XEA 201- FINANCIAL ACCOUNTING

LECTURE ONE
INTRODUCTION TO THE DISCIPLINE OF ACCOUNTING

Lecture Content
1.1 Introduction
1.2 Objectives
1.3 Evolution of accounting
1.4 The purpose (importance) of accounting
1.5 Users of accounting information
1.6 Business goals and activities
1.7 Financial accounting and managerial accounting
1.8 Summary

Objectives
At the end of this lecture you should be able to:
● Explain the historical development of Accounting
● Explain the meaning and purpose (importance) of accounting
● Identify users and uses of accounting
● Identify and describe the key goals and activities of business organizations
● Distinguish between managerial and financial accounting

Perspective (Role of Accounting In Society)

Accounting is one of the most popular fields of study in colleges and universities and one of the
fastest-growing professions in the world. The reason for this growth is quite simple: accounting
is the financial information system that provides relevant financial information to every person
who owns or uses economic resources or otherwise engages in an economic activity involves
using or dispensing financial information. Accounting is vital to our economic system.
NB
Regardless of one’s pursuit or occupation, the need for financial information is inescapable.
Such common activities as:
- earning a living
- spending Money
- buying on credit
- making investments
- paying taxes
- managing a business
- etc
You will probably find that of all the business knowledge you will learn in your
undergraduate (and even graduate programmes), the study of accounting will be the most
useful. Your financial and economic decisions as a student and consumer involve
accounting information.

For example when you file your tax returns (which are now mandatory for all income earners)
accounting information will help determine your taxes payable.
Understanding the discipline of accounting will also influence many of your future professional
decisions. Simply, you cannot escape the efforts of accounting information on your personal and
professional life.

ACCOUNTING DEFINED
Definition
“Accounting is the process of providing quantitative information about economic entities to aid
users in making decisions concerning the allocation of economic resources (AICPA)
There are four key elements in the above definition.
 (1) Firstly, the Process of providing – Which means that there is a series of activities
leading upto and including the communication of accounting information. These
activities are;
(i) Identifying the information (i.e. selecting economic events ((transactions),
(ii) Measuring economic events (Quantify in Shillings, Pounds, Dollars)
(iii) Recording economic events (record, classify and summarize)
(iv) Communicating economic events (prepare accounting reports, analyzing and
interpreting for users)
Alternative definitions
∙ “Accounting is an information system that measures, processes, and
communicates financial information about an identifiable economic unit.

∙ Accounting is the process of identifying, measuring, recording and

communicating economic information to permit informed judgments and decision
by the users of the information. (American Accounting Association).

(2) Second, Quantitive - means that the information is communicated by using numbers; in
accounting numbers are usually numbers of monetary unit (Shilling/dollar/pound /Euro).
(3) Third, Economic entities, - means that accounting applies to all economic units viz;
(i) Business organizations e.g. Barclays bank, Uchumi supermarkets, Nakumatt,
etc
(ii) Non-business organizations

(a) Government and Government agencies e.g.

- Central government – Ministries & government departments
- Local government cities, municipalities, councils Whether etc
- Kenya Revenue Authority
- Kenya Airports Authority
- Kenyatta National Hospital, KWS, KARI
(b) Not-for-Profit organizations e.g.

- Charitable organizations (International Red-cross, ed. TWA)

- Churches e.g. Catholic diocese of Nairobi, NPC, etc.
- Hospitals – e.g. Mater, Nairobi, Aga Khan
- Educational e.g. U.o.N, Nairobi school institution, KTTC.
- Political parties- e.g. KANU, NARC

(4) Fourth, Decisions concerning the allocations of economic resources which include
among others
- Whether to buy, sell or hold investments. (Investment decisions)
- Whether to extend credit to a company desiring a loan (credit decisions)
- Whether to manufacture and sell a particular product (operating/managerial
decisions)
- Whether to modify the income tax regulations to stimulate business attitudes (fiscal
decision) etc

NB:
These and other decisions will be discussed throughout this course to show how accounting
information can be used in decision making.

Business Activities ACCOUNTING Decision making

MEASUREMENT/Input
(DATA) PROCESSING Output/Communication
(Financial report)
E.g. Sales, Invoice
 DISTINTNCTION BETWEEN BOOKKEEPING AND ACCOUNTING

Many individuals mistakenly consider book-keeping and accounting to be one and the same.
This confusion is understandable because the accounting process includes the bookkeeping
function. However, accounting encompasses much more.
Definition

Bookkeeping-
“Is the process of recording financial transactions and keeping financial records”. It is
mechanical and repetitive; book keeping is therefore a small but important part of accounting.

NB:
The Bookkeeping function is often performed by individuals with limited skills in accounting.
As a result, it is not surprising that the increased use of computers by business enterprises has
resulted in much of the detailed work that is part of the bookkeeping process being performed by
machines.

Accounting
By contrast, accounting includes the design of an information system that meets the users’
needs. The major goals of accounting are the analysis, interpretation, and use of financial
information. In any event, the accountant must have a much higher level of knowledge,
conceptual understanding, and analytical skills than is required of the bookkeeper.

Course Emphasis
The foundations course of Accounting will focus on the information systems for business
enterprises. Business forms can be broadly categorized into three classes;
(i) Service forms
(ii) Merchandising forms
(iii) Manufacturing forms

Business Goals and Activities

Definition (business defined)
“A business is an economic unit that aims to sell goods and services to customers at prices that
will provide an adequate return to its owner”. For example, listed below are some companies
and the principal goods or services they sell;

(1) Unga Ltd Food products

(2) Bidco Ltd Food products
(3) Steers Ltd Food service
(4) Hilton Hotel Ltd Hotels & Resort service
(5) Kenya Airways Passenger and cargo airline service
(6) Standard Chartered Banking services
(7) Insurance Co. of East Africa Insurance
(8) Galsheet Manufacturing (Iron sheets)
(9) Unilever Tea Ltd Agricultural products
(10) Kenya Power & Lighting Co. Energy
(11) Mobil Petroleum products

NB:
Despite their differences, all these businesses have similar goals and engage in similar
activities as shown in the diagram below:

BUSINESS GOALS BUSINESS ACTIVITIES

PROFITABILITY
LIQUIDITY
INV

Figure 1: Business Goals and Activities

Business Goals:

(1) Profitability Goal

Each entity will endeavour by selling goods and services, get enough money from customers to
pay all the costs of doing business, with enough left over as profit for the owners so as to stay in
the business.

(2) Liquidity Goal

Liquidity means having enough funds (cash) available to pay debts when they are due. For
example, Toyota Kenya may meet the goal of profitability by selling many cars at a price that
earns a profit, but if its customers do not pay for their cars quickly enough to enable it to pay its
suppliers and employees, the company may fail to meet the goal of liquidity.

NB
Both goals must be met if a company is to survive and be successful in a competitive
environment.
Business Activities
All businesses pursue their goals by engaging in similar activities. The three activities are:
 (1) Financing activities
(2) Investing activities
(3) Operating activities

(1) Financing Activities

First each business must engage in financing activities to obtain adequate funds, or capital, to
begin and continue operating.
Financing activities include;
- Obtaining capital from owners and from creditors such as banks and suppliers
- Repaying creditors and paying a return to the owners.

(2) Investing Activities

Secondly each business must engage in investing activities to spend the capital it receives in
ways that are productive and will help the business achieve its objectives. Investing activities
include:-
- Buying land, buildings, equipment and other resources that are needed in the
operation of the business
- Selling the above resources when they are no-longer needed.

(3) Operating Activities

Thirdly, each business must engage in operating activities. Operating activities include:-
- Selling goods and services to customers
- Employing managers and workers
- Buying and producing goods and services
- Paying taxes to the government

USERS OF ACCOUNTING INFORMATION

Because Accounting communicates financial information about a business enterprise, it is often
called “the language of business”.
The information that a specific user needs depends upon the kinds of decisions that the user
makes. The differences in the decisions divide users into two broad groups.

(1) Internal users: those who manage the business (offices and other decision makers)

(2) External users: those outside the business who have either a present or potential
(a) direct financial interest eg investors and creditors or
(b) an indirect financial interest (tax authorities, regulatory agencies, labour unions,
customers, and economic planners, students, business analysts, etc)

(1) Internal Users – Management

Management, collectively, is the people who have overall responsibility for
operating a business and for meeting its profitability and liquidity goals.
NB: - In small businesses, the management may include the owners.
- In a large business, management more often consists of people who have been hired.
Management must decide what to do (i.e. plan), how to do it, and whether the results
match their original plans. Successful managers consistently make the right
decisions, based on timely and valid information. To make good decision, managers
need answers to such questions as:
▪ What was the company’s net income (profit) during the past quarter?
▪ Is the rate of return to the owners adequate?
▪ Does the company have enough cash, to pay debtors?
▪ Which products are most profitable?
▪ What is the cost of manufacturing each product?
▪ Are customers paying their bills promptly?
▪ What costs exceed budget?
▪ Can we afford to give employees pay rises this year?
▪ How much money must be borrowed to expand the factory?
 ▪ etc

To assist management in answering these questions, accounting provides internal reports.

Examples include:
- Financial comparison of operating alternatives.
- Projections of income from new sales campaigns and
- Forecasts of cash needs for the next year.
- In addition, statements on the financial position and results of operations for the
entire business are prepared.

(2) External Users: Users with a Direct Financial Interest

Another group of decision makers who need accounting information are those with a direct
financial interest in a business. They depend on accounting to measure report information about
how a business has performed. Most business periodically publishes a set of general-purpose
financial statements that report their success in meeting the goals of profitability and liquidity.
These statements show what has happened in the past and are important indicators of what is
going to happen in the future. Many people outside the company carefully study these financial
reports. The two most important outside groups are investors and creditors

(1) Investors (Owners)

Those who invest or may invest in a business and acquire a part ownership are interested in
its past success and potential earnings. A thorough study of a company’s
financial statements help potential investors judge the prospects for a profitable
investment. After investing in a company, investors must continually review their
commitment, again by examining the company’s financial statements. In other words,
investors judge the wisdom of buying, holding, or selling their financial interest on the
basis of accounting data.

(2) Creditors (lenders and suppliers)

Most companies borrow money for both long-term and short-term operating needs. Creditors,
(those who lend money or deliver goods and services before being paid), are interested mainly in
whether a company will have the cash to pay interest charges and repay debt at the appropriate
time. They study a company’s liquidity and cash flow as well as profitability.
Banks, finance companies, mortgage companies, insurance firms, suppliers and other lenders
must analyze a company’s financial position before making a loan.
The creditor evaluates the request to grant credit or lending money on the basis of the accounting
information obtained about a particular business.

NB:
Some of the questions asked by investors and creditors about a company might be;
- Is the company earning a satisfactory income?
- How does the company compare in size and profitability with competition?
- Will the company be able to pay its debts as they become due?
- Are interest payments and dividends protected by an adequate inflow of cash from
operations?

(3) External Users: - Users with an Indirect Financial Interest

In recent years, society as a whole, through government and public groups, has become one of
the biggest and most important users of accounting information: Users who need accounting
information to make decisions on public issues include:
(i) Tax authorities (KRA) – who want to know if the company complies with tax
laws. Government at every level is financed through the collection of taxes.
Companies and individuals pay many kinds of taxes including
- Income taxes,
- Payroll taxes,
- Excise taxes,
- Sales taxes (VAT)
Each tax requires special tax returns and often a complex set of records as well.

(ii) Regulatory Authorities: Most companies must report to one or more regulatory
agencies. For example
- all publicly quoted companies must report periodically to the Capital Markets
Authority
- all banks and financial institutions must report periodically to the Central Bank of
Kenya
- all Insurance companies must report periodically to the Commissioner of Insurance
- all communications companies must report periodically to the Communications
Commission of Kenya

(iii) Other Groups

(a) Customers: - are interested in whether the company will continue to honour
product warranties and otherwise support its product lines.
(b) Labour unions: - study the financial statements of a company as part of
preparation for contract negotiations. They want to know if the company has
the ability to pay increased wages and benefits.
(c) Economic planners: - use accounting information to analyze and forecast
economic activity.
(d) Investor and Creditor advisors

- Financial analysts and advisors

- Brokerage firms
- Underwriters
- Lawyers
- Economists
- Financial press
- etc
 all use accounting information to establish the financial prospects of the business.

Distinction Between Financial and Management Accounting

The role of Accounting is to assist decision makers by measuring, processing, and
communicating information. It is usually divided into two categories:-
(1) Management Accounting
(2) Financial Accounting

(1) Management Accounting

Management accounting provides internal decision makers who are charged with
achieving the goals of profitability and liquidity with information about financing,
investing and operating activities.
Managers and employers who conduct the activities of the business need information that
tells them how they have done in the past and what they can expect in the future. For
example, Uchumi supermarkets need an operating report on each outlet (store) that tells;
- how much was sold out at outlet and
- what costs were incurred and
- It needs to budget for each outlet that projects the sales and costs for the next year.

(2) Financial Accounting

Financial accounting generates reports and communicates them to external decision makers so
that they can evaluate how well the business has achieved in goals. These reports to external
users are called Financial Statements.
The Uchumi Supermarkets Ltd, for instance, will send its financial statements to its owners
(called stockholders or shareholders), (ii) its banks and other creditors, and (iii) government
regulators.
Financial statements report directly on the goals of profitability and liquidity and are used
extensively both inside and outside a business to evaluate the business’s success. It is important
for every person involved with a business to understand financial statements. They are a
central feature of accounting and are the primary forms of this course.

Accounting for Non-Business Organizations

“Non-business organizations are economic entities that are organized to provide a socially
desirable service without regard to financial gain”. They are not, operated for the financial
benefit of any specific individual or group of individuals. Thy comprise a sizeable portion of
total business in a country, and control a sizeable portion of a nations income (GDA)

Classifications of Non-Business Organizations

There are five major classifications of non-business organizations.

(i) Governmental Units

Government units include:-
- Central government units
- Local governmental units
- Cities
- Municipalities
- Schools

(ii) Hospitals
(iii) Colleges and Universities
(iv) Voluntary Health & Welfare Organizations
These derive their revenue from voluntary contributions of the general public to be used
for purposes connected with health, welfare, or community services
Examples of such organizations include:-
- Heart to heart foundation
- Family Planning Association of Kenya
- Diabetic Association of Kenya
- Kenya Society for the blind
(v) Other Non-business Organizations:
These take a variety of forms
They include such organizations as:
- Trade Associations e.g. Kenya National Chambers of Commerce & Industry, Kenya
Association of Manufactures
- Professional Associations e.g.
∙ Institute of Certified Public Accountants/Secretaries (ICPAK)
∙ Law Society of Kenya
∙ Institute of Engineers
- Performing arts organizations
∙ Kenya National Theatre,
∙ Phoenix Players

- Sports Associations e.g.

● Kenya Football Federation (KFF & FIFA)
● International (Athletics Kenya)
- Religious Organizations e.g.
• Anglican Church of Kenya
• NCCCK
• Muslim
• Hindu Council of Kenya
- Research & Scientific Organizations
● KEMRI
● ICIPE
● ICRAF
- NGO’S
- The NGO Council of Kenya
- United Nations
 - International Red Cross
- Catholic Relief Services
- Plan International
- Action Aid
- Oxfam
- etc

Distinction Between Non-Business Organizations and Profit Oriented Enterprises

(1) Profit makers

In Non-business organizations there is an absence of a deliberate or conscious effort to
derive a profit. The performance of services by non-business organizations is based on
social needs rather than the profit motive.

(2) Persons who contributes resources to a non-business organization receive no equity interest
in the net assess of the organization, and there is no equity (ownership) interest there-in
that can be sold or exchanged.

(3) Non-business organizations do not often finance their operations through adequate charges to
the direct beneficiaries of their service. Thus, they rely on political action. (For
example, tax levies) or fundraising campaigns to sustain their activities and replenish
their financial resources.

NB:
Those who contribute resources to non-business organizations do not necessarily benefit
proportionately (taxes) or at all from the services provided by such organizations. As a result, the
net income (profit) concept cannot be used to measure the effectiveness of the management of
resources dedicated to non-business objectives. Therefore, the income determination Model of
accounting is generally not applicable to such organizations.

In profit-oriented enterprises, net income functions as an implicit regulator in the sense that in
the long-run the organization must operate profitably to survive. In the absence of this implicit
regulator, regulation of the allocation and utilization of the financial resources of non-business
organizations is often achieved by the imposition of stringent controls. Such controls may be:
(i) Legally imposed (as is the case with governmental activities).
(ii) Imposed through formal action by the governing board.
(iii) Directly imposed by the individuals or groups that contribute such resources. For
example most non-business organizations receive gifts, grants, or endorsements
that are to be used only for specific purposes designated by the donor, such as;
- Construction of buildings,
- Research activities,
- Scholarships,
- Operating parties,
- Recreational programmers,
- The acquisition of land
In addition, the donor may stipulate that the principal gift is to remain intact and that only the
income on the invested principal is to be used for the purpose designated by the donor.

Fund Accounting
In order to account for these legally imposed, externally imposed, and, and self imposed
restrictions. Its limitations on the utilizations of their resources, non-business organizations have
generally adopted the concept of fund-accounting.

In fund accounting, each fund consists of assets, liabilities, and a fund balance and constitutes a
separate accounting entity created and maintained for a specific purpose. The inflow and
outflow of resources of each fund must be accounted for in such a way that they can be
compared with the approved or stipulated resource flows for that fund.

Users of Non-Business Accounting Information

Like in business organization the decision makers in non-business organizations fall into two
classes.

(1) Internal users

Management of the organization who need to plan and control the organizations
operations. Accounting information is required in making financing, investing and operating
decisions.

This group comprises managers, directions and trustees.

(2) External users

The potential users of financial reports (statements) of non-business organizations include:-
- Tax payers,
- Construction – NSSF/NHIF
- Donors
- Creditors
- Employees
- Service beneficiaries
- Taxing authorities (Donations may be tax exempted)
- Regulatory authorities (e.g. NGO Council)
- Legislators
- The financial press
- Reporting agencies
- Labour Unions
- Trade Associations
- Researchers
- Teachers
- Students
 LECTURE TWO
CONCEPTUAL FRAMEWORK UNDERLYING FINANCIAL ACCOUNTING AND
REPORTING
Lecture Content
2.1 Nature and Content
2.2 Generally Accepted Accounting Principles
2.3 Accounting Environment
23.1 Economic Environment
2.3.2 Social Economic Studies
2.3.3 Legal and Statutory Environment
2.3.4 Management
2.4 Environmental Assumptions in Accounting
2.4.1 Accounting Entity Assumption
2.4.2 Periodicity Assumption
2.4.3 Going Concern Assumption
2.4.4 Monetary Assumption
2.5 Disciplines in Accounting
2.5.1 Management Accounting
2.5.2 Financial Management
2.5.3 Tax Accounting
2.5.4 Auditing

2.1 The Nature and Content of Financial Accounting and Reporting

The term financial accounting and reporting encompasses the dual role of the financial
accountant mainly measuring and recording an entity’s economic activities and
communicating the recorded data to the external users of financial information.
Financial accounting and reporting provides a continuous history quantified in
monetary terms of the economic resources and obligations of a business enterprise and
the economic activities that change those resources and obligations.

This encompasses the published financial statements and supplementary information

required under the generally accepted accounting principles. The main objective of
financial accounting and reporting is to provide information needed by current and
prospective investors and creditors of a business enterprise in their decision making.

2.2 Generally Accepted Accounting Principles (GAAPs)

These consist of the accounting and reporting conventions, rules and procedures that a
business entity must use in preparing external financial statements. The G.A.A.Ps are
usually prescribed by authoritative bodies e.g. International Accounting Standard
Board (IAS), Financial Accounting Standards Board (FASB) of the United States, etc.
However some are simply practices that accountants generally follow based on both
practical and theoretical considerations and often represent a consensus among
accountants as to what is considered acceptable practice.

The G.A.A.P serves three basic purposes:-

(i) Help increase the confidence of financial statements as being
representationally faithful.
(ii) They provide companies and accountants with guidance on how to prepare
financial statements with guidance on how to report for unreported economic
activities.
(iii) They provide independent auditors of financial statements with a basis for
evaluating the fairness and completeness of those statements.
The Financial statements and reports require many estimates, assumptions and
professional judgment by both management and accountants e.g. estimates of
uncollectible accounts, calculation of depreciation expenses etc. call on the
accountant to make judgment based on various assumptions. A slight
 mis-assessment of facts, personal bias, errors in estimation may enter into the
measurement and communication of economic events which would adversely affect
decision based on them.

The importance of standards cannot be over emphasized for without them to guide the
accounting and reporting practice, all accountants would have to develop their own
financial statement theory, practice and procedures. The users of accounting
information would find reported information of little help in making economic
decisions and would have little assurance of the credibility of the reported data.

2.3 The Accounting Environment and Role of Financial Accounting and Reporting.
The environment within which accountants operate is made up of interrelated micro
and macro social economic activities. Since accounting covers the entire administration
and management of information for all social economic activities and conditions in both
micro-and macro economic sectors, covering internal and external information needs it
is important to have a clear understanding of the accounting environment.

The environment in developing and underdeveloped economies is different from that in

developed economies. In the latter, we find sophisticated accounting systems, processes
and procedures compared to the simple and sometimes obsolete systems and processes
in use in under developed economies. Regardless of the set up, the accounting practice
is influenced by the economic, social, legal and managerial environments.

2.3.1 Economic Environment

As countries developed, accounting systems have evolved over a long period of time.
For centuries after the systems of double entry book keeping appeared, accounting was
devoid methodology or any form of theory. It was in the 19th century that we saw a
move from book keeping to accounting, which is a move from the relatively simple
recording and analysis of transactions towards a comprehensive accounting information
system in the 20th century when the theoretical framework began to develop. This
framework provided technical means to measure, value and communicate information
of economic and financial nature. In keeping with mass production techniques and
high capital investment, there have been refinements along the way and cost and
management accounting systems have emerged.

Government accounting has for a long time been linked to taxation and revenue
control and to the recording and accountability of receipts and expenditure. In
developing countries, these have largely continued to be the same but in developed
countries refined planning\budgeting and control techniques have been developed.

2.3.2 Social EconomicStudies.

These studies include social economic facts dealing e.g. with poverty, social security,
ecology and a whole range of other aspects in society for which accounting
measurement and reporting are warranted. This one is referred to as social accounting
and even corporate bodies have to take social aspects into consideration. Environmental
pollution, products or service contribution, human resources as well as community
development have come within the domain of corporate social accounting and
reporting.
It is now well recognized that corporate activities have economic consequences and a
well structured cost benefit analysis of an organization’s activities is considered more
significant than a limited study of revenues and expenses.

2.3.3 Legal and Statutory Environment

Accounting theory and practice is influenced very strongly by requirements imposed by
the companies Act and other regulatory agencies. Adherence to the statues enhances
comparability between different companies or between different time periods.

2.3.4 Management
The management of the firm has a lot of discretion on the activities that an organization
should engage in and the timing of those transactions. This discretion greatly influences
the practices of accounting.

2.4 ENVIRONMENTAL ASSUMPTIONS IN ACCOUNTING

From the foregoing, the environment within which financial accounting and reporting
exists has been described. The following are the environmental assumptions that
provide the context for Financial Accounting and Reporting
(i) Accounting entity assumption.
(ii) Periodicity assumption.
(iii) Going concern assumption.
(iv) Monetary assumption.

2.4.1 Accounting Entity Assumption

This assumption establishes boundaries or limits as to what information should be
included in the financial statements of a given accounting entity e.g. the economic
activities of a single or sole proprietorship. The entity for which financial reports are
prepared may or may not correspond to a legal entity e.g. the entity may be a
corporation (legal entity), a division or department within a corporation (within and
legal entity) or a group of legal entities for which consolidated Financial Statements are
prepared.

2.4.2 Periodicity Assumption.

A feature of the economic environment is that investors, creditors and other parties
make resource allocation decisions on continuing basic and need timely financial
information to assist in decision making as such users of financial information impose
periodicity on an accounting entity because they need annual, quarterly (3 months) or
even monthly information.
The periodicity assumption implies that the economic activities undertaken during the
life of an accounting entity are assumed to be divisible into various artificial time
periods for financial reporting purposes. For example the revenue generating activities
of an entity do not “pause” at the end of the accounting period for the accountant to
make financial statements but we assume guided by the various principles that he can
make a reasonable assessment of revenue, expenses etc on an annual or quarterly basis.

2.4.3 Going Concern Assumption

This is also known as the continuity principle and basically means that accountant
assumes the business entity will continue to exist indefinitely into the foreseeable
future, without the likelihood of closing down or significantly curtailing the scale of its
operations. This is a fundamental assumption underlying Financial Accounting and
without it the practice as we know it will be highly compromised. For example,
consider the possibility that an entity were to cease operations. Certain liabilities would
mature immediately and require a payment in excess of their carrying amount.
Productive assets like machinery might have to be sold at a substantial loss because the
book values and the market values may differ significantly. The assumption of
continued existence provides the logical basis for recording probable future economic
benefits as assets and probable future outlays as liabilities.

The continuity principle does not imply permanency of existence but simply that the
business will continue long enough to carry out present plans and meet contractual
commitments. The principle also affects the classification of assets and liabilities in the
balance sheet. Since it is assumes that assets will be used and obligations paid in the
normal course of operations, no attempt is made to classify assets and liabilities in terms
of their disposition values or legal priority as is the case with liquidation.

2.4.4 Monetary Assumption

This assumption/principle means that accountants assume money to be a useful
standard measuring unit for reporting the effects of business transactions. All financial
transactions must be capable of being quantified and expressed in monetary terms. As
such financial information will be expressed in terms of dollar, pound, Euro, shillings,
etc.

This assumption assumes stability over time as compared to other measures eg

kilograms, meters, etc. Just as a kilogram in 1980 was the same weight as it is today, so it
is assumed that the dollar or shilling today would have the same purchasing power
they had in 1980. This is not the case and as such this is a major weakness of the
monetary assumption. Though financial information is universally expressed in
monetary terms, some of the information necessary to give a comprehensive picture of a
business enterprise is difficult or impossible to quantify and express in monetary or
other units of measurement for example, the competence, health, and morale of
management and employees. This is not practicable and a possible alternative would be
to use notes to the financial statement to communicate this information.

2.5 DISCIPLINES OF ACCOUNTING

It is very important to have a wide understanding of what accounting is and the
breadth of the work that an accountant might be called upon to undertake. Accounting
is divided to specialization which includes the following:-
2.5.1 Management accounting
Financial accounting is mainly a method of reporting the results and financial
position of a business at a particular time. It is not primarily concerned with
providing information as a guide to the efficient conduct of the business.
Management principles function is to satisfy the information need of a person
involved in this day to day running of the business. The information needs of
management go beyond those of other account users.
 Shareholders for example will be contempt if they see that profits and dividends
are rising, the tax authorities will be satisfied if the amount of the companies
taxable profits are calculated and paid. However, managers have the
responsibility of planning and controlling the resources of the business and to do
these they need much more detailed information than the financial accounts may
disclose. Management accounting is a management information system which
collects, analyzes data to provide information as a basis for managerial action.
The concern of a management accountant is to present accounting information in
the form most helpful to management and not necessarily in accordance with
legal requirements.

The accounting statements drawn up by a management accountant are often

prepared and presented very differently from those of the financial accountant
and often includes estimates. The nature, scope and content depend on the
reasons for preparing management accounts and the different people to whom
they may be addressed.

2.5.2 Financial Management

This is a separate discipline from both management accounting and financial
accounting. The financial manager is responsible for raising finance and
controlling financial resources. The kind of decisions he/she will be required to
make include those that will involve answering the following questions. e.g.
i) Should the firm borrow from a bank or raise funds by issuing shares?
ii) How much should be paid out as dividends.
iii) Should the firm spend money on new machinery?
iv) How much credit should be given to customers?
v) How much discount should be given to customers who pay early?
The details of the subject of the financial management are covered in courses in finance.
 2.5.3 Tax Accounting
Taxes raised by the state and local government are usually based on income earned by
the tax payers who may include both individuals and organizations. The amount of
taxes is computed on what the law defines as income. Tax accounting practitioners help
tax payers comply with the law by preparing their tax returns.
Tax accounting also involves planning future transactions to minimize taxes. Large
organizations usually have employees who are responsible for tax returns and tax
planning. They occasionally consult with other tax accounting experts when they need
tax advice. Small organizations heavily rely on experts for much of their tax accounting.

Non-profit organizations are major employers of tax services especially the Kenya
Revenue authority (K.R.A). The K.R.A is responsible for collecting taxes within Kenya
and enforcing the tax law. K.RA employees peruse revenue tax returns filed by the tax
payers and also after assistance to tax payers, help write regulations and investigate
possible violation of tax laws.

2.5.4 Auditing
The annual accounts of a limited company must be audited by a person independent of
the company, who is a practicing auditor. He investigates the accounts prepared by the
company and makes a report as to whether or not they present fairly the companies
results for the year and its financial position at the end of that year.
When the auditors have completed their work they must prepare a report explaining
the work they have done and the opinion they have formed. If the accounts show a true
and fair view and are properly prepared in accordance with the G.A.AP or any relevant
legislation then the auditor gives an unqualified (clean) audit report.
Sometimes the auditors may disagree with the accounts and if this affects in a
significant manner, the auditor gives a qualified report showing that he/she has some
reservations on the accounts as presented.
It is important to note that the accountant begins from the transactions. He accumulates
information to prepare financial statements (the end result). The auditor on the other
hand begins with the financial statements and authenticates the information through
the accounts up to the transactions to give an audit report. He moves in the reverse
direction to the accountant.

LECTURE THREE
BASIC FINANCIAL STATEMENTS AND TRANSACTIONS

Lecture Content
3.1 Introduction
3.2 Objectives
3.3 Forms of business organizations
3.4 Financial statements of business organizations
3.5 The generally accepted accounting principles
3.6 The accounting equation.
3.7 Transactions analysis and the accounting
3.8 Summary

3.2 Objectives
By the end of this lecture, you should be able to:
● Identify the three basic forms of business organizations
● Identify the types of activities performed by business organizations
 ● Describe the four financial statements of a business organization,
and explain the meaning of assets, liabilities, equity, revenues,
expenses and net income
● Define and explain generally accepted accounting principles
● Define and explain the accounting equation
● Define a transaction and describe source documents and their
purpose
● Analyze business transactions using the accounting equation
● Prepare financial statements from business transactions

(1) Forms of Business Organizations

A business is organized and operated to make a profit. Because of this, a business
is often called a profit oriented organization.
Accountants frequently refer to a business organization as an accounting entity
or a business entity. A business is any business organization, such as a hardware
store or grocery store, that exists as an economic unit. For accounting purposes,
each business organization or entity has an existence separate from its owner(s),
creditors, employees, customers, and other businesses. This separate existence of
the business organization is known as the business entity principle/concept.
Thus, in the accounting records of the business entity, the activities of each
business should be kept separate from the activities of other business and from
the personal financial activities of the owner(s).

The business entity concept applies to the three forms of businesses:-

- Sole proprietorship
- Partnership
- Corporations/companies
 Thus, for accounting purposes, all three business forms are separate from other
business entities and from their owner(s) although legally only the company is
considered separate from its owner.
(1) Sole/Single Proprietorships
A sole proprietorship is a business owned by one person. No special legal
requirements must be met to start a sole proprietorship.
NB: (i) While it is a separate entity for accounting purposes,
it is not a separate legal entity from its owner. This means, for
example, a court can order an owner to sell personal belongings to
pay a proprietorship debt. An owner is even responsible for debts
that exceed an owners net investment in the proprietorship. This
unlimited liability of a proprietorship is sometimes a
disadvantage.
(ii) Tax authorities do not separate a proprietorship from its owner.
This means the profits of a proprietorship are not subject to a
business income tax, but must be reported and taxed on the
owners’ personal income tax return.
(iii) Sole proprietorships are by far the most common forms of business
organizations in our society.

(2) Partnership
A partnership is a business owned by two or more persons, called partners.
Like a proprietorship, no special legal requirements must be met in starting a
partnership.
NB: A partnership, like a proprietorship, is not legally separate from its owners. This
means that each party share of profits is reported and taxed on that partners tax
return. It also means unlimited liability for its partners.

(3) Company (Corporation)

A company is a business legally separate from its owners. This means a company
is responsible for its own acts and its own debts. It can enter into its own
contracts and it can buy, own, and sell property. It can also sue and be sued.
Separate legal status means a company can conduct business with the rights,
duties, and responsibilities of a person.

NB:
(i) A company acts through its managers, who are its legal agents.
(ii) Separate legal status also means its owners, who are called
Shareholders, are not personally liable for a company’s acts and
debts. Shareholders are legally distinct from the business and their
loss is limited to their net investment in shares purchased. This
limited liability is a key to why companies can raise resources
from shareholders who are not active in managing the business. It
also encourages more fishy investment with higher expanded
returns.
(ii) A company is legally incorporated under the laws of Kenya (Cap.
486). Separate legal status results in a company having unlimited
life. Ownership, or equity, of all companies is divided into units
called shares or stocks. Owners of shares are called Shareholders
or Stockholders. A Shareholder can sell or transfer shares to
another person without affecting the operations of a corporation.
When a company uses only one class of stock, we call it
Common/Ordinary stock or capital stock.
(iii) A company is taxed on its net income. Further, any distribution of
company earnings (called dividends) is also taxed as part of their
personal income.
Types of Activities Performed By Business Organizations
Business entities can also be grouped by the type of business activities
they perform- viz;
- Service companies
- Merchandising companies
- Manufacturing companies
Any of these activities can be performed by companies using any of the three forms of
business organizations.

(i) Service Firms

These companies perform services for a fee.
This group includes:-
- accounting firms
- law firms
- dry cleaning establishments
- banks investment firms
- insurance companies
- etc

(ii) Merchandising Firms

These firms purchase goods that are ready for sale and then sell them to
customers. Merchandising companies include;-
- Auto dealerships - DT Dobie, CMC, Car & General, Toyota Kenya
- Clothing stores – Deacons, Njirris, Y-fahions
- Supermarkets - Uchumi , Carrefour, Naivas, Quickmart, etc
- Wholesalers - Nyanza Petrolerium
- Retailers - Metro Cash &Ccarry, Hardwares, Biashara Street type of
businesses, etc
 (ii) Manufacturing Firms
These buy materials, convert them into products, and then sell the products to
other companies or to the final consumers. Manufacturing companies include:-
- Steel mills – e.g Mabati Rolling Mills
- Brewers - e.g East African breweries, Castle brewing, Keroche etc
- Detergents - e.g Unilever, Bidco, Cussons
- Clothing Manufacturers - Manchester outfitters, Nakuru Blankets,
Rivatex etc

NB: All these entities produce financial statements as the final end product of their accounting
process. These financial statements provide relevant financial information both to those inside
the company (i.e management) and those outside the company (i.e creditors, stockholders, and
other interested parties as discussed above.

Financial Statements of Business Organizations

3.1 Introduction

Business entities have two primary objectives, profitability and solvency (liquidity).
Profitability is the ability to generate income. Solvency (liquidity) on the other hand is the
ability to pay debts as they become due. Unless a business can produce satisfactory income and
pay its debts as they become due, the business cannot survive to realize its objectives.
 As we have seen, accounting is an information system that provides financial data to
interested parties for decision –making purposes. Financial statements report on the
financial performance (profitability) and condition (solvency/liquidity) of an
organization. They are one of the most important products (outputs) of accounting, and
are useful to both internal and external decision makers
NB: Some knowledge of the content of financial statements and the types of
information they are designed to communicate will help you better understand the
underlying concepts and measurement processes followed in accounting.
The objective of financial statements is to report the economic effects of
completed business transactions and other events on an organization. To
accomplish this purpose, four types of financial statements are produced:
(i) Balance sheet (Statement of Financial Position).
(ii) Income statement (Statement of Financial Performance).
(iii) Statement of Changes in Owners Equity (Statement of Retained Earnings).
(iv) Statement of Cashflows.

The four statements are linked in time as illustrated below:

Income statement

Beginning Statement of Ending Balance

Balance Sheet changes in Sheet
owners equity
 Statement of cashflows

Point in Point in
Time time

(1) The Balance Sheet (Statement of Financial Position)

The balance sheet reports the financial position of a company at a point in time (date) usually the
end of month or year. Because of its implies on financial position, it is also called the Statement
of Financial Position.

The balance sheet describes the financial position by listing the types and shillings amounts of
assets, liabilities, and equity.

That is the balance sheet presents a view of the business as the holder of resources, or assets, that
are equal to the claims against those assets. The claims consist of the company’s liabilities and
the owners equity in the company.
(ASSETS = LIABILITIES + OWNERS EQUITY)
ILLUSTRATION

FORTRAN COMPANY
BALANCE SHEET AS AT 31ST DECEMBER 2008
Kshs Kshs
ASSETS LIABILITIES
Cash 15,500 Accounts Payable 600
Accounts Receivable 700 Notes Payable 6,000
Trucks 20,000 Total Liabilities 6,600
Office Equipment 2,500 OWNERS EQUITY
32,10
Peter Kaluma 0
38,70
38,700 0

Three elements in the balance sheet.

(i) Assets
(ii) Liabilities
(iii) OWNERS/STOCKHOLDERS EQUITY

(i) ASSETS
Assets are economic resources that are owned by a business and are expected to provide future
benefits to the business. In most cases, the benefit to future operations comes in the form of
future cashflows. The positive future cashflows may come:
(i) Directly as the asset is converted into cash e.g collection of a receivable) or
(ii) Indirectly as the asset is used in operating the business to create other assets that
result in positive future cashflows (e.g buildings, land, and equipment are used to
manufacture a product for sale).
NB: Assets may have definite physical form (tangible) such as buildings, machinery, or an
inventory of merchandise. On the other hand, some assets exist not in physical or tangible form,
but in the form of valuable legal claims or rights, examples include:
- Amounts due from customers (also receivable)
- Investments in government bonds and bills.
- Patent rights

(ii) Liabilities
Liabilities are obligations of a business and represent future sacrifices (outflows) of
economic benefits. A common characteristic of liabilities is their potential for reducing
future assets or requiring future services or products.

NB: Liabilities include such things as:-

(a) amounts owed to suppliers of goods and services purchased on credit
(Accounts payable),
(b) amounts borrowed from banks or other lenders (notes payable),
(c) amounts owed to employees for salaries and wages (wages/salaries payable),
(d) amounts owed to tax agencies for taxes incurred but not paid (taxes payable)
Individuals and organizations who own the right to receive payment from a business are called
its creditors. If a business fails to pay its obligations, the law gives creditors a right to force the
sale of business assets to obtain the money to meet creditor’s claims. When assets are sold under
these conditions, creditors are paid first, but only up to the amounts of the claims. Any residual
money, goes to the owners of the business. Creditors often use a balance sheet to help decide
whether to loan money to a business. They compare the amounts of liabilities and assets. A
loan is less risky if liabilities are small in comparison to assets. This is because there are more
resources than claims on resources. A loan is more risky if liabilities are large compared to
assets.

(iii) Owners Equity (Equity).

 Equity is the owner’s claim on the assets of a business. It is the residual interest in the
assets of a business after deducting liabilities (i.e Equity = Assets – Liabilities).
Equity is also called net assets.
NB:
(a) The term used for equity depends on the form of business as follows:
(i) Sole proprietorship – Owners Equity
(ii) Partnership – Partners Equity
(iii) Company – Stockholders/Shareholders Equity

(b) Owners Equity is increased by owners’ investments and by

revenue. It is decreased by owner withdrawals and expenses.

OWNERS INVESTMENT Owners Withdrawal

Owners Equity

Revenues Expenses

▪ Owners Investment:- These are assets put into the business by the
owner(s)
▪ Owner withdrawal:- These are assets taken away from the business by the
owner(s) also known as drawings.
(2) The Income Statement (Profit & Loss Statement)
An Income Statement reports revenues earned and expenses incurred by a business over a period
of time. Expenses are subtracted from revenues on the Income Statement to show whether the
business earned a net income. A Net Income means revenue exceed expenses. A Net loss, or
simply loss means expenses exceed revenues. The Income Statement of fast forward’s first
month of operation is as shown below:

FOTRAN COMPANY
Income Statement for the Month Ended Dec. 31, 2008
Kshs Kshs
Revenues:
5,70
Service Revenues 0
Expenses:
2,60
Salaries expense 0
Rent expense 400
Car and oil expense 600
3,60
Total expenses 0
2,10
Net Income 0

NB: (1) An Income Statement does not simply report net income (profit) or net loss. It lists the
types and amounts of both revenues and expenses. This is crucial information for users as it
helps in understanding and predicting company performance. Income Statement heading
identifies the company, the type of statement, and the time period covered.

(2) Identification of the period of the time period covered is particularly important because it
indicates the length of time it took to earn the reported net income.
Revenues
Revenues are inflows of assets in exchange for products and services provided to customers as
part of a company’s primary operations.

NB: Although revenues often consists of cash, it may consist of any asset received such as:-
- a customers promise to pay in the future (ie an amounts receivable or
- the receipt of property from a customer
Examples of type of revenues include:
- Compensation for the sale of goods,
- Rent received
- Interest received on lending,
- Dividends received on stock owned etc
- Commissions revenue
- etc
Expenses
Expenses are outflows or the using up of assets from providing products and services to
customers.

NB: (i) Expenses are measured by the amount of assets consumed or the
amount and liabilities incurred. They may be:
(a) Immediate cash payments, such as current wages and salaries or
(b) Promises to pay cash in the future for survices received, such as advertising
(ii) In some cases, cash may be paid out before the expense is incurred, as, for
example, in payment for next month’s rent. These prepayments represent assets
in the balance sheet until they are used.
(iii) The Net Income earned represent an increase in owners equity. Since revenues
result in an increase in owner’s equity and expenses result in a decrease in
 owner’s equity, the difference between the two net-income, must represent a net
increase in owners equity.

3.3 The Statement of Changes in Owners’ Equity

The Statement of changes in owners’ equity shows the change in owners capital over the
reporting period. It serves as a link between the balance sheet and the income statement by
explaining the changes that took place in owner’s equity during the period covered.

This statement starts with the beginning equity and adjusts it for events that:
- Increase it - Investment by the owner and net income(s)
- Decrease it - net loss and owners withdrawal.
The Statement of changes in owner’s equity for Fotran Company’s first month of
operation is as shown below:

FOTRAN COMPANY
Statement of Changes in Owner’s Equity for the Month Ended
Dec. 31, 2008
Kshs Kshs
Peter Kaluma, capital, December 2008 0
30,00
Add: Investment by owner 0
Net Income 2,400
Total 32,400
Less : withdrawal by owner -600
Peter Kaluma, capital, December 31, 2008 31,800

NB: When the business is incorporated (ie a company) this statement is called the Statement of
Retained Earnings, and it explains the changes in retained earnings between two balance sheet
dates. These changes usually consist of the addition of net income (or deduction of net loss0 and
the deductions of dividends.

Dividends are the means by which a company rewards its stockholders (Owners) for providing it
with investment funds. A dividend is a payment (usually of cash) to the owners of the business:
it is a distribution of income to owners rather than an expense of doing business. Because
dividends are not an expense, they do not appear on the income statement.

3.4 The Statement of Cash flows

NB: Whereas the income statement focuses on a company’s profitability goal, the statement of
cash flows is directed toward the company’s liquidity goal.

The statement of cash flows shows (reports) the inflows and outflows of cash into and output of
a business. Therefore it describes the sources (inflows) and uses (outflows) of cash for a
reporting period.

Net cash lows are the difference between the inflows and outflows.

Nb: The statement of cash flows is organized by a company’s major activities: Operating,
Investing, and Financing. Since a company must carefully manage cash if it is to survive and
prosper, cash flow information is important.

(i) Operating activities:- generally include the effects of transaction and other events that
enter into the determination of net income.

(ii) Investing activities:- generally include business transactions involving the acquisition or
disposal of long-term assets such as land, buildings, and
equipment.

(iii) Financing activities:- generally include the cash-effects of transactions and other events
involving creditors and owners (Stockholders.
 FORTRAN COMPANY
STATEMENT OF CASH FLOWS FOR THE MONTH ENDED 31st DECEMBER,
2008
Cash flows from Operating Activities: Kshs Kshs
Net Income 2,100
Non-cash expenses and Revenues, included in Net income
Increase in Accounts Receivable -700
Increase in account payable -600
Net cash provided by Operating Activities 2,000
Cash flows from Investing Activities
-20,00
Purchase of trucks 0
Purchase of equipment -2,500
-22,50
Net cash used by Investing Activities 0
Cash flows From Financing Activities
Proceeds from notes payable 6,000
30,00
Proceeds from investment by P. Kaluma 0
36,00
Net cash provided by financing Activities 0
15,50
Net increase in cash 0
Add: cash at beginning of the month 0
15,50
Cash balance on December 31, 2008 0

NB:
At this point in this course and for this course, you need to understand what a statement
of cash is flows is rather than how to prepare it.
3.9 Summary

The income Statement, Statement of Retained Earnings, Balance sheet,

and the Statement of cash flows of Fotran Company are the result of
management’s past decisions.

They are the end product of the accounting process, which will be
explained in the next lecture. These financial statements give a picture
of the solvency (Liquidity) and profitability of the company.

The accounting process (cycle) details how this picture was made.
Management and other interested parties use these statements to make
future decisions. Management is the first to know the financial results,
then, it publishes the financial statements to inform other users.
 LECTURE FOUR
ANALYZING AND RECORDING BUSINESS TRANSACTIONS

Lecture Outline
4.1 Introduction
4.2 Objectives
4.3 Forms of business organizations
4.4 Financial statements of business organizations
4.5 The generally accepted accounting principles
4.6 The accounting equation.
Transactions analysis and the accounting equation
4.7 Summary

4.1 Introduction
Accounting provides information to help people make better decisions. This information is the
result of an accounting process that captures business transactions and events, analyzes and
records their effects, and summarizes and prepares information in reports and financial
statements. These reports and statements are used in making investing, and other important
decisions.

4.2 Objectives
By the end of this lecture, you should be able to:
● Identify the three basic forms of business organizations
● Identify the types of activities performed by business
organizations
● Describe the four financial statements of a business
organization, and explain the meaning of assets, liabilities,
equity, revenues, expenses and net income
● Define and explain the accounting equation
 ● Define a transaction and describe source documents and their
purpose
● Analyze business transactions using the accounting equation
● Prepare financial statements from business transactions

Definitions of Terms
Before we begin our study of recording procedures, the following important terms will be
defined:
1. The account.
2. The ledger
3. The general ledger
4. Chart of accounts
5. Debits and credits
6. Double-entry accounting (system)
7. Double – entry procedure (debit- credit procedure)

1. The Account (What is an account?)

An account is a detailed record of increases and decreases in a specific asset, liability, equity,
revenue or expense.
NB
Information is taken from accounts, analyzed, summarized and presented in reports and
financial statements useful for decision makers. A separate account is maintained for
items of importance to information users.

2. The Ledger (What is a ledger?)

A ledger is a record containing all accounts used by a business. That is, the entire group of
accounts maintained by a company is referred to as a ledger. The ledger keeps in one place all
the information about changes in specific account balances.
NB
Companies may use various kinds of ledgers, but every company has a general ledger.
3. The General Ledger. (What is a General Ledger?)
A general ledger contains all the assets, liabilities and stockholders equity accounts (i.e. all items
that appear on financial statements). A business can use a loose-leaf binder or card file for the
ledger with each account kept on a separate sheet or card.

NB
1. The General ledger should be arranged in statement order:
(a) Beginning with - the balance sheet accounts - First in order is the asset accounts,
followed by liability accounts.
(b) Then revenue and expense accounts (i.e. income statement accounts) are
provided.
(c) Each account is numbered (coded) for easier identification.
2. The information in the ledger provides management with the balances in various
accounts. For example, the cash account enables management to determine the amount
of cash that is available to meet current obligations.
Amounts due from customers and the amounts owed to creditors can be determined by
examining the accounts receivable and accounts payable respectively.

4. Chart of Accounts (What is a Chart of Account?)

A chart of accounts is a list of all accounts used by a company. The chart includes an
identification number (code) assigned to each account. Companies assign account
identification numbers in an orderly manner. A small business might use the following
numbering system for its accounts:

101 – 199 - Asset Accounts

201 – 299 - Liabilities accounts
301 – 399 - Owner’s equity accounts
401 – 499 - Revenue accounts
501 – 599 - Expense accounts
 Example of a Chart of Accounts for a Small Business
Account Account
Number Name Description
ASSETS
111 Cash Money and any medium of exchange,
including coins, currency, checks, postal and
express money orders and money on deposit
in a bank.
112 Notes Receivable Amount due from others in the form of
promissory notes (written promises to
pay definite sums of money at fixed
future dates)
113 Accounts Receivable Amounts due from others for credit
sales (sales on account)
114 Fees Receivable Amount arising from services
performed but not yet billed to customers
115 Art Supplies Prepaid expense; art supplies
purchased and not used.
116 Office Supplies Inventory Prepaid expense; office supplies
purchased and not yet used.
117 Prepaid Rent Prepaid expense; rent paid in advance
and not used.
118 Prepaid insurance Prepaid expense; insurance purchased
and not yet expired; unexpired insurance.
141 Land Properties owned for use in the business.
142 Buildings Structures owned for use in the business.
143 Accumulated Depreciation, Sum of the periodic allocation of the
Building cost of building to expense.
144 Art Equipment Art equipment owned for use in the
 business
145 Accumulated Depreciation, Sum of the periodic allocation of the
Art Equipment cost of art equipment to expense
146 Office equipment Office equipment owned for use in the
business
147 Accumulated Depreciation, Sum of the periodic allocation of the
Office equipment cost of office equipment to expense.

LIABILITIES
211 Notes Payable Amounts due to others in the form of
promissory notes
212 Account Payable Amounts due to others for purchases on
credit.
213 Unearned art fees unearned revenue; advance deposits for
artwork to be provided in the future.
214 Wages payable amounts due on employees for wages
earned and not paid.

221 Mortgage Payable Amounts due on loans that are backed

by the company’s property and buildings

Owner’s Equity
311 Capital Owner’s investment in the company
312 Withdrawals of Assets Withdrawals from the business by
the owner for personal use.
313 Income Summary Temporary account used at the end
of the accounting period to summarize
revenues and expenses for the period.
 Revenues
411 Advertising Fees Earned Revenue derived from performing
advertising services
412 Art Fees Earned Revenue derived from performing art
services.

Expenses
511 Wages Expense Amounts earned by employees

512 Utilities Expense Amounts for utilities, such as water,

electricity, and gas, used.
513 Telephone expense Amounts for telephone services used.
514 Rent Expense Amounts for rent on property and
building used.
515 Insurance Expense Amounts for insurance used.
516 Art Supplies Expense Amounts for art supplies used.
517 Office Supplies Expense Amounts for office supplies used.
518 Depreciation Expense, Amount of buildings’ cost allocated to
Building expense
519 Depreciation Expense, Amount of art equipment costs allocated
Art Equipment to expense.
520 Depreciation Expense, Amount of office equipment costs allocated
Office Equipment to expense
512 Interest Expense Amount of interest on debts

5. Debits and Credits (What does a Debit/Credit mean?)

The terms debit and credit means left and right sides of an account respectively. They are
commonly abbreviated as “DR” for debit and “CR” for credit.
NB:
(1). These terms do not mean increase or decrease. The terms debit and credit are used
repeatedly in the recording process. For example, the act of entering an account on the
left side of the account is called debiting the account and making an entry on the right
side is crediting the account.
When the totals of the two sides (i.e. debit and credit side) are compared an account will
have either a:
a) Debit balance if the total of the debit amounts exceed, the credit amounts.
b) Credit balance if the
total credit amounts exceed the total debit amounts.
Title of Account
Left or debt side Right or credit side

(2). The procedure of having debits on the left and credits to the right is an accounting custom or
rule. Accountants could function just as well if debits and credits were reversed.

6. Double – Entry Accounting (What Is Double-Entry Accounting ?)

Double-entry accounting means, every transaction affects and is recorded in at least two
accounts. This means the total amount debited must equal the total amount credited for
each transaction.
Since each transaction is recorded with total debits equal to total credits, the sum of the debits
for all entries must equal the sum of all credit entries. The sum of debit account balances in
the general ledger must equal the sum of all credit account balances. The only reason the sum
of the debit balances would not equal the sum of credit balances is that an error has occurred.
Double-entry accounting helps prevent errors by assuring that debits and credits for each
transaction are equal.

7. Double-Entry Procedure (Debit and Credit Procedure)

The system for recording debits and credits follow from the accounting equation.

Assets = Liabilities + Owner’s equity

- Assets are on the left side of this equation

- Liabilities and equity are on the right side

NB
Two points are important to note here:
 1. First, like any mathematical relation, increases or decreases on one side have equal
effects on the other side. For example, the net increase in assets must be
accompanied by an identical net increase in the liabilities and equity side. Recall that
some transactions only affect one side of the equation. This means that two or more
accounts on one side are affected, but their net effect on this one side is zero.
2. Second, we treat the left side (debit side) of account as the normal balance side for
assets, and the right side (credit side) as the normal balance for liabilities and equity.
This matches their layout in the accounting equation.

ASSETS = LIABILITIES + OWNERS EQUITY

Debit Balances Credit Balances
The normal debit balances of asset accounts and the normal credit balances of liabilities
accounts again follow from the accounting equation. This means that increases in asset
accounts are recorded with debits, while increases in liability and equity accounts are
recorded with credits. These important relations are captured here-below:

ASSETS = LIABILITIES + OWNERS’ EQUI

DR for CR for DR for CR for Dr for Cr for
Increases decreases decreases increases decreases increases
(+) (-) (-) (+) (-) (+)

Three important rules for recording transactions in a double-entry accounting system follow
from the above diagram:
1. Increases in assets are debits to asset accounts. Decreases in assets are credits to
assets accounts.
2. Increases in liabilities are credits to liabilities accounts. Decreases in liabilities are
debits to liability accounts.
3. Increases in owners’ equity are credits to owner’s equity accounts. Decreases in
owners’ equity are debits to owners equity account.
NB:
We have explained how owner’s equity increases from owner’s investment (i.e. assets
invested in the business by owners or shareholders’) and asset inflows from operating
activities (i.e. revenues). We also described how owner’s equity decreases from
expenses and withdrawals (dividends). These important owners’ equity relations are
conveyed by expanding the accounting equation as follows:

ASSETS = LIABILITIES + OWNERS’ EQUITY

ASSETS = LIABILITIES + OWNERS - OWNERS + REVENUES -

EXPENSES
CAPITAL WITHDRAWS
DR Cr DR Cr DR Cr DR Cr DR Cr DR Cr

+ - - + - + + - - + +
-
or incase of an incorporated business:
STOCKHOLDERS EQUITY

ASSET = LIABILI +
TIES
Assets = Liabilities + Common + Retained - Divide + Revenu - Expens
stock earnings nds es es
Dr C Dr C D Cr Dr Cr D Cr D Cr D Cr
r r r r r r
+ - - + - + - + + - - + + -
NB:
Increase in capital or revenues increase owner’s equity, while increases in withdrawals /
dividends or expenses decreases owners’ equity. These relations are reflected in the following
important rules.
1. Investments are credited to owner’s capital (common stock) because they increase
equity.
2. Withdrawals / dividends are debited to owner’s withdrawals (dividends or retained
earnings) accounts because they decrease equity.
3. Revenues are credited to revenue accounts because they increase equity.
4. Expenses are debited to expense accounts because they decrease equity.

Our understanding of these diagrams and rules is crucial to analyzing and recording transactions.
It also helps us prepare and analyze financial statements.

Important Observations
We can use good judgment to our advantage in applying double-entry accounting. For
example, revenues and expenses normally (but not always) accumulate (grow) in business.
This means that they increase and rarely decrease during an accounting period. Accordingly, we
should be alert to decreases in these accounts (such as debit to revenue accounts or credit to
expense) to be certain sure that this is our intent.

THE ACCOUNTING PROCESSING CYCLE

Introduction
Now that we have reviewed the basics of the double entry systems lets look closer at the process
used to identify, analyze, record, and summarize transactions and prepare financial
statements.
The Accounting cycle is a series of steps performed during the accounting period (some
throughout the period and some at the end) to analyze, record, classify, summarize, and report
useful information for the purpose of preparing financial statements. In other words, the
accounting cycle is a series of steps leading the financial statements. This cycle is repeated each
reporting period (normally a year). The ten steps in the accounting cycle are shown in the
diagram here below:
The Accounting Cycle - Overview

The ten steps in the accounting process are:

1. Identifying and Measuring transactions or events to be recorded:

Objective: To gather information generally in the form of source documents

about transactions and event.

2. Recording transaction (Economic events in a journal:

Objective: To identify, assess and record the impact of transactions on the firm in a
chronological record (journal), in a form to facilitate transfer to the accounts.
3. Post from the Journal to the General Ledger:
Objective: To transfer the information from the journal to the ledger, the device that
stores the Accounts.
4. Prepare an Unadjusted Trial Balance:
Objective: To provide a convenient listing to check for debit–credit equality and to
provide a starting point for adjusting journal entries.
5. Prepare Adjusting Journal entries and post to the Ledger:
Objective: To record accruals, expiration of deferrals, estimation and other events not
signaled by a new source document.
6. Prepare Unadjusted Trial Balance:
Objective: To check for debit – credit equality and to simplify preparation of the
financial statements.
7. Prepare Financial Statements:
Objective: To prepare information useful to external decision makers.
8. Prepare Closing Journal entries and post to the Ledger:
Objective: To close temporary accounts and transfer net income amount to
retained earnings.
9. Prepare a Post – closing Trial Balance:
Objective: To check for debit – credit equality after the closing entries.
10. Prepare Reversing entries (optional) and post to the Ledger:
Objective: To simplify certain subsequent journal entries and reduce accounting costs.
Step 1: Identifying and Analyzing Transactions and Other Events to be Recorded

The first step in the accounting process is to identify the transactions and events that cause a
change in the firms resources (assets) and obligations (liabilities and equity) and to collect
relevant economic data about those transactions. (That is identifying transactions affecting the
accounting equation). Events that change a firm’s resources or obligations are categorized into
three types:
i) Exchanges of resources and obligations: between the reporting firm and outside
parties. These exchanges are either reciprocal transfers (e.g. sale of goods) or non
reciprocal transfers (e.g. payments of cash dividends).
ii) Internal events within the firm that affects its resources or obligations but do not
involve outside parties.

Examples are: (a) recognition of depreciation/amortization of long lived assets and

(b) the use of inventory (raw materials) for the production.

iii) External economic and environmental events beyond the control of the company.
Examples include (a) casualty losses arising from fire, floods, earthquakes, theft etc
and (b) changes in the market values of assets and liabilities.
NB

An accountant usually does not directly witness business transactions. A mechanism

therefore, is needed to relay the essential information about each transaction to the
accountant. Source documents such as sales invoices, bills from suppliers, and cash
register tapes serve this need. These source documents usually identify the dates and
nature of each transaction, the participating parties, and the monetary terms. For
example, a sales invoice identifies the specific goods sold, the shilling amount of the sale,
and the payment terms. With this information, the accountant analyzes (i.e. transactions
analysis step), the source document to determine the dual effect on the accounting
equation and the specific elements involved.
STEP 2: RECORD THE TRANSACTION IN A JOURNAL

(JOURNALIZE TRANSACTIONS AND EVENTS)

The second step in the accounting process is to record the transactions in a journal. Journals
provide a chronological (order of time) record of all economic events affecting a firm. Each
journal is expressed in terms of equal debits and credits to accounts affected by the transaction
being recorded. The process of entering transactions into the journal is called journalizing. The
effects of each transaction are recorded by a double entry change in the accounts called journal
entry.

Companies may use various kinds of journals, but every company has the most basic form of a
journal, a general journal. Typically, a general journal provides the following information:

i) The date of the transaction.

ii) The account and amounts to be debited (DR)
iii) The account and amounts to be credited (Cr)
iv) References (A place to enter account numbers as per chart of accounts after posting.
v) An explanation of the transaction or economic event.
NB

Partial General Journal for Fotran:

General Journal

Date Account Titles and Posting Dr Cr

Explanation Revenue Ksh. Ksh.
Dec 2004 1 Cash 30,000
C. Tarus, capital 30,000
(Investment by owner)
2 Supplies inventory 2,500
Cash 2,500
 (purchased store supplies for
cash )
3 Equipment 20,000
Cash 20,000
(Purchased copy equipment
for cash)
6 Supplies inventory 1,100
Equipment 6,000
Account payable 1,100
6,000
Note payable
(purchased supplies and
equipment on credit)

1. Any type of transaction can be recorded in a general journal.

2. It is important to use correct and specific account titles in journalizing. Since most
accounts appear later in financial statements, erroneous account titles lead to incorrect
financial statements. Some flexibility exists initially in selecting account titles. The
main criterion is that each title must appropriately describe the content of the account.
For example, the account title used for cost of delivery trucks may be delivery
equipment, delivery trucks or trucks. Once a specific title has been chosen, all
subsequent transactions involving the account should be recorded under that
account title. (In home-work problems, when specific account titles are given, they
should be used).
3. If an entry involves only two accounts, one debit and one credit, it is considered a
simple entry. When three or more accounts are required in one journal entry, the
entry is referred to as a compound entry.
4. Most business use special journal in addition to the general journal including:
i) Cash receipts journal

ii) Cash payment journal

iii) Sales Journal

 iv) Purchases journal
Special journals summarize transactions possessing a common characteristic, thereby
reducing the time necessary to accomplish the various book-keeping tasks.
5. In the general journal the posting reference indicates the Ledger Account number in the
chart of accounts.

Step 3: Post from Journals to the General Ledger (Posting)

The items in a general journal must be transferred to the general ledger. Transferring
transactions data from the journal to the ledger is called posting and is part of the
summarizing and classifying process. Recall that a ledger is simply a collection of all the
company’s various accounts. Each account provides a summary of the effects of all events
and transactions on an individual account. Posting involves transferring debits and credits
recorded in individual debits and credits recorded in individual journal entries to specific
accounts affected.

NB
1. Most accounting systems today are computerized with the journal and ledger kept on a
disk. For these systems, the journal input information is automatically and instantly
posted to the ledger accounts.

The steps involved in the posting process are as follows:

1. Identify the ledger account that was debited (dr) in the journal entry.
2. Enter the date that the transactions occurred as shown in the journal in this ledger
account.
3. Enter the source of the debit in the posting reference (PR) column of the ledger
account, both the journal and page no from which the entry is being posted. E.g.
the letter G shows that it came from the general journal.
4. Enter the amount debited (dr) from the journal entry into the debit column of the
ledger account.
5. Compute and enter the accounts new balance in the Balance column of the ledger
 account.
6. Enter in the posting reference column of the journal the account numbers to which
the debit amount was posted.
7-11 Repeat steps 1 through 6 for the credit part of the entry.

In procedure 3 (above), the posting reference in the general ledger indicates the journal and
page number from which the transaction was taken. This provides a convenient means for
tracing an amount recorded in an individual account back to the general journal when additional
information is needed about the posting. The account number, entered in the posting reference
column of the general journal in procedure 6, above, tells the account number to which the
amount was posted in the general ledger. A number in this column indicates that the amount
has been posted. In other words, this number is entered in the journal only after posting has
been completed.
 Posting an entry to the ledger.
General Journal
Page 1

Date Account Title and Pr Debit Credi

explanation t
Dec Cash 101 30,00
1,2008 0

C. Tarus, Capital 301 30,00

0
 GENERAL LEDGER
Cash
Account No. 101
Date Explanatio Pr Debit Credit balance
n
Dec1, G1 30,000 30,000
2008

C. Tarus, capital Account No.

301
Date Explanatio Pr Debi Credit balance
n t
Dec1, 30,000 30,000
2008 G1

Keys:
1. Identify account 3. Enter journal page 5. Enter account balance.
2. Enter date 4. Post the amount 6. Enter account number.
NB 3. Recall that accounting systems have two types of Ledgers: the general ledger and
subsidiary ledgers.
i) The general ledger holds the individual accounts that feature in the
financial statements. (i.e. Assets, Liabilities, Equity, Revenues, Expenses,
Losses and gains accounts.
ii) Subsidiary ledgers support general ledger accounts and comprise many
separate individual accounts. For example, a firm with a substantial
number of customer accounts receivable will maintain one ledger
account per customer stored in an account receivable subsidiary ledger.
The individual customer account is called the subsidiary account. The
general ledger holds only the control account, the balance of which
reflects the sum of all the individual customers account balances. Only
the control accounts are used in compiling financial statements.

Step 4: Prepare Unadjusted Trial Balance

Before financial statements are prepared and before adjusting entries (which record internal
transactions) at the end of an accounting period, an unadjusted trial balance usually is
prepared.

A trial balance is simply a list of general ledger accounts and their balances at a particular
date. Its purpose is to check for completeness and to prove that the sum of the accounts with
debit balances equals the sum of the accounts with credit balances, (that is. the accounting
equation is in balance. If the sums of the debit and credit balances are not equal, the error
must be found and corrected). A re-examination of source documents and posting is one way
to discover the source of an error.
 FOTRAN
Trial Balance
December 31, 2008
Debit Credit
Ksh Ksh
Cash 7,950
Prepaid insurance 2,400
Supplies 3,720
Equipment 26,000
Account payable 1,100
Unearned consulting revenue 3,000
Note payable 5,100
C. Tarus, capital 30,000
C. Tarus, withdrawals 600
Consulting revenue 3,800
Rental expense 300
Rent expense 1,000
Salaries expense 1,400
Utilities expense 230
Total 43,300 43,300

NB
1. The fact that the debit and credits are equal does not necessarily mean that the
equal balances are correct. Numerous errors may exist even though the trial balance
columns agree. For example, a trial balance may balance even when:

i) A transaction is not journalized

ii) A correct journal entry is not posted
iii) A journal entry is posted twice
iv) Incorrect accounts are used in journalizing or posting or
v) Offsetting errors are made in recording the amount of a transaction.
In other words, as long as equal debit and credit are posted, even to the wrong account or
in the wrong amount, the total debits will equal the total credits.

2. The procedures for preparing a trial balance consist of the following steps:

i) Determining the balances of General Ledger accounts by ascertaining the sum

of debit and credit entries in each account.
ii) Listing the account titles and their balances
iii) Totaling the debit and credit columns of the trial balance
iv) Proving the equality of the two columns

3. The unadjusted trial balance is a list of general ledger accounts and their account
balances in the following order:
i) Assets
ii) Liabilities
iii) Owners equity
iv) Revenues
v) Expenses
vi) Gains and
vii) Losses
 For General Ledger accounts with subsidiary ledgers, only the control account
balances are entered into the trial balance, after reconciliation with the subsidiary ledger.

4. The unadjusted trial balance is the starting point for developing adjusting entries (Accrual
basis of accounting and for the worksheet).

Step 5: Prepare Adjusting Journal Entries and Post to the General Ledger

Step 5 in the accounting processing cycle is to record in the general journal and post to the
general ledger accounts, internal events that affect the accounting equation. These
transactions do not involve an exchange transaction with another entity and therefore are not
initiated by a source document. They are recorded at the end of any period when financial
statements must be prepared. These transactions are commonly referred to as adjusting
entries.

Adjusting entries are required to implement the accrual accounting model. More specifically
these entries are required to satisfy the revenue recognition (realization) principle and the
matching principle. That is adjusting entries help ensure that all revenues earned in a
period are recognized in that period, regardless of when cash payment is received. Also,
they enable a company to recognize all expenses incurred during a period regardless of
when cash payment is made. The consequences of making adjusting entries are as follows:

a) A period’s income statement provides a more complete measure of a company’s

operating performance and a better measure for predicting future operating cash
flows.
b) The balance sheet also provides a more complete assessment of assets and
liabilities as sources of future receipts and disbursements.
 You might think of adjusting entries as a method of bringing the company’s financial
information up to date before preparing the financial statements. The information may be
incomplete due to a number of reasons including the following:

i) Some events are not journalized daily because it is inexpedient to do so.

Examples are the consumption of supplies office or factory and the earnings of
wages by employees.
ii). Some costs are not journalized during the accounting period because these costs
expire with the passage of time rather than as a result of recurring daily
transactions. Examples of such costs are building and equipment depreciation;
rent, and insurance.

iii). Some items may be unrecorded. An example is a utility service bill that
will not be received until the next accounting period.
NB

1. Adjusting entries are required every time financial statements are prepared.
The procedures for preparing adjusting entries are as follows:
An essential starting point is an analysis of each account in the trial balance to determine
whether it is complete and up-to-date for financial statement purposes. The analysis
requires a thorough understanding of the company’s operations and the interrelationship
of accounts. In practice Adjustments are often prepared after the balance sheet date.
However, the entries are dated as of the balance sheet date.

2. Types of Adjusting entries

Adjusting entries can be classified as either prepayments (deferrals) or accruals. Each of
these has two subcategories as shown below:

a) Prepayments (Deferrals)
 i) Prepaid (deferral) expenses: Expenses paid in cash and recorded as assets
before they are used or consumed.

ii) Unearned (deferred) revenues: Revenues received in cash and recorded as

liabilities before they are earned.

b) Accruals
iii) Accrued revenues: Revenues earned but not yet received in cash or
recorded.

iv) Accrued expenses: Expenses incurred but not yet paid in cash or
recorded.

Step 6: Prepare the Adjusted Trial Balance

After the adjusting entries are posted to the general ledger accounts, the next step 6 – in the
processing cycle is to prepare an adjusted trial balance. The term adjusted refers to the fact
that adjusting entries have been posted to the accounts. Recall that the column titled post ref;
(Posting reference) is the number assigned to the general ledger account that is being debited or
credited.

The adjusted trial balance lists all account balances that will appear in the financial statements
(with the exception of retained earnings, which does not reflect current years net income or
dividends). The purpose of the adjusted trial balance is to confirm debit – credit equality, taking
all adjusting entries into consideration.

Step 7: Prepare Financial Statements

The purpose of each of the steps in the processing cycle up to this point is to provide information
for step 7 – preparation of the financial statements (in other words, the financial statements are
the culmination of the accounting cycle). The adjusted trial balance contains the necessary
information to accomplish their purposes. After all, the financial statements are the primary
means of communicating financial information to external parties. The statements prepared
include (Recap)
1) The Income statements:

The purpose of the income statement is to summarize the profit generating

activities of a company that occurred during a particular period of time. It is a
change statement in that it reports the changes in stakeholders’ equity (retained
earning) that occurred during the period as a result of revenues, expenses, gains
and losses.

2) The Balance Sheet.

The purpose of the balance sheet is to present the financial position of the
company on a particular date. Unlike the income statement, which is a change
statement reporting events that occurred during a period of time, the balance
sheet is statement that presents an organized list of assets, liabilities, and
stockholders equity at a point in time.
3) The statement of cash flows
Similar to the income statement the statement of cashflows is a change
statement disclosing events that caused cash to change during the period. The
statement classifies all transactions affecting cash into one of three categories:

i) Operating activities
ii) Investing activities
iii) Financing activities

4) The statement of shareholders equity

The final statement, the statement of shareholders equity, also is a change
statement. It discloses the sources of changes in the various permanent
shareholders equity accounts that occurred during the period.
Step 8: Prepare Closing Journal Entries and Post to the General Ledger
At the end of the financial year, two final steps are necessary:

- Closing the temporary accounts – steps 8

- Preparing a post closing trial balance step 9.

The closing process serves a dual purpose:

1. The temporary accounts (revenues, expenses, gains and losses) are reduced to zero
balances, ready to measure activity in the upcoming accounting period and
2. These temporary account balances are closed (transferred) to retained
earnings/owners capital to reflect the changes that have occurred in that account
during the period.
Often, an intermediate step is to close revenue and expenses to income summary; (profit and
loss) then income summary is closed to retained earnings.
The use of the income summary account is just a book keeping convenience that provides a
check that all temporary accounts have been properly closed (i.e. the balance equals net income
or loss).

Step 9: Prepare a Post - Closing Trial Balance

After the closing entries are posted to the general ledger accounts, post-closing trial balance is
prepared. The purpose of this trail balance is to verify that the closing entries were prepared and
posted correctly and that the accounts are now ready for next years transactions.
A post-closing trial balance lists only the balances of the permanent accounts after the closing
process is finished (the temporary amounts have balances of zero). This step is taken to check
for debit-credit equality after the closing entries are posted. Firms with a large number of
accounts find this a valuable checking procedure because the chance of error increases with the
number of accounts and postings. The retained earnings account is now stated at the correct
ending balance and is the only permanent account (real account) with a balance different
from the one shown in the adjusted trial balance.
 Step10: Reversing Entries (Optional)

This is the final step in the accounting process (cycle). After the financial statements have been
prepared and the books have been closed, it is often helpful to reverse some of the adjusting
entries before recording the regular transactions of next period. Such entries are called
reversing entries. A reversing entry is made at the beginning of the next accounting period
and is the exact opposite of the related adjusting entry made in the previous period. The
recording of the reversing entries is an optional step in the accounting cycle that may be
performed at the beginning of the next accounting period.

The purpose of reversing entries is to simplify the recording of transactions in the next
accounting period.

NB:
The use of reversing entries does not change the amounts reported in the financial
statements for the previous period.

THE ACOUNTING CYCLE ILLUSTRATED – PLASMA ADVERTISING CO

PHASE 1: ANALYZING AND RECORDING TRANSACTION DURING THE

ACCOUNTING PERIOD.

The first three steps of the accounting cycle are carried out continuously during the period as
transactions occur.
1. Identifying and analyzing transactions and economic events
 2. Journalizing
3. Posting to the general ledger

NB:
4. A Trial Balance may be prepared (i.e. step 4) at any time during the period to verify the
equality of the account balance.

Illustrative Problem of Accounting for a Service Firm.

The October transactions for the Plasma Advertising Co. (a service enterprise) are used to
explain the accounting cycle. Analysis of company’s chart of accounts; 1 – 19 indicate assets
accounts; 20 -29 indicate liability accounts; 40 – 49 indicate stockholders’ equity accounts; 50 –
59 revenues; and 60 -69 expenses. The chart of accounts for Plasma Advertising Agency Co. is
as shown below.

Assets
1. Cash
6. Accounts receivable
8. Advertising supplies on hand
10. Prepaid insurance
15. Office equipment
16. Accumulated depreciation –office equipment.

Liabilities
25. Notes payable
26. Accounts payable
27. Interest payable
28. Unearned fees
29. Salaries payable

Stockholders Equity
40. Common stock
41. Retained earnings
42. Dividends
49. Income summary

Revenues
50. Fees earned

Expenses
60. Salaries expense
61. Advertising supplies expense
62. Rent expense
63. Insurance expense
64. Interest expense
65. Depreciation expense
Illustration 1 to 9 shows the basic steps in the recording process, using the October transactions
of the Plasma Advertising Company. We will assume that its accounting period is one month.
A basic analysis and debit – credit analysis precede the journalizing and posting of each
transaction. The purpose of transaction analysis is first to identify the type of accounts involved,
and then to determine whether a debit or a credit to an account is required.
NB:
You should always perform this type of analysis before preparing a journal entry.
Doing so will help you understand the journal entries that you ultimately make.
Keep in mind that every journal entry affects one or more of the following items:
Assets, liabilities, stockholders equity, retained earnings, dividends, revenues or
expenses. By becoming skilled at transaction analysis you will be able to recognize
 quickly the impact of any transaction on these seven items (i.e. financial statement items).
For simplicity, the T – account is used in the illustration instead of the standard account
form.

Step 1: Identifying Transactions - External Transactions for October

1.

2.

3.

4.
5.

6.

7.

8.

9.
10

Step 2: Analyzing and Recording Transactions.

1. Investment of Cash by Owners’.

Common stock 40
Oct. 1, 10,000
Cash 1
Oct. 1, 10,000
Oct.1 Cash 1 10,000
Common stock 40 10,000
(Issued shares of stock for cash)
2. Purchase of Office Equipment on Credit

Note Payable 25
Oct. 1, 5,000
Cash 15
Oct. 1, 5,000
Oct.1 Office equipment 15 5,000
Note payable 25 5,000
(Issued three – month, 12% note
For office equipment)
 3. Receipt of Cash for Future Services.

Oct.1 Cash 1 1,200

Unearned fees 40 28 1,200
(Received advance from
R. Knox for future service)
4. Payment of Monthly Rent

Rent expense 62
Oct. 3 900
Cash 1
Oct. 1 10,000 Oct.3 900
2 1,200
Oct.3 Rent expense 62 900
Cash 1 900
(Paid October rent)
5. Payment for Insurance

Prepaid Insurance 10
Oct 4 600
Cash 1
Oct. 1 10,000 Oct 3 900
Oct 2 1,200 Oct 4 600
Oct.4 prepaid insurance 10 600
Cash 1 600
(paid a one-year policy;
effective date October 1)
6. Purchase of supplies on credit
 Account Payable 26
Oct,5 2,500
Advertising supplies inventory 8

Oct. 5. 2,500
Oct.5 cash Advertising Supplies inventory 8 2,500
Accounts Payable 26 2,500
(Purchase supplies on
Account from Aero Supply)
7. Hiring of Employees

8. Declaration and Payment of Dividends by the Company

 Dividends 42
Oct. 20, 500
Cash 1
Oct. 1, 10,000 Oct 3 900
2, 1,200 4 600
20 500
Oct.20 Dividends 42 500
Cash 1 500
(Declared and paid a cash
Dividend)

9. Payment of Salaries
 Salaries Expense 60
Oct. 26, 4,000
Cash 1
Oct. 1, 10,000 Oct 3 900
2, 1,200 4 600
20 500
26 4,000

Oct.26 Salaries Expense 60 4,000

Cash 1 4,000
(Paid salaries to date)
10. Receipt of cash for fees earned.
 Fees earned 50
Oct. 31, 10,000
Cash 1
Oct. 1, 10,000 Oct 3 900
2, 1,200 4 600
31, 10,000 20 500
26 4,000

Oct31 Cash 1 10,000

Fees Earned 50 10,000
(Received cash for fees earned)

NB:
Keep in mind that every journal entry affects one or more of the following items: assets,
liabilities, stockholders’ equity, retained earnings, dividends, revenues or expenses. By becoming
skilled at transaction analysis, you will be able to recognize quickly the impact of any transaction
on these seven items. For example, the t- account is used instead of the standard account form.

Summary Illustration of Journalizing and Posting

The journal for Plasma Advertising Co. for the month of October is summarized in illustration.

STEP 2: Journalizing

General journal Page GJ 1

Date Account Titles and Explanation Ref. Debit Credit
2004 Oct. 1 Cash 1 10,000
Common stock 40 10,000
(issued shares of stock for cash)
1 Office equipment 15 5,000
Notes Payable 25 5,000
(issued three-month, 12% note for office
equipment)
2 Cash 1 1,200
Unearned fees 28 1,200
(received advance from R. Knox for future
service)
3 Rent expense 62 900
 Cash 1 900
( paid October rent)
4 Prepaid insurance 10 600
Cash 1 600
(paid one year policy; effective date,
October 1)
5 Advertising supplies inventory 8 2,500
Account payable 26 2,500
(purchased supplies on account from
Aero Supply)
20 Dividends 42 500
Cash 1 500
(declared and paid a cash dividend)
26 Salaries Expense 60 4,000
Cash 1 4,000
(paid salaries to date)
31 Cash 1 10,000
Fees Earned 50 10,000
(received cash for fees earned

Step 3: Posting to the General Ledger.

GENERAL LEDGER
Cash No.1 Account payable No. 26
Dat Explanati Re Debit Cre Balan Date Explana Ref. Deb Credit Balance
e on f. dit ce tion it
200 2004
4
Oct Common G 10,00 10,00 Oct Advertis GJ1 2,500 2,500
1 stock GJ 0 0 5 ing
1 supplies
inventor
y
Unearne GJ 1,200 11,20
2 d fees 1 0
Rent GJ 900 10,30 Unearned Fees No.
3 expense 1 0 28
Prepaid GJ 600 Date Explana Re Debit Cred Balance
4 insuranc 1 9,700 tion f. it
e
Dividend GJ 500 9,200
20 s 1
Salaries GJ 4,00 5,200 2004
26 expense 1 0
Fees GJ 10,00 15,20 Oct. cash GJ 1,20 1,200
31 earned 1 0 0 2 1 0

Advertising Supplies inventory Common Stock No. 40

No. 8
Dat Explanati Re Debit Cre Balan Date Explana Re Debit Cred Balance
e on f. dit ce tion f. it
200 2004
4
Oct Accounts GJ 2,500 2,500 Oct cash GJ 10,0 10,000
5 payable 1 1 1 00
Dividends No.
42
Prepaid Insurance Date Explana Re Debit Cred Balance
No. 10 tion f. it
Dat Explanati 20 2004
e on 04
200 Oct Cash GJ 500 500
4 20 1
Oct Cash GJ 600 600
4 1

Office Equipment Fees Earned No. 50

No.15
Dat Explanati Re Debit Cre Balan Date Explana Re Debit Cred Balance
e on f. dit ce tion f. it
200 2004
4
Oct Notes GJ 5,000 5,000 Oct cash GJ 10,0 10,000
1 payable 1 31 1 00

Notes Payable Salaries Expense No. 60

No. 25
Dat Explanati Re Debit Cre Balan Date Explana Re Debit Cred Balance
e on f. dit ce tion f. it
200 2004
4
Oct Office GJ 5,00 5,000 Oct cash GJ 4,000 4,000
1 equipme 1 0 26 1
nt

Rent Expense No. 62

 Date Explana Re Debit Cred Balance
tion f. it
2004
Oct cash GJ 900 900
3 1

Step 4: Preparing the Unadjusted Trial Balance

A trial balance is a list of accounts and their balances at a given time. Customarily, a trial balance
is prepared at the end of an accounting period. The accounts are listed in the order in which they
appear in the ledger, with debit balances listed in the left column and credit balances in the right
column. The totals of the two columns must be in agreement.
The primary purpose of a trial balance is to prove the mathematical equality of debits and
credits after posting. Under the double – entry system this equality will occur when the sum of
the debit account balances equals the sum of the credit account balances. A trial balance also
uncovers errors in journalizing and posting. In addition, it is useful in the preparation of
financial statements.
Procedures for preparing a trial balance consist of:
1. Listing the account titles and their balances.
2. Totaling the debit and credit columns.
3. Proving the equality of the two columns.

The trial balance prepared from the ledger of Plasma Advertising Co. is presented below:

Plasma Advertising Co.

Unadjusted Trial Balance On October 31, 2008

Accoun Account Title Debit Credit

 t No.
Ksh. Ksh.
1 Cash 15,200
8 Advertising 2,500
Supplies Inventory
10 Prepaid Insurance 600
15 Office Equipment 5,000
25 Note Payable 5,000
26 Accounts Payable 2,500
28 Unearned Fees 1,200
40 Common Stock 10,000
42 Dividends 500
50 Fees Earned 10,000
60 Salaries Expense 4,000
62 Rent expense 900
28,700 28,700

NB:
That the total debits of Ksh 28,700 equal the total credits Ksh 28,700
 LECTURE FIVE
COMPLETING THE ACCOUNTING CYCLE

Lecture Outline
5.1 Introduction
5.2 Objectives
5.3 The Need for closing entries
5.4 Journalizing and posting closing entries
5.5 Preparing a post closing trial balance
5.6 Correcting errors
5.7 Preparing the classified financial statement
5.8 The worksheet as a tool
5.8 Summary

5.2 Objectives
By the end of this lecture, you should be able to:
● Identify the steps required in the accounting cycle
● Describe temporary (nominal) and permanent (real) accounts
● Explain the purpose of the closing process
● Define closing entries and explain the process of closing the
books
● Prepare closing entries and postings to the general ledge
● Explain and prepare a post-closing trial balance
● Explain and prepare reversing entries
● Explain and prepare a classified balance sheet

Completing the Accounting Processing Cycle

Phrase 3: Accounting Cycle Steps 8, 9 And 10 of Accounting Cycle
Overview of the Accounting Process (Recap)
The accounting cycle refers to the steps in preparing financial statements. It is called a cycle
because the steps are repeated each reporting period. In other words, the Accounting cycle is a
series of steps in the accounting system whose purpose is to measure business activities in the
form of transactions and to transform these transactions into financial statements that will
communicate useful information to decision makers. These steps are as depicted here below:
Introduction to the Closing Process
Financial statement preparation is the major purpose of accounting. Many of the important steps
leading to financial statements were explained in previous classes (Lessons).the third and final
phase of the accounting cycle is referred to as the closing process. This phase encompasses steps
8 and 9 of the accounting cycle. The closing procedures are performed after the preparation of
financial statements which is the major purpose of financial accounting.

In earlier lessons, we learned that revenues, and expense accounts and dividends (withdrawals)
accounts are subdivision of owner’s equity (specifically retained earnings in the case of
companies) which is reported in the stockholders equity section of the balance sheet. Because
revenues, expenses and dividends relate only to a given accounting period they are considered
to be temporary or nominal accounts. In contrast, all balance sheet accounts are considered
to be permanent or real accounts because they are carried forward into future accounting
periods.

Account Classifications
The accounts in the general ledger fall into one of two categories:

1. Temporary (nominal accounts)

2. permanent (real accounts)

Temporary Accounts Permanent (Real) Accounts

1. Temporary (nominal accounts)

These accumulate data (i.e. revenues, expenses, gains and losses) related to one accounting
period. They include all income statement accounts, withdrawal or dividend accounts and
income summary.

NB:
i) They are temporary because the accounts are opened at the beginning of a period,
used to record events for that period, and then closed at the end of the period.
ii) They are nominal because the accounts describe events or changes that have occurred
(already) rather that conditions that exist at the end of the period. The closing
process applies only to temporary accounts.
2. Permanent (real) accounts
These report on activities related to one or more future accounting periods. They carry their
ending balances into the next period and include all balance sheet accounts. Assets,
liabilities, and owner’s equity account are not closed as long as the company continues to:
a) Own the assets
b) Owe the liabilities
c) Have owner’s equity.
They are real because they describe existing conditions.

The closing process is an important process at the end of the accounting period.
At the end of the accounting period, the temporary account balances are transferred to the
permanent stockholder’s equity account, Retained Earnings, through the preparation of closing
entries. Closing entries formally recognize in the ledger the transfer of net income (or loss) and
dividends/withdrawal to retained earnings (capital) as shown in the statement of retained
earnings (statement of changes in owners’ equity). These entries also produce a zero balance in
each temporary account so it can be used to accumulate record) data in the next accounting
period

NB:
 This step (closing entries) is performed after financial statements have been
prepared. In contrast to the steps in the accounting cycle that you have already studied,
closing entries are generally journalized and posted only at the end of a company’s
annual accounting period. This practice facilitates the preparation of annual financial
statements because all temporary accounts will contain data for the entire year.

Purposes of the Closing Process. (Why do we need to close some accounts? Need for
closing entries?)

. The purposes of the closing process are two-fold:

1. First, it resets revenue, expense, and withdrawal account balances, to zero at the end of
every period. This is done so that these accounts can measure income and
withdrawal/dividend amounts for the next period. Remember that the income statement
reports net income (or less) for a single account period and shows revenues and
expenses for that period only. For the income statement to present the activity of a
single account period, the revenue and expense accounts must begin each new
period with zero balances. The zero balances are obtained by using closing entries to
clear the balances in the revenue and expense accounts at the end of each accounting
period. The withdrawals/dividend account is closed in a similar manner.

2. Second purpose of the closing process is that it helps in summarizing a period’s

revenue and expenses. This is done by transferring the balances of revenues and
expenses to the income summary (P&L) account. This temporary account which
appears in the chart of accounts between the withdrawals accounts and the first
revenue account provides a place to summarize all revenues and expenses. It is used
only in the closing process and never appears in the financial statements.
NB:
The balance of the income summary account equals the net income or loss reported on
the income statement. The net income or loss is then transferred to the capital or
 (retained earnings) account. This is done because even though revenues and expenses are
recorded in revenue and expense accounts, they actually represent increase and
decreases in owners equity, Closing entries transfer the net effect of increase (revenues)
and decrease (expenses) to the owners capital (retained earnings) accounts.

What are the Components of the Closing Process?

The closing process encompasses the following steps:
i) Identifying accounts for closing.
ii) Recording (journalizing) and posting the closing entries.
iii) Preparing a post-closing trial balance.
Step 8: Recording and Posting Closing Entries

The eighth step in the accounting cycle involves preparation of closing entries and posting to the
general ledger.

What are closing entries?

Closing entries are journal entries made at the end of an accounting period (or before the
beginning of a new accounting period) to transfer revenue, expense and dividend account
balances to the Retained Earnings account (or owner’s capital account in the case of a sole
proprietorship firm.

Closing entries are journalized in the general journal, the adjusting entries are separated from
the closing entries by the caption “closing entries”. Then the closing entries are posted to the
ledger accounts. Separate closing entries could be prepared for each nominal (temporary)
account, but the following four entries accomplish the desired result more efficiently.

Step 1: Closing Credit Balances in Revenue Accounts to Income Summary

The first closing entry transfers credit balances in revenue accounts to the income summary
account. We get accounts with credit balances to zero by debiting them. The income summary
account is created and used only for the closing process. Hence, debit each revenue account for
its balance and credit income summary for total revenues e.g.
Dec. 31 Dr. Consulting Revenue 5,800
Dr. Rental revenue 300
Cr. Income summary 6,100
(To close revenue accounts)

Step 2: Close the debit balances in expense accounts to income summary

The second closing entries transfers debit balances in expense accounts to the income
summary account. This step gathers all the expense account’s debit balances to zero by crediting
them. This allows these accounts to accumulate a record of new expenses in the next period.
(i.e. debit income summary for total expenses and credit each expense account for its balance.).
For example:

Dec 31 Income summary 4,365

Depreciation expense 375
Salaries expense 1,610
Insurance expense 100
Rent expense 1,000
Supplies expense 1,050
Utilities expense 230
(To close expense account)
NB:
The posting of this entry gives each expense account a zero balance.

Step 3: Close Income Summary Account to Owners’ Capital

 The third closing entry transfers the balance of the income summary account to the Owners’
Capital account or Retained Earnings account. After the first two closing entries are posted, the
balance formerly reported in the individual revenue and expense accounts are in the income
summary account.

If revenue exceeds the expenses, a net income is earned and the income summary account will
contain a credit balance.

If expenses exceed revenues, a net loss is indicated and the account will have a debit balance. In
either case, the balance is transferred to Owners’ Capital / Retained Earnings account. That is the
entry closes the income summary account and adds the company’s net income to the owners’
capital account (Retained Earnings Account). For example

Dec 31 Income Summary 1,785

C. Kamau, capital (retained earnings) 1,785
(To close the income
Summary account)

NB:
The income summary account has a zero balance after posting this entry. It continues to have a
zero balance until the closing process occurs at the end of the next period. The Owners’
Capital/ Retained Earnings account now has been increased by the amount of the net income,
because the normal balance of Owners’ Capital is a credit, increases to Owners’ Capital from net
income are credits.

Step 4: Close Withdrawals / Dividends Account to Owners’ Capital

(Retained earnings / dividends).
The fourth closing entry transfers any debit balance in the Withdrawals (Dividends) account to
the owners’ capital account. (Retained Earnings) account (i.e. debit Owners Capital / Retained
Earnings account and credit withdrawals / Dividends account for the same amount).

E.g.
Dec 31 C. Kamau, capital / Retained Earnings 600
C. Kamau, withdrawals (dividends) 600
(To close the withdrawals/dividends account)

This entry gives the withdrawals account a zero balance, and the account is ready to accumulate
next period’s payments to owners’ (shareholders). This entry also restores the capital account
(retained earnings) account balance to the amount reported on the balance sheet.
 CLOSING PROCESS ILLUSTRATED – PLASMA ADVERTISING CO

Step 8: Preparing Closing Entries and Posting to the General Ledger.

To illustrate the journalizing and posting of closing entries, we will assume that Pioneer
Advertising Co. closes its books monthly

PIONEER ADVERTISING AGENCY CO.

Adjusted Trial Balance
October 31,2004
Dr. Cr.
Cash Ksh. 15,200
Account receivable 200
Advertising Supplies 1,000
inventory
Prepaid Insurance 550
Office Equipment 5,000
Accumulated Depreciation-
Office Equipment 40
Note Payable 5,000
Accounts Payable 2,500
Interest Payable 50
Unearned Fees 800
Salaries Payable 1,200
Common Stock 10,000
Retained Earning -0-
Dividends 500
Fees Earned 10,600
 Salaries Expense 5,200
Advertising Supplies
Expense 1,500
Rent Expense 900
Insurance Expense 50
Interest Expense 50
Depreciation Expense 40
Ksh 30,190 Ksh 30,190

The closing journal entries at October 31 are shown here – below.

General journal GJ3

Date Account Title and Explanation Ref. Debit Credit
Pos
t
Closing entries

(a) Oct 31 Fees Earned 50 10,60

0
Income Summary 49 10,60
0
(To close revenue account)

(b) 31 Income Summary 49 7,740

Salaries Expense 60 5,200
Advertising Supplies Expense 61 1,500
Rent Expense 62 900
Insurance Expense 63 50
Interest Expense 64 50
 Depreciation Expense 65 40
(To close expense accounts)

(c) 31 Income Summary 49 2,860

Retained Earnings 40 2,860
(To close net income to retained
earnings)

(d) 31 Retained earnings 40 500

Dividends 41 500
(To close dividends to retained earnings)

NB:
A couple of cautions in preparing closing entries:
(1) Avoid unintentionally doubling the revenue and expense balances rather than
zeroing them.
(2) Do not close dividends through the income summary account. Dividends are not
expenses, and therefore are not a factor in determining net income.

Posting of closing entries:

The posting of closing entries and the ruling of the accounts are shown in the next page. Note
that all temporary accounts have zero balances. In addition, you should realize that the balance
in retained earnings represents the accumulated undistributed earnings of the company at
the end of the accounting period. This balance is shown on the balance sheet and is the ending
amount reported on the retained earnings statement. The income summary account is used only
in closing. No entries are journalized and posted to this account during the year.

GENERAL LEDGER: Permanent Accounts

 Cash No.1 Salaries payable No. 29
Dat Explanati Re Debit Cred Balan Date Explan Ref. Deb Credit Balance
e on f. it ce ation it
200 2004
4
Oct GJ 10,000 10,00 Oct Adj. GJ2 1,200 1,200
1 1 0 Dr 31 entry Cr
GJ 1,200 11,20
2 1 0
GJ 900 10300 Common stock No.
3 1 40
GJ 600 9,700 Date Explan Re Debit Cred Balance
4 1 ation f. it
GJ 500 9,200
20 1
GJ 4,00 5,200 2004
26 1 0
GJ 10,000 15,20 Oct. GJ 10,0 10.000
31 1 0 1 1 00 Cr

Account Receivable No. 6 Retaining Earnings No. 41

Dat Explanati Re Debit Cred Balan Date Explan Re Debit Cred Balance
e on f. it ce ation f. it
200 2004
4
Oct Adj. entry GJ 200 200 Oct -0- Cr
31 2 Dr 1
 31 Income GJ 2,86 2,860
summa 3 0
ry
(Closin
g entry)
31 Dividen GJ 500 2.360
ds 3
(Closin
g entry)
Advertising Supplies Inventory No.8
Dat Explanati Re Debit Cred Balan NB:
e on f. it ce The permanent accounts for Plasma
200 Advertising Co are shown here; the temporary
4 accounts shown in illustration below. Both
Oct GJ 2,500 2,000 permanent and temporary accounts are part
5 1 Dr of the general ledger; they are segregated
31 Adj. entry GJ 1,50 1,000 here to aid in learning.
2 0

Prepaid Insurance No. 10

Dat Explanati Re Debit Cred Balan
e on f. it ce
200
4
Oct GJ 600 600
4 1 Dr
Adj. entry GJ 50 550
31 2
 Office Equipment No.
15
Dat Explanati Re Debit Cred Balan
e on f. it ce
200
4
Oct. GJ 5,000 5,000
1 1 Dr

Accumulated depreciation- office equipment

No. 16
Dat Explanati Re Debit Cred Balan
e on f. it ce
200
4
Oct Adj. entry GJ 40 40 Cr
31 2

Notes payable
No.25
Dat Explanati Re Debit Cred Balan
e on f. it ce
200
4
OC GJ 5,00 5,000
T1 1 0 Cr
 Accounts Payable
No.26
Dat Explanati Re Debit Cred Balan
e on f. it ce
200
4
Oct GJ 2,50 2,500
5 1 0 Cr

Interest Payable No.

27
Dat Explanati Re Debit Cred Balan
e on f. it ce
200
4
Oct Adj. entry GJ 50 50 Cr
31 2

Unearned Fees No. 28

Dat Explanati Re Debit Cred Balan
e on f. it ce
200
4
Oct GJ 1,20 1,200
2 1 0 Cr
31 Adj. entry GJ 400 800
2
General Ledger: Temporary Accounts
 Dividends No. 42
Date Explan Ref Debit Cred Balance
ation . it
2004
Oct GJ1 500 500
20
31 Retaine GJ 500 -0-
d 3
earning
s
(Closin
g entry)

Income Summary
No.49
Date Explan Ref Debit Cred Balance
ation . it
2004
Oct Fees GJ 10,6 10,600
31 earned 3 00
(Closin
g entry)
31 Expens GJ 7,740 2,860
es 3
(Closin
g entry)
31 Retaine GJ 2,860 -0-
d 3
earning
 s
(Closin
g entry)

Fees Earned No. 50

Date Explan Ref Debit Cred Balance
ation . it
2004
Oct GJ1 10,0 10,000
31 00
GJ2 10,400
31 400
GJ2 10,600
31 200
31 Income GJ 10,60 -0-
summa 3 0
ry
(Closin
g entry)

Salaries Expense No. 60

Date Explan Ref Debit Cred Balance
ation . it
2004
Oct GJ1 4,000 4,000
26
GJ2 1,200 5,200
31
 31 Income GJ 5,20 -0-
summa 3 0
ry
(Closin
g
Entry)

Advertising supplies Expense No.

61
Date Explan Ref Debit Cred Balance
ation . it
2004
Oct GJ2 1,500 1,500
31
31 Income GJ 1,50 -0-
summa 3 0
ry
(Closin
g entry)

Rent Expense No.62

Date Explan Ref Debit Cred Balance
ation . it
2004
Oct GJ1 900 900
3
31 Income GJ 900 -0-
summa 3
ry
 (Closin
g
entry0

Insurance Expense No. 63

Date Explan Ref Debit Cred Balance
ation . it
2004
Oct GJ2 50 50
31
31 Income GJ 50 -0-
summa 3
ry
(Closin
g entry)

Interest Expense No.

64
Date Explan Ref Debit Cred Balance
ation . it
2004
Oct GJ2 50 50
31
31 Income GJ 50 -0-
summa 3
ry
 (Closin
g entry)

Depreciation Expense
No.65
Date Explan Ref Debit Cred Balance
ation . it
2004
Oct GJ2 40 40
31
31 Income GJ 40 -0-
summa 3
ry
(Closin
g entry)

Step 9: Preparing a Post Closing Trial Balance – Plasma Advertising Co.

After all closing entries has been journalized and posted, another trial balance called a
post-closing trial balance is prepared from the general ledger. A post-closing trial balance is a
list of permanent accounts and their balances after closing entries have been journalized and
posted. The purpose of this trial balance is to prove the equality of the permanent account
balances that are carried forward into the next accounting period. Since all temporary
accounts will have zero balances, the post-closing trial balance will contain only permanent-
balance sheet accounts.
The procedures for preparing a post closing trial balance again consists entirely of listing the
accounts and their balances. These balances are the same as those reported in the company’s
balance sheet as illustrated below. The post-closing trial balance for Pioneer Advertising Co. is
shown in illustration below.

PLASMA ADVERTISING CO.

Post-Closing Trial Balance
October 31, 2008

Account Title Debit Credit

Cash Ksh. 15,200
Account receivable 200
Advertising Supplies 1,000
Inventory
Prepaid Insurance 550
Office Equipment 5,000
Accumulated Depreciation-
Office Equipment Ksh 40
Notes Payable 5,000
Accounts Payable 2,500
Interest Payable 50
Unearned Fees 800
Salaries Payable 1,200
Common Stock 10,000
Retained Earning 2,360
Ksh 21,950 Ksh 21,950

NB:
1. The post- closing trial balance is prepared from the permanent accounts in the
General ledger. The permanent accounts of Pioneer Advertising are shown in the general
 ledger illustration below. Because the balance of each account is computed after every
posting, no additional work on these accounts is needed as part of the closing
process. The remaining accounts in the general ledger are temporary accounts. After the
closing entries are posted, each temporary account has a zero balance. These
accounts are double-ruled to finalize the closing process.
2. A post-closing trial balance provides evidence that the journalizing and posting of closing
entries has been properly completed. In addition, it shows that the accounting equation
is in balance at the end of accounting period. However, as in the case of the unadjusted
and adjusted trial balance, it does not prove that all transactions have been recorded or
that the ledger is correct. For example, the post closing trial balance will balance even if
the following held;

i. a transaction is not journalized and posted or

ii. If a transaction is journalized and posted twice.

Step 10: Reversing Entries – An Optional Step

Some accountants prefer to reverse certain adjusting entries at the beginning of a new accounting
period. A reversing entry is made at the beginning of the next accounting period and is the
exact opposite of the adjusting entry made in the previous period. The preparation of reversing
entry is an optional book keeping procedure that is not a required step in the accounting
cycle.
The purpose of reversing entries is to simplify the recording of a subsequent transaction related
to an adjusting entry, because it can be recorded as if the related adjusting entry has never been
made.

Illustration of reversing entry

Reversing entries are most often used to reverse two types of adjusting entries:
 a. accrued revenues (unrecorded revenues) and
b. accrued expenses.(unrecorded expenses)
They are seldom made for prepaid expenses and unearned revenues. To illustrate the optional use
of reversing entries for accrued expenses, we will use the salaries expense transactions for
Pioneer Advertising Co. The transaction and adjustment data are as follows:
1. October 26 (initial salary entry) Ksh 4,000 of salary earned between October 15
and October 26 are paid.
2. October 31 (adjusting entry) salaries earned between October 29 and October 31
are Ksh 1,200. these will be paid in the November 9 payroll
3. November 9 (subsequent salary entry) salaries paid are Ksh 4,000. Of this
amount, Ksh 1,200 applied to accrued wages payable and Ksh 2,800 was earned
between November 1 and November 9.
The comparative entries with and without reversing entries are as shown below:

Accrued salaries on October 31,2004

Dr. Salaries expense 1,200

Cr.Salaries Payable 1,200

Salaries Expense
Date Exp Dr Cr Balanc
 e
Oct. 26 4,000 - 4,000
31 Adj. Entry 1,200 - 5,200
31 Closing - 5,200 -0-
entry

Salaries Payable
Date Exp Dr Cr Balanc
e
Oct. 31 Adj. Entry - 1,200 1,200

No reversing entry recorded on Nov 1 2008 -OR - Reversing

entry recorded on Nov 1 2004

Nov 1 Nov 1 Dr. salaries payable 1,200

NO JOURNAL ENTRY Cr. Salaries expense
1,200

Salary Expense Salary Expense

Date Exp Dr Cr Balance Date Exp Dr Cr Balance
Nov. - - - Nov. Rev. - 1,20
1 1 entr 0
y

Salaries Payable Salaries Payable

Date Exp Dr Cr Balance Date Exp Dr Cr Balance
Oct. Adj. - 1,20 1,200 Oct. Adj. - 1,20 1,200
31 Entry 0 Cr 31 entry 0
Nov. Rev. 1,20 - -0-
1 entr 0
y

Pay the accrued and current salaries on November 9, the first payday in November.

Nov 9 Dr. Salaries Expense 2,800 Nov 1 Dr. Salaries Expense 4,000
Dr. Salaries Payable 1,200 Cr. Cash
Cr. Cash 4,000
4,000
Salary Expense Salary Expense
Date Exp Dr Cr Balance Date Exp Dr Cr Balance
Nov. Cash 2,80 - 2,800 Nov. Rev. - 1,20
9 0 Dr. 1 entr 0
y
Nov. Cash 4,00 - 2,800
9 0 Dr.
Salaries Payable Salaries Payable
Date Exp Dr Cr Balance Date Exp Dr Cr Balance
Oct. Adj. - 1,20 1,200 Oct. Adj. - 1,20 1,200
31 Entry 0 Cr 31 entry 0
Nov. Cash 1,20 - -0- Nov. Rev. 1,20 - -0-
9 0 1 entr 0
y

Under both approaches, the expense and liability accounts have

identical balances after the cash payment on November 9.
Salaries Ksh
expense 2,800
Salaries Ksh -0-
payable
In our example, on November 1st the Salaries Payable, a liability account is debited for Ksh
1,200 meaning that this account now has a zero balance after the entry is posted. Note that, the
Salaries Payable account temporarily understates the liability but this is not a problem since
financial statements are not prepared before the liability is settled on November 9. The credit to
the Salaries Expense account on Nov 1st is unusual because it gives the account an abnormal
credit balance. We highlight an abnormal balance by circling it.

Because of the reversing entry, the November 9 entry to record payment of salaries is straight
forward. This entry debits the Salaries Expense account and credit cash for the full Ksh 4,000
paid. It is the same as all other entries made to record 2- week’s salary for the 4 employees (each
Ksh 500 per week or Ksh 100 per work-day).

We should look at the accounts on the lower side of the illustrative diagram above. After the
payment entry is posted, salaries expense account has a Ksh 2,800 balance that reflects 7 days
salary of Ksh 400 per day (For all the 4 employees). The zero balance in the Salaries Payable
account is now correct.

The lower section of the diagram shoes that the expense accounts have exactly the same balances
whether reversing occurs or not. This means that either approach produces identical results.

Correcting Entries
Errors that occur in recording transactions should be corrected as soon as they are discovered by
journalizing and posting correcting entries.

NB:
You should recognize several significant differences between correcting entries and adjusting
entries.
(i) First, adjusting entries are an integral part of the accounting cycle; where as
correcting entries are unnecessary if the records are free of errors.
 (ii) Second, adjustments are journalized and posted only at the end of an accounting
period; in contrast, correcting entries are made whenever an error is discovered.
(iii) Finally, adjusting entries always affect at least one balance sheet account and one
income statement account. In contrast, correcting entries may involve any
combination of accounts I need of correction.

To determine the correcting entry, it is useful to compare the incorrect entry with the correct
entry. Doing so, helps identify the accounts and amounts that should – and should not be
corrected. After comparison, a correcting entry is made to correct the accounts. This approach is
illustrated in the following two cases:

Case 1:
Supposing that, on May 10, a Ksh 5,000 cash collection of an Accounts Receivable from a
customer is journalized and posted as a credit to cash ksh 5,000 and a credit to Fees Earned Ksh
5,000. The error is discovered on May 20, when the customer pays the balance in full.

Incorrect Entry (May 10) Correct Entry (May 10)

May 10 Dr. Cash 5,00 Dr. Cash 5,000
0
Cr. Fees earned 5,000 Cr. Account 5,000
receivable

A comparison of the incorrect entry with the correct entry reveals that the debit to cash ksh 5,000
is correct. However, the ksh 5,000 credit to fees earned should have been to accounts receivable.
As a resulted, both fees earned and account receivable are overstated in the ledger. The following
correcting entry is required:

Correcting Entry
 May 20 Fees earned 5,000
Account receivable 5,000
( to correct entry of May 10)
Case 2:
Supposing that, on May 18, office equipment costing Ksh 45,000 is purchased on account
(Credit). The transaction is journalized and posted as a debit to Delivery Equipment Ksh 4,500,
and a credit to Account Payable Ksh 4,500. The error is discovered on June 3, when the monthly
statement for May is received from the creditor.

Incorrect Entry (May 18) Correct Entry (May 18)

Dr Cr Dr cr
Delivery equipment 4,500 Office Equipment 45,000
Account payable 4,500 Account payable 45,000

A comparison of the two entries shows that three accounts are incorrect.
i. Delivery equipment is overstated ksh 4,500;
ii. Office equipment is understated by Ksh 45,000; and
iii. Account payable is understated ksh 40,500 (45,000 – 4,500). The correcting entry is:

Correcting Entry
June 3 Office Equipment 45,000
Delivery Equipment 4,500
Account Payable 40,500
( To correct entry of May 10 entry )

Instead of preparing a correcting entry, it is possible to reverse the incorrect entry and then
prepare the correct entry. This approach will result in more entries and posting than a correcting
entry, but it will accomplish the desired result.
The Classified Financial Statements
The financial statements illustrated upto these point were purposely kept simple. In practice
however companies also prepare classified financial statements.

The Classified Balance Sheet

An unclassified balance sheet is one where its items are broadly grouped into Assets, Liabilities
and Stockholders’ Equity (e.g. Pioneer Advertising Co.)

A classified balance sheet organizes assets and liabilities into important subgroups. The
information in a balance is more useful to decision makers if assets and liabilities are classified
into subgroups. One example is information to distinguish liabilities that are due soon from those
not due for several years. This information helps us assess a company’s ability to meet liabilities
when they come due.

Classification Structure
There is no required layout for a classified balance sheet. Yet a classified balance sheet often
contains common groupings as shown below.

Assets Liabilities
- Current assets Current Liabilities
- Long-term investments - Long-term liabilities
- Property, plant and equipment
- Intangible asset Stockholders (Owners’ Equity)
- Paid –in Capital
- retained Earnings
NB:
These classification sections help the financial statement user to determine such matters as:
1. The availability of assets to meet debts as they come due and
 2. The claim of short- term and long term creditors on total assets.
3. A classified balance sheet also makes it easier to compare companies in the same industry
such as General Motors and CMC Motors.

1. Current Assets
Current assets are cash and other resources that are reasonably expected to be realized in
cash or sold or consumed in the business within one year of the balance sheet date or the
company’s operating cycle, which ever is longer. For example, Accounts Receivable is
included in the current assets because they will be realized in cash through collection within one
year. In contrast, a prepayment such as Supplies Inventory is a current asset because of its
expected use or consumption in the business within one year.

NB:
(1) In service enterprises, it is customary to recognize four types of current assets:
a. Cash
b. Marketable securities such as G.o.K bonds held as temporary (short- term)
investments.
c. Receivables (Note Receivable, Accounts Receivable, Interest Receivable)
d. Prepaid expenses (Insurance and Supplies)
(2) A company’s current assets are important in assessing the company’s short-term
debt-paying ability.

2. Long Term Investments

Like current assets, long-term investments are resources that can be realized in cash.
However, the conversion into cash is not expected within one year or the operating cycle
whichever is longer. In addition, long-term investments are not intended for use or consumption
within the business.

NB:
 This category often just called “investments” normally includes stocks and bonds of other
companies. It could also include land (real estate) held as an investment.

3. Property Plant and Equipment

Property, plant and equipment are tangible resources of a relatively permanent nature that
are used in the business and not intended for sale. This category includes:
− Land
− Buildings
− Machinery and equipment
− Delivery equipment
− Furniture and fixtures
NB:
Assets subject to depreciation should be reported at cost less accumulated depreciation.

4. Intangible Assets
Intangible assets are long –term resources used to produce or sell products or services that
do not have physical substance and their benefits are uncertain. Examples of intangible
assets are:
− Patents
− Copyrights
− Trademarks or
− Trade names
These items give the holder exclusive right to use them for a specified period of time. Their
value to a company is generally derived from the rights or privileges granted by governmental
authority.

5. Current Liabilities
Current liabilities are obligations due to be paid or settled within the longer of one year or
the operating cycle. They are usually settled by paying out current assets. Current liabilities
include:
(i) Debts related to the operating cycle, such as:
− Accounts payable
− Wages and salaries payable

(ii) Short-term debts such as:

− Bank loan payable
− Interest payable
− Taxes payable
− Current maturities of long-term obligation

6. Long- Term Liabilities

Long-term liabilities are obligations not due within the longer of one year or the operating
cycle. Examples include:
− Notes payable (loan)
− Mortgages payable
− Bonds payable
− Lease obligations
− Obligations under employee pension plans

7. Stockholders (Owners) Equity

The content of the owner’s equity section varies with the form of business organization.
a) In a proprietorship, there is one capital account.
b) In a partnership, there is a capital account for each partner.
c) For a company, owners’ (stockholders) equity is divided into two accounts
− Capital (common / ordinary) stock
− Retained savings
Classified Balance Sheet Illustrated

The classified balance sheet of Plasma Advertising is presented below:

PlasmaAdvertising Co.
Balance Sheet
October 31, 2008
Assets
Current assets
Cash Ksh 15,200
Accounts receivable 200
Advertising supplies 1,000
Prepaid insurance 550
Total current assets 16,950

Property, plant and equipment

Office equipment Ksh 5,000
Less: Accumulated Depreciation (40) 4,960
Total assets Ksh 21,910

Liabilities and stockholders’ equity

Current liabilities
Notes payable 1,000
Accounts payable 2,500
Interest payable 50
Unearned fees 800
Salaries payable 1,200
Total current liabilities 5,550

Long-term Liabilities
Notes payable 4,000
Total liabilities 9,550

Stockholders’ equity
Common stock 10,000
Retained earnings 2,360
Total liabilities and stockholders’ equity Ksh 21,910
Worksheet as A Tool of Preparing Adjusting Entries and Financial Statements
There is an optional step in the accounting cycle. A worksheet may be used in the preparation of
adjusting entries and financial statements.

A worksheet is a device designed to bring in one place the information needed to prepare
formal financial statements (except the statement of cashflows), and to record the adjusting
and closing entries. Worksheets are generally prepared in pencil so that errors can be erased and
corrected before the entries are recorded in the journal. Here are some facts about a worksheet:
1. It is not part of permanent accounting records.
2. It is not prepared for use by the owners or the management of the firm (i.e. a worksheet is
not a required financial report). It is not usually given to decision makers.
3. It replaces neither the financial statements nor the necessity to journalize and post the
adjusting and closing entries; and
4. It is simply a tool used to gather and organize the information needed to complete the
accounting cycle.

Benefits of a Worksheet
1. It helps preparers avoid errors when working with accounting systems involving
many accounts and adjustments.
2. It captures the entire accounting process, linking transactions and events to their
effects in financial statements.
3. Auditors of financial statements often us a worksheet for planning and organizing
the audit. It can be used to reflect any adjustments necessary as a result of the
audit.
4. It is useful in preparing interim (monthly or quarterly) financial statements when
journalizing and posting adjusting entries are postponed until the year- end.
5. It is helpful in showing the effects of proposed or “what –if” transactions.
Preparation of a Worksheet
A worksheet can simplify efforts in preparing financial statements. It is prepared before making
adjusting entries at the end of the reporting period. The worksheet stores information about the
following:
i. accounts
ii. The needed adjustments and
iii. The financial statements
A complete worksheet contains all information recorded in journals and shown in the financial
statements.
The multicolumn worksheet provides two columns each for:
i. The unadjusted trial balance
ii. The adjustments
iii. The adjusted trial balance
iv. The income statement and
v. The balance sheet and statement of changes in owners’ equity.

There are 5 steps followed in the preparation of a worksheet. We will use the information of
Plasma Advertising Co. to describe and interpret the worksheet.
 Work Sheet
Account Unadjusted Adjustmen Adjuste Income Balance Sheet
Title Trial ts d Statement
Balance Trial
Balance
Dr. Cr. Dr Cr Dr. Cr Dr Cr Dr Cr
.

Step 1: Enter (Prepare) the Unadjusted Trial Balance

The first step in using a worksheet is to list the title of every account with a balance in the
company’s general ledger. The unadjusted debit or credit balances for accounts in the ledger are
then recorded in the two columns of the unadjusted trial balance. The totals of these two columns
must equal.
In the case of Plasma Advertising Co, the unadjusted trial reflects the account balance after the
December transactions are recorded but before any adjusting are entries are journalized or
posted.

Step2: Enter The Necessary Adjustments In The Adjustments Columns.

The second step in preparing a worksheet is to enter adjustments in the columns labeled
adjustments. An identifying letter relates the debit and credit of each adjustment. This is called
keying the adjustments.

NB:
i. After preparing a worksheet, we still must enter adjusting entries in the journal
and post them to the general ledger. The identifying letters help match correctly
the debit and credit of each adjusting entry.
ii. It is important to recognize that the adjustments are not journalized until the
worksheet is completed and the financial statements have been prepared.
The adjustments for Pioneer Advertising Co. are the same as the adjustments we
did earlier. They are keyed in the adjustments columns of the worksheet as
follows:
(a) An additional account, advertising supplies expense. Is debited ksh 1,500
for the cost of supplies used, and advertising supplies is credited ksh
1,500.
 (b) An additional account, insurance expense, is debited ksh 50 for the
insurance that has expired, and prepaid insurance is credited ksh 50.
(c) Two additional accounts are needed. Depreciation expense is debited ksh
40 for the month’s depreciation, and accumulated depreciation –office
equipment is credited ksh 40.
(d) Unearned fees is debited ksh 400 for fees earned, and fees earned is
credited ksh 400.
(e) An additional account, Account Receivable, is debited ksh 200 for fees
earned but not billed, and fees earned is credited 200.
(f) Two additional accounts are needed, Interest Expense is debited Ksh 50
for accrued interest, and interest payable is credited ksh 50.
(g) Salaries Expense is credited Ksh 1,200 for accrued salaries, and an
additional account, salaries payable, is credited ksh 1,200.

NB:
In the illustrations that after all the adjustments have been entered, the adjustment columns are
totaled and the equality of the totals is proved.

Step 3: Prepare an Adjusted Trial Balance

The adjusted trial balance is prepared by combining the adjustments with the unadjusted
balances for each account. For example, the prepaid insurance in the trial balance columns has a
Ksh 600 debit balance. When this is combined with the Ksh 50 credit in the adjustment columns,
the result is a Ksh 550 debit balance recorded in the adjusted trial balance columns. For each
account on the worksheet, the amount in the adjusted trial balance that will appear in the
ledger after the adjusting entries have been journalized and posted.
After the balances of all accounts have been entered in the adjusted trial balance columns, the
columns are totaled and their equality are proved. The agreement of the column totals facilitates
the completion of the worksheet. If these columns are not in agreement, the statement columns
will not balance and the financial statements will be incorrect.

Step 4: Extend Adjusted Trial Balance Amounts to Appropriate Financial Statement

Columns

This step involves sorting (extension) of adjusted trial balance amounts to their last four
columns of the worksheet proper financial statement columns (i.e. last our columns of the
worksheet).
− Expense items go to the income statement debit column and revenues to the
income statement credit column.
− Assets and withdrawals (dividends) go to the statement of changes in owners’
equity (retained earning) and balance sheet debit column. Liabilities and
owner’s equity (capital stock) go to the statement of changes in owner’s equity
and balance sheet credit column.

Step 5: Total the Statement Columns, Compute the Net Income (Or Net Loss), and
Complete the Worksheet.

Each of the financial statement columns must be totaled. The net income or loss for the period is
then found by computing the difference between the totals of the two income statement
columns. If total credits exceed total debits, net income has resulted. In such a case, as shown in
the Pioneer illustration, the words “net income” are inserted in the account title space. The
amount is then entered in the income statement debit column and the balance sheet credit
column. The debit amount balances the income statement columns and the credit amount
balances the balance sheet columns. In additional, the credit in the balance sheet columns
indicates the increase in stockholders equity resulting from net income.
After the net income or net loss has been entered, new column totals are determined. The totals
shown in the debit and credit income statement columns will be identical. The totals shown in
the debit and credit balance sheet columns will also be identical.

NB:
(1) If either the income statement columns or the balance sheet columns are not equal after
the net income or net loss has been entered, an error has been made in completing the
worksheet. The errors can be mathematical or can involve errors in sorting one or more
amounts to columns.
(2) A balance in the last two columns is no proof of no errors.

Preparing Financial Statements From a Worksheet

After a worksheet has been completed, the statement columns contain all the data that are
required for the preparation of financial statements.
● The income statement is prepared from the income statement columns
● Balance sheet and statement of retained earnings are prepared from the balance sheet
columns.
NB:
Using a worksheet, accountants can prepare financial statements before adjusting entries
are journalized and posted. However, the completed worksheet is not a substitute for
formal financial statements. Rather, a worksheet is essentially a working tool for the
accountant and is not distributed to management and other parties.

PLASMA ADVERTISING CO
Worksheet
For the month ended October 31, 2004
Unadjusted Adjustments Adjusted Trial Income Balance Sheet
Trial Balance Balance Statement
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,20 15,20 15,20
0 0 0
Advertising 2,500 (a) 1,000 1,000
supplies inventory 1,500
Prepaid insurance 600 (b) 550 550
50
Office equipment 5,000 5,000 5,000
Notes payable 5,000 5,000 5,000
Accounts payable 2,500 2,500 2,500
Unearned fees 1,200 (d) 800 800
400
Common stock 10,00 10,00 10,00
0 0 0
Dividends 500 500 500
Fees earned 10,00 (d) 10,60 10,60
0 400 0 0
(e)
200
Salaries Expense 4,000 (g) 5,200 5,200
1,200
Rent Expense 900 900 900
Totals 28,70 28,70
0 0
Advertising (a) 1,500 1,500
Supplies Expense 1,500
Insurance Expense (b) 50 50
50
Accum. (c) (c) 40 40
Depreciation- 40 40
Office Equipment
Depreciation (c) 40 40
Expense 40
Interest Expense (f) 50 50
50
Interest Payable (f) 50 50
50
Accounts (e) 200 200
Receivable 200
Salaries Payable (g) 1,200 1,200
1,200
Totals 3,440 3,440 30,19 30,19 7,740 10,60 22,45 19,59
0 0 0 0 0
Net Income 2,860 2,860

Totals 10,60 10,60 22,45 22,45

0 0 0 0
 Plasma Advertising Co
Income Statement
For the Month Ended October 31, 2008

Revenues
Fees earned Ksh.
10,600

Expenses
Salaries expense Ksh.
5,200
Advertising supplies expense 1,500
Rent expense 900
Insurance expense 50
Interest expense 50
Depreciation expense 40
 Total expenses 7,740
Net income 2,860

PLASMA ADVERISING Co.

Retained Earning Statement
For the Month Ended October 31, 2008

Retained earnings, October 1 Ksh.

-0-
Add: net income 2,860
2,860
Less dividends 500
Retained earnings, October 31 Ksh. 2,360

Plasma Advertising Co
Balance Sheet
For the Month Ended October 31, 2008

Assets
Cash Ksh.
15,200
Account receivable 200
Advertising supplies 1,000
Prepaid insurance 550
Office equipment Ksh
5,000
Less : accumulated depreciation 40 4,960
Total assets Ksh
21,910
Liabilities and Stockholders’ Equity
Liabilities
Notes payable Ksh 5,000
Accounts payable 2,500
Interest payable 50
Unearned fees 800
Salaries payable 1,200
Totals liabilities 9,950
Stockholders’ equity
Common stock 10,000
Retained earnings 2,360
Total liabilities and stockholders’ Ksh.
equity 21,910
 LECTURE SIX

ACCOUNTING FOR MERCHANDISING ACTIVITIES

Lecture Outline
6.1 Introduction
6.2 Objectives
6.3 Financial statements for a merchandising company
6.4 Inventory systems.(perpetual & periodic)
6.5 Accounting for merchandise purchases
6.6 Accounting for merchandise sales.
6.7 Accounting for operating expenses
6.8 Trial balance for a merchandising firm
6.9 Summary

6.2 Objectives
By the end of this lecture, you should be able to:
● Describe merchandising activities and identify business
examples
● Identify the components on measuring net income (profits) in a
merchandising
● Distinguish between the periodic and the perpetual inventory
system
● Analyze and record transactions related to sales and purchase
of merchandise under the perpetual inventory system
● Prepare adjusting and closing entries for a merchandising
company
● Prepare financial statements for a merchandising company
INTRODUCTION

Our emphasis thus far (i.e. accounting cycle) has been on the accounting and reporting activities
of companies providing services such as Kenya – Airways, Syuntra Stock Brokers, City Bank,
Kenya Revenue Authority, UAP Insurance, White – Rose Dry Cleaners, and UON etc. In return
for services provided to their customers, a service company receives:-

a. Commissions - Syuntra stocks, KRA

b. Fares- Kenya Airways, KENATCO, Maersk, shipping line.
c. Fees – University of Nairobi, USIU, CITY Bank, Hospitals.
d. Premiums (UAP),

as revenue. Its net income for a reporting period is the difference between its revenues and
operating expenses incurred in providing services.

In this lesson, we explain and illustrate another type of enterprise called a Merchandising or
trading concern. These enterprises buy and sell goods rather than perform services to earn a
profit. Merchandisers are often identified as either wholesalers e.g. metro cash & carry) or
retailers (Uchumi supermarket).

- A wholesaler is a middleman who buys a product from manufacturers or other

wholesaler and then sells them to retailers or to other wholesalers.
- A retailer is a middleman that buys products from manufacturers or wholesalers and sells
them to consumers (e.g. Kenol, Kobil, Naivas, etc).

NB:
Although the steps in the accounting cycle for a merchandising company are the same as the
steps for a service enterprise, you must be sure to understand the following (a) the additional
 accounts and entries required in recording merchandising transactions and (b) the proper
financial statement presentation of these accounts.

Accounting Issues
(i) Measuring income (profits) in a merchandising company
(ii) Inventory systems.
(iii) Accounting for sales revenue (Accounting for merchandise sales)
(iv) Accounting for cost of goods sold (Accounting for merchandise purchases
(v) – perpetual inventory systems.
- periodic inventory systems.
-
Measuring Income in a Merchandising Company
Measuring net income for a merchandising company is conceptually the same as for a service
enterprise. That is net income (or loss) results form the matching of expenses with revenues.
In a merchandising company:,

(a) The primary source of revenues is the sale of merchandise, often referred to simply as
sales revenue or sales.
(b) Expenses are divided into two categories
(i) The cost of goods sold
(ii) Operating expenses

The cost of goods sold is the total cost of merchandise sold during the period. This expense is
directly related to the revenue recognized from the sale of goods.
Sales less cost of goods sold is called gross profit (or gross margin) on sales. For example, when
a mobile phone costing sh 10,000 is sold for sh 15,000, the gross profit is sh 5,000.
Merchandising companies customarily report gross profit on sales on the income statement.
After gross profit is calculated, operating expenses are deducted to determine net income or
loss. Operating expenses are incurred in the process of earning sales revenue. Examples of
operating expenses are:-

- Sales salaries

- Advertising expenses

- Insurance expenses etc.

Computing income for both a merchandising company and a service company

(a) Service company

(b) Merchandising company

NB:

The operating expenses of a merchandising company include many of the expenses found in a
service enterprise. Hence, in this lesson, we will focus primarily on the recording of sales
revenue and related cost of goods sold that produce gross profit.

Balance Sheet
The Balance Sheet Of A Merchandising Company Includes An Additional Item Merchandise
Inventory Which Is Reported As A Current Asset.
Inventory Accounting Systems
We have explained that a merchandising company’s income statement includes an item called
cost of goods sold and its balance sheet includes a current asset called inventory.

Cost of goods sold is the cost of merchandise sold to customers during a period. It is often the
largest single deduction on the income statement of a merchandiser.

Inventory refers to products a company owns and expects to sell in its normal operations.

NB:

These items are part of merchandising activities captured in the figure below;

This diagram shows two things

(i) that a company’s Merchandise available for sale is a combination of what it begins
with (beginning inventory) and what it purchases (net cost of purchases).

(ii) the merchandise available for sale is either sold (cost of goods sold) or kept for future
sales (ending inventory)

There are two inventory accounting systems used to collect information about cost of goods sold
and cost of inventory on hand (ending inventory). The two systems are called:
 (i) Period inventory system
(ii) Perpetual inventory system.

(1) Periodic Inventory System

A periodic inventory system requires updating the inventory account only at the end of a
period to reflect the quantity and cost of both
a. goods on hand and
b. goods sold.

It does not require continual updating of the inventory account. Its key (principal) features are as
follows:-

(i) The company records the cost of new merchandise in a temporary purchases
account.

(ii) When merchandise is sold, revenue is recorded but the cost of the merchandise sold
is not yet recorded as a cost.

(iii) When financial statements are prepared, the company takes a physical count of
inventory by counting the quantities of merchandise on hand. Cost of merchandise
on hand is determined by relating the quantities on hand to records showing each
item’s cost. The cost of merchandise on hand is then used to compute cost of goods
sold. The inventory account is adjusted to reflect the amount-computed from the
physical count of inventory.

NB:

Historically, periodic inventory systems were used by companies such as hardware shops
drug stores, supermarkets etc that sold large quantities of low – value items. Without today’s
 computers and scanners (e.g. supermarkets) it was not feasible for accounting systems to
tract such small items as pencils, toothpaste, paper clips, socks & toothpicks through
inventory and into customer’s hands.

(2) Perpetual Inventory System

A perpetual inventory system keeps a continuous record of amount of inventory on hand. A
perpetual system accumulates the net cost of merchandise purchases in the inventory account
and subtracts the cost of each sale from the same inventory account. When an item is sold, its
cost is recorded in a cost of goods sold account.

NB: (i) With a perpetual system we can find out the cost of merchandise on hand at any
time by looking at the balance of the inventory account.
(ii) We can also find out the current balance of cost of goods sold anytime during a
period by looking in the cost of goods sold account.

Before advancements in computing technology, a perpetual system was often limited to

businesses making a limited number of daily sales such as automobile dealers and major
appliance stores. Because there were relatively few transactions, a perpetual system was feasible.
In today’s information age, with widespread use of computing techniques, the use of a perpetual
system has dramatically grown. Also, the number of companies using a perpetual system
continues to increase.

Perpetual Inventory System

Accounting for Sales Revenue (Merchandise Sales)
(A) Sales Transactions

In accordance with the revenue recognition principle, sales revenues, like service revenues, are
recorded when earned. Typically, sales revenue are earned when the goods are transferred from
the seller to the buyer. At this point, the sales transaction is completed and the sales price is
established.

Each sales transaction for a seller of merchandise involves two related parts.
(i) One part is the revenue received in the form of an asset (usually cash or accounts
receivable) from a customer.
(ii) The second part is recognizing the cost of merchandise sold to a customer.
Accounting for sales transactions means capturing information about both parts.

Sales transactions of merchandisers usually include both sales for cash and sales on credit.
Whether a sale is for cash or on credit, a sales transaction requires two entries one for revenue
and one for cost.

Illustration.
Assume Z-mart sold ksh 24,000 of merchandise on credit on November 3. The cost of the
merchandise sold was sh 18,000.

(a) The revenue of this transaction is recorded as follows:-

Nov 3 Dr. Accounts receivable 24,000 A = L + OE

Cr. Sales 24,000 -= 0 +
{To record sale per invoice No. (22)}

This entry reflects and increases in Z-marts assets in the form of an accounts receivable. It also
shows the revenue from the credit sale.

(b) The entry to record the cost part of this sales transaction (under a perpetual system) is:
 Nov 3: Dr. Cost of goods sold 18,000 A = L + OE
Cr. Merchandise inventory 18,000 -= 0 -
(To record the cost of November sale)
NB:
Since the cost part is recorded each time a sale occurs, the merchandise inventory account
reflects the cost of the remaining merchandise on hand.

(B) Recording Returns and Allowances Transactions

A customer may be dissatisfied with the merchandise received because the goods are damaged or
defective, or of inferior quality, or not in accord with the customers’ specifications. In such
cases, the customer may return the goods to the seller for credit if the sale was made on credit or
for a cash refund if the sale was originally for cash. This transaction is known as a sales return.
Alternatively, the customer may choose to keep the merchandise if the seller is willing to grant
an allowance (deduction) from the selling price. This transaction is known as a sales allowance.
For accounting purposes, sales returns and sales allowances are combined into one account, sales
returns & allowances.
NB:
To give the customer a sales return or allowance, the seller normally prepares a credit
memorandum. It is a document issued by the seller to inform a customer that a credit has been
made to the customers account receivable for a sales return or allowance.

The seller’s entry to record a credit memorandum involves a debit to the sales returns and
allowances account and a credit to accounts receivable, as shown below.

Nov. 6 Dr. Sales returns and allowances 8,000 A = L + OE

Cr. Accounts receivable 8,000 -= 0 -

(To record allowance for damaged goods per credit memo No.72)
For a sales return or allowance on a cash sale, a cash refund is normally made. In such a case,
sales returns and allowances is debited and cash is credited.

Sales returns and allowances is a contra revenue account to sales. The normal balance of sales
returns and allowances is a debit. A contra account is used, instead of debiting sales, to disclose
the amounts of sales returns and allowances in the accounts and in the income statement.
Disclosure of this information is important to management. For example, excessive returns and
allowances suggest inferior merchandise, in efficiencies in filing orders, errors in billing
customers, and mistakes in delivery or shipment of the goods.

NB: (i) If merchandise returned to Z-mart is not defective and can be resold to another
customer then Z-mart returns these goods to its inventory. The entry necessary to
restore the cost of these good to the merchandise inventory account is as follows.

Nov. 6 Dr. Merchandise inventory 6,000 A = L + OE

Cr. Cost of goods sold 6,000 += 0 -
(To record goods returned to inventory)
(ii) But if the merchandise returned is defective, the seller may discard the returned items.
In this case, the Cost of returned merchandise is not restored to the merchandise
inventory account. Instead, most companies leave the cost of defective merchandise in
the cost of goods sold account.
(iii) Another possibility is that sh 8,000 of the merchandise Z-mart sold on Nov 3 is
defective but the customer decides to keep it because Z-mart grants the customer a price
reduction of say sh 5,000. The only entry Z-mart must make in this case is one to reflect
the decrease in expected revenues and assets.

Nov 6. Dr. Sales returns & allowances 5,000

Cr. Accounts receivable 5,000
 (To record sales allowances)

NB:
Published income statements usually omit the sales returns and allowances details and only show
net sales.

(C) Accounting for Sales Discounts

The terms of a credit sale may include an offer of a cash discount, called a sales discount, to the
customer for prompt payment of the balance due. This incentive offers advantages to both
parties, the purchaser saves money, while the seller is able to convert the accounts receivable into
cash earlier.

The credit terms specify the amount and time period for the cash discount in which the purchaser
is expected o pay the full invoice price e.g. 2/10 net 30.

NB:
A seller does not know whether a customer will pay within the discount period and take
advantage of a cash discount at the time of a credit sale. This means a sales discount is usually
not recorded until a customer pays within the discount period.

Illustration
Assume that z-mart completed a credit face sale Ksh 10,000 on Nov 12, subject to terms 2/10 net
30. The entry to record this sale is as follows:

Nov 12 Dr. Accounts receivable 10,000

Cr. Sales 10,000
(To record sale of merchandise under terms 2/10 net 30)

Nov 12 Dr. Cost of goods sold 7,000 A = L + OE

 Cr. Merchandise Inventory 7,000 += 0 +

Now, if the customer pays on or before Nov 22, Z-mart would record the payment as follows:-

Nov 22 Dr. Cash 9,800

Dr. Sales discounts 200
Cr. Accounts receivable 10,000
(To record collection within discount period)

Sales discounts are recorded in a contra-revenue account called sales discount (instead of
debiting sales). This is done so hat management can monitor sales discounts to assess their
effectives and cost. The sales discounts account is deducted from the sales account when
computing a company’s net sales. While information about sales discounts is useful, it is
seldom reported on income statement distributed to external uses.

Income Statement Presentation (Sales Returns, Allowances & Sales Discount)

As contra revenue accounts, sales returns and allowances and sales discounts are deducted from
sales in the income statement to arrive at net sales. The sales revenue section of the income
statement may appear as follows:-

Z-mart
Partial income statement for the month ended Nov 30

Sales Revenue
Ksh Ksh
Sales 34,000
Less: Sales returns & allowances (8,000)
Sales discounts (200) (8,200)
Net Sales ksh 25,800

Accounting for Cost of Goods Sold (Perpetual Inventory System)

Recall, that under a perpetual system; the merchandise inventory account is updated after each
purchase and each sale. The cost of goods sold account also is updated after each sale so that
during the period, the account balance reflects the periods total cost of goods sold to date.
Under a perpetual system, each purchase, purchase return and allowance, purchase discount and
transportation – in transaction is recorded in the merchandise inventory account.

(A) Recording Merchandise Purchases

Assume the Z-mart purchased merchandize at a cost of sh 120,000 cash on Nov 2.

The entry made will be as follows:-

Nov 2 Dr. Merchandise inventory 120,000
Cr. Cash 120,000
To record purchase of merchandise)

NB: The amount recorded for merchandise inventory includes its purchase cost, shipping
fees, taxes (V.A.T) and any other costs necessary to make it ready for resale.

To compute the total cost of merchandise, we must adjust the invoice cost for:

(i) Any returns and allowances for unsatisfactory items received from a supplier.

(ii) Any discounts given to a purchaser by a supplier

(iii) Any required transportation (freight) costs paid by the purchaser.

(B) Recording Purchase Returns and Allowances
Purchases returns are merchandise received by a purchaser but returned to the supplier.
A purchase allowance on the other hand, is a deduction in the cost of defective merchandise
received by a purchaser from a supplier. The purchaser initiates the request for a reduction of the
balance due through the issuance of a debit memorandum. A debit memorandum is a
document issued by a buyer to inform a seller that a debit has been made to the seller’s
account because of unsatisfactory merchandise. The original copy of the memorandum is sent to
the seller and one copy is retained by the purchaser.

NB: The purchaser’s accounting for a debit memorandum requires updating the merchandise
Inventory account to reflect returns and allowances.

Illustration
Assume that on Nov 15, Z-mart wrote a debit memorandum issuing it to Steve suppliers
requesting for an allowance of sh 3,000 from the goods purchased on Nov 2 which were found to
be defective. The entry made by Z-mart will be as follows:-

Nov 15: Dr. Accounts payable 3,000

Cr. Merchandise inventory 3,000
(To record allowance for defective merchandise)

(C) Recording Purchases Discount

Credit terms may permit the buyer to claim a cash discount for the prompt payment of a
balance due. The buyer calls this discount a purchases discount. Like a sales discount, a
purchases discount is based on the invoice less returns and allowances if any.
Purchases discounts are deducted from merchandise inventory.
Illustrations
Assume Z-marts purchases merchandise for Ksh 20,000 was on credit terms 2/10 net 30, on Nov
12 Z-marts entry to record this credit purchase is.

Nov 12 Dr. Merchandise inventory 20,000

Cr. Accounts payable 20,000
(To record purchase of merchandise
on credit invoice terms 2/10 net 30)

If Z-mart takes advantage of the discount and pays the amount due on November 22, the entry to
record the payment would be as follows:-

Nov 22 Dr. Accounts payable 20,000

Cr. Merchandise inventory 400
Cr. Cash 19,600
(To record payment within discount period)

The merchandise inventory account now reflects the net cost of merchandise purchased. It’s
accounts payable show a zero balance, meaning the debit is satisfied.

(D) RECORDING TRANSPORTATION COSTS (FREIGHT COSTS)

The sales agreement should indicate whether the seller or the buyer is to pay the cost of
transporting the goods to the buyer’s place of business. The cost principle requires that the
transportation costs be included as part of the cost of purchased merchandised if borne by
the purchaser. This means a separate entry is necessary when they are not listed on the invoice.
Illustration
Assume Z-mart paid sh 7,500 in transporting the goods purchased on Nov 2 the entry will be as
follows:-

Nov 2 Dr. Merchandise inventory 7,500

Cr. Cash 7,500
(To record payment of freight
charges on purchased merchandise)

NB: Transportation - in costs are different from the costs of shipping goods to customers.
Transportation – in costs are included in the cost of merchandise inventory whereas the costs of
transporting (shipping) goods to customers are not. The costs of shipping goods to customers
is recorded in a delivery expense account (transportation out) when the seller is responsible
for these costs.

Periodic Inventory System Cost of Goods Sold Determination

Recall that under a periodic inventory system, the merchandise inventory account is updated only
once each accounting period. This update occurs at the end of the period. During the next period,
the merchandise inventory balance remains unchanged. It reflects the beginning inventory
balance until it is updated again at the end of he period. Similarly, in a periodic inventory system,
cost of goods sold is not recorded as each sale occurs. Instead, the total cost of goods sold
during the period is computed at the end f the period.

Recall, under a perpetual system, each purchase, purchase return and allowance, purchase
discount, and transportation – in transaction is recorded in the merchandise inventory account.
By contract under a periodic system, a separate temporary account is set-up for each of these
items. At the end of a an accounting period, each of these temporary accounts is closed and the
merchandise inventory account is updated.
(A) Recording Purchase of Merchandise (Periodic System)
When merchandise is purchased for resale to customers, the temporary account merchandise
purchases or simply purchases, is debited for the cost of the goods.

NB:
(i) Not all purchases are debited to purchases account. For example, purchases of assets
acquired for use and not for resale, such as supplies, equipment and similar items are
debited to specific asset accounts rather than to purchases.
(ii) Every purchase should be supported by business documents that provide written
evidence of the transaction. E.g. cancelled cheques, cash receipt or purchase invoices
received from supplier.

Illustration The entry to record Z-mart’s purchase of merchandise for sh 120,000 on credit will
be as follows on November 2.

Nov 3 Dr. Purchases 120,000

Cr. Accounts payable 120,000
(To record goods purchased
on account terms 2/10 net 30)

(b) Recording Purchase Returns and Allowances

Under the periodic inventory system when a buyer returns the item for a cash refund or credit on
account, the amount of the return or allowance is recorded in the purchases returns and
allowances account.

This account is a contra account to purchasers and its normal balance is a credit, and is
deducted from purchases on the income statement. The contra account is used instead of
crediting purchases in order to disclose both the shilling amount of return & allowances and the
percentage of gross purchases that have proven to be unsatisfactory. Excessive purchases returns
and allowances may indicate inefficiencies in a company’s purchasing procedures or the need to
find more reliable suppliers.

Illustration
Assume that on November 5, Z-mart returns merchandise purchased on Nov 2 back to the
supplier – (Steve) balance of defects. The cost of the merchandise is sh 3,000. Z-mart records the
return with the following entry.

Nov 5 Dr. Accounts payable 3,000

Cr. Purchases returns & allowances 3,000
(To record return of defective goods)

(C) Recording Purchase Discounts

Under the periodic inventory system, when a buyer receives a cash discount for prompt payment
of a balance due, the amount of the discount is recorded in a purchases discount account
Purchases discounts represents a reduction in the cost of goods purchased for resale. As is the
case of purchase returns and allowances, a purchase discount is a contra account to purchases.
Its normal balance is a credit.

Illustration
If Z-mart pays the supplier of the Nov 12 purchase on Nov 22 (i.e. within the discount period),
the required payment is 19,600 (i.e. 98% x 20,000) and it is recorded as follows:-

Nov 12 Dr. Accounts payable 20,000

Cr. Purchases discount 400
Cr. Cash 19,600
 (To record payment within the discount period)
NB:

So as not to miss purchase discounts, unpaid invoices should be filed by due dates.

(D) RECORDING TRANSPORTATION IN COSTS (FREIGHT IN)

Under the periodic inventory system, when the purchaser directly incurs the transportation costs
on purchases. The account transportation – in is debited. Like purchases transportation – in is
temporary account whose normal balance is a debit.

Transportation – in is part of cost of goods purchased. The reason is that cost of goods
purchased should include any transport charges necessary to bring the goods to the purchaser.
The use of transportation – in account enables management to determine the materiality
(magnitude) of these costs.

NB:
Transportation costs are not subject to a purchase discount. Purchase discounts apply to the
invoice cost of the merchandise.
Assume that Z-mart paid sh 7,500 transportation charge to haul merchandise purchased on
November 2 to its store. The entry is as follows.

Nov 2 Dr. Transportation – in costs 7,500

Cr. Cash 7,500
(To record payment of freight on
goods sold FOB destination).
Determining Cost of Goods Purchased
In explaining the accounting for goods purchased for resale, we discussed the following
temporary accounts.

Account Normal Balance

Purchases Debit
Purchase returns & allowances Credit
Purchase discounts Credit
Transportations – in costs Debit
The procedure for determining the cost of goods purchased is as follows:-
(i) The accounts with credit balances (Purchase Returns and allowances and Purchase
discount) are subtracted from purchases to produce net purchases.
(ii) Transportation – in costs is then added to net purchases to produce cost of goods
purchased.

Illustration
Assume that Z-mart shows the following balances for the accounts above on November 30,
Purchases sh 325,000; Purchases returns and allowances sh 10,400; Purchases discounts Ksh
6,800; and Transportation – in costs Ksh 12,200. Net purchases and cost of goods purchased are
sh 307,800 and sh 320,000, respectively, as computed below.

Purchases Ksh 325,000

(i) Less: Purchase returns and allowances 10,400
Purchase discounts 6,800 (17,200)

Net Purchases………………………………. 307,800

(ii) Add: Transportation – in costs 12,200
Cost of goods purchased 320,000
Computing Cost of Goods Sold
Computing the cost of goods sold also involves two steps:

(a) The cost of goods purchased (as computed above) is added to the cost of gods on hard at
the beginning of the period (beginning inventory) to obtain the cost of goods available
for sale.
(b) The cost of goods on hand at the end of the period (ending inventory) is subtracted
from the cost of goods available for sale to arrive at the cost of goods sold.

For Z-mark assume that beginning and ending inventory were sh 36,000 and 40,000 respectively.
In this case the cost of goods available for sale and the cost of goods available for sale and the
cost of goods sold will be sh 356,00 and sh 316,0000, respectively, computed as follows.

Beginning inventory ksh 36,000

(i) Add: Cost of goods purchased 320,000
Cost of goods available for sale 356,000

Less: Ending inventory (40,000)

Cost of goods sold 316,000

Gross Profit
Recall, on the income statement of a merchandising firm, the cost of goods sold is deducted
from sales revenue (net) to determine gross profit. The sales revenue figure used for this
computation is net sales.

Assume gross sales for the month of November were Ksh 500,000 and sales returns and
allowances were Ksh 10,000 and sales discounts Ksh 30,000
Assume the net sales of Z-mart for the month of November were ksh 460,000 then Gross Profit
is computed as follows:-

Sales 500,000
 Less: sales returns and all sales discounts 10,000
30,000
Net sales Ksh 460,000
Less: Cost of goods sold (316,000)
Gross profit Ksh 144,000

NB: Gross profit represents the merchandising profit of a company. It is not a measure of
the overall profitability of a company. This is because operating expenses have not
been deducted. Nevertheless, the amount and trend of gross profit is closely watched by
management and other interested parties.

Operating Expenses
Operating expenses are the third component in measuring net income (profits) for a
merchandising company. As already noted earlier, these expenses are similar in merchandising
and service enterprises.

Illustration
Assume that Z-mart’s operating expenses for November were sh 114,000. Then net income is
determined by subtracting operating expenses from gross profit. Thus, net income is sh 30,000 as
shown below.

Gross profit Ksh 144,000

Less: Operating expenses (114,000)
Net income Ksh, 30,000)

In conclusion, the income statement for retailers and wholesalers contains three features not
found in the income statement of a service enterprise. The features are:-
 (i) A sales revenue section
(ii) A cost of goods sold section
(iii) Gross profit

Illustration.
Assume Z-mart sold Ksh 24,000 of merchandise on credit on November 3. The cost of the
merchandise sold was Ksh 16,000.

(a) The revenue of this transaction is recorded as follows:-

Nov 3 DR Accounts receivable 24,000
CR Sales 24,000
{To record sale per invoice No. (22)}

This entry reflects and increases in Z-marts assets in the form of an accounts receivable. It also
shows the revenue from the credit sale.

(b) The entry to record the cost part of this sales transaction (under a perpetual system) is:
Nov 3: Cost of goods sold 16,000
Merchandise inventory 16,000

(To record the cost of November sales)

Nov. 6 Sales returns and allowances 8,000
Accounts receivable 8,000

(To record allowance for damaged goods per credit memo No 72)
Nov. 6 Merchandise inventory 6,000
Cost of goods sold 6,000
(To record goods returned to inventory)
Nov 6. Sales returns & allowances 5,000
Accounts receivable 5,000
(To record sales allowances)

Nov 12 Accounts receivable 10,000

Sales 10,000
(To record sale of merchandise under terms 2/10 net 30)

Nov 22 Cash 9,800

Sales discounts 200
Accounts receivable 10,000
(To record collection within discount period)
Nov 2 Merchandise Inventory 120,000
Cash 120,000
(To record purchase of merchandise)

Nov 15: Accounts payable 30,000

Merchandise inventory 30,000
(To record allowance for defective merchandise)

Nov 2 Merchandise inventory 120,000

Accounts payable 120,000
(To record purchase of merchandise on credit invoice terms 2/10 net 30)

Nov 12 Accounts payable 20,000

Merchandise inventory 400
Cash 19,600
(To record payment within discount period)
 Nov 2 Merchandise inventory 3,000
Cash 3,000
(To record payment of freight
charges on purchased merchandise)

Nov 12 Purchases 120,000

Accounts payable 120,000
(To record goods purchased on
account terms 2/10 net 30)
Nov 5 Accounts payable 3,000
Purchases returns & allowances 3,000
(To record return of defective goods)

Nov 12 Accounts payable 20,000

Purchase discount 400
Cash 19,600
(To record payment within the discount period)
Nov 2 Transportation – in costs 7,500
Cash 7,500
(To record payment of freight on
goods sold FOB destination).

Accounting for Merchandising Activities

Z- Mart Company Ltd
Summary Of Transactions
Perpetual Inventory System Periodic Inventory System
Date Account Title & Dr Cr Date Account Title & Dr Cr
Explanation Explanation
Nov. 2 Merchandise Inventory 120,0 Nov. Purchases 120,0
00 2 00
Account Receivable 120,0 Accounts Payable 120,0
00 00
 (To record goods (To record goods
purchased on account purchased on account
terms 2/ net 30) terms 2/ net 30)

Nov 2 Merchandise Inventory 7,500 Nov Transportation-in costs 7,500

2
Cash 7,500 Cash 7,500
(To record payment of (To record payment of
freight charges on goods freight charges on
purchased) goods purchased)

Nov 3 Accounts Receivable 24,00 Nov Accounts receivable 24,00

(a) 0 3 0
Sales Revenue 24,00 Sales Revenue 24,00
0 0
(To record sale per (To record sale per
invoice No. 22) invoice No. 22)

Nov 3 Cost of Goods sold 16,00

(b) 0
Merchandise Inventory 16,00 No Entry
0
(To record cost of
merchandise sold)

Nov 5 Accounts payable 3,000 Nov Accounts Payable 3,000

5
Merchandise inventory 3,000 Purchase Returns & 3,000
Allowances
(To record allowance for (To record allowance for
defective merchandise) defective merchandise)

Nov 6 Sales Returns & 8,000 Nov Sales Returns & 8,000
(a) Allowances 6 Allowances
Accounts Receivable 8,000 Accounts Receivable 8,000
(To record allowance for (To record allowance for
damaged goods per damaged goods per
credit memo No. 72) credit memo No. 72)

Nov 6 Merchandise Inventory 6,000

(b)
Cost of Goods sold 6,000 No Entry
(To record goods
returned to inventory)
Nov Accounts Receivable 10,00 Nov Accounts Receivable 10,00
12 (a) 0 12 0
Sales Revenue 10,00 Sales Revenue 10,00
0 0
(To record sale of (To record sale of
merchandise under merchandise under
terms 2 (10 net 30) terms 2 (10 net 30)

Nov Cost of Goods sold 7,000

12 (b)
Merchandise Inventory 7,000 No Entry
(To record sale of
merchandise under
terms 2 (10 net 30)

Nov Merchandise Inventory 20,00 Nov Purchases 20,00

12 0 12 0
Accounts Payable 20,00 Accounts Payable 20,00
0 0
(To record purchase of (To record purchase of
merchandise on credit merchandise on credit
invoice terms 2/10 net invoice terms 2/10 net
30) 30)

Nov Accounts Payable 20,00 Nov Accounts Payable 20,00

22 0 22 0
Merchandise Inventory 400 Purchases Discount 400
Cash 10,00 Cash 19,60
0 0
(To record collection (To record collection
within discount period) within discount period)

Nov Cash 9,800 Nov Cash 9,800

22 22
Sales Discount 200 Sales Discount 200
Accounts Receivable 10,00 Accounts Receivable 10,00
0 0
(To record collection (To record collection
within discount period) within discount period)
XEA 201- FINANCIAL
ACCOUNTING

PART
THREE
 LECTURE SEVEN
ACCOUNTING FOR PARTNERSHIPS

LESSON CONTENT
● Introduction
● Partnership Deed
● Appropriation of Profits
● Final Accounts of Partnership
● Changes and Dissolutions
● Calculating Goodwill
● Changes in Partnership
● Dissolution of Partnership

INTRODUCTION
A partnership maybe defined as a relationship that subsists between two or more
persons carrying on a business in common with a view to making a profit. In a
partnership two or more persons jointly run a business, the liability of the individual
partners is unlimited unless the partnership agreement provides for any limitation.
A partnership should consist of not more than 20 persons and the minimum number is
two except in certain cases e.g. practicing advocates, professional accountants, members
of the securities exchange or any other group who may have obtained permission from
the relevant government organ where this figure may be exceeded. Any other group
carrying on a business and exceeding twenty (20) will be an illegal group unless
registered as a limited company. It will be unable to enforce any contracts it may have
entered into. Normally the number of partners varies between two to five.
Partnership Deed
This is the written agreement among the partners regarding the terms and conditions of
the partnership business. The essence of a partnership is mutual agreement among the
partners and they may agree on any matter regarding the running of the partnership
and the agreement will be binding on all the other partners. Partnership entails mutual
agency and any action taken by any one partner within the scope of the agreement will
also be binding on all the other partners. However, the Partnership Deed usually
addresses the following issues:
I. Partners’ Capital and Current Accounts
The partners of a partnership business contribute capital as specified in the Partnership
Deed. The capital (equity) is debited to the cash or bank account and credited to the
capital account of the individual partners. The double entry will be as follows:-

Dr: Cash or Bank Account

Cr: Capital (Equity account)
Sometimes capital may also be contributed in the form of other assets e. g a motor
vehicle, land, etc. The treatment will be as follows:
Dr: Motor vehicle account
Cr: Capital Account (at the agreed valuation)
It has been accepted in practice that the capital account balances remain constant and
these are changed only in the case of change in the partnership. The partners’ capital
account is maintained on the columnar format and the layout is as follows:-
DR PARTNER CAPITAL ACCOUNT CR
Dat A B C A B C
e

Dec X X Ja X X X
31 Bal c/f X n 1 Bank

X X X X X X

In the partnership business, Current accounts are maintained separately. The work of
these accounts is to process adjustments to capital such as profit share, salaries, interest
of capital, etc. These adjustments cannot be done in the capital accounts because a
partner may overdraw his capital to the detriment of the business. Therefore, it is
recommended that these adjustments be done in the current accounts. The current
account is also maintained on the columnar format and will appear as follows:

DR PARTNER CURRENT ACCOUNT CR

Dat Particular A B C Dat Particular
e s e s
Dec Drawing X X X Jan Bal b/f
31 1
Dec Interest X X X Dec Profit
31 on drawings 31 share
Dec Bal c/f X X X Salaries
31
Interest of
capital
X X X

In the balance sheet these accounts will be indicated as follows:

Balance Sheet ( Extract)
CAPITAL (EQUITY) A/C £
A X
B X
C X
X
CURRENT ACCOUNTS
A X
B X
C X
 X

II. Profit and Loss Sharing Ratios

The profit and loss sharing ratios are usually fixed at the outset and are indicated in
Partnership Deed. These ratios may be fixed in view of capital contributed by the
partners but it is not essential that the profit and loss sharing ratios and capital ratios be
equal because other considerations may come into play. These ratios are expressed in
the form such as 1:1:2, which means that partners A, B and C will be given ¼ , ¼ and ½
respectively of the residual profit.
III Partners Drawing Rights
The partners may be entitled to withdraw funds from the business for their personal
use. The rights of drawings are usually mentioned in the Partnership Deed. The rights
will address issues to do with the amount and the frequency of withdrawals. Usually
the partners will be required to pay interest on the drawings. The purpose of this is to
discourage partners from withdrawing funds from the business unnecessarily as funds
withdrawn will not be available for the running of the business; hence the charge of
interest on the drawings. The rate of interest is usually agreed at the outset.
IV. Interest on Capital
The partnership agreement may provide for the payment of interest on the partners’
capital at a specific percentage of the amounts contributed. If the amounts contributed
by the various partners are different, then the payment of interest will give more benefit
to the partners who have contributed greater amounts. This interest is credited to the
partners’ current account. The payment of interest is an internal arrangement among
the partners and must not be treated as a business expense.
V. Partners Salaries
Where a partner is responsible for the performance of extra duties as compared to the
other partners, it may be provided that he/she be paid a salary. This will also be agreed
in the Partnership Deed. The salaries are not also a business expense and are paid out of
profit. The salaries are also credited to the partners’ current account.
VI. Valuation of Goodwill
A partnership is not a separate legal entity as it is a combination of individuals to
conduct a business with a view to making a profit. If a partner leaves or any new
partner is admitted then the old partnership ceases and a new one is formed. In such a
case goodwill is calculated whose purpose is to give benefit to the old partners for
having established the business and running it successfully to date. The method for
calculating Goodwill will be given in the partnership deed.
When a partnership does not have an agreement express or implied then the provisions
of the Partnership Act of 1890 applies. Section 24 of this Act states as follows:
1) That profits and losses are to be shared equally.
2) No interest to be paid on capital.
3) No interest to be charged on drawings.
4) No partner is entitled to a salary.
5) Any loan made to the partnership by a partner is to carry interest at the rate of
5% per annum.

FINAL ACCOUNTS OF A PARTNERSHIP

The final accounts of a partnership consist of the trading account, the profit and loss
account, appropriation of profit and loss account and the balance sheet.
The trading and profit and loss account are prepared in the normal manner after which
the profit and loss appropriation account is prepared. The normal appropriations are
interest on capital, partners’ salaries and the profits share. Any interest on drawings is
added to the trading profits. It means the items relating to the partnership deed are
taken to the appropriation account. The accounting entries will be done as follows:
(a) Net profit Dr: Profit and Loss Account
Cr: Appropriation Account
(b) Partners’ Salaries: Dr: Appropriation Account
Cr: Current Account of the partner
(c) Interest on Capital Dr: Appropriation
Cr: Current Account
(d) Interest on drawings Dr: Current Account
Cr: Appropriation Account
(e) Share of profit Dr: Appropriation
Cr: Current A/c
(f) Share of loss Dr: Current A/c
Cr: Appropriation A/c
(g) Drawings Dr: Current A/c
Cr: Drawings A/c for each partner
EXAMPLE:
A and B are in partnership sharing profit & losses in the ratio 3:2 respectively. During
the year 31 December 2005 the net trading profit was £ 15,500 and the partners’
drawings were:
A- £ 3,000
B- 2,500

Interest is charged on partners’ capital at the rate of 5% and no interest is charged on

drawings.
B is entitled to a salary of £ 1,500 per annum. The balances on the partners accounts (all
credit balances) were as follows at 1 January.
Capital Current
£ £
A 20,000 1,570
B 15,000 890
Required:
Prepare the Profits & Loss Appropriation accounts for the year ended 31st
December2005.
Appropriation Account
£ £ £
 A Net profit 15,50
b/d 0
Interest on 1,000
capital
Profit share 7,350
8,350
B
Interest on 750
capital
Salary 1,500
Profit share 4,900
7,150
15,50 15,50
0 0

Currents Accounts
D Part A B D Part A B
ate icular ate icular
D 3 2 J Bala 1 8
ec 31 Drawings ,000 ,500 an 1 nce b/f ,570 90
Bala 6 5 Inte 1 7
nce c/d ,920 ,540 rest on ,000 50
capital
Sala - 1
ry ,500
Prof 7 4
it share ,350 ,900
9 8 9 8
,920 ,040 ,920 ,040

WORKINGS
Interest on capital
A 5% of 20,000 = £ 1000
B 5% of 15,000 = £ 750
Profit share:
Profit to be divided £ 15,500-£ 1,000-£ 750-£ 1500 = £ 12,250
A: 3/5 of 12,250 = £ 7,350
 B: 2/5 of 12,250 =£ 4,900
Debit Balance Current Accounts:
At times a partner may overdraw his current account by taking more than his share of
profits. His current account will be said to have a debit balance. This debit balance in
reality means that the amount is due to the business from that partner. This is the
principle reason why adjustments to capital are not done in the Capital accounts.
This debit balance will be shown as a deduction from the credit balances in the current
account of the other partners in the balance sheet.
This debit balance can be adjusted in the following year against the profit for that
partner in that year. The balance sheet extract will be as follows:
Balance sheet
£ £
CURRENT A/c
A X
B (X)
C X

X
PRACTICE EXERCISE:
John Dobson and William Spencer are in partnership sharing profits and losses equally.
The following Trial Balance was extracted from their books at the close of business on 3l
October2006.
Dr Cr
£ £
Purchases and sales 18,250 36,360
Wages and salaries 7,320
Office Furniture 820
Debtors and Creditors 6,800 7,900
Motor Vehicles 7,000
Rent, rates and insurance 2,100
Bank Balance 3,950
Cash in hand 260
Discounts 580 370
Fixtures and fittings 1,200
Sundry expenses 175
Stock 1st November 2005 3,840
Motor Vehicle Expenses 815
Capital Accounts 1 st November 2005
Dobson 7,000
Spencer 5,000
Current Accounts 1st November 2005
Dobson 1,230
Spencer 1,160
Drawings: Dobson 3,100
Spencer 2,600

Purchase and Sales Returns 270 480

£59,290 £59,290

The following factors need to be taken into consideration at the end of the year.
1. The stock at 31st October 2006 is valued at £5,160.
2. The Partners’ Capital Accounts are to remain FIXED at the figures shown in the
Trial Balance.
3. Interest is to be allowed on the Capital Accounts at the rate of 5% per annum.
4. Depreciation at the rate of 20% is to be allowed on the book value of the Motor
Vehicle. No depreciation is to be allowed on the Office Furniture or Fixtures and
Fittings.
5. Salaries of £100 are to be accrued at 31st October 2006.

Required
a) The Trading and Profit and Loss Account for the year ended 31st October 2006.
b) Balance Sheet of the partnership as at 31st October 2006.
 DOBSON AND SPENCER
a)Trading, Profit And Loss Account for the Year Ended 31st October 2016
£ £ £
Sales 36,36
0
Less: Sales returns 480 35,80
0
Less : Cost of sales:
Opening stock 3,840
Purchase 18,25
0
Less: Purchase returns 270 17,98
0
21,82
0
Less closing stock 5,160 16,66
0
19,22
0
Gross profit
Add: Income-
Discount received 370
19,59
0
Less: Expenses-
Wages and salaries 7,420
(£7,320+100)
Rent, rates and insurance 2,100
Discounts allowed 580
Sundry expense 175
Motor vehicle expense 815
Depreciation: Motor vehicle 1,400 12,49
(20%* £7,000) 0
Net profit for the year
Appropriation
Interest on capital
Dobson 350
Spencer 250 600
Balance of profits
Dobson (50%) 3,250
Spencer (50%) 3,250 6,500
£7,10
0
b) Balance sheet at 31st October 2006
£ £ £
Cost Accumulated
Net book depreciation
value
Fixed Assets
Fixtures and fittings 1,200 - 1,200
Office furniture 820 . 820
Motor vehicle 7,000 1,400 5,600
£9,02 £1,400 £7,620
0
Current Assets
Stock 5,160
Debtors 6,800
Bank balance 3,950
Cash in hand 260
16,180
Less: Current Liabilities
Creditors 7,900
Accrued Wages and Salaries 100 8,000 8,170
£15,79
0
Capital Accounts:
Dobson 7,000
Spencer 5,000 12,000
Currents accounts
Dobson 1,730
(£1,230+350+3,250-3,100)
 Spencer 2,060 3,790
(£1,160+250+3,250-2,600)
£15,79
0

CHANGES AND DISSOLUTION

CHANGE IN PARTNERSHIP
The partnership is not a separate legal entity as it is an association of two or more
individuals carrying on a business with a view to profit. It is viewed as a temporary
type of organization because any change in the partnership means that the old
partnership ceases and a new partnership comes into existence.
There will be a change in partnership when any of the following arises:
a) A new partner is admitted
b) An old partner dies or retires.
c) Two separate businesses are amalgamated together.
When there is a change in partnership, the issue of the capital gains made or goodwill
built by the old partners must be addressed. Goodwill must be credited to the capital
accounts of the old partners to the exclusion of the incoming partner. The main purpose
of this is to give some benefit to the old partners for their hard work done in the past to
establish the business and running it successfully to date.

To achieve this objective, any of the following two methods may be adopted:
1. Goodwill method
2. Revaluation of assets

These are briefly explained as follows:-

GOODWILL
Goodwill is an unidentifiable intangible asset, arising from a business’s ability to earn
more profits as compared to other firms in the same industry with the same net assets
base.
The value of business enterprises is based on the appraisal of its earning power, and this
appraisal is based in part on the information in the financial records as to the past
performance of the business. The difference between the values of its net assets is called
goodwill.
Goodwill is the result of income in the past and a forecast of income in the future. It
exists only as a part of a business as a whole and it has no separate existence.
Goodwill may arise from all or any of the following:
- Monopoly power enjoyed by the business.
- Better quality of goods dealt in.
- Favourable location or site of the business.
- The possession of popular trademarks and patents.
- Good reputation of the owners.

Valuation of Goodwill
There is no exact formula for valuing good will. Goodwill is evaluated in the following
cases:-
a) Where there is a change in the partnership such as admission of a new
partner or the retirement or death of an existing partner.
b) Where there is a sale of a running business

In the case of change in the partnership, the method for the calculation of goodwill
will be detailed in the partnership deed. The value of goodwill may be calculated in
view of the past profits but when a running business is sold as a going concern, then
any excess price paid for the purchase of that business by the buyer as compared to
the value of assets will be regarded as goodwill
The following two methods are commonly used for the valuation of good will in the
case of changes in partnership:
1. Average Profits Approach
In this method, the average profits for the last few years are calculated and these
profits multiplied by a specific number of years. The resultant figure is taken as
goodwill. Sometimes, these average profits are calculated after deducting reasonable
remuneration of partners and interest on their capital from the total profits. These
adjustments are necessary because some part of profits is due to their personal
efforts and reward for their capital invested in the business. This part of profit is not
due to the good reputation of the business.

EXAMPLE 1
Profits of A.B. & Co. for last three years were:-
2007 £15,000
2008 £20,000
2009 £25,000
Calculate the value of goodwill on the basis of 2 years’ purchase of the average
profits of last three years.
ANSWER
Total Profits £60,000
Average profits £20,000 per annum
Two years purchase £40,000
Goodwill £40,000
 EXAMPLE 2
On the basis of information given in Example 1, calculate the value of goodwill deducting;
i) Partner’s salaries £15,000 for last three years
ii) Interest on partner’s capital £9,000 for last three years

ANSWER

£ £
Total Profits 60,000
LESS:
(i) Partner’s salaries 15,000
(ii) Interest on Capital 9,000 24,000
Balance 36,000
Average Profit 12,000
Two Years’ purchase 24,000
Goodwill 24,000

2. SUPER PROFITS APPROACH

In this method, the rate of expected return is computed on the agreed net assets figures.
The excess of the actual profits over the expected return is considered to be super-profits.
The super-profits are then capitalized at a specific risk rate, and the resultant figure is the
value of the goodwill.

EXAMPLE 3:
The profits of A, B & Co for the last five years average £50,000 p.a. Net capital
employed is £180,000.
The expected rate of return is estimated at 15%. The risk factor is assessed at 5%.
Calculate the value of Goodwill.
ANSWER
(i) 15% Return on capital employed £
15% of 180,000 =27,000
(ii) Average profits =50,000
(iii) Super-Profits =33,000
(iv) Estimated rate of return plus risk
factor =20%
(v) Capitalized at 20% £33,000
£33,000 x (100/20)
=165,000
Goodwill =165,000

Adjustment for Goodwill:

Goodwill is treated as follows:-

(i) Goodwill Created

DR: Goodwill Account
CR: Old Partner’s Capital Accounts in the old profit sharing ratio.

(ii) Goodwill written off

Goodwill, being an intangible asset, is not normally shown in the books of accounts. It is written
off as under:-
DR: New partners capital accounts in the new profit sharing ratio.
CR: Goodwill Account.

This can also be remembered as “Credit at Old-Debit at New”.

Cash Paid for Goodwill by Incoming Partner.

Sometimes the new partner may agree to pay a sum of money to the old partners for his
share of the goodwill that they have built up.
In this case:-
(a) DR: BANK ACCOUNT
CR: CAPITAL ACCOUNT of the new partner with amount of capital and premium
(b) DR: NEW PARTNER’S ACCOUNT with amount of premium
CR: OLD PARTNER’S CAPITAL ACCOUNT.
(c) If the Premium is withdrawn by the old partners.
DR: OLD PARTNER’S CAPITAL ACCOUNTS
CR: BANK ACCOUNT.

EXAMPLE 4
Green and Red are in a partnership and share profit and losses in the ratio 4:5 respectively.
On 1st January they admit Blue as their third partner on the following condition:
(i) Blue was to bring in £3,000 as capital
(ii) The goodwill of the practice, immediately before Blue’s admission would be
valued at £3,600.
(iii) The profit sharing ratios of the three partners would be:
Green 4/9ths
3
Red /9ths
2
Blue /9ths

On 1st January, the Balance Sheet of Green and Red was as follows:
Capital Accounts: £ £
Green 5,000 Goodwill -
 Red 4,000 Sundry Assets 8,000
Creditors 2,000 Cash at Bank 3,000
11,000 11,000

From the above information, state the various methods of dealing with goodwill on
the admission of a new partner. In each case draw up the balance sheet as it would
look after the goodwill has been treated in the manner stated by you.

ANSWER
There are two main methods of dealing with goodwill on the admission of a new
partner. These are:-
1. Goodwill account is opened and it is shown in the balance sheet as an asset
2. Goodwill created is written off and it is not shown in the final accounts

METHOD 1
PARTNER’S CAPITAL ACCOUNTS
JAN I GREEN RED BLUE JAN 1 GREEN RED BLUE
BALANC £ £ £ BALANCE £ £ £
E b/f
6,600 6,000 3,000 5,000 4,000 -
c/d JAN 1
- - 3,000
BANK A/C
1,600 2,000 -
GOODWILL

6,000 6,000 3,000 A/C 6,000 6,000 3,000

 GOOD WILL ACCOUNT BANK
ACCOUNT
JAN 1 £ £ £
JAN 1 JAN 1 JAN 1
Green 1,600 BALANCE 3,600 BALANCE 3,000 BALANCE 6,000
Red 2,000 c/d b/f c/d
JAN 1
BLUE
3,000
3,600 3,600
6,000 6,000

BALANCE SHEET
AS 1ST JANUARY
CAPITAL ACCOUNTS
£ £ £

GREEN 6,600 GOOD WILL 3,600

RED 6,000 SUNDRY ASSETS 8,000

BLUE 3,000 15,600 CASH AT BANK 6,000

CREDITORS 2,000
17,600 17,600

NOTE: Goodwill £ 3,600 has been credited to the capital accounts of the old partners at
the old profit and loss sharing ratio
METHOD 2

PARTNER’S CAPITAL ACCOUNTS

JAN1 GREE RED BLUE JANI GREE RED BLU
N BALANCE N E
GOODWIL £ £ £ b/f £ £ £
L A/C 1,600 1,200 800 JAN 1 5,000 4,00 -
BANK A/C 0
JAN 1 5,000 4,800 2,200 JAN - 3,000
BALANCE GOODWIL 1,600 - -
c/d L 2,00
A/C 0
6,000 6,000 3,000 6,600 6,00 3,000
0

GOOD WILL ACCOUNT

£ £
GREEN 1,600 GREEN 1,600
RED 2,000 3,600 RED 1,200
BLUE 800 3600
3,600 3,600

NOTE: Goodwill has been credited to the old partner’s capital accounts at the old profit
sharing ratio and debited to the new partners’ capital accounts at the new profit and
loss sharing ratio.

BALANCE SHEET
AS AT 1ST JANUARY
SUNDRY ASSETS 8,000 CAPITAL ACCOUNT –
- GREEN 5,000
- RED 4,800
CASH AT BANK 6,000 BLUE 2,200 12,000
CREDITORS 2,000
14,000 14,000

REVALUATION OF ASSETS
The other method designed to give some benefits to the old partners in the case of
change in partnership is the revaluation of assets. When a prospective partner is to be
admitted, the current partners must ensure that they receive their full entitlement to
partnership profits up to the date of the change in composition. The new partner will
similarly not wish to bear any losses which may have arisen prior to his admission.

Consequently, some items of Property, Plant and Equipment like premises or machinery
may have to be revalued and the new values introduced. These assets may be taken in
the books of the new partnership at the new values. The increase in value can then be
credited to the capital accounts of the old partners at the old profit and loss sharing
ratios.

ADJUSTMENT TO ASSESTS REVALUED

The assets revalued are adjusted as follows:-
(a) Open a Revaluation Account
i) DR. The Assets A/C with any increase in value.
CR Revaluation A/C
ii) DR Revaluation A/C
CR Assets A/C with any decrease in value
(b) Transfer of profit (if any) to the old partner’s capital accounts.
DR. Revaluation A/C
CR. Capital A/Cs in old profit sharing ratio

(c) If part of the capital is then withdrawn:

DR. Capital A/Cs
CR. Bank A/C
EXAMPLE 5
Smith and David are in partnership sharing profits and losses in the ratio 3:2. On 31st
December 2007, the balance sheet of Smith and David was as follows:
BALANCE SHEET
FIXED ASSETS CAPITAL ACCOUNT
£
FREEHOLD £ SMITH 20,000
PROPERTY 20,000 DAVID 10,000 30,000
MOTOR CARS 5,000
OFFICE
EQUIPMENT 3,000 28,000
CURRENT ASSETS CURRENT LIABILITIES
Stock 3,000 CREDITORS 5,000
Debtors 2,500
Cash at Bank 1,500 7,000
35,000 35,000
On 1st JANUARY 2008, they admit JOHN as their partner on the following conditions:
(i) John was to bring in £ 10,000 as capital
(ii) The profit sharing ratio would be 3:1:1
It was agreed to revalue certain assets before admitting John as follows:
Freehold property 27,000
Motor cars 4,000
Officer equipment 2500
Stock 3750
Required:
Show the Balance Sheet as at 1st JANUARY 2008 after the admission of John.
The revaluation account and partners’ capital accounts have to be prepared first. These
would appear as follows:-
REVALUATION ACCOUNT
MOTOR CARS 1,000 FREEHOLD PREOPERTY 7,000
OFFICE EQUIPMENT 500 STOCK 750
CAPITALS ACCOUNT
SMITH 3,750
DAVID 2500 6250
7750 7,750

Partner’s Capital Accounts

Smith Davi John Smith David John
d
£ £ £ £ £ £
Jan 1 balance 23,750 12,50 10,000 Jan 1 balance b/f 20,000 10,000 -
c/d 0 Jan 1 Bank A/C - - 10,000
Jan 1 Revaluation 3,750 2,500 -
account
23,750 12,50 10,000 23,750 12,500 10,000
0

Balance Sheet as at
1st January 2008
£ £ £
Fixed Assets Capital Accounts
£
Freehold property 27,000 Smith 23,750
Motor cars 4,000 David 12,500
Office equipment 2,500 33,500 John 10,000 46,250

Current assets Current liabilities

Stock 3,750 Creditors 5,600
Debtors 2,500
Cash at Bank 11,500 17,750
51,250 51,250

Note:
In the revaluation account only the difference in value is taken into account. Any
increase in the asset value is credited and any decrease debited to the revaluation
account. The profit on revaluation is credited to the old partners’ capital accounts at the
old profit sharing ratios.

Partnership Changes During a Financial Period

If a change in the composition of a partnership takes place during the financial year the
profit and loss appropriation account will have to be prepared in two stages in
columnar forat. It is generally assumed that profit is earned evenly over a period unless
otherwise informed, but the following should be borne in mind.
(i) If an employee for example is admitted to the partnership in mid-year, his
salary whilst an employee is an expense chargeable wholly against profits of
the first part o the year and subsequent withdrawals on account are debited
to his current account in the normal manner.
(ii) If a partner leaves in mid-year and a loan account is created, interest on the
loan account is chargeable as an expense against profits of the last part of the
year only.

DISSOLUTION OF PARTNERSHIP
When a partnership business is discontinued for any reason, this is referred to as the
dissolution of the partnership. In this case, the assets are disposed of and any profit or
loss is shared between the partners in their profit and loss sharing ratio. A partnership
may be dissolved for any one of the following reasons.
1. The partnership period expires.
2. A dispute arises among the partners.
3. A partnership is converted into a limited company.

On the dissolution of partnership, the closing entries are made in the books of account
of the partnership. In general, four steps are taken as follows.
(i) Non-cash assets are sold for cash and a gain or loss on the liquidation is
recorded.
(ii) The gain or loss on liquidation is allocated to the partners using their income
and loss sharing ratios.
(iii) The liabilities are paid
(iv) The capital and current accounts are combined into an equity account and
remaining is distributed to the partners based on their equity account
balances.
The following is the detailed procedure adopted for this purpose:

i) All balances in the current accounts of the partners are transferred to

the capital accounts
ii) Open a REALISATION ACCOUNT and transfer all assets except cash
to this account.
In this case:
DR: Realization account with the book value of the assets
CR: The Assets accounts
This transfer will close all the asset accounts.
(iii) Assets disposed of:
DR: Bank or Cash account
CR: Realization account with the proceeds
(iv) Assets taken over by partners
DR: Partners capital accounts
CR: Realization account at agreed values.

(v) Dissolution Expenses

If paid
DR: Realization account
CR: Bank or cash account
If borne by a partner
DR: Realization account
CR: Partner’s capital account

(vi) Payment to creditors

DR: Creditors account
CR: Bank account
Discount Received from Creditors (if any).
DR: Creditors account
CR: Realization account.

(vii) The balance on Realization account is transferred to the partners’ capital accounts
at the profit and loss sharing ratios.
(viii) After all these adjustments, the balances on the capital accounts and bank account
will be opposite and equal to each other. There will be a credit balance in capital
accounts and a debit balance in the bank account. In this case:
DR: CAPITAL ACCOUNTS with amount due to each partner
CR: Bank account
Note: lf a partner’s capital account shows a debit balance then:
DR: BANK ACCOUNT
CR: PARTNER’S CAPITAL ACCOUNT
These entries will close the books of account of a partnership business.

EXAMPLE 6
Black and white, who share profits and losses equally, decide to dissolve their
partnership as at 31st December, 2008. Their balance sheet on that date was as follows:

Balance sheet
As at 31st December 2008

Fixed Assets Capital Accounts

£ £ £ £
Plant & Machinery 10,000 Black 12,000 20,000
Motor cars 5,000 15,000 White 8,000
Current assets Current liabilities
Stock 4,500 Black 1,500
Debtors 3,200 White 800 2,300
Cash at Bank 3,200 13,000
28,000 28,000

The debtors realized £5,000, plant and machinery £8,000. Motor vehicles £5,500 and
stock £3,800. The expenses of dissolution were £200 and discount received from
creditors £300.

Required:
Prepare the accounts necessary to show the results of the realization and of the disposal
of the cash.
Answer
Realization account
£ £
Plant & Machinery 10,000 Asset sold bank account
Motor vehicles 5,000 Plant & Mach 8,000
Stock 4,500 Debtors 5,000
Debtors 5,300 Motor vehicles 5,500
Bank A/C
(Dissolution Expenses) 200 Stock 3,800
Creditors Account
Discount received 300
Loss on Realization
Black 1200
white 1200 2,400
25,000 25,000
 Bank Account
£ £
Balance b/f 3,200 creditors 5,400
Realization A/C
Asset sold Realization Account
Dissolution expenses 200
Plant & Machinery 8,000
Debtors 5,000 Capital A/C’s
Motor vehicles 5,500 Black 12,300
Stock 3,800 White 7,600 19,900
25,000 25,000

Partner’s Capital Accounts

Black White Black White
Loss on Realization £ £ £ £
Realization A/C 1,200 1,200 Balances b/f 12,000 8,000
Bank A/C 12,300 7,600 Current accounts 1,500 800
13,500 8,800 13,500 8,800

Current accounts
Black White Black White

Transferred to 1,500 800 Balances b/f 1,500 800

capital accounts
1,500 800 1,500 800

Creditors account
£ £
Bank A/C 5,400 Balance b/f 5,700
Realization A/C
Discount received 300
5,700 5,700

NOTE:
On dissolution, no problem arises with regard to the book-keeping entries for bad debts
as they are automatically adjusted in the realization account.

THE RULE IN GARNER Vs. MURRAY (1903)

A situation may arise where at least one partner has a debit balance in his or her equity
account at the final stage of the distribution of the cash. This may arise from liquidation
losses, excessive withdrawals before liquidation or recurring losses in prior periods. A
partner with an equity deficiency is expected to cover the deficiency by paying cash
into the partnership. The entry for this will be:

DR. Cash
CR. Capital Account of the paying partner
The above will apply unless you are informed that the partner is insolvent and as a
consequence not able to pay in cash. Since there is unlimited liability in partnership, a
partner’s unpaid deficiency has to be absorbed by the remaining partners with credit
balances.
In this case then the Rule in Garner vs. Murray will apply. This rule is based on a
decision given by Mr. Justice Joyce in 1903. According to this decision, the debit balance
in the account of the insolvent partner must be written off to the other partners’ capital
accounts in the ratio of their last agreed capital account ratios. These ratios may be
determined normally in view of the balances on the capital accounts before the
dissolution. This debit balance must not be written off in the profit sharing ratios.
EXAMPLE 7
A, B and C are in partnership sharing profits and losses in the ratio of 3:2:1.The
following is their balance sheet as at 31st December 2008.
Balance sheet
As at 31st December, 2008
Fixed assets Capital accounts
£ £ £ £
Premises 15,000 A 12,000
Motor vehicles 3,800 B 8,000
Furniture C 4,000 24,000
Fittings 1,200 20,000
Current Assets Current accounts
£ £
Stock 5,500 A 2,000
Debtors 3,700 B 1,800
Cash at Bank 1,400 10,600 C (2,800)

Current liabilities
Creditors 5,600
30,600 30,600
The partners decide to dissolve the partnership as at 1st January 2009. The premises and
stocks were sold for £13,000. The debtors realized £3,000. Motor vehicles and furniture
and fittings were sold for £2,500 and £1,100 respectively. C is declared insolvent.

Required:
Show how the above transactions would be dealt with in the Realization, Bank and
Capital accounts.
ANSWER
Partner’s capital accounts
A B C A B C
 £ £ £ £ £ £
Current A/C - - 2,80 Balances b/f 12,000 8,000 4,000
Realization A/C 4,800 3,200 0 Current A/C 2,000 1,800 -
C’s A/C 240 160 1,60 A’s A/C - - 240
Bank A/C 8,960 6,440 0 B’s A/C (Share of - - 160
- Deficiency
-
14,00 9,800 4,40 14,000 9,800 4,400
0 0

Realization accounts
£ £
Premises A/C 15,000 Bank Account
Motor vehicles 3,800 Assets sold
Furniture & Fittings 1,200 Stock & Premises 13,000
Debtors 3,700 debtors 3,000
Stock 5,500 Motor vehicles 2,500
Furniture & Fitting 1,100
Capital A/Cs
(Loss on Realization)
£
A 4,800
B 3,200
C 1,600 9,600
29,200 29,200
 Bank account
£ £
Balance b/f 1,400 Credit 5,600
Realization A/C
(Assets Sold) Capital Accounts
£
Stock premises 13,000 A 8,960
Debtors 3,000 B 6,440 15,400
Motor Vehicles 2,500
Furniture & Fittings 1,100
21,000 21,000

NOTE: There will be a debit balance in Partner ‘C’s account after all the adjustments.
This loss is shared between A and B at the capital account ratio i.e. £12,000:£8,000 or 3:2.
It means £240 will be borne by A and £160 by B
=E N D=
 LECTURE EIGHT

COMPANY ACCOUNTS
LESSON CONTENT
● Introduction
● Public and Private companies
● Advantages and Disadvantages of a corporation
● Classes of Capital
● Types of shares
● Other Issues in company accounts
● Final Accounts of Companies
● Issues of Shares and Debentures
● etc

INTRODUCTION
A limited Company is a most important type of organisation these days in the private
sector. A limited Company is formed under the Companies Act prevailing in the
Country. A Company is a legal entity separate and distinct from its members. There are
three main ways of forming companies, namely, by charter, by legislation or by
registration under the Companies Act. Most commercial companies are formed by
registration under the Companies Act in force.

A registered company is legally constituted by means of:

1. Memorandum of Association
2. Articles of Association
The Memorandum of Association defines the objectives and powers of a Company. It
also states the name, the registered office and the capital of the Company. The Articles
of Association on the other hand defines the rules and regulations governing the
management of the Company affairs, the rights of the members of the Company, and
the duties and powers of the directors.
There are two kinds of Companies namely, private and public companies.

Private Companies
A private company is defined in the Companies Act as a Company which by its articles:
1. Restricts the right to transfer its shares.
2. Limits the number of its members to fifty.
3. Prohibits any invitation to the public to subscribe for any shares or debentures of
the Company.
The Companies Act 1980 (U.K.) states that private Companies will no longer be subject
to the Statutory restrictions on maximum number of members or restrictions on transfer
of shares

Public Companies
Previously all Companies were public unless they met the definition of a private
Company. The Companies Act 1980 (U.K.) stated that in future, all Companies will be
private unless they meet the definition of a public company. Under this Act, a public
company is one which fulfills the following requirements.
1. It is limited by shares or limited by guarantee and has a share capital.
2. It has a memorandum which states that it is a public company.
3. It has at least two shareholders
4. It has an allotted share capital whose nominal value is not less than the
authorized minimum (£50,000) paid up as required.
The Companies Act of Kenya which is based on the Companies Act 1948 U.K. states the
following features for a public company.
1. It must have a minimum of seven members and there is no maximum limit.
2. Its shares are freely transferable e.g. by sale on the stock exchange.
3. Shares and debentures can be offered to the public for subscription.
NOTE: For the preparation of the final accounts of a limited company, private and
public companies are treated in the same manner.

SIGNIFICANCE OF A LIMITED COMPANY

A limited Company is considered a most important type of organization as it enables
the members to limit their liabilities of trading losses. Under normal circumstances the
only liability of members is to pay the cost of their shares. In view of this limited
liability, more persons become willing to buy shares. A limited Company is of
permanent nature and a shareholder may sell their shares freely and this will not affect
the existence of the Company.

The directors who are elected from the shareholders are responsible for the day to day
management of the Company. A limited company is more suitable for large commercial
and industrial concerns.

FORMATION OF A CORPORATION
A corporation has to be registered under the Companies Act prevailing in the country. It
is registered with the Articles of Association and Memorandum of Association. The
Memorandum of Association deals with the following clauses:-
1. The Purpose and Name of the corporation
2. Authorized Capital of the corporation and its division
3. The Registered office of the corporation
The Articles of Association on the other hand regulates the rights of the members of the
corporation and the manner in which the business of the company shall be conducted.
It covers the following issues:-
1. Issue of the share capital
2. Alteration of share capital
3. Rights of members
4. Powers and duties of director
The corporation is said to exist when it acquires a certificate of incorporation or
corporate charter from the Registrar of Companies.

OWNERS EQUITY OF A CORPORATION

The owners’ equity in a corporation is commonly referred to as stockholders equity,
shareholder’s investment or simply share capital. The main sources of stockholders
equity are:-
1. Investments contributed by the stockholders called paid in capital or contributed
capital. The paid in capital is recorded in accounts maintained for each class of
capital stock. If there is only one class of stock, the account is called common
stock or ordinary share capital.
2. Net income retained in the business called retained earnings. The retained
earnings amount results from transferring the balance in net income account to a
retained earnings account at the end of operating year. The general term applied
to the shares of ownership is share capital or capital stock. The number of shares
that a corporation is authorized to issue will be set out in its charter. The shares
of capital stock are often assigned a fixed amount known as par value. The par
amount is printed on the stock certificate which is the certificate of ownership
issued to shareholder. In certain cases shares may also be issued without par in
which case it is called “no par” capital stock but this is not the local experience.
3. Due to the limited liability feature the creditors of a corporation have no claim
against the personal assets of the stockholders. However, the law requires that
some specific minimum contribution be retained by the corporation for the
protection of its creditors. This amount is known as the legal capital and includes
the par or stated value of the shares of capital stock issued.

ADVANTAGES AND DISADVANTAGES OF A CORPORATION

Advantages of a Corporation
 1. Limited Liability:- The creditors can only lay a claim against the assets of the
firm and not those of the individual owners unlike inn partnership and sole
proprietorship
2. Broad Source of Capital:-The corporation gives both small and large investors a
chance to participate in the ownership of the business.
3. Transfer of Ownership:- A shareholder can readily convert their shares into cash
if the need arises since the shares are freely transferable.
4. Going Concern:- The corporation continues in existence even if ownership
changes. The life of the corporation is set by its charter and state laws. A
partnership or sole proprietorship ceases to exist in the event of death of the
owner or owners.
5. Professional Management:- The company hires professionals to handle the
activities of the firm since the management is separated from ownership. This is
unlike other forms of businesses managed by owners who may not have
specialist knowledge.
6. Lack of Mutual Agency:- There is no mutual agency in the corporate form of
business. If a stockholder acting as an owner tries to enter into a contract for the
corporation, the corporation will not be bound by the contract unlike in the
partnership.
7. Centralized Authority and Responsibility:- The board of directors represent the
stockholders and delegates the authority or responsibility for the day to day
operation of the business to a single person known as the chief executive. The
operating powers are not divided among the owners of the business. On his part,
the chief executive may delegate authority over certain segments of the business
to others but he will be accountable to the Board of Directors. If the Board is
dissatisfied with the performance of the CEO then it can replace him in an annual
general meeting.

Disadvantages of a Corporation
 1. Government Regulation:- Corporations must meet the laid down requirements
by the government. As legal entities, the corporations are subject to greater
control and regulation by the state than any other form of business. Corporations
must file many reports with the government in the countries they operate.
Corporations that are publicly quoted must also file reports with the securities
exchange, capital markets authority, etc in compliance with their various
requirements. Adherence to these requirements may be costly.
2. Taxation:- A major disadvantage of the corporate form of business is double
taxation since as a separate legal entity, its earnings are subject to corporation tax
which is usually a fixed percentage of the corporation’s earnings. If any of the
corporation’s after-tax earnings are then paid out as dividend, the earnings are
taxed again as income to the stockholder. The earnings of a sole proprietorship
and partnership are taxed once as personal income to owners.
3. Limited Liability:- The limited feature can also be a disadvantage since it
restricts the ability of a small corporation to borrow money since creditors can
lay claim to the assets of the corporation. They limit their loans to the level
secured by those assets or ask the stockholders to guarantee the loans personally.
4. Separation of Ownership and Control:- Just like in limited liability, this can also
be a drawback. Sometimes, management may make decisions that are not good
for the corporation as a whole. Poor communication can also make it hard for the
stockholders to exercise control over the corporation or even to recognize that
management decisions are detrimental to the corporation.

CLASSES OF CAPITAL
The capital of a limited company is divided into shares which are allotted to the
members for cash or other assets transferred by them to the company. The main types of
capital are the following:-

1) Authorized Capital
This is also referred as the nominal or registered capital. It is the amount upto which the
Company may issue shares. For the purpose of illustration assume the authorized share
capital for ABC company is Sh. 10 billion.

2) Issued and Unissued Capital

That part of authorized share capital which has been issued is called Issued Capital and
the remaining part which has not been issues is referred to as Unissued Capital. For
ABC Company above assume the initial offers Sh. 8 billion to the public. This is the
issued capital and the balance of Sh. 2 billion is unissued capital.

3) Subscribed Capital.
This is the amount of issued capital which has been taken up or subscribed for by
shareholders. The stock market is a free market and once shares have been offered to the
public for subscription, not all the shares may be taken up depending on the potential
investors’ appraisal of the issue. Suppose for ABC company of the Sh. 8 billion offered
the investors just take up Sh. 7 billion. This is the subscribed capital and the balance of
Sh. 1 billion is unsubscribed capital.

4) Called up Capital
This is the portion of subscribed capital which has been called up to payment. The
company may issue the shares on a subscription basis as follows. Assume the par and
issue price is Sh. 20 per share broken down as follows:
On application Sh. 10
On allotment 5
On First and Final Call 5
Total 20
If the Company has received the application and allotment moneys, then the called up
capital per share is Sh. 15. The balance of uncalled capital will be requested for by the
company according to laid down procedures as per articles.
5) Paid Up Capital
This is the part of called up capital actually paid. Of the called up capital, some
shareholders may not have paid up as required due to various reasons. The Articles of
Association details the procedures to be followed where some shareholders are unable
to pay amounts as requested by the directors.

TYPES OF SHARES
The share capital of the company may consist of:-

1. Ordinary Shares
These are commonly referred to as equities. The holders of these shares are the real
owners of the Company because they have the voting rights. Ordinary shares do not
carry a fixed rate of dividend. Dividends are that part of profit which is distributed
among shareholders as determined by the directors at the end of the year. They are paid
after preferential rights have been satisfied

2. Preference Shares
These shares carry preferential rights to dividend. The preference dividend is paid at a
fixed predetermined rate. Preference shares may be further subdivided into:-

(a) Cumulative Preference Shares

These carry the right to receive arrears of preference dividend omited in earlier years
before any dividend is paid to ordinary shareholders.

(b) Participating Preference Shares

These entitle the holder to receive a further dividend in addition the fixed rate e.g. a
further 2% for each 10% of the ordinary dividend when the company performance
allows.

c) Redeemable Preference Shares

These shares are redeemed or repaid at a future date. Redemption entails paying back to
the holders of these shares the par value of their shares at a future predetermined date
as detailed in the articles of association.

3. Deferred Shares
These may be issued to vendors or sellers as part of the purchase consideration on the
purchase of a business. These shares are also called founder’s or management shares.
These rank for dividend after all the other classes of shares.

LOAN CAPITAL
A limited Company can issue shares up to the limit of the Authorized share capital. If
the Company needs more funds for expanding its business activities then the Company
can obtain long term loans. For this purpose, the Company can issue debentures or loan
stock.

Debenture or Loan Stock

A debenture may be defined as the written acknowledgement of a debt incurred by a
limited company. Debentures are the capital raised by a company and for which interest
is paid usually half yearly at a fixed rate. The debentures may be secured on the
company’s assets or unsecured. This is to ensure that in the event of default, the lender
may realize his security to recover moneys loaned. There may be a floating charge ie
generally on all assets or a fixed charge on a specific asset.
Debentures should be limited in a company’s capital structure to such an amount that
interest charges can be met even in times of depression otherwise in the event of
default, the debenture holders might take steps leading to the liquidation of the
Company.

Convertible loan stock may also be issued. This can be converted on predetermined
dates and at the option of the holder into ordinary shares of the same company.
Convertible loan stock would he issued where a company wishes to delay the
introduction of ordinary shares.

OTHER ISSUES IN COMPANY ACCOUNTS

1. Bonus Issue or Scrip Issue
The directors of a limited company may decide to issue more shares to existing
shareholders against the reserves or profit and loss account balance. In this case, the
share holders are not supposed to make any payment. Such an issue is referred as
Bonus issue or scrip issue. Bonus issue is actually the distribution of profits in the form
of shares. These shares may be also issued against the share premium account balance.
Bonus issue is actually the capitalization of reserves by a company.

Entries are made as follows:-

DR Reserves or Profit and Loss Account

CR Share Capital Account

EXAMPLE ONE
On 31 December 2008 the following information was provided for Rex Limited.
Authorized Share Capital 100,000 shares of1 each issued share capital 50.000 shares of
£1 each.

The balance in the profit and loss account was £ 30,000 (CREDIT). The directors decided
to make a bonus issue of one ordinary share fully paid for every two held.
Show the necessary entries in the ledger of Rex Limited.

ANSWER
ORDINARY SHARE CAPITAL ACCOUNT
£ £
2008 2008
Dec 31 Balance c/d 75,000 Dec 31 Balance b/f 50,000
Dec 31 Profit & Loss A/C 25,000

75,000 75,000

Profit & Loss Account

£ £
2008 2008
Dec 31 share capital A/C 25,000 Dec 31 Balance b/f 30,000

Dec 31 Balance c/d 5,000

30,000 30,000

2. RIGHTS ISSUE
A Rights Issue may be defined as the raising of new capital by a company by giving
existing shareholders the right to subscribe to new shares or debentures in proportion to
their current holdings. A shareholder not wishing to take up a rights issue may sell the
rights on the open market. In the case of rights issue, the shares are issued at par or at a
reduced market price to the existing shareholders. A rights issue does not affect the
voting power because the proportion of shareholding remains the same.
 3. CAPITAL RESERVES
The amounts reflected in the capital reserves cannot be paid out or distributed to
shareholders as dividends. The three types of capital reserves are as follows:-
Share Premium:- A share premium arises when the company issues shares at a price
that is more the par value. The share premium may be applied in the following ways:-
● Paying unissued shares
● Writing off preliminary expenses
● Writing off discounts on shares.
Revaluation Reserve:- Any gain made on revaluation of noncurrent assets especially
for Land and Buildings. When the company sells its property to realize the gain, the
amount is transferred to the Profit and Loss Account.

Capital Redemption Reserve:- A reserve created after the redemption or repurchase of

Redeemable Preference Shares without issuing new equity shares to finance the
redemption. The transfer is made either from the share premium or the profit and loss
account.

4. REVENUE RESERVES
The revenue reserves can be distributed and include the retained profits (P & L A/c)
and the General Reserves. Transfers are made from profits to the General reserves to
provide for the expansion of the business of for the purchase of noncurrent assets. The
General Reserves can also be used to issue bonus shares.

FINAL ACCOUNTS OF COMPANIES

The Profit and Loss Account (Income Statement) of a company is the same as that of a
sole proprietorship but there are additional expenses that are unique to the company
and therefore should be included. These are as follows:-
● Directors’ salaries and fees
● Audit fees
● Amortization e.g. goodwill
● Debenture Interest

In addition, just as is the case with Partnership accounts, an appropriation account is

prepared which shows the allocation of the net profit for the period to various uses. The
format is as shown in the illustration below.

FINAL ACCOUNTS OF COMPANIES

FORMATS
APPROPRIATION OF PROFIT AND LOSS
ACCOUNT
Net profit for the Year X
ADDA: P & L A/c Balance b/f X
X
Less:
Corporation Tax X
General Reserves X
Dividends : Paid X
Proposed X X X
Profit and Loss Account Balance c/f X
The Balance Sheet (Statement of Financial
Position) is prepared in a similar manner as the
sole proprietorship in that it is a listing of all the
assets, liabilities and capital. However for the
company, the authorized share capital is shown
separately if different from the issued share
capital. The capital reserves and revenue reserves
will be shown separately under their respective
captions in the balance sheet.
Companies are required to show the cost the fixed
assets, accumulated depreciation which is
deducted to derive the net book value. The
investments of a limited company are shown
separately under the headings as follows:
● Trade Investments
● Quoted Investments
● Unquoted Investments
 A.B Limited
Balance Sheet as at 31st December 2008
Fixed assets Cost Acc. Dep Net
Land & Building x x x
Plant and machinery x x x
Motor vehicles x x x
Furniture and fittings x x x
x x x

Investments
Quoted x
Unquoted x

Current Assets
Stock x
Debtors x
Cash at Bank x
x

Less: Current Liabilities

Creditors x
Corporation Tax x
Proposed Division x x
Working capital x
Net assets x

Financed by:
Authorized share capital: 200,000 ordinary shares of £ 1 each 200,000
Issued share capital: 100,000 ordinary shares of 1 each 100,000

Share premium X
General reserves X
Profit and Loss account X
10% Debentures X
X

Note the Following:-

1. Director’s salaries:- Comprises salaries, fees and other expenses in relation to the
directors. These are treated as expenses as far as company accounts are
concerned. Contrast this with the partnership and sole proprietorship where they
are shown as appropriations.

2. Audit Fees:- All companies are required to prepare the accounts which should be
audited and therefore any fees paid in relation to the audit and accountancy are
treated as expenses.

3. Debenture Interest:- As noted above, this is the interest paid on loans taken by
the company. These are charged as an expense and any unpaid amount will be
shown as a liability in the accounts. The debenture is classified under noncurrent
liabilities.

4. Corporation Tax:- Companies pay corporation tax on the profits the earn. This is
shown in the accounts because a company is a separate legal entity unlike for the
sole traders and partnerships whose tax is shown as drawings. The tax is listed
together with the other items in the appropriation section. In the account there
may be Under/over provision for previous period, Transfer to deferred tax,
Corporation tax for the year. The under provision and corporation tax relate to
direct liability to the government and therefore is a deduction from the net profit
for the period. The transfer to deferred tax is to cater for future possible tax
liability.
 ILLUSTRATION
The following balances remained in the books of DYKE Ltd. at 30 June, 2005 after the
preparation of the Trading Account.
£
Share capital, authorized and issued
60,000 £1 ordinary shares 60,000
20,000 8% £1 Preference shares 20,000
Stocks at 30 June, 2005 41,926
Debtors and prepayments 13,600
Creditors and accruals 6,861
Bank balance 3,891
10% Debentures 8,000
General Reserve 14,000
Bad debts 170
Gross Profit for the period 40,754
Wages and salaries 14,100
Rates and insurance 705
Postage and telephone 310
Light and heat 608
Debenture interest (1/2 year to 31 December 2004) 400
Directors fees 1,250
General expenses 1,554
Vehicles (cost £9,700) 3,400
Office fittings and equipment’s (cost £22,320) 13,720
Land and building at cost 66,100
Profit and Loss Account at 1 July, 2004 12,126
The following information is also available:
i. Office fittings and equipment are to be depreciated at 15% on cost, and vehicles
at 20% on cost.
ii. A bill for £274 in respect of electricity consumed up to 30 June, 2005 has not been
entered in the ledger.
iii. The amount for insurance includes a premium of £150 paid in December, 2004 to
cover the company against fire loss for the year 31st December, 2004 to 31st
December, 2005.
iv. Provisions are to be made for:
Directors’ Fees £2,500
Audit Fee 600
The outstanding debenture interest
v. The Directors have recommended that:
1) £6,000 be transferred to General Reserve
2) The Preference Dividend be paid
3) A 10% Ordinary Dividend be paid

Required:
Prepare the Profit and Loss and Appropriation Account for the period ended 30th June,
2005 and a Balance Sheet as at that date.
 SOLUTION

DYKE LTD
Profit and Loss Account and Appropriation Account for the Year Ended 30th June 2005
£ £ £
Gross Profit b/d 40,75
4
Less: EXPENSES
Bad Debts 170
Wages and salaries 14,100
Rates and insurance: Paid 705
Less: prepaid 75 630
Postage and telephone 310
Light and heat: Paid 608
Add: Accrued 274 882
Debenture interest: Paid 400
Add: Accrued 400 800
Directors fees: Paid 1,25
0
Add: Provision 2,50 3,750
0
Audit fee 600
General expenses 1,554
Depreciation
Motor vehicles 1,940
Office fittings and equipment 3,348 27,08
4
NET PROFIT 12,67
0
Net Profit b/d 12,67
0
Add: Profit and Loss Account balance b/f 12,12
6
24,79
6
Less: Appropriations:
Transfer to general reserves 6,000
Divided: Preference 1,60
0
Ordinary 6,00 7,600 13,60
0 0
Profit and loss account balance c/f 11,19
6

NOTE: Preference dividend 8% of £20,000= £1,600

Ordinary dividend 10% of £60,000=£6,000
 DYKE LTD
Statement of Financial Position as at 30th June 2005
FIXED ASSETS £ £ £
Land and building at cost 66,100
Motor vehicles at cost 9,700
Less: Accumulated Depreciation 8,240 1,460
Office fittings and equipment at cost 22,320
Less: Accumulated Depreciation 11,948 10,372
77,932
CURRENT ASSETS
Stock 41,926
Debtors and prepayments 13,600
Prepaid insurance 75
Cash at Bank 3,498
59,099
LESS: CURRENT LIABILITIES
Creditors and accruals 6,861
Proposed dividends: Preference 1,600
Ordinary 6,000
Accrued light and heat 274
Provision for directors fees 2,500
Provision for audit fee 600 17,835
Working capital 41,264
119,19
6
FINANCED BY
Share capital: Authorized and Issued
60,000 £1 Ordinary shares 60,000
20,000 8% £1 Preference shares 20,000
General reserves 20,000
Profit and loss account balance c/f 11,196
Total share capital and Reserves 111,196
10% Debentures 8,000
119,19
6

ISSUE OF SHARES
Companies raise their capital by issuing shares to the members of the public. This is an
important exercise and elaborate provisions are put in place in the articles of association
to regulate this exercise. Once the shares of the Company are offered to the public the
interested persons apply for these shares on prescribed forms. After receiving the
applications, the directors allot the shares to the successful applicants after which the
allotment letter is sent to the successful applicants. If the applications received are more
than the number of shares offered then some applications may be rejected or the
allotment is done partially e.g 2 shares for every 3 applied for.

The persons to whom these shares are allotted are supposed to pay the cost ol these
shares as required by the directors. The shares may be issued at par or premium. If the
shares are issued at par, then the shareholder will he required to pay the nominal values
of the shares issued to him. When the shares are issued at premium then the
shareholders ate supposed to pay more than the nominal value of the shares. For
example, if a share with a nominal value of Sh. 20 is issued at Sh. 25, then Sh. 5 will be
the premium. This premium is commonly referred to as share premium and it is
credited to a separate share premium account.
When shares are offered to the public, the cost of these shares may be payable in
installments. These installments are normally payable on application, on allotment, on
first call and second call. To record the transactions in relation to the issue of shares,
various, ledger accounts are opened as follows:-

Entries in the Ledger Accounts:

1. Application Money Received
DR: Bank account
CR: Application and Allotment account.

2. Application Money refunded to unsuccessful applicants:

DR Application and Allotment account
CR Bank Account

3. Allotment by Directors:
Money to be received at the time of allotment and application
DR: Application and Allotment account
CR; Share Capital account.
Note: It is at this point that the amounts received are recognized as part of share capital.
4. Share Premium money received:
DR: Application and allotment account
CR: Share Premium account

5. Allotment Money Received:

DR: Bank account
CR: Application and Allotment account

6. Call made by Directors

DR: Call account.
CR: Share Capital account
7. Call money received
DR: Bank account
CR: Call account

8. Call in advance
DR: Bank account
CR: Calls in Advance account

EXAMPLE 2
ABSA Company Ltd offered 100,000 ordinary shares of £1 each at par, payable as
follows:-
£0.35 on application
£0.35 on allotment
£0.30 on first and final call

Applications were received for 120,000shares. On July 1, 2005 applications for 10,000
shares were rejected and application money was refunded to the unsuccessful
applicants. Allotment was made on July 10, and applicants for 20,000 shares were
allotted a half of the number for which they had applied, excess application money
being used to reduce the amount due on allotment. On 15th July, all money due on
allotment was received. The first and final call was made on 1st September and the
money due on call made was received on 10th September.

Required:
Show the entries necessary to record the above matters in the Company’s Bank account
and ledger, balancing off at the end of September 2005.
ANSWER
BANK ACCOUNT
2005 £ 2005 £

July 1 App: & 42,000 July 1 APP&

All: A/C ALL.A/C 3,500

July 15 APP: & ALL: 31,500 Sep. 30 Balance 100,000

A/C C/d
Sep. 10 Call A/C 30,000

______ _________
103,500 103,500

APPLICATION AND ALLOTMENT ACCOUNT

2005 £ 2005 £
July I APP ALL. A/C 3,500 July 1 Bank A/C 42,000
July 10 Share 70,000 July 15 Bank A/C 31,500
Capital
A/C
________ _________
73,5000 73,500

CALL ACCOUNT
2005 £ 2005 £
Sep 1 Share Capital A/C 30,000 Sep. 10 Bank A/C 30,000
______ ________
30,000 30,000
 Ordinary share capital
£ 19-5 £
Sep 30 Balance 100,000 July 10 App
c/d all: A/C 70,000
Sept 1 Call A/C 30,000

100,000 100,000

NOTE: Application money received was £42,000 (i.e. £0.35 120,000), £3,500 was
refunded to unsuccessful applicants and £3,500 was retained against the allotment
money due from the applicants to whom only 10,000 shares were allotted instead of
20,000 shares. Money due on allotment was £35,000 but £3,500 had already been
received so the balance £31,500 was received on 15th July.
Calls in Arrear and Calls in Advance
Calls in Arrears
When shareholders fail to pay sums due from them on shares allocated to them, the
total of these amounts will constitute the calls in arrear. The treatment of these can be
either carrying them down to the debit of the allotment account or transferring to the
debit of a call in arrears account in the ledger. Failure to pay calls may lead to the
forfeiture of the shares or any declared dividends.

Calls in Advance
Some shareholders may not wish to be troubled by repeated calls and in this case, they
may pay for their shares in full before the calls are made by the directors. In such cases,
the money received by the company in excess of what has been called up is put to a
separate calls in advance account. No dividend will be payable on this money for it
does not yet form part of the company’s share capital. However interest may be paid on
such money if the articles of association provide for this. When the calls are made, a
transfer must be made debiting the calls in advance account and crediting the share
capital account.

Treatment in the Balance Sheet

Though calls in arrears and calls in advance are separate accounts in the ledger, the calls
in arrears are not shown as a separate item on the asset side of the balance sheet nor do
calls in advance shown as a separate item on the liabilities side. The calls in advance are
added and calls in arrears deducted from the share capital account in the balance sheet.

Forfeiture of shares
When a shareholder fails to pay calls in arrears within a stipulated time, the directors
generally have power to cancel such shares and appropriate any moneys paid on those
shares to date but after due notice has been given to the affected shareholders. These
shares are then said to be forfeited and the shareholder ceases to be a member of the
company. The ex-shareholder is strictly speaking still liable even after forfeiture for the
sum owing on the shares. However, for all practical purposes the amount is a bad debt
and is usually written off. The ex-shareholder’s liability ceases as soon as payment for
the shares is received from a third party.

Entries in the Accounts

The amount called up on the shares has been credited to capital account and debited to
allotment or call account in anticipation of the money, being paid. These entries must be
cancelled by the following entries.
Dr: Share capital A/C – with full amount called up on shares
Cr: Call accounts – with amounts of unpaid calls
Cr: Forforeited shares account with amounts for which cash was received.

Alternatively
Dr: share capital account with full amount called upon
Cr: Forfeited shares account
Dr: Forfeited shares account with amount of unpaid calls
Cr: Calls account

Re-issue of Forfeited Shares

As the forfeiture of shares is not a reduction of capital within the meaning of the
Companies Act, the articles of association gives the directors power to re-issue forfeited
shares. These may be issued at par, at a premium or even at a reduced price. The
reduction however should not exceed the amount paid up on the shares as this will be
tantamount to issuing the shares at a discount.

On re-issue, a journal entry is made debiting the person to whom the shares have been
reallocated with amount he has agreed to pay for them, debititing forfeited shares
account with reduction in price (if any) and crediting share capital with the called up
value of the shares. Any balance remaining on forfeited shares account after all shares
have been re-issued is transferred to share premium account.

The forfeiture and re-issue procedure can be summarized as follows:

1. Calls in Arrear
DR: Calls in Arrear account
CR: Call account

2. Shares forfeited due to

Calls in arrear:
Called up value
DR: Share Capital account
CR: Forfeited Shares account

3. Calls in Arrear on Forfeited Shares:

DR: Forfeited Shares account
CR: Calls in arrear account

4. Forfeited shares re-issued:

DR: Forfeited shares re-issued account
CR: Share Capital account

5. Amount received prior to forfeiture:

In respect of shares re-issued
DR: Forfeited Shares account
CR: Forfeited Shares re-issued account
6. Amounts Received on re-issue:
DR: Bank account
CR: Forfeited Shares re-issued account
7. Share premium on re-issue (if any):
DR: Forfeited shares re-issued A/C
CR: Share premium account

EXAMPLE 3
Rocky Limited offered 50,000 ordinary shares of £1 at £1.25 payable as follows:-
£0.25onapplication
£0.50 On allotment (including premium)
£0.25 on first call
£0.25 on Second call
Applications were received for 60,000 shares. An application for 10,000 shares was
rejected. Allotment moneys due was receive, first call was’ made after the month and
second call after two months on first and second call were received except for
1000shftres. These shares were forfeited after three months and then re-issued for £0.70
each as fully paid.
Required:
Show the necessary entries in the Bank Account and ledger of the Company

ANSWER
Bank account
£ £
App: Allot account 15,000 App: & Allotment A/C 2,500
App: Allot A/C 25,000 Balanced c/d 62,700
First Call A/C 12,500
Second Call A/C 12,250
Re-issue of forfeited share A/C 700
65,200 65,200
 APPLICATION AND ALLOTMENT ACCOUNT
£ £
Bank A/C 2,500 Bank A/C 15,000
Capital A/C 25,000 Bank A/C 25,000
Share premium A/C 12,500
40,000 40,000

FIRST CALL ACCOUNT

£ £
Share Cap: A/c 12,500 Bank A/C 12,250
Calls in arrear A/C 250

12,500 12,500
 SHARE CAPITAL ACCOUNT
£ £
Forfeited share A/C 1,000 Application & Allotment 25,000
Bal c/d 50,000 First call A/C 12,500
Second call A/C 12,500
Forfeited share re-issued 1,000

51,000 51,000

SECOND CALL ACCOUNT

£ £
Share capital A/C 12,500 Bank A/C 12,500
Calls in Arrears A/C 250

12,500 12,500

SHARE PREMIUM ACCOUNT

£ £
Balance c/d 12,700 App: All A/C 12,500
Forfeited share
Re-issued A/C 200

12,700 12,700
 CALLS IN ARREAR ACCOUNT
£ £
First Call A/C 250 Forfeited share A/C 500
Second Call A/C 250

500 500

FORFEITED SHARES ACCOUNT

£ £
Calls in arrear A/C 500 Share Capital A/C 1,000
Forfeited shares Re-issued A/C 500

1,000 1,000

FORFEITED SHARES RE-ISSUED ACCOUNT

£ £
Share capital A/C 1,000 Bank A/C 700
Share premium A/C 200 Forfeited share A/C 500

1,200 1,200

BALANCE SHEET
£ £
Ordinary share capital 50,000 Bank A/C 62,700
Share premium 12,700

62,700 62,700