Chapter One: Introduction to Book-keeping
Introduction
Book-keeping equips students with essential skills and knowledge vital for their future careers. When students master Book-keeping principles and concepts, they will gain a solid foundation for understanding financial transactions and record them accurately. A strong understanding of Book-keeping knowledge and skills empowers students to contribute effectively to both financial success in business arena and in managing personal financial matters. In this chapter, you will learn concept of Book-keeping by focusing on the origin, meaning, scope, purpose, types of Book-keeping methods or systems, relationship with other disciplines and basic terms used in Book-keeping. The competencies developed will enable you to appreciate the importance of keeping business financial transactions and have ability to negotiate and reason effectively during business deals.
Think
On the ways in which your parents or guardians are keeping records of their income and expenses.
Concept of Book-keeping
One of the common occupations that form an important part of day-to-day income generation in any country is business. Although, many businesses are also conducted by large companies both locally and internationally, a significant number of people in business are involved in small businesses. We interact with small businesses every day in the process of buying our daily needs. Typical small businesses include hawkers, vegetable vendors, street retail shops, shoe shining, newspaper vending, salon businesses (hair dressers), artisans and many others. All these businesses make different financial transactions, involving buying inputs or materials, doing some processing, and selling their goods or delivering services.
Book-keeping is a necessary process for any business enterprise. Business operators or owners without the proper knowledge of Book-keeping will somehow unknowingly apply Book-keeping principles in order to achieve various objectives of their businesses.
Take an example of Mrs Chaza who starts a food vending business by the name of Swahili-bites. This business operates near Jenga-afya Secondary School in Maruku. The business will need equipment like cookers, pans and serving utensils. It will also need some furniture like benches, tables and cupboards. It will buy raw food and cook it for sale. To ensure that the food business runs successfully, Mrs Chaza might be required to do the following:
- Hire some cooks and service attendants,
- Supervise cooking activities,
- Sell food,
- Receive cash from sales made, and
- Record credit sales (in case some food is sold on credit).
All these activities will involve movement of money. Eventually, Mrs Chaza would need to evaluate whether the business is achieving its objectives. One of the likely objectives is to make a profit from such operations. This means that Mrs Chaza will need to calculate whether her business has generated a profit or not. To be able to determine the profit or a loss, some calculations will have to be done by comparing the sales (revenue) made from selling food against the costs of materials and services used. To do this, there would be a need to keep records of money paid on each material and services, as well as money received from selling food to customers. Simply put, the process of keeping records of money spent on each material and service as well as money received from selling goods to customers is what is known as "Book-keeping".
Origin of Book-keeping
The origin of Book-keeping can be traced back to the ancient civilisations like Sumeria and Egypt. These societies developed systems to record and track transactions and goods exchanged. Overtime, Book-keeping principles advanced to various techniques through contributions from Greeks and Romans entrepreneurs. In the medieval period, Luca Pacioli in 1494 played a significant role in promoting double entry Book-keeping system. This introduction was a significant development that revolutionised the field of Book-keeping. Since then, Book-keeping has continued to evolve, adapting to changing economic systems and technological advancements. As we speak, Book-keeping remains a vital part of accounting and financial management, ensuring maintenance of records, facilitating financial reporting, analysis, and maintaining transparency and accountability in financial affairs.
Meaning of Book-keeping
Book-keeping is an important part of the accounting process. It plays an important role in the early stages in the accounting process. As explained earlier, Book-keeping can be defined as the art of recording business financial transactions in the books of accounts in an orderly manner. In principle, every transaction has to be recorded in a systematic manner. Such recording includes proper classification according to the nature of the transaction. The end result of Book-keeping is to have net figures or balances in the ledger accounts. This will help to determine a profit or a loss and the financial position of the business. Book-keeping also helps in the management of credit dealings, proper control of the business and appropriate computation of taxes. Hence, Book-keeping is the systematic recording, organising and tracking of financial transactions and activities within a business.
Activity 1.1
Visit any nearby food vendors or mobile money service shops and investigate various activities, involving keeping financial records. Thereafter, read textbooks or online reliable sources. Compare what you have seen and read, then write down your understanding about the concept of Book-keeping in your own words.
Scope of Book-keeping
The process of Book-keeping covers the recording, classification, organisation and maintenance of records of financial transactions. It plays central role in providing accurate financial information for decision making, legal and regulatory compliance and financial analysis within a business.
Purpose of Book-keeping
The purpose of Book-keeping is to enable business to record and track the financial transactions of an enterprise or business activities. Book-keeping provides clear and organised records of business financial transactions, including sales, purchases, consumption, payments and receipts. The specific purposes of Book-keeping include:
- Financial records: Book-keeping ensures all financial records are properly documented and easily accessible when needed. It provides a comprehensive record of financial transactions, which helps in maintaining a clear and accurate account of the enterprise's financial activities.
- Compliance and legal requirements: Book-keeping plays a crucial role in fulfilling legal and regulatory obligations. Organised and appropriate financial records are necessary for preparing tax returns and, meeting financial reporting requirements.
- Financial management: Book-keeping provides information for effective financial management. It enables businesses to track expenses, monitor cash flow, and evaluate financial resources. By having up-to-date financial records, an enterprise can make informed decisions regarding investment, budgeting and resource allocation.
- Facilitating business decision making: Book-keeping provides insights into revenue generation, cost management, and profitability. The information helps in making sound business decisions.
Management with accurate financial data can analyse different aspects of the business, identify areas for improvement, and make strategic decisions to drive business growth.
Importance of Book-keeping
Book-keeping is important to business owners and other parties outside the enterprise in the following ways:
Determination of profits or losses
Book-keeping helps a business to determine whether it is making a profit or a loss. This is possible because Book-keeping helps the enterprise to keep complete, accurate and up-to-date financial records that are used in preparing financial statements. Take an example of Mrs Chaza on page 2 Book-keeping assists the business to calculate profits or losses made for any period from the food vending business.
Knowledge of credit transactions
Many businesses are conducted on both cash and credit basis. For example, Mrs Chaza, would sell most of its food for cash, but she would occasionally sell to some customers on credit. Similarly, it is possible that Mrs Chaza buys some of its raw foods on credit from the market. In practice, many businesses have a significant volume of transactions conducted on credit. Book-keeping helps the enterprises to maintain appropriate records of their credit transactions and know the amount due from each of its debtors and the amount owing to each of its creditors. Such records can systematically be kept following Book-keeping principles.
Debtor: This is a customer who has bought goods on credit from business and promises to pay at a later date.
Creditor: This is a supplier who sold goods or provided service on credit to the business for payment to be made at a later date.
Control of business
To have an effective control of a business, the owner of the business needs to keep proper records of his or her financial matters. These records, in the long run, help the owner to decide on matters such as expansion or reduction of the business. If Mrs Chaza sells breakfast, lunch and dinner; appropriate record keeping may assist in deciding on the extent of efforts to dedicate to each of the menus. Additionally, in case the food is sold from more than one location or centre; Book-keeping may suggest whether the volume in one or another centre may need to be expanded or reduced according to the sales records. Book-keeping can also help the proprietor to see whether there are possible incidences where money, foodstuff or materials have been stolen or misused. This can be useful in making a decision on the corrective measures to be taken where necessary.
Determination of business's financial position
Book-keeping helps the owner to determine the financial position of his or her enterprise. It enables him or her to understand the value of assets, liabilities, and the amount of capital contributed by the owner. This can be useful in establishing whether the business has grown or not. Knowing the financial position of a business can also assist in applying for a loan or other form of credit for expanding its operations.
Tax assessment
Tax authorities such as the Tanzania Revenue Authority (TRA) and Zanzibar Revenue Authority (ZRA) need to receive and examine the books of accounts of every enterprise operating in the United Republic of Tanzania. This is important in calculating the amount of tax that should be paid by the enterprises. Tax laws in Tanzania use self-assessment system, where for some taxes the taxpayer is required to make own calculation of tax payable. Thus, proper keeping of financial records helps both the owner and tax authorities to assess the amount of tax payable. Tax laws in Tanzania also penalise businesses that do not maintain financial documents and records properly. Book-keeping therefore, may help the business save money that would otherwise be paid as penalties for not maintaining financial records.
Figure 1.1: Logos of key organs responsible for revenue administration in Tanzania
(a) Tanzania Revenue Authority
(b) Zanzibar Revenue Authority
Accounting process or accounting cycle
The determination of a profit or a loss, together with other objectives, is done through the preparation of financial statements. The entire process that businesses undertake to prepare financial statements from accounting records is known as the accounting cycle. The accounting cycle involves eight stages, and Book-keeping plays an active role in the first seven. The stages in the accounting cycle are summarised as follows:
- Identifying transactions using the source documents,
- Recording the transactions in the books of prime entry,
- Posting transactions to the ledger accounts,
- Extracting the trial balance,
- Making adjusting entries and correction of errors,
- Extracting the adjusted trial balance,
- Preparing the financial statements, and
- Analysing and interpreting the financial statements.
Identifying transactions and recording in source documents
This is the first stage in the accounting process where financial transactions are identified and evidenced through source documents such as receipts, payment vouchers, invoices, cheques, debit note and credit note. For a transaction to be identified and evidenced, it must be of a financial value and it must affect at least two items of the accounting equation.
Recording the transactions in the books of prime entry
The second stage is to record such transactions in the books of prime entry, which are also known as books of original entry. The transaction is initially recorded in these books before it is recorded or posted anywhere else. This book will focus on six types of books of prime entry, namely a sales journal, a purchases journal, a sales returns journal, a purchase returns journal, a general journal, and a cash book.
Posting transactions to the ledger accounts
The third stage in the accounting cycle is posting transactions to the ledger accounts. This process involves the posting of entries that were initially recorded in the books of prime entry to the ledger accounts. The posting of entries to the respective ledger accounts is done by following the double entry system of Book-keeping.
Extracting the trial balance
The fourth stage in the accounting cycle is the extraction of the trial balance. The trial balance is a list prepared at a specific date showing net figures or balances of all general ledger accounts. The account balances extracted from the general ledger are listed in the debit and credit columns of the trial balance. The debit and credit columns must balance. The trial balance is usually prepared to check the arithmetical accuracy of double entries made to the ledger accounts, and it acts as a compiled list of balances for use in the preparation of financial statements.
Account: This is a summarised record of business transactions. It can be presented on a page of a ledger book.
Debit and Credit: These are two terms which are used in describing the two sides of an account, that is, the left-hand side (Debit) and the right-hand side (Credit).
Double entry: This is the system or principle of Book-keeping whereby each business transaction is recorded in the book of accounts.
Making adjusting entries and correction of errors
A trial balance is expected to reveal some errors made when transactions are first entered in the books of prime entry or when double entry is done in the ledger. These errors need to be corrected. This is a process that goes together with making any necessary adjustments of the balances before the preparation of financial statements.
Extracting the adjusted trial balance
After correcting the errors and making adjusting entries, the adjusted trial balance will need to be prepared. This is the one that has balances that are used in the preparation of financial statements.
Preparing the financial statements
Financial statements are prepared using figures extracted from the adjusted trial balance. The aim of preparing the financial statements is to know the performance, financial position and cash flows of the enterprise. This includes determining whether the enterprise is making profits or losses (usually done through preparing an income statement) and to show the financial wealth of the enterprise. This is done through the statement of financial position.
Analysing and interpreting the financial statements
The financial statements need to be analysed and interpreted to assess the performance of the enterprise. This is done in comparison with other enterprises, as well as the progress made from one period to another. One of the tools used for analysing financial statements is ratio analysis. Analysed financial information is useful to several users such as owners, lenders and creditors in making informed decision.
Types of Book-keeping methods/systems
Modern Book-keeping uses double entry system. However, some businesses still find it adequate to use a single entry system. The following are the two systems of Book-keeping:
Double-entry Book-keeping
Double-entry Book-keeping is a more comprehensive and widely used method that provides a more accurate and detailed representation of business's financial transactions. It follows the principle that every transaction has equal and opposite effects on at least two accounts. Each transaction is recorded with a debit entry in one account and an equal credit entry in another. This method maintains a system of accounts, including assets, liabilities, equity, revenue, and expenses. Double-entry book-keeping ensures that the accounting equation (Assets = Liabilities + Equity) remains balanced and allows for the preparation of accurate financial statements such as statement of financial position and income statements.
Single-entry Book-keeping
Single-entry book-keeping is a simple and straightforward method primarily used by small businesses or individuals with relatively few repetitive and uncomplicated financial transactions. In this method, only a single entry is made for each transaction, typically in a revenue or expense journal or a cash book. It records income and expenses, but it does not track individual accounts for assets and liabilities. Single-entry book-keeping is used for basic record-keeping purposes such as tracking cash receipts and payments.
These two types of Book-keeping methods differ in complexity and the level of financial details they provide. While single-entry Book-keeping is suitable for small businesses with straightforward transactions, double-entry Book-keeping is the standard method used by most businesses due to its accuracy, reliability, and ability to provide a comprehensive financial overview.
Common terms used in Book-keeping
Book-keeping includes the recording and organisation of financial transactions in a systematic manner. The recording and organisations of financial inspections involve the use of various terms. These terms provide the basic understanding of the concepts and terminologies used in Book-keeping. The following are some basic terms used in book-keeping:
| Term | Definition |
|---|---|
| Assets | Resources controlled by a business owner that have economic benefits to the business. These include cash, inventory, equipment, and property. |
| Liabilities | Debts or obligations of a business to external parties, such as loans, trade and other payables, and accrued expenses. The business has duty to settle such obligations through economic resources, for example cash. |
| Expenses | Costs incurred by a business in the process of generating revenue, including salaries, rent, utilities, supplies, and other operating expenses. |
| Debit entry | An entry on the left side of an account, representing an increase in assets or expenses or a decrease in liabilities or revenue. |
| Credit entry | An entry on the right side of an account, representing an increase in liabilities, or revenue or a decrease in assets or expenses. |
| Double-entry | A system of book-keeping that records each financial transaction with equal and opposite entries on two different accounts. |
| Ledger | is a book or digital record in which financial transactions are recorded. It is a fundamental element of book-keeping used in tracking, organising, and summarising financial information. |
| Journal | The book or electronic record where financial transactions are initially recorded in chronological order. |
| Debtor | This term refers to a customer who buys goods or services from an enterprise on credit. Thus, a debtor is a person who owes money to the business. He or she has an obligation to the business. The amount receivable from the debtors of the enterprise is an asset to such enterprise and is treated as a current asset in the statement of financial position. Another name for debtor is accounts receivable. |
| Creditor | This refers to a person who sells goods or renders services on credit to an enterprise. Therefore, a creditor is a person to whom the enterprise owes money. The amount payable to creditors of the enterprise is a liability to that enterprise and is treated as a current liability in the statement of a financial position. Another name for creditor is accounts payable. |
| Trade receivables | This refers to money owed to a business by its customers for goods or services sold on credit. |
| Other receivables | This refers to amounts receivable from persons other than those resulting from credited sales of goods or services to customers. An example of other receivables are the ones resulting from the business lending money to its employees. |
| Trade payables | This refers to money owed by a business to its creditors or suppliers for goods or services purchased on credit. |
| Other payables | This refers to amounts payable to persons that result from transactions with the business other than purchases of goods for resale. An example is where the business buys a non-current asset on credit. |
| General ledger | This refers to the central repository of all financial transactions recorded by a business. It is categorised by accounts such as cash, accounts payable, and accounts receivable. |
| Trial balance | It is a list of all general ledger accounts and their balances. It checks whether debits equal to credits and to detect any errors before preparing financial statements. |
| Revenue | The terms refers to income generated by a business through its primary operations, such as sales of goods or services. |
| Depreciation | This refers to the systematic allocation of the cost of a long-term asset over its useful life to match such cost with the revenue generated by the asset over its life. |
| Cashflow | This refers to the movement of cash into and out of a business over a specific period. Cashflows can either be cash inflows or cash outflows. |
| Business | This refers to any legal activity undertaken with the aim of achieving a particular objective, such as making profits, and reaching a targeted service level. Examples of business include farming, a restaurant, a salon and a kiosk. |
| Capital | It is the amount of money or money's worth provided by the owner to start an enterprise or to expand it. The money contributed by the owner can be used to finance business operations or grow and expand the business. |
| A sole proprietor | A sole proprietor is the owner of the enterprise who provides capital to start or expand the enterprise alone. The sole proprietorship is the form of business enterprises that is owned by one person. In most cases, sole proprietorship is a family business and is the easiest type of business to establish and operate because it is not highly regulated by the government. |
| Goods | These are items bought and sold by the proprietor and they have the characteristics of being seen and touched. Goods are sold by business people to satisfy the needs of customers. Examples of goods include pens and exercise books for a stationeries business, food for restaurant business and cement for a hardware business. |
| Services | These are activities performed by the enterprise in the course of business that does not involve itself in selling physical goods. Examples of services offered by different enterprises are hairdressing, drama shows, advertising and training. It should be noted that some businesses deal with both goods and services. |
| Profit | Result achieved by the business when revenues are greater than expenses for a particular period or activity. In other words, profit is the excess of revenue over expenses for a particular period or activity. |
| Loss | A business is said to make loss when expenses are greater than revenues for a particular period or activity. A loss is not desired by any enterprise because it reduces the amount of capital of such enterprise. |
| Transaction | A transaction is a business event that has monetary impact on business financial statements, and is recorded as an entry in the business' accounting records. It also refers to the movement of money or money's worth between two or more parties. For example, Juma paid Paula TZS 20,000 to buy a pair of shoes. This is a transaction because TZS 20,000 have been transferred from Juma to Paula and at the same time, the pair of shoes has been transferred from Paula to Juma. |
Activity 1.2
Sakara is a businessman who does not have a Book-keeping knowledge and has been running a restaurant for years. His friend, Kapesa told Sakara about you, specifying that you are a student studying Book-keeping at Busara Secondary School. She informs Sakara that you can explain some of the basic concepts of Book-keeping to him. You are approached by Sakara to clarify for about Book-keeping and the importance of using Book-keeping in his business. Prepare a brief note that will guide your talk to Sakara in relation to his concerns.
Relationship between Book-keeping and other disciplines
Book-keeping supports operationalisation of other disciplines. The knowledge and skills acquired in Book-keeping are also applicable in different subject areas covered in the Ordinary Secondary Education Curriculum and beyond. The relationship that exists between Book-keeping and some other disciplines is explained as follows:
Accountancy
Book-keeping lays down the foundation of the Accountancy subject. It deals with recording and posting entries to various ledgers that are used by accountants to analyse, interpret and make informed decisions about the business. Accountants produce reports popularly known as financial statements. These financial statements are prepared using balances that are generated from the ledgers, which are prepared by book keepers. Financial information is important for business management, investments, tax assessment, and government regulations activities. Therefore, without the knowledge of Book-keeping, it would be difficult, for accountants to prepare and analyse financial statements.
Business studies
Book-keeping provides skills for preparing manufacturing accounts and how to accumulate various costs which are related to commercial activities. The relationship between Business Studies and Book-keeping lies in their business activities which result in financial generation. Business Studies provide a broader understanding of the overall business environment and operations, while book-keeping is a systematic recording of financial transactions gained from business activities.
Economics
Book-keeping knowledge allows students of Economics to calculate real costs. Also, Book-keeping develop skills for maintaining economics records, calculating national income, performing cost analysis and production costs. Both disciplines contribute to the effective financial management and informed economic decision-making.
Home Economics
Book-keeping supports Home Economics by providing a system to financial record-keeping, budgeting, expenses tracking, financial planning, tax preparation and decision-making within household. It helps individuals and families to effectively manage their resources, making informed financial choices and achieve their financial goals.
Computer Science
Book-keeping and computer science relate through the preparation and analysing of financial statements. Computer has automated tools that enhance financial record-keeping, data analysis, security measures, and reporting processes. Computer scientists contribute by creating accounting software, ensuring data integrity, implementing security measures, utilising artificial intelligence to prepare financial statements and reports.
Agriculture
Book-keeping is closely tied to agriculture through financial tracking, cost analysis, budgeting, financial planning, inventory management, tax compliance, and financial analysis. It helps farmers to maintain financial records, assess profitability, optimise resource allocation, comply with tax obligations, and make informed decisions to achieve sustainable and profitable agricultural operations. Also, agriculture deals with farming management that requires the preparation of farm records and farm accounting. This includes depreciating the value of farming equipment and keeping inventories of farm produce. The analysis of farming accounts is done after preparing their books of accounts. In order to do that, one needs to have Book-keeping knowledge and skills.
Exercise 1.1
- What do you understand by Book-keeping? Explain its importance and scope.
- What are the basic concepts of Book-keeping? Why is it important for a business person to use Book-keeping systems to keep financial records?
Summary
Book-keeping is a fundamental concept in financial management, involving the systematic recording, organising, and summarising of information about financial transactions. Its origins can be traced back to ancient civilisations where basic record-keeping practices were employed. Today, Book-keeping has evolved into a structured discipline with defined principles and techniques.
The purpose of Book-keeping is to provide a basis for a clear and accurate representation of business's financial activities. It encompasses tasks such as recording transactions, classifying them into appropriate accounts, and generating financial statements. Book-keeping plays a vital role in supporting decision-making by providing insights into cashflows, assets, liabilities, revenue, and expenses. It also ensures compliance with legal and regulatory requirements, facilitates financial analysis, and enhances transparency and accountability.
Within the realm of Book-keeping, various terms are commonly used in describing key concepts. These include assets (the resources owned by a business), liabilities (the debts or obligations), revenue (the income generated), expenses (the costs incurred), accounts receivable (amounts owed to the business by its customers), accounts payable (amounts owed by the business to its suppliers), cashflows (the movement of cash), journals (chronological records of transactions), ledgers (individual account records), and financial statements (such as statement of financial position and income statements). Familiarity with these terms is crucial for accurate record-keeping and effective financial management.
Revision exercise 1
- Explain how the origin and historical development of Book-keeping as a concept has influenced modern accounting practices.
- Describe the scope of Book-keeping and its role within the broader field of financial management.
- Explain the purposes of Book-keeping and its contribution to financial decision-making.
- Describe types of financial transactions covered in Book-keeping.
- Provide a brief overview of Book-keeping and highlight its importance in managing financial records.
- Identify and describe the eight stages in the accounting cycle, explaining the purpose and activities involved in each stage.
Chapter Two: Basic Principles of Book-keeping
Introduction
The basic principles of Book-keeping provide students with the necessary skills and knowledge of maintaining appropriate financial records, complying with regulations, and making informed decisions. These principles enable students to pursue various career paths in the field of accounting and finance. In this chapter, you will learn accounting principles and assumptions, single entry and double entry system of Book-keeping. The competencies developed will enable you to use basic accounting principles in recording and preparing financial statements.
Think
What would it be if there were no basic principles and guidelines in Book-keeping.
Accounting Principles and Assumptions
In the world of Book-keeping, the recording and presenting of financial information is guided by book-keeping principles. Book-keeping principles refer to the various frameworks which guide the practice of accounting. These principles guide the procedures and practices in measuring, recording, and communicating financial information to different users. Book-keeping principles are concerned with appropriately presenting an enterprise's financial information. Accounting concepts are concerned with guiding recording of transactions and preparations of financial statements. In this chapter, some accounting principles and concepts shall be discussed in detail.
Monetary Unit Principle
This is also known as the unit of measurement principle. It states that financial transactions should be recorded and reported using a common unit of measurement in monetary terms. Most countries would require that financial statements are presented in their local currency, for example, Tanzanian shillings (TZS).
The monetary measurement principle states that only transactions or events that can be expressed in monetary terms should be included in the accounting records. This principle implies that only measurable and quantifiable economic events should be recognised and reported in the financial statements. Items that can not be quantified in monetary terms are not recorded in financial statements. This is because they lack a reliable monetary value. For example, the skills of employees and reputation of an enterprise. This principle along with other accounting principles and concepts, provide a framework for preparing financial statements that are comparable. It ensures that financial information is recorded, measured, and reported consistently, allowing for meaningful analysis and decision-making.
Going Concern Principle
The going concern principle, also known as the continuity assumption, assumes that a business will continue its operations beyond a reasonable length of time it will not be forced to liquidate or cease operations in the foreseeable future. This principle underlies the preparation of financial statements and the basis for valuing assets and liabilities. The going concern principle assumes that the business can realise its assets, settle its liabilities, and fulfil its commitments in the normal course of operations. As a result, assets are generally recorded at their historical cost and are not immediately adjusted to their liquidation or forced-sale values, unless evidence suggests that it will cease to operate in the near future (within the next 12 months).
The going concern principle is significant in assessing the financial health and viability of a business. Financial statements prepared using this principle provide information to users about the enterprise's ability to meet its financial obligations, continue operations, and generate profits in the long term. However, if circumstances arise that raise doubts about the business's ability to continue as a going concern, such as significant financial difficulties or legal issues, the going concern principle may be questioned. In such cases, additional disclosures or adjustments may be required to reflect the potential impact on the financial statements.
The going concern principle ensures that financial statements reflect the assumption of business continuity. It also allows stakeholders to make informed decisions based on the assumption that the enterprise will continue its operations in the foreseeable future.
Time Period Principle
The time period principle, also known as the periodicity concept, suggests that the financial activities of a business should be divided into specific and meaningful time periods for reporting purposes. This principle allows for the systematic and regular preparation of financial statements, providing timely and relevant information to users.
Under this principle, the financial year is divided into shorter periods, such as months, quarters or years, depending on the reporting requirements and industry practices. Financial transactions and events are recorded and summarised within these designated time periods, enabling the preparation of interim and annual financial statements. The time period principle helps to facilitate the analysis and comparison of financial information over different periods. By breaking down the financial activities into uniform time intervals, it allows stakeholders to assess the business's performance, identify trends, and make informed decisions based on up-to-date information.
Matching Principle
This is a fundamental accounting principle that guides the recognition of expenses in financial statements. It states that expenses should be recognised and recorded in the same accounting period in which they are incurred to generate revenue. The principle aims to achieve a proper matching of expenses with the revenues earned during a specific period. This provides a more accurate representation of the business's financial performance.
According to the matching principle:
- Expenses should be recognised when the related revenue is recognised: When a business earns revenue from the sale of goods or the provision of services, it should also recognize the expenses directly associated with generation of that revenue in the same period. This ensures that the costs incurred to generate revenue are properly matched with the revenue in the financial statements.
- Expenses should be recognised in a systematic and rational manner: The matching principle requires expenses to be recognised in a logical and consistent manner over the accounting periods. It discourages the recognition of expenses only when payment is made or received.
By following the matching principle, businesses can provide more accurate meaningful measure of performance. It allows users of financial statements to assess the profitability and financial performance of a business by matching the expenses directly to the revenues they helped to generate.
Example 2.1
An enterprise sells products in February but had incurred the associated manufacturing costs in November. The matching principle requires matching the costs incurred in November on manufacturing the goods, with the revenue generated in February when the products are sold.
Revenue Recognition Principle
This is a fundamental accounting principle that determines when and how revenue should be recognised or recorded in the financial statements. It provides guidance on when to recognize revenue and how to measure it. It also ensures that revenue is reported accurately and in the appropriate period. According to the revenue recognition principle, revenue should be recognised when it is both realised or realisable and earned. This occurs when the following criteria are met:
- Identification of the contract: There should be a legally enforceable agreement between the seller and the buyer, outlining the rights and obligations of both parties.
- Delivery of goods or services: The seller has transferred control of the goods or services to the buyer.
- Determination of the transaction price: The transaction price is determined and can be reasonably estimated. It includes consideration received or expected to be received from the buyer in exchange for the goods or services.
- Collectability probability: It is probable that the seller will collect the amount he or she is entitled to receive from the buyer.
Once these criteria are met, revenue should be recognised in the accounting records. The amount recognised is typically the fair value of the consideration received or receivable in exchange for the goods or services provided. The revenue can be recognised at a point in time (for example, when the goods are delivered) or over time (for example, as services are performed). It is important to note that specific industries or transactions may have additional guidance or standards for revenue recognition, such as long-term construction contracts or software sales. These industry-specific rules may provide further criteria or guidelines to determine when revenue should be recognised.
In summary, the revenue recognition principle insists on recognising revenue in the books when activities involving sale of goods or service have reasonably been performed, amount is known and has been collected or is reasonably expected to be collected.
Accrual Basis Accounting Principle
This is the method of recording and reporting financial transactions based on when they occur, regardless of the timing of cash inflows or outflows. In the accrual basis, revenue is recognised when it is earned, and expenses are recognised when they are incurred, regardless of when cash is received or paid. The key principles of the accrual basis of accounting include:
- Revenue recognition: Revenue is recognised when it is earned, meaning when goods are delivered, services are rendered, or contractual obligations are fulfilled. It is recognised even if payment is not received at that time. This principle ensures that revenue is matched with the period in which it is earned. This provides a more accurate depiction of an enterprise's financial performance.
- Expense recognition: Expenses are recognised when they are incurred, meaning when goods or services are received or consumed, regardless of when payment is made. This principle ensures that expenses are matched with the related revenues or the period in which they contribute in generating revenue.
Activity 2.1
Imagine you are in charge of tracking money for a small shop. Can you tell your friend about a time when the shop spent or earned money? Then, explain how you would write it down in the shop's money records. You need to write down two things: one for the money that goes out and one for the money that comes in. Can you also explain why you are writing those things down?
Materiality Principle
The materiality principle states that financial information should be reported and disclosed if it has the potential to influence the decision-making of users of the financial statements. Materiality is determined by the nature and amount of an item or event. If an item or event is significant to impact the assessment or evaluation of a business's financial position, performance, or cash flows, it should be disclosed in the financial statements. The materiality principle recognises that not all financial information is of equal importance. It allows accountants to focus on reporting information that is relevant and significant, while avoiding excessive detail that may not affect the decision-making process. Allowing excessive details may crowd the important information that would be the focus of the users of accounting information. This principle encourages someone to exercise professional judgment in determining material information that requires clear and transparent disclosure in the financial statements. Information is therefore material if its inclusion or omission in the financial statements can affect the decision of the users of financial statements.
The materiality principle acknowledges that financial statements should present a true and fair view of a business's financial position and performance. It enables users to make informed decisions based on the significant factors affecting the business's financial outcomes. Applying the materiality principle requires someone to exercise professional judgment, considering both quantitative and qualitative factors. Accountants must consider the impact of an item or event on the financial statements and the potential influence it may have on the decisions of users.
By considering materiality principle, financial statements can provide a balance between the need for comprehensive and accurate reporting and the practicality of focusing on information that is most relevant and significant to the users of the financial statements.
Historical Cost Principle
Historical cost accounting is an accounting principle that states that, assets should be recorded and reported at their original cost when acquired by an enterprise. According to this principle, the initial cost of an asset represents its value, regardless of any changes in market value over time. In this principle, when an enterprise acquires an asset, it is recorded on the financial position statement (balance sheet) at the price paid to acquire or produce the asset. This cost includes the purchase price and any additional costs incurred to bring the asset to its present condition and location, such as transportation costs and installation fees.
The rationale behind the historical cost principle is to provide a reliable and objective basis for financial reporting. By using the original cost of an asset, financial statements reflect the actual resources expended by the enterprise at the time of acquisition. This principle promotes consistency and comparability in financial statements. It avoids general estimates of an asset's value and prevents manipulation of reported figures based on market fluctuations.
However, critics argue that the historical cost principle may not provide a relevant and accurate representation of an asset's true value, particularly for long-lived assets like property, plant, and equipment. Over time, the market value of assets may change due to factors such as inflation, technological advancements, or changes in market conditions. Some alternative valuation methods, such as fair value accounting, attempt to address these limitations by valuing assets at their current market value. Despite its limitations, the historical cost principle remains widely used in financial reporting, especially for assets that do not have determined market values. It provides a conservative approach to valuing assets and is considered a fundamental principle in traditional accounting practices. Historical cost principle is in line with the going concern principle.
Consistency Principle
This principle states that once an accounting method or principle has been chosen and applied, it should be consistently used for similar transactions and events in subsequent periods. In other words, an entity should not change its accounting methods or principles arbitrarily from one period to another, as it can create confusion and make it difficult to compare financial information across different periods.
Consistency in accounting allows for better comparability of financial statements, enabling users to make meaningful comparisons and assessments of an entity's financial performance and position over time. If a change in accounting methods or principles is deemed necessary, it should be accompanied by proper disclosure and justification, typically in the notes to the financial statements. It is important to note that the consistency principle does not mean that accounting methods cannot be changed or updated. Changes in accounting standards, regulations, or circumstances may require adjustments to accounting methods. However, any changes should be made with careful consideration and with the aim of improving the relevance and reliability of financial information.
Prudence/Conservatism Principle
Prudence, also known as the conservatism principle, is an important concept in Book-keeping and accounting. It suggests that when faced with uncertainty or doubt, accountants should exercise caution and choose the option that is more conservative or prudent. In other words, it is better to make mistakes on the side of understating assets and revenues or overstating liabilities and expenses rather than overstating assets and revenues or understating liabilities and expenses.
The prudence principle helps to ensure that financial statements are not too optimistic or misleading. It encourages a conservative approach to reporting financial information, which can help to prevent overstatement of assets or income and mitigate the risk of financial misstatements or manipulation. By recognising potential losses or risks more quickly and being cautious in revenue recognition, the prudence principle promotes a more realistic and reliable representation of an entity's financial position and performance.
It is important to note that the prudence principle should be applied judiciously and should not be used as a justification for intentionally understating assets or income or overstating liabilities or expenses. The principle aims to strike a balance between caution and providing a true and fair view of an entity's financial position and performance.
Dual Aspect or the Duality Principle
In Book-keeping, the dual aspect or duality principle is a fundamental concept in accounting that forms the basis for the double-entry Book-keeping system. According to the duality principle, every financial transaction has two offsetting effects. Each transaction affects at least two accounts, with equal effects that cancel each other. This principle recognises that every transaction involves a give-and-take relationship. This is the foundation of the double entry principle that has become a strong principle applied in the field of accounting.
Double Entry System
This is an accounting system whose application promotes accuracy and reliability in recording financial transactions. It is used in maintaining systematic and balanced records of an enterprise's financial transactions. Double entry system follows the fundamental principle that every financial transaction has dual effects on enterprise's accounts. This means that for every debit entry recorded, there must be an equal and corresponding credit entry. Double-entry system provides a more comprehensive view of an enterprise's financial position. It also allows for better analysis and facilitates the preparation of more detailed financial statements.
Single Entry System
Single entry system is sometimes called single entry Book-keeping. It is a simplified Book-keeping method used by small businesses or individuals to track their financial transactions, primarily cash transactions. This is different from double entry system which follows the principle of recording every transaction with at least two entries. Single entry system makes a single entry for each transaction. Single-entry Book-keeping may be simpler and more accessible for small businesses with straightforward financial transactions; the system lacks capacity to deal with records of large entities with varieties of transactions and high volume of trade.
As businesses grow or become more complex, they often change from single-entry system to double-entry system to ensure better financial control and reporting.
Example 2.2
Let say you have a retail shop selling cereals. On 15th September 2023 you sold 10 kilogrammes of rice for TZS 3,000 per kilogramme in cash. 18th September 2023 paid TZS 50,000 as a transport cost for goods purchased. In your single-entry book-keeping system, you would record these transactions as cash inward and outward. You would enter the details as follows:
| Date | Description | Receipts (TZS) | Payment (TZS) |
|---|---|---|---|
| 2023 | |||
| 15/09 | 10 kilogrammes of rice @3,000 | 30,000 | |
| 18/09 | Transport cost | 50,000 |
Characteristics of Single Entry System
These are few examples of characteristics of single-entry system in the recording of financial transactions:
- The level of accuracy on recording financial transactions is different. Single-entry system does not maintain the same level of details and accuracy as double-entry does. It is more straightforward and less comprehensive. Also, it lacks self-checking mechanism in contrast with double entry.
- Every transaction is recorded only once, typically in a simple ledger or journal.
- The main focus is primarily on tracking cashflows, such as receipts and payments.
- The single entry is normally recorded as either a receipt or payment representing an increase or decrease in the cash balance. It would not use two sides to record transactions.
- Single-entry system does not maintain a formal ledger with separate accounts. Instead, it relies on a running total of cash inwards and outwards.
- Financial statements, such as income statements and financial positions, are not readily available with single-entry system.
Activity 2.2
Read more about accounting principles and concepts from various reliable sources, then write short notes, and finally keep your notes in a portfolio for future reference.
Relevance of Accounting Concepts and Principles in Book-Keeping
The relevance of accounting concepts and principles in Book-Keeping is to improve the communication of financial information in language that is acceptable and understandable among enterprises. The principles promote uniformity in the preparation of financial statements, making it possible for persons to compare the financial performance and position of different enterprises. The concepts are there to make financial statements and reports relevant, reliable, and understandable to users of financial information.
Relationship between Accounting Principles and Concepts
None of the accounting concepts presented is expected to be applied in isolation. In many cases, the application of some accounting concepts will reinforce others. A few examples are given to explain such relationships.
Going Concern Principle and the Historical Cost Concept
The assumption of a going concern has an effect on the values of assets and liabilities that are reported in the financial statements. When thinking about the figure to be reported for different assets in the financial statements, a business has to avoid looking at the value such that each asset can be sold in the market at present time. This is because doing so will reflect an assumption that the assets are held for the purpose of being sold rather than for the purpose of being used in a business. Reporting assets at market value would be appropriate when the business is expected to be closed in the near future (That is, within the next 12 months) or the business is no longer a going concern. The historical cost concept makes this possible by prescribing that assets should be reported at their historical cost unless there are reasons to conclude that the business is no longer a going concern.
Going Concern Concept and the Accounting Period Concept
The going concern principle literally assumes no end in the lifespan of a business. It means that one would have to wait up to the end of the business to determine a profit or a loss. Because of the need to know the performance of the business, the life of the business is divided into uniform accounting periods at the end of which financial statements are prepared and presented. In this way, the going concern principle is observed, but without affecting the ability of the business to measure its performance.
Accounting Period Concept and the Matching Principle
As already defined, the accounting period is reflected in the act of dividing the life of a business into a uniform length of accounting periods. It is known that at the end of each period, the performance of the entity is measured by matching revenue and expenses. If there was no uniformity in the period covered by expenses and the one covered by revenue, then there would not be any meaningful profit or loss reported.
Exercise 2.1
Imagine that you are starting a small business selling handmade crafts. Before you begin recording your financial transactions, what are the fundamental principles and concepts of Book-keeping that you think you should be aware of? Use three principles or concepts to explain their functions in recording business transactions.
Summary
This chapter, explored the fundamental principles and concepts of Book-keeping, gaining a solid understanding of the core concepts that form the backbone of financial record-keeping. The following is a summary of the key points in the chapter:
- Double-entry system: The double-entry system is the foundation of Book-keeping, where every financial transaction involves at least two accounts, completing a debit entry and a credit entry. This system ensures that the accounting equation (Assets = Liabilities + Equity) remains balanced, promoting accuracy and integrity to financial records.
- Practical application: Understanding Book-keeping principles is essential for effective financial management in both personal and business contexts. Accurate Book-keeping activities help to monitor cashflow, make informed financial decisions, comply with tax regulations, and evaluate the financial health of an enterprise.
By grasping these basic principles and concepts of Book-keeping, you have equipped with a valuable skillset for managing finances and supporting business growth. Moving forward, you can build upon this foundation, exploring more advanced topics and refining Book-keeping practices to foster financial success and stability.
Revision exercise 2
- Explain the core principle that serves as the basis of Book-keeping, requiring every financial transaction to be recorded with a minimum of two accounts, one debit and one credit.
- Why is understanding of Book-keeping principles important for effective financial management in both personal and business contexts?
- Write a brief note explaining why the double entry system is a cornerstone of Book-keeping.
Chapter Three: Application of the Double Entry System
Introduction
The use of the double entry system requires that every business transaction must be recorded twice in the books of accounts. In this chapter, you will learn accounting equation, statement of affairs and the concept of double entry. The competencies developed will enable you to use double entry principles appropriately on posting the business transactions in the books of accounts.
Think
On the way in which the business should keep record of the machine acquired and cash paid.
Accounting Equation
The accounting equation shows resources owned by a business against those due to others. To understand this equation, think of Habibu, who just started a barber shop business on 1st January 2020. To start this business, he rented a room, bought equipment (shaving machines), furniture (chairs and shelves), fittings (wall fittings and glasses), and consumables (soap, creams and towels). He also had some cash to pay day to day running costs such as electricity, water and repairs. The items needed to start and operate this business (equipment, furniture, fittings, consumables and cash) are called assets.
Assets are resources that an enterprise controls and uses to conduct its business. Also, they include goods kept for sale or consumed in the process of providing services, which are called stock or inventory.
Stock (inventory) are goods which are held by the business for resale, or consumed in the process of providing services. For a manufacturing firm, they may be finished goods, partly finished goods or raw materials awaiting conversion or processing into finished goods which will then be sold.
The question here would be, how did Habibu's business come to have these assets? One of the possible answers is that Habibu saved money from his previous work and decided to invest this money into his business. In this case, the amount that Habibu saved to start the business is referred as capital. Another possibility is that Habibu borrowed money from friends, relatives, banks or other financial institutions to start a business. In this case, the amount borrowed by Habibu as debts is commonly known as liabilities. Capital, also known as owner's equity may thus be defined as amount of resources contributed by the owner to start or expand a business. Assuming that the business starts by owner's resources without any external funding, then the total assets equal the amount of capital, in this case the accounting equation is represented as:
Liabilities arise from having persons other than the owners of the business provide resources to start, expand or run the day-to-day activities of the business. Liabilities are obligations that a business has to settle by means of transferring economic resources to other person(s) or business (es). When a business has resources supplied both by the owner and others who do not own the business, the accounting equation changes to be:
The equation can also be changed or written in words as follows:
(Assets) = (Capital + Liabilities)
Example: Habibu's Business
Assume that the values of each item are as presented below:
Habibu's assets at 1st January 2020
| Item(s) | TZS |
|---|---|
| Shaving machines | 480,000 |
| Furniture | 620,000 |
| Fittings | 216,000 |
| Consumables (soap, creams and towels) | 115,000 |
| Cash | 510,000 |
| Total Assets | 1,941,000 |
To be able to arrive at the accounting equation, you are firstly required to add up all assets. The total obtained by adding up all the listed assets is TZS 1,941,000. Secondly, you were to show the resources that are used in acquiring the assets.
Assume that the business has not taken any liabilities to meet the above costs of resources, then Habibu must be the only source of funding. From these figures, applying the equation ASSETS = CAPITAL, find that Capital = TZS 1,941,000, being the sum of the assets that is, TZS (480,000 + 620,000 + 216,000 + 115,000 + 510,000). This means Habibu supplied TZS 1,941,000 to business and used that amount to start his business.
Assuming that Habibu used own funds to finance the starting of the business, except for the furniture and fittings that were borrowed from Mwakapande, the accounting equation will be shown as follows:
1,941,000 = 1,105,000 + 836,000
Liabilities are composed of the value of borrowed furniture (TZS 620,000), and fittings (TZS 216,000) and capital reflects the amounts paid by Habibu for shaving machines (TZS 480,000), consumables (TZS 115,000) and cash (TZS 510,000).
Types of Book-keeping Accounts
Book-keeping entries are made to reflect effects of transactions of different accounts. These accounts can be further classified according to elements of financial statements which are:
| Element | Description | Examples |
|---|---|---|
| Assets | Resources that a business controls and use in the operations | Cash, trade receivables, inventory, equipment, buildings, and investments |
| Liabilities | What a business owes to others, including debts and obligations | Trade payables, loans payable, accrued expenses, and mortgages |
| Revenue (Income) | Money earned by the business through its normal operations | Sales revenue, service revenue, interest income, and rental income |
| Expenses | Costs incurred by the business in generating revenue | Salaries, rent, utilities, office supplies, advertising expenses, and depreciation |
| Capital | Owner's equity or net worth in the business | Initial capital, additional contributions, retained earnings |
Components of Capital Account
The capital account is a fundamental component of a business's financial accounting, and it represents the owner's equity or net worth in the business. The following are the key components of the capital account:
- Initial capital: The amount of money or assets that the owner(s) initially invested in the business when it was started
- Additional contributions: If the owner(s) inject more money, assets, or value into the business at a later stage
- Net income (net loss): The capital account is affected by the net income or net loss generated by the business
- Drawings or withdrawals: If the owner(s) withdraw funds or assets from the business for personal use
- Retained earnings: The portion of net income that is not distributed to the owner(s) as dividends but is instead reinvested back into the business
The formula to calculate the balance of the capital account is:
Statement of Affairs
Statement of affairs can show the effect of different changes in the accounting equation. It lists the elements of the accounting equation in a systematic manner to show how such equation balances. The statement lists all the assets (with their values) together, and in the same manner lists all items of capital and liabilities.
Statement of affairs: A statement which lists all assets and liabilities (together with their financial value) at a particular date to enable one calculate value of capital.
Habibu's Statement of Affairs as at 1st January 2020
| Details | TZS |
|---|---|
| Assets: | |
| Shaving machines | 480,000 |
| Furniture | 620,000 |
| Fittings | 216,000 |
| Consumables (soap, creams, and towels) | 115,000 |
| Cash | 510,000 |
| Total Assets | 1,941,000 |
| Capital and liabilities: | |
| Liabilities | - |
| Total liabilities | - |
| Capital | 1,941,000 |
| Total capital and liabilities | 1,941,000 |
Concept of Double Entry
The accounting equation is the foundation of the concept of double entry. Double entry deals with the recording and posting of business transactions in the books of accounts. Business transactions are posted to ledger accounts following principle of double entry.
Double Entry System of Book-keeping
Double entry system of Book-keeping records each transaction by making two corresponding entries in the books of accounts. The reason for making two corresponding entries in the books is to simultaneously take into account the two effects of each transaction on the accounting equation. The entries are therefore made so that they cancel each other to reflect the two effects on the accounting equation. By doing this, the accounting equation would balance at any point in time.
Rules for Debit and Credit Entries
| Element | Increases | Decreases |
|---|---|---|
| 1. Assets | Debit | Credit |
| 2. Liabilities | Credit | Debit |
| 3. Capital (owner's equity) | Credit | Debit |
| 4. Revenue (gain) | Credit | Debit |
| 5. Expenses (losses) | Debit | Credit |
Steps for Making Double Entry
What is needed is to:
- Establish the specific items in the elements of accounting equation that are affected by the two effects of the transaction
- Establish the effect, whether it is an increase or decrease in each case
- Make respective entries for recording each effect accordingly
Example 3.1: Applying the Double Entry Rules
Take an example of the following transactions conducted by Habibu's business:
- Paid cash TZS 25,000 on 31st January in respect of electricity bill for the month.
- Received TZS 20,000 from a customer for a haircut of her four children.
Solution:
For transaction 1:
The transaction involves an increase in expenses (electricity) by TZS 25,000 and a decrease in asset (cash) by TZS 25,000.
Debit: Electricity expense TZS 25,000
Credit: Cash TZS 25,000
For transaction 2:
The transaction involves an increase in asset (cash) by TZS 20,000 and an increase in revenue by TZS 20,000.
Debit: Cash TZS 20,000
Credit: Service revenue TZS 20,000
Steps for Identifying and Posting Transactions
Steps to be followed when identifying and posting transactions in the ledger accounts:
- Step 1: In each transaction, identify two accounts involved in the transaction
- Step 2: Find out the element to which each of the accounts involved belong
- Step 3: Indicate the effect of transaction (increase or decrease)
- Step 4: Debit and credit appropriate ledger accounts by applying the rules of double entry
Example 3.2: Identifying Accounts and Effects
For each of the following transactions below, identify two accounts involved, their types, and state which account should be debited and which one should be credited.
| Date | Transaction | Accounts Involved | Element | Effect | Debit/Credit |
|---|---|---|---|---|---|
| 2020 Jan 1 | Diana started a business by depositing TZS 2,000,000 capital in the bank account | Bank account, Capital account | Asset, Capital/equity | Increase, Increase | Debit, Credit |
| Jan 4 | Bought machinery worth TZS 200,000 on credit from Alpha | Machinery account, Alpha account | Asset, Liability | Increase, Increase | Debit, Credit |
| Jan 8 | Purchased goods worth TZS 400,000 on credit from Julius | Purchases account, Julius account | Expense, Liability | Increase, Increase | Debit, Credit |
| Jan 12 | Sold goods for cash TZS 150,000 | Cash account, Sales account | Asset, Revenue | Increase, Increase | Debit, Credit |
Importance of Double Entry
The use of the double entry system is important in accounting process due to the following reasons:
- Makes it easier to show the two effects of each transaction: The double entry system requires every transaction to be recorded twice, making it easier to understand which accounts have been affected
- Assures arithmetic accuracy in the accounts thus minimising the possibility of errors: Since every debit must have a corresponding credit entry, arithmetic accuracy is assured
- The basis of the balances used in preparing the financial statements: Balances used in preparing trial balance and financial statements are extracted from ledger accounts following double entry system
- Ensures that financial records are kept properly: Double entry ensures that financial records are kept permanently and properly in the books of accounts
Activity 3.2
Your friend, Zawadi has approached you to clarify an important aspect in Book-keeping. She has heard you speaking about double entry, and she believes that the use of double entry will:
- Double the work of the book-keeper and thus, spend more resources of the enterprise
- Encourage recording transactions twice, which is misleading as it doubles the amounts reported; thus, some kind of cheating may occur
Prepare a short presentation that you will use to explain to her the double entry system and show its benefits to the enterprise.
Summary
The principle of double entry is a fundamental concept in accounting and book-keeping. It ensures that every financial transaction has an equal and opposite effect on at least two accounts. This system is widely used in maintaining accurate and balanced financial records. By following the double entry system, businesses can achieve logically organised records that can be used in preparing financial statements. This, in turn, enables them to analyse their financial performance, financial position and cashflow make informed decisions, and meet reporting requirements. The application of the principle of double entry provides a strong and consistent framework for recording financial transactions, helping businesses to maintain a clear and accurate representation of their financial activities and facilitating effective financial management.
Revision Exercise 3
- Complete the gaps in the following table:
Assets TZS Liabilities TZS Capital TZS (a) 1,650,000 507,000 ? (b) ? 516,000 1,032,000 (c) 1,083,000 ? 855,000 - Complete the columns to show the effects of the following transactions by inserting a (+) sign for the increase and a (-) sign for the decrease
- From the following items below, identify which ones are assets and which ones are liabilities
- Classify the following items into liabilities and assets
- Complete the following table by showing the effects, the account to be debited, and the account to be credited
Chapter Four: Recording of Business Transactions
Introduction
Recording of transactions in the books of accounts is the initial and very critical stage in accounting. Correctness of the first record (prime or original) in the books of accounts for a transaction is the basis for having appropriate accounting records. In this chapter, you will learn books of prime entry and preparation of such books. The competencies developed will enable you to prepare books of prime entry according to the required principles.
Think
Operating a business without recording its financial transactions.
Books of Prime Entry
Books of prime entry, also known as books of original entry or daybooks, form an essential part of the double-entry accounting system used by businesses to record their financial transactions. These books serve as the first point of entry for all the business transactions before they are posted into the ledger or processed further towards preparation of financial statements. The use of books of prime entry ensures that transactions are recorded promptly and accurately, minimising the risk of errors and providing a comprehensive record of financial activities. Daybooks are the principal sources of transactions posted into the general ledger, which ultimately lead to the preparation of financial statements. Overall, books of prime entry play a crucial role in maintaining an efficient and organised accounting system for any business.
Meaning of Books of Prime Entry
Books of prime entry (journals) are the books of accounts that are used to record any transaction for the first time. In the books of prime entry, each transaction is recorded with as much detail as possible, in order to provide information concerning the transaction. The name journal is adopted from a French word for diary. It is therefore, a good practice to record transactions in the books of prime entry in a chronological order. Transactions are also recorded as soon as possible from the time they occur to avoid situations where they may be forgotten or have their source documents misplaced.
Types of Books of Prime Entry
Books of prime entry are also known as journals or day books, except for a cash book. These books are commonly termed as special journals or daybooks because they are used to record transactions of specific type on the daily basis. There are six types of books of prime entry as presented below:
- Sales journal (sales daybook)
- Purchases journal (purchases daybook)
- Sales returns journal (sales returns daybook)
- Purchase returns journal (purchase returns daybook)
- Cash book
- General journal (journal proper)
Use of Books of Prime Entry
As their names suggest, each book serves its own purpose:
| Book | Purpose |
|---|---|
| Purchases daybook | Used to record transactions related to credit purchases of goods |
| Sales daybook | Used to record transactions related to credit sales of goods |
| Sales returns daybook | Used to record details of transactions related to sales returns from customers |
| Purchase returns daybook | Used to record transactions related to purchase returns to suppliers |
| Cash book | Used to record transactions related to receipt and payment of cash as well as bank transactions |
| General journal | Used to record transactions related to other items not recorded in special journals |
Source Documents
The information recorded in the books of original entry is taken straight from the documents that may either have been issued by the business or by its suppliers. These documents are called source documents, because they are the source of information for recording transactions in the books.
Common Source Documents
Cash Receipt Voucher
Company name and address
Voucher Number: ...... Date: ......
| S/N | DESCRIPTION | UNIT PRICE | QUANTITY | AMOUNT (TZS) |
|---|---|---|---|---|
TOTAL
Amounts in words: ......
Cash/ Cheque Number ......
Received by: ...... Signature ...... Date: ......
Activity 4.1
Prepare a sample of cash receipt voucher and demonstrate how to fill it out.
Payment Voucher
Company name and address
PV No: ______
Amount: ______ Date: ______
Method of Payment
Cash: ______ Cheque: ______
To: ______
The Sum of:
Being: ________________________
Payee: _______________________
Approved By: ___________ Paid By: ___________ Signature ___________
Invoice
Company Name
Address ________________________ Date ________________
Phone No 1 +255-000-000-000
Phone No 2 +255-000-000-000
Fax +255-000-000-000
Email sales@enterprise.com
website www.enterprise.com
Bill To:
Name ________________________
Address ______________________
Tin No _______________________
Phone No _____________________
| S/N | DESCRIPTION | UNIT PRICE | QUANTITY | AMOUNT (TZS) |
|---|---|---|---|---|
Subtotal _______ Taxable _______ Tax rate (18%) _______ Tax due _______ TOTAL _______
Preparation of Books of Prime Entry
As per the accounting cycle or process introduced in chapter one; once transactions are identified, they are entered in the books of prime entry, followed by posting the entries to relevant ledger accounts.
Purchases Daybook or Purchases Journal
When goods are purchased on credit, the seller will prepare and send an invoice to the buyer. The buyer will record this transaction in the purchases daybook because the transaction involves a credit purchases, meaning that the buyer did not pay for the goods at the time of purchase.
Example 4.1
Record the following transactions in the purchases daybook for the month of July 2023.
2023 July 1 Bought from Tom Ltd. invoice number 043516:
10 bags of rice, each with 5kgs @ TZS 10,000
20 bags of sugar, each with 5kgs @ TZS. 15,000
July 9 Bought from Asha invoice number 03167:
10 boxes of pens @ TZS 2,000
5 cartons of ruled papers @ TZS 30,000
July 16 Bought goods from Katabo for TZS 60,800 invoice number 06312
July 29 Bought from Mwanaidi, invoice number 09842:
15 pairs of sandals @ TZS 15,000
14 boxes of kids drawing pens @ TZS 5,000
Solution
10 bags of rice(5kgs) @ TZS 10,000
20 bags of sugar (5kgs) @ TZS 15,000
300,000
10 boxes of pens @ TZS 2,000
5 cartons of ruled paper @ TZS 30,000
150,000
Goods
15 pairs of sandals @ TZS 15,000
14 boxes of kids drawing pens @ TZS 5,000
70,000
Sales Daybook or Sales Journal
When the supplier sells goods on credit, he or she prepares and sends an invoice to the buyer. The invoice is usually prepared in duplicate, and the seller remains with a copy after issuing the original invoice to the buyer. The retained copy serves as a source document that helps the seller to prepare the sales daybook.
Example 4.2
Kassimu made the following sales during June 2023. You are required to record the transactions in the sales journal for the month.
2023 June 1 Sold to Mambo Ltd. invoice number 04318:
80 packets of rice @ TZS 2,200
60 bags of wheat flour, each with 3kgs @ TZS 4,500
June 12 Sold to Kifundo Enterprise, invoice number 04319:
15 boxes of toothpaste @ TZS 2,600
16 pieces of writing pads @ TZS 2,350
June 19 Sold to Rudia stores, invoice number 04320:
11 pairs of running shoes @TZS 6,000
20 shirts @ TZS 1,200
June 25 Sold goods to Kalumanzira worth TZS 82,000 on credit and issued invoice number 04321
June 28 Sold to Glory, invoice number 04322:
15 pairs of sandals @ TZS 8,500
10 bags of rice, each with 3kgs @ TZS 6,000
Solution
80 packets of rice@ TZS 2,200
60 bags of wheat flour (3kgs)@ TZS 4,500
270,000
15 boxes of toothpaste @ TZS 2,600
16 pieces of writing pads @ TZS 2,350
37,600
Sales Returns Daybook
There is time when goods sold to the customer are returned to the seller. Goods might be returned by the customer due to several reasons including late delivery, low quality goods, different types or specifications (colour or size), damaged goods, expired goods or excessive quantity (oversupplied).
General Journal (Journal Proper)
The general journal is a book of prime entry used to record business transactions that are not recorded in special journals. Examples of entries recorded in the general journal are entries for:
- Purchases or disposal of business assets not meant for sale
- Correction of Book-keeping errors
- Adjustments of balances prior to the preparation of financial statements
- Closing entries
- Opening entries used in determining capital of an ongoing business that did not use double entry before
The name of the account to be credited.
A brief narrative of the transaction.
Example 4.5: Recording in the General Journal
Purchase of non-current asset on credit: Furniture is purchased on 16 January 2023 for TZS 550,000 on credit from Jerome.
Other Payables
Being the purchase of furniture on credit from Jerome
Summary
Records of business transactions encompass the systematic documentation of all financial activities and events undertaken by an enterprise. These records are vital for maintaining accurate and comprehensive accounting information, which serves as the foundation for financial management, analysis, and decision-making. Each transaction is recorded in chronological order, supported by source documents such as invoices, receipts, and bank statements, providing evidence and ensuring transparency in the financial process. By adhering to the principle of double entry, businesses ensure that their financial records are balanced and reliable. These records facilitate the preparation of financial statements including components such as the statement of financial position, income statement, and cash flow statement. They are also useful in audits, tax reporting, and compliance with regulatory requirements.
Maintaining accurate records of business transactions is crucial for business owners and managers to gain insights into the enterprise's financial performance. These records enable businesses to monitor cash flow, track revenue and expenses, and identify trends and potential areas for improvement. Additionally, detailed records of transactions support strategic decision-making by providing real-time financial data and performance metrics, helping businesses identify opportunities and mitigate risks effectively. By utilising modern accounting software and automation tools, businesses can streamline the record-keeping process by reducing manual errors. They can also increase efficiency, and ensure that critical financial information is securely stored and easily accessible for informed business planning and growth.
Revision Exercise 4
- Describe various source documents that are employed in the preparation of the books of prime entry, clearly showing the role played by each document in the accounting process.
- Why is it important for businesses to prepare journals in their accounting processes?
- Enter the following transactions in Joanita's purchases daybook, purchase returns daybook, and show total purchases and returns for the month of May 2022.
- Following the information extracted from James trader's books who sells a variety of goods on credit, prepare a purchases daybook for the month ending 31st January 2023.
- Umoja wa Vijana Co. Ltd. sells the following items on credit during March 2023: Enter the above details into the Sales daybook for the month of March 2023.
Chapter Five: Ledgers
Introduction
Ledgers plays a crucial role in accounting and financial management for enterprises. They serves as a key component of the accounting process, because the balances from ledgers form contents of financial statements. Posting of entries to the ledger involves posting the entries to both subsidiary and general ledgers. In this chapter, you will learn concept of a ledger and the posting of entries to the ledgers. The competencies developed will enable you to post entries from various books of prime entries to respective ledger accounts and balance the ledger accounts.
Think
On the ways in which your parents or guardians are keeping monetary records of their properties and obligations.
Concept of a Ledger
Concept of a ledger is fundamental to accounting. A ledger is a principal book or digital record where business transactions are systematically and chronologically recorded. It serves as a permanent and comprehensive repository of all transactions. It provides a clear and organised picture of the enterprise's balances that will be used in determining financial performance and position. This section presents the meaning of a ledger, types of ledgers, the importance of ledgers, the classification of accounts and the posting of entries to the ledger.
Meaning and Format of a Ledger
Meaning of a ledger: Ledger is a book used to record transactions. It is used for keeping track of expenses, revenue, receipts, payments, and other financial matters. It is, therefore, a record in which accounts are kept. The ledger is often referred to as the main book of accounts. This is because balances that are used for the preparation of financial statements are from ledgers. Entries of different transactions are posted to the ledgers from the books of prime entries. The posting is done to specific accounts in the ledgers.
Format of a ledger: A ledger contains specific records called accounts. An account is a record which shows increases and decreases of a specific asset, liability, revenue, expense or capital item in the ledger. The ledger account has two sides. These are the left-hand side, which is called the debit side (abbreviated as Dr.) and the right-hand side which is called the credit side (abbreviated as Cr.).
Each side of the ledger account has the following columns:
- Date: This column is used to write the date, month, and year of the transaction.
- Particulars: This column indicates the short description of the entry for the transaction recorded. In the ledger account, this column indicates the name of the account to which the corresponding entry has been made for the transaction (remember the principle of double entry).
- Folio: This column records pages of reference in books of accounts.
- Amount: This column records the amount of money being transacted.
Types of Ledgers
There are two main types of ledgers which are subsidiary ledger and the general ledger:
Subsidiary Ledger
A subsidiary ledger is a ledger that contains accounts of individuals for the purpose of recording transactions between the entity and each individual. The most common subsidiary ledgers are sales ledger and purchases ledger. However, different enterprises may have some other subsidiary ledgers depending on the volume of transactions and the need for details on different classes of transactions.
| Type | Description | Alternative Names |
|---|---|---|
| Sales Ledger | Used to record transactions regarding credit customers (debtors) | Accounts receivable ledger, debtors' ledger, trade receivables ledger |
| Purchases Ledger | Used to record transactions with creditors or suppliers of goods or services on credit | Accounts payable ledger, creditors' ledger, trade payables ledger |
General Ledger
The general ledger contains different accounts that do not record transactions relating to individuals. Instead, it deals with total amounts from day books or special journals, or postings from the general journal to accounts that represent each class of transactions, namely revenue, expenses, assets, liabilities and owners' equity (capital). Posting of entries to the general ledger follows the double entry principle and form the basis of balances used in preparing financial statements.
Private Ledger
There are ledgers that directors would not want their staff to see due to confidentiality. These types of ledgers are called private ledgers. A private ledger is a ledger used to keep confidential information of the business owner. In this regard, the owner restricts access to the ledger to selected individuals. Examples of private ledgers are capital ledger, and drawings ledger.
Importance of Ledgers
Every enterprise needs to post financial transactions in ledgers as they play important roles as follows:
- They enable double entry to be completed: The posting of entries in ledger accounts follows the principle of double entry
- They are used in the classification of accounts: The preparation of ledgers enables the book-keeper to classify accounts easily according to their nature
- Information extracted from a balanced ledger can be used for statistical purposes: Balances extracted from ledger accounts can be used as inputs for further analysis and projections
- They are used to keep financial records permanently: Financial transactions posted on ledger accounts are permanent and cannot be altered
- They are used in the preparation of a trial balance: A ledger balance forms the basis for the preparation of a trial balance
- They provide information that is used as inputs when preparing the financial statements: Financial information that is used as inputs in the preparation of financial statements originate from ledgers
Classification of Accounts
This is the process of grouping accounts with similar nature and characteristics. The posting of entries from both general and special journals involves opening different ledger accounts. Different types of ledger accounts influence the way such accounts affect the financial statements. There are two main types of accounts, namely personal accounts and impersonal accounts.
Personal Accounts
These types of accounts record transactions relating to persons. There are two types of persons:
- Natural person: A person who was born biologically. Examples: Juma, Asha, and Anna
- Artificial person: The one formed under the law and empowered to perform activities in their own name. Examples: Tanzania Institute of Education and Kijiko Sports Club
Impersonal Accounts
These are types of accounts that record all other transactions except those recorded in personal accounts. They do not record transactions relating to persons or firms. Impersonal accounts are further classified into real accounts and nominal accounts:
| Type | Description | Examples |
|---|---|---|
| Real Accounts | Record transactions relating to assets and liabilities. These accounts are not closed at the end of the accounting period | Land and buildings, machinery, furniture and fittings, motor vehicles, accounts receivable, cash at bank, accounts payable, bank loans |
| Nominal Accounts | Record transactions relating to expenses and revenues. These accounts are closed at the end of the accounting period | Rent, salaries, purchases, carriage, advertising, discounts allowed, bad debts, sales, interest income, commission income |
Example 5.1: Classification of Accounts
| No. | Name of Account | Classification |
|---|---|---|
| 1 | Anna | Personal account |
| 2 | Furniture | Real account |
| 3 | Sales | Nominal account |
| 4 | Losses | Nominal account |
| 5 | Cash | Real account |
| 6 | Capital | Personal account |
| 7 | Buildings | Real account |
Activity 5.1
Read different reliable sources and then indicate whether the following accounts are nominal, real or personal accounts.
| No. | Name of Account | Classification |
|---|---|---|
| 1 | Abela | |
| 2 | Drawings | |
| 3 | Advertising | |
| 4 | Fixtures | |
| 5 | Purchases returns |
Posting Entries to a Ledger
Posting of entries to a ledger follows the double entry principle of Book-keeping. For the case of a general journal, the journal entry would have already specified the name of the accounts and amounts to be debited and credited for each transaction. In case of day books or special journals, the journal entries do not give direct guidance on accounts to be debited and credited.
When posting, a consideration will be made on:
- The nature of the account: The posting will be made depending on what element of the accounting equation is affected by the transaction
- The effect of the transaction: Once it is known which element is affected by the transaction, it is important to establish whether the transaction involves an increase or a decrease in that element
Two-stage Posting from Special Journals
An important feature of posting from special journals is that the entries are posted in two stages, namely posting to subsidiary ledger and posting to the general ledger.
Posting from the Sales Journal
Stage one: Posting to a subsidiary ledger
Posting to individual accounts of each customer who appears in the journal. The entries are recorded on the debit side of the respective accounts.
Stage two: Posting to the general ledger
The general ledger posting involves the periodic record of the total from the journal. These are posted to the sales account and the trade receivables account.
Entries made:
Debit: Trade receivables account
Credit: Sales account
Posting from the Sales Returns Journal
Stage one: Posting to a subsidiary ledger
Posting to individual accounts of each customer in the journal. The entries are made on the credit side of the respective accounts.
Stage two: Posting to the general ledger
The general ledger posting involves the periodic totals of the journal. These are posted to the sales returns account and the trade receivables account.
Entries made:
Debit: Sales returns account
Credit: Trade receivables account
Example 5.2: Sales Journal Posting
Kassimu made the following sales during the month of June 2023 and some goods were returned. You are required to enter the transactions in the sales journal and sales returns journal and then, post the entries to the relevant subsidiary ledger and the general ledger accounts.
Sales Transactions:
- June 1: Sold to Mambo - 80 packets of rice @ TZS 2,200 and 60 bags of wheat flour @ TZS 4,500
- June 12: Sold to Kifundo Enterprise - 15 boxes of toothpaste @ TZS 2,600 and 16 pieces of writing pads @ TZS 2,350
- Additional sales...
Returns:
- June 2: Mambo returned 10 packets of rice @ TZS 2,200 (spoiled)
- June 8: Rudia stores returned 3 pairs of running shoes @ TZS 6,000 (oversize) and 2 school shirts @ TZS 1,200 (wrong colour)
Balancing of Accounts
The ledger postings are made for the purpose of obtaining balances that are needed for different uses in the business. A balance of an account is the difference between the total of the entries in the debit side of the account and the total of credit entries in an account at any particular date or time.
Steps in Balancing an Account
- Calculate the total amounts of money on the debit side and credit side of the account
- Calculate the difference between the totals obtained in step (a) above
- Insert the difference obtained in step (b) above on the side that had a lower amount of total
- Write the totals of each side which should now be the same for both sides
The balance is labelled 'balance carried forward' (balance c/f) to indicate that the balance is carried forward to the next date/month/year. At the beginning of the next period, the balance will be labelled 'balance brought forward' (balance b/f).
Activity 5.2
After completing the posting of entries to the ledger, it is important that each ledger account is balanced. You have attended a class on balancing of accounts and your teacher, Ms Mwendamseke has assigned you a task to explain the account balancing process and its importance to two of your classmates who had emergencies and could not attend the class.
Write a brief summary that you will use in making the clarification to them.
Concept of Normal Balances
The accounts balancing process has different results. Each of the results has its implication on the balance of the account being balanced. The implications will decide whether the account has a debit balance or a credit balance.
| Results | Account Balance |
|---|---|
| Debit entries total exceeds the credit entries total | Debit balance |
| Credit entries total exceeds the debit entries total | Credit balance |
| Debit entries total equals the credit entries total | NIL balance |
Summary of Double Entry Rules and Normal Balances
| Element | Increases | Decreases | Normal Balance |
|---|---|---|---|
| Assets | Debit | Credit | Debit |
| Liabilities | Credit | Debit | Credit |
| Capital (Owner's Equity) | Credit | Debit | Credit |
| Revenue (Gain) | Credit | Debit | Credit |
| Expenses | Debit | Credit | Debit |
Activity 5.3
Read more reliable sources about normal balances and show the effect and normal balances of the following accounts:
| Name of Account | Increase | Decrease | Normal Balance |
|---|---|---|---|
| Motor van | |||
| Inventory | |||
| Loan from bank | |||
| Account payable | |||
| Capital |
Summary
A ledger is a fundamental component of the double entry accounting system. It is used in maintaining a detailed and organised record of all financial transactions for a business. It serves as a central repository where individual accounts are maintained, summarising the impact of each transaction on specific assets, liabilities, equity, revenues, and expenses. The ledger ensures accuracy and completeness by recording both the debit and credit entries for every transaction, allowing for easy tracking and analysis of the enterprise's financial position and performance.
In the ledger, each account is represented in a T-shaped format, with debits on the left hand side and credits on the right. The ledger acts as a detailed reference in organising financial data into specific accounts. It makes it easier for accountants and financial analysts to prepare financial statements and conduct audits. Through the ledger, businesses can monitor the flow of funds, track revenue and expenses, identify patterns or irregularities, and ensure compliance with accounting standards. The ledger's accuracy and reliability are paramount in providing stakeholders with a clear understanding of the enterprise's financial health and aiding in making informed decisions to drive the business's success.
Revision Exercise 5
- Write up a sales returns day book and show the total sales returns for the month of June 2023 and post the entries to respective subsidiary and general ledger accounts.
- Mkomwa started business on the 1st May 2023 with a capital of TZS 2,000,000 in cash. Record the transactions in the general journal, post the entries to the ledger, balance the accounts at the end of the month and carry down the balances.
- Sambo started business on the 1st June 2023 with capital in cash TZS 3,000,000. Record the transactions in the general journal, post the entries to the ledger, balance the accounts at the end of the month and carry down the balances.
- You are given the following transactions of Kulindajana. Record the transactions in the general journal, post the entries to the ledger, balance the accounts at the end of the month and carry down the balances.
- Indicate whether the following accounts are nominal, real, or personal accounts.
Chapter Six: Trial Balance
Introduction
The trial balance serves a critical role in accounting, offering accuracy checks, error detection, and support for financial statements preparation. By promoting the accuracy of financial data, the trial balance contributes to reliable financial reporting and informed decision-making within a business or enterprise. In this chapter, you will learn concept of a trial balance and how to prepare it. The competencies developed will enable you to prepare the trial balance from a given list of general ledger balances, as well by processing transactions from the source documents up to extracting a trial balance.
Think
On the ways in which a shop keeper can establish a total outstanding amount of money from credit customers.
Concept of a Trial Balance
The trial balance extraction is a fundamental phase in accounting and serves as an important step in the accounting cycle.
Meaning of a Trial Balance
A trial balance can be defined as a list of balances extracted from general ledger accounts at a particular date. In simple words, a trial balance is a snapshot or a picture of ledger accounts balances at a specific date. The trial balance is prepared using debit and credit balances extracted from general ledger accounts. In chapter five you learnt that the entries are posted to the general ledger accounts following the double entry principle of Book-keeping. This means that, at any time the trial balance should balance. In other words, if the posting of the entry in the ledger accounts is done correctly, the total of debit balances and the total of credit balances must be equal.
Advantages of a Trial Balance
A trial balance has the following advantages to an enterprise:
Provides a summary of balances used in the preparation of financial statements
Debit and credit balances extracted from general ledgers are listed on the trial balance. Then, these balances are used as inputs in the preparation of financial statements. In simple terms, balances are extracted from ledgers to a trial balance, then from a trial balance to financial statements. One does not need to go back to each general ledger account to find balances for the purpose of preparing financial statements.
Financial statements are financial reports produced at the end of the accounting period. Examples of financial statements are an income statement and a statement of financial position.
Helps to detect errors that could have occurred in the posting process
The trial balance is prepared using debit and credit balances extracted from general ledger accounts. Since the entries in the general ledger accounts are posted following the double entry principle the trial balance should balance at any point in time. Therefore, if the trial balance does not balance, it could mean that errors have been made in the posting process. In view of this, the trial balance is used to detect errors made during the posting process.
Checks the correctness of double entries made to the accounts
If entries made to ledger accounts were wrongly done, the trial balance will not balance. In this regard, the trial balance is used for checking the correctness of the double entries made to the accounts.
Checks whether computations of the ledger accounts balances were performed correctly
Double entries might be done properly, but mistakes can occur when computations regarding the figures posted are done. Mistakes in the calculation will result into incorrect balances extracted from the ledger accounts. This will prevent the trial balance from balancing. Therefore, the trial balance checks whether computations of the figures on the trial balance were performed correctly.
Helps the enterprise to keep its records systematically
The trial balance is the summary of debit and credit balances extracted from the general ledger. In the trial balance, balances from the general ledger accounts are listed systematically.
Limitations of a Trial Balance
Even though a trial balance is important to the entity, it also has its limitations. The main limitation of the trial balance is that it cannot detect all possible errors in the ledger accounts. This means that the agreement of the totals of debit and credit balance is not enough to conclude that there was no error made when posting the transactions to the general ledger accounts. This is because some errors may still exist even though the totals of the credit and debit balances agree. For example, a wrong amount is posted for a transaction such that both debit and credit entries are posted using wrong amount, or a posting is done to a wrong account. In such cases, the trial balance would still agree while there are errors in the posting process.
Additionally, the trial balance does not:
- Prove that all transactions have been recorded
- Find the missing entry from the journals or in the ledger
- Protect the repetition of postings
- Prove that the ledger is correct
- Detect off-setting errors
In short, a trial balance does not guarantee that recording of entries will be error-free.
Activity 6.1
Mr Haiujuani is a businessman who does not appreciate the preparation of trial balances. He believes that once the ledger balances are established, he can go straight to the preparation of financial statements. Write a short report about importance of a trial balance for his business.
Preparation of a Trial Balance
A trial balance is prepared from debit and credit balances extracted from the general ledger accounts. When preparing the trial balance, two basic steps must be followed:
- The first step involves identifying the debit and credit balances in the general ledger. Performing this step depends on the data available. There are cases where a list of the general ledger balances is given, and there are cases where one is given transactions and has to process them (journalising, posting to the general ledger, balancing the accounts and extracting the trial balance).
- The second step is the actual listing of the balances in the trial balance. This is done by listing the debit balances on the debit side of the trial balance and the credit balances on the credit side of the trial balance.
The Format of a Trial Balance
Explanation of a Trial Balance
The name of the business owner or enterprise it written at the top of the trial balance. This indicates the ownership of the trial balance. Also, below the name of the business owner, the word "A trial balance as at (date, month, and year)" is shown. This is important since it shows the actual date at which balances used were extracted from the general ledger. A change in the date could bring a lot of changes in the trial balance since the posting of transactions to the general ledger is a continuous exercise.
Important columns of the trial balance are:
- Details: It is the column that records names of the ledger accounts from which the balances have been extracted.
- Debit balances: It is the column in that records the debit balances extracted from general ledger accounts.
- Credit balances: It is the column in which records the credit balances extracted from the general ledger accounts.
Example 6.1: Preparing a Trial Balance from a Given List of Balances
You are given the following list of balances extracted from the general ledger of Asam Traders at 30th November 2021, from which you are required to extract a trial balance.
| Account Name | Amount (TZS) |
|---|---|
| Sales | 172,720,000 |
| Purchases | 83,896,000 |
| Rent and rates expenses | 3,296,000 |
| Lighting and heating expenses | 412,800 |
| Salaries and wages | 40,720,000 |
| Insurance expenses | 1,608,000 |
| Building | 67,360,000 |
| Furniture | 864,000 |
| Trade receivables | 24,672,000 |
| Electricity expenses | 326,400 |
| Trade payables | 11,984,000 |
| Balance at bank | 11,160,000 |
| Equipment | 20,000,000 |
| Motor van | 11,680,000 |
| Motor running expenses | 3,278,400 |
| Capital | 83,400,000 |
| Stock at 1st December 2020 | 1,169,600 |
| Stock at 30th November 2021 | 978,550 |
| Discount received | 2,339,200 |
Solution
First, identify whether the balances are debit or credit, using the concept of normal balances:
| Name of account | Element | Normal balance |
|---|---|---|
| Sales | Revenue | Credit |
| Purchases | Expense | Debit |
| Rent and rates expenses | Expense | Debit |
| Lighting and heating expenses | Expense | Debit |
| Salaries and wages | Expense | Debit |
| Insurance expenses | Expense | Debit |
| Building | Asset | Debit |
| Furniture | Asset | Debit |
| Accounts receivable (Debtors) | Asset | Debit |
| Electricity expenses | Expense | Debit |
| Accounts payable (Creditors) | Liability | Credit |
| Balance at bank | Asset | Debit |
| Equipment | Asset | Debit |
| Motor van | Asset | Debit |
| Motor running expenses | Expense | Debit |
| Capital | Capital | Credit |
| Stock at 1st December 2020 | Asset | Debit |
| Stock at 30th November 2021 | Asset – not part of the trial balance | Debit |
| Discount received | Revenue | Credit |
Exercise 6.1
- Why is the stock at 30th November 2021 not part of the trial balance?
- What are the alternative terms used to refer to debtors and creditors in accounting?
- What is meant by drawings? Explain why drawings have a normal balance of debit?
Example 6.2: Preparing a Trial Balance from a Given List of Transactions
Record the following transactions in the general journal, ledger accounts of Jamal for January 2020, and then balance off the ledger accounts, and extract a trial balance as at 31st January 2020.
- January 1: Started business by depositing cash in the bank account TZS 13,500,000
- January 2: Purchased a business building from Kamara for TZS 7,500,000, paying TZS 5,000,000 by cheque and promising to pay the balance as early as possible next month
- January 4: Purchased office furniture by cheque from John TZS 250,000
- January 5: Purchased goods on credit from Madina TZS 500,000
- January 8: Jamal added in the business TZS 600,000 by cheque
- January 10: Sold goods to Mahinda on credit worth TZS 120,000
- Additional transactions...
Solution Approach:
In this kind of situation, the first step involves the application of the double entry principle to make entries in the general journal, post the entries to the general ledger, and balance the ledger accounts. The second step will involve extracting the debit and credit balances from the general ledger accounts for the trial balance.
Activity 6.2
A trial balance is used as a tool to check the arithmetical accuracy of recording and posting double entries. Sometimes the balancing of the trial balance does not justify that everything was done correctly. Make a discussion with your colleague and write down possible reasons that may cause the trial balance to agree even if some of the entries posted in the general ledgers are not correct.
Summary
A trial balance extraction is a fundamental phase in the accounting process or cycle it summarises the balances of all ledger accounts at a specific point in time. It plays a crucial role in the double-entry accounting system, serving as a preliminary check to ensure the accuracy of financial records. The trial balance lists all general ledger accounts, with their corresponding debit and credit balances. By comparing the total debits and total credits, businesses can verify that the accounting equation (Assets = Liabilities + Equity) is in balance. If the trial balance balances, it suggests that the double-entry accounting system has been applied correctly, and the total debits equal the total credits. However, a balanced trial balance does not guarantee the absence of errors, as mistakes could offset each other, leading to an appearance of accuracy despite the presence of inaccuracies.
While a balanced trial balance indicates overall accuracy, it does not pinpoint specific errors. It acts as a useful tool for detecting certain types of mistakes, such as transposition errors or omissions, but it may not identify more complex errors, such as incorrect postings or compensating errors. As such, accountants should conduct further analysis and reconciliation to ensure the integrity of financial records. The trial balance is an essential step in the accounting process and is typically prepared at the end of an accounting period, aiding in the preparation of financial statements and providing a starting point for more detailed financial analysis and decision-making.
Revision Exercise 6
- Enter the transactions in questions 1 - 5 in the general journal, post the entries to the general ledger accounts, balance the accounts at the end of the respective months and extract a trial balance as at the end of the month in each case.
- Mr Mloka, who is very weak in Book-keeping has provided you with the following trial balance which does not balance. You are required to redraft it and make it balance.
- You are required to prepare a trial balance as at 31st December 2020 from the following balances.
Chapter Seven: Basic Financial Statements
Introduction
Basic financial statements provide business stakeholders, such as investors, creditors, and managers, with a comprehensive understanding of a business financial performance and position. They are essential tools for making informed decisions, assessing profitability, solvency, liquidity, and overall financial health of the business. In this chapter, you will learn concept of financial statements, an income statement, a statement of financial position and how to prepare them. The competencies developed will enable you to prepare the income statement and the statement of financial position appropriately.
Think
How a shopkeeper can identify the amount of profit generated and the value of the shop in certain month.
Concept of Financial Statements
This section presents the meaning, purposes, and common users of financial statements.
The Meaning and Purpose of Financial Statements
The meaning of financial statements: Financial statements are statements that are prepared periodically to present the results of the business for the period. While there are five components of financial statements, but the focus is on two, namely income statement and a statement of financial position. The income statement, which is also known as a statement of profit or loss, is prepared in order to determine a profit or a loss made by the business in a particular accounting period. On the other hand, the statement of financial position which is also known as a balance sheet, is prepared in order to show the financial position of a business by considering the balances of assets, liabilities and capital.
Some businesses, for example, companies, are required by law to prepare financial statements. For sole owners, financial statements may not be legally required (except for tax purposes), but the needs of the owners would be met through the use of financial statements, especially in evaluating performance of the business for the period. There are also other users who would benefit from the financial statements of a business. This is because their understanding of financial and operational affairs of the business can be useful in making informed decisions.
Purpose of Financial Statements
Detailed descriptions of the purpose of preparing financial statements are to:
Show profitability of the business
Many businesses are established for the purpose of making profits. Therefore, it is important to measure whether this objective has been achieved. This is because, owners will have an opportunity to evaluate whether the management has met their targets or not. It will also assist owners in making decision on whether to continue with the business or not.
Show the financial position of the business
When a business gets into a difficult financial position, for example, being overburdened by liabilities, it may face the risk of closure due to inability to pay debts. Similarly, when the business has a large proportion of its assets on non-productive assets, this creates a possibility of failure of the business in the future. On the other hand, a good proportion of productive assets forecasts a bright future for the business.
Non-productive assets: These are assets existing in the business but not fully utilised to generate revenue. For example, a large office building in excess of the business requirements may represent a non-productive asset.
Help in assessing the efficiency of business operations
Efficiency of business operations is useful in ensuring that the business achieves its profit-making objective. Examples of efficiency measures include assets utilisation and frequency of stock movements (stock turnover). Assets utilisation is usually used in measuring how well the business is using its available assets to make money. Stock turnover is a measure used for establishing how many times a business has sold and replaced its inventory during a given period. Figures used to calculate ratios for these measures are usually obtained from financial statements. When there is an unsatisfactory level of efficiency, the business can plan ways to improve its performance.
Facilitate compliance with tax laws
Amounts of different taxes payable by the business are computed from the figures obtained from financial statements. Profit and sales figures provide a reasonable basis for calculating taxes related to turnover or profits. These figures can be easily obtained from the business financial statements.
Facilitate planning and evaluation
Planning and evaluation are among the main functions of management. Financial statements are useful in evaluating the performance of a business for the period. This can be done through comparing the targets established at the beginning of the year with the actual results that are obtained from the financial statements. Moreover, the performance of the current year can form the basis for setting plans for the next year.
Establish the riskiness of the business
Different stakeholders dealing with the business, for example, banks, customers, and suppliers will need to be sure about the risk associated with the business. In this context, a risk may be defined as the probability that actual results will differ from the expected results. Traditionally, risk has been defined in terms of the possibility of danger, loss, injury or other negative outcomes. For example, customers would want to be assured of steady supplies of goods, while banks and suppliers would want to be sure of the ability of the business to settle their debts. Since financial statements provide the results of business performance, they are usually considered as a reliable source of information. The information will help stakeholders to have answers for their questions including the risks associated with the business.
Types of Financial Statements
Financial statements are used by various stakeholders, including investors, creditors, management, and regulators, to assess the enterprise's financial health and make informed decisions. The three common components of financial statements are:
Income Statement (Profit or Loss Statement)
The income statement presents the financial performance of a business resulting from its operating activities over a specific period, for example, a quarter or a year. It provides a summary of revenues, expenses, and the resulting profit or loss. The income statement follows the basic formula:
Key figures included in the income statement are:
- Revenues (sales, service income)
- Cost of goods sold (COGS) - applicable for businesses selling products
- Gross profit (revenues - cost of goods sold)
- Operating expenses (selling, general, and administrative expenses)
- Operating income (gross profit - operating expenses)
- Other income and expenses (interest income, interest expenses)
- Profit or loss for the period
Statement of Financial Position (Balance Sheet)
The statement of financial position presents the financial position of a business at a specific point in time, usually the end of a quarter or a year. It shows what the resources of the business (assets), what it owes to others (liabilities), and the residual interest of the owners (equity).
The statement of financial position follows the accounting equation:
Key elements of a statement of financial position include:
- Assets (current assets and non-current assets)
- Liabilities (current liabilities and non-current liabilities)
- Capital or Equity (fund invested in a business for example, initial capital and retained earnings)
Cash Flow Statement
The cash flow statement provides an overview of an enterprise's cash inflows and outflows over a specific period. It shows how cash is generated and used by operating, investing, and financing activities of the enterprise during the period. The cash flow statement is divided into three sections:
- Operating activities: Cash flows resulting from day-to-day business operations, including cash received from customers and cash paid to suppliers and employees.
- Investing activities: Cash flows resulting from buying or selling long-term assets, such as property, equipment or investments.
- Financing activities: Cash flows resulting from transactions with the enterprise's owners and loan providers, including issuance or repurchase of shares, acquisition or repayment of loan as well as payment of dividends.
These financial statements components are critical for assessing an enterprise's financial performance, liquidity, solvency, and overall financial health. Together, they provide a comprehensive view of the enterprise's financial position and serve as valuable tools for decision-making and financial analysis. In this chapter, only income statement and statement of financial positions will be discussed, while cashflow statements will be discussed in higher forms.
An Income Statement
An income statement is a statement prepared at the end of an accounting period to calculate the profit or loss made. The statement calculates profit or loss for the period by comparing revenue earned during the period and expenses incurred during the same period. It is therefore in the income statement where the matching principle, as highlighted in chapter one is applied.
Calculation of Profit or Loss
The purpose of preparing an income statement is to calculate the amount of profit or loss for a particular period. Profit or loss for a merchandising business is calculated in two stages. The first stage compares the amount of net sales and cost of goods sold to obtain the gross profit or loss. The second stage compares the gross profit (obtained from the first stage) and other incomes with different expenses incurred in operating the business during the period. The result is the profit or loss for the period.
Terms Used in an Income Statement
Net Sales
The figure of net sales is made by two aspects which are sales and sales returns. The sales figure is the credit balance transferred from the sales account in the general ledger. It is the total of all sales (both credit and cash) made during the period under consideration. Sales returns are those goods that were previously sold to a customer but were later returned due to different reasons. Therefore, the net sales is calculated by taking sales less the sales returns which is also known as returns inwards.
Net Purchases
The figure for net purchases is obtained after taking into consideration several aspects. The first aspect is the debit balance found in the account of purchases itself. This figure is the total purchases (cash and credit) done in the whole accounting period.
The second component included in the calculation of the net purchases figure is the purchases returns or returns outwards. Purchases returns refer to those goods which were previously purchased by the entity but were later returned to the supplier due to several reasons. It should be noted that the figure for purchases shows the total amount (credit and cash) of purchases made without deducting those goods that were returned to the supplier. Therefore, to determine at a net purchases figure, purchases returns must be deducted from the purchases figure.
The complete equation of net purchases is stated as net purchases is equal to purchases less purchases returns.
Because of the objective of the process, that is, calculation of the cost of goods sold, another item considered as part of such cost is the carriage inwards costs. These are costs of transferring or transporting the purchased goods from where they were procured to the premises of the enterprise. In simple terms, the cost of goods purchased is the total of the cost paid to purchase such goods plus the transportation cost of bringing those goods to the enterprise's premises. For example, the supplier sold goods for TZS 100,000 and TZS 10,000 is incurred by the buyer to transport such goods from the supplier's premises to his or her premises. In this case, the cost of such goods, is not only TZS 100,000 but is TZS 110,000 (TZS (100,000 +10,000)).
Opening Inventory and Closing Inventory
An opening inventory is the inventory of goods held by the entity at the beginning of the accounting period. On the other hand, a closing inventory is the inventory of goods held by the entity at the end of the accounting period.
Sample Income Statement Format
Sales: XXX
Less: Sales returns: (XXX)
Net Sales: XXX
Opening inventory: XXX
Add: Purchases: XXX
Less: Purchases returns: (XXX)
Add: Carriage inwards: XXX
Cost of goods available for sale: XXX
Less: Closing inventory: (XXX)
Cost of goods sold: (XXX)
Rent expense: XXX
Salaries and wages: XXX
Utilities: XXX
Advertising: XXX
Depreciation: XXX
Total operating expenses: (XXX)
Sample Statement of Financial Position Format
Non-current Assets
Property, plant and equipment: XXX
Furniture and fittings: XXX
Motor vehicles: XXX
Total non-current assets: XXX
Current Assets
Inventory: XXX
Trade receivables: XXX
Cash and bank: XXX
Total current assets: XXX
TOTAL ASSETS: XXX
Equity
Capital: XXX
Add: Net profit: XXX
Less: Drawings: (XXX)
Total equity: XXX
Liabilities
Non-current Liabilities
Long-term loans: XXX
Total non-current liabilities: XXX
Current Liabilities
Trade payables: XXX
Short-term loans: XXX
Total current liabilities: XXX
TOTAL EQUITY AND LIABILITIES: XXX
Common Users of Financial Statements
Financial statements serve various stakeholders who have different interests in the business:
| User Group | Interest in Financial Statements |
|---|---|
| Owners/Shareholders | Assess profitability and return on investment, evaluate management performance |
| Management | Make strategic decisions, plan for future operations, evaluate performance |
| Creditors/Lenders | Assess ability to repay loans, evaluate creditworthiness |
| Suppliers | Determine credit terms, assess ability to pay for goods supplied |
| Employees | Assess job security, evaluate prospects for salary increases |
| Government/Tax Authorities | Determine tax liabilities, ensure compliance with regulations |
| Investors | Evaluate investment opportunities, assess potential returns |
| Customers | Assess business stability and ability to provide ongoing services |
Summary
Financial statements are essential tools that provide a comprehensive view of a business's financial performance and position. The income statement shows the profitability of the business over a specific period by matching revenues and expenses. The statement of financial position presents the financial position at a particular point in time through the accounting equation (Assets = Liabilities + Equity).
These statements serve multiple purposes including showing profitability, demonstrating financial position, assessing operational efficiency, facilitating tax compliance, supporting planning and evaluation, and establishing business risk. Various stakeholders including owners, management, creditors, suppliers, employees, government authorities, investors, and customers rely on financial statements to make informed decisions.
Understanding how to prepare and interpret these basic financial statements is crucial for effective financial management and informed decision-making in any business enterprise.
Revision Exercise 7
- Explain the difference between an income statement and a statement of financial position.
- Describe the purpose of preparing financial statements for a business enterprise.
- Identify and explain three key users of financial statements and their specific interests.
- Calculate gross profit and net profit from the following information:
- Sales: TZS 5,000,000
- Sales returns: TZS 200,000
- Purchases: TZS 2,500,000
- Purchases returns: TZS 100,000
- Operating expenses: TZS 1,200,000
- Opening inventory: TZS 500,000
- Closing inventory: TZS 600,000
- Prepare a simple statement of financial position using the following information:
- Cash: TZS 800,000
- Inventory: TZS 1,200,000
- Equipment: TZS 2,500,000
- Accounts receivable: TZS 600,000
- Accounts payable: TZS 900,000
- Bank loan: TZS 1,500,000
- Capital: TZS 2,700,000
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