(Source: Short , Daniel G & Glen A.

WELSCH (1990)(1)Fundamentals of financial accounting

Boston.Richard D Irwin ,Invc.)

Accounting defined.

Accounting can be defined as the collection and processing (analysis, measurement, and
recording) of financial data about an organization and the reporting of that information to
decision makers. An accounting system processes data concerning the (a)flows of resources into
and out of an organization,(b) resources controlled (i.e. assets) by the organization , and (c)
claims against those resources .The flow of accounting information is summarized in figure
1.Notice that the end product of an accounting system are financial statements that are prepared
for decision makers.

Figure 1: Flow of Economic Information in an Accounting System

DIAGRAM

Financial statements are prepared primarily for investors and creditors and those that advise
investors and creditors. Financial statements are prepared under the assumption of reasonably
sophisticated and diligent users.

Economics has a special relationship with accounting. Economics is the study of how people and
society choose to employ scarce productive resources that could have alternative users to
produce various commodities and distribute them for consumption, now or in the future, among
various persons and groups in society.

Like economics, accounting has a conceptual foundation that provides guidelines for the
collection, measurement and communication of financial information about an organization. In
general, accounting reports how an entity has allocated its scarce resources. Thus, accounting
collects, measures, interprets and reports financial information on the same activities that are the
focus of economics. Economics explains economic relationships on a conceptual level, whereas
accounting reports the economic relationships on a practical level. However, accounting
measurements are as consistent with economic concepts as is possible. Accounting must cope

1
with the complex and practical problems of measuring in monetary terms the economic effects of
exchange transactions (i.e. resource inflows and outflows). These effects relate to the resources
held and the claims against the resource of an entity.

Accounting operates in a complex environment. The environment in which accounting operates

is affected by such forces as the type of; (a) government (for example, democracy versus
communism, (b) economic system (for instance, free enterprise versus socialism), (c) industry
(for example, technological versus agrarian), (d) organizations within that society (for instance,
labour unions, and regulatory controls (i.e. private sector versus governmental). Accounting is
influenced significantly by the educational level and economic development of the society.

Fundamental to a dynamic and successful society is the ability of each organization to measure
and report its accomplishments to undergo critical self analysis and through sound decisions, to
strengthen itself and grow .Essentially ,society and the various organization actions that comprise
it, thrive in direct proposition to the efficiency with which scarce resources of human talent,
materials services and capital are allocated .To achieve their goals ,organization need
information about how resources are obtained and used. Accounting information is designed to
meet this need.

Accounting is a system that is continuously changing to meet the evolving needs of the
society .The environmental characteristics of society are diverse and complex, therefore,
accounting is always facing new challenges for example, during a period of significant inflation,
special accounting concepts and procedures are able to report real effects separately from purely
inflationary effects.

(Source, Gautier, M.W &B .Under down (2001) accounting: Theory and practice. Essex CM20 2
JE, England. Pearson Education limited.

Scope of accounting.

Accounting is in an age of rapid transition, its environment has undergone vast changes in the
last two decades and an accelerating rate of change is in perspective to the future. Changing
social attitudes combine with developments in information and manufacturing technology ,the
adoption of the new management philosophies and the growing intensity of competition ,both

2
local and global to affect radically the environment in which accounting operates today, thereby
creating the need to re-evaluate the objectives of accounting in a wide perspective .Accounting is
moving away from its traditional procedural base ,encompassing recording –keeping and such
related work as the preparation of budgets and final accounts, towards a role which emphasizes
its social importance.

The changing environment has not only extended the boundaries of accounting but has created a
problem in defining the scope of the subject .There is a need for definition which is broad
enough to delineate its boundaries, while at the same time being sufficiently precise as a
statement of its essential nature. It’s interesting to contrast definitions which were accepted a
little time ago with more recent statements. According to a definition made in 1953,The central
purpose of accounting is to make possible the periodic matching of costs(efforts)and revenues
(accomplishments).This concept is the nuclear of accounting theory and a benchmark that

PAGE 3/4- EBBY

Affords a fixed point of references for accounting discussions.(Littleten,1953).

The committee on terminology of the American Institute of Certified Public Accountants

formulated the following definition in 1961; Accounting is the art of recording ,classifying and
summarizing in a significant manner and in terms of money ,transactions and events which are in
past at least of a financial characters and interpreting the result thereof(AICPA,1961)

Amore recent definition is less restrictive and interprets accounting as the provision of
information about the reporting entity‘s financial performance and financial position that is
useful to a wide range of users for assessing the stewardship of management and for making
economic decisions (ASB, 1999).

An earlier definition which additionally acknowledges welfare objectives is closer to an

interpretation of the scope of accounting and the manner in which accounting should be treated.
A rider should be added that accounting is the moving towards a consideration of social welfare
objectives. Accordingly, the purpose of accounting is to provide information which is potentially
useful for making economic decisions and aims to assess the impact of an organization or
company on people both inside and outside’(Gonella et al, 1998).

3
According to this latter viewpoint, the scope of accounting should not be restricted to the private
use of information which has the limited perspective of being concerned with the impact of
information on the welfare of individuals as such. The social welfare viewpoint is concerned
with the allocation of scarce resources. Another aspect of this viewpoint is reflected in the
development of social accounting. In the past, the interests of shareholders, investors, creditors
and managers have exerted a dominating influence on the development of accounting practices.
The social welfare theory of accounting requires that the interests of employees, trade unions and
consumers be taken into account, and that the traditional imbalance existing in the supply of
information should be corrected. Social accounting draws attention to the gulf existing between
the sectarian interests represented in conventional business accounting and its focus on profit and
the need to see the entire social role of business organization in the context of all those affected
by its activities.

The emerging role of accounting

The history of accounting illustrates how accounting is a product of its environment and at the
same time a force for changing it. From today’s perspective, we may distinguish three phases
which may be said to correspond with its developing role.

Stewardship accounting has its origin in the function which accounting served from the earliest
times in the history of our society of providing the owners of wealth with a means of
safeguarding it from embezzlement. Wealthy men employed stewards to manage their property.
These stewards rendered periodical accounts of their stewardship and this notion still lies at the
root of financial report today. Essentially, stewardship accounting involves the orderly recording
of business transactions, and accounting records of this type date back to as early as
4500BCstewardship accounting is associated, therefore with the need of those in business to
keep record of their transactions, the manner in which they invested their wealth and the debts on
to them and by them.

Financial reporting has a more recent origin and dates from the development of large-scale
businesses which were made possible by the industrial revolution indeed, the new technology not
only destroyed the existing social framework but altered completely the method by which
business was financed. The industrial expansion in the early part of the 19 th century necessitated

4
access to large amounts of capital. This led to the advent of the joint stock company, which
enables the public to provide capital in return for shares in assets and the profits of the company.
The Joint stock Companies Act 1844 permitted the incorporation of such companies by
registration without the need to obtain a royal charter as a special Act of Parliament in 1855,
however, the limited liability Act permitted such companies to limit the liability of their
members the nominal value of their shares. This meant that the liability of shareholder for the
debts incurred by the company was limited to the amount which they had agreed to subscribe. In
effect, by applying for $ 1share, a shareholder agreed to subscribe $1 and once he had paid that
$1, he was not liable to make any further contribution in the event of the company’s insolvency.
Parliament eventually restated the doctrine of stewardship in a legal form. It made the disclosure
of information to shareholders a condition attached to the privilege of joint stock status and of
limited liability. This information was required to be in the form of annual profit and loss
accounts and balance sheets. Briefly, the former is a statement of the profit or loss made during
the year of the reports, and the balance sheet indicates the assets held by the firm and how those
assets were financed.

The reluctance of company directors to disclose more than the minimum information required by
law, disquiet as to the usefulness of the information contained in financial accounts culminated
in the extension of disclosure requirements in the United Kingdom by means of the Companies
Act.

The demand for improvements in corporate governance, ie the system by which companies are
directed and controlled, has continued this process. For example the Turnbull Committee’s
Report (ICAEW, 1999) provides guidance to assist companies to implement disclosure
requirements in respect of internal controls. This report requires directors to disclose in their
annual report that there is an ongoing process for identifying, evaluating and managing the
significant risks faced by a company.

The legal importance attached to financial accounting statements stems directly from the need of
a capitalist society to mobilize savings and direct them into profitable investments. Investors, be
they large or small, must be provided by reliable and relevant information in order to be able to
make efficient investment decisions.

5
3. Management accounting is also associated with the advent of industrial capitalism, for the
Industrial Revolution of the 18th century presented a challenge to the development of accounting
as a tool of industrial management. In isolated cases there were some, notably Josiah
Wedgwood, who developed costing techniques as guides to management decisions. But the
practice of using accounting information as a direct aid to management was not one of the
achievements of the Industrial Revolution: this new role for accounting really belongs to the 20 th
century.

Certainly, the genesis of modern management with its emphasis on detailed information for
decision making provided a tremendous impact to the development of management accounting in
the early decades of this century [20 th], and in so doing considerably extended the boundaries of
accounting. Management accounting shifted the focus of accounting from recording and
analyzing financial transactions to using information for decisions affecting the future.

The advent of management accounting once again demonstrated the ability and capacity of
accounting to develop and meet changing socio-economic needs. Management accounting has
contributed in a most significant way to the success with which modern capitalism has succeeded
in expanding the scale of production and raising standards of living.

ACCOUNTING IN A CHALLENGING ENVIRONMENT

The process of change has had a dramatic impact on accounting theory and practice in recent
years. Rapid changes in the environment have caused much concern and necessitated changes in
accounting. The factors which have caused this concern may be identified as follows:

1. The status of accounting profession has depended on some extent on its monopoly of the
auditing and external reporting function. However an important discussion document has
attacked the concepts upon which financial statements are based on the grounds that they
are neither consistent nor logical and do not lead to a portrayal of economic reality
(ICAS, 1988). Much criticism has been directed at the lack of uniformity in the manner in
which periodic profit is measured and the financial position of the enterprise represented.
Also severe criticism has been directed at an external financial reporting system that
allows management to provide cosmetic improvements to the firm’s accounting
performance, by the phenomenon of ‘creative accounting’ (Whelan and McBarnet, 1999).

6
 Furthermore, historic cost accounting procedures misleadingly high profits in times of
inflation.
2. Accounting is shaped by the environment in which it operates. Since this differs from
country to country (due to legal, economic, political, cultural, etc differences) very
diverse national accounting systems have developed. For example, in some countries
financial accounting developed to ensure that the proper amount of income tax is
collected by the national government. In an expanding global economy where
management and investors are increasingly making cross-border decisions, comparability
of international financial information is essential.
3. Since the mid-1980s, following changes in the environment in which many organizations
operate, traditional management accounting practices have attracted criticism for lagging
behind the times, especially in view of technological developments. The argument has
largely centered on the view that the managers faced with having to make decisions in
fully technology-driven situations are supplied with information by their firm’s internal
management systems which is inadequate. Johnson and Kaplan (1987) came to the
conclusion that, in general management accounting systems are not providing useful,
timely information for process control, product costing performance evaluation of
managers.
4. Increasingly, management is being held responsible not only for the efficient conduct of
business as expressed in profitability but also for what it does about an endless number of
social problems. Hence, with changing attitudes, the time-honored standards by which
performance is measured have fallen into disrepute. There is a growing consensus that the
concepts of growth and profit as measured in traditional balance sheets and profit and
loss accounts are too narrow to reflect what many companies are trying as are supposed
to be trying to achieve.

Accountants have responded to those concerns as follows:

1. In the United Kingdom the need to improve accounting practice was recognized formally
by the creation of the accounting standard committee in 1970. More recently the Dearing
Report’s in 1988 proposals have led to a new administrative structure for accounting

7
 standard setting that is designed to improve the quality of accounting standards and to
strengthen the enforcement process.

Much effect has been directed towards developing theoretical framework for a validity external
financial reporting in terms of their perceived objectives to enable future development to take
place in accordance with those objectives. In US the financial accounting standards board, since
its inception in 1972, has been engaged in developing a series of statements which have
established a conceptual framework for financial reporting. More recently a conceptual
framework have been issued by the institute of chartered accountants of Scotland (making
corporate reports valuable ICAS, 1988), the international accounting standards committee
(framework for the preparation and presentation of financial statement, IASC 1989) the institute
of chartered accountants in England and wales ( Guidelines for Financial Reporting standards ,
the Solomons report, ICAEW 1989) and the Accounting standards Board (standard of principles
for Financial Reporting , ASB, 1999.

2. In 1973 the international accounting standards committee (IASC) was founded by the
accountancy bodies of nine countries with the fundamental aim of increasing comparability of
financial information world wide –or more formally to formulate and publish in the public
interest accounting standards to be observed in the presentation of financial statements and to
promote their world wide acceptance and observance : the IASC has expanded rapidly and now
(2001) has 128 bodies in 91 countries.

3. New management accounting system has emerged in recent years. Those systems have
promoted the following comments:

Management accounting systems have removed with times and now new techniques and
approaches have grown to response to an increasingly competitive market environment
for almost all business. As a consequence the breadth of activity and the rigours with
which it is being monitored and measured within most companies has grown rapidly in
the last ten years. (Eccles and Kahn,1999).

4. The emergency of social accounting imposes new information objectives for accountants,
which will require a new accounting methodology. Latterly, the concept of social accounting has

8
been enlarged to include a concern for ecology in the form of what has become known as ‘green
accounting’

Accounting as an international system

Accountants select raw data relevant to their purposes. The filtering process by which they select
accounting data is provided by the conventions of accounting, which play a deterministic role in
defining accounting information. This filtering process may be taken as one boundary between
the system and its environment: that point at which raw data becomes input data. The data
selected forms the input data. The data selected forms the input into the processing system which
provides accounting information. This information output is used by groups of decision maker,
which are identifiable, and it is evident that a decision-oriented information system should
produce information which meets the needs of its users. Clearly, these should be specified in
accordance with a theory of users’ requirements. It may be said, therefore, that the other
boundary to an accounting information system is established by the specific information needs of
its users. These boundaries may be modeled as in the figure 1 below.

This analysis of accounting as an information system enables the making of some important
deductions. First, the goal of the system is to provide information which meets the needs of its
users. If these needs can be sufficiently and accurately identified, then the nature and character of
the output of the system. Second, the output requirements should determine the type of data
selected as the input for processing into information output. Third, welfare consideration may be
taken into account in the selections of data, in accordance with the objectives of accounting.

Figure 1

Environment INPUT Processing OUTPUT Users

(unlimited data) (selected data) (information)

CONTROL

In this connection, the idea of control indicated (in figure 1) shows that users’ needs should
determine not only the nature of data input, but also the extent of the input which should be

9
determined by a cost-benefit analysis related to these needs and the impact of their decision on
society.

The output of an information system

The foregoing discussion has served to indicate the importance of users of accounting
information, for such needs determine the objectives of an accounting system.

There are several groups of who have vested interests in a business organization, _ messengers,
shareholders, employers, customers and creditors. Additionally, the community at large has
economic and social interest in the activities of business organizations. This interest is expressed
at national level by the concern of government in various aspects of firms activities, such as their
economic well-being, their contribution to welfare, their part in the growth of the national
product, to mention but a few examples; and at local levels by the concern of local authorities
and bodies in the direct socio-economic impact of the activities of local businesses.

Accounting to the decision usefulness approach to accounting, uses of accounting information

should be regarded as decision makers interested in determining the sacrifices which must be
made to obtain the benefits which are expected to flow from decisions to which they commit
themselves. Since all the scarifies and the benefits necessary materialize and in the future, by
reason of a nature of the decision-making process, uncertainty plays a critical role in accessing
the sacrifices and benefits associated with particular decisions.

The information needs of shareholders and investors

Historically, business accounting developed to supply information to those who had invested
their wealth in business venture. Financial accounting emerged in 19 th century as a result of need
to protect investors in joint stock companies trading under limited liability. It has been evident
for a long time that the information needs of investors are not completely met by published
balance sheets and profit and loss accounts.

10
The information needs of management

Organizations fall into two broad classes: those having profit objectives, and those having
welfare objectives. Although the concern here is mainly with business organizations it should be
remembered that many accounting methods employed in business organizations are also
employed by welfare as non-profit organizations. As regards the management of organizations,
little difference may exist between information needs of managers of business organizations and
those of managers of welfare organizations.

The management process may be analyzed into three major functions- planning, organizing and
controlling the activities of the organization. These various management functions have one
thing in common; they are all concerned with making decisions which have their own specific
information requirements. Planning decisions for example are directed towards realizing broad
goals which in addition to the organization’s survival and its profitability usually include the
intention to grow and to capture a large share of the market for its products and services. Other
goals include product leadership, increased productivity and improved industrial relations. There
is an element of conflict between various organizational objectives and it is the function of the
management to reconcile them through the planning process.

The Information needs of Employees.

It is a popular view that the interests of employees are indirect conflict with those of the firm and
in particular those of the management. Unless employees are able to share in the profits of
business organizations, they are effectively dissociated from their activities if it is supposed that
the objective of business organizations is to maximize profits and maximize returns to
shareholders. This classical concept of the objective of business enterprises is being replaced as a
result of the social changes taking place in society and there is a broadening view of the social
and economic responsibilities of management.

It is recognized that employees have a vested interest in the outcome of management decisions of
every kind. Improvements in industrial democracy through employee participation in
management decisions have important implications for the supply of information to employees.
Many firms are already investigating this question. As regards the settlement of wage disputes

11
the question of profit sharing among employees, shareholders and management can only be
settled properly on the basis of a full disclosure of the relevant facts.

The Information needs of Governments.

Government agencies such as central statistical services, ministries of commerce, industry,

employment etc collect information about the various aspects of the activities of business
organizations. Much of this information is a direct output of the accounting system, for example,
levels of sales activity, profits, investments, stocks, liquidity, dividend levels, proportion of
profits absorbed by taxation etc. This information is very important in evolving policies for
managing the economy.

Governments, in addition, can compel the disclosure of information which is not otherwise made
available to the public, such as future investment Plans, expected future profits and so on

By and large, however, governments expect accounting information to be presented in a uniform

manner, so that the rules applying to accounting methods and the preparation of accounting
reports for government use are the same as those which govern the nature of accounting
information disclosed to investors and shareholders. If governments base policy decisions on
accounting information which distorts the true position, it is evident that the ill effects of such
decisions will be widely felt.

The information needs of creditors

Creditors are defined as those who have provided goods, money or services to business
organizations and have accepted a delay in payment or repayment creditors may be short-term as
long-term lenders. Short-term creditors include suppliers of materials and goods, normally
described as trade creditors, credit institutions such as banks and hire purchase firms which lend
money at interest on a relatively short term basis and those who have provided services and are
awaiting payment, for example, employees, outside contractors who have made repairs or
electricity and gas undertakings which have rendered invoices and have not yet been paid. Long
term creditors are those who have lent money for a long period, often in the form of secured
loans. The main concern of creditors is whether not the enterprises are creditworthy, that is will

12
it be able to meet its financial obligations? Creditors are interested in the enterprise’s profitability
only in so far as it affects its ability to pay its debts. On the offer hand, creditors are very
concerned with the firm’s liquidity that is those cash or near cash resources which may be
mobilized to pay them, as well as the willingness of banks and other creditors to await payment.
Creditors react quickly to changes of opinion about a firm’s creditworthiness, and if there is any
doubt about a firm’s ability to pay, they will press for immediate payment of debts and probably
drive into liquidation a firm whose prospects in the medium and longer term are not necessarily
bad. Creditors are interested, therefore, mainly in financial accounting information which affects
solvency, liquidity and profitability, that is, with obtaining reports which will describe a firm’s
financial standing.

The information needs of other groups

There are two other groups in society interested in the activities of business organizations, and
which are pretty well excluded from receiving information; the local community and customers

The information needs of the local community

Local communities are very dependent on local industries, not only because they provide
employment, but also because they directly affect the entire socio-economic structure of the
environment firms provide employment, create a demand for local services, because an
expansion in commercial activities, as well as extensions in the provision of welfare services as
the economic well-being of the community improves. Large firms, in particulars, are able to
exert a dominating influence on the local social framework which offer is rejected in the
corporate personality of the inhabitants. Local industries have both positive and negative
influences on the locality. Pollution, despoliation and congestion are all negative aspects of their
activities that constitute external direct and indirect social and economic costs, which are borne
by the community.

13
The local community has an interest in the activities of local industries and requires much more
information on social benefits and costs than the public relations type information that is
(currently) disclosed. The social audit points to a possible remedy for the lack of objectivity in
the information that is (at present) disclosed.

The information needs of customers

In recent years, consumers councils and other bodies have restored in some measure the
disproportionate balance of power which has appeared in our society between the large powerful
producers of consumer goods and the voiceless masses of our population who have been at the
formers merely in a few instances, the monopolies commission has acted to protect consumers,
but its power to intervene is based upon law.

Customers may well have little influence in markets increasingly dominated by large business
organizations and it is difficult to see how, even if more information were made available, the
balance might be redressed. Certainly, customers are interested in information indicating the
fairness of pricing policies, such as the relative proportion of unit price which consists of costs,
profit and taxes, and in the differential costs between one product and another produced by the
same firm at a different price. For example, why should one electric shaves cost £10 more than
another, and in what ways is this difference value for money? Clearly, there will be many more
social changes in our society before questions of this sort will be recognized and adequately
answered.

Accounting information and the allocation of resources

The various groups of information users just discussed share a common concern, which is to
make decisions about the allocation of scarce resources between competing ends. Students of
economics will find that such a statement echoes a popular definition of the subject matter of

14
economics. The importance of accounting information is that it makes such an allocation
possible in a market economy, where individuals and organizations are largely free to allocate
the resources which they control between competing ends. Therefore, one object accounting
information system is to enable information users to make decisions which improve the
allocation of available resources within their control such decision making may be understood
only in relation to the objectives of decision makers, so that the various groups of information
users whose needs we have just discussed may be competing decision objectives. Therefore, the
objective of accounting information systems is to enable decision makers to improve the
allocation of the resources which they control and to assess the actual results of their decisions
against the forecast results.

Behavioral aspects of decision making

The central purpose of accounting is to produce information which will influence behaviors
unless accounting reports have the potential to influence decisions and actions; it is difficult to
justify the cost of preparing such reports. Traditionally, accounting reports have been addressed
to shareholders and investors. The response of the stock exchange to the disclosure of
accounting information through the reaction of share prices is one way in which the influence of
accounting reports of investors may be judged.

Since, from a management point of view, the purpose of accounting information is to enable, the
organization to attain its goals it must follow that the effectiveness of accounting information is
evidenced in the manner in which it affects behaviors. In this sense, unless accounting
information produces the desired action, it has served no purpose at all.

The role of accounting theory

Underlying the discussion of accounting as an information system is the important question of

the field of knowledge to which accounting information refers. This raises issues about the
nature and significance of accounting theory and the relationship between accounting theory and
accounting practice.

15
The mature of theories

Essentially, theories are generalizations which serve to organize otherwise meaningless masses
of data and which thereby establish significant relationships in respect of such data. The
constitution of theories requires a process of reasoning about the problem implicit in the data
under observation, as a means of distinguishing the basic relationships. Thus theory construction
is a process of simplification, which requires assumptions that permit the representation of reality
by a generalization that is easily understood. The close association of theory and data, or f acts is
fundamental to the notion of good theory, for the reliability of a theory is dependent not only
upon the facts to which it refers, but also upon an interpretation of those facts requiring
validation and continuous reassessment.

Theories are concerned with explanation.

Explanation relates a set of observations to a theoretical construction of reality which fits those
observations. If no theoretical scheme that does this reasonably well is available, the desire for
explanation leads to the creation of a scheme of ideas which provides a distinction of the
problem observed, as well as an understanding of it, in the form of explanation. In both cases
relating observations to existing theory and constructing theory to fit observations, have the
objective of providing an explanation of those observations.

A misunderstanding of the relationship that exists between facts and theories gives rise to a great
deal of misconception about the role of theories. Thus, the complaint that it’s a right in theory
but not in practice implies that the person making the complaint must hold the belief that an
alternative theory provides a different explanation of the facts in question.

The world theory itself gives rise to misunderstanding and may mean different things to different
people. This arises because explanations are made at different levels. At one extreme,
explanations are purely speculative, resulting in speculative theories, for example, that outer
space probes are affecting the weather. To the natural scientist, speculative theories are not
really theories at all and explanations have to be conclusive before they are given to the status of

16
theories. To this end their assumptions require verification by the test of experience. At another
extreme are to be found explanations which are accepted only when they have been verified.
Empirical theories are constructed by the process of verifying assumptions, or hypothesis,
through the test of experience. This process is known as the ‘scientific method’ and is illustrated
below.

World of facts

Recognition of a problem

Collection and organization of date

Formulation of propositions and definitions

Development of hypothesis

Testing hypothesis

17
 Theory verification, modification or rejection

Theory acceptance

Empirical theories assist in making ‘predictions’ for while they consist of generalizations which
explain the present, future occurrence also replicate the same conditions. It is in providing both
explanation and predictions that empirical theories have acquired such importance in making
decisions about the future which are based on assumption derived from experience.

Accounting theory

The word ‘theory’ is also used at different levels in the literature of accounting. Thus, reference
to ‘accounting’ theory may mean purely speculative interpretations or empirical explanations.
These references usually do not indicate the level of theory which is implied.

According to Hendrickson (1992)

Accounting theory may be defined as logical reasoning in the form of a set of broad principles
that

i) Provide a general framework of reference by which accounting practice can be

evaluated and
ii) Guide the development of new practices and procedures. Accounting theory may also
be used to explain existing practices to obtain a better understanding of them. But the

18
 most important goal of accounting theory should be to provide a coherent set of
logical principles that form the general frame of reference for the evaluation and
development of sound accounting practice.

Approaches to the development of accounting theory

Several approaches to the development of accounting theory have emerged in the last two
decades. These approaches may be identified as follows:-

1. Descriptive
2. Decision usefulness
i) Empirical
ii) Nonnative

3. Welfare

The descriptive approach

Theories developed using the descriptive approaches are essentially concerned with what
accountants do. In developing such explanations, descriptive theories rely on a process of
inductive reasoning, which consists of making observations and of drawing generalized
conclusions from those observations. In effect, the objective of making observations is to look
for similarity of instances, and to identify a sufficient numbers of such instances as will induce
the required degree of assurance needed to develop a theory about all the instances which belong
to the same class phenomena

As applied to the construction of accounting theory, the descriptive approach has emphasized the
practice of accounting as a basis from which to develop theories. This approach has attempted to
relate the practices of accountants to a generalized.

19
 Theory about accounting. in this view, accounting theory is to be discovered by observing the
practices of accountants because accounting theory is primarily a concentrate distilled from
experience it is experience intelligently analyzed that produces logical explanation and it
springs (Littleton and Zimmerman, 1962)

The descriptive approach results in descriptive or positive theories of accommodating, which

explain what accountants do and enable predictions to be made about behaviors, for example,
how a particulars matter will be treated. Thus, it is possible to predict the receipt of cash will be
entered in the debit side of the cash book.

In effect, the descriptive approach is concerned with observing the functional tasks which
accountants have traditionally performed in 1952 the institute of chartered Accountants in
England and Wales stated that the primary purpose of the annual accounts of a business is to
present information to proprietors showing how their funds have been utilized, and the profits
derived from such use (ICAEW).

Underlying the descriptive of financial statements is associated with the stewardship concept of
the owners of businesses with information relating to the manners in which their assets have
been managed in this view company directors occupy a position of responsibility and trust in
regard to shareholders and the discharge of these obligations requires the publication of annual
reports to shareholders. With the growth of large corporate enterprises, the weakening of the
links between ownership and management created a need for a more elementary notion of
stewardship, in which the disclosure of financial information was aimed at protecting
shareholders from fraudulent management practices. It is evident that the descriptive approach to
the theory construction in accounting plays an influential role in shaping perceptions of the
problems of accounting and the manner in which they should be solved. Reduction in the
diversity of accounting practices is attained through the process of standardization.

The following figure illustrates the framework within which descriptive accounting theory has
developed.

Elements Concepts accounting procedures

Assets
20
Liabilities

Capital
 Entity Recording
transactions,
Money classifying
measurement transactions,
Going concern summarizing
transactions
Cost
Reporting
Realization transactions,
interpreting
Accrual
transactions

Decision usefulness approaches

The expansion of behavioral research into accounting during the 1970s resulted in an interest in
decision usefulness theories of accounting. This mood was well captured in the following
statement by the American Accounting Association in 1971.

To state the matter concisely, the principal propose of accounting reports is to influence action,
that is behaviors. Additionally, it can be hypothesized that the very process of accountant
information, as well as the behavior of those who do the accounting will affect the behavior of
others. In short, by its very nature, accounting is a behavioral process.

Two types of decision usefulness theories of accounting have resulted from this approach,
namely, empirical and normalize theories.

Empirical approach

21
The early 1970s witnessed a substantial increase in empirical research which was designed to
make accounting research more rigorous and to improve the reliability of results sophisticated
statistical techniques became increasingly used for this purpose. Furthermore, the expansion of
university causes in accounting increased the numbers of students with a quantitative
background, who could conduct research in this way. The implications of the empirical
approach to research in accounting were significant in the development of accounting theory.

Normative approach

Unlike empirical research, which concentrates o how this information in decision making, the
normative approach to theory construction is concerned with specifying the manner in which
decisions ought to be made as a precondition to considering the information requirement.

The normative approach focuses on the decision models which should be used by decision
makers seeking to make rational decisions. This focus is seen as presiding insights on the
information needs of decision makers, as a basis for developing accounting theory.

The welfare approach

The welfare approach is an extension of the decision making approaches, which considers the
effects of decision making on social welfare. Basically, decision making approaches limit the
field of interest to the private use of accounting information. If accounting information had a
relevance limited to private interests, the decision making approaches would provide a sufficient
analysis of information needs. It is because of the external social effects of decisions made on
the basis of accounting information that there is imputed a social welfare dimension to
accounting theory.

The effects of financial information on welfare may be viewed from the standpoint of the vested
interests of groups within an organization. The needs of these groups have already been noted
previously. It is evident that the alternation of accounting policies in favor of one group and
away from another will affect the distribution of income and wealth within society. In this

22
respect, the movement towards disclosing information to employees and the concept of social
accounting are clearly causing such a change.

Accounting policy makers

There are two main groups which determine accounting policy. First, the government employs
the legislative process to ensure that a minimum level of information is disclosed in company
reports. It also acts as a spur to prompt the accountancy profession into action, where there is an
apparent urgent need. An example of this influence was the establishment of the Sandi lands
committee by the government to consider the price level changes. Another example was the
employment protection Act 1975, which places a general duty on the employer to disclose
information requested by the trade union representatives act all stances of collective bargaining

Second, the accountancy profession itself acts as a regulatory body and deals with the problems
of accounting standards implied I financial reports.

Financial accountability statements

The descriptive approach lists the elements contained in its framework: transactions, revenues,
expenses, and profit, examine these elements and illustrate how they are incorporated in financial
statement, which is a summary of all the individual transactions recorded during a period of time.
A transaction is financial in character and is expressed in terms of money. Financial statements
are the fines product of the accounting functions. They give interested readers the opportunities
to see what occurred in a neat summary. There are these basic statements, which are in
extricable tied together:-

1. The profit and loss account

2. The balanced sheet

3. The cash flow statement

23
The profit and loss account

The measurement of profit is probably the most important function of financial accounting.
Investors, managers, bankers and others are interested in knowing how well a business is doing.
The profit and loss account shows the results of the ‘flow’ of activity and transactions and is
designed to report the profit performance of a business for a specific period if time, such as a
year, a quarter as month profit represents the differences between revenues and expenses. The
profit and loss account reports for a specific period of time the items that comprise the total
revenue and total expenses and the resulting net profit.

The profit and loss account by Albert Trader is shown below note how the heading of the
statement specifically identifies the name of the business, the tithe of the report and the period of
time over which the reported net profit was earned.

Albert Trader

Profit and loss account for the year ended 31st December 2040

£ 000 £ 000

Sales revenue 220

Cost of sales 103

Gross trading profit 117

Less: Other expenses

Rent and rates 6

Lighting and heating 4

Wages 40

Depreciation of shop equipment 8 58

24
Profit before interest and tax 59

Less: Interest expense 1

Profit before taxation 58

Taxation 20

Net Profit 38

Sales revenue

Revenue is earned by a business when it provides goods and services to customers. Whereas a
trading business, like that of Albert Traders, will devise revenue mainly from sale of
merchandise, a business which tenders services, such as a solicitor, will devise revenue as a
result of charging for that service. It is not necessary for a business to receive cash before
recognizing that revenue has been earned. The accruals concept recognizes revenue which arises
from the sale of goods or services on credit.

Cost of goods sold

This shows the cost of goods sold to produce the revenue. For a trading business like Albert
Trades, cost of goods sold equals opening stock, plus purchases, minus closing stock when
calculating business profit for a period, the sales revenue for that period and the costs of earning
that revenue must be matched with one another in the profit and loss account.

Other expenses

In addition to the cost of goods sold other expenses such as rent and rates, lighting and heating
and wages, as shown in Albert. Trader’s profit and loss account are incurred in earning revenue.
Such expense may require the immediate payment of costing, in the case of credit, the payment
of cash some time offer the expenses is incurred. In some cases, cash is paid before the expenses

25
is incurred, as in the case of the payment of office rent in advance of occupancy for accounting
purposes, an expense is recognized in the period in which it is incurred, which is not necessarily
the same as the period in which the cash is paid. The period in which an expense is deemed to
be incurred in the period in which the goods are used or the services received.

An expense may represent the cost of using equipment or buildings that were acquired and are
being held for use in operating the business rather than for sale. Such items often have a high
initial cost at the date of acquisition and, through use, are consumed over an extended period of
time known as their useful life. As they are used is operating the business, a portion of their
initial cost becomes an expense, known as depreciation in Albert Trader’s profit and loss
account £8000 depreciation of shop equipment is recorded.

Net profit

Net profit is the excess of total revenues over total expenses. If the total expenses exceed the
total revenues, a net loss is reported where revenues and expenses are equal for the period; the
business is said to breakeven.

The balance sheet

The balance sheet, sometimes called the statement of financial position, lists the assets owned by
a business, the liabilities owed to others the accumulated investment of its owners. The balances
at a specific date. Even though the business is the result of trading over time, the balance sheet is
only a ‘snapshot’ of what the business’s resources and obligations are at a stated time. This
differs from the profit and loss account which reports inflows and outflows of resources over a
period of time.

The balance sheet may provide helpful information in determining the degree of financial risk.
For example, a bank considering a short term loan to a business would want to know the
financial position of the business at the time of the loan.

Albert Trader’s balance sheet is shown below. Note how the heading of the balance sheet
specially identifies the name of the business, the title of the report and the specific date of the

26
statement. To assist the preparation of the cash flow statement, the balance sheet shows figures
for two years.

Assets

Assets are things of value which are possessed by a business. To be classified as an asset, the
money measurement concept (to be later discussed) demands that thing must have the quality
e.g. being measurable in terms of money. The assets of a business are classified into fixed and
current assets as shown in Albert Trader’s balance sheet

Albert Trader

Balance sheet at 31 December 20 * 1 and 20 * 0

Fixed Assets £ 000 £ 000 £ 000 £ 000

Store Equipment at cost 90 60

Accumulated Depreciation 20 12

Net book value 70 48

Current Assets

Stock 80 60

Debtors 21 10

Cash 1 2

Current Liabilities 102 72

Trade Creditors 26 32

Working Capital 76 40

Owners Capital 146 88

27
 Opening Balance 88 16

Net Profit for Year 38 126 32 88

Long term liability

Loan 20 --

Fixed Assets

Fixed Assets are used in the business and are not intended for resale. They include assets having
a long life such as buildings, equipment and vehicles. Fixed assets, with the exemption of land
are depreciated over time as they are used since their productive life is limited, their initial cost is
apportioned to expense over their estimated useful life. The amount of depreciation for the years
is recorded in the profit loss account as an expense. The cumulative amount of depreciation
expense for all past periods since acquisition is deducted on the balance sheet from the cost of
the asset to derive the net book value of the asset. This does not represent the current value of the
asset. In the case of Albert Trader, the net book value of his fixed assets is shown as £ 70,000 at
31.12. 20*1.

A fixed asset for one business may be a current asset for another. For example, a car is a
fixed asset if it’s to be driven by a salesman for the next two years, but as a current asset it is
held as stock for sale by a car sales company.

Current Assets

Current assets are those which are expected to be transformed during the next future, usually one
year, into cash. They include stocks such as materials, supplies, work-in-progress and finished
goods as well as debtors. Debtors represent amounts due from customers in respect of past sales
on credit cash is the amount of cash in the premises, or in the bank, at the balance sheet date.
Assets are reported in the balance sheet in order of increasing liquidity, i.e. the list starts with the
items least likely to be turned into cash in the near future.

Current Liabilities

28
Current liabilities are the amounts owing by the business, which will fall due for payment within
one year. Most firms find it convenient o buy merchandise and services on credit terms rather
than to pay cash. This gives rise to liabilities known as trade creditors — £ 26, 000 at 31.1.20*1
in the case of Albert Trader. The reason why amounts of money owed to the creditors of a
business are known as liabilities is that the business is liable to them for the amounts owed.

Working Capital

A business must have sufficient working capital to be able to pay its way and settle its immediate
obligations. This implies that there must be funds available for the purchase of stock
requirements, for the payment of these creditors and general running expenses of the business
working capital of Albert Trader at 31.12.20*1 is;

Current Assets – Current Liability = Working capital

£ 102,000 -- £ 26,000 = £ 76,000

The business has an excess of £ 76,000to use in operations after the current assets are converted
into cash and the current liabilities are paid. From a banker’s point of view, a trader with a huge
amount of trading capital maybe considered a good credit risk because the business can make its
best payments conversely, it may also show that the trader is mismanaging his stocks by holding
too many goods or too much cash. The proper amount of working capital depends on the
industry concerned.

Owners Capital

Owner’s capital (or owner’s equity) represents he owns investments in business. Albert Trader’s
balance sheet shows that the net profit for the year is added to the owner’s opening capital.

Loan

The loan shown in Albert Trader’s balance is classified a long term liability. Long-term
liabilities, which are due in a period exceeding one tear, arise when a firm borrows money as a

29
means of supplementing the funds invested by the owner. In the case of Albert Trader the Profit
and loss account shows that £ 1000 was paid in interest on the loan during the year.

THE ACCRUAL BASIS OF ACCOUNTING

The profit and loss account and balance sheet are base on accrual accounting. As already
explained, profit or loss is measured by matching a periods sales revenue with the expenses
incurred in earning those revenues. In accrual accounting cash receipts and payments are
replaced by revenues earned and expenses incurred. Any outstanding amounts of cash owed to,
or owed by, the business are than recorded as debtors or creditors (as the case may be) in the
balance sheet at the end of the period. It is generally agreed that profit measured in this way is a
better indicator of a business economic performance in a period than profit determined on cash
in/out basis.

THE CASH FLOW STATEMENT

Cash is the lifeblood of a business. A healthy cash flow (measured as cash inflows minus cash
outflows) is fundamental to a business’ ability to survive and prosper. Users for financial
statements who look merely at the profit and loss account for a measure of financial health can
be deceived. Indeed’ many businesses with apparently strong profits have foundered through
poor control owes their cash flow. The cash flow statement can be used by management to avoid
such liquidity problems. Its purpose is to show what cash flow has been generated by a
business’s operations and where the cash has gone. The importance of cash flow was recognized
by the Accounting Standards Board’s first standard which came into effecting 1992, and which
was revised in 1996.

A cash flow statement classifies the sources and uses of cash flow from several types of business
activities:

i. Operating Activities

Cash flows from operating activities are the cash effects of transactions relating to operating or
trading activities. They are the cash effects of transactions that enter into the determination of
operating profit, i.e. profit before interest and tax.

30
 ii. Returns on investments and servicing of finance

These are receipts resulting from the ownership of an investment and payments to providers of
finance. They include interest received and interest paid

iii. Taxation

These are tax flows to and from taxation authorities.

iv. Capital Expenditure

These are cash flows associated with the acquisition and disposal of fixed assets.

v. Financing Activities

These compromise receipts from, or payments to external providers of financing.

These activities are disclosed clearly in cash flow statements as illustrated in the Albert Traders
case.

Cash flow statement for the year ended 31.12.20*1

Operating activities £ 000 £ 000

Operating profit 59

Add back non cash expenses

Depreciation Charge 8

Adjust for changes in working capital 67

Stock (increase) (20)

Debtors (increase) (11)

Creditors (decrease) (6) (37)

Net cash flow from operating activities 30

Returns on investment & servicing of finance

31
Interest paid

Tax paid (1)

Capital expenditure (30)

Financing activities

Proceeds from loan 20

Decrease in Cash (1)

PREPARATION OF CASH FLOW STATEMENT

The preparation of the cash flow statement requires the following information:

a. The profit and loss account for the current period.

b. The balance sheet for the current period
c. The balance sheet for the prior period.

Operating activities

In the operating activities section of the cash flow statement, accountants calculate the cash
generated from the day to day operations of a business. The accrual basis net profit is converted
to a cash basis by two adjustments:

1. Add back non-cash expenses. For example, depreciation is a ‘book item’ only and does
not represent an outflow of cash. Such an outflow occurs when fixed assets are purchased
or disposed of, an occurrence which is included later in the investing activities section.
2. Adjust net profit for changes in working capital. A comparison of the stock figure in
Albert Trader’s balance sheet shows that this item increased by £ 20,000 during the
current period (from £ 60,000 to £ 80,000). This indicates an increase in cash
requirements. Similarly, both Albert Traders debtors require an increase in cash. In total,
changes in working capital over the years require the use of £ 37,000 additional cash.

Interest Paid

32
Albert Trader paid £ 1,000 in interest on the loan he took out during the year.

Tax period

Albert Trader paid £ 20,000 in tax.

Capital Expenditure

When a business buys or sells a long-term asset like a building or piece of equipment, the cash
relating to the transaction is reflected in the capital expenditure section of the cash flow
statement. In the case of Albert Trades, £ 30,000 was invested in shop equipment between the
two balance sheet dates and this is shown in the cash flow statement.

Financing activities

The two balance sheets show that Albert borrowed £ 20,000 during the year in order to finance
the increase in working capital and the purchase of shop equipment.

Decrease in cash balance

Albert Trader’s cash flow statement explains why the cash balance has decreased by £ 1,000
despite borrowing £ 20,000 in the form of a loan and generating £ 67,000 from operating profit
plus depreciation. £ 37,000 was required to adjust for changes in working capital and £ 30,000
was required to finance the purchase of fixed assets.

FINANCIAL ACCOUNTING CONCEPTS

The concept of accounting may be seen as related to the general problem of developing viable
theories of financial accounting. Their origin lies in a historical process of development. The
nature of financial accounting information is not dictated by the needs of external users, but
rather is determined to a considerable extent by the concepts which exist among accountants for
identifying evaluating and communicating financial information. The need for these concepts is
discussed, as well as problems which they pose.

THE NATURE OF FINANCIAL ACCOUNTING CONCEPTS

33
Accounting concepts define the assumption on which the financial accounts of a business are
prepared. Financial transactions are interpreted in light of the concepts which govern accounting
methods. In effect, the concepts of financial accounting largely determine the interpretations
given in financial reports of the events and results which they portray. For example, the concept
relating to recognition of revenue determines the dimension of the profit reported to shareholders
and the value of the enterprise as judged from the balance sheet. The following figure illustrates
the manner in which financial accounting concepts acts as giters in selecting data input into the
processing system and as output of information for users.

Environment INPUT Processing OUTPUT

(Unlimited data) (Selected data) (repucts)

FINANCIAL ACCOUNTING CONCEPTS

Financial accounting is founded on the following concepts:

a) Entity
b) Money measurement
c) Going concern
d) Cost realization
e) Accruals
f) Matching
g) Periodicity
h) Consistency
i) Prudence/conversation

34
 a. The Entity concept

The practise of distinguishing the affairs of the business from the personal affairs of its owner
originated in the early days of double entry book keeping some 400 years ago. Accounting has a
history which dates back to the beginning of civilization, and archaeologists have found
accounting records which date as far as 4000 B.C, well before the invention of money.
Nevertheless, it was until the 15th Century that the separation of the owners wealth from the
wealth invested in a business venture was recognised as necessary. This arose from the use of
paid managers and stewards to run a business who were required to render accounts of their
stewardship of the funds and assets. Consequently the ‘capital’ invested in the business
represented not only the initial aspects of the business, but a measure of indebtedness to the
owner. This principle remains enshrined in modern financial accounting and the owner is shown
as entitled to both the ‘capital’ which s/he has invested in the business, and also the profits which
have been made during the year. The accounting and legal relationship between the business and
its owner is shown on the balance sheet which states the firm’s assets and liabilities and hence
indicates its financial position and well being.

Example 1:

J. Soap recently inherited £ 30,000 and decides that the moment is opportune for him to
realize his lifetime ambition and open a hair dressing salon. Accordingly, he makes all the
necessary arrangements to begin on 1 April 20*0, under the name ‘J Soap - Ladies Hairdresser ‘,
and commits £ 10,000 of his money to that business. He therefore opens an account at his bank
under the name ‘J Soap –Ladies Hairdresser.

As a result, the financial position of the firm on 1 April 20*0, from an accounting point
of view, will appear as follows:

J Soap – Ladies Hairdresser

Balance sheet at 1 April 20*0

Capital £ 10,000 Bank balance £ 10,000

35
The business is shown as having £ 10,000 as its assets at the date, and as owing J Soap £ 10,000,
that is, recognizing its indebtedness to him in respect of the capital he has invested therein.

The accounting effect of the entity concept is to make clear a distinction between J Soaps private
affairs and his business affairs: what he does with the remaining £ 20,000 is of no concern to the
accountant, but what happens to the £ 10,000 invested in the business is the subject matter of
accounting.

The interesting aspect of the entity concept is that it establishes fictional distinction between J
Soap and the business which is not recognized in law: he remains legally liable for the debts of
the business, and should the business fall; he will have to pay the creditors out of his private
funds.

In the case of corporations, there is a legal distinction between the owners that is, the
shareholders and the business, so that the shareholders aren’t liable for the corporation’s debts
beyond the capital which they have agreed to insest. The accounting treatment of the relationship
between the shareholders and the corporation is no different from that accorded to the sole trader
and his business, except that the capital of the corporation is divided into a number of shares.

Example 2:

Multiform Toys PLC was registered on 1 st April 20*0 as a public limited company, the objective
being to manufacture a wide range of children toys. The promoters need £ 100,000 to launch the
company. They offer for sale 100,000 £1 ordinary shares to the public, and agree themselves to
subscribe for 25,000 shares. If we assume that all shares have been issued and paid for on 1 May
20*0, the balance sheet will be as follows:

Multiform Toys PLC Balance sheet AT 1 May 20*0

Share Capital £ 100,000 Bank balance £ 100,000

36
The promoters are now shareholders together with those members of the public who have
subscribed for the shares. The liability of the company to the shareholder amounts to £ 100,000,
and the company has £ 100,000 cash to pursue its objectives.

The effect of the entity concept in the case of an incorporated business is to recognize the
separate identity of the company from that of the shareholders. The shareholders themselves are
not liable for the debts of the company, and their liability is limited to the £ 100,000 which they
have subscribed.

b. The Money Measurement Concept

Both trade and accounting existed before the invention of money, which we know began to
circulate in the 6th Century B.C. Its role as a common denominator, by which the value of assets
of different kinds could be compared, encouraged the extension of trade. By Roman times,
money had become the language of commerce, and accounts were kept in money terms. Hence
there’s an accounting tradition which dates back some 2,000 years of keeping the records of
valuable assets and transactions in monetary terms. It is not surprising therefore, that accounting
information today reflects the time –hallowed practice of dealing only with matters capable of
expression in money.

The monetary measurement concept sets an absolute limit to the type of information
which may be selected and measured by accountants, hence limits the type of information which
accountants may communicate about a business enterprise.

Example 3:

37
The Solidex Engineering Co Ltd is a long-established Co which specializes in the production of
a single component used in the manufacture of mining gear. The balance sheet at 31 st December
20*0 reveals the following position:

The Solidex Engineering Co Ltd

Balance sheet at 31st December 20*0

Fixed Assets £ £

Land and Buildings 30,000

Equipment 25,000

55,000

Current Assets

Stock 30,000

Bank Balance 15,000

45,000

100,000

Share Capital 100,000

100,000

For some time, it has been known that a competitor has developed a better product and
that the company is likely to lose its market. The managing director is ill, the production
manager and the accountant are not on speaking terms and the labour force is resentful about the
deterioration in working conditions in the factory. The buildings are dilapidated, but the land
itself is valuable. The equipment is old and needs a great deal of maintenance and as a result,
there is considerable wastage of labour hours because of machinery breakdown.

38
 It is clear from the foregoing example that the most significant information of interest to
shareholders is not what is contained in the balance sheet but the information which is left out ,
which is much more relevant to an understanding of the firms position. Yet the accountant is
unable to measure and communicate that information to shareholders directly in money terms,
although all these facts may explain poor profit figures. The reader of the financial accounting
report should not expect, therefore that all or perhaps even the most important facts about the
business will be disclosed, and this is why there is such a premium on the inside information in
order to make correct assortments of a firms true position. One of the major problems of
accounting today is to find means of solving the measurement problem: how to end the quality
and the coverage of information in a way which is meaningful. The advantage of money terms is
that the layman is able to grasp the meaning of facts which are stated in money, and it remains
the obvious standard of measurement.

There are further problems associated with the practice of using money as a standard of
measurement in accounting. Money does not have a constant value through time nor does the
value of specific assets remain the same in relation to money. Until recently, accountants turned
a blind eye to this problem by assuming that the money standard did have a constant value. The
rising rates of inflation in the 1960s and 70s destroyed this fiction.

Financial accounting records have two distinct and important purposes. First they provide
evidence of the financial dimensions of rights and obligations resulting from legal contracts. For
this purpose these records must be kept in the form of unadjusted money measurements.
Secondly, they are used as a basis for providing financial information to shareholders, investors
and a variety of users who need such information for decision making. For this purpose money
measurement must reflect the economic reality of business transactions and for this reason must
be adjusted for changes in price levels.

The Going concern Concept

The valuation of assets used in a business is based on the assumption that the business is a
continuing one, not on the verge of cessation. This concept is important: many assets derive their
value from their employment in the firm, and should the firm cease to operate the value which

39
could be obtained for these assets on a closing-down sale would probably be much less than their
book value.

Example 4:

The Zimbabwe Gold Mining Co Ltd has been mining gold for many years. Its assets consist of a
mine-shaft half a mile deep which enables the company to reach the gold reef, small-gauge
railway tracks and trucks within the mine, lifting gear, conveyor belts, crushing plant and sundry
equipment. The balance sheet as at 1st April 20*0 shows the following position:

The Zimbabwe Gold Mining Co Ltd

Balance sheet as at 1st April 20*0

Fixed assets £ £

Mine shaft 500,000

Land and buildings 25,000

Plant and Equipment 200,000

725,000

Current assets

Tools 15,000

Gold in transit 50,000

Bank balance 10,000

75,000

800,000

Owners Capital

Share Capital 500,000

40
 Retained profit 300,000

800,000

The mine shaft was sunk originally with the money raised by the issue of shares and the other
assets were financed out of loans which were repaid out of profits which were not distributed to
shareholders. In terms of the entity convention the total indebtedness of the company to
shareholders is, therefore £ 800,000- which is the amount they might expect to receive if the
company ceased to operate. For the time being, apart from £ 60,000 in gold or cash, their interest
is substantially the mineshaft and the plant and the equipment amounting to £ 700,000. If the
gold reef ceased to be economically workable and the mine had to be abandoned, the mine shaft,
being purely a hole in the ground, would become valueless, as would most of the plant. Hence, it
is unlikely that shareholders would get back even a fraction of their investment.

The going concern concept underpins the historical cost values shown in the balance
sheet. To abandon this concept would imply that assets should be valued on a realizable value
basis. In recent years, the concept has been extended to include the survival of the enterprise for
the foreseeable future.

c. The Cost Concept

Accountants calculate the value of an asset by reference to the cost of acquisition, and not
by reference to the value of the returns which are expected to be realized. Hence, the value in use
of assets which the going concern concept maintains is the cost of acquisition. To the accountant,
the difference between the value in use and the cost of acquisition of an asset is profit:

Value in Use -- Cost of Acquisition = Profit

Example 5:

W. E Audent & Son is a firm of chartered accountants with a large audit practise. Its
major asset is the staff of audit clerks. The value in use of the staff may be calculated by
reference to the hourly rate at which their services are charged out to clients; the cost of securing

41
their services to the firm is represented by their salaries; and the annual profit of the firm is the
difference, less the administrative expenses of running the firm.

In accounting, cost is used as a measure of the financial ‘effort’ exerted in gaining access
to the resources which will be deployed in earning revenues. Since these resources are secured
through financial transactions, the financial effort is measured at the time of acquisition, which
coincides with the legal obligation to pay for these resources in money. The cost concept raises
the following problems:

1. The historical cost of acquisition of assets is not a dependable guide to their current value
because it fails to reflect:
a) Changes in the general purchasing power of money
b) Changes in the specific value of individual.......

Assets in relation to money.

1. The historical cost of acquisition of assets used up in the activity of earning profit does
not form a dependable basis for calculating profits.
Example 6
John smith is a dealer in hides; he obtains his yearly supplies from Canada in the autumn,
and sells them in the United Kingdom during the ensuing 12 months. In October 2040 he
bought 2,000 hides at an average cost of $20 Canadian, equivalent to, let us says, $10,
and by September 2041 had sold them all at an average price of $20, making a profit of
$20,000. Meanwhile, the price of Canadian hides has increased by 50% so that to replace
stock he has sold during the year he will now have to pay an average of $ 15 a hide.
Hence, the profit of $20,000 is overstated by $10,000 because the hides sold have been
valued at $10 instead of $15 each which is their current value in Canada.
2. The accountability practice of writing off the costs of certain assets as depreciation
against revenue means that it is possible to remove the cost of these assets from the
accounts altogether. For a long time, for example, it was the practice of banks to reduce
the value of land and buildings to $ 1 and so create secret reserves.
3. Since incurring a cost depends upon a financial transaction, there are assets which create
profits for the firm which can never appear as such in the account often the major asset of

42
 highly successful firm is the knowledge and the skill created as a result of teamwork and
good organization. This asset will not appear in the accounts, since the firm has paid
nothing for it, except in terms of salaries which have been written off against yearly
profits. Allied to this problem is the failure to make any mention in the balance sheet of
the value of the human assets of the firm, long ago, the economist Alfred Marshall stated
that the most available of all capital is that invested in human beings (Marshall, 1964),
and it is universally recognized that the firm’s human assets are its chief source of wealth.
Yet, it is only recently that accounts have begun to recognize this fact, and efforts are
now being made to find ways in which information on the value of human assets may be
most appropriately presented. Other important assets of which no mention is made in
financial accounting statements are, for example, the value to the firm of its hold on the
market, which may be very valuable assets if the firm enjoys a monopoly position, and
the value of the firm’s own information system, which will affect the quality of its
decisions.
Many of the most controversial issues in financial accounting theory and practice
revolve around the cost concept. External users of financial statements basically wish to
have information on the current worth of the firm on the basis of which they many make
investment decisions. In order to make their balance sheets more realistic, many
companies carry some fixed assets, especially properties in their accounts at revalued
amounts.
The Realization concept
The realization concept is also closely related to the cost concept, for as the
recorded value of an asset to the firm is determined by the transaction which was
necessary to acquire it, so any change in its value may only be recognized at the moment
the firm realize or disposes of that asset. The realization concept reflects totally the
historical origin of accounting as a method for recording the results of transactions. To an
accountant there is no certainty of profit until a sale has been made; hence, increases in
value which have not been realized are not recorded as profit.
The realization concept is strongly criticized by economists. They argue that if an
asset has increased in value then it is irrelevant that it has not been said. For economists,

43
 it is sufficient that the gain in value could be realized for that gain to be recognized. The
realization concept, it is true may lead to absurd conclusions.
Example 7
William James and George Lloyd have bought a pair of dilapidated cottages in
Gluynedd for $50,000. They spent $20,000 on restoring cottages is so their total costs
amounts to $ 70,000. Cottages are identical and form part of one, unit that is, they are
semi-detached, the cottage were bought as part of speculative venture to make profit out
of the popularity of Welsh cottages as holiday homes. A businessman from Manchester
offers to buy both cottages for $100,000 each, but the parties decide to sell only one of
the cottages and to retain the other for sale at a higher price in the future.
From an accounting point of view, the cottage which is sold is recognized as being worth
$100,000, and the difference of $65,000 between the accounting cost and the sale price is
the realized profit. The second cottage which could also have been sold $100,000 to the
same man is recorded as worth being only $35,000being the costs associated with
acquiring and restoring it.
Unrealized gains in value are widely recognized by non- accountants. Bankers, who are
perhaps the most courtiers of people are prepared to lend money on unrealized values;
business people reckon as gains increases in the value of assets even though they are
unsold yet accountants will not do so unless and until a contract of sale has taken place
which creates a legal right to receive the agreed value of the asset sold.
As a result of the realization concept ,two classes of gains may be distinguished –
‘holding gains’, which are increases in value resulting from holding an asset and ‘trading
or operating gains’, which are gains realized as a result of selling assets. ‘Holding gains’
are not recorded, but ‘operating gains’ are not reported. The realization concept means, in
effect, that the reported profit of a business is only a part of the total increases in value
which accrue to a firm during an accounting period.
The realization concept does not require the accountant to await the receipt of
cash before recording a transaction. Indeed, in many cases the delivery of goods and the
receipt of cash occur after the legal agreement which determines the forming of the
transaction.
The Accruals Concept

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 The realization concept asserts that gains in value may not be recognized until
the occurrence of a transaction is reinforced by the accruals concept, which applies
equally to revenues and expenses.
The accruals concept makes the distinction between the receipt of cash and the right to
receive cash and the payment of cash and the legal obligation to pay cash, because in
practice there is usually no coincidence between cash movements and the legal
obligations to which they relate.

How does accruals concept apply to revenue?

Revenue may be declined as the right to receive cash and accountants are concerned with
recording those rights cash receipts may occur as follows;
1. Concurrently with the sale;
2. Before a right to receive arises;
3. After the right to receive has been created;
4. In error

The accruals concept provides a guideline as to how to treat these cash receipts and the right
related thereto.

Example 8

Mrs. Smith is an old lady who occupies a flat owned by mereworth properties ltd. The
rent is paid monthly in advance on the first day of each month and amount to $250 a
month. She is very forgetful and rarely does a month pass without some complication in
the payment of her rent.

On 1 January she sends her cheque for $250 for the rent for January. This rent is due and
payable to the company, and must be included as revenue for that month. On 10 January
Mrs. Smith sends another cheque for $250, thinking that she had not paid her rent for
January. This is a cash receipt to which the company is not at present entitled, and it must
either be returned to Mrs. Smith either to be returned to Mrs. Smith 105 kept on her
behalf for February rent. The company returns her cheque saying that she has already
paid her rent for January and receives this letter on 20 January. She forgets to pay her rent

45
 on 1 February. The accountant is obliged to include the rent due in February in the
revenue for that month, even though it is ultimately paid on 15 marches until Mrs. Smith
has paid her rent for February, she will be a debtor of the company for the rent owing.

Similar rules apply to the treatment of expenses incurred by the firm. Expenses may be
declined as legal obligations incurred by the firm to pay in money or money’s worth for the
benefit of goods or services which it has received , cash payments may occur as follows;

1. At the time of purchase;

2. Before they are due for payment
3. After due date for payment
4. In error

The accruals concept requires the company to treat as expense only these sums which are
due and payable. If payment is made in advance, it must not treated as an expense, and the
recipient is a debtor until his or her right to receive the cash matures. Cash paid in error is never
an expense and until it is recovered the person to whom it was paid is also a debtor. Where an
expense has been incurred, however and no payment has been made, the expense must be
recorded and the person to whom the payment should have been made is shown as creditor.

This concept is important as regards record keeping and the presentation of financial accounting
statements.

The matching concept

One of the important purposes of financial accounting is to calculate profit resulting from
transactions. This means identifying the gains resulting from transactions and settling off against
those gains the expenses which are related to those transactions. The realization concept
identifies the training of gains and the accruals concept enables the accountant property to record
revenues and expenses; neither however, helps the accountant to calculate profit. The matching
concept links revenues with their relevant expenses.

Example 9

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On 1 April cash and carry ltd purchase for resale 2,000 tins of bins at a cost of $5 a tin. The
selling price is $8 a tin. During the month of April 1,000 tins are sold. What is the profit for the
month which is attributable to these lines of goods?

We know that the expenses are 2,000 x $5 =$ 100, and that the revenue are 1,000 x $8 = 80. This
conclusion is nonsense because we are setting off against the sale proceeds of 1,000 tins of the
cost of acquiring 2,000 tins.

In accordance with the matching concept, the accountant establishes the profit for the month of
April by calculating the cost of purchasing 1,000 tins of beans and selling this expense against
the revenue realized from the sale of these tins.

Sales revenue 1,000 tins @$8= $ 80

Cost of sales 1,000 tins @ $5 = $ 50

Profits = $ 30

The 1,000 tins remaining unsold remain in the accounting records as assets, and when they are
eventually sold the profit from sales will be calculated by deducting the cost of acquisition from
the sales revenue realized.

The matching of revenue and expenses is sometimes a most difficult problem in accounting,
because many types of expenses are not easily identifiable with revenues.

Example 10

Bloxwich pharmaceutical co ltd manufactures and sells pharmaceuticals products. Its major
activity is the manufacturer of antibiotics, which accounts for 80% of its sales revenue. The
remaining 20% of its sales is derived from beauty creams. Its expenses for the year 2040 are as
follows:

Manufacturing of antibiotics $500,000

Manufacturing costs of beauty creams $ 20,000

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 Administrative costs 100,000

Selling and financial costs 50,000

Research and development costs 150,000

Total expenses for the year $ 820,000

In the same year, the total revenue from sales of both antibiotics and beauty creams amounts to
$1,000,000. Calculate the profits on the antibiotics side of the business.

We begin to answer this problem as follows;

Saves revenue from antibiotics (80% of total) $800,000

Manufacturing costs of antibiotics 500,000

300,000

Other expenses ?

Profit of antibiotics ?

Clearly we need more information in order to allocate the administrative, selling and
financial costs between antibiotics and beauty creams. It is unlikely that an exact allocation could
be made, and in the end an estimate would be made.

The research and development costs of new antibiotics and beauty creams are a more
different are a more difficult problem. Strictly speaking, we should not set these costs against the
revenue of the year, since the benefit will not occur in this year. Much of it, however, may not
lead to new products. Therefore, if we ignore this expenditure, the company’s reported profit will
be inflated and unrealistic.

From the foregoing example, it is seen that the exact matching of revenues and expenses is
often impossible. Nevertheless, the computation of periodic profit requires that the expenses

48
allocated where necessary, in order that the financial results may be stated in a consistent
manner.

The concept of periodicity.

The custom of making periodic reports to the owner of a business dates from the time when
wealthy men employed servants to manage and oversee their affairs. Periodic accounting has its
origin in the ideas of control, and company law sees the role of financial reports as being
essentially the communication of information from the managers of the business that is the
directors, to the owners of the business, that is the shareholders. However much we may disagree
with this view of relationship of directors and shareholders as being unrealistic, we must accept
that there is an element of shareholders control over directors which stems from the legal duty
laid on the latter to issue reports on their stewardship of the firm’s assets.

The concept of periodicity is now established by law as regards certain types of reports
such as balance sheet and profit and loss accounts. The companies act requires yearly reports to
shareholders, and the Income Tax Acts require accounts for all businesses to be submitted
annually. However, there is nothing to prevent companies from providing information at more
frequent intervals to investors, if they so wish.

Annual accounts have grown out of custom, and many would question the wisdom of
selecting an arbitrary period of twelve months as a basis for reporting upon the activities of a
business. The idea of annual reports is deeply entrenched and even the government runs its
business on a yearly basis and budgets for one year, although many of its activities are
continuing ones which cannot be seen correctly in the perspective of twelve months. This is also
issue for all large companies and mainly smaller businesses.

Example 11

Universal chemicals ltd manufactures a wide range of chemical products and has factories
throughout the country. Owing to unusually difficult labor relations, rising raw materials cost
and stiffening competition, its reported profit for the year ended 31 December 2040 has
decreased by 10% from that of the previous year. Its borrowing , however, have increased by

49
20% owing to an enlarged capital investments program which is designed to add substantially the
profit in about five years time.

Clearly, in this case the reader of the report for the year 2040 should consider the report in
context and look to the long term trend of profits and the better financial position which is
expected in the future. The concept of periodicity as expressed in yearly accounting fails to make
the important distinction between the long term trend and the short term position. Hence, it limits
the usefulness of the information communicated to shareholders and investors.

The matching and periodicity concepts seek to relate the transactions of one particular
year with the expenses attributable to those transactions from a practical point of view,
accountant carry focus and expenses until they can be regarded as the revenue of a particular
year in accordance with the realization convention . Since all assets become costs in accounting
the convention of periodicity creates difficulties with regard to the allocation of fixed assets as
expenses of particular years.

The concept of consistency

The usefulness of financial information lies to a considerable extent in the conclusions which
may be drawn from the comparison of the financial statements of on year with those of preceding
years, and the financial reports of one company with those of another company, it is in this way
that may be deduced some of the most important for decision making ,such as an indication that
there has been an improvement in profit since last year and that therefore it is worth buying more
shares ,or the profit of company A is better than that of company B and given current share
prices one should switch from holding shares in company B a nod buy those of company A.

The compatibility of financial statements depends largely upon the choice of accounting
methods and the consistency with which they are applied. A charge in the basis on which a firm
values stacks, for example, may result in profit figure different from that which would have been
computed had the accountant adhered to a consistent basis of valuation if firms wish to change
their method for treating a particular problems, such as the valuation of stocks as the value
attached to a particular asset, they may do so but they should mention the effect on the profit of
the charge in accounting methods.

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 Composing the accounts of different companies is much more difficult and unfortunately, the
accounting methods of individual firms are not always the same. There is no uniformity of
accounting methods which would provide the consistency of treatment of information necessary
for the comparison of the accounts of different companies. Whereas the accounting concept of
consistency is generally followed by individual firms, there is no agreement at all that different
firms should use the same accounting methods. Hence, the needs of investors for greater
comparability of information between companies is frustrated by accounting concepts which
insists on consistency , but allows different methods of measurements and treatment which
cannot yield comparable results. The accounting standards Board is charged with the task of
trying to secure agreement on appropriate accounting methods which will ensure a higher degree
of comparability of accounting information.

The concept of prudence /conservation

Prudence reflects accountant’s view of their social rule and their responsibilities towards
those for whom they provide information .it is seen at work in some of the concepts already
examined here, for example, the realization of a gain before it may be recognized and the cost
convention which holds that value of an asset is the cost of acquisition.

There are two principal rules which stem directly from the concept of prudence;

1. The accountant should not anticipate profit and should provide for all possible losses.
2. Faced with two or more methods o f valuing an asset the accountant should choose that
which leads to the lesser value.

These two rules contravene some accounting concepts for example the costs concept, for if
the market value of trading stocks has fallen below the cost of acquisition it must be valued at the
market value. Equally, the logic which underlies the realization concept as regards gains, that
there is no certainty of a gain until there is a sale, does not extend to the treatment of anticipated
losses. Thus, accountants provide for losses in value which are sufficiently foreseeable to make
them a present reality, on the basis that to ignore such losses might mislead the user accounting
information. One of the clearest explanations of the policy of prudence was made by GO May as
long ago as1946:

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 The great majority of ventures fail and the fact that enterprises nevertheless
continue is attributable to the incurable optimism (often disassociated from
experience) as well as to the courage of mankind. In my experience, also, losses
from unsound accounting have most commonly resulted from the hopes rather
than the achievements of management being allowed to influence accounting
dispositions. To me, conservations is still the first virtue of accounting and I am
wholly unable to agree with those who would bar it from the books of accounts
and statements prepared there from and would relegate it to footnotes.

Financial accounting standards

The financial accounting concepts already discussed were seen as core elements in the
development of a descriptive theory of financial accounting. The review of the concepts of
financial accounting which was conducted by the accounting profession in the 1970s, and which
has resulted in the publication of a series if financial accounting standards, is past of the ongoing
process of developing accounting practice by seeking consensus among practitioners .

The concepts allow a variety of alternative practices to coexist. As a result, the financial
results of different companies cannot be compared or evaluated unless full information is
available about the accounting methods which have been used. Not only have the variety of
accounting practices permitted by the conventions of financial accounting made it difficult to
compare the financial results of different companies , but the application of alternative
accounting methods to the preparation of the financial reports of the same company have
enabled entirely different results to be reported to shareholders.

The need for imposition of standards arose because of lack of uniformity existing as to the
manner in which periodic profit was measured and the financial position of the enterprise
represented. The purpose here is to examine the significance of the development of accounting
standards for descriptive theory of financial accounting based on concepts and consensus.

The importance of comparability

The information contained in published financial statements is especially important to

external users, such as shareholders and investors, for without such information they would have

52
to take decisions about their investments under considerable degree of uncertainty. A major
problem ids that there are no formal channels for communicating to companies the type and
nature of the financial information which the external users believe they may require and the
manner in which such information ought to be presented. Traditionally, parliament has assumed
the responsibility for legislation specifying the type and the minimum level of information which
companies should disclose, and the accounting profession has assumed the responsibility for
ensuring the proper presentation of such information. In this respect, it is evident that the
concepts applied to the presentation of financial information should not permit too much
discretion, and that the manner in which financial information is treated in financial statement
should contain to carefully considered standards.

The function of accounting standards maybes is examined by reference to the basic purpose
of financial statements, which may be stated as being concerned with the communication of
information affecting the allocation of resources. Ideally such information should make it
possible for investors to evaluate the investment opportunities offered by different firms and to
allocate scarce resources to the most efficient. In theory, this process should result in the optimal
distribution of resources within the economy and should maximize their potential benefit to
society.

In this analysis of the purpose of financial statements, it is apparent that one of the most
important criteria for the presentation of financial information is that which assures an
appropriate standard of comparison between different firms. The accounting methods used by
different firms for presenting information should allow appropriate comparisons to be made. For
example, they should not enable a company to report profits which result simply from a change
in accounting methods, rather than from increased efficiency. If companies were free to choose
their accounting methods in this way, the consequence might well be that deliberate distortions
would be introduced in the pricing of shares on the Stock Exchange, leading to eventually
misallocation of resources in the economy, This would occur because relatively less efficient
companies would be able to report victitious proeits, and as a result divest capital to themselves
on more favorable terms than those available to the more efficient companies which have
adopted rigorous accounting methods.

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Reasons for Concerns about Standards.

In the United Kingdom, the institute of Charted Accountants in England and Wales began to
make recommendations about accounting practices as early as 1942.Ultimately, a series of 29
recommendations on accounting practices were issued with the objectives of codifying the best
practices which ought to be used in particular circumstances .However, there were several
disadvantages to this procedure:

a. The recommendations were not mandatory, and were issued for the guidance of members
of the institute.
b. The recommendations did not result from fundamental research into the objectives of
accounting but merely codified existing practices.
c. The recommendations did not reduce the diversity of accounting methods. For example,
Recommendations No.23, 1960, which was concerned with stock Valuation, advocated
five different methods of computing the cost of stock. Furthermore, four of these methods
could be computed differently for partly and fully finished stocks. To complicate matters
further, Recommendation 22 stated that cost could be defined in three different ways.

In the late 1960’s, there was a spate of public criticism of financial reporting statements of a
number of companies. These included Perganon Press, General Electric Company and Vehicle
and General Company. The manner in which these cases jolted the accounting profession may be
judged from the example of General Electric Company.

In 1967, the General Electric Company (GEC) made a takeover bid for Associated Electric
Industries (AEI). AEI produced a profit forecast for that year for $10 million, which was based
on ten months actual profits and two months budgeted profit. The GEC takeover bid was
successful, and afterwards GEC reported that, in fact AEI had made a loss of $4.5 million for
that year.

According to GEC auditors, $9.5 million of the $ 14.5 million difference between the two
calculations of profits for 1967 was due to a difference in judgment about such matters as the

54
amounts written off stock and the amount of estimated losses. The angry reaction of the press to
the disclosure of the amended figures for 1967 centered on the fact that two accounting firms
could justifiably produce such widely differing results for the same year. One observer
commented that it appeared that accounting was really an art form and that it seemed that two
firms of accountants looking at the same figures were capable of producing profit figures as far
as apart as Rubens is from a Rembrandt.

The Accounting Standards Committee

The response of the accounting profession to this criticism was to establish the Accounting
Standards Committee. This was replaced in the 1990 by the Accounting Standards Board. The
prime objective of the Accounting Standards Committee was to narrow the areas of difference
and variety in accounting practice. The procedure used for this purpose was initiated by the issue
of an ‘Exposure Draft’ on a specific topic for discussion by Accountants and the public at large.
Comments made on the Exposure Draft were taken into consideration when drawing up a formal
statement of the accounting method to be applied when dealing with that specific topic. This
formal statement was known as a Statement of Standard Accounting Practice (SSAP). Once the
Statement of Standard Accounting Practice had been adopted by the accounting profession, any
material departure from the standard used in presenting a financial report was to be disclosed in
that report.

The following Statements of Standard Accounting Practice were issued:

SSAP 1 ‘Accounting for the results of Associated Companies’

SSAP 2 ‘Disclosure of Accounting Policies’

SSAP 3 ‘Earnings per Share’

SSAP 4 ‘The Accounting Treatment of Government Grants’

SSAP 5 ‘Accounting for Value Added Tax’

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SSAP 6 ‘Extraordinary Items and Prior Year Adjustments’

SSAP 8 ‘The Treatment of Taxation under the Imputation Systems in the Accounts of
Companies’

SSAP 9 ‘Stocks and Long term Contracts’

SSAP 10 ‘Statements of Source and Application of Funds’

SSAP 12 ‘Accounting for Depreciation’

SSAP 13 ‘Accounting for Research and Development’

SSAP 14 ‘Group Accounts’

SSAP 15 ‘Accounting for Deferred Taxation’

SSAP 16 `Current Cost Accounting (abandoned in 1988)

SSAP 17 `Accounting for Post Balance Sheet Events’

SSAP 18 `Accounting for Contingencies’

SSAP 19 `Accounting for Investment Properties’

SSAP 20 `Foreign Currency Translation’

SSAP 21 `Accounting for Lease and Hire Purchase Contracts’

SSAP 22 `Accounting for Goodwill’

SSAP 23 `Accounting for Acquisitions and Mergers’

SSAP 24 `Accounting for Pension Costs’

SSAP 25 `Segmental Reporting’

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The list of topics on which statements of Standard Accounting Practice were issued shows that
the work of the Accounting Standard Committee profoundly affected the development of
accounting theory and methods.

The earlier discussion here of the relationship between accounting concepts and accounting
methods implies matters of accounting policy. For this reason. SAP 2, which deal with the
disclosure of accounting policies, are highly significance provisions will now be examined in
detail.

SSAP 2 `Disclosure of Accounting Policies’

SSAP 2 is addressed to the relationship among accounting methods and accounting policies. The
relationship is illustrated in the following figure, where it is seen that accounting concept
provides the foundations to both accounting methods and policies.

Accounting Concepts

Accounting Bases

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 Accounting policies

SSAP 2 defines accounting concepts, accounting bases and accounting policies as:

a. Fundamental accounting concepts are broad general assumptions which underlie

the periodic financial accounts of business enterprises.

b. Accounting bases are the methods which have been developed for expressing as
applying fundamental accounting concepts to finance transactions and items. By
their nature, accounting bases are more diverse and numerous than fundamental
concepts. Since they have evolved in response to the variety and complexity of
types of business and business transaction and for this reason, there are many
justifiably exist more than one recognizes accounting basis for dealing with
particular items.

c. Accounting policies are the specific bases judged by business enterprise to be

most appropriate to their circumstances and adopted by them for the purpose of
preparing their financial accounts.

SSAP 2 states that there four fundamental accounting concepts which should be regarded
as established standard concepts. They are:

a. The going concern concept, which implies that the enterprise will continue in
operational existence, for the foreseeable future. This means, in particulars, that

58
 the profit and loss account and balance sheet assume no intention as necessarily to
liquidate or reduce significantly the scale of operation.

b. The accruals concept, which requires that revenue and costs are accrued, matched
with one another so far as their relationship can be established as justifiably
assumed, and dealt with in the profit and loss account of the period to which they
relate, provided, generally, that where the prudence concept, the latter prevails.
The accruals concept implies that the profit and loss account reflects changes in
the amount of net assets that arise out of the transactions of the relevant period,
other than distribution as subscriptions of capital. Revenue and profits dealt with
in the profit and loss account are matched with associated costs by including in
the same account the cost incurred in earning them, so far as these are material
and identifiable.
c. The consistency concept, which requires that there should be consistency of
accounting treatment of like items within each accounting period and from one
period to the next.
d. The concept of prudence, which requires that the revenue and profits are not
anticipated, but recognized by inclusion in the profit and loss account only when
realized in the form either of cash as of assets(usually legally enforceable
debts),the ultimate cash realization of which can be assessed with reasonable
certainty; provisions should be made for all known liabilities(expenses and
losses)whether the amount of these is known with certainty as is a best estimated
in the light of the information available.
In December 1999.the Accounting Standards Board issued an Exposure Draft which is intended
to replace SSAP.The most significant proposed change is that the Exposure Draft emphasizes
comparability rather than consistency and links prudence to reliability rather than to realization.

SSAP 2 is concerned with ensuring that accounting bases are disclosed in financial reports,
whenever significant items are shown which have their significant in value judgments, estimated
outcome of future events or uncompleted transactions rather that ascertained amounts. In the
words of SSAP 2,

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 In circumstances where more than one accounting basis is acceptable in principle, the
accounting policy followed, can significantly affect company`s related results and
financial position, and the view presented can be properly appreciated only if the
principal policies followed are also described. For this reason, adequate disclosure of the
accounting policies should be regarded as essential to the fair presentation of financial
accounts.

Concern that the public receive further information about the risks of business failure led the
Cadbury Committee,in1992,to recommend additional disclosure relating to the going concern
concept.Furthermore,the Auditing Practices Board,in1994,issued a statement of Auditing
Standards(SAS 130)which provides guidance for auditors in respect of their consideration of the
going concern basis. According to this standard, auditors should perform procedures specifically
designed to identify indications that the going concern concept basis may not be valid. They
should also obtain a statement from the directors confirming their considered view that the
company is a going concern. In forming an opinion on whether the company is a going concern,
the auditors should look ahead one year from the date of the directors’ approval of accounts.

The Accounting Standards Board.

The Accounting Standards Board (ASB) replaced the Accounting Standards Committee in 1990;
following the review of the standard-setting process under the chairmanship of Sir Ron Dearling
(1988).This report suggested wide ranging changes to the formulation of accounting standards.

At the first meeting the ASB unanimously agreed to adopt the 22 extent SSAPs issued but the
ASC.However, they made it plain that they were going to work from principles which, in due
course may make some of these SSAPs in need of substantial change. The ASB’s consultative
process includes: first the issue of Working Drafts for Discussions(DDS);these then became
Financial Reporting Exposure Drafts (FREDs);and result in the publication of Financial

60
Reporting Standards(FRSs).The following Financial Reporting Standards have so far been
issued:

FRS 1`Cash Flow Statement’ (supersedes SSAP 10).

FRS 2`Accounting for Subsidiary Undertakings’ (supersedes SSAP 14)

RFS 3`Reporting Financial Performance’ (supersedes SSAP6 and SSAP 3)

RRS 4`Accounting for Capital Instruments’

FRS 5`Reporting the Substance of Transactions’

FRS 6`Acquisations and Mergers’ (supersedes SSAP 23)

FRS 7`Fair Values in Acquisition Accounting’

FRS 8`Related Party Disclosures’

RFS 9`Associates and Joint Ventures’ (supersedes SSAP 1)

RFS 10`Goodwill and Intangible Assets’ (supersedes SSAP 22)

RFS 11`Impairement of Fixed Assets and Goodwill’

RFS 12`Provisions, Contingent Liabilities and Contingent Assets’ (supersedes SSAP 18)

RFS 13`Derivaties and Other Financial Instruments: Disclosure’

RFS 14`Earning per Share’ (supersedes SSAP 3)

RFS 15`Tangible Fixed Assets’ (supersedes SSAP 12)

RFS 16`Current Tax’ (supersedes SSAP 8)

FRSSE`Financial Reporting Standards for Smaller Entities’

As previously noted, in the area of accounting standard setting, there is an increasing demand for
uniform standards that apply internationally.Consequently,the international dimension plays a
prominent part in shipping the Board`s agenda.

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 The ASB has accepted the argument that there should really be only one way of
accounting for similar transactions throughout the world…unless we disagree with the
International trend we try to align our standards closely to those of the International
Accounting Standards Committee (Tweedie, 1999).

Almost all the Board`s recent work on new standards has been concerned with international
harmonization.

Standards and the Companies Acts

There are legal requirement which apply to the financial reporting proceedings of companies and
the manner in which financial accounting information must be disclosed in the profit and loss
accounts and balance sheets. Two aspects of this requirement are directly related to the
accounting concepts and standards considered here.

First, the four fundamental accounting concepts of SSAP 2 have become enshrined in law by the
Companies Act 1981.Final accounts prepared within the terms of this Act must follow this
concepts. Second, since 1948 all final accounts prepared for the purpose of compliance with the
Companies Acts have been required to give a `true and fair view’, an obligation described as
`overriding’. This implies that if the final accounts are to contain information which is sufficient
in quantity to satisfy the reasonable expectations of users then they should be prepared in
accordance with the concepts and standards formulated by the accountancy profession. Third, the
Companies Act 1989 introduced a requirement to state whether the accounts have been prepared
in accordance with applicable accounting standards and give details of, reason for, any material
departures.

The Generation of Financial Accounting Data.

Earlier was examined the nature and the boundaries of the financial accounting system. We
noted that the concepts of financial accounting constituted one of the boundaries as so far as they
act as a filtering process for the data which is fed into the financial accounting system. We
concluded that these concepts played a crucial role in determining the nature of financial
accounting information.

62
Here we examine the processes involved in the generation of financial accounting data prior to
its transformation into accounting information.

An Outline of the Information Generation Process.

The output of financial accounting information is the result of a process involving the following
stages;

a. the preparation of source documents;

b. the entry of basic data into the source records;
c. the posting of data from the source records into the ledges, which is a permanent
record of data.
The production of financial accounting information in the form of reports is illustrated below:

Source Documents-invoices, etc

Source Books

Ledger

Financial Reports

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Although the principles underlying the financial accounting system remain unchanged, its
processes have undergone and are continually undergoing modification and improvement. In
particular, technologies change has dramatically affected these processes. The advent of the
computer has considerably speeded up and streamlined the data recording process, and indeed,
has permitted the integration of several stages of this process into a single operation.

Source Documents

Financial accounting data originates in transactions; Source documents capture the details of
these accounting events. They also have a very important functional purpose as regards the
activities of an enterprise.

Data flows are generated by a business and classified according to their sources.

1. Financial accounting data flows are generated from activities conducted between the firm
and external groups such as customers and suppliers of materials, goods, services and
finance.
2. Data flows generated internally constitute a substantial volume of the total information
flows.

These flows are generated and channeled through a management information

system(IMIS)the functions of which is to meet the needs of management for the purpose of
planning and control. Accounting data plays a focal role in relation to the firm`s basic
operation, as well as the nature of the source documents involved in the generation of
financial accounting data.

64
 Source Documents Related to Sales

The functions of the sales department is to encourage the sales of the firm`s products. Once a
salesperson has concluded a sale with a customer, s/he completes a sales order form. The original
is sent to the customer as an acknowledgment of the order, and in the case of a credit sale, one
copy of the sales order form goes to the credit control department for approval. If the goods are
in stock, the credit control department will pass the authenticated sale order form to the stock
control department so that the release and dispatch of the goods may be effected. An advice note
sent to the customer when the goods are dispatched advising the date of are normally
accompanied by a delivery note stating the description of the goods and the quantity involved
though not the price. The customer acknowledges receipt of the goods by singing the delivery
note.

When the goods have been released by the stock control department for dispatch, a further copy
of the sales order stating the date of dispatch is sent to the sales invoice section of the accounts
department, so that the sales invoice may be prepared. The sales invoice states the nature,
quantity and price of the goods ordered and the amount due to the firm from the customer.
Customers are normally to pay within one or more months, depending on the agreed credit
terms.Often,however,customers are required to pay on receipt of the invoice, though some firms
issue statement each month showing the number of invoices sent to the customer during the
month and the total sum due in respect of the month`s orders.

The copy sales invoice is the source document which provides data which will be recorded in the
financial accounting system.

The sales order form is used, therefore, for the following purpose:

1. As a record and confirmation of a sale, one copy of the sales order form will be kept by
the sales department.
2. As a means of initiating a procedure for checking the creditworthiness of a customer prior
to proceeding with the completion of the orders.

65
 3. As a document authorizing the release of the goods from stock. One copy of the sales
order will be retained by the stock control department.
4. As a means of checking and dispatching the right goods to the right customer by the
dispatch department. One copy of the sales order is kept by the department for this
purpose.
5. As a means of preparing the sales invoice which will state the amount due from the
customer. One copy of the sales order will be retained by the accounts department.
Where goods are not kept in stock, but are manufactured to order, the receipt of an order
puts the production process in motion. A copy of the production manager and one copy to
the accounts department, which is responsible for collecting all the costs associated with
the manufacture of the goods ordered. The materials required may be obtained either
from existing stocks or by purchase. Where the requirement materials are held in stock,
the issue of a materials requisition form to the stock control department will procure the
release of these materials. One copy of the materials requisition form will be retained by
the stock control department and one copy will be sent to the accounts for costing
purposes. Where the required materials have been purchased, the production department
issues a purchase requisition form to the purchasing department.

Sources Documents Related to Purchases.

The purchasing department obtains raw materials, equipment and supplies needed by the firm,
each request is made on a requisition form stating the nature and the quantity required, which is
signed by an authorized person. The purchasing department selects a suitable supplier and sends
a purchase order form setting out the description, quantity and required delivery date of the
goods, together with instructions as regards dispatch and invoicing. The purchase order will refer
to the price quoted of the goods according to the supplier`s catalogue or other statement of the
supply price, although quoted prices in advertisement are not binding on supplier. In effect, the
purchase order form is an offer to purchase and when accepted by the supplier constitutes a legal
contract between buyer and seller copies of purchase order are distributed to the several
department concerned, namely the receiving department which need to know the details and the
date of receipt of the goods, the stock control department to advise of the pending arrival of

66
goods and to serve as a check on the receiving department, the accounts departments for
checking that the price quoted compares with the price list, and the ordering department, to
confirm that the order has been placed.

Sources Documents Related to the Receipt of Goods.

Upon delivery of the goods, the receiving department verifies that the goods delivered compare
in every detail to the copy purchase order. When they agree, a good received note is prepared
which details the description of the goods received, their quantity, quality and conditions. A copy
of the goods received note is sent to the department concerned with the audit of the receipt of
goods, which is usually the purchasing department. A copy is also sent to the accounting
department and the department responsible for the order. The stock control department is also
notified because it is responsible for the storage, distribution and control of stocks. The stock
control department maintains records of stocks, and ensures that adequate stock levels are
maintained.

In due course, the supplier sends an invoice stating the description, quantity and price of the
goods ordered, the date of acceptance of the order, which is usually shown as the date of
despatch of the goods, and the amount now owing. The invoice is checked by the accounts
department against the goods received note, and if there are no queries then the invoice is cleared
for payment in due course.Normally,invoices are paid monthly. This permits the workflow in the
accounting department to be efficiently organized and allows the payment procedure to be
properly supervised.

The Entry of Basic Data in the Source Books

The accounting record of the events described in the source documents begins with the issue of
receipt of invoices. Although legal obligations are created with the acceptance of an order, either
by the firm of its supplier, for practical reasons, these obligations are not recorded until they are

67
formally stated. Should there be any dispute, however, about existence of an order, the
appropriate source document provides evidence of that order.

The practice of keeping daily records of accounting events in a diary or rough book date from the
early history of accounting. The practice of keeping a daily journal was recommended by Paciolo
in 1494 for the purpose of enabling the business.

Sman to check daily the records kept by his clerks. Once agreed they could be entered into the
ledges. It became a golden rule in accounting that no entry should appear in the ledger which has
not first been entered in the journal.

At first the journal was used to record all commercial transactions. They were entered in a
chronologically and showed the details of these transactions as well as the ledgers account to
which the entry was ultimately posted, as shown below.

1. The date of the transaction,

2. The name of the purchases as the assets purchased
3. The name of the seller as the assets sold.
4. The sum involved.
5. A short narrative describing the transaction.

Date Journal description Folio Debit Credit

5th Jan Goods Dr L5 100
To A. Smith being L7 100
100 shirts bought for
resale
5th Jan B Jones Dr L10 5
To cash 5
Being wages due to the
week ending 5th Jan

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Periodically, the entries in the journal were transacted to the main record, described as the
ledgers, by a procedure known as posting. The folio references in the journal indicated the pages
in the ledger to which the postings were made.

As trade expanded and the number of transactions increased, it became the practice to group the
entries to be made in the journal into the following cases:

1. Purchases of trading goods on credit

2. Sales of trading goods on credit
3. Cash receipts and payments
4. All offers transactions

This classification enabled entries of like nature to be kept together, and facilitated the operation
of entering data into the source books. It led to the division of the of the journal into four parts
which were renamed as follows

1. The purchases day books, in which were entered credit purchases.

2. The sales day book, in which were recorded credit sales.
3. The cash book, in which were recorded all cash transactions.
4. The journal proper, in which were recorded transactions which could not be recorded in
the after source books. The journal proper has been retained as a book of original entry
for such transactions

THE DAY BOOKS

Since the bulk of the source documents relate to the purchase or sale of goods, the function of
the purchases and sales day books is to allow such data to be collected and posted to the
ledger. An example of a purchases day book is given below:

Purchase day book

Date Name Invoice No Folio

1st June S. Smith 101 L15 50
2 W. Wright &Co 113 L20 35
2 J. James 148 L10 140

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 3 T. Tennant 184 L16 20
3 Transferred to 245
purchase
account

The posting of the purchases day book to the ledger is effected by crediting the account of
each supplier with the value of the goods supplied and transferring the total value of all the
purchases in the period to the purchase account. The details entered in the day books are
obtained from the invoice which are filed and kept.

The sale day book is written up in the same manner as the purchases day book, except that
the source document is a copy of the invoice sent to the customer.

THE CASH BOOK

Only cash transactions are entered in the cash book, the purpose of which is to record all
receipts and payments of cash. The cash book has a dual role, being a journal and a ledger
account.

As the practice grew of using cheques for the settlement of business debts, so the cash book
came to reflect this practice, and to record all payments out of and into the firms’ bank
account.

Unlike the day books, the cash book records receipts and payments side by side, so that flows
in and out are together and their impact on the balance may be readily seen. At the end of the
accounting period, the cash book is reconciled with the books statement which explains why
any differences between the balance recorded in the cash book and that recorded by the bank.
The difference is due to the time lag between the posting of a cheque to a creditor and its
clearly through the bank, delays in clearing cheque paid in bank charges and direct payment
into and out of the bank.

Where transactions take place in cash as well as by cheques, and cash discounts are given
and allowed the cash book is given extra columns, and becomes known as a three column

70
 cash book. The transfer of cash in and out of the bank account is recorded as well as the
receipts and payments by cheques as follows:

CASH BOOK

Date Details Foli Discount Cash Ban Date Detail Foli Discount Cash Bank
o allowed k s o s
received
Jan Balance 01 50 800 1 B. L3 7 103
1 Jan Brow
n
1 Sales L15 60 1 purch L14 20
ases
s1 W.White L9 5 95 1 cash 20
1 Bank 20

The explanation for some of these entries is as follows:

1 Jan B. Brown – this represents the payment of an account owing to Brown amounting to
ksh 110 which was settled by the payment of ksh 103, the balance being in the forum of a
discount which was received.

2 Jan W. White – this represents the receipt of a cheque of ksh 95 in settlement oa an amount
owning of ksh 100, a discount of ksh 5 being allowed.

1Jan Bank - this represents a cash cheque drawn on the bank for ksh 20. The corresponding
payment of cash by the bank is shown on the other side of the cash book.

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 For security reasons, few firms like to keep large sums in cash about their premises and cash
takings are banked daily. Moreover, it is sound practice to use cheques for the settlement of
debts, so that there is generally no need to keep cash on hand beyond relatively small sums.
All firms therefore, tend to have a petty cash box to meet any immediate need for cash, for
example enabling a secretary or porter to take a taxi to deliver a document or to buy a small
article which is urgently required.

The cashier is usually entrusted with the petty cash box and any payments must be claimed
by means of a petty cash voucher signed by an authorized person, who is usually a head of
department. The cashier is given a cash float which may be, says Kshs. 50 and pays out petty
cash only against petty cash vouchers, which are retained. As the petty cash float does eases,
so petty cash vouchers of an equivalent value accumulate in the petty cash box. In due
course, the vouchers are checked or audited and the petty cash paid out is refunded to the
cashier, hereby restarting the petty cash float to its original sum.

DIVISION OF THE LEDGER

A firm large enough to divide its journal into day books and cash books with probably also
need to divide its ledger. The sale ledger (or debtor’s ledger) contains all the personal
accounts of the firm’s customers. The purchases ledger (or creditor’s ledger) contains all the
personal accounts of the firms’ suppliers. The nominal ledger (also general ledger or private
ledger) contains the rest of the firm’s accounts. The main reason for dividing the ledger is
that it allows several people to be engaged in the recording process and permits
sectionalization of the work around these groups of accounts.

DATA PROCESSING AND DOUBLE – ENTRY BOOK KEEPING

As previously dissolved, financial accounting date has it’s source in a signal records of
financial transactions. Two very important aspects of data generation were noted. First, when
reporting to external users, accounting information is presented usually in a form which is
concerned with the monetary aspect of a firm’s activities. Second, accounting conventions
play a determining role as regards the nature and quality of the data which is processed.

Here we examine the structure which has evolved for handling financial accounting data.

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 THE ACCOUNTING EQUATION

Financial accounting is based on a single notion known as the accounting equation. The
accounting equation depicts the equality which exists between the resources owned by the
enterprise and the claims against the enterprise in relation to those resources.

One side of the accounting equation expresses, in monetary terms the resources held by the
enterprise. These resources are known as ‘assets ‘. The acquisition of assets by the enterprise
will have been financed by funds provided either by the owner(s) or from borrowings. The
funds provided by the owner(s) constitute the capital of the enterprise. The funds borrowed
constitute liabilities and are known as such. Therefore, the other side of the accounting
equation describes how the acquisition of the assets has been financed and the claims which
exist against the business result,

The accounting equation may be stated as follows:

Capital + Liabilities = Assets

The concept underlying the accounting equation is that the enterprise itself is a vehicle
through which assets are held and utilized, end that claims exist against those assets to their
full monetary valu given that liabilities arising from borrowing are stated as legal debts of
determined monetary sums, the owners of the enterprise are entitled to the balance of the
assets after liabilities have been settled accordingly, the accounting equation may be used to
express capital as follows:

Capital = Assets – Liabilities

It follows that the balance sheet is founded on the accounting equation, for it is a list of assets
held by the enterprise against which is set a list of the claims existing against the enterprise. Both
lists are equal in total.

TRANSACTIONS AND THE ACCOUNTING EQUATION.

Given that the balance sheet indicates the financial position of an enterprise at a given point
in time, successive transactions would maintain the accounting equation on which the balance

73
sheet rests, though its dimensions and constituent elements would vary. It is possible to record
the effects of successive transactions on the balance sheet equation.

TRANSACTION 1.

Refurnishing to the example cited earlier, where J. Soap invested Kshs.10,000 on 1 st April
20X0 in a ladies hairdressing business, on 1st April 20X0 the opening transaction would be
shown as follows:

Balance sheet 1.

Kshs. Kshs.

Capital 10,000 Assets: Bank balance 10,000

The manner in which the subsequent transactions affect the balance sheet through the
accounting equation may be seen from the following example:

TRANSACTION 2.

J. Soap paid the monthly rent for the business amounting to Kshs. 500. This is an expense of
the month which will ultimately be taken into account in determining the profit or loss foor the
period. Since the profit made, or loss suffered, in effect aligments or diminishes the funds
contributed to the business by the proprietor, the expense may be interpreted as a temporary
reduction in proprietorship equity which must be offset against revenue earned in order to
measure the net increase or reduction in proprietorship equity resulting from trading operations.

From the point of view of the accounting equation, therefore, the effect of the transaction on the
balance sheet is to reduce cash by Kshs. 500, and at the same time reduce the capital by the same
amount. The balance sheet after this transaction would appear as:

Balance sheet 2.

Kshs. Kshs.

Capital 9,500 Assets: Bank balance 9,500

TRANSACTION 3.

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 J. Soap purchased equipment for Kshs. 2,000 from Hairdressers’ Supplies ltd on credit. As a
result, a new asset appears on the balance sheet as the equipment, and a liability of Kshs. 2,000
appears in respect of the amount owing. The balance sheet now appears as follows:

Balance sheet 3.

Kshs. Kshs.

Capital 9,5000 Assets: Equipment 2,000

Liability : Bank balance 9,500

Creditor 2,000

11,500 11,500

It will be noted that, although the balance sheet totals increase by Kshs. 2,000, there is no change
in the capital of the business. Instead, the balance sheet shows that the equipment purchase has
been financed by a liability of exactly that amount.

TRANSACTION 4.

J. Soap paid wages amounting to Kshs. 200 in cash for part time assistance. This is an
expense of the month, and its effect on the balance sheet is to reduce cash by Kshs. 200 and the
capital by the same amount. The balance sheet now appears as follows:

Balance sheet 4.

Kshs. Kshs.

Capital 9, 300 Assets: Equipment 2,000

Liability: Bank balance 9,300

Creditors 2,000
11,300
11,300

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 TRANSACTION 5

J. Soap’s revenue from clients for April amounted to Kshs. 1,500 of which Kshs, 1,400was
received in cash. Revenue earned from sales will ultimately be compared with costs and
expenses incurred in order to ascertain the change in proprietorship equity resulting from
operations in the period. therefore, the effect of these transactions is to increase the capital by
Kshs. 1,500 and to increase cash at bank with Kshs. 1,400. The amount outstanding of Kshs. 100
requires a new asset account to be opened – debtors- in the sum of Kshs. 100. The balance sheet
now appears as follows:

Balance sheet 5.

Kshs. Kshs.

Capital 10, 800 Assets: Equipment 2,000

Liability: Debtors 100

Creditors 2,000 Bank balance 10,700

12,800
12,800

TRANSACTION 6.

J. Soap withdraws the sum of 400 pounds in cash for his own use. The effect of this withdrawal
is to reduce capital by 400 pounds and cash by the same amount. The withdrawal of cash from
the business is the reverse of the first transaction in which J. Soap invested in the business.
Consequently, the capital account is reduced by the amount of the withdrawal. The balance sheet
now stands as follows:

Balance Sheet 6
Pounds Pounds
Capital 10400 Assets; Equipment 2000
Liability Debtor 100
Creditor 2000 Bank balance 10300
12400 12400
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Simplifying the recording of transactions
The process of drawing up a new balance sheet after each transaction would be extremely
cumbersome in practice, given the large number of transactions which an enterprise may conduct
daily. The problems are threefold: First, how to calculate the effects of successive transactions in
terms of the profit they have generated? Such a calculation would explain why there occurred an
increase in the capital from an original amount of #1000 to #10800, prior to the withdrawal made
by J. Soap. Second, how to reflect the investment of the owner, J. Soap, in a convenient manner?
Such a calculation would involve summarizing the effects of transactions on the capital account
as it stands at the end of the accounting period. Third, how to device a system of recording
transactions which avoids the necessity of drawing up successive balance sheets?
The first problem is resolved by summarizing all transactions associated with the profit-
earning process during the period in a statement known as the profit and loss account. Unlike the
balance sheet, which states the financial position of the enterprise at different points in time, the
profit and loss account seeks to establish the success or failure of the enterprise as the result of
transactions over a period of time.

The preparation of the profit and loss account involves identifying the revenues of the period,
and the expenses which may properly be charged against those revenues. In the example of J.
Soap above, the successive balance sheets for the month of April, which resulted in the capital
account from pounds 10000 to pounds 10800 by balance sheet 5, may be summarized by a profit
and loss account for April 20X0 as follows:
J. Soap- Ladies’ Hair dresses Profit and loss account for April 20X0
pounds Pounds
Revenue 1500
Expenses
Rent 500
Salaries 200 700
Net profit for April 800

77
 The second problem, namely, portraying the investment of the owner of the business at the
close of the accounting period, involves using both the profit and loss account of the period and
the balance sheet at the close of the period. In this respect, the profit and loss account and the
balance sheet complement each other. The profit and loss account summarizes the operating
results between successive balance sheets, and these results are reflected in the capital shown on
the closing balance sheet. The factors which have affected the amount of the owner’s capital at
the date of the closing balance may be summarized in a detailed statement of the capital account
as regards the example of J. Soap given above, the analysis of the capital account would be
shown on the closing balance sheet as follows:

J. Soap – Ladies’ Hair dresses Capital account as at 30 April 20X0

Balance/ April 20X0 pounds Pounds 10000
Net profit for April 800
Less: Drawings 400 400
Balance, 30 April 20X0 10400

The third problem, that of devising a system of recording transactions which avoids
drawing up successive balance sheets, was resolved centuries ago by the invention of the system
of double-entry book keeping.

The nature of double-entry book keeping

The collection and recording of data is called book keeping. The practices of recording
financial data in ‘books’ dates from a very long time ago. These books were usually ‘bound-
books’- bound so as to prevent the possibility of fraud by either the insertion or the removal of
pages. Nowadays, mechanical and electronic data processing have frequently removed the book
keeper as a person concerned with entering the results of financial transactions into the books.
The double-entry system of bookkeeping; however, remains the basis for record keeping,
regardless of whether or not a firm employs advanced data- processing techniques, mechanical or
manual methods. It is therefore, the logical method for recording financial information, and as
such the basis of financial accounting practice.

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 The term ‘double entry ’ adds a special meaning to the process of book keeping. It is a
method of recording financial data as transactions involving flows of money or money value
between different accounts, in which an account is designated for each accounting item. The
entries recorded on the successive balance sheets of J. Soap for April 20X0 would appear in a
double – entry book keeping system.A

TRANSACTION 1

The initial investments of Kshs. 10,000 cash by J. Soap in the ladies’ hairdressing business
is shown as a fllow of money from the capital account to the cash book, as follows:

Capital Cash book

flow out flow in
to Kshs10,000

Business transactions are represented in double-entry book keeping as flows of money as

money value between the various accounts concerned, but clearly any one transaction involves
only one flow, as shown above. In order to identify the direction of any one flow, all accounts
are divided into two parts. A flow out of the account is recorded on the right-hand side, and a
flow into an account is recorded on the left-hand side. Hence, the transaction shown above would
appear as follows:
Capital Cash book
flow out flow in K$.
to 10,000

Flows out could conveniently be described by a minus sign, but the accounting convention
which dates from the Italian origins of book keeping utilizes the term credit (Cr.), which means
‘to give’. Likewise, flows in could be described by a positive sign, but the accounting appellation
is debit (Dr.) which means ‘to owe’. Hence, this additional information may be inserted in the

79
accounts to identify the direction of the flow, and replacing the arrow which we have used up to
now.
Capital account cash book
C Dr
r
Kshs. Kshs.
10,000 10,000

There are now only two additional items of information which are required to identify the
transaction which are required to identify the transaction flow, namely, the point of origin and
the point of destination. These, too, are made easy in book keeping by the simple expedient of
describing in the credited account where the flow has gone, and by inserting in the debited
account the source of the flow.
Capital account cash book
C Dr
r
Cash Kshs. Capital Kshs.
10,000 10,000

In practice, accountants know very well that the left hand side of an account is the debit side, and
the vice versa for the right hand side, so that they do not head up the accounts with Dr or Cr. In
the old days, they used to add the word BY on the narration of credit entries, and TO on the
narration of debit entries- but this too is unnecessary, and most accountants have abandoned the
practice.
Lastly, the date of the transaction must be recorded, and it is done as follows:

Capital accounts.

Yr(20X0) Kshs Yr(20X0) Kshs.

1 April cash 10,000

Cash book

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Yr(20X0) Kshs. Yr(20X0) Kshs

1 April capital 10,000

To simplify the exposition of the double entry booking keeping system in the examples which
follows, the dates will be omitted.

In the manner in which transactions are recorded under this method, an important feature may
have been noticed- the flow has remained constant in value as it has moved from the credited
account to the debited accounts as a result, double entry book keeping possesses a mathematical
foundation which has its logic in the simple proposition that as regards any transaction the credit
must be equal to the debit at any time, therefore the arithmetical precision of the book keeping
process may be checked by adding up all the debit entries. If the total debit entries do not equal,
that is balance with, the credit entries, there has been an error in the recording process. A trial
balance is the means whereby accountants check for arithmetical errors in recording transactions.
If the trial balance shows a difference as little as 1 pound between the total credits and the total
debits, the error must be found. This is because accountants know that the result of a great many
cumulative errors may boil down to a difference of only 1 pound.

Double entry book keeping is logical and precise system for recording financial
transactions as flows of monetary as money value. It is easy to operate, and adapt to modern
computers methods by using positive and negative electric charges to signal whether an account
should be debited or credited.

TRANSACTION 2.

The payment of Kshs. 500 rent by J. Soap is interpreted as flow of money from the cash book
to the rent account. It reduces cash by Kshs. 500 and appears as an increase in the balance shown
in the rent account by Kshs. 500. The rent account is an expense account which will be
transferred later for the purposes of calculating the net profit for April. The entries will appear as
follows:

Cash book

Folio Kshs. Folio Kshs.

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 Rent 500

Rent account.

Folio Kshs. Folio Kshs.

Cash 500

TRANSACTION 3.

The purchase of equipment on credit for Kshs. 2,000 by J. Soap from Hairdressers’ Supplies
Ltd does not yet involve the payment of cash, but requires the debit owing to Hairdressers’
Supplies Ltd to be shown. This is effected by crediting the account of Hairdressers’ Supplies Ltd
with Kshs. 2,000. Therefore, the firm acquires a liability in order to acquire an asset. The entries
would be as follows:

Hairdressers’ Supplies Ltd account.

Folio Kshs. Folio Kshs.

Equipment 2,000

Equipment account.

Folio Kshs. Folio Kshs.

Hairdressers’ Supplies Ltd 2,000

TRANSACTION 4.

The payment of Kshs. 200 as wages is another example of an expense account. Note that in the
case of such an accounts, the person receiving payments are not named on the accounts
themselves. Separate records would be kept in the form of wage book, rent book, e.t.c. this
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transaction decreases cash by Kshs. 200 and increases wages by the same amount. The entries
would be as follows:

Cash book.

Folio Kshs. Folio Kshs.

Wages 200

Wages account.

Folio Kshs. Folio Kshs.

Cash 200

TRANSACTION 5.

The treatment of the revenue generated from the sale of hairdressing services involves two
problems. Firstly, the cash sales involving the receipt of cash amounting to Kshs. 1,400 are
entered directly as follows.

Sales book.

Folio Kshs. Folio Kshs.

Cash 1,400

Cash book.

Folio Kshs. Folio Kshs.

Sales 1,400

The treatment of credit customers is rather more complex. First, the individuals concerned are
shown in the debtors’ ledger. The total amount of credit sales during the month of Kshs. 100
appears in a summary account. The entries are as follows:

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Sales account.

Folio Kshs. Folio Kshs.

debtors 100

Debtors account.

Folio Kshs. Folio Kshs.

Sales 100

The payments made by debtors during the month totaled to Kshs. 1,400, leaving an amount
outstanding of Kshs. 100 at the end of April and shown as follows:

Kshs. Kshs.

1,500 Cash 1,400

Sales 1,500 Balance 100

1,500

TRANSACTION 6

J. Soap withdrew Kshs. 400 for his personal use. This transaction, which reduces his capital
account by Kshs. 400 could be entered directly as follows:

Capital account.

Folio Kshs. Folio Kshs.

Cash 400 Cash 10,000

Debtors account.

Folio Kshs. Folio Kshs.

84
Capital 400

The effect of this transaction would be to reduce the capital account by Kshs. 400 to Kshs. 9,600.
This reduction could be shown as follows:

Capital account.

Kshs. Kshs.

10,000 Cash 10,000

Cash 400

Balance c/d 9,600

10,000

Balance b/d 10,000

In order to minimize entries in the capital account in respect of regular withdrawals by the
owner of a business, the normal practice is to show them in a separate drawings account. At the
end of the accounting period, the drawings account is transferred to the capital account, so that
only one entry is made in respect of drawings. Using the drawings account, the withdrawal of
Kshs. 400 would be shown as follows:

Drawings account.

Folio Kshs. Folio Kshs.

Cash 400

85
 Cash book.

Folio Kshs. Folio Kshs.

Drawings 400

The capital account illustrates a technical operation known as balancing an account. Where
there is more than one entry in an account, the net effect of transactions affecting that account
may be determined by calculating the balance of the amount. This is the difference between the
sum of the credit entries and the sum of the debit entries. In the case of the capital account the
um of the credit entries exceeds the sum of the debit entries. The balance is described as a credit
balance. A debit entry is made in the account for the balance, which is said to be carried down
(C/d); a credit entry is made on the next line to record the amount of the balance brought down
(b/d) and to preserve the principle of double entry.

DOUBLE-ENTRY BOOK KEEPING AS A ‘CLOSED’ SYSTEM.

The term system is commonly used to mean any unit which may be identified as an
independent whole, having its own objectives and its own internal functions. An ‘open’ system
is one whose behavior is affected by external factors. The British economy for example, is an
‘open system’ because it is affected by its trading relationships with the rest of the world. A
‘closed’ system is one in which all the functions are internalized in the system, and are not
affected by outside factors. Double entry book keeping has the characteristics of a closed system
in that all the transactions recorded takes place within the accounts system. By this we mean that
all flows resulting from transactions are depicted as having their origin in an account which is
found in the system and they have their destination in another account the system .it is
impossible for a flow to originate from an account outside the accounts system.

Example 1

Let us go back to the example given above .j soap opens a business under the name of j soap-
ladies hairdresser. He invests 10000 in cash into business .The effect of the entry convention is
that j soap opens and keeps separate books for the business of j soap –ladies hairdresser which is

86
regarded as a separate entity from j soap himself .Double –entry bookkeeping gives expression to
the entity convention since all the accounts of j. soap –ladies hairdresser relate only to the
financial transactions of that business. soap himself is an external party as far as the business is
concerned.

The question is _how can we depict the flow of 10000 from j soap into the business and now we
have said that no flow may originate from the outside accounts system. Hence, we must have an
account within the accounts system where it has originated .That account is the account of j. soap
himself in his capacity as the owner of the business ,which we described above as the capital
account .The source of flow of 10000 is therefore found in the capital account and its destination
is the cash account

Capital account

Ksh 20X0 Ksh

1 April 10,000

20X0 Ksh &

1 April cash 10,000

Let us suppose for a moment that on 2 Neril j soap decides that he has put too much money in
the business and wishes to take out n3000 .in the accounts system ,the transaction could be
shown as follows;

87
 Capital account

20X0 Ksh
Ksh

2 April cash 3,000 1 April cash

10,000

Ksh
Ksh

20X0 20X0

1 April capital 10,000 2 April cash 3,000

The significance of these entries reflects the fact that accounting is not concerned with the
ultimate destination of the actual sums of money, but simply with portraying the full transaction
as a record of the flow of money. Successive entries are made in accounts which have been
opened, and where a transaction involves a new account then that account is opened. Likewise, if
an account is no longer needed it I closed.

The implications of these statements as far as book-keeping being a closed system of accounts
are:

1. The book-keeping system of any firm is infinitely elastic in size. As many accounts are
opened as are necessary to record in full the transactions which have taken place. It is not
surprising therefore, that large businesses have many thousands of accounts.
2. All the accounting flows of money or money value take place between the various
accounts found in the system. The accounts system, therefore, consists of a set of
interlocking accounts.

88
 3. The accounts themselves represent realities-whether they are persons or assets involved
in transactions.
4. Firms are continually involved in transactions; this activity is mirrored in the constant
flow of money and of money value in the accounts systems.
5. Since all the flows have both their source and their destination in the accounts to be found
in the system, the total debits and the total credits remain equal at all times. If this is not
so, there are one or more errors.

Accounts as descriptions of transactions

The accounts system is used to describe the direction of a flow of money or of money value as
well as the timing of the flow. Business transactions affect a firm in different ways; some are
concerned with the acquisition of assets to be used in earning profits, others concern the supply
of finance to the firm, either by the owner or by lenders, others relate to goods purchased or sold
to persons so that the exchange of goods expressed as money value creates rights or liabilities in
money terms and others yet relate to revenues and costs.

If a firm is to make any sense of the large number of accounts kept, some grouping is necessary,
so that accounts of the same business nature are kept together. The integration of accounts into
groupings enables the accountant to extract information with much greater ease. For example, to
find out how much is owed to persons by the business, the accountant has to merely go to the
accounts of creditors. This term means that such persons have been the source of a flow of
money or of money value to the firm and have not been repaid. Likewise, the debtors’ accounts
are referred to, to find out how much is owing to the business by those people who have received
money or money value and have not settled their accounts.

Transactions frequently involve two or more different classes of accounts.

Example 2: J Soap supplies hairdressing services to Mrs. B Brown to the value of €20 on 1
April 20*0.in the accounts of J. soap, the transaction will be shown as a flow of money value
(goods) from the sales account, which is a nominal account, to Mrs. B Brown’s account, which
is a personal account. Nominal accounts contains all of the items that are transferred to the profit
and loss account and so include items such as sales, purchases, wages and expenses.

89
Sales account

€
20*0
1 April Mrs. B. Brown

Mrs. B. Brown account

20*0 €
1 April sales
20

Since mars brown has received services from J. soap, she is a debtor to the account of € 20.at the
end of the month. soap will sent her a statement showing that €20 is due for payment. Mrs.
Brown sends her cheque for €20 which will be banked on 1 may. This is shown as another
transaction, the settlement of a debt, as follows:

Mrs. B. Brown’s account

€ €
20*0 20*0
1 April sales 1 May cash 20
20

Cash book

€ €
20*0
1 May Mrs. Brown 20

90
Thus this transaction is one between a personal account and a real account. At this point, two
interesting observations may be made:

1. A credit transaction is a flow of money value to or from a personal account, and involves
the creation of a debt towards the business, or a liability against the business. Hence, the
use of the terms debtor and creditor respectively to denote the nature of such legal rights
and obligations.
2. The payment of any liability involves another accounting transaction which records the
flow of money from or to the appropriate personal account to or from the cash book. In
this connection, the cash book records all the money flows through the firm’s bank
account.

The mathematical implications of double entry book keeping

As already noted, the arithmetical accuracy of the entries made in the accounts may be verified
by means of a trial balance which involves comparing the total debits with the total credits.

During any accounting period, there may have been several entries in an account, so that several
debits and several credits may be shown. A simple calculation may be made to calculate the net
balance, for the purposes of the trial balance itself, and to ascertain the net state of the account.

Example 3

In the foregoing example several cash transactions took place, during the month of April, as
follows:

Cash book

€ €
Capital 10,000 Rent 500
Sales 400 Wages 200
Debtors 1000 Drawings 400
If we wish to ascertain the balance on the cash book, the procedure for so doing is simply to add
up both sides of the account and to calculate the difference. The difference is the balance.

91
Cash book

€ €
Capital 10,000 Rent 500
Sales 400 Wages 200
Debtors 1000 Drawings 400
Balance 10,300
11,400 11.400
This balance represents the excess of the debits over the credits and it indicates that the bank
balance is €10,300 in hand. In order to show this fact in the account after it has been balanced,
the balance is brought down as a debit balance.

Cash book

€ €
Capital 10,000 Rent 500
Sales 400 Wages 200
Debtors 1000 Drawings 400
Balance c/d 10,300
11,400 11,400
Balance b/d 10,300
Balancing the accounts is the first stage in preparing the trial balance. Some accounts will have
debit balances and others will have credit balances when we compare the total balances, they
should be equal.

The trial balance

The trial balance is a list of balances extracted from all the accounts arranged in such a way that
the debit balances is listed on one side and the credit balances on the other side.

Example 4

The following trial balance was extracted on 30 April 20*0 from the balance of J, soap-----ladies
hairdresser:

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 Debit balances credit balances
€ €
Capital account on 1 April 20*0
10,000
Drawings 400
Cash 10,300
Rent 500
Wages 200
Equipment 2000
Sales 1500
Debtors 100
Creditors 2000
13,500 13,500

The trial balance not only secures to act as a check on the arithmetical accuracy of the book
keeping process but is a summary of the balances of all the accounts, which servers as a working
paper in the course of pre passing financial statements. It is noted that in the process of
summarizing information for the for the purpose of trial balance, the personal accounts of the
debtors and the creditors have been totalled. The trial balance will not reveal the following type
of errors;

1. Errors of omission where a transaction has been completely overlooked.

2. Errors of principles where an amount Is correctly recorded but it is placed in the wrong
account for example where the purchases rather than under equipments.
3. Errors of commission, where an amount is correctly recorded in the correct class of
accounts but is entered in the wrong account for example where a sale of pounds 50 to
mr brown is entered in Mrs Browns account.
4. Errors of originalentry where the transaction is recorded in the wrong amount for
example where a sale to mrs brown of goods to the value of 20 pounds is recorded as 2
pounds in the sale journal;
5. Errors in recording the direction of the flow although the correct amount is recorded for
example instead of being shown as a debit to the cash book and a credit to mrs B Brown’s
account it is shown as the other way round.
6. Compensating errors which cancel each other out will not be revealed. Thus an error in
adding up the trade creditors will not be revealed
93
Example 5

Fairburn is a retailer and on 1 january 20X0 his assets were;

Cash on bank 686

Stock on trade 916

Furniture and fittings 396

Sundry debtors Grime 36

Spear 78

Murta 52

It is only liabilities were to the following suppliers;

Windle 24

Naik 42

The following transactions took place during January

Event January

1 1 sold goods to spear on credit 248

2 5 paid wages 24

3 6 bought goods on credit from winlde 300

4 8 crime settled his account

5 9 paid the amount owing to Naik

6 10 cash sales 128

7 13 paid wages 28

8 17 bought goods for cash 150

9 18 paid Windle the balance on his account

10 19 bought a new office desk for cash 64

11 20 paid wages 34

12 23 cash sales 220

94
13 24 paid office expenses 6

14 25 spear paid on account 50

15 26 cash sales 168

16 27 paid wages 30

17 30 cash sales 60

Required

Enter these transactions in fairburn’s accounting records and test the arithmetical accuracy of
your work by preparing a trial balance at 31 january 20X0.

Solution

Bank account

Ksh Kshs
Balance b/d 686 2 wages 24
4 Grime 36 3 Naik 42
6 sales 7 wages 28
12 sales 220 8 purchases 150
14 spear 50 9 Windle 324
15 Sales 168 10 fittures and fittings 64
17 Sales 60 11 wages 34
13 office expenses 6 16 wages 30
Balance c/d 646
1,348 1,348
Balance b/d 646

Capital account

Balance c/d 2,098 2,0

98

Balance b/d
2,098

Fixtures and fittings account

95
 Balance b/d 396

10 bank 64 Balance c/d 4600

4600 460
0

Sales account

1 spear 248

6 bank 128

12 bank 220

15 bank 168

Balance c/d 824 17 bank 60

824 824

Balance b/d 824

Wages account

2 bank 24

7 bank 28

11 bank 34

16 bank 30 Balance c/d 116

116 116

Balance b/d 116

Purchase account

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 3 windle 300

8 bank 150 Balance c/ d 4 50

450 450

Balance b/d 450

PG 69,

Office expenses account.

Ksh Ksh

(13) Bank 6 Balance c/d 6

6 6

Balance b/d 6

Grime’s account.

Ksh Ksh

Balance b/d 36 (14) Bank 36

Spear’s account.

Ksh Ksh

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Balance b/d 78 (14) Bank 50

(1) Sales 248 Balance c/d 276

326 326

Balance c/d 276

Murta’s account.

Ksh Ksh

Balance b/d 52 Balance c/d 52

Balance b/d 52

Windler’s account

ksh Ksh

(9) Bank 324 Balance b/d 24

(2) Purchases 300

324 324

98
Naik’s account.

Ksh Ksh

(5) Bank 42 Balance b/d 42

FAIRBURN TRIAL BALANCE AS AT 31.1.20X0.

Ksh Ksh

Debit (Dr.) Credit (Cr.)

Bank 646

Capital 2,098

Stock 916

Fixture and fittings 460

Sales 824

Wages 116

Purchases 450

Office expenses 6

Debtors – Spear 276

2,922
Murta 52

2,922

DOUBLE- ENTRY BOOK KEEPING AND PERIODIC MEASUREMENTS.

99
 We previously examined the double entry method as a means of recording financial
transactions as flows of money as of money value. It was disclosed* that firms are continually
involved in transactions, and that this activity is mirrored in the double-entry book keeping
process by the constant flow through the accounts system of the money as money values
involved in those transactions.

The accounts system is merely a repository of financial date about transactions. To be

meaningful, this date must be extracted from the accounts system and organized in such a way
that it is useful to those who need information for decision making. The concept of periodicity
represents the view that, although the activities of a firm continue through time so that the
decisions taken at one point in time can not be separated from their effects whenever they
materialize, these activities should nevertheless be regularly reported on. In other words, the
financial health of a business should be tested at periodic intervals. The concept of periodicity
poses problems in adapting the data recorded in the accounts system so that it will correctly
reflect the results of the transactions included in the selected period, and the financial health of
the firm at the end of that period. the two accounting statements employed for this purpose are
the profit and loss account for the year, and the balance sheet at the end of the year.

We here examine the preliminary stages in the preparation of these statements.

PROBLEMS IN PERIODIC MEASUREMENT

It should be noted that not only the transactions of a period should be identified but also that the
expenses attributable to those transactions should be matched with the revenues derived from
them in accordance with the matching concept.

The first major problem, therefore, in adapting the information recorded in the accounts system
has a two fold aspect, i.e to identity;

1.The revenues attributable to transactions during the year,

2. The expenses related to those revenues.

The second major problem concerns adjustments which must be made in order to arrive at a
measure of the surplus or deficit of revenues over the expenses. These adjustments involve an
element of judgment, for example, how much to provide for depreciation and bad debts, and
100
what adjustments to make in respect of expected losses, such adjustments are made because the
end product is a statement of the profit or loss made in the accounting period.

IDENTIFYING THE REVENUES AND EXPENSES OF THE PERIOD.

The data recorded in the accounts system provides the basis for identifying the revenues and
expenses of an accounting period. Firstly, we need to extract from the accounts system the data
recorded in respect of all the transactions concluded in the period. the summary of all the
transactions is obtainable by means of a trial balance drawn up on the last day of the accounting
period.

EXAMPLE 1: The following trial balance was extracted from the books of John Smith on 31 st
December 20X0, being the end of the first year of trading.

Kshs. Kshs.

Debit (Dr.) Credit (Cr.)

Capital 25,000

Motor Vehicles 10,000

Fixture and fittings 2,500

Purchases 31,000

Bank balance 6,000 98,500

Sales

Debtors 18,000

Creditors

Rent 4,500

Salaries 22,800

Insurances 400 70,000

Motor Expenses 2,000

101
 Light and heat 1,000 3,500

General expenses 300

98,500

The meaning of revenue and expense.

The trial balance does not distinguish between flows of profit and flow of capital, neither does it
make a distinction between expenditures incurred to earn revenue and expenditure on the
acquisition of assets. The first problem is to identify the revenue of the year, and this is a matter
of definition. By revenue we mean the flows of funds, that is money or rights to money, which
has resulted from the trading activities of the business as distinct from funds (capital) invested by
the owner as loan made by creditors and others. In this case, the only revenue item shown on the
trial balance is from sales amounting to Kshs. 70,000.

The second problem is to identify the expenses are defined as the cost of running the business
during the accounting period. in contrast capital expenses are the costs incurred in acquiring
fixed asssets or adding to the profit-earning structure of the firm. The calculation of periodic
profit is by means of a formula which deducts expenses from revenues:

Periodic profit = revenue – expenses

Looking at the trial balance the expenses of the year, as defined are as follows:

102
 Kshs.

Purchases 31,000

Rent 4,500

Salaries 22,800

Insurances 400

Motor expenses 2,000

Light and heat 1,000

General expenses 300

An alternative definition of expenses is that adopted by accountants, who treat as expenses all
those costs the benefit of which has been used up during the year. Looking at the expenses which
we have identified in the trial balance, it is clear that the benefit derived by the firm from
expenditure on those items is limited to the accounting period. the only exception is the goods
purchased which have not been sold by the end of the year, a problem to be dealt with later.

We have completed therefore, the first stage in periodic measurement by identifying the
revenues and expenses attributable to the profit- earning transactions of the firm during the year,
which we may list as follows:

Kshs. Kshs.

Purchases 31,000 Sales 70,000

Rent 4,500

Salaries 22,800

Insurance 400

Motor expenses 2,000

Light and Heat 1,000

General expense 300

103
 PERIODIC MEASUREMENTS AND THE ACCRUALS CONCEPT.

The next task of the accountant is to ensure that the revenues and expenses are attributable to the
accounting period. it is the normal practice to record in the expense accounts only those amounts
actually paid during the period. as a result, at the end of the period, these amounts may be
understated or overstated . likewise it is also possible that there may be some outstanding
revenue due to the business, other than sales revenue, which must be brought into the year’s
profit.

The governing principle which affects these adjustments is the accruals concept. The accruals
concept makes a distinction between the receipt of cash and the right to receive cash, and the
payment of cash and the legal obligation to pay cash. As there is often no coincidence in time
between the creation of legal rights and obligations and the transfer of cash, it follows that the
accountant must scrutinize the revenue and expenses account to make sure that amounts due and
payable accrued. Similarly, payments made in advance must be excluded and carried forward to
the next accounting period. the adjustments are effected in the accounts themselves.

An accrued expense is a cost that has expired during the accounting period, but has not been
recognized in the accounts. Accrued expenses often include salaries, interest, business rent, taxes
and other expenses. In the case of an accrued expense, both an expense and a liability exist at the
end of the accounting period without having been recorded in the books. The nature of the
problem becomes clear when we look at some examples.

The accrual of income.

At the end of an accounting period, the total sales revenue will have been recorded in the
accounts system, and the amounts unpaid by customers in respect of these sales will have been
recorded under sundry debtors. The outstanding income which may not already have
been recorded is limited, therefore, to income other than sales, such as rent
receivable, commissions receivable, etc. The accountant must adjust his end-of-year
figures so as to include all the income to which the business is legally entitled, even
though it has not been received.

Example 2

On 1 December 20X0, John Smith had sublet a portion of his premises which had
never been utilized for a monthly rent of £ 60 payable in advance on the first of each
month. By 31 December 20X0, the date on which the trial balance was extracted, the

104
rent receivable had not yet been received. To accrue the rent receivable, the
accountant must enter the amount accrued in the rent receivable account as follows:

Rent Receivable Account

20X0 £

31 Dec Accrued 60

This amount is taken to the profit and loss account as profit for the year 20X0.

£ £

20X0 20X0

31 Dec Profit & Loss Account 60 31 Dec Accrued c/d 60

20X1

1 Jan Accrued b/d 60

It is a puzzle that rent receivable should be a credit. The reason is that the rent
receivable account is used to denote the source of funds so that there is a flow out
from the rent receivable account into the cash account. Let us assume that on 1
January 20X1, the rent outstanding is paid. The entries would be as follows:

Rent Receivable Account

20X1 £ 20X1 £

1 January Accrued b/d 60 1 January cash 60

20X1 £

1 January rent receivable 60

In adjusting the receipts for the year so that they will correctly show the income of the
year, the accountant accrues income not yet received, as we have seen above, but also
carries forward to the following year any receipts of the current year which are the
income of the following year.

If, however, there has been an omission of income from the accounts of the preceding
year, and this income is received in the current year, it would not be practical to go
back and adjust the accounts of the previous year. These accounts will have been

105
closed at the end of that accounting period. The accountant will include last year’s
income in the current year’s account, and indicate that it was an omission from last
year, or explain how this income arose. Adjustments of this nature often arise out of
the settlement of legal disputes or compensation claims.

The Accrual of Expenses

The accrual of expenses occurs much more frequently than the accrual of income, for
it is the nature of things that firms delay the payment of expenses. As a result,
nominal accounts such as rent, insurance, wages, light and heat, etc have to be
adjusted to show the total payments due and payable in respect of the accounting
year. Occasionally, however, firms are obliged to pay in advance for services, so that
there is a possibility that a portion of the payment relates to the next accounting
period. Accordingly, the accrual of expenses involves two types of adjustments:

1. An accrual in respect of expenses of the year which have not yet been paid;

2. An exclusion from the recorded expenses of that part which relates to the
next year.

Example 3:

Let us return to the trial balance extracted from John Smith’s books. We are informed
that:

1. The yearly rent is £ 6,000 payable quarterly. The rent of £ 1,500 payable on 1
December had not been paid.

2. Insurance premiums paid amounting to £ 400 included a payment of £ 50 in

respect of a new policy taken out on 31 December 20X0.

It is clear, therefore, that the legal obligation in respect of the rent is understated in
the rent account by £ 1,500. Equally, the insurance premiums applicable to the year
ended 31 December 20X0 amount to £ 350 not £ 400. It is necessary to adjust these
accounts as follows:

1. To increase the rent chargeable as an expense by £ 1,500.

2. To decrease the insurance chargeable as an expense by £ 50.

Underpayment of Rent: Rent Account

20X0 £

I February Cash 1,500

106
1 May Cash 1,500

1 August Cash 1,500

The amount which should be charged against the income for the year ended 31
December 20X0 is £ 6,000. The rent unpaid at 31 December 20X0 may be accrued as
follows:

Rent Account

20X0 £

1 February Cash 1,500

1 May Cash 1,500

1 August Cash 1,500

31 December Accrued 1,500

Having made this adjustment, the rent account for the year ended 31 December 20X0
may be closed by transferring the rent of £ 6,000 to the profit and loss account for the
year ended 31 December 20X0. The rent unpaid is a liability to the firm on 31
December 20X0, and is shown by bringing down the amount accrued as a credit
balance on the rent account. The adjusted rent account will appear as follows:

Rent Account

20X0 £ 20X0 £

1 February 1,500 31 December Profit & Loss a/c 6,000

1 May 1,500

1 August 1,500

31 December c/d 1,500

6,000 6,000

20X1

1 January Accrued b/d 1,500

We note the rent outstanding at 31 December 20X0 is £ 1,500, and we have brought
this amount down to show:

1. That there is a credit balance outstanding at 31 December 20X0;

107
 2. That on 1 January 20X1 there is an outstanding liability in respect of the
previous year, so that firm will have to pay £ 7,500 during the year ended 31
December 20X1. The trial balance on 31 December 20X0 may now be
adjusted as follows:

£ £

Rent 6,000

Rent Accrued 1,500

If the firm pays the rent outstanding on 2 January 20X1, and thereafter pays the rent
on due date, the rent account for the year 20X1 will appear as follows:

Rent Account

20X1 £ 20X1 £

2 January Cash 1,500 1 January Accrued b/d 1,500

1 February Cash 1,500 31 December Profit& Loss a/c 6,000 1

May Cash 1,500

1 August 1,500

1 December 1,500

7,500 7,500

Prepayment of Insurance

For certain services, payments are made before the associated benefits are received,
i.e. the payment is made in advance. In these cases an arithmetic apportionment of
the amount paid must be made between the two consecutive accounting periods.

Let us assume that the insurance premiums were paid in advance as follows:

1 January 20X0 £ 350

31 December 20X0 50

£ 400

These transactions will be shown in the insurance account as follows:

20X0 £

1 January Cash 350

31 December Cash 50

108
The premium paid on 31 December 20X1 is the prepayment for an expense for the
year ending 31 December 20X1. Hence, it cannot be shown as an expense for the year
ended 31 December 20X0. Thus the purpose for the adjustment is:

1. To measure the expense applicable to the year ended 31 December 20X0, and
to transfer this amount to the profit and loss account for that year;

2. To carry forward the premium paid in advance to the following year. The
adjusted account will appear as follows:

Insurance Account

20X0 £ 20X0 £

1 January Cash 350 31 December Profit & Loss a/c 350

31 December Cash 50 31 December Prepaid c/d 50

400 400

20X1

1 January Prepaid b/d 50

It may be noted that the insurance prepaid at 31 December 20X0 is brought down by
a debit balance on 1 January 20X1, and as a result:

1. There is a debit balance in favour of the firm on 31 December 20X0;

2. The firm will not have to pay the premium of £ 50 in the subsequent year, if the
yearly premium is only due and payable on 1 January each year.

The trial balance on 31 December 20X0 may now be adjusted to read as follows:

£ £

Insurance 350

Insurance Prepaid 50

Assuming that the firm pays the insurance premium in the following year on the due
date, the insurance account for that year will be as follows:

20X1 £ 20X1 £

1 January Prepaid b/d 50 31 December Profit & Loss a/c 400

1 January Cash 350

400 400

109
The Results of the Accrual Adjustments

It will be recalled that the trial balance is merely a working paper which the
accountant uses to extract the information which he requires from the accounts
system, and to check its accuracy. We may alter the original details shown on the first
trial balance to reflect the adjustments which we have so far made.

Example 4:

The adjusted trial balance for John Smith’s business as at 31 December 20X0 may be
as follows:

£ £

Dr Cr

Capital 25,000

Motor Vehicles 10,000

Furniture and Fittings 2,500

Purchases 31,000

Bank Balance 6,000

Sales 70,000

Debtors 18,060

Creditors 3,500

Rent 6,000

Rent Accrued 1,500

Insurance 350

Insurance Prepaid 50

Salaries 22,800

Motor Expenses 2,000

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Light and Heat 1,000

General Expenses 300

Rent Receivable 60

100,060 100,060

The effect of these adjustments on the revenues and expenses for the year ended 31
December 20X0 may be summarized as follows:

£ £

Purchases 31,000 Sales 70,000

Rent 6,000 Rent Receivable 60

Salaries 22,800

Insurance 350-

Motor Expenses 2000

Light and Heat 1,000

General Expenses 300

It will be noted also that the adjustments have given rise to the following balances on
the accounts:

£ £

Dr Cr

Rent Accrued 1,500

Insurance Prepaid 50

Rent Receivable 60

As these balances represent sums owing by the business and debts due to the
business, they will be shown as liabilities and assets respectively at the end of the
accounting period.

The Matching of Revenues and Expenses

The purpose underlying the accountant’s efforts to identify and correctly measure the
revenues and expenses of an accounting period is to attempt to match them so as to
obtain a measure of the ‘financial effort’ of earning the revenues of that period. The
matching of revenues and expenses is far more complicated than appears at first

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sight. So far, we have assumed that by correctly measuring the expenses and revenues
attributable to the accounting year they have been correctly matched. In other words,
we have made the assumption that the expenses of the accounting period are the
expenses related to the revenues of that period. The realization concept permits the
accountant to recognize only financial results in the form of sales revenues. It is well-
known that there is a time-lag between buying and or manufacturing goods for sale
and selling them. At the end of the accounting period, therefore, there will always be
goods awaiting sale and raw materials unused. The expenses attributable to unsold
goods and unused materials, usually described as stocks, must be excluded from the
expenses of the period and carried forward to the next accounting period, when the
goods will have been sold and the materials used. The importance of stock
adjustments to the correct measurements of periodic profit is crucial.

Example 5:

Mr Hancock’s trial balance at 31 December 20X0 included the following debits:

Rent 1,800

Business Rates 760

Light and Heating 1,180

Insurance 520

Rent of £ 600 for the last three months of 20X0 had not been paid and no entry had
been made in the books. Of the rates, £ 560 was for the year ended 31 March 20X1.
The remaining £ 200 was for the three months ended 31 March 20X0. In accordance
with the matching concept the rates included in the profit and loss account would be
£ 200 + (£ 560×3/4) = £ 620.

Fuel had been delivered on 10 December 20X0 at a cost of £ 30 and had been
consumed before the end of 20X0. The invoice had been received for this fuel in 20X0;
however, no entry had been made in the records of the business. £ 70 of the insurance
paid was in respect of insurance cover for the year 20X1.

The above information would be recorded in the following accounts which show
transfers to the profit and loss account for the year ended 31 December 20X0.

Rent Account

£ £

31 December Balance b/d 1,800 31 Dec Profit & Loss a/c 2,400

31 December Balance c/d 600

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 2,400 2,400

1 January Balance b/d 600

Rates Account

£ £

31 December Balance b/d 760 31 December Profit & Loss a/c 620

31 December Balance c/d 140

760 760

1 January Balance b/d 140

Light and Heating Account

£ £

31 December Balance b/d 1,180 31 December Profit & Loss a/c 1,210

31 December Balance b/d 30

1,210 1,210

Balance b/d 30

Insurance Account

£ £

31 December Balance b/d 520 31 December Profit & Loss a/c 450

31 December Balance c/d 70

520 520

1 January Balance b/d 70

Stock Adjustments

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By definition, the closing stock at the end of an accounting period is the residue of the
purchases of that period which remains unsold or unused:

Example 6

John Smith’s purchases account includes all goods purchased during the year ended
31 December 20X0. At the end of the year the stock of materials unused is quantified,
and its stock price is valued at £ 3,000. The accounting problems relating to this stock
are as follows:

1. Since the business has to pay for all goods purchased, it would be imprudent to
reduce the purchases account by the amount of stock at the end of the year.
Hence, the purchases account must not be adjusted and the total purchases
must be charged as expenses.

2. By charging all purchases against sales, however, the profit for the year would
be understated by £ 3,000. Means must be found, therefore, to take the closing
stock out of the calculation. This is effected by opening a stock account on 31
December 20X0 and posting the stock to it.

Stock Account

20X0 £

31 December 3,000

As soon as an account is opened for the purpose of recording a flow of value it is

necessary to describe the source of the flow and its destination. The purchases
account is not the source of the flow of stocks to the stock account, because we have
deliberately refused to adjust the purchases account. We need to value stocks in order
to calculate the profit or loss for the period. The accountant states that the stock
adjustment comes from the profit and loss account which is employed to measure
profit. The full entries are therefore as follows:

Profit and Loss Account for the Year Ended 31 December 20X0

20X0 £

31 December Stock 3,000

Stock Account

20X0 £

31 December Profit & Loss a/c 3,000

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The effect of these entries is to solve the problem of profit measurement, because the
credit flow from the profit and loss account is taken into the calculation of profit, as
follows:

£ £

Purchases 31,000 Sales 70,000

Closing Stocks 3,000

The stock account is an interesting account because it exists to measure profit and
since this is done on the last day of the accounting year, the stock account exists only
for one day. In fact, the closing stock on the last day of the year is the opening stock
on the first day of the next accounting year. Hence, on the first day of the next
accounting period, the stock must be posted to the profit and loss account of the next
period, as follows:

20X0 £ 20X0

1 January Stock 3,000

Stock Account

20X1 £ 20X1 £

31 December Profit & Loss a/c 3,000 1 January Profit & Loss a/c 3,000

It will now be observed that the stock account has served its purpose and may be
closed. This is done by drawing a double line beneath the entries.

Stock Account

20X0 £ 20X1 £

31 December Profit & Loss a/c 3,000 1 January Profit & Loss a/c 3,000

In practice, the accountant will not reverse the stock into the profit and loss account
of the year 20X1 until 31 December 20X1 when preparing that account. As a result,
the trial balance for the year ended 31 December 20X1 will include a debit balance in
respect of the stock account in the amount of £ 3,000. As the trial balance is always
extracted before the stock adjustment is made, the opening stock always appears on
the trial balance, but the closing stock is never shown.

Losses in Asset Values and Periodic Measurement

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We have discussed the various adjustments to the data in the double-entry
bookkeeping system so that this data might correctly reflect the income and expenses
appropriate to the activities conducted during the accounting period in question. The
accrual of revenues and expenses involved the exclusion of payments and receipts for
other periods.

Here we discuss adjustments which are made in respect of losses in asset values:

i. Depreciation of fixed assets

ii. Loss in the value of debtors caused by the recognition that a portion of the
debtor balances will not be paid and must be recognized as bad debts, and
that a further portion may ultimately prove to be bad so that a provision for
doubtful debts must also be made.

The Treatment of Losses in Asset Values

The concept of prudence requires that losses should e recognized as soon as they
become evident, so as to ensure that profit and capital values are not overstated in
financial reports. Losses in asset values appear in a variety of guises. Losses of cash
and stock by theft, embezzlement or accidental damage are written off against income,
insurance recoveries being treated as a separate matter. Losses to fixed assets due to
accidental damage, theft or other causes are also written off against income, as the
losses arising on the sale of fixed assets which results from a difference between the
sale price and the book value of the assets sold (the book value means the value
according to the accounting records). Most fixed assets also diminish in value as their
usefulness is exhausted over a period of years. Finally, losses in asset values also
result from the exercise of judgement, as in the case of bad debts when accountants
have to decide whether a recorded value does exist at all.

Losses in the Value of Fixed Assets

Losses in the value of fixed assets arising through sale, accidental loss or theft present
no difficulties from an accounting viewpoint, for such losses are written off
immediately against income. By contrast the diminution in value described as
depreciation has been the subject of much controversy. Depreciation is of a complex
nature and now occupies an important role in three different areas of the subject.
First, it is related to problem of cost allocation, both as regards the matching of
revenues and expenses in the process of profit measurement, and as regards product
costing in management accounting. Second, it is related to the concept of capital
maintenance in income theory. Third, it is central to decision making as regards the
life and replacement of fixed assets. The notion of depreciation has varied and
multiplied in such a way that its analysis is not an easy matter. Here we take a limited
view of depreciation, and concern ourselves solely with its financial accounting
implications.

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The Nature of Depreciation

The term ‘depreciation’ is susceptible to four different meanings:

1. A fall in price;

2. Physical deterioration;

3. Fall in value;

4. An allocation of fixed-assets costs.

Depreciation as a fall in price

A fall in the price of an asset is one aspect of depreciation, but it is not a reliable guide
to a valid accounting concept of depreciation. A fall in price may occur independently
of any decrease in the usefulness of an asset, for example the immediate fall in price
occurring on the purchase of a new asset.

Depreciation as physical deterioration

Depreciation in this sense means impaired utility arising directly through deterioration
or indirectly through obsolescence. It is implied in much of the discussion of this
concept of depreciation that an asset is ‘used up’, so that the ‘use’ of an asset is the
extent to which it has been used up. It is evident that these evident that these ideas
are represented in the rates of depreciation which are attached to depreciable assets.
It should be noted, however, that an asset is not necessarily ‘used up’ through the
use, because adequate maintenance may prevent deterioration in some cases. Thus,
for example, if irrigation ditches are well-maintained, they will not deteriorate through
use.

The concept of depreciation as deferred maintenance has not been investigated,

although it is a concept of depreciation which may be more relevant than conventional
concepts as regards certain types of assets.

Depreciation as a fall in value

There are problems associated with the use of the term ‘value’ and the relationship of
depreciation to the concept of value. Value may mean ‘cost value’, ‘exchange value’,
‘use value’ (utility), or ‘esteem value’. Clearly, ‘cost value’ is not affected by events
occurring after acquisition, so that it is not meaningful to relate depreciation in this
sense to a fall in cost value. ‘Exchange value’ changes only twice in the experience of
the owner of an asset – at the point of purchase and at the point of sale. In this sense,
depreciation may mean only a fall in price between two points, and this concept of
depreciation has already been discussed. Depreciation as a decrease in utility is also
already covered by the concept of physical depreciation, while the notion of the esteem

117
value of an asset is entirely subjective and not amenable to an objective concept of
measurement.

If one attempts to relate the notion of depreciation to economic income, however, one
would have the basis of an accounting concept of particular usefulness for decision
making. The economic value of an asset is regarded as the discounted value of
expected future cash flows associated with that asset in a particular use. Hence,
depreciation may be conceptualised and measured as the progressive decrease in the
net cash flows yielded by the asset as its economic utility declines through time, for
whatever reason. Normally, its income-earning capacity falls due to increasing
inefficiency arising from physical deterioration. As regards certain classes of assets, for
example computers, falls in economic value have occurred more rapidly from
obsolescence.

Depreciation as cost allocation

The orthodox view of accountants is that depreciation represents that part of the cost
of a fixed asset which is not recoverable when the asset is finally put out of use.
Provision for this loss of capital is an integral cost of conducting the business during
the effective commercial life of the asset and is not dependent upon the amount of
profit earned.

The practice of treating depreciation as an allocation of historical cost is based on two

assumptions:

1. That the expected benefit to be derived from an asset is proportional to an

estimated usage rate;

2. That it is possible to measure that benefit.

Hence, the current practice is part of the procedure of matching periodic revenues
with the cost of earning those revenues. The essential difference between fixed assets
and current operating expenses is that the former are regarded as costs which yield
benefits over a period of years and hence must be allocated as expenses against the
revenues of those years, whereas the latter yield all their benefits in the current year,
so that they may be treated as the expenses of that year and matched against the
revenues which they have created.

The practice of treating depreciation as an allocation of costs presents a number of

serious theoretical problems. The known objective facts about an asset are few, and
adequate records are not usually kept of the various incidents in the life in use of an
asset apart from its purchase price. Repair and maintenance costs, for example, are
charged separately, as are running costs. Other unresolved problems come in the
selection of appropriate bases for allocating the cost of depreciable assets, for example
should depreciation be calculated by reference to units of actual use rather than time
use? Finally, should the residual value of an asset be regarded as a windfall gain or

118
should it be set off against the replacement cost of the asset rather than used as a
point of reference for calculating the proportion of the cost of fixed assets which
should be allocated as depreciation?

The Accounting Concept of Depreciation

According to AICPA, depreciation accounting is ‘a system of accounting which aims to

distribute the cost...of tangible capital assets, less salvage (if any), over the estimated
useful life of the unit...in a systematic and rational manner. It is a process of
allocation, not of valuation’ (AICPA, 1953).

From the foregoing, two important points may be made:

1. Depreciation accounting is not concerned with any attempt to measure the

value of an asset at any point in time. One is trying to measure the value of
the benefit the asset has provided during a given accounting period, and
that benefit is valued as a portion of the cost of the asset. Hence, the
balance sheet value of the depreciable assets is the portion of the original
cost which has not yet been allocated as a periodic expense in the process
of profit measurement. It does not purport to represent the current value of
those assets.

2. Depreciation accounting does not itself provide funds for the replacement of
depreciable assets, but the charging of depreciation ensures the
maintenance intact of the original money capital of the entity. Indeed, a
provision for depreciation is not identified with cash or any specific asset or
assets.

Factors in the measurement of depreciation

Four factors are important in the process of measuring depreciation from an

accounting viewpoint, as follows;

1. Identifying the cost of the asset;

2. Ascertaining its useful value;

3. Determining the expected residual value;

4. Selecting an appropriate method of depreciation which must be systematic and

rational.

Identifying the cost of the asset

Depreciation is calculated on historical cost values, which include acquisition costs

and all incidental costs involved in bringing an asset into use. In the case of buildings,

119
for example, costs include any commissions, survey, legal and other charges involved
in the purchase together with the costs incurred in preparing and modifying buildings
for a particular use. In the case of plant and machinery, all freight, insurance and
installation costs should be capitalized.

Problems occur where a firm manufactures assets, for example, if an engineering firm
constructs a foundry. In such cases, the cost of labour, materials, etc associated with
the activity of construction should be segregated from those associated with the
normal trading activities and capitalized. There are costing problems involved in
ascertaining such costs. Moreover, improvements effected to existing assets should be
capitalized. The distinction between a repair and an improvement is not always easy to
establish. In some circumstances, the intention may be to repair, but the cheaper
solution is a replacement. An older boiler, for example, may be replaced more cheaply
than repaired. The cost of repair is chargeable as a current expense: The cost of
replacement should be capitalized.

Ascertaining the useful life of an asset

The useful life of an asset is defined as that period during which it is expected to be
useful in the profit earning operations of the firm. In most cases, the useful life is
determined by two factors:

1. The rate of deterioration

2. Obsolescence

The rate of deterioration is a function of the type of use to which the asset is put, and
the extent of that use. A lorry used by civil engineering contractors may have a shorter
life expectancy than a lorry employed by cartage contractors, for the former may
operate in rough terrain, whereas the latter is used on roads. It is not unusual to find
that the estimated useful life in the first case may be two years, or less, whereas the
estimated life in the second may be four years. Moreover, an asset used intensively will
have a shorter life than one used for shorter periods. In this respect, assets are built to
certain specifications which determine to some extent their durability in use. The
useful life is determined on the basis of part experience, which is a good indicator of
the probable life of a particular asset.

It should be pointed out, however, that the estimated useful life of an asset is also a
question of policy and many are determined accordingly. Thus, a car hire firm may
decide to renew its fleet each year, and in this case the useful life of its fleet of cars is
one year for the purpose of calculating depreciation.

The problem of taking obsolescence into account in assessing the useful life of an
asset is altogether more complex, for obsolescence occurs with the appearance of an
asset incorporating the result of technological developments. In respect of certain
assets, such as cars, each year may see the introduction of an improved model, so

120
that owners of fleets of cars may decide that obsolescence, or assumed obsolescence is
a more important factor in the useful life of cars than depreciation. Relying on new
models or improved versions each year, a firm may decide to renew its fleet each year.
However, it is hard to distinguish the extent to which such decisions are influenced by
the need to have the latest product or to have excessive repair bills stemming from
large mileages. It would seem, therefore, that obsolescence is one factor which affects
the useful life of fixed assets and accelerates their progress towards the scrapheap.
Accordingly, the estimated useful life of an asset is determined by that length of time
for which as a matter of policy, it is wished to employ an asset. That length of time will
be a function of a number of factors, but the most important will be the increasing
cost of employing that asset due to higher yearly maintenance cost and possible
declining revenues.

The residual value of an asset is estimated at the time of acquisition so that the net
cost may be allocated to the accounting periods during which the asset is usefully
employed. The residual value is the expected reliable value of the asset at the end of
its useful life. Hence, the residual value will depend on the manner and on the length
of time that the asset is to be used. Where, for example, it is intended to use an asset
until it is completely worn out or obsolete, its residual value will be negligible. Where
as in the replacement of fleets of cars, the length of useful life is shortened to one year;
the residual value will be higher.

Where it is intended to extract the maximum use from an asset, the residual value
should be normal: Where it is intended to replace the asset when it still has some
useful life, its residual life should be estimated to minimize the effect of variations in
the price of second-hand assets. The cost allocated against revenues of the accounting
periods involved are calculated as follows:

Cost of Acquisition (say) £ 2,000

Residual Value (say) £ 200

Cost to be Allocated as Depreciation £ 1,800

Selecting the Method of Depreciation

There are several methods of depreciation, but the most common are Straight-line
Method and the Decreasing Balance Method.

The matching convention requires that ‘the choice of the method of allocating the cost
of a long-term asset over its effective working life should depend upon the pattern of
expected benefits obtainable in each period from its use’ (Barton 1984).

The Straight-Line Method

The formula for calculating the annual depreciation provision under the Straight-Line
Method is as follows:

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Annual Depreciation Provision = Acquisition – Estimated Residual Value

Expected Useful Life in Years

Example 1

A Lorry is acquired at a cost of £ 3,000. Its estimated useful life is three years, and its
residual value is estimated at £ 600.

Annual Depreciation Provision = £ 3,000 - £ 600 = £ 800 Per annum

3 Years

The straight-line method allocates the net cost equally to each year of the useful life of
an asset. It is particularly applicable to assets such as patents and leases where it is
the key factor in the effluxion of the benefits to be derived from the use of an asset.
Although it is in general use for other fixed assets, it suffers from the following
disadvantages;

1. It does not reflect the fact that the greatest loss in the market value occurs in
the first year of use;

2. It does not reflect the unevenness of the loss in the market value over several
years;

3. It does not reflect the diminishing losses in value which occur in later years, as
the asset approaches the end of its useful life.

For these reasons, the straight-line method of depreciation does not provide an
accurate rate of measure of the cost of the service potential allocated to the respective
accounting periods during which an asset is employed.

The Decreasing-Balance Method

To calculate the annual depreciation position under this method, a fixed percentage is
applied to the balance of the net costs no yet allocated as an expense at the end of the
previous accounting period. The balance of unallocated costs decreases each year, and
theoretically, the balance of unallocated costs at the end of the estimated useful life
should equal the estimated residual value. The formula used to calculate the fixed-
percentage to be applied to the allocation of net costs as depreciation is:

r =1 – n √s/c

Where; n = the expected useful life in years

s = the residual value (this value must be significant or depreciation rate

will be nearly one)

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 c = the acquisition cost

r = the rate of depreciation to be applied.

Example 2

Calculate the rate of depreciation to be applied to a lorry acquired at a cost of £ 3,000,

having an expected useful life of three years and an estimated residual value of £ 600.

r = 1 – 3 √ £600/£3000 = 0.4152 0r 41.52 %

The depreciation calculation for each of the three years would be as follows:

Cost £ 3,000

Year 1 Depreciation at 41.52% of £ 3,000 £ 1,246

Unallocated costs at end of year 1 £ 1,754

Year 2 Depreciation at 41.52% of 1,754 £ 728

Unallocated Costs at end of year 2 £ 1,026

Year 3 Depreciation at 41.52% of 1,026 £ 426

Residual value at end of year 3 £ 600

In practice, the annual percentage rate of depreciation is not calculated so precisely. A

rate is selected which approximates to the estimated useful life, for example an
estimated useful life of three years would imply a 33 1/3 percent rate of depreciation.
The advantage of the decreasing-balance method is that it approximates reality in
respect of certain assets, for example motor vehicles, where the depreciation
calculated in the first year is greatest, thereby reflecting the greater loss in market
value at this stage of a vehicle’s life.

Accounting for Depreciation

There are several methods of providing for depreciation. Legislation requires that the
following information in respect of fixed assets be shown on the balance sheet:

1. The cost or valuation, as the case may be;

2. The aggregate amount provided or written off since the date of acquisition or
valuation, as the case may be, for depreciation or diminution in value.

The net book value is the difference between 1 and 2 above.

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Example 3

The historical cost of plant and machinery is £ 100,000. Accumulated depreciation to

date is £ 60,000 and the net book value is, therefore, £ 40,000. This information is
disclosed as follows:

Fixed Assets Cost Accumulated Depreciation Net Book Value

£ £ £

Plant and
Machinery 100,000 60,000 40,000

The accounting procedure required to generate this information is to debit the

acquisition cost, or valuation as the case may be, in the asset account, and to
accumulate depreciation yearly in a provision for depreciation account. The annual
provision for depreciation is charged to the profit and loss account.

Example 4

Assume that the plant and machinery shown in the previous example was acquired on
1 January 20X0 for £ 100,000 that its estimated useful life is five years, the expected
residual value is nil, and that depreciation is calculated on a straight-line basis at the
rate of £ 20,000 a year. The appropriate accounts would record the following data by
the end of year 20X2.

Plant and Machinery Account

20X0 £ 20X0 £

1 January Cash 100,000 31 December Balance c/d 100,000

100,000 100,000

20X1 20X1

1 January Balance b/d 100,000 31 December Balance c/d 100,000

20X2 20X2

1 January Balance b/d 100,000 31 December Balance c/d 100,000

20X3

1 January Balance b/d 100,000

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Provision for Depreciation Account

20X0 £ 20X0 £

31 December Balance c/d 20,000 31 December profit & loss a/c 20,000

20,000 20,000

20X1 20X1

31 December c/d 40,000 1 January Balance b/d 20,000

40,000 31 December Profit & Loss a/c 20,000

40,000

20X2 20X2

1 January Balance b/d 40,000

31 December Balance c/d 60,000 31 December Profit & Loss a/c 20,000

60,000 60,000

20X3

1 January Balance b/d 60,000

Profit and Loss Account for the Year Ended 31 December 20X0

£ £

Provision for depreciation 20,000

Profit and Loss Account for the year Ended 31 December 20X1

£ £

Provision for depreciation 20,000

Profit and Loss Account for the Year Ended 31 December 20X2

£ £

Provision for depreciation 20,000

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Accounting for the Disposal of Assets

The cost of the benefits derived from the use of assets cannot be ascertained until the
assets have completed their useful life and have been sold or otherwise disposed of. In
the meantime, the annual provision for depreciation is merely an estimate of the
actual cost. The practice is to make an adjustment to the profit for the year of sale in
respect of any difference between the book value and the realized value of the asset. It
is not the practice, therefore, to attempt to open previous years to make a correction
for the actual depreciation suffered.

The method is to open an asset realization account, often called a ‘disposal account’ ,
and to reverse the existing entries in the asset realization account and the provision
for depreciation account in respect of the asset sold or disposed of, recording directly
in the asset realization account the sale price, if any, obtained.

Example 5

On 31 December 20X0, plant and machinery acquired at a cost of £ 100,000 three

years ago was sold for £ 30,000. The accumulated depreciation to date was £ 60,000.
The accounting procedure for dealing with this event is as follows:

Plant and Machinery Account

20X0 £ 20X0 £

1 January Balance b/d 100,000 31 December Asset Realization 100,000

100,000 100,000

Provision for Depreciation Account

20X0 £ 20X0 £

31 December Asset
Realization 60,000 1 January Balance b/d 60,000

60,000 60,000

Cash Book
20X0 £

31 December Asset
Realization 30,000

Asset Realization Account

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20X0 £ 20X0 £

31 December Plant &

Machinery 100,000 31 December Cash 30,000

31 December
Provision for Depreciation 60,000

31 December Profit & Loss a/c 10,000

100,000 100,000

Profit and Loss for the Year Ended 31 December 20X0

Loss on Sale of Plant and

Machinery 10,000

Therefore the gain or loss on disposal of fixed assets would be reported on the profit
and loss account, and the machinery would no longer be reported on the balance
sheet.

Losses Arising from the Default of Debtors

The necessity to give credit to customers results in the investment of substantial funds
in what are in effect short-term loans. There are three important financial aspects as
regards debtors which are of interest to both management and investors. First, there
is the problem of working capital management in respect of the balance of claims in
favour of and against the firm, and its implications in respect of liquidity and solvency.
Second, there is the problem of the overall level of debtors in relation to other assets,
and the need for the firm to have sufficient funds to invest in the maintenance and
expansion of its profit-earning structure. This has implications for present and future
profitability. Third, there is the risk associated with the recovery of amounts due from
debtors. This is a problem of credit control and the prevention of losses due to default
of debtors.

The valuation of amounts due from debtors at the end of an accounting period
presents no difficulty as regards determining debtor balances in an objective manner.
Provided that accounting records have been kept properly, the objectivity of the
valuation of debtors is founded in the law of contract and is a claim enforceable at law
against debtors. The recoverability of debts, however, is a question to which the
accountant must address himself, since the concept of prudence requires that losses
be recognized when they arise. The recoverability of debts for financial reporting

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purposes is a question of law in some cases and of judgement in others. Thus, where a
debtor has been declared bankrupt the recoverability of the debt is subject to the law
of bankruptcy, and where no dividend is likely, the loss must be recognized and the
amount written off as bad. When, however, a debtor cannot be traced or is unable to
pay owing to personal circumstances, and the sum involved does not warrant legal
action, then the decision to recognize the loss is a matter of judgement. By and large,
accountants examine the debtors’ ledger at the end of the financial year and identify
those debts likely to be bad debts by reference to the delay in payment and the
attempts made to secure payment. Debts considered irrecoverable are written off by
debiting the profit and loss account and crediting debtors, and if they should be
recovered subsequently, then the debt is restored in the debtors’ ledger.

Failure to deal adequately with the problem of defaulting debtors will distort the
measurement of profit and asset values in the following respects:

1. The measurement of profit for an accounting period will be overstated to the

extent that any credit sales taken into profit have created debts which are not
recoverable.

2. The measurement of profit for the subsequent accounting period will be

understated to the extent that debts created in the previous accounting period
are recognized belatedly as bad and written off against the profit of the
subsequent accounting years.

3. The balance sheet statement of the value of debtors includes debts which,
though legally enforceable, are irrecoverable. It is not possible, for example, to
recover debts from bankrupt persons, or persons who cannot be traced.

Accordingly:

1. Bad debts should be recognized as soon as they arise;

2. The risk of further possible losses should be anticipated in accordance with the
concept of prudence;

Accounting practice is to deal separately with the problem of debts which are
recognized as bad, and to anticipate further losses in the future. In effect, three types
of debts are distinguished:

1. Good debts;

2. Bad debts;

3. Doubtful debts.

The Treatment of Bad Debts

128
Careful supervision of debtors’ accounts will minimize bad debts. The enforcement of
time limits for settlement of accounts helps in the prevention of a build-up of arrears
and in identifying doubtful debts. Once a debt is recognized as bad, it should be
written off immediately, so that the list of debtor accounts represents only good debts,
that is, those expected to be paid in full.

Example 6

H. Smith Ltd, a firm of building contractors, had been regular customers of Hervey
Building Supplies Ltd and enjoyed a credit limit of £ 1,000. On January 1 20X0 the
balance of its account in the books of Hervey was £ 900 and purchases in January
20X0 totalled £ 150. H. Smith informed Hervey on 5 February of its inability to pay its
account. Hervey stopped further credit to H. Smith until the position was clarified.
Shortly thereafter, it was discovered that H. Smith was insolvent, and that it was
unlikely that any of the debt of £ 1,050 would be paid. On 1 March, it was decided to
treat the debt as a bad debt.

The accounting entries in the books of Hervey would be as follows:

H. Smith Ltd Account

20X0 £ 20X0 £

1 January Balance 900 1 March Bad Debt 1,050

31 January Sales 150

1,050 1,050

Bad Debts Account

20X0 £

1 March H. Smith Ltd 1,050

At the end of the accounting period, the total on the bad debts accounts is debited to
the profit and loss account.

Example 7

Assume the only bad debt suffered by Hervey Building Supplies Ltd was in respect of
H. Smith Ltd in the sum of £ 1,050, as above. The bad debt account for the year ended
31 December 20X0 would be closed as follows:

Bad Debts Account

129
20X0 £ 20X0 £

1 March H. Smith Ltd 1,050 31 December Profit & Loss a/c 1,050

1,050 1,050

Profit & Loss Account for the Year Ended 31 December 20X0

20X0 £ 20X0 £

Bad Debts 1,050

The treatment of doubtful debts

The question of doubtful debts, as distinct from bad debts, is examined only at the
end of each accounting period. A final scrutiny of the debtors’ account will eliminate
all those accounts considered to be bad and the necessary transfers will be made to
the bad debts account of the remaining debtors, some may ultimately prove to be bad,
but these may be reasonable grounds for hoping that all remaining debtors will settle
their accounts. The concept of prudence requires that the risk should be discounted
of further debts proving to be bad. The normal practice is to create a provision for
doubtful debts out of the current year’s profit, without seeking to identify particular
debts as being doubtful of recovery. There several methods of estimating doubtful
debts. The most common method is to allow past experience to establish the
percentage of debtors which has proved to be bad, and to calculate the provision for
doubtful debts by applying this percentage to the debtors outstanding at the end of
the accounting period. A more accurate method is to classify debtor balances in terms
of their age, and to apply to the several groups of debts the loss rates established by
experience

Example 8

The sales ledger balances existing in the books of Bumpa Trading Company at the end
of the financial year are as follows:

Duration of Debts Amount Loss Rate % Provision

£ £

Less than 1 month 10,000 1 100

1 – 2 months 3,000 3 90

130
2 – 3 months 1,000 5 50

3 – 4 months 500 10 50

Over 4 months 100 20 20

14, 600 310

One of the advantages of this method of creating a provision of doubtful debts is that it
enables management to understand the relationship between the slow collection of
debts and the financial losses caused by defaulting debtors.

The accounting entries would be as follows:

Profit and Loss Account for the Year Ended 31 December 20X0

Provision for doubtful debts 310

Provision for Doubtful Debts Account

20X0 £

Profit & Loss Year ending 31 Dec 310

The provision for doubtful debts is not identified with any individual debtors. It is
carried forward as an estimated liability, and may be shown on the balance sheet as
follows:

Balance Sheet as at 31 December 20X0

£ £

Debtors 14,600

Less Provision for

doubtful debts 310 14290

In this manner, the objective of presenting a realistic valuation of trade debts is

achieved.

Example 9

During 20X0 J. Snow had to write off the debts of C. Wild and J. Hope who owed £80
and £ 260 respectively. At 31 December 20X0 the total of sundry debtors was £2,880.
Snow made a provision of doubtful debts of 5 per cent.

131
On 3 March 20X1 J. Hope unexpectedly paid his debt. At 31 December 20X1 the total
sundry debtors, other than Wild and Hope, was £ 2,520 and the provision was
maintained at 5 per cent.

J. Snow’s accounting entries would be as follows:

Bad Debts Account

20X0 £ 20X0 £

31 Dec C. Wild 80 31 Dec Profit & Loss a/c 484

J. Hope 260

Provision for
doubtful debts 144

484 484

Profit and Loss Account for the Year Ended 31 Dec 20X0

Bad debts 340

Provision for bad debts 144

Balance Sheet as at 31 December 20X0

£ £

Debtors 2,880

Less: Provision 144 2736

C. Wild

20X0 £ 20X0 £

1 January Balance b/d 80 31 December bad debts 80

J. Hope

20X0 £ 20X0 £

1 January Balance b/d 260 31 December bad debts 260

Provision for Doubtful Debts Account

132
20X1 £ 20X0 £

31 December bad debts 31 December bad debts 144

(excess provision) 18

Balance c/d 126

144 144
20X1

1 January balance b/d 126

Bad Debts Recovered

20X1 £ 20X1 £

31 Dec Profit & Loss a/c 260 3 March J. Hope 260

Profit & Loss Account for the Year Ended 31 December 20X1

Bad debts recovered 260

Excess provision for

doubtful debts 18

Balance Sheet as at 31 December 20X1

£ £

Debtors 2,520

Less Provision 126 2,394

The decrease in sundry debtors from £ 2,880 to £ 2,550 reduces the provision for
doubtful debts by £ 18 (5% of 360) at 31 December 20X1.

Preparing a Profit and Loss Account and a Balance Sheet

The trial balance has the role of a working paper which enables the accountant not
only to check the arithmetical accuracy of the entries recorded during an accounting
period, but also serves as a basis for considering adjustments to be made for the
purpose of measuring profit. The extraction of a trial balance at the close of the
accounting period is the first step, therefore, in the preparation of a profit and loss
account and a balance sheet.

133
We have already examined how the trial balance is adjusted in respect of the accrual
into the accounting period of revenues and expenses, and also have analysed the
nature of the losses in asset values which have to be taken into consideration in the
measurement of periodic profit.

The purpose here is to summarize the various adjustments which must be made to the
trial balance, and the manner in which these adjustments are incorporated into the
process of preparing a profit and loss account and a balance sheet.

Preparing a Profit and Loss Account

The preparation of a profit and loss account is a two-stage exercise. The first stage is
the informal one and consists of using the trial balance as a worksheet for
accumulating all the data which incorporate all the various adjustments referred to
earlier. The adjustments are then entered in the appropriate accounts, and the profit
and loss account is formally included in the accounts system. It is important to
remember that the profit and loss account is an account to which the revenue and
expense accounts for the accounting period are transferred as summarized totals, and
which exists solely for the purpose of measuring the accounting profit for that period.

The following example illustrates the nature of the profit and loss account.

Example 1

Let us return to the trial balance given previously, which listed the balances extended
from the books of John Smith on 31 December 20X0 at the end of the first year of
trading:

£ £

Dr Cr

Capital 25,000

Motor Vehicles 10,000

Furniture and Fittings 2,500

Purchases 31,000

Bank Balance 6,000

£ £

Dr Cr

Sales 70,000

Debtors 18,000

134
Creditors 3,500

Rent 4,500

Salaries 22,800

Insurances 400

Motor Expenses 2,000

Light and Heat 1,000

General Expenses 300

98,500 98,500

We noted earlier that the following adjustments were required:

1. Profit unpaid at the end of the year was £ 1,500

2. Insurance paid in advance amounted to £ 50

3. Rent receivable, but not recorded in the account, amounted to £ 60

4. Closing stock at 31 December 20X0 was valued at £ 3,000

We are now given the following additional information:

1. Depreciation is to be provided on the under-mentioned assets and calculated on

the reducing balance method. Their estimated residual values are shown in
brackets.

Motor Vehicles 20% (£ 1,000)

Furniture and Fittings 10% (£ 250)

2. Bad debts to be written off to £ 180, and a provision for doubtful debts is to be
made of £ 178.

Adjusting for Accruals

We saw also that the adjustments for accruals and payments resulted in the following
revisions of balances in the trial balance:

Original Balance Adjustment New Balance

£ £ £

1 Rent 4,500 1,500 6,000

2 Insurance 400 50 350

135
3 Insurance Prepaid 50 50

4 Rent Receivable 60 60

It was explained that items 1, 2 and 3 represented adjustments to the revenues and
expenses of the year and affected the profit and loss account. The following resulting
balances of the accounts affect the balance sheet, and later, it would be demonstrated
how they are incorporated in that statement:

£ £

Dr Cr

Rent Accrued 1,500

Insurance Prepaid 50

Rent Receivable 60

The corrected total revenues and expenses may now be listed on a worksheet used in
the preparation of the profit and loss account:

Draft Profit and Loss Account for the year Ended 31 December 20X0

£ £

Purchases 31,000 Sales 70,000

Rent 6,000 Rent Receivable 60

Salaries 22,800

Insurance 350

Motor Expenses 2,000

Light and Heat 1,000

General Expenses 300

Adjusting for Stocks

It was noted previously that the periodic measurement involved valuing the stocks of
goods unsold at the end of the accounting period. The closing stock is valued in
accordance with the cost concept, and represents the residue of the purchases of the
year which have not been sold at the year end, though they may be sold in the next
accounting period. Opening stocks are shown, therefore as a debit balance in the trial
balance, whereas closing stocks do not appear, since they are valued after the close of

136
the accounting period. It is for this reason that the appropriate entries must be made
in the stock account to make possible the measurement of periodic profit. In the
example in question, there is no opening stock because it is the first year of trading.

It has already been seen that the adjustment for closing stock had a twofold effect.
First, it is effected by means of a credit to the profit and loss account and a debit in
the stock account. Second, it results in debit balance in the stock account which must
be incorporated in the balance sheet.

The closing stock is entered on the draft profit and loss account as follows:

Draft Profit and Loss Account for the Year Ended 31 December 20X0

£ £

Purchases 31,000 Sales 70,000

Rent 6,000 Rent Receivable 60

Salaries 22,800 Closing Stock

Insurance 350 31 December 20X0 3,000

Motor Expenses 2,000

Light and Heat 1,000

General Expenses 300

Adjusting for the Loss in Asset Values

As already noted previously, the most important losses are asset values which the
accountant has to recognize in the measurement of periodic profit. We are not
interested here in dealing with the variety of gains and losses in asset values which
may occur, but we are concerned with only the process of periodic measurement and
with the most significant losses in asset values which enter into that process.

In the example, we are required to deal with depreciation, bad and doubtful debts.

Calculation of Depreciation

It is the usual practice to detail in the profit and loss account the component elements
of the provision for depreciation, and as will be seen later fixed assets are also
described in their categories on the balance sheet. The provision for depreciation in
respect of the different fixed assets may be reconciled, therefore, with the yearly
provision for depreciation shown on the balance sheet.

137
 1. Motor Vehicles

Cost 10,000

Estimated Residual Value 1,000

Net Cost for Depreciation Purposes 9,000

Depreciation for the year 20X0 @ 20% 1,800

Residual Balance for Depreciation in Following Years 7,200

1. Furniture and Fittings

Cost 2,500

Estimated Residual Value 250

Net Cost for Depreciation Purposes 2,250

Depreciation for the Year 20X0 @ 10% 225

Residual Balance for Depreciation in Following Years 2,025

Total Depreciation for the year: 1,800

225

2,025

Calculation of Provision for Doubtful Debts

Duration of Debt Balance Loss Rate % Provision

Less than 1 month 15,960 ½ 80

1 – 2 months 1,800 5 90

2 – 3 months 40 10 4

Over 3 months 20 20 4

138
 17,820 178

These adjustments may be included in the draft profit and loss account as shown
below:

Draft Profit and Loss Account for the Year Ended 31 December 20X0

£ £

Purchases 31,000 Sales 70,000

Rent 6,000 Rent Receivable 60

Salaries 22,800 Closing stock at

31 December 20X0 3,000
Insurance 350

Motor Expenses 2,000

Light and Heat 1,000

General Expenses 300

Depreciation

Motor Vehicles 1,800

Furniture and Fittings 225

Bad Debts 180

Provision for Doubtful Debts 178

Calculating the Periodic Profit

The details shown on the draft profit and loss account above are sufficient to permit
the calculation of the profit for the year ended 31 December 20X0. The profit and loss
account is set out, however, so as to enable significant information to be immediately
apparent. In this respect, a distinction is made between gross profit and net profit, the
former being the profit resulting after the deduction from the gross sales revenue of
expenses directly connected with the production or purchase of the goods sold, while
the latter reflects the deduction of overhead expenses from gross profit. Although the
net profit is the most important result, dividing the profit and loss account into two
parts highlights the burden of overhead expenses, as well as focussing attention on
important aspects of business activity.

*Calculating Gross Profit

139
In the case of a trading business............as is the case in the example quoted..........
the gross profit from trading may be shown as follows:

£ £

Purchases 31,000 Sales 70,000

Less: Closing Stock at

31 December 20X0 3,000

Cost of Sales 28,000

Gross Trading Profit 42,000

70,000 70,000

This arrangement shows the following points:

1. Although purchases amounted to £ 31,000, the cost of goods actually sold

amounted to only £ 28,000. Hence, the gross trading profit expressed as a
percentage of sales is :

42,000 × 100 = 60%

70,000

This percentage is often referred to as the gross profit ratio. Expressed as a percentage
of cost of sales, the gross trading profit is:

42,000 × 100 = 150%

70,000

2. The level of trading activity may also be judged from the average length of time
stock is held. The rate of stock turnover may be calculated as follows:

Cost of Sales
Average Stock

The average stock is obtained by the arithmetic mean of the opening and closing
stock. In the example under consideration, the rate of stock turnover for the year was
as follows:

28,000 = 9.3 times

3,000
So that stock was held for approximately 39 days (365 days / 9.3), or replaced
approximately 9.3 times in the year.

140
 The segregation of the gross trading profit in the process of calculating periodic profit
provides useful ratios for analysis of trading performance, and for indicating areas of
trading where efficiency might be improved.

It is the practice for firms to identify the nature of gross profit. Thus manufacturing
firms show manufacturing gross profit, contracting firms show contracting gross profit
and so on.

The problem of deciding which expenses to include in the calculation of the gross
profit lies in defining direct as distinct from indirect operating expenses. Direct
expenses, such as purchases, freight and other expenses associated with the
acquisition of goods for resale, for example, are included in the calculation of gross
profit.

Calculating the Net Profit

The calculation of the net profit is affected by charging against the gross profit the
indirect expenses accumulated in the trial balance, and other expenses such as
depreciation, bad debts and provisions for the year ended 31 December 20X0 may be
calculated as shown:

Net Profit for the Year Ended 31 December 20X0

£ £

Rent 6,000 Gross Trading Profit 42,000

Salaries 22,800 Rent Receivable 60

Insurance 350

Motor Expenses 2,000

Light and Heat 1,000

General Expenses 300

Depreciation

Motor Vehicles 1,800

Furniture & Fittings 225

Bad Debts 180

Provision for Doubtful Debts 178

34,883

Net Profit 7,227

141
 42,060 42,060

Miscellaneous income, such as interest, rents and dividends, which forms a minor
element in the business profit, is usually shown in the calculation of the net profit
rather than in the calculation of the gross profit.

The segregation of the net profit calculation also affords a clearer view of significant
ratios. The net profit is itself the most significant performance result, and its
dimensions may be assessed not only in relation to the gross trading profit, but also to
gross revenue. The net profit as a percentage of sales indicates the level of activity
required to produce £ 1 of net profit, and may be calculated as follows:

Net Profit before Interest and Tax

Sales
Thus, whereas the percentage of gross profit to sales was 60%, the percentage of net
profit to sales was only 13%, indicating thereby not only the relative burden of direct
and indirect expenses, but also the relative efficiency of the business.

The Formal Presentation of the Profit and Loss Account

Although the profit and loss account is part of the account system, and may be shown
in an account form, its formal presentation has been influenced by its use as a finance
reporting statement. This influence has encouraged the further classification of
indirect expenses into selling, administration and financial expenses, and the
presentation of the profit and loss account in a vertical form as follows:

John Smith Trading as General Dealer Profit and Loss Account for the Year
Ended 31 December 20X0

£ £

Sales 70,000

Cost of Sales

Purchases 31,000

Less: Closing Stock 3,000

28,000

Gross Trading Profit 42,000

Other Income: Rent 60

Selling and Distribution Expenses

142
 Sales Representatives’ Salaries 12,000

Motor Expenses 2,000

Depreciation – Motor Vehicles 1,800 15,800

Administrative Expenses

Rent 6,000

Office Salaries 10,800

Insurance 350

Light and Heat 1,000

General Expenses 300

Depreciation – Furniture & Fittings 225 18,675

Financial Expenses

Bad Debts 180

Provision for Doubtful Debts 178 358

Total Overhead Expenses 34,833

Net Profit 7,227

Preparing a Balance Sheet

The preparation of the balance sheet is a two-stage process, and, in this sense it
follows the same pattern as the preparation of the profit and loss account, that is an
informal stage based on worksheet, and a formal stage represented by the balance
sheet presented as a financial report, There are, however, a number of important
differences between a profit and loss account and a balance sheet. First, from a
procedural point of view, the profit and loss account is part of the accounts system
and it is itself an account as already noted. By contrast, the balance sheet is not an
account, but a list showing the balances of the accounts which remain following the
preparation of the profit and loss account. Second, the profit and loss account is the
effective instrument of periodic measurement in accounting, whereas the balance
sheet does not do other than state residual balances. Third, residual debit balances
are shown on the balance sheet as assets. Fourth, by attaching measurement to debit

143
and credit balances described as assets and liabilities respectively, the balance sheet
is often interpreted as indicating the net worth of the business.

Collecting and Classifying Balances

The preparation of the balance sheet need not await the entry of all the adjustments
into the individual accounts following the preparation of the profit and loss account. It
may be prepared in draft form from the trial balance and the finalized draft of the
profit and loss account.

Debit balances are either assets, losses or expenses. The preparation of the profit and
loss account involves the removal from the trial balance of all expenses in respect of
the year, so that any debit balances remaining are treated as assets. These assets, as
defined, are classified as follows:

1. Long-term assets representing an enduring benefit to the enterprise. Long-

term assets described as fixed assets, for example, plant and machinery are
subject to depreciation. Other long-term assets such as land and intangible
assets may or may not be subject to depreciation or other changes in their
book value.

2. Short-term assets, described as current assets, include the following:

a) Closing stocks at the end of the accounting period;

b) Trade debtors;

c) Prepayments on expense accounts, for example, insurance paid in

advance;

d) Bank balance and cash.

By contrast, credit balances are either, liabilities, revenues or investments in the firm
in the form of capital and long-term loans. The removal of periodic revenues from the
trial balance means that the remaining credit balances are either liabilities or
investments. The provision for depreciation is one of a number of exceptions to this
rule. These exceptions as in the case of prepayments shown as debit balances, arise
from accounting procedures. Credit balances are collected and classified as follows:

1. Capital account, representing the owner’s original investment in the firm and
accumulated profits less drawings;

2. Long-term borrowings;

3. Short-term liabilities, described as current liabilities, which include such credit

balances as sundry creditors, accrued expenses, payments received in advance,
provision for taxation and bank overdrafts.

144
The Formal Presentation of the Balance Sheet

In the case of corporations, legislation provided rules for the presentation of both the
profit and loss account and the balance sheet. These rules apply to published financial
reports. The rules reflect the practices of the accounting profession, and are designed
not only to secure sufficient disclosure but also to permit salient features to be quickly
recognized.

It is usual, therefore, to classify assets and liabilities in groupings earlier mentioned,

and to rank them according to liquidity. Thus, asset groupings are shown from the
most fixed to the most liquid and liabilities from long-term to the most current.

The importance of the balance sheet, together with the profit and loss account for the
purpose of financial reporting and investment decision making, has focused attention
on the arrangement of particular groupings to assist the interpretation and the
analysis of results. The relationship between long-term finance and long-term
investment needs of the firm (long-term capital as defined in finance) and long-term
investment needs of the firm (working capital) is important to financial analysts. Other
areas of interest are the return on capital employed which is the ratio of net profit to
equity capital (owner’s Investment in the firm), liquidity and solvency.

The vertical form of presentation of the balance sheet is illustrated below:

John Smith Balance Sheet as at 31 December 20X0

Fixed Assets Cost Depreciation Net

to Date
£ £ £ £ £
Motor Vehicles 10,000 1,800 8,200

Furniture &
Fittings 2,500 225 2,275

12,500 2,025 10,475 10,475

Current Assets

Stocks at Cost 3,000

Debtors 17,820

Less: Provision
For Doubtful Debts 178 17,642

Accruals and
Prepayments 110

145
Bank Balance 6,000

26,752

Current Liabilities

Creditors 3500

Accruals 1,500 5,000

Net Current Assets 21,752

32,227

Capital Employed

Capital Account 25,000

Net Profit for the Year 7,227

32,227

Example 3

The following trial balance was extracted from the books of Peter Ardron as at 31
December 20X0:

£ £

Purchases 54,520

Sales 79,060

Salaries 8,760

Rates 1,170

Office Expenses 3,950

Motor Expenses 3,790

Capital Account 1 January 20X0 13,640

Freehold Properties at Cost 7,500

Furniture & Fittings at Cost 2,000

Motor cars at Cost 6,300

Accumulated Depreciation

Freehold Properties 450

146
 Furniture & Fittings 800

Motor Cars 2,370

Stock 1 January 20X0 6,740

Drawings 4,800

Provision for Doubtful debts 1 Jan 20X0 600

Loan 4,000

Debtors 9,240

Creditors 10.040

Bank Balance 2,190

110,960 110,960

The following are to be taken into account:

1. Stock at 31 December £ 7,330

2. Rates paid in advance 31 December £ 250

3. Provision for doubtful debts to be made equal to 5% of debtors at 31 December.

4. Provide depreciation for the year at the following annual rates calculated at
cost, assuming no scrap value:

Freehold Properties 1%

Furniture and Fittings 10%

Motor Cars 20%

5. Provide for interest for the loan at 5% per annum.

Solution

Peter Ardon’s profit and loss account for the year ended 31 December 20X0 and a
balance sheet at that date appear as follows:

147
Peter Ardon

Profit and Loss Account for the Year Ended 31 December 20X0

£ £ £

Sales 79,060

Cost of Sales

Opening Stock 6,740

Purchases 54,520

61,260

Less: Closing Stock 7,330 53,930

Gross Profit 25,130

Expenses

Salaries 8,760

Rates £ (1,170-250) 920

Office Expenses 3,950

Motor Expenses 3,790

Doubtful dates not required (138)

Loan Interest 200

Depreciation: Freehold Properties 75

Fixtures & Fittings 200

Motor Cars 1,260 1,535 19,017

Net Profit 6,113

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Balance Sheet at 31 December 20X0

£ £ £

(Cost) (Dep’n) (NBV)

Fixed Assets

Freehold Properties 7,500 525 6,975

Furniture & Fittings 2,000 1,000 1,000

Motor Cars 6,300 3,630 2,670

15,800 5,155 10,645

Current Assets

Stock 7,330

Debtors 9,240

Less: Provision for doubtful debts 462

8,778

Prepayments 250

Bank Balance 2,190

18,548

Current Liabilities

Creditors 10,040

Accruals 200 10,240 8,303

Net Current Assets 18,953

Capital Account

Balance b/d 13,640

Profit for Year 6,113

19,753

149
 Drawings 4,800 14,953

Loan 4,000

18,953

Workings

Provision for Doubtful Debts Accounts

£ £

Balance c/d (5%×9,240) 462 Balance b/d 600

(Provision no longer required) 138

600 600

150