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KENYATTA UNIVERSITY
BAC 813: FINANCIAL ACCOUNTING
LECTURER 1
THEORETICAL FRAMEWORK OF ACCOUNTING

Definition- it‟s a coherent system of interrelated objectives and fundamentals that can
lead to consistent standards and that prescribes the nature accounting

Importance
– For standard setting
– For better understanding and confidence of financial repotting
– Enhance comparability among companies
– Any new practical problem solved easily

What is accounting?
Accounting is simply a language of business. It‟s a man made means of communication
of certain business information. It derives its usefulness from the social value of the
environment in which it is developed. Its scope and definition change with the passage of
time. In general, it is argued that accounting is concerned with the provision of
information about the financial position, performance and changes in financial position of
an enterprise that is useful to a wide range of potential users in making economic
decisions.
People involved in accounting are:-
(a) Business owners/ Entrepreneurs
(b) Managers
(c) Bankers.
(d) Stock brokers & lawyers.
Accounting information describes the events that make up the day existence of every
business. Its information is used for controlling the use of resources owned by a business.
It‟s also used for measuring the performance of a business entity

Summary: use of accounting information.

(a) Describe the events taking place in a business
(b) Used to control resources owned by a business
(c) Used in meaning performance of a business.

The financial accounting environment

The nature of financial Accounting

Accounting can easily be treated as an information system.
Purpose of accounting therefore is to identify, collect, measure & communication of
information about economic units‟ i.e

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-Sole traders: for example, doctor, dentist, small shopkeeper. Each is the sole owner
of his or her business.
-Partnerships: for example, as above. The main difference is that a business formed
under a partnership structure has shared ownership between at least two
people.
-Limited companies: for example, ICI, Marks & Spencer. There are two types of
limited company, namely, private (ltd) and public limited companies
-Other corporations: for example, enterprises owned by the government.
-Not-for-profit organizations Charities: such as Oxfam, Help the Aged, Save the
children.
-Clubs and societies: such as students‟ union, golf clubs.
-Government and quasi-governmental bodies: such as local councils,
-Others: such as trusts and mutual associations.

The users of accounting information are divided into two

1). External Users
2). Internal Users

External Users – Shareholders, Potential investors, creditors, rank & file employees‟
customer, competitors, financial analysts & advisors, brokers, underwriters, the stock
exchange, lawyers, economist, taxing & regulatory authorities, legislature, the financial
press departing agencies, labor unions, trade association, Business, researches, teachers
students and the public.
They make decision on:-
a) Whether to invest
b) Whether to extend credits
c) Whether to do business
The process of developing and reporting accounting in formation to external decision
makers is called financial accounting

Finance accounting is concerned with the manner and extent to which business
communicate financial information about themselves to the outside world / public.
Outside world / Public – Individual who invest in them, lend money etc
These people rely on a company‟s financial investment and other financial decision
related to the company.

NB/ Many issues involved in the public accounting are controversial, and difference of
opinion & interpretations may have a substantive impact on the public‟s decision making
process.
Only rarely there is a single, correct resolution or definitive answer to financial
accounting issues.

The accounting body has set a net of accounting concepts principle and procedures to
assume that external financial statements are relevant known as GAAP (General
Acceptable Accounting Principles.)

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Internal decision makers – are the managers of an entity
Management is responsible for:-
a) Planning the future of a business
b) Implement plans
c) Control daily operations
d) Dispatch information to other operating officers

The process of developing and reporting financial information for internal users is called
management accounting.
To accomplish the necessary reporting, two basic financial statements are used:-
1. The Balance Sheet – show the company‟s financial position as of a
specific point in time. It shows the assets, liabilities and owners‟ equity
Also called a statement of financial positions
2. Statements that relate to a specified period of time
a. Income statement – reports the company revenue, gains,
expenses, losses & net income. Also called the statement of
income
b. Statement of retained earnings – reports changes of the
company‟s accumulated earnings.
c. Statement of cash flow – report the company cash flow from
operating investing and financial activities.

Features/ characteristics of accounting information

1. Financial reporting should provide information that is useful to present and
potential investors & creditors
2. Information should be comprehensive to those who are reasonably understanding
the business & economic activities
3. Its should help investors and creditors to assess the amounts, timing & uncertainty
of prospective cash receipts
4. To assess the prospects of cash resale redemption & maturity of loan
5. Provide information about the economic resource of an enterprise

Functions of accounting
It is generally accepted that accounting should serve the following functions:
1. Recording: accounting systems supply a means of recording and classifying data
as to enable the production of summarized financial statements relating to
the entity‟s results and current state of affairs. Records also enable one-
off requests for data to be complied with.

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2. Measuring: accounting tries to assist in the measurement of the economic results of
the entity‟s activities, usually with a view to sharing out the results among
the various interested parties: for example, government (taxes), employees
(wages), shareholders (dividends).
3. Stewardship: accounting provides a record of how the funds entrusted to
managers have been used by them, and to what ends.
4. Monitoring, planning and control: accounting should provide sufficient
information on the results of past activities to enable management to
monitor the results, and take action if necessary, and to formulate plans for
the future.
5. Information for decisions: accounting should assist investors, for example in
deciding how to allocate their limited resources.
6. Communication: accounting should communicate information to both internal
and external users. (Financial statements are the main tools used to
achieve this function for external users.)
Question
What is the purpose of financial statement information?
Who are the users of accounting information and how do they use the information

Interaction of Financial accounting with its Environment/ importance of financial

reporting
1. Accounting helps decision makers evaluate opportunities by providing
measurements such as net income, total assets etc
2. It define the tax payment given by the statutory condition
3. Establishes the attractiveness of a company as a takeover target
4. Evaluate the effectiveness of individual managers
5. Determine whether bond & other contract provisions are satisfied
6. Acts as a regulator for decision making
7. Helps lenders to measure the risk of their loans
8. Influence the effectiveness of a company to its workers
9. Suggests bargain strategies for union organizers
10. Affects willingness of supplies to enter into long-term contracts
11. Attracts the attention of the government unit because of unusual profit
performance
12. Affects customer‟ willingness to purchase co- products

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 Factors that influence accounting information compilation and reporting
procedures
1). Accounting principles & standards
2). The legal system of the country
3). Regulatory structure eg public untidy regulatory commission
4). Company dilemma in a competitive environment not the release its information for
few years reducing the competitive advantage
5). The demand for information by the users.
6). The cost and benefits of alternative reporting
7). The importance of the quality of information supplied
8). The development of new financial instruments – e.g. computerization

Conceptual framework of Accounting

Financial Report

Presentation Usefulness

Compatibility Understandability Relevance Reliability

Consistency Disclosure Classification Productive value Conformity

value
Usability

Limitations Objective Prudence

Substance over form

Complete

Timeliness Benefits/cost Materiality Accuracy

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 LECTURE 2
The fundamental theory of accounting and the accounting concepts
Theory of accounting
The nature of any theory is to provide a logical basis for the practice or procedure to
which the theory is applied. Accounting theory has evolved through a long passage of
time during which substantial changes in human behavior and market structures have
taken place.
(a) History of accounting goes to ancient Mesopotamia in Egypt. Accounting
records were kept as rudimentary documents
(b) In Greek and Roman, accounts were mostly based on the “charge & discharge
principles.”
A steward, a public official or other person entrusted with money or property
rendered account periodically to his master during the period of his
stewardship.
The “Charge” consisted of the balance due to his master at the beginning of
the period. The “Discharge” consisted of sums disbursed or goods sold or
consumed during the period, plus the balancing figure of money or goods due
to the accountant‟s master.
(c) The next most important development that occurred in Italy was doubled entry
book – keeping in 13th & 14th Century.
The principles of charge & discharge were extended to the cashier of the firm
who was charged with the receipts & discharged with payments
(d) It refinement of the above system was developed by Luca Pacioli (1445-
1515).
Luca developed the murder system of book keeping and double entry system
of accounting.
He developed the use of journal as a book of original entry and ledger as the
book of accounts. The only notable shortcoming of Pacoili‟s system was the
failure to distinguish between the proprietor of a business as an individual &
the business as an entity independent of its own.
(e) The development of modern accounting practices began within the industrial
revolution, the development of the railway, the creation of just stock
companies and as a manger academic discipline. The theory of scientific
management has also had some influence on the development of modern
accounting through practices.

What is meant by the term ‘accounting concepts’?

It is a common misconception for financial statements to be considered as „right‟ in an

absolute sense, especially as regards profit. There is, as yet, no universally accepted
measure of profit as there is for, say, weight (though even this is subject to different units
of measurement, which may need to be converted). Because of this, accountants have, in
the light of experience, identified certain broad assumptions on which the financial
results of a business are prepared. These assumptions, also known as „accounting

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concepts‟, define the rules under which the financial statements of an entity should be
prepared.

These are the common basis for the preparation and reporting of financial information
usually referred to as “the generally accepted accounting principle”.
Accounting principles are also referred to as standard, assumption, postulates and
concepts.
Accounting principles includes:-
(a) Going concern
(b) Consistency
(c) Prudence
(d) The accruals concept
(e) Substance over firm
(f) Materiality.
1. Going concern
The valuation of assets used in business is based on the assumption that the business is
continuity. One not in the verge of collapse
Assets on a closing down business fetch lower value.
This means if a business is to continue to operate in a foreseeable future, its considerable
sensible to the use of the cost concept when arriving at the valuation of assets. Example
Where a business is to close in future, ii) Where shortage of cash is almost certain,
business will close down.

2. Substance over form

It can happen that the legal form of a transaction can differ from its real substance. Where
this happens accounting should show the transaction in accordance with its real substance
which is basically how the transaction affects the economic situation of the firm. In this
case, it will not reflect the exact legal position concerning that transaction.
e.g Hire purchased vehicle
Under normal circumstance, it belongs the personal using it , but the exact legal position
it belongs to the seller until the buyer finishes paying the installments.

3. Accrual / matching concept

It makes the distinction between the receipt of cash and right to receive cash and the
payment of cash and the legal obligation to pay cash. Expenses( trading events) leading
to reduction in wealth, are matched to particular revenue that they helped to generate in
the same period e.g. where the sale of goods is recognized as revenue in a particular
accounting period , the cost of acquiring those goods should be treated as an expense of
the same period irrespective of when goods were acquired. In practice there is no
coincidence in time between cash movements and the legal obligations to which they
relate

Example
Accrual concepts apply to revenue/ or receive cash in various ways.
i.e cash received may occur in different ways
(i) Concurrently with the sale

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 (ii) Before right to receive arise
(iii) After the right to receive has been created
(iv) In error
The accrual concept provides a guideline as to how to treat these cash receipts and the
rights related to them.

The concept of consistency

If you have to make comparison and come up with a decision, the information must
always be given a change to reach the conclusion.
The comparability of financial statements depends largely upon the choice of accounting
method and the consistency with which they are applied.
If firms wish to change their method for treating a particular problem such as the
valuation of stocks they may do so but should mention the effect on profit of the change
in accounting of the previous method. Consistence should be observed. In accounting it‟s
important to be consistent in the methods used before a decision is arrived to change or
not.

Materiality
In accounting there is one overriding rule applied to anything that appears in a financial
accounting statement. It must be material - i.e. it should be of interest to the stakeholders,
i.e those people who make use of financial accounting statements. It need not be material
to every stakeholder, but it must be material to a stakeholder before it merits conclusion.

Prudent / Convertism
- Sensible and careful attitudes that make an investor to avoid making unnecessary
risks. It is a guiding principle in resolving uncertainties. Accounting must not
anticipate profit and should provide for all foreseeable losses and when faced with
two or more methods valuing an asset, the accountant should choose the method
which gives the lesser value.
Assignment
Write short notes on the following concepts
 Historical cost concept
 Replacement cost measurement
 Objective concept
 Subjective concept

NB /You should understand the distinction between accounting concepts, accounting

bases and accounting policies.
1. Accounting concepts we have just explained.
2. Accounting bases are the various methods of applying accounting concepts that
have been developed in practice (e.g. methods of stock valuation and
depreciation).
3. Accounting policies are the specific accounting bases chosen and applied by an
accounting entity (see below) in preparing its financial statements, hopefully
those best suited to its particular circumstances. In many countries (including the
UK), accounting policies must be disclosed by entities in their annual financial

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 reports in order to assist readers to understand and interpret the financial
statements properly.

Concept of capital and capital maintenance

Assets – liabilities = owners equity/ Capital

-Capital maintenance concept arises from the fact that distribution made to owners should
not exceed the amount of profit generated if capital is to be maintained.
-Excess distribution would obviously lead to depression of capital. There are two
concepts which attempts to explain capital statement.

1. Financial capital maintenance concept - Under this concept profit is earned only if
the difference between the financial (monetary value of the net asset at the end of
the period, after any distribution to and contribution by the shareholders exceed
the net asset at the beginning of the period.

Capital = net asset or equity.

The financial capital can be measured in either monetary value (units) or constant
purchasing power.

2. Physical capital maintenance -This is where profit is earned only if the physical
productive capacity cooperating capacity of the enterprise at the end of the year
exceeds the physical productive capacity at the beginning of the year.

Capital is equal to the production capacity of an enterprise. It requires adoption of

current cost basis of measurement.

LECTURE 3
Accounting standards
These are the common basis for the preparation and reporting of financial information
usually referred to as “the generally accepted accounting standards”
Accounting standards are also referred to as principles assumption, postulates and
concepts.
Board /Organizations that have responsibilities for setting accounting standards
1). Financial Accounting Foundation (FAF)
2). Financial Accounting Standard Board (FASB)
3). Government Accounting Standard Board (GASB)
4). Financial Accounting Advisory Council (FAAC)
5). Government Accounting Advisory Council (GAAC)
6). International accounting standards board (IASB)

The major difference in Financial Accounting Standard Board and the others are:-
1). Membership Number
2). Financial Independence

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 3). Reporting autonomy
4). Board representation
5). Increased staff & advisory support

Since 1973, the Financial Accounting Standards Board (FASB) has been responsible for
establishing the accounting standard that constitute generally accepted accounting
procedures

The FASB currently follows a due process procedure in developing accounting

standards. This process uses an open format that provides an opportunity for interested
parties to express their views.
The standard process uses the following steps:-
i. Select and prioritize issues of the Boards Agenda
ii. Appoints a representation task force to identity & define the problems &
alternatives related to each and conduct a research & analysis about it.
iii. Prepare a discussion memorandum on the issue to interest parties
iv. Invite public comment of the memorandum
v. Schedule public hearing following the discussion memorandum, Analyze the
comments given.
vi. Determine whether to issue a standard, if yes prepare an exposure draft of
the standard & distribute to all interested parties
vii. Analyze the comments about the explosive draft from the public
viii. Public hearing
ix. Approve / disapprove the exposure as revised by a vote for at least of the
seven Board members. If approved, it becomes a new standard.
NB
For complex and controversial issues some of these steps can be repeated

Question: What is Generally Acceptable Accounting Principle (GAAP)? How are

they prepared?

Solution
This refers to the board guideline, conventions, rule and procedures of accounting
This body has noted the following as controversial issues
1. Capitalization Vs expensing
a) Research development costs
b) Software development costs
c) Interest costs
d) Oil and Gas accounting
2. Off-balance sheet financing
a) Leasers
b) Pensions
c) Unconsolidated finance subsidence‟s
d) Purchase commitments
3. Income taxes

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 a) Deferred taxes
b) Investment tax credit
4. Changing Prices
a) Price Level Adjustment
b) Current value

These issues have more than one solution and that the choice of treatment makes a
substance difference in the amounts reported in the financial statement
The complex changes affecting business include
 The growth of absentee ownership and increasing importance of stock exchange
securities / share
 Increase in power of national government tax
 Confidence of the public in financial reporting

SUMMARY (I AS))
International accounting standards
These are guidelines & working notes and procedures formulated by the international
accounting standard board (IASB) to guide accounting practice.
They describe the methods of accounting deemed mandatory for application to all
financial statements other than those prepared for internal rules.

Procedure for development of IAS

(1) A problem / topic identified and presented to the board. Issues identified and
reviewed.
(2) A study / research is taken / conducted and views collected.
(3) Consultations conducted within the board.
(4) Formation of advisory board ( steering committee)
(5) Publishing for public comment
(6) An exposure draft approved by at least 2 board members published.
(7) Consideration of comments
(8) Public hearings.
(9) Approval of the standards by at least ¾ of the board.

Benefits of IAS
o Uniformity
o Quality
o Saves time
o Promotes growth in accounting methodology.
Disadvantages
1. Financial statements are to be used by a variety of users and it is uncertain that a
single prescribed standard can be suitable for all use.
2. They stifle the creativity, as the accountants are restricted to laid down procedures
& rules.
3. They at times offer too many alternatives thus creating room for subjectivity
4. They may at times be incompatible with the laws of the country.

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Reasons for the change from Kenya accounting standards to / as International
trends
1. Due to the flow of international investment across geographical boundaries it
became necessary to adopt IAS.
2. Regional consideration- Kenya was a member of ECASAFA which strongly
support adoption of IASICPAK. Felt that it will be risking its leadership position
if it rugs behind on the issue.
3. Local pressure- Regulators have continuously turned to IAS rather that KAS as an
indicator of what the best practice should be. The institute therefore was
marginalized by the regulators e.g central bank, market authority, stock exchange
e.t.c.
4. Resource limitations- The institute did not have resources to develop standards
and it would be a great saving to use already developed standards.
5. Past experience- Every KAS issue intended to comply with IAS as such as
possible because the institute has never found it necessary to challenge any IAS.
Prolonged inflation periods e.g weakness of historical cost based accounting.

Demand arose for some uniformity in recording business transaction and presenting
financial statements of public owned companies. Similar principals and standards had
to be put in place.

Process of measurement of financial statements

-It‟s the assignment of numbers to properties and characteristics of objects.

In accounting several measurement systems can be used:-

1. Historical cost measurement- assets recorded at their actual/ original cost
2. Replacement cost measurement / assets value carried at the replacement cost
3. Rate of return measurement / realizable- assets carried at the amount they would
be disposed
4. Present value /Discounted cash flows – assets carried at present discounted value
of the future cash flow

To enable users to implement statement with confidence companies in similar industries

should use the same measurement concept and principles.
In some countries this concepts and principles are prescribed by Government bodies. In
U.S.A they are embodied in the generally accepted principles (GAAP) which is a
consensus of various experts in accounting.

Direct measurement- occurs if a number assigned to an object is an actual measurement

of the desired property.
This measurement may not be accurate.
Indirect measurement – One that must be made by roundabout means for measuring
the desired attributes. This may include average price of commodities.

NB/ Direct measurement are usually preferable to indirect one.

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Assessment & prediction measures
Assessment measures are concerned with particular attributes of objects. They can be
direct or indirect.

Prediction measures Are concerned with factors that may be indicative of conditions of
a future point in time e.g. income of a present period be used as a predictor of dividends
for the following year.

Types of measurement
1. Nominal scale – A simple classification system e.g classifying students according to
provinces they came from.
1. Coast
2. Central.
2. Ordinal scale
Where numerals are assigned in ordinary ratings that indicate an order of preference of 1,
2, 3 good, very good
In accounting, ordinal measurement is used to determine liquidity in the balance sheet.
Internal scale
- Here the change in the attributes measures between assigned numbers e.g. 1-5-9.
Ratio scale
-Assigns equal value of intervals between assigned numbers.
¼-½-¾

LECTURE 4
REVIEW OF ACCOUNTING CYCLE
Definition
It‟s the sequence of activities beginning with the occurrence of a transaction. It‟s a series
of sequential steps leading to the financial statements.

-Depending on the information processing technology used, certain accounting cycle

steps are combined or some cases omitted. The fundamental process, however, is
independent on the technology used.

-Many systems are computerized to increase speed and accuracy in the cycle worksheets
and can be used to perform several task /steps at a go.

Steps in the accounting cycle

Identify the transaction
(Identify the event as a transaction & generate the source document.

Analyze the transaction

Determine the transaction amount which accounts are affected and in which
direction.

Journal entries
The transaction is recorded in the journal as a debtor or Credit.

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 Post the ledger
The journal entries are transferred to the appropriate T- accounts in the ledger

Trial balance
A trial balance is calculated to verify that the sum of the debits is equal to the sum of
the credits.

Adjusting entries
Adjusting entries are made for accrued and deferred items. The entries are journalized and
posted to the T- Accounting in the ledger

Adjusting trial balance

A new trial balance is calculated after making the Adjustment entries

Financial statements are prepared.

Closing entries
Transfer the balance of the temporary accounts e.g. revenues and expenses to owner’s
equity.

After – closing trail balance

A final trial balance is calculated after the closing entries are made

This diagram shows that the financial statements as being prepared after adjusting entries
and adjusting trail balance.
- The financial statement can also be prepared before the adjusting entries with the
help of a worksheet that calculates the impact of the adjusting entries before they
are actually posted.

Identifying transaction or events to be recorded

The purpose of this is to collect relevant data about the transaction.
Events that change a firm‟s resource are categorized into 3 types.
1. Exchange of resources between the reporting firm and outside parties e.g. sale of
goods for cash or otherwise require a journal entry.
2. Internal events within the firm that affects its resource but do not involve outside
parties e.g. recognition of depreciation and amortization for assets. These events
also require a journal entry.
3. Economic and environmental events beyond the control of the company. E.g
changes in market value of assets and liabilities and casualty losses. Only some of
these require journal entry.

Transactions are often accompanied by a source document. Source document are paper
records that describes the transaction, the parties involved, the date, amount and other
aspect of the event

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Examples of source documents- includes: - Sale invoices, fright bills, cash register
receipts etc.

In certain events, eg accrual of interest, are not singled by a separate transaction or source
document. Recording Sources documents are also used for subsequent tracing and
verification for evidence in legal proceeding and for this transaction requires reference to
the underlying contract or other source document supporting the original exchange or
resources.

Accounts, transaction recording, and financial statement

Financial accounting information is recorded in accounts that are formal records of

specific resources, obligations and their changes.

The seven major types of accounts are grouped into two fundamental classifications

1. Permanent accounts (assets liabilities and owners equity accounts)

2. Temporary accounts. (Revenues, expenses, gains and losses)

The permanent accounts appear in the balance sheet (This accounts are carried over to a
future accounting period)

The following accounting equations / identify relates to the balances of the permanent
A/CS.
Assets = Liabilities + Owners’ Equity

This identity indicates the recorded value of assets and their sources. The equation
facilitates the computation of capital as long as the assets & liabilities of the business are
known at a given time. This difference is also referred to as “Net-worth” of the business
to the proprietor. There is a balance on the assets to the liabilities and owners‟ equity
resulting to a balance sheet

A statement of financial position – A statement showing the layout of the assets,

liabilities and Net-worth of a business

Characteristics
(a) Total assets must be equals to total figure of liabilities & owner equity.
The two sides of the balance sheet are always equal
(b) It‟s only true at a given time only.

Example
Assets = 774,000
Liability = 200,000
Calculate the owner equity.

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Effects of a business transaction upon the statement of financial position
Any business transaction can be expressed in terms of accounting equation

Assume the following

Kikuyu Cleaners
Balance sheet as at 31/1/2006

Assets Liabilities
Cash 219,000(-80,000) Bank loan 120,000
Land 80,000 Creditors 80,000 (-80,000)
Building 390,000 Capitals 574,000
Office equity 10,000 774,000
Motor van 75,000
774,000
Assume all creditors were paid by cash on 2/2/2006. Show new balance sheet.

Kikuyu cleaners
Balance sheet as at 2/2/2006

Assets
Cash (219,000- 80,000) 139,000 Bank Loan 120,000
Land 80,000
Building 390,000
Office Equip 10,000 Capital 574,000
Motor van 75,000 694,000`
694,000
NB: An increase in asset is accompanied by an equal increase in either liability or capital.

Similarly any decrease in asset is accompanied by an equal decrease of either liabilities or

capital.

Question.
On 1st Jan 2006, Meshack Masati started a business with the following assets and
liabilities.

Assets:- Cash 16,800, Stock on had 48,000

Furniture 76,000, Machinery 80,000
Debtors 22,000

Liabilities:- Creditors 30,000 Bank overdraft 12,000

Required:
Calculate M. Masati opening capital and record the following transactions

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- Bought more stock by cash sh. 4000
- Debtors piaid by cheque 5000 and by cash shs. 3000
- Slod machinery by on credit shs. 6000

Presentation of a statement of financial position

Format :- (a) Horizontal format
(b) Vertical format.

A) Horizontal Format
Rose Amukoya
Financial position as At 1st July 2006

Liabilities Assets
Long term fixed assets
Loan CDC XX Land and buildings XX
Furniture & fittings XX
Motor van XX
XX
Current liabilities Current Assets
Creditors XX Stock XX
Overdraft XX Debtors XX
Cash XX
Capital XX XX
Total Assets XX
XX XX

Vertical format
Rose Amukuya
st
Financial position as at 1 July 2006
Fixed assets
Land & building XX
Furniture and fittings XX
Motor van XX
XX

Current Assets
Stock XX
Debtors XX
Cash XX
Total Current assets XX XX

Less current liabilities

Creditors XX
Bank overdraft XX XX
Total current liabilities

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Working capital XX
XX

Financed by

Owners Equity XX
Loan CDC XX
XX

NB/ Assets and liabilities are arranged in the order of their liquidity.

Question
Prepare a statement of financial position as at 1st July 2000 using following information
in a vertical and according to order of the items liquidity.

Motor vehicle 60,000

Fixtures and fittings 12,000
Lands and buildings 8 2,000
Cash in hand 2,000
Debtors 42,000
Stock 50,000
Overdraft 10,000
Creditors 26,000
Loan / CDC 50,000
Capital ?
Drawings 2,000

-The temporary accounts charges to permanent accounts related to income – generating

activities.

e.g. Rent payable is recognized as an expense resulting to decrease in cash

temporary accounts are closed at the end of the accounting period.

Recording of economic events is a central feature of accounting. This recording affects at

least two accounts.

The practice is called double entry system. It records the change in a resource and the
reason for or source of the change.

When double entry is done, it ensures that accounting identity / equation remains in
balance.

Example
Receipt of Ksh. 3,000 from Adam a debtor.

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Effect
(i) Increase in cash in hand by Ksh. 3000
(ii) Decrease in debtors‟ amount by Ksh. 3000.

NB We post the debits of accounts payment to the individual accounts daily. This is
shown by a tick. At the end of the month the totals are posted into the ledger account
In a business which has a large number of accounts with customer and creditors, it is
customary important to divide the ledger
(i) Control account/ General ledger
(ii) Accounts payable ledger.
(iii) Account receivable ledger/ Debtor ledger.
General ledger contains all other accounts which one not either account receivable and
not creditor ledger, It contains at the revenue & expenses accounts except creditors
debtors.

Recording transactions in ledger Accounts.

Once the opening of the balance sheet has been done in their respective ledger accounts,
the next thing is to record transactions. Transactions results in increase or decrease the
values of various individual balance sheet items.
Rules
1. All assets have a debit balance and increase in asset accounts are also recorded as
debits. Decrease in assets is credited.

2. All liabilities are credited. Increase in liabilities is also credited. Decrease in

liabilities is debited.

3. Capital/Owners equity is recorded as credits. Increase in owners‟ equity, are

credited. Decrease in owners‟ equity, is recorded as debits.

This rule is extended to cover revenues and expenses accounts.

4. Revenues increases owners‟ equity and therefore recorded as credits.

5. Expenses decreases owners‟ equity and therefore recorded as debits.

Examples
The following balance sheet was provided.
Kikuyu cleaners
Financial position as at 2/2/2006

Assets
Cash 139,000 Bank Loan 120,000
Land 80,000
Building 390,000
Office Equip 10,000 Capital 574,000

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Motor van 75,000 694,000`
694,000

Assume land was sold against cash for Kshs 90,000 on 5/2/08. Record the transaction in
respective ledger account

Dr Land A/c Cr
2/2/08 Bal b/f 80,000 5/2/08 cash 80,000

Cash A/C
2/2/08 Bal b/f 139,000
5/2/08 Cash 90,000

P& L A/c
5/2/08 Land 10,000

Activity 1
State the effect of the following transactions on the balance sheet.
a) Kikuyu cleaners bought a new office, calculator worth Kshs 150,000 for cash.

Effect
1. Decrease in cash
2. Increase in office equipment account.

b) Purchase of cleaning clinical worth Ksh. 30,000 on credit

Effects :- Increase chemical A/c.
Increase in liabilities
c) The company was owed Ksh 50,000 for liability delivered to the owners
during the month.

Effects: - (i)
(ii)
d) Wages due & unpaid at month end amounted to Ksh.7, 500.
Effects:- (i)
(ii)
e) Monthly rent of Ksh 10,000 was paid in cash
Effects :- (i)
(ii)

Treatment of expenses & revenues

Any expense is a loss and therefore results to a decrease in capital which is debited
Revenue on the other hand leads to a profit and therefore results in an increase in capital
which is credited.

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Separate ledger accounts are opened for different expenses and revenues (Not mixed).

E.g
Dr Salaries Cr Dr Rent A/c Cr

Dr Discount received A/c Cr

Example
(i) Paid rent by cash Ksh 9000
(ii) Received rent by cheque Ksh. 10,000

Dr Rent expense A/c Cr Dr Rent income A/c Cr.

4Cash 9000 5th Bank 10,000

Treatment of stock a/c

At the beginning of the account period the value of sold goods is referred to as stock.
During the accounting period, some goods may be entries relating to sales and purchases.

We maintain several accounts for stock as follows.

(a) On stock account in which we record value of unsold goods at the
beginning of the accounting period
(b) One purchase account for recording all purchases of goods for resale
(Debit all purchases)
(c) One account for recording all sales which are credited.
(d) One account for goods which are returned after purchase (Purchase
returns/ return outwards)
This is a reduction of expenses or purchases & hence always credited.
(e) One account for goods refund after sales (Sale returns or returns inwards).
This is a reduction in sales income and hence always debited in the sales
returns account.

Stock accounts are as follows:

Dr Stock A/c Cr Dr Purchase A/c Cr

a) Bal b/f 20,000 b) KNTC 10,000

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 © Dr Returns outwards Cr
Sales A/C
Mweni 5000 Kamau 400

Returns inwards

Kimeto 200

Treatment of capital
Capital is money put in the business to earn profit. Capital is credited and increase in
capital credited. Decrease in capital is debited if a person takes something from business
for personal use, instead of debiting it to his capital account, it is prudent to post a
separate account called a drawings account.
All goods and cash taken from business for personal use are debited in the drawings
account.

Example
Muoki took ksh.200 per personal use.

Dr Drawing A/c Cr Dr Cash A/c Cr.

Cash 200 Drawing 200

NB: After recording all the transactions the accounts must be balanced we final the totals
on the debit and the totals on the credit side and then calculating the difference. The side
with the smaller total has a balance of the last day of the accounting period referred as
balance c/f or bal c/d after which the both side will show the same totals.

Example 3
Read the following.

2006 of May
- 1 started a business with Ksh. 100,000 in the bank.
- 2 Bought fixtures Ksh.500 on credit from Rungai Ltd.
- 5 Bought van paying by cheque Ksh.80, 000.
- 8 Bought van on credit from super motors Ksh.60, 000
- 12. Took Sh.1000 out of the bank and put it into the cash till.
- 15 Bought office fixtures paying cash Sh.600.
- 19 Paid super motors a cheque for Sh.60, 000
- 21 a loan of Sh. 1000 cash is received from James
- 28 Paid Sh.800 of the cash in had into the bank A/c
- 30 bought more office fixtures sh. 400 cash.

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Required
Write up asset capital and liability accounts in books of Rotice to record the transactions
(20 marks).

Example2
A company acquires $ 10,000 worth equipments by tendering a note to a seller for the
full price, both assets and liabilities increases by $ 10,000

Equipments A/c Note payable A/C

Note payable 10,000 Equipment 10,000

The double entry aspect of transaction recording recognizes the debit – credit convention.
This convention divides accounts into two sides. The debit (Dr) side always the left side
and the credit (Cr) side always the right side.

Permanent account

Dr Furniture A/c Cr Dr Assets Cr

Debit credit
Payment a/c Increases Decrease

Liabilities Owners equity

Debit Credit
Decrease Increase Debit credit
Decrease increase

Temporary accounts
Expenses Revenues
Debit Credit Debit Credit
Increase Decrease Decrease Increase

Losses Gains
Debit Credit Debit Credit
Increase Decrease Decrease Increase

NB: The debit change is equal to the credit change.

When the sum of the debit and the credits are not equal, an error has been made.

Example
Payment of an account payable would result in two decreases
1. Decrease in cash
2. Decrease in accounts payable

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At the end of a reporting period, after all transactions and events are recorded and the
account adjusting entries are recorded, the financial statements are prepared.

Financial statements includes:-

1. Income statement
2. Financial position
3. Cash flow statement
4. Retained earnings statement
5. Stock holders equity statement.
The financial statements report account balances, changes in account balance and
aggregations of account such as net income.

Income statement = Net income = revenue – expenses + Gains – losses.

1. Retained earnings = ending = beginning + net income- Dividend declared.

retained retained
Earnings earnings

2. Statement of stockholders = Ending = Beginning + Net + Current - Dividends

Stock stock holders income Period declared
Holders equity stockholders
Equity contribution

3. statement of financial = Ending - Ending + Ending

position Total total stockholders
assets liabilities equity

-The net income statement reports the portion of the changes in net assets (owners equity)
described by income producing activities.

-The retained earnings ending balance is component of ending total owner‟s equity.

The balance sheet follows the accounting identity / equations.

JOUNALIZING TRANSACTION & EVENTS

The purpose is to measure and record the economic impacts of the transaction in a form
that simplified transfer to the accounts
Accounting principles that guide measurement recognition & classification of account are
classified of accounts are applied in this step.

A journal entry is a debit-credit recording of transactions that include the date accounts
& amount involved, and a description. It‟s a temporary recording. The account balance
are not charged until the information is transferred to the ledger Accounts, it‟s also called
the book of original entry.
Journalizing of transactions can be done continually or done in a batch at the end of the
day.

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Example
General Journal
Date Explanation Post ref. Debit Credit
Jan 1 Equipment 15,000
cash 5,000
Note payable 10,000

Purchased
equipment for
use in the
business paid
5000 cash and
gave 10,000 one
year note with
15% interest rate
payable at
maturity

Accounting system has types of journals: - the general journal & several special journals
Entries involving infrequently or Non repetitive entries / entries of the general nature are
recorded in the general journal

Advantages of Journals
1). Show all information about a transaction
2). Provides chronological record of all events
3). Use of the Journal prevents errors
4). Particulars of every action most be recorded in the journal before posting

Example 2
General Journal
Date A/C Explanation / Dr Cr
Details
2002 Jan 1 Cash 60,000
Robert Capital 60,000

Invest cash in business

2 Land 20,000
Cash 20,000
Purchase land for office
site

Special Journals
1). Sales Journal – Recording all credit sales.
2). Sales Return Journal – record returns from sales

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3). Purchase Journal – Recording all credit purchase
4). Purchase Return Journal – for return that had been purchased
5). Cash receipt Journal – Record transaction involving receipts of cash
6). Cash payment Journal – used for recording all cash payments

Record following transaction in their respective journals / Books of original entry of

Jogoo Mpya for May 2002

May
1. Paid rent by cheque 2000
2. Sold for Cash Shs 5,000
3. Bought furniture by cheque Shs 15,000 less 10% discount
4. Bought stock for cash sh. 2,600 less 5% discount
5. Sold stock on credit to Mail Ksh. 700
6. Bought a delivery van Ksh 190,000 on credit from Dubby LTD.
7. Purchased Goods on credit from Kilos worth Kshs 90,000

Cash Payment Journal

Date Details L/F Cash Bank D.R
May 1 Rent 2,000
3 Furniture 13,500 150
Purchase 2,470 130

Cash received Journal

Date Details L/F Cash Bank D.A
May 2 Sales 5,000

Sales Journal/ sales day book

Date Details / Particulars Credit note No Amount
Invoice No.
May 5 Muli 700

General Journal
Date Details L/F Dr. Cr.
May 6 Delivery Van 190,000
Dobby LTD 190,000

To record purchase
of a delivery van on
credit fun Dobby
LTD

Purchase return Journal/ purchase return day book

Date Details Particulars Debit Note No. Amount
May 7 Kilos 90,000

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NB/Some authors do mix the entire journal in a statement as follows;
Example
Journalize the following the following transaction in May 2007
1. Stated business with 60,000 paid 30,000 into bank account
2. Bought furniture for cash sh. 10,000
3. Bought goods for cash shs 30,000
4. Sold goods for cash shs.6000

Date Particulars L.F Dr. Cr.

2007 Cash 60,000
may 1. Capital 60,000
(Cash brought to start a
business)

1 Bank 30,000
cash 30,000
(cash deposited with bank)

2 Furniture 10,000
Cash 10,000
(Furniture bought on
credit) 30,000
3 Purchases 30,000
cash
(goods bought for cash)

4 Cash 6,000

Sales 6,000
(Goods sold for cash)

Posting the Journals to the ledger

The process of transferring transaction date from the journal to individual accounts is
called Posting. Usually there are two types of ledgers
1. General Ledger
2. Subsidiary Ledgers

General ledger holds the individual accounts that are grouped together. Subsidiary
ledgers supports specific general ledger A/Cs that consist of many separate, individual
accounts
Eg
A firm has a substantial customers accounts receivable, one ledger A/C, stores these
separate accounts in an account receivable subsidiary ledger.

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The individual customer account is called subsidiary account
The general ledger now needs only one account for account receivable called the control
account

General Ledger
Accounts receivable control Graphics
6,000 30,000

Digital Micro-tech
20,000 10,000

The balance in account receivable control is the sum of all the individual customer
account balance in compiling Financial Statements only the control / accounts one
considered.

Posting of ledgers (examples) from journals

Dr. Bank A/c Cr. Rent A/c

May/ rent 2000 May 1 bank 2000

Cash A/c Sales A/c

May 2 5000 May 2. cash 5000
5 Muli 700

Delivery van Dobby Ltd.

May 6 Dobby Ltd. 190,000 May 6 Delivery van 190,000

Purchase A/c Muli A/C

May 7 Kilos 90,000 May 5 sales 700

Kilos A/C

May 7 Purchase 90,000

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Preparing unadjusted Trial balance
This is prepared at the end of the reporting period, after all the transaction entries are
recorded in journals and posted in the Ledger A/Cs
The Unadjusted Trial balance is the list of balance from general ledger accounts & their
account balances
Layout
Example
SONORA Company
Unadjusted Trial Balance
Dec. 31 2000
Account Dr Cr
Kshs Kshs
Cash 67,000
Bank 45,000
Allowance for doubtful 1000
A/Cs
Inventory 75,000
Notes receivable 8,000
Prepaid Insurance 600
Land 8,000
Buildings 160,000
Accumulated depreciation 90,000
(Building)
Accounts payable 29,000
Equipments 91,000
Bounds payable, 6% 50,000
Common Stock per & 10 150,000
Contribution Capital in 20,000
excess of par
Retained Earning 31,500
Sales Revenue 325,200
Interest Revenue 500
Rent Revenue 1,800
Purchases 130,000
Freight on purchases 4,000
Purchase Return 2,000
Selling Expenses 104,000
General & Administrator 23,600
expense
Interest Expense 2,500
Extra – Ordinary loss 9,000
(pretax)
728,000 728,000

USES

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  It‟s a convenient means for check fore the sum of the debit account balances
equals to the sum of the credit account balances
 It‟s the stating point of developing adjustments closing and reversing entries & for
the worksheet, if used.

Errors of trial balance

A trial balance may show that the debits are equal to credits but still has errors (This are
referred as errors not disclosed by the trial balance.

Those that we can obvious see are referred to as errors disclosed by the trial balance.

Errors disclosed.
1 Over stating/ understating of amounts.
2 Entering debits as credits & vise versa
3 Accounting errors in copying balances.
4 Errors of addition of trial balance.
5 Arithmetic mistakes in balancing of A/Cs

Errors not disclosed are:-

(a) Errors of original entry – where the original figure is incorrect, yet double entry is
still observed using this incorrect figure.
(b) Errors of commission- entering a transaction more than once but in the wrong
person‟s account.
(c) Compensating errors-. - making an error that exactly offsets the effect of another
error.
(d) Error of omission- where a transaction is completely omitted from the books
(e) Error of complete reversal- where correct account are used but each item is
shown on the wrong side of the account
(f) Error of principal- where an item is entered in the wrong class of account- e.g
motor van debited to an expense account

Discovery of errors
Errors may be determined in one of these several ways:-
(i) By audit procedures
(ii) By chance discovery
(iii) Through the medium of trial balance.
(iv) Through customer complaints
.
Errors disclosed by the trial balance should be corrected before the financial statements
are prepared.

Questions
1. Does the equality of debit & credit in a trial balance assure of the absence of
errors in the Accounts Explain
2. Does the sum of the debit column in an unadjusted trial balance represent a
meaningful total? If not, why is it computed?

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 3. Why might the retained earning Account balance in the unadjusted trial balance
reflect the beginning of year balance?

Journalizing and posting adjusted journal entries

A firm‟s financial statement cannot be prepared until adjusting Journal entries are
recorded
This is required when a source document is not timely. It can be done at the end of the
financial. Doing it frequently is costly.

Accrual basis accounting requires this adjustment to reflect changes in resources under
the revenue.
Adjusted journals are recorded and dated as of the last day of the financial period. They
are recorded in the general journal and posted to the ledger accounts

Example Correction of errors

Error of omission
`
Assume sale of goods worth Sh. 900 to Gakundu was omitted from the books. The
journal entry to correct the error would be

General Journal
Dr Gakundu 900
Cr Sales 900
To correct omitted sales.

Errors of commission
Usually occurs where there are accounts with almost similar names.

A purchase of Sh. 2000 worth of goods from K. Kamotho was credited to K. Kimotho‟s
account.

Dr. K. Kimotho‟s A/c 2000

Cr. K. Kamotho A/c 2000
To correct error of commission

Error of principle
This error violates the general acceptable accounting principles.
E.g. purchase of a photocopy for Sh 50,000 by hardware‟s Ltd and was included with
purchases for resale.

The correct journal entry

Dr Office equipment 50,000
Cr Purchases 50,000

To correct error of principle

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Compensating error

This error occurs when debits and credits in different accounts are overstated or under
stated by some figure.

Assume the credit balance in the sale accounts overstated by Sh.1,500, since the debits &
the credits are overstated by the same amount, this type of error would not affect the trial
balance.

Correction
Dr sales 1,500
Cr general expense 1,500
T o correct overstatement of the A/cs

Error of original entry

The error occurs normally when the figures are transposed
E.g. Assume expenditure of Sh 2980 for office stationary was recorded as 2890/=.

Dr. Office stationary 90

Cr. Cash 90

To correct error of original entry

Error of complete reversal

This type of error occurs where a transaction is recorded in the reverse manner

For example
Sale is recorded as purchase. Assume goods worth Sh. 3,200 were sold to Kibaso but sale
was recorded as purchase from Kibaso.

Correction
Dr Kibaso 6,400
Cr Purchases 3,200
Cr Sales 3,200

There are two recording methods

1. Standard recording method – records an asset on payment of cash before
receiving a good or service or a liability on receipt of cash before providing a
good or service
Eg.
If two months rent is prepaid in July, the standard method debits prepaid rent for
the total amount.
An adjustment is necessary later in the year to recognize rent expense and the
expiration of prepaid rent.

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 2. Expedient Recording Method - Record an expense on payment of cash before
receiving a good or service
In the rent example, the expedient method debit rent expense is two months rent. This
method is expected because many such cash payments are receipts related to expenses
that apply only to the year in which the cash flow occurs. No adjustment is required
for correct reporting of account balance at the end of the year.

Adjusting Journal entries are categorized into three:-

1. Deferrals / prepayments – cash flow occurs before expense and revenue recognition
The portion of the expense or revenue that applies to future periods is deferred as a
prepaid asset or unearned revenue. In both cases, asset is paid or received before the asset
is used or service is provided. Prepaid rent & revenue collected in advance are examples

2. Accruals - Cash flows occurs after expense and revenue recognition. These adjusted
Journal entries are used when cash will be paid or received in a future accounting period,
but all as a portion of the future cash flow applies to expenses or revenue of current
periods
Eg. Unpaid wages accrued as wage expense that at the end of year represent
wage cost, matched against current year revenue which is to be paid next year.

3. Other Adjusting entries

 Reclassification of permanent Accounts
 Estimation of expense (bad – debts) expenses example
 Cost allocation (depreciation)
 Recognition of costs of goods sold & inventory losses
 Correction of errors

Activity
Assume Mr. Daiko was paid sh. 1,200 and the payment was entered on the receipts side
to Mr. Daiko‟s account, what journal entries would you need to correct this error?

Deferred Revenue
Sonora leased a small office in his building to a client on January and recorded as a debit
to cash and credit to rent revenue for 18 months rent, which is due in Dec 31, 2000. The
unadjusted Trial balance reports Kshs 1,800 in rent revenue which is overstated by Kshs.
600. Adjusted Journal entry is to be Ksh. 1,200 and creates a liability equal to the amount
of rent Ksh 600

Dec. 31, 2000

Dr. Rent Revenue 600

Cr. Rent expense 600
Accruals
Sonora previously issued at face value Ksh. 50,000 at 6% bonds paying interest yearly
each Oct. 31. For the current accounting period a two month interest Obligation
developed, between Oct 31, 2000 and Dec 31, 2000. Under matching principle, Sonora

33
recognizes the apparent amount of interest expense against the benefits obtained by using
creditor‟s money.
The amount for the two months period is

(Kshs 50,000 x 0.06 x 2/12)

= 500/=
Therefore both interest expenses & associated payable interest are recognized in adjusted
journal entries

Dec. 31, 2000

Dr. Interest expense 500
Cr. Interest payable 500

Bad – debts – These are uncollectible debts estimated / experience most large company‟s
are of uncollectible accounts. Bad debts reduces the amount of accounts receivables
Estimates of uncollectible accounts are based on credit sales for the period

Example
Sonora extended credit sales amounting to Kshs. 12,000. Prior experience indicates 1%
average bad debt on credit sales.
He treats bad debts as a component of selling expenses to be recorded

Dec 31, 2000

Dr. Selling expense (12,000 x 0.01) 120
Cr. Allowance for doubtful debt 120

Cost of Goods Sold

Assume an item that sells at Kshs 300 is carried in inventory at a cost of Kshs 180. The
sale of this item require two entries

Dr. Cash / Account receivable 300

Cr. Sales revenue 300

Dr. Cost of goods sold 180

Cr. Inventory 180

The suspense Account

Why suspense accounts
Suspense is associated with uncertainty. It‟s simply that it‟s not clear where an item
should be posted. E.g. cash may be received but not sure from whom therefore put in a
suspense account. When the two sides of the trial balance do not balance, the reason for
the inequality is uncertain and the trial balance is made to balance by inserting the
amount of the difference in a suspense account. The intension is to make totals of either
side of the balance equal. If the error cannot be found as seen above, then the amount of
the error is entered on a suspense account and carried forward to the balance sheet as

34
either a debit or a credit amount depending on whether the amount making the trial
balance was a debit or credit balance.

When discovered later, they should be corrected and the suspense account eliminated
from the books. In correcting errors affecting the trial balance, it should be corrected
before the final accounts are prepared.

Example
Dr Cr
Totals 150,000 110,000
Suspense a/c 40,000
150,000 150,000

After rechecking the sales were under-estimated by Ksh. 40,000.

Correcting the entry

Dr Suspense a/c 40,000

Cr sales a/c 40,000
To record sales correctly

If it was found that the sales was under estimated by 30,000 and 10,000 paid by a
customer (Mr Okundi)

Correction
Dr suspense 40,000
Cr sales 30,000
Cr Okundi 10,000
To correct the accounts & eliminate suspense account

Examples 1
Assume an error of Sh. 400 is found the following year of 31st March 2006. The error
was that sales a/c was under-cast by 400,

Correction
Dr Cr
Suspense a/c 400
Sales 400

We open suspense account to close.

Suspense a/c
31st March sales 400 Dec 31 Difference 400

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 Sales
2005
March31suspense 400

Example 2
Shs. 550 received from sales of goods has been entered in the sales account.

Corrections
Dr. Cash a/c sh 550
Cr. Suspense a/c sh 550

To correct the sale of office equipment recorded in sale a/c

Cash a/c Suspense a/c

Office equipment 550 office equipment 550 sales
550

Example
An account clerk extracts a trial balance which fails to agree by shs.2000. He places the
difference on the credit side of suspense account and then proceed to prepare a draft
trading profit and loss account for the year ended 31st may 2007 which resulted into profit
of shs 800,000. Later he attempts to find the errors which had caused the difference.
Investigation reviewed the following;
1. The purchase day book had been under cast by 16,000
2. The cost of new equipment (sh12, 000) had been debited to repairs account.
Depreciation on this equipment should be provided at 15% per annum on
straight line basis
3. A balance of sh 8,000 due from J.Ketel was omitted from total debtors
4. An entry of 2,000 with respect to returns outwards was made in the sales day
book instead of purchase returns day book
5. A cheque for shs.5,000 paid to Rukia ( a creditor) was correctly entered in the
cashbook but was credited to her accounts
6. A debt of shs. 5,000 should have been written off from one of the debtors
account
7. Goods with a sale value of shs.40, 000 had been taken for the proprietors own
use. These were not recorded anywhere
8. A discount of shs 18,000 received had been correctly entered in the cashbook
but had been posted to the wrong side of the discounts received account
Required
a. Journal entries necessary to correct errors
b. Suspense account to clear the difference
c. Statement of adjusted profit

Solution

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 Suspense P& L

Bal 2000 G.p b/d xxxx

Balc/f 800,000

Journals
Dr. Purchase A/c 16,000
Cr. Suspense A/c 16,000
To record under- cast of purchase account

Dr. Equip A/c 10,200

Dep A/c 1,8,00
Cr repair A/c 12,000
To record cost of new equipment

Dr. J. Ketel A/c A/c 8,000

Cr. Suspense A/c 8,000
To record omission of funds from a debtor

Dr. Sales A/c 2,000

Cr. Purchase returns A/c 2,000
To record returns previously recorded in the sale day book

Dr. Rukia A/c 10,000

Cr. Suspense A/c 10,000
To record payment of Rukia that was credited in her account

Dr. bad debt written -off A/c 5,000

Cr. Debtors A/c 5,000
To record writing of bad debt
Dr. Drawings A/c 40,000
Cr. Stock A/c 40,000
To record drawings by owner

Dr. Suspense A/c 36,000

Cr. Discount received A/c 36,000
To record correction of discount received posted in the wrong side of the account

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 Suspense A/C Adjusted profit

Discount received 36,000 Bal 2000 N/p b/d 800,000

Debtor 8,000 les under cast (16,000)
Rukia 10,000 depreci (1,800)
Purchases 16,000 adjusted NP 782,200
36,000 36,000

Un adjusted trial balance – A trial balance that appear on the ledger before any
adjustment is made.

Adjusted trial balance – A trial balance after adjustment of accounts, pre-payments &
apportionment of costs are done. Its from the adjusted trial balance that the final accounts
are prepared.

Exercise1
Use suspense a/c to correct the following errors.
(ii) Purchase of a book has been overcast by Sh.600
(ii) A cheque of Ksh 930 received from sand had been correctly entered in the
cash book but had not been entered in sand‟s account.

Exercise 2
From the following errors were found in the books of Kamugi Grocers. prepare the
necessary journal entries to correct the errors.
(a) Shs. 5,000 paid for furniture had been debited to purchase a/c.
(b) An amount of Sh 1,000 withdrawn by the owner had been debited to
general expenses a/c.
(c) Shs. 1,000 paid for rent had been debited to the landlord‟s a/c.
(d) Sh 1,500 received from Shangira had been wrongly credited to
Shangazi a/c.
(e) Sh 800 paid by a debtor were wrongly credited to the cash a/c.

Q2. Prepare journal entries to correct the following errors through the suspense account
show the suspense account.
(a) The total of sales was under cost by Kshs. 1000/=
(b) Goods worth Kshs. 1,500 returned by Gikundi have not been recorded
anywhere.
© Goods worth Kshs. 2,500 had been posted to the debit of the supplier Gutero &
Co.
(d) Discount of Kshs. 150 received from Rugina had not been entered in the
discount account.
(e) Discount of Kshs. 180 allowed the machelle had not been entered in the
discount account.

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 Adjusting Entries
Adjustments
It‟s the process of putting some items to change due to some effects Almost every
adjusting entry affects both the balance sheet amount and the income statement amount.
This characteristic of adjusting entries reflects their dual purpose of:-
(a) proper valuation of assets and liabilities
(b) Proper measurements of income.

Some adjustments includes

o Prepayments
o Accruals
o Bad debts
o Depreciation
o Arrears
o Revenue arising
o Provisions
Prepayments- These are expenses which have already been paid at but relate to the
following accounting period. Also referred to as income in advance
It leads to an overpayment in the process of making payment. Its reflected in the balance
sheet as a current asset.
Treatment
Dr. Prepayment expense a/c xx
Cr. P& L xx

P& L A/C Balance sheet

Insurance xx current assets
Less stock xx
Prepayment xx Debtors xx
Prepayments xx
Accruals _ Expenses which are outstanding and have not been paid as a result of
underpayment. It‟s also referred to as Accrued expense and reflected in the final balance
sheet as a current liability.

39
Treatment
Dr. P & L a/c xx
Cr. Accrued expense account xx
P & L A/C Balance sheet
Salaries xx Current liabilities
Add accruals xx Creditors xx
XX Stock xx
Overdraft xx
Accruals xx
Accrued income
Dr. Accrued income a/c xx
Cr. P& L a/c xx

P & L a/c BALANCE SHEET

Rent receivable xx
Add accrued income xx Current assets
Accrued rent income xx

Income in advance
Dr P& L a/c xx
CR. Income in advance a/c
P & L A/C BALANCE SHEET
Rent receivable xx
Less rent in advance xx Current liabilities
Rent in advance
xx

II. Bad Debts.

Are uncollectible debts that a business finds not able to collect from debtors because of
various reasons ranging from bankruptcy, jail, insolvency e.t.c. They are expenses to a
business.

40
Treatment
Dr. P & L a/c xx
Cr. Bad debts written off accounts a/c xx

P & L A/C Bad debt written off

Expenses P & L xx
Bad debts xx

Provisions for bad debts

Creation of an amount to cater for bad debts as it is common that parts of the debts will
remain outstanding. The provision is created and charged to profit and loss account and
credited to the provision for bad debts accounts.
Treatment
Dr. P & L a/c xx
CR. Provision for bad debts xx
P&L BALANCE SHEET
Provision for bad debt xx Current assets
Debtors xx
Less provision
for bad debts xx
When provided both bad debts and provision for bad debts, the following are the
treatment
Dr. Bad debts
Cr. Provisions for bad debts

P& L a/c Balance Sheet

Bad debts xx Debtors xx

Less provision xx
for bad debt

41
Reserves -Those amounts which are set a side out of the profit to retain assets in the
business in order to strengthen the financial position of the business. The amounts
transferred to reserves cannot be used for distributing profits under normal circumstances.
They are usually retained profits for general purpose.
Treatment
Dr. P & L a/c
Cr. Reserve a/c
P& L Balance sheet
Reserve xx Current asset
Reserves xx

ARREARS
These are amounts that ought to be paid but not yet paid to an individual or business e.g
salary arrears are reflected in the balance sheet as a current asset.
Balance sheet
Current assets
Arrears xx

Revenue Owing
These are receivables that a business is supposed to receive from its debtors. It‟s reflected
in the P&L
P&L a/c Balance sheet
G.P. B/d xx Current asset
Revenue owing xx Revenue
owing xx

Depreciation
Wearing out of machinery such as motor vans, buildings e.t.c. it represents a decrease in
value of the fixed asset. The loss in venue is chargeable against profit made during the
working life of the asset. It‟s calculated annually

42
Treatment
Dr. P & L A/C xx
Cr. Asset account xx
P& L a/c Balance sheet
Depreciation xx Fixed asset
Machinery xx
Less depre xx
Provision for depreciation
Amounts set aside out of profits for a specific purpose, in this case for depreciation. It‟s
made in view of some expected events.
Treatment
P& L BALANCE SHEET

Expenses Machinery xx
Provision
for depreciation xx Less provision Depreciation xx

Adjusting entries can be classified into the following groups:-

(a) Appointment of recorded costs
(b) Apportionment of recorded revenue.
© Accrued of unrecorded expenses
(c) Valuation of receivables

(a) Apportionment recorded costs.

Example: - Allocation of periodic depreciation expense.

Dr. Depreciation expense 12,000

Cr. Accumulated depreciation 12,000

Assume an office supplies was worth Kshs. 5000 end of the year inventory (physical
show the item is worth Kshs. 550/=.

The adjusting entry requires us to transfer the expired portion of the cost as an expense
account.

43
 Office Stationery Inventory_________________
Bal 5,000 Supplies exp. 4,450
Bal. c/d 550
5,000 5,000

Office supplies expense___________________________

Office stat inventory 4,450

(b) Appointment of recorded revenue

When cash is received, the original entry may be recorded in either of these two ways.
-A liability account may be created
-A revenue account may be created.

Example
Assume that a customer pays Kshs. 500,000 for magazines subscriptions during the year;
however Kshs. 75,000 of this represents payments of copies to be delivered the following
year. The adjusting entries for each of the two methods would be:–

Assets and liability account created upon receipt of cash.

Subscription Account
Dec 1 500,000
Subscriptions receipt &
Revenue 425,000 payments
Bal C/d 75,000
(Unearned
Revenue)
500,000 500,000

Nb unearned revenue appears as a current liability to the business

Balance sheet

Liabilities
Unearned revenue 75,000

© ACCRUAL OF UNRECORDED EXPENSES

In order to achieve a realistic measurement of the expenses of the period, an adjusting
entry is required to record accrued expenses and the corresponding liability.

Example
Assume that interest of 6% is paid on a 600,000 note payable semi-annually on 1st
march and 1st Sept of each year

44
The adjusting entry of this expense at 31st Dec. would be as shown below.

Dr. Interest expense 12,000

Cr. Accrued interest payable 12,000

Calculation
(6/100 x 600,000 x ½)/6 x 4 months = 12,000
In order to measure income properly during each operation period and to avoid shifting of
income between periods, revenue should be recognized in the period earned.

Example
Assume rent totaling to Kshs. 500 for the month of Dec. has been earned but neither
collected nor recorded.

The adjusting entry would be necessary for complete reporting of revenue and asset.

Dr. Rent receivable 500

Cr. Rent revenue 500
To record rent earned for the month of December.

(a) Valuation of receivables

Once the estimates of uncollectible accounts are established, the adjustment should be
made.

Dr. Un-collectable account expense 2,500

Cr. Allowance for uncollectible/doubtful debt 2,500

To record estimated expenses on doubtful debts.

Example
Using the following information, prepare adjusting entries for the situation described
below.

(a) The closing stock includes goods worth Kshs. 22,500 for which the invoice has not
received.

Dr. Invoice records 22,500

Cr. Closing stock 22,500
To reduce goods included in the closing stock.

(b) On Ist Jan 2007 Kshs. 3,000 was paid for rent up to 31st Dec. 2008. This amount was
debited in to the buildings account. The firm‟s fiscal year ends at 31st Dec.

45
 Dr. Rent expense 3,000
Cr. Building 3,000

To record rent amount to the correct account.

Exercise
Prepare adjusting entries for the situation described below.
1. During the year a machine sold for Kshs. 14,000. The sale was credited to the sales
account. The book value of the machine was Kshs. 18,000
2. On Dec. 25th a fire destroyed goods worth Kshs. 50,000. The insurance company has
admitted the claim in full.
3. During the year an old lorry was traded in for a new one. The book value of the old
lorry was Kshs. 100,000 and the car dealer gave Kshs. 64,000 trade- in allowance.
The cost of the new lorry is Kshs. 350,000 (No entries had been made) Depreciation
on the lorry should be provided as 15% per annum on cost from the year of purchase.
4. A Provision for bad debt of 6% should be made on the debtor‟s balance of Kshs.
155,000.
5. Unpaid wages at the end of the financial year amounted to Kshs. 15,800/=

Preparing Adjusted Trial balance

At this point, the transaction of the adjusted journal entries are journalized and posted and
an adjusted trial balance is prepared.
The trial balance lists all the account statements with the exception of retained earnings.
The purpose of the adjusted trial balance is to confirm debit – credit equity taking the
adjusted journals into considerations

Sonaro
Adjusted Trial Balance
31st Dec 31, 2000
Accounts Dr Cr
Cash 67,300
Account received 45,000
Allowance for doubtful A/C 2,200
Notes received 8,000
Inventory 90,000
Interest received 100
Prepaid Insurance 400
Land 8,000
Building 160,000
Accumulated depreciation 100,000
(Building)
Equipments 91,000
Accumulated dep. Equip. 36,000
Accounts payable 29,000
Interest Payable 500

46
Rent Revenue Collected in 600
advance
Income tax payable 20,000
Bounds payable 6% 50,000
Common Stock sh 10per 150,000
Contributed Capital in excess 20,000
of per
Sales Revenue 325,000
Rent Revenue 1,200
Interest Revenue 600
Cost of goods sold 117,000
Selling expenses 113,000
General & Adm. exp. 34,600
Interest expense 20,000
Extraordinary loss 9,000
766,800 766,800

During adjustment new accounts that were previously not there may be created.
The new accounts created are;
 Interest receivable
 Interest payable
 Rent revenue etc

Preparing Financial Statements

The primary objective of financial accounting is to provide information useful to decision
makers. The financial statement can be produced for a period of any duration However,
monthly, Quarterly and annual statements are the most common

The following revenue & gain account are made from Sonora Books

Dec 31, 2000

Dr Sales Revenue 325,000
Interest revenue 600
Rent Revenue 1,400
Cr Income Summary 327,000

To close the expenses & loss account to income summary

Dr. Income Summary 297,000

Cr Cost of goods sold 117,000
Selling Expenses 113,400
General Adam Exp 3,000
Extraordinary loss 90,000
Income tax expense 20,000

47
To close income summary ie transfer net income to retained earnings
Dr. Income Summary 30,000
Cr. Retained Earning 30,000

After the first two closing entries are recorded and posted, the balance in income
summary equal net income (30,000) shown in the T-account

Income Summary
297,000 327,000
30,000

At this point, the temporary account have a zero balance and are already to begin the next
account and transfer of net income to retained earnings

Dividends
When cash dividends are declared, we first debit either retained or cash divided declared,
a temporary account is opened.
Dividends payable are credited. If cash divided declared is credited to close accounts
required.

Dr. Retained earnings xx

Cr. Cash divided declared xx

In the case, the net result of closing entries is to transfer the retained earning an equal
amount to earnings less divided declared for a period.

9. Preparing Post closing Trial balance

A post closing Trial balance shows a list of only the balance of the permanent accounts
after closing process is finished (Temporary A/Cs here have zero balances)
This step is taken to check the debit – credit equality after the closing entries are posted.
Any error would be discovered

The retained earning is now stated at the correct ending balance and is the only
permanent account with a balance different from the one shown in the adjusted trial
balance

Example
Sonora LTD
Post – closing Trial Balance
Dec 31, 2000
Account Dr Cr
Cash 67,300
Allowance for doubtful 2,2000
account
Account Received 45,000

48
Interest payable 1,000
Notes receivable 8,000
Inventory 90,000
Prepaid Insurance 400
Land 8,000
Building 160,000
Accumulated dep. 10,000
(Building)
Equipment 91,000
Accumulated dep. (Equip) 36,000
Accounts payable 29,000
Rent revenue collected is 600
advance
Interest payable 500
Income tax payable 20,000
Bonds payable 6% 50,000
Common stock & 10 per 150,000
Contributed Capital in 20,000
excess
Retained earnings 61,500
Total 469,800 469,800

10. Journalizing and post reversing journal entries.

After the adjusting and closing entries, are journalized and posted to the general ledger,
the accounts are ready for recording in the next period.

The revised journal entry may be used to simplify certain journal entries for the next
accounting period.

Revised journal entries are:-

(i) Dated the first day of the accounting period

(ii) Used the same accounts and amounts as adjusted journal entries, but with the
debits and credits reversed.
(iii) Are posted to the ledger

Revised journal entries

Dec. 31, 2000
Dr. Interest expense 400
Cr. Interest payable 400

Jan I, 2001
Dr. Interest payable 400
Cr. Interest expense 400

Assume on Nov. 1, 2000, $ 300 is paid in advance for three months rent.

49
Reporting Expedient method
Nov. 1 2000
Dr. Rent expense 300
Cr. Cash 300

Dec 31, 2000

Dr. Rent prepaid 200
Cr. Rent expense 200

With revising entry

Jan 1, 2001
Dr. Rent expense 100
Cr. Prepaid rent 100

Standard method
With or without revised journal entries rent expense is recorded in 2000 is
Reported as

Nov 1, 2000
Dr. Prepaid rent 300
Cr. Cash 300

Dec 31, 2000

Dr. Rent expense 200
Cr. Prepaid rent 200

Jan 1, 2001
Dr. Rent prepaid 100
Cr. Rent expense 100

Accrued item
Assume that the last payroll for Dec. 200 is Dec. 28. Wages earned through Dec. 28 are
included in this payroll. The next payroll ends at Jan 4, 2001 at which Kshs. 28,000 of
wages will be paid. Wages earned for the three – day period ending Dec. 31, 2000, are
Kshs. 15,000 which will be paid in 2001.
Required
Make a report

Dec. 31, 2000

Dr. Wages expenses 15,000
Cr. Wages payable 15,000

With revising entries

Jan 1, 2001
Dr. Wages payable 15,000

50
 Cr. Wages expenses 15,000
Jan 4, 2001
Dr. Wages expenses 28,000
Cr. Cash 28,000

Without revising Jan 4, 2001

Dr. Wages expense 13,000
Dr. Wages payable 15,000
Cr. Cash 28,000
Questions
1. How are the balance sheet and income statement related?
2. Explain the benefit of double entry system. What additional benefits do the debit
– credit convention provide.
3. Give four example of internal cost allocation that requires adjusting entries.

LECTURE 8
MEASURING BUSINESS INCOME
Meaning of income
Income- The difference between revenue of expenses incurred during a trading period.

Hicks defined. Income as the maximum value which he can consume during a period
and still be as well off at the end of that period he was at the beginning.

The amount of money available for purchasing goods would have been termed “Capital”.
Income can be calculated as the change in capital between the beginning and ending
capital balances.

Distinction between Capital and Revenue Expenditure

Capital Expenditure – These are expenditures incurred in the acquisition of assets

which will be used in the business for more than one accounting period which is normally
one year.

Revenue expenditure- Expenses by a business to acquire assets that are used up in the
course of one accounting period e.g labour, promotion, expenses, distribution and selling
expenses.

Looking at the trial balance again- it‟s a statement which summarizes all the balances in
the ledger accounts as shown earlier.
Summarizing a trial balance
Divided into three sections
(i) Properties or real accounts.
(ii) Personal accounts
(iii) Nominal accounts

51
Real or property – Accounts presenting properties that a person has e.g cash in hand,
cash in bank machinery, stock e.t.c.

Personal account – Accounts representing the indebtedness of the business to others

businesses e.g creditors, debtors etc.

Nominal accounts- Represents expenses or income of the business e.g purchases, wages,
sales, transport, rent income e.t.c.

NB:
1. When all real and personal accounts are summarized in one statement, they form the
balance sheet of the business at a particular period.

2. When all the expenses and incomes (nominal accounts) are summarized in one
statement. They make the profit and loss statement.

-The objective of the accounting function is the calculation of the profit earned by a
business or losses incurred by it. Earning of profit is the main reason why the business
was established.

Reasons for knowing the value of profit

 To assist to plan ahead
 To help the owner to obtain loans
 To show to a prospective partner or person to whom he hopes to sell the
business.
 To know his profits for income tax purposes.

Calculating profit
Profit is calculated in two stages.
(i) Gross profit
(ii) Net profit

Gross profit is the excess of net sales over direct expenses. (Direct expenses are expenses
relating to purchase of goods), Examples- Carriage inwards, purchase expenses e.t.c.

Gross profit = Sales - Direct expenses

= Sales -Cost of sales.

Net profit is the excess of Gross profit over indirect expenses. (Indirect expenses –
expenses that are not a must or not related to purchase of goods for resale), Examples-
Carriage outwards, wages, rent, insurance, telephone bill, water bill e.t.c.

Net profit = Gross profit - Direct expenses.

Calculating Gross profit

Nyangweso gave the following information as at 30th Dec. 2007

52
 Opening stock 35,000
Purchases 350,000
Sales 500,000
Closing stock 15,000

Calculate the gross profit.

G.P. = Sales – cost of sales (direct expenses)
= Sales - (Opening stock + purchases of closing stock)
= 500,000 - (35,000 + 350,000 - 15,000)
= 500,000 - 370,000
G.P. = 130,000
Exercise
Q1. Mwongera gave the following information on 31st Dec. 2006.
Sales 800,000
Purchases 450,000
Opening stock 60,000
Closing stock 70,000
Sales returns 5,000
Purchases returns 3,000
Compute the Gross profit.

Q2. Mwongeza accounts disclose the following information as at 31st July 2007.
Opening stock 15,000
Purchases 150,000
Closing stock 25,000
Sales 220,000
Wages 20,000
Electricity 5,000
General expenses 7,000
Rent received 15,000

Compute (i) Gross profit

(iii) Net profit

53
(a) Trading account- A financial statement which shows the revenue from sales, the cost
of sales and Gross profit arising during a given period.
Layout (Horizontal)
Mwanzia enterprises
Trading A/C for the year ended 2000

Opening stock XX Sales XX

Add purchases XX Less returns inwards XX
Add carriage inwards XX
Less purchases returns XX
Less closing stock XX
Gross profit/ loss XX
XXX XXX

Vertical method
Mwanzia enterprises
Trading A/C for the year ended 2000
Sales XX
Cost of sales
Purchases XX
Less purchase returns XX
XX
Add carriage inwards XX
XX
Less closing stock XX
Cost of sales XX
Gross profit /loss XX

54
Example
The following trial balance was extracted from B swift business in 2006.
B SWIFT
Trial balance as on 31st Dec. 2006
Dr Cr
Capital 303,200
Drawings 32,000
Opening stock 46,100
Purchases 284,000
Returns outwards 3,600
Returns inwards 15,200
Carriage inwards 2,700
Carriage outwards 10,000
Wages 47,000
Carriage outwards 25,000
Motor van 584,200
Cash 600
Closing stock 60,000
Sales _________ 800,000
1,106,800 1,106,800
Required
Prepare a trading statement / trading account.

Solution

55
 B.SHIFT
TRADING STATEMENT FOR THE YEAR ENDED 32ST DEC. 2006.

Opening stock 46,100 Sales 800,000

Purchases 284,000 Less returns (15,200)
Returns (3,600) 784,800
280,400
Carriage inwards 2,700
283,100
Less closing stock (60,000)
2231,100
Gross profit 561,700_ _______
784,800 784,800

(b) Profit and loss statement.

It‟s a statement which shows the net profit or loss of a business for a given accounting
period.
Example
Mwenza enterprises
Profit and loss statement on 31st Dec. 2006

Expenses (indirect) Gross profit B/d xx

Discount allowed xx Add
Salaries xx (Income) xx
Electricity xx
Carriage outwards xx
Net profit xx
XX XX

56
Example
The following balances were extracted from the books of Mutero on 31st Dec. 2005.
Sales 300,000
Sales returns 5,000
Purchases 190,000
Purchase returns 2,000
Carriage outwards 2,400
Stock (opening) 22,000
Rent 8,000
Insurance 6,000
Salaries 3,600
Discount received 2,800
Cash 13,000
Closing stock 42,000
Prepare a trading and loss account
Mutero Enterprises
Trading, profit and loss statement for the year ended 31st Dec/ 2005.
Opening stock 22,000 Sales 300,000
Purchases 190,000 Returns 5,000
Returns 22,000 295000
188,000
Cost of goods available for sale 210,000
Closing stock 42,000
Cost of sales 168,000
Gross profit 127,000 ________
295,000 295,000
Indirect expenses Gross profit B/d 127,000
Rent 8,000 Discount received 2,800
Insurance 6,000
Salaries 3,600
Carriage outwards 2,400

57
Net profit 112,200 __________
129,800 129,800
Net profit B/D 112,200/=
Exercise
(a)From the following information of Mukero enterprises at 31st July 20007, prepare a
profit and loss statement.
Gross profit 600,000
Rent received 7,000
Drawings 3,000
Wages 2,000
Motor expenses 1,000
General expenses 3,000
Returns inwards 1,000
Carriage inwards 2,000
Carriage outwards 1,500
Electricity & water 2,500

Q2. From the following information of Kyango prepare a trading and profit & loss
statement.

Stock ( 1.3.2000) 25,000

Purchases 250,000
Sales 520,000
Salaries 24,200
Returns outwards 40,000
General expenses 48,000
Returns inwards 70,000
Carriage inwards 20,000
Carriage outwards 15,000
Insurance 4,800
Electricity 3,250

58
Stock ( 31.3.2000) 3,200

Q3. From the following trial balance of B Webb prepare a trading, profit and loss account
for the year ended at 31st Dec. 2007.
B. Webb
Trial Balance as on 31st Dec. 2007.
Dr Cr
Sales 18,462
Purchases 14,629
Salaries 2,150
Motor expenses 520
Rent 670
Insurance 111
General expenses 105
Premises 1,500
Motor van 1,200
Debtors 1,950 1,538
Cash in hand 40
Drawings 895
Capital _____ 5,424
25,424 25,424
Stock at 31st Dec. 2007 was 2,548.

FINAL BALANCE SHEET

It‟s prepared after all the business transactions have been made. Adjustments and
profits are also included.
Example
FINAL BALANCE SHEET
It‟s prepared after all the business transactions have been made. Adjustments and
profits are also included.

59
 Example
FINAL BALANCE SHEET (LAYOUT)
EGEN TRADERS
Balance sheet at 31st Dec. 2007
Capital xx Fixed assets
Add net profit xx Plant & machinery xx
xx Less (depreciation & provision xx
Less drawings xx for depreciation)
Net capital xx Bookvalue / Salvage value xx

xx Furniture xx
xx
Current liabilities
Creditors xx Current Assets
Loan xx
Overdrafts xx Stock xx
Accruals xx Debtors xx
Provisions for bad debts xx
xx Bank xx
Prepayment xx
xx xx
xx

Question
The following information relate to Kiene enterprises
Motor van Kshs. 60,000
Plant & machinery 90,000
Provision for depreciation
-(plant machinery) 5,000
-motor van 5,000

Additional information
Depreciation was 10% on cost to machinery and 20% to motor van.

Required
Work out the book value and show their treatment.

Solutions
Book value = (Value – Provision)
Motor van = (60,000 – 5,000) = 55,000
Machinery = (90,000- 5,000) = 85,000
Depreciation
(i) Motor van = 55,000 x 20/100 = 11,000

60
(ii) Machinery = 85,000 x 10/100` = 8,500

Motor van (dep + provision)

= 11,000 + 5,000
= 16,000

Machinery (Dep + Provision)

= 5,000 + 8,500
= 13,500

Treatment

Balance sheet P & L A/C

Plants & machienery 90,000 Dep Mach. Motor 8,500

Les (Prov. + Dep) 13,500 Dep. Motor 11,000
76,500

Motor van 60,000

(Prov. + Dep) 16,000
44,000

ACTIVITY
The following account balances were found in the books of Mwako Ltd. On 31st Dec.
2004
Sale of merchandise 8,440.000
Commission received 35,000
Warehousing expenses 45,000
Wages and salaries 50,000
Telephone 21,000
Electricity 75,000
Administrative expenses 729,600
Depreciation expenses:
(a) Buildings 65,000
(b) Motor vans 90,000
Furniture 23,000

Additional information
1. Accrued wages amounted to Kshs. 60,000
2. No depreciation was recorded for motor van bought on 1st July for Kshs.
300,000. Depreciation of motor van is at 15% p.a.
3. Administrative expenses included the cost an electric typewriter bought on
30th Dec. for Kshs. 50,000/=
4. Electricity bill owing amounted to Kss. 80,000

61
Required
Make the necessary adjustments to the accounts. Show the treatment.

NB/ Sundry Revenue- Includes all revenues put together (we close all the other
accounts.

Sundry expenses A/c - Include all expenses put together.

Q2. From the following trial balance of R. Graham , draw up a trading and profit and loss
account for year ended 30th September 2006 and a balance sheet as at that date.

G. GRAHAM
Trail balance as at 30th Sept. 2006.
Dr Cr
Stock 1 Oct. 2005 23,680
Carriage outwards 2,000
Carriage inwards 3,100
Returns inwards 2,050
Returns outwards 3,220
Purchases 11,872
Salaries and wages 38,620
Rent 3,040
Sales 186,000
Insurance 780
Motor expenses 6,640
Other expenses 2,160
Lighting 1,660
General expenses 3,140
Premises 50,000
Motor vans 18,000
Fixtures 18,000
Debtors 3,500
Creditors 17,310
Cash at Bank 4,820
Drawings 12,000
Capital 126,360
332,890 332890

Stock at 30th Sept 2006 was 29,460

62
Q3. The following trial balance was extracted from the books of James traders at 31st
Dec. 2007.

Dr Cr
Stock 1 Jan 2007 62,000
Freehold premises 44,100
Bills variables 32,000
Purchases 144,000
Salaries and wages 36,200
Sales 246,380
Fixtures and fittings 6,000
Discount allowed 13,200
Discount received 8,200
Plant and machinery 50,000
Returns inwards 2,000
Rates 3,600
Insurance 2,400
Carriage inwards 3,000
Advertising 9,600
General office expenses 12,000
Bills payable 10,400
Provision for bad debts 2,400
Sundry debtors 70,000
Sundry creditors 60,000
Returns outwards 1,820
Cash at bank 22,000
Cash at hand 1,200
Drawings 6,000
Capital account 190,000
519,200 519,200

63
The following information is provided at 31st Dec. 2007.
1) Provide for depreciation of freehold premises at 2 ½ % per annum, fixtures
and fittings at 10% per annum.
2) Increase the provision for bad debts to an amount equal to 5% of the sundry
debtors.
3) Prepaid insurance amounted to Kshs. 400
4) Rates accrued is Kshs. 220
5) Closing stock was valued at Kshs. 60,000
6) During the year Mr. James took goods worth Kshs. 1,200 for his personal use.
Required
1. Trading, profit and loss account for the year ended, 3rd Dec. 2007.
2. Balance sheet at the same date.

Preparation of published account statements

.
Example
The following trial balance was extracted from the books of A/c Ltd. as on 31st Dec.
2002.
TRIAL BALANCE
DR ( $) CR ($)
Share capital authorized is issued
40,000 ordinary share, $ 1 each 40,000
Share premium A/c 3,600
st
Provision for depreciation motor van to 31 Dec. 2001 2,845
Motor vans at cost ($ 5,750) less sale on 1st Jan 2002 5,150
Freehold lands building at cost 37,000
Stock in trade 31st Dec. 2001 9,500
Purchases and sales 92,000 132,025
Trade debtors and creditors 12,618 10,370
Wages and salaries 15,312
Motors and delivery expenses 1,481
Rates and insurance 639
General expenses 6,984
Cash and bank 11,796
Directors fees 4,500
Profit and loss balance at 31st Dec. 2001 8,500
197,540 197,540
You are also provided with the following information
1) Stock on trade 31st Dec. 2002, & 8,800

64
2) Provision for depreciation of motor van is to be made at the rate of 20% per
annum on cost
3) A motor van which had costed $ 800 was sold on 1st Jan 1994 for $ 240.
Depreciation provided for this van up to 31st Dec. 2001 was $ 520.
4) Rates and insurance paid in advance at 31st Dec. 2002 was $ 112.
5) The cash in bank shown include a postdated cheque of $ 28 which had been
cashed for by a customer on 31st Dec. 2002.
6) The amount shown in the trial balance for sales and trade debtors include goods
sent out on sale or return invoiced at $ 300 which represented cost plus 50%.
These goods were returned on 3rd Jan 2002.
7) In December 2002, goods to the cost of 725 were destroyed by fine. The
insurance company has agreed to pay in full a claim for this amount, but no entry
has been made to company‟s books.
8) Directors have decided to recommend a dividend o f10% for the year.
Required
a. Prepare a trading, project and loss statement as per the companies Act.
b. Prepare the balance sheet as at 31st Dec. 2002.

Solution
Notes/adjustments/working

i) Balance motor van (5,750 -800) = 4950

ii) Depreciation
Provision 2,845
Dep. Of sold van 520
2345
990
Depreciation 3,315----- wi

ii) Loss on sale of van

Cost 800

Depreciation 520
Cash 240
760
Loss on sales 40

iii) Debtors (Trade)

65
 Debtors 12,618
Returns 300
12,318/=

iv) 300 = Cost + 50/100 of 300

300 = Cost + 150
300-150 = Cost
150= Cost

Goods = 300 -150

= 150
Closing stock is increased by 150 units

vi) Purchases figure 92,000

Less goods destroyed by fire 725
91,275

ABC TRADING, PROFIT AND LOSS STATEMENT FOR THE YEAR ENDED
31ST DEC. 2002

Sales 132,025
Sales return 300
Net sales 131,725

Cost of sales
Opening stock 9,500
Purchases 91,275
Goods available for sale 100,775
Less closing stock (8,800 + 150) 8,950
91,825
39,900
Expenses
-Depreciation motor van (20% of 4,950) 990
-Loss of sale of motor van
(800 – (520+240) 40
-Rates and insurance
(639-112) 527
-Wages and salaries 15312
-General expenses 6,984
-Directors fee 4,500
-Net profit 10,096 _____
39,900 39,900
Bal b/d 10,096
Profit & loss 8,500
Jan 2002 18,590

66
 Bal B/d 18,599

Less ordinary shares dividend 4,000

Net P/L 14,596

ABC BALANCE SHEET

AS AT 31ST DEC. 2002
Fixed asset at cost depreciation book value
Freehold land 37,000 37,000
& building at cost
Motor van (5730-800) 4950 (990-520+2845) 1635
Total fixed assets 38,635

Current Assets
Stock 8,950
Debtors (12618 -300) 12,318
Prepayment insurance 112
Cash / Bank (11796 -28) 11,750
Other Debtors (725 + 28) 753
33883
Liabilities
-Trade creditors 10,370
Proposed ordinary
shares dividend 4,000
(10% 40,000) 14,370
19,513
58,149

Financed by
40,000 ordinary shares 40,000
At $ 1 each
Share premium 36,000
Profit and loss (14,590)
58,149
Example 2
The following trial balance was extracted from the books of Mombasa LTD as at 30th
Sept 2002

TRIAL BALANCE
DR CR
Share capital authorized & share $ $
25,000 ordinary share at $ 1 each 25,000
$ 1 each
Directors account: Wanjala 600
Abdi 390

67
Motor van (cost $4800) 2880
Freehold properties at cost 20,000
Profit & loss at 31st Sept. 2001 7360
Purchases & sales 91,375 118,400
Stock in trade 30th Sept. 2001 10,750
Loan X Ltd. At 5% per annum 5,000
Goodwill 3,000
Bad debts 470
Motor & Delivery expenses 772
Cash at Bank 2008
Directors salary 4,750
Wages and salaries 12,425
Rates and insurance 460 ______
166,780 166,780

Additional information
a. Stick on trade at 30/9/2002, $11,550
b. The provision for bad debts is to be increased to $ 300
c. Wages & salaries outstanding at 30/9/2002, $ 200
d. Rates & insurance paid in advance at 30/9/2002 $ 62
e. The item rent receivable $ 250, include $ 50 in respect to the period from
1/10/2002 to 31/12/2002.
f. Provision is to e made for depreciation of motor vans at rate of 20% per annum on
cost
g. During the year to 30/9/2002, Wanjala one of the Directors took goods costing
($175) out of the business stock, for his own use. No entry for this matter had
been made in the books.
Required
1. Prepare a trading, profit and loss statement for the year ended 30/Sept.
2002.
2. Prepare a balance sheet at the same date ( ignore taxation).

Solution
Note/adjustment/working
i)Purchase 91,375
Directors goods 175
91,200

ii) Interest on loan

5% of 5000 =250

68
 iii) Directors current account
Wanjala 680
175
Abdi 505
Total 390
895

(iv) Provision for depreciation on motor van

20% of 4,800 = 960
Accumulated depreciation (960 + (4800 – 2800) = 2880

(v) Rent receivable (250 – 50) = 200

(vi) Rates & Insurance 460

Prepayment 62
398
(vii) Wages & salaries outstanding
Wages 12,425
Outstanding 200
Total 12,625

(viii) Provisions for bad debts

Debtors 13,560
Provisions
(140 +300) 440
Uncorrectable amount 13,060

MOMBASA TRADING, PROFIT AND LOSS STATEMENT FOR THE YEAR

ENDED 30TH SEPT 2002.
Sales 118,400
Cost of sales
Stock 30th Sept 2001 10,750
Purchases (91375 – 175) 91,200
101,950
Less closing stock 11,550
Cost of sales 90,400
Gross profit 28,000
Rent receivable 200
28,200
Expenses
Bad debts 470
Provision for bad debts 160
Wages (12425 + 200) 12,625
Rate & insurance (460 – 62) 398
Depreciation motor van
(20% of 4800) 960

69
Directors salaries 4750
Loan interest 250
Motor & Delivery expenses 772
General expenses 4,330
Bal C/D net profit 3,485 ______
28,200 28,200
Net profit B/d 3,485
Profit and loss b/d 30/1/2001 7,360
Bal c/d 10,845 10,845

MOMBASA LIMITED
BALANCE SHEET AS AT 30TH SEPT 2002.
Fixed assets at cost Dep+ Provision Book value
Good will 3,000
Freehold premises 20,000 20,000
Motor van 4,800 (960 + 1920), 2880 1920
24,920
Current Assets
Stock 11,550
Trade debtors(13,560 -300) 13,262
Rates paid in advance 62
Cash at bank 2008
26,880
Liabilities
Interest on loan 500
Creditors 9310
Accruals
Wages 200
Rent 50 250
(10,060)
16820
41,740
Financed by
-Issued capital fully
Paid 25,000 ordinary 25,000
Share at $ 1
-profit & Loss 10,845
-Directors current a/c 895
-Loan from X Ltd 5,000
41,740

Example 3
The following balances are extracted from VO1 Ltd which is a private company at 31st
Dec. 2002.

70
 TRIAL BALANCE
Stock 1/1/2002 $
(a) Raw materials 17,817
(b) Finished goods 5,212
Packing for dispatches 8,035
Factory maintenance 7,546
Wages 48,414
Lighting 250
Motor & traveling expenses 569
Sales 255,795
Director‟s remuneration 3,500
Travelers & commission 4,978
Insurance 550
Postage 165
Rent received 480
Freehold property (cost) 13,296
Tools and utensils (valued at 650 on 1st Jan 2002) 879
Proceeds of sales of van 200
Trade debtors 8,249
Cash at bank (Dr) 5069
Trade creditors 6,594
Share capital authorized and issued
Ordinary shares at 10,000 at $ 1 10,000
Debenture interest paid 100
General reserves 25,000
Interim dividends paid 400
Purchases
(a) Cocoa beans and butter 100,810
(b) Sugar 16.000
Other raw materials 34,457
Power 5,669
Carriage inwards 2,784
Salaries 2,924
Discount allowed 2,595
Advertising 115
Rates 488
Telephone 146
Printing 146
General expenses 616
Bad debts 85
Investment income 42
Plant and machinery at cost 24,225
Depreciation (Plant & machinery) 7049
Motor vehicle at cost 2,463
Depreciation motor van 761
Investment quoted 433

71
4% debentures secured 5,000
Profit and loss credit balance1st Jan 2002. (10,489)

Other information provided

i)Stock at 31st Dec. 2002 were
Raw materials $ 17,061
Finished goods $ 7,546
ii) Tools and utensils at 31st Dec. 2002 were valued by the directors at $ 500
ii) The two directors each paid $ 1750 per annum on is responsible for production and the
other for sale.
iv) Expenses not included above (other then the debenture interest) which had accrued
due at 31st Dec. 2002 were
Electricity $ 19
Power 201
220
Gas- power 55
Audit fee 158
Wages 279
v) Payment in advance at 31st Dec. 2002 were
Insurance $ 119
Electricity $20
Deposit $ 20
vi) The figure for motor vehicles includes a second hand van bought on 1st July 2002 for
400. The van sold was bought second hand on 1st Jan 1996 for $ 600
Vii) Depreciation is provided annually on written down values as follows.
Plant 10% per annum
Motor van 25% per annum
viii) Directors decided to transfer $ 10,000 to general reserves and to pay a final dividend
of 10%.
ix) The market value of investments at 31st Dec. was $ 692.

Required
1. Prepare a trading profit and loss account for the year ended 31st Dec. 2002.
2. Prepare a balance sheet at the same date.
Solution
i) Tools and utensils 650
Revaluation value 229
879
Depreciation 379
500

ii) Directors remuneration 3,500

iii) Accruals
Lighting 250
Add accrual amount 19

72
 269
iv) Power 5,669
Accruals 256
5,825
Audit fee 158
Wages 48,414
Accruals 279
48,693
v) Prepayments
Insurance 550
Less prepayment 119
431
Electricity prepayment $ 20
vi)Depreciation
Plant 24,225
Depreciation 7,049
17,176.0
Less ( 10% of 17,176) 1,717.6
15458.40
vii) Depreciation sold motor van ( 25% on cost)
Cost 600
Dep. 1996 (25% of 600) 150
450
Dep ( 1997) ( 25% x 450) 113
337
Dep ( 1997) ( 25% x 337) 84
253
Dep. 1998 ( 25% of 253) 63
190
Dep. 2000 ( 25% of 190) 47
143
Dep (2001) (25% of 143) 36
Written down value ( 1.1.2002) 107
Proceeds from sale 200
Profit on sale $ 93

(vii) Motor van excluding old van

Cost dep book value
(2463- 400) 2063 761

73
 Less van sold 600 493
1463 268
Dep to 81/12/2001 268
Value of vans retained 1,195

Depreciation at 25% per annum for six months 1st July – Dec. 2002, for 1 year
400 50
1195 299
1595 349
617
Total depreciation of
motor van excluding of old van 617

VOI LIMITED
TRADING, PROFIT & LOSS A/C FOR THE YEAR
ENDED 31ST DEC. 2002
To raw materials 255,795
Stock 1.1. 2002 17,817
Cost of sales
Purchases
Cocoal braw & Butter 100,810
Sugar 16001
Other raw materials 34,457
169,085
Carriage inwards 2,784
Finished goods 5,212
17,7084
Less closing stock (Finished good) 7546
169,538
Gross profit 86,257
Rent Received 86,257
Investment income 480
Profit on sale of motor van 93
86,872
Expenses
-Packaging for dispatch 8,035
-Carriage outward 844
-Discount allowed 2,594
-Wages (48444 + 279) 48,693
-Directors remuneration 3,500
-Travellers salaries 4,978
-Insurance (550-119) 431
-Postage 165
-Dépréciation utensils 379
-Depreciation motor 349
-Lighting (250+19) 269

74
-Salaries 2,924
-Advertising 115
-Rates 488
-Telephone 146
-Printing 169
-Bad debts 85
-Audit fee 158
76,596
10,276
-Debenture interest
(4% of 5000) (200)
-Net profit b/d (Jan 2002) 10,489
20,565
-Dividend paid
(10% of 10,000) 1,000
-Transfer reverse 10,000
11,000
Net profit for distribution 9,565

VOI LIMITED
BALANCE SHEET AS AT 31ST DEC. 2002
Fixed assets at cost prov. + dep book value
Freehold property 13,296 13,296
Plant and machinery 24,255 (8767) 15,454
Motor vehicle 1863 617 1246
Tools and utensils 500
30,500
Current assets
Stock (17061 + 7540) 24,607
Trade debtors 8,249
Payment in advance
(119 + 20) 139
Quoted investment
(Market value 693) 433
Cash at bank 5069
38,497
Current liabilities
Trade creditors 6594
Accrued expenses 712
Debenture interest 100
Final dividend 1000
8,406
30,091
60, 591

Financed by

75
 Ordinary shares 10,000 at $ 1
General reserves (25,000 + 10,000) 35,000
4% debenture 5,000
Net profit (xx) 9,565
60,591

NB – Raw materials are not sold the difference in opening stock is a result of
production or remain destruction or pilferage.

Exercise
Question I
Mombasa sports Ltd, has an authorized share capital kshs. 1, 500,000 made up ordinary
shars of Kshs. 20 each. On 31st Dec. 2008 the following balances were extracted from the
company‟s books of accounts.
Shs. 20 ordinary shares
Fully paid up 1,000,000
General reserves 800,000
Plant replacement reserves 600,000
Lease hold land and buildings1,310,000
Motor vans at cost 213,000
Plant and machinery 1,088,000
Creditors 648,000
Cash at bank 1,784,200
Sales 3,610.600
Purchases 3,650,600
Stock (1.1.2008) 212,800
Selling expenses 328,560
Other expenses 389,120
Administrative expenses 447,840
Profit and loss account (1.1.2008) 548,920
Trade debtors 1,135,000
Taxation account 140,000
th
Interim dividend 30 June 200849,000

Provision for depreciation to 1 Jan 2008

Leasehold lad and building 655,000
Plant and machinery 605,800
Motor vehicles 128,400
Provision for doubtful and bad debts 20,000
Cash in hand 185,000
The following additional information is given
A. Closing stock 31st Dec. 2008 is Kshs. 229.000
B. Administrative expenses include Kshs. 200.000

76
C. And Kshs. 120,000 salaries for managing director and the marketing director
respectively. The managing director received other benefits from the company worth
Kshs. 9180 for the year.
D. Provision for doubtful debts and bad debts is to be adjusted to 2% of the outstanding
trade debts as on Dec. 31st 2008.
E. Auditing fee is fixed by directors at Kshs. 6,300
F. Depreciation is provided as follows 5% on cost
G. Plant and machinery at 12 ½ % on cost
H. Motor vehicle at 20% cost.

I. Provision is made for non- executive directors remuneration ( allowance ) for Kshs.
20,000
J. Taxation balance represents the provision made on 31st Dec. 2007 for corporation tax
and not yet paid. The corporation tax for the year ended 31st Dec. 1990 is estimated
at Kshs. 152,000 based on a rate of 50%,
K. The board of directors wishes to transfer kshs. 200, 000 to general reserves and
recommend a final dividend of Kshs. 0.70 per share.
Required
1. Prepare the profit and loss account for the year ended 31st Dec. 2008.
2. Prepare a balance sheet as at 31st Dec. 2008.

Questions 2
The following balances were extracted from the books of JKL at 31st Dec. 2006.
Ordinary share capital fully paid 75,000
Profit and loss account (1.1.2006) 6,750
Overdraft 18,060
Interest on overdraft 1,425
General reserves 37,500
Sales 562,500
Proceeds from sale of vehicles 95
Vehicle purchase during the year 485
Cost of goods sold 405,860
Trade creditors 63,305
Stock of finished goods 92,345
Value added tax – credit balance 3,075
Debtors 140,340
8% debentures 10,000
Emoluments of directors 10,000

77
 Other administrative & distribution Costs 73,035
Prepaid assets, net book value 480
Fixed assets, net book value at Jan. 2006 31,840
Account expenses 375
Equipment wire 345
Salaries and wages 42,600
Audit fees 55
Corporation tax- debit balance 65
Interim dividend paid in Aug. 2006 4500
Deferred tax 1,725
The following additional information is given
1) The authorized share capital consists 25,000 ordinary shares of kshs. 2.50 per
share
2) The vehicle disposed of originally cost kshs. 265,000 and had a written down
value of Kshs. 150,000 and were used for distributing company goods.
3) Outstanding audit fee of Kshs. 35,000 have not been recorded.
4) Debenture interest for the year had not been recorded.
5) The debenture are redeemable in 2008
6) Salaries and wages, director‟s emoluments and other administration and
distribution cost are to be apportioned in the ratio 3:7 to administrative and
distribution.
7) A final dividend of 4% is proposed to be paid in February 2007.
8) Fixed asset at Jan 2008 were analyzed as follows.
a. Buidings Vehicles
b. Cost 29,655,000 9,570,000
Provision
Depreciation 3,035,000 4,350,000
9) Depreciation for the year
10) Buildings Kshs. 340,000 of which 120,000 in to be changed to administration.
Vehicles Kshs. 900,000 of which Kshs. 30,000 is to be changed to administrative.

Required
a. Prepare a profit and loss account
b. Prepare a balance sheet in accordance to companies act.
Working should be shown

78
 LECTURER 6
CASH FLOW
Introduction
After the preparation of profit and loss accounts and the balance sheets at the end of
the accounting period , these two discloses the profit and loses and how resource one
being used at the end of the period.

They do not show how the company has used its resources, whether in a good way.
The two statements above are not enough as they do not give enough information. We
need to know the funds coming into the company and what it ahs done with the
resources.

Funds flow statement – Shows the movement of cash funds that includes cash and
bank funds and the movement of working capital.

Financial statement concerned with cash funds are known as cash flow statements.
They are concerned with examining the reason underlying the rise or fall in cash
funds over a period.

Financial statements concerned with working capital funds are normally known as
Statements of resources and application of funds.

-It‟s a statement that reports cash flow data.

-it helps investors and creditors projects the future cash flows of he company being
studied.

There are 6 items reported in cash flow statements.

(i) Cash flows from operating activities.

(ii) Cash flows from investing activities.
(iii) Cash flows from financing activities
(iv) Effects of foreign exchange changes
(v) Net increase/ decrease in cash during the period.
(vi) Non- cash investing and financing activities.

Cash flow from operating activities.

-Including all cash flows not defined as investing / from operation point of view.
-Includes all cash inflows and outflows that are violated to net income.

Inflows operating activities – Received.

From:-
-Customers
-Interest and receivables
-Dividends from investments
-Refunds from suppliers.

79
Outflows – Paid to
Purchase of goods for resale
-Interest on liabilities
-Income tax, duties and fines
-Salaries and wages

Funds come from sources Funds go to

Cash funds
In Out
Profits
Sales of fixed assets Losses
Decrease in stock Purchase of fixed assets
Decrease in debtors Increase in debtors
Capital introduced Drawings / dividends
Loans received Loans repaid
Increase in creditors Decrease in creditors.

The difference between inflow and outflow is called net inflow/ outflow from operating
activities.

2. Cash flow from investing activities

-Movement of cash that is related to acquisition or disposal of facilities i.e plant, property
equipment and other assets.

Inflows
-Disposal or sale of property & equipments
-Disposal of investing activities
-Collection from loan excluding interest.

Outflows
Cash paid for:-
(a) Acquisition of property
(b) Investments in long-term debts
(c) Loans to other parties
(d) Acquisition of other assets used in production excluding inventory.

3. Cash flows form financing activities

Represent inflow and outflows that are related to how cash was raised and deployed in
financing the company‟s business. Shows financing activities used to obtain cash for the
business.

Inflow
-Cash from owners after issue of equity and securities.
-Cash from creditors in terms of borrowing, mortgages and bond‟s
Outflows – cash paid to
-Owners for dividends.

80
-Owners for treasury stock
-Repayment of borrowed funds excluding interest which is operating activities.

4. Effects of foreign exchange rate changes

-Applied to companies that have foreign operations whose changes affect the movement
of cash in the balances sheet.

5. Reconciling balances – reports of three related amount, net increase/ decrease in cash,
beginning cash balance and remaining cash balance.

6. Non- Cash investing and financing activities

-Involves investing financing activities that results to exchange of values of other than
cash.
E.g. Issue of a company‟s capital stock to a creditor to cover a certain debt.

Usefulness of a cash flow statement

- Provide feed back about cash inflows and outflows to investors, creditors and
other investors.
- Required by decision makers to estimate the amounts the company generates for
decision masking
- Provide useful information on the company‟s borrowing patterns and subsequent
payments
- Helps to asses financial strengths of a business

FORMAT OF CASH FLOW STATEMENT

There are three methods applied
(a) Direct method
(b) Indirect method
(c) Cash account Method

Direct
It starts by finding the company net cash flow, by totaling the individual inflows from
customers, interest and dividend on investments, refunds from suppliers and deducting
individual outflows from purchase of goods for resale, salaries and wages interest on
debts obligation and income tax.

Indirect method-
It starts with net income and adds back expenses and charges that did not entil cash
payment e.g. depreciation, amortization e.t.c.

CASH FLOW STATEMENT

Standard layout (direct method)

81
 ABC CASH FLOW
FOR THE YEAR ENDED 31ST DEC 2006

Changes in cash ( X- Y) XXX

Net income / profit XX

Items not affecting cash
(a) Depreciation xx
Cash from operating activities
(b) Decrease / increase in receivables xx
© Increase / decrease in prepaid
Expenses xx
(d) Increase / decrease in accounts
Payable xx
(e) Interest payable xx Inflow and outflow
(f) Increase / Dec. of wages & salaries xx
(g) Paying other expenses xx
(h) Paying government taxes xx
(i) Sales of goods and services xx
(j) Dividends received xx
(k) Profit from sale of fixed assets xx
XX
Investing activities
Inflow
-Sale of property and equipment xx
-Sale for debt equity and securities xx
-Collection of principal on loan xx
XX
Outflow
Purchase of property and equipment xx
Purchase debtors equity xx
Paying of loans xx
XX XX
Financing activities
Inflow
-Sale of own equity xx
-issuance of debts bonds xx XX

Outflow
-Shareholders dividend xx
-Redeemed long term xx
XX

Net change in cash XXX

82
Example 2
XYZ limited cash flow statement as at 31st Dec. March 2001 (layout)

Operating profit 6021

Depreciation 893
Loss on sale of tangible fixed assets 6
Increase in stocks (194)
Increase in debtors (72)
Increase in creditors 234
Cash flow from operating activities 6889

Cash from investing activities

Interest received 3,011
Interest paid (12)
2,999
-Payments to acquire in tangible fixed assets (71)
-Payments to acquire tangible assets (1496)
-Receipt from sale of tangible fixed assets 42
1,525
-Corporation tax paid (2922)
-Management of liquid assets (650)
-Purchase of treasury bills (200)
850

Cash from financing activities

Issue of ordinary share capital 211
Repurchase of debenture loan (149)
Expenses paid in connection with share issue (5)
57
Change in cash 3181

Extract / Illustration I
The following balances were extracted from T. Holmes balance sheet as at 31st dec. 20- 6
and 31st dec. 20- 7.

31ST DEC 20 – 6 31ST DEC. 20 -7

Fixed assets
Premises at least 25,000 28,800
Current assets
Stock 12,500 12,850
Debtors 21,650 23,140
Cash and bank balances 4,300 5,620
38,450 41,610

Current Liabilities
Creditors 11,350 11,120

83
 27,100 30,490
52,100 59,290
Finance by
Capital
Opening bal b/f 52,660 52,100
Net profit 16,550 25,440
69,210 77,540
Less drawings 17,110 18,250
52,100 59,290

NB/ No depreciation have been changed in the accounts.

Required
Prepare a cash flow statement for T Holmes.

T. HOLMES
CASH FLOW STATEMENT
FOR THE YEAR ENDED 31ST DEC. 20-7

Change in cash (5,620 – 4,300) = 1,320

-Net profit 25,440

-Premises at cost (28,000 – 25,000) Increase (3,800)
Premises bought
-Stock (12,850 – 12,500) (350)
(More stock bought)
-Debtors (23,140 – 21, 650) (1,490)
(Loss cash)
-Creditors (11,120 – 11,350) (230)
(Loss cash)
Drawings
(loss cash) (18,250)
(24,120)
Net change in cash 1,320

EXAMPLE 2
The following information relates to south End Ltd for the year ended 31st dec 2 008

Cash and cash equivalents 000

Jan 2008 8,952
Dec 2008 10,043
Operating profit 4,100
Depreciation charges 1080
Proceeds of sale of tangible assets book value $ 116,000 96
Increase in working capital 165

84
Issuance of ordinary share capital 400
Expenses in connection with share 10
Purchases of intangible fixed assts 150
Purchases of tangible fixed assts 2540
Corporation tax paid 2460
Dividends paid 1570
Interest received 2290

Required
Prepare a cash flow statement for the year ended 31st dec 2008

Solution
South End Ltd
Cash flow statement for the year ended 31st Dec. 2008

Change in cash 10,043 – 8952= 1091

Profit before tax 4,100
Depreciation (loss of cash) 1,080

Operating activities
Increase in working capital (165)
Proceed in the sale of fixed asset 96
Loss in the sale of tangible assets (116- 96) (20)
5131
Investing Activities
Purchase of tangible fixed assets (2540)
Purchase of intangible fixed assets (150)
Corporation tax (2460)
Dividends paid (1570)
(6720)
Financing Activities
Ordinary share capital 400
Share expenses (10)
Interest received 2290
2680
1091

EXAMPLE 3
The following was balance sheets of R Lester
31st Dec. 20 – 3 31st Dec. 20 – 4

Fixed assets
Equipment at cost 28,500 26,100
Depreciation 11,450 13,010
17,050 13,090
Current assets

85
Stock 18,570 16,250
Debtors 8,470 14,190
Less Bad debt 420 800
8,050 13,390
Cash at bank 4,060 3,700
Balances 30,680 33,340
Less current liabilities
Creditors 4140 5,730
26,540 27,610
43,590 40,700
Financed by
Capital
Opening bal/b/f 35,760 33,590
Add net profit 10,240 11,070
Add cash introduced - 600

46,200 45,260
Less drawings 12,410 8,560
33,590 36,700
Loan J. grocery 10,000 4,000
43,590 40,700

Other information
Equipment with a book value of $ 1,350 was sold for $ 900. Depreciation written off
during the year was 2,610

Required
Draw a cash flow statement

Solution
R. LESTER
Cash flow statement for the year ended 31st Dec. 2004.

Change in cash (3,700 – 4,060) = (360)

Net profit before tax 11,070

Depreciation 2,610
Loss on sale of fixed asset
(900-1350) 450
Increase in bad debts provision 380
(800 – 420) 3,440
Net profit after adjustment 14,510
add
Operating activities
Sales of equipment 900
Dec. in stock (16,250- 18,570) 2,320

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Increase in creditors 1,590
(5730-4140)
Increase in debtors (14,190- 8,470) (5,720)
Capital introduced 600
5,410
19,920
Application of funds / investing activities
Loan required to gorsy (6,000)
Drawings (8,560)
(20,280)
Cash in hand (360)

Examples 4
The following is a balance sheet of Wajo LTD. As at 31st Dec. 2006 and at 31st Dec. 2007

Fixed assets
2006 2007
(000) (000) (000) (000)
Hand and buildings cost 2,400 3,000
Depreciation in building (450) (525)
Plant and equipment cost 3,000 5,100
Depreciation on plant (1,350) (1,875)
3,600 5,700

Current Assets
Stock 900 1,125
Debtors 450 675
Cash 300 -
1,650 1,800

Current Liabilities
Creditors 300 450
Taxation 375 450
Dividends 225 225
Overdrafts 75
Net current assets 900 750 1,200 600
4,350 6,300

Capital and reserves

-Ordinary shares 3,000 4,500
-Share premium 300 600
-Retained earnings 750 1200
-10% debenture repayable 300 _____
4,350 6,300

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Extract from profit and loss account for the year 31st Dec. 2004.

000 000
Profit before tax 1,350
Taxation for the year 525
Gross profit 825

Dividend for the year

Interim dividends 150
Final dividend 225
375
Retained profit for the year 450
Retained profit at Jan 2004 750
Retained profit 31st Dec. 2004 1,200

Further information
1. Depreciation charged for the year amounted to Kshs. 900,000
2. An item of plant was disposed off during the year for 225,000. It had costed Ksh.
450,000 when new and had a depreciated value of Kshs. 150,000

Prepare a cash flow.

Direct method.
Difference in cash XX
1. Cash from operating activities xx
2. Cash from inventory activities xx
3. Cash from financing activities xx
Cash difference XX

Adjustments
1 Operating profit before tax 1350.000

2. Fixed asset land equip

2400 3000
Cost of diposal 450
2550
Closing balance 3000 5100
Change 600 2550
3.

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 WAJO LTD
Cash flow statement for the year ended 31st Dec. 2007.

Change in cash (300) + (75) = (375)

Operating profit 1,350

Interest debenture paid (10% of 300,000) 30
1,380
Depreciation 900
Profit on sale of fixed asset [(450-150)-225)] 75
Cash from operating activities
Increase in stocks (1,125-900) (225)
Increase in debtors (675-450) (225)
Increase in creditors (450-300) 150
Net cash from operating activities 1,905

Cash from investing activities.

Payment of acquired fixed assets (2,550+600) (3,150)
Receipt from sale of fixed asset 225
(2,925)
Dividends paid (225+375-225) (375)
Corporation tax (375+525-450) (450)
Interest paid (30% of 300,000) (30)
(1,875)
Cash from financing activities
Issuance of ordinary shares
(4,500-3,000 +300 share premium) 1,800
Less debenture loan 300
1,500
Cash in hand (375)

Exercise
Question 1

The records of Ranger Company provided the selected data given for the period reporting
ended 31st Dec 2001.

Balance sheet
Cash paid dividend 10,000
-Established an external construction fund at
18% interest (building) 60,000
-Increase inventory of merchandise 14,000
-Borrowed long term notes 14,000
-Acquired 5 acres of land for future use of the
Company and paid in full by receiving 3,000 shares
of range capital stock per value at $ 10, when the quoted

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 market price per share was $ 15
-Increase in prepaid expenses expense 3,000
-Decrease in account receivable 7,000
-Payment of bonds payable in full 97,000
-Increase in account payable 5,000
-Dec in rent receivables 2,000
-Cash from disposable of old operating assets
(at book value) 12,000

Income statement
Sales revenue 40,000
Rent revenue 10,000
Cost of goods sold 170,000
Depreciation expenses 20,000
Renting expenses (97,000)
Net income 103,000

Prepare a cash flow statement by filling the gap.

Change in cash (Y - X)
Cash flow from operating activities
Operating profit xx
Depreciation xx
Interest payable xx
Profit of sale of fixed assets xx
Increase in stocks xx
Increase in debtors‟ xx
Increase in creditors‟ xx
xx
Cash flow from investing activities
Debenture xx
Interest received xx
Payment of acquired
intangible assets (xx)

Payment of acquired tangible assets (xx)

Receipt from sale of tangible assets xx
xx
Corporation tax (xx)

Cash flow from financing activities

Purchases of treasury bills (xx)
Sale of treasury bills xx
Ordinary shares issue xx
Repurchase of debenture loan xx
xx

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Change in cash XX

Question 2
TRACK CONSTRUCTION
BALANCE SHEET

2000 2001
Cash 49,000 37,000
Account receivable 36,000 26,000
Land - 70,000
Prepaid expenses - 6,000
Building 20,000
Depreciation (building) (11,000)
Equipment - 68,000
Depreciation (equipment) (10,000)

Liabilities
Account receivable 5,000 40,000
Bonds payable 150,000
Common shares 60,000 60,000
Retailed earnings 130,000 20,000

Income Statement 2003

Revenues 492,000
Operating expenses 269,000
Dep. Expenses 21,000
290,000
Income from operations 202,000
Income tax 68,000
Net income 134,000
Additional information
1. In 2001- The company paid a cash dividends of Kshs. 18,000
2. The company obtained Kshs.150,000 cash through the issue of long-term bonds
3. Land, building and equipment were acquired for cash.

Required
Prepare a cash flow statement for the year ended at 31st Dec. 2001.

Solution

First step
1. Note first the change in cash
(37,000 – 49,000) = (12,000)

2nd step

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 Note The change as shown
A/c receivable 10,000 DEC
Prepaid expenses 6,000 INC
Land 70,000 INC
Building 200,000 INC
Dep. Building 11,000 INC
Equipment 68,000 INC
Dep. Equipment 10,000 INC

Change liabilities
A/c payable 35,000 INC
Bonds payable 150,000 INC
Common shares -0-
Retained earnings 116,000 INC

Step 3
Prepare a cash flow

Fill in the gaps

ROCKS CONSTRUCTION
CASH FLOW FOR THE YEAR ENDED 2002 (31ST DEC.)

Change in cash (37,000- 49,000) = (12,000)

Cash from operating activities

Net income 134,000
Dec. in A/C receivable xx
Increase prepaid expenses (xx)
Increase in A/C payable xx
Depreciation expenses xx
XX
194,000

CASH FROM INVESTING ACTIVITIES

Purchase of land (xx)
Purchase of building (xx)
Purchase of equipment (xx)
(338,000)

Cash from financing activities

Issuance of bonds 150,000
Payment of cash dividends (18,000)
132,000
Net change in cash (12,000)

92
 LECTURE7
ACCOUNTING FOR PRICE CHANGES

Depreciable fixed assets are either sold of scrapped at the end of their useful life.
The accounting implication:-
(i) Entries are required to record the sale or scrapping of the assets in the
appropriate accounts.
e.g The cost assets account, and the accumulated depreciation is removed from
the relevant accumulated depreciation account.

(ii) Any difference between the disposal value is regarded as a gain or loss as the
case may be and show in the income statement n the year of disposal.

Example
Assume some office equipment has bought for sh. 50,000. It has been fully
depreciated and is now being scrapped. There is no salvage value.

Entry to record the scrapping

Dr. Accumulated depreciation 50,000

Cr. Office Equipment 50,000

When fully depreciated, the assets account and the accumulated depreciation account
should remain in the books without further entries until the asset is retired.

Gains & loss on disposal

Since the residue value and the useful life of plant assets are only estimates, it is not
uncommon for plant assets to be sold at a price which differs from the book value at the
date of disposal.

Book value/carrying value of an asset is the cost of the asset minus total recorded
depreciation

BV = C – Depreciation
Gains or loss on sale of an asset is computed by comparing the book value with proceeds
of the sale. If the proceeds of sales are greater than the book value of the assets, this is a
gain if the proceeds are less than book value; this is recorded as a loss.

Example 1
Disposal at a gain
An asset that originally cost Ksh. 10,000 has after several years of use a recorded
depreciation of Sh. 8,000. This machine has an un-depreciated cost or book value of Sh.
2,000. If this machine is sold for sh. 3000 in cash, a gain of shs.1,000 is realized on
disposal of this asset. The accounting entry to records the disposal of this asset is as
follows.

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Dr. Cash 3,000
Dr Accumulated depreciation 8,000

Cr. Asset 10,000

Cr. Gain or sale of assets 1,000
To record the sale of machine at a gain of Sh. 1,000

Example 2
Disposal at a loss
Assume that the same machine is sold at Ksh. 500 cash. This price is below the book
value of ksh. 2000.

Entry
Dr. Cash 500
Dr. Loss 1,500
Dr. Accumulated 8,000
Cr. Asset/ machinery 10,000
To record sale of assets at a loss

Disposal at book value

If the machine/ asset was sold at Ksh. 2000, a price equal to the book value.

Entry
Dr. Cash 2,000
Dr. Accumulated depreciation 8,000

Cr. Assets machine 10,000

To record sale of asset at book value

DEPRECIATION FOR FRACTIONAL PERIOD BEFORE DISPOSAL

When an asset is retired from use at dates other than the end of the financial year, it is
necessary to record the depreciation for the fraction of the year.

Assume that a piece of equipment costing Ksh. 10,000 has been depreciated at an annual
rate of 10% per annum for 8 years. In the middle of the 9th year the machine is sold for
sh. 1,750. No depreciation had been recorded since the accounts were adjusted and closed
on 31st Dec of year 8.

Two journal entries are necessary at the time of disposal of the equipment.
(i) One to record depreciation for six months ending with the date of disposal.
Dr. Depreciation equipment 500
Cr. Accumulated depreciation 500
To record depreciation expense for 6 months for 6 of year 9

(ii) The other to record the sale of equipment.

Dr. Cash 1,750

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 Dr. Accumulated depreciation (8,000 + 500) 8,500

Cr. Asset equipment 10,000

Cr. Gain on sale of equipment 250
To record sale of equipment at a price above the book value

TRADE-IN AND EXCHANGE OF PLANT ASSETS

Certain types of depreciable assets, such as ears & office machines are commonly traded
in, or exchange for new assets of the same kind.
There may be or may not be any exchange of cash in the transaction.

(i) Trade-in allowance – An allowance granted by the dealer from the list price of the
new assets in exchange for the assets being traded-in. If the trade-in allowance is greater
than the book value of the assets being traded in, there is a suggestion of a gain being
realized in the trade-in & verse versa

NB There is suspicion often that the list prices are set higher than realistic cash price to
permit the offering of inflated trade-in allowance.

There are two methods commonly used in accounting for trade-in:-

(a) Cost basis method
(b) Gain or loss trade-in method

Cost basis – The cost of the new asset shall be the same of the book value of the old asset
trade-in, plus the additional amount period to acquire the new asset.

Example
Assume an old truck had been acquired for shs. 80,000. Its estimated useful life is 5 years
with no residue value after four years it is traded in for a new truck at list price of Ksh.
100,000. A trade-in allowance of Ksh. 24,000 is granted.

Determine the cost of the new truck.

Solution
Cost of the old truck 80,000
Less (Accumulated depreciation (16,000 x 4 yrs) 64,000
5
Book value 16,000

Add
Cash payment for new truck
(100,000 – 24,000) 76,000
Cost of new truck 92,000

Entries
Dr. Motor new truck 92,000

95
Dr. Accumulated depreciation 64,000

Cr. Motor old truck 80,000

Cr. Cash 76,000
To record acquisition of new vehicle by trade-in the truck

Note
- Trade in allowance is not recorded in the accounts.
- The list price is not recorded in the accounts
- The trade-in allowance and list price are used for computing the cash payment for
the new vehicle
This compound journal entry can be broken into two:-

Dr. New motor vehicle 92,000

Cr. Cash 76,000
Cr. Old truck value 16,000

To record acquisition of the new truck vehicle for cash and trade-in of old truck recorded
at book value

Dr. Accumulated depreciation 64,000

Cr. Old truck 64,000
To remove the accumulated depreciation & the depreciated cost of the old truck from the
books

Gain or loss trade-in

Assume the old asset described above is at a loss of shs. 8,000

Journal entry
Dr. Machine (new) 100,000
Dr. Accumulated depreciation 64,000
Dr. loss 8,000

Cr. Machinery (old) 80,000

Cr. Cash 92,000
To record sale of the asset at a loss of Ksh. 8,000

Accounting convention do not recognize gains on trade-in since it is not possible to make
a gain in the process of acquiring assets. Gains are made from production and sale of
goods.

ACTIVITY
1. The following information was extracted from the machinery ledger account of keron
works Ltd.

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Jan 1 Acquired four machinery Ksh. 180,000 each 720,000
Jan 2 in station costs 72,000
Total cost of machine 792,000

31st Deduct proceeds from sale of one machine 82,000

Balance in machine account 710,000

Machinery was being depreciated on a straight line basis over a five year useful life and a
salvage value of shs. 18,000 per machine

REQUIRED
Show the amount of the gain or loss on sale of the one machine on 31st Dec and prepare a
correct journal entry to show the disposal of the machine. What is the correct balance of
the machine account?

2. A lather machine which costs sh. 280,000 had an estimated useful life of 5 years and
an estimated salvage value of sh. 14,000 straight line method of depreciation was used.
Give the journal entry necessary to record each of the following alternative assumptions.

(a) The lathe was sold for sh. 24,000 after two years of use.
(b) The lethe was traded-in after 3 years for a new lethe with a list price of Ksh.
360,000 trade in allowance was shs. 160,000
(c) The lathe was scrapped after 4 years of use. Proceeds from sale of scrap were shs.
15,000
ACCOUNTING FOR INFLATION
Provisions of IAS 29

Worst Hyperinflations in World History

Highest Monthly Inflation Rates in History

Month with
Highest monthly Equivalent daily Time required for
Country highest inflation
inflation rate inflation rate prices to double
rate

Hungary July 1946 4.19 × 1016 % 207 % 15 hours

Zimbabwe November 2008 7.96 × 1010 % 98 % 24.7 hours

Yugoslavia January 1994 3.13 × 108 % 64.6% 1.4 days

97
Germany October 1923 29,500 % 20.9 % 3.7 days

Greece October 1944 13,800 % 17.9 % 4.3 days

China May 1949 2,178 % 11% 6.7 days

The discussion on income and capital has shown that income or profit is the amount an
enterprise earns after maintaining its capital.
The capital to be maintained depends on the measurement approach used by the
enterprise. The approaches include:
(i) Historical cost approach (nominal capital maintenance)
(ii) Financial capital maintenance (adjusted for inflation)
(iii) Physical capital maintenance.

This yields three methods of accounting that is:

(i) Historical cost accounting.
(ii) Current purchasing power.
(iii) Current cost accounting method.

Historical cost accounting

This is the conventional accounting approach. It is the generally accepted method of
accounting. According to this approach, income is the increase in net worth (assets-
liabilities) based on their cost of acquisition and before any distribution in form of
dividends.

Limitations of Historical Cost Accounting (HCA)

Although accounting transactions are measured in monetary terms, money is not a
uniform measure of value especially in periods of changing prices. The following are
some of the shortcomings of historical cost accounting.

(a) Valuation of fixed assets

Historical cost states fixed assets at the cost of acquisition. Such values of assets are not
realistic, as they bear no relation to actual values of benefits to be derived from the use of
the assets.

(b) Consistency violation

Items included in the balance sheet may not be consistently valued in terms of the unit of
measure. For instances whereas the assets, particularly fixed assets and stock, are valued
at historical costs, the liabilities as well as monetary assets are valued at current realizable
or payable amounts. Moreover, comparison of accounting figures over a period of time
based on HCA is not possible in times of rising prices.

98
(c) Depreciation
One of the purposes of depreciation is to provide funds for the replacement of assets.
HCA depreciation does not provide for adequate replacement fund because it is based on
the HC of acquisition rather than replacement values. Thus the depreciation based on
historical cost of fixed assets is an adequate measure of the value of the assets consumed
during a given period.

(d) Holding gains vis-à-vis operating gains

HC accounting does not distinguish between holding gains and the profits from business
activities. Holding gains are the benefits arising from holding goods for sale during times
of rising price. That portion of gross profit for the year, which is „holding gains‟, is not
disclosed under historical cost accounting method.

(e) Gains and losses on monetary items

A business may gain as a result of obtaining credit at times of increasing prices.
Similarly, it would lose in terms of purchasing power if it sells on credit in terms of rising
prices. Historical cost accounting fails to disclose the gains on holding net monetary
liabilities, or losses on holding net monetary assets.

(f) Analysis and interpretation of accounts

Analysis of financial statements based on historical cost figures can give misleading and
sometimes awkward results. For example, return on investments computation will be
based on undervalued assets in the balance sheet and overstated profit in the profit and
loss account.

(g) Cost of sales

In times of rising prices the cost of replacing goods sold is higher than the historical cost
of sales. The conventional methods of determining cost of sales (e.g. FIFO, LIFO, etc)
will result in an inadequate charge against sales revenue. The resulting profit figure is
likely to be exaggerated.

(h) Taxation and dividend

The effect of undercharging depreciation and cost of sales is to overstate profits. This
may lead to higher taxation than warranted. Moreover it may exaggerate the business
ability to pay dividends and therefore lead to distributions of dividends or payment of tax
out of capital rather than profits.

Current purchasing power (CPP) method

CPP is a method of accounting for inflation, which is based on general price level index
used as a deflator of the nominal value arrived at using historical cost accounting. The
objective of deflation is to maintain the purchasing power of capital to that at the
beginning of the period. The assumption of CPP is that prices of individual items move I
the same direction and in same rate (hence general price index number). For the purpose
of CPP it is important to distinguish between two classes of items, monetary and non-
monetary items.

99
Monetary items
These are those items, which are fixed by contract or by their nature and are expressed in
money worth regardless of changes in price level. They include cash, debtors, loans,
creditors and claims to specified amounts of money. Holders of monetary liabilities gain
at the expense of the creditors during period of inflation. Those whom hold monetary
liabilities gain at the expense of the creditors during period of inflation. Those who sell
on credit lose in times of inflation unless payments are pegged to price level changes.

Non-monetary items
These are items whose value is not fixed in any way and therefore would not lose or gain
as a result of inflation or deflation. Examples include assets and liabilities such as fixed
assets, stock and shareholders equity. For instance, increase in price of stocks may not
cause any loss, as at the time of sale value will compensate the loss in purchasing power.

Conversion of historical costs under CPP method

Under this method, expenditures and receipts made or received in shillings of „past
purchasing power‟ are converted into shillings of „current purchasing power‟ by use of
price indices. The conversion is effected using the following formula:

Converted amount= actual amount current index number

Spent or X index number at
Received (Ksh) date of transaction

The conversion to current purchasing power is effected for all the balances appearing in
the profit and loss account and balance sheet except monetary assets and liabilities.
Monetary items including cash, debtors, creditors, accruals, repayments, etc, appear in
the CPP balance sheet at the same value as which they appear in the historical cost
accounting balance sheet. They represent the amounts realizable or payable, as the case
would be.

Gains on holding monetary assets and liabilities

Gains or losses on holding monetary assets and liabilities result from stating the monetary
assets and liabilities in the CPP balance sheet at the same value at which these are stated
in the historical cost balance sheet in a period when the purchasing power of the currency
is changing.

The above procedure requires that the dates of the transactions that change the net total
monetary assets be identified. However, those transactions, which simply result in a

100
change in the composition of net monetary assets, need not be considered. For example,
purchase of goods on credit immediately reduces net monetary assets by virtue of the
increase in creditors (stock is non-monetary asset) while subsequent payment of the debt
has no effect on net monetary assets as it reduces cash and creditors by the same amount.

It is worth noting that a company‟s net monetary assets are essentially made up of its
current assets (excluding stock), current liabilities and its longer-term liabilities. The
long-term liabilities would include debentures and other forms of loan capital. The rights
of preference shareholders are usually fixed in money terms. This is so if they are entitled
to a fixed dividend and to a fixed sum payable on the liquidation of the company. In such
a case preference shares would be included in the long-term net monetary assets. The
adjustment of historical cost value to current purchasing power value is based on the
notion that profit can only be recognized if the purchasing power of capital is maintained.

Accounting for price level changes using CPP method involves the following steps.

 Convert the balance sheet items of year x0 to the general price index at year x0.
 Adjust the balance sheet converted in step 1 to general price index at the end of year
x1.
 Compute the monetary gain\loss.
 Convert the profit and loss for the year x 1 to price index at end of year x1.
 Convert the balance sheet of year x1 to general price index at end of year x1.

Advantages and disadvantages with CPP method

Advantages of CPP
1. The financial statement drawn under CPP method is objective in the sense that it
does not depart from the principle of historical-cost based measurement.
2. Price level adjustments based on general price levels are verifiable by reference to
the index used to measure changes in purchasing power of money.
3. Financial statements drawn on CPP methods are comparable because of the
consistency of approach.

Weakness with CPP

1. CPP is based on the concept of general price index. There is actually nothing like
a „general purchasing power‟. Instead, firms and people see themselves as holding
specific purchasing power.
2. There are computations (statistical) as well as interpretation (conceptual)
limitations of using price index number. There are many types of index numbers
that may be used yet there is no agreement on which provides the general price
level index.

101
3. The income arrived at using CPP approach is rather meaningless. It does not
represent the earnings potential of capital but rather an average (index) value. It
does not explain strictly what the firms have actually earned.
4. General Price level indices assume that prices of different commodities change in
the same direction and magnitude. In reality prices do not necessarily move in the
same direction let along same magnitude.

Illustrations
Naitex Ltd. prepares its financial statements on both historical cost accounting basis and
inflation adjusted accounting basis using current purchasing power method. Given below
are the trading, profit and loss accounts for the year ended 31 March 2009 and
comparative balance sheets of the company for the year ended 31 March 2008 and 31
March 2009.

Profit and Loss Account for the Year

Ended 31 March 2009
(Historical Cost Accounting basis)
Sh.’000’ Sh.’000’
Sales 90,000
Opening stock 30,000
Purchases 65,000
95,000
Closing stock (35,000)
Cost of sales (60,000)
Gross profit 30,000
Expenses:
Loan interest 500
Salaries and wages 3,500
Depreciation 5,000
Other expenses 1,000 (10,000)
Profit before tax 20,000
Taxation (8,000)
Profits after tax 12,000
Dividends paid:
Ordinary 2,500
Preference 1,000
Dividends proposed:
Ordinary 2,500
Preference 1,000 (7,000)
Retained profits for the year 5,000

Balance Sheets as at 31 March

(Historical cost basis)
2009 2008

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Sh.’000’ Sh.’000’
Fixed assets 70,000 58,000
Stocks 35,000 30,000
Debtors 40,000 34,000
Prepayments 2,000 1,000
Bank balance 5,000 8,000
152,000 131,000
Ordinary share capital 70,000 60,000
10% preference share capital 20,000 20,000
Reserves 23,000 18,000
113,000 98,000
Loan 18,000 20,000
Trade creditors 17,200 12,500
Accruals 300 500
Proposed dividend 3,500 -
39,000 33,000
152,000 131,000

The following additional information is provided:

1. Out of the total sales for the year, Sh. 30,000 was a special order and was made in
Mid-January 2009. Purchases for the special order were made in the same period.
Other sales and purchases were made uniformly throughout the year. Gross profit
rate on all sales was 33 1/3% of sales value.
2. Closing stocks represented an average of two months purchases.
3. Loan interest was paid in two equal installments on 15 September 2008 and 15
March 2009.
4. Salaries and wages and other expenses paid in cash accrued evenly throughout the
year.
5. Tax was paid in two equal installments on 30 September 2000 and 31 March
2001.
6. Interim dividend was paid on 30 September 2000.
7The business purchased fixed assets worth Sh. 17,000,000 on 15 October 2000. These
assets
Were depreciated by Sh.1, 000,000 in the year ended 31 March 2001. Other fixed
assets were
Purchased when the retail price index was 120.
8. The company issued 500,000 ordinary shares of Sh.20 each, at par on 15 June
2000. The
Remaining ordinary shares were issued at the inception of the company when
retail price
Index was 100.
9. Retail price moved uniformly throughout the two years.
10. Retail price indices prevailing for some selected dates were as follows:

Year ended 31 March

2001 2000

103
 Mid-January 144 120
Mid-March 148 124
Mid-June 154 130
Mid-September 160 136
Mid-December 166 142
Average index 137 -
Index on 31 March 149 125
Mid- October - 138

Required
Using the current purchasing power accounting method and rounding the
workings to the
Nearest thousand:
(a) Determine the revenue as at 31 March 2000. (5 marks)
(b) Calculate the gain or loss on holding monetary items. (5 marks)
(c) Prepare the trading, profit and loss account for the year ended 31 March
2001 and
Balance sheet as at that date. (10 marks)
(Total: 20 marks)

Current cost accounting (CCA) method

Current cost accounting is a method that modifies historical cost profit to arrive at the
surplus after allowing for the impact of price changes on the funds needed to continue the
existing business and to maintain its operating capabilities equal to that it had at the
beginning of that period. CCA is thus based on the principal of physical capital
maintenance.

The basic objective is to provide users of financial statements with more information than
is availed by historical cost approach so as to enable them understand such issues as
financial viability of the business, returns on investments, pricing policies and gearing.

Proponents of CCA method argue that the historical cost accounts overstate or understate
profits during time of inflation due to four factors.
1. The depreciation charge on historical cost accounts is based on historical cost of
the fixed assets. If prices are increasing the replacement cost of the assets will be
higher than their historical cot. Depreciation on historical cost does not provide
sufficient replacement funds. For that reason then the firm will suffer a severe
working capital loss on the year of replacement of that asset because it did not set
aside enough replacement resources. CCA method argues that an additional
depreciation is required to supplement historical depreciation so as to achieve the
desired current cost depreciation. This adjustment is called Depreciation
Adjustment.

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2. Like in the case of fixed assets, the firm changes cost of sales based on historical
cost of the goods. In times of inflation the firm finds that it requires more
resources to replace the goods sold than the cost they have charged in historical
cost accounts. The historical cost profits will thus be eroded by the need to
replace goods at a higher price than the price they were acquired. To solve this
problem, CCA charges an additional cost to adjust historical cost of sales to
current cost of sales. This additional cost is the cost of sales adjustment.

3. The operation of any business requires sufficient working capital. In times of

inflation working capital in form of cash and bank balances, debtors and other
receivables lose value so much that the purchasing power of the amounts
recovered out of such assets is lower than the value at acquisition. As if to
mitigate the losses, working capital liabilities such as creditors equally lose value
and thus the firm pays less in purchasing power than that at which it acquired
them. Where a company is in a net debtor position (that is positive working
capital) then the effect is a loss of purchasing power in times of inflation. There is
a need to provide additional working capital to compensate for this loss of value.
This additional working capital is made in the form of monetary working capital
adjustments. It is likely that the movement of prices with respect to cost of sales
is similar to that of monetary working capital. Therefore, the method used to
compute the cost of sales adjustments.

4. The three adjustments mentioned above are known as operating adjustments. The
rationale of the operating adjustments is to restrict distributable profits so as to
provide a sufficient base of resources that would maintain the operating capability
of the firm.
This restraint is borne by the shareholders (distributable profit goes to shareholders) but
only if the firm is fully financed by share equity. However, to the extent that the firm is
financed through borrowing, then the debt equity holders would share in the loss
occasioned by the operating adjustment aforementioned.

In an indirect way it means that the debt holders will lose part of their investment worth
owing to the fact that the amount payable to them will be less in purchasing power than
the amounts they contributed to the firms. There is thus a need for a fourth adjustment;
this time being a charge of the operating adjustments to the debt holders in the proportion
they bear capital contribution to the firm. This extra adjustment is known as gearing
adjustment.
The rationale of gearing adjustment is to charge equitably the operating
adjustments in order that the full burden should not fall on ordinary shareholders, where
such shareholders have not financed the entire assets in respect of which the operating
adjustments are made.

The gearing adjustment factor is given by L

L+S
Where L= Average net liabilities
S= Average shareholders equity

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Net liabilities is given by the difference between
(a) The aggregate of all liabilities and provisions (including deferred tax but
excluding dividend which is considered part of the shareholders equity) other
than those considered in monetary working capital adjustments, and
(b) The aggregate of all current assets other than those subject to cost of sales
adjustment and those included in monetary working capital adjustment.
The shareholders equity must be considered in the same current value terms as the net
liabilities.(Note: Net liabilities are monetary items which are stated at current value terms
while shareholders equity is a non-monetary item). For this purpose shareholders equity
must include current cost reserve (discussed below).

Current value shareholders equity is arrived at as follows:

Ordinary share capital xxx
Share premium xxx
Other capital reserve (other than revaluation reserve) xxx
Current cost retained profit xxx
Current cost reserve xxx
Dividends (proposed) xxx

The current cost reserve is an additional reserve to those in the historical cost balance
sheet, which include:
(i) Unrealized amount equal to the revaluation surplus on fixed assets, stocks and
investments.
(ii) Realized amounts equal to the cumulative net total of operating adjustments
and gearing adjustments.

Limitations of CCA Method

1. The valuation of items in CCA method is too subjective and open to many
interpretations; it is thus unverifiable from an auditor‟s point of view.
2. CCA is actually not a system of accounting for inflation, because successive
balance sheets are stated at different purchasing power values.
3. CCA is time consuming and expensive compared to CPP.
4. CCA has failed to attract widespread support and acceptance by accountants.

Latema Ltd. Was incorporated and commenced business in 1995 specializing in the
import and export of a variety of goods throughout the East, Central and South
African region.
Due to the sustained inflationary conditions under which the company has
operated since inception, management has always considered that the traditional
financial statements based on historical cost basis are more informative and relevant
if supplemented with corresponding current cost accounts.
You have been approached to prepare the current cost accounts for the year ended
31 December 2001 and have been provided with the following information in respect
of the company.

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 Latema Ltd.
Balance sheet as at 31 December 2000
Current cost accounting basis
Sh.‟000‟ Sh‟000‟
Assets
Non-current assets 13,650
Current assets
Stock 4,848
Trade debtors 3,852 8,700

Equity and liabilities

Capital and reserves
Ordinary shares 6,000
Share premium 2,000
Current cost reserve 1,900
Retained earnings 1,850 11,750

Non- current liability

Loan 4,000

Current liabilities
Taxation 2,000
Trade creditors 2,800
Proposed dividends 300
Bank overdraft 1,500 6,600
22,350

Profit and Loss Account for the year

Ended 31 December 2001
Historical cost accounting basis
Sh.‟000‟ Sh.‟000‟
Sales 96,000
Opening stock 4,800
Purchases 73,200
Cost of goods available for sale 78,000
Closing stock 6,000 (72,000)
Gross profit 24,000
Expenses:
Loan interest expense 350
Administration expenses 8,600
Selling and distribution expenses 4,250
Depreciation 1,800 (15,000)
Profit before tax 9,000
Taxation (4,000)
Profits after tax 5,000

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Dividends
-Interim paid 300
-Final proposed 600 (900)
Retained profit for the year 4,100

Additional information
1. During the year ended 31 December 2001, the company paid all the
loan interest,
Administration expenses and selling and distribution expenses.
2. Proposed dividends as at 31 December 2000 were paid in 2001
together with the interim dividends for the year 2001.
3. The company received Sh. 992,604,000 from its trade debtors and paid
sh. 72,500,000 to its trade creditors in the year ended 31 December
2001.
4. Total amount paid for taxation in the year ended 31st December 2001
was
sh.4, 500,000
5. the loan attracted an interest of ten per annum and sh. 1,000,000 of the
loan was repaid on 30 June 2001.
6. The non-current asset consists of a fixed asset purchased in January
1998 at a cost of sh.18, 000,000 and is being depreciated on a straight
–line basis over a ten-year period based on cost.
7. The historical cost accounting accumulated depreciation on the asset
as at 31st December 2001 was sh 5,400,000.
8. The appropriate current cost accounting were as follows

Price index
1 January 1998 date of purchase 120
31 December 1999 125
31 December 2000 130
31 December 2001 135

Current cost accounting depreciation adjustments is based on year-end

current cost value of the fixed asset.
9. The average age of stocks is one month and the suitable price indices
applicable
To stock and monetary working capital moved as follows:
Price index
1 November 2000 100
31 December 2000 102
Average for 2001 112
I November 2001 120
31 December 2001 122
10.It is the group‟s policy to treat the balance at bank and bank overdrafts as
part of monetary working capital.

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 Required
(a) Current cost profit and loss account for the company for the year
ended 31
December 2001. (30 marks)
(b) Current cost balance sheet of the company as at December 2001.
(10 marks)
{NB: Round figures to the nearest thousand shillings}.
Total:
20
Question Two

Question Three
Zetoxide Limited is a small chemical manufacturing company, which supplies
Zinc Oxide to a number of major manufacturers in the rubber industry in the East
African region. It
Operates a single production line in rented premises situated in the Industrial Area
of
Nairobi. On 1 April 2000 it took advantage of falling rents in Nairobi to move
into spacious
Premises at the same rent as it was paying previously. On the same date, it sold its
previous
Production line to a competitor and purchased a new cost-effective production
line that could
Be operated independently of electricity. The historic cost balance sheets as at 30
September
1999 and 2000and the historic cost income statement for the year ended 30
September 2000
Are as follows:

Balance sheet as at 30 September Income statements

For the year ended 30
September 2000
1999 2000
Sh.‟000‟ Sh.‟000‟ Sh.‟000‟
Sh.‟000‟
Property, plant and equipment
Production plant. Cost 6,000 16,000 Sales revenue 96,000
Depreciation (4,200) (800) Raw materials
(49,000)
1,800 15,200 Changes in
Inventory 2,100
Current assets Inventory 7,200 5,100
(46,900)
Trade receivables 6,300 8,000 Staff cots
(36,000)

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 Cost at bank 1,200 - Depreciation
800
14,200 13,100 other operating
Expenses (7,600)
Current liabilities: Bank overdraft - 900
(91,900)
Trade payables 2,900 4,200 Profit from 4,100
Operations
Current tax 2,300 - Profit on sale
Of plant 2,100
5,200 5,100 Finance costs
(300)
Net current assets 9,500 8,000 5,900
11,300 23,200 Taxation:
Current
Nil
Ordinary share capital Deferred (2,300)
200,000 ordinary shares of Sh10 2,000 2,000 (2,300)
Retained earnings 8,400 12,000 Net profit
Retained 3,600
Shareholders funds 10,400 14,000
Non- current liabilities
Deferred tax 900 3,200
Debentures - 6,000
900 9,200
11,300 23,200

Additional information
1. The directors of the company produce current cost accounts each year in addition
to the Historic cost accounts.
Sales, purchases and expenses have occurred evenly over the year.
2. Sales, purchases and expenses have occurred evenly over the year.
3. Opening stocks represents two months purchases while closing stock represents
one month‟s
Purchases.
4. Debtors and creditors at each balance sheet date represent one month‟s sales and
purchases.
5. Zetoxide Ltd. Depreciates property, plant and equipment, both for historic cost
and current cost purposes, from the date of purchase of the assets pro-rata with
time at 10% per annum: no depreciation is charged in the year of sale. The old
plant sold on 1 April 2000 had been
Purchased on 1 October 1992.
6. The following price indices are appropriate
Old Plant New Plant Stock Debtors
Creditors
1 October 1992 120 - -

110
 1 August 1999 238 - 360
1 September 1999 239 - 363
1 October 1999 240 - 366
1 April 2000 264 250 384
1 August 2000 - 267 395
1 September 2000 - 271 398
1 October 2000 - 275 402
Average for the year ended
30 September 2000 - - 384
7.Zetoxide Ltd. Bases its current cost depreciation charge on the year-end value of
property, plant
And equipment. Any current cost profit or loss on disposal is based on the depreciated
current cost at the date of disposal. The cost of sales adjustments and the monetary
working capital adjustments are both computed on the averaging method. No part of the
bank balance or bank overdraft should be included in monetary working capital. The
gearing adjustment is always computed on the simple arithmetic average gearing for the
year.
8.Zetoxide Ltd.‟s current cost reserves, as at 30 September 1999 was Sh. 3,680,000.
Required
Zetoxide Limited‟s Current Cost Profit and Loss Account (starting with the historic cost
before finance costs) for the year ended 30 September 2000, its Current Cost Balance
Sheet as at 30 September 2000 and the reconciliation of the Current Cost Reserve for the
year ended 30 September 2000. Round all figures to nearest Sh. 000.
(20 marks)

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