UNIT 2:ACCOUNTING SOURCE DOCUMENTS►

UNIT 1:GENERAL INTRODUCTION AND OVERVIEW OF ACCOUNTING

  • UNIT 1:GENERAL INTRODUCTION AND OVERVIEW OF ACCOUNTING

    a

     Read the following case study and answer the given questions 
    using the knowledge acquired in entrepreneurship subject.

    Accounting is an essential function of any business entity. It gives the 
    framework to record all the business transactions and events that happen 
    during the working of the business entity. Accounting is the language 
    of business, with books of accounts being its script and debit-credit its 
    style, i.e., the way of expressing it.
    According to the American Accounting 
    Association, Accounting is the process of identifying, measuring, and 
    communicating information to permit judgment and decisions by the 
    users of accounts. According to the American Institute of Certified 
    Public Accountants, Accounting is the art of recording, classifying, and 
    summarizing in a significant manner and in terms of money, transactions, 
    and events, which are at least of a financial character and interpreting the 
    result thereof. 
    Accounting is an art as well as a science. Accounting is an art of 
    recording, classifying, and summarizing all business transactions. It is a 
    science as well as it follows certain guiding accounting principles and 
    standards. It records financial transactions only, which can be expressed 
    in terms of money. First, the transactions are recorded and then classified 
    and summarized to interpret the business’s financial performance and 
    position. One needs to keep in mind that Accounting and Accountancy 

    are two different concepts. 

    Experimenal version

    Accounting is the recording, classifying, and summarizing of business 
    transactions to ascertain the financial performance and position of the 
    business firm. On the other hand, Accountancy is the body of knowledge 
    based on principles for recording, classifying, and summarizing business 

    transactions to help in the decision-making function of management.

    1. Accounting gives the -------------- to record all the business 
    transactions.
    b) Framework
    c) Process
    d) Money 

    e) Classification

    2. Accounting is the art of recording, classifying, and summarizing in a 
    significant manner and in terms of money, transactions, and events 
    which are, in part at least of a financial character and interpreting 

    the result thereof. This accounting definition is given by:

    a) Institute of Certified Public Accountants of Rwanda
    b) American Accounting Association
    c) American Institutes of Certified Public Accountants
    d) International Financial Regulation System
    3. Accounting is called science because it follows certain guiding 
    -------------
    4. Accounting records only --------------------- transactions 

    5. Who are the users of accounting information?

    Experimenal version

    1.1 Meaning and Purpose of Accounting

    w

     1.1.1 Meaning of accounting

    Accounting is defined as the process of identifying, recording, classifying and 
    summarizing economic data so as to come up with useful information to help 
    users make informed decisions. Many businesses carry out transactions. Some 
    of these transactions have a financial implication i.e. either cash is received or 
    paid out. Examples of these transactions include selling goods, buying goods, 
    paying employees and so many others.
    Accounting is involved with identifying these transactions measuring (attaching a 
    value) and reporting on these transactions. If a firm employs a new staff member 
    then this may not be an accounting transaction. However, when the firm pays 
    the employee salary, then this is related to accounting as cash involved. This has 
    an economic impact on the organization and will be recorded for accounting 
    purpose. A process is put in place to collect and record this information; it is 
    then classified and summarized so that it can be reported to the interested 
    parties.
    Accounting, as a preamble, could be termed the language of business. It is the 
    common media through which people of all walks can effectively communicate 

    business matters and understand one another equally. 

    Experimenal version

    It is the language accountants use to communicate i.e. record business 
    transactions and summarize results of business operations. Accounting is the art 
    of recording, classifying, and summarizing in a significant manner, and in terms 
    of money, transactions, and events of a financial character, and interpreting the 
    results thereof. It encompasses the recording of information of economic value 

    to a business. The information then forms the basis for judgment by the users.

    1.1.2 The objectives of accounting 

    Accounting has many objectives; including letting people and organizations 
    know: 
    – If they are making a profit or a loss;
    – What their business is worth;
    – What a transaction was worth to them;
    – How much cash they have;
    – How wealthy they are;
    – How much they are owed;
    – How much they owe to someone else;
    – Enough information so that they can keep a financial check on the 
    things they do.
    However, the primary objective of accounting is to provide information for 
    decision making. The information is usually financial, but can also be given in 
    volumes, for example the number of cars sold in a month by a car dealership 
    or the number of cows in a farmer’s herd herd (this kind of non-financial 
    information, however is more useful in management/managerial accounting than 
    it is in financial accounting). So, for example, if a business recorded what it 
    sold, to whom, the date it was sold, the price at which it was sold, and the date 
    it received payment from the customer, along with similar data concerning the 
    purchases it made, certain information could be produced summarizing what 
    had taken place. The profitability of the business and the financial status of the 
    business could also be identified, at any particular point in time. It is the primary 
    objective of accounting to take such information and convert it into a form that 

    is useful for decision making

    Experimenal version

    1.1.3 Branches of Accounting

    Accounting, in all its broadness, can be sub-divided into areas of specialization;
    a) Financial accounting; concerns itself with the collection and 
    processing of accounting data and reporting to interested parties 
    inside and outside the firm.
    b) Tax accounting; deals with the determination of the firm’s tax liability 
    which could be, Value-added tax (VAT), customs duty, Pay As You 
    Earn (PAYE), corporation tax, etc.
    c) Cost accounting; helps establish costs relating to the production of a 
    good or service and allocating it to the various factors that contributed 
    to the cost of production.
    d) Managerial accounting; deals with the generation of accounting 
    information to be used categorically by the firm’s internal management 
    in their day-to-day decision making.
    e) Auditing; concerns itself with the vouching and verification of 
    transactions from the financial accounting to determine that they are a 
    true representation of the business’ activity i.e. the true and fair view of 
    the company’s state of affairs.

    Other subdivisions of accounting include forensic accounting which combines 
    accounting, auditing, and investigative skills to examine the finances of an 
    individual or business, fiduciary accounting which is the recording of transactions 
    associated with a trust or estate and accounting information system which is a 
    computer-based method, it tracks accounting activity that has been combined 

    with information technology resources

    Application activity 1.1

    1. Explain the term accounting
    2. What do you understand by accounting information
    3. Mention two objectives of accounting
    4. State the uses of accounting information
    5. Mention five different branches of accounting
    6. State two differences between financial accounting and management 

    accounting

    Experimenal version

    1.2 Users of Accounting Information 

    Activity 1.2

    Refer to the knowledge acquired in Entrepreneurship and state who you 
    think need accounting information of a certain business.
    Today, more people than ever before recognize the importance of accounting 
    information and the profound effect that unethical and misleading financial 
    reports can have on a business, its owners, its employees, its lenders, and the 
    financial markets. 
    The people who use accounting information to make decisionscan be classified 
    into three categories:
    – Those who manage a business
    – Those outside a business enterprise who have a direct financial interest 
    in the business 
    – Those who have an indirect financial interest in a business
    These categories apply to governmental and not-for-profit organizations as well 
    as to profit-oriented ventures.
    Note that the users may also be classified into internal and external users of 
    accounting information. Internal users are those within an organization who use 
    financial information to make day-to-day decisions. External users are those 
    outside of the organization who use the financial information to make decisions 

    or to evaluate an entity’s performance and position

    1.2.1 Management

    Management refers to the people who are responsible for operating a 
    business and meeting its goals of profitability and liquidity. In a small business, 
    management may consist solely of the owners. In a large business, managers 
    are not necessarily the owners and thus may be agents of the owners. 
    Managers must decide what to do, how to do it, and whether the results match 
    their original plans. Successful managers consistently make the right decisions 
    based on timely and valid information. Note that managers and other employees 

    are internal users of accounting information.

    Experimenal version

    1.2.2 Users with a direct financial interest

    Another group of decision makers who need accounting information are those 
    with a direct financial interest in a business. They depend on accounting to 
    measure and report information about how a business has performed. Most 
    businesses periodically publish a set of general-purpose financial statements 
    that report their success in meeting the goals of profitability and liquidity. 
    These statements show what has happened in the past, and they are important 
    indicators of what will happen in the future. Many people outside the company 
    carefully study these financial reports. The two most important groups are 

    investors (including owners) and creditors.

    1.2.2.1 Investors

    Those are current and future stockholders who may invest in a business and 
    acquire a part ownership in it are interested in its past success and its potential 
    earnings. A thorough study of a company’s financial statements helps potential 
    investors judge the prospects for a profitable investment. After investing, they 
    must continually review their commitment, again by examining the company’s 
    financial statements.
    1.2.2.2 Creditors
    Most companies borrow money for both long- and short-term operating needs. 
    Creditors, those who lend money or deliver goods and services before being 
    paid, are interested mainly in whether a company will have the cash to pay 
    interest charges and to repay the debt at the appropriate time. They study a 
    company’s liquidity and cash flow as well as its profitability. Banks, finance 
    companies, mortgage companies, securities firms, insurance firms, suppliers, 
    and other lenders must analyze a company’s financial position before they make 
    a loan. Note that investors and creditors are primary external users of accounting 
    information.
    1.2.3 Users with an indirect financial interest
    In recent years, society as a whole, through governmental and public groups, has 
    become one of the largest and most important users of accounting information. 
    Users who need accounting information to make decisions on public issues 

    include tax authorities, regulatory agencies, and various other groups

    Experimenal version

    1.2.3.1 Tax Authorities

    Government at every level is financed through the collection of taxes. Companies 
    and individuals pay many kinds of taxes, including national, and city income 
    taxes; Social Security and other payroll taxes; excise taxes; and sales taxes. 
    Each tax requires special tax returns and often a complex set of records as well. 
    Proper reporting is generally a matter of law and can be very complicated. The 
    Internal Revenue Code, for instance, contains thousands of rules governing the 
    preparation of the accounting information used in computing federal income 

    taxes.

    1.2.3.2 Regulatory Agencies

    Most companies must report periodically to one or more regulatory agencies 
    at the national and local levels. For example, all publicly traded corporations 
    must report periodically to Capital Market Authority (CMA). (CMA) is a public 
    institution established by Law No.23 /2017 of 31/05/2017 responsible for 
    developing and regulating the capital markets industry, commodities exchange 
    and related contracts, collective investment schemes and warehouse receipts 
    system. Companies listed on Rwanda Stock Exchange (RSE) must meet 
    the special reporting requirements of their exchange. Another example of a 
    regulatory agency is the National Bank of Rwanda – All financial institutions are 

    required to report periodically to the National Bank of Rwanda. 

    1.2.3.3 Other groups 

    Labor unions study the financial statements of corporations as part of preparing 
    for contract negotiations; a company’s income and costs often play an important 
    role in these negotiations. Those who advise investors and creditors—financial 
    analysts, brokers, underwriters, lawyers, economists, and the financial press—
    also have an indirect interest in the financial performance and prospects of a 
    business. Consumer groups, customers, and the general public have become 
    more concerned about the financing and earnings of corporations as well as the 
    effects that corporations have on inflation, the environment, social issues, and 
    the quality of life.
    Note that a part from managers and employees who are internal users, all other 

    users are external users of financial information

    Experimenal version

    Application activity 1.2

    1. State three categories of users of accounting information
    2. Match the terms below with the type of user of accounting information 

    (Some answers may be used more than once):

    1. Tax authorities 
    2. Investors
    3. Management 
    4. Creditors
    5. Regulatory agencies
    6. Labor unions and 

    consumer groups

    a. Internal user
    b. Direct external user

    c. Indirect user

    3. Why the following are interested accounting information 
    a) Creditors
    b) Tax authorities 
    c) Investors

    d) General public

    Experimenal version

    1.3 Forms of Business Organizations

    Activity 1.3

    j

    Read the following case study and answer the given questions 
    Kamariza, a bright final year student was waiting for her result to be 
    declared. While at home, she decided to put her free time to use. Having 
    a painting talent, she tried decorating clay pots and bowls with designs. 
    She was excited at the praise showed on her by friends on her work. She 
    even managed to sell few pieces of unique hand pottery for her home to 
    people living in and around her village. Operating from home, she was able 
    to save on rental payments. She gained a lot of popularity by word of mouth 
    publicity as a sole proprietor. She further perfected her skills of painting 
    pottery and created new designs. All this generated great interest among 
    her customers and provided a boost to the demand for her products. By 
    the end of summer, she found that she had been able to make a profit of 
    FRW 100,000. She felt motivated to take up this work as a career. She has, 
    therefore, decided to set up her own business. 
    She can continue running the business on her own as a sole proprietor, 
    but she needs more money for doing business on large scale. Her father 
    has suggested that she should form a partnership with her cousin to meet 
    the need for additional funds and for sharing the responsibilities and risks. 
    Besides, he believes that it is possible that the business might grow further 
    and may require forming a company.
    a) She is in a dilemma as to what form of business organisation she 
    should go in for? 
    b) Which factors to be considered in selecting an appropriate form 

    of business?

    Experimenal version

    To start a business, a potential owner must have a sufficient amount of capital 
    and must choose an appropriate form of business organization. The three basic 
    forms of business organization are the sole proprietorship, the partnership, 
    and the corporation. Accountants recognize each form as an economic unit 
    separate from its owners. Legally, however, only the corporation is separate 
    from its owners. The characteristics of corporations make them very efficient in 
    amassing capital, which enables them to grow extremely large. As even though 
    corporations are fewer in number than sole proprietorships and partnerships, 

    they contribute much more to the economy in monetary terms. .

    1.3.1 A sole proprietorship

    Sole means “single” or “one.” Proprietor means “owner.” A sole proprietorship, 
    therefore, is a business owned by one person. It is sometimes simply called a 
    proprietorship. Being a sole proprietor does not mean working alone. Based on 
    the operation’s size and scope, a sole proprietorship may have many managers 
    and employees. The oldest and most common form of business organization, 
    the sole proprietorship is the easiest business form to start. Little or no legal 
    paperwork (forms and documents) is required. The success or failure of the 

    business depends heavily on the efforts and talent of the owner

    A sole proprietorship advantages and disadvantages

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    1.3.2 A partnership

    A partnership is a business owned by two or more persons, called partners, 
    who agree to operate the business as co-owners. The partners share the profits 
    and losses of the business according to agreed proportions.

    The partners share between them ownership of the business and the obligation to 
    manage its operations. Professional people, such as accountants, solicitors and 
    doctors, commonly organize their business activities in the form of partnerships. 
    Accounting statements are required as a basis for allocating profits between the 
    partners and, again, for agreeing tax liabilities with the Tax Revenue Authority. 
    Business partners usually enter into a written, legal agreement. This agreement 
    specifies each partner’s investment in money or property, responsibilities, 
    and percentage of profits and losses. Partnerships are often formed when a 
    business needs more capital than one person can invest. Partnerships are not 

    always small. 

    A Partnership advantages and disadvantages 

    i

    1.3.3 A corporation

    A corporation, on the other hand, is a business unit chartered by the state 
    and legally separate from its owners (the stockholders). The stockholders, 
    whose ownership is represented by shares of stock, do not directly control 
    the corporation’s operations. Instead, they elect a board of directors to run the 
    corporation for their benefit. In exchange for their limited involvement in the 
    corporation’s operations, stockholders enjoy limited liability; that is, their risk of 

    loss is limited to the amount they paid for their shares. 

    Thus, stockholders are often willing to invest in risky, but potentially profitable, 
    activities. Also, because stockholders can sell their shares without dissolving the 
    corporation, the life of a corporation is unlimited and not subject to the whims 
    or health of a proprietor or a partner. The business owner(s) may “incorporate” 
    to obtain money needed to expand. To raise this money, organizers sell shares 
    of stock to hundreds or even thousands of people. These shareholders, or 
    stockholders, are the corporation’s legal owners.

    A Corporation advantages and disadvantages

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    Other forms of businesses 

    A part from the above three main types of businesses we also have other forms 

    of entity that may not necessarily be referred to as businesses but they relate 

    to businesses and some authors refer to them as other forms of businesses. 

    Those are: 

    • Cooperatives: members come together to start the business to satisfy 
    their needs/common interest 
    • Not for profit entity: they are started to just offer a given service or 
    good mostly to their members or to a particular group of people with 
    common interest but they do not have profit as the motive. 

    • Parastatal: is a company wholly owned by the government 

    Application activity 1.3

    1. Mr. Gasagure is a sole proprietor. Over the past decade, his 
    business has grown from operating a neighborhood corner shop 
    selling different items to retail chain with three branches in the city. 
    Although he looks after the varied functions in all the branches, he 
    is wondering whether he should form a company to better manage 
    the business. 
    a) Explain two benefits of remaining a sole proprietor
    b) Explain two benefits of converting to a limited liability company 
    2. Match the descriptions on the left with the forms of business 

    organizations on the right: 

    1. Pays dividends 
    2. Owned by only one person
    3. Multiple co-owners
    4. Management appointed by 
    board of directors
    5. Most numerous but usually 
    small in size
    6. Biggest segment of the 

    economy

    (a) Sole proprietorship
    (b) Partnership

    (c) Corporation

    1.4 Accounting Concepts

    Activity 1.4

    Why do you think accounting concepts and conventions are important to a 

    business entity?

    Activity 1.4

    Accounting concepts, conventions, or principles are the basic ground rules that 
    must be followed when financial accounts are prepared and presented. They 
    are also referred to as assumptions or prepositions that underlie the preparation 

    and presentation of financial statements.

    1.4.1 Business entity assumption

    This concept states that business is regarded as a separate entity different/
    distinct from owners and managers. This means assets and liabilities of the 

    business should be separated from those of the owners. 

    1.4.2 Monetary unit assumption/ Money measurement 

    concept 

    This concept states that only items which can be expressed in monetary terms/
    value are to be recorded in book. An economic entity's accounting records 
    include only quantifiable transactions. For example, certain economic events 
    that affect a company, such as hiring a new chief executive officer or introducing 
    a new product, cannot be easily quantified in monetary units and, therefore, do 

    not appear in the company's accounting records. 

    1.4.3 Time period assumption

    This concept states that financial statements must be prepared on regular 
    intervals. Most businesses exist for long periods of time, so specific time periods 
    must be used to report the results of business activity. Depending on the type of 
    report, the time period may be a day, a month, a year, or another arbitrary period. 
    However, the most common reporting period is one year. Using artificial time 
    periods leads to questions about when certain transactions should be recorded. 
    For example, how should an accountant report the cost of equipment expected 
    to last five years? Reporting the entire expense during the year of purchase might 
    make the company seem unprofitable that year and unreasonably profitable in 
    subsequent years. Such issues like allocation of the cost of an asset over its 

    useful life are dealt with in subsequent units/levels. 

    1.4.4 Accrual basis accounting

    This concept states that a transaction is recorded when it occurs rather than 
    when cash is paid or received. In most cases, the principle requires the use of 
    accrual basis accounting rather than cash basis accounting. Accrual basis 
    accounting, which adheres to the revenue recognition, matching, and cost 
    principles discussed below, captures the financial aspects of each economic 
    event in the accounting period in which it occurs, regardless of when the cash 
    changes hands. Under cash basis accounting, revenues are recognized only 
    when the company receives cash or its equivalent, and expenses are recognized 
    only when the company pays with cash or its equivalent. 
    According to the accruals assumption, in computing profit revenue earned must 
    be matched against expenditure incurred in earning it. This is also known as 

    matching convention.

    1.4.5 Historical Cost principle

    The principle states that aAssets are recorded at cost, which equals the value 
    exchanged at their acquisition. Even if assets such as land or buildings appreciate 
    in value over time, they are not revalued for financial reporting purposes if they 

    are measured on historical cost basis. 

    1.4.6 Going concern principle

    Unless otherwise noted, financial statements are prepared under the assumption 
    that the company will continue in operation for the foreseeable future . Therefore, 
    it is assumed that the entity has neither the intention not the need to enter into 
    liquidation or to cease trading. If such a need or intention exists, the financial 
    statements will have to be prepared on a different basis and they would mention 

    such a basis. 

    1.4.7 Consistency Concept 

    Consistency refers to using the same methods for the same items (i.e. 
    consistency of treatment) either from period to period within a reporting entity 

    or in a same period across entities.

    1.4.8 Principle of conservatism/ prudence 

    As per the conceptual framework, prudence is described as the exercise of 
    caution when making judgements under conditions of uncertainty. The exercise 
    of prudence means that assets and incomes are not overstated and liabilities 
    and expenses are not understated. Accountants must use their judgment to 
    record transactions that require estimation. The number of years that equipment 
    will remain productive and the portion of accounts receivable that will never be 
    paid are examples of items that require estimation. In reporting such financial 
    data, accountants follow the principle of conservatism, which requires that 
    the less optimistic estimate be chosen when two estimates are judged to be 
    equally likely. For example, suppose a manufacturing company's Warranty Repair 
    Department has documented a three-percent return rate for product X during 
    the past two years, but the company's Engineering Department insists this 
    return rate is just a statistical anomaly and less than one percent of product X 
    will require service during the coming year. Unless the Engineering Department 
    provides compelling evidence to support its estimate, the company's accountant 
    must follow the principle of conservatism and plan for a three-percent return 
    rate. Losses and costs—such as warranty repairs—are recorded when they are 

    probable and reasonably estimated. Gains are recorded when realized. 

    1.4.9 Materiality principle

    Accountants follow the materiality principle, which states that the 
    requirements of any accounting principle may be ignored when there is no effect 
    on the users of financial information. Certainly, tracking individual paper clips or 
    pieces of paper is immaterial and excessively burdensome to any company’s 
    accounting department. Although there is no definitive measure of materiality, 
    the accountant’s judgment on such matters must be sound. Several thousand 
    francs may not be material to an entity such as BRALIRWA, but that same figure 

    is quite material to a small business. 

    1.4.10 Duality/ double entry concept 

    It requires a transaction to be recorded twice (dual recording). The dual aspect 
    rule is recognition that every transaction involves giving and receiving effect. 
    When somebody gives something, another must receive it. This is in effect a 
    requirement for double-entry bookkeeping. Double entry is a principle rule or 
    principle in accounting and is thoroughly explored in later chapters. For now, 
    it suffices to mention that the receiving account is debited while the giving 
    account is credited. Double-entry therefore means that one account is debited 
    while another is credited. The meaning of debit and credit are also explained in 

    later chapters. 

    Application activity 1.4

    1. The recognition that every transaction has two sides to it, is the leading 
    principle of 
    b) Accrual concept
    c) Duality concept 
    d) Matching concept
    e) Going concern concept
    2. The ------------- concept means that similar items in a set of accounts 
    should be given similar accounting treatment and it should be applied 
    from one period to another.
    a) Going concern
    b) Prudence 
    c) Consistency 

    d) Materiality 

    3. Accounting does not record non-financial transactions because of -----
    a) Economic entity concept
    b) Accrual concept
    c) Monetary unit concept
    d) Going concern concept
    4. Recognize the accounting concept in the following:
    a) The transactions are recorded at their original cost.
    b) The business will run for an indefinite period.
    c) Every transaction has two effects to be recorded in the books of 
    accounts.
    d) Accounting treatment once decided should be followed period 

    after period

    1.5 Accounting cycle 

    Activity 1.4

    Describe the Accounting cycle

    Accounting cycle is the process which is followed by accountants and 
    bookkeepers in processing raw financial data into output information in form of 
    financial statements. This process ranges from occurrence and documentation 
    of transactions up to the production of final accounts or financial statements. 
    It is called a cycle because the same procedure is repeated from one financial 
    year to another. When the financial year ends, books are closed and the financial 
    statements extracted, when the new financial year starts, the same books are 
    opened and the same procedure followed. It is therefore a cycle. 
    The accounting process or cycle is described below.
    Stage 1: Occurrence and documentation of business transactions
    Business transactions must be concluded first before anything is documented 
    and recorded. When a business transaction occurs, the immediate thing to 
    do is to prepare a business document to show evidence of the transaction. 
    Documents are means of accountability. Various parties including auditors will 
    want to ascertain whether the transactions took place and were authorized 
    by examining the documents. Besides for accountability, documents are also 

    important as sources of generating the information to be entered into books of 

    account. The key documents normally prepared are invoices, payment vouchers, 

    receipts, cheques, local purchase orders, delivery notes, goods received notes, 

    bank paying-in slips, etc.

    Stage 2: Entering transactions into journals

    Journals are books of original or prime entry. They are the first books to which 
    transactions are entered. Information entered into journals is generated from the 
    documents described above. There are several types of journals, the major ones 
    include the general journal, sales journal/sales day book, purchases journal/
    purchases day book and the cash book (the cash book is sometimes taken to 
    be part of the ledger). Details of these journals including their preparation will 
    be treated later.
    Stage 3: Posting of transactions to the ledger
    The information which had been entered into the journals is posted to the 
    ledger. It is therefore true to say that the journal feeds the ledger. A ledger 
    is a book which contains a collection of accounts. For easy of recording, the 
    ledger is sometimes subdivided into subsidiary ledgers. Detailed information on 
    preparation of the ledger will be seen later.
    Stage 4: Preparation of the trial balance
    At the end of a period, normally a month, all accounts are closed or balanced 
    off and the trial balance is extracted. A trial balance is a list of debit and credit 
    balances extracted from the ledger. Its purpose is to check the accuracy of 
    the double entry i.e. to check whether the double entry was complete and to 
    check whether no arithmetical errors of addition or subtraction were made in 
    the balancing of the ledger. If the double entry rule was not observed, the trial 
    balance will not balance, like wise if arithmetical errors were made, it will not 
    balance.
    Stage 5: End of year adjustments and preparation of financial 
    statements/ final accounts
    Financial statements are prepared from the trial balance. However, before 
    this is done, the trial balance needs to be adjusted at the end of the year in 
    order to make it up-to-date. The major adjustments or provisions made before 
    preparation of final accounts include, provision for depreciation, provision for 
    bad and doubtful debts, adjustments prepaid expenses and incomes, accrued 
    expenses and incomes, provision for corporation taxes, appropriations such as 

    provisions for dividend, transfers to reserve, etc

    Once the above adjustments have been made, financial statements are prepared. 
    The major financial statements include the income statement also called the 
    trading profit and loss account sometimes abbreviated as the profit and loss 
    account. This account or statement shows the profitability of the business. 
    Another major statement is the balance sheet which shows the assets of the 
    business and the claims against the assets. These claims are the owner’s equity 
    and liabilities. The third major statement is the cash flow statement which shows 
    the source of cash and how it was disbursed. These are the financiers of the 
    assets of the business. These financial statements will be treated in more details 
    later.
    Stage 6: Analysis and interpretation of financial statements
    This is not supposed to be the work of an accountant but is the domain of 
    the financial analyst. Strictly speaking, the work of an accountant stops at the 
    preparation of financial statements. However, an accountant could also analyze 
    and interpret his statements. Though it could be advisable to have another 
    independent person to analyze and interpret the accounts.
    Analysis and interpretation of financial statements makes the statements user 
    friendly. Lay people in accounting cannot read the figures in the financial 
    statements and the jargon used by accountants. These people need to be told in 
    simple terms whether the business is healthily operating in terms of profitability, 
    solvency/ liquidity etc. Analysis and interpretation of financial statements is 

    majorly done by the use of accounting ratios. 

    Application activity 1.5

    1. What is the accounting cycle?
    2. What is the main purpose of accounting cycle?
    3. What is the name of the book in which the transactions are initially 
    recorded with brief explanation of the debit and credit analysis?
    4. Which is the list of debit and credit balances of the ledger account?
    5. What is the main objective of preparing a financial statement?
    6. Why the specific process of accounting is called accounting cycle?
    7. In the accounting cycle, which step immediately comes before 

    analyzing transactions?

    1.6 Accounting equation

    e

    The ability to read financial statements requires an understanding of the 
    items they include and the standard categories used to classify these items. 
    The accounting equation identifies the relationship between the elements of 
    accounting.
    A business owns properties. These properties are called assets. The assets are 
    the business resources that enable it to trade and carry out trading. They are 
    financed or funded by the owners of the business who put in funds. These funds, 
    including assets that the owner may put is called capital. Other persons who are 
    not owners of the firm may also finance assets. Funds from these sources are 
    called liabilities.
    The total assets must be equal to the total funding i.e. both from owners and 
    non-owners. If all the resources of the business are supplied by the owner, the 

    accounting equation will be presents as follows:

    Assets = Capital
    However, some of the assets normally have been provided by some other person 
    than the owner. This indebtedness of a firm is referred to as Liabilities. 

    Therefore, the equation is now referred to as:

    p

    Each item in this equation is briefly explained below:

    Assets

    An asset is a present economic resource controlled by the entity as a result of 
    past events. An economic resource is a right that has the potential to produce 
    economic benefits. An example is if a business sells goods on credit then it has 
    an asset called a debtor. The past event is the sale on credit and the resource 
    is a debtor. This debtor is expected to pay so that economic benefits will flow 
    towards the firm i.e. in form of cash once the customers pays. 
    Current assets typically include cash and assets the company reasonably 
    expects to use, sell, or collect within one year. Current assets appear on the 
    balance sheet (and in the numbered list below) in order, from most liquid to 
    least liquid. Liquid assets are readily convertible into cash or other assets, and 
    they are generally accepted as payment for liabilities. 
    Assets are classified into two main types:
    a) Non-current assets (formerly called fixed assets)
    b) Current assets
    Non-current assets are acquired by the business to assist in earning revenues 
    and not for resale. They are normally expected to be in business for a period of 
    more than one year. Current assets are not expected to last for more than one 
    year. They are in most cases directly related to the trading activities of the firm. 
    Examples of non-current assets include:
    Major examples include:
    – Land and buildings
    – Plant and machinery 
    – Fixtures, furniture, fittings and equipment

    – Motor vehicles

    Current assets typically include cash and assets the company reasonably 
    expects to use, sell, or collect within one year. Current assets appear on the 
    balance sheet (and in the numbered list below) in order, from most liquid to 
    least liquid. Liquid assets are readily convertible into cash or other assets, and 
    they are generally accepted as payment for liabilities. 
    Current assets are not expected to last for more than one year. They are 
    in most cases directly related to the trading activities of the firm. Examples 
    include:
    – Stock of goods – for purpose of selling. Inventory is the cost to acquire 
    or manufacture merchandise for sale to customers. Although service 
    enterprises that never provide customers with merchandise do not use 
    this category for current assets, inventory usually represents a significant 
    portion of assets in merchandising and manufacturing companies. 
    – Accounts receivable are amounts owed to the company by customers 
    who have received products or services but have not yet paid for them. 
    – Other debtors – owe the firm amounts other than for trading.
    – Cash at bank
    – Cash in hand
    – Marketable securities include short-term investments in stocks, bonds 
    (debt), certificates of deposit, or other securities. These items are 
    classified as marketable securities—rather than long-term investments—
    only if the company has both the ability and the desire to sell them 
    within one year. 
    – Prepaid expenses are amounts paid by the company to purchase items 
    or services that represent future costs of doing business. Examples 
    include office supplies, insurance premiums, and advance payments 
    for rent. These assets become expenses as they expire or get used up. 
    Liabilities
    A liability is a present obligation of the entity to transfer an economic resource 
    as a result of past events.
    Liabilities are the company's existing debts and obligations owed to third parties. 
    Examples include amounts owed to suppliers for goods or services received 
    (accounts payable), to employees for work performed (wages payable), and to 
    banks for principal and interest on loans (notes payable and interest payable). 
    An example is when a business buys goods on credit, then the firm has a liability 
    called creditor. The past event is the credit purchase and the liability being the 
    creditor the firm will pay cash to the creditor and therefore there is an out flow 

    of cash from the business

    Liabilities are also classified into two main classes
    i) Non-current liabilities (or long term liabilities)
    ii) Current liabilities.
    Liabilities are generally classified as short-term (current) if they are due in one 
    year or less. Long-term liabilities are not due for at least one year. 
    Non-current liabilities are expected to last or be paid after one year. This 
    includes long-term loans from banks or other financial institutions. 
    Current liabilities last for a period of less than one year and therefore will be 
    paid within one year. Major examples:
    – Trade creditors/ or accounts payable: owed amounts as a result of 
    business buying goods on credit.
    – Other creditors: owed amounts for services supplied to the firm other 
    than goods
    – Bank overdraft: amounts advanced by the bank for a short-term.
    – Accrued expenses
    Capital (Equity)
    Equity is the residual interest in the assets of the entity after deducting all its 
    liabilities. Owner´s Equity represents the amount owed to the owner or owners 
    by the company. Algebraically, this amount is calculated by subtracting liabilities 
    from each side of the accounting equation. Owner's equity also represents 
    the net assets of the company. Items like introduced capital, profit/ loss and 
    drawings appear under equity. By rearranging the accounting equation, we can 
    define owner’s equity in this way::
    Owner’s equity = Assets – Liabilities
    In a sole proprietorship or partnership, owner’s equity equals the total net 
    investment in the business plus the net income or loss generated during the 
    business’s life. Net investment equals the sum of all investment in the business 
    by the owner or owners minus withdrawals made by the owner or owners. 
    The owner’s investment is recorded in the owner’s capital account, and any 
    withdrawals are recorded in a separate owner’s drawing account. For example, 
    if a business owner contributes FRW 10,000,000 to start a company but later 
    withdraws FRW 1,000,000 for personal expenses, the owner’s net investment 
    equals FRW 9,000,000. Net income or net loss equals the company’s revenues 
    less its expenses. Revenues are inflows of money or other assets received from 
    customers in exchange for goods or services. Expenses are the costs incurred 

    to generate those revenues.

    e

    Example: Johnson Company had assets of FRW 140,000 and liabilities of FRW 
    60,000 at the beginning of the year, and assets of FRW 200,000 and liabilities 
    of FRW 70,000 at the end of the year. During the year, FRW 20,000 was 
    invested in the business, and withdrawals of FRW 24,000 were made. What 
    amount of income did the company earn during the year?
    Beginning of the year 
    Assets Liabilities Owner’s equity
    FRW 140,000 = FRW 60,000 + FRW 80,000
    During the year 
    Investment 20,000
    Withdrawals 24,000
    Net Income ?
    End of the year
    FRW 200,000 FRW 70,000 FRW 130,000
    Answer 
    Net income FRW 54,000
    Start by finding the owner’s equity at the beginning of the year. (Check: FRW 
    140,000-FRW 60,000 = FRW 80,000). 
    Then find the owner’s equity at the end of the year. (Check: FRW 200,000 – 
    FRW 70,000 = FRW 130,000).
    Then determine net income by calculating how the transactions during the 
    year led to the owner’s equity amount at the end of the year. (Check FRW 

    80,000+20,000 – FRW 24,000 +54,000 = 130,000)

    o

    r

    0

    h

     i

    j

    Note: The loan was deposited on the bank account and it is reflected as an 
    asset. Cash at bank is sometimes abbreviated as simply bank. The liabilities also 
    increases by 10,000,000 because of the loan acquired.

    9. Used 100,000 of the business to campaign for a local election.

    u

    Balance sheet using the vertical format which is shown below:

     g

    p

    Please pay attention to the format. The Non-Current assets are listed in order 
    of permanence as shown i.e. from Land and Buildings to motor vehicles. The 
    Current Assets are listed in order of liquidity i.e. which asset is far from being 
    converted into cash. Example, stock is not yet sold, (i.e. not yet realized yet) 
    then when it is sold we either get cash or a debtor (if sold on credit). When the 
    debtor pays then the debtor may pay by cheque (cash has to be banked) or 
    cash. The current Liabilities are listed in order of payment i.e. which is due for 
    payment first. Bank overdraft is payable on demand by the bank, then followed 
    by creditors. 
    Note that in the vertical format, current liabilities are deducted from current 
    assets to give net current assets. This is added to Non-Current assets, which 
    give us net assets. Net assets should be the same as the total of Capital and 

    Non-Current liabilities

    j

    Application activity 1.6

    1. Which of the following is not an asset?

    a) Building 
    b) Cash balance 
    c) Trade receivables
    d) Loan from Kamanzi
    2. Which of the following is a liability?
    a) Machinery 
    b) Trade payables for goods
    c) Moto vehicles 
    d) Cash at bank 

    3. Which of the following items are shown under the wrong headings:

    h

    5. Which of the following is incorrect?

    h

    You are required to prepare a simple Balance Sheet as at 31 
    December 2021
    7. Mukamana sets up a new business. Before he actually sells 
    anything he has bought motor vehicles of FRW 3,000, premises 
    of FRW 7,000, stock of goods FRW 2,000. He still owes FRW 
    800 in respect of stock purchased. He had borrowed FRW 4,000 
    from Kanyemera. After the events just described and before trading 
    starts, he had FRW 300 cash in hand and FRW 600 cash at bank.

    You are required to calculate the amount of his capital

    1. Mention two objectives of accounting?
    2. Mention five different branches of accounting?
    3. Why Creditors, Tax authorities, Investors, and general public are 
    interested in accounting information? 
    4. Match the terms below with the type of user of accounting information 

    (Some answers may be used more than once):

    g

    7. Which of the following is a form of internal control that ensures the 
    ledger is balanced?
    a) Financial statements
    b) Sequentially numbered source documents
    c) Trial balance
    d) Journal entries
    8. In each of the following pairs of activities, tell which activity is done first 
    in the accounting cycle
    (a) Close the accounts or adjust 
    the accounts 
    (c) Record the transactions in the 
    journal or prepare the initial trial 
    balance 
    (b) Analyze the transactions or 
    post the entries to the ledger 
    (d) Prepare the post-closing trial 
    balance or prepare the adjusted 
    trial balance 

    9. You are to complete the gaps on the following table?

    h

    10. Mugabowindekwe has the following items in his balance sheet as on 
    30 June 2021. Capital FRW 41,800, Creditors FRW 3,200, Fixtures 
    FRW 7,000, Motor Vehicles FRW 8,400, Stock of goods FRW 9,900, 
    Debtors FRW 6,560, Cash at bank FRW 12,900 and Cash in hand 

    FRW 240

    During the first week of July 2021:

    a) He bought extra stock of goods FRW 1,540 on credit.
    b) One of the debtors paid him FRW 560 in cash.
    c) He bought extra fixture by cheque FRW 2,000. 
    You are to draw up a balance sheet as on 7 July 2021 after the above 

    transactions have been completed

    UNIT 2:ACCOUNTING SOURCE DOCUMENTS►