Teaching Material

Principles of Accounting I
Fess Warren 16 Ed Edited by: Andualem Tsegaye

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CHAPTER ONE
Accounting is a process of interpreting, recording, summarizing and reporting financial
information to decision makers. Thus, the purpose of accounting to help decision-makers
to make informed judgments and decisions
If accounting information is not capable of helping to make better decision. Then it is
waste of time and money to produce.
Accounting is often called the “language of business” an information system that
provides essential information about the financial activities of an entity to various
individuals or groups for their use in making informed judgments and decisions.
Users of Accounting information
For accounting information to be useful, an accountant must be clear about for whom the
information is being prepared and for what purpose the information will be used.
Generally Every one in a society make decisions from very minor simple and ones to
very broad and complex; In one way or another most decisions, use accounting
information. Thus, in short we can say every body in a society use accounting
information. However, when we speak about particular business organization, we can
categorize accounting information users in to two broad groups as:
1. The internal user group
2. The external user group
1. The internal user group - these include management and employees of the business
enterprise.
Those who are in the day-to-day operation of the enterprise
Those who are part and parcel of the value chain of the enterprise.
Purpose by internal users
Planning current and long-term operations
Controlling (Evaluating) current operations Means of accelerating favorable
trends and reducing those that are unfavorable
Management Accounting is designed to satisfy information need of this group.
2. External user groups- those who are not in the day-to-day operation of the business
enterprise, but those who have some interest in the reporting enterprise. These are
collectively known as stakeholders. Indeed here are: customers, suppliers,
government, owners, etc
Purpose by external users
The purposes by external users are quite different; each group within the external user
group has their own interest:-Look at the following table, why each of the user group
needs accounting information relating to a business.
User group Use

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Customer To assess the ability the business to continue in

business and to supply the needs of the customers.
Government To assess how much tax the business should pay,
whether it complies with agreed prices, policies or
whether financial support is needed.
Owners To assess how effectively the managers are running
the business and to make judgments about likely
levels of risk and return in the future (profitability
and going-concern)
Creditors To assess the ability of the business to meet its
obligations and pay interest and to repay the
amount borrowed.
Liquidity; ability of the business to repay
short-term debt as they due
Solvency; ability of the business to repay all
kinds of debt as they due
The above descriptions show some of the purposes by some of the accounting
information users in the external user group. Note that there are many accounting
information users in the external user group; and the purpose mentioned here is not a
complete list. However it is clear that because there are different user groups having
different interest (objectives) their accounting information need is also different.
You may raise a question like this; how is possible to satisfy different user groups
having different interest?
It is by providing general purpose financial statements. General purpose statements is
financial statements that are prepared by following generally accepted accounting
principles (GAAPS) or international financial reporting standards (IFRS) and that will be
used by different user groups for different purposes.
A single balance sheet is used by creditor to evaluate liquidity /solvency and by investor
to evaluate attractiveness of the business in terms of risks and return.
Financial Accounting is designed to satisfy the information need of the external user
group.
Profession of Accountancy
Accounting can be characterized as a profession that has experienced rapid development
during the current century. As professionals, accountants are typically engaged in either:-
1. Private Accounting or
2. Public Accounting
Private Accounting; Accountants employed by a particular business firm not-for-profit
organization or by government entities as chief accountant, controller or any other
accounting position are said to be engaged in private accounting.
Public Accounting; Accountants who render accounting services on a fee basis and staff
accountants employed by them are said to be engaged in public accounting.

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Business Transactions
A business transaction is the occurrence of an event or a condition that must be recorded.
Example: Payment of telephone bill of 100birr
Purchase of merchandise on credit for 1200birr
Acquisition of Land and Building for 210,000birr
A particular business transaction may lead to an event or a condition that result in another
transaction. For example, the purchase of merchandise on credit will be followed by
payment to the creditor, which is another transaction. Each time a portion of a
merchandise sold, another transaction occurs.
Business transaction could be internal transaction or External transaction. External

transactions are an exchange of goods or services between the business and an outsider.
Internal transactions are not an exchange of goods and services between the business and
an outsider, but these are conditions that must be recorded.
Examples: - the wearing-out of building, consumption of office supplies, etc.
ASSETS, LIABILITES AND OWNER’S EQUITY
Assets: - The properties owned by a business enterprise are referred to as assets.

Economic resources-things of value-owned by a business
Liabilities : -- The right of creditors /debts of the business.
Owner’s Equity : - The right of owner /owners
The properties owned by a business enterprise are referred to as assets and the rights or
claims to the properties are referred to as Equities. Note that always assets of business
enterprise are equal with Equities. As mentioned above equities are divided into two
principal types: the right of creditors and the right of owners. The right of creditor is
liability where as the right of the owner is owner’s equity.
Assets = Liabilities + Owners Equity
It is customary to place “liabilities” before” owner’s Equity” in accounting equation

because creditors have preferential rights to assets
Note ; Any increase or decrease in assets results in corresponding in liabilities or owner’s
Equity or both. The two sides of the equation must always be equal.
Transaction and the Accounting Equation
All business transactions, from the simplest to the most complex, can be stated in terms
the resulting change in the three basic elements of the accounting equation.
Illustration: - Assume that Mr. X establishes a sole proprietorship to be known as x- taxi.

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Transaction a
Mr. X’s first transaction is to deposit 10,000bir in a bank account in the name of x-taxi
price. The effect of this transaction is to increase the asset (cash), on the left side of the
equation by 10,000birr and to increase the owner’s equity, on the other side of the
equation by the same amount.
Assets = Liabilities + owner’s equity

Cash Mr. X-capital
10,000 10,000
It should be noted the equation relates only to the business enterprise Mr. X’s personal
assets, such as his home and his personal bank account, and his personal liabilities are
excluded from consideration. The business is treated as a separate entity, with cash of
10,000 (asset) and owners’ Equity of 10,000.
This is known as Business Entity concept.
Business Entity concept; States regardless of the form of the business organization, the
business affairs of the business should be separate from that of owners.
Generally there are three forms of business organization namely: Sole proprietorships,
partnerships, or corporations.
- A sole proprietorship is owned by one individual
- A partnership is owned by two or more individuals in accordance with a
contractual agreement
- A corporation is a separate legal entity in which ownership is divided in to
shares of stock.
Transaction b
Mr. X next transaction is to purchase land as a future building site for which 7500 in cash
is paid. This transaction changes the composition of the assets but does not change the
total amount.
Assets Liabilities + Owner’s Eq.
Cash + Land
Beg. Bal 10,000
b -7,500 + 7500
10,000
End. Bal 2500 7500
10,000 = 10,000

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Cost principle - On the date it occurs, a financial transaction is recorded at the value of
the transaction.
Transaction c
During the month, Mr. X – purchases 85birr of gasoline, oil and other supplies from
various suppliers, is agreeing to pay in the near future. This type of transaction is called a
purchase on Account and the liability created is termed accounts payable.
The effect of this transaction is to increase assets and liabilities by 850birr a follow:
Assets Liabilities + Owner’s Equity
Cash + Supplies + Land Accounts P. + X- Capital
2500 850 7500 850 10,000
10,850 10,850
Transaction d
During the month, 400birr is paid to creditors on account, thereby reducing both assets
and Liabilities. The effect of this equation is as follow:

Cash + Supplies + land
Beg. Bal 2500 Account payable + x- capital
(d) - 400 850 7500 850 10,000
Bal. 2100 -400
Bal. 450 10,000
10,450
10,450
10,450
Transaction e
During the first month operation’s Mr. X- business earned 4500birr receiving the amount
in cash. The total effect of these transaction is to increase cash by birr 4500 and to
increase owners’ equity by the same amount. In terms of the accounting equation, the
effect of the receipt of cash for the services performed is as follow:
Cash + Supplies + Land Accounts pay. X- capital
Bal. 2100 850 7500 450 10,000
e + 4500 + 4500
Bal. 6,600 850 7500 450 14,500

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14,950 14,950
In general, the amount charged to customers for goods or services sold to them is called
revenue. Other terms may be used for certain kinds of revenue, such as sales for the sale
of merchandise or business services, fees earned for charges by physician to patients, rent
earned for the use of real estate or other property, and fares earned by Taxi service
providers.
Instead of requiring the payment of each at the time goods or services are sold, a business
may make sales on account, allowing the customer to pay later. In such cases, the firm
acquires an account receivable , which is a claim against the customer. An account
receivable is as much an asset as cash and the revenue is realized in exactly the same
manner as if cash had been immediately received.
At a later date, when money is collected, there is only an exchange of one asset for
another, with cash increasing and accounts receivable decreasing.
Transaction (f)
In broad sense, the amount of assets consumed or services used in the process of earning
revenue is called expense. Expenses would include supplies used wages of employees
and other assets and services used in operating the business.
For x- taxi various business expenses incurred and paid during the month were as
follows: Wages, 1, 125birr, Rent, 850birr; Utilities 150birr; miscellaneous 75birr. The
effect of this group of transactions is to reduce cash and to reducer owner’s equity, as
follow:
Cash + Supplies + Land Acct. pay. + x-capital
Bal. 6600 850 750 450
(f) - 2,200 14,500
-1,125 Wages Exp.
- 850 Rent Exp.
- 150 Uti. Exp.
-75 Mis. Exp
4400 850 750 = 450 12, 300
12,750 12,750
Transaction (g)
At the end of the month it is determined that the cost of the supplies on hand is 250, the
remainder (850-250) having been used in the operations of the business. This reduction
600birr in supplies and owner’s equity is shown as follows:-
Assets
Cash + Supplies + Land Liabilities + Owner’s Equity

Acct. Pay. X- Capital
Bal. 440 85 7500 450 12,300

0 0

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(g) -600 -600supp.exp.

Bal. 4400 250 7500 450 117000
12,150 === 12,150
Transaction h
At the end of the month, Mr. X - withdraws, from the business 1000birr in cash for his
personal use. This transaction, which reduces cash and reduces owner’s equity, is the
exact, opposite of an investment in the business by the owner.
It is not a business expense, but a withdrawal of a portion of the owner’s equity. The
effect of the 1000 withdrawal is as follow:-
Assets
Cash + Supplies + Land liabilities + Owner’s Eq.
Acc. Pay.
Bal. 4,400 250 7500 450 11,700
h -1000 -- -- -- -1,000 withdrawal
Bal. 3400 250 7500 450 10,700
11,150 == 11,150
Summary:-
The business transactions of x- taxi are summarized in tabular form, as follows. The
transactions are identified by letter; the balance of each item is shown after each
transaction.
Assets = Liabilities + Owner’s

Equity
Cash + Supplies + Land Accounts. Pay + x- Capital
a + 10,000 + 10,000
b -7500 +7500 ------
2500 7500 10,000

c 2500 + 850 7500 +850 10,000
2500 850 7500 850 10,000
d -400 _____ _____ -400 ______
2100 850 7500 450 10,000
e + 4500 _ _--___ __--___ __--___ 14500
6600 850 7500 450 14500
f -2200 -1125W.Exp
-850 R.Exp.
-150.U.Exp.
______ _________ _______ _________ - 75 Mis. Exp.
4400 850 7500 450 12300

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g _____ -600 _____ ______ -600

4400 250 7500 450 11700
h -1000 _____ _____ ______ -1000
3400 250 7500 450 10,700
Note the following observation, which apply to all types of business.

1. The effect of every transaction can be stated in terms of increases and /or
decreases in one or more of the accounting equation element.
2. The equality of the two sides of the accounting equation is always maintained.
3. The owner’s equity is increased by amounts invested by owner and decreased by
withdrawals by the owner. In addition, owner’s equity is increased by revenues
and is decreased by expenses.
Owner’s Equity
Decreased by Increased by
Owner’s withdrawals Owner’s Investments

Expenses Revenues
Effects of transactions owner’s Equity
Exercise
Transaction
Portrait- painting business of Rahel
1. On January 1, 2014, Rahel began her business by investing br. 35,000 in cash in a
checking account that she opened in the name of business.
2. On January 2 Rahel rented a small room in the basement of a house for a studio.
She paid br. 900 for a year’s rent in advance.
3. On January 3, Rahel purchased art supplies for br.1,000 on credit.
4. On January 4, Rahel purchased furniture and fixtures costing br. 2,000 for cash.
5. On January 10, Rahel delivered her first painting to a customer, with the painting,
Rahel delivered a bill for services rendered of br.3,000 on credit.
6. On January 11, the customer in transaction 5 paid half of his bill.
7. On January 12, the account payable that result from transaction 3 was paid in full.
8. On January 15, Rahel withdrew br.1,000 from the business for her personal use.
9. On January 15, Rahel paid br.100 to sure-clean Inc-to clean the studio.
10. On January 31, Rahel determined that she had br.900 of art supplies left on hand.
11. On January 31, Rahel determined that unused prepaid rent was br.825.
12. On January 31, Rahel estimated depreciation on Furniture and fixtures for the
month was br. 25.

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Required show the effect of each of the above transactions on the accounting equation
elements; show the balance after each transaction.
Financial Statements
After the effect of individual transaction has been determined, the essential information is
communicated to users. The accounting statements that communicate this information are
called financial statements. Financial statements are the result of financial accounting
process.
There are four principal financial statements for proprietorships and partnerships:
1. Income statement; Presents the results of operations of an entity for a particular
period of time. It is a summary of the revenue and the expenses of a business
entity for a specific period of time, such as a year or month.
2. Balance sheet; Presents information about the financial position of an entity at a
particular date. It is a list of assets, liabilities and owner’s equity of a business
entity as of a specific date, usually at the close of the last day of a month or a
year.
3. Statement of Cash flow; a summary of cash receipts and cash payments of a
business entity for a specific period of time such as a month or a year.
4. Statement of Owner’s Equity; Presents information about how owner’s equity has
changed over a particular period of time. It is the summary of the changes in the
owner’s equity of a business entity that have occurred during a specific period
time.
Income Statement
The excess of revenue over the expenses incurred in the earning the revenue is called net
income. If the expenses of the enterprise exceed the revenue, the excess is a net loss.
It is ordinarily impossible to determine the exact amount of expense incurred in
connection with each revenue transaction. Therefore, it is satisfactory to
determine the net income or net loss for stated period of time.
The determination of periodic net income or net loss is a matching process
involving two steps.
First, Revenues are recognized during the period. Second, the assets consumed in
generating the revues must be matched against the revenues in order to determine
the net come or the loss.
Example of Income Statement
Rahel Portraits
Income Statement
For the month ended January 31, 2014
Revenue (sales)-----------------------------------------------------------3,000
Expenses:
Cleaning expenses-------------------100
Supplies expense---------------------100
Rent Expense ------------------------75

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Depreciation----------------------------25 300
Net income----------------------------------------------------------- 2700
Note that, income statement shows financial performance of the business during a
period; it shows by how much the business was better off or worse off during the period.
Balance sheet - the purpose of balance sheet is to show financial position an entity on a
particular date. Balance sheet format could vary from business to business. The most
common and acceptable formats are: Report format, Account format and financial
position format. The difference between these formats lies on the manner in which the
information’s are arranged in the statement; therefore it is a matter of the appearance of
the report not the content.
Report format – Under the report format liabilities and owner’s equity are listed
below the asset section.
Account format – Under this formats assets are listed on the left and liabilities and
owner’s equity are listed on the right. It resembles the accounting equation.
Financial position format- It is a vertical format in which current liabilities are
deducted from current assets to derive working capital. Other assets then are
added and other liabilities are deducted leaving a residual amount as a owner’s
equity.
Example
Rahel Portraits
Balance sheet
January 31, 2014
Assets Liabilities
Cash------------------------- 31500 AlP--------------------------- 0
Accounts Receivable------ 1500 Owner’s Equity
Art Supplies---------------- 900 Rahel, Capital---------- 36700
Prepaid Rent 825
Furniture and Fixture------ 1975
Total Assets 36700
Statement of Owner’s Equity

Generally we have said that three types of transactions affect owner’s Equity during a
period:-
1. Investment by owner
2. Revenues and Expenses as a result of operation of a business: and
3. Withdrawal by owner.
The purpose of preparing statement of owners’ Equity is to summarize these

transactions effect in summary form. It is considered as a link between the balance sheet
and the income statement.
Example

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Rahel Portraits
For the month ended, January 31, 2014
Balance Before January 1 ------------------------0
Add: Investments in January-----------35000
Net income for January----------------- 2700
Sub-total------------------------------------37700
Less Withdrawals in January------------(1000)
Balance , January 31----------------------36,700
Statement of Cash flows (SCF)

In the statement of cash flow, it is customary to report cash flows (cash receipts and cash
payments) in three sections
1. Operating activities
2. Investing activities
3. Financing activities
Operating activities - Cash flows that result from the day-to-day income producing
activities of business.Cash flows in this section includes cash transactions that enter in to
the determination of net income.
Examples include
Cash in flows:- Collection of Receivable, sale of merchandise on cash, collection of
interest Revenue collection of dividend from investment in other co.
Cash out flows:- Payments for creditors for purchase of inventory or supplies; and other
payment for business operating costs, payment for interest on debt.
Investing activities - Cash flows from investing activities section reports the cash
transactions for the acquisition and sale of relatively long- term or permanent type assets.
It includes purchase or sale of productive assets like: Building, Land, Machinery,
furniture and Fixtures, etc and Purchase or sale of other companies debt or equity long
term securities.
Financing activities - the cash flows from financing activities section reports the cash
transactions related to cash investments by the owner, borrowings and cash withdrawals
of owner. For corporation form of business this include payment of dividend to
stockholders; issuance of equity or debt securities; repayment of the loan principal.
Example
Rahel Portraits
Statement of Cash Flows
For the month ended, January 31, 2014
Cash flows from operating activities:
Cash Received from customers------------------------------------1500
Cash payments for expenses and to creditors------------------ (2000)
Net cash flow from operating activity (500)
Cash flow from investing activity

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Cash payments for purchase of Furniture and Fixture-------(2000)

Cash flow from Financing activity
Cash withdrawal by owner--------------------------------------(1000)
Net cash flow during the period ( 3500)
Cash balance Jan1, 2014-------------------------------------------------------35000
Cash balance Jan31, 2014-----------------------------------------------------31,500
Financial statement for corporation; lecture

Read from the book - principles of Accounting 16 th ed. Fees warren
Assignment one
1. Assume that a company has the following balances on December 31, 2013:
Total assets------------------------------- 20,000
Total liabilities--------------------------- 15,000
Required:
A.What is the amount of owner’s equity?
B.What is the amount of net asset?
2. Indicate the net effect each of the following transaction has on the amount of assets,
liabilities, and owner’s equity. ( + for an increase, - for a decrease and – 0 – for no
change).
Assets Liabilities Owner’s Equity A.
Purchase of Supplies for cash
B. Purchase of supplies on credit
C. Payment of Monthly water bill
D. Payment of Employee salaries
E. Payment of Rent for one month in advance
F. Payment of fee of independent accountant
G. Payment of telephone bill
H. Payment of the next three years’ property insurance premiums in advance
3) The following are group of accounts as of January 31,2014
Cash---------------------------------- 15,000
Acc. Rece.--------------------------- 6,000
Inventory---------------------------- 7,000
Furniture Fixture------------------- 10,000
Accounts payable----------------- ?
J. Jones, capital------------------- ?
The J. Jones, capital account balance on January 1, 2014, was 4000, J. Jones invested
4,000 of his personal funds in the business during January. She withdrew no funds during
the month, the net income for the month of January was 2,000.

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Required:
A. Determine the balance of Accounts payable and J. Jones, capital as of January
31, 2014.
B. Prepare a balance sheet as of January 31, 2014.
4) The following are the year-end balance sheet amounts for company for three years
31 Dec. 31Dec. 3Dec. 31

Assets 2011 2012 2013
Cash-------------------------------------- 10,000 15,000 16,000
Accounts Receivable------------------- 12,000 14,000 16,000
Supplies------------------------------------ 1,000 1,000 2,000
Equipment--------------------------------- 10,000 12,000 14,000
Total Assets 33,000 42,000 48,000
Liabilities and Owner’s Equity
Accounts payable---------------- 1000 2000 3000
Bank Loan payabl 10,000 15,000 17,00
X- Capital 22,00 25,000 28,000
Total Liabilities and owner’s
Equity 33,000 42,000 48,000
Additional information
2011 2012 2013
Personal withdrawals by-Mr. X 1000 2000 3000
Investments in business by Mr. X 9000 7000 9000
The balance in Mr. Xs’ Capital on January 1, 2011 was br.
8,000 Required:-
A. What was the net income or net loss for the business for 2011, 2012, and for
2013?
B. On the basis of business’s earning trend, do you think that a bank should lend
the business more money? Explain.

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5. Mr.Abebe established Abebe services on July 1 of the current year. The effect of each
transaction and the balances after each transaction for the month of July are as
follows:
Assets = Liabilities + Owner’s
Equity
Cash + Accounts Supplies Accounts. Pay + Joan Bow an
Receivable + Capital
a + 3000 + 3000investm.
b -2000 -2000
Bal. 1000 1000

c -------- + 550 + 550 --------
Bal. 1000 550 550 1000
d -4500 _____ ________ _+4500Fee
Bal. 5500 550 550 5500
e -250 ____ _-250_ _____
Bal. 5250 550 300 5500

f ----- + 12500 ------- -------- +1250Fees Ea.
Bal 5250 1250 550 300 6750
g -380-Auto.Ex.
-655 --------- --------- ---------- -275 Mis.Ex.
Bal. 4595 1250 550 300 6,095
h -1000 ________ ________ __________ -1000saler. Ex.
Bal. 3595 1250 550 300 5095
i _______ ________ -125 ________ -125 supp.Ex.
Bal. 3595 1250 425 300 4970

j -1200 __________ _______ ___________ -1200withd.
Bal. 2,395 1,250 425 300 3770
Required:
1. Prepare income statement for the month ended July 31.

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2. Prepare balance sheet as of July 31.

3. Prepare a statement of owner’s Equity for the month ended July 31.
4. Prepare a statement of cash flows for the month ended July31
6. following are the amounts of ABC Corporations assets and liabilities at October 31,
the end of the current year, and its revenue and expenses for the year ended on that
date, listed in alphabetic order.ABC Corporation had capital stock of br. 50,000 and
retained earnings of birr 16,765 on November 1, the beginning of the current year.
During the current year, the corporation paid cash dividends of birr 15,000 and
received cash from sale of capital stock of birr 20,000. Cash received from customers
was birr 189,500 and cash paid for expenses and to creditors was birr 185,500.
Accounts payable-------------------------------------------------------------- br.12,100

Accounts receivable----------------------------------------------------------- 21,250
Advertising expense----------------------------------------------------------- 5,500
Cash------------------------------------------------------------------------------ 16,500
Insurance expense-------------------------------------------------------------- 1,900
Land------------------------------------------------------------------------------ 80,000
Miscellaneous expense-------------------------------------------------------- 1,750
Prepaid insurance -------------------------------------------------------------- 950
Rent expense-------------------------------------------------------------------- 42,000
Salaries payable---------------------------------------------------------------- 2,250
Salaries expense---------------------------------------------------------------- 85,500
Fees earned---------------------------------------------------------------------- 206,500
Supplies-------------------------------------------------------------------------- 865
Supplies expense--------------------------------------------------------------- 6,125
Taxes expense------------------------------------------------------------------ 5,775
Utilities expense---------------------------------------------------------------- 24,500
Required
A. Prepare income statement for the current period ended , October 31
B. Prepare a retained earning statement for the current period ended , October 31
C. Prepare balance sheet as of October 31 of the current year
D. Prepare statement of cash flows for the current year ended October 31. The cash
balance on November 1, the beginning of the current year, was birr 7,500.

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Chapter two
The Accounting Cycle
From lessons in chapter one, we have seen the transactions completed by an enterprise
during a specific period may cause increases and decreases in many different assets,
liability and owner’s equity item. To have the details of these transactions readily
available and to prepare periodic financial statements the effects of transactions must be
recorded in systematic manner.
Although all transactions can be analyzed and recognized in terms of their effect on
accounting equation, such a format is not practical a design for actual accounting system.
Accountants must provide information on business transactions for use in directing
operations and for the preparation of timely periodic financial statements. These goals are
met by keeping a separate record for each item that appears on financial statements. The
individual records are then summarized at periodic intervals and the data thus obtained
are presented in the financial statements or other reports.
For example, a record would be used only for recoding increases and decreases in cash,
another record would be used only for recording increases in Supplies, another for Land,
Prepaid Rent, Sales, Salary expense, Rent expense, etc.
The type of record traditionally used for the purpose of recording individual transactions
is called an account. A group of related accounts that comprise a complete unit, such as
all of the accounts of a specific business enterprise, is called a ledger.
Classification of Accounts
Accounts in the ledger are customarily listed in the order in which they appear in
financial statements, and classified according to common characteristics. Balance sheet
accounts are classified as assets, liabilities and owner’s equity. Income statement
accounts are classified as revenues or expenses. In addition, there may be sub groupings
within the major categories.
Assets:
Any physical thing (tangible) or right (intangible) that has a monetary value is an
asset.Assets are , customarily divided into some groups for presentation on the balance
sheet. The two groups used most often are:-

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1. Current Assets
2. Plant Assets
Current Assets:- Cash and other assets that may reasonably be expected to be realized in
cash or sold or used up usually within one year or less, through the normal operations of
the business, are called current assets.
Examples include: - Cash, Accounts Receivable, Inventories, Prepaid Rents, Supplies,
etc. Plant Assets: - Tangible assets used in the business that is a permanent or relatively
fixed nature are called Plant assets or fixed assets.
Examples include:- Equipment, Machinery, buildings, Land, vehicles, etc. With the
exception of land, such assets gradually wear out or otherwise lose their usefulness with
the passage of time is called depreciation.
Intangible Assets:- Nonphysical things controlled by the business: Examples include:-
Good will, Patents, Copyrights, Trade marks, Franchises, etc.
Liabilities; Liabilities are debts owed to outsiders (creditors) and are frequently described
on the balance sheet by titles that include the word “payable” The two
categories occurring most frequently are :-
Current Liabilities
Long-term Liabilities
Current Liabilities:- Liabilities that will be due with in a short time (usually one year or
less ) and that are to be paid out of current assets are called current liabilities. Examples
include: - Accounts payable, Notes payable salaries payable, Taxes payable, etc.
Long-term Liabilities:- Liabilities that will not be due for a comparatively long time
(usually more than one year) are called long- term liabilities or fixed liabilities. As they
come with in the one-year range and are to be paid, such liabilities become current.
If the obligation is to be renewed rather than paid, at maturity, however, it would
continue to be classified as long-term. When payment of a long-term debt is to be spread
over a number of years, the installment due with in one year from a balance sheet date are
classed as current liabilities.
Examples include:- Notes payable (long-term) , mortgage payables, etc.
Owner’s Equity - is the residual claim against the business after the total liabilities are
deducted. For a corporation, owner’s Equity is frequently called Stockholder’s equity or
shareholder’s equity.
Capital, Capital stock, Retained Earning
Capital - is the owner’s equity in a sole proprietorship or partnership form business.
Capital stock – represents the investment of stockholders.
Retained Earning - represents the net income retained in business.
Revenues – are the gross increases in owner’s Equity as a result of the sale of
merchandise, the performance of services for customer or a client, the rental of property,
the lending of money, and other business and professional activities. Revenue from sale
of merchandise is often identified as sales. Other terms used to identify sources of
revenue include professional fees, commission’s revenue; fares earned, and interest
income. If an enterprise has various types of revenue, a separate account should be
maintained for each.
Expenses - Costs that have been consumed in the process of producing revenue are
expired costs or expenses. The number of expense categories and individual expense
accounts maintained in the ledger varies with the nature and the size of the business.

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CHART OF ACCOUNTS
A listing of the accounts in a ledger is called a chart of accounts. The order of items
(accounts) in the chart of accounts should agree with the order of the items in the balance
sheet and the income statement. The accounts are numbered to permit indexing and also
for use as references. For most simple (small) business organization has two digits: The
first digit indicates the major division of the ledger in which the account is placed.
Accounts beginning with 1 represent asset, 2 liabilities, 3 owner’s equity and drawing, 4
Revenue and 5 expenses. The second digit indicates the position of the account with in its
division.
A numbering system of this type has the advantage of permitting the later insertion of
new accounts in their proper sequence without disturbing the other account numbers. For
a large enterprise with a number of departments, or branches, it is not unusual for each
account number to have four or more digits.
Balance sheet Income statement

1.Assets 4 Revenue
11Cash 41Sales
12Accounts Receivable 5 Expenses
14Supplies
15Prepaid Rent 51Supplies Expense
18Photographic Equipment 52Salary Expense
19Accumulated Depreciation 53Rent Expense
2Liabilities 54Depreciation
21Accounts Payable Expense
22Salaries Payable 55 Miscellaneous
3 Owner’s Equity Expense
31 X- Capital
32 X- Withdrawal
Nature of An Account
The simplest form of an account has three parts:
1. A title - This is the name of item recorded in the account.
2. A space for recording increases in the amount of the item, in terms of money, and
3. A space for recording decreases in the amount of the item, in terms of monitory
units.
This form of an account is known as T- account because of its similarity with the letter T.
Title
Left side Right side

Debit Credit

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Debit: The left side of an account is called debit.

Credit: The right side of an account is called credit.
The word “charge” is sometimes used as synonym for debit. Amounts entered on the left
side of an account regardless of an account title are called debits or charges to the
accounts and the account is said to be debited or charged . Amounts entered on the right
side of an account called credits and the account is said to be credited.
Rule of Debit and Credit
Every Business transaction affects a minimum of two accounts. For each transaction the
debit amount (or the sum of all debit amounts, if there are more than one) must equal the
credit amount (or the sum of all the credit amounts). This is known as double–entry
system.
It follows that recording of a transaction in which debits do not equal credits is incorrect.
For all the accounts combined, the sum of the debit balances must equal the sum of the
sum of the debit balances must equal the sum of the credit balances; otherwise some
thing has been done incorrectly. Thus, the debit and credit arrangement used in
accounting provides a useful means of checking the accuracy with which the transactions
have been recorded.
Double-entry system is based on accounting equation

Assets = Liabilities + Owner’s Equity
For every dollar/birr entered as a debit to one account, a dollar /birr must be entered as a
credit to some other account.
Debit side Credit side

(Positive asset balance) (Positive liabilities and owners’ Equity
All Asset Accounts increase on the left hand side or debit side; and decrease on the right
hand side or credit side. All Liabilities and Owner’s Equity accounts increase On the
right hand side or credit side and decrease On the left hand side or debit side. This is
known as General rule of debit and credit.
Debit Credit Debit Credit Debit Credit

+ - - + - +
The rules for recording revenues and expenses are derived from the rules for owner’s
Equity. By definition revenue increases owner’s equity; and we have said that owner’s
equity increase in the right (credit) side. It necessarily follows that revenues increase in
credit side and decrease on debit side.
Expenses are the opposite of revenues in that expenses decrease owners’ equity.
Therefore it follows that Expenses increase with debit side and decrease with credit side.
Drawing or Dividends, similar with expense decrease owners’ Equity; therefore increase
with debit side and decrease with credit side.
Nominal or Temporary accounts Vs Real or Permanent Accounts

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Because Revenue and expense accounts are periodically closed, they are some times
called temporary accounts or Nominal accounts. The balances of the accounts reported in
the balance sheet are carried forward from year to year and because of their permanence
are referred to as real accounts or permanent accounts. In short, all income statement
accounts are nominal or temporary accounts that are going to be closed to the Balance
sheet account ) owner’s Equity). Thus, the normal balance for an asset account is a debit
balance and a normal balance for a liability or owner’s equity account is a credit balance.
The normal balance for an expense account is a debit balance and a normal balance for a
revenue account is a credit balance.
Summary:
Balance sheet Accounts Increas Decrease Norma

e Balance
Assets Credit Debit
Liabilities Debit Debit Credit
Credit
Owners Equity
(Capital) Capital stock) Credit Debit Credit
Retained Earning Credit Debit
Credit
Drawing /Dividend Debit Credit Debit
Income statement Accounts
Revenue Credit Debit Credit

Expense Debit Credit Debit
Note that when an account that normally has a debit balance actually has a credit balance,
or vice versa, it is an indication of an accounting error or unusual situation. For example,
a credit balances in asset account such as building, Land, Inventory, Equipment, etc.
could result only from an accounting error. On the other hand, a debit balance in liability
account could result from over payment.
Illustration of Recording transactions in T- Accounts.

Assume that the following transaction take place during the month of November for the
George Duncan Lumber company:-
Nov1. The business is stated when George Duncan invests 100,000 in cash in a bank
account in the company’s name.
Nov.4 The Company purchases land for 28,000 in cash
Nov.7 The Company purchases buildings for 42, 000paying 12,000 in cash and signing a
mortgage payable of 30,000.
Nov.10. the Company purchases office equipment for 4,000 in cash
Nov.15 Duncan transfers to the company the title of a truck he owns that is worth
5000. The company will use the truck solely for making deliveries.
Nov.18 Duncan withdraws 1000 from the company for his personal use.

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Nov.21 The Company purchases offices supplies for 750 on credit.

Nov.23 the truck received from Duncan has been found to be too small. Thus, the
Company acquires a larger truck by trading in Duncan’s truck and paying 3000 in cash.
Nov.28 The Company pays 200 of the 750 owed for the office supplies purchased on
Nov. 21.
Nov. 30 The Company pays 300 on the mortgage payable.
Note: - Debits are listed vertically in chronological order on the debit (left) side of each
account and that credits are listed vertically in chronological order on the credit (right)
side of each account. In each case the date of the transaction is entered along the debit or
credit.
Transaction Date
Nov.1 Effect of transaction

(Analysis of transaction)
Increase cash, and increase George Duncan, Capital
Cash George Duncan Capital
Nov.1 100,000 Nov.1 100,000
Nov.4 Cash Increase Land, Cash decrease
Nov.1 100,000 Nov.4 28,000
Land
Nov.4 28,000
Nov.7 Effect of Transaction

Building increase, cash decreased and Mortgage
payable increase
Cash Mortgage payable
Nov.1 100,000 Nov.4 28000 Nov.7 30,000

Nov.7 12,000
Transaction Date
Building

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Nov.7 420000
Nov.10 Office Equipment increase and Cash decrease

Cash Office Equipment
Nov.1 100,000 Nov.4 28000 Nov.10 4000
Nov.7 12000
Nov.10 4000
Nov. 15 Truck /Vehicles increase, and capital increase
Delivery vehicle George Duncan, capital

Nov. 15 5000 Nov.1 100,000
Nov.15 5000
Nov.18 Cash and George Duncan capital decrease
Cash George Duncan, capital

Nov.1 100000 Nov.4 28000 Nov.1 100,000
Nov.7 12000 Nov.15 5000
Nov.10 4000 Nov.18 1000
Nov.18 1000
Nov.21 Effect of Transaction office supplies

and Accounts payable account
increase
Office Supplies Accounts payable
Nov.21 750 Nov.21 750
Transaction Date
Nov.23 Delivery Vehicle both decrease and increase; cash decrease
Delivery Vehicle Cash
Nov. 15 5000 Nov.23 5000 Nov.1 100000 Nov.4 28000

Nov. 7 12000
Nov. 10 4000
Nov. 18 1000
Nov. 23 3000

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Nov. 28 Accounts payable is decreased and cash also

decrease
Cash Accounts payable
Nov.1 100,000 Nov.4 28000 Nov.30 200 Nov.21 750

Nov.7 12000
Nov.10 4000
Nov.18 1000
Nov.23 3000
Nov. 28 200
Nov. 30 Mortgage payable decrease and cash
also decrease
Cash Mortgage payable
Nov.1 100,000 Nov.4 28,000 Nov.30 300 Nov7. 30,000

Nov.7 12,000
Nov.10 4000
Nov.18 1000
Nov.23 3000
Nov.28 2000
Nov.30 300
Journals and Accounts
The flow of accounting data from the time a transaction occurs to its recording in the
ledger may be diagramed as follow:
Business Business Entry Entry

TRANSACTIONS DOCUMENT Recorded in Posted to
Occurs ⇒ Prepared ⇒ JOURNAL ⇒ LEDGER
The initial record of each transaction, or of a group of similar transactions, is evidenced

by a business document; such as sales ticket, a bill, cash register tape. On the basis of the
evidence provided by the business documents, the transactions are entered in
chronological order in a journal .
The amounts of the debits and the credits in the journal are then transferred to the
accounts in a ledger. This process of transferring the amounts of the debits and credits
from the journal to the accounts in the ledger is known as Posting.
Two – Column Journal

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There is great variety in both the design of journals and the number of different journals
that can be employed by an enterprise. A business may use a single all purpose two-
column journal (general journal) or it may use a number of multi column journals (special
journals) , restricting each for a single type of transaction.
Before a transaction is entered in the two-column journal, it should be analyzed according
to the following sequence of steps:-
1. Determine whether an asset, a liability, owner’s equity, Revenue or Expense is
Affected Determine; accounts(s) affected
2. Determine whether the affected, liability, owner’s equity revenue or
expense Increases or decreases
Determine, whether the affected account increases or decreases.
3. Determine whether the effect of the transaction should be recorded as a debit

or as a credit in an asset, liability, owner’s equity, revenue, or expense
account. Determine whether the effect (increase or decrease) should be
recorded as debits or credits.
The process of recording a transaction in a two-column journal is summarized as follow:
1. Record the date

Insert the year at the top only of the Date Column of each page, except when the year
date change. Insert the month on the first line only of the date column of each page,
except when the month date changes. Insert the day in the date column on the first line
used for each transaction, regardless of the number of transactions during the day.
2. Record the debit

Insert the title the account to be debited at the extreme, left of the description
column and enter the amount in the debit column.
3. Record the credit

Insert the title of the account to be credited below the title of the account debited
moderately indented, and enter the amount in the credit column.
4. Write an explanation
Brief explanations may be written below each entry, It should be noted that all
transactions are recorded only in terms of debits and credits to specific accounts.The titles
used in the entries should be the same as the titles of accounts in the ledger. The line
following an entry is left blank in order to clearly separate each entry.
Look at the following General Journal and notice where each of the above information is
found.
Journal Page__________
Date Description P.R. Debit Credit
Year
Month Day Debited Account title xx xx
Credited Account title xx xx
Explanation
Each one set of debits and credits for a transaction is called a journal entry.

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Posting from the journal to the Ledger

After the information about a business transaction has been journalized, that information
is transferred to the specific accounts affected by each transaction. This process of
transferring the information is known as posting.
Two – Column Accounts and Four – Column Accounts

A simple form of an account is a T- account illustrated earlier; beside the T- account; The
account could be a two- column account or a four – column account for each of them
look at the following accounts format:-
The two- column account Account No._____________
Date Item P.R Debit Date Item P.R Credit
The Four – Column account
Date Item P.R Debit Credit Balance

Debit Credit
The following are advantages of the four column account form:

1. Only a single date column is required, with each debit and credit appearing in its
chronological order.
2. The debit or credit nature of an account balance is more easily determined and more
Prominently displayed in the account
3. Having immediately adjacent debit and credit columns makes it easier to examine
the data in an account.
Steps in Posting:
When posting is done manually, the debits and credits in the journal may be posted in the
order they occur on if many items are to be posted at one time, all the debits may be
posted first, followed by the credits. The posting of a debit or credit journal entry to an
account in the ledger is performed as follow:
1. Record the date and amount of Dr. and Cr. Entry to the account.
2. Insert journal page number in the P.R (Posting Reference ) column of the account.
3. Insert the account number in the P.R of the journal.

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Illustration of Journalizing and Posting
Hill Photographic Studio Chart of Accounts:-

1 Asset:
11 Cash
12 Accounts Receivable
14 Supplies
15 Prepaid Rent
18 Photographic Equipment
19 Accumulated Depreciation – Photographic Equipment
2 Liabilities
21 Accounts Payable
22 Salaries Payable
3 Owner’s Equity
31 Ann Hill, Capital
32 Ann Hill, Drawing
33 Income Summary
4 Revenue
41 Sales
5 Expenses
51 Supplies Expense
52 Salary Expense
53 Rent Expense
54 Depreciation Expense
59 Miscellaneous Expense
Transactions
Mar 1, 1990. Ann Hill operated a photographic business her home on a part –time basis.
She decided to move to rented quarters as of March 1 and to devote full time the business
which was to be known as Hill photographic studio. The following assets were invested
in the enterprise; cash, 3500, accounts Receivable 950 supplies 1200; and photographic
equipment 15000. There Were no liabilities transferred to the business.
March 1. Paid 2400 on a rental contract, the payment representing three months’ rent of
quarters for the studio
March 4. Purchased additional photographic equipment on account for 2500
March 5. Received 850 from customers in payment of their accounts
March 6. Paid 125 for a newspaper advertisement – Advertising expense considered as
miscellaneous expense by Ann Hill
March 10. Paid 500 for the debt as a result of March 4 transactions
March 13. Paid receptionist 575 for two weeks’ salary
March 16. Received 1,980 from sale of service
March 20. Paid 650 for supplies purchase
March 27. Paid 575 receptionists for two weeks’ salary
March 31. Paid 69 for telephone bill for the month

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March 31. Paid 175 for electric bill for the month
March 31. Received 1870 from sales of service
March 31. Make sales on account for 1,675
March 31. Hill withdrew 1500 for her personal use advertising expense, Electric expense,
and telephone expense are classified as miscellaneous expense by Ann Hill. Required:
Journalize and Post the above transaction.
General Journal Page 1
Date Description P.R Debit Credit

1990 Cash- 3500
March 1 Accounts Receivable 950 00
Supplies 1200 00
Photographic Equipment 15000 00
Ann Hill, Capital 00 20650 00
1 Prepaid Rent 2400 00

Cash 2400 00
4 Photographic Equipment 2500 00
Accounts payable 2500 00
5 Cash 850 00
Accounts Receivable 850 00
6 Miscellaneous Expense 125 00
Cash 500 00
10 Accounts payable 500 00
Cash 500 00
Date Description P.R Debit Credit
13 Salary Expense 575 00
Cash 575 00
16 Cash 1980 00
Sale 1980 00
20 Supplies 650 00
Cash 650 00
27 Salary Expense 575 00
Cash 575 00
Cash 69 00
Cash 175 00
31 Cash 1870 00
Sales 1870 00
31 Accounts Receivable 1675 00

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Sales 1675 00
31 Ann Hill Drawing 1500 00
Cash 1500 00
These Journal Entries are posted to the accounts in the accounts in the ledger as follow:
Account Cash Account No11
Balance
Date Item P.R Debit Credit Debit Credit
1990
March 1 1 3500 00 3500 00
1 1 2400 00 1100 00
5 1 850 00 1950 00
6 1 125 00 1825 00
10 1 500 00 1325 00
13 1 575 00 750 00
16 1 1980 00 2730 00
20 1 650 00 2080 00
27 1 557 00 1505 00
31 1 69 00 1436 00
Balance
Date P.R Debit Credit Debit Credit
Item
1990
March 31 1 175 00 1261 00
31 1 1870 00 3131 00
31 1 1500 00 1631 00
2. Account Receivable Account No. 12

Balance
1990
March 1 1 950 00 950 00
5 1 850 00 100 00

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31 1 1675 00 1775 00
3. Account supplies Account No.14
Balance
1990
March 1 1 1200 00 1200 00
20 1 650 00 1850 00
4. Account Prepaid Rent Account No. 15

Balance
1990
March 1 1 2400 00 2400 00
5. Account Photographic Equipment Account No. 18

Balance
1990
March 1 1 15000 00 15000 00
4 1 2500 00 17500 00
6. Account accounts Payable Account No. 21

Balance
1990
March 4 1 2500 00 2500 00
10 1 500 00 2000 00
7. Account Ann Hill Capital Account No.31

Balance
1990
March 1 1 20650 00 20,650 00

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8. Account Ann Hill, Drawing Account No.32

Balance
1990
March 31 1 15000 00 15000 00
9. Account Sales Account No. 41

Balance
1990
March 16 1 1980 00 1980 00
31 1 1870 00 3850 00
31 1 1675 00 5525 00
10. Account Salary Expense Account No.52

Balance
1990
March 13 1 575 00 575 00
27 1 575 00 1150 00
11. Account Miscellaneous Expense Account No. 59

Balance
1990
March 6 1 125 00 125 00
31 1 69 00 194 00
31 1 175 00 369 00

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ASSIGNMENT TWO
Journalize and post the following transactions completed by bati transport in the month of
Meskerem 2007, and prepare trial balance as of Meskerem 31
Meskerem 1. Ato Yimer, the owner took birr 450,000 from his personal savings and
deposited it in the name of Bati transport.
Meskerem 2. Bati transport purchased two used trucks for birr 150,000 each on cash.
Meskerem 4. Bati transport received a check for birr 650 for services given to Ato Alem
trading.
Meskerem 11. Paid birr 600 for Awash insurance company to buy an insurance policy for
its trucks.
Meskerem 16. Ato Yimer issued (signed) a check for birr 9400 to the workers as a salary
for two weeks.
Meskerem 20. Bati transport Billed Muradu Supermarket for goods transported from
Djibuti to Addis birr 2,650.
Meskerem 21. Bati transport purchased stationary materials and other supplies for birr
740 on account.
Meskerem 22. Office Equipment of birr 11,600 is bought on account.
Meskerem 23. Purchased an additional truck for birr 250,000 paying birr 100,000 in cash
and issuing a note for the difference.
Meskerem 23. Recorded services billed to customers on account birr 14,600.
Meskerem 25. Received cash from customers on account birr 15,000.
Meskerem 27. The owner withdrew birr 500 in cash for his personal use.
Meskerem 28. Paid birr 9400 to workers as a salary for the last two weeks of the month.
Meskerem 30. Paid telephone expense of birr 95 and electric expense of birr 125 for the
month.
Meskerem 30. Paid other miscellaneous expenses birr 50.
Meskerem 30. Paid birr 4000 as a rent for a building used for office.
Required
A. Journalize and post the above transactions
B. Assumed chart of Accounts; Electric, Telephone and Water Expenses are
considered as one account known as Utilities Expense by Bati Transport.
C. Prepare the trail balance /after the discussion

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TRIAL BALANCE
The equality of debits and credits in the ledger should be verified at end of each
accounting period, such verification, which is called a trail balance, may be in the form of
calculator tape or in the form below.
A trial balance is a two column listing of the accounts in the ledger and their balance to
make sure that the total debit balances equals the total credit balances. As the first step in
preparing the trial balance, the balance of each account in the ledger should be
determined.
Example-
Debit Credit
Hill Photographic Studio
Trial Balance
March 31, 1990
Photographic Equipment 17500 00
Accounts payable 2500 00
Ann Hill, Capital 20650 00
Ann Hill, Drawing 1500 00
Sales 5525 00
Salary Expense 1150 00
Miscellaneous Expense 369 00
Total 28175 00 28175 00
Proof provided by trial Balance
The trial balance does not provide complete proof of the accuracy of the ledger. It
indicates only that the debits and the credits are equal. This proof is of value because
most errors affect equality of debits and credits. If the two totals of a trial balance are not
equal it is probably due to one or more of the following types of errors:
1. Error in preparing the trial balance , such as:

a) One of the columns of the trial balance was incorrectly added.
b) The amount of an account balance was incorrectly recorded on the
trial balance.
c) A debit balance was recorded on a trial balance as a credit or vice-
versa, or a balance was omitted entirely.
2. Error in determining the account balances, such as:
a) A balance was incorrectly computed
b) A balance was entered in the wrong balance column.
3. Errors in recording a transaction in the ledger, such as:
a) An erroneous amount was posted to the account
b) A debit entry was posted as a credit or vice versa

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c) A debit or credit posting was omitted
Among the types of errors that will not cause an inequality in the trial balance totals are
the following:
1. Failure to record a transaction or to post a transaction
2. Recording the same erroneous amount for both debit and
credit part of a transaction
3. Recording a single transaction more than once
4. Posting a part of a transaction correctly as a debit or credit
but to the wrong account.
CHAPTER THREE
COMPLETION OF THE ACCOUNTING CYCLE
Accounting Cycle - is the sequence of accounting procedures of a fiscal period is
known as Accounting cycle.
Fiscal Year; Annual accounting period adopted by an enterprise is known as fiscal Year.
Fiscal year ordinary begin with the first day of a particular month selected and end on the
last day of the twelfth month hence.
It could be coincide with calendar year but not mandatory
America case most (64%) – fiscal year from January 1, to December 31.
Ethiopia case most (Hamle 1-to –Sene 30)
The following are basic phases in Accounting cycle

1. Transactions are analyzed and recorded in the journal
2. Transactions are posted to the ledger
3. Trial balance is prepared, data needed to adjust the accounts are assembled, and
the work sheet is completed
4. Financial statements are prepared
5. Adjusting and closing entries are journalized
6. Adjusting and closing entries are posted to the ledger
7. Post-closing trial balance is prepared
8. Reversing certain adjusting entries (optional)
Accrual basis of Accounting Vs cash basis of Accounting
1. Accrual basis of Accounting- Revenues are reported in the period they are earned, and
expenses are reported in the period incurred regardless of the time of cash receipt or
payment. Revenues Earned- when a service /product is sold to customers. i.e. when the
seller’s side obligation is complete. Expenses are incurred when the service of some asset
is used, when some assets are consumed or when the services of some Employees or
party is used rather than when cash is paid. Accrual basis of Accounting is used by most
business enterprises and it is inline with GAAPs basically the matching principle.

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2. Cash basis of Accounting- Revenues are reported in the period in which cash is
received and expenses are reported in the period in which cash is paid.Net income (or net
loss) is the difference between cash receipts and cash disbursements in operating activity.
Small service enterprises, which have few receivables and payables such as accountants,
physician, may use the cash basis of accounting. It is not in line with GAAPs; basically it
violates the matching principle.
Matching Principle
The Expenses incurred in producing revenue should be matched with recognized revenue.
Nature of the adjusting process
Financial reporting on annual, quarterly or monthly basis requires accountants to
summarize the operations of business enterprises for specific time period. All the trial
balance amounts are not necessarily correct at the end of a particular period because of
adjustment requirements.
The entries required at the end of an accounting period to bring the accounts up-to-date
and to assure proper matching of revenues and expenses are called adjusting entries.
Adjusting entries are required only under accrual basis of accounting.
Adjusting entries are end of accounting period entries because some financial events are
not recognized on a day-to-day basis.
Note- 1. If all financial events are recognized on a day-to-day basis, there is no need of
adjusting entry.
Note-2. Every adjusting entry affects both a balance sheet account and an income
statement account.
Generally, there are two types of Adjusting entries:
1. To apportion prepayments of Expenses or pre collection of Revenue
(Deferrals)
2. To record Accrued Expenses and Revenue (Accruals)
Purpose of adjusting Entries
1. To measure all assets and Liabilities correctly

2. To measure net income correctly by matching expired costs (Expenses)
with realized revenue.
1. To apportion prepayments of Expenses or pre-collection of Revenue (Deferrals)
a) Apportionment of Recorded costs.
b) Apportionment of Recorded Revenues
2. To record Accrued Expenses and Revenue (Accruals)
a) Accrual of unrecorded Expenses
b) Accrual of unrecorded revenue
1. Deferrals
a. Apportionment of rerecorded costs:
I. Pre payments (prepaid Expenses): Eg. Supplies, prepaid Rent, prepaid insurance, etc.
Two alternative ways of recording the pre payments initially:

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1. Pre-payments are initially recorded in asset account:

Adjusting entry- Reduce asset account and increase expense account for the amount of
asset consumed or for cost expired during a period.
Example: 1. According to the Hill photographic studio trial balance, the balance in trial
balance for supplies account is 1850. Clearly some of these supplies have
been used during the past month (March) and some may be still in stock.
Therefore either of the two information is used to enter the required journal entry to up
date supplies account and supplies expense account. Assuming that the inventory supplies
on March 31 is determined to be 890.
Supplies available on book. (Balance in the account)-----------------1850.
Less supplies on hand (inventory)--------------------------------------- --890
Supplies used (amount of adjustment)-------------------------------- 960
Adjusting entry- decrease asset account and increase expense account for the amount
of adjustment:
Therefore: Supplies Supplies Expense
Mar1, 1200
20, 650 960 960
31, 890 1850
Example: 2. The debit balance of 2400 in Hill’s prepaid rent account represents a pre
payment on March1 of rent for three months. (March, April and May)
At the end of March, the rent expense account should be increased (debited) and the
prepaid Rent account should be decreased (credited) by the amount of prepaid rent
expired for march- 2400/3 = 800
Prepaid Rent Rent Expense
March1, 2400 800 800

1600
If the preceding adjustments for supplies (960) and prepaid rent(800) are not recorded,
the financial statements prepared as of March31, will be incorrect (misleading) to the
extent indicated as follow:
On Income statement:
Expenses (supplies Expense for 960
Rent Expense for 800 will be understated ---------1760
Net income will be overstated----------------------- 1760

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On statement of Owner’s Equity:

Net income will be overstated---------------------------1760
Ending Owner’s Equity will be over stated ------------1760
On balance sheet:
Assets (Supplies and prepaid Rent) overstated---------------------1760
Owner’s Equity will be overstated ----------------------------------1760
2. Pre-payments are initially recorded in an Expense account

Adjusting Entry- Reduce expense account and increase asset account for the amount of
asset not yet consumed or cost not expired. On the 1 st day of the next period reversing
entries are required to facilitate consistency in recording.
Example1. If Hill recorded purchase of supplies in a supplies expense account at the time
of purchase; before adjustment supplies Expense Account has a debit balance of 1850.
The adjusting entry reduces the supplies expense account and increase the supplies
account for the unconsumed part of supply.
Supplies Expense Supplies

Mar1.1200
20 650 M31890
Mar31 890
960 1850
Example 2.
Similarly if Hill recorded payment of rent in advance as an expense (Rent Expense)
before adjustment Rent Expense account has a debit balance of 2400. Therefore, the
adjusting entry reduce Rent Expense account and increase the asset pre-paid rent for the
amount of pre-payment not yet expired.
Rent Expense Prepaid Rent

Mar1. 2400 1600
Mar31. Mar31.1600
800
Exercise: If the above adjusting entries are not made what is the effect on income
Statement, statement of owner’s Equity and balance sheet prepared as
of March 31 under case 2 above
II. Plant Assets

Like supplies and other pre-payments plant asset was used in operation once acquired.
Unlike supplies there is no visible reduction in the quantity of plant asset. However, as
time passes, plant asset lose its capacity to provide useful services. This decrease in
usefulness is a business expense, which is called depreciation expense.

0926 17 58 17
The adjusting entry to record depreciation is similar to the adjusting entry for
prepayments when initially recorded as assets. i.e. adjusting entry reduces the asset
account and increases the expense account.
Example: Assume that estimated amount of deprecation for Hill is 175 for March.
Photographic Equipment Accumulated Depreciation-Equipment
Mar1. 15000
4 2500 Mar.31 175
17500
Depreciation Expense
Mar.31.175
Apportionment of Recorded Revenue

When a business enterprise receives payment for goods and services before goods are
delivered or the services are performed, a liability exist until performance takes
place.When cash is received, the original transaction may be recorded by a credit to a
liability (Unearned Revenue) account or to a revenue account.
1. Advance (pre) collection is initially recorded in a liability account.
Adjusting Entry: - Reduce the liability account and increase the Revenue account for the
earned portion of revenue during the period.
Example: Assume that customer paid 500,000 birr for magazine subscription at the
beginning of the year. Assuming that only magazines having a price of 425,00birr have
been delivered to customers during the year; and the collection of cash was initially
recorded as a liability the following adjusting entry is required at end of this year:
Unearned subscription Subscription Revenue
Bal.Dec.31 500,000
425,000
Adj. Entr.425, 000
2. Advance (pre) collection is initially recorded in a revenue account.

Adjusting Entry: - Reduce the revenue account and increase the liability account for the
unearned portion of revenue during the period. On the 1 st day of the next period,
reversing entry is required to facilitate recording consistency.
Example: Assume the above example, except the initial collection of cash was recorded
in a revenue account.
Subscription Revenue Unearned subscription

0926 17 58 17
Bal.Dece.31 500,000
75,000
Adjusting Entry 75000
2. To record Accrued Expenses and Revenue

(Accruals) a. Accrual of unrecorded Expenses
Accrued Expenses or accrued liabilities, are expenses that have been incurred but have
not been recorded in the accounts. The incurring of certain expenses is related to the
passage of time. The expenses generally are not recorded until payment is made, unless
the end of accounting period comes before the required date of payment.
Examples: Interest, salaries, Taxes
In order to measure expenses accurately for a period, an adjusting entry is necessary to
record the accrued expenses and the corresponding liability.
Example1: Assume that interest of 18000 on a 400,000 note payable is paid on March1
and September 1 of each year. If expenses and liabilities are to be reported the
following year end adjusting entry is required on December 31 of the
year.
Interest Expense Interest payable
Adj. Entry 12000 12,000
6 month 6 month
J F M - A - M - J - J - A- S- ON - D_-__
(1)
(1)
Annual Expense = 18000X2 = 36000
Monthly Expense = 36000/12 = 3000
From September 1-to – December 31 = 4 months
Interest Expense = 4 x 3000 = 12000
On March 1 (next year) payment comes:
Interest expense -------- 6000
Interest payable--------12000
Cash--------------------------- 18000
Example 2. The debits of 575 on March 13 and 27 in a salary expense account for Hill
photographic studio were biweekly payments on alternate Fridays for the payroll periods
ended on those days. The salaries earned on Monday and Tuesday March 30 and 31, total
115. This amount is additional expense of March 31, therefore credited to Salaries
payable:
Salaries payable Salaries Expense

0926 17 58 17
Mar.13 575
Mar. 31 115 27 575
1150
31 115
1265
b. Accrual of Unrecorded Revenue

Revenue that has been realized but not recorded must be recognized at the end of an
accounting period. Accrued revenues or accrued assets, are revenues that have been
earned but have not been recorded in the accounts.
Examples include: Fees for services that an attorney has provided but has not billed to
the client at the end of the period, unbilled commissions by travel agent, accrued interest
on notes receivable, and accrued rent on property rented to others.
In order to measure accurately the results of operations, revenues are recognized in the
period earned.
Example: Assume that rent totaling 625 that has been realized but not collected for the
month of adjusting entry on December 31, is required to measure assets and Revenue
correctly.
Rent Receivable Rent Revenue
625
Dece31. Ad. Entry 625
Example: At the end of the current year, 7,260 of fees have been earned but have not
been billed to clients. The required adjusting journal entry is:
Accounts Receivable Fees Earned
Dec31, 7,260 7,260
Example 2: refer to example 1 under accrued expense.
The interest expense accumulated for the borrower is the interest revenue accumulated
for it is a liability for the borrower and is an asset (interest receivable) for the lender;
hence on the book of the lender the required adjusting entry is
Interest Receivable Interest Revenue

0926 17 58 17
Adj. Entry—12,000 12,000
Summary of Basic Adjustments:

Type of Adjustment Adjusting Entry Effect of omitting
Adjusting Entry on
Deferred Expense---xx B/sheet and/statement
I. Deferrals Expense (1) Asset--------xx - Expense understated and

NI
overstated
- Assets and owners
Equity overstated
(2) Asset---xx - Expense overstated and
Expense----xx NI understated
Deferred
Revenue (1) Liability—xx - Revenues understated
and NI understated
Revenue---xx - Liabilities overstated
And owner’s Equity
Understated
(2) Revenue ----xx - Revenues overstated and
NI overstated
Liability-----------xx - Liabilities understated
And owners Equity
overstated
Fixed Assets Expense ------xx - Expenses understated
and NI overstated
Contra Asset-------xx - Assets overstated and
owner’s Equity
overstated
II. Accruals Accrued Expense---xx - Expense understated
Expense Liability----xx -Liabilities understated
and owner’s Equity
overstated
Accrued Asset-------xx - Asset understated and
Revenue owner’s Equity
understated
Revenue------xx - Revenues understated

0926 17 58 17
and Net income

understated
Worksheet
Accountants often use working papers for collecting and summarizing data they need for
preparing various analysis and reports. Such working papers are useful tools, but they are
not considered as part of formal financial statements.
Work sheet is a working paper that accountants can use to summarize adjusting entries
and the account balances for financial statements.
A work sheet is an important tool, but is not an essential part of the accounting system,
like accounts, journal, or ledger; for example for small companies with few accounts and
adjustments, a worksheet may not be necessary. The work sheet is identified by:
1. the name of the enterprise

2. the nature of the form (work sheet)
3. the period of time involved.
A commonly used work sheet has an account title column and ten (10) money columns
divided in to five pairs of debits and credit columns.
The main headings of the five pairs of money columns are:

1. Trial Balance
2. Adjustments
3. Adjusted Trial Balance
4. Income Statement
5. Balance sheet

0926 17 58 17
Example-Work sheet
Hill photographic studio
Work sheet
For the month ended march31, 1990
S.N Account Title Trial Balance Adjustment Adjusted Trial Balance Income Statement Balance Sheet
Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
1 Cash 1631 00 1,631 00 1631 00
2 Accounts Recv. 1775 00 1775 00 1775 00

3 Supplies 1850 00 a. 00 890 00 890 00
960
4 Prepaid rent 2400 00 b. 00 1600 00 1660 00
800
5 Photographic Equ. 17500 00 17500 00 17500 00
6 Accounts Payable 2000 00 2000 00 2000 00

7 Ann Hill Capital 20650 00 20650 00 20650 00
8 Ann Hill, drawing 1500 00 1500 00 1500 00
9 Sales 5525 00 5525 00 5525 00
10 Salary Expense 1150 00 d. 00 1265 00 1265 00
115
11 Miscellaneous Exp. 369 00
12 28175 00 28175 00
13 Supplies Expense a.960 00 960 00 960 00
14 Rent Expense b. 00 800 00 800 00
800
15 Depreciation Exp. c. 00 175 00 175 00
175
16 Accumulated Dep. c.175 00 175 00 175 00
17 Salaries paya. d. 115 00 115 00 115 00
18 2050 00 2050 00 28465 00 28465 00 3569 00 5525 00 24896 00 22940 00
19 Net Income 1956 00 1956 00
20 5525 00 5525 00 24896 00 24896 00
TRIAL BALANCE COLUMN
Lists account balances before adjustment.
2. ADJUSTMENT COLUMN
Both the debit and credit parts of an adjustment should e inserted on the appropriate lines before
going on to another adjustment. Cross referring the related debit and credits of each adjustment
by letters (numbers) is important for reviewing the work sheet later, and also when recording the
adjusting entries in the journal. The order in which the adjustments are entered on the work sheet
is not important most accountants enter the adjustments in the order in which the data are
assembled.
If the titles of some of the accounts to be adjusted do not appear in the trial balance, they should
be inserted in the Account Title column, below the trial balance totals.Explanation for Entries in
adjustment columns of the Hill photographic studio work sheet:
a. Supplies: - The supplies account has a debit balance of 1,850 under the trial balance
column. This represent the acquision cost of supplies; but as discussed
Earlier, the cost of supplies; on hand at the end of the period is 890; there
fore the adjustment is entered by writing 1. Supplies Expense in the
Account title column and 2. 960 in the adjustments Debit column on the
same raw, 3. 960 in the Adjustment credit column on the line with
supplies.
b. Rent: - The prepaid rent account has a debit balance of 2400; earlier we have
determined the rent expense for March amounts 800. Therefore, the
adjustment is entered on the work sheet by writing:
1. Rent Expense in Account title column
2. 800 in the adjustments Debit column on the same line.
3. 800 in the adjustments credit column on the line with prepaid rent
c. Depreciation: - Depreciation of photographic Equipment was estimated at 175 for

the month. Therefore the adjustment is entered by writing:
1. Depreciation Expense on Account Title column
2. 175 in the adjustment Debit column of the Depreciation Expense account line.
3. Accumulated Depreciation in the Account title column and 4. 175 in the
adjustments credit column on the line with Accumulated Depreciation.
45 | P a g e
d. Salaries: - Salaries accrued, but not paid at the end of March amounts to 115. The
adjustment is entered by writing
1. 115 on the adjustments debit column on the same line with
salary Expense.
2. Salaries payable in the Account Title column
3. 115 on the adjustments credit column on the same line with salaries payable.
The final step in completing the Adjustments columns is to prove the equality of debits and
credits.
3. Adjusted Trial Balance Columns
The data in the trial balance columns are combined with the adjustments column data and
extended to the Adjusted trial balance column.
4. And 5. Income statement and Balance sheet column
The data in the adjusted trial balance column is extended to any one of the remaining four
columns under the Income statement and Balance sheet columns.
All Balance sheet accounts:- Assets, liabilities and owner’s Equity (capital and Drawing) are
extended to the balance sheet column having their appropriate balances.All income statement
accounts are i.e Revenues and Expenses are extended to Income statement column of the
worksheet.
After all of the balances have been extended each of the four columns is totaled, the net income
or the net loss for the period is the amount of the difference between the totals of the two income
statement columns. If the credit column total is greater than the debit column total, the excess is
the net income, if the reverse is true, then the excess is the net loss. After this difference (Net
Income /Loss) is computed this is inserted in the worksheet by writing.
1. Net Income (Loss) under the Account Title column
2. The amount is entered in the debit column of the income statement column if it is
Net income; or entered in the credit column of the income statement column if it is
Net loss.
3. The amount is entered in the credit column of the Balance sheet column if it is net income;
and it is entered in the Debit column of the balance sheet column if it is net loss.
After the final entry is made on the worksheet, each of the four columns is totaled to verify
arithmetic accuracy.
A. Financial Statements
The worksheet is an aid in preparing financial statements. The income statement, statement of
owner’s equity, and balance sheet are prepared from the work sheet. Journalizing and posting
Adjusting Entries.
At the end of the accounting period, the adjusting entries appearing in the
worksheet are recorded in the journal and posted to the ledger. This procedure
brings the ledger into agreement with the data reported on the financial statement.
The adjusting entries are dated as of the last date of the period.
46 | P a g e
Closing Entries
The revenue, Expense, drawing (dividend) accounts are temporary accounts used in classifying
and summarizing changes in the owner’s Equity during the accounting period.
To report amounts only for one period temporary accounts should have zero balances at the
beginning of a period. Closing entries transfer the balances of temporary accounts to the owner’s
capital account. An account titled “ Income summary” is used for summarizing the data in the
revenue and expense accounts.
It is used only at the end of the accounting period and is both opened and closed in the closing
process. Others use for the same purpose account titles such as: Expense and Revenue Summary,
Profit and Loss Summary, or Income and Expense Summary.
Four entries are required in order to close temporary accounts of a sole proprietor ship at the end
of a period:
1. Each Revenue account is debited for the amount of its balance, and Income
Summary is credited for the total revenue
Revenue1---------xx
“ 2--------xx
“ 3-------xx
Income Summary-----------xx
2. Each expense account is credited for the amount of its balance, and Income Summary is
debited for the total expense.
Income Summary-----------xx
Expense 1-------------------- xx
Expense 2-------------------- xx
Expense 3-------------------- xx
3. Income Summary is debited for the amount of its balance (net income) and the capital account
is credited for the same amount. (Debit and credit are reversed if there is net loss.)
4. The drawing account is credited for the amount of its balance, and the capital account is
debited for the same amount.
Example- For Hill photographic studio
1. To close Revenue:
Sales------------------------5525
Income Summary--------------------5525
2. To close Expenses:
Income summary------------3569
Salary Expense-----------------------1265
Miscellaneous Expense-------------369
Supplies Expense-------------------960
Rent Expense-------------------------800
Depreciation Expense---------------175
3. To close the Income Summary:
Income Summary------------1956
47 | P a g e
Ann Hill, Capital---------------- 1956

4. To close Drawing account
Ann Hill, Capital-------- 1500
Ann Hill, Drawing---------- 15000
Post closing Trial Balance

The last procedure of the accounting cycle is the preparation trial balance after all of the
temporary accounts have been closed. The purpose is just to make sure that the ledger is in
balance at the beginning the new accounting period. The account titles and amounts should agree
exactly with the accounts and amounts listed on the balance sheet at the end of the period.
Example:
Hill photographic studio

Post-closing Trial Balance
March 31, 1990
Cash --------------------------------------------- 1631

Accounts Receivable-------------------------- 1775
Supplies----------------------------------------- 890
Prepaid Rent----------------------------------- 1600
Photographic Equipment-------------------- 17500
Accumulated Deprecation---------------------------------- 175
Accounts payable-------------------------------------------- 2000
Salaries payable----------------------------------------------- 115
Ann Hill, Capital---------------------------- ---------------- 21,106
23,396 23,396
Assignment three
1. The balance in the supplies account, before adjustment at the end of the year is
1,475. Journalize the adjusting entry required if the amount of supplies on hand at the
end of the year is 241.
2. At December 31, the end of the first month of operations the usual adjusting entry
the income statement transferring supplies used to an expense account is omitted.
Which items will be incorrectly stated, because of the error on: -
a. income statement
b. the balance sheet
c. Indicate whether the items in error will be overstated or understated
3. The balance in pre-paid Insurance account before adjustment at the end of the year is
4,280. Journalize the adjusting entry required under each of the following alternatives
for determining the amount of adjustment.
a) The amount of Insurance expired during the year is 1,020.
b) The amount of un expired Insurance applicable to the future period is 3,260.
48 | P a g e
4. The balance in the unearned fees account, before adjustment at the end of the year
is 6,750. Journalize the adjusting required if the amount of unearned fees at the end
of the year is 2,800.
5. At the end of the current year, 7,260 of fees have been earned but have not been
billed to customers. Journalize the adjusting entry to record the accrued fees.
6. The accountant for maxim medical co. mistakenly omitted adjusting eateries for
to customers. Journalize the adjusting entry to record the accrued fees.
A. Unearned Revenue 10,390 and
B. Accrue wages for 2,440
Indicate the effect of each error, considering individually, on the income statement for
current year ended December 31. Also indicate the effect of each error on December 31,
balance sheet. Note that the unearned revenue account was initially recorded in a liability
account.
7. From the following list, identify the accounts that should be closed to
Income summary at the end of Fiscal year:
A. Accounts payable
B. Accumulated Depreciation- Building
C. Depreciation Expense- Building
D. x, Capital
E. x, Drawing
F. Equipment
G. Fees Earned
H. Land
I. Salaries payable
J. Supplies
K. Supplies Expense
8. Which of the following accounts will appear in the post-closing trial balance?
A. Accounts Receivable
B. Accumulated Depreciation
C. Cash
D. Depreciation Expense
E. Equipment
F. y, capital
G. y, Drawing
H. Fees earned
I. Supplies
J. Wages Expense
K. Wages payable
9. The trial balance of Addis Company on July 31, 2014, the end of current fiscal year, is
shown at the below
Addis Company
Trial Balance
July 31, 2014
49 | P a g e
Cash----------------------------------------------- 3,290
Supplies------------------------------------------- 5,850
Prepaid Insurance-------------------------------- 3,000
Equipment--------------------------------------- 109,750
Accumulated Depreciation----------------------------------------- 52,700
Accounts payable----------------------------------------------------- 4,950
Addis, Capital--------------------------------------------------------- 39,450
Addis, Drawing----------------------------------- 3,500
Service Revenue------------------------------------------------------ 77,900
Wages Expense---------------------------------- 23,400
Rent Expense------------------------------------ 16,400
Utilities Expense--------------------------------- 8,500
Miscellaneous Expense------------------------- 1,310
175,000 175,000
The data needed to determine year-end adjustments are as follow:
a. Supplies on hand at July 31, are 1,140.

b. Insurance premiums expired during the year are 1,500.
c. Depreciation of equipment during the year is 6,000.
d. Wages accrued but not paid at July31 are 1,100.
Instructions:
1. Enter the trial balance on a ten-column worksheet and complete the work sheet. Add
accounts as needed.
2. Prepare an income statement, a statement of owner’s Equity (No additional investment were
made during the year), and the balance sheet.
3. On the basis of adjustment data in the work sheet, journalize the adjusting entries.
4. On the basis of the data in the worksheet, journalize the closing entries.
50 | P a g e
CHAPTER FOUR
ACCOUNTING FOR MERCHANDISING BUSINESS
Merchandising enterprise acquires merchandise for resale to customers. Difference Between
merchandising, manufacturing and service Enterprises:
Merchandising enterprise acquires an item for resale to customers having the original
form. Eg. Retailers, whole sellers
Manufacturing companies acquire raw material and convert the raw material in to some
product and sale the product.
Service companies render a service to customers; these companies do not have any
inventory to be reported except supplies.
Accounting for Inventories

Purchase of merchandise are treated based on the inventory system employed by business
Enterprise. There are two alternative inventory systems that can be employed by businesses.
These are:
1. Periodic inventory system
2. Perpetual inventory system
1. Periodic inventory system:
Under this system the cost of all merchandise purchased is accumulated in a “Purchase” account;
i.e when purchases are made for cash or on account the transactions are recorded as follow:
Purchase-------------------------------------------xx
Cash) Account payable)--------------------------xx
When sales are made, the revenues from sales are recorded when sales are made, but no
attempt is made on the sales date to record the cost of merchandise sold. The cost of merchandise
sold during the period and the cost of inventory on hand is determined through the physical cont
of inventory and cost flow assumptions.
2. Perpetual merchandise Inventory system:

Purchase of inventory is directly accumulated in the “Inventory” account. When merchandise is
sold the amount is recorded in cost of goods sold, In this manner the accounting records
continuously (perpetually) disclose the inventory on hand.
Purchase Discount
The arrangements agreed upon by the buyer and the seller as to when payments for
merchandise are to be made are called credit terms.
If payment is required immediately up on delivery, the terms are said to be “cash” or “net
cash” otherwise the buyer is allowed a certain amount of time, known as the credit
period, in which to pay.
It is usual for the credit to begin with the date of sale as shown by the date of invoice or
bill. If payment is to due within a stated number of days after the date of invoice, say
60days, the terms are said to be “net 60days” which may be written as “n160”
If payment is due by the end of the month in which sales was made, it may be expressed
as “nleom.”
51 | P a g e
As a means of encouraging payments before the end of credit period, the seller may offer a
discount for early payment of cash. Thus, the expression “4120, n160” means that, though the
credit period is 60 days, the buyer may deduct 4% of the amount of invoice if payment is made
with in 20 days after the invoice date. This deduction is known as cash discount.
From the buyer’s stand point, it is important to take advantage of all available discounts, even it
is necessary to borrow the money to make the payments, when the discount given is attractive as
compared with the market interest rate.
When there is purchase discount, two methods of accounting for purchases of merchandise are
used under the periodic method. These are the gross method and the net method.
i. The Gross method- under this method, the purchase is recorded at the invoice
amount before deduction of any related cash discount.
ii. The Net method- under this method purchase is recorded at the invoice
amount less any related cash discount.
Example: If Faros company purchases merchandise costing 1,000birr on July 15. On terms
2110, n130, the transaction is recorded under the two methods as follow:
Gross Purchase------------------------ 1, 000

Method: Accounts payable-------------------- 1, 000
Net method Purchase ----------------------- 980

Accounts payable----------------- 980
If the payment is made with in the discount period (10 days for example above) , the buyer is
entitled to pay the net amount(980). Under the Gross method a purchase discount account is used
by the purchases to accumulate discounts actually taken. However, if the net method is
employed, cash discounts taken are not recorded. Thus, if the discount is taken by the purchaser,
the cash payment is taken by the purchaser, the cash payment is the same under both methods,
further, both methods result in the same cost of purchases if discount is taken. This is because,
under the gross method, purchase discounts are subtracted from purchases account on the income
statement.
If payment is not made with in the discount period, the discount is lost and the total invoice
amount (1000 here) going to be paid by the buyer. Under the gross method, since the invoice
amount (1000) liability is recorded, the Discount lost is not recorded in the books. However,
under the net method, the Discount lost is rerecorded.
For Example above
A. Payment with in the Discount period

i. Gross method:
Accounts payable-------- xx1,000
Purchase Discount----------------xx20
Cash------------------------------ xx980
52 | P a g e
ii. Net method:

Accounts payable ---------xx980
Cash ------------------------------- xx1, 000
B. Payment after Discount Period Expire

i. Gross method:
Accounts Payable------------------ xx1,000
Cash----------------------------------- xx1,000
ii. Net method
Accounts payable -------------------- xx980
Discount lost--------------------------- xx20
Cash---------------------------------------- xx1000
Under the net method, discounts are recorded in the accounts only if they are lost. This procedure
calls management’s attention to cares, which should be taken in payment bills. Under the gross
method, purchase discount is subtracted from the purchase accounts to determine cost of goods
sold. However, under the net method, purchase Discount lost is an expense that is classified
under the other Revenue and Expense. Theoretically, the net method is preferable because
purchases and resulting liabilities are recorded at their cash equivalents. In practice, however,
more firms use the gross method of recording Purchases because it is simpler and because the
birr (dollar) difference between the two methods is normally not significant.
Purchase Returns and Allowances

Some times merchandise received from suppliers is defective or otherwise not acceptable. In
such event, the buyer may return it (purchase return) or the buyer may negotiate on price
adjustment (purchase Allowance). In either case part or all of the purchaser’s liability to the
supplier is eliminated. To make this information more ready available to management, the
purchase Returns and Allowance account is credited for the amount of liability (Account
payable) eliminated.
The details of why the return or allowance is requested may be stated in a letter or by a debit
memorandum form used by the buyer. The seller may confirm through credit memorandum.
Purchase returns and Allowance is a contra purchase account, same with purchase discount
account.
Example: If half of the 1,000 worth of merchandise acquired by Fraol Company on July 15 were
returned, on July 20, the following entry would be required using gross method:
Accounts payable---------------------xx500
Purchase
Returns and Allowance ----------------- xx500
If the net method is used; Accounts payable is debited and purchase return and Allowance is
credited for the percentage proportion of the return in the original invoice; computed as follow
for the above example:
53 | P a g e
= Cost of product Returned

(Price Reduction)/Total invoice price X Net purchase price after discount
= 500/1000 X 980 = 490, hence:
Accounts payable ---------------- 490
Purchase Return Allowance----------- 490
Accounting for sale

Revenues from merchandise sales are usually identified in the ledger as sales. A business may
sell merchandise for cash or on credit. Some times sales of merchandise may be done through
different credit cards. Sales to customers who use bank credit cards (such as Master card and
VISA -us case) are generally treated as cash sales. Sales made by the use of nonblank credit
cards (such as American express) generally must be reported periodically to the card company
before cash is received. Therefore, such sales create a receivable with the card company. Before
the card company remits cash it normally deducts a service fee.
Thus, sale of merchandise is recorded as:

1. Cash ---------- xx
Sales------------------- xx
2. Account Receivable------- xx
Sales------------------------- xx
Example: A sale of merchandise for 1000birr cash is recorded as:

Cash----------------- 1, 000
Sales---------------------- 1, 000
The same sale on Account is recorded as:

Account Receivable ----------- 1,000
Sale---------------------------- 1, 000
At the time of collection, cash is debited and Accounts Receivable is credited; If the receivable is
as a result of credit card sale credit card collection expense is debited for the expense amount, the
receivable Account is credited for the total amount and the cash account is debited for the
difference.
Sales Discount
The seller refers to the discounts taken by the buyer for early payment of an
invoice as sales discounts. They are recorded by debiting the sales Discount
account and are considered to be reductions in the amount initially recorded in
sales. That is, the balance of sales discounts account is viewed as a contra (or off
setting) account to sales.
Trade Discounts
Many manufacturers and whole sellers periodically publish catalogs advertising
54 | P a g e
their merchandise at list prices. However, a reduction from list price may be
granted based on the volume of merchandise purchased or on the nature of the
purchaser (whole- seller, retailer, or ultimate consumer.) A trade discount is a
convenient means of making price reductions without reprinting catalogs. Thus
business may offer special discount from the list price for customers that order
large quantities. Both buyers, and sellers do not normally record the list prices
of merchandise and the related trade discounts in their accounts.
i.e. Trade discounts are not recorded in the accounts of either the seller or the buyer
but are deducted from the product list price in arriving at the selling price; both the
purchaser and seller record the transaction at the determined selling price.
Example: Wholesaler sells merchandise with a list price of 1,000 birr at a trade discount
of 20 percent, a sale of 800 will be recorded by the seller. Similarly purchase
a of 800 is recorded by the buyer.
If an additional cash (sales) discount is involved, it is based on invoice price rather on the list
(gross) price. Trade discounts are frequently stated in terms of a series of discounts, such as
25/20/10, i.e. 25% of list price, 20% of remainder and again 10% of reminder.
Example: If a wholesaler sells merchandise with a list price of 1,000, at a trade discount
stated as 25/20/10, then the items selling price would be:
List price-----------------1, 000

Less 25% discount---- (250)
Remainder--------------750
Less 20% discount ------(150)
Remainder----------600
Less 10% discount------- 60
Selling price---------------540
Sales Returns and Allowances

To maintain good customer relationship, many businesses permit buyers to return merchandise
(sales Return) so long as it is undamaged and is returned with in a reasonable period. In some
situations the purchaser may prefer to retain the goods, rather than return them, provided a price
adjustment (sales allowance) is made. The sales Returns and Allowance account is used to
record both sales returns and sales allowances.
If the return or allowance is for sale on Account, the seller usually gives the buyer a credit
memorandum, which shows the amount in particular receivable account is to be credited and the
reason therefore.
Example: If a merchandise costing 100 birr is returned:

The journal entry to record the return:
A. If the sale was made on credit
Sales Return and allowance--------100
Account Receivable------------------100
B. If the sale was made on cash:
Sales Returns and Allowance-------100
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Cash---------------------------------------100
Sales Taxes
Almost all states (governments) levy a tax on sales of merchandise, except when merchandise is
purchased for reselling purpose. i.e. Business that purchase merchandise for resale to others are
normally exempt from paying sales taxes on their purchases. Only final buyers (ultimate users of
the item) normally pay sales taxes. The liability for the sales tax is ordinarily incurred at the time
the sale is made regardless of the terms of sale.
Cash (Account Receivable) --------xx

Sales-------------------------------xx
Sales tax payable-----------------xx
EXERCISES
The following transactions were completed by ABC company during October of the
current year.
Oct.1. Purchased Merchandise from XYZ co. for birr 10,500, terms FOB destination,
n130.
3. Purchased merchandise from QRS co. for birr 8,000, terms FOB shipping point 2110,
n/eom. Transportation costs of 150 birr were paid by ABC Co.
4. Purchased merchandise from EDF Co. for birr 7500, terms FOB destination, 2110,
n130.
6. Issued debit memorandum to EDF Co. for 1,000 birr of merchandise
returned from purchase on October 4.
13. Paid QRS Co. for invoice of October 3
15. Paid EDF Co. for invoice of October 4.
19. Purchased merchandise from KLM Co. for 5,000 birr, terms FOB shipping point
n/eom.
Paid transportation charges of 120 birr on October 19 purchase.

Purchased merchandise from GHI Co. for 8000birr, terms FOB destination 1/10 n130.
30. Paid GHI Co. for invoice of October 20.
31. Paid XYZ co. for invoice of October 1.
31. Paid KLM co. for invoice of October 19.
Required:
Journalize the entries to record the transactions of ABC Company for October.
Example: a sale of merchandise for 1000birr on Account subject to a 4% sales tax is recorded:
Account Receivable ------------1,040
Sale---------------------------------1000
Sales Tax payable----------------- 40
Periodically, the appropriate amount of sales tax is paid to the taxing unit, and sales Tax payable
is debited.
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Perpetual Inventory system

As stated earlier, in perpetual inventory system, each purchase and sale of merchandise is
recorded in an inventory account. As a result the amount of merchandise available for sale and
the amount sold are continuously (perpetually) disclosed in inventory records.
Accounting for Purchase

Under the perpetual inventory system merchandise purchases are recorded as follow:
Merchandise Inventory---------------------xx
Cash or Account payable----------------xx
Example: Purchase merchandise having a price of 15000 on Account is recorded as

Merchandise Inventory-----------------------15, 000
Account payable----------------------------------15000
Purchase Discount
Under perpetual system also, there is possibility of using the gross method or the net, method for
recording the purchases of merchandise. But the gross method is widely used and it is
merchandise inventory, which is going to be credited when discount is taken.
Example: Purchase inventory at a price of 1500 terms 2110,n130 on January 12
is recorded as follow:
Gross method:
Merchandise inventory----------1500
Account payable----------------1500
i. Payment within the discount period
Account payable-------------1500
Cash-----------------------------1470
ii. Payment after discounts period Expires:
Account payable-----------------1500
Cash-----------------------------------------1500
Net Method:
Merchandise Inventory--------------------1470
Account Payable---------------------------1470
i. Payment within the discount period:
Account payable-------------------1470
Cash---------------------------------------1470
ii. Payment after discount period Expires:
Account payable----------------------1470
Discount lost-----------------------------30
Cash--------------------------------------1500
Purchase Returns and Allowances

Purchase Returns and allowances are recorded in perpetual system as:
Accounts payable (cash) ------------xx900
Merchandise Inventory-------------------xx900
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Accounting for sales:

The sale transaction is recorded in similar manner as sin the case of periodic inventory system;
However, under the perpetual inventory system, the cost of merchandise sold and the reduction
in merchandise inventory should also be recorded.
Sale: Cash /Account Receivable -----------xx

Sale---------------------------- xx
To record sale
CGS: Cost of goods sold------------------xx

Merchandise Inventory--------------- xx
Sales Discount
Same with periodic inventory system; i.e. if the discount is taken by the buyer the record is as
follow:
Cash------------xx
Sales Dis. -----xx
Accounts Rec.--------xx
To record collection within discount
period Sales Returns and Allowances
Same with periodic inventory system; but under the perpetual system, to keep the cost of goods
sold and merchandise inventory accounts up to date, a record debiting merchandise inventory
and crediting cost of goods sold is also necessary. Thus, sales returns and Allowance is recorded
as follow:
Sales Return and Allowance---------------xx

Account Receivable (cash)---------------xx
To record sales return or Allowance
Merchandise Inventory------------xx
Cost of merchandise sold-----------xx
To record cost of merchandise returned
Transportation Costs (Freight Cost)

The terms of sale should indicate when the ownership (title) of the merchandise posses to the
buyer. This point determines which party the buyer or the seller, must pay transportation cost.
The ownership of merchandise may pass to the buyer when the seller delivers the merchandise to
the transportation company or freight carrier. In this case, the terms are said to be FOB (Free on
board) shipping point. Under this term the buyer bears the transportation costs.
The shipping point is, the point where the shipment originates. The buyer then pays the
transportation costs to the final destination, such costs are part of the buyers the buyer’s total
cost of purchasing inventory and should be added to the cost of the inventory by debiting
purchase (periodic inventory system) or merchandise inventory (perpetual inventory system).
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Example: Assume that on June 10,ABC Company purchases form XYZ Company on account for
1850, terms FOB shipping point, and pays transportation cost of 150 birr. ABC Company
records this transaction as follow:
1. Perpetual system:
i. Merchandise Inventory-------------1850
Account payable----------------------------1850
To record purchase merchandise
ii. Merchandise Inventory----------------150
Cash---------------------------------150
To record payment of shipping cost
2. Periodic system
i.Purchase--------------------1850
Accounts payable------------------1850
To record purchase of merchandise
ii. Purchase--------------------1850
Cash-------------------------------1850
To record payment of shipping cost.
Sometimes, ownership of the merchandise may pass to the buyer when the buyer receives the
merchandise in its warehouse. In this case, the terms are said to be FOB destination, and the
seller bears the transportation cost.
In this case, the seller debits Transportation out or Delivery Expense, which is reported on the
seller’s income statement as an expense.
Shipping Freight Destination

Point Cost
Seller’s Warehouse Buyer’s Warehouse

1. FOB shipping point- buyer pays transportation cost and.
debits merchandise inventory (purchase) account
2. FOB Destination- seller pays transportation costs and
debits transportation (Freight) out or Delivery Expense
account.
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EXERCISE
Each merchandising transaction affects a buyer and a seller. This exercise shows how the same
transactions would be recorded by both the seller and the buyer. Assume the seller is Fraol
Company and the buyer is Roza Company. Record the following transactions on both the
seller (Fraol) and buyer (Roza) Company. Use perpetual Inventory system.
July1. Fraol Company sold merchandise on account to Roza Company for 7500birr,
terms FOB shipping point, n145. The cost of merchandise sold was birr 4500.
July 2. Roza Company paid transportation costs of birr 150 on July1. Purchase from
Fraol Company.
July 5. Fraol Company sold merchandise on account to Roza Company for 5000 birr,
terms FOB destination, and n130. The cost of merchandise sold was 3500birr.
July 7. Fraol Company paid transportation of 250birr for delivery of merchandise sold to
Roza Company on July 5.
July 13. Fraol Company issued Roza Company a credit memorandum for merchandise
returned having a price of 1000 birr. The merchandise had been purchased by
Roza Company on account on July5. The cost of merchandise returned was
7000birr.
July 15. Fraol Company received payment from Roza Company for purchase of July5.
July 18. Fraol Company sold merchandise on Account to Roza Company for birr
12,000, terms FOB shipping point 2110, nleom. Fraol Company prepaid
transportation cost of 500birr, which were added to the invoice. The cost of the
merchandise sold was 7200.
July 23. Fraol Company received payment from Roza Company for purchase of July 18.
Periodic Reporting for Merchandising Enterprise

Trought the life of a business enterprise, the operating data for the fiscal year must be
summarized and reported for the use of managers, owners, creditors, various governmental
agencies, and other interested persons. Summaries of the various assets of the enterprise on the
last day of the fiscal year, together with the status of the equities of creditors and owners, must
also be reported. The ledger which contains the basic data for the reports, must then be brought
sequence of accounting cycle remain the same for all kinds of business except the nature of the
transaction and the accounts affected.
Cost of Merchandise Sold

For merchandising enterprise that use periodic system, the cost of merchandise sold during the
period is reported in separate section in the income statement. The general formula for
computing cost of merchandise sold during a period is:
Beginning merchandise Inventory-------------------- xx
Add: Net Purchases------------------------------xx
: Transportation In--------------------------xx
Merchandise available for sale ---------- xx
Less: Ending Merchandise inventory---------xx
Cost of Merchandise sold--------------xx
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Example: Given the following data for ABC co. for 1991-
Merchandise Inventory, July 31, 1991-------------- 125,000
Merchandise Inventory, August 31,1990---------- 115,000
Purchases ---------------------------------------------- 550.000
Purchase Returns and Allowances------------------- 4, 250
Purchase Discounts------------------------------------ 3, 200
Transportation In--------------------------------------- 3, 950
On the basis of the above data, prepare the cost of merchandise sold, for the fiscal year ended
July31, 1991 for ABC Company.
Solution:
Beginning inventory------------------------ 115, 000
Add: Net purchase
(550,000-4,250-3200)-------------- 545,750
: Transportation In--------------------- 3, 950
Cost of Merchandise available for
sale------- 546, 500
Less: Ending Merchandise inventory-------- 125, 000
Cost of Merchandise sold----------------- 21, 500
Adjusting Entries for Merchandising Business:

Merchandise adjustments
The best method of making the data reading available, for reporting the cost of merchandise sold, is
to maintain a separate account entitled merchandise Inventory. Thought an accounting period this
account shows the inventory at the beginning of the year under periodic inventory system.
At the end of the period it is necessary to remove from merchandise inventory at the beginning
of the period and to replace it with the amount representing the inventory at the end of the
period. This is accomplished by two adjusting entries. The first entry transfers the beginning
inventory to Income summary. Since this beginning inventory is part of the cost of merchandise
sold, it is debited to Income summary. It is also a subtraction from the asset account,
Merchandise Inventory, hence is credited to merchandise inventory.
For the amount of beginning
Income summary------------xx inventory
Merchandise Inventory--------xx
To transfer the beginning inventory to Income summary
The second adjusting entry debits the cost of the merchandise inventory at the end of the period
to the asset account, merchandise Inventory. The credit portion of the entry effects a deduction of
the unsold merchandise from the cost of merchandise available for sale during the period.
For the amount of ending
Merchandise Inventory-----------xx inventory
Income Summary--------xx
Adjustments for Deferrals and Accruals
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Financial Statements
The basic financial statements for merchandising enterprise include: Income statement, statement
of owner’s Equity, and balance sheet. For corporate enterprise, the statement includes statement
of Retained earning instead of statement of owner’s Equity. The basic difference between the
financial statement of a merchandising enterprise and a service enterprise include the cost of
merchandise sold section of the income statement, and the inclusion of merchandise inventory on
the balance sheet as current asset.
Income Statement
There are two widely used formats for preparing an income statement for a merchandising
business: Multiple step and single step.
1. Multiple-step Form
The multiple-step income statement contains several section, subsections and subtotals. In
practice, there is considerable variation in the amount of detail presented in these sections. For
example instead of reporting separately the gross sales and related returns, allowances and
discounts, the statement may begin with net sales. Similarly, the supporting data for the
determination of the cost of goods sold may be omitted from the statement.
A- Typical model of or a multiple-step income statement
ABC Company
Income statement
For the year Ended December 31,2006
Revenues From Sale:
Sales--------------------------------------------------------------- xx
Less: Sales Ret. All--------------------------------- xx
Sales Discount------------------------------- xx xx
Net
sales-------------------------------------------------------
---- xx
Cost of merchandise sold:
Beginning Merchandise Inventory------------------------xx
Purchases----------------------------------------- xx
Less: Purch.Ret.Al------------------------------ xx
Purch. Discount------------------------ xx xx
Cost of goods available for
sale------------------------------ xx
Less: Merchandise, ending---------------------------------- xx
Cost of merchandise sold------------------------------------- xx
Gross
profit----------------------------------------------------- xx
Operating Expenses:
Selling Expense:
Sales salaries Expense----------------- xx
Advertising Expense------------------- xx
Deper. Exp-store Equipment---------- xx
Miscellaneous selling Expense-------- xx
etc
Total selling Expense ---------------------------- xx
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Administrative Expenses:
Administrative salary expense------------------ xx
Rent Expense-------------------------------------- xx
Insurance Expense-------------------------------- xx
etc
Total Administrative Expense------------------------- xx
Total operating Expense
--------------------------------------------
--------- xx
Operating
Income-----------------------------------
--------------------------- xx
Other income:
Interest Income------------- xx
Rent income----------------- xx
Total other income------------------ xx
etc
Other Expenses-------------- xx
Interest Expense-------------- xx
Total other Expense---------------- xx xx
Net
income------------------------------
----------------------------- xx
The sections of the multiple-step-income statement

Revenues From sale: The total of all charges to customers for merchandise sold, both for cash
and on account, is reported in this section. Sales returns and allowances and sales Discounts are
deducted from the gross amount to yield net sales.
Cost of Merchandise sold: The cost of merchandise sold during the period may also be called the
cost of goods sold or cost of sales.
Gross profit : The excess of net sales over the cost of merchandise sold is called gross profit. It
is sometimes called gross profit on sales or gross margin.
Operating Expenses: Most merchandising business classify operating expenses as either selling
expense or administrative expenses. Expenses that are incurred directly in the selling of
merchandise are selling expenses. They include such expenses as a salesperson’s salary store
supplies used, depreciation of store equipments, and advertising. Expenses incurred in the
administration or general operations of the business are Administrative expenses or general
expenses. Examples of these expenses include president salary, depreciation of office equipment,
office supplies used. Credit card expenses are also classified as administrative expense. Expenses
that are related to both selling and administration may be divided between the two
classifications. In small business, however such expenses as Rent, Insurance, and taxes are
commonly reported as administrative expenses. Transactions for small, infrequent expenses are
often reported as miscellaneous selling expense or miscellaneous Administrative expense.
Income from Operation- The excess of gross profit over the total operating expenses is called
income from operation or operating income. The relationship of income from operations to total
assets and to net sales are important factors in judging the efficiency and profitability of
operations. If operating expenses are greater than the gross profit, the excess is called loss from
operation.
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Other income and other expenses

Revenue from sources other than the principal or primary operating activity of a business is
classified as other income. In merchandising business, these items include income from interest,
Rent, gains from sale of fixed assets. Expenses that cannot be traced to directly to operations are
identified as other expenses. Interest expenses that result from financing activity and losses
incurred in the disposal of fixed assets are examples of these items.
Other income and other expenses are offset against each other on the income statement. If the
total of other income exceeds the total of other expense, the difference is added to income from
operation if the revers is true; the difference is subtracted from income from operations.
Net income;The final figure on the income statement is net income (net loss). It is the net
increase (or net decrease) in owner’s equity as a result of the period’s activities.
2. Single-step Form
In a single-step income statement, the total of all expenses is deducted in one step from the total
of all revenues. The single-step form emphasizes total revenues and total expenses as the factors
that determine net income. A criticism of a single-step form is that such amounts, as gross profit
and income from operations are not readily available for analysis. But its advantage is that it is
simple.
A typical model for a single-step income statement
ABC Company
Income Statement
For the year ended, December31, 2006
Revenues:
Net sales--------------------- xx
Interest Income------------ xx
Rent Income---------------- xx
Total Revenue------------------------------- xx
Expenses:
Cost of merchandise sold-------xx
Selling Expenses----------------xx
Administrative Expenses------- xx
Interest Expenses---------------xx
Total Expenses-------------------- xx
Net
Income----------------------------
-- xx
Retained Earnings statement

The retained earnings statement summarizes the changes, which have occurred in the retained
earnings account during a fiscal year. It serves as a connecting link between the income
statement and the balance sheet.
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A typical model for statement of Retained Earning:
ABC Company
Retained Earnings statement
For the year ended, December31, 2006
Beginning Retained Earning-------------------------------------------------- xx

Add: Net income for the year----------------------------------------xx
Subtotal xx
Less: Dividends during the year--------------------------------------- xx

Retained Earning End of year------------------------------------------ xx
Sometimes, the analysis of retained earnings may be added at the bottom of the income statement
to form a combined income and retained earnings statement.
Note; the statement of Retained earnings is prepared only for corporate form of business.
For sole proprietorship and partnership form of business, statement of owner’s Equity is
prepared. The statement of owner’s equity for merchandising business is prepared in the same
manner for service business.
A typical model for statement of Owner’s Equity:
ABC Company
For the year ended, December 31,2006
Beginning Capital------------------------------------------------------ xx
Add: Net income-------------------------------------- xx
: Additional investment-------------------------- xx xx
Sub-
total------------------------------------------------------------
---- xx
Less: Withdrawal----------------------------------------------------- xx
Ending,
capital--------------------------------------------------------- xx
Balance Sheet
The balance sheet of a merchandising business could be prepared in any of the formats discussed
in earlier chapters; i.e. Account form (Liabilities and owner’s equity on the right hand side and
assets on the left hand side), Report form or Financial position format (down ward sequence of
assets, liabilities and owner’s Equity). The balance sheet of a merchandising business is slightly
different from that of service business because of the inclusion of merchandise inventory at the
end of the period in the current asset section of the merchandising business.
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A typical model of Balance sheet:

ABC Company
Balance Sheet
As of December 31, 2006
Assets:
Current Assets:
Cash------------------------------------------ xx
Accounts Receivable----------------------xx
Interest Receivable------------------------- xx
Merchandise inventory-------------------- xx
Office Supplies----------------------------- xx
Prepaid Insurance-------------------------- xx
Total current Asset--------------------------- xx
Plant Assets:
Land-------------------------------------------- xx
Equipment ------------------------ xx
Less: Acc. Depn. ----------xx
Total Plant Asset------------------------------ xx
Total Asset------------------------------------- xx
Liabilities:
Current Liabilities:
Accounts payable----------- xx
Salaries payable-------------- xx
Total current Liabilities------------------- xx
Ling term Liabilities:
Notes payable----------------- xx
Mortgage bond payable------ xx
Total Long-term Liabilities----------------- xx
Total Liabilities------------------------------ xx
Owner’s Equity
A, Capital ----------------------- xx
B, Capital------------------------ xx
C, Capital ------------------------ xx
Total Capital---------------------------- xx
Total Liabilities and Owner’s Equity-------------- xx
If the form of business is corporate form, the owner’s equity section is different from this mode,
it reports balances in ending retained earnings, and stock issued and outstanding on the statement
date.
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Adjusting Entries
Adjusting Entries for Merchandising Business:
Merchandise adjustments
The best method of making the data reading available, for reporting the cost of merchandise sold,
is to maintain a separate account entitled merchandise Inventory. Thought an accounting period
this account shows the inventory at the beginning of the year under periodic inventory system. At
the end of the period it is necessary to remove from merchandise inventory at the beginning of
the period and to replace it with the amount representing the inventory at the end of the period.
This is accomplished by two adjusting entries. The first entry transfers the beginning inventory
to Income summary. Since this beginning inventory is part of the cost of merchandise sold, it is
debited to Income summary. It is also a subtraction from the asset account, Merchandise
Inventory, hence is credited to merchandise inventory.
For the amount of beginning
Income summary------------xx inventory
Merchandise Inventory--------xx
To transfer the beginning inventory to Income summary.

The second adjusting entry debits the cost of the merchandise inventory at the end of the period
to the asset account, merchandise Inventory. The credit portion of the entry effects a deduction of
the unsold merchandise from the cost of merchandise available for sale during the period.
For the amount of ending
Merchandise Inventory-----------xx inventory
Income Summary--------xx
Adjustments for Deferrals and Accruals

Same with what was discussed in previous chapter
Worksheet – same
Merchandise Inventory shrinkage

Under the perpetual inventory system, a separate merchandise inventory account is maintained in
the ledger to record increases and decreases in the account. During the accounting period, this
account shows the amount of merchandise for sale, at any time. However, merchandising
business may experience some loss of inventory due to shoplifting, employee theft, or errors in
recording or counting inventory. As a result, the physical inventory taken at the end of the
accounting period may be differ from the amount of inventory shown in the inventory records.
The difference is known as inventory shrinkage or inventory shortage. The adjusting entry debits
cost of goods sold and credits the merchandise inventory account for the amount of shrinkage.
Example: If the inventory records of a company shows that 63,950 of merchandise inventory
balance, but the physical inventory taken on the same date indicates a balance of only 62,150- it
means that a shrinkage for this year is 1800(63950-62150) and the following adjusting entry is
required.
Cost of merchandise sold-------- 1800

Merchandise Inventory---------- 1800
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Closing Entries
The closing entries for a merchandising business are similar to those for service business. The
first entry closes the temporary accounts with credit balances such as sales, purchase Returns and
Allowance, purchase Discount, Interest Income, rent income, etc to Income summary.i.e,
Sales----------------------------------xx
Purchase Return allowance--------xx
Purchase Discount------------------xx
Interest Income --------------------xx
Income summary------------------xx
To close all income statement Accounts with credit balance.
The second entry closes the temporary accounts with debit balances, such as, purchase, sales
Returns and allowances, Sales Discounts, cost of merchandise sold, Transportation in operating
Expenses, etc. to Income summary account.
i.e,
Income summary--------------------xx
Sales Returns and allowance------------xx
Sales Discounts----------------------------xx
Purchases------------------------------------xx
Transportation in --------------------------xx
Different operating Expenses-------------xx
The third entry closes the balance of the income summary account to the owner’s capital account
or Retained Earnings account.
i.e; If there is net income (credit balance in Income summary account after the 1st and
2nd closing entry)
Income summary--------------------xx
Capital /retained Earnings--------------xx
If there is net loss, the account debited and credited is reversed as follow:
Capital, Retained Earnings-----------xx
Income Summary----------------xx
To Close the Income summary account
The fourth entry closes withdrawal (Drawing) or Dividend account to owner’s capital or
Retained Earnings.
i.e,
Owner’s, Capital /Retained Earnings------------xx
Owner’s, drawing/Dividends---------------xx
To close Drawing or Dividend account.
The income summary account, as it will appear after the merchandise inventory adjustments and
the closing entries have been posted has a balance, which is either a credit (net income) or a debit
(net loss).
After all temporary accounts have been closed; the only accounts with a balance are assets,
contra assets, liability and owner’s equity accounts. These accounts are listed in a post-closing
68 | P a g e
trial balance to verify the debit –credit equality of the balances of these accounts, which should
correspond exactly with the amounts appearing on the balance sheet.
Reversing Entries
Some of the adjusting entries recorded at the end of a fiscal year have an important effect on
transactions that will occur in the following year. To simplify the analysis and recording of
subsequent transactions related to such adjusting entries, an optional procedure-the use of a
reversing entry-may be used. As the term implies, the reversing entry is the exact reverse of the
adjusting entry to which it relates, i.e, the amounts and the accounts are the same, the accounts
debited and credited are merely reversed.
Reversing Entries may be required (suggested) after the following adjusting eateries:
I. Deferrals
1. Prepaid Expenses- When prepaid Expenses are initially recorded as expenses
2. Pre (Advance) collection- when pre-collections are initially recorded as
Revenues.
Reversing Entry helps here in order to keep consistency in recording in the following year.
II. Accruals
1. Accrued Expenses /Liabilities
2. Accrued Revenues /assets
Here, reversing entry helps to simplify the analysis and recording of subsequent transaction
related to these adjusting eateries.
Interim Statements
Businesses frequently prepare financial statements at intervals with in the fiscal year, such as
monthly, quarterly, or semi annually. Statements issued for periods covering less than a fiscal
year are called interim statements. The analysis and recording of transactions is performed on a
continuous basis through out the fiscal year, regardless of when financial statements are
prepared. When interim financial statements are to be prepared, the adjustment data are
assembled and the worksheet is completed as of the end of the interim period. However,
adjusting and closing entries are not recorded in the accounts. These eateries are recorded only at
the end of the fiscal year.
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CHAPTER-5
ACCOUNTING FOR MANUFACTURING ENTERPRISES
Comparison of merchandising and manufacturing enterprises
o merchandisers
buy and resell goods
only one type of inventory – merchandise inventory
o manufacturers
convert raw materials into finished goods using direct labor (DL) and factory or
manufacturing overhead (MOH) costs
o three types of inventories
A. raw material (RM) inventory – stocks of raw materials to be used in the production process
B. work in progress (WIP) inventory – products some way in the production process i.e. products
not yet completely manufactured
C. finished goods (FG) inventory – completely manufactured goods awaiting sale
cost of goods manufactured = WIPB + RMused + DLcost incurred + MOHcost incurred –
WIPE Cost classification
o different costs classification bases
behavior – variability with volume of activity
A.fixed cost – doesn’t change in total with changes in the volume of
activity e.g. rent expense, depreciation expense
B.variable cost – changes in total in proportion to the changes in the volume of activity e.g. sales
commission, raw material used, etc
traceability – relationship with cost object (anything for which a cost measurement is
necessary e.g. product, customer, department, process A.direct
costs – costs incurred for the benefit of one specific cost object B.indirect
costs – costs incurred for the benefit of more thane one cost object
controllability – level of control over incurrence of the cost
A.controllable costs – costs which may be directly regulated at a given level of management
authority e.g. variable costs are generally controllable
B.uncontrollable costs – costs which cannot be influenced by the action of a specified member of
the enterprise e.g. fixed costs are generally uncontrollable
relevance – whether it can be affected by particular action or decision being made
A.relevant costs – are future costs which differ under different alternatives and influence or make
a difference in a decision being made
B.irrelevant costs – are costs that will not be affected by a decision (cost that do not change
regardless of the action being taken or decision being made
inventoriable – whether cost should be expensed or recorded as asset when incurred
A.product (also called inventorable/manufacturing) – costs (including DM, DL and MOH) that
should be debited to inventory account and then to cost of goods sold when the inventory is
sold
B.period costs – costs that should be expensed at the time of incurrence
o note that a given cost type may be place in more than one classes of costs depending on
purpose for which cost is being determined e.g.
o classifications are useful in understanding cost patterns, analyzing performance, and
planning future operations
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Manufacturing costs (Product Costs)

o manufacturing cost (also called factory or product cost – refer to total costs of
manufacturing a product and include
A.direct material cost – costs of materials that are
used only in manufacturing a product
clearly and easily traceable to the product
included in the final product and its cost
include purchase price, transportation, storage and handling costs
B.direct labor costs – wages, salaries and other benefits paid to all employees actually working
on materials to convert them into finished goods
C.manufacturing over head costs – manufacturing costs that cannot be traced directly to a
specific unit of product and include:
indirect material costs – costs of materials used in manufacturing a product but
cannot/will not, for practical reasons, be traced directly to the products e.g. factory
supplies and cleaning materials, lubricants,
indirect labor – wages, salaries and other benefits paid to employees that cannot or will
not, for practical reasons, be traced to a product being manufactured e.g. salary to factory
maintenance and cleaning employees, storekeepers, etc
depreciation on factory capital assets, factory utilities, factory rent, etc
Manufacturing cost terminologies

o prime costs –sum of DM and DL costs incurred to manufacture a product
o conversion costs –sum of DL and MOH costs
Prime Cost
Direct Direct Manufacturing Product cost

material + + = (manufacturing or
labor cost overhead costs
cost factory cost)
Conversion costs
o non-manufacturing costs (also called period costs) – refer to expenditures more related
to a time period rather than to a final product and include
· selling and marketing costs – all costs necessary to secure customer orders and
deliver finished products to the customer e.g. sales commissions, advertising,
delivery, sales supplies, depreciation on store and marketing/selling facilities
· administrative costs – all costs incurred outside the manufacturing and marketing
units of a company or incurred for the benefit of the company as a whole e.g.
salaries, wages and benefits to officers and employees outsider manufacturing and
marketing units, office supplies, rent, insurance, and depreciation on office facilities
· non-manufacturing costs are expensed when incurred
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5.1 General and cost accounting systems

o two types of accounting systems in manufacturing enterprise
1.general accounting system
records all transactions and events outside the manufacturing
unit provides information mainly useful to external users
2.cost accounting system
records manufacturing activities
provides information about manufacturing activities for :
A. Planning, organizing and controlling activities and evaluating
performance.
B. other decision making including product costing and
pricing C. preparation of reports for external purposes
Two basic cost accounting systems

job order costing
process costing
5.2 Flow of product costs through accounts (perpetual inventory system)

o purchase of raw materials (direct and indirect) on account
raw materials xx
accounts payable xx
o transfer of raw materials (direct and indirect) to production (uses of raw materials)
work in process xx
raw materials xx
o accrual of wages, salaries and other benefits (direct and indirect)

work in process xx
wages, salaries and other payables xx
o recording of MOH costs other than indirect material and indirect labor
work in process xx
accumulated depreciation – factor equipment xx
factory utility payable xx
factory prepaid insurance xx
o transfer of work completed

finished goods xx
work in process xx
o sales of finished goods

accounts receivable xx
cost of goods sold xx
sales xx
72 | P a g e
finished goods xx
73 | P a g e
5.3 Flow of product costs in the manufacturing process
M a t e r ia ls A c t
iv it y P r o d u c t io n a c t iv it y
( R a w M a t e r ia ls ) ( G o o d s in P r o c e s s )
R a w M a t e r ia ls G o o d s in P r o c e s s F in is h e d G o o d s
( B e g in n in g In v e n t o r y ) ( B e g in n in g In v e n t o r y ) ( B e g in n in g I n v e n t o r y )
GoodsManufactures
R a w m a t e r ia l U s e d
R a w m a t e r ia ls P u r c h a s e s
D ir e c t la b o r U s e d
FactoryOverheadUsed
R a w M a t e r ia ls G o o d s in P r o c e s s F in is h e d G o o d s C o s t o f g o o d s S o ld
E n d in g In v e n t o r y E n d in g In v e n t o r y E n d in g In v e n t o r y
( B a la n c e s h e e t ) ( B a la n c e s h e e t ) B a la n c e s h e e t ( In c o m e S t a t m e n t )
74 | P a g e
5.4 Financial statements and year-end entries for manufacturing enterprises

o statement of cost of goods manufactured – a schedule used to summarize
manufacturing costs and determine cost of goods manufactured
ABC Pharmaceuticals Share Company

Statement of Cost of Goods Manufactured
For the year ended December 31, 2007
Direct materials:
Raw materials, January 1, 2007 $70,000
Add: Purchases of raw materials 390,000
Raw materials available for use $460,000
Deduct: Raw materials, December 31, 2007 (50,000)
Raw materials used in production $410,000
Direct labor 60,000
Manufacturing overhead:
Insurance, factory $6,000
Indirect labor 100,000
Machine rental 50,000
Utilities, factory 75,000
Supplies 21,000
Depreciation, factory 90,000
Property taxes, factory 8,000
Total overhead costs 350,000
Total manufacturing costs $820,000
Add: work in process, January 1, 2007 90,000
Total cost of goods in process $910,000
Deduct: work in process, December 31, 2007 (60,000)
Cost of goods manufactured $850,000
o income statement
Income Statement
Sales $1,500,000
Cost of goods sold:
Finished goods, January 1, 2007 $125,000
Add: cost of goods manufactured 850,000
Goods available for sale $975,000
Less: Finished goods, December 31, 2007 (175,000)
Cost of goods sold (800,000)
Gross margin $700,000
Less: operating expense:
Selling expense $250,000
Administrative expense 300,000 (550,000)
Net income $150,000
75 | P a g e
o comparative income statement for a merchandising business
ALEM Drugs Share Company

Income Statement
Sales $1,000,000
Cost of goods sold:
Merchandise inventory, January 1, 2007 $100,000
Add: purchases 650,000
Goods available for sale $750,000
Less: Merchandise inventory, December 31, 2007 (150,000
)
Cost of goods sold (600,000)
Gross margin $400,000
Less: operating expenses:
Selling expense $100,000
Administrative expense 200,000 (300,000)
Net income $100,000
o balance sheet (current assets section)

Balance Sheet
Assets:
Current assets:
Cash $15,000
Accounts receivable 100,000
The inventories for a Inventories:
manufacturing entity consist Raw materials $50,000
of materials to be used in Work in process 60,000
production, goods partially Finished goods 175,000 285,000
manufactured, and goods Prepaid expenses 10,000
completely manufactured. Total current assets $395,000
ALEM Drugs Share Company

Balance Sheet
Assets:
Current assets:
Cash $10,000
Accounts receivable 60,000
Merchandise Inventory 150,000
Prepaid expenses 5,000
Total current assets $225,000
76 | P a g e
o adjusting entries
 raw materials and work in process accounts are adjusted using
manufacturing summary account while finished goods are adjusted using
income summary account
i) adjustment for inventories (periodic inventory system)
 eliminate beginning inventory balances
manufacturing summary 160,000
raw materials 70,000
work in process 90,000
income summary 125,000

finished goods 125,000
 record ending inventory balances

raw materials 50,000
Work in process 60,000
manufacturing summary 110,000
Finished goods 175,000
Income summary 175,000
ii) adjustment for deferrals and accruals

iii) adjustment for capital assets
o closing entries
 close all manufacturing accounts with debit balance to the manufacturing
summary account
Manufacturing summary xx
Raw materials purchases xx
Freight-in (raw materials) xx
Direct labor xx
Factory overhead costs
xx
· close all manufacturing accounts with credit balance to the manufacturing

summary account
Raw materials purchase discount xx
Raw materials purchase return and allowances xx

· close manufacturing summary account to income summary account

Income summary xx
77 | P a g e
· close all temporary accounts with credit balances to income summary

account
· close all temporary accounts with debit balances to income summary
account
· close income summary to capital (retained earnings) account
· close drawing account to capital account
5.5 Exercises
1. Hiwot Pharmaceuticals Share Company manufactures a single product. The following
data present transactions and additional information for November 2007, the
company’s first month of operation:
Direct materials purchased on account $58,000
Direct materials issued to production 40,000
Direct labor costs accrued 26,000
Factory insurance expired 3,000
Factory utility paid 2,500
Factory depreciation 6,000
Finished goods, November 30 3,100 units
Indirect materials purchased on account 5,000
Indirect materials issued to production 2,000
Indirect labor costs paid 8,000
Marketing depreciation 1,800
Miscellaneous office expenses 7,000

Miscellaneous marketing expenses 5,500
Office depreciation 2,500
Office salaries and wages 8,000
Sales on account 106,000($20 per unit)
Sales salaries and wages 9,000
Work in process, November 30 14,000(4,000 units)
Required: Using perpetual inventory system, determine

a) units sold in November
b) unit manufactured in November
c) total cost of goods manufactured in November
d) unit cost of goods manufactured in November
e) prepare entries to record the flow of costs for November
f) prepare income statement for November
2. Cost of goods sold for Fews Share Company for June 2007 was $350,000. Work in
process inventory on June 30, 2007 was 95% of work in process inventory on June 1,
2007. Manufacturing overhead costs are determined to be 80% of direct labor costs.
During June 2007, $110,000 of direct materials were purchased. Other information
for June 2007 follows:
78 | P a g e
June 1, 2007 June 30, 2007

Direct materials $22,200 $19,000
Work in process 40,000 ?
Finished goods 108,500 105,000
Required: For June 2007

a) prepare a schedule to compute prime costs incurred
b) prepare a schedule to compute conversion costs incurred
c) prepare a schedule of cost of goods manufactured
d) prepare a schedule of cost of goods sold
79 | P a g e

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Principles of Accounting I

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Users of Accounting information

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Customer To assess the ability the business to continue in

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Business transaction could be internal transaction or External transaction. External

ASSETS, LIABILITES AND OWNER’S EQUITY

Assets: - The properties owned by a business enterprise are referred to as assets.

Assets = Liabilities + Owners Equity

It is customary to place “liabilities” before” owner’s Equity” in accounting equation

Illustration: - Assume that Mr. X establishes a sole proprietorship to be known as x- taxi.

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Assets = Liabilities + owner’s equity

End. Bal 2500 7500

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Assets Liabilities + Owner’s Equity

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Cash + Supplies + Land Liabilities + Owner’s Equity

Bal. 440 85 7500 450 12,300

Fess Warren 16 Ed Edited by: Andualem Tsegaye

(g) -600 -600supp.exp.

12,150 === 12,150

Assets = Liabilities + Owner’s

2500 7500 10,000

Fess Warren 16 Ed Edited by: Andualem Tsegaye

g _____ -600 _____ ______ -600

Note the following observation, which apply to all types of business.

Owner’s withdrawals Owner’s Investments

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Example of Income Statement

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Statement of Owner’s Equity

The purpose of preparing statement of owners’ Equity is to summarize these

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Statement of Cash flows (SCF)

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Cash payments for purchase of Furniture and Fixture-------(2000)

Financial statement for corporation; lecture

3) The following are group of accounts as of January 31,2014

Fess Warren 16 Ed Edited by: Andualem Tsegaye

31 Dec. 31Dec. 3Dec. 31

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Bal. 1000 1000

Bal. 5250 550 300 5500

Bal 5250 1250 550 300 6750

Bal. 4595 1250 550 300 6,095

h -1000 ________ ________ __________ -1000saler. Ex.

Bal. 3595 1250 550 300 5095

i _______ ________ -125 ________ -125 supp.Ex.

Bal. 3595 1250 425 300 4970

Bal. 2,395 1,250 425 300 3770

Fess Warren 16 Ed Edited by: Andualem Tsegaye

2. Prepare balance sheet as of July 31.

Accounts payable-------------------------------------------------------------- br.12,100

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Balance sheet Income statement

Left side Right side

Fess Warren 16 Ed Edited by: Andualem Tsegaye

Debit: The left side of an account is called debit.

Double-entry system is based on accounting equation

Debit side Credit side

g ___ -600 _ ____ -600

h -1000 __ -1000saler. Ex.

i _ -125 __ -125 supp.Ex.