HBT2103 Financial Accounting

JOMO KENYATTA UNIVERSITY
OF
AGRICULTURE & TECHNOLOGY
SCHOOL OF OPEN, DISTANCE &

eLEARNING
IN COLLABORATION WITH
SCHOOL OF HUMAN RESOURCE
MANAGEMENT
DEPARTMENT OF COMMERCE &

ECONOMIC STUDIES
HBT 2103: FINANCIAL ACCOUNTING
P.O. Box 62000, 00200

Nairobi, Kenya
JOMO KENYATTA UNIVERSITY
OF
AGRICULTURE & TECHNOLOGY
SCHOOL OF OPEN, DISTANCE AND eLEARNING

P.O. Box 62000, 00200
Nairobi, Kenya
E-mail: elearning@jkuat.ac.ke
HBT 2103 FINANCIAL ACCOUNTING
LAST REVISION ON May 5, 2017

This presentation is intended to covered within one week. The notes,

examples and exercises should be supplemented with a good textbook.
Most of the exercises have solutions/answers appearing elsewhere and
accessible by clicking the green Exercise tag. To move back to the same
page click the same tag appearing at the end of the solution/answer.
Errors and omissions in these notes are entirely the responsibility of
the author who should only be contacted through the Department
of Curricula & Delivery (SODeL) and suggested corrections may
be e-mailed to elearning@jkuat.ac.ke.
iii
HBT 2103: FINANCIAL ACCOUNTING
Course Description
Introduction to Accounting :Meaning of accounting ,Nature and scope of ac-
counting,Users of accounting information,Purpose of accounting,Specializations
of accounting,Introduction to conceptual framework for financial accounting,Objectives
of financial accounting,Qualitative characteristics of accounting information,Accounting
elements,Limitations of preparing financial reports. Introduction To Account-
ing Equation And Double Entry System:Meaning of the Accounting Equa-
tion,Double entry system,Debit and Credit entries,Accounting for Assets, Lia-
bilities and Capital,Accounting for Sales, Purchases, Incomes and Expenses,Asset
of Stock. The Accounting Cycle,Sources of financial data,Journal entries,Ledger
accounts,Cash book and Petty cash book,Trial balance,Adjustment entries to
the journals, ledgers and trial balance,Extracting financial statements. Errors
and Suspense Accounts,Types of errors,Errors revealed a trial balance,Errors
not revealed a trial balance,Correction of errors,Suspense accounts. Bank Rec-
onciliation Statements:Bank statements,Bank reconciliation statements,Reconciliation
of cash book balances and bank statement balances. Control Accounts,Importance
of control accounts,Sales ledger control accounts,Purchases ledger control ac-
counts,Contra settlements,Reconciliation of purchases and sales ledger with
their respective control account. Adjustments to Final Accounts:Adjustments
in the trading account,Accrued expenses and income,Prepaid expenses and in-
come,Bad debts written off and provision for bad and doubtful debts,Depreciation,
provision for depreciation and disposal of non current assets. Financial State-
ments of a Sole Trader:Income statement,Balance sheet,Illustrations.Partnerships:Define
a partnership and the provisions governing its formation,Trading and profit
and loss and appropriation account of a partnership,Prepare a balance sheet for
partnership business,Companies:Define the term company,Company finance
and how they are recorded in the books of accounts,Trading and profit and
loss and appropriation account of a company,Prepare balance sheet of a com-
pany. Non-profit making organisation:Define a non-profit making organiza-
tion,Sources and the uses of finances,Receipt and payment account,Income
and expenditure account,Statement of affairs and a balance sheet.Ratio anal-
iv
ysis:Calculate profitability index,Analyze the liquidity ratio,Determine the

stock market ratio
Prerequisite: None
Course Aims
The purpose of this course is to equip students with perfect understanding on
the nature, scope and relevant concepts of Accounting with an aim of imparting
the students with necessary skills and knowledge on preparation of financial
statements and accounting for various business transactions and resources.
Learning Outcomes
Upon completion of this course you should be able to;
1. Identify, describe and analytically evaluate the uses and users of account-
ing information and its context in the market and managerial decision
making.
2. Identify, describe and analyze the key components of Annual Financial

Reports.
3. Evaluate the institutional accounting environment for decision making.
4. Prepare company account
5. Prepare accounts for nonprofit making organizations
Instruction Methodology
Lectures and tutorials, Case studies, Group Discussions
Course Text Books

• Wood, F and Sangster, A (2010), “Business Accounting”, Eleventh Edi-
tion, ISBN 978-81-317-2914-4
• Horngren, C. T., Sundem, G. and Elliott, J. (2002). Introduction to

Financial Accounting, 8th Edition, Prentice Hall; ISBN: 0130410233.
v
• Weygandt, J., Kieso, D. and Kimmel, P. (2008). “Financial Accounting”,

4th Edition, John Wiley & Sons; ISBN: 0471072419.
Reference Text Books

• Warren, C.S., Reeve, J. and Fess P.E. (2001). “Accounting”, 2nd Edition,
South-Western College Publishing, ISBN: 0324025424
• Ross, S., Westerfield, J. and Jordan, F. (2008). Corporate Finance, 8th

Edition McGraw-Hill, Irwin.
• Garrison, R. (2005). Managerial Accounting, 6th edition Irwin, Interna-

tional Financial Reporting Standards 2010
Course Journals
• Journal of Accountancy by American Institute of Certified Public Ac-
countants
• Journal of Accounting Research by Wiley
• Journal of Accounting and Economics by Elsevier: A Practical Guide
Reference Journals
• Journal of Accounting and Economics by Elsevier
• The Journal of Accounting, Auditing, and Finance (JAAF) Sage Publi-

cations
• The International Journal of Accounting by University of Illinois
Assessment Information
The module will be assessed as follows;
• 20% of marks from two (2) assignments
• 20% of marks from one written CAT to be administered at JKUAT main

campus or one of the approved centres
• 60% of marks from written Examination to be administered at JKUAT

main campus or one of the approved centres
vi
Contents
1 Conceptual Framework Underlying Financial Accounting 1

1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Definition of conceptual framework . . . . . . . . . . . . . . . 2
1.2.1 Need for a conceptual framework. . . . . . . . . . . . 2
•.1 The first level . . . . . . . . . . . . 3
•.2 The second level . . . . . . . . . . . 3
•.3 The third level . . . . . . . . . . . . 3
1.3 Objectives of Financial Accounting . . . . . . . . . . . . . . . 4
1.4 Qualitative Characteristics of accounting information . . . . . 4
1.4.1 Primary qualities relating to content . . . . . . . . . . 5
• Relevance . . . . . . . . . . . . . . . . . . . . 5
• Reliability . . . . . . . . . . . . . . . . . . . 6
1.4.2 Primary qualities relating to presentation . . . . . . . . 8
• Understandability . . . . . . . . . . . . . . . 8
• Comparability . . . . . . . . . . . . . . . . . 8
1.5 Elements of Financial Statements . . . . . . . . . . . . . . . . 9
1.5.1 Elements in the Balance Sheet . . . . . . . . . . . . . 9
• Assets . . . . . . . . . . . . . . . . . . . . . 9
• Liabilities . . . . . . . . . . . . . . . . . . . . 10
• Equity/ Capital . . . . . . . . . . . . . . . . 11
1.5.2 Elements in the Income Statement . . . . . . . . . . . 11
1.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2 Introduction to Accounting Equation and Double Entry Sys-

tem 15
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.2 The Accounting Equation . . . . . . . . . . . . . . . . . . . . 16
vii
2.3 The Double Entry System . . . . . . . . . . . . . . . . . . . . 20

2.4 The Debit and Credit Entries . . . . . . . . . . . . . . . . . . 20
2.5 Double Entry System for the Various Elements of Financial
Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.5.1 Accounting for Assets, Liabilities and Capital . . . . . 21
2.5.2 Accounting for Sales, Purchases, Incomes and Expenses 24
2.5.3 Double Entry System for Elements in the Income State-
ment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
2.6 The Asset of Stock (Inventory) . . . . . . . . . . . . . . . . . 27
2.6.1 Accounts to record increase of stock . . . . . . . . . . 27
• Purchases Account . . . . . . . . . . . . . . . 27
• Returns Inwards Account (Sales Returns Ac-
count) . . . . . . . . . . . . . . . . . . . . . 27
• Drawings Account (Goods Drawing) . . . . . 28
3 The Accounting Cycle 33

3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
3.2 Capture Source Documents . . . . . . . . . . . . . . . . . . . 34
• Sales Invoice . . . . . . . . . . . . . . . . . . 35
• Purchases Invoice . . . . . . . . . . . . . . . 35
• Credit note . . . . . . . . . . . . . . . . . . . 35
• Debit note . . . . . . . . . . . . . . . . . . . 36
• Receipts . . . . . . . . . . . . . . . . . . . . 36
• Cheques . . . . . . . . . . . . . . . . . . . . 36
• Petty cash vouchers . . . . . . . . . . . . . . 37
• Other correspondence . . . . . . . . . . . . . 37
3.3 Journalizing . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
3.4 Ledger Accounts . . . . . . . . . . . . . . . . . . . . . . . . . 43
3.5 Cash Books . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
3.6 Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
3.7 Petty Cash Book and the Imprest system of Accounting . . . . 46
3.8 Extraction of a Trial Balance . . . . . . . . . . . . . . . . . . 47
3.9 Adjustment entries to the journals, ledgers and trial balance . 48
3.10 Preparation of Financial Statements . . . . . . . . . . . . . . 48
viii
4 Error , Suspense Accounts and Bank Reconciliation State-

ments 55
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
4.2 Errors on Accounts . . . . . . . . . . . . . . . . . . . . . . . . 56
4.2.1 Errors that affect the balancing of a trial balance . . . 56
4.2.2 Errors that DO NOT affect the balancing of a trial bal-
ance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
4.3 Suspense Account . . . . . . . . . . . . . . . . . . . . . . . . 59
4.4 Bank Reconciliation Statement . . . . . . . . . . . . . . . . . 60
4.4.1 Reasons for differences in the bank statement balance
and the cash book balance . . . . . . . . . . . . . . . 60
4.4.2 Importance of a bank reconciliation statement . . . . . 62
4.4.3 Steps in preparing a bank reconciliation statement . . 62
5 Control Accounts and Adjustments to Final Accounts 69

5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
5.2 Control Accounts . . . . . . . . . . . . . . . . . . . . . . . . . 70
5.2.1 Sales ledger control Account . . . . . . . . . . . . . . 70
• Items that Increase Debtor’s Balance (They
are debited) . . . . . . . . . . . . . . . . . . 70
• Items that Decrease Debtor’s Balance (They
are credited) . . . . . . . . . . . . . . . . . . 71
5.2.2 Importance of Control Accounts . . . . . . . . . . . . . 72
5.3 Adjustments in the Trading Account . . . . . . . . . . . . . . 72
5.4 Accruals and Prepayments . . . . . . . . . . . . . . . . . . . 74
5.4.1 Accruals . . . . . . . . . . . . . . . . . . . . . . . . . . 75
5.4.2 Prepayments . . . . . . . . . . . . . . . . . . . . . . . 75
5.5 Bad and Doubtful Debts . . . . . . . . . . . . . . . . . . . . . 76
5.5.1 Bad Debts Recovered . . . . . . . . . . . . . . . . . . 77
5.6 Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
5.6.1 Causes of Depreciation . . . . . . . . . . . . . . . . . . 78
5.6.2 Methods of Calculating Depreciation . . . . . . . . . . 79
5.6.3 The other methods include: . . . . . . . . . . . . . . . 80
5.6.4 Accounting Treatment on Depreciation . . . . . . . . . 81
ix
5.6.5 Accounting Disposal of fixed assets . . . . . . . . . . . 82
6 Financial Statements 91
6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
6.2 Income Statement . . . . . . . . . . . . . . . . . . . . . . . . 92
6.3 Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . 92
7 Partnership Accounts 101

7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
7.2 Why Form Partnerships? . . . . . . . . . . . . . . . . . . . . 102
7.3 Disadvantages of partnership . . . . . . . . . . . . . . . . . . . 102
7.4 Accounting Entries . . . . . . . . . . . . . . . . . . . . . . . . 103
7.4.1 Fluctuating capital account . . . . . . . . . . . . . . . 104
7.5 Profit and Loss Appropriation account . . . . . . . . . . . . . 105
8 Company’S Account 108

8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
8.2 Ordinary shares . . . . . . . . . . . . . . . . . . . . . . . . . . 109
8.3 Preference shares . . . . . . . . . . . . . . . . . . . . . . . . . 109
8.4 Accounting Entries . . . . . . . . . . . . . . . . . . . . . . . . 110
8.4.1 Sale of Company Shares . . . . . . . . . . . . . . . . . 110
8.5 Share Premium . . . . . . . . . . . . . . . . . . . . . . . . . . 110
8.6 Debenture . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
8.7 Accounting Entries for the Sale of Debentures . . . . . . . . . 110
8.8 Corporation Tax . . . . . . . . . . . . . . . . . . . . . . . . . 111
8.9 Audit Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
8.10 Appropriation Account . . . . . . . . . . . . . . . . . . . . . . 111
9 Non-profit Making Organization 114

9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
9.2 Uses of Finances . . . . . . . . . . . . . . . . . . . . . . . . . 115
9.3 Management committee . . . . . . . . . . . . . . . . . . . . . 116
9.4 Receipt and payment accounts . . . . . . . . . . . . . . . . . 116
9.5 Income and expenditure account . . . . . . . . . . . . . . . . . 116
9.6 Accumulated fund . . . . . . . . . . . . . . . . . . . . . . . . 117
x
10 Ratio Analysis 119

10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
10.2 Types of ratios . . . . . . . . . . . . . . . . . . . . . . . . . . 120
10.2.1 Profitability Ratios . . . . . . . . . . . . . . . . . . . . 120
10.2.2 Revenue Ratios . . . . . . . . . . . . . . . . . . . . . . 121
• Gross Profit Ratio . . . . . . . . . . . . . . . 121
• Net Profit Ratio . . . . . . . . . . . . . . . . 121
• Cash Ratio . . . . . . . . . . . . . . . . . . . 121
10.2.3 Liquidity Ratios . . . . . . . . . . . . . . . . . . . . . 122
• Current Ratio . . . . . . . . . . . . . . . . . . 122
• Quick Acid Test Ratio/ Quick Asset Ratio/
Liquid Ratio . . . . . . . . . . . . . . . . . . 122
10.2.4 Capital Structure /Gearing Ratios . . . . . . . . . . . 122
• Debt-equity ratios . . . . . . . . . . . . . . . 123
• Equity Ratio . . . . . . . . . . . . . . . . . . 123
10.2.5 Coverage Ratios Or Stability Ratios . . . . . . . . . . 123
10.2.6 Activity Ratios . . . . . . . . . . . . . . . . . . . . . . 124
10.2.7 Stock Market Ratios . . . . . . . . . . . . . . . . . . . 126
Solutions to Exercises . . . . . . . . . . . . . . . . . . . . . . . 133
xi
HBT 2103 INTRODUCTION TO ACCOUNTING
LESSON 1
Conceptual Framework Underlying Financial
Accounting
Learning Outcomes
A study of this chapter should enable students to:
• Explain the importance of a conceptual framework for financial account-

ing.
• Know the objectives of financial accounting.
• Describe the qualitative characteristics of accounting information.
• Differentiate between the qualities relating to content and those relating

to presentation of accounting information.
• Identify and explain the accounting elements.
• Highlight the limitations of preparing financial reports
1
1.1. Introduction
Accounting has been defined as both a science as well as an art. When de-
fined as an art, it refers to “the how of accounting” while when accounting
is defined as a science, it refers to the “why of accounting”. Accounting
is a science because it is backed by a body of knowledge that is a concep-
tual framework. This lesson discusses the theoretical foundation of accounting
highlighting the definition of the conceptual framework; the need for a con-
ceptual framework; the makeup of the conceptual framework and the reasons
for the absence of a universally accepted conceptual framework underlying
financial accounting.
1.2. Definition of conceptual framework

A conceptual framework is a constitution, a coherent system of interrelated
objectives and fundamentals that can lead to consistent standards and that
prescribes the nature, function and limits of financial accounting and financial
accounting statements.
A conceptual framework underlying financial accounting cannot be viewed as
the description of fundamental truths and axioms as found in theories regard-
ing the natural sciences which are derived from and proven by the laws of
nature. A conceptual framework, rather, is created, developed or decreed on
the basis of environmental factors, intuition, authority and acceptability. The
credibility of the conceptual framework rests upon its general recognition and
acceptance by preparers, auditors and users of financial statements.
1.2.1. Need for a conceptual framework.

It enables the development and issuance of a coherent set of accounting stan-
dards and practices built upon the same foundation. Increases financial state-
ment users’ understanding of and confidence in financial reporting. It enhances
comparability among financial statements of different companies due to sim-
ilarity in accounting for similar transactions and events. Resolves new and
emerging practical problems by providing a frame of reference. Defines the
bounds of judgment in the preparation of financial statements.
2
Figure 1.1: Overview of a Conceptual Framework for Financial Accounting
•.1. The first level This level comprises the objectives that identify the
goals and purposes of accounting and are the cornerstones for the conceptual
framework.
•.2. The second level This level comprises the qualitative characteristics
of accounting information and definition of elements of financial statements.
The qualitative characteristics are the characteristics that make accounting
information useful while elements are definitions of financial statements com-
ponents. Together these two categories provide the foundation for developing
recognition and measurement guidelines to be used in practice.
•.3. The third level This is the final level that holds the recognition
and measurement guidelines that accountants use in establishing and applying
accounting standards. The recognition and measurement guidelines encompass
assumptions, principles and constraints that describe the present reporting
environment.
3
Figure 1.2: The relationship between the qualitative characteristics of good

accounting information
1.3. Objectives of Financial Accounting

The objective of financial reporting is to provide information about the finan-
cial position, performance and changes in financial position of an enterprise
that is useful to a wide range of users in making economic decisions. Financial
statements prepared for this purpose meet the common needs of most users.
General purpose financial statements, however, do not provide all the informa-
tion that user may need to make economic decisions since they largely portray
the financial effects of past events and do not necessarily provide non-financial
information
1.4. Qualitative Characteristics of accounting information

These are the characteristics that make the information provided in financial
statements useful to users for assessing the financial position, performance and
financial adaptability of an enterprise.
Some qualitative characteristics relate to the content of information while oth-
ers relate to how that information is presented in the financial statements. The
primary qualitative characteristics relating to content are relevance and reli-
ability. The primary qualitative characteristics relating to presentation are
comparability and understandability.
4
NB
The primary qualitative characteristics relating to content are relevance and
reliability.
The primary qualitative characteristics relating to presentation are compara-
bility and understandability.
1.4.1. Primary qualities relating to content

It is generally agreed that relevance and reliability are the two primary qual-
ities that make accounting information useful for decision making. Each of
these qualities is achieved to the extent that information incorporates specific
capabilities (ingredients) as discussed below.
• Relevance
Information is relevant when it has the ability of influencing the decisions
of users (i.e. it is capable of making a difference in a decision). If certain
information is disregarded because it is perceived to have no bearing on a
decision, it is irrelevant to that decision. Information is said to be relevant
when it has:
• Predictive value - helps users make predictions about the outcome of

past, present, and future events.
• Feedback value - confirms or corrects prior expectations
• Timely - available to decision makers before it loses its capacity to influ-

ence their decision
For example, when a company issues an interim report, this information is

considered relevant because it provides a basis for forecasting annual earnings,
and provides feedback on past performance.
It follows that for information to be relevant, it must also be timely - available
to decision-makers before it loses its capacity to influence their decision. For
example, if a company did not report its interim results until six months after
the end of the period, the information would be much less useful for decision-
making purposes. For information to be relevant, it should have the ingredients
of predictive value, feedback value, and timeliness.
5
• Reliability
Information has the quality of reliability when it is free from material error
and bias and can be depended upon by users to represent faithfully that which
it either purports to represent or could reasonably be expected to represent.
The secondary qualities that give rise to the quality of reliability include:
1. Faithful Representation
To be reliable, information must represent faithfully the transactions
and other events it either purports to represent or could reasonably be
expected to represent. Accountants are required to use accurate figures
as far as possible and reasonable estimates otherwise when accounting
for transactions and events.
Most financial information is subject to some risk of being less than a
faithful representation of what it purports to portray. This is not due to
bias, but rather to inherent difficulties either in identifying the measure-
ment and presentation techniques that convey messages that correspond
with those transactions and events.
2. Substance Over Form

As stated earlier, for information to be reliable, it must represent faith-
fully the transactions and other events it either purports to represent or
could reasonably be expected to represent.
If information is to represent faithfully the transactions and other events
that it purports to represent, it is necessary that they are accounted for
and presented in accordance with their financial substance and economic
reality and not merely their legal form (legal interpretation).
The substance of transactions or other events is not always consistent
with that which is apparent from their legal or contrived form. For
example, accountants present assets that are the subject of hire-purchase
transactions on the balance sheet of the purchaser even though legally
title may not have yet passed from the vendor to the vendee. Another
example is where a sale is not reported in the case of a sale lease back
transaction where the lease qualifies as a finance lease.
6
3. Neutrality
To be reliable, the information contained in financial statements must be
neutral, that is, free from bias. Financial statements are not neutral if by
the selection or presentation of information, they influence the making
of a decision or judgment in order to achieve a predetermined result or
outcome.
4. Prudence
The preparers of financial statements do, however, have to contend with
the uncertainties that inevitably surround many events and circum-
stances, such as the collect ability of doubtful receivables, the probable
useful life of plant and equipment and the number of warranty claims
that may occur. Such uncertainties are recognized by the disclosure of
their nature and extent by the exercise of prudence in the preparation
of the financial statements.
Prudence is the inclusion of a degree of caution in the exercise of the
judgments needed in making the estimates required under conditions of
uncertainty, such that assets or income are not overstated and liabilities
or expenses are not understated. The exercise of prudence, however,
does not allow, for example, the creation of hidden reserves or excessive
provisions, the deliberate understatement of assets or income, or the
deliberate overstatement of liabilities or expenses, because the financial
statements would not be neutral and, therefore, not have the quality of
reliability.
5. Completeness
To be reliable, information contained in financial statements must be
complete within the bounds of materiality and cost. An omission can
cause information to be false or misleading and thus unreliable and de-
ficient in terms of its relevance.
Information may be relevant but so unreliable in nature or representa-
tion that its recognition may be potentially misleading. For example, if
the validity and amount of a claim for damages under legal action are
disputed, it may be inappropriate for the enterprise to recognize the full
7
amount of the claim in the balance sheet, although it may be appropriate

to disclose the amount and circumstances of the claim.
1.4.2. Primary qualities relating to presentation

• Understandability
An essential quality of the information provided in financial statements is that
it is readily understandable by users. For this purpose, users are assumed
to have a reasonable knowledge of business and economic activities and ac-
counting and willingness to study the information with reasonable diligence.
Information about complex matters that should be included in the financial
statements because of its relevance to the economic decision-making needs of
users, however, should not be excluded merely on the grounds that it may be
too difficult for certain users to understand.
• Comparability
Users must be able to compare the financial statements of an enterprise over
time in order to identify trends in its financial position and performance. Users
must also be able to compare the financial statements of different enterprises in
order to evaluate their relative financial position, performance and changes in
financial position. Hence, the measurement and display of the financial effect
of like transactions and other events must be carried out in a consistent way
throughout an enterprise and over time for that enterprise and in a consistent
way for different enterprises.
An important implication of the qualitative characteristics of comparability is
that users be informed of the accounting policies employed in the preparation
of the financial statements, any changes in those policies and the effects of such
changes. Users need to be able to identify differences between the account-
ing policies for like transactions and other events used by the same enterprise
from period to period and by different enterprises. Compliance with account-
ing standards, including the disclosure of the accounting policies used by the
enterprise, helps to achieve comparability.
The need for comparability should not be confused with mere uniformity and
should not be allowed to become an impediment to the introduction of im-
proved accounting standards. It is not appropriate for an enterprise to continue
8
accounting in the same manner for a transaction or other event if the policy
adopted is not in keeping with the qualitative characteristics of relevance and
reliability. It is also inappropriate for an enterprise to leave its accounting
policies unchanged when more relevant and reliable alternatives exist.
Because users wish to compare the financial position, performance and changes
in financial position of an enterprise over time, it is important that the financial
statements show corresponding information for the preceding periods.
1.5. Elements of Financial Statements

An important aspect of the theoretical structure is the establishment and def-
inition of the basic categories of items to be included in financial statements.
At present, accounting uses many terms that have peculiar and specific mean-
ing in the language of business. It seems necessary, therefore, to develop a
basic definition framework for the elements of accounting. Such definitions
provide guidance for identifying what to include and what to exclude from the
financial statements.
1.5.1. Elements in the Balance Sheet

• Assets
Assets are economic resources controlled by an entity as a result of past trans-
actions or events from which future economic benefits may be obtained. Assets
have three essential characteristics: They embody a future benefit that involves
a capacity, singly or in combination with other assets, to contribute directly
or indirectly to future net cash flows
The entity can control access to the benefit
The transaction or event giving rise to the entity’s right to, or control of, the
benefit has already occurred.
It is not essential for control of access to the benefit to be legally enforceable
for a resource to be an asset, provided the entity can control its use by other
means. Assets are classified into;
• Non Current Assets or Fixed Assets.
• Current Assets.
9
• Intangible Assets
1. Non Current Assets or Fixed Assets.

Non Current Assets are not easily convertible to cash or not expected to
become cash within one year e.g land, buildings, plant and machinery,
equipment, furniture, motor vehicles etc. These assets are expected to
be in a particular business for a period of more than one year to assist
in earning revenues.
2. Current Assets
Current Assets can be converted to cash or used to pay current liabilities
within one year e.g cash in hand, cash at bank, accounts receivables,
inventory etc. Current assets are not expected to last for more than one
year.
3. Intangible Assets
These assets include those that lack the physical substance e.g goodwill,
intellectual property like patents etc.
• Liabilities
Liabilities are obligations of an entity arising from past transactions or events,
the settlement of which may result in the transfer or use of assets, provision of
services, or other yielding of economic benefits in the future. Liabilities, like
assets, have three essential characteristics:
• They embody a duty or responsibility to others that entails settlement

by future transfer or use of assets, provision of services or other yielding
of economic benefits, at a specified or determinable date, on occurrence
of a specified event, or on demand
• The duty or responsibility obligates the entity, leaving it little or no

discretion to avoid it; and
• The transaction or event obligating the entity has already occurred.
Liabilities are classified into;
10
• Long term Liabilities or Non Current Liabilities
• Current Liabilities
1. Long term Liabilities or Non Current Liabilities

These are economic obligations that are due in more than one year e.g
debentures, long term loans etc
2. Current Liabilities
These are economic obligations due within one year e.g short term debts,
accounts payables, bank overdraft etc.
• Equity/ Capital
Equity is the ownership interest in the assets after deducting its liabilities.
1.5.2. Elements in the Income Statement

Revenues
Revenues are increases in economic resources, either by way of inflows or en-
hancements of assets or reductions of liabilities, resulting from the ordinary
activities of an entity, normally from the sale of goods, the rendering of ser-
vices, or the use by others of entity resources yielding rent, interest, royalties
or dividends.
Expenses
Expenses are decreases in economic resources, either by way of outflows or
reductions of assets or incurrence of liabilities, resulting from the ordinary
revenue-earning activities of any entity.
Gains
Gains are increases in equity from peripheral or incidental transactions and
events affecting an entity, and from all other transactions, events and circum-
stances affecting the entity except those that result from revenues or equity
contributions.
11
Losses
Losses are decreases in equity from peripheral or incidental transactions and
events affecting an entity and from all other transactions, events and circum-
stances affecting the entity except those that result from expenses or distribu-
tions of equity.
NB
The elements in the balance sheet are changed by elements in the income
statement, and at any time is the cumulative result of all changes. This inter-
action is referred to as articulation, and results in financial statements that
are fundamentally interrelated.
1.6. Summary
A conceptual framework for financial accounting enables the development and
issuance of a coherent set of accounting standards and practices, increases
financial statement users’ understanding of and confidence in financial report-
ing, enhances comparability and assists in the resolution of new and emerging
practical problems.
Objectives of accounting identify the goals and purposes of accounting and
are the cornerstones for the conceptual framework. The qualitative charac-
teristics are the characteristics that make accounting information useful while
elements are definitions of financial statements components. Together these
two categories provide the foundation for developing recognition and measure-
ment guidelines to be used in accounting practice.
Despite the desire for a universal conceptual framework for accounting, the
same has not been achieved. The variety of users of financial statements
and the time and resources needed to develop a universally agreed concep-
tual framework perhaps are some of the factors inhibit the development of a
universally agreed conceptual framework.
Example . Explain the difference between revenue and a gain.
Solution:
Gains are increases in equity from peripheral or incidental transactions and
events affecting an entity, and from all other transactions, events and circum-
stances affecting the entity except those that result from revenues or equity
contributions.
12
Losses are decreases in equity from peripheral or incidental transactions and

events affecting an entity and from all other transactions, events and circum-
stances affecting the entity except those that result from expenses or distribu-
tions of equity.

13
Revision Question.
Exercise 1. Discuss the importance of a conceptual framework to financial

accounting.
Exercise 2. Differentiate between general purpose financial statements
and specific purpose financial statements.
Exercise 3. Briefly discuss the objectives of financial reporting.
Exercise 4. Of what importance in a conceptual framework are definitions
of element of the financial statements?
Exercise 5. A conceptual framework for financial accounting and report-
ing sets forth objectives and fundamentals that should provide the basis for
developing financial accounting and reporting standards. The framework also
examines the qualitative characteristics that make accounting information use-
ful. Identify and discuss the benefits that can be expected from a conceptual
framework.
References and Additional Reading Materials

• Garrison, R. (2005). Managerial Accounting, 6th edition, Irwin, Inter-
national Financial Reporting Standards 2010
14
LESSON 2
Introduction to Accounting Equation and Double
Entry System
• Explain what is meant by the Accounting Equation
• Have a clear perspective of the double entry system
• Understand how the double entry system follows the rules of the ac-
counting equation
• Describe the debit and credit entries with corresponding transactions
• Accounting for Assets, Liabilities and Capital
• Accounting for Sales, Purchases, Incomes and Expenses
• Understand the Asset of Stock
15
2.1. Introduction
This chapter introduces the application of the Accounting Equation that forms
the basis of the double entry in accounting. Debit and credit entries are used in
accordance to a particular transaction and for the double entry to be observed,
every debit entry must be corresponded with a credit entry or a set of credit
entries and vice versa.
2.2. The Accounting Equation

Initially when a business enterprise starts operating, it owns property inform
of assets that are equivalent to the start up capital. Later on after continuance
in the business, obligations inform of liabilities are incurred hence the equation
changes. The total assets are now equivalent to the capital plus the liabilities
in the business.
ASSET S = LIABILIT IES + CAP IT AL
The accounting equation is summarized in the balance sheet as illustrated

below;
(Horizontal Format) Balance sheet as at 31.12.20x3
16
(Vertical Format I) Balance sheet as at 31.12.20x3
(Vertical Format II) Balance sheet as at 31.12.20x3
17
Activity 3.1
The following transactions demonstrate the application of the accounting equa-
tion in a balance sheet.
1. Introduction of Capital for a New Business

01/01/20x3; XYZ traders started business by depositing Ksh 90,000 in
a business bank account
Balance sheet as at 01/01/20x3
ASSETS Kshs CAPITAL Kshs
Cash at bank 90,000 Capital 90,000
90,000 90,000
2. Purchase of a Non Current Asset via Cheque

04/01/20x3; XYZ bought a motor vehicle for the business worth Ksh
40,000 paying by cheque
Motor vehicle 40,000 Capital 90,000
Cash at bank 50,000
90,000 90,000
3. Purchase of a Current Asset on Credit

07/01/20x3; XYZ purchased goods for Ksh 13,000 on credit terms.
Stock 13,000 Liability
Cash at bank 50,000 Creditor 13,000
103,000 103,000
4. Sale of a Current Asset on Credit Terms

11/01/20x3; XYZ made credit sales costing Ksh 5,000 to ABC enter-
prises.
18

Stock 8,000
Debtor 5,000 Liability
103,000 103,000
5. Sale of a Current Asset on Cash Terms

14/01/20x3; XYZ made cash sales costing Ksh 7,000 to KK enterprises
Stock 1,000
103,000 103,000
6. Payment of a liability
16/01/20x3; XYZ paid Ksh 11,000 for the goods bought on credit
Stock 1,000
92,000 92,000
7. Collection of a current asset

30/01/20x3; ABC enterprises paid XYZ traders Ksh 3,500 being part
settlement of the account.
19

Stock 1,000
92,000 92,000
2.3. The Double Entry System

Accounting equation forms the basis of the double entry system. Change in a
business involving Assets, Liabilities or Capital MUST have an effect that is
interrelated to the three components of the accounting equation. This is known
as a double effect such that assets will always be equal to liabilities plus capital.
For Example if the owners of a business enterprise put in additional capital
into the business via bank, this will increase the cash at bank and the capital
amount will also increase hence the equation is still maintained. According to
the accounting equation if all assets are represented by liabilities and capital
then all debit entries should be the same as credit entries.
2.4. The Debit and Credit Entries

The Debit Entry is shown on the left hand side of an account (Commonly
referred to as a “T – Account) while the Credit Entry is shown on the right
hand side of an account (Commonly referred to as a “T – Account). Assets
are recorded on the debit side while all the liabilities and capital are recorded
on the credit side. Assets and Liabilities are classified into various categories
as covered in lesson two and every type of asset or liability must have its own
account whereby all transactions affecting them are recorded in that particular
account.
This means that there should be individual accounts for Buildings, Equipment,
Machinery, Motor vehicles, Furniture & fittings, Debtors, Creditors, etc. For
the double entry to be reflected in the accounts, every debit entry must have
a corresponding credit entry or a set of credit entries and vice versa. The
transactions affecting these accounts are posted in the account as debit entry
and credit entry to complete the double entry.
20
The following is a layout of accounts with a debit and credit side:
Title of Account
Left-hand side Right-hand side
This side represents the ‘debit’ side This side represents the ‘credit’ side.
These accounts are commonly referred to as T – Accounts because the lines

separating the two sides form a ‘T’. This is simply illustrated as:
2.5. Double Entry System for the Various Elements of Financial

Statements
As covered in lesson two, we now have an idea of elements used in financial
statements. Remember we have elements for the income statement as well
as those for the balance sheet. The double entry system that is based on
the Accounting Equation has interconnectivity with the discussed elements of
financial statements.
2.5.1. Accounting for Assets, Liabilities and Capital

Assets, Liabilities and Capital comprise of the elements in the Balance Sheet.
Activity 2.2, illustrations 6 and 7 have been revolving with these elements.
The following summary indicates the double entries relevant to account for
them.
Increase in ASSET = DEBIT entry
Decrease in ASSET = CREDIT entry
Increase in LIABILITY = CREDIT entry
Decrease in LIABILITY = DEBIT entry
Increase in CAPITAL = CREDIT entry
Decrease in CAPITAL = DEBIT entry
21
Table 2.1: Summary table for Balance Sheet Elements
Example . Illustration
Prepare Asset, Liability and Capital Accounts for Michael who had the fol-
lowing transactions for the month of January, 20x3.
01/01/20x3: Started business by depositing Ksh 500,000 in the bank.
02/01/20x3: Purchased a Motor Vehicle paying by cheque Ksh 120,000.
05/01/20x3: Purchased Fixtures & Fittings Ksh 40,000 on credit from ABC
Ltd.
08/01/20x3: Purchased another Motor Vehicle on credit from XYZ Ltd for
Ksh 80,000.
12/01/20x3: Withdrew Ksh 10,000 from the bank and put it into the cash till.
15/01/20x3: Purchased extra Fixtures & Fittings paying by cash Ksh 6,000.
19/01/20x3: Paid XYZ Ltd by cheque Ksh 80,000.
21/01/20x3: Received a loan of Ksh 100,000 in cash from KK financers.
25/01/20x3: Deposited cash amount of Ksh 80,000 into the bank account.
30/01/20x3: Purchased more Fixtures & Fittings by cheque worth Ksh 30,000.
Solution:
Capital A/c
20x3 Sh. 20x3 Sh.
30/1 Bal c/f 500,000 1/1 Bank 500,000
500,00 500,00
22
Bank A/c
20x3 Sh. 20x3 Sh.
1/1 Capital 500,000 2/1 M/vehicle 120,000
25/1 Cash 80,000 12/1 Cash 10,000
19/1 XYZ Ltd 80,000
30/1 Fixtures 30,000
30/1 Bal c/f 340,000
580,00 580,00
.
23
Points to Note:
• The difference between the debit and credit side is the balancing figure
shown in the form of ‘Bal c/f’ meaning balance carried forward as at the
end of that financial period.
• Most Assets have a balance on the credit side while most Liabilities and
capital accounts will have a balance on the debit side. This is not always
the case because for example a bank account (asset account) can have
a balance on the debit side meaning its overdrawn that is it has a bank
overdraft hence converting the account into becoming a liability.
A balance sheet from the above accounts will be as follows:
2.5.2. Accounting for Sales, Purchases, Incomes and Expenses

The above comprise the Income statement elements. Sale and purchases might
appear to be new but Sales form part of Revenue while purchases indicate
increase in stock or inventory for a particular business. These elements will be
later discussed into details.
2.5.3. Double Entry System for Elements in the Income Statement

Increase in EXPENSES = DEBIT entry
24
Decrease in EXPENSES = CREDIT entry

Increase in INCOME/ REVENUE = CREDIT entry
Decrease in INCOME/ REVENUE = DEBIT entry
Table 2.2: Summary table Income Statement Elements
Table 2.3: Summary table All elements
Accounting for Sales:

Sales are realized after selling goods that were initially bought or purchased by
a business with the purpose of resale. Sales generate revenue for a particular
business and can be sub-divided into either Cash Sales or Credit Sales.
• Accounting Treatment for Cash Sales

Debit : Cash/ Bank Account
Credit : Sales Account

Debit : Debtors Account/ Accounts receivable Account
Credit : Sales Account
25
Accounting for Purchases:

Purchases involve buying of goods meant for resale by a business firm. Pur-
chases can also be sub-divided into either for Cash Purchases or Credit Pur-
chases.

Debit : Purchases Account
Credit : Cash/ Bank Account
• Accounting Treatment for Credit Purchases

Debit : Purchases Account
Credit : Creditors Account/ Accounts Payable Account
Accounting for Income:

A business firm may generate other income apart from that generated from
trading (sales). These other incomes can include e.g. Rent, Bank interest
received, Discounts received etc.
• Accounting Treatment for Income received

Debit : Cash/ Bank Account or Account receivable
Credit : Income Account
NB:
• Each Income should have an individual account.
• Incomes increase the capital of a business thus this being the reason as
to why they are posted on the credit side of their respective accounts.
Accounting for Expenses:

Expenses involve amounts incurred in furtherance of generating revenue for a
business. Expenses are paid out for services rendered other than those paid for
purchases. Expenses may include; Electricity bill, Salaries and wages, Bank
charges, Motor vehicle expenses, Rent and rates, Telephone bills, Advertising
etc.
26
• Accounting Treatment for Expenses

Debit : Expenses Account
Credit : Cash/ Bank Account or Account Payable
NB:
• Each expense should have an individual account.
• Expenses decrease the capital of a business thus this being the reason as
to why they are posted on the debit side of their respective accounts.
2.6. The Asset of Stock (Inventory)

A Stock Account is NEVER maintained because sales are not priced at cost
hence sales figures include elements of profit and loss, and do not represent
cost of stock of goods. Stock is therefore subdivided into several accounts each
showing the movement of stock.
2.6.1. Accounts to record increase of stock

Accounts that record any increase in stock are:
• Purchases Account
• Return Inwards Account
• Purchases Account
Records purchases of additional goods either on credit or cash as discussed
earlier.
• Returns Inwards Account (Sales Returns Account)

Records return of goods previously sold by a business its customers or debtors.
Goods may be returned for various reasons like being; faulty, wrong type of
goods or oversupply. Return inwards may relate to cash sales or credit sales.
Goods returned in relation to a cash sale that was initially made, cash is
refunded to the customer. Return inwards in relation to a credit sale that was
initially made, cash is not refunded to the debtor.
27
• Accounting Treatment for Return Outwards relating to Cash

Purchases:
Debit : Cash/ Bank Account or Cashbook
Credit : Return Outwards Account
• Accounting Treatment for Return Outwards relating to Credit Purchases:

Debit : Creditors Account
Credit : Return Outwards Account
• Accounting treatment for Return Outwards in the trading ac-

count:
Return outwards is deducted from PURCHASES AMOUNT
• Drawings Account (Goods Drawing)

Drawings in the form of Goods arises when the owner(s) of the business takes
out some of the business goods out of the stock or purchases made for his own
use.
• Accounting Treatment for Goods Drawing:

Debit : Drawings Account
Credit : Purchases Account
Example . Illustration
The following transactions relate to Kencom Enterprises. You are required
to complete the double entry in the relevant accounts for the month of May,
20x3.
01/05/20x3: Started business by depositing Ksh 200,000 in the bank.
02/05/20x3: Purchased goods worth Ksh 17,500 on credit from MM Whole-
salers.
03/05/20x3: Bought Equipment for Ksh 15,000 paying by cheque.
05/05/20x3: Sold goods for cash worth Ksh 27,500.
06/05/20x3: Bought goods on credit worth Ksh 11,400 from Pp Shah.
10/05/20x3: Paid rent by cash Ksh 1,500.
12/05/20x3: Bought stationery for Ksh 2,700, paying in cash.
28
18/05/20x3: Goods returned to MM Wholesalers were amounting to Ksh

2,300.
21/05/20x3: Received rent by cheque for Ksh 500.
23/05/20x3: Sold goods on credit to Unity for Ksh 7,700.
24/05/20x3: Bought a motor vehicle paying by cheque Ksh 30,000.
30/05/20x3: Paid the wages by cash amounting to Ksh 11,700.
31/05/20x3: The owner made cash drawings for personal use worth Ksh 4,400.
Solution:
29
.
30
Revision Questions
Exercise 6. Illustration
The following information relates to Alpha traders as at 31st December 20x3.
You are required to prepare a balance sheet as at that date.
Ksh
Land & Buildings 450,000
Furniture & Fittings 75,500
Motor Vehicles 95,800
Stocks 57,000
.
Debtor 17,600
Cash a bank 21,500
Creditors 97,700
Capital 224,200
Loan 400,000
Exercise 7. The following assets and liabilities are owned by Jacob a sole
trader as at 01/01/20x3.
Ksh
Accounts payable 56,500
Machinery 150,000
Motor Vehicles 260,600
Stocks 105,000
Accounts receivable 155,700
Cash a bank 90,000
Cash 34,000
The following transactions were also captured during the financial period that
ended 31/12/20x3.
a) A new machine was purchased on credit worth Ksh 21,500.
b) Additional stock for Ksh 64,000 was purchased via bank.
c) Creditors were partly settled by payment of Ksh 20,000 by cheque.
d) The current debtors paid their account by Ksh 72,000 on cash.
e) Jacob deposited Ksh 5,000 into the bank account as capital.
Required:
i. Determine the capital amount for the business at the beginning of the
financial period.
31
ii. Extract a trial balance that captures all the transactions reported .

tion, ISBN 978-81-317 2914-4
32
LESSON 3
The Accounting Cycle
Learning outcomes
Upon completing this topic, you should be able to:
• Identify the various sources of financial data
• Prepare journal entries per transactions
• Post journal entries into respective ledger accounts
• Preparation of a cash book and a petty cash book
• Extraction of a trial balance
• Adjustment entries to the journals, ledgers and trial balance
• Understand the procedures to preparing financial Statements
• Understand and clearly define the accounting cycle with its various steps
33
3.1. Introduction
The accounting cycle involves a series of steps undertaken in order to produce
financial statements to aid in economic decision making for the various users
of the accounting information. Basically the accounting cycle comprises of the
following major parts;
1. Capture source documents.
2. Enter transactions in the books of original entry (Journalizing).
3. Post journal entries to ledgers.
4. Extract a trial balance.
5. Adjustment entries.
6. Prepare financial statements.
3.2. Capture Source Documents

This step involves collection and capturing of source documents that record the
evidence of a business transaction that occurred. The documents are collected,
recorded, filed and the postings made in the books of prime entry. Main Source
documents include;
• Sales invoice
• Purchases invoice
• Credit note
• Debit note
• Receipts
• Cheques
• Petty cash vouchers
• Any other correspondences
34
• Sales Invoice
A sales invoice is sent by a business firm to its debtors after transacting a
credit sale. Particulars of a sales invoice include;
• Business name and address of the transacting parties.
• Date of the sale.
• Sales invoice number and amount due.
• Good description.
• Terms of sale.
• Purchases Invoice
A purchase invoice is sent by a creditor to a business firm that makes a credit
purchase. Particulars of a purchases invoice include;
• Date of the purchase.
• Purchases invoice number and amount due.
• Goods description.
• Terms of purchase.
• Credit note
A credit note is sent by a business firm to a debtor in response to some goods
returned by the debtor back to the business firm. Particulars of a credit note
include;
• Date.
• Credit note number.
• Amount to be refunded.
• Reason for goods returned. (Sales Returns)
35
• Debit note
A debit note is sent by the creditor to a business firm that returns some goods
to the creditor after it had initially made credit purchases. Particulars of a
credit note include;
• Date.
• Debit Note number.
• Amount to be refunded.
• Reason for goods returned. (Purchases Returns)
• Receipts
A receipt is sent by the business firm to its customers or debtors after trans-
acting inform of cash or cheques. Particulars of a credit note include;
• Date.
• Receipt number.
• Amount received. (Cash or Cheque)
• Cheques
A business firm can make payments against the account held in the bank
via cheques. The cheque authorizes the respective bank to honour payments
against the business firm’s account name. Particulars of a cheque include;
• Name of payee and drawer
• Date.
• Amount payable in words and figures
• Cheque number
• The authorized signature(s)
36
• Petty cash vouchers

A petty cash voucher is sent by a cashier requesting for payment of trivial
cash or petty cash to seek authority for payments. Particulars of a petty cash
vouchers include;
• Date.
• Amount paid.
• The authorized signature(s)
• Payment reason.
• Person(s) responsible for approving and receiving.
• Other correspondence
Any other correspondence can emanate from internal or external side of the
business firm as long as it has a financial implication in the accounts. For
example extra charges made in the accounts.
3.3. Journalizing
Journalizing involves recording transactions in a journal. It also involves the
initial record of transactions in Books of Original Entry. Books of original
entry can also be referred to as; Books of Prime Entry or Subsidiary Books/
Journals/ Day Books/. These are books where transactions are first recorded
and they include;
Sales Journal
Sales journal is also known as Sales Day Book. It records all sales invoices
issued by the firm during a particular time. Individual entries on the sales day
book are posted on the debit side of debtors account in the sales ledger. The
total is posted on the credit side of general ledger.
The following is an illustration to show a sales journal.
37
Example . You are to enter up the sales journal from the following details.
Post the items to the relevant accounts in the sales ledger and then show the
transfer to the sales account in the general ledger.
Date Credit Sales to Amount
1/6/20x3 Michel Sh. 1,800
4/6/20x3 Herbert Sh. 2,000
7/6/20x3 Jessica Sh. 900
.
9/6/20x3 Cecilia Sh. 450
16/6/20x3 Andrew Sh. 1,390
21/6/20x3 Richard Sh. 380
30/6/20x3 Albert Sh. 500
Solution:
Date Detail Folio No. Amount
1/6/20x3 Michel 0010 Sh. 1,800
4/6/20x3 Herbert 0020 Sh. 2,000
7/6/20x3 Jessica 0030 Sh. 900
Sales journal
9/6/20x3 Cecilia 0040 Sh. 450
16/6/20x3 Andrew 0050 Sh. 1,390
21/6/20x3 Richard 0060 Sh. 380
30/6/20x3 Albert 0070 Sh. 500
Sales ledger
38
Purchases Journal
Purchases Journal is also known as Purchases Day Book. It records all pur-
chase invoices received by the firm during a particular financial period. Indi-
vidual entries are posted to the credit side of creditors account in the purchase
ledger. The total is posted to the debit side of the purchases account in the
general ledger.
Return Inwards Journal

Return Inwards Journal is also known as Return Inwards Day Book. It records
all credit notes received by the firm. Individual entries in a return inwards day
book are posted to the credit side of the debtors account in the sales ledger and
the total is posted in the debit side of return inwards account in the general
ledger.
Return Outwards Journal

Return Outwards Journal is also known as Return Outwards Day Book. It
records all debit notes sent to suppliers. Individual entries in a return outwards
39
day book are posted to the debit side of the creditors account in the purchases
ledger and the total is posted to the credit side of return outwards account in
the general journal.
Example . The following transactions relate to Jasho Enterprises. Enter

the transactions in the relevant books of original entry and show the postings
made in the general ledger.
1/10/20x3 Credit purchases from: Martin Sh. 38,000; Mark Sh. 5,000; Mike
Sh. 1,060.
3/10/20x3 Credit sales to: Rick Sh. 5,100; Raps Sh. 2,460; Rachael Sh. 3,560.
5/10/20x3 Credit purchases from: Matthew Sh. 2,000; Mabel Sh.1,800 ; Mar-
shal Sh. 4,100; Michael Sh.660.
8/10/20x3 Credit sales to: Stephen Sh. 3,070; Stella Sh. 2,500; Samuel Sh.
1,850.
12/10/20x3 Returns outwards to: Mark Sh. 300; Mike Sh. 160.
14/10/20x3 Returns inwards from: Raps Sh. 180; Rachael Sh. 220.
20/10/20x3 Credit sales to: Raps Sh. 1,880; Shakes Sh. 3,100; Slim Sh. 4,200.
24/10/20x3 Credit purchases from: Peter Sh. 5,500; Patrick Sh. 9,000.
31/10/20x3 Returns inwards from: Raps Sh. 270; Rick Sh. 300.
31/10/20x3 Returns outwards to: Mabel Sh. 130; Michael Sh. 110.
Solution:
Sales Journal
40
Sales Ledger
Purchases Journal
Purchases Ledger
41
General Ledger
General Journal
General Journal is also known as Journal Proper. It is used to record trans-
actions or correspondences that are not in other prime books. It contains the
date, details, debit and credit columns, explanation/ narrative of the transac-
tion and folio reference to source documents. The General Journal uses double
entry system where a debit entry must be corresponded with a credit entry or
a set of credit entries and vice versa.
Uses of a General journal

1. Used to correct presence of any errors in ledger accounts.
2. Used to make necessary adjustments to entries in the ledgers.
3. Records purchase and sale of non current assets on credit.
4. Used to record bad debts written off.
5. Records opening and closing balances of assets and liabilities.
6. Records drawings for goods or other assets from the business by the
owner.
The following is a general journal format :
NOTE: Debit entries should be recorded first on the first line then followed
by the credit entries being on the second line.
Exercise 8. Record the following entries in a journal for the year 2011.
On May 1st bought a vehicle on credit from Kenya motors for Kshs 96,000.
42
On May 3rd a debt of Kshs 6,000 owing from John was written off as a bad
debt.
On May 8th credit purchase of furniture for 12,500 was returned to the supplier
BB ltd as it was unsuitable and full allowance will be given.
On May 12th a Ken a debtor who owed us Kshs 4,000 was declared bankrupt
and we received Kshs 1050 in full settlement of the debt.
On May 14th we take goods costing Kshs 3,500 out of the business stock
without paying for them.
On May 28th we discovered that Kshs 1,500 of the insurance paid, belonged
to private use.
On May 30th bought machinery for Kshs 25,000 on credit from Electronics
ltd.
3.4. Ledger Accounts

Once entries are made in books of original entry they are summarized using
double entry concept to accounts in various ledgers.
Types of Ledgers
1. Sales Ledger; used to record debtors personal accounts.
2. Purchases Ledger; used to record creditors personal accounts.
3. General Ledger/ Nominal Ledger; Used to record accounts not repre-

sented in the sales or purchases account e.g. accounts related to expenses,
incomes, other assets, liability and capital.
The ledger accounts can also be classified as follows:
43
3.5. Cash Books

A Cash Book is used to record all the Receipts and Payments inform of cash
or cheques for a particular financial period. The cashbook also shows the
available cash at bank and cash in hand. The cashbook forms part of the
general ledger and records the source documents; that is receipts and cheques.
Types of cash books

One Column Cash Book/ Single Column Cash Book
It contains an individual cash or bank account column but not both at the
same time.
Two Column Cash Book/ Double Column Cashbook

This cash book combines both cash and bank accounts. The amount column
is sub-divided into two; cash and bank columns.
Three Column Cash Book

This cash book combines cash, bank and discounts columns. The amount
column is sub-divided into three; cash, bank and discounts columns.
The balances in the cash book form part of the ledger balances. The cash book
can have either a credit or debit balance. A debit balance means the business
has cash at the bank and a credit balance means that the account at the bank
is overdrawn resulting to a bank overdraft (That is, the business firm owes the
bank some money).
Totals from discounts allowed and discounts received columns are posted to
the respective discount accounts.
44
Purpose of keeping three column cash book

1. Accurate recording of cash discounts allowed (Dr. side) and cash dis-
count received (Cr. side)
2. Accurate recording of cash and cheque receipts and payments.
3. Records opening and closing balances at beginning and end of financial

year respectively.
4. Helps detect errors and fraud.
3.6. Discounts
Discounts are allowances given by a trader or manufacturer to another trader
or customer to enable or encourage them pay promptly or buy in bulk or earn
profits. Discounts can be classified into either:
1. Trade Discount
2. Quantity Discount
3. Cash Discount
(a) Discount Allowed

(b) Discount received
Trade Discount
Trade discount is allowance given by a trader to another trader to enable them
earn a profit on goods that have low profit margin or have fixed prices.
Quantity Discount
Quantity discount is allowance given by a trader to encourage bulk purchasing
from the customers.
Accounting treatment for Trade and Quantity discounts

These discounts are shown as a deduction from invoice price and only NET
AMOUNT paid or received is treated in the books of accounts.
45
Cash Discount
Cash discount is allowance given to encourage buyers or customers to pay
promptly within the stipulated period. Cash discount is further sub-divided
into two:
(i) Discount Allowed

Discounts allowed are allowances made by a business firm on the amounts
receivable from customers so as to encourage prompt payment. The amount
for discount allowed is deducted from the sales invoice. This allowance given
to debtors and is treated as an EXPENSE.
Accounting treatment for Discount Allowed

When incurred Debit : Discount allowed Account
Credit : Debtors Account/ Accounts Receivable
At year end Debit : Income Statement/ Profit and loss Account
Credit : Discount allowed Account
(ii) Discount Received

Discounts received are allowances given by the creditors or suppliers to a busi-
ness firm to encourage payment of amount due within the agreed time. The
amount for discount received is deducted from the invoice price. This allowance
is given by creditors and is treated as INCOME.
Accounting treatment for Discount Received

When incurred Debit : Creditors Account/ Account Payable
Credit : Discount received Account
At year end Debit : Discount received Account
Credit : Income Statement/ Profit and loss Account
3.7. Petty Cash Book and the Imprest system of Accounting

A Petty Cash Book records all the petty cash vouchers maintained by a cashier.
The petty cash vouchers summarize expenses paid by the cashier. These ex-
penses are classified in the petty cash book as per the individual expense.
46
Format of a Petty Cash Book:
The Closing balance of the petty cash book represents the balance of cash in
hand. The totals amount of the expenses is posted to the debit side of the
expense accounts. In case a business firm operates another cashbook together
with a petty cash book, then the totals of the expenses are posted on the credit
side of the cash in hand cashbook.
The Imprest system

The imprest system refers to the system where a petty cashier is given enough
cash by an accountant to meet the petty cash needs for a particular period.
At the end of the period, the accountant finds out the amounts spent by the
petty cashier, by accessing the Petty Cash Book.
The accountant now reimburses the value of the amount spent on petty cash
in the period to the petty cashier with the aim of restoring back the amount
that was available at the beginning of the period. This system is referred to
as the Imprest System and the reimbursed amount is referred to as the Petty
Cash Float.
The following illustrates how an imprest system works

Ksh Petty Cash Float at the beginning of the period 20,000
Expenses incurred and fully paid (14,500)
Balance 5,500
Reimbursement 14,500
The Cash float still remains to be the same that is 20,00
3.8. Extraction of a Trial Balance

A trial balance is a list of balances extracted from ledger accounts including
cash book balances. Trial balance is extracted after the ledger entries are made
and balanced off. It summarizes the status of each ledger account.
Purpose / Importance of a trial balance

1. Instrumental for preparing financial statements.
47
2. Used to check for errors and fraud.
3. Summarizes ledger accounts.
4. Used to assess accuracy of recording.
Trial Balance Format
Example . With reference to the previous exercise ?? , a trial balance

extracted from the transactions would appear to be as follows;
Solution:
.

3.9. Adjustment entries to the journals, ledgers and trial balance

Adjustments can further be made on the books of accounts depending the
necessary changes, omitted transactions or errors realized. Errors in the books
of accounts will be covered in the next lesson.
3.10. Preparation of Financial Statements

The most important and basic financial statements used for reporting account-
ing information in a business firm are:
48
• Income Statement/ Statement of financial Performance/ Trading, Profit

and Loss account
• Balance sheet/ Statement of financial position
• Cash Flow statement
These statements are prepared after the necessary adjustment have been made
in the journals, ledgers and trial balance. These statements will be covered
into detail later in the next lessons.
Example . Prepare journal entries to record the following transactions that
took place in the month of February, 20x3:
01/02/20x3: Bought office fittings on credit from Heritage Ltd for Ksh 77,000.
05/02/20x3: Goods costing Ksh 34,000 were taken out of the business without
paying for them.
08/02/20x3: Ksh 6,800 of the goods taken by us on 5th February is returned
back into the business stock by us and no money is taken in exchange for the
return.
13/02/20x3: Johnson owes us Ksh 26,400 and he is unable to pay his debt so
we agree to take some of his computers worth the same amount to cancel his
debt.
17/02/20x3: Paid Heritage Ltd Ksh 50,000 by cheque in partial settlement of
the amount due.
25/02/20x3: A debt owing to us by Hicks of Ksh 13,450 is written off as a bad
debt.
28/02/20x3: Bought equipment on credit from ART Ltd for Ksh 31,500.
Solution:
49
.

50
Revision Questions
Exercise 9. ABC Ltd has a cashier who was issued with Ksh 20,000 as
the Cash Float at the beginning of the month of May, 20x3. The following
petty expenses were incurred during the month. Prepare a detailed petty cash
book showing the balance to be carried forward to the next period.
02/05/20x3: Bought stamps for 800
03/05/20x3: Paid bus fare for 1,200
05/05/20x3: Cleaning materials 2,400
07/05/20x3: Bought fuel 1,500
10/05/20x3: Cleaning wages 3,000
14/05/20x3: Bought stamps 2,000
19/05/20x3: Paid Jack (creditor) 4,000
22/05/20x3: Fuel costs 1,500
24/05/20x3: Bought 2 packets of biro pens 1,450.
Exercise 10. The following details belong to JJ Wholesalers. Prepare a
two column cashbook for the month ending March, 20x3.
01/03/20x3: Started business with capital inform of cash Sh. 100,000.
02/03/20x3: Paid rent by cash Sh 10,000.
03/03/20x3: Received Loan of Sh 500,000 via cheque from Barclays bank.
04/03/20x3: Paid Kenya Motors Sh 65,000 by cheque.
05/03/20x3: Made Cash sales of Sh 98,000.
07/03/20x3: Nathan a debtor paid us by cheque Sh 62,000.
09/03/20x3: Paid Bakes Ltd in cash Sh 22,000.
11/03/20x3: Made cash sales paid directly into the bank for Sh 53,000.
15/03/20x3: Gilbert paid us in cash Sh 65,000.
16/03/20x3: Took Sh 50,000 out of the cash till and deposited it into the bank
account.
19/03/20x3: Made loan repayment of Sh 100,000 by cheque to Barclays Bank
22/03/20x3: Made cash sales paid directly into the bank for Sh 66,000.
26/03/20x3: Paid motor expenses by cheque Sh 12,000.
30/03/20x3: Withdrew Sh 100,000 cash from the bank for business use.
31/03/20x3: Paid wages in cash for Sh 97,000.
51
Exercise 11. Mwananchi traders had the following account balances as

at 1st January 20x3. Cash Ksh 2,900 Bank Ksh 65,400
Debtors accounts: Creditors accounts:
Benson Ksh 12,000 Unity Ltd Ksh 6,000
Nathan Ksh 28,000 ABC Ltd Ksh 44,000
Dennis Ksh 4,000 Riper Ltd Ksh 10,000
The following transactions also took place in the month of January;
02/01/20x3: Benson cleared his account by cheque after deducting 8% cash
discount.
08/01/20x3: Mwananchi traders paid Riper Ltd by cheque less 5% cash dis-
count.
11/01/20x3: Made drawings for Ksh 10,000 from the bank for business use.
16/01/20x3: Nathan paid us his amount due by cash after deducting 3%
discount allowed.
25/01/20x3: Mwananchi traders paid office expenses in cash for Ksh 9,200.
28/01/20x3: Dennis settled his account by cash.
29/01/20x3: Paid Unity Ltd the amount due by cheque.
30/01/20x3: Paid ABC Ltd partly Ksh 40,000 by cheque.
Exercise 12. Michael Kamau runs a general groceries shop in Nairobi.
The following transactions relate to the shop for the month of September
20x3.
Sept 1st : Cash in hand Sh. 31,400; Bank balance Sh. 50,800; Capital account
Sh. 82,200
Sept 3rd: Bought goods in cash for Sh. 8,200
Sept 4th: Purchased goods on credit from Jambo ltd for Sh. 11,600 less 10%
trade discount.
Sept 7th: Sold goods on credit to Simon at Sh. 17,800 less 20% trade discount.
Sept 10th: Withdrew cash from the bank amounting to Sh. 1,000 for private
use.
Sept 12th: Sold goods on credit to Eric at Sh. 12,800.
Sept 14th: Paid Sh. 10,000 in cash to Jambo ltd in full settlement of their
account.
Sept 15th: Received Sh. 8,000 in cash from Eric in part settlement of his
account
52
Sept 17th: Goods worth Sh. 800 were returned by Eric.

Sept 21th: Purchased goods on credit at Sh. 17,400 from Shauri ltd.
Sept 24th: Paid Sh. 12,000 to Shauri ltd by cheque; discount given was Sh.
600.
Sept 25th: Purchased furniture on credit from Magic furniture for Sh. 16,000
Sept 26th: Transferred Sh. 4,400 from the cash till to the bank account.
Sept 27th: Eric was declared bankrupt and could only pay Sh.2,000 of the
debt by cheque the rest being treated as a bad debt.
Sept 28th: Goods worth Sh. 1,200 were returned to Shauri ltd.
Sept 29th: Goods worth Sh. 800 were taken by Michael Kamau for his personal
use.
Sept 29th: Paid Sh. 1000 by cheque for advertising.
Sept 29th: Paid wages to shop assistant in cash amounting to Sh. 3,600.
Sept 29th: Made cash sales of Sh. 43,600
Sept 29th: Banked Sh. 40,000
Sept 29th: Received cash of Sh. 11,800 from Simon in part payment of their
account after allowing a discount of Sh. 200.
Required;
a) Record the above transactions in the appropriate ledger accounts including
the three column cash book.
b) Extract a trial balance as at 30th September 20x3.
53

tion, ISBN 978-81-317 2914-4

4th Edition, John Wiley & Sons; ISBN: 0471072419
54
LESSON 4
Error , Suspense Accounts and Bank Reconciliation
Statements
Learning outcomes
• Describe the various types of errors.
• Differentiate between errors that are revealed by the trial balance and
those that are not.
• Correct errors that do not affect the balancing of a trial balance.
• Explain the importance of suspense accounts.
• Preparation of suspense accounts.
• Explain the importance of bank reconciliation statements
• Identify items that cause the cash book balance to differ with the bank
statement balance
• Reconcile Cash Book balances with bank statement balances
55
4.1. Introduction
This lesson covers the various types of errors can be experienced in preparation
of books of accounts. The lesson shall identify errors that affect the balancing
of a trial balance and those that do not. Correction of a range of errors arising
when financial transactions are entered in the ledger accounts and preparation
of suspense accounts will also be introduced.
This lesson also equips the students on how to prepare a bank reconciliation
statement and explains the essence of preparation. There are various items
that lead to a difference in the cash book balance as well as the bank statement
balance and they are clearly highlighted hence leading to the reconciliation of
the Cash Book balances with bank statement balances.
4.2. Errors on Accounts

Errors in books of accounts can be classified in two major categories;
1. Errors that affect the balancing of a trial balance
2. Errors that DO NOT affect the balancing of a trial balance
4.2.1. Errors that affect the balancing of a trial balance

Presence of these errors is revealed by the trial balance owing to the fact that
the debit side and the credit side of the trial balance does not balance. They
include:
• Arithmetic errors in the trial balance.
• Arithmetic errors from the ledgers.
• Partial recording or not observing double entry rule when recording

transactions.
• Failure to bring forward balances from previous accounting period.
• Failure to list some accounts in the trial balance or omitting a balance

from the ledger.
56
4.2.2. Errors that DO NOT affect the balancing of a trial balance

Presence of these errors is not revealed by the trial balance because the debit
side and the credit side of the trial balance appear to be balancing at a common
amount. On a close look on the transactions posted in the ledgers, errors might
have been made hence leading to an overstatement or understatements of the
posted figures or amounts. These errors include:
Error of omission
This error occurs when a transaction is completely omitted from the book of
accounts and hence the double entry is not observed.
For Example:
Credit sales of Ksh 30,000 made to Albert a debtor being totally omitted in
the books of accounts. This understates both the debtors and sale figures.
Correction of the Error:
Debit Albert Account (Debtors Account) and Credit Sales account with Kshs
30,000.
Error of Commission
This error occurs when a transaction is posted to a wrong personal account
but in the same class of accounts.
For Example:
Credit sales of Ksh 5,000 made to J. Patel is posted M. Patel’s account instead
yet the double entry is still observed.
Debit J. Patel account with Ksh 5,000 (to now have a correct entry in the
account) and Credit M. Patel account with Ksh 5,000 (to cancel the previous
wrong entry). The corresponding credit entry in the sales account is correct
so it remains the same.
Error of principle
This error occurs when a transaction is posted to a wrong class of account yet
the double entry is still observed.
For Example:
57
Cash Purchase of a motor vehicle for Ksh 200,000 is debited in Purchases

Account.
Debit Motor Vehicle Account with Ksh 200,000 (to now have a correct entry
in the account) and credit Purchases Account with Ksh 200,000 (to cancel the
previous wrong entry).
Note: Motor Vehicle falls under the category of a non current asset thus a
capital expenditure and not revenue expenditure as posted earlier.
Complete reversal of entries

This error occurs when a transaction is posted to the correct accounts but to
the wrong sides of the accounts that is a debit entry is posted as a credit entry
and a credit entry is posted as a debit entry.
For Example:
Credit sales of Ksh 40,000 made to Simon a debtor. An error of complete
reversal occurs when Sales account is debited with Ksh 40,000 and Simon’s
account is credited with Ksh 40,000. This error understates both the debtors
and sale figures.
To correct this error it requires doubling the amounts used so as to cancel the
error first and leave a correct entry. Debit Simon Account with Ksh 80,000
and Credit Sales Account with Ksh 80,000.
Error of Original entry

This error occurs when a transaction is posted to the correct accounts but the
amount posted is wrong or not correct. (Amount might either be understated
or overstated)
For Example:
Credit sales of Ksh 10,000 made to Jack a debtor is wrongly recorded in the
books of accounts as Ksh 8,000. This means that Jack Account is debited
with Ksh 8,000 instead of Ksh 10,000 while Sales Account is credited with
Ksh 8,000 instead of Ksh 10,000.
58
To correct this error it requires doubling the amounts used so as to cancel the
error first and leave a correct entry. Debit Simon Account with Ksh 80,000
and Credit Sales Account with Ksh 80,000.
Compensating Errors
This error occurs when transactions that are wrongly posted in the books of
accounts tend to cancel out each other.
For Example:
A debit entry that is overstated with a particular amount on one account and
a credit entry that is also overstated with a similar amount in another account
or a debit entry that is understated with a particular amount on one account
and a credit entry that is also understated with a similar amount in another
account. A debtor account being overstated with Ksh 2,000 on the debit side
and the sales account being overstated with Ksh 2,000 on the credit side.
Credit Debtor account with Ksh 2,000 so as to reduce the overstated amount
and Debit Sales account with Ksh 2,000 so as to also reduce the overstated
amount in the sales account.
Transposition error
This error occurs where a wrong sequence of digits within a number is entered.
For Example:
Recording a credit purchase of Ksh 1,240 as Ksh 1,420 instead hence this
appears to be an overstatement of Ksh 180.
Debit creditors account with the difference that is Sh. 180 and credit purchases
account with Sh. 180.
4.3. Suspense Account

A Suspense Account takes charge of the amount of difference on the debit and
credit of a trial balance mostly due to errors. If errors are not found before
the financial statements are prepared, the suspense account balance will be
included in the balance sheet. If the suspense account is a debit balance, it
59
will be shown on the asset side and if it is a credit balance, it will be shown
on the capital and liabilities side.
Trial Balance Extra
4.4. Bank Reconciliation Statement

A bank reconciliation statement explains the difference between the balance
reported in the bank statement and that reported in the cashbook.
Bank statement
This is a periodic statement sent by the bank to the bank account holder show-
ing transactions with the bank that is withdrawals, deposits, bank charges and
balances. In the bank statement; DEPOSITS are credited while WITH-
DRAWALS are debited.
4.4.1. Reasons for differences in the bank statement balance and the
cash book balance
Bank column of the cash book should show some information as the bank
statement but in many occasions they reflect different balances due to;
1. Items Appearing In The Cashbook And Not Reflected In The Bank

Statement.
60
(a) Unpresented Cheques: These are cheques issued by the business

firm for payment to the creditors or other supplies but have not
been presented to the firm’s bank for payment although they are
recorded in the cash book. They appear on the credit side of the
cash book but don’t appear in the bank statement.
(b) Uncredited deposits/cheques: These are cheques and deposits
from customers and other sources that are not credited by a bank
so as to avail funds for the business firm’s account.
(c) Errors in the cashbook: This includes recording errors in the
cash book from either receipts or payments e.g
• Over or understated payments.
• Over or understated deposits.
• Mis-posted deposits and payments
• Over or undercasting the balance b/f or c/f in the cashbook.
2. Items appearing in the bank statement and not reflected in the cashbook
(a) Bank charges: these charges levied by the bank and not in the
cash book.
(b) Interest charges: these include charges on overdrafts and loans.
(c) Direct Debits: these are payments made by the bank without
necessarily giving it instructions but instead the creditor is given
permission to collect money from the bank.
(d) Standing orders: these are payments made by the bank on behalf
of the business according to the instructions given to the bank by
the business.
(e) Dishonored cheques/ Return to Drawer cheques: these are
cheques received by the bank but not honoured due to may be
insufficient funds in the account, the cheque was stale, post dated
cheque or a cheque whose amount in words differ from those in
figures.
(f) Direct credits: these are amounts paid into the bank directly.
61
(g) Interest Income/Dividend incomes

(h) Errors in the bank statements: these errors may arise when
recording deposits or withdrawals e.g. over or understating deposits
or withdrawals.
4.4.2. Importance of a bank reconciliation statement

• To update cash book with items appearing on bank statement and not
t in the cash book.
• To correct and detect errors from the cash book or bank statement.
• To record omissions.
• Explain the difference in the cash book balance and bank statement
balance.
4.4.3. Steps in preparing a bank reconciliation statement

• Update the cash book with items appearing in the bank statement and
not appearing in the cash book apart for the errors made in the bank
statement. Errors in the cash book should also be corrected.
• Compare the debit side of cash book with credit side of the bank state-
ment to determine uncredited deposits by the bank.
• Compare the credit side of the cash book with debit side of bank state-
ment to determine Unpresented cheques.
• Prepare the bank reconciliation statement.
Format (i) for a Bank Reconciliation Statement
62
Format (ii) for a Bank Reconciliation Statement
Example . MM Traders when preparing their financial statements realized

the following errors upon investigation in the books of accounts.
a) Extra capital of Ksh 400,000 paid into the bank had been credited to Sales
account.
b) MM took goods for own use Ksh 7,000 but this had been debited to General
Expenses.
c) Private insurance Ksh 1,500 had been debited to Insurance account.
d) A credit purchase of goods from ABC Ltd Ksh 35,000 had been entered in
the books as Ksh 25,000.
e) Credit sales of Ksh 14,500 to Albert did not appear anywhere in the books.
f) Cash drawings of Ksh 4,000 had been credited to the bank column of the
cashbook.
g) Returns inwards Ksh 16,800 from Simon had been entered in error in Simp-
son account.
h) A sale of a motor van Ksh 240,000 had been credited to Motor Expenses.
Required:
Prepare journal entries to correct the above errors.
Solution:
63
MM Traders Journal entries
Example . The following bank statement and cash book relates to Sun-
shine Enterprises. Prepare an updated cash book and a bank reconciliation
statement to explain the difference in their balance as on 31st December 20x3.
64
Solution:
65
Revision Questions
Exercise 13. The trial balance for XYZ ltd at 31 December 20x3 showed
a difference of Sh. 8,000, being a shortage on the debit side. Show the journal
entries to correct the following errors and prepare a suspense account.
1. Extra capital of Sh. 5,000 paid into the bank had been credited to sales
account.
2. Sales account had been overcast by Sh. 9,000
3. Insurance expense was undercast by Sh. 4,000
4. Private rent of Sh. 1,900 had been debited in the rent account.
5. Cash of Sh. 5,000 received from a debtor was entered in the cash book only.
6. A credit purchase of Sh. 5,900 was entered in the books as Sh. 9,500
Exercise 14. Tempo Ltd prepared a trial balance that failed to balance
having a shortage on the credit side. A suspense account was opened for
the difference. Upon some thorough investigations the following errors were
discovered.
a) Sales day book had been undercast by Sh 4,000.
b) Credit sales of Sh 12,200 to JJ Electronics had been debited in error to JJ
Enterprise account.
c) Rent account had been undercast by Sh 18,000.
d) Discounts Allowed account had been overcast by Sh 2,000.
e) The sale of a computer at net book value had been credited in error to the
Sales account Sh 4,600.
Required:
i. Journal entries to correct the discovered errors.
ii. A suspense account and determine the difference as per the trial balance.
Exercise 15. Haze Ltd had a Credit balance of Ksh 351,300 in the bank
statement and a debit balance of Ksh 389,600. Upon investigation the follow-
ing transactions were missing in the books of accounts.
Deposits made but not yet entered on bank statement 606,000
Bank charges on bank statement but not yet in cashbook 28,000
Unpresented cheques amounted to 117,000
A standing order for salaries entered on bank statement, but not in cash book 55,000
Credit transfer from a customer entered on bank statement only 189,000
66
Required:
Prepare a bank reconciliation statement to reconcile the difference in the two
balances.
Exercise 16. The following cash book relates to Jockey Ltd for the month
of October, 20x3. The bank statement had a debit balance of Sh 1,353,000.
On investigation the following was discovered;

1. Bank charges of Sh. 136,000 in the bank statement have not been reflected
in the cash book.
2. Cheques drawn amounting to Sh. 267,000 had not been presented to the
bank for payment.
3. Cheques received totaling to Sh. 726,000 had been entered in the cash book
but credited by the bank by 3rd November.
4. A cheque for Sh. 22,000 for expenses had been entered in the cash book as
a receipt instead of a payment
5. A cheque received from John for Sh. 80,000 had been returned by the bank
and marked “No Funds Available”. No adjustment has been made in the cash
book
6. A standing order for business rates of Ksh 150,000 on 30th October had
not been entered in the cash book.
7. Dividends of Sh. 62,000 were received and credited directly to the bank
account with no entries in the cash book.
8. A cheque drawn for Sh. 66,000 for stationery had been incorrectly entered
in the cash book as Sh. 60,000.
9. The balance brought forward in the cash book should have been Sh. 711,000
not Sh. 761,000.
Required:
Prepare an adjusted cash book and a bank reconciliation statement as at 31
October, 20x3 to reconcile the difference in the cash book and bank statement
67
balance.

tion, ISBN 978-81-317 2914-4
68
LESSON 5
Control Accounts and Adjustments to Final Accounts
Learning outcomes
• Explain the importance of control accounts
• Prepare sales ledger control accounts
• Prepare purchases ledger control accounts
• Explain contra settlements
• Reconcile the purchases and sales ledger with their respective control
accounts
• Make adjustments in the trading account
• Make adjustments for accrued expenses and income
• Make adjustments for prepaid expenses and income
• Record accruals and prepayments in the financial statements
• Explain how bad debts are written off in the books of accounts
• Understand why a provision for bad and doubtful debts is made
• Make entries to record a provision for doubtful debts and bad debts
written off
• Define depreciation and understand why it is prepared
• Calculate depreciation on non current assets
• Make entries to record a provision for depreciation and disposal of non

current assets
69
5.1. Introduction
This lesson explains the benefits of using control accounts in manual account-
ing systems and how to prepare the sale ledger control account and the pur-
chases ledger control account.
This lesson also covers several adjustments made to final accounts at the end of
a financial period. The adjustments range from adjustments made in the trad-
ing account to; accounting for accrued income and expenses, prepaid income
and expenses, bad debts written off and provision for bad and doubtful debts,
depreciation and disposal of non-current assets. The various adjustments will
require appropriate entries to be made in the books of accounts for instance
recording an increase or decreases in the provision for doubtful debts.
5.2. Control Accounts

These accounts are used to check the accuracy and correctness of posting in
a ledger to which the control account belongs or relates to. The control mean
that the total on the control accounts should be the same as the totals on the
ledger accounts. The two main types of control accounts include:
5.2.1. Sales ledger control Account

Sales Ledger Control Account is also referred to as Total Debtors Account. The
balance on the sales ledger control account should be the same as the total of
the balances in the sales ledger. It deals with credit customers (debtors). This
control account is used to check the posting in the sales ledger account. Debit
entries increase debtors balance and Credit entries decrease their balance.
• Items that Increase Debtor’s Balance (They are debited)

• Credit Sales
• Dishonoured cheques
• Interest Charged on overdue accounts
• Refunds to credit customers
70
• Items that Decrease Debtor’s Balance (They are credited)

• Cash/ bank payments from debtors
• Return inwards
• Discount allowed
• Contra Settlements/ Set offs
• Bad debts written off
Format of Sales Ledger Control Account
Example . Draw a Sales Ledger control A/c to record the following details
relating to a business.
Sh.
Sales ledger debit balance at the beginning of the period 18,940
Total credit sales for the month 102,900
Total cheques received from customers 72,840
Total cash received from customers 12,360
Total return inwards from customers 2,960
Sales ledger debit balance at the end of the period 33,680
Solution:
71
5.2.2. Importance of Control Accounts

• Facilitates detection of errors and fraud committed in either the sales
ledger or purchases ledger.
• To provide a very quick method of supervising the junior staff by the

senior staff hence it’s a supervision tool.
• To facilitate delegation of duties among the debtors and creditors clerks.
Points to Note:
• Refunds to debtors increase their balance and their accounting treatment

is as follows;
– Debit : Debtor’s Account

– Credit : Cashbook
• Cash sales should NOT be included in sales ledger control account
• Cash purchases should NOT be included in Purchases ledger control

account.
• Only cash discounts that are either allowed or received should be in-
cluded. Trade discounts should NOT be included.
• Provision for doubtful debts is NOT included in the sales ledger control
account.
5.3. Adjustments in the Trading Account

A trading account captures elements that lead to generation of the Gross
Profit.
Returns
Return inwards (sales return) is deducted from sales while return outwards
(purchases return) is deducted from purchases as discussed in Lesson Three.
Carriage(Freight)
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Carriage or freight is the transportation cost incurred by a trader to carry

purchased goods to the premises or when giving an after sale service to the
customers. Carriage can be classified as either;
Carriage Inwards: Transportation cost incurred by a business on purchases.
It is added to purchases in the trading account. The accounting treatment is
as follows:
Dr: Carriage inwards Account
Cr: Bank/ Cash Account.
Carriage Outwards: Transportation cost incurred by a business on sales to
the customers. It is treated as an expense in the profit and loss A/c. The
accounting treatment is as follows:
Dr: Carriage inwards Account
Cr: Bank/ Cash Account
Omissions
Transactions left out from the books of accounts should be recorded appro-
priately for example omitted sales should be added back to sales amount that
was initially reported.
Drawings
Drawings can be made by the owner(s) of a firm in various ways
1. Drawings in the form of Goods; arises when the owner(s) of the

business takes out some of the business goods out of the stock or pur-
chases made for his own use. This was covered in lesson three. This is
the ONLY form of drawings that is accounted for in the trading account.
Accounting treatment for goods drawings in the trading ac-
count
Credit : Purchases Account
Accounting treatment at the end of the financial period (in the
balance sheet)
Debit : Capital Account
Credit : Drawings Account
73
2. Cash or bank withdrawals; arises when the owner(s) withdraws money

from the business for other objectives (E.g personal objectives) other
than that of the business.
Accounting treatment for cash or bank drawing
Credit : Cash/ Bank Account
Accounting treatment at the end of a financial period
3. Drawings in the form of Personal expenses paid by the business;

arises when the owner(s) pay for personal expenses being included in
under the business expenses.
Accounting treatment for drawings in the form of personal ex-
penses
Credit : Expense Account
Accounting treatment at the end of a financial period
5.4. Accruals and Prepayments

In accordance to the Accrual Concept, revenue and costs are recognized when
earned or incurred and not when money is received or paid therefore all incomes
and expenses relating to a particular financial period will be matched together
to determine the profit for the year. The Matching principle holds that costs
incurred are matched with their associated revenues. This is a principle of
profit determination whereby profits are determined by comparing revenues
and expenses.
74
5.4.1. Accruals
Accrued Expenses: This is an expense that is payable or due for payment
in a financial period but has not yet been paid during that period.
Accrued expenses should be charged to the income statement (profit
and loss account) by adding them back to the expenses and they
are also treated as a current liability in the balance sheet.
Accrued Income: This is income earned in the current year but cash is not
yet received. An accrued income should be reported in the income
statement (profit and loss account) by adding them back to other
incomes and they are also treated as a current asset in the balance
sheet.
5.4.2. Prepayments
Prepaid Expenses: A prepaid expense is an expense that is not payable
but cash has already been paid. A prepaid expense should not
be charged in the income statement (profit and loss account) thus
deducted from the reported expenses therefore should be carried
forward to the next financial period. Prepaid expenses are treated
as a current asset in the balance sheet.
75
Prepaid Income: This is income that is not yet due but cash has been
received for it. This is income paid in advance. Prepaid income
should not be reported to the income statement (profit and loss
account) thus deducted from the reported income therefore should
be carried forward to the next financial period. Prepaid income is
treated as a current liability in the balance sheet.
5.5. Bad and Doubtful Debts

A business that has debtors is not guaranteed to collect all the amounts owed
by the credit customers. Some credit customers may fail to pay their accounts
due for various reasons like; going bankrupt, death, change of business etc.
Such accounts that are not in a position to be paid up end up becoming bad
debts.
Business firms should write off bad debts and this is treated as an expense in
the income statement. Practically a business firm may not be certain whether
it will collect all the amounts due from the debtors because some will not
honour their obligations and some might only partly honour them. This gives
room for doubtful debts. Business firms should therefore provide a provision
for such debts and this is referred to as Provision for doubtful debts. The
provision may either maybe specific or general. A specific provision relates
to a specific debtor (with a specified amount) whom the business is doubtful
with while a General Provision relates to the debtors generally and it’s mostly
given as a certain percentage of the debtors.
Accounting treatment for Bad debts
Debit : Bad debts Account
Credit : Debtor Account
Debit : Income statement/ Profit & loss Account
Credit : Bad debts Account
Accounting treatment for provision for bad debts & doubtful debts
Accounting for the provision for bad debts will depend on:
1. If it’s the First time a provision for doubtful debts is given

Debit : Income statement/ Profit & loss Account
Credit : Provision for doubtful debts
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2. If it’s in subsequent years; when there is an increase in provision

for doubtful debts
Debit : Income statement/ Profit & loss Account (with the increase only)
Credit : Provision for doubtful debts (with the increase only)
3. If it’s in subsequent years; when there is a decrease in provision

for doubtful debts
Debit : Provision for doubtful debts (with the decrease only)
Credit : Income statement/ Profit & loss Account (with the decrease
only)
5.5.1. Bad Debts Recovered

A bad debt that was previously written off by a business firm may be recovered
again. If such a situation is present, the following entries are made:
1. The bad debt recovered is first reinstated by;

Debit : Debtors Account
With amount recovered
Credit : Bad debts recovered Account
2. When payment is received from the debtor in settlement of all or part

of the debt:
With the cash received
Credit : Debtors Account
3. Accounting treatment in the income statement;

Debit : Bad debts recovered account
Credit : Income Statement (Profit & Loss A/c)
Example . A business firm that had previously written of bad debts amount-
ing to Ksh 34,000 now recovers the same amount that was paid by cheque. In
the same financial year the debtor account amount to Ksh 270,000 and out of
this the firm will write off bad debts amounting Ksh 20,000.
Required:
i. Debtors Account
ii. Bad debts (written off) Account
77
iii. Bad debts recovered Account

iv. Bank Account
Solution:
5.6. Depreciation
This is that part of the original cost of a non current asset that is consumed or
lost during its period in a business. The loss in value is treated as an expense
in the profit & loss A/c.
5.6.1. Causes of Depreciation

• Physical Factors
These factors include wear and tear, rot, decay, rust or erosion due to
elements of nature like rain.
• Economic Factors
These factors occur when an asset either becomes;
78
Obsolete – Where the non-current assets becomes out of date or not

fitting with modern technology
Inadequate – Where the non-current assets lose value due to becoming
inadequate for example after a business prospers and expands, some of its
buildings may become inadequate due to limited space hence no longer
used due to changes in size of the business firm.
• Time Factors
These factors apply to assets which have a legal life fixed in terms of
years for example properties on lease terms.
• Depletion
This is depreciation made on non-current assets of wasting character for
instance mineral fields will depreciate due to constant extraction of raw
materials.
5.6.2. Methods of Calculating Depreciation

These are the methods used ascertain the depreciation charge for non-current.
The depreciation is charged in the income statement as an expense. The two
main methods are; Straight-line method and Reducing Balance method.
There are other methods for calculating depreciation that will be briefly high-
lighted in this chapter.
Straight Line Method

Depreciation is charged evenly for all the years. The cost is divided by the
number of estimated years of use. A certain percentage can also be given to
calculate straight line depreciation on cost.
Cost – Scrap Value (Salvage/ Residue Value)
Depreciation Useful Life in years
Example . A Machine was bought for Sh. 220,000 and it was estimated to
be in operation for 4 years with a residue value of Sh. 20,000. Calculate the
depreciation expense for each year.
Solution:
220,000−20,000
4
= 50, 000
In case there was no residue value
79
220,000
4
= 55, 000
Reducing Balance Method/ Diminishing Balance Method

A fixed percentage for depreciation is deducted from the cost in the first year
and in the later years it is deducted from the net book value (NBV)
Example . Calculate the reducing balance depreciation charged at 20% for
the first 3 years on a machine bought for Sh. 10,000.
Solution:
5.6.3. The other methods include:

Sum of Years Digits Method
A base from sum of all years of estimated life is obtained. Each year’s depre-
ciation rate is obtained by reversing the years of the estimated life divided by
the base.
Example . A company purchased a machine at a cost of Sh. 450,000.
The estimated life of this machine is 5 years. Using the sum of years digits
determine its depreciation.
Solution:
Sum of years = 5 + 4 + 3 + 2 + 1 = 15
80
Revaluation Method
Depreciation is calculated by adding assets bought during the year to the
opening balance then LESS assets sold during the year while together with
the closing balance of assets.
Depreciation p.a. = {Opening balance + Purchases} - {Closing
balance + Disposals}
Machine Hour Method

Depreciation is based on the number of hours the machine operated during
the period compared to the total expected hours.
Hours Operated
Depreciation p.a. = Total expected hours × COST
Depletion Unit Method

This method is applied to assets of wasting character. Depreciation rate is
based on quantity extracted compared with the total estimated quantity avail-
able.
Quantity extracted
Depreciation p.a. = Total quantity available × COST
Unit of Output Method

The method establishes the total expected units of output expected from the
asset and depreciation is based on cost less the salvage value multiplied to
periodic production or units produced as a proportion total expected output.
Units produced
Depreciation = Total expected units × COST-Salvage value
Example . A machine is expected to produce 10,000 electrical gadgets in

its useful life. It has a cost of Sh. 6,000 and has an expected salvage value of
Sh. 1,000. If in the first year a total of 1,500 gadgets are produced, what is
the depreciation for the year?
Solution:
1,500
10,000
× (6, 000 − 1, 000 = Sh. 750

5.6.4. Accounting Treatment on Depreciation

Depreciation for non current assets is posted directly into the provision for
depreciation account and the accounting treatment is as follows;
81
Debit: Income Statement Account (Profit and Loss A/c)
Credit: Provision for depreciation A/c (Accumulated Depreciation account)
5.6.5. Accounting Disposal of fixed assets

When a non current asset is disposed, it may involve disposal in either of the
following ways;
1. Sale of the non current asset.

When non current asset are sold, they should be removed from the books
of accounts. This means that the cost of the asset needs to be deducted
from the asset account, the accumulated depreciation of the asset also
needs to be deducted from the provision for depreciation account and
lastly profit or loss on sale should be reflected in the profit & loss account.
Accounting Treatments when asset is sold
Debit : Asset disposal Account

(a) With cost of asset being disposed
Credit : Asset Account
Debit : Provision for depreciation Account
(b) With Accumulated depreciation
Credit : Asset disposal Account
(c) With amount received on disposal
(d) If a Profit on disposal
Credit : Income statement (Profit & Loss A/c)
Debit : Income statement (Profit & Loss A/c)
(e) If a Profit on disposal
2. Non current asset written-off due to damage, accident or theft

When a non current asset is insured, in the case of loss of the asset the
insurance company is obliged to meet the liability.
If by the end of the financial period the insurance company has
not yet paid the obligation;

(a) With cost of asset being disposed
82

Debit : Insurance receivable Account
(c) With amount expected from the insurance
(e) If a Profit on disposal
If by the end of the financial period the insurance company has paid
the obligation, instead of having the Insurance receivable account, it will
change to Cash/ bank and the accounting treatment is as follows;
Debit :Cash/ Bank Account

(a) With amount expected from the insurance
3. Non current asset that is scrapped (Asset not in use anymore)

Non current asset that are no longer used in a business firm will need to
be eliminated from the books of accounts. Entries to eliminate them are
to be made in the asset account and provision for depreciation account
only. The accounting treatment is as follows;

(a) With cost of asset no longer in use
(c) If a Profit on disposal
Example . The following information relates to Zeta Ltd for the month of
June, 20x3.
Balances as at 1st June,20x3
83
Sales Ledger Sh. 642,000 on Debit side

Purchases Ledger Sh. 103,700 on Credit side
The following were the transactions during the month
Credit Purchases 4,225,700
Returns outwards 109,800
Cheques paid to suppliers 3,876,500
Discounts received from suppliers 88,700
Refunds from suppliers 21,500
Credit Sales 1,280,000
Cheques received from debtors 1,037,000
Discounts allowed 39,500
Contra settlements on ledger A/cs 14,500
Solution:
Example . The debtors account for ABC Ltd was Ksh 500,000 by end of
the year 20x3. Bad debts amounting to Ksh 50,000 were written off from this
balance. The specific provision stood at Ksh 10,000 while the general provision
was maintained at 5% on the debtors balance.
Required:
i. Debtors Account
84
ii. Bad debts Account

iii. Provision for bad debts Accounts
iv. Income statement Extract
v. Balance sheet Extract
Solution:
85
Revision Questions
Exercise 17. The following information was obtained from Juja traders
as at 31/12/2010. Balances as at 1st January 2010 are as follows;
Sales Ledger Purchases Ledger
Sh.120,000 on Debit side Sh. 186,000 on Credit side
Sh. 15,000 on Credit side Sh. 8,000 on Debit side
The following transactions took place during the year 2010;
Sh. Sh.
Sales in cash 150,000 Bad debts 14,600
written off
Sales in credit 425,000 Return inwards 12,300
Purchases in 38,000 Return 22,000
cash outwards
Purchases in 560,000 Refunds to 3,200
credit credit customers
Cheques from 178,000 Provision for 1,400
credit customers doubtful debts
Cheques to 258,000 Creditors 16,400
credit suppliers cheques
dishonoured
Contra 9,000 Refunds from 4,400
Settlements creditors
Customer 21,000 Balance as at
cheques 31/12/2010
dishonoured
Interest charged 5,600 Sales ledger 18,000 (Cr. Bal)
on overdue
debtors
Discount 12,000 Purchases ledger 14,000 (Dr. Bal)
Allowed
Discount 9,600
Received
Required: Prepare sales ledger and purchases ledger control accounts
Exercise 18. The following transactions relate to Jaime Ltd for the month
86
of December 20x3. Prepare sales ledger and purchases ledger control account
for that month.
Sh.
Balances on 1 December 20x3:
Sales ledger 9,123,000 (debit balance)
211,000 (credit balance)
Purchases ledger 4,490,000 (credit balance)
88,000 (debit balance)
Transactions during the month of December 20x3:
Purchases on credit 18,135,000
Allowances from suppliers 629,000
Receipts from customers by cheques 27,370,000
Sale on credit 36,755,000
Discount received 1,105,000
Payments to creditors by cheques 15,413,000
Contra settlements 3,046,000
Bills of exchange receivable 6,506,000
Allowances to customers 1,720,000
Customers cheques dishonored 489,000
Cash received from credit customers 4,201,000
Refunds to customers for overpayments 53,000
Discounts allowed 732,000
Balances on 30 November 1997
Sales ledger 136,000 (credit balance)
Purchases ledger 67,000 (debit balance)
Exercise 19. XYZ Ltd started trading on 1 January 20x3. The following
are some of the bad debts that were written off during two years that XYZ
Ltd has been trading.
Year 20x3 Amount (Ksh) Year 20x4 Amount (Ksh)
14/04/20x3 8,500 12/03/20x4 18,000
06/07/20x3 14,000 23/08/20x4 6,000
——- ——– 16/10/20x4 25,000
On 31 December 20x3 debtors balance was Ksh 4,050,000. Provision for bad
debts was maintained at 3%.
On 31 December 20x4 debtors balance increased to Ksh 4,730,000. Provision
87
for bad debts was maintained at 5%.

Required:
i. Debtors Account for the two years
ii. Bad debts Account for the two years
iii. Provision for bad debts Accounts for the two years
iv. Income statement Extract for the two years
v. Balance sheet Extract for the two years
Exercise 20. With reference to exercise 19 assume that;
On 31 December 20x4 debtors balance decreased to Ksh 3,600,000. Provision
for bad debts was maintained at 3% the same as the previous year.
Required:
i. Debtors Account for the two years
ii. Bad debts Account for the two years
iii. Provision for bad debts Accounts for the two years
iv. Income statement Extract for the two years
v. Balance sheet Extract for the two years
Exercise 21. A business firm started trading on 1st January in year 20x3.
On 1st April, it bought a new motor vehicle costing Ksh 400,000 and later on
1st July it bought another motor vehicle costing Ksh 550,000. The financial
year for the business ends on 31st December and it has a policy of depreciating
motor vehicles at 20% p.a. using straight line basis.
Required:
i. Motor vehicle account as at 31st December 20x3
ii. Provision for depreciation account as at 31st December 20x3
iii. Income statement extract for year ending 31st December 20x3
iv. Cash/ bank account extract
Exercise 22. XYZ Ltd has three machines in operation. Machine A was
bought on 1st January 20x3 at Ksh 250,000 and the other two machines;
machine B and machine C were bought on 1st January 20x4 at Ksh 350,000
and Ksh 300,000 respectively. The business has a policy to depreciate all non
current assets at 15% using straight line basis of depreciation. On 1st July
20x4, XYZ Ltd disposed off the machine bought on 1st January 20x3 for Ksh
188,000. Assuming that the financial year of XYZ Ltd ends on 31st December.
88
Prepare the following accounts relating to financial year ending 31st December
20x4 only.
i. Machine Account
ii. Provision for depreciation Account
iii. Disposal Account
Exercise 23. A company depreciates its plant at the rate of 20% p.a.
straight line method for each month of ownership.
On 1st January 1999 bought plant costing Sh. 9,000. On 1st October 1999
also bought plant costing Sh. 6,000. On 1st July 2001 bought plant costing
Sh. 5,500.
On 30th September 2002, the plant that had been bought for Sh. 9,000 on 1st
January 1999 was sold for Sh. 2,750.
Required: (a) Plant A/c (b) Provision for depreciation A/c (c) Disposal
A/c
89

• Horngren, C. T., Sundem, G. and Elliott, J. (2002), “Introduction to
Financial Accounting”, 8th Edition, Prentice Hall; ISBN: 0130410233.

4th Edition, John Wiley & Sons; ISBN: 0471072419
90
LESSON 6
Financial Statements
Learning outcomes
• Prepare an income statement
• Calculate cost of goods sold, gross profit, and net profit
• Prepare a balance sheet
• Accounting for all the necessary adjustments in the financial statements
• Understand and explain the notes attached to the financial statements
91
6.1. Introduction
This lesson covers the preparation of financial statements, more so the income
statement and the balance sheet. It captures various aspects of adjustments
necessary in the final accounts that have been discussed in the previous lessons.
6.2. Income Statement

The income statement is also referred to as the Statement of financial perfor-
mance or also the Trading, profit and loss account. An income statement is
used to ascertain the financial performance of a business firm.
Format of an Income Statement relating to a sole trader
6.3. Balance Sheet

The balance sheet is also referred to as the statement of financial position.
It’s used to ascertain the financial position of a firm. The balance sheet sum-
92
marizes the accounting equation that is given as; ASSETS = CAPITAL +

LIABILITIES. This was well discussed in Lesson Three.
The following is a format for a balance sheet relating to a sole trader
OR
93
Example . The following trial balance was extracted from books of Simp-
son, a sole trader as at 31st Dec 20x3.
94
Additional information
Stock as at 31st Dec 20x3 was valued at Sh. 1,760,000
Depreciation on fixtures and fittings and motor vehicle is provided at 5% and
10% p.a. on cost respectively.
Included in sales are goods for Sh. 13,000 ordered by Mr. Patel in the month
of April. He has never communicated though the goods have been included in
the closing stock.
Rates prepaid as at 31st Dec 20x3 amounted to Sh. 25,600.
Unexpired insurance as at 31st Dec 20x3 was Sh. 4,000.
Provision for bad debts as at 31st Dec 20x3 is to be made at 2.5 % of net trade
debtors.
Required:
• Trading and profit and loss account for year ended 31st Dec 20x3
95
• Balance sheet as at 31st Dec 20x3.
Example .
Solution:
SIMPSON SOLE TRADER
TRADING, PROFIT & LOSS A/C
FOR THE YEAR ENDING 31st DECEMBER 20x3
Workings
96
Net debtors = Sh. Motor vehicle Dep. 10% of 1,280,000 = Sh. 1,280,000
1,821,400 –of bad debts =
Provision Furniture and fittings Dep. 5% of 576,000 = Sh. 28,800
Sh. 13,000x=2.5%
1,808,400 Sh. = Sh.
1,808,400
45,210
Decrease in provision = Sh.
50,000 – Sh. 45,210 = Sh.
4,790
SIMPSON SOLE TRADER

BALANCE SHEET
AS AT 31ST DECEMBER 20x3
97
Revision Questions
Exercise 24. Maxwell is a sole proprietor operating business in Juja and

the following trial balance relates to his business for the year ended 31st De-
cember, 20x3.
1. Stock at 31/12/20x3 amount to Kshs 3,000,000
2. Motor vehicle expenses unpaid amount to Kshs 300,000.
3. A quarter of telephone bills relate to the year 20x4.
4. Un paid electricity and water amount to Ksh 100,000
5. Depreciation on motor vehicles and fixtures is at 20% and 10% respectively
on cost.
6. Salary and rent prepaid were Kshs 200,000 and Kshs 100,000 respectively.
7. Interest on loan was outstanding as at 31st December 20x3.
Required:
98
i. Income Statement for the year ended 31/12/20x3.

ii. Balance sheet as at 31/12/20x3.
Exercise 25. The following trial balance was extracted from the books of
K. Kalif a sole trader as at 31st Dec 20x3.
The following additional information is relevant:

1) Stock as at 31st Dec 20x3 amounted to Sh. 3,072,600
2) Amounts accrued as at 31st Dec 20x3. • Electricity Sh. 15000 • Bonus to
employees Sh. 100,000
3) Insurance prepaid at 31st Dec 20x3 was Sh. 35,000.
4) Included in the insurance payment is an amount of Sh. 15,500 for K. Kalif’s
personal vehicle.
5) Provision for bad and doubtful debts is 5% of debtors.
6) Interest on loan had not yet been paid.
7) Depreciation is to be provided as follows;
• 20% on motor vehicle on reducing balance.
• 10% on building on straight line basis.
Required:
a) Income Statement for the year ended 31st Dec 20x3.
99
b) Balance sheet as at 31st Dec 20x3.
100
LESSON 7
Partnership Accounts
Learning outcomes
• Define a partnership and the provisions governing its formation.
• Prepare the trading and profit and loss and appropriation account of a
partnership.
• Prepare a balance sheet of a partnership business.
101
7.1. Introduction
A partnership is unincorporated business owned by two or more persons vol-
untarily associated as partners. A partnership is formed by at least two per-
sons known as partners. Maximum number of partners is limited to twenty.
However, in a partnership where all partners are professional e.g. Bankers,
accountants, there is no maximum on the number of partners. The business
entity established by the partners is known as a firm.
7.2. Why Form Partnerships?

• Each partners contributes a share toward the partnership capital
• Partners exchange useful ideas on how to improve their business and

therefore quality business decisions are likely to be arrived at.
• Partners share the business risks e.g. If the business make losses, these
losses are shared amongst the partners.
• Possibility of raising large sums of capital
7.3. Disadvantages of partnership

Partnership is not a separate legal entity and hence partners have unlimited
liability towards the partnership debts, except a limited partner
Personal effort and initiative is not adequately rewarded since the partners
share the profit generated.
Partnership agreement (deed)
Partners must spell out the terms, which govern their relationship as they
undertake the business together in order to minimize conflict in future.
The agreement may be verbal or in writing and it must clearly state:
• Capital to be contributed by each partner
• Profit and losses sharing ratios
• Interest if any lobe paid on capital before the profits are shared. Interest
paid to the partners to reward his/her capital contribution.
102
• Rate of interest, if any, to be charged on partner’s drawings. Done to

discourage excessive drawings by the partners.
• Salaries, if any to be paid to the partners. The salary is given to the

partner for the services rendered to the firm
• Procedure to be followed when new partner(s) is/are being admitted
• Procedure to be followed when a partner retires or dies.
7.4. Accounting Entries

James and Laban entered into a partnership business where they agreed to
contribute capital as follows:
James - sh. 10,000
Laban - sh. 8,000
On 1/1/02, they contributed their capital in form of cash and the following
double entries were made in their partnership books of accounts.
The resources contributed by the partners are invested in the business. Profit
or losses may be generated from the business activities, which are shared
amongst the partners at predetermined ratios.
A fixed capital account is maintained for each partner and is credited with the
capital contributed.
A current account is maintained for each partner and is credited with any
item the partner is entitled to from the business e.g. Share of profit, interest
on capital, salaries, commission, etc. The account is debited with items the
103
partners owes the business e.g. Drawings made, interest on drawings charged,
share of losses. The resources contributed by the partners are invested in the
business. Profit or losses may be generated from the business activities, which
are shared amongst the partners at predetermined ratios.
A fixed capital account is maintained for each partner and is credited with the
capital contributed.
A current account is maintained for each partner and is credited with any
item the partner is entitled to from the business e.g. Share of profit, interest
on capital, salaries, commission, etc. The account is debited with items the
partners owes the business e.g. Drawings made, interest on drawings charged
and share of losses.
7.4.1. Fluctuating capital account

A single capital account is maintained for each partner This account is credited
with:
1. Initial capital contribution by the partner
2. Any salary earned by the partner
3. Interest payable on capital
4. Share of profit to the partner
5. Other gains due to the partner from the firm
This account is debited with:
1. Drawings made by the partner from the firm
2. Interest charged to the partner on drawings by the firm
3. Share of loss to the partner
4. Other items due to the firm from the partner
Therefore, the partner’s capital varies at the end of every year. Example James
— capital account
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7.5. Profit and Loss Appropriation account

It shows the total profits generated by the firm and how the profit is distributed
to amongst partners
If no partnership deed exists the Partnership Act 1890 states that:
105
1. Profits and losses are to be shared equally
2. There is to be no interest allowed on capital
3. No interest is to be charged on drawings
4. Salaries are not to be paid to any partner.
5. If any partner advances some loan to the firm the same is repaid at an
interest not exceeding 5% per annum.
Example . outline the contents of a partnership deed

Solution:
Partners must spell out the terms, which govern their relationship as they
undertake the business together in order to minimize conflict in future.
The agreement may be verbal or in writing and it must clearly state:
i) Capital to be contributed by each partner
ii) Profit and losses sharing ratios
iii) Interest if any lobe paid on capital before the profits are shared. Interest
paid to the partners to reward his/her capital contribution.
iv) Rate of interest, if any, to be charged on partner’s drawings. Done to
discourage excessive drawings by the partners.
v) Salaries, if any to be paid to the partners. The salary is given to the partner
for the services rendered to the firm
vi) Procedure to be followed when new partner(s) is/are being admitted
vii) Procedure to be followed when a partner retires or dies.
106
Revision questions
Exercise 26. For the year ended, 31/12/02, James and Laban partnership
had generated a profit of shs.6,000. Partnership provided that they share profit
and losses in the ratio 3:2. James was entitled to a salary of shs.600, Laban
shs.400. Partners were entitled to an interest of 10% per annum on their capital
contributions. Laban had withdrawn shs.500 from the business and was to be
charged interest on such drawings at the rate of 20%. This information can
be presented on:
i) Profit and loss appropriation account
ii) Current account
as follows:
Exercise 27. The following balances were taken from the books of A and
B partnership as at 31/12/01.
Capital A –Sh. 12,000 B- Sh. 15,000 Salaries A-Sh. 2,400 B- Sh. 1,400 Draw-
ings A-Sh.3,000 B-Sh. 4,000 The firm net profit for the year was sh.32,000.
Interest on capital is to be allowed at 8% per annum. Interest on drawings is
15% per annum. Profit and losses are to share at the ratio of A to B at 2:3
respectively.
Required
i. Profit and loss appropriation account
ii. Partner’s current account
iii. Balance sheet extract as at 31/12/02
iv. Draw the partners fluctuating capital account as at 31/12/01
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LESSON 8
Company’S Account
Learning outcomes
Upon completing this lesson, you should be able to:
• Define the term company
• Explain how a company raise its finances and how they are recorded in
the books of accounts.
• Prepare a trading and profit and loss and appropriation account of a

company
• Prepare balance sheet of a company
108
8.1. Introduction
A company is a corporate association of persons formed to carry out specific
business activity with a view to make profit and share it among the owners.
The owners of the company are known as shareholders who contribute their
capital to the company through buying shares of the company. The capital
pf the company is divided into units of uniform value known as shares. The
value of one share is known as par value/nominal value/face value.
Example company xyz has a capita! of 1 million shillings divided into ten
thousands shares of one hundred shillings each. To raise this capital the com-
pany sells the shares to the members of the public who purchase any number
of shares depending on their financial ability. The value of the shares owned by
one share holder constitute the wealth he owns in the company. The company
ban sell different type of shares which have varied rights. The most commonly
sold shares are
8.2. Ordinary shares

These shares are not entitled to a fixed rate of dividends i.e. the dividends
they receive from the company’s profit varies from one year to another. If the
company makes huge profits in a given year the ordinary shareholders receives
high dividends and vice versa. Companies have no obligations to pay dividends
to the ordinary shareholders. Ordinary shareholders receive dividends after the
preference shareholders.
8.3. Preference shares

Are entitled to a fixed rate of dividend every year e.g 10% preference shares
are entitled to receive 10% of their capital as dividends when the company’s
profits are being shared.
At the end of the financial year, the profits made by the company are dis-
tributed to the shareholders as dividends according to their share holdings.
The shareholders elect some directors from among themselves to run the com-
pany on their behalf. The directors are paid some remunerations known as
directors salaries or fees which is treated as a company operating expense
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8.4. Accounting Entries

8.4.1. Sale of Company Shares
The shareholders are issued with the share certificate showing the number
of share they own in that company and their value If a shareholder want to
withdraw his ownership from the company, the company cannot refund him
back his capital contribution. Instead he has to look for another person to buy
his shares in the company.
8.5. Share Premium

A company may sell its shares at a price higher than the par value of the share
when the demand for shares is high. E.g. the par value of the share may be
Shs 10 but it is sold at Shs 12. The difference of Shs 2 per share constitutes a
profit on the sale of share to the company and it is known as share premium.
The share premium belongs to the shareholders and it is shown as a separate
item in the balance sheet below the capital item.
8.6. Debenture
Is a document to acknowledge that the company has borrowed a specific
amount of money from the person/institutions named on the face of the deben-
ture certificate. The company sell debenture as a way of borrowing long term
loans which are repayable after several years.
The company pays debenture interest at a fixed rate per annum to the deben-
ture holders e.g. 8% debenture means that every year the company has to pay
debenture interest at a rate of 8% of the debenture principle amount which is
treated as a business operating expense.
8.7. Accounting Entries for the Sale of Debentures
Example . On 1/1/99 the company sold 1.000, 5% debentures of Shs 10

each on cash basis. Double entries for this transaction is shown below
Solution:
110
8.8. Corporation Tax

Legally the company is treated as a separate entity from the owners and there-
fore required to pay tax to the government based on the net profit made by the
company. The corporation tax is treated as appropriation of the net profit.
8.9. Audit Fees

The company accounts must be examined by an independent auditor to ascer-
tain that they reflect a true and fair view of the company’s financial position.
The auditor is paid some money for the services rendered known as audit fees
which is treated as company’s operating expense.
8.10. Appropriation Account

The account shows how the net profit of the company is allocated or shared
by various interested parties e.g. the government through taxation, share-
holders through dividends, the company through reserves or retained profits
Preparation of Trading and profit and loss and appropriations and Balance
sheet
Example . differentiate between Ordinary shares and Preference shares
Solution:
Ordinary shares are not entitled to a fixed rate of dividends i.e. the dividends
they receive from the company’s profit varies from one year to another. If the
company makes huge profits in a given year the ordinary shareholders receives
high dividends and vice versa. Companies have no obligations to pay dividends
to the ordinary shareholders. Ordinary shareholders receive dividends after the
preference shareholders.
Preference shares are entitled to a fixed rate of dividend every year e.g 10%
preference shares are entitled to receive 10% of their capital as dividends when
111
the company’s profits are being shared.At the end of the financial year, the
profits made by the company are distributed to the shareholders as dividends
according to their share holdings. The shareholders elect some directors from
among themselves to run the company on their behalf. The directors are paid
some remunerations known as directors salaries or fees which is treated as a
company operating expense

112
Revision questions
Exercise 28. 1/1/99 Company xyz sold 1,000 ordinary shares of par value
Shs 10 each on cash basis.
2/1/99: The company sold 5,000, 8% preference shares of par value Shs 5 each
on cash basis.
Required Open the ledger account and post the above transactions.
Exercise 29. The following trial balance was extracted from the books of
P.K Co Ltd as at 31st December 1998
1. Value of the closing stock shs.8,000
2. Directors proposed to pay dividend to preference share holders
3. Directors proposed to pay dividend to ordinary share holders at a rate of
5%
4. Provide for corporation tax at a rate of 10% of the net profit.
113
LESSON 9
Non-profit Making Organization
Learning outcomes
Upon completing this lesson, you should be able to:
• Define a non-profit making organization.
• Explain the sources and the uses of finances.
• Prepare a receipt and payment account.
• Prepare an income and expenditure account.
• Prepare a statement of affairs and a balance sheet.
114
9.1. Introduction
Non-profit making organizations are formed by members whose common ob-
jective is to further their interest collectively or together e.g. Footballers may
form a club that will enable them to train together, improve their sporting
skills, participate. In tournaments and eventually uplift standard of this game.
However their main objective is not profit making.
Other forms of non-profit making organization are like churches, hospitals,
NGO’s etc.
Sources of Finance to the Organization
1. Entrance fee. On admission each member is required to pay a set fee

called entrance fee.
2. Membership fee or annual subscription. Every year, each member is re-

quired to renew his or her membership by paying an annual subscription
fee.
3. Donations from friends and well-wishers
4. Profits from some business activities undertaken by the organization in

the process of furthering their interest e.g. the club may set up a canteen
where members go for entertainment. Members will buy items such as
sodas, snacks etc. from the canteen.
5. Fundraising activities. The club may organize for dinner dance to raise
finances.
6. Gate collection fees. The spectators attending various marches recharged

some fee at the gate.
7. Renting out rental premises, e.g. Renting out? Football pitch.
9.2. Uses of Finances

1. To buy the necessary equipment needed in their activities e.g. Sports
uniforms and equipment in case of football clubs.
2. Leasing a play ground where games will be held
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3. Pay allowances to the members affecting various meeting and participat-

ing in various sports activities
4. Buy motor vehicles for transporting members to various destinations.
5. Finances for maintaining a canteen
6. Organizing fundraising activities like dinner dance etc.
9.3. Management committee

The day to day running of the organization is in the hands of a management
committee. The committee consists of the chairman, secretary, treasurer and
other members. Occasionally, they hold meetings to deliberate on the matters
of the organization and are paid sifting allowances from the organizations
funds. This is known as honorarium. The committee may hire employees for
various activities who are paid salaries by the organization.
9.4. Receipt and payment accounts

This account is equivalent to the cashbook in a profit making organization. It
contains the details of all receipts (whether by cash or cheques) and all the
payments (whether by cash or cheques). Usually the organization operates a
bank where its cash and equivalents are held or kept.
9.5. Income and expenditure account

There are organizations that do not carry out the trading activities and there-
fore need not to maintain the trading, profit and loss account.
An equivalent of the trading, profit and loss account is an income and ex-
penditure account showing the income received on the credit side and all the
expenses incurred on the debit side.
The excess of income over the expenses is known as a surplus. The excess
of expenses over income is known as a deficit. The posting to receipt and
116
payment account and income and expenditure account also follows the double
entry system.
9.6. Accumulated fund

This is equivalent to the capital account in a profit making organization hence
the accounting equation for non-profit making organization will appear as:
Assets = accumulated f und + liabilities
Preparation of the income and expenditure and the balance sheet
Example . Prepare an income and expenditure accounts and the balance

sheet using the information given below.
Solution:
Income and expenditure account
117
Revision Questions
Exercise 30. using an example show where an income and expenditure

account is preferred over trading, profit and loss account.
Exercise 31. show how a receipt and payment account is prepared .
Exercise 32. illustrate how a statement of affairs and a balance sheet is
prepared.
118
LESSON 10
Ratio Analysis
Learning outcomes
• Calculate profitability index
• Analyze the liquidity ratio
• Determine the stock market ratio
119
10.1. Introduction
This is a tool used by individuals to conduct quantitative analysis of informa-
tion in a company’s financial statements.
10.2. Types of ratios

10.2.1. Profitability Ratios
These are used to measure the ability of a firm to convert sales into profits and
earn profits as on assets employed These ratios indicate the degree of success
in achieving profit levels They include:
a) Return On Capital Employed

P rof it bef ore interest and taxation
Return on capital employed = × 100
Capital employed
Capital employed means net capital or long tern capital i.e. Total share capital
Reserves+ Loan Capital. It may also be expressed as follows:
• Fixed Assets + Current Assets –Gross capital employed
• Fixed Assets + Current |Assets – Current Liabilities-Net Capital Em-

ployed
• Fixed Assets + Current Assets- Current Liabilities and Long term debt-
Shareholders’ capital employed or Net worth
Which particular convention to adopt depends on the purpose for which the
return is being calculated. If it to assess the earnings for the shareholders, the
return on share capital and reserves would be most appropriate. In assessing
the efficiency of an organization as a whole, the return on gross on net capital
employed would be most appropriate. The return on capital employed ratio is
also known as return on assets
b) Return on Investment
This measures the return on the proprietor’s investment in the company, being
their total share capital plus the reserves that they indirectly own. Naturally,
they are interested in the profits available for distribution, i.e. the post-tax
profit figure
120
P rof its af ter T ax

R.O.I = × 100
T otal Share Capital plus Reserves
The ratio may also be called as “Return on Owners’ Equity Ratio”
N et prof it Af ter T ax
Return on Owners0 EquityRatio = × 100
Owners0 Equity
c) Profit Margin
P rof it bef ore Interest and T axation
P rof it margin = × 100
Sales
d) Assets Turnover
Sales
Assets T urnover(T urnoverRatio) = × 100
Capital Employed
R.O.C.E = Profit Margin * Asset Turnover
10.2.2. Revenue Ratios

These ratios measure the cost and profit structure of the company in relation
to sales revenue
• Gross Profit Ratio

This ratio indicates the margin of sales price compared to factory cost or
bought cost
Gross P rof it
Gross P rof it Ratio = × 100
Sales
• Net Profit Ratio
This ratio indicates the percentage of net profit of sales revenue
N et P rof it
N et prof it ratio = × 100
Sales
• Cash Ratio
Any item of cost may be expressed as a percentage
1.
Cost of sale
× 100
Sales
121
2.
Selling And Distribution Expenses
× 100
Sales
3.
Administration Expenses
× 100
Sales
10.2.3. Liquidity Ratios
These ratios indicate the liquidity position of a company They measure the
ability of a company to meet its current liabilities as the fall due. If a company
has insufficient assets in relation to its current liabilities, it might be unable
to meet its commitments and be forced into liquidation. Thus ratios which
compare the relationship between various groups of current asset and current
liabilities are compute to measure the liquidity position of the company. Such
ratios help in ascertaining the effectiveness of the working capital management
• Current Ratio
It measures current assets against current liabilities
Current Assets
Current ration =
Current Liabilities
The ratio must be 2:1 in the normal situation but the ratio may be different
for different firms
• Quick Acid Test Ratio/ Quick Asset Ratio/ Liquid Ratio

This ratio relates quick assets (i.e. current assets) to current liabilities
current assets less stock

Quick or acid test ratio =
Current liabilities
For the purpose of raising quick cash, stock should not be regarded as a liquid
asset This ratio must be 1:1 in normal situation. This ratio 1:1 is usually
considered an ideal and satisfactory
10.2.4. Capital Structure /Gearing Ratios

These ratios measure the contribution of financing by owners compared with
the financing provided by the firm’s creditors. These creditors include pref-
122
erence shareholders, debenture holders, and other long term creditors. These
ratios measure the ability of a firm to pay all of its long term debts.
• Debt-equity ratios
This ratio shows the relationship between the owner’s funds and the borrowed
funds. The larger the portion of funds provided y the owners; the less risk is
assumed by creditors. It is expressed under:
T otal Debt T otal

Debt − Equity Ratio =
Owners Equity
This ratio may also be expressed under:
F ixed Interest Capital

Capital Gearing Ratio =
Equity Capital
• Equity Ratio
This ratio represents the relationship between owner’s equity and total assets
or total capital employed. This is a measure of the financial strength or weak-
ness of the enterprise. If the owner’s equity is a small proportion of the total
asses or capital employed then the enterprise may be considered financially
weak and vice versa
T otal Capital Employed

Equity Ratio =
Equity Capital
Equity capital includes ordinary share capital and reserves attributed to ordi-
nary share holders
10.2.5. Coverage Ratios Or Stability Ratios

The coverage ratio means the relationship between what is normally available
from operations of the enterprise and the claims of the outsiders. In the normal
circumstances, the claims of the creditors are not met out of the sale proceeds
of the fixed assets of the firm. The obligations of a firm are normally met out
of the earnings or profits These claims include:
• Interest on loans
• Preference dividend
123
• Repayment of loans
• Redemption of preference shares on maturity
a. Interest coverage ratio

A company is considered solvent if its revenues are more than its interest
and other expenses. The interest coverage ratio measures how many times a
company could pay its interest expenses
N et P rof it bef ore Interest and T ax

Interest Coverage Ratio =
F ixed Interest Charges
This ratio measures the ability of a firm to protect the interest of long-term
creditors In order to ensure and adequate protection to the long-term creditors
this ration should be 2 or more
b. Preference Dividend Coverage Ratio

This ratio measures the ability of a firm to pay dividend on preferences shares
which carry a fixed rate of return
N et P rof it af ter T ax
P ref erence Dividend Coverage =
P ref erence Dividend
This ratio reveals the safety margin available to the preference shareholders.
The higher the margin, the better it is forming the poi not view of the prefer-
ence shareholders
c. Total Coverage Ratio or The Fixed Charge Coverage

This ratio takes into account all the fixed obligations of a firm e.g. interest on
loan, preference dividend and the repayment of the principal
N et P rof it bef ore Interest and T axation

T otal Coverage =
T otal F ixed Charges
10.2.6. Activity Ratios

These ratios are also known as assets or turnover ratios They measure the
efficiency of the firm in employing the available resources. Such ratios reflect
the degree of effectiveness of assets utilization in the business enterprise
124
These ratios make comparison between the levels of sales and the investments
in various assets. A rise in these ratios indicates that the company is expanding
too quickly. On the other hand, a decline in these ratios can indicate a decline
in efficiency or a fall in demand for the firm’s products.
a) Rate of stock turnover

This is calculated by dividing the cost of sales by the average stock held during
the year. The average stock is taken to the average of opening and closing stock
Cost Of Sales
Rate of Stock T urnover =
Average Stock
b) Debtors ratio
Debtors are divided by sales (excluding cash sales) to obtain the average credit
period allowed to debtors. A factor 365 is used in order to express the results
in days rather than as fraction of a year.
Debtors
Debtors ratio = × 100
Sales
c) Creditors ratio
Creditors are divided by purchases (excluding cash purchases) to give the
average credit period to creditors
Creditors
Creditors ratio = × 100
P urchases
d) Sales/fixed assets ratio
The ratio shows whether the trading value of a company is large enough to
justify its investment in fixed assets
Sales
Sales/F ixed Assets Ratio =
F ixed assets
e) Total assets turnover
This ratio measures the overall performance and activity of the business orga-
nization
Sales T otal
T otal Assets T urnover =
Assets
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10.2.7. Stock Market Ratios

These are also called shareholders’ or investor ratios They are concerned with
the market value of the securities. They are also used to measure the return
on investments and determine the future prospects.
a) Dividend Yield
This measures the real rate of return to ordinary shareholders.
Dividend per Share(Gross)

Dividend Y ield = × 100
M arket P rice per Share
OR
Gross Dividend on All Shares
× 100
This ratio indicates the return of shareholders in relation to the market value
of the shares. In order to ascertain whether this return is satisfactory or not,
this ratio should be compared with returns on other investments e.g. interest
rate on fixed deposits. If dividend yield is higher as compared to returns on
other investments, then it is satisfactory and vice versa.
b) Dividend Cover
This is the number of times that the actual dividend could be paid out of cur-
rent profits. The dividend cover also indicates the proportion of undistributed
profit for the year.
N etP rof it af ter T ax and P ref erence Dividend

Dividend Cover = × 100
Ordinary Dividend (T otal)
Earnings per Share

Dividend Cover = × 100
Dividend per Share
This represents the ordinary dividend cover. A high dividend cover gives the
confidence to the ordinary shareholders that they will get an adequate return
on their shareholdings.
126
c) Dividend Per Share

This is the earnings distributed to ordinary shareholders divided by the number
of ordinary shares.
Earnings Distributed T o Shareholders

D.P.S =
N umber of Shares
d) Dividends Pay Out Ratio
This represents the dividends as a percentage of earnings per share. It shows
the company’s retention policy. If dividend pay out ratio is low, then the
retention percentage is high and vice versa
Dividend per Share

Dividend P ay Out Ratio = × 100
Earnings per Share
e) Earnings Per Share
The total earnings per share attributable to ordinary shareholders whether
distributed or retained are shown by this ratio.
N et P rof it af ter T ax and P ref erence Dividends

E.P.S = × 100
N umber of Ordinary Shares
This ratio shows the profitability of the firm on per share basis. It doesn’t
show how much is paid as dividends and how much is retained in the business.
E.P.S over years indicate whether or not the company’s profitability per shares
has changed favorably
f ) Price/Earning Ratio (P/E)

This ratio relates the market price of a share and earnings per share. The
P/E ratio is the most important yard-stick for assessing the relative worth of
a share. It represents the number of years that it would take to get back the
current market price
M arket per Share

P/E ratio = × 100
Earnings per Share
If this ratio is low, it shows that a potential shareholder will get back his
investment in a relatively short period provided that there are no retentions.
127
A low P/E ratio helps to raise the market price of the shares in the stock
exchange and vice versa.
g) Earnings Yield
It shows how much profit has been earned by the market value of the ordinary
shares
Earnings per Share

Earnings Y ield = × 100
T otal Earnings Attributable T o Ordinary Shareholders

Earnings Y ield = ×100
T otal M arket P rice of SharesIssued
This ratio represents the earnings as a percentage to the market price of shares.
If this ratio is high hen it is considered favorable and vice versa
Example .
Outline five limitations of ratios as the basis for financial analysis. (10 marks)
Solution: Limitations of ratio analysis
i) Different accounting practices can distort comparisons. For instance, the
use of different inventory valuation or depreciation methods affect financial
statements by varying both reported profits and the value of assets. Thus,
comparisons should be made only between or among firms that employ similar
accounting policies, unless adjustments are made to ensure comparability of
data used in the analysis.
ii) If firms use different accounting years and if seasonal factors are important,
this may influence comparative ratios. It is clear, for instance that seasonal
forces can have an influence on inventory turnover. Distortions arising from
seasonal variations can be smoothed by using monthly average.
iii) Conformity with industry composite ratios does not establish with certainty
that the firm is performing normally or is well managed. In the short run, firms
can adopt window dressing measures to enable their ratios look good in relation
to industry standards. For instance, a firm can improve its liquidity position
by borrowing just before the end of year and holding the loan proceeds as cash
for a few days before using the loan for the intended purpose.
128
iv) Difficulty is encountered in judging whether a ratio is good or bad and

such judgment should be made with caution. For instance, a high fixed assets
turnover ratio may indicate either that a firm uses its assets efficiently (good)
or that the firm is so undercapitalized it cannot afford to buy enough assets
(bad).
v) Effect of inflation: Inflation distorts firms’ balance sheet figures, as histor-
ical figures reported are often substantially different from true values. Fur-
ther, inflation affects both depreciation charges and inventory costs and hence
affects reported profits. For instance, when prices of goods are rising, the
first-in-first-out (FIFO) method of inventory valuation tends to show higher
inventory values, lower cost of goods sold and higher net income performance
than the last-in-first-out (LIFO) method. Similarly, a firm with ‘newer’ fixed
assets reflects higher asset acquisition costs because of inflation and less ac-
cumulated depreciation. To compare firms with different accounting practices
under inflationary conditions, therefore, calls for adjustments to ensure a level
of similarity.

129
Revision Questions
Exercise 33. The following information represents the financial results

and financial position of AMETEX Ltd for the year ended December, 31,
2011.
130
Additional Information:
1. The company’s ordinary shares are selling at KES 20 in the stock market.
2. The company has a constant dividend payout ratio of 10 percent.
Required:
(i) Acid test ratio (2 marks)
(ii) Operating ratio (2 marks)
(iii) Return on total capital employed (2 marks)
(iv) Price-earnings ratio (2 marks)
(v) Interest coverage ratio (2 marks)
(vi) Total assets turnover (2 marks) Total: (22 marks)
Exercise 34. The following financial statements relates to ABC limited
for the year ending 2006.
131
Required: Calculate the following ratios:
132
Figure 10.1: Overview of a Conceptual Framework for Financial Accounting
Solutions to Exercises
Exercise 1.
It enables the development and issuance of a coherent set of accounting stan-

dards and practices built upon the same foundation. Increases financial state-
ment users’ understanding of and confidence in financial reporting. It enhances
comparability among financial statements of different companies due to sim-
ilarity in accounting for similar transactions and events. Resolves new and
emerging practical problems by providing a frame of reference. Defines the
bounds of judgment in the preparation of financial statements.
The first level
This level comprises the objectives that identify the goals and purposes of
accounting and are the cornerstones for the conceptual framework.
The second level
This level comprises the qualitative characteristics of accounting information
and definition of elements of financial statements. The qualitative character-
istics are the characteristics that make accounting information useful while
133
elements are definitions of financial statements components. Together these

two categories provide the foundation for developing recognition and measure-
ment guidelines to be used in practice.
The third level
This is the final level that holds the recognition and measurement guidelines
that accountants use in establishing and applying accounting standards. The
recognition and measurement guidelines encompass assumptions, principles
and constraints that describe the present reporting environment.
Exercise 1
Exercise 6.
Solution using horizontal format
Solution using vertical format
134
. Exercise 6
Exercise 7.
i. Capital can be derived using the accounting equation.

ASSET S = LIABILIT IES + CAP IT AL
Therefore; CAP IT AL = ASSET S–CAP IT AL
ASSETS Ksh LIABILITIES Ksh
Accounts receivable 155,700 Accounts payable 56,500
Machinery 150,000
Motor Vehicle 260,600
Stock 105,000
Bank 90,000
Cash 34,000
795,300
Capital = Assets – Liabilities
Capital = 795,300 – 56,500 = Ksh 738,800
ii. To Extract a balance sheet we need to consider the reported
135
transactions
Credit purchase of new machine will Increase both machinery and accounts
payable by Ksh 21,500
Purchase of stock via bank will Increase stock and Reduce bank by Ksh 64,000.
Payment of Creditors by cheque will Reduce accounts payable and bank by
Ksh 20,000.
Debtors cash payment will Reduce accounts receivable and Increase cash by
Ksh 72,000.
Bank deposit of Ksh 5,000 (as capital) by Jacob will Increase both capital and
bank.
This can be summarized as follows:
With the above adjustments the balance sheet will now appear to be as follows:
136
. Exercise 7
Exercise 8.
.
Exercise 8
Exercise 9.
Petty cash book
.
Exercise 9
Exercise 10.
137
Two column cashbook
.
Exercise 10
Exercise 11.
Two column cashbook

SALES LEDGER
PURCHASES LEDGER
GENERAL LEDGER
Exercise 11
138
Exercise 12.
Three column cashbook
Ledger Accounts
Ledger Accounts(cont’d)
.
Exercise 12
Exercise 13.
139
XYZ Journal entries as at 31st December 2009
Exercise 13
Exercise 14.
140
Tempo Ltd Journal Entries
Exercise 14
Exercise 15.
141
Exercise 15
Exercise 16.
Point to Note:
A debit balance in the bank statement means this is negative amount that is
an overdraft.
Exercise 16
Exercise 17.
142
Exercise 17
Exercise 18.
143
Exercise 18
Exercise 19.
144
Provision for doubtful debts for Provision for doubtful debts for
year 20x3 year 20x4
3% × 4, 027, 500 = 120, 825 5% × 4, 681, 000 = 234, 050
Note: Provision for doubtful debts is calculated on the net debtors, that is,
after deducting the bad debts written off in a particular financial year or
period.
145
Note: In the balance sheets we deduct the whole provision for doubtful debts
that relates to a particular financial year from the debtors amount under the
current assets.
We do not deduct the increase or decrease in provision as it is the case of the
income statement. Exercise 19
Exercise 20.
146
Provision for doubtful debts for Provision for doubtful debts for
year 20x3 year 20x4
3% × 4, 027, 500 = 120, 825 3% × 3, 600, 000 = 108, 000
147
Exercise 20
Exercise 21.
148
Workings
Depreciation charge for motor vehicle bought on 1st April; 20% x
400,000 x 9/12 = 60,000
Depreciation charge for motor vehicle bought on 1st July; 20% x
550,000 x 6/12 = 55,000
Total depreciation charge = 115,00
Exercise 21
Exercise 22.
149
Points to Note
Asset (Machine) account is always maintained at cost
Balance b/f in the provision for depreciation account relates to machine A
(15% x 250,000 = 37,500)
The disposal in the provision for depreciation account is the accumulated de-
preciation for machine A since 1st January 20x3 to 1st July 20x4
For year 20x3 = (15% x 250,000 = 37,500)
For year 20x4 = (15% x 250,000 x 6/12 = 18,750)
Total = 37,500 + 18,750 = 56,250
Exercise 22
Exercise 23.
150
Year Depreciation Amount

1999 20% of 9,000 = 1,800; 20% of 6,000 (3/12) = 300; 1,800 + 300 = 2,100
2000 20% of 15,000 = 3,000
2001 20% of 15,000 = 20% of 5,500 (6/12) = 550; 3000 + 550 = 3,550
3,000;
2002 20% of 11,500 = 20% of 9,000 (9/12) = 1,350 (Part of plant that
2,300; depreciated
& later sold)
2,300 + 1,350 = 3,650
Accumulated depreciation for plant disposed; Has been in
operation for 3 years and 9 months 20% of 9,000 x 3.75 years =
6,750
Exercise 23
Exercise 24.
151
MAXWELL SOLE TRADER

INCOME STATAEMENT
FOR THE YEAR ENDING 31 DECEMBER 20x3
Workings
Wk1 = 41 × 300, 000 = 75, 000
Wk2 = depreciation on motor vehicle 20% × 5, 600, 000 = 1, 120, 000
Wk3 = depreciation on fixtures 10% × 3, 200, 000 = 320, 000
152
MAXWELL SOLE TRADER

BALANCE SHEET
Exercise 24
Exercise 25.
153
K. KALIF SOLE TRADER

INCOME STATEMENT
Workings
Depreciation on m/vehicle (reducing
Provision for bad debts = 5% of balance) 20% of (1,600,000-700,000) =
1,920,000 = Sh. 96,000 Sh. 180,000
Depreciation on building (straight
Increase in provision = 96,000 – line)
72,000 = 10 % of ( 3,000,000) = Sh. 300,000
Sh. 24,000
154
K. KALIF SOLE TRADER

BALANCE SHEET
AS AT 31ST DEC 20x3
Exercise 25
Exercise 26.
155
Balance sheet extract
Exercise 26
Exercise 28.
156
Exercise 28
Exercise 30.
There are organizations that do not carry out the trading activities and there-
fore need not to maintain the trading, profit and loss account.
An equivalent of the trading, profit and loss account is an income and ex-
penditure account showing the income received on the credit side and all the
expenses incurred on the debit side.
The excess of income over the expenses is known as a surplus. The excess
of expenses over income is known as a deficit. The posting to receipt and
payment account and income and expenditure account also follows the double
entry system. Exercise 30
Exercise 33.
Analysis through ratios
157
Interest coverage ratio
Earnings bef ore interest and taxes

Interest expense
= (127000 + 4000)/4000 = 32.75×
Exercise 33
Exercise 34.
158
159
160
161
Exercise 34
162

HBT2103 Financial Accounting

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JOMO KENYATTA UNIVERSITY

SCHOOL OF OPEN, DISTANCE &

DEPARTMENT OF COMMERCE &

HBT 2103: FINANCIAL ACCOUNTING

P.O. Box 62000, 00200

SCHOOL OF OPEN, DISTANCE AND eLEARNING

HBT 2103 FINANCIAL ACCOUNTING

LAST REVISION ON May 5, 2017

This presentation is intended to covered within one week. The notes,

HBT 2103: FINANCIAL ACCOUNTING

ysis:Calculate profitability index,Analyze the liquidity ratio,Determine the

2. Identify, describe and analyze the key components of Annual Financial

3. Evaluate the institutional accounting environment for decision making.

4. Prepare company account

5. Prepare accounts for nonprofit making organizations

Course Text Books

• Horngren, C. T., Sundem, G. and Elliott, J. (2002). Introduction to

• Weygandt, J., Kieso, D. and Kimmel, P. (2008). “Financial Accounting”,

Reference Text Books

• Ross, S., Westerfield, J. and Jordan, F. (2008). Corporate Finance, 8th

• Garrison, R. (2005). Managerial Accounting, 6th edition Irwin, Interna-

• Journal of Accounting Research by Wiley

• Journal of Accounting and Economics by Elsevier: A Practical Guide

• The Journal of Accounting, Auditing, and Finance (JAAF) Sage Publi-

• The International Journal of Accounting by University of Illinois

• 20% of marks from one written CAT to be administered at JKUAT main

• 60% of marks from written Examination to be administered at JKUAT

1 Conceptual Framework Underlying Financial Accounting 1

2 Introduction to Accounting Equation and Double Entry Sys-

2.3 The Double Entry System . . . . . . . . . . . . . . . . . . . . 20

3 The Accounting Cycle 33

4 Error , Suspense Accounts and Bank Reconciliation State-

5 Control Accounts and Adjustments to Final Accounts 69

5.6.5 Accounting Disposal of fixed assets . . . . . . . . . . . 82

7 Partnership Accounts 101

8 Company’S Account 108

9 Non-profit Making Organization 114

10 Ratio Analysis 119

• Explain the importance of a conceptual framework for financial account-

• Know the objectives of financial accounting.

• Describe the qualitative characteristics of accounting information.

• Differentiate between the qualities relating to content and those relating

• Identify and explain the accounting elements.

• Highlight the limitations of preparing financial reports

1.2. Definition of conceptual framework

1.2.1. Need for a conceptual framework.

Figure 1.1: Overview of a Conceptual Framework for Financial Accounting

Figure 1.2: The relationship between the qualitative characteristics of good

1.3. Objectives of Financial Accounting

1.4. Qualitative Characteristics of accounting information

1.4.1. Primary qualities relating to content

• Predictive value - helps users make predictions about the outcome of

• Feedback value - confirms or corrects prior expectations

• Timely - available to decision makers before it loses its capacity to influ-

For example, when a company issues an interim report, this information is

2. Substance Over Form

amount of the claim in the balance sheet, although it may be appropriate

1.4.2. Primary qualities relating to presentation

Exercise 1. Discuss the importance of a conceptual framework to financial