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ABM312 Financial Accounting 2015 Module
ABM312 Financial Accounting 2015 Module
FINANCIAL ACCOUNTING
(ABM312)
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Contents
ABOUT THIS TRAINING MODULE.................................................................................................. iv
Chapter 1................................................................................................................................................. 1
Scope of accounting and book-keeping .............................................................................................. 1
What is accounting? ........................................................................................................................ 1
Objectives of accounting................................................................................................................. 1
Uses and users of accounting information ..................................................................................... 2
Accounting principles ...................................................................................................................... 2
Equality of an accounting equation .................................................................................................... 3
The fundamental of accounting equation ...................................................................................... 3
Chapter 2................................................................................................................................................. 8
Double entry book-keeping ................................................................................................................ 8
The double entry system ................................................................................................................ 8
Effects of transactions on the basic accounting equation (BAE) .................................................... 9
Double entry for assets and interest .............................................................................................. 9
Double entry for expenses and revenue....................................................................................... 12
Basic format of a balance sheet .................................................................................................... 15
Chapter 3............................................................................................................................................... 18
Information processing ..................................................................................................................... 18
Accounts, debts and credits .......................................................................................................... 18
The journal .................................................................................................................................... 20
The general ledger ........................................................................................................................ 22
Posting........................................................................................................................................... 23
The trial balance............................................................................................................................ 25
Suspense accounts and errors ...................................................................................................... 30
Debits equals credits ..................................................................................................................... 36
Components of the financial results (income statement) of a trading concern........................... 36
Inventory system........................................................................................................................... 36
Value Added Tax ........................................................................................................................... 39
Chapter 4............................................................................................................................................... 44
Financial statements ......................................................................................................................... 44
Computerized processing systems................................................................................................ 45
T-accounts ..................................................................................................................................... 45
Control and subsidiary accounts ................................................................................................... 46
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Chapter 5............................................................................................................................................... 46
Adjustment, process and related entries.......................................................................................... 46
Illustration of prepaid insurance ................................................................................................... 46
Prepaid rent .................................................................................................................................. 46
Supplies ......................................................................................................................................... 46
Depreciation.................................................................................................................................. 47
Unearned revenue ........................................................................................................................ 48
Accruals ......................................................................................................................................... 49
Chapter 6: Cash flow statement ........................................................................................................... 51
Chapter 7: Financial ratio analysis ........................................................................................................ 55
Categories of financial ratios ............................................................................................................ 56
Analysing liquidity............................................................................................................................ 58
Analyzing activity ............................................................................................................................. 60
Analysing debt .................................................................................................................................. 62
Analysing profitability ...................................................................................................................... 65
A complete ratio analysis .................................................................................................................. 67
Chapter 8: The Cash Budget.................................................................................................................. 67
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ABOUT THIS TRAINING MODULE
The Module titled “FINANCIAL ACCOUNTING” is offered only to Agricultural Business Students
(ABM) in their Third year. It is meant to prepare these students to handle FINANCIAL matters that
relating to FINANCES of the modern world. The module teaches finances from such basics as basic
tasks of basic bookkeeping and, measures of financial statements, taxes, depreciation, cash flows,
financial statements, and cash budgets.
The aim of this module is to equip you with knowledge of the fundamental principles of financial
accounting, with clear emphasis on short term financial accounting principles and practices.
Target Groups
This Module is intended for use by financial managers in any financial planning and decision
making; manager who need financial knowledge in analysing the major financial problems facing
businesses of all sizes , Student of financial management to better understand the problems facing the
business environment.
The ideal number of trainees is 15-20 when they come for their residential school. A slightly
larger audience can be taken on but ideally should not exceed 30 people per session.
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ASSESSMENT
This module is divided into 7 sections. Each section addresses some of the learning outcomes. You
will be asked to complete various tasks so that you can demonstrate your competence in achieving the
various outcomes.
Assessment methods
Under this module, you will have two assignments and one continuous assessment test. You will write
the first assignment and a test during your residential school following the beginning of a trimester.
These make up your continuous assessment (CA) which contributes 30% of your final mark in the
course.
Each assignment will contribute 5% of the final mark (10% for the two assignments)
The continuous assessment test will contribute 20% of the final mark.
A written examination set by the college at the end of the trimester will contribute 70% of the
final mark.
LEARNING TIPS
Duration:
You will most likely to take about 40 hours to work through this module. This includes the time you
will spend on the activities and self-help questions.
Study activities:
In this module a variety of examples and exercises are given. You should do these examples and
exercises by yourself also and compare your attempt with the solutions given in the module and
requested answers for exercise. It also contains self-evaluation questions, to encourage your active
participation in the learning process. These are combination of reading, studying, doing and thinking
activities that are presented in a flexible manner. This will enable you to absorb the knowledge
content of the topic, to practice tour understanding and to direct your thoughts.
This is important because as you encounter these study activities and actually perform them, you will
become directly involved in controlling the extent and the quality of your learning experience. In
short, how much and how well you learn, will depend on the extent of your progress through the study
activities, and the quality of your effort.
In cases where examples and exercise are given, the questions should be answered without reference
to the study material. You should then mark your answer against the answer given in the study
module. Where your answer differs from that given in the study module, ask yourself why? How?
Where? What did I do wrong? If more than 25% is incorrect, try again to answer the question without
referring to the study module or your previous attempt.
It will be necessary for you to contact us by phone for various consultations. As such enquire from the
program coordinator regarding the telephone numbers that you may have to call. You can also come
to college whenever you are in Lusaka or if you live in Lusaka. In addition, you will be advised
(during your residential school) regarding contacting your lecturers or tutors by e-email. However feel
free to contact your lecturer whenever you experience problems.
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Use of financial calculators
As a financial management student, we would advise you to use a financial calculator to perform most
of the calculations in this course. Please ensure that you acquire one.
Email: dkatebe@yahoo.com
Cell: 0966162357
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Chapter 1
Scope of accounting and book-keeping
What is accounting?
Accounting can be defined as the orderly and systematic recording of the monetary values of the
financial transaction of an individual or business enterprise, the reporting of the results of these and the
provision of financial information by submitting financial statements as a basis for decision making.
Identifying – selecting those events that are considered evidence of economic activity
(transactions) relevant to a particular business.
Recording the monetary value of the economic events in an orderly and systematic manner.
Communications of recorded information to interested users, through the preparations of and
distribution of accounting reports such as financial statement (e.g. income statement,
statement of changes in equity, balance sheet and cash flow statement).
Accounting is something that we do every day both individually and severally. Accounting is done both
by small firms and big firms.
When we plan how much money to spend, how much to save, we are using accounting knowledge.
Accounting is therefore financial decision making based on knowledge. Some knowledge is written
down whereas some is held in the subconscious memory.
Objectives of accounting
Accounting has many objectives; including letting people and organizations know:
However, the primary objective of accounting is to provide information for decision making.
Book-keeping is that part of accounting that concerned with recording data. Up until the beginning of
the last century, a lot of accounting was recorded in books, hence the term book-keeping. Nowadays
the bulk of accounting is recorded using computers, but the term book-keeping still exists.
In short accounting is concerned with the uses derived from information and data kept by a book-
keeper.
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Uses and users of accounting information
Accounting principles
The techniques in practice of accounting are based on conceptual and theoretical ideas. These ideas are
generally known as accounting principles. The following are the more important principles:
a) The accrual principle – any transaction or event that that take place has an influence of the
financial position of a business enterprise. According to accrual principle, transaction or event
must be recorded in the financial period in which it occurs irrespective of when the cash is
received or paid.
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b) The principle of consistency – once a specific basis, method, procedure or approach has been
chosen, it must be maintained. Users of financial information usually compare the performance
of an enterprise from one period to the next, and if the policies were not consistent, these
comparisons would not be valid. Consistency does not prevent an enterprise from changing its
policy but if a policy is changed, it must be disclosed in the financial statements.
c) The prudence principle – when there is uncertainty about the value of an element or event
(assets, liabilities, income and expenses). The principle of prudency must be applied. This means
that the preparers of financial statements must be conservative in their approach to these
uncertainties and use the value which has the most unfavorable effect on the equity of the
enterprise.
d) The principle of materiality – require that all material transactions and events should be
disclosed separately in the financial statements as these could influence decision makers.
Immaterial amounts need not be disclosed separately, but must be grouped with amounts of a
similar nature.
e) The matching principle – is based on the accrual principle. Income and expenses incurred in
generating that income must be brought into account during the same financial period. This
means that expenses which are incurred in producing income must be matched against that
income in the same financial period.
f) The realization principle – income is brought into account as soon as it has been earned and
realized. For income to be realized, the collectability of the income must be reasonably certain,
and it must be measurable. The same principle applies to expenses.
Since the interests are represented by assets, the assets must be equal to interests. The two sides of the
equation must therefore be equal to each other.
An owner begins a business and deposit K10, 000 as opening capital in the enterprise’s bank account.
The financial position of the enterprise will be as follows:
ASSETS INTERESTS
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Net worth
The difference between the value of assets owned by an enterprise and the liabilities it has incurred
represents net worth. If we express this as an equation, then
Net worth represents the portion by which the assets exceed the liabilities. Net worth is therefore also
called equity.
Assets and interest are the two elements which make up an entity’s financial position. These concepts
are defined briefly below.
Assets are possessions of the entity. In accounting terms possessions are referred to as assets.
Interests consist of funds supplied by either the owner or creditors. These funds are used by the
business to acquire necessary assets. These are two types of interested parties, namely owners and
creditors.
Equity represents the interest which the owner has in the business. It is personal money or assets which
he or she has invested in the enterprise. We can also see it as the amount which the enterprise owes
the owner. In other words, these are funds which have been obtained from the owner. It is sometimes
called net assets because it is equivalent to assets minus liabilities for a particular business. Who are the
owners? The answer depends on the legal form of an entity; examples of entity types include: Sole
proprietorship, partnership and corporation.
A sole proprietorship is a business owned by one person and its equity would typically consist of a
single owner’s capital account.
Partnership is a business owned by more than one person with its equity consisting of separate capital
account for each partner.
Finally a corporation is a very common entity form with its ownership interest being represented by
divisible units of ownership called shares of stock. These shares are easily transferable, with the current
ownership of the stock being the owners. The total owner’s equity of a corporation usually consist of
several amounts generally corresponding to the owner investment in the capital stock (by shareholders)
and additional amounts generated through earnings that have not been paid out to shareholders as
dividend (dividends are distributed to shareholders as return on the their investment). Earnings give rise
to increase “in retained earnings” while dividends and losses decreases.
Liabilities are creditors’ interests or interest of parties other than the owner. We also speak of the
enterprise’s debt. Liabilities may be loans which have been entered into and which are available to the
enterprise over the long term or the short term. Liabilities may also be debts arising from the purchase
of assets on credit.
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is worth according to those accounting records. The whole of financial accounting is based upon this
very simple idea. It is known as the accounting equation.
If the business is to be set up and start trading it will need resources. Let’s assume first that it is the
owner of the business who has supplied all of the resources. This can be shown as:
Capital = Assets
Usually people other than the owner have supplied some of the resources (assets). Liabilities are the
name given to amounts owing to those people for these assets.
Capital = Assets – Liabilities
This is how the accounting equation is presented. The two sides of the equation will have the same
totals. To see clearly the value of assets in the business (resources) you can switch assets and capital
around.
Assets = Capital + Liabilities
With what we have leant about assets and interests we can now present the equations as follows:
A–L = E (1) or
A = E+L (2)
Where A = Assets
L = Liabilities
E = Equity (Capital)
Equation (2) is normally used and is called the basic accounting equation or BAE.
Assets = Interests
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Example
The asset of Tembo Services amount to K30, 000 and its liabilities (creditors) to K5000. Calculate the
equity. We use the BAE. The amounts which are given are substituted for the appropriate symbol and
the unknown symbol is calculated.
A = E + L
E = A - L
E = K30, 000 - K5, 000
E = K25, 000
Example
Mr James Kamana is the owner of Zebra Services which offers a carpet cleaning services. On 30th
November 2009 Zebra Services owns equipment amounting to K100, 000, clients owes K40, 000 for
services and Zebra Services owes K20, 000 to a supplier for parts purchased. Zebra services also have
K10, 000 in cash in the bank.
Show the BAE for Zebra Services and determine the equity.
A = E + L
E = A - L
E = K (100,000 + 40,000 + 10,000) – K20, 000
E = K130, 000
The accounting equation is expressed in a financial position statement called the balance sheet. The
balance sheet shows the financial position of an organization at a point in time. It represents a snapshot
of the organization at the date for which it was prepared.
Zebra services financial position can also be represented in form of a balance sheet as follows:
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The double entry principle
The double entry principle is based on the fact that every transaction affects two or more items in the
BAE. In principle it means that each transaction must be recorded in such a way that the equation
remain in balance. The dual effect which each transaction has on the elements of the BAE is the
fundamental principle on which all entries in an accounting system are based.
To determine the net profit or net loss which the enterprise has made, an income statement is
compiled which shows the income the enterprise has earned during a specific period and the
expenditure it has incurred in earning this income. If the enterprise income is more than its
expenditure, it is making a profit. If its expenditure is greater than its income, the result is a loss. This
gives us the following equation.
Income
The income, objective of every enterprise is to earn as large an income as possible. The following are
the examples of income: fees earned (for services rendered), sales (e.g. in a commercial enterprise),
rent income, commission income, interest income, dividend income, discount received, profit on the
sale of an asset and bad debts recovered.
Expenditure
Expenditure is incurred to earn income. The following are examples of expenditure: purchase of
inventory, carriage on purchases, customs and exercise duty, carriage on sales (delivery costs), salaries
and wages, stationery, repairs, petro, water and electricity bills, telephone and advertisements,
postage, rent expenses, assessment rates, insurance, bank charges, interest, bad debts and discount
allowed.
A E L
Capital + Income -
Expenditure
Example
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A = E + L
K50, 000 = K30, 000 + K20, 000
For the year ended 28 February 2010 he had the following income and expenditure:
Chapter 2
Double entry book-keeping
To make a double entry correctly, you need a good working knowledge of the appropriate names for
different things in accounting and particularly the concepts of “debit” and “credit”. It is very important
that you master this study since it explains the foundation on which the accounting system is build.
Think about the effect of the transaction is going to be on the BAE, in other words, how it is
going to affect the financial position of the enterprise (the balance sheet).
Identify the components (accounts) which are involved, that is the components which will have
the desired effect on the equation.
Determine which accounts have to be debited and which accounts have to be credited.
Be sure that the amounts debited are equal to the amounts credited.
Be able to indicate the date of the transaction.
Indicate the name of the contra ledger account in the account in which you are doing the entry.
The contra account is the other account which is involved in the transaction: the one account
refers to the other.
Indicate the folio number of the subsidiary journal.
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Effects of transactions on the basic accounting equation (BAE)
A transaction is an agreed upon transfer of value from one party to another which affects (changes)the
amount, nature or composition of an enterprise’s assets, liabilities or equity. In other words it affects
the BAE. Entering into transaction gives rise to the first step in the accounting cycle, namely the
completion of a source document.
1. Capital contributions
Transaction K Chanda decided to start a carpet cleaning business called FIX-n-Mat. He
1 February 2010 withdrew K130,000 from his personal savings account and deposited it in
Fix-n-Mart’s bank account.
Analysis 1) The asset “Bank” increases by K130, 000 and there is now money in
FIX-n-Mat’s bank account.
2) The owner, K Chanda, provides Fix-n-Mat with funds and increases
his interest in Fix-n-Mat. The equity “capital” increases by K130,
000.
Comments
In an organization which has not yet entered into any transaction, the elements of the equation
will always be 0.
The terms “bank” and “bank” in the analysis are actually names of accounts.
The investment of capital is usually the first transaction.
Capital may be contributed in the form of cash or any other asset (e.g. furniture), “furniture”
instead of “bank” will then increase.
The BAE balances after the transaction.
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2. Acquisition of loan
Transaction Fix-Mat obtained a loan of K25, 000 with a payback period of more than a
2 February 2010 year from Barclays Bank. The amount was paid into its bank account.
Comments
The result of the first transaction forms the balance which is brought down in this
transaction.
Liabilities arise when another party or institution supplies funds (make loans) to the
enterprise.
Amounts (in this case K25, 000) are added to both the left hand side and the right BAE.
The BAE balances after the transaction.
Analysis 1) The asset “Bank” decreases by K100, 000 since money has been
withdrawn.
2) The asset “equipment” increases.
Comments
Asset now consists of bank and equipment.
The left hand side of the equation increases and decreases. One asset is exchanged for
another asset.
The BAE balances after the transaction.
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Transaction Fix-n-Mat bought furniture for K2,000 on credit from Joc Limited
10 February 2010
Comments
Assets may also be bought on credit and a creditor comes into being.
The transaction is recorded when it is entered into and not when the payment is made.
The left hand side and the right hand side of the BAE increases
The BAE balances after the transaction.
5. Payments to creditors
Transaction Fix-n-Mat paid Joc Limited’s account of K2,000
11 February 2010
Comment
The right hand side and the left hand side of the BAE decreases
The BAE balances after the transaction.
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Analysis 1) Fix-n-Mat’s “Bank” decreases by K1, 000
2) The “capital” at decreases by K1,000.
Comments
Withdraws are the opposite of capital contributions and reduces capital, remember withdraws
are not expenditure.
Where the enterprise pays a personal expense of the owner’s, it is also treated as a withdrawal.
The left hand side and the right hand side of the BAE are reduced.
The BAE balances after the transaction.
Comments
Income earned increases the equity. It is the objective of the enterprise to earn income for the
entrepreneur.
The left hand side and the right hand side of the BAE increase.
The BAE balances after the transaction.
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8. Expenditure (cash)
Transaction Fix-n-Mat paid wages by cheque K800
16 February 2010
Comments
In essence expenditure incurred decreases income and therefore also decreases the
equity.
The left hand side and the right hand side of the BAE decreases.
The BAE balances after the transaction.
9. Income (credit)
Transaction Fix-n-Mat provided services worth K6,000 to C Canon on credit.
18 February 2010
Comments
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Organizations or clients who owe money to an enterprise are known as debtors and
arise from rendering goods or services on credit.
The left hand side and the right hand side of the BAE increases.
The realization principle applies here, and the income is shown as having been earned when the
service was provided and not when the cash is received.
Comments
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This transaction
-K2,000 0 0 +K2,000 0 0 0 0
New balance K6,000 K2,000 K100,000 K54,200 = K129,000 K6,000 K25,000 K200
Comments
The effect of each of these eleven accounting transaction upon the two sections of the balance sheet is
shown below:
Current liabilities
Creditors 200
160,200 160,200
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Comments
The balance sheet balances and shows the same totals as the BAE.
Note the heading – the balance sheet is prepared to reflect the financial position on a specific
sate.
The withdrawals are subtracted from the capital. As mentioned, withdrawals are not an
expenditure item.
A summary of the effect upon assets, liabilities and capital of each type of transaction you have been
introduced to so far is shown below.
Activity 1
1. Show the effect of the following transactions on the balance sheet. Show effect upon asset,
liability and capital.
i) On 1 May 2007, B Banda started a business and deposited K60, 000 into a bank account
opened for the business.
ii) On 3 May 2007, B Banda buys a small shop for K32, 000 paying by cheque.
iii) On 6 May 2007, B Banda buys some goods for K7, 000 from D. Mwale and agrees to pay
for them sometime within the next two weeks.
iv) On 10 May 2007, goods which cost K600 were sold to J Tembo for the same amount,
the money to be paid later.
v) On 13 May 2007, goods which cost K400 were sold to D Lungu for the same amount.
Lungu paid for them immediately by cheque.
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vi) On 15 May 2007, Banda pays a cheque for K3, 000 to D Lungu in part payment of the
amount owing.
vii) J Tembo who owed Banda K600 makes a part payment of K200 by cheque on 31 May
2007.
4. B Busiku is setting up a new business. Before actually selling anything, he bought fixtures for K1,
200, a van for K6, 000 and an inventory of goods for K2, 800. Although he has paid in full for the
fixtures and the van, he still owes K1, 600 for some of the inventory. B Mwenda rent him K2,
500. After the above B Busiku has K200 in the business account and K175 cash in hand. You are
required to calculate his capital.
5. G Mwamba has the following items in his balance sheet as on 30 April 2005. Capital K18,400,
accounts payable K2,100, fixtures K2,800, car K3,900, inventory K4,550, accounts receivable,
K2,780, cash at bank K6,250, cash at hand K220.
During the first week of May 200
a) He bought extra inventory for K400 on credit
b) One of the debtors paid him K920 by cheque
c) He bought a computer by cheque K850
You are required to draw up a balance sheet as on 7 May 2008 after the above transaction have been
completed.
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Chapter 3
Information processing
Accounts, debts and credits
Accounts
The records that are kept for the individual asset, liability, equity, and revenue and dividend component
are known as accounts.
The business would maintain an account for cash, another account for investment and so forth every
other financial statement element. All accounts collectively are said to compromise a firm’s general
ledger.
In annual processing system you could imagine the general looking more than a note book with a
separate page for every account. Thus you could number through the note book to see the “ins” and
“outs” of every account as well as existing balances.
Example of an account
This account reveals that cash has a balance of 63,000 as of January 12, by examining you can see
transactions that caused increases and decreases to the 50,000 beginning of month cash balance. If you
were to prepare a balance sheet on January, this could include cash for the indicated amount and so for
each of the other assets.
Instead of saying cash has “increased” or “decreased” we say that cash is “debited” or “Credited”.
Why use the complexity and not best use plus and minus for debits and credits.
Every transaction can be described debit/credit and for every transaction, debits=Credits.
The facility of “+/-“ Nomenclature) increase/decrease), let’s take this example; if services are provided
to customers for cash, bot cash and revenue would increase (a “+/+” outcome). On the other hand,
paying an account payable causes a decrease in cash and a decrease in account payable (a “-/-
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“outcome). Finally some transactions are a mixture of increase/decrease effects using cash to buy land
causes cash to decrease and land to increase (a “-/+” outcome).
Assets/expenses, dividends
Debits increases this account and credit decreases this account. These accounts normally carry a debit
balance.
Liability/revenue/equity
These three types of accounts follow rules that are opposite of those just described above. Credits
increase liabilities, revenues and equity, while debits results in decreases. These accounts normally carry
a credit balance.
Then, debits and credits are applied to the accounts, utilizing the rules set forth in the proceeding
paragraphs.
A recordable transaction will be evidenced by some “source documents” that supports the underlying
transaction. A cash disbursement will be supported by the issuance of a cheque. A sale might be
supported by an invoice issued to a customer. Receipts maybe retained to show the reason for a
particular expenditure. A time report may support payroll costs. A tax statement may document the
amount paid for taxes. A cash register tape may show cash sales. A bank deposit slip may show
collection of customer receivables. Suffice to say there are many potential source documents and this is
just a small sample.
Source documents serve as a trigger for initiating the recording of a transaction. The source documents
are analyzed to determine the nature of a transaction and what accounts are impacted.
Source documents should be retained as an important part of the records supporting the varies debits
and credits that are entered into the account reports.
There are many safe guards that can be put in place to avoid transactions go unrecorded, that include
use renumbered documents and regular reconciliations.
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The cash account presented earlier is repeated below with more traditional debit/credit column
headings.
Account: Cash
Date Description Debit Credit Balance
Jan 1, 2013 Balance B/F 50,000
Jan 2, 2013 Collected receivables 10,000 60,000
Jan 3, 2013 Cash sales 5,000 65,000
Jan 5, 2013 Paid rent 7,000 58,000
Jan 7, 2013 Paid salary 3,000 55,000
Jan 8, 2013 Cash sales 4,000 59,000
Jan 8, 2013 Paid bulls 2,000 57,000
Jan 10, 2013 Paid tax 1,000 56,000
Jan 12, 2013 Collected receivables 7,000 63,000
The journal
Most everyone is intimidated by new terminology (like debits, credits, journals). What do you know
about the journal (not an accounting journal, just any journal)? It’s just a logbook, right? A place where
you can record a history of transactions and events usually in date (chronological) order.
An accounting journal is just a logbook that contains chronological listing of a company’s transactions
and events, the journals lists items by a “firm” of short hand notation?
Specifically the notation indicates the accounts involved and whether each is debited or credited. The
system must be sufficient to fuel the preparation of the financial statements and be capable of
maintaining retrievable documentations for each and every transaction.
The general journal is sometimes called the book of original entry. This means that source documents
are retrieved and interpreted as to the accounts involved. Then they are documented in the journal via
their debit/credit format.
The journal is not sufficient by itself to prepare financial statements. The objective is fulfilled by
subsequent steps. But maintaining the journal is the point of beginning toward the end objective.
Special journals
All transactions and events can be recorded in the general journal. However the business may use
“special journals”. Special journals are totally optional; they are typically employed when there are
many redundant transactions.
The business could have special journals, for each of the following; cash receipt journal, cash payment
journal, sales journal, purchases journal, sales return journal, purchases return journal. These special
journals do not replace the general journal. Instead they just strip out recurring type of transactions and
place them in their own separate journals. The transaction description associated with each transaction
found in the general journal is not normally needed in a special journal, given that each transaction is
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redundant in nature. Without special journals, you could well imagine how voluminous a general journal
could become.
Page numbering
Although the journal is chronological, it is helpful to have the page number indexing for transactions
cross referencing and working backward from financial statement amounts to individual transactions.
The general journal is a great tool to capture transactions and events details, but it does nothing to tell a
company about the balance in each specific account. A better way is needed. This is where general
ledger comes into play.
Let’s analyze and record the following transactions into the general journal:
i) On Jan 1, 2013 James Phiri General Dealer issued stock to shareholders in exchange for cash
amounting to K25, 000.
ii) On Jan 4, 2013 Carried out advertisement in a local Newspaper for K2,000.
iii) On Jan 4, 2013, offered services to a customer for cash K4,000.
iv) On Jan 15, 2013, received a bill from a utility company (Zesco) K1,000.
v) On Jan 17, 2013, provided services to a customer on credit K8,000.
vi) On Jan 18, 2013, paid half of the amount due to a utility company (ZESCO).
vii) On Jan 25, received 60% of the amount due on the receivable that was established on Jan
17, 2013.
viii) On Jan 28, 2013, purchased land by giving K5,000 cash and promising to pay the remainder
in 90 days.
General journal Page 1
Date Accounts Debit Credit
Jan 1, 2013 Cash 25,000
Capital 25,000
Issued stock to shareholders in exchange for
cash
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General journal Page 2
Date Description Debit Credit
Jan 15, Utilities expenses 1,000
2013 Accounts payable 1,000
Received bill for utility costs incurred
In contrast, the general ledger is in essence another notebook that contains a page for each and every
account in use by a company. The ledger for Mukombwe would include the cash page as shown below:
Account : Cash
Date Description Debit Credit Balance
Jan 1, 2013 Balance brought forward -
Jan 1, 2013 Journal page 1 25,000 25,000
Jan 4, 2013 Journal page 1 2,000 23,000
Jan 8, 2013 Journal page 2 4,000 27,000
Jan 18, 2013 Journal page 2 500 26,500
Jan 25, 2013 Journal page 2 4,800 31,300
Jan 28, 2013 Journal page 2 5,000 26,300
- Cash
22
- Accounts receivables
- Land
- Accounts payable
- Notes payable
- Capital stock
- Source revenue
- Advertising expense
- Utilities expense
Therefore Mukombwe Corporation’s general ledger will include a separate page for each of these nine
accounts.
Posting
We are going to determine the balance of each account by posting. To do this we will copy (post) the
entries listing in the journal into their respective ledger accounts.
In other words, the debits and credits in the journal will be accumulated (“transferred/sorted”) into the
appropriate debits and credits columns of each ledger page.
Notice that arrows are drawn to show how the first journal entries posted. A similar process would
occur for each of the other accounts.
In reviewing the ledger accounts at the right, notice that the “description” column includes a cross
reference back to the journal page in which the transaction was initially recorded.
This reduces the amount of detailed information that must be recorded in the ledger and provides an
audit trial back to the original transaction in the journal.
23
cash Jan 28 Journal page 2 15,000 15,000
24
by giving 5,000 Jan 4 Journal page 1 2,000 2,000
cash and
promising to pay
the remainder in
90 days
Account : Utilities expense
Activity 2
Enter the following transactions into the general journal and then post to the general ledger for James
Banda using T- accounts.
The trial balance always has the date of the last day of the accounting period to which it relates. It is a
snapshot of the balances on the ledger accounts at that date.
Following is a trial balance prepared from the general ledger of Munkombwe Corporation.
25
Mukonmbwe’s Corporation
Trial Balance
Debits Credits
Cash 26,300
Account receivable 3,200
Land 15,000
Accounts payable 500
Notes payable 10,000
Capital stock 25,000
Service revenue 12,000
Advertising expenses 2,000
Utility expenses 1,000
47,500 47,500
When transactions are entered in our ledger using this rules, then when we extract the trial balance, the
totals of the two columns would be the same.
Types of errors
1. Error of omission – where a transaction is completely omitted from the books. If we sold K90
goods to John, but did not enter it in either the sales account or John’s personal account, the
trial balance would still balance.
2. Error of commission – this type of error occurs when the correct amount is entered but in the
wrong account, e.g. where a sale of K11 to C Green is entered in the account of K Green.
3. Error of principle – where an item is entered in the wrong class of account, e.g. if purchase of
fixed asset, such as a van is debited to an expense account, such as motor expenses account.
4. Compensating errors – where errors cancel each other out. If the sales account was added up to
be K10 too much and the purchases account was also added up to be K10 too much, then these
two errors would cancel out in the trial balance. This is because the totals of both the debits and
credits side of the trial balance will be overstated by K10.
5. Errors of original entry – where the original figure is incorrect, yet double entry is correctly done
using the incorrect figure. Where a sale should have totaled K150 but an error is made in
calculating the total on the sales invoice. If it were calculated as K130, and a K130 were credited
as sales and K130 debited to the personal account of the customer, the trial balance would still
balance.
6. Complete reversal of the entries – where the correct accounts are used but each item is shown
on the wrong side of the account. Suppose we had paid a cheque to D Williams for K200, the
26
double entry of which should be debit D Williams K200, Credit bank K200. In error it is entered
as debit Bank K200, credit D Williams K200. The trial balance totals will still balance.
7. Transposition errors – where the wrong sequence of the individual characters within a number
was entered (for example, K142 entered instead of K124). This is a common type of error and is
very difficult to spot when the error has occurred in both the debit and credit entries, as the
trial balance would still balance.
Correction of errors
Most errors are found after the date on which they are made. When we correct errors, we should not
do so by crossing out items, tearing out accounts and throwing them away, or using chemicals to make
the writing disappear.
1. Error of omission
A sale of K59 worth of goods to E George has been completely omitted from the books. We must
correct this by entering the sale in the books. The journal entry for the correction is:
The journal
Dr Cr
K K
E George 59
Sales 59
2. Error of commission
A purchase of K44 worth of goods from C Simons on 4 Sepetmber was entered in error in C Smpson’s
account. The error was found on 30 September. To correct this, it must be cancelled out of C Smpson’s
account and entered where it should be (in C Simon’s account). The journal entry will be:
The journal
Dr Cr
K K
C Smpson 44
C Simons 44
C Smpson
Sept 30 C Simons: Error 44 Sep 4 Purchases 44
corrected
C Simons
27
Sept 30 Purchases:
Entered originally in C
Simpson’s account
3. Error of principle
The purchase of machine for K200 is debited to purchases account instead of being debited to
machinery account. We therefore cancel the item out of the purchases account by credited that
account. It is then entered where it should be by debited the machinery account.
The journal
Dr Cr
K K
Machinery 200
Purchases 200
Correction of error: purchase of fixed asset debited to purchases account
4. Compensating error
In the cash book, the amount of cash sales transferred to the sales account was oversted by K20 and the
amount transferred to the wages account was also overstated by K20. The trial balance therefore still
balances.
The journal
Dr Cr
K K
Sales 20
Wages 20
Corrections of two overcasts of K20 posted from cash book to the sales account and wages account
which compensated for each other.
28
M Dickson
Cash 16
M Dickson
Cash 16
We can see that we have to enter double the original amount to correct the error.
Cash
M Dickson 16 M Dickson 32
M Dickson
Cash (error corrected) 32 M Dickson 16
Overall, when corrected, the K16 debit and K32 credit in the cash account means there is a net credit of
K16, similarly, Dickson’s account shows K32 debit and K16 credit, a net debit of K16. As the final (net)
answer is the same as what should have been entered originally, the error is now corrected.
The journal
Dr Cr
K K
M Dickson 32
Cash 32
Payment of cash K16 debited to cash and credited to M Dickson in error on …. Error now corrected
7. Transposition error
A credit purchase from P Maclaran costing K56 was entered in the books as K65. The K9 error needs to
be removed.
The journal
Dr Cr
K K
P Maclaran 9
Purchases 9
Correction of error whereby purchases were overcasted by K9
Activity
1. Show the journal entries necessary to correct the following errors:
a) A sale of goods for K412 to T More had been entered in T Mone’s account.
b) The purchase of a machine on credit from J Frank for K619 had been completely omitted
from our books.
c) A sale of K120 to B Wood had been entered in the books, both debit and credit, as K102.
29
d) A purchase of goods for K372 had been entered in error on the debit side of the drawings
account.
e) Purchases of goods K1182 had been entered in error in the furnishing account.
f) A sale of fittings K320 had been entered in the sales account.
g) A cash withdrawal from the bank K200 had been entered in the cash column on credit side
of the cash book and in the bank column on the debit side.
2. After preparing its draft final accounts for the year ended 31 March 2006 and its draft balance
sheet as at 31 March 2006 a business discovered that the inventory lists used to compute the
value of inventory as at 31 March 2006 contained the following entry:
Inventory Number Cost per unit Total cost
Y 4003 100 K1.39 K1390
Required
Suspense account
We should try hard to find errors when trial balance totals are not equal. When such errors cannot be
found, the trial balance totals can be made to agree with each other by inserting the amount of the
difference between the two totals in a suspense account.
Example
Dr Cr
K K
Totals after all the accounts have been listed 100,000 99,960
Suspense 40
100,000 100,000
30
To make the two totals the same, a figure of K40 for the suspense account has been shown on the credit
side of the trial balance. A suspense account is opened and the K40 difference is also shown there on
the credit side.
Suspense
2008 K
Dec 31 Difference per trial balance 40
Correction of errors
When errors are found they must be corrected using double entry. Each correction must forst have an
entry in the journal describing it, and then be posted to the accounts concerned.
Credit sales account to show item where it should have been: K40.
Sales
2009 K
March 31 Suspense 40
The journal
Dr Cr
2009 K K
March 31 Suspense 40
Sales 40
Correction of undercstting of sales by K40 last year
31
Example
The trial balance at 31 December 2007 showed a difference of K77, being a shortage on the debt side. A
suspense account is opened, and the difference of K77 is entered on the debit side of the account. On
28 February 2008 all the errors from the previous year were found.
a) A cheque of K150 paid to K Kent had been correctly entered in the cash book, but had not been
entered in Kent’s account.
b) The purchases account had been undercast by K20
c) A cheque of K93 received from K Sand had been correctly entered in the cash book, but had not
been entered in the sand’s account.
These three errors resulted in a net error of K77, shown by the debit of K77 on the debit side of the
suspense account. These are corrected as follows:
L Kent
2008 K
February 28 Suspense a) 150
Purchase
2008 K
February 28 Suspense b) 20
K Sand
2008 K
February 28 Suspense c) 93
Suspense
2008 K 2009 K
January 1 Balance b/d 77 February 28 L Kent a) 150
February 28 K Sand c) 93 28 Purchases b) 20
170 170
The journal
Dr Cr
2008 K K
Feb 28 L Kent 150
Suspense 150
Cheque paid omitted from Kent’s account
28 Purchases 20
Suspense 20
Undercasting of purchases by K20 in last year’s accounts
28 Suspense 93
K Sand 93
Cheque received omitted from sand’s account
32
Note: Only errors which make the trial balance totals different from each other can be corrected using a
suspense account.
K Davis
Income Statement for the year ending 31 December 2005
K K
Sales 180,000
Less Cost of goods sold:
Opening inventory 15,000
Add Purchases 92,000
107,000
Less Closing inventory (18,000)
(89,000)
Gross profit 91,000
Add Discounts received 1,400
92,400
Less Expenses:
Rent 8,400
Insurance 1,850
Lighting 1,920
Depreciation 28,200
(40,370)
Net profit
52,030
current liabilities
Accounts payable 14,000
33
Capital
Balance as at 1.1.2005 46,250
Add Net profit 52,030
98,280
Less Drawings (31,700)
Total equity and liabilities 80,580
Example
Assume that the K80 debit balance on the suspense account was because of the following error:
On 1 November 2005 we paid K80 to a creditor T Monk. It was correctly entered in the cash book. It was
not entered anywhere else. The error was identified on 1 June 2006.
The journal
Dr Cr
2006 K K
June 1 T Monk 80
Suspense 80
Payment to T Monk on 1 November 2005 not entered in his account.
Correction now made.
Both of these accounts appeared in the balance sheet only with T Monk as part of account payable. The
net profit of K52,030 does not have to be changed.
Example
Assume that the K80 debit balance was because the rent account was added up incorrectly. It should be
shown as K8,480 instead of K8,400. The error was identified on 1 June 2006. The journal entries to
correct it are:
The journal
Dr Cr
2006 K K
June 1 Rent 80
Suspense 80
Correction of rent undercast last year
Rent last year should have been increased by K80. This would have reduced net profit by K80. A
statement of corrected profit for the last year is now shown.
34
K Davis
Statement of corrected Net Profit for the year ended 31 December 2005
K
Net profit per the financial statements 52,030
Less Rent undercasted (80)
Corrected net profit for the year 51,950
Note: Error (D) is know as error of transposition; as the correct numbers have been included but in the
wrong order, i.e. they have been transposed; it did not affect the trial balance, so it is not included in
the K80 adjustment made by opening the suspense account.
The entries in the suspense account and the journal entries will be as follows:
Suspense Account
2006 K 2006 K
January 1 Balance b/d 80 March 31 Sales A) 90
March 31 E Silva C) 50 31 Purchases B) 40
130 130
The journal
Dr Cr
2006 K K
March 31 Sales 90
Suspense 90
Sales overcast of K90 in 2005
31 Insurance 40
Suspense 40
Insurance expense undercast by K40 in 2005
31 Suspense 50
E Silva 50
Cash received omitted from accounts receivable account in 2005
31 Creditor’s account 36
Purchases 36
Credit purchase of K59 entered both as debit and credit as K95 in 2005
Note: Remember that in (D), the correction of the overstatement of purchases does not pass through
the suspense account because it did not affect the balancing of the trial balance.
35
Now we can calculate the corrected net profit for the year 2005. Only items A), B) and D) affect figures
in the income statement. These are the only adjustments to be made to profit.
K Davis
Statement of corrected Net Profit for the year ended 31 December 2005
K
Net profit per the financial statements 52,030
Add Purchases overcasted D) 36
52,066
Less Sales overcast A) 90
Insurance undercast B) 40
(130)
51,936
Corrected net profit for the year
Error (C), the cash not posted to an accounts receivable account, did not affect profit calculations.
You should also be aware that a balanced trial balance is no guarantee of correctness. For example
failing to record a transaction, recording the same transaction twice or posting an account to the wrong
account would produce a balanced trial balance (but incorrect).
Gross profit
This is the difference between sales and the “cost price of sales”. The relevant accounts are closed off
to the trading account.
Net profit
This is the amount which remains from the gross profit after all expenditure necessary to manage the
business has been subtracted and other income has been added. These income and expenditure
accounts are closed off and transferred to the profit and loss account.
Inventory system
Depending on the nature of the business, the type of merchandise sold and the level of computerization
in the business, a business can either use a perpetual (continuous) inventory system or a periodic
inventory system.
36
With a perpetual inventory system the business will keep a continuous track of inventory levels for the
different inventory items it sells. This method is ideally suited to a business that sells items that can be
easily identified, measured and a value attached to them. The use of scanners and bar codes enables
many businesses to apply this method of inventory recording.
If the business sells items that cannot be easily identified, measured or have a value attached to them
(for example goods sold by a café) the business could use the periodic inventory system.
37
Cr Inventory (an asset is decreased- less inventory because of goods returned)
As a result of the above procedure it should be clear that under periodic inventory system, the cost of
sales is not determined at the time of the recording of the sale. The cost of sales can thus only be
determined at the end of the financial period after a physical inventory count has been done.
The cost price of inventory sold during an accounting period will thus bet determined as follows:
Cost price of inventory at the beginning of the financial year (closing inventory of previous year)
Add: Cost price of inventory purchased during the financial year. (this is the total amount spent on
purchases)
Less: Cost price of inventory at the end of the financial year, determined by a physical inventory count.
(This is unsold inventory)
The accounting entries associated with a periodic inventory system can be summarized as follows:
38
Dr Inventory (an asset account which is created with inventory on hand at the end of
financial year)
Cr Trading account (nominal account which is used to determine the gross profit and which
increases equity if a gross profit is made)
The concept underlying VAT is that tax is paid by the ultimate consumer of the goods or services but
that everyone in the supply chain must account for and settle up the net amount of VAT they have
received in the VAT tax period. If they have received more in VAT than they have paid out in VAT, they
must send that difference to ZRA. If they have paid out more than they have received, they will
reimbursed the difference.
Goods pass through at least two sellers (the manufacturer and the retailer) before they are finally sold
to the consumer. These intermediate-stage VAT payments will be cancelled out when the final stage in
the chain is reached and the good or service is sold to its ultimate consumer.
(6) Retailer
Manufacturer (2) Retailer pays pays K3.50
K117.50
39
6. The amount of VAT paid for the goods by the retailer to the manufacturer (K17.50) is deducted
from the VAT received by the retailer from the customer (K21) and the difference of K3.50 is
then sent to ZRA.
Only the ultimate consumer has actually paid any VAT. Unfortunately, everyone in the chain has to
send the VAT charged at the step when they were in the role of seller.
In theory, the amount received in stages by ZRA will equal the amount of VAT paid by the ultimate
consumer in the final stage of the supply chain.
Imagine that trader A (a farmer) sells some of the plants they have grown to the general public.
The full amount of VAT has fallen on the person who finally buys the goods. The seller have merely
acted as unpaid collectors of the tax for Zambia Revenue Authority.
The value of goods and services supplied by a business is known as the outputs. VAT on such items
is called output tax. The value of goods bought in and or services supplied to a business is known as
the inputs. The VAT on these is, therefore called input tax.
Output Tax minus Input Tax = amount payable/refundable, i.e. the amount payable to Zambia
Revenue Authority or the amount that can be claimed from Zambia Revenue Authority.
To grasp the concept of VAT, work through the following exercise thoroughly.
to make calculations easy for teaching purposes and because the real percentage of VAT tend to
change , we use 10% for our calculation of VAT.
The following information relates to Rundu Dealers, who is registered as a VAT vender and who use
the periodic inventory system:
40
262635 262635
7 Received a cheque from W Wolf for K561 in full settlement of his account.
Received a cheque from L Lion for K737 and allowed K33 discount.
12 Received an account from Stationers Ltd for the printing of documents, K759.
13 Credit sales:
- L Lion K2178
- W Wolf K1584
14 Sold an old type writer to O Old for K297 and received his cheque for the
amount due.
21 Issued a credit note to L Lion for an overcharge on the invoice of the 13th K55.
29 Issued cheques for salaries and wages, K5746 and for purchases K7700.
Required
41
Amount received from cash sales
5 T Tiger/Creditor Control 2310
Bank 2200
VAT Input 100
Discount Received 10
Paid T Tiger and received a discount of K110
7 Bank 561
Discount Allowed 20
VAT Output 2
W Wolf/Debtor Control 583
Received payment from W Wolf and allowed a
discount
7 Bank 737
Discount Allowed 30
VAT Output 3
L Lion/Debtor Control 770
Received a cheque from L Lion and allowed a
discount
12 Printing 690
VAT Input 69
Stationers Ltd/Creditor control 759
Account received for printing
13 L Lion/Debtor Control 2178
Sales 1980
VAT Output 198
Credit sales
13 W Wolf/Debtor Control 1584
Sales 1440
VAT Output 144
Credit sales
14 Bank 297
Equipment 270
VAT Output 27
Sold Old typewriter for cash and received a cheque
14 Bank 6600
Sales 6000
VAT Output 600
Cash sales
21 Sales return 50
VAT Output 5
L Lion/Debtor Control 55
Credit note to L Lion for invoice overcharge
23 Carriage on purchase 1030
VAT Input 103
Bank 1133
Paid C Cheetah for carriage on goods purchased
28 Purchases 12750
VAT Input 1275
T Tiger/Creditor Control 14025
Received credit invoice for goods purchased
29 Salaries/Wages 5746
42
Bank 5746
Issued cheques for salaries and wages
29 Purchase 7000
VAT Input 700
Bank 7700
Issued cheque for purchases
30 T Tiger/Creditor Control 770
Purchases returns 700
VAT Input 70
Issued debit notes for goods returned to T Tiger
31 ZRA: VAT 4782
VAT Input 4782
Transfer of VAT Input to Zambia Revenue Authority:
VAT account
31 VAT Output 5243
ZRA: VAT 5243
Transfer of VAT Output to the Zambia Revenue
Authority: VAT account
NB: The last two accounts can only be done after the VAT Input account and the VAT Output
account in the general ledger have been completed. It is in fact the balances of these two accounts
that are transferred to ZRA: VAT account.
RUNDU DEALERS
General ledger
Dr VAT Input Cr
2004 K 2004 K
March Balance 2715 March 31 Creditors control 10
1 Bank 803 Creditors control 70
31 Creditors control 1275 ZRA: VAT 4782
Creditors control 69
4862 4862
Dr VAT Output Cr
2004 K 2004 K
March Debtors Control 5 March 1 Balance 2925
31 Debtors Control 5 31 Bank 1986
ZRA: VAT 5243 Debtors control 342
5253 5253
Dr ZRA: VAT Cr
2004 K 2004 K
March VAT Input 4782 March 31 VAT Output 5243
31 Balance 461
5243 5243
2004
43
April 1 Balance b/d
461
A cheque must be issued to the Zambia Revenue Authority for this amount before the due date.
Chapter 4
Financial statements
Financial statements from the trial balance
The basic process is transfer amounts from the general ledger to the trial balance, then into the
financial statements.
Munkombwe’s Corporation
Income Statement
For year ending January 31, 2013
Revenue 12,000
Services to customers
Expenses
Advertising 2,000
Utilities 1,000 3,000
Munkombwe’s Corporation
Statement of changes in equity
For year ending January 31, 2013
Capital at the beginning – January 1, 2013 25,000
Plus: Net income 9,000
Less: Dividend -
Capital at the end – January 31, 2013 34,000
Munkombwe’s Corporation
Balance Sheet
January 31, 2013
ASSETS
Cash 36,300
Accounts receivable 3,200
Land 15,000
TOTAL ASSETS 44,500
EQUITY AND LIABILITIES
STOCKHOLDERS’ EQUITY
Capital stock 25,000
Retained earnings 9,000
Stockholder’s equity 10,500
44
LIABILITIES
Accounts payable 5,000
Notes payable 10,000
Total liabilities 34,000
TOTAL LIABILITIES AND EQUITY 44,500
Attempt to simplify and automate data entry (e.g. point of sale terminal may actually become a date
entry device so that sales are automatically “booked” into the accounting system as they occur).
Frequently divide the accounting process into modules related to functional areas such as
sales/collections, purchasing/payments and payments.
Attempts to be “user friendly” by providing data entry blanks that are easily understood in relation to
the underlying transactions.
Attempt to minimize key strokes by using “pick lists” automatic call-up functions and auto complete
type technology.
Are built on database logic allowing transactions data to be sorted and processed based on any query
structure (e.g. produce an income statement.) for July; provide listing of sales to customer Smith, etc.)
Provide up-to date data that may accessed by key business decision makers.
Are capable of producing numerous specialized reports in addition to the key financial statements.
After the data are input, the subsequent processing (posting, etc.) is totally automated.
Despite each product own look and feel, the persons primarily responsible for the maintenance and
operation of the accounting function must still understand accounting basics; such as accounts, debits,
credits and journal entries, without this intrinsic knowledge the data decisions will quickly go astray and
the output of the accounting system will become hopelessly trashed.
T-accounts
A useful tool for demonstrating certain transactions and events is the T – account. Importantly one
would not use T – accounts for maintaining the accounts of the business. They are just a quick way to
figure out how a small number of transactions and events will impact a company. They are useful
communication devices to discuss, illustrate and think about the impact of transactions.
The physical shape of a T – account is a “T” and debits are on the left and credits on the right. The
balance is the amount by which the debits exceed credits or vice versa. Below is a T – account for cash
for the transaction and events of Munkombwe.
Dr Cash Cr
25,000 2,000
4,000 500
4,800 5,000
45
Balance C/D 26,300
33,800 33,800
Balance b/d 26,300
Chapter 5
Prepaid rent
A prepaid expense is an expense which has been paid during the current financial period, where all or
part of the expense relates to a future period.
Assume a two month lease is entered and rent paid in advance on March 1, 2011, for K3000. The
following entry would be needed to record the transaction on March 1.
Journal
Date Account Debit Credit
March 1, 2011 Prepaid rent 3000
Cash 3000
Prepaid a two month lease
By March 31, 2011 half of the rental period has lapsed. If financial statements were to be prepared at
the end of March, an adjusting entry to record rent expense and reduce prepaid would be needed on
that financial statement date.
Journal
Date Account Debit Credit
March 31, 2011 Rent expense 1500
Prepaid rent 1500
To adjust prepaid rent for portion lapsed
(3,000/2=1,500)
As the results, the income statement for March would report rent expense of K1,500 and balance sheet
at March 31, would report prepaid rent K1500(K3000 debit lessK1500 credit). The remaining K1,500
prepaid amount would be expensed in April. The prepaid amount is a temporary asset on the date of
the balance sheet under current assets.
Supplies
The initial purchase supplies are recorded by debiting supplies and crediting cash. Supplies expense
should subsequently be debited and supplies be credited for the amount used. This results in supplies
46
expense on the income statement being equal to the amount of supplies used, while the remaining
balance of supplies on hand is reported as an asset on the balance sheet.
The following illustrates the purchase of K900 of supplies; subsequently K700 of this amount is used,
leaving K200 of supplies on hand in the supplies account.
Journal
Date Account Debit Credit
Dec 8, 2011 Supplies 900
Cash 900
To record purchase of supplies
Dec 31, 2011 Supplies expense 700
Supplies 700
Adjusting entry to reflect supplies
If additional K1000 of supplies is purchased during 2012 and the ending balance at Dec 31, 2012 is
physically counted at K300, then the entries would be needed.
Journal
Date Account Debit Credit
X - X, 2011 Supplies 1000
Cash 1000
Purchase of supplies K1000
Dec 31, 2011 Supplies expense 900
Supplies 900
Adjusting entry to reflect supplies used
Depreciation
Many assets have a very long life span e.g. buildings and equipment’s. These assets will provide
productive benefits to a number of periods. The portion of the cost of the assets is allocated to each
accounting period. The process is called depreciation.
One simple method of depreciation is called straight line method. Under this method an equal amount
of asset cost is assigned to each year of service life. The cost of the asset is divided by the years of useful
life, resulting in annual depreciation expenses.
Example: If a K150,000 truck with a 3 year life was purchased on January 1 of year 1, depreciation
expenses would be K50,000(K150,000/3 = K50,000) per period. K50, 000 of expense would be reported
on the income statement each year for three years. Each year’s journal entry record depreciation
involves a debit to depreciation expense and a credit to accumulated depreciation.
Journal
Date Account Debit Credit
Dec 31, 2011 Depreciation expense
Accumulated depreciation
To record annual depreciation expense
47
Accumulated depreciation is a very unique account. It is reported on the balance sheet as a contra
asset. A contra account is an account that is subtracted from a related account. As the result contra
accounts have opposite debit/credit rules from those of associated accounts. In other words
accumulated depreciation increases with credit, because the associated asset normally has a debit
balance.
Balance sheet
Big Ring Company
Jan 1, 2013
Asset
Truck 150,000
Less: Accumulated depreciation (150,000) -
Unearned revenue
The business will collect monies in advance of providing goods and services. For example a magazine
publisher may sell a Multi-year subscription and collect the full payment at or near the beginning of the
subscription period. Such payments received in advance are initially recorded as debit to cash and credit
to unearned revenue.
Unearned revenue is reported as a liability reflecting the company’s obligations to deliver products in
future.
Revenue cannot be recognized in the income statement until the earning process in complete. As goods
and services are delivered unearned revenue is reduced (debited) and revenue is increased (credited).
The balance sheet at the end of the accounting period would include the remaining unearned revenue
48
for those goods and services not yet delivered, as a current liability. Revenue (income statement) should
only be reflected as goods and services are actually delivered.
Example: The software developer sold a one year software license to end user for K1, 200 with effect
from April 1, 2011. On December 31, 2011end of financial year, the adjustment would be as follows:
Journal
Date Account Debit Credit
April 1, 2011 Cash 1,200
Unearned revenue 1,200
Sold a one year software license for 1,200
Dec 31, 2011 Unearned revenue 900
Revenue 900
Year-end adjusting ending to reflect earned
portion of the software license (9 months at
100 per month)
Accruals
An accrued expense is an expense which relates to the current financial period, but which is still unpaid
at the end of that period.
Accruals are expenses and revenues that gradually accumulate throughout an accounting period.
Accruals expenses relate to such things as salaries, interest, rent, utilities and so forth.
Accrued salaries
Suppose a business has employees that collectively earn K1,000 per day. The last payday occurred on
December 26, Employees worked three days the following week, but would not be paid for this time
until January 9, 2019. As end of accounting period, the company owes employees K3,000. As the result
the adjusting entry to record the accrued payroll would appear as follows:
Journal
Date Account Debit Credit
Dec 31, 2011 Salaries expense 3,000
Salaries payable 3,000
To record accrued salaries
The above entry records the K3,000 of expense for salaries rendered by the employees to the company
during 2011 and establishes the liability for the amounts that have accumulated in the next round of
pay cheques.
Accrued interest
Most loans include charges for interest. Interest charges are based on agreed rates such as 6% per year.
The amount of interest depends on the amount borrowed (Principal), the interest rate (rate), and the
length of the borrowing period (time). The total amount of interest is calculated as principal x Rate. If
K100, 000 is borrowed at 6% per year for 18 months, the total interest amount would be K9, 000 (K100,
000 x 6% x 1.5 years).
49
It is necessary to assign the correct interest cost to each accounting period. Assume our 18 month loan
was taken out on July 1, 2011, and was due on December 31, 2012. The accounting for the loan on
various dates would be as follows:
Journal
Date Account Debit Credit
July 1, 2011 Cash 100,000
Loan payable 100,000
To record the borrowing of 100,000 at 6% per
annual principal and interest due in Dec 31, 2012
Dec 31, 2011 Interest expense 3,000
Interest payable 3,000
To record accrued interest for 6 months (100,000 x
6% x 6/12)
Dec 31, 2013 Interest expense 6,000
Interest payable 3,000
Loan payable 100,000
Cash 109,000
To record repayment of loan and interest (note
that 3,000 of the total interest was previously
accrued).
Accrued rent
Accrued rent is the opposite of the prepaid rent. Accrued rent relates to rent that has not yet been paid,
but the utilization of the asset has already occurred.
Example: Assume that office space is leased and terms of the agreement stipulates that rent will be paid
within 10 days after the end of each month at the rate of K400 per month. During December of 2011
Cabul Company occupied the lease space, and appropriate adjustment entry for December follows:
Journal
Date Account Debt Credit
Dec 31, 2011 Rent expense 400
Rent payable 400
To record accrued rent
- When rent is paid on January 10, 2012, this entry would be needed
Journal
Date Account Debt Credit
Jan 10, 2012 Rent payable 400
Cash 400
To record payment of accrued rent
Accrued revenue
This refers to revenue earned for services rendered but not yet received.
50
Chapter 6: Cash flow statement
Cash flow statement Reports the entity’s cash flows (cash receipts and cash payments) during the
period.
What is cash?
Cash include cash on hand, cash in the bank, cash equivalents – that include short term investments
that can be converted into cash with little delay. Example include government treasury bills.
Statement of cash flow include three sections: Operating, Investing and Financing activities.
Indirect method reconciles from net income to net cash provided by operating activities.
Direct method reports all cash receipts and cash payments from operating activities
The two methods have no effect on investing or financing activities.
Indirect method
Net income XXX
Adjustments:
Depreciation, etc. XXX
Net income provided by operating activities XXX
Direct method
Collection from customers XXX
Deductions:
Payment to suppliers, etc. XXX
Net income provided by operating activities XXX
Indirect method
Cash flow from operating activities:
Net income
Adjustments to reconcile net income to net cash provided by operating activities
+ Depreciation/amortization expense
+ Loss on sale of long-term assets
51
- Gain on sale of long-term assets
- Increases in current assets other than cash
+ Decreases in current assets other than cash
+ Increase in current liabilities
- Decrease in current liabilities
Depreciation 4,000
Since depreciation, depletion and amortization are not cash transactions, they should be added
back to net income.
Changes to long-term assets that happens when an asset is purchased or sold should be treated
as follows: when long term assets are purchased they should be recorded in the Investing
section of the cash flow statement, but when sold they should be reported in the income
statement.
When preparing cash flow statement we need to reverse their effect as follows:
Increase in current assets decreases cash. Any increase in current assets either uses cash through
increase in inventory and decrease in cash or is increased by a non-cash transaction such as accounts
receivable.
Decrease in current assets increases cash. If account receivable decreases that means we collected cash.
That cash needs to be added back to net income. If inventory, supplies or other current assets decreases
52
that means we debited an expense but did not credit cash, so we add back those decreases to net
income.
Decreases in current liabilities decreases cash and increase in current liabilities increases cash. When
payable increase, they create an expenses, but the expense is the non-cash expense. So add back to net
income.
Liabilities
Current:
Accounts payable 91 57 34
Salary payable 34 6 (2)
Accrued liabilities 1 3 (2)
Long-term debt 160 77 83
Stockholder’s equity
Common stock 359 258 101
Retained earnings 110 86 24
Total 725 487 238
Expenses:
Cost of goods sold 150
Salary and wages expense 56
Depreciation expense 18
Other operating expense 17
Interest expense 16
53
Income tax expense 15
Total expenses 272
Net profit 41
54
Statement of cash flows (indirect method)
Year ended December 31 2002
Net cash provided by operating activities 68
Net cash used for investing activities (255)
Net cash provided by financing activities 167
Net decrease in cash (20)
Cash balance, December 31 2001 42
Cash balance, December 31 2002 22
This study unit covers the evaluation of financial statements using the technique of ratio analysis. Ratio
analysis is used by prospective shareholders’ creditors and the firm’s own management to measure the
firm’s operating and financial health. Three types of comparison analysis are defined: cross-sectional
analysis, time series analysis and combined analysis. The ratios are divided into four basic categories:
liquidity, activity, debt and profitability. Each ratio is defined and calculated. A brief explanation of the
applications of the deviation from industry standard ratios is offered.
Ratio analysis does not merely involve the application of a formula to financial data in order to calculate
a given ratio. More important is the interpretation of the ratio value. To answer such questions as, is it
too high or too low? is it good or bad?, a meaningful standard or basis for comparison is needed. Two
types of ratio comparisons can be made: cross-sectional and time-series.
Cross-sectional analysis
Cross-sectional analysis involves the comparison of different firms' financial ratios at the same point in
time. The typical business is interested in how well it has performed in relation to its competitors. (If the
competitors are also corporations, their reported financial statements should be available for analysis.)
Frequently, a firm will compare its ratio values to those of a key competitor or group of competitors that
it wishes to emulate. This type of cross-sectional analysis, called benchmarking, has become very popular
during recent years. By comparing the firm's ratios to those of the benchmark company (or companies), it
can isolate areas in which it excels and, more importantly, isolate areas of opportunity for improvement.
Another popular type of comparison is with industry averages.
Time-series analysis
Time-series analysis is applied when a financial analyst evaluates performance over time. Comparison of
current with past performance, using ratio analysis, allows the firm to determine whether it is progressing
as planned. Developing trends can be seen by using multi-year comparisons, and knowledge of these
trends should assist the firm in planning future operations. As in cross-sectional analysis, any significant
year-to-year changes can be evaluated to assess whether they are symptomatic of a major problem. The
theory behind time-series analysis is that the company must be evaluated in relation to its past
performance, developing trends must be isolated, and appropriate action taken to direct the firm towards
immediate and long-term goals. Time-series analysis is often helpful in checking the reasonableness of a
firm's projected (pro forma) financial statements. A comparison of current and past ratios to those
resulting from an analysis of projected statements may reveal discrepancies or over-optimism.
55
Combined analysis
The most informative approach to ratio analysis is one that combines cross-sectional and time-series
analyses. A combined view permits assessment of the trend in the behaviour of the ratio in relation to the
trend for the industry.
Financial ratios can be divided into four basic categories: liquidity ratios, activity ratios, debt ratios and
profitability ratios. Liquidity, activity and debt ratios primarily measure risk; profitability ratios measure
return. In the near term, the important elements are liquidity, activity and profitability, since these provide
the information critical to the short-run operation of the firm. (If a firm cannot survive in the short run,
we need not be concerned with its longer-term prospects.) Debt ratios are useful primarily when the
analyst is sure the firm will successfully weather the short run.
As a rule, the necessary inputs to an effective financial analysis include, at a minimum, the income
statement and the balance sheet. The 2002 and 2001 income statements and balance sheets for Bartlett Oil
56
are presented, respectively, to demonstrate ratio calculations. Note that the ratios presented in the
remainder of this Unit are 'conventional' ratios that can be applied to nearly any company.
57
Less Accumulated depreciation 2295 2056
Net non-current assets K2374 K2266
Total assets K3597 K3270
Shareholder’s equity
Preference shares – cumulative 5%, K100, 2000
Share issue K200 K200
Notes
a In 2002 the firm has a six year financial lease requiring annual beginning of the year payments of K35
000. Four years of the lease have yet to run.
b Annual principal repayments on a portion of the firm’s total outstanding debt amount to K71 000.
c The annual preference dividend would be K5 per share (5 per cent × K100 par), or K10 000 annually
(K5 per share × 2000 shares).
Analysing liquidity
The liquidity of a business firm is measured by its ability to satisfy its short-term obligations as they
come due. Liquidity refers to the solvency of the firm's overall financial position. The three basic
measures of liquidity are: (1) net working capital, (2) the current ratio, and (3) the quick (acid-test)
ratio.
Net working capital, although not actually a ratio, is commonly used to measure a firm's overall
liquidity. It is calculated as follows:
Net working capital = current assets - current liabilities
This figure is not useful for comparing the performance of different firms, but it is quite useful for
internal control. Often the contract under which a long-term debt is incurred specifically states a
minimum level of net working capital that must be maintained by the firm. This requirement is
intended to force the firm to maintain sufficient operating liquidity and helps to protect the creditor. A
58
time-series comparison of the firm's net working capital is often helpful in evaluating its operations.
Current ratio
Current ratio, one of the most commonly cited financial ratios, measures the firm's ability to meet its
short-term obligations. It is expressed as follows:
A current ratio of 2.0 is occasionally cited as acceptable, but acceptability of the value depends on the
industry in which a firm operates. For example, a current ratio of 1.0 would be considered acceptable
for an electricity supplier but might be unacceptable for a manufacturing firm. The more predictable a
firm's cash flows, the lower the acceptable current ratio. Since Bartlett Oil is in a business with a
relatively predictable annual cash flow, its current ratio of 1.97 should be quite acceptable.
If the firm's current ratio is divided into 1.0 and the resulting quotient subtracted from 1.0, the
difference multiplied by 100 represents the percentage by which the firm's current assets can shrink
without making it impossible for the firm to cover its current liabilities. For example, a current ratio
of 2.0 means that the firm can still cover its current liabilities even if its current assets shrink by 50
per cent ([1.0 - (1.0/2.0)] X 100).
A final point worthy of note is that whenever a firm's current ratio is 1.0, its net working capital is
zero. If a firm has a current ratio of less than 1.0, it will have negative net working capital. Net
working capital is useful only in comparing the liquidity of the same firm over time and should not be
used to compare the liquidity of different firms; the current ratio should be used instead.
The quick (acid-test) ratio is similar to the current ratio except that it excludes inventory, which is
generally the least liquid current asset. The generally low liquidity of inventory results from two
primary factors: (1) many types of inventory cannot be easily sold because they are, for example,
partially completed, obsolete and special-purpose items; and (2) the items are typically sold on credit,
which means that they become an account receivable prior to being converted into cash. The quick
ratio is calculated as follows:
−
=
59
liquidity only when a firm's inventory cannot easily be converted into cash. If inventory is liquid, the
current ratio is a preferred measure of overall liquidity.
Note that for all three liquidity measures—net working capital, current ratio and quick (acid-test)
ratio—the higher their value, the more liquid the firm is typically considered to be. Excessive
liquidity reduces a firm's risk of being unable to satisfy its short-term obligations as they come due but
sacrifices profitability because (1) current assets are less profitable than non-current assets, and (2)
current liabilities are a less expensive financing source than long-term funds. For now, suffice it to say
that there is a cost of increased liquidity—tradeoffs exist between profitability and liquidity (risk).
Analyzing activity
Activity ratios are used to measure the speed with which various accounts are converted into sales or
cash. Measures of liquidity are generally inadequate because differences in the composition of a firm's
current assets and liabilities can significantly affect the firm's 'true' liquidity. For example, consider
the current portion of the balance sheets for firms A and B in the following table.
Firm A
Cash K0 Accounts payable K0
Marketable securities 0 Notes payable 10 000
Accounts receivables 0 Accruals 0
Inventories 20 000 Total current liabilities K10 000
Total current assets K20 000
Firm B
Cash K5 000 Accounts payable K5 000
Marketable securities 5 000 Notes payable 3 000
Accounts receivables 5 000 Accruals 2 000
Inventories 5 000 Total current liabilities K10 000
Total current assets K20 000
Although both firms appear to be equally liquid, since their current ratios are both 2.0 (K20 000 ÷
K10 000), a closer look at the differences in the composition of current assets and liabilities suggests
that firm B is more liquid than firm A. This is true for two reasons: (1) firm B has more liquid assets
in the form of cash and marketable securities than firm A, which has only a single and relatively
illiquid asset in the form of inventories; and (2) firm B's current liabilities are in general more flexible
than the single current liability—notes payable—of firm A.
It is therefore important to look beyond measures of overall liquidity to assess the activity (liquidity)
of specific current accounts. A number of ratios are available for measuring the activity of the most
important current accounts, which include inventory, accounts receivable and accounts payable. The
activity of non-current and total assets can also be assessed.
Inventory turnover
Inventory turnover commonly measures the activity, or liquidity, of a firm's inventory. It is calculated
as follows: Measures the activity, or liquidity, of a firm's
60
2 088 000
= = 7.2
289 000
The resulting turnover is meaningful only when compared with that of other firms in the same
industry or to the firm's past inventory turnover. An inventory turnover of 20.0 would not be unusual
for a grocery store, whereas a common inventory turnover for an aircraft manufacturer would be 4.0.
Inventory turnover can easily be converted into an average age of inventory by dividing it into 360—
the number of days in a year. For Bartlett Oil, the average age of inventory would be 50.0 days
(360/7.2). This value can also be viewed as the average number of days' sales in inventory.
Many firms remove as much inventory as possible from their balance sheets. They transfer inventory
risk to suppliers wherever possible.
The average collection period, or average age of accounts receivable, is useful in evaluating credit
and collection policies. It is derived by dividing the average daily sales into the accounts receivable
balance:
=
360
The average collection period is meaningful only in relation to the firm's credit terms. If, for instance,
Bartlett Oil extends 30-day credit terms to customers, an average collection period of 58.9 days may
indicate a poorly managed credit or collection department, or both. Of course, the lengthened
collection period could be the result of an intentional relaxation of credit term enforcement by the
firm in response to competitive pressures. If the firm had extended 60-day credit terms, the 58.9-day
average collection period would be quite acceptable. Clearly, additional information would be
required in order to draw definitive conclusions about the effectiveness of the firm's credit and
collection policies.
=
ℎ
61
=
ℎ
360
The difficulty in calculating this ratio stems from the need to find annual purchases—a value not
available in published financial statements. Ordinarily, purchases are estimated as a given percentage
of cost of goods sold. If we assume that Bartlett Oil's purchases equalled 70 per cent of its cost of
goods sold in 2002, its average payment period is:
The total asset turnover indicates the efficiency with which the firm uses all its assets to generate
sales. Generally, the higher a firm's total asset turnover, the more efficiently its assets have been used.
This measure is probably of greatest interest to management, since it indicates whether the firm's
operations have been financially efficient. Total asset turnover is calculated as follows:
The company therefore turns its assets over 0.85 times a year.
One caution with respect to use of this ratio: it uses the historical costs of total assets. Because some
firms have significantly newer or older assets than others, comparing total asset turnovers of those
firms can be misleading. Because of inflation and the use of historical costs, firms with newer assets
will tend to have lower turnovers than those with older assets. The differences in these turnovers
could therefore result from more costly assets rather than from differing operating efficiencies. The
financial manager should be cautious when using this ratio for cross-sectional comparisons.
Analysing debt
The debt position of the firm indicates the amount of other people's money being used in attempting
to generate profits. In general, the financial analyst is most concerned with non-current debts, since
these commit the firm to paying interest over the long term, as well as eventually repaying the
principal borrowed. Since the claims of creditors must be satisfied prior to the distribution of earnings
to shareholders," present and prospective shareholders pay close attention to the degree of indebted-
ness and ability to repay debts. Lenders are also concerned about the firm's degree of indebtedness
and ability to service debts, since the more indebted the firm, the higher the probability that the firm
62
will be unable to satisfy the claims of all its creditors. Management obviously must be concerned with
indebtedness in recognition of the attention paid to it by other parties and in the interest of keeping the
firm solvent.
In general, the more debt a firm uses in relation to its total assets, the greater its financial leverage, a
term used to describe the magnification of risk and return introduced through the use of fixed-cost
financing such as debt. In other words, the more fixed-cost debt, or financial leverage, a firm uses, the
greater will be its risk and return.
Measures of debt
There are two general types of debt measures: measures of the degree of indebtedness and measures
of the ability to service debts. The degree of indebtedness measures the amount of debt against other
significant balance sheet amounts. One of the most commonly used measures is the debt ratio, which
is discussed below.
The second type of debt measure, the ability to service debts, refers to the ability of a firm to make the
contractual payments required on a scheduled basis over the life of a debt. With debts come scheduled
fixed-payment obligations for interest and principal. Lease payments, as well as preferred share
dividend payments, also represent scheduled obligations. The firm's ability to pay certain fixed
charges is measured using coverage ratios. Typically, higher coverage ratios are preferred, but too
high a ratio (against norms) may indicate a low use of debt (fixed-payment) which may result in
unnecessarily low risk and returns. Alternatively, the lower the firm's coverage ratios, the more risky
the firm is considered to be. 'Riskiness' here refers to the firm's ability to pay fixed obligations. If a
firm is unable to pay these obligations, it will be in default, and its creditors may seek immediate
repayment. In most instances, this would force a firm into bankruptcy. Two ratios of coverage—times
interest earned and fixed-payment coverage—are discussed below."
Debt ratio
The debt ratio measures the proportion of total assets financed by the firm's creditors. The higher this
ratio, the greater the amount of other people's money being used in an attempt to generate profits. The
ratio is calculated as follows:
=
The debt ratio for Bartlett Oil in 2002 is:
K1 643 000
= 0.457 = 45.7%
K3 597 000
This indicates that the company has financed 45.7 per cent of its assets with debt. The higher this
ratio, the more financial leverage a firm has.
The following ratio differs from the debt ratio by focusing on long-term debts. Short-term debts, or
current liabilities, are excluded, since most of them are spontaneous (that is, they are the natural result
of doing business) and do not commit the firm to the payment of fixed charges over a long period of
time.
63
The times interest earned ratio measures the ability to make contractual interest payments. The higher
the value of this ratio, the better able the firm is to fulfil its interest obligations. Times interest earned
is calculated as follows:
Applying this ratio to Bartlett Oil yields the following 2002 value:
= =4.5
The value of earnings before interest and taxes is the same as the figure for operating profits shown in
the income statement. The times interest earned ratio for Bartlett Oil seems acceptable. As a rule, a
value of at least 3.0—and preferably closer to 5.0—is suggested. If the firm's earnings before interest
and taxes were to shrink by 78 per cent [(4.5 - 1.0)/4.5], the firm would still be able to pay the K93
000 in interest it owes. Thus, it has a good margin of safety.
The fixed-payment coverage ratio measures the firm's ability to meet all fixed-payment obligations,
such as loan interest and principal, lease payments and preferred dividends. Like the times interest
earned ratio, the higher this value, the better. Principal payments on debt, scheduled lease payments
and preference dividends are commonly included in this ratio. The formula for the fixed-payment
coverage ratio is as follows:
− =
+
1
+ + ( + )×[
1− ]
where T is the corporate tax rate applicable to the firm's income. The term ( ) is included to adjust
the after-tax principal and preference dividend payments back to a before-tax equivalent consistent
with the before-tax values of all other terms. Applying the formula to Bartlett Oil's 2002 data yields:
− =
418 000 + 35 000
1
93 000 + 35 000 + ( 71 000 + 10 000) × [1 − 0.29]
453 000
= = 1.9
242 000
Since the earnings available are nearly twice as large as its fixed-payment obligations, the firm
appears able to safely meet its fixed payments.
Like the times interest earned ratio, the fixed-payment coverage ratio measures risk. The lower the
ratio, the greater the risk to both lenders and owners, and vice versa. This risk results from the fact
that if the firm were unable to meet scheduled fixed payments, it could be driven into bankruptcy. An
examination of the ratio therefore allows owners, creditors and managers to assess the firm's ability to
handle additional fixed-payment obligations such as debt.
64
Analysing profitability
There are many measures of profitability. Each relates the returns of the firm to its sales, assets, and
equity or share value. As a group, these measures allow the analyst to evaluate the firm's earnings
with respect to a given level of sales, a certain level of assets, the owners' investment or share value.
Without profit, a firm could not attract outside capital; moreover, present owners and creditors would
become concerned about the company's future and attempt to recover their funds. Owners, creditors
and management pay close attention to boosting profits, due to the great importance placed on
earnings in the marketplace.
The gross profit margin indicates the percentage of each sales kwacha remaining after the firm has
paid for its goods. The higher the gross profit margin the better, and the lower the relative cost of
merchandise sold. Of course, the opposite case is also true, as the Bartlett Oil example shows. The
gross profit margin is calculated as follows:
The value for Bartlett Oil's gross profit margin for 2002 is:
This value is shown on line (a) of the common-size income statement in Table 3.5.
The operating profit margin represents what are often called the pure profits earned on each sales
kwacha. Operating profits are pure in the sense that they ignore any financial or government charges
(interest or taxes) and measure only the profits earned on operations. A high operating profit margin is
preferred. The operating profit margin is calculated as follows:
The value for Bartlett Oil's operating profit margin for 2002 is:
K418 000
= 13.6%
K3 074 000
This value is shown on line (b) of the common-size income statement in Table 3.5.
The net profit margin measures the percentage of each sales kwacha remaining after all expenses,
including taxes, have been deducted, The higher the firm's net profit margin, the better. The net profit
margin is a commonly cited measure of the corporation's success with respect to earnings on sales.
'Good' net profit margins differ considerably across industries. A net profit margin of 1 per cent or
less would not be unusual for a grocery store, while a net profit margin of 10 per cent would be low
for a retail jewellery store. The net profit margin is calculated as follows:
65
Bartlett Oil's net profit margin for 2002 is:
231 000
= 7.5%
3 074 000
This value is shown on line (c) of the common-size income statement in Table 3.5.
The return on total assets (ROA), which is often called the firm's return on investment (ROI), measures
the overall effectiveness of management in generating profits with its available assets. The higher the
firm's ROA, the better. The ROA is calculated as follows:
231 000
= 6.4
3 597 000
To assess Bartlett's 6.4 per cent return on total assets, appropriate cross-sectional and
time-series data would be needed.
The return on equity (ROE) measures the return earned on the owners' investment in the firm. Generally,
the higher this return, the better off is the owners. ROE is calculated as follows:
=
ℎ ℎ
The firm's earnings per share (EPS) are generally of interest to present or prospective shareholders and
management. The EPS represent the number of kwachas earned on behalf of each share. They are closely
watched by the investing public and are considered an important indicator of corporate success.
ℎ ℎ
=
ℎ
66
The value of Bartlett Oil's EPS in 2002 is:
221 000
= 2.90
76 262
The figure represents the kwacha amount earned on behalf of each share. It does not represent the amount
of earnings actually distributed to shareholders.
ℎ
=
If Bartlett Oil's ordinary shares at the end of 2002 were selling at K32.25 using the EPS of K2.90 from
the income statement in Table 3.2, the P/E ratio at year-end 2002 is:
K32.25
= 11.1
K2.90
This figure indicates that investors were paying K11.10 for each K1.00 of earnings.
The cash budget represents a detailed plan of future cash flows and is composed of four
elements: cash receipts, cash disbursements, net change in cash for the period, and new
financing needed.
To demonstrate the construction and use of the cash budget, consider Salco Furniture
Company. Inc., a regional distributor of household furniture. Salco's sales are highly
seasonal, peaking in the months of March through May. Roughly 30 percent of Salco's
sales are collected one month after the sale, 50 percent two months after the sale, and the
remainder during the third month following the sale.
67
Salco attempts to pace its purchases with its forecast of future sales. Purchases
generally equal 75 percent of sales and are made two months in advance of anticipated
sales. Payments are made in the month following purchases. For example, June sales are
estimated at $100,000, thus April purchases are .75 X $l00,000 = $75,000.
Correspondingly, payments for purchases in May equal $75,000. Wages, salaries, rent,
and other cash expenses are recorded in Table 1, which gives Salco's cash budget for the
six-month period ended in June 1998. Additional expenditures are recorded in the cash
budget related to the purchase of equipment in the amount of $14,000 during February
and the repayment of a $12,000 loan in May. In June, Salco will pay $7,500 interest on
its $150,000 in long-term debt for the period of January-June, 1998. Interest on the
$12,000 short-term note repaid in May for the period January through May equals $600
and is paid in May.
Salco presently has a cash balance of $20,000 and wants to maintain a minimum
balance of $10,000. Additional borrowing necessary to maintain that minimum balance
is estimated in the final section of Table 1. Borrowing takes place at the beginning of the
month in which the funds are needed. Interest on borrowed funds equals 12 percent per
annum, or 1 percent per month, and is paid in the month following the one in which funds
are borrowed. Thus, interest on funds borrowed in January will be paid in February equal
to 1 percent of the loan amount outstanding during January.
The financing-needed line on Salco's cash budget indicates that the firm will need to
borrow $36,350 in February, $65,874 in March, $86,633 in April, and $97,599 in May.
Only in June will the firm be able to reduce its borrowing to $79,875. Note that the cash
budget indicates not only the amount of financing needed during the period but also when
the funds will be needed.
68
TABLE 1
Worksheet Oct. Nov. Dec. Jan. Feb. Mar. Apr. May June July Aug.
Sales $55,000 $62,000 $50,000 $60,000 $75,000 $88,000 $100,000 $110,000 $100,000 $80,000 $75,000
Collections:
Cash receipts:
Cash disbursements:
Plus: Beginning cash balance 20,000 12,750 10,000 10,000 10,000 10,000
Equals: Ending cash balance—no borrowing 12,750 (26,350) (19,524) (10,759) (966) 27,724
Financing neededa - 36,350 29,524 20,759 10,966 (17,724)b
The cash budget given in Table 1 for Salco, Inc., is an example of a fixed budget. Cash flow
estimates are made for single set of monthly sales estimates. Thus, the estimates of expenses
and new financing needed are meaningful only for the level of sales for which they were
computed. To avoid this limitation, several budgets corresponding to different sets of sales
estimates can be prepared. Such a flexible budget fulfills two basic needs: first, it gives
information regarding the range of the firm's possible financing needs, and second it provides a
standard against which to measure the performance of subordinates who are responsible for the
various cost and revenue items contained in the budget.
This second function deserves some additional comment. The obvious problem that arises
relates to the fact that costs vary with the actual level of sales experienced by the firm. Thus, if
the budget is to be used as a standard for performance evaluation or control, it must be
constructed to match realized sales and production figures. This can involve much more than
simply “adjusting cost figures up or down in proportion to the deviation of actual from planned
sales"; that is, costs may not vary in strict proportion to sales, just as inventory levels may not
vary as a constant percent of sales. Thus, preparation of a flexible budget involves re-
estimating all the cash expenses that would be incurred at each of several possible sales levels.
This process might utilize a variant of the percent of sales method discussed earlier.
Budget Period
There are no strict rules for determining the length of the budget period. However, as a general
rule it should be long enough to show the effect of management policies, yet short enough so
that estimates can be made with reasonable accuracy. Applying this rule of thumb to the Salco
example in Table 1, it appears that the six-month budget period is too short, in that whether the
planned operations of the firm will be successful over the coming fiscal year is not known; that
is, for most of the first six-month period the firm is operating with a cash flow deficit. If this
does not reverse in the latter six months of the year, then a reevaluation of the firm's plans and
policies is clearly in order.
Longer-range budgets are also prepared in the form of the capital-expenditure budget.
This budget details the firm's plans for acquiring plant and equipment over a 5-year, 10-year,
or even longer period. Furthermore, firms often develop comprehensive long-range plans
extending up to 10 years into the future. These plans are generally not as detailed as the annual
cash budget. But they do consider such major components as sales, capital expenditure new-
product development, capital funds acquisition, and employment needs.