O-LEVEL/IGCSE ACCOUNTING

THEORY & PRACTICE (a complete text book)

Recommended for CIE Exams
(4th edition)

Muhammad Nauman Malik

MS Accounting (Gold Medalist), FCMA, MBA (Finance), PIPFA, DCMA, B.Com (Gold Medalist)
Keynesian Institute of Management & Sciences (KIMS)

Reviewed By
Sajid Munir
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any
form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written
permission of the Author.

Cambridge International has not provided these questions or answers and can take no responsibility whatsoever for
their accuracy or suitability for the examinations.

Title O-Level Accounting Theory and Practice (4th edition)

Author Muhammad Nauman Malik
Cell: 0300-8414262, 0321-8414262
E-mail: nauman.kims@gmail.com

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 3

PREFACE
Current financial reporting practices have been under major review with the approach of a single market,
moving towards harmonization. Consequently, all global syllabuses, from December 2007 onwards, use
international terminology. The globalized frame work of Cambridge International Ordinary Level, in
practice over 125 countries, has led to the introduction of an international format and layout for all its
syllabuses.

Unfortunately, no book on ‘O’ Level accounting, with the international terminology, is available in the
market. To provide relief to the students of accounting, this book uses international terminology to
prepare them for CIE Ordinary Level Exams.
This book is intended to cover the accounting content of CIE Ordinary Level syllabus comprehensively.
With a thorough discussion of the basic double entry principles for the beginners, it is also useful for those
who have some knowledge. The strengths and weaknesses of accounting practices are reinforced by a set
of Review Questions at the end of each chapter, enabling the students to put, what is learnt, into practice.
These Questions have been developed by the author and are not taken from past exam papers. The topic
of company accounts have been completely updated in the current edition in the light of new syllabus.
Solutions to odd numbered questions are given in the appendix at the end of the book. In addition
solutions to even numbered questions are available in a separate manual. Teachers using “O Level
Accounting - Theory & Practice” as a text book, may get the free manual by applying officially on a school
letterhead.
Providing the students with a solid foundation in the “Why” as well as the “How” of accounting concepts,
the emphasis is put on understanding rather than mere cramming. A brief list of learning objectives at the
beginning of each chapter will assist the readers to determine the things they should understand while
going through the chapter. Hence, checking back may help them to identify weak areas which still need
thorough review.
I would like to thank numerous people for the contribution they made to the writing of this book. In
particular, I gratefully acknowledge the input that Mr. Sajid Munir made in developing the Review
Questions, text for various chapters and for his constructive criticism throughout the process of developing
the book. In addition, my thanks owe to Rabia Malik, Rizwan ul Hassan, Muhammad Afzal, Sh Khurram
Maqbool, Aitzaz Ahmad Tarrar, Ghulam Yaseen and many more for their continuous support and insightful
comments and suggestions during several stages of the book development.
Constructive criticism and suggestions to make the subsequent editions more useful would be appreciated
and thankfully acknowledged.

Muhammad Nauman Malik

Mobile No: 0300-8414262, 0321-8414262
Email: nauman.kims@gmail.com
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Table of Contents

PREFACE 3

CHAPTER 1 BOOKKEEPING AND ACCOUNTING 13

1.1 BRANCHES OF ACCOUNTING ............................................................................................................... 13
1.2 ACCOUNTING EQUATION ................................................................................................................... 13
1.2.1 Assets 14
1.2.2 Liabilities 14
1.2.3 Equity 14
1.2.4 Drawings 14
1.2.5 The Entity Concept and the Accounting Equation 14
1.2.6 The Dual Aspect Concept and the Accounting Equation 15
1.3 TRANSACTION ................................................................................................................................. 15
1.3.1 Cash Transactions 15
1.3.2 Credit Transactions 15
1.4 STATEMENT OF FINANCIAL POSITION (STATEMENT OF FINANCIAL POSITION) ................................................ 17
1.4 .1 Statement of Financial Position (Horizontal Style) 17
1.4 .2 Statement of Financial Position (Vertical Style) 17
REVIEW QUESTIONS ................................................................................................................................. 18

CHAPTER 2 ACCOUNTING FOR ASSETS, LIABILITIES AND CAPITAL 22

2.1 EVOLUTION OF BOOK KEEPING ........................................................................................................... 22
2.2 RULES OF DEBIT AND CREDIT .............................................................................................................. 22
2.3 LEDGER .......................................................................................................................................... 23
2.4 ACCOUNT ....................................................................................................................................... 23
2.4.1 “T” Account 23
2.4.2 Three Column Ledger Account (Running Balance Method) 24
2.5 DOUBLE-ENTRY RELATING TO ASSETS AND LIABILITIES .............................................................................. 24
2.5.1 EXAMPLE 24
2.6 BALANCING OF AN ACCOUNT .............................................................................................................. 26
2.6.1 When should accounts be balanced? 28
2.7 TRIAL BALANCE................................................................................................................................ 28
2.7.1 Uses of a Trial Balance 29
2.7.2 Why is it Necessary for a Trial Balance to ‘Balance’? 29
2.7.3 Trial Balance - An aid to Financial Statements 29
REVIEW QUESTIONS ................................................................................................................................. 31

CHAPTER 3 ACCOUNTING FOR INVENTORIES 33

3.1 INVENTORY OF GOODS ...................................................................................................................... 33
3.2 BOOKKEEPING FOR INVENTORY OF GOODS ............................................................................................ 33
3.3 WHY INVENTORY ACCOUNT DOES NOT INCLUDE PURCHASES AND SALES OF GOODS ...................................... 33
3.4 PURCHASES ..................................................................................................................................... 34
3.4.1 Cash Purchases 34
3.4.2 Credit Purchases 34
3.5 SALES............................................................................................................................................. 34
3.5.1 Cash Sales 34
3.5.2 Credit Sales 35
3.6 PURCHASES RETURNS (RETURN OUTWARDS)..................................................................................... 35
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3.7 SALES RETURNS (RETURNS INWARDS).............................................................................................. 36

3.8 TRADING SECTION OF INCOME STATEMENT ....................................................................................... 36
3.9 CLOSING OF INCOMES AND EXPENSES .............................................................................................. 36
3.10 CLOSING INVENTORY ......................................................................................................................... 37
3.11 OPENING INVENTORY ........................................................................................................................ 38
REVIEW QUESTIONS ................................................................................................................................. 40

CHAPTER 4 ACCOUNTING FOR INCOMES AND EXPENSES 43

4.1 INCOMES ........................................................................................................................................ 43
4.2 EXPENSES ....................................................................................................................................... 43
4.3 DOUBLE-ENTRY FOR EXPENSES AND INCOMES (REVENUES) ....................................................................... 43
4.4 BOOKKEEPING FOR INCOMES AND EXPENSES ......................................................................................... 44
4.5 CALCULATION OF NET PROFIT ............................................................................................................. 45
4.6 CLOSING OF INCOMES AND EXPENSES................................................................................................... 45
4.7 SERVICE BUSINESSES ......................................................................................................................... 46
4.7.1 Difference between Trading and Service Businesses 46
REVIEW QUESTIONS ................................................................................................................................. 47

CHAPTER 5 FINANCIAL STATEMENTS-AN INTRODUCTION 49

5.1 NEED FOR INCOME STATEMENT ........................................................................................................... 49
5.2 USES OF INCOME STATEMENT ............................................................................................................. 49
5.3 CARRIAGE INWARDS ......................................................................................................................... 49
5.4 CARRIAGE OUTWARDS ...................................................................................................................... 49
5.5 INCOME STATEMENT AND STATEMENT OF FINANCIAL POSITION-AN IMPORTANT CONSIDERATION...................... 50
5.6 ACCOUNTING PERIOD ....................................................................................................................... 50
5.7 DRAWINGS ..................................................................................................................................... 50
5.8 ASSETS ........................................................................................................................................... 50
5.8.1 Non-Current Assets 51
5.8.2 Current Assets 51
5.9 LIABILITIES ...................................................................................................................................... 51
5.9.1 Current Liabilities 51
5.9.2 Non-Current Liabilities 51
REVIEW QUESTIONS ................................................................................................................................. 55

CHAPTER 6 BOOKS OF ORIGINAL ENTRY & DIVISION OF LEDGER 60

6.1 ADVANTAGES OF MAINTAINING BOOKS OF ORIGINAL ENTRY ..................................................................... 61
6.2 COMPONENTS OF BOOKS OF ORIGINAL ENTRY ....................................................................................... 61
6.3 SALES JOURNAL ............................................................................................................................... 61
6.3.1 Posting from the Sales Journal to the Ledger 62
6.3.2 Trade Discount 62
6.3.3 Sales on Credit Card 63
6.4 PURCHASES JOURNAL ........................................................................................................................ 63
6.4.1 Posting from the Purchases Journal to the Ledger 63
6.5 RETURN INWARDS JOURNAL ............................................................................................................... 64
6.5.1 Posting from the Returns Inwards Journal to the Ledger 64
6.6 RETURN OUTWARDS JOURNAL ............................................................................................................ 65
6.6.1 Posting from the Returns Outwards Journal to the Ledger 65
6.7 GENERAL JOURNAL ........................................................................................................................... 66
6.8 CASH BOOK .................................................................................................................................... 67
6.8.1 Two Column Cash Book 67
6.8.2 Three Column Cash Book 67
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6.9 PERSONAL LEDGERS .......................................................................................................................... 68

6.10 CASH BOOK .................................................................................................................................... 68
6.11 GENERAL LEDGER ............................................................................................................................. 68
REVIEW QUESTIONS ................................................................................................................................. 70

CHAPTER 7 CASH BOOK 74

7.1 TWO COLUMN CASH BOOK ................................................................................................................ 74
7.2 FOLIO COLUMNS .............................................................................................................................. 74
7.3 DISHONOURED CHEQUES ................................................................................................................... 74
7.4 CONTRA ENTRIES ............................................................................................................................. 75
7.5 BALANCING OF CASH AND BANK COLUMNS ........................................................................................... 75
7.6 TRADE DISCOUNT............................................................................................................................. 76
7.7 CASH DISCOUNTS ............................................................................................................................. 77
7.8 THREE COLUMN CASH BOOK .............................................................................................................. 78
7.9 NATURE OF DISCOUNTS COLUMNS ...................................................................................................... 78
7.10 CASH BOOK IN RECENT TIMES ............................................................................................................ 79
7.11 PETTY CASH BOOK ........................................................................................................................... 79
7.12 IMPREST SYSTEM.............................................................................................................................. 79
7.12.1 Advantages 79
REVIEW QUESTIONS ................................................................................................................................. 80

CHAPTER 8 BANK RECONCILIATION STATEMENTS 86

8.1 DIFFERENCE BETWEEN BANK STATEMENT AND CASH BOOK....................................................................... 86
8.2 REASONS FOR DIFFERENCE BETWEEN CASH BOOK AND BANK STATEMENT BALANCE....................................... 86
8.2.1 Items in the Bank Statement but not in the Cash Book 86
8.2.2 Items in the Cash Book but not in the Bank Statement 87
8.3 BANK RECONCILIATION STATEMENT ..................................................................................................... 87
8.4 STEPS FOR PREPARING A BANK RECONCILIATION STATEMENT ..................................................................... 87
8.5 USES OF BANK RECONCILIATION STATEMENT.......................................................................................... 91
REVIEW QUESTIONS ................................................................................................................................. 92

CHAPTER 9 CAPITAL AND REVENUE 99

9.1 TREATMENT OF CAPITAL AND REVENUE ITEMS IN FINANCIAL STATEMENT ..................................................... 99
9.2 DISTINCTION BETWEEN CAPITAL AND REVENUE EXPENDITURES.................................................................. 99
9.2.1 Expenditures for Acquisition of a Non-current asset 99
9.2.2 Expenditures for Improving Efficiency /Capacity of a Non-current asset 99
9.2.3 Expenditure at the Initiation of Business 100
9.2.4 Expenditure on Extension of Business 100
9.2.5 Expenditures to Increase the Useful Life of an Asset 100
9.2.6 Expenditures of Abnormal Amounts 100
9.3 APPLICATION OF MATERIALITY CONCEPT ............................................................................................. 100
9.4 DIFFERENCE BETWEEN CAPITAL AND REVENUE RECEIPTS ........................................................................ 100
9.4.1 Revenue Receipts 100
9.4.2 Capital Receipts 100
9.5 EFFECTS OF WRONG TREATMENT OF CAPITAL AND REVENUE ITEMS ......................................................... 101
REVIEW QUESTIONS ............................................................................................................................... 103

CHAPTER 10 ACCOUNTING FOR NON-CURRENT ASSET 106

10.1 DEPRECIATION ............................................................................................................................... 106
10.1.1 Amortisation and Depletion 106
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10.2 EFFECTS ON CASH FLOWS ................................................................................................................ 106

10.3 RELATIONSHIP WITH MARKET VALUE.................................................................................................. 106
10.4 CAUSES FOR DEPRECIATION .............................................................................................................. 106
10.5 FACTORS FOR CALCULATING DEPRECIATION ......................................................................................... 107
10.5.1 The Original Cost of Asset 107
10.5.2 The Estimated Useful Life 107
10.5.3 The Approximate Residual Value 107
10.6 CHARACTERISTICS OF DEPRECIATION .................................................................................................. 107
10.7 WHY DEPRECIATION IS CHARGED?...................................................................................................... 107
10.8 METHODS FOR CALCULATING DEPRECIATION ....................................................................................... 108
10.8.1 Revaluation Method 108
10.8.2 Straight Line Method or Original Cost Method 108
10.8.3 Reducing Balance Method 109
10.9 ANNUAL DEPRECIATION UNDER REDUCING BALANCE & STRAIGHT LINE METHODS ...................................... 110
10.10 DISTINCTIVE FEATURES OF STRAIGHT LINE AND REDUCING BALANCE METHOD ........................................... 110
10.11 CHOICE OF A METHOD .................................................................................................................... 111
10.12 DIFFERENCE BETWEEN DEPRECIATION AND PROVISION FOR DEPRECIATION ................................................ 111
10.13 DEPRECIATION POLICIES................................................................................................................... 111
10.14 DEPRECIATION ACCOUNTING ............................................................................................................ 111
10.15 DEPRECIATION AND ACCOUNTING CONCEPTS....................................................................................... 113
REVIEW QUESTIONS ............................................................................................................................... 115

CHAPTER 11 BAD DEBTS AND PROVISION FOR DOUBTFUL DEBTS 120

11.1 BAD DEBTS ................................................................................................................................... 120
11.2 BAD DEBTS RECOVERY ..................................................................................................................... 120
11.3 DOUBTFUL DEBTS........................................................................................................................... 121
11.4 PROVISION FOR DOUBTFUL DEBTS ..................................................................................................... 121
11.4.1 General Provision for Doubtful Debts 121
11.4.2 Specific Provision for Doubtful Debts 121
11.4.3 Calculation of Provision for Doubtful Debts 121
11.4.4 Treatment of Provision in Financial Statements 121
11.4.5 General Journal Entries 122
11.5 AGEING SCHEDULE ......................................................................................................................... 123
11.6 BAD DEBTS RECOVERY ..................................................................................................................... 124
11.7 CASH DISCOUNTS ALLOWED AND PROVISION FOR DISCOUNTS ALLOWED .................................................. 124
11.7.1 Why Cash Discounts are offered? 124
11.8 WHY PROVISIONS ARE MADE FOR DOUBTFUL DEBTS AND DISCOUNTS ALLOWED ........................................ 125
11.9 SALIENT POINTS TO NOTE ................................................................................................................ 125
REVIEW QUESTIONS ............................................................................................................................... 126

CHAPTER 12 CONTROL ACCOUNTS 130

12.1 CONTROL ACCOUNTS IN CAMBRIDGE ORDINARY LEVEL SYLLABUS ............................................................. 130
12.2 THE FORMAT OF CONTROL ACCOUNTS ............................................................................................... 130
12.3 HOW CONTROL ACCOUNTS ARE PREPARED? ........................................................................................ 131
12.4 CONTRA ENTRY.............................................................................................................................. 132
12.5 TWO BALANCES OF CONTROL ACCOUNTS............................................................................................ 133
12.5.1 Reasons for Having Two Balances of a Control Account 133
12.5.2 Treatment of Two Balances in the Statement of Financial Position 133
12.6 ADVANTAGES OR USES OF CONTROL ACCOUNTS ................................................................................... 136
REVIEW QUESTIONS ............................................................................................................................... 137

CHAPTER 13 CORRECTION OF ERRORS AND SUSPENSE ACCOUNT 143

 8

13.1 TYPES OF ERRORS ........................................................................................................................... 143

13.1.1 Errors Not Affecting Agreement of Trial Balance 143
13.1.2 Errors Affecting Agreement of Trial Balance 145
13.2 SUSPENSE ACCOUNT ....................................................................................................................... 145
13.3 EFFECT ON PROFIT OF CORRECTING ERRORS ........................................................................................ 147
13.4 EFFECTS ON STATEMENT OF FINANCIAL POSITION OF CORRECTING ERRORS ................................................ 148
REVIEW QUESTIONS ............................................................................................................................... 149

CHAPTER 14 INVENTORY VALUATION 155

14.1 BASIS FOR INVENTORY VALUATION...................................................................................................... 155
14.2 COST ........................................................................................................................................... 155
14.3 NET REALISABLE VALUE ................................................................................................................... 155
14.4 DIFFERENCE BETWEEN COST & NET REALISABLE VALUE ......................................................................... 155
14.5 BASIS FOR INVENTORY VALUATION...................................................................................................... 155
14.6 WHY INVENTORY VALUED AT LOWER OF COST & NRV ........................................................................... 155
14.7 INVENTORY VALUATION AND ACCOUNTING PRINCIPLES .......................................................................... 155
14.8 SEPARATE VALUATION OF INVENTORY ITEMS ........................................................................................ 156
14.9 EFFECTS OF ERRORS IN VALUING INVENTORY ....................................................................................... 156
REVIEW QUESTIONS ............................................................................................................................... 157

CHAPTER 15 FINANCIAL STATEMENTS WITH ADJUSTMENTS 160

15.1 CASH AND ACCRUAL BASIS OF ACCOUNTING........................................................................................ 160
15.2 NEED FOR ADJUSTMENTS................................................................................................................. 160
15.3 TYPES OF ADJUSTMENTS .................................................................................................................. 160
15.4 INVENTORY AT YEAR END ................................................................................................................. 161
15.4.1 Closing Inventory in Trial Balance 161
15.5 DRAWINGS OF GOODS FOR OWNER’S PERSONAL USE ........................................................................... 161
15.6 ACCRUED EXPENSES........................................................................................................................ 161
15.7 ACCRUED INCOMES ........................................................................................................................ 162
15.8 PREPAID EXPENSES (OTHER RECEIVABLES) ........................................................................................... 163
15.9 PRE-RECEIVED /DEFERRED INCOMES .................................................................................................. 163
15.10 TREATMENT OF OPENING ACCRUALS OR PREPAYMENTS ......................................................................... 164
15.11 DEPRECIATION ............................................................................................................................... 164
15.11.1 Methods of Depreciation 164
15.11.2 Depreciation Policies 164
15.11.3 Recording of Depreciation 165
15.12 BAD DEBTS ................................................................................................................................... 166
15.12.1 Bad Debts written off 166
15.12.2 Bad Debts to be written off (given as an adjustment) 166
15.13 PROVISION FOR DOUBTFUL DEBTS ..................................................................................................... 166
15.14 CALCULATION OF PROFITS FOR SERVICE BUSINESSES .............................................................................. 169
REVIEW QUESTIONS ............................................................................................................................... 170

CHAPTER 16 ACCOUNTS FROM INCOMPLETE RECORDS 178

16.1 THE REASONS FOR INCOMPLETE RECORDS........................................................................................... 178
16.2 NEED FOR PREPARING FINANCIAL STATEMENT FROM INCOMPLETE RECORDS .............................................. 178
16.3 CALCULATING PROFITS AND LOSSES FROM CHANGES IN CAPITAL/NET ASSETS ............................................ 178
16.3.1 Statement of Affairs 179
16.3.2 Statement of Profit or Loss 179
16.4 CALCULATION OF GROSS PROFIT FROM INCOMPLETE RECORDS................................................................ 180
16.4.1 Calculation of Total Sales 180
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16.4.2 Calculation of Total Purchases 181

16.5 MARK-UP AND MARGIN ................................................................................................................. 182
16.5.1 Use of Mark-Up and Margin to calculate Missing Items in Trading Account 182
16.5.2 Conversion of Mark-Up into Margin 184
16.5.3 Conversion of Margin into Mark-Up 185
16.6 DISADVANTAGES OR DEFECTS OF ACCOUNTS PREPARED FROM INCOMPLETE RECORDS ................................. 186
REVIEW QUESTIONS ............................................................................................................................... 187

CHAPTER 17 ACCOUNTS OF NON PROFIT ORGANISATIONS 194

17.1 COMPARISON BETWEEN PROFIT AND NON- PROFIT MAKING ORGANISATIONS ............................................ 194
17.2 INCOMES AND EXPENSES OF NON PROFIT ORGANISATIONS..................................................................... 194
17.2.1 Incomes of Non Profit Organisations 194
17.2.2 Expenses of Non Profit Organisations 194
17.3 SOME PECULIAR TERMS OF NON PROFIT ORGANISATIONS ...................................................................... 195
17.3.1 Grants and Donations 195
17.3.2 Gift 195
17.3.3 Legacy 195
17.3.4 Life Membership fee 195
17.4 ACCOUNTING BY NON PROFIT ORGANISATIONS .................................................................................... 195
17.4.1 Receipts and Payments Account 195
17.4.2 Income and Expenditure Account 196
17.4.3 Trading Account 196
17.4.4 Income and Expenses on Same Head 196
17.4.5 Calculation of Expenses to be shown in Financial Statements 197
17.4.6 Calculation of Incomes to be shown in Financial Statements 198
17.4.7 Accounting for Subscriptions 199
17.5 PREPARATION OF FINANCIAL STATEMENTS ........................................................................................... 200
REVIEW QUESTIONS ............................................................................................................................... 202

CHAPTER 18 ACCOUNTING CONCEPTS AND CONVENTIONS 207

18.1 CONVENTIONS AND CONCEPTS – AN IMPLICATION ................................................................................ 207
18.2 DUAL ASPECT CONCEPT ................................................................................................................... 207
18.3 BUSINESS ENTITY CONCEPT .............................................................................................................. 207
18.4 MONEY MEASUREMENT CONCEPT .................................................................................................... 208
18.5 GOING CONCERN CONCEPT.............................................................................................................. 208
18.6 REALISATION CONCEPT .................................................................................................................... 208
18.7 PRUDENCE CONCEPT ...................................................................................................................... 208
18.8 HISTORICAL COST CONCEPT ............................................................................................................. 209
18.9 CONSISTENCY CONCEPT ................................................................................................................... 209
18.10 MATERIALITY CONCEPT ................................................................................................................... 209
18.11 MATCHING CONCEPT ...................................................................................................................... 210
18.12 ACCRUAL CONCEPT......................................................................................................................... 210
18.13 INTERNATIONAL ACCOUNTING STANDARDS (IASS) ................................................................................ 210
18.13.1 Aims of the Accounting Standards 210
18.13.2 Scope of the Accounting Standards 211
18.13.3 Benefits of International Accounting Standards 211
18.14 USERS OF FINANCIAL STATEMENTS ..................................................................................................... 211
18.15 LIMITATIONS OF FINANCIAL STATEMENTS............................................................................................. 212

CHAPTER 19 PARTNERSHIP ACCOUNTS 213

19.1 ADVANTAGES AND DISADVANTAGES OF THE PARTNERSHIP ...................................................................... 213
 10

19.2 PARTNERSHIP AGREEMENT .............................................................................................................. 214

19.2.1 Contents of Partnership Agreement 214
19.3 PROVISION OF PARTNERSHIP ACT 1890 IN THE ABSENCE OF PARTNERSHIP DEED ....................................... 214
19.4 FINANCIAL STATEMENTS OF A PARTNERSHIP......................................................................................... 214
19.4.1 Appropriations of profit 214
19.4.2 Statement of Financial Position of Partnership 216
19.5 ACCOUNTING RECORDS FOR PARTNERS .............................................................................................. 216
19.5.1 Partners' Capital Accounts 216
19.5.2 Drawings Accounts 218
19.5.3 Partners’ Loan Account 218
19.6 CALCULATION OF INTEREST ON CAPITAL .............................................................................................. 219
19.7 CALCULATION OF INTEREST ON DRAWINGS .......................................................................................... 220
19.8 AMALGAMATION OF SOLE-PROPRIETORSHIPS....................................................................................... 222
19.8.1 Reasons for Amalgamation 222
19.8.2 Accounting Procedure 222
19.8.3 Goodwill on Amalgamation 223
REVIEW QUESTIONS ............................................................................................................................... 224

CHAPTER 20 MANUFACTURING ACCOUNTS 232

20.1 THE PRIME COST SECTION ............................................................................................................... 232
20.1.1 Raw Materials Cost 232
20.1.2 Direct Labour Cost 232
20.1.3 Direct expenses 232
20.2 FACTORY (PRODUCTION) OVERHEADS ................................................................................................ 233
20.3 MANUFACTURING ACCOUNTS FOR SEPARATE PRODUCTS........................................................................ 234
20.4 PURPOSE OF MANUFACTURING ACCOUNTS ......................................................................................... 234
20.5 TRADING SECTION .......................................................................................................................... 234
20.6 PROFIT AND LOSS SECTION............................................................................................................... 234
20.7 STATEMENT OF FINANCIAL POSITION .................................................................................................. 235
20.7.1 Inventories in a Manufacturing Business 235
REVIEW QUESTIONS ............................................................................................................................... 240

CHAPTER 21 COMPANY ACCOUNTS 248

21.1 THE NEED FOR COMPANIES .............................................................................................................. 248
21.2 ADVANTAGES AND DISADVANTAGES OF FORMING A LIMITED COMPANY .................................................... 248
21.2.1 Advantages of a Company 248
21.2.2 Disadvantages of Forming a Limited Company 249
21.3 SOURCES OF FINANCE FOR A COMPANY .............................................................................................. 249
21.4 TYPES OF SHARES ........................................................................................................................... 249
21.4.1 Ordinary Shares 249
21.4.2 Preference Shares 250
21.5 DEBENTURES ................................................................................................................................. 250
21.6 TYPES OF PREFERENCE SHARES ......................................................................................................... 251
21.6.1 Redeemable Preference Shares 251
21.6.2 Non-Redeemable Preference Shares 251
21.7 FORMS OF CAPITAL ......................................................................................................................... 251
21.7.1 Authorised Share Capital 251
21.7.2 Issued Share Capital 251
21.7.3 Called Up Share Capital 252
21.7.4 Paid Up Capital 252
21.8 FINANCIAL STATEMENTS OF COMPANIES ............................................................................................. 252
 11

21.9 FINANCIAL STATEMENTS OF LIMITED COMPANIES.................................................................................. 252

21.10 STATEMENT OF CHANGES IN EQUITY................................................................................................... 253
21.10.1 Dividends 253
21.10.2 Transfer to General Reserve 254
21.10.3 Retained Profits 254
21.11 STATEMENT OF FINANCIAL POSITION .................................................................................................. 255
21.12 A COMPARISON OF FINANCIAL STATEMENTS OF BUSINESS ORGANISATIONS ................................................ 256
REVIEW QUESTIONS ............................................................................................................................... 257

CHAPTER 22 RATIO ANALYSIS 263

22.1 FINANCIAL RATIOS .......................................................................................................................... 263
22.2 ANALYSIS OF RATIOS ....................................................................................................................... 263
22.2.1 Comparing one year with another (Trend or Time Series Analysis) 263
22.2.2 Comparing One Business with another Business (Cross-Sectional Analysis) 263
22.3 DEMONSTRATION OF RATIOS ............................................................................................................ 263
22.4 PROFITABILITY RATIOS ..................................................................................................................... 264
22.4.1 Gross Profit Ratio 264
22.4.2 Net Profit Ratio 264
22.4.3 Return on Capital Employed (ROCE) 265
22.5 LIQUIDITY RATIOS ........................................................................................................................... 266
22.5.1 Current Ratio 266
22.5.2 Liquid Ratio 267
22.6 TURNOVER RATIOS ......................................................................................................................... 267
22.6.1 Inventory Turnover Ratio 267
22.6.2 Trade Receivables’ Collection Period 268
22.6.3 Trade payables’ Payment Period 269
REVIEW QUESTIONS ............................................................................................................................... 271

SOLUTION TO ODD-NUMBERED QUESTIONS 278

CHAPTER 1 .............................................................................................................................................. 278
CHAPTER 2 .............................................................................................................................................. 279
CHAPTER 3 .............................................................................................................................................. 283
CHAPTER 4 .............................................................................................................................................. 286
CHAPTER 5 .............................................................................................................................................. 288
CHAPTER 6 .............................................................................................................................................. 291
CHAPTER 7 .............................................................................................................................................. 294
CHAPTER 8 .............................................................................................................................................. 296
CHAPTER 9 .............................................................................................................................................. 298
CHAPTER 10 ............................................................................................................................................ 299
CHAPTER 11 ............................................................................................................................................ 304
CHAPTER 12 ............................................................................................................................................ 307
CHAPTER 13 ............................................................................................................................................ 309
CHAPTER 14 ............................................................................................................................................ 313
CHAPTER 15 ............................................................................................................................................ 314
CHAPTER 16 ............................................................................................................................................ 318
CHAPTER 17 ............................................................................................................................................ 322
CHAPTER 19 ............................................................................................................................................ 325
CHAPTER 20 ............................................................................................................................................ 330
CHAPTER 21 ............................................................................................................................................ 334
CHAPTER 22 ............................................................................................................................................ 337
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KEY TO EVEN-NUMBERED QUESTIONS 342

INDEX 350
Chapter 1 13 Book Keeping and Accounting

Chapter 1 Bookkeeping and Accounting

Learning Objectives
This chapter is aimed at helping students to
 define bookkeeping and accounting differentiate between the two
 identify the different branches of accounting
 explain the meanings of the terms assets, liabilities, capital and drawings
 define and differentiate cash and credit transactions
 understand the nature and significance of the accounting equation
 understand the concept of entity & dual aspect & their impact on accounting equation
 define and prepare simple Statement of Financial Positions
Accounting has its origins from the earliest times in the history of our society. Accounting is primarily concerned with
providing information for internal and external users. Users of accounting information may well be included include
management, lenders, customers, government, tax authorities, prospective investors etc.
Financial information can only be provided if there is a proper system of recording transactions of the organisation.
This process of recording transactions is called book keeping. Initially, the records were hand written in the books
however in recent times much of the work of a book keeper can be accomplished by the use of electronic and
mechanical devices. Nonetheless both ways of recording information work on the same principles.
Accounting measures, summarises and then communicates the information recorded by book keepers in the form
of accounting reports using acknowledged methods and techniques which may ultimately be used for decision
making. The role of accountants is therefore to supervise the bookkeeper.
The importance of accounting cannot be overemphasised as this is as important for a business as fresh air for a
human to exist. In the absence of a proper accounting system healthier survival of an organisation would be at stake.
This should also be remembered that the role of accounting is not only confined to business concerns but it is also
useful for all classes and forms of organisations or individuals.

1.1 Branches of Accounting

Firstly accounting is related to recording of transactions. The process of recording transactions in the books is called
“Book Keeping” as records are kept and stored in the books of accounts. Secondly accounting is concerned with
measuring, summarizing and presenting the data, recorded by book keepers in monetary terms, to the persons who
need this information. This aspect of accounting is called “Financial Accounting”. Thirdly it is linked with controlling
what is happening within the organisation. This is called “Managerial Accounting” as this branch of accounting helps
the managers to control the ongoing activities and to make better decisions.

1.2 Accounting Equation

The whole accounting system has developed from the basic tenet of a single equation. As we know that a business
does not own any thing at its own so whatever resources it owns may come from two sources as shown below.
Resources of the business = Sources of resources
Initially all the assets may be provided to the business by the owner and some businesses solely rely on owner’s
investment. In that case accounting equation may be expressed as
Assets = Capital
However as it is usual for the businesses to borrow amounts from outsiders in addition to owner’s investment so in
that case the accounting equation may be stated as follows:
Assets = Liabilities + Equity
The equation shows that at any given time the assets of any entity must be equal in monetary terms to the total
amount of its liabilities and capital. This also shows that an entity does not own any asset at its own rather these are
provided by either of its owner or lenders. The lenders have a claim against the assets of the entity until the liabilities
are paid. The owner, therefore, has a claim only on the remaining assets of the entity once lenders are paid off.
Another way of expressing this mathematical relationship involves a simple variation in the equation which shows
that difference between what businesses own and what they owe represent owner’s capital.
Chapter 1 14 Book Keeping and Accounting

Equity = Assets  Liabilities

In order to understand the relationship between assets, liabilities and capital it is important to have some basic
understanding of these accounting terms.

1.2.1 Assets
Assets are monetary or economic resources which are owned by an entity and are expected to benefit it in
future. Moreover they must be quantified and expressed in monetary (dollar) terms.
Some items like company's outstanding reputation, customers’ loyalty, its popular brands and its skilled and
experienced work force etc. though benefit the business but cannot be quantified and expressed in monetary
terms. In the absence of any objective monetary value these items are not reported as assets in the accounting
records.
Examples of assets include land, buildings, equipment, vehicles, investments, inventory, accounts receivable,
cash etc.
1.2.2 Liabilities
Liabilities are obligations of an organisation to pay to other entities including individuals, government, financial
institutions, or other businesses. They represent amounts owed to lenders and suppliers. Liabilities include bank
overdrafts, loans taken out for the business. Liabilities may also include advances from customers for a future
sale or for rendering a service in future.
1.2.3 Equity
This is the investment made by owner in his business including any accumulated profits and reduced by losses
and withdrawals by him. In most cases owner’s capital takes the form of cash, inventory, vehicle or any other
asset brought into the business by the owner. However owner may introduce capital by paying a business
liability out of his personal account. Similar to liabilities capital is also an obligation of the business to pay to the
owner however business is not obligated to pay the amount of capital in the normal course of events.

1.2.4 Drawings
Drawings represent the amounts of business cash or other assets withdrawn by the owner for his personal use.
Drawings also occur when business makes payment for owner’s private expenses.
In order to avoid unnecessary detail in the owner’s capital, a separate record is kept for drawings to include all
the withdrawals made by the owner during the year. At the conclusion of an accounting period, the total amount
in the drawings account is closed and adjusted against the owner's capital to determine the net value of owner’s
investment left within the business after all withdrawals.

1.2.5 The Entity Concept and the Accounting Equation

Under Entity concept, a business is considered as a self-contained entity different and separate from its owners
or those who are connected with it. This concept asserts that private or personal transactions made by the
owners of the business must be separated from the transactions of the business itself.
This means the only time that the owner’s transactions appear in the accounting records of business when
owner gives anything to the business-capital; or takes anything out of the business-drawings.
For example, a vehicle bought and paid by a business for office use is treated as a business asset however when
a similar type of vehicle is purchased from business funds for owner’s private use then this is regarded as
drawings. Such distinction between the owner’s personal transactions and the business transactions helps
accountants in reporting business performance and determining business financial position more objectively
and fairly.
The most important aspect of business entity concept in relation with the accounting equation is that the terms
‘Assets’, ‘Liabilities’ and ‘Capital’ are defined from the enterprise’s point of view and not from the owners’ view
point . This is important as one man’s expense is another’s income and one’s right is another’s obligation.
Capital, which represents finances contributed by the owner towards the acquisition of assets of the business,
is a liability for the business as long as it retains and uses these assets to sustain its operations. Capital, though
an asset for the owner, but business must recognise it as an obligation towards the owner for assets provided.
Chapter 1 15 Book Keeping and Accounting

1.2.6 The Dual Aspect Concept and the Accounting Equation

The concept of dual aspect is a matter of common observation, an everyday give-and-take phenomenon. In
financial terms, it means that every transaction has two aspects. Every time a business transaction occurs, it
affects the accounting equation in such a way that the equilibrium of assets, liabilities and capital remains intact.
This means a change in the amount of total assets is necessarily complemented by an equal change in the total
of liabilities and equity (capital).
The equilibrium of accounting equation provides the very foundations on which the whole accounting structure
rests. It holds true for all situations no matter what financial transaction takes place. The accounting equation
as discussed earlier may be expressed as follows:
The equilibrium of accounting equation provides the very foundations on which the whole accounting structure
rests. It holds true for all situations no matter what financial transaction takes place. The accounting equation
as discussed earlier may be expressed as follows:

Assets = Liabilities + Equity

1.3 Transaction
Before illustrating the accounting equation, first we should know that accounting equation is only affected when
business enters into a transaction. The term transaction is defined below:
Transaction is an event or happening that changes financial position and/or earnings. An event is said to be a
transaction when
(i) two or more than two parties are involved
(ii) the transaction is measureable in terms of money
(iii) the transaction involves exchange of goods or services
Transaction is the basic element of accounting that gives rise to entries in accounting records. Transactions may be
categorised as

1.3.1 Cash Transactions

Cash transactions occur when cash is paid or received at the time of transaction.

1.3.2 Credit Transactions

In case of credit transactions payment or receipt of cash is deferred to a future date.
EXAMPLE
Let’s take an example to understand the effects of transactions on the equilibrium of the accounting equation.
Transaction 1
Henry Hodgson starts off with a trading business by putting his $50 000 savings in the business bank account.
Effects
Capital increased as owner’s investment within
Asset of Bank ↑ $50 000 Capital ↑ $50 000
the business has increased
The accounting equation will show this transaction as follows:
Assets = Capital + Liabilities
Bank $50 000 = $50 000 + $0

Transaction 2
Henry Hodgson got an opportunity to have a financing from ABC Bank for purchase of office furniture costing $10
000.
Effects
Asset of Liability to pay As increase is financed by bank (liability) so
↑ $10 000 ↑ $10 000
Furniture to ABC Bank capital amount remains unchanged.
The accounting equation will show these changes as follows:
Chapter 1 16 Book Keeping and Accounting

ASSETS = CAPITAL + LIABILITIES

Bank $50 000 = $50 000 + ABC Bank $10 000
Furniture $10 000 ______ ______
Total $60 000 = $50 000 + $10 000

Transaction 3
Henry Hodgson acquires a suitable business premises for $20 000 paying out of the business bank account.
Effects
There is no change in the total of either side of the
Asset of Asset of equation as only the composition of the assets is
↑ $20 000 ↓ $20 000
Premises Bank changed i.e. ↑ in asset of Premises is compensated by
↓ in the asset of Bank.
The accounting equation equilibrium now shifts to a new level:
ASSETS = CAPITAL + LIABILITIES
Bank $30 000 $50 000 ABC Bank $10 000
Furniture $10 000
Premises $20 000 ______ ______
Total $60 000 = $50 000 + $10 000
Transaction 4
Henry Hodgson brought his personal vehicle costing $4 000 within the business:
Effects
Capital increased as owner’s investment
Asset of Vehicle ↑ $4 000 Capital ↑ $4 000
within the business has increased

The accounting equation will then include

ASSETS = CAPITAL + LIABILITIES
Bank $30 000 $54 000 ABC Bank $10 000
Furniture $10 000
Premises $20 000
Vehicles $4 000 _______ ______
Total $64 000 = $54 000 + $10 000

Transaction 5
Some inventory of goods was purchased on credit from a supplier D. Ingram for $3 000.
Effects
Asset of Liability to pay As purchase is financed by a payable so capital
↑ $3 000 ↑ $3 000
Inventory to D. Ingram amount remains unchanged.
The accounting equation equilibrium now shifts to a new level:
ASSETS = CAPITAL + LIABILITIES
Bank $30 000 $54 000 ABC Bank $10 000
Furniture $10 000 D. Ingram (payable) $3 000
Premises $20 000
Vehicles $4 000
Inventory $3 000 _______ ______
Total $67 000 = $54 000 + $13 000

Transaction 6
Henry Hodgson paid $1 000 to D. Ingram by cheque. This would reduce bank balance (asset) and capital investment
of the owner.
Effects
Chapter 1 17 Book Keeping and Accounting

Asset of Liability to pay As business bank account is used to settle a liability

↓ $1 000 ↓ $1 000
Bank to D. Ingram so capital amount remains unchanged.
The accounting equation will show this transaction as follows:
ASSETS = CAPITAL + LIABILITIES
Bank $29 000 $54 000 ABC Bank $10 000
Furniture $10 000 D. Ingram (payable) $2 000
Premises $20 000
Vehicles $4 000
Inventory $3 000 _______ ______
Total $66 000 = $54 000 + $12 000

1.4 Statement of Financial Position (Statement of Financial Position)

The Statement of Financial Position is a statement (not an account) which shows financial position of an entity at a
certain date. It is one of the most important financial statements prepared by a business. It is a snapshot of what an
organization owns (assets) and owes (liabilities) at a specific date.
1.4 .1 Statement of Financial Position (Horizontal Style)
Though sometimes Statement of Financial Position is prepared in two sided format, but do not think that it is a
ledger account. It is presented in this format purely for ease of understanding. It is actually the expression of the
accounting equation in a more detailed and organised form. We can see that Statement of Financial Position
prepared below verifies the accounting equation.
Statement of Financial Position (horizontal style)
Assets $ Liabilities and Capital $
Premises 20 000 ABC Bank 10 000
Furniture 10 000 D. Ingram (payable) 2 000
Vehicles 4 000 Capital 54 000
Inventory 3 000
Bank 29 000 _____
66 000 66 000
It is called a Statement of Financial Position because its two sides always balance. This makes sense as a business
does not own anything at its own and it has to pay for all of its assets by either getting them from owners
(capital/equity) or borrowing money (liabilities) from outsiders.

1.4 .2 Statement of Financial Position (Vertical Style)

This is in fact another way of expressing accounting equation. Instead of accounting equation being applied
horizontally across the page, it may be written down the page. The two totals are directly underneath instead of
being side by side. In CIE examinations Statement of Financial Position should be prepared in vertical style unless
clearly specified.
Statement of Financial Position (vertical style)
ASSETS $ $
Premises 20 000
Furniture 10 000
Vehicles 4 000
Inventory 3 000
Bank 29 000 66 000
LIABILITIES
ABC Bank 10 000
D. Ingram (payable) 2 000 *(12 000)
CAPITAL 54 000
*Use of parentheses
An amount in parentheses indicates a negative amount. In this case liabilities which are shown on the other side
of the equation are subtracted from assets to determine amount of capital.
Chapter 1 18 Book Keeping and Accounting

REVIEW QUESTIONS
1.1
State which of the following is an asset, liability or a capital?

Office equipment Motor vehicles

Receivables Inventory of goods
Bank balance Loan from Y
Payables Investment by owner

1.2
State which of the following is an asset, liability or a capital?

Premises Inventory of goods

Cash balance Loan to X
Fixtures and fittings Payable to owner
Loan from bank Plant and equipment

1.3
Complete the following table
Assets Liabilities Capital
(i) 50 000 10 000 ?
(ii) 60 000 ? 45 000
(iii) ? 5 000 50 000
(iv) 40 000 ? 40 000
(v) ? 20 000 20 000
(vi) 60 000 4 000 ?

1.4
Complete the following table
Assets Liabilities Capital
(i) 70 000 20 000 ?
(ii) ? 15 000 75 000
(iii) 35 000 ? 30 000
(iv) ? 20 000 20 000
(v) 30 000 ? 30 000
(vi) 55 000 10 000 ?

1.5
Show the effects of each transaction given in the following table

Transactions Assets Liabilities Capital

Owner started business with cash
Bought Furniture for cash
A vehicle bought on credit from XYZ Motors
Cash deposited into bank
Sold furniture on credit to P. Jones
Amount borrowed from bank
Cash paid to XYZ Motors in part payment
Furniture sold for cash
Cash received from P. Jones
Owner withdrew cash for his personal use
Chapter 1 19 Book Keeping and Accounting

1.6
Complete the following table to show the effects of the following transactions.
Transactions Assets Liabilities Capital
Owner started business with cash
Cash deposited into bank
Purchased equipment paying by cheque
A loan received from M. Harry
Purchased furniture on credit from G. Prince
Sold equipment for cash
Repaid part of M Harry loan by cheque
Owner brought his personal vehicle for business use
Cash withdrawn from bank for office use
Cash withdrawn from bank for owner’s personal use
1.7
A sole trader has the following items among its assets, liabilities and capital at the end of January 20X7.
$
Cash 22 000
Inventory 28 000
Receivables 21 000
Machines 20 000
Payables 21 000
Bank loan 10 000
Capital 60 000
The following transactions occurred during the following month.
(i) Purchased inventory for cash $2 000.
(ii) Sold a machine for $3 000 on credit.
(iii) Bought two machines on credit for $5 000.
(iv) Repaid part of bank loan $4 000.
(v) Received $2 000 from a receivable.
(vi) Returned a machine with purchase price of $1 000 and amount was adjusted against the amount owed.
(vii) The owner withdrew $1 000 in cash for his personal use.
REQUIRED
Show the effect of above transactions on assets, liabilities and capital in the form of accounting equation.
1.8
The following balances of assets, liabilities and capital are taken from the books of a sole trader at the end of October
20X9.
$
Cash at bank 18 000
Inventory 31 000
Receivables 19 000
Vehicles 25 000
Payables 13 000
Bank loan 10 000
Capital 70 000
The following transactions occurred during November 20X9.
(i) Owner invested a further sum of $2 000 into the business.
(ii) Sold inventory for cash $3 000.
(iii) Bought a vehicle on credit $4 000.
(iv) Borrowed a further loan of $2 000 from the bank.
(v) Sold a vehicle for $2 000 on credit.
(vi) Paid payables an amount of $3 000.
(vii) The owner brought his personal vehicle costing $4 000 into the business.
Chapter 1 20 Book Keeping and Accounting

REQUIRED
Show the effect of above transactions on assets, liabilities and capital in the form of accounting equation.

1.9
The following transactions relating to a sole trader are summarised below in the form of an equation.
Assets = Liabilities + Capital
Cash + Inventory + Machines + Furniture = Payables + Equity
(i) 20 000 20 000
(ii) 3 000 3 000
(iii) (2 000) 2 000
(iv) 1 500 (1 000) 500
(v) (400) (400)
(vi) 5 000 5 000
(vii) (1 000) (1 000)
18 100 + 2 000 + 5 000 + 2 000 = 7 600 + 19 500

REQUIRED
Write down a separate sentence to explain nature of each transaction.

1.10
The following transactions relating to a sole trader are summarised below in the form of an equation.
Assets = Liabilities + Capital
Cash + Bank + Machines + Vehicles = Bank loan + Payables + Equity
(i) 30 000 30 000
(ii) 2 000 2 000
(iii) 10 000 10 000
(iv) (1 500) 1 500
(v) (3 000) 3 000
(vi) 2 500 2 500
(vii) 1 000 (1 000)

29 500 + 7 500 + 3 000 + 4 500 = 10 000 + 2 000 + 32 500

REQUIRED
Write down a separate sentence to explain nature of each transaction.

1.11
A sole trader M Flint has the following items among its assets, liabilities & capital at 31 December 20X4.
$
Cash 22 000
Inventory 28 000
Receivables 11 000
Machines 25 000
Vehicles 15 000
Payables 21 000
Bank loan 10 000
Capital 70 000

REQUIRED
Prepare a Statement of Financial Position as at 31 December 20X4 to show the above assets, liabilities and capital.

1.12
A sole trader M Barry has the following items among its assets, liabilities & capital at 31 December 20X4.
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