Zica T1 - Financial Accounting

CHAPTER 1 INTRODUCTION TO FINANCIAL ACCOUNTING This chapter introduces the nature and objectives of financial accounting. Before you learn how to process transactions and eventual preparation of financial statements, it is important that you understand why accounting information is necessary and the assumptions on which it is based. This is because accounting has limitations on the scope and use of accounting information. It is equally important to know the type of business entities that operate in communities from which accounting information is derived. TOPICS 1.

What is financial accounting?

2.

Types of business entities.

3.

Description of users of financial accounting information.

4.

What makes accounting information to be useful?

5.

The scope and objectives of financial accounting

LEARNING OUTCOMES At the end of this chapter you should be able to: -

Explain the need and objectives of financial accounting.

-

Identify the users of financial accounting information as prepared by different types of business units.

-

Describe qualities of good accounting information.

1

WHAT IS ACCOUNTING? 1.1

Accounting is the process of identifying, measuring, recording, summarizing economic information and finally communicating it to interested parties (users)

1.2

ANALYSIS OF DEFINITION (a)

Process mean accounting has steps and procedures of doing things.

(b)

Identifying means accounting is only concerned with activities or transactions relating to the business.

(c)

Measuring means that all activities related to the business should be stated in monetary terms. 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.

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CHAPTER 2 INTRODUCTION TO FINANCIAL STATEMENTS INTRODUCTION

In this chapter we introduce financial statements by explaining the terms used in classifying income, expenditure, assets and liabilities. Before demonstrating how financial statements are prepared we explain what the accounting equation is. TOPIC LIST

1 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.

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3.2.16 Classification of Expenses When preparing income statement, indirect expenses are classified as: -

Selling and distribution Administration Finance costs

3.2.17 Selling and Distribution expenses These are expenses incurred in the process of selling goods: examples will include: -

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

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

Salaries of general staff Rent & rates Insurance Telephone Heating

3.2.19 Finance costs These may be related to servicing borrowings. Examples: -

Interest on loan Interest on bank overdraft

3.2.20 Simple example of Income Statement -

Bought goods costing K250 When buying the goods transport costs of K20 were incurred to bring the goods into the business premises (carriage inwards) The same goods bought were all sold for K450. The business has an assistant who is paid a fixed salary of K55.

-

Required: Calculate: (a) (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.

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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 Net purchases

XX (XX) 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:    

Distinguish between internal and external documents Mention the name of the document sent at each stage of business activities List the essential part of a document Explain the purpose of each accounting document: the Invoice, the credit Note and the Debit Note

PURPOSE OF DOCUMENTS Documents serve to provide evidence of transactions that took place. In the event of a dispute the document will be referred to. If the dispute is not resolved and the matter is taken to court, the document will be presented as legal evidence of what took place. Documents are also used by auditors to verify the transactions that took place previously. DOCUMENTING BUSINESS TRANSACTIONS Business transactions can be between departments within the same organization or between two separately managed organizations. An external document is one that is sent between two or more organizations. Examples of such documents are invoice, credit note and receipts. Documents may not necessarily be accounting. Some documents are administrative in nature. Examples include Inquiry and Acknowledgement. An internal document is one that is sent between two departments within the same organization. The following are examples of internal documents:     

Staff schedules Supplier Lists Inventory Lists Goods Received Notes Expense Claim Forms

44

The list above is not exhaustive. You should read more books to know more documents. It will also be important to visit an organization to go and see samples of documents they handle in their business. ESSENTIAL FEATURES OF A BUSINESS DOCUMENT Most documents will contain the following:  Name and address of the business  Name and address of the other business  Document serial number  Date of business activity  Description of the activity  Quantity, unit price and total amount of goods  Other details such as delivery address, references, Value Added Tax and discount terms. It should be noted that the contents of a document will be determined by the purpose it will serve. For example, an invoice will contain details of Value Added Tax whereas a delivery note may not. CIRCULATION OF DOCUMENTS In practice most documents are prepared in duplicate. There are circumstances in which a document should be prepared in triplicate depending on who require a copy for use and the importance of keeping the document safely for future reference. Technology has also introduced electronic documentation and it will be in order for those organizations that can afford to acquire such systems, and comply with the relevant legal provisions. ACCOUNTING USE OF DOCUMENTS The seller often issues documents. When a buyer has issued a document, it merely serves as a reminder for the seller to issue the relevant document. An invoice is sent when goods are sold on credit. The seller uses duplicate invoices to compile a record of all sales in the Sales Day Book. The original sales invoice is what the buyer will call the Purchase Invoice. Therefore the buyer uses the original invoices to compile a record of all purchases in the Purchases Day Book. When the customer returns goods, the seller of the goods will send a Credit Note to evidence the transaction. The seller will use the duplicate Credit Note to prepare the Sales Returns Day Book. The buyer will use the original Credit Note to prepare the Purchases Returns Day Book. Invoices are the source documents for the credit transactions that are recorded in the Sales Day Book and the Purchases Day Book.

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:    

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: 

The journal proper contains journals for transactions that are infrequent. Each journal indicates how the amounts involved will be posted to the ledger accounts.

53



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

EXERCISES 1

Calculate the value of premises from the following balances of assets and liabilities: K000 Premises ? Trade Payables 5 600 Trade Receivables 8 250 Cash in Hand 4 520 Loan 9 000 Cash at Bank 6 440 Rates Prepaid 830 Salaries accrued 590 Machinery 7 250 Inventory at start 3 207 Capital 30 307

2

Write the journal entry for the following transactions: Lily owns a truck which he wishes to use exclusively for business. The truck is worth K 30 000 000. She obtains a loan from a bank of K 20 000 000.

54

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 30 000 Capital introduced in the form of a vehicle Bank 20 000 Loan 20 000 Bank loan obtained on commencement of business.

55

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

56

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

CUSTOMERS

April 2005 1 5 13 15

FOLIO

TOTAL K

Chisakaila Ngosa Mulota Mambwe

TOTAL

VALUE ADDED TAX K

TRADE RECEIVABLE K

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

2 922 950.00

432 950.00

2 490 000.00

57

OTHER RECEIVABLE K



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



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



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

1.2 JOURNAL ENTRY Posting the totals to the ledger will be explained in the next chapter. For now it suffices to mention that the two accounts identifiable from entries in the sales day book are: DEBIT CREDIT K K Trade Receivable 2 922 950 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

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



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



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



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



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

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

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



The calculation of Value Added Tax is the same as explained for entries in the purchases daybook.



The day books are mere listings of transactions that took place in the period. They are maintained as memorandum information for future reference.

4.2 JOURNAL ENTRY The amounts will be posted to the ledger as follows: DEBIT CREDIT K K Trade Payables account 78 300.00 Purchases Returns account 66 638.30 Value Added Tax account 11 661.70 In the next section the cash book will be discussed as the day book for cash transactions.

4.3 CHAPTER SUMMARY 61

You should now have learnt that:    

Day books are records compiled and preserved for future reference The invoice is the source document for preparing the sales day book and the purchases day book The credit note is the source document for preparing the Sales Returns Day Book and the Purchases Returns Day book The labels of analyses columns should be determined by the information needs of users within the organization.

EXERCISES 1. Enter the following transactions in the appropriate day books. VAT is charged at the rate of 17.5%. a) March 2.

Sold goods on credit to Akabondo K 845 000 net.

March 8.

Sold goods on credit to Mubita K 780 000 net. The customer is entitled to 2% prompt discount if payment is made within 14 days.

March 14.

Issued an invoice to Mubiana K680 000 net.

March 16

Sold goods on credit to Mundia K750 000 net.

March 18.

Akabondo returned goods, K 325 000 net (He is entitle to prompt discount of 2%)

b) March 7.

Purchased goods on credit from Siwale K 424 000. The invoice stated a tax inclusive amount.

March 12.

Received an invoice for the 10 ton truck bought on credit from Del Equipment K40 000 000 gross

March 15.

Purchased Goods on credit from Simpasa K 380 000 gross value.

March 19.

Received a bill for electricity from Solarpower Co.The total of the bill was K502000

March 22

Returned goods worth K 83 600 to Siwale . This is a tax inclusive figure.

April 24.

Received a credit note from Simpasa for K 42 500 (gross amount).

2. Write the journals for the totals of the Day books you prepared in Question 1. SOLUTIONS TO EXERCISES 62

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

Non current assets (e.g Machinery) 40 000 000 Other Payables 63

40 000 000

Expense Account (e.g electricity) Other Payables

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  Explain the purpose of the cash book  Prepare analytical cash book  State the source document for entries in each day book. 1.0 ANALYTICAL CASHBOOK The cash book is a book of prime entry in which cash transactions are recorded. Cash transactions are those in which goods are exchanged for cash in the form of notes and coins, or are paid for using the cheque system and the debit cards (ATM Cards). Cash transactions involving the exchange of notes and coins with goods are used to compile the cash account. Transactions involving cheques are used to compile the bank account. A section on the bank payment systems will be discussed in the chapter on bank reconciliation. 2.0 CASH ACCOUNT The entries in the cash book are analysed by type of receipts and type of expenditure. Entries in the cash account would be analysed as follows:

65

ILLUSTRATION Fix-it, a retired engineer, received interest from his fixed deposit account of K8 000 000. He opened a business bank account withdrew K3 000 000 for office use. The following are the transactions for the first month of trading: April 2005 April 1. 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

SALES

RECEIVABLE S K

RECEIVABLE S K

K

K 94 500 70 000

LOANS

540 000 400 000 667 755 270 000

30

TOTAL

164 500

940 000

667 755

270 000



The cashbook is the only book of prime entry that is also part of the ledger. The ledger is the main book of account and will be discussed in much more detail in the next chapter.



The column for Other Receivables would further be analysed into, commission received, rent received, etc. To be consistent if you use the term ‘Other Receivables’ on the receipts side of the cash book, then use ‘Other Payables’ on the payments side.



The column for Trade Receivables capture amounts received from our customers as payments on account. Value Added Tax is not calculated on amounts from customers since it is already recorded in the sales daybook. Value Added Tax is, however, 66

calculated on cash sales and recorded in the Value Added Tax column for posting the amount to the ledger. 

The column headings are actually the names of accounts to which totals for each column will be posted in the ledger. The accounts are nominal in the case of income, and are real in the case of loans and non-current assets.



The cash book usually starts with a balance representing the cash that remained in the till when the accounts for the preceding accounting period were prepared. This is the K 8 000 000 you can see in the cash book above. The balance at start is not a transaction and so it will not be posted to any account in the ledger.

2.2 CASH BOOK ( CASH -PAYMENTS SIDE ) DATE

PARTICULAR S

8 13 19 20 26

Wages Bank Repairs Stationery Purchases

30 30

Balance TOTAL

FOLI

C/d

TOTAL

Value Added

CASH

TRADE

WAGES &

TAX K

PURCH K

PAYABLES K

SALARIES K 150 000

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

K

130 000

150 00

150 000

130 000



The payments side of the cash book is analysed into amounts paid to suppliers (Trade Payables), amounts paid for expenses (e.g repairs) and amounts paid for non-current assets bought for cash. The term Other payables would be used if payment was made as a settlement of an outstanding amount owed to a supplier of a non-current asset, or to a provider of a service on credit. The cash book would therefore have more columns in practice than are illustrated above.



The column headings are actually the names of accounts to which totals for each column will be posted in the ledger. The accounts are nominal in the case of expenses, and are real in the case of trade payables and other payables.



Amounts transferred from the cash account to the bank account and vice versa are marked with ‘c’, meaning contra entry. Two accounts are involved: the cash and bank accounts, and so the double entry completes within the cash book. Such amounts are not posted to any account in the ledger because the two accounts involved are already in the cashbook



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

67

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

APRIL 1 4 13

PARTICULAR S

FOLIO

TOTAL

Value Added

CASH

TRADE

OTHER

TAX

SALE S K

RECEIVABLE S K

RECEIVABLE S K

K

LOANS

Capital Loan Cash

K 8 000 000 12 000 000 200 000

30

TOTAL

20 200 000



The column for other receivables would further be analysed into rent receivable, commission receivable, etc. In practice there would also be columns for discount allowed, capital and contra entries;

K 12 000 000

12 000 000

3.2 CASH BOOK ( BANK -PAYMENTS SIDE ) DATE

1 14 25 28 29 30 30 30

PARTICULAR S

Cash Drawings Salaries Rent L-Stone Motors Kunda Balance TOTAL

FOLIO

c

C/d

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

PURCH

PAYABLES

SALARIE S K

PAYABLE

VEHICLES

K

K

K

K

300 000 520 000

10 000 00 227 430 227 430

300 000

520 000



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



At the end of the month (or year as the period of account may be), a balance is found separately for cash account and for bank account. The total columns are used to find the 68

10 000 00

balance on each account. The balance represents the amount of cash remaining at the end of the period of account and will be the opening balance for the cashbook of the following period. 

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

CHAPTER SUMMARY You should now have learnt that:  

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



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

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

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

Value Added

CASH

TRADE

OTHER

TAX

SALES

RECEVBL S K

RECEVBLE S K

K 5 000 000 493 500 634 500 400 000

6 528 000

K 73 500 94 500

K

LOANS

420 000 540 000 400 000

168 000

960 000

400 000

CASH BOOK (CASH -PAYMENTS SIDE) DATE

PARTICULAR S

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

March 1 22

31

PARTICULARS

FOLIO

TOTAL

Capital Loan

K 15 000 00 30 000000

TOTAL

45 000 000

Value Added

CASH

TRADE

OTHER

TAX

SALE S K

RECEIVABLE S K

RECEIVABLE S K

K

LOANS

K 30 000 000

30 000 000

71

350 00

CASH BOOK (BANK -PAYMENTS SIDE) DATE

PARTICULAR S

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

PURCH

PAYABLES

SALARIE S K

PAYABLE

PAYABLS

K

K

K

K

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. 73

Therefore, the analytical petty cash book could be defined as: A book used by a business to record payments of small amounts in cash. The use of cheques for such payments is considered to be uneconomical.

2.

THE PURPOSE OF PETTY CASH

2.1

It is a common feature that almost in every business, there will be a number of small expenses that have to be paid for cash, instead of other methods. To make these payments, which could be on daily bases, a certain amount of cash has to be kept within the business offices.

3.

WHAT ARE PETTY CASH ITEMS?

3.1

These are payments for small expenses required in cash. It is important at this stage to be mindful that what is a petty item will depend on nature and size of an organization, for example, a giant mining company buying an office stapler would be petty item, but a small school with may be 6 students a stapler would be a material item. 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. 74

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

4.3

CONTROL Petty cash should be used only for small items of expenditure and not for large expenses, such as office furniture or airfares. Paying large amounts from petty cash would be an obvious target for theft. (a) To avoid such, it is important to monitor and control petty cash spending by ensuring that all payments are properly authorized. (b) There must be in place also a limit to petty cash payments. For example management may decide that all petty cash payments should be limited to K100 000 amounts more than the limit should be paid by other means, for example by cheques. (c ) Authorization for payments out of petty cash can be done by either the petty cashier or Supervisor. The petty cashier could be allowed to authorize cash payments up to a certain. Amount within the limit, say K40, 000 within the K100, 000 limit. Amounts above that up to K100, 000 could be authorized by supervisor or appointed person.

5.

PETTY CASH EXPENDITURE (PETTY CASH VOUCHER) 5.1 The initial payment of record of payment is the petty cash voucher. The 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

76

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.

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

77

IOU is a good as cash, and the document should be placed in cash box and be treated as cash. When counting cash in cash box IOU must be added as cash equivalent. Example cash and IOU. The monthly petty cash float is K500, 000. During the month total expenditure amounted to K285, 000 and an individual borrowed out of petty cash K35, 000. At the time of balancing the petty cash book, the individual had not paid back the K35, 000. How much cash is available at that time? The following format will help you calculate the cash balance remaining. Physical cash available 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. 78

o The analysis columns in petty cash book will vary depending on the organization’s pattern and nature of expenditure.

Example: Analytical petty cash book. RECEIPTS (DR) PAYMENTS (CR) Total Date Details Voucher Total Office Postage Cleaning Travelin Motor Ledger DR No. CR Expense g 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) June 1 Petty cash June 30 petty cash

Cr 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; 80

40,000

Dr

Stationery A/C

Cr

June 30 Petty cash 192,000 Dr

Cleaning A/C

Cr

K June 30 Petty cash 115,000 Dr

K 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

4 Reams A4 Paper

Amount K 90,000

S/No. (05) Date: 02.06.05

Amount K Repairs to computer 145,000 81

Value Added Tax 17.5% 15.75 Total 105.75

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 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. 82

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

EXERCISES 1. 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

Date

Details

V/N

Dec 1 Dec 2 Dec 4 Dec 6 Dec 9 Dec 10 Dec 12

Cash Station S/Exps C/Sales Repairs Recpt/Phone Station

Dec 14 Dec 19 Dec 25

S/Exps C/Sales Station

Total

CR(K) Station

1 2

10,800 21,700

3

42,500

4

90,000

5

28,200

6

47,800 241,000

160,000 68,936.18

12,063.82

641,000 400,000

Dec 31 Dec 31

Cash Bal c/d

Jan 1

Bal b/d

400,000 641,000

84

Repairs

S/Exps

9,191.50 18,468.09 36,170.21

1, 3,

6,

76,595.7 5

13, 24,000.00

40,680.8 5 126,468. 1

Value Add Tax

4,

7 36,170.21

42,468.09

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:  

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: 85

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. 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).

April 7. April 12. April 13. April 13. April 13 April 15 April 17. April 18. April 19. April 19.

SALES DAY BOOK DATE April 2005 1 5 13 15

PARTICULARS

FOLIO

TOTAL K

Chisakaila Ngosa Mulota Mambwe

634 937 470 881

TOTAL

VALUE ADDED TAX K

500.00 200.00 000.00 250.00

94 500.00 137 200.00 70 000.00 131 250.00

2 922 950.00

432 950.00

TRADE RECEIVABLE K 540 800 400 750

OTHER RECEIVABLE K

000.00 000.00 000.00 000.00

2 490 000.00

SALES RETURNS DAY BOOK DATE

PARTICULARS

TOTAL

K

April 2005 7 17

FOLIO

VALUE ADDED TAX K

TRADE

OTHER

RECEIVABLE K

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

86

PURCHASES DAY BOOK DATE

April 2005 12

PARTICULARS

FOLIO

TOTAL

K Kunda

13

L-Stone Motors Ltd

18

Mwape

19

Zam Hydropower

282 000.00 40 000 000 . 00 270 000.00 320 000.00

TOTAL

40 872 000.00

VALUE ADDED TAX K 42 000.00

TRADE

OTHER

PAYABLE K

PAYABLE K

240 000.00 40 000 000.00

40 212.76

229 787.24 320 000.00

82 212.76

469 787.24

40 320 000.00

PURCHASES RETURNS DAY BOOK DATE

PARTICULARS

FOLIO

TOTAL

April 2005 13 19

K

VALUE ADDED TAX K

TRADE

OTHER

PAYABLE K

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 K Sales 2 922 950.00 410 550.00

Sales Returns

87

SALES Trade Receivables

2 490

000.00 SALES RETURNS Trade Receivables

350 000.00 TRADE PAYABLE

Purchases Returns 000.00

78 300.00

Purchases

552

OTHER PAYABLE - (Non Current Asset) Motor Vehicles

400

000.00 OTHER PAYABLE - (Electricity) Electricity PURCHASES Trade Payable

320 000.00

469 787.24 MOTOR VEHICLES

Other Payable

40 000 000.00 ELECTRICITY

Other Payable

320 000.00 VALUE ADDED TAX

Payables 82 212.76 661.70 Trade Receivable 60 550.00 950.00

Payables Trade Receivable

88

11 432

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. The double entry can be represented in the following journal: DR (K) CR(K) Purchases 469 787.24 Value Added Tax 82 212.76 Electricity 320 000.00 Trade Payable (for goods) 552 000.00 Other Payable –(Electricity) 320 000.00 The amount in the other payables –electricity account is the gross amount because Value Added Tax on this purchase has been ignored for simplicity’s sake The journal for the non current asset is : Debit the Motor Vehicles account (representing the business, or the activity done) and credit the Other Payable –Non Current asset account (representing the giver, L-Stone Motors). The cost of the motor vehicle is gross because the Value Added Tax component is not passed on to the customer. The vehicle is not for re-sale. 2.0 CHAPTER SUMMARY By now you should have learnt that 

The implication of the entity concept is important if you are to apply the rule of double entry correctly 89

  

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.

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: 90

  

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 April 29. April 30

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 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

Bank

1

Sales

13

Sales

22

Ngosa

28

Commission rec.

30

TOTAL

FOLIO

TOTAL

3 000 000 634 500 470 000 667 755 270 000

5 042 255

VALUE ADDED TAX

94 500 70 000

CASH

TRADE

OTHER

SALES

RECEIVABLES

RECEIVABLES

540 000 400 000 667 755 270 000

164 500

1.2 CASH BOOK (CASH -PAYMENTS SIDE) 91

940 000

667 755

270 000

LOANS

DATE APR 8

PARTICULARS

FOLIO

TOTAL

Wages

13

Bank

19

Repairs

20

Stationery

26

Purchases

30

Balance

30

TOTAL

C/d

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 00

150 000

130 000

15000

1.3 CASH BOOK (BANK -RECEIPTS SIDE) DATE APRIL 1

PARTICULARS

FOLIO

Capital

4

Loan

13

Cash

30

TOTAL

TOTAL

VALUE ADDED TAX

CASH

TRADE

OTHER

LOANS

SALES

RECEIVABLES

RECEIVABLES

8 000 000 12 000 000 200 000

12 000 000

20 200 000

12 000 000

1.4 CASH BOOK (BANK -PAYMENTS SIDE) DATE APR 1

PARTICULARS

FOLIO

Cash

14

Drawings

25

Salaries

28

Rent

29

L-Motors

30

Kunda

30 30

Balance TOTAL

C/d

TOTAL

3 000 000 100 000 300 000 520 000 10 000 000 227 430 6 052 570 11 272 000

VALUE ADDED TAX

CASH

TRADE

WAGES &

RENT

MOTOR

PURCH

PAYABLES

SALARIES

PAYABLE

VEHICLES

300 000 520 000

10 000 00 227 430 227 430

300 000

520 000

2.0 POSTING TO THE LEDGER Since the cash book is part of the ledger, the receipts are effectively on the debit side of the cash/bank account, and payments are correspondingly on the credit side of the cash/bank account. The ledger accounts which follow below therefore will carry only the other entry of the double entry. Journal entries would also be written for each of the transactions, for example: 92

10 000 00

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 STATIONERY

Cash

150 000 RENT

Bank

520 000 93

940 000

VALUE ADDED TAX Payables 661.70 Trade Receivables 432 950.00 Cash 164500.00

82 212.76 Payables

11

60 550.00 Trade Receivables 36 750.00

Cash

LOAN Bank

12 000

000 L-STONE MOTORS Bank

10 000 000

2.1 COMMENTS ON ENTRIES IN THE ACCOUNTS 

In the accounts above cash transactions have been posted to the ledger. What was given/received was cash. The entries that would be in the trade receivables account and trade payables account have not been reproduced accordingly.



The entries in the Value Added Tax account show that tax arise both from credit transactions and cash transactions. The net of the credit entries and the debit entries is the amount that becomes payable to the tax authorities.



The entry in the Lstone-Motors account is a part payment for the truck we bought on credit from them (Refer to the entries in the Purchases Day Book in the previous chapter)



Note also that an account can capture both amounts from the cash and the bank accounts, which are in the cash book.

In the next chapter we discuss how ledger accounts are closed for preparation of the trial balance and eventually the financial statements.

3.0 SUMMARY You should now have learnt that:

94

  

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.

95

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:  

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):

96

SALES Trade Receivables 000.00 Trading

2 490

3 430 000.00 Cash 3 430 000.00

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 552 000.00 Bank Discount Received Balance c/d

78 300.00

Purchases

227 430.00 11 970.00 234 300.00 552 000.00

552 000.00 Balance b/d

234 300.00

Closing books would literally mean that accounts with something continuing on them are 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.

97

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 000.00 Balance c/d

10 000 000.00 Motor Vehicles

40 000

30 000 000.00 40 000 000.00

40 000 000.00 Balance b/d

30 000 000.00

ZAM HYDROPOWER CO. - (Other Payables) Balance c/d

320 000.00 Electricity

320 000.00

320 000.00

320 000.00 Balance b/d

320 000.00

PURCHASES Trade Payable Cash 787.24

469 787.24 210 000.00

Trading

679 787.24

679 679

787.24

PURCHASES RETURNS Trading c/d

66 638.30 Trade Payables 66 638.30

98

66 638.30 66 638.30

MOTOR VEHICLES L-Stone Motors

40 000 000.00 Balance c/d

40 000 000.00

40 000 000.00

40 000 000.00

Balance b/d

40 000 000.00 ELECTRICITY

Zam Hydropower Co 000.00

320 000.00 Profit & Loss

320

320 000.00

320 000.00

DRAWINGS Bank

100 000.00 Capital

100 000.00

100 000.00

100 000.00

TRADE RECEIVABLES Sales 550.00

2 922 950.00 Sales Returns Cash Discount All Balance c/d 2 922 950.00

Balance b/d

410 667 755.00 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

000.00 450 000 99

450 000.00

REPAIRS Cash 000.00

130 000.00

Profit & Loss c/d

130 000.00

130 130 000.00

STATIONERY Cash 000.00

150 000.00

Profit & Loss c/d

150

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 661.70 Trade Receivable 950.00 Cash 164 500.00 Balance c/d

82 212.76

Payables

11

60 550.00

Trade Receivable

432

36 750.00

Cash

429 598.94 609 111.70 111.70

609 Balance b/d

429 598.94

LOAN Balance c/d 000.00

12 000 000.00

Bank

12 000 000.00

12 000 12 000

000.00 Balance c/d 000.00 100

12 000

CAPITAL Balance c/d 000.00

8 000 000.00 Bank

8 000

8 000 000.00

8 000

000.00 Balance c/d 000.00

8 000

DISCOUNT ALLOWED Trade Receivables 35 145.00

35 145.00

Profit & Loss

35 145.00

35 145.00

DISCOUNT RECEIVED Profit & Loss 970.00

11 970.00 Trade Payables 11 970.00

11 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

14 147 430 6 052

570 20 200 000 Balance b/d

6 052 570 CASH

101

20 200 000

Total Receipts

5 042 255

Total Payments

876

Balance c/d

4 165

750 505 5 042 255

5 042

255 Balance b/d

4 165 505

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

CR 3 430 000.00 234 300.00 30 000 000.00 320 000.00 66 638.30

102

Commissioned Received Wages & Salaries Repairs Stationery Rent Value Added Tax Loan Capital Discount Allowed Discount Received Bank Cash

270 000.00 450 000.00 130 000.00 150 000.00 520 000.00 429 598.94 12 000 000.00 8 000 000.00 35 145.00 11 970.00 6 052 570.00 4 165 505.00 ______________ 54 762 507.24 ______________

______________ 54 762 507.24 _____________

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

SELF-TEST QUESTIONS 1. Re-attempt the whole exercise and see whether you can do it up Trial balance 2. What is the accounting treatment of discount allowed and discount received?

103

EXERCISES Question 1 Lambdar started business with K15 000 000 in his bank account and owned a truck worth K30,000 000 which he intended to use exclusively for business purposes. The following are his cash transactions for the month of March 2006: March 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.

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. 104

March 22 March 24. March 25. March 26 March 27 March 28 March 29. March 30

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.

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.

105

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 March 8 Furniture 3 500 000 Bank Purchases of office desk by cheque March 12 Motor Vehicle 30 000 000 Del Equipment Purchases of a Truck S/No on credit 30 000 000 Loan (Mini Finance) Loan obtained from Mini Finance

CR 3 500 000

30 000 000

March 22 Bank

March 22 Del Equipment 25 000 000 Bank Part payment for the motor vehicle bought on credit on 12 March 2006

106

30 000 000

25 000 000

SALES DAY BOOK DATE March 2006 2 8 14 16

CUSTOMERS

FOLIO

VALUE ADDED TAX K

TOTAL K

Akabindo Mubita Mubiana Mundia

TOTAL

TRADE RECEIVABLE K

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

3 586 895.00

531 895.00

3 055 000.00

OTHER RECEIVABLE K

SALES RETURNS DAY BOOK DATE

CUSTOMER

FOLIO

March 2006 18 21

TOTAL K

VALUE ADDED

TRADE

OTHER

TAX

RECEIVABLE K

RECEIVABLE K

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

PURCHASES DAY BOOK DATE

March 2006 7 12 15 19

SUPPLIER

FOLIO

VALUE ADDED TAX K

TOTAL

K

TRADE

OTHER

PAYABLE K

PAYABLE K

Siwale Del Equipment Simpasa Solarpower Co.

424 000.00 30 000 000 .00 380 000.00 502 000.00

63 149.00

360 851.00

56 596.00

323 404.00

TOTAL

31 306 000.00

119 745.00

40 000 000.00 502 000.00

684 255.00

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 30 502 000.00 107

K 360 851.00 323 804.00 684 255.00

30 502 000.00

PURCHASES RETURNS DAY BOOK DATE

SUPPLIER

FOLIO

TOTAL

March 2006 22 24

VALUE ADDED

TRADE

OTHER

TAX

PAYABLE K

PAYABLE K

K

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

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

SALES

RECEVBL S K

RECEVBLE S K

K 73 500 94 500

K

LOANS

420 000 540 000 400 000

168 000

960 000

400 000

2.2 CASH BOOK (CASH -PAYMENTS SIDE) DATE

PARTICULAR S

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

350 00 180 000 220 000

3 898 000 6 528 000

220 000

180 000

3.1 CASH BOOK (BANK -RECEIPTS SIDE) DATE

PARTICULARS

FOLIO

TOTAL

March 1 22

Capital Loan

K 15 000 000 30 000 000

31

TOTAL

45 000 000

STATIONERY

VALUE ADDED

CASH

TRADE

OTHER

TAX

SALE S K

RECEIVABLE S K

RECEIVABLE S K

K

LOANS

K 30 000 000 30 000 000

108

350 00

3.2 CASH BOOK (BANK -PAYMENTS SIDE) DATE

PARTICULAR S

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

TAX

PURCH

PAYABLES

K

K

WAGES & SALARIE S K

K

RATES

OTHER

PAYABLE

PAYABLS

K

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

SALES Trading

Trade Receivables Cash

4 015 000

3 055 000 960 000

4 015 000

4 015 000

SALES RETURNS Trade Receivable

625 000

Trading

625 000

625 000

625 000

TRADE PAYABLE

000

Purchases Returns

126 100

Bank 330 750 Discount Received Balance c/d 340 400

Purchases

804

6 750

804 000

804 000 Balance b/d

340 400

DEL EQUIPMENT - (Other Payables) Bank

25 000 000 Motor Vehicles Balance c/d 5 000 000 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

109

-------------------

28 500 00

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 Trading c/d

Trade Payables

107 319 107 319

107 319 107 319

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

Cash

Sales Returns 733 238 400 000

Balance c/d

2 453 657 3 586 895

FURNITURE Bank

3 500 000

Balance b/d

3 500 000 3 500 000

Balance c/d

3 500 000 3 500 000

WAGES & SALARIES Cash 000

220 000 Bank

800 000

110

Profit & Loss c/d 1 020

1 020 000

1 020 000

FURNITURE REPAIRS Cash

180 000

Profit & Loss c/d 180 000

180 000

180 000

STATIONERY Cash

350 000

Profit & Loss c/d 350 000

350 000

350 000

RATES 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

119 108 107 340

745 238 316 400

718 676

Trade Payables Trade Receivable Cash

18 781 531 895 168 000 718 676 340 400

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

BANK ACCOUNT Total Receipts

6 750

45 000 000

111

Total Payments

35 681 300

Balance c/d 45 000 000 Balance b/d

9 318 700 45 000 000

9 318 700 CASH

Total Receipts

Balance b/d

6 528 500

Total Payments 2 630 000 Balance c/d 3 898 000

6 528 000

6 528 000

3 898 000

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

613 234 112

Value Added Tax Cash account Cash purchases with Value Added Tax

107 316 720 550

Trade Payables -Cash -Discount Rcvd Cash Discount Received Settlement of amount owed to a supplier

330 750 6 750 330 750 6 750

SOLUTION 3 VALUE ADDED TAX Trade Payables

98 000

Balance c/d

28 000 126 000

Trade Payables Trade Receivable Cash

Balance b/d

21 000 70 000 35 000 126 000 28 000

SOLUTION 4 VALUE ADDED TAX Trade Payables Bank Balance c/d

13 800 6 800 4 861 126 000

113

Balance b/d Trade Receivable

Balance b/d

7 200 18 261 126 000 4 861

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. 114

It is prepared to check that the total of debit balances and credit balances are equal and offer reassurance that double entry in the ledger is complete.

7.2

Trial Balance example To understand clearly how the trial balance operates, let us do examples. 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

Capital Sales

K 115

Cr. K 8,000 75 325 50 2,150 10,600

Cr. K

Cash

8,000

Balance b/d

8,000 7,325

Dr.

Dr. Bank Dr. Bank Payables Dr. Cash

Rent Purchases Electricity Balance c/d

Capital account K Cash Rent account K 250 Purchases account K 400 575 Stationery account K 75

Dr.

Sales account K Cash Receivables

Dr.

Payables (Suppliers) account K Purchases

Dr. Cash Dr. Sales

Wages account K 325 Receivables (customers) account K 780 116

250 400 25 7,325 8,000

Cr. K 10,000 Cr. K

Cr. K

Cr. K

Cr. K 600 780 Cr. K 575 Cr. K

Cr. K

Dr.

Electricity account K 25

Bank Dr.

Drawings account K 50

Cash N.B.

Cr. K

Cr. K

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 117

4 5 6

Sales returns Opening inventory Drawings

4 5

Purchases returns Capital

Closing inventory does not appear in trial balance because it comes as an adjustment after physical stock take. It is not a transaction, though inventory account is opened and debited with value, because it is an asset remaining and will be shown as current asset in balance sheet. CHAPTER SUMMARY -

A trial balance provides reassurance that double entry book keeping has been done correctly. 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 118

Required: Prepare trial balance as at 31 December 20X5.

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

119

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.

120

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.

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.

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. 121

April 19. April 19. April 22. April 30

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%

SALES DAY BOOK DATE April 2005 1 5 13 15

PARTICULARS

FOLIO

TOTAL K

Chisakaila Ngosa Mulota Mambwe

634 937 470 881

TOTAL

VALUE ADDED TAX K

500.00 200.00 000.00 250.00

94 500.00 137 200.00 70 000.00 131 250.00

2 922 950.00

432 950.00

TRADE RECEIVABLE K 540 800 400 750

OTHER RECEIVABLE K

000.00 000.00 000.00 000.00

2 490 000.00

SALES RETURNS DAY BOOK DATE

PARTICULARS

FOLIO

TOTAL

K

April 2005 7 17

VALUE ADDED TAX K

TRADE

OTHER

RECEIVABLE K

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

PURCHASES DAY BOOK DATE

April 2005 12

PARTICULARS

FOLIO

TOTAL

K Kunda

13

L-Stone Motors Ltd

18

Mwape

19

Zam Hydropower

TOTAL

282 000.00 40 000 000 . 00 270 000.00 320 000.00

40 872 000.00

PURCHASES RETURNS DAY BOOK

122

VALUE ADDED TAX K 42 000.00

TRADE

OTHER

PAYABLE K

PAYABLE K

240 000.00 40 000 000.00

40 212.76

229 787.24 320 000.00

82 212.76

469 787.24

40 320 000.00

DATE

PARTICULARS

FOLOI

TOTAL

April 2005 13 19

VALUE ADDED TAX K

K

TRADE

OTHER

PAYABLE K

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

1.3 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

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

Sales Returns

176 250.00

Balance c/d

705 000.00 881 250.00

TRADE RECEIVABLES ACCOUNT BALANCES LISTING: K Chisakaila 634 500.00 Mulota 470 000.00 Mambwe 705 000.00 TOTAL 1 809 500.00 123

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

MWAPE Purchases Returns Balance c/d

35 700.00

Purchases

270 000.00

234 300.00 270 000.00

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. 124

1. The Value Added Tax amount on sales returns from Ngosa did not take into account the entitlement to cash discounts. The mistake was made in the personal account only. 2. Discount allowed was not posted to the trade receivables account in the general ledger. The calculation of Value Added Tax on sales returns from Ngosa is 200 000 x 0175 = 34 000 The Trade Receivables accounts would be drafted as follows:

TRADE RECEIVABLES Sales

2 922 950.00

Balance b/d

2 922 950.00 1 844 645.00

Sales Returns Cash Balance c/d

410 550.00 667 755.00 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 1 809 500 125

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.

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 130 000 126

Cr Trade Receivables Ledger with K 130 000

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

List of trade payables balances

a. b. c. d.

No adjustment Increase by K4 500 No effect Increase by K4 500

K 4 500 Credit K 4 500 Credit K 29 340 Debit K 33 840 Debit

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. 127

SOLUTIONS TO EXERCISES 1. TRADE PAYABLE K000 Balance b/d 6 500 90 Purchases 34 000 Purchases 20 Trade Receivables 70 Discount Received 50 Balance c/d 14 328 Balance b/d Purchases Returns Bank

K000 45

48 583

42 000

48 583 Balance b/d

14 328

d 2

a

3 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 7 457 3 244 128 400 896 608 2 119

13 173

TRADE PAYABLE

563

Balance b/d Purchases Returns

K 1 985

32 662

K Balance b/d Purchases

Bank

300 912 Trade Receivables Discount Received 9 027 Balance c/d 83 403 Balance c/d

48 583 Balance b/d (1985 – 1525)

460

128

7 457 460

48 583 Balance b/d

83 403

26 423

408

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

Explain the terms used in describing transactions processed through the bank account To prepare a bank reconciliation statement

TOPICS 1. 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    

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 

Direct debits: 129

Amounts debited on the bank statement but are not on the cashbook bank account. Consequently if we are to update our cashbook the amounts should be recorded on the credit side as they represent payments made directly by the bank on our behalf.



Direct credits: Amounts credited on the bank statement but are not on the cashbook bank account. When updating the cashbook the amounts will have to be recorded on the debit side as they represent receipt of cash directly through the bank.



Standing order: The name is derived from the activity that creates it. The business issues a standing order to the bank by letter. The letter contains an instruction to the bank to pay a specified fixed amount on a stated date at regular interval (eg quarterly). When the time is due for the matter the bank acts on the standing order and pay the amount. The amount is shown on the debit side of the bank statement and so it will be recorded on the credit side of the updated cashbook.



Deposits not yet credited by the bank: Such deposits are usually made on the last day of the month or year. The processing of the deposit slips by the bank takes place the following day. So the bank statement for the month or year under review does not show entries for such deposits, even though they have already been recorded in the cash book.



Unpresented cheques: These are cheques we issued to pay for goods or services but the cheques have not been taken to the bank for cashing by the suppliers we paid. The cheques are already recorded in our cash book but have not been reflected on the bank statement.



Dishonoured cheques: Cheques that once were received, recorded in the cash book but the bank refuses to honour them for one reason or the other. Such cheques are returned to the customer (trade receivable) who paid the amount, and the earlier receipt is reversed.

130

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 131

transactions that have been processed in both sets of accounts correctly. 2. Starting with the closing balance on the cash book, prepare an updated cashbook by debiting amounts that appear in the credit column of the bank statement, and vice versa. 3. Starting with the revised cashbook balance in step 2, prepare a bank reconciliation statement. The amounts recorded in the cashbook but not processed by the bank are reversed accordingly. In practice more rigorous verification is done since a lump sum shown on the bank statement may have to be broken down into several transactions and matching entries identified separately. Extensive schedules of unmatched entries are prepared, and totals used for preparation of bank reconciliation statements. SOLUTION 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 reversed. 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

132

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? CHAPTER SUMMARY You have now learnt that: 

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



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

EXERCISES 1. Your firm’s cash book shows a credit balance of K12 400 at 30 June 2005. Upon comparison with the bank statement you determine that there are unpresented cheques totalling K4 500, and a receipt of K1 400 which has not been passed through the bank. The bank statement shows bank charges of K740 which have not been entered in the cash book. What is the balance on the bank statement? 2. Your firm’s cash book at 30 September 2005 shows a balance at the bank of K24 900. A comparison with the bank statement at the same date reveals the following differences:    

Unpresented cheques 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

133

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. 134

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

135

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.

136

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 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

Balance c/d

137

Cr. K 276,000 _______ 276000

20X7 Jan. 1 Balance b/d

276,000

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

15.2

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

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 138

Dr.

Bad debts account

Mr. Fix

K 276,000

Cr.

Income Statement

_______ 276,000

K 276,000 ______ 276,000

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 Example: Bad debts recovered 139

with amount received

A debt previously written off Mr. Fix K276,000 has now been fully recovered with a payment by cheque.

Dr.

Mr. Fix account

Balance

K 276,000

b/d

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:

15.5

-

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.

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.

140

-

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

Total amount Estimated Allowance for owing % Doubtful doubtful debts K K 11,300,000 1% 113,000 7,400,000 4% 296,000 2,500,000 6% 150,000

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.

XX (1,350)

Allowance for doubtful debts account 141

Cr.

Balance c/d

K 1,350 ____ 1,350

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. 142

Compare the balance b/d in the allowance for doubtful debts account with the newly calculated figure, the difference is the increase which should be charged to income statement and added to allowance b/d from previous year. -

The new balance is always the figure to be deducted in balance sheet from year end receivables.

Double entry will be as follows: Debit: Income Statement (as expense) Credit: Allowance for Doubtful Debts (with the increase) Example 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

Balance c/d

K 1,620 ____ 1,620

Balance b/d Income statement

K 1,350 270 1,620

Balance b/d

1,620

Balance sheet (20X8) Current assets

K

Receivables Less: Bad Debts

K

54 000 1,620 52 380

(b)

If decrease in allowance for doubtful debts 143

Cr.

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 30,000 (1,500) 28,500

Receivables Less: Bad debts

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

144

Income Statement (20X9)

K

K

Gross profit Add: other income Decrease in provision for doubtful debts Less: Expenses Bad debts

XX 765 XX 1,500

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

Balance

K 268,000

Bad debts Balance c/d

______ 268,000 Balance b/d Dr. Receivables

K 18,000 250,000 _______ 268,000

250,000 Bad debts account K 18,000

Cr. K

Allowance for doubtful debts

_____ 18,000 Dr.

Cr.

Allowance for doubtful debts account 145

18,000 _____ 18,000 Cr.

Bad debts Balance c/d

K 18,000

K 27,800 15,200 _____ 43,000 25,000

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. 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

20X6 20X7 20X8

20,000 25,000 23,000

1,000 1,250 1,200

20X6 20X7 20X8

K20,000 K25,000 K23,000 Dr.

-

1,000 1,250 1,200

= = =

Allowance for cash discounts % 3 3 3 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

Cr. K

570

Income statement

570

570 20x7 Balance c/d

713 ___ 713

570 Balance b/d Income statement

20x8 146

570 143 713

Income statement Balance c/d

59 654 713

Balance b/d

713 ___ 713 654

Balance b/d

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

147

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. 148

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.

2,000

280 280

20X7 Balance b/d Income statement

280 1,720

Balance b/d

2,000

2,000 In balance sheet 149

2,000

20X6 Receivables (K28,000 – 280) K27,720 20X7 Receivables (40,000 – 2,000) K38,000

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: • • • • 16.1

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. 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 150

A business rents a shop for K1,200 per annum (K100 per month). If at year end, the business has only paid K1000, a full years charge of K1,200 will be expensed in income statement. The K200 though not paid will be included because it relates to the same period. Accruals or accrued expenses are expenses which are charged against the profits of a particular period, even though they have not been paid, because they were incurred in that period. N.B. Accruals can be owing by the business or to the business. Example 1: Owing by the business. 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

151

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. 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. 152

Example 1. T.K. Furnishers Ltd sublets part of the buildings at an annual rent of K1200 000 (K100 000 per month). During the year ended 31 December 20X8, T.K. discovers that the tenant had only paid K1 000 000. Show rent receivable account and statement to be shown in income statement and interpret the balance brought down. Solution: Dr.

Rent Receivable Account

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 153

income for 20X9 to be added to gross profit in income statement. In this example there’s nothing owing at year end.

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 154

Cr.

Bank (14 x 74)

K 1 036 000

Balance b/d

________ 1 036 000 148 000

Income statement Balance c/d

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.

-

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 Income statement 740 000 _______ 888 000

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. 155

-

Any amount receivable paid in advance would not be included in income statement in the year it is received.

-

It should be accounted for in the period the service will be provided.

-

In balance sheet it should be reflected under current liabilities as other payables.

Example 1: Prepayments to the business. Gas Pipe runs a service station and sales fuel among other services. Some well established individuals make advanced payments to Gas Pipe for fuel. During the year ended 31.12.20X7, a payment of K3 000 000 was paid in advance for fuel by a customer. 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. Income statement Balance c/d

Fuel Account 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 156

Examples given so far for prepayments and accruals are straight forward. This has been done to have basic knowledge on the subject matter. -

In examination questions, however, one may be confronted with complicated situations involving several receipts or payments made in the year covering different periods. In such situations particular attention should be made on dates.

Example 1: Fitwell Garage pays fire insurance annually in on 1 June each year. From the following record of insurance payments, calculate the charge to income statement for the financial year to 28 February 20X8. 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 (3/12 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

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. 157

-

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).

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).

158

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.

Rent and Rates Account

Cr.

Balance b/f Bank (rent) Bank (rates) Balance c/d

K 250 000 Balance b/f 4 000 000 Income statement 3 600 000 (Balancing figure) 200 000 balance c/d 8 050 000

K 500 000

000 Balance b/d

150 000

Balance b/d

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

159

7 400 000 150 000 8 050 200 000

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 160

• • • • • • •

11.0

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

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 161

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: “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.

162

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

11.5

11.6

K80 000 000 (K3 000 000) K77 000 000 is depreciable amount over 5 Years

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. 163

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

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. 164

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.

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 2 165

+ 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

Year 2

4

Year 3

3

Year 4

2

/15 x depreciable amount /15 x depreciable amount /15 x depreciable amount /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

Year 2

4

Year 3

3

Year 4

2

Year 5

1

/15 x K570 000 = K190 000 /15 x K570 000 = K152 000 /15 x K570 000 = K114 000 /15 x K570 000 = K 76 000 /15 x K570 000 = K 38 000 K570 000 + K 30 000 K600 000

Residual value

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 166

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)

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: 167

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.

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.

168

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 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. 169

20X2 1 July

bought 3 machines at cost K40 000 each.

20X3 1 October

bought another machine for K25 000

20X4 1 December

bought fixtures for K18 000.

NOTES: Machinery is depreciated at the rate of 15% per annum on cost and fixtures at the rate of 5% using the reducing balance method. Depreciation is to be charged fully for the whole year disregarding the purchase date. Required: Show (a) The machinery account (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

Machinery 2

-

18 000 18 000 18 000 54 000

Machinery 3

-

-

Total

9 000 27 000 30 750 30 750 97 500

9 000 9 000 9 000 36 000

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 ______ 170

Balance c/d

60 000 _______

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

Dr

205 000

Allowance for depreciation account (Machinery)

20X1 Balance c/d 20X2 Balance c/d 20X3 Balance c/d 20X4 Balance c/d

K 9 000 _____ 9 000

20X1 Income statement 20X2 Balance b/d Income statement

36 000 36 000

20X3 Balance b/d Income statement

66 750 66 750

20X4 Balance b/d Income statement

97 500 97 500

Cr K 9 000 _____ 9 000 9 000 27 000 36 000 36 000 30 750 66 750 66 750 30 750 97 500

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

171

20X4 Balance b/d Bank Dr

38 000 18 000 56 000

Balance c/d

56 000 _____ 56 000

Allowance for depreciation account (Fixtures)

Cr

K 20X1 Balance c/d 20X2 Balance c/d 20X3 Balance c/d 20X4 Balance c/d

K 20X1 Income statement

1 900 _____ 1 900

1 900 _____ 1 900 1 900 1 805 3 705 3 705 1 715 5 420 5 420 2 529 7 949

20X2 Balance b/d Income statement

3 705 3 705

20X3 Balance b/d Income statement

5 420 5 420

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 20X1 Machinery Fixtures

Cost 60 000 38 000 172

Depreciation N.B.V. 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

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 173

(a)

The method should allocate costs in proportion to the benefits i.e. (i) (ii)

11.4

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.

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. 174

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 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. 175

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 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

176

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. -

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. 177

-

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.

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

100 000 ______ 100 000

June 30

Disposal

20X6

1 Jan. Balance b/d 20X7

1 Jan. Balance b/d

178

100 000 ______ 100 000

Dr

Allowance for depreciation K

31 Dec. Bal. c/d

10 000 ______ 10 000

Cr

20X5

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 25 000

Dr 20X7

1 Jan. Balance b/d 20 000 30 June Inc. statement 5 000 (Depreciation) _____ 25 000

Disposal account K

30 June Van at cost 100 000 _______ 100 000

20X7

Cr 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. 179

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

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

K

30 June Disposal

600 000

31 March (20X9) Bal c/d 850 000 ________ _______ 1 450 000 1 450 000 1 April 20X0 Bal. b/d 850 000 Dr 20X8

Disposal account K

30 June M/Vehicle 600 000 _______ 600 000

180

20X8

30 Acc. Dep. Trade in All Loss (P/L A/c)

Cr 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 CR -

Disposal account with Trade in allowance (255 000) Cash account with M/Vehicle (K595 000)

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. -

11.19.0

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.

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. 181

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.

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

•

Fair value is the amount for which an asset could be exchanged between

•

Carrying amount is the amount for which an asset is recognized after deducting any

•

Recoverable amount is the amount which the entity expects to recover from the

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.

knowledgeable, willing parties in an arms length transaction.

accumulated depreciation and impairment losses.

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. 182

(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. 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: The cost of site preparation Initial delivery and handling costs Installation costs Professional fees (architects, engineers)

o o o o

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).

183

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) (c)

11.19.12

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 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 184

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 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 185

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.

Impairment of asset values 11.19.26

The carrying amount of an item or group of identical items of property, plant and equipment should also be reviewed periodically. This is to assess whether the recoverable amount has declined below the carrying amount. When there has been such a decline, the carrying amount should be reduced to the recoverable amount.

11.19.27

Recoverable amounts should be considered on an individual asset basis or for groups of identical assets. Retirements and disposals

11.19.28

When an asset is permanently withdrawn from use, or sold or scrapped, and no future economic benefits are expected from its disposal, it should be withdrawn from the balance sheet.

11.19.29

Gains or losses are the difference between the estimated net disposal proceeds and the carrying amount of the asset. They should be recognized as income or expense in the income statement. Disclosure

11.19.30

The standard has a long list of disclosure requirements, only some of which are relevant to your syllabus. • • • • •

Measurement bases for determining the gross carrying amount (if more than one, the gross carrying amount for that basis in each category) Depreciation methods used Useful lives or depreciation rates used Gross carrying amount and accumulated depreciation at the beginning and end of the period Reconciliation of the carrying amount at the beginning and end of the period showing: 186

o o o o o o

11.19.31

Additions Disposals Increases/decreases from revaluations Reductions in carrying amount Depreciation Any other movements The financial statements should also disclose the following: • • • •

11.19.32

Revalued assets require further disclosures • • • • • •

11.19.33 • • • •

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

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 standard also encourages disclosure of additional information, which the users of financial statements may find useful.

The carrying amount of temporarily idle property, plant and equipment The gross carrying amount of any fully depreciated property, plant and equipment that is still in use The carrying amount of property, plant and equipment retired from active use and held for disposal When the benchmark treatment is used, the fair value of property, plant and equipment when this materially different from the carrying amount.

11.19

RESEARCH AND DEVELOPMENT COSTS (IAS 38)

IAS 38 – INTANGIBLE ASSETS An intangible asset is an identifiable non monetary asset without physical substance. The asset must be: (a)

Controlled by the entity as a result of event in the past.

(b)

Something from which the entity expects future economic benefits to them. 187

Examples: -

Goodwill Development costs

RESEARCH AND DEVELOPMENT COSTS RESEARCH -

This is an investigation undertaken in order to discover new facts or get additional information.

Research could be used for new or improved products, processes and methods. Research is a cost to an entity. DIVISION OF RESEARCH 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. 188

-

Overhead costs which may be allocated because they relate to research and development.

ACCOUNTING FOR RESEARCH AND DEVELOPMENT COSTS THE ACCOUNTING PROBLEM The costs of Research and Development can run into millions of kwachas. However, it may take many years before the new technology or product is commercialized. Following the accruals concept, the cost of research and development should be capitalized when incurred, and then amortised when the product is eventually marketed. This would then match the costs with the benefits. However, prudence would say that the eventual profits are so uncertain and so it would be better to write off research and development costs in income statement when they arise. THE SOLUTION 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. 189

-

The straight line method of depreciation assumes that the asset will be used evenly through out its life and therefore some amount is charged to income statement from one year to the next.

-

Reducing balance method assumes that the asset will be used more in its earlier years than later years, thus the depreciation amount will be reducing with time.

-

Non current assets may be sold off before their life span expires. A disposal account is opened to determine whether a profit or loss has been made on disposal.

-

It is also important that an organization keeps a non current asset register for control purposes.

EXERCISES 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)

Date of purchase Description and location Original cost Depreciation method and rate 190

(e)

Accumulated depreciation to date

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 191

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.

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: 192

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

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 193

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

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) 18.3

(K80 000) K566 000

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 194

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

Required: Calculate cost of sales. Solution K Cost of sales: Opening inventory Purchases Carriage inwards Less: Closing inventory Cost of sales 18.4

55 000 75 000 3 000 133 000 (85 000) 48 000

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 195

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)

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

740

196

K’000 Cash

K’000 750

Dr

Trade Payables

Cr

Cash Balance c/d

K’000 60 Purchases 20 80

K’000 80 __ 80

Dr

Balance b/d Purchases account

20 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 25 Income statement 25

K’000 25 25

Payables Cash

Dr Sales

Dr Income Statement

197

___ 175

Dr

Inventory account

Income statement Balance b/d

Cr

K’000 35 Balance c\d ==== 35

K’000 35 ====

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 115 Closing inventory 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. 198

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) 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. 199

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. (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 A B C

Cost K 17 000 8 500 23 000

N.R.V. K 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 ======

K45 000 is the value that should appear in balance sheet as value of inventory. Comparing K48 500 with K51 100 and valuing inventory at K48 500 would be inappropriate because there would be covering up. Example 3: The following figures relate to inventory held at the year end. A K 200

B K

C K

Cost Selling price Modification costs Marketing costs Units held

20 000 30 000 7 000

9 000 12 000 2 000 2 000

12 000 22 000 8 000 2 000

200 000

150 000

300 000

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 Total Value Units K000 200 000 4 000 000 150 000 1 200 000 300 000 3 600 000 8 800 000 ========

Note: Net Realisable Value Item A: K300 000 – K7 000 = K23 000 B: K12 000 - K4 000 = K8 000 C: K22 000 - K10 000 = K12 000 18.7

Determining the purchase cost of inventory Depending on the type of business, inventory could be (i) (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.

201

There are many techniques which are used to value such items of inventory. They include the following: -

12.16 (a)

First in first out (FIFO) Last in first out (LIFO) Average cost (AVCO) Replacement cost

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 32 202

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. 203

(b) Date

LIFO METHOD Purchased

1 June 6 June

400 @ K17 each

Sales -

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

-

Inventory Balance After each transaction

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

204

(c) Date 1 June 6 June

Using AVCO Purchased

Sales

400 @ 17 each

-

200 x K12 each K2 400

-

K6 800 + K2 400

K6 800 9 June

K9000

Inventory Balance After each transaction

300 @ 30 (300)

K9 200

600 300 @ 15 each K4 500

15 June

17 June

21 June

-

250 @ 32 K8 000

100 @ 18 each K1 800 -

-

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. 205

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.

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

8 600 206

K 18 920

Closing inventory

(1 530) (7 070) 11 850

Profit

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? 207

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.

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

208

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 209

-

Errors of Principle Errors of Commission Compensating errors Errors of Original entry Complete reversal of entries

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 210

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 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

211

Rent account Cash

5

Cash account 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)

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. 212

8.2

Errors disclosed by trial balance In some cases, the trial balance totals may not be the same. This may mean a lot of things. 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. 213

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: Rent Cash Suspense

Dr 100

Cr 170

70 170

Suspense account will be opened with debit balance

214

170

Dr

Suspense account

Balance -

Cr

70

error corrected 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)

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 215

(iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi)

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 An invoice for car repairs K380 had been entered in the wages account. The rent received account balance of K600 had been entered on the wrong side of the trial balance and income statement. Advertising account with a balance of K2,759 had been omitted altogether. Closing inventory had omitted some items valued at cost K2,000. 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) (iv) (v) (vi) (vii) (viii)

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 Suspense account (rent) Rent

380

Advertising

300 18 120 200 380 1,200 1,200 2759

216

Cr

(ix)

Suspense account (advertising)

2759

(x)

Closing Inventory account Income Statement

2,000 2,000

Discount allowed account Discount received account Suspense account

150 150

(xi)

(b)

Dr

Suspense account

Balance Sales Rent

1421 576 1200

Petty cash Bad debts Advertising Discount all. Discount rec.

____ 3197 (c)

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 217

expenses are included as expenses in the year to which they relate. Profits should reduce by K371

-

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 218

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).

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.

219

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) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi)

Discount allowed K480 had been entered on the credit side of discount allowed account. The bank statement balance of K560 overdraft had been included in trial balance instead of the cashbook balance of K63 debit. The provision for bad debts account of K150 had been entered on wrong side of trial balance Rent receivable account was over cast by K20 Drawings of K250 had been included in purchases account The sale of furniture (non current asset) had been included in sales account of K300 Payment for insurance of K45 was entered in insurance account as K54 Discounts received was overstated by K100. A cheque for K200 for car repairs had been posted to the building repairs account Provision for depreciation account K270 was entered on wrong side of trial balance 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.

220

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)

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

623

Rent receivable account Suspense account

300 20 20

Drawings account Purchases account

250

Sales account Disposal account

300

250 300

Suspense account Insurance account

9 9

Discount received account Suspense account

100

Car repairs account Building repairs account

200

Suspense account Trial balance (with provision for

540

100 200

221

depreciation account) (xi)

540

Income Statement account Lorry account

Dr

375 375

Suspense account

Provision for bad debts Insurance Provision for depreciation Balance

300 9 540 874 1723

222

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

223

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)

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 224

(f) (g)

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. 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)

add accrued

K’000 50 50 ___ 1,00

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’000 225

Receivables Less: Bad debts Remaining receivables

K’000 18 30 12

(ii)

Allowance for bad debts is New balance Increase in allowance is

(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.

810 (6) 804

K’000 804 7 (30) 781

Depreciation: (i)

(ii)

(iii)

Buildings:

Warehouse:

Balance as per trial balance charge to income statement (2% x 8,300)

Balance as per trial balance charge to income statement (15% x 1,800)

Motor vehicles: Balance as per trial balance Charge to income statement (25% x 1650)

K’000 1,020 166 1,186 K’000 290 270 560 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:

K’000 13,207

226

Opening inventory Purchases (2) Less: Returns outwards Add: Carriage inwards Less: Closing inventory Gross profit

1,530 8,118 (150) 700 (1,660) (8,538) 4,669 100 4,769

Add: Discount received 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

Land Buildings Warehouse Motor Vehicles

1510 8300 1800 1680

1186 560 1040

N.B.V. K’000 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 235 227

Non current Liabilities

10% Loan

1000

Current liabilities

Trade payables (820 + 18) Accrued expenses (120 + 190 + 50)

838 360

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 K1,000 228

(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. 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

229

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. 230

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.

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: 231

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. -

21.3

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.

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. 232

Therefore the best way of assessing departmental performance could be through contribution.

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.

233

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

Shared expenses: Depreciation: Buildings Motor vehicles Rates Electricity

Total

K

K 462,700

K 264,700

43,600 137,000 180,600 (17,000) (163,600) 101,100

(248,600) 214,100

34,000 20,100

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

21.4

Electrical

(59,700 53,300

Contribution

(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.

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 234

Apart from deciding whether to close a department or not which is not easy, departmentalizing a business may provide vital information such as: (a) (b) (c)

Profitability of each department for the purpose of may be expanding a profitable department. 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. 235

(v)

Departmental managers are entitled to 10% commission on sales

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

236

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 44,000 600,000 350,000 740,000 636,000 400,000 784,000 (25,000) (33,200) (41,750) (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 ______ ______ (40,000) (27,500) (52,500) (120,000) 24,100 37,500 (29,900) 31,700

237

2.

Papa Departmental income statement for the year ended 30 June 20x5 K Sales Cost of sales: Opening inv. Purchases Closing inv. Gross profit

Drugs K 675,000

75,000 900,000 ______ 975,000 (60,000) ______ (915,000) (240,000)

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 =======

Perfumes K K 500,000

Toiletries K 300,000

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)

(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

238

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: 239

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.

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 240

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.

22.5

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.

INTERNATIONAL FEDERATION OF ACCOUNTANTS (Public Sector) (IFAC) The International Federation of Accountants is an organization of national professional accountancy organization that represents accountants employed in public practice, business and industry, the public sector and education. IFAC has a Public Sector Committee (PSC). The PSC focuses on the accounting, auditing and reporting needs of national, regional and local governments, related governmental entities and the constituencies they serve. It addresses these needs by issuing and promoting benchmark guidance, conducting research and educational programs, and facilitating the exchange of information among accountants and all those who work within the public sector.

22.6

FINANCIAL REPORTING UNDER THE CASH BASIS a)

Cash basis This accounting system recognizes only cash inflows and cash outflows. The resulting final accounts are summarized cash books. There are no balance sheets under this system because there are no other assets (apart from cash) and liabilities in the books other than cash balances.  

Sales are recognized only when cash is recorded. So there are no receivables. Purchases are only recognized when cash is paid. So there are no payables.

241



  b)

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 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 242

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. 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)

22.7

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.

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 243

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. Below-the-line: This term refers to exceptional and extraordinary items which are not included in the calculation of profit (above the line). The items relate to capital income and expenditure. Virement: This deals with the transfer of items from one financial account to another. 24 CHAPTER SUMMARY 

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



Users of public sector financial reports include: i) Authorities (including parliament) ii) Heads of government departments iii) Tax payers iv) The public (the electorate) v) Donors & International financiers such as the World Bank



The cash basis of accounting recognizes transactions and events only when cash is received or paid. Notes to the financial statements may provide additional information about liabilities and other non cash assets (payables and receivables)



Accruals based accounting recognizes income and expenditure when it accrues and not when cash is received or paid.

244

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 245

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.

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. 246

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)

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 247

Income statement – shared,

proprietor only

23.7

appropriation section

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.

248

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: 249

-

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 250

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

100,000 200,000 300,000

Current accounts: Banda Bwalya

22,750 36,250 59,000 359,000

If one partner had finished with a debit balance in current account, the balance will be shown in brackets in balance meaning it should be deducted. 23.8 Most examination questions specify Capital and current accounts should be shown separately. Occasionally you may be faced with a question specifying only one account for each partner. Such an account acts as a capital and current account combined thus the term Fluctuating Capital. In fluctuating capital, all entitlements are credited to capital accounts and drawings and interest on drawing debited capital accounts. In this situation current accounts are irrelevant. Therefore capital figures in balance will be inclusive of current account items and will be changing from year to year. 251

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

130,750 Balances b/d 122,750

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

252

20,000 5,000 17,750 242,750 236,250

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.

253

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.

254

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

255

(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 18,000 256

Cr.

Z

14,000

X Y Z

4,800 800 2,400

(32,000) Interest on capital:

(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 profits13,572 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) 3,876 257

Z

7,957 (3,155)

Current liabilities Payables

36,480 133,325

258

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: -

24.1

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. 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.

259

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. 260

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)

24.4

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.

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.

261

Example: Bar income statement. Armstrong Body Building Club Bar Income Statement K Bar Sales Less cost of sales: Bar opening inventory Bar purchases

30 160 ___ 190 (80)

Less: Bar closing inventory

(110) 130 (70) ___

Less: Bar man’s wages Net profit (transferred to income and expenditure account) 24.6

K 240

60

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.

262

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. 263

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.

264

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.

265

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. 266

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. 267

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

268

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

269

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 Income Subscriptions Ticket sales Less cost of prizes Profit on competition Donations

K

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

270

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.

271

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 36,200 326,000 272

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.

273

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 Balance c/d

8,790 Balance b/d

40 470 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

274

____ 1,620 50

4.

The correct answer is C. Assets Equipment Premises Bar inventory Subscriptions in arrears Cash Liabilities Bar payables Wages owing Prepaid subscriptions

K 1,500 16,000 1,300 500 1,900

21,200

1,100 250 350 (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

K

190,000 (1,800) 700 188,900 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 275

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

276

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.

277

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)

Excess of payments over receipts Add: Opening Balance Closing Balance

(3 259) (1 300) 4 559

278

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 279

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 Balance c/d

Balance b/d Purchases

34 000 4 600 38 600

Balance b/d

3 800

K 000 34 800

4 600

38 600

EQUIPMENT Balance b/d Bank Balance b/d

K 000 8 200 5 520 13 720 12 500

P/L -Deprec

1 220

Balance c/d

12 500

K 000

13 720

LOAN K 000 Balance c/d

Balance b/d

10 000 10 000

Balance b/d

10 000 10 000

K 000 10 000

CAPITAL K 000 Balance c/d

Balance b/d

4 880 4 880

Balance b/d

4 880 4 880

K 000 4 880

INVENTORY Balance b/d

K 000 3 200

K 000 Trading c/d

3 200

PURCHASES

280

3 200 3 200

K 000 34 800

Trade Payables

K 000 Trading c/d

38 400

34 800

38 400

SALES RETURNS K 000 450

Trade Receivable

K 000 Trading c/d

450

450 450

SALES K 000 Trading c/d

Cash Trade Receivables

63 245 63 245

4 200

K 000 59 045 63 245

BAD DEBTS K 000 325

Balance b/d

K 000 P/L

325

c/d

325

325

DISCOUNT ALLOWED Trade Receivables

K 000

800

800

K 000 P/L c/d

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

c/d

8 300

8 300

LOAN INTEREST Bank Balance c/d

K 000 700 500 700

P/L c/d

K 000 1 200 700

281

Balance b/d

500

INSURANCE K 000 909

Bank

K 000

909

P/L c/d

909

Balance b/d P/L c/d Balance c/d

420

Balance b/d P/L c/d

300

Balance b/d

320

909

RENT & RATES K 000 Bank

3 640

Balance b/d

3 640 380

380

K 000 2 840 3 640

ELECTRICITY K 000 Bank Balance

c/d

1 580 320 1 900

K 000 1 600 1 900

DRAWINGS Bank

K 000 1 200

K 000 Capital c/d

1 200

1 200 1 200

COMMISSION K 000 P/L c/d

Bank

3 700 3 700

3 700

K 000

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 Inventory b/d

K 000 3 200 38 000 4 500

K 000 34 800 Inventory

c/d

Trading (I/S) 4 500

33 500 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:

282

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

Joel Mutale BALANCE SHEET as at 30 June 2005 Km Non current Assets: Equipment

Km 12 500

283

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. 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. 1. The skill of writing ledger accounts should be perfected, otherwise the figure you derive for transfer to the income statement will be incorrect 284

2. 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. 3. An incomplete records situation can be more involving than a single entry situation.

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: 285

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

SOLUTION TO EXERCISE MPOMWA

Statement of affairs as at 1 January 2006 K000 Assets: Fixtures Inventory Trade receivable Bank

2 500 1 950 170 620 286

5 240 Liabilities: Trade payables Capital

960 4 280 CAPITAL K 000 Balance c/d

4 930 4 930

Balance b/d Bank

4 280 650

Balance b/d

4 930

K 000

4 930

CASH K 000 Trade receivable

Balance b/d

48 580 48 580

Wages General Expenses Bank Balance c/d

K 000

350

110

48 120

48 580

TRADE RECEIVABLES Balance b/d Sales

K 000 170 48 620

Balance b/d

48 580 210

Cash

48 580

Balance c/d

210 48 580

K 000

TRADE PAYABLES K 000 Bank

32 890

Balance c/d

1 270 34 160

FIXTURE Balance b/d Bank

K 000 2 500 800

Balance b/d

3 300 3 300

Balance b/d Purchases

960

Balance b/d

1 270

K 000 33 200

34 160

S 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

287

3 760 3 760

RENT K 000 Bank

K 000 1 200 1 200

Drawings P/L c/d

2 400 3 640

3 640

WAGES Bank Cash

K 000 760 350 1 110

K 000 1 110

P/L c/d

1 110

DRAWINGS Bank Rent Inventory

K 000 5 870 1 200

K 000 320

7 390

Capital c/d

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 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 288

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

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. 289

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. 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. 290

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.

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

X 291

Income tax Dividends paid Net cash from operating activities

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.

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

Net cashflow from operating profit Interest paid 292

Income tax paid Dividends paid Net cash from operating activities

X X X

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. ILLUSTRATION The balance sheets of Prenodia Plc as at 30 June 2004 and 2005 and the summary income Statement for the year ended 30 June 2005 were as follows: Balance sheet as at 30 June 2004 Km Km

2005 Km Km

Non current Assets: Premises Less: Accumulated Depreciation

130 30

130 32

Plant & Machinery Less: Accumulated Depreciation

70 17

100

98 80 23

53 293

57

Current Assets: Inventory Trade receivables Short term investments Cash at bank & in hand

25 16 -

Total assets Share Capital Profits & loss reserve

41 194

69 224

100

100

36

Non current Liabilities: 10% Debentures Current Liabilities: Trade Payables Income Tax Proposed dividend

24 26 12 7

40 136

140

20

40

19 7 12

22 8 14 38 194

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

Operating profit Interest receivable Profit before tax Income Tax Profit after tax 294

Proposed dividend Retained profit for the year

(14) 4

ADDITIONAL INFORMATION During the year a machine costing K15 was sold for K 4m. Depreciation on the machine had accumulated to K10m. REQUIRED Prepare a cashflow statement for Prenodia Plc for the year ended 30 June 2005

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 295

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: 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

Net cash flow from operating profit 296

Interest received Interest paid Income tax paid Dividends paid Net cash from operating activities

2 (2) (15) (12) 20

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 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

25 120 24 PURCHASES

297

Trading (IS) 95 Balance c/d

96 120

24

Trade Payables

95

Inventory Balance c/d

95

95

0 95

TRADE PAYABLES Bank Balance c/d

92 22 114

Balance B/d Purchases Balance b/d

19

95

114 22

DIVIDEND Bank Balance c/d

12 14

Balance B/d IS

12 14

Balance b/d

14

26

26

TAXATION Bank Balance c/d

15 8 23

Balance B/d Income statement

7

Balance b/d

16 8

23

PLANT & MACHINERY Balance B/d Bank

70 25 95 80

Balance b/d

Disposal Balance c/d

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 0 15

15 Accumul Depreciation Bank 4 IS-Profit & Loss 1 15

10

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 298

account implying that the credit was in the bank account. Therefore there was an outflow in K12m. CHAPTER SUMMARY You should now have learnt that  Preparing a cashflow statement is important because the users of financial statements need to know where cash resources came from and what uses they were put to in the past year. This information would enable them to make reasonable cashflow forecasts as well as other economic decisions.  The cashflow statement should be presented according to the format recommended in the accounting standard (IAS7)

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 Non current assets: Property, plant & equip Accumulated depreciation Current assets: Inventory Trade receivables Bank

2005 K000

K000

2 800 (650) 2 150

1 100 540 120

K000 2 100 (490) 1 610

850 470 1 760 3 910

Total assets Equity and liabilities: 299

1 320 2 930

Ordinary share capita Share premium Retained earnings

l 2 200 260 400

1 600 865 2 860

2 465

340

140

Non current liabilities: Loan notes Current liabilities: Trade payables Bank overdraft Taxation

430 280

110 45 170 710 3 910

325 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)

Calculate the operating profit of Tokozile Ltd for the year ended 30 June 2006

(b)

Prepare a cashflow statement for Tokozile Ltd for the year ended 30 June 2006 in accordance with IAS 7 (revised). QUESTION TWO 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 300

SHARE CAPITAL K000 1,100 300

Balances at start (31/03/06) Issues of shares Profit for year Dividend Balance at end 31 March 2007

1,400

KONKOLA BALANCE SHEET AS AT 31 JUNE 2006 K000 Non current assets: Furniture & Fittings 750 Accumulated depreciation (210)

SHARE PREMIUM K000 260 60

538 (98) 520

320

2007 K000

K000

K000

930 (265) 540

665

Motor Vehicles at cost 780 Accumulated depreciation (305)

885 (350) 475 90 1,105

Investments at cost Current assets: Inventory Trade receivables Bank

RETAINED PROFIT K000 80

535 170 1,370

615 574 (14)

456 792 452 1 175

Total assets

2,280 301

1,700 3,070

Equity and liabilities: Ordinary share capital Share premium Retained earnings Non current liabilities: Loan notes Current liabilities: Trade payables Proposed dividend Taxation

1,100 260 80

1 400 320 520 1,440

2,240

160

60

540 35 105

565 80 125 680 2,280

770 3,070

Additional information for the year to 31 March 2007: a) Vehicles which had cost K145 000 were sold during the year when their net book value was K 55,000. b) There were no accruals or prepaid expenses at the end of the year. REQUIRED: a. Prepare a cashflow statement for Konkola for the year ended 31 March 2007 using the DIRECT method. Show any additional notes and reconciliation required. b. Explain briefly the usefulness of cashflow statements to external users SOLUTION 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)

Net cash flow from operating profit Interest paid Income tax paid 302

Net cash from operating activities

(210)

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

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

303

Balance b/d IS-Depreciation

490 220 710

Balance b/d

650

P P & EQUIP DISPOSAL Property, Plant, etc IS-Profit & Loss

75 270

195 Bank

Accumul. Depreciation 210 000 270

60

TAXATION Bank Balance c/d

230 280 510

Balance B/d Income Statement

170

Balance b/d

280

000

340 510

Note: Cost of plant sold is NBV + Depreciation, and the amount of tax charged to the income statement of a balancing figure on the Income tax account.

SOLUTION TWO

Direct method Cash flow from Operating Activities: K000 K000 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

615

304

Trading (IS)

1,250

Purchases

1,701 456

Balance b/d

1,091

Balance c/d

1,701

456

PURCHASES Trade Payables

1,091 1,091

Inventory

0000

1,091 1,091

TRADE PAYABLES Bank Balance c/d

1,066 565 1,631

Balance B/d Purchases

540

Balance b/d

0000 1,631 565

Balance B/d IS

35 98

Balance b/d

80

1,091

DIVIDEND Bank Balance c/d

53 80 133

133

TAXATION Bank Balance c/d

112 125 237

Balance B/d Income statement

105

Balance b/d

125

132 237

MOTOR VEHICLE Balance B/d Bank

780 250 1,030 885

Balance b/d

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 IS-Profit

12 157

145 Bank

Accumul Depreciation 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

305

210

90

Balance B/d

265 265

IS- Depreciat

55 265 350

Balance b/d

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)

K000 K000 (14) 306

Increase in cash (from cashflow statement) Balance of cash/bank at end 31 March 2007

466 452

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. 2. 3. 4. 5. 6.

Company finance Classes of shares Debentures Issue of shares Share capital structure 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. 307

• • • •

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:

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: 308

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

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 309

___________________________________________________________________ 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. 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.

310

ACTIVITY 1 Hightech Ltd was formed with the legal right to be able issue 100 000 shares of K100 each. The company has actually issued 80 000 shares. None of these shares have been fully paid up. So far the company has made calls of K60 per share. All the calls have been paid by shareholders except for K200 000 unpaid by one shareholder. Calculate the following: a) b) c) d) e)

26.6

Authorised share capital Issued share capital Called up share capital Paid up share capital Calls in arrears

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. 311

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 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: 312

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 Inventory at 1st January 2006 Discounts Carriage outwards 10% debentures 2010 Debenture interest paid Administrative expenses Staff salaries (excluding directors) Preference dividend paid Profit and loss account b/d

60 000 40 000 1 600 3 200

800 200 000

20 000 16 000 16 000 4 000 1 524 800

32 000 1 524 800

Adjustments are required for: 1. Inventory at 31st December 2004, at cost K60 000 000. 2. Directors' salaries not yet paid K20 000 000. 3. Income tax for the year K8 600 000. 4. Proposed ordinary dividend K10 per share. 5. Depreciation on buildings for the year K18 400 000 and plant and machinery is to be depreciated at 10% on cost. 6. Accrued audit fee K4 000 000. 7. Creation of a plant replacement reserve of K4 000 000. You are required to prepare the Income Statement for the year ended 31st December 2006 and a Balance Sheet as at that date. 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 313

K’000 364 000

180 000 184 000

Add Gains: Discount received Total income Less Expenses: Discount allowed Carriage outwards Administrative expenses Staff salaries Directors' salaries accrued Audit fee accrued Depreciation: - buildings - Plant and machinery Debenture interest Total expenses Net profit before tax Less: Income tax Net profit after tax Transfer to plant replacement reserve Dividends: - Preference (paid) - Preference (proposed) - Ordinary (proposed)

800 184 800 1 600 3 200 16 000 16 000 20 000 4 000 18 400 30 000 20 000 129 200 55 600 8 600 47 000 4 000 4 000 8 000 4 000 20 000 27 000 32 000 59 000

Retained profit for the year Retained earnings b/d Retained earnings c/d 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

8 000 8 600 314

Dividends payable (4 000 + 8 000) Accruals (20 000 + 4 000)

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.

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 Inventory at 1st April 2006 180 000 Sales 2 000 000 Purchases 1 542 000 9% debentures 2010 150 000 Share premium account 40 000 Administrative costs 200 000 Provision for doubtful debts 4 000 Interim dividends paid 6 000 Profit and loss account balance 90 000 2 730 000 2 730 000 The following final adjustments are required: 315

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.

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 316

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 1 500

890 100

890 100

Additional information available: 1. During the year the following transpired in relation to motor vans: a) A new motor van was purchased on 1st January 2006 on credit for K24 million. The amount was still due to the supplier on 31st March 2006. b) A motor van which had cost K16 million four years ago when new was sold for K6.6 million. The proceeds from the sale had not yet been received on 31st March 2006. None of the above matters had been recorded in the books of the company. 2. Depreciation on motor vans has been and is to be provided at the rate of 20% per annum on cost and is charged in full in the year of acquisition and none in the year of disposal. 3. The cost of buildings is K100 million. 4. Depreciation on buildings, and plant and machinery is to be charged as follows: Buildings 2% on cost Plant and machinery 10% on cost 5. On 31st March 2006 the company issued bonus shares to the ordinary shareholders on a one (1) to ten (10) basis. No entry relating to this has yet been made in the books. 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 31 March 2006. st

317

(11 marks) st

c) Prepare the company’s Balance Sheet as at 31 March 2006. (14 marks) (NATech: December 2006)

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 30 000 318

Retained profit for the year Retained earnings b/d Retained earnings c/d

31 300 90 000 121 300

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 13 500 319

175 900 687 200

Total Equity and liabilities SOLUTION TWO a)

i) Balance b/d Payable

ii)

iii)

b)

Motor Van Account K’000 140 000 Disposal 24 000 Balance c/d 164 000

Motor Van Accumulated Depreciation Account K’000 Disposal (16 000 x 20% x 4) 12 800 Balance b/d Balance c/d 73 600 I. S. (148 000 x 20%) 86 400 Motor Van Disposal Account K’000 Motor van 16 000 Accumulated dep. Income statement (bal. fig.) 3 400 Disposal proceeds 19 400 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

K’000 16 000 148 000 164 000

K’000 56 800 29 600 86 400

K’000 12 800 6 600 19 400 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

Profit before taxation Less: Income tax Profit after taxation 320

Less: appropriations: Dividends: interim – ordinary - preference Proposed – ordinary (5% x 220 000) - preference

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

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: 321

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

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 322

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

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) b) c) d)

Fair Presentation Going Concern Accruals 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. 323

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. 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. 324

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.

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. 2. 3. 4. 5.

Ratio analysis technique Types of Ratios Calculation of Ratios Interpretation of statements Limitation of Ratio analysis

LEARNING OUTCOMES At the end of the chapter, the student should be able to: 325

-

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. 2. 3. 4. 5.

Profitability ratios Liquidity ratios Efficiency ratios Solvency ratios Investors’ ratios

28.2.1 Profitability Ratios These ratios tell us whether a business is making profits and if so whether at an acceptable rate. a) Return on capital employed (ROCE) The ratio tells us what returns management has made on the resources made available to them before making any distributions of these returns. The higher the return the better, especially in high risk businesses. A very low return has a negative impact on internal growth sustenance of a company. Formula: ROCE = Profit before interest and tax x 100 Capital employed The capital employed is taken to be the total assets less current liabilities of the business or share capital plus reserves plus long term liabilities. This ratio is further broken down into two ratios: i) Operating profit margin on sales Given a constant gross profit margin, the operating profit margin tells us about the company’s ability to control the level of its operating costs or overheads. The higher the operating profit margin, the better. An increasing operating profit margin indicates better control of costs, and a decreasing profit margin indicates worse control of costs or 326

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.

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 327

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.

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. 328

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

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. 329

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 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: 330

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 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 Current market value of the share

x 100

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: 331

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 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 8 000 332

Retained profit for the year

9 000

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

The market value of each ordinary share is K2 040. From the above details, you are required to calculate the following ratios: a) b) c) d) e) f) g) h) i) j) k) l) m) n) o) p) q) r) s) t) u)

Return on capital employed (ROCE) Operating profit margin on sales Gross profit Margin Current ratio Quick ratio Inventory turnover Inventory days Receivables turnover ratio Receivables collection period Payables turnover ratio Payables credit period Non-current assets turnover ratio Total gearing ratio Debt to equity ratio Interest Cover Dividend per share Dividend cover Dividend yield Earnings per share (EPS) Price Earnings ratio (P/E ratio) Earnings yield 333

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 d) Current ratio Current ratio =

= 24.9%

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 =

157 000 = 4.0 times /2 (37 000 + 42 000)

1

g) Inventory days Inventory days = Average inventory x 365 days Cost of sales 334

= 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 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 – 25 000 335

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

or = Earnings per share Net dividend per share

= 17 000 – 2 000 = 2.5 times 6 000

r) Dividend yield Dividend yield = Dividend on the share for the year x 100 Current market value of the share =

86 x 100 = 4.2% 2 040

s) Earnings per share Earnings per share =

Earnings Issued ordinary shares

= 15 000 = K214 per share 70 000 t) Price Earnings ratio P/E = Current market value Earnings per share = 2 040 = 9.5 214 u) Earnings yield Earnings yield = Earnings per share x 100 Current market value =

214 x 100 = 10.5% 2 040 336

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 This is after charging: Depreciation Debenture interest Audit fees

2004 K’000 22 400 16 920 930

2003 K’000 19 500 13 650 640

720 160 24

560 120 20

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

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 337

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.

SOLUTION a) i)

Year Current ratio

2003

2004

3 380 000

3 900 000

/1 690 000

/1 910 000

= 2.0 Quick ratio

= 2.04

3 380 000 – 980 000

/1 690 000

3 900 000 – 1 280 000

/1 910 000

= 1.42 Debtors turnover

= 1.37

2 1600 000

/19 500 000 x 365

2 460 000

/22 400 000 x 365

= 40 days Creditors turnover

1 380 000

/13 650 000 x 365 = 37 days

Stock turnover

13 650 000

/980 000 338

= 40 days 1 500 000

/16 920 000 x 365 = 32 days 16 920 000

/1 280 000

= 13.9 times

= 13.2 times

ii) Comments: Liquidity ratios: •

The current ratio has improved slightly over the year and is marginally higher than the industry average. The ratio is in line with what is generally regarded as satisfactory (2:1)

•

The quick ratio has declined marginally but is still better than the industry average. This suggests that Austin Plc has no short term liquidity problems and should have no difficulty in paying its debts as they become due.

Efficiency ratios: •

Receivables turnover – receivables as a proportion of sales is unchanged from 2003 and are considerably lower than the industry average. Consequently, there is probably little opportunity to reduce this further and there may be pressure in the future from customers to increase the period of credit given.

•

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. 339

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.

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

25 228 21 685 2 895

Summarised balance sheets Non current assets Current assets: Inventory Receivables Bank 340

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

48 722

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

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. 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

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

342

iv) Quick ratio

v) Earnings per share

vi) Dividends cover

=

46 224 – 20 073 18 432

49 808 – 25 228 21 238

=

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

b) Return on capital employed has increased marginally by about 4%, indicating that profits have increased marginally. The Non current assets turnover has drastically reduced. This reduction could be as a result of the high investment in non current assets. This investment would in future help to increase profitability and turnover. The current ratio has decreased though still at an acceptable level. The quick ratio has also decreased though also still above the desirable level of 1. The company should however observe this decline in the liquidity position to ensure that it does not persist for a long time. The earnings per share have increased by K54 per share. This is due to the improved profits in 2006. The dividends cover has improved. This is as a result of the decrease in profits paid out as dividends which is not proportional to the increase in profits. SOLUTION TWO Comments on the financial performance and position of H Ltd and G Ltd 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. 343

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.

CHAPTER 29 MANUFACTURING ACCOUNTS INTRODUCTION In this chapter we shall look at the preparation of financial statements for manufacturing organisations. A manufacturing organisation is one that manufactures (produces) goods for sale. This could either be a sole trader, a partnership or a company. TOPICS 1. 2. 3. 4.

Manufacturing account Work in progress Transfers of goods at market value 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. 344

- 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. 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 ______ 345

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.

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 346

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

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

38 900 330 914 347

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.

Example: The following information has been extracted from the books of Meleki manufacturing company for the year to 30th September 2006: K'000 Deprecation for the year to 30th September 2006: Factory equipment 21 000 Office equipment 12 000 Direct wages 120 000 Factory: insurance 3 000 Heat 45 000 Indirect materials 15 000 Power 60 000 Salaries 75 000 st Finished goods at 1 October 2005 72 000 Office: electricity 55 000 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 Raw material inventory at 1 October 2005 24 000 Advertising 6 000 Sales revenue 1 537 200 348

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.

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 75 000 219 000 349

Less: closing work in progress Production cost

939 000 36 000 975 000 27 000 948 000

Market value Less: production cost Manufacturing profit

978 000 948 000 30 000

Add: opening work in progress

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 350

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.

Example: The following balances as at 31st December 2006 have been extracted from the books of Simon Choolwe, a manufacturer: K'000 Inventory at 1st 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): 351

At cost Provisions for depreciation Payables Receivables Drawings Balance at bank (Dr) Capital at 1st January 2006 Allowance for unrealised profit at 1st January 2006 Motor vehicles running costs

16 000 4 000 5 500 28 000 11 500 16 600 48 000 1 380 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: Plant and machinery 10% Motor vehicles 25% 4. Amounts accrued due on 31st December 2006 for direct labour amounted to K3 000 000 and rent and rates prepaid at 31st December 2006 amounted to K2 000 000. Required: Prepare the Manufacturing Account, Income Statement for the year ended 31st December 2006, and a Balance Sheet as at that date.

SOLUTION: Simon Choolwe 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 3 000 352

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

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

353

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: 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 2 300 355

Rent Insurance General administrative expenses Bank charges Discount allowed Carriage outwards Receivables Payables Bank Cash Sales revenue

2 400 840 2 680 460 960 1 180 28 460 25 000 11 360 300 284 360

200 000 284 360

Notes at 31st December 2004: 1. Inventory of raw materials K4 800 000, Inventory of finished goods K8 000 000, Work In Progress K3 000 000. 2. Lighting, rent and insurance are to be apportioned: factory 5/6ths, administration 1/6th. 3. Depreciation on productive machinery and accounting machinery at 10% per annum on cost. Required: Prepare the Manufacturing Account, Income Statement for the year ended 31st December 2006 and a Balance sheet as at that date.

QUESTION TWO The following trial balance was extracted from the books of Panuka Ltd after completion of the manufacturing account for the year ended 31st March 2003. Dr 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)

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 27 080 356

Bank Rent General expenses Distribution costs Bad debts Administrative salaries Advertising expenses Preference divided paid Suspense

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: 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. 357

(11 marks) (NATech June 2004)

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 2 740 358

K’000

74 100 36 000 1 400 111 500

Rent (5/6 x 2 400) Insurance (5/6 x 840) Depreciation on productive machinery (10% x 56)

2 000 700 5 600 47 490 158 990 2 700 161 690 3 000 158 690

Add: opening work in progress Less: closing work in progress Production cost

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 Insurance (1/6 x 840) 140 General administrative expenses 2 680 Bank charges 460 Discount allowed 960 Carriage outwards 1 180 Depreciation on accounting machine (10% x 4m) 400 Total expenses Net profit 359

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

Dep. K’000 15 600 2 000 17 600

4 800 3 000 8 000

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: Payables Total capital and liabilities

Journal entries i)

Receivables in Trial balance Suspense

ii) Suspense Discount Received iii) Suspense Administrative salaries iv) Suspense Sales revenue v) Suspense Bank

b)

73 320 25 000 98 320

SOLUTION TWO a)

Value K’000 40 400 2 000 42 400

K’000 4 600

K’000 4 600

120 120 9 9 8 000 8 000 100 100

Suspense Account 360

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

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 55 137 361

Profit before taxation Less: Income tax Profit after taxation Dividends Preference -paid - proposed Ordinary – proposed

41 183 15 000 26 183 700 700 4 000 5 400 20 783 17 080 37 863

Retained profit for the year Add: Retained profit brought forward Retained profit carried forward

(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 47 863 107 863 362

Current liabilities: Payables Taxation Dividend payable: - preference - ordinary

10 000 15 000 700 4 000 29 700 137 563

Total capital and liabilities

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.

363

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).

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

Average cost

A

202, 205

B

Above-the-line 244 account transfers 103 Account transfers 56 Accounting Concepts 322 Accounting Conventions 322 accounting equation is 12 accounting for prepayments 150 accounting information 1 Accounting information 8 accruals 223 Accruals 20 Accruals accounting 243 accruals concept 20, 150, 189, 192, 263, 271 Accrued expenses 14 Accumulated depreciation 173 Accumulated fund 271 Adding Value 37 Administration 23 aged schedule 141 Allowance for cash discounts 146 allowance for doubtful debts 140 Analytical cash book 65 APPLIED RESEARCH 188 appropriation account 245, 248, 250, 253, 255 asset 13, 20, 21, 26, 32, 37, 39, 40, 41, 42, 50, 60, 67, 89, 90, 98, 118, 137, 153, 158, 159, 160, 161, 162, 163, 164, 165, 166, 167, 168, 169, 170, 173, 174, 175, 176, 177, 178, 180, 181, 182, 183, 184, 185, 186, 187, 189, 190, 198, 207, 208, 210, 212, 213, 218, 220, 230, 249, 261, 263, 264, 266, 267, 268, 279, 297, 312, 324, 327, 330, 364 Asset 88, 159, 174, 177, 181, 249, 327 Assets 7 auditing 241 Authorised share capital 310, 311

bad debts 127, 136, 138, 139, 140, 141, 142, 143, 144, 145, 146, 148, 217, 218, 220, 222, 223, 225, 226, 231, 291, 292, 296, 302, 316, 364 Bad debts 28, 29, 30, 33, 34, 118, 119, 128, 136, 137, 138, 139, 140, 142, 143, 144, 145, 146, 148, 149, 216, 217, 225, 226, 227, 228, 229, 254, 256, 357, 361 BAD DEBTS RECOVERED 139 Bad debts recovered account 139 balance sheet 12, 13, 14, 17, 18, 25, 26, 31, 32, 35, 36, 40, 41, 42, 96, 97, 98, 101, 102, 103, 118, 126, 129, 133, 137, 139, 140, 142, 143, 148, 149, 150, 151, 152, 153, 154, 155, 156, 158, 159, 168, 169, 170, 173, 183, 184, 185, 186, 198, 200, 207, 208, 209, 213, 218, 219, 223, 226, 229, 230, 231, 234, 240, 248, 251, 252, 253, 259, 260, 262, 263, 265, 266, 267, 268, 269, 273, 277, 285, 290, 297, 299, 310, 311, 312, 323, 324, 325, 328, 340, 364 Balance sheet 223 Bank Account 65, 68 Bank overdraft 14 bank reconciliation 65, 129, 131, 132, 133, 134 bank reconciliation statement 129, 131, 132, 133, 134 Bar income statement 262 Below-the-line 244 bonus shares 312, 317 BOOK KEEPING 2 BUSINESS 2 business entity concept 49 Business Entity Concept 324

C capital 2, 11, 12, 13, 15, 16, 21, 31, 32, 35, 36, 37, 38, 39, 40, 41, 42, 43, 52, 53, 68, 101, 115, 169, 196, 210, 243, 244, 245, 246, 247, 248, 249, 250, 251, 252, 253, 254,

365

255, 256, 257, 260, 261, 262, 266, 271, 272, 274, 279, 291, 292, 293, 296, 302, 307, 308, 309, 310, 311, 312, 313, 314, 315, 319, 321, 326, 327, 328, 330, 333, 334, 335, 337, 341, 343, 347, 356, 360, 362, 363, 364 Capital accounts 249 CAPITAL AND REVENUE EXPENDITURE 37 capital expenditure 36 Capital income 39 Capital reserves 312 CAPITALISATION 189 carriage inwards 191 Carriage inwards 22 Carriage outwards 22 Carrying amount 182 Cash Account 65 Cash basis 241 cash book 61, 65, 66, 67, 68, 69, 73, 74, 78, 79, 80, 81, 82, 83, 84, 90, 91, 92, 93, 94, 101, 129, 130, 131, 132, 133, 134, 177, 242, 259, 260, 279, 357 Cash in bank 13 Cash in hand 13 Cash transaction 56 Cash transactions 90 cashflow statements 290 Change in estimated life 175 CIRCULATION 45 Closing accounts 96 Closing inventory 118 Closing Inventory 18, 26, 217 company 3 COMPANY 3 company law 3, 307 comparability 11 Comparability 6, 10 compensating errors 219 Completeness 6, 11 Consistency Concept 324 Contra agreements 126 contra entries 68 Contribution 232 Contributions 364 Control accounts 120 correcting errors 209 Cost 182 Cost model 184 Cost of goods sold 192 Cost of sales 24 credit 7, 13, 14, 21, 24, 25, 27, 40, 44, 45, 47, 48, 49, 50, 51, 53, 56, 57, 58, 59, 60, 61, 62, 67, 68, 70, 78, 85, 86, 89, 90, 92, 94, 96, 97, 102, 104, 105, 106, 115, 117, 118, 121, 122, 126, 130, 131, 132, 133, 136, 137, 138, 151, 177, 178, 185, 196, 211, 213, 217, 218, 219, 220, 221, 225, 251, 253, 260, 266, 279, 285, 286, 298, 299, 317, 329, 333, 335, 339, 344, 363, 364 Credit Notes 47 Credit transactions 56 current accounts 245, 247, 250, 251 Current accounts 250 current assets 13, 14, 15, 16, 17, 18, 19, 22, 31, 35, 37, 39, 40, 41, 42, 50, 51, 63, 67, 89, 137, 152, 153, 155, 160, 161, 162, 168, 169, 170, 172, 175, 177, 181, 189, 190, 191, 219, 242, 251, 257, 260, 265, 266, 268, 271, 284, 291, 292, 293, 294, 295, 296, 299, 300, 301, 302, 314, 319, 330, 333, 335, 337, 340, 341, 342, 343, 347, 354, 360, 364 Current assets 14 Current Assets 142

Current liabilities 14, 31, 34, 228, 230, 258, 271, 276, 300, 302, 314, 319, 322, 327, 328, 333, 334, 337, 341, 347, 354, 363 Customs duty 22

D day books 85 Day books 62 Debenture 15 Debit Note 48 Debit notes 126 decision making 2 Decision-making 231 Dedicated workforce 7 departmental accounts 231 depreciation 40, 160, 162, 163, 164, 165, 166, 167, 168, 169, 170, 171, 172, 173, 174, 175, 176, 177, 178, 179, 180, 181, 182, 184, 185, 186, 187, 190, 191, 220, 222, 223, 224, 228, 233, 234, 254, 260, 266, 284, 288, 291, 296, 299, 301, 313, 316, 317, 325, 346, 351, 352, 356 Development Costs 188 Direct credits 130 Direct debits 129 direct labour 345, 352 Direct materials 345 Directly attributable costs 183 Discount allowed 125 Discount received 22 discounts 125, 136, 146, 147, 216, 279, 329, 357 dishonoured cheques 132 Dishonoured cheques 130, 133 disposal of non current assets 160 Distributions 364 Dividend 22, 134, 292, 293, 300, 301, 303, 312, 331, 333, 336, 341, 363 Dividends292, 293, 297, 306, 311, 314, 315, 318, 319, 321, 322, 331, 332, 336, 340, 341, 343, 362 DOCUMENTS 44 Donations 267 Donors 244 doubtful debts 136, 142 DOUBTFUL DEBTS 136, 140 Drawing 101 Duality 49, 50 duality concept 49

E Elements 364 equity 19 Errors 114, 133, 209 Errors not disclosed by trial balance 114 Errors of Commission 210 Errors of Omission 209 Errors of Original entry 210 Errors of Principle 210 Exchange of assets 183 expenditure 12 Expenditure 2, 20, 37, 242, 270, 274, 275 expense 42, 79, 80, 82, 139, 141, 143, 144, 150, 151, 152, 154, 158, 162, 169, 183, 184, 185, 186, 189, 193, 194, 207, 208, 216, 218, 242, 253, 255, 311, 351, 364 Expense Claim Forms 44

F Fair value FIFO FINAL ACCOUNTS Finance costs financial accounting Financial accounting Financial analyst

366

182 202, 203, 206, 207, 208 12 23 1 4, 7 5

Financial analyst and advisers 5 Financial reporting 239 Financial statement 213 financial statements 114, 150 Financial statements 2, 5, 6, 7, 12, 31, 242, 245, 277, 289, 311, 325 financial year end 223 Financing Activities 292 First in first out 202 fixed asset 286 future economic benefits 182

279, 289, 290, 297, 299, 300, 302, 308, 314, 315, 319, 320, 321, 322, 323, 325, 326, 327, 333, 337, 341, 347, 360, 363, 364 Liability 159, 199, 363 Life Membership 266 LIFO 202, 203, 204, 206, 207, 208 Limited Partners 246 liquidation 3 Local authorities 240 losses 7

G 246 312 323 44 161 188 4 22 235

Managers 4 Manufacturing Account 344, 345, 346, 349, 352, 356 margin 326, 327, 333, 334, 341 market value 167, 168, 184, 331, 332, 333, 336, 344, 348, 349 Matching 20 Materiality 324 MATERIALITY CONCEPT 324 Methods of depreciation 160 Money Measurement 324 Mortgage 15

325

N

General Partners general reserve Going Concern Concept Goods Received Notes goodwill Goodwill Government agencies Gross profit growth and trimming

M

H Historical Cost

Net book value non current assets Non current assets NOT-FOR-PROFIT

I IAS 16 181 imprest system 73, 77, 82, 83 income statement 21 Income statement 98, 138 Income Statement 28, 223 Incomplete 213, 219, 277 Incomplete records 277 indirect expenses 22, 23, 208, 234 Initial measurement 183 Intangible assets 160 Interest on capital 250 Interest on drawings 249, 250, 254, 255, 256 INTERIM REPORTS 12 internal 44, 56, 129, 133, 189, 307, 315, 326 INTERNATIONAL ACCOUNTING STANDARD 325 International Accounting Standards 243, 322, 323 International Federation of Accountants 239 inventory 191 Inventory 13, 26 Inventory Counting 199 Inventory Lists 44 inventory valuation 191 Investing Activities 292 invoice 57 IOU 78 Issued share capital 310

175 160 13 259

O Objectivity 6 Obsolescence 163 Operating Activities 291 Operating and Financial Review 289 Ordinary shares 308, 332 Other Receivables 66 overheads 32, 326, 345, 346, 349, 351, 353, 358 Owners’ wealth 364

P Partners salaries 250 PARTNERSHIP 3 Partnership agreement 245 Payment of bonuses 235 perfect integration 121 personal accounts 120 petty cash book 73 PETTY CASH BOOK 73, 78, 84 petty cash voucher 73 plant replacement reserve 313, 314 Posting entries 90 potential investors 4 preference shares 316, 357 prepayments 223 Prepayments 13, 17, 32, 154, 155, 156, 157, 158, 227, 230, 257 Prepayments to the business 155 prime cost 345 Private companies 3 PRIVATE COMPANIES 3 profit and loss account 98, 103, 312 Profitability 235 Profits 7 Property, plant and equipment 182 PRUDENCE 324 prudence concept 142, 169 PUBLIC COMPANIES 3 Purchases 121 Purchases account 102 Purchases Day Book 45, 57, 63, 94

J journal 52, 53, 54, 60, 70, 89, 105, 133, 209, 210, 212, 214, 216, 219, 220, 279, 357 Journal Proper 56

L Last in first out 202 Ledger accounting 242 ledger accounts53, 56, 60, 85, 91, 92, 94, 96, 103, 114, 120, 121, 180, 196, 279, 282, 283, 284, 290, 291, 297, 309, 317 LEDGER ACCOUNTS – PART ONE 85 Legal costs 37 Legal status 245 Lenders 4 liabilities 7, 8, 11, 12, 13, 14, 15, 16, 18, 19, 31, 32, 34, 49, 52, 53, 54, 117, 151, 152, 156, 158, 187, 199, 230, 234, 241, 242, 244, 259, 260, 261, 262, 265, 271, 272, 278,

367

Purchases on credit Purchases Returns Day Book

89 57

Skill of staff 7 sole trader 2 Sole trader 15 SOLE TRADER 2 Specific allowance 148 Staff schedules 44 Standing order 130 Statement of profit adjustment 217 statutory reserves 312 Straight line 163 STRAIGHT LINE METHOD 163 subscriptions 259, 261, 263, 264, 265, 266, 267, 268, 272, 273, 274, 275 Subscriptions account 263 Subscriptions in arrears 263 SUBSTANCE OVER FORM 324 Sum of digits 163 Supplier Lists 44 Suspense account 213

R Ratios 325, 326, 327, 328, 330, 332, 337, 339, 340 REALISATION CONCEPT 324 Rebates 127 receipts and payments account 260 receipts and payments accounts 259, 271 Receivables 13 Recognition 182 Recoverable amount 182 Reducing balance method 163, 190 relevance 243, 323 Relevance 5 Reliability 5, 10, 11 Replacement cost 202 research 161 Residual value 182 Returns inwards 127 Returns outwards 127 Revaluation 163, 166, 167, 184, 187, 312, 333 Revaluation method 163 Revaluation model 184 revaluation surplus 185 Revaluations 184 REVENUE 36, 37 Revenue expenditure 36 Revenue income 39 Revenue reserves 312 Rights issue 308, 310 rule of double entry 50 RULE OF DOUBLE ENTRY AND THE JOURNAL 49

T Tax payers 241 Taxation 15, 18, 19, 300, 302, 303, 314, 319, 322, 332, 333, 337, 340, 341, 363 the FLOW 50 The Journal 214 The public 5 Timeliness 6 Trade contacts 4 Trade creditors 14 Trade Payables 67, 97, 120 Trade Receivables 66, 125 Trade Receivables’ 97 trade union representatives 5 Transfers 96 trial balance 66, 85, 94, 96, 102, 103, 105, 114, 115, 117, 118, 119, 139, 173, 209, 210, 211, 213, 214, 215, 216, 217, 218, 219, 220, 221, 226, 254, 272, 355, 356 true and fair 168, 176, 243

S Sales Day Book 57 sales ledger 121, 125, 138, 139 Sales Ledger 121 Sales on credit 89 Sales Returns 89 Sales Returns Day Book 57 sales tax 60, 125 Sales Tax 52 secured loan stock 333 SECURITY 74 Selling and distribution 23 SEPARATE VALUATION PRINCIPLE 324 share capital 310, 312, 364 Share of profits 250 Shareholders 3, 4 Short term investments 13 Single entry bookkeeping 277

U Understandability Unpresented cheques useful life

6 130 186

V Virement

244

W WHAT IS ACCOUNTING 1 Work in progress 201, 344, 345, 346, 347, 349, 351, 352, 355 Working capital 31

368