ACCOUNTANCY As LEVEL(FORM FIVE) NOTES – ACCOUNTING ENTRIES

ACCOUNTING ENTRIES

1. On setting aside the amount of depreciation:

DR: Depreciation a/c or P+L a/c

CR: Depreciation Fund a/c

Note: The amount to be charged by way of depreciation is determined on the basis of the sinking fund table.

For investing the money charged by way of depreciation:

DR: Depreciation Fund Investment a/c

CR: Bank a/c.

(b) At the end of each subsequent accounting year:

(i) For receipt of interest:

DR: Bank a/c

CR: Depreciation Fund a/c

(ii) For setting aside the amount of depreciation:

DR: P & L a/c

CR: Depreciation Fund a/c

(iii) For investing money:

DR: Depreciation Fund Investment a/c

CR: Bank (annual installment + Interest received)

2. At the end of last year, for the receipt of interest:

DR: P & L

CR: Depreciation

3. For setting aside the amount of depreciation:

DR: P & L

CR: Depreciation

4. For the sale of Investment:

DR: Bank.

CR: Depreciation Fund Investment a/c.

The profit or loss on the sale of Depreciation Fund investment will be transferred to a Depreciation Fund a/c.

For the sale of old asset:

DR: Bank

CR: Assets

The balance on the Depreciation Fund represents accumulated depreciation. It will be transferred to the old assets a/c.

The proceeds or the sales realized on account of its sale and investment will be utilized in the purchase of new assets.

DR: New asset

CR: Bank

ILLUSTRATION (1)

Sunshine Company Ltd bought a plant on 1.1.2005 for a sum of Tshs 100,000/= having a useful life of 5 years. It is estimated that the plant has a scrap value of Tshs 16,000/= at the end of its useful life.

Sunshine Co. decided to charge depreciation according to the depreciation fund method. The depreciation fund investments are expected to earn an interest of 5% p.a. The sinking fund table shows that Tshs 0.180975, if invested yearly at 5% p.a, produces Tshs 1 at the end of 5 years. The investments are sold at the end of the 5^th year for sum Tshs 65,000. A new plant was purchased for Tshs 120,000 on 1.1.2010. The scrap of the old plant realizes Tshs 17,000. You are required to prepare:

1. Plant a/c
2. New plant a/c
3. Depreciation plant a/c
4. Depreciation Fund investment a/c

DR PLANT A/C CR

DR DEPRECIATION FUND A/C CR

DR. DEPRECIATION AND INVESTMENT A/C CR

DR DEPRECIATION FUND INVESTMENT A/C CR

FINANCIAL STATEMENTS ANALYSIS AND INTERPRETATION

RATIO ANALYSIS

A ratio is one number expressed in terms of another number to show the relationship between the numbers. For example, the relationship between 24 and 6 is 24/6 or 4:1, indicating that the former figure is four times as great as the latter figure. A variation is to use a base of 100. This is called percentage. Using the figures 24 and 6, the percentage becomes 24/6 × 100 = 400%.

Financial statements (trading profit and loss A/C and balance sheet) are produced not just for their own sake, but for the use to which they can be put by the various parties interested in different aspects of these statements.

Example

1. The DIRECTORATE – interested in overall figures which show whether the company is profitable and whether it is on a sound financial footing.
2. In a manufacturing business, foremen may be concerned with time taken to complete a job or material usage.
3. Department and general managers are concerned about measurements relating to matters falling within their individual responsibilities.
4. Shareholders (actual and prospective) are interested in their earnings (current & future) out of which dividend can be paid, the security of dividend (dividend cover), return on their investment (yield), etc.
5. External interested parties include loan creditors, for example debenture holders who are concerned that the company is solvent and there is adequate cover for their interest; trade creditors (actual and prospective) who want to be assured that the company is both solvent and liquid, that is, it has adequate cash or cash convertible resources to meet current liabilities as they fall due. Financial statement analysis consists of applying any tools and techniques to financial statements (and other relevant data) to obtain useful information. This information is shown as significant relationships between data and trends in those data assessing the company’s past performance and current financial position.

The information shows the results or consequences of prior management decisions. In addition, the information is used to make predictions that many users of financial statements rely on.

In financial statement analysis, it is drawn that there are certain important relationships (expressed by means of RATIOS) between items within the trading A/C, the profit & loss A/C and balance sheet, and between the items of one statement and another. Ratio analysis is a further helping hand to the interested parties of accounting information in making their rational decisions.

CATEGORIES OF ACCOUNTING RATIOS

Normally classified according to the aspects of business they are designed to highlight. These aspects fall under the following categories:

• Financial soundness and stability, short & long term. During the short term, the interest is liquidity and during the long term the interest is solvency.
• Profitability and return on equity or assets.
• Activity or efficiency measures.
• Capital structure and gearing measures.
• Market based ratios.

FINANCIAL SOUNDNESS AND STABILITY

These ratios measure the ability of the firm to meet its:

1. Current or working capital ratio

Working capital is the excess of current assets over current liabilities. The current ratio indicates the ability of a company to pay its current liabilities from current assets. In this way, it may show the strength of the company’s working position. It is calculated as:

Current ratio = (Current Assets) / (Current Liabilities)

The current ratio provides a better index of a company’s ability to pay current debts than does the absolute amount of working capital.

Note: A number greater than one indicates a firm has the ability to meet its current liabilities and vice versa. But this is not conclusive evidence.

2. Acid test / Quick Asset ratio

Current ratio assumes that current assets could be turned into cash immediately. However, not all current assets can be readily converted into cash. The acid test ratio recognizes this limitation and excludes stocks and prepaid expenses in its computation because they might not be readily convertible into cash.

The formula is:

Acid test ratio = (Quick assets) / (Current liabilities)

OR

(Current assets – stock – prepaid expenses) / (Current liabilities)

3. Debt service coverage ratio / time interest earned / interest coverage ratio

It measures the ability of a firm to service debt from operations. This ratio is computed as:

Interest coverage ratio = (Profit before interest and tax) / (Annual interest payment)

4. Debt repayment coverage ratio

Gives an indication of the length of time it will take to repay borrowings out of profit of the business.

It is calculated as:

= (Long term liabilities + Current liabilities + Current assets) / (Annual profit after interest and income tax)

5. Time preferred dividend earned ratio

This measures the ability of a company to make preferred dividend payments each year.

It is given as:

= (Net profit after interest and tax) / (Annual preferred dividend)

B: PROFITABILITY AND RETURN ON EQUITY OR ASSETS

Ratios falling into this group measure the ability of a firm to generate profit.

The ability can be measured according to volume of sales or resources employed in generating the profits. These ratios measure the rate of profitability. Profit is taken to be net profit prior to interest and taxes. Ratios falling under this group are:

1. Gross margin / Gross profit ratio

Specific trades / industries. The sales figure is VAT exclusive. A high gross profit percentage does not result in a large (absolute) figure of gross profit.

It is given by:

(Gross profit) / Sales × 100

2. Operating margin / Net profit ratio / Net profit to sales percentage

Reflects the percentage of each shilling of net sales that becomes net operating profit / Net profit.

The sales figure is VAT exclusive.

It is calculated as:

Operating margin / Net profit ratio = (Profit before interest and tax) / (Net sales) × 100

Or

(Net operating income) / (Net sales) × 100

3. Return on capital employed (ROCE)

This ratio measures profit per value of net assets. The net assets figure is arrived at by using the following alternative formula:

1. Fixed assets + current assets – current liabilities
2. Total assets – current liabilities

It is given by the formula:

Return on capital employed = (Profit before interest and tax) / (Capital employed) × 100

4. Return on total assets

This ratio measures the ability of a firm in utilizing its total assets to generate profits.

It is given by the formula:

Return on total assets = (Profit before interest and tax) / (Total assets) × 100

5. Return on owner’s equity

This ratio measures the return earned by the company on each shilling of shareholders’ equity invested.

It is given by:

C. ACTIVITY OR EFFICIENCY RATIOS

Various aspects of the efficiency with which assets can be used can be derived from turnover ratios.

The most important ones are:

1. Inventory turnover

This ratio shows the number of times a company’s average inventory / stock is sold during a period. If the rate is too low or decreasing, this may indicate overstocking or presence of obsolete merchandise.

If it is too high, it may indicate understocking or other problems, depending on the nature of the business and industry.

It is given as:

2. Accounts receivable turnover

This is the number of times per year that the average amount of receivables (debtors) is collected.

It is given as:

This ratio provides an indication of how quickly the receivables (debtors) are collected.

3. Debtors average collection period / Average collection period for accounts receivable

Good credit control is an important aspect of sound financial management. The average length of time debtors take to pay is important.

It is given by:

Creditors average payment period

To put the debtors average collection period in perspective, the credit period granted to customers should not be out of line with the credit period granted by suppliers. Good financial management should ensure a proper balance. This ratio indicates the average period measured in terms of months, weeks, or days for which creditors remain unpaid.

It is given by:

4. Total assets turnover / sales to total assets ratio

This ratio measures the efficiency with which a company uses its assets to generate sales.

That is, it indicates how much a shilling of an asset generates in terms of sales value. The larger the total asset turnover, the larger will be the income on each shilling invested in the assets of the business.

It is given by:

5. Sales to capital employed ratio

It indicates the efficiency of utilization of capital employed in generating revenue.

It is given by:

D. CAPITAL STRUCTURE AND GEARING MEASURES

Under this category, the following ratios can be looked at as equity or longer-term solvency ratios.

They show the relationship of debt and equity financing in a company. It measures the riskiness of the business.

1. Equity or stockholders equity ratio

It indicates the proportion of total assets that is provided by stockholders (owners) on any given date.

The formula for the equity ratio is:

2. Stockholders’ equity to debt ratio

This indicates the measure of the relative proportion of stockholders and creditors.

It is given by:

3. Long term debt to shareholders funds

It indicates the extent of cover for fixed liabilities (loans, debentures).

It is given by:

4. Gearing

This ratio defines the proportion of debt capital and ordinary shares/equity capital. It indicates the degree of vulnerability of earnings available for ordinary shares.

Given by:

Note: Some companies use ordinary shareholder’s funds as denominator i.e. ordinary share capital plus reserves and some use the book value of loans and shares. Usually a gearing of greater than 1:1 is high and less than 1:1 is low. In practice, greater than 0.6:1 is regarded as high and less than 0.2:1 as low, with the range between these two extremes being regarded as relatively high or relatively low.

E. MARKET BASED RATIOS

These are additional ratios that can be computed when data from stock exchange are incorporated. The most common ones are as follows:

1. Dividend per share

Indicates the dividend and retention policy of the company when used in line with earnings per share (below).

It is calculated as:

2. Dividend yield (on common stock)

Indicates “current return on investment” that is it measures the real rate of return comparing the dividend paid and the market price of a share or that it measures the return on the shares invested using current market price of the shares.

It is given by:

It provides the investor with a measure of the opportunity cost of his or her investment in terms of yield.

3. Dividend cover

It indicates the ability of a firm to sustain dividend payments out of its distributable profit.

4. Earnings per share (EPS)

It indicates the amount of the net profit after tax (but before extraordinary items) attributable to each ordinary share in issue, and available for dividend during the period.

It is calculated as follows:

Note: Earnings available to common stockholders (ordinary shareholders) is equal to Net profit after tax (net income) minus the current year’s preferred dividends, whether such dividends have been declared or not. And it presents the fund which supports the distribution of profit by way of dividend to ordinary shareholders.

5. Price earnings ratio (P/E) ratio

It is usually used in establishing the market value of a company. It indicates the number of years purchase of the earnings and is regarded internationally as an indicator of future performance. It acts as the index of whether a stock is relatively cheap or expensive based on ratio.

The price earnings ratio is calculated by using the following formula:

6. Earning yield

It indicates potential return on investment. It highlights the amount earned on the ordinary share relative to their market price.

It is given by:

LIMITATIONS OF RATIO ANALYSIS

In using ratios, the analyst must keep a few general limitations in mind. The main limitations attached to it are:

1. It lacks standard values for the ratio; therefore, scientific analysis is not possible.
2. As there are no standards to compare, it fails to throw light on the efficiency of any activity of the business.
3. It gives only the relationship between different variables and the actual magnitudes are not known through ratio.
4. Ratios are derived from the financial statements and naturally reflect their drawbacks.
5. It fails to indicate immediately where the mistake or error lies.
6. It does not take into consideration the market and other changes.
7. Seasonal factors can upset ratio analysis.
8. The basis of asset valuation can be misleading.
9. A set of accounts never shows a complete picture of a company’s activities.
10. Ratios vary enormously between different industries.

PROBLEM

The trading stock of Joan Street, retailer, has been reduced during the year ended 31^st March 2008 by Tshs 6,000 from its commencing figure of Tshs 21,000. A number of financial ratios and related statistics have been compiled relating to the business of Joan Street for the year ended 31^st March 2008. These are shown below:

• Net profit as % net capital employed (see below)
• Net profit 15
• Sales 9
• Sales 166 2/3
• Net capital employed
• Fixed assets 45%
• Working capital ratios
• Current assets 400%
• Current liabilities
• Acid test ratio
• Bank + Debtors 275%
• Current liabilities
• Gross profit 25%
• Sales
• Debtor’s collection period:
• Debtors x 365 days 36 ½ days
• Sales
• Stock turnover (based on average stock for the year 10 times)

Prepare the trading and profit and loss account for the year ended 31^st March 2008 and balance sheet as at that date of Joan Street in as much detail as possible.

Note: Take the closing figure at 31^st March 2008.

Solution

Opening stock 21,000

Closing stock = 21,000 – 6,000 = 15,000

Cost of goods sold = 18,000 × 10 = 180,000

Opening stock + purchases – closing stock = cost of goods sold

21,000 + purchases – 15,000 = 180,000

Purchases = 180,000 + 15,000 – 21,000

= 174,000/=

Gross profit = 25%

Sales = 25/100 = ¼ – 1 = 1/3 × 60,000

Sales = GP + Cost of goods sold

= 60,000 + 180,000

= 240,000

Net capital employed

Current assets = 400

Current liabilities 100

Current assets = 4 × current liabilities

Working capital = CA – CL

But CA = 4CL

WC = 4CL – CL

WC = 3CL

Working capital = capital employed – fixed assets

WC = 144,000 – 108,000

WC = 36,000

WC = 3CL

36,000 = 3CL

CL = 12,000

Debtors × 365 = 36 ½

Debtors × 365 = 36 ½ × 240,000

Debtors = 24,000

EXERCISE

The balance sheet and supplementary data for the KWABWANYENYE LTD. are shown below:

Kwabwanyenye Ltd

Balance sheet December 31, 1997

Assets Tshs

• Cash in hand a/c 50,000
• Marketable securities 80,000
• Accounts receivable, net C.A 70,000
• Inventory A.C 150,000
• Building F.A 400,000
• Less: accumulated depreciation 100,000 300,000
• 600,000

Liabilities and stockholders equity TSHS

• Accounts payable C.L 30,000
• Bank payable C.L 10,000
• Mortgage notes payable due in 2000 L.K 40,000
• Bonds payable 10% due Dec 31, 2002 L.L 100,000
• Common stock, Tshs 100 par value capital 300,000
• Retained earnings reserve 120,000
• Total liabilities and stockholders equity 600,000

Supplementary data:

• 1997 net income Tshs 60,000
• 1997 cost of goods sold Tshs 540,000
• 1997 sales Tshs 900,000
• Inventory January 1, 1997 Tshs 100,000
• Interest expenses Tshs 15,000
• 1997 net income before interest and taxes Tshs 130,000
• Net accounts receivable on January 1, 1997 Tshs 50,000
• Total assets on January 1, 1997 Tshs 540,000
• 1997 dividend paid Tshs 240,000
• Current market price per share Tshs 150

Require: compute the following ratios:

• Current ratio
• Acid test ratio
• Accounts receivable turnover
• Inventory turnover
• Total assets turnover
• Equity ratio
• EPS of common stock
• P/E ratio
• Dividend yield
• Gearing
• Earnings yield
• Debtors days