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PRINCIPLES OF ACCOUNTING I
TOPIC TWO: ACCOUNTING CYCLE
Accounting cycle follows the processes adopted to record transactions in the books of accounts. It is
summarized by the following diagram.
a) Source documents where original information is found – in this activity the source document used to
record transactions include: sale and purchase invoice, debit and credit note for returns, banking in
slips, cheque counterfoils and correspondence containing other financial information.
b) The second stage is to record the transactions in the books of original entry commonly known as day
books. Here – transaction is classified and entered into books of original entry such as the cash book,
sales and purchases day book, return inwards, return outwards, petty cash, three column cash book
and journal proper.
c) Double entry – This is the third stage which reflects the duo aspects of the transaction which states
that for every debt entry, there is at least two accounts to be affected, one is debited and the other is
debited. The accounts are found in the general ledger (real /property and nominal accounts), sales
ledger (debtors account), purchases ledger (creditors account), cash book (cash book and petty cash)
etc.
d) The accounts are closed and the balance carried down to the trial balance. This is the fourth stage of
the accounting stage. It tests the arithmetic accuracy of the recording of transactions in ledger
accounts.
e) Preparation of trading profit and loss account. This is the fifth stage of accounting cycle where a
trading account and profit and loss account are prepared to ascertain if the business is making gross
profit/gross loss and Net profit or Net loss respectively.
f) Preparation of the balance sheet – This is the final stage in the accounting cycle where a financial
statement showing liabilities, assets and capital at the end of the accounting period is prepared.

Figure 1: Accounting Cycle

Source documents Original entry Double entry in ledger

books/day books accounts

Balance sheet Trading Profit and loss Trial balance

Balance Sheet and Accounting Equation

The book keeping equation states that the resources owned by the business are equal to the amount
contributed by the owner and the amounts borrowed from other sources. The resources owned by the
business are called Assets and the amount contributed by the owner is called capital. The amount/obligations
borrowed from outside are called Liabilities. The following formula summarizes the book keeping equation.
Asset = Capital + Liabilities
A=C+L
C=A–L
L =A – C
Where A = Assets
C = Capital
L = Liabilities

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Balance Sheet
This is the financial statement which is prepared at the end of financial period to show the assets and
liabilities of the business. It is prepared at the end of the accounting period to show the financial position of
the business which in turn is reflected by the value of assets and liabilities.

Balance Sheet Terms

1. An asset- It is an item of value owned by the business. These are resources which are owned and used by
the business. They are further subdivided into:
- Fixed assets / Non current assets
- Current assets
- Neither current nor fixed assets.

a) Fixed asset
These are items of value which are owned and are acquired by the business to used for further production.
They stay in the business for along period of time. They assist the business to contact business transactions
smoothly
They include: Land, Premises /buildings, Fixtures and fittings, Equipment, motor vehicles, plant and
machinery and furniture.
b) Current assets
These are items of value or resources which are owned by the business and stay in the business for a short
time period or short term. They are either in the form of cash in the short period. Some are acquired to be
resold to make profits. They are called working capital items. They include: Stock, Debtors, Bills receivable,
Cash at hand, pre-payments, Preliminary expenses and Accrual income.

c.) Assets that is neither fixed nor current

These are those assets which are shown between fixed and current.
These assets in the balance sheet are further classified into: Investment and Intangible asset.
Investment - These refers to amount of money invested in securities such as shares in group companies,
related companies and non related companies, debentures and government treasury bonds and treasury bills.
Intangible assets - These are those assets which have no material existence. They are intellectual properties
which are owned by the business and are used to create income. They include: goodwill, patents, copyrights,
trademarks, franchises, leases, development and research costs etc.

2. Liabilities
These are financial obligation or money owed to other people or institutions.
It is further sub divided into:- Long term and Current/short term
(i) Long term
These are those liabilities which are payable at a date more than one financial year from the balance sheet
date i.e. after one financial year. They are obligations of the business which are repayable after one financial
period. They include: Bank loans, cooperative loans and loans from building societies.

(ii) Current liabilities

These are those financial obligations which are payable by the business within one financial year of the
balance sheet date. They are called short term liabilities. They include: Bank overdraft, Outstanding
expenses, Taxation payable, Bills payable, Creditors

3. Capital
This is the amount invested in the business by owner(s). It represents the claim by the owner. It is the only
internal source of money as capital although it can include the external sources.
It is used to buy fixed assets like machines, motor vehicles, equipments & furniture. The term Capital used in
diversify ways such as:
a) Equity Capital
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b) Borrowed Capital
c) Working Capital
d) Capital Employed

a) Equity Capital
This is the capital invested by the owner of business plus any profit attributable to the owner’s less drawings.
b) Loan capital/Borrowed Capital
It’s the amount borrowed by the business. The owners are called the lenders, They are paid at the fixed rate
of interest, They do not share the profit of business. These amount is repaid at the later date.
c) Working Capital
It is the different between current assets and current liabilities of the business.
It represents the liquid or cash resources of the disposal of business available to meet immediate liabilities.
WC = CA – CL.
d) Capital employed
Gross capital is the sum of fixed asset and current asset
Net capital employed is the sum of fixed assets and net current assets.
NCA = Fixed Assets (FA) + Current Assets (CA) – Current Liabilities (CL)
CE = FA + WC

Sources of Capital to businessmen

(i) Personal resources
(ii) Bank loans
(iii) Trade Credit
(iv) Bank overdraft
(v) Loans from cooperative societies
(vi) Loans/ assistance from the government
(vii) Finance from the donors
(viii) Inheritance and gifts etc

Capital and revenue transaction items

(i) Capital Expenditure
• Capital Expenditure (CapEx) refers to the funds that a business spends on acquiring, upgrading, or
maintaining long-term assets.
• These assets are expected to provide value over multiple accounting periods, typically exceeding one
year.
• Capital expenditures are essential for a company’s growth, expansion, and overall operations. These
refers to the amount of money the business incurred to acquire fixed assets.
• These expenditure is not deducted from the income in any trading period to arrive at the profit e.g.
Purchase of land, Equipment, Furniture e.t.c

(ii) Capital Receipts

• Capital Receipts refer to funds received by a business or organization that are primarily related to its
long-term financing and investments.
• Unlike revenue receipts, which result from the core operations of a business (such as sales of goods
or services), capital receipts are typically one-time inflows that affect the company’s balance sheet by
increasing its equity or liabilities.
• This refers to the amount of money the business receives from the sale of fixed assets.
• It is not included in the income of any trading period to arrive at the profit unless it is the profit on
the sale of fixed assets. Examples include: Sale of equipments, Building, Land, Motor vehicles and
Machinery.

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(iii) Revenue expenditures

• Revenue Expenditures refers to the expenses a business incurs in its day-to-day operations. These
expenditures are necessary for running the business but do not contribute to the acquisition of long-
term assets.
• Unlike capital expenditures, which are related to long-term investments that will benefit the company
over several periods, revenue expenditures are incurred to generate revenue in the current accounting
period.
• Refers to the amount of money spend or incurred for making normal trading transaction or paying for
consumable services e.g. rent, service and wages, electricity, advertising and others.

(iv) Revenue Receipt

• Revenue Receipt refers to the funds that an organization earns from its core operations during a
specific period.
• These receipts are primarily generated from the sale of goods and services, and they reflect the
standard income streams that contribute to the organization's overall revenue.
• Revenue receipts are crucial for assessing the financial performance of a business or government
entity, as they show how effectively the entity generates income from its regular activities.
• Refers to the amount of money derived from the sale of trading assets or operational activities of the
business e.g. sale of stocks, rent received, interest received etc.

The following is its format of the Balance Sheet.

Example

Name of the proprietor /Business Name

Balance sheet as at (Horizontal format)…………..

Shs Shs
Capital xx Fixed assets
Add net profit xx Land xx
Less drawings xx xxx Building /premises xx
Plant and machinery xx
Long term liability Fixtures and fitting xx
Bank loan xx Motor vehicles xx
AFC loan xx Equipment xx
Co-op loan xx xxx Furniture xx xxx

Current liabilities Current assets

Creditors xx Stock xx
Bills payable xx Debtors xx
Accruals xx Bills receivable xx
Banking draft xx xxx Pre-payments xx
Cash in bank xx
Cash at hand xx xxx

xxxx xxxx

Or

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The Balance Sheet Can Be Presented Using Vertical Format As Indicated Below

Name of the Proprietor/Business

Balance Sheet As At (Vertical Method) …

Fixed assets/ Non current assets Cost Dep NBV

Sh Sh. Sh
Land xx xx
Building/Premises xx ( xx) xx
Plant and machinery xx ( xx) xx
Fixtures and fittings xx ( xx) xx
Motor vehicle xx ( xx) xx
Equipment xx ( xx) xx
Furniture xx ( xx) xx
Investment xx ( xx) xx
xx xx xx
Add WC (CA – CL)
Current Assets
Closing stock/inventory xx
Debtors xx
Less provision for bad debts xx
Prepayments xx
Preliminary expenses xx
Accrued income xx
Cash in Bank xx
Cash at hand xx
xx
Current Liabilities
Creditors xx
Bills payable xx
Accruals xx
Prepaid income xx
Bank overdraft xx (xx) xx
Capital employed xx

Financed by xx
Capital xx
Net profit xx
Drawings xx
Bank loan xx
Cooperative loan xx xx

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Illustration I: The following information was extracted from the books of accounts of Grace a retailer in
Kimumu as at 31st Dec 2023.
Shs.
Land 100000
Equipment 60000
Furniture 40000
Capital 300000
Bank loan 200000
Co-operative loan 120000
Creditors 80000
AFC loan 100000
Bills payable 70000
Accruals 30000
Bills receivable 60000

Pre –payment 40000

Cash in bank 100000
Cash at hand 70000
Fixtures and fittings 140000
Debtors 80000
Plant and machinery 60000
Motor vehicles 100000
Bank overdraft 50000
Net profit 40000
Drawings 20000
Stock 50000
Premises 70000

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Miss Grace Retailers

Balance sheet as at 31st Dec. 2023

Shs Shs Shs Shs

Capital 300000 Fixed assets
Add N.P 40000 Land 100000
Less Drawings (20000) Premises 70000
320000 Plant and 60000
Long term liabilities machinery 140000
Bank loan 200000 Fixtures and 100000
AFC loan 100000 fitting 60000
Co-operative loan 120000 420000 Motor vehicle 40000
Equipment 570000
Current liabilities Furniture
Creditors 80000
Bill payable 70000 Current assets
Accruals 30000 Stock 50000
Bank over draft 50000 230000 Debtors 80000
Bills receivable 60000
Prepayment 40000
Cash in bank 100000
Cash at hand 70000 400000

Totals 970000 Totals 970000

Required:-
a) Prepare the above balance sheet using vertical method as at 31st Dec. 2023
(10 mks)
b) What are fixed assets? Is it possible in the long run they can be non fixed or current?
(5mks)
c) Why do we use the words as at, at the beginning of the balance sheet?

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Illustration II: The following information was provided by Momanyi sole proprietor as at 31st
March 2023

Net profit 100000

Land 160000
Premises/buildings 100000
Equipment 140000
Bank overdraft 60000
Furniture 70000
Drawings 40000
Capital 400000
Stock 60000
Bank loan 240000
Co-op bank 160000
Creditors 80000
AFC loan 120000
Bills payable 90000
Accrual 50000
Bills receivable 60000
Pre –payments 140000
Cash in bank 100000
Cash at hand 120000
Fixtures and fittings 80000
Debtors 80000
Plant and machinery 90000
Motor vehicles 60000

Required
Prepare a Balance sheet using both horizontal and vertical method.

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Mr. Momanyi Sole Proprietor /Business

Balance Sheet as at 31st March 2023

Shs Shs Fixed Assets Shs Shs

Capital 400000 Land 160000
Add N.P 100000 Building /premises 100000
Less drawings (40000) Plant and machinery 90000
460000 Fixtures and fittings 80000
Long term Motor vehicles 60000
liabilities Equipment 140000
Bank loan 240000 Furniture 70000
AFC loan 120000 700000
Co-op loan 160000 520000 Current Assets
Stock 60000
Current liabilities Debtors 80000
Creditors 80000 Bills receivable 60000
Bills payable 90000 Pre-payments 140000
Accruals 50000 Cash in bank 100000
Bank over draft 60000 280000 Cash at hand 120000 560000

Totals 1,260,000 Totals 1,260,000

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Momanyi Sole Proprietor /Business

Balance Sheet as at 31st March 2023

Fixed Assets/ Non Current Assets Cost Dep NBV

Uses Sh Sh. Sh and
Land 160000 160000
Building/Premises 100000 100000
Plant and machinery 90000 90000
Fixtures and fittings 80000 80000
Motor vehicle 60000 60000
Equipment 140000 140000
Furniture 70000 70000
Investment 700000 700000

Add WC (CA – CL)

Current Assets 60000
Closing stock/inventory 80000
Debtors 60000
Less provision for bad debts 140000
Prepayments 100000
Preliminary expenses 120000
Accrued income 560000
Cash in Bank
Cash at hand

Current Liabilities
Creditors 80000
Bills payable 90000
Accruals 50000
Prepaid income 60000 (280000) 280000
Bank overdraft 980000
Capital employed

Financed by
Capital 400000
Net profit 100000
Drawings (40000)
Bank loan 240000
AFC loan 120000
Cooperative loan 160000 980000

Limitations of a Balance Sheet

• A balance sheet is a financial statement that provides a snapshot of an organization's financial
position at a specific point in time.
• It presents the company’s assets, liabilities, and equity, reflecting the accounting equation: Assets =
Liabilities + Equity. Here are the key uses and limitations of a balance sheet:
Uses of a Balance Sheet
i) Financial Position Assessment:
• A balance sheet allows stakeholders to evaluate the financial health of a business,
showing what it owns (assets) versus what it owes (liabilities).

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ii) Investment Analysis:

• Investors use balance sheets to assess the company's liquidity and solvency, enabling
them to make informed decisions regarding investment opportunities.
iii) Creditworthiness Evaluation:
• Lenders and creditors review balance sheets to determine a company's ability to repay
loans.
• A strong balance sheet with ample assets in relation to liabilities can indicate
creditworthiness.
iv) Performance Measurement:
• It can help in comparing the company’s financial position over different periods, allowing
management to assess growth, financial trends, and the effectiveness of its strategies.
v) Asset Management:
• Balances can identify underperforming or unnecessary assets that may need to be
disposed of or optimized for better returns.
vi) Regulatory Compliance:
• Companies may need to prepare balance sheets for regulatory purposes to comply with
accounting standards and provide transparency to government agencies and stakeholders.
vii) Guidance for Strategic Planning:
• By reviewing the balance sheet, management can make informed decisions regarding
capital investment, financing, and operations.
Limitations of a Balance Sheet
i) Timing:
• A balance sheet represents a snapshot of financial position at a specific date, which may
not reflect the organization’s ongoing operational performance or financial changes
occurring immediately before or after the date.
ii) Valuation of Assets:
• Assets are recorded at historical cost less depreciation (for tangible assets) or not at all
(for intangible assets), which may not accurately represent their current market value.
iii) Non-Financial Factors:
• A balance sheet does not capture qualitative factors such as brand value, market
conditions, customer loyalty, or management effectiveness that may influence a
company's real value.
iv) Incompleteness:
• Certain valuable assets, such as intellectual property or good will, may not be fully
represented, leading to an undervaluation of the company's total worth.
v) Subjectivity in Estimates:
• The value of certain liabilities, provisions, and contingent liabilities may rely on
management’s estimates, introducing a level of subjectivity and potential bias.
vi) Lack of Dynamic Information:
• The balance sheet doesn’t show the dynamics of cash flow or income, which are crucial
for understanding liquidity and operational performance.
vii) Potential for Misinterpretation:
• Users may misinterpret the data if they do not possess a comprehensive understanding of
accounting principles
• For example, a high asset value could be misleading if associated liabilities are also high.

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Activity I: The following information was extracted from books of account of Lagat, a businessman in
Langas selling second hand clothes. Use it to prepare the trial balance both in Horizontal method and vertical
method as at 31st December 2023.
Dr (Shs) Cr (Shs.)
Land 140000
Premises 160000
Debtors 100000
Creditors 80000
Capital 200000
Net profit 100000
Drawings 20000
Bills receivable 60000
Cash in bank 80000
Cash at hand 40000
Bank loan 200000
AFC loan 140000
Cooperative loan 160000
Building society loan 100000
Fixtures and fittings 180000
Equipments 120000
Furniture 70000
Investments 30000
Bills payable 80000
Motor van 100000
Plant and machinery 60000
Accruals 40000
Prepaid income 20000
Prepaid expenses 30000
Preliminary expenses 50000
Provision for depreciation
Buildings 10000
Fixtures and fittings 20000
Motor van 10000
Equipments 10000
Furniture 20000
Plant and machinery 10000
1240000 1240000

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