Mwangaza Traders: The Profit the Owner Wants the Bank to See
Mwangaza Traders' draft accounts for the year ended 31 December 2024 show a profit of KSh 1,850,000. The owner intends to file them with Wema Bank in support of a KSh 3,000,000 loan application and asks you to sign them off. Before signing you note: (i) goods invoiced at KSh 480,000 were sent to a customer on a sale-or-return basis on 20 December and recorded as a sale; they cost KSh 336,000 and the customer had not adopted them by year end; (ii) a debtor owing KSh 620,000 entered liquidation in November, with recovery expected at 15%, but no provision has been made; (iii) a vehicle bought on 1 April 2024 for KSh 2,400,000 was depreciated at 25% reducing balance for a full year; (iv) KSh 180,000 of insurance covering the calendar year 2025 was charged to 2024; (v) slow-moving stock costing KSh 90,000 has a net realisable value of KSh 55,000.
1. Prepare a schedule adjusting the draft profit, showing the direction and amount of each adjustment.
Read the worked answer
| Item | Adjustment | Effect on profit (KSh) |
|---|---|---|
| (i) Sale or return - reverse sale | (480,000) | |
| (i) Reverse matching cost of sale | 336,000 | |
| Net effect | (144,000) | |
| (ii) Doubtful debt: 620,000 × 85% | no provision exists, so create full amount | (527,000) |
| (iii) Depreciation: charged 2,400,000 × 25% = 600,000; correct 600,000 × 9/12 = 450,000 | overcharge reversed | +150,000 |
| (iv) Insurance for 2025 charged in 2024 | prepayment | +180,000 |
| (v) Stock write-down: 90,000 − 55,000 | (35,000) |
Reconciliation 1,850,000 − 144,000 − 527,000 + 150,000 + 180,000 − 35,000 = KSh 1,474,000
Check: the adjusted figure is KSh 376,000 lower, about 20% of the draft profit. The two largest adjustments (sale or return, bad debt) are both unrecorded receivables-side items - a pattern, not bad luck.
2. Justify the treatment of items (i) and (ii), and respond to the owner's argument that 'prudence means showing the strongest profit we can honestly defend'.
Read the worked answer
(i) Sale or return. Control has not transferred: the customer may still return the goods and has not adopted them. Revenue is recognised only where it is highly probable there will be no significant reversal, so the KSh 480,000 cannot stand as a sale. The goods remain Mwangaza's inventory (held by a third party), and the matching cost of KSh 336,000 must come back into stock rather than remain in cost of sales. Net effect on profit: KSh 144,000 down.
(ii) Impaired debtor. Liquidation is objective evidence of impairment at the reporting date, not a post-balance-sheet surprise. The receivable is measured at the present value of expected recovery: 620,000 × 15% = KSh 93,000, so an allowance of KSh 527,000 is required. Holding it at face value overstates both assets and profit.
On 'prudence' The owner has the concept backwards. Prudence is the exercise of caution under uncertainty - it never permits overstatement of income or assets, and it is not a licence to overstate anything. More fundamentally, IAS 1 requires fair presentation: transactions are recorded on their economic substance, not on the version of them that best supports a loan file. Recognising a sale that may reverse and carrying a dead debtor at face value are not 'strong' accounts; they are misstated accounts, and a bank that discovers them after drawdown has a contractual and potentially criminal remedy. The correct answer to the owner is that the adjusted profit of KSh 1,474,000 is the figure the business can actually defend.
3. The owner instructs you to sign the draft accounts as they stand. What are the consequences for the loan application and for you professionally?
Read the worked answer
For the loan application
- The bank will lend against overstated profit and an overstated receivables book; a KSh 376,000 overstatement of profit plus a KSh 480,000 fictitious receivable changes the affordability and security picture it is pricing.
- If the accounts are submitted knowingly, the misrepresentation may void the facility, trigger acceleration and support a claim in deceit; the bank will also reassess the owner's integrity, which is usually fatal to a facility irrespective of the numbers.
- Any subsequent restatement damages the firm's ability to raise finance at all.
For you
- Signing accounts you know to be misstated breaches integrity and objectivity, and professional competence and due care - you would be associated with misleading information.
- It is not a private matter between you and the client: the accounts are going to a third party who will rely on them, so confidentiality does not protect the instruction.
Action
- Set out the adjustments in writing and quantify them (the schedule above).
- Ask the owner for written instruction if he insists; do not sign.
- Escalate within your firm and, for a signing engagement, consider withdrawing and reporting to the engagement partner.
- If the accounts are nevertheless filed or submitted, record your dissent and consider reporting obligations to the relevant professional body.
Test to apply: would you be comfortable explaining the adjustment to the bank's credit committee? If not, it does not go in the file.