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INSTITUTE OF ACCOUNTANCY ARUSHA

PRINCIPLES OF ACCOUNTING (POA)

TOPIC: APPLICATION OF ACCOUNTING PRINCIPLES

Learning objectives
✓ Key accounting terms
✓ Accounting processes or cycle
✓ Double entry system
✓ Books of origin entry

Key accounting terms

Liabilities: They are obligations that are to be discharged or repaid. If an organization needs to
purchase assets but cannot afford on its own, it has to borrow money in order to acquire assets.
This results into liabilities to the organization because that borrowed money gives rise to an
obligation of repaying the amount. Liabilities are categorized into two: Current liabilities and
Noncurrent liabilities/long term liabilities.

Purchases: In accounting purchases occur when goods for resale are bought. Any other purchases
not intended for resale e.g., purchase of fixed assets like land is not treated as a purchase and such
entries are not made to the purchases account.

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Equity: also known as shareholders' equity or owner's equity, represents the residual interest in the
assets of a company after deducting its liabilities. It is the ownership stake held by the shareholders
in a business and reflects the company's net assets.

Sales: In accounting, a sale is said to occur when goods which were bought for purpose of resale
are sold and the domain of the business is to sell such goods. If the business sells such items that
had been bought not with the purpose of resale e.g., the disposal of an old machine, it is not treated
as sales and that transaction should not be entered into the sales account.

Returns: In some cases, goods which had been bought or sold are returned. If a customer is not
satisfied with the items, he or she can return them to the seller. Goods which had been sold and
returned are called returns inwards or sales returns in the book of the seller. The purchaser in
his/her books calls such returned goods returns outwards or purchases returns. In the trading
account, sales returns (returns inwards) are deducted from sales while returns outwards (purchases
returns) are deducted from purchases.

Revenue: refers to the total income generated by a business entity through its primary operating
activities, such as sales of goods or services. It represents the inflow of assets (usually cash or
accounts receivable) as a result of the company's ongoing operations.

Expenses: Expenses are the costs incurred to generate revenue. These can include salaries, rent,
utilities, and more. If a company spends Tshs. 500,000 on rent and Tshs. 3,000,000 on employee
salaries, those are considered expenses.

Accounting process/cycle

Accounting process/cycle can be defined as, the process which is followed by accountants in
processing raw financial data into output information in form of financial statement. The
process ranges from the occurrence and documentation of transactions up to the production of
final accounts or financial statements.

Note: It is called a cycle because the same procedure is repeated from one financial year to another.
When the financial year ends, books are closed and financial statements are extracted, when the
new financial year starts, the same books are opened and the same procedure is followed.

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Stages of accounting cycle

Stage one: Occurrence and documentation of business transactions.

When a 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 are invoices, payment
vouchers, receipts, cheques, delivery notes, goods received notes, bank paying-in slip etc.

Stage two: Entering Transactions into Journals.

Journals are books of original entry. They are the first books to which transactions are entered.
Information entered into journal is captured from the source documents. There are several types
of journals; major ones include general journal, sales journal/sales day book, purchases
journal/purchases day book and cash book (Cashbook is sometimes taken to be part of the ledger).

Stage three: Posting of transactions to the ledger.

The information which had been entered into the journals is posted to the ledger. A ledger is book
is which it contains a collection of accounts. For ease of recording, the ledger is sometimes
subdivided into general and subsidiary ledgers.

Stage four: Preparation of the trial balance.

At the end of the period, normally a month, all accounts are closed or balanced off and the trial
balance is extracted from the ledger. Its purpose is to check the accuracy of the double entry i.e.,
to check whether the double entry was complete and to check whether no arithmetical errors of
addition or subtraction were made in balancing of the ledger. If double entry rule was not observed
the trial balance will not balance, likewise if arithmetical errors were made, it will not balance.

Stage five: End of Year adjustments and preparations of financial statements/final accounts.

Financial statements 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. The major
adjustments or provisions made before preparation of final accounts include, provision for
depreciation, provision for bad and doubtful debts, adjustments for prepaid expenses and incomes,
accrued expenses and incomes, provision for corporation taxes, appropriations such as provisions
for dividends, transfers to reserve etc.

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Double entry system

The principle or rule of double entry states that for every debit entry there must be a
corresponding credit entry and for every credit entry there must be a corresponding debit
entry. For each transaction total debits must be equal to total credits. Double entry rule is very
important in accounting. Failure to conform to the rule of double entry will mean that accounts
including balance sheet/statement of financial position will not balance.

Debit and credit

Under double entry, accounts are debited and credited. It is important at this time to understand
what these words mean. Debit and credit are means of either increasing or decreasing an account.
They represent plus or minus in arithmetic. Depending on the nature or the type of an account,
debiting or crediting could mean either increasing or decreasing it.

Classification of accounts

Accounts can be classified into two main categories:

A. Personal accounts

B. Impersonal accounts

A. Personal Accounts

Personal accounts are accounts that relate to individuals, entities, or organizations with whom a
business has financial transactions.

B. Impersonal accounts

Impersonal accounts, also known as real accounts and nominal accounts, do not represent specific
individuals or entities. Instead, they represent assets, liabilities, expenses, and revenues.
Impersonal accounts are further divided into two categories:

I. Real accounts

Real accounts represent tangible and intangible assets of a business. These accounts are not closed
at the end of an accounting period and maintain their balances over time. Examples include cash,
equipment, inventory, and trademarks.

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II. Nominal accounts

These compose revenue and expenses accounts.

Nominal accounts represent income, expenses, gains, and losses incurred by a business. These
accounts are temporary and are closed at the end of each accounting period. For instance, "Sales
Revenue" and "Rent Expense" are nominal accounts.

A summarized table

Type of account Increase Decrease Normal balance

Asset Dr Cr Dr
Liability Cr Dr Cr

Capital and reserves Cr Dr Cr

Income and revenue Cr Dr Cr

Expenses/Cost Dr Cr Dr

Books of origin entry

Books of account are broadly divided into two: Journals and Ledgers

Journal is a French word meaning ‘Daily record’ and it was called so because everything that
happened everyday was entered into the book at once before the business man could forget the
exact details of the transactions.

Journal is the first accounting record where transactions are entered, it is sometimes referred to as
a record of original entry or prime entry. The transactions are entered in a chronological order
in the order in which they happen day by day.

Whenever business transactions occur, they must be recorded in journals before being posted to
the ledger. Journals are prepared from source documents such as invoices, bank paying in slip,
voucher. The process of recording business transaction in a journal is called journalizing a
transaction.

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Types of journals

✓ General journals
✓ Sales Journal or sales day book
✓ Purchases journal or purchases day book
✓ Return inwards book
✓ Return outward books

General journal

This is the simplest type of journal. It has two money columns for debits and credits. It may be
used for any type of transaction. However, in practice credit sales and credit purchases of the
trading stock, cash transactions, return inwards and outwards are recorded in specialized journals.
This leaves purchase and sales of fixed assets, correction of errors and adjusting entries to be
recorded in the general journal.

NB: For learning purpose all transactions should be entered into a general journal initially because
it clearly shows how the double entry is fulfilled.

Format of the general journal (Journal Proper)

Date Account title and explanation Folio Debit Credit

Sales journal

It is a book of original entry used for taking records of only credit sales. It is a specialized journal
for only credit sales.

When credit sale takes place, the seller sends an invoice to the buyer. This invoice is made out in
duplicate, and the seller retains a copy. This copy is the source document from which a sales
journal or a sales day book is written up. The individual sales to the buyer are recorded in the sales
day book are immediately posted to debit of the buyers’ or customers’ accounts in the sales ledger
while the total sales of the sale day book are posted to the credit side of the sales account in the
general ledger at the end of each month.

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Format of sales Journal

Date Account debited (debtors Accounts) Invoice No. folio amount

Purchases journal

It is a book of original entry for taking records of only credit purchases. It is a specialized journal
for only purchases on credit.

When goods are purchased on credit, the seller will send an invoice to the buyer. The record of
this purchase in the books of the business would be entered in the purchase’s day book. The
individual entries in the purchase’s day book are immediately posted to the credit of the suppliers’
or creditors’ account in the purchase’s ledger while the total of the purchase’s day book is posted
to debit of the purchases account in the General ledger usually on the last day of the month.

Format of purchases Journal

Date Accounts Credited (Creditors Account) Invoice No. Folio Amount

Purchases return day book

The purchases return day book, sometime referred to as the return outwards journal, is used to
record goods returned by the customer to the supplier. There are various reasons which prompt the
buyer to return goods to the supplier. Some of these reasons are: Goods not up to the sample, goods
damaged in transit and goods not of the quality ordered.

As soon as goods are returned the supplier issues the customer with a credit note. A credit Note
informs the customer that his account with the seller has been duly credited to reduce the amount
of sales previously made to him. In turns the customer debits the supplier’s account to reduce the
amount of purchases previously made from him. It should however be noted that a credit note is
sometimes used to rectify an overcharge on the invoice or to provide an allowance. On the credit
note full explanation or reasons for the allowance should be given.

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Format of purchases returns journal

Date Particulars Folio Amount

Sales return day book

When goods are returned by customers to the supplier, a credit note is issued by the supplier to the
customer acknowledging the receipt of goods returned and informing the customer that his account
has been duly credited. The supplier will then record the return of the goods in sales return day
book. The individual returns recorded in the sales return day book are immediately posted to the
credit side of customers’ account in the sales ledger while the total of sales returns day book is
debited to returns inwards account in the general ledger.

At time, customers return goods to supplier along with a debit note as an indication that the
suppliers account has been duly debited. But debit note is not very much in use, the polite way is
the customer to wait for a credit note from the supplier.

Format of sales return day book

Date Particulars Folio Amount

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Ledgers

A business may use accounts in recording its transactions. Each account is placed on a separate
page in a bound or loose-leaf book, or on a separate card in a tray of cards. If accounts are kept in
a book, the book is called the ledger. If they are kept on cards in a file tray, the tray of cards is a
ledger.

Ledger means a group of accounts or a place where accounts are kept. Transactions are posted
from the journals to the ledger. An account is defined as means or heading under which related
transactions are brought together i.e., classification of similar transactions in a chronological order.

Types of ledgers

Ledgers are broadly categorized under the following:

✓ General ledgers
✓ Subsidiary ledgers

A. General Ledgers/Main ledger

The general ledger is the main ledger of an organization. It is supposed to contain all ledger
accounts of the organization. In case there are too many accounts in the organization, it is only
control accounts that should appear in the general or main ledger and others are recorded in the
subsidiary ledgers.

The general ledger is supposed to contain all accounts of that organization. However, for ease of
recording and retrieval of accounts, the general ledger is separated into subsidiary ledgers.

B. Subsidiary Ledger

In order to avoid crowding the general or main ledger with all accounts, subsidiary ledgers are
created. Subsidiary ledgers are sub-divisions of the general or the main ledger. It is only the major
accounts that appear in the general ledger. Details of the general ledger accounts can be seen in
the subsidiary ledgers.

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Types of subsidiary ledger

✓ Debtors or sales ledger

Note: Sales and purchases ledgers are sometimes referred to as nominal ledger because they show
purchases and sales which are nominal accounts.

Debtors’ subsidiary ledger (sales ledger)

It is often difficult to show each and every debtor’s account and its transactions in the general
ledger. To overcome this problem, debtor’s subsidiary ledger is prepared. This subsidiary ledger
shows the position of each debtor’s account. The total of individual debtors’ account balances in
the debtors or subsidiary ledger should reconcile with the balance of the debtors control account
in the main or general ledger.

Creditors subsidiary ledger (purchases or bought ledger)

The creditors subsidiary ledger shows the details of each creditor’s account. It is not possible to
show this in the general ledger. The total of individual creditors’ account balances in the creditors’
or purchases subsidiary ledger should reconcile with the creditors control account in the general
ledger.

Private ledger

It is a store place for accounts that management may wish to keep secret. The accounts to be kept
secret vary from one organization to another. Many organizations keep their capital, drawings,
purchases, turnover, etc. accounts private.

*Class assignment

Get a set of review questions “SET 1” and thoroughly engage in practice with the available
questions. Ensure a comprehensive understanding of each question. In the upcoming session, we
will commence solving these questions, and any participant may be selected to present their
solutions.

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