Mt Kenya University

SCHOOL: BUSINESS AND PUBLIC MANAGEMENT

DEPARTMENT: ACCOUNTING AND FINANCE

COURSE CODE: MAF 5101

COURSE TITLE: Financial Accounting

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 COURSE OUTLINE
Purpose: To develop the learners understanding of the principles of book-keeping
and accounts and the ability to maintain books of accounts and preparation of
financial statements

Specific Objectives
By the end of the course the learner should be able to:-
• Explain the nature and purpose of accounting
• Write up books of original entry
• Prepare final accounts for sole traders, partnerships and companies
• Interpret accounting information

Contact Hours: 42 divided into fourteen three hour sessions

Assessment
Continuous Assessment Tests (CATs) and Assignments 30%
University End-of-semester 2 hour Examination 70%
Total 100%

Course Content
Lesson One 5
Accounting 5
Functions of accounting 7
Creating accounting information 8
Communicating accounting information 9
Financial statements 10
Accounting equation 11
Distinction between accounting and bookkeeping 16
Accounting principles, concepts and conventions 16
Concept of capital and capital maintenance 18

Lesson Two 19
The Double entry 19
Recording transactions in the ledger 20
What is an account? 20
Journalizing transactions and events 24
Preparing unadjusted trial balance 29
Errors of trial balance 30
The suspense account 34
Adjusting entries 38
Preparing adjusted trial balance 42
Preparing post closing trial balance 44

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Lesson Three 49
Measuring business income 49
Distinction between capital and revenue expenditure 49

Lesson Four 63
Accounting for cash 63
Control of cash through bank accounts 65
Cash flow statement 76
Funds flow statement 77

Lesson Five 88
Accounting for receivables/debtors 88
Accounting for property, plant and equipment 94
Depreciation 100
Disposal of plant assets 111
Accounting for intangible assets 116
Goodwill 118
Preparing financial statements from incomplete records 125
Statement of affairs 127

Lesson Six 134

Partnership accounts 134
Features of a partnership 134
Partnership accounts 137
Admission of a new partner 146
Retirement of a partner 155
Dissolution of partnership 157

Lesson Seven 170

Company accounts 170
Accounting for manufacturing enterprises 186

Lesson Eight 196

Accounting for non-profit making organizations 196

Lesson Nine 212

Basic accounting ratios 212

Teaching/Learning Methodologies
Lectures and tutorials, group discussions, demonstrations, Individual assignments
and Case studies

Instructional Materials and Equipments

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 Projector, text books, designed catalogues computer laboratory, designed
software and simulators

Recommended Text Books

i. Preeti Hiro (2008); Basic Accounting; Prentice-hall of India Pvt Ltd
ii. Stice (2008); Financial Accounting : Reporting And Analysis; Cengage
Learning ( Thompson )
iii. Reimers (2006);Financial Accounting; Dorling Kindersley (India) Pvt Ltd
iv. Meigs, Walter B; Accounting, the basis of business decisions (latest
edition)

Text Books for further Reading

i. Wood, Frank. (2003); Business Accounting (17th Edition); International
Thompson
ii. Honrgren and Sundem, G.L (2004); Introduction to Financial Accounting
(6th Edition); New York Prentice Hall

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 LESSON ONE
Learning Objectives
By the end of this lesson, the student should be able to:
i. Define and explain the purpose of an accounting system
ii. Explain the phrase „„generally accepted accounting principles‟‟
iii. Describe a balance sheet: define assets, liabilities, and owner‟s equity
iv. Discuss the accounting principles involved in asset valuation
v. Indicate the effects of various transactions upon the balance sheet
What is accounting?
Nearly everyone practices accounting in one form or another on an almost daily
basis. It is the art of interpreting, measuring, and describing economic activity.
Whether you are involved in preparing your household budget, balancing your
chequebook, preparing your income tax returns, or running Safaricom Ltd, you
are working with accounting concepts and accounting information.

Accounting has therefore been called simply a „„language of business‟‟.

Accounting terms and concepts have over the years been used to describe the
resources and the activities of every business, large or small by people involved in
the business world including:-
a) Business owners/ Entrepreneurs
b) Managers
c) Bankers.
d) Stock brokers & lawyers.

We are experiencing an era when accountability is key to all the decisions that are
being made in our country. The accounting function therefore is very vital to
every unit of our society whereby: -

a) An individual
• Account for his or her income by filing income tax returns
• Must supply personal accounting information in order to buy or sell property
including a car or a home, to qualify for a college scholarship or loan, to
secure a credit card, or to obtain a bank loan

b) Large corporations are accountable to their shareholders, to government

agencies, and to the public.

c) The central government, local authorities and counties all must use accounting
as a basis for controlling their resources and measuring their
accomplishments.

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 d) In every future election, the voters are expected to make decisions at the ballot
box on issues involving accounting concepts.

Some knowledge of will therefore be needed by all citizens if they are to act
intelligently in meeting the challenges of our society. This course will help you
develop your knowledge of accounting and your ability to use accounting
information in making economic and political decisions.

The purpose of accounting and nature of accounting information

The underlying purpose of accounting is to provide financial information about an
economic entity. Accounting information describes the events that make up the
daily activities of every business. In this regard the economic entity that will be
subject of our discussion in this course will be a business enterprise. The
information is used for controlling the use of resources and measuring the
performance of a business entity which include: -
- Sole traders: e.g a doctor, a dentist, a small shopkeeper. Each is the sole
owner of his or her business.
- Partnerships: as above. The main difference is that a business formed
under a partnership structure has shared ownership between at
least two people.
- Limited companies: e.g EABL, GM, Marks & Spencer etc. There are two
types of limited company, namely, private (ltd) and public limited
companies
- Other corporations: especially 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 authorities,
- Others: such as trusts and mutual associations.

Financial information about an enterprise is needed by: -

i. Management (internal users), to help them plan and control the activities of a
business enterprise. 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.

ii. Outsiders (external users) including owners, creditors, potential investors,

the government, and the public who have supplied money to the business or

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 who have some other interests in the business that will be served by
information about its financial position and operating results. They make
decisions on:-
• Whether to invest
• Whether to extend credits
• Whether to do business
The process of developing and reporting accounting information to external
decision makers is called financial accounting.

The business organization‟s accounting system develops and communicates the

information that the various users require. Accounting information contains the
following characteristics: -
1. Accounting information should provide information that is useful to
present and potential investors and creditors. Information is useful if it
is: -
• Understandable
• Timely
• Relevant
• Fair and Objective (free from bias)

2. Information should be comprehensive to those who are able to

reasonably understand the business and economic activities

3. It should help investors and creditors to assess the amounts, timing &
uncertainty of prospective cash receipts

4. Should assist in assessing the prospects of cash resale, redemption and

maturity of loans

5. Should provide information about the economic resources of an

enterprise

Functions of accounting
It is generally accepted that accounting should serve the following functions:
(i) 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.

(ii) Measuring: accounting assists 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 including the government (taxes), employees
(wages), and shareholders (dividends).

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(iii) Stewardship: accounting provides a record of how the funds entrusted to
Managers have been used by them, and to what extent.

(iv) Monitoring, planning and control: accounting provides 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.

(v) Information for decisions: accounting assists investors in deciding how to

allocate their limited resources.

(vi) Communication: accounting communicates information to both internal and

external users. (Financial statements are the main tools used to
achieve this function for external users.)

Creating accounting information

An accounting system consists of methods, procedures, and devices used by an
entity to keep track of its financial activities and to summarize these activities in a
manner useful to decision makers. The accounting system may make use of: -
• Computers and video displays
• Handwritten records
• Reports printed on paper

An accounting system, whether simple or sophisticated, require three basic steps

to be performed on the data concerning financial activities. The data must be
recorded, classified, and summarized.

(a) Recording financial activity

The accounting system must create a systematic record of the daily business
activity, in terms of money.
Example: the record should indicate how: -
- Goods and services are purchased and sold
- Credit is extended to customers
- Debts are incurred
- Cash is received and paid out

These are typical transactions of a business which can be expressed in

monetary terms. They must be entered in accounting records. A transaction
refers to a complete action rather than an expected or possible future action.
The recording of a transaction maybe performed in many ways such as: -
- Writing with a pen or pencil

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 - Entering data through computer keyboard
- Passing machine-readable price tags over an optical scanner
Not all business events can be objectively measured and described in
monetary terms. We therefore do not record in the accounting records such
events as death of a key executive or a threat by a labour union to call a strike.

(b) Classifying data

Data must be classified into related groups or categories of transactions
otherwise a complete record of all business activities usually amounts to a
huge volume of data (large and diverse) to be useful to decision makers such
as managers and investors

(c) Summarizing data

To be useful to decision makers, accounting data must be highly summarized.
Example:
- The employees responsible for ordering merchandise need sales
information summarized by product
- Stores managers will want sales information summarized by
department
- Top management will want sales information summarized by store
- Outsiders (shareholders and government revenue authorities) will most
probably be most interested in a single sales figure which represents
the total sales of the entire company.

The three steps of recording, classifying, and summarizing are the means of
creating accounting information. However accounting process also involves
communicating this information to interested parties and interpreting
accounting information to help in the making of specific business decisions.

Communicating accounting information

An accounting system must provide information to managers and also a number
of outsiders who have interest in the financial activities of the business enterprise.

The persons receiving accounting reports are termed the users of accounting
information. The type of information a specific user will require will depend upon
the kind of decisions that person must make.
Example:
- Managers need detailed information about daily operating costs for
purposes of controlling the operations of the business and setting
reasonable selling prices

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 - Outsiders, on the other hand, usually need summarized information
concerning resources on hand and information on operating results for the
past year to use in making investment decisions, computing income taxes,
or making regulatory decisions.
Information needs of various users differ hence accounting system of a business
must be able to provide various types of accounting reports. The reports must be
presented in accordance with certain „„ground rules‟‟ and assumptions

Financial statements
They are the most important and widely used of all accounting reports. They are
the main source of financial information to persons outside the business
organization and are also useful to management. They summarize the activities of
a business for a specified period of time, such as a month or a year. They show
the financial position of the business at the end of the time period and also the
operating results by which the business arrived at this financial information. The
primary purpose of financial statements is to assist decision makers in evaluating
the financial strength, profitability, and future prospects of a business.

Note: A Business entity is an economic unit that engages in identifiable business

activities. The business entity is regarded as being separate from personal affairs
of its owner.

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. It
is also called a statement of financial positions.

Assets: Are economic resources which are owned by a business and are
expected to benefit future operations. Assets may have definite physical
form such as buildings, machinery, or merchandise. Some assets exist in
the form of valuable legal claims or rights such as amounts due from
customers, investments in government bonds, and patent rights.

Assets are divided into two:-

i. Fixed assets – Items which are permanent in nature. They are
not held for resale or productive purpose and include furniture,
machinery, and land.
ii. Current assets – Assets of temporally nature also referred to
as floating or circulating assets as they change from one form
to another. They are converted to cash easily and include
stocks, raw materials, finished goods, cash in bank, cash in
hand, debtors, and short term investments.

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 Liabilities: Are debts. All business concerns have liabilities as businesses
find it convenient to purchase merchandise and supplies on credit rather
than to pay cash at the time of each purchase. The liability arising from
purchase of goods or services on credit is called an account payable, and
the person or company to whom the account payable is owed is called the
creditor.

Liabilities are also divided into two:-

a) Long-term liabilities – Debts whose claim is made after
one year e.g Loan to be paid with a period of 5 years.
b) Current liabilities/Short-term liabilities. – Claims that
must be paid in full within a period of one year e.g
Purchases of goods on credit, bank over drafts, unpaid
salaries, outstanding rents etc.

Capital/owners Equity: This represents the resources invested by the

owner. It is the total assets minus the liabilities. The equity of the owner is
a residual claim because the claims of the creditors legally come first.
Owners are entitled to what remains after the claims of the creditors are
fully satisfied.

Accounting equation
A fundamental characteristic of every balance sheet is that total figure for assets
always equal the total figure for liabilities and owner‟s equity. It shows the
relationship between assets liabilities and owner‟s equity/capital. The two sides of
a balance sheet are merely two views of the same business resources. The listing
of assets shows what resources the business owns while the listing of liabilities
and owner‟s equity shows who supplied these resources to the business and how
much each supplied. The accounting equation is as follows: -
Assets = Liabilities + Owner’s Equity
Or
Assets - Liabilities = Owner’s Equity
This equation facilitates the computation of capital as long as the assets and
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.

BALANCE SHEET
Balance Sheet is a position statement which presents the financial position of business on a
fixed date.
Characteristics of Balance Sheet:
a) It is prepared not for a period but for a certain date, and is true on that date
only because even a single transaction affects a balance sheet.
b) It is prepared after the preparation of trading and profit and loss account.

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c) Capital is equal to the difference between assets and outside liabilities that is
why both the sides of a balance sheet are equal. If they are not equal there is
some error.

Example
Assets = Ksh. 774,000

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 Liabilities = Ksh. 200,000
Calculate the owner‟s equity.
Owner‟s Equity = Assets – Liabilities
Ksh. 774,000 – Ksh. 200,000 = Ksh. 574,000

Effects of business transactions upon a balance sheet

Every business transaction, no matter how simple or how complex, can be
expressed in terms of its effect on the accounting equation.

Assume the following,

Mt. Kenya Cleaners
Balance sheet as at 31/08/2010

Assets Amount(Ksh) Liabilities Amount (Ksh)

Cash 219,000 Bank loan 120,000
Land 80,000 Creditors 80,000
Building 390,000 Owner‟s Equity/Capital 574,000
Office equip. 10,000
Motor vehicles 75,000
774,000 774,000
Assume all creditors were paid by cash on 02/02/2011. Show new balance sheet.

Mt. Kenya cleaners

Balance sheet as at 02/02/2010
Assets Amt (Ksh) Liabilities Amt (Ksh)
Cash 139,000 Bank Loan 120,000
Land 80,000
Building 390,000
Office Equip 10,000 Owner‟sEquity 574,000
Motor van 75,000
694,000 694,000

A decrease in asset as is indicated above is accompanied by an equal decrease of

either liabilities or capital and likewise an increase in asset is accompanied by an
equal increase in either liability or capital.

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Question
On 1st Jan 2009, Masafa Mafupi started a business with the following assets and
liabilities denominated in Ksh.

Assets: Cash Ksh. 16,800 Stock on had Ksh. 48,000

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

Liabilities: Creditors Ksh. 30,000 Bank overdraft Ksh. 12,000

Required:
Calculate Masafa Mafupi‟s Owner‟s Equity/capital.

The presentation of a balance sheet may be in two ways/formats: -

(a) Horizontal format
(b) Vertical format.

Horizontal Format

Rose Juma
Balance Sheet as at xxxx

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

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The above format of the balance sheet is the horizontal format however currently the practice is
to present the Balance Sheet using the vertical format which is shown below.

Vertical format

Rose Juma
Balance sheet as at xxxx
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 XX
Working capital XX

Financed by

Owners Equity XX
Loan by AFC XX
XX

Please pay attention to the format. The Non Current assets are listed in order of
permanence as shown i.e. from Land and Buildings to motor vehicles. The Current Assets
are listed in order of liquidity i.e. which asset is far from being converted into cash.
Example, stock is not yet sold, (i.e. not yet realised yet) then when it is sold we either get
cash or a debtor (if sold on credit). When the debtor pays then the debtor may pay by
cheque (cash has to be banked) or cash.
The Current Liabilities are listed in order of payment i.e. which is due for payment first.
Bank overdraft is payable on demand by the bank, then followed by creditors.
Note that in the vertical format, current liabilities are deducted from current assets to give
net current assets. This is added to Non Current assets, which give us net assets.
Net assets should be the same as the total of Capital and Non Current Liabilities.

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Example 1.1
Nyamache has a business that has been trading for some time. You are given the following
information as at 31.12.2011
Sh.’000’
Buildings 11,000
Furniture & Fittings 5,500
Motor Vehicles 5,800
Stocks 8,500
Debtor 5,600
Cash a bank 1,500
Cash in hand 400
Creditors 2,500
Capital 30,800
Loan 5,000

You are required to prepare a Balance Sheet as at 31 December 2011

Nyamache
Balance Sheet as at 31 December 2011

Non Current Assets sh.’000’ sh.’000’

Buildings 11,000
Furniture & Fittings 5,500
Motor Vehicles 5,800
22,300

Current Liabilities
Stock 8,500
Debtors 5,600
Cash at bank 1,500
Cash in hand 400
16,000
Creditors (2,500)
Net Current Assets 13,500
Net Assets 35,800

Capital 30,800
Non-Current Liabilities
Loan 5,000
35,800

Example 1.2
Ogutu sets up a new business. Before he actually sells anything he has bought motor
vehicles of sh.3, 000, 000, premises of sh.7, 000, 000, stocks of goods sh.2, 000, 000. He
still owes sh.800, 000 in respect of them. He had borrowed sh.4, 000, 000 from D Evans.

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After the events just described and before trading starts, he had sh.300, 000 cash in hand
and sh. 600, 000 cash at bank.
You are required to calculate the amount of his capital.

Solution:
Assets: sh.’000’ sh. ‘000’
Motor Vehicle 3,000
Premises 7,000
Stock 2,000
Cash at bank 600
Cash in hand 300
12,900

Liabilities:
Creditors 800
Loan - D Evans 4,000 (4,800)
8,100

Capital 8,100

Remember the Accounting equation:

Assets = Liabilities + Capital.

To get capital we rearrange the equation as follows:

Capital = Assets - Liabilities

Total Assets = sh.12, 900, 000

Total Liabilities = sh.4, 800, 000
Capital = sh. 12,900 - 4,800, 000
= sh. 8,100,000

Example 1.3
Nyamira has the following items in his balance sheet as on 30 June 2010.
Capital sh. 41,800, 000, Creditors sh. 3,200, 000, Fixtures sh. 7,000, 000 Motor Vehicles
sh. 8,400, 000, Stock of goods sh. 9,900, 000, Debtors sh. 6,500, 000 Cash at bank sh.
12,900, 000 and Cash in hand sh. 240, 000.

During the first week of July 2010:

a. He bought extra stock of goods sh. 1,540, 000 on credit.
b. One of the debtors paid him sh. 560, 000 in cash.
c. He bought extra fixture by cheque sh. 2,000, 000.

You are to draw up a balance sheet as on 7 July 2010 after the above transactions have
been completed.
First we need to look at the effect of the above transactions on the assets and liabilities of C
Kings.
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For
(a) Buying extra stock increases the level of stock by sh.1, 540, 000 and because this is
bought on credit the creditors increase by sh.1,540, 000 also.
(b) Amount received from the debtor means that the level of debtors reduces and cash
increases by sh.560, 000.
(c) Extra fixtures bought by cheque, will increase the fixtures and reduce the cash at
bank by sh.2,000, 000

This can be summarized as follows:

Opening Increase/ (Decrease) Closing

Balances Balances
Sh.’000’ sh. ‘000’
Capital 41,800 - 41,800
Creditors 3,200 1,540 4,740
Fixtures 7,000 2,000 9,000
Motor Vehicles 8,400 - 8,400
Stock 9,900 1,540 11,440
Debtors 6,560 (560) 6,000
Cash at bank 12,900 (2000) 10,900
Cash in hand 240 560 800

Given these closing balances then the balance sheet can be drawn as follows:

Nyamira
Balance sheet as at 7 July 2002.

Non Current Assets sh. ‘000’ sh. ‘000’

Fixtures 9,000
Motor Vehicles 8,400
17,400

Current Assets
Stock 11,440
Debtors 6,000
Cash at bank 10,900
Cash at hand 800
29,140
Current Liabilities
Creditors (4,740)
Net Current Assets 24,400
Net Assets 41,800

Capital 41,800

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From the illustration remember that any change in the items of the balance sheet will have
a double effect on the accounting equation has a double effect and therefore the equation
will always balance.

Question
Prepare a balance sheet for Thika Enterprises as at 1st July 2010 based on the
following information using the horizontal and vertical methods according to
order of the items liquidity.
Motor vehicle 60,000
Fixtures and fittings 12,000
Lands and buildings 2,000
Cash in hand 2,000
Debtors 42,000
Stock 50,000
Overdraft 10,000
Creditors 26,000
Loan by AFC 50,000
Capital 80,000
Drawings 2,00

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2. Statements that relate to a specified period of time
a) Income statement – reports the company’s revenues, gains, expenses,
losses and net income. Also called the statement of income

b) Statement of retained earnings – In addition to the balance sheet and

income statement, most corporations include a statement of retained
earnings and a statement of cash flows. A statement of retained
earnings shows prior period adjustments, net income, and dividends to
report changes of the company‟s accumulated earnings.

A simplified example
Mzalendo Corporation Statement of Retained Earnings
For the Year Ended December 31 2010
Retained earnings at the beginning of year Ksh.620,000
Net income for the year 280,000
Subtotal Ksh.900,000
Less: Dividends 100,000
Retained earnings at end of year Ksh.800,000

c) Statement of cash flows – the basic purpose of a statement of cash

flows is to provide information about the cash receipts and cash
payments of a business entity during the accounting period. The term
cash flows include cash receipts and cash payments. In addition, the
statement is intended to provide information about all the investing
and financing activities of the company during the period. The
statement should assist investors, creditors, and others in assessing
such factors as:
- The company’s ability to generate positive cash flows in future
periods.
- The company’s ability to meet its obligations and to pay
dividends.
- Reasons for differences between the amount of net income and
the related net cash flow from operations.
- Both the cash and noncash aspects of the company’s
investment and financing transactions for the period.

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The distinction between accounting and bookkeeping
Bookkeeping means recording of transactions, the record-making phase of
accounting. It is mechanical and repetitive. It is a small part of accounting and the
simplest. Accounting includes the maintenance of accounting records, the design
of an efficient accounting system, the performance audits, and the development of
forecasts, income tax work, and the interpretation of accounting information.

Accounting principles, concepts and conventions

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

These are the common basis for the preparing and reporting financial information
usually referred to as “the generally accepted accounting principles”. Accounting
principles are also referred to as standards, assumptions, postulates and concepts.

They include: -
a) Going concern
b) Consistency
c) Prudence
d) The accruals concept
e) Substance over form
f) Materiality.

1. Going concern
The valuation of assets used in business is based on the assumption that a
business entity will continue in operation indefinitely and thus will carry out
its existing commitments. It means the business entity is not on the verge of
collapse. Assets on a closing down business fetch lower value.

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 purchase vehicle.

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 Under normal circumstances, it belongs to the person using it, but the exact
legal position is that it belongs to the seller until the buyer completes 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
revenues 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 revenues in various ways.
i.e cash received may occur in different ways
i. Concurrently with the sale
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.

4. Consistency
States that once a particular accounting method is adopted, it will not be
changed f r o m one period to another. It is intended to make financial
statements of a given company comparable from year to year.

5. Materiality
In accounting there is one overriding rule applied to anything that appears in a
financial accounting statement. It must be material which refers to the relative
importance of an amount or item (it should be of interest to the stakeholders).
An item which is not significant enough to influence the decisions of users of
financial statements is considered as not material.

6. Prudence/conservatism
Sensible and careful attitudes that make an investor to avoid making
unnecessary risks. It is a guiding principle in resolving uncertainties.
Accountants 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 lower value.

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 Note
i. Accounting b a s e s : are t h e various methods of applying
accounting concepts that have been developed in practice (e.g.
methods of stock valuation and depreciation).

ii. Accounting policies: are the specific accounting bases chosen

and applied by an Accounting entity in preparing its financial
statements, hopefully those best suited to its particular
circumstances. In many countries accounting policies must be
disclosed by entities in their annual financial reports in order to
assist readers to understand and interpret the financial
statements properly.

Concept of capital and capital maintenance

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 lead to depression of capital. There are
two concepts which attempts to explain capital maintenance: -
• 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.

• Physical capital maintenance: This is where profit is earned only

if the physical productive 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.
Questions
- What is the purpose of accounting information?
- Discuss the main users of accounting information and how they use the
information
- Differentiate between bookkeeping and accounting.
- What is meant by the term „accounting concepts‟?
- Accounting principles are also referred to as standards, assumptions,
postulates and concepts. Explain in detail the various concepts.

18
 LESSON TWO
DOUBLE ENTRY
By the end of this lesson the student should be able to:
• Explain the double-entry system of accounting
• Explain the purpose of a journal and its relationship to the ledger
• Prepare journal entries to record common business transactions
• Prepare a trial balance and explain its uses

Double entry
The rules of debit and credit are designed so that equal amounts of debit and
credit entries are needed to record every business transaction. Recording of
economic events is a central feature of accounting. This recording affects at least
two accounts. This is because every financial transaction possesses two aspects of
receiving and giving of a benefit. In this regard every transaction must be
recorded twice in the books of accounts, one from the point of view of receiving
and the other from the point of view of giving out a benefit. In other words each
transaction has a double entry. When double entry occurs, it ensures that
accounting identity/equation remains in balance (it ensures the equality of debits
and credits).

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

Effect
(i) Increase in cash in hand by Ksh. 3,000 (Receiving)
(ii) Decrease in debtors‟ amount by Ksh. 3,000 (Paying).

NB: We post the debits of account 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 customers and creditors, it is important to divide the ledger into: -
a) Control account/ General ledger
b) Accounts payable ledger
c) Accounts receivable ledger/ Debtor ledger

General ledger contains all the revenues and expenses accounts except creditors
and debtors. Accounts payable ledger is a subsidiary ledger containing an account
with each supplier or vendor. The total of the ledger agrees with the general
ledger controlling account (accounts payable). Accounts receivable ledger
contains an account with each credit customer. The total ledger agrees with the
general ledger controlling account (accounts receivable)

19
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 result in an
increase or decrease in the values of various individual balance sheet items.

Rules
(i) All assets have a debit balance and any increase in asset accounts are also
recorded as debits. Decrease in assets is credited.
(ii) All liabilities are credited. Any increase in liabilities is also credited.
Decrease in liabilities is debited.
(iii) Capital/Owners equity is recorded as credits. Increases in owner‟s equity,
are credited. Decrease in owner‟s equity, is recorded as debits.
NB: This rule is extended to cover revenues and expenses
accounts.
(iv)Revenues increases owners‟ equity and are therefore recorded as credits.
(v) Expenses decreases owners‟ equity and are therefore recorded as debits.

What is an account?
An account is a place where all the information relating to a particular asset or
liability or capital is entered. Each account should be shown on a separate page.
Double entry system divides the account into two; right hand side (Debit side)
and left hand side (credit side). The title is written on top across.

Examples
1) A proprietor starts a business with Ksh. 10,000 in cash on 1st August 2010.
Effect is increase in the assets (Dr. Cash a/c) and decrease in capita (Cr. the
Capital a/c)
Dr Cash Account Cr
1/8/10Bal. b/f 10,000

Dr Capital Account Cr
1/8/10 cash 10,000

2) The following balance sheet has been provided.

Katiba Mpya Cleaners
Financial position as at 2/2/2006

Assets Ksh. Liabities

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

20
Motor van 75,000
694,000 694,000

Assume land was sold for cash at Ksh. 90,000 on 5/2/2010. Record the transaction
in respective ledger account

Dr Land Account Cr
2/2/10 Bal b/f 80,000 5/2/10 cash 80,000

Cash Account
2/2/10 Bal b/f 139,000
5/2/10 Cash 90,000

Profit and Loss Accountr

5/2/10 Land 10,000
3) State the effect of the following transactions on the balance sheet.
a) Katiba Mpya cleaners bought a new office, calculator worth Kshs
150,000 for cash.

Effect
• Decrease in cash
• Increase in office equipment account.

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

Effects :-
• Increase chemicals
• Increase in liabilities

State the effect from the following transactions: -

• The company was owed Ksh. 50,000 for supplies delivered to

the owners during the month.

• Wages due and unpaid at month end amounted to Ksh.7, 500.

• Monthly rent of Ksh 10,000 was paid in cash

Treatment of expenses and revenues

Any expense is a loss and therefore results to a decrease in capital which is a
debit. Revenue on the other hand leads to a profit and therefore results in an
increase in capital which is a credit. Separate ledger accounts are opened for
different expenses and revenues.
e.g

21
Dr Salaries account Cr Dr Rent account Cr

Dr Discount received account Cr

Example
• Paid rent by cash Ksh 9000
• Received rent by cheque Ksh. 10,000

Dr Rent expense Account Cr Dr Rent income Account Cr.

Cash 9000 Bank 10,000

Treatment of stock account

At the beginning of the account period the value of unsold 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) stock account where 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
and hence always credited.
e) One account for goods returned 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
Bal b/f 20,000 KNTC 10,000

Dr Returns outwards A/c Cr

Sales A/c
Mweni 5000 Kamau 400

22
Dr Returns inwards A/c Cr

23
 Kimeto 200

Treatment of capital
Capital is money put in the business to earn profit. Capital is credited and any
increase in capital credited. Decrease in capital is debited. If the owner takes
something from business for personal use, instead of debiting it to his capital
account, it is prudent to post the amount into 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 for personal use from his business
Dr DrawingsA/c Cr Dr CashA/c Cr.
Cash 200 Drawings 200

NB: After recording all the transactions the accounts must be balanced.
We find the totals on the debit and the totals on the credit side and then
calculate the difference. The side with the smaller total amount has a
balance of the last day of the accounting period referred as balance
carried forward (bal c/f) or balance carried down (bal c/d) after which
both sides will show the same totals.

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

Dr. Equipments A/c Cr. Dr. Notes payable A/C Cr.

Notes payable a/c 10,000 Equipment a/c 10,000

The double entry aspect of transaction recording recognizes the debit and credit
convention. This convention divides accounts into two sides. The debit (Dr) side
always the left hand side and the credit (Cr) side always the right hand side. When
the sum of the debits and the credits are not equal, an error has been made.

23
Journalizing transactions and events
Journal
In the preceding discussion, business transactions were recorded directly in the
ledger accounts. This was to stress the effects of business transactions upon the
individual asset, liability, and owner‟s equity accounts appearing in the
company‟s balance sheet. In an actual accounting system, the information about
each business transaction is initially recorded in an accounting record called the
journal. After recording the transaction in the journal, the debit and credit changes
in the individual accounts are entered in the ledger. The journal is also sometimes
called book of original entry since transactions are first recorded there. A journal
records all daily transactions of a business in the order of their occurrence. A
journal may, therefore, be defined as a book containing a chronological record of
business transactions. A journal does not replace, but precedes the ledger. The
process of recording transactions on the basis of rules of double entry system in a
journal is termed as “journalizing.” The record of a business transaction in a
journal is called journal entry.

Advantages of Journal
The unit of organization for the journal is the transaction, whereas the unit of
organization for the ledger is the account. The recording of business transactions
in journal book on the basis of double entry system has following advantages: -
(i) Complete Information about the Business
The journal shows all information about a business transaction in one
place and also provides an explanation of the transaction. Accounts to be
debited and credited are recorded together. The journal shows the
complete story of a transaction in one place.

(ii) Chronological record of all events

If we need to look up for facts about a transaction of some months or years
back, all we need is the date of the transaction in order to locate it in the
journal.

(iii)Prevent errors
If transactions were recorded directly in the ledger, it would be very easy
to make errors such as omitting the debit or credit, or entering the debit or
credit twice. Such errors are not likely to be made in the journal, since the
offsetting debits and credits appear together for each transaction.

Rules of Debits and Credits

All transactions in the journal are recorded on the basis of rules of debit and
credit. For this purpose, transactions have been classified into three categories:
• Transactions relating to persons

24
 • Transactions relating to properties and assets
• Transactions relating to incomes and expenses

On the basis of the categories outlined above, it is necessary to keep the accounts
in respect of the following:
• Each person with whom he deals (customer, suppliers)
• Each property or asset which he owns (building, machinery etc.)
• Each item of income and expense (commission, rent, salary etc.)

Journalizing of transactions can be done continually or done in a batch at the end

of the day.

Example
General Journal
Date Explanation Post Debit Credit
ref.
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

The accounting system has two types of journals: - the general journal and several
special journals. Entries involving infrequently or non repetitive entries (entries of
the general nature) are recorded in the general journal

Example
General Journal
Date A/C Explanation / Details Dr Cr
2002 Jan 1 Cash 60,000
Robert Capital 60,000
To record investment of cash in business
2 Land 20,000
Cash 20,000
To record purchase of land for office site

25
Special Journals
i. Sales Journal – Record all credit sales.
ii. Sales Return Journal – record returns from sales
iii. Purchase Journal – Record all credit purchases
iv. Purchase Return Journal – for returns that had been purchased
v. Cash receipt Journal – Record transactions involving receipts of cash
vi. Cash payment Journal – used for recording all cash payments

Sometimes entries in the entire journal are mixed in a statement as follows;

Example
Journalize the following transactions that occurred in May 2011
1. Started business with Ksh.60,000 paid Ksh. 30,000 into bank account
2. Bought furniture for cash Ksh. 10,000
3. Bought goods for cash Ksh. 30,000
4. Sold goods for cash Ksh.6,000

Date Particulars L.F Dr. Cr.

2011 may 1 Cash 60,000
Capital 60,000
(Cash brought to start a business)

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

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

4 Cash 6,000

Sales 6,000
(Goods sold for cash)

Journalize the following information in the books of original entry on 1.1.2011 on

the basis of the following information taken from the business of Mr. Shaka Zuru
in South Africa
1. Cash in hand-- Rs. 20,000

26
 2. Sundry Debtors-- Rs. 60,000
3. Stock in Trade-- Rs. 40,000
4. Plant and Machinery-- Rs. 50,000
5. Land and Building-- Rs. 100,000
6. Sundry Creditors-- Rs. 100,000

Solution
Date Particulars L.F. Debit Credit
(Rs.) (Rs.)
1.1.2001 Cash A/c 20,000
Sundry Debtors 60,000
Stock in Trade 40,000
Plant and Machinery 50,000
A/c
100,000
Land and Building A/c
To Sundry Creditors
A/c
100,000
To Capital A/c
170,000

(Being the balances

brought forward from
the last year)
Posting the Journals to the ledger
The process of transferring transactions from the journal to individual accounts is
called Posting. Usually there are two types of ledgers
• General Ledger
• Subsidiary Ledgers

General ledger holds the individual accounts that are grouped together. Subsidiary
ledgers support specific general ledger accounts that consist of many separate,
individual accounts.

Example
A firm has substantial customers‟ accounts receivable, one ledger account, and
stores these separate accounts in an account receivable subsidiary ledger. The
individual customer account is called subsidiary account. The general ledger now
needs only one account for accounts receivable called the control account.

27
General Ledger
Accounts receivable control Graphics

60,000 30,000

Digital Micro-tech

20,000 10,000

The balance in the accounts receivable control is the sum of all the individual
customers‟ account balances. In compiling Financial Statements only the control
accounts are considered.

Posting of transactions to the ledgers from the journals

Date Particulars L.F Dr. Cr.

2011 may 1 Cash 60,000
Capital 60,000
(Cash brought to start a business)

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

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

Cash 6,000

4 Sales 6,000
(Goods sold for cash)

28
Dr. Cash A/c Cr. Capital A/c

May1 Bal b/f 60,000 May1 30,000 May 1cash 60,000

Bank A/c Furniture A/c

May 1 30000 May 2. Creditor 10,000

Creditor A/c
May 2 furniture10, 000

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 accounts. The unadjusted Trial
balance is the list of balances from the general ledger accounts and their account
balances

Example of an unadjusted trial balance

Sungura Company
Unadjusted Trial Balance
Dec. 31 2010
Account Dr Cr
Kshs Kshs
Cash 67,000
Bank 45,000
Allowance for doubtful A/Cs 1000
Inventory 75,000
Notes receivable 8,000
Prepaid Insurance 600
Land 8,000
Buildings 160,000
Accumulated depreciation (Building) 90,000
Accounts payable 29,000
Equipments 91,000
Bounds payable, 6% 50,000
Common Stock per & 10 150,000
Contribution Capital in excess of par 20,000
Retained Earning 31,500
Sales Revenue 325,200

29
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 expense 23,600
Interest Expense 2,500
Extra – Ordinary loss (pretax) 9,000
Total 728,000 728,000

Uses: -
• It‟s a convenient means for check for the sum of the debit account
balances equals to the sum of the credit account balances
• It‟s the starting point of developing adjustments closing
and reversing entries and 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.
These are referred to as errors not disclosed by the trial balance. Those that we
can obviously see are referred to as errors disclosed by the trial balance.

Errors disclosed: -
• Over stating/understating of amounts
• Entering debits as credits and vice versa
• Accounting errors in copying balances
• Errors of addition of trial balance
• Arithmetic mistakes in balancing of accounts
Errors not disclosed: -
• Errors of original entry; where the original figure is incorrect, yet double
entry is still observed using this incorrect figure.
• Errors of commission; entering a transaction more than once but in the
wrong person‟s account.
• Compensating errors; making an error that exactly offsets the effect of
another error.
• Error of omission; where a transaction is completely omitted from the
books
• Error of complete reversal; where the correct accounts are used but
each item is shown on the wrong side of the account
• Error of principal; where an item is entered in the wrong class of account
(e.g motor van debited to an expense account)

30
Discovering errors
Errors may be determined in one of these several ways:-
• By audit procedures
• By chance discovery
• Through use of the trial balance.
• Through customer complaints
Errors disclosed by the trial balance should be corrected before the financial
statements are prepared.

Journalizing and posting adjusted journal entries

A firm‟s financial statement cannot be prepared until adjusting Journal entries are
recorded. It can be done at the end of the financial period. Doing it frequently is
costly. Accrual basis of accounting requires this adjustment to reflect changes in
resources under the revenues. 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 on correction of errors

i. Error of omission
Assume that a sale of goods worth Ksh. 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.

ii. Error of commission

Usually occurs where there are accounts with almost similar names. e.g. A
purchase of Ksh. 2,000 worth of goods from K. Kamotho was credited to
K. Kimotho‟s account.

Dr. K. Kimotho‟s A/c 2,000

Cr. K. Kamotho A/c 2,000
To correct error of commission

iii. Error of principle

This error violates the general acceptable accounting principles. e.g. a
purchase of a photocopier for Ksh. 50,000 by Hardware‟s Ltd and was
included with purchases for resale.

The correct journal entry

Dr Office equipment 50,000

31
 Cr Purchases 50,000

To correct error of principle

iv. Compensating errors
These errors occur when debits and credits in different accounts are
overstated or under stated by some figure. Assume that the credit balance
in the sales accounts is overstated by Ksh.1,500. Since the debits and the
credits are overstated by the same amount, this type of error would not
affect the trial balance.

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

v. Error of original entry

The error occurs normally when the figures are transposed. e.g. Assume an
expenditure of Ksh. 2,980 for office stationary was recorded as Ksh.
2,890/=.

Dr. Office stationary 90

Cr. Cash 90

To correct error of original entry

vi. 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
Ksh. 3,200 were sold to Kibaso but the sale was recorded as purchase
from Kibaso.

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

There are two methods of recording transactions: -

a. 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. For example, 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.

32
 b. Expedient Recording Method: records an expense on payment of cash
before receiving a good or service. In the example above, 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:-

a. 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 and revenue collected in advance are examples.

b. Accruals: Cash flows occur after expense and revenue recognition. These
adjusted Journal entries are used when cash will be paid or received in a
future accounting periods, but all as a portion of the future cash flow
applies to expenses or revenue of current periods e.g. 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.

c. Other Adjusting entries

• Reclassification of permanent Accounts
• Estimation of expense (bad – debts)
• Cost allocation (depreciation)
• Recognition of costs of goods sold and inventory losses
• Correction of errors

Deferred Revenue
Surora 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 Ksh. 1,800 in rent revenue which
is overstated by Ksh. 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
Surora previously issued at face value Ksh. 50,000 of 6% bonds paying interest
yearly each on October 31. For the current accounting period, a two month
interest obligation has developed, between October 31, 2000 and December 31,

33
2000. Under matching principle, Surora 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)

= Ksh. 500
Therefore, both interest expenses and 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/experienced by most

companies. Bad debts reduce the amount of accounts receivables Estimates of
uncollectible accounts are based on credit sales for the period.

Example: Surora extended credit sales amounting to Ksh. 12,000. Prior

experience indicates a 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 Ksh. 300 is carried in inventory
at a cost of Ksh. 180. The sale of this item require two entries as below: -

Dr. Cash / Accounts receivable 300

Cr. Sales revenue 300

Dr. Cost of goods sold 180

Cr. Inventory 180

The Suspense Account

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 one may not be sure from
whom, therefore such cash is 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 intention is to make totals of either side of the trial balance equal. If
the error cannot be found as seen above, then the amount of the error is entered on

34
a suspense account and carried forward to the balance sheet as either a debit or a
credit amount depending on whether the amount making the trial balance not to
balance was a debit or credit balance.

When discovered later, such balances should be corrected and the suspense
account eliminated from the books. Correction of errors affecting the trial balance
should be undertaken before the final accounts are prepared.

Example
Dr. Cr.
Trial balance 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.

Correction of the error

Dr Suspense a/c 40,000

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

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

Correction of error
Dr suspense 40,000
Cr sales 30,000
Cr Onkundi 10,000
To correct the error and eliminate suspense account

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

Correction
Dr Cr
Suspense a/c 400
Sales 400

We open suspense account to close.

35
 Suspense a/c
31st Mar. Sales 400 Dec 31 Difference 400

Sales a/c
2005
Mar. 31suspense 400

Example
Ksh. 550 received from sale of office equipment has been entered in the sales
account.

Correction
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 equip Ksh. 550 office equip. Ksh. 550 sales Ksh. 550

Example
An account clerk extracts a trial balance which fails to agree by Ksh.2,000. 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 Ksh. 800,000. Later he attempts to find the errors
which had caused the difference. Investigations revealed the following;
1. The purchase day book had been under cast by Ksh.16,000
2. The cost of new equipment (Ksh.12,000) 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 Ksh. 8,000 due from J. Ketel was omitted from total debtors
4. An entry of Ksh.2,000 with respect to returns outwards was made in the
sales day book instead of purchase returns day book
5. A cheque for Ksh.5,000 paid to Rukia (a creditor) was correctly entered in
the cashbook but was credited to her accounts
6. A debt of Ksh.5,000 should have been written off from one of the debtor‟s
account
7. Goods with a sale value of Ksh.40,000 had been taken for the proprietors‟
own use. These were not recorded anywhere

36
 8. A discount of Ksh.18,000 received had been correctly entered in the
cashbook but had been posted to the wrong side of the discounts received
account
Required
i. Journal entries necessary to correct errors
ii. Suspense account to clear the difference
iii. Statement of adjusted profit

Solution
Suspense P& L

Bal 2,000 G.pb/d xxxx

Bal c/f 800,000

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

Dr. Equip A/c 10,200

Dep A/c 1,800
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

37
 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

Suspense A/C

Discount received 36,000 Bal 2000

Debtor 8,000
Rukia 10,000
Purchases 16,000
36,000 36,000

Adjusted profit
N/p b/d 800,000
less under cast (16,000)
depreciation (1,800)
adjusted NP 782,200

Adjusting Entries
The purpose of adjusting entries is to record certain revenues and expenses that
are not properly measured in the course of recording daily business transactions.
Adjusting entries help in achieving the goals of accrual accounting (recording
revenue when it is earned and expenses when the related goods and services are
used). Adjusting entries are needed whenever transactions affect the revenue or
expense of more than one accounting period. Almost every adjusting entry affects
both the balance sheet amount and the income statement amount.

A business may need to make a dozen or more adjusting entries at the end of each
accounting period. The number of adjustments depends upon nature of a
company‟s business activities but mainly fall into four general categories: -

Entries to apportion recorded costs: a cost that will
benefit more than one accounting period usually is recorded by debiting an asset
account. The benefits from the use of the asset are allocated to each period as a
portion of the asset‟s cost to expense through an adjusting entry.

Entries to apportion unearned revenue: where
revenues are collected in advance for services to be rendered in future accounting
periods, an adjusting entry is made to record the portion of the revenue earned
during the period.

Entries to record unrecorded expenses: an expense
may be incurred in the current accounting period even though no bill has yet been

38
 received and payment will not occur until a future period. Such unrecorded
expenses are recorded by an adjusting entry made at the end of the accounting
period.

Entries to record unrecorded revenue: revenue may be
earned during the current period, but not yet billed to customers or recorded in the
accounting records. Such unrecorded revenue is recorded by making an adjusting
entry at the end of the period.

Adjusting entries have two important characteristics that reflect their dual purpose
of:-
- Proper valuation of assets and liabilities
Every adjusting entry involves the recognition of either revenue or expense which
represents changes in owner‟s equity. Change in owner‟s equity must be
accompanied by a corresponding change in either assets or liabilities. Therefore,
every adjusting entry affects both an income statement account (revenue or
expense) and a balance sheet account (asset or liability)

- Proper measurements of income

Adjusting entries are based upon concepts of accrual accounting, not upon
monthly bills or month-end transactions.
Some adjustments includes: -
o Prepayments
These are expenses which have already been paid 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. It‟s 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

o Accruals
Expenses which are outstanding and have not been paid as a result of
underpayment, also referred to as Accrued expenses. They reflected in the final
balance sheet as a current liability.
Treatment
Dr. P & L a/c xx
Cr. Accrued expense account xx

39
 P & L A/C Balance sheet
Salaries xx Current liabilities
Add accruals xx Creditors xx
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

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

40
Provisions for bad debts
It involves creation of a provisional 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 for both bad debts and provision for bad debts, the following are
the treatments
Dr. Bad debts xx
Cr. Provisions for bad debts xx

P& L a/c Balance Sheet

Bad debts xx Debtors xx

Less provision xx

o Depreciation
Is the decrease in value of a fixed asset, such as motor vans, buildings e.t.c., due
to wear and tear. The loss in venue is chargeable against profit made during the
working life of the asset. It‟s calculated annually.
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.

41
 Treatment
P& L a/c Balance Sheet

Expenses Machinery xx
Provision
for depreciation xx Less provision Depreciation xx

o Arrears
o Revenue arising
o Provisions

Preparing Adjusted Trial balance

After all necessary adjusting entries have been journalized and posted, an adjusted
trial balance is prepared to prove that the ledger is still in balance. It also provides
a complete listing of the account balances to be used in preparing financial
statements.

Sungura Company
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 (Building) 100,000
Equipments 91,000
Accumulated dep. Equip. 36,000
Accounts payable
29,000
Interest Payable 500
Rent Revenue Collected in advance 600
Income tax payable 20,000
Bounds payable 6% 50,000
Common Stock sh 10par 150,000
Contributed Capital in excess of per 20,000
Sales Revenue 325,000

42
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 include: -
 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 and gain account are made from Sungura Books
Dec 31, 2000
Dr Sales Revenue 325,000
Interest revenue 600
Rent Revenue 1,400
Cr Income Summary 327,000

Dr. Income Summary 297,000

Cr Cost of goods sold 117,000
Selling Expenses 113,400
General Admin Exp 3,000
Extraordinary loss 90,000
Income tax expense 20,000
To close the expenses & loss account to income summary

Dr. Income Summary 30,000

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

43
After the first two closing entries are recorded and posted, the balance in income
summary equal net income (Ksh. 30,000) shown in the T-account

Income Summary
297,000 327,000
Bal 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 dividend
declared, a temporary account is opened. Dividends payable are credited.
Dr. Retained earnings xx
Cr. Cash dividend declared xx

Preparing Post closing Trial balance

A post closing Trial balance shows a list of only the balances 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 occurring 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
Sungura Company
Post – closing Trial Balance
Dec 31, 2000
Account Dr Cr
Cash 67,300
Allowance for doubtful account 2,2000
Account Received 45,000
Interest payable 1,000
Notes receivable 8,000
Inventory 90,000
Prepaid Insurance 400
Land 8,000
Building 160,000
Accumulated dep. (Building) 10,000
Equipment 91,000
Accumulated dep. (Equip) 36,000
Accounts payable 29,000
Rent revenue collected is advance 600

44
Interest payable 500
Income tax payable 20,000
Bonds payable 6% 50,000
Common stock & 10 par 150,000
Contributed Capital in excess 20,000
Retained earnings 61,500
Total 469,800 469,800

Journalizing and posting 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 reversed
journal entry may be used to simplify certain journal entries for the next
accounting period.

Reversed 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

Reversed journal entries

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

Jan 1, 2001
Dr. Interest payable 400
Cr. Interest expense 400

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

45
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. 2000 is Dec. 28. Wages earned through Dec.
28 are included in this payroll. The next payroll ends at Jan 4, 2001 at which Ksh.
28,000 of wages will be paid. Wages earned for the three – day period ending
Dec. 31, 2000, are Ksh. 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 reversing entries

Jan 1, 2001
Dr. Wages payable 15,000
Cr. Wagesexpenses 15,000

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

Without reversing Jan 4, 2001

Dr. Wages expense 13,000
Dr. Wages payable 15,000
Cr. Cash 28,000

46
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 examples of internal cost allocation that requires adjusting
entries.
4) The following are transactions as per May 2010 records of Dreams Ltd
- 1 started a business with Ksh. 100,000 in the bank.
- 2 Bought fixtures Ksh.500 on credit from Thika tex Ltd.
- 5 Bought a 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 Mjomba
- 28 Paid Sh.800 of the cash in had into the bank A/c
- 30 bought more office fixtures sh. 400 cash.
Required
Write up asset capital and liability accounts in books of Dreams to record
the transactions (20 marks).
5) Does the equality of debit and credit in a trial balance assure of the
absence of errors in the Accounts? Explain
6) Does the sum of the debit column in an unadjusted trial balance represent
a meaningful total? If not, why is it computed?
7) Explain the term journal and state its significance
8) Use suspense a/c to correct the following errors.
i. Purchase of a book has been overcast by Ksh.600
ii. A cheque of Ksh. 930 received from Mr. Sand had been
correctly entered in the cashbook but had not been entered in
Mr. Sand‟s account.
9) The following errors were found in the books of Kamugi Grocers. Prepare
the necessary journal entries to correct the errors.
i. Ksh. 5,000 paid for furniture had been debited to purchase
account
ii. An amount of Ksh. 1,000 withdrawn by the owner had been
debited to general expenses account
iii. Ksh. 1,000 paid for rent had been debited to the landlord‟s
account
iv. Ksh. 1,500 received from Shangira had been wrongly credited
to Shangazi‟s account
v. Ksh. 800 paid by a debtor were wrongly credited to the cash
account

47
10) Prepare journal entries to correct the following errors through the suspense
account show the suspense account.
i. The total of sales figure was under cast by Ksh. 1,000
ii. Goods worth Ksh. 1,500 returned by Gikundi have not been
recorded anywhere.
iii. Goods worth Ksh. 2,500 had been posted to the debit of the
supplier Gutero and Company
iv. A discount of Ksh. 150 received from Rugina had not been
entered in the discount account
v. A discount of Ksh. 180 allowed to Machelle had not been
entered in the discount account
11) Prepare adjusting entries for the situations described below: -
1. During the year, a machine was sold for Ksh. 14,000. The sale was
credited to the sales account. The book value of the machine was
Ksh. 18,000
2. On Dec. 25th a fire destroyed goods worth Ksh. 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 Ksh. 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 for at 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 Ksh. 155,000.
5. Unpaid wages at the end of the financial year amounted to Ksh.
15,800/=

48
 LESSON THREE

MEASURING BUSINESS INCOME

At the end of this lesson the student should be able to: -
 Explain the nature of income, revenue and expenses
 Prepare the trading profit and loss account and explain its relationship to
the balance sheet

Income: The difference between revenue and expenses incurred during a trading
period. Hicks defined income as the maximum value which a businessman can
consume during a period and still be as well off at the end of that period as he/she
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 or
expansion of plant and are recorded in asset accounts. These assets are used in the
business for more than one accounting period which is normally one year.

Revenue expenditure: Expenditures for ordinary repairs, maintenance, fuel, and

other items necessary to the ownership and use of plant and equipment. They are
recorded by debits to expense accounts. The charge to an expense account is
based on the assumption that the benefits from the expenditure will be used up in
the current period, and the cost should therefore be deducted from the revenue of
the current period in determining the net income.

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
businesses are established.

Reasons for knowing the value of profit

 To assist to plan ahead
 To help the owner obtain loans
 For use by a prospective partner or person to whom he/she hopes
to sell the business
 For income tax purposes.

Calculating profit
Profit is calculated in two stages.
i. Gross profit

49
 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
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

Trading Account

Trading Account displays the gross profit or gross loss of the business for a certain period.

It is actually the goods account for the proprietors as all the items relating to goods e.g. Operating stock,
Purchases, Sales, Purchases returns, Sales returns, Closing stock are shown herein and gross profit is
determined. Difference of net sales and cost of goods sold is actually the gross profit. Cost of goods
sold is different for a trader and a manufacturer it includes cost of raw materials and expenses of
production.

Items of Trading Accounting

1. Opening Stock: - Closing stock of last year becomes opening stock for the year. It is recorded
through an opening entry. There is no opening stock in first year of business. It is recorded on
the debit side of trading account.

50
 2. Purchases and Purchases Returns:- Total purchases of goods or raw materials during the year
is disclosed by Purchases account and returns outward by Purchase Returns account in the
ledger.
Net purchases are shown in trading account on debit side as:
Ksh. Ksh.
To Purchases ………..
Less: Purchase Returns ……….. ………..
3. Direct Expenses and Manufacturing Expenses: - All such expenses which are incurred on
goods or raw materials purchased and making them saleable are classified under it. Such
expenses are:
i) Carriage and Freight inward: - If is debited to Trading Account. It is a cost incurred
on goods or materials brought to the business. Carriage on Machinery or any other asset
purchased increases cost of asset and it is not shown here.
ii) Productive Wages: - Wages paid to factory workers for manufacturing are debited to
Trading Account.
iii) Fuel and Power: - Fuel used for Boilers and power for machines are included in it and
is shown on the debit side of Trading Account.
iv) Factory Lighting: - Light used in the workshop is production expense and is debited to
Trading Account. Light used for office and administration is not included in trading
account.
v) Factory Rent and Taxes: - Rent paid for factory building, municipal taxes, water used
for production is debited to Trading account.
vi) Other Direct Expenses: - All other expenses on production i.e. import duty; cartage
etc. is to be debited to Trading account.
4. Sales and sales Returns:- All sales, cash and credit, as disclosed by Sales Account in ledger
less returns inward ( sales return) are shown on the credit side of Trading Accounts as:
Ksh. Ksh.
By Sales ………..
Less: Sales Returns ……….. ………..

5. Closing Stock and its Valuation: - Goods purchased for sale and a raw material for production
not used as such on the last day of Accounting year is closing stock. It is properly valued and a
journal entry is passed by which it is shown on the credit side of Trading Account.

Profit and Loss Account

Profit and loss Account starts with credit entry of gross profit in all cases, except when there is gross
loss, which is shown on debit side. All the revenue expenses, not shown in Trading a/c, are shown on
debit side of profit and loss account. Incomes and gains are shown on credit side. Only revenue incomes
and expenses relating to the year are shown in Profit and Loss Accounts.

1. Items shown on Debit side of Profit & Loss a/c:

i) Selling and Distribution Expenses:

a) Salaries and Commission of Salesmen

b) Agent’s Commission

c) Advertisement

d) Go down Expenses

e) Packing expenses

51
 f) Freight & Cartage on sales

g) Export Duty

h) Customs duty not recovered

i) Operating & Maintenance Expenses of vehicles used for goods sold

j) Insurance of finished goods and goods in transit

k) Bad debts

(ii) Administrative Expenses:

a) Salaries of office staff and officers

b) Rent and Taxes of office building

c) Light and Water of office building

d) Printing and Stationary

e) Postage, Telegram, Telephone Expenses

f) Legal charges

g) Audit Fees

(iii) Financial Expenses:

a) Interest on Loan

b) Charges on bills discounted

c) Discount allowed to customers

(iv) Other Expenses and Losses:

a) Depreciation on assets

b) Rebates and allowances made

2. Items shown on credit side of Profit & Loss a/c:

Interest, Commission, Dividends, Discounts, and Rent etc. received as income.

Items not shown in profit & loss a/c:

a) Drawings:- It is capital withdrawn from business, it is, therefore, deducted from proprietor’s
capital a/c

b) Income Tax: - Income tax paid by sole trader is drawings and is debited to capital account.
However, in companies and partnerships it is treated as business expenses and debited to profit
and loss account.
52
 c) Sales Tax: - Sales tax received from customers is to be paid to Government. If it has not been
paid, it will be shown on liabilities side of Balance Sheet.

Key Terms

Carriage: - Cost of transporting goods to the business premises or to customers. (Ware house) from the
suppliers

Cash discount:- Allowance given in the form of debt reduction as a result of prompt payment.

Bad debts:- A debt owed to a business that is not expected to be received or are those debts that the
business is not able to collect. These are written off as an expense.

Returns inwards: - Goods sold but returned by customers. It also known as sales returns

Returns outwards: - Goods bought but returned to suppliers. Also known as purchases returns

Drawings: - Cash or goods taken out of business by the owner for personal use.

Accruals: - Expenses incurred but not paid for by the end of the accounting period.

Prepayment: - Expenses paid for in advance of the period in which they will be incurred.

Depreciation: - A mount charged to the profit and loss account to reflect the wearing out of a fixed asset
over its useful life as a result of its usage or passage of time.

Layout:
53
i. 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

ii. Vertical layout

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

Example
The following trial balance was extracted from the books of Kazi Nzuri Ltd in
2006.
Kazi Nzuri Ltd
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

51
Cash 600
Closing stock 60,000
Sales 800,000
1,106,800 1,106,800
Required
Prepare a trading statement/trading account.

Solution
Kazi Nzuri Ltd
Trading statement for the year ended 31st Dec. 2006.

Opening stock 46,100 Sales 800,000

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

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

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

52
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 22,000 295,000
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
Net profit 109,800
129,800 129,800
Net p B/d 109,800
Final balance sheet
It‟s prepared after all the business transactions have been made. Adjustments and
profits are also included. It shows the financial position of a business at a
particular date. It consists of a listing of the assets and liabilities of a business and
the owner‟s equity

53
Example of a Final balance sheet
Eagles Dare 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/ Salvag 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 Kienjeku 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 provided at 10% on cost to machinery

and 20% on the motor van.

Required
Work out the book value and show their treatment.

Solution
Book value = (Value – Provision)
Motor van = (60,000 – 5,000) = 55,000

54
Machinery = (90,000- 5,000) = 85,000
Depreciation
(i) Motor van = 55,000 x 20/100 = 11,000

(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

Preparation of published account statements

Example
The following trial balance was extracted from the books of ABC Ltd. as at 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
Provision for depreciation motor van to 31st 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

55
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
P & L bal. at 31st Dec. 2001 8,500
197,540 197,540
You are also provided with the following information: -
i. Stock on trade as at 31st Dec.
2002, $ 8,800
ii. Provision for depreciation of
motor van is to be made at the rate of 20% per annum on cost
iii. A motor van which had cost
$ 800 was sold on 1st Jan 1994 for $ 240. Depreciation provided for this
van up to 31st Dec. 2001 was $ 520.
iv. Rates and insurance paid in
advance at 31st Dec. 2002 was $ 112.
v. The cash in bank shown
include a postdated cheque of $ 28 which had been cashed for by a
customer on 31st Dec. 2002.
vi. 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.
vii. 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.
viii. Directors have decided to
recommend a dividend of 10% for the year.
Required
Prepare a trading, project and loss statement as per the companies Act.
Prepare the balance sheet as at 31st Dec. 2002.

Solution
Notes/adjustments/workings

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

ii) Depreciation
Provision 2,845
Dep. Of sold van 520
2345

56
 990
Depreciation 3,315

Loss on sale of van

Cost 800

Depreciation 520
Cash 240
760
Loss on sales 40

Debtors (Trade)
Debtors 12,618
Returns 300
12,318

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 Account 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

57
 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 18,596

Bal B/d 18,596

Less ordinary shares dividend 4,000

Net P/L 14,596

ABC Trading
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
33,883
Liabilities
-Trade creditors 10,370
Proposed ordinary
shares dividend 4,000
(10% 40,000) 14,370
19,513
58,149

58
Financed by
40,000 ordinary shares 40,000
At $ 1 each
Share premium 36,000
Profit and loss (14,590)
58,149
Exercises
1. 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.

2. 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
ii. Net profit

3. Mombasa sports Ltd, has an authorized share capital kshs. 1,500,000 made
up ordinary shares 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 buildings 1,310,000
Motor vans at cost 213,000
Plant and machinery 1,088,000
Creditors 648,000
Cash at bank 1,784,200

59
 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
Interim dividend 30th June 2008 49,000

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

st
A. Closing stock 31 Dec. 2008 is Kshs. 229.000
B. Administrative expenses include Kshs. 200.000
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%

60
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.

4. 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
Stock ( 31.3.2000) 3,200

5. From the following trial balance of Webs Ltd prepare a trading, profit and
loss account for the year ended at 31st Dec. 2007.
Webs Ltd
Trial Balance as at 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

61
Stock at 31st Dec. 2007 was 2,548.

62
 LESSON FOUR

ACCOUNTING FOR CASH

Learning Objectives
At the end of the lesson the student should be able to prepare a bank
reconciliation statement and understand how to control cash through bank
accounts. The student should also be able to understand what the cash flow
statement is and especially the four classifications. The student should also be
able to prepare a cash flow statement from information contained in the profit and
loss account and the balance sheet. The student should know the advantages of a
cash flow statement

Accounting for cash

Cash account: Includes only those items immediately available to pay
obligations

Cash includes:-
-deposits with financial institutions
-Coins and currency,
-petty cash
-Certain negotiable instrument acceptable by financial institutions for immediate
deposit and withdrawal e.g ordinary cheques, cashier‟s cheques, money orders,
money market funds.

Cash equivalents: Items similar to cash not classified as such e.g treasury bills,
commercial paper and certificates of deposits. Cash equivalents are generally
recorded in short – term investment accounts. It also includes postage stamps and
travel advances to employees (prepaid expenses) as well as receivables from
company employees, and cash advances either to employees or outside parties
(receivables).

-At the end of the accounting period, undelivered cheques are not deducted from
the cash account. Entries already made to record such cheques are reversed before
preparing the financial statements because this resources were exchanged.

An overdraft: Is negative bank account balance reported as a current liability if a

depositor overdraws an account but has positive balances in other account with
the bank. It is appropriate to affect the negative and positive balances. In this case
the bank is both a creditor and a debtor. In overdraft repayment is demand, higher
interest involved, amount determined by negotiation ability of the borrower.

63
 A compensating balance: Is a minimum balance that must be maintained in
depositors account as support for funds borrowed by the depositor. Not included
in the cash accounts because they are not currently available for use.

Sinking fund: An amount of cash set aside for debt retirement.

Internal cash control

It is a set of policies and procedures designed to:-
(a) protect assets
(b) Ensure compliance with laws and company policy
(c) Promote accurate accounting records and
(d) Evaluate performance.

A petty cash fund: Is a type of imp rest fund providing ready currency for
routine disbursements. It‟s the method of dealing with petty transactions also
known as imp rest system. Petty cash cashiers are supplied with a fixed sum of
fund which is sufficient to cover petty cash payments for a stated period. At the
end of that period the total payment are ascertained and additional cash supplied
to the cashier.
Petty cash funds are intended to handle many types of small payments including
- Employee transportation
- Postage
- Office supplies
- Delivery charges.

Assume a Kshs. 3000 fund is established at a specific location. This account saves
as minimum administrative cost and interest.

The journal to establish the fund is

Dr. Petty cash 3000

Cr. Cash 3000

2. Authorization should be done on vouchers for each requests and dispenses that
require cash. The voucher should be equal to 3000

3. At the end of the year 560 remained in the fund, the followed individual
vouchers accompanied the fund, postage 900, office supplies, tax fares 800, cash
short over 40,

64
Reporting
Postage 900
Office supplies 700
Transport 800
Cash short over 40
2,440

Same (3000- 560) = 2,400

When a petty cash fund is increased, decreased or closed, an entry is made
affecting both the petty cash and cash account. e.g The fund is increased to 5000
in the petty cash.
Entry

Dr. petty cash 2000

Cr. Cash 2000

Example
Okulu enterprise established a petty cash fund of floats amounting to kshs 4000 at
the beginning of Nov 2006. The following transactions relate to the payment out
of the cash fund. Bought stamps 150, paid telegram 60, paid transport 380, paid
travelling expenses 180, paid causal labour 550, bought stationary 180, paid for
advertisement 250, donated for a harambee 350

Required
• Prepare a petty cash control Account
• Prepare a columnar petty cash book and fill the expenses
Solution
Date Ref. Amt. Date Ref. Amt.
Nov cash 4,000 Nov stamps 150
Telegram 60
Traveling 180
Casual 550
Stationary 180
Advertising 250
Harambee 350
Balance 2000
4,000 4,000

Control of cash through bank accounts

The use of accounts with banks and other financial institutions is an important
means of cash control.

65
 Bank accounts provide several advantages
- cash is physically protected
- A separate record of cash is maintained by the bank
- Cash handling and theft risk are kept to a minimum.
- Customers may remit payments directly to the bank
- Financial institutions provide cash management services such as chequing
privileges, investment advice.

Floats: Uncollected or un-deposited cheques. Firms attempt to maximize payment

float to increase interest earned on the funds supporting cheques written to other
firms and minimize float to reduce interest lost on cheques received from other
banks.

Electronic funds transfer (EFT): Transferring funds between banks and firms
by telephone or computer system. This is a means of reducing float. It reduces
paperwork, fewer errors and lower transaction costs.

Disadvantages: Cost of buying equipments internal control system requires EFT

facilities.

Reconciliation of bank and cash balances

Banks send a monthly statement to each depositor, indicating the beginning and
ending balances per the bank and transactions occurring during the month.
These transactions include cheques clearing the accounts, deposits received, and
service charges.

Monthly reconciling of the bank balance with the depositor‟s cash in bank balance
is an essential cash control procedure.

Bank reconciliations are used to:-

a. determine whether the bank account and company‟s cash balance
are in agreement
b. Isolate recording errors and other problems in the company
recording system.
c. Establish the correct ending cash balances
d. Supply information for adjusting entries.

Reconciliation procedures
There are 3 methods of reconciliation

(1) Bank balance and book balance to true cash balance

(2) Bank balance to book balance
(3) Comprehensive bank reconciliation or proof of cash.

66
 Bank and book balance to correct cash balance method.
It begins with the two balances and lists those differences between those balances
and the true ending balances.
-One or more items are recorded to reconcile the books balance.

Example
The ending balance reported is 38,900
Bank 35,300 cash balance
Nb: Any un-deposited cheque is added to the bank balance

Deposit in transits – Deposit made too late to be reflected in the bank statement.

NB:- Items not appearing in the bank statement

- deposits into the customer's bank account awaiting clearance( not yet
accounted for by the bank)
- Cheques issued by customer but not yet presented to the bank for payment
- Errors in the bank‟s accounting
Items not appearing in the cash book
- amount paid directly to the business‟ bank account (credit transfer)
- amounts paid out by the bank on the instructions of the customer (standing
order)
- amount recovered by the bank from customers bank account e.g. bank
charges and interest
- error in the cash book

Activity
Trace each item in the bank statement to the bank account in the cash book to
ensure every item is appearing in both,
Trace each item in both to identify
a) bank deposit awaiting clearance
b) cheques drawn but not presented in the bank

Example
Bank balance Book balance
Ending bank balance 38,900 Ending bank balance 35,300
Additions Additions
Cash on hand (un-deposited) 990 Note collected by bank
Deposit in transit 3000 Principal 1000
Deductions Interest 100
Cheques outstanding (7000) Deductions
Correct balance 35,890 NSF cheque (3000)
Bank service charges (200)
Total cash shortage 35,900

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 2. Bank to book balance method

West Company

Bank reconciliation Bank balance to book balance method

Ending bank balance 38,900

Add
Cash on hand 990
Deposit in transit 3000
Bank service charges 200
NSF cheque 300
Cash shortage 10
4,500

Subtract
Outstanding cheques 7,000
Note collected by bank 1,100 (8,100)

Ending book balance 35,300

Adjustment to cash account 590
35,890

2. Proof of cash method

West Company
Items Bank Book
Balance Balance
Ending balances 31st July 32,000 29,550
Deposit in transits end of July 5,000
Cash on hand (un-deposited) 1000
Cheques outstanding end July (8000)
Note collected for the company 600
Bank services for July 150
Collect cash balance July 31 30,000 30,000

Example 1
Cash book
20-0 $ 20-0 $
June 1 Bal c/f 80 June 27 Gordon 35
8 D. fines 100 29 Tyrell 40
30 Bal c/d 105
180 180

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 July 1 Bal B/d 105

Bank statement
20-0 Dr Cr Bal
June 26 Bal c/f 80
28 Banking 100 180
30 Gordon 35 145

Required
Prepare a reconciliation statement.

Solution
Cash book Bank statement
Ending balance
As per cash book 105 Ending balance 145
Additions Addition / deductions
Un-presented cheque 40 Un- presented cheque (40)
145 105

Example 2
Cash book
2000 2000
Dec 27 Bal B/f 2000 Dec 27 Bal b/f 1,600
29 potter 60 28 J Jacobs 105
x
31 Johnson (B) 220 x 30 m chawood 15
31 Bal c/f 56
2280 2280
Bal B/d 560

Bank statement
2000 Dr. Cr Balance
Dec. 27 Bal b/f 400
29 cheque 60 460
30 Jacobs 105 335
x
30 Credit transfer ( show) 70 425
x
30 Bank charges 20 405

Items not in both cash and bank statement

i. chatwood $ 15- sent by business to chetwood (-)

ii. M. Johnson 220 – sent to business by Johnson (+)

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iii. Shaw 70 - Paid to business ( +)
iv. Bank charges -Deducted from business (-)

RECONCILIATION

BANK CASH BOOK

Balance end (bank) 560 Balance (end) cash 405
Additions Additions
Unpresented cheque 15 Johnson 220

Credit transfers 70 Bank commission 20

85 240
645 645

Deductions
Bank commission 20
Bank cheque not entered in Bank
statement 220
(Johnson) 240
405

Example 3

The cash account of Brain company at Feb. 28 2003 is as follows

Cash Book A/c

Feb 1 Bal 3,995 Feb 3 400
6 800 12 3,100
15 1,800 19 1,100
26 1,100 25 500
28 2,400 27 900

Feb 28 balance 4,095

Company receives a bank statement on Feb 28 2003.

Bank statement Feb 2003

Beginning balance 3,995

Deposits
Feb 7 800

70
 15 1,800
24 1,100
3,700

Cheques (total per day)

Feb 8 400
16 3100
23 1,100
(4,600)
Other Items
Service charge (10)
NSF cheque not receivable
for the company 1000
EFT – Monthly rent expenses (330)
Interest on account balance 15

Ending balance 3,070

x
Includes interest of $ 199

Additional information
Brain Company deposits all cash receipts in the bank and makes all cash
disbursements in cheques.

Required
1. Prepare a bank reconciliation of Brain company at Feb 28 2003
2. Record entries based on the Brain reconciliation:-

Brain Company
Bank reconciliation
Feb 28, 2003
Bank Reconciliation Cash reconciliation
End balance 3,070 End balance 4,095
Deposits cheques 2,400 Receivable 1,000
5,470 Interest earned on
Outstanding cheques bank balance 15
(5000 + 900) (1,400)
5,110
Adjusted bank balance 4,070 Less service charges 10
NSF cheque 700
EFT Rent expenses 330
1,040

71
 Adjusted book 4,070
Journal Entries
2 Feb
28 Dr. Cash 1000
Cr. Note receivable 1000

Feb Dr. Cash 15

28 Cr. Interest revenue 15
Interest earned on bank balance

Feb
28 Dr. Miscellaneous expenses 10
Cr. Cash 10
Bank service charge

Feb
28 Dr. Account receivable 700
Cr. Cash 700
NSE cheque returned by bank

Feb
28 Dr. Rent expense 330
Cr. Cash 330
Monthly rent expenses.

Example
The following information relates to Jogoo Kweri Company Ltd on 31st dec 2009.
Balance as per bank is 1,202,000. Balance as per cash book 809,100. An
examination of the cash book and the bank statement reviewed the following;
i. There were bank charges of shs 6000 for the month of December
ii. Interest of shs 2,000 on treasury bonds held by bank in December
for Jogoo Company was collected by the bank but not yet recorded in Jogoo
Company
iii. A deposit of shs 36,000 was mailed on 31st Dec but does not
appear on the bank statement
iv. A cheque outstanding on 31st dec totaled 400,000
v. A cheque issued by Jogoo Company in the amount of 17,000
accompanied the bank statement and was incorrectly charged to Jogoo Company

72
 vi. A cheque of shs 40,000 issued by Jogoo company had been
erroneously recorded in the bank as 4,000
vii. A receipt of kshs 11,000 from a debtor was entered as 1100 in the
cash book
viii. A cheque of ksh 190,000 to a creditor was recorded as 180,000 in
the cash book
ix. A cheque of kshs 20,000 from Mungai a debtor accompanied the
bank statement and was marked RTD, return to drawer
Required
Prepare bank reconciliation statement as at 31st Dec 2009 using the two
alternative methods
Prepare journal entries to update the cash book

Solution
Jogoo company
Reconciliation statement as at 31st Dec 2009
Balance as per bank 1,202,000
Additions
Bank charges 6,000
Un-deposited cheques 36,000
Creditor cheque un-presented 10,000
NSF 20,000

Subtractions
Interest 2000
Erroneous payment 40,000
Outstanding cheque 400,000
Error of deposit 17,000
Undercast 9,900
Balance as per cash book 809,100

Jogoo company
Reconciliation statement as at 31st Dec 2009

Balance as per cash bank 809,100

Additional
Interest 2000
Erroneous payment 40,000
Outstanding cheque 400,000
Error of deposit 17,000
Undercast 9,900

Subtractions

73
 Bank charges 6,000
Un-deposited cheques 36,000
Creditor cheque un-presented 10,000
NSF 20,000

Balance as per cash book 1,202,000

Journals
Dr. Bank charges 6,000
Cr cash/bank 6,000

Dr. Cash/Bank 2,000

Cr interest revenue 2,000

Dr. Bank / cash 400,000

Cr account payable 400,000

Dr. Jogoo 17,000

Cr cash/bank 17,000

Dr. Bank /cash 36000

Cr account payable 36,000

Dr. Bank/cash 9900

Cr debtor/ account receivable 9900

Dr. Creditor 10,000

Cr cash/bank 10,000

Dr. Mungai 20,000

Cr cash/bank 20,000

Question
The following information relates to transaction for Biwott Company in 2009
Cash balance at 31st 2009 is shs 84,288 and an overdraft of 361,362
a. Bank charges kshs 3,500
b. Outstanding charges kshs 188,200
c. Proceed of bank loan not recorded in accounting records kshs 500,000
d. Direct deposit by a debtor Kanini Kaseo ksh 15,000
e. Deposit on 31st dec recorded by bank 58,050

74
f. Deposit on 29th dec recorded by bank ksh 8,000 correctly in cash book in
current account as shs 80,000
g. Cheque 2040 to suppliers recorded by bank shs 4,000 recorded correctly
in the cash book incorrect amount of kshs 40,000
h. Cheque returned by bank from customers shs 28,300
Required
Prepare bank reconciliation statement as at 31st Dec 2009
Prepare final entries to adjust the accounting records on 31st dec 2009

Solution
BIWOTT COMPANY
Reconciliation statement as at 31st Dec 2009
Balance as per bank (361,362)
Additional
Bank proceeds 500,000
Direct deposited 15,000
Cheque ont recorded by bank 58,050
NSF 28,300
Deposit 29th 72,000

Subtractions
Bank charges 3500
Outstanding cheques 188,200
Outstanding cheque 36,000
Balance as per cash book 84,288

BIWOTT COMPANY
Reconciliation statement as at 31st Dec 2009
Balance as per cash bank 84,288
Additional
Bank charges 3500
Outstanding cheques 188,200
Outstanding cheque 36,000

Subtractions
Bank proceeds 500,000
Direct deposited 15,000
Cheque ont recorded by bank 58,050
NSF 28,300
Deposit 29th 72,000

Balance as per bank (361,362)

75
Journals
Dr. Bank charges 3,500
Cr cash/bank 3,500

Dr. Outstanding charges 188,200

Cr interest revenue 188,200

Dr. Bank / cash 50o000

Cr bank loan 400,000

Dr. cash 15,000

Cr account receivable 15,000

Dr. Bank /cash 50,050

Cr account receivable 50050

Dr. Bank/cash 8000

Dr. accrued 72,000
Cr account receivable 80,000

Dr. suppliers r 4,000

Accrul 36,000
Cr cash/bank 40,000

Dr. Account receivable 28,300

Cr cash/bank 28, 300

Cash flow statements

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 or bad 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 has done with the resources.

76
Funds flow statement
The statement shows the movement of cash funds that includes cash and bank
funds and the movement of working capital.

Financial statements concerned with cash flows 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.

A statement of resources
-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.

• Cash flows from operating activities.
• Cash flows from investing activities.
• Cash flows from financing activities
• Effects of foreign exchange changes
• Net increase/ decrease in cash during the period.
• Non- cash investing and financing activities.

Cash flows from operating activities.

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

Inflows operating activities: Received from:-

-Customers
-Interest and receivables
-Dividends from investments
-Refunds from suppliers.
Outflows: Paid to
-Purchase of goods for resale
-Interest on liabilities
-Income tax, duties and fines
-Salaries and wages

The difference between inflows and outflows is called net inflows/outflows from
operating activities.

77
 Cash flows 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.

Cash flows from financing activities

Represent inflows 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.

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

Effects of foreign exchange rate changes

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

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

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.

78
 Usefulness of a cash flow statement
- Provide feedback about cash inflows and outflows to investors, creditors
and other investors.
- Required b y decision m a k e r s 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 method
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 entail
cash payment e.g. depreciation, amortization e.t.c.
Standard layout (direct method)

ABC cash flow statement

FOR THE YEAR ENDED 31ST DEC 2006

Changes in cash (X- Y) XXX

Net income / profit XX

Add items not affecting cash e.g.
(a) Depreciation xx

Cash from operating activities

(b) Decrease/increase in receivables xx
( c) Increase/decrease in prepaid Exp. xx
(d) Increase/decrease in accts Payable xx
(e) Interest payable xx
(f) Increase / Dec. of wages & salaries xx
(g) Paying other expenses xx

79
(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
Financing activities
Inflow
-Sale of own equity xx
-issuance of debts bonds xx XX

Outflow
-Shareholders dividend xx
-Redeemed long term xx
XX XX

Net change in cash XXX

Illustration 1
XYZ limited
Cash flow statement
For the year ended 31st Dec. March 2001

Operating profit 6021

Depreciation 893
Loss on sale of tangible fixed assets 6
6920
Cash from operating activities
Increase in stocks (194)
Increase in debtors (72)
Increase in creditors 234
Cash flow from operating activities -32
6,888

80
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 1,474
-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 9,269

Illustration 2
The following balances were extracted from T. Holmes balance sheet as at 31st
Dec. 2009 and 31st Dec. 2010.

31st Dec 2009 31st Dec. 2010

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
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

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 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. 2010

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

Illustration 3
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
Issuance of ordinary share capital 400
Expenses in connection with share 10
Purchases of intangible fixed assts 150
Purchases of tangible fixed assts 2540

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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
Change in cash 1091

Exercises
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

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-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
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)

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 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
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 payable 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.

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 Solution

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

2nd step
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

TRACK CONSTRUCTION
Cash flow for the year ended 31st Dec 2002

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)

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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)

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 LESSON FIVE

ACCOUNTING FOR RECEIVABLES/DEBTORS

Learning Objectives
At the end of this lesson, the student should be able to explain the various types of
receivables and understand the effects of bad debts on financial statements. The
student should also be able to distinguish between tangible and intangible assets,
capital and revenue expenditure. The student should also be able to determine the
basis of valuation of plant and equipment, understand the concept of depreciation
and the various methods of calculating depreciation. The student should also be
able to prepare financial statements from incomplete records provided, and
prepare a statement of affairs.

Receivables
include:-
- Claims for money from other firms
- Claims for goods and services
- Claims for other non cash assets

They are classified as (1) current or (2) non-current depending on the time of
maturity expected. Notes receivable are usually supported by formal promissory
notes.

Trade receivables: are amounts owed to the company for goods and services.

Recognition of accounts receivable

A/C receivables are amounts owed by customers for goods and services sold in
the firm‟s normal operations. The receivables are supported by invoices and other
documents or other written promises. Generally 30 – 60 days period are allowed
for payment. Any prepayments or over payments are reported to as liabilities in
the Balance sheet.

Accounts receivables are recognized when the criteria of recognition are fulfilled.
They are valued at the exchange price less adjustments e.g. discounts, allowances
e.t.c. bringing to net realizable value.

Cash Discounts
Cash discount is an amount deducted from the gross invoice price if payment is
received within the designated period.
Usually used to:-
(1) Increase sales
(2) Encourage prompt payment

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(3) Reduce uncollectible accounts.
Typical terms 2/10, n/30 meaning, 2% cash discount if paid within 10days,
otherwise the net is due within 30 days; Beyond 10 days no. discount allowed.

Illustration
Assume North Company sold merchandise to south company at a gross sale price
of $ 1000 terms 2/10, n/30
August 1, 1991 – To record credit sale
Net method
2% x 1000 = 2/100 x 1000 = 20

Net method
Dr. Account receivable 980
Cr. Sales revenue 980

Gross Method
Dr. Account receivable 1000
Cr. Sales revenue 1000
Or
Net method

Dr. Cash 980

Cr. Account receivable 980

Gross method

Dr. Cash 980

Sales discount 20
Cr. Account receivable 10000

Entry to record collection entry after 10 – day discount period

Net method
Dr. Cash 1000
Cr. A c c o u n t s discount 980
Sales discount 20

Gross method
Dr. Cash 1000
Cr. Accounts relievable 1000

NB/ The net method identifies discount fortified by customers

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Adjusting entries
At the end, under the net method, if the discount period on a material has lapsed,
an adjusting entry is required. This entry recognizes fortified discounts increases
accounts receivables.

Example
Assume that $ 980, 0000 accounts receivable recorded at net, the discount period
lapsed.
Assuming the credit term sale 2/10, n /30 net

Solution
Dr. A/C receivable 0.02 (980,000 / 98) 20,000
Cr. S a l e s discount fortified 20,000

Trade discounts
They are efficient means of advertising. It reduces the final sales price and is not
affected by the date of payment.

Example
An item is priced at $ 50 and carries a trade discount of (40% for quantities over
1,000)

Unit price = $ 50 x 0.6 = $ 30

Trade discounts are not entered in the accounting books but rather help to define
the invoice price.

For 1,100 units, the price total amount payable 1,100 x 30

= 33,000/=
Sales return and allowances.
-Returns are usually made for defective items or otherwise un- acceptable
merchandise.
-Sale allowances arises from in contrast, arise from dissatisfaction with a product
attribute or from minor damage.
-To encourage the customer to keep the merchandise, the seller offers to reduce
the amount owed by the customer.
-Sales returns and allowances reduce both net accounts receivable and the net
sales.

Example
90
 Assume a company experiences $ 16,000 of returns and allowance in 1991 the
summary entry record would be:-

Dr. Sales return & allowances 16,000

Cr. Account receivable 16,000

Example
Assume the total estimated sales and return allowances are 2% of the total 1
million sales for the year.

Sales returns and allowances

(0.02 (1,000,000) – 16,000) = 4,000

Dr. Sales and return allowances 4,000

Cr. Allowances for sales returns and allowances 4,000

Example
Astro Turf Ltd Company recognizes 5% of its $ 1,000,000 trade receivables
outstanding are returned.
The omission of a $ 50,000 charge could have a material effect on the net income.
(0.05 x 1,000,000) = 50,000/=
Dr. Sales returns and allowances 50,000
Cr. Allowances for sale and returns allowances 50,000

NB/ Returns and allowances are accumulated separately instead of

debiting directly to the sales account.

-The allowance is an asset valuation account and is deducted from total account
receivables.

Measuring uncollectible account receivables (Bad debts)

When credits are extended, some amounts are uncollectible.
Some firms attempt to develop a credit policy.

Past records of payment and financial condition and income of customers are Key
inputs to consider coming up with this policy.

- Uncollectible A/C must be recorded in the accounts. The matching principle

requires that the loss from uncollectible are recognized in the period of sale.

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 Accounts receivables and income are reduced to reflect future uncollectible from
current year sales.
- Estimated uncollectible are recorded in bad debt expenses, an
operating expense usually classified as a selling expense.

- If uncollectible accounts are not probable or estimable, no adjustment to

income or accounts receivable is required i.e. accounts are written off when
considered uncollectible.
Accounting for uncollectible debts
If a company estimates that $ 9,000 of bad debts will be incurred during the year

Report this

Dr. Bad debts expense 9,000

Cr. Allowance for doubtful a/cs 9,000

Allowance for doubtable accounts is a contra account to account receivable.

Usually subtracted from the A/C receivables (debtors)
Balance sheet

A/C receivables xxx

Bad debt on item off xxx
xxx

Effects of bad debts on financial statement

Bad debt expense should be reflected in the financial statements for the year in
which sale was made even if the accounts are not determined to be uncollectible
until the succeeding account period.
Bad debts must appear in both the income statement and the balance sheet.

Balance sheet

Accounts receivable 31/85 200,000

Estimated uncollectible a/c 10,000
Realizable value 190,000

To record bad debts

Dr. Bad debt expense 10,000

Cr. Allowance for bad debts a/c 10,000

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Allowance for bad debt
This is a valuation a/c used for the purpose of determining the estimated
realizable value of A/C receivables.
This amount is credited in the estimated bad debts a/c

-Allowance for bad debts serves to reduce the accounts receivable to net
realization value.

Percentage method
Ngege Company has determined that 2% of its sales in the past resulted to bad
debts. During the current period credit sales totaled to Kshs. 675,000. The
estimated bad debts for the company will be calculated as follows.

Bad debt = 675,000 x 0.02

= 13,500

Dr. Bad debt expense 13,500

Cr. Allowance for bad debts 13,500
To record provision of bad debts

Writing off bad debts

This is the removal of an account receivable from the accounting records because
it is considered uncollectible.
The balance of the customers‟ a/c is reduced to zero.

Example
Account receivable 31st Dec. 2000 200,000
Allowances for doubtful debt 10,000
During the month of Jan 2001, a customer by name Maskani became bankrupt
and that A/C receivable for him is Kshs. 1,000 has to be written off. Make entries.

Dr. Allowance for doubtful debt 1000

Cr. A/C receivable masikini 1000

Accounts receivable
A/c receivable 200,000
Allowance for doubtful debt 10,000
Bal. C/f 190,000

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 Doubtful debt written off
maskani 1,000

Amount realizable after writing off

A/c Receivable 199,000
Less doubtful debt 9,000
190,000

Recovering an amount previously written off

The Ksh. 1,000 previousl y written off in res pect to Maskani is
event uall y
recovered in full.

The entry restores Maskani A/C

Dr. A/C receivable ( Maskani) 1000

Cr. Allowance for doubtful debt 1000

Partial recovery
If only Kshs.600, is recovered we reverse the entry as follows:

Dr. Accounts receivable (Masikini) 600

Cr. Allowance for doubtful A/cs 600

Collection of cash in full

Dr. cash 1000
Cr. A/c receivable ( Maskani) 1000

To collect partial payment

Dr. Cash 600

Cr. A/C receivable ( Maskani) 600

Accounting for property, plant and equipments

Plant & Equipments
This item is used to describe all-long –lived physical assets acquired and used in
the operation of a business and not intended for resale. Other terms used –
tangible assets

Intangible assets –These are things which cannot be physically measured, such
as copyright in a book, the goodwill or acquired skill of a staff.

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Tangible assets-term denoting physical substance as exemplified by such things
as land, a track of timber, a bridge, a piece of machinery

Divided into two:

(a) Plant & Equipment
(b) Land
a) Plant & Equipments-with exception of land all items of plants & equipments
have limited useful lives. The investment in such items is not fixed .it disappear
and its reduction is counted a cost of the productive services yielded by the
physical property.
(b) Land-A kind of physical property that has indefinite service life.

Land is counted as a non-depreciable permanent asset.

Exception cases of depreciation may occur when:-
(i)Agriculture land loses fertility through erosion
(ii)Building site destroyed by floods, landslide or earthquake.

The above assets appear in the balance sheet under other assets/investments.

Asset value
Refer to legal right which offers the prospect of future benefits to the accounting
entity in which the right is vested.
Asset value goes two distinct stages,
(i) Recognition of asset value which confers legal rights to the entity for the use of
the asset in its building operation e.g. purchase of a building site
(ii) Depending on the possibility that it will continue to have a use of income
generating process of the firm. E.g. a site will gain value as more buildings are
constructed in a place

Capital Expenditure
Fixed assets or plant and equipment represent expenditure which has been
capitalized in the process of income determination of the current and previous
years. It involves the purchase of something that will be shown as a fixed asset in
the balance sheet e.g. purchase of a building.

Revenue Expenditure
Any expenditure that will benefit only the current accounting period. A current
asset such as purchase of merchandise for resale is a Revenue expenditure

Basis of valuation of plant & equipment

At the time of acquisition, cost is an objective measure of exchange.
Market price represents the agreement of two parties’ i.e. the buyer & seller
sometimes due to error of judgment, a buyer may pay too high a price or seller
may

95
 accept too low price but in all cases the consideration given or the price paid
constitute the cost of the asset whether a scalping or a bargain. The cost may not
be the same as the carrying value

The principle for determining cost of plant and equipment

(1)The total cost of plant & equipment is the cash outlay or its equivalent made to
acquire the asset and put it in operation conditions.

Problem arising from this principle:-

a. What should be included in the acquisition costs of an asset?
b. How is the acquisition cost measured?
c. How are costs subsequent to acquisition recorded?

E.g. - Expenditure to maintain assets in good operating conditions are viewed as

expenses of the period in which they occur.

Cost- is mostly determined when an asset is purchased for cash. Then the cost of
the asset is equal to the cash outlay necessary in acquiring the assets itself plus
any expenditure for freight, insurance while in transit, installation costs necessary
to make the asset ready for use.

Note: When an asset is acquired in an installment plan or by issuance of a note

payable, the interest element or the financing charge should be recorded as
interest expense and not part of the cost of the plant asset.

EXAMPLE
Assume a customer buys a machine from a factory and the details of the
transaction are as follows,

List price ksh .10,000,terms 2/1on/30 sales text 6%, freight charges sh.1,250
road transport ksh.150, installation cost is ksh.400.Assuming the machine is paid
for during the discount period, the cost of the machine would be constituted as
follows:-

List price Ksh.10,000

Loss cash discount 200
(2%x10,000)
Net cash price 9,800
Sales tax(6%x9,800) 588
10,388

Freight charges 1,250

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 11,638

Road Transport 150

Installation costs 400

Total cost of machine 12,188

NB/ If the service acquired are consumed within the current operating period,
there revenue expenditure, but if the services benefit the future period, then they
are capital expenditure and are commonly said to be capitalized.

Acquisition of land includes:-

• The purchase price paid to the seller.
• All costs of closing the transaction such as perfecting of title
investigations etc.
• All costs of surveying, landscaping etc.
• Costs of land improvement that have an indefinite life such as installation
of sewers.

Acquisition of a building
When buildings are acquired, all changes clearly relating to the building must be
included as cost .If it was found that there is an expensive repairs required, such
expenses must rest on the evidence of purchase. There are two alternatives.

(a)Buyer recognizes the need of repairs at the time of negotiating the price. Then
the cost for repairs is part of the cost of the building.

b) The building purchased under assumption that it is in a condition of immediate

occupancy, and it’s later discovered that it needs immediate repairs. The
expenditure to rectify the defects should be treated as an expense in the current
period.

Leasehold – A lease is a personal property right granting the lessee the use of real
property for a specified length of time according to the leasehold agreement or
contract.

Lease- This is the contract under which the right of leasehold is granted.

Lessor - The owner of the leasehold property.

Lessee- The person had given the right to use the property by the leasehold
contractual obligation to make future rental payment.

97
Leasehold improvements- These are improvements made on leasehold property
in the form of buildings and other improvement by the lease. The cost of these
improvements should be recorded in a separate account. The service life of these
improvements must be related to the duration of the leasehold contract and cannot
be greater than the balance of the lease.

Machinery and equipment

The cost of machinery must be carefully determined especially the self-
constructed assets.

E.g. In self constructed assets – all direct costs such as – raw materials, labour
design, and engineering should be capitalized.

Lump – sum acquisition- a term used to refer to the price paid for the acquisition
of two or more assets. If the assets in question have different service lives, e.g.
land and building, it is necessary to allocate the lump sum cost among them in
order to provide a proper basis for allocating the cost of the depreciable asset over
its service life. When land and buildings are purchased for a lump sum, the
purchase price must be apportioned between them. This can be done on the basis
of appraisal.
Example
Assume for example that a lump sum of Kshs. 250,000 was paid for land and
building. On appraisal land was found to be worth Kshs. 120,000 and building
180,000. The apportionment on the basis of appraisal would be:-

Appraisal percentage of Apportionment of

Value Total Cost.
Land 120,000 40% 100,000
Building 180,000 60% 150,000
300,000 100,000 250,000

When a piece of land is purchased as a building site and on it there is an old

building which is not suitable for the buyer’s use. The cost of leaving the building
down to make the site suitable for use should be charged to the land account.

Natural Resources
Mining properties e.g. oil, gas wells and tracts of timber are leading examples of
natural resources or wasting assets. These goods are physically consumed and
converted into inventory.

Natural resources should be recorded at cost in the accounting records. As the

asset is removed through the process of mining or cutting or drilling, the asset

98
 account must be proportionally reduced by transferring a portion of the original
cost of the unit to the cost of goods mined or sold account.

Cost of natural resources

These include all measurable and necessary expenses for such services as
surveying, exploratory and development activities, if these expenses are
reasonably certain to produce future revenue.

Depletion- A term used to describe the pro-rata allocation of cost natural

resources to the units removed.

Example
Assume that 2 millers paid for a coal mine with approximately 1,000,000 ton of
coal.

Depletion cost = 2,000,000 = 2/= per ton

Per unit 1000,000

If we assume 200,000 tons were mined in a year, then the depletion charge for the
year is
200,000 x 2 = 400,000
Dr. Depletion expense 400,000
Cr. Accumulated depletion 400,000

Depletion expense might be compared with the purchases account in a

merchandise sign business.
Eg.
Opening stock + purchase = goods available for sale.
Opening stock + current depletion + Goods available for sale

Ending inventory + the inventory of coal mined and not sold.

The unsold coal represents depletion change carried forward as part of inventory
for sale in the following period.

Depletion expense is recorded in the year in which the extraction of the product
occurs but become a deduction from revenue in the period in which the product is
sold.

Other costs of inventory of coal & other extracted products.

- Labour cost
- Other expenditure incurred in bringing the coal to its present
- Position and condition.

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Example
An oil well may cost Ksh. 1,000,000 to contain an estimated 10,000 barrels of oil.
The depletion rate would be

1000,000 = Ksh. 100 per barrel

10,000

If 3,000 barrels are extracted during the year, depletion expense would be
(3000 x 100) = 300,000
The depletion entry for the year

Dr. Depletion expense 300,000

Cr. Accumulated depletion 300,000

If 4,500 barrels are removed the next year, that period depletion is
(4,500 x 100) = 450,000
Accumulated depletion is a contra account similar to accumulated depreciation.

Reporting Example
Property, plants & equipment
Land 1,200,000
Building 8,000,000
Equipment 1,600,000
9,600,000
Less Accumulated depreciation 410,000
5,500,000

Oil
3,400,00
0 2,500,000
Less accumulated depletion 900,000 9,200,000

Depreciation
It’s a term most often employed to indicate that tangible assets have declined in
service potential. For natural resources such as timber, oil, coal etc, the term
depletion is employed. For intangible assets are such as patents, goodwill and
others, amortization is applied.

For accounting purposes, these terms are used to describe the rational and
systematic allocation of the cost of various assets, less any salvage (residual)
value, over useful life.

When a fixed asset is bought then later put out of use by the firm, that part of cost
that is not recovered on disposal is called Depreciation.
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 Provision for depreciation or loss of value suffered will therefore have to be made
in the books of account in order that the net profits ascertained may be profits
remaining after changing all the expenses of the period.
The amount charged for depreciation is based during an accounting periods,
multiplied by the estimated cost of each limit.

There are four man classes into which causes of depreciation may be divided:-
(a) Economic factors – obsolescence
(b) Time factors – e.g. Patents
(c) Depletion – e.g. Timber.

There are many methods that are acceptable for apportioning the cost of an asset
over its useful life and there is no one best method.

All the methods in question take the following factors: -

(a) Cost of the assets
(b) Useful life
(c) The use of the asset
(d) Repairs and maintenance
(e) Scrap or salvage valve
(f) Systematic allocation of cost.

Methods of calculating Depreciation

(a) Straight line method
(b) Declining balance method
(c) Sum of the year’s‟ digits method
(d) Present value based depreciation
(e) Limits of output method
(f) Sinking fund method.

1. Straight line method

Under this method, depreciation is considered a function of the passage of time.
It’s widely used because of its simplicity.
Circumstances
• The decline in economic services potential of the assets is approx
the same for each period.
• The decline in economic services potential of the asset is related to
passage of time rather than use.
• Use of the asset is consistent from period to period
• Repairs & maintenance are essentially the same for each period.

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Depreciation is calculated in an equal amount each year. The choice of this
method implies that the operating efficiently of the asset remains constant
throughout its life and that cost of repairs are constant.

Formula used is as follows.

Depreciation (D) = Original cost (c) –scrap value(s)
No of years of expected useful life (n)

D=C-S
N
Example 1
A machine costing Ksh. 100,000 has a scrap value of Ksh. 2,560 expected remain
useful for 4 years.
Annual depreciation would be = 100,000 –2,560
4yrs

= 97,440
4

= Ksh.24,360
Example 2
Assume a machine value Ksh. 500,000 which has scrap value of 50,000 & useful
life of 5 years. What is the yearly depreciation?

D= Cost –Scrap
Useful life

= 500,000 –50,000
5yrs

= Ksh. 90,000

Amortization schedule
Year Depreciation expense Book value Rate of return
O 500,000
1 90,000 410,000 100,000
2 90,000 320,000 100,000
3 90,000 230,000 100,000
4 90,000 140,000 100,000
5 90,000 50,000 100,000

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 2. Output based method/ productive output method
This is also called production method.
It is used where an asset has an estimated total output.

Characteristics
i. Depreciation charges fluctuate with use.
ii. Each unit of output is charged with a constant amount of depreciation.
iii. The cost to be depreciated is divided by the services life is units to derive
depreciation rate per unit for output or service.
iv. Depreciation is greater where usage is higher and less where usage is low.

This can also be called the production method.

Repair does not enter as a factor into the choice of this method.

Formula
D = No. of unit produced X cost scrap value
Total output

3. Accelerated methods based on time

These methods are based on the assumption that new assets are more efficient
rendered by the asset are greater during the early life of the assets, therefore the
economics service potentials rendered by the asset are greater during the early life
of the asset. Argent in support of accelerated depreciation change should decrease
as repair costs on the asset increase, thus resulting in more equitable charge to the
operating periods for the use of the asset.

Fixed percentage on declining balance

This procedure produces the highest amount of depreciation in the first years
declining year by year. It implies that the operating efficiency of the asset is
declining and mostly send for vehicle and other kinds of fixtures

Formula
Rte = I- n
S
C
Where n – Year of use
S – Salvage value
C – Cost.

Example
A vehicle valued & 10,000 has a useful life of 4years and salvage value of & 256
What is the rate of depreciation?

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 R= 1 - 4th 256
10,000

ACTIVITY METHOD
This method determines depreciation as a function of use or productivity instead
of the passage of time. It results in good matching of costs and revenues when
benefits received from an asset are a function of fluctuating activity or
productivity.

Formula
Depreciation = Cost –Salvage X Hrs this year
Total estimated Hrs.

Example
A machine value Ksh. 500,000 has a salvage value of 50,000. It has 4000hrs of
use during the first year. The machine has a total number of 30,000hrs of use.

Calculate depreciation.
D = Cost –Salvage X Hrs of use
Total estimated hours

= (500,000 –50,000) X 4,000 hrs

30,000hrs

= Ksh. 60,000

DOUBLE DECLINING METHOD

Uses a depreciation rate (expressed as a % and called the declaiming balance rate)
which remains the same throughout the assets life, and is applied to reduce book
value each year to determine the depreciation expense.

Assume a machine valued 500,000 with a useful life of 10years.

Rate of depreciation 10%

Double straight line rate (10% x 2)

= 20%
DEPRECIATION SCHEDULE

YEAR Book Rate DEP. Exp Acc x Period

Value depression value
1 500,000 20% 100,000 100,000 400,000
2 400,000 20% 80,000 180,000 320,000

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 3 320,000 20% 64,000 244,000 156,000
4 156,000 20% 31,200 275,000 124,800
6 124,800 20% 24,960 300,160 97,840

PRESENT VALUE BASED DEPRECIATION METHOD

Under this method, the cost of a plant asset is equated to present value of the
stream of cash receipts generated by the asset.
Each receipt consists of interest (return on investment) and principal
(Depreciation expense)

Example
Assume a firm purchases an asset with a two year useful life on Jan 1 2000 for &
10,000. The firm anticipates a 6% return on its investment in the asset, equivalent
to a net cash flow of & 5,454 per year, computed as follows.

10,000 = (PVA, 6% 2) (annual not cash flow)

Annual net cash flow = 10,000
(PVA, 6% 2)

= 10,000
1.83339

= Ksh. 5,454
ANNUITY METHOD
Periodic cost depreciation of using depreciable asset is considered to be equal to
the total of the expired cost of the asset and the cost on the unrecorded investment
in the asset.
Amount of depreciation is written off yearly (Calculated on a straight line
method).

EXAMPLE
A lather machine was bought at Sh. 1,600,000. Its estimated life is 5yrs with
salvage value of 134,776. The prevailing rate of return for this type of asset is
10% compounded annually.

Depre. = Cost of asset –Salvage value

(PVA, 10% 5)

= 1,600,000 –134,776
3.790787

= 1516,300
3.790757

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 = 400,000/=

ANNUITY METHOD DEPRECIATION SCHEDULE

Year Dep. Interest Accumulated Bal Acc. Book

Expense (10%) Depreciation Dep Value
Revenue
0 1,600,000
1 400,000 16,000 (a) 240,000 (b) 240,000 1,360,000
2 400,000 136,000 (ai) 264,000 504,000 ©

3 400,000 109,600 290,400 794,400 1,096,000

4 400,000 80,560 319,440 1,113,840 805,600
5 400,000 48,616 351,384 1,465,224 486,160
134,776

240,000 (a) = 400,000 160,000

136,000 (b) = 1,600,000 240,000
160,000 (a) = 10% of 1,600,000
(a)
= 10% of 1,360,000

Journal entries
Year 1
Depreciation Expense 400,000
Interest Revenue 136,000
Accumulate depreciation 240,000
To record annual depreciation expense

Year 2
Depreciation expense 400,000
Interest revenue 136,000
Accumulated depreciation 264,000

Sinking Fund deposit 1,600,000

(PVA 10% 5Years)

= 1,600,000 –134776
6.1051
= 240,000/=

SINKING FUND METHOD

Sinking fund method is used when a fund is to be accumulated to replace a fixed
asset at the end of its useful life. The amount of annual depreciation is equal to the

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increase in the asset replacement fund. An amount is set aside each year, which
with the interest earned, will be sufficient to provide a sum equal to the cost of the
asset less residue value. The increase in the fund would be made up equal periodic
deposits plus the interest revenue

Formula

Sinking Fund Deposit = Cost of assets - Residue Value

Amount of ordinary annuity rate + No. of years

Example
Kengo‟s Business Information
Purchase Price 1,600,000
Useful Life 5 years
Residue Value 134,000
Rate of interest 10%

Sinking Fund Deposit = 1,600,000 - 134,776

(PVA, 10%, 5 yrs)

= 1600000 - 134,776
6. 1051

= 240,000

SINKING FUND SCHEDULE

Year Annual Interest Total Fund Bal Dep. Acc Dep Book
Deposit Fund Expe value
0 1,600,000
1 240,000 0 240,000 240,000 240,000 240,000 136,000
2 240,000 24,000 240,000 504,000 264,000 504,000 1,096,000
3 240,000 50,400 314,400 818,400 394,400 718,400 781600
4 240,000 81,840 396,200 1,214,600 396,200 1,214,600 385,400
5 240,000 38,540 514,660 1,732,260 514,660 1,732,269 -
1,200,000 265,224 1,465,224 1,465,224

Year 1
Sinking fund 240,000
Cash 240,000
To transfer fund to sinking fund

Year 2
Sinking fund 264,000
Cash 240,000

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 Interest revenue 24,000

QUESTIONS
Assume a company purchases a fork lift for Ksh. 500,000. The estimated useful
life for it is 4yrs with a salvage value of Ksh. 100,000.
The anticipated revenue firm the use of machine is Ksh. 200,000 per year and
operating expenses exclusive of depreciation ia Sh. 80,000 per year.
Required
Show the illustration (straight method)

Year Revenue Operating Dep per Total Net Carrying

expense year expense income value
1 200,000 80,000 100,000 180,000 20,000 500,000
2 200,000 80,000 100,000 180,000 20,000 400,000
3 200,000 80,000 100,000 180,000 20,000 300,000
4 200,000 80,000 100,000 180,000 20,000 200,000

Dep = 500,000 –100,000

4

= 400,000
4

= 100,000/=

QUESTION 2
A bus valued 1,800,000 is estimated to have a useful life of 2,500,000Km and a
salvage value of Ksh. 300,000
What should be the depreciation change in a year when the bus traveled 300,000
kilometers?

Depreciation charge

Cost of the bus 1,800,000

Less salvage 300,000
1,500,000

Dep change per km 1,500,000

2,500,000

= 15 = 3 = 0.6%
25 5

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Depreciation charge for 300,000km

= 300,000 x 0.6

= 180,000KM

ACTIVITY
1. An asset which cost Ksh. 1,445,500 with an estimated residue value of Ksh.
45,000 and an estimated life of seven years is to be depreciated life of seven years
is to be depreciated by the sum of year digit method. What is the amount of
depreciation for the third year of use?

2. A diesel – powered compressor machine which cost shs. 70,000 are expected to
have a useful life of 120,000 hours. During the year ended 30th April 2005, the
compressor was operated for 4,800 hrs. Determine the depreciation expense for
the year.
Amendments
1. Useful life longer than anticipated
When useful life of an asset is longer than anticipated, the total provision for
depreciation should not exceed the total depreciation, as previously projected.
Therefore once the depreciable cost has been allocated to the expected years of
useful life, no further provisions are required irrespective of how many more
years the asset is in use.

2. Useful life is shorter than expected.

Where the problem is that the provision charged is less than the depreciation
suffered. Corrective action is applied in the assets disposal account.
The profit & loss account of the year during which the assets is out of use s
charged not only with the basic amount of depreciation but also with an extra
amount. This amount will make up the difference between expected and actual
depreciation.

3. Adjustment of depreciation provision rate

Revision of depreciation provision percentage will have to be made, if during the
life of the asset it becomes obvious that the provision in use is excessive or
inadequate. Each case has to be considered separately.
He should know how should inflation affect the measurement of depreciation
expense and how should it be disclosed in financial statements.

Depletion
It deals with you portion of cost assigned to property contain natural resources
that is applicable to the units removed from the property. Examples of such
resources are oil, coal or timber. The original cost of such asset is recorded in

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harmony with the cost principle. The cost is subsequently amortized over the total
production.

Development costs. - Expenditures include for example exploring, drilling,

excavating and preparation for the removal of the resources. They should be
amortized in properties to the removal of the natural resources.

Depletion base – The difference between the cost of acquiring the assets and the
residue value of the land after the natural resources has been removed.

Example
Assume that the wasting assets costs Ksh. 720,000 and that there are 1,200,000
recovered units of the resources. The residue value of the land is Ksh. 60,000.
The depletion per unit is calculated as follows.

Depletion (per unit) = Cost minus residue value

Total recovered units (Total potential)

= 720,000 –60,000
1,200,000

= 0.55 per unit.

If 300,000 units were removed in a year and 200,000 there sold, the cost of goods
sold would be determined as follows:-
Unit cost
Depletion cost (300,000 x 0.55) 165,000 0.55
Materials, labour & overheads 237,000 0.79
Depreciation, equipment 15,000 0.05
Total cost of production 417,000 1.39
Less ending currently (100,000 x 1,39) 139,000

Cost of goods (200,000 x 1.39) 278,000

Calculation
If 165,000 0.55
237,000 ?

= 237,000 x 0.55 = 0.79

165,000

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 OTHER METHODS
(a) Depletion = No. of units extracted x (C-S)
Total potential

(b) Depletion = No. of units sold x C-S)

Total potential

ACTIVITY
An item of equipment acquired at the beginning the current fiscal year at a cost of
sh. 600,000 has an estimated useful life of 5 years and a salvage of Sh. 60,000

Determine the annual depreciation for each of the 5 years of use the accumulated
depreciation at the end of each year and the book value of the asset at the end of
each year by:-
(a) The straight line method
(b) The double declining method

Q2 On 1st Jan 2000 Naivasha enterprises acquired a piece of land with mineral
right at a cost of Sh. 840,000. The mineral deposit is estimated to contain
1,000,000 tons of ore of uniform quality. It is estimated that 50,000 tons of ore
will be mined during the year. Give an entry to record depletion cost for the year.

Q3 Diggers Company recognizes Kshs. 100 depletion for each ton of ore mined.
During the current year the company mined 60,000 tons and sold 45,000 tons.
How much depletion should be recognized from the current year’s revenue?

DISPOSAL OF PLANTS ASSETS

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 values 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

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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.

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

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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 9 th y e a r 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
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.

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 (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 (80,000 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
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.

114
- 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 does 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.

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

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 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 lathe 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 lathe 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 intangible assets

(Patents, Copy Writes, Trade Marks,Franchise, Goodwill)

Intangible assets lack physical existence. They are classified into two.
(a) Intangible assets having a limited existence
(The service life of some intangible assets is limited by law or by contract e.g.
copyrights and patents. The cost of acquiring such asset is a mortised over their
useful life.

(b) Intangible assets having an indefinite existence. E.g. Trademarks

franchise.
The cost of their service is indefinite.

Advantages of intangible assets

• Monopoly position in business
• Good industrial relations.
• Technical expertise of employees of the firm

Similarities of tangible & intangible assets

a) Both have a potential economic benefit/ earning power
b) Both have value
c) Value of both is related to the continued profitable operations of
the business.

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The acquisition cost of intangible assets is debited to an asset account. The in
tangible is expensed through amortization the system reduction of lump-sum
amounts.
Amortization applies to intangible assets the same way depreciation does or
depletion to natural resources.
Amortization is generally computed on a straight line basis over the assets
estimated – useful life to a max of 40 years according to useful life of the
intangible assets.

Amortized expense is written of directly against the asset account rather than hold
in an accumulated amortization account
The residue value of most intangible assets is zero.

Example
Assume a business purchases a patent or a special manufacturing process legally
the patent may run for 17 years.

The business realizes however, that the new technologies will limit patented
process’s life to 4 years. If the patent cost is & 80,000, each year’s amortization
expense is
(80,000) = 20,000.
4
The balance sheet reports the patent has a $60,000 balance (80,000 – 20,000) after
two years a $40,000 balance and so on

Patent – are federal government grants giving the holder the exclusive right for
17 years to produce and sell an invention patented products include Sony compact
disk players like any other product, a patent may be purchased.

Example
Suppose a company pays $170,000 to acquire a patent, and the business believes
the expected useful life of the patent is only 5 years.
Amortization expense is $ 34,000 per year (170,000). The company acquisition
and amortization entries for the Patent are: - 5

Jan 1 Dr. Patent 170,000

Cr. Cash 170,000

31st Jan
Dr. Amortization expense 34,000
Cr. Patent 34,000
To amortize the cost of a patent

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 Copywriters
Are exclusive rights to produce & sell a book, musical composition film, out
work?
Computer software eg. Ms Windows copywriters extend 50 years and beyond to
the artist life.

Trade marks
Are distinctive identification of products or services e.g. co cola
industries.
The cost of a trade mark is amortization over its useful life not to exceed 40 years.
The cost of advertising and promotions that use the trademark is not part of the
assets cost but a debit to the advertising expense account.

Franchises
Privileges granted by a private business to or government to sell a product or
service i n accordance with specified conditions. City h o p p e r a r e
f r a n c h i s e business (Individual owners put their buses in one management and
earn certain agreed amount of money monthly

A leaseholder
Is a prepayment that a lessee (Renter) makes to secure the use of an asset from the
lesser (Land lord). The lessee debits the monthly lease payment to the rent
expense account.

Valuation and Amortization of intangible assets

Goodwill - intangible asset values whose source cannot be identified are usually
described under the general heading goodwill.

Regardless of its source the only acceptable evidence on accounting goodwill is

the ability to earn income in excess of the normal rate on the investment in the
business.

Goodwill is the difference between the value of a business entity taken as a whole
and the sum of the valuations attaching to its individual assets.

Positive goodwill exist when a firm is able to earn superior earnings, namely
when the value of its net asset is greater than shown in the books. Negative
goodwill will exist when the book value of the asset exceeds the value of the
company as a whole.

Recognition of goodwill
Goodwill can be recognized in the accounts under the following circumstances.

(a) When its amount is substantiated by arms length transaction.

118
 (b) When the entire net assets of a business or a substantial interest in the net
asset of a business have been purchased.

The following steps should be followed in estimating good will.

(i) Estimate the current fair value of the tangible and intangible assets and
deduct from this amount of liabilities.
(ii) Forecast the average annual net income that the business may be
expected to earn in the future.
(iii) Choose an appropriate rate of return for use in estimating the present
value of future earnings.
(iv) Compute the amount of expected future superior earnings.

Recognition of good will

Intangible assets values whose source cannot be identified
It‟s the ability to earn income in excess of the normal rate on the investment in the
business.

It‟s the difference between the value of business entity taken as a whole and the
sum of the valuation attaching to its individual assets. It allows a business to
enjoy a higher level of earning than normal.

There are two types of good will:

(a) Positive good will

(b) Negative good will

Positive good will exists when a firm is able to earn superior earning, i.e. when
the net asset is greater than shown in the books.

Negative good will exist when the book value exists when the book value of the
asset exceeds the value of the company as a whole.

Characteristic of good will

Computation

Positive good will

Assume Abdi company was acquired by Bellen company for Sh. 450,000/=
The fair market value of its sundry assets was Ksh. 510,000. The liabilities which
were also fairly valued amounted to Kshs. 80,000.

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Required:
(a) Compute the good will for the acquisition
(b) Make journal entries

Solution
(a) Purchase Asset 450,000
Sundry Asset 510,000
Liabilities 80,000
430,000

Good will 20,000

(b) Journal entries
Dr. Sundry Asset 510,000
Good will 20,000

Cr. Liabilities 80,000

Cr. Vendors A/C 430,000

To record acquisition of Abdi company by Bella Company

Negative Good will

Assume Clume Company acquires Brenda Company for Ksh. 840,000.
The fair market value of the company is Ksh. 1,700,000 and a liability of market
value of Ksh. 700,000/=.

Required
(a) Calculate the good will
(b) Prepare journal entries

Solution
Purchase consideration 840,000
Sundry Asset 1,700,000
Liabilities 700,000 1,000,000
(160,000)
Journal entries
Dr. Sundry Asset 1,700,000
Cr. Cash 840,000
Liabilities 700,000
Good will 60,000
(Excess of book value)

To record acquisition of Chuma company by Brenda

120
 Before a negative good will, it is recommended strongly that the separable non-
contract account be checked carefully to ensure the fair, values so as to reduce
overstating. If such items are found to be overstated, the excess book value over
cost amount should be allocated to reduce their assigned value.

Example
Abdi Company was acquired by Bella Company for Kshs. 840,000. The fair valu
of assets was estimated to be Kshs. 1,700,000and the liabities of Kshs. 700,000.
Further scrutiny reveals that the estimated value by Kshs. 90,000.

Make journal entries to record this acquisition.

Dr. Sundry Asset 91,700,000- 90,000)
Cr. Cash 840,000
Liabilities 700,000
Negative good will
Excess book value over cost) 70,000

Non- Purchased Good will

In the normal process of building up a business, an element of good will is
developed. It is referred to as internally developed good will or non- purchased
good will.

Difference between purchased good will and non purchased good will is that
purchased good will arises out of a particular pointing time. The existence of
internally developed good will as an asset lacks objective evidence.

In accounting therefore this two good will are treated differently eg. Non-
purchased good will should not be recognized in financial statements as an asset.

Reasons
• Recognition would be in violation of the cost principal.

• There has not been any direct or indirect disbursement of assets for the acquisition
of good will

• Any expense which might have indirectly contributed to the creation of good will
have been changed against past income statement as expenses. Any attempt to try
to allocate some of these expenses to good would be quite arbitrary.

Accounting for good will

There are two recommended methods for accounting good will.

1. Immediate write off

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 Purchased good will should be eliminated from the accounts by immediate write
off a reserve account. Writing off the good will against a reserve account does not
interfere with the results of operation. Existence of good will in the account will
make proposed customers to see as if they are cheated. They may not understand
the value of good will or what they are buying called good will.

2. Gradual Amortization.
Positive good will can be recognized in the accounts. I as allows a company to
carry positive good will as an asset and amortize it through the profit & loss
account over its useful economic life. Purchased good will should not be carried
in the balance sheet of a company as a permanent asset.

Example
Biko Company acquired Amigo fire years ago recognizing good will in the
amount of Shs. 150,000. The good will was estimated to last for 10 years and was
amortized on straight line basis. At the end of 5 years, it was felt that the carrying
value of the good will is only worth Shs. 20,000. At its estimated useful life is
2years.

Prepare journal entries.

Amortization Schedule

150,000 = 15,000 per year

10
Accumulate Amortized good will (5 years)
= 15,000 x 5
75,000
Book value Balance 75,000
New estimation of goodwill 20,000

Dr. Goodwill fair value 20,000

Amortized actulated goodwill 75,000
Losses of good will 55,000
Cr. Goodwill 150,000
To record Amortization & loss of good will.

NB: Characteristics

(i) Good will is strictly identified within an enterprise as a whole.

(ii) Good will as an asset is inseparable from that enterprise.

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 (iii) Good will is separated exchangeable

(iv) Its not predictable

(v) Value of good will fluctuates according to internal & external

factors.

(vi) Good will can be highly subjective (It’s unique to the value at the time) valid only
at a time).

(vii) Individual intangible factors which may result to good will cannot be valued. Eg.
Monopoly trade name, good customer relation, trademarks, etc.
Purchased Good will
Occurs when an entire enterprise is acquired as going concern. It is represented by the
excess cost over the fair market value. Its recognized from all other assets in the accounts
by the characteristic that it cannot be realized separately from the business as a whole.

Example (positive good will)

1. Questions
On Jan 2000, Gikomba wares acquired a patent for Kshs. 700,000. The patent has
a legal life of 11 years but is expected to have a valuable life of 7 years. Show
entries to record amortization of the patent for the fiscal year to 31st Dec. 2000.

Question 2
Nyakua carriers acquired a packaging patent for Kshs. 40,000 on 4 th Jan. 2001.
The patent had been acquired at book value after 2 years of use. The legal life of
the patent as per seller‟s record

Question 3
A company bought goodwill for Kshs. 96,000 based on 3 years excess earning of
B Company‟s net asset. B Company‟s net assets are Kshs. 400,000 and the normal
industry return is 12%. Determine B Company‟s return on its net asset per annum

Question 4
Mr. Author a prolific writer, receives commissions on his works on the following
fomula

Sales
Kshs. O - 150,000 - 0%
250,000 - 250,000 - 10%
400,000 and above - 1%

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During the year, 600,000 of his work were sold. Calculate the commission earned.

Question 4
Abdi Company was acquired by Bella Company for Kshs. 450,000. The fair
market value of its sundry assets was 510,000. The liabilities which were also
fairly valued amounted to Kshs. 80,000. The computation of goodwill following
the acquisition of this company is given below.

Purchase consideration 450,000

Sundry assets 510,000
Less liabilities 80,000
Net asset 430,000
Goodwill 20,000

Journal entry
Sundry asset 510,000
Goodwill 20,000

Liabilities 80,000
Vendors A/c 430,000

To record acquisition of Abdi Company by Bella company.

Negative goodwill
Example (Chuna company)
Purchase consideration 840,000
Sundry asset 1,700,000
Liabilities 700,000
1,000,000
Goodwill (160,000)

Journal
Dr. Sundry assets 1,700,000

Cr. Cash 840,000

Liabilities 700,000
Goodwill (excess of book value) 160,000
To record acquisition of chuma Company

Example 1
Suppose a company pays Kshs.170, 000 to acquire a patent on Jan 1, and the
business believes the expected useful life of a patent is 5 yrs.

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Amortization expenses = 170,000
5 yrs.

= 34,000
Entries

Jan. 1. Dr. Patent 170,000

Cr. Cash 170,000

31st Dec. Dr. Amortization expense (34,000)

Cr. Patent 34,000

To amortize the cost of a patent

Example 2
Suppose a business purchases a patent on a special manufacturing process, legally
the p a t e n t many run for 20 yrs. The b u s i n e s s r e a l i z e s h o w e v e r t h a t
n e w technologies will limit the patent process life to 4yrs.
If the patent cost 80,000

Amortization for each year = 80,000

4
= 20,000
The balance sheet reports the patent at its acquisition cost loss amortization
expense to data. After one year, the patent has 60,000 balance (80,000- 20,000).
After two years, patent value is 100,000 and so on.

Exercises
The perm store acquired a plot of land adjoining its store paying Ksh. 600,000 for
land and 280,000 for an old building located on the land. The net cost of
preparing the plot and to building luxury apartment after deducting amount
received on the sale of salvaged building materials was Ksh. 30,000. What
account would be affected by the above transaction?

Preparing financial statements from incomplete records

In practice, part of the information relating to cash receipts or payment may be
missing due to e.g. single entry, when this happens to totals will not agree. In
Kenya majority of businessmen run their businesses without keeping proper
records (because they are illiterate or semi-illiterate). In constructing the financial
statement, it would be done by making inquiries.

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Methods of preparing financial statement from incomplete records
Step 1- We look at the trader‟s balances or balance sheet at the beginning of the
period.
-We calculate the capital of business
A- L = C

Step 2– Look at the available balances at the end of the current period in order to
work out the capital balance.
-Any increase in capital comes about
(a) Through additional investment
(b) Through earned profit.

If not given any information about investment, we assume that the increase in
capital is a result of profits.

Example
Assume the following information.
Beginning capital 250,000
Ending capital 470,000
No additional investment or drawing reported.

Profit = Ending capital - Beginning capital

= 470,000 - 250,000
= 220,000

-Ending capital can also be calculated as follows.

Beginning capital + profit – drawings = Ending capital

Profit = Ending capital + drawing -Beginning capital

Suppose the following information is provided

Beginning capital 250,000

Drawings 25,000
Ending capital 470,000
Calculate profit

Beginning capital + profit – drawings =Ending capital

250,000 + P – 25,000 = 470,000
P= 470,000 – 250,000 + 25,000 = 245,000

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Statement of affairs
It‟s a form of a balance sheet, with one side giving estimates of assets and other
side giving estimates of liabilities and the owner‟s capital (equity).

The statement is drawn up both at the beginning of the period and at the end of
the period in order to compare the two capital balances.

Example
Mrs Otieno started a business on January with capital Kshs. 15,000. She did not
keep any books of accounts during year but was able to give her account. The
following figures:

Stock 10,500
Furnitures and fittings 14,250
Typewriter 6,900
Debtors 9,600
Cash 675
Bank loan 1,110
Creditors 8,559

Calculate her (1) capital at the end of the year

(ii) Calculate her total assets

Balance sheet/ statement of affairs

Assets
Furniture 14,250 Capital 15,000
Typewriter 6,900 Profit 17256
21,150

Current assets Liabilities

Debtors 9,600 Creditors 8,559
Cash 675 Bank loan 1,110
Stock 10,500
41,925 41,925

New capital will be:-

= 15,000 + 17,256
32,256

NB/ A statement of affairs are appropriate when there is a scanty of information

i.e. where information is un-available. We go ahead and to analyse the balances
accordingly.

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 Activity
Muoki started a business with Kshs. 25,000 during the year end ended 2005, he
had not recorded this information in the books. He informed his accountant the
following information.

Furniture and fittings 12,250

Stock 20,000
Typewriter 7,000
Debtor‟s 26,000
Loan 26,000
Cash 5,600
Creditors 7,800
Cash at bank 3,500

Prepare the statement of affairs and show.

(a) The capital at the end of the year
(b) The profit for the year.

Analyzing of cash balance

After getting the new capital, we need to analyze the cash balance by opening a
cash summary account.

In a cash summary account, we debit all the cash undertakings, showing a

different column for the bank.

-We break the cash into different sources:-

(a) Debtors
(b) Additional investment
© Sales of assets
(d)Income not from businesses

Payment is also broken in different categories

(i) Payment for rent
(ii) Payment for wages
(iii) Insurance expenses
(iv) Personal expenditure e.t.c

We should investigate the amount that has been banked and trace the use to which
cash has been put e.g. purchase of goods, payment of expenses e.t.c.
All personal drawings or private use not connected with business should be
debited to drawings account and credited to cash summary account.

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 Entries
1. Receipt cash from debtors
Dr. Cash summary A/c
Cr. Total debtor‟s a/c

2. Receipt of cash for sales of assets

Dr. Cash summary a/c
Cr. Relevant sales a/c
3. Cash payment
Dr. relevant revenue a/c
Cr. Cash summary a/c
(a) Payment for purchases
Dr. Total creditor‟s a/c
Cr. Cash summary a/c
(b) personal drawings
Dr. drawing‟s a/c
Cr. Cash summary a/c
(c) Payment of expenses
Dr. relevant expense a/c
Cr. Cash summary a/c

(d) Acquisition of assets through purchases

Dr. Asset account
Cr. Cash summary a/c

Cash summary A/C

Debtors xx Creditors xx
Assets xx Drawings xx
Expenses xx

Example
Record the following in the total / debtors A/C and find the amount of sales

Beginning balance of debtors Kshs. 30,000

Cash received 105,000
Debtors outstanding at the end of the year 36,000

Dr. Debtors A/C Cr

Bal b/f 30,000 Cash 105,000
Sales 111,000 Bal c/d 36,000
141,000 141,000

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Dr. Cash summary A/C CR

Debtors 105,000

Example 2
The following information was given to you.

-Creditors at the beginning of the period 200,000

-Payment during the year 350,000
-Closing balance at the end of the year 400,000

Find the amount of purchases

Creditors A/c

Cash 350,000 Bal b/f 200,000

Bal c/f 400,000 Purchases 550,000
750,000 750,000

Bal b/d 400,000

Example 3
Assume the following information
Opening stock 150,000
Purchases for the year 185,000
Gross profit is 20% of cost of sales = 30,000
Determine the closing stock

Cost of sales = opening stock + purchases – closing stock

G.P. = 30,000

Cost of sales = 100%

If 20% = 30,000
5
100% = 100 x 30,000
20

Cost of sales = 150,000/=

150,000 = 150,0000 + 185,000 - closing stock
185,000 = Closing stock.

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 Example 3
From the books Daniel Tototich, a rich trader in Mombasa, we are able to get
the following balances.
Statement of affairs Statement of
affairs
31st Dec. year 1 31st Dec. Year 2.
-Buildings 87,500 82,500
-Vehicle 32,000 27,500
-Stock 66,250 93,750
-Debtors 21,750 26,250
-Creditors 55,000 45,000

Other information
-He had paid additional funds into the business amounting to 112,500
-He had withdrawn Kshs. 92,500 from the profits of the year.

Required
(i) Prepare a statement of affairs at the year beginning and the end of the year.
(ii) Compute the profit of the year.

Solution
Balance Sheet Balance sheet

Capital 152,500 Buildings 87,500 Capital 185,000 Building 2,000

Vehicles 32,000 Vehicles 27,500
Liabilities
Creditors 55,000 Current Assets Liabilities Current
assets
Stock 66,250 creditors 45,000Stock 93,750
Debtors 21,750 Debtors 2 6,250
88,000 120,000
207,000 207,000 230,000

(i) Opening capital + additional investment + net profit – drawings =

Closing capital

Additional investment = 112,500

Drawings = 92,500

152,000 + 112,500 + Net profit – 92,500 = 185,000

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152,000 + 112,500 - 92,000 + 112,500 = - Net profit

185,000 + 92,000 – 152,000 + 112,500 = Net profit

277,500 – 264,5000 = Net profit
13,000 = Net profit.
Exercise
Mr.Maundu a trader in Kitui gave the following information.

Year 1 Year 2.
Furniture & fittings 50,000 46,800
Motor vehicle 80,000 76,000
Stock 40,000 93,600
Debtors 21,000 36,000
Creditors 55,000 46,000

He gave the following additional information.

-He had invested additional funds of Kshs. 102,000 in the business
-He had taken Kshs. 62,000 for personal use during the year.

Required
(i) Prepare a statement of affairs at the beginning and at the end of the period.
(ii) Compute his profit for the year.

Question
Mr. Mwendadu runs a retail shop in Kisii. From his records we get the following
details.
As his accountant, prepare his profit and loss account statement, balance sheet as
at 31st Dec. year

These facts were given:-

-He sold mainly on credit and during the year he received Kshs. 3,00 in cash and
Kshs. 57,000 through the bank.
-He withdrew cash amounting to Kshs. 3,120/= during the year.
-He paid the cheque Kshs. 43,200 to suppliers.
-He used straight line method depreciating method and a role of 10%. His fixed
assets were only furniture and fittings amounting to Kshs. 4,800 at the end of year
1.

Year 1 Year 2.
Stock 9,540 10,200
Expenses payable - 300
Debtors 6,600 7,920
Creditors 2,400 3,900

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 Cash at bank 6,700 18,300
Cash at hand 480 60

Prepare a cash summary account.

Question 3
Kimeto runs a retail shop in Mombasa. His records are as follows: -
-He sold mainly on credit during the year and received Kshs. 4,000 cash and
56,00 through the bank.
-He withdrew the cash Kshs. 3,200 during the year
-Paid suppliers by cheque 33,000
-Furniture had depreciated by 15% using straight line method of depreciation.

Year 1 Year 2
Stock 9,540 10,200
Debtors 6,600 7,920
Expenses payable - 500
Creditors 3,400 3,900
Cash (bank) 6,900 16,500
Cash (hand) 580 600

(i) Prepare a cash summary account

(ii) Statement of affairs at the end of the 2nd year. Calculate his net profit.
(iii) Make up the incomplete records for total debtors and creditors accounts.
Calculate the sales and purchases for the year.

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 LESSON SIX
PARTNERSHIP ACCOUNTS
Learning Objectives
By the end of this lesson, the student should have a comprehensive knowledge on
drawing up partnership accounts and adjustments of the accounts in case of
changes in partnership.

Introduction
Partnership is a relationship between two or more persons carrying on a business
in common view of making profits.

Features of a partnership
- An association of two or more person.
- There must be a business which includes trade, profession or occupation.
- The business must be carried on by all or anyone of the acting on behalf of
all.
- Business must be carried on for the purpose of earning a profit.
- It‟s an easy and simplest form of business to form. Has very few legal
formalities required. Maximum no. of people to form a partnership according to
partnership Act is 20.
- Minimum number of partners are 2 (partnership agreement can be written
or verbal or even inferred from the conduct of the parties.)
- It‟s generally recommended that a partnership construct agreement should
be written to lessen chance of misunderstanding and future disagreement.
- A partnership has a limited life
- A partnership forms a mutual agency on all partners while each partner is
himself a principal; he is also an agent for other partners.

Formation of a partnership
- Formed under the partnership Act Cap 29 minimum number of persons are
2 and maximum 20. Beyond 20, it shall be registered under the company act.
- When the two or more agree to form a business an agreement is made
which can be written or verbal or even inferred from the conduct of the parties.
- It‟s recommended to have the agreement written to avoid future
misunderstanding.
- The written agreement is referred to as Partnership deed.

Contents of partnership deed

-Location and name of the business
-Nature of the business
-Amount of capital contributed by each partner.

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 -Ratio of sharing profits
-Ratio of interest to be allowed on invested capital and rates of interest charged on
drawings.
-Salaries to be allowed to partners and other benefits.
-Procedure of admission and retirement of partners
-Procedure followed to the event of a dispute
-Preparation of accounts and their audit.

Dissolution of a partnership
A partnership has limited life. It may end at any time due to the following
circumstances/ reasons.

(i) Death of a partner / withdrawal of any member

(ii) Bankruptcy of any partner
(iii) Mental incapacity of a partner
(iv) The expiration of the period of time specified in the partnership
contract.
(v) Completion of work for which the partnership was formed.
(vi) Admission of a new partner which technically brings the old
partnership to an end.
In the absence of a partnership deed the following rights and duties of partners are
in force:-

Rights
-Every partner has a right to take part in the management of the business.
-Every partner has a right to be consulted on all matters affecting the business.
-Every partner has a right to access all records of the business.
-Every partner is entitled to share profits.
-every partner has the right indemnified on any act done by him on behalf of the
partnership.
-Every partner has a right to continue in the partnership business.
-Every partner must be consulted before a new partner is admitted.
-Every partner is a joint owner of the partnership property.
-Every partner has a right to retire in accordance with the partnership deed.
-No majority of partners can expel any partner unless such power is specifically
conferred by the partnership deed.

Duties of a partner
-Every partner is bound to carry on the partnership business diligently.
-To keep and render, true, proper and correct accounts of all transactions
(honesty)
-Every partner must act faithful in respect to other partners.

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 -Every partner is bound to indemnify the firm for any loss caused by his willful
neglect or fraud.
-A partner must not carry any compelling business nor use partnership property
for personal business. If he does so, he should surrender the gains made by such
business to the partnership.
-A partner is bound to act within the scope of his authority.
-No partner can transfer or assign his partnership interest to another person
without consent of the other partners.
-Every partner is bound to share profit and losses equally or in accordance to
some agreed formula.

Partnership property rights and profits

a. All property and rights and interest in property owned by the partnership
must be held and applied by the partners exclusively for the purpose of
partnership business.
b. The contribution of capital can be made by partners in any proportions a
din a manner as may be mutually agreed upon. In the event of dissolution, the
property may be shared in any proportions the partners agreed upon.

In absence of an agreement Cap 29, laws of Kenya stipulates:_

(a) All partners are entitled to equal share of profits and must contribute
equally towards losses.
(b) No partner is entitled to interest on capital subscribed before the
ascertainment of profits.
(c) No partner shall be entitled to remuneration for acting in the partnership
business.
(d) A partner is entitled to interest at 6% on any amount of capital which has
agreed to subscribe.
(e) Should give a public notice of his withdrawal
(f) A new member joining an existing partnership may or may not assume
liability for debts incurred by the firm prior to his admission.

Advantages and disadvantages of a partnership

Advantages.
-Opportunity to bring together sufficient capital to carry on a business.
-Opportunity to combine special skills of different partners.
-Formation of a partnership as much easier and less expensive than the formation
of a corporation.
-Partners enjoy more freedom and flexibility in managing the affairs of their
business than in corporation.
-Pays less taxes as compared to corporations

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 -partners may withdraw funds from business without necessity of legal formalities
found in corporations.

Disadvantages.
-A partnership has a limited life.
-Liability of partnership is unlimited
-Mutual agency makes a partner liable for acts of co-partners.
-A partner does not have such ready access to a wide pool of capital as a
corporation does.
-The number of partners is in most cases limited by statute.

Questions.
Q1. Explain the application of the concept of partnership property, rights and
interests in property in relation to a partner.

Q2. What is the significance of the partnership act given that a partnership is a
voluntary business venture?

Q3. What is the meaning of the term “unlimited liability” in relation to a

partnership?

Partnership accounts
Accounts of a partnership are prepared in the same way the accounts of other
business organizations.
The differences are found in the presentation and procedures in the owner’s equity
section.
-Accounting for partnership assets, liabilities follows the same principle and
procedure as for other forms of business organizations.

Partnership accounting requires maintenance of the following accounts.

(i) A separate capital A/c for each partner (account credited with the
capital subscribed by each partner)
Capital Ali Capital Bukari

Cash XX Cash XX

Drawings Ali Drawings Bukari

Cash XX Cash XX

(ii) A separate drawings account for each partner – (account debited with
all drawings made by the partner).

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(iii) A separate current account for each partner (account normally credited
with the annual share by profits, interests on capital and any other appropriation
of capital. It‟s also debited with interest on drawings. Where fluctuating capital
accounts are maintained this account is normally ignored.

Current Account
Dr
Cr
Ali Bukari Ali Bukari
Drawings xx Drawings Interest on Salary xx
xx Capital xx
Interest on drawings xx
Profit xx Interest on
Capital xx

(iv) Division of each year‟s net profit or loss among the partners.

Opening of accounts of a new partnership.

Most businesses are commenced with the investment of cash by the owners.

Example
Ali and Bukari commenced their partnership business on 1st April 2005. Ali
invested Kshs. 130,000 and Bukari Kshs. 140,000.

Record the transactions in the partnership books.

Capital A/C Ali Capital A/C Bukari

April 2005 April 2005

1. Cash 130,000 1. Cash 140,000

Cash Accounts
April 2005
1 Capital Ali 130,000
1 Capital Kukari 140,000

Journal entry
D r. Cash 270,000
Cr. Capital Ali 130,000
Cr. Capital Bukari 140,000
To record commencement of partnership business

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 A partnership may result where a sole trader invites another person to join him
into business. For this to be done, the traders business needs to be valued in order
for the assets and liabilities to be known.

Valuation of assets is important for:-

(a) Sole trader to know his equity
(i) The balance sheet on Chungu traders on 31st March 2005 was given as follows.
(b) To show any information that may have been left out (a good opportunity to
review the records).
© Incoming partner needs to be assured of the assets and liabilities are properly
recorded and valued.
(d) Incoming partner need to know the real equity of the sole trader before he
commits himself.
(e) Incoming partner needs to know at the liabilities and that they are properly
accounted for.

Example
BALANCE SHEET AS AT 31ST MARCH 2005
Assets
Fixed assets 135,000 Capital Chunga 300,000
Other assets 45,000
180,000

Current Liabilities
Current Liabilities
Stock 100,000 Creditors 50,000
Debtors 60,000 Accruals 30,000
Prepayments 20,000 Bank loan 20,000
Cash 40,000
400,000 400,000
st
(ii) On 1 April 2005, Donga was invited to join a partnership with Chunga
traders on payment of Kshs. 200,000 cash for 2/5 interest in partnership. The
following entry would be made.
Journal
Dr. Cash 200,000
Cr. Donga capital 200,000
To record Donga‟s investment into Chunga business

Ledger Entry
Cash A/c Donga Capital
2003 2003
April 1. Capital 200,000 April1. Cash 200,000
Donga

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 Example 2.
Assume that on 1st April 2005, when Donga was invited to join Chunga traders,
the assets and liabilities of the business were valued as follows.
-Fixed assets 245,000
-Other assets 35,000
-Stock 130,000
-Debtors 55,000
-Prepayments 15,000

The following liabilities were not recorded.

-Creditors for purchases 13,000
-Accrued utility expenses 5,000
-Bank interest 2,000
Solution
NB: The following entry would make to record Donga‟s investment of Kshs.
200,000
(a) The revelation of assets
(b) The recording of unrecorded liabilities.
Journal entry
Dr. Cash 200,000
Fixed assets
(245,000-135,000) 110,000
Stock (130,000 – 100,000) 30,000

Cr. Capital - Donga 200,000

Other assets (45,000 -35,000) 10,000
Prepayments (20,000 – 15,000) 5,000
Debtors (60,000 – 55,000) 5,000
Creditors 13,000
Accruals utility expense 5,000
Bank interest 2,000
Capital – Chunga 100,000

To record admission of Donga, Revaluation of assets and recording unrecording

liabilities
Cash A/C Fixed Assets

April 2000 Bal 240,000 Bal 1/4/2005 245,000

Debtors Prepayments
Bal 1/4/05 55,000 Bal 1/4/2005 15,000

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 Chunga Capital Donga Capital
Bal 1/4/05 400,000 Bal1/4/05 200,000

Creditors Accruals
Bal 1/4/05 63,000 Bal 1/4/05 35,000

Bank Loan Bank interest

Bal 1/4/05 20,000 Bal 1/4/05 2000

The following points should be observed

(i) The effect of revaluation of assets is to restate and record them in their
new value.
(ii) The unrecorded liabilities were brought into the accounts
(iii) The effects of the revaluation of the assets and the recording of
unrecorded liabilities were to increase Chunga‟s capital by Kshs. 100,000.

NB: The revaluation of assets could have been recorded formally in a new
account called Asset revaluation Account in Chunga Traders Books.
-Increase in the value of assets would be recorded as credits in the assets
Revaluation a c c o u n t a n d D e c r e a s e w ou l d b e r e c o r d e d a s d e b i t s .
Reason- increase in assets reduces the owners equity of the trader, decrease
increases owners’ equity

Dr. Assets Revaluation A/c Cr.

Other assets 10,000 Fixed assets 110,000
Debtors 5,000 Stock 30,000
Prepayments 5,000
Bal to chunga capital 120,000
140,000 140,000

Chunga‟s capital account would look as follows

Chunga – Capital

Bal 420,000 Bal 300,000

Asset revaluation 120,000

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 420,000 420,000

But Chunga‟s account after revaluation and admission of Donga shows 400,000
and not 420,000. This 20,000 difference is the amount that offset the increase in
liabilities which had previously gone unrecorded.

The alternative revaluation account would be:-

ASSET REVALUATION ACCOUNT

Other assets 10,000 Fixed assets 110,000

Debtors 5,000 Stock 30,000
Prepayments 5,000
Purchases 13,000
Accruals 5,000
Bank Interest 2,000
Balance Chunga‟s 100,000
140,000 140,000

Chunga and Donga partnership balance sheet as at 1st April 2005 would be as
follows.

Chunga & Donga partnership Balance sheet as at 1/4/2005

Assets Capital Chunga 400,000

Fixed Assets 245,000 Capital Donga 200,000
Other assets 35,000
600,000
280,000 Liabilities
Stock 130,000 Creditors 63,000
Debtors 55,000 Accruals 35,000
Prepayments 15,000 Bank Interest 2,000
240,000
440,000 Payable
Bank loan 20,000
120,000
720,000 720,000

NB/ when the partnership commences trading, all the necessary revenue and
expenses accounts will be opened in the normal way. At the end of the accounting
period the results of operations for that period are summarized in the familiar
trading, profit and loss account.
The profit earned in partnership consists of three district elements:-

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 (a) Compensation for the personal service rendered by the partners.
(b) Compensation or interest for use of invested capital
(c) Pure profit or reward for entrepreneur functions.

-Any salary authorized is regarded as a preliminary step in division of profits and

losses and not an expense of the business.

(A partner is considered as an owner of equated to the fair market value of the

personal services (salary fixed arbitrary without the arm‟s length bargaining
typical of employer- employee contracts.)

Besides the partner‟s capital account two other proprietorships accounts are
maintained for each partner. These accounts are the drawings accounts and the
current accounts.

Drawings account
Serves as the same purpose as a drawings account of a sole trader.
The following transactions are normally debited in the drawings account.

(i) Cash or other assets withdrawn by a partner

(ii) Payments from partnership funds of the personal debts of a partner.
(iii) Partnership cash collected on behalf of the partnership but retained by
the partner personally.

NB: Credit entries in this account are rare.

Current account
The salaries, profits, interests on capital and commissions to which a partner may
be entitled are credited in this account which is opened for each partner drawings,
and interest charge on partner‟s drawings are debited to this account.

A credit balance in the current account at the end of the financial year represents
the amount of undrawn profits. A debit balance represents drawings in excess of
partner‟s share of the profits.

Fixed Capital Accounts

This is an arrangement among partners whereby the capital account for each
partners remains at the same figure year after year. This figure represents the
agreed capital that each partner had to contribute.

Fluctuating capital
In this arrangement the distribution of profits would be credited to the capital
account and drawings and interest on drawings debited to the same account. In

143
 this case the balance of the capital account will change each year and hence the
term fluctuating capital.

Questions
Write short notes on the following:-
- Partners capital account
- Partners current account
- Drawings account
- Interest on capital
- Interest on drawings
- Partner‟s salary.

Example 2
Kamau gave the following information on 31st July 2007.
Assets
Fixed 100,000 Capital 100,000
Current assets Liabilities
Stock 50,000 Creditors 50,000
Debtors 20,000 co-op loan 30,000
Pre-payment 10,000 Overdraft 10,000
Cash 10,000
190,000 190,000

On 1st AUG 2009 John was invited to the partnership and he was to contribute
Kshs200,000 for 2/5 of the benefits.

Revaluation of items has shown the following:

Fixed Assets 140,000

Stock 60,000
Pre-payments 5,000
Creditors 55,000

Required
(i) What is Kamau‟s current capital
(ii) Open suitable ledger accounts.
(iii) Show how the assets revaluation account would look like.
(iv) Prepare Kamau and John partnership Balance sheet.

Journal entry
Dr
Cash 200,000
Fixed assets (140,000-100,000) 40,000

144
 Stock (60,000 - 50,000) 10,000
Creditors (55,000- 50,000) 5,000
Cr
Creditors (55,000 – 50,000) 5,000
Pre-payments (10,000 – 5,000) 5,000
Capital John 200,000
Capital Kamau 50,000

Kamau‟s capital = 100,000+50,000=150,000

(ii) Ledger A/cs

Fixed Assets Stock

Bal 1/8/07 140,000 Bal 1/8/07 60,000

Pre-payments Creditors
Bal 1/8/07 5,000 Bal 1/8/07 55,000

Debtors Cash

Bal 1/8/07 20,000 Bal 1/8/07 210,000

Co-op loan Overdraft

Bal 1/8/07 30,000 Bal 1/8/07 10,000

John capital Capital Kamau

Bal 1/8/07 200,000 Bal 1/8/07 150,000

iii) ASSET REVALUATION ACCOUNT

Dr Assets revaluation A/c Cr

Decrease in assets & Increase in assets & liabilities

Liabilities

Dr Assets Revaluation A/c Cr

Pre-payments 5,000 Fixed assets 40,000

Stock 10,000

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 Capital Balance 50,000 creditors 5,000
50,000 50,000

iv) John and Kamau Partnership

Balance sheet as at 1st Aug 2007

Fixed assets 140,000 Capital Kamau

140,000
Capital John
200,000

Current assets Liabilities

Stock 60,000 Creditors 55,000
Pre-payments 5,000 Loan co-op 30,000
Cash 210,000 Overdraft 10,000
Debtors 20,000
435,000 435,000

NB: the balance of 10,000 is the amount to offset the liabilities which had
previously gone unrecorded

Admission of a new partner

A partnership may admit another person to the business only with the consent of
all the other partners.

There are two ways in which a partnership can be admitted.

(a) Buying an interest in the partnership from one or more of the current
partner.
(b) By making an investment in the partnership through contribution of assets.

On the first instance, the consideration paid by the incoming partner is partly a
private arrangement between a buyer and the seller. The transaction involved does
not affect the total capital of the partnership.

In the second case, the incoming partner acquires equity in the firm by making an
investment of assets in the business. Both the capital asset and the total capital of
the business are increased by the amount paid by the new partner.

In both cases the incoming partner is created with his share of partnership interest
of the old partner(s) in the first instance the partnership interest of the old

146
partner(s) is reduced by the proportion sold to the incoming partner. In the 2 nd
case the new share of the partnership interest in accordance with the terms of his
admission. The partnership interest of the old partners is adjusted accordingly.

Admission by purchase of an interest from an existing partner

Here payment is made directly to the existing partner. This payment is not
recorded in the accounts of the partnership. The only change in the account is the
transfer of capital account owner to the incoming partner.

Example.
Assume Otula has a capital balance of Kshs.50,000 in the partnership of Boranga
and Chuka. Otula decides to sell two fifths of his equity to Doba at Kshs. 25,000
cash. The other partners agreed the admission of Doba.
2
/5 of 50,000 = 20,000

Dr. Otula 20,000

Cr. Doba 20,000
To record transfer of 2/5 of Otula‟s equity to Doba

Effects of the transaction of the partnership account

Otula A/C Doba A/C

Doba 20,000 Bal 50,000 Otula 20,000

Example 2
Assume Otula, Boranga and Chuka have capital balances of 60,000 each and they
agree to admit Doba into the firm by each selling ¼ of his equity to Doba.

Dr. Otula 15,000

Boranga 15,000
Chuka 15,000
Cr. Doba 45,000/=
To record admission of Doba to ¼ interest in the firm by purchase of ¼ of the
equity of each partner

Note the payment made by Doba, is not given for it‟s a personal matter between
him and the individual partners. If the firm had a good reputation, he may have
paid more than 45,000 and vise-versa.
After admission of Doba the total capital of the firm is Kshs. 180,000 in which
Doba has interest of Kshs. 45,000.

147
 Otula - 60,000
Boranga - 60,000
Chuka - 60,000
180,000
It should be noted that, it does not necessarily follow that Doba will be entitled to
a ¼ interest of partnership profit. Division of profits or losses will be accordance
with the new partnership agreement.

Otula A/C Borange

Doba 15,000 Bal 60,000 Doba 15,000 Bal 60,000

Chuka A/C Doba A/C

Doba 15,000 Bal 60,0000 Otula 15,000
Borange 15,000
Chuka 15,000

2. Admission by Contributing of Assets.

An incoming partner may acquire an interest in a partnership by contributing
assets into the business instead of buying an interest from the existing partners. In
this case is as the payment is made to the partnership, both the total assets and the
total capital of the firm are increased.

Example
Lukas, Makau are partners with capital of Kshs. 35,000 and 25,000 respectively.
On 1st June 2006, Ngugi invested Kshs. 20,000 cash in the business for which he
was to receive ¼ equity in the firm.

The entry record of admission will be:-

Dr. Cash 20,000
Cr. Ngugi capital 20,000
To record admission of Ngugi for ¼ interest of the firm
Admission of Ngugi brings to total capital to Ashes. 80,000 i.e (35,000 + 25,000
+ 20,000) in which he has ¼ interest

Effects
Partnership A/cs
Net Assets Ngugi Capital

Bal 60,000 Net assets 20,000

Ngugi 20,000

148
 Lukas Makau

ALLOWING BONUS TO FORMER PARTNERS

Sometime if the partnerships have a high population the new partner may be
required to pay a bonus to the existing partners as a condition for admission.
The amount agreed upon is credited to the partner accounts of the existing
partners in the agreed ratio.

Example
Juma and Kubaso are partners of a wholesale business. They agreed to admit
Luka if he agrees to pay substantial amount as bonus to existing partners. The
capital balances of Juma and Kubaso are determined as Kshs. 100,000 each. Luka
agrees to be taken into the partnership on payment of Kshs. 240,000 for ½ interest
is the capital of firm and ½ interest is the profit.

Record Juma admission into the business.

Solution
Net asset of the old partners 200,000
Cash entrustment 240,000
Net asset (New partnership) 440,000
½ Lukas interest (½ of 440,000) = 220,000
Bonus to add partners.
(240,000 – 220,000) = 20,000

20,000 will be divided among the partners (old) in their original sharing ratio
Entry for admission of Luka, assign Juma and Kubaso share profits equally would
be as follows:

Dr. Cash 240,000

Cr. Juma capital 10,000
Kubaso capital 10,000
Luka capital 220,000
To record admission of Luka with a ½ of interest in assets and profit

149
 Allowing bonus to the new partners
Bonus will be allowed to the incoming partners due to one of the following
reasons.
(a) A partnership may be in dire need of cash that the incoming partner
may be able to provide
(b) An incoming partner may be a person of extra ordinary ability, which
will make partnership, have a competitive edge.
(c) Incoming partner may possess advantageous business contracts that
would make business to operate more profitably.

Example
Bukenge & Chalo are equal partners each having a capital of Shs. 108,000.
The firm is desperate and needs degree to join them as partner on providing an
offer to a 1/3 interest in the firm on payment of Kshs. 72,000 in cash.

Make entries
Net asset (old partners) 108,000 x 2 = 216,000
New entrustment of new partnership = 72,000
Total capital of new partnership = 288,000

Capital of each partner in the new firm

Bukenge (288,000 x 1/3) = 96,000
Chalo (288,000 x 1/3) = 96,000
Dege (288,000 x 1/3) = 96,000

Journal entries to record Dege admission

Dr. Cash 72,000
Bukenge 12,000
Chalo 12,000
Cr. Dege capital 96,000
To record admission of Dege and allowance of a bonus to him

Goodwill
When a new partner is admitted into a partnership, good will, attributable to either
old partners or to the incoming partners may be recognized.
The amount of good will agreed is revealed in the partnership account as an asset
with corresponding credit to the appropriate capital accounts.

150
Example.
Asume Jedida and Kate admit Lida who is to contribute Kshs. 30,000. After
revaluation of the old partnership capital balances of Jedida and Kate are
determined to be 40,000 and 48,000 respectively.
The parties agree that the business is worth at least Ksh. 100,000.The excess of
Shs 100,000 over to the total of capital balances of Shs. 88,000 indicates existence
of good will of Shs. 12,000.
The different between the fair values of the net tangible asset is the overall value
of the firm will be allocated to the capital accounts of the original partners in
accordance with their profit sharing ratio.

Entries to record good will and admission of Linda

Dr. Cash 30,000
Goodwill 12,000

Cr. Capital Linda 30,000

Capital Jedida 6,000
Capital Kate 6,000
To record investment of Linda and goodwill divided equally by Jedida and Kate.

NB/ The presence of good will in financial statements of a firm is likely to eroke
criticism for example if a goodwill account shared a balance of Shs 100,000 and
the partner wanted to sell the good will of Shs. 25,000. This might create a filling
that the purchaser is being robbed. However the purchase might have been quit
content to pay Shs. 25,000 if good will account had never existed in the books.
(Prime reason for creating good will account is to deny an incoming partner from
sharing in the good will created by old partners, recognizing goodwill and writing
it off immediately would solve any future problem.)

Example
Anyango and Baya are partners who share profit equally and have capital of Shs.
50,000 each. They agree to admit Chege to ¼ interests in asset and a ¼ share of
profits upon paying investment of Kshs. 60,000

The computation of partnership asset will be as follows:-

Net asset old partners (50,000 x 2) = 100,000
Investment (Chege) 60,000
Total assets (of few partnership) 160,000
Chege share of equally (¼ of 160,000) 40,000
Bonus / good will for new partners
(60,000 – 40,000) = 20,000

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Entry (Bonus Method)
Dr. Cash 60,000
Cr. Capital Chege 40,000
Anyango 10,000
Baya 10,000

To record admission of Chege and recognize bonus to Anyango and Baya

Goodwill method
Net assets old partner (50,000 x 2) 100,000
Chege‟s investment 60,000
160,000

Total net asset of new partnership

Implied by Chege investment 180,000
(60,000 + 60,000 + 60,000)

Goodwill to old partners 20,000

Entries (Goodwill)
Dr. Cash 60,000
Goodwill 20,000
Cr. Chege capital 60,000
Anyango capital 10,000
Buyer capital 10,000
To record Cheges Admission and recognition of goodwill credited to Anyango
and Bayas capital accounts.

Partnership A/c after admission

Anyango A/C Baya A/C Chege A/C

Bal 50,000 Bal 50,000 Cash 60,000
Gw 10,000 Gw 10,000

Total net asset to = (60,000 + 60,000 + 60,000)

= 180,000

If the goodwill is written off and assume Anyango & Baya continue to share
profit and losses equally the partners‟ position would be.

152
 Anyango Baya Chege Total
Capital Bonus method 60,000 60,000 40,000 160,000
Capital Goodwill method 60,000 60,000 60,000 180,000
Write of goodwill (1/3 each) 6,667 6,666 6,667 20,000
Capital after write off 53,333 53,333 53,333 160,000

Assume the three partners agree on sharing profit in the ratio 4:4:2.
The goodwill method would then benefit Chage and injure both Anyango and
Baya because Chege‟s share of equity interest is not the same as his share of
profit.

Anyango Baya Chege Total

Capital Bonus method 60,000 60,000 40,000 160,000
Capital Good will method 60,000 60,000 60,000 180,000
Write of goodwill (4:4:2 each) 8,000 8,800 4,000 20,000
Capital after write off 52,000 52,000 56,000 160,000

The table indicates that, the use of the good will method in admitting Chege and
the subsequent write – off of the goodwill cause a shift of Shs. 16,000 from
Anyango and Baya to Chege

Hence - bonus method should be preferred to goodwill method in admission

of a new partner.

Example 3
Ayub and Bashir are partners and share profits and loses equally. They agreed to
admit Cheka to a 1/3 interest in net assets and 1/3 share of profit upon his
investment of Shs. 70,000. The time when Cheka was admitted the capital balance
of the partnership was Kshs. 100,000 each.

Compute Cheka‟s share in the partnership

Solution
Net asset old partner (100,000 x 2) 200,000
Cheka‟s investment 70,000
Total net asset (New partnership) 270,000

Cheka‟s share (1/3 of 270,000) 90,000

Bonus (90,000 - 70,000) 20,000

153
Entries
Dr. Cash 70,000
Bonus 20,000
Cr. Cheka 70,000
Ayubu 10,000
Bashir 10,000
To record admission of Cheka and recognition of bonus to Cheka

Good will method.

Net asset of old partner 200,000
Cheka,s investment 70,000
270,000
Recognition of Cheka‟s bonus a being worth Shs. 100,000 allows him a good will
of Kshs. 30,000

Entries
Dr. Miscelleous assets 70,000
Good will 30,000
Cr. Cheka‟s capital 100,000
Exercise

Question 1
On July 1st 2006 Musaimo and Nina who share profit 7 losses equally decided to
admit Otieno to a ¾ interest in the partnership net asset and profit and losses. On
this date, the capital account of Musaimo and Nina were as follows.

Capital account: Musaimo 360,000

: Nina 580,000
Current account: Musaimo 120,000
: Nina (40,000)
Drawings : Musaimo 125,000
: Nina 60,000

Otieno investment Shs. 300,000 cash in the partnership

Required
Prepare the necessary journal entries to record Otieno admission.

Question 2
Kisumu and Ndege are partners who share profit and losses equally. The
partnership account shows their capital a balance was 2,000,000 and 1,100,000

154
 respectively. They both agreed to admit Panda on condition he gets ½ interest on
the partnership net assets and profit and losses by investing 2,400,000

Required
Prepare the entire necessary journal entries to record Pang‟a‟s admission.

Retirement of a partner
When a partner retires or withdraws from the partnership for some reasons: -
(a) Remaining partners may purchase the withdrawing partners interest in
the firm in order to avert any interruption.
(b) Partnership may be dissolved.

NB/ On what should happen after withdrawal, this is a provision in the partnership
deed otherwise an agreement will be drawn between the remaining partners.

Entry requirement
Debit to the capital account of the withdrawing partners and credit to the capital
account of the partner acquiring the interest.

Example
Mutuku, Nyingi and Omolo are partners whose capital balances after revaluation of
assets are Kshs 85,000,Kshs110, 000 and Kshs 70,000 respectively. If Omolo
wishes to withdraw from the partnership and arranges privately to sell his interest
to Mutuku and Nyingi. Assume Mutuku and Nyingi acquires equal shares.

Required
Make entries.

Dr. Omolo capital 70,000

Cr. Mutuku Capital 35,000
Cr. Nyingi Capital 35,000
To record Omolo‟s retirement and acquisition of his interest to Mutuku & Nyingi

If the settlement with the withdrawing partner is made from the partnership asset,
the effect would be to reduce the assets and the capital invested in the firm.
The withdrawing parties could: -
(I) Loan the amount due to him to the partnership
(II) All or part of the amount due, repaid in lump sum or in
installments.

If loaned to the partnership the assets and liabilities of the firm should be adjusted
to reflect their fair current values.

155
 Any increments or losses in value should be allocated to the partners in their
profits and loss-sharing ratio.

Death of a partner
o The death of a partner legally dissolves the partnership immediately.
o The accounts of the partnership should be closed as of the date of the
death of the partner and profit earned up to the time of death allocated to the
partners in their profit and losses sharing ratio.
o The balance in the capital account of the deceased partner, if not paid
immediately is transferred to a liability count in the partnership books. The
surviving partners or dissolves it. Retirement or death does not release the
outgoing partner from his liability for debt contracted before his retirement or
death.

Activity
Mutira, Sikanja and Teju are partners sharing profits and losses equally, on 30th
April 2007, Mutira decided to retire from the partnership.
At this date the partnership net asset were Mutira Kshs.350, 000, Sikanja Kshs.
400,000 and Jeju Kshs 250,000 before determining Mutira‟s interest in the
partnership, the following adjustment were agreed Upon: -

Fixed asset to be increased by Kshs.180, 000, investment to be reduced by 45,000,

bad debt to be written off in the amount of 15,000 and a provision for bad debts of
Khs.8, 000 be made, Stock to be reduced Shs.60, 000.
In order not to disrupt the operation of the partnership, the partnership books were
to remain in use until the end of the fiscal year Dec. 31st 2007.
The net profit, which occurred evenly, during the period, amounted to Ksh.
400,000. The amount due to Mutira was retired in the fine as a long-term loan,
interest of 15% per annum.

Required
Determine the amount due to Mutira as at Dec 31st 2007.

Solution
Revaluation Account

Investments 45,000 Fixed assets 180,000

Debtors 15,000
Provision for bad Debts 8,000
Stock 60,000
To partner A/C
Mutira 17,333
Sikanja 17,333

156
 Tenju 17,333
180,000 180,000

(iii) Sharing of profit on the 1st 4 months (upon 30th April 2007)

Profit for the year 4000,000

Monthly profit (400,000 )

12

Profit for 4 months 400,000/12 x 4

= (400,000)
3
Mutiras profit due = (400,000/3 :- 3)

= 400000 x 1/3 )
3
Mutiras profit due = 400000
9
= 44,444/=

Total amount due to Mutira as at 31st Dec 2007

=350,000 + 17,333 + 44,444

= 411,777

Dissolution of Partnership

Dissolution of partnership means winding up of the business usually by: -

-Selling the assets
-Praying liabilities
-Distributing remaining cash

NB / The process of liquidation may be completed quickly or it may require

several months or years.
-When the partnership is to be dissolved, accounts should be adjusted and closed
and the net profit of loss for the final period transferred to the capital accounts of
the partner.

157
 The dissolution process usually begins with the sale of assets which is commonly
referred to as asset realization the gain or losses from realization of assets should
be divided among the parties in the profit of losses sharing ratio and entered in
their capital accounts.
The amount appearing as balance in partner‟s capital account at this point
represents each partner‟s claim
As cash is realized from the sale of assets, it is applied first toward the payment of
all creditors. After the payment of creditors the remaining cash is distributed
amongst the partners based on their ownership equities as evidenced by their
capital balances.
Any unpaid creditors may act to enforce collection from the personal assets of the
partners.

Distribution of loss or gain

Dissolution cannot be determined until the capital accounts have been adjusted for
the share of loss or gain on the realization of assets.
Partners may sometime choose to receive certain assets as vehicles, furniture etc.
rather than having them converted to cash. Such distribution of assets should be
made until after all possible losses and dissolution exposes have been taken into
account.
Failure to observe this, results to overpayment of a partner. If the partner cannot
return the excess payment, the person who authorized that payment may become
personally
Liable and be required to compensate the partnership for the loss.

The realization account

This is the account in which profit of loss realization of assets is calculated. The
profit or loss so calculated is transferred to capital accounts of the partners, which
will increase or decrease the balances of the partner‟s capital accounts.
The amount realize upon the sale of the assets are credited to this account, all
dissolution expenses will also be debited in this account.
The profit or loss realized will be transferred to partner‟s capital account.
In summary, the amount due to each partner is divided into three:-

(a) Capital be invested into the barriers

(b) His share of operating not profit/ loss less drawings
(c) His gains or loss from the realization of assets.

Distribution of cash
Partnership act cap 29, Kenya laws stipulate that cash after dissolution should be
used to:
o Pay all the creditors in full
o Pay of partner‟s loan, accounts.

158
 o Pay of partners‟ capital account.

If a partner has a debit balance in his capital account, any credit balance in this
loan account must be offset against the capital deficiency.

NB/ If partners loan account, cannot be repaid until all creditors have been paid in full.
The total amount of cash received by a partner will always be the same whether
his loan account is treated independently from his capital account or the two are
merged into the figure.

Illustration
Akamba, Borana and Chuka partnership share profits in the ratio 5:3:2 agreed to
dissolve the partnership on 31st July 2005. After discounting the ordinary business
of the firm and disclosing the accounts, the summary of the general ledger shown
below was prepared.

Akamba, Borana Chuka Partnership

Dr Cash 22,000
Non Cash Assets 128,000
Cr. All liabilities 18,000
Akamba capital 44,000
Borana capital 44,000
Chuka capital 44,000
150,000 150,000

It‟s assumed that all the new cash assets are disposed off in a single transaction
and all liabilities paid at once. Assets and liabilities would be affected by the
transaction.

Gain on Realization.
Assume all non cash assets are sold at Kshs.144, 000/=

A gain of Kshs. 16,000 will be realized. The gain will be divided among the
partners in their profit and loss sharing ratio. The liabilities are then paid of and
the remaining amount is shared to the partners according to the balances in their
capital accounts.

159
 TABLE SHOWING SEQUENCE OF TRANSACTION
CAPITAL ACCOUNT
Cash Non- Liabilities Akaluba Borana Chuka
Cash 5 3 2
Items
Balances 22,000 128,000 18,000 44,000 44,000 44,000
before
realization

Sale of 144,000 (128,000) 8,000 4,8,00 3,200

assets

Balance 166,000 -0- 18,000 52,000 48,800 47,200

after
realization

Payment of
liabilities 18,000 - 18,000

Balances 148,000 - 0- 52,000 48,000 47,200

Distribution - 148,000 -52,000 - 48,000 - 47,000

of cash
Accounting entries
Realization A/C

Sundry assets 128,000 Cash 144,000

Akamba 8,000
Borana 4,800
Chuka 3,200

144,000 144,000

CAPITAL ACCOUNT
Akamba Borana Chuka Akamba Borana Chuka
Bal 44,000 Bal 44,100 Bal 44,000
Cash 52,000 Cash 48,800 Cash 47,200
Realz. 8000 Realiz. 4800 Realiz. 3,200

-
52,000 48,000 47,000 52,000 48,000 47,000

160
 Cash A/C Liabilities A/C

Bal. 22,000 Liabilities 18,000 Cash 18,000 Bal. 18,000

Realiz. 144,000 Akamba 52,000
Borana 48,800
Chura 47,200

166,000 166,000

Journal entries to record various steps in dissolution

Sale of Assets
Dr. Cash 144,000
Cr. Sundry Asset 128,000
Gain on realization 16,000
To record the sale of sundry assets

Distribution of Gain
Dr. Gain in Realization 16,000
Cr. Akamba capital 8,000
Borana Capital 4,800
Chuka capital 3,200
To distribute the gain of profit sharing of 5:3:2 among partners

Payment of liabilities

Dr. Liabilities 18,000

Cr. Cash 18,000
Payment off the liabilities

Distribution of cash to partners

Dr. Akamba capital 52,000
Borana capital 48,800
Chuka capital 47,200
Cr. Cash 148,000
To distribute the remaining cash to purchasers according to the capital balances

Loss on realization and no capital deficiencies

161
Assume the non cash assets were sold for Kshs.108, 000 resulting to a loss of
Kshs.20, 000.

TABLE SHOWING SEQUENCE OF TRANSACTION

Cash Non cash Liabilities Akamba Borana Chuka

item 5 3 2
Balance 22,000 128,000 18,000 44,000 44,000 44,000
before
realization

Sale of
assets 108,000 -128,000 (10,000) (6,000) (4,000)
Division of
loss

Balances 130,000 18,000 34,000 38,000 40,000

-
Payment of 18,000 - 18,000
liabilities

Balances 112,000 0 34,000 38,000 40,000

Distribution -112,000
of cash -34,000 -38,000 -40,000

ENTRIES OF BOOKS OF A/C S

Realization A/C
Sundry asset 128,000 Cash 108,000
Akamba 10,000
Borana capital 6,000
Chuka capital 4,000

128,000 128,000

162
 CAPITAL ACCOUNT
Akamba Borana Chuka Akamba Borana Chuka
Realiz 10,000 Realiz 6,000 Realize. 4,000 Bal. 44,400 Bal. 44,000 Bal. 44,000

Cash 34,000 Cash 38,000 Cash 40,000

44,000 44,000 44,000 44,000 44,000 44,000

Cash A/C Liabilities A/C

Bal 22,000 Liabilities 18,000 Cash 18,000 Bal 18,000

Realiz. 108,000 Akamba cap. 34,000
Borana Cap. 38,000
Chuka cap. 40,000

130,000 130,000

Loss on realization: capital deficiency of one partner.

A deficiency in a partner‟s capital account makes a partner “Quasi debtor”, he

must pay the partnership sufficient cash to eliminate the deficiency: If he does not
pay, the available partnership cash will not be enough to pay other partners in full.
If the deficient partner cannot settle his deficiency either in full or in part,
whatever is not paid must be absorbed by other partners as an additional loss. In
most cases, the partnership deed provides that this loss shall be shared in the
normal profit sharing ratio of the partnership.

Illustration
Akamba, Borana and Chuka sold for Kshs. 20,000 incurring a loss of Kshs.
108,000 Akambas capital is changed with Ksh. 54,000 which 50% of Kshs.
108,000.

This amount exceeds his capital account balance by 10,000. This amount Kshs.
10,000 deficiency is a potential loss to Borana and Chuka. Akamba was able to
meet his deficiency.

Table of showing sequence of transaction

CAPITAL ACCOUNTS
Balances 22,000 128,000 18,000 44,000 44,000 44,000
before
realization

Sale of asset

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division of
Kshs. 108,000 20,000 -128,000 (54,000) (54,000) (21,600)
loss

Balance

Payment 42,000 18,000 -10,000 11,600 22,400

liabilities
-0-
Balance 18,000 -18,000

Cash paid by
Akamba 24,000 -10,000 11,600 22,400

Balance 10,000 +10,000

Balance 34,000 -0- -0- 11,600 22,400

distribution of
cash
- -11,600 -22,400
34,000

ENTRIES
REALIZATION A/C
Sundry assets 128,000 Cash 20,000
Akamba 54,000
Borana cap. 32,000
Chuka cap. 21,000

128,000 128,000

CAPITAL ACCOUNTS
Akamba Borana Chuka Akamba Borana Chuka
Realize 54,000 Realize 32,400 Realize 21,600 Bal 44,000 Bal 44,000 Bal 44,000
Cash 11,600 Cash 22,400 Cash 10,000

54,000 44,000 44,000 54,000 44,000 44,000

CASH A/c LIABILITIES A/c

Bal 22,000 Liabilities 18,000 Cash 18,000 Bal 18,000

Realize 20,000 Borana 11,600

Akamba Chuka 22,400

Capital 10,000 52,000
52,000

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Journal entries
Asset sale
Dr cash 20,000
Loss on sale 108,000
Cr Sundry asset 128,000
To record sale of sundry asset at a loss

Distribution of loss
Dr Akamba capital 54,000
Borana 32,400
Chuka 21,600
Cr. Loss of sale of asset 108,000
To record distribution of loss on sale of sundry assets

Payment of liabilities
Dr Liability (ies) 18,000
Cr. Cash 18,000
To record payment of liabilities

Settling a deficiency
Dr cash 10,000
Cr Akamba a/c 10,000
To record payment by Akamba to settle deficiency

Distribution of cash among partners

Dr Borana capital 11,600

Chuka capital 22,400
Cr cash 34,000
To distribute cash among partners

(B) Assume Akamba will not be able to contribute cash to cover his deficiency.
The loss is shared by Chuka and Borana in the agreed ratio.

TABLE SHOWING SEQUENCE OF TRANSACTION

CAPITAL
ACCOUNT
Cash Non-cash Liabilities Akamba Borana Chuka
items
Balance
before
realization 22,000 128,000 18,000 44,000 44,000 44,000

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Sales of
assets 20,000 -128,000 (-54,000) (- (-
32,000) 21,600)
Balance 42,000 -0- 18,000 -10,000 11,600 22,400

Payment of
liabilities 18,000 -18,000
Balances 24,000 -0- -10,000 11,600 22,400

Distribution
of Akamba
loss to
Boana & +10,000 (6,000) (4,000)
Chuka
Balance 24,000 -0- 56,00 18,400

Distribution
of cash (24,000) (5,600) (18,400)

Entries in the books (Partnership records)

REALIZATION A/C

Sundry asset 128,000 Cash 20,000

Akamba 54,000
Borana 32,400
Chuka 21,600
128,000 128,000

CAPITAL A/C
Akamba Borana Chuka Akamba Borana Chuka
Realize 54,000 Realize 32,400 Realize 21,600 Bal 44,000 Bal 44,000 Bal 44,000
Def. 6,000 Def. 4,000 Borana 6,000
Cash 56,000 Cash 18,000 Chuka 4,000
54,000 44,000
44,000 54,000 44,000 44,000

Cash Liabilities
Bal. 22,000 Liability 18,000 Cash 18,000 Bal. 18,000
Realize 20,000 Boran 5,600
Chukka 18,400
42,000 42,000

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Sale of assets
Dr. Cash 20,000
Loss 108,000
Cr. Record sales of sundry assets at a loss 128,000
Distribution of loss
Dr. Akamba capital 54,000
Borana Capital 32,400
Chuka capital 21,600
Cr. Loss or realization 108,000
To record distribution of loss on realization among partners

Payment of liabilities
Dr. Liability 18,000
Cr. Cash 18,000
To record payment of liabilities

Akamba deficiency
Dr. Borana capital 6,000
Chuka capital 4,000
Cr. Akamba capital 10,000
To record akamba deficiency among solvent partners

Distribute remaining cash

Dr. Borana capital 5,600
Chuka capital 18,400
Cr. Cash 24,000
To distribute remaining cash between Boran and Chuka

Exercise 1
Kagume, Suswa and Thirigwa are partners‟ sharing profit and loss in the ratio of
4:3:1 respectively.
Their balance sheet on 1st April 2006 is given below.

sh. Shs.
Cash 17,900 Creditors 35,000
Debtor 24,400 current A/C Kagure 5,200
Stock 30,000 Thirigwa 86,000
Investment 31,640 Capital Kagume 92,000
Fixed assets 29,320 Suswa 46,000
Equipment 54,040 Thirigwa 23,000
209,800 209,800

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Partnership decided to dissolve the partnership on this date. Suswa agreed to take
over of the stock at cash.
Kagume agreed to take over the balance of the stock, fixed asset and investment
for Sh. 120,000. Creditors were settled for Shs. 32,000 and debtors realized Sh.
21,120 equipment were sold at a profit of Ksh. 13,000

Required
Prepare the necessary accounts to dissolve this partnership showing clearly the
final settlement by or each partner.

Exercise 2
Kirach, Buret and Chuma are partners sharing profit in the ratio of 3:2:1
respectively on Dec. 31st 2006partnership
Trial balance is shown below.

Dr. Cr.
Land 200,000
Building 410,000
Equipment 190,000
Investment 80,000
Motor van 660,000
Capital account A 680,000
B 900,000
C 800,000

Current A/Cs A 150,000

B 20,000
C 80,000
Sales 1,097,000
Purchases 800,000
Purchase returns 80,000
Sale returns 120,000
Debtor/ creditors 280,000 245,000
Stock (1.1.2006) 200,000
Transport in 40,000
Sutarres & wages 400,000
General expenses 250,000

Drawing A 60,000
B 40,000
C 20,000
Discounts 90,000 150,000
Spoiled stock 110,000

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Investment income 8,000
Cash 4, 190, 00 4,190,000

Additional information
1. Closing stock was Ksh. 400,000
2. The market value of investment on this date was Kshs. 95,000
3. All fixed assets approximate their fair market value.
4. The partners decided to dissolve the partnership on this date.
5. The proceeds from all firm assets accounted to Kshs. 2,150,000 Dissolution
expenses were Ksh. 55,000

Required
1. Trading, profit and loss account for the year ended at Dec. 31 2006
2. Realization account.
3. Cash account showing distribution of available cash.

169
 LESSON SEVEN
COMPANY ACCOUNTS
Learning Objectives
This lesson introduces the students to the basics of company accounts. Students
are expected to understand how to prepare profit and loss account and balance
sheet. The student should also be able to determine the cost of work in progress
and prepare closing entries for a manufacturing company. The student should also
be able to determine the cost of work in progress and prepare closing entries for a
manufacturing company.

Introduction
The two main advantages of partnership are that:-
(i) Number of owners cannot exceed twenty, if they do, should registered
as a company
(ii) Partners has unlimited liabilities in that failure of business could result
in a partner losing both his share of business assets as also part of his private asset
as well.

-The forms of organization to which these two limitations do not apply are known
as limited liability companies.
-The capital of a limited company is dividing into shares. This can be of any
denomination such as $ 5 Shares or $1 shares.
-To become a member of a limited company, alternatively called a shareholders
person must buy one or more shares. He may either pay in full for the shares that
he takes or the shares may be partly paid for, the balance to be paid as and when
the company may arrange.

-The liability of a member is limited to the shares that he holds, or when a share is
only partly paid he is also liable to hare to pay the amount owing by him on the
shares.
Thus even if the company losses all its assets a member's private position cannot
be touched to pay the company's debt, other, than in respect of the amount owing
on partly paid shares.
Companies thus fulfill the need for the capitalization of a firm where the capital
required is greater than that which twenty people can contribute, or where limited
liability for all members is disserved.

There are two main types of companies

(a) Private Company
(b) Public Company

Private company - Characterized by the Following features:-

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 (i) Minimum shareholders are two and maximum are 50 excluding
employees.
(ii) Shares and debtors are not freely transferable.
(iii) I must of them run by family members.
(iv) Allowed to function with only one director.
(vi) Required to prepare the audited book of accounts but not to publish
them.
(vii) Business starts immediately after inception.

Public Companies - Characterized by the following features:-

(i) Minimum shareholders are 7 without maximum.
(ii) Shares and debentures are transferable.
(iii)Affairs run by elected persons known as directors. Shares have no direct say
in the affairs of company management.
(v) Company is perpetual and not affected by death or bankrupted of a
shareholder
(vi) Company must prepare a audited books of account and publish them.
(vii) Allowed by low to advertise and invite public for purchase of shares.

NB/ The name of a public company must either end with a word public limited
company or abbreviation LTD.
A limited company is an artificial person that can own property, make contract
due and beside

DIFFERENT BETWEEN A COMPANY AND A PARTNERSHIP

COMPANY PARTNERSHIP
1. Formed under the companies 1. Formed under the partnership act of
act of 1964 laws of Kenya 1964 laws of Kenya.
2. Have limited liabilities 2. Have unlimited liabilities
3. Companies are perpetual. 3. Partnership does not have continuity
4. Owners are shareholders 4 Owners are partners.
5. Rewards are dividends 5. Reward is profits

SHARE CAPITAL
A shareholder of a limited company obtain his reward in the form of a share of the
profits known as dividend. The directors‟ consider the amount of profit and
decide on the amount of profit which are placed to reserves out of the profit
remaining, the director then propose the payment of a certain amount of dividend
to be paid. Shareholders can not propose a high dividend than that proposed by
the directors they can however propose a lesser dividend although the action is
very rare. If directors propose no dividend at all, shareholders are powerless to
alter the decision.The dividend is expressed as a percentage which is later
subjected to taxation before release to the shareholders.

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 Example
Ignoring income tax, a dividends of 10% in firm A on 500,000 ordinary share of
Kshs. 1 each amount to (10% of 500,000) = 50,000
In Firm B, Dividends 6% on 200,000 ordinary shares of Kshs. 2 each amount to:
(6/100 of (2x200, 000) = (6% of 400,000) = Kshs. 24,000
Shareholders who have 100shares in firm A would receive dividends:-

Share dividends
500,000 - 50,000
100shares =?

100 / 500,000 x 50,000 = Kshs 10

A. Shareholders who have 100 shares in firm
B. Would receive dividends:-
200,000 shares- 24,000/=
100shares - ?
100 x 24,000 = Kshs 12/=
200,000

FORMATION OF A LIMITED COMPANY

Chapter 486 of the laws of Kenya have set out the legal requirements for the
formation, regulation and dissolution of companies act three types of companies
can be registered.
(a) A company limited by shares.
(b) A company limited by guarantee
(c) An unlimited company

For the purpose of these studies, we share consider companies limited by shares.
Under this consideration, there the company is regulated by two documents
(a) Memorandum of association
(b) Article of association.

Memorandums of association - A document that define the relationship of the

company with outsider consist of the following clauses / contents.

i. Name clause - Name of the company should end with the word Limited. It
reminds the people that the company has limited liabilities. Any name can be used
so long it does not corresponds to the already existing ones and does not give a
false idea of the nature of the company.
ii. Situation clause / location of the registered office where official notices
and other communications can be received and sent. Its important to mention the
country in which office is situated.

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iii. Objective clause/objects for which the company was formed - outlines the
activities that the company engage in. This serves as a warning that these are the
only activities authorized company cannot act beyond this objective and such
dealings are considered void by the law.
iv. Capital clause of the company - states the share capital one wishes to
have of the amount of the capital to start the business and the division of this
capital in to units. It includes.
(a) Total amount of the share capital
(b) Units under which it is dividend.
(c) Value of each share.
(d) Type of shares.

v. Liability clause - states the liability of members and how it will be.
vi. Declaration clause - states the desire of the promoters to form themselves
into a limited company. It must be signed by the shareholders at least 7 persons in
public companies and 2 for private companies.

THE CAPITAL OF LIMITED COMPANIES

The owner capitals in a limited company are shareholders.
Shares - unit of companies‟ capital that can be in denominated units of monotony
value e.g. Sh. 5, Shs 10 or whatever deemed appropriate.
The face value of the shares is called normal value or per value.
Share may be issued at a value higher than face value i.e. at a premium.
E.g. Shs. 10 ordinary shares issued at Kshs 15. Shares are not normally issued at a
discount.

Authorized, issued, called up and paid up share capital

i) Authorized (or nominal capital) - maximum amount of shares capital that a
company is entitled to issue by its memorandum of association.
ii) Issued capital - Amount of a company's authorized share capital that has been
actually issued.
iii) Un issued capital -Part of authorized share capital which is not been issued.
iv) Subscribed capital - Is the amount of issued capital which has been taken up
or subscribed for by shareholders.
v) Called up capital - Portion of issued shares capital which has been called up
for payment.
vi) Paid up capital - Part of the issued share for which the shareholders have
actual paid.

Type of share capital

The ownership of a company is through shares, which have been issued by the
company. The accounting entries for shares issued for cash are.
Dr. cash xx

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 Cr. Share capital A/C xx
To record sale of shares for cash
There are three main classes of shares which a limited company issue.
(a) Ordinary shares
(b) Preference shares
(c) Deffered shares.

1) Ordinary shares / Common shares,

Shares that do not carry fixed reforms investment. Dividends are only given
depending on the profit made. Have no fixed rate of the dividends the amount of
profit allocated to them depends upon what remains after all creditors and
shareholders with prior claim have been paid.
-There is no special security for such investment other than the soundness of the
company. They are the most common and important class of shares.

-Shareholders are the real owners of the company and carry a voting right which
confer control over the company affairs through the right to elect its directors.
Usually companies declare only a portion of the net assets as divided and the
balance of the undistributed profits to provide additional capital for investment
purpose.

2). Preference shares.

Shares that carry fixed returns dividend. They earn fixed rate of dividend.
Dividends are paid after creditors but before ordinary shares. They assume a
proportionally lesser risk than the common shares.
They do not carry any voting rights. Divided into three main clauses:-

1. Cumulative preference shares - share in additional to the above rights have the
right to arrears of dividend carried forward to subsequent years until paid.
This means that if the dividend in any period is not paid, then it is not lost but
carried forward and the fall back log must be paid before any ordinary dividend
are paid.
Preference shares are generally cumulative unless expressively issued as non-
Cumulative

2. Redeemable preference shares – Shares that can be bought back. These shares are
offered were a company needs capital for a reasonable short period. Irredeemable
shares cannot be bought back.

3. Participating preference shares. – These are shares that may participate in the net
profit available for distribution after other shareholders have received a started
dividend percentage. Thus, these entitle the holders to receive a further dividend

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 in addition to the fixed rule e.g. a further. 2% for each 10% for the ordinary
dividend in a good year.

Deferred Shares
These shares rank for dividends after all other clauses of shares. They have the
opposite characteristics of preference shares for these shares are not entitled to
receive dividends until ordinary shareholders have been paid a started dividend
percentage. These shares are also called founder or management shares, under
conditions of prosperity, differed shares attract a considerable high dividend rate.

Dividends
Dividends represent the mean story which profits from a company are shared to
the shareholders. Profits are accumulated from the sale of merchandise and profit
realized from the fixed assets.
Any accumulated losses will be deducted from accumulated profits in order to
determine the amount available for distribution.

NB/ Share premium, the revaluation of fixed asset, reserves and capital
redemption reserve are not available for appropriate as dividends.

Dividend may be of two types

(a) Interim divided
(b) Final dividend.

Interim dividend- Dividend declared by directors during the course of the year in
respect of the same accounting period.

Entry.

Dr. Dividend A/c xx

Cr. Bank xx

The dividend account is closed off to the profits and loss account at the year end.

(i) Final dividend – Dividend declared by the shareholders at the annual

general meeting of the company on recommendation of the board of directors.

NB/ The power to declare interim dividend rest in the Board of directors of the
company and the power to declare final dividends rest in the shareholders.
Generally the final dividend as shown as a current liability in the balance sheet

175
 Entries
Dr. Profits and loss account xx
Cr. Dividends proposed account xx
It should be noted that preference shares have preferential claim over ordinary
shares to any distributable profits made by the company. Dividends may be
expressed in either of the following two ways:-.

As Kshs. X per share

As Y percent, which means:-
Y % of the nominal value of share in issue

Example
BAT limited issued share capital of 100,000 Kshs. 20 ordinary shares which were
issued at a premium of Kshs. 4 per share.

The directors propose to pay a dividend of Kshs. 200,000

Required.
State this dividend in (i) as Kshs. X per share or Y% of the nominal Value of
share in issue

Solution
Share capital
100,000, Ordinary
(100,000 x 20 (fully paid) 2,000,000

Premium (100, 000 x 4) 400,000

2,400,000

The directors may propose the 200,000 dividend either as

(i) A dividend of Kshs.2 per share or
(ii) A dividend of 10%

Calculations
(a) 100,000 shares -Ksh. 200,000 dividend
1 Share ?

1/ 100,000 x 200,000 = Kshs. 2

Dividend = Ksh. 2 per share.

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 (c) NB- Premium on share not distributed as dividend.

2,000,000 = 100%
200,000 = ?

200,0000 x 100 = 10%

200,000

Dividend policy
In recommending dividends the directors will have to consider the following:-
- The availability of distributed funds
- Availability of cash to pay the dividend
- The level of revenue reserves with respect to the company‟s objectives on
working capital expansion and other activities.
- The effect of dividends on the market price of the share
- The company goals with respect to dividend growth and capital growth.
- The impact of taxation arising from the payment of dividends.
Retained profits – The balance which remains on the P & L account after
deducting dividends. It‟s also referred to as undistributed profits. They are the
earnings for ploughing back into the business and represent an important source
of funds for the company for investment.

Reserves- These represents the ordinary shareholders interest in the company

over and above nominal value of the ordinary share capital.
There are two categories of reserves.
(i) Revenue reserves
(ii) Capital reserves

(i) Revenue Reserves- These represents undistributed trading, profit i.e

they are the accumulated retained earning Revenue reserves can be distributed as
dividend if the company wishes to do so especially, in periods when losses are
incurred and there are no profits to be appropriated as dividends.

Entries
Dr. Profits and loss A/C xx
Cr. Reserves account xx

Other non-statutory reserves – The company may decide to set up other

reserves especially for specific purposes such as for replacing plant and
machinery, legally these reserves remain available for distribution of dividends if
the company so wishes.

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(i) Capital reserves- These represents earnings which are not associated
are with normal trading activities. There are three common forms of capital
reserves.
(a) Share premium account
(b) Revaluation reserve
(c) Capital redemption reserve.

a) Share premium A/C- This is a reserve which comes into being when a
company issues shares at a price in excess of their nominal revenue.

Example – If a company issued 200,000 ordinary shares of kshs. 10 nominal

value at Ksh. 20 per share. The premium of the shares would be (20-10) = Ksh. 10
.
The share premium account constitute capital of the company and therefore once
established cannot be distributed as dividend.

(b) Revaluation reserve- A company may revalue its fixed assets. Any increase in
the value assigned to the asset will result to corresponding increase to capital.
This increase in capital represents unrealized profits and cannot be distributed as
dividends. Where the fixed is sold, the amount realized can now be distributable.

Example
ABC Ltd. purchased a freehold land and building for Ksh. 1,000,000 in 2006.
The property‟s net book value depreciation of the building is now Kshs. 950,000.
A professional valuation by Karanja valuers gave the property to value Ksh.
2,500,000 in 2008.

The directors wish to reflect this in the accounts.

Solution
The revaluation surplus

(2,500,000 – 95,000) = 1,550,000

Accounting entries
Dr. Freehold property 1,550,000
Cr. Revaluation reserves 1,550,000

Balance sheet
Fixed assets

Free hold
After valuation 2,500,000

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 Less reserve
value 250,000

Revaluation
Reserve 1,550,000
c) Capital redemption reserve
Reserves set up for redeeming its shares which may be ordinary or preference
shares. The shares must have been situated on issue as redeemable at a specified
price.
Capital redemption reserve cannot be used to distribute dividends.

NB/ Reserves are just a form of capital and reflect the shareholders claim on
assets on the company.
All reserves are owned by the ordinary shareholders who are the real owners of
the company.

Reserves and provisions

Although both reserves and profits involve setting aside funds, the nature of
reserves is completely different from that of provisions. A reserve is an
appropriation of distributed profits for a specific purpose such as replacement of
machinery whereas provision is an amount charged against revenue as an
expense. A provision is set up to take care of those charges, such as doubtful
debtors, audit fees, depreciation e.t.c.

Bonus Issue
Bonus shares are shares issued to shareholders, without payment as means of
capitalizing accumulated retained earnings in proportion to their existing
shareholdings.

-The issue of the bonus share is made by transferring from the reserve an amount
equivalent to the nominal value of the share issued.

-The issue of Bonus do not change the asset structure of the company nor the
value of the individual investor‟s interest in the company change. It‟s purely a
paper exercise which raises no funds as no payment is made for these shares,
since this is a capitalizing transaction, any reserve including capital reserve may
be used.

Rights issue
A right issue is an issue which offers the existing shareholders the right to
purchase in cash new shares in the company in proportion of their existing share
holdings. The price of the new shares is often below the current marked valued.

179
The existing shareholders may sell these rights if they do not wish to take
advantage of them, in which case the proportion of their interest in the company
will change.

Rights issue is different to Bonus issue in that it raises new funds from
shareholders in respect to the new shares issued. It also gives rise to a change in
the value of the individual investor‟s shareholding in the company if the
shareholder sells the rights issue instead of exercising them himself.

Company formation expenses

These are expenses incurred when a company is newly set up. These expenses can
either be debited in the share premium account if any or debited to the profit and
loss account as an expense.

Loan capital
It is common for companies to make provision for borrowing in the articles of
association. Borrowing powers would include borrowing funds on a long term
basis. Long- term borrowing is called Loan Capital.

One important form of long term capital (loan capital) is the Debenture
A debenture –a written acknowledgement of a debit incurred by a limited
company.
Debentures are usually divided into units rather like shares so as to attract a wider
range of investors.
-Debentures carry fixed rate of interest which is normally paid semi annually.
-Debentures may be secured or unsecured, totaling charge or fixed charge.
They could also be convertible to ordinary shares.
-Debenture should be limited to the company‟s capital structure to such an extent
that interest charges can be met without driving the company into insolvency.
-Debenture interest is normally stated as a percentage of nominal value of the
debentures.

Differences between debentures and shares

Debentures Shares
1)-Debentures holders are 1) -Shareholders are members of the company
Creditors
2)-Received dividends appropriated from profits
2)-Receive interest which is a fixed
charge against revenue.
3)-Shares are not secured.
3)-Debentures are secured
4) - Shareholders cannot enforce payment
of dividends
4)-Debenture holders can enforce
payments of interests

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 5) Ordinary shares generally non-redeemable
5)-Debentures are generally
redeemable 6) -Ordinary shares cannot be converted to
debentures
6)-Debentures can be converted
To ordinary shares 7) -Shareholders especially ordinary have
Voting rights
7) -Debenture holders have no voting
rights

Redeemable debentures
Most debenture stock is redeemable which means that after some time the
company must pay back the money it had borrowed on predetermined terms.
Redemption of debentures can be made “at per” at the denominated nominal value
of the debenture stock. Debentures can be irredeemable.

Example
Payment of Kshs.100 must be made per Kshs.100 of debentures are reduced at a
price higher than the nominal value i.e. at a premium e.g. Kshs.110 to be paid per
Kshs.100 debenture in issue which is a redemption premium of 10%.
Convertible Debenture
Debenture may carry an option to convert into shares in addition to the option of
redemption. The decision to convert into shares will depend on such factors as the
performance of the company, the market price of the shares, and the solvency of
the company at the time of choice.

Sinking Fund
In order to ensure that a company is in a position to repay borrowings on a due
date, cash must be made available by establishing a shrinking fund also referred to
as debenture redemption reserve.

This is a device or method of saving up the funds necessary for the redemption of
debentures. Here a company sets aside annually an amount of cash which together
with any income earned to produce the amount of repayment. The annual
allocation is an appropriation out of profits to a sinking fund account.

Taxation
Companies pay corporation tax which is a provision for taxed based on the profit
for the year. This is shown in the books as follows.

(a) The charge for corporation tax on profits for the year is shown as a
deduction from net profit before appropriations in the P & L account.
(b) Tax payable is shown in the Balance sheet as a current liability.

ENTRIES

181
 Dr. Profit and Loss A/c
Cr. Corporation tax payable a/c

When tax is payable

Dr. Corporation tax payable a/c
Cr. Bank A/c / cash A/C

The accounts of a company

The accounts of a limited company are similar to a sole trader except in a few
items in the profit & loss account and balance sheet.

Main Difference
(a) Corporation tax which is a provision for tax base in the profit for
the year.
(b) Dividends which is distribution of profits to share holders and is
equivalent to drawing A/C of a sole trader.
(c) Transfer reserves which are an appropriation of profits so as to
ensure that the amount is kept in company and not distributed as dividends.

P and Loss of a sole trader

Sales xx
Cost of sales
Opening stock xx
Purchases xx
xx
Less closing stock xx
xx
G.P. xx

Less expenses xx
Net profit xx

P&L COMPANY (LTD)

Sales xx
Cost of sales
Opening stock xx
Purchases xx
xx
Closing stock xx
Cost of sales xx
Gross profit xx

182
 Less expenses xx
Net profit before tax xx
Less corporation tax xx
Net profit xx
Less divided xx
Transfer to reserves xx
Retained profit for the year XX

BALANCE SHEET
The main difference in the balance sheet of a sole trader and a company is in the
capital section.
The following items appear in this section:-

a) Share capital which shows the ownership of the company through shares
which have been issued.
b) Reserves which comprises of the cumulative total of the company is
retained profits and represent the retention of an amount of profit of the company.

c) Debentures which are long term liabilities.

Balance sheet (Sole trader)

Capital xx
Profit for the year xx
Less drawings xx
Proprietors interest/
New capital xx

BALANCE SHEET (LIMITED COMPANY)

Share capital xx
Reserves xx
Share holders fund xx
Debentures xx
Capital employed xx

Example
Oyagi and Kuti Ltd is a trading company whose trial balance at 31st Dec 2007 is
as follows:-

Dr Cr
Ordinary shares of Ksh 2.50 920,000

183
 Share premium 160,000
Profit & loss 1st Jan 2007 29,000
8% debenture payable 2012 280,000
Leased property at 1,080,000
(Accumulated depreciation)
on property 244,000
Equipment & at cost 580,000 192,000
(Accumulated depreciation on machinery)
Stock at cost 1st Jan 2007 188,000
Trade debtors 218,280
Balance at bank 75,600
Trade creditors 119,700
Sales
1,820,800
Purchases 1,303,800
Rates & Rents 92,840
Salaries & Wages 157,200
Distribution Cost 67,600
Debenture interest 22,400
Telephone postage 3,200
Proceeds of equipment sold 20,000
3,786,920 3,786,920

The following are additional information.

1. Stock at cost on 31st Dec 2007 was 250,280/=.

2. The proceeds of equipment sold relates to equivalent which had cost Sh

80,000 and accumulated depreciation of 56,000 and was sold on 2nd Jan 2007. The
equipment is still included in the trial balance. Depreciation of Ksh100,000 as to
be provided being 20% of the cost
3. A bonus issue of one share for ten holders was made during the year for
share premium cost. This has not been seconded in the accounts. The new shares
rank for dividend in the current period.

4. Lease hold property was revalued on 1st Jan 2007 to Sh 1,200,000. This is
to be depreciated over 40yrs.

5. Corporation tax of Shs32,000 is to be provided.

6. A dividend of Shs 0.10 per share is proposed.

Required
A trading Profit &loss account for the year ended at 31 st Dec 2007 and the
balance sheet at the same date.

184
Solution

Oyugi & Mkuti, Company Ltd

Trading, Profit & Loss A/C for the year ended 31st Dec 2007
Sales 1,820,800

Less
Cost of sales
Opening stocks 188,000

Purchases 1,303,800
Less closing stock 250,280
1,053,520
Cost of good sold 1,241,520
Gross profit 579,280
Expenses
Depreciation leased (property) 1year 1,200,000 30,000
40 years
Prov. Dep. Equipment 1 year 100,000
Depr Equip 56,000
Rates & rents 92,840
Salaries 157,000
Distribution cost 67,000
Debenture interest 22,400
Telephone & postage 3,200
Net profit C/f 50,840
579,280 579,280
Net profit b/d 50,840
Share premium 160,000
Revaluation reserve 364,000
Profit before tax 574,840
Less tax 32,000
Profit after tax 542,840
Less divided app.
(0.1 of 950,000)/2.5 38,000
Transfer to reserve 504,840

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 OYUGI & KUTI COMPANY LTD
BALANCE SHEET AS AT 31ST DEC 2007

Liabilities
Fixed assets Creditors 119,720
Leased house hold 1,080,000 Debenture interest
Property (8% of 280,000) 22,400
Depreciation 244,000 Capital
835,000 Ordinary 920,000
Premium 160,000
Profit from trading a/c 29,600
Revaluation value 364,000 8% Debenture 280,00
1,200,000
less dep 1yr 30,000
1,170,000
Equipment & machinery 580,000 Revaluation 364,000
Sale 80,000 Proceed for equipment 20,000
500,000 384,000
Less dep (192,000- 56,000) 136,000
444,000
Dep equip 100,000
344,000
Current Assets
Stock 118,000
Debtors 218,000
Cash (20,000 + 24,000) 44,000
Bank 73, 600
453, 600 Profit from operations xxxxx
1,967,600 1,967,600

Accounting for manufacturing enterprises

Introduction
Manufacturing is defined as the transformation of raw materials to finished
saleable products.

To take account of the manufacturing activity, the following information is

required:-

(a) Manufacturing of factory costs.

(b) Stock of raw materials / work in progress.
(c) Finished goods.

186
 (d) Manufacturing plant and equipments.

Manufacturing accounts – It contains all the expenses associated with the

factory cost of production. It therefore attempts to build up the product cost in a
logical way.
Raw materials are entered first, direct labour second, Followed by other direct
cost (costs which are directly as a result to a change in output)
These three components i.e.

(i) Raw materials

(ii) Labour costs are referred to as prime cost.
(iii) Direct expenses

Factory overheads consist of all costs or expenses which cannot be directly

identified with a product and therefore cannot be included under direct materials
includes depreciation on factory building and equipments, factory rents and rates,
factory costs such as wages of factory supervisors, cleaners, timekeepers and
indirect materials such as factory supplies and lubricant for machines.
These costs may be summarized as follows.

Direct materials
Direct labour Prime cost Production costs
Direct expenses
Plus
Factory overhead

Expenses Total cost.

Plus
Administrative expenses
Selling and distribution
Expenses

Illustration
Manufacturing accounts
To the year ended 31st Dec. 2004
Direct materials
Opening stock 4,000
Purchase 16,000
20,000
less closing stock 3,000

187
 Cost of sales / direct materials consumed 17,000
Direct labour 24,000
Direct expenses 1,000
Prime cost 42,000

Plus
Factory overheads
- Factory power 1,000
- Factory heat &1st 1,000
- Plant depreciation 6,000
- Building depreciation 7,000
- Indirect wages 2,000
- Rates and insurance 1,000
Total Factory overhead 18,000
Factory production cost consumed 60,000

Plus
Work in progress
Opening stock 4,000
Loss close stock 2,000
Work in progress stock 2,000
Total cost of goods 62,000

(a) Inventories for a manufacturing business

At any given moment, a manufacturing firm would have three types of stock
accounts.
(i) Stock of raw materials A/C
(ii) Goods in progress A/C
(iii) Finished goods A/C

So a manufacturing firm has 3 separate inventories above.

a) Raw materials inventory – Represents the unused portion of the raw materials
on hand and not committed to the production process.
b) Work in progress- Partially completed goods on hand in the factory.
C) Finished goods inventory-show the cost of goods, unsold goods on hand which
are already completed in production

Example
Prepare manufacturing accounts from the following information made available
from the books of Mandebe manufacturing for the year ended 2004
Kshs.

188
 Purchase of raw materials 1,000,000
Carriage inwards 130,000
Returns outward 45,000
Returns inward 70,000
Sales of finishing goods 3,500,000
Production wages 200,000
Office wages 72,000
Production salaries 140,000
Office salaries 350,000
Audit fees 92,000
Deprecation on plants and machinery 94,000
Deprecation of other fixed materials 112,000
Factory rates & rent 49,000
Factory power 128,000
Sales promotion 137,000

You are also given the following information

1. Stocks as on Jan 20 x 4 were
Raw materials 100,000
Work in progress 17,000
Finished Goods 160,000

2. Stock on Dec 31st 20 x 4 were

Raw materials 113,000
Work in progress 14,000
Finished goods 180,000

Solution
MADEBE MANUFACTURING LIMITED
MANUFACTURING ACCOUNT FOR THE YEAR
ENDED DEC 2004
Raw materials
Opening stock 100,000
Purchases raw material 1,000,000
Add carriage in 130,000
1,230,000
Less return outwards 45,000
Raw materials available 1,185,000
Less closing stock 113,000
Raw materials used 1,072,000
Direct Labour Production wages 200,000
Prime cost 1,272,000
Factory overheads

189
 Salaries production 140,000
Power (factory) 128,000
Depreciation plant machinery 94,000
Rates & rent 49,000
Total factory overhead 411,000
Production cost / Factory Cost 1,683,000
Add
work in progress
Opening stock 17,000
Less closing stock 14,000
3,000
Total cost of finished goods 1,686,000
transferred to trading A/C

TRADING ACCOUNT
Trading A/C occurs after the sale of production made by the producer.
The main objective of a manufacturing enterprise is:-
(a) To make saleable product
(b) To sell the product.
Instead of buying saleable products from outside, suppliers, the manufacture
makes the products himself.
After the manufacturing A/C has been prepared, trading account must be prepared
to account for the sale of product to the customer.
In trading A/C, there is no purchases listed the finished goods manufactured are
transferred to the warehouse to await sale at their manufactured cost. The
manufactured cost become part of the calculation to determine the cost of sales
and this is used to determine the gross profit in the trading account.
Illustration
Layout of a proforma trading A/C

TRADING ACCOUNT
FOR THE YEAR ENDED 31ST DEC. 2005

Sales 200,000

Cost of sales goods

- Opening stock of finished goods 10,000
- Factory cost of finished goods produced 62,000
72,000
- Less closing stock of finished goods 8,000
- Cost of goods sold 64,000
Gross profit 136,000

190
Illustration 2
Mandebe LTD gave the following information on 31st Dec 20x6
MANDEBE MANUFACTURING LTD
TRADING ACCOUNT FOR THE YEAR ENDED 31ST DEC 20X6

Sales 3,500,000
Return inwards (70,000)
Net sales 3,430,000
Cost of goods sold
Opening stock finishing good 160,000
Factory cost of finished goods b/f 1,686,000
1,840,000
Less closing stock of finished goods 180,000
Cost of goods sold 1,660,000
Cross profit 1,770,000

Profit and loss account

The P&L of manufacturing firm is similar to that of a trading firm with exception
of purchase that are replaced by the factory cost of finished goods produced.

Trading, Profit & loss accounts for the year ended 31st Dec 2006
Sales 200,000
Cost of goods sold
Opening stock of finished goods 10,000
Factory cost of finished goods produced 62,000
72,000
Loss closing stock of finished goods 8,000
Cost of sales 64,000
Gross profit 136,000

Loss expenses
- Selling and distribution expenses 12,000
- Administration expense 60,000
- Financial expense 16,000
Total expenses 88,000
Net Profit 48,000

Manufacturing profit
A manufacturer may be viewed as operating two businesses jointly. i.e that of a
producer, and that of a trader. In this case the performance of each of these
activities may have to be determined.
The profit from manufacturing may be shown by transferring the goods produced
to profit and loss account at market price, i.e. the price at which key could have

191
been purchased from outside suppliers. This profit shows the advantage gained
from producing (making) rather than buying from outside suppliers.

Assume in the illustration one (1) above, that the market value of goods produced
is Ksh. 70,000
The manufacturing account would read:-
Factory cost of finished goods 62,000
Add manufacturing profit 8,000
Market value of goods 70,000

Trading, profit and loss A/C after the above

Sale 200,000

Cost of sale sold

Opening stock of finished goods 10,000
Market value of goods complete 70,000
80,000
Less closing stock finished 8,000
Trading profit 72,000
128,000
Manufacturing profit 8,000
Gross Profit 136,000

THE BALANCE SHEET

The balance sheet of a manufacturing firm will show similar items as those of
trading enterprises except under current asset where there will be three different
classes of stocks namely :- Raw material stock
-work in progress
- finished goods

Illustration
BALANCE SHEET
AS AT 31ST DEC. 20X6
Fixed assets cost Dep. Book value
Land and building 200,000 200,000
Plant and equipment 68,000 51,900 17,300
Furniture 4,600 2,760 1,840
219,140
Current assets

192
 Stock at cost
Raw materials 3,800
Work in progress 7,600
Finished Goods 11,400
22,800

Debtor 23,000
Less provision for bad debts 1,150
21,850
Prepayment 200
Bank 1,350
46,200
Less
Current Liabilities
Creditors 21,500
Accruals 1,400
22,900
23,300
Working capital 242,440

Financed by
Capital 212,780
Net profit for the year 44,660
Less drawings 15,000
29,660
242,440

Exercise
Q1. Briefly explain the following terms.
(a) Manufacturing A/c
(b) Prime cost
(c) Manufacturing profit
(d) Work in progress

Q2. The following information was extracted from Kamato manufacturing factory
at Nyeri.
Opening stock raw material 25,000
Purchases of raw materials 423,000
Indirect materials 24,200
Factory power and lighting 20,800
Carriage inwards 26,700
Returns outwards 50,000
Direct wages 190,300

193
Factory rents and rates 13,500
Repair to plant 25,200
Production salaries 159,900
Closing stock of raw materials 58,200
Cost of plant and machinery 400,000
Depreciation on plant and machinery
at 10% on cost

Required
Prepare manufacturing account of Kimeto manufacturing factory.

Questions 3
Njenga owns and manages a small manufacturing business in Nairobi City. The
following trial balance was provided o 31st Dec. 2002

Dr. Cr.
Administrative expenses 37,590
Sales promotion 3,000
Cash 1,350
Debtors 5,000
Capital ( 1 Jan 20 x1) 12,780
Sales 207,360
Factory direct wages 17,000
Factory indirect wages 4,000
Drawings 15,000
Office furniture‟s and fittings 4,600
Factory power , heating and lighting 4,000
Plant and machinery 69,200
Plant hire 1,000
Provision for bad debts 800
Provision for depreciation
(at I Jan 20 x 1)
Plants and machinery 34,600
Furniture and fittings 2,300
Selling expenses 16,600
Raw materials purchases 57,000

Stock at cost
(at I Jan 20 x1)
Raw materials 2,000
Work in progress 4,000
Finished goods 6,000
279,340 279,340

194
 The following informal was also provided

1. Stock 31st Dec. 2002 was value at cost as follows

Raw materials 3,800
Work in progress 7,600
Finished goods 11,400

2. Expenditure on heat and lighting in the apportioned between the factory

and the office in the ratio 9 to I.
3. Expenses for rent in to be shared between the factory and office in the
ratio of 3 to 2.
4. provision for bad debts is to be made at 5% of debtors outstanding at 31st
Dec. 2002
5. Accruals at 31st Dec. 2002 are
Factory power 400
Rent 1,000
Prepaid salesmen‟s
car insurance 200

These items were not included in the trial balance shown above.

6. Depreciation on plant and machinery is at 50% per annum using reducing

balance method.
7. Depreciation on furniture and fittings was at 100% per annum using the
straight line method.

Required.
Prepare Njenga‟s manufacturing trading, profit and loss accounts for the year
ended 31st Dec. 2002.

195
 LESSON EIGHT
ACCOUNTS OF NON-PROFIT MAKING ORGANISATIONS
Learning Objectives
The student should be able to appreciate the differences between accounts of non-
profit making organizations and other entities.

Introduction
Non- profit making organizations includes: - schools, hospitals, clubs and other
voluntary bodies. The non-profit making organizations have a characteristic of
both a business entity and a governmental unit. The non-profit making
organization's goal is not to generate profits, but to provide services to the society.

-A NPO is also like a business entity in that it does not have automatic sources of
funding, but must generate resources from :-
(i) Donations
(ii) Grants
(iii) Debts and
(iv) User charges

-Donors and creditors generally want to assess the NPO financial health and
management decisions before making contributions or granting loans.

Characteristics of non profit making organizations

-Significant amounts of organizations‟ resources come from provides who expect

to receive neither profit nor economic benefit.

-The primary mission of the organizations to provide services to the society.

-There is no ownership interest that can be sold, transferred or redeemed NPO are
owned by its members or by the public and run by a board of directors or trustees.

-Assets are often restricted either to a particular use or for use during a certain
period of time.

-Non profit organizations can be categorized as follows.

(i) Voluntary organizations

(ii) Colleges, schools and universities
(iii) Hospitals and other medical institutions
(iv) clubs

196
 Goals of financial reporting by Non-profit making organizations

Unlike for profit business, NPO are not expected to generate net incomes for their
activities. However, they are expected to use contributions for their intended
purposes, choose activities which effectively further organizations goals, and
operate efficiently. Readers of NPO financial statements should be able to find
evidence on these dimensions of performance.

Readers of NPO statements may be:-

-Resources contributors
-Lenders
-Organization members
-Watchdog groups
- Managers
-The general public.

Watchdogs groups and contributors are interested in what part of each coin
contributed is spent on administration and fund raising and how much is spent on
services for members or the community.

-Lenders are concerned with the organizations ability to meet obligations as they
come.
-All external readers are interested in whether the activities of the organization are
above board and within the organization‟s mission.

Reporting Concepts for Non-profit making organizations

Objectives of NPO:-
(a) Financial information should be useful to contributors, lenders, suppliers
and organization members in making resource allocation decision.

(b) Financial information should be useful in evaluating the services provided

by the organization and in determining its ability to continue as a going concern.

(c) Financial information should be useful in assessing the performance of

management.

FASB, concluded that net assets (equity) section in non-profit making

organizations balance sheet be partitioned in three classes.

(i) Permanently restricted net assets – contributions that impose

restriction of us indefinitely.
(ii) Temporary restricted net assets

197
(iii) Unrestricted net assets.

Likew ise it’s concluded that non-profit making organization presents the
following statements.
(a) Statement of financial position
(b) A statement of activities
(c) A statement of cash flow
GASB ( Government A c c o u n t i n g S t a n d a r d B o a r d ) w a s c r e a t e d i n 1 9 8 4
for
establishing financial accounting standards for all state and local governmental
bodies, and the FASB is responsible for establishing financial accounting
standards for all other business organizations.

a) A STATEMENT OF FINANCIAL POSITION

Present assets, liabilities and net assets of the organization. Important features
are:-
-Net assets must be presented in the three net asset categories
discussed above
-Assets and liabilities are classified according to liquidity
-Basic concepts of business.

-Accounting are followed in valuing assets and liabilities except for investments
in debt and equity securities where SFAB 124 requires that fair value be used for
all investment in debt securities and investments in equity securities with
determinable fair value.

-Cash or other assets donor – restricted in a way that limits their use over the
long-term such as for acquisition or construction of a long-term asset, should be
separated in a different category from unrestricted cash and other assets that are
available for current use.
b) STATEMENT OF ACTIVITIES- Shows change in each of the net assets
categories during the year. Important features:-
Inflows – from contribution, sales e.t.c are reported as increases in the appropriate
net asset category e.g unrestricted donation are reported as increase in unrestricted
net assets
-Contributions restricted by the donor for use in particular purposes are reported
as increase in temporally restricted net assets e.t.c.

-As donor- imposed temporary restrictions are met either because of time passed
or the contributions were used for intended purpose. These items are shown
separately on the statement of activities as net asset released from restrictions.

198
-Expenses are reported as reduction in the unrestricted net assets category only.
Expenses included are – Administrative costs, membership development costs,
fund raising costs, salaries, rent, and depreciation investment debts.
c) THE STATEMENT OF CASH FLOW – shows the format, the cash flow
from operations, investing and financing except that contribution and income
which are donor restricted for long-term purposes.

Example
Statement of financial position

NON PROFIT ORGANIZATION

STATEMENT OF FINANCIAL POSITION
AS AT 31ST DEC. 2004
Assets
Cash and cash equivalents xx
Accounts and interest receivable xx
Inventories and prepaid expenses xx
Contributions receivable xx
Short – term investment xx
xx
Non- current assets
-Assets restricted to investment
In land, building and equipment xx
-Long-term investments xx
xx
Total assets xxx

Liabilities
Current liabilities
Accounts payable xx
Refundable contributions xx
Grants payable xx
xx
Non –current liabilities
Non payable xx
Annuity obligators xx
Long-term debt xx
Total liabilities xx
Net assets xx

Unrestricted xx
Temporary restricted xx
Permanently restricted xx

199
Total Net assets xx
Total liabilities and net assets xxx

B/ Exhibit of statement of activities

Non profit organization STATEMENT OF

ACTIVITIES FOR THE YEAR ENDED
AT 31ST DEC. 20044

Unrestricted Temporary Permanent Total

Revenues against
Contributions xx xx xx xx
Fees xx
Investment income xx xx xx
Net realized & unrealized
Gains on long-term
Investment xx xx xx xx
Net assets released from
Restrictions xx xx
Satisfaction program
Restrictions xx (xx)
Expiration of time
Restriction (xx) xx
Total revenue, gains (A) xx xx xx xx

Expenses & losses

Child care programs xx xx
Family support programs xx xx
Community education xx xx
Administrative xx xx
Fund raising xx xx
Total expenses (B) xx xx

Change in net assets xx xx xx xx

(A-B)
Net asset, beginning
xx xx xx xx
Net asset end of year xx xx xx xx

200
 Accounting for clubs, societies and associations
There are entities that are not incorporated under the companies whose objectives
are to provide services to members or to pursuit one or a number of activities
rather than earning of profit
Such entities are small in both membership and in wealth
They can also be very large so long as subscriptions are charged; there is need for
financial records, the minimum being a cash book or a petty cash book
Clubs which rely on this minimum package often confine their annual accounts to
a receipts and payment account showing the amount received and paid during the
period.

Dr. EXPENDITURE Cr. INCOME

Alternative layout
Income xxx

Expenditure xxx

Surplus/ deficit xxx

The argument in favor of accrual accounting apply to clubs as well as to profit

making entities and most large clubs do produce financial statements based on
accrual accounting.
Many clubs produce income and expenditure accounts and balance sheet but rely
on an incomplete record system
Club members:
o Probably take active part in running the club than the shareholders
o Clubs do not trade, if they do, trading forms only part of their activities
o Clubs obtain income from members of different sources

Highlight the differences between club members and club shareholder

Example
A Tennis club runs a tournament which has the tournament expense and entry
fees. The expense of the tournament can be shown as follows;
Expense of the tournament 1,500
Less Entry Fee 200
Total Expense 1,300

201
Special funds
Clubs may receive donations or other forms of income which are tied to a specific
purpose, e.g a political association may have a special election fund or it may
wish to make a transfer from its general funds to the special fund account. A
member may decide to put his fund to a bequest account such that in case he dies
all his claims in the club is treated as a special fund to the club. This is part of the
club donation but only accounted after death of the member.
Entry for donation
Dr. Cash 105
Cr Election fund 105

Entry for donation after death of a member

Dr. Members Account 2000
Cr Bequest Account 2000

If the transfer is made from the accumulated fund,

Dr. Accumulated fund 1,200
Cr. Election fund 1200

Example

Southern Branch of the centre party balance sheet as at 31st Dec 2019

Accumulated fund balance 2009 120,000

Add Excess of income over expenditure 50,000
Less transfer to election fund 20,000
30,000
150,000

Election fund
Balance 1 Jan 2009 30,000
Add Donations 18,000
Transfer from accumulated fund 20,000

38,000
68,000
Less Election Expense 15,000
52,000
202,000
Outstanding subscriptions
A person wishing to resign from the club does not bother to send the secretary a
formal letter of resignation. The member just does not bother to pay the next
subscription. Because of this practice many clubs take credit for subscriptions

202
 received in cash and ignore the outstanding subscriptions even if they use accruals
accounting for all other items.

Life subscriptions and entry fees

The problem with these items is that they cover more than one year. The best way
to deal with them is to estimate the life expectancy of the member and to credit
the amount to the income and expenditure account over that period. This is rarely
done, and life subscription and entry fees may either be credited to the period in
which the member joins, or credited to that account over an arbitrary time period,
or credited direct to the accumulated fund

Question
How should life subscriptions be dealt with in theory? How are they dealt
with in practice?

Practical Example
The treasurer of Jumia Golf Club has prepared the following receipts and
payments for the year ended 30th Sept 2006
Receipts Payments

Balance at Oct, 2000 682 Functions 305

Subscriptions 2,930 Repairs 146
Functions 367 Telephone 67
Sales of land 1,600 Extension of clubhouse 600
Bank interest 60 Furniture 135
Bequest 255 Heat and Light 115
Sundry income 46 Salary and wages 2,006
Sundry expenses 104
Bal C/d
Bank 2,300
Cash 102
2,402
5,940 5,940

The treasurer has applied the following additional information:

1) Subscription received included shs. 65,000 which had been in arrears, at 30th
Sep 2005 and shs. 35,000 which had been paid for the year commencing 1 st Oct
2006.
2) Land sold had been valued in the club‟s books at cost shs. 500,000
3) Accrued expenses

Items Oct 2005(shs. 30th Sep, 2006(shs. 000)

203
 000)
Heat and light 32 40
Wages 12 14
Telephone 14 10
58 64

4) Depreciation is to be charged on the original cost of assets appearing in the

books at 30th sep 2006 as follows;
Building 5%
Fixtures and fittings 10%
Furniture 20%
5) the following balances are from the club‟s book at 30th sep 2005
Shs. 000
Land at cost 4,000
Building at cost 3,200
Building provision for depreciation 860
Fixture and fittings 470
Fixtures and fittings provisions for depreciation 82
Furniture at cost 380
Furniture provision for depreciation 164
Subscription in arrears (including shs. 15,000
from a lapsed member 80
Subscription in advance 30
Accrued expenses 58
Bank 600
Cash 82
Accumulated fund 7,618
Required: An income and expenditure account for the year ended 30th Sep, 2006
and a balance sheet at the date (20mks)

Solution
Adjustments
Subscriptions (w1)

Subscriptions arrears 80 bal b/d 30

Bal c/d 35 End subscriptions 2930
Income and exp 2860 Bad debts (subscriptions) 15
2975 2975

Land sale income – (1600 – 500) - (w2)

Accruals expenses
a) Heat and lighting beginning - 32

204
 Expenses for the year (End) 115
83
Accrual expenses 40
123 (w3)

b) Wages and salaries beginning -12

Expenses for the year end 2066
Wages and expenses for for that year paid for 2054
Accrued wages to be paid next year 14
Wages expense for the year 2068 (w4)

c) Telephone accruals beginning - 14

telephone for the end year 67
Telephone expense for that year 53
Accrued telephone expense 10
Telephone expense for the year 63 (w5)

d) Depreciation
Building at cost 4,000
Dep 5% of 4,000 160

Fixture at cost 470

Dep 10% of 470 47

Furniture at cost (380 + 135) 515

Dep 20% of 515 103

Clubhouse at cost 600

Dep 5% of 600 30

Dr Income and expenditure accounts Cr

Subscriptions bad debts 15 - subscription w1 2860

Repair 146 - functions (367 – 305) 62
Telephone (67 – 14 + 10) 63 - sales of land (1600 – 500) 1,100
Heat and light (115 – 33 + 40) 123 - Bank interest 60
Salaries and wages (2066 – 12 +14) 2068 - sundry income 46
Sundry expense 104
Depreciation
Building 160
Clubhouse 30
Fixture 47

205
 Furniture 103
Surplus 1269
4098 4098

Nb/ Bequests are incomes from dead members/retired members accounted as

part of accumulated fund

b) BALANCE SHEET

Fixed assets at cost dep prov Total dep Book

value
Building 3,200 160 860 1,020 2,180
Fixture & fittings 470 47 82 129 341
Furniture 515 103 164 267 248
Clubhouse 600 30 570
Land 3,500 3,500
6,839
Current assets
Bank 2,300
Cash 102
2,402
Current liabilities
Accrued expenses (40 + 14 + 10) 64
Subscription in advance 35
99
2303
9,142

Financed by
Accumulated fund/ capital 7,618
Surplus 1269
Bequests 255
9,142
REVISION QUESTIONS
1. It really does not matter whether the accounts of a clubhouse of a club are
correct or not, because clubs are not incorporated under the companies Act.
Discuss

2. The objective of golf club is very different from those of a grocer, yet the only
differences between their financial accounts are terminologies. Discuss

206
Accounting for schools, hospitals and other voluntary organizations

NB/ although colleges and universities use funds accounting, the combination of
funds and emphasis on funds differ them to those of municipalities and the central
government.

These institutions are accounted for by preparing income and expenditure

accounts and require therefore proper recording of trust funds endorsement funds
grants e.t.c.

-Ordinary the capital fund given to a school may not be used for revenue
expenditure purpose and income for investment on the fund account, if not wholly
used in any year must be carried forward and not diverted to other purposes. The
main purpose is to ensure funds deployed to a certain purpose are used for the
same purpose, and not in any other way.
For financial reporting purpose, unrestricted assets and related liabilities and fund
balances should be reported separately from restricted assets, liabilities and fund
balances. Revenue expenditure and transfer must also be classified as being
related to restricted or unrestricted current funds.

Illustration 5
Balance sheet of a college
(Financial Position Statement)
As at 31st Dec. 2004)

Assets
Cash in bank 1,250
Fees owing 50
Investments Government stock
& deposits 22,500
Building society 4,300
Stationery on hand (Net) 200
Equipment and furniture 10,000
Library 3,000
Buildings (Net) 30,000
71,300

Liabilities & Capital

Sundry outstanding Liabilities 250
Loan A/c 5,000
Kipling endowment fund 4,000
Vincent Toywa endorsement fund 4,000
Staff endorsement fund 10,000

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Accumulated fund 40,050

The following activities took place the following year.

To balance B/d 1,250

Students fees 6,450
Govt. Grants
(a) General 20,000
(b) Equipment 5,000

Interest Vincent Toywa fund 200

Interest from buildings society 250
Old boys memorial scholarship fund 1,000
Staff endowment collected from staff 1040
Buy equipments 4,500
Loan repayment 1,000
Repairs and painting casual wages 350

Required
Compute the income and expenditure account and the balance sheet.

Solution
Step 1:Set up the balances in the original balance sheet in ledger accounts
Step 2: Bring forward the adjustments
Step 3: Prepare a Trial balance

Trial balance
(Including adjustment)
Government grant for general purposes xx
Government grant for equipment xx
Student‟s fees outstanding xx
Staff endowment fund xx
Loan xx
Kipling fund xx
Kipling fund income (interest) xx
Vincent Toywa fund xx
Wanyua endowment fund xx
X building society xx
Memorial scholarship fund xx
Equipment and furniture xx
Buildings xx
Govt. stock xx
Library xx

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Cash at Bank xx
Salaries xx
Stationery xx
Repairs and painting xx
Interest on loans xx
Xx xx

Income and expenditure A/C

For the year ended 31st Dec. 20 x 4
Income
Grant xx
Students‟ fees xx
Buildings society xx
General interest xx
Xx
Expenditure
Staff salaries xx
Sundry expenses xx
Staff endowment fund xx
Stationery xx
Repairs and painting xx
Casual wages xx
Advertisement and printing xx
Xx
Bal C/F (surplus of income)

QUESTION
The following are balances of Moi 2000 academy in Nyeri as at 31st Dec. 2008.

Non- current assets 2008 2007

Property and equipments 8,422,741 7221,254
Current assets
Inventory 18753 51787
Receivables
Cash and Bank balances 1,369,033 1,293,075
1,511,293 1,624,335

Total assets 9934,037 9,345,589

Equity and liabilities

Capital reserve 11,777,737 10,741,143
Accumulated fund (4,085,071) 2,981,353

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 Development fund 1,464,063 1,096,045
Compile project (285,669) 311,633
Ministry of education 260,420 54,996
ECD account 151 31,347
9,131,629 8,630,545

Current Liabilities
Payables and accruals 661,600 697,847
Feeding program 140,805 17,197
802,405 715,044
Total equity and liabilities 9,934,037 9,345,589

Other information
1. Depreciation was agreed as follows:-

Computers 30%
Land & buildings Nil
Furniture, fittings and equipments 20%
Drainage, water tanks and fencing 12.5%
Playground paths and landscape 10.0%

(ii) Inventory has been stated at the lower cost and net realizable value.
(iii) Receivables are carried at their anticipated realizable values, Bad debts are
written off during the year in which they are identified.

Prepare cash flow statements

Question 2
i. What characteristics distinguish non- profit making business and profit
oriented enterprises.
ii. Define term fund as it is applied in the accounting for government
activities.
iii. Distinguish between an expense and expenditure.

Question 3
The following balances were extracted from Kabatura Secondary School in year
20 x 6

Trial Balance
Dr Cr
Inventory 8,420

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 Property and equipment 8,000,000
Fees receivables and prepayment 12,000,000

Cash and bank balances 1000,000

Capital reserve 11,000,000
Development fund 1,460,000
Payables and accruals 661,000
Feeding program 140,000
Depreciation 198,480
Printing 5,200
Advertisement 7,300
Teachers salaries 273,000
Furniture 187,390
NSSF 4,800
Traveling 8,000
Bank charges 5,000
Electricity 10,000
Tex books 177,000
Telephone & postage 37,800
Quality issuance 8,700
Parents accounts 180,000
Repairs and maintenance 38,000
Activity fee 14,000
Capital 12,000,000

Prepare
(i) A statement of financial position
(ii) Income and expenditure account.

211
 LESSON NINE

BASIC ACCOUNTING RATIOS

Learning Objectives
By the end of this lesson the student should be able to calculate the different
classes of ratios including liquidity, profitability, efficiency, leverage etc. the
student should also be able to interpret these ratios given a set of data.

Introduction
At the end of the accounting period, trader will need to know the performance of
the business or measure the level of success. These can be done using different
ways.

(a) Comparing of business performance during the current year and the past
year.
(b) Comparing business with those others selling the same commodity.
(c) Knowing the strength of the business in terms of debts as they occur.

We use ratios to help us achieve this.

Terms
Financial analysis- This is the process of identifying the financial strengths and
weakness of the firm, by properly establishing relationships between the items of
the profit or loss account and the balance sheet.
Financial analysis can be undertaken by various decision makers such as
management owners‟, creditors, investors‟ e.t.c.

Purpose of using financial data

1. To appraise the past performance (to asses the business success and
effectiveness of management.)
2. To evaluate present condition
3. To predict the future potential (assess how firm may respond to future
economic developments).

Decision maker‟s needs information about the profitability, efficiency and

financial soundness of the business.
e.g Creditors are interested to know whether the firm will be able to meet their
claims over a short period of time.
-Debenture holders are interested in the firm long-term solvency and survival,
shareholders are interested are concerned on the firm‟s profitability overtime.

Summary on merit of financial analysis / ratios

212
 1. Helps in making investment decisions.
2. Useful in simplifying accounting figures for easy understanding. Give
relationship that exists between two segments of business.
3. Asses the operational, efficiency of a business e.g revealing liquidity,
profitability, solvency e.t.c
4. Helps in forecasting business trends for successive financial years.
5. Assists in locating the weak points of a business. Hence important in
planning of business activities.
6. Assists in comparison of performance of various departments within a
firm.

Limitations/ Demerits of financial analysis / ratios

(i) Sometimes give false results in case of incorrect accounting data.
(ii) Ratios based on historical data and the world is dynamic and changing
in market structure may not be revealed.
(iii) Different firms use different methods of calculating financial ratios,
making comparison difficult.
e.g depreciation – some uses straight line and others using diminishing method.
(iv) Change i n p r i c e l e v e l of commodities renders comparison
very
difficult.
(v) Different business enterprises operate on different environments so,
ratio cannot act as a single denominator for comparison.
(vi) The difference in the definitions of items in the balance sheet & P& L
makes interpretation difficult. Concentration exclusively on accounting ratios can
distract attention from significant key aspects which amounts in isolation.
(vii) Difference in technology, raw materials, market strategies, skills and
capabilities of employees may render comparative ratios invalid.

NB/ Accounting statements can be analyzed and evaluated in a number of ways

one of these in practice is through the use of ratios. Ratio analyses a very
important tool where financial statements are reduced into numbers which may
provide a basis of Comparison.

Basis of comparison / What do we compare

-Past periods – How the firm has been fairing overtime.

-Planned performance – Projected plans and targets to show the strengths and
weakness for the future.

-Other firms in the same industry – to know whether the firm is competitive
enough / have a competitive edge over the competitors.

213
 -Industrial comparison- To show whether the firm has characteristics which
influence operation in the entire industry.

Types of Ratios
They are classified in the following categories.
(a) profitability ratios
(b) Activity ratios
(c) Liquidity ratios
(d) Gearing ratios
(e) Financial strength ratios
(f) Trend ratios

Profitability Ratios
They show the measure of the efficiency of the firm in the generation of profit.
Include ratios which relates to sales and ratios that express profit in relationship to
employment of resources.
Example
a. Gross profit Margin
b. Mark- up
c. Return on investment

a) Gross profit Margin- a profitability ratio in relation to sales

Calculated as follows:- Gross Profit margin = G.P x 100 %
Sales
Note- the higher the margin , the better the firm‟s performance which is a sign of
good management.

b) Mark-up = G.P x 100%

Cost of sales
A gross ratio may increase due to any of the following factors.
i. High sale , price of goods sold remaining constant
ii. Lower cost of goods, sale price remaining constant
iii. An increase in the proportion of items for sale.
Note- a low margin ratio should be investigated. It reflects:-
a. High cost of goods sold
b. Inefficient utilization of plant and machinery
c. A fall in prices in the market
d. Mismanagement of firm
Relationship between mark-up and margin

Mark – up Margin
1 1
a a+1

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 1 1
a-1 a

Net profit margin

Net profit margin = Net profit before tax x 100

Sales
Interpretation
It shows the overall measures of the firm‟s ability to turn each of the sales into
profit. If the net margin is inadequate, the firm will fail to achieve satisfactory
return on owner‟s equity. The ratio indicates the firm‟s capacity to withstand
adverse economic conditions.

Return to investment (ROI)

Profitability of the firm is also measured in relation to the employment of
resources i.e. the investment. The ratios that goes with investment are, return of
capital employed, net assets return on shareholders’ equity.

Return on capital employed = Net profit before tax and investment x 100
Capital employed

Capital employed = (Fixed Assets + Working Capital)

Working Capital- Measures the ability of the company to fulfill its current
liabilities in an abnormal situation.

WC = (CA - CL)

Therefore- Capital employed = FA + (CA -CL)

Return on Assets (ROA)

ROA = Net profit before tax and interest x 100

Net assets

Interpretation- the higher the ratio, the better and suggests effective trading

Return on shareholders Equity (ROSE)

ROSE = Net profit after taxes and interest x 100

Share capital and reserves

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Interpretation
The ratio shows how well the firm has used the resources provided by the owners.
Return on net assets seeks to assess the effectiveness of management in generating
profit from the assets at its disposal. Return on equity, on the hand, looks at the
position from the shareholders point of view.

Example
Johana gave the following fund accounts for the recent two years.

Johana Trading LTD

TRADING, PROFIT & LOSS A/C FOR THE YEAR
ENDED 31ST DEC
2002 2003
(000) (000)
Sales 10,874 11,450
Costs of sales 6,351 6,907
4,523 4,523
Trading expenses 3,452 3,098
Net profit before tax & interest 1,071 1,445
Less long term loan interest 350 280
Net profit before tax 721 1,165
Taxation 203 327
Net profit after tax 518 838
Less dividend 200 200
Retained profit 318 638

Johana Balance sheet

As at Dec
2002 2003
(000) (000) (000) (000)
Fixed assets
Freehold premises 4,025 4,025
Plants equipment 2,167 2,750
6,192 6,775
Current assets
Stock 2,625 1,863
Trade debtors 2,277 1,980
Cash 198 193
5,100 4,036
Less
Creditors 1,175 1,432
Taxation 203 327

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 Dividend due 200 200
1,578 1,959
Net Assets (current)
3,522 2,077
Total assets less current liabilities 9,714 8,852
Long term liabilities 2,500 2,000
7,214 6,852

Financed by capital & Reserves

Share capital 1,000 1,000
Reserves 6,214 5,852
7,214 6,852

Calculate
i) Gross profit margin
ii) Mark up.
iii) Return on capital employed.
iv) Return on assets.
v) Return on share holders‟ equity.

Solution
Gross profit margin = G.P x 100
Sales

G.P = 4,523 (2002)

= 4,543 (2003)
2002 2003

Gross profit margin = 4,523 x 100 4,543 x 100

10,874 11,450

= 41.5% = 39.3%

Interpretation- In year 2002, the margin is higher showing good management in

the year and bad management in year 2003.

Markup = G.P. X 100

Cost of sales

2002 2003
Cost of sales = 6351 Cost of sales = 6907

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Markup = 4523 x 100
6351
= 71.2%

Markup = 4543 x 100

(2003) 6907
= 66.8%

Net profit margin = Net profit before tax x 100

Sales

2002 2003

= 721 x 100 1165 x 100

10870 11.450

= 6.6% = 10.3%

Return on capital employed.

Roce = Net profit before tax & interest x 100

Capital employed.

2002 2003
Net profit before tax 1071 1445

Capital employed
FA + (CA - CL) 9714 8852

2002 2003

Roce = 1071 x 100 =11% Roce = 1445 = 16.3%

9714 8852

Return on assets (ROA)

ROA = Net profit before interest & taxation x 100

Net sales

2002 2003

ROA = 1071 x 100 1445 x 100

10,874 11.450

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 = 0.98% = 12.6%

Return on shareholders equity (Rose)

ROSE = Net profit after interest & taxes x 100

Shareholders equity & reserves
2002 2003
Net profit 518 838

Shareholders
Equity and reserve 7214 6852

Rose = 518 x 100 Rose = 638 x 100

7214 6852

= 7.2% = 12.2%

In 2003, resources were used well than in 2002.

ACTIVITY RATIOS – Attempts to assess the effectiveness with which the firm
recourses have been employed.

They includes:-
(i) Stock turn over
(ii) Debtors turnover
(iii) Ratio of assets value to sales
(iv) Creditors‟ payment period.

Stock turnover / inventory turnover – indicates the efficiency of firms inventory

management.

Stock turnover = cost of goods sold

Average stock

Stock turnover represent the number of times the stock has been replaced during a
particular year.

Average stock = (opening stock + closing stock)

2

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Stock turnover (Johana traders)
2002 2003
Stock turnover = 6351 6907
2625 1863

= 2.4 times 3.7 times

= 3 times 4 times

Debtors turnover =Refers / represents the number of times debtors settles

their account in response to credit sales in a year. 5 times turnover in a year is
rather too low. Eight times turnover is ideal in a year.

Debtors turnover = Sales on credit

Debtors amounts.

When credit sales, opening & closing stocks are not available, the ratio can be
calculated as follows.

Debtors turnover = Total sales

Debtors

Creditors‟ turnover - Shows the number of times credit purchases are settled
within a trading period. 7 times credit turnover would be ideal 4 times credit
turnover would be too low and company may loose its credit worthiness.

Credit turnover = Credit purchases

Creditors amounts.

Debts collection periods

-Shows the nature of firm credit policy and the quality of the debtors.

Debtors‟ratio- Shows the average credit period allowed to debtors.

A common factor of 365 days is used.

Debtors ratio = Debtors amounts x 365 days

Credit sales

Creditors‟ ratio -shows the number of credit period allowed to creditors for
payment.

Creditors ratio= Trade credit amounts x 365 days

Purchases on credit

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 On average 60 days credit period is idea.

-90 days is too bad (hence the shorter the credit period the better the quality of the
debtor/ creditor.

Ratio of assets value to sales

It show whether the trading value of the business is large enough to justify its
investment in fixed assets. High sales / fixed asset ratio is a justification in
investment in fixed assets.

Sales / fixed asset ratio = Sales

Fixed assets
LIQUIDITY RATIOS
They measure the ability of a business to meet its immediate financial obligations
and thus avoid the possibility o f insolvency.

It‟s important for a firm to ensure that:-

(i) Does not suffer from funds

(ii) Ensure funds available is not too much

NB: Failure of a business to meet its obligations, due to lack of adequate liquidity,
will result in bad credit rating, loss of creditor’s confidence, or even law suits
resulting in the closure of the business. A very high degree of liquidity is also not
good as there would be too much of idle cash that earns nothing. It‟s necessary to
strike a balance.

Ratios used to measure liquidity are

(a) Current ratio - Measures current assets against current liabilities if

the ratio is more, the business is well managed. If the ratio is 1:3, means the
business is near to insolvent unless funds are borrowed from outside to settle
debts. Normal current ratio is 1:1. If the ratio is 3:1, it implies there is too much of
idle cash.

CR = CA
CL

Current ratio = Current assets

Current liabilities

Quick Ratio / Acid Test Ratio

221
 Measure how capable a business can be able to meet its immediate debts without
selling stock. The higher the acid test ratio, the better the performance of the
business.

Acid tests ratio = Current assets less stock

Current liabilities

It only takes the assets that can be converted to cash immediately or reasonably
soon without a loss of value. Cash is the most liquid asset.

GEARING RATIOS
It measures the long-term financial position of a firm leverage and capital
structure. Approximate the debts and the owner‟s equity of the firm.

Ratio includes
(a) Debt to equity ratio
(b) Leverage / Gearing

Debts to equity ratio = Long term borrowing x 100

Total equity

Leverage / Gearing = Long-term debt

Ordinary share equity
Example
Kego Ltd. Has a capital structure which includes Kshs. 4,000,000 of 12%
debenture and 500,000 ordinary shares of Kshs. 10 each fully paid and Kshs.
3,000,000 reserves.

Calculate the gearing / leverage

Gearing = Long term debt

Owner equity

= 4,000,000
8,000,000

=Owners equity = 500,000 x 10 = ordinary

= 5,000,000 + Reserves
= 5,000,000 + 3,000,000
= 8,000,000

= 0.5 or 50%

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 Or Gearing = Long term debt
Long-term debt + owners‟ equity

= 4,000,000
4,000,000 + 8,000,000

= 0.3 0r 33%

Generally higher levels of leverage are more appropriate. A very high debt to
equity ratio is unfavorable for the firm. A low debt to equity ratio represents a
satisfactory capital structure.

Times Interest Earning Ratios - Measures the relationship between loan interest
obligation and profit interest and tax. It assesses how well interest payments are
covered by profits available to meet them.

Times interest earned ratio = Net profit before tax and interest

Interpretation
A high ratio is desirable but a too high ratio shows the company is not using credit
to the best advantage of the share holders. A too low ratio shows in efficient
operations.

INVESTMENT RATIOS
These relate to earnings on shares as opposed to earnings of the company itself
and provide valuable information to actual or potential share holders. They are the
greatest to management as the company depends on shareholders and potential
shareholders for its capital.

These ratios are:-

(a) Earning per share ratio (EPS)
(b) Price earnings ratios (PE)
(c) Dividend ratio
(d) Dividend cover ratio
(e) Earning yield.

(a) Earning per share ratio (EPS)

EPS = Net profit after tax & interest - Preference dividend

Number of ordinary shares

(b) Price earnings (P/E) Ratio.

223
 -Measures the number of years it would take to recover the share price out of the
current earnings of the firm. It is basically an indicator of market confidence in a
firm and at times referred to as the capitalization factor.

The price earnings ratio various firm company to company depending on the
market expectations of a particular company’s growth rate.

(1)The market expectations of a particular company’s growth rate

(ii) The area in which the company operates

P/E ratio = Price per share

Earnings per share

Or P/E ratio = Price of one share

Profit attributed to ones share

Example
Kenya breweries Ltd. Has in issue 200,000 ordinary shares with a per value of
Kshs. 10 each and market price of Kshs. 32 per share and EPS of Kshs. 4/= on its
2006 published accounts.

Required
Calculate the price/earnings ratio for the company
(iii) Determine the value of the company.

Price / earnings ratio = Price per share

Earnings per share

= 32/4

= 8

Value of the company = capitalization factor X net profit after tax & interest.
= 8(4 X 200,000)

= 6,400,000

Value of the company = Market price of shares X No. of shares

= 32 x 200,000

= 6,400,000

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Interpretations – A lower price earnings ratio indicates a lack of confidence in
the company‟s ability to maintain earnings. A higher price earnings ratio
suggests a belief that the company is expected to increase earnings in the future.

Dividend yield
It‟s the ratio of dividend receivable to the price for share. It focuses closely on the
value of the declared dividend to an investor. It‟s important to an investor who is
holding the shares as a regular source of income.

Dividend yield = Dividend per share

Market price per ordinary share

Dividends cover ratio/ payout ratio

Measure the relationship between the profits available for distribution to
shareholders and dividends actually declared. It indicates the proportions of
earnings retained by the company and the level of risk in future years should
earnings declines for the company to be able to maintain the same dividend
payments.

Thus the ability of a company to continue to pay current dividends levels in the
future may be forecast by the dividend ratio.

It‟s calculated as:-

Dividend cover ratio =Net profit after interest and preference dividend and tax
Ordinary dividend payable

Earnings yield
This is the reciprocal of the price earnings ratio. It expresses the earnings of the
company as a percentage of the market price of the share. Can be calculated in
two ways

i) Earnings yield = (Net profit after tax and interest - Preference divided) x 100
Market value of shares

ii) Earnings yield = (Dividend yield x dividend cover) x 100

Users of Financial ratios

Users Types of ratios Reason

1. Shareholders -Profitability ratios -To know the profits made
-Gearing leverage -To know how effective the
firm has been managed
2. Government Profitability by To allocate taxation to the firm

225
 3. Management -Profitability -To asses the performance and
-Activity asses the efficacy of the policy
-Liquidity put in place.
-Gearing
-Investment
4. Creditors -Liquidity -Firms being able to meet its
-Profitability commitment.
-Measure the ability of the
firm to service.
5. Long term lenders -Profitability - To know the firm is able to
-Liquidity meet its long-term obligation
-Gearing
Employee / unions -Profitability -Survival of the business and
-Liquidity ability to meet the employee‟s
-Activity needs as far as supply of
labour is concerned.

Examination Questions
a. What is gearing?
b. State and briefly explain the advantage and disadvantages of leverage.
c. What are the limitations of using financial statements in easing liquidity?
d. What is the purpose of calculating profitability ratios?
e. Define the price earnings ratio
f. How is dividend yield calculated?

Q2.
The following is a summary of trading profit and loss of Jeribu motor company in
year 2004 and 2005 and a balance sheet at both years.

2004 2005
Shs. Shs. Shs. Shs.
Sales 800,000 1,269,000
Less
Cost of sales
Opening stock 40,000 50,000
650,000 1,100,000
690,000 1,150,000
Less closing stock 50,000 100,000
640,000 1,050,000
Gross profit 160,000 210,000
Less expenses 80,000 100,000
Net profit 80,000 110,000

BALANCE SHEET AS
AT 31ST, 2004, 2005

Ksh Ksh. Kshs. Kshs.

Fixed assets 178,000 186,000

226
 Current assets 50,000 100,000
Trade debtors 100,000 210,000
Cash at bank 20,000 10,000
170,000 320,000
Total assets 348,000 506,000
Financed by
Capital 200,000 200,000
Net profit 80,000 110,000
Drawings 44,000 36,000 64,000 46,000
236,000 282,000
Current liabilities
Creditors 112,000 224,000
348,000 506,000

Required
Calculate the following ratios and comment.

(i) Gross profit on sales

(ii) Mark- up
(iii) Current ratio
(iv) Quick ratio
(v) Return on capital employed
(vi) Stock turnover
(vii) Debtors collection period

MOCK EXAMINATION

MOUNT KENYA UNIVERSITY NAIROBI CAMPUS

MAF 5101: FINANCIAL ACCOUNTING
DATE: TIME: 3 HOURS

INSTRUCTIONS: Answer Question ONE and Any Other Two Questions.

QUESTION ONE
(a) Distinguish between each of the following pairs of terms:
(i) Receipts and revenue. (3 marks)
(ii) Balance sheet and statement of affairs. (3 marks)
(iii) Cash basis of accounting and accrual basis of accounting. (3 marks)

(b) Explain the term "bank reconciliation" and state the reasons for its preparation.
(6 marks)
(c)A and B own a grocery shop, their first financial year ended on 31 December 2011.
The following balances were taken from the books on that date:

227
 Capital: A- Ksh.60, 000; B – Ksh.48, 000.
Partnership salaries: A - Ksh.9, 000; B - Ksh.6, 000.
Drawings: A – Ksh.12, 000; B – Ksh.13, 400.
The firm’s net profit for the year was Ksh.32, 840.
Interest on capital is to be allowed at 10% per year.
Profits and losses are to be shared equally.
(a) From the information above prepared the firm’s appropriation account and the
partners’ current accounts.
(15 marks)
(Total: 30 marks)

QUESTION TWO
Nyaundi carries on a manufacturing business in Eldoret. The trial balance extracted from his
books as at 31 March 2004 was as follows:

Sh.’000 Sh.’000
Stock at 1 April 2003:
Raw materials 16,200
Finished goods 58,000
Purchases of raw materials 409,600
Manufacturing wages 92,200
Rent, rates and insurance 15,400
Salaries 102,400
Discounts allowed 4,000
Carriage inwards 7,600
General expenses 53,800
Professional charges 6,400
Carriage outwards 9,400
Motor vehicles at cost 24,400
Plant and machinery at cost 96,000
Leasehold premises (acquired on 1 April 2003) 140,000
Capital as at 1 April 2003 200,000
Sales 841,600
Discounts received 5,000
Provision for doubtful debts (1 April 2003) 10,000
Sundry creditors 59,000
Provision for depreciation (1 April 2003):
Plant and machinery 26,800
Motor vehicles 11,600
Sundry debtors 79,000
Bank balance ___39,600 ________
1,154,000 1,154,000

Additional information:
1. Sales included Sh.46, 000,000 in respect of goods charged out to customers at cost plus
25% on a sale or return basis. The goods remained unsold as at 31 March 2004.
228
 2. The stock of finished goods and raw materials at cost as at 31 March 2004 amounted to
Sh.63, 600,000 and Sh.15, 800,000 respectively.
3. Prepaid insurance as at 31 March 2004 was Sh.400, 000 and Sh.1, 000,000 owed for
lighting and heating as at the same date. Lighting and heating is accounted for through
the general expense account.
4. Included in the salaries account were drawings by Nyaundi amounting to Sh.400, 000
per week. (Assume a 52 – week year)
5. A debt of Sh. 1,000,000 is to be written off and provision for doubtful debts is to be
reduced to Sh.8,000,000
6. During the year, motor vehicles which had cost Sh.12, 000,000 and which had been
written down to Sh.4, 000,000 were sold for Sh.9, 600,000. This amount has been
credited to motor vehicles account.
7. Legal fees amounting to Sh.2, 800,000 in respect of acquisition of the leasehold
premises are included in the professional charges account. The lease costs are to be
amortised over 20 years.
8. Provision for depreciation on motor vehicles and plant and machinery is to be made at
Sh.3, 800,000 and Sh.5, 000,000 respectively.

Required:
(a) Manufacturing, trading and profit and loss accounts for the year ended 31 March 2004.
(10 marks)
(b) Balance sheet as at 31 March 2004. (10 marks)
(Total: 20 marks)

QUESTION THREE:
(a) Define the following accounting concepts and for each explain their implication in
the preparation of financial Statements.
(i) The Going concern concept. (4 marks)
(ii) Business entity concept. (4 marks)
(iii) Materiality. (4 marks)

(b) Briefly explain the following types of errors:

(i) Error of commission (2 marks)
(ii) Error of principle (2 marks)
(iii) Complete reversal of entries (2 marks)
(iv) Compensating errors (2 marks)

(Total: 20 marks)

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QUESTION FOUR:

a) Briefly explain the nature and purpose of accounting for depreciation. (5 marks)
b) The chief accountant of Hyundai Ltd has encountered difficulties while accounting for
fixed assets and the related depreciation in the company’s draft accounts for the year ended
30 April 2000. He has decided to seek your professional advice and presented the
following balances of fixed assets as at 1 May 1999:

Acquisition Accumulated Depreciation

Cost Depreciation Rates
Sh. Sh. %
Furniture 900,000 300,000 12.5
Trucks 3,525,000 1,470,000 25
Plant and machinery 7,387,500 4,462,500 10
Land 2,775,000 - Nil
Buildings 2,925,000 292,500 2.5

The following additional information was also available:

1. It is the company’s policy to write off cost of the assets using above percentages on cost.
2. Depreciation is fully charged in the year of acquisition and none in the year of disposal.
3. A three year old machine acquired for sh.187, 500 was sold for sh.15, 750.
4. It has been decided to adjust and charge depreciation on buildings at 4%.
5. A used delivery truck purchased three years ago for sh.248, 250 was traded in during the
year at a value of sh.157, 500 in part exchange of the new delivery truck costing sh.450,
000.
6. Land, buildings and machinery were acquired for sh.1, 350,000 from a company that went
out of business. At the time of acquisition sh.90, 000 was paid to have the assets revalue
by a professionally qualified value. The revaluation indicated the following market values.
Sh.
Land 900,000
Buildings 600,000
Machinery 300,000

Required:
A schedule of movement of fixed assets as requested by the Chief Accountant for inclusion in
the company’s accounts for the year ended 30 April 2000. (15 m
(Total: 20 marks)

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QUESTION FIVE:
The following version of the receipts and payments account has been provided by the treasurer
of Maendeleo Social club for the year ended 31 October 2003:

Receipts Payment
s
Shs.’ 000 Shs.’ 000
Opening Balance 500
Accountancy Fees 200
Bar Purchases 24,000
Bar sales 55,000
Dances: Expenses 900
Ticket Sales 1,600
Foods: Purchases 4,500
Sales 8,000
Insurance 500
Electricity 1,500
Members Subscriptions 35,000
Office Expenses 22,000
Purchase of Furniture 4,000
Rates 2,000
Salaries and Wages: Bar Staff 10,000
Other Staff 14,000
Telephone 3,000
Travelling Expenses 13,000
Balance c/f _______ 500
100,100, 100,100

Additional Information: Shs. 000 Shs. 000

1. Fixed Assets: At November 2002
Club Premises at Cost 18,000
Furniture and Fittings at Cost 35,000
Less Provision for depreciation 14,000 21,000
39,000

2. Accruals and Sundry Creditors at Nov 2002 at 31 Oct 2003

Shs. 000 Shs. 000
Accountancy Fees 200 250
Bar Purchases 1,500 2,000
Electricity 400 300
Members Subscriptions (Paid in Advance) 1,000 800
Telephone 600 700
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3. Sundry Prepayments and Receivables
Insurance 300 200
Members Subscriptions (In Arrears) 6,000 7,000
4. Maendeleo Social Club had a Bank Account, which had a balance of Shs. 2,500,000 on
1 Nov 2002. This Bank account was not used during the year to 31 Oct 2003and the
only entry made in this account was for the interest of shs. 200,000 which were
credited yo the bank on 31 Oct 2003.
5. Depreciation on Furniture and fittings is at the rate of 10% per annum on cost. A full
year’s depreciation is provided for any furniture bought during the year.
6. Bar stock was valued at shs. 7,000,000 0n 1 Nov 2002 and at Shs. 1,500,000 on 31 Oct
2003.
7. No Apportionment of costs is made between bar activities and other club activities.

Required:
i. Income and Expenditure Account for the year 31 Oct 2003. (12 Marks)
ii. Balance Sheet (8 Marks)
(Total: 20 Marks)

END OF MOCK EXAMINATION

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