[DCT2305B] [FINANCIAL APPLICATIONS]

FUNDAMENTALS OF ACCOUNTING

THE ACCOUNTING CYCLE

The accounting cycle is a series of steps taken by an accountant to maintain a
business’s books of account and prepare its financial statements. The accounting
cycle consist of the following steps:

1. Business transactions occur as revealed by documentary evidences known as

source documents e.g., invoices, cash receipts etc.
2. Recording transactions in the journals getting information from the source
documents.
3. Posting transactions from the journals to their respective ledger accounts.
4. Balancing the ledger accounts.
5. Preparing a trial balance from ledger accounts balances.
6. Making end of year adjustments.
7. Preparing financial statements:
(a) Income statement (trading and profit and loss account)
(b) Statement of financial position (balance sheet)
(c) Statement of cash flows
8. Analysing the financial statements.
(a) Ratio analysis
(b) Cash flow analysis

BUSINESS TRANSACTIONS
A business transaction is any activity involving the exchange of goods and services
for another thing of value such as money e.g.,
(i) Buying goods or services in cash or credit from the sellers/suppliers.
(ii) Selling goods or services in cash or credit to the buyers/customers.
(iii) Payment of wages and salaries to workers for services provided.
(iv) Payment of rent and other expenses.

Types Of Business Transactions

There are 2 types of business transactions:
1. Cash Transactions
This is when goods are bought and sold on cash basis i.e., money/cheques paid or
received immediately.
2. Credit Transactions
This is when cash is not paid or received immediately. In this case, cash is paid
or received after a specific period from the date of transaction.
When credit transactions occur, a business will have debtors and creditors.
• Debtors – these are persons to whom goods are sold on credit basis. They owe
money to the business. Debtors are also known as accounts receivable or trade
receivables.
• Creditors – these are persons from whom goods are bought on credit basis. The
business owes money to them. Creditors are also known as accounts payable or
trade payables.

SOURCE DOCUMENTS
A source document is a form of written evidence that a business transaction has
occurred. It is a document on which an accounting entry is based in the books of
account.

Types of Source Documents

1. Invoice
It is issued when goods are bought or sold on credit. There are two types of
invoices. These are:

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(a) Sales invoice – it is issued by a business to a debtor-customer when it
sells goods on credit. It contains the following:
(i) Name and address of the business
(ii) Name and address of the debtor-customer
(iii) Date of making the sale – invoice date
(iv) Invoice number
(v) Amount due (net of trade discount)
(vi) Description of goods sold
(vii) Terms of sale

(b) Purchases invoice – it is issued by the seller-creditor to the business

when it buys goods on credit. It contains the following:
(i) Name and the address of the seller-creditor
(ii) Name and address of the business
(iii) Date of the purchase (invoice date)
(iv) Invoice number
(v) Amount due
(vi) Description of goods sold
(vii) Terms of sale

2. Credit note
It is a document issued by a business to the debtor-customer when he/she
returns some goods back to the business. Its purpose is to inform the debtor-
customer that the amount due to the business has been reduced or cancelled.
A credit note can also be issued when a business allows a discount on the
amounts due from the debtor-customers. It contains the following:
(i) Name and address of the business
(ii) Name and address of the debtor-customer
(iii) Amount of credit
(iv) Credit note number
(v) Reason for credit e.g., if goods sent but of the wrong type or a
discount allowed.

3. Debit note
It is issued by the creditor-supplier to the business when it returns some
goods to the creditor-supplier. Its purpose is to inform the business that the
amount due to the creditor-supplier has been reduced or cancelled. It contains
the following:
(i) Name and address of the business
(ii) Name and address of the creditor-supplier
(iii) Amount of debit
(iv) Debit Note number
(v) Reason for the debit

4. Cash sale receipt

It is issued by the business to customers or debtors when they make payments
in the form of cash or cheques. It contains the following:
(i) The name and address of the business
(ii) The date of the receipt
(iii) Amount received (cash or cheque or other means of payment)
(iv) Receipt number.

5. Cheques
When a business opens a current account with the bank, a cheque book
containing cheques is issued to the business. The cheques allow the business
to make payments against its account with the bank. When a business issues a
cheque to its suppliers for payments, it authorizes the bank to honour

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payments against the business’s account with the bank. The cheque contains the
following information:
(i) Name and account number of the business (account holder)
(ii) The date of the cheque
(iii) Name of the payee (seller)
(iv) Name of the business’s bank
(v) Amount payable in words and figures
(vi) The cheque number
(vii) The authorized signature(s)

6. Petty cash vouchers

A petty cash voucher is raised by a cashier to seek authority for payments
(payments of small value in the business which require cash payments (e.g.,
fuel, bus-fare, office snacks), which is approved by a senior manager and
filed for record purpose. It shows:
(i) Date of payment
(ii) Amount paid
(iii) Reason for payment
(iv) Authorized signature(s):
(v) Person approving
(vi) Person receiving
The person receiving the money must then return a document supporting how the
money was utilized e.g., on fuel receipt, bus ticket etc.

Other types of source documents are:

− Quotations
− Purchase order
− Remittance advise note
− Statement of account
− Other correspondences.

ACCOUNTING EQUATION
The accounting equation means that for any form of business to operate, it needs
resources known as assets which have to be provided to the business. Where these
assets are provided by the owner(s) of the business it is known as capital (or
owner’s equity). If all assets of a business are provided by its the owner(s) then
the following accounting equation applies: 𝑨𝒔𝒔𝒆𝒕𝒔 = 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
However, if some of the assets are provided by outsiders (persons other than
owner(s)) it is known as liabilities. In this case, the accounting equation becomes
𝑨𝒔𝒔𝒆𝒕𝒔 = 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 + 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
The assets side show what resources a business owns and controls while the capital
and liabilities side show who has provided these resources and how much each group
has provided.
NB/: - The two sides will always be equal regardless of the number of transactions
a business enters into.
This equation can be used to calculate the value of the unknown variable if the
values of any two variables are known i.e.,

(i) 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

(ii) 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

(iii) 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

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DEFINITIONS OF THE ACCOUNTING EQUATION ITEMS
The accounting equation shows the relationship between the values of assets,
capital and liabilities of a business. Accounting equation items are defined as
follows:

1. ASSETS
These are resources owned and controlled by a business for the purpose of
conducting its activities. Assets can be classified into 2 broad categories namely:

(a) Tangible assets

These are assets that can be seen and touched i.e., they have physical attributes.
They can further be sub-divided into 2 types:

(i) Non-Current Assets

They were known as fixed assets or long-term assets. These are assets acquired and
held by a business for use in the business for a long period of time usually for
more than 1 year. Non-current assets include:
− Land,
− Buildings,
− Furniture, fixtures and fittings,
− Plant and machinery,
− Equipment,
− Motor vehicles,
− Computers etc.

(ii) Current Assets

They were known as short-term assets. These assets are in the business for a short
period of time usually less than 1 year. This is because they constantly change
from one form to another form. They are used to meet the day-to-day requirements of
a business. They are either in form of cash or are convertible to cash in a short
period. Current assets include:
− Inventory (stock of goods held for resale),
− Accounts receivable or trade receivables (debtors),
− Prepaid expenses (expenses paid in advance),
− Accrued/outstanding income (income earned but not yet received),
− Cash at bank
− Cash in hand.

(b) Intangible assets

These are assets of value but cannot be seen or touched i.e., they have no physical
attributes or material existence. Intangible assets include:
− Goodwill,
− Patents,
− Copyrights,
− Trade marks,
− Royalties
− Brand reputation and
− Trade agreements etc.

2. LIABILITIES
These are resources borrowed by a business from outsiders. They are debts of a
business which are supposed to be paid at some time in the future. The liabilities
of a business can be classified into 2 categories namely:

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(a) Non-Current Liabilities
They were known as long-term liabilities. These debts will be paid back by a
business for a long period especially for more than 1 year. Non-current liabilities
include:
− Loans from banks
− Debentures etc.

(b) Current Liabilities

They were known as short-term liabilities. These debts will be paid back by a
business in a short period of time especially within 1 year. Current liabilities
include:
− Accounts payable or trade payables (creditors),
− Bank overdrafts
− Accrued/outstanding expenses (costs incurred but not yet paid).
− Income received in advance (money received but not yet earned)
− Tax payable
− Dividends payable etc

3. CAPITAL
It is also known as owner’s equity. These are resources provided to the business by
its owner(s) from their personal property. These resources could be in form of
money (cash/cheques) or other assets such as furniture, a computer, a motor vehicle
etc.

EFFECTS OF TRANSACTIONS ON ACCOUNTING EQUATION

Every business transaction has an effect on the accounting equation i.e., the
values of some items in the accounting equation will either increase or decrease
after every transaction. A single transaction will affect at least 2 items in the
accounting equation.

DOUBLE ENTRY SYSTEM OF ACCOUNTING

Accounting is based on a system of “double-entry”. This is because a transaction
affects at least 2 items in the accounting equation. One entry is to show the
effect upon one item (i.e., increase or decrease) and the second entry to show the
effect upon the other item (i.e., increase or decrease). This is double entry
system of accounting. The double entry system requires that “for every debit entry,
there is a matching credit entry”.

Debit and Credit Entries

These terms are used to signify either an increase or decrease of financial
statements’ items in a business i.e., assets, liabilities, capital, incomes and
expenses. The short form for debit is DR and the short form for a credit is CR.
These terms are NOT the same as debtors and creditors respectively.
To show whether an item is to be debited or credited, it will depend on its nature.

The following are the rules of double entry:

Item To record Entry in the Accounts
1. Asset an increase Debit
a decrease Credit
2. Liability an increase Credit
a decrease Debit
3. Capital an increase Credit
a decrease Debit
4. Income an increase Credit
a decrease Debit

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5. Expense an increase Debit
a decrease Credit

RECORDING BUSINESS TRANSACTIONS

All business transactions are recorded in the books of account. The books of
account may be classified as:

1. JOURNALS
Journals are also known as day books or books of original entry or subsidiary
books. Business transactions are recorded in journals on a daily basis. A journal
is a record in which transactions are first recorded in a chronological order. This
information is gotten from source documents.

Types of Journals

(a) Sales Journal

It is used to record the value of goods (i.e., stock) sold by a business on credit.
Each time stock is sold on credit, an invoice is issued to the debtor-customer.
This invoice serves as a source document for making an entry in the sales journal.

The format of a sales journal is as follows:

Date Debtor Invoice No. Folio Amount
20X9 Ksh.
1/3 Joseph Kariuki 927364 (1) 2,000
3/3 Hellen Watetu 927365 (2) 1,500
Total 3,500

(b) Purchases Journal

It is used to record the value of goods (stock) bought by a business on credit.
Each time stock is bought on credit, an invoice is received from the creditor-
supplier. This invoice serves as a source document for making an entry in the
purchases journal.

The format of a purchases journal is as follows:

Date Creditor Invoice No. Folio Amount
20X9 Ksh.
2/3 Grace Muthoni 673949 (3) 4,000
6/3 Evans Koome 265944 (4) 8,500
Total 12,500

(c) Sales Returns Journal

It is also known as Returns Inward Journal. It is used to record the value of stock
returned back to the business by credit-customers. Each time goods sold on credit
are returned, a credit note is issued to the credit-customer (debtor). This credit
note serves as a source document for making an entry in the sales returns journal.

The format of a sales returns journal is as follows:

Date Debtor Credit Note No. Folio Amount
20X9 Ksh.
5/3 Hellen Watetu 639218 (2) 500
Total 500

(d) Purchases Returns Journal

It is also known as Returns Outward Journal. It is used to record the value of
stock returned back by the business to the credit-suppliers (creditors). Each time
stock bought on credit is returned, a credit note is received from the creditor.

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This credit note serves as a source document for making an entry in the purchases
returns journal.
The format of a purchases returns journal is as follows:

Date Creditor Credit Note No. Folio Amount

20X9 Ksh.
6/3 Evans Koome 169374 (4) 1,500
Total 1,500

(e) Cash Journal

It is also known as a cash book. It is used to record all cash receipts and cash
payments. Each time stock or other assets such as motor vehicles or furniture etc
are sold in cash, a cash receipt is issued to the buyer. Each time stock or other
assets are bought in cash, a cash receipt is received from the seller. These
incoming or outgoing cash receipts serve as source documents for making entries in
the cash journal or cash book.

(f) General Journal

It is used to record any transaction that cannot be recorded in any other journal
other than cash journal. The general journal is used to record:
− Purchases or sales of non-current assets whether in cash or on credit.
− Introduction of capital in a form other than cash by the owner.
− Opening and closing entries
− Adjusting entries
− Correction of errors.

The general journal is different from other journals in that it shows both debit
and credit entries separately.

The Format of a General Journal

Date Details L.F Dr. Cr.
Ksh. Ksh.
Name of account to be debited XX
Name of account to be credited XX
(Explanation)

Features Of a General Journal

(i) Date column – it is used to record the day, the month and the year when the
transaction takes place.
(ii) Details column – the name of the account to be debited is entered in the
first line. The name of the account to be credited is entered in the second
line and indented. The narration or a brief explanation of the transaction is
entered in the third line.
(iii) L.F column – L.F means Ledger Folio. It is a numbered page in a ledger book.
This column is entered the page numbers in which the various accounts appear
in the ledger book.
(iv) Dr. column – it enters the amount to be debited in money terms.
(v) Cr. column – it enters the amount to be credited in money terms.

Date Details L.F. Dr. Cr.

20X9 Ksh. Ksh.
5/6 Motor vehicle 600,000
“ Cash in hand 600,000
(Motor vehicle bought in cash)

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Advantages of Journal
(i) The transactions are recorded in journal as and when they occur so the
chances of errors are minimized.
(ii) It helps in preparation of ledgers.
(iii) Any transfer from one account to another account is made through Journal.
(iv) The entry recorded in journal are self-explanatory as it includes narration
also.
(v) It can record any such transaction which cannot be entered in any other books
of account.
(vi) Every transaction is recorded in chronological order (date wise) so the
chances of manipulations are reduced.
(vii) Journal shows all information in respect of a transaction at one place.
(viii)The closing balances of previous year of accounts related to assets and
liabilities can be brought forward to the next year by passing journal entry
in journal.

2. LEDGERS
A ledger account is a form of record that contains information relating to a
particular asset, liability, capital, income and expense. All these separate ledger
accounts are usually kept in pages which make a ledger book or simply a ledger. A
ledger account is therefore a page in a ledger book in which is recorded increases
or decreases of an item in the business.

Types Of Ledger Accounts

Ledger accounts may be classified as:

(a) Personal Accounts

These accounts contain the name of a business (i.e., artificial person) or an
individual (i.e., natural person) with whom our business deals with such as Kamau
Account, Kenya Airways Account etc. There are 3 types of personal accounts:
(i) Capital Account
It records transactions between the owner(s) and the business i.e., anything put in
or removed from the business by the owner(s).
(ii) Debtor Account (Accounts receivable)
A debtor is a person who owe money to the business. A separate debtor account is
maintained for each debtor.
(iii) Creditor Account (Accounts payable)
A creditor is a person to whom money is owed by a business. A separate creditor
account is maintained for each creditor.

(b) Impersonal Accounts

These accounts do not contain the name of any individual or business. They are of 2
kinds:
(i) Real Accounts
These are accounts of tangible and intangible assets.
(ii) Nominal Accounts
These accounts deal with expenses, income, gains and losses e.g., wages account,
rent expense account, rent income account, discounts received account, discounts
allowed account, trading account, profit and loss account etc.

Kinds of Ledgers
The main kinds of ledgers are:

(i) Sales Ledger or Accounts Receivable’s Ledger

This ledger is used to maintain the personal accounts of all debtors i.e., accounts
receivables.

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Format Of a Sales Ledger Control

Dr. Sales Ledger Control Account Cr.

Ksh. Ksh.
Bal. b/f XX Bal. b/f XX
Total credit sales for the period XX Total cash received from debtors XX
Refunds to customers XX Total cheques received from XX
debtors
Dishonoured cheques XX Total returns-inwards XX
Bad debts recovered XX Total cash discount allowed to XX
customers
Bad debtors written-off XX
Cash received from bad debtors XX
recovered
Purchases Ledger contra XX
Allowances to customers XX
Bal. c/f XX Bal. c/f XX

(ii) Purchases Ledger or Accounts payable’s Ledger

This ledger is used to maintain the personal accounts of all creditors i.e.,
accounts payables.

Format Of a Purchases Ledger Control Account

Dr. Purchases Ledger Control Account Cr.

Ksh. Ksh.
Bal. b/f XX Bal. b/f XX
Total cash paid to creditors XX Total credit purchases for the XX
period
Total cheques paid to creditors XX Refunds from suppliers XX

Total cash discounts received XX

Allowances by suppliers XX
Sales ledger contra XX
Total returns outwards XX
Balance c/f XX Balance c/f XX

(iii) General Ledger

This ledger contains the accounts relating to the proprietor i.e., capital
accounts, assets i.e., real accounts and all nominal accounts i.e., incomes,
expenses etc

POSTING
This is the process of transferring information from the journal to the ledger for
the purpose of summarising information of every item in the financial statements.
This process is based on the principle of double entry system of accounting i.e.,
for every debit entry there is a matching credit entry.
The net effect of all the transactions is then determined by balancing the ledger
accounts.

Features of a Ledger Account

A ledger account has the following features:
1. It is drawn in a T – shape. It means that each ledger account is divided in
two parts i.e., left side and right side. In this case a ledger account is
also known as a T – Account.
2. The left side is used for debit (Dr) entry and the right side is used for
credit (Cr) entry.

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3. It has a title which is the name of a specific asset, liability, capital,
income or expense.
4. It has 4 columns on the debit side and the credit side i.e.,
− Date column
− Details column
− Ledger folio column
− Amount column

Dr Title (Name of Account) Cr

Date Details L.F. Ksh. Date Details L.F. Ksh.

A summary of the accounts:

Dr Asset Account Cr Dr Liability Account Cr

Increase Decrease Decrease Increase

Dr Expense Account Cr Dr Income Account Cr

Increase Decrease Decrease Increase

Dr Capital Account Cr Dr Drawings Account Cr

Increase Increase

NB/: -
A decrease in capital is not debited in the capital account but it is debited in a
drawings account.
Drawings consist of a business assets removed from the business by the owners for
private use i.e., personal purpose or personal use.
Owners may make drawings from their business in various ways including:
(i) When they take away money from the business cash box or from business bank
account for personal use.
(ii) When they take away some stock from the business for personal use.
(iii) When their personal expenses are paid for by the business.
(iv) When they take away some of the non-current assets from the business for
personal use.

The Asset of Stock (Inventory)

Stock refers to goods bought by a business for resale. Stock is analysed in the
following kinds for accounting purposes:

1. Purchases
This is stock bought by a business from suppliers within an accounting period. The
cost price is recorded on the debit side of a Purchases Account. It shows an
increase of the asset of stock in the business. It also shows an increase of
expense in the business.

Dr Purchases Account Cr
√

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2. Sales
This is stock sold by a business to customers within an accounting period. The
sales value is recorded on the credit side of a Sales Account. It shows a decrease
of the asset of stock in the business. It also shows an increase of income in the
business.

Dr Sales Account Cr
√

3. Purchases returns/Returns outward

These are stocks returned back by a business to the suppliers. The cost price is
recorded on the credit side of a Purchases Returns Account or Returns Outward
Account. It shows a decrease of the asset of stock in the business.

Dr Purchases Returns Account Cr

√

4. Sales returns/returns inward

These are stocks returned back to the business by customers. The sales value is
recorded on the debit side of a Sales Returns Account or Returns Inward Account. It
shows an increase of the asset of stock in the business.

Dr Sales Returns Account Cr

√

CARRIAGE INWARDS AND CARRIAGE OUTWARDS

1. Carriage Inwards
This is transport cost incurred by a business in moving purchases from the
suppliers’ premises to the business. This cost is recorded on the debit side of a
Carriage Inwards Account.

Dr Carriage Inwards Account Cr

√

2. Carriage Outwards
This is transport cost incurred by a business in moving goods sold (sales) from the
business to the customer’s premises. This cost is recorded on the debit side of a
Carriage Outwards Account.

Dr Carriage Outwards Account Cr

√

Balancing the Ledger Accounts

“Account balance” is an accounting term representing the difference between the
total of the debit side and credit side of a ledger account. The following
procedure can be used in balancing a ledger account:
(i) Calculate the total on the debit side and total of the credit side of the
ledger account.
(ii) Select the greater of the two totals and make it the total of the debit side
and the credit side on the amount columns.
(iii) Calculate the balancing (missing) figure on the side with a shortfall and
call it balance carried down (Bal. c/d) or balance carried forward (Bal.
c/f).
(iv) Transfer this balancing figure to the opposite side of the account below the
total and call it balance brought down (Bal. b/d) or balance brought forward
(Bal. b/f).

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TRIAL BALANCE
At the end of every accounting period, all ledger accounts are balanced. A ledger
account can have either a debit balance or credit balance or self-balancing.
However, only debit balances and credit balances are used to prepare a trial
balance.
A trial balance is, therefore, a list of all debit balances and credit balances
extracted from the ledger accounts as at a specific date. It is prepared by listing
all debit balances on the debit column and all the credit balances on the credit
column of the trail balance.
The total of all debit balances must be equal to total of all credit balances if
there are no errors in the ledger accounts.

Purpose Of a Trial Balance

1. To check the arithmetical accuracy of the work done when posting and balancing
the ledger accounts i.e., whether correct additions and subtractions were done
in the ledger accounts.
2. To check whether the double entry system of accounting has been followed when
posting transactions to the ledger accounts i.e., for every debit entry, make
a matching credit entry.
3. To provide a summary of the work done in the ledger accounts by listing down
the balances of individual ledger accounts.
4. To provide information needed to prepare financial statements.

Format of a Trial Balance

DCT2305B Ltd.
Trial Balance
As At 31 December 20X9
Dr. Cr.
Ksh. Ksh.
Capital xx
Drawings xx
Any asset xx
Any liability xx
Any expense xx
Any income xx
xx xx
Note:
Assets, expenses and drawings are listed on the debit column while capital,
liabilities and incomes are normally listed on the credit column.

Accounting Errors
When the total of the debit balances is equal to the total of credit balances the
trial balance is said to be balanced. However, if the two totals are not equal it
means that there is an error either in the trial balance or in the ledger accounts.
However, 2 types of accounting errors may occur:

1. Errors That Affect the Agreement of The Trial Balance Totals

These errors are disclosed by a trial balance because the totals of the debit side
and credit side will not be equal i.e., will not agree. These errors include:
(a) Arithmetic errors relate to wrong additions or subtractions when balancing
the
ledger accounts.
(b) Single entry error occurs when a debit entry is made in a ledger account and
no matching credit entry is made.
(c) Transposition error occurs when the position of a specific character in a
given

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figure is altered e.g., make a debit entry of 65 and a matching credit entry
of 56.
(d) A debit balance of a particular ledger account is transferred to the credit
column of the trial balance or vice versa.
(e) Transferring a wrong balance from a ledger account to the trial balance.
(f) Omission of a balance in the trial balance.

2. Errors That Do Not Affect the Agreement of The Trial Balance Totals
The following errors may have been committed in the books of account despite the
fact that the debit and credit column totals of the trial balance are equal.
(a) Error of Omission
It occurs when a transaction is not posted to the ledger accounts e.g., a business
sold goods in cash Ksh.1,000. The cash account was not debited with Ksh.1,000 and
the sales account was not credited with Ksh.1,000.
(b) Error of Commission
It occurs when a transaction is recorded in the correct class of account but in the
wrong person’s account e.g., a business bought goods worth Ksh.2,000 from S. Otieno
on credit. The purchases account was correctly debited with Ksh.2,000 but a credit
entry was wrongly made in S. Atieno account with Ksh.2,000, who is a different
supplier/seller.
(c) Error of Principle
It occurs when a transaction is entered in the wrong class of account e.g., a
business bought furniture worth Ksh.5,000 for cash. The purchases account was
wrongly debited with Ksh.5,000 instead of debiting the furniture account but a
credit entry was correctly made in the cash account with Ksh.5,000. Furniture is a
non-current asset while purchases (stock) is a current asset.
(d) Error of Original Entry
It occurs when a wrong amount in a transaction is debited and credited in the
correct ledger accounts e.g., a business sold goods worth Ksh.750 in cash. The cash
account was wrongly debited with Ksh.7,500 and the sales account was wrongly
credited with Ksh.7,500.
(e) Compensating Error
It occurs when an error, by coincidence, cancels out another error i.e., it occurs
when an error on the debit side of an account is offset by an error of equal amount
on the credit side of another account. It is an error that overstates (or
understates) both a debit side and credit side of different accounts by the same
amount e.g., the credit balance of the sales account is overstated by Ksh.200 and
the debit balance of the wages account is overstated by Ksh.200.
(f) Error of Complete Reversal of Entries
It occurs when the correct amount is posted in correct accounts but on the wrong
side of the accounts i.e., double entry rules are ignored when posting a
transaction to the accounts e.g., a business sold goods worth Ksh.1,000 in cash.
Instead of crediting the sales account, it was wrongly debited with Ksh.1,000 and
instead of debiting the cash account, it was wrongly credited with Ksh.1,000.

CASH BOOK
A cash book is both a specific journal and a ledger account.
It is a specific journal for recording all cash receipts and cash payments. It is a
book of original entry since cash transactions are recorded for the first time from
the source documents i.e., cash receipts.
It is a ledger account in the sense that it is drawn like any other ledger account.
A cash book puts together cash in hand account and cash at bank account on one page
in the ledger. Previously, these two accounts were shown on two separate pages of
the ledger.
All cash and cheque receipts are recorded on the debit side of the cash book. It
shows an increase of the asset of cash in the business. All cash and cheque

CPA NJIRU_NJERU ALEX 13

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payments are recorded on the credit side of the cash book. It shows a decrease of
the asset of cash in the business.
The word “cash” is normally used to mean both cash in hand and cash at bank.

Types of Cash Books

There are 4 types of cash books as follows:
1. Single column cash book
2. Double column cash book
3. Triple column cash book
4. Petty cash book

1. Single Column Cash Book

It is also known as One Column Cash Book. It is used by traders who carry out all
their transactions in cash only. All cash receipts are recorded on the debit side
and all cash payments are recorded on the credit side. It is a one column cash book
since it has one column for the amount on the debit side and the credit side.

Dr Single Column Cash Book Cr

Date Details Folio Ksh. Date Details Folio Ksh.

2. Double Column Cash Book

It is also known as Two Column Cash Book. Most traders find it convenient to open a
bank account for their business and make some of their receipts and payments
through it. Such traders use a double column cash book. It has a cash in hand and
cash at bank columns on the debit side and credit side. These columns are headed as
‘Cash’ and ‘Bank’ i.e.,

Dr Double Column Cash Book Cr

Date Details Folio Cash Bank Date Details Folio Cash Bank
Ksh. Ksh. Ksh. Ksh.

If a trader receives a cheque or deposits any cash in the bank, he enters it in the
Bank column on the debit side of the cash book. If the trader issues a cheque or
withdraws money from the bank, he enters it in the bank column on the credit side
of the cash book. Cash receipts and payments are entered in the debit and credit
sides respectively in cash columns of the cash book. It is a double column cash
book since it has two columns for the amount on the debit side and the credit side.

Contra Entries:
If some cash is deposited with the bank out of the business cash box an entry would
made as follows:
(i) In the Bank column on the debit side of the cash book to signify that the bank
has received the money.
(ii) In the cash column on the credit side of the cash book to signify that some
cash has left the business cash box.

Entries that appear on opposite sides of the same account (page) are called Contra
Entries. Recall that a cash book is also a ledger account.
Contra entries also appear when cash is withdrawn from bank to be kept in the
business cash box. In this case contra entries would be as follows:
(i) In the cash column on the debit side of the cash book to signify that cash has
entered the business cash box.
(ii) In the bank column on the credit side of the cash book to signify that some
cash has left the bank.

CPA NJIRU_NJERU ALEX 14

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When contra entries are made in the cash book, letter ‘C’ is written against them
in the folio column. If there are many contra entries then they are identified as
C1, C2, --------- Cn etc.

3. Triple Column Cash Book

It is also known as Three Column Cash Book. Certain traders may offer or receive
discount on goods sold or bought respectively. These traders use a triple column
cash book. There are two kinds of discount:
(a) Discount Allowed
It is a discount which is allowed to the debtors. It is a loss to the business
(i.e., an expense) and so it is debited in the ledger account.
(b) Discount Received
It is a discount which is received from the creditors. It is a gain to the business
(i.e., an income) and so it is credited in the ledger account.
It is a three-column cash book since it has three columns for the amount on the
debit side and the credit side.

Dr Triple Column Cash Book Cr

Date Details Folio DA Cash Bank Date Details Folio DR Cash Bank
Ksh. Ksh. Ksh. Ksh. Ksh. Ksh.

BANK RECONCILIATION STATEMENT

At regular intervals, banks send statements of accounts to those persons that have
current accounts with them. These statements show cash balance at the start of a
month, all the deposits and payments (withdrawals) of cash and cheques during the
month, any charges, daily balances and the balance at the end of the month. These
statements of accounts are known as a Bank Statements.
The transactions which take place between the bank and a business which is a
customer of the bank are recorded in:
(i) Cash book of the business prepared by the business. Cheque and cash
paid/deposited into the bank is debited in the cash book which shows an
increase of the asset of cash at bank in the business while a cheque issued is
credited to show a decrease of the asset of cash at bank in the business.
(ii) Bank statement of the business prepared by the bank. Cheque and cash received
by the bank from the business is credited in the business bank account to show
an increase of a liability in the bank while a withdrawal will be debited in
the business bank account to show a decrease of a liability in the bank.
The amount of cash at bank which is to appear on the statement of financial
position as a current asset of a business should be that adjusted amount of cash
owned at the close of business on that date. To determine this amount, it is
necessary to reconcile the periodic bank statement balance with the balance of cash
at bank as shown by the business cash book bank columns. This is because the
balance as shown on the bank statement will usually be different with that shown on
the business cash book bank columns since certain transactions will have been
recorded by the business but not by the bank and vice versa. To explain or
reconcile the difference that exist between these two figures (i.e., balances), a
statement known as a Bank Reconciliation Statement is prepared. The items which
contribute to this difference are:
1. those on the bank statement but not on the business cash book,
2. those on the business cash book but not recorded by the bank.

1. Items appearing on the bank statement but not in the cash book
(a) Direct credits or deposits – these are cash or cheque deposits made by
customers in the business’s account without the knowledge of the business.

CPA NJIRU_NJERU ALEX 15

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In this case, the business will update its cash book by adding these
amounts on the debit side.
(b) Bank commissions and service charges – the bank may impose some charges on
the business bank account for services provided. In this case, the
business will update its cash book by deducting these amounts on the
credit side.
(c) Credit transfers or collections – the bank may collect some funds on
behalf of the business and deposit (i.e., credit) the amount in the
business account e.g., dividends. In this case, the business will update
its cash book by adding these amounts on the debit side.
(d) The bank may deposit (i.e., credit) the business account with interest
earned on the deposits. In this case, the business will update its cash
book by adding these amounts on the debit side.
(e) The bank may charge (i.e., debit) the business account with interest
incurred on loan. In this case, the business will update its cash book by
deducting these amounts on the credit side.
(f) Standings orders – these are orders by the business to the bank to make
regular payments of fixed amounts at stated dates to certain organisations
or persons from its account. In this case, the business will update its
cash book by deducting these amounts on the credit side.
(g) Dishonoured cheques (bounced cheques)– the bank may refuse to clear a
cheque that was deposited by the business due to various reasons such as
stale cheques, post-dated cheques, insufficient funds, difference in
amount in words and figures etc. Thus, the bank will debit this cheque in
the business account. In this case, the business will update its cash book
by deducting the cheque amount on the credit side.
(h) Direct debits or withdrawals – it occurs when a business allows another
person to get or withdraw funds from its account directly e.g., a business
may allow its suppliers to withdraw the amount due to them at the end of
every month. In this case, the business will update its cash book by
deducting the amount on the credit side.
(i) Bank errors – these are wrong entries made by the bank in business
account. However, bank errors are not entered in the cash book. They
should be noted and brought to the attention of the bank and corrected by
the bank.

2. Items that appear in the cash book but not on the bank statement
(a) Un-presented cheques – these are cheques issued by the business to 3rd
parties. On issue of these cheques, the business records these in its cash
book on the credit side. However, the holders of the cheques may not
present them to the bank immediately for payment. In such a case, the
business account in the bank is not recorded with these cheques.
(b) Un-credited cheques – these are cheques received and recorded in the cash
book but not credited by the bank. The bank requires time to establish the
validity of the cheques before it makes credit entries in the business
account.
(c) Book errors – these are mistakes done by the business bookkeepers when
entering amounts in the cash book on the debit side or credit side. Once
noted, the business will correct these errors in the cash book.

The Procedure of Preparing a Bank Reconciliation Statement

1. The business receives a bank statement from the bank.
2. The business compares the entries in the cash book with those entries in the
bank statement.
3. If there are entries in the bank statement but not in the cash book, then the
business will update its cash book with those entries. Corrections should also

CPA NJIRU_NJERU ALEX 16

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be made in the cash book for book errors. Finally, the updated cash book will
show a new balance carried down.
4. If there are entries in the cash book and not in the bank statement, the
business will not be able to update the bank statement. Therefore, it will
identify those items and prepare a bank reconciliation statement as follows:

Bank Reconciliation Statement

As at 31.12.20X9

Ksh. Ksh.
Balance as per updated cash book xx
Add: Un–presented cheques xx
Errors by bank that increase bank balance xx xx
xx
Less: Un-credited cheques xx
Errors by bank that reduce bank balance xx (xx)
Balance as per bank statement xx

4. Petty Cash Book

It may be necessary to keep some cash in the office to meet certain urgent or minor
expenses which cannot conveniently be paid by cheques e.g., stationery, bus fare,
newspapers for the office, milk for office tea, entertainment etc. Such minor
expenses are called petty expenses. The cash kept in the office by a clerk known a
petty cashier to pay for petty expenses is called petty cash fund. These payments
are then recorded in a petty cash book.

The Layout of a Petty Cash Book

The petty cash book has the following columns:
1. Date column
2. Detail column
3. Petty cash voucher number (PCV No.) column
4. Receipts column to record the amount received by the petty cashier from the main
cashier.
5. Payments column
6. Analysis column which has sub-columns for recording payments made for various
items i.e., each sub-column being reserved for a particular expense account.
7. Ledger sub-column. It is the last of analysis sub-column in which is recorded
those payments which there is no specific analysis column.

Format of a Petty Cash Book

Date Detail PCV No. Receipts Payments Analysis

Wages Postage Stationery Transport Ledger

The Imprest System

Most petty cash funds are managed based on the imprest system. Under this system,
the petty cashier is given a certain amount of money i.e., a cash float known as
imprest the time fund is first established. The petty cashier maintains records of
all the expenses paid out either by keeping receipts or preparing petty cash
vouchers which are signed against. At the end of each month, the petty cashier is
reimbursed the exact amount spent on the expenses during the month so that at the
start of the next month the petty cashier has the same cash float e.g., if the cash
float is Ksh.1,000 and the petty cashier has spent Ksh.873 in September, he would
be left with Ksh.127 on 30 September. On 1 October the petty cashier will be
reimbursed with a cheque for Ksh.873, thus restoring the cash float to Ksh.1,000.

CPA NJIRU_NJERU ALEX 17

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When the petty cashier is reimbursed, he/she is asked to surrender all the petty
cash vouchers for the month which are carefully checked by the main cashier before
issuing the reimbursement cheque. It there follows that at any given moment the
petty cashier is in possession of petty cash vouchers for only the current month.
This means that the total vouchers paid up to any date and the amount of cash with
the petty cashier should be equal to the cash float. This serves as a useful
control over the efficiency and honesty of the petty cashier.

PREPARATION OF FINANCIAL STATEMENTS

Introduction
At the end of every accounting period a business is required to prepare financial
statements. The financial statements are in the form of:
1. Income statement
2. Statement of financial position
3. Statement of cash flows

1. INCOME STATEMENT
It shows the profit or loss made by a business from all its activities during an
accounting period. Profit or loss is determined in two stages:

Stage 1: Determination of gross profit or loss

Gross profit is the income received by a business because of trading in stock.
Gross loss is the expense incurred by a business because of trading in stock.

Gross profit or loss may be calculated using the following formula:

𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡/(𝑙𝑜𝑠𝑠) = 𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 (𝑜𝑟 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠)

Where:
(i) 𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 = 𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 − 𝑅𝑒𝑡𝑢𝑟𝑛𝑠 𝑖𝑛𝑤𝑎𝑟𝑑
(ii) 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑠𝑎𝑙𝑒 – 𝑐𝑙𝑜𝑠𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
(iii) 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑠𝑎𝑙𝑒 = 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 + 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 + 𝐶𝑎𝑟𝑟𝑖𝑎𝑔𝑒 𝑖𝑛𝑤𝑎𝑟𝑑𝑠 − 𝑅𝑒𝑡𝑢𝑟𝑛𝑠 𝑜𝑢𝑡𝑤𝑎𝑟𝑑

Gross profit or loss can also be determined by preparing a Trading Account.

Format of a Trading Account

DCT2305B Ltd
Trading Account
For the Year Ended 31.12.20X9
Ksh. Ksh. Ksh.
Stock 1.1.20X9 XX Total sales XX
add Purchases XX less Returns inward XX
add Carriage inwards XX Net sales XX
XX
less Returns outward XX XX
Cost of goods available for sale XX
less Stock 31.12.20X9 XX
Cost of sales XX
Gross profit c/f XX
XX XX
Gross profit b/f XX

Stage 2: Determination of net profit or loss

To determine the net profit or loss, the operating expenses of a business are
deducted from the gross profit or loss determined in Stage 1 plus other incomes
from sources other than those from its daily trading activities.

CPA NJIRU_NJERU ALEX 18

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Net profit or loss may be calculated using the following formula:

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡/ (𝐿𝑜𝑠𝑠) = 𝐺𝑟𝑜𝑠𝑠 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠

Where:
(i) 𝐺𝑟𝑜𝑠𝑠 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡/(𝑙𝑜𝑠𝑠) + 𝑂𝑡ℎ𝑒𝑟 𝑖𝑛𝑐𝑜𝑚𝑒𝑠
(ii) 𝑂𝑡ℎ𝑒𝑟 𝑖𝑛𝑐𝑜𝑚𝑒𝑠 = 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑, 𝑟𝑒𝑛𝑡 𝑖𝑛𝑐𝑜𝑚𝑒, 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑖𝑛𝑐𝑜𝑚𝑒, 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑒𝑡𝑐
(iii) 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 = 𝑠𝑎𝑙𝑎𝑟𝑖𝑒𝑠 𝑎𝑛𝑑 𝑤𝑎𝑔𝑒𝑠, 𝑐𝑎𝑟𝑟𝑖𝑎𝑔𝑒 𝑜𝑢𝑡𝑤𝑎𝑟𝑑𝑠, 𝑟𝑒𝑛𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒, 𝑏𝑎𝑛𝑘 𝑐ℎ𝑎𝑟𝑔𝑒𝑠 𝑒𝑡𝑐

Net profit or loss can also be determined by preparing a Profit and Loss Account.

Format profit and loss account

DCT2305B Ltd
Profit and Loss Account
For the Year Ended 31.12.20X9
Operating Expenses: Ksh. Ksh. Ksh.
Rent and rates XX Gross profit b/f XX
Carriage outwards XX add Discounts income XX
Depreciation XX add Interest income XX
Wages and salaries XX add Rent income XX
Discounts allowed XX add Other incomes XX
Insurance XX Gross income XX
Bank charges XX
Electricity XX
Other expenses XX XX
Net profit c/f XX
xx XX
Net profit b/f XX

NB/: -
In practice, the trading account and the profit and loss account are combined to
form one account known as the trading and profit and loss account. Currently, the
trading and profit and loss account is known as the Income Statement.

Format of an Income Statement

DCT2305B Ltd
Income Statement
For the Year Ended 31.12.20X9
Ksh. Ksh. Ksh.
Stock 1.1.20X9 XX Sales XX
add Purchases XX less Returns inward XX
add Carriage inwards XX Net sales XX
XX
less Returns outward XX XX
Cost of goods available for sale XX
less Stock 31.12.20X9 XX
Cost of goods sold XX
Gross profit c/f XX
XX XX
less Operating expenses: Gross profit b/f XX
Rent and rates XX add Discounts income XX
Carriage outwards XX add Interest income XX
Depreciation XX add Rent income XX
Wages and salaries XX add Other incomes XX
Discounts allowed XX Gross income XX

CPA NJIRU_NJERU ALEX 19

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Insurance XX
Bank charges XX
Electricity XX
Other expenses XX XX
Net profit c/f XX
XX XX
Net profit b/f XX

2. STATEMENT OF FINANCIAL POSITION

It is prepared after the preparation of the income statement. It shows the
financial status of a business as at a particular date i.e., it basically shows the
value of assets a business owns and what obligations it owes to the owner(s) (i.e.,
capital) as well as to outsiders (i.e., liabilities) as at a specific date, usually
at the end of an accounting period.

Changes of Capital in the Statement of Financial Position

Capital represents owner’s equity or claims in a business and it keeps changing
when preparing a statement of financial position. Capital can change due to the
following:
(i) Profit – the net profit generated by the business increases capital in the
statement of financial position.
(ii) Loss – the net loss generated by the business reduces capital in the
statement of financial position.
(iii) Drawings – this is cash or other assets taken away from the business by the
owner (s) for personal use and so reduces capital in the statement of
financial position.
(iv) Additional investments – this is cash or other assets brought into the
business by the owner(s) from personal belongings and so increases capital in
the statement of financial position.

The statement of financial position is based on the accounting equation i.e.,

𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

If all double entry rules are followed, the statement of financial position should
balance.
The financial status of a business can also be determined by preparing a statement
of financial position.

Format of a Statement of Financial Position

DCT2305B Ltd
Statement of Financial Position
As At 31.12.20X9
Cost A/Dep NBV
Non-Current Assets: Ksh. Ksh. Ksh. Ksh. Ksh.
Land XX - XX Capital XX
Buildings XX XX XX add Net profit XX
Fixtures, furniture and fittings XX XX XX XX
Motor vehicles etc XX XX XX less Drawings XX
XX XX XX XX
Current Assets: Non-Current Liabilities:
Stock XX Bank loan XX
Accounts receivable XX Debentures XX XX
less Provision for doubtful debts XX XX Current Liabilities:
Prepaid expenses XX Accounts payable XX
Receivable incomes XX Bank overdrafts XX
Cash at bank XX Unpaid expenses XX

CPA NJIRU_NJERU ALEX 20

[DCT2305B] [FINANCIAL APPLICATIONS]
Cash in hand XX XX Income received in advance XX XX
XX XX

END OF YEAR ADJUSTMENTS

After the preparation of a trial balance, new or additional information on incomes
and expenses is received by a business. This is because transactions take place
throughout the accounting period. However, some transactions may affect incomes or
expenses of more than one accounting period. Therefore, adjusting entries are
needed at the end of each accounting period to accommodate this new or additional
information.

Types of Adjusting Entries

The exact number of adjustments needed at the end of each accounting period depends
upon the nature of the business’s activities. Most adjusting entries however, fall
into one of the following general categories:
1. Unpaid /accrued /outstanding expense
2. Prepaid /unexpired expense
3. Receivable / accrued /outstanding income
4. Income received in advance/prepaid income
5. Bad debts
6. Provision for doubtful debts
7. Provision for depreciation of non-current assets

1. Unpaid/Accrued /Outstanding Expense

This is an expense that has been incurred by a business in the accounting period
but not yet paid. In this case the adjustment will be as follows:
(a) The unpaid expense will be debited in the relevant expense account, and
(b) The unpaid expense will be shown as a current liability in the statement of
financial position.

2. Prepaid/Unexpired Expense
This is an expense paid for in advance. In this case the adjustment will be as
follows:
(a) The prepaid expense will be credited in the relevant expense account, and
(b) The prepaid expense will be shown as a current asset in the statement of
financial position.

3. Receivable/Accrued/Outstanding Income
This is income earned during the accounting period but has not yet been received as
at the end of the accounting period. In this case the adjustment will be as
follows:
(a) The receivable income will be credited in the relevant income account, and
(b) The receivable income will be shown as a current asset in the statement of
financial position.

4. Income Received in Advance/Prepaid Income

This is income received during the accounting period but not yet earned. In this
case the adjustment will be as follows:
(a) The income received in advance is debited in relevant income account, and
(b) The income received in advance will be shown as a current liability in the
statement of financial position.

5. Bad Debts
A large portion of business sales are on credit. However, some of these credit
sales are not paid for and are known as bad debts. Bad debts are therefore the
irrecoverable debts from the customer-debtors. Usually, they occur because of any
of the following reasons:

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(i) the debtor has died;
(ii) the debtor has been declared bankrupt by a court of law;
(iii) the debtor refusing to pay;
(iv) the debtor cannot be traced etc

These debts are regarded as a loss to the business and therefore written off as
operating expenses. In this case the adjustment will be as follows:
(a) The bad debts will be credited in the accounts receivable account,
(b) The bad debts are treated as an operating expense in the profit and loss
account, and
(c) The accounts receivable account balance will be shown as a current asset in
the statement of financial position.

6. Provision for Doubtful Debts

Doubtful debts are those whose recovery is in doubt i.e., the amount to be received
from debtors may or may not be received. Debtors with such debts take so long to
pay. Businesses anticipate losses on such debts and therefore provide for them in
advance by charging them as an operating expense in the profit and loss account.
Sometimes the provision for doubtful debts created may be an over estimate or
underestimate which result to it being more or less than the actual bad debts. In
this case the adjustment will be as follows:
(a) If there is an increase in provision for doubtful debts it is treated as an
operating expense in the profit and loss account.
(b) If there is a decrease in provision for doubtful debts it is treated as other
income in the profit and loss account.

NB:
Provision for doubtful debts is also known as provision for bad debts or provision
for bad and doubtful debts.

7. Provision for Depreciation of Non-current Assets

Depreciation refers to the estimated loss (fall) in value of non-current assets due
to Usage over time i.e., wear and tear

Methods of Estimating Depreciation Amounts:

There are 2 main methods that may be used to estimate depreciation amounts:

(a) Straight-line method

Under this method, a uniform amount of depreciation is charged every year
throughout the useful life of the asset.

Depreciation to be charged per year can be estimated as follows:

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡 – 𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑐ℎ𝑎𝑟𝑔𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 =
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒

The expected useful life of an asset is the number of years the asset is estimated
to be used productively by the business.
Scrap value is the estimated market price of the asset at the end of its useful
life. It is also knowns residual value.

If the scrap value of an asset nil, then:

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑐ℎ𝑎𝑟𝑔𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 =
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒

Alternatively, it can be estimated as follows:

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𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑐ℎ𝑎𝑟𝑔𝑒 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 (%) × 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡

(b) Reducing balance method

Under this method, the amount of depreciation charged during the year is estimated
as a percentage on the net book value of the asset at the beginning of the
accounting period i.e.,

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑐ℎ𝑎𝑟𝑔𝑒 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 (%) × 𝑁𝑒𝑡 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒

Where:
𝑁𝑒𝑡 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡 − 𝐴𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

FUNDAMENTALS OF STOCK CONTROL

MEANING OF WORKING CAPITAL

Working capital is the value of current assets less the value of current
liabilities.

𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

OBJECTIVES OF WORKING CAPITAL MANAGEMENT

The two main objectives of working capital management are:
1. To increase the profits of a business.
2. To provide sufficient liquidity to meet short term obligations as they fall
due.

COMPONENTS OF WORKING CAPITAL

1. Current assets
(a) Inventories (Stocks)
(b) Accounts receivable (debtors)
(c) Prepaid expenses
(d) Receivable/accrued incomes
(e) Bills receivable
(f) Short-term investments e.g., treasury bills
(g) Loans and advances to other entities
(h) Cash at bank
(i) Cash in hand

2. Current liabilities
(a) Accounts payable (creditors)
(b) Outstanding/accrued expenses
(c) Bills payable
(d) Short-term loans and advances from other entities
(e) Dividend payable
(f) Bank overdraft
(g) Provision for taxation

Working capital management is concerned with the ways and means of making current
assets adequate to meet the firm’s short-term obligations i.e., current
liabilities.

IMPORTANCE OF WORKING CAPITAL MANAGEMENT

An accountant should manage the current assets and current liabilities efficiently
so as to ensure that the company has sufficient working capital due to the
following reasons:
- to facilitate its operations
- for smooth running of business

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- profitability with manageable risk
- to increase the possibility growth and development
- enhance smooth payment
- increase its goodwill to various stakeholders
- to have a better trade relationship etc
Thus, a company should avoid situations of inadequate working capital or excessive
working capital but rather hold optimum levels of working capital – neither too
little nor too high

STOCK MANAGEMENT
Stock can be defined as idle items held in the store waiting to be sold outside the
business.

Setting Stock Levels

Stock levels are usually set by businesses as a policy matter. Management must make
decisions about the control of stock levels with a view to minimizing the cost of
the business while achieving more efficiency in the availability of stock to fulfil
planned usage requirements. Consideration should be given to the following control
levels:

1. Minimum Stock Level

This is the level below which stock should not normally be allowed to fall. Minimum
stock level is calculated as follows:

𝑴𝒊𝒏𝒊𝒎𝒖𝒎 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝒍𝒆𝒗𝒆𝒍 = 𝒓𝒆𝒐𝒓𝒅𝒆𝒓 𝒍𝒆𝒗𝒆𝒍 − (𝒏𝒐𝒓𝒎𝒂𝒍 𝒖𝒔𝒂𝒈𝒆 × 𝒏𝒐𝒓𝒎𝒂𝒍 𝒓𝒆𝒐𝒓𝒅𝒆𝒓 𝒑𝒆𝒓𝒊𝒐𝒅)

2. Maximum Stock Level

This is the upper limit above which stock should not normally be allowed to exceed.
Maximum stock level may be computed as follows:

𝑴𝒂𝒙𝒊𝒎𝒖𝒎 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝒍𝒆𝒗𝒆𝒍 = 𝒓𝒆𝒐𝒓𝒅𝒆𝒓 𝒍𝒆𝒗𝒆𝒍 + 𝒓𝒆𝒐𝒓𝒅𝒆𝒓 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 − (𝒎𝒊𝒏𝒊𝒎𝒖𝒎 𝒖𝒔𝒂𝒈𝒆 × 𝒎𝒊𝒏𝒊𝒎𝒖𝒎 𝒓𝒆𝒐𝒓𝒅𝒆𝒓 𝒑𝒆𝒓𝒊𝒐𝒅)

3. Reorder Quantity
This is the quantity that should be purchased when the reorder level is reached.
Reorder quantity may be calculated as follows:
𝑹𝒆𝒐𝒓𝒅𝒆𝒓 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 = 𝒎𝒂𝒙𝒊𝒎𝒖𝒎 𝒔𝒕𝒐𝒄𝒌 𝒍𝒆𝒗𝒆𝒍 − 𝒓𝒆𝒐𝒓𝒅𝒆𝒓 𝒍𝒆𝒗𝒆𝒍 + (𝒎𝒊𝒏𝒊𝒎𝒖𝒎 𝒖𝒔𝒂𝒈𝒆 × 𝒎𝒊𝒏𝒊𝒎𝒖𝒎 𝒓𝒆𝒐𝒓𝒅𝒆𝒓 𝒑𝒆𝒓𝒊𝒐𝒅)

4. Reorder Level
Is a point that lies between maximum and minimum stock levels at which purchase
orders must be placed to ensure that goods ordered are received before the minimum
stock level is reached. Reorder level may be calculated as follows:

𝑹𝒆𝒐𝒓𝒅𝒆𝒓 𝒍𝒆𝒗𝒆𝒍 = 𝒎𝒂𝒙𝒊𝒎𝒖𝒎 𝒖𝒔𝒂𝒈𝒆 × 𝒎𝒂𝒙𝒊𝒎𝒖𝒎 𝒓𝒆𝒐𝒓𝒅𝒆𝒓 𝒑𝒆𝒓𝒊𝒐𝒅

5. Average Stock Level

The number of units expected in the store at any one time. Average stock level may
be calculated as follows:

(𝒎𝒂𝒙𝒊𝒎𝒖𝒏 𝒔𝒕𝒐𝒄𝒌 𝒍𝒆𝒗𝒆𝒍 + 𝒎𝒊𝒏𝒊𝒎𝒖𝒎 𝒔𝒕𝒐𝒄𝒌 𝒍𝒆𝒗𝒆𝒍)

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒔𝒕𝒐𝒄𝒌 𝒍𝒆𝒗𝒆𝒍 =
𝟐

6. Reorder Period/Lead-Time
The period of time expressed in days, weeks, months between ordering and
replenishment i.e., when goods are available for use. Average reorder period can be
computed as follows:

CPA NJIRU_NJERU ALEX 24

[DCT2305B] [FINANCIAL APPLICATIONS]
(𝒎𝒂𝒙𝒊𝒎𝒖𝒎 𝒓𝒆𝒐𝒓𝒅𝒆𝒓 𝒑𝒆𝒓𝒊𝒐𝒅 + 𝒎𝒊𝒏𝒊𝒎𝒖𝒎 𝒓𝒆𝒐𝒓𝒅𝒆𝒓 𝒑𝒆𝒓𝒊𝒐𝒅)
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒓𝒆𝒐𝒓𝒅𝒆𝒓 𝒑𝒆𝒓𝒊𝒐𝒅 =
𝟐

Balanced Stock Position

The business should maintain a sound stock position. It should have adequate stock
to run its business operations. Both excessive as well as inadequate inventories
are dangerous from the business’s point of view. Excessive stock means holding
costs and idle funds which earn no profits for the business.

(a) Dangers of excessive stock

- It results in unnecessary accumulation of inventories. Thus, chances of
stock mishandling, waste, theft and losses increase.
- It is an indication of defective credit policy and slack collection
period. Consequently, higher incidence of bad debts results, which
adversely affects profits.
- Excessive stock makes management complacent which degenerates into
managerial inefficiency.
- Tendencies of accumulating inventories tend to make speculative profits
grow. This may tend to make dividend policy liberal and difficult to cope
with in future when the business in unable to make speculative profits.
- Excessive stock results in locking up of excess stock.

(b) Dangers of inadequate stock

- It stagnates growth. It becomes difficult for the business to undertake
profitable projects for non-availability of stock funds.
- It becomes difficult to implement operating plans and achieve the
business’s profit target.
- Operating inefficiencies creep in when it becomes difficult even to meet
day-to-to-day commitments.
- Non-current assets are not efficiently utilised for the lack of stock
funds. Thus, the business’s profitability would deteriorate.
- Paucity of stock funds render the business unable to avail attractive
credit opportunities etc.
- The business losses its reputation when it is not in a position to honour
its short-term obligations. As a result, the business faces tight credit
terms.
- Inadequate stock cannot buy its requirements in bulk order.
- The rate of return on investments also falls with the shortage of stock.
- It reduces the overall operation of the business.

An enlightened management should, therefore maintain the right amount of stock on a

continuous basis. Only then a proper functioning of business operations will be
ensured.

Stock control systems

1. ABC System or Pareto analysis

It is also called the 80/20 rule, control by importance/ exception. It concentrates
on high value items. Here, Items are categorised into three classes as follows:
Class A:
These are high cost, fast moving and high usage items. They are few taking only 20%
of the total number of items and the rest take 80% of the total stock budget. The
20% items are worth being under highest control.
Class B:
These are medium moving goods. They account for 15 percent of the total number of
the budget. They are moderately controlled.

CPA NJIRU_NJERU ALEX 25

[DCT2305B] [FINANCIAL APPLICATIONS]
Class C: These are slow moving low value items. They are very many accounting for
65% of the total number of items and only 5% of the total stock budget. These items
might be under simple physical control.

2. Material Requirements Planning (MRP)

This is flow method system in the sense that it orders only what is required to
maintain the production flow. The orders can be for purchased parts or internally
manufactured parts and MRP thus provides the basis for production scheduling and
raw material purchasing.
MRP operates by first determining the requirements for raw material components and
sub-assemblies at each of the prior stages of production.

3. Periodic order system

The business receives a new order of the amount specified by the order quantity at
equal intervals of time. The order quantity is based on the likely demand (factors
that affect demand of the firm’s product), and the current stock levels. The firm
determines the maximum and minimum stock, the safety stock and the reorder level.
For instance, a firm may be supplied with fixed amount of stock every Monday of the
week for the entire period under consideration. This is mostly the case where
consumption is uniform throughout the period.
The stock levels are reviewed at fixed intervals and a replenishment order is
issued where necessary. The review is deemed beneficial as obsolete stock can be
identified and eliminated at the earliest possible instance.

4. Continuous Review System

The firm places orders at regular intervals but the order quantity varies according
to how much a firm requires to bring the level to some predetermined size or value
(to replenish the stock already consumed). This is common with most businesses.
This system exists where consumption fluctuates throughout the period.

5. Just-in-Time Stock System

This concept advocates zero stock and stockless production through just-in-time
purchasing and just-in-time production. Organisations create a closer relationship
with the suppliers and arrange for more frequent deliveries of small quantities.
The objective of just-in-time purchasing is to purchase goods so that delivery is
made immediately before their use.

Valuation of Stock (Issues and closing stock)

A basic condition of a stock control system is that stock movements (issues and
receipts) are accurately recorded. That most frequently maintained records of
inventories in manual systems are Bin Cards and Stock Records. It aims at attaching
a monetary value of stock in the stores or issued for production. This is useful in
costing the output and pricing production, as well as decision making.

A number of methods may be used in the valuation of stock issues. These methods
include:
1. First in first out (FIFO) Method
It is based on the assumption that the stock purchased first is issued first.
Prices of stock purchased first are used to determine the cost or value of stock
issued. Closing inventories are carried at the latest costs.
2. Last in first out (LIFO) Method
It is based on the assumption that the stock purchased last is issued first.
Stock valuation is therefore based on the prices ruling on the purchase of the
last batch of stock.
3. Weighted average price (WAP) Method
Here, the issue price is recalculated after each receipt of inventories taking
into account both quantities and money vale of the inventories received

CPA NJIRU_NJERU ALEX 26

[DCT2305B] [FINANCIAL APPLICATIONS]
(perpetual weighted average). The stock used or unused is based on the average
price per unit where the average price per unit is calculated as follows:

𝑻𝒐𝒕𝒂𝒍 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒑𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕 =
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒐𝒇 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚

Format of a Stores ledger card

DATE RECEIPTS ISSUES BALANCE
20X9 QUANTITY COST/UNIT TOTAL COST QUANTITY COST/UNIT TOTAL COST QUANTITY TOTAL COST
Ksh. Ksh. Ksh. Ksh. Ksh.

FUNDAMENTALS OF PAYROLL
The wages department is responsible for the preparation of the payroll and the
payment of wages. The routine will require:
(a) Analysis of clock cards and check of overtime authorization,
(b) Calculation of bonus,
(c) Compilation of gross earning,
(d) Calculations of deductions,
(e) Preparation of pay details for each employee showing net wages.
(f) Arranging for payment of wages to employees.

Calculation of Deductions
To arrive at net wages, a range of deductions are made from gross earnings when
calculating the net payment due to the employee such deductions may be statutory,
obligatory or voluntary in nature:
(a) Statutory deductions are pay as you earn (PAYE) tax, pensions, and employees’
national insurance contributions. The employer calculates the amount due to be
deducted using the relevant rates in force and then arranges to make a total
payment in respect of all employees to the relevant parastatal bodies to which
they act as agents. Examples of such bodies include Kenya Revenue Authority
(KRA) to whom PAYE tax deducted is remitted, National Hospital Insurance Fund
to whom the national insurance contributions deducted are submitted.
(b) Obligatory deductions are most likely to comprise payments to an approved
pension fund. e.g., National Social Security Fund (NSSF). Once again it is
likely that the employer will make a contribution in addition to the
employee’s contribution.
(c) Voluntary deductions include items such as trade union subscription, charity
deductions and contributions to saving schemes.

The following is a format of a payroll:

PAYROLL
[Link] Name Total hours Rate Gross Net Advance Balance
worked wage Deductions wages due
P.A..Y.E N.S.S.F N.H.I.F Total

------------------------------©THE KIAMBU NATIONAL POLYTECHNIC------------------------------

October 2024

CPA NJIRU_NJERU ALEX 27