bakari Chando
Goodwill c/f 8,000 4,000 2,000 Balance b/d 16,000 10,000
Balance c/d 16,000 11,600 10,000 8,400 5,600
12,000
24,400 15,600 12,000 24,400 15,600 12,000
Wk 3
Salaries:
Bakari = 3/12x 4,000,000 = 1,000,000
= 9/12 x 6,000,000 = 4,500,000
5,500,000
Chomba = 9/12 x 6,000,000 = 4,500,000
Wk 4
Salaries expense = 3/12 x 8,000,000 = 2,000,000
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S T U D Y T E X T
Wk 5
Loss in sales of stock = 750,000 – 280,000
= 470,000
Wk 6
Provision for bad and doubtful debts
= 3% x 3,500,000 = 105,000
Wk 7
Equipment = 10% x 8,000,000 =800,000 (wrong provision)
Correct = 15% x 3,200,000 = 480,000
Reduction in provision for depreciation 320,000
Drawings in goods
= 100,000 + 900,000 + 600,000 = 2,500,000
Question 2 (December 2005 Question1)
ARAKA LIMITED
STATEMENT OF COMPREHENSIVE INCOME
For the year ended 30/9/2005
Sh. ‘000’ Sh. ‘000
Sales 1,312,567
Less cost of sales
Opening inventory 41,912
Purchases 839,004
880,916
Less closing inventory (62,047) (818,869)
Gross profit 493,698
Gain on disposal 1,375
Bad debt recovered 612
495,685
Expenses
Electricity 6,917
Motor expenses (4,174 + 412) 4,586
Sundry expenses (2,002 + 91) 2,093
Salaries and wages (121,600 + 36) 121,636
Directors’ remuneration 48,888
Bank charges (1,621 + 533) 2,154
Depreciation: Freehold building W3 8,620
Plant and machinery
W3
9,620
Motor vehicle W3 7,450
Bad debts (1,370 + 512) 1,882
Provision for bad debts W2 1,194 (215,040)
Profit before tax 280,645
Corporation tax (131,700)
Profit after tax 148,945
Less proposed dividend (5,000)
Retained profit for the year 143,945
Retained profit b/f 296,057
Retained profit c/f 440,002
ANSWERS TO EXAM TYPE QUESTIONS
3 4 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
Araka Limited
Statement of financial position
As at 30/9/2005
Sh. ‘000’ Sh. ‘000’ Sh. ‘000’
Non-current assets Cost Depreciation NBV
Freehold land 121,500 - 121,500
Freehold buildings 431,000 (77,580) 353,420
Plant and machinery 64,172 (25,694) 38,478
Motor vehicles 29,800 (17,287) 12,513
646,472 120,561 525,911
Current assets
Inventory 62,047
Accounts receivable (59,704 – 1,194) 58,510
Cash in hand [1,268 – (412 + 91 +36)]
N9
729
Cash at bank (1,210 – 533) N4 677
121,963
Current liabilities
Accounts payable 21,172
Tax payable 131,700
Proposed dividends 5,000 (157,872) (35,909)
490,002
Ordinary share 50,000
Retained profits 440,002
490,002
Workings:
1. Gain on sale of motor vehicles
Disposal of vehicles A/c
Dr. Cr.
Sh.
‘000’
Sh. ‘000’
Cost 6,500 Depreciation 4,875
Profit and loss 1,375 Bank 3,000
____ ____
7,875 7,875
Depreciation = 6,500 x 25% x 3 years = Sh 4,875
2. Accounts receivable
Sh. ‘000’ Sh. ‘000’
As per trial balance 61,074
Less bad debts W/o 1,370
General provision 2% x (61,074 – 1,370) 1,194 (2,564)
58,510
3. Depreciation of non-current assets
Sh. ‘000’
Freehold building 20% x 431,000 8,620
Plant and machinery 20% x[64,172 – 16,074] 9,620
Motor vehicles 25% [28,900 – 6,500 + 7,400] 7,450
345
S T U D Y T E X T
CHAPTER 10
QUESTION 1
a) Amount of cash stolen
Cash in hand 129600
Petty cash balance 15260
Reimbursement of petty cash 9740
Cash from sales 14th DecDec 259320
413920
Disbursements (13690)
Cash in store/Stolen 400,230
b) Value of stock (at cost) stolen (Sh000)
Opening stock 1st December 32,540
Additional stock 5784
Less stock sold
1st December - 6th December 5376
7th December – 13th December 3091333
14th December 486.667 (8954)
29370
Stolen stock (18070)
Balance in store 11300
􀀀 Value of stolen stock is 18,070,000
c) Bank Balance
Balance b/f 6,625,080
Cash banked
1st December – 6th December 1,429,710
7th Dec. – 13th Dec. 1,644,500
Cheques from customers 15,867,110
25,566,400
Withdrawals and payments
Staff Wages 361590
Suppliers 17118360
Petty cash 9749 (17,489,690)
Balance in bank 8,076,710
ANSWERS TO EXAM TYPE QUESTIONS
3 4 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
CHAPTER 11
QUESTION 1
(a) What benefits will a computerized accounting system bring your company?
• automatic posting
• automatic reports generation
• automatic documents printing
• more accuracy
• more faster to prepare an accounting report
(b) What should I be looking for when selecting a computerized package?
• easy to use
• suitable range of reports
• capable for the storage to store large amount of data
• provided security length
• expandability
• sufficient field length
(c) If we get a Sales Ledger package what kind of reports should we expect?
• sales daybook/journal
• sales invoices
• sales analysis
• VAT analysis
• aged debtor analysis
• customer mailing lists
• statement of accounts
• examinations of accounts details
(d) What’s the difference between a stand-alone package and an integrated package?
What are the advantages and disadvantages of each?
Stand-alone package is an accounting software that have used to prepare a report and no
updating of the reports.
Integrated package is an accounting software package where the insertion of one record can
automatic update the other records.
347
S T U D Y T E X T
Advantages of integrated packages:
• Automatic updating of report - faster
• Better for a large firm which has large amount of customers and employees - the firm
can save more money.
Disadvantages
• Inserted a wrong type of accounting is not easy to correct them
• Difficult to know which employee had done the error
(e) Our computer support staff say that we’ll have to configure the package before we
can use it. What do they mean by that? Explain what configuration involves.
• Configuration the package means that before we used the integrated package, we must
match the software and hardware devices.
• A typical system configuration involved:
o company name and address
o computer hardware configuration
o printer configuration
o page format configuration
o tax rate
o alter user table
ANSWERS TO EXAM TYPE QUESTIONS
3 4 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
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S T U D Y T E X T
CHAPTER FOURTEEN
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S T U D Y T E X T
REVISION TEST PAPERS
Test paper 1
Question 1
NMGC Company is issuing one million 7% preference shares of Sh 1 each, payable 10% on
application, 20% on allotment, 40% on first call and 30% on second call. Applications are received
for 1550 shares. A refund of the money is made in respect of 50 shares, while for the remaining
1500 applied for, an allotment is to be made on the basis of 2 shares for every 3 applied for.
The excess application monies are set off against allotment monies asked for. The remaining
requested installments are all paid in full.
You are required to show the journal entries of the above issue and then draw the relevant
accounts. (20 marks)
Question 2
The directors of Chimney, a limited liability company, wish to compare the firm’s most recent
financial statements with those of the previous year. The company’s financial statements are
given as follows:
Chimney income statements
Year ended
31st March
2006
31st March
2007
Sh. ‘000 Sh . ‘000
Sales Revenue(80% on credit, 20% on
cash)
1,800
2,500
cost of sales(see note below)
1,200
1,800
Gross Profit
600
700
Distribution costs
160
250
3 5 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Administrative expenses
200
200
operating profits
240
250
Finance cost 50
50
Profit before tax
190
200
Income tax expense 44
46
Net profit for the year
146
154
Note; cost of sales figures are made as
follows
Year ended
31st March
2006
31st March
2007
Sh . ‘000 Sh. ‘000
Opening stock
180
200
Purchase( all on credit)
1,220
1,960
1,400
2,160
Less closing inventory
200
360
Cost of sales
1,200
1,800
353
S T U D Y T E X T
Statements of financial position
As at
31st March 2006 31st March 2007
Sh. ‘000 Sh. ‘000 Sh. 000 Sh. ‘000
Assets
Non current assets at cost 3100 3674
Less accumulated depreciation 1214 1422
1886 2252
Current assets
Inventory 200 360
Trade receivables 400 750
Cash at bank 100 120
700 1230
total assets 2586 3482
Equities and Liabilities
Capital and reserves
Issued ordinary share capital* 1000 1200
Share premium account* 400 600
Income statement 168 322
1568 2122
Non current liability
10% Loan notes 500 500
Current liabilities
Trade payables 210 380
Sundry payables 260 430
Tax payable 48 50
518 860
2586 2586
• *The additional share capital was issued on 1st April, 2006
Required
a) Calculate, for each of the two years, eight accounting ratios that should assist the directors
in their comparison, using the closing figures for the statement of financial position items
needed. (16 marks)
b) Comment on the ratios. (4 marks)
REVISION TEST PAPERS
3 5 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
Question 3
Chemilil Sugar Company, a leading manufacturer of sugar had a trial balance as at 31st December
2006 as follows,
Sh Sh
Delivery van expense 7,500
Lighting and heating; factory 8,577
Lighting and heating; office 3,330
Manufacturing wages 136,410
General expenses; factory 16,920
Office 11,448
Sales representative commission 23,580
Purchases 117,162
Rent; factory 14,400
Office 6,600
Machinery (cost of Sh 150,000) 97,500
Office equipment (cost of Sh 45,000)33,000
Office salaries 18,855
Debtors 85,110
Creditors 58,350
Bank 40,011
Sales 409,500
Premises (cost of Sh 150,000) 120,000
Stocks as at 31st December 2005
Raw materials 25,695
Finished goods 88,440
Drawings 25,680
Capital 412,368
355
S T U D Y T E X T
Additional information;
a. Stocks as at 31st December 2006:
Raw materials Sh 27,150
Finished goods Sh 93,600
There is no work in progress.
b. Depreciate machinery for Sh 6,000, equipment for Sh 4,500 and premises for Sh 3,000.
c. Manufacturing wages due but unpaid at 31st December 2006 are Sh. 915, prepaid office
rent, Sh 324
Required
Prepare the manufacturing, statement of comprehensive income s for the year ended 31st
December 2006 and a statement of financial position as at that date.
Question 4
a) List three errors that affect control accounts separately, three that affect ledger
balance separately and two that affect both the control accounts and ledger balances.
(8 marks)
b) The balances and transactions affecting Abramovich’s control accounts for the month
of May 2005 are listed below. You are required to prepare sales ledger and purchases
ledger control accounts for the month of May. (12 marks)
REVISION TEST PAPERS
3 5 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
Billion Pounds
Balances as at May 1st, 2005
Sales ledger 91,230 debit
2,110 credit
Purchases ledger 44,900 credit
880 debit
Transactions during May,
Credit purchases 181,350
Returns outwards 6,290
Banking by customers 273,700
Credit sales 367,550
Discounts received 11,050
Bankings to suppliers 154,130
Contra 30,460
Returns inwards 17,200
Bills of exchange receivable 65,060
Customers’ cheques dishonored 4,890
Cash receipts from credit customers 42,010
Refunds to customers for overpayments530
Discounts allowed 7,320
Balances as at 31st May, 2005
Sales ledger 1,360 credit
Purchases ledger 670 debit
357
S T U D Y T E X T
Question 5
Differentiate between the following terms, giving examples where possible.
i Matching concept and Realization concept
ii. Capital expenditure and Revenue expenditure
iii. Accrual concept and Prudence concept.
iv. Profitability ratios and Solvency ratios
v. Business entity concept and Going concern concept.
(Each 4 marks)
Test paper two
Question 1
Victoria J is having problems reconciling her bank account with the cash book as at 31st October
2000. Her cashbook at that date had a credit balance of Sh 27,780.
The reconciled bank balance by the books as at November 1st 1999was an overdraft of Sh 52,240.
The bank statement had a debit balance of Sh 19,740 at 31st October 2000.
Victoria J., a boutique operator in Westlands has no enough expertise to reconcile her bank
account to her cashbook. She has requested for your expertise with the following information:
a) Cheques in respect to purchase of hair products on the following dates had not yet been
presented to the bank prior to 31st October 2000:
28th August, 2000 3,300
14th September, 2000 3,920
25th September, 2000 10,520
26th September, 2000 400
29th October, 2000 1,580
b) Bank charges of Sh 4,100 have been debited by the bank in the bank statement but no
corresponding entries in the cashbook have been made.
c) A subtotal of the credit side of the cashbook of Sh 444,000 had been carried forward to the
subsequent page as Sh 440,400.
REVISION TEST PAPERS
3 5 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
d) In August 2000, Victoria took an 8% loan from Beckham of Sh 138,000. The loan interest
payments were to fall due on the 2nd of each month, the first one falling due on August
2nd. All payments have to be made by standing orders on the due dates, but no payments
relating to the payments have been made in the cashbook.
e) A cheque amounting to Sh 1,580 lodged in the bank on May 31st 2000 were returned by
the bank marked ‘refer to drawer’. Though it was not presented to the bank by 31st October
2000, it was subsequently paid but no adjustments have been made in the cashbook in
respect of the return of the cheque by the bank.
f) A bank lodgment of Sh 18,620on October 6th 2000 has been entered in the cashbook as
Sh 18,260.
Using your accounting expertise, update Victoria’s cashbook balance and reconcile it with the
bank statement amount for her as at 31st October 2000. (20 marks).
Question 2
Merv Fishback, a trader in shipping business had the following financial position on March 1st,
2004.
Premises $42,000
Motor vehicles $41,300
Cash at bank $10,500
Cash in hand $112
Trade debtors $490
Trade creditors $420
Stock $22,470
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S T U D Y T E X T
a) Enter the entries in the general journal and post the necessary accounts
The following transactions were carried out during the month of March 2004:
1. Sold goods on credit to Victor for $5,800 and to Moore for $6,100.
2. Anthony, a debtor by March 1st 2004 owing $280 was Declared bankrupt and his debt
written off.
3. Purchased goods on credit from Rose worth $1,820 and from Frank for $3,500
4. Paid Charles, the only creditor as at 1st March 2004 all his dues by cheque.
5. Withdrew $2,590 from bank for office use.
6. Received goods being returns from Moore $840.
7. David, a debtor by March 1st 2004 sent a cheque for $140 and was allowed $35 cash
discount.
8. Sold goods for cash amounting to $9,800.
9. Settled Rose’s account by cheque, receiving a 10% cash discount.
10. Purchased motor vehicle on credit from General Motors company limited for $21,000
11. Paid rent by cash $392.
12. Banked $9,450.
13. Purchased Plant and Machinery for $11,900 paying by cheque.
14. Fishback deposited $14,000 in the business bank account from his own money and
immediately made $2,800 purchases by cheque.
15. Paid wages for $2,177 by cash.
Required
b) Enter the above transactions in the appropriate books of original entry using a triplecolumn
cashbook.
c) Post the entries from the books of original entry to the appropriate ledgers.
d) Extract a trial balance as at 31st March, 2005.
REVISION TEST PAPERS
3 6 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
Question 3
a) Differentiate between the free-floating petty cash system and the imprest system.(5
marks)
b) The petty cashier of Mugo and Farm Company had the following transactions in the month
of April 2007.
April
1. Received cash float Sh 35,000
2. Paid sundry expenses of Sh 350 and hotel charges of Sh 1,050
3. Paid Muhindi’s account Sh 1,575
4. Settled Gorogoro account Sh.700
5. Paid for vehicle fuel Sh 350 and bought office envelopes Sh 525
6. Paid sundry expenses Sh 700 and hotel expenses Sh 1,225.
7. Made postages worth Sh 875
8. Fueled the company’s vehicles for Sh 700 and settled Michael’s ledger account for
Sh 350
9. Purchased stationery for Sh 525, fuelled the manager’s official car for Sh 350 and paid for
hotel charges while on official duty Sh 1,225
10. Made sundry expenses Sh 175 and hotel charges Sh 1,575
11. Paid for petrol Sh 700, purchased postage stamps Sh 1,050 and settled Mutua’s ledger for
Sh 1,225.
12. Purchased office stationery for Sh 525
13. Received an amount to maintain the imprest.
Required
Enter the above in a petty cashbook with analysis columns for hotel charges, postages and
stationery, motor vehicle expenses, sundry and ledger accounts (15 marks)
361
S T U D Y T E X T
Question 4
Maendeleo ya Wanaume Society is a not-for profit organization that arranges for forums for its
members. The society also runs school for the members’ children. Subscriptions are separate for
the school and for general membership. The society has given you the following information for
the year ended 31stDecember 2001.
a) Salaries and wages amounting to Sh 19,000 were outstanding at the start of the year and
Sh 15,000 at the year end.
b) Books for the school were purchased costing Sh 21,800, normally included in postage and
stationery in the general accounts of the society.
c) Salaries and wages paid to the school staff amounted to Sh 13,000
d) Amounts owing to the society for vacancy adverts were Sh 14,400 at the start of the year
and Sh 22,000 at year end.
e) Sh. 51,800 is owing to suppliers of school stationery at the start of the year and Sh. 55,800
at the end of the year.
f) Subscriptions for the school for the year of 2001 received in 2000 were Sh 47,600 and for
2002 received in 2001 were Sh 37,000.
g) The society had office equipment in its assets at the start of the year at a cost of Sh
192,000 and an investment of Sh 878,000 also at cost.
h) Annual subscriptions received include Sh 7,400 for 2000 and Sh 47,000 for 2002.
i) Office equipment at the end of the year was valued at Sh 198,000.
REVISION TEST PAPERS
3 6 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Alongside the above information, the society treasurer also hands you the following account for
the year ended 31st December 2001.
Receipts and Payments account
Sh. Sh.
Bank balance, January
1
118,000 School stationery
203,000
Annual subscriptions
371,000 Society seminar costs
47,000
Investment income
65,800 Postage and stationery
57,400
School adverts
89,000 Telephone
14,400
School subscriptions
189,800 Sundry expenses
57,800
New equipment
28,000
Rent and rates
41,000
Salaries and wages
197,000
Bank balance,
December 31
190,000
835,600
835,600
Required
a. prepare the statement of comprehensive income for the school for the year ended 31st
December 2001.( 6 marks)
b. Prepare the general statement of comprehensive income for the same period.(6
marks)
c. A statement of financial position as at the end of 2001. (8marks)
363
S T U D Y T E X T
Question 5
a) Name six users of accounting information, the information is useful to each.(12 marks)
b) Give four advantages of historical cost accounting (4 marks)
c) Differentiate between a general ledger and the sales ledger. (4 marks)
Test paper 3
Question 1
a) Give a brief overview of the accounting process (8 marks)
b) Write short notes on:
i. Purchased goodwill and non-purchased goodwill (4 marks)
ii. Bonus shares and rights issue ( 4 marks)
iii. Interim dividends and proposed dividends. ( 4 marks)
Question 2
(a) The net assets of Altese, a trader, at 1 January 2002 amounted to $128,000.
During the year to 31 December 2002 Altese introduced a further $50,000 of capital and made
drawings of $48,000.
At 31 December 2002 Altese’s net assets totaled $184,000.
Required:
Using this information compute Altese’s total profit for the year ended 31 December 2002.
(3 marks)
REVISION TEST PAPERS
3 6 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
(b) Senji does not keep proper accounting records, and it is necessary to calculate her total
purchases for the year. Ended 31 January 2003 from the following information:
Trade payables 31 January 2002 130,400
31 January 2003 171,250
Payment to suppliers 888,400
Cost of goods taken from inventory by Senji for her personal use 1,000
Refunds received from suppliers 2,400
Discounts received 11,200
Required:
Compute the figure for purchases for inclusion in Senji’s financial statements. (3 marks)
(c) Aluki fixes prices to make a standard gross profit percentage on sales of 331/3%.
The following information for the year ended 31 January 2003 is available to compute her sales
total for the year.
Inventory: 1 February 2002 243,000
31 January 2003 261,700
Purchases 595,400
Purchases returns 41,200
Required:
Calculate the sales figure for the year ended 31 January 2003. (3 marks)
(9 marks)
365
S T U D Y T E X T
Question three
(a) The term ‘reserves’ is frequently found in company statements of financial position.
Required:
(i) Explain the meaning of ‘reserves’ in this context:
(ii) Give two examples of reserves and explain how each of your examples comes
into existence.
(b) A company’s issued share capital may be increased by a bonus (capitalization) issue or by a
rights issue.
Required:
Define ‘bonus issue’ and ‘rights issue’ and explain the fundamental difference between
these two types of share issue.
REVISION TEST PAPERS
3 6 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
QUESTION FOUR
Extracts from the financial statements of Apillon for the years ended 31 March 2002 and 2003 are
given below:
Year ended 31 March
Statement of comprehensive income 2002 2003
Sh Sh Sh Sh
Sales revenue (including cash sales
($300,000 in 2002 and $100,000 in 2003) 3,100,000 3,800,000
Cost of sales
Opening inventory 360,000 540,000
Purchases (all on credit) 2,080,000 2,580,000
———— ————
2,440,000 3,120,000
Less: closing inventory 540,000 (1,900,000) 720,000 (2,400,000)
———— ———— ———— ————
Gross profit 1,200,000 1,400,000
Expenses (900,000) (1,100,000)
————— —————
Net profit 300,000 300,000
————— —————
Balance Sheet
Current assets
Inventory 540,000 720,000
Trade receivables 450,000 700,000
———— 990,000 ———— 1,420,000
Current liabilities
Trade payables 410,000 690,000
Bank overdraft 20,000 430,000 170,000 860,000
———— ————
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S T U D Y T E X T
Required:
(a) Calculate the following for each of the two years:
(i) Current ratio;
(ii) Quick ratio (acid test);
(iii) Inventory turnover period (use closing inventory);
(iv) Average period of credit allowed to customers;
(v) Average period of credit taken from suppliers.
Calculate items (iii), (iv) and (v) in days.
(b) Make four brief comments on the changes in the position of the company as revealed by
the changes in these ratios and/or in the given figures from the financial statements.
QUESTION FIVE
Mr. Ancentus Okwengo is the sole proprietor of a small business. The following trial balance was
extracted from his books at March 2000
Sh ‘000’ Sh ‘000’
Capital
Land
Plant and machinery
Provision on depreciation of plant and machinery
Delivery vans
Provision for depreciation of delivery vans
Loose tools at valuation on April 1 199nce 9
Stocks on 1 April 1999
Purchases
Loose tools
Sales
Wages and salaries
Rates and insurance
Repairs and maintenance of buildings
Sales expenses including vehicle running costs
Electricity and power
Industrial training levy
Administration expenses
Provision for doubtful debts
Debtors and creditors
REVISION TEST PAPERS
3 6 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
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S T U D Y T E X T
CHAPTER FIFTEEN
ANSWERS TO TEST PAPERS
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S T U D Y T E X T
ANSWERS TO TEST PAPERS
Question 1
General Journal
Debit Credit
Sh. Sh
Bank 155,000
Application account 155,000
To record reception of application money
Application 5,000
Bank 5,000
To record refund on oversubscription
Application 50,000
Allotment 50,000
to move over application funds to offset allotment receivable
Application 100,000
7% Preference Share Capital 100,000
To transfer Application account into 7% Preference share capital
account
Bank 150,000
Allotment account 150,000
To record reception of allotment money
Allotment account 200,000
7% Preference Share Capital 200,000
To transfer Allotment account into 7% Preference share capital
account
First call account 400,000
7% Preference Share Capital 400,000
To record the making of the First call
Bank 400,000
First Call account 400,000
To record reception of First Call on Preference shares
Second Call account 300,000
7% Preference Share Capital 300,000
To record the making of the Second Call on shares
Bank 300,000
Second Call account 300,000
To record reception of Second Call monies
3 7 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
Bank
Application 155,000 Application 5,000
Allotment 150,000
First Call 400,000
Second Call 300,000 Balance c/d 1,000,000
1,005,000 1,005,000
Application account
Bank 5,000 Bank 155,000
Allotment 50,000
7% Preference Share
Capital
100,000
155,000 155,000
Allotment account
Bank 150,000
7% Preference Share
Capital
200,000
Application
50,000
200,000 200,000
First Call account
7% Preference Share
Capital
400,000
Bank
400,000
Second Call account
7% Preference Share
Capital
300,000
Bank
30,000
7% Preference Share Capital
Application 100,000
Allotment 200,000
First Call 400,000
Balance c/d 1,000,000 Second Call 300,000
1,000,000 1,000,000
373
S T U D Y T E X T
Question two
2006 2007
i) Gross profit margin
600/1800X 100 33.30%
700/2500X100 28.00%
ii) operating profit margin
240/1800X100 13.30%
250/2500X100 10.00%
iii) Return on capital employed
190/1568X 100 12.10%
200/2122X100 9.40%
iv) Current ratio
700:518 1.35:1
1230:860 1.43:1
v) Quick/ Acid test ratio
500:518 0.96:1
870:860 1.01:1
vi) Inventory turnover(days)
200/1200X 365 60.8 days
360/1800 X 365 73.0 days
vii) Trade receivables - Average collection period in days
400/1440 X 365 101.4 days
750/2000 X 365 136.9 days
viii)
Trade payables - Average time to pay
in days
210/1200 X 365 62.8 days
380/1960 X 365 70.8 days
b)
i) Gross profit percentage on sales has declined from 33.3% to 28.0%, a substantial
drop. This could possibly be due to a decision to lower prices in order to increase sales
revenue, which has risen by38.9%. A drop in the gross profit percentage might be an
indicator of possible error or fraud if another explanation such as lowering prices cannot
be found.
ii) Net profit as a percentage of sales revenue is down from 13.3% t0 10%. This is a large
drop, but not as large as the drop in gross profit percentage. A large rise in distribution
costs as a percentage of sales helps to explain this drop.
ANSWERS TO TEST PAPERS
3 7 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
iii) Return on capital employed has declined from 12.1% to 9.4%. It is a reflection of the
decline in profitability as shown by ratio (ii) above.
(iv and v) The two liquidity ratios have changed minimally between the two periods. This
may be suggesting that the liquidity position is satisfactory in both periods.
vi) The inventory turnover ratio has increased because the inventory level has risen faster
than the increases in cost of sales and sales revenue. The higher inventory level could
be reflecting slowing demand for the company’s products towards the end of the period
and/ or slackness in the company’s inventory control procedures.
vii) The average receivables collection period has increased considerably from 101.4 days
to a higher level of 136.9 days. The increase suggests slackness in the company’s
credit control and debt collecting procedures.
viii) There has been a relatively small increase in the average time to pay suppliers. The
increase I perhaps due to pressure on the company’s liquid resources as a result of
increased inventory and trade receivables.
Question 3
CHEMILIL SUGAR COMPANY
MANUFACTURING ACCOUNT
FOR THE YEAR ENDED 31ST DECEMBER 2006
Sh Sh
Opening stock of Raw materials 25,695
add purchases 117,162
less closing stock of raw materials
(27,150)
Cost of Raw materials used 115,707
add direct wages 137,325
Prime cost 253,032
Add factory overheads
Lighting and heating 8,577
General expenses 16,920
Rent 14,400
Depreciation on machinery 6,000
45,897
Production cost 298,929
375
S T U D Y T E X T
CHEMILIL SUGAR COMPANY
STATEMENT OF COMPREHENSIVE INCOME
FOR THE YEAR ENDED 31ST DECEMBER 2006
Sh Sh
Sales 409,500
less cost of sales
Opening stock of finished goods 88,440
add production cost 298,929
less closing stock
(93,600)
(294,769)
Gross profit 115,731
less expenses
Office salaries 18,855
General expenses 11,448
Office rent 6,276
Office lighting and heating 3,330
Commission 23,580
Delivery van expenses 7,500
Depreciation on equipment 4,500
Depreciation on premises 3,000
(78,489)
37,242
ANSWERS TO TEST PAPERS
3 7 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
CHEMILIL SUGAR COMPANY
STATEMENT OF FINANCIAL POSITION AS AT 31ST
DECEMBER 2006
Non Current assets Sh. Sh. Sh.
Premises
150,000 33,000 117,000
Machinery
150,000 58,500 91,500
Equipment 45,000 16,500 28,500
345,000
108,000
237,000
add working capital
Current assets
Stock, finished goods 93,600
Stock, raw materials 27,150
Debtors 85,110
Prepayment 324
Bank 40,011
246,195
less current liabilities
Creditors 58,350
Accrual 915
59,265
186,930
423,930
Financed by;
Capital;
Opening balance
412,368
add net profit 37,242
less drawings 25,680
423,930
Question 4
a) Errors that affect the control accounts
• Errors in the totals of the journals; overcastting and undercasting errors
• Errors of omissions; transactions not recorded in the control accounts
• Errors in posting entries in the control accounts e.g. total of sales journal posted
to the credit side of the control account
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S T U D Y T E X T
Errors that affect ledger balances
• Balances omitted from the list or entered wrongly e.g. a debit balance entered as
a credit balance
• Arithmetical errors in calculating individual balances
• Errors of omission i.e. transactions not recorded in the ledgers
Errors that affect both
• Error of original entry; when the entry in the journal is incorrect and the incorrect
figure is carried forward to the ledger.
• Errors of complete omission from both the control accounts and in the ledger
balances.
b)
Sales Ledger Control account
£, billion
£,
billion
Balance b/d 93030 Balance b/d 2110
Sales 367550 Bank receipts 273700
Dishonored cheques 4890 Contra 30460
Refund 530 Returns inwards 17200
Balance c/d 1360 Bills Receivable 65060
Cash receipts 42010
Discount allowed 7320
Balance c/d 29500
467360 467360
Purchases Ledger Control account
£, billion
£,
billion
Balance b/d 880 Balance b/d 44900
Payments 154130 Purchases 181350
Returns outwards 6290 Balance c/d 670
Contra 30460
Discount received 11050
Balance c/d 24110
226920 226920
ANSWERS TO TEST PAPERS
3 7 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
Question 5
i) Matching concept states that revenues of a certain period should be compared with
the expenses incurred in that period to earn the revenues. It dictates for exclusion
of any prior period payments or the payments for future period expenses. It requires
recognition of cost as expenses when the goods or services represented by the cost
contribute to revenue.
Realization concept states that a sale should be recognized when the event from which
it arises has taken place and the receipt of cash from the transaction is reasonably
certain. For example, a sale should not be recognized when the order is placed by a
prospective customer as there is no confirmation of the sale yet. The placing of an order
should not be treated as a sale yet as the customer may decide to cancel the order.
Instead the sale should be recognized when the when the sales invoice is prepared or
when the goods are delivered to the customer.
ii) Capital expenditure is made when a firm spends money either to buy a new fixed asset
or to add to the value of an existing one. Included in such amounts includes the cost
of acquiring the asset, installation, delivery costs, legal costs of buying property and
any other costs necessary to get the asset in a condition ready for use like testing and
inspection fees, architect’s fees, demolition costs of a building. Capital expenditure is
shown in the Statement of financial position.
Revenue expenditure is incurred when money is spent for the day-to-day running of the
business. They are amounts to restore and repair rather than to acquire and install. A
repair to an existing motor vehicle is a revenue expenditure because it adds no value
but restores the asset to its original value.
iii) In accrual concept, revenues and costs should be recognized when earned or incurred
and not when the money is received or paid.
Prudence states that when alternatives exist, the one selected should be that which gives the
most cautious presentation of the financial position or result of the business. Assets and profits
should not be overstated, but a balance must be achieved to prevent the material overstatement
of liabilities and losses. It means that accountants should not anticipate for gains but should
provide for losses.
iv) Profitability ratios are used to measure profit growth. Most of the values used to measure
the profitability ratio are found in the income statement. Examples include gross profit
margin ratio, net profit margin ratio and return on capital employed.
Solvency ratios on the other hand measure a firm’s capacity to pay its debts. The debt ratio
indicates how much the company owes in relation to its size. It measures the proportion of
liabilities to total assets. Gearing ratio measures the company’s long-term capital structure.
Gearing is the proportion of a company’s total capital provided by loan capital as opposed to
equity.
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S T U D Y T E X T
v) Business entity concept states that a business is a separate entity, distinct from its
owners and managers. It means that the financial affairs of the business should not be
mixed with those of its owners and other businesses. For example the withdrawal of a
business asset for personal use should be recognized as a withdrawal of capital.
Going concern concept assumes that an enterprise will continue in operational existence for
the foreseeable future. It guides the management towards the appropriateness of the financial
statements. It means that the business is not assumed to close down, or at least the closure of
the business is currently uncertain. The available financial information should be considered for
the foreseeable future covering, but not limited to, the twelve months from the reporting date.
Test paper 2 answers
Question 1
Updated Cashbook
Sh SHSSh
Cashbook error 340 Balance b/d 27780
Standing order 2760
Dishonored cheques 1560
Cashbook error 3600
Balance c/d 39460 Bank charges 4100
39800 31880
Victoria J
Bank Reconciliation Statement
As at 31st October 2000
Updated cashbook balance (39,460)
Add unpresented cheques 19,720
Balance as per the bank statement
(19,740)
ANSWERS TO TEST PAPERS
3 8 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
Question 2
a)
General Journal
Date Particulars Debit Credit
2004 Sh Sh
1-Mar Premises 42,000
Motor vehicles 41,300
Cash at bank 10,500
Cash in hand 112
Trade debtors 490
Stock 15,400
Trade creditors 420
Capital
109,382
To record opening balances
109,802
109,802
Motor Vehicle account
2004 Sh 2004 Sh
1-Mar Balance b/d 41,300
General Motors
21,000
31-Mar
B a l a n c e
c/d
62,300
62,300 62,300
1-Apr Balance b/d 62,300
Stock account
2004 Sh 2004 Sh
1-Mar Balance b/d
22,470
31-Mar
Balance
c/d
22,470
1-Apr Balance b/d 22,470
Capital account
2004 Sh 2004 Sh
1-Mar
Balance
b/d 109,382
31-Mar Balance c/d 123,382 Bank 14,000
123,382 123,382
1-Apr
Balance
b/d 123,382
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S T U D Y T E X T
b) Books of original entry.
Sales Journal
Date Particulars Invoice No. Amount,Sh
2004
March Victor 5,800
Moore 6,100
11,900
Purchases Journal
Date Particulars Invoice No. Amount, Sh
2004
March Rose 1,820
Frank 3,500
5,320
Sales Returns Journal
Date Particulars Credit note no. Amount,$
2004
March Moore 840
840
Triple-column Cashbook
Date Particulars
Disc.
Allowed. Cash Bank Date Particulars
Discount
Received Cash Bank
2004 Sh Sh Sh 2004 Sh Sh Sh
1-Mar Balance b/d 112 10,500 4-Mar Charles
420
5 Bank 2,590 5 Cash
2,590
7 David 35 140 9 Rose 182
1,638
8 Cash sales 9,800 10 Rent 392
14 Capital 14,000 12 Bank 9,450
13 Plant& Mach
11,900
14 Purchases
2,800
15 Wages 2,177
31 Balance c/d 483
5,292
35 12,502 24,640 182 12,502
24,640
April
1 Balance b/d 483 5,992
ANSWERS TO TEST PAPERS
3 8 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
c) Ledgers
Purchases ledger
Creditor Rose
Bank 1,638
Discount Received 182 Purchases 1,820
1,820 1,820
Creditor Frank
Balance c/d 3,500 Purchases 3,500
Balance b/d 3,500
Sales Ledger
Debtor Victor
Sales
5,800 Balance c/d
5,800
Balance
b/d
5,800
Debtor Moore
Sales
6,100
Sales
Returns
840
Balance c/d
5,260
6,100
6,100
Balance
b/d
5,260
General Ledger
Purchases account
Creditors 5,320
Bank 2,800 Balance c/d 8,120
8,120 8,120
Balance b/d 8,120
Sales account
Debtors 11,900
Balance c/d 21,700 Cash 9,800
21,700 21,700
Balance b/d 21,700
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S T U D Y T E X T
Plant and Machinery
Bank 11,900 Balance c/d 11,900
Balance b/d 11,900
Wages
Cash 2,177 Balance c/d 2,177
Balance b/d 2,177
Rent
Cash 392 Balance c/d 392
Balance b/d 392
d)
Merv Fishback
Trial Balance
As at 31st 2004
Debit, Sh Credit, Sh
Wages 2,177
Purchases 8,120
Motor Vehicles 62,300
Rent 392
Debtors 11,095
Creditors 3,500
Returns Inwards 840
Plant and Machinery 11,900
Stock 22,470
Capital 123,382
Bad debts 1,960
Cash 483
Bank 5,992
General motors 21,000
Discount allowed 35
Discount received 182
Sales 21,700
Premises 42,000
169,764 169,764
ANSWERS TO TEST PAPERS
3 8 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
Question 3
a) In free-floating petty cash system, the petty cashier makes payments infinitely getting
refunds of whatever amounts he/she requests from the petty cash fund. There is
normally no fixed time of refunding nor is there a fixed amount to be maintained by the
petty cashier.
Imprest system on the other hand requires a reimbursement to the petty cashier only
the amounts that have been used away from the set amount such that the opening
balance is always at a fixed amount. The petty cashier also receives replenishments at
certain specific times like at the end of each week, month or a fortnight.
b) Mugo and Farm company
Petty Cashbook
Receipts Folio Date Particulars Voucher no. Total Hotel charges Sh 2007 Sh Sh 35,000 CB2 1-Apr Cash
2 Sundry expenses 350 2 Hotel charges 1,050 1,050
3 Muhindi 1,575 4 Gorogoro 700 5 Fuel 350 5 Envelopes 525 6 Sundry expenses 700 6 Hotel charges 1,225 1,225
7 Postages 875 8 Petrol 700 8 Michael 350 9 Stationery 525 9 Petrol 350 9 Hotel charges 1,225 1,225
10 Sundry expenses 175 10 Hotel charges 1,575 1,575
11 Petrol 700 11 Postages 1,050 11 Mutua 1,225 12 Stationery 525 5,075 15,750 13 Cash GL 10 13 Balance c/d 35,000
50,750 50,750
35,000 CB5 14 Balance b/d
385
S T U D Y T E X T
ANSWERS TO TEST PAPERS
company
Cashbook
Postages & stationery Motor exp. Sundrya/cs Leger folio Ledger a/cs
Sh Sh Sh Sh
350
PL2 1,575
PL3 700
350
525
700
875
700
PL4 350
525
350
175
700
1,050
PL5 1,225
525
3,500 2,100 1,225 3,850
GL 15 GL 16 GL 22
Mugo and Farm company
Petty Cashbook
Receipts Folio Date Particulars Voucher no. Total Hotel charges Postages & stationery Motor exp. Sundrya/cs Leger folio Ledger a/cs
Sh 2007 Sh Sh Sh Sh Sh Sh
35,000 CB2 1-Apr Cash
2 Sundry expenses 350 350
2 Hotel charges 1,050 1,050
3 Muhindi 1,575 PL2 1,575
4 Gorogoro 700 PL3 700
5 Fuel 350 350
5 Envelopes 525 525
6 Sundry expenses 700 700
6 Hotel charges 1,225 1,225
7 Postages 875 875
8 Petrol 700 700
8 Michael 350 PL4 350
9 Stationery 525 525
9 Petrol 350 350
9 Hotel charges 1,225 1,225
10 Sundry expenses 175 175
10 Hotel charges 1,575 1,575
11 Petrol 700 700
11 Postages 1,050 1,050
11 Mutua 1,225 PL5 1,225
12 Stationery 525 525
5,075 3,500 2,100 1,225 3,850
15,750 13 Cash GL 10 GL 15 GL 16 GL 22
13 Balance c/d 35,000
50,750 50,750
35,000 CB5 14 Balance b/d
b)
3 8 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
Question 4
Workings
Accumulated Fund calculation
39,083
39,447
Bank
118,000
190,000
Salaries and expenses owing
19,000
15,000
School adverts owing
14,400
22,000
School stationery owing
51,800
55,800
Prepaid subscription income(school)
47,600
37,000
Equipment
192,000
198,000
Investment
878,000
Annual subscription income owing
7,400
Annual subscription income prepaid
47,000
Accumulated Fund
1,091,400
Annual subscription income a/c
Arrear b/d 7,400 Cash
371,000
Income and Expenditure 310,600
Prepaid C/d 47,000
371,000
371,000
387
S T U D Y T E X T
ANSWERS TO TEST PAPERS
School Subscription income
Income and expenditure 202,400
Prepaid
b/d
47,600
Prepaid c/d 37,000 Cash
191,800
239,400
239,400
School Statement of comprehensive income
Expenditure Sh. Income Sh.
School stationery 207,000 School subscription
202,400
Books 21,800 School adverts
96,600
School staff salary 13,000
Surplus 57,200
299,000
299,000
Genera Income and Expenditure
Expenditure Sh. Income Sh
Salaries 180,000 Surplus from school
57,200
Seminar costs 47,000 Annual subscription
316,600
Postage and stationery 35,600 Investment income
65,800
Telephone 14,400
Sundry expenses 57,800
rent and rates 41,000
Depreciation 22,000
Surplus 41,800
439,600
439,600
3 8 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
MAENDELEO YA WANAUME SOCIETY
STATEMENT OF FINANCIAL POSITION AS AT 31ST DECEMBER 2001
Non-Current
assets Accumulated Fund 1,091,400
Equipment cost 220,000 Surplus 41,800
Less
accumulated
depreciation 22,000
1,133,200
198,000 Current liabilities
Investment 878,000
Prepaid school
subscription 37,000
Current assets
Annual subscription
prepaid 47,000
Adverts owing 22,000
School stationery
owing 55,800
Bank 190,000 Salaries 15,000
212,000
154,800
1,288,000
1,288,000
Question 5 answer
a) Users of accounting information.
(i) Management – management of business entities need accounting information to assist
for planning and decision making. They will need the information to prepare budgets
and compare with the actual results of operations. They will also be interested in the
cost consequences of a particular course of action to assist them in making decisions
(ii) Present and potential investors – they need accounting information to assess the
risk inherent in, and the return provided by their investments. They need information to
decide whether they should maintain, increase, Decrease of dispose altogether their
investments.
(iii) Employees are interested about the stability and profitability of their employer. It is a
source of sustainability for them and they need to know whether to start searching for
employment elsewhere or keep their current postings. They are also concerned about
the ability to provide remuneration, retirement benefits and employment opportunities.
(iv) Lenders. They are the givers some part of the company’s capital. They need to know if
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S T U D Y T E X T
the loans and the corresponding interests will be paid when due.
(v) Customers. They require financial data in order to anticipate price changes and to
seek alternative sources of supplies when necessary.
(vi) The government. Governments and their agencies require information to regulate the
activities of the enterprises. They also need the financial information to determine level
of taxation and also in preparation of national statistics.
b) Advantages of historical cost accounting
a. They can be determined with greater precision than those of other bases of
measurements. Their verifiability makes them more reliable.
b. If current value accounting were to be adopted, a firm’s assets and liabilities would
have to be revalued each time the financial statements were prepared. This would be
expensive and time consuming.
c. Historical accounting is closely related to objectivity and revenue realization principle.
Historical costs are regarded as relatively objective measurements and that accountants
normally ignore increases in the values of recorded assets until the increases have
been validated by a sale.
d. Historical cost figures provide a basis for comparison with the other enterprises of
similar periods
c)
A general ledger usually records the nominal accounts while the other ledgers, including
sales ledger and purchases ledger records personal accounts.
The general ledger will keep such nominal accounts such as purchases account, sales
accounts, expenses accounts.
Sales ledger on the other hand contained personal accounts such as the individual
debtor accounts. It generates its data from the books of original entry.
ANSWERS TO TEST PAPERS
3 9 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
Test paper 3 answers
Question 1
Overview of accounting process
1. Recording phase
1) Appropriate business documents are prepared or received. The documentation provides
the basis for making an initial record of each transaction. Examples of such documents
are sales invoices, cash register, cheques etc
2) Basing upon the supporting document, each transaction is recorded in a chronological
order in the books of original entry or journals.
3) Each transaction, as classified and recorded in the journals, is posted to the appropriate
accounts in the ledgers.
2. Summarizing phase
4) A trial balance of the accounts in the ledger is taken. It provides a summary of the
information as classified in the ledger, as well as a general check on the accuracy of the
recording and posting.
5) The data required to bring the accounts up to date are compiled. This is done through
the adjusting entries.
6) Accounts are closed. Balances in the nominal accounts are closed and transferred to
the income statement. Balances of the real accounts are carried forward to the next
period.
7) Financial statements are prepared. At this stage, the two main statements are prepared;
the statement of comprehensive income and the Statement of financial position.
8) A post-closing trial balance is prepared
9) Reversing entries are made for accruals and prepayments to start a new accounting
period.
b)
i) Purchased goodwill and non purchased goodwill.
Non purchased goodwill is the goodwill inherent in the business. It is extremely difficult
to measure such goodwill because the business is a going concern. It is a goodwill not
yet paid for and therefore has a no objective value. It keeps on changing. One bad act
by an employee might damage it instantly.
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S T U D Y T E X T
Purchased goodwill on the other hand occurs when the business is being sold. When a
buyer purchases an existing business, he will buy not only the existing tangible assets
but also the goodness the existing business has ploughed to itself over the period of
existence. It appears in the statement of financial position as a long-term intangible
(fictitious) asset.
ii) Bonus and rights issue.
A bonus issue is one in which a proportional distribution of additional shares to the
company’s existing shareholders. Also called a script issue, it is a way of issuing
dividends without giving soft cash. It can be termed as being issue of capital to the
exiting shareholders for free.
A rights issue on the other hand is an issue of shares for cash to the existing shareholders.
The rights are offered to the existing shareholders who may decide to sell them, exercise
them or do nothing. Rights issues give the shareholder an option to acquire a specified
number of shares under specified conditions within a specified period.
iii) Interim dividends and proposed dividends.
Interim dividends are issued during the period for which they are payable and an actual
payment in cash is made to the shareholders.
Proposed dividends represent the proportion of the year’s dividends that the directors
indicate will be transferred from the retained earnings. This proposal is made during the
annual general meeting and there fore they are not payable by the year end. They are
shown in the statement of financial position alongside other payables within a year.
question 2
3 (a)
$
Opening capital 128,000
Capital introduced 50,000
————
178,000
Less: Drawings 48,000
————
130,000
Closing capital 184,000
————
Profit is therefore 54,000
————
ANSWERS TO TEST PAPERS
3 9 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
(b)
Purchases Control Account
Balance brought forward 130,400
Payments to suppliers 888,400 Goods taken by Senji 1,000
Discounts received 11,200 Refunds from suppliers 2,400
Purchases 937,050
Balance carried forward 171,250
——— ———
1,070,850 1,070,850
——— ———
(c)
Cost of sales:
Opening inventory 243,000
Purchases 595,400
Less: Returns 41,200 554,200
———— ————
797,200
Less: Closing inventory 261,700
————
535,500
————
Sales figure is therefore $535,500 x 3/2 = $803,250
question 3
(a)
(i) Reserves are balances in a company’s statement of financial position forming part of
the equity interest and representing surpluses or gains, whether realized or not.
(ii) Share premium account
The surplus arising when shares are issued at a price in excess of their par values.
(iii) Revaluation reserve
The unrealized gain when the amount at which non-current assets are carried is
increased above cost.
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S T U D Y T E X T
(b)
A bonus issue is the conversion of reserves into share capital, with shares being issued to
existing members in proportion to their shareholdings, without any consideration being given by
the shareholders.
A rights issue is again an issue of shares to existing members in proportion to their shareholdings,
but with payment being made by the shareholders for the shares allotted to them. The fundamental
difference between them is that the rights issue raises funds for the company whereas the bonus
issue does not.
ANSWERS TO TEST PAPERS
3 9 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
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S T U D Y T E X T
REFERENCES
S TSUTDUYD YT ETXETX T
3 9 6 FINANCIAL ACCOUNTING
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S T U D Y T E X T
REFERENCES
1. BPP (2008) Financial Accounting.
2. BPP (2008) Financial Reporting (Int).
3. Rose and Kolari 1995.
4. Accounting an introduction, 2002.
5. Frank Wood’s Business Accounting 1 and 2
6. KASNEB http://www.kasneb.or.ke/bboard.htm
7. Business Daily http://www.businessdailyafrica.com/
8. http://basiccollegeaccounting.com/category/computerised-accounting/
9. http://www.softwareforbusiness.net/accounting-software/types-of-accountingsoftware.
html
10. http://web.ifac.org/download/IPSASB_Process_Final_version_Oct_08.pdf
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S T U D Y T E X T
GLOSSARY
S TSUTDUYD YT ETXETX T
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S T U D Y T E X T
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S T U D Y T E X T
GLOSSARY
Accounting - the process of identifying, measuring, recording and communicating financial
information in order to permit users to make informed decisions
Sales - this term is used to refer to the transfer of goods in return for money
Purchases - these are goods bought by a business in order to be resold
Journal - this is the first record of a transaction that is made in a firm’s books
Ledger - this is an account in which transactions initially recorded in journals are
transferred (or posted) to
Business - an organisation that exists in order to make profit
Debtor - a person that owes the business money
Creditor - a person that the business owes money
Cashbook - an account in which transactions concerning cash are recorded, such as
payments made or amounts received from debtors
Carriage in - the cost of transporting goods from a supplier to the business
Carriage out - the cost of transporting goods from the business to a customer who has
bought them
Returns inwards - goods returned by customers to the business
Returns outwards - goods returned by the business to the supplier
Transactions - activities of buying and selling that the business engages in
Profit - the excess of incomes made over expenditure
Loss - the excess of expenditure over income
Assets - things of value to the business
Liabilities - amounts owed by the business to external parties
Capital - the amount of money or other assets introduced by the owner of the business
Partnership - a business venture whereby two or more persons run a business together
with the objective of making profit
Company - an organization that is a legal person and has limited liability
Sole proprietorship - a business run by a single individual with an aim of making profit
Financial statements - a business run by two or more people together in order to make a profit
4 0 2 FINANCIAL ACCOUNTING
S T U D Y T E X T
403
S T U D Y T E X T
INDEX
S TSUTDUYD YT ETXETX T
4 0 4 FINANCIAL ACCOUNTING
S T U D Y T E X T
405
S T U D Y T E X T
INDEX
A
Account:7, 462
Accounting equation:7
accounting information:8
Accounting Principles:10
Accrual concept:10
Accrual expenses:89
Accrued income:91
Acid test or quick ratio:219
Activity ratios:219
Allotment:246, 429
Assets:121
Audit:479
Auditing:5
Auditors:455, 456
average collection period:222
B
BALANCE SHEET:121
Balance sheet:479
balance sheet:121
be work in progress:205
board of directors:235
Branches of accounting:5
Business entity concept:9
C
Calls:238
Capital:416, 479
Capital clause:416
Capital reserves:239
Cash turnover/Operating turnover:223
Cash working cycle/Working capital cycle/Operating cycle.:223
Charges:424
Class:441, 442, 479
4 0 6 FINANCIAL ACCOUNTING
S T U D Y T E X T
Classifying phase:5
Comparability:8
Concepts of Accounting:9
Consistency:11
Cost accounting:5
Creditor’s turnover:222
Customers.:6
D
Debentures:427, 428
Debtor’s days:222
Debtor’s turnover.:222
Debt equity ratio:220
Debt ratio:220
Directors:442, 443, 445
Discounts received:94
Discount allowed:92
Disposal of an a:113
Dividend cover:224
Dividend pay out ratio:224
Dividend per share:224
Dividend retention ratio:224
Dividend yield.:225
DRAWINGS:133
drawings account:131, 133
Duality:12
E
Employees:5
Equitable mortgage:480
Equity:7
equity ratios:219
Estoppel:430, 480
F
Finance charges:203
Financial accounting:5
Floating charge:480
407
S T U D Y T E X T
Forfeiture:431, 480
Formation:413
G
GEARING OR LEVERAGE RATIOS:220
gearing ratio. See debt ratio
gearing ratios. See Liquidity ratios
General meetings:480
Going concern:9
Goodwill:162
Gross profit margin:221
Group accounts:480
H
Historical cost:10
I
Increase in provision for bad debts:98
INDIRECT MANUFACTURING COSTS.:203
Interest on capital:145
Interest on drawings:146
Interpretation:5
Investment ratios. See equity ratios
ISSUANCE OF SHARES:246
L
Lenders:6
Leverage ratio:219
LIABILITIES:122
Liability:7, 414, 416, 426
Lien:416, 481
Life Membership fund:192
Limited liability:480
Liquidation:432
LIQUIDITY RATIOS:219
Liquidity ratios:219
Loan capital:236
M
Managerial accounting:5
INDEX
4 0 8 FINANCIAL ACCOUNTING
S T U D Y T E X T
MANUFACTURING ACCOUNT:201
Materiality:11
Member:430, 481
Memorandum of association:481
Monetary principle:10
N
Name clause:416
Negligence:481
Net assets turnover:221
Net profit margin:221
Non- cumulative preference shares:237
NON PROFIT MAKING ORGANIZATIONS:187, 188
Non purchased:162
O
Operating expenses ratio:221
Operating profit/margin ratio:221
Oppression:481
Ordinary shares:236
P
partnership:142
capital account, current account:142
Partnership agreements:143
Phases of the accounting process:4
Premium:481
Prepaid expenses:86
Prepayments:10
Present and potential investors:5
Price earnings ratio:225
PRODUCTION COSTS:201, 202
Profitability ratios:219, 228
PROFIT AND LOSS ACCOUNT:83
Prospectus:481
PROVISION FOR UNREALIZED PROFIT.:207
Proxy:481
Prudence:11
409
S T U D Y T E X T
Purchased goodwill:162
Q
Qualification shares:482
Quorum:442, 482
R
RATIO ANALYSIS:218
Recording phase:4
Redeemable preference shares:482
Reduction:422
Registrar:453
Reissue of forfeited shares:247
Relevance.:8
Reliability:8
Removal:445
Resolutions:423
Return on capital employed:220
Return on equity:221
Return on investment:221
Revenue realization concept:11
Revenue reserves:239
S
Secured:428, 482
Share capital:236
Sole traders:132
Stamp duty:473
SUBSCRIPTION.:191
Substance over form:12
Summarizing phase:5
T
Tax accounting;:5
Termination:414
The government.:6
Timely:8
Times interest cover:220
Transfer:413, 416, 429, 430, 482
INDEX
4 1 0 FINANCIAL ACCOUNTING
S T U D Y T E X T
Transmission:430
Trust:425, 426
U
Ultra vires:482
Understandability:8
Users of financial information:5
V
veil of incorporation.:234
Voting:416, 442
W
Warrant:482