Chapter ONE

INTRODUTION TO ACCOUNTING

a) NATURE OF ACCOUNTING
Accounting, as a preamble, could be termed the language of business. It is the common media through
which people of all walks can effectively communicate business matters and understand one another
equally.
It is the language accountants use to communicate i.e. record business transactions and summarize
results of business operations. Accounting can be defined as the art of recording, classifying and
summarizing in a significant manner, and in terms of money, transactions and events which are of a
financial character, and interpreting the results thereof.
It encompasses the recording of information of economic value to a business. The information then
forms the basis for judgment by the users.

Accounting is defined as the process of identifying, measuring and reporting economic information to
the users of this information to permit informed judgment.
Many businesses carry out transactions. Some of these transactions have a financial implication i.e.
either cash is received or paid out. Examples of these transactions include selling goods, buying goods,
paying employees and so many others.
Accounting is involved with identifying these transactions measuring (attaching a value) and reporting
on these transactions. If a firm employs a new staff member then this may not be an accounting
transaction. However when the firm pays the employee salary, then this is related to accounting as cash
involved. This has an economic impact on the organization and will be recorded for accounting
purposes. A process is put in place to collect and record this information; it is then classified and
summarized so that it can be reported to the interested parties.
PHASES OF THE ACCOUNTING PROCESS
From the above definition, we can clearly see that accounting is a process that can be divided into four
phases;
1. Recording phase: involves the routine and mechanical process of writing business

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 transactions and events in the books of accounts – also called books of original entry
or simply journals - in a chronological order in accordance with the entity’s and other established
accounting rules and procedures.
2. Classifying phase: involves sorting and grouping of similar transactions into their respective classes
by posting them into a ledger.
A ledger is a group of accounts of a similar nature
An account is the basic record of accounting which measures increases or decreases in a particular
asset, liability, income or expense account.
3. Summarizing phase: this involves the preparation of financial statements or reports. It is usually
done periodically e.g. monthly, annually etc.
4. Interpretation: this refers to the analysis of the accounting information. It involves communication
of financial information to help users in making economic decisions.
This is the reason why accounting is called the language of business.

b) USERS OF ACCOUNTING INFORMATION

Accounting information is produced in form of financial statement. These financial statements provide
information about an entity financial position, performance and changes in financial position.
Financial position of a firm is what the resources the business has and how much belongs to the owners
and others.
The financial performance reflects how the business has performed, whether it has made profits or
losses. Changes in financial positions determine whether the resources have increased or reduced.
The users of accounting information have an interest in the existence of the firm. Therefore the
information contained in the financial statements will affect the decision making process.

The following are the users of accounting information:

i. Owners:
They have invested in the business and examples of such owners include sole traders, partners
(partnerships) and shareholders (company). They would like to have information on the financial
performance, financial position and changes in financial position.
This information will enable them to assess how the managers of the business are performing
whether the business is profitable or not and whether to make drawings or put in additional capital.

ii. Customers

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 Customers rely on the business for goods and services. They would like to know how the business
is performing and its financial position.
This information would enable them to assess whether they can rely on the firm for future supplies.

iii. Suppliers
They supply goods or services to the firm. The supplies are either for cash or credit. The suppliers would
like to have information on the financial performance and position so as to assess whether the business
would be able to pay up for the goods and services provided as and when the payments falls due.

iv. Managers
The managers are involved in the day-to-day activities of the business. They would like to have
information on the financial position, performance and changes in financial position so as to
determine whether the business is operating as per the plans.
In case the plan is not achieved then the managers come up with appropriate measures (controls) to
ensure that the set plans are met.
v. The Lenders
They have provided loans and others sources of capital to the business. Such lenders include banks
and other financial institutions. They would like to have information on the financial performance
and position of the business to assess whether the business is profitable enough to pay the interest
on loans and whether it has enough resources to pay back the principal amount when it is due.

vi. The Government and its agencies

The Government is interested in the financial performance of the business to be able to assess the
tax to be collected in the case there are any profits made by the business.
The other government agencies are interested with the financial position and performance of the
business to be able to come with National Statistics. This statistics measure the average
performance of the economy.

vii. The Financial Analyst and Advisors

Financial analyst and advisors interpret the financial information. Examples include stockbrokers
who advise investors on shares to buy in the stock market and other professional consultants like
accountants. They are interested with the financial position and performance of the firm so that they

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 can advise their clients on how much is the value their investment i.e. whether it is profitable or not
and what is the value.
Others advisors would include the press who will then pass the information to other relevant users.

viii. The Employees

They work for the business/entity. They would like to have information on the financial position
and performance so as to make decisions on their terms of employment. This information would be
important as they can use it to negotiate for better terms including salaries, training and other
benefits.
They can also use it to assess whether the firm is financially sound and therefore their jobs are
secure.

ix. The Public

Institutions and other welfare associations and groups represent the public. They are interested with
the financial performance of the firm. This information will be important for them to assess how
socially responsible is the firm.
This responsibility is in form the employment opportunities the firm offers, charitable activities and
the effect of firm’s activities on the environment.

BRANCHES OF ACCOUNTING
Accounting, in all its broadness, can be sub-divided into areas of specialization;
a. Financial accounting; concerns itself with the collection and processing of accounting data and
reporting to interested parties inside and outside the firm.
b. Tax accounting; deals with the determination of the firm’s tax liability which could be, Value added tax
(VAT), customs duty, Pay as you earn (PAYE), corporation tax etc.
c. Cost accounting; helps establish costs relating to the production of a good or service and allocating it to
the various factors that contributed to the cost of production.
d. Managerial accounting; deals with the generation of accounting information to be used categorically by
the firm’s internal management in their day-to-day decision making.

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e. Auditing; concerns itself with the vouching and verification of transactions from the financial
accounting to determine that they are a true representation of the business’ activity i.e. the true and fair
view of the company’s state of affairs.

The general purpose of accounting can therefore be summarized into five purposes;
i. Helps in decision making
ii. Ascertain the value of the business
iii. Know the profit and or loss position
iv. Ascertain the assets and liabilities of the firm
v. Know the cash and wealth of the business

QUALITIES OF GOOD ACCOUNTING INFORMATION

For accounting information to be able to effect the purpose for which it was meant, there are certain
attributes that it must fulfill. These include:
(a) Understandability. For accounting information to be considered useful, it must be well understood by
the parties for which it was prepared for. The parties must be able to derive satisfaction from the financial
data represented by accounting.
(b) Relevance. The accounting information should be able to influence the important decisions in the
company. The information should be verifiable, neutral and truthful.
(c) Reliability. Reliability means that the accounting information should have differing methods or ways of
doing it and yet arrive at the same or similar conclusions.
(d) Comparability. The accounting information should be able to be compared with other information
from different organizations or of the same organization at differing periods.
(e) Timely. If the accounting information is not availed to the deserving user at the time of need, then it
may as well be useless. For accounting information to be useful, it must be presented to the party in need at
the time of the need.
LIMITATIONS OF ACCOUNTING INFORMATION
o Historical
Accounting information is prepared based from past period monetary transactions. It is hardly feasible that
what happened in the past will hold on in the future and so the accounting information may be considered
irrelevant on that basis alone.

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o Too quantitative rather than qualitative
Accounting information consists of too many figures and less of explanations. For any system to be useful,
it must strike a balance between quantitative and qualitative measures.
o Only comparable to similar businesses
Accounting information makes it only comparable to businesses of similar nature. It is difficult to compare
a service oriented organization to a manufacturing based firm.

CHAPTER TWO

THE PRINCIPLES, CONCEPTS AND CONVENTIONS

UNDERLYING THE ACCOUNTING REPORTS

Fast forward – Prudence, substance over form and materiality should govern the selection and application
of accounting policies.
After defining what accounting is all about, we now need to know the environment that accounting
operates. Just like any other field of study, accounting has developed its own concepts that govern its
application. These concepts form the fundamental accounting assumptions underlying the preparation of
financial statements.

THE CONCEPTS
There are four main concepts:
Going concern
It is assumed that the operation will continue in operational existence into the foreseeable future. This
implies that the management should view all the available information in the light of the foreseeable future,
but not only for the current period.
Accounting period convention
Also known as the time concept. It is assumed that the continuous lifetime of the entity is divided into
small equal periods to ease the burden of reporting. These subdivisions are called the financial year.
Business entity concept

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The assumption is that the business is a separate legal entity; distinct from the owners and the management.
The financial affairs of the business entity are recorded and reported separately from those of the owners of
the capital or the managers
Fast forward – Prudence, substance over form and materiality should govern the selection and application
of accounting policies.
After defining what accounting is all about, we now need to know the environment that accounting
operates. Just like any other field of study, accounting has developed its own concepts that govern its
application. These concepts form the fundamental accounting assumptions underlying the preparation of
financial statements.

THE ACCOUNTING PRINCIPLES

Historical cost
Postulates that assets should be recorded at cost, at the purchase price or at the acquisition price. This
ignores the effects of inflation on cost as the assets are kept by the business over the years.
It recognizes that for example a building purchased 40 years ago for Sh 29,000 would be reported today in
the statement of financial position at that historical price even though its actual worth today may be Sh 2.9
million.
However, this problem has been overcome by asset revaluation as an alternative to the historical cost of
accounting.
Monetary principle
This principle holds that accounting will only endeavor to deal with those items to which a monetary value
can be attached. As such, financial statements reflect only the items that can be measured in monetary
terms. Goodwill for example is never shown in the statements because it has no monetary measurement.
Accrual concept
The accruals concept is also known as matching concept.
In the principle, revenues and costs are recognized when earned or incurred and not as the monetary
attachment is received or paid. What this means is that the time when the revenue is received or the
expense is incurred is completely disregarded. This leads into two scenarios; prepayments and accruals
Prepayments occur when money is received for a period that it has yet to be earned, or an expense is paid
for but has not yet been incurred.
Accruals occur when the expense for the money is being paid for has already been incurred i.e. the expense
belongs to a past period, or when an income is received way after the period of earning has expired.

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Revenue realization concept
It states that a sale should be recognized when the event from which it arises has taken place and the receipt
of cash from the transaction is reasonably certain. Revenue can be recognized at different levels of selling
such as when the inquiry is made, during delivery, at issue of invoice or when payment is made.
Revenue realization demands that only when the money receivable is reasonably certain of reception
should accountants recognize it as income. For instance, it may not be prudent to recognize a sale when a
customer makes an inquiry because the requisition may be revoked well before the goods are even ordered
or delivered.
Prudence
Prudence states that where alternatives exist, the one selected should be one that gives the most cautious
presentation of the financial position of the business. Assets and profits should not be overstated, but a
balance must be achieved to prevent the material overstatement of liabilities and losses.
Where a losses foreseen, it should be anticipated and taken immediately into account. In other words,
accountants should never anticipate for gains but must always provide for losses.
Consistency
The items in the financial statement should be presented and classified in the same manner from one period
to the next unless there is a significant change in the nature of the operations of the business, or a review of
its financial statement presentation demonstrates that relevance is better achieved by presenting items in a
different way, or a change is required by a new international standard.
For instance, an entity is not allowed to change form LIFO to FIFO or otherwise unless:
- there is a significant change in the business
- there is a new accounting order
- It helps present the information better.
Materiality
Information is material if its non-disclosure could influence the decisions of users. Materiality depends on
the size and the nature of the item being judged. Strict adherence to accounting rules is not necessary in
accounting for trivial items such as loose tools, e.g. a stapler should not be capitalized, and a bribe cannot
be itemized under expenses.

Duality

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Duality principle emphasizes the double entry book-keeping entry that every transaction has two effects,
for every debit there is a corresponding, equal and opposite credit entry. As such it forms the basis of the
double entry system of book keeping.
Substance over form
Some transactions have a real nature that differs from their legal form. This principle states that whenever it
is legally possible, the real substance prevails over the legal form.

CHAPTER THREE

THE ACCOUNTING EQUATION

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

ASSETS = LIABILITIES + CAPITAL

Each item in this equation is briefly explained below.

Assets:
An asset is a resource controlled by a business entity/firm as a result of past events for which economic
benefits are expected to flow to the firm.
An example is if a business sells goods on credit then it has an asset called a debtor. The past event is
the sale on credit and the resource is a debtor. This debtor is expected to pay so that economic benefits
will flow towards the firm i.e. in form of cash once the customers pays.

Assets are classified into two main types:

i) Non current assets (formerly called fixed assets).
ii) Current assets.

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Non-current assets are acquired by the business to assist in earning revenues and not for resale. They are
normally expected to be in business for a period of more than one year.
Major examples include:
 Land and buildings
 Plant and machinery
 Fixtures, furniture, fittings and equipment
 Motor vehicles
Current assets are not expected to last for more than one year. They are in most cases directly related to
the trading activities of the firm. Examples include:
 Stock of goods – for purpose of selling.
 Trade debtors/accounts receivables – owe the business amounts as a resort of trading.
 Other debtors – owe the firm amounts other than for trading.
 Cash at bank.
 Cash in hand.

Liabilities:
These are obligations of a business as a result of past events settlement of which is expected to result to
an economic outflow of amounts from the firm. An example is when a business buys goods on credit,
then the firm has a liability called creditor. The past event is the credit purchase and the liability being
the creditor the firm will pay cash to the creditor and therefore there is an out flow of cash from the
business.

Liabilities are also classified into two main classes.

i) Non-current liabilities (or long term liabilities)

ii) Current liabilities.

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

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  Trade creditors/ or accounts payable – owed amounts as a result of business buying
goods on credit.
 Other creditors - owed amounts for services supplied to the firm other than goods.
 Bank overdraft - amounts advanced by the bank for a short-term period.

Capital:
This is the residual amount on the owner’s interest in the firm after deducting liabilities from the
assets.
The Accounting equation can be expressed in a simple report called the Balance Sheet. The basic
format is as follows:

Name
Balance sheet as at 31.12.
Sh Sh Sh Sh
Capital xx Non Current Assets
Land & Buildings xx
Non Current Liabilities Plant & Machinery xx
Loan xx Fixtures, furniture & fittings xx
Motor vehicles xx
Current liabilities xx
Overdraft xx Current Assets
Creditors xx xx Stocks xx
Debtor’s xx
Capital and Liabilities Cash at bank xx
Cash in hand xx xx
xx Total assets xx

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

Name
Balance sheet as at 31.12.

Non Current Assets Sh Sh Sh

Land & Buildings xx
Plant & Machinery xx
Fixtures, furniture & fittings xx
Motors vehicles xx
xx
Current Assets
Stocks/inventories xx
Debtors/ trade receivables xx
Cash at bank xx
Cash in hand xx

Current Liabilities
Bank Overdraft xx
Creditors/trade payables xx (xx)
Net Current Assets xx
Net assets xx

Capital xx
Non Current Liabilities
Loan (from bank or other sources) xx
xx

Example 1.1
B Kelly has a business that has been trading for some time. You are given the following information as
at 31.12.2002
£
Buildings 11,000
Furniture & Fittings 5,500
Motor Vehicles 5,800
Stocks 8,500
Debtor 5,600
Cash a bank 1,500
Cash in hand 400
Creditors 2,500
Capital 30,800
Loan 5,000

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You are required to prepare a Balance Sheet as at 31 December 2001

B Kelly
Balance Sheet as at 31 December 2001

Non Current Assets £ £ £

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

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

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

Example 1.2
L Stokes sets up a new business. Before he actually sells anything he has bought motor vehicles of
₤3,000, premises of ₤7,000, stock of goods ₤2,000. He still owes ₤800 in respect of them. He had
borrowed ₤4,000 from D Evans. After the events just described and before trading starts, he had ₤300
cash in hand and ₤600 cash at bank.

You are required to calculate the amount of his capital.

Remember the Accounting equation:

Assets = Liabilities + Capital.

To get capital we rearrange the equation as follows:

Capital = Assets - Liabilities

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 Example 1.3
C Kings has the following items in his balance sheet as on 30 June 2002.
Capital £41,800, Creditors £3,200, Fixtures £7,000, Motor Vehicles £8,400, Stock of goods £9,900,
Debtors £6,500, Cash at bank £12,900 and Cash in hand £240.

During the first week of July 2002:

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

You are to draw up a balance sheet as on 7 July 2002 after the above transactions have been completed.

First we need to look at the effect of the above transactions on the assets and liabilities of C Kings.
For
(a) Buying extra stock increases the level of stock by £1,540 and because this is bought on credit
the creditors increase by £1,540 also.
(b) Amount received from the debtor means that the level of debtors reduces and cash increases by
£560.
(c) Extra fixtures bought by cheque, will increase the fixtures and reduce the cash at bank by
£2,000.

This can be summarized as follows:

Opening Increase/(Decrease) Closing

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

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

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

Example 1.6

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Write up the asset, capital and liability accounts in the books of M Crash to record the following
transactions:
2002
June 1 Started business with £50,000 in the bank.
“ 2 Bought motor van paying by cheque £12,000.
“ 5 Bought Fixtures £4,000 on credit from Office Masters Ltd.
“ 8 Bought a van on credit from Motor Cars Ltd £8,000.
“ 12 Took £1,000 out of the bank and put it into the cash till.
“ 15 Bought Fixtures paying by cash £600.
“ 19 Paid Motor Cars Ltd by cheque £8000.
“ 21 A loan of £10,000 cash is received from J Marcus.
“ 25 Paid £8,000 of the cash in hand into the bank account.
“ 30 Bought more Fixtures paying by cheque £3,000.

Note that the difference between the debit side and the credit side is the balancing figure. Most assets will
have a balance on the credit side and most liabilities and capital accounts will have a balance on the debit
side.
A simple balance sheet from these balances will be as follows:

Question: Also prepare the balance sheet statement

Example 1.8
You are to enter the following transactions, completing the double entry in the books for the month of May
2002.
2002
May 1 Started business with £2,000 in the bank.
“ 2 Purchased goods £175 on credit from M Rooks.
“ 3 Bought furniture and fittings £150 paying by cheque.
“ 5 Sold goods for cash £275.
“ 6 Bought goods on credit £114 from P Scot.
“ 10 Paid rent by cash £15.
“ 12 Bought stationery £27, paying in cash.
“ 18 Goods returned to M Rooks £23.
“ 21 Let off part of the premises receiving rent by cheque £5.
“ 23 Sold goods on credit to U Foot for £77.
“ 24 Bought a motor van paying by cheque £300.
“ 30 Paid the month’s wages by cash £117.
“ 31 The proprietor took cash for himself £44.

Also prepare the balance sheet statement

TRIAL BALANCE
The trial balance is a simple report that shows the list of account balances classified as per the debits and
credits. The purpose of the trial balance is to show the accuracy of the double entries made and to
facilitate the preparation of final accounts i.e. the trading, profit & loss account and a balance sheet.
The debits of the trial balance should be the same as the credits, if not then there is an error in one or more
of the accounts.

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The trial balance in example 1.8 would be extracted as follows:

Name
Trial balance as at 31 May 2002
Debit Credit
£ £
Rent – income 5
Debtor – U Foot 7
Motor vehicle 300
Bank 1555
Purchases 289
Wages 117
Capital 2000
Creditor – M Rooks 152
Furniture & Fittings 150
Sales 352
Cash in hand 72
Creditor – P Scot 114
Expenses – Rent 15
Expenses – 27
Stationery
Returns Outwards 23
Drawings 44 .
2464 2464

From the trial balance please note that assets and expenses are on the debit side. Capital, liabilities and
incomes are normally listed on the credit side.
The next example is a detailed one that shows extracting of trial balance once all the postings have been
made in the relevant accounts.

CHAPTER FOUR

THE REGULATION OF ACCOUNTING PROFESSION

THE INTERNATIONAL ACCOUNTING STANDARDS BOARD (IASB)
The IASB is an independent, privately funded accounting standard setter based in London.

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The 14 members of the IASB come from nine countries and have a variety of backgrounds with a mix of
auditors, preparers of financial statements, users of financial statements and an academic.
The board consists of 12 fulltime members and two part-time members.
In March 2001 the International Accounting Standards committee (IASC) was formed as a notfor-profit
corporation incorporated in the USA. The IASC foundation is the parent entity of the IASB.
From April 2001 the IASB assumed accounting standards setting responsibilities from its predecessor
body, IASC. This restructuring was based upon the recommendations on shaping IASC for the future.
Objectives of the International Accounting Standards Board
1. To develop, in the public interest, a single set of high quality, understandable and enforceable global
accounting standards that require high quality, transparent and comparable information in general purpose
financial statements.
2. To provide the use and vigorous application of those standards.
3. To work actively with the national accounting standard setters to bring about convergence of national
accounting standards and IFRS to high quality solutions.

THE INTERNATIONAL FEDERATION OF ACCOUNTANTS (IFAC)

The IFAC is a private sector body established in 1977 and which now consists of over 100 professional
accounting bodies from around 80 different countries. The IFAC’s main objective is to co-ordinate the
accounting profession on a global scale by issuing and establishing international standards on auditing,
management accounting, ethics, education and training. The IFAC has separate committees working on
these topics and also organizes the world congress of accountants, which is held every five years. The
IASB is affiliated with the IFAC.

INTERNATIONAL PUBLIC SECTOR ACCOUNTING STANDARDS BOARD (IPSAB)

Regulation of public not-for-profit entities, principally local and national governments and governmental
agencies, is by the IPSAB, which comes under the IFAC.
Fast forward – ICPAK, RAB and KASNEB jointly form the framework of regulation of the accounting
profession in Kenya.
It is important to put accounting into practical perspective. This will be made possible by looking at the
institutions that regulate the climate within which the accounting profession is practiced.
The Accounting Act was enacted by the parliament into chapter 531, Laws of Kenya in1977.

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The Act then established the Institute of Certified accountants of Kenya (ICPAK), the Registration of
Accountants Board (RAB) and the Kenya Accountants and Secretaries National Examinations
Board (KASNEB).
The three jointly form the framework of regulation of the accounting profession in Kenya.
Role of ICPAK
1. To provide standards of professional competence and practice among its members.
2. To promote research into the subjects of accountancy, finance and related matters, and the publication of
books, periodicals, articles and journals in that connection.
3. To promote the international recognition of the institute.
4. Advise the examinations board on matters relating to examination standards and policies.
5. Carry out any other functions prescribed for it under any other provision or under other written law
6. Do anything incidental or conducive to the performance of any of the preceding
Functions
Role of KASNEB
1. Prepare syllabuses for accountants and secretaries examinations
2. Make rules in relation to the examinations
3. Issue certificates to candidates who have satisfied the examination requirements.
Role of RAB
1. Register the accountants that have been certified by the examination body to have fulfilled the
examination requirement.
2. Issuance of practicing certificates to those wishing to render the accounting services to the public

CHAPTER FIVE
ACCOUNTING PROCEDURES AND TECHNIQUES

BOOK KEEPING
N/B: - Book keeping is intended to record all the accounting data in such a way that one can make a
deduction based on it.

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Book keeping defined as the process of recording business transactions (data) in a systematic manner. It
can also be defined as that part of accounting that is concerned with recording data.

Book keeping is intended to record all the accounting data in such a way that one can make a deduction
based on it. The deductions could be such as:

• How much sales has been achieved over a given period of time, be it a day, a month, or a year.
• How much is owed to the creditors.
• How much is available in the bank, among others.
The whole process of book keeping is in the form of a cycle i.e. the accounting cycle.

THE ACCOUNTING CYCLE

The accounting process can be perceived as a cycle which starts with the occurrence of a transaction,
recording of the transaction and finally the preparation of the financial statements.

Financial statements are reports on results of all the transactions that occur during the year and the position
of the business as at the last date of the accounting period. A transaction is an activity which involves the
exchange of goods and services for another thing of value e.g. when the business purchases goods for sale,
sells goods to customers on credit, pays for services e.g. telephone.

A transaction is first recorded in the source documents e.g. the cash sale receipt, the invoices received from
creditors, debit and credit notes issued and received etc

The daybooks as the name suggests they are filled daily showing all the transactions that occurred during
the day. Such information is obtained from the source documents.

The data in the day books is then filled in the ledger accounts and a trial balance extracted as the end of the
accounting period. Adjustments e.g. for prepayments and accruals are then made and an adjusted trial
balance is drawn reflecting these changes.

From this trial balance, the final statements are prepared i.e. the statement of comprehensive income which
reveals whether the company made a profit or loss from the transactions carried out in the year, and the
statement of financial position which tells of the financial position of the business in terms of its assets and
liabilities as at that closing date.

After these, the closing entries are made to prepare the accounts to receive the data for the following
financial period and a closing trial balance extracted.

This marks the end of journals

For every transaction entered into the business enterprise, there is the primary book where it will be
initially recorded. This is known as books of original entry.

Transaction Journals (Day Ledgers Financial

documents book)

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TRANSACTION DOCUMENTS

A transaction is a business event. Its an exchange of value between the business and another entity.
Transactions include such events as sales, purchases and payments. The transactions should be properly
recorded.

The tools used to capture and record transactions are called transaction documents.

Transaction documents are the business records in which events are first recorded. Examples include:

 Cash receipts
 Invoice
 Goods received note
 Cheque

 Salary slip
 Debit/ credit note
 Payment voucher

i. Date of transactions
ii. Details of transaction
iii. Type of transaction
iv. Reference number
v. Beneficiary of the transactions
vi. Mode of payments
vii. Execution officer
viii. Authorization officer

BOOKS OF ORIGINAL ENTRY

N/B - Accounts can be divided into personal accounts and impersonal accounts.

Books of original entry can be defined as the books in which we first record a transaction. These books
essentially record the following details of a transaction:

• Date of the transaction

• The name of the person/ firm with whom the transaction took place
• The details of an item bought or sold e.g. a motor vehicle stock e.t.c
• Details for cross referencing
• The amount (shown in monetary terms) of the transaction
Books of original entry are known as journals or daybooks. Both terms are used interchangeably.
The commonly used books of original entry are:

i. PURCHASES JOURNAL

20
 a) Invoice no. 005 purchases from Bamburi Limited shs. 5,000 on 1/1/04
b) Invoice no. 201 purchases from mumias limited shs. 10,000 on 2/1/04
c) Invoice no. 352 purchases from athi river miners limited on 4,000 on 3/1/04

d) Invoice no.221 purchases from unga group limited shs. 2,000 on 5/1/04 Solution

XYZ Limited
Purchases Journal
Date Invoice no. Details Folio Amount
1/1/04 005 Bamburi Ltd 5,000
2/1/04 201 Mumias Ltd 10,000
3/1/04 352 Athi R. Miners Ltd 4,000
4/1/04 020 Bamburi Ltd 2,000
5/1/04 221 Unga Group Ltd 2,000
Total 23,000

ii. SALES JOURNAL

A sales journal records credit sales only.
Illustration 2
st
on 1 Jan 2004, XYZ Limited made credit sales as follows:
a) Invoice no.001 sales to Musa shs, 5,000
b) Invoice no.002 sales to kimani shs, 2,000
c) Invoice no.003 sales to Mwanza shs, 3,000

d) Invoice no.004 sales to otieno shs, 1,500 Solution

XYZ Limited
Sales Day Book
Date Invoice no. Details Folio Amount
1/1/04 001 Musa 5,000
1/1/04 002 Kimani 2,000
1/1/04 003 Mwanza 3,000
1/1/04 004 Otieno 1,500
Total 11,500

Illustration 3
ABC Ltd made credit sales as follows:
a) On 1/1/04 invoice no.251 sales to Macharia shs. 5,000
b) On 2/1/04 invoice no.252 sales to Akinyi shs. 2,000
c) On 3/1/04 invoice no.253 sales to Mutua shs. 1,000
d) On 4/1/04 invoice no.254 sales to Abdi shs. 2,500
e) On 5/1/04 invoice no.255 sales to Macharia shs. 3,000
f) On 6/1/04 invoice no.256 sales to abdi shs. 4,000

Required :
Draw the sales day book and summarises it as 6/1/04

21
 Folio is a key or page of reference. Notice that the sales daybook summarises total credit sales for a
given period (day) and through the sequence of the invoice numbers confirms completeness of credit
sales records.

iii. RETURN OUTWARDS JOURNAL

It records goods returned by the business to the suppliers for the reason that they are either tampered
with, are not of the kind ordered for, are damaged, or are in excess of the amount ordered.

iv. RETURN INWARDS JOURNAL

This journal is used to record all the goods that are returned to the business by the customers because
they were not the kind ordered for or were in excess e.t.c

v. General journal (Journal Proper)

All other transactions not falling into any of the above journals are recorded in this journal. In the
general journal the following details relating to the transaction are included; date, the name of the
account to be debited, the name of the account to be credited and a brief narration or description of the
transaction as illustrated below.

GENERAL JOURNAL
Date Details Debit (Dr ) Credit (Cr)
--/---/-- Account to be debited XXX
Account to be credited XXXX
(a brief narrative to describe the above
transaction)

vi. Cash Book

This is a book of original entry that is used to record all cash received or paid out by the business via
the cash till or via the business‟ bank account. A cash book is a unique journal since it acts both as a
book of original entry as well as a ledger account where all transactions affecting cash are recorded.

A general journal has the following uses:

• Recording the purchase or sale of fixed assets on credit
• Correction of errors in the ledger accounts
• Adjustment of ledger entries
• Writing off of bad debts

POSTING

When all transactions have been entered into the specific journals, they are then entered into their
respective accounts in the ledger in a process referred to as posting. An account is a place where all details
relating to a particular asset, liability or capital, is recorded. There could be an account for motor vehicles,

22
another for buildings, another one for a specific creditor and yet other separate accounts for each debtor
e.t.c.

Accounts can be divided into two:

• Personal accounts
• Impersonal accounts.
Personal accounts are accounts dealing with customers and suppliers i.e. debtors and creditors.
Impersonal accounts on the other hand can further be divided into:

Real account used for recording possessions like land, motor vehicles, buildings, furniture and fittings.

Nominal account used for recording capital, income and expenses.

All accounts are prepared in a „T‟ format and thus generally referred to as T- accounts. The T accounts
have two sides; the debit side on the left and the credit side on the right of the account as shown below.

<Name of the account>

Dr Cr
Date Particulars Folio Amount Date Particulars Folio Amount

Every transaction in a business affects two accounts. One of the accounts is debited while the other is
credited by the same amount giving rise to double entry book keeping i.e. for each entry recorded in the
journals there will be a debit and a credit entry in two separate accounts in the ledger.

A brief example would be when we buy a motor vehicle for cash. Two items will be affected:
• We will have a new asset; known as a car (a motor vehicle)
• On the other hand, the asset cash will have reduced by the amount we pay for the car.

Generally a transaction either increases or decreases an asset, liability or capital. This is reflected in the
accounts as follows:

(i) When we increase an asset we make a debit entry to the asset account
(ii) When we decrease an asset we make a credit entry to that account
(iii) When we increase our liabilities or capital, we make a credit entry
(iv) When we decrease our liability or capital we make a debit entry to that account.

Uses of special journal

23
• They facilitate grouping transactions which are alike together, recording them to provide relevant
transaction details.

• It facilitates easier mechanization of the recording process

• It makes the posting work easier because numerous ledger accounts take the totals.
• They minimize possible errors.

THE LEDGER

N/B - All accounts that do not fall under either the sales or purchases ledger are held
under the general ledger.

The ledger is a book in which various accounts are kept. There are three main types of ledgers:
i. Sales ledger

ii. Purchases ledger

iii. General ledger

(i) SALES LEDGER

After all transactions have been recorded in the sales journal, the next step is to post these transactions using
double-entry book keeping into the various ledgers. The sales ledger is made up of individual accounts of the
debtors i.e. customers who have purchased from us on credit.

To maintain double entry, the sales ledger is posted as follows:

1) For all the customers in the sales journal, debit their individual accounts in the sales ledger.

2) Make the corresponding credit entry in the sales account which is in the general ledger.

To avoid having too many entries in the sales account, we sum up all the individual debtors account and post
the total to the credit side of the sales account in the general ledger. This total should equal to the total as
reported in the sales journal i.e. the first book in which the all the credit sales were initially recorded before
being posted to the ledger accounts. The two totals will however be equal if and only if double entry concept
was adhered to in the posting process.

Recall the sales journal illustrated earlier (Illustration 3). The transaction recorded in this journal can be posted
as follows in the sale ledger:

Macharia a/c
Dr Cr
Date Particulars Folio Amount Date Particulars Folio Amount
01/01/04 Sales 5,000
5/01/04 Sales 3,000

24
 8,000

Akinyi a/c
Dr Cr
Date Particulars Folio Amount Date Particulars Folio Amount
02/01/04 Sales 2,000

2,000

Abdi a/c
Dr Cr

Date Particulars Folio Amount Date Particulars Folio Amount

04/01/04 Sales 2,500

06/01/04 Sales 4,000

6,500

Mutua a/c
Dr Cr
Date Particulars Folio Amount Date Particulars Folio Amount
03/01/04 Sales 1,000

1,000

(ii) PURCHASES LEDGER

After all the transactions have been entered on the purchases journal, the entries are then posted in the purchases
ledger. The purchases ledger is made up of individual creditors‟ account. Every credit purchase made by
customers is recorded on the credit side of their individual account in the purchases ledger. The totals of this
ledger are then posted to the debit side of the purchases account in the general ledger, again to avoid having too
many individual creditors‟ entries in the purchases account. This total should equal the total of the purchases
journal, if the posting process was done correctly.

Recall the purchases journal illustrated earlier( Illustration 1). The transaction recorded in this journal can be
posted as follows in the purchases ledger:

Bamburi a/c
Dr Cr

25
 Date Particulars Folio Amount Date Particulars Folio Amount
01/01/04 Purchases 5,000
04/01/04 Purchases 2,000

7,000

Note : Practice the rest 3.

(iii) GENERAL LEDGER

All other accounts that do not fall under either the sales or purchases ledger are held under the general ledger.
Such accounts would include:

(i) Fixed assets accounts e.g. furniture and fittings account, plant and equipment account

(ii) Expenses accounts e.g. electricity account insurance, expense account e.t.c

(iii) Return inwards account

(iv) Return outwards account

Illustration 4
Entries in the General ledger
XYZ Limited

Purchases Control a/c

Dr Cr
Date Particulars Folio Amount Date Particulars Folio Amount
05/01/04 Credit 23,000
Purchases

23,000

ABC Limited
Sales Control a/c
Dr Cr
Date Particulars Folio Amount Date Particulars Folio Amount
06/01/04 Credit Sales 17,500

17,500

>>> Example 1

Given the following details; enter them in the sales journal, purchases journal, general journal, and then post them
to the relevant ledger accounts.

Year 2006

26
May 2 Credit sales to E. Kamau Sh 12,800

“2 Credit purchases to H Opati Sh 9,600

“4 Credit sales to J Omondi Sh 11,700
“7 Credit sales to N.Kimanzi Sh 20,700
“8 Credit sales to P.Amino Sh. 4,900

“12 credit Credit purchases from M. Kibaki Sh 7,200 “13 Credit

sales to E. Kamau Sh 42,000

“13 Credit Credit purchases from G.Njenga Sh. 9,700 “15 return
Return inwards from J Hadija Sh. 200 “16 return Return
outwards to K Nyongesa Sh.1, 200 “20 credit Credit purchases
from H. Opati Sh. 11,200 “21 credit Credit purchases from E.
Joe Sh 4,900 “23 credit Credit purchases from O. Mbiyu Sh.
4,500 “27 bought Bought motor vehicle cash Sh 20,000 “30
Sales to E Williams Sh. 10,600

CASH BOOK

A cash book is a document or a record of all transactions involving cash in business organization. It keeps
track of all incoming and outgoing cash i.e. cash receipts and payments.

TWO COLUMN CASH BOOK

Usually a business maintains two cash books; cash-in-hand cash book and cash-at-bank cash book. A cash-
in-hand cash book records all transactions relating to cash paid out or received through the cash till. The cash
at bank cash book handles transactions relating to cash that goes through the bank e.g. payments by cheque.
Normally these two cash books are combined to form a two column cash book, the two columns being the
cash and bank column.

A contra entry, for cash book items, is where both the debit and the credit entries are shown in the cash book,
such when cash is paid into bank or withdrawn.

A withdrawal of cash from bank would appear in the cash book as a debit for cash and a credit for bank of
the same amount and vice versa for a deposit. Both the debit and credit entries are in the same book. When
this happens it is known as a contra item. Format of a two column cash book:

ABC Limited

One column cash book

Dr Cr
Date Particulars Folio Amount Date Particulars Folio Amount

27
 Format of a two column cash book:
ABC Limited

Two column cash book

Dr Cr
Date Particulars Folio Cash Bank Date Particulars Folio Cash Bank

>>> Example

Mr. Tamaa started a business on 1st January 2007.during the first month of trading the following
transactions took place.

Wrote a personal cheque and deposited into the business bank account Sh800,000 Withdrew
Sh200, 000 from the bank and put it into the cash till. 2nd Jan, Purchased goods by cheque
Sh70,000

3rd Jan, Bought furniture for cash Sh25,000

3rd Jan, Bought equipment on credit Sh75,000

4th Jan, Sold goods for cash Sh100,000

5th Jan, Bought goods and paid by cheque Sh.200,000 6th Jan,
Bought a motor van paying by cheque Sh.210,000 10th Jan, Obtain
loan from the bank Sh.500,000 12th Jan, Sold goods on credit
Sh75,000

16th Jan, Sold goods payment made by cheque Sh.100,000 16th Jan,
Received a cheque from a debtor Sh.60,000 30th Jan, Took Sh10,000
from the cash till personal use.

Using the given details write up a two column cash book for Mr. Tamaa for the month of January 2007

Sol

Note : try it out

Notes

(i) It is important to note that only transactions involving cash are entered into the cash book. Credit sales and credit
purchases are not entered until the customer pays or the supplier is paid.

(ii) When cash is withdrawn from bank and put in the cash till the entry made to capture this transaction is

referred to as a contra entry. A contra entry affects both sides of the cashbook; the bank column on one side and a
cash column on the other. A contra entry may also arise if cash from the cash till is deposited into the bank
account. It‟s denoted by a „c‟ indicated in the folio column.

28
(iii) When all transactions have been entered into the cash book we then balance it off. Normally the cashbook
will have debit balance in both the cash and bank columns.

However, a bank overdraft will result into a credit balance in the bank column. A bank overdraft is
a facility offered by the bank where the account holder is allowed to withdraw more cash than the
remaining balance in his account.

(iv) The debit side of the cash book generally records cash/bank receipts while the credit side
records cash/bank payments.

THREE COLUMN CASH BOOKS

Sometimes businesses maintain a three column cash book. The additional column is the
discounts column, i.e. discount received on the credit side and the discount allowed on debit side.
Format of a three column cash book:

ABC Limited

Three column cash book

Dr Cr
Date Particulars Folio Cash Disc Bank Dat Particu Folio Cas Discou Bank
ount e lars h nt
Allo Receive
wed d

Example:

Enter the following transactions in a three column cash book.

(i) Balance brought forward cash Sh 4700 bank Sh 17000

(ii) Cash sales Sh 20000 (discount 8%)

(iii) Cash sales Sh 42000

(iv) Cash purchases Sh 18000 (discount 10%)

(v) Sales paid for by cheque of Sh 40000 after deducting a 20% discount

(vi) Paid Sh 50000 by cheque after deducting 20% cash discount.

(vii) Purchases by cheque Sh 12000

Soln :
Required : do the three column cash book

29
Notes

30
(i) It is important to check whether the amounts of sales or purchases are shown as gross or net
of discount.

From (v) above, the amount is shown as net and for the purposes of knowing the
discount, we work backwards so as to ascertain the discount amount as follows:
Net amount = Sh 40,000

Discount allowed = 20%

Therefore the net amount = Gross amount (n) x (100-20) %

n = 40000 = Shs.50000
0.8
Therefore discount allowed = Sh 50,000 – 40,000 = Sh 10,000

(ii) The amounts of both discounts allowed column and discounts received are treated as follows:

Discount allowed

The totals will be posted to the debit side of the discount allowed account in the general ledger.

… Limited

Discount allowed
Dr Cr
Date Particulars Folio Amount Date Particulars Folio Amount
30/04/06 Debtors 11,600 2006

11,600

Discount allowed

The totals of the discounts received column will be posted to the credit side of the discounts
received account in the general ledger

… Limited

Discount Received
Dr Cr
Date Particulars Folio Amount Date Particulars Folio Amount
2006 30/04/06 Sundry 14,300
creditors

14,300
 BANK AND CASH BOOK RECONCILIATION

Fast forward – Differences between the cash and the bank statement arise for three reasons;
errors, usually in the cash book, omissions, such as bank charges not posted in the cash book and
timing differences, such as un-presented cheques.

At the end of a particular period (mostly one month) the balances of the cash book should be extracted
and in many instances, the cash at bank balance in the cash book does not agree with the bank
statement over the same period though theoretically it should. This is a normal occurrence and the two
needs to be reconciled so that any material errors can be identified as early as possible. The causes of
the disagreement may be as a result of:

(i) Items that appear on the cash book but not on the bank statement.

(ii) Items that appear on the bank statement but not on the cashbook

(iii) Errors when entering amounts in the cash book

(v) Errors by the bank while posting transactions

Items that appear on the cash and not on the bank statement

(i) Un-credited amounts (cheques/deposits) This item mainly affects the cheques. Due to the nature of
the cheque clearing process, a firm may deposit a cheque and thus debit the cashbook, but by the time
the bank statement is being prepared, the amounts are not yet available. The cheque could also bounce
and before the bank can communicate to the account holder, the balances in the bank statement and in
the cash book will not tally.

(ii) Un-presented cheques These are the cheques issued to the suppliers by the firm and shown as
payments in the cash book. The suppliers may hold the cheque for a number of days before presenting
it to the bank for payment and thus the bank will not have recorded such a payment in the bank
statement hence will reflect a different balance from that in the cash book.

Items appearing in the bank statement and missing in the cash book

i) Direct Credits: when a customer deposits either cash or a cheque directly into the
business‟ bank account without informing the business.

ii) Bank Charges: when the bank debits (decreases) the account of the business with charges e.g.
cheque book charges, ledger fees, commissions on electronic funds transfer both incoming
and out going e.t.c.

iii) Direct Debits; when the bank pays/ honors a standing order, deducts loan payment from the
account e.t.c

iv) Interest Income; when the bank credits (increases) with the amount of interest earned on
the account.
 v) Dishonored Cheques; when a cheque earlier deposited is dishonored

vi) Interest charges with regard to bank facilities e.g. overdraft, credit card e.t.c.

Errors while entering the amounts in the cashbook would include

 Overstatement/understatement of receipts and payments in the cash book

 Mis-posting of deposits or payments in the cash book.

Bank reconciliation is used to bring the two balances into agreement i.e. the back balance in the cash
book and the bank balance in the bank statement.

The first thing to do while reconciling a bank statement is to update the cashbook. This is done by
entering all the transactions that ought to be in the cashbook but were missing, as well as correct all
errors in the cash book.

Such entries would include

• Bank charges

• Direct credits and debits

• Dishonored cheques

• Overstatement/understatement of receipts in the cashbook

• Over/understatement of payments in the cash book

• Misposting of deposits or payments in the cash book

The second step is to prepare a bank reconciliation statement which expected to make adjustments on the
balance in the bank statement to agree with the new balance obtained from the adjusted cashbook.

The following items will now be shown under the bank reconciliation statement

• Un-presented cheques

• Un-credited deposits

• Errors in the bank statement

• The updated cash book balance

The Format of a bank reconciliation statement

Format 1

<Name of business>

BANK RECONCILIATION STATEMENT AS AT

Sh Sh

Balance as per bank statement xxx

Add;Un-presented cheques xxx
Errors that increase bank balance xxx xxx

Less: Uncredited cheques xxx

Errors on bank statement that reduce bank balance xxx (xxx)

Balance as per bank statement xxx

Note: Errors in the bank statement that reduce bank balance

 Understatement of deposits into the bank account

 Overstatement of payments from the bank account

Errors that increase bank balance

 Overstatement of deposits

 Understatement of payments

> Example:

On 31st December 2006 the cash book of H. Njeri showed a balance at the bank of Sh Sh8, 100. The bank
statement however showed a balance of Sh 6,700. Going through the bank statement she found out that:

(i) A cheque received from Taifa Ltd on 1st December for Sh 600 and entered into the cash
book did not appear on the bank statement

(ii) A cheque paid to E. Kamara Sh 700on 25th December had not been presented

(iii) A cheque received from N Njiru on 24th December Sh 600 and entered into the cash
book was returned dishonored. No entry in this regard was recorded I the cash book

(iv) Bank charges amounting to Sh 100 had not been entered into the cash book

(v) The bank received directly Sh 1000from E.A.B.L as dividends on 18th December on
behalf of H. Njeri

(vi) A cheque payment of Sh 2000 to Olivia had been entered in error Sh200 in the cashbook

Required :

(a) Make the necessary entries to update the cash book

(b) Prepare a bank reconciliation statement for H. Njeri for the month of December 2006
 Example 2:

A trainee accountant working for a sole trader, Juma Mambo Leo had prepared the following

summary of the cash book for the month of March 1999

Cash book Sh Sh
Opening balance b/d 561000 Payments 4,189,000
Receipts 3748000 Closing balance c/d 120,000
4309000 4309000

Whilst checking the cash book against t the bank statement you find the following discrepancies;

(i) Bank charges of Sh 8000 shown in the bank statement have not been entered in the cash book

(ii) The bank has debited a cheque of Sh 37000 in error in the account of Juma Mambo Leo

(iii) Cheques totaling Sh 96000 have not been presented to the bank for payment.

(iv) Dividends received for Sh 4200 have been credited on the bank statement but not yet recorded
on Juma Mambo Leo‟s cash book

(v) There were cheques received of Sh 484000 which were entered in the cash book but not yet
credited by the bank.

(vi) A cheque of Sh 17000 has been returned by the bank marked as „refer to drawer‟ but no entry
relating to this has been made in the books.

(vii) The opening balance in the cash book should have been Sh 651000 and not Sh 561000

(viii) The bank statement shows that there is n overdraft at 31st march 1999 of Sh 198000
Required

(i) State and briefly explain two purposes of a bank reconciliation statement.

(ii) Entries necessary to correct the cash book

(iii) A bank reconciliation statement as at 31st march 1999

THE PETTY CASH BOOK

Fast forward – Most businesses keep petty cash on the premises, which is topped up from the main
account

Majority of business payments are made by cheque. However for some amounts, the cashier need not
write a cheque for each. Examples of such payments includes when a staff member is given some bus fare
from office to town on official duty, when stationery is bought e.g. pens e,t,c. Such transactions involve
fairly small amount s which does not warrant the writing of a cheque. For this reason most businesses
maintain a petty cash usually handled by the petty cashier. The petty cashier is usually given a certain
amount to use in the payments, called a cash float. The petty cashier maintains records of all the expenses
paid out (either by keeping receipts or preparing petty cash vouchers which are signed against). After
some time the petty cashier will request to be reimbursed for all the amounts paid out of the cash float
given to him. This system of reimbursing some amount to the petty cashier after a certain period of time
to maintain the cash float is known as the imprest system.

The format is as shown:

Petty Cash Book

Receipts Date Detail Payments Expenses The

Amount Postage Stationery Traveling Ledger

The balance c/d of the petty cash book will signify the balance of cash in hand or form part of
cash in hand. The totals of the expenses are posted to the debit side of the expense accounts. If a
firm operates another cashbook in addition to the petty cash book, then the totals of the expenses
will also be posted on the credit side of the cash in hand cashbook.

The ledger column is used to record the amount paid by petty cash to a person/ business with
whom we have an account. A good example is when we pay creditors the amount owed using the
petty cash.

The Imprest system

This system of accounting operates on a simple principle that the cashier is refunded the exact
amount spent on the expenses during a particular financial period. At the beginning of each
period, a cash float is agreed upon and the cashier is given this amount to start with. Once the
cashier makes payments for the period he will get a total of all the payments made against which
he will claim a reimbursement of the same amount that will bring back the amount to the cash
float at the beginning of the period.

This is demonstrated as follows:

 £
Start with (float) 1,000
Expenses paid (720)
Balance 280
Reimbursement 720
Cash float 1,000

Example 2.8

A cashier in a firm starts with £2,000 in the month of March (that is the cash float). I n the
following week, the following payments are made:

£
st
1 March – bought stamps for 80
nd
2 March – paid bus fare for 120
nd
2 March – cleaning materials 240
rd
3 March – bought fuel 150
rd
3 March – cleaning wages 300
th
4 March – bought stamps 200
th
4 March – paid L. Thompson (creditor) 400
th
5 March – fuel costs 150
th
On the 5 of March the cashier requested for a refund of the cash spent and this amount was
reimbursed back.

Required:

Prepare a detailed petty cash book showing the balance to be carried forward to the next period
and the relevant expense accounts, as they would appear on the General Ledger.
Answer

Receipts Date Detail Payments Expenses THE

LEDGER
Amount Postage Cleaning Travel
(£) (£) (£) (£) (£) (£)
2000 1/3 Bal b/d
1/3 Stamps 80 80
2/3 Bus Fare 120 120
2/3 Cleaning 240 240
Materials
3/3 Fuel 150 150
3/3 Cleaning wages 300 300
4/3 Stamps 200 200
4/3 L Thompson 400 400
5/3 Fuel 150 . . 150 .
1640 280 540 420 400
1640 5/3
5/3 Bal c/d 2000
3640 3640
2000 6/3 Bal b/d

Illustration
Given the information below write up a petty cash book with the following columns; :
i. Postage and telegram
ii. Stationery
iii. Traveling
iv. Office expenses
v. The ledger
i) January 1 received petty cash Sh 20000
ii) January 1 paid for sugar Sh 700
iii) January 2 bought pencils and pens Sh 800
iv) January 4 bus fare Sh 400
v) January 5 telegram Sh 1500-
vi) January 8envelops Sh 900
vii) January 9paid David (trade creditor) Sh 6000
viii) January 9 coffee Sh 200
ix) January 15 cleaning Sh14000

SOLN
 Chapter Six

INTRODUCTION TO INITIAL ACCOUNTS

So far we have looked at books of original entry. After the initial recording, the transactions are then
entered into individual accounts in the ledger. The accounts are either personal or impersonal.

Personal accounts deal with individuals (debtors and creditors)

Impersonal accounts are either real or nominal. Real accounts record assets (things of value) while
nominal accounts record revenues, expenses and capital.

RECORDING TRANSACTIONS WITH REGARD TO LIABILITIES

When we increase our liabilities it means we have obligations to fulfill in the future. On the other
hand for all these obligations we have an asset to be exchanged for the liability that we take up.
All increase in liabilities:
Dr. Asset account
Cr. Liability account

Illustration (i)
On 3rd June 2004 Ramani stores bought stock on credit from Jitegemea stores. The stock was

worth shsSh200000Sh 200000

Dr. Purchase account 200000

Cr. Jitegemea Stores (creditor) shsSh200000Sh200000 (To

record purchase of stock on credit)
For most businesses expenses, the services are first offered and then paid for later.

Illustration (ii)
Electricity for June 2005 was Sh.40000 it was paid for at a later date.

SOLN:

RECORDING TRANSACTIONS WITH REGARD TO CAPITAL

When the owner injects more capital into the business Dr.
Cash/bank
Cr. Capital account

Sometimes however the capital may not be in the form cash but he may introduce his own asset to be
used in the business. In that case the particular asset account will be debited instead of cash.

Illustration iii

On 1st January 2005 Mr. Makhoha started a business. He decided to make a building which he
previously rented out to be his operating premises. In addition, he deposited Shs1000000 Sh
1000000 into the business‟ bank account. The building was worth Sh 400000.

The entry will be as follows.

Dr. bank Sh 100000
Dr. Building Sh 400000
Cr. Capital SH 1400000

The entries will appear as follows in the specific accounts.

SOLN

RECORDING TRANSACTIONS WITH REGARD TO INCOME

When we make sales the following is possible:

• The customer to pay in cash

• The customer to purchase on credit

Illustration
Lenana store sold goods worth shs Sh 90000 to Batian stores on 25th November 2006

Batian stores immediately paid for the goods worth Sh 20000 a cheque. The transaction will be
recorded as follows:

SOLN

Illustration II

If Batian stores did not pay immediately, the entries made by Lenana stores would have been as
follows.

Dr. Batian stores a/c debtor Sh 90000

Cr. Sales account Sh 90000
On the day that Batian stores will pay, the following g entries will be made.
Dr. Cash/ bank Sh 90000

Cr. Batian stores a/c debtor Sh 90000

SOLN:

BALANCING OFF ACCOUNTS

When balancing off accounts we add up the debit side of each account and compare it with the

sum of the credit side of the same account. The difference is put as the balance carried down

(Balance c/d) on the side that is less such that the two sides now balance.

On the opposite side of the balance c/d and below the balancing totals, the opening balance for

the next accounting period is indicated as balance brought forward (balance b/f)

Example I

Enter the following transactions in a cash account and then balance it off showing clearly the
balances c/d and balances b/f

i) Balance brought forward in the cash till at 2000 1 May 2006

ii) Cash sales of 10000 4 May 2006
iii) Cash received from debtors 2500 11May 2006
iv) Expenses paid 4500 7 May 2006

v) Cash purchases 9700 11May 2006

Cash account
2006 Sh 2006 Sh
1/5 Balance b/f 2000 7/5 Expenses 4500
4/5 Sales 10000 11/5 Purchases 9700
8/5 Debtor 2500 31/5 Balance c/d 300
14500 14500
1/6 Balance b/f 300

When balancing off accounts:

i) The totals should appear on the same line on the credit and the debit side

ii) A single line should be drawn above the totals and a double line below the totals on both the credit and
debit sides.
iii) The balance C/D can be on either side depending on which side has the higher amount.
 However in common practice the following can be deduced concerning the balance b/d of various
accounts:
• All assets have debit balances

• All liabilities Have credit balances

• Capital always has credit balance
• Income accounts have credit balances
• Expenses accounts have debit balances.

A credit balance means that the totals on the credit side as higher than those on the debit side hence the
balancing figure (balance c/d) goes to the debit side. A debit balance occurs when the debit side is higher
than the credit side hence the balancing figure (balance c/d) goes to the credit side.

The purposes of balancing off accounts would be

• Identify how much is outstanding in a particular account. Ee.g. how much credit sales are yet to be paid
for?
• Determine the expenses that have been incurred

• To determine how much the business owes to the suppliers

To identify transactions that may have been omitted for debtors.

In balancing off accounts you will realize that not all accounts have a balance at the end of a particular
period. An example would be when a particular customer purchased goods on credit worth
Shs.400000and later paid the entire amount of Shs400000 before the accounts were balanced off. His
account will have no balance to carry forward to the next period and would not be included in the
balances appearing in the sales ledger.
RECORDING TRANSACTIONS WITH REGARD TO ASSETS
All accounting in the business organization will fall under the defined terms.
Increase in an asset can be due to any of the following:.

i) Buying a new asset either in cash/bank

ii) Revaluing existing assets
iii) Buying a new asset on credit

For all the above entries we make a debit to the assets account and credit to the respective account as
follows.

Cash purchase:

i) Dr. Motor vehicle account Cr.

Cash/bank

ii) Dr. Motor vehicle a/c` (with increase in value) Cr.

revaluation
iii) Dr. Motor vehicle a/c

Cr. Creditor a/c

When we increase an asset, we make a debit entry into the account.
For example; on 7th June 2006, Mr. Matatu bought a motor vehicle for cashssh Sh hs50000. The
following will be the entry

Dr. Assets account (motor vehicle) 50000

Cr. Cash at bank account 50000
When we decrease an asset, we make a credit entry into the account.

Decrease in an asset can be as a result of of:

• Selling an existing asset for cash
• Selling an existing asset on credit
• Revaluation of an asset below its net book value
• Writing off an existing asset for no value.

The transaction is recorded as follows:

Selling an existing asset on cash:
Dr. Cash/bank account (with cash received)
Cr. Asset account

Selling an existing asset on credit:

Dr. Debtor account (with the sales value)
Cr. Asset account

Revaluation of existing assets:

Dr. Asset revaluation account
Cr. Asset account

Sometimes the current assets may be disposed at a value higher than their book value. This results into a
gain on disposal. The same asset can be disposed at a lower value than its book value resulting to a loss on
disposal.

In this case transactions are recorded as follows:

Gain on disposal:
Dr. Cash/ bank/ debtor account (selling price of the asset)
Cr. Asset account (with the book value of the asset)

Cr. Gain on disposal account (with the amount of the selling price above the
book value)
Loss on disposal:
Dr. Cash /bank/ debtor account (with the selling price of the asset)

Dr. Loss on disposal account (with the amount of selling price below the book value)
Cr. Asset account (with the book value of the asset)

>>> Illustration 1
Doe Co. LTD sold on e of the existing machinery for Sh 200000. The machinery was received in cash.
The entry will be as follows:

Dr. cash 200000

Cr. Machinery 200000
 Machinery a/c
Sh Sh
27/5 /5 Cash 200000

Cash a/c

Sh Sh
27/5 Machinery 200,000
 Chapter Seven

EXTRACTION OF THE TRIAL BALANCE

At the end of a given period, all the accounts are balanced off and the balances brought forward are
then extracted and used to prepare what is known as a trial balance.

A trial balance can be defined as a list of account tittles and their balances in the ledger on a specific
date shown in debit and credit columns.

If the double entry in the respective was done correctly then the trial balance should balancei.e. the
debit and the credit balances should equal.

However strange, as it may seem, a balanced trial balance is no guarantee that posting was done
correctly since there are some errors that could pass unnoticed and the trial balance still balances.
These will be discussed later on this chapter.

trial balance should have the exact date in which it was extracted. This is because, a trial balance is a
“snap-shot” of a particular day and any other day would have a trial balance with totally different
figures.

>>> Illustration

Record the following transaction s for the month of November for M.S Suppliers. Balance off all

the accounts and extract a trial balance as at 30th November

2006 Year 2006

November 1 Started Started business with Sh.175000 in cash

November 2 Put Put Sh140000 of the cash into the bank
account November 3 Bought goods for cash worth Sh.7500

November 4 Bought Bought stationery on credit Sh.17000 from Nzomo

November 5 Bought goods on credit from Isaac Sh 18000, Philips Sh.24500, Timothy Sh.5500 Mathew
Sh17000

November 6 Paid rent by cheque Sh.2750

November 7 Sold goods on credit to Njeri Sh 4500, Onyango Sh7500 Muiru Sh 9500
Tinga Sh 8000

November 8 Bought Bought furniture from Irungu Suppliers on credit Sh 24000

November 12 Paid Paid salaries and wages Sh 6000 cash

November 14 Returned goods to Timothy Sh 3000, Philip Sh 2000

November 15 bought Bought an old motor van by cheque Sh 35000

November 16 received Received loan from Henry by cheque Sh 30000

November 17 Goods returned to us by Njeri Sh1000 Sh1000 Muiru Sh 2000

November 18 Cash sales Sh 450

November 21 Sold goods on credit to Pauline Sh5750, Onyango Sh 50100 Tinga Sh

4500 November 24 We paid the following by cheque Philips Sh 2250 Timothy Sh2500
November 25 Received a cheque from Pauline Sh 5750, onyango Sh 12500 November
28 Received a further loan from Henry Sh 10000 cash November 30 Received Sh 25000
Received Sh 25000 from Tinga in cash.

Solution
Cash a/c

2006 Sh 2006 Sh
1/11 Capital 175000 2/11 bank 140000
18/11 Sales 4500 3/11 Purchases 7500
28/11 Henry 10000 12/11 Salaries and wages 6000
30/11 Tinga 25000 30/11 Balance c/d 61000
214500 214500
1/12/ Balance b/d 61000

Capital a/c
2006 Sh 2006 Sh
30/11 Balance c/d 175000 1/11 Cash 175000
1/12 Balance b/d 175000
 Bank a/c
2006 Sh 2006 Sh
2/11 Cash 140000 6/11 Rent 2750
16/11 Loan Henry 30000 15/11 Motor van 35000
25/11 Pauline 5750 24/11 Philips 22500
5/11 Onyango 12500 24/11 Timothy 2500
30/11 Balance c/d 125500
188250 188250
30/11 Balance b/d 125500
M.S SUPPLIES
TRIAL BALANCE AS AT 30TH NOVEMBER 2006
Dr. Cr.
Cash 61000
Bank 125500
Capital 175000
Sales returns 3000
Purchases 72500
Sales 61750
Purchases returns 5000
Furniture 24000
Motor van 35000
Rent 2750
Salaries and wages 6000
Henry loan account 40000
Stationery account 3500
Njeri(SL) 8500
Tinga (SL) -
Muiru (SL) 7500
Nzomo (PL) 8500
Isaac (PL) 18000
Mathew(PL) 17000
Irungu(PL) 24000
349250 349250
ERRORS NOT AFFECTING THE TRIAL BALANCE

If double entry is followed when recording all transactions into the books of accounts, then the trial
balance would balance. However there are some errors that would occur while entering the
transactions but this would not affect the balancing of the trial balance.

The following are the errors that do not affect the balancing of the trial balance

(i) Errors of Omission

This is an error that occurs when a transaction is completely omitted from the books of accounts.

For example if we bought a motor van shs Sh 90000 cash and we neither debit the motor vehicle account
nor credit the cash account the trial balance would not be affected and it would still balance.

(ii) Errors of Principle

This occurs when we enter a transaction in the wrong class of account, but still observe double entry. For
example we purchase furniture (fixed asset) worth shs Sh 200000 for cash. We debit purchases account
instead of debiting the furniture account and crediting the cash account. In such an instance the trial
balance would still balance.

iii) Errors of Commission

These types of errors occur when the correct amount is entered but in the wrong persns personalaccount
though the account is in the same class of accounts. For example sales of shs Sh 20000 sold to D. Waithaka but
posted to P. Waithaka‟s account in the sales ledger. The transaction would be as follows.
Dr. P. Waithaka 20000
Cr. Sales 20000

The correct entry would have been

Dr. D Waithaka 20000
Cr sales 20000

Dr. D. Waithaka 20000

CR. D Waithaka 20000

This is just a reversing transaction that transfers the amount from P. Waithaka to the correct account of D
Waithaka. You will note that the sales entry is no affected by the reversal and since both P. Waithaka
and D. Waithaka are in the sales ledger, the trial balance would still balance.
iv) Compensating Errors

These are errors that cancel out each other e.g. an error that overstates booth the credits and the debits or
an error that understates both the debits and the credits by the same amount. E.g. If the purchases returns
was overstated by shsSh2000 2000 and the sales return overstated by Sh 2000. Since the purchases
returns appear on the credit side and the sales returns appear on the debit side of the trial balance, the
two would cancel out each other.

To correct the above error

Dr. Purchases returns Sh 2000
Cr. Sales returns Sh 2000

Another example would be overstating purchases as well as sales by the same amount; overstating both
sides of a particular account by the same amount e.t.c.

v) Errors of Original Entry

These are errors that occur when the original figure is incorrect and yet double entry is still
observed using the incorrect figure. The figure cold either could either be understated or overstated.

Example

Purchases worth shs20000 Sh 20000 recorded as Sh 200000 in both the purchase account and the
cash account.

The incorrect entry would appear as follows

Dr. Purchases 200000

Cr. Cash/ bank 200000

The correct entry should have been

Dr. Purchases account 20000

CR. Cash/bank 20000

To correct the error, we make the following entries.

Dr. Cash at bank Sh 180000

Cr.Purchase Sh180000
vi) Complete Reversal of Entries

This is an error that occurs when the correct amount is posted in the correct account but in the wrong side
of the account. For Example: if we sold goods on credit to D. Kameme worth shs 100000 the wrong
entry would appear as follows.

Dr. Sales 100000

Cr. P. Kameme 100000

The correct entry would have been

Dr P Kameme 200000
Cr. Sales 200000
Correcting the above error is done in two stages:
• Canceling the initial recording
• Recording the correct entry.
This is done as follows:
Dr P. Kameme 100000
Cr. Sales 100000
(To cancel the initial entry in the accounts)

Dr. P Kameme Sh 100000

Cr. Sales 100000
(To Record the correct entry)

Vi) Transposition errors

This is a special type of an error of original entry. It occurs when the wrong sequence of individual
characters in a figure is entered. Example For example entering, entering shsS870 h 870 as Shs 780. It is
an error that is very difficult to trace, however if it occurs only on one side of the entry then the difference
will be a number divisible by nine and hence easier to trace.

>>> Illustration

Cash sales Sh 9260 entered as Sh 6290 on both cash book and sales ledger

The wrong entry would appear as follows.

Dr. Cash Sh 6290

Cr. Sales Sh 6290
The correct entry would have been

Dr. Cash Sh 9260

Cr. Sales Sh 9260

To correct the above entry

Dr. Cash (9260 - 6290) Sh 2970

Cr. Sales (9260 - 6290) Sh 2970

Chapter Eight

PREPARATION OF FINANCIAL STATEMENTS

FORMAT OF THE STATEMENT OF COMPREHENSIVE INCOME

A statement of comprehensive income basically represents the performance of a business. It is

the sales (revenue) for the business less all the expenses incurred to generate the sales. The end
product is ether profit or loss.

A statement of comprehensive income can be prepared in two formats; the vertical or horizontal
format. The horizontal format is however the most common one.
Notes

(i) Carriage inwards forms part of the cost of sales. It represents the amount paid for the
transportation of goods into the business premises before they are sold.

(ii) Carriage outwards is a business expense. It represents the amount paid to transport

goods to the customer‟s premises.

(iii) All costs incurred to put the goods into saleable condition form part of the cost of sales

e.g. cost of transportation to the warehouse, insurance while goods are on transit to the
warehouse, warehouse expenses.

(iv) Incase the net sales are less than cost of sales the difference is referred to as gross loss.
(v) If the expenses are more than the gross profit the difference is referred to as net loss

(vi) Other incomes represent that portion of revenues not directly related to the main business
e.g. commissions, rent receivable e.tc

Illustration 1

Given the following trial balance for BCD Ltd draw up a statement of comprehensive
income BCD Ltd for the year ended 31 December 2007

Sh Sh
Sales 205,500
Purchases 129,000
Opening stock 16,000
Rent 42,000
Lighting expenses 8,000
General expenses 17,000
Fixture and fittings 4,800
Debtors 148,000
Creditors 37,000
Bank 14,300
Cash 2,800
Drawings 14,000
Capital 128,000
Commissions 24,000
Returns inwards 4,600
Return outwards 6,000
400,500 400,500
The closing stock as at 31st march 2007 was Sh 9000

Soln:

ACCOUNTS ADJUSTMENTS

Before preparing a statement of comprehensive income for a particular period, there are
adjustments that are made to particular accounts to ensure the profit and loss statement shows
accurate results of profits and losses. These accounts include:

i) Prepayments accounts
ii) Accruals accounts
iii) Bad and doubtful debts accounts
iv) Depreciation account
v) Discounts allowed accounts
vi) Discounts received accounts
vii) Commissions received accounts
viii) Commissions paid account
PREPAYMENTS AND ACCRUAL ACCOUNTS
(I) PREPAYMENTS ACCOUNTS
These could either be prepaid incomes or prepaid expenses.

Prepaid expenses

For some businesses expenses may tend to be prepaid in nature. An example would be insurance
premiums or, rent and rates. This are usually paid for one year upfront. However the period for
which the expenses relate may not match with the accounting year. Take for instance a business
that commences operations on 1st January 2006. Beginning 1st April 2006 they pay for
insurance for one year. The premiums would thus cover the period 1st April2006 to 31st
march2007. On the other hand the business accounting period would cover from 1st January
2006 to 31st December 2006. Therefore by the end of the accounting period, premiums with
respect to three months would not have been expensed, yet they have already been paid for. This
is what results to a prepayment which is an asset to the business at the end of the accounting
period.

Example:

Jumba Agro vet started business on 1st January 2005. On 1st May 2006 they acquired a go
down next to BOC Gas Suppliers. They immediately insured it against fire paying insurance
premiums Sh1200000 to cover the go down for the next one year. Show the entries as they
would appear in the accounts on 31st December2006.
The prepaid amount shown in the prepaid insurance account represents an asset that will be

under the current assets in the balance sheet. It represents the amount of money (current asset)

that could still be lying in the bank had the company opted to pay for 8 months only to the close

of the year i.e. May – December

(i) prepaid income

Prepaid income on the other hand represents income already received yet the services or the

goods have not been delivered e.g. for a business dealing in renting out houses and they receive

rent for consequent periods then a certain portion of this rent at the end of the accounting period

will relate to the next accounting period. Such incomes received in advance form a liability to the

business since they remain indebted to deliver the service already paid for. It appears as under

the current liabilities section of the balance sheet.

Example

On 1st April 2006 Josmumo enterprise received rent for 12 months amounting to Sh 144000 for
a part of a building they had rented out since it was not being used. The rent money received
covered the period beginning 1st April 2006 and ending 31st March 2007. Show this
transaction in the books of Josmumo as at 31st December 2006 i.e. of financial year

Solution:
On receiving cash
Dr. Cash/Bank Sh 144000
Cr. Rent income Sh 144000
At close of accounting period
Dr. rent income a/c 36000
Cr. Rent received in advance a/c 36000
The balance in the rent received in advance account is posted in the statement of financial

position as a short-term liability. This is simply because the money for the period 30th March has

been paid yet the services have not been delivered. This is in line with the revenue recognition

principle. The balance of Sh 36000would thereby be in the incoming years of income

In the subsequent accounting period:

Dr. Rent received I advance a/c
Cr. Rent receivable
(income) account

II) ACCRUAL ACCOUNTS

Accrual accounts affect both the incomes and expenses.

Accrued expenses

Accrued expenses represent that portion of expenses that has been used but has not been paid for.

It is common for established businesses to consume services first and pay for them later, say

after 30 days e.g. motor vehicle repairs. On the other hand there are expenses that cannot be

determined in advance until they have been consumed e.g. electricity telephone e.t.c. A common

occurrence with such accounts is that by the time the final statements are being prepared, a

portion of the expenses will not have been paid most likely because the bills have not been

received. These expenses need to be recognized in the period in which they were incurred.

This will be in line with the matching concept which states that expenses should matched with

income.

Illustration

JKT Enterprises prepares its financial statements for periods ending 31st December. On 31 st
December 2005 a bill for electricity amounting to Sh 27000 had been received by the
accountant. Other bills received for the period amounted to Sh 210000. These had been paid for
as at 31st December 2005.

Required:
Show the necessary entries with regard to electricity:
i) Dr. Electricity expense a/c 210000
Cr. Cash/ bank 210000
(To record electricity expense for the year paid for)

ii) Dr. Electricity expense 27000

Cr. Accrued electricity for the period

27000 (To record accrued electricity expense for the period.)

You will note that there are two debits to the electricity expense account. This represents the
total of electricity expense incurred in the year. The entries will appear as follows in their
respective accounts:
The total of Sh 237,000 will be taken to the expenses account in the statement of comprehensive
income

The balance b/d in the accrued expenses account is taken as a current liability to the balance
sheet. Once the payment is made in the following period

Dr. accrued expenses a/c 27000

Cr. Cash/ bank 27000
Accrued income

It is usual phenomenon for business enterprises to sell goods on credit. This would then mean
that at the close of the financial period, there are some amounts yet to be cleared by the
customer.

For the main line of business this income is captured in the books of original entry i.e. general
ledger sales ledger. Therefore revenue owing for direct sales is already in the books (in the sales
account in the general ledger and the debtors account in the sales ledger) and no further entries
are needed.

However, there may be other types of revenues for the business all of which have not been
received at the end of the financial period. Such would include rent and commission receivable
e.t.c. Since they do not form major part of the sales they are usually not systematically recorded
as the other business sales. There is need therefore at the end of the period to recognize them.

>>> Example

Due to empty spaces in the warehouse XYZ Ltd Decided to sublet it at a monthly fee of
Sh20000. The payments were supposed to be made at the end of every month on 31st December
when XYZ was preparing its financial statements. The rent for December was still outstanding.
Adjust for it in the books.

Rent income A/c

2006 Sh 2006 Sh
bank 220000
Rent receivable 20000

Bank A/c

2006 Sh 2006 Sh
Rent received 20000

Rent receivable A/c

2006 Sh 2006 Sh
Rent 20000

DISCOUNT ALLOWED

Represent an amount allowed to a customer on his sales amount usually given as an incentive for
bulk purchasing or for prompt payment.
Discount given to encourage bulk purchasing are referred to as trade discounts. Usually they do
not feature in the books of account since the invoiced amount is usually net of such discount
and the invoice itself is the source document for sales.

The discount given to encourage prompt payment is referred to as the cash discount. After a
credit purchase the customer is offered a discount at a certain rate if he /she pays within given

period e.g. a 2% discount if payment is made 10 days from the invoice date otherwise the
credit period may be 30days.
Such terms will be indicated as 2/10 net 30
The sale is recorded at the invoice value and if the customer qualifies for the discount it is recognized in
such a way as to reduce the customer‟s account by the amount of the discount.

Discount allowed is deducted from the sales to get a net figure of sales in the trading account.
The conventional way of treating discounts in the P& L is to view them as finance charges. This
then makes discount allowed fall under operating expense and discount received as income. The
entries for discount allowed as follows:
Dr. Discount allowed

Cr. Debtors account

>>> Illustration

Mr. Jomens bought goods from us worth Sh100000. The terms were 5/15 net 30 days. Seven

days later he settled his account fully. Show the following entries in the ledger accounts.

Solution:
The terms 5/15 net 30 days will be interpreted as follows:

Jomenes qualifies for a 5% cash discount if he pays within 15 days. The maximum credit period
is 30 days.

The discount then would be

5/100 x 100000 = Sh 5000 if he pays within 15 days

Since he paid d within 7 days he qualifies for the cash discount.

The entries for the discount allowed would be as follows:
Dr, discounts allowed a/c 5000
Cr. Jomenes a/c 5000

If he paid on the 16th day he would have to settle the whole amounted Sh 100000 and would not
qualify for the discount.

The journal entries for the transaction as a whole would be:

Dr. Jomenes account Sh 100000
Cr. Sales account Sh 100000
When he pays on the 7th day:
Dr. cash/Bank Sh 95000
Cr. Discounts allowed 5000
Cr. Jomenes account 100000
The ledger account would appear as follows.

Note: Prepare ledger accounts

The balance in the discount allowed account is transferred to the statement of comprehensive
income as an expense.
Discounts received

The discount received represents cash discount received by a business when it pays its suppliers

for the amounts outstanding. They are given as incentive to encourage prompt payment of the

amounts owing to the suppliers. It is important to note that discount received do not represent a

Decrease in the purchase price of goods but rather as an income to the business. This is the most

conventional way of treating discount received. Some scholars however argue that discounts

received and allowed are a reduction to the purchase price and the selling price respectively.

The entries in the books of accounts are as follows:

Dr. Creditor accounts

Cr. Discounts received

>>> Illustration

Mabati enterprises ole Mlango suppliers Sh200000. it pays on time to qualify for a 10% cash

discount. Show how the entries would appear in the books of Mabati enterprises.

Soln

Show entries and ledgers

The balance in the discounts received account is taken to the statement of comprehensive
income as an income under other incomes.

PROVISION FOR BAD AND DOUBTFUL DEBTS

A large portion of sales for most of the business organizations are made on credit. The business
thus undertakes the risk that some of the sales may not end up being paid. Indeed some of the
sales are not paid for and such are referred to as bad debts.

They are a common business expense as long as credit sales exist. Usually they occur in the
following situations:

(i) Bankruptcy of a business enterprise

(ii) Debtor refusing to pay a particular invoice
(iii) Debtor refusing to pay part of the invoice.
(iv) After they have been outstanding for a long period of time as learnt from experience.
When it occurs a bad debt is treated as follows:
Dr. bad debts expense (to recognize an expense)

Cr. Debtors account (to clear the asset; debtor)

PROVISION FOR BAD DEBT

When it is certain that some amounts will not be collected, it is prudent to clear the debt from the
books and charge as an expense in the P& L account. However it‟s hard to tell before hand that a
certain debt will not be paid. For this reason most business make an estimation of the amount of
debts that will not be paid in a given accounting period, and charge it as an expense in the
statement of comprehensive income of that accounting period This amount will usually be very
subjective sometimes based only on past experiences which might not necessarily recur in future.
The amount set aside to cater for future debts that might never be paid for in future is referred to
as the provision for bad debts. It‟s also known as provision for doubtful debts.

Provision for bad debts should be recognized while preparing the financial statements. It serves
two main purposes:

(i) To match expenses and revenues by recognizing the part of a debt that will never be paid for
(ii) To recognize a figure of debtors that is close to the realizable amount of debtors as possible.

Decrease in provisions

As indicated earlier, the provision for bad debts is a very subjective estimate. As such it‟s prone
to constant adjustments due changing circumstances under which it is made. For example:

Assume from the books of Mali Raha Stores the total amount of debtors for the previous period
was Sh 400000. Assume further that Mali Raha had estimated that out of this amount 50000 i.e.
(12.5%of the debtor‟s balance) would not be bad debt. However after a careful consideration
they discover that this figure was overestimated. It‟s agreed that a figure 10% of the balance of
debtors is what should be maintained as provision for bad debts. In the current period the balance
of debtors is Sh 450000.

The entries as they would appear in the books. Maintain a rate of 10% for provision of bad
debts would be:

Provision for bad debts = 450000x 10/100 = Sh 45000

This would be the amount of the provision for the year. However in the previous year, Sh 50000
had already been provided for. Therefore instead of increase in the provision this time w reduce
it to Sh45000 as this is the balance that should appear in the closing balance of the provision
account.

The reduction in provision for is treated as income in under “other incomes” in the statement of
comprehensive income

The entries would be:

Dr. Provision for doubtful debts (50000 - 45000) 5000

Cr. Profit & loss account/statement of comprehensive income. 5000

To record reduction in provision for doubtful debts.

The accounts would appear as follows:

 Provision for bad debts account
Sh Sh
Statement of comprehensive 5000 Balance b/d 50000
Income 45000
50000 50000
Extract of the Statement of comprehensive income for the current period
Sales xxx
Less: cost of sales (xx)
Gross profit xxx

Other incomes:
Reduction in provision for depreciation 5000

Less
Expenses (xxx)

Net profit xxx

In the balance sheet, the balance of debtors should be net of provision of doubtful debts
carried forward.

For the example earlier given:

Statement of financial position Extract As At ending date of the current period

Non current assets xxx
Current assets:
Debtors 450000
Less Provision for bad debts (45000)

(ii) During the following accounting period the statement of financial position would be as
follows (assume the case of increase in provision).

Increase in provision for bad debts

A company may find it necessary to increase the amount asset aside for bad debts to a figure
higher than that provided for in the previous period. In such a case the amount by which the
provision is increased is treated as an expense in the statement of comprehensive income for the
period in which the increase is made.

The accounting entries would be:

Dr. Expense (an expense account in the P&L)

Cr. Provision for bad debts

From the example of Mali Raha Store above, if the provision for bad debts was to be increased from
50000 for the previous period to 55000 for the current period the increase of 5000 would be

Dr. P&L account 5000

Cr. Provision for bad debts account 5000.

(To record the increase in the provision for bad debts by 5000)
 Provision for bad debts a/c

Sh Sh
Balance c/d 55000 Balance b/d 50000
Profit and loss a/c 5000
55000 55000
Extract of the Statement of comprehensive income for the current period
Sales xxx

Less: cost of sales (xx)

Gross profit xxx

Less expense:
Increase in provision for bad debts (5000)

Net profit xxx

The balance of debtors in the statement of financial position would now be reported net of 55000
i.e. the new provision for bad debts. This is as shown in the following statement of financial
position extract:

Statement of financial position Extract As At ending date of the current period

Non current assets xxx
Current assets:
Debtors 450000
Less Provision for bad debts (55000)

Points to note

(i) The statement of financial position figure for debtors is given as:

Gross figure less provision C/F or

Gross figure less doubtful debts as a percentage of debtors.

(ii) The figure of provision of bad debts in the P&L should be balance of doubtful debts carried forward
less provision provided for in the previous year. i.e. the increase or Decrease in the provision .

(iii) Incase during the year there were some bad debts written-off then the provision for bad debts should
be provided for after deducting such bad debts.

(iv) In cases of examination questions, if bad debts appear on the trial balance then the figure of debtors in

the statement of financial position is net of such debts and should not be adjusted further. This is so
because of the rule of double entry. For bad debts to appear in the trial balance the entries that have been
passed are as follows:

Dr. bad debts a/c xxx

Cr. Debtors a/c xxxx

If however the bad debts appear in the additional information, then the following entries need to be
passed in the books to adjust the debtors figure:
 Dr. bad debts

Cr. Debtors

After these the provision for bad debts is adjusted as usual.

 DEPRECIATION

Fast forward - There are two major methods of charging depreciation:

• straight line method
• reducing balance method

Depreciation can be defined as that part of the original cost of fixed assets that are consumed
during its period of use in the business.

Depreciation can also be defined as the loss in the value due to of usage of an asset. Almost all
business assets have a given time duration for their existence and as they are used/ consumed
their value keeps on Declining.

CAUSES OF DEPRECIATION

Depreciation caused by the factors discussed below;

i) Physical deterioration
ii) Economic factors
iii) Time
iv) Depletion

i) Physical deterioration

Almost all assets are affected by wear and tear. Example motor vehicle, furniture used in the
office, e.t.c.

ii) Economic factors

These are factors that are not related to the physical condition of an asset but are largely due to
economic conditions e.g.

a) Obsolescence: this is when an asset becomes out of date. For example, the typewriters are fast
becoming obsolete and being replaced with computers. Thus even if it were new, it would be
overtaken by events. Technological advancements are the largest contributors to the
obsolescence.

b) Inadequacy: this happens when an asset can no longer be used mainly due to growth of size
of a business. For example a start up business in the transportation industry is using a small pick-
up and as it grows it may find large tracks more economical and convenient.

iii) Time

Time is also a key contributor to depreciation in the sense that even if an asset was left unused;
its value would fall considerably with passage of time.

iv) Depletion
This is the case of exhaustion of natural resources with time. As extraction of such assets
continues they become of lesser value e.g. mines oil fields, quarries, e.t.c

DEPRECIATION AS AN EXPENSE

Depreciation is an operating expense in the business that reflects the loss in value of an asset
during a given accounting period. Depreciation is recognized in line with such concepts as
matching concept whereby we match revenues of a particular period with the expenses incurred
in the same period.
Methods of charging depreciation
There are two major methods of charging depreciation;

i) Straight line method ii) Reducing balance method

Other methods are:

• Revaluation method
• Depletion unit method
• Machine hours method
• Sum of years digit method

Depreciation is arrived at by simply taking the total cost of the assets less any amounts received
during its disposal. The resulting figure ids known as the residue value.

The depreciation will be the difference between the cost and the amount received. The problem
arises when an asset is used for more than one accounting period. We therefore can only estimate
how much to allocate to each accounting period. The methods used are:

Straight line method

This method assumes that an asset is depreciated uniformly over its useful life.

Useful life in this case is taken in form of years.

Depreciation is calculated as follows:

Depreciation = Cost estimated disposal value (residue value)
number of expected years of usage

The depreciation could also be calculated as a percentage of total cost. The percentage is
calculated as follows.

1x 100
No. of expected years of usage

For example if the number of useful years is five years, we can calculate the percentage of
depreciation each year as

1 x 100 = 20%
5
Therefore each year our calculation would be as follows:
(Cost-estimated residue value) x 20%

Example 1

X ltd bought furniture worth Sh 200000. The furniture was expected to last 8 years and would be
disposed off for Sh 40000 at the end of the eighth year. Show how depreciation to be allocated
in each of the accounting period for the 8 years using the straight line method of depreciation.
Depreciation = 200000 - 40000 = Sh 20000

8
Each year the depreciation charge would be Sh 20,000

If an asset is estimated not to have any residue value at the end of its life time,
depreciation equals to the total cost of the asset divided by its life time.
Example 2
If the furniture in example 1 had a nil residue value, depreciation allocated each year would be:

Depreciation = 200000 - 0 = Sh 25000

8

Reducing balance method

In this method, the depreciation is charged at a fixed percentage over the remaining cost of an
asset. It‟s a method conveniently for assets that are assumed to have a higher depreciation rate
over their first few years of use. More so, advocates of this method argue that the cost of running
an asset is not depreciation only but also costs to do with maintenance and repairs.

They argue that during the first year, costs of repairs and maintenance will be minimal and hence
charge minimal depreciation during the first years to match the low repairs and maintenance
cost. During later years, depreciation charge will be minimal whereas repairs and maintenance
will have increased significantly. This will therefore tend to give a uniform cost of running an
asset. However this is not always the case.

Example 3

An equipment is bought for Sh300000 and depreciation is to be charged at 25% on the reducing
balance method show the calculation of depreciation charge for the first years of use. 1st year
300000 x 25% = 75000

2nd year (300000 - 75000)*25% = 56250

3rd year (225000 - 56250)*25% = 42187.5

You will realize that:

During the first year depreciation was higher then becoming smaller and smaller as the years
go by.

To obtain the percentage for reducing balance we use the following formulae:

r=1-n s

Where:
r Is the rate of depreciation to be applied

n is the number of useful life

s is the net residue value (this must be a significant figure or else the answer will be
absurd) c s the cost of the asset
Machine-hour method

Under this method, the asset is depreciated on the basis of the number of hours operated during
a specific accounting period. Compared to the number of hours expected to run during its life
time.

>>> Example 4

XYZ Co. Ltd bought a machine for Sh 120000. The machine is expected to run for Sh 20000
during its life time and have a scrap value (residue value) of Sh 20000. During its first year of
operation it was run for 5000 hours. Calculate the depreciation charge for that year.
Total during the accounting period will be
Charge per hour X no of hours
=5 X 5000
=Sh 25000

Sum of all years digit method

Under this method, a higher amount of depreciation is charged during the initial year of service
and a lower amount as the asset becomes old. The depreciation charge is calculated by taking
the sum of years the asset is expected to last and then comparing it with the number of years
the asset is expected to last during an accounting period as follows. For an asset expected to
last 3 years it will be:

1st year expected to last 3 years

2nd year expected to last 2 years
3rd year expected to last 1 year
Sum 6 years

During the year : no. of years expected to last as at this year X depreciable
amount No. of sum of all years expected to last

: 3 x depreciable amount
6
>>> Illustration

Calculate the depreciation amount per year for a machine costing

Sh225000 And expected to last for five years with no residue value
Depreciable amount = cost – residue value

=225000- 0
=225000

Sum of years 1st = 5yrs

2nd = 4yrs

3rd = 3yrs
4th = 2yrs
5th = 1yrs
Sum 5yrs

1st = 5 x 225000 = 75000

15

2nd = 4 x 225000 = 60000

15

3rd = 3 x 225000 = 45000

15

4th = 2 x 225000 = 30000

15

5th = 1 x 225000 = 15000

15

225000

Depletion unit method

This is a method mainly used in the extraction of minerals e.g. quarry, oil fields e.t.c.
Depreciation is calculated as:

Cost of the asset x no. of units taken in the period expected

total content in units

Illustration

An oil field is acquired for $1000000 and expected to produce 100000 litres of crude oil .during
the first year a total of 20000 litres were extracted. Calculate the depreciation charge during the
year using the depletion unit method.
Depreciation = $1000000 x 20000 = $200000
10000

Units of output method

Under this method, depreciation is measured in terms of expected output of an asset during
its lifetime compared to the output during a particular accounting period.

Depreciation = No. of units during a particular period x depreciable amount

total no. of units expected during life time

> Illustration
A machine is expected to produce 100,000 toys. During a particular accounting
Period ended 31st December 2007, a total of 10000 units were produced. The machine had cost
Sh180000 and was expected to have a salvage value of Sh 30000
Calculate depreciation as at 31st December 2007

10,000 x (180,000 30,000) = 15,000

100,000

Revaluation method

This is a method used to calculate depreciation on small parts of equipment and tools in an
organization. An organization will find it appropriate to group the tools together and have a
single figure and then revalue them at the end of the accounting period. For example, in the
construction industry, one would group together screw drivers, hammers mattocks, spades and
all other small equipments and then revalue after a certain period of time to arrive at the
depreciation during a specific accounting period.

Depreciation will be
Cost/valuation as at the beginning of the year xxx

Add
Purchases during the year xxx
Less
(xxx)
Valuation as at the end of the xxxx
year Depreciation for the year

ACCOUNTING FOR DEPRECIATION