INTRODUCTION TO ACCOUNTING

INTRODUCTION TO

ACCOUNTING

MORRIS I. KARIUKI FIRST EDITION

INTRODUCTION TO

ACCOUNTING FIRST EDITION

MORRIS I. KARIUKI

Introduction to Accounting First Edition

Š 2017 Morris I. Kariuki

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ABOUT THE AUTHOR DR. MORRIS I. KARIUKI, BAM, MBA (FINANCE), CPA(K), CPS(K), Ph.D.

M. I. Kariuki is currently a lecturer at the Department of

Finance

and Accounting, University of Nairobi. He is a graduate of Egerton University. He received his MBA from Kenyatta University and his Ph.D from the Jomo Kenya University of Agriculture and Technology.

He is a Certified Public Accountant (CPA) of Kenya and Certified Public Secretary (CPS) of Kenya. He is a member of the Institute of Certified Public Secretary of Kenya (ICPSK). He taught under the Teacher Service commision (TSC) from 1995 to 1998. He has also served as an Accountant, Senior accountant and Finance manager in three different companies in Nairobi, Oloitokitok and Arusha. He has also served as partime lecturer at Chuka University.

Contents CHAPTER ONE: INTRODUCTION

1

Business Goals and Activities

1

Accounting as an Information System

6

Users of Accounting Information

7

Specialization of Accounting

10

Forms of Business Organization

12

CHAPTER TWO: CONCEPTUAL FRAMEWORK

17

Elements of the Financial Statements

17

Financial Statements

20

The Qualitative Characteristics of Accounting Information

26

Accounting Assumptions and Generally Accepted Accounting Principles

28

CHAPTER THREE: REGULATIONS IN FINANCIAL REPORTING.

37

Accounting Standards

37

International Harmonization

42

Regulation of Accounting Profession

45

The accounting profession in Kenya

48

CHAPTER FOUR: RECORDING BUSINESS TRANSACTIONS

51

Double Entry Rule

51

The Accounting cycle

51

Rules of accounting

61

Cash versus accrual basis accounting

67

CHAPTER FIVE: ACCOUNTING FOR SERVICE BUSINESS

.

75

Revenues From Services

75

Expenses Paid to Render Services

75

CHAPTER SIX: ACCOUNTING FOR MERCHANDISING BUSINESS.

85

Inventory Valuation

85

Inventory System

85

Statement of Income for Merchandising Business

91

CHAPTER SEVEN: ACCOUNTING FOR ACCOUNTS RECEIVABLE

97

Estimating Bad and Doubtful debts

97

Provision for Bad and Doubtful Debts

97

CHAPTER EIGHT: ACCOUNTING FOR NON-CURRENT ASSETS

105

Capital and Revenue Expenditure

105

Provision for Depreciation

107

Disposals of Non-current Assets

110

Change of Depreciation Policy

113

Revaluation of Non-current Assets

114

Property, Plant and Equipment Schedule

115

CHAPTER NINE: ACCOUNTING FOR CASH AND BANK

127

Petty cashbook

127

Cash Books

129

Bank Reconciliation Statements

130

CHAPTER TEN: FINANCIAL STATEMENT ANALYSIS

149

Classification of Financial ratios

149

CHAPTER ELEVEN: STATEMENT OF CASH FLOWS

175

Format of Presentation

182

CHAPTER TWELVE: ACCOUNTING AND INTERNAL CONTROL SYSTEM

207

Accounting systems

207

Internal controls

207

ADDITIONAL EXERCISES

221

REFERENCES 240

CHAPTER ONE INTRODUCTION BUSINESS GOALS AND ACTIVITIES A business is an economic unit that aims to sell goods and services to customers at prices that will provide an adequate return to its owners.

Examples of business units in Kenya include Mombasa Maize Millers Limited, East African Portland Cement Company Limited, Kenya Airways, Barclays Bank of Kenya Limited, TUSKYS, Mumias Sugar Company Limited, Kenya Power Company and Insurance Company of East Africa Limited. Despite their differences, all businesses have similar goals and engage in similar activities. The two key objectives of every business are to operate profitably and stay liquid. Both the goals of profitability and liquidity must be met if a business is to survive and be successful. All businesses pursue their goals by engaging in similar activities.

The three are: (i)

Operating activities,

(ii)

Investing activities, and

(iii)

Financing activities.

Figure 1. 1: Business goals and activities

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Business goals (i) Profitability goal Profitability is the primary goal of all business ventures. Profitability refers to the ability to yield profits. Profit refers to that amount of income that is in excess of costs. Businesses must take in enough money from their customers to pay all costs of doing business, with enough left over as profit for the owners to want to stay in the business.

(ii) Liquidity goal Liquidity refers to the ability of a business to pay its debts as and when they fall due. For example, Toyota Kenya may meet the goal of profitability by selling many cars at a price that earns a profit, but if its customers do not pay for their cars quickly enough to enable Toyota Kenya to pay its suppliers and employees, the company may fail to meet the goal of liquidity. Both the goals of profitability and liquidity must be met if a business is to survive and be successful.

Business activities (i) Operating activities Operating activities refers to the primary revenue producing activities of an enterprise. Examples of operating activities include: a) Sale of goods and rendering of services, b) Purchase of suppliers for goods and services, c) Employment of managers and workers, and d) Payment of taxes to the government

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(ii) Investing activities These refer to the acquisition and disposal of long term assets and other investments. Examples of investing activities are: a) Acquisition of property, plant and equipment, intangibles and other long term assets, b) Sale of property, plant and equipment, intangibles and other long-term assets, c) Acquisition of shares, bonds and debentures of other enterprises, and d) Sale of shares, bonds and debentures of other enterprises.

(iii) Financing activities These activities result in changes in size and composition of the equity capital and borrowings of the enterprise. Examples of financing activities are: a) Issuing shares or other equity instruments, b) Redemption of an enterprise’s shares, c) Issuing of debentures, loans, notes, bonds, mortgages and other short or long-term borrowings; and d) Repayments of amounts borrowed.

Nature, Scope and Purpose of Accounting Accounting is widely used to describe all types of business activity, it for this reason that it is sometimes referred to as the language of business.

Understanding and using accounting information is an important ingredient of any business undertaking. Investors, creditors, managers and others having a financial interest in an enterprise need a clear understanding of accounting terms and concepts. To account is to render an explanation.

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The American Institute of Certified Public Accountants (1961) defined accounting as ‘the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events, which are, in part of at least of a financial character, and interpreting the results thereof’ The Accounting Standards Board (1991) on the other hand has defined accounting as “the provision of information about the financial position, performance and financial adaptability of an enterprise that is useful to a wide range of potential users in making economic decisions”.

Prof N.D Nzomo in Basic Accounting defines accounting as ‘the art and science of recording transactions, processing the recorded transactions into a comprehensible form and communicating the information to interested parties.’

The American Accounting Association (1966) defined accounting as the process of identifying, measuring and communicating economic information to permit informed judgments by users of information.

The definition provided by the American Institute of Certified Public Accountants (AICPA) focuses more on the procedures of accounting while the definition provided by the Accounting Standards Board (ASB) focuses on the purpose of accounting.

The underlying purpose of accounting as implied in the definition provided by ASB is to provide information about an economic entity to individuals to aid them in the making of economic decisions.

Accounting therefore is not an end by itself , rather it is a means to an end. ‘It may be useful to emphasize at this juncture that the role of financial accounting and reporting in the economy is to facilitate the making of commercial and economic decisions but not to determine what those decisions should be (N.D Nzomo, Advanced Financial Accounting, Kenya Literature Bureau, Nairobi; 1992 pp.1).

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The use of accounting is not limited to the business world. Rather, virtually everyone engages in a form of accounting. Individuals must account for their incomes and file income tax returns. This is now mandatory for every person even if employment is the only source of income and Pay As You Earn (PAYE) is the final tax. Individuals often have to supply personal accounting information to financing institutions to qualify for loans or obtain credit. The central government, local authorities, educational institutions, religious organizations use accounting information as a basis of operations, measuring accomplishments and performances as well as controlling their resources. The study of accounting is therefore not limited to those engaged in accounting or finance but to everyone who engages in economic activity. Accountants serve decision makers by providing them with financial information about an economic entity.

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ACCOUNTING AS AN INFORMATION SYSTEM Accounting as a social science lends itself easily to its analysis as an information system. It has the attributes of a system; (i)

It has a basic goal, which is to provide information,

(ii)

It has clear and well defined elements in the form of people and equipment, and

(iii) It has the typical activities of a system, namely; input, process and output.

ENVIRONMENT

ENVIRONMENT

Figure 1. 2: Accounting as an information system

An important aspect of accounting as an information system is the definition of its boundaries. The first boundary is the filtering process by which the accountant selects data. The filtering process is provided by the conventions of accounting, which play a deterministic role in defining accounting information. The second boundary is established by specific information needed of its users. The output requirements determine the type of data selected as the input.

As illustrated in the above diagram, the idea of control refers to the extent to which users’ needs should determine not only the nature of data input but also the extent of the data input which should be determined by a cost benefit analysis. The output of the system is the financial statements and reports. The task of the accountant Pg 6

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is therefore to transform raw data into information; a form that has meaning and is able to influence decisions. The analysis of accounting as an information system enables us to make some important deductions: (i) The goal of the system is to provide information which meets the needs of its users. (ii) The output requirements determine the type of data selected as the input for processing into information output.

USERS OF ACCOUNTING INFORMATION Users of accounting information are varied and use accounting information to satisfy their different needs for information. The users can be grouped into two broad categories (i) Internal users, and (ii) External users.

Internal users (Management) These are persons who have the overall responsibility for operating a business and for meeting its financial goals. Management requires accounting information to assist them in discharging their managerial function.

The management process may be analyzed into three major functions – planning, organizing and controlling the activities of the enterprise.

These various management functions have one thing in common: they are all concerned with making decisions.

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External users They include:

(a) Present and Potential investors.

The providers of risk capital and their advisers are concerned with the risk inherent in, and return provided by their investments. They need information to help them determine whether they should buy, hold or sell. Shareholders are also interested in information which enables them to assess the ability of the enterprise to pay dividends.

Profitability and financial soundness would, therefore, be matters of prime importance to them.

(b) Lenders, suppliers and other creditors.

These are entities that have extended or consider to extend loans or credit. Lenders are interested in information that enables them to determine whether their loans and the interest attaching to them will be paid when due. Suppliers and other creditors are interested in information that enables them to determine whether the amounts owing to them will be paid when due. They will be concerned about the liquid assets of an enterprise relative to the amount of liability falling due in the near future, and about the owner’s investment relative to outside funding. To the lenders, suppliers and other creditors, owner’s investment serves as a protecting buffer between lenders, suppliers and other creditors and any losses which may befall the enterprise

(c) Employees Employees and their representative groups are interested about the profitability and stability of their employers.

They are also

interested in information which enables them to assess the ability of Pg 8

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enterprises to provide remuneration, job security, retirement benefits and employment opportunities, promotional opportunities and career development prospects

(d) Governments and their agencies.

Governments and their agencies are interested in the allocation of resources and therefore the activities of enterprises. They also require information in order to regulate the activities of enterprises, determine taxation policies and as a basis for national income and similar statistics. These will include employment, provision of goods and services and the contribution of enterprises to socio– economic development.

(e) Customers Customers have an interest in information of an enterprise indicating the continuance of an enterprise especially when they have a longterm involvement with, or are dependent on the entity. Customers would also be concerned about the financial stability of an enterprise, fairness of pricing policies, differential costs between one product and another produced by the same firm at a different price.

(f) Competitors Enterprises compare their performance with those of other enterprises.

They assess their position against their competitors.

Financial

statements enable them to know profit – margins, value of assets, resource utilization among other items of their competitors.

(g) Public.

The public is very dependent on enterprises because they provide employment and also affect the entire socio-economic structures of the environment. Firms provide employment, create demand for local Introduction to Financial Accounting

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services, as well as extension in the provisions of welfare services; such as medical services, sports facilities and educational institutions.

The general public, therefore, requires information on the activities of enterprises in light of social benefits and costs that accrue to the community.

SPECIALIZATION OF ACCOUNTING To meet the varied needs of users of accounting information accounting has developed specializations and sub-specializations.

The main specialization of accounting are 1. Financial accounting.

2. Managerial accounting.

3. Tax accounting Other specializations include fund accounting, auditing, human resource accounting, social accounting, environmental accounting (green accounting), forensic accounting. Here we shall focus on three specialization of accounting.

1. Financial Accounting.

This is the process of recording the financial activity of a business and reporting summarized information to individuals or groups who are not involved in the day-to day operations of an organization. These individuals or groups include the owner(s), creditors, governmental agencies, or prospective investors. The information is communicated primarily through general purpose financial statements.

Financial

statements describe the condition of the organization and the events that happened during a period. Since the interested parties do not have direct access to business records, and must rely on the authenticity of reports, there have been some standard practices established to be followed by all accounting entities.

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Within financial accounting is the very specialized task of record keeping (Book Keeping) which is often confused with accounting.

Bookkeeping is the procedural part of financial accounting; the dayto-day recording of business transactions and other events either manually or using computers, classifying and summarizing the recorded information under meaningful headings and the proving of the arithmetical accuracy of the book records. It is at the start of all accounting activity.

Accounting, on the other hand, is concerned with identifying how transactions and events should be described in financial reports. It is also concerned with designing book keeping systems that make it easy to produce useful reports and to control the operations of the business. Accounting involves more professional expertise and judgment than book keeping because the accountants must analyze complex and unusual events and must be able to interpret the information contained in the accounting reports.

2. Managerial Accounting This specialization deals with the development of information to be used specifically by the entity’s management in discharging its managerial functions. Management accounting provides internal decision makers who are charged with achieving the goals of profitability and liquidity with Information about financing, investing and operating activities.

Management accounting utilises the techniques of both budgeting and cost accounting.

Budgeting is the process of developing

plans or goals for the future while cost accounting is the process of determining the cost of each product or service of a business, evaluating the profitability of each and making recommendations for controlling costs.

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3. Tax Accounting This specialization deals with the process of establishing tax liability of an accounting entity, preparing and submitting tax returns, reviewing returns with income tax auditors and planning for the minimization of tax liabilities and payments.

FORMS OF BUSINESS ORGANIZATION There are several common forms of business organizations: a. Sole proprietorship b. Partnership c. Company d. Cooperatives e. Public Corporations f.

1.

Not for profit organisations

Sole Proprietorship a. This is an unincorporated business owned by one person b. No special legal requirements must be met to start a sole proprietorship c. They are usually small in size and common in the service, retailing and farming industry d. Often the owner is the manager. e. Legally the business and the owner are not separate entities. f. The proprietor has unlimited liability as far as the proprietorship is concerned.

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g. Tax authorities do not separate the proprietor from the proprietorship h. Accountants view sole proprietorships as separate entities that must be accounted for separately from the owner

2. Partnership a. This is an unincorporated business owned by two or more persons known as partners b. Legally, a partnership is not separate from its owners. c. Tax authorities ,like in the case of a proprietorship, do not distinguish between the partners and the partnership d. Each partner in a general partnership has unlimited liability e. For accounting purposes, however, a partnership is assumed to be a separate entity from its owners.

3. Company a. Is an incorporated business legally separate from its owners. b. It is a legal person capable of engaging in economic activities; entering into contracts, owning property, disposing property, suing and be sued etc c. The owners are called shareholders d. Ownership is represented by shares of capital e. The shareholders enjoy limited liability f.

A company is taxed on its net income.

g. Any distribution of the company earnings (Dividends) is also taxed as part of the personal income of the shareholders Introduction to Financial Accounting

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4. Cooperatives a. Is an incorporated business legally separate from its owners. b. It is a legal person capable of engaging in economic activities; entering into contracts, owning property, disposing property, suing and be sued etc c. The owners are called Members d. Ownership is represented by shares of capital e. The shareholders enjoy limited liability f.

A company is taxed on its net income.

g. Any distribution of the company earnings (Dividends) is also taxed as part of the personal income of the members

5. Parastatals a. Is an incorporated business legally separate from its owner. b. It is a legal person capable of engaging in economic activities; entering into contracts, owning property, disposing property, suing and be sued etc c. The owner is the government d. They are financed by the government e. The government enjoy limited liability

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EXERCISE 1.1 1. Briefly explain why the following parties may be interested in the financial statements of an organisation: a) Employees b) Financial analysts c) The Government. d) The public.

2. Distinguish between bookkeeping and accounting and explain the functions of accounting.

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CHAPTER TWO CONCEPTUAL FRAMEWORK ELEMENTS OF THE FINANCIAL STATEMENTS These are items included in financial statements namely assets, liabilities, equity, revenues, expenses, gains and losses. It is useful to think of the elements as two distinct groups. The first group of three elements that is assets, liabilities, and equity describe amounts of resources or claims to resources at a moment in time and appear in a Statement of financial position. The other four elements namely revenues, expenses, gains and losses, describe transactions, events and circumstances that affect an enterprise during a period of time and are presented in either in a single Statement of comprehensive income or in a separate Statement of income

Assets These can be divided into two non-current and current. Non-current assets are those resources held by the entity for over 12 months with a view of generation benefits to the entity. Non-current assets are also divided into tangible and intangible assets. They can also be classified as either natural or man-made. Examples of tangible assets include land, building, motor vehicles, machinery, equipment, furniture, etc.

Example of intangible assets include copyrights, patents, goodwill, trademarks, franchise, software, etc.

Current assets are those resources held by the entity for less than 12 months. Current assets are not expected to last for more than one year. They are in most cases directly related to the trading activities of the firm.

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Examples include: •

Inventory – good held by the business for purposes of selling.

•

Accounts receivables – persons who owe the business amounts as a result of trading.

•

Prepayments

•

Cash at bank.

•

Cash in hand.

Liabilities These are obligations or debts of an enterprise. Non-current liabilities are expected to last or be paid after one year. This includes long-term loans from banks or other financial institutions. Current liabilities last for a period of less than one year and therefore will be paid within one year. Major examples: •

Accounts payable – owed amounts as a result of business buying goods on credit.

•

Bank overdraft - amounts advanced by the bank for a shortterm period.

•

Accruals

Equity Refers to owners claims against assets of an entity in sum, equity is equal to net assets Example includes share capital, share premium, general reserves, retained earnings, revaluation reserves, etc.

Revenues Revenues refers to any increases in assets or reductions of liabilities, resulting from the ordinary day to day activities of an entity, normally Pg 18

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from the sale of goods, or the rendering of services. A firm may have other incomes apart from that generated from trading (sales). Such incomes includes rental income, bank interest received, discounts received, dividend received, fees received, commissions received, etc.

Expenses Expenses refer to any decreases in assets or incurrences of liabilities, resulting from the ordinary revenue-earning activities of any entity.

Examples includes postage, stationery, salaries and wages, telephone bills, motor vehicle running expenses, bank charges, etc.

Gains Refers to increases in equity from something other than the day to day earnings from recurrent operations i.e. is an economic benefit outside the normal operations of a business. Examples includes gains on asset disposal, foreign exchange gains, etc

Losses Refers to decreases in equity that is outside the normal operations of the business. Examples includes loss on asset disposal, foreign exchange losses, etc

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FINANCIAL STATEMENTS The end result of the accounting process is the preparation of financial statements and reports that serve as communication tools.A complete set of financial statements comprises: 1. Statement of income 2. Statement of changes in equity 3. Statement of financial position 4. Statement of cash flows 5. Notes to the financial statements; comprising a summary of significant accounting policies and other explanatory notes.

Statement of Income It shows the results of operations (performance) of a business entity during an accounting period. The results are reflected by comparing revenues earned with the expenses incurred to generate the revenue.

Revenues > expenses = Profit Revenues < expenses = Loss Revenues refers to increases in assets or reductions of liabilities, resulting from the ordinary day to day activities of an entity, normally from the sale of goods, or the rendering of services. Expenses refer to decreases in assets or incurrences of liabilities, resulting from the ordinary revenue-earning activities of any entity. Equity refers to owners claims against assets of an entity.

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The Statement of income is illustrated below;

Mwembe Enterprise Limited Statement of income For the period ended 31st December 2017 Revenues Service revenue

Sh. 4,700,000

Expenses Salaries expense

900,000

Rent expense

600,000

Insurance expense

400,000

Advertising expense

200,000

Electricity expense

200,000

Total expenses

2,300,000

Net profit for the period

2,400,000

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The Statement of financial position This is a statement that reports (reflects) the financial position of an entity at a given point in time. The financial position of an entity is reflected by the amounts of: 1. assets, 2. liabilities, and 3. ownersâ&#x20AC;&#x2122; equity of the entity.

Statement of financial position

is a detailed expression of the

accounting equation.

The Accounting Equation Assets= Equity + Liabilities

ASSETS A business owns properties. These properties are called assets. The assets are the business resources that enable it to trade and carry out trading. They are financed or funded by the owners of the business who put in funds. These funds, including assets that the owner may put is called capital. Other persons who are not owners of the firm may also finance assets. Funds from these sources are called liabilities. The total assets must be equal to the total funding i.e. both from owners and non-owners. This is expressed inform of accounting equation which is stated as follows:

ASSETS = LIABILITIES + CAPITAL

An asset is a resource controlled by a business entity as a result of past events for which economic benefits are expected to flow to the firm.

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Some assets may have a physical substance while some exist not in physical or tangible form but in the form of valuable legal forms or rights. Assets are classified for purposes of the Statement of financial position into: 1. Non-current assets 2. Current assets

Liabilities These are obligations or debts of an enterprise. Liabilities are classified for purposes of the Statement of financial position into: 1. Non-current liabilities 2. Current liabilities

Equity This refers to the Owners’ claim against the assets of a company Remember: ASSETS = EQUITY + LIABILITIES Therefore; Equity= Assets – liabilities Assets – Liabilities = Net assets Equity = Net assets

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The Statement of financial position is illustrated below; Mwembe Enterprise Limited Statement of Financial Position As At 31st December 2017 Assets

Sh.

Non â&#x20AC;&#x201C;current assets Equipment

1,800,000

Motor vehicles

5,200,000 7,000,000

Current assets Inventory

1,200,000

Accounts receivable

1,400,000

Cash

8,050,000 10,650,000

Total assets

17,650,000

10,000,000

Equity and Liabilities Capital and reserves: Capital Retained Profit

1,050,000 10,050,000

Non-current liabilities Bank loan

5,000,000

Current liabilities Accounts Payable

Total equity and liabilities Pg 24

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1,600,000

17,650,000

Statement of Changes in Equity This serves as a connection between the Statement of financial position and the Statement of income by explaining the changes that have taken place in ownersâ&#x20AC;&#x2122; equity during the period covered. The Statement of changes in equity is illustrated below;

Mwembe Enterprise Limited Statement of changes in equity For the period ended 31st December 2017

Capital Sh. As at 1st January 2017 Additional capital

10,000,000

Profit

Dividends paid 15,000,000

Total

Sh. 300,000

5,000,000

Net Profit for the period

As at 31st December 2017

Retained

Sh. 10,300,000 5,000,000

2,350,000

2,350,000

(1,000,000)

(1,000,000)

1,050,000

16,050,000

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THE QUALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION These are qualities of good accounting information that can enable us to distinguish between better (more useful) information from inferior (less useful) information for decision-making purposes. These qualities are relevance, reliability, understandability and comparability.

Relevance Information is relevant if it makes a difference, it has predictive value, is timely and has feedback value

Reliability Information is reliable if (a) it is free from error or bias that is reasonably free from bias that is it is neutral, (b) it is verifiable that is similar results are achieved if the same measurement is used, (c) it is a faithful representation of what actually happened, (d) it is complete meaning there is no intentional omissions to mislead and (e) finally, it has substance over form meaning every transaction is accounted for in accordance with their substance and economic reality and not merely by their legal, contrived or paper form It is very important to Tradeoffs of qualities the relevance and reliability. Accountants often must make a tradeoff between relevance (timeliness of financial information) and reliability (verifiability) of financial information while in the same breath considering the needs of the users of accounting information in making a good decisions.

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Understandability Information is understandable if (a) it allows informed users to see the significance of the information (Abilities of users considered), (b) it provides â&#x20AC;&#x153;enoughâ&#x20AC;? aggregation and classification so that it is clear. A company may present highly relevant and reliable information, however it is useless to those who do not understand it.

Comparability Information is comparable if (a) it allows users to identify real similarities and differences for same and different companies, (b) it has been measured and reported in a similar or consistent manner. Information is said to be consistent if similar events have the same accounting treatment within the period and from one period to another. There should be adequate disclosures to aid comparability

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ACCOUNTING ASSUMPTIONS AND GENERALLY ACCEPTED ACCOUNTING PRINCIPLES The basic objective of accounting is to provide information useful in making economic decisions. It is therefore of vital importance that the information be highly relevant, reliable, clearly understandable and comparable. To ensure the financial statements will be of value to users of accounting information, a set of practices, called fundamental accounting

assumptions

and

generally

accepted

accounting

principles have been developed to provide guidelines for financial accounting. Fundamental accounting assumptions are the factors that define the financial reporting environment. They are also referred to as “Environmental assumptions.” The accounting principles, on the other hand, constitute the ground rules for financial reporting and are referred to as “the Generally accepted accounting principles (GAAP)”.

Accounting assumptions and principles are not like physical laws; they do not exist in nature awaiting discovery by man. Rather, they are developed by man in light of what man considers to be the most important objectives of financial reporting.

Accounting Assumptions.

The Separate Entity Assumption An accounting entity is any economic unit that controls resources and engages in economic activities. An individual, a business enterprise whether organized as a proprietorship, partnership or corporation, governmental agencies, non-governmental organizations and all non profit making entities are accounting entities regardless of the form of the organization. The accounting entity of concern is assumed to be separate and distinct from all other entities regardless of the form of the organization. The affairs of the accounting entity are distinguished even from those of its owners and information is prepared for the entity alone.

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The â&#x20AC;&#x2DC;Going â&#x20AC;&#x201C; concernâ&#x20AC;&#x2122; or Continuity Assumption.

In accounting for an accounting entity, it is to be assumed that the accounting entity will continue in operation for the foreseeable future.

It is assumed that the accounting entity has neither the

intention nor the necessity of liquidation or of curtailing materially the scale of its operations. This assumption provides the foundation for accrual accounting. Under accrual accounting, revenues are to be recognized when the effort to earn that revenue is complete or substantially completed irrespective of whether cash is received or not and expenses are recognized when incurred irrespective of whether cash has been received or not. When the accounting entity ceases to be a going concern, the accounting approach changes from accrual to realization and liquidation. The assumption also influences the classification of assets and liabilities on the Statement of financial position. Without the going-concern assumption, all assets and liabilities would be current with the expectation that the assets would be liquidated and the liabilities settled in the near future.

The Periodicity (Time period) Assumption.

The periodicity or time assumption implies that the assumed indefinite life of the accounting entity can be divided into artificial time periods.

Accountants, therefore, measure the operating progress and changes in economic position at relatively short time intervals during this indefinite life. Some enterprises select an accounting period known as a natural business year that ends when the operations are at low ebb in order to facilitate a better measurement of performance and financial position. Others use the calendar year and thus end the accounting period on December 31st. Some select a 12-month accounting period known as an accounting period which ends at a month other than December. The accounting period may be shorter than a year.

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The Monetary or Unit of Measure Assumption.

Accountants need some standard of measure to bring financial transactions together in a meaningful way. Out of the several standards of measure, accountants have concluded that money is the best for the purpose of measuring financial transactions. Accountants assume that the monetary unit (money) is a stable unit of value capable of acting as a common denominator of values. The impact of transactions is quantified and assessed in terms of some unit of measure. Different countries call their monetary unit different names. They also attach different values to their monetary unit. In Kenya the monetary unit is the shilling.

Generally Accepted Accounting Principles The generally accepted accounting principles are also referred to as “Implementation principles.” They include:

The Historical Cost Principle Generally accepted accounting principles require that most transactions and events be recognized in the financial statements at the amount of cash and cash equivalent paid or received or the fair value ascribed to them when they took place. Historical cost is usually definite and verifiable. As per this principle, assets are initially recorded at cost.

In most cases no adjustment is made to this valuation in later periods, expect to allocate a portion of the original cost to expense as the assets expire. At the time the asset is acquired, cost represents the fair market value as evidenced by an arm’s-length-transaction.

With the passage of time, the fair market value of an asset may change greatly from its original cost (historical cost). These changes in the ‘fair market value’ are generally ignored in the accounts and the assets have continued to be shown at historical cost less the portion that has been allocated to expenses.

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The Revenue Recognition Principle This principle provides guidance in answering the question of when should revenue be recognized. In general, the point of recognition of revenue should be the point that revenue can be reasonably and objectively determined. Revenue is considered realized when the following conditions are met: i) The earning process is essentially complete. The entity must have completed a significant portion of its responsibility. ii) Objective evidence exists as to the amount of revenue earned. The amount of revenue recognized must be measurable objectively. iii) A major portion of the costs associated with the revenue has been incurred or can be estimated. iv) The actual collection of cash is reasonably assured.

Generally, revenue is recognized at the point of sale. At this time, the earning process is essentially complete and the exchange value can be determined.

The Matching Principle This principle provides the guidance in answering the question of when should a cost be recognized. To measure the profitability of an economic entity, revenue is to be matched against costs associated in generating this revenue. The matching of business enterpriseâ&#x20AC;&#x2122;s expenses (the cost of goods and services used to obtain revenue) with its revenue is the primary activity in the measurement of the results of operations for that period.

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The Objectivity Principle The term ‘objectivity’ refers to measurements that are unbiased and subject to verification by independent entities. The principle requires that the value of transactions, assets and liabilities be verifiable. It implies that valuation must be independent of the person valuing the asset or liability. The parties involved in any transaction have opposing interests and bargain to arrive at the equilibrium of exchange equivalents.

If a valuation is objective, a disinterested third party

within the same facts would come up with the same valuation. This is generally referred to as an ‘Arms length transaction’. Accountants rely on various kinds of evidence to support their financial measurements but they seek always the most objective evidence available. Despite the goal of objectivity, it is not possible to divorce completely accounting information from opinion and judgement. For example, the cost of a depreciable asset can be determined objectively but not the periodic depreciation expenses. Objectivity in accounting has its roots in the search for reliability.

The Consistency Principle.

The principle of consistency implies that there should be consistent treatment of similar or the same items from one accounting period to another. This adds to usefulness of financial reports since the reports from one period are comparable to those of another period.

This also facilitates the detection of trends. In principle, once an accounting procedure has been adopted for a class of items, it should be consistently applied from period to period. The principle of consistency does not mean that a company should never make a change if a proposed new accounting method will provide more useful information than does the method presently in use. Entities sometimes need to change particular accounting approaches in order to adapt to changes in the environment.

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Where a significant change has been made, the fact that a change has been made and the shilling effects of the change should be fully disclosed in the financial statements. Consistency facilitates both comparability and understandability.

The Full Disclosure Principle.

Accounting reports must disclose all facts that may influence the judgment of an informed reader. Adequate disclosure means that all material and relevant facts concerning financial position and the results of operations are communicated to users. This can be accomplished either in the financial statements or in the notes accompanying the financial statements. Several approaches of disclosure exist; parenthetical explanations, supporting schedules, cross-references and footnotes. Such disclosure should make the financial statements more useful and less subject to misinterpretation.

Adequate disclosure does not require that information be presented in great detail. Financial statements are expected to summarize the financial effects of transaction and events on the accounting entity under review. Excessive disclosure could distort full disclosure. It does require, however, that no important facts be withheld.

On reporting the impact of transactions, the economic substance of the transaction takes precedence over the legal (Substance over Form). Due to the complexity of many businesses and increased expectations of the public, full disclosure has become one of the most difficult principles for the accountant to apply. Accountants are frequently charged in courts of law with failure to make adequate disclosures.

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Exception Principles (Modifying Rules) Materiality The term materiality refers to the relative importance of an item or an event. An item is â&#x20AC;&#x2DC;materialâ&#x20AC;&#x2122; if it might reasonably influence the decisions of users of financial statements; if its inclusion or exclusion would influence or change the judgment of a reasonable person.

Accountants must be sure that all material items are properly reported in the financial statements. Accountants must consider many concepts and principles when determining how to handle a particular element of the financial statements. The proper use of these concepts and principles may be costly and time consuming.

The financial reporting process should, however, be cost-effective; the value of the information should exceed the cost of its preparation. By definition, the accounting treatment accorded to immaterial items is of little or no value to decision makers. Therefore, accountants should not waste time accounting for immaterial items; these items may be treated in the easiest and most convenient manner. The concept of materiality allows accountants to ignore or modify other accounting principles with respect to items that are not material. Materiality of an item is a relative matter; what is material to one entity may not necessarily be material to another entity.

Conservatism/Prudence The principle holds that where equally acceptable alternatives exist, the alternative with the smallest yield to avoid exaggeration of economic values should be selected. This principle is most useful when matters of judgement or estimates are involved and is regarded as a powerful influence against the danger of overstating earnings or financial position. This concept is, therefore, applied where alternative measurements exit, each of which has reasonable support.

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The concept does not mean deliberate understatement of net assets and profits. This principle is used in many a situation which include the writing down of inventories to net realizable value, providing for uncollectible debts, recognizing of losses on long term construction contracts when the losses can reasonably be estimated and estimation of warranty expenses.

Industrial Peculiarities The peculiar nature of some industries and some business concerns sometimes require departure from the general theory underlying financial accounting. In the flower industry and meat-packing industry, for example, it is difficult very difficult to determine the cost of inventory.

The inventory, in such industries, is valued at the net realizable value.

This would be a departure from the historical cost principle and in some cases from the revenue recognition principle. The accounting profession is making efforts to reduce or eliminate specific industry practices. Industry practices that depart from typical accounting procedures will probably never be eliminated. Some industries have legitimate peculiarities that call for accounting procedures other than the customary ones.

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EXERCISE 2. 1 Briefly explain the following accounting Concepts. a) Going concern b) Accruals c) Consistency d) Prudence or conservatism e) Materiality f)

Money measurement

g) Historical cost

EXERCISE 2. 2 a) Distinguish between non- current assets and current assets b) Discuss the THREE financial statement prepared by a business organization clearly showing the use of each c) â&#x20AC;&#x153;Qualitative characteristics are the attributes that make information provided in financial statements useful to users.â&#x20AC;? Discuss

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CHAPTER THREE REGULATIONS IN FINANCIAL REPORTING. ACCOUNTING STANDARDS The variety of different procedures and valuations permitted under generally accepted accounting has given rise to multiple problems.

In order to ensure that accounting information has an identity of meaning to all its users, a set of rules commonly known as accounting standards were developed. A prerequisite to ensuring uniformity is that accounting procedures should themselves be standardized in such a way as to guarantee that information resulting from application of these procedures to data will be identical in meaning to all users.

Objectives of International Accounting Standard Board are: a) To develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standard that require high quality, transparent and comparable information in financial statements and other financial reporting to help participants in the worldâ&#x20AC;&#x2122;s capital markets and other users make economic decisions. b) To promote the use and rigorous application of those standards. c) To bring about convergence of national accounting standards and international accounting standards to high quality solutions.

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Development of Accounting Standards Although the possibility of international standards has been debated since early 20th century, the most successful programme began with the formation of the International Accounting Standards Committee, IASC in 1973. In 2001, it changed its name to the International Accounting Standard Board, IASB. The old IASC published International Accounting Standards. One of the main aims of the IASC and IASB is to achieve global convergence of accounting standards.

The founder members were drawn from professional Accountancy Bodies in the following counties: Australia, Canada, France, Germany, Japan, Mexico, United Kingdom, The Republic of Ireland and the United States of America. Over one hundred and forty professional accountancy bodies including nine associate and affiliate members, from 104 counties have now been admitted to membership and these represent counties at different levels of economic development The objective of the IASC as stated in the original 1973 agreement was: â&#x20AC;&#x153;to formulate and publish in the public interest basic standards to be observed in the presentation of audited accounts and financial statements and to promote their worldwide acceptance and observance.â&#x20AC;?

Under a revised agreement entered into in 1982, the reference to the basic standards was removed and the revised objectives became:1. To formulate and publish in the public interest accounting standards to be observed in the presentation of the financial statements and to promote their worldwide acceptance and observation, and 2. To work generally for the improvement and harmonization of regulation, accounting standards and procedures relating to the presentation of financial statements

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The members of the IASC enter into the following undertaking â&#x20AC;&#x153;to support the work of the IASC by publishing in their respective counties every international accounting standard approved for issue by the board of IASC and by using best endeavours.â&#x20AC;? a) To ensure that published financial statements comply with international accounting standards in all materials respects and disclose the fact of such compliance b) To persuade governments and standard-setting bodies that published financial statements should comply with international accounting standards in all material respects c) To persuade authorities controlling securities markets and the industrial and business community that published financial statements should comply with international accounting standards in all material respects and disclose the fact of such compliance d) To ensure that the auditors satisfy themselves that the financial statements comply with international accounting standards in all material respects, and e) To foster acceptance and observance of the international accounting standards internationally

Sources of Authority and Accounting Standards There is a large and increasing body of rules with which accountants need to be familiar with when preparing or interpreting financial statements. Such rules are laid down by: 1. Companies Act 2. The securities exchange requirementsâ&#x20AC;&#x201C; where companies have shares listed on the securities exchange or quoted on requirements laid down by the securities exchange.

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These rules require the provision of both some more information and some more frequent information than that required by law.

3. The industry or sector requirements 4. Accounting, assumptions, principles and conventions 5. Accounting and reporting standards

Purpose of Accounting Standards 1) To narrow the areas of difference and variety in accounting practice especially because there are a variety of methods of preparing financial reports due to the diversity and complexity of business 2) To disclose accounting bases used because of a number of items reported in financial reports require subjective judgment or estimates 3) To disclose departures from established definitive accounting standards so that its effects can be isolated and analyzed

Advantages of accounting standards a) They reduce or eliminate confusing variations in the methods used to prepare accounts b) They provide a focal point for debate and discussions about accounting practice therefore giving room for improvement. c) They oblige companies to disclose the accounting policies used in the preparation of accounts d) They are a less rigid alternative to enforcing conformity by means of legislation e) They have obliged companies to disclose more accounting information than they would otherwise have done if accounting standards did not exist Pg 40

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Disadvantages of Accounting Standards a) A set of rules, which give backing to one method of preparing accounts, might be inappropriate in some circumstances b) Standards may be subject to lobbying or government pressure especially those contravening laws of the land c) Some standards are not based on a conceptual framework of accounting d) Until now, setting of standards has not directly involved user groups in the creation of such accounting standards e) They give no room for innovation since existing rules inhibit innovation

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INTERNATIONAL HARMONIZATION Harmonization is making reporting standards similar in different countries or organizations

Benefits for Harmonization To investors They would want to compare financial results of companies both nationally and internationally. Differences in accounting practice acts as a barrier to such cross border analysis

To multinationals a) They would have better access to funds and finances from international markets b) Material

control

would

be

improved

because

harmonization helps internal communication of financial information c)

It would be easier to conform to the reporting requirements of the overseas securities exchange

d) Consolidation of foreign subsidiaries and associated companies would be easier e) May reduce their audit cost since auditor have been trained on the same accounting standards. f) Transfer of accounting staff across borders would be easier g) Since Financial statements are crucial for mergers, takeover, etc harmonization becomes important for appraisal of foreign enterprises

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To government By use of the same accounting standards, governments may be able to control multinational particularly those operating in developing countries.

To tax authorities It would become easier to calculate tax liability on income received from overseas to

To regional economic groups It would aid regional economic groups as the members would understand one anotherâ&#x20AC;&#x2122;s accounting practices

To large international auditing firms Their training costs would reduce because they donâ&#x20AC;&#x2122;t have to trains accountants in different standards

Barriers to Harmonization 1.

Different purposes

Counties attach different purposes to financial statements e.g. for some, the main purpose are tax assessment, investment, etc.

Developing countries may require harmonized accounting standards for purposes of monitoring performance of companies operating in the country and their subsidiary abroad.

2.

Different legal systems

This prevents developments of certain accounting practices and restricts the options available

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3.

Needs for developing countries

Developing countries are reluctant to develop basic standards and principles already in place in developed countries 4.

Culture differences

This makes the objectives for accounting system different from one country to another. Muslim countries do not believe in profit.

5. Nationalism Some counties are not willing to accept another countryâ&#x20AC;&#x2122;s standards.

For example Pakistan, Iran, Iraq cannot accept positions advanced

by America.

6.

Unique circumstances

Examples are civil wars (Somalia), hyperinflations (Zimbabwe), currency restrictions, etc 7.

National standards setters

Lack of strong accounting bodies in some countries acts as a barrier to harmonization. Such accounting bodies cannot lobby for the harmonization of standards.

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REGULATION OF ACCOUNTING PROFESSION The question that has been extensively debated is whether or not the accounting profession should be regulated. This has been argued on the basis that companies have some incentives that force them to report to interested parties without necessarily making them to do so through regulation. The argument for and against the regulation has been advanced.

Arguments for unregulated accounting profession 1. Agency theory It argues that since the management is engaged in agency contract with the owners of the company, they must ensure that information information is supplied to the stakeholders regularly. Since the shareholders would like to monitor management and such monitoring cost like audit fees may have a direct bearing on the compensation paid to the management; management is compelled to report regularly so as to enhance their image and improve their compensation. Thus firms will disclose all information voluntarily.

2. Competitive Capital Market Because firms have to raise capital funds from a competitive environment in the capital markets, they will be compelled to disclose voluntarily so as to attract such funds from investors. It is generally accepted that firms that report regularly in the capital market have an enhanced image and could easily attract funds from investors. Thus firms have an incentive to give regular financial reports otherwise they could secure capital at a lower cost. Thus regulating accounting will be imposing rules in a self- regulating profession.

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3. Private Contracting opportunities theory It has been argued that users who need information may enter into a contract with a private organization who can supply them with such information. This will ensure users get detailed and specific information suiting their requirement instead of the general-purpose information provided by financial reports as regulated by the legislation. Such allpurpose data may be relevant to the userâ&#x20AC;&#x2122;s needs.

Arguments against unregulated accounting report Arguments in support of accounting regulation are usually based on the doctrine of market failure. Market failure refers to a situation where the market is unable to efficiently allocate resources because of the imperfections that exist in that market or because the way the market is structured is poor.

Market failure also occurs when the market is unable to provide information to those who are in need of it. Because of existence of market failure is providing the accounting information, it has been argued that the accounting profession should be regulated so as to serve its users effectively and efficiently.

Specific reasons why market failure occurs include:

1. The monopoly in the market The existence of monopoly in the supply of information about itself, that is, the entity, is the only one in control of the supply of the internal information; will introduce certain imperfections in the supply of such information. There will be restriction in the supply of absolute information and it may not be available to those who need it. Even if suppliers of such accounting information were to charge prices, fears have been expressed that such prices will be prohibitive for more people.

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Further doubts have been expressed on whether firms can supply all the necessary information both positive and negative, especially where such firms operate in a competitive environment. This will be common in countries like Kenya where capital markets are not developed. Thus there is an urgent need to make financial reporting mandatory through a regulatory framework.

2. Failure of financial reporting and auditing Financial reporting standards have failed to correct instances of public fraud through fraudulent reporting and this has been so because of laxity in regulating accounting practices. The existence of a variety of methods of doing one thing and too much flexibility in accounting practice, have enabled the management of firms to manipulate accounts to suit their needs.

Auditing itself has been inadequate and not geared towards detection of frauds because auditors hardly ever carry 100% examination of records and transactions. Thus there is a serious need to control accounting practice through stringent standardization guidelines. This calls for a regulated accounting profession.

3. Public good characteristics of accounting information Accounting information has characteristics of a public good. The moment accounts are released to one person; it cannot be restricted from getting to other persons. This implies that buying accounting information through private contracting will be virtually impossible because its supply cannot be restricted and thus they cannot make money out of it and will be difficult to decide on the price to charge.

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THE ACCOUNTING PROFESSION IN KENYA In Kenya accounting is regulated under Accountants Acts cap 531 (revised Cap 15 of 2008). The main institutions are Kenya Accountants And Secretariats National Examination Board (KASNEB), Registration of Accountants Board (RAB) and

Institute of certified Public

Accountants Of Kenya (ICPAK) The major functions of KASNEB i. To prepare syllabus for accountants and secretaries examination ii. To make rules with respect to examination iii. To arrange and conduct examinations iv. To issue certificate to candidates who have certified examination requirements Registration of Accountants Board (RAB) under the revised Act, RAB is no longer a corporate body on its own but itâ&#x20AC;&#x2122;s now a department under the ICPAK. The major tasks of the board include: a) Registration of the accountants as members of the ICPAK or accounting practitioners. b) Issuance of the membership and practicing certificate to those eligible The function of the Institute of certified Public Accountants Of Kenya (ICPAK) include a) To provide standard of professional competence and practice amongst members of the institute b) To promote research into the subject of accounting and finance and related matters and publication of books, periodical, journals and articles in connection herewith c) To promote the international recognition of the institute d) To advice the examination board on matter related to the examination standards Pg 48

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Problems created by regulation of the accounting profession In practice regulation of any field brings misallocation of resources because production is not geared toward the market forces of demand and supply. Regulation of the accounting profession has led to the following problems.

1. Standard overload Because of the overstatement of demand for standards, there has been a tendency to overproduce standards. Many people who contribute during the standard setting process may not be active demanders of information to be supplied by such standards and very often the professional standard committee takes into account the view of such people leading o misallocation of resources.

2. Politicizing of standard setting Regulation is political process intended to protect the conflict interest of various user group. This leads to dilution of accounting standard as they are compromised by being based on bargaining instead of technical suitability

3. Social legitimacy The standard setting process requires social legitimacy in order to be effective that is, the regulating body should consist of person representing various user group of financial report. The professional standard committee lacks social legitimacy to set standards as most of its members are drawn from the accounting profession and not the business and the public community.

It is perceived that these accounting professionals know the need of business and the public communities when using financial reports.

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4. Economic consequences Sometimes regulation overburden companies with unnecessary regulation that might have negative economic consequences. This is especially so when companies device ways and means of avoiding certain regulation for one reason or another.

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CHAPTER FOUR RECORDING BUSINESS TRANSACTIONS DOUBLE ENTRY RULE The Accounting equation forms the basis of double entry and therefore it should always be maintained. Any change in assets, liabilities or capital will have a double effect such that assets will always be equal to liabilities plus capital. If the owners put in additional capital then this will increase the cash at bank and the capital amount therefore the equation is still maintained.

THE ACCOUNTING CYCLE 1. Analyzing of business transactions and events 2. Journalizing business transactions and events 3. Posting transactions to the

accounts (also called the

general ledger) 4. Preparing the unadjusted trial balance 5. Journalizing and posting adjusting entries 6. Preparing the adjusted trial balance 7. Preparing financial statements from the adjusted trial balance 8. Posting closing Entries

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Analysing of business transactions and events Conducting business involves a number of business transactions and events such as buying equipment, purchasinggoods and services, paying expenses, making sales, distributing goods and services etc.

Each transaction is recorded on a source document that forms the basis forrecording in a business’s accounting system. The information in the source document serves as the basis for preparing a journal entry.

Source Documents This shows the evidence transactions. They are collected, filed and posted in the books of prime entry. For example, if a firm sells goods on credit, then an invoice is raised. The source documents as shown in the above include: •

Sales invoice

•

Purchases invoice

•

Credit note

•

Debit note

•

Receipts, cheques and petty cash vouchers

•

Other correspondences.

Sales Invoice The sales invoice is raised by the firm and sent to the debtor/ customer when the firm makes a credit sale.

The sales invoice contains the following: i.

Name and address of the firm

ii. Name and address of the buying firm

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iii. Date of making the sale â&#x20AC;&#x201C; invoice date. iv. Invoice number v. Amount due (net of trade discount) vi. Description of goods sold vii. Terms of sale

Purchases Invoice A purchase invoice is raised by the creditor and sent to the firm when the firm makes a credit purchase. It shows the following: i.

Name and the address of the creditor/seller

ii. Name and address of the firm iii. Date of the purchase (invoice date) iv. Invoice number v. Amount due vi. Description of goods sold vii. Terms of sale

Credit note A credit note is raised by the firm and issued to the debtor when the debtor returns some goods back to the firm. Itâ&#x20AC;&#x2122;s contents include: i.

Name and address of the firm

ii. Name and address of the debtor iii. Amount of credit iv. Credit note number v.

Reason for credit e.g. if goods sent but of the wrong type.

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The purpose of the credit note is to inform the debtor or customer that the debtorâ&#x20AC;&#x2122;s account with the firm has been credited i.e. the amount due to the firm has been reduced or cancelled. The credit note may also be issued when the firm gives an allowance of the amounts due from the debtors. From the context we can assume that all credit notes are issued when goods are returned.

Debit note This is raised by the creditor and issued to the firm when the firm returns some goods to the creditor. It includes the following items: i.

Name and address of the firm

ii. Name and address of the creditor iii. Amount of debit iv. Debit Note number v. Reason for the debit The purpose of the debit note is to inform the firm that the amount due to the creditor has been reduced or cancelled.

Receipts A receipt is raised by the firm and issued to customers or debtors when they make payments in the form of cash or cheques. It shows: i.

The name and address of the firm

ii. The date of the receipt iii. Amount received (cash or cheque or other means of payment) iv. Receipt number.

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Cheques When a firm opens a current account with the bank, a cherub book containing cherubs issued.

The cherubs allow the firm to make

payments against the account with the bank. When a firm issues a cherub to its creditors for payments, it authorizes the bank to honor payments against the firmâ&#x20AC;&#x2122;s account with the bank. The cherub contains the following information: i.

Name and account number of the firm (account holder)

ii. The date of the cheque iii. Name of the payee (creditor) iv. Name of the firmâ&#x20AC;&#x2122;s bank v. Amount payable in words and figures vi. The cheque number vii. The authorized signature(s) Analyzing of

business transactions and events basically involves

identifying the elements affected and whether the element is been increased or reduced.

Example 4. 1 ABC limited purchased machinery at Sh. 2,765,000 by cheque Here a non-current assets called machinery and a current asset namely bank were affected where machinery account was increased while the bank account was reduced

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Journalizing business transactions The Journal In explaining the rules of debit and credit, we

do not recorded

transactions directly in the accounts. To have a permanent record of an entire transaction, the accountant uses a book or record known as a journal. A journal is a chronological (arranged in order of time) record of business transactions. A journal entry is the recording of a business transaction in the journal. A journal entry shows all the effects of a business transaction as expressed in debit(s) and credit(s) and may include an explanation of the transaction. A transaction is entered in a journal before it is entered in ledger accounts. Because each transaction is initially recorded in a journal rather than directly in the ledger, a journal is called a book of original entry.

There are two types of journal entries; simple and compound journal entries . A simple journal entries involved one debit and one credit.

Many business transactions, however, affect more than two accounts.

The journal entry for these transactions involves more than one debit and/or credit. Such journal entries are called compound journal entries. A general journal contains the following columns: Date column. The first column on each journal page is for the date.

For the first journal entry on a page,this column contains the year, month, and day (number). For all other journal entries on a page, this column contains only the day of the month, until the month changes.

Account titles and explanation column. The first line of an entry shows the account debited. The second line shows the account credited. Notice that we indent the credit account title to the right. Any necessary explanation of a transaction appears on the line(s) below the credit entry and is indented halfway between the accounts debited and credited.

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A journal entry explanation should be concise and yet complete enough to describe fully the transaction and prove the entryâ&#x20AC;&#x2122;s accuracy. When a journal entry is self-explanatory, we omit the explanation.

Posting reference column. This column shows the account number of the debited or credited account.

Debit column. In the debit column, the amount of the debit is on the same line as the title of the account debited.

Credit column. In the credit column, the amount of the credit is on the same line as the title of the account credited.

A summary of the functions and advantages of using a journal are; It a) Records transactions in chronological order. b) Shows the analysis of each transaction in debits and credits. c) Supplies an explanation of each transaction when necessary. d) Serves as a source for future reference to accounting transactions. e) Eliminates the need for lengthy explanations from the accounts. f)

Makes possible posting to the ledger at convenient times.

g) Assists in maintaining the ledger in balance because the debit(s) must always equal the credit(s) in each journal entry. h) Aids in tracing errors when the ledger is not in balance.

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Journalizing is the process of entering the effects of a transaction in a journal. Then, the information is transferred, or posted, to the proper accounts in the ledger.

Example: On 1.1.2018 ABC Limited invested Sh. 50,000 cash and Sh. 340,000 into business.

Account titles and

Date

Ref

Dr

Cash

100

50,000

Bank

120

340,000

explanation

1.1.2018

Capital

501

Cr

390,000

(To record intial capital)

Example : On 31.1.2018 ABC Limited purchases an equipment at Sh. 70,000 paying by cheque.

Date

Account titles and

Ref

Dr

200

70,000

Cr

explanation 31.1.2018

Equipment Bank

120

70,000

(To record purchase of equipment)

Posting transactions to the general ledger Posting is the process of recording in the accounts the information contained in the journal.

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An account is a part of the accounting system used to classify and summarize the increases, decreases, and balances of each asset, liability, shareholders’ equity item, dividend, revenue, and expense.

Firms set up accounts for each different business element, such as cash, accounts receivable, and accounts payable. Every business has a Cash account in its accounting system because knowledge of the amount of cash on hand is useful information.

Format of an account.

Dr. Date

Detail

Name of account Folio

Amount

Date

Detail

Folio

Cr.

Amount

In this account the date will show the opening period of the asset, liability or capital i.e. the balance brought forward. It will also show the date when a transaction took place (i.e. either an asset was bought or liability incurred).

The detail column (also called the particulars column) shows the corresponding ledger . The Folio Column for purposes of detailed recording shows the reference number of the corresponding account.

The amount column shows the amount of the asset, liability or capital.

Accountants use the term debit instead of saying, “Place an entry on the left side of the account”. They use the term credit for “Place an entry on the right side of the account”. Debit (abbreviated Dr.) simply means left side; credit (abbreviated Cr.) means right side. Thus, for all accounts a debit entry is an entry on the left side, while a credit entry is an entry on the right side.

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All assets have the debit side balance while all the liabilities and capital have credit side balances. Each type of asset or liability must have its own account whereby all transactions affecting them are recorded in this account. Therefore, there should be an account for buildings, machinery, inventory, accounts receivable, accounts payable, etc.

Under the accounting equation if all assets are financed by either liabilities or capital therefore all debits should be the same as credits.

For the double entry to be reflected in the accounts, every debit entry must have a corresponding credit entry. The transactions affecting these accounts are posted in the account as debit entry and credit entry to complete the double entry. This rule was founded by Prof.

Luca Pacioli, a Italian monk in 1494. The accounts are all contained within a ledger (also called a general ledger), which is simply a collection of all the different accounts operated by the business.

The chart of accounts is a complete listing of the titles and numbers of all the accounts in the ledger. The chart of accounts can be compared to a table of contents. The groups of accounts usually appear in this order: assets, liabilities, shareholdersâ&#x20AC;&#x2122; equity, dividends, revenues, and expenses. A chart of account is usually organized by codes. That is individual accounts are in sequence in the ledger. Each account typically has an identification number and a title to help locate accounts when recording data. For example, a company might number asset accounts, 100-199; liability accounts, 200-299; shareholdersâ&#x20AC;&#x2122; equity accounts and Dividends account, 300-399; revenue accounts, 400499; and expense accounts, 500-599.

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RULES OF ACCOUNTING When we make a debit entry we are either: 1) Increasing the value of an asset.

2) Reducing the value of a liability.

3) Reducing the value of capital.

4) Reducing the revenues 5) Increasing the expenses 6) Increasing the losses 7) Reducing the gains 8) Increasing distributions (drawing or dividends) When we make a credit entry we are either: 1) Reducing the value of an asset.

2) Increasing the value of a liability.

3) Increasing the value of capital.

4) Increasing the revenues 5) Reducing the expenses 6) Reducing the losses 7) Increasing the gains 8) Reducing distributions (drawing or dividends) Note that posting is always starts from the journal to the ledger accounts. Postings to thr ledger can be made (1) at the time the transaction is journalized; (2) at the end of the day, week, or month; or (3) as each journal page is filled and approved. The choice is a matter of acceptable practice in the particular business.

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When posting the journal, the date used in the ledger accounts is the date the transaction was recorded in the journal, not the date the journal entry was posted to the accounts. Frequently, accountants must check and trace the origin of their transactions, so they find it important to provide cross-indexing.

Cross-indexing is the placing of (1) the reference number of the account in the

journal and (2) the

journal page number in the

account. Cross-indexing aids the tracing of any recorded transaction, either from general journal to general ledger or from general ledger to general journal. Normally, they place cross-reference numbers in the Reference column of the journal when the entry is posted. If this practice is followed, the cross-reference numbers indicate that the entry has been posted.

Preparing the unadjusted trial balance Periodically, accountants use a trial balance to test the equality of their debits and credits. A trial balance is a listing of the ledger accounts and their debit or credit balances to determine that debits equal credits in the recording process. The trial balance is a simple report that shows the list of account balances classified as per the debits and credits. The purpose of the trial balance is to show the accuracy of the double entries made and to facilitate the preparation of final accounts i.e. Statement of Income and Statement of financial position. The debits of the trial balance should be the same as the credits, if not then there is an error in one or more of the accounts.

From the trial balance please note that assets, expenses, losses and distributions are on the debit side. Equity, liabilities, revenues and gains are normally listed on the credit side.

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Errors in Accounts There are two types of errors in accounts: •

Errors that don’t affect the trial balance

•

Errors that affect the trial balance

Errors that don’t affect the trial balance The trial balance produced from the accounts appears to be correct that is the debits and the credits are equal. However, on taking a close check on the balances and transactions posted, errors may have been made and therefore the balances shown on the trial balance may be incorrect. There are six main types of errors that don’t affect the trial balance and these are explained as follows:

a) Error of omission Here, a transaction is completely omitted from the accounts and therefore the double entry is not made. For example, a sales invoice of Sh. 400 is not posted in the sales journal therefore no entry is made in the Accounts receivable and the Sales account i.e. both debit of Sh. 400 in Accounts receivable and credit of Sh. 400 in the Sales account.

To correct this error debit of Sh. 400 in Accounts receivable and credit of Sh. 400 in the Sales account.

b) Error of Commission This error occurs when a transaction is posted to a wrong account but the account is of the same class. For example, a credit sale to Mwembe Traders is posted to Mwembe Enterprises’ account for an amount of Sh. 2,000. Instead of a debit to Mwembe Traders’ account it is made to Mwembe Enterprises’ account and the corresponding credit in the Sales account is correct.

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Although the debit entry is made into the wrong account, the two accounts are of the same class i.e. Accounts receivable. To correct this error debit Mwembe Traders account and credit Mwembe Enterprisesâ&#x20AC;&#x2122; account by Sh. 2,000 respectively.

c) Error of principle In this type of error a transaction is posted not only to the wrong account but also of a different class e.g. Motor vehicle purchased for Sh. 400,000 is posted to the motor vehicle expenses account. Instead of debiting Motor vehicles and crediting the Cash/Bank account. The motor vehicles account is a non-current asset, and motor vehicles expenses a/c is an expense account. Therefore, a capital expenditure has been posted as revenue expenditure. To correct this error debit Motor vehicles account and credit the Motor expenses by Sh. 400,000 each

d) Complete reversal of entries A transaction is posted to the correct accounts but to the wrong sides of the accounts i.e. a debit is posted as a credit and a credit is posted as a debit. Example: cash drawn from the bank of Sh. 15,000 for business use is posted as a debit in the bank account and credit in cash in hand. To correct this error, two entries are made in the relevant accounts: (i)

Correct the error

(ii)

Post the transaction correctly

The entries will therefore be as follows: (i)

Debit Cash account by Sh. 15,000

Credit bank account by Sh. 15,000

(To correct the error of Sh. 15,000 posted in the wrong sides of these account)

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(ii)

Debit cash by Sh. 15,000

Credit bank by Sh. 15,000

(To post the entries correctly)

Introduction to Financial Accounting

e) Error of Original entry Here a transaction is posted to the correct accounts but the amount posted is not correct i.e. it is either under/over stated. In some cases, this is known as a transposition error. For example, cash received from a debtor of Sh. 980 is credited to the customerâ&#x20AC;&#x2122;s account as Sh. 890. To correct this error, the amount understated or overstated is posted to these accounts to reflect the correct balance. In this case, we will:

Debit Cash account

Sh. 90

Credit Accounts receivable

Sh. 90

f) Compensating Errors These are errors that tend to cancel out each other i.e. if the effect of one error is to understate the debits or credits then another error may take place to overstate the debits or credits by the same amount, hence canceling out each other. For example, if the balance c/d of the Purchases account is Sh. 3,980 but shown in the trial balance as Sh. 3,890 and another error carried to the trial balance of Furniture account amounting to sh. 4,540 instead of Sh. 4,450: Purchases account Correct b/d

Sh. 3,980

Furniture account Correct b/d

Sh. 4,540

Trial balance figure Sh. 3,890

Trial balance figure Sh. 4,450

(90)

90

Uses of Suspense account Errors will cause the two side of the trial balance are

not equal.

These type of errors are corrected by use of a Suspense account.

For example, if the debits > credits, then an amount is included on the credit side of the trial balance so that the debits = credits.

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This is a credit balance and will be taken to the suspense account on the credit side. To correct the above errors, the appropriate or the adjusting entries are made through the suspense account. The errors discovered in the other accounts are posted to the Suspense account. Posting the correct entries should eliminate the balance on the Suspense account.

Journalizing and posting adjusting entries The need for adjusting entries The Statement of income of a business reports all revenues earned and all expenses incurred to generate those revenues during a given period. A Statement

of income that does not report all revenues

and expenses is incomplete, inaccurate, and possibly misleading.

Similarly, the Statement of financial position does not report all of an entityâ&#x20AC;&#x2122;s assets,liabilities, and shareholdersâ&#x20AC;&#x2122; equity at a specific time may be misleading. Each adjusting entry has a dual purpose: (1)

to make the Statement of income report the proper revenue or expense and

(2)

to make the Statement of financial position report the proper asset or liability. Thus, every adjusting entry affects at least one of Statement of income account and one of Statement of financial account.

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CASH VERSUS ACCRUAL BASIS ACCOUNTING Professionals such as physicians and lawyers and some relatively small businesses may account for their revenues and expenses on a cash basis. The cash basis of accounting recognizes revenues when cash is received and recognizes expenses when cash is paid out.Accountants use the accrual basis of accounting. Under the accrual basis of accounting, they recognize revenues when the company makes a sale or performs a service, regardless of when the company receives the cash. They recognize expenses as incurred, whether or not the company has paid out cash. Periodicity and the matching principle necessitate the preparation of adjusting entries.

Adjusting entries are journal entries made at the end of an accounting period to bring about a proper matching of revenues and expenses.

The matching principle requires that expenses incurred in producing revenues be deducted from the revenues they generated during the accounting period. The matching principle is one of the underlying principles of accounting. This matching of expenses and revenues is necessary for the Statement of income to present an accurate picture of the profitability of a business.

Classes and types of adjusting entries Adjusting entries fall into two broad classes: deferred (meaning to postpone or delay) items and accrued (meaning to grow or accumulate) items. Deferred items consist of adjusting entries involving data previously recorded in accounts. These entries involve the transfer of data already recorded in asset and liability accounts to expense and revenue accounts, respectively. Accrued items consist of adjusting entries relating to activity on which no data have been previously recorded in the accounts. Revenue and expenses must be recognized as they are earned or incurred, not as money is received or paid.

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They must be matched with one another so far as their relationship can be established or justifiably assumed, and dealt with in the Statement of income of the period to which they relate. Therefore all incomes and expenses that relate to a particular financial period will be matched together to determine the profit for the year.

Deferred Items Prepaid Expenses A prepaid expense is an expense that is not payable but cash has already been paid.

A prepaid expense should not increase the

periodâ&#x20AC;&#x2122;s expenses but should be carried forward to the next financial period and should be shown in the Statement of financial position as a current asset e.g. Prepaid insurance.

Prepaid Income This is income that is not yet due but cash has been received for it.

This happens where an income is payable in advance e.g. Rent payable 3 months in advance. A prepaid income should not be reported in the current financial period but should be carried forward and reported in the period it relates to. The accounting treatment will be to show it as a current liability called Unearned premiums

Adjustments for prepaid expenses Micro Sacco purchased for cash an insurance policy on its matatus for the period year ended December 2017.

1.

The journal entry to record the purchase of the policy was: Debt the Prepaid Insurance Account by Sh. 240,000 Credit Cash/bank account by Sh. 240,000 (Purchased truck insurance to cover a one-year period)

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Introduction to Financial Accounting

2.

Monthly Journal entry Debt the Insurance expenses account by Sh. 20,000 Credit Prepaid Insurance account by Sh. 20,000 (To allocate insurance expense for January 2017)

Adjustments for prepaid income In January 2017, Jubilee Insurance received annual premiums for the year ending December 2017. a)

The journal entry to record the receipt of insurance in advance was: Debt the Cash/bank account by Sh. 240,000 Credit the Unearned Premiums by Sh. 240,000 (Receipt of insurance premiums for Jan to Dec. 2017)

b)

Monthly Journal entry Debt the Unearned premiums account by Sh. 20,000 Credit the Premiums revenue account by Sh. 20,000 (To allocate insurance premiums for January 2017)

Accrued items Adjustments for Accrued Income This is income that relates to the current year but cash has not yet been received. An accrued income should be reported in the Statement of income and the same income will be shown in the Statement of financial position as a current asset e.g. interest receivable

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a)

The journal entry to record interest earned in arrears is: Debt the interest receivable account by Sh. 76,000 Credit the interest income by Sh. 76,000 (To accrue interest income for the year Jan to Dec. 2017)

b)

The journal entry to record interest received in arrears is: Debt the Cash/bank account by Sh. 76,000 Credit the interest receivable account by Sh. 76,000 (Receipt of interest receivable for the year Jan to Dec. 2017)

Accrued items Accrued items require two types of adjusting entries: asset/revenue adjustments and liability/expense adjustments. The asset/revenue adjustments involves accrued assets while the liability/expense adjustments involves accrued liabilities. Accrued assets/revenues include interest receivable or dividend receivable, that have not been recorded by the end of an accounting period. These assets represent rights to receive future payments that are not due at the Statement of financial position date. Accrued liabilities/expense are those not yet recorded at the end of an accounting period. They represent obligations to make payments not legally due at the Statement of financial position date, such as employee salaries. For this reason, we also call these obligations accrued salaries. Tax expenses is an outstanding accrued item. Although dividends are not defined as expenses, the are also routinely accrued.

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Accrued Expenses An accrued expense is an expense that is payable or due for payment but has not yet been paid during that period.

An accrued expense

should be charged in the Statement of income and shown in the Statement of financial position as a current liability e.g. accrued wages

Adjustments for Accrued Expenses a)

The journal entry to record accrued expenses is: For example Debt the Electricity expenses by Sh. 7,240 Credit the Accruals account Sh. 7,240 (To record electricity bill for Dec. 2017)

b)

The journal entry to record payment of accrued expense is: Debt the Accruals account by Sh. 7,240 Credit the Cash/bank account by Sh. 7,240 (To record payment of electricity bill for Dec. 2017)

Adjustments for Accrued Tax a)

The journal entry to record Tax expenses is: Debt the Tax expense account by Sh. 1,343,000 Credit the Taxation payable account by Sh. 1,343,000 (To record tax expense for the year Jan to Dec. 2017)

b)

The journal entry to record payment of accrued expense is: Debt the Accruals account by Sh. 7,240 Credit the Cash/bank account by Sh. 7,240 (To record payment of electricity bill for Dec. 2017)

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Adjustments for Accrued dividends a)

The journal entry to record dividends expenses is: Debt the Dividend expense account by Sh. 1,159,000 Credit the Dividend proposed/ payable account by Sh. 1,159,000 (To record dividend proposed /declared for the year Jan to Dec. 2017)

b)

The journal entry to record payment of dividend for the year is: Debt the Proposed dividend account by Sh. 1,159,000 Credit the Cash/bank account by Sh. 1,159,000 (To record payment ofdividends for the year ended Dec. 2017)

The Closing Entries To prepare the closing entries do the following; 1.

To close the accounts listed in the Statement of income, those with credit balances are debited while and the Income summary is credited

2.

To close the accounts listed in the Statement of income, those with debit balances are credit while the Income summary is debited

3.

To close the Income summary, transfer the balancing figure to the retained earnings

4.

To close the drawing/dividend account, debit the Retained earning account and credit the Drawings/dividend account.

Note the Income Summary is (a) temporary account. (b) It exists only during

the closing process. (c) It does not appear on

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Introduction to Financial Accounting

any financial

EXERCISE 4.1 1.

Briefly explain the following types of errors: i.

Error of commission

ii. Error of principle iii. Complete reversal of entries iv. Compensating errors

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CHAPTER FIVE ACCOUNTING FOR SERVICE BUSINESS. REVENUES FROM SERVICES A firm that offers services may generated incomes such as •

Rental income

•

Bank interest

•

Discounts received.

•

School fees

•

Agency commissions etc

When the firm receives cash, from these incomes, the following entries are made: - Debit Cash /Bank account - Credit the respective income account.

Each type of income should have its own account e.g. rent income, interest income.

Incomes increase the value of capital and that is the reason why they are posted on the credit side of their respective accounts.

EXPENSES PAID TO RENDER SERVICES These are amounts paid out for services rendered other than those paid for purchases. Examples include: • Postage • Stationery •

Salaries and wages

•

Telephone bills Introduction to Financial Accounting

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•

Motor vehicle running expenses.

•

Bank charges

•

Supplies expenses

When a firm pays for an expense, we: i.

Debit the respective expense account.

ii. Credit the Cash/Bank account Each expense should also have its own account where the corresponding entry will be posted. Expenses decrease the value of capital and thus the posting is made on the debit side of their accounts.

EXERCISE 5.1 The transactions of G2S Delivery for March 2017 were as follows: Mar. 1 The company started with Sh. 2,300,000 in bank.

2 Paid Sh. 26,000 by cheque for March rent for a completely furnished building.

5 Paid by cheque for delivery trucks, Sh. 480,000.

9

Paid Sh. 12,200 for office supplies received and used in March.

12 Performed delivery services for customers who promised to pay Sh. 627,000 at a later date.

20 Collected cash of Sh. 104,500 from customers on account 21 Received a bill for Sh. 31,200 for advertising in the local newspaper in March.

27 Paid cash for electricity bill consumed in March at Sh. 9,500.

31 Paid Sh.100,400 salaries to employees for March by cheque.

31 Paid telephone bill Sh. 11,000 cash Pg 76

Introduction to Financial Accounting

Required: Complete the accounting cycles by; a) Prepare the journal entries b) Posting the joural to the accounts c) Extracting the unadjusted trail balance. d) Prepare financial statements

EXERCISE 5.2 Economy Laundry had the following transactions in August 2017: Aug. 1. Started business with Sh. 550,000 in bank.

3. Borrowed Sh. 340,000 from the bank .

4. Purchased cleaning equipment for Sh. 250,000

by

cheque.

6. Performed services for customers who promised to pay later, Sh.160,000.

7. Paid this monthâ&#x20AC;&#x2122;s rent on a building, Sh. 28,000.

10. Collections were made for the services performed on August 6, Sh. 32,000.

14. Supplies were purchased on account for use this month, Sh. 30,000.

17. A bill for Sh. 4,000 was received for electricity for this month.

25. Laundry services were performed for customers who paid immediately, Sh. 220,000 cash.

31. Paid employee salaries, Sh. 60,000.

31. with drew for personal used, Sh. 20,000 cash.

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Required: Complete the accounting cycles by; a) Prepare the journal entries b) Posting the joural to the accounts c) Extracting the unadjusted trail balance. d) Prepare financial statements

EXERCISE 5.3 Flames Tree traders started a retail business on 1st June 2017. The following transactions occurred during the month; June 1: Opened a bank account for the business and deposited Sh. 2,340,000 and cash in hand was Sh. 293,000 June 3:

Converted a personal saloon car worth Sh. 561,000 to business use

June 3:

Bought a fridge at Sh. 195,000 cash

June 4: Bought furniture at Sh. 156,000

by cheque and

telephone at Sh. 19,000 cash.

June 6: Paid Sh. 160,000 by cheque for rent and Sh. 125,000 cash as insurance for the business.

June 7:

Borrowed Sh. 850,000 loan from the bank which was credited in bank.

June 8: Rendered services and was received Sh. 490,000 by cheque

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June 16: Hired a driver and paid him Sh.15,000 in cash June 17: Rendered services worth Sh. 740,000 on credit June 21: Received Sh.105,000 cash on account.

June 23: Rendered services worth Sh. 243,000 and received half the amount in cash.

June 25: Sh. 200,000 cash was banked June 26: Bought a motor van for Sh. 419,000 by cheque June 28: Withdrew Sh. 77,000 by cash for personal use.

June 29: Paid salaries

of Sh. 75,000

by cheque, electricity

Sh.13,000 by cheque , water bill Sh. 19,000 in cash, repairs of Sh.17,000 by cheque and telephone bill Sh. 8,000 cash June 30: Rendered services at Sh. 226,000 to Rungu traders on credit Required: Complete the accounting cycles by; a) b) c) d)

Prepare the journal entries Posting the joural to the accounts Extracting the unadjusted trail balance.

Prepare financial statements

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EXERCISE 5.4 The trial balance of Kanana Golf Place at the end of the first 11 months of its fiscal year follows: Kanana Golf Place Trial Balance For period ended 30th November 2017 No.

Account Title

Debits

Credits

100 Cash

711,800

103

Accounts Receivable

817,500

130

Land

600,000

200

Accounts Payable

187,500

201

Bank loan

150,000

300

Capital

500,000

310

Retained Earnings, 2017 January 1

537,000

413

Membership and Lesson Revenue

505

Advertising Expense

210,000

507

Salaries Expense

660,000

511

Electricity Expense

515

Rent Expense

518

Supplies Expense

22,500

530

Repairs Expense

15,000

531

Entertainment Expense

8,700

540

Interest Expense

3,000

21,000 330,000

3,39,9500

Total

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2,025,000

Introduction to Financial Accounting

3,399,500

Transactions for December were: Dec.1. Paid building rent for December, Sh. 40,000.

2. Paid creditors on account, Sh. 180,000.

5. Purchased photocopiers for cash, Sh. 100,000.

7. Sold memberships on account for December, Sh. 270,000.

10. Paid the bank loan of Sh. 150,000, plus interest of Sh. 1,5000.

13. Cash collections from customers on account, Sh. 360,000.

19. Received a bill for repairs, Sh. 2,250.

24. Paid the December electricity bill, Sh. 1,800.

28. Received a bill for December advertising, Sh. 10,650.

29. Paid the equipment repair bill received on the 19th, Sh. 2,250.

30. Gave golf lessons for cash, Sh. 40,500.

30. Paid salaries, Sh. 60,000.

30. Sales of December memberships on account since December 7, Sh. 180,000 30. Costs paid in entertaining customers in December, Sh. 3,500.

30. Drew for personal used, Sh. 15,000 cash.

Required a) Prepare entries in the journal for the transactions during December 2017. b) Post the journal entries to ledger accounts. c) Prepare unadjusted trial balance d) Prepare financial statements Introduction to Financial Accounting

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EXERCISE 5.6 The Chief Accountant of Rural Hospital has extracted the following unadjusted trial balance as at 31 October 2017 Sh. 000â&#x20AC;&#x2122; Share capital

Sh. 000â&#x20AC;&#x2122; 30,350

10% debentures

3,500

Retained Profit November 2016

4,850

Motor vehicles Freehold property Account receivable

3,235 44,500 1,375

Accounts payable Medical supplies

845 95,650

127,450

Medical fees Furniture and fittings Goodwill

4880 500

Salaries and wages General expenses Vehicles running expenses

2,285 358 2,470

Bad debts expense

124

Telephone and postage

568

Water and electricity

269

Rates and insurance

289

Bank

10,492

______

166,995

166,995

Notes: 1. Credit services amounting to Sh. 165,000 were made on 31 October 2017 but no entries were made in the books.

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2. Salaries and telephone bills amounted to Sh. 134,000 and Sh.55,000 respectively for October 2013 were paid on 5th November 2017.

3. Rate and insurance account includes Sh. 49,000 which related to November and December 2017 4. The debenture interest has not yet been paid.

Required: (a) The adjusted trial balance for the year ended 31th December 2017 (b) The Statement of income for the year ended 31th October 2017 (C) The Statement of financial position as at 31th October 2017

EXERCISE 5.7 The unadjusted trial balance of Precious angles Academy as at 31th December 2017 was as follows: Sh. Share Capital

400,000

School fees Accounts receivable

Sh. 1,900,000

400,000

Account payables

440,000

Retained profit

385,000

Rent expense

440,000

Buildings at cost

720,000

Plant at cost

690,000

Advertising expenses

225,000

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Bank

140,000

10% Debentures Furniture at cost

1,000,000 330,000

Repairs expenses

80,000

General expense

480,000

Salaries expenses

561,000

Motor expenses

59,000 4,125,000

4,125,000

Additional information: a) Salaries and wages for the month of December 2017 of Sh. 51,000 had not been paid b) The general expenses included an amount of Sh. 120,000 paid as insurance premium for next year c) Debenture interest for the year had not been paid d) An fee receipt of Sh. 150,000 done on 31.12.2017 had not been booked e) Rent of Sh. 40,000 per month is paid quarterly and in advance. The last quarter for the year relating to December, January and February 2018 was paid on 5th January, 2017 f) Actual advertising cost amounted to Sh. 15,000 per month. The business had paid for the first three month of 2018 during the year. g) The amount indicated as furniture and fitting includes an amount of Sh. 120,000 relating to an office machine.

Required: (a) Adjusted trial balance for the year ended 31 December 2017 (b) Statement of income for the year ended 31 December 2017 (c) Statement of financial position as at 31 December 2017 Pg 84

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CHAPTER SIX ACCOUNTING FOR MERCHANDISING BUSINESS. INVENTORY VALUATION Inventories are valued in line with IAS 2. Inventories in a firm includes: (a) Finished goods (assets held for sale) (b) Work in progress (assets still in production for purposes of sale) (c) Raw materials (to be used in production process).

The cost of inventories should include all costs of purchase. (Purchase price and other taxes like import duties), costs of conversion (e.g. direct labour) and other costs incurred in bringing the inventories into their present location and condition (carriage inwards).

Inventories is a sensitive area, as it does not form part of the double entry. In most cases either carrying out stocktaking or checking the stock records that the firm is kept determines the value of stock at the end of the financial period. Stocktaking involves counting the number of units of finished goods, work in progress or raw materials available or in the stores/warehouse/saleroom. The value of stock to the final accounts is then derived by multiplying the cost per unit to the total number of units available.

INVENTORY SYSTEM There are two systems are used: 1. Periodic Inventory System 2. Perpetual Inventory System Introduction to Financial Accounting

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The foundation of the periodic inventory system is a physical count of the goods in hand at the end of the period. This procedure, called taking a physical inventory is both inconvenient and costly. Therefore it is only recommended at year end only. Thus periodic inventory system is suited for preparation of annual financial statements but not recommended for making accounts for shorter accounting period e.g. monthly, quarterly, etc.

Under perpetual inventory procedure, the Merchandise inventory account is continuously updated to reflect items on hand. Companies use perpetual inventory procedure in a variety of business settings.

Historically, companies that sold merchandise with a high individual unit value, such as automobiles, furniture, and appliances, used perpetual inventory procedure. Today, computerized cash registers, scanners, and accounting software programs automatically keep track of inflows and outflows of each inventory item. Computerization makes it economical for many retail stores to use perpetual inventory procedure even for goods of low unit value, such as groceries. For example, your supermarket uses a scanner to ring up your purchases.

Sales and Purchase of Inventory Sales: This is the sale of goods that were bought by a firm (the goods must have been bought with the purpose of resale). Sales are divided into cash sales and credit sales. When a cash sale is made, the following entries are to be made. i.

Debit the Cash/Bank account

ii. Credit the Sales account

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Introduction to Financial Accounting

For a credit sale: i.

Debit the Accounts receivable account

ii. Credit the Sales account A new account for sales is opened and credited with cash or credit sales.

Purchases: Buying of goods meant for resale. Purchases can also be for cash or on credit. For cash purchases: i.

Debit the Purchases account

ii. Credit the Cash /Bank account For credit purchases: i.

Debit the Purchases account

ii. Credit the Accounts payable account A new account is also opened for purchases where both cash and credit purchases are posted.

Note: no entry is made into the inventory account.

Sales Returns and Purchases Returns Sales Returns (also called Returns Inwards) refer to goods that have been returned by customers due to various reasons e.g. i.

They may be defective/damaged,

ii. Being of the wrong type . iii. Excess goods being delivered.

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Pg 87

Goods returned may relate to cash sales or credit sales. For the goods returned in relation to cash sales and cash is refunded to the customer the following entries are made: i.

Debit returns inwards account

ii. Credit Cash/Bank account For goods returned that relate to credit sales; no cash has been given to customer, the following entry is to be made. i.

Debit returns inwards account

ii. Credit the account receivable account Purchase returns (also called Returns Outwards) refer to goods returned to suppliers/creditors. They may be for cash purchases or for credit purchases. For cash purchases a cash refund given to the firm by the supplier, i.

Debit the Cash/Bank account

ii. Credit the returns outwards account.

For credit purchases and no refund has been made: i.

Debit the accounts payable account

ii. Credit the returns outwards account

Transportation costs Carriage in is the expense of transporting the goods to the premises of the trader. Carriage in form an important part of cost of sales. While carriage out to a customerâ&#x20AC;&#x2122;s premises is treated as delivery expense; this selling expense appears on the Statement of income with other selling expenses.

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Accounting for drawings The owner makes drawings from the firm in various ways:

a)

Cash or bank withdrawals

When the owner withdraws money from the business we debit the Drawings account and credit the Cash/Bank account

b)

Taking goods for own use

When the owner takes out some of the goods for his own use, we debit the Drawings account and credit the Purchases account

c)

Personal expenses, paid by the business

Here we debit the Drawings

account and credit

the respective

expense account

d)

Taking some of the other assets from the business

Sometimes the owner may take over some of the assets of the business e.g. vehicle or converting business premises into living quarters or not paying into the business cash collected personally from the customers.

When this happens we debit the

drawings

account and credit the relevant asset account e.g. motor vehicles, premises or some building or even debtors.

Accounting for Discounts Allowed and Received Discounts are normally allowed or received

based on the invoice

amount.

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Discounts received.

A discount received is an allowance by the creditors to the firm to encourage the firm to pay the amount dues within the agreed time. It is an amount deducted from the invoice price.

When a discount is given by the supplier then we debit Accounts payable account and credit Discounts received account e.g. A. Ltd sells some goods on credit to B Ltd. @1,000 under the terms of sale, B Ltd, will receive a discount of 5% if they pay the amount due within one month. B decides to take up the offer and pays the amount within the given time. B will record the transaction as follows.

Discounts Allowed These are the allowances made by a firm on the amounts receivable from the customers to encourage prompt payment.

The amounts

deducted from the sales invoice. In the previous example when A Ltd issued the discount and was taken up by B the entries will be: i.

Debit the Discount allowed account

ii. Credit the Accounts receivable account

Accounting for Dividends Dividends are the means by which a corporation rewards its shareholders (owners) for providing it with investment funds. A dividend is a payment (usually of cash) to the owners of the business; it is a distribution of income to owners rather than an expense of doing business. Corporations are not required to pay dividends and, because dividends are not an expense, they do not appear on the Statement of income. The effect of a dividend is to reduce cash and retained earnings by the amount paid out. Then, the company no longer retains a portion of the income earned but passes it on to the shareholders.

Receiving dividends is, of course, one of the primary reasons people invest in corporations.

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STATEMENT OF INCOME FOR MERCHANDISING BUSINESS The Statement of income summarises the trading activities (sale and purchase of goods/inventory) of the

business and tries to determine

the gross profit for the relevant financial period. It also shows the net profit or net loss that the business has made from all the activities during a financial period.The net profit (or loss) is determined by deducting all the expenses from all the incomes of the same financial period. Format for the Statement of income is shown below.

ABC Limited Statement of income For the period ending ended 31 Dec 2017 Sh. in Million Revenues Sales

1000

Less: Returns Inwards

20

980

Cost of Sales Opening inventory

50

Purchases

500

Add: Carriage Inwards

100

Less: Returns Outwards

(20)

Less: Closing inventory

(30)

Gross Profit

600 380

Other incomes Discount received

10

Rent received

15

Interest received

5

30

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410 Pg 91

Expenses Carriage Outwards

7

Discounts allowed

3

Postage & stationary

8

Salaries & wages

12

Rent expense

4

Insurance

10

Bank charges

6

50

Profit before taxes

360

Taxation

100

Profit after taxes

240

Statement of Financial Position for Merchandising Business This is a simple report that shows the assets and liabilities of the business and the owner equity as at a certain point in time. The format is at shown below: ABC Limited Statement of Financial Position As at 31 Dec 2017 Sh. in Million Non Current Assets

Cost

Acc. Dep

NBV

1,000

200

800

Plant & Machinery

600

150

450

Furniture & Fittings

500

50

450

Motor vehicles

500

100

400

Land & Buildings

2,100

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Introduction to Financial Accounting

Current Assets Inventories Accounts receivables Less: provisions

170 180 (4)

176

Prepayments

10

Bank

11

Cash

13

Total assets

380 2,480

Financed by: Equity and Reserves Share Capital Retained profit General reserves

1,000 200 50

1,250

Non-current Liabilities Loan

1,050

Current Liabilities Bank overdraft Accounts payable

20 100

Tax payable

40

Dividend payable

20

Accruals

10

Total Equity and Liabilities

180 2,480

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EXERCISE 6. 1 Beach road traders started a retail business on 1st September 2017.

The following transactions occurred during the month; Sept. 1: Opened a bank account for the business and deposited Sh. 3.980,000 and cash in hand was Sh. 310,000 Sept. 3: Converted personal motor vehicle worth Sh. 978,000 to business use Sept.3: Bought a photocopier at Sh. 650,000 in cheque Sept. 4: Bought furniture at Sh. 360,000 by cheque and fax at Sh. 15,000 cash.

Sept.6: Paid Sh. 160,000 cash for advertising and Sh. 125,000 by cheque as insurance for the business.

Sept.7: Borrowed Sh.1,250,000 loan

which was credited in

bank.

Sept.8: Bought goods for resale at Sh. 410,000 by cheque Sept.10: Bought goods for resale at Sh. 690,000 from Madaraka traders and paid Sh. 210,000 by cheque Sept.11: Sold goods at Sh. 350,000 in cash to several customers Sept.13: Sold goods to Ukunda wholesaler and invoiced Sh. 950,000 where Ukunda wholesaler paid Sh. 550,000 by cheque and Sh. 50,000 cash Sept. 13: Goods

of Sh. 70,000

wholesaler as defective.

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Introduction to Financial Accounting

was returned by Ukunda

Sept. 16: Hired a driver and paid him Sh. 25,000 in cash Sept. 17: Bought goods invoiced at Sh. 440,000 on credit from Fayaz traders Sept. 18: Goods of Sh. 50,000 was returned to Fayaz traders as defective.

Sept.19: Paid Madaraka traders Sh. 550,000 account

by cheque on

Sept. 21: Received Sh. 120,000 by cheque from Ukunda wholesaler on account.

Sept. 23: Sold goods at Sh. 430,000 to Rogo traders and received half the amount in cash.

Sept. 25: Paid Fayaz traders by cheque in full and received a discount of 5 % on invoice Sept.26: Sh. 330,000 cash was banked Sept. 27: Bought a motor van for Sh. 1,150,000 by cheque Sept. 28: Received the full amount due from Ukunda wholesaler by cheque after allowing a discount of 3 % on invoice Sept. 29: Withdrew Sh. 95,000 by cheque for personal use.

Sept. 30: Paid salaries of Sh. 103,000 by cheque, electricity Sh. 52,000 by cheque , water bill Sh. 23,000 in cash, repairs of Sh. 15,000 cash and telephone bill Sh. 17,000 by cheque.

Sept. 31: Sold goods invoiced at Sh. 620,000 to Odhoya traders on credit

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Required: Assuming all goods were sold during the month of September 2017; 1. Journalize the above transactions 2. Post the journals to the ledgers 3. Extract unadjusted trial balance 4. Prepare the financial statements

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CHAPTER SEVEN ACCOUNTING FOR ACCOUNTS RECEIVABLE Accounts receivable must be reported at their estimated realizable value – i.e., net of an provision for doubtful debts so as to obey the prudency principle while bad debt expenses must be recorded in the same accounting period as the sale so as obey the matching principle.

ESTIMATING BAD AND DOUBTFUL DEBTS The estimate of uncollectible accounts may be based on:

•

Percentage of Sales (or net sales) is referred to as the Income Statement approach

•

Outstanding Accounts Receivable is referred to as the Statement of financial position approach

•

Aged debtors analysis

Many companies use the % of sales method during the year and adjust at year end based on the receivables approach

PROVISION FOR BAD AND DOUBTFUL DEBTS Some debtors may not pay up their accounts for various reasons e.g. a debtor may go out of business. When a debtor is not able to pay up his/her account this becomes a bad debt. Therefore the business/firm should write it off from the accounts and thus it becomes an expense that should be charged in the Statement of income.

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In practice a firm may also be unable to collect all the amounts due from debtors. This is because a section of the debtors will not honor their obligations. The problem posed by this situation is that it is difficult to identify the debtors who are unlikely to pay their accounts.

Furthermore the amount that will not be collected may also be difficult to ascertain. These debts that the firm may not collect are called doubtful debts. A firm should therefore provide for such debts by charging the provision in the Statement of income. Provision for doubtful debts maybe specific or general. Specific relate to a debtor whom we can identify and we are doubtful that he may pay the debt (if one of our debtor goes out of business).

Accounting for Bad & Doubtful Debts.

Bad debts When a debt becomes bad it should be removed from the books. This is referred to as writing off the debt. The following entries are made: i.

Debit the Bad debts expense account Credit the Account receivable account

Doubtful Debts A provision for doubtful debts can either be for a specific or a general provision. A specific provision is where a debtor is known and chances of recovering the debt are low.

The general provision is where a provision is made on the balance of the total debtors i.e. Debtors (now called accounts receivable) less Bad debts and specific provision. The accounting treatment of provision for doubtful debts depends on the year of trading and the entries will be as follows. If it is the first year of of making provision:

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a) Debit the Bad debts expenses account. b) Credit the Provision for doubtful debts account In the subsequent periods, it will depend on whether if it is an increase or decrease required on the provision.

If it is an increase: debit or credit with the increase only; a) Debit the Bad debts expenses account. b) Credit the Provision for doubtful debts account .

If it is a decrease: debit or credit with the decrease only; a) Debit provision for doubtful debts account. b) Credit the Bad debts expenses account.

The provision for doubtful debt may be Specific or general provision or both

Accounting for Bad Debts Recovered A firm may be able to recover a debt that was previously written off.

Please note that this should be for the amount to be recovered.

The following entries will be made if this happens: i.

Debit the Accounts receivable account

Credit

the Bad debts expenses/recovered account to

restore the bad debtor in the book. This is referred as writing back ii. Debit â&#x20AC;&#x201C; Cashbook

Credit â&#x20AC;&#x201C; Accounts receivable account

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Aged Debtors Analysis In this method accounts receivable are analysed using the duration they have been in the books.

EXERCISE 7.1 The Aged Debtors schedule for Niger Limited is as follows; Age in days Amounts in Sh.‘000 Probability of collecting

Current

30-60

60-90

90-120

120-180

Over 180

1,200

500

640

400

600

350

95%

80%

70%

50%

30%

10%

It is the company’s policy to provide for doubtful debts but account which are over 180 days are treated as bad debts.

Required: a) Compute doubt debts b) Compute bad debts c) Prepare necessary journal entries

EXERCISE 7.2 The Aged Debtors schedule for The Retadi Limited is as follows; Age in days Amounts in Sh.‘000

Probability of

Current

30-60

60-90

90-120

120-180

Over 180

1,800

900

870

480

690

300

5%

10%

20%

30%

50%

90%

uncollectibility

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Introduction to Financial Accounting

It is the company’s policy to provide for doubtful . The provision for doubtful debts and bad debts expenses had balances bought down of Sh. 800,000 and Sh. 152,000 respectively Required: a) Compute doubt debts b) Prepare necessary journal entries c) Prepare necessary ledger accounts

EXERCISE 7.3 The Aged Debtors schedule for French Limited is as follows; Age in days Amounts in

Current

30-60

60-90

90-120

120-180

Over 180

1,800

1200

690

380

880

300

95%

85%

70%

65%

40%

10%

Sh. ‘000 Probability of collecting

It is the company’s policy to provide for doubtful but account which are over 180 days are treated as bad debts. The provision for doubtful debts and bad debts expenses had balances bought down of Sh. 990,000 and Sh. 114,000 respectively Required: a) Compute doubt debts b) Compute bad debts c) Prepare necessary journal entries d) Prepare necessary ledger accounts

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EXERCISE 7.4 The Aged Debtors schedule for Bechuana The ABC Limited is as follows; Age in days

Current

30-60

60-90

90-120

120-180

Over 180

1,800

900

870

480

690

300

85%

70%

70%

50%

40%

10%

Amounts in Sh.‘000 Probability of collecting

It is the company’s policy to provide for doubtful account but accounts which are over 180 days are treated as bad debts. The provision for doubtful debts and bad debts expenses had balances bought down of Sh. 2,100,000 and Sh. 152,000 respectively Required: a) Compute doubt debts b) Compute bad debts c) Prepare necessary journal entries d) Prepare necessary ledger accounts

EXERCISE 7.5 The Aged Debtors schedule for Fernado Limited is as follows; Age in days Amounts in

Current

30-60

60-90

90-120

120-180

Over 180

2,800

1200

880

460

640

400

6%

10%

15%

20%

60%

80%

Sh.‘000

Probability of uncollectibility Pg 102

Introduction to Financial Accounting

It is the companyâ&#x20AC;&#x2122;s policy to provide for doubtful . The provision for doubtful debts and bad debts expenses had balances bought down of Sh. 1,520,000 and Sh. 154,000 respectively Required: a) Compute doubt debts b) Prepare necessary journal entries c) Prepare necessary ledger accounts

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CHAPTER EIGHT ACCOUNTING FOR NON-CURRENT ASSETS CAPITAL AND REVENUE EXPENDITURE Capital Expenditure: This is the amount spent on the acquisition of a non-current asset or adding value to a non-current asset.

Examples of expenses incurred in acquisition: (i) Purchase price/cost of the asset. (ii) Delivery/carriage inwards costs (e.g. shipping charges or import taxes). (iii) Costs incurred to get the asset in use (e.g. assembly, testing) (iv) Installation (v) Demolition costs in order to construct a new building. (vi) Architect fees for construction and supervision (vii) Legal fees incurred in acquisition of a new asset (e.g. lease agreement)

Examples of expenses incurred in adding value to an asset: (i) Modify plant to increase its useful life. (ii) Upgrading plant to improve quality of output. (iii) Adopting or upgrading the production process to improve or reduce costs.

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Revenue Expenditure: There’s an amount spent by the firm in the normal trading process or to assist in earning revenues or income.

Examples: (i) Postage and stationery. (ii) Carriage outwards (sales). (iii) Repairs and maintenance.

Example For the business of Spinal Traders, a wholesaler, classify the following between ‘capital’ and ‘revenue’ expenditure: a) Purchase of an extra motor van. b) Cost of rebuilding warehouse wall, which had fallen down. c) Building extension to the warehouse. d) Painting extension to warehouse when it is first built. e) Repainting extension to warehouse three years later than that done in (d). f)

Carriage costs on bricks for new warehouse extension.

g) Carriage costs on purchases. h) Carriage costs on sales. i)

Legal costs of collecting debts.

j)

Legal charges on acquiring new premises for office.

k) Fire insurance premium. l)

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Costs of erecting new machine.

Introduction to Financial Accounting

PROVISION FOR DEPRECIATION Depreciation is the loss of value of a non-current asset throughout its period of use by the firm. IAS 16 on property, plant and equipment defines depreciation as the allocation of a depreciable amount of a non-current asset over its estimated useful life. Under the matching concept, all incomes or revenues and expenses for a particular period should be reported in the financial statements and because depreciation is an expense of the business therefore, it will be charged in the Statement of income.

Causes of Depreciation 1. Physical Factors a) Wear and tear: Some non-current assets depreciate or lose value due to use overtime b) Rot, decay and rust:: This happens on assets that are not well maintained by the firm.

2. Economic Factors

a) Inadequacy: Some assets lose value due to them

becoming inadequate e.g. when a business grows or expands then some buildings may become inadequate due to space. Also some machines that are unable to manufacture a large number of goods.

b) Obsolescence: Some assets become obsolete due

to change in technology or different

methods of production e.g.

computers.

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3. Time Factors Some assets have a legal non-current time e.g. properties on lease.

4. Depletion This occurs when some assets have a wasting character due to extraction of raw materials, minerals or oil.

Such assets include

mines, oil wells, and quarries.

Methods of Calculating Depreciation These are the methods developed to assist in estimating the amount of depreciation to be charged in the Statement of income as an expense. The methods chosen by a firm should be in accordance with the agreed accounting practice, accounting standards and suit the firmâ&#x20AC;&#x2122;s non-current assets.

1. Straight-Line Method This is most common method of depreciation. This method ensures that a uniform amount of depreciation is charged to Statement of income for a particular asset and is based on the following formula:

Depreciation for year =

Cost assets - Scrap value Estimated useful life .

Scrap value refers to the amount the firm expects to sell the asset after the period of use in the firm, also called residual or salvage value.

While the estimated useful life refer the period the asset is expected to be used by the firm.

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2. Normal reducing Balance Method The firm determines a fixed percentage rate that is applied on the cost of the asset during the first period of use. The same rate is applied in the subsequent financial periods but the rate is applied on the reduced value of the asset that cost of asset less the accumulated depreciation provided to date. This method ensures that higher amount of depreciation are charged in the Statement of income in the earlier periods of use and lower amounts in the latter periods.

Normal reducing balance method (also normal diminishing balance method) assumes that benefits accruing from the use of an asset are higher in the first periods of use and lower in the latter periods.

The other methods include: a) Accelerated reducing balance method. This is also diminishing balance method although it is accelerated in most case by two. b) Sum of the digits methods. This uses a formula c) Machine-Hour method. Here depreciation is based on number of hours a machine is expected to operate per annum. d) Unit of output method. Here depreciation is based on the number of units a machine is expected to produce in its lifetime. e) Depletion rate method. Here depreciation is based on number of units extracted from the

natural asset per

year.

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Accounting for Depreciation When non-current assets are depreciated, a new account for each type of asset is opened; this account is called a Provision for depreciation whereby the following entries are done using the amount of depreciation charged for the period: Debit the Depreciation expense account Credit the Provision for depreciation account

DISPOSALS OF NON-CURRENT ASSETS A firm may dispose of its non-current assets in the following 3 ways: a) Selling the asset. b) Asset being written-off from damage/accident/theft. c) Asset is scrapped that is it is not in use anymore. d) Disposal by trade in When an asset is disposed, appropriate entries should be made in the asset account and the Provision of depreciation account however the entries required will depend on the type of disposal.

Sale of a non-current asset.

When the asset is sold, the following three journal entries are made.

Journal entry (a) uses the the cost of the asset being disposed; Journal (b) uses the total accumulated depreciation to date on the asset while Journal (c) uses actual proceed received on disposal.

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(a)

Debit the Asset disposal account

Credit the specific asset account

Introduction to Financial Accounting

(b)

Debit the Provision for depreciation account of

specific asset .

Credit the Asset disposal account

(c)

Debit the Cash or Bank account

Credit the Asset disposal account

Disposal due to damage, accident or theft When an asset is written off as a result of damage, accident or theft.

If it was insured and the insurance company accept liability but by the end of the period the insurance company has not yet paid. In this case, the following three journal entries are made. Journal entry (a) uses the the cost of the asset being damaged or stolen; Journal (b) uses the total accumulated depreciation to date on the asset while Journal (c) use the amount expected from the insurance company. (a)

Debit the Asset disposal account

Credit the specific asset account

(b)

Debit the Provision for depreciation account for that

specific asset

Credit the Asset disposal account

(c)

Debit the Account receivable account

Credit the Asset disposal account

If the insurance pays before the end of the financial period, it will not be necessary to create a debtor so the following entries will be made: Debit the Cash or Bank account Credit the Asset disposal account

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When the Assets is worthless If the asset is not used anymore or scrapped by the firm, the appropriate entries will be made in the asset account and provision for depreciation account only. In this case, the following two journal entries are made. Journal entry (a) uses the the cost of the asset no longer in use while journal (b) uses the total accumulated depreciation to date on the asset a)

Debit the Asset disposal account

Credit the specific asset account

b)

Debit the Provision for depreciation Account of the

specific asset

Credit the Asset disposal account

The balance in the Asset disposal account after the above entries will either be a debit balance or a credit balance. A credit balance represents a Gain on disposal, which is reported in the Statement of income together with other incomes.

A debit balance in the

Asset disposal account is Loss on disposal which is reported in the statement of income as an expense.

Disposal by trade in If the firm trades in an old asset for a new one, a journal with three entries is done as follows: Debit the specific asset account with value of the new asset Credit the Cash or Bank account with cash paid being the difference of new value and trade in value of old asset Credit the Asset disposal account with trade-in value of old asset Pg 112

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Fractional depreciation Asset may acquired at other time than the beginning of an accounting period and depreciation should be calculated for partial periods. With the straight line method, the partial period depreciation is simply a fraction of the annual amount. There are two sub rules under straight line fractional depreciation (a) nearest month rule and (b) half year rule

Nearest month rule Under this rule, the full month depreciation expense is recorded if the asset is held for more 15 days or more whereas no depreciation is recognized in a month where usage is less than 15 days.

Half year rule Under this rule the depreciation expense is equal to the depreciation to only half the annual charge in the year of acquisition or disposal.

CHANGE OF DEPRECIATION POLICY A firm may change its depreciation policy in several ways e.g. from straight line to reducing balance or vice versa, or it may increase/ decrease the number of estimated useful years of an asset. A firm should always follow the depreciation policy adopted consistently and incase there is need to change the policy may be due to a new accounting standard or change in circumstances. This change should be disclosed in the financial statements. When there is change in the depreciation policy this may result in an increase or a decrease in the depreciation to be charged in the Statement of income.

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REVALUATION OF NON-CURRENT ASSETS Some non-current assets such as e.g. land and buildings tend to appreciate in value rather than depreciate. IAS 16 on property, plant and equipment requires that such assets may

be carried in their

accounts at the revalued amounts usually based on the their market price. Land is not depreciated, and therefore the adjustments required are minimal, but for buildings, changes should be made at the cost and Revaluation reserve account is usually opened for the purpose of these adjustments.

The following entries would be made (a)

Debit the Land Account with revaluation gains

Credit the Revaluation Reserve account with the

revaluation gains

(b)

Debit the Building account with revaluation gains

Credit the Revaluation Reserve account with the

revaluation gains (c)

Debit the Provision for depreciation for buildings

account

Credit the Revaluation Reserve account

Journal (c) is used to credit the total accumulated depreciation charge to date on buildings now transferred to revaluation reserve account.

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PROPERTY, PLANT AND EQUIPMENT SCHEDULE The property, plant and equipment schedule is a summary report on the balances and transactions of the asset and provision for depreciation account as per the requirements of IAS 16 to be reported in the published accounts of companies. Reclassifications of assets usually occur when some of the non-current assets are transferred to a different class. For example, some of the properties held under long leases (over 50 years) will be transferred to the short leases classes when their term becomes less than 50 years. This therefore is a reclassification from long lease to short lease and so is shown in the schedule at the value of transfer as a deduction in the long lease class and on addition in the short lease class. The format is as follows: Property, Plant and Equipment Schedule: Freehold property

Leasehold Property Long leases

Cost/ Valuation Bal as at 1/1/2017

Sh.

Sh.

Plant and Machinery

Furniture & fittings

Sh.

Sh.

Total

Short lease

Sh.

Sh.

X

x

x

X

X

x

Additions

Xx

xx

xx

Xx

xx

xx

Revaluations (gains)

Xx

-

-

-

-

xx

Reclassifications

-

(xx)

xx

-

-

-

(xx)

(xx)

(xx)

(xx)

(xx)

(xx)

Xx

xx

xx

Xx

xx

xx

Balance as at 1/1/2017

Xx

-

xx

Xx

xx

xx

Charge for year

Xx

-

xx

Xx

xx

xx

(xx)

-

(xx)

(xx)

(xx)

(xx)

Disposals Bal as at 31/12/2017 Depreciation/Amortization

Eliminated on Revaluation Eliminated on Disposal

(xx)

-

(xx)

(xx)

(xx)

(xx)

Balance as at 31/12/2017

(xx)

-

(xx)

(xx)

(xx)

(xx)

N.B.V as at 31/12/2017

Xx

xx

xx

Xx

xx

xx

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EXERCISE 8.1 While research and development costs of a project may meet the definition of an asset, the cost may not meet the criteria used in recognizing an asset. Define the term â&#x20AC;&#x153;assetâ&#x20AC;? and explain the criteria used in recognizing an asset.

EXERCISE 8.2 Fayas bakers bought a machinery at Sh. 720,000. The machinery has a life of 5 years.

Required: a) Compute depreciation charge per year using any applicable method b) Prepare depreciation schedule

EXERCISE 8.3 Labda traders bought a pick-up van at Sh. 880,000. The van has a life of 5 years and a scrap of Sh. 100,000 Required: a) Compute depreciation charge per year using any applicable method b) Prepare depreciation schedule

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EXERCISE 8.4 Congo stationers bought a photocopier at Sh. 880,000. Depreciation is charged at 12.5% Required: a) Compute depreciation charge per year using any applicable method b) Prepare depreciation schedule

EXERCISE 8.5 Mwembe manufacturers purchased a machinery of Sh. 500,000. The equipment is expected to produce 1 million pencils during its life time.

For the ten years, the schedule of actual production is as follows; Year

1

2

3

4

5

6

7

8

9

10

total

units

150

140

120

100

90

100

110

80

60

50

1000

produced in â&#x20AC;&#x2DC;000

Required: a) Calculate the depreciation charge per pencil b) Provide the depreciation schedule of this machinery using the units of production approach

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EXERCISE 8. 6 Fayas bakers bought a machinery of Sh. 500,000. The Machinery is expected to produce 1 million loaves during its life time and has a salvage value of Sh. 50,000. For the ten years, the schedule of actual production is as follows; Year

1

2

3

4

5

6

7

8

9

10

total

Loaves

150

140

120

100

90

100

110

80

60

50

1000

produced in â&#x20AC;&#x2DC;000

Required: c) Calculate the depreciation charge per pencil d) Provide the depreciation schedule of this machinery using the units of production approach

EXERCISE 8.7 Makongo limited started operations on 1st January 2012, the financial year ends on 31st December. The following are the details of the company motor vehicles Registration

Date of purchase

Amount in Sh.

KBB 234T

01.01.2012

800,000

KBC 555Y

01.10.2012

1,200,000

KBD 245V

01.01.2013

600,000

KCA 455V

01.07.2013

900,000

KCB 195 C

01.09.2013

1,000,000

The company policy is to provide for depreciation on a straight line basis over a useful life of ten years. You are further informed that the

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three vehicles, KCA 455V and KCB 195 C were disposed off as shown below.

Registration

Date of disposal

KCA 455V

30.06.2017

Amount in Sh. 800,000

KCB 195 C

31.12.2017

750,000

You are required to prepare the following as at 31st December 2017 using straight line fractional depreciation. a) Motor vehicle account b) Provision for depreciation account

c) Motor vehicle disposal account

EXERCISE 8.8 Malili Limited started operations on 1st January 2012, the financial year ends on 31st December. The following are the details of the company motor vehicles Registration

Date of purchase

Amount in Sh.

KBB 234T

11.01.2012

800,000

KBC 555Y

22.10.2012

1,200,000

KBD 245V

07.01.2013

600,000

KCA 455V

09.07.2013

900,000

KCB 195 C

21.09.2013

1,000,000

The company policy is to provide for depreciation on a straight line basis over a useful life of ten years. You are further informed that the two vehicles KCA 455V and KCB 195 C were disposed off as shown below.

Registration

Date of disposal

KCA 455V

23.06.2017

Amount in Sh. 800,000

KCB 195 C

14.12.2017

750,000

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You are required to prepare the following as at 31st December 2017 using straight line fractional depreciation rules: a) Motor vehicle account b) Provision for depreciation account

c) Motor vehicle disposal account

EXERCISE 8.9 The property, plant and equipment balances of Matano Limited comprise the following as at 1st January 2017.

Cost Sh.’000

Acc. depreciation

Net book value

Sh.’000

Sh.’000

Freehold land

30,000

-

30,000

Buildings

38,520

-

38,520

Plant &Machinery

70,200

37,812

32,388

Motor vehicles

37,800

23,040

14,760

The company uses the straight line method of depreciation on assets as follows: •

10% per annum for Plant &Machinery

•

10% per annum for motor vehicles

Additional information 1. It is the company’s policy to make a depreciation charge proportionate to the period of usage of the asset.

2. An item of machinery bought on July 1st 2013 for Sh. 10,080,000 was sold on 1st April 2017 at Sh. 6,000,000 3. From the year ended 31st December 2017, the

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Introduction to Financial Accounting

management

of

the

company

decided

to

charge

depreciation on building at 2.5% per annum. The building were all completed on 1st July 2013.

4. On 1st January 2017, a vehicle purchased on 1st May 2014 for Sh. 12,600,000 was traded in at a value of Sh. 7,320,000 in part exchange for a new vehicle costing Sh. 18,000,000.

5. Included in the machinery is an old machine which originally cost Sh. 13,500,000 and which was already fully depreciated and not expected to yield any material amount on either use or resale.

6. On June 30th 2017, a machine costing Sh. 13,500,000 was purchased from a vendor who had used it for three years. The vendor had bought the machine at Sh. 18,000,000. Another machine costing Sh.10,500,000 was purchased on 1st August 2017.

7. On 31st December 2017, freehold land was valued at Sh. 35,000,000.

Required: A schedule of movement of property, plant and equipment for the years ended 31st December 2017.

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EXERCISE 8.10 Zebra limited prepares its annual accounts on 30th June every year.

The company has the following non-current asset values included in its Statement of financial position on 1st July 2017.

Land

Cost

Accumulated depreciation

Sh.’000

Sh.’000

80,000

nil

Building

44,000

16,000

Plant and Machinery

32,000

12,000

Motor vehicles

12,000

4,000

The company’s policy is to charge depreciation on cost at the following rates; Rate per annum Land Building

nil 2%

Plant and Machinery

15%

Motor vehicles

20%

Additional information A proportionate charge is made in the year of purchase, sale or revaluation of an asset. The following transaction took place during the year ended 30th June 2017.

1. On January 2017 the company adopted a policy of revaluing its building. A professional valuer engaged for this purpose revalued the buildings at Sh. 68 million.

2. On January 2017, a plant that had cost Sh. 6 million was sold for Sh. 1 million. The net book value on this plant on 30th June 2016 amounted to Sh. 4.6 million. A new Pg 122

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plant was then purchases at accost of Sh. 8 million on the same date.

3. A new motor vehicle was purchases for Sh. 600,000 on 1st April 2017. Part of the purchase price was settled by exchanging another motor vehicle at an agreed value of Sh. 240,000. The balance of Sh. 360,000 was paid in cash. The vehicle which was given in part exchange had cost Sh. 400,000 and had a net book value of Sh. 200,000 as at 30th June 2016.

Required: a) Individual asset accounts b) Individual provision for depreciation accounts c) Individual asset disposal accounts Property, plant and equipment movement schedule for the years ended 30th June 2017.

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EXERCISE 8.11 a) Briefly explain the nature and purpose of accounting for depreciation. b) The chief accountant of Jetho Ltd has encountered difficulties while accounting for non-current assets and the related depreciation in the companyâ&#x20AC;&#x2122;s draft accounts for the year ended 30 April 2019. He has decided to seek your professional advice and presented the following balances of non-current assets as at 1 May 2016.

Acquisition

Accumulated

Depreciation

Cost

Depreciation

Rates

Sh.

Sh.

%

Furniture

900,000

300,000

12.5

Trucks

3,525,000

1,470,000

25

Plant and machinery

7,387,500

4,462,500

10

Land

2,775,000

-

Nil

Buildings

2,925,000

292,500

2.5

The following additional information was also available: 1. It is the companyâ&#x20AC;&#x2122;s policy to write off cost of the assets using above percentages on cost.

2. Depreciation is fully charged in the year of acquisition and none in the year of disposal.

3. A three year old machine acquired for Sh. 187,500 was sold for Sh. 15,750.

4. It has been decided to adjust and charge depreciation on buildings at 4%.

5. A used delivery truck purchased three years ago for Sh. 248,250 was traded in during the year at a value of Pg 124

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Sh. 157,500 in part exchange of the new delivery truck costing Sh. 450,000.

6. Land, buildings and machinery were acquired for Sh. 1,350,000 from a company that went out of business. At the time of acquisition Sh. 90,000 was paid to have the assets revalued by a professionally qualified valuer. The revaluation indicated the following market values.

Sh.

Land 900,000 Buildings 600,000 Machinery 300,000

Required: A schedule of movement of non-current assets as requested by the Chief Accountant for inclusion in the companyâ&#x20AC;&#x2122;s accounts for the year ended 30 April 2017.

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EXERCISE 8.12 Makongo limited started operations on 1st July 2012, the financial year end being 30th June. The following are the details of company motor vehicles: Registration

Date of purchase

Amount

KBV 234A

12th September 2012

800,000

KBX 555X

19th December 2012

1,400,000

KBW 345F

13th August 2013

900,000

KCA 196D

27th November 2014

750,000

KCB 614S

10th May 2015

1,000,000

KCC 999Z

22th November 2015

1,200,000

KCE 167D

18th May 2016

1,800,000

KCF 017F

9th January 2017

2,000,000

The company policy is to provide for depreciation on a straight line basis over a useful life of 10 years. You are also informed that the following vehicles were disposed.

Registration

Date disposed

Amount

KBX 555X

19th December 2015

250,000

KBW 345F

13th August 2016

300,000

KCA 196D

11th March 2017

450,000

KCC 999Z

22th May 2017

700,000

Required Prepare relevant ledgers as at 30 June 2017 using i.

Nearest month method

ii. Half year method

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CHAPTER NINE ACCOUNTING FOR CASH AND BANK PETTY CASHBOOK A petty cash voucher is raised by a cashier to seek authority for payments (payments of small value in the firm which require cash payments e.g. fuel, bus-fare, office snacks), which is approved by a senior manager and filed for record purpose. It shows: i.

Date of payment

ii. Amount paid iii. Reason for payment iv. Authorized signature(s) v. Person approving vi. Person receiving The person receiving the money must then return a document supporting how the money was utilized e.g. fuel receipt, bus ticket etc. Petty Cash Book is a record of all the petty cash vouchers raised and kept by the cashier. The petty cash vouchers will show summary expenses paid by the cashier and this information is listed and classified in the petty cash book under the headings of the relevant expenses such as: •

Postage and stationery

•

Traveling

•

Cleaning expenses.

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The format is as shown: Petty Cash Book Float/ Date

Details

Imprest

EXPENSES Tea

Meals

stationery

Fares

Running Totals

The balance carried down of the petty cash book will signify the balance of cash in hand. The totals of the expenses are posted to the debit side of the expense accounts.

The Imprest system This system of accounting operates on a simple principle that the cashier is refunded the exact amount spent on the expenses during a particular financial period. At the beginning of each period, a cash float is agreed upon and the cashier is given this amount to start with.

Once the cashier makes payments for the period he will get a total of all the payments made against which he will claim a reimbursement of the same amount that will bring back the amount to the cash float at the beginning of the period. If a firm operates main cashbook in addition to the petty cash book, then the totals imprest will be posted on the credit side of the cash in hand cashbook.

Why is Petty cash important 1. The petty cash book saves the main cash book and accounts from containing a lot of trivial details.

2. The use of the petty cash book enables the chief cashier to delegate this type of work to a more junior member of staff 3. Under the imprest system, at the end of a period, the cashier is able to reimburse the petty cashier the amount spent in the that period, so as to make up the cash float.

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CASH BOOKS A cashbook records all the receipts (cash and cheques from customers and debtors or other sources of income) and all the payments (to creditors or suppliers and other expenses) for a particular financial period. The cashbook will also show us the opening and closing Cash and Bank account balances. Therefore are two columns in above cashbook ;On the cash column we records the cash transactions of the firm or business while in the bank column we records the transactions at or with the Bank. The cashbook is the most important book of prime entry because it forms part of the general ledger and records the source documents (receipts and cheques). The cash at bank cashbook and cash in hand cashbook are combined together to get a two-column cashbook. It is thus called the Two columnar Cashbook.

Sometimes an additional columns for discounts allowed and discounts received can be included with the cash and bank columns to get a Three column cashbook. The balance carried down (Bal c/d) for cash in hand and cash at bank will form part of the ledger balances and the discounts allowed and discounts received columns will be added and the totals posted to the respective discount accounts. The discount allowed total will be posted to the debit side of the discount allowed account in the general ledger and the total of the discount received will be posted to the credit side of the discount-received account of the general ledger. Bank account can have either a credit or debit balance. A debit balance means the firm has some cash at the bank and a credit balance means that the account at the bank is overdrawn that is the firm owes the bank money.

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BANK RECONCILIATION STATEMENTS The cashbook for cash at bank records all the transactions taking place at the bank i.e. the movements of the account held with the bank. The bank will send information relating to this account using a bank statement for the firm to compare. Ideally, the records as per the bank and the cashbook should be the same and therefore the balance carried down in the cashbook should be the same as the balance carried down by the bank in the bank statement. In practice however, this is not the case and the two (balance as per the bank and firm) are different. A Bank reconciliation statement explains the difference between the balance at the bank as per the cashbook and balance at bank as per the bank statement.

Causes of the differences: Items appearing in the cashbook and not reflected in the bank statement.

•

Unpresented Cheques: Cheques issued by the firm for payment to the creditors or to other supplies but have not been presented to the firm’s bank for payment.

•

Uncredited

deposits/cheques:

These

are

cheques

received from customers and other sources for which the firm has banked but the bank has not yet availed the funds by crediting the firm’s account.

•

Errors made in the cashbook: These include: • Payments over/understated • Deposits over/understated • Deposits and payments misposted • Overcastting and undercasting the balance bought or carried down in the cashbook.

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Items appearing in the bank statement and not reflected in the cashbook: a)

Bank charges: These charges include service, commission or cheques.

b) Interest charges on overdrafts. c) Standing orders d) Direct Debits e) Dishonored cheques: A cheque would be dishonored because: • Stale cheques • Postdated cheques • Insufficient funds • Differences in amounts in words and figures. f)

Direct credits includes Interest Income and Dividend incomes

Errors of The Bank Statement (made by the Bank) Such errors include: • Payments over/understated • Deposits over/understated • Erroneous payment and deposits

The Purposes of a bank reconciliation statement.

1. To update the cashbook with some of the items appearing in the bank statement e.g. bank charges, interest charges and dishonoured cheques and make adjustments for any errors reflected in the cashbook.

2. To detect and prevent errors or frauds relating to the cashbook.

3. To detect and prevent errors or frauds relating to the bank.

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Steps in preparing a bank reconciliation statement.

1. To update the cashbook with the items appearing in the bank statement and not appearing in the cashbook except for errors in the bank statement.

Adjustments

should also be made for errors in the cashbook.

2. Compare the debit side of the cashbook with the credit side of the bank statement to determine the uncredited deposits by the bank.

3. Compare the credit side of the cashbook with the debit side of the bank statement to determine the unpresented cheques.

4. Prepare the bank reconciliation statement which will show a) Unpresented cheques b) Uncredited deposits c) Errors on the bank statement d) The updated cashbook balance.

The format is as follows: ABC Limited Adjusted Cashbook For the month of December 2017

Sh. Balance per Cashbook

440

Less: Bank charges

(11)

Less: Standing orders

(19)

Add: Direct deposits

280

Balance per adjusted Cashbook

690

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Introduction to Financial Accounting

ABC Limited Bank Reconciliation Statement For the month of December 2017 Sh. Balance per Bank statement

660

Less: Unpresented cheques

(60)

Less: Errors on Bank Statement

(10)

Add: Uncredited deposits

100

Balance per adjusted Cashbook

690

Note 1: These types of errors will have an effect of increasing the balance at bank e.g. an overstated deposit or an understated payment by the bank.

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EXERCISE 9.1 Write the two-column cash book the Mbuvi Traders.

2017 Sep.

1

Transactions

Sh.

Put capital into a bank account for the

94,000

business. “

2

Received a cheque from Mambo

11,500

“

4

Cash sales.

10,200

“

6

Paid rent by cash.

3,500

“

7

Banked cash held by the firm.

5,000

“

15

Cash sales paid direct into the bank.

“

23

Paid a cheque to S. Wing.

27,700

“

29

Withdrew cash from bank for business

12,000

“

30

4,000

use.

Paid wages in cash.

11,800

EXERCISE 9.2 Write the two-column cash book for Bargain Centre 2017

Transactions

Jan.

1

Started business with Sh. 40,000 in the bank.

“

2

Paid fixtures by cheque Sh. 16,600.

“

4

Cash sales Sh. 22,250.

“

5

Paid rent by cash Sh. 11400.

“

6

Karim paid us by cheque Sh. 10,880.

“

8

Cash sales paid direct into the bank.

“

10

Kibe paid us in cash Sh. 3,000.

“

12

Paid wages in cash Sh.12,750.

“

14

Titus lent us Sh. 25,000 paying by cheque.

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Introduction to Financial Accounting

“

15

Withdrew Sh. 22,000 from the bank for business use.

“

20

Bought stationery paying by cash Sh. 6,000.

“

22

We paid Funga by cheque Sh.10,660.

“

28

Cash drawings Sh.10,000.

“

30

Daudi paid us by cheque Sh. 2,070.

“

31

Cash sales Sh. 6,600

EXERCISE 9.3 Write a two-column cash book for Juma Auto 2017

Transactions

Nov.1

Balances brought forward from last month: Cash

Sh.

1,050, Bank Sh. 2,164. “

2

Cash sales Sh. 6,050.

“

3

Took Sh. 5,000 out of the cash till and paid it into the bank.

“

4

Mary paid us by cheque Sh. 21,700.

“

5

We paid for postage stamps in cash Sh. 600.

“

6

Bought office equipment by cheque Sh. 18,900.

“

7

We paid Lilian by cheque Sh. 5,000.

“

9

Received rates refund by cheque Sh.72,000.

“

11

Withdrew Sh. 25,000 from the bank for business use.

“

12

Paid wages in cash Sh. 2,390.

“

14

Paid motor expenses by cheque Sh. 5,700.

“

16

Tito lent us Sh. 20,000 in cash.

“

20

Kimani paid us by cheque Sh. 11,000.

“

28

We paid general expenses in cash Sh. 2,200.

“

30

Paid insurance by cheque Sh.7,400.

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EXERCISE 9.4 Flames traders started a retail business on 1st June 2016. The following transactions occurred during the month; June 1:

Opened a bank account for the business and deposited Sh. 2,340,000 and cash in hand was Sh. 593,000

June 3:

Bought a fridge at Sh. 195,000 cash

June 4: Bought furniture at Sh. 156,000

by cheque and

telephone at Sh. 19,000 cash.

June 6: Paid Sh. 160,000 by cheque for rent and Sh. 125,000 cash as insurance for the business.

June 7: Borrowed Sh. 850,000 loan from the bank which was credited in bank.

June 8: Bought goods worth Sh. 490,000 by cheque for resale from Mara traders June 10: Bought goods worth Sh. 478,000 from Jamhuri traders and paid Sh. 189,000 cash June 11: Sold goods at Sh. 664,000 in cash to several customers June 13: Sold goods at Sh. 764,000 to Mtwapa wholesaler and received Sh. 386,000 cheque and Sh. 78,000 cash.

June 16: Hired a driver and paid him Sh. 15,000 in cash June 17: Bought goods worth Sh. 740,000 for resale on credit from Arcade traders June 19: Paid

Jamhuri traders Sh. 550,000

account Pg 136

Introduction to Financial Accounting

by cheque on

June 21: Received Sh. 105,000 by cheque from Mtwapa wholesaler on account.

June 23: Sold goods at Sh. 643,000 to Haji traders and received half the amount in cash.

June 24: Paid Arcade traders by cheque in full and received a discount of 5 % on invoice June 25: Sh. 236,000 cash was banked.

June 26: Bought a motor van for Sh. 919,000 by cheque June 27: Received the full amount due from Mtwapa wholesaler by cheque after allowing a discount of 5 % of invoice June 28: Withdrew Sh. 77,000 by cash for personal use.

June 29: Paid salaries of Sh. 75,000 by cheque, electricity Sh. 13,000 by cheque , water bill Sh.19,000 in cash, repairs of Sh. 17,000 by cheque and telephone bill Sh. 8,000 cash Required: Write a three-column cashbook

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EXERCISE 9.5 Safaa Hassan, a sole trader, received a Bank statement for the month of May as follows: May 2017

Dr.

1

Opening balance

3

123456

15,000

9

123450

4,200

14

Sundry credit

Cr.

Balance 8,500 6,500

O/D

10,700

O/D

21,000

10,300

35,000

42,900

18

Interest

20

Sundry credit

2,400

7,900

22

123457

22,000

20,900

23

123448

10,000

10,900

24

Standing order – rent

1,000

9,900

25

Sundry credit

53,100

63,000

26

Credit transfer – Mills

2,500

65,500

28

423460

10,000

55,500

30

123459

40,500

15,000

31

Closing balance

15,000

For the corresponding period, Leah’s own records contained the following cashbook account: Bank May

Sh.

May

Sh.

14

Cheque from G. Smith

21,000

1

Balance b/d

20

Cash Sales

35,000

3

Electricity

5,700 123456

15,000

25

Cheque from F Jones

41,000

22

Wages

123457

22,200

25

Cheque from R Black

12,100

23

Purchases

123458

41,500

31

Cheque from W Wayne

19,600

30

Rent

123459

40,500

31

Balance c/d

900

31

Purchases

123460

1 29,600

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Introduction to Financial Accounting

4,700

1 29,600

Prepare a) Adjusted cashbook b) Bank reconciliation statement.

EXERCISE 9.6 The cash book of Jay traders showed a balance at the bank of Sh. 57,000 in hand on 31 January 2018. At the same date, the bank statement balance of Jay tradersâ&#x20AC;&#x2122; account was Sh. 44,600 overdrawn. The difference was accounted for as follows: 1) Cheques for Sh.155,500 sent to creditors on 30 January were not paid by the bank until 8 February.

2) Cheques amounting to Sh. 252,000 paid into the bank on 31 January were not credited by the bank until 1 February.

3) A standing order for a charitable subscription of Sh. 6,000 had been paid by the bank on 21 January but no entry had been made in the cash book.

4) A cheque paid by Jay traders for rent on 15 January for Sh. 34,500 had been entered in his cash book as Sh. 35,400.

Prepare c) Adjusted cashbook d) Bank reconciliation statement.

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EXERCISE 9.7 Rangers â&#x20AC;&#x2122;s Cash Book at 30th November 2017 showed an overdrawn position of Sh. 3,630 which did not match with her bank statement which had an overdrawn balance of Sh. 30,780. Detailed examination of the two records revealed the following: (a) The debit side of the cash book had been undercast by Sh. 3,000. (b) A cheque for Sh. 15,600 in favour of Z Suppliers Ltd., had been omitted by the bank from its statement, the cheque having been debited to another customerâ&#x20AC;&#x2122;s account. (c) A lodgement of Sh. 10,800 on 30th November had not been credited by the bank. (d) Interest amounting to Sh. 2,280 had been debited by the bank but not entered in the cash book.

Required: a) Adjusted cashbook b) Bank reconciliation statement

EXERCISE 9.8 Hassan has received his bank pass sheets for the year to 30 September 2013. At the date, his balance at the bank amounted to Sh. 14,130 whereas his own cash book showed a balance of Sh. 20,000. His accountant investigated the matter, and discovered the following discrepancies: (a) Hay had brought down his opening cash book balance of Sh. 6,585 as a debit balance instead of as a credit balance. (b) Hay had entered a payment of Sh. 560 in his cashbook as Sh. 650.

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(c) A cheque of Sh. 7,210 drawn by Hassan in July 2013 had not been presented to the bank. (d) One of Hassanâ&#x20AC;&#x2122;s customers had agreed to settle their debts Sh. 450 by direct debit though nothing was entered in the cashbooks yet. Unfortunately, the bank had credited the direct debit to another customerâ&#x20AC;&#x2122;s account.

Required: a) Adjusted cashbook b) Bank reconciliation statement

EXERCISE 9.9 (a) Differentiate between a petty cashbook and a threecolumn cashbook. (b) Briefly explain why it is important for a business entity to prepare a bank reconciliation statement. (c) You have recently been employed in a medium size company and deployed in the accounts department.

Your head of section has given you the following extract from the cashbook for the month of April 2017: Sh.

Sh.

Receipts during the month

2,938,000

Balance brought forward (1.4.2017)

1,522,000

Balance carried forward (30.4.2017)

1,108,000

Payments during the month

2,524,000

4,046,000

4,046,000

The head of section further informs you that all receipts are banked intact and all payments are made by cheque. On investigation, you discover the following:

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Pg 141

1. Bank charges and commissions amounting to Sh. 272,000 entered on the bank statement had not been entered in the cashbook.

2. Cheques drawn amounting to Sh. 534,000 had not been presented to the bank for payment.

3. Cheques received totaling Sh. 1,524,000 had been entered in the cashbook and paid into the bank, but had not been credited by the bank until May 2017.

4. A cheque for Sh. 44,000 had been entered as a receipt in the cashbook instead of a payment.

5. A cheque for Sh. 50,000 had been debited by the bank by mistake.

6. A cheque received for Sh. 160,000 had been returned unpaid. No adjustment had been made in the cashbook.

7. All dividends receivable are credited direct to the bank account.

During the month of April 2017. Dividends

totaling Sh. 124,000 were credited by the bank and no entries had been made in the cashbook.

8. A cheque drawn for Sh. 12,000 had been incorrectly entered in the cash book as Sh. 132,000.

9. The balance brought forward should have been Sh. 1,422,000.

10. The bank statement as at 30 April 2017 showed on overdraft of Sh. 2,324,000.

Required: (i) The adjusted cashbook as at 30 April 2017 (ii) Bank reconciliation statement as at 30 April 2017.

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EXERCISE 9.10

a) Explain the term “bank reconciliation” and state the reasons for its preparation. b) Nazir, a sole trader received his bank statement for the month of June 2017. At that date the bank balance was Sh. 706,500 whereas his cash book balance was Sh. 2,366,500. His accountant investigated the matter and discovered the following discrepancies: 1. Bank charges of Sh. 3,000 had not been entered in the cashbook.

2. Cheques drawn by Nazir totaling Sh. 22,500 had not yet been presented to the bank.

3. He had not entered receipts of Sh. 26,500 in his cashbook.

4. The bank had not credited Nazir with receipts of Sh. 98,500 paid into the bank on 30 June 2017 5. Standing order payments amounting to Sh. 62,000 had not been entered into the cashbook.

6. In the cashbook Nazir had entered a payment of Sh. 74,900 as Sh. 79,400.

7. A cheque for Sh. 15,000 from a debtor had been returned by the bank marked “refer to drawer” but had not been written back into the cashbook.

8. Nazir had brought forward the opening cash balance of Sh. 329,250 as a debit balance instead of a credit balance.

9. An old cheque payment amounting to Sh. 44,000 had been written back in the cashbook but the bank had already honored it.

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10. Some of Nazir’s customers had agreed to settle their debts by paying directly into his bank account. Unfortunately, the bank had credited some deposits amounting to Sh. 832,500 to another customer’s account. However acting on information from his customers, Nazir had actually entered the expected receipts from the debtors in is cashbook.

Required: i.

A statement showing his adjusted cashbook balance as at 30 June 2017.

ii. A bank reconciliation statement as at 30 June 2017.

EXERCISE 9.11 The books of Ndiya limited for the year 30th June 2017 show the balance at bank recorded in the cashbook as Sh. 1,254,800. This balance differed with the actual bank balance. The book of account were investigated and the following information was revealed.

1. Cheque numbers 113571 dated 12th May 2017 for Sh. 324,000 in favour of Miriam ltd was correctly recorded in the bank statement but recorded in the cashbook as Sh. 234,000 2. Bank commission charged of Sh. 24,500 and bank interest of Sh. 18,100 were not recorded in the cashbook.

3.

A cheque for Sh. 46,500 received from Bado Ltd and recorded in the cashbook was returned by the bank with the stamp “insufficient funds”.

4. A cheque for Sh. 65,000 for payment of electricity had been entered twice in the cashbook Pg 144

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5. Cash received on 30th June 2016 amounting to Sh. 352,500 had been recorded in the cashbook but not yet banked 6. A standing order payment for rent of Sh. 98,000 had not been recorded in the cashbook.

7. Cheques paid by Ndiya Traders amounting to Sh. 84,500 were unpresented to the bank as at 30th June 2017 8. Jamii Ltd , a debtor, cleared their debt of Sh. 285,500 on 28th June 2017 through a direct deposit in the bank. This has not been recorded in the cashbook Required: i.

A statement showing adjusted cashbook balance as at 30 June 2017.

ii. A bank reconciliation statement as at 30 June 2017.

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Pg 145

EXERCISE 9.12 a) Describe the three benefits of preparing a bank reconciliation statement on a monthly basis

b) The cashbook of KK Ltd for the month of April 2017 was a follows: April

Sh.

April

Cheque no.

Sh.

1

b/d

271,940

3

Dime ltd

052315

25,080

1

Thames Ltd

53,400

4

Seven ltd

052316

31,720

1

Dove Ltd

62,850

8

Clyde ltd

052317

121,860

13

Vale ltd

1,793,480

9

Rubble ltd

052318

1,374,290

20

Cold ltd

2,404,370

13

See ltd

052318

10,350

20

Dons ltd

052320

642,130

24

Water ltd

Direct debit

32,000

26

Axel ltd

052321

90,440

26

County ltd

Standing

123,570

order 27

Salaries

-

940,600

28

Y & son ltd

â&#x20AC;&#x2DC;052322

4,300

30

c/d

1,189,700

4,586,040

4,586,040

On 5th May 2017, KK ltd received their bank statement for the month of April 2017 shown below.

April

Description

1

b/d

2

052314

86,160

372,280

5

052313

100,340

271,940

8

052315

25,080

246,860

12

Direct debit-insurance

26,260

220,600

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Debit Sh.

Credit Sh.

Balance 457,440

Introduction to Financial Accounting

13

Cheque deposit

13

052317

121,860

1,892,220

15

052318

1,374,290

517,930

16

052316

31,720

486,210

20

Cheque deposit

22

Direct debit-water

1,793,480

2,404,370

2,014,080

2,890,580

32,000

2,858,580

23

052319

10,350

2,848,230

26

Standing orders

123,570

2,274,660

28

Transfers

940,600

1,784,060

29

Interest on loan

11,190

1,772,870

30

Bank charges

7,370

1,765,500

30

052320

642,130

1,123,370

Required: i.

A statement showing adjusted cashbook balance as at 30 April 2017.

ii. A bank reconciliation statement as at 30 April 2017.

EXERCISE 9.13 Mtwapa Traders Limited started a merchandising business on 1st October 2017. The following transactions occurred during the month; Oct. 1:

Opened a bank account for the business and deposited Sh. 4,796,000 and cash in hand was Sh. 890,000

Oct. 1

Bought a machinery at Sh. 2,765,000 by cheque

Oct. 4:

Bought office furniture at Sh. 132,000 by cheque

Oct. 6: Paid Sh. 35,000 by cash as fire insurance for the business.

Oct. 7:

Borrowed Sh. 2,700,000 loan which was deposited to his bank account.

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Oct. 10: Bought inventory worth Sh. 756,000 from Safari wholesalers and paying Sh. 310,000 by cheque Oct. 13: Sold inventory at Sh. 1,232,000 to Budget supermarket and received Sh. 734,000 cheque and Sh. 85,000 cash Oct. 16: Paid the lorry driver Sh. 15,000 by cheque as wage Oct. 19: Paid Safari wholesalers Sh. 233,000 account

by cash on

Oct. 21: Received Sh. 135,000 by cash from Budget supermarket on account.

Oct. 22: Sold inventory at Sh. 490,000 to Mwembe traders and received half the amount by cheque Oct. 24: Paid Lamu wholesalers by cheque in full and received a discount of 2 % Oct. 25: Sh. 600,000 cash was banked Oct. 26: Bought land for Sh. 6,500,000 by cheque Oct. 27: Received the full amount due from Budget supermarket by cheque after a discount of 2.5 % Oct. 28: Used Sh. 120,000 cash for personal use.

Oct. 29: Paid salaries of Sh. 275,000 by cheque, electricity Sh. 52,500 by cash , water bill Sh. 15,700 by cash, repairs of Sh. 30,300 by cheque and telephone bill Sh. 18,000 by cheque.

REQUIRED: Assuming all inventory were sold during the month of October 2017; 1. Prepared three column cashbook 2. Extract unadjusted trial balance Pg 148

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CHAPTER TEN FINANCIAL STATEMENT ANALYSIS Understanding the financial statements of a firm is critical since it is often the only source of information with which we must make investment decisions; i.e. whether or not to loan the company money or invest some equity. There is a rationale behind the construction of the financial statements that helps us to interpret the information that is contained within them. The Statement of income is broken down by functional area e.g. manufacturing, selling and administration, etc.

This allows us to more accurately determine where our strengths or weaknesses lie. The Statement of financial position is constructed in a very methodical manner. On the Asset side, the assets are listed in order from liquid to the least liquid. Similarly, on the Liability & Equity side, the accounts are listed in order from the most immediately due to the least. From a financial perspective, the Statement of Cash Flows is the most important financial statement because it integrates the Statement of Income and Statement of financial position while adjusting the accounting figures based upon accrual accounting into actual cash flow.

FINANCIAL RATIOS The financial statements are often the only information upon which to base an investment decision (as an equity holder or a lender), so it is imperative that we be able to determine what economic information the statements contain. Financial Ratios are used as tools to help us squeeze as much information as possible from the financial statements.

It must be kept in mind, however, that a financial ratio is only one number divided by another and only yields a number. The ratio takes on meaning when compared with other firms or industry averages (a Introduction to Financial Accounting

Pg 149

static analysis) or when compared with previous periods for trends to see if a firm’s position is improving or deteriorating (a dynamic analysis). A ratio is simply a mathematical expression of an amount or amounts in terms of another or others. A ratio may be expressed as a percentage, a fraction, or a stated comparison between two amounts.

Financial ratios have two primary uses: a) Financial control (or analysis) and b) Financial planning.

Financial ratios are used to compare actual financial results with various benchmarks of performance, such as a) a firm’s own historical financial ratios to identify improving and deteriorating trends, b) comparable ratios from other firms in the same industry, or c) comparison of actual ratios versus a previously developed financial plan.

We call the activity of comparing ratios to any of these benchmarks financial control. Financial ratios also are used to project a firm’s future financial position. We call this activity financial planning. Financial ratios are used in trends analysis and cross sectional analysis. Trend analysis (also known as time series analysis, horizontal analysis or temporal analysis) involve comparison of the present performance with the result of previous periods for the same enterprise. Trend analysis is done when financial data is available for three or more periods.

Cross sectional analysis involve comparison of the performance of two or more firm with respect to result of same period.

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Classification of financial ratios Financial ratios often are classified into five categories: •

Liquidity ratios,

•

Activity or turnover ratios

•

Profitability ratios, and

•

Debt ratios,

•

Market ratios.

Liquidity Ratios Liquidity ratios are designed to measure the extent to which our shortterm, or liquid, assets exist to cover our short-term obligations.

Working capital = Current assets – Current liabilities It represents that portion of current assets financed by liabilities not requiring immediate payment. Current Ratio must be 2:1 in normal situation

Current Ratio =

Current Assets Current Liabilities

The current ratio is looking at those assets that are expected to be converted into cash with one year, relative to those liabilities that come due within a year.

A more stringent measure is the Quick (or Acid Test) Ratio. This ratio recognizes that some current assets are more liquid than others.

While the book defines the quick ratio’s numerator as being the Introduction to Financial Accounting

Pg 151

Current Assets less Inventories, the general definition used in practice excludes other current assets that are not liquid in nature, such as prepaid expenses. The idea behind excluding inventories is twofold: first, inventories are generally illiquid and can only be converted into cash by selling at steep discounts. Secondly, most companies sell inventories on credit, so they become an account receivable which must then be collected. By excluding inventories, the quick ratio is therefore recognizing the fact that they are one step further removed from becoming cash than other current assets. The ratio must be 1:1 in normal situation

Quick (Acid Test) Ratio =

Current Assets - Inventory - Prepayment Current Liabilities

Cash ratio =

Cash + bank Current Liabilities

Activity /turnover ratios

The inventory turnover ratio can, alternatively, be stated as the average sales period (also Average Age of Inventory); i.e., how long on average does an inventory item sit in the warehouse before it is sold:

The second major category, at least of current assets, for most firms is the amount of money that is tied-up in Accounts Receivable. The Average Collection Period (also Pg 152

average Days Sales Outstanding)

Introduction to Financial Accounting

tells you how long, on average, it takes for a firm to collect the money due on a sale made on credit:

Average Collection Period =

Average Accounts Receivable Ă&#x2014; 365 Credit Sales

One problem with the Current and Quick Ratios as measures of liquidity is the fact that they are predicated upon the liquidation of the current assets of the firm in order to satisfy the short-term liabilities.

Generally, however, one is not interested in liquidating a firm in order to cover its short-term obligations (except in extreme cases). For this reason, the cash cycle is often looked at in order to see the extent to which the ongoing operations of the firm cover short-term requirements (primarily in the area of accruals and payables). In order to calculate the cash cycle, we need to look at a measure of the short-term liability encompassed by the trade credit that our supplier provide to us: We compute Average payment period (also) as follows;

The cash conversion cycle looks at how long a company has money tied-up in its operations. Money is invested in inventories, which sit in the warehouse for a certain period of time and then are sold on credit which takes so-long to collect; but this length of time (known as the operating cycle) is reduced by the fact that our suppliers do not require immediate payment for the inventories that we purchase.

Cash Cycle = Average sales period + Average Collection Period - Average payment period

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While a short cash cycle is considered to be an efficient use of money, what are the dangers of having: 1) A low average age of inventory 2) A short average collection period 3) A long average payables period The firmâ&#x20AC;&#x2122;s cash cycle is looking at how long, and hence, how much, cash is tied up. Decreasing the cash cycle decreases the amount of cash investment is required. As will be seen when working capital is addressed, cash can be free-up by accelerating inflows (shortening the average collection period) or delaying outflows (stretching out the average payables period) as well as by liquidating assets such as inventory (and increasing inventory turnover which is the same as decreasing the average age of inventory).

Asset utilization ratios are designed to give insight into how effectively a company is managing its assets. For many firms, inventories are its largest category of assets. Why is it bad to have too much inventory?

Why is it bad to have too little? One way to look at the amount of assets that a firm holds in relation to its level of sales The final major category of assets, particularly manufacturing firms, is that of Property, Plant & Equipment, or Fixed Assets. The Fixed Asset Turnover ratio looks at the amount of productive equipment that a firm has relative to the amount of sales that it is generating. In one sense, this could be interpreted as a measure of the amount of capacity utilization that a firm has.

Fixed Asset Turnover =

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Introduction to Financial Accounting

Sales Net Fixed Assets

A final measure looks at all of the firmâ&#x20AC;&#x2122;s investment in assets relative to its sales level. This is the Total Asset Turnover ratio:

Total Asset Turnover =

Sales Total Assets

Cost ratio have an item of cost expressed as a percentage of sales

=

Administra tion expenses Ă&#x2014; 100 sales

Profitability Ratios One of the best measures for evaluating management lies in their ability to control costs. Thus, profit margins are an important means of assessing this ability:

Gross Profit Margin =

Operating Profit Margin =

Net Profit Margin =

Gross Profit Sales

Operating Income Sales

Profit before Tax Sales

Another important factor has to do with the amount of profit being made relative to the investment in assets that support the operations

Introduction to Financial Accounting

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and sales.

Note that this ratio can be decomposed into the Net

Profit Margin and the Total Asset Turnover. This has two important implications:

First, it illustrates that there are two ways to make

money â&#x20AC;&#x201C; have a high profit margin and a low turnover rate, or a low profit margin and a high turnover rate. Secondly, it provides us a means by which to determine where problems, or strengths, reside. If the net ROA is low, is it because we are not controlling costs (in which case, is it in production, selling and administrative, or financing costs), or is it because we have too many assets relative to sales (such as too much inventory, too long a collection period, too many unutilized non-current assets). This approach to locating the source(s) of the problems is known as the DuPont method of analysis.

Return on assets (ROA) ratio measures how well management has employed assets. It can be measures as below in two ways.

Finally, equity investors are concerned with the rate of return that is being generated on their investment in the company. ROE measures the ability of an enterprise to generate income for its owners

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Introduction to Financial Accounting

Where

Capital employed = Fixed asset + working capital

Debt Ratios The Debt-to-Assets Ratio looks at how much of a companyâ&#x20AC;&#x2122;s assets are financed with debt; i.e., other peopleâ&#x20AC;&#x2122;s money.

Debt/Asset Ratio =

Total Debt Total Assets

A variation on the Debt-to-Asset Ratio that is more commonly used in practice is the Debt-to-Equity Ratio which simply expresses the debt as a percentage of equity rather than total assets. The two measures are equivalent as indicated by the second part of the equation:

Debt/Equity Ratio =

Debt Equity

Sometimes it is desirable to break down the use of debt into shortterm and long-term debt. Which type of debt do you think is more risky for the company to utilize?

Just as in accounting where changes in current liabilities are included as a part of operating cash flows (since accounts payable and Introduction to Financial Accounting

Pg 157

accruals such as wages payable arise from operations), sometimes only the long-term portions of debt are considered. This is because oftentimes a company is viable in the long-run but faces short-term liquidity problems. The capitalization ratio looks at the long-term debt financing that a company uses:

Capitalization Ratio =

Long - term Debt Long - term Capital

While short-term solvency is obviously important, the long-term aspects are relevant for long-term debt/investment considerations.

Proprietory ratio This ratio measures the proportion of assets financed by the owners.

It is calculated as follows:

Proprietory Ratio =

Total Equity Total Assets

While the preceding measures of the extent to which a company uses debt to finance its assets are important, what is probably of more concern is the ability of the company to service its debt. The following ratios look at the ability of the company to make debt service payments to its creditors. The most common of these, particularly when only the financial statements are available, is the Times Interest Earned ratio:

Times Interest Earned =

EBIT Interest Expense

More important to many lenders is the ability of the company to not only make interest payments, but also to repay the principal of the loan. The Debt Service Coverage Ratio considers both interest and Pg 158

Introduction to Financial Accounting

principal payments that are required.

Debt Service Coverage =

EBIT Principal Pymt.

Int. Exp. + 1- t

Finally, it is common for lenders (such as banks) to look more toward the cash flow coverage of debt payments that a company can make.

For this reason, the Operating Income (EBIT) has the non-cash charges of Depreciation and Amortization added back (just like they are in the Operating Cash Flow section of the Statement of Cash Flows).

Cash Coverage =

=

EBIT + Depreciation & Amortization Interest Expense EBITDA Interest Expense

Market Ratios These are designed to look at market-related measures of performance:

DPS reflects the amount of dividend paid per share

Dividend yield ratio =

DPS Market price per share

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Price/Earnings Ratio =

Market Price/share Earnings per Share

P/E ratio is used in comparing shares investment opportunities. It is an index of determining whether shares are relatively cheap or relatively expensive.

Earnings yield Ratio =

EPS Market price/share

Earning yield ratio shows the earning return being provided by the share.

Dividend payout ratio =

Dividend per share Earnings per Share

Dividend payout ratio reflects a companyâ&#x20AC;&#x2122;s dividend policy.

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EXERCISE 10. 1 KCT limited sells consumer durable goods on hire purchase. It has recently subscribed to an an interfirm comparison service. Members usually submit accounting ratios as specified by the service operator and in return members receive the average figures for each of each of the specified ratio taken from all the companies in the same sector that subscribe to the service. The specified ratio and the average figures from Hire purchase sector are shown below for the period ended 31st December 2017.

Return on capital employed Net asset turnover

22.1% Average payment period 1.8 times Debt to equity ratio

Gross profit margin

30%

Net profit margin

Dividend yield

1.6:1

Quick ratio

0.9:1

Inventory holding period

46 days

Average collection period

45 days

40% 6%

12.5% Dividend cover

Current ratio

55 days

3 times

The financial statement for KCT limited for the year to 31st December 2017 are below: Statement of Income Sh. in million Sales revenue

2,425

Cost of Sales

1,870

Gross profit

555

Other operating expenses

(215)

Operating profits

340

Interest payable

(34)

Exceptional items(note ii)

(120)

Profit before tax

186

Income tax

(90)

Profit after tax

96 Introduction to Financial Accounting

Pg 161

Extract from the Statement of Equity Retained profit on 01.01.2017 Profit for the period

Sh. in million 179 96

Interim dividends

(90)

Retained profit on 31.12.2017

185

Statement of Financial Position Sh. in million Assets Non-current assets (note 1)

540

Current assets Inventory Bank

Account receivable

275 320 1,135

Equity and liabilities Equity and reserves: Ordinary share capital(25 cents each)

150

Retained profits

185

Non-current Liabilities: 8% loan note

300

Current liabilities:

Bank overdraft

65

Trade payables

350

Taxation

85 1,135

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Introduction to Financial Accounting

Notes: 1) The details of the non-current assets are given in million as below:

As at 31.12.2017

Cost

Accumulated depreciation

Net book value

3,600

3,060

540

2) The exceptional item is due tom loss on the sales of a batch of fridges that had become worthless doe to improvement in the designs 3) The market price of KCT limited’s shares throughout the year averaged Sh. 6.00 each.

REQUIRED a. Explain the problem that are inherent when ratios are used to assess a company’s financial performance, especially when using the industry’s averages provided by a interfirm service provider as illustrated above b. Calculate the ratios of KCT limited equivalent to those provided by the interfirm service provider c. Write a report analyzing the financial performance of KCT limited based on a comparison with the hire purchase sector’s average

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EXERCISE 10. 2 The financial data of Beta Company for the years 2016 and 2017 are as shown below: Statement of income Year ending December 2017 2016

2017

12,000

19,000

Cost of sales

7,200

12,000

Depreciation expense

1,200

1,500

Sales

Sales, general and administration expense

700

1,000

Interest expense

1,300

1,200

Income before taxes

1,600

3,300

Income taxes expense

700

1,440

Net income

900

1,860

Statement of financial position As at December 2017 2016

2017

Cash

2,000

2,200

Accounts receivable

3,000

3,500

Inventory

4,000

4,200

9,000

9,900

Assets

Current assets Noncurrent assets at cost

22,000

24,300

Accumulated depreciation

(9,000)

(10,500)

Net non current assets

13,000

13,800

22,000

23,700

Accrued expenses

1,600

1,760

Accounts payable

2,400

2,640

Current liabilities

4,000

4,400

Total assets

Liabilities and equity

Pg 164

Introduction to Financial Accounting

Notes payable

11,000

11,800

Long term debt

4,000

3,204

Share capital

2,000

2,300

Retained earnings

1,000

1,996

22,000

23,700

Total liabilities and equity

Required: a)

Calculate the following ratios for 2017 1. Activity Ratios a) Inventory turnover b) Accounts receivable turnover c) Noncurrent asset turnover d) Total asset turnover 2. Liquidity ratios a) Current ratio b) Quick ratio c) Cash ratio 3. Solvency ratios a) Debt to equity b) Debt to capital c) Times interest earned 4. Profitability ratios a) Gross margin b) Operating income to sales c) Return on sales d) Return on assets e) Return on equity Introduction to Financial Accounting

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EXERCISE 10. 3 You have been told to analyze SGQ Transportersâ&#x20AC;&#x2122;s financial statement for the period ended 31st December 2017. The folowing information is available: 1. Beginning and ending balances are identical for both accouts recievable and inventory 2. Net income is Sh. 1,300,000 3. Times interest earned is 5 (income taxes are zero). company has 5% bonds outstanding issued at par 4. Net profit margin is 10%. Gross profit margin 30%.

Inventory turnover is 5 times 5. Average collection period is 72 days 6. Sales to end of year working capital s 4. Current ratio is 1.5 7. Acid test ratio is 1.0 (excludes prepaid expenses) 8. Plant and equipment is Sh. 6000,000, it is one-third depreciated 9. Dividend paid on 8% non participating prefered are sh40,000. Thereis no change in common shares. The prefered shares were isssued two years ago at par 10. Earnings per share are Sh. 3.75 11. Ordinary shares has a Sh. 5 par value and was issued at par 12. Retained earnings at January 1, 2017 are Sh. 350,000

REQUIRED: a) Given the information available , prepare the companyâ&#x20AC;&#x2122; Statement of income and the Statement of financial position at December 31, 2017 (include the following Pg 166

Introduction to Financial Accounting

account

classifications:

cash,

inventory,

prepaid

expenses, plant and equipment (net), current liabilities and shareholderâ&#x20AC;&#x2122;s equity) b) Determine the amount of dividend paid on the ordinary shares in year 2017.

EXERCISE 10. 4 Ocean Importers limited Statement

Statement of financial position and

of income are shown below. Figures are shown in

thousands Statement of financial position ASSETS Bank

2015

2016

2017

74,950

70,390

89,200

Account receivable

160,710

117,060

105,350

Inventory

293,090

249,560

251,520

Prepayment

127,660

130,730

161,900

Plant and Machinery

320,840

390,880

424,340

977,250

958,620

1,032,310

322,360

275,780

325,430

65,340

142,060

179,460

(10/=each)

275,900

279,500

289,400

Retained profits

189,410

147,020

154,640

Preference Shares

124,240

114,260

93,380

977,250

958,620

1,042,310

Total

EQUITY AND LIABILITIES Accounts payable Debenture Ordinary share

Total

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Pg 167

Statement of Income 2016

2017

Sales (25% are cash)

921,750

1,098,210

Cost of sales

575,310

592,020

Operating expenses

233,220

364,290

Interest expenses

35,490

43,440

Income taxes

28,250

39,250

Net income

49,480

59,210

Additional information:

2016

2017

25

28

40,000

45,000

Market price in Sh. Dividends paid on ordinary shares in million.

Required: Based on the data given above, compute

and interpret any 20

financial ratios for the years shown. Trend analysis is expected,

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EXERCISE 10. 5 Nguvu Nyingi Limited and Mwenda Hadhari Limited are in the same line of business and are direct competitors in a large metropolitan area.

Both have been in business approximately 10 years, and each has had steady growth. The management of each has a different viewpoint in many respects. Mwenda Hadhari Limited is more conservative, and as its Managing Director said, “We avoid what we consider to be undue risk.” Neither company is publicly held.

The 2017 financial statements for Nguvu Nyingi Limited and Mwenda Hadhari Limited are summarized below: Nguvu Nyingi Ltd. Mwenda Hadhari Ltd. Statement of Financial Position Sh. 000 Sh. 000 Assets Cash Accounts receivable (net) Inventory Intangible assets

35,000

22,000

40,000

30,000

100,000

40,000

85,000

308,000

Property, plant and equipment (net)

140,000

400,000

Total assets

400,000

800,000

100,000

50,000

60,000

70,000

Liabilities and Equity Accounts payable Long-term debt (10%) Share Capital (par Sh. 10)

150,000

500,000

Share premium

30,000

110,000

Retained earnings

60,000

70,000

400,000

800,000

Total liabilities and equity

Statement of income Sh. ‘00 Sh. ‘000 Sales revenue (1/3 on credit)

450,000

810,000

Cost of goods sold

(245,000)

(405,000)

Expenses (including interest and income tax)

(160,000)

(315,000)

45,000

90,000

Net income

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Selected data from the 2016 statements Sh.â&#x20AC;&#x2122;000

Sh. â&#x20AC;&#x2DC;000

Accounts receivable (net)

20,000

38,000

Inventory

92,000

45,000

Long-term debt

60,000

70,000

Other data

Per share price at end of 2017 (offering price)

Sh. 18

Average income tax rate Dividends paid in 2017

Sh. 15

30%

30%

36,000,000

15,000,000

Required: A client of yours has the opportunity to buy 10 per cent of the shares in one or the other company at the per share prices given and has decided to invest in one of the companies. Based on the data given, prepare a comparative written evaluation of ratio analyses (and any other available information) and give your recommended choice.

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EXERCISE 10. 6 a) Summarise the three limitations of ratio analysis b) The following financial statement were extracted from the books of Major Traders for the years ended 31 December 2016 and 2017.

Statement of income 2016

Sales –all credit Cost of sales Gross profit Expenses

2017

Sh.’000

Sh.’000

200,000

200,000

(120,000)

(100,000)

80,000

100,000

(60,000)

(60,000)

Net profit

20,000

40,000

Dividends

(20,000)

(20,000)

To Retained profit

-

20,000

B/d retained profit

25,000

25,000

C/d retained profit

25,000

45,000

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Statement of financial position 2016

2017

Sh.â&#x20AC;&#x2122;000

Sh.â&#x20AC;&#x2122;000

63,000

44,000

Non-current assets Land Plant and Machinery-Cost Building -Cost

6,000

8,500

79,000

60,000

80,000

53,000

228,000

165,500

Inventory

65,000

55,000

Accounts receivables

50,000

40,000

Investment-Cost Current assets

115,000

95,000

343,000

260,500

Shares capital

50,000

40,000

Share premium

14,000

13,000

Revaluation reserves

20,000

-

25,000

45,000

109,000

98,000

Total assets Equity and reserves

Revenue reserves

Non-current liabilities 10% debenture

150,000

100,000

Accounts payable

60,000

40,000

Proposed dividends

20,000

20,000

4,000

2,500

Current liabilities

Bank Total equity and liabilities

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Introduction to Financial Accounting

84,000

62,500

343,000

260,500

Additional information 1. Ordinary shares with a nominal values of Sh. 10,000,000 were repurchased at a premium during the years. All necessary approvals were obtained for the transactions.

2. Part of debentures were redeemed at par during the year 3. Ignore taxation Required: Based on the data given above, compute and interpret relevant financial ratios for the years shown.

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CHAPTER ELEVEN STATEMENT OF CASH FLOWS The basic purpose of a Statement of cash flows is to provide information about the sources and application of cash and cash equivalents of an entity. Information about cash receipts and cash payments of an entity during an accounting period would help creditors and others in assessing: a) the entity’s ability to generate positive cash flows in future periods. b) the entity’s ability to meet its obligations and to pay dividends. c) the reasons for the difference between the accounting net income and the related net cash flows from operations of an entity for an accounting period. d) both the cash and non-cash aspects of an entity’s investment and financing transactions for the period.

The two key financial objectives of every entity are to operate profitably and stay liquid and solvent. The Statement of income is designed to measure the results of operations of an entity in meeting its profit objective for a given period of time. The Statement of income is based on accrual accounting. Therefore, the revenues, expenses, gains, and losses reported in the Statement of income do not necessarily represent cash inflows and outflows. In general, five distinct classes of items cause differences between income flows and cash flows: a) Items that appear on the Statement of income that do not represent cash inflows and outflow, such as depreciation, amortization expense and depletion. Such items are referred to as non-cash items.

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b) Operating cash flows that do not appear on the Statement of income but appear instead on the Statement of financial position as prepayments, deferrals, unearned revenue, or reductions of accruals. c) Credit items that have been included in the calculation of operating profit but do not affect the cash inflows and outflows in the same period. Examples include credit sales, credit purchases and accrued expenses. d) Activities that result in changes in size and composition of equity capital and borrowings of the enterprise. Such activities referred to as financing activities, usually affect cash but may not be reflected fully in the Statement of income. Examples include the issuing of shares, redemption of shares, borrowings and repayment of the principal amount borrowed. e) Activities that result in the acquisition and disposal of long term assets and other investments not included in cash equivalents. Such activities, referred to as investing activities, usually affect cash flows but may not be fully reflected on the Statement of income. Examples include the purchase or sale of equity and or debt instruments of other enterprises and the purchase or sale of items of property, plant and equipment.

The Statement of financial position reflects the financial position of an entity at a particular point in time. To some extent, the Statement of financial position may be able to reflect the liquidity and solvency of an accounting entity. Users of accounting information, however, require more information to enable them assess the ability of an entity to meet her obligations as and when they fall due. This need is best served through the preparation and presentation of a Statement of cash flows.

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Introduction to Financial Accounting

Unlike the Statement of financial position and the Statement of income, which are required by the Companies Act, the Statement of cash flows is a requirement of the International Financial Reporting Standards, International Accounting Standard No.7 in particular. The Statement of cash flows or Statement of sources and application of funds or Statement of changes in financial position is not a legal requirement.

Benefits of cash flow information. a)

A Statement of cash flows when used in conjunction with

the rest of the financial statements provides information that enables users to evaluate the changes in net assets of an enterprise, its financial structure (i.e. liquidity and solvency) and its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances and opportunities. b) Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash equivalents and enables users to develop models to assess and compare the present value of the future cash flows of different enterprises. c) A Statement of cash flows enables the comparability of the reporting of results by different enterprises because it eliminates the effects of using different accounting treatments for the same transactions and events. d) Cash flow information is also useful in checking the accuracy of past assessments of future cash flows and in examining the relationship between profitability and net cash flow and the impact of changing prices. e) Historical cash flow information is often used as an indicator of the amount, timing and certainty of cash flows.

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Definitions a) Cash comprises of cash on hand, and demand deposits (including those in foreign currencies) net of bank overdrafts. b) Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are not subject to any significant risk of changes in value. They include short-term securities; investments that have a short maturity of three months or less from the specified redemption date. c) Cash flows are inflows and outflows of cash and cash equivalents

Presentation of Statements of cash flows.

The Statement of cash flows should classify cash flows during the period between: a) operating activities, b) investing activities, and c) financing activities.

Operating activities.

Cash flows from operating activities are primarily derived from the principle revenue producing activities of an enterprise. They generally arise from transactions that involve the determination of net profit.

Examples of operating activities include: a) cash receipts from the sale of goods and rendering of services; b) cash receipts from royalties, fees, commissions and other revenues; Pg 178

Introduction to Financial Accounting

c) cash payments to suppliers for goods and services; d) cash payments to and on behalf of employees; e) cash receipts and payments of an insurance enterprise for premiums and claims, annuities and other policy benefits; and f) cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities; and Where an enterprise holds securities for trade purposes, cash flows arising from the sale or purchases of such securities are classified as operating activities since they are similar to inventory acquired specifically for resale.

In the case of financial institutions, cash advances and loans made by them are classified as operating transactions since they relate to the main revenue producing activities of that enterprise.

Investing activities.

These are the acquisition and disposal of long term and other investments not included in cash equivalents. Separable disclosure of cash flows arising from investing activities is important because the cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows. Examples of cash flows arising from investing activities are: a) cash payments to acquire property, plant and equipment, intangibles and other long term assets. These payments include those relating to capitalized development costs and self constructed property, plant and equipment; b) cash receipts from sales of property, plant and equipment, intangibles and other long-term assets;

Introduction to Financial Accounting

Pg 179

c) cash payments to acquire equity or debt instruments of other enterprises and interests in joint ventures (other than payments of those instruments considered to be cash equivalents and those held for dealing or trading purposes); d) cash receipts from sales of equity or debt instruments of other enterprises and interests in joint ventures (other than receipts for those instruments considered to be cash equivalents and those held for dealing or trading purposes); e) cash advances and loans made to other parties (other than advances and loans made by a financial institution); and f)

cash receipts from the payment of advances and loans made to other parties (other than advances and loans for a financial institution).

Financing activities.

These are activities that result in changes in size and composition of the equity capital and borrowings of the enterprise. Examples of cash flows arising from financing activities are: a) cash proceeds from issuing shares or other equity instruments; b) cash payments to owners to acquire or redeem the enterpriseâ&#x20AC;&#x2122;s shares; c) cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or long-term borrowings; d) cash repayments of amounts borrowed; and e)

Pg 180

cash payments by a lessee for the reduction of outstanding liability relating to a finance lease.

Introduction to Financial Accounting

Investing and financing transactions that do not require the use of cash or cash equivalents should be excluded from a Statement of cash flows. Such transactions should be disclosed elsewhere in the financial Statements in a way that provides all the relevant information about these investing and financing activities. Examples of such transactions include: a) the conversion of debt into equity; b) the acquisition of an entity by means of an equity issue; and c) the acquisition of assets either by assuming directly related liabilities.

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FORMAT OF PRESENTATION Enterprises are required to report cash flows from operating activities using either the a) direct method, or b) indirect method.

The direct method: Under this method information about major classes of gross cash receipts and gross cash payments are disclosed.

The Direct method XYZ LTD. Statement of Cash Flows For the period ended 31st December 2017.

Cash flows from operating activities:

Cash receipts from customers

Cash paid to suppliers and employees

Cash generated from operations

Income taxes paid

Net cash from operating activities

Sh. XX (XX) XX (XX) XX

Cash flows from investing activities: Interest received

XX

Dividends received

XX

Proceeds from sale of marketable securities

Purchase of marketable securities

(XX)

Purchase of plant and equipment

(XX)

Proceeds from sale of equipment

XX

Net cash from investing activities

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Introduction to Financial Accounting

XX

XX

Cash flows from financing activities Proceeds from issue of share capital

XX

Proceeds from long term borrowing

XX

Interest paid

(XX)

Dividends paid

(XX)

Net cash from financing activities

XX

Change in cash and cash equivalents

XX

Add: Cash and cash equivalents at beginning of period

XX

Cash and cash equivalents at end of period

XX

The indirect method XYZ CO. LTD. Statement of Cash Flows For the period ended 31st December 2017 Cash flows from operating activities:

Net profit before tax

Sh. XX

Adjustments items Depreciation of tangible assets

XX

Amortization of intangible assets

XX

Gain on asset disposal

(XX)

Loss on asset disposal

XX

Investment income

(XX) XX

Interest expense Operating profit before working capital changes

XX

(Increase) Decrease in receivables

(XX)/XX

(Increase) Decrease in inventory

(XX)/XX

(Increase) Decrease in prepayments

(XX)/XX (XX)(XX

(Decrease)Increase in accruals

(XX)/XX (Decrease) Increase in trade payables Cash generated from operations

XX Introduction to Financial Accounting

Pg 183

Income taxes paid Net cash from operating activities

(XX) XX

Cash flows from investing activities Interest received

XX

Dividends received

XX

Proceeds from sale of marketable securities

XX

Purchase of marketable securities

(XX)

Purchase of plant and equipment

(XX)

Proceeds from sale of equipment

XX

Net cash from investing activities

XX

Cash flows financing activities Proceeds from issue of share capital

XX

Proceeds from long-term borrowing

XX

Interest paid

(XX)

Dividends paid

(XX)

Net cash from financing activities

XX

Change in cash and cash equivalents

XX

Add: Cash and cash equivalents at beginning of period

XX

Cash and cash equivalents at end of period

XX

NB: Adjustments items are those used in the determination of net profit but do not involve movement of cash in the current accounting period

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Introduction to Financial Accounting

EXERCISE 11. 1 a) Why is it necessary to prepare a Statement of cash flow? b) The following information has been availed to you with respect to Kana Limited. Statement of Income For the year ended 30th September 2017 Sh. Million Sales

1660

Cost of sales

(840)

Gross profit

820 60

Other Operating income

880 Administration costs

(240)

Selling and distribution costs

(240)

Operating profit Investment income

400 20

Finance Costs

(20)

Profit before taxation

400

Income tax expense

180

Net profit for the period

220

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Pg 185

Statement of changes in equity For the period ended 30th September 2017

Share

capital

Sh. million

Share premium Sh. million

Revaluation reserve Sh. million

Retained profit Sh. million

Total Sh. million

27

66

400

766

Net Profit for the period

220

220

Dividends paid

(30)

(30)

As at 1st October 2016

273

Issue of new shares As at 30th Sept. 2017

77

3

350

30

80 66

590

1036

Statement of Financial position As at 30th September 2017 2016

2017

Sh.Million

Sh.Million

60

164

Assets Non â&#x20AC;&#x201C;current assets Freehold Property Plant and Machinery

360

450

Furniture and fittings

40

32

Motor Vehicles

23

20

Goodwill

10

10

334

351

827

1027

Investments

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Introduction to Financial Accounting

Current assets Inventories Accounts receivable Prepayments

34

46

203

164

15

10

33

76

285

296

1112

1323

273

350

Share Premium

27

30

Revaluation reserve

66

66

Cash and cash equivalents

Equity and Liabilities Capital and reserves Share capital

Retained Profit

400

590

Shareholdersâ&#x20AC;&#x2122; funds

766

1036

212

164

112

98

Non-current liabilities 16% debentures

Current Liabilities Accounts Payable Taxation Payable

22

25

134

123

1112

1323

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Pg 187

Additional information Kana Limited disposed off, during the year, a piece of machinery with a net book value of Sh. 20 million. It is the policy of the company not to depreciate freehold property. Total depreciation charge for the year amounted to Sh. 220 Million. Other operating income relates to disposal of machinery.

Required: A Statement of cash flow of Kana Limited for the period ended 30th September 2017 in accordance with the requirements of International Accounting Standard No.7

EXERCISE 11. 2 The following are the financial statements of Riddle Limited for the last two years: The Statements of financial position as at 31 March 2017 2016 Non-current assets: Property, plant and equipment, at cost

Less; accumulated depreciation

2017 (Sh. in Million)

Investments

540

720

(145)

(190)

395

530

115

140

Current assets: Inventory

315

418

Trade receivables

412

438

Bank Total assets

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Introduction to Financial Accounting

48

51

775

907

1,285

1,577

Equity and reserves: Ordinary shares

600

Share premium

` 40

800 55

Retained earnings

217

311

857

1166

250

200

139

166

Non-current liabilities: 12% debentures Current liabilities: Accounts payables Taxation Total equity and liabilities

39

45

178

211

1,285

1,577

Statement of comprehensive income for the year ended 31 March 2017 Sh. in million Sales

2,460

Cost of sales

1,780

Gross profit

680

Distribution costs

(124)

Administration expenses

(300)

Operating profit

256

Interest on debentures

(24)

Profit before tax

232

Tax

(48)

Profit after tax

184

Additional note 4. The Statement of changes in equity disclosed a dividend of Sh. 90 Million

Introduction to Financial Accounting

Pg 189

Required: (a) Prepare the Statement of cash flows for Riddle Ltd for the year ended 31 March 2017 and showthe operating cash flows using the ‘indirect method’. (b) Calculate the cash generated from operations using the ‘direct method’.

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Introduction to Financial Accounting

EXERCISE 11. 3 The following are the financial statements of Tahidi limited Statement of Financial position as at 31st October 2017

2016

Sh.â&#x20AC;&#x153;million

Sh.â&#x20AC;&#x153;million

Property, plant and equipment

380

305

Intangible assets

250

200

Non-current assets

Investments

-

25

630

530

Inventory

150

102

Accounts receivable

390

315

Current assets

Short-term investments Cash

50

-

2

1

592

418

1222

948

Share capital

200

150

Share premium

160

150

Revaluation reserves

100

91

Total assets Equity and reserves

Revenue reserves

160

100

620

491

170

50

127

119

85

98

Taxation

120

110

Proposed dividends

100

80

432

407

1222

948

Non-current liabilities Debenture Current liabilities Accounts payables Bank

Total equity and liabilities

Introduction to Financial Accounting

Pg 191

Additional information 1. 5,000,000 ordinary shares of Sh. 10 each were issued during the year at a price of Sh. 12 per share 2. Fixtures and fittings which had an original cost of Sh. 8.5 million and a net book value of Sh. 45 million were sold for Sh. 32 million during the years.

3. The proceeds of the sale of long term investment amounted to Sh. 30 million 4. The following information relates to tangible non-current assets:

2017

2016

Sh.â&#x20AC;&#x2122;million

Sh.â&#x20AC;&#x2122;million

Cost

720

595

Accumulated

340

290

380

305

depreciation Net book value Required: Statement of cash flow in accordance with ISA 7 for the year ended 31st October 2017

EXERCISE 11. 4 a)

Distinguish between the terms cash and cash equivalent in

relation to the Statement of cash flows.

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Introduction to Financial Accounting

b)

The following Statement of financial position relates to Happy

Limited for two years ended 31st March.

2017

2016

Sh.â&#x20AC;&#x2122;000

Sh.â&#x20AC;&#x2122;000

Property, plant and equipment

2,000

1,625

Intangible assets

1,150

900

-

125

3150

2650

Non-current assets

Investments Current assets Inventory Accounts receivable 90 days deposits Cash

600

520

2000

1475

250

-

50

20

2900

2015

6050

4665

1000

750

Share premium

800

750

Revaluation reserves

500

450

Total assets Equity and liabilities Capital and reserves Share capital Sh. 50@

Revenue reserves

700

400

3000

2350

8% Debenture

400

300

10 year Bank loan

500

-

900

300

Accounts payables

610

540

Bank

940

925

Non-current liabilities

Current liabilities

Taxation Total equity and liabilities

600

550

2150

2015

6050

4665

Introduction to Financial Accounting

Pg 193

Additional notes 1. Dividends amounting to Sh. 400,000 were paid during the year ended 31st march 2017 2. Tax paid during the year ended 31st march 2017 amounted to Sh. 550,000 3. The proceeds of sales of the investment were Sh. 150,000 4. Interest of Sh. 375,000 was paid and interest of Sh. 125,000 was received during the year ended 31st march 2017 5. The property, plant and equipment as at 31st March each year were as follows;

Cost Accumulated depreciation Net book value

2017

2016

Sh.â&#x20AC;&#x2122;000

Sh.â&#x20AC;&#x2122;000

3,700

3,075

(1,700)

(1,450)

2,000

1,625

Required: Statement of cash flow in accordance with ISA 7 for the year ended 31st March 2017

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Introduction to Financial Accounting

EXERCISE 11. 5 Given below are the comparative Statement of financial position for Taoma Ltd., a trading company, for the years ended 31 October 2016 and 2017: Assets

2017

2016

Sh.’000’

Sh.’000’

Non-current assets: Goodwill

23,500

32,650

Premises

200,000

80,000

Plant and machinery

290,100

278,200

Office equipment

126,250

87,360

639,850

478,210

Inventory

88,890

67,815

Accounts receivable

57,890

52,015

9,210

-

Current assets:

Bank

155,990

119,830

795,840

598,040

425,000

250,000

10% preference shares

75,000

160,000

Share capital

33,000

-

Capital redemption reserve

30,000

-

General reserve

38,000

12,000

Retained Profit

22,300

11,200

623,300

433,200

63,000

50,000

Accounts payables

49,820

40,290

Current tax

30,500

28,500

Proposed ordinary dividends

26,000

18,000

Total assets Equity and Liabilities Capital and reserves: Ordinary shares

Non-current liability Bank loan Current liabilities

Introduction to Financial Accounting

Pg 195

Accruals

3,200

Bank overdraft Total Equity and Liabilities

5,420

-

22,630

109,540

114,840

795,840

598,040

The following additional information is provided: 1.

Some of the preference shares which had been issued at par, were redeemed at a premium of 2%. To finance the redemption and comply with the Companies Act requirements, the company simultaneously carried out the following: (i) Issued 5,500,000 additional ordinary shares of Sh. 10 at a total premium of Sh. 34,700,000. (ii) Transferred sufficient amounts to the capital redemption reserve. (iii) Financed the premium on redemption out of the premium received on issue of the additional ordinary shares.

2.

Preference dividends are paid at the end of each financial year on shares outstanding then.

3.

Part of plant and machinery which had cost Sh. 60,000,000 on acquisition and on which Sh. 42,000,000 accumulated depreciation had been provided was sold for Sh. 25,000,000 during the year.

4.

Included in the depreciation charge for the year is Sh. 15,100,000 in respect of plant and machinery.

5.

New office equipment was purchased in the year for Sh. 55,000,000. There was no disposal of office equipment during the year.

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Introduction to Financial Accounting

6.

It is the companyâ&#x20AC;&#x2122;s policy not to depreciate premises.

The

change in the premises account balance was due to a revaluation of the asset.

7.

The revaluation reserve arising in (6) above was all to finance the issue of fully paid-up bonus shares of Sh. 10 each to ordinary shareholders.

8.

A new bank loan of Sh. 25,000,000 was received in the year.

Bank interest of Sh. 8,000,000 was also paid in the year.

9.

Current tax liability is in respect of the tax charge for the respective year.

10.

During the year ended 31st October 2017 an interim dividend of Sh. 14,000,000 was paid.

Required: Statement of cash flow in accordance with IAS 7.

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Pg 197

EXERCISE 11. 6 (a)

Briefly explain the objectives and scope of IAS 7 (Cash Flow Statements).

(b)

The following are extracts from the financial statements of Webb Ltd. As at 31 March: 2017

2016

Sh.’000’

Sh.’000’

Non-current assets 2,800

2,900

Freehold land and building

Goodwill

16,800

12,000

Plant and machinery (NBV)

5,860

6,350

Investment at cost

3,600

3,750

29,060

25,000

10,050

8,700

Accounts receivable

6,140

7,800

Investments

1,710

840

Current assets: Inventory

Cash at hand and bank Total assets

200

430

18,100

17,770

47,160

42,770

Equity and liabilities Capital and reserves: 18,000

15,000

Share premium

Ordinary shares Sh. 10

1,500

750

Revaluation reserve

4,500

-

Retained profit

6,150

5,250

30,150

21,000

9,510

9,000

15% debentures

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Introduction to Financial Accounting

Current liabilities Bank overdraft

2,390

6,540

Accounts payable

5,850

5,250

450

380

Proposed dividends Taxation Total Equity and liabilities

820

600

8,590

12,770

47,160

42.770

The Statement of income for the year ended 31 March 2017 is given below: Sh.’000’

Sh.’000’ 2,400

Net profit before tax Less: Corporation tax

900 1,500

Profit after tax Dividends: Interim (paid)

150

Proposed (paid)

450

600 900

The following additional information is provided: 1.

Profit for the year is arrived at after charging: Sh.’000’

Depreciation on plant and machinery Goodwill amortisation

1,150 420

2.

During the year, plant with a net book value of Sh. 750,000 was sold for Sh. 1,470,000. The plant had originally cost Sh. 3,000,000.

3.

The investments portfolio was reduced by selling one block of shares at a profit of Sh. 160,000.

Required: Statement of cash flow in accordance with IAS 7.

Introduction to Financial Accounting

Pg 199

EXERCISE 11. 7 (a)

Briefly explain the importance of a Statement of cash flow to a business entity.

(b)

Bonga Ltd., a medium sized trading company, closes its books every 31 December. Given below are the comparative Statement of financial position for Bonga Ltd. for the years ended 31 March 2016 and 2017.

Statement of financial position as at 31 March 2017

2016

Sh. ‘000’

Sh. ‘000’

Land and buildings

95,000

55,000

Motor vehicles

46,000

35,000

Assets: Non-current assets:

Furniture and fixtures

25,000

28,000

166,000

118,000

Inventory

28,000

20,000

Accounts receivable

14,000

16,000

Current assets:

Prepayments Bank balance and cash in hand Total assets

6,000

8,000

-

3,000

48,000

47,000

214,000

165,000

Equity and liabilities: Capital and reserves: Ordinary share capital

50,000 80,000

Share premium

20,000

15,000

Revaluation reserve

15,000

25,000

Retained profit

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Introduction to Financial Accounting

18,000

15,000

133,000

105,000

Non-current liabilities: 10% debentures

30,000

20,000

Bank loan

6,000

10,000

36,000

30,000

Trade payables

23,000

15,000

Interest payable

9,000

6,000

Current tax

6,000

5,000

Bank overdraft

4,000

-

Current liabilities:

Proposed dividends Total equity and liabilities

3,000

4,000

45,000

30,000

214,000

165,000

The following additional information is provided for the year ended 31 March 2017: 1.

Land and buildings were revalued upwards by Sh. 10,000,000 during the year. In addition, an acquisition of land and building of Sh. 40,000,000 was made.

2.

Depreciation on motor vehicles amounting to Sh. 4,000,000 was provided in the Statement of income for the year. Motor vehicles having a net book value of Sh. 8,000,000 were sold at a profit of Sh. 3,000,000 during the year.

3.

Bonus shares of Sh. 20,000,000 were issued at par during the year by utilizing the revaluation reserve Bongo Ltdâ&#x20AC;&#x2122;s ordinary shares have a par value of Sh. 20.

4.

Interest expense charged to the Statement of income for the year amounted to Sh. 8,000,000.

Introduction to Financial Accounting

Pg 201

5.

During the year, tax amounting to Sh. 6,000,000 was paid.

6.

Total dividends for the year (both interim and proposed) amounted to Sh. 5,000,000.

7.

The profit after tax for the year amounted to Sh. 8,000,000.

Required: Statement of cash flow (in accordance with the requirements of IAS 7) for the year ended 31 March 2017.

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Introduction to Financial Accounting

EXERCISE 11. 8 The following is an extract from the Statement of financial position for the year ended 30 September: 2016 Sh. ‘000’

2017 Sh. ‘000’

Non-current assets 11,040

13,800

Provision for depreciation: Building

Building at cost

(2,070)

(2,415)

Plant and equipment at cost

13,800

23,460

Provision for depreciation: plant & equipment

(6,210)

(8,625)

4,600

5,518

Motor vehicles at cost Provision for depreciation: motor vehicles

(2,070)

(2,932)

19,090

28,806

Inventory

4,140

5,175

Accounts receivable

2,070

2,519

Current assets

Cash in hand and at bank

85

-

7,060

7,694

26,150

36,500

15,800

22,700

Share premium

1,380

2,760

Retained profits

3,450

5,520

Total assets Equity and liabilities Capital and reserves: Ordinary share capital

10% debentures

1,380

-

22,010

30,980

Accounts payable

1,380

2,070

Taxation

1,725

2,070

Dividends

1,035

1,035

Current liabilities

Bank overdraft Total equity and liabilities

345 4,140

5,520

26,150

36,500

Introduction to Financial Accounting

Pg 203

The following is an extract from the Statement of Income for the year ended 30 September 2017: Sh. ‘000’ Profit before taxation

6,210

Taxation for the year

(2,451)

Dividends for the year: Interim – paid Final – proposed

690 1,035

Retained profit for the year

(1,725) 2,070

Additional information: 1.

An item of plant was disposed of during the year ended 30 September 2017 for Sh. 1,035,000. It had cost Sh. 2,070,000 and had an accumulated depreciation of Sh. 690,000.

2.

The 10% debentures were redeemed at a premium of 10% during the year ended 30 September 2017.

Required: Statement of cash flow, in conformity with the requirements of IAS 7, for the year ended 30 September 2017.

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Introduction to Financial Accounting

EXERCISE 11. 9 The following balance sheets were extracted from the books of Joshua Ltd. As at 30 June 2016 and 2017: 2016

2017

Sh. ‘000’

Sh. ‘000’

Non-current assets: Cost

85,000

119,000

(26,000)

(37,000)

59,000

82,000

Inventories

34,000

40,000

Trade receivables

26,000

24,000

Cash at bank

10,000

14,500

70,000

77,500

Total assets

129,000

159,500

26,000

28,000

Share premium

12,000

13,000

Retained earnings

31,000

53,500

69,000

94,500

20,000

10,000

Trade payables

15,000

23,000

Taxation

12,000

15,000

Dividends

13,000

17,000

40,000

55,000

129,000

159,500

Accumulated depreciation Current assets:

Equity and liabilities: Capital and reserves: Ordinary share capital (Sh. 100 per value)

Non-current liability: 10% debentures Current liability

Total equity and liabilities

Introduction to Financial Accounting

Pg 205

Additional Information: 1.

There were no disposals of non-current assets during the year ended 30 June 2017.

2.

Sh. 10 million of the 10% debentures were redeemed on 31 December 2016.

3.

During the year ended 30 June 2017, a dividend of Sh. 17,000,000 was proposed.

4.

Taxation for the year ended 30 June 2017 was agreed at Sh. 15,000,000.

Required: Statement of cash flow for the year ended 30 June 2017, in accordance with the requirements of IAS 7 2018

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CHAPTER TWELVE ACCOUNTING AND INTERNAL CONTROL SYSTEM ACCOUNTING SYSTEMS Per ISA 400 accounting systems refers to the systems and procedures that management has put in place to ensure that the company maintains proper books of accounts. The auditor should ascertain the clientâ&#x20AC;&#x2122;s system of recording and processing transactions and assess its adequacy as a basis for the preparation of financial statements. An accounting system provides for the orderly assembly of accounting information and appropriate analysis to facilitate the preparation of financial statements. The management of an organization requires complete and accurate accounting and other records to assist in: a) Controlling the business b) Safeguarding the assets c) Preparation of the financial statements d) Complying with legislation

INTERNAL CONTROLS If the auditor wishes to place reliance on any internal controls he should ascertain and evaluate those controls and perform compliance tests on their operation. If the clients system is evaluating as being effective, the auditor can rely on these controls and reduce the level of detailed substantive work.

Definition An internal control systems consists of all the policies and procedures (internal controls) adopted by management of an entity to assist in achieving managementâ&#x20AC;&#x2122;s objective of ensuring, as far as practicable the orderly and efficient conduct of its business, including adherence to management policies, safeguarding of assets, the prevention and Introduction to Financial Accounting

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detection of fraud and error, the accuracy and completeness of the accounting records and the timely preparation of reliable financial information. The internal control system extends beyond these matters, which relate directly to the functions of the accounting system.

Control environment ISA 400- Paragraph 8 This refers to the overall attitude, awareness and actions of directors and management regarding the internal control system and its importance in the entity. The control environment has an effect on the effectiveness of the specific control procedures. A strong control environment, for example, one with tight budgetary controls and an effective internal audit function can significantly complement specific control procedures. Factors reflected in the control environment include: a) The function of the board of directors and its committees. b) Managementâ&#x20AC;&#x2122;s philosophy and operating style. c) The entityâ&#x20AC;&#x2122;s organisational structure and methods of assigning authority and responsibility. d) Personnel policies and procedures and segregation of duties.

Importance of the internal control system 1.

Enables management to carry out the business in an orderly and efficient manner. Internal controls lay out the various procedures to be followed in conducting the affairs of the organisation.

E.g. There will be procedures laying out the procedures to be followed in procuring raw materials

2.

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Ensures adherence to management policies

Introduction to Financial Accounting

3.

Management policies vary from the broad objectives to the detailed policy matters necessary to make those objectives realisable.

4.

Safeguard the companyâ&#x20AC;&#x2122;s assets .

Some controls are designed specifically to ensure the assets of the company are protected from theft, destruction and that they are used in the best interest of the company. This can either be directly through physical locking up or indirectly through recording. It includes

assessing assets and ensuring that

any access is authorised. Also ensure that accuracy and completeness of accounts is maintained.

5.

ICS help in ensuring completeness and accuracy of the records maintained. The companyâ&#x20AC;&#x2122;s Act requires that a company keep proper books of accounts. These records are the basis for the preparation of the financial statements.

6.

Strong internal controls help in preventing and detecting errors and frauds. The responsibility for the prevention and detection of fraud and error rests with management. This is achieved through the implementation and continuous operation of an adequate system of internal controls. Such a system reduces but does not eliminate the possibility of fraud and error.

7.

For the auditor a good system justifies a reduction in the level of substantive testing but does not eliminate it fully.

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Types of Internal Controls This refers to the various types of control procedures that management can put in place in running the operations of the company. The mix of types of controls implemented by management will depend on the control objectives in each accounting area.

(a) Organizational plans/controls Companies should have proper organisation plans.

They seek to ensure that the entity is properly departmentalised. The functions of every department are specified and the duties of every individual in the department are specified. Delegation of authority and limits of authority should be well and clearly defined. Such a plan boosts accountability within the organisation and reduces duplication of effort.

(b) Segregation of duties This refers to the separation of the various duties and responsibilities such that one person cannot process and record complete transactions from beginning to the end without being checked by another person.

E.g. in the purchase of a companyâ&#x20AC;&#x2122;s non-current assets a single individual should not authorise the purchase, place the order, receive the asset and record the transaction in the accounting records. To minimise the risk of error and/or intentional manipulation of information.

In this regard for every transaction the following functions should be performed by different individuals and departments as much as possible and practicable.

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1. Initiation 2.

Authorisation- different levels of management should be given authority limits as to what they can authorise or commit the companyâ&#x20AC;&#x2122;s resources. The authority limit should depend on the position, integrity, qualifications and competence.

3. Execution- transactions should be carried out by persons independent from those who authorise the transactions. If one person authorises expenditure a different person should execute.

4.

Custody of the asset- officials authorising/executing a transaction should not have custody to the assets arising out of the transaction.

5. Recording 6.

Segregation of duties also covers internal check which refers to the activities of one person must be complementary to the activities of another or subjected to independent checking.

(c) Physical controls

These are security measures concerned with the custody of assets by limiting access to authorised people only. Restriction of access to valuable assets to only authorised persons. There should be direct measures and indirect measures.

Direct measures include:a) Lock and key b) Watchmen or guards c) Proper fence d) Mirrors e) Closed circuit TVâ&#x20AC;&#x2122;s Introduction to Financial Accounting

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Indirect measures will include documentation of all transactions.

Controls aim at restricting valuable, portable, exchangeable and desirable assets.

(d) Authorisation and approval Authorisation should be done by responsible persons. In other words a transaction that commits organisationâ&#x20AC;&#x2122;s resources should be subject to authorisation and approval by a responsible official. The limits for authorisation should also be specified.

(e) Arithmetical and accounting control.

These are controls within the accounting function, which check that transactions are authorised, correctly and accurately recorded. This is aimed at ensuring completeness and accuracy of the accounting records.

Key features are: i.

Use of standardised documentation raised at every stage of the transaction.

ii. Use of pre-numbered documents. iii. Documents should be issued in sequence. iv. Monitor movement of documents by use of a register. v.

Production of exceptional reports for example when a local purchase order has been raised and the order has not been fulfilled by the supplier.

vi. Reconciliation between the different accounts and related control accounts.

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(f) Personnel Proper functioning of any system is dependent on the competence and integrity of those operating it. The entity must therefore recruit competent staff who have integrity. Staff should be assigned responsibilities that match their capabilities. Staff should undergo proper training to ensure that the companyâ&#x20AC;&#x2122;s operations are carried out in the best way possible.

(g) Supervision Day to day transactions and their recording should be subjected to supervision by competent responsible officials.

(h) Management controls These controls are exercised by management outside the day to day routine of the system. They include: i.

Review of management accounts.

ii. Comparison of actual performance with budgets. iii. Internal audit function. iv. Any other special review procedures. (i) Rotation of duties Duties should be rotated between personnel at the same level. Staff should be encouraged to take annual leave.

(j) Routine and automatic checks.

These are checks conducted on routine duties and operations to ensure that they are operating efficiently. Such checks are conducted on a surprise basis to minimise errors and frauds. These include controls such as surprise cash counts and physical inspection of noncurrent assets.

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(k) Internal audit This is a control function set up by management to review the accounting and internal control systems. Internal audit carries out continuous evaluation of the operating effectiveness of the internal control policies and procedures. The findings and recommendations are reported to management.

Limitations of the internal control system No internal control system, however elaborate, can be by itself guarantee efficient administration and completeness and accuracy of the records nor can it be proof against fraudulent collusion, especially on the part of those holding positions of authority and trust. This is mainly due to the following inherent limitations of an internal control system: a)

Management has to ensure that the benefits expected from an internal control system outweigh the costs. As a result certain important controls might not be put in place due to the costs involved. e.g. a small entity might not have the resources to employ sufficient staff to ensure proper segregation of duties.

b)

Most internal controls tend to be directed towards routine transactions rather than non-routine transactions. This leaves gaps that can be exploited.

c)

Human error due to carelessness, distraction, mistakes of judgement and misunderstanding instructions could undermine the internal control system.

d)

Controls could be circumvented through collusion by a member of management or an employee with persons outside or inside the entity.

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e)

Abuse of responsibility e.g. a member of management overriding an internal control

f)

The possibility that procedures maybe inadequate due to changes in conditions.

Advantages of Internal Control System Advantages of ICS to the Auditor 1.

ICS will reduce the amount of audit work to be done in so far as the auditor will be able to use systems based audits to apply tests which will facilitate his audit work.

2.

A strong ICS will minimise chances of errors and frauds, and the introduction of inter-checking supervision and improved custody will in turn minimise liabilities to third parties, who would have depended on his opinion with greater surety and speed.

3.

Will reduce the amount of audit evidence to be gathered, because it will facilitate reaching and

using a greater

variety of audit evidence available within the business. This will enable him to form an opinion with greater surety and speed.

4.

The presence of an internal check system strengthens the credibility of audit evidence gathered.

5.

ICS minimises the work load and the time need to take in order to produce his report.

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6.

The preparation of an ICS will identify those areas prone to errors and frauds, which will enable the auditor to plan his audit work so that he allocates more time and effort to those areas where for organisational reasons the internal check system is weakest.

7.

ICS emphasises the use of control accounts thus assuring the auditor of up to date account reconciliation information which will facilitate his examinations.

8.

ICS enables him reduce the sample size to be tested and thus facilitate his ability to carry out as many varied audit checks as possible.

9.

ICS can only be strong normally with support of a strong internal audit function which in turn enables the auditor to use internal auditorâ&#x20AC;&#x2122;s work to facilitate his work.

10. A strong ICS boosts accountability which depends on clearly segregated and defined duties and responsibilities and this will enable the auditor to know who to contact in case of difficulties.

11.

It also helps him to give quality advice to management; this in turn may minimise his work load in future audits.

12.

ICS enables the auditor to have greater knowledge of his clientâ&#x20AC;&#x2122;s business and facilitates the drawing up of a balanced audit opinion.

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Disadvantages of Internal Control System Disadvantages of ICS to the Auditor 1.

The management may over rely on the strength of the ICS and therefore relax their supervision which may leave room for errors and frauds thus exposing the auditor to potential civil liabilities.

2.

The presence of ICS may lead to the auditor reducing the volume of examination carried out which may lead to smaller samples of data thus leaving other areas to possibilities of errors and frauds which may expose him to civil liabilities.

3.

It may be frustrated by management through collusion and manipulation which may mislead the auditorâ&#x20AC;&#x2122;s opinion leading to biased reports.

4.

The presence of ICS is supposed to minimise the auditorâ&#x20AC;&#x2122;s volume of tests but not his liabilities which means that its strength may leave some errors and frauds undetected due to relaxed tests.

This will increase his liabilities. ICS may be manipulated so that errors and frauds by the management cannot be easily detected and this may lead to a biased opinion.

5.

ICS may reduce the auditorâ&#x20AC;&#x2122;s vigilance and observations with an unfavourable effect on the quality of the audit.

6.

ICS may be abused by the internal auditors through collusion with the management and this may lead to the external auditor being mislead.

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Advantages of ICS to the Client 1.

Safeguarding clientâ&#x20AC;&#x2122;s assets against:

a) Misuse b) Misappropriation c) Manipulations d)

Abuse of the Companyâ&#x20AC;&#x2122;s assets (for reasons that will not benefit the Company)

e)

Facilitates optimal use of the Companyâ&#x20AC;&#x2122;s assets.

2.

Reduces audit fees. This is because less audit work is needed and less audit staff.

3.

Increased efficiency through management supervision and a defined organisation chart. Routine and automatic checks also increase efficiency.

4.

Chances of errors and frauds are minimised.

5.

This ensures minimum losses, facilitates audit work and hence early reports and attainment of budgeted performance.

6.

Facilitates corrective measures in so far as the objectives of the business are better defined and therefore the facilities available can be suitably directed to their achievements.

7.

Facilitates up to date records.

8.

This is advantageous in that is prompts decisions through feed back to management which helps detect irregularities.

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Introduction to Financial Accounting

9.

Leads to balanced opinion (unqualified report) improving public opinion of the business.

10.

This helps in raising finances by selling shares through public sale and improving investment implementation.

11.

It boosts morale of staff through motivation of supervision. This may lead to high output and high profitability.

12. ICS helps in the redress of disastrous decisions especially in high risk situation. This is done through close application of management controls in development situations.

13. ICS assists in the co-ordination of operations. This is done through definition of duties and responsibilities of all employees and it boosts efficiency in the: a) Carrying out of operations, b) Efficiency in delegation, c) Efficiency in execution.

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Disadvantages of ICS to the Client 1.

ICS is expensive to install and maintain.

For example, the

physical control security systems require qualified personnel to maintain them and constant servicing.

2.

ICS could lead to a problem of over reliance on the ICS. This may lead to relaxation in supervision and allow manipulation of accounts and assets and can also bring about inefficiencies.

Maintaining controls requires constancy and consistency.

3.

If not well instituted it may encourage over staffing.

4.

Rigid implementation may lead to a slow down in the operation of the business.

5.

The ICS requires continuous updating as the organisation changes, if not the ICS may become increasingly obsolete.

6.

Use of wrong controls may expose the Company to more problems, e.g. errors and frauds.

These are more easily

perpetrated if the ICS used is inappropriate.

7.

ICS may be frustrated if through changes in company organisation the checks become uncoordinated.

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Introduction to Financial Accounting

ADDITIONAL EXERCISES EXERCISE 13. 1 Okemos Enterprises Ltd is a medium sized company operating in Industrial area, Mombasa. The company’s accountant has extracted the following unadjusted trial balance for the period ended 31 December 2017.

in ‘000

Land

20,000

8,500

Building

In ‘000

Machinery

34,000

Furniture

38,000

ordinary share

80,000

Provision for depreciation : Machinery

12,000

Provision for depreciation : Furniture and Fiittings

15,000

10% Debenture

18,000

Retained profit

4,261

Inventory Purchases/Sales Account receivable/payable Bank

11,520

198,120

55,790

38,740

Carriage in

250

Carriage out

310

Provision for doubtful debts

140,200

430

2,100

Salaries

29,120

Wages

11,220

Water

2,540

Bad debts expense

760

Returns

342

198

Debenture interest

1,350

Drawings

6,400

General expenses

8,954

Discounts TOTALS

469

876

369,725

369,725

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Additional information 1)

The general expense include an amount of Sh. 235,000 for insurance which relates to the four months ending February 2018

2)

December 2017 wages unpaid by 11th January 2018 were Sh. 675,000

3)

Inventory on 31.12.2017 were valued at Sh. 10,970, 000

4)

Depreciation is to be provided on the furnitute and fitting at 15% using the normal reducing method

5) Depreciation is to be provided on the Machinery at 12% using the straight line method 6)

The provision for doubtful debts is to be provided at 10% of accounts receivables.

7)

Debenture interest for the last quarter year had not been paid

8)

A sales and purchase invoice of Sh. 312,000 and Sh. 198,000 had been recorded twice

Required: (a) Show your workings (b)

Prepare adjusted trial balance

(c)

Statement of income

(d)

Statement of financial position

(e)

Statement of changes in equity

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EXERCISE 13. 2 Durbar Enterprises Ltd is a medium sized company operating in Industrial area, Mombasa. The company’s accountant has extracted the following unadjusted trial balance for the period ended 31 December 2017.

in ‘000

Land

22,000

In ‘000

Building

12,000

Machinery

28,000

Furniture(cost Sh. 44 Million)

24,000

ordinary share

Provision for depreciation : Machinery

8,000

Provision for depreciation : Furniture and Fiittings

12,000

10% Debenture

12,000

4,261

Retained profit Inventory Purchases/Sales Account receivable/payable Bank

11,530

75,000

137,112

189,843

54,900

42,720

269

Carriage in

178

Carriage out

208

Provision for doubtful debts

1,780

salaries

37,140

Wages

5,680

Water

1,056

Bad debts expense

450

Returns

154

Debenture interest

600

Drawings

2,500

General expenses

8,954

Discounts TOTALS

189

565

965

347,027

347,027

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Additional information 1)

The general expense include an amount of Sh. 115,000 for insurance which relates to the four months ending March 2018.

2)

December 2016 wages unpaid on 7th January 2018 were Sh. 435,000.

3)

Inventory on 31.12.2016 were valued at Sh. 12,790, 000.

4)

Depreciation is to be provided on the furnitute and fitting at 12.5% using the normal

5)

reducing method.

Depreciation is to be provided on the Machinery at 8% using the straight line method

6)

The provision for doubtful debts is to be provided at 10% of accounts receivables.

7)

Debenture interest for the last half year had not been paid.

8)

A sales invoice of Sh. 280,000 had been recorded twice.

9)

A purchase invoice of Sh. 176,000 had not been recorded .

Required: (a) Show your workings (b) Prepare adjusted trial balance (c) Statement of income (d) Statement of financial position (e) Statement of changes in equity Pg 224

Introduction to Financial Accounting

EXERCISE 13. 3 Nyali reef ltd is a medium sized company operating in Industrial area, Mombasa. The companyâ&#x20AC;&#x2122;s accountant has extracted the following trial balance as at 31st December 2017. in Sh. Bank

in Sh.

341,000

Account receivable/account payable

1,520,000

426,000

Purchases/Sales

2,750,000

6,500,000

Inventory

1,200,000

Retained profit

520,000

General reserves

1,100,000

6% debenture

1,000,000

Ordinary shares (Sh. 2 each)

2,000,000

Plant and equipment

2,720,000

Provision for depreciation: plant &

223,000

equipment Furniture and fitting

870,000

Provision for depreciation: furniture and

57,000

fittings Provision for doubtful debts

100,000

Salaries and wages

440,000

Water and electricity

200,000

Director fees

600,000

General expenses

350,000

Advertising expense

206,000

Distribution expense

459,000

Audit fees

250,000 11,906,000

11,906,000

Additional information a)

Salaries and wages for the month of December 2017 of Sh. 40,000 had not been paid Introduction to Financial Accounting

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b)

Provision for doubtful debts to be maintained at 10% of account receivable

c)

The general expenses included an amount of Sh. 50,000 paid as insurance premium for next year

d)

Plant and equipment is estimated to have a useful life if 20 years and is depreciated on a straight line method.

e)

Furniture and fittings is estimated to have a useful life if 10 years and is depreciated on a straight line method.

f)

Inventory on 31.12.2017 were valued at Sh.1,500,000

g)

The directors have also agreed to transfer Sh.150,000 profit to the general reserves

h)

Debenture interest for the year had not been paid

i)

An sales invoice of Sh. 150,000 done on 31.12.20117 had not been booked.

j)

The directors have decided to provide for dividends of Sh. 0.20 per ordinary shares

Required a) Statement of Statement of income b) Statement of shareholdersâ&#x20AC;&#x2122; equity c) Statement of financial position as at that 31.12.2017 (20 marks

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Introduction to Financial Accounting

EXERCISE 13. 4 Mwamba Traders is a medium sized company operating in Industrial area, Mombasa. The company’s accountant has extracted the following trial balance as at 31st December 2017.

Sh.‘000

Sh.‘000

Bank

1,380

Account receivable/account payable

2,560

1,840

17,400

29,600

Purchases/Sales Inventory

2,150

Retained profit

2,060

General reserves

3,900

10 % preference shares (Sh. 50 each)

3,000

14% debenture

12,000

3 million ordinary shares (Sh. 5 each)

15,000

Plant and equipment

30,000

Accumulated depreciation plant &

6,000

equipment Free hold land

12,000

Provision for doubtful debts

100

Salaries and wages

4,290

Water and electricity

190

Debenture interest

840

Director fees

570

Interim dividends- ordinary shares 5 %

750

Interim dividends- Preference shares 4 %

140

General expenses

520

Advertising expense

200

Drawings

510 73,500

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73,500

Pg 227

Additional information a)

Salaries and wages for the month of December 2017 of Sh. 510,000 had not been paid

b)

Provision for doubtful debts to be maintained at 5% of account receivable

c)

The general expenses included an amount of Sh. 50,000 paid as insurance premium for next year

d)

Plant and equipment is estimated to have a useful life if 10 years and is depreciated on a straight line method.

e)

Inventory on 31.12.2017 were valued at Sh. 1,954,000

f)

The directors have decided to provide for final dividends of 5% on ordinary shares and the balance due to preference shares

g)

The directors have also agreed to transfer Sh. 150,000 to the general reserves

h)

Debenture interest for the second half of the year had not been paid

i)

An sales invoice of Sh. 250,000 done on 31.12.2017 had not been booked.

Required a) Statement of Statement of income b) Statement of shareholdersâ&#x20AC;&#x2122; equity c) Statement of financial position as at that 31.12.2017

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EXERCISE 13. 5

HK Ltd has prepared its draft trial balance to 30 June 2017, which is shown below.

Sh.000 Freehold land

Sh.000

102,100

Freehold buildings (cost Sh. 4,680,000)

4,126

Plant and machinery (cost Sh. 3,096,000)

1,858

Fixtures and fittings (cost Sh. 864,000)

691

Goodwill

480

Accounts receivables

7,263

Accounts payables

2591

Inventory

11,794

Bank

11,561

Profit on sale of freehold land

621

Sales

381,600

Purchases

218,979

Administration expenses

9,000

Distribution costs

35,100

Directors’ emoluments

562

Bad debts

157

Auditors’ remuneration

112

Hire of plant and machinery

2,400

Loan interest

605

Dividends paid during the year – preference

162

Dividends paid during the year – ordinary

426

9% loan

7,200

Share capital – preference shares

3,600

Share capital – ordinary shares

5,400

Retained earnings

6,364

Total

407,376

407,376

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The following information is available: (a)

The issued share capital is 4,000,000 9% preference shares of Sh. 0.9 each18,000,000 ordinary shares of Sh. 0.20 each.

(b)

Provide for depreciation at the following rates:(i) Plant and machinery 20% on cost; (ii) Fixtures and fittings 10% on cost; (iii) Buildings 2% on cost

(c) Provide income tax at 30 % (d)

The loan was raised in September 2016 and

outstanding

interest has not yet been accrued at the year-end. e)

A final ordinary dividend of Sh.0.3 per share is declared and was an obligation before the year-end, together with the balance of the preference dividend. Neither dividend was paid at the yearend.

f)

Provided for doubtful debts at 2 % of accounts receivable

g)

Administration expenses includes Sh. 180,000 premium for the period ended October 2017

h)

Closing inventory is Sh. 9.5 million.

Required: a) Statement of income b) Statement of financial position c) Statement of changes in equity

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EXERCISE 13. 6 Toshiba Enterprises Ltd is a medium sized company operating in Industrial area, Mombasa. The company’s accountant has extracted the following unadjusted trial balance for the period ended 31 October 2017.

Accounts

Sh.‘000

Premises

34,000

Machinery (cost Sh. 78Million)

70,000

Furniture (cost Sh. 44 Million)

32,000

Ordinary share @ Sh. 10

Sh.‘000

50,000

10% Preference shares @ Sh. 100

10,000

9% Debenture

12,000

General Reserves

6,900

4,330

Retained profit Inventory Purchases/Sales Account receivable/payable Bank

11,530

137,112

259,843

54,680

42,530

299

Carriage in

106

Carriage out

168

Provision for doubtful debts Administration cost Operating cost

1,640

42820

1878

Bad debts expense

370

Returns

112

Debenture interest

810

2,000

interim dividends:ordinary (4%)

144

interim dividends:preference (5%)

500

Discounts

550

950

388,636

388,636

TOTALS

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Additional information 1)

The operating cost include an amount of Sh. 56,000 for insurance which relates to the four months ending January 2018 while  October 2017 salaries were paid on 5th November 2017 for Sh. 387,000

2)

Inventory on 31.10.2017 were valued at Sh. 11,890, 000

3)

Depreciation is to be provided on the furniture and fitting at 15% using the normal reducing method and to Machinery at 10% using the straight line method.

4)

The directors have decided to provide a final dividend of 6% on the ordinary shares and the balance due to the preference shares. They have also decided to

transfer profits of Sh. 1

million to General reserves.

5)

The provision for doubtful debts is to be provided at 5% of accounts receivables.

6)

The company usually makes annual provisions of Sh. 450,000 and Sh. 3 million for audit and directors fees respectively.

7)

Debenture interest for the last quarter had not been paid

8)

A sales and purchase invoice of Sh. 180,000 and Sh. 95,000 respectively had been recorded twice

9)

Corporation tax rate is 30%

Required: a) Show your workings b) Prepare adjusted trial balance c) Statement of income d)

Statement of financial position

e) Statement of changes in equity Pg 232

Introduction to Financial Accounting

EXERCISE 13. 7 Nafuu Foods Ltd. is a company in the hospitality industry. The following trial balance has been extracted from its books on 31 October 2017:

Sh.’000’

Revenue

Sh.’000’ 816,160

Cost of sales

401,000

Wages and salaries

186,440

Adversing expenses

95,860

Insurance expenses

1,180

Directors’ fees

960

Ordinary share ; 5,200,000 shares of Sh. 20

104,000

each Retained Profit ; 1 November 2016

77,600

10% debenture loan

160,000

Share premium

18,000

Capital redemption reserve

56,400

Accounts receivable/payable

63,860

Bad debts expenses Audit fees

400

Interest on loan

13,900

Depreciation expense

17,300

Accruals

900

Interim dividends paid

26,000

Freehold land and buildings

164,600

Leasehold land and buildings (over 50 years)

125,600

Leasehold land and buildings (under 50 years)

51,900

Furniture and equipment

85,600

Inventory

46,400

Prepayments

61,520

240

720

Bank balance

2,820

Investments

9,800

______

294,580

294,580

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Pg 233

You are provided with the following additional information: 1.

The balances of non-current asset accounts as at the beginning of the year and additions during the year were as follows: Cost or

Accumulated

Additions

valuation

depreciation

during the year

1 November 2016 Sh.’000’ Freehold land and buildings Leasehold land and

Sh.’000’

Sh.’000

157,000

-

7,600

1,800

-

3,800

60,200

5,800

-

150,800

52,200

1,800

buildings (Over 50 years) Leasehold land and buildings (Under 50 years) Furniture and equipment

2.

The company does not provide for depreciation on freehold properties or properties held on lease with 50 years or more.

Properties held on lease with less than 50 years to run are depreciated and equipment are depreciated at 10% straight line.

3.

Some of the leasehold property in the books costing Sh. 7,500,000 had less than 50 years remaining on the lease in October 2016 and has not yet been transferred to the under 50 years category.

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4.

Disposals during the year included the following: Cost Sh.`000’

Freehold land and buildings

3,600

Leasehold under 50 year

2,300

Accumulated

Sale

depreciation

proceeds

Sh.`000’

Sh.’000.’

4,800

1,700

960

No adjustment has been made on disposed assets.

4.

Freehold land was revalued on an existing use basis by a professional valuer but the surplus of Sh. 6,000.000 has not yet been brought into account.

5.

Additional audit fees of Sh. 600,000 need to be provided for and outstanding interest on loan need to be paid

6.

The corporation tax for the year’s profit has been estimated at Sh. 27,000,000.

7.

The directors have decided to recommend a final dividend of Sh. 5 per ordinary share.

Required: a) A schedule showing non-current assets movements for the year ended 31 October 2017. b)

Statement of income for the year ended 31 October 2017.

c)

Statement of financial position as at 31 October 2017.

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EXERCISE 13. 8 The following balances were extracted from the books of Upendo Ltd for the year ended 31st December 2017.

Sh.â&#x20AC;&#x2122;000 Ordinary shares

120,000

8% preference shares

40,000

Inventory 31.12.2017

83,852

Accounts receivable

27,200

Bank

7,796

10% Debentures

16,000

General reserves

28,000

Gross profit

81.508

Bad debts Salaries and wages Insurance

340 28,200 1,410

Telephone expenses

620

Electricity expenses

1,216

Debentures interest

800

Directors fees

2,500

General expenses

3,108

Motor vehicle-Cost

29,100

Provision for depreciation-Motor vehicles

22,300

Office equipment-Cost

44,640

Provision for depreciation-Motor vehicles

12,100

Land

100,000

Building-Cost

32,200

Accounts payable

13,722

Provision for depreciation-Building Retained Profit -1.1.2017

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5,100 24,252

Additional information 1.

Accrued electricity expenses as at 31st December 2017 amounted to Sh. 548,000

2.

The amount for insurance includes a premium of Sh. 300,000 paid in September 2017 to cover the company for six months from 1st October 2017 to 31st march 2018.

3.

4.

5.

Depreciation is to be provided as follows: •

Office equipment at 15% per annum straight line

•

Motor vehicles at 20% per annum reducing balance

•

Building at 2% per annum straight line

Provision are to be made for : •

Directors fees at Sh. 5,000,000

•

Audit fees at Sh. 1,200,000

•

Outstanding debenture interest

•

Doubtful debts at 5%

•

Taxation at 30%

The directors have recommended the following; •

Sh. 12,000,000 be transferred to general reserves

•

Dividend on preference shares be paid

•

Payment 10% dividend on ordinary shares

Required: a) Show your workings b) Prepare adjusted trial balance c) Statement of income d)

Statement of financial position

e) Statement of changes in equity Introduction to Financial Accounting

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EXERCISE 13. 9 Toshiba Enterprises Ltd is a medium sized company operating in Industrial area, Mombasa. The company’s accountant has provided you with the following account balances.

Sh. ‘000

Land

Sh. ‘000

20,000

8,500

Machinery

34,000

Furniture

38,000

Building

Ordinary share

80,000

Provision for

12,000

depreciation:Machinery Provision for depreciation:Furniture

15,000

10% Debenture

18,000

Retained profit

4,261

Inventory Purchases/Sales Account receivable/payable Bank

11,520

198,120

55,790

38,740

Carriage in

250

Carriage out

310

Provision for doubtful debts

140,200

430

2,100

salaries

29,120

Wages

11,220

Water

2,540

Bad debts expense

760

Returns

342

198

Debenture interest

1,350

Drawings

6,400

General expenses

8,954

Discounts TOTALS

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469

876

369,725

369,725

Additional information a)

The general expense include an amount of Sh. 235,000 for insurance which relates to the four months ending April 2018

b)

December 2017 wages unpaid by 31 December were Sh. 675,000

c)

Inventories on 31.12.2017 were valued at Sh. 10,970, 000

d)

Depreciation is to be provided on the Furnitute and fitting at 15% using the normal reducing method

e)

Depreciation is to be provided on the Machinery at 12% using the straight line method

f)

The provision for doubtful debts is to be provided at 10% of accounts receivables.

g)

Debenture interest for the last quarter year had not been paid

h)

A sales and purchase invoice of Sh. 312,000 and Sh. 198,000 had been recorded twice

Required i.

Prepare the Statement of income

ii. Prepare the Statement of shareholders equity iii. Prepare the Statement of financial position

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REFERENCES Collier, P. M. (2003). Accounting for Managers: Interpreting accounting information for decision-making, Electronic ed. England: John Wiley & Sons Ltd Duchac, J. E., Reeve, J. M & Warren, C. S. (2007). Financial Accounting: An Integrated Statements Approach, 2nd Ed., Electronic ed. USA: Thomson South-Western Edwards, J. D, Tull J. M. & Hermanson, R. H. (2016). Accounting Principles: A Business Perspective, Volume 1, Electronic ed. USA: Endeavour International Corporation, Elliott, B. & Elliott, J. (2011). Financial Accounting and Reporting.

14th ed., Electronic ed. New York:Pearson Education Limited Fabozzi, F. J. & Peterson, P. P. (2003). Financial statement analysis, 2nd Ed, Electronic ed. New Jersey: John Wiley & Sons Horngren, C. T, Harrison Jr. W. T. & Oliver M. S. (2012). Financial and Managerial Accounting, 3rd Ed. US: Prentice-Hall.

Libby R, Libby P. A. & Short,

D. G. (2005), Financial Accounting,

4th Ed. US: McGraw-Hill Pandey, I. M. (2000). Financial Management, 9th Ed. Bombay: Vikas Publishing House Pvt. Ltd. Wood, F. & Sangster, A. (2008). Business Accounting 2, 11th ed.

England: Pearson education:

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ABOUT THE AUTHOR DR. MORRIS I. KARIUKI, BAM, MBA (FINANCE), CPA(K), CPS(K), Ph.D. M. I. Kariuki is currently a lecturer at the Department of Finance and Accounting, University of Nairobi. He is a graduate of Egerton University. He received his MBA from Kenyatta University and his Ph.D from the Jomo Kenya University of Agriculture and Technology. He is a Certified Public Accountant (CPA) of Kenya and Certified Public Secretary (CPS) of Kenya. He is a member of the Institute of Certified Public Secretary of Kenya (ICPSK). He taught under the Teacher Service commision (TSC) from 1995 to 1998. He has also served as an Accountant, Senior accountant and Finance manager in three different companies in Nairobi, Oloitokitok and Arusha. He has also served as partime lecturer at Chuka University.

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