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Accounting is the art and science of recording, summarizing, classifying, analyzing and interpreting business transactions.
Why do we study accounts?
Book keeping
This is careful recording of business transactions in monetary terms ie recording must be made in monetary terms but not quantity.
It involves the recording, posting and processing of business records, accounting goes beyond and involves the analysis and interpretation of transactions recorded ie book keeping is part of accounting.
Importance of book keeping
Users of accounting information.
Internal users
External users
Business transaction.
A transaction is any business activities that involves the receipt payment of money (exchange of value) through the purchase or sale of goods and purchases and settlement of payment may be at the time the transaction takes place or at a later date.
It refers to any business dealing between two or more people who involves physical transfer of goods and services in exchange inform of either money or other goods and services.
Cash transaction. Is when goods are purchased and sold on cash basis, these transactions are called cash transaction. In cash transactions. A business pays cash when goods are delivered by the supplier. Similarly a business receive cash when goods are sold to the customers. The two situations are referred as cash purchase and cash sales respectively.
Credit transactions are those transactions when cash is not paid or received at the time of transaction. In this case, cash is received or paid after a specific period from the date of transaction.
When credit transactions are made, a business will have some debtors and creditors.
Debtors. Are those persons or organisation to whom goods are sold on credit basis. They owe money to a business. Money due from debtors is considered as current asset.
Creditors. Are those persons or organisation from whom goods are purchased on credit basis. Money due to creditors is taken as current liabilities.
ASSETS AND LIABILITIES.
Assets and liabilities of any business enterprise are always equal to each other. The two fundamental accounting terms are explained as under.
Assets.
Assets means anything of value owned by a business. These may be classified as under;
Fixed assets. Fixed assets are those assets which are retained for use in the business for a long period of time. Examples include: premises, buildings, plant and machinery, motor vehicles, furniture and fittings and land. These assets are obtained at the start of business. These assets are required to conduct business transactions smoothly.
Intangible assets, these are assets which have no material existence e.g good will, patent right and copy rights, franchise, computer software. If a long established business is purchased by a person then he is supposed to pay something for the reputation of this business.
Current assets. These are short term. These are either inform of cash or can easily be converted to cash in the short period. Some examples of current assets are stock held for resale, debtors, and cash in hand or cash at bank.
Current assets many include also prepayment and payments in advance and incomes outstanding. E.g prepaid rent, prepaid electricity, and outstanding income.
These are used to meet the day to day requirements of the business. These assets provide the liquid resources for the purpose of making payment to the creditors and to the employees.
Liabilities.
Liabilities mean the financial obligation of a business. These may be classified as under;
Long term liabilities or fixed liabilities. These liabilities are payable at a date more than one year form the balance sheet date. These liabilities consist of capital and long term loans. Capital introduced by the owner is intended to remain in the business for as long as it continues to exist. They also include, debentures, mortgages and loans (10 years, 5 years)
Current liabilities.
These are payable by the business for a short period of time. E.g creditors. Bank overdraft, outstanding expenses, taxation payable.
Balance sheet. Is a financial statement prepared to show the position of the business as at a given date. It shows the value of assets and liabilities of that business. The assets and liabilities of a business must always equal to each other. It means the total of assets must be equal to the total liabilities.
Capital. It means a claim by the owner against business. It represents the amount invested by the owner in the business. When a person wants to start a business, he is required to invest money in that business.
The capital is used to buy fixed assets like machines, tools, motor van etc.
Types of capital.
Equity capital. The capital invested by the owner of a business plus any profits attributed to owners is known as equity capital.
Loan capital. Is the amount borrowed by the business. The providers of loan capital are normally paid a fixed rate of interest and they do not share in the profit of a business.
Working capital. May be defined as the difference between current assets and current liabilities of a business. There should be enough working capital for the smooth running of a business.
Capital employed. The term capital employed is used in two different meanings.
Gross capital employed consists of fixed assets plus current assets. Net current assets mean current assets minus current liabilities. The term capital employed is normally used in the sense of net capital employed.
Sources of capital
From the above discussion, we can conclude that capital to start a business may be obtained from.
Book keeping equation.
The fundamental equation of book keeping is the equality between assets and liabilities. It is expressed as under
Liabilities = Assets
(L) = (A)
The above equation can now be expressed as
Capital + Liabilities = Assets
(C) + (L) = (A)
Or
Capital = Assets – Liabilities
(C) = (A) – (L)
Or Capital = Net assets
Net worth = Net Assets
The net assets of a business are referred to as the net worth of that business. It represents owner’s claim on the business. It is also called owner’s equity.
The value of assets, capital and liabilities may change but the equality of the two sides will always be true. The business transactions will affect the position of assets and liabilities over a specific trading period.
The balance sheet is prepared in the basis of the accounting equation which states that
Assets = capital + liabilities
Calculate the capital using the accounting equation.
Example 1
Given that;
Stock shs 10,000
Debtors shs 12,000
Land shs 60,000
Cash shs 8,000
Creditors shs 50,000
Capital = A – L
Capital = shs 90,000 – shs 50,000
Capital = shs 40,000
Example 2
The following balances were extracted from the books of A. Smith as at 31st dec 1998.
Loan from bank shs 50,000
Creditors shs 10,000
Office machinery shs 200,000
Stock of goods shs 35,000
Debtors shs 45,000
Cash at bank shs 30,000
Capital = A – L
Capital = 310,000 – 60,000
Capital = shs 250,000
HOW TO PREPARE A BALANCE SHEET.
There are various ways of preparing a balance sheet.
Use order of liquidity.
Is the presentation of items in the balance sheet according to how easy it is to convert them into cash. Ie from current assets to fixed assets and from current liabilities to long term liabilities.
Order of permanency.
Here items are arranged in the balance sheet according to how permanent they are to stay in the business. Ie from fixed assets to current assets and from fixed liabilities to current liabilities.
Format of a balance sheet.
A balance sheet must have a tittle with name of a business, name of the statement and date of preparation.
Assets are put on one side and liabilities on the other side.
Current assets are separated from fixed assets and so is the case with liabilities.
Example one
The following balances were extracted from the books of A. Smith as at 31 Dec. 1998.
Shs
Capital 250,000
Loan from bank 50,000
Office machinery 200,000
Creditors 10,000
Stock of goods 35,000
Debtors 45,000
Cash at bank 30,000
Required – prepare A. Smith balance sheet as at 31.dec.1998. Showing
We can find out net worth from the above balance sheet as under
Total assets = shs 310,000
Outside liabilities = Loan + creditors
50,000 + 10,000
= shs 60,000
Net worth = Total assets – outside liabilities
Net worth = 310,000 – 60,000
= shs 250,000
Now it is clear that net worth of a business means capital or claim of the owner on the assets of a business.
Revenue and capital expenditure.
The expenditure incurred for conducting a business may be classified
Revenue expenditure is incurred for making normal trading transactions. This expenditure is incurred on the purchase of goods for resale; payment of wages and salaries, rent, water and electricity bills and so on. This expenditure is deducted from the total income of trading period for determining the profit for that period.
Capital expenditure is incurred in the acquisition or addition of fixed assets. This expenditure is not deducted from the income of any trading period while calculating profit for that period. This expenditure is represented in the form of fixed assets in the balance sheet of any business enterprise.
Deferred revenue expenditure is that expenditure the benefit of which will be received in future periods as well as the current period e.g advertisement expenditure.
Accounting Concepts or principles
Accounting concepts are those assumptions, principles or conditions on which the accounting system is based. Principles are set of rules to be followed in accounting. The following are important accounting concepts or principles.
SINGLE ENTRY BOOK KEEPING
This is a system of book keeping where the recording of transaction (entries) is done only when cash is received or paid out by the business. This payment may be by cash or cheque.
This system is outdated and common in small businesses especially retail businesses where most transactions are on cash basis and in small amounts. This means that it is unsuitable for large businesses whose transactions are not necessary effected on a cash basis.
Accounts
An account refers to a record of where transactions which are similar in nature are kept. It is a statement in the ledger, which indicates the dealings with a particular person or item.
Business transactions are recorded in an account. It is divided into two equal sides, one side is the debit (DR) and the other is the credit side (CR)
FEATURES OF ACCOUNT
With the “T” – account format, both the debits and credits are presented on opposite sides of the same page.
The double entry system has accounts categorized as assets (like machinery, motor vehicle, furniture etc), liabilities (like creditors, loan bank overdraft), capital, income and expenses accounts.
Example one
Record the following transactions in Mukene’s cash account and balance off at the end of the month September 2004.
1st commenced business with cash in hand shs 20,000
5th bought goods for cash shs 8,000
10th sold goods for cash shs 5,000
15th paid salary in cash shs 2,500
22nd paid rent in cash shs 800
25th paid rates in cash shs 2,200
28th cash sales to date shs 2,000
30th cash purchases shs 5,400
Example two
Record the following transactions in Kato’s cash account and thereafter balance it off.
2000 shs
May
1st started business with cash 10,000
3rd Bought goods for cash 3,000
6th cash sales to date 4,500
8th Bought land for cash 4,000
11th paid for office expenses in cash 1,800
14th paid for stationary 2,000
18th sold goods for cash 4,800
23rd paid general expenses 2,200
31st cash purchases 1,500
Enter the following transactions in KAWUKI DAVID’S single column cash book that took place in the month of August 2001, balance off the cash book at the end of the month.
August
1st started business with 1,500,000 as capital
3rd paid for welding machine 650,000
5th bought raw materials of 550,000
15th paid for rent in cash for 300,000
17th sold goods for cash 500,000
18th paid for wages in cash 300,000
30th received cash from Paul 400,000
31st paid for electricity in cash 200,000
DOUBLE-ENTRY BOOK KEEPING
By the end of this chapter you should be able to:
Double entry system. This is the system of recording transaction twice as they occur. It is the recording of the double aspect or double affair for every transaction. Every transaction involves two entries in the same set of accounts. Ie a debit entry recording value received while a credit entry recording value given away.
Business transactions are recorded in accounts. The maintenance and recording of transactions within these accounts is known as double-entry bookkeeping. The
‘double-entry’ term is used because each transaction can be seen to have two separate effects on the business.
What does the account show?
Given the ‘T’ shaped appearance of the accounts they are often referred to as ‘T’ accounts. Each of these accounts will show the following:
Account name
The name of the account refers to the type of transaction. For example, if the account is dealing with buying or selling machinery, then the account could simply be known as ‘machinery’. This means that each different type of transaction would be recorded in a separate account.
Debits and credits
The debit side (Dr) and credit side (Cr) refer to the left-hand and right-hand sides of each account. These terms can be used to refer to how entries are made. For example, if we talk of ‘debiting’ an account, all we mean is that we would be placing an entry on the debit side – the left-hand side – of the account.
Account details
The details element of each side of the account will contain the name of the other account which the transaction also affects. As a form of symmetry, each transaction will affect two accounts – hence the term ‘double-entry’ – and the details included in each account will refer to the other account to be affected.
There are some basic principles that must be applied when recording double-entry transactions:
Rules for double-entry transactions
It is vital that transactions are recorded correctly. For this we need to establish on which ‘side’ of the account each transaction needs to be recorded – i.e. should we ‘debit’ or ‘credit’ an account? This will depend on the type of account that we are dealing with.
In Chapter 1 we were introduced to the terms asset, liability and capital. To start with we will consider three separate types of account: for assets, liabilities and capital.
The rules for recording the double-entry transactions are as follows:
Another way of remembering double entry rule
An Asset Debit
Elephant Expense Debit
Is Income / revenue Credit
Lumpy Liabilities Credit
These rules will make more sense if we see some examples of them in action
Example 2.1
On 1 November, the owner places shs 5,000 of her own money into the bank account of the new business.
Explanation
The asset of bank has increased – so we debit that account.
The capital of the business has increased – so we credit that account.
Notice how the detail of each transaction cross-references the other account to be
affected – providing a useful way of locating the other account that is to be affected by the transaction.
Example 2.2
On 3 November, machinery is purchased for shs 2,000, payment made by cheque.
Explanation
The asset of machinery has increased – so we debit that account.
The asset of bank has decreased due to the payment made – so we credit that account.
Example 2.3
On 9 November, equipment is purchased on credit from Perkins Ltd for shs 320.
Explanation
The asset of equipment has increased – so we debit that account.
The liability of creditor* Perkins Ltd has increased – so we credit that account.
* Note: A creditor is someone the business owes money to who is likely to be repaid in the near future..
Advantages of the double entry system
General rules for balancing accounts
Although balancing accounts is fairly straightforward, it can initially cause problems.
Most problems can be avoided if the following points are remembered:
Procedures of balancing
Advantages of balancing accounts.
The following hints will help you avoid errors.
Example one
Annet started business with cash shs 5,000,000 on 1st may 2012
2nd May purchased goods for cash shs 750,000
3rd May opened a bank account and deposited shs 2,000,000
5th May cash sales paid direct into the bank shs 800,000
10th May paid salaries and wages by cheque shs 200,000
12th May cash sales shs 1,000,000
16th May bought motor van by cheque shs 420,000
20th May withdrew shs 600,000 from the bank
22nd May sold goods on credit to Freddie for shs 520,000
25th May received a bank loan by cheque shs 300,000
28th May received a cheque from Freddie for 450,000
30th May bought a generator by cheque shs 6,000,000
Required:
Complete the principle of double entry and extract a trial balance at the end of the period
Accounting process
This is the process which is followed by accountants and book keepers in the processing raw financial data into output information in form of financial statement. The accounting process or cycle is described below.
Stage 1. Occurrence and documentation of business transaction.
Business transaction or deals must be concluded first before anything is documented and recorded. When business transaction occurs, the immediate thing to do is to prepare a business document to show evidence of the transaction. The key documents normally prepared include invoices, payment voucher, receipts, cheques , local purchase orders, delivery notes, goods received notes, bank paying – in – slip etc
Stage 2. Entering transactions to the journals.
Journals are books of original or prime entry; they are the first books to which transactions are entered. Information entered into journals is generated from documents described above. Examples of journals include sales journal, purchases journal, returns journals and the cash book.
Stage 3. Posting of transactions to the ledger.
The information which had been entered into the journals is posted to the ledger. It is therefore true to say that the journal feeds the ledgers. A ledger is a book which contains a collection of accounts.
Stage 4. Preparation of the trial balance.
At the end of a period, normally a month, all accounts are closed or balanced off and the trial balance is extracted. A trial balance is a list of debit and credit balances extracted from the ledger.
Stage 5. End of year adjustments and preparation of financial statement / final accounts.
Financial statement / final accounts are prepared from the trial balance. However, before this is done, the trial balance needs to be adjusted at the end of the year in order to make it up to date. Major adjustments include provision for depreciation , provision for bad debts, adjustment for prepaid expenses and incomes, accrued expenses and incomes etc.
Stage 6. Analysis and interpretation of financial statement.
This is not supposed to the work of accountant but is the domain of the financial analysis strictly speaking the work of accountant stops at the preparation of final accounts or financial statement.
TRIAL BALANCE
Trial balance is a statement containing the various ledger balances on a particular date.
This statement is prepared to check the correctness of ledger posting and balancing of accounts. If the total of the debit balances is equal to the credit balances. It is implied that posting and balancing of accounts are correct
Features of trial balance
Objectives of trial balance
The following are the objectives of preparing trial; balance
SOURCE DOCUMENTS
These are written documents that provide documentary evidence that a transaction has taken place or took place. In other words, they are a proof that a given transaction took place in a business. They include;
An invoice
This is a document sent by the seller to the buyer showing a description of goods sold, it shows the quantity , quality, unit price, total price, discounts if any and the latest date when settlement of debts should be effected.
Delivery note
This is a document sent by the seller to the buyer, to verify that goods or services have been delivered and the customer (buyer) has received them.
Bank statement
This is a document issued by the to a customer for a specified period, showing the details of deposits and withdraws made by the account holder. It alsoshows interest paid or earned, ledger fees (if any) etc
Credit note
This is a document sent by the supplier to the customer to show that there is a reduction in the amount that is owed , it normally happens when some of the goods purchased are returned.
Credit notes can be” incoming credit notes” which are sent by creditors or “ outgoing credit notes” which are sent to debtors.
Cash receipts
These show how much cash was received by the business and from whom the cash was got.
Sales receipts
These show a record of sales made in a given period of time for instance a day.
Debit note
This is a document sent by a seller to the buyer to correct an undercharge on an original invoice. It is also called a supplementary invoice. For instance, it can be sent to the buyer who failed to return the packing materials which were not accounted for an original invoice.
Purchase order
This is sent by the buyer to show a proof that commitments have been made to buy from a named supplier.
Bank deposit slip
It is a document that confirms that cash or a cheque has been deposited into the named bank account.
Payment voucher
It is a document that confirms that payment has been made by the business. It contains the amount , purpose of payment, and date of payment, who received and who authorized the payment.
Staff files
This shows details on personnel in a business, names, when they were recruited, their obligations, qualification and how much they are to be paid.