CHAPTER 1
INTRODUCTION TO FINANCIAL ACCOUNTING
This chapter introduces the nature and objectives of financial accounting.
Before you learn how to process transactions and eventual preparation of financial statements, it
is important that you understand why accounting information is necessary and the assumptions
on which it is based. This is because accounting has limitations on the scope and use of
accounting information. It is equally important to know the type of business entities that operate
in communities from which accounting information is derived.
TOPICS
1.
What is financial accounting?
2.
Types of business entities.
3.
Description of users of financial accounting information.
4.
What makes accounting information to be useful?
5.
The scope and objectives of financial accounting
LEARNING OUTCOMES
At the end of this chapter you should be able to:
-
Explain the need and objectives of financial accounting.
-
Identify the users of financial accounting information as prepared by different types of
business units.
-
Describe qualities of good accounting information.
1
WHAT IS ACCOUNTING?
1.1
Accounting is the process of identifying, measuring, recording, summarizing
economic information and finally communicating it to interested parties (users)
1.2
ANALYSIS OF DEFINITION
(a)
Process mean accounting has steps and procedures of doing things.
(b)
Identifying means accounting is only concerned with activities or
transactions relating to the business.
(c)
Measuring means that all activities related to the business should be stated
in monetary terms.
1
(d)
Recording is the aspect of writing down business transactions in
accounting books. This is called BOOK KEEPING.
(e)
Summarising means analyzing all recorded information in categories and
preparing financial statements.
Financial statements include:
(i)
(ii)
(f)
Income statement, which is a summary of trading activities to
establish profit or loss achieved during a trading period.
Balance sheet which is a summary of what the business owns or
owes at a given time.
Financial statements should be provided to any body interested for
assessment and decision making (communication).
ACTIVITY 1.1
In communities we live in people work in different organizations. Some work as accountants.
Can you describe who an accountant is?
2.
TYPES OF BUSINESSES
2.1
WHAT IS A BUSINESS?
A business is defined variously to suit one’s requirements. In our studies we shall
define a business as: “a person, firm, company or other organisation which makes
or produces some kind of service usually for the purpose of making profits.”
Profit is excess of Income over Expenditure
Loss is excess of Expenditure over Income
Business can be organised at different levels with a major limiting factor being
resources (capital).
Businesses range from basic simple business to a more complex one.
2.2
SOLE TRADER
This is the type of business owned and operated by one person. However, the
person running this business can have employees.
The sole trader, as an individual will provide the resources and skills to operate
the business.
Maintaining accounting records in a sole trader may vary from basic to complex
as some sole trader may grow very big.
2
2.3
PARTNERSHIP
This is a type of business where two or more persons put their resources together
to carry on business for the purpose of making profits. There is a limit as to the
number of partners depending on the type of business to be carried on.
2.4
COMPANY
This is a formal association of persons for business purposes. A company is
legally incorporated under company law.
Members of a company are called shareholders.
Companies are usually limited (Ltd) meaning that if the company goes into
liquidation because of debts, each member will only lose the cost of his shares i.e.
amount contributed in the business and no more.
2.5
TYPES OF LIMITED COMPANIES
(a)
PRIVATE COMPANIES
They are private in the sense that membership is restricted to well known
individuals and members are few in numbers.
Private companies usually have the word “LIMITED” at the end of the
name. Other countries use the word “PRIVATE”.
They do not invite members of the public to subscribe for shares and
members are not allowed to transfer their shares without agreement of the
other shareholders.
(b)
PUBLIC COMPANIES
They offer shares to the public and there is no limit to membership.
Shareholders can transfer shares without restrictions. Such a company
must include the words PUBLIC LIMITED COMPANY (Abbr. PLC)
after its name.
ACTIVITY 1.2
Distinguish the following terms: enterprise, business, company and firm.
3
USERS OF ACCOUNTING INFORMATION
When financial statements are prepared they are passed on to interested parties who might need
them for various reasons.
The following might be interested in financial information.
(a)
Managers of the organization:
Managers are people appointed by owners of the company to supervise the daily
activities of the company.
Managers need accounting information to make planning decisions.
(b)
Shareholders and potential investors:
A shareholder is a member of limited company and therefore holds one or more shares in
that company. Potential investors are people with resources but are yet to make a
decision as to where to invest.
Shareholders are interested in profits and security of their investment. They need to look
at accounting information to access profitability of the company and will make decisions
such as retaining their investment in the company or invest it somewhere else.
(c)
Trade contacts:
Trade contacts are suppliers of goods and services to the company. They also include
customers.
Credit suppliers are interested in the ability of the company to pay its debts should they
supply to it.
Customers are interested in continuous supply with no danger of the business closing.
Financial accounting information may just satisfy their concerns.
(d)
Lenders
Lenders provide finance to companies in form of loans which could be short or long term.
Their main concern is to whether a company will be able to pay interest on loans and also
eventually repay the loan itself.
This information may be provided by accounting information.
(e)
Government agencies
Government needs to know how the economy is performing in order to plan for
financial and industrial policies.
Tax authorities would also want to know the business profits in order to assess
4
the tax payable by the company.
Financial statements could be used as a basis.
(f)
Employees and trade union representatives
Employees are workers in a company. Their concern is job security and better conditions
of services.
They will need accounting information as a basis for negotiating for improved salaries
and conditions of services. Accounting information may also disclose that the company
is threatened with closure and employees will have to make a decision of staying or not.
(g)
The public:
People in general want accounting information because enterprises affect them in many
ways.
Companies are found where people live. Companies provide jobs for the people and they
also use local suppliers. Companies may also affect the environment through pollution.
(h)
Financial analyst and advisers:
These are specialists in economic trends. They need accounting information in order to
advise their clients on best investment options and generally to inform the public on
financial matters.
ACTIVITY 1.3
It is easy for people working in an organization to have access to accounting information. For
people outside it may be difficult. How can external people access accounting information?
4.
QUALITIES OF GOOD ACCOUNTING INFORMATION
For information to be of good quality, it must be able to satisfy the needs and
requirements of those looking at it. Here are some of them.
(a)
Relevance
Accounting information is relevant if it is connected with what the user wants.
That is, it must influence them to make a decision.
(b)
Reliability
Accounting information provided should be depended upon when making
decisions. For accounting information to be reliable it must be audited
(Examined) by qualified and experienced auditors so that accounts are free from
error.
5
(c)
Comparability
An exercise undertaken to judge to what extent accounting information is similar
or not similar.
For reasonable conclusion to be made about the business it is important that its
accounting information is comparable.
N.B. When comparing use similar businesses both in size and nature, or use
accounting information from the same business from previous year. If business is
starting for the first time a budget could also be used.
(d)
Understandability
For anybody to make a meaningful decision they should have clear knowledge of
what they are looking at. Any difficulties arising from its interpretation must be
dealt with by those who understand it.
(e)
Completeness
When financial statements are prepared they should have all its parts and should
portray a whole or rounded picture of the business activities.
(f)
Objectivity
Financial statements should be free from opinions. They should not be prepared
in order to satisfy a particular group. They should be actual facts otherwise they
would be considered biased. The problem of bias is dealt with by external audit.
(g)
Timeliness
For information to be meaningful, it should be provided at the time it is required
so that timely decisions could be made.
Accounts are usually published soon after the year end.
ACTIVITY 1.4
Looking at the qualities of accounting information, could you identify a problem
that may arise with each one of them?
ACTIVITY 1.5
Identify areas of conflict for qualities of good accounting information or are they
all compatible?
6
5
THE SCOPE OF FINANCIAL ACCOUNTING
5.1
Financial statements are prepared and presented in monetary terms. But the
success of the business does not entirely depend on machinery and other items
that can be measured in monetary values.
A business could be successful because of:
(i)
(ii)
(iii)
Good management
Dedicated workforce
Skill of staff
5.2
The above cannot be measured in monetary terms and therefore do not appear in
financial statements because they are non financial matters in nature.
5.3
Financial accounting information is concerned with the following:
-
Profits or losses in a period
Assets and liabilities of the business
Cash flows in the business
The list is non exhaustive.
5.4
Why keep accounts?
(a)
An account is simply a record of activities taking place in a business.
Example:
-
Bought stamps and paid cash for them K2,000.
Bought machinery on credit from XYZ Ltd K15,000,000.
In the accounting books we need to keep a record of stamps we bought
and how much cash was paid thus Stamps Account K2,000 and Cash
Account K2,000 then Machinery Account K15,000,000 and XYZ Ltd
Account K15,000,000 because XYZ Ltd is yet to be paid for the
machinery he supplied.
(b)
It is important that accounting records are free from errors (accurate)
because users will need to make decisions from them. Accounting records
should also be updated all the time.
Well maintained and updated records may help in the followings:
(i)
Help managers to control the business resources
(ii)
Indicate how successfully managers are performing
(iii)
Provide information about the resources and activities of the
business.
7
(iv)
Help in calculating profits
(v)
Provide information about what the business owns (assets) and
what the business owes (liabilities)
(vi)
Help in answering audit queries.
CHAPTER SUMMARY
-
The chapter introduced what financial accounting is and its main users.
-
Accounting is the process of collecting, recording, summarizing and communicating
financial information.
-
Accounting information is essential to the efficient running of a business. It helps
managers to control the use of resources and plan effectively for the future.
-
Accounting information is used by many interested parties both within and outside the
business. It is used as a basis for communicating information about business activities.
-
Accounting information can only be useful if it satisfies the need and requirements of
those using it.
-
The scope of accounting is very wide, but it is limited to items which have a monetary
value.
8
EXERCISES
1.
Name five groups of people who might use accounting information of a business.
2.
What are the main elements of financial statements?
3.
Accounting information is limited to items having monetary value. True or False.
4.
List the characteristics of qualitative accounting information.
9
SOLUTIONS FOR ACTIVITY QUESTIONS
ACTIVITY 1.1
Accountants are employees found in both profit-making and non-profit making organizations.
They are custodians of finances. Their responsibility is to ensure that funds of an organization
are used for intended purpose by keeping records of where money came from and how it has
been used.
They prepare financial statements which are communicated to users. They also advise
management on financial matters such as investment opportunities.
ACTIVITY 1.2
An enterprise is the most general term, referring to just about any organization with people
having a common goal. It can be a business or a club or local authority.
A business is also a general term and is used to describe any existing organization involved in
trading to make profits.
A Company is an enterprise constituted by law usually involving limited liability for its
members.
Companies need not be business e.g. charities could be constituted as companies.
A firm is a much general term. It is loosely used to describe a business or company. A firm could
also be used to describe an unincorporated business such as a partnership.
ACTIVITY 1.3
Limited companies are required by law to make certain accounting information public. They
send copies of accounting information to the registrar of companies. People can have access to
the information from the registrar of companies at a small fee.
This does not apply to Sole Traders or Partnerships.
ACTIVITY 1.4
Relevance
-
The problem is to identify the needs since there are many users.
Reliability
-
The problem is modern business has become so complex thus
making reliability difficult to achieve.
Comparability -
The use of different methods by business in preparing
financial statements has made it difficult to compare.
However, this has been reduced by Accounting standards.
Understandability
-
Not all users have a sound financial background. It may be
difficulty to make sense of accounting information if you have no
knowledge.
10
Completeness
-
Completeness may be difficult to achieve because of the
volume of work involve.
Objectivity
-
Though financial statements are prepared by management
and bias removed an audit, some people question the
effectiveness of an audit.
Timelines
-
Due to volume of work financial statements may not be
provided at the time they are required. Accounts prepared quickly
will be based on estimates and estimates may reduce reliability.
SOLUTIONS TO EXERCISES
1.
2.
Any of the following
-
Management
-
Lenders
-
Shareholders
-
The Public
-
Employees
-
Financial Analyst and advisers
-
Trade contracts
-
The government
The main elements of financial statements are:
-
Income statement prepared to find the Gross Profit and the Net profit.
The Balance sheet prepared to show a summary of assets, liabilities and capital of
an enterprise.
3.
True – accounting information is limited to items having monetary value.
4.
Relevance, Reliability, understandability, comparability, objectivity and timeliness.
11
CHAPTER 2
INTRODUCTION TO FINANCIAL STATEMENTS
INTRODUCTION
In this chapter we introduce financial statements by explaining the terms used in classifying
income, expenditure, assets and liabilities. Before demonstrating how financial statements are
prepared we explain what the accounting equation is.
TOPIC LIST
1
2
3
4
Financial statements
Assets in the balance sheet
Liabilities in the balance sheet
Income and expenditure
LEARNING OBJECTIVES
At the end of this chapter you should be able to
Define and give examples of assets and liabilities
Explain what income is
Explain what expenditure is
Prepare the income statement
Prepare the balance sheet
1.0
CLASSIFICATION OF FINANCIAL STATEMENTS
Financial statements are sometimes called FINAL ACCOUNTS.
Financial statements are usually prepared at the end of the accounting period i.e. on
yearly basis.
They could also be prepared on quarterly basis called INTERIM REPORTS.
3.2.1
WHAT ARE FINANCIAL STATEMENTS?
These are documents prepared showing financial performance and the state of
financial position of an organisation. They usually list assets and liabilities
including capital – The Balance Sheet.
They also give account of the Profit and Loss – The Income Statement.
3.2.2
THE BALANCE SHEET
The word balance in accounting could mean two things:
(i)
Having two sides equal, or
12
(ii)
Value of an item remaining
Therefore, a balance sheet is a statement prepared which has two sides with equal
values. These values are assets, liabilities and capital.
In summary the accounting equation of the balance sheet is:Assets = Capital + Liabilities
On one side the balance sheet must have assets and on the other side capital and
liabilities and the two sides must be equal as illustrated above.
3.2.3
ASSETS
An asset is anything owned by an organisation that has monetary value. Value
because the organisation will derive economic benefit from its use.
3.2.4
TYPES OF ASSETS
Assets are classified as current assets and non current assets.
(a)
Current assets
They are called current assets because they are temporal in nature. They
easily change in value with time and can be turned into cash fairly soon.
Examples of current assets are:
•
•
•
•
•
•
Inventory – stock of goods
Receivables – amounts owing to the business by credit customers
(receivables)
Prepayments – amounts paid in advance by the business for which
a service has not yet been provided.
Short term investments – this is the use of business money in other
activities to generate income or profits within a short period of
time e.g. within 1, 2, 3 months.
Cash in hand – this is cash available for use in the office.
Cash at bank – this is money the business has with the bank.
ACTIVITY 3.1
Give reasons why inventory, receivables, prepayments, cash at bank and
in hand are classified as current assets?
(b)
Non current assets
Sometimes called fixed assets or capital assets.
These are possessions which do not change in value easily. They are long
lasting and help generate income for the business on long term basis.
13
They are acquired not for sale as long as they are useful to the business.
Examples of non current assets includes:-
Land
Buildings
Tangible non current assets
Machinery
Furniture and fittings
Long term investments
Goodwill, development costs and other intangible assets.
ACTIVITY 3.2
Non Current assets are arranged in a certain order in the balance sheet.
Describe the arrangement.
3.2.5
LIABILITIES
These are amounts owed by the business (debts) to its trade payables and to its
owner(s). They represent the business’s obligation to transfer economic benefits
to a third party.
3.2.5.1 TYPES OF LIABILITIES
(a) Current liabilities
These are debts of the business that must be paid within a fairly short
period of time. A fairly short period of time may be taken as one year.
In the accounts of limited companies, the Companies Act. 1994 requires
the use of the term “Creditors: amounts falling due within one year” rather
than “current liabilities”.
Examples of current liabilities may include the following:
-
Trade creditors
– suppliers to whom the business
owes money for goods supplied on
credit.
-
Accrued expenses
- They represent bills for expenses
for services which the business
been provided but has not yet been
paid for at the time the balance sheet
is being prepared.
Bank overdraft
- These are short term borrowings
repayable on demand. This
happens when a business overdraws from its bank current
account e.g. a business may have
K100 000 in its current account, with
-
14
prior consent from the bank
manager, the business may be
allowed to withdraw K120 000 The
excess K20 000 withdrawn is bank
overdraft, which must be shown
as current liability at the balance
sheet date as long as it is not paid
at that date.
(b)
-
Loans repayable within one year. Some loans maybe obtained to
be repaid over a period of more than 1 year, in the year of
repayment they would be stated as current liabilities.
-
Taxation payable
- These are tax amounts not yet
paid to tax authorities.
Non current liabilities
They may also be called long term liabilities. These are debts by
arrangement with creditors concerned, have to be paid over a long period
of time, usually more than one year e.g. 5 year loan.
This 5 year loan will be shown as non current liability for the first 4 years.
In the 5th year it would appear under current liabilities.
Examples of non current liabilities may include:
-
Loan
- These could be bank loans as long
as they are not repayable within
one year.
-
Mortgage Loan
- This is loan issued for capital
expenditure. It is usually secured
against some property. Should
the business fail to pay the loan
the lender will have claim on the
property.
-
Debenture loans
- These are securities issued by a
limited company at a fixed rate of
interest. They are repayable on
agreed terms.
ACTIVITY 3.3
What is the difference between tangible and intangible non current assets.
3.2.6
Capital (Sole trader)
This is other than money assets such as machinery, buildings, etc. put into
business to carry on business for profit purposes.
15
Capital put in by owners is also called EQUITY.
The capital of a business can be analysed as follows:
Capital at the beginning of period
Add: additional capital introduced
during the period
XX
Add: Profit earned during period
XX
Less: Drawings
XX
___
XX
Capital at end of period
XX
For more details on above refer to the accounting equation.
3.2.7
Capital and business - relationship
Capital is a liability to the business because it belongs to the owner. See business
entity concept.
ACTIVITY 3.5
Categorise the following as tangible non current assets, intangible non current
assets, investments current assets, current liabilities or non current liabilities.
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
(l)
Shares in Chilanga Cement Plc, intended to be held on long term.
Machinery used in production
Inventory – Goods for resale
Bank overdraft
A mortgage loan
Trade payables
Trade receivables
Goodwill
Rent paid in advance by the business
Rent paid in advance to the business
Accrued income to the business
Accrued expenses by the business.
16
3.2.8
Format of the Balance Sheet (Sole trader)
The International Accounting Standard (1AS1) recommends the following
accounting equation when preparing the balance sheet:
Assets = Capital + Liabilities
In vertical format:
A
=
C
+
L
A detailed format is as follows:
Name of organisation:
Balance sheet as at (indicate date)
NON CURRENT ASSETS
Tangible non current assets
Land----------------------------------------XX
Buildings ----------------------------------XX
Machinery ---------------------------------XX
Fixtures & fittings ------------------------XX
Motor vehicles ----------------------------XX
XX
Intangible non current assets
Goodwill ----------------------------------XX
Development costs ----------------------XX
XX
Long term investments
Shares in another company. -----------------------------XX
XX
CURRENT ASSETS
Inventory ---------------------------------XX
Receivables ------------------------------XX
Prepayments ---------------------------- XX
Cash in Bank --------------------------- XX
Cash in Hand --------------------------- XX
XX
17
TOTAL ASSETS ------------------------------------------------- XX
FINANCED BY:
Capital and liabilities
Capital at start -----------------------------------XX
Add Net Profit/Less Net Loss -----------------XX (XX)
Less Drawings ----------------------------------(XX)
XX
Non current liabilities
5 year loan -------------------------------------------------XX
Current Liabilities
Trade creditors -------------------------XX
Accrued expenses --------------------- XX
Bank overdraft ------------------------- XX
Taxation -------------------------------- XX
TOTAL EQUITY & LIABILITY
XX
XX
N.B. non current assets plus current assets = Total assets
Total assets = Capital plus profit less drawing
Plus non current liabilities plus current liabilities.
The format given is not exhaustive neither is it inclusive.
Full Example – Preparation of balance sheet.
The following information is related to Kuku Hardware Stores, as at 31 December
20X6. From it prepare a balance sheet.
K
Capital 1 January 20X6
47,600
Profit made during the year
8,000
Insurance prepaid
300
Rent accrued by Kuku
600
Receivables
500
Tax payable
3,500
Motor vehicles
9,000
Bank overdraft
2,000
Closing Inventory 31.12. 20X6
16,000
Fixtures and fittings
8,000
Cash in hand
100
Payables
1,200
Drawings
4,000
Premises
50,000
5 year loan
25,000
18
SOLUTION
KUKU HARDWARE & STORES
BALANCE SHEET AS AT 31 DECEMBER 20X6
Non current assets:
Premises
Fixtures and fittings
Motor vehicles
K
Current Assets:
Inventory
Receivables
Prepayment
Cash in hand
K
50,000
8,000
9,000
67,000
16,000
500
300
100
16,900
83,900
Total assets
Financed by:
Capital at start
Add: Net profit
47,600
8,000
55,600
(4,000)
Less: Drawings
51, 600
Non current liabilities:
5 year loan
25,000
Current Liabilities
Payables
Bank overdraft
Taxation payable
Accrued expenses
1,200
2,000
3,500
600
7,300
83,900
Total equity and liabilities
19
ACTIVITY 3.5
Prepare a Balance Sheet for Freedom Enterprises as at 31 December 20X4 from
the information below:
3.2.9
Land and buildings
Inventory
Payables
Profit for the year to 31.12. 20X4
Capital introduced during the year
Receivables
Fixtures and fittings
Expenses not yet paid by business
K
80,000
2,500
4,000
6,600
5,000
3,000
27,000
500
Drawings for the year
Amounts paid in advance by business
Motor vans
Cash at bank
Mortgage
Capital as at 1 January 20X4
3,000
1,000
15,000
4,600
70,000
50,000
The Income Statement
The income statement is a statement showing in detail how the profit or loss of a
period has been made. It is a summary of the business trading activities over a
period of time.
Thus: Income Less Expenditure = Profit.
3.2.10 The Matching or Accruals Concept
The income statement is prepared on the principle of matching or accruals. When
calculating profit, all income whether received or not as long as they relate to the
accounting period under-review should be matched with expenditure whether paid
or not as long as expenditure relates to the same accounting period.
3.2.11 Difference between Cash and Profit
Because of the matching/accruals concept used in calculating profits, profits and
cash will always be different.
Remember that cash is an asset while profit is an income.
20
Example:
•
The business started with capital in cash of K100.
Assets = Capital + Liabilities
Cash 100 = Capital 100 + 0
•
The same K100 cash is used to buy goods
Assets = Capital + Liabilities
Cash 0 + Inventory 100 = Capital 100 + Liabilities 0
N.B. The asset of cash has been transformed into another asset of
inventory. The capital is no longer tied in cash but in inventory.
•
All the inventory is sold to customers on credit for K150 (refer to
realization concept).
The asset of inventory has also been transformed another asset receivables
K150. Assets have increased because goods have been sold at a profit of
K50.
This means capital should also increase by the same amount. (Refer to the
accounting equation).
Assets = Capital + Liabilities
Receivables = capital + profit
150
=
100 + 50
N.B While it is agreed that the business has made profit of K50, the
business has no cash because the receivables are not yet to pay.
•
If the goods had been sold on cash basis, the profit will remain at K50 but
cash will be K150.
3.2.12 Division of the income statement
The income statement is divided into two parts. The gross profit part and the net
profit part.
3.2.13 The Gross Profit part
This part of the income statement is concerned with income generated from sale
of goods (sales) and the cost of goods sold (purchases + direct expenses).
Thus: Sales – Cost of Goods Sold = Gross Profit.
21
Direct expenses are added to purchases because they are incurred at the time of
buying and bringing goods into premises. These expenses could be avoided if one
never went to buy goods, so they increase cost of purchases.
Examples:
-
Carriage inwards
Customs duty
Gross profit is not final profits because there could be other indirect expenses to
be deducted.
The gross profit part answers questions such as “are you doing fine in what you
are buying and selling”. Is it a profitable business?
3.2.14 The Net Profit Part
Net means final.
In carrying out a business there could be other expenses that may be incurred
which have no direct bearing on purchases. These may be incurred whether you
buy goods or not. They are called indirect expenses. They may include:
-
Salaries of workers
Rentals
Electricity etc.
Carriage outwards.
Therefore Net Profit = Gross Profit less Indirect Expenses.
Please note that the business may have gross profit but end up with Net loss.
The division of the income statement will help management identify where the
problem is i.e. is it on selling part or expenses part.
3.2.15 Other Income
Sometimes a business may engage itself in other income generating activities
apart from the core business. Other income is added to gross profit before
deducting indirect expenses.
Examples of other Income:
-
Dividend or interest received from investments
Profit on sale of non current assets
Income from Rentals
Discount received from suppliers.
22
3.2.16 Classification of Expenses
When preparing income statement, indirect expenses are classified as:
-
Selling and distribution
Administration
Finance costs
3.2.17 Selling and Distribution expenses
These are expenses incurred in the process of selling goods: examples will
include:
-
Salaries of sales staff
Commission to sales staff
Travelling and entertainment expenses of sales staff.
Marketing costs e.g. advertising and any sales promotion expenses
3.2.18 Administration expenses
These are expenses related to the day to day running of the business. Examples
may include:
-
Salaries of general staff
Rent & rates
Insurance
Telephone
Heating
3.2.19 Finance costs
These may be related to servicing borrowings. Examples:
-
Interest on loan
Interest on bank overdraft
3.2.20 Simple example of Income Statement
-
Bought goods costing K250
When buying the goods transport costs of K20 were incurred to bring the
goods into the business premises (carriage inwards)
The same goods bought were all sold for K450.
The business has an assistant who is paid a fixed salary of K55.
-
Required:
Calculate:
(a)
(b)
Gross profit
Net profit
23
(a) Gross Profit
K000
450
Sales
Cost of sales:
Purchases
Add: Carriage inwards
250
20
(270)
180
Gross profit
(b) Net profit
K000
180
Gross profit
Less: Indirect Expenses
Salary
Net profit
(55)
125
The full income statement would then be:
Sales
Cost of sales:
Purchases
Carriage Inwards
450
250
20
(270)
180
Gross profit
Less Indirect Expense
Salaries
Net profit
(55)
125
ACTIVITY 3.6
On 1 June 20X5 Snow White commenced business dealing in ice cream.
(a)
He rented a van at a cost of K1,000 for three months. Running
expenses for the van averaged K300 per month.
(b)
He hired a part time helper at a cost of K100 per month.
(c)
He borrowed K2,000 from his bank and the interest cost of the
loan was K25 per month.
(d)
His main business was selling ice cream from the van, but he also
did some special catering supplying ice creams for office parties.
Sales to these customers were usually on credit.
(e)
For the three months to 31 August 20X5, his total sales were
K10,000 (K8,900, credit K1,100).
24
(f)
He purchased his ice cream from a local manufacturer, Palmer Ltd.
The cost of purchases in the three months to 31 August 20X5 was
K6,200 and at 31 August he had sold every item of stock. He still
owed K700 to Palmer Ltd for purchases on credit.
(g)
One of his credit sale customers has gone bankrupt, owing Snow
White K250. Snow White has decided to write off the debt in full.
(h)
He used his own home for his office. Telephone and postage
expenses for the three months to 31 August were K150.
(i)
During the period he paid himself K300 per month
Required:
Prepare an income settlement for the three months 1 June to 31
August 20X5
3.2.21 Relationship between the income statement and the Balance Sheet
Balance sheets are pictures of the business at particular points in time, while the
income statements show the activities of the business in between those balance
sheet dates. Therefore the linkage between the accounting statements can be seen
as:
Balance sheet at start of
period
Plus profit or less loss
for the period
Cash in
Movement of cash to or
from proprietors
Cash out
Balance sheet at end of
period
Thus, the balance sheets are not merely isolated statements, they are linked over
time by the profit or loss. See also accounting equation.
25
3.2.22 Inventory
When a business buys goods for resale, they are called inventory.
3.2.23 Closing Inventory
These are goods unsold at the end of the accounting period. Closing inventory is
determined by physical stock taking.
When calculating profit/loss, closing inventory is deducted from the total
inventory figures, because profit/loss is calculated on the cost of what has been
sold. Since the business is continuing the remaining inventory will be carried
forward to the next accounting period.
Example: in year 1 the following transactions took place
Bought 10 shirts at K5 each
Of the 10 shirts only 7 shirts were sold for K8 each.
Calculate profit
Solution:
Profit will only be calculated on the 7 shirts sold. The other 3 shirts will be
carried forward and profit will be calculated when they will be sold.
Thus:
K
Sales (7 x 8)
Cost of sales:
Purchases (10 x 5)
Less: closing inventory
(3 x 5)
K
56
50
(15)
(35)
21
Profit
Closing inventory will appear as a current asset in the balance sheet.
3.2.24 Opening inventory
What is considered closing inventory at the end of an accounting period will be
taken in the new accounting period as opening inventory, and will be added to the
cost of goods which will be bought in the new year.
Example: Continuing from previous example:
In the following year 2 the following transactions took place.
-
Bought 14 shirts at K5 each
Sold 11 shirts at K10 each
26
Calculate profit?
Solution
Note that in year 1, 3 shirts at K5 each were not sold and so they are brought to
year 2 as opening inventory.
K
K
Sales (11 x 10)
110
Cost of Sales
Opening stock (3 x 5)
Add: purchases (14 x 5)
Less: Closing inventory
(6 x 5)
15
70
85
(30)
(55)
55
Profit
3.2.25 Purchases Returns and Sales Returns
When calculating the figure of Net purchases, all goods returned to supplies must
be deducted.
Thus:
Purchases
Less: purchases
Returns
XX
(XX)
Net purchases
XX
Net purchases represented the actual amount paid or to be paid to suppliers for
goods bought only. Purchases returns is also called returns outwards.
Sales returns or returns inwards represents goods returned to the business from
cash or credit customers.
When computing revenue income from sales of goods, sales returns is deducted
because it no longer sales since goods which were sold have been returned.
Thus income statement:
Sales
Less: Sales Returns
XX
(XX)
Turnover/Net sales
XX
N.B. Turnover is sales less sales returns.
27
3.2.26 Format of Income Statement (sole trader)
Name of organization
Income Statement for the period end …………………………. (Date)
Sales
Less: Sales returns
Turnover
XX
(XX)
XX
Cost of Sales
Opening inventory
Purchases
Less purchases returns
Net purchases
Direct expenses
Carriage inwards
Customs duty
XX
XX
(XX)
XX
XX
XX
+
+
XX
Cost of purchases
Total cost of inventory
Less closing inventory
XX
XX
(XX)
(XX)
XX
Gross profit/loss
Add other income
Discount received
Commission received
XX
XX
XX
Less Expenses:
Carriage outwards
Discount allowed
Salaries & wages
Rent
Bad debts
Depreciation
Light & heat e.t.c
XX
XX
XX
XX
XX
XX
XX
__
(XX)
Net Profit/Loss
N.B.
XX
Cost of purchases is:
Net purchases (actual value of goods bought)
Plus
Direct expenses
Full worked example on income statement:
28
On 31 December 20X3 Mungo, a wholesaler, had the following details in his
books.
K
Opening inventory
5,000
Sales
25,000
Purchases returns
2,000
Discount allowed
300
Returns inwards
500
Salaries and wages
8,000
Discount received
250
Rent
400
Electricity
100
Carriage inwards
50
Bad debts
75
Postage & stationery
80
Carriage outwards
95
Closing inventory
3,000
Purchases
12,000
From the above information prepare the income statement for the year ended 31
December 20X3.
Solution:
MUNGO
Income Statement for the year ended 31 December 20X3
K
K
Sales
25,000
Less: Sales returns
(500)
Turnover
K
24,500
Cost of sales:
Opening inventory
Purchases
Less purchases returns
Net purchases
Carriage Inwards
Cost of purchases
Total cost of inventory
Less closing inventory
5,000
12,000
2,000
10,000
50
10,050
15,050
(3,000)
(12,050)
12,450
250
12,700
Gross profit
Add: Discount received
Less: Indirect Expenses
Discount allowed
Salaries and wages
Rent
Electricity
300
8,000
400
100
29
Bad debts
Postage and stationery
Carriage outwards
75
80
95
9,050
Net profit
3,650
ACTIVITY 3.7
Mr. Buju, has been in business for sometime now, as a timber merchant. The
information below has been extracted from his books as at 30 June 20X4, the end
of the accounting period.
K
Capital at start 1 July 20X3
121,900
Trade payables
19,000
Sales
280,000
Returns outwards
13,000
Discounts allowed
2,000
Discounts received
1,500
Fixtures and fittings @ cost
120,000
Depreciation fixtures & fittings
12,000
Trade receivables
24,000
Inventory 1 July 20X3
50,000
Purchases
135,000
Returns inwards
5,000
Carriage outwards
4,000
Drawings
18,000
Carriage inwards
11,000
Rent
7,000
Rates
8,000
Insurance
10,000
Heating & lighting
12,000
Postage
500
Stationery
700
Telephone
400
Advertising
5,000
Salaries & wages
35,000
Bad debts
1,500
Cash in bank
6,000
Cash in hand
300
5 year loan from Banda
20,000
Inventory at 30 June 20X4
17,000
Required:
Prepare income statement for the year end 30 June 20X3 and a Balance Sheet as
at that date.
30
3.2.27 Working capital
This is money needed by a business in order to keep operating (trading). It is
calculated as a difference between current assets and current liabilities.
Thus: working Capital = Current Assets Less Current Liabilities
A deficiency in working capital may indicate liquidity problems in a business.
CHAPTER SUMMARY
-
Financial statements are classified into Income Statement and Balance Sheet.
-
A balance sheet shows the financial position of a business.
-
The income statement shows in detail how the profit or loss in an accounting period
arises.
-
A distinction is made in the balance sheet between non current liabilities and current
liabilities and between non current assets and current assets.
-
Capital is what the business owes to the owner
-
“Current” means within the coming one year from the balance sheet date. Current assets
are expected to be converted into cash within one year. Current liabilities are debts
payable within one year.
-
The working capital of a business is the difference between its current assets and current
liabilities.
-
The income statement is divided between Gross profit and Net profit.
31
EXERCISES
1.
What is a balance sheet?
A.
B.
C.
D.
2.
A list of all assets and liabilities of a business
A statement of the net worth of a business
A statement which shows how the net assets of a business have changed over
time.
A statement of the assets and liabilities of a business at a point in time in financial
terms.
Fill in the blanks
________________ and ________________ are examples long term liabilities.
3.
Which of the following is not a current asset?
A.
B.
C.
D.
Machinery
Stock
Prepayments
Debtors
4
Working capital is another term for net assets. True or False?
5.
Gross profit is best described as?
A.
B.
C.
D.
6.
Three sources of income other than the sale of goods which could appear in the income
statement are:
(i)
(ii)
(iii)
7.
Sales less expenses
Invoiced sales less purchases of stock
Net profit less business overheads
Sales less cost of goods sold
____________________________________
____________________________________
____________________________________
Four items which might be included in selling and distribution expenses are:
(i)
(ii)
(iii)
(iv)
____________________________________
____________________________________
____________________________________
____________________________________
32
SOLUTIONS TO ACTIVITY QUETIONS
ACTIVITY 3.6
MR BUJU
INCOME STATEMENT FOR THE YEAR ENDED 30 JUNE 20X4
K
Sales
Less returns inwards
Turnover
COST OF SALES:
Opening inventory
Purchases
Less: returns outwards
K
280,000
(5,000)
K
275,000
50,000
135,000
(13,000)
122,000
11,000
Carriage inwards
Cost of purchases
Total cost of inventory
Less: Closing inventory
133,000
183,000
(17,000)
(166,000)
109,000
1,500
110,500
Gross profit
Discount received
EXPENSES:
Discount allowed
Depreciation: fixtures & fittings
Carriage outwards
Rent
Rates
Insurance
Heating & lighting
Postage
Stationery
Telephone
Advertising
Salaries & wages
Bad debts
2,000
12,000
4,000
7,000
8,000
10,000
12,000
500
700
400
5,000
35,000
1,500
(98,100)
12,400
Net profit (transferred to Balance Sheet)
33
MR BUJU
BALANCE SHEET AS AT 30 JUNE 20 X4
Non Current Assets
Fixtures & fittings
Current Assets
Inventory (closing)
Receivables
Cash in Bank
Cash in hand
Cost
(K)
120,000
Dep.
(K)
12,000
N.B.V.
(K)
108,000
17,000
24,000
6,000
300
47,300
155,300
Total Assets
Financed by:
Capital at start
Add: Net profit
121,900
12,400
134,300
(18,000)
116,300
Less Drawings
Non current liabilities
5 year loan
20,000
Current liabilities
Payables
19,000
155,300
ACTIVITY 3.8
Snow White
Income Statement for the three months ended 31 August 20X5
K
10,000
(6,200)
3,800
Sales
Less cost of sales
Gross Profit
Expenses:
Wages (3 x 100)
Van Rental
Van expenses (3 x 300)
Bad debts
Telephone and postage
Interest charges (3 x 25)
300
1,000
900
250
150
75
(2,675)
1,125
Net profit
34
SOLUTIOS TO EXERCISES
1.
D, the balance sheet is only correct at a point in time
2.
Loans, mortgages or debentures (any one of them).
3.
A, machinery
4.
False, working capital is another term for net current assets
5.
D, cost includes direct expenses
6.
Any of the following:
7.
Profit on sale of non current assets
Discount received
Rental income
Interest or dividends received from investments.
Include
Salaries of sales staff
Commission to sales staff
Travelling and entertainment of sales staff
Marketing costs
35
CHAPTER 3
REVENUE AND CAPITAL EXPENDITURE
INTRODUCTION
This chapter is very much linked to financial statements preparation. Certain items of
expenditure are shown in income statement and others in balance sheet and yet they are all
expenditure. Explanation is given so that users are not misled in their interpretation as they
make decisions.
The distinction between the two is very important as far as financial statement preparation is
concerned.
In addition distinction between capital income and revenue income is also covered.
TOPICS
1.
What is capital expenditure?
2.
Examples of capital expenditure
3.
What is Revenue expenditure?
4.
Examples of revenue expenditure
5.
Treatment of capital and revenue expenditure in financial statements
6.
Capital income with examples
7.
Revenue income with examples
8.
Treatment of capital and revenue income in financial statements
9.
Explain why some expenditure is part capital & part revenue.
LEARNING OUTCOMES
At the end of this chapter you should be able to:
-
Define capital and revenue expenditure giving examples
Show how they are treated in financial statements
Describe revenue and capital income and their treatment in financial statements.
Describe why failure to distinguish the above may lead to distortion of financial
statements
36
CAPITAL AND REVENUE EXPENDITURE
Expenditure means spending money to acquire items. Items could be goods or services.
The type of item acquired is what is called capital expenditure or revenue expenditure.
4.1
Capital expenditure
When a business spends money to buy non current assets and subsequently adding value
to them is called capital expenditure. For example, acquiring land, buildings, vehicles
etc.
4.2
Adding Value
Adding value means spending money on an existing asset in order to improve its
performance or increase production capacity. E.g. carrying out renovations on machinery
in order to increase production capacity.
4.3
Other capital expenditure
Included in capital expenditure are amount spent on non current assets to put them in a
workable condition. Such amounts may include
-
Transport costs to bring them into business premises
Legal costs incurred in acquiring buildings
Any other costs incurred before non current assets could be put to use.
4.4
Revenue expenditure
This is expenditure incurred on the running of the business on a day to day basis as the
business is carrying on its trading activities. It is also incurred in maintaining the non
current assets.
Examples may include:
-
4.5
Repairing machinery
Replacing broken window panes to a building
Electricity expenses in running machinery
Petrol costs in running the vehicle
Purchase of goods for resale
Warning
What is to be called capital or revenue expenditure will depend on what the business is
dealing in. If for example the business is buying and selling vehicles to make profits,
purchase of a vehicle will be revenue expenditure. But if it buys a vehicle to be used in
business, that will be capital expenditure.
37
EXAMPLE
Baobab is in business as a general retailer. He bought a vehicle for use in his business at a cost
of K2,000. In bringing the vehicle to his premises he incurred transport costs of K500, customs
duty of K700. Before he could use the vehicles, the vehicles had to be serviced and this costed
K50.
When the vehicle was in use, he insured it against theft and fire and this cost K100. In running
the vehicle fuel costs amounted to K150, and replaced tyres with new ones and this cost K70.
He decided to put in a musical system which cost K40. Insurance cover to bring the vehicle into
business premises amounted to K80.
Required:
(a)
Identify items which are capital expenditure and what will be the cost the vehicle in the
books.
(b)
Identify revenue expenditure
SOLUTION
K
K
Capital expenditure
Cost of vehicle
Transport costs
Customs duty
Service charges
Music systems
Insurance cover
Cost of vehicle
in books
Revenue expenditure
2,000
500
700
50
40
80
______
3,370
Insurance charges
fuel costs
new tyres
100
150
70
___
320
ACTIVITY 4.1
Give reasons why expenditure in activity 4.1 has been identified to be capital expenditure and
revenue expenditure.
38
4.6
Joint expenditure
A builder was engaged to do some work on the business buildings. The whole work was
to cost K40,900 broken down as follows:
-
K 30,000 to add an extension on building
K 10,000 for wages of the builder for extension only
K 900 to replace a few broken windows and some missing tiles.
The case above is an example of joint expenditure. In this case capital expenditure
should be separated from revenue expenditure. Thus
K 30,000 extension to building
K 10,000 wages
K 40,000 would be capital expenditure
4.7
Capital and revenue income
Income is proceeds coming into the business. Where income is coming from is what
would be identified as capital or revenue income.
(a)
Capital income
Capital income are proceeds arising from the sale of non current assets and long
term investments. The profits or losses from the sale of non current assets are
included in the income statement for the year in which the sale took place.
Example: suppose a machinery is bought for K10,000, and four years later sold
for K8,000. The K10,000 would be treated as capital expenditure and K8,000
capital income. The loss K2,000 (10,000 – 8,000) would be shown in income
statement.
(b)
Revenue income
This is income generated in the normal cause of running the business. Included
are:
-
revenue from ordinary trading (sales)
interest received
dividends received
discount received
commission received etc.
ACTIVITY 4.2
A business obtains a loan from the bank to finance the purchase of a non current asset. The
business would be paying interest annually.
How would you identify the loan and loan interest? Is it capital or revenue income.
39
ACTIVITY 4.3
Classify each of the following items as ‘Capital’ or ‘Revenue’ expenditure or income.
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
(l)
Purchase of leasehold premises
The annual depreciation of leasehold
Solicitors fee in connection with the purchase of leasehold premises
The costs of adding extra storage capacity to a mainframe computer used in the business
Computer repairs and maintenance costs
Profit on the sale of an office building.
Revenue from sales by credit card
The cost of new machinery
Customs duty charged on the machinery when imported into the country
Carriage costs of transporting the new machinery
The cost of installing the machinery in the business premises
The wages of machine operators
4.8
Treatment of “Capital” and “Revenue” expenditure and machines in financial statements.
(a)
Capital expenditure
Capital expenditure is shown in balance sheet under non current assets.
(b)
Revenue expenditure and income
This is stated in the income statement
(c)
Capital income
Capital income does not include raising capital from the owner(s) of the business,
or raising and repaying loans. These transactions add to the cash assets of the
business, thereby creating a corresponding increase in capital or loan. When the
loans is repaid, it reduces the liability (loan) and the asset of cash.
4.9
Incorrect treatment
If capital expenditure is treated as revenue expenditure or revenue expenditure is treated
as capital expenditure, then:
-
Both balance sheet figures and income statement figures will be wrong
Profit will be over stated if revenue expenditure is treated as capital expenditure
and non current assets will also be overstated
Profit will be understated if capital expenditure is treated as revenue expenditure
and non current assets in the balance sheet will be understated.
40
CHAPTER SUMMARY
-
Capital expenditure is money spent to acquire non current assets and adding value to
them, including expenditure incurred to bring the asset to the business premises.
-
Revenue expenditure is related to running the business. For example, administration,
selling expenses etc. It is also expenditure on maintaining the earning capacity of non
current assets e.g. repairs.
Purchase of inventory and related expenses are also revenue expenditure
-
Capital income arises from the sale of non current assets
-
Revenue receipts is income generated in the process of trading
-
Capital expenditure is shown in balance sheet and revenue expenditure in income
statement.
-
Failure to distinguish capital and revenue expenditure will distort financial statements.
41
EXERCISES
1.
Which of the following explains the distinction between capital and revenue expenditure?
A.
B.
C.
D.
2.
Revenue expenditure is an expense in the income statement, capital expenditure is
an asset in the balance sheet.
Revenue expenditure is an expense in the income statement, capital expenditure is
a liability in the balance sheet.
Capital expenditure results in acquisition or improvement of non current asset,
revenue expenditure is incurred for the purpose of trade or to maintain the earning
capacity of non current assets.
Revenue expenditure results in the acquisition of or improvement of non current
assets, capital expenditure is incurred for the purpose of trade or to maintain the
earning capacity of non current assets.
The data below relates to F Juma’s business, who is an engineer. This is for the financial
year ended 31 December 20X4.
(a)
(b)
(c)
(d)
(e)
Purchase of extra milling machine (includes K50 for repairs of an old machine)
K1,700
Rentals K250
Electric expenses (includes new wiring K250, part of premises improvement)
K2,450
Carriage inwards (includes K70 carriage on new cement mixer) K780
Purchase of extra milling machine K2,100
Required:
Allocate each or part of the items mentioned to either ‘capital’ or ‘revenue’ expenditure
42
SOLUTIONS TO ACTIVITY QUESTIONS
ACTIVITY 4.1
-
All expenses under capital expenditure are directly attributable to the purchase of
vehicle before it could be used in the business. The purchase of music system is
adding value.
-
The other expenses are simply running expenses and are revenue expenditure.
ACTIVITY 4.2
It’s neither capital nor revenue expenditure (see notes).
ACTIVITY 4.3
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
(l)
Capital expenditure
Revenue expenditure
Capital expenditure
Capital expenditure
Revenue expenditure
Revenue income
Revenue income
Capital expenditure
Capital expenditure
Capital expenditure
Capital expenditure
Revenue expenditure
SOLUTION TO EXERCISES
1.
C
2.
(a)
K1650 capital expenditure
K50 repairs of old machine is revenue expenditure
(b)
Revenue expenditure K250
(c)
K250 wiring of part of improvement of premises is capital expenditure
2,200 is revenue expenditure
(d)
Carriage on new mixer is capital expenditure K70
Carriage on goods for resale K710 is revenue expenditure
(e)
Capital expenditure K2,100
43
CHAPTER 4
DOCUMENTATION
INTRODUCTION
Business activities are called transactions. The first record of a transaction is made on source
document that will serve as evidence of what took place on the material day.
In this chapter you will learn the types of documents that are in business use and essential
features of a document. Special emphasis will be put on the documents that are referred to when
making entries in books of account.
Learning Objectives
After you have studied this chapter, you should be able to:
ƒ
ƒ
ƒ
ƒ
Distinguish between internal and external documents
Mention the name of the document sent at each stage of business activities
List the essential part of a document
Explain the purpose of each accounting document: the Invoice, the credit Note and the
Debit Note
PURPOSE OF DOCUMENTS
Documents serve to provide evidence of transactions that took place. In the event of a dispute the
document will be referred to. If the dispute is not resolved and the matter is taken to court, the
document will be presented as legal evidence of what took place. Documents are also used by
auditors to verify the transactions that took place previously.
DOCUMENTING BUSINESS TRANSACTIONS
Business transactions can be between departments within the same organization or between two
separately managed organizations.
An external document is one that is sent between two or more organizations. Examples of such
documents are invoice, credit note and receipts. Documents may not necessarily be accounting.
Some documents are administrative in nature. Examples include Inquiry and Acknowledgement.
An internal document is one that is sent between two departments within the same organization.
The following are examples of internal documents:
ƒ
ƒ
ƒ
ƒ
ƒ
Staff schedules
Supplier Lists
Inventory Lists
Goods Received Notes
Expense Claim Forms
The list above is not exhaustive. You should read more books to know more documents. It will
also be important to visit an organization to go and see samples of documents they handle in
their business.
44
ESSENTIAL FEATURES OF A BUSINESS DOCUMENT
Most documents will contain the following:
ƒ Name and address of the business
ƒ Name and address of the other business
ƒ Document serial number
ƒ Date of business activity
ƒ Description of the activity
ƒ Quantity, unit price and total amount of goods
ƒ Other details such as delivery address, references, Value Added Tax and discount terms.
It should be noted that the contents of a document will be determined by the purpose it will
serve. For example, an invoice will contain details of Value Added Tax whereas a delivery note
may not.
CIRCULATION OF DOCUMENTS
In practice most documents are prepared in duplicate. There are circumstances in which a
document should be prepared in triplicate depending on who require a copy for use and the
importance of keeping the document safely for future reference. Technology has also introduced
electronic documentation and it will be in order for those organizations that can afford to acquire
such systems, and comply with the relevant legal provisions.
ACCOUNTING USE OF DOCUMENTS
The seller often issues documents. When a buyer has issued a document, it merely serves as a
reminder for the seller to issue the relevant document.
An invoice is sent when goods are sold on credit. The seller uses duplicate invoices to compile a
record of all sales in the Sales Day Book. The original sales invoice is what the buyer will call
the Purchase Invoice. Therefore the buyer uses the original invoices to compile a record of all
purchases in the Purchases Day Book.
When the customer returns goods, the seller of the goods will send a Credit Note to evidence the
transaction. The seller will use the duplicate Credit Note to prepare the Sales Returns Day Book.
The buyer will use the original Credit Note to prepare the Purchases Returns Day Book.
Invoices are the source documents for the credit transactions that are recorded in the Sales Day
Book and the Purchases Day Book.
45
No.
Name of Organisation
INVOICE
Tel.
Fax.
P O Box
To…………………………………….
……………………………………….
……………………………………….
S/No.
DESCRIPTION
QTY
Date: …………………..
Unit Price
K
n
Total Amount
K
n
TOTAL
Amount in words: …………………………..
……………………………………………….
E& O E
Goods once delivered cannot be returned.
………………………………………………. ……………………………………………
Receiver's signature
Organisation official
46
979
Credit Notes are the source documents for credit transactions that are recorded in the Sales
Returns Day Book and the Purchases Returns Day Book.
No.
917
Name of Organisation
CREDIT NOTE
Tel.
Fax.
P O Box
To…………………………………….
……………………………………….
……………………………………….
S/No.
DESCRIPTION
QTY
Date: …………………..
Unit Price
K
n
Total Amount
K
n
TOTAL
Amount in words: …………………………..
……………………………………………….
E& O E
Goods once delivered cannot be returned.
………………………………………………. ……………………………………………
Receiver's signature
Organisation official
It can be seen from the specimen source documents on the preceding page that some documents
have certain details pre-printed as long as the details are standard to all situations. Other
documents may only have a structure and the details will be filled in according to the event.
Source documents are serially numbered and they always have to be signed by the person
preparing it and by the person checking the accuracy or authorizing the details on it.
More will be discussed on daybooks in the next chapter.
47
CHAPTER SUMMARY
You should now have learnt that:
• Business transactions should be evidenced by documentation.
• Documentation gives authority to account for the amounts involved in a transaction.
• Documents provide a useful record for future reference and are presented as evidence to
auditors and court officials when settling a dispute.
• A Debit Note is sent when there is an undercast in the original invoice. The buyer may
send a debit note together with the goods returned to remind the seller to send a credit
note in turn.
EXERCISE
Research on the documents retention policies of three organizations of your choice.
48
CHAPTER 5
RULE OF DOUBLE ENTRY AND THE JOURNAL
INTRODUCTION
Preparing accounts depends wholly on the application of the rule of double entry. Topics at
advanced levels adopt varied formats but that does not water down the importance of the rule. In
this chapter we will explain the rule of double entry at so early the stage that you will be able to
appreciate what it is and competently apply it to transactions as they are introduced in
subsequent chapters. Further, we also explain the Journal, a book of prime entry in which
transactions that do not have a regular day book are recorded.
TOPICS
1. The two Primary Concepts: The business Entity Concept and the Duality Concept
2. The Journal
LEARNING OBJECTIVES
After you have studied this chapter, you should be able to:
ƒ
ƒ
ƒ
ƒ
Define and explain the implications of the business Entity Concept
Define and explain the implications of the Duality Concept
Trace the flow in each transaction and correctly debit the receiving account and credit the
giving account
Prepare journals for transactions
Entries in the books of prime entry are then posted to the ledger. The ledger is the main book of
account. To illustrate how this is done we will introduce the first two concepts that guide the
preparation of accounts: the Entity Concept and the Duality Concept. Subsequent to this we will
post entries that are trading in nature first then later on post entries that are administration.
1.0 TWO PRIMARY CONCEPTS
1.1 The Entity Concept
This concept states that a business is a separate entity or person from its owner. Like a biological
person the business can exercise rights to own assets and powers to borrow and incur liabilities.
At law the business (applied to limited liability companies) is a legal person. For accounting
purposes even an unincorporated entity is treated as a ‘person’ separate from the owner who
formed it
The implication of this concept is that assets and liabilities of the business should be kept
separate from those of its owner. The student is in the position of the accountant for the business,
not for the owner of the business. He should view the owner as if he were an out side party or
entity.
49
1.2 The Duality Concept
This concept states that there are two aspects to every transaction:
a) the giving aspect, which creates a liability, and
b) the receiving aspect, which creates an asset.
It is from this concept that the rule of double entry is derived.
The rule of double entry states that for every debit entry to an account there is a corresponding
credit entry in another account. ‘Corresponding’ means of equal magnitude in value.
Consequently to post transactions to the ledger, you debit the receiving account and credit the
giving account
What is given or received (the Flow) in a business transaction can be analysed as follows:
1
Goods:
Are given/received in a credit transaction
Can be trading goods (goods for re-sale)
Can be non current assets (for use in business)
The name of an outside entity is always given in a credit transaction.
2
Cash:
Is given/received in a cash transaction
Can be in the form of notes and coins
Can be in the form of cheques, electronic money transfers, etc
Cash account is involved when notes and coins are given/received
Bank account is involved when cheques, etc are involved
In all situations, the name of the second account affected by a transaction is deduced from the
name of the business activity that has been carried out, for example, sales, purchases returns,
rent, motor vehicles, etc.
50
The guidelines above can be presented in the form of a chart as follows:
THE
FLOW
GOODS
For use in
business
CASH
For
re-sale
The first account will be named after
the OUTSIDE ENTITY given in the
transaction
BUSINESS
ACTIVITY
BUSINESS
ACTIVITY
Cash in the form
of notes & coins
Cheques, debit
cards, EFTs,
CASH
ACCOUNT
BANK
ACCOUNT
The second account will be named after
the ACTIVITY the business has carried
out
The chart above gives you a reliable guide to applying the rule of double entry to all business
transactions you will come across in career. Understand it so that it can become second nature.
Full application of the chart above will be made when posting transactions from day books to the
ledger in a later chapter.
2.0 THE JOURNAL PROPER
This is a book of prime entry in which transactions that are infrequent are recorded. Because of
their infrequence, the transactions are not provided with a separate day book. Such transactions
include the purchase of non-current assets, correction of errors and year end transfers and
adjustments. All these terms will be explained in subsequent chapters.
The mode of recording entries in the Journal, as it is loosely referred to, is to indicate the account
to debit and the account to credit plus a brief description of the business activity that took place.
The description of the transaction is called the narration.
51
2.1 STARTING A BUSINESS
The first journal written is the one when a business just starts. For example: Fix-it, a retired
engineer, received interest on his fixed deposit account of K 8 000 000. He opened a business
bank account.
The journal would be written as shown below:
Debit
K 000
8 000
Bank account
Capital account
Credit
K 000
8 000
Being capital introduced in business by the proprietor.
The bank account represents the cash available to the business to finance business activities. The
capital account represents the amount the business owes its owner. In case of cessation of trading
activities, the business would pay the owner the amount shown on the capital account.
The owner injects funds into the business as initial capital. The capital is expected to grow (i.e
increase by the amount of profits he later makes through trading activities).
The journal above shows that bank account in the ledger will be debited, and capital account will
be credited.
2.1 A CONTINUING BUSINESS
The capital of a continuing business is derived from a given list of assets and liabilities.
Supposing a business had the following assets and liabilities at the start of business: Furniture
and fittings K5 245 000, Inventory K8 692 000, Cash at bank K8 000 000, Trade
Receivables: Chibuye K235 000; Mambwe K390 000, Rent prepaid K332 000, Loan K5 000
000, Trade Payables: Chibale K160 000; Mwape K164 000, Electricity due K221 000, Value
Added Tax outstanding K2 375 000; the journal would be written as follows:
ASSETS:
Furniture & Fittings
Inventory
Cash at Bank
Trade Receivables: Chibuye
Mambwe
Rent prepaid
LIABILITIES:
Loan
Trade Payables: Chibale
Mwape
DR
K 000
5 245
8 692
8 000
CR
K 000
235
390
625
332
5 000
160
164
324
221
2 375
Electricity due
Value Added Tax outstanding
52
Capital (Balancing figure)
14 974
TOTALS
22 894
22 894
The capital is obtained by deducting total liabilities from total assets. Suffice to mention here
that assets are debit balances and liabilities are credit balances as shown above.
2.2 PURCHASE OF A NON CURRENT ASSET
Other examples of transactions that by their nature would first be recorded in the journal are:
April 13.
Received an invoice for the 10 ton truck bought on credit from L-Stone Motors K
40 000 000 gross
April 29.
Paid L-Stone Motors K 10 000 000 by cheque for the truck bought earlier.
The entries in the journal for the above transactions would be:
Debit
K 000
40 000
Motor Vehicles account
L-stone Motors account
Purchase on credit of a truck S/no. ……….
from L-Stone (Invoice No. ……….)
Credit
K 000
40 000
L-Stone Motors account
Bank account
Part payment for the truck S/no. ……….. which
was bought on credit.
10 000
10 000
2.3 ACTIVITY
April 22.
Fix-it buys on credit a compactor to be used in road works from Kabamba
Construction for 42 000 000.
Write the journal for the above transaction.
Note: In practice the narration for the journal should be comprehensive enough to describe what
business transaction took place. All relevant reference documents should be quoted.
Journals will again be discussed in the chapter on correction of errors.
CHAPTER SUMMARY
You should now have learnt that:
ƒ
The journal proper contains journals for transactions that are infrequent.
Each journal indicates how the amounts involved will be posted to the ledger accounts.
53
ƒ
A journal should include a narration of the transaction, referring to relevant source
documents.
EXERCISES
1
Calculate the value of premises from the following balances of assets and liabilities:
K000
Premises
?
Trade Payables
5 600
Trade Receivables
8 250
Cash in Hand
4 520
Loan
9 000
Cash at Bank
6 440
Rates Prepaid
830
Salaries accrued
590
Machinery
7 250
Inventory at start
3 207
Capital
30 307
2
Write the journal entry for the following transactions:
Lily owns a truck which he wishes to use exclusively for business. The truck is worth
K 30 000 000. She obtains a loan from a bank of K 20 000 000.
54
SOLUTIONS TO EXERCISES
Q1
The value of premises is K15 000 as shown in the working below
Working
DR
K 000
ASSETS:
Premises (balancing figure)
Machinery
Inventory
Trade Receivables
Cash at Bank
Cash at bank
Rates prepaid
15 000
7 250
3 207
8 250
6 440
4 520
LIABILITIES:
Salaries accrued
Trade Payables
Loan
Capital
TOTALS
Q2
CR
K 000
590
5 600
9 000
30 307
45 497
45 497
The journals would be:
DR
K 000
CR
K 000
Motor Vehicles
30 000
Capital
Capital introduced in the form of a vehicle
30 000
Bank
20 000
Loan
20 000
Bank loan obtained on commencement of business.
55
CHAPTER 6
PREPARING BOOKS OF PRIME ENTRY
INTRODUCTION
Business activities are called transactions. There are three types of transactions:
(a)
Cash transaction
(b)
Credit transactions
(c)
Account transfers
Cash transactions are those business activities in which cash is given or received. Cash may be
in the form of notes and coins or in the form of cheques, credit card and electronic funds.
Credit transactions are those business activities in which one person gives goods (or provides a
service) to another without the immediate exchange of cash.
Account transfers are transactions internal to the business and involve transfers of funds from
one account to another. They are usually handled at the end of the year and when correcting
errors that arise in the course of preparing ledger accounts.
Numerous as they are, transactions have been grouped into:
1) those involving trading goods and cash, and take place frequently,
2) those that are infrequent. Transactions that occur regularly are recorded in Day Books.
Those that rarely occur are recorded in the Journal Proper as their book of prime entry
(explained in the preceding chapter).
The structure of the day book is often determined by the type of information required by the user
(in this case, management). The information must be comprehensive when it comes to reporting
on business activities. In practice the day books may have more columns than are illustrated
below. Nevertheless, we will include here all columns that are relevant for accounting purposes.
In this and subsequent chapters we attempt to explain the preparation of books of accounts in
such a way that you will be able to develop the necessary competence and work in industry with
confidence.
BOOKS OF PRIME ENTRY – CREDIT TRANSACTIONS
In this chapter we will explain how books of prime entry (Day books) are compiled for credit
transactions. Credit transactions include those for sales of goods on credit, purchases of goods on
credit, and returns of goods either to suppliers or by customers. In this type of transaction what is
given or received are goods (Refer to the chart in Chapter 2).
56
TOPICS
1.
2.
3.
4.
Preparing Sales Day Book
Preparing Sales Returns Day Book
Preparing Purchases Day Book
Preparing Purchases Returns Day Book
LEARNING OBJECTIVES
After you have studied this chapter, you should be able to
ƒ Explain the purpose of each day book
ƒ Prepare analytical day books
ƒ Mention the ledgers to which entries in each day book are posted
ƒ State the source document for entries in each day book.
1.0 ANALYTICAL SALES DAY BOOK
The sales daybook is a book of prime entry in which transactions of sales of goods on credit are
recorded. The source document for the entries in the sales daybook is sales invoice. The seller
prepares it in duplicate (or triplicate as is the practice in some organizations), issues the top copy
(the original) and retains the duplicate copy. The duplicate copy is used in the preparation of the
sales daybook.
1.1 ILLUSTRATION
The following transactions will be entered in the sales day book
April 1 Sold goods on credit to Chisakaila K 540 000 net. VAT is charged at the rate of
17.5 %.
April 5 Sold goods on credit to Ngosa K 800 000 net. The customer is entitled to
2% prompt discount if payment is made within 14 days.
April 13 Issued an invoice to Mulota K400 000 net.
April 15 Sold goods on credit to Mambwe K750 000 net.
SALES DAY BOOK
DATE
CUSTOMERS
April
2005
1
5
13
15
FOLIO
TOTAL
K
VALUE ADDED
TAX
K
TRADE
RECEIVABLE
K
Chisakaila
Ngosa
Mulota
Mambwe
634 500.00
937 200.00
470 000.00
881 250.00
94 500.00
137 200.00
70 000.00
131 250.00
540 000.00
800 000.00
400 000.00
750 000.00
TOTAL
2 922 950.00
432 950.00
2 490 000.00
57
OTHER
RECEIVABLE
K
ƒ
The transactions are entered in strict chronological order as they occur. The names of
businesses are entered in the particulars or customers column. If the column were named
‘Customers’ then we would need a column for account numbers. The account number
column is not shown here for convenience’s sake.
ƒ
Value Added Tax has been calculated as follow: On the net figure 0.175 x K 400 000 =
K70 000. The total amount is the sum of the net figure and the Value Added Tax.
K 400 000 + 70 000 = K 470 000
ƒ
When the invoice carries an entitlement of cash discount, Value Added Tax is calculated
on the value after deducting the discount. The tax authorities presume that the cash
discount will be taken up. Thus, value for Value Added Tax is K 800 000 x 0.98 = K784
000, and Value Added Tax is 784 000x 0.175 = K137 200. The gross amount is the sum
of the Value Added Tax and the original invoice value (not the value for Value Added
Tax).
1.2 JOURNAL ENTRY
Posting the totals to the ledger will be explained in the next chapter. For now it suffices to
mention that the two accounts identifiable from entries in the sales day book are:
DEBIT
CREDIT
K
K
Trade Receivable
2 922 950
Sales account
2 490 000
Value Added Tax account
432 950
1.3 FURTHER ANALYSES
The sales day book can further be analysed as:
a) Sales by product
b) Sales by geographical location. All these analyses are for management information, not
necessarily for posting to accounts in the ledger.
2.0 ANAYTICAL SALES RETURNS DAY BOOK
Sales returns day book is a book of prime entry in which goods initially sold on credit but are
now returned are recorded. The source document for goods returned is the credit note. The seller
prepares the credit note in duplicate and issues the top copy to the customer. The duplicate is the
one used to compile the sales returns day book.
2.1 ILLUSTRATION
April 7.
April 17.
Ngosa returned goods, K 200 000 net (He is entitled to prompt discount of
2 %)
We sent a credit note to Mambwe, K 150 000, net
58
SALES RETURNS DAY BOOK
DATE
CUSTOMER
FOLIO
April
2005
TOTAL
Value
Added
TRADE
OTHER
TAX
RECEIVABLE
K
RECEIVABLE
K
K
7
17
ƒ
K
Ngosa
Mambwe
234 300.00
176 250.00
34 300.00
26 250.00
200 000.00
150 000.00
TOTAL
410 550.00
60 550.00
350 000.00
The commentary on Value Added Tax and prompt discount applies here too. A separate
section is included later on Value Added Tax. Value Added Tax will further be discussed
in much more detail in a later chapter.
3.0 ANALYTICAL PURCHASES DAY BOOK
The purchases daybook is a book of prime entry in which transactions of purchases of goods on
credit are recorded. The source document for the entries in the sales daybook is purchases
invoice. The supplier prepares the invoice in duplicate (or triplicate as is the practice in some
organizations), issues the top copy (the original) and retains the copy. The original top copy is
therefore used in the preparation of the purchases daybook.
3.1
ILLUSTRATION
April 12.
April 13.
April 18.
April 19.
Purchased goods on credit from Kunda K 282 000. The invoice stated a tax
inclusive amount.
Received an invoice for the 10 ton truck bought on credit from L-Stone Motors K
40 000 000 gross
Purchased Goods on credit from Mwape K 270 000 gross value.
Received a bill for electricity from Zam Hydropower. The total of the invoice was
K 320 000
PURCHASES DAY BOOK
DATE
April
2005
12
13
18
19
SUPPLIER
FOLIO
TOTAL
K
Value
Added
TRADE
OTHER
TAX
PAYABLE
K
PAYABLE
K
K
Kunda
L-Stone Motors Ltd
Mwape
Zam Hydropower
282 000.00
40 000 000 .00
270 000.00
320 000.00
42 000.00
240 000.00
40 212.76
229 787.24
TOTAL
40 872 000.00
82 212.76
59
40 000 000.00
320 000.00
469 787.24
40 320 000.00
ƒ
The amounts above are all tax inclusive. The amount of Value Added Tax is obtained as
follows:
K 282 000 x 7/47 = K 42 000 The net amount is the difference between the two figures,
ie K 282 000 –K 42 000 = K 240 000
ƒ
The column for other payables can be sub-divided into: Other Payables –Expenses,
K 272 340.43 and Other Payables –Non current Assets, K 40 000 000.00. In the
ledger these accounts have been referred to as L-Stone Motors and Zamhydro Power
Company, more specifically.
ƒ
The Value Added Tax on the non-current asset is not claimable since the business is
taken as the final consumer of the motor vehicle that has been bought for use in business.
This is the reason why no tax is recorded in the column for Value Added Tax in respect
of the purchase for the motor vehicle.
ƒ
When posting to the ledger, the payables accounts are credited with the gross amounts ( i.
e. tax inclusive figures). So there is need to accurately identify the amounts involved and
the specific names of payables who will be paid.
3.2 JOURNAL ENTRY
Posting the totals to the ledger will be explained in more detail in the next chapter. For now it
suffices to mention that the accounts identifiable from entries in the purchases day book are:
Purchases account
Value Added Tax account
Motor Vehicles
Electricity
DEBIT
K
469 787.24
82 212.76
40 000 000.00
320 000.00
Other Payables -Expenses
Other Payables –Non-current Assets
Trade Payable account
CREDIT
K
320 000.00
40 000 000.00
552 000.00
Note that when a journal has been prepared correctly the total of amounts in the debit column
will always be equal to the total in the credit column. This is also a sign that you have understood
the principle of double entry.
3.3 FURTHER ANALYSES
The Purchases day book can further be analysed as follows: a) purchases by product
b) purchases by geographical location. Such analyses are for management information, not
necessarily for posting to ledger accounts in the ledger.
60
4.0 ANALYTICAL PURCHASES RETURNS DAY BOOK
Purchases returns day book is a book of prime entry in which goods initially bought on credit
but are taken back to the supplier are recorded. The source document for goods returned is the
credit note. The supplier prepares the credit note in duplicate and issues the top copy to us. The
original copy of the credit note is the one we use to compile the purchases returns daybook.
4.1 ILLUSTRATION
April 13
April 19.
Returned goods worth K 42 600 to Kunda . This is a tax inclusive figure.
Received a credit note from Mwape for K 35 700 (gross amount).
PURCHASES RETURNS DAY BOOK
DATE
SUPPLIER
April
2005
13
19
FOLIO
TOTAL
K
Value
Added
TRADE
OTHER
TAX
PAYABLE
K
PAYABLE
K
K
Kunda
Mwape
42 600.00
35 700.00
6 344.68
5 317.02
36 255.32
30 382.98
TOTAL
78 300.00
11 661.70
66 638.30
ƒ
The calculation of Value Added Tax is the same as explained for entries in the purchases
daybook.
ƒ
The day books are mere listings of transactions that took place in the period. They are
maintained as memorandum information for future reference.
JOURNAL ENTRY
The amounts will be posted to the ledger as follows:
DEBIT
K
78 300.00
Trade Payables account
Purchases Returns account
Value Added Tax account
CREDIT
K
66 638.30
11 661.70
In the next section the cash book will be discussed as the day book for cash transactions.
61
4.3 CHAPTER SUMMARY
You should now have learnt that: ƒ
ƒ
ƒ
ƒ
Day books are records compiled and preserved for future reference
The invoice is the source document for preparing the sales day book and the purchases
day book
The credit note is the source document for preparing the Sales Returns Day Book and the
Purchases Returns Day book
The labels of analyses columns should be determined by the information needs of users
within the organization.
EXERCISES
1. Enter the following transactions in the appropriate day books. VAT is charged at the
rate of 17.5%.
a)
March 2.
Sold goods on credit to Akabondo K 845 000 net.
March 8.
Sold goods on credit to Mubita K 780 000 net. The customer is entitled to
2% prompt discount if payment is made within 14 days.
March 14.
Issued an invoice to Mubiana K680 000 net.
March 16
Sold goods on credit to Mundia K750 000 net.
March 18.
Akabondo returned goods, K 325 000 net (He is entitle to prompt discount of 2%)
b)
March 7.
Purchased goods on credit from Siwale K 424 000. The invoice stated a tax
inclusive amount.
March 12.
Received an invoice for the 10 ton truck bought on credit from Del Equipment
K40 000 000 gross
March 15.
Purchased Goods on credit from Simpasa K 380 000 gross value.
March 19.
Received a bill for electricity from Solarpower Co.The total of the bill was
K502000
March 22
Returned goods worth K 83 600 to Siwale . This is a tax inclusive figure.
April 24.
Received a credit note from Simpasa for K 42 500 (gross amount).
2. Write the journals for the totals of the Day books you prepared in Question 1.
62
SOLUTIONS TO EXERCISES
Q1
Total of Sales Day Book columns:
Trade Receivable
Value Added Tax
Other Receivables
K 3 571 295
K 516 295
K
nil
Total of Sales Returns Day Book columns:
Trade Receivables
K 726 738
Value Added Tax
K 101 738
Other Receivables
nil
Total of Purchases Day Book columns:
Trade Payables
Sales Tax
Other Payables –NCA
Other Payables –Expenses
K 804 000
K 119 745
K 40 000 000
K
502 000
Total of Purchases returns Day Book columns:
Trade Payables
K
Value Added Tax
K
Q2
126 100
18 781
The journals would be written as follows:
DEBIT
K
For the Sales Day Book totals:
Trade Receivables
Value Added Tax
Sales account
For the Sales Returns Day Book:
Trade Receivables
Value Added Tax
Sales Returns Account
For the Purchases Day Book totals:
Trade Payables
Value Added Tax
Purchases
For the Purchases Returns Day Book:
Trade Payables
Value Added Tax
Purchases Returns Account
CREDIT
K
3 571 295
516 295
3 055 000
726 738
101 738
625 000
805 000
119 745
694 255
126 000
18 781
107 319
63
Non current assets (e.g Machinery) 40 000 000
Other Payables
Expense Account (e.g electricity)
Other Payables
40 000 000
502 000
502 000
64
CHAPTER 7
BOOKS OF PRIME ENTRY - CASH TRANSACTIONS
INTRODUCTION
In this chapter we will explain how to record cash transactions. Depending on what is given or
received, the first record can be in the Cash Account or in the Bank Account.
TOPICS
1
2
3
4
Analytical cash book
Cash Account –Receipts and Payments
Bank Account –Receipts and Payments
Summary
LEARNING OBJECTIVES
After you have studied this chapter, you should be able to
ƒ Explain the purpose of the cash book
ƒ Prepare analytical cash book
ƒ State the source document for entries in each day book.
1.0 ANALYTICAL CASHBOOK
The cash book is a book of prime entry in which cash transactions are recorded. Cash
transactions are those in which goods are exchanged for cash in the form of notes and coins, or
are paid for using the cheque system and the debit cards (ATM Cards). Cash transactions
involving the exchange of notes and coins with goods are used to compile the cash account.
Transactions involving cheques are used to compile the bank account. A section on the bank
payment systems will be discussed in the chapter on bank reconciliation.
2.0 CASH ACCOUNT
The entries in the cash book are analysed by type of receipts and type of expenditure. Entries in
the cash account would be analysed as follows:
65
ILLUSTRATION
Fix-it, a retired engineer, received interest from his fixed deposit account of
K8 000 000. He opened a business bank account withdrew K3 000 000 for office use. The
following are the transactions for the first month of trading:
April 2005
April 1.
April 4.
April 8.
April 13.
April 13.
April 14
April 19.
April 20.
April 22.
April 25.
April 26
April 28
April 29.
April 30
Sold goods for cash K 540 000 net. VAT is charged at the rate of 17.5 %
Borrowed K 12 000 000 from Credit Funds Bank, cheque received same day
Paid wages in cash K 150 000
Cash sales K400 000 net.
Banked K200 000 from cash till.
Drew from bank for private use K 100 000
Paid cash for repairs to furniture K130 000
Cash purchases of stationery K150 000 (all tax-exempt).
Ngosa paid his account in full less 5% cash discount K 667 755.
Paid Salaries in by cheque K 300 000
Bought goods for re-sale in cash, K 246 750 gross.
Paid rent K 520 000 by cheque and received commission for selling scratch cards
K 270 000 by cash
Paid L-Stone Motors K 10 000 000 by cheque for the truck bought earlier.
Settled Kunda’s account by cheque, less cash discount of 5% K227 430.
Enter the transactions in the appropriate day books, post to the ledger and extract a trial balance
at the end of the month.
2.1 CASH BOOK ( CASH -RECEIPTS SIDE )
DATE
APRIL
1
1
13
22
28
PARTICULARS
Bank
Sales
Sales
Ngosa
Commission rec.
FOLIO
(c)
TOTAL
K
3 000 000
634 500
470 000
667 755
270 000
5 042 255
Value Added
CASH
TRADE
OTHER
TAX
K
SALES
K
RECEIVABLES
K
RECEIVABLES
K
94 500
70 000
LOANS
540 000
400 000
667 755
270 000
30
TOTAL
164 500
ƒ
The cashbook is the only book of prime entry that is also part of the ledger. The ledger is
the main book of account and will be discussed in much more detail in the next chapter.
ƒ
The column for Other Receivables would further be analysed into, commission received,
rent received, etc. To be consistent if you use the term ‘Other Receivables’ on the
receipts side of the cash book, then use ‘Other Payables’ on the payments side.
ƒ
The column for Trade Receivables capture amounts received from our customers as
payments on account. Value Added Tax is not calculated on amounts from customers
since it is already recorded in the sales daybook. Value Added Tax is, however,
66
940 000
667 755
270 000
calculated on cash sales and recorded in the Value Added Tax column for posting the
amount to the ledger.
ƒ
The column headings are actually the names of accounts to which totals for each column
will be posted in the ledger. The accounts are nominal in the case of income, and are real
in the case of loans and non-current assets.
ƒ
The cash book usually starts with a balance representing the cash that remained in the till
when the accounts for the preceding accounting period were prepared. This is the K 8 000
000 you can see in the cash book above. The balance at start is not a transaction and so it
will not be posted to any account in the ledger.
2.2 CASH BOOK ( CASH -PAYMENTS SIDE )
DATE
PARTICULARS
FOLI
TOTAL
Value
Added
CASH
TRADE
WAGES &
REPAIRS
TAX
K
PURCH
K
PAYABLES
K
SALARIES
K
150 000
K
8
13
19
20
26
Wages
Bank
Repairs
Stationery
Purchases
30
30
Balance
TOTAL
ƒ
The payments side of the cash book is analysed into amounts paid to suppliers (Trade
Payables), amounts paid for expenses (e.g repairs) and amounts paid for non-current
assets bought for cash. The term Other payables would be used if payment was made as a
settlement of an outstanding amount owed to a supplier of a non-current asset, or to a
provider of a service on credit. The cash book would therefore have more columns in
practice than are illustrated above.
ƒ
The column headings are actually the names of accounts to which totals for each column
will be posted in the ledger. The accounts are nominal in the case of expenses, and are
real in the case of trade payables and other payables.
ƒ
Amounts transferred from the cash account to the bank account and vice versa are
marked with ‘c’, meaning contra entry. Two accounts are involved: the cash and bank
accounts, and so the double entry completes within the cash book. Such amounts are not
posted to any account in the ledger because the two accounts involved are already in the
cashbook
ƒ
Posting the totals to the ledger will be explained in the next chapter. For now it suffices to
mention that the two accounts identifiable from entries in the cash book are: cash account
(the Total Column), purchases account, Value Added Tax account, repairs account,
wages and salaries, stationery and trade payables accounts.
C/d
150 000
200 000
130 000
150 000
246 750
36 750
210 000
4 165 505
5 042 255
36 750
210 000
STATIONERY
130 000
150 00
67
150 000
130 000
150 00
3.0 BANK ACCOUNT
The Bank Account is also part of the cash book and entries in it are those for receipt of cheques
and payments by cheque or credit cards.The bank account is analysed much the same way the
cash account was done above.
3.1 CASH BOOK ( BANK -RECEIPTS SIDE )
DATE
PARTICULARS
FOLIO
TOTAL
Value Added
CASH
TRADE
OTHER
TAX
K
SALES
K
RECEIVABLES
K
RECEIVABLES
K
LOANS
APRIL
1
4
13
Capital
Loan
Cash
K
8 000 000
12 000 000
200 000
30
TOTAL
20 200 000
ƒ
The column for other receivables would further be analysed into rent receivable,
commission receivable, etc. In practice there would also be columns for discount
allowed, capital and contra entries;
K
12 000 000
12 000 000
3.2 CASH BOOK ( BANK -PAYMENTS SIDE )
DATE
PARTICULARS
FOLIO
c
TOTAL
K
3 000 000
100 000
300 000
520 000
10 000 000
227 430
6 052 570
20 200 000
Value
Added
CASH
TRADE
WAGES &
RENT
MOTOR
TAX
K
PURCH
K
PAYABLES
K
SALARIES
K
PAYABLE
K
VEHICLES
1
14
25
28
29
30
30
30
Cash
Drawings
Salaries
Rent
L-Stone Motors
Kunda
Balance
TOTAL
ƒ
Accounts that are similar can be combined (eg wages and salaries). Rent payable and
motor vehicles are examples of other payables. In practice the payments side of the
cashbook would also have columns for drawings, discount received, and contra entries.
Amounts in the columns for contra entries are not posted to the ledger because double
entry is completed between the cash account and the bank account, both of which are
within the cash book itself.
ƒ
At the end of the month (or year as the period of account may be), a balance is found
separately for cash account and for bank account. The total columns are used to find the
balance on each account. The balance represents the amount of cash remaining at the end
C/d
300 000
520 000
10 000 00
227 430
227 430
68
300 000
520 000
10 000 00
of the period of account and will be the opening balance for the cashbook of the
following period.
ƒ
Posting the totals to the ledger will be explained in the next chapter. For now it suffices to
mention that the accounts identifiable from entries in the cash book above are: cash
account (total columns), Trade Receivables, sales account, other receivables account, and
loan account.
CHAPTER SUMMARY
You should now have learnt that: ƒ
ƒ
The cash book is compiled for all cash transactions and preserved for future reference
The receipts and cash payment requests are the source documents for preparing the Cash
book
ƒ
The labels of analyses columns should be determined by the accounting information
needs of users within the organization.
The Cash Book is the only day book that is both a book of prime entry and a part of the ledger,
since it contains the Cash and Bank Accounts.
69
EXERCISES
1. Clatus
Clatus started business with K15 000 000 in his bank account and owned a truck worth
K30 000 000 which he intended to use exclusively for business purposes. The following
are his cash transactions for the month of March 2006:
March 1. 2006
March 2.
Drew from bank for office use K 5 000 000
March 4.
Paid rent in cash K 600 000
March 8.
Bought furniture by cheque K 3 500 000
March 8.
Drew cash for private use K 250 000
March 13.
Cash sales K420 000 net. VAT is charged at the rate of 17.5 %
March 13.
Bought stationery K350 000 for cash.
March 14
Sold goods for cash K 540 000 net. VAT is charged at the rate of 17.5 %
March 19.
Paid cash for repairs to furniture K180 000
March 20.
Paid delivery expenses in cash K630 000.
March 22.
Mini-Finance Bank lent us K30 000 000 and paid Del Equipment K25 000
000 for the truck we earlier bought on credit.
March 25.
Paid Salaries in by cheque K 800 000
March 26
Bought goods for re-sale by cheque, K 720 550 gross.
March 27
Settled Simpasa’s account of K337500 by cheque, less 2% discount
March 28
Paid rates K 330 000 by cheque
March 29.
Paid in cash wages K 220 000, Solarpower for electricity K400 000
March 30
Akabondo paid K 400 000 on account.
Enter the transactions in the appropriate Cash book and find the closing balance at the end of the
month.
2. Refer to Question 1:
Prepare journal entries for the cash sale on March 13, the cash purchase on March 26 and the
supplier payment on March 27
70
SOLUTIONS TO EXERCISES
QUESTION ONE
CASH BOOK (CASH-RECEIPTS SIDE)
DATE
March
2
13
14
30
31
PARTICULARS
Bank
Sales
Sales
Akabondo
FOLIO
(c)
TOTAL
TOTAL
K
5 000 000
493 500
634 500
400 000
6 528 000
Value
Added
CASH
TRADE
OTHER
TAX
K
SALES
K
RECEVBLS
K
RECEVBLES
K
73 500
94 500
420 000
540 000
LOANS
400 000
168 000
960 000
400 000
CASH BOOK (CASH -PAYMENTS SIDE)
DATE
PARTICULARS
4
8
13
19
20
29
29
Rent
Drawings
Stationery
Furniture repairs
Delivery expnss
Wages
Solapwer -Elect
31
31
Balance
TOTAL
FOLI
TOTAL
Value
Added
CASH
TRADE
WAGES &
RENT &
TAX
K
PURCH
K
PAYABLES
K
SALARIES
K
REPAIRS
K
600 000
600 000
250 000
350 000
180 000
630 000
220 000
400 000
C/d
STATIONERY
350 00
180 000
220 000
3 898 000
6 528 000
220 000
780 000
CASH BOOK (BANK -RECEIPTS SIDE)
DATE
PARTICULARS
FOLIO
TOTAL
March
1
22
Capital
Loan
K
15 000 00
30 000000
31
TOTAL
45 000 000
Value Added
CASH
TRADE
OTHER
TAX
K
SALES
K
RECEIVABLES
K
RECEIVABLES
K
LOANS
K
30 000 000
30 000 000
71
350 00
CASH BOOK (BANK -PAYMENTS SIDE)
DATE
PARTICULARS
FOLIO
2
8
22
25
26
27
28
Cash
Furniture
Del Equipment
Salaries
Purchases
Simpasa
Rates
c
31
31
Balance
TOTAL
C/d
TOTAL
K
5 000 000
3 500 000
25 000 000
800 000
720 550
330 750
330 000
9 318 700
45 000 000
Value
Added
CASH
TRADE
WAGES &
RATES
OTHER
TAX
K
PURCH
K
PAYABLES
K
SALARIES
K
PAYABLE
K
PAYABLS
3 500 00
25 000 00
800 000
107 316
613 234
330 750
330 000
107 316
613 234
330 750
800 000
330 000
Note: Some entries have not been extended in the analysis columns because of computer
field limitation.
QUESTION TWO
JOURNAL ENTRIES
Bank
K
493 000
Sales
Value Added Tax
Cash sales with Value Added Tax at 17-1/2 %
Purchases
613 234
Value Added Tax
107 316
Bank
Cash purchases with Value Added Tax at 17.5%
K
420 000
73 500
720 550
Trade Payables (Simpasa)
337 500
Bank
330 750
Discount Received
6 750
Full settlement of a debt owed with 2% cash discount
72
28 500 00
CHAPTER 8
THE ANALYTICAL PETTY CASH BOOK
INTRODUCTION
Chapter 7 covered the three-column cashbook. The cashbook comprises a cash account, a bank
account and a cash discount column. This chapter covers the other type of cashbook called the
petty cash book. In this chapter we will discuss the purpose of the petty cash book, the way
entries are made and posted to ledger and the source documents used in preparation of the book.
We will also explain the operation of the imprest system and how it may differ with the
operation of the three-column cash book.
TOPICS
1)
2)
3)
4)
5)
6)
7)
8)
9)
What is petty cash book
The purpose of petty cash book
What is to be paid out of petty cash
Personal security and control of petty cash
The petty cash voucher
The imprest system
Recording in petty cash book including Value Added Tax (VAT)
Balancing the petty cash book
Posting petty cash book to the ledger (double entry)
LEARNING OUTCOMES
After you have studied this chapter, you should be able to:
-
Describe the petty cash book and its intended purpose.
Identify what should be paid out of petty cash.
Prepare a petty cash voucher as a source document for entries in the petty cash book.
Make appropriately entries in petty cash book, balance off at the end and post to the
ledger.
Restore imprest in order to start a new period.
1. DEFINITION OF ANALYTICAL PETTY CASH BOOK
1.1 Analytical means the petty cash book is separated into columns for different categories of
expenses, for example,different columns for expenses relating to postage, stationery,
cleaning, and motor expenses.
1.2 Petty means small items of expenditure the business may incur in the course of its daily
operations.
Therefore, the analytical petty cash book could be defined as:
A book used by a business to record payments of small amounts in cash. The use of
cheques for such payments is considered to be uneconomical.
73
2.
THE PURPOSE OF PETTY CASH
2.1
It is a common feature that almost in every business, there will be a number of small
expenses that have to be paid for cash, instead of other methods. To make these
payments, which could be on daily bases, a certain amount of cash has to be kept within
the business offices.
3.
WHAT ARE PETTY CASH ITEMS?
3.1
These are payments for small expenses required in cash. It is important at this stage to be
mindful that what is a petty item will depend on nature and size of an organization, for
example, a giant mining company buying an office stapler would be petty item, but a
small school with may be 6 students a stapler would be a material item.
Different business institutions have different rules about what is to be paid out of petty
cash. Because of its nature, cash is highly open to abuse and requires responsible officers
to handle it. Management of the organization should specify who could receive money
out of petty cash.
The list of petty cash items should remain flexible for adjustment to include other small
items that may arise in due course.
If a list of petty items is not available, like in some businesses, the responsible officer in
charge of petty cash may rely on judgment, in consultation with the supervisor.
Petty cash items may include the following:
3.2
3.3
3.4
3.5
o
o
o
o
Travel expenses for employees and refunds of the same
Other expenses such as printing, stationery, milk, tea, stamps
Fuel expenses
Cleaning, just to mention a few
4.
PERSONNEL, SECURITY AND CONTROL OF PETTY CASH
4.1
PERSONNEL
Cash by nature is highly open to misappropriation. It is for his reason that whatever
amount is involved, it must be entrusted in the hands of a responsible officer. For petty
cash this responsibility is given to a petty cashier. In the absence of petty cashier a
deputy can takeover the responsibility.
4.2
SECURITY
It is the responsibility of the petty cashier to ensure that:
(a) Petty cash is held in a safe place. It must be well secured in a lockable box (petty
cash box) with keys to it kept by the petty cashier. No one should be allowed access
to petty cash box apart from the petty cashier and any other authorized officer.
(b) He or she should be the only one to make actual payments of petty cash.
(c) All payments are fully and properly authorized and are being made for valid reasons
and intended purpose.
74
4.3
CONTROL
Petty cash should be used only for small items of expenditure and not for large expenses,
such as office furniture or airfares. Paying large amounts from petty cash would be an
obvious target for theft.
(a) To avoid such, it is important to monitor and control petty cash spending by ensuring
that all payments are properly authorized.
(b) There must be in place also a limit to petty cash payments. For example management
may decide that all petty cash payments should be limited to
K100 000 amounts more than the limit should be paid by other means, for
example by cheques.
(c ) Authorization for payments out of petty cash can be done by either the petty
cashier or Supervisor. The petty cashier could be allowed to authorize cash
payments up to a certain. Amount within the limit, say K40, 000 within the
K100, 000 limit. Amounts above that up to K100, 000 could be authorized
by supervisor or appointed person.
5.
PETTY CASH EXPENDITURE (PETTY CASH VOUCHER)
5.1 The initial payment of record of payment is the petty cash voucher. The petty
cash voucher is prepared by the petty cashier whenever a payment is requested.
Petty cash vouchers are serially–numbered slips in a padded booklet. The booklets
are obtainable from stationery suppliers. The following details are found on the petty
cash voucher:
o Description or details of payment i.e. item of expenditure, for example, 4 realms
A4 paper.
o The amount i.e. amount required for the item to be bought
o Name and signature of the one preparing the petty cash voucher (usually petty
cashier).
o Name and signature of the person authorizing payment (usually petty cashier or
supervisor depending on amount).
o Name and signature of the person to receive cash.
o The date when payment is made
o The voucher number
75
Example of petty cash voucher.
NO………………
PETTY CASH VOUCHER
DATE……………..
DESCRIPTION/DETAILS
AMOUNT
PREPARED BY:
AUTHORISED BY:
RECEIVED BY:
5.2
RECEIPTS
A receipt is a document prepared by a person receiving money acknowledging that
money has been received for goods or services supplied.
A person buying items using petty cash must obtain a receipt from the supplier. The
receipt should be given to the petty cashier as evidence of purchases. The petty cashier
will then attach the receipt to the petty cash voucher as supporting document for
payment. The petty cashier can then record in the book that payment has been made.
5.3
RECEIPTS NOT AVAILABLE.
There could be certain requested payments, which cannot be backed up by a receipt, for
example, Taxi fares, bus fares. In these cases payment should be sanctioned by a
supervisor and properly authorized.
5.4
VALUE ADDED TAX RECEIPTS
If there’s an amount for Value Added Tax in a payment, and the tax can be claimed from
Zambia Revenue Authority (ZRA), the receipt must show the following details:
o
o
o
o
Total amount paid
The tax paid
The suppliers name, address and Value Added Tax registration number.
The date of the transaction.
76
6.
THE IMPREST SYSTEM
6.1
The imprest system is where a petty cashier is reimbursed what has been spent in order to
restore the petty cash float.
6.2
Float is the sum of money the petty cashier must start with at the beginning of every
month. It’s decided by management and is usually fixed but can be adjusted to suit
current requirement.
Example of imprest system
The imprest amount (float) is K600, 000. During a particular month a total of
K450 000 was paid out of petty cash.
In the above situation, the petty cashier is remaining with K150, 000 in cash box,
therefore, in order to restore the imprest amount, the petty cashier will need
reimbursement or top up of K450 000 to restore the imprest amount.
Imprest amount
Cash payments
Balance
Reimbursement
Imprest amount
K600, 000
K450, 000
K150, 000
K450, 000
K600, 000
Imprest system
IOUs AND PETTY CASH. (I OWE YOU)
7.1
Some organizations allow individuals to borrow money from petty cash, just for a short
period of time, say a day or two.
In such cases the petty cashier must prepare an IOU slip, which shows
o Amount borrowed
o Name and signature of borrower
o The date the amount is borrowed.
7.2
Example of IOU.
I OWE PETTY CASH K20, 000
MARY BANDA
20/02/07
IOU is a good as cash, and the document should be placed in cash box and be treated as
cash. When counting cash in cash box IOU must be added as cash equivalent.
Example cash and IOU.
The monthly petty cash float is K500, 000. During the month total expenditure amounted
to K285, 000 and an individual borrowed out of petty cash K35, 000.
77
At the time of balancing the petty cash book, the individual had not paid back the
K35, 000. How much cash is available at that time?
The following format will help you calculate the cash balance remaining.
Physical cash available
Plus IOU
Plus total expenditure
Equals imprest amount
xx
xx
xx
xx
For the above example, the solution is;
Imprest amount (float)
Less expenditure
Physical cash available
Plus IOU
Petty cash balance
7.3
500,000
(285,000)
215,000
35,000
250,000
When the borrowed money is paid back, the petty cashier will put back the money in cash
box and remove IOU slip, which is torn as if nothing happened.
IOU should not be encouraged but if it happens, measures should be put in place to
control it. Employees who do not pay back are identified and amounts recovered from
their monthly salary through payroll.
8.
RECORDING THE ANALYTICAL PETTY CASH BOOK
8.1
All payments before being recorded in petty cash book must be supported with petty cash
vouchers and receipts. It is highly recommended that the petty cash book be updated
(recorded) on daily basis in order to have accurate information on petty cash expenditure.
Balancing the petty cash book will depend on the volume of transactions for petty
expenditure. In busy organizations it can be every two weeks others on monthly basis.
Division of the petty cash book.
The petty cash book is divided into two parts, left and right hand sides.
o The left hand is the debit side. This side is used to record any cash received by
petty cashier.
o The right hand side is the credit side. This is where expenses in the period are
analysed.
o The analysis columns in petty cash book will vary depending on the
organization’s pattern and nature of expenditure.
78
Example: Analytical petty cash book.
RECEIPTS (DR)
PAYMENTS (CR)
Total
Date Details Voucher Total Office
Postage Cleaning Traveling Motor
Ledger
DR
No.
CR
Expense
expense
8.2
Example : Preparing the petty cash book
Lakefield Ltd make use of a petty cash book as part of their bookkeeping system. The
following is a summary of the petty cash transactions for the month of time
20 X7.
June 1. Opening petty cash float received from
Cashier……………………………………………
2. Cleaning material………………………………….
3. Postage stamps……………………………………
4. Envelopes…………………………………………
K
700,000
30,000
25,000
10,000
June 8. Taxi fare……………………………………………
10 Petrol for company car…………………….
14 Typing paper………………………………………
15 Cleaning material…………………………………
16 Bus fare……………………………………………
20 visitors lunches…………………………………..
21 Mops and bushes for cleaning…………………….
23 Postage stamps………………………………….
27 Envelops…………………………………………
29 Visitors lunch…………………………………….
30 Photo copying paper………………………………
65,000
100,000
80,000
29,000
10,000
45,000
56,000
15,000
7,000
60,000
95,000
You are required to draw up a petty cash book for the month using analysis columns for
stationery cleaning, entertainment, traveling and postage.
Show clearly the receipt of the amount necessary to restore the float and the balance
brought forward for the start of the following month.
79
SOLUTION
The Analytical Petty Cash Book
DR (K)
Receipts
700,000
627,000
1,327,000
700,000
CR(K)
Date
Jun 1
Jun 2
Jun 3
Jun 6
Jun 8
Jun 10
Jun 14
Jun 15
Jun 16
Jun 20
Jun21
Jun 23
Jun 27
Jun 29
Jun 30
Details
Cash
C/Mat
Stamps
Envelops
T/Fares
Petrol
T/Paper
C/Mat
B/Fares
V/Lunch
Mops/Brushes
Stamps
Envelops
V/Lunch
P/Paper
Jun 30
Cash
Bal c/d
Jul 1
V/n
1
2
3
4
5
6
7
8
9
10
11
12
13
14
Total
Stat
30,000
25,000
10,000
65,000
100,000
80,000
29,000
10,000
45,000
56,000
15,000
7,000
60,000
95,000
627,000
Cleaning
Entertt
Travel
Postage
30,000
25,000
10,000
65,000
100,000
80,000
29,000
10,000
45,000
56,000
15,000
7,000
60,000
95,000
192,000
115,000
105,000
175,000
700,000
1,327,000
Bal b/d
N.B
When petty cash is established and restored every month double entry is:
Dr-petty cash
Cr- Bank A/C (when money is withdrawn from bank in the above example:
Dr
Bank A/C (Cash Book)
Cr
June 1 Petty cash
June 30 petty cash
700,000
627,000
For expenses the petty cash book is used as on accumulative book for small expenses,
where each expense account is updated on monthly basis after they have accumulated.
As in example the double entry would be;
Dr
Stationery A/C
Cr
June 30 Petty cash 192,000
Dr
Cleaning A/C
K
June 30 Petty cash 115,000
Cr
K
80
40,000
Dr
Entertainment A/C
Cr
K
June 30 Petty cash 105,000
Dr
K
Traveling A/C
June 30 Petty cash
Cr
K
175,000
Dr
K
Postage A/C
June 30 Petty cash
Cr
K
K
40,000
N.B
When balancing the petty cash book, balance c/d and b/d is the actual imprest amount (or
float). The amount remaining with the petty cashier is not shown as part of balance. It
therefore means that, before balancing the petty cash book the cash spent should first be
reimbursed to the cashier, then put in petty cash box with the amount that remained. This
is restoring the imprest amount, which is the balance.
8.3
Petty cash payments with Value Added Tax.
If a petty cash transactions (i.e. receipts and payment) involves Value Added Tax,
Value Added Tax should be accounted for separately as long ass there’s evidence of
Value Added Tax (i.e. Value Added Tax receipt).
Example: Value Added Tax receipt and petty cash record.
RECEIPTT
S/No. (04)
RECEIPT
Date: 01.06.05
Amount
K
90,000
4 Reams A4
Paper
Value Added Tax 17.5%
15.75
Total
105.75
S/No. (05)
Date: 02.06.05
Amount
K
Repairs to computer
145,000
Add 17.5%
Value Added Tax
25,375
170,375
The two Value Added Tax receipts will be recorded as follows in the petty cash book
81
PAYMENTS SIDE
Date
Details
02.06.05 4 Ream of
paper
02.06.05 Repairs
V. No.
Total
04
105.75
05
170.375
Stationery
Repairs
90,00
145,000
Value
Added
Tax
15.75
25,375
9. CHAPTER SUMMARY
You should have now learned that:
o Petty cash is used to make small payments.
o Petty cash must be kept safely in a lockable cash box.
o Because of its nature, for security reasons petty cash should be in the hands of a
responsible officer and that not every body in an organization is eligible for petty
cash.
o Petty cash is operated on an imprest system. This is where the petty cashier is
reimbursed what has been spent in order to restore the imprest amount.
Thus: FLOAT
Less expenditure
Balance
Reimbursement
FLOAT
xx
xx
xx
xx
xx
o All payments out of petty cash must be fully authorized by signing on the
voucher.
o If there’s no receipt (document) to support the claim, the petty cashier must
consult the supervisor.
o Entries made (recorded) in petty cash book originate from a document called
petty cash voucher.
o The petty cash book is used as an accumulative book for small expenses of
which the totals for the period are transferred to respective expense account in
general ledger.
o Petty cash expenditure involving Value Added Tax, should be recorded
separately in petty cash book with separate amounts in the Value Added Tax
column.
82
EXERCISES
1.
2.
3.
4.
What is the purpose of the petty cash book?
Who is responsible for maintaining cashbook?
What is the imprest amount (petty cash float)?
The petty cash book is maintained on a system called imprest system. What is imprest
system?
5. What is the source document for entries in petty cash book?
6. What is the division of the petty cash book?
7.
The following petty cash transactions were recorded during the month of December
20x6.
1.
2.
4.
6.
9.
10.
12.
14.
19.
25.
Petty cash float was K400, 000 was obtained by withdrawal
of cash from the Bank.
Paid for stationary………………………………… 10,800
Paid for sundry expenses…………………………. 21,700
Cash sales………………………………………… 30,000
Repairs to vehicles……………………………….. 42,500
Cash received from staff telephone calls………… 18,000
Paid for stationery……………………………….. 90,000
Paid for sundry expenses………………………… 28,200
Cash sales…………………………………………. 33,000
Paid for stationary………………………………… 47,800
All expenses and income listed above are inclusive of Value Added Tax at 17.5%.
Required:
Record all the transactions in petty cash book and balance off as at 31 December 20x6 and
restore the imprest amount.
83
SOLUTIONS TO EXERCISES
1. The purpose of petty cash book is to record small items of expenditure
2. The petty cashier.
3. This is a fixed amount a petty cashier requires at the beginning of every period.
4. This is a system where the petty cashier is reimbursed what has been spent in order to
restore the imprest amount.
5. The petty cash voucher with actual receipt of amount spent.
6. The petty cash book is divided into two sides.
Left side and right side
Left side to record receipts
Right side to record payments.
7 PETTY CASH BOOK
DR(K)
Net Recpt
SalesTax
Total
400,000
25,531.92
4,468.08
30,000
15,319.15
2,680.85
18,000
28,085.11
4,914.89
33,000
160,000
68,936.18
12,063.82
641,000
400,000
Date
Details
Dec 1
Dec 2
Dec 4
Dec 6
Dec 9
Dec 10
Dec 12
Dec 14
Dec 19
Dec 25
Cash
Station
S/Exps
C/Sales
Repairs
Recpt/Phone
Station
S/Exps
C/Sales
Station
Dec 31
Dec 31
Cash
Bal c/d
Jan 1
Bal b/d
V/N
Total
CR(K)
Station
1
2
10,800
21,700
3
42,500
4
5
90,000
28,200
76,595.75
6
47,800
241,000
40,680.85
126,468.1
400,000
641,000
84
Repairs
S/Exps
9,191.50
18,468.09
36,170.21
36,170.21
Value Add
Tax
1,
3,
6,
24,000.00
13,
4,
42,468.09
7
35,
CHAPTER 9
PREPARING LEDGER ACCOUNTS – PART ONE
INTRODUCTION
In this chapter we will discuss how credit transactions recorded in the day books are posted to
the accounts in the ledger. The ledger is the main book of account. It is in this book that the rule
of double entry must be applied. At the end of the exercise of posting entries to ledger accounts,
the accounts are closed and balances extracted in the form of a trial balance. The trial balance is
then used to prepare the Income Statement and Balance sheet.
TOPICS
1. Preparing ledger accounts
2. Summary
LEARNING OBJECTIVES
After you have studied this chapter, you should be able to:
ƒ
ƒ
Understand how to apply the rule of double entry to transactions
Post the entries in the day books to the ledger
1.0 PREPARING LEDGER ACCOUNT
With the guidelines in the preceding section we will use an exercise to illustrate how the rule of
double entry is applied to posting transactions to the ledger. First we will handle trading
activities and later on other operational activities. For convenience sake we have reproduced the
transactions and the day books we prepared in the previous chapter.
1.1 ILLUSTRATION
Fix-it, a retired engineer, received interest on his fixed deposit account of K 8 000 000 and
opened a business bank account. He immediately withdrew K 3 000 000 for office use. VAT is
charged at the rate of 17.5 %. The following are transactions for the first month of trading:
April 1.
Sold goods on credit to Chisakaila K540 000 net.
April 5.
Sold goods on credit to Ngosa K800 000 net. The customer is entitled to less 2 %
prompt discount if payment is made within 14 days.
Ngosa returned goods, K200 000 net (He is entitled to prompt discount of
2%)
Purchased goods on credit from Kunda K282 000. The invoice stated a tax
inclusive amount.
Received an invoice for the 10 ton truck bought on credit from L-Stone Motors
K40 000 000 gross
Issued an invoice to Mulota K400 000 net.
Returned goods worth K42 600 to Kunda. This is a tax inclusive figure.
Sold goods on credit to Mambwe K750 000 net.
85
April 7.
April 12.
April 13.
April 13.
April 13
April 15
April 17.
April 18.
April 19.
April 19.
We sent a credit note to Mambwe, K150 000, net
Purchased Goods on credit from Mwape K270 000 gross value.
Received a bill for electricity from Zam Hydropower. The total of the invoice
was K320 000
Received a credit note from Mwape for K35 700 (gross amount).
SALES DAY BOOK
DATE
April
2005
1
5
13
15
PARTICULARS
FOLIO
TOTAL
K
VALUE ADDED
TAX
K
TRADE
RECEIVABLE
K
Chisakaila
Ngosa
Mulota
Mambwe
634 500.00
937 200.00
470 000.00
881 250.00
94 500.00
137 200.00
70 000.00
131 250.00
540 000.00
800 000.00
400 000.00
750 000.00
TOTAL
2 922 950.00
432 950.00
2 490 000.00
OTHER
RECEIVABLE
K
SALES RETURNS DAY BOOK
DATE
PARTICULARS
FOLIO
K
April
2005
7
17
TOTAL
VALUE ADDED
TAX
K
TRADE
RECEIVABLE
K
Ngosa
Mambwe
234 300.00
176 250.00
34 300.00
26 250.00
200 000.00
150 000.00
TOTAL
410 550.00
60 550.00
350 000.00
OTHER
RECEIVABLE
K
PURCHASES DAY BOOK
DATE
April
2005
12
13
18
19
PARTICULARS
FOLIO
TOTAL
K
VALUE ADDED
TAX
K
TRADE
PAYABLE
K
Kunda
L-Stone Motors Ltd
Mwape
Zam Hydropower
282 000.00
40 000 000 .00
270 000.00
320 000.00
42 000.00
240 000.00
40 212.76
229 787.24
TOTAL
40 872 000.00
82 212.76
86
OTHER
PAYABLE
K
40 000 000.00
320 000.00
469 787.24
40 320 000.00
PURCHASES RETURNS DAY BOOK
DATE
PARTICULARS
FOLIO
April
2005
13
19
VALUE ADDED
TAX
K
TOTAL
K
TRADE
PAYABLE
K
OTHER
PAYABLE
K
Kunda
Mwape
42 600.00
35 700.00
6 344.68
5 317.02
36 255.32
30 382.98
TOTAL
78 300.00
11 661.70
66 638.30
1.2 LEDGERS
Explanatory notes follow after all the accounts have been written.
Note: All amounts on Debits and Credits are in Kwacha Currency.
TRADE RECEIVABLES
K
Sales
2 922 950.00
Sales Returns
K
410 550.00
SALES
Trade Receivables
2 490 000.00
SALES RETURNS
Trade Receivables
350 000.00
TRADE PAYABLE
Purchases Returns 78 300.00
Purchases
552 000.00
OTHER PAYABLE - (Non Current Asset)
Motor Vehicles
400 000.00
OTHER PAYABLE - (Electricity)
Electricity
87
320 000.00
PURCHASES
Trade Payable
469 787.24
MOTOR VEHICLES
Other Payable
40 000 000.00
ELECTRICITY
Other Payable
320 000.00
VALUE ADDED TAX
Payables
Trade Receivable
82 212.76
60 550.00
Payables
Trade Receivable
11 661.70
432 950.00
1.3 COMMENTS
In the accounts above credit transactions have been posted to the ledger. What was
given/received were goods. The names of the outside entities were given (see the day books
reproduced here also).
Sales on credit
The trade receivables account is debited with K 2 922 950.00 because it represents customers
who received the goods. The sales account represents the business we are doing accounts for and
it gave the goods. The credit is split between sales account and Value Added Tax account. The
Trade receivables are debited with the gross amount because the customers are expected to pay
the total amount of both the net value of goods and the Value Added Tax on them. The cash is
eventually received the Value Added Tax becomes payable to the Govt whereas the net amount
is kept by the business.
Sales Returns
The customers gave the goods they returned to us and so the trade receivable account is credited
with the gross amount of K 410 550.00. We received the goods and the account representing our
business, sales returns account, has been debited with the net amount whereas the associated tax
is debited to the Value Added Tax account as amount not payable to the govt.
Purchases on credit
The term ‘purchases’ conventionally refer to goods bought for re-sale and so excludes purchases
of non current assets.
88
The double entry can be represented in the following journal:
DR (K)
Purchases
469 787.24
Value Added Tax
82 212.76
Electricity
320 000.00
Trade Payable (for goods)
Other Payable –(Electricity)
CR(K)
552 000.00
320 000.00
The amount in the other payables –electricity account is the gross amount because Value Added
Tax on this purchase has been ignored for simplicity’s sake
The journal for the non current asset is : Debit the Motor Vehicles account (representing the
business, or the activity done) and credit the Other Payable –Non Current asset account
(representing the giver, L-Stone Motors). The cost of the motor vehicle is gross because the
Value Added Tax component is not passed on to the customer. The vehicle is not for re-sale.
2.0 CHAPTER SUMMARY
By now you should have learnt that
ƒ
ƒ
ƒ
ƒ
The implication of the entity concept is important if you are to apply the rule of double
entry correctly
Proper accounting entries are made by applying the rule of double entry to transactions
without exception
Closing accounts is dependent on whether something is continuing about the fund in the
account or not
What can continue on an account is either the physical existence of an asset or the future
receipt/payment of cash.
EXERCISES
Refer to the Question bank at the end of Chapter 11.
89
CHAPTER 10
PREPARING LEDGER ACCOUNTS – PART TWO
INTRODUCTION
In this chapter we explain how the rule of double entry is applied when posting entries from the
cash account and from the bank account (the cash book is part of the ledger also). It is important
to refer to the page with guidelines on identifying the flow, account to debit and account to credit
before you proceed.
TOPICS
1. Cash transactions
2. Posting entries in the cash book to the ledger
3. Summary
LEARNING OUTCOMES
After you have studied this chapter, you should be able to:
ƒ
ƒ
ƒ
Apply the rule of double entry to cash transactions
Post the entries in the cash book to the appropriate ledger accounts
Calculate Value Added Tax on cash purchases and cash sales
1.0 CASH TRANSACTIONS
With the guidelines in the preceding section we will use an exercise to illustrate how the rule of
double entry is applied to posting transactions to the ledger. This time we will handle cash
transactions. For convenience sake we reproduce the cash transactions and the cash book
compiled in chapter 5.
Fix-it, a retired engineer, received interest on his fixed deposit account of K8 000 000 and
opened a business bank account. He immediately withdrew K3 000 000 for office use. The
following are transactions for the first month of trading:
April 2005
April 1.
April 4.
April 8.
April 13.
April 13.
April 14
April 19.
April 20.
April 22.
April 25.
April 26
April 28
Sold goods for cash K540 000 net. VAT is charged at the rate of 17.5 %
Borrowed K12 000 000 from Credit Funds Bank, cheque received same day
Paid wages in cash K150 000
Cash sales K400 000 net.
Banked K200 000 from cash till.
Drew from bank for private use K100 000
Paid cash for repairs to furniture K130 000
Cash purchases of stationery K150 000 (all tax-exempt).
Ngosa paid his account in full less 5% cash discount K667 766.
Paid Salaries by cheque K300 000
Bought goods for re-sale in cash, K246 750 gross.
Paid rent K520 000 by cheque and received commission for selling scratch cards
K270 000 by cash
90
April 29.
April 30
Paid L-Stone K10 000 000 by cheque for the truck bought earlier.
Settled Kunda’s account by cheque, less 5% cash discount K227 430.
1.1 CASH BOOK (CASH -RECEIPTS SIDE)
DATE
PARTICULARS
APRIL
1
1
13
22
28
Bank
Sales
Sales
Ngosa
Commission rec.
3 000 000
634 500
470 000
667 755
270 000
TOTAL
5 042 255
30
FOLIO
TOTAL
VALUE ADDED
TAX
CASH
SALES
94 500
70 000
540 000
400 000
TRADE
RECEIVABLES
OTHER
RECEIVABLES
LOANS
667 755
270 000
164 500
940 000
667 755
270 000
1.2 CASH BOOK (CASH -PAYMENTS SIDE)
DATE
APR
8
13
19
20
26
30
30
PARTICULARS
FOLIO
Wages
Bank
Repairs
Stationery
Purchases
Balance
TOTAL
C/d
TOTAL
VALUE
ADDED
TAX
CASH
TRADE
WAGES &
PURCH
PAYABLES
SALARIES
150 000
200 000
130 000
150 000
246 750
36 750
210 000
4 165 505
5 042 255
36 750
210 000
REPAIRS
STATIONERY
150 000
130 000
150 0
150 000
130 000
1500
1.3 CASH BOOK (BANK -RECEIPTS SIDE)
FOLIO
TOTAL
VALUE ADDED
TAX
DATE
PARTICULARS
CASH
SALES
TRADE
RECEIVABLES
OTHER
RECEIVABLES
LOANS
APRIL
1
4
13
Capital
Loan
Cash
8 000 000
12 000 000
200 000
12 000 000
30
TOTAL
20 200 000
12 000 000
1.4 CASH BOOK (BANK -PAYMENTS SIDE)
DATE
APR
1
14
25
28
29
30
30
30
PARTICULARS
Cash
Drawings
Salaries
Rent
L-Motors
Kunda
Balance
TOTAL
FOLIO
C/d
TOTAL
VALUE
ADDED
TAX
3 000 000
100 000
300 000
520 000
10 000 000
227 430
6 052 570
11 272 000
CASH
TRADE
WAGES &
RENT
MOTOR
PURCH
PAYABLES
SALARIES
PAYABLE
VEHICLES
300 000
520 000
10 000 0
227 430
227 430
91
300 000
520 000
10 000 0
2.0 POSTING TO THE LEDGER
Since the cash book is part of the ledger, the receipts are effectively on the debit side of the
cash/bank account, and payments are correspondingly on the credit side of the cash/bank
account. The ledger accounts which follow below therefore will carry only the other entry of the
double entry. Journal entries would also be written for each of the transactions, for example:
Debit: Cash a/c (in the cash book)
Credit: Commission a/c
K 270 000
K 270 000
TRADE PAYABLE
Bank
227 430
TRADE RECEIVABLES
Cash
667 755
COMMISSION
Cash
270 000
SALES
Cash
PURCHASES
Cash
210 000
WAGES
Cash
Bank
150 000
300 000
REPAIRS
Cash
130 000
92
940 000
STATIONERY
Cash
150 000
RENT
Bank
520 000
VALUE ADDED TAX
Payables
Trade Receivables
Cash
82 212.76
60 550.00
36 750.00
Payables
Trade Receivables
Cash
11 661.70
432 950.00
164500.00
LOAN
Bank
12 000 000
L-STONE MOTORS
Bank
10 000 000
2.1 COMMENTS ON ENTRIES IN THE ACCOUNTS
ƒ
In the accounts above cash transactions have been posted to the ledger. What was
given/received was cash. The entries that would be in the trade receivables account and
trade payables account have not been reproduced accordingly.
ƒ
The entries in the Value Added Tax account show that tax arise both from credit
transactions and cash transactions. The net of the credit entries and the debit entries is the
amount that becomes payable to the tax authorities.
ƒ
The entry in the Lstone-Motors account is a part payment for the truck we bought on
credit from them (Refer to the entries in the Purchases Day Book in the previous chapter)
ƒ
Note also that an account can capture both amounts from the cash and the bank accounts,
which are in the cash book.
In the next chapter we discuss how ledger accounts are closed for preparation of the trial balance
and eventually the financial statements.
93
3.0 SUMMARY
You should now have learnt that:
ƒ
ƒ
ƒ
When cash is paid the cash account is credited and the account representing the activity is
debited
When cash is received the cash account is debited and the account representing the
activity is credited.
Where the cash is paid / received by an outside entity, then the account for that entity will
also be updated with the transaction.
94
CHAPTER 11
CLOSING ACCOUNTS AND EXTRACTING A TRIAL
BALANCE
INTRODUCTION
In the previous chapters we applied the rule of double entry to post original transactions to the
ledger. In this chapter we will move a step further and illustrate how accounts are closed and a
trial balance extracted.
TOPICS
1.
2.
3.
4.
Transfers to Income Statement (Trading & Profit & Loss account)
Transfers to the following period( Balance sheet items)
Extracting a trial balance
Summary
LEARNING OBJECTIVES
After you have studied this chapter, you should be able to:
ƒ
ƒ
Identify accounts whose balances are reported in the income statement, and those whose
balances are reported in the balance sheet
Close accounts in the correct way and extract a trial balance accordingly
1.0 CLOSING LEDGER ACCOUNTS
Closing accounts is done prior to preparation of final accounts (Trading and Profit & Loss
account). Principally the income statement comprises these two accounts. The purpose of the
income statement is to provide a summary of accounts and reveal if the business made any profit
or loss on the activities carried out during the year.
At this stage it is important to note that a different set of ‘transactions’ is handled. The
transactions are called transfers. Amounts are transferred either to the income statement if there
is nothing continuing on the account, or to the following year if there is something continuing.
What is said to continue on an account can either be payment or receipt of cash, or physical
existence of what the account represents.
1.1 NOMINAL ACCOUNTS
When handling transfers you should first note where the funds are in an account: debit or credit,
and then introduce an entry on the opposite side. Then complete double entry in one of the
accounts in the income statement or in the same account but of the following period of account.
Here is an example of how it is done (The ledger accounts have been reproduced from the
previous chapters and include both entries for cash and credit transactions):
95
SALES
Trading
Trade Receivables
Cash
3 430 000.00
3 430 000.00
2 490 000.00
940 000.00
3 430 000.00
SALES RETURNS
Trade Receivable
350 000.00
Trading
350 000.00
350 000.00
350 000.00
The entry described ‘Trade Receivables’ completes double entry with the Trade Receivables
account. The entry described as ‘Trading’ completes double entry with the trading account which
is a segment of the Income Statement. For example, the total of sales K3 430 000.00 is being
transferred to the Income Statement for reporting purposes. The transfer starts with a debit entry
in the Sales account and so it will end with a credit entry in the trading account of the Income
Statement.
1.2 REAL ACCOUNTS
Here is an example for transferring balances to the following period, and to be reported in the
balance sheet.
TRADE PAYABLE
Purchases Returns
Bank
Discount Received
Balance c/d
78 300.00
227 430.00
11 970.00
234 300.00
Purchases
552 000.00
552 000.00
552 000.00
Balance b/d
234 300.00
Closing books would literally mean that accounts with something continuing on them are reopened in the books of the following period of account. We would have to transfer the unpaid
amount on the Trade Payables above to a Trade Payables account for the following month. The
transfer would start with a debit of K 234 300.00 described as Balance c/d above and end with a
credit entry in the Trade Payables account of the following period and described as balance b/d.
In the ledger we simply write the two entries on the same account: one above the total lines and
the other below the total lines but on the opposite side as can be seen above.
96
1.3 OTHER ACCOUNTS BELOW
The other accounts are closed according to the principle highlighted in 1.1 and 1.2 above.
Transfers to the Income statement can be either to trading account or to profit and loss account,
depending on whether the account has to do with goods or with services consumed respectively.
The account balances that are summarized in the balance sheet are closed by ‘balance c/d’ and
balance b/d’ because on them there is some thing continuing to the next period: payment or
receipt of cash or physical existence of the asset and future use.
L-STONE MOTORS -(Other Payables)
Bank
Balance c/d
10 000 000.00
30 000 000.00
Motor Vehicles
40 000 000.00
40 000 000.00
40 000 000.00
Balance b/d
30 000 000.00
ZAM HYDROPOWER CO. - (Other Payables)
Balance c/d
320 000.00
Electricity
320 000.00
320 000.00
320 000.00
Balance b/d
320 000.00
PURCHASES
Trade Payable
Cash
469 787.24
210 000.00
Trading
679 787.24
679 787.24
679 787.24
PURCHASES RETURNS
Trading c/d
66 638.30
Trade Payables
66 638.30
66 638.30
66 638.30
97
MOTOR VEHICLES
L-Stone Motors
40 000 000.00
Balance c/d
40 000 000.00
Balance b/d
40 000 000.00
40 000 000.00
40 000 000.00
ELECTRICITY
Zam Hydropower Co
320 000.00
Profit & Loss
320 000.00
320 000.00
320 000.00
DRAWINGS
Bank
100 000.00
Capital
100 000.00
100 000.00
100 000.00
TRADE RECEIVABLES
Sales
2 922 950.00
Sales Returns
Cash
Discount All
Balance c/d
2 922 950.00
Balance b/d
410 550.00
667 755.00
35 145.00
1 809 500.00
2 922 950.00
1 809 500.00
COMMISSION
Profit & Loss
270 000.00
Cash
270 000.00
270 000.00
270 000.00
WAGES & SALARIES
Cash
Bank
150 000
300 000
Profit & Loss c/d
450 000
450 000.00
450 000.00
98
REPAIRS
Cash
130 000.00
Profit & Loss c/d
130 000.00
130 000.00
130 000.00
STATIONERY
Cash
150 000.00
Profit & Loss c/d
150 000.00
150 000.00
150 000.00
RENT
Bank
520 000.00
Profit & Loss c/d
520 000.00
520 000.00
520 000.00
VALUE ADDED TAX
Payables
Trade Receivable
Cash
Balance c/d
82 212.76
60 550.00
36 750.00
429 598.94
Payables
Trade Receivable
Cash
609 111.70
11 661.70
432 950.00
164 500.00
609 111.70
Balance b/d
429 598.94
LOAN
Balance c/d
12 000 000.00
Bank
12 000 000.00
12 000 000.00
12 000 000.00
Balance c/d
12 000 000.00
CAPITAL
Balance c/d
8 000 000.00
Bank
8 000 000.00
8 000 000.00
8 000 000.00
Balance c/d
99
8 000 000.00
DISCOUNT ALLOWED
Trade Receivables
35 145.00
Profit & Loss
35 145.00
35 145.00
35 145.00
DISCOUNT RECEIVED
Profit & Loss
11 970.00
Trade Payables
11 970.00
11 970.00
11 970.00
The amounts in the cash and bank accounts below are a summary of the entries in the cash book
prepared in the preceding chapter. Drawings are principally transferred to capital account
because in the balance sheet the amount of drawings is deducted from the balance on the capital
account.
BANK ACCOUNT
Total Receipts
20 200 000
Total Payments
Balance c/d
20 200 000
Balance b/d
14 147 430
6 052 570
20 200 000
6 052 570
CASH
Total Receipts
5 042 255
Total Payments
Balance c/d
5 042 255
Balance b/d
876 750
4 165 505
5 042 255
4 165 505
100
2.0 EXTRACTING THE TRIAL BALANCE
The trial balance is a schedule of account balances that help in the confirmation that the rule of
double entry was correctly applied. It is NOT an account to which amounts are posted to
complete double entry. When the Trial balance fails to balance it means that either the rule of
double entry was not applied accurately or errors have been made in the accounts. Correction of
errors is a subject of another topic. Only when the trial balance has balanced can the next step of
preparing the Income Statement and balance sheet be carried out.
2.1 HOW IT IS DONE
Amounts are listed on the trial balance on the side they appear or would appear below the total
lines on the account. For example, Value Added Tax of K429 598.94 is listed on the credit side
in the trial balance because it is on the credit side below total lines on the account in the ledger.
Purchases account balance of K679 787.24 is listed on the debit side of the trial balance because
the entry described as ‘trading’ on the account would be on the debit side if it were written (by
extension) below the total lines on the ledger account itself. Alternatively, the transfer of funds to
Trading account will throw funds on the debit side of that account. It is that debit that is
effectively listed on the trial balance.
FIX-IT
TRIAL BALANCE AS AT 30 APRIL 2005
DR
Sales
Sales Returns
350 000.00
Trade Payables
L-Stone Motors
Zam Hydro Power Co.
Purchases
679 787.24
Purchases Returns
Motor Vehicles
40 000 000.00
Electricity
320 000.00
Drawings
100 000.00
Trade Receivables
1 809 500.00
Commissioned Received
Wages & Salaries
450 000.00
Repairs
130 000.00
Stationery
150 000.00
Rent
520 000.00
Value Added Tax
Loan
Capital
Discount Allowed
35 145.00
Discount Received
Bank
6 052 570.00
Cash
4 165 505.00
______________
54 762 507.24
______________
CR
3 430 000.00
234 300.00
30 000 000.00
320 000.00
66 638.30
270 000.00
429 598.94
12 000 000.00
8 000 000.00
11 970.00
______________
54 762 507.24
_____________
101
CHAPTER SUMMARY
You have seen that to prepare ledger accounts that lead to a balancing trial balance you need to
be thorough when recording entries in the books of prime entry ( day books) and to apply the
rule of double entry to every transaction without exception. You also need to understand the
logic of account transfers to the income statement (profit and loss account), and transfers to the
same account but of the following period (balance c/d and balance b/d). These balances are the
amounts that are reported in the balance sheet as a summary of ledger account balances. The
challenge is all yours to master the application of the rule of double entry. You will convince
yourself that you have developed the competence if you manage to balance the illustrative
question again and the question in the exercises section of this chapter. Your progression will be
steady and sure if you do this.
SELF-TEST QUESTIONS
1. Re-attempt the whole exercise and see whether you can do it up Trial balance
2. What is the accounting treatment of discount allowed and discount received?
102
EXERCISES
Question 1
Lambdar started business with K15 000 000 in his bank account and owned a truck worth
K30,000 000 which he intended to use exclusively for business purposes. The following are his
cash transactions for the month of March 2006:
March 2005
March 2.
March 2.
March 4.
March 7.
March 8.
March 8.
March 8.
March 12.
March 13.
March 13.
March 14
March 14.
March 15.
March 16
March 18.
March 19.
March 19.
March 20.
March 21.
March 22.
March 22
March 24.
March 25.
March 26
March 27
March 28
March 29.
March 30
Drew from bank for office use K5 000 000
Sold goods on credit to Akabondo K845 000 net.
VAT is charged at the rate of 17.5 %
Paid rent in cash K 600 000
Purchased goods on credit from Siwale K424 000. The invoice stated a tax
inclusive amount.
Bought furniture by cheque K3 500 000
Sold goods on credit to Mubita K780 000 net. The customer is entitled to
2 % prompt discount if payment is made within 14 days.
Drew cash for private use K250 000
Received an invoice for the forklift bought on credit from Del Equipment
K30 000 000 gross
Cash sales K420 000 net. VAT is charged at the rate of 17.5 %
Bought stationery K350 000 for cash.
Sold goods for cash K540 000 net. VAT is charged at the rate of 17.5 %
Issued an invoice to Mubiana K680 000 net.
Purchased Goods on credit from Simpasa K 380 000 gross value.
Sold goods on credit to Mundia K750 000 net.
Akabondo returned goods, K325 000 net (He is entitle to prompt discount of 2 %)
Received a bill for electricity from Solarpower Co. The total of the bill was
K502 000
Paid cash for repairs to furniture K180 000
Paid delivery expenses in cash K630 000.
We sent a credit note to Mundia, K300 000, net
Mini-Finance Bank lent us K30 000 000 and later the same day paid Del
Equipment K25 000 000 for the forklift we earlier bought on credit.
Returned goods worth K83 600 to Siwale . This is a tax inclusive figure.
Received a credit note from Simpasa for K42 500 (gross amount).
Paid Salaries in by cheque K800 000
Bought goods for re-sale by cheque, K 720 550 gross.
Paid Simpasa’s account in full by cheque, less 2% discount
Paid rates K330 000 by cheques.
Paid in cash wages K220 000, Solar power for electricity K400 000
Akabondo paid K400 000 on account.
Enter the transactions in the appropriate day books, post to the ledger and extract a trial balance
at the end of the month.
103
Question 2
Refer to Question 1: Prepare journal entries for the transactions on March 13, March 26
and March 27.
Question 3
Winwell owns a fast-food store, which is Value Added Tax registered. During the day’s
trading he entered into the following transactions:
A credit sale of K470 000
A cash sale of K200 000 net
A purchase for K700 000 list price net of Value Added Tax, less 20% trade discount
A returns outward was made for K150 000 list price from the same supplier.
At the start of the day there was nil balance on the Value Added Tax account. The rate of Value
Added Tax is 17.5%
What is the closing balance on Winwell’s Value Added Tax account following the above
transactions?
Question 4
At the beginning of February 20x6 Vumbi owed K7 200 000 to ZRA A summary of the
transactions of Vumbi plc , which is registered for Value Added Tax at 17.5%, shows the
following for the month of February 20x6:
Outputs (inclusive of Value Added Tax)
Inputs (exclusive of Value Added Tax)
K 122 610 000
K 78 857 000
During February 20X6 Vumbi paid ZRA K6 800 000. Calculate the amount owing to ZRA on 28
February 20x6.
104
SOLUTIONS TO EXERCISES
SOLUTION ONE
(Note: In this solution some words have been abbreviated to their consonants only for
convenience)
1.
LAMBDAR - CALCULATION OF CAPITAL
K
Assets:
Cash
15 000 000
Motor Vehicle
30 000 000
K
45 000 000
Liabilities:
None
Capital
__________
45 000 000
==========
JOURNAL ENTRIES
DR
3 500 000
CR
March 8 Furniture
Bank
Purchases of office desk by cheque
3 500 000
March 12 Motor Vehicle
30 000 000
Del Equipment
Purchases of a Truck S/No on credit
30 000 000
March 22 Bank
30 000 000
Loan (Mini Finance)
Loan obtained from Mini Finance
30 000 000
March 22 Del Equipment
25 000 000
Bank
Part payment for the motor vehicle
bought on credit on 12 March 2006
25 000 000
SALES DAY BOOK
DATE
March
2006
2
8
14
16
CUSTOMERS
FOLIO
TOTAL
K
VALUE ADDED
TAX
K
TRADE
RECEIVABLE
K
Akabindo
Mubita
Mubiana
Mundia
992 875.00
913 770.00
799 000.00
881 250.00
147 875.00
113 770.00
119 000.00
131 250.00
845 000.00
780 000.00
680 000.00
750 000.00
TOTAL
3 586 895.00
531 895.00
3 055 000.00
105
OTHER
RECEIVABLE
K
SALES RETURNS DAY BOOK
DATE
CUSTOMER
FOLIO
VALUE ADDED
TOTAL
TAX
March
2006
18
21
K
K
TRADE
RECEIVABLE
K
Mubita
Mundia
380 738.00
352 500.00
55 738.00
52 500.00
325 000.00
300 000.00
TOTAL
733 238.00
108 238.00
625 000.00
OTHER
RECEIVABLE
K
PURCHASES DAY BOOK
DATE
March
2006
7
12
15
19
SUPPLIER
FOLIO
VALUE ADDED
TAX
K
TOTAL
K
Siwale
Del Equipment
Simpasa
Solarpower Co.
424 000.00
30 000 000 .00
380 000.00
502 000.00
TOTAL
31 306 000.00
TRADE
PAYABLE
K
63 149.00
360 851.00
56 596.00
323 404.00
OTHER
PAYABLE
K
40 000 000.00
502 000.00
119 745.00
684 255.00
30 502 000.00
Workings
1 Trade Payable account
Siwale
Simpasa
Total
K
424 000.00
380 000.00
804 000.00
2 Other Payables
Solarpower Co.
Del Equipment
Total
502 000.00
30 000 000.00
30 502 000.00
K
360 851.00
323 804.00
684 255.00
PURCHASES RETURNS DAY BOOK
DATE
SUPPLIER
FOLIO
TOTAL
VALUE ADDED
TAX
March
2006
22
24
K
K
TRADE
PAYABLE
K
Siwale
Simpasa
83 600.00
42 500.00
12 451.00
6 330.00
71 149.00
36 170.00
TOTAL
126 100.00
18 781.00
107 319.00
106
OTHER
PAYABLE
K
CASH BOOK (CASH-RECEIPTS SIDE)
DATE
PARTICULARS
March
2
13
14
30
Bank
Sales
Sales
Akabondo
31
TOTAL
FOLIO
(c)
TOTAL
K
5 000 000
493 500
634 500
400 000
6 528 000
VALUE
ADDED
CASH
TRADE
OTHER
TAX
K
SALES
K
RECEVBLS
K
RECEVBLES
K
73 500
94 500
420 000
540 000
LOANS
400 000
168 000
960 000
400 000
2.2 CASH BOOK (CASH -PAYMENTS SIDE)
DATE
PARTICULARS
4
8
13
19
20
29
29
Rent
Drawings
Stationery
Furniture repairs
Delivery expnss
Wages
Solapwer -Elect
31
31
Balance
TOTAL
FOLI
TOTAL
VALUE
ADDED
CASH
TRADE
WAGES &
REPAIRS
TAX
K
PURCH
K
PAYABLES
K
SALARIES
K
K
600 000
250 000
350 000
180 000
630 000
220 000
400 000
C/d
STATIONERY
350 00
180 000
220 000
3 898 000
6 528 000
220 000
180 000
OTHER
RECEIVABLES
K
LOANS
350 00
3.1 CASH BOOK (BANK -RECEIPTS SIDE)
DATE
PARTICULARS
FOLIO
TOTAL
VALUE ADDED
TAX
March
1
22
Capital
Loan
K
15 000 000
30 000 000
31
TOTAL
45 000 000
K
CASH
SALES
K
TRADE
RECEIVABLES
K
K
30 000 000
30 000 000
3.2 CASH BOOK (BANK -PAYMENTS SIDE)
DATE
PARTICULARS
FOLIO
2
8
22
25
26
27
28
Cash
Furniture
Del Equipment
Salaries
Purchases
Simpasa
Rates
c
31
31
Balance
TOTAL
C/d
TOTAL
K
5 000 000
3 500 000
25 000 000
800 000
720 550
330 750
330 000
9 318 700
45 000 000
VALUE
ADDED
CASH
TRADE
WAGES &
RATES
OTHER
TAX
K
PURCH
K
PAYABLES
K
SALARIES
K
PAYABLE
K
PAYABLS
3 500 00
25 000 00
800 000
107 316
613 234
330 750
330 000
107 316
107
613 234
330 750
800 000
330 000
28 500 00
SALES
Trading
Trade Receivables
Cash
4 015 000
4 015 000
3 055 000
960 000
4 015 000
SALES RETURNS
Trade Receivable
625 000
Trading
625 000
625 000
625 000
TRADE PAYABLE
Purchases Returns
Bank
Discount Received
Balance c/d
126 100
330 750
6 750
340 400
Purchases
804 000
Balance b/d
804 000
------------------340 400
804 000
DEL EQUIPMENT - (Other Payables)
Bank
Balance c/d
25 000 000
5 000 000
Motor Vehicles
30 000 000
30 000 000
30 000 000
Balance b/d
5 000 000
SOLARPOWER CO.-(Other Payables)
Cash
Balance c/d
400 000
102 000
Electricity
502 000
502 000
502 000
Balance b/d
102 000
PURCHASES
Trade Payable
Bank
684 255
613 234
Trading
1 297 489
1 297 489
1 297 489
PURCHASES RETURNS
Trade Payables
Trading c/d
107 319
107 319
107 319
107 319
108
MOTOR VEHICLES
Capital
L-Stone Motors
30 000 000
30 000 000
Balance c/d
60 000 000
Balance b/d
60 000 000
60 000 000
60 000 000
ELECTRICITY
Solarropower Co
502 000
Profit & Loss
502 000
502 000
502 000
DRAWINGS
Cash
250 000
Capital
250 000
250 000
250 000
TRADE RECEIVABLES
Sales
3 586 895
Balance b/d
3 586 895
2 453 657
Sales Returns
Cash
733 238
400 000
Balance c/d
2 453 657
3 586 895
FURNITURE
Bank
3 500 000
Balance c/d
Balance b/d
3 500 000
3 500 000
3 500 000
3 500 000
WAGES & SALARIES
Cash
Bank
220 000
800 000
Profit & Loss c/d
1 020 000
1 020 000
1 020 000
FURNITURE REPAIRS
Cash
180 000
Profit & Loss c/d
180 000
180 000
180 000
STATIONERY
Cash
350 000
Profit & Loss c/d
350 000
350 000
350 000
109
RATES
Cash
Bank
600 000
330 000
Profit & Loss c/d
930 000
930 000
930 000
VALUE ADDED TAX
Trade Payables
Trade Receivable
Bank
Balance c/d
119 745
108 238
107 316
340 400
Trade Payables
Trade Receivable
Cash
18 781
531 895
168 000
718 676
718 676
340 400
Balance b/d
LOAN
Balance c/d
30 000 000
Bank
30 000 000
30 000 000
30 000 000
Balance c/d
CAPITAL
Motor Vehicles
Balance c/d
45 000 000
Bank
12 000 000.00
15 000 000
30 000 000
45 000 000
45 000 000
Balance c/d
45 000 000
DELIVERY EXPENSES
Cash
630 000
Profit & Loss
630 000
630 000
630 000
DISCOUNT RECEIVED
Profit & Loss
6 750
Trade Payables
6 750
6 750
6 750
BANK ACCOUNT
Total Receipts
45 000 000
Total Payments
Balance c/d
45 000 000
Balance b/d
35 681 300
9 318 700
45 000 000
9 318 700
CASH
Total Receipts
6 528 500
Total Payments
Balance c/d
6 528 000
Balance b/d
2 630 000
3 898 000
6 528 000
3 898 000
110
LAMBDAR
TRIAL BALANCE AS AT 31 MARCH 2006
DR
K
Sales
Sales Returns
Trade Payables
Del Equipment
Solarpower Co.
Purchases
Purchases Returns
Motor Vehicles
Electricity
Drawings
Trade Receivables
Furniture
Wages & Salaries
Repairs
Stationery
Rates
Value Added Tax
Loan
Capital
Delivery Expenses
Discount Received
Bank
Cash
CR
K
4 015 000
625 000
340 400
5 000 000
102 000
1 297 489
107 319
60 000 000
502 000
250 000
2 453 657
3 500 000
1 020 000
1 80 000
350 000
930 000
383 377
30 000 000
45 000 000
630 000
6 750
9 318 700
3 898 000
84 954 846
84 954 846
SOLUTION 2
DR
493 500
Cash account
Sales
Value Added Tax
Cash sales with Value Added Tax
CR
420 000
73 500
Purchases
Value Added Tax
Cash account
Cash purchases with Value Added Tax
613 234
Trade Payables -Cash
-Discount Rcvd
Cash
Discount Received
Settlement of amount owed to a supplier
330 750
6 750
107 316
720 550
111
330 750
6 750
SOLUTION 3
VALUE ADDED TAX
Trade Payables
98 000
Balance c/d
28 000
Trade Payables
Trade Receivable
Cash
21 000
70 000
35 000
Balance b/d
126 000
28 000
126 000
SOLUTION 4
VALUE ADDED TAX
Trade Payables
Bank
Balance c/d
13 800
6 800
4 861
Balance b/d
Trade Receivable
7 200
18 261
Balance b/d
126 000
4 861
126 000
112
CHAPTER 12
MORE ABOUT THE TRIAL BALANCE
INTRODUCTION
So far what has been covered in the previous chapters is the recording of transactions in the
books of original entry and posting to the ledger to complete double entry. The trial balance is
the next progression towards the preparation financial statements.
Before financial statements are prepared, it is important to carry out a test on the accuracy of
records in the books of the prime entry and the ledger.
TOPICS
1
2
3
4
5
What a trial balance is
Its format and preparation
Analysis of trial balance
Errors not disclosed by trial balance
Errors disclosed by trial balance
LEARNING OBJECTIVES
At the end of this chapter, one should be able to:
-
Prepare trial balance from the ledger accounts
Explain the use and purpose of trial balance
Describe and explain why the trial balance totals are equal
Identify and describe errors not disclosed by trial balance and errors disclosed by trial
balance.
7.1
THE TRIAL BALANCE
The word trial is taken from the word try. Which is an attempt, experiment or test to see
whether work done is satisfactory.
Therefore, a trial balance could be defined as a means of checking the correctness of a set
of accounts from the ledger.
It is prepared to check that the total of debit balances and credit balances are equal and
offer reassurance that double entry in the ledger is complete.
113
7.2
Trial Balance example
To understand clearly how the trial balance operates, let us do examples.
The following transactions of Big Brown, a sole trader, took place from 1 January to 31
December 20X5.
-
Started business with capital in cash K10 000
Deposited K8,000 cash into the bank
Paid for rentals by cheque K250
Bought goods and paid by cheque K400
Paid for stationery in cash K75
Sold goods and received cash K600
Bought goods on credit from suppliers K575
Paid wages by cash K325
Sold goods on credit to customers K780
Withdrew K50 cash for personal use
Paid electricity by cheque K25
Required:
Open the necessary accounts and prepare a trial balance as at 31 December 20X5.
Solution
Dr.
Cash account
Balance b/d
K
10,000 Bank
600 Stationery
Wages
Drawings
Balance c/d
10,600
2,150
Dr.
Bank account
Cash
K
8,000
Balance b/d
8,000
7,325
Capital
Sales
114
Rent
Purchases
Electricity
Balance c/d
Cr.
K
8,000
75
325
50
2,150
10,600
Cr.
K
250
400
25
7,325
8,000
Dr.
Dr.
Bank
Dr.
Bank
Payables
Dr.
Capital account
K
Cash
Rent account
K
250
Purchases account
K
400
575
Cr.
K
10,000
Cr.
K
Cr.
K
Stationery account
K
75
K
Dr.
Sales account
K
Cash
Receivables
Cr.
K
600
780
Dr.
Payables (Suppliers) account
K
Purchases
K
575
Cash
Dr.
Cash
Dr.
Sales
Dr.
Bank
Dr.
Cash
Wages account
K
325
Receivables (customers) account
K
780
Cr.
Cr.
Cr.
K
Cr.
K
Electricity account
K
25
K
Drawings account
K
50
K
115
Cr.
Cr.
N.B.
For every transaction a debit entry was also represented by a credit entry and vis
versa (double entry).
When preparing a trial balance, an account debited in the ledger will also be shown as a
debit in trial balance and an account credited in the ledger will be shown as credit in trial
balance.
A trial balance is not part if double entry. It is a memorandum statement.
Using the accounts in the ledger we can now prepare a trial balance. Thus:
Trial Balance as at 31 December 20X5
Dr.
K
2,150
7,325
Cash in hand
Cash in bank
Capital
Rent
Purchases
Stationery
Sales
Payables
Wages
Receivables
Electricity
Drawings
Cr.
K
10,000
250
975
75
1,380
575
325
780
25
50
11,955
______
11,955
The order in which accounts appear in the trial balance does not matter, because it is not
mandatory that a business must prepare a trial balance.
7.3
Analysis of trial balance
In our analysis of the trial we shall look at what to debit and credit in trial balance using a
table.
Dr.
Cr.
1
All assets
1 All liabilities
2
All expenses
2 All losses
3
Purchases
3 Sales
4
Sales returns
4 Purchases returns
5
Opening inventory
5 Capital
6
Drawings
Closing inventory does not appear in trial balance because it comes as an adjustment after
physical stock take. It is not a transaction, though inventory account is opened and
debited with value, because it is an asset remaining and will be shown as current asset in
balance sheet.
116
CHAPTER SUMMARY
-
A trial balance provides reassurance that double entry book keeping has been done
correctly.
A trial balance is just a memorandum statement; it is not part of double entry
A trial balance is the first step in the preparation of financial statements, i.e. Income
Statement & Balance Sheet.
A trial balance may have equal totals on debit and credit side; however, it does not reveal
all possible errors.
EXERCISES
1.
What is a trial balance?
2.
What are the uses of a trial balance?
3.
The following information is extracted from the books of B Stepson, a sole trader, whose
financial year ends on 31 October 20X5.
K
204,235
46,000
234,000
288,000
2,000
3,000
5,000
150
13,000
13,850
8,000
48,000
35,000
50,000
1,000
350
780
475
132,000
880
550
Capital 1 January 20X5
Opening inventory
Purchases
Sales
Light & heat
Advertising
Insurance
Bad debts
Rent
General
Drawings
Receivables
Payables
Bank overdraft
Returns inwards
Returns outwards
Carriage inwards
Carriage outwards
Machinery
Discounts allowed
Discount received
Required:
Prepare trial balance as at 31 December 20X5.
117
SOLUTION TO EXERCISES
1.
A trial balance is listing of balances taken from the ledger.
2.
The use of trial balance is to provide reassurance that double entry is correct in
the ledger. It is also used for the preparation of financial statements.
3.
B Stepson
Trial balance as at 31 December 20X5
Dr.
K
Capital 1 January 20X5
Opening inventory
Purchases
Sales
Light & heat
Advertising
Insurance
Bad debts
Rent
General
Drawings
Receivables
Payables
Bank overdraft
Returns inwards
Returns outwards
Carriage inwards
Carriage outwards
Machinery
Discounts allowed
Discount received
Cr.
K
204,235
46,000
234,000
288,000
2,000
3,000
5,000
150
13,000
13,850
8,000
48,000
35,000
50,000
1,000
350
780
475
132,000
880
543,135
118
550
543,135
CHAPTER 13
CONTROL ACCOUNTS
INTRODUCTION
In the chapters on posting to the ledger we discussed how to post entries to the Trade
Receivables and Trade Payables accounts. The amounts posted to those accounts were totals
from various day books. In this chapter we discuss how individual personal accounts of suppliers
and customers are maintained.
TOPICS
1.
2.
3.
4.
5.
6.
Manual and computer accounting systems
Need for control accounts
Posting to personal accounts
Posting to Control accounts
Errors and their correction
Summary
LEARNING OBJECTIVES
After you have studied this chapter you should be able to
•
•
•
Explain why control accounts are maintained by most large organizations
Post entries correctly to personal accounts in the Sales and Purchases Ledgers
Reconcile the control account balance with the sum of balances on personal ledger
accounts
1.0 ACCOUNTING SYSTEMS
A business can have a manual accounting system or a computerized accounting system.
In a manual system records are kept in the form of books. First transactions are recorded in ink in
the books of prime entry. Then at another time the entries in the day books are posted to the
ledger. The exercise becomes tedious when the organization grows big in size. Large numbers of
transactions would have to be posted to the personal accounts of suppliers and customers. The
need for computerizing the accounting system arises.
In a computerized accounting system the various stages of preparing accounting records are
electronically integrated. A transaction entered in a daybook will automatically post the entry to
the ledger accounts (assuming perfect integration). In this case the need to have control accounts
does not arise. There are computer systems in which the sales ledger and purchases ledger are
maintained as sub systems in relation to the general ledger. The balance on the trade receivable
or trade payable should then be reconciled with the sum of balances on personal accounts in the
subsystems.
119
1.1 PURPOSE OF CONTROL ACCOUNTS
Personal accounts of customers and suppliers are maintained so that the enterprise can send
account statements at the end of the month. The customers are provided with a way of
verifying the transactions and confirm the amounts due from them.
Similarly, at the end of the month we receive account statements from suppliers. We have to
verify the correctness of entries in the individual personal accounts of each supplier. We
will be able to identify payments to them that are not yet processed in their accounting
system.
Maintaining personal accounts of individual customers and suppliers is a conventional
practice that enable enterprises to identify errors that may have been made and correct them.
Ultimately they confirm amounts due on account receivables and accounts payables, and
report them in financial statements without undue delay.
1.2 COMPILING PERSONAL ACCOUNTS
Given below is a set of transactions we handled in a preceding chapter. We will this time post to
the Sales Ledger and the Purchases ledger to illustrate the use of control accounts. For
conveniences sakes we have reproduced the day books from which we will extract the entries to
personal accounts of customers and suppliers.
April 1.
April 5.
April 7.
April 12.
April 13.
April 13.
April 13
April 15
April 17.
April 18.
April 19.
April 19.
April 22.
April 30
Sold goods on credit to Chisakaila K 540 000 net.
VAT is charged at the rate of 17.5 %
Sold goods on credit to Ngosa K 800 000 net. The customer is entitled to less 2
% prompt discount if payment is made within 14 days.
Ngosa returned goods, K 200 000 net (He is entitled to prompt discount of
2 %)
Purchased goods on credit from Kunda K 282 000. The invoice stated a tax
inclusive amount.
Received an invoice for the 10 ton truck bought on credit from L-Stone Motors K
40 000 000 gross
Issued an invoice to Mulota K 400 000 net.
Returned goods worth K 42 600 to Kunda . This is a tax inclusive figure.
Sold goods on credit to Mambwe K 750 000 net.
We sent a credit note to Mambwe, K 150 000, net
Purchased Goods on credit from Mwape K 270 000 gross value.
Received a bill for electricity from Zam Hydropower. The total of the invoice
was K 320 000
Received a credit note from Mwape for K 35 700 (gross amount).
Ngosa paid his account in full less 5% cash discount.
Settled Kunda’s account by cheque, less cash discount of 5%
120
SALES DAY BOOK
DATE
April
2005
1
5
13
15
PARTICULARS
FOLIO
TOTAL
K
VALUE ADDED
TAX
K
TRADE
RECEIVABLE
K
Chisakaila
Ngosa
Mulota
Mambwe
634 500.00
937 200.00
470 000.00
881 250.00
94 500.00
137 200.00
70 000.00
131 250.00
540 000.00
800 000.00
400 000.00
750 000.00
TOTAL
2 922 950.00
432 950.00
2 490 000.00
OTHER
RECEIVABLE
K
SALES RETURNS DAY BOOK
DATE
PARTICULARS
FOLIO
TOTAL
K
April
2005
7
17
VALUE ADDED
TAX
K
TRADE
RECEIVABLE
K
Ngosa
Mambwe
234 300.00
176 250.00
34 300.00
26 250.00
200 000.00
150 000.00
TOTAL
410 550.00
60 550.00
350 000.00
OTHER
RECEIVABLE
K
PURCHASES DAY BOOK
DATE
April
2005
12
13
18
19
PARTICULARS
FOLIO
TOTAL
K
VALUE ADDED
TAX
K
TRADE
PAYABLE
K
OTHER
PAYABLE
K
Kunda
L-Stone Motors Ltd
Mwape
Zam Hydropower
282 000.00
40 000 000 .00
270 000.00
320 000.00
42 000.00
240 000.00
40 212.76
229 787.24
TOTAL
40 872 000.00
82 212.76
40 000 000.00
320 000.00
469 787.24
40 320 000.00
PURCHASES RETURNS DAY BOOK
DATE
PARTICULARS
April
2005
13
19
FOLOI
TOTAL
K
VALUE ADDED
TAX
K
TRADE
PAYABLE
K
OTHER
PAYABLE
K
Kunda
Mwape
42 600.00
35 700.00
6 344.68
5 317.02
36 255.32
30 382.98
TOTAL
78 300.00
11 661.70
66 638.30
121
1.3 POSTING TO THE SALES LEDGER
Posting to any ledger must always be guided by the rule of double entry. You have to trace
the flow of goods: who is giving and who is receiving. Even though you write one entry in
the control account, you still have to see the second entry in the other account mentally.
CHISAKAILA
Sales
634 500.00
Balance b/d
634 500.00
634 500.00
Balance c/d
634 500.00
634 500.00
Sales Returns
Cash
Discount All
Balance c/d
234300.00
667 755.00
35 145.00
nil
937 200.00
Balance c/d
470 000.00
470 000.00
Sales Returns
176 250.00
Balance c/d
705 000.00
881 250.00
NGOSA
Sales
937 200.00
937 200.00
MULOTA
Sales
470 00.00
Balance b/d
470 000.00
470 000.00
MAMBWE
Sales
881 250.00
Balance b/d
881 250.00
705 000.00
TRADE RECEIVABLES ACCOUNT BALANCES LISTING:
K
Chisakaila
634 500.00
Mulota
470 000.00
Mambwe
705 000.00
TOTAL
1 809 500.00
POSTING TO THE PURCHASES LEDGER
KUNDA
Purchases Returns 42 600.00
Bank
227 430.00
Discount Received 11 970.00
Purchases
282 000.00
282 000.00
282 000.00
122
MWAPE
Purchases Returns
35 700.00
Balance c/d
234 300.00
Purchases
270 000.00
270 000.00
270 000.00
Balance b/d
234 300.00
TRADE PAYABLES ACCOUNT BALANCES LISTING:
K
Mwape
TOTAL
234 300.00
234 300.00
The listings made of account balances in the sales and purchases ledgers agree with the total
balance on the corresponding total (control account) in the general ledger. The control
accounts are shown below accordingly
TRADE RECEIVABLES
Sales
2 922 950.00
Balance b/d
2 922 950.00
1 809 500.00
Sales Returns
Cash
Discount All
Balance c/d
410 550.00
667 755.00
35 145.00
1 809 500.00
2 922 950.00
TRADE PAYABLE
Purchases Returns 78 300.00
Bank
227 430.00
Discount Received 11 970.00
Balance c/d
234 300.00
Purchases
552 000.00
552 000.00
552 000.00
Balance b/d
234 300.00
Let us suppose that the following errors were made in the account. We will show what the
balances would be on the accounts and the eventual correction of the errors.
1. The Value Added Tax amount on sales returns from Ngosa did not take into account the
entitlement to cash discounts. The mistake was made in the personal account only.
2. Discount allowed was not posted to the trade receivables account in the general ledger.
The calculation of Value Added Tax on sales returns from Ngosa is
200 000 x 0175 = 34 000
The Trade Receivables accounts would be drafted as follows:
123
TRADE RECEIVABLES
Sales
2 922 950.00
Balance b/d
2 922 950.00
1 844 645.00
Sales Returns
Cash
410 550.00
667 755.00
Balance c/d
1 844 645.00
2 922 950.00
The account for Ngosa would be drafted as follows:
NGOSA
Sales
937 200.00
Balance b/d
937 200.00
300.00
Sales Returns
Cash
Discount All
Balance c/d
234300.00
667 755.00
34 000.00
300.00
937 200.00
The account listing of the sales ledger would be as follows:
K
Chisakaila
634 500
Ngosa
300
Mulota
470 000
Mambwe
705 000
Total
1 809 800
CORRECTION OF ERRORS
It is important to note that errors occurred in different parts of the accounting records. The
balance that is affected is the one to correct. You should look at each error made and identify
how it affected the accounts. Correction may require reversing what was done or recalculation or amounts and posting the difference to the correct side of the ledger account.
Invariably you will be ill-equipped to correct errors if your grasp of double entry is weak.
The Sales Ledger Control account balance will be corrected as follows:
K
Balance on TR account
1 844 645
Less: Discount Allowed
35 145
Adjusted balance
1 809 500
The Sales Ledger Listing total of balances will be corrected as follows:
SL Listing
Less: Undercast in Sales Returns
Adjusted total
1 809 800
300
1 809 500
The two balances have been reconciled. Few errors have been used here for the sake of
simplicity so that the principles involved can be clearly understood.
124
CHAPTER SUMMARY
You should now have learnt that control accounts are a useful tool for detecting errors that may
have been made in the accounts. They make ready an account balance that will be reported in the
balance sheet without undue delay. Work done on individual accounts
by staff in the Sales Ledger section can be verified and possible fraud can be discovered.
Correction of errors should be done to the amount that was affected by the error.
EXERCISES
1. A manufacturing business had trade payables of K 6 500 000 outstanding at the
beginning of the year. There were also amounts due from suppliers of K 45 000. During
the year the following transactions took place:
K
Remittances to suppliers
34 000 000
Receipts for cash purchases
3 000 000
Contra agreements
70 000
Invoices from suppliers
42 000 000
Credit notes received
90 000
Debit notes from suppliers
20 000
Discounts for prompt payment
50 000
The amounts due from suppliers at the end of the year were K 63 000.
Write the trade payables account and determine the closing balances on account at
the end of the year?
2. Kenny trades with Cynthia with whom she both buys and sells goods on credit. At the
end of the financial year Kenny owes Cynthia K 150 000 and she owes him
K 130 000. They both agree to setting off the amounts outstanding.
What would be the contra entry in Kenny’s books?
a) Dr Trade Receivables with K 150 000
Cr Trade Payables with K 150 000
b) Dr Sales Account with K 150 000
Cr Purchases Account with K 150 000
c) Dr Purchases Account with K 130 000
Cr Sales Account with K 130 000
d) Dr Trade Payables Ledger with K 130 000
Cr Trade Receivables Ledger with K 130 000
125
3. For the month of October 20X5 Kawape’s purchases totaled 225 600 with Value Added
Tax of K 33 840. The total of K 259 440 has been credited to the trade payables control
account as K254 940.
Which of the following adjustments is correct?
Control account
List of trade payables balances
a. K 4 500 Credit
b. K 4 500 Credit
c. K 29 340 Debit
d. K 33 840 Debit
No adjustment
Increase by K4 500
No effect
Increase by K4 500
4. Ignatius had the following balances on his trade receivables and trade payables on 1
December 2006.
Customers owed K40 250 and he owed suppliers 26 423. Credit balances in the trade
receivables ledger amounted to K3 845 and debit balances in the trade payables ledger
amounted to K1 985.
During the month his daybooks showed the following totals:
Purchases
Sales
Returns inwards
Returns outwards
Payments to suppliers
Receipts from customers
Discounts received
Discounts allowed
Amounts written off to bad debts
Transfers between the receivables ledger and the payables
Ledgers
Rebates on customer invoices
Refunds of cash from suppliers
408 563
854 239
44 271
32 662
300 912
675 843
9 027
20 275
13 173
7 457
3 244
5 877
On 31 December 2006 amounts owed to customers were K2 119. Suppliers who owed
him amounts at start of the year had paid K1 525.
REQUIRED
Prepare a trade receivables control account and a trade payables control account,
showing the balances to carry forward to the following month.
126
SOLUTIONS TO EXERCISES
1.
TRADE PAYABLE
Balance b/d
Purchases Returns
Bank
Trade Receivables
Discount Received
Balance c/d
K000
45
90
34 000
70
50
14 328
Balance b/d
Purchases
Purchases
48 583
48 583
Balance b/d
2
3
K000
6 500
42 000
20
14 328
d
a
4
TRADE RECEIVABLES
Balance b/d
Sales
Balance b/d
Balance b/d
K
40 250
854 239
Balance b/d
Retuens inwards
Bank
Discount All
Bad debts
Trade Payables
Returns inwards
Balance c/d
2 119
896 608
128 400
Balance b/d
K
3 845
44 271
675 843
20 275
13 173
7 457
3 244
128 400
896 608
2 119
TRADE PAYABLE
Balance b/d
Purchases Returns
Bank
Trade Receivables
Discount Received
Balance c/d
K
1 985
32 662
300 912
7 457
9 027
83 403
Balance b/d
Purchases
K
26 423
408 563
Balance c/d
460
48 583
Balance b/d
(1985 – 1525)
48 583
460
Balance b/d
127
83 403
CHAPTER 14
BANK RECONCILIATION
INTRODUCTION
The receipts and payments we make in our cash book are also recoded by the bank in there
books. The cash book contains the cash account and the a bank Account. The balance on the
bank account must be exactly equal to the amount the bank will show on the bank statement sent
to us at the end of the month. If the two balances are not the same then investigations should be
instituted to establish the causes of the difference. The cash book is thereafter updated with
entries that are on the bank statement but not in the cash book, and a bank reconciliation
statement is compiled for the entries that are in the cash book but are not on the bank statement.
LEARNING OBJECTIVES
By the end of this chapter you should be able to:
ƒ
ƒ
Explain the terms used in describing transactions processed through the bank account
To prepare a bank reconciliation statement
TOPICS
1.
2.
3.
4.
1.0
Why prepare a bank reconciliation statement
Terms in frequent use
Preparing a bank reconciliation statement
Summary
WHY PREPARE A BANK RECONCILIATION STATEMENT
ƒ
ƒ
ƒ
ƒ
2.0
To provide a means of internal control which the auditors can rely on.
To reveal the volume of transactions that the bank have not processed in their
accounting system by the end of the period under review, eg a month.
To correct the errors that may have been made in the accounting records.
To provide a verifiable balance at the bank that is to be included in the balance
sheet without any undue delay to the preparation of financial statements at the
year-end.
TERMS IN FREQUENT USE
ƒ
Direct debits:
Amounts debited on the bank statement but are not on the cashbook bank account.
Consequently if we are to update our cashbook the amounts should be recorded
on the credit side as they represent payments made directly by the bank on our
behalf.
128
ƒ
Direct credits:
Amounts credited on the bank statement but are not on the cashbook bank
account. When updating the cashbook the amounts will have to be recorded on the
debit side as they represent receipt of cash directly through the bank.
ƒ
Standing order:
The name is derived from the activity that creates it. The business issues a
standing order to the bank by letter. The letter contains an instruction to the bank
to pay a specified fixed amount on a stated date at regular interval (eg quarterly).
When the time is due for the matter the bank acts on the standing order and pay
the amount. The amount is shown on the debit side of the bank statement and so
it will be recorded on the credit side of the updated cashbook.
ƒ
Deposits not yet credited by the bank:
Such deposits are usually made on the last day of the month or year. The
processing of the deposit slips by the bank takes place the following day. So the
bank statement for the month or year under review does not show entries for such
deposits, even though they have already been recorded in the cash book.
ƒ
Unpresented cheques:
These are cheques we issued to pay for goods or services but the cheques have not
been taken to the bank for cashing by the suppliers we paid. The cheques are
already recorded in our cash book but have not been reflected on the bank
statement.
ƒ
Dishonoured cheques:
Cheques that once were received, recorded in the cash book but the bank refuses
to honour them for one reason or the other. Such cheques are returned to the
customer (trade receivable) who paid the amount, and the earlier receipt is
reversed.
129
3.0
PREPARING A BANK RECONCILIATION STATEMENT
The following exercise will illustrate how to prepare a bank reconciliation statement.
EXERCISE
The bank columns in the cashbook for May 2005 and the bank statement for that month
for G Hoglah are as follows:
CASH BOOK
Debit side
May 1 Balance b/d
May 8 R Mbewe
May 17B Jere
May 29F Banda
May 31D Phiri
K000
3 250
720
685
372
582
5 609
Credit side
K000
May 6 Kundananji
165
May 13K Mwila
454
May 17P Muma
38
May 30Daka Bowling
44
May 31Balance c/d
4 908
5 609
BANK STATEMENT
2005
May 1
May 8
May 9
May 17
May 18
May 19
May 29
May 30
May 31
May 31
DEBIT
K000
Balance b/d
Cheque
Suwilanji
Cheque
K Mwila
P Muma
Cheque
GYM:Standing order
Akazipo: Trader’s credit
Bank charges
CREDIT
K000
720
220
685
454
38
372
63
85
52
BALANCE
K000
3 250
3 970
3 750
4 435
3 981
3 943
4 315
4 252
4 337
4 285
You are required to:
a)
b)
Write the cashbook up to date to take the above into account, and
then
Draw up a bank reconciliation statement as at 31 May 2005
1. Identify entries appearing on both the cash book and the bank
statement. The matching field is either the date or the description.
The amount should be matched last. These entries represent
transactions that have been processed in both sets of accounts
correctly.
2. Starting with the closing balance on the cash book, prepare an
updated cashbook by debiting amounts that appear in the credit
column of the bank statement, and vice versa.
3. Starting with the revised cashbook balance in step 2, prepare a
bank reconciliation statement. The amounts recorded in the
cashbook but not processed by the bank are reversed accordingly.
130
In practice more rigorous verification is done since a lump sum shown on the bank statement
may have to be broken down into several transactions and matching entries identified separately.
Extensive schedules of unmatched entries are prepared, and totals used for preparation of bank
reconciliation statements.
SOLUTION
UPDATED CASHBOOK
May 31Balance b/d
May 31Akazipo
June 1 Balance b/d
K000
4 908 May 31Suwilanji
85 May 31GYM Club
May 31Bank Charges
May 31Balance c/d
5 609
K000
220
63
52
4 658
5 609
4 658
The rationale of how entries are treated in the bank reconciliation statement is that cashbook
entries not processed by the bank are reverse d. Thus payments made are added to the cashbookrevised balance as if they were not made, and receipts are deducted accordingly:
BANK RECONCILIATION STATEMENT as at 31 May 2005
K000
4 658
Balance per updated Cashbook
Add: Unpresented cheques
Kundananji
Daka Bowling
165
44
209
4 867
Less: Deposits not yet credited
D Phiri
Balance per bank statement
582
4 285
The double entry for dishonoured cheques is similar to that done for bank charges when updating
the cashbook with entries that appeared on the bank statement but not in the cashbook:
DR
K000
52
Bank charges
Bank account (in CB)
CR
K000
52
GYN Club
Bank account (in CB)
63
Trade receivables (Dishonoured cheque)
Bank account (assumed fig)
337
63
337
ACTIVITY: Write the journal for the traders credit made by Akazipo in the exercise above.
How would treatment of the entries in the bank reconciliation statement change if you started
with the balance as per bank statement?
131
CHAPTER SUMMARY
You have now learnt that: ƒ
Bank reconciliation is mandatorily prepared because it is a form of internal
control that auditors will rely on to certify the verifiability of the bank balance
shown in the balance sheet.
ƒ
Errors and unprocessed transactions can be revealed in the course of the bank
reconciliation exercise. Financial information is more reliable when it is free from
error.
EXERCISES
1. Your firm’s cash book shows a credit balance of K12 400 at 30 June 2005. Upon
comparison with the bank statement you determine that there are unpresented cheques
totalling K4 500, and a receipt of K1 400 which has not been passed through the bank.
The bank statement shows bank charges of K740 which have not been entered in the cash
book.
What is the balance on the bank statement?
2. Your firm’s cash book at 30 September 2005 shows a balance at the bank of K24 900. A
comparison with the bank statement at the same date reveals the following differences:
ƒ
ƒ
ƒ
ƒ
Unpresented cheques
Dishonoured cheques
Receipts not credited
Bank charges
8 400
1 400
4 700
500
Find the correct balance on the cash book at 30 September 2005
132
3. Trotters Grotto Ltd prepared the following summary of receipts and payments account for
the month of April 2006:
K000
K000
Receipts
1 478 Balance b/d
770
Balance c/d
662 Payments
1370
2140
2140
Trotters Grotto Ltd make all payments by cheques and all monies received are banked
immediately.
Before preparing bank reconciliation an investigation revealed the following:
a) The balance brought forward from March 2006 in the cash book should be
K750 000 and not K770 000
b) A cheque drawn for K128 000 for advertising had been incorrectly entered in the cash
book as K125 000.
c) Dividends received in the month of April of K89 000 were credited by the bank but
no entries were made in the cash book.
d) Business rates are paid directly by the bank under a standing order arrangement. An
amount of K120 000 was paid on 30 April 2006 and no entries have been made in the
cash book.
e) A cheque received from Kebby for K207 000 had been returned by the bank and
marked ‘insuffficient funds’. No adjustment has been made in the cashbook.
f) A cheque for K35 000 for miscellaneous consumables was entered in the cashbook as
a receipt instead of as a payment.
g) Cheques received totalling K807 000 had been entered in the cashbook and paid into
the bank, but had not been credited by the bank until 3 May.
h) Cheques drawn amounting to K345 000 had not been presented to the bank for
payment.
i) Bank service charges of K67 000 appearing on the bank statement have not been
entered in the cashbook.
REQUIRED:
i) Calculate the closing balance that should appear on the cashbook, taking into
account the appropriate information from the investigation.
ii) Prepare a bank reconciliation statement as at 30 April 2006.
133
SOLUTIONS TO EXERCISES
Q1
K 10 040
Q2
K 23 100
Q3
UPDATED CASH BOOK
April 30Suspense
April 30Dividend received
April 30 Balance c/d
K000
20 April 30 Bal b/d
89 April 30 Suspense
April 30 Rates
April 30 Kebby
April 30 Suspense
April 30 Bank Charges
1 020
5 609
May 1 Balance b/d
K000
662
3
120
207
70
67
5 609
1 020
BANK RECONCILIATION STATEMENT
Balance per revised Cashbook (overdraft)
Add: Deposits not yet credited
Less: Unpresented cheques
Balance per Bank Statement
134
K 000
1 020
807
1 827
345
1 482
CHAPTER 15
BAD DEBTS AND ALLOWANCES FOR DOUBTFUL DEBTS
INTRODUCTION
This chapter covers how a business deals with bad debts and anticipated future discounts.
TOPICS
1
2
3
4
5
6
7
8
What are bad debts?
Accounting for bad debts
Treatment of bad debts in financial statements
Bad debts recovered, accounting and treatment in final accounts
Allowances for doubtful debts
Accounting for allowance for doubtful debts
Treatment of allowance for doubtful debts in financial statements
Accounting and treatment for allowance for discounts allowed
LEARNING OUTCOMES
When studying this chapter, one should be able to:
•
•
•
Describe and account for bad debts and the treatment in financial statements
Explain why allowance for doubtful debts are provided
Account for allowance for doubtful debts and how they are calculated.
15.1 BAD DEBTS
As a business grows in size, some of its sales may be made on credit. Customers will be
able to access the goods from the business and arrangement will be made when to settle
the amount.
By doing so the business is taking a risk because some customers may fail to pay for
various reasons which may include:
-
Restrictions by a country to transfer cash (foreign exchange) to another country.
The customers business may just close down (liquidated)
Some customers may not be genuine and may just disappear without paying.
When a business fails to recover its money from credit customers, after making all
efforts, the amount is written off as a bad debt.
-
Bad debts are a loss to the business.
When a business sells goods to a customer on credit, double entry is
DR. – Customers account
CR. – Sales account
135
The customers account will appear in the receivables ledger as an asset.
Example: Sale of goods on credit.
Beatle is in business as a wholesaler merchant.
During the year 20X6, on 1 November it sold goods on credit to one of its regular
customer Mr. Fix, for K276,000.
In sales or receivable ledger.
Dr.
Mr. Fix account
Cr.
K
Sales 276,000
Nov. 1
K
In general ledger
Dr.
Sales account
Cr.
K
Nov. 1
Sales
K
276,000
-
Mr. Fix owes the business K276,000 and therefore, he is an asset to the
business by virtual of the amount owed.
-
If at year end 31 December 20X6, Mr. Fix is still owing the amount, he
will appear together with others in balance sheet, under current assets as
Trade receivables.
-
Mr. Fix account will be balanced as
Dr.
20X6
Nov. 1
Mr. Fix account
K
Sales 276,000
______
276 000
20X7
Jan. 1 Balance b/d
Balance c/d
Cr.
K
276,000
_______
276000
276,000
When the new year begins on 1 January 20X7, Mr. Fix is still a receivable
(debtor) with K276,000.
-
Assuming Mr. Fix’s credit period expires and the business fails to recover
the money, then the business has incurred bad debts.
136
15.2
ACCOUNTING FOR BAD DEBTS
Double entry:
DR. – Bad debts account (in general ledger)
CR. – Mr. Fix account (in sales ledger)
-
Using the above example:
Dr.
Mr. Fix account
20X7
Jan. 1 Balance
K
276,000
Bad debts
_______
276,000
Dr.
K
276,000
______
276,000
Bad account
Mr. Fix
Cr.
K
276,000
Cr.
K
-
Mr. Fix is no longer a receivable (debtor) to the business, so his account is closed
to bad debts which is a loss. The bad debts account will remain open throughout
the accounting period.
-
Should some more customers fail to pay, their accounts will be closed off to the
same bad debts account.
-
At year end when preparing financial statements, the bad debts account is
transferred to income statement as a charge against profits.
Double entry is:
Dr. – Income statement (with total amount of bad debts)
Cr. – Bad debts account
-
Using Mr. Fix
Dr.
Bad debts account
Mr. Fix
K
276,000
Income Statement
_______
276,000
Cr.
K
276,000
______
276,000
137
NOTES:
15.3
-
When adding receivables (debtors) in sales ledger Mr. Fix will not be
included as a receivable because his account has been closed off to bad
debts.
-
When trial balance is extracted bad debts appear on debit side as an
expense.
BAD DEBTS DISCOVERED AT YEAR END
At the end of the accounting period, before financial statements are prepared, all accounts
in business books are reviewed for adjustment.
It may happen that after reviewing the receivables ledger and preparation of aged
receivables analysis, some receivables may be discovered bad. An adjustment must be
made for both receivables total and bad debts.
-
When preparing financial statements, bad debts discovered at year should be
added to bad debts in trial balance to show total bad debts in income statement.
-
In balance sheet, the receivables figure should be adjusted by reducing with the
bad debts just discovered.
15.4 BAD DEBTS RECOVERED
A debt previously written off may be recovered in full or partially.
Steps in recovery:
(a)
The debt must first be reinstated to facilitate the recording of cash coming in.
DR. – the receivable (Debtor) account
CR. – Bad debts recovered account.
(b)
When payment is received:
DR. – Cash or Bank account
CR. – Receivables (Debtors) account
with amount received
Example: Bad debts recovered
A debt previously written off Mr. Fix K276,000 has now been fully recovered
with a payment by cheque.
138
Dr.
Mr. Fix account
Balance
b/d
K
276,000
Bad debts
_______
276,000
Cr.
K
276,000
_______
276,000
Bad debts recovered 276,000
Bank
276,000
276,000
276,000
Dr.
Bad debts recovered account
Income statement
K
276,000
Mr. Fix
_______
276,000
Cr.
K
276,000
_______
276,000
NOTES:
-
The bad debts recovered account is closed off to income statement as
income. It will be added to gross profit.
-
Sometimes cash may not be received immediately but reasonable
assurance is given that the amount will be paid. The debt should still be
reinstated but if at the balance sheet the amount is not yet received, the
debt must be included in total receivables figure.
15.5 ALLOWANCE FOR BAD AND DOUBTFUL DEBTS
Because of past experiences where some debts become bad, some organizations find it
more prudent to provide for future bad debts.
-
An allowance for doubtful debts is a general estimate of the percentage of debts
which are not expected to be repaid.
An aged schedule of receivables may help in estimating the allowance. It is well
known that the longer a debt is owing, the more likely that it will become bad
debt.
Example of aged schedule of receivables
Period debt is owing
Less than 30 days
30 days less than 60 days
60 days less than 90 days
Allowance for
Total amount Estimated
owing
% Doubtful doubtful debts
K
K
11,300,000
1%
113,000
7,400,000
4%
296,000
2,500,000
6%
150,000
139
Accounting for allowance for doubtful debts
(a)
Upon creation:
Dr. – Income statement
Cr. – Allowance for doubtful debts account
NOTE: In income statement the provision is deducted from gross profit as an
expense.
Example:
The financial year of Mafuso ends on 31 December each year. On 31 December
20X7 receivables accounts totaled K50 000. It was decided to write off K5 000 as
bad debts. It is also estimated that 3% of the remaining receivables may
eventually prove to be bad and it is decided to make a provision for doubtful
debts.
In income statement
Dr.
Income statement account (20X7)
K
Cr.
K
Expenses:
Allowance for doubtful
debts
1,350
Gross profit
XX
OR
Gross profit
Less: Expenses
Allowance for doubtful debts
Dr.
Balance c/d
XX
(1,350)
Allowance for doubtful debts account
K
1,350
____
1,350
140
Cr.
31 Dec. 20X7
Income statement
K
1,350
____
1,350
1 Jan. 20X8 Bal. b/d
1,350
Balance sheet (extract) as at 31 December 20X7.
Current Assets
Receivables (50,000 – 5,000)
Less: Allowance for Bad Debts
45 000
1,350
43 650
NOTES:
-
The allowance for bad debts account is closed off to balance sheet or by
bringing down the balance into the next account period, awaiting to be
used when bad debts occur.
-
In balance sheet, the allowance is deducted from the total receivables
figures, in order to show what is expected to be received from the
receivables.
The prudence concept is at play in this case.
-
It is also important to remember that allowance for bad debts are estimated
from good receivables (debtors). If receivables figure is inclusive of bad
debts, bad debts must be deducted before estimating for allowance for
provision for bad debts.
Using previous example:
Income statement
Gross profit
Less: Expenses
Bad debts
Allowance for bad debts
K
K
XX
5,000
1,350
6,350
15.5.1 In subsequent years, adjustments may be made to the allowance for doubtful debts. The
allowance may increase or decrease due to economic factors which may change from
year to year.
(a)
If increase in allowance for doubtful debts.
Compare the balance b/d in the allowance for doubtful debts account with the
newly calculated figure, the difference is the increase which should be charged to
income statement and added to allowance b/d from previous year.
-
The new balance is always the figure to be deducted in balance sheet from
year end receivables.
Double entry will be as follows:
Debit: Income Statement (as expense)
Credit: Allowance for Doubtful Debts (with the increase)
141
Example
In 20X8, receivables in Mafuso amounts to K54,000 after deducting
K3,000 bad debts. It is decided to maintain the 3% allowance for bad
debts on receivables.
3% X K54,000 = K1,620
The increase from 20X7 is K270 (1,620 – 1,350).
In Income Statement:
Income statement (20X8)
Gross profit
Less: Expenses:
Bad debts
Allowance for bad debts
K
K
XXX
3,000
270
3,270
Dr.
Allowance for doubtful debts account
K
1,620
____
Balance c/d
Cr.
K
1,350
270
Balance b/d
Income statement
1,620
1,620
Balance b/d
1,620
Balance sheet (20X8)
Current assets
K
Receivables
Less: Bad Debts
54 000
1,620
K
52 380
(b)
If decrease in allowance for doubtful debts
Assuming in 20X9, the economic environment is very conducive for business and
most of the receivables are paying, the allowance for doubtful debts may be
reduced.
Example:
The allowance for doubtful debts has been in existence for the past two (2) years
in the books of Mafuso. At 31 December 20X9, receivables were K30,000. After
reviewing the receivables ledger it is discovered that K1,500 will not be recovered
and 3% allowance for doubtful be maintained on remaining receivables.
K
142
Receivables
Less: Bad debts
30,000
(1,500)
28,500
Remaining receivables: 28,500 x 3% allowance = K855
Double entry when the allowance is reduced will now be the opposite.
Dr. – Allowance for doubtful debts account (to reduce)
Cr. – Income statement (add to gross profit)
NOTE:
The reduction is treated as income and is added to gross profit.
Where bad debts (expense) exist when the reduction takes place, it is advisable to
net off the two since they are related. Thus in given example, instead of adding
decrease to gross profit it will be:
Bad debts (Expense)
Decrease in allowance for
Doubtful debts (income)
-
K
1,500
765
735 to be shown as bad debt in income
statement
showing bad debts and allowance for bad debts separately.
Dr.
Income statement
Balance c/d
Allowance for bad debts account
Cr.
K
765
855
____
1,620
Balance b/d
K
1,620
Balance b/d
_____
1,620
805
Income Statement (20X9)
K
Gross profit
Add: other income
Decrease in provision for doubtful debts
Less: Expenses
Bad debts
XX
765
XX
1,500
143
K
15.5.2 When bad debts are incurred where allowance for doubtful debts exists.
Remember the purpose of allowance for doubtful debts is to accommodate future bad
debts. So when bad debts are incurred when an allowance for it exists. Double entry is:
DR. – Allowance for doubtful debts account (with amount of bad debt)
CR. – Bad debts account
Example: Transferring bad debts to allowance for doubtful debts account.
Expert builders has total receivables amounting to K268,000 as at 31 December 20X7. It
is discovered that of this amount K18,000 is not recoverable and should be written off as
bad debts. At 1 January 20X7, a balance of K27,800 was brought forward from 20X6 in
allowance for doubtful debts.
It is believed that of the remaining receivables 10% may not pay.
Dr.
Receivables account
Cr.
Balance
K
268,000
K
18,000
250,000
_______
268,000
Bad debts
Balance c/d
______
268,000
Balance b/d
Dr.
Receivables
250,000
Bad debts account
K
18,000
Cr.
K
Allowance for doubtful
debts
_____
18,000
18,000
_____
18,000
Dr.
Allowance for doubtful debts account
Cr.
Bad debts
K
18,000
K
27,800
15,200
_____
43,000
25,000
Balance c/d
Balance b/f
Income statement
25,000
43,000
Balance b/d
NOTES:
Bad debts K18,000 is a charge against the allowance for doubtful debts.
The net charge is K15,200 (18,000 – 2,800) to income statement.
144
If the amount of allowance is not enough for bad debts suffered, the remainder
will be charged against profits in that year.
15.6 ALLOWANCE FOR CASH DISCOUNTS ON RECEIVABLES.
This is an allowance created to accommodate future cash discounts on receivables. It is
treated exactly like allowance for doubtful debts in terms of how it is accounted for.
The estimate of discounts to be allowed should be based on the net figure of receivables
after deducting allowances for doubtful debts.
Example: Allowance for cash discounts
The following information is available in the books of Home Made Furnishers Ltd as at
30 June, end of each financial year.
Year ended 30
June
Receivables
K
Allowance for
doubtful debts
K
Allowance for
cash discounts
%
20X6
20X7
20X8
20,000
25,000
23,000
1,000
1,250
1,200
3
3
3
20X6
20X7
20X8
K20,000
K25,000
K23,000
Dr.
-
1,000
1,250
1,200
=
=
=
19,000 X 3% = 570
23,750 X 3% = 713
21,800 X 3% = 654
Allowance for cash discounts on receivables account
K
20x6
Balance c/d
20x7
Balance c/d
20x8
Income statement
Balance c/d
Cr.
K
570
570
Income statement
570
570
713
___
713
Balance b/d
Income statement
570
143
713
59
654
713
Balance b/d
713
___
713
654
Balance b/d
145
Income Statement
K
Gross profit for (20X6, 20X7, 20X8)
Expenses:
20X6 Allowance for discounts allowed
(570)
20X7 Increase in allowance for discounts allowed (143)
(20X8) Add decrease in allowanced for discounts
59
In Balance Sheet
Current Assets
20X6 Receivables (20,000 – 1,000 - 570)
K
18,430
20X7 Receivables (25,000 – 1,250 – 713)
23,037
20X8 Receivables (23,000 – 1,200 – 654)
21,146
146
K
XX
CHAPTER SUMMARY
-
Bad debts are amounts a business fails to recover from receivables
-
Bad debts are expenses and are charged to income statement
-
Bad debts recovered are debts previously written off but have been recovered. They are a
gain and are added to gross profit in income statement.
-
Allowance for doubtful debts are amounts set aside from profits to meet future bad debts.
-
Allowance for doubtful debts balance is deducted from receivables figure in balance
sheet.
-
Specific allowance for doubtful debts must be deducted from the receivables figure
before calculating general allowance for doubtful debts. However, in balance sheet the
total allowance will be specific plus general.
EXERCISES
1.
What is double entry to write off bad debts?
2.
What is double entry for bad debts recovered?
3.
What is double entry for allowance for doubtful debts?
4.
What is double entry for decrease in allowance for doubtful debts?
5.
Bird Cage has total receivables balances outstanding at 31 December 20X6 of K28,000.
She believes that about 1% of these balances will not be paid and wishes to make an
appropriate allowance.
Before now, she has not made any allowance for doubtful debts at all.
On 31 December 20X7, her receivables balances amount to K40,000. Her experience
during the year has convinced her that an allowance of 5% should be made.
What accounting entries should she make on 31 December 20X6 and 20X7 and what
figures for receivables should appear in her balance sheets as at those dates.
147
SOLUTIONS TO EXERCISES
1.
Dr. – Income Statement
Cr. – Bad debts account
2.
Dr. – Receivables account
Cr. – Bad debts recovered account
to reinstate the receivable
then
Dr. – Cash or Bank account
Cr. – Receivables account
3.
On creation or increase in allowance for doubtful debts.
Dr. – Income statement
Cr. – Allowance for doubtful debts account
4.
When allowance for doubtful debts reduces
Dr. – Allowance for doubtful debts account
Cr. – Income statement.
5.
Dr.
Balance c/d
Allowance for doubtful debts account
K
280
K
20X6
Income statement
280
Balance c/d
Cr.
20X7
Balance b/d
Income statement
2,000
2,000
Balance b/d
In balance sheet
20X6 Receivables (K28,000 – 280) K27,720
20X7 Receivables (40,000 – 2,000) K38,000
148
280
280
280
1,720
2,000
2,000
CHAPTER 16
PREPAYMENTS AND ACCRUALS
INTRODUCTION
The income statement of a business measures the profit by considering revenues earned and
expenses incurred in an accounting year.
Sales less cost of sales equals Gross Profit.
Gross profit less expenses equals net profit. The precise amount of net profit is calculated on the
accruals or matching concept.
TOPICS
1.
2.
3.
4.
5.
6.
What are accruals
Ledger accounting for accruals
Treatment of accruals in financial statements
What are prepayments
Ledger accounting for prepayments
Treatment of prepayments in financial statements
LEARNING OUTCOMES
At the end of the Chapter, you should be able to:
•
•
•
•
To prepare expense account and interpret balance brought down as an accrual or
prepayment.
To adjust expenses for accruals and prepayments in income statement
To prepare income account with adjustment for amounts owing and prepaid
To show accruals and prepayments appropriately in balance sheet.
16.1 ACCRUALS
The accruals concept states that income and expenses should be included in the income
statement of the period in which they are earned or incurred and not paid or received.
Example
A business rents a shop for K1,200 per annum (K100 per month). If at year end, the
business has only paid K1000, a full years charge of K1,200 will be expensed in income
statement. The K200 though not paid will be included because it relates to the same
period.
Accruals or accrued expenses are expenses which are charged against the profits of a
particular period, even though they have not been paid, because they were incurred in that
period.
N.B. Accruals can be owing by the business or to the business.
149
Example 1: Owing by the business.
Using the above example the rent expense account would look like:
Dr.
Rent Account
Bank
Balance c/d
K
1 000
200
_____
1 200
Cr.
Income Statement
K
1 200
Balance b/d
____
1 200
200
By now one should know that a balance b/d on credit side of an account could be
interpreted as a liability or income depending on what type of account one is looking at.
Therefore, the rent expense account with balance brought down on credit is a liability
(amount owing).
-
But the amount to charge in income statement will be K1200 including K200 not
paid because it relates to the same period.
-
In balance sheet K200, will be shown under current liabilities as accrued
expenses.
Assuming in the following year K1 400 is paid for rent, the account will be as follows:
Dr.
Bank
Rent Account
K
1 400
Cr.
K
Opening balance from
previous year
Income Statement
Account
_____
1 400
200
1 200
____
1 400
The K1 400 paid is first to pay the previous years balance of K200 and the remainder K1
200 is what should be charged to the second year’s income statement.
The K200 has now been paid and will not appear anywhere in financial statements.
Example 2: Owing by the business
Genuine Motor Spares, is a dealer in motor spares. The financial year for the business
ends on 28 February each year. His telephone was installed on 1 April 20x6 and receives
his telephone account quarterly at the end of each quarter. He pays it promptly as soon as
it is received. On the basis of the following data, calculate the telephone expense to be
charged to the income statement for the year ended 28 February 20x7.
150
The following payments were made.
K
23.50
27.20
33.40
36.00
30.6.20x6
30.9.20x6
31.12.20x6
31.3.20x7
Solution:
Dr.
Telephone Account
Bank
Bank
Bank
Balance c/d
K
23.50
27.20
33.40
24.00
_____
108.10
Cr.
Income Statement
K
108.10
Balance b/d
_____
108.10
24.00
The K24 would be shown under current liabilities as an accrual. The K24 represents two
months arrears for January and February which were still due by 28 February 20X7.
16.2 Amounts accrued to the business
While the business may owe others for expenses, the business may also be owed for other
amounts apart from trade among others:
-
Rent receivables
Commission receivable
Unsettled claims for insurance etc.
Using the matching or accruals concepts, all income whether received or not as long as it
relates to the accounting period under review, should be included as income in income
statement for that period.
Since amounts are not yet received, they should be shown in balance sheet under current
assets as other receivables.
Example 1.
T.K. Furnishers Ltd sublets part of the buildings at an annual rent of K1200 000 (K100
000 per month). During the year ended 31 December 20X8, T.K. discovers that the
tenant had only paid K1 000 000.
Show rent receivable account and statement to be shown in income statement and
interpret the balance brought down.
Solution:
151
Dr.
Rent Receivable Account
Income Statement
K
1 200 000
Balance b/d
________
1 200 000
200 000
-
Bank
Balance c/d
Cr.
K
1 000 000
200 000
________
1 200 000
The amount to be shown in income statement is not K1 000 000 paid, but will
also include K200 000 not paid.
So the total to include in income statement is K1 200 000, to be added to Gross
profit.
-
In balance sheet the K200 000 will be shown under current assets as other
receivables.
Example 2:
Using example 1, assuming in the following year 20X9, the tenant pays K1 400
000 for rentals, the rent receivable account will be:
Dr.
Rent Account
Balance b/f
Income Statement
K
200 000
1 200 000
1 400 000
Bank
Cr.
K
1 400 000
________
1 400 000
-
In 20X9, the opening balance b/f of K200 000 is a debit representing amounts not
yet received (asset).
-
When the tenant pays K1 400 000, the whole amount is not for 20X9. Part of it is
to clear the debt K200 000 from 20X8 and the remaining amount is the rent
income for 20X9 to be added to gross profit in income statement. In this example
there’s nothing owing at year end.
152
16.3 PREPAYMENTS
Prepayments are amount paid in advance before a service is provided.
It is important to note that payments in advance can be made by the business or to the
business.
Example 1: Payments in advance by the business.
A business has a fixed rate for electricity of K74 000 per month. It is the business
tendancy that when their liquidity position is favourable they pay in advance for certain
services including for electricity.
For the year ended 31.12.20X8 the business had paid for electricity total of K1 036 000 to
cover a period of 14 months to 28 February 20X9.
Show the electricity account, stating the amount to be included in income statement and
interpret the balance b/d.
DOUBLE ENTRY
1.
Upon payment Dr – Electricity account
Cr – Bank account
2.
Income statement Dr. Income statement with annual expense
Cr. Electricity account
In balance sheet. Dr. Electricity (Balance sheet) with balance b/d (Dr.)
Therefore:
Dr.
Electricity Account
Bank (14 x 74)
K
1 036 000
Balance b/d
________
1 036 000
148 000
Income statement
Balance c/d
Cr.
K
888 000
148 000
________
1 036 000
Notes:
-
Though K1 036 000 was paid during the year, the only expenses is K888 000
(74 000 x 12 months). The other amount K148 000 is for the year to come
(prepayment) and it will be accounted for in that year.
-
Total charge to income statement is K888 000.
153
-
The balance b/d will be shown in balance sheet under current assets as
prepayments.
Example 2:
Assuming the balance in example 1 of K148 000 is carried forward to the next year and
the business in the new year is only able to pay K740 000.
Solution:
Dr.
Electricity Account
Balance b/f
Bank
K
148 000
740 000
_______
888 000
Income statement
Cr.
K
888 200
888 000
Notes:
-
Though only K740 000 has been paid for current year, i.e. for 10 months, the
other amount of K148 000 paid in advance the previous accommodates the first 2
months of the year making a full payment for the year of K888 000 to be charged
to income statement.
-
K148 000 is no longer an advance payment because it has now been used in the
year for which it was paid.
-
In above case no amount will appear in balance sheet.
16.4 Prepayments to the business
Other persons or organizations make payments in advance to the business for certain
items e.g. for rent receivable and any other income.
-
Any amount receivable paid in advance would not be included in income
statement in the year it is received.
-
It should be accounted for in the period the service will be provided.
-
In balance sheet it should be reflected under current liabilities as other payables.
Example 1: Prepayments to the business.
Gas Pipe runs a service station and sales fuel among other services.
Some well established individuals make advanced payments to Gas Pipe for fuel.
154
During the year ended 31.12.20X7, a payment of K3 000 000 was paid in advance for
fuel by a customer.
It now is discovered that the customer had actually withdrawn fuel amounting to
K2 488 000 as at 31.12.20X7.
Show the necessary account to record the above information and state the unused amount
which will be shown in financial statements.
Solution:
Double entry
1.
Upon receipt of amount
Dr. – Cash book with K3 000 000
Cr. – Fuel account (Income)
2.
At year end, adjustments will be
Dr. – Fuel account with K512 000 balance c/d
Cr. – Prepayment (fuel) balance b/d to be shown in balance sheet under current
liabilities as other payables.
Dr.
Fuel Account
Income statement
Balance c/d
K
2 488 000
512 000
________
3 000 000
Cr.
Bank
K
3 000 000
Balance b/d
________
3 000 000
512 000
Notes:
The business is holding K512 000 cash for which fuel is yet to be withdrawn. The fact
that this amount could be claimed by customer before fuel is withdrawn makes it become
a liability to the business.
16.5 DIFFICULT SITUATIONS
Examples given so far for prepayments and accruals are straight forward. This has been
done to have basic knowledge on the subject matter.
-
-
In examination questions, however, one may be confronted with complicated
situations involving several receipts or payments made in the year covering
different periods.
In such situations particular attention should be made on dates.
Example 1:
Fitwell Garage pays fire insurance annually in on 1 June each year.
155
From the following record of insurance payments, calculate the charge to income
statement for the financial year to 28 February 20X8.
1 June 20X6 insurance paid is K600 000
1 June 20X7 insurance paid is K700 000
Dr.
Balance b/f
Bank
Balance b/d
Insurance Account
K
150 000
700 000
_______
850 000
175 000
Income statement
Balance c/d
Cr.
K
675 000
175 000
______
850 000
Notes:
(a)
(b)
(c)
K
The 3 months, 1 March – 31 May 20X7 ( /12 x 600 000)
150 000
The 9 months, 1 June 20X7 – 20 February (20X8) 9/12 x 700 000 525 000
Insurance cost for year charged to income statement
675 000
3
CHAPTER SUMMARY
-
Accruals are amounts the business has not yet paid or received for services provided.
-
Accruals can be by the business or to the business.
-
Prepayments are amounts paid in advance by the business or to the business.
-
The matching or matching concept requires that income and expenses whether paid or not
as long as they relate to the accounting period under review, should be matched when
computing profit for that period.
-
Accruals by the business are included as a charge in income statement, and shown under
current liabilities in balance sheet (accrued expenses).
-
Accruals to the business (income) are also included in income statement added to amount
received, but stated as current asset in balance sheet (other receivables).
-
Prepayments by business are excluded in income statement from total amount paid and
reflected as current asset in balance sheet (prepayments).
-
Prepayments to the business are also deducted from total amount received in income
statement but shown as current liability in balance sheet (other payables).
156
EXERCISES
1.
If a business has paid rent of K1 000 000 for the year to 31 March 20X7, what is the
prepayment in the accounts for the year to 31 December 20X6.
2.
Define an accrual
3.
What is the meaning of balances brought at year end in the following accounts
-
4.
Debit balance in expense account
Credit balance in expense account
Debit balance in income receivable account
Credit balance in income receivable account
A business maintains one account for rent and rates.
During the year ended 31 December 20X5, the following information was made available
for rent and rates.
-
At 1 January 20X5, there was K250 000 rates which had been paid in advance in
20X4, and K500 000 rent was owing on the same date.
-
The following payments were made during 20X5, rent K4 000 000 and rates
K3 6000 000.
-
On 31 December 20X5, rent of K200 000 is owing and rates of K150 000 are paid
in advance.
Required:
Prepare the rent and rates account (combined and appropriately bring down the balance).
157
SOLUTIONS TO EXERCISES
1.
K1 000 000 X 3 months = K250 000
12
2.
An accrual is an amount not yet paid in received at end of accounting period.
3.
-
Asset (prepayment)
Liability (amount owing)
Asset (amount not yet received but to be received)
Liability (amount receivable paid in advance to the business).
Dr.
Balance b/f
Bank (rent)
Bank (rates)
Balance c/d
Balance b/d
Rent and Rates Account
Cr.
K
250 000
4 000 000
3 600 000
200 000
8 050 000
150 000
K
500 000
Balance b/f
Income statement
(Balancing figure)
balance c/d
Balance b/d
Note:
In balance sheet: Rent is current liability (K200 000)
Rates is current asset (150 000).
158
7 400 000
150 000
8 050 000
200 000
CHAPTER 17
NON CURRENT ASSETS AND INTANGIBLE ASSETS
INTRODUCTION
This chapter deals with non current assets and depreciation. It looks at what non currents are,
depreciation and how it is provided and eventually leading to disposal. The non current asset
register is also discussed.
Additionally the chapter covers the basics of research and development costs and goodwill
TOPICS
1
2
3
4
5
6
7
Non current assets – what are they?
Depreciation
Methods of depreciation
Accounting for depreciation
The disposal of non current assets
The non current asset register
ISA 38 - Intangible assets
LEARNING OUTCOMES
After studying this chapter, the student should be able to:
•
•
•
•
•
•
•
•
•
•
•
•
•
Define non current assets giving examples
Distinguish clearly between non current assets and current assets
Define depreciation and explain why it is provided
Identify causes of depreciation
Calculate and account for depreciation using different methods
Identify the steps in disposal of non current asset
Describe the importance of maintaining a non current asset register
Define research
Distiguish between pure or basic research and applied research
Define development costs and explain how they are treated in financial statements
Define goodwill
Distiguish between purchased and inherent goodwill
Explain and apply the accounting treatment for both types of goodwill
159
11.0
NON CURRENT ASSETS
11.1
DEFINITION
A non current asset is one bought by the business not for resale but to be used in
the business to help generate income over a number of years.
-
Non current assets are divided into tangible and intangible assets.
-
Tangible non current assets include:
•
•
•
•
-
Intangible non current assets include:
•
•
•
11.2
Land
Buildings
Fixtures and fittings
Motor vehicles
Goodwill
Patents
Trade marks
CURRENT ASSETS
These are assets that are temporal in nature. They change in value with time, and
examples includes:-
Inventory
Receivables
Cash in bank and
Cash in hand
Current assets are easily convertible into cash.
NOTE: What is non current asset will depend on the nature of the business. If a
business is dealing in motor vehicles and it buys motor vehicles for resale, then
motor vehicles will be classified as inventory under current assets. Then motor
vehicles bought to be used in the business will be classified as non – current
assets.
11.3
DEPRECIATION
Definition: (IAS 16 Property, plant and equipment)
IAS 16 which deals with property, plant and equipment defines depreciation as:
160
“the allocation of the depreciable amount of an asset over its estimated useful
life”.
Depreciation for the accounting period is charged to income statement for the
period either directly or indirectly. Depreciation is an expense. No cash is
involved.
11.4
KEY TERMS (IAS 16)
(a)
Depreciable assets are assets which
-
(b)
are expected to be used during more than one accounting period.
have a limited useful life and
are held by an enterprise for use in the production or supply of
goods and services, for rental to others, or for administrative
purposes.
Useful life is either:
-
the period over which a depreciable asset is expected to be used by
the enterprise or
the number of production or similar units expected to be obtained
from the asset by the enterprise.
(c)
Depreciable amount of a depreciable asset is the historical cost or other
amount substituted for historical cost in the financial statements, less the
estimated residual value.
(d)
Residual value
Sometimes called scrap value. This is the estimated value of an asset at
the end of its life. Residual value is not depreciable. In most cases
residual value is immaterial. It is usually estimated at the time the asset is
being purchased. The estimation may be based on similar assets in
existence in the business.
Example 1: Equipment costing K80,000,000 which has an expected life
of five years and nil residual value will be depreciated as:
Cost
K80 000 000
Residual value
NIL
K80 000 000
depreciable amount over 5 years
Example 2: Equipment costing K80 000 000 which has an expected life of
five years with K3 000 000 residual value will be depreciated as:
Cost
Residual value
K80 000 000
(K3 000 000)
K77 000 000 is depreciable amount over 5 Years
161
11.5
11.6
CAUSES OF DEPRECIATION
(a)
Wear and tear - This is when assets deteriorate because of being used.
(b)
Natural causes - This is when elements of nature take its effect e.g.
erosion of land, rust on machinery, rot and decay in furniture.
(c)
Obsolescence - This is where an asset becomes outdated because of
technological changes even when the asset is new e.g. computers.
(d)
Inadequacy - This arises when an asset is no longer used because of the
growth and changes in the size of the business. For instance a business is
operating a bicycle to deliver oranges to its customers. When demand
increases, the business will need a van. The bicycle can be sold else
where.
(e)
Depletion - Natural resources such as mines, quarries and oil wells are
wasting assets. As raw materials are extracted they do not regenerate.
METHODS OF DEPRECIATION
There are many different methods of depreciation. The following are selected for
your study.
Straight line
Reducing balance method
Sum of digits
Revaluation method
11.7
THE STRAIGHT LINE METHOD
In this method the depreciable amount is charged equally from one accounting
period to the other over the expected useful life of the asset. It is assumed that the
business will enjoy equal benefits from the use of the assets throughout its life.
N.B.V
TIME
In this way the net book value of an asset declines at a steady rate, or in a straight
line over time. The formula is:
Annual depreciation = Cost of an asset – residual value
Expected useful life of the asset
162
Example 1: Straight line method
A machine was bought on 1 January 20X4 at a cost of K800 000. The machine is
expected to be used over a period of 5 years with no residual value.
Annual depreciation would be:
Depreciation = (K800 000 – 0)
5
= K160 000 P.A.
Example 2: Straight line method
A vehicle cost K500 000 will be in use in the business for 4 years after which it
will have residual value of K20 000. Annual depreciation over 4 years will be:
(K500 000 – K20 000)
4
= K480 000
4
= K120 000 P.A.
Sometimes the depreciation charge may be given as a percentage on cost.
In example 1 above, the % on cost will be:
160 000
x 100
= 20%
800 000
Every year for 5 years 20% will be calculated on K800 000 to find annual
depreciation.
In example 2 above, the % will be calculated on depreciable amount after
deducting residual value.
Remember residual value is not depreciable.
120 000
x 100 = 25%
480 000
Every year for 4 years, 25% will be used on K480 000 which is the depreciable
amount.
163
11.8
The Reducing Balance Method
In this method depreciation is calculated as a fixed percentage of the net book
value of the asset, as at the end of previous accounting period.
This method assumes that the business will benefit more from the use of the asset
in earlier years than later years.
Example: Reducing Balance Method
Machine was bought at a cost of K150 000. Depreciation is to be charged at the
rate of 20% per annum. Calculate depreciation for the first 3 years.
K
20% x 150 000
(30 000)
20% x 120 000
(24 000)
20% x 96 000
(19 200)
76 800
Year 1
Year 2
Year 3
11.9
Depreciation
N.B.V
Depreciation
N.B.V
Depreciation
Sum of digits method
This method is very similar to reducing balance method. Depreciation is also
charged more in earlier years than later year. What makes it different from
reducing balance method is the way it is calculated.
What is referred to as sum of digits are the years the asset will be in use i.e.
estimated life.
If the life of an asset is 5 years then the sum of digits will be:
Year 1
+
Year 2
+
Year 3
+
Year 4
+
Year 5
15 is the sum of digits
Since depreciation is more in the first year than later years, each year depreciation
charge will be:
Year 1
5
/15 x depreciable amount
Year 2
4
/15 x depreciable amount
164
Year 3
3
/15 x depreciable amount
Year 4
2
/15 x depreciable amount
1
Year 5
/15 x depreciable amount
Example: Sum of digits method
Ever green purchased a non current asset for K600 000 on 1 January 20X4. The
useful life of the asset is 5 years after which it will have a residual value of
K30,000. The depreciation charge every year will be:
Depreciable amount is K600 000 – K30 000 = K570 000
K570 000 is depreciable amount over 5 years
Year 1
5
/15 x K570 000 = K190 000
Year 2
4
/15 x K570 000 = K152 000
Year 3
3
/15 x K570 000 = K114 000
Year 4
2
/15 x K570 000 = K 76 000
Year 5
1
/15 x K570 000 = K 38 000
K570 000
+
K 30 000 Residual value
K600 000
If the asset had no residual value, then the depreciable amount would be the
whole K600 000 spread over 5 years.
11.10 Revaluation method
-
Fall in value of asset
When the market value of a non current asset falls below its net book
value, and the fall in value is expected to be permanent, the asset should
be written down to its new market value. Revaluation means giving a new
value to an asset which could be gains or losses.
NOTE: Market value is value of asset it can currently fetch on the market
which is different from net book value which is cost minus depreciation.
The charge in the income statement for the reduction in the value of the
asset during the accounting period is:
K
Net book value at start of year
XX
Less: New value
(XX)
165
Charge for impairment (Depreciation)
XX
Example: Fall in value of an asset
A business purchased buildings on 1 January 20X3 at a cost of K300 000.
The buildings are expected to be used over a period of 20 years. After 5
years in use on 1 January 20X8, the land is now worth K200 000 and the
reduction is permanent.
Solution:
Annual depreciation: 300 000
= 15 000 x 5 years = K75 000
20
K75,000 depreciation has accumulated over 5 years.
N.B.V. after 5 years:
300 000 Cost
(75 000) Depreciation
225 000 N.B.V.
200 000 New value
25 000 Further loss (depreciation
due to revaluation)
As at 31 December 20X7 the total charge to income statement would be:
K
Normal annual depreciation charge
15 000
Add loss through revaluation
25 000
40 000
The buildings will now be stated in the books @ K200 000 to be
depreciated over 15 years remaining.
New annual depreciation from 20X8 on wards will be:
200 000
15
= K13 333
11.11 Increase in value of asset
Due to inflation, the market value of certain non current assets go up, especially
land and buildings. A business is not obliged to revalue non current assets in its
balance sheet. However in order to give a ‘true and fair view’ the business may
decide to revalue the asset upwards. Depreciation would then be charged on the
new revalued amount.
166
Example: Increase in value of an asset
Musuku Ltd commenced business on 1 January 20X3, and bought buildings
costing K275 000. The buildings are to be depreciated on a straight line basis
over a period of 25 years with no residual value.
After 4 years on 1 January 20X7, the buildings are revalued to K260 000 with a
life span of 21 years.
Solution:
Annual depreciation:
K275 000
25 years
= K11 000 p.a.
Accumulated depreciation over 4 years: 4 x K11 000 = K44 000
K
Net book value at 31 December 20X6: 275 000 cost
44 000 accumulated depreciation
231 000 N.B.V.
Gain in value:
Net book value
Net value
K
231 000
260 000
29 000
The buildings would now be stated in the books at K260 000 and will be
depreciated over a period of 21 years.
As from 31 December 20X7 onwards annual depreciation would be:
K260 000
21
= K12 381
NOTE: The increase as a result of revaluation of K29 000 will not be shown as
income in income statement because the gain is not realized as the buildings are
still being used in the business. Instead the gain will be reflected in the
revaluation reserve account and added separately to capital in the balance sheet.
Remember the prudence concept.
11.12 Accounting for depreciation
167
Non current assets are maintained in the books at historical cost i.e. the amount
paid to acquire or produce it. An account for depreciation in the general ledger is
opened to record accumulated depreciation to date. This account is called
Allowance for depreciation account.
-
Allowance for depreciation account
Each accounting period a depreciation charge is made to the income
statement and another record will be made in the allowance for
depreciation account, which is cumulative in nature.
-
Double entry for depreciation
DR. – Income statement with depreciation expense
CR – Allowance for depreciation account
-
In the Balance Sheet
The accumulated depreciation amount is shown as deduction from cost of
the non current asset to arrive at net book value.
-
There is an allowance for depreciation account for each separate category
of non current assets, e.g. for buildings, machinery, furniture, motor
vehicles etc. If a business has 20 vehicles there will be only one
depreciation account for all the vehicles even if they have been bought at
different times and years.
-
Example: Recording allowance for depreciation. Fast track company
maintains non current assets at cost. Separate allowance for depreciation
accounts are kept for each category of assets.
The following transactions took place:
20X1 1 January
bought machinery for K60 000 and fixtures
for K38 000.
20X2 1 July
bought 3 machines at cost K40 000 each.
20X3 1 October
bought another machine for K25 000
20X4 1 December
bought fixtures for K18 000.
NOTES: Machinery is depreciated at the rate of 15% per annum on cost
and fixtures at the rate of 5% using the reducing balance method.
Depreciation is to be charged fully for the whole year
disregarding the purchase date.
Required: Show
168
(a) The machinery account
(b) The fixtures account
(c) The two separate allowance for depreciation
account
(d) Extracts of the income statement and balance sheet
for each of the years 20X1, 20X2, 20X3 and 20X4.
Solution:
It may help to put up a table showing the build up of depreciation for each
category of non current assets
Category of asset
20X1 20X2 20X3 20X4 Total
Machinery 1
9 000
9 000 9 000 9 000 36 000
Machinery 2
-
18 000 18 000 18 000 54 000
Machinery 3
-
-
Total
9 000 27 000 30 750 30 750 97 500
3 750 3 750 7 500
20X1
20X2 20X3 20X4 Total
Fixtures 1
1 900
1 805 1 715 1 629 7 049
Fixtures 2
-
-
Total
1 900
1 805 1 715 2 529 7 949
-
900
900
Machinery Account
20X1 Bank
60 000
______
60 000
Balance c/d
60 000
_______
60 000
20X2 Balance b/d
60 000
Bank (3 x 40,000) 120 000
180 000
Balance c/d
180 000
_______
180 000
20X3 Balance b/d
Bank
180 000
25 000
205 000
Balance c/d
205 000
______
205 000
20X4 Balance b/d
205 000
Balance c/d
205 000
205 000
169
205 000
Dr
Allowance for depreciation account (Machinery)
20X1
Balance c/d
K
9 000
_____
9 000
20X2
Balance c/d
20X1
Income statement
20X3
Balance c/d
20X3 Balance b/d
Income statement
66 750
66 750
20X4
Balance c/d
K
9 000
_____
9 000
9 000
27 000
36 000
36 000
30 750
66 750
66 750
30 750
97 500
20X2 Balance b/d
Income statement
36 000
36 000
20X4 Balance b/d
Income statement
97 500
97 500
Cr
Fixtures Account
20X1 Bank
38,000
______
38 000
Balance c/d
38 000
______
38 000
20X2 Balance b/d
38 000
_____
38 000
Balance c/d
38 000
______
38 000
20X3 Balance b/d
38 000
_____
38 000
Balance c/d
38 000
_____
38 000
20X4 Balance b/d
Bank
38 000
18 000
56 000
Balance c/d
56 000
_____
56 000
Dr
Allowance for depreciation account (Fixtures)
K
20X1
Balance c/d
20X2
Balance c/d
Cr
K
20X1
Income statement
1 900
_____
1 900
20X2 Balance b/d
Income statement
3 705
3 705
170
1 900
_____
1 900
1 900
1 805
3 705
20X3
Balance c/d
20X4
Balance c/d
20X3 Balance b/d
Income statement
5 420
5 420
3 705
1 715
5 420
5 420
2 529
7 949
20X4 Balance b/d
Income statement
7 949
7 949
Income statement (Extract)
K
Gross profit
Less: Expenses
20X1 Depreciation: Machinery
Fixtures
K
XX
9 000
1 900
(10 900)
XX
20X2 Depreciation: Machinery
Fixtures
27 000
1 805
(28 805)
XX
20X3 Depreciation: Machinery
Fixtures
30 750
1 715
(32 465)
20X4 Depreciation: Machinery
Fixtures
30 750
2 529
(33 279)
Balance Sheet (Extracts)
Non current assets
Cost
Depreciation N.B.V.
20X1 Machinery
Fixtures
60 000
38 000
9 000
1 900
51 000
36 100
20X2 Machinery
Fixtures
180 000
38 000
36 000
3 705
144 000
34 295
20X3 Machinery
Fixtures
205 000
38 000
66 750
5 420
138 250
32 580
20X4 Machinery
Fixtures
205 000
56 000
97 500
7 949
107 500
48 051
171
In the trial balance
Depreciation is an end of the year adjustment, therefore in the year of acquisition
of a non current asset depreciation will not be reflected in the trial balance, but
will start appearing in subsequent years.
In previous exercise depreciation will only start appearing in 20X2, thus:
Trial Balance as at 31 December 20X2
Machinery
Accumulated depreciation
Fixtures
Accumulated depreciation
Dr
180 000
Cr
9 000
38 000
1 900
Trial Balance as at 31 December 20X3
Dr
Cr
Machinery
205 000
Accumulated depreciation
36 000
Fixtures
38 000
Accumulated depreciation
3 705
Any depreciation shown in the trial balance is what has accumulated from
previous years. For the year under review it has to be calculated and shown in the
income statement. The figure shown in income statement will be added to the
figure in the trial balance and the accumulated total shown in the balance sheet.
11.13 Choice Of Depreciation Method
Any method of depreciation can be used on a non current asset, but the method chosen
must be fair in allocating the charges between different accounting periods.
CONSIDERATION WHEN SELECTING METHOD OF DEPRECIATION
(a)
The method should allocate costs in proportion to the benefits i.e.
(i)
(ii)
Use reducing balancing method if the business will benefit more from the
asset in earlier years than later years
Use the straight line if benefits will be spread equally over the life of the
asset
(b)
Consistency must be observed. Same depreciation method must be used for
similar assets, and from one year to another.
(c)
Choose a method which is easy to apply.
172
11.4
Asset Acquired During An Accounting Period
If a non current asset is purchased during an accounting period it might be fair to charge
depreciation according to the period the asset has been used i.e. on monthly basis.
However, this basis may apply when straight line method is in use.
Examination questions will usually state the way depreciation is to be applied.
Examples:
(a)
(b)
(c)
(d)
Charge a full year’s depreciation in the year of acquisition or nothing in the year
of disposal. In this instruction dates of purchase should be ignored even if the
dates are given.
Charge a full year’s depreciation on the value of asset available at year end.
(explanation same as in a)
Depreciation should be charged on monthly basis.
If instructions are silent and dates of purchase are given, then the monthly basis
should be adopted.
Example: Assets acquired during the year.
A business has an accounting period which runs from 1 January to 31 December.
On 1 October 20X5 the business purchased furniture for K500 000 cost. The life
span of the furniture is 10 years with no residual value.
What is the depreciation charge for the year ended 31 December 20X5?
Solution
Annual depreciation is K500 000
= K50 000
10 years
The asset was acquired on 1 October 20X3 and will be depreciated only for 3
months in 20X5.
K50 000 x 3 months
12 months
= K12 500
11.15 Change in estimated life
When the life span of an asset changes i.e. increased or reduced, the net book value of the
asset at the time of change is what will be spread on the remaining life.
Example 1: Increase in life of an asset
173
A business purchased a motor vehicle at a cost of K400 000 with an estimated life of 6
years. It is to be depreciated on straight line basis over its life. However, after 2 years in
use, it is discovered that the asset life has 2 more years making a total of 8 years.
What will be the depreciation charge from year 3 on wards.
Solution:
Annual depreciation is K400 000
6 years
= K66 667
K66 667 x 2 years = K133 334.
Net book value after 2 years K400 000
133 334
266 666 N.B.V.
Net book value to be spread over new life i.e. 6 years. From year 3 onwards annual
depreciation will be:
K266 666
6 years
= K44 444
Example 2: Decrease in life of asset
A business bought non current assets at a cost of K100 000. It is estimated that the assets
will be used in the business for a period of 7 years with K10 000 residual value. After
one year in use, it was reviewed that the assets life span be reduced to 3 years from the
remaining 6 years. What will be depreciation from year 2 onwards.
Solution
Annual depreciation (100 000 – 10 000)
7 years
= K12 857
Net book value after 1 year 90 000 – 12 857 = K77 143.
N.B.V. of K77 143 will now be spread over 3 years.
From the second year onwards annual depreciation will be
K77 143
3
= K25 714
11.16 Change in Depreciation Method
It is allowed to change the depreciation method if it is discovered that a wrong method
was adopted initially, and is not true and fair, or if there is a change in the pattern of
consumption of economic benefits from the non current asset. Every year end a business
174
will normally review its accounts and this is the time such a discovery may be made.
Changes should be necessary and not done at will otherwise comparison will be difficult
because of inconsistency.
Example: Change in depreciation method
A business bought furniture on 1 January 20X3 at a cost of K80 000. The asset is to be
depreciated using straight line method over a 5 year period.
At 1 January 20X5, a review was conducted, and it was agreed to change the method to
reducing balance method at the rate of 20% per annum.
Show the necessary entries to adjust to new method.
Solution:
Using straight line method
K80 000
5 years
= K16 000 annual depreciation
Accumulated depreciation at time of change K16 000 x 2
K32 000
Net book value after 2 years K80 000 – K32 000 = K48 000
From year three onwards using reducing balance method, depreciation will be:
Year 3 48 000 x 20%
(9 600) Depreciation
Year 4 38 400 x 20%
(7 680) Depreciation
30 720 x 20% etc.
11.17 The Disposal of Non Current Assets
When a business buys non current assets, they are meant to be used in generating income
for the business over a period time (more than 1 year). They are not meant for resale to
make a profit.
However, the non current assets might be sold off at some stage before even their useful
life is over. Reasons for selling or disposal may include:
-
Inadequacy – where an asset fails to meet increased demand for a product
Obsolescence etc
(a)
The Disposal Account
When non current assets are disposed of, a disposal account is opened. This
account will reveal whether a profit or loss has been made on the asset sold. The
profit or loss on disposal are reported in the income statement.
175
-
-
Ledger accounting on disposal of non current asset. The profit or loss on
disposal is the difference between net book value of non current asset and
the net sale price, which is the price minus any costs of making the sale.
A profit is made when sales price is more than net book value
A loss is made when sales price is less than net book value of a non
current asset.
Double entry when an asset is disposed of.
Step 1:
Debit – Disposal account
Credit – Asset account
with value of asset usually at
cost
Step 2:
Debit – Allowance for depreciation account with accumulated
Credit – Disposal account
depreciation at the
time of sale
Note: The two steps in disposal account reveals the net book value of the
asset.
Step 3:
Debit – Receivable account (if sale is on credit) or
Debit – cash book (if sale is on cash or by cheque
Credit – Disposal account
with sale price of the asset
Step 4
The balancing figure in disposal account will be profit or loss on disposal.
-
If balancing figure is on debit of disposal account, a profit has been
achieved.
If balancing figure on disposal account is on credit side, then a loss
is recorded.
Examples: Disposal of non current asset.
Green Grass purchased a van on 1 January 20X5 for K100 000. He
estimated that its resale value on 31 December 20Y0 after six years use
would be K40 000 and depreciated it on a straight line basis. He sold it on
30 June 20X7 for K55 000.
176
Solution:
The amount to be charged as depreciation each year is
Cost – residual value
Estimated economic life
= (K100 000 – K40 000)
6 years
= K10 000
Green Grass owned the asset for two years and six months, thus the total
depreciation charged since acquisition is K10 000 x 21/2 years = K25 000.
This means that the net book value at the date of disposal was K100 000 –
K25 000 = K75 000.
Since the sale proceeds amounted to K55 000, a loss on disposal of
K55 000 – K75 000 = K20 000 has been made.
Ledger accounting on disposal.
Dr
20X5
1 Jan. Bank
Van account (at cost)
Cr
K
K
100 000
_______
100 000
31 Dec. Balance c/d 100 000
______
100 000
100 000
______
100 000
31 Dec. Balance c/d 100 000
_______
100 000
1 Jan. Balance b/d
100 000
______
100 000
June 30
Dr
Allowance for depreciation
31 Dec. Bal. c/d
10 000
20X6
1 Jan. Balance b/d
20X7
K
______
10 000
Disposal
20X5
100 000
______
100 000
Cr
K
31 Dec. Inc. statement 10 000
(Depreciation)
_____
10 000
20X6
31 Dec. Bal. c/d
20 000
______
20 000
1 Jan. Balance b/d 10 000
31 Dec. Inc. statement 10 000
(Depreciation)
______
20 000
20X7
30 June Disposal
25 000
177
1 Jan. Balance b/d
20 000
25 000
Dr
20X7
30 June Inc. statement 5 000
(Depreciation) _____
25 000
Disposal account
K
30 June Van at cost 100 000
_______
100 000
Cr
20X7
K
30 June Allow. For Dep. 25 000
30 June Bank
55 000
Loss (to inc. state.) 20 000
______
100 000
Example 2: Trading in or part exchange on disposal.
On 1 April 20X8, Quick Fix owned a motor vehicle which was bought on
1 October 20X5 at a cost of K600 000. Its estimated residual value after
five years in use would be K80 000.
Quick Fix’s policy is to provide depreciation on straight line method on
monthly basis.
During the financial year ended 31 March 20X9, the following occurred:
On 30 June 20X8, the motor vehicle was traded in and replaced with a
new one. The trade in allowance was K255 000. The new vehicle cost
K850 000. The balance after deducting the trade in allowance was paid by
cheque.
The new motor vehicle is expected to have a residual value of K100 000
after its life of 8 years.
Required:
Show the necessary ledger accounts to record the above information.
Solution:
Annual depreciation: K600 000 – K80 000
5 years
For old vehicle
= K104 000
Accumulated depreciation = K104 000 x 2.75 = K286 000
Net book value = K600 000 – K286 000 = K314 000
178
Therefore a loss on disposal of K255 000 trade in allowance minus Net
book value of K314 000 = K59 000 was made. This is because 2.75 is the
period of 2 years 9 months that the old motor vehicle was owned by Quick
Fix.
Note: Trade in allowance is what should have been realized if the asset
was sold for cash.
Ledger accounting:
Dr
20X8
Motor Vehicle account
Cr
K
30 June Balance
600 000
30 June New M/Veh.
(255 000 + 595 000) 850 000
________
1 450 000
K
30 June Disposal
600 000
31 March (20X9) Bal c/d 850 000
_______
1 450 000
1 April 20X0 Bal. b/d 850 000
Dr
20X8
Disposal account
K
30 June M/Vehicle 600 000
Cr
20X8
30 Acc. Dep.
Trade in All
Loss (P/L A/c)
_______
600 000
K
286 000
255 000
59 000
______
600 000
Note: Double entry for new motor vehicle:
DR – Motor Vehicle account with
Trade in allowance (255 000)
Cash (595 000)
CR - Disposal account with Trade in allowance (255 000)
CR - Cash account with M/Vehicle (K595 000)
179
11.18 Controlling Tangible Non Current Assets.
Most organizations will own a number of non current assets and their control is vital to
the efficient running of the organization. A non current asset register should be
maintained for this purpose.
Non Current Asset Register.
This register will contain the following information for each non current asset.
-
the date of purchase
the name and address of supplier
the cost of the asset
the estimated useful economic life of the asset
the estimated residual or resale value of the asset at the end of its useful life
a description of the asset
a code number for easy identification
the method of accumulated depreciation to be used
the accumulated depreciation of the asset
details of disposal of the asset
the location of the asset within the organization
the extent to which it is being used
the repairs carried out and how much they cost
the expiry dates of any licences permitting the organization to use it.
11.19.0
IAS 16 PROPERTY, PLANT AND EQUIPMENT
11.19.1
This standard covers all aspects of accounting for property, plant and equipment.
This represents the bulk of items which tangible long term asserts.
11.19.1
IAS 16 should be followed when accounting for property, plant and
equipment unless another international accounting standard requires a different
treatment.
11.19.2
IAS 16 does not apply to the following:
(a) Forests and other regenerative natural resources
(b) Mineral rights, exploration for and extraction of minerals, oil, gas and other
regenerative resources.
Definitions
11.19.3
This standard gives a large number of definitions.
180
KEY TERMS
• Property, plant and equipment are tangible assets that:
Are held by an entity for use in the production or supply of goods or services, for rental
to others, or for administrative purposes; and
Are expected to be used during more than one period.
• Cost is the amount of cash equivalents paid or the fair value of the other consideration
given to acquire an asset at the time of its acquisition or construction.
• Residual value is the estimated amount that an entity would currently obtain from
disposal of the asset after deducting the estimated costs of disposal if the rest were
already of the age and in the condition expected at the end of its useful life.
• Fair value is the amount for which an asset could be exchanged between
knowledgeable, willing parties in an arms length transaction.
• Carrying amount is the amount for which an asset is recognized after deducting any
accumulated depreciation and impairment losses.
• Recoverable amount is the amount which the entity expects to recover from the
future use of an asset, including its residual value on disposal.
Recognition
11.19.4 In this context, recognition simply means incorporation of the item in the
Businesses accounts, in this case as a non current asset. The recognition of
Property, plant and equipment depends on two criteria.
(a) It is probable that future economic benefits associated with the asset will flow to
the entity.
(b) The cost of the asset to the entity can be measured reliably.
11.19.5 Property, plant and equipment can amount to substantial amounts in financial
statement, affecting both the presentation of the company’s financial position in
the balance sheet and the profitability of the entity as shown in the income
statement. Smaller items such as tools are often written off as expenses of the
period. Most companies have their own policy on this –items below a certain value
are charged as expenses.
Initial measurement
11.19.6 Once an item of property, plant and equipment qualifies for recognition as an
asset, it will initially be measured at cost.
181
Components of cost
11.19.7 The standard lists the components of the cost of an item of property, plant and
equipment.
• Purchase price, less any trade discount or rebate
• Initial estimate of the costs of dismantling and removing the item and
restoring the site on which it is located
• Directly attributable costs of bringing the asset to working condition for its
intended use, eg:
o
The cost of site preparation
o
Initial delivery and handling costs
o
Installation costs
o
Professional fees (architects, engineers)
11.19.8
The following costs will not be part of the cost of property, plant or equipment
unless they can be attributed directly to the asset’s acquisition, or bringing it into
its working condition.
•
•
•
•
Expenses of operations that are incidental to the construction or
development of the item
Administration and other general overhead costs
Start-up and similar pre-production costs
Initial operating losses before the asset reaches planned performances
All of these will be recognized as an expense rather than an asset.
Exchange of assets
11.19.9
Exchange or part exchange of assets occurs frequently for items of property, plant
and equipment. IAS 16 states that the cost of an item obtained through (part)
exchange is the fair value of the asset received (unless this cannot be measured
reliably).
Subsequent expenditure
11.19.10
How should we treat any subsequent expenditure on long-term assets, after their
purchase and recognition? Subsequent expenditure is added to the carrying
amount of the asset, but only when it is probable that future economic benefits, in
excess of the originally assessed standard of performance of the existing asset,
will flow to the enterprise. All other subsequent expenditure is simply recognized
as an expense in the period in which it is incurred.
11.19.11
The important point here is whether any subsequent expenditure on an asset
improves the condition of the asset beyond the previous performance. The
standard gives the following examples of such improvements.
(a)
(b)
Modification of an item of plant to extend its useful economic life,
including increased capacity
Upgrade of machine parts to improve the quality of output
182
(c)
11.19.12
Adoption of a new production process leading to large reductions in
operating costs.
Normal repairs and maintenance on property, plant and equipment items merely
maintain or restore value, they do not improve or increase it, so such costs are
recognized as an expense when incurred.
Measurement subsequent to initial recognition
11.19.13
The standard offers two possible treatments here, essentially a choice between
keeping an asset recorded at cost or revaluing it to fair value.
(a)
(b)
Cost model. Carry the asset at its cost less depreciation and any
accumulated impairment losses.
Revaluation model. Carry the asset at a revalued amount, being its fair
value at the date of the revaluation less any subsequent accumulated
depreciation. Revaluations should be made regularly enough so that the
carrying amount approximates to fair value at the balance sheet date. The
revaluation model is only available if the item can be measured reliably.
Revaluations
11.19.14
The market value of land and buildings usually represents fair value, assuming
existing use and line of business. Such valuations are usually carried out by
professionally qualified valuers.
11.19.15
In the case of plant and equipment, fair value can also be taken as market value.
Where a market value is not available, however, depreciated replacement cost
should be used. There may be no market value where types of plant and
equipment are sold only rarely or because of their specialized nature (i.e. they
would normally only be sold as part of an ongoing business).
11.19.16
The frequency of valuation depends on the volatility of the fair values of
individual items of property, plant and equipment. The more volatile the fair
value, the more frequently revaluations should be carried out. Where the current
fair value is very different from the carrying value then a revaluation should be
carried out.
11.19.17
Most importantly, when an item of property, plant and equipment is revalued, the
whole class of assets to which it belongs should be revalued.
11.19.18
All the items within a class should be revalued at the same time, to prevent
selective revaluation of certain assets and to avoid disclosing a mixture of costs
and values from different dates in the financial statements. A rolling basis of
revaluation is allowed if the revaluations are kept up to date and the revaluation of
the whole class is completed in a short period of time.
11.19.19
How should any increase in value be treated when a revaluation takes place?
The debit will be the increase in value in the balance sheet, but what about the
credit? IAS 16 requires the increase to be credited to a revaluation surplus (ie
183
part of owners’ equity), unless the increase is reversing a previous decrease which
was recognized as an expense. To the extent that this offset is made, the increase
is recognized as income; any excess is then taken to the revaluation reserve.
11.19.20
IAS 16 makes further statements about revaluation, but these are beyond the
scope of your syllabus.
Depreciation
11.19.21
The standard reflects the following approach to depreciation.
•
•
•
The depreciable amount of an item of property, plant and equipment
should be allocated on a systematic basis over its useful life.
The depreciation method used should reflect the pattern in which the
asset’s economic benefits are consumed by the enterprise.
The depreciation charge for each period would be recognized as an
expense unless it is included in the carrying amount of another asset.
Most of the comments on depreciation in IAS 16 are dealt with in Section 2.
11.19.22
Land and buildings are dealt with separately even when they are acquired
together because land normally has an unlimited life and is therefore not
depreciated. In contrast buildings do have a limited life and must be depreciated.
Any increase in the value of land on which a building is standing will have no
impact on the determination of the building’s useful life.
11.19.23
Depreciation is usually treated as an expense, but not where it is absorbed by the
enterprise in the process of producing other assets. For example, depreciation of
plant and machinery is incurred in the production of goods for sale (inventory
items). In such circumstances, the depreciation is included in the cost of the new
assets produced.
Review of useful life
11.19.24
A review of the useful life of property, plant and equipment should be carried out
at least annually and the depreciation charge for the current and future periods
should be adjusted if expectations have changed significantly from previous
estimates.
Review of depreciation method
11.19.25
The depreciation method should also be reviewed periodically and, if there has
been a significant change in the expected pattern of economic benefits from those
assets, the method should be changed to suit this changed pattern. When such a
change in depreciation method takes place the change should be accounted for as
a change in accounting estimate and the depreciation charge for the current and
future period should be adjusted.
184
Impairment of asset values
11.19.26
The carrying amount of an item or group of identical items of property, plant
and equipment should also be reviewed periodically. This is to assess whether the
recoverable amount has declined below the carrying amount. When there has
been such a decline, the carrying amount should be reduced to the recoverable
amount.
11.19.27
Recoverable amounts should be considered on an individual asset basis or for
groups of identical assets.
Retirements and disposals
11.19.28
When an asset is permanently withdrawn from use, or sold or scrapped, and no
future economic benefits are expected from its disposal, it should be withdrawn
from the balance sheet.
11.19.29
Gains or losses are the difference between the estimated net disposal
proceeds and the carrying amount of the asset. They should be recognized as
income or expense in the income statement.
Disclosure
11.19.30
The standard has a long list of disclosure requirements, only some of which are
relevant to your syllabus.
•
•
•
•
•
11.19.31
Measurement bases for determining the gross carrying amount (if more
than one, the gross carrying amount for that basis in each category)
Depreciation methods used
Useful lives or depreciation rates used
Gross carrying amount and accumulated depreciation at the beginning
and end of the period
Reconciliation of the carrying amount at the beginning and end of the
period showing:
o
Additions
o
Disposals
o
Increases/decreases from revaluations
o
Reductions in carrying amount
o
Depreciation
o
Any other movements
The financial statements should also disclose the following:
•
•
•
•
Existence and amounts of restrictions on title, and items pledge as
security for liabilities
Accounting policy for restoration costs
Amount of expenditures on account of items in the course of
construction
Amount of commitments to acquisitions
185
11.19.32
Revalued assets require further disclosures
•
•
•
•
•
•
11.19.33
The standard also encourages disclosure of additional information, which the
users of financial statements may find useful.
•
•
•
•
11.19
Basis used to revalue the assets
Effective date of the revaluation
Whether an independent valuer was involved
Nature of any indices used to determine replacement cost
Carrying amount of each class of property, plant and equipment that
would have been included in the financial statements had the assets been
carried at cost less depreciation.
Revaluation surplus, indicating the movement for the period and any
restrictions on the distribution of the balance to shareholders.
The carrying amount of temporarily idle property, plant and equipment
The gross carrying amount of any fully depreciated property, plant and
equipment that is still in use
The carrying amount of property, plant and equipment retired from active
use and held for disposal
When the benchmark treatment is used, the fair value of property, plant
and equipment when this materially different from the carrying amount.
RESEARCH AND DEVELOPMENT COSTS (IAS 38)
IAS 38 – INTANGIBLE ASSETS
An intangible asset is an identifiable non monetary asset without physical substance. The asset
must be:
(a)
Controlled by the entity as a result of event in the past.
(b)
Something from which the entity expects future economic benefits to them.
Examples:
-
Goodwill
Development costs
RESEARCH AND DEVELOPMENT COSTS
RESEARCH -
This is an investigation undertaken in order to discover new facts
or get additional information.
Research could be used for new or improved products, processes and methods.
Research is a cost to an entity.
186
DIVISION OF RESEARCH
Research costs can be divided as follows:
1.
PURE OR BASIC RESEARCH
This is research carried out to advance knowledge without specific objectives.
2.
APPLIED RESEARCH
This utilizes pure research to attain specific objectives. Research used to extend
knowledge of problems in industry, health, education, etc.
3.
DEVELOPMENT
This is making use of the results of research to produce or develop new or existing
products or services.
Examples:
-
Designing tools involving new technology
Design, construction and operation of pilot project not for commercial production.
COMPONENTS OF RESEARCH AND DEVELOPMENT COSTS
Research and development costs will include all costs that are directly attributable to research
and development activities, or that can be allocated on a reasonable basis.
Selling costs are not included in research and development.
Examples of Research & Development Costs
-
Salaries and wages and other related employment costs of personnel engaged in research
and development activities.
Costs of materials and services used in research and development activities.
Depreciation of property, plant and equipment used for research/development activities.
Overhead costs which may be allocated because they relate to research and development.
ACCOUNTING FOR RESEARCH AND DEVELOPMENT COSTS
THE ACCOUNTING PROBLEM
The costs of Research and Development can run into millions of kwachas. However, it may take
many years before the new technology or product is commercialized.
Following the accruals concept, the cost of research and development should be capitalized when
incurred, and then amortised when the product is eventually marketed. This would then match
the costs with the benefits.
However, prudence would say that the eventual profits are so uncertain and so it would be better
to write off research and development costs in income statement when they arise.
187
THE SOLUTION
IAS 38 has found a compromise between accruals and prudence.
-
All research costs must be charged to the income statement as it is incurred. This is
because there is a long time gap between research commencing and a profitable product
being launched.
-
Development costs should be capitalized if it meets certain conditions.
CONDITIONS FOR CAPITALISATION
(i)
(ii)
(iii)
(iv)
(v)
(vi)
The project is technically feasible.
The enterprise intends to complete the project and use or market the product.
The enterprise has the ability to use or sell the asset.
There is either an external market for the asset or an internal use for it.
The company has the financial resources to complete the project.
The related costs can be measured reliably.
AMORTISATION
Capitalised development costs can be carried forward until the product being developed is ready
for production. At this point it must be amortised over the expected commercial life of the
product.
CHAPTER SUMMARY
-
Non current assets are acquired not for resale but to be used in organization to
help generate income over a period of more than one year.
-
Non current assets are depreciated over a period of their estimated life span
-
Depreciation is the allocation of the cost of the asset over its economic life
-
Depreciation is a non cash expense and it is charged to income statement.
-
The straight line method of depreciation assumes that the asset will be used
evenly through out its life and therefore some amount is charged to income
statement from one year to the next.
-
Reducing balance method assumes that the asset will be used more in its earlier
years than later years, thus the depreciation amount will be reducing with time.
-
Non current assets may be sold off before their life span expires. A disposal
account is opened to determine whether a profit or loss has been made on
disposal.
-
It is also important that an organization keeps a non current asset register for
control purposes.
188
EXERCISES
1.
Fill in the blanks.
Net book value is ………………………… less…………………………
2.
Two common methods of depreciation are:
(a)
……………………………………………..
(b)
…………………………………………….
3.
A non current asset (cost K10 000, depreciation K7 500) is given in part exchange
for an new asset costing K20 500. The agreed trade in allowance is K3 500.
Calculate profit or loss on disposal.
4.
The details about a non current asset that would be included in a non current asset
register are:
SOLUTIONS TO EXERCISES
1.
Net book value is cost less accumulated depreciation
2.
(a)
Straight line
(b)
reducing balance
3.
Net book value (K10 000 – K7 500) = K2 500
Trade in allowance
= K3 500
Profit on disposal
K1 000
4.
(a)
(b)
(c)
(d)
(e)
Date of purchase
Description and location
Original cost
Depreciation method and rate
Accumulated depreciation to date
189
CHAPTER 18
ACCOUNTING FOR INVENTORIES
INTRODUCTION
Profit is excess of income over expenditure. The purpose of this chapter is to describe how
inventory valuation affects gross profit and the impact it has on current assets in the Balance
Sheet.
TOPICS
1 What is inventory?
2 Cost of goods sold
3 Accounting for opening and closing inventories
4 Carriage costs
5 Inventory counting and inventory accruals
6 Valuing inventory and effect on profit
Learning Outcomes
At the end of this chapter, students should be able to:
-
Describe inventory
Explain the application of accounting concepts to the valuation of inventory
Explain the methods of valuing inventory when items have been purchased at different
prices.
Explain the impact of inventory valuation methods on profit and net assets
Explain the effect of carriage inwards on goods purchased
Calculate the value of closing inventory
Report closing inventory in the final accounts.
18.1 What is inventory
International Accounting Standard (IAS 2) defines inventory as:
-
Assets held for sale in the ordinary course of business.
Items in the process of production for sale
Raw materials or supplies to be consumed in the production process or in the
rendering of services
Inventory is also called stock.
190
18.2 Cost of goods sold
The accruals concept requires that income should be matched with expenses incurred in
earning that income. Goods bought in an accounting period may not all be sold at end of
period. The unsold goods will be held in the business warehouse as inventory. These
goods should not be included in the cost of sales for the period.
Profit is calculated on what has been sold.
Calculation of cost of goods sold
Opening inventory
Add: purchases
xx
xx
xx
(xx)
xx
Less: closing inventory
Cost of goods sold
Example
A trader is in business buying and selling radios. His financial year ends on 31 March
each year.
During the financial year ending 31 March 20x7, the following is a summary of the
transactions that took place.
-
bought 30 radios at K40 000 each
sold 21 radios at K55 000 each
During the year to 31 March 20x8 he continued with his business and the following took
place.
-
bought some more radios 35 at K40 000 each
sold 38 radios at K57 000 each
Required:
Calculate the gross profit for each of the two years?
Solution:
K
K
Year to 31 March 20x7
Sales (21 x K55 000)
Cost of sales
Purchases (30 x K40 000)
Less: closing inventory
(9 x K40 000)
1 155 000
1 200 000
(360 000)
(840 000)
Gross profit
315 000
191
NOTE: Though 30 radios were bought only 21 radios were sold. Profit will be
calculated on the 21 radios sold, thus 21 x K40 000 = K840 000 is cost of radios sold at
(21 x K55 000 = K1 155 000). The 9 radios not sold will be considered as closing
inventory.
What is closing inventory in 20x7 will be opening inventory in 20x8.
Year to 31 March 20x8
Sales (38 x K57 000)
Cost of sales:
Opening inventory (9 x 40 000)
Add: Purchases (35 x K40 000)
Less closing inventory
(6 x K40 000)
K2 166 000
K360 000
K1 400 000
K1 760 000
(K240 000)
(K1 520 000)
Gross profit
K646 000
NOTE: For the year to 31 March 20x8, the business had a total of 44 radios i.e. 9 from
20x7 plus 35 bought during the year. Out of 44 radios only 38 were sold leaving 6
unsold (closing inventory). Therefore profit is calculated of the cost of the 38 radios
sold. The concept of going concern is in play for taking closing inventory to the next
accounting period.
Inventory stolen or destroyed or lost
If inventory bought is stolen or destroyed that is considered a loss to the business. When
calculating profit it will be part of cost of sales or shown separately as an expense.
Example in inventory stolen or destroyed
Using example 12.4, assuming 2 radios were stolen, the situation will now be as follows:
Sales (38 x K57 000)
K2 166 000
Cost of sales:
Opening inventory (9 x 40,000)
Add purchases (35 x K40,000)
K360 000
K1 400 000
K1 760 000
Less closing inventory
(4 x K40 000)
(K160 000)
(K1 600 000)
Gross profit
K566 000
192
In the above example, since only 4 radios are remaining, the 2 radios stolen will be
included as part of cost of sales when calculating profit.
An alternative method will be to deduct the stolen radios from the total inventory and
show it as a separate expense as follows:
Sales (38 x K57 000)
K2 166 000
Cost of sales:
Opening inventory (9 x K40 000)
Add: Purchases (35 x K40 000)
K360 000
K1 400 000
K1 760 000
(K80,000)
K1 680 000
(K160,000)
Less: Inventory stolen (2 x 40,000)
Less: Closing inventory (4 x 40 000)
K1 520 000
K646 000
Gross profit
Expenses:
Inventory stolen (2 x 40 000)
(K80 000)
K566 000
18.3 Inventory and cost of carriage inwards and carriage outwards.
Carriage refers to the cost of transporting purchased goods from the supplier to the
premises of the business which has bought them. This cost is sometimes paid by
customer or supplier.
-
When the buyer (customer) pays the cost it is called carriage inwards
When the seller (supplier) pays the cost, the cost to the supplier is called carriage
outwards
Carriage inwards is added to cost of purchases. It is a direct expense and
therefore included in cost of sales
Carriage outwards is a selling and distribution expenses in the income statement.
It is an indirect expense.
Example Carriage inwards and outwards
The following amounts appear in the books of a trader at the end of the financial year.
K
Opening inventory
55 000
Closing inventory
85 000
Carriage outwards
62 000
Purchases
75 000
Returns inwards
5 000
Carriage inwards
3 000
193
Required:
Calculate cost of sales.
Solution
K
Cost of sales:
Opening inventory
Purchases
Carriage inwards
Less: Closing inventory
Cost of sales
55 000
75 000
3 000
133 000
(85 000)
48 000
18.4 Accounting or opening and closing inventories
In order to calculate gross profit, it is necessary to work out the cost of goods sold, and in
order to calculate the cost of goods sold, it is necessary to have values for the opening
inventory and closing inventory.
Assuming the inventory value is given, double entry will be as follows:
-
Transferring purchases to income statement
DR – Income Statement
CR – Purchases Account
-
Value of inventory is arrived at after counting or conducting physical stock take.
This is usually done at year end to determine closing inventory. When this is
done, double entry is:
DR – Inventory Account (closing inventory value)
CR – Income Statement
When closing inventory is credited in income statement it means it will be added
to sales figure, but because of the format of the income statement which is vertical
presentation, closing inventory is shown as a deduction from purchases in arriving
at cost of sales.
-
Closing inventory (stock) at end of one period becomes opening inventory at start
of next period. The inventory account remains the same until the end of the next
period, when the value of opening inventory is taken to the income statement.
Any purchase made in the period will be recorded in the purchases account.
DR – Income Statement
CR – Inventory account (with value of opening inventory)
194
Example: Ledger accounting for inventory
Sky Ltd sets up business with capital in cash of K750 000. During the first year trading
to 31 December 20X8, recorded the transactions below:
Bought goods on credit for resale K80 000
Bought goods and paid by cash K95 000
Sold goods for cash to different customers K150 000
Sold goods on credit also to different customers K105 000
Receipts from credit customers K70 000 cash
Payments to credit suppliers K60 000
Purchased motor van for use in the business K50 000 cash
Sundry expenses paid in cash K25 000
A physical stock take was conducted and closing inventory was valued at K35 000.
Required:
Prepare ledger accounts for the above transactions and draft an income statement for the
year ended 31 December 20x8.
Solution:
Because this is the first year in business, there is no opening inventory.
Dr
Capital
Sales
Receivables
Balance b/d
Dr
Cash account
Cr
K’000
750
Purchases
150
Payables
70
Motor van
Expenses
___
Balance c/d
970
K’000
95
60
50
25
740
970
Capital account
Cr
K’000
K’000
750
740
Cash
Dr
Trade Payables
Cr
Cash
Balance c/d
K’000
60
Purchases
20
80
K’000
80
__
80
Balance b/d
Purchases account
20
Dr
195
Cr
K’000
80
Income Statement
95
___
175
K’000
175
Trade Receivables
Cr
K’000
105
Cash
___
Balance c/d
105
K’000
70
35
105
Sales account
Cr
K’000
255
Cash
___
Receivables
255
K’000
150
105
255
Dr
Motor van account
Cr
Cash
K’000
50
Balance c/d
50
K’000
50
50
Dr
Sundry Expenses account
Cr
Cash
K’000
Income statement
25
25
K’000
25
25
Dr
Inventory account
Cr
K’000
35
Balance c\d
====
35
K’000
35
====
Payables
Cash
Dr
Sales
Dr
Income Statement
Income statement
Balance b/d
196
___
175
SKY LTD
Income statement for the year ended 31 December 20x8
(using vertical format)
K’000
Sales
K’000
255
Cost of sales:
Purchases
Less: Closing inventory
175
35
(140)
115
Gross profit
Less: Expenses
Sundry expenses
Net profit
(25)
90
===
SKY LTD
Income statement for the year ended 31 December 20x8
Using T Format)
Dr
Cr
Purchases
Gross profit c/d
Sundry Expenses
Net profit
N.B.
K’000
175
Sales
Closing inventory
115
290
K’000
255
35
290
25
90
115
115
___
115
Gross profit b/d
The balance on the inventory account is K35 000 which will appear in balance
sheet as a current asset.
As it is the K35 000 closing inventory is the only entry in the inventory account.
There’s no figure for opening inventory.
If opening inventory was there, it would have been eliminated by transferring it as
a debit balance to the income statement.
DR – Income statement (with value of opening inventory)
CR – Inventory account (with value of opening inventory)
197
18.5 Inventory Counting
-
A business is regarded as a going concern unless it is otherwise it is stated. As the
business continues with its operations financial statements must be drawn up at
regular intervals, usually on yearly basis. The time when financial statements are
being prepared, the activities of the business are frozen in order to determine the
assets and liabilities available at that date. This is also the time that inventory
quantities are established, and this can be done by physical counting. The time
taken will vary from size of organization and inventory involved. If the
organization is large and involves different types of stock (inventory), it may be
necessary to:
(a)
(b)
close down the business while stock take takes place
maintain continuous inventory records manually or using a computerized
system where records are updated immediately an entry is made for
receipts and issues.
Inventory accruals
This is where goods have been received before the year end and included in inventory,
but no invoice has yet been received. Without an invoice no record can be made in
accounting books to show the business indebtedness or liability to suppliers.
To determine the price of the uninvoiced goods a goods received note (GRN), delivery
notes or current order forms may be used for this purpose.
-
Double entry would then be effected as:
DR – Purchases account
CR – Payables (Liability)
18.6 Inventory Valuation
IAS 2 provides guidance and rules governing inventory valuation. There are
many methods in theory which may be used to value inventory. The following
are some of them.
(a)
(b)
(c)
(d)
-
Selling price
Net realizable value i.e. sales minus expenses
Historical cost i.e. amount at which it was originally bought
Current replacement cost i.e. how much it would cost to replace.
IAS 2 (inventories) states that inventory should be valued at the lower of cost and
net realizable value.
Therefore (a) and (d) above are eliminated.
(a) because selling price may include profit before goods are sold thus going
against the prudence and realization concepts.
198
(d) because replacement cost may over state inventory especially where
prices are continuously rising.
Example 1: Net Realisable Value (N.R.V.)
An item is purchased for K45 000 (cost). Another K7 000 has to be spent to get it
ready for sale. After which the item will be sold for K60 000.
N.R.V. = K60 000 – K7 000 = K53 000.
Therefore valuing it at K53 000 in balance sheet will be to anticipate a profit of
K53 000 – K45 000 = K8 000.
In this case the appropriate valuation will cost K45 000 because it is lower of
N.R.V. of K53 000.
Example 2: With different items of inventory
If a business has many inventory items on hand the comparison of cost and
N.R.V. should be carried out for each item separately. Do not aggregate costs and
N.R.V. for all items and compare the two totals.
At the year end on 31 March 20x6, a business has three (3) items of inventory
remaining in warehouse, for which the cost and N.R.V. is given below.
Inventory item
Cost
N.R.V.
17 000
8 500
23 000
23 000
5 000
23 100
Lower of cost/N.R.V.
K
17 000
5 000
23 000
48 500
======
51 100
======
45 000
======
K
A
B
C
K
K45 000 is the value that should appear in balance sheet as value of inventory.
Comparing K48 500 with K51 100 and valuing inventory at K48 500 would be
inappropriate because there would be covering up.
Example 3:
The following figures relate to inventory held at the year end.
Cost
Selling price
Modification costs
Marketing costs
A
K
20 000
30 000
7 000
B
K
9 000
12 000
2 000
2 000
C
K
12 000
22 000
8 000
2 000
Units held
200 000
150 000
300 000
199
Required:
Calculate the value of inventory held
Solution
Item
A
B
C
Cost
K
20 000
9 000
12 000
N.R.V.
K
23 000
8 000
12 000
Valuation
K
20 000
8 000
12 000
Qty
Units
200 000
150 000
300 000
Total Value
K000
4 000 000
1 200 000
3 600 000
8 800 000
========
Note:
Net Realisable Value
Item
A: K300 000 – K7 000 = K23 000
B: K12 000 - K4 000 = K8 000
C: K22 000 - K10 000 = K12 000
18.7
Determining the purchase cost of inventory
Depending on the type of business, inventory could be
(i)
(ii)
(iii)
raw materials i.e. if the business is producing its own goods
finished goods which could have been produced or bought elsewhere for resale.
Work in progress (WIP) i.e. work yet to be completed.
The easiest way of valuation of inventory is to use historical cost i.e. the amount paid at
the time of buying the inventory.
However, actual cost may be applicable to businesses dealing in specialized items of high
value, and separately identifiable e.g. Toyota cars may be identified separately as camry,
vista, chaser, corsa, etc.
Certain items may not be identifiable separately. As items are bought they may be stored
in bins, shelves or pallets, where they are mixed with other items bought previously. As
these items are issued or sold, they will be removed in their mixed state regardless of
which came in first or last.
When valuing inventory this may create problems especially when items were bought at
different prices.
There are many techniques which are used to value such items of inventory. They
include the following:
-
First in first out (FIFO)
Last in first out (LIFO)
Average cost (AVCO)
Replacement cost
200
12.16 (a)
FIFO
In this method it is assumed that items are issued or sold in order in which they
were received. The oldest items are issued or sold first.
(b)
LIFO
This is the opposite of FIFO. Item of inventory are issued or sold starting with
the most recently received or bought, while the earlier stock will be issued or sold
last.
(c)
AVCO
As purchase price change with each new consignment, the average price of
components in stock is constantly changed. Each component of stock at any
moment is assumed to have been purchased at the average price of all components
in stock at that moment.
(d)
Replacement cost
This method assumes that the cost at which inventory was bought is the amount it
would cost to replace it. This is often (but not necessarily) the unit cost of
inventories bought in the next consignment following the issue of the component
to production. For this reason, a method which produces similar results to
replacement costs is called NIFO (Next in first out).
When preparing financial statements FIFO and AVCO are preferred treatments.
LIFO is not permitted as an alternative treatment (IAS 2)
12.17 Example: Valuation methods
The following transactions took place during the month of June 20x8
QUANTITY
UNIT COST
K’000’
1 June
Opening inventory
200
12
6 June
Purchases
400
17
9 June
Sales
300
30
15 June
Sales
250
32
17 June
Purchases
100
18
21 June
Sales
60
32
201
Required:
Show how continuous inventory records will be and how closing inventory will be valued
using each of the following:
(a)
(b)
(c)
FIFO
LIFO
AVCO
Prepare income statements for each of the above methods.
Solution
(a)
Date
1 June
6 June
FIFO METHOD
Purchased
-
400 @ $17 each
Sales
Inventory Balance
After each transaction
-
200 x K12 each K2 400
-
K6 800
+
K2 400 K$9 200
K6 800
9 June
-
300 @ K30 each
K9000
(200 @ 12)
(100 @ 17)
300 @ 17
(2 400)
(1 700)
5 100
15 June
-
250 @ 32 each
K8 000
300 @ 17
(250 @ 17)
50 @ 17
5 100
(4 250)
850
1 800
2 650
50 @ 17
10 @ 18
90 @ 18
(850)
(180)
1 620
17 June
100 @ $18 each
21 June
-
K8 600
-
60 @ 32 each
K1 920
K18 920
Closing inventory using FIFI is 90 units remaining from the last cost of 100 @ K18 each
thus 90 units @ K18 each = K1620.
202
(b)
Date
LIFO METHOD
Purchased
1 June
6 June
-
400 @ K17 each
Sales
Inventory Balance
After each transaction
-
200 @ 12 each K2 400
-
K6 800
+
K2 400
K9 200
600
(300 @ 17)
100 @ 17
200 @ 12
300
1 700
2 400
4 100
300
(100 @ 17)
(150 @ 12)
50 @ 12
K600
K6 800
9 June
-
15 June
300 @ K30
K9000
-
250 @ 32
K 8 000
17 June
100 @ K18 each
K1 800
-
50 @ 12
100 @ 18
150
K600
K1 800
K2 400
21 June
-
60 @ 32
K1 920
150
60 @ 18
40 @ 18
50 @ 12
90
K720
K600
1320
K8 600
K18 920
Closing inventory using LIFO is 90 units broken down as follows:
40 @ 18 = K720
50 @ 12 = K600
K1 320
203
(c)
Date
1 June
6 June
Using AVCO
Purchased
-
400 @ 17 each
Sales
Inventory Balance
After each transaction
-
200 x K12 each K2 400
-
K6 800
+
K2 400
K6 800
9 June
K9000
300 @ 30
(300)
K9 200
600
300 @ 15 each K4 500
15 June
-
250 @ 32
K8 000
17 June
100 @ 18 each
K1 800
21 June
-
-
60 @ 32 each
K1 920
300
(250)
50 @ 15 each
K750
50 @ 15 each K 750
100 @ 18 each K1 800
150
K2 550
150
(60)
90 @ 17
K1 530
Using the AVCO method closing inventory is at 90 x K17 = K1 530.
Average cost takes place when purchases are made.
Average cost is taken to be: total cost
Number of units
The remaining units will be valued at K15 each thus;
300 units x K15 = K4 500
On 15 June 250 units are sold. The remaining 50 units will be valued still at K15 each
Thus 50 units x K15 = K750.
On June 17, 100 units are purchased. The number of units are now 100 + 50 units from
15 June making a total of 150 units.
204
Any remaining inventory will be valued at:
K2550
150 = K17 each
The closing inventory as at 31 June will be:
90 units x K17 = K1530.
(d)
Inventory valuation and profit
Each method of inventory valuation produces different cost of closing inventory
and cost of sales, and this will produce different profit figures.
Using the previous example, income statements using different methods will be as
follows:
(i)
FIFO
Income Statement
K
Sales
Purchases
Closing inventory
8 600
(1 620)
(6 980)
11 940
Profit
(ii)
K
18 920
LIFO
Income Statement
K
Sales
Purchases
Closing inventory
8 600
(1 320)
(7 280)
11 640
Profit
(iii)
K
18 920
AVCO
Income Statement
K
Sales
Purchases
Closing inventory
K
18 920
8 600
(1 530)
(7 070)
11 850
Profit
205
CHAPTER SUMMARY
-
Profit is calculated on inventory sold. Unsold inventory at year end (closing inventory) is
carried forward to the next accounting period as opening inventory.
-
Cost of sales is calculated as:
Opening inventory
Purchases
Less: Closing inventory
XX
XX
XX
(XX)
XX
-
Carriage inwards is included as part of cost of inventory because the expense is directly
attributable to purchases.
-
Inventory account is opened at year end as an adjusting item. This takes place after
physical stock count or continuous inventory count. The value is based on lower of cost
and net realizable value for each separate item or group (separate valuation concept).
-
Cost is purchase cost plus direct expenses.
-
N.R.V. is selling price minus completion and selling costs.
-
Valuation methods for inventory includes the following
FIFO
LIFO
AVCO
-
Closing inventory is created in income statement and shown as current asset in balance
sheet.
EXERCISES
1.
What is the formula for calculating cost of goods sold?
2.
What is the difference between carriage inwards and carriage outwards and how are they
treated in financial statements.
3.
How is inventory determined and how is it incorporated in financial statements.
4.
Distinguish between cost and net realizable value in relation to inventory.
206
5.
Identify three methods of pricing inventory.
SOLUTION TO EXERCISES
1.
Opening inventory
Purchases
Less: closing inventory
XX
XX
(XX)
XX
2.
They are all transport expenses. Carriage inwards is a direct expense incurred at the time
of buying the goods and therefore is added to purchases as part of cost.
Carriage outwards is selling expense and appears under indirect expenses in income
statement.
3.
Inventory is arrived at by conducting physical stock count or continuous count. Closing
inventory is credited to income statement and shown as current asset in balance sheet.
4.
Cost includes amount spent to buy goods plus direct expenses.
Net realisable value (N.R.V.) is value of inventory calculated as follows:
Selling
Price -
expenses incurred in putting the item in a saleable
condition
Inventory is valued at lower of cost and net realisable value.
5.
FIFO, LIFO, AVCO
207
CHAPTER 19
CORRECTION OF ERRORS AND THE SUSPENSE
ACCOUNT
INTRODUCTION
In Chapters 11 and 12 on Trial balance it was clearly stated that when trial balance totals are
equal, does not mean that the information is free from errors.
This chapter will discuss errors that the trial may disclose and those that may not be disclosed,
and how they are corrected.
TOPICS
1
2
3
Errors not disclosed by the trial balance
Errors disclosed by the trial balance
The journal, suspense account and the correction of errors.
LEARNING OBJECTIVES
At the end of the chapter, the student should be able to:
-
Identify different types of errors and how to correct them
Distinguish between errors affecting trial balance and those not
Adjust profit figure after correcting errors
Show correctly suspense account in balance sheet before errors are corrected
8.1
Errors not disclosed by trial balance
These are errors where trial balance totals are equal but with mistakes.
It is not possible to draw up an exhaustive list of all the errors which might be made.
Below are some of the common ones which might cover most of the errors.
-
Errors of transposition
Errors of Omission
Errors of Principle
Errors of Commission
Compensating errors
Errors of Original entry
Complete reversal of entries
208
When errors are detected they should be corrected immediately. The journal is the book
of prime entry used for the correction of errors.
There is no rule regarding how errors should be corrected. One should just first
understand how the error was made and how it should be corrected.
(a)
Errors of transposition or errors of original entry
This occurs when a number of digits in an amount are accidentally recorded the
wrong way round. For example, a sales invoice shows sales of K1478. When
recorded in sales journal it is shown as K1487. Double entry will be based on the
wrong figure in correct accounts, therefore, the trial balance will have equal
totals.
(b)
Errors of Omission
This is where a transaction is not recorded in the accounting books. Therefore,
double entry will be based on recorded transaction and the trial balance will have
equal totals based on processed activities.
Example
A business has sent a lot of sales invoices to different customers one of them
being K260 sent to customer. If it is omitted both the Debit and Credit sides of
trial balance will be down by K260. The trial balance totals will be equal based
on the other correctly processed sales invoices.
(c)
Errors of principle
These errors are a result of one’s failure to correctly apply the principles of
accounting or accounting concepts. The common ones are failure to appreciate
the distinction between capital and revenue expenditure and capital income and
revenue income.
Example 1
Bought non current asset (furniture) by cash K670.
Correct double entry in correct account
DR – Furniture account
CR – Cash account
Correct double entry but in wrong account
DR – Purchases account
error of principle
CR – Cash account
Please note that furniture has wrongly been debited in purchases account instead
of Furniture account. The fact that both have debit entries, the trial balance totals
209
will be equal but with wrong figure of purchases and none in furniture. Record of
furniture will not be there since it is included in purchases.
(d)
Errors of Commission
Commission in this context means failure to do work to ones best ability.
Errors of commission are very common for customers or supplier with similar
names. Also common with mixing up expenses, e.g. recording a debit entry or
credit entry in the wrong account.
Example 1:
Sold goods on credit to J Bush of Northern region but was by mistake recorded in
J Bush of Eastern region.
N.B. Both are receivables are supposed to be debited.
Example 2:
Repairs expenses of K35 recorded in Insurance account.
N.B. Both are expenses and have debit entry for this example.
(e)
Compensating errors
To compensate means to make up e.g. being paid some cash for injury while on
duty.
Compensating errors arise as a result of making mistakes in one account which is
compensated by another mistake in another account (i.e, the errors cancel each
other).
Example
Bought postage stamps by cash K5.
Paid for rent in cash K10.
Stamps account
Cash
10
Rent account
Cash
5
Cash account
210
Stamps
Rent
5
15
Trial Balance
Dr.
10
5
__
15
Stamps
Rent
Cash
Cr.
15
15
Please note that figures in stamps and rent are switched. Error made in stamps
has been compensated by another error in rent. Trial balance totals will be equal
but with errors.
(f)
Complete reversal of entries
This is when double entry for a transaction is reversed i.e. Debiting an account
which should be credited and crediting an account which should be debited.
Example:
Paid for stationery in Cash
Correct double entry
K4
Dr – Stationery account K4
Cr – Cash account K4
Reversed entry
Dr – Cash account K4
Cr – Stationery account K4
Trial balance will agree because correct amount and equal in value is debited and
credited in correct accounts but wrong sides.
Activity 1
Identify the errors in the following situations.
(i)
(ii)
(iii)
8.2
Recording motor repairs in motor account
Recording sale of non current asset in sales account
Translating purchases invoice figure of K505 into purchases journal as
K550.
Errors disclosed by trial balance
In some cases, the trial balance totals may not be the same. This may mean a lot of
things.
211
When the trial balance fails to agree sometimes it could just be a simple additional error
within the trial balance. It is advisable to sum up the trial balance once or even twice
again. If this produces same results then it could be one of the following or combination
of errors.
(i)
(ii)
(iii)
8.3
Incomplete double entry. Recording only one account a transaction. The trial
balance will not agree.
Debiting one figure and crediting a different figure for same transaction e.g.
bought stamps for cash K5. Debit stamps with K5 but credit cash with K4.
Transposition e.g. paid for stationery in cash K15. Debit stationery with K15 but,
credit cash with K51.
Correction of errors
When totals in trial balance are not equal, a temporal account is opened called the
suspense account.
8.4
Suspense account
The suspense account is opened for the difference in the trial balance because it is not
clear what caused the difference. However, it is not encouraged to all the time open
suspense account when trial balance totals disagree, except under certain circumstances
e.g. where it is suspected that the difference may be as a result of many errors which
might take sometime to discover.
Also where the bookkeeper does not know where to post one side of a transaction e.g. a
cash payment is credited to cash, but the bookkeeper does not know what the payment
was for and so will not know which account to debit.
8.5
Suspense account and Financial statement
Suspense account is always placed where there’s a deficit in trial balance, which could be
debit side or credit side, thus forcing temporally the trial balances totals to be equal.
With the suspense in trial balance, the financial statements could now be prepared.
-
-
Suspense account will appear in balance sheet. If suspense account is debit
balance, it is shown separately under current asset.
If suspense balance is credit, it is shown separately as under current liability.
It is important to note that showing suspense account as such in balance sheet
does not mean that it is an asset or liability but that is the only place it fits if
balance sheet is to remain balanced, while investigations are being carried out.
When financial statements are prepared with suspense there could be a possibility
that the profit calculated is wrong and may require adjustment when errors are
detected and corrected.
212
8.6
The Journal and correction of errors
All errors once detected are corrected via the journal. When correcting errors it is
important that some will affect suspense account and others not.
-
Errors not causing imbalance in trial balance will not affect suspense account.
Errors causing imbalance in trial balance will be corrected via suspense account.
Example 1: Suspense account not involved
Both T Flash light and T Flash bulb are our customers. On 1 January 20X5 sold goods to
T Flash light but by mistake it was recorded in T Flash bulb account K150.
Solution:
It is assumed that the sales account was correctly credited with K150 but instead of
debiting T Flash light with K150, T Flash bulb was debited instead. The trial balance is
not affected by this error because double entry in figure terms is correct. To correct this
error it should be:
Dr – T Flash light account
Cr – T Flash bulb account
Example 2: Suspense account involved
Paid rent in cash K170
Rent account is debited with K100
Cash account is credited with K170
Solution
The trial balance totals will not be equal. One side (Cr) will be greater than debit side by
K70. This error should be corrected via suspense account.
Trial balance before error is corrected will be:
Dr
100
Rent
Cash
Suspense
Cr
170
70
170
170
Suspense account will be opened with debit balance
Dr
Balance
-
Suspense account
70
error corrected
213
Cr
Dr – Rent account with K70 i.e. to bring rent figure to K170
Cr – Suspense account with K70 i.e. to clear debit balance shown in suspense
account.
After correction the accounts will now be:
Dr
Rent account
Cash
Suspense account
100
70
Dr
Suspense account
Balance
70
Cr
Cr
Rent
70
70
70
Corrected trial balance
Rent
Cash
Dr
170
170
Cr
170
170
N.B. Suspense account is now closed and rent adjusted by K70 to K170. The
error has been corrected and trial balance will agree with adjusted figure of rent.
Cash was correctly recorded and so is not affected by the error.
Example 3: With more than one error
C.H. Systems Ltd is a hardware business, whose financial year ends on 31
December each year. At 31 December 20X5 a trial balance was extracted which
revealed a deficit of K1421 on the debit side. This was resolved by opening a
suspense account, and financial statements where prepared and showed a profit of
K12,600.
In January 20X6 investigation revealed that:
(i)
(ii)
(iii)
(iv)
(v)
(vi)
A page of sales day book totaling K576 had not been posted to sales
account.
An accrual of rates K371 had not been taken into account
A repayment part of the loan from the bank K300 had been entered on the
loan interest account
The petty cash balance had been included as K57 instead of K75.
A bad debt of K120 had been entered in the customers account but not in
the expense account.
Drawings K200 had been entered in the sundry expenses account
214
(vii) An invoice for car repairs K380 had been entered in the wages account.
(viii) The rent received account balance of K600 had been entered on the wrong
side of the trial balance and income statement.
(ix)
Advertising account with a balance of K2759 had been omitted altogether.
(x)
Closing inventory had omitted some items valued at cost K2,000.
(xi)
Discount allowed of K150 had been credited to discounts received.
Required:
(a)
(b)
(c)
Show by means of journal to correct the above errors (narratives are not
required).
Clear suspense account balance after the correction of errors and
Prepare a statement showing the corrected amount of the profit.
Solution:
(a)
The Journal
(i)
(ii)
(iii)
Suspense account
Sales account
Income Statement
Rates account
Dr
576
576
371
371
Bank loan account
Interest account
300
Petty cash account
Suspense account
18
Bad debts account
Suspense account
120
Drawings account
Sundry expenses account
200
Car repairs account
Wages account
(viii) Suspense account (rent)
Rent
380
(iv)
(v)
(vi)
(vii)
(ix)
(x)
(xi)
Cr
300
18
120
200
380
1,200
1,200
Advertising
2759
Suspense account (advertising)
2759
Closing Inventory account
Income Statement
2,000
2,000
Discount allowed account
150
215
Discount received account
Suspense account
(b)
Dr
Suspense account
Balance
Sales
Rent
1421
576
1200
Petty cash
Bad debts
Advertising
Discount all.
Discount rec.
____
3197
(c)
150
300
Cr
18
120
2759
150
150
3197
Statement of profit adjustment:
Net profit before adjustments
Add sales omitted
Less rates accrual
Add loan repayment entered in loan interest
Less bad debts
Add drawings entered in sundry expenses
Add rent received entered on wrong side
Less advertising omitted
Add omitted inventory
Less discount allowed (150 x 2)
Adjusted profit
K
12600
576
(371)
300
(120)
200
1200
(2759)
2000
300
13926
Notes
-
Error (i) is an error of undercast in sales account. The trial balance will
not balance because the receivables figure will be more by K576 on credit.
The suspense account is involved in correcting this error. Profits should
adjust by adding sales of K576.
-
Error (ii) rates accruals comes as a year end adjustment. The trial balance
is not affected by this error but profits will be over stated since accrued
expenses are included as expenses in the year to which they relate. Profits
should reduce by K371
216
-
Error (iii) the trial balance is not affected because the loan repayment
should have been debited to loan account instead of loan interest. Double
entry was achieved but in a wrong account. However, the loan interest
account was overstated by K300. therefore profits should be increased by
K300.
-
Error (iv) this error will affect the trial balance and suspense account is
involved in correcting it. Petty cash is an asset and was transposed. The
debit side of trial balance will be less by K18. However, profit is not
affected by this error because cash does not appear in Income Statement
but as a current asset in balance sheet.
-
Error (v) this is incomplete double entry and the trial balance will not
balance thus the reason for the suspense account. Since bad debt is an
expense, its omission increases profits. Therefore, after correcting the
error the profits should be reduced by the amount of the bad debts.
-
Error (vi) this is an error of principle and the trial balance is not affected.
Drawings should have been debited but instead sundry expenses were
debited. Double entry was correct but debited in wrong account.
-
Error (vii) same as error (vi).
-
Error (viii) The rent account in the ledger was correct with a credit entry.
On taking it to trial balance it was recorded on the debit side instead of
credit side. This made the debit side of trial balance to be twice bigger the
amount, and the trial balance would not balance. The trial balance should
be credited with rent receivable by K1200 (600 x 2). The first K600 to
cancel the debit and the other K600 to reinstate the rent receivable. Rent
receivable is an income and increases profit by crediting the income
statement. Now that it was debited in income statement, the profit were
understated by twice the amount, so add back twice the amount.
-
Error (ix) advertising account is the ledger but was not transferred to trial
balance. This will cause an imbalance in trial balance. Therefore, it
should just be included by crediting suspense account with advertising. Its
omission from trial balance also means that it was omitted from income
statement thus overstating profits. This profits should now be reduced by
the amount.
-
Error (x) closing inventory is a year end adjustment after physical stock
take. It does not appear in trial balance and so the error is outside trial
balance. However, profits were understated because cost of sales were
higher. Profits should now be increased by the same amount.
-
Error (ix) see error (viii).
217
CHAPTER SUMMARY
The trial balance totals may not be equal because of errors which may include:
(i)
(ii)
(iii)
Additional errors
Incomplete double entry
Transposition errors
When the trial balance does not balance a temporal account called suspense account is opened.
Suspense does not appear in Income Statement but in balance sheet.
-
If suspense account balance is debit, it is shown separately under current assets
-
If suspense account balance is credit, it is shown as current liability
Only errors that cause the trial balance not to balance are corrected via suspense account.
Errors not affecting trial balance include:
(i)
(ii)
(iii)
(iv)
(v)
errors of omission
errors of principle
errors of commission
complete reversal of entries
compensating errors
All errors are corrected through the journal.
-
When all errors are corrected the trial balance totals will be equal with adjusted figures.
-
If after correction of errors a balance remains in suspense account, it may indicate errors
in correcting them or not all errors have been identified. A good question will mention
the outcome.
218
EXERCISES
1.
Identify four (4) errors not affecting trial balance
2.
When is the suspense account used?
3.
What does a credit balance on suspense account indicate?
4.
The trial balance of John Black as at 31 March 20X9 did not agree, there being a shortage
of K 874 on the debit side. A suspense account was opened for the difference.
Subsequent investigation showed:
(i)
Discount allowed K480 had been entered on the credit side of discount allowed
account.
(ii)
The bank statement balance of K560 overdraft had been included in trial balance
instead of the cashbook balance of K63 debit.
(iii) The provision for bad debts account of K150 had been entered on wrong side of
trial balance
(iv)
Rent receivable account was over cast by K20
(v)
Drawings of K250 had been included in purchases account
(vi)
The sale of furniture (non current asset) had been included in sales account of
K300
(vii) Payment for insurance of K45 was entered in insurance account as K54
(viii) Discounts received was overstated by K100.
(ix)
A cheque for K200 for car repairs had been posted to the building repairs account
(x)
Provision for depreciation account K270 was entered on wrong side of trial
balance
(xi)
The scrapping of an old lorry with net book value of K375 was omitted from the
books.
Required:
(a)
(b)
Correct the errors via the journal
What was the balance on suspense account before the errors were corrected.
219
SOLUTIONS TO EXERCISES
1.
2.
3.
4.
Errors of omission, errors of principle, errors of commission and compensating
errors.
When the trial balance totals are not equal.
It indicates a shortage on credit side of trial balance.
The Journal
K
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(viii)
(ix)
(x)
(xi)
Discount allowed account (480 x 2)
Suspense account
K
960
960
Trial balance (Bank account)
Bank account
Trial balance (Bank account)
560
63
Suspense account
Trial balance (with provision for bad
debts)
300
Rent receivable account
Suspense account
20
Drawings account
Purchases account
250
Sales account
Disposal account
300
Suspense account
Insurance account
9
623
300
20
250
300
9
Discount received account
Suspense account
100
Car repairs account
Building repairs account
200
Suspense account
Trial balance (with provision for
depreciation account)
540
Income Statement account
Lorry account
375
100
200
540
375
220
Dr
Suspense account
Provision for bad debts
Insurance
Provision for depreciation
Balance
300
9
540
874
1723
221
Discount allowed
Bank account
Rent receivable
Discount received
Cr
960
623
40
100
1723
CHAPTER 20
FINANCIAL STATEMENTS WITH ADJUSTMENTS
INTRODUCTION
This chapter summarises all the adjustments so far discussed in previous chapters in order to
prepare financial year end statements. This chapter contains exercises for practice, thus
consolidating the knowledge in the previous chapters. The student is advised to attempt the
questions before seeing the solutions.
TOPICS
1
2
Income Statement with adjustments
Balance sheet with adjustments.
LEARNING OBJECTIVES
At the end of this chapter, the student should be able to:
Prepare income statement and balance sheet with correct treatment of:
-
prepayments
accruals
bad debts and provision for depreciation
opening and closing inventory
222
Exercise 1
Shoe Black, is a sole trader operating as a retailer. The following information is extracted from
his accounting books as at 31 December 20X7.
K’000
1460
Distribution expenses
10% Loan
Trade payables
Cash at bank
Allowance for doubtful debts
Trade receivables
Motor vehicles at cost
Accumulated depreciation motor vehicles
Warehouse at cost
Accumulated depreciation warehouse
Buildings at cost
Accumulated depreciation buildings
Land at cost
Interest on loan paid
Salaries and wages
Discounts allowed and received
Returns inwards
Returns outwards
Carriage inwards
Carriage outwards
Inventory 1 January 20X7
Purchases
Sales
Capital 1 January 20X7
K’000
1000
820
140
18
810
1680
620
1800
290
8300
1020
1510
50
1590
80
400
100
150
700
250
1530
8100
13600
10782
28400
28400
The following additional information is available:
(a)
(b)
(c)
(d)
(e)
(f)
(g)
Closing inventory is K1,660,000
Trade balances totaling K6,000 are to be written off and the allowance for doubtful debts
increased to K30,000.
Salaries and wages owing K190,000 with K70,000 paid in advance.
Distribution expenses of K60,000 were prepaid and K120,000 not paid as at 31
December 20X7.
Interest of K50,000 is owing
In January 20X8, the business received invoices for credit purchases totaling K18,000 for
goods delivered before 31 December 20X7.
It was also found that credit sales invoices totaling K7,000 for goods delivered to
customers before 31 December 20X7 had by mistake been dated in January 20X8 and
thus excluded from sales for the year and from account receivables at the year end.
NOTE: The goods received had been included in the year end inventory figures given at
(a) above, and the goods sold had been excluded from it.
223
No adjustment to the inventory figure is therefore required:
(h)
Depreciation should be provided as follows:
-
Land nil
Buildings 2% on cost per annum
Warehouse 15% on cost per annum
Motor vehicles 25% on cost per annum
Required:
(a)
Prepare income statement for the year ended 31 December 20X7 and
(b)
Balance sheet as at 31 December 20X7.
Solution:
Workings:
1.
K’000
Sales
13,600
Sales excluded
7
13,607
4.
Distribution expenses
K’000
1,460
add owing
120
Less prepaid
(60)
1,520
2.
Purchases
8,100
Purchases for
Invoices not
Received
18
8,118
5.
Interest on loan
3.
Salaries and wages
K’000
1,590
Add owing
190
Less prepaid
(70)
1,710
6.
(i)
(ii)
add accrued
N.B. 10% x 1000 = 100
only K50,000 has been paid the
other K50,000 is still owing
Bad debts and allowance for bad debts
K’000
Receivables
810
Less: Bad debts
(6)
Remaining receivables
804
Allowance for bad debts is
New balance
Increase in allowance is
K’000
50
50
___
1,00
K’000
18
30
12
224
(iii)
Bad debts and allowance for bad debts in
Income statement will be
K’000
Bad debts written off
6
Increase in allowance
12
18
(iv)
Receivables in balance sheet will be:
Remaining receivables
Add omission
Allowance for bad debts
7.
K’000
804
7
(30)
781
Depreciation:
(i)
Buildings:
Balance as per trial balance
charge to income statement
(2% x 8,300)
K’000
1,020
166
1,186
K’000
Balance as per trial balance
290
charge to income statement
(15% x 1,800)
270
560
(ii)
Warehouse:
(iii)
Motor vehicles: Balance as per trial balance
Charge to income statement
(25% x 1650)
K’000
620
420
1,040
Shoe Black
Income statement for the year ended 31 December 20X7
K’000
13,607
(400)
Sales (1)
Less: Returns inwards
Turnover
Cost of sales:
Opening inventory
Purchases (2)
Less: Returns outwards
Add: Carriage inwards
Less: Closing inventory
Gross profit
K’000
13,207
1,530
8,118
(150)
700
(1,660)
(8,538)
4,669
100
Add: Discount received
225
4,769
Less: Expenses
Loan interest
Bad debts & allowance (6) (iii)
Salaries and wages (3)
Discounts allowed
Distribution Expenses
Carriage outwards
Depreciation: Buildings (7 (i))
Warehouse (7 (ii))
Motor vehicles (7 (iii))
100
18
1,710
80
1,520
250
166
270
420
(4,534)
235
Net profit
Shoe Black
Balance Sheet as at 31 December 20X7
Non Current Assets
Cost
K’000
Depreciation
K’000
N.B.V.
K’000
Land
Buildings
Warehouse
Motor Vehicles
1510
8300
1800
1680
1186
560
1040
1510
7114
1240
640
10504
Current Assets
Inventory (closing)
Receivables (6 (iv))
Prepayments (60 + 70)
Cash at Bank
1660
781
130
140
2711
Total Assets
13215
Financed by:
Capital at start
Add Net Profit
10782
235
Non current Liabilities
10% Loan
1000
Current liabilities
Trade payables (820 + 18)
Accrued expenses (120 + 190 + 50)
838
360
226
1198
13215
Exercise 2
Mr. Bird Rock has been in business for some time trading in motor spares. The list below has
been taken from his books for the financial year ended 30 September 20X8.
K
910,000
136,500
15,400
400,000
95,000
15,210
10,625
55,000
110,300
5,266
315,000
88,000
11,000
50,781
16,000
4,242
112,000
156,000
1,200,400
14,000
40,000
2,745
271,000
1,103,179
2,000,000
Fixtures and fittings
Accumulated depreciation
Discounts received
Trade receivables
Carriage inwards
Postage and stationery
Telephone expenses
Bad debts
Returns inwards
Carriage outwards
Drawings
Rent & rates
Insurance
Heating and lighting
Advertising
Cash in hand
Cash at bank
Inventory 1 October 20X7
Purchases
Discounts allowed
Allowance for doubtful debts
Returns outwards
Trade payables
Capital 1 October 20X7
Sales
Additional Information at 30 September 20X8.
(i)
Inventory is valued at K127,666.
(ii)
Depreciation charge for the year is 10% on reducing balance method.
(iii)
Rates prepaid K910
(iv)
Telephone owing K1,000
(v)
Heating & Lighting owing K4,616
(vi)
Allowance for Bad debts to be adjusted so that it is 5% of trade receivables.
Required:
Prepare income statement for Mr. Bird Rock for the year ended 30 September 20X8 and a
balance sheet as at that date.
227
Solution
Mr. Bird Rock
Income statement for the year ended 30 September 20X8
K
Sales
2,000,000
Less: Returns inwards
(110,300)
Turnover
Cost of Sales:
Inventory 1/10/20X7
Purchases
Returns outwards
Carriage inwards
Less: Closing inventory
1,889,700
156,000
1,200,400
(2,745)
95, 000
_________
1,448,685
(127,666)
1,320,989
568,711
15,400
584,111
Gross Profit
Discount Received
Expenses:
Postage and stationery
Telephone expenses (10,625 + 1,000)
Bad debts (55,000 – 20,000)
Carriage outwards
Rent and rates (88,000 – 910)
Insurance
Heating and lighting (4,616 + 50,781)
Advertising
Discounts allowed
Depreciation: Fixtures and fittings
K
15,210
11,625
35,000
5,266
87,090
11,000
55,397
16,000
14,000
77,350
(327,938)
256,173
Net Profit
228
Mr. Bird Rock
Balance sheet as at 30 September 20X8
Non Current Assets
Fixtures and fittings
Cost
910,000
Depreciation
213,850
N.B.V.
696,150
Current Assets
Inventory 30/09/20X8
Trade receivables (400,000 – 20,000)
Prepayments
Cash in Bank
Cash in hand
127,666
380,000
910
112,000
4,242
624,818
1,320,968
Total Assets
Financed by:
Capital 1/10/20X7
Net profit
1,103,179
256,173
1,359,352
Less: Drawings
(315,000)
1,044,352
Current liabilities
Trade payables
Accruals (1,000 + 4,616)
271,000
5,616
276,616
1,320,968
CHAPTER SUMMARY
1.
Income statements are prepared on matching and accruals concepts. That is matching
income with expenses, whether received or not and whether paid or not, as long as they
relate to a particular period under review.
2.
Prepayments made in one period are not a charge in that period. In income statement
they are deducted from the appropriate expenses charge and shown in balance sheet as
current asset. Prepayments will be a charge to the period for which they have been paid.
3.
Amounts not paid by the business at the balance sheet date, should be accounted for as
expenses in that period in income statement and shown as current liabilities in balance
sheet.
4.
Any increase in Allowance for bad debts should be charged to income statement and any
decrease treated as income (gain) and netted off with bad debts because they are related.
5.
The closing balances in Allowance for bad debts is the amount to be deducted from Trade
receivables in balance sheet.
229
CHAPTER 21
DEPARTMENTAL ACCOUNTS
INTRODUCTION
A business dealing in unrelated range of products under one roof, might wish to know the
performance of each product and make decisions such as to continue or withdraw.
The range of products will be divided into departments such as drappery, hardware, kitchen, etc,
and each department will be a cost centre and prepare its own income statement. This chapter
shows how to prepare departmental accounts and their usefulness.
TOPICS
1
2
3
4
5
Why prepare departmental accounts
Expense apportionment
Departmental income statement
The balance sheet
Decision-making
LEARNING OBJECTIVES
At the end of this chapter, the student should be able to:
-
Identify reasons why dividing a business into departments could be helpful
Apportion expenses between departments using appropriate basis
Prepare departmental income statements using the gross profit and contribution basis.
21.1 PREPARING DEPARTMENTAL ACCOUNTS
Departmental accounts are prepared to assess the performance of each department. The
layout of departmental accounts is not different from what has been covered in earlier
chapters. The primary difficulty in preparing departmental accounts is that many
expenses are shared. Common expenses shared may include:
-
Rent and rates
Electricity
Insurance
Transport
Telephone
A business with separate departments for drappery, kitchenware and toiletries may prepare
departmental accounts as follows:
230
Drappery
Sales
Cost of sales
Gross profit
K
120,000
(75,000)
45,000
Kitchen
Ware
K
200,000
(150,000)
50,000
Toiletries
Total
K
50,000
(80,000)
(30,000)
K
370,000
(305,000)
65,000
The above information shows that Toiletries is a loss department. Without it gross profit
would have been K95,000. A decision has to be made on how to improve the operations
of the toiletry department, or replace it with another which is profitable.
LOSS LEADER
It is important to be mindful that certain business have a deliberate policy of reducing
prices in one department to increase customer flow and hoping that customers will also
buy from other departments. Thus loss in one department to be offset by profits in other
departments. This policy should be reviewed and be done away with if it is not yielding
profitable results for the whole business.
In the above example the end result is gross profit. This is because at this stage it is
relatively easy to keep separate records for sales, purchases and inventories of each
department.
21.2 EXPENSES
Some expenses in a departmentalized business could be considered as direct and others
shared expenses.
-
-
Examples of direct expenses include salaries or wages of personnel identified
with each department where they work.
Most of the expenses are shared and should therefore be divided between the
departments using the most fair basis, because they cannot be traced to a
particular department.
Examples of shared costs include electricity, transport, rentals, telephone,
insurance, advertising, etc.
21.3 CONTRIBUTION AND NET PROFIT
-
-
Contribution is the difference between sales and direct expenses attributable to
each department i.e. expenses which would not be paid if the department was
closed.
When calculating net profit, expenses not traceable to the department and which
will still be paid even if the department was closed, are considered.
Therefore the best way of assessing departmental performance could be through
contribution.
231
Example: Complete departmental income statement.
The business of Opani has two departments, hardware and electrical. The
information below was taken from his books as at 31 December 20x7, the end of
the financial year.
Sales
Purchases
Opening inventory
Wages
Other expenses
Building at cost
Motor vehicles at cost
Rates
Accumulated depreciation:
Buildings
Motor vehicles
Electricity
Hardware
K
198,000
75,000
25,000
35,000
24,700
Electrical
K
264,700
137,000
43,600
34,000
20,100
Unspecified
K
146,000
145,000
15,000
37,000
60,300
20,000
Notes:
(a)
Depreciation policy is 20% straight line on buildings and 40% on motor
vehivles using reducing balance method.
(b)
Buildings are used 4/5 hardware and 1/5 electrical
(c)
Motor vehicles are used equally between the two departments.
(d)
Electricity and Rates are apportioned on floor area occupied 2/3 hardware
and 1/3 electrical.
(e)
Closing inventory is K15,000 and K17,000 respectively for hardware and
electrical.
Required:
(a)
(b)
Prepare income statement for the year ended 31.12.20x7
Assess the impact of closing down either department.
232
Solution:
(a) Opani,
Departmental income statement for the year ended 31.12.20x7.
Hardware
K
Sales
Cost of sales:
Opening inventory
Purchases
Less: closing inventory
25,000
75,000
100,000
(15,000)
(85,000
113,000
Gross profit
Direct expenses:
Wages
Other expenses
35,000
24,700
Electrical
Total
K
K
264,700
K
462,700
43,600
137,000
180,600
(17,000)
(163,600)
101,100
(248,600)
214,100
34,000
20,100
(59,700
53,300
Contribution
Shared expenses:
Depreciation:
Buildings
Motor vehicles
Rates
Electricity
23,360
16,940
10,000
13,333
(54,100)
47,000
(113,800)
100,300
(34,447)
12,553
(97,080)
3,220
5,840
16,940
5,000
6,667
(63,633)
(10,333)
Net profit
(b) -
K
198,000
Some costs are fixed e.g. rates, depreciation, electricity and
these would not be saved even if Hardware department is closed.
-
Contribution by hardware department is very good though it has
made a net loss. The problem could be on the apportionment of
indirect expenses.
-
Some customers might not use the business if the other department
is closed down.
21.4 THE BALANCE SHEET
The balance sheet is prepared as a single entity. It does not show separate assets and
liabilities for each department.
21.5 DECISION MAKING
Apart from deciding whether to close a department or not which is not easy,
departmentalizing a business may provide vital information such as:
(a)
Profitability of each department for the purpose of may be expanding a profitable
department.
233
(b)
(c)
Payment of bonuses or commission to employees may be based on departmental
profits.
Promotion of departmental managers could also be based on departmental profits.
CHAPTER SUMMARY
-
Depending on the nature and size of the business it may be more convenient to divide the
business into departments.
By departmentalizing a business, profitability of each department would be assessed and
decisions made.
Separate gross profit and contribution is shown with direct departmental expenses and
shared expenses.
Decisions about growth and trimming, closing down can be made.
EXERCISES
1.
Yugo owns a super market which is divided into three departments namely butchery,
grocery and beverages.
For the year ended 30 June 20x5, the following details were taken from his books.
Sales
Purchases
Sales Returns
Salaries & wages
Opening inventory
Rentals
Equipment at cost
Administrative expenses
Butchery
K
854,000
600,000
88,000
36,000
55,000
-
Grocery
K
605,000
350,000
20,000
90,000
50,000
47,000
-
Beverages
K
936,500
740,000
75,000
44,000
30,000
-
Unspecified
K
45,000
75,000
Additional information:
(i)
Closing inventory is valued as follows:
- Butchery
- Grocery
- Beverages
K25,000
K33,200
K41,750
(ii)
Equipment is depreciated at 10% p.a. on cost.
(iii)
Rent is to be divided equally between the three departments
(iv)
Administrative expenses 2:1:3 respectively between butchery, grocery and beverages.
(v)
Departmental managers are entitled to 10% commission on sales
234
Required:
(i)
Prepare departmental income statement for the year ended 30 June 20x5.
2.
Papa is in business running a pharmacy, which is divided into drugs, perfumes and
toiletries.
The balances below have been taken from his books as at 31 December 20x9.
K
675,000
500,000
300,000
900,000
350,000
225,000
75,000
60,000
45,000
80,000
35,000
20,000
25,000
33,000
66,000
15,000
66,000
19,000
200,000
Sales: drugs
Perfumes
Toiletries
Purchases: Drugs
Perfumes
Toiletries
Opening inventory: Drugs
Perfumes
Toiletries
Salaries and wages: Drugs
Perfumes
Toiletries
Lighting and heating
Telephone expenses
Motor expenses
Insurance
Fixtures and fittings
Office expenses
Buildings at cost
Additional information:
(i)
(ii)
(iii)
Depreciation is: fixtures and fittings 10% and building 15% and is to be
apportioned equally for the three departments.
All other expenses to be apportioned 0.5 drugs, 0.25 perfumes and 0.25 toiletries.
Closing inventory is valued as follows:
Drugs
K60,000
Perfumes
K35,000
Toiletries
K21,000
235
Required:
Prepare Papa’s departmental income statements for the year ended 31 December 20x9.
SOLUTIONS TO EXERCISES
1.
Yugo
Departmental income statement for the year ended 30 June 20x5
Sales
Sales returns
Cost of sales:
Opening inv.
Purchases
Closing invent.
Gross profit
Direct expenses:
Salaries/wages
Depreciation
Commission
Butchery
K
K
854,000
______
854,000
Grocery Beverages
K
K
K
605,000
936,500
(20,000) _______
______
585,000
936,500
Total
K
2,395,500
(20, 000)
2,375,500
36,000
50,000
44,000
350,000
740,000
600,000
636,000
400,000
784,000
(33,200)
(41,750)
(25,000)
(611,000)
(366,800)
(742,250) (1,720,050)
________
_______
_______ ________
243,000
218,200
194,250
655,450
88,000
5,500
85,400
______
CONTRIBUTION
OTHER EXPENSES:
Rent
15,000
Admin. Expenses 25,000
______
Net profit
K
90,000
75,000
4,700
3,000
58,500
93,650
_____
______
(178,900)
(153,200)
(171,650) (503,750)
________
________
________ ________
64,100
65,000
22,600
151,700
15,000
15,000
12,500
37,500
______
______
(27,500)
(52,500) (120,000)
(40,000)
37,500
(29,900)
31,700
24,100
236
2.
Papa
Departmental income statement for the year ended 30 June 20x5
Drugs
K
675,000
Perfumes
K
K
500,000
Toiletries
K
300,000
75,000
900,000
______
975,000
(60,000)
______
(915,000)
(240,000)
60,000
350,000
______
410,000
(35,000)
_______
(375,000)
125,000
45,000
225,000
______
270,000
(21,000)
_______
249,000 (1,539,000)
51,000
(64,000)
K
Sales
Cost of sales:
Opening inv.
Purchases
Closing inv.
Gross profit
Direct expenses:
Salaries/wages
(80,000)
Contribution
(320,000)
OTHER EXPENSES:
Depreciation:
Fixtures/fittings
2,200
Buildings
10,000
Lighting & heat 12,500
Telephone
16,500
Motor expenses 33,000
Insurance
7,500
Office expenses
9,500
(91,200)
_________
311,200
=======
(35,000)
90,000
31,000
2,200
10,000
6,250
8,250
16,500
3,750
4,750
2,200
10,000
6,250
8,250
16,500
3,750
4,750
(51,700)
______
38,300
237
Total
K
1,475,000
(20,000) (135,000)
(199,000)
(51,700) (194,600)
_______ ________
20,700 ( 393,600)
======= =======
CHAPTER 22
PUBLIC SECTOR ACCOUNTING REPORTING
INTRODUCTION
This chapter is designed to set in context the discussion of public sector accounting at an
introductory level. Its purpose is to set out briefly the description of the public sector accounting
and reporting in conformity to the international public sector accounting standards.
TOPICS
1
2
3
4
5
6
Description of public sector
Users of public sector financial statements
International Federation of Accountants (Public Sector)
Financial reporting under cash basis and accruals basis
International public sector accounting standards
Reporting and the media
LEARNING OBJECTIVES
After studying this chapter, the student should be able to:
1. Describe what a public sector is.
2. Identify the users of public sector financial reports and the decisions they can make.
3. Explain the role of the International Federation of Accountants in public sector
accounting.
4. Distinguish between the cash basis reporting and accruals basis reporting.
5. Identify international accounting standards on public sector accounting
6. Differentiate between above the line and below the line accounting.
22.1 PUBLIC SECTOR
There is a range of meanings given to the phrase ‘public sector’ but for our studies we
shall adopt the following:
‘In a mixed economy, public sector is that part of the economy that is owned and
operated by government authorities and public corporations.’
Public sector includes the following:
a)
State owned enterprises
Also called public enterprises. This is a publicly owned commercial or
industrial organization that performs some essential service such as ZESCO
and ZNBC, or produces some essential commodity such a lime.
238
b)
Local government or local authorities
This is an elected local government organization and employees who have
legal power and duty to provide and administer many local services for which
rates are paid to run it. The rates are a form of revenue to the government.
Areas falling in this category of revenue source are markets, schools, roads
and public health centers.
Public sector organizations are funded mainly by the central government and also raise
funds on their own through taxes, rates, borrowing etc, and as such they keep records of
sources and application of funds.
Financial reports are prepared for accountability purposes and communicated to users
who in turn will make decisions affecting the community at large.
It should be made clear that public sectors exhibit a variety of social, economic, political
and legal characteristics. They have different powers and responsibilities and they display
varied patterns of accountability. They have different objectives and are financed in
different ways. They also have different organization structures.
Recent years has seen public sectors being exposed to competition and market
mechanisms from the private sector. Certain ranges of services provided are required to
be awarded on the basis of competitive tenders, with private sector contractors competing
with public sector organizations e.g. waste management services, road maintenance,
cleaning, etc.
22.2 PUBLIC SECTORS POWERS AND RESPONSIBILTIES
As far as powers and responsibilities are concerned all public sector bodies have one
feature in common: There specific powers are derived ultimately from parliament and are
ultimately responsible to parliament.
Local authorities are partially accountable to parliament and more immediately
answerable to a local electorate.
22.3
PUBLIC SECTOR FINANCIAL REPORTS
By law and accounting standards, companies are required to produce annual reports and
financial statements. These include income statements, balance sheet and cash flow
statement together with accompanying notes. They are audited before they are published.
In public sector the same reports have been introduced, though some details are different.
These are forwarded to interested partied.
22.4 USERS OF FINANCIAL REPORTS
Users of public sector financial reports include the following:
a)
Authorities –this could be the central government.
Government generally is interested in assessing how these organizations have
utilized the funding allocated to them for control and planning purposes.
239
b)
Mangers –these are officials who are trustees and ensure that the daily activities
of their organizations are running smoothly. They have a keen interest and ensure
that all activities are being carried out as per budgetary plan and justification
made for extraordinary activities.
c)
Tax payers . They are interested in how government are using money they pay as
tax, and also to assist in predicting future tax levels.
d)
Public. The public generally includes workers (those who pay tax) and non
workers. Is the government providing good education, health, etc? If not then
where is the money they need to assess performance of their elected
representatives.
e)
International funding organizations. These are organizations such as International
Monetary Fund (IMF) World Bank, etc. who provide developmental funding to
government. They would want to know if the funds have been used for the
intended purpose.
22.5 INTERNATIONAL FEDERATION OF ACCOUNTANTS (Public Sector) (IFAC)
The International Federation of Accountants is an organization of national professional
accountancy organization that represents accountants employed in public practice,
business and industry, the public sector and education.
IFAC has a Public Sector Committee (PSC). The PSC focuses on the accounting,
auditing and reporting needs of national, regional and local governments, related
governmental entities and the constituencies they serve. It addresses these needs by
issuing and promoting benchmark guidance, conducting research and educational
programs, and facilitating the exchange of information among accountants and all those
who work within the public sector.
22.6 FINANCIAL REPORTING UNDER THE CASH BASIS
a)
Cash basis
This accounting system recognizes only cash inflows and cash outflows. The
resulting final accounts are summarized cash books. There are no balance sheets
under this system because there are no other assets (apart from cash) and
liabilities in the books other than cash balances.
ƒ
ƒ
ƒ
ƒ
ƒ
b)
Sales are recognized only when cash is recorded. So there are no receivables.
Purchases are only recognized when cash is paid. So there are no payables.
There is no inventory adjustment because the accounts are not concerned with
recording usage. There is no opening or closing inventory except that cash has
been paid for it.
There are no non current assets.
There are no current and non current liabilities
The cash accounting and accounting documents
240
Under this system the main book of accounting is the cash book. Entered in the
cash book are simply cash receipts and cash expenditure using receipts and
payments vouchers. This is where the analysis cash book column cash book is
used with columns for cash receipts and expense columns. Double entry is
completed with the cash book.
Ledger accounting: Separate ledger cards are kept for all receipts and payments
on a cumulative basis.
Financial statements: Under this systems financial statements may comprise:
i)
Expenditure reports –which is a summary of expenditure on activities
carried out during a period, and
ii)
A statement of cash position. This is a summary of sources and
expenditure and the resulting balance.
c)
Advantages of cash basis accounting
Cash is clearly the livelihood of any organization. Through cash basis accounting
government would be able to assess from its use.
i) how much tax to collect through budgets. If the government spends less than
the budget, then it is better off at the year-end and can spend excess cash on
other developmental issues, pay back borrowings or reduce tax.
If it spends more than the budget, then it is worse off meaning money will
have to be borrowed or increase taxes
ii)
iii)
iv)
v)
d)
Cash basis accounting is perceived to be easier to prepare and
understand
Cash reporting instills confidence in an organization from
interested parties as it reflects the ability of an organization to
manage its finances.
Organisations are forced to prioritise their activities and live within
their limits, as funding is not always enough.
Cash basis accounting is not subjective as it addresses actual
activities.
Disadvantages of cash basis accounting
Cash basis accounting has also come under criticism because:
i)
it focuses only on cash
ii)
how much an organization is worth is not only cash but also other assets
and liabilities. Therefore financial statements on cash basis
are incomplete and may be misleading about an organisation’s position.
e)
Accruals accounting
Revenue and costs are accrued (i.e recognized as they are earned or incurred, and
not as money is received or paid), matched with one another so far as their
relationship can be established or justifiably assumed, and dealt with in the
income statement of the period to which they relate.
241
Meaning:
i)
The earning of revenue is generally taken to mean that invoices have been
issued.
ii)
Costs are incurred when services are received. Therefore recognition of
income and costs is not when cash is received or paid.
There has been critical argument that the accruals accounting is too
subjective and hide crucial information about an organisation’s
performance.
Advantages:
i) It provides measures of economic goods and services consumed, transformed
and earned.
ii)
Accruals accounting yields an income figure. More profit implies
more success.
iii)
Accruals accounting yield a measure of capital. Income is only recognized
after capital has been maintained in real terms.
Disadvantages:
i)
ii)
iii)
iv)
Accruals accounting introduces subjectivity into the accounts. It
brings in adjustments which are judgmental e.g. provision for doubtful
debts, which may distort accounting information away from the ‘true and
fair’ expectation.
The relevance of accruals accounting, when it is linked with
historical costs, and during periods of rising prices, is limited.
In comparison with cash basis accounting, accruals adjustments demand a
higher administrative and accounting cost.
It provides an opportunity for manipulation that is a problem associated
with financial control. With cash based accounting manipulation of
accounting results could be affected by postponing cash payments just to
show that the organization is financially sound.
In accruals postponement of cash payments in receipts has no effect.
Manipulation may come in by bringing in invoices for goods supplied just
to ensure that the accounts are within budget.
22.7 INTERNATIONAL PUBLIC SECTOR ACCOUNTING STANDARDS (IPSAS)
The public sector committee (PSC) of the International Federation of Accountants
(IFAC) issues these accounting standards. These standards apply to national, regional and
local governments and their related government entities. The approach taken is to base
IPSAS on the International Accounting Standards (IASs) of the International Accounting
Standards Committee. Subsequently issues related to the public sector but which have not
been dealt with by IASs will be addressed.
23 REPORTING AND MEDIA
Above-the-line: This term refers to revues and expenses that relate to normal on-going
operations of an organization and which when netted produces the reported operating
profit.
242
Below-the-line: This term refers to exceptional and extraordinary items which are not
included in the calculation of profit (above the line). The items relate to capital income
and expenditure.
Virement: This deals with the transfer of items from one financial account to another.
24 CHAPTER SUMMARY
ƒ
Public sector accounting deals with accounting which applies to national, regional
and local government and their related government entities
ƒ
Users of public sector financial reports include:
i)
Authorities (including parliament)
ii)
Heads of government departments
iii)
Tax payers
iv)
The public (the electorate)
v)
Donors & International financiers such as the World Bank
ƒ
The cash basis of accounting recognizes transactions and events only when cash is
received or paid. Notes to the financial statements may provide additional
information about liabilities and other non cash assets (payables and receivables)
ƒ
Accruals based accounting recognizes income and expenditure when it accrues
and not when cash is received or paid.
243
CHAPTER 23
PARTNERSHIP ACCOUNTING
This chapter introduces a type of business called partnership. Partnership is wide. At this stage
emphasis is on the nature and principles on which financial statements of partnerships are
prepared.
TOPICS
1.
2.
3.
4.
5.
6.
7.
8.
9.
Definition of partnership as a form of business
Legal status of a partnership
Types of partners in partnership
Partnership agreement
Advantages and disadvantages of a partnership
Partnership current accounts
Partnership capital accounts
Profit and loss appropriation account
Financial statements of partnership
LEARNING OBJECTIVES
At the end of this chapter, the student should be able to:
-
Explain what a partnership is and how it differs from a sole trader.
Explain the features of a partnership agreement.
Distinguish the treatment of profit and loss of a partnership and sole trader.
Prepare partnership financial statements.
23.1 DEFINITION OF PARTNERSHIP
This is a form of business where two or more persons carry on business together for the
purpose of making profits.
A partnership usually is a progression from a sole trader
23.2 LEGAL STATUS OF PARTNERSHIP
In some countries a partnership is not a corporate entity. It does not exist separately from
its owners. In others it is a legal entity separate from partners.
However, for accounting purposes the partnership will be treated as a separate legal
person from partners.
244
23.3 TYPES OF PARTNERS IN A PARTNERSHIP RELATIONSHIP
In a partnership one may find limited partners and general or unlimited partner.
-
Limited Partners
These are partners with limited liability. They are only liable or limited to the
amount of capital they have provided. Such partners usually do not participate in
management of the business.
-
General Partners
Sometimes called unlimited or ordinary partners. These have unlimited liability.
The debts of the business is beyond their capital contribution in the business. As
such they are responsible for the day to day affairs of the business.
Therefore, in any partnership at least there must be a general partner.
23.4 THE PARTNERSHIP ADMINISTRATION
Before a partnership can be operational, partners must agree on how the business will be
organized and run. The law does not state the contents of the agreement but may contain
the following.
-
The capital contribution by each partner.
How profits and losses will be shared i.e. profit sharing ratio.
If capitals will attract interest. If yes, how much in percentage terms.
Are partners going to be allowed drawings and will the drawings attract interest.
If partners will be working in the business, are they going to be entitled to a
salary.
Should a new partner be admitted or old an partner retires what will be the
arrangements and procedures to be followed.
Name of firm, the type of business.
Settling disputes
Preparation and audit accounts.
-
Though not required by law the partnership agreement must be put in writing, so that partners
know their rights and responsibilities. This also helps to reduce disputes.
In the absence of a formal agreement by partners The Partnership Act of 1890 will guide
administration and management of a business owned by partners. This is a UK Act which is
also enforceable in Zambia because this country is a former British colony. Some of the
provisions of the Act are:
-
Partners are to share profits or losses equally.
Interest shall not be charged on partnership capital.
Interest shall not be charged on drawings.
(refer to a text book on business law for more information)
245
23.5 ADVANTAGES AND DISADVANTAGES OF PARTNERSHIP
Advantages:
Comparing a partnership to sole trading, the advantages of operating as a partnership are
as follows:
-
Business risks are spread among more than one person.
Partners will learn new skills from other partners
A partner may take leave while others remain working. A sole trader will have in
most cases close business to take a rest.
Capital resources could be larger because of so many persons contributing.
-
Disadvantages could be:
-
While risks are spread among many persons, some partners may feel
uncomfortable to share profits.
Disputes may arise on management issues and this may lead to partnership
closure.
A decision made by a partner in relation to business, is usually binding to other
partners. This means if a partner is being sued in relation to the business, other
partners are equally affected.
-
23.6 ACCOUNTING IN PARTNERSHIP
The accounting techniques in partnership are very similar to that of a sole trader.
Partnerships also keep books of prime entry and ledgers, but there are certain important
differences as shown in the table.
Item
Sole trader’s books
Partnership books
Capital Introduced
Capital account
Partners fixed capitals
accounts
Partners current accounts
Drawings and share Capital account
of profits
Division of profits Inapplicable – one
proprietor only
246
Income statement – shared,
appropriation section
23.7 PREPARING PARTNERSHIP FINANCIAL STATEMENTS
(i)
Income Statement
Income statement of sole trader and partnership are very much the same.
However, a partnership extends the income statement by including the
appropriation account.
The appropriation account of the income statement shows how profits and
entitlements to partnership are distributed.
N.B. Net profit in sole trader is all his and thus the whole amount is added to
capital in balance sheet.
For partnership profits there is need to show how profits are shared between
partners.
Expenses related to partners such as salaries, interest on capital and drawings are
treated as appropriations. However, similar expenses which related to others such
as employees will be treated as operating expenses in income statement.
Example 1
Banda and Bwalya have been in partnership just for one year.
-
They are sharing profits and losses equally.
They are entitled to 10% on capitals per annum. Banda and Bwalya have
K100,000 and K200,000 as capitals respectively
Banda is entitled to a salary of K3,000, and Bwalya K5,000.
Interest is charged on partners drawings. Banda is charged K2,000 and
Bwalya K1,500.
Drawings during the year were Banda K6,000 and Bwalya K5,000.
The net profit before the distribution as at 31.12.20X4 amounted to
K70,000 i.e. after preparing the income statement which is same as sole
trader.
247
Banda and Bwalya
Income Statement for the year ended 31.12.20X4
K
Net profit
Add: Interest on drawings
Banda
Bwalya
Less: Appropriations:
Salaries:
K
70,000
2,000
1,500
73,500
Banda
Bwalya
3,000
5,000
(8,000)
Interest on capitals:
Banda
Bwalya
Share of profits:
Banda ½
Bwalya ½
10,000
20,000
(30,000)
35,500
======
17,750
17,750
35,500
======
(ii)
Capital accounts
When a partnership is being set at the beginning, partners have to agree the
amount of capital contribution to introduce. This could be in form of cash or
other assets. Double entry would be:
DR.
CR.
Asset account (whatever asset)
Capital account of each partner separately
The capital will usually remain fixed for the duration of the business but could
change under the following circumstances:
248
-
When partners in the process of conducting business introduce further
capital.
When a partner retires and capital is withdrawn.
When assets are revalued.
Using example 1, the capital accounts presented in columnar would be:
Capital accounts
Dr.
Banda
Bwalya
K
Banda
K
Bal.
(iii)
Bwalya
Cr.
K
K
100,000 200,000
Current accounts
Current accounts are used to deal with regular transactions between the partners
and the firm.
These are matters that may not be dealt with in capital accounts. These may
include:
-
Share of profits
Interest on capital
Drawings
Interest on drawings
Partners salaries
For entitlements such as salaries, interest on capital and share of profits, Double
entry is:
DR.
CR.
Income Statement (Appropriation account)
Current Accounts of partners
For drawings
DR.
CR.
Current Accounts of partners
Cash book or Purchases account
For interest on drawings
DR.
CR.
Current accounts of Partners
Income statement (appropriation account)
Using example 1, current accounts would be:
Current Accounts
249
Dr.
Banda Bwalya
Drawings
6,000 5,000
Interest
on drawings 2,000
1,500
Balances c/d 22,750 36,250
30,750
42,750
Banda
Bwalya
10,000
3,000
17,750
20,000
5,000
17,750
30,750
Balances b/d 22,750
42,750
36,250
Interest
on capital
Salaries
Share of
Profits
Cr.
The balance of the current accounts at the end of each financial year will then
represent the amount of undrawn or withdrawn profits.
(iv)
-
A credit balance like in example represents amounts to be withdrawn by
partners i.e. the partners are payables to the firm.
-
A debit balance will represent partners have withdrawn more than their
entitlements, so they are receivables to the firm.
The balance sheet
Partnership balance sheet as far as non current and current assets are concerned
will be same as sole trader. The difference is under capital part.
Using example 1
Balance Sheet as at 31.12.20X4 (extract)
Financed by:
Capitals:
Banda
Bwalya
100,000
200,000
Current accounts: Banda
Bwalya
22,750
36,250
300,000
59,000
359,000
If one partner had finished with a debit balance in current account, the balance
will be shown in brackets in balance meaning it should be deducted.
23.8 Most examination questions specify
Capital and current accounts should be shown separately. Occasionally you may be faced
with a question specifying only one account for each partner. Such an account acts as a
capital and current account combined thus the term Fluctuating Capital.
In fluctuating capital, all entitlements are credited to capital accounts and drawings and
interest on drawing debited capital accounts. In this situation current accounts are
irrelevant. Therefore capital figures in balance will be inclusive of current account items
and will be changing from year to year.
250
Using example 1: Fluctuating capitals
Capital accounts
Dr.
Banda Bwalya
Banda
Balance
Interest
on capital
Salaries
Share of
Profits
Drawings
6,000
5,000
Interest
on drawings 2,000
1,500
Balances c/d 122,750 236,250
130,750 242,750
Bwalya
100,000 200,000
10,000
3,000
17,750
20,000
5,000
17,750
130,750
Balances b/d 122,750
242,750
236,250
The balance sheet will then only show capital accounts as follows:
Balance sheet as at 31.12.20X4 (Extract)
Financed by:
Capital accounts:
Banda
Bwalya
122,750
236,250
359,000
251
Cr.
CHAPTER SUMMARRY
Accounting for partnership is similar to that of sole trader in many respects, except that any
profit or loss needs to be allocated between partners.
Partners need to prepare a partnership agreement that will outline the roles and responsibilities of
each partner
EXERCISES
1.
Why do people want to form a Partnership?
2.
Some partnerships don’t bother drawing up a partnership agreement. How do the
partners in those partnerships know what rights and responsibilities they have?
3.
In the balance sheet of a partnership, how is a loan from a partner disclosed?
4.
Interest on a loan made by a partner is shown as appropriation of profit, not as an
expense. True or false?
5.
A and B are in partnership sharing profits and losses in the ratio 3:2.
Under the terms of the partnership agreement, the partners are entitled to interest on
capital at 5% per annum.
B is entitled to a salary of K4,500. Interest is charged on drawings at 5 percent per
annum and the amounts of interest are A K400 and B K300.
The net profit of the firm, before interests and salary for the year ended 30 June 20X7
was K25,800.
The partners capital at 1 July 20X6 were A K30,000 and B K10,000.
At 1 July 20X6, there was a credit balance of K1,280 on B’s current account while A’s
current account balance was K500 debit.
Drawings for the year to 30 June 20X7 amounted to K12,000 and K15,000 for A and B
respectively.
Required:
Prepare, for the year to 30 June 20X7:
(a)
(b)
The partnership appropriation account
The partners current account.
252
6.
X, Y and Z are in partnership business sharing profits and losses 4:1:3 respectively. The
firms trial balance as at 31 December 20X1, was as follows:
Dr.
K
Sales
Returns Inwards
Purchases
Carriage Inwards
Inventory 1 Jan. 20X1
Discounts allowed
Salaries and wages
Bad debts
Provision for doubtful debts
1 January 20X1
General expenses
Business rates
Postage
Computers at cost
Office equipment at cost
Provision for depreciation at
1 January 20X1:
Computers
Office equipment
Payables
Receivables
Cash at bank
Drawings:
X
Y
Z
Current accounts:
X
Y
Z
Capital accounts:
X
Y
Z
Cr.
K
334,618
10,200
196,239
3,100
68,127
190
54,117
1,620
950
1,017
2,900
845
8,400
5,700
3,600
2,900
36,480
51,320
5,214
39,000
16,000
28,000
5,940
2,117
_______
494,106
9,618
60,000
10,000
30,000
_______
494,106
Additional information
(i)
Inventory 31 December 20X1 K74,223
(ii)
Business rates paid in advance K200
(iii) Stock of postage stamps K68
(iv)
Increase provision for doubtful debts to K1,400
(v)
Partners salaries: Y K18,000, Z K14,000
(vi)
Interest on drawings: X K300, Y K200, Z K240
(vii) Interest on capital is at 8 percent per annum.
(viii) Depreciate computers by K2,800 and office equipment by K1,100.
253
Required:
Draw up a set of financial statements for the year ended 31 December 20X1.
SOLUTIONS TO EXERCISES
1.
The answer should include:
-
2.
The capital required is more than one person can provide.
The experience or ability required to manage the business cannot be found
in one person alone
Many people want to share management instead of doing everything on
their own.
In the absence of a partnership agreement, the Partnership Act 1890 governs the
situation and states that:
(a)
(b)
(c)
(d)
(e)
Profits and losses are to be shared equally
No interest is allowed on capital
No interest to be charged on drawings
Salaries are not allowed
Any loan by a partner or excess capital will attract interest of 5% per
annum.
3.
A loan from a partner is shown separately as a non current liability
4.
False. Interest on a loan is an expense charged against profit in income statement.
5.
(a)
Partnership appropriation account for the year ended 30 June
20X7.
K
K
Net profit 30.06.20X7
25,800
Add: Interest on drawings
A
400
B
300
700
26,500
Less: Appropriations:
Interest on capital
A
1,500
B
500
(2,000)
Salary
B
4,500
(4,500)
20,000
Share of profits
A3/5 12,000
B 2/5 8,000
20,000
254
(b)
Current Accounts
Dr.
A
Balance b/f
Drawings
Interest on
Drawings
Balances c/d
500
12,000 15,000
Balance b/d
6.
B
A
Balances b/f
1,280
Interest on
capital
1,500
Salary
Share of profits 12,000
Balance c/d
14,780
400
300
2,380
____________
14,780 15,800
-
2,800
Balance b/d
2,380
B
500
4,500
8,000
2,800
15,800
-
XYZ Income statement for the year ended 31 December 20X1
K
K
Sales
334,618
Less: Returns Inwards
(10,200)
324,418
Cost of sales:
Opening inventory
68,127
Purchases
196,239
Carriage inwards
3,100
267,466
Less: closing inventory
(74,223)
(193,243)
Gross profit
131,175
Less: Expenses
Discounts allowed
190
Salaries & wages
54,117
Bad debts (1620 + 450)
2,070
General expenses
1,017
Business rates (2,900 – 200)
2,700
Postage (845 – 68)
777
Depreciation: computers
2,800
Office equipment
1,100
(64,771)
Net profit
66,404
Interest on drawings: X
300
Y
200
Z
240
740
67,144
Less: appropriations:
Salaries
Y
18,000
255
Cr.
Z
14,000
(32,000)
Interest on capital:
X
Y
Z
4,800
800
2,400
(8,000)
Share of profits:
X 4/5
Y 1/8
Z 3/8
14,022
3,506
10,516
(27,144)
_
______
Current accounts
Dr.
X
Y
Balance
Drawings
Interest on
Drawings
Balances c/d
- 2,117
39,000 16,000
300
Z
200
3,876
39,300 22,193
Balance b/d
14,988
X
Y
- Balances
5,940
28,000 Salaries
Interest on
240 capital
4,800
7,957 Share of profits 13,572
Balances c/d 14,988
36,197
39,300
-
-
Balance b/d
Z Cr.
- 9,618
18,000 14,000
800 2,400
3,393 10,179
22,193 36,197
-
3,876
7,957
XYZ
Balance sheet as at 31 December 20X1
Non current assets
Cost
K
8,400
5,700
14,100
Computers
Office equipment
Current assets
Inventory 31.12.20X1 (74,223 + 68)
Receivables (51,320 – 1,400)
Prepayments
Cash at bank
Total assets
Financed by:
Capital accounts:
Dep.
K
6,400
4,000
10,400
N.B.V.
K
2,000
1,700
3,700
74,291
49,920
200
5,214
129,625
133,325
X
Y
Z
60,000
10,000
30,000
100,000
Current accounts:
X
Y
(14,988)
3,876
256
Z
7,957
(3,155)
Current liabilities
Payables
36,480
133,325
257
CHAPTER 24
ACCOUNTING FOR NON-PROFIT MAKING ORGANISATIONS
INTRODUCTION
This chapter is concerned with the preparation of financial statements of not profit making
organisations and whose objectives are to provide services to their members or the pursuit of one
or a number of activities rather than the earning of profit.
Since running organisations involves cash and other assets and liabilities, there’s need to also
keep records of all activities (transactions).
TOPICS
1
2
3
The receipts and payments account
Income and expenditure account
The balance sheet
LEARNING OBJECTIVES
After studying this chapter, the student should be able to:
-
explain the difference between receipts and payments accounts and the cash book and
how they are prepared.
prepare income and expenditure accounts
make appropriate entries relating to subscriptions, life membership and donation
calculate profit or loss on other activities and incorporate them into financial
statements.
differentiate the financial statements of an incorporated organization with the profit
making organisations.
24.1 NOT-FOR-PROFIT ORGANISATIONS
The main purpose of such organisations is to provide social amenities to its members
such as games of tennis, soccer, etc. They can also be charities to help people. They
exist not to make profits, thus the name not for profit making organisations.
They may be engaged in profit making activities, but profits arising from such is not
shared by members but ploughed back in the organisation to improve on services to
members.
The accounting system can be basic to complex depending on size of the organisation.
258
24.2 RECEIPTS AND PAYMENTS ACCOUNT
The receipts and payments account is effectively the cash book. It is a summary of cash
receipts and cash payments.
Smaller clubs and charities with no other assets (apart from cash) and no liabilities will
use the receipts and payments account as a financial statement. No balance sheet is
produced.
Example: receipts and payments account
ARMSTRONG Body Building Club
Receipts and payments account for the year ended
31 December 20X4
Receipts
Payments
K
Balance b/f
Subscriptions
Bar Sales
Donations
200
6,450
240
150
K
Bar purchases
Rental
Care takers wages
Printing & postage
Heat & light
Repairs
Balance c/d
_____
7,040
Balance b/d
N.B.
160
720
1,800
22
60
15
4,263
_____
7,040
4,263
The receipts side is same as debit and payments side credit of the cash
book.
Advantages and disadvantages of receipts and payments account:
Advantages
(a)
(b)
(c)
Very easy to prepare
Very easy to understand especially cash position
It is used as a basis for the preparation of the income and expenditure account
Disadvantages
(a)
(b)
(c)
(d)
Only accounts for cash. There could be other assets in use.
Does not account for any amounts paid in advance or owing.
Does not distinguish between capital and revenue expenditure
Does not account for depreciation of non current assets.
259
24.3 INCOME AND EXPENDITURE ACCOUNT
Organisations apart from cash asset may have other assets and liabilities. Therefore, the
receipts and payments account may be inadequate to be used as a financial statement,
because it does not show the other assets and liabilities.
The receipts and payments account does not also show whether the members
contributions are being used effectively.
(a)
(b)
To reveal a complete picture of assets and liabilities a Balance Sheet must be
prepared.
To show any increase or decrease in capital the income and expenditure account
is prepared.
24.4 TERMS USED IN COMPARISON WITH TRADING ORGANISATIONS
Profit making organisations
Not for profit making organisations
(i)
Cash book
Receipts and payments account
(ii)
Income statement
Income and expenditure account
(iii)
Profit or loss
Surplus or deficit
(iv)
Capital
Accumulated fund
Income and expenditure account is the same as income statement for trading
organisations.
The principals of matching or accruals concepts are applied to income and expenditure
accounts in the same way as for income statement in trading organisations.
24.5 TRADING ACTIVITIES WITHIN THE NOT-FOR- PROFIT ORGANISATION
The main source of income for non trading organisations is subscriptions from members.
However, they may engage in profit ventures like owning a bar.
In such a case a separate bar income statement will be prepared to determine profit or loss
arising from it, and transferred to income and expenditure account.
For other profit ventures such as dinner dance or fete income and expenses are netted and
the resultant profit or loss also transferred to income and expenditure account.
260
Example: Bar income statement.
Armstrong Body Building Club
Bar Income Statement
K
Bar Sales
Less cost of sales:
Bar opening inventory
Bar purchases
K
240
30
160
___
190
(80)
Less: Bar closing inventory
(110)
130
(70)
___
Less: Bar man’s wages
Net profit (transferred to income and
expenditure account)
60
24.6 Accumulated fund
In a trading organisation it is known as capital. In most cases it may not be given. It
should be calculated by identifying assets and liabilities given at a particular time . Thus:
Accumulated fund = Assets – Liabilities
Example: accumulated fund
The North East Rotary Club had the following assets and liabilities as at 1 January 20X1,
the beginning of the year.
Cash and Bank balances K210, Equipment at valuation K975, Subscriptions in arrears
K65, Subscriptions in advance K10, Owing to suppliers of competition prizes K58 and
Inventory of competition prizes K38.
Required:
Calculate the accumulated fund as at 1 January 20X1, to be included in balance sheet.
261
Solution:
Assets:
Cash and bank balance
Subscriptions in arrears
Equipment
Inventory of competition prizes
K
210
65
975
38
K
1288
Liabilities:
Subscriptions in advance
Owing to suppliers
10
58
68
1220
Accumulated fund at 1 January 20X1
24.7
Subscriptions
This may be the main source of income for not profit making organisations.
Subscription is an agreed amount each member must pay at regular intervals e.g. monthly
or annually. Members will enjoy facilities of the organisation at no cost, while non
members will have to pay high fees to use same facilities and sometimes may be denied
access even if they have money.
(a)
Subscriptions account
A subscription account is always maintained to show the amount collected,
amount not collected and amounts paid in advance.
N.B. Members who have not paid the subscriptions and their membership has
not lapsed are considered as receivables because they have not paid the institution
and yet they have been enjoying the services. This is called subscriptions in
arrears.
Subscriptions in arrears should be included as part of income (subscriptions) in
the year they are not paid and shown as current asset in the balance sheet.
Remember the matching or accruals concept. When they are paid the following
year, they should not be included into subscriptions for that year and are no longer
assets.
Example: Subscriptions
The North East Rotary Club had the following details relating to subscriptions for
the year 1 January 20X1 to 31 December 20X1.
Cash received from members during the year to 31 December 20X1 K1987.
On 1 January 20X1, some members still owed the club K65 for 20X0, and some
members had also not paid K85 for 20X1.
262
On 1 January 20X1, some members had paid in advance K10 in 20X0 for 20X1,
and also at 31 December 20X1, some members had paid K37 in advance for
20X2.
Required:
Show how the entries will be made in subscription account and then show amount
to be shown in income and expenditure account as subscriptions for 20X1.
Solution:
Step 1:Open subscription account and show the opening balances
Dr.
Subscription account
1 January 20X1 Bal. b/f
K
65
Cr.
K
1 January 20X1 Balance b/f 10
The amount of K65 appearing on the debit side is an asset. Money is for the club
though not yet paid. K10 is liability. Money is not yet for club though the club
has it.
Step 2: Upon receiving cash as subscriptions from members.
Dr. Cash account
Cr. Subscription account
Dr.
Subscription account
Cr.
1 January 20X1 Bal. b/f
K
65
Dr.
Cash account
Cr.
K
Subscriptions
K
1987
K
1 January 20X1 Balance b/f
10
Cash
1987
Step 3: Put in the closing balances for accruals and prepayments. The
balancing figure is subscription for 20X1.
263
Dr.
Subscription account
Cr.
K
65
K
1 January 20X1 Bal. b/f
1 January 20X1 Balance b/f
Income and expenditure
account (balancing figure) 1980
Cash
31 December Balance c/d
31 December Balance c/d
37
1987
2082
Balance b/d
85
10
85
2082
Balance b/d
37
K1980 will be credited to income and expenditure account.
The amount to be shown as income from subscriptions for 20X1 is K1980.
K85 will be shown in balance sheet under current assets as subscriptions in
arrears.
K37 will be shown in balance sheet under current liabilities as subscriptions in
advance.
In statement form it will be shown as:
K
Subscriptions received (cash)
Add: Subscription paid in advance 20X0
Subscription in arrears 20X1
K
1987
10
85
95
2082
Less: Subscriptions paid in advance 20X2
Subscriptions in arrears 20X0
37
65
(102)
1980
Activity 1
The following information relates to a Tennis Club.
20X1 subscriptions owing to the club at the start of 20X2 was K410
20X1 subscriptions received in cash by club during 20X2 was K370
20X2 subscriptions received during 20X2 K6730
20X3 subscriptions received during 20X2 K1180
20X2 subscriptions unpaid at end of 20X2 K470.
264
The club takes credit for subscriptions when it becomes due, but takes a prudent view
on overdue subscriptions. What amount is credited to the income and expenditure
account for the year 20X2.
24.8
Life Membership
Life membership means members pay a substantial amount now and enjoy the club
facilities for the rest of their lives. This amount should not be treated as subscription
income in the year it is paid, but should be spread over the life period of members.
A life membership account should be opened
Dr.
Cr.
Cash account
Life membership account
The balances on life membership will be shown in balance sheet as non current liability.
Life period could be estimated by the organisations based on may be age. In this way,
life membership will be treated the same way non current assets are treated with
depreciation.
If a member outlives life membership contribution, the organisation will decide whether
the members will continue paying or be exempted completely.
If a member dies before the life period, the remaining amount should be transferred to
accumulated fund (capital).
Some organisation may take advantage of life membership fund by investing it to
generate income in form of interest.
In this case the investment will remain fixed over a period of years and will be shown as
non current asset in balance sheet.
Annual interest generated on the investment will be considered as annual subscription
and credited to subscription account.
Example: Life membership
The old timers Bowling Club has introduced a life membership scheme for its members.
It is decided that life membership will be for five years i.e. any amounts received for life
membership will be spread over a period of five (5) years from year of payment.
At the start of the year ended 31 December 20X3, the amount on life membership
account stood at K7,480. Of this amount K1,850 should be treated as subscriptions for
the year 20X3.
During the year ended 31 December 20X3, some members had paid another K3,000 for
life membership.
Required:
Show how entries will be made in the subscriptions account and the life membership
account.
265
Dr.
Subscription account
Cr.
K
K
2450
Life membership
Dr.
Life membership account
Subscription
Balance c/d
K
2450 Balance
8030 Cash
____
10,480
Balance b/d
Cr.
K
7480
3000
_____
10,480
8030
Workings: 3,000 ÷ 5
= K600 per annum for new life members
+
1850 per annum for old life members
____
2450 amount deducted from life membership account and
credited to subscriptions account for 20X3.
K2450 will be added together with amounts received from members who pay on
annual basis. The total amount will then be shown in income and expenditure
account for 20X3.
The balance of K8030 in life membership account will be shown as non current
liability in balance sheet.
24.9
DONATIONS AND ENTRANCE FEES
(a)
Donations are amounts other well wishers may give an organisation
Donations in cash will be treated as income in the year the donation is made.
Double entry is:
Dr.
Cr.
- Cash account
- Donation account with cash
If donation is in form non current asset e.g. Van.
Dr.
Cr.
(b)
- Van account
- Accumulated fund
Entrance fees are amounts members may be requested to pay when they first join
the club. This amount is also treated as income in the year it is collected.
Dr.
Cr.
- Cash account with entrance fees
- Entrance fees with cash received.
266
The entrance fees account is at year end transferred to income and expenditure
account.
Dr.
Cr.
- Entrance fees account
- Income and expenditure account.
24.10 Accounting for the sale of investments and non current assets.
Just like trading organizations, non profit making organizations also sale non current
assets and investments.
Accounting treatment is basically the same where the disposal account is opened to
determine profit or loss arising from the sale.
The difference is on the treatment of profit or loss on sale.
Remember profit could be:
(i)
(ii)
Sales – cost (if asset is maintained at cost) or
Sales – Net book value (if asset is depreciated)
If profit or loss is made using (i) above, the profit or loss will be directly added or
subtracted – to or from accumulated fund in balance sheet.
If (ii) is used then profit or loss is shown in income and expenditure account.
Full worked example: Income and expenditure
The following is a summary of the receipts and payments of North East Rotary Club
during the year ended 31 December 20X1.
North East Rotary Club
Receipts and payments accounts for the year ended
31 December 20X1
Dr
K
Cash and bank balance
210
Sales of competition tickets 437
Members subscriptions
1987
Donations
177
Refund of rent
500
Balance c/d
13
____
3,324
K
Secretarial expenses
Rent
Visiting speakers expenses
Donations to charities
Prizes for competitions
Stationery & printing
Balance b/d
267
163
1402
1275
35
270
179
____
3,324
13
Cr.
The following valuations are also available:
As at 31 December
Equipment (original cost K1,420)
Subscriptions in arrears
Subscriptions in advance
Owing to suppliers of competition prizes
Inventory of competition prizes
20X0
K
975
65
10
58
38
20X1
K
780
85
37
68
46
Required:
(a)
(b)
Calculate the value of the accumulated fund of the club as at 1 January 20X1.
Reconstruct the following accounts for the year ended 31 December 20X1.
(i)
(ii)
(c)
the subscription account
the competition prizes account
Prepare an income and expenditure account for the club for the year ended 31
December 20X1 and a balance sheet as at that date.
Solution:
(a)
Accumulated fund
Assets:
Cash and bank balance
Subscriptions in arrears
Equipment
Inventory of competition prizes
K
210
65
975
38
K
1288
Liabilities:
Subscriptions in advance
Owing to suppliers
10
58
Accumulated fund at 1 January 20X1
(b)
(i)
68
1220
Subscription account
Dr.
Balance b/d
Income & exp.
account
Balance c/d
K
K Cr.
65
Balance b/d
Cash
10
1987
Balance c/d
85
2082
1980
37
2082
268
Competition prizes account
(ii)
Dr.
K
K Cr.
Balance b/d
Bank
38
270
Balance c/d
68
Balance b/d
Cost of prizes given to
income and expenditure
account (Bal. Fig)
Balances c/d
376
Balance b/d
46
58
272
46
376
Balance b/d
68
North East Rotary Club
Income and Expenditure account for the year
ended 31 December 20X1
K
Income
Subscriptions
Ticket sales
Less cost of prizes
Profit on competition
Donations
K
1980
437
(272)
165
177
2322
Expenditure
Secretarial expenses
Rent (1402 – 500)
Speakers expenses
Donations to charities
Stationery and printing
Depreciation
163
902
1275
35
179
195
(2749)
(427)
Deficit
269
North East Rotary Club
Balance sheet as at 31 December 20X1
Non current assets
Equipment
Cost
1420
Current assets
Inventory of prizes
Subscriptions in arrears
Dep.
640
N.B.V.
780
46
85
131
Total assets
911
Financed by:
K
1220
(427)
793
Accumulated fund at 1 January 20X1
Less deficit
Current liabilities
Payables for prizes
Subscriptions paid in advance
Bank overdraft
68
37
13
118
911
CHAPTER SUMMARY
-
The receipts and payments accounts only shows the cash position of the organization. It
is just a summary of cash receipts and payments. It may be the source of information for
the income and expenditure account.
-
The income and expenditure account is prepared to determine surplus (profit) or deficit
(loss). It is prepared on matching or accruals concept.
-
The main source of income for clubs is subscription. Subscription should be adjusted for
arrears and prepayments.
-
Accumulated fund is same as capital in trading organizations and is calculated thus
Assets – liabilities.
-
Any trading activities should be shown separately and profit or loss is what is shown in
income and expenditure or netting off within the income and expenditure account.
270
EXERCISES
1.
Identify three areas of difference between the accounts of a non trading organization and
that of a trading organization.
2.
If a “not for profit” organization makes a surplus it will be?
(a)
(b)
(c)
(d)
3.
A club has 150 members who pay K10 each for membership. The opening subscription
receivable was K70 and 5 members had paid subscriptions in advance at the year end.
How much money was collected from members?
(a)
(b)
(c)
(d)
4.
K1,500
K1,740
K1,620
K1,520
The assets and liabilities of a social club on 31.12.20X1 were equipment K1,500,
premises K16,000, bar inventory K1,300, bar payables K1,100, wages owing K250,
subscriptions in arrears K500, subscriptions prepaid K350, cash in hand K1,900. The
accumulated fund is:
(a)
(b)
(c)
(d)
5.
Credited to capital
Credited to accumulated fund
Shared among members
Kept in the bank account
K21,200
K19,650
K19,500
K200,000
The accounting records of Up Hill cricket club are given in the following trial balance as
at 31 December 20X4:
Dr.
Cr.
K
K
Clubhouse
140,000
Equipment
18,000
Profits from raffles
6,000
Accumulated fund
40,000
Bar inventory 1 January 20X4
9,000
General expenses
31,500
Wages of bar workers
30,000
Subscription received
190,000
Bar purchases
40,000
Caretakers wages
20,400
Bar sales
90,000
Cash in hand
900
Cricket professional’s salary
36,200
326,000
271
326,000
The following additional information is also available.
(i)
(ii)
(iii)
(iv)
The inventory in the bar at 31 December 20X4 was valued at K5,600
Depreciation on equipment should be at 131/3%.
All sales and purchases for the bar were on cash basis.
As at 31 December 20X4 some members had paid subscriptions in advance
amounting to K1,800 and some members were owing K700.
Required:
Prepare income and expenditure account for the year ended 31 December 20X4 and a
balance sheet as at that date.
272
SOLUTIONS TO ACTIVITY QUESTIONS
Activity 1
Subscriptions account
Dr.
Cr.
K
Balance b/f
410
Income & Expenditure
Account (balancing figure)
7,200
Balance c/d
1,180
Bank (370 + 6730 + 1180)
K
8,280
Subscriptions written off
40
Balance c/d
470
8,790
Balance b/d
8,790
470
Balance b/d
1,180
Note:
Subscriptions written off amounting to K40 is the difference between the subscriptions owing at
the start of the period amounting to K410 and the amounts received during the year in relation to
these subscriptions amounting to K370.
SOLUTIONS TO EXERCISES
1.
(i)
(ii)
(iii)
The capital account is the accumulated fund
The profit/loss is the surplus/deficit
The Income Statement is the income and expenditure account
2.
The correct answer is B.
3.
The correct answer is C.
Subscriptions account
Dr.
Cr.
K
Balance b/f
Subscriptions to (Income
& Expenditure) (150 x 10)
Balance c/d
70
K
1,620
Bank
1,500
50
1,620
Balance b/d
273
____
1,620
50
4.
The correct answer is C.
Assets
Equipment
Premises
Bar inventory
Subscriptions in arrears
Cash
K
1,500
16,000
1,300
500
1,900
Liabilities
Bar payables
Wages owing
Prepaid subscriptions
1,100
250
350
21,200
(1,700)
19,500
Accumulated fund
5.
K
Bar income statement for the year ended 31 December 20X4.
K
Bar sales
Cost of sales:
Bar opening inventory
Bar purchases
K
90,000
9,000
40,000
49,000
Less: bar closing inventory
5,600
Gross profit on bar
Less: wages of bar workers
(43,400)
46,600
(30,000)
Net profit
16,600
Up Hill Cricket Club
Income and Expenditure account for the year ended
31 December 20X4
Income
Subscriptions
Less subscriptions prepaid
Add subscriptions owing
K
190,000
(1,800)
700
K
188,900
16,600
6,000
211,500
Bar profits
Raffle profits
Expenditure
General expenses
Care takers wages
Salary for professionals
Depreciation: equipment
31,500
20,400
36,200
2,400
(90,500)
121,000
Surplus
274
Up Hill Cricket Club
Balance sheet as at 31 December 20X4
K
Cost
140,000
18,000
158,000
Non Current Assets
Club house
Equipment
Current Assets
Bar inventory
Subscriptions in arrears
Cash in hand
K
Dep.
2,400
2,400
K
N.B.V.
140,000
15,600
155,600
5,600
700
900
7,200
162,800
Financed by:
Accumulated fund @ start
Add: Surplus
40,000
121,000
161,000
Current liabilities
Subscriptions in advance
1,800
162,800
275
CHAPTER 25
INCOMPLETE RECORDS
INTRODUCTION
Sole traders do not often keep an elaborate set of books of accounts. The books they keep
comprise mainly a record of receipts and payments and file of unpaid invoices in the
correspondence file.
Even where an elaborate set of books is kept unexpected disasters such as fires may occur. As a
consequence the available books may contain insufficient information for the preparation of the
Income Statement and balance sheet. The owner of the business will ask for these statements at
the end of the year.
The above sample situations pose a challenge on the accountant to prepare the financial
statements from whatever records that are available.
TOPICS
1. Single entry bookkeeping
2. Incomplete records
3. Preparing Financial statements
LEARNING OBJECTIVES
After studying this chapter the student should be able to:
•
•
•
Explain the difference between single entry and incomplete records
Prepare a set of financial statements from a limited set of records
Prepare a set of records for an incomplete records situation
We will use the following question to illustrate the stages of compiling financial statements from
a set of limited records.
SINGLE ENTRY BOOKEEPING
Single entry is a generic term used to refer to a business situation in which only a limited number
of records are kept. Principally there is always a record of receipts and payments and some
documentary evidence of other transactions. Accounts can be compiled from the information
available by completing double entry for all the transactions that took place. Day books may not
have been prepared because the administration of the business does not yet have a defined
complete accounting system as such.
276
ILLUSTRATION FOR INCOMPLETE RECORDS
Joel Mutale is a sole trader and provides you with the following summarized data . He would like
you to prepare appropriate statements to show
1. Capital on 1 July 2004
2. Profit for the year ended 30 July 2005
3. A list of assets and liabilities as at 30 June 2005
RECEIPTS AND PAYMENTS
K 000
Cash receipts
Commision received
Trade Receivable
Cash sales
K 000
3 700
12 500
4 200
20 400
Cash Payments
Electricity
Rent and Rates
Drawings
Cash banked
1 580
3 640
1 200
6 000
(12 420)
7 980
3 000
10 980
Excess of receipts over payments
Add: Opening Balance
Closing Balance
Summary of transactions through the bank
K 000
K 000
RECEIPTS
Cash banked
Trade Receivables
6 000
42 870
48 870
PAYMENTS
Equipment
Insurance
Trade Payable
Loan Interest
Wages & Salaries
Stationery
5 520
909
34 000
700
8 300
2 700
(52 129)
(3 259)
(1 300)
4 559
Excess of payments over receipts
Add: Opening Balance
Closing Balance
277
The following additional notes were extracted from Joel’s correspondence box files:
As at
1 July 2004
K 000
8 200
3 200
10 000
420
300
6 300
3 800
Equipment
Inventory
Bank loan
Rates due
Rent prepaid
Electricity owing
Trade receivables
Trade payables
As at
30 June 2005
K 000
12 500
4 500
10 000
380
320
8 400
4 600
As you settle down to do work, Joel tell you that he pays loan interest at 12 % and there is an
amount that is not yet paid. He further say that during the year he received cash discounts of K
800 000, issued credit notes for K 450 000 and cancelled irrecoverable debts of K 325 000
SOLUTION
The following steps will help you to be methodical in your approach:
Steps:
1. Calculate the amount of capital by preparing an opening journal, listing assets and
liabilities separately. The liabilities are credit balances and so they are deducted from the
total of assets that are debit balances.
2. Draw up the ledger accounts in T form and put the opening balances in their right places:
on the debit side of an asset account and on the credit side of a liability account.
3. Leave space for current year entries (3 – 5 lines) and put in the closing balances: above
total lines on the debit side and below total lines on the credit side for liability accounts,
and on the credit side above total lines and on the debit side below total lines for asset
accounts.
4. The cashbook contains one entry of the double entry. Complete the second entry in the
ledger accounts by posting to the credit side if the entry is on the debit side of the cash
book account, or to the debit side if the entry is on the credit side of the cash book
account.
5. Care must be taken to open accounts for additional transfers of funds and completing
double entry for them. For example, amounts written off as bad are credited to Trade
Receivables account and debited to Bad debt account. Amounts returned by customers
are credited to Trade Receivables account and debited to Sales returns account. Amounts
allowed receipts from customers are debited to Discount allowed account and credited to
Trade Receivables account.
6. The balancing figure on each account represents the amount to be transferred to the
Income Statement, whereas the closing balance is the amount to report in the Balance
sheet.
The ledger accounts follow then the Income Statement and Balance Sheet finally. It is always
better to draw up nominal accounts on separate pages from the ones on which real and control
278
accounts are. Doing so will facilitate thoroughness in ensuring that no transfer to the Income
Statement is missed, and that work is properly organized.
TRADE RECEIVABLES
Balance b/d
Sales
K 000
6 300
59 045
Balance b/d
65 345
8 400
Bank
Sales Returns
Cash
Discount All
Bad Debts
Balance c/d
K 000
42 870
450
12 500
800
325
8 400
65 345
TRADE PAYABLES
K 000
Bank
34 000
Balance c/d
4 600
38 600
Balance b/d
Purchases
K 000
3 800
34 800
Balance b/d
38 600
4 600
P/L -Deprec
K 000
1 220
EQUIPMENT
Balance b/d
Bank
K 000
8 200
5 520
Balance b/d
13 720
12 500
Balance c/d
12 500
13 720
LOAN
K 000
Balance c/d
Balance b/d
K 000
10 000
Balance b/d
10 000
10 000
10 000
10 000
CAPITAL
K 000
Balance c/d
Balance b/d
K 000
4 880
Balance b/d
4 880
4 880
4 880
4 880
INVENTORY
Balance b/d
K 000
3 200
K 000
Trading c/d
3 200
279
3 200
3 200
PURCHASES
Trade Payables
K 000
34 800
K 000
Trading c/d
38 400
34 800
38 400
SALES RETURNS
Trade Receivable
K 000
450
K 000
Trading c/d
450
450
450
SALES
K 000
Cash
Trade Receivables
Trading c/d
63 245
63 245
K 000
4 200
59 045
63 245
BAD DEBTS
Balance b/d
K 000
325
K 000
P/L c/d
325
325
325
DISCOUNT ALLOWED
Trade Receivables
K 000
800
K 000
P/L c/d
800
800
800
DEPRECIATION
Equipment
K 000
1 220
K 000
P/L c/d
1 220
1 220
1 220
STATIONERY
Bank
K 000
2 700
K 000
P/L c/d
2 700
2 700
2 700
WAGES & SALARIES
Bank
K 000
8 300
K 000
P/L
8 300
280
c/d
8 300
8 300
LOAN INTEREST
Bank
Balance c/d
K 000
700
500
700
P/L c/d
K 000
1 200
Balance b/d
700
500
INSURANCE
K 000
909
Bank
K 000
P/L c/d
909
909
909
RENT & RATES
K 000
Bank
3 640
Balance b/d
3 640
380
Balance b/d
P/L c/d
Balance c/d
K 000
420
2 840
380
3 640
ELECTRICITY
K 000
Bank
Balance
c/d
1 580
320
1 900
Balance b/d
P/L c/d
K 000
300
1 600
Balance b/d
1 900
320
DRAWINGS
Bank
K 000
1 200
K 000
Capital c/d
1 200
1 200
1 200
COMMISSION
K 000
Bank
P/L c/d
3 700
3 700
K 000
3 700
3 700
The alternative to calculating cost of sales on the face of the Income Statement is writing the
following account:
COST OF SALES
Inventory b/d
Purchases
K 000
3 200
34 800
Inventory b/d
38 000
4 500
K 000
Trading (I/S)
Inventory c/d
281
33 500
4 500
38 000
COMMENTS
The full ledger accounts have been written here to illustrate how they would be drawn up in
practice. A student who has understood the principles of double entry would list the amounts
straight on the Income Statement, depending on whether the amount is earned/incurred or not.
For example, the amounts to charge as expenses in respect of Electricity and Rent & Rates are
shown below:
ELECTRICITY
Amount paid
1 580
Add: Amount owing at end
320 Incurred but not yet paid for
1 900
Less: Amounts owing at start 300 settled now but incurred last year
Profit & Loss charge
1 600 Incurred for this year only
RENT & RATES
Cash paid
3 640
Less: Amount owing at start 420 settled now but incurred last year
3 220
Less: Amounts prepaid at end 380 Not incurred but paid for
Profit & Loss charge
2 840 Incurred for this year only
The rationale flows because referring to the accounts, amounts on the same side are added,
whereas amounts on the opposite sides of an account are netted. This logic can be applied to any
account without exception. You only need to understand double entry and the format of ledger
accounts.
JOEL MUTALE
INCOME STATEMENT for the year ended 30 June 2005
K000
Sales (less Sales Returns)
Less: Cost of Sales
Gross Profit
Add: Income
Commission received
K000
62 795
33 500
29 295
3 700
32 995
Less: Expenses
Bad Debts
Discount Allowed
Depreciation
Electricity
Rent & Rates
Insurance
Loan Interest
Wages & Salaries
Stationery
325
800
1 220
1 600
2 840
909
1 200
8 300
2 700
19 894
13 101
Net Profit
282
Joel Mutale
BALANCE SHEET as at 30 June 2005
Km
Non current Assets:
Equipment
Km
12 500
Current Assets:
Inventory
Trade receivables
Rent & Rates
Cash at bank & in hand
4 500
8 400
380
10 980
24 260
36 760
Total assets
Capital
Balance at start
Add: Net Profit
4 880
13 101
Less: Drawings
1 200
16 781
Non current Liabilities:
Loan
Current Liabilities:
Trade Payables
Loan Interest
Electricity
Bank Overdraft
10 000
4 600
500
320
4 559
9 979
36 760
Note also that depreciation has been deducted directly from Equipment account because the
closing balance given for this account imply that non current assets are kept at their net book
value (not at cost, in which case there would be a separate account for Accumulated
depreciation).
INCOMPLETE RECORDS
An incomplete records situation presents a greater challenge than merely applying double entry
to transactions. The owner of the business may have not cared to keep any records and will rely
on his memory and a few source documents to provide figures for preparation of financial
statements. Sometimes the situation may be caused by an unexpected event such as fire or a
burglary.
To prepare financial statements from the limited information available you will have to derive
most figures either as balancing figures or as complementary figure after applying some ratios.
283
CHAPTER SUMMARY
You should by now have learnt that:
Understanding double entry is very important. You cannot correctly handle a question on
single entry without it.
2. The skill of writing ledger accounts should be perfected, otherwise the figure you derive for
transfer to the income statement will be incorrect
3. You should understand what a debit balance on an accounts represents and what a credit
balance on an account means, otherwise you will not list balances under the correct heading
on the balance sheet.
4. An incomplete records situation can be more involving than a single entry situation.
1.
284
EXERCISE
Mpomwa has been trading for the last five years. He has been using the front half of the house he
has rented as a shop, with the consent of the landlord. Mpomwa maintains no formal accounting
system for the purpose of recording business transactions. He, however, needs to calculate the
profit earned during the year 2006 for tax purposes.
The following is a summary of Mpomwa’s business bank account:
RECEIPTS:
Cash from customers
Sales of private motor car
Total
K000
48 120
650
48 770
PAYMENTS:
Cash paid to suppliers
Rent of entire premises
Wages of part-time staff
New counter and shelving
General expenses
Drawings
Total
32 890
2 400
760
800
3 650
5 870
46 370
The following additional information is obtained:
1.
2.
3.
4.
5.
6.
7.
8.
The landlord considers accommodation to be divided equally between private and
business use.
The fixtures and fittings in the shop were valued at K2 500 000 at the beginning of
the 2006. It is intended to depreciate fixed assets at 10% on the year end balance.
It was discovered that not all the cash received was banked. Wages for part-time staff
and general expenses amounting to K350 000 and K110 000 respectively were paid
direct from the till.
Inventory was valued at K2 560 000 at 31 December 2006 and estimated at K1 950
000 at the beginning of the year.
From files of invoices it was discovered that K960 000 was owed to suppliers at the
beginning of the year and $1 270 000 at the end of the year.
Cash at bank on 1 January amounted to K620 000.
There are just a few families to which Mpomwa allows credit. The owed him K170
000 on 1 January 2006 and K 210 000 at 21 December 2006.
Mpomwa took goods from the shop costing K320 000 for personal use during the
year.
REQUIRED:
(a)
(b)
(c)
A statement of affairs for the business at 1 January 2006
The Income Statement for the year ended 31 December 2006
The Balance Sheet as at 31 December 2006
285
SOLUTION TO EXERCISE
MPOMWA
Statement of affairs as at 1 January 2006
K000
Assets:
Fixtures
Inventory
Trade receivable
Bank
2 500
1 950
170
620
5 240
Liabilities:
Trade payables
Capital
960
4 280
CAPITAL
K 000
Balance c/d
Balance b/d
Bank
K 000
4 280
650
Balance b/d
4 930
4 930
4 930
4 930
CASH
K 000
Trade receivable
Wages
General Expenses
Bank
Balance c/d
48 580
48 580
K 000
350
110
48 120
48 580
Balance b/d
TRADE RECEIVABLES
Balance b/d
Sales
K 000
170
48 620
Balance b/d
48 580
210
Cash
Balance c/d
K 000
48 580
210
48 580
TRADE PAYABLES
K 000
Bank
32 890
Balance c/d
1 270
34 160
286
Balance b/d
Purchases
K 000
960
33 200
Balance b/d
34 160
1 270
FIXTURE S
Balance b/d
Bank
K 000
2 500
800
Balance b/d
3 300
3 300
K 000
Balance c/d
3 300
3 300
GENERAL EXPENSES
Bank
Cash
K 000
3 650
110
3 760
K 000
P/L c/d
3 760
3 760
RENT
K 000
Bank
Drawings
P/L c/d
2 400
3 640
K 000
1 200
1 200
3 640
WAGES
Bank
Cash
K 000
760
350
1 110
P/L c/d
K 000
1 110
1 110
DRAWINGS
Bank
Rent
Inventory
K 000
5 870
1 200
320
K 000
Capital c/d
7 390
7 390
7 390
MPOMWA
INCOME STATEMENT for the year ended 31 December 2006
K000
Sales (less Sales Returns)
Less: Cost of Sales
Gross Profit
Less: Expenses
Rent
Wages
General expenses
Depreciation
K000
48 620
32 270
16 350
1 200
1 110
3 760
330
6 400
9 950
Net Profit
287
MPOMWA
BALANCE SHEET as at 31 December 2006
K000
Non current Assets:
Fixtures
Less: Accumulated depreciation
K000
3 300
330
3 970
Current Assets:
Inventory
Trade receivables
Bank(620+48 770-46 370)
2 560
210
3 020
5 790
8 760
Total assets
Capital
Balance at start
Add: Net Profit
Less: Drawings
4 930
9 950
14 880
7 390
7 490
Non current Liabilities:
None
Current Liabilities:
Trade Payable
210
210
8 760
Working:
Cost of sales is calculated as follows:
Inventory at start
Purchases
1 950
33 200
35 150
Less: Inventory at end
Drawings
2 560
320
2 880
32 270
288
CHAPTER 26
CASHFLOW STATEMENTS
INTRODUCTION
Financial statements are a means of informing the users of financial information about
performance in terms of profitability or otherwise, and of the position in term of assets and
liabilities. They comprise the Income Statement, the Balance Sheet and the Cash flow Statement,
at the minimum. Other reports include a statement of accounting policies and the Operating and
Financial Review. Discussion of the last two statements is outside the scope of this syllabus.
In this chapter we discuss the contents of IAS 7 and the essence of preparing a cash flow
statement.
TOPICS
This chapter will discuss the following topics:
1. Why prepare the cashflow statements
2. Contents of the cashflow statement
3. Methods of preparing cashflow statements
4. How to prepare the cashflow statements
5. Summary
LEARNING OBJECTIVES
After studying this chapter the student should be able to:
• Explain the importance of the cash flow statement
• Prepare the cash flow statement for a single entity
THE CASH FLOW STATEMENT
The cashflow statement provides information about the sources of cash and the uses to which
cash was put for a specified period. Some writers refer to these as sources and applications of
cash. Admittedly the information on cash can be obtained from the cash and bank accounts in the
Cashbook. In practice the cash transactions are so numerous that it becomes tedious to obtain
cashflow information from the Cashbook. Consequently, the entries for cashflows are obtained
from individual ledger accounts where they are already summarised.
Cashflow statements also serve the following purposes:
1. To explain the difference between the reported profit or loss in the Income Statement
and the cash and bank balances reported in the balance sheet. The reported profit is
calculated under the accruals basis and so includes non cash items.
2. To communicate the solvency of the company: whether the entity has sufficient cash
resources to support continuity of business. Solvency is much more critical than mere
liquidity. Liquidity problems can be solved by borrowing whereas an insolvent company
cannot borrow funds from anywhere, having exhausted all possible means.
289
3. To serve as a source of information for making cash flow forecasts. Management can
make projections of future cash receipts and payments, having regard to proper timing of
cash.
4. The following are the key definitions:
Cash: Amounts of money received or paid in the form of notes or cheques in each
transaction.
Cashfow: The volume of cash that comes into and goes out of the business for a given
period of time.
Cash equivalents: These are financial instruments (bank drafts, loan notes, etc) that can
be used to pay for goods or settle liabilities.
Operating activities: These are business transactions which include trading activities
(buying and selling) and administrative activities that lead to either receipt or payment of
cash.
Investing activities: These are transactions that result in acquisition or disposal of non
current assets and investments.
Financing activities: These are transactions by means of which the business raises funds
of a capital nature. Examples include loans, finance leases, and issues of shares.
FORMATS OF CASHFLOW STATEMENTS
Cash flows are classified under three major headings in the cashflow statements: operating
activities, investing activities and financing activities. The format below outline the contents of a
cash flow statement as required by IAS 7.
Under the direct method cashflow figures are obtained from the ledger accounts for trade
receivables, trade payables and expenses. Depending on the information provided there might be
need to adjust the cashflow figure with amounts for non cash items such as depreciation and
increases/decreases in allowances for bad debts.
290
ABC Ltd
CASHFLOW STATEMENT (DIRECT METHOD)
for the year ended 31 December 2005
K000 K 000
Cashflow from Operating Activities:
Receipts from customers
Payments to suppliers
Payments for expenses
X
X
X
X
Adjustments for Non-cash items:
Depreciation
Loss on sale of non current assets
Decrease in provisions for bad debts
X
X
X
Net cashflow from Operating profit
X
X
Interest paid
Income tax
Dividends paid
Net cash from operating activities
X
X
X
X
Cashflow from Investing Activities:
Purchase of non current assets
Disposal of non current assets
Interest received
Dividend received
Short term investments
Net cash used in investing activities
Cashflow before financing
X
X
X
X
X
X
X
Cashflow from Financing Activities:
Issue of Share Capital
Share Premium
Issue of debentures (or Loan stock)
Finance Leases
Net cash used in financing
Increase/decrease in cash and cash equivalents
X
X
X
X
X
X
There are two methods of preparing cashflow statements: The direct method and the indirect
method. The difference between the two methods lies in the way cashflow from operating
activities is calculated.
291
ABC Ltd
CASHFLOW STATEMENT (INDIRECT METHOD)
for the year ended 31 December 2005
K000 K 000
Cashflow from Operating Activities:
Profit before tax
Adjustments for Non-cash items:
Depreciation
Loss on sale of non current assets
Decrease in provisions for bad debts
X
X
X
X
X
Changes in working capital:
Decrease in inventory
Increase in debtors
Increase in creditors
X
X
X
X
X
X
X
X
X
Net cashflow from operating profit
Interest paid
Income tax paid
Dividends paid
Net cash from operating activities
Cashflow from Investing Activities:
Purchase of non current assets
Disposal of non current assets
Short term investments
Interest received
Dividend received
Net cash used in investing activities
Cashflow before financing
X
X
X
X
X
X
X
Cashflow from Financing Activities:
Issue of Share Capital
Share Premium
Issue of debentures (or Loan stock)
Finance Leases
Net cash used in financing
X
X
X
X
X
Net increase/decrease in cash and cash equivalents
Cash and cash equivalents b/f
Cash and cash equivalents c/f
X
X
X
Under the indirect method operating activities is adjusted from the accruals figure to a pure
cashflow amount with non-cash items and movements in working capital. The rest of the
cashflow statement is prepared as is done under the direct method. You should be able to obtain
cashflow figures from the appropriate accounts by applying knowledge acquired in previous
chapters. The cashflow figure is the entry that goes to the account from either the cash account of
bank account.
We now use a question to illustrate how to prepare the cash flow statement.
292
ILLUSTRATION
The balance sheets of Prenodia Plc as at 30 June 2004 and 2005 and the summary income
Statement for the year ended 30 June 2005 were as follows:
Balance sheet as at 30 June
Non current Assets:
Premises
Less: Accumulated Depreciation
2004
Km Km
2005
Km Km
130
30
130
32
100
Plant & Machinery
Less: Accumulated Depreciation
70
17
98
80
23
53
Current Assets:
Inventory
Trade receivables
Short term investments
Cash at bank & in hand
25
16
-
69
224
100
36
Non current Liabilities:
10% Debentures
Current Liabilities:
Trade Payables
Income Tax
Proposed dividend
24
26
12
7
41
194
Total assets
Share Capital
Profits & loss reserve
57
100
40
136
140
20
40
19
7
12
22
8
14
38
194
293
44
224
Prenodia
Income Statement for the year ended 30 June 2005
Km
Sales
Less: Cost of Sales
Gross Profit
Less: Expenses
Sundry expenses
Interest payable
Loss on sale of non current assets
Depreciation –Premises
Depreciation –Plant
Km
173
96
77
24
2
1
2
16
45
32
2
34
(16)
18
(14)
4
Operating profit
Interest receivable
Profit before tax
Income Tax
Profit after tax
Proposed dividend
Retained profit for the year
ADDITIONAL INFORMATION
During the year a machine costing K15 was sold for K 4m. Depreciation on the machine had
accumulated to K10m.
REQUIRED
Prepare a cashflow statement for Prenodia Plc for the year ended 30 June 2005
294
SOLUTION
The following part of the cashflow statement can be done as a working in the notes to the
statement or it can be included on the main Cashflow Statement.
Direct method
Cash flow from Operating Activities:
Km
163
(92)
(45)
Receipts from customers
Payments to suppliers
Payments for expenses
Km
26
Adjustments for Non-cash items:
Depreciation
Loss on sale of non current assets
Interest payable (Has its own entry )
18
1
2
21
47
Net cash flow from Operating profit
Indirect method
Km Km
Cash flow from Operating Activities:
Profit before tax
Interest payable (Has its own entry on the statement)
Interest receivable (Has its own entry on the statement)
Adjustments for Non-cash items:
Depreciation (2 + 16)
Loss on sale of non current assets
Decrease in provisions for bad debts
34
2
(2)
18
1
19
Movements in working capital:
Decrease in inventory
Increase in trade receivables
Increase in trade payables
1
(10)
3
(6)
47
Net cash flow from operating profit
Net cash flow from operating profit has been calculated in different ways under the two methods.
Under the direct method the figure of expenses was obtained straight from the Income Statement
and so it is a figure after deducting depreciation and loss on disposal. Consequently it was
necessary to adjust for these non-cash items. Otherwise they would not have been added back to
net profit.
Under the indirect method interest was adjusted for because it is dealt with separately on the face
of the Cash flow Statement. This reversal was not necessary for interest receivable under the
direct method because it was not part of the expenses figure mentioned above.
The rest of the cashflow statement is completed in the same way under both methods as follows:
295
CASHFLOW STATEMENT (INDIRECT METHOD)
for the year ended 31 December 2005
Km
Cash flow from Operating Activities:
Profit after tax
Interest payable
Interest receivable
Adjustments for Non-cash items:
Depreciation (2 + 16)
Loss on sale of non current assets
Decrease in provisions for bad debts
Km
34
2
(2)
18
1
19
Movements in working capital:
Decrease in inventory
Increase in trade receivables
Increase in trade payables
1
(10)
3
(6)
47
2
(2)
(15)
(12)
20
Net cash flow from operating profit
Interest received
Interest paid
Income tax paid
Dividends paid
Net cash from operating activities
Cashflow from Investing Activities:
Purchase of machinery
Disposal of machinery
Short term investments
Net cash used in investing activities
Cashflow before financing
(25)
4
(12)
(33)
(13)
Cashflow from Financing Activities:
Issue of Share Capital
Share Premium
Issue of debentures (or Loan stock)
Net cash used in financing
Increase in cash and cash equivalents
20
20
7
The following are the steps to follow when obtaining cash flow figures from ledger accounts:
1. Write the account and, using the information in the balance sheet as at the end of the
preceding year, put the opening balance on the side it would appear depending on
whether it is an asset or a liability.
2. Using information from the balance sheet as at the end of the current year, insert the
closing balances on the account on the side they would be above total lines and below
total lines depending on whether they are assets or liabilities.
3. In between the two balances (enough space should have been left for this depending on
the expected number of entries) project ‘back wards’ the figure from the income
296
statement on the side it would be when the entry for the transfer of funds to the trading,
profit and loss was made.
4. Complete the account, slotting in the missing figure on the side with a smaller total. This
figure is the amount of cash flow, the entry from either the bank account or cash account.
The accounts are now shown below with the cashflow figure highlighted in bolt type.
TRADE RECEIVABLES
Balance B/d
Sales
Balance b/d
16
173
189
26
Bank
Balance c/d
163
26
189
INVENTORY (Cost of Sales)
Balance B/d
Purchases
Balance b/d
25
95
120
24
Trading (IS)
Balance c/d
96
24
120
Inventory
Balance c/d
95
0
95
PURCHASES
Trade Payables
95
95
TRADE PAYABLES
Bank
Balance c/d
92
22
114
Balance B/d
Purchases
19
95
Balance b/d
114
22
DIVIDEND
Bank
Balance c/d
12
14
26
Balance B/d
IS
12
14
Balance b/d
26
14
TAXATION
Bank
Balance c/d
15
8
23
Balance B/d
Income statement
7
16
Balance b/d
23
8
PLANT & MACHINERY
Balance B/d
Bank
Balance b/d
70
25
95
80
Disposal
Balance c/d
297
15
80
95
ACCUMULATED DEPRECIATION
Disposal
Balance B/d
10
23
33
Balance b/d
ISBalance b/d
17
16
33
23
P & M DISPOSAL
Plant & Machinery
15
Accumul Depreciation
Bank
IS-Profit & Loss
0
15
10
4
1
15
OTHER OBSERVATIONS
The cash flow from debentures is simply the difference between the closing balance and the
opening balance. There being an increase of K20m then this was a credit entry in the account
implying that the debit was in the bank account. The debit in the bank account represents a cash
inflow.
Similarly, there was no balance at start of the period on the Short-term investments. The account
shows a closing balance of K12m representing new investment. The balance is a debit on the
account implying that the credit was in the bank account. Therefore there was an outflow in
K12m.
CHAPTER SUMMARY
You should now have learnt that
ƒ Preparing a cashflow statement is important because the users of financial statements
need to know where cash resources came from and what uses they were put to in the past
year. This information would enable them to make reasonable cashflow forecasts as well
as other economic decisions.
ƒ The cashflow statement should be presented according to the format recommended in the
accounting standard (IAS7)
298
EXERCISES
QUESTION ONE
The balance sheet given below together with comparative figures are a for Tokozile Ltd, a
private company that has been operating for the last three years.
TOKOZILE LTD
BALANCE SHEET AS AT 30 JUNE
2006
K000
K000
Non current assets:
Property, plant & equip
2 800
Accumulated depreciation
(650)
2 150
Current assets:
Inventory
Trade receivables
Bank
1 100
540
120
2005
K000
2 100
(490)
1 610
850
470
1 320
1 760
Total assets
Equity and liabilities:
Ordinary share capita
Share premium
Retained earnings
3 910
l 2 200
260
400
2 930
1 600
865
Non current liabilities:
Loan notes
Current liabilities:
Trade payables
Bank overdraft
Taxation
K000
2 860
2 465
340
140
430
280
110
45
170
710
325
3 910
2 930
Additional information:
a) During the year the company sold a piece of equipment with a net book value of K
135,000 at a profit of K75,000.
b) Depreciation charged for the year ended 30 June 2006 was K220,000.
c) Interest paid during the year ended 30 June 2006 was K37,000.
d) Income tax paid during the year amounted to K 230,000.
e) The company paid no dividend in the year under review.
REQUIRED:
(a)
(b)
Calculate the operating profit of Tokozile Ltd for the year ended 30 June 2006
Prepare a cashflow statement for Tokozile Ltd for the year ended 30 June 2006 in
accordance with IAS 7 (revised).
299
QUESTION TWO
KONKOLA
INCOME STATEMENT for the year ended 31 March 2007
K000 K000
Revenue
2,150
Cost of sales
(1,250)
Gross profit
900
Distribution cost
98
Administration expenses
122
(220)
Operating profit
680
Profit on disposal of non current assets
12
Dividend received
14
Interest paid
(36)
(10)
Profit before tax
670
Taxation
(132)
Profit after tax
538
STATEMENT OF CHANGES IN EQUITY
SHARE
CAPITAL
K000
Balances at start (31/03/06)
1,100
Issues of shares
300
Profit for year
Dividend
Balance at end 31 March 2007
1,400
300
SHARE
PREMIUM
K000
260
60
320
RETAINED
PROFIT
K000
80
538
(98)
520
KONKOLA
BALANCE SHEET AS AT 31 JUNE
2006
K000
K000
Non current assets:
Furniture & Fittings
750
Accumulated depreciation (210)
540
Motor Vehicles at cost
780
Accumulated depreciation (305)
Non current liabilities:
Loan notes
Current liabilities:
Trade payables
Proposed dividend
Taxation
K000
930
(265)
665
475
90
1,105
615
574
(14)
535
170
1,370
456
792
452
1 175
2,280
Total assets
Equity and liabilities:
Ordinary share capital
Share premium
Retained earnings
K000
885
(350)
Investments at cost
Current assets:
Inventory
Trade receivables
Bank
2007
1,100
260
80
1,700
3,070
1 400
320
520
1,440
2,240
160
60
540
35
105
565
80
125
770
680
2,280
3,070
Additional information for the year to 31 March 2007:
a) Vehicles which had cost K145 000 were sold during the year when their net book
value was K 55,000.
b) There were no accruals or prepaid expenses at the end of the year.
REQUIRED:
a. Prepare a cashflow statement for Konkola for the year ended 31 March 2007
using the DIRECT method. Show any additional notes and reconciliation
required.
b. Explain briefly the usefulness of cashflow statements to external users
301
SOLUTION TO EXERCISES
SOLUTION ONE
CASHFLOW STATEMENT (INDIRECT METHOD)
for the year ended 30 June 2006
K000 K 000
Cash flow from Operating Activities:
Loss after tax
Adjustments for Non-cash items:
Depreciation
Loss on sale of non current assets
Decrease in provisions for bad debts
(88)
220
(75)
145
Movements in working capital:
Increase in inventory
Increase in trade receivables
Increase in trade payables
(250)
(70)
320
(00)
57
(37)
(230)
(210)
Net cash flow from operating profit
Interest paid
Income tax paid
Net cash from operating activities
Cash flow from Investing Activities:
Purchase of machinery
Disposal of machinery
Interest received
Net cash used in investing activities
Cash flow before financing
(895)
210
(00)
(685)
(895)
Cash flow from Financing Activities:
Issue of Share Capital
Share Premium
Loan notes
Net cash used in financing
Increase in cash and cash equivalents
600
260
200
1060
165
Proof:
Balance of cash /bank at start (overdraft)
Increase in cash (from cashflow statement)
Balance of cash/bank at end 30 June 2006
K000 K000
(45)
165
120
302
Workings:
Calculation of operating profit:
Retained profit at end –30 June 2006
Retained profit at end –30 June 2005
Loss for the year 2006
Add: Dividend
Taxation
Interest charge
Operating loss
400
865
(465)
340
37
(88)
Relevant Ledger accounts:
PROPERTY, PLANT & EQUIPMENT
Balance B/d
Bank
Balance b/d
210
895
2995
2800
Disposal
Balance c/d
195
2800
2995
ACCUMULATED DEPRECIATION
Disposal
Balance B/d
60
650
710
Balance b/d
IS-Depreciation
Balance b/d
490
220
710
650
P P & EQUIP DISPOSAL
Property, Plant, etc
195
IS-Profit & Loss
75
270
Accumul. Depreciation
Bank
60
210
000
270
TAXATION
Bank
Balance c/d
230
280
510
Balance B/d
Income Statement
Balance b/d
170
340
000
510
280
Note: Cost of plant sold is NBV + Depreciation, and the amount of tax charged to the
income statement of a balancing figure on the Income tax account.
303
SOLUTION TWO
Direct method
Cash flow from Operating Activities:
K000 K000
1,932
(1066)
(220)
646
Receipts from customers
Payments to suppliers
Payments for expenses
Adjustments for Non-cash items:
Depreciation -Furniture
Depreciation –Motor Vehicles
55
135
190
836
Net cash flow from Operating profit
TRADE RECEIVABLES
Balance B/d
Sales
Balance b/d
574
2,150
2,724
792
Bank
Balance c/d
1,932
792
2,724
INVENTORY (Cost of Sales)
Balance B/d
Purchases
Balance b/d
615
1,091
1,701
456
Trading (IS)
Balance c/d
1,250
456
1,701
Inventory
1,091
0000
1,091
PURCHASES
Trade Payables
1,091
1,091
TRADE PAYABLES
Bank
Balance c/d
1,066
565
1,631
Balance B/d
Purchases
Balance b/d
540
1,091
0000
1,631
565
Balance B/d
IS
35
98
Balance b/d
133
80
DIVIDEND
Bank
Balance c/d
53
80
133
TAXATION
Bank
Balance c/d
112
125
237
304
Balance B/d
Income statement
105
132
Balance b/d
237
125
MOTOR VEHICLE
Balance B/d
Bank
Balance b/d
780
250
1,030
885
Disposal
Balance c/d
145
885
1,030
ACCUMULATED DEPRECIATION -MV
Disposal
Balance B/d
90
350
440
Balance b/d
ISBalance b/d
305
135
440
350
P & M DISPOSAL -MV
Plant & Machinery
145
IS-Profit
12
157
Accumul Depreciation
Bank
90
67
000
157
FURNITURE & FITTINGS
Balance B/d
Bank
Balance b/d
750
180
930
930
Balance c/d
930
930
ACCUMULATED DEPRECIATION -FF
Balance B/d
265
265
Balance b/d
IS- Depreciat
Balance b/d
305
210
55
265
350
KONKOLA
CASHFLOW STATEMENT For the year ended 31 March 2007
K000 K000
Cashflow from Operating Activities:
Net cash flow from operating profit(W1)
Interest paid
Income tax paid
Dividends paid
Net cash from operating activities
Cashflow from Investing Activities:
Purchase of furniture
Purchase of motor vehicle
Disposal of motor vehicle
Purchase investments
Net cash used in investing activities
Cashflow before financing
836
(36)
(112)
(53)
635
(180)
(250)
67
(80)
(429)
206
Cashflow from Financing Activities:
Issue of Share Capital
Share Premium
Loan notes
Net cash from financing
Increase in cash and cash equivalents
300
60
(100)
260
466
Proof:
Balance of cash /bank at start (overdraft)
Increase in cash (from cashflow statement)
Balance of cash/bank at end 31 March 2007
K000 K000
(14)
466
452
306
CHAPTER 26
COMPANY ACCOUNTS
INTRODUCTION
A company can be defined as a business incorporated under company law by a group of
members known as shareholders. In this chapter we look at the preparation of financial
statements for internal use for Limited Companies. Guidance on the structure and content of the
financial statements is provided for in IAS 1: Preparation of Financial Statements.
TOPICS
1. Company finance
2. Classes of shares
3. Debentures
4. Issue of shares
5. Share capital structure
6. Preparation of financial statements
LEARNING OUTCOMES
At the end of the chapter, the student should be able to:
•
•
•
•
•
•
•
Explain sources of finance for companies.
Explain the classes of shares.
Explain debentures.
Explain the process of issuing shares.
Distinguish between a Bonus issue and a Rights issue.
Record the issue of shares at par value and at a premium.
Explain the following share capital structure terms: Authorised, Issued, Called up, Paid up,
Calls in arrears and Calls in advance.
• Prepare the Income Statement and Balance Sheet for a company.
26.1
Company finance
Generally, the finances of a company are raised from two main sources: the
shareholders (through the share capital) and outside lenders of finance (debentures
holders).
26.2
Classes of Share Capital
The ownership of a company is through shares. Share capital represents part of the
capital invested in the company by its shareholders but may also represent past
reserves of the company, which have been capitalised by an issue of the shares.
A company may issue different classes of shares, the most common are being the
following:
307
a) Ordinary shares
These are the normal shares issued by the company. The normal rights of ordinary
shareholders are to vote at company meetings and to receive dividends from the
remainder of profits.
b) Preference shares
These are shares carrying a fixed rate of dividend, the shareholders of which have a
prior claim to any company profits for distribution. Preference shares do not carry
a voting right. Preference shares could either be cumulative or non-cumulative.
26.3
Debentures
This is a written acknowledgement of a loan to a company, given under the
company's seal, which carries a fixed rate of interest. The conditions and regulations
of the debenture are set out in a debenture trust deed.
Debentures are not part of the company's share capital - they are third party liabilities.
Debenture interest is a charge against profit and must be paid whether or not a company
makes profit.
26.4
Issue of Shares
A company raises capital by issue of shares. The process of issuing shares is the same
whether it is a newly formed company issuing shares for the first time or an established
company asking for more capital to extend its operations.
Each share issued has a stated nominal value (also called a par value), for example
20 000 shares of K1 each, the K1 per share is the nominal value. Shares could be issued
at par value or at a premium. The double entry for recording the issue of shares is as
follows:
a) Shares issued at nominal value
Dr - Cash book
Cr - Share capital account
For example, suppose 100 000 ordinary shares of K1 each are issued at nominal value.
The ledger accounts recording this issue will be as shown below:
Bank account
___________________________________________________________________
K'000
K'000
Ordinary share capital
100
Ordinary share capital account
___________________________________________________________________
K'000
K'000
Bank
100
308
b) Shares issued at a premium
Dr - Cash book
Cr - Share capital account, with nominal value
Cr - Share premium account, with excess over the nominal value
For example 100 000 ordinary shares of K1 each are issued at a price of K1.20 each.
The ledger accounts to record the issue will be:
Bank account
___________________________________________________________________
K'000
K'000
Ordinary share capital
120
Ordinary share capital account
___________________________________________________________________
K'000
K'000
Bank
100
Share premium account
___________________________________________________________________
K'000
K'000
Bank
20
26.4.1 Bonus issue
A bonus issue also called a Script or Capitalisation issue represents the issue of shares to
the existing shareholders in proportion to their existing holding. No cash or other
consideration is passed from shareholders to the company. Any reserve may be used to
finance the bonus issue.
The double entry for a bonus issue is:
Dr - Reserves
Cr - Share capital, with the amount of bonus issue
26.4.2 Rights issue
A rights issue represents the offer of shares to existing shareholders in proportion to
their existing holdings at a stated price. Unlike the bonus issue, the shareholders do not
have to take up their offer and have the alternative of selling their rights on the stock
market.
309
The double entry for recording a rights issue is:
Dr - Cash book
Cr - Share capital, with nominal value
Cr - Share premium, with the premium (if any)
26.5
Share Capital Structure
The share capital structure is as follows:
i)
Authorised share capital: - is the maximum share capital that a company is allowed
to issue. It is also known as the Nominal capital.
ii)
Issued share capital: - is the actual share capital issued to shareholders at any point in
time. It is the issued share capital that appears on the company's balance sheet.
iii)
Called up share capital: - is part of the nominal value payable on each share that has
been called for. However most capital is issued on a fully paid up basis.
iv)
Paid-up share capital: - is that part of the nominal value that is paid at current date.
v)
Calls in arrears: - is the amount requested for (called for) but not yet received.
vi)
Calls in advance: - is the amount received prior to payment being requested.
ACTIVITY 1
Hightech Ltd was formed with the legal right to be able issue 100 000 shares of K100 each.
The company has actually issued 80 000 shares. None of these shares have been fully paid up.
So far the company has made calls of K60 per share. All the calls have been paid by
shareholders except for K200 000 unpaid by one shareholder.
Calculate the following:
a) Authorised share capital
b) Issued share capital
c) Called up share capital
d) Paid up share capital
e) Calls in arrears
310
26.6
Financial statements for companies
The Income Statement and the Balance Sheet for limited companies are drawn in a
similar manner as to that of a sole trader and the partnership. The main differences
in the financial statements of a company are:
i) The income statement
The income statement has an extra section called an Appropriation Account that
shows how the profits are distributed or used by a company. The following items are
found in this section:
a) Income tax: this is a tax levied as a percentage of the taxable profits. Income tax is
not an expense but an appropriation of profits by the government. It is deducted
separately immediately after net profit. Income tax is an estimate of the tax liability
and is normally paid some months after the end of the accounting period. It is
therefore shown as a current liability in the balance sheet before it is paid.
b) Dividends: A dividend is a return of part of the profits made by a company to the
shareholders. Dividends can be stated as a percentage of the nominal value of the
share or alternatively as an amount per share. For example: K100 000 dividends on
1 000 shares of K1 000 per share can be expressed as a dividend of 10% per share
or K100 per share.
The directors of the company as part of their responsibility can declare an interim
dividend during the accounting period on the account of the total dividend of the
year. The balance after an interim dividend is paid will be declared at the general
meeting upon recommendation from the directors as a final dividend.
The double entry bookkeeping for both the interim dividend and final dividend is as
follows:
For the interim dividend
Dr - Dividend account
Cr - Cash book
For the final dividend
Dr - Profit and loss account
Cr - Proposed dividends account
The total of the interim dividend and the final dividend appear in the income
statement but it is only the final proposed dividend that will appear in the balance
sheet as a liability.
c) Transfers to reserves: A reserve is a profit set aside for a particular purpose. For
example a fixed asset replacement reserve used to set aside profits for replacing fixed
assets during a period of rising prices.
There are two types of reserves namely:
a) Capital reserve
b) Revenue reserve
311
Capital reserves (also known as statutory reserves) are established by law. They
include share premium, Capital Redemption Reserve and Revaluation Reserve. Capital
reserves can not be distributed to shareholders as dividends. The share premium
account, which arises on issue of shares, as shown under issue of shares above can be
used for the following purposes:
-
financing the issue of fully paid bonus shares
writing off preliminary expenses on the formation of a company
writing off expenses, commission or discount on share or debenture issue
providing the premium on the redemption of debentures and on redeemable of
shares
Revenue reserves arise when a company makes profits and does not pay out all the
profits to the shareholders. There is no statutory requirement for a company to have
any amount in its revenue reserve. Revenue reserves can be used for any purpose by
the company. However, where profits are transferred to a named reserve, the directors
are indicating that these amounts are not available to support a dividend payment
(although there is nothing in law to prevent their distribution). Revenue reserves
include, fixed assets replacement reserve, general reserve, profit and loss account
(reserve) etc.
ii) The balance sheet
The main difference in the balance sheet of a limited company as compared to that of sole
traders and partnerships lies in the capital section. The capital section of a company is
made up of shareholders' funds, which comprise, share capital and reserves.
Example:
You are provided with the following Trial Balance of Hightech Ltd at 31st December
2006:
Dr
Cr
K'000
K'000
Ordinary share capital (K1 000 shares)
400 000
10% preference share capital (K1 000 shares)
120 000
Freehold Premises at cost
920 000
Provision for depreciation - buildings
400 000
Plant and machinery (cost K300 million)
180 000
Sales
364 000
Purchases
196 000
Carriage inwards
4 000
Receivables and Payables
64 000
8 000
Cash at bank
60 000
40 000
Inventory at 1st January 2006
Discounts
1 600
800
Carriage outwards
3 200
10% debentures 2010
200 000
Debenture interest paid
20 000
Administrative expenses
16 000
Staff salaries (excluding directors)
16 000
Preference dividend paid
4 000
Profit and loss account b/d
32 000
1 524 800
1 524 800
312
Adjustments are required for:
1. Inventory at 31st December 2004, at cost K60 000 000.
2. Directors' salaries not yet paid K20 000 000.
3. Income tax for the year K8 600 000.
4. Proposed ordinary dividend K10 per share.
5. Depreciation on buildings for the year K18 400 000 and plant and machinery is to be
depreciated at 10% on cost.
6. Accrued audit fee K4 000 000.
7. Creation of a plant replacement reserve of K4 000 000.
You are required to prepare the Income Statement for the year ended 31st December 2006 and a
Balance Sheet as at that date.
SOLUTION
Hightech Ltd
Income statement for the year ended 31st December 2006
K’000
Sales revenue
Opening inventory
40 000
Purchases
196 000
Carriage inwards
4 000
240 000
Less: closing inventory
60 000
Cost of sales
Gross profit
Add Gains:
Discount received
Total income
Less Expenses:
Discount allowed
1 600
Carriage outwards
3 200
Administrative expenses
16 000
Staff salaries
16 000
Directors' salaries accrued
20 000
Audit fee accrued
4 000
Depreciation: - buildings
18 400
- Plant and machinery
30 000
Debenture interest
20 000
Total expenses
Net profit before tax
Less: Income tax
Net profit after tax
Transfer to plant replacement reserve
4 000
Dividends: - Preference (paid)
4 000
- Preference (proposed)
8 000
- Ordinary (proposed)
4 000
K’000
364 000
180 000
184 000
800
184 800
129 200
55 600
8 600
47 000
20 000
27 000
32 000
59 000
Retained profit for the year
Retained earnings b/d
Retained earnings c/d
313
Hightech Ltd
Balance sheet as at 31st December 2006
Non current assets:
Freehold land and buildings
Plant and machinery
Cost
K’000
920 000
300 000
1 220 000
Current assets:
Inventory
Receivables
Cash at bank
Dep.
K’000
418 400
150 000
598 400
Value
K’000
501 600
150 000
651 600
60 000
64 000
60 000
184 000
835 600
Total assets
Capital and reserves:
Ordinary share capital
10% preference share capital
Plant replacement reserve
Accumulated profit
400 000
120 000
4 000
59 000
583 000
Non-current liabilities
10% debentures 2009
200 000
Current liabilities
Payables
Taxation
Dividends payable (4 000 + 8 000)
Accruals (20 000 + 4 000)
8 000
8 600
12 000
24 000
52 600
835 600
Total Equity and liabilities
CHAPTER SUMMARY
The chapter started by looking at the financing of limited companies which is mainly by share
capital and third party liabilities. It has also been noted that dividends are a means of distributing
profits to shareholders, while income tax is an appropriation of profits by the government.
Profits undistributed are retained in the business by means of reserves.
The chapter has also looked at the preparation of financial statements for internal use in a
company.
314
EXERCISES
QUESTION ONE
You are presented with the following summarised Trial Balance of MK Ltd in respect of the
year ended 31st March 2007:
Dr
Cr
K'000
K'000
Ordinary share capital (K500 shares)
200 000
Plant and machinery:
Cost
616 000
st
Depreciation (1 April 2006)
170 000
Receivables
104 000
Payables
76 000
Cash at bank
82 000
180 000
Inventory at 1st April 2006
Sales
2 000 000
Purchases
1 542 000
9% debentures 2010
150 000
Share premium account
40 000
Administrative costs
200 000
Provision for doubtful debts
4 000
Interim dividends paid
6 000
Profit and loss account balance
90 000
2 730 000
2 730 000
The following final adjustments are required:
1.
2.
3.
4.
5.
The allowance for bad debts is to be adjusted to 5% of the receivables figure.
Income tax on the current year profits is estimated at K62 400 000.
The directors propose a final dividend of K60 per share.
Depreciation at 10% of cost of plant and machinery is to be provided.
Debenture interest for the year ended 31st March 2007 was paid on 1st April 2007. No
accrual has been made.
6. Inventory at 31st March 2007 was valued at K122 000.
You are required to prepare the Income Statement account for the year ended 31st March 2007
and a Balance Sheet as at that date.
315
QUESTION TWO
The following Trial Balance was extracted from the books of Hillside Plc at 31st March 2006:
K’000
K1 000 ordinary shares
8% K1 000 preference shares
7% debentures
Land and buildings: cost
Accumulated depreciation on buildings on 1st April 2005
Plant and machinery (K348 million cost)
Motor vans at cost
Accumulated depreciation on vans on 1st April 2005
Profit and loss account b/f
Share premium account
Inventory at 1st April 2005
Sales
Trade Receivables and Payables
Bank
Purchases
Distribution costs
General administration expenses
Debenture interest
Interim dividends:
Ordinary
Preference
Allowance for doubtful debts
K’000
200 000
70 000
100 000
130 000
30 000
262 500
140 000
56 800
20 000
60 200
35 000
45 000
5 800
166 100
18 000
44 900
7 000
344 600
27 000
10 000
2 800
890 100
1 500
890 100
Additional information available:
1. During the year the following transpired in relation to motor vans:
a) A new motor van was purchased on 1st January 2006 on credit for K24 million. The
amount was still due to the supplier on 31st March 2006.
b) A motor van which had cost K16 million four years ago when new was sold for
K6.6 million. The proceeds from the sale had not yet been received on 31st March
2006.
None of the above matters had been recorded in the books of the company.
2. Depreciation on motor vans has been and is to be provided at the rate of 20% per annum on
cost and is charged in full in the year of acquisition and none in the year of disposal.
3. The cost of buildings is K100 million.
4. Depreciation on buildings, and plant and machinery is to be charged as follows:
Buildings
2% on cost
Plant and machinery
10% on cost
5. On 31st March 2006 the company issued bonus shares to the ordinary shareholders on a one
(1) to ten (10) basis. No entry relating to this has yet been made in the books.
316
6. Inventory at 31st March 2006 was valued at K51 million.
7. A bill for administrative expenses for K150 000 was unsettled as at 31st March 2006.
8. Distribution costs include an insurance premium for delivery vans of K200 000 which relates
to the period 1st July 2005 to 30th June 2006.
9. The allowance for doubtful debts is to be 21/2% of receivables outstanding on 31st March
2006.
10. The directors wish to provide for:
a) A final ordinary dividend of 5%
b) A final preference dividend.
11. Income tax for the year is estimated at K18 million.
Required:
a) Using additional information (1) and (2), prepare the following ledger accounts:
i) Motor van account
ii) Motor van accumulated depreciation account
iii) Motor van disposal account
(7 marks)
b) Prepare the company’s Income Statement for the year ended 31st March 2006.
(11 marks)
c) Prepare the company’s Balance Sheet as at 31st March 2006.
(14 marks)
(NATech: December 2006)
317
SOLUTIONS TO EXERCISES
SOLUTION ONE
MK Ltd
Income statement for the year ended 31st March 2007
K’000
Sales revenue
Opening inventory
Purchases
K’000
2 000 000
180 000
1 542 000
1 722 000
122 000
Less: closing inventory
Cost of sales
Gross profit
Less Expenses:
Administrative expenses
Increase in allowance for doubtful debts
Debenture interest accrued (9% x 150 000)
Depreciation on Plant and machinery
Total expenses
Net profit before tax
Less: Income tax
Net profit after tax
Dividends: - interim
- proposed
1 600 000
400 000
200 000
1 200
13 500
61 600
276 300
123 700
62 400
61 300
6 000
24 000
30 000
31 300
90 000
121 300
Retained profit for the year
Retained earnings b/d
Retained earnings c/d
318
MK Ltd
Balance sheet as at 31st March 2007
Cost
K’000
616 000
Non current assets:
Plant and machinery
Current assets:
Inventory
Receivables (104 000 – 5 200)
Cash at bank
Dep.
K’000
231 600
Value
K’000
384 400
122 000
98 800
82 000
302 800
687 200
Total assets
Capital and reserves:
Ordinary share capital
Share premium account
Accumulated profit
200 000
4 000
121 300
361 300
Non-current liabilities
9% debentures 2009
150 000
Current liabilities
Payables
Taxation
Dividends payable
Accruals
76 000
62 400
24 000
13 500
175 900
687 200
Total Equity and liabilities
SOLUTION TWO
a) i)
Balance b/d
Payable
ii)
iii)
Motor Van Account
K’000
140 000
Disposal
Balance c/d
24 000
164 000
K’000
16 000
148 000
164 000
Motor Van Accumulated Depreciation Account
K’000
Disposal (16 000 x 20% x 4) 12 800
Balance b/d
I. S. (148 000 x 20%)
Balance c/d
73 600
86 400
K’000
56 800
29 600
86 400
Motor Van Disposal Account
K’000
Motor van
16 000
Accumulated dep.
Income statement (bal. fig.) 3 400
Disposal proceeds
19 400
K’000
12 800
6 600
19 400
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b)
Hillside Plc
Income statement for the year ended 31st March 2006.
K’000
Sales revenue
Opening inventory
35 000
Purchases
166 100
201 100
Less: closing inventory
51 000
Cost of sales
Gross profit
Add: Gains:
Profit on disposal
3 400
Decrease in allowance for doubtful debts
300
Total income
Less: expenses:
Distribution costs (18 000 – 50)
General administration expenses (44 900 + 150)
Debenture interest
Depreciation: - Buildings
- Plant and machinery
- Motor van
Profit before taxation
Less: Income tax
Profit after taxation
Less: appropriations:
Dividends: interim – ordinary
- preference
Proposed – ordinary (5% x 220 000)
- preference
K’000
344 600
150 100
194 500
3 700
198 200
17 950
45 050
7 000
2 000
34 800
29 600
136 400
61 800
18 000
43 800
10 000
2 800
11 000
2 800
26 600
17 200
(20 000)
(2 800)
Retained profit for the year
Retained earnings brought forward
Retained earnings carried forward
320
c)
Hillside Plc
Balance Sheet as at 31st March 2006.
COST
K’000
130 000
348 000
148 000
626 000
Non-current Assets:
Land and buildings
Plant and machinery
Motor van
Current Assets:
Inventory
Trade receivables
Less: allowance for doubtful debts
DEP.
K’000
32 000
120 300
73 600
225 700
NBV
K’000
98 000
227 700
74 400
400 100
51 000
48 000
1 200
46 800
6 600
5 800
50
Receivable for the motor van
Bank
Prepayment
110 250
510 350
Total assets
Capital and reserves:
Ordinary share capital (200 000 + 20 000)
8% preference share capital
Share premium account (60 200 – 20 000)
Accumulated profit
220 000
70 000
40 200
(2 800)
327 400
Non-current liabilities:
7% debentures
100 000
Current liabilities:
Trade payables
Creditor for the motor van
Taxation
Dividends payable - preference
- ordinary
Accrual
10 000
24 000
18 000
2 800
11 000
150
82 950
510 350
Total Equity and liabilities
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CHAPTER 27
ACCOUNTING CONCEPTS AND PRINCIPLES
INTRODUCTION
This chapter looks at the accounting concepts and principles which underlie the preparation of
financial statements. Some of these concepts have already been explained in the previous
chapters.
TOPICS
1. Nature and purpose of Accounting Concepts
2. Accounting concepts and conventions
3. International Accounting Standards (IAS)
LEARNING OUTCOMES
After studying this chapter, the student should be able to:
- explain the nature and purpose of accounting concepts
- Explain a number of Accounting Conventions and Concepts
- Explain International Accounting Standards (IAS)
27.1
Nature and Purpose of Accounting Conventions
Accounting conventions are principles or accepted practice which apply generally to
transactions. Some conventions are of more relevance to some transactions than to
others, but all have an influence in determining:
•
•
•
•
27.2
Which assets and liabilities are recorded on a balance sheet
How assets and liabilities are valued
What income and expenditure is recorded in the income statement
At what amount income and expenditure is recorded
ACCOUNTING CONCEPTS
Accounting concepts are the broad assumptions which underline the periodic
financial accounts of business enterprises. Assumptions mean that:
- These concepts are not necessarily obvious, nor are the only concepts which could
be used, but they the ones in use currently.
- These concepts look at why certain items are treated in specific ways and
- Where there’s a choice of treatment, how to decide which treatment to use.
- National legal requirements
- National accounting standards
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27.3
THE CONCEPTS
The International Accounting Standards (IAS) 1 – Preparation of Financial Statements
lists a number of accounting principles and conventions that must be followed when
preparing financial statements. The major accounting concepts that must be followed
are:
a) Fair Presentation
b) Going Concern
c) Accruals
d) Consistency
a) Fair Presentation
Fair presentation requires the faithful representation of the effects of transactions,
other events and conditions in accordance with the definitions and recognition
criteria for assets, liabilities, income and expenses.
b) Going Concern Concept
This states that the business will continue in operational existence for the
foreseeable future, and that there is no intention to put the company into
liquidation, unless otherwise it is known.
c) The Accruals/Matching Concept
This states that, in computing profits, revenue earned must be matched against the
expenditure or incurred in earning it.
d) The Consistency Concept
This states that in preparing accounts consistency should be observed i.e. certain
items should be treated using different methods, the method chosen should be used
consistently from one year to the next so that reasonable conclusions can be made
on the performance of the business, for example Depreciation, Stock Valuations.
OTHER CONCEPTS
e) Prudence Concept
This states that where alternative procedures or alternative valuations, are possible,
the one selected should be the one which gives the most cautious presentation of
the business financial position or results.
f) The Business Entity Concept
This concept states that a business and the owner should be treated separately.
g) Money Measurement Concept
This states that accounts should deal only with items to which a monetary value
can be attributed.
h) The Separate Valuation Principle
This states that in determining the amount to be attributed to an asset or a liability
in the balance sheet, each component item of the asset or liability must be valued
separately.
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i) The Materiality Concept
This is judgemental depending on the nature and size of the business.
A matter is material if its omission or misstatement would reasonably influence the
decisions of a user of the accounts.
j) Substance Over Form
It can happen that the legal form of a transaction can differ from its real substance,
where this happens accounting should show the transaction in accordance with its
real substance e.g. goods bought on hire purchase.
k) Neutrality/Objective Concept
This states that accountants should be free from bias when preparing financial
statements e.g. internally generated goodwill should not be recorded in the books
because of its uncertainty as to its true value.
l) The Accounting Period Concept
This states that there must be a standard shorter period in which to measure
performance of a business. Twelve months period is normally adopted for this
purpose. This time interval is the accounting period.
m) The Realisation Concept
This states that profits are realized immediately goods or services exchange hands
whether cash has been paid or not.
n) The Historical Cost Concept
This state that assets should be recorded in the accounting books at cost i.e. price
paid to acquire it. These assets are systematically reduced by the process called
depreciation.
27.4
INTERNATIONAL ACCOUNTING STANDARD (IAS)
These are standards which are used in preparing financial statements in order to
provide users with an accurate picture of the profit and financial position of the
enterprise.
CHAPTER SUMMARY
The chapter has looked at the accounting concepts and principles that underlie the preparation of
Financial Statements. Accounting concepts influence the assets, liabilities, income and
expenditure and the amounts at which these are recorded in the balance sheet.
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CHAPTER 28
INTERPRETATION OF FINAL ACCOUNTS
INTRODUCTION
Financial statements summarise the economic performance and situation of a business. This
information needs further analysis and interpretation to deduce its meaning for the benefit of the
users. Ratio Analysis is on of the means by which financial statements are interpreted. Ratio
analysis makes uses of accounting ratios to draw relationships between sets of accounts.
TOPICS
1. Ratio analysis technique
2. Types of Ratios
3. Calculation of Ratios
4. Interpretation of statements
5. Limitation of Ratio analysis
LEARNING OUTCOMES
At the end of the chapter, the student should be able to:
- Explain the ratio analysis technique
- Calculate ratios
- interpret the ratios
- Explain the limitation of Ratio Analysis
28.1
Ratio analysis Technique
The key to obtaining meaningful information from ratio analysis is comparison. This may
involve comparing ratios over time within the same business to establish whether things are
improving or declining; and comparing ratios between similar businesses to see whether the
business you are analysing is better or worse than average within its specific business sector.
28.2
Types of Ratios
Interpretation of accounts makes use of five main categories of ratios, these are:
1. Profitability ratios
2. Liquidity ratios
3. Efficiency ratios
4. Solvency ratios
5. Investors’ ratios
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28.2.1 Profitability Ratios
These ratios tell us whether a business is making profits and if so whether at an acceptable rate.
a) Return on capital employed (ROCE)
The ratio tells us what returns management has made on the resources made available to
them before making any distributions of these returns. The higher the return the better,
especially in high risk businesses. A very low return has a negative impact on internal
growth sustenance of a company.
Formula:
ROCE = Profit before interest and tax x 100
Capital employed
The capital employed is taken to be the total assets less current liabilities of the
business or share capital plus reserves plus long term liabilities. This ratio is further
broken down into two ratios:
i) Operating profit margin on sales
Given a constant gross profit margin, the operating profit margin tells us about the
company’s ability to control the level of its operating costs or overheads. The higher the
operating profit margin, the better. An increasing operating profit margin indicates
better control of costs, and a decreasing profit margin indicates worse control of costs or
too low selling prices.
Formula:
Operating profit margin = Profit before interest and tax x 100
Sales
ii) Asset turnover
This measures the company’s ability to generate sales revenue in relation to the size of
the asset investment.
Formula:
Asset turnover =
Sales
Capital employed
b) Gross profit margin
The ratio tells us about the ability of the company to consistently control its production
costs or to manage the margin it makes on its products. The higher the gross profit margin,
the better. An increasing gross profit margin indicates better control of production costs or
management of margin, and a decreasing gross profit margin indicates worse control of
production costs or too low selling prices.
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Formula:
Gross profit margin = Gross profit x 100
Turnover
Where turnover = sales less sales returns
28.2.2 Liquidity Ratios
These ratios indicate how capable a business is in meeting its short term obligations as they fall
due.
a) Current ratio
The ratio, also referred to as the working capital ratio, measures whether the business can
pay debts due within one year from assets that it expects to turn into cash within that year.
A ratio of less than one (1) is often a course of concern, particularly if it persists for any
length of time.
Formula:
Current ratio =
Current assets
Current liabilities
b) Quick/Liquidity ratio (or Acid Test ratio)
This ratio shows the ability of the business to pay current liabilities out of ‘quick’
assets, i.e. assets which are either in cash or quickly convertible into cash. Some assets
take time to convert into cash, for example, raw materials and other inventory must first be
turned into final product, the product sold and then cash collected from debtors. The quick
ratio therefore adjusts the current ratio to eliminate all assets that are not already in cash or
near cash form. The higher the quick ratio, the better for a business. A ratio of less than
one would start to send out danger signals on the liquidity of the organisation.
Formula:
Quick ratio = Current assets – Inventory
Current liabilities
Note: Higher current and quick ratios are not always good indicators. Sometimes, this may
indicate that working capital is inefficiently used. The efficiency ratios below will
highlight this. In other words, such ratios should be within acceptable range, i.e. not
too high and not too low.
28.2.3 Efficiency Ratios
These ratios tell us how efficiently the business is employing the resources invested into fixed
assets and working capital.
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a) Inventory turnover ratio
This ratio shows on average how many times in a month the inventory is turned over.
The higher the inventory turnover ratio, the quicker the inventory is being turned over. It
helps us check whether we have got too much money tied up in inventory. A decreasing
inventory turnover figure or one which is much lower than the average for the industry may
indicate poor inventory management. On the other hand, a high turnover ratio indicates a
good movement in inventory, thus reducing obsolescence.
Formula:
Inventory turnover =
Cost of sales
Average inventory value
Alternatively the ratio can be expressed in inventory days. A higher inventory days figure
or one which is much larger than the average for the industry may indicate poor inventory
management.
Formula:
Inventory days = Average inventory x 365 days
Cost of sales
Note: If the average inventory cannot be calculated then the inventory at the balance sheet
date should be used.
b) Receivables turnover
This ratio shows the average period taken by receivables to pay. It indicates whether the
receivables are being allowed excessive credit. A decreasing trade receivables turnover
figure or one less than the industry average may suggest general problems with debt
collection (such as delays in invoicing or failure to screen the credit worthiness of new
customers) or the financial position of major customers.
Formula:
Receivables turnover = Credit Sales
Trade receivables
Alternatively the ratio can be expressed in terms of Receivables collection period. This
shows the average number of days it takes receivables to pay their accounts. An increasing
higher figure or one more than the industry average may suggest problems with debt
collection or the financial position of major customers.
Formula:
Receivables payment period = Trade receivables x 365 days
Credit Sales
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d) Payables turnover
This ratio tells us whether a business is taking full advantage of full trade credit available to
it. A decreasing trade payables turnover or one lower than the average industry indicates
that you are taking longer to pay suppliers. This may not give any room to the business to
be able to negotiate better credit terms from suppliers, cash discounts lost and future supplies
being at risk.
Formula:
Trade payables turnover = Credit Purchases
Trade payables
Alternatively the ratio can be expressed in terms of Payables credit period. This
shows the average number of days it takes the organisation to pay its suppliers. An
increasing payables credit period indicates that you are taking longer to pay your suppliers,
and a decreasing period indicates that you are paying quicker.
Formula:
Payables credit period = Trade payables x 365 days
Credit Purchases
Note: Where the purchases figure can not be calculated then the cost of sales figure
may be used.
d) Non-current assets turnover
This ratio tells us about the non-current asset capacity. A reducing sales value generated
from each Kwacha invested in non-current assets may indicate over capacity or poor
performing equipment.
Formula:
Non-current assets turnover =
Sales
Non-current assets
28.2.4 Solvency or Gearing Ratios
These ratios concentrate on the long-term health of a business, particularly the effect of
capital/finance structure on the business i.e. it establishes the relationship between the proportion
of Capital Employed that is borrowed and the proportion that is provided by shareholders’ funds.
The higher the level of gearing (borrowing) the higher are the risks to a business since the
payment of interest and repayment of debts are not ‘optional’ in the same way as dividends.
However, gearing can be a financially sound part of a business capital structure particularly if the
business has strong, predictable cash flows.
Capital gearing can be calculated in two ways:
a) Total gearing
This ratio shows the proportion of the company’s assets which are financial by
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borrowing and so gives an indication of the amount of further secured borrowings that
might be undertaken.
Formula:
Total gearing = Preference share capital + interest bearing Loans
Assets employed (or Total capital)
b) Debt to equity ratio
This ratio shows a more pronounced change if either fixed return capital or equity
capital changes. A ratio of 2 indicates that the debt is twice higher the equity.
Formula:
Equity gearing = Preference share capital + interest bearing loans
Ordinary share capital + Reserves
Interest cover
This measures the ability of the business to service its debts. The ratio answers the
question: Are the profits sufficient to be able to pay interest and other finance obligations?
A high rate indicates that the company is in a strong position (security) as regards payment
of interest. The measure should indicate the number of times the profits can meet interest
obligations.
Formula:
Interest cover = Profit before interest and tax
Interest payable on loans
28.2.5 Investors’ ratios
These are the ratios used by investors to assess the performance of a business as an investment.
An investor is interested in the income earned by the company for him/her and the return on
his/her investment (i.e. the income earned in relation to the market price of the investment).
a) Dividend per share
This measures the amount of dividend available per ordinary share. The higher the
dividend per share, the better to the shareholder.
Formula:
Dividend per share = Dividends for ordinary shares
Number of ordinary shares
b) Dividend Cover
This ratio shows the proportion of profit on ordinary activities that is available for
distribution to shareholders and what proportion will be retained in the business to finance
future growth. A dividend cover of 2 times would indicate that the company had paid 50%
of its distributable profits as dividends, and retained 50% in the business to help finance
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future operations. A decreasing dividend cover would indicate a fall in profits but the
dividend level is maintained as in the previous years, so as to keep shareholder expectations
satisfied.
Formula:
Dividend cover = Profit for the financial year
Ordinary dividend
or = Earnings per share__
Net dividend per share
c) Dividend yield
Dividend yield is the return a shareholder is currently expecting on the shares of a
company. On the stock market the dividend yield is normally stated gross of tax. This
enables the yield on shares to be compared with yields on interest stocks (company and
government stocks).
Formula:
Dividend yield = Dividend on the share for the year x 100
Current market value of the share
d) Earnings per share (EPS)
Earnings per share look at the theoretical profits that could be paid to each ordinary
shareholder. Earnings are the net profits after tax, interest, minority interest earnings and
dividends on other classes of shares.
Formula:
Earnings per share =
Earnings
Issued ordinary shares
e) Price Earnings ratio (P/E ratio)
The price earnings ratio is the ratio of a company’s current share price to the earnings
per share. A high P/E ratio indicates strong shareholder confidence in the company
and its future, e.g. in profit growth, and a lower P/E ratio indicates lower confidence.
Formula:
P/E = Current market value
Earnings per share
f) Earnings yield
Earnings yield is measured as earnings per share expressed as a percentage of the
current share price. It indicates what the dividend yield would be if the company paid
out all its profits as dividends and retained nothing in the business.
Formula:
Earnings yield = Earnings per share x 100
Current market value
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28.3 Calculating Ratios
Calculating ratios is part of the process of ratio analysis. We shall illustrate the calculation of the
above ratios using the following example.
A public limited company quoted on the Lusaka Stock Exchange produced the following results
as at 31st December 2006:
Profit and loss account for the year ended 31st December 2006
K’000
Sales revenue
Opening inventory
37 000
Purchases
162 000
199 000
Closing inventory
42 000
K’000
209 000
157 000
52 000
Gross profit
Distribution costs
Administration expenses
Interest
10 000
13 000
2 000
25 000
27 000
10 000
17 000
Net profit
Taxation
Net profit after taxation
Dividends: Ordinary shares
Preference shares
6 000
2 000
8 000
9 000
Retained profit for the year
Balance sheet as at 31st December 2006
K’000
Non-current assets (net book value)
Current assets:
Inventory
Trade Receivables
Bank
K’000
130 000
42 000
29 000
3 000
74 000
204 000
Total assets
Capital and reserves:
Ordinary share capital (K500 shares)
8% Preference shares (K1 000 shares)
Share premium account
Revaluation reserve
Accumulated profit
35 000
25 000
17 000
10 000
31 000
118 000
Non-current liabilities
5% secured loan stock
Current liabilities
Trade payables
Taxation
40 000
36 000
10 000
46 000
204 000
332
The market value of each ordinary share is K2 040.
From the above details, you are required to calculate the following ratios:
a) Return on capital employed (ROCE)
b) Operating profit margin on sales
c) Gross profit Margin
d) Current ratio
e) Quick ratio
f) Inventory turnover
g) Inventory days
h) Receivables turnover ratio
i) Receivables collection period
j) Payables turnover ratio
k) Payables credit period
l) Non-current assets turnover ratio
m) Total gearing ratio
n) Debt to equity ratio
o) Interest Cover
p) Dividend per share
q) Dividend cover
r) Dividend yield
s) Earnings per share (EPS)
t) Price Earnings ratio (P/E ratio)
u) Earnings yield
SOLUTION
a) Return on capital employed
ROCE = Profit before interest and tax x 100
Capital employed
= 27 000 + 2 000 x 100
133 000
= 21.8%
b) Operating profit margin
Operating profit margin = Profit before interest and tax x 100
Sales
= 29 000 x 100
209 000
= 13.9%
c) Gross profit margin
Gross profit margin = Gross profit x 100
Turnover
= 52 000 x 100
209 000
= 24.9%
333
d) Current ratio
Current ratio =
Current assets
Current liabilities
= 74 000
46 000
= 1.6 times
e) Quick ratio
Quick ratio = Current assets – Inventory
Current liabilities
= 74 000 – 42 000
46 000
= 0.7 times
f) Inventory turnover ratio
Inventory turnover =
Cost of sales
Average inventory value
=
1
= 4.0 times
157 000
/2 (37 000 + 42 000)
g) Inventory days
Inventory days = Average inventory x 365 days
Cost of sales
= 39 500 x 365 = 92 days
157 000
h) Receivables turnover
Receivables turnover = Credit Sales
Trade receivables
= 209 000 = 7.2 times
29 000
i) Receivables collection period
Receivables collection period = Trade receivables x 365 days
Credit Sales
= 29 000 x 365 = 50.6 days
209 000
j) Payables turnover
Trade payables turnover = Credit Purchases
Trade payables
= 162 000 = 4.5 times
36 000
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k) Payables credit period
Payables credit period = Trade payables x 365 days
Credit Purchases
= 36 000 x 365 = 81.1 days
162 000
l) Non-current assets turnover
Non-current assets turnover =
Sales
Non-current assets
= 209 000 = 1.6 times
130 000
m) Total gearing
Total gearing = Preference share capital + interest bearing loans x 100
Assets employed (or Total capital)
= 25 000 + 40 000 x 100 = 41.1%
158 000
n) Debt to equity ratio
Equity gearing = Preference share capital + interest bearing loans x 100
Ordinary share capital + reserves
= 25 000 + 40 000 x 100 = 69 .9%
118 000 – 25 000
o) Interest cover
Interest cover = Profit before interest and tax
Interest payable on loans
= 29 000
2 000
= 14.5 times
p) Dividend per share
Dividend per share = Dividends for ordinary shares
Number of ordinary shares
=
6 000 = K86 per share
70 000
q) Dividend Cover
Dividend cover = Profit for the financial year
Ordinary dividend
= 17 000 – 2 000 = 2.5 times
6 000
335
or = Earnings per share
Net dividend per share
r) Dividend yield
Dividend yield = Dividend on the share for the year x 100
Current market value of the share
=
86 x 100 = 4.2%
2 040
s) Earnings per share
Earnings per share =
Earnings
Issued ordinary shares
= 15 000 = K214 per share
70 000
t) Price Earnings ratio
P/E = Current market value
Earnings per share
= 2 040 = 9.5
214
u) Earnings yield
Earnings yield = Earnings per share x 100
Current market value
=
214 x 100 = 10.5%
2 040
Interpretation of Financial Statements
The basis of interpretation is the ability to make use of the information provided by the
ratios. Ratios are only a means to an end; they are not an end in themselves. By comparing
relationships between figures, ratios merely highlight trends in the accounts and so one should be
in position to comment on the reported trends i.e. be able to define the reasons for the trends
disclosed. Do not hesitate to make obvious comments such as ‘the gross profit percentage has
increased from last year’ as this entails stating that the business is more profitable.
Example:
The following information has been extracted from the published accounts of Gideon Plc.
Extracts from the profit and loss accounts
Sales revenue
Cost of sales
Net profit before tax
2004
K’000
22 400
16 920
930
2003
K’000
19 500
13 650
640
This is after charging:
Depreciation
Debenture interest
Audit fees
720
160
24
560
120
20
336
Balance sheet as at 31st December
Non-current assets
Current assets:
Inventory
Trade receivables
Cash
Total assets
Capital and reserves:
Ordinary share capital
Reserves
Long-term liabilities:
10% debentures
Current liabilities:
Bank overdraft
Trade payables
Taxation
Total capital and liabilities
2004
K’000
3 700
2003
K’000
2 860
1 280
2 460
160
3 900
980
2 160
240
3 380
7 600
6 240
1 600
2 490
4 090
1 600
1 750
3 350
1 600
1 200
220
1 500
190
1 910
160
1 380
150
1 690
7 600
6 240
The latest industry average ratios are:
Current ratio
Quick ratio
Receivables turnover
Payables turnover
Inventory turnover
1.90
1.27
52 days
49 days
18.3 times
Required:
a) Calculate comparable ratios (to two decimal places where appropriate) for Gideon Plc for the
years 2003 and 2004.
b) Comment on the liquidity and efficiency ratios of Gideon Plc, comparing the results
against the two years and against the industry.
337
SOLUTION
a)
i)
Year
2003
Current ratio
3 380 000
2004
3 900 000
/1 690 000
= 2.0
Quick ratio
Debtors turnover
= 2.04
3 380 000 – 980 000
3 900 000 – 1 280 000
= 1.42
= 1.37
/1 690 000
2 1600 000
/19 500 000 x 365
2 460 000
= 40 days
Creditors turnover
1 380 000
/13 650 000 x 365
= 37 days
Stock turnover
/1 910 000
13 650 000
/980 000
= 13.9 times
/1 910 000
/22 400 000 x 365
= 40 days
1 500 000
/16 920 000 x 365
= 32 days
16 920 000
/1 280 000
= 13.2 times
ii) Comments:
Liquidity ratios:
•
The current ratio has improved slightly over the year and is marginally higher than
the industry average.
The ratio is in line with what is generally regarded as satisfactory (2:1)
•
The quick ratio has declined marginally but is still better than the industry average.
This suggests that Austin Plc has no short term liquidity problems and should have
no difficulty in paying its debts as they become due.
Efficiency ratios:
•
Receivables turnover – receivables as a proportion of sales is unchanged from 2003
and are considerably lower than the industry average.
Consequently, there is probably little opportunity to reduce this further and there
may be pressure in the future from customers to increase the period of credit given.
338
•
Payables turnover – the period of credit taken from suppliers has fallen from 37
days’ purchases to 32 days’ and is much lower than the industry average.
With this it may be possible to finance any additional receivables by negotiating
better credit terms from suppliers.
•
Inventory turnover has fallen slightly and is much lower than the industry average.
This may partly reflect stocking up ahead of a significant increase in sales.
Alternatively, there is some danger that the inventory could contain certain
absolute items that may require writing off. The relative increase in the level of
inventory has been financed by an increased overdraft which may reduce if
inventory levels can be brought down.
Limitations of Ratio Analysis
The limitations of ratio analysis can be summarised as follows:
a) Companies use different accounting policies and so can be used to manipulate company
results
b) Availability of comparable information is quite difficult because no two businesses are
identical
c) Use of historical/out of date information may not be useful for future decision making
d) Ratios are not definitive – they are only a guide
e) Interpretation needs careful analysis and should not be considered in isolation. Some items in
the financial statements are of vital importance in assessing the position of a business.
f) It is a subjective exercise
g) A number of ratios are based on balance sheet figures as at a particular point in time and so
they may not be representative of the financial position for the whole year.
CHAPTER SUMMARY
The chapter has looked at the Accounting Ratios used in interpreting the financial performance
and position of companies. The four main categories of accounting ratios are: Profitability,
Liquidity, Efficiency, Solvency and Gearing. Calculating one ratio is not an end in itself, but
should help one draw conclusions about the company. You should also remember that ratio
analysis has its own draw backs such as being subjective and being based on historical
information.
Overall, ratios are very useful in interpreting the financial performance and position of
companies beyond the traditional income statement and balance sheet. When used appropriately
they are good tools in predicting the future outcome of the company.
339
EXERCISES
QUESTION ONE
The following are the summarised financial statements for X Ltd for 2005 and 2006:
Summarised income statements
Turnover
Operating profit
Interest payable
Profit before taxation
Taxation
Profit after tax
Dividends
Retained profit for the year
Retained profit b/f
Retained profit c/f
2005
K’000
243 150
8 619
992
7 627
2 867
4 760
1 120
3 640
11 770
15 410
2006
K’000
291 950
10 335
992
9 343
3 513
5 830
1 200
4 630
15 410
20 040
2005
K’000
2 498
2006
K’000
6 350
20 073
20 105
6 046
48 722
25 228
21 685
2 895
56 158
4 960
15 410
4 960
20 040
9 920
9 920
16 302
1 237
893
48 722
18 615
1 630
993
56 158
Summarised balance sheets
Non current assets
Current assets:
Inventory
Receivables
Bank
Total assets
Capital and reserves:
Ordinary share capital of K250 per share
Retained earnings
Non current liabilities:
10% debentures
Current liabilities:
Trade payables
Taxation
Dividends payable
Total equity and liabilities
Required:
a) Calculate for each year the following ratios:
i) Return on capital employed
ii) Non current assets turnover
iii) Current ratio
iv) Quick ratio
v) Earning per share
vi) Dividend cover
b) Comment briefly on the changes in the ratios calculated in (a) above between the two years.
340
QUESTION TWO
The following ratios were calculated from the financial statements of H Ltd and G Ltd:
H Ltd
G Ltd
Profitability
Return on capital employed
Gross profit margin
Net profit/sales ratio
27.5%
34%
19%
15.5%
28%
15%
Gearing
Total gearing
Interest cover
29.5%
6 times
13.5%
9 times
Liquidity
Current ratio
Quick ratio
1.0
0.6
1.4
1.0
Efficiency
Receivables collection period
Inventory turnover
63 days
4.5 times
250 days
3 times
Required: comment of the financial performance and position of H Ltd and G Ltd.
341
SOLUTIONS TO EXERCISES
SOLUTION ONE
a)
2005
i) ROCE
ii) Non current assets turnover
iii) Current ratio
iv) Quick ratio
v) Earnings per share
vi) Dividends cover
2006
=
8 619 x 100
30 290
10 335 x 100
34 920
=
28.5%
29.6%
=
243 150
2 498
291 950
6 350
=
97.3 times
46 times
=
46 224
18 432
49 808
21 238
=
2.5
2.3
=
46 224 – 20 073
18 432
=
1.4
1.2
=
4 760
19 840
5 830
19 840
=
K239.9 per share
K293.9 per share
=
4 760
1 120
5 830
1 200
=
4.3 times
4.9 times
49 808 – 25 228
21 238
b) Return on capital employed has increased marginally by about 4%, indicating that profits
have increased marginally. The Non current assets turnover has drastically reduced. This
reduction could be as a result of the high investment in non current assets. This investment
would in future help to increase profitability and turnover.
342
The current ratio has decreased though still at an acceptable level. The quick ratio has also
decreased though also still above the desirable level of 1. The company should however
observe this decline in the liquidity position to ensure that it does not persist for a long time.
The earnings per share have increased by K54 per share. This is due to the improved profits
in 2006. The dividends cover has improved. This is as a result of the decrease in profits
paid out as dividends which is not proportional to the increase in profits.
SOLUTION TWO
Comments on the financial performance and position of H Ltd and G Ltd
Profitability
H Ltd has performed better than G Ltd both in terms of profitability to capital employed and
profitability to sales.
Gearing
H Ltd is highly geared in comparison to G Ltd. G Ltd has a better interest cover that H Ltd.
However, the interest cover for H Ltd of 6 times is quite good despite the company having a high
gearing ratio. This might indicate that H Ltd used the funds borrowed to acquired profit
generating assets.
Liquidity
G Ltd shows better current and quick ratios than H Ltd, indicating a better liquidity position. A
comparison with the industry average would help to identify as to how poor or good the ratios of
the two companies are.
Efficiency
H Ltd has better receivables collection period and inventory turnover than G Ltd. The
receivables collection period is too long for G Ltd which might indicate that G Ltd has a poor
credit control policy.
Conclusion
Provided that the two companies are in the same industry and are of the same size, then it can be
concluded that H Ltd’s finance performance and position is better than that of G Ltd.
343
CHAPTER 30
MANUFACTURING ACCOUNTS
INTRODUCTION
In this chapter we shall look at the preparation of financial statements for manufacturing
organisations. A manufacturing organisation is one that manufactures (produces) goods for sale.
This could either be a sole trader, a partnership or a company.
TOPICS
1. Manufacturing account
2. Work in progress
3. Transfers of goods at market value
4. Provision for unrealized profits
LEARNING OUTCOMES
At the end of the chapter, the student should be able to:
-
Explain the purpose of a Manufacturing Account
Explain the treatment of opening and closing Work In Progress in Manufacturing Accounts
Calculate the profit or loss on manufacturing
Account for provision for unrealised profits on finished goods.
Prepare Manufacturing Account, Income Statement and Balance Sheet for sole traders,
partnerships and companies.
30.1 Manufacturing Account
A Manufacturing Account is an account that collects together all the costs involved in production
to determine the production cost of goods completed. To ascertain the production cost of the
goods completed, charge all the elements of production cost (i.e. direct materials, direct labour,
direct expenses and production overheads) to the Manufacturing Account.
Direct materials, labour, and expenses are all those costs involved in production that are
traceable to units of goods produced. The total of all direct costs incurred in a year is called the
prime cost. Production overheads are all those costs incurred in a factory, but cannot be easily
traced to the units of goods produced.
At the end of the year, the cost of goods manufactured is then transferred, as the figure
equivalent to purchases, to the income statement.
30.2 Opening and closing work in progress
The goods partly completed at the start and end of the accounting period are respectively known
as opening work in progress and closing work in progress. The value of the opening work in
progress is added to the total production cost for the period while the value of the closing work in
progress is deducted in arriving at the production cost of goods completed.
344
Example:
Joshua Muleya is a manufacturer. His Trial Balance as at 31st December 2006 is as follows:
Dr
Cr
K’000
K’000
Capital
274 912
Drawings
17 120
Premises
80 000
Machinery
65 000
Office equipment
22 000
Delivery van expenses
5 000
Lighting and heating: Factory
5 718
Office
2 220
Manufacturing wages
90 940
General expenses: Office
7 632
Factory
11 280
Purchases of raw materials
78 108
Salesmen commission
15 720
Rent: Factory
9 600
Office
4 400
Office salaries
12 570
Receivables and Payables
56 740
38 900
Bank
26 674
Sales revenue
273 000
Inventory at 1st January 2006:
Raw materials
15 130
Finished goods
48 500
Work in progress
10 460
______
586 812
586 812
Additional information:
1. Inventory at 31st December 2006 were:
Raw materials
Finished goods
Work in progress
K18 100 000
K49 560 000
K12 840 000
2. Ignore depreciation of fixed assets.
Required: From the above details, prepare the Manufacturing Account, the Income Statement
for the year ended 31st December 2006 and a Balance Sheet as at that date.
345
SOLUTION:
Joshua Muleya
Manufacturing account for the year ended 31st December 2006
K’000
Raw materials:
Opening inventory
17 130
Purchases
78 108
Total inventory available
95 238
Less: closing inventory
18 100
Cost of raw materials consumed
Direct labour:
Wages
Prime cost
Add: production overheads:
Lighting and heating
5 718
General expenses
11 280
Rent
9 600
K’000
77 138
90 940
168 078
26 598
194 676
10 460
205 136
12 840
192 296
Add: opening work in progress
Less: closing work in progress
Production cost
Joshua Muleya
Income Statement for the year ended 31st December 2006
K’000
Sales revenue
Opening inventory
48 500
Production cost
192 296
240 796
Less: closing inventory
49 560
Cost of sales
Gross profit
Less expenses:
Administrative expenses
5 000
Lighting and heating
2 220
General expenses
7 632
Rent
4 400
Office salaries
12 570
Salesmen's commission
15 720
Total expenses
Net profit
346
K’000
273 000
191 236
81 764
47 542
34 222
Joshua Muleya
Balance sheet as at 31st December 2006
Cost
K’000
80 000
65 000
22 000
167 000
Non-current assets:
Premises
Machinery
Office equipment
Current assets:
Inventory: - Raw materials
- Work in progress
- Finished goods
Receivables
Cash at bank
Dep.
K’000
-
Value
K’000
80 000
65 000
22 000
167 000
18 100
12 840
49 560
56 740
26 674
163 914
330 914
Total assets
Capital and liabilities:
Capital
Add: net profit
274 912
34 222
309 134
17 120
Less: drawings
292 014
Current liabilities:
Payables
Total capital and liabilities
38 900
330 914
30.3 Transfer of goods at market value
In manufacturing organisations, it is usual to allocate the gross profit earned by the business
between the factory and the selling department so that the actual profit earned from mere selling
can be revealed. This split may also allow the production manager to earn a commission. To
achieve this, the finished goods are transferred from the factory to the selling department with a
profit element (i.e. profit loading).
When goods are transferred at market value, there will be a balance in the manufacturing account
representing a profit or a loss arising from manufacturing the goods instead of buying them as
finished products. To close the manufacturing account, the profit or loss should be transferred to
the income statement.
347
Example:
The following information has been extracted from the books of Meleki manufacturing company
for the year to 30th September 2006:
K'000
th
Deprecation for the year to 30 September 2006:
Factory equipment
21 000
Office equipment
12 000
Direct wages
120 000
Factory: insurance
3 000
Heat
45 000
Indirect materials
15 000
Power
60 000
Salaries
75 000
Finished goods at 1st October 2005
72 000
Office: electricity
55 000
General expenses
27 000
Postage and telephones
8 700
Salaries
210 000
Raw material purchases
600 000
Carriage inwards on raw materials
6 000
st
24 000
Raw material inventory at 1 October 2005
Advertising
6 000
Sales revenue
1 537 200
Work in progress at 1st October 2005
36 000
Notes:
1. At 30th September 2006, the following were on hand:
K'000
Raw materials
30 000
Work in progress
27 000
Finished goods
90 000
2. At 30th September 2006, there was an accrual for advertising of K3 000 000, and it was
estimated that K4 500 000 had been paid in advance for electricity. These items had not been
included in the books of account for the year to 30th September 2006.
3. Goods produced during the year are to be transferred to the Income Statement at a market
value of K978 000 000.
4. For the purpose of inventory valuation, finished goods have been valued at cost.
Required: Prepare in the vertical columnar form, the company's Manufacturing Account,
Income Statement for the year to 30th September 2006.
348
SOLUTION:
Meleki Manufacturing Company
Manufacturing account for the year ended 30th September 2006
K’000
K’000
K’000
Raw materials:
Opening inventory
24 000
Purchases
600 000
Add: carriage inwards
6 000
606 000
Total inventory available
630 000
Less: closing inventory
30 000
Cost of raw materials consumed
600 000
Direct labour:
Wages
120 000
Prime cost
720 000
Add: production overheads:
Depreciation - factory equipment
21 000
Insurance
3 000
Heat
45 000
Indirect materials
15 000
Power
60 000
Salaries
75 000
219 000
939 000
Add: opening work in progress
36 000
975 000
Less: closing work in progress
27 000
Production cost
948 000
Market value
Less: production cost
Manufacturing profit
978 000
948 000
30 000
349
Meleki Manufacturing Company
Income Statement for the year ended 30th September 2006
K’000
Sales revenue
Opening inventory
Market value
1 537 200
72 000
978 000
1 050 000
90 000
Less: closing inventory
Cost of sales
Gross profit on trading
Add: profit on manufacturing
Less expenses:
Advertising
Add: accrual
Depreciation - office equipment
Electricity
Less: prepayment
K’000
960 000
577 200
30 000
607 700
6 000
3 000
9 000
12 000
45 000
4 500
40 500
27 000
8 700
210 000
General expenses
Postage and telephones
Salaries
Total expenses
Net profit
307 200
300 000
30.4 Allowance for unrealised profit
In cases where goods are transferred at market price to the selling department, there may be
some of these goods that remain unsold at the end of the year. If the inventory of such goods is
valued at the transfer price or market price, then in order to arrive at the true profit, it is
necessary to provide in the accounts for unrealised profits included in the valuation of
inventories. The allowance for Unrealised Profit Account is opened to account for such profits.
This account is prepared in the same manner as the Allowance for doubtful debts Account, i.e. an
increase in the account balance is treated as an expense, while a decrease is treated as a gain in
the income statement. The balance on the Provision for Unrealised Profit Account is at the end of
the year deducted from the closing inventory of finished goods in the Balance Sheet.
350
Example:
The following balances as at 31st December 2006 have been extracted from the books of Simon
Choolwe, a manufacturer:
K'000
st
Inventory at 1 January 2006:
Raw materials
7 000
Work in progress
5 000
Finished goods
6 900
Purchase of raw materials
38 000
Direct labour
28 000
Factory overheads:
Variable
16 000
Fixed
9 000
Administrative expenses:
Rent and rates
19 000
Heat and light
6 000
Stationery and postage
2 000
Staff salaries
19 380
Sales revenue
192 000
Plant and machinery:
At cost
30 000
Provisions for depreciation
12 000
Motor vehicles (for sales deliveries):
At cost
16 000
Provisions for depreciation
4 000
Payables
5 500
Receivables
28 000
Drawings
11 500
Balance at bank (Dr)
16 600
st
Capital at 1 January 2006
48 000
Allowance for unrealised profit at 1st January 2006
1 380
Motor vehicles running costs
4 500
Additional information:
1. Inventories at 31st December 2006, were as follows:
K'000
Raw materials
9 000
Work in progress
8 000
Finished goods
10 350
2. The factory output is transferred to the income statement at factory cost plus 25% for factory
profit. The finished goods inventory is valued on the basis of amounts transferred to the
debit of the income statement.
3. Depreciation is provided annually at the following percentages of the original costs of fixed
assets held at the end of each financial year:
351
Plant and machinery
Motor vehicles
10%
25%
4. Amounts accrued due on 31st December 2006 for direct labour amounted to K3 000 000 and
rent and rates prepaid at 31st December 2006 amounted to K2 000 000.
Required:
Prepare the Manufacturing Account, Income Statement for the year ended 31st December 2006,
and a Balance Sheet as at that date.
SOLUTION:
Simon Choolwe
Manufacturing account for the year ended 31st December 2006
K’000
Raw materials:
Opening inventory
7 000
Purchases
38 000
Total inventory available
45 000
Less: closing inventory
9 000
Cost of raw materials consumed
Direct labour:
Wages
28 000
Add: wages accrued
3 000
K’000
36 000
31 000
67 000
Prime cost
Add: factory overheads:
Variable
Fixed
Depreciation - plant and machinery
16 000
9 000
3 000
Less: closing work in progress
Factory cost
28 000
95 000
5 000
100 000
8 000
92 000
Market value
Less: factory cost
Manufacturing profit
115 000
92 000
23 000
Add: opening work in progress
352
Simon Choolwe
Income Statement for the year ended 31st December 2006
K’000
K’000
Sales revenue
Opening inventory
6 900
Market value
115 000
121 900
Less: closing inventory
10 350
Cost of sales
Gross profit on trading
Add: profit on manufacturing
Less expenses:
Rent and rates
Less: prepayment
Provision for unrealised profit (w1)
Heat and light
Stationery and postage
Staff salaries
Depreciation - motor vehicles
Motor vehicle running costs
Total expenses
Net profit
19 000
2 000
K’000
192 000
111 550
80 450
23 000
103 450
17 000
690
6 000
2 000
19 380
4 000
4 500
53 570
49 880
Balance sheet as at 31st December 2006
Cost
K’000
30 000
16 000
46 000
Non current assets:
Plant and machinery
Motor vehicles
Current assets:
Inventories: - raw materials
- work in progress
- finished goods
10 350
less: allowance for unrealised profit 2 070
Dep.
K’000
15 000
8 000
23 000
Value
K’000
15 000
8 000
23 000
9 000
8 000
8 280
28 000
16 600
2 000
Receivables
Cash at bank
Rent and rates prepaid
71 880
94 880
Capital account
Balance on 1st January 2006
Add: net profit
48 000
49 880
97 880
11 500
Less: drawings
86 380
Current liabilities:
353
Payables
Direct labour accrued
5 500
3 000
8 500
94 880
Workings
1.
Allowance for Unrealised Profit Account
___________________________________________________________________
K'000
K'000
Balance
c/d
2 070 Balance
b/d
1 380
Income Statement
690
2 070
2 070
Note: Closing balance amount = K10 350 000 x 25/125 = K2 070 000
354
EXERCISES
QUESTION ONE
The following is a trial balance for J Mutinta as at 31st December 2006:
Dr
Cr
K’000
K’000
Capital
59 360
Drawings
4 000
Productive machinery (cost K56m)
46 000
Accounting machinery (cost K4m)
2 400
Royalties
1 400
Carriage inwards on raw materials
700
Purchases of raw materials
74 000
Inventory at 1st January 2006:
Raw materials
4 200
Finished goods
7 780
Work in progress
2 700
Wages (direct K36m, factory K29m)
65 000
General factory expenses
6 200
Lighting
1 500
Factory power
2 740
Administrative salaries
8 800
Salesmen's salaries
6 000
Commission on sales
2 300
Rent
2 400
Insurance
840
General administrative expenses
2 680
Bank charges
460
Discount allowed
960
Carriage outwards
1 180
Receivables
28 460
Payables
25 000
Bank
11 360
Cash
300
200 000
Sales revenue
284 360
284 360
Notes at 31st December 2004:
1. Inventory of raw materials K4 800 000, Inventory of finished goods K8 000 000, Work In
Progress K3 000 000.
2. Lighting, rent and insurance are to be apportioned: factory 5/6ths, administration 1/6th.
3. Depreciation on productive machinery and accounting machinery at 10% per annum on cost.
Required:
Prepare the Manufacturing Account, Income Statement for the year ended 31st December 2006
and a Balance sheet as at that date.
355
QUESTION TWO
The following trial balance was extracted from the books of Panuka Ltd after completion of the
manufacturing account for the year ended 31st March 2003.
Dr
K’000
Ordinary share capital
7% preference share capital
Sales revenue
Production cost
Receivables
Payables
Inventory:
Finished goods (1st April 2002)
Raw materials (31st March 2003)
WIP (31st March 2003)
Premises at cost
Accumulated depreciation on buildings
Plant and machinery at cost
Depreciation on plant and machinery:
Accumulated provision
Charge for the year
Retained profit (1st April 2002)
Bank
Rent
General expenses
Distribution costs
Bad debts
Administrative salaries
Advertising expenses
Preference divided paid
Suspense
Cr
K’000
40 000
20 000
200 000
106 400
21 400
10 000
52 000
11 000
6 200
35 000
2 000
12 000
4 800
1 200
27 080
8 528
3 500
3 060
21 316
400
21 615
5 590
700
308 709
3 629
308 709
Additional information:
1.
Closing inventory of finished goods on 31st March 2003 was valued at K46 600 000.
2.
Depreciation on buildings is K400 000.
3.
4.
Included in rent paid is a 16 months rental of K1 680 000 payable as from 1st July 2002.
Provision for Income tax on profits for the year of K15 000 000 is to be made.
5.
The directors decided to provide for a 10% dividend on ordinary shares and a final dividend
on preference shares.
6.
Investigations on the causes of the difference in books revealed the following errors. These
errors had no effect on the production cost:
356
i)
A debit balance of K4 600 000 owing by a customer was omitted in the trial
balance.
ii)
The total of the discounts received column in the cash book, K120 000, had not
been posted to the nominal ledger.
iii)
A payment for administrative salaries, K1 323 000, was posted to the general
ledger as K1 332 000.
iv)
A sales invoice for K8 000 000 had been omitted from the sales account.
v)
A cheque issued for general expenses for K50 000 had been posted to the debit
of the bank account.
Required:
a) Show the journal entries to correct the errors in six (6) above. Narratives are not
required.
(5 marks)
b) Open up the suspense account to clear the difference in books.
(3 marks)
c) Taking into account the corrected errors, you are to prepare:
i)
ii)
Panuka Ltd’s Income Statement for the year ended 31st March 2003.
(12 marks)
st
Panuka Ltd’s Balance Sheet as at 31 March 2003.
(11 marks)
(NATech June 2004)
357
B
SOLUTIONS TO EXERCISES
SOLUTION ONE
J Mutinta
Manufacturing account for the year ended 31st December 2006
K’000
Raw materials:
Opening inventory
4 200
Purchases
74 000
Carriage inwards
700
Total inventory available
78 900
Less: closing inventory
4 800
Cost of raw materials consumed
Direct labour:
Wages
Direct expenses:
Royalties
Prime cost
Add: factory overheads:
Indirect wages
29 000
General factory expenses
6 200
Lighting (5/6 x 1 500)
1 250
Factory power
2 740
Rent (5/6 x 2 400)
2 000
5
700
Insurance ( /6 x 840)
Depreciation on productive machinery (10% x 56) 5 600
K’000
74 100
36 000
1 400
111 500
47 490
158 990
2 700
161 690
3 000
158 690
Add: opening work in progress
Less: closing work in progress
Production cost
358
J Mutinta
Income Statement for the year ended 31st December 2006
K’000
K’000
Sales revenue
Opening inventory
7 780
Market value
158 690
166 470
Less: closing inventory
8 000
Cost of sales
Gross profit
Less expenses:
Lighting (1/6 x 1 500)
250
Administrative salaries
8 800
Salesmen’s salaries
6 000
Commission on sales
2 300
Rent (1/6 x 2 400)
400
1
Insurance ( /6 x 840)
140
General administrative expenses
2 680
Bank charges
460
Discount allowed
960
Carriage outwards
1 180
Depreciation on accounting machine (10% x 4m)
400
Total expenses
Net profit
K’000
200 000
158 470
41 530
23 570
17 960
J Mutinta
Balance sheet as at 31st December 2006
Cost
K’000
56 000
4 000
60 000
Non current assets:
Productive machinery
Accounting machinery
Current assets:
Inventories: - raw materials
- work in progress
- finished goods
Receivables
Cash at bank
Cash in hand
4 800
3 000
8 000
Dep.
K’000
15 600
2 000
17 600
Value
K’000
40 400
2 000
42 400
15 800
28 460
11 360
300
55 920
98 320
Total assets
Capital account
Balance on 1st January 2006
Add: net profit
59 360
17 960
77 320
4 000
Less: drawings
Current liabilities:
359
73 320
Payables
Total capital and liabilities
25 000
98 320
SOLUTION TWO
a)
Journal entries
i)
K’000
4 600
Receivables in Trial balance
Suspense
4 600
ii) Suspense
Discount Received
120
120
iii) Suspense
Administrative salaries
iv) Suspense
Sales revenue
9
9
8 000
8 000
v) Suspense
Bank
b)
K’000
100
100
Suspense Account
Discount Received
Administrative salaries
Sales revenue
Bank
K’000
120
9
8 000
100
8 229
K’000
Balance b/d
3 629
Receivables in Trial balance 4 600
8 229
360
c)
(i)
Panuka Ltd Income Statement for the year ended 31st March 2003.
K’000
Sales revenue (200 000 + 8 000)
Opening inventory
Production cost
K’000
208 000
52 000
106 400
158 400
46 600
Less: closing inventory
Cost of sales
Gross profit
Add: Gains:
Discount received
Total income
Less: Expenses:
Rent [3 500 – (1680 ÷ 16 x 7 months)]
General expenses
Distribution costs
Bad debts
Administrative salaries (21 615 – 9)
Advertising expenses
Depreciation on Buildings
111 800
96 200
120
96 320
2 765
3 060
21 316
400
21 606
5 590
400
55 137
41 183
15 000
26 183
Profit before taxation
Less: Income tax
Profit after taxation
Dividends
Preference -paid
- proposed
Ordinary – proposed
700
700
4 000
5 400
20 783
17 080
37 863
Retained profit for the year
Add: Retained profit brought forward
Retained profit carried forward
361
(ii)
Panuka Ltd Balance Sheet as at 31st March 2003.
COST
K’000
35 000
12 000
47 000
Non current Assets:
Premises
Plant and machinery
Current Assets:
Inventory:
Finished goods
Raw materials
W-I-P
DEP.
K’000
2 400
6 000
8 400
NBV
K’000
32 600
6 000
38 600
46 600
11 000
6 200
63 800
26 000
8 428
735
Receivables (21 400 + 4 600)
Bank (8 528 – 100)
Rent prepaid
98 963
137 563
Total assets
Capital and reserves:
Ordinary share capital
7% preference share capital
Accumulated profit
40 000
20 000
47 863
107 863
Current liabilities:
Payables
Taxation
Dividend payable: - preference
- ordinary
10 000
15 000
700
4 000
29 700
137 563
Total capital and liabilities
362
TERMINOLOGY
1.
Assets: A resource or right under the entity’s control acquired as a result of a past transaction or
event, and the business expects to derive economic benefits as a result of that control.
Items of possession and have value. The owner has a right of claim to the value of the assets. An
example would be inventory, trade receivables (debtors), cash, motor vehicles, etc
2.
Liability: A legal obligation to transfer out economic benefits as a result of a past transaction or
event.
A legal obligation to pay money or in kind to somebody else. An example would be a bank loan,
trade payables account balance, electricity bill still outstanding, etc.
3.
A customer: someone we sell trading goods to on credit. Consequently he owes us money. An
account for a customer is called a trade receivables account.
4.
A supplier: someone we buy trading goods from on credit. Consequently we owe him money. An
account for a supplier is called a trade payables account.
5.
Cash transactions: business activities in which money is immediately given in exchange for
goods or services.
6.
Credit transactions: Business trading activities in which goods or services are provided without
any immediate exchange of cash. The name of the outside entity is always mentioned in a credit
transaction because it is implied that actual cash will be paid or received in future.
7.
Cash can refer to amounts paid in notes and coins or by cheque, debit card (ATM access card) and
credit card.
8.
An item of income is a source of revenue, which comes in the form of cash. An example would be
sales, rent receivable, commission received, etc.
9.
An expense is an item of expenditure and cash is paid out as a result of it. An example would be
electricity paid, purchases of goods for resale, rent payable, carriage inwards, carriage outwards,
etc
10. A gain is a form of income. It is extra funds generated after undertaking some business
transaction. An example would be cash proceeds of a sale of a fixed asset above its book value,
discount received, etc.
11. A loss is an amount that reduces owner’s wealth and arises from operating activities. It is an item
of expenditure that could not generate a corresponding cash receipt. An example would be
discount received, bad debts, etc.
12. Non current assets: Items of value, which the business intends to use operationally for more than
one accounting period (usually 1 year). They are not intended to be re-sold. E.g. Buildings, motor
vehicles, machinery, etc
13. Current assets: Assets that are continuously changing, kept up-to-date, kept current. E.g. stock,
debtors, cash,etc
14. Long term liabilities: amounts that we owe and repayment will be in more that one accounting
period, e.g. bank loans, debentures, finance leases, etc
15. Current Liabilities: amounts we owe others and payment for them will be made within the next
12 months (one accounting period).
363
16. Owners’ wealth: This is the amount the owner contributed from his private resources into the
business, plus any profits he has made. This is sometimes called owners’ equity or capital
17. Drawings: Amounts the owner of the business withdraws from the business to go and use in his
private capacity at home. It is a reduction in the owners’ wealth.
18. Recognition: This term refers to inclusion in the statement totals of an element in one of the
financial statements. This is achieved by journalizing the entry either to add to or deduct from the
existing balance. For example, the value of a car just bought would be added to the balance of
motor vehicles in the balance sheet. Reducing a statement total is referred to as de-recognition,
e.g. When part of the loan is settled, the loan balance in the balance sheet would be reduced.
19. Elements of financial statements: This term refers to the major classifications adopted in the
financial statements into which all transactions would fall. These are assets, liabilities,
contributions, distributions, gains, losses, income, expenses and owner’s wealth.
20. Contributions: Refers to amounts the owner of the business inject into it as capital from his
private recourses, e.g. new share capital.
21. Distributions: Refers to amounts of resources the owner withdraws from the business for
private use, e.g. drawings, dividends.
364
Completeness, 11
Consistency concept, 323
Contra entries, 68
Credit notes - Debt notes, 44, 45
Current accounts, 244, 249
Current assets, 13, 250
Current liabilities, 14
A
Account transfers, 56, 95
Accounting concepts, 190
Accounting conventions, 322
accounting for prepayments, 153
Accounting information, 5, 8
Accruals concept, 20,
Administration expenses, 23
Allowance for cash discounts, 144, 145, 146
Analytical cash book, 65
Asset, 13
Authorised share capital, 309
Average cost, 200, 201
D
Debenture, 291
Depreciation, 159, 160, 162, 163, 164, 165,
166, 167, 168
Development costs, 193
Direct credits, 129
Direct debits, 128
Direct labour, 344,
Direct materials, 344
Discounts, 125
Dishonoured cheques, 129
Dividend, 35
Doubtful debts, 134
Duality concept, 49
B
Bad debts, 135, 222
Balance sheet, 12, 13
Bank Account, 68
Bank reconciliation, 128
Bank reconciliation statement, 128
Below-the-line, 249
Books of original entry, 112
Business, 2
E
Errors not disclosed by trial balance, 208,
209, 210
Exchange of assets, 182
Expenditure, 37,
Expense, 182,
Expense claim forms, 44
C
Capital, 2, 15, 16
Capital accounts, 249
Capital and revenue expenditure, 36
Capital expenditure, 36
Capital income, 39
Capital reserves, 312
Capi talisation , 188
Carriage inwards, 23, 193
Carriage outards, 23, 193
Cash basis, 240
Cash book, 66, 67,
Cash at bank, 13
Cash in hand, 13
Cash transaction, 50
Cashflow statements, 289, 290
Change in estimated life, 173
Company, 3
Company law, 3,
Comparability, 5, 12
F
Fair value, 181
FIFO, 200, 201, 202, 205, 206, 207
Final accounts, 12
Finance costs, 23
Financial accounting, 7
Financial reporting, 238, 239, 240
Financial statements, 241,
G
General reserve, 312
Going concern concept, 323
H
Historical cost, 161
365
Preference shares, 308
Prepayments, 13
Prime cost, 344
Private companies, 3
Profit and loss account, 102
Property, plant and equipment, 160
Prudence concept, 323
Public companies, 3
Purchases day book, 45, 59, 86, 106
I
IAS 16, 180
Imprest system, 73, 74, 75, 76
Incomplete, 217
Interest on drawings, 249
International accounting standards, 322
Issued share capital, 310
J
R
Journal, 53, 54
Ratios, 325, 326, 327, 328, 329,
Realisation concept 324
Recognition, 181
Recoverable amount, 181
Reducing balance method, 188
Relevance, 5
Reliability, 5, 10
Replacement cost, 183
Research, 186
Revaluation, 183,
Revenue expenditure, 36
Revenue income, 39
Revenue reserves, 312
Rule of double entry, 49
L
Ledger accounting, 56, 178, 149
Lenders, 4
Liability, 10
Life membership, 265
LIFO, 199, 200, 201, 202
Limited partners, 244
Local authorities, 238
M
Managers, 4
Manufacturing account, 344
Market value, 183
Matching concept, 21
Materiality, 324
Money measurement, 323
Mortgage, 16
S
Sales day book, 57
Sales ledger, 121
Selling and distribution, 32, 193
Separate valuation principle, 323
Shareholders, 3, 4
Statutory reserves, 312
Straight line method, 162
Subscriptions, 261, 262, 263, 264, 265
Substance over form, 324
Sum of digits, 162, 164
Supplier lists, 44
Suspense account, 208
N
Net book value, 174
Non current assets, 14, 180
Not for profit, 258
O
Objectivity, 6
Obsolescence, 162
Operating activities, 290
Operating as a partnership, 246
Ordinary shares, 308
Overheads, 326
T
Tax, 240
Timeliness, 6
Trade contacts, 4
Trade creditors, 15
Trade payables, 67, 96, 119
Trade receivables, 66, 123
Transfers, 97
Trial balance, 66, 95, 101,
P
Partnership, 3
Partnership current accounts, 251
Petty cash book, 73, 74, 75
366
True and fair, 166, 174
V
U
Virement, 243
Understandability, 6
Unpresented cheques, 129
W
Work in progress, 343
Working capital, 31
367