Professional Documents
Culture Documents
Accounting
1BE
Edited by
2022/2023
1
Preface
This Book Explains the Main Accounting Terms In Every
days Transactions at any enterprise from this Point, this Book
Includes Five Chapters, the First Chapter Accounting frame
work the Second Chapter The accounting equation, the Third
Chapter accounting cycle, the Fours Chapter Shows Preparing
Financial Statements and The Fifth chapter Deals With the
Accounting Adjustments and closing entries and the sixth
chapter deal with financial statements analysis
2
رؤيـة ورســالة األكاديمية الحديثة
: • الرؤيــة
تتطلع األكاديمية الحديثه لعلوم الكمبيوتر وتكنولوجيا اإلدارة إلى أن تكون متميزة فى
.مجاالت تخصصاتها لمسايرة المستجدات المحلية واإلقليمية والعالمية فى مجال األعمال
: • الرسالة
تلتزم األكاديمية الحديثه لعلوم الكمبيوتر وتكنولوجيا اإلدارة بإعداد كوادر متخصصة فى
مجاالت علوم الحاسب اآللى وتكنولوجيا المعلومات ونظم المعلومات االدارية والمحاسبة
والمراجعة وإدارة االعمال واإلقتصاد وذلك إلمداد المجتمع المحلى والعربى بالكوادر,
البشرية المؤهلة والمزودة باألسس النظرية والتطبيقية الالزمة لسوق العمل فى التخصصات
وتواكب األكاديمية التطورات العلمية والتكنولوجية بأنشطتها البحثية كما تساهم.المذكورة
ويتم ذلك فى إطار من اإللتزام بالقيم األخالقية،فى خدمة المجتمع وتنمية البيئة فى محيطها
.والعلمية المتعارف عليها
Vision:
Modern Academy for Computer Science and Management Technology in Maadi vision
is to achieve excellence in its fields of specialization to match the new local, regional,
and international updates in the labor market.
Mission
The modern academy is committed to prepare professional graduates specialized in
the fields of Computer Science, information technology, Management of Information
Systems, Accounting and auditing, Business Administration and Economic to provide
the regional and Arab community with professional cadres equipped with theoretical
and professional bases required in the labor market in the aforementioned fields. The
academy keeps up with scientific and technological advancements through research
activities besides participating in the surrounding community and environmental
services, all this within the frame of committed recognized moral and scientific values.
3
رؤية ورسالة برنامج االدارة
▪ رؤية برنامج ادارة االعمال
تحقيق التميز القائم على أسس جودة التعليم فى مجال االدارة لتأهيل كوادر لديهم قدرة على المنافسة
.محلياً واقليمياً وصوالً للمستوى الدولى
▪ PROGRAM VISION
The program vision is to achieve excellence in the field of business
administration to prepare a graduate capable for competing locally,
regionally and up to the international level within educational quality frame.
▪ رسالة برنامج االدارة
يلتزم برنامج االدارة باألكاديمية الحديثة لعلوم الكمبيوتر وتكنولوجيا اإلدارة بتقديم خدمات تعليمية
مطوره تواكب معايير جودة التعليم بما يسهم فى إعداد خريج متميز له القدرة على المنافسة فى
ولديه القدرة على إجراء أبحاث علمية متقدمة وتقديم خدمات فعالة للمجتمع،تخصص ادارة االعمال
.والبيئة المحيطة
▪ PROGRAM MISSION
The program is committed to provide updated educational services that
match the standards of the quality of education, in order to prepare a
distinguished graduate having the ability to compete in the field of business
administration, conduct advanced scientific researches and provide
effective services to the society and surrounding environment.
4
1- 1- Course Specifications
Academic year / Level: first Specialization: Business – E (CR. H)
Title: principles of financial accounting Code: A101 – اطار مرجعي
Lecture: 3 Tutorial: 1 Practical: ---- credit hours (3)
2 – Overall Aims After complete studying of this course successfully the student should
of Course: understand theoretical framework of financial accounting ,recognize
the nature of the role of accounting in the management Objectives,
recognize the nature of accounting as information system and Prepare
the final financial statements that reflect entity’s result of operation and
the financial position. Closing entries and preparing financial
statements in sole unit , partnership and corporations , accounting
treatments of financial statements elements like inventory , debtors ,
long term assets and owner equity finally financial statements analysis
to improve decision making process .
3 – Intended Learning Outcomes of Course (ILOs):
A-Knowledge and A1
Understanding a1 Identify the nature of service, commercial and industrial entities and
the forms of financial statements in each of them.
A2
a2 Identify the characteristics of different types of institutions and their
impact on accounting as an information system.
A7
a3 Defines the role of accounting in achieving management objectives
by providing useful information in the field of decision-making through
the financial statements.
A8
a4 explains the theoretical bases on which accounting is based and its
impact on accounting cycle procedures and technical treatments.
A11
a5 explains the complementary relationship between accounting and
other social sciences
A17
a6 Express the appropriate professional practices needed to apply the
accounting cycle procedures to prepare the final financial statements.
5
B5
B-Intellectual b1 Interprets economic transactions and analyzes their impact on the financial position
Skills: equation.
B8
b2 demonstrate the result of business and financial position through the disclosed financial
statements
B9
b3 demonstrate the results of business and financial position in accordance with general
accepted accounting principles GAAP
B10
b4 uses documents and book to record economic transactions and balances.
C6
C- c1 use Ledger in the classification of accounts to summarize transactions and prepare the
Professional trial balance.
and C7
Practical c2 measure the impact of business results from profit or loss on equity and dividends
Skills: C9
c3 uses accounting cycle procedures to operate inputs and produce useful outputs in decision
making
C13
c4 perform financial statements showing the results of business, financial position,
cash flow position and change in equity
D4
D-General d1 uses the scientific library and research through the Internet in the development of
and knowledge and intellectual perception.
Transferable D5
Skills: d2 uses self-teaching methods through research and investigation.
D13
d3 uses technical corrections associated with data processing processes and methods and
extraction of results.
Practical
Lectures
Section
4-Contents: No.
No Topic of
hours
The theoretical framework of accounting science and its 6 6 2
1
relationship to other sciences
2 Accounting as an information system 3 3 1
types and forms financial statements in service , 3 3 1
3
commercial and industrial units
4 Accounting equation and its applications 6 6 2
6
Lectures: ( y ) Practical training: (…) virtual lab (…)
5–Teaching
and Exercises: ( y ( Presentation: (Y) movie lecture (y)
Learnin Open Discussion: ( y) Projects: (y) voice lecture (y )
g E. Learning: ( y ) Web-Site searches: (y)
Method Self-Studies: (y) Case Study: (y)
s: Simulation lab: (…) Virtual classes (…)
7
B- Essential 1- Horngren Harrison Oliver , “ Accounting “ , Pearson , 2012 .
books
C- • Financial & Managerial Accounting: A Basis for Business
Recomme Decisions, Jan Williams, Sue Haka, Mark Bettner, Robert
nded
Books
Meigs. 12th edition.
Online books • http://www.freebookcentre.net/business-books-
download/Principles-of-Accounting.html
D- • www.ssrn.com
Periodical
• www.fasb.org
s, Web-
Sites,
9- Facilities
and 1- White Board Y 2- PC / Laptop y
Lecture…..Class….. Lab…… Lecture…..Class….. Lab…
teaching
materials: 3- Printers ... 4- Data Show y
Lecture…..Class….. Lab…… Lecture…...…..Class………..
Lab…….….
5- White Board for Y 6- Laser Pointer y
Presentation
7- Laboratories(List): ... 8- Software Packages (list): ...
…………………..… ……………………..
9- Supplies and raw ... 10- Library y
materials(list):
11- Others(list): ...
8
Matrix (1) Course Intended Learning Outcomes
Understanding
c. Professional
a. Knowledge
b. Intellectual
D. General
Skills
Skills
Skills
and
Hours
Course Content
Lab.
Lec.
Tut.
b4
a5
b1
b2
b3
d1
d2
d3
a1
a2
a3
a4
a6
c1
c2
c3
c4
The theoretical framework of √ √ √ √ √ √ √
6 2
accounting science and its
relationship to other sciences
Accounting as an information 3 1 √ √ √ √ √ √
system
types and forms financial √ √ √ √
3 1
statements in service ,
commercial and industrial units
Accounting equation and its 6 2 √ √ √ √ √ √ √ √
applications
Accounting cycle steps 9 3 √ √ √ √ √ √ √
Prepare financial statements. 9 3 √ √ √ √ √
Adjusting accounts and closing 3 1 √ √ √ √ √ √ √ √ √ √ √ √ √
entries
Financial statement analysis 3 1 √ √ √ √ √ √ √ √ √ √ √
Total 42 14
Matrix (2) Teaching and learning methods versus Intended Learning Outcomes
d.
a. Knowledge b. Intellectual c. Professional
General
Teaching &Understanding Skills Skills
Skills
Activities
C2
b1
b3
b4
d1
d2
d3
c1
c3
c4
b2
a1
a2
a3
a5
a6
a4
1. Lectures √ √ √ √ √ √ √ √ √ √ √ √ √ √
2. Exercises √ √ √ √ √ √ √ √ √ √ √
3. Presentation √ √ √ √ √ √ √ √ √ √ √ √
4. Open discuss √ √ √ √ √ √ √ √ √
5. E- learning √ √ √ √ √ √ √ √ √ √ √ √ √
6. Self-study √ √ √ √ √ √ √ √ √ √ √ √ √ √ √ √ √
7. Website resear √ √ √ √ √ √ √ √ √ √ √ √
8. Case study √ √ √ √ √ √ √ √ √ √ √
9. Voice lecture √ √ √ √ √ √ √ √ √ √ √ √
10. Movie lecture √ √ √ √ √ √ √ √
11. Virtual classes √ √ √ √ √ √ √ √
9
Matrix(3) of Course Assessment Methods versus Intended Learning
Outcomes
a. Knowledge B. Intellectual c. Professional d. General
Methods Of &Understanding Skills Skills Skills
Evaluating ILO's
a6
b1
b3
d1
d2
d3
c1
c2
c3
c4
b4
a4
a5
b2
a1
a2
1. Assignments √ √ a3
√ √ √ √ √ √ √ √ √
2-Quizzes √ √ √ √ √ √ √ √
3-Reports √ √ √ √ √ √ √ √ √ √
4-Researches √ √ √ √ √ √ √
5- Projects √ √ √ √ √ √ √ √ √ √ √
6- Discussions √ √ √ √ √ √ √ √ √ √ √ √
7-Presentations √ √ √ √ √ √ √ √ √ √ √ √
9- Midterm exam √ √ √ √ √ √ √ √ √ √ √
10-Practical exam √ √ √ √ √ √ √ √ √ √
11- Final exam √ √ √ √ √ √ √ √ √ √ √
10
Chapter One
Accounting framework
11
1 - INTRODUCTION
Financial accounting is concerned with the way business
communicate financial information to the public: the various categories
of people who invest in, lend money to, or do business with a company.
These people rely on a company's financial statements and other
information reports to make investment and other financial decisions
about the company. Financial accounting practices and issues apply to
large, publicly owned corporations, smaller sole proprietorships, and
every type and size of business enterprise in between.
13
Regulatory agencies, such as the Securities and Exchange Commission
and the Federal Trade Commission, want to know whether the
company is operating within prescribed rules. Customers are interested
in whether a company like General Motors will continue to honor
product warranties and support its product lines.
2 - What is accounting?
15
Illustration 1-1 summarizes the activities of the accounting process.
16
In 1941, American institute certified public accountant (AICPA)
define Accounting is art of recording, classifying, summarizing and
interpreting business transactions in financial or many terms.
1. Recording function.
2. Classifying function.
3. Summarizing function.
4. Interpreting function.
- Determine net cash flows for this entity during the same period.
17
- Provide information, which it helps in planning, control and making
decisions.
18
This type of accounting provides environmental information of the
environmental expenses, and revenues of environmental management
system. Business organizations are complied with environmental laws,
and regulations, costs and benefits of implementing these
environmental regulations are computed and recorded by
environmental accounting.
Environmental accounting reports are prepared to present the efforts
and achievements of a company to protect the environment, and
biodiversity species against damages caused by pollution generated by
the company's activities.
• External users
• Internal users.
A – External Users.
19
and their agencies and the public , they use Accounting information in
order to satisfy some of their different needs for information these
needs include the following:
1- Investors
20
4- Governments and their agencies.
2- Employees.
21
The cost and productivity of their employees they compare
employee performance with management expectations, Accounting
information helps managers assess employee performance. And helps
employees assess the risk and return of their employment contract.
6- Organization That Affect Accounting Implementation
THE FINANICAL ACCOUNTING STANDARDS BOARD: (FASB)
The early 1970s saw the AICPA and other interested parties agree
to create the Study Group on Establishment of Accounting Principles
(the Wheat Committee) to ascertain whether improvements in the
standard-setting process were possible. The leaders of the profession
were fearful of, and wished to avoid, government intervention in the
standard-setting process. The committee recommended a new and more
independent standard-setting organization to replace the Accounting
Principles Board. This recommendation was approved by the AICPA,
and in 1973 the Financial Accounting Standards Board (FASB) was
established.
22
APB's Opinions. Several differences between the FASB and its
predecessors make it more effective. They are
1. Smaller size: The FASB has 7 voting members, whereas the APB
had 18.
2. Financial independence: The FASB is financed by a wide cross-
section of organization, none of which contributes a large
percentage of its budget, and its members are paid a full-time salary.
Further, the Board produces substantial cash inflows through its
publications. Previously, Board members were paid directly by the
organizations from which they were appointed. The APB had no
separate funding.
3. Reporting autonomy: Board members resign from their prior
organization and are answerable only to the Financial Accounting
Foundation. Members cannot retain investments in companies and
hence may be more objective.
4. Board representation: Members are not required to be CPAs.
(Lack of representation. Particularly of business, on the APB was
an important factor in the replacement of the APB with FASB.).
5. Increased staff and advisory support: The FASB has its own
staff, a research group, and a widely based advisory body (the
Financial Accounting Standards Advisory Committee) available to
advise the Board on its agenda and proposed releases. Further, it can
create additional groups to help expedite its mission.
6. Service: Board members serve full time and for up to 10 years,
providing greater continuity than in the past.
23
The FASB is the most influential body associated with the setting of
accounting standards.
The current structure of the FASB and associated organizations
responsible for setting accounting principles is shown later.
The Financial Accounting Foundation and the Financial
Accounting Standards Advisory Council are described briefly next.
24
necessarily amenable to quick resolution. Its members are drawn
primarily from senior technical partners of the larger CPA firms and
preparer associations. The conclusions of this group have generally
received the same status as Board standards. In 1992, the AICPA's
Auditing Standards Board designated EITF consensuses to accounting
issues as authoritative accounting literature for all companies.
25
1- Pronouncements by designated authoritative bodies that must be
followed in all applicable cases: the Financial Accounting Standards
Board (statements an Interpretations), accounting Principles Board
(Opinions), Committee on Accounting Procedure (ARBs), the
Securities and Exchange Commission (regulations for listed
companies), and AICPA (Accounting Interpretations, or AINSs).
26
the accounting standards issued by the International Accounting
Standards Board (IASB). These standards are called
International Financial Reporting Standards (IFRS).
27
This U.S. GAAP is currently moving to converge with International
Accounting Financial Reporting Standards (IFRS). IFRS is more
specific in its regulation, but IFRS less specific, and based more on
generally principles, more professional judgment is allowed.
Accounting assumptions and principles provide the essential the
theoretical for accounting practice as follows.
7/1 Accounting Entity
Accounting entity is defined as the organizational unit for
Accounting records are maintained, this concepts is necessary for
separate business entity from its owners.
Businesses may be classified into two categories: these that are distinct
legal entities a part from their owners.
A – Proprietorships & partnerships.
Proprietorships & partnerships are business organizations that do not
have legal identities distinct form their owners.
Proprietorships have only one owner but partnerships have more than
one owner, for most proprietorships and partnerships owners also
manage the business, in fact in a legal sense, the owners are the
business.
B – Corporations.
28
Corporations may be very large or fairly small organizations; small
corporations often are managed by their owners. The owners of most
large corporations do not manage their companies, instead they his
professional managers, these owners have the right to vote on certain
major decisions but they do not control be operations of their
corporations on a day – to – day basis one reason must large businesses
are organized as corporations is that they typically have greater access
to financial market than other types of organizations.
29
The financial statements are normally prepared on the assumption
that on enterprise is a going concern and will continue in operation for
the near future, hence, it is assumed that the enterprise has neither the
intention nor the need to liquidate or curtail materially.
7/4 Periodically
30
To determine net income during financial period, we matching
between revenues and expenses
The realization principle states that the amount that recognized revenue
is the amount that recognized as revenue is the amount that is
reasonably certain to be realized.
7/8 Objectivity
Full disclosure
31
Full disclosure requires that all materiality information must be
disclosed in reports prepared for users.
7/9 Consistency
(1) Understandability.
An essential quality of the information provided in financial
statements is that it is readily understandable by users. For this purpose,
users are assumed to a have a reasonable knowledge of business and
economic activities and Accounting.
(2) Primary qualities.
A – Relevance.
To be useful, information must be relevant to the decision –
making needs of users, relevance depend on timeliness, feedback value
and predictive value.
B - Reliable.
To be useful, information must also be reliable, information has
the quality of reliability when it is free form material error and bias and
can be depended upon by users to represent faithfully and verifiability
and neutrality.
3- Secondary qualities.
A – Comparability.
33
Users must be able to compare the financial statements of an
enterprise through time in order to identify trends in its financial
position and performance, users must also be able to compare the
financial statements of different enterprises in order evaluate their
relative financial position performance and changes in financial
position.
b- Consistency.
34
Efficient and effective accounting information systems are based on
certain basic principles. These principles are:
(1) cost effectiveness, (2) usefulness, and (3) flexibility.
If the accounting system is cost effective, provides useful output,
and has the flexibility to meet future needs, it can contribute to both
individual and organizational goals.
Computerized Accounting Systems
Many small businesses eventually replace their manual accounting
system with a computerized general ledger accounting system.
General ledger accounting systems are software programs that
integrate the various accounting functions related to sales, purchases,
receivables, payables, cash receipts and disbursements, and payroll.
They also generate financial statements. Computerized systems
have a number of advantages over manual systems. First, the company
typically enters data only once in a computerized system. Second,
because the computer does most steps automatically, many errors
resulting from human intervention in a manual system, such as errors
in posting or preparation of financial statements, are eliminated.
Computerized systems also provide information up-to-the-
minute. More timely information results in better business decisions.
Many different general ledger software packages are available.
CHOOSING A SOFTWARE PACKAGE
To identify the right software for your business, you must understand
your company’s operations. For example, consider its needs with
regard to inventory, billing, payroll, and cash management.
35
In addition, the company might have specific needs that are not
supported by all software systems. For example, you might want to
track employees’ hours on individual jobs or to extract information for
determining sales commissions. Choosing the right system is critical
because installation of even a basic system is time-consuming, and
learning a new system will require many hours of employee time.
ENTRY-LEVEL SOFTWARE
Software publishers tend to classify businesses into groups based on
revenue and the number of employees. Companies with revenues of
less than $5 million and up to 20 employees generally use entry-level
programs. The two leading entry-level programs are Intuit’s
QuickBooks and Sage Software’s Peachtree. These programs control
more than 90% of the market. Each of these entry-level programs
comes in many different industry-specific versions.
For example, some are designed for very specific industry applications
such as restaurants, retailing, construction, manufacturing, or
nonprofit.
36
Questions :-
2) What are the two basic types of financial statements are used?
37
8) Define what is accounting information system?
Chapter Two
38
The Accounting equation
39
financed by different means either owner’s means, which are called
equity, either means provided by the creditors, called liabilities. These
means of finance are claims of the financers to the assets of the entity.
40
Let us look in more detail at the categories in the basic accounting
equation.
Assets:
Assets are resources a business owns. The business uses its assets to
have benefits in carrying out such activities as production and sales,
Assets are classified according to liquidity into:
A- Current assets: which can be transferred to cash easily during the
period such as:-
1. Cash: available on hand or deposit in a bank account.
2. Marketable securities :-are securities and bonds can be sold any
time at stock market
3. Account Receivable (A/R):- amount of money due by credit sales
customers (on account) with no notes
4. Notes receivable (N/R) :-amount of money due by credit sales
customers with written notes.
5. Inventory:- is the stock of goods available for sale and stored to be
sold at next period
B- Long term assets (fixed assets) :-are assets bought to be used in
the business and not for sale .and can not be transferred to money in
short time
- which also dividend into
Tangible assets which are not for sale but are used to provide goods
and services (over a period of a year or more), e.g. property, land,
cars, machines and equipment
41
Intangible asset Long – term legal rights resulting from the ownership
of patents, (copyrights, trademarks, and similar items)
Liabilities:
Are debts owed by a business towards creditors who owned the debts
and must be paid in a certain date. such as:-
1. Notes payable (N/P):- are the written promise to repay a mount
owed to creditor in specific date with interest .
2. Account payable :- amount of money owed to creditor with no
written notes
• Liabilities are classified according to time into:
1-Current liabilities:
Are debts that must be paid in less than 1 year, ex: short term loan,
accounts/ notes payable.
Stockholders’ Equity
43
and rent.
EXPENSES are the cost of assets consumed or services used in the
process of earning revenue. They are decreases in stockholders’
equity that result from operating the business. Like revenues,
expenses take many forms and are called various names depending
on the type of asset consumed or service used. For example,
Campus Pizza recognizes the following types of expenses: cost
of ingredients (flour, cheese, tomato paste, meat, mushrooms, etc.);
cost of beverages; wages expense; utilities expense (electric, gas,
and water expense); telephone expense; delivery expense
(gasoline, repairs, licenses, etc.); supplies expense (napkins,
detergents, aprons, etc.); rent; interest and property tax expense.
DIVIDENDS
Net income represents an increase in net assets which are then available
to distribute to stockholders. The distribution of cash or other assets to
stockholders is called a dividend. Dividends reduce retained earnings.
However, dividends are not an expense. A corporation first determines
its revenues and expenses and then computes net income or net loss. If
it has net income and decides it has no better use for that income, a
corporation may decide to distribute a dividend to its owners (the
stockholders).
In summary, the principal sources (increases) of stockholders’
equity are in- vestments by stockholders and revenues from business
44
operations. In contrast, reductions (decreases) in stockholders’ equity
result from expenses and dividends.
45
In a proprietorship, owner’s investments and revenues increase
owner’s equity.
Investments by owner are the assets the owner puts into the business.
These investments increase owner’s equity. They are recorded in a
category called owner’s capital.
Revenues are the gross increase in owner’s equity resulting from
business activities entered into for earning income. Generally,
revenues result from selling merchandise, performing services, renting
property, and lending money. Common sources of revenue are sales,
fees, services, commissions, interest, dividends, royalties, and rent.
Revenues usually result in an increase in an asset. They may arise
from different sources and are called various names depending on the
nature of the business.
E - DECREASES IN OWNER’S EQUITY
In a proprietorship, owner’s drawings and expenses decrease
owner’s equity.
Drawings: An owner may withdraw cash or other assets for
personal use. We use a separate classification called drawings to
determine the total withdrawals for each accounting period. Drawings
decrease owner’s equity.
46
Expenses: Expenses are the cost of assets consumed or services
used in the process of earning revenue. They are decreases in owner’s
equity that result from operating the business.
Transaction Analysis
In order to analyze transactions, As part of this analysis, we will expand
the basic accounting equation. This will allow us to better illustrate the
impact of transactions on equity. Recall that equity is comprised of
two parts: share capital ordinary and retained earnings. Share capital
ordinary is affected when the company issues new ordinary shares in
47
exchange for cash. Retained earnings is affected when the company
earns revenue, incurs expenses, or pays dividends.
Share
Capital—Ordinary Retained Earnings
48
The asset Cash increases $15,000, and owner’s equity (identified as
Owner’s Capital) increases $15,000.
Observe that the equality of the accounting equation has been
maintained. Note that the investments by the owner do not represent
revenues, and they are excluded in determining net income. Therefore,
The asset Cash decreases $7,000, and the asset Equipment increases $7,000.
Observe that total assets are still $15,000. Owner’s equity also remains at
$15,000, the amount of Ray Neal’s original investment.
49
bill in October. This transaction is a purchase on account (a credit
purchase). Assets increase because of the expected future
benefits of using the headsets and computer accessories, and
liabilities increase by the amount due to Mobile Solutions.
The asset Supplies increases $1,600, and the liability Accounts
Payable increases $1,600.
50
The two sides of the equation balance at $17,800. Service
Revenue is included in determining Softbyte’s net income.
Note that we do not have room to give details for each
individual revenue and expense account in this illustration. Thus,
revenues (and expenses when we get to them) are summarized
under one column heading for Revenues and one for Expenses.
However, it is important to keep track of the category (account)
titles affected (e.g., Service Revenue) as they will be needed
when we prepare financial statements later in the chapter.
TRANSACTION (5). PURCHASE OF ADVERTISING ON
CREDIT Softbyte receives a bill for $250 from the Daily News
for advertising on its online website but postpones payment until
a later date. This transaction results in an increase in liabilities
and a decrease in owner’s equity.
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The two sides of the equation still balance at $17,800. Owner’s
equity decreases when Soft byte incurs the expense. Expenses are
not always paid in cash at the time they are incurred. When Soft
byte pays at a later date, the liability Accounts Payable will
decrease, and the asset Cash will decrease [see Transaction (8)].
The cost of advertising is an expense (rather than an asset)
because the company has used the benefits. Advertising Expense
is included in determining net income.
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the future. When it later receives collections on account, Soft
byte will increase Cash and will decrease Accounts Receivable
[see Trans- action (9)].
The two sides of the equation now balance at $19,600. Three lines
in the analysis indicate the different types of expenses that have
been incurred.
TRANSACTION (8). PAYMENT OF ACCOUNTS
PAYABLE Soft byte pays its $250 Daily News bill in cash. The
company previously [in Transaction (5)] recorded the bill as an
increase in Accounts Payable and a decrease in owner’s equity.
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Observe that the payment of a liability related to an expense that
has previously been recorded does not affect owner’s equity. The
company recorded this expense in Transaction (5) and should not
record it again.
TRANSACTION (9). RECEIPT OF CASH ON ACCOUNT Soft
byte receives $600 in cash from customers who had been billed for
services [in Transaction (6)]. Transaction (9) does not change total
assets, but it changes the composition of those assets.
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Note that the dividend reduces retained earnings, which is part of
equity. Dividends are not expenses. Like shareholders’
investments, dividends are excluded in determining net income.
Summary of Transactions
Illustration 1-10 summarizes the September transactions of Softbyte
Inc. to show their cumulative effect on the basic accounting equation.
It also indicates the transaction number and the specific effects of
each transaction. Finally, Illustration 1-10 demonstrates a number of
significant facts:
1. Each transaction must be analyzed in terms of its effect on:
b. The three components of the basic accounting equation.
c. Specific types (kinds) of items within each component.
2. The two sides of the equation must always be equal.
3. The Share Capital—Ordinary and Retained Earnings columns
indicate the causes of each change in the shareholders’ claim on
assets.
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Example2:
1) Ahmed invests $20,000 cash to start the business
The effect on accounting equation is:
Assets = Liabilities + Equity
Accounts Notes Owner
Cash Supplies Equipment Payable Payable Capital
(1) $ 20,000 $ 20,000
$ 20,000 $ - $ - $ - $ - $ 20,000
$ 20,000 = $ 20,000
$ 20,000 = $ 20,000
$ 20,000 = $ 20,000
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Assets = Liabilities + Equity
Accounts Notes Owner
Cash Supplies Equipment Payable Payable Capital
(1) $ 20,000 $ 20,000
(2) (1,000) $ 1,000
(3) (15,000) $ 15,000
(4) 200 1,000 $ 1,200
$ 21,200 = $ 21,200
$ 25,200 = $ 25,200
$ 25,200 = $ 25,200
$ 26,900 = $ 26,900
Ex (3) The items making up the balance sheet of truck rental at December 31 are
listed below in tabular form of accounting equation
Owner’s
+ Liabilities = Assets
equity
+ Office
Capital A/P + N/P = + Truck + A/R + Cash
Equipment
During a short period after December 31, truck rental had the following transactions:
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Capital A/P + N/P = Build +office + Trucks + A/R + Cash
+
equipment
= + + + Beg
55000 + 5200 + 20000 3800 58000 8900 9500
.balance
2700 + + -2700 1)
- 2)
+4000
4000
- 3200 - 3200 3)
+10000 +10000 4)
+15500 + - 15000 5)
45500 30500
88500 2600 Balance
+ 20000 + 20000 6)
75000 + 2000 + 45500 = 6500 + 88500 + 4900 + 22600 Balance
4. Borrowed 10,000 from a bank signed a note payable for that amount.
5. Purchased two tucks for $30,500 paid $15,000 cash and signed a note payable
for the balance.
Required:
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a. List the December 31 balance of assets, liabilities, and owner’s equity
in tabular form as shown above.
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The following conclusions are summarized:
1. Increase in owner's equity comes from:
1.1 Depositing cash or other assets in a business by owner.
1.2 Profit or earnings generated by profitable transactions.
2. Decrease in owner's equity is caused by:
2.1 Drawing an amount of cash by the owner to cover his own expenses.
2.2 Losses caused by the unprofitable transactions of the business.
3. Cash sales revenue increases cash balance, profit of these
revenue increases owner's equity.
4. Cash operating expenses decrease cash.
5. Purchased on credit of ban asset increase assets and liabilities
(account payable).
6. Sales on credit increase accounts receivable.
7. At the end of each day of operating business a balance sheet
is prepared using the ending balances of assets and liabilities
in addition to owner's equity balance.
Financial statements
Companies prepare four financial statements from the summarized
accounting data:
1. An income statement presents the revenues and expenses and
resulting net income or net loss for a specific period of time.
2. A retained earnings statement summarizes the changes in retained
earnings for a specific period of time.
3. A statement of financial position (sometimes referred to as a
balance sheet) reports the assets, liabilities, and equity of a
company at a specific date.
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4. A statement of cash flows summarizes information about the
cash inflows (receipts) and outflows (payments) for a specific
period of time.
These statements provide relevant financial data for internal and
external users. Illustration 1-11 shows the financial statements of
Softbyte Inc. Note that the statements shown in Illustration 1-11 are
interrelated:
1-Income Statement
The income statement reports the success or profitability of the
company’s operations over a specific period of time. The heading of
the statement identifies the company, the type of statement, and the
time period covered by the statement.
The income statement lists revenues first, followed by expenses.
Finally, the statement shows net income (or net loss). When revenues
exceed expenses, net income results. When expenses exceed revenues,
a net loss results.
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Note that the income statement does not include investment and
dividend transactions between the shareholders and the business in
measuring net income. For example, as explained earlier, the cash
dividend from Softbyte Inc. was not regarded as a business expense.
This type of transaction is considered a reduction of retained
earnings, which causes a decrease in equity.
2-Retained Earnings Statement
Retained earnings statement reports the changes in retained earnings
for a specific period. The period is the same as that covered by the
income statement; Data for the preparation of the retained earnings
statement come from the retained earnings columns of the tabular
summary and from the income statement.
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a company’s most liquid resource. The statement of cash flows
provides answers to the following simple but important questions.
1. Where did cash come from during the period?
2. What was cash used for during the period?
3. What was the change in the cash balance during the period?
5- Analyze Transactions
As part of this analysis, we will expand the basic accounting
equation. This will allow us to better illustrate the impact of
transactions on stockholders’ equity. Recall that stockholders’
equity is comprised of two parts: common stock and retained
earnings. Common stock is affected when the company issues
new shares of stock in exchange for cash. Retained earnings is
affected when the company earns revenue, incurs expenses, or
pays dividends. Illustration 1-8 shows the expanded accounting
equation.
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Every transaction is recorded by equal dollar amount of DR and
CR The reason for this equality lies in the relationship of the debit
and credit rules to the accounting equation.
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credits provides the basis for the double-entry system of
recording transactions.
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Land would indicate a recording error. Similarly, a debit balance
in a liability account such as Wages Payable would indicate an
error. Occasionally, though, an abnormal balance may be correct.
The Cash account, for example, will have a credit balance
when a company has overdrawn its bank balance (i.e., written a
“bad” check). (Notice that when we are referring to a specific
account, we capitalize its name.)
Owner’s Equity. As Chapter 1 indicated, owner’s
investments and revenues increase owner’s equity. Owner’s
drawings and expenses decrease owner’s equity.
Companies keep accounts for each of these types of
transactions.
Owner’s Capital. Investments by owners are credited to the
Owner’s Capital account. Credits increase this account, and
debits decrease it. When an owner invests cash in the business,
the company debits (increases) Cash and credits (increases)
Owner’s Capital. When the owner’s investment in the business
is reduced, Owner’s Capital is debited (decreased).
Owner’s Drawing: An owner may withdraw cash or other assets
for personal use. Withdrawals could be debited directly to
Owner’s Capital to indicate a decrease in owner’s equity.
However, it is preferable to use a separate account, called
Owner’s Drawing. This separate account makes it easier to
determine total withdrawals for each accounting period. Owner’s
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Drawing is increased by debits and decreased by credits.
Normally, the drawing account will have a debit balance.
The Drawing account decreases owner’s equity. It is not
an income statement account like revenues and expenses.
Revenues and Expenses: The purpose of earning revenues is to
benefit the owner(s) of the business. When a company earns
revenues, owner’s equity
Therefore, the effect of debits and credits on revenue accounts
is the same as their effect on Owner’s Capital. That is, revenue
accounts are increased by credits and decreased by debits.
Expenses have the opposite effect: Expenses decrease
owner’s equity. Since expenses decrease net income, and
revenues increase it, it is logical that the increase and decrease
sides of expense accounts should be the reverse of revenue
accounts.
Thus, expense accounts are increased by debits and
decreased by credits.
Credits to revenue accounts should exceed debits. Debits to
expense accounts should exceed credits. Thus, revenue accounts
normally show credit balances, and expense accounts normally
show debit balances.
In summary …double- entry accounting is a system of
recording every business transaction with equal dollar amounts
of both debit and credit entries. As a result of this system , the
accounting equation always remains in balance.
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Assets = Liabilities + owner’s
equity
Debit balance = Credit balances
Increase assets Increase liabilities
Decrease in liabilities Decrease in assets
Decrease in owner’s equity Increase in owner’s equity
• expenses • revenues
• purchases • sales
• losses • profits
• withdrawals • purchase return/discount
• sales return/discount • investment
Basic
Equation Assets = Liabilities + Owner's Equity
Expanded
Equation Assets = Liabilities + Owner's – Owner' + Rev. - Exp.
Capital Drawing
Debit / Credit DR Cr DR Cr DR Cr DR Cr DR Cr DR Cr
Effects + - - + - + + - - + - +
Questions
1- Define all the following items:
a) Assets b) Liabilities
c) Owner's Equity d) Accounting Cycle
2- How does owner's equity increasing or decreasing?
3- Write the basic steps of accounting cycle & draw it.
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4- Put (T) or (F) for each of the following statements:
a) Increasing in any asset makes it debit.
b) Increasing in any liability makes it debit.
c) Decreasing in owner's Equity makes it credit.
d) Building is an asset.
e) Land is a liability.
f) N/P is an asset.
g) Any expense is always debit.
h) Any revenue is always debit.
5- Choose the correct answer:
a. Ahmed purchased a truck for L.E.12000, making a down
payment of L.E.5000 cash and signing L.E.7000 note
payable. The effect of this transaction on the accounting
equation is:
a- Total assets increased by L.E.12000.
b- Total liabilities decreased by L.E.7000.
c- The cash decreased by L.E.5000 and liabilities decreased by
L.E.7000.
d- The cash decreased by L.E.5000 and liabilities increased by
L.E.7000.
b. A transaction caused a L.E. 10000 decrease in both total
assets and total liabilities. This transaction could have been:
a- Purchase of a truck for L.E.10000 cash.
b- An asset with a cost of L.E.10000 was destroyed by fire.
c- Repayment of L.E. 10000 a bank loan.
d- Collection of L.E.10000 account receivable.
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b. ? 562,500 L.E. 375,000
c. 307,000 ? 142,500
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h. Purchased office equipment for cash.
i. Collected an account receivable.
Indicate the effects of each of these transactions upon the total
amounts of the company’s assets, liabilities, and owner’s equity.
Organize your answer in tabular form, using the column headings
shown below and the code letters I for increase, D for decrease,
and NE for no effect. The answer for transaction (a) is provided
as an example:
Owner’s
Assets = Liabilities +
equity
(a) I I NE
Assets = Liabilities + Owner’s Equity
Office N/P
Cash + Land Building
+ + = A/P + Soha, Capital
equipment +
37,000 95,000 125,000 51,250 80,000 28,250 200,000
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L.E.55,000 was the value of the building. Paid L.E.22,500 in
cash and signed a note payable for the remaining L.E. 67,500.
c. Bought several computer systems on credit for L.E. 8,500.
d. Obtained a loan from the National bank in the amount of
L.E. 10,000 and singed a note payable.
e. Paid the L.E. 28,250 account payable owed as of December
31.
Required:
List the December 31 balances of assets, liabilities, and owner’s
equity in tabular form shown and show the effect of each
transaction in the table.
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Chapter Three
Accounting Cycle
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1- Explain what an account is and how it helps in the recording
process.
2- Define debits and credits and explain their use in recording
business transactions.
3- Identify the basic steps in the recording process.
4- Explain what a journal is and how it helps in the recording
process.
5- Explain what a ledger is and how it helps in the recording
process.
6- Explain what posting is and how it helps in the recording
process.
7- Prepare a trial balance and explain its purposes.
The contents of Chapter Three are as follows:
1- Identify The Account (Debits and credits)
2- Identify Steps of the Recording Process, and How to enter the
transaction information in a journal. (Journal)
3- Transfer the journal information to the appropriate accounts in
the ledger.
4- Identify how to prepare The Trial Balance.
1- Introduction
In Chapter 2, we analyzed business transactions in terms of the
accounting equation, and we presented the cumulative effects of
these transactions in tabular form. Imagine a company with great
Investments Deal in a complex transactions. In every single day,
this company engages in thousands of business transactions. To
record each transaction this way would be impractical, expensive,
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and unnecessary. Instead, companies use a set of procedures and
records to keep track of transaction data more easily.
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For example, the act of entering an amount on the left side of
an account is called debiting the account. Making an entry on
the right side is crediting the account.
When comparing the totals of the two sides, an account
shows a debit balance if the total of the debit amounts
exceeds the credits. An account shows a credit balance if the
credit amounts exceed the debits. Note the position of the
debit side and credit side in Illustration 2-1.
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a balance of zero and now has $8,050 in its Cash account.
DEBIT AND CREDIT PROCEDURE
In Chapter 1, you learned the effect of a transaction on the
basic accounting equation. Remember that each transaction
must affect two or more accounts to keep the basic
accounting equation in balance. In other words, for each
transaction, debits must equal credits. The equality of debits
and credits provides the basis for the double-entry system of
recording transactions.
Under the double-entry system, the dual (two-sided) effect
of each transaction is recorded in appropriate accounts. This
system provides a logical method for recording transactions.
As discussed in the Feature Story about MF Global, the
double-entry system also helps ensure the accuracy of the
recorded amounts as well as the detection of errors. If every
transaction is recorded with equal debits and credits, the sum
of all the debits to the accounts must equal the sum of all the
credits.
The double-entry system for determining the equality of the
accounting equation is much more efficient than the plus/minus
procedure used in Chapter 1.
DR./CR. PROCEDURES FOR ASSETS AND LIABILITIES
In Illustration 2-2 for Softbyte Inc., increases in Cash—an
asset—were entered on the left side, and decreases in Cash
were entered on the right side. We know that both sides of the
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basic equation (Assets 5 Liabilities 1 Stockholders’ Equity)
must be equal. It therefore follows that increases and
decreases in liabilities will have to be recorded opposite from
increases and decreases in assets. Thus, increases in liabilities
must be entered on the right or credit side, and decreases in
liabilities must be entered on the left or debit side.
Asset accounts normally show debit balances. That is,
debits to a specific asset account should exceed credits to that
account. Likewise, liability accounts normally show credit
balances. That is, credits to a liability account should exceed
debits to that account. The normal balance of an account is
on the side where an increase in the account is recorded.
Knowing the normal balance in an account may help you
trace errors. For example, a credit balance in an asset account
such as Land or a debit balance in a liability account such as
Salaries and Wages Payable usually indicates an error.
Occasionally, though, an abnormal balance may be correct.
The Cash account, for example, will have a credit balance
when a company has overdrawn its bank balance.
Assets Liabilities
Debit for /Credit for Debit for/Credit for
increase decrease decrease increase
Normal Normal
balance balance
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Salaries and Wages Payable usually indicates an error.
Occasionally, though, an abnormal balance may be correct.
The Cash account, for example, will have a credit balance
when a company has overdrawn its bank balance (i.e., written
a check that “bounced”).
STOCKHOLDERS’ EQUITY
As Chapter 1 indicated, there are five subdivisions of
stockholders’ equity: common stock, retained earnings,
dividends, revenues, and expenses. In a double-entry system,
companies keep accounts for each of these subdivisions, as
explained below.
COMMON STOCK
Companies issue common stock in exchange for the owners’
investment paid in to the corporation. Credits increase the
Common Stock account, and debits decrease it. For example,
when an owner invests cash in the business in exchange for
shares of the corporation’s stock, the company debits
(increases) Cash and credits (increases) Common Stock.
RETAINED EARNINGS
Retained earnings is net income that is kept (retained) in the
business. It represents the portion of stockholders’ equity that the
company has accumulated through the profitable operation of the
business. Credits (net income) increase the Retained Earnings
account, and debits (dividends or net losses) decrease it.
DIVIDENDS
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A dividend is a company’s distribution to its stockholders on
a pro rata (equal) basis. The most common form of a
distribution is a cash dividend. Dividends reduce the
stockholders’ claims on retained earnings. Debits increase the
Dividends account, and credits decrease it.
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the stockholders’ equity section of the balance sheet. They
report dividends on the retained earnings statement. In addition,
they report revenues and expenses on the income statement.
Dividends, revenues, and expenses are eventually transferred to
retained earnings at the end of the period. As a result, a change
in any one of these three items affects stockholders’ equity.
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carefully. It will help you understand the fundamentals of the
double-entry system.
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chapters. The other two steps in the recording process are
explained in the next sections.
The Journal
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)1(the date of the transaction, (2) the accounts and amounts to
be debited and credited, and (3) a brief explanation of the
transaction.
Illustration 2-14 shows the technique of journalizing, using the
first two transactions of Softbyte Inc. On September 1,
stockholders invested $15,000 cash in the corporation in
exchange for shares of stock, and Softbyte purchased computer
equipment for $7,000 cash. The number J1 indicates that these
two entries are recorded on the first page of the journal.
Illustration 2-14 shows the standard form of journal entries for
these two transactions. (The boxed numbers correspond to
explanations in the list below the illustration.)
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credit is recorded in the Credit column.
4 A brief explanation of the transaction appears on the line
below the credit account title. A space is left between journal
entries. The blank space separates individual journal entries
and makes the entire journal easier to read.
5 The column titled Ref. (which stands for Reference) is left
blank when the journal entry is made. This column is used
later when the journal entries are transferred to the ledger
accounts.
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Company purchases a delivery truck costing $14,000. It pays
$8,000 cash now and agrees to pay the remaining $6,000 on
account (to be paid later). The compound entry is as follows.
GENERAL JOURNAL J1
Date Account Titles and Explanation Ref. Debit Credit
2015
July 1 Equipment 14,000
Cash 8,000
Accounts Payable 6,000
(Purchased truck for cash with
balance on account)
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not be possible if transactions were recorded directly in ledger
accounts:
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determine the number and type of journal needed. The simplest type
of journal is called a general journal. A general journal has only two
columns, one for debits and the other for credits it may be used for
recording any type of transaction.
The process of recording a transaction in a journal is called
journalizing the transaction.
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the asset accounts, followed by liability accounts,
stockholders’ equity accounts, revenues, and expenses. Each
account is numbered for easier identification.
The ledger provides the balance in each of the accounts. For
example, the Cash account shows the amount of cash
available to meet current obligations. The Accounts
Receivable account shows amounts due from customers. The
Accounts Payable account shows amounts owed to creditors.
Posting merely copies existing information from one accounting
record to another. The process of transferring from the journal to
individual accounts in the ledger named (posting to the ledger).
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2. In the reference column of the journal, write the account number
to which the debit amount was posted.
3. In the ledger, in the appropriate columns of the account(s)
credited, enter the date, journal page, and credit amount shown
in the journal.
4. In the reference column of the journal, write the account number
to which the credit amount was posted.
5. Illustration 2-18 shows these four steps using Softbyte Inc.’s
first journal entry. The boxed numbers indicate the sequence of
the steps.
Posting should be performed in chronological order. That is, the
company should post all the debits and credits of one journal entry
before proceeding to the next journal entry. Postings should be
made on a timely basis to ensure that the ledger is up to date.2
Example (1)
Hani center is a new business was organized on January 1, the following
transactions occurred during January prior to the company :-
Jan. 1 Hani opened a bank account in the name of the business with a deposit
of L.E 45,000.
Jan. 2 Purchased building for a total price of L.E 140,000. Cash down
payment of L.E 28,000 was made and the remaining by note payable.
Jan. 5 purchased equipment for L.E 4000 cash
Jan. 12 purchased goods on credit from AL SALAM Company for 3000.
Jan. 14 Paid L.E 2000 of the owed to AL SALAM Company.
Jan. 20Paid utilities expenses amount to 2500 L.E.
Jan. 28Earned fees revenue amount to 5000 L.E and received half cash.
Required: Prepare journal entries for the month of January.
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The solution
1- General journal
Date Description debit Credit
Cash 45000
Hani capital 45000
January 1
(Owners invested cash to begin
business)
Building 140,000
January 2 Cash 28000
Notes payable 112000
( purchased build., paid part cash and
issued a note payable for the balance)
Equipment 4000
January 5 Cash 4000
( purchased equipment for each)
Purchases 3000
Accounts payable 3000
January 12
(Purchased stock on credit from AL
SALAM Co.)
Account payable 2000
Cash 2000
January 14
(paid part of account payable to
ALSALAM Co.
Utilities exp. 2500
January 20 Cash 2500
(paid utilities exp)
Cash 2500
A/R 2500
January 28
Fees revenue 5000
(earned fees revenue)
2-Ledger
Cash
Dr. (debit) Cr. (Credit)
Hani capital 45000 building 28000
Fees revenue 2500 equipment 4000
A/P 2000
Utilities exp. 2500
End. balance 11000
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47500 47500
Building
Dr. (debit) Cr.(Credit)
Cash , 28,000 End. Balance 140,000
N/P 112000
140,000 140,000
Equipment
Dr. (debit) Cr.(Credit)
Cash 4,000 End. Balance 4,000
4,000 4,000
Purchases
Dr. (debit) Cr.(Credit)
A/P 3,000 End. Balance 3,000
3,000 3,000
Notes payable
Dr. (debit) Cr.(Credit)
End. Balance 112,000 Building 112,000
112,000 112,000
Account payable
Dr. (debit) Cr.(Credit)
cash 2,000 Purchases 3,000
End.balance 1,000
3,000 3,000
Hani capital
Dr. (debit) Cr.(Credit)
End. Balance 45,000 Cash 45,000
45,000 45,000
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Utilities expenses
Dr. (debit) Cr.(Credit)
cash 2,500 End. balance 2,500
2,500 2,500
A/R
Dr. (debit) Cr.(Credit)
fees revenue 2,500 End. balance 2,500
2,500 2,500
Fees revenue
Dr. (debit) Cr.(Credit)
End. Balance 5,000 Cash, 2500
A/R 2500
5,000 5,000
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error at MF Global discussed in the Feature Story. In
addition, a trial balance is useful in the preparation of
financial statements,
The steps for preparing a trial balance are:
1. List the account titles and their balances in the appropriate
debit or credit column.
2. Total the debit and credit columns.
3. Prove the equality of the two columns.
Trial balance:
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7 - Uses and limitation of the trial balance:
1- The trial balance: provides proof that the ledger is in balance.
2- The purpose of the trial balance is to verify the accuracy of the posting.
3- The agreement of the debit and credit totals of the trial balance gives
assurance that:
(a) Equal debits and credits have been recorded for all transactions.
(b)The debit or credit balance of each account has been correctly
computed.
(c) The addition of the account balances in the trial balance has been
correctly performed.
The preparation of a trial balance does not prove that transactions
have been correctly analyzed and recorded in the proper accounts, if
for example:
1- A receipt of cash erroneously, recorded by debiting the land account
instead of the cash account, the trial balance would still balance.
In brief: the trial balance proves only one aspect of the ledger, and
that is the equality of debits and credits.
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serve as a convenient stepping – stone for the preparation of
“financial statement”.
The balance sheet and other financial statements can be prepared more
conveniently from the trial balance than directly from the ledger,
especially if there are many ledger accounts.
1. Limitations of a Trial Balance
2. A trial balance does not guarantee freedom from recording errors,
how- ever. Numerous errors may exist even though the totals of the
trial balance columns agree. For example, the trial balance may
balance even when:
1. A transaction is not journalized.
2. A correct journal entry is not posted.
3. A journal entry is posted twice.
4. Incorrect accounts are used in journalizing or posting.
5. Offsetting errors are made in recording the amount of a transaction.
3. As long as equal debits and credits are posted, even to the wrong
account or in the wrong amount, the total debits will equal the total
credits. The trial balance does not prove that the company has
recorded all transactions or that the ledger is correct.
Locating Errors
Errors in a trial balance generally result from mathematical mistakes,
incorrect postings, or simply transcribing data incorrectly. What do you
do if you are faced with a trial balance that does not balance? First,
determine the amount of the difference between the two columns of the
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trial balance. After this amount is known, the following steps are often
helpful:
1. If the error is $1, $10, $100, or $1,000, re-add the trial balance columns
and re compute the account balances.
2. If the error is divisible by 2, scan the trial balance to see whether a
balance equal to half the error has been entered in the wrong column.
3. If the error is divisible by 9, retrace the account balances on the trial
balance to see whether they are incorrectly copied from the ledger. For
example, if a balance was $12 and it was listed as $21, a $9 error has
been made. Reversing the order of numbers is called a transposition
error.
4. If the error is not divisible by 2 or 9, scan the ledger to see whether an
account balance in the amount of the error has been omitted from the
trial balance, and scan the journal to see whether a posting of that
amount has been omitted.
Ex(2):- The Sun Company was a new business ,the following
transactions occurred during January 2021:
Jan 1: The owner started his business by depositing L.E.500000 in
the account of the company.
Jan 4: purchased office equipment for L.E.50000 cash.
Jan 6: purchased a truck for L.E.80000 on account
Jan 10: purchased land for L.E.50000 paid half cash.
Jan 15: purchased furniture for L.E. 10000 cash.
Jan 20: paid the on account of date Jan 6.
99
Jan 22: paid L.E.1000 rent, for his own home
Jan 31: paid the on account of date Jan 10.
Required: Prepare: 1) Journal 2) Ledger 3) Trial balance
Solution
General journal:
Date Description debit Credit
Cash 500000
1/1 capital 500000
(Owners invested cash to begin business)
Equipment 50,000
4/1
Cash 50000
( purchased equipment, paid cash)
truck 80000
6/1 A/P 80000
( purchased truck on account)
land 50000
A/p 25000
10/1
cash 25000
(Purchased land paid half cash)
Furniture 10000
15/1 Cash 10000
( purchased equipment, paid cash)
A/P 80000
20/1 Cash 80000
(paid A/P cash)
Withdrawals 1000
Cash 1000
22/1
(paid owner home rent expenses )
A/P 25000
31/1
Cash 25000
(paid A/P cash)
2- Posting to ledger:-
Cash
Dr. (debit) Cr. (Credit)
Capital 500000 Equipment 50000
land 25000
A/P 80000
Furniture 10000
100
A/P 25000
withdrawals 1000
End. Balance 309000
500000 500000
Truck
Dr. (debit) Cr.(Credit)
A/P 80000 End. Balance 80,000
80,000 80,000
Equipment
Dr. (debit) Cr.(Credit)
Cash 50,000 End. Balance 50,000
50,000 50,000
Furniture
Dr. (debit) Cr.(Credit)
cash 10,000 End. Balance 10,000
10,000 10,000
account payable
Dr. (debit) Cr.(Credit)
cash 105,000 Truck 80,000
end balance Zero land 25000
105,000 105,000
Capital
Dr. (debit) Cr.(Credit)
End. Balance 500,000 Cash 500,000
500,000 500,000
Withdrawals
Dr. (debit) Cr.(Credit)
cash 1000 End. Balance 1000
1000 1000
Land
Dr. (debit) Cr.(Credit)
cash 2,5000 End. Balance 50000
101
A/P 25000
50000 50000
Truck 80,000
Equipment 50,000
Capital 500,000
Furniture 10000
Withdrawals 1000
Land 50000
Total 500,000 500,000
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Summary of the Chapter Three:
1- Explain what an account is and how it helps in the recording process.
An account is a record of increases and decreases in specific asset,
liability, and owner’s equity items.
2- Define debits and credits and explain their use in recording business
transactions. The terms debit and credit are synonymous with left and
right. Assets, drawings, and expenses are increased by debits and
decreased by credits. Liabilities, owner’s capital, and revenues are in-
creased by credits and decreased by debits.
3- Identify the basic steps in the recording process. The basic steps in the
recording process are: (a) analyze each transaction for its effects on the
accounts, (b) enter the trans- action information in a journal, (c) transfer
the journal information to the appropriate accounts in the ledger
4- Explain what a journal is and how it helps in the recording process. The
initial accounting record of a transaction is entered in a journal before
the data are entered in the accounts. A journal (a) discloses in one place
the complete effects of a transaction, (b) provides a chronological
record of transactions, and (c) prevents or locates errors because the
debit and credit amounts for each entry can be easily compared.
5- Explain what a ledger is and how it helps in the recording process. The
ledger is the entire group of accounts maintained by a company. The
ledger keeps in one place all the information about changes in specific
account balances.
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6- Explain what posting is and how it helps in the recording process.
Posting is the transfer of journal entries to the ledger accounts. This
phase of the recording process accumulates the effects of journalized
transactions in the individual accounts.
7- Prepare a trial balance and explain its purposes. A trial balance is a list
of accounts and their balances at a given time. Its primary purpose is to
prove the equality of debits and credits after posting. A trial balance
also uncovers errors in journalizing and posting and is useful in
preparing financial statements.
104
Questions
The First Questions Answer The Following :
3. The left side of the account is known as the _______, while the
right side of the account is known as the _________.
105
(g) Capital is decreased through drawing
Solution:
(a) Cr. (b) Cr. (c) Cr. (d) Dr. (e) Dr. (f ) Cr. (g) Dr.
Problem 2
Solution:
Item Dr. Cr.
Cash 20,000
Accounts Receivable 14,000
Supplies 6,000
Equipment 18,000
Accounts Payable 9,000
Notes Payable 11,000
Capital 32,000
Drawing 4,000
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Fees Income 26,000
Salaries Expenses 8,000
Rent expenses 5,000
Supplies expenses 2,000
General expenses 1,000
78,000 78,000
Problem 3:
Below each entry, write a brief explanation of the transaction that
might appear in the general journal.
Dr. Cr.
(a) Equipment 10,000
Cash 2,000
Accounts Payable 8,000
(b) Accounts Payable 8,000
Notes Payable 8,000
(c) Notes Payable 8,000
Cash 8,000
Solution:
Problem 4:
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Cash 12,000
Supplies 1,400
Equipment 22,600
Furniture 10,000
Cash 12,000
Supplies 1,400
Equipment 22,600
Furniture 10,000
Problem 5:
If, in the last Problem, Dr. Wallace owed a balance of $3,500 on
the equipment, what would the opening entry be?
Solution:
Dr. Cr.
Cash 12,000
Supplies 1,400
Equipment 22,600
Furniture 10,000
Accounts Payable 3,500
P. Wallace, Capital 42,500
108
Unsolved problems:-
1. Answer the following questions:
1. List the basic steps of the accounting cycle and show the
illustration.
2. For each of the following financial statements, indicate whether
the statement relates to a single date or to a period of time:
(1) Balance sheet.
(2) Income statement.
(3) Statement of owner’s equity.
3. Financial statements are a set of four related accounting
reports, consisting of:
a- ………………....................
b- …………………………....
c- …………………………....
d- ………………………….....
2. Choose the correct answer:
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formal financial statements such as the balance sheet and
the income statement.
2. According to the rules of debit and credit for the balance
sheet accounts, which of the following statements is true:
(a) Increases in asset, liability and owner’s equity accounts
are recorded by debits.
(b) Decreases in asset and liability accounts are recorded
by credits.
(c) Increases in asset and owner’s equity accounts are
recorded by debits.
(d) Decreases in liability and owner’s equity accounts are
recorded by debits.
3. The following journal entry was made in Al Ahram stores’
accounting records:
Cash …………………………………L.E. 12,000
Notes Receivable…………………….L.E. 48,000
Land…………………………….L.E.60,000
This transaction:
(a) Involves the purchase of land for L.E. 60,000.
(b) Involves a L.E. 12,000 cash payment.
(c) Involves the sale of land for L.E. 60,000.
(d) Causes an increase in total assets of L.E. 12,000.
3. Indicate the following statements are true or false:
1. Before recording the business transactions in the accounting
system, the transactions must be analyzed to determine which
account should be debited or credited and for what monetary
amount.
2. Every transaction is recorded by equal monetary amount of
debits and credits.
3. Posting is the process of transferring information from the
journal to individual accounts in the ledger.
4. At the end of every accounting period, it is not necessary to post
balance sheet accounts in the ledger.
5. The trial balance provides proof that the journal is in balance.
6. In the trial balance, the debit balances are listed in the right- hand
column and the credit balances are listed in the left- hand
column.
7. Credit is an amount entered on the right- hand side of a ledger
110
account. A credit is used to record a decrease in an asset or an
increase in a liability or in owner’s equity.
8. Debit is an amount entered on the left- hand side of a ledger
account. A debit is used to record an increase in an asset or a
decrease in a liability or in owner’s equity.
9. The effect of events on the business is recognized as services
are rendered or consumed rather than when cash is received or
paid.
Exercise 3:
The Sun Company was a new business started on 1/1/2021.
The following transactions occurred during January 2021:
Jan 1: The owner started his business by depositing L.E.500000 in
the account of the company.
Jan 4: The owner purchased office equipment for L.E.50000 cash.
Jan 6: He purchased a truck for L.E.80000 on account
Jan 10: He purchased land for L.E.50000 paid half cash.
Jan 15: He purchased furniture for L.E. 10000 cash.
Jan 20: He paid the on account of date Jan 6.
Jan 22: He paid L.E.1000 rent, for his own home, taken from the
cash of the company.
Jan 31: He paid the on account of date Jan 10.
Required:
Prepare: 1) Journal 2) Ledger 3) Trial balance
Exercise 4:
The following transactions occurred during March 2021 at
ABC Company:
Mar.1: Mona started the business by investing L.E 300000 cash.
Mar.8: Purchased land for L.E.100000, paid half cash and the
remaining by notes
Mar.10: Purchased building for L.E 70000, paid half by notes.
Mar.15: Purchased equipment for L.E.90000, paid half cash.
Mar.18: Purchased inventory L.E.20000 cash.
Mar.20: Paid salaries L.E.2000, rent L.E.30000, and utilities
L.E.1000.
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Mar.22: Sold half the land for L.E.56000, collected half cash.
Mar.24: Received advertising bill for L.E.1000.
Mar.28: Paid the on account of date Mar.8.
Mar.30: Paid half the on account of date Mar.10.
Mar.31: Collected the on account of date Mar.22.
Required:
Prepare: 1) Journal 2) Ledger 3) Trial balance
Exercise 5:
Collected the following information from XYZ Company:
July 1: Sara started the business by investing L.E.400000
involving L.E.150000 land and the remaining cash.
July 2: Purchased building for L.E.60000, paid one third cash
and signed a note for the remaining amount
July 7: Purchased equipment for L.E.90000.
July 10: Purchased stocks for L.E.20000 cash.
July 15: Purchased car for L.E.50000 cash.
July 20: Sold half the stocks for L.E.9000.
July 25: Sent a bill L.E.2000 to customers for a service rendered.
July 27: Paid the on account of date July 7.
July 30: Received the on account of date July 20.
Required:
Prepare: 1) Journal 2) Ledger 3) Trial balance
Exercise 6:
Collected the following information from Modern Company:
Aug.1: Ahmed started his business by investing L.E.250,000,
L.E.150,000 buildings and the remaining cash.
Aug.3: Purchased land for L.E.50,000 cash.
Aug.5: Purchased inventory for L.E.40,000, paid one quarter cash.
Aug.6: Purchased computer for L.E.10,000.
Aug.10: Made a deal to sell the inventory for L.E.38,000.
Aug.15: Sold half the land for L.E.30,000 cash.
Aug.20: Sold the inventory for L.E.38,000, received 18,000 cash.
Aug.22: Paid the on account of date Aug.5.
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Aug.25: Withdrew L.E.2,000 cash for his personal use.
Aug.30: Received the on account of date Aug.20.
Aug.31: Paid salaries L.E.20,000 cash.
Required:
Prepare: 1) Journal 2) Ledger 3) Trial balance
Exercise 7:
Prepare the journal entries required for each of the following
transactions:
a- Baher invested L.E. 50,000 cash in his business.
c- Received L.E.800 cash for services performed for customers.
d- Services were performed for customers on account amounted
to L.E.1,200.
e- Purchased office supplies L.E.1,000.
f- Purchased a computer system L.E. 3,000, paid half by notes.
g- Paid L.E.5,000 salaries.
h- Agreed to perform services on credit.
Exercise 8:
Collected the following information during October:
Oct.1: Akram started his business by investing L.E.500,000
consisting of L.E.100,000 land, L.E.150,000 equipment and the
remaining cash.
Oct.5: He purchased car for L.E.100,000, paid half cash.
Oct.7: Purchased building for L.E.80,000.
Oct.10: Paid cash L.E.12,000 salaries, L.E.3,000 rent, and
L.E.5,000 insurance.
Oct.15: Received advertising bill L.E.2,000.
Oct.18: Agreed to sell half the land for L.E.60,000.
Oct.20: Paid the on account of date October 10th .
Oct.25: Sold half the land for L.E.60,000, collected half cash.
Oct.30: Sent a bill L.E.2,500 to customers for services rendered.
Oct.31: Received the on account of date October 25th.
Required:
Prepare: 1) Journal 2) Ledger 3) Trial balance
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Exercise 9:
The following transactions occurred during May 2021 in the
King Company:
a- The owner invested L.E. 80,000 cash in the business.
b- Purchased delivery equipment on account for L.E. 50,000.
c- Earned, but did not yet receive delivery fee revenue L.E.1,000.
d- Collected the account receivable for the delivery fees L.E.1,000.
e- Paid the account payable for the delivery equipment purchased
L.E.50,000.
f- Paid utilities for the month in the amount of L.E. 500.
g- Paid L.E.1,500 salaries for the month.
h- Incurred delivery expenses L.E.400, but did not yet pay for them.
i- Purchased more delivery equipment for cash L.E.10,000.
j- Performed delivery services on account L.E.5,000.
Required: Prepare (journal - ledger- trial balance).
Exercise 10:
The balance sheet for Badr Company at December 31, 2020 :
Badr Company
Balance Sheet
31/12/2020
Assets Liabilities & Owner's Equity
Fixed Assets Liabilities
Land 80,000 Fixed Liabilities
Current Assets Loan 50,000
Cash 100,000 Current Liabilities
A/R 20,000 A/P 50,000
Owner's Equity
Badr, Capital 100,000
Total 200000 Total 200000
The following transactions happened during January 2021:
Jan.1: Badr purchased a computer for L.E.20,000 cash.
Jan.3: He purchased inventory for L.E.30,000.
Jan.6: Purchased furniture for L.E.30,000.
Jan.12: Sold half the land for L.E.45,000 cash.
Jan.17: Sold the inventory for L.E.28,000, received half cash.
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Jan.22: Paid the on account of date Jan.6.
Jan.23: Paid salaries L.E.15,000 cash.
Jan.27: Received the on account of date Jan.17.
Required:
Prepare: 1) Journal 2) Ledger 3) Trial balance
Exercise 11:
Collected the following information about Huda Company:
Hoda Company
Balance Sheet
December 31, 2020
Assets Liabilities & Owner’s Equity
Fixed Assets Liabilities
Land 150,000 Fixed Liabilities
Building 80,000 Loan 120,000
Accumulated Dep.: B (16,000) Current Liabilities
Equipment 50,000 N/P 40,000
Accumulated Dep.: E (10,000) A/P 30,000
Current Assets
Cash 100,000 Owner’s Equity
A/R 20,000 Hoda, Capital 234,000
Inventory 50,000
Total 424,000 Total 424,000
The following transactions occurred during January 2021:
Jan.2: Hoda deposited L.E. 50,000 of her personal funds in the
bank account of the business.
Jan.10: Sold one quarter of the equipment for L.E.12,000.
Jan.15: Purchased inventory for L.E.5,000 cash.
Jan.20: Collected the on account of date Jan.10th.
Jan.25: Paid the notes payable owed last year.
Required:
Prepare: 1) Journal 2) Ledger 3) Trial balance
115
Exercise 12:
Collected the following information about Nora Company:
Nora Company -Balance Sheet
December 31, 2020
Fixed Assets Liabilities & Owner’s Equity
Car 50,000 Liabilities
Office Furnishings 40,000 Current Liabilities
Computer System 7,000 A/P 50,000
Current Assets
Cash 80,000 Owner’s Equity
N/R 33,000 Nora, Capital 160,000
Total 210,000 Total 210,000
The following transactions occurred during January 2021:
Jan.5: Nora purchased office furnishings for L.E.2,000.
Jan.6: Paid rent L.E.2,500.
Jan.17: billed customers for services rendered L.E.5,000.
Jan.19: Paid half the accounts payable owed last year.
Jan.22: Collected half the on account of date Jan.17th.
Jan.28: Paid the on account of date Jan.5th.
Jan.30: Withdrew L.E.8,000 for her personal use.
Required:
1) Journal 2) Ledger 3) Trial balance
116
Chapter (4)
117
1 – Introduction
Companies prepare four financial statements from the
summarized accounting data:
1- An income statement presents the revenues and expenses and
resulting net income or net loss for a specific period of time.
118
(a) The income statement :
A financial statement summarizing the results of operations
of a business by matching its revenue and related expenses for a
particular accounting period shows the net income or net loss.
(b) The statement of owner’s equity:
A financial statement summarizing the changes in owner’s
equity occurring in a business organized as a sole proprietorship
covers the same period of time as does the income statement.
(c) The balance sheet:
A financial statement showing the financial position of an
entity by summarizing its assets, liabilities, and owner’s equity at
one specific date.
(d) The statement of cash flows:
A financial statement summarizing the cash receipt and
payments in the time period covered by the income statement.
(a) The Income Statement
A financial statement summarizing the results of operations
of a business its revenue and related expenses for a particular
accounting period shows the net income or net loss.
Net profit:
Net income is an increase in owner’s equity resulting from the
profitable operations. Also, the excess of revenue earned over the
related expenses for a given period. Therefore, accountants say that
net income is equal to revenue mines expenses.
Net loss:
119
Net loss is a decrease in owner’s equity resulting from the
unprofitable operations. The excess of expenses than revenues
(b) The statement of Owner’s Equity
The statement of owner’s equity summarize the increase and
decrease during the accounting period in the amount of owner’s
equity increases results from earning net losses and from
withdrawals of assets by the owner.
(C) The balance sheet
The purpose of a balance sheet is to show the financial position of
a given business entity at a specific date. Every business prepares a
balance sheet at the end of the year, and many companies prepare
one at the end of each month. A balance sheet consists of a listing
of the assets, the liabilities and the owner’s equity of a business.
The balance sheet date is important, as the financial position of a
business may change quickly. A balance sheet is most useful if it is
relatively recent.
120
Cars XX - with drawls XX
Intangible assets XX + net income XX
Investment in XX
Subsidiaries
Machinery XX
XX XX
This format based upon preparing financial position statement
in two sides, the debit sides represent assets and other side (credit)
represents liabilities and owner’s equity, so that using balance sheet
term to show financial position as follows:
121
top of the balance sheet, immediately below accounts
receivable.
Merchandising activities compared with the Manufacturing
activities:-
Most merchandising companies purchase their inventories
from the other business organization in a ready- to – sell
condition companies that manufacture their inventories,
such as General Motors, Apple Computer, and Boeing
Aircraft, are called Manufactures, rather than the
merchandise. the operating cycle of a manufacturing
company is longer and more complex than that of a
merchandising company, because the first transactions –
purchasing merchandise – is replaced by the many
transactions involved in manufacturing the merchandise.
Our examples and illustrations in this chapter are
limited to companies that purchase their inventory in a ready
–to- sell condition. The basic concepts, however, also apply
to manufacturers.
Income statement of a merchandising company
Selling merchandise introduces a new and major cost of
doing business :
The cost to the merchandising company of the goods which
it resells to its customers . this cost is termed the cost of
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goods sold . In essence , the cost goods sold is an expense ;
however , this item is of such importance to a merchandising
company that it is shown separate from other expenses in
the income statement.
A highly condensed income statement for a
merchandising business is shown below . in comparison
with the income statement of a service- type business, the
new features of this statement are the inclusion of the cost
of goods sold and a subtotal called gross profit .
Hani Company
Considered income statement
For the year ended December, 31 , 2020
Revenue from sales………………………………………… 262000
Less: cost of goods sold…………………………………… (159000)
Gross profit …………………………………………………103000
Less: expenses ………………………………………………(75700)
Net income ………………………………………………… 27300
123
Gross profit is a useful means of measuring the
profitability of sales transactions , but it does not represent
the overall profitability of the business . A merchandising
company has many expenses other than the cost of goods
sold . Examples include salaries , rent , advertising , and
depreciation . The company only earns a net income if its
gross exceeds the sum of these other expenses.
Classified income statement
To this point , we only illustrated unclassified income
statement The unclassified income statement has only two
categories of items. revenues and expenses. Now a
classified income statement will be introduced .
A classified income statement divides both revenues and
expenses into operating and non operating items. The
statement also separates operating expenses into selling and
administrative expenses . A classified income statement is
also called a multiple – step income statement.
Note that the income statement has four major sections:
1. Operating revenues.
2. Cost of goods sold.
3. Operating expenses.
124
4. Non-operating revenues and expenses (other
revenues and other expenses) .
The term operating revenues refers to the revenues
generated by the major activities of the business – usually
the sale of products or services or both.
Cost of goods sold is the major expense in
merchandising companies It is common to highlight the
amount by which sales revenues exceed the cost of goods
sold in the top part of the income statement .The excess of
net sales over cost of goods sold is called margin or gross
profit.
Operating expenses for a merchandising company are
those expenses, other than cost of goods sold , incurred in
the normal buying , selling , and administrative functions of
a business. Operating expenses are usually classified as
either selling expenses or administrative expenses.
Selling expenses are those expenses which are incurred In
the selling and marketing efforts. Examples include salaries
and commissions of salespersons, salespersons’ travel ,
delivery , advertising, rent on sales building , sales supplies
used , utilities on sales building, and depreciation on
equipment used in sales.
125
Administrative expenses are those expenses incurred in the
overall management of a business. Examples include
executive salaries , rent on administrative building ,
insurance , administrative supplies used , and depreciation
on office equipment.
Certain operating expenses may be related partly to the
selling function and partly to the administrative function.
For example, rent, taxes, and insurance on building might
be incurred for both sales purposes and administrative
purposes.
Expenses covering both the selling and administrative
functions may be analyzed between the two functions in the
income statement.
Non operating revenues ( other revenues) are
revenues not related to the sale of products or services
regularly offered for sale by business . An example for non
operating revenue is interest earned on notes receivable by
a company .
Non operating expenses ( other expenses ) are those
not related to the acquisition and sale of products or services
regularly offered for sale . An example for a non operating
expense is interest incurred on borrowed money.
126
The more important relationships in the income
statement of a merchandising firm can be summarized
in equation form as follows:
1. Net sales= Gross sales – Sales discounts – Sales
returns and allowances.
2. Cost of goods sold = Beginning inventory + Net
cost of purchases – Ending inventory.
3. Net cost of purchases = Net purchases +
Transportation-in
4. Net purchases = Purchases – Purchases discounts
– Purchases returns and allowances.
5. Gross margin = Net sales _ cost of goods sold.
6. Net income from operations = Gross margin –
operating ( selling and administrative ) expenses.
7. Net income = Net income from operations + Non
operating revenues – Non operating expenses.
Inventory
Inventory is defined as tangible personal property:
1- Held for sale in the ordinary course of business or (finished goods)
2- In the process of production for such sale, or (work-in-process)
3- To be used currently in the production of goods or services to be available
for sale... (Raw martial)
127
We must distinguish between inventories in
128
A- Trade discount:- B- Cash discount:-
Note that:
The cash discount is called purchase discount from the buyers’ point of view, and
sales discount from the sellers’ point of view.
2- Determining inventory and cost of goods sold:
The determination of cogs and inventory depends upon the method used to record
the inventory: Periodic or perpetual.
A- Periodic system
Under this system, the inventory on hand and the cost of goods sold for the year
are not determined until year-end. A+ the end of the year, all goods on hand are
counted and then priced at cost using one of the regular methods.
(Weighted – average, FiFo, Lifo) and simple average cost of foods sold is then,
computed as follows:
1- For Merchandising co.:
+ Beginning inventory xx
Add: Purchases daring the year xx
- cost of goods available for sale xx
Less: Ending inventory xx
CGS xxx
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2- For manufacturing co.:
Beginning inventory xx
Add: Cost of goods manufactured * xx
-------
Cost of goods available for sale xx
Less: Ending inventory xx
--------
CGS xx
* Cost of goods manufactured is computed as Follows: *
Direct materials used xx
+ Direct Labor xx
+ Factory overheads xx
---------
Total Manufacturing costs xx
+ WIP, beginning xx
- WIP, ending xx
---------
Cost of goods manufactured xxx
* To compute the value of direct materials used, we apply the following formula:
Beginning inventory of raw materials xx
+ Purchases of raw materials xx
-----
Cost of materials available for use xx
- ending inventory of raw materials xx
-----
Cost of material used xx
It should be noted that in all Cases merchandising and manufacturing companies",
any write-down of inventory should be removed when computing cogs. [By
deducting it from the end inventory value]
Under the periodic inventory system:
When goods are purchased:
The entry is:
Purchases xx
Cash xx
Or accounts payable xx
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When goods are sold:
The entry is:
Cash xx
Or accounts receivable xx
Sales xx
B- Perpetual inventory system:
Under the perpetual inventory system, a running total is kept of the units on hand
(and possibly their value) by recording all increases and decreases as they occur.
Under this system:
when goods are purchased (purchased inventory):
the entry is:
inventory xx
cash xx
or A/P xx
When goods are sold (sales inventory)
We prepare two entries
Cash xxx
Or Acc. receivables xxx
Sales xxx
C.G.S xxx
Inventory xxx
The cost of goods sold is determined using one of the regular methods
Summary
Accounting for merchandising Activities
131
Inventory x purchases x
A/P/cash x A/P/cash x
Sales of merch. :
Sales of merch. :
A/R/cash x
Sales x A/R x
------------------------------- Sales x
Cost of goods sold x
Payments of A/P:
Inventory x
A/P x
Payments of A/P: Cash x
A/P x
Collecting receivables :
Cash x
Collecting receivables : Cash x
Cash x A/R x
A/R x Taking a physical inventory (end-bal)
Purchases return :
A/P x Cost of goods sold xxx
Inventory x Inventory (Beg) x
Taking a physical inventory (end Bal) Purchases x
Cost of goods sold x
Inventory (end) x
Inventory x
Cost of goods sold x
Income Statement: Income Statement
* cost of goods sold = Beg. Inventory
Net sales Xx
(-) Cost of goods sold (x)
+ Net purchases
Gross profit Xx - End Inventory
Operating expanses (-) * Net purchases = purchases
Selling expenses X
General expenses X X
+ freight in expenses
Operating income Xx - Purchases count
(+) interest revenue X - purchases return
(-) loss or sales (x)
Income before tax Xx Gross profit margin Gross profit
(-) interest expenses (x) ----------------
(-) Tax (x) net sales
Net income Xx
* Net sales = gross sales –
sales return – sales
discount- sales allowance
Hany Company
Income statement
For the year ended June,30, 2020
132
Operating revenues:
Gross sales ………………………………….…. $ 282,0000
Less: Sales discounts ………………………… $ 5,000
Sales returns and allowances…………… 15,000 20,000
Net sales ……………………………………… $ 262,000
Cost of goods sold:
Merchandise inventory , July 1 , 2013……….. $ 24,000
Purchases…………………………………………. $ 167,000
Less: Purchases discounts………………………. $ 3,000
Purchases returns and allowances……….. 8,000 11,000
Net purchases ……………………………………. $ 156,000
Add: transportation –in ………………………….. 10,000
Net cost of purchases…………………………… 166,000
Cost of goods available for sale…………………. $ 190,000
Less: merchandise inventory, June 30,2004…….. 31,000
Cost of goods sold………………………………... 159,000
Gross margin…………………………………… $ 103,000
Operating expenses:
Selling expenses:………………………………….
Sales
Sales salaries
salaries and commissions …………………
……………… $ 26,000
Salespersons’ travel……………………………… 3,000
Delivery………………………………………………. 2,000
Advertising……………………………………… 4,000
Rent-store building………………………………….. 2,500
Supplies used………………………………………… 1,000
Utilities…………………………………………………. 1,800
Depreciation – store equipment……………………… 700
Other selling expenses…………………………………. 400 $ 41,400
Administrative expenses: ……………………………..
Salaries , executive ……………………………………. $ 29,000
Rent – administrative building………………………… 1,600
Insurance……………………………………………….. 1,500
Supplies used………………………………………… 800
Depreciation – office equipment………………………. 1,100
Other administrative expenses…………………………. 300
34,300
Total operating expenses $ 75,700
Net income from operations $ 27,300
Non operating revenues and expenses:
Non operating revenues:
Interest revenue 1,400
$ 28,700
Non operating expenses:
Interest expense 600
Net income $ 28,100
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Problem:
C M S COMPANY
Trial balance
July , 31, 2020
Debits Credits
Cash………………………………………………………. $ 34, 780
Accounts receivable……………………………………… 4, 600
Merchandising inventory, 8/1/2013…………………… 31,400
Prepaid fire insurance……………………………………. 720
Prepaid rent………………………………………………. 4,800
Office equipment………………………………………… 12,000
Accumulated depreciation – office equipment…………. $ 4,500
Accounts payable……………………………………….. 8,000
Clay Camp, capital ……………………………………… 22,000
Clay Camp, drawing …………………………………….. 20,000
Sales……………………………………………………… 300,000
Sales returns and allowances…………………………….. 1,000
Purchases………………………………………………… 199,200
Purchases returns and allowances………………………. 1,400
Advertising expenses…………………………………….. 1,000
Supplies expenses……………………………………….. 1,800
Salaries expense …………………………………………. 23,200
Utilities expense………………………………………….. 1,400
$ 335,900 $335,900
335,900
Additional data:
1. A 12 month fire insurance policy was purchased for $ 720 on April 1 ,
2020 the date on which insurance coverage began.
2. On February 1 , 2020 Camp paid $ 4,800 for the next 12 months’ rent .
the payment was recorded in the prepaid rent account.
3. depreciation expense on the office equipment is $ 1,500.
4. Merchandise inventory at July 31 , 2020 was $ 26,400.
Required:
a- Prepare a classified income statement for the fiscal year ended
July 31, 2020.
b- Prepare a statement of owner’s equity for the fiscal year ended July
31, 2020.
c- Prepare a 10-column worksheet for the fiscal year ended July 31,
2020.
d- Prepare a classified balance sheet for July 31, 2020.
e- prepare closing entries.
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Solution
C M S COMPANY
Statement of owner’s Equity
For the year ended July 31, 2020
Capital, August 1, 2020…………………… $ 22,000
Net income for the year……………………… 64,660
Total ……………………………………. $ 86,660
Less: drawings ……………………………….. 20,000
Capital , July , 31 , 2020 $ 66, 660
135
CMS COMPANY
Worksheet
For the year ended July 31,2020
Adjusted trial
Accounts titles Trial balance Adjustments Income statement Balance sheet
balance
Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr
Cash 34,780 34,780 34,780
Accounts receivable 4,600 4,600 4,600
Merchandising inventory 31,400 31,400 31,400 26,400 26,400
Prepaid fire insurance 720 (1) 720 480 1,100 480
Prepaid rent 4,800 (2) 2,400 2,400 2,400
Office equipment 12,000 12,000 12,000
Accumulate depreciation – office equipment 4500 (3) 1,500 6,000 6,000
Accounts payable 8,000 8,000 8,000
Clay Camp, capital 22,000 22,000 22,000
Clay Camp, drawing 20,000 20,000 20,000
Sales 300,000 300,000 300,000
Sales returns and allowances 1,000 1,000 1,000
Purchases 199,200 199,200 199,200
Purchases returns and allowances 1,400 1,400 1,400
Advertising expenses 1,000 1,000 1,000
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C M S COMPANY
Balance sheet
July , 31, 2020
Assets
Current assets:
Cash………………………………………………….. $ 34, 780
Accounts receivable…………………………………… 4,600
Merchandise inventory………………………………… 26,400
Prepaid fire insurance………………………………….. 480
Prepaid rent……………………………………………. 2,400
Total current assets $ 68,600
Property , plant, and equipment:
Office equipment………………………………………. $ 12,000
Less: accumulated depreciation …………………….. 6,000
Total property , plant, and equipment…………….. 6,000
Total assets…………………………………….. $ 74,660
Liabilities:
Account payable ………………………………………. $ 8,000
Owner’s equity:
Clay Camp , capital ………………………………….. 66,660
Total liabilities and owner’s equity $ 74,660
137
Net Depreciati Rent Fire Utilities Salaries Supplies CMS
income on expense expense insurance expense expense expense COMPAN
– office expense Y
equipment Worksheet
Accounts For the
titles year ended
July
31,2020
138
nts
4,140 Cr
100,660 Dr
Balance
sheet
100,660 64,660 Cr
e- Closing entries
2020
July 31 Merchandise inventory …………… 26,400
Sales………………………………… 300,000
Purchase returns and allowance……. 1,400
Income summary ………………... 327,800
139
Illustration: (1)
140
EL-SALAM AUTO SERVICE Trial balance -December 31, 2020
Debit Credit
Cash……………….. 13,420
Account receivable………………………. 600
Shop supplies………………….. 1,000
Land……………………………………… 52,000
Building………………………………… 36,000
Accumulated depreciation building 1800
Tools and equipment ……………… 12,000
Accumulated dep. : tools & equipment 1200
Notes payable……………… 30,000
Accounts payable……….. 8,870
The capital 75,000
Withdrawals by owner……… 3,100
Repair service revenue ……… 10,380
Advertising expenses……………… 830
Wages expenses……… 4,900
Supplies expenses…………. 400
Depreciation expenses : building……… 1800
Depreciation expenses : tools & equipment 1200
$127250 $127250
Required :
1- Prepare income statement
2- Prepare owner's equity
3- Prepare balance sheet
141
Solution
AL- SALAM AUTO SERVICES
Income statement For the month ended December 31, 2020
Revenue :
Repair service revenue……….. 10,380
Expenses:
Advertising expenses…………. 830
Wages expenses ……………… 4,900
Supplies expenses…………….. 400
Depreciation expenses: building 1800
Depreciation expenses: tools increase
1200 9,130
&equipment owner’s
Net income (profit) 1250 equity
Cash………………………………………. 13,420
Accounts receivable……………………… 6,00
Supplies………………………………….. 1,000
Land……………………………………… 52,000
Building………………………………….. 36,000
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Less: accumulated depreciation 1800 34200
Tools and equipment 12,000
Less: accumulated depreciation 1200 10,800
112,020
Liabilities & owner’s equity
Illustrate (2) : the following is the trial balance for “X” company:
143
Creditors 50000
Capital 149000
Total 554000 554000
Required:
Prepare the income statement and balance sheet for “X” company, if you know
that ending inventory = 7000 and depreciation rate = 10%.
Solution:
Income statement:
Item Parts Parts Total
Sales 200000
- sales return 2000
- sales discount 1000
Net sales 197000
Beginning inventory 10000
Purchases 20000
+ transportation in 2000
Gross purchases 22000
- purchases return 2000
- purchases discount 3000
Net purchases 17000
Cost of goods available for sale 27000
- ending inventory 7000
Cost of goods sold 20000
Gross profit 1770000
- rent expenses 5000
- salaries 10000
- transportation out 3000
- depreciation expenses (a) 10000
Total expenses 28000
Net profit 149000
Note:
(a) Depreciation expense = fixed assets * depreciation rate.
= 100000 (equipment) * 10/100 = 10000.
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Balance sheet:
Assets Parts Total Liabilities & O.E Parts Total
Cash 100000 Loan 100000
Account receivables 100000 Accounts payable 50000
Ending inventory 7000 Creditors 50000
Total current assets 207000 Total current liab. 100000
Land 200000 Total liabilities 200000
Equipment 100000 Capital 149000
- accumulated dep. 10000 - drawings 1000
Net fixed assets 290000 + profit 149000
Total O.E 297000
Total assets 497000 Total liabilities & 497000
O.E
Illustrate (3): You have the following trial balance for “XYZ”
company at 31/12/2020:
Required:
145
Solution:
1- Trial balance
ITEM DR CR
Land 100000
Building 60000
Cash 52000
Machines 50000
Acc.dep building 12000
Acc.dep machines 5000
Beg inv 20000
Sales 80000
Sales discount 2000
Sales return 4000
Purchases 30000
Purchase return 3000
Purchase discount 2000
Transportation in 3000
Transportation out 2000
A/P 20000
Loan 40000
Withdrawals 2000
Salaries 6000
Insurance 4000
Heat & light 2000
Capital 175000
Total 337000 337000
Income statement:
Item Parts Parts Total
Sales 80000
- sales return (4000)
- sales discount (2000)
Net sales 74000
Beginning inventory 20000
Purchases 30000
+ transportation in 3000
- purchases return (3000)
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- purchases discount (2000)
- ending inventory (10000)
Cost of goods sold (38000)
Gross profit 36000
- heat & light 2000
- salaries 6000
- transportation out 2000
-insurance 4000
-dep. Exp. (building) 6000
-dep .exp. (machine) 5000
Total expenses (25000)
Net profit 11000
Balance sheet:
Assets Parts Total Liabilities & O.E Parts Total
Cash 52000 Loan 40000
Accounts payable 20000
Ending inventory 10000
Total current assets 62000
Land 100000 Total liabilities 60000
Machines 50000 Capital 175000
-acc. dep. Machine (10000) 40000
Building 60000 - drawings (2000)
-acc. Dep. Building (18000) 42000
Net fixed assets 182000 + profit 11000
Total O.E 184000
Total assets 244000 Total liabilities & O.E 244000
147
Summary:
1 – Prepare the four financial statements:
• The balance sheet statement.
• The statement of owner’s equity.
• The income statement.
• The statement of cash flows.
2 -Understand that income statement lists revenues first, followed
by expenses. Finally the statement shows net income (or net
loss). Net income results when revenues exceed expenses. A
net loss occurs when expenses exceed revenues.
3 -Understand that the owner’s equity statement reports the
changes in owner’s equity for a specific period of time. The
time period is the same as that covered by the income statement.
4 -Observe that the balance sheet lists assets at the top, followed
by liabilities and owner’s equity. Total assets must equal total
liabilities and owner’s equity.
5 -Observe that the statement of cash flows provides information
on the cash receipts and payments for a specific period of time.
The statement of cash flows reports (1) the cash effects of a
company’s operations during a period, (2) its investing
transactions, (3) its financing transactions, (4) the net increase
or decrease in cash during the period, and (5) the cash amount
at the end of the period.
148
6 -The income statement, owner’s equity statement, and
statement of cash flows are all for a period of time, whereas the
balance sheet is for a point in time.
149
Questions
The First Questions Answer The Following:
1. Another term for an accounting period is an _______.
2. The statement that shows net income for the period is known
as the ______ statement.
3. Two groups of items that make up the income statement are
_____ and _________.
4. Assets must equal _________.
5. Expense and income must be matched in the same
___________.
Answers: 1. accounting statement; 2. income; 3. income, expense;
4. liabilities and capital; 5. year or period
The First Questions Solve The Following Problems:
Problem 1: Indicate the name of the account group—Income
(I), Expense (E), Asset (A), Liability (L), or Capital (C)—in
which each of the following accounts belongs:
(a) Accounts payable (g) Equipment
(b) Accounts receivable (h) Fees income
(c) Building (i) Interest expense
(d) Supplies (j) Interest income
(e) Cash (k) Notes payable
(f) Drawing (l) Rent income
Solution:
(a) L (b) A (c) A (d) A (e) A (f ) C (g) A (h) I (i) E ( j) I (k) L (l) I
150
Problem 2: Below is an income statement with some of the
information missing. Fill in the information needed to complete
the income statement.
Sales Income (b)
Operating Expenses:
Wages Expense $16,000
Rent Expense (a)
Utilities Expenses $3,150
Total Expenses $32,150
Net Income $41,300
Solution:
(a) $13,000
(b) $73,450
Unsolved problems:
Exercise 3:
During June 2020, transactions made by Amgad Crop Dusting
Company were as follows:
June 1: Amgad deposited L.E.60,000 cash in a bank account in the
name of the business.
June 2: Purchased a crop-dusting aircraft for L.E.220,000. Made
L.E.40,000 cash down payment and issued a note payable for
L.E.180,000.
June 4: Paid rent L.E.2,500 to rent office and hanger space for the
month.
June 15: Billed customers L.E.8,320 for crop-dusting services
rendered during the first half of June.
June 18: Paid L.E.1,890 for maintenance and repair services.
June 25: Collected L.E.4,910 of the amounts billed to customers on
151
June 15.
June 30: Billed customers L.E.16,450 for crop-dusting services
rendered during the second half of the month.
June 30: Paid L.E.11,880 salaries to employees for services rendered
during June.
June 30: Received a fuel bill for L.E.2,510 of aircraft fuel purchased
during June. This amount is due by July 10.
June 30: Amgad withdrew L.E.2,000 cash from the business for
personal use.
Required:
1) Journal
2) Ledger
3) Trial balance
4) An income statement, owner’s equity statement, and balance sheet.
Exercise 4:
The business transactions, during September 2020, made by
Karim Pediatric Dentistry are listed below:
Sep.1: Karim opened a bank account in the name of the business
by depositing L.E. 50,000 cash, which he had saved over a number
of years .
Sep.10: Purchased a small office building for a total price of
L.E.182,400, of which L.E.106,000 was applicable to the land and
L.E.76,400 to the building. A cash payment of L.E.36,500 was made
and a note payable was issued for the balance of the purchase price.
Sep.15: Purchased a microcomputer system from Computer Stores,
Inc., for L.E.4,680 cash.
Sep.19: Purchased office furnishings, including dental equipment,
at a cost of L.E.5,760. A cash down payment of L.E.960 was made,
152
the balance to be paid in three equal installments due September 28,
October 28, and November 28. The purchase was on open account
and did not require signing of a promissory note.
Sep.26: AL.E.140 monitor in the microcomputer system purchased
on September 15 stopped working. The monitor was returned to
Computer Stores, Inc., which promised to refund the L.E.140 within
five days.
Sep.28: Paid L.E.1600 cash as the first installment due on the
account payable for office furnishings.
Sep.30: Received L.E.140 cash from Computer Stores ,Inc., in full
settlement of the account receivable created on September 26.
Required:
Prepare: 1) Journal 2) Ledger 3) Trial balance
4) An income statement, owner’s equity statement, and balance sheet.
Exercise 5:
Maged center is a new business organized on May 1, 2020.
The following transactions occurred during May prior to the
company beginning its regular business operations:
May 1: Maged opened a bank account in the name of the
business with a deposit of L.E 130,000 cash.
May 2: Purchased an office building for L.E 80,000 cash.
May 6: Purchased land for a total price of L.E 150,000. Cash
down payment of L.E 30,000 was made and a note payable
was issued for the balance of the purchase price.
May 15: Purchased office equipment L.E 12,000on credit from
153
Al Ahram Company.
May 29: Paid L.E10,000 of the amount owed to Al Ahram Company.
Required:
1) Prepare journal entries for the month of May.
2) Post to ledger accounts.
3) Prepare a trial balance at May 31, 2020.
4) Prepare an income statement, owner’s equity statement, and
balance sheet.
Exercise 6:
Noha Enterprise
Adjusted Trial Balance
December 31, 2020
Cash L.E. 41,100
Accounts receivable 7,800
Buildings 180,000
Accumulated depreciation : L.E. 36,000
Equipment 270,000
buildings
Accumulated depreciation: 90,000
Accounts payable 23,100
equipment
Salaries payable 6,900
Noha, Capital (December 31, 331,560
Noha, Drawing 75,000
2007)
Admission revenue 576,000
Advertising expense 45,000
Rent expense 108,000
Repairs expense 15,600
Salaries expense 237,000
Light & power expense 13,500
Depreciation expense : 18,000
Depreciation expense : 45,000
buildings
Insurance expense 7,560
equipment
Total L.E.1,063,560 L.E.1,063,560
L.E.1,063,560 L.E.1,063,560
154
Required:
1) Prepare an income statement and a statement of owner’s equity
for the year ended December 31, 2020.
2) Prepare a balance sheet as of December 31, 2020.
3) Is 2020 first year of operations for Noha Enterprise? Explain
Exercise 7:
The transactions for October 2020 for the Delivery Services
Company are given below:
Oct.1: The owner invested cash L.E. 16,000.
Oct.3: Borrowed L.E. 5,000 from the bank on a note.
Oct.4: Purchased a truck for L.E. 9,300.
Oct.6: Delivery services L.E. 3,600 were performed for
customers who promised to pay later ,
Oct.7: Employee services received and paid for L.E. 1,400.
Oct.10: Collections were made for the services performed on
October 6th.
Oct.14: Office supplies were purchased for L.E. 500.
Oct.17: A bill for L.E. 500 was received for gas and oil.
Oct.25: Delivery services were performed for customers who
paid immediately L.E. 4,500.
Oct.31: Wages paid L.E. 1,500.
Oct.31: The owner withdrew L.E. 400.
Required:
1) Prepare journal entries for the month of October.
2) Post to ledger accounts.
3) Prepare a trial balance at October 31, 2020.
155
4) Prepare an income statement, owner’s equity statement, and
balance sheet.
Exercise 8:
The transactions appearing below are those of Repair Service
Company for the month of July 2020:
July 2: The owner invested L.E. 10,000 cash in the business.
July 3: Paid rent for July L.E. 500.
July 5: A truck was purchased for L.E. 3,000 cash.
July 9: A bill for L.E. 500 for adv for July was received and paid.
July 14: Cash of L.E. 1,400 was received for repair services performed.
July 15: Wages of L.E. 400 for the first half of July were paid.
July 20: Performed repair services on account L.E.400.
July 22: Office furniture was acquired for L.E. 800 on account.
July 25: The owner withdrew L.E. 300 cash.
July 30: L.E. 2,250 cash was received for repair service performed.
July 31: Wages of L.E. 400 for the second half of July were paid.
Required:
1) Prepare journal entries for the month of July.
2) Post to ledger accounts.
3) Prepare a trial balance at July 31, 2020.
4) Prepare an income statement, owner’s equity statement, and
balance sheet.
156
Exercise 9:
Presented below are the transactions of the Premier Company,
owned by Hamdy, for the month of March 2020.
Mar.1: The owner invested L.E. 20,000 cash.
Mar.5: Paid L.E.1,800 as the rent for March on an office building.
Mar.7: Billed clients L.E.16,000 for commissions’ revenue for March.
Mar.9: Paid L.E.200 for office supplies received and used in March.
Mar.15: Borrowed L.E. 5,000 from the bank on a note.
Mar.18: Collected L.E. 12,000 cash on accounts receivable.
Mar.20: Received a bill for L.E. 600 for advertising appearing in the
local newspaper in March.
Mar.25: Paid cash for gas and oil consumed in March L.E. 425.
Mar.28: Paid L.E.16,000 to employees for services provided in March.
Mar.30: The owner withdrew L.E.500 cash.
Required:
1) Prepare journal entries for the month of March.
2) Post to ledger accounts.
3) Prepare a trial balance at March 31, 2020.
4) Prepare an income statement, owner’s equity statement, and
balance sheet.
Exercise 10:
During the first month of operations of Focus Company, the
following events and transactions took place:
April 1: The owner invested L.E.32,000 cash and L.E.11,000
equipment in the business.
157
April 2: Hired a secretary at a salary of L.E. 230 per week payable
monthly.
April 3: Purchased supplies on account L.E.700.
April 7: Paid office rent of L.E.550 for the month.
April 11: Billed client L.E.1,100 for services rendered.
April 12: Received cash L.E.3,200 on a management consulting
engagement.
April 15: Purchased a new computer for L.E.8,300 with personal
funds (The computer will be used exclusively for business purposes).
April 17: Received cash L.E.900 for services completed.
April 21: Paid insurance expense L.E.110.
April 30: Paid secretary L.E. 920 for the month.
Required:
1) Prepare journal entries for the month of April.
2) Post to ledger accounts.
3) Prepare a trial balance.
4) Prepare an income statement, owner’s equity statement, and
balance sheet
158
CH 5: Adjusting & closing entries
159
1 – Introduction
Suppose that a corporation has closed its books and issued
financial statements.
160
1. Some events, such as the consumption of supplies and the
earning of wages by employees, are not journalized daily
because it is inexpedient to do so.
161
balance sheet date. Normally the adjustments are classified in the
following manner:
Prepaid (deferred) items:
Prepaid expenses (e.g., prepaid insurance)
Unearned revenues (e.g., rent received in advance)
Accrued items:
• Accrued expenses or liabilities (e.g., unpaid salaries)
• Accrued revenues or assets (e.g., interest earned but not
collected)
• Estimated items (e.g., depreciation)
The Basics of Adjusting revenues and expenses
In order to revenues to be recorded in the period in which
they are earned, and for expenses to be recognized in the period
in which they are incurred, adjusting entries are made at the end
of the accounting period. In short, entries needed to ensure that
the revenue recognition and matching principles are lowed.
The use of adjusting entries makes it possible to report on
the balance sheet the appropriate assets, liabilities, and owner's
equity at the statement date and to report on the income statement
the proper net income (or loss) for the period. However, the trial
balance-the first pulling together of the transaction data may
not contain up-to-date and complete data. This is true for the
following reasons:
162
supplies and the earning of wages by employees.
2. Some costs did not journalized during the accounting period
because these costs expire with the passage of time rather than
because of recurring daily transactions. Examples of such costs
are building and equipment deterioration and rent and
insurance.
3. Some items may be unrecorded. An example is a utility
service bill that will not to receive until the next accounting
period.
Adjusting entries are required every time financial statements
are prepared. An essential starting point is an analysis of each
account in the trial balance to determine whether it is complete
and up-to-date for financial statement purposes.
The analysis requires a thorough understanding of the
company's operations and the interrelationship of accounts. The
preparation of adjusting entries is often an involved process. In
accumulating the adjustment data, the company may need to make
inventory counts of supplies and repair parts. In addition, it may
be desirable to prepare supporting schedules of insurance policies,
rental agreements, and other contractual commitments.
Adjustments are often prepared after the balance sheet date.
However, the adjusting entries dated as of the balance sheet date.
163
these classes has two subcategories
Prepayments
1. (Prepaid Expenses) Expenses paid in cash and recorded as assets before
consumed.
2. (Unearned Revenues) Cash received and recorded as liabilities before
revenue earned.
Accruals
1. (Accrued Revenues) Revenues earned but not yet received in cash
recorded as assets.
2. Accrued Expenses. Expenses incurred but not yet paid in cash recorded
as liabilities.
Steps in accounting cycle:
The basic steps in accounting cycle are:
(1) Identification and measurement of transactions and other events.
(2) Journalizing
(3) Posting.
(4) Unadjusted trial balance.
(5) Adjustments.
(6) Adjusted trial balance.
(7) statement presentation .
(8) closing.
164
Adjusting entries can be classified as either prepayments or
accruals.
• Prepayments
3. Prepaid Expenses. Expenses paid in cash and recorded as
assets before they are used or consumed.
4. Unearned Revenues. Cash received and recorded as
liabilities before revenue is earned.
• Accruals
2. Accrued Revenues. Revenues earned but not yet received
in cash or recorded.
3. Accrued Expenses. Expenses incurred but not yet paid in
cash or recorded.
Adjusting
expenses revenues
Basic adjustments
165
1-Prepaid expense. An expense paid in cash and recorded in an
asset or expense account in advance of its use or consumption.
2- Unearned revenue. Cash received and recorded in a liability or
revenue account before it is earned
3- Accrued liabilities: (expenses). Expenses incurred but not yet paid
4- Accrued assets: (revenues). Revenues earned but not yet
received
5- Estimated items. Expenses recorded on the basis of subjective
estimates of unknown future events or developments
1. Accrual basis :
Same small and service businesses use cash basis accounting. This
accounting method aim to record only cash revenues and cash expenses.
Accrual Vs. Cash Basis Of Accounting
What you have learned in this chapter is the. Accrual basis
accounting means that transactions that change a company's financial state-
ments are recorded in the periods in which the events occur, rather than in
the periods in which the company receives or pays cash.
For example, using the accrual basis to determine net income means
recognizing revenues when earned rather than when the cash is received,
and recognizing expenses when incurred rather than when paid.
166
Information presented on an accrual basis reveals relationships likely to be
important in predicting future results.
To illustrate, under accrual accounting, revenues generally
recognized when services are performed so they can be related to the
economic environment in which they occur. Trends in revenues are thus
more meaningful for decision-making purposes.
Under cash basis accounting, revenue is recorded only when the cash
is received, and an expense is recorded only when cash is paid.
As a result, the cash basis of accounting often leads to misleading
financial statements. For example, it fails to record revenue which has
been earned but for which the cash has not been received, violating the
revenue recognition principle.
In addition, expenses are also not matched with earned revenues and
therefore the matching principle is not followed. Therefore, the cash basis
of accounting is not in accordance with generally accepted accounting
principles.
Example:
El Aqsa Company performed services and earned revenue, LE
15000 on April 7, 2020. collected LE 12000 on April 16, 2020.
Required: Journal entries using:
(a)Accrual accounting method
(b) Cash basis accounting
Solution:
(A) Accrual basis:
167
Date Accounting titles and Debit Credit
explanation
2020 Accounts Receivable 15000
April , 7 Rendered Service Revenue 15000
Services revenue earned.
April 16 Cash 12000
2020 Accounts Receivable 12000
Collect LE 12000 cash from
accounts receivable
(B)Cash basis
Date Accounting titles and explanation Debit Credit
2020 Cash 12000
April 16 Rendered service revenue 12000
Service revenue collected
From the previous two examples, we can conclude:
(1) Revenues using accrual accounting method are LE 15000
(2) Revenue using cash basis are LE 12000.
3. The Accounting Period Concept:
Accountants slice the operating life of a business organization
into small segments, such as a month, quarter, or year. Financial
statements are prepared periodically for one of these accounting
periods. However, the basic accounting period is one year and
most companies prepare annual financial statements. For most
companies the annual accounting period is the calendar year,
from January 1 through Dec 31
4. Adjusting Revenue Account:
4.1 Service company:
To apply accrual accounting method, revenues earned
during the fiscal year presented in the income statement.
Amounts collected in advance do not represent revenue, because
these amounts have not been earned. Amounts collected from
customers in advance recorded by debiting the cash account and
crediting an unearned revenue account. Unearned revenue also
called deferred revenue.
168
For a service company, money collected in advance from its
customers is an obligation to render services by this company in
the future. As a result, the balance of an unearned revenue account
considered a liability; it is presented in the liability side of the
balance sheet, not in the income statement.
When a company renders the services, for which customers
have paid in advance,
It is working off its liability to these customers and is
earning revenue. At the end of the accounting period, an adjusting
entry made to reduce the balance of unearned revenue with an
appropriate amount of rendered services to be recorded in
rendered service revenue account.
This adjusting entry consists of a debit to unearned revenue
account and a credit to a revenue account.
Example:
El NASR Company collected LE 65,000 from AL shams factory
on February 6, 2020 to provide transportation services during the
next three months.
On December 31, 2020 the total amount of rendered
transportation services to Al shams factory is LE 45,000
Required:
1. Make the journal entries to record and adjust accounts on
December 31, 2020.
2. Prepare unearned revenue account in the ledger.
Solution:
Date Account titles & Explanation Debit Credit
169
2020 Cash 65,000
Feb. 6 Unearned revenue 65,000
Collected unearned revenue from al shams factory
Unearned revenue
Rendered service revenue 45,000
To record rendered services to Al shams factory 45,000
Notes:
1. Revenue earned and presented in the income statement for
the year ended December 31, 2020, LE 45000.
2. Balance of unearned revenue is LE 20,000 presented as a
liability in the balance sheet prepared at December 31,
2020.
170
4.2 Merchandizing Companies:
(a) Sales on credit (unearned revenues)
Merchandizing companies sell goods to customers. Sales on
credit are recording by debiting accounts receivable account and
crediting sales revenue account.
At the year end, credit sales may not be recorded for delivery
delay of merchandise or for another reason. These unrecorded
sales are recorded by an adjusting journal entry. By this adjusting
entry, accounts receivable is debit and sales revenue is credit.
Revenues received in cash and recorded as liabilities before
they are earned are called unearned revenues. Airlines such as
united, American, and delta, for insurance, treats receipts from
the sale of tickets as unearned revenue until the flight service is
provided.
171
practical to make daily recurring entries as the revenue is earned.
In such cases, the recognition of earned revenue is delayed until
the adjustment process. Then an adjusting entry is made to record
the revenue that has been earned and to show the liability that
remains. A liability –revenue account relationship therefore exists
with unearned revenues. In the typical case, liabilities are
overstated and revenues are understated prior to adjustment.
Thus, the adjusting entry for unearned revenues results in a debit
to a liability account and a credit to a revenue account.
172
Dec. 31
Unearned rent revenue 20,000
Rent revenue 20,000
(To recognize as revenue one-third of $ 60,000)
Example:
El shorouk trading had the following balances on Dec 31, 2020
LE 860,000 Accounts Receivable – LE Sales Revenue 3,510,000
LE 37,500 Rent Revenue - LE 15,000 Unearned Rent Revenue.
Other information:
1. There is a bill of credit sales not recorded yet in journal, LE 48,000.
2. Rent revenue was collected for 15 month.
Required:
1. Prepared adjusting entries.
2. Post to accounts receivable, rent revenue and unearned rent
revenue accounts.
3. Show the effects of the adjusted accounts on income
statement and balance sheet for the year ended December
31, 2020.
Solution:
General Journal
Date Accounts titles & Explanation Debit Credit
2020 Accounts receivable 48000
Dec. Sales revenue 48000
31 To adjust accounts receivable and sales
receivable
Rent revenue 7,500
Unearned rent revenue 7500
Dec. To adjust rent revenue by unearned rent
31 revenue
Dr. Accounts Receivable Cr.
Balance Dec. 31, 2020 860,000
Dec. 31, 2020 48,000
Balance Dec. 31, 2020 908,000
173
Dr. Rent revenue Cr.
Dec. 31, 2020 7,500 Balance 37,500
Dec.31, 2020
Balance 30,000
Dec.31, 2020
174
been earned during the period. An asset- revenue account
relationship exists with accrued revenues. Prior to adjustment,
both assets and revenues are understated. Accordingly, an
adjusting entry for accrued revenues results in a debit an asset
account and a credit to a revenue account.
Illustration
Assume that office space is rented to a tenant at $ 1,000 per
month, that the tenant has paid the rent for the first 11 months of
the year and that the tenant has paid no rent for December. The
adjusting entry on December 31 is:
Dec. 2 Dr. Cr.
Rent receivable 1,000
Rent revenue 1,000
(To record December rent)
As a result of this entry, an asset of $ 1,000, rent receivable,
appears on the balance sheet disclosing the amount due from the
tenant as of December 31. The income statement discloses rent
revenue of $ 12,000, the $ 11,000 for the first 11 month and the $
1,000 for December entered by means of the adjusting entry.
To apply accrual accounting method, accountant record the
revenues of the fiscal year regardless these revenues have been
collected or not.
If there is uncollected revenue at the year-end, an adjusting entry
is made by debiting uncollected revenue account and crediting
revenue account.
175
Example:
Top Quality Store had the following balances on December 31,
2020:
Investments LE 300000 - investment revenue LE 20000.
Other information:
1. Annual interest rate on investment, 12%.
Required:
1. Make adjusting entry on December 31, 2020
2. Post to Investment revenue account.
Solution:
General Journal
Date Account tittles & explanation Debit Credit
Uncollected revenue 16000
Investment revenue 16000
Uncollected investment revenue
(300000 x 12% - 20000)
Dr. Investment revenue Cr.
Balance Dec. 31, 2020 20000
Dec. 31, 2020 16000
Balance Dec. 31, 2020 36000
176
agreement to provide goods to a customer for LE 200000 is not
recorded as revenue.
5. Adjusting Expenses:
Prepaid Expenses:
Prepaid expenses are payments in advance for more one
accounting period or one fiscal year.
These payments in advance are made for such items as rent
insurance and office supplies.
177
relationship exists with prepaid expenses. Prior to adjustment,
assets are overstated and expenses are understated.
Cash 1,200
Dr Cr.
Dec. 31
Insurance expense 400
Prepaid insurance 400
(To charge one- third of insurance premium to expense)
Now shows an expense for insurance is $ 400 and the asset,
of prepaid insurance is $ 800. (Account titles synonymous with
unexpired insurance are prepaid or prepaid insurance expense.)
178
in the accounting period in which the service or the supplies are
used, Prepaid expenses are presented as an asset in the balance
sheet.
Example:
The following are some of the ledger account balances of MAC
store on Dec. 31, 2020:
Rent expense LE180000 – Insurance policy LE 25000
Other information:
1. Rent per month, LE 10000.
2. Insurance policy was paid for 5 years.
Required:
1. Prepare adjusting entries for the year ended December 31, 2020.
2. Post adjusting entries to prepaid rent and prepaid insurance.
3. Present the accounting balances of the above-mentioned
expenses and prepaid expenses in the income statement and
balance sheet on December 31, 2020.
Solution:
General Journal
Date Account titles & explanation Debit Credit
Dec. 31, Prepaid rent 60000
2020 Rent expense 60000
To record and adjust prepaid rent.
25000
Prepaid expense
Dec. 31, 25000
Insurance policy
2020
To close insurance policy account.
179
Insurance expense
Prepaid expense 5000
To adjust prepaid insurance 5000
Dr Prepaid Rent Cr
Dec. 31, 2020 60000
Balance Dec. 31, 2020 60000
Dr Prepaid Insurance Cr
Dec. 31, 2020 25000 Dec. 31, 2020 5000
Balance, Dec. 31, 2020 20000
Income statement
For the year ended Dec. 31, 2020
Less:
Rent expense 120000
Insurance expense 5000
Balance Sheet
Assets liabilities
Prepaid rent 60000
Prepaid insurance 20000
180
At the end of the accounting period, an adjusting entry
should be made to record any expense that have accrued but that
have not yet been recorded.
The adjusting entry of an accrued expense consists of a debit to this
expense account and a credit to a liability.
Illustration:
When employees wages are paid on the last day of the
month, there are no accrued wages and salaries at the end of the
month or year because all employees will have been paid all
amounts due them when they are paid on a weekly or biweekly
181
basis. However, it is usually necessary to make an adjusting entry
for wages and salaries earned but not paid at the end of the fiscal
period. The reason: The reporting period’s last day rarely lands
on a payday.
Assume that a business pays its sales staff every Friday for
a five- day week that the total weekly payroll is $ 8,000 and that
December 31 falls on Thursday. On December 31, the end of the
fiscal period, the employees has worked one – sixth of a year for
which they have not been paid.
The adjusting entry on December 31 is:
182
Date Account titles & explanation Debit Credit
Dec. 31, Salaries Expense 160,000
2020 Salaries Payable 160,000
To record accrued salaries for the year
2020.
Dec. 31, Bank loan interest expense 2,000
2020 Interest payable 2,000
Unpaid bank loan interest
Dec. 31, Electricity expense 1,800
2020 Electricity payable 1,800
Accrued electricity
Dr Salaries Expense Cr
Balance Dec. 31, 2020 680,000
Dec. 31, 2020 160,000
Balance 840,000
Dr Salaries Payable Cr
Dec. 31, 2020 160,000
Balance 160,000
Dr Interest Payable Cr
Dec. 31, 2020 2000
Dec. 31, 2020 2000
Income Statement
For the year ended December 31, 2020
Less:
Salaries expense 840,000
Bank loan interest expense 5,000
Electricity expense 16,800
Balance Sheet
December 31, 2020
Assets Liabilities
183
Accrued Expenses:
Salaries payable 160,000
Interest payable 2,000
Electricity payable 1,800
184
Dec.31 Dr. Cr.
Example : (X) Company gives the following info. at dec, 31, 2018:
Account Dr. Cr.
Cash 200,000
Account receivable 50,000
Land 200,000
Building 300,000
Vehicles 500,000
Equipment 50,000
Inventory 80,000
Supplies 10,000
Supplies Expense 2,000
Salaries Expense 10,000
Electricity Expense 5,000
Water Expense 3,000
Maintenance Expense 10,000
Notes payable 50,000
Accounts payable 100,000
Salaries payable 10,000
capital 650,000
Revenue 530,000
Unearned Revenue 80,000
Total 1,420,000 1,420,000
Other data:
1. Depreciation rate of building 25%.
2. Depreciation for vehicles is LE. 6250.
3. Depreciation for Equipment ( useful life 5 Years)
4. Supplies remain unused 1,000
5. Accrued salaries 100,000.
6. A client paid in advance 80,000 for service rendered last month .
7. Unearned revenue, LE 20000.
8. Inventory of bus supplies, LE 5000.
185
9. Insurance was paid for three years.
Required:
a. Journalize the adjusting entries.
b. Post the adjusting entries to the ledger accounts.
c. Prepare the adjusted trial balance.
Solution:
General Journal
Date Account titles & Explanation Debit Credit
Dec. Rent expense 60,000
31, Prepaid rent 60,000
2014 To adjust prepaid rent account
Salary expense
Accrued salary 8,000
To record accrued salary 8,000
Fuel expense
10,000
Accrued salary
10,000
To adjust fuel expense account
Unearned revenue 300,000
Service revenue 300,000
To adjust unearned revenue
Supplies expense 5,000
Bus supplies 5,000
To adjust bus supplies
Insurance expense 4,100
Prepaid insurance 4,100
To adjust Prepaid insurance
Dr Prepaid Rent Cr
Balance Dec. 31, 2018 90,000 Dec. 31, 2018 60,000
Dec. 31, 2018 30,000
Dr Business Supplies Cr
186
Balance Dec. 31, 2018 5,000
Dr Supplies Expense Cr
Dr Salary Expense Cr
Balance Dec. 31, 2018 400,000
Dec.31, 2018 8,000
Balance Dec. 31, 2018 408,000
Dr Accrued Salaries Cr
Dec. 31, 2018 8,000
Dec. 31, 2018 8,000
Dr Fuel Expense Cr
Balance Dec. 31, 2018 128,000
Dec. 31, 2018 10,000
Balance, Dec. 31, 2018 138,000
Dr Accrued Fuel Cr
Dec. 31, 2018 10,000
Balance Dec. 31, 2018 10,000
Dr Unearned Revenue Cr
Dec. 31, 2018 300,000 Balance Dec. 31, 2018 320,000
Balance, Dec. 31, 2018 20,000
Dr Service Revenue Cr
Balance, Dec. 31, 2018 1,200,000
Dec. 31 300,000
Balance, Dec. 31, 2018 1,500,000
Dr Prepaid Insurance Cr
Balance, Dec. 31, 2018 12,300 Dec. 31 4,100
Balance, Dec. 31, 2018 8,200
Dr Insurance Expense Cr
Balance, Dec. 31, 2018 4,100
Balance, Dec. 31, 2018 4,100
187
Adjusted Trial Balance
December 31, 2018
ITEM Debit Credit
Cash 345,360
Accounts receivable 561,200
Bus supplies 5,000
Supplies expense 180,000
Prepaid rent 30,000
Buses 1,300,000
Account payable 240,000
Advertising expense 800
Salary expense 408,000
Electricity expense 60,000
Fuel expense 138,000
Accrued fuel 10,000
Accrued salaries 8,000
Rent expense 60,000
Service revenue 1,500,000
Unearned revenue 20,000
Tools & Equipment 46,000
Elkarim, Drawing 3,400
Elkarim, Capital 1,372,060
Prepaid insurance 8,200
Insurance expense 4,100
Total 3150060 3150060
188
At the end of each period an estimate is made of the amount
of current period sales an account that will later prove to be
uncollectible. The estimate is based on the amount of bad debts
experienced in past years, general economic conditions, the age
of the receivable, and other factors that indicate the element of
uncollectible. Usually it is expressed as a percent of the sales on
account of the period. Or it may be computed by adjusting the
allowance for Doubtful Accounts to certain percent of the trade
accounts receivable and trade notes receivable at the end of the
period.
EX (1):
The trial balance of the balance Karnak Company at December 31 of the
current year includes, among other items, the following account balances:
Credits Debits
3,000 Office supplies on hand
3,900 Prepaid insurance
12,600 Prepaid rent
100,000 Buildings
16,625 Accumulated expenses
189
62,000 Salaries expenses
Additional data:
1. The inventory of supplies on hand at December 31 amounts to $1,200.
2. The debit balance in the prepaid insurance account is the advance
premium for one year from October 1 of the current.
3. The debit balance in the prepaid rent account is for a one year period that
began May 1 of the current year.
4. The annual depreciation for the building is based on the cost shows in the
building account less an estimated salvage value of $ 5,000. The estimated
useful lives of the buildings are 40 year each.
5. Since the last payday, office employees have earned additional salaries of
$ 3,000.
Required: Prepare the adjusting journal entries at December 31.
Solution:
Karnak Company
General journal
190
8400 Rent expenses 31
8400 Repaid rent
To record rent expense
($ 12,600 x 8/12)
2375 Depreciation expense – buildings 31
Accumulated depreciation –
2375
buildings
To record depreciation
[ ($ 100,000 - $ 5,000) / 40years]
3000 Salaries expense 31
3000 Accrued salaries payable
To record accrued salaries
EX 2:
The trial balance for MOON insurance company at November 30 is
shown below.
Dr. Cr.
Cash 6560
A/R 17050
Office supplies 500
Office equipment 18000
Accumulated depreciation: Office 600
Accounts payable 1260
Capital 35000
Drawings 2500
Commissions earned 15555
Advertising expenses 1400
Salaries expenses 2600
Rent expense 3800
52415 52415
Required:
a. Prepare adjusting entries at November 30 to reflect the office
supplies used in November and depreciation expense for the month.
b. Prepare an adjusted trial balance at November 30, 2020.
191
c. Prepare an income statement and statement of owner’s equity
for the month and a balance sheet November 30, 2020
Solution
a. adjusting entries :
JOURNAL
Date Account titles and explanation DR CR
($ 18,000 / 60 months )
192
Depreciation expense 300
Total 52715 52715
Revenue:
Commissions earned 15,555
Expenses:
Advertising expense 1,400
Salaries expense 2,600
Rent expense 3,800
Supplies expense 200
Depreciation expense 300
Total cost (8300)
Net income 7255
MOON insurance agency
Subtotal $
42,255
Assets
Cash $ 6,565
Accounts receivable 17,050
Office supplies 300
Office equipment 18,000
Less: Accumulated dep. equipment (900) 17100
Total assets 41015
Liabilities& owner’s equity
193
Liabilities: ……………………………………………….
Accounts payable 1,260
Owner’s equity: ……………………………………………..
Pat Riley Capital 39,755
Total liabilities & owner’s equity $ 41,015
EX (3):- The following is the trial balance for (X) Company at 31/12/2020.
Items Dr. Cr
Land 400.000
Building 300.000
Accumulated dep. Of Building 60.000
Cash 200.000
Account receivable 100.000
Unearned Revenues 200.000
Account payable 150.000
Notes payable 50.000
Capital 595.000
Salaries 45.000
Insurance 15.000
Interest credit 5.000
1.060.000 1.060.000
Additional data:
1- Expired salaries 48.000.
2- Insurance Paid on 1/4/2020 for three years.
3- Expired revenues 180.000.
4- Accrued interest 1000.
5- Dep. Rate of fixed assets 10%
Required:
1- Adjusting Journal Entries.
2- Income Statement.
3- Balance Sheet.
Solution:
1- Working paper:-
1-Salaries 45000
194
48000 48000 – 45000 = 3000
Salaries Expense. Accrued Salaries
(Other Cr. Balances)
2-Insurance 15000
195
Revenues:
Revenue 180000
Interest revenue 6000
Total Revenue 186000
(-) Expenses:
Salary Expense 48000 (-)
Insurance Expense 3750
Dep. Of building 30000
Total Expenses (81750)
Net Profit 104250
4-balance sheet
Assets Parts Total Liab. + O.E Parts Total
Liabilities
Fixed As. A/P 150000
Land
N/P 50000
Building 300000 400000
(-) Acc. Dep. (90000) Total Liabilities 200000
Total F.A 210000 Owner's equity
Current As. 610000 Capital 595000
Cash 200000 Net profit 104250
A/R 100000 300000 Total O.E
Total C.A Other Cr. Bal. 699250
Other Dr.Bal:
Accrued Salaries 3000
Prepaid Ins. 11250
Accrued Inter. 1000 Unearned Rev. 20000
Total Dr. Bal. 12250 T. Other Cr. Bal. 23000
Total Assets 922250 Total Liab. O.E 922250
196
If you know that :-
-End Inventory 14000, Annually Depreciation rate of (building
5% - cars 10%)
- Expired salaries 18000 – expired sales 145000 – rent paid at (1/5
for one year)
Required:
Prepare - (Trial Balance, the income statement and balance
sheet of (MAX) company at 31-12-2020
Solution
1- Trial balance
Item DR CR.
Land 100000
Building 60000
Acc. dep. building 6000
Cars 50000
Acc. Dep. Cars 10000
Cash 30000
Purchases 80000
Purchase. Disc 5000
Purchase .return 3000
Transportation in 2000
Sales 150000
Sales return 7000
Sales discount 3000
Beg inv 10000
Transportation out 3000
Rent 12000
Utilities 3000
Salaries 15000
Loan 60000
A/P 30000
Withdrawals 2000
Capital 113000
Total 377000 377000
1- Expired salaries 18000 –15000 = 3000 accrued salaries other cr.
B)--B.S
18000 salaries expenses -------income statement
2- rent 12000 paid for 12 month at 1-5 :
197
rent exp. = 12000 *8/12= 8000 -----income statement
Prepaid rent = 12000- 8000= 4000 (other dr. balance) ------ B.S
3- expired sales = 145000 (income stat.)
Unearned revenues = 150000 – 145000 = 5000 (other cr. bal) -B.S
Depreciation of building = 60000 x 5/100 =3000 I/S (dep. Exp.)
Accumulated Dep. Of building. = Accumulated Dep. + Depreciation
= 6000 + 3000 = 9000 B/S (cr)
- Depreciation of cars = Fixed Assets x Percentage
=50000 x 10/100 =5000 I/S (dep. Exp.)
Accumulated Dep. Of cars = Accumulated Dep. + Depreciation
= 10000 + 5000 = 15000 B/S (cr)
3- Income statement:
Item Parts Total
Sales 145000
- sales return (7000)
- sales discount (3000)
Net sales 135000
Beginning inventory 10000
Purchases 80000
+ transportation in 2000
- purchases return (3000)
- purchases discount (5000)
- ending inventory (14000)
Cost of goods sold (70000)
Gross profit 65000
- rent expenses 8000
- salaries 18000
- transportation out 3000
-utilities exp 3000
Building dep. Exp. 3000
car dep.exp 5000
Total expenses (40000)
Net profit 25000
4- Balance sheet:
Assets Parts Total Liab&O.E Parts Total
198
Current assets Loan 60000
Cash 30000 A/P 30000
Ending inventory 14000
Tot al current assets 44000
Fixed assets:- Total liabilities 90000
Land 100000
Cars 50000 Capital 113000
-acc.dep. cars (15000) 35000
Building 60000 -Drawings (2000)
-acc .dep .building (9000) 51000 + net profit 25000
Net fixed assets 186000 Total O.E 136000
other dr. balances Other cr. Bal.
Prepaid rent 4000 Accrued salary 3000
Unearned rev. 5000
Total 8000
Total assets 234000 Total liabi & O.E 234000
EX 5:- The following is the trial balance for (Y) Company at 31/12/2020.
Items Dr. Cr
Land 600.000
Equipment 400.000
Accumulated dep. Of Equip 80.000
Cash 300.000
Account receivable 200.000
Revenues 300.000
Account payable 250.000
Notes payable 100.000
Capital 860.000
Salaries 70.000
Insurance 30.000
Interest credit 10.000
TOTAL 1.600.000 1.600.000
Additional data:
1- Expired salaries 75.000.
2- Insurance Paid on 1/4/2020 for three years.
3- Expired revenues 280.000.
4- Accrued interest 2.000.
5- Depreciation of Fixed Assets 10% - Straight line method.
Required:
-Adjusting Journal Entries.
-Income Statement. - Balance Sheet.
Solution:
199
1- Working paper:-
Salaries 70000
Insurance 30000
Revenues 300000
200
Interest Revenue 2000
Depreciation Exp. of Equipment 40000
Accumulated Dep. Of Equip. 40000
2- Income Statement:
Item Parts Total
Revenues:
Revenue 280000
Interest revenue 12000
Total Revenue 292000
(-) Expenses: (-)
Salary Expense 75000
Insurance Expense 7500
Dep. Exp. Of Equip. 40000
Total Expenses (122500)
3- Balance Sheet:
Assets Parts Total Liab. + O.E Parts Total
Fixed As.: Liabilities:
Land 600000 A/P 250000
Equipment 400000 N/P 100000
(-) Acc. Dep. (120000) Total Liab. 350000
Total F.A 880000
O. equity
Capital 860000
Current As.: 300000 Net profit 169500
Cash 200000 Total O.E 1029500
A/R
Total C.A 500000 Other Cr, Bal
Accrued Salaries 5000
Other Dr. B Unearned Rev. 20000
Prepaid Insure. 22500 T. Cr. Bal. 25000
Accr. Int. Rev. 2000
Total Dr. Bal. 24500
201
Accumulated dep. Of building 40000
Cash 100.000
A/R 150.000
A/P 100000
Capital 113.000
Revenues 200.000
Salaries 30.000
Bad debts 20.000
1.500.000 1.500.000
Additional data:
1- Depreciation of fixed assets 10%.
2- Expired revenues 230.000 L.E
3- Accrued salaries 6.000.
4- Bad debts 5000.
REQUIRED:
1- Adj. entries.
2- Income statement.
3- Balance sheet.
Solution:
1- Working paper:-
Salaries
Revenues
202
Income statement Balance sheet
20000 +5000 = 25000 5000
Bad debits A/R =A/R -bad debts
=150000-5000=145000
-Depreciation of Equipment = Fixed Assets x rate
= 300000 x 10/100 =30000 I/S (dep. Exp.)
Accumulated Dep. Of Equip. = Acc. Dep. + Depreciation
= 30000 + 30000 = 60000 B/S (cr)
- Depreciation of building = Fixed Assets x Percentage
=400000 x 10/100 =40000 I/S (dep. Exp.)
Accumulated Dep. Of building. = Acc Dep. + Depreciation
= 40000 + 40000 = 80000 B/S (cr)
3-Income Statement:
Item Parts Total
203
Revenues:
Revenue 230000
Total Revenue
(-) Expenses: (-)
Salary Expense 36000
Bad debits 25000
Dep. Exp. Of Equip. 30000
Dep. Exp. Of building 40000
Total Expenses (131000)
Net Profit
99000
4-Balance Sheet:
Assets Part Total Liab. + O.E Part Total
Fixed As.: Liabilities:
Land 500000 A/P 100000
Equipment
(-) Acc. Dep. Of Equip. 300000 Total Liabilities 100000
(60000) 240000
building Owner's equity
(-)Acc .dep. building 400000 Capital 1130000
Total F.A (80000) 320000 Net profit 99000
Current As.:
Cash 1060000 Total O.E 1229000
A/R
Total C.A 100000 Other Cr,
Other Dr, Balances: 145000 Balances 6000
Accr revenues 245000 Accrued Salaries
204
Land 1800.000
Equipment 1400.000
Accumulated dep. Of Equip 280.000
Building 1600.000
Accumulated dep. Of build 320000
cars 800.000
Accumulated .dep. cars 80000
Cash 600.000
A/R 400000
Bank 400000
Rent 60000
Supplies on hands 100000
Inventory 100000
A/P 200000
N/P 100000
Unearned revenues 800.000
Capital 5580000
Salaries 100000
Utilities 20000
Bad debts 20000
Provision of doubtful 30000
Interest expenses 20000
Interest revenues 30000
Total 7420.000 7420.000
Additional data:
1- Depreciation of fixed assets 10%.
2- Expired revenues 700.000
3- Expired salaries 120.000.
4- Accrued interest exp. 10000.
5- Accrued interest rev. 10000
6- Prepaid rent 12000
7- Used supplies 60000
8- Bad debts 40000
9- Provision of doubtful 10%
205
REQUIRED:
(Adjusting entries. - Income statement - Balance sheet).
6-supplies
206
Supplies expenses prepaid supplies
(Other Dr. Balances)
7-bad debit
8- Provision of doubtful
207
Prepaid supplies 40000
Supplies exp. 40000
Bad debts 40000
Debtors(A/R) 40000
3-Income Statement:
4-Balance Sheet:
Assets Parts Total Liab. + O.E Parts Total
208
Fixed As.: Liabilities
Land 1800000 A/P 200000
Building 1600000 N/P 100000
(-)Acc. dep. (480000) 1120000 Total Liabilities 300000
Equipment 1400000 Owner's equity
(-) Acc. Dep. (420000) 980000 Capital 5580000
cars 800000 Net profit 16000
(-)Acc .dep. (160000) 640000 Total O.E 5596000
Total F.A 4540000
Current Assets Other Cr, Balances
Cash 600000 Accrued Salaries 20000
A/R 360000 Unearned revenues 100000
(-)Prov. of dou (36000) 324000 Accrued interest exp. 10000
Bank 400000
Inventory 100000 Total Other cr, Bal.
Total C.A 130000
Other Dr, Bal 1424000
Prepaid rent 12000
Accru Int Rev. 10000
Prepaid sup. 40000
Total Other Dr. Bal. 62000 Liab & O.E
209
To facilitate the end- of- period ( monthly, quarterly , or annually)
accounting and reporting process , accountants frequently use a work sheet
. ِِA worksheet is a columnar sheet of paper used to adjust the account
balances and prepare the financial statements.
Additional data:
210
1- the debit balance in the prepaid insurance account is the advance
premium for one year from October ,1 of the current year.
2- The rent paid in advance on Dec. 1, 2020 to cover a three month period.
3- The actual physical inventory at the end of the month showed that only
$ 900 of supplies were on hand.
4- Estimated salvage value of the trucks 4000 $ , useful life estimated to
be four years.
5- One third of the delivery services paid for in advance have been
performed by the end of Dec., 2020.
6- The company performed 1000 $ of delivery services on account in
client in the last few days of December because it takes time to do the
paper work, the clients will be billed for the services in January
7- Accrued salaries payable account to 180 $ at the end of December.
Required:
1- journalize adjusting entries.
2- prepare worksheet
3- prepare financial statements.
General journal
Date Accounts and explain Debit credit
211
2020 31 200
Insurance expense
Dec.
Prepaid insurance 200
212
213
SUN DELIVERY COMPANY
Income statement
For the month ended December 31, 2020
Revenue :
Delivery service revenue ……………………. $ 13,200
Expenses:
Advertising ………………………………… 50
Gas and oil ………………………………… 680
Salaries …………………………………… 3,780
Utilities …………………………………… 150
Insurance…………………………………. 200
Rent………………………………………. 400
Supplies…………………………………… 500
Depreciation delivery trucks………………. 750
Total expenses 6,510
Net income $ 6,690
Statement of owner’s equity
The statement of owner’s equity is a financial statement that
summarize the transactions affecting the owner’s capital account
balance . Such a statement is prepared by showing the beginning
capital account balance , adding net income ( or deducting net
loss) , and then subtracting the owner’s withdrawals. The ending
capital balance is then carried forward to the balance sheet. The
statement of owner’s equity helps to relate income statement
information to balance sheet information; it indicates how net
income relates to the balance sheet account , owner’s capital.
Statement of owner’s equity
SUN DELIVERY COMPANY
Statement of owner’s equity
For the month ended December 31 , 2020
John Turner , capital 1, 2020………………… $ 50,000
Net income for December ………………… 6,690
Total $ 56,690
Less: drawings …………………………….. 3,000
214
John Turner , capital , December 31, 2020 $ 53,690
Balance sheet :
The balance sheet is then completed from the information
in the balance sheet columns of the worksheet . the balance sheet
for SUN delivery company is shown below
215
owner’s capital account. However, owners, managers , investors,
and others need to know amounts of specific revenues and
expenses , and the amount of net income earned in the period.
Therefore, we maintain separate ledger accounts to measure each
type of revenue and expense , and the owner’s drawings.
216
Revenue and expense accounts are closed at the end of each
accounting period by transferring their balances to a summary
account called income summary .
when the credit balances of the revenue accounts and the
debit balances of the expense accounts have been transferred into
one summary account , the balance of this income summary will
be the net income or net loss for the period . If the revenue ( credit
balances) exceeds the expenses ( debit balances) , the income
summary account will have a credit balance representing net
income. Conversely , if expenses exceed revenue , the income
summary will have a debit balance representing net loss. This is
consistent with the rule that increase in owner’s equity are
recorded by credits and decreases are recorded by debits.
Closing entries for revenue accounts
Revenue accounts have credit balances . therefore, closing a
revenue account means transferring its credit balance to the
income summary account . This transfer is accomplished by a
journal entry debiting the revenue account in an amount equal to
its credit balance, with an offsetting credit to the income summary
account . The debit portion of this closing entry returns the
balance of the revenue account to zero ; the credit portion
transfers the former balance of the revenue account into the
income summary account.
The only revenue appearing in the income statement credit
column for The SUN delivery company is delivery service
217
revenue of $ 13,200 . Since revenue accounts have credit balances
, they must be debited for an equal amount to bring them to a zero
balance . the credit in the closing entry is made to income
summary
General journal
2020
Delivery service revenue 13200
Dec. 31
Income summary 13200
To close the revenue account in
The income statement credit
Column to income summary
General journal
2020
Income summary 6510
Dec. 31
Advertising expense 50
Salaries expense 680
Utilities expense 3780
Insurance expense 150
Rent expense 200
Supplies expense 400
Depreciation expense – delivery 500
trucks
218
To close the expense accounts 750
Appearing in the income statement
Debit column to income summary
The debit of $ 6,510 to the Income Summary account agrees with
the Income Statement debit column subtotal in the worksheet .
this shows another way in which the worksheet is helpful in
preparing closing entries. It can serve as a check to make certain
that all revenue and expense items are listed and have been
closed, had the debit in the above entry been for a different
amount than the column subtotal, there would be an error in the
closing entry for expense.
Now the Income Summary account needs to be closed to the owner’s
capital account . the entry to do this is :
General journal
2020
Income summary 6690
Dec. 31
John Turner , capital 6690
To close the income summary
Account to the Owner’s Capital
account
.
Closing the owner’s drawing account
The last closing entry that needs to be made is to close the
owner’s drawing account. This account has a debit balance before
closing . To close the account , the owner’s drawing account is
credited and the owner’s capital account is debited.
219
General journal
2020
John Turner , capital 3000
Dec. 31
John Turner , Drawing 3000
To close owner’s drawing
Account to owner’s capital
Account.
220
EXAMPLE(2)
Hany stable
Trial balance
July 31, 2020
Debits Credits
Cash ………………………………………. $ 9,500
Accounts receivable………………………….. 8,100
Land……………………………………………. 40,000
Building……………………………………….. 24,000
Accounts payable…………………………….. $ 1,100
Loan payable ( due June 2005) 40,000
Capital………………………………………. 36,600
Drawing………………………………………. 700
Horse boarding fees……………………………. 4,500
Riding and lesson fees………………………… 3,600
Feed expense………………………………….. 1,100
Salaries expense………………………………. 1,400
Miscellaneous expense……………………….. 1,000
$ $ 85,800
85,800
Additional data:
1. Depreciation expense for the month is $ 200.
2. Accrued salaries at the end of the month are $ 100.
Required:
a. Prepare a 10 – column worksheet for the month ended July 31, 2020.
b. Prepare an income statement for the month ended July 31 2020.
c. Prepare a statement of owner’s equity for the month ended
July 31, 2020.
d. Prepare a balance sheet as of July 31, 2020 (classify the items to
the extent possible).
221
e. Journalize the adjusting entries.
f. Journalize the closing entries.
222
Solution:-
Hany stable
Worksheet
For the year ended July 31,2020
Adjusted trial Income
Accounts titles Trial balance Adjustments Balance sheet
balance statement
Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr
Cash 9,500 9,500 9,500
Accounts receivable 8,100 8,100 8,100
Building 40,000 40,000 40,000
Accounts payable 1,100 1,100 1,100
Loan payable 40,000 40,000 40,000
Barbara Macon , capital 36,600 36,600 36,600
Barbara Macon , drawing 700 700 700
Horse boarding fees 4,500 4,500 4,500
Riding and lesson fees 3,600 3,600 3,600
Fees expense 1,100 1,100 1,100
Salaries expense 1,400 (2) 100 1,500
Miscellaneous expense 1,000 1,000 1,000
85,800 85,800
Depreciation expense –building (1) 200 200 200
Accumulated depreciation building (1) 200 200 200
223
Adjusted trial
Accounts titles Trial balance Adjustments * Income statement Balance sheet
balance
Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr
Accrued salaries payable (2) 100 100 100
300 300 86,100 86,100 3,800 8,100
Net income 4,300 4,300
8,100 8,100 82,300 82,300
224
Hany stable
Income statement
For the month ended July 31, 2020
Revenues : Hany stable
Income statement
For the month ended July 31, 2020
Revenues :
Horse boarding fees …………………………. $ 4,500
Riding and lesson fees……………………….. 3,600
Expenses: $ 8,100
Feed…………………………………………. $ 1,100
Salaries…………………………………………. 1,500
Miscellaneous…………………………………. 1,000
Depreciation – building………………………... 200
Total expenses ………………………………… 3,800
Net income…………………………………… $ 4,300
(2)
*Adjustments:
(1) to record depreciation of building for July.
(2) To record accrued salaries.
Hany stable
Statement of owner’s equity
For the month ended July 31, 2020
Capital July , 1 $ 36,600
Net income for July 4,300
…………………………………………
Total……………………………………………………… $ 40,900
Less: 700
drawings……………………………………………….
Capital , july , 31…………………………………………… $ 40,200
225
Hany stable
Balance sheet
July 31,2020
Assets
Current assets:
Cash $ 9,500
Accounts receivable 8,100
Total current assets $ 17,600
Property ,plant , and equipment:
Land $ 40,000
Building $ 24,000
Less: accumulated depreciation 200 23,800
Total property , plant , and equipment 63,800
Total assets $ 81,400
General journal
2020
Dec. 31 Depreciation expense – building 200
226
General journal
31 Capital 700
Drawing 700
To close the owner’s drawing
account
227
Summary:
Prepare reversing entries; reversing entries are the opposite
of the adjusting entries made in the preceding period. Some
companies choose to make reversing entries at the beginning of a
new accounting period to simplify the recording of later
transactions related to the adjusting entries. In most cases, only
accrued adjusting entries are reversed.
228
Questions
Exercises & Problems
1. What is the difference between accrual accounting and cash – basis accounting?
2. Define revenue recognition principle.
3. Why accounts adjusted at the end of an accounting period.
4. Identify which of the following accounts is DR or CR:
a. Accrued salary.
b. Unpaid electricity.
c. Unearned revenue.
d. Unpaid telephone.
e. Prepaid insurance.
5. On March 1, 2018 a company prepaid 18 months of rent, LE 108000.
Required:
a. The journal entry for the March 1, payment.
b. Prepare the adjusting entry required at Dec. 31, 2014.
c. Post to the two accounts involved and show their balances at Dec. 31, 2018.
6. Fast travel borrowed LE 200000 on February, 2018 by signing a one – year
note payable to Environmental Development Bank. Interest rate is 13%. Fast
travel interest expense balance on December 31, 2018, LE 12000. The interest
is paid per year, and the loan is paid to the bank after 3 years.
Required:
1. Make the journal entry of borrowing money from the bank of February 1, 2018.
2. Make the adjusting entry to accrue interest expense at December 31, 2018.
3. Post to the two accounts affected by the adjustment.
7. (MAC) company completed the following adjusting transactions
during April, 2018:
April 1, 2018 paid the monthly salaries, LE 36000.
4 Prepaid rent for 6 months, LE 60000.
6 paid cash for kitchen equipment, LE48000.
11 received LE 18000 from a customer to provide meals after 3 days.
18 Made an adjusting entry for prepaid insurance (LE 12000, paid for 6 months).
22 Paid electricity expenses, LE 800
26 Prepaid advertising expense, LE 1200.
29 accrued salary expense, LE 900.
30 Adjust prepaid rent for the month of April.
Required:
Prepare journal entries for the above mentioned transactions.
229
Answer The Following
1. The basis of accounting that recognizes revenue when it is
earned, regardless of when cash is received, and matches the
expenses to the revenue, regardless of when cash is paid out,
is known as the _______.
230
Answer The Problems:
Problem 1:
A business pays weekly salaries of $10,000 on Friday for
five days work per week. Show the adjusting entry when the fiscal
period ends on (a) Tuesday; (b) Thursday.
Solution:
(a) Salaries Expense 4,000
Salaries Payable 4,000
(b) Salaries Expense 8,000
Salaries Payable 8,000
Problem 2:
An insurance policy covering a two-year period was
purchased on November 1 for $600. The amount was debited to
Prepaid Insurance. Show the adjusting entry for the two-month
period ending December 31.
Solution:
Insurance Expense 50*
Prepaid Insurance 50
* ($600/ 2 years) multiplied by (2/12) years equals $50
Problem 3
Machinery costing $12,000, purchased November 30, is
being depreciated at the rate of 10 percent per year. Show the
adjusting entry for December 31.
Solution:
Depreciation Expense—Machinery 100*
Accumulated Depreciation—Machinery 100
*$12,000 times 10% per year times (1/12) year equals $100
231
Problem 4
(a) The balance in the Prepaid Insurance account, before
adjust-ments, is $1,800, and the amount expired during the
year is $1,200. The amount needed for the adjusting entry
required is _____.
(b) A business pays weekly salaries of $4,000 on Friday. The
amount of the adjusting entry necessary at the end of the fiscal
period ending on Wednesday is _______.
(c) On December 31, the end of the fiscal year, the supplies
account had a balance before adjustment of $650. The fiscal
supply inventory account on December 31 is $170. The
amount of the adjusting entry is _______.
Solution:
(a) $1,200
(b) $2,400
(c) $480
232
Exercise 1:
The trial balance at March 31 of the current year includes the
following selected accounts, before the adjusting entries have
been prepared:
Item Debit Credit
Prepaid Insurance L.E. 3,600
Supplies 2,800
Delivery Equipment 25,000
Accumulated depreciation: Equipment L.E.
8,400
Notes Payable 20,000
Service Revenue 69,300
Wages Expense 14,000
An analysis of the accounts shows the following:
1. The delivery equipment depreciates at a rate of L.E.500 per month.
2. One third of the service revenue was earned during the quarter.
3. Accrued wages at March 31 amounted to L.E.2,100.
4. Supplies on hand L.E.750.
5. Insurance expires at the rate of L.E.175 per month.
Required:
Prepare the adjusting entries at March 31, assuming that adjusting
entries are made quarterly.
233
Exercise 2:
The trial balance for Bravery Company at December 31, 2020
includes, among other items, the following account balances
on the debit side:
Prepaid Insurance L.E.25,000
Prepaid Rent L.E.28,000
Supplies L.E.6,600
Examination of the records shows that the annual adjustments
should be made for the following items:
1. Only L.E.10,000 of the prepaid insurance in the trial
balance is expired.
2. The balance in the prepaid rent account is for a 12-month
period that started October 1 of the current year.
3. Supplies used during the year amounted to L.E.3,600.
Required:
Prepare the annual adjusting journal entries at December 31, 2020.
234
Exercise 3:
Omar Company has the following account balances, among
others, in its trial balance at December 31, 2020:
Item Debit Credit
Accounts Receivable L.E.25,000
Supplies 1,290
Prepaid Rent 2,400
Service Revenue L.E.87,000
Salaries Expense 41,000
Additional data:
1. The amount of supplies on hand at December 31 is L.E.90.
2. The balance in the prepaid rent account is for a one-year
period starting October 1 of the current year.
3. Since the last payday, the employees of the company have
earned additional salaries of L.E.2,030.
4. Services, performed in December, which will not be billed
until January amounted to L.E.6,000.
Required:
a- Prepare the annual adjusting journal entries on December 31.
b-Prepare the ledger accounts for each of the accounts involved.
235
Exercise 4:
The trial balance of Sun Company is as follows:
Sun Company
Trial Balance
December 31,2020
Item Debit Credit
Cash L.E. 2,300
Accounts Receivable 2,600
Supplies 1,100
Equipment 6,000
Accumulated Depreciation:
L.E. 1,200
Equipment
Accounts Payable 1,100
Common Stock 6,400
Retained Earnings 600
Fees Revenue 3,300
Salaries Expense 500
Miscellaneous Expense 100
Total L.E.12,600 L.E.12,600
Additional data:
1. Supplies on hand at December 31 amounted to L.E.620.
2. Equipment is depreciated at a rate of L.E.120.
3. Unearned fees amounted to L.E.400 on December 31.
4. Accrued salaries are L.E.800.
Required:
a- Prepare the annual adjusting journal entries at December 31, 2020.
b- Is 2020 the first year of operations for Sun Company? Explain.
236
Exercise 5:
The trial balance of Nader Plumbing Company at December
31, 2020, is as follows:
Nader Plumbing Company
Trial Balance
December 31,2020
Item Debit Credit
Cash L.E.45,000
Accounts Receivable 13,600
Supplies 2,000
Prepaid Insurance 1,800
Building 70,000
Accumulated Depreciation: Building L.E.12,500
Equipment 18,000
Accumulated Depreciation: Equipment 4,500
Accounts Payable 11,000
Nader, Capital ---------
Nader, Drawing 20,000
Service Revenue 140,000
Salaries Expense 48,000
Utilities Expense 1,700
Total L.E.220,100 L.E.220,100
Additional data:
1. Supplies on hand at December 31, 2020 have a cost of L.E. 600.
2. The balance in the prepaid insurance account represents
the cost of a two-years insurance policy covering the
period from January 1, 2008 till December 31, 2021.
237
3. Depreciation expense is L.E.1,250 on the building and L.E.900
on the equipment.
Required:
a- Calculate the missing figure.
b-Prepare the annual adjusting journal entries at December 31,2020.
c- Prepare an income statement and a balance sheet
Exercise 6:
Shown below are the trial balance and additional information
for Walid Equipment Rental Company:
Walid Equipment Rental Company
Trial Balance
December 31, 2020
Item Debit Credit
Cash L.E.64,000
Accounts Receivable 44,000
Prepaid Rent 7,200
Prepaid Insurance 3,600
Equipment 120,000
Accumulated Depreciation: Equipment L.E.40,000
Accounts Payable 31,000
Walid, Capital 139,000
Walid, Drawing 24,000
Service Revenue 350,000
Salaries Expense 250,000
Travel Expense 35,200
Miscellaneous Expense 12,000
238
Total L.E.560,000 L.E.560,000
Additional data:
1. The prepaid rent was for the period starting January 1,
2019 till December 31, 2020.
2. The depreciation on the equipment is L.E.8,000 per year.
3. The prepaid insurance was for the period starting April 1, 2020
till March 31, 2021.
4. Accrued salaries amounted to L.E.3,000 at December
Required:
a- Prepare the annual adjusting journal entries at December 31,2020.
b- Prepare an income statement and a balance sheet.
Exercise 7:
Shown below are the trial balance before adjustment of Hany
Company and additional data:
Hany Company
Trial Balance
December 31, 2020
Item Debit Credit
Cash L.E.50,000
Accounts Receivable 20,000
Loan L.E.40,000
Land 100,000
Accounts Payable 20,000
Inventory 20000
Equipment 30,000
Building 50000
Accumulated Depreciation: 10,000
Building
Purchase 70000
239
Purchase Discount 15,000
Sales 90,000
Sales Return 10000
Transportation-in 20000
Transportation -out 3000
Salaries Expense 5000
Wages Expense 10000
Rent Expense 5000
Hany, Drawing 10000
Hany, Capital .................
Total L.E.385000 L.E.385,000
Additional data:
1. The depreciation is calculated at 10%.
2. Ending inventory is L.E.22,000.
Required:
-Calculate the missing figure.
-Prepare the adjusting entries.
-Prepare an income statement and a balance sheet.
Exercise 8:
Shown below are the trial balance before adjustment of
Ashraf Company and additional data:
Ashraf Company
Trial balance
December 31, 2020
Item Debit Credit
Cash L.E.30,000
Accounts Receivable 20,000
Supplies 10000
Inventory 30000
Accounts Payable 25000
Notes Payable 30,000
Land 100000
Loan 45,000
Building 100,000
Accumulated Depreciation: B 10,000
Equipment 80000
240
Accumulated Depreciation: E 8,000
Purchase 50000
Purchase Return & Allowance 5000
Sales 100,000
Sales Discount 3000
Sales Return 2000
Transportation-in 2000
Salaries Expense 10000
Utilities Expense 5000
Interest 6,000
Ashraf, Drawing 15000
Ashraf, Capital 228,000
Total 457000 457000
Additional data:
1. The depreciation is calculated at 10%.
2. Ending inventory is L.E.28,000.
Ahmed Company
Trial Balance
December 31, 2020
Item Debit Credit
Cash L.E.40,000
Accounts Receivable 10,000
Inventory 50,000
Accounts Payable L.E.50,000
Loan 40,000
Notes Receivable 7,000
Land 80000
Building 70,000
Accumulated Depreciation: B 21,000
Equipment 30,000
Accumulated Depreciation: E 6,000
241
Net Purchases 50000
Sales 120000
Sales Discount 5,000
Transportation-out 10,000
Salaries Expense 20,000
Administrative Expense 2,000
Utilities Expense 3000
Wages Expense 15000
Rent Expense 10000
Interest 3000
Interest 7000
Ahmed, Drawing 5,000
Ahmed, Capital 166000
Total L.E.410,000 L.E.410,000
Additional data:
1. The depreciation is calculated at 10%.
2. Ending inventory is L.E.40,000.
Required: Prepare the adjusting entries and the financial statements.
Exercise 10:
Collected the following information from Nour Company:
Nour Company
Trial Balance
December 31, 2020
Item Debit Credit
Cash L.E.20,000
Accounts Receivable 10,000
Accounts Payable L.E30000
Equipment 5,000
Notes Payable 5,000
Inventory 40000
Land 50000
Building 80000
Accumulated Depreciation: 16000
Building
Purchases 50000
242
Purchase Discount 4000
Sales 134,000
Sales Return 3,000
Transportation-in 2,000
Salaries Expense 20,000
Rent Expense 12,000
Wages Expense 15000
Nour, Drawing 5,000
Nour, Capital 123,000
Total L.E.312,000 L.E.312,000
Additional data:
1) Depreciation is calculated at rate 10%.
2) Salaries expired L.E.24,000.
3) Rent used per month L.E.1,000.
4) Ending inventory L.E.55,000
Required:
1) Prepare the adjusting entries.
2) Prepare an income statement and a balance sheet.
Exercise 11:
Aziz Company
Trial Balance
December 31, 2020
Item Debit Credit
Cash 30000
Accounts Receivable 30000
Inventory 20000
Accounts Payable 30000
Trucks 180000
Accumulated Depreciation: Trucks 18000
Net Purchases 50000
Sales 80000
243
Sales Discount 2000
Sales Return 3000
Prepaid Salaries 20000
Wages Expense 8000
Rent Expense 7,000
Aziz, Capital 222000
Total 350,000 350,000
Additional data:
1) Depreciation is calculated at rate 10%.
2) Salaries used L.E.15,000.
3) Accrued wages L.E.10,000.
4) Ending inventory L.E.22,000
Required:
1) Prepare the adjusting entries.
2) Prepare an income statement and a balance sheet.
Exercise 12:
Collected the following information from Sherif Company:
Sherif Company
Trial Balance
December 31, 2020
Item Debit Credit
Cash 40,000
Accounts Receivable 10,000
Supplies 10000
Inventory 30000
Accounts Payable 60,000
Land 80,000
Equipment 20,000
Building 60,000
Accumulated Depreciation: B 12,000
Purchases 60000
Purchase Discount 2000
Purchase Return 3000
244
Sales 120000
Sales Return 4000
Sales Allowance 2000
Transportation-in 1000
Rent Expense 8000
Wages Expense 5000
Prepaid Advertising 36000
Interest Expense 7000
Interest Revenue 5000
Sherif, Drawing 5000
Sherif, Capital 176,000
Total 378000 378000
Additional data:
1) Rent used per month L.E.1,000.
2) Supplies on hand L.E.6,000.
3) Accrued wages L.E.3,000.
4) Advertising was paid since 1/7/2020 for 3 years in advance.
5) Accrued interest revenue L.E.3,000.
6) Ending inventory L.E.35,000.
7) Depreciation is calculated at rate10%.
Required:
Prepare:
1) the adjusting entries.
2) an income statement.
3) a balance sheet.
Exercise 13:
Collected the following information from Mansour Company:
Mansour Company
Trial Balance
December 31, 2020
Item Debit Credit
Cash L.E.16,000
Accounts Receivable 49,000
245
Inventory 62,000
Unexpired Insurance 1,800
Land 17,000
Buildings 60,000
Accumulated Depreciation: Buildings L.E.2,400
Equipment 16,000
Accumulated Depreciation: Equipment 4,800
Accounts Payable 47,900
Supplies 1,300
Mansour, Capital 99,500
Mansour, Drawing 18,000
Sales 326,000
Sales Returns & Allowances 5,200
Purchases 190,000
Purchases Returns & Allowances 2,000
Purchases Discount 400
Transportation-in 4,800
Salaries Expense 40,00
Property Taxes Expense 1,100
Total L.E.482,600 L.E.482,600
Additional data:
1. Examination of policies showed L.E.600 unexpired
insurance on December 31.
2. Supplies on hand at December 31 were estimated to
amount to L.E.300.
3. The buildings are being depreciated over a 25-years useful life.
The equipment is being depreciated over a 10-years useful life.
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4. Accrued salaries as of December 31 were L.E. 5,000.
5. Inventory of merchandise on December 31 was L.E. 44,600.
Required:
Prepare:
1) the adjusting entries.
2) an income statement.
3) a balance sheet
Exercise 14:
Maha Company
Trial Balance
December 31, 2020
Item Debit Credit
Cash 35,320
Accounts Receivable 79,760
Merchandise Inventory 142,600
Supplies 2,680
Prepaid Fire Insurance 2,400
Prepaid Rent 28,800
Stores Equipment 44,000
Accumulated Depreciation: Stores Equipment 8,800
Accounts Payable 51,400
Maha, Capital 210,000
Sales 561,000
Sales Returns and Allowances 2,580
Purchases 250,420
Purchase Returns and Allowances 2,020
Transportation-in 3,920
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Sales Salaries Expense 69,200
Advertising Expense 39,000
General Office Expense 45,340
Officers Salaries Expense 80,000
Utilities Expense 7,400
Interest Revenue 500
Interest Expense 300
Total 833,720 833,720
Additional data:
1. Only L.E.1,700 of the prepaid fire insurance was expired.
2. Supplies consumed amounted to L.E.1,830.
3. Prepaid rent expired during the year amounted to L.E.25,300.
4. The interest revenue included L.E.100 unearned revenue.
5. The depreciation of fixed assets is calculated at a rate of 10%.
6. Ending inventory is L.E. 60,000.
Required:
Prepare: 1) the adjusting entries.
2) an income statement.
3) a balance sheet.
Exercise 15:
Ayman Company
Trial Balance
December 31, 2020
Cash L.E.28,600
Accounts Receivable 24,150
Prepaid Insurance 1,450
Merchandise Inventory 20,800
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Land 30,000
Store Building 55,000
Accumulated Depreciation: Store Building L.E.16,500
Store Fixtures 27,800
Accumulated Depreciation: Store Fixtures 5,560
Accounts Payable 18,950
Ayman, Capital 110,090
Sales 275,750
Sales Returns and Allowances 2,850
Purchases 156,450
Purchase Discounts 1,300
Purchase Returns and Allowances 700
Transportation-in 3,650
Sales Salaries Expense 32,000
Advertising Expense 6,000
Delivery Expense 2,300
Wages Expense 37,000
Interest Revenue 200
Interest Expense 1,000
Total L.E.429,050 L.E.429,050
Additional data:
1. Depreciation expense on the store building is L.E.1,100.
2. Depreciation expense on the store fixtures is L.E.2,780.
3. Accrued sales salaries are L.E.700.
4. Insurance expired in 2002 is L.E.1,250.
5. Cost of merchandise inventory on hand at December 31 is 27,750.
6. Accrued interest revenue is L.E.400.
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Required:
Prepare: 1) the adjusting entries.
2) an income statement.
3) a balance sheet.
Chapter 6
Financial statements analysis
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Financial Ratios Analysis
Introduction
Ratio analysis is a diagnostic tool that helps to identify problem areas
and opportunities within a company. There several ratios that the
auditor can consider while performing analytical procedures. Among
the dozens of financial ratios available, we’ve chosen the most
relevant to and organized them into eight main categories as per the
following list:
1- LIQUIDITY MEASUREMENT RATIOS
Liquidity ratios analyze the ability of a company to pay off both its
current liabilities as they become due as well as their long-term
liabilities as they become current. In other words, these ratios show
the cash levels of a company and the ability to turn other assets into
cash to pay off liabilities and other current obligations.
Liquidity is not only a measure of how much cash a business has. It
is also a measure of how easy it will be for the company to raise
enough cash or convert assets into cash. Assets like accounts
receivable, trading securities, and inventory are relatively easy for
many companies to convert into cash in the short term. Thus, all of
these assets go into the liquidity calculation of a company.
•Current Ratio
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The current ratio is a liquidity and efficiency ratio that measures a
firm’s ability to pay off its short-term liabilities with its current assets.
The current ratio is an important measure of liquidity because short-
term liabilities are due within the next year.
This means that a company has a limited amount of time in order to
raise the funds to pay for these liabilities. Current assets like cash,
cash equivalents, and marketable securities can easily be converted
into cash in the short term. This means that companies with larger
amounts of current assets will more easily be able to pay off current
liabilities when they become due without having to sell off long-term,
revenue-generating assets.
The current ratio is calculated by dividing current assets by current
liabilities.
•Quick Ratio
The quick ratio or acid test ratio is a liquidity ratio that measures the
ability of a company to pay its current liabilities when they come due
with only quick assets. Quick assets are current assets that can be
converted to cash within 90 days or in the short-term. Cash, cash
equivalents, short-term investments or marketable securities, and
current accounts receivable are considered quick assets.
Short-term investments or marketable securities include trading
securities and available for sale securities that can easily be converted
into cash within the next 90 days. Marketable securities are traded on
an open market with a known price and readily available buyers. Any
stock on the New York Stock Exchange would be considered a
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marketable security because they can easily be sold to any investor
when the market is open.
The quick ratio is often called the acid test ratio in reference to the
historical use of acid to test metals for gold by the early miners. If the
metal passed the acid test, it was pure gold. If metal failed the acid
test by corroding from the acid, it was a base metal and of no value .
The acid test of finance shows how well a company can quickly
convert its assets into cash in order to pay off its current liabilities. It
also shows the level of quick assets to current liabilities.
Formula = Cash + Cash equivalents + Short term investment +
Current receivables/Current liabilities
The quick ratio is calculated by adding cash, cash equivalents, short-
term investments, and current receivables together then dividing them
by current liabilities.
•Cash Ratio
The cash ratio or cash coverage ratio is a liquidity ratio that measures
a firm’s ability to pay off its current liabilities with only cash and cash
equivalents. The cash ratio is much more restrictive than the current
ratio or quick ratio because no other current assets can be used to pay
off current debt-only cash.
This is why many creditors look at the cash ratio. They want to see if
a company maintains adequate cash balances to pay off all of their
current debts as they come due. Creditors also like the fact that
inventory and accounts receivable are left out of the equation because
both of these accounts are not guaranteed to be available for debt
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servicing. Inventory could take months or years to sell and receivables
could take weeks to collect. Cash is guaranteed to be available for
creditors.
The cash coverage ratio is calculated by adding cash and cash
equivalents and dividing by the total current liabilities of a company.
•Cash Conversion Cycle
The cash conversion cycle is a cash flow calculation that attempts to
measure the time it takes a company to convert its investment in
inventory and other resource inputs into cash. In other words, the cash
conversion cycle calculation measures how long cash is tied up in
inventory before the inventory is sold and cash is collected from
customers. The cash cycle has three distinct parts. The first stage of
the cycle represents
the current inventory level and how long it will take the company to
sell this inventory. This stage is calculated by using the days
inventory outstanding calculation. The second stage of the cash cycle
represents the current sales and the amount of time it takes to collect
the cash from these sales. This is calculated by using the days sales
outstanding calculation. The third stage represents the current
outstanding payables. In other words, this represents how much a
company owes its current vendors for inventory and goods purchases
and when the company will have to pay off its vendors. This is
calculated by using the days payables outstanding calculation.
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The cash conversion cycle is calculated by adding the days inventory
outstanding to the days sales outstanding and subtracting the days
payable outstanding.
•Working Capital Ratio
The working capital ratio, also called the current ratio, is a liquidity
ratio that measures a firm’s ability to pay off its current liabilities with
current assets. The working capital ratio is important to creditors
because it shows the liquidity of the company. Current liabilities are
best paid with current assets like cash, cash equivalents, and
marketable securities because these assets can be converted into cash
much quicker than fixed assets. The faster the assets can be converted
into cash, the more likely the company will have the cash in time to
pay its debts.
The reason this ratio is called the working capital ratio comes from
the working capital calculation. When current assets exceed current
liabilities, the firm has enough capital to run its day-to-day operations.
In other words, it has even capital to work. The working capital ratio
transforms the working capital calculation into a comparison between
current assets and current liabilities.
The working capital ratio is calculated by dividing current assets by
cur rent liabilities .
•Times Interest Earned Ratio
The times interest earned ratio, sometimes called the interest coverage
ratio, is a coverage ratio that measures the proportionate amount of
income that can be used to cover interest expenses in the future. In
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some respects the times interest ratio is considered a solvency ratio
because it measures a firm’s ability to make interest and debt service
payments. Since these interest payments are usually made on a long-
term basis, they are often treated as an ongoing, fixed expense. As
with most fixed expenses, if the company can’t make the payments,
it could go bankrupt and cease to exist. Thus, this ratio could be
considered a solvency ratio as well.
The times interest earned ratio is calculated by dividing income
before interest and income taxes by the interest expense.
SOLVENCY RATIOS
Solvency ratios, also called leverage ratios, measure a company’s
ability to sustain operations indefinitely by comparing debt levels
with equity, assets, and earnings. In other words, solvency ratios
identify going concern issues and a firm’s ability to pay its bills in the
long term. Many people confuse solvency ratios with liquidity ratios.
Although they both measure the ability of a company to pay off its
obligations, solvency ratios focus more on the long-term
sustainability of a company instead of the current liability payments.
Solvency ratios show a company’s ability to make payments and pay
off its long-term obligations to creditors, bondholders, and banks. Put
differently, solvency ratios indicate a more creditworthy and
financially sound company in the long-term.
The most common solvency ratios include:
•Debt to Equity Ratio
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The debt to equity ratio is a financial, liquidity ratio that compares a
company’s total debt to total equity. The debt to equity ratio shows
the percentage of company financing that comes from creditors and
investors. A higher debt to equity ratio indicates that more creditor
financing (bank loans) is used than investor financing (shareholders).
The debt to equity ratio is calculated by dividing total liabilities by
total equity. The debt to equity ratio is considered a balance sheet ratio
because all of the elements are reported on the balance sheet.
•Equity Ratio
The equity ratio is an investment leverage or solvency ratio that
measures the amount of assets that are financed by owners’
investments by comparing the total equity in the company to the total
assets. The equity ratio highlights two important financial concepts of
a solvent and sustainable business. The first component shows how
much of the total company assets are owned outright by the investors.
In other words, after all of the liabilities are paid off, the investors will
end up with the remaining assets.
The second component inversely shows how leveraged the company
is with debt. The equity ratio measures how much of a firm’s assets
were financed by investors. In other words, this is the investors’ stake
in the company. This is what they are on the hook for. The inverse of
this calculation shows the amount of assets that were financed by
debt. Companies with higher equity ratios show new investors and
creditors that investors believe in the company and are willing to
finance it with their investments.
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The equity ratio is calculated by dividing total equity by total assets.
Both of these numbers truly include all of the accounts in that
category. In other words, all of the assets and equity reported on the
balance sheet are included in the equity ratio calculation.
•Debt Ratio
Debt ratio is a solvency ratio that measures a firm’s total liabilities as
a percentage of its total assets. In a sense, this ratio shows a
company’s ability to pay off its liabilities with its assets. In other
words, this shows how many assets the company must sell in order to
pay off all of its liabilities. Companies with higher levels of liabilities
compared with assets are considered highly leveraged and more risky
for lenders.
This helps investors and creditors analysis the overall debt burden on
the company as well as the firm’s ability to pay off the debt in future,
uncertain economic times.
The debt ratio is calculated by dividing total liabilities by total assets.
Both of these numbers can easily be found on the balance sheet. Here
is the calculation:
PROFITABILITY INDICATOR RATIOS
Profitability ratios compare income statement accounts and
categories to show a company’s ability to generate profits from its
operations. Profitability ratios focus on a company’s return on
investment in inven¬tory and other assets. These ratios basically
show how well companies can achieve profits from their operations.
Investors and creditors can use profitability ratios to judge a
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company’s return on investment based on its relative level of
resources and assets. In other words, profitability ratios can be used
to judge whether companies are making enough oper¬ational profit
from their assets. In this sense, profitability ratios relate to efficiency
ratios because they show how well companies are using their assets
to generate profits. Profitability is also important to the concept of
solvency and going concern.
Here are some of the key ratios that investors and creditors consider
when judging how profitable a company should be:
•Profit Margin Analysis
The profit margin ratio, also called the return on sales ratio or gross
profit ratio, is a profitability ratio that measures the amount of net
income earned with each dollar of sales generated by comparing the
net income and net sales of a company. In other words, the profit
margin ratio shows what percentage of sales are left over after all
expenses are paid by the business .
Creditors and investors use this ratio to measure how effectively a
company can convert sales into net income. Investors want to make
sure profits are high enough to distribute dividends while creditors
want to make sure the company has enough profits to pay back its
loans. In other words, outside users want to know that the company is
running efficiently. An extremely low-profit margin would indicate
the expenses are too high and the management needs to budget and
cut expenses.
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The return on sales ratio is often used by internal management to set
performance goals for the future.
The profit margin ratio formula can be calculated by dividing net
income by net sales.
•Effective Tax Rate
The effective tax rate is the average rate at which an individual is
taxed on earned income, or the average rate at which a corporation is
taxed on pre-tax profits.
The formulas for effective tax rate are as follows:
Effective tax rates simplify comparisons among companies or
taxpayers. This is especially true where a progressive, or tiered tax
system is in place. Those subject to progressive taxes will see
different levels of income taxed at different rates.
•Return on Assets
The return on assets ratio, often called the return on total assets, is a
profitability ratio that measures the net income produced by total
assets during a period by comparing net income to the average total
assets.
In other words, the return on assets ratio or ROA measures how
efficiently a company can manage its assets to produce profits during
a period. Since company assets’ sole purpose is to generate revenues
and produce profits, this ratio helps both management and investors
see how well the company can convert its investments in assets into
profits. Analysts look at ROA as a return on investment for the
company since capital assets are often the biggest investment for most
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companies. In this case, the company invests money into capital
assets and the return is measured in profits.
The return on assets ratio formula is calculated by dividing net income
by average total assets.
•Return on Equity
The return on equity ratio or ROE is a profitability ratio that measures
the ability of a firm to generate profits from its shareholders
investments in the company. In other words, the return on equity ratio
shows how much profit each dollar of common stockholders’ equity
generates. This is an important measurement for potential investors
because they want to see how efficiently a company will use their
money to generate net income. ROE is also an indicator of how
effective management is at using equity financing to fund operations
and grow the company.
The return on equity ratio formula is calculated by dividing net
income by shareholder’s equity.
•Return on Capital Employed
Return on capital employed or ROCE is a profitability ratio that
measures how efficiently a company can generate profits from its
capital employed by comparing net operating profit to capital
employed. In other words, return on capital employed tells investors
how many dollars in profits each dollar of capital employed generates.
ROCE is a long-term profitability ratio because it shows how
effectively assets are performing while taking into consideration
long-term financing. This is why RoCE is a more useful ratio than
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return on equity to evaluate the longevity of a company. This ratio is
based on two important calculations: operating profit and capital
employed.
Net operating profit is often called EBIT or earnings before
interest and taxes. EBIT is often reported on the income statement
because it shows the company profits generated from operations.
EBIT can be calculated by adding interest and taxes back into net
income if need be.
Capital employed is a fairly convoluted term because it can be
used to refer to many different financial ratios. Most often capital
employed refers to the total assets of a company less all current
liabilities. This could also be looked at as stockholders’ equity less
long-term liabilities. Both equal the same figure.
Return on capital employed formula is calculated by dividing net
operating profit or EBIT by the employed capital.
EFFICIENCY RATIOS
Efficiency ratios also called activity ratios measure how well
companies utilize their assets to generate income. Efficiency ratios
often look at the time it takes companies to collect cash from customer
or the time it takes companies to convert inventory into cash—in other
words, make sales. These ratios are used by management to help
improve the company as well as outside investors and creditors
looking at the operations of profitability of the company.
Efficiency ratios go hand in hand with profitability ratios. Most often
when companies are efficient with their resources, they become
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profitable. Wal-Mart is a good example. Wal-Mart is extremely good
at selling low margin products at high volumes. In other words, they
are efficient at turning their assets. Even though they don’t make
much profit per sale, they make a ton of sales.
Here are the most common efficiency Ratios include:
•Account Receivable Turnover Ratio
This is an efficiency ratio or activity ratio that measures how many
times a business can turn its accounts receivable into cash during a
period. In other words, the accounts receivable turnover ratio
measures how many times a business can collect its average accounts
receivable during the year. A turn refers to each time a company
collects its average receivables. This ratio shows how efficient a
company is at collecting its credit sales from customers. Some
companies collect their receivables from customers in 90 days while
other take up to 6 months to collect from customers.
In some ways the receivables turnover ratio can be viewed as a
liquidity ratio as well. Companies are more liquid the faster they can
convert their receivables into cash.
Accounts receivable turnover is calculated by dividing net credit sales
by the average accounts receivable for that period.
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because it shows the liquidity of the company. Current liabilities are
best paid with current assets like cash, cash equivalents, and
marketable securities because these assets can be converted into cash
much quicker than fixed assets. The faster the assets can be converted
into cash, the more likely the company will have the cash in time to
pay its debts.
The reason this ratio is called the working capital ratio comes from
the working capital calculation. When current assets exceed current
liabilities, the firm has enough capital to run its day-to-day operations.
In other words, it has even capital to work. The working capital ratio
transforms the working capital calculation into a comparison between
current assets and current liabilities.
The working capital ratio is calculated by dividing current assets by
cur rent liabilities.
•Asset Turnover Ratio
The asset turnover ratio is an efficiency ratio that measures a
company’s ability to generate sales from its assets by comparing net
sales with average total assets. In other words, this ratio shows how
efficiently a company can use its assets to generate sales.
The total asset turnover ratio calculates net sales as a percentage of
assets to show how many sales are generated from each dollar of
company assets. For instance, a ratio of .5 means that each dollar of
assets generates 50 cents of sales.
The asset turnover ratio is calculated by dividing net sales by average
total assets.
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•Inventory Turnover Ratio
The inventory turnover ratio is an efficiency ratio that shows how
effectively inventory is managed by comparing cost of goods sold
with average inventory for a period. This measures how many times
average inventory is “turned” or sold during a period. In other words,
it measures how many times a company sold its total average
inventory dollar amount during the year. This ratio is important
because total turnover depends on two main components of
performance. The first component is stock purchasing. If larger
amounts of inventory are purchased during the year, the company will
have to sell greater amounts of inventory to improve its turnover. If
the company can’t sell these greater amounts of inventory, it will
incur storage costs and other holding costs. The second component is
sales. Sales have to match inventory purchases otherwise the
inventory will not turn effectively. That’s why the purchasing and
sales departments must be in tune with each other.
The inventory turnover ratio is calculated by dividing the cost of
goods sold for a period by the average inventory for that period .
•Days’ sale to Inventory
The days sales of inventory value measures a firm performance by
telling readers of financial statements how long it takes a firm to turn
its inventory (including goods that are a work in progress, if
applicable) into sales. This ratio is important to creditors and
investors as it measures value, liquidity, and cash flows. Investors and
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creditors are always interested in knowing the value of a trade
partner’s inventory.
DEBT RATIOS
•Debt Ratio
Debt ratio is a solvency ratio that measures a firm’s total liabilities as
a percentage of its total assets. In a sense, the debt ratio shows a
company’s ability to pay off its liabilities with its assets. In other
words, this shows how many assets the company must sell in order to
pay off all of its liabilities. This ratio measures the financial leverage
of a company. Companies with higher levels of liabilities compared
with assets are considered highly leveraged and more risky for
lenders.
This helps investors and creditors analysis the overall debt
burden on the company as well as the firm’s ability to pay off the debt
in future, uncertain economic times.
The debt ratio is calculated by dividing total liabilities by total assets.
Both of these numbers can easily be found the balance sheet. Here is
the calculation.
•Debt-Equity Ratio
The debt to equity ratio is a measure of the relationship between the
capital contributed by creditors and the capital contributed by
shareholders. It also shows the extent to which shareholders’ equity
can fulfill a company’s obligations to creditors in the event of a
liquidation .
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Both total liabilities and shareholders’ equity figures in the above
formula can be obtained from the balance sheet of a business. A
variation of the above formula uses only the interest bearing long-
term liabilities in the numerator.
•Capitalization Ratio
The capitalization ratio compares total debt to total capitalization
(capital structure). The capitalization ratio reflects the extent to which
a company is operating on its equity. Capitalization ratio is also
known as the financial leverage ratio.
It tells the investors about the extent to which the company is
using its equity to support its operations and growth. This ratio helps
in the assessment of risk. The companies with high capitalization ratio
are considered to be risky because they are at a risk of insolvency if
they fail to repay their debt on time.
Companies with a high capitalization ratio may also find it
difficult to get more loans in the future. A high capitalization ratio is
not always bad, however, higher financial leverage can increase the
return on a shareholder’s investment because usually there are tax
advantages associated with the borrowings.
The capitalization ratio is calculated by dividing the long-term
debt by the total shareholder’s equity and long-term debt. This can be
expressed as:
The capitalization ratio is a very meaningful debt ratio because it
gives an important insight into the use of financial leverage by a
company. It focuses on the relationship of long-term debt as a
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component of the company’s total capital base. The total capital is the
capital raised by the shareholders and the lenders.
The company’s capitalization (it should not be confused with
the market capitalization) explains the make-up of the long-term
capital of the company. Capitalization is also known as capital
structure. A company’s long-term capital consists of long-term
borrowings and shareholder’s equity.
•Interest Coverage Ratio
The interest coverage ratio (ICR) is a measure of a company’s ability
to meet its interest payments. The interest coverage ratio is a measure
of the number of times a company could make the interest payments
on its debt with its EBIT. It determines how easily a company can pay
interest expenses on outstanding debt. Interest coverage ratio is equal
to earnings before interest and taxes (EBIT) for a time period, often
one year, divided by interest expenses for the same time period.
The interest coverage ratio is calculated by dividing a
company’s earnings before interest and taxes (EBIT) by the
company’s interest expenses for the same period.
The lower the interest coverage ratio, the higher the company’s
debt burden and the greater the possibility of bankruptcy or default.
A lower ICR means less earnings are available to meet interest
payments and that the business is more vulnerable to increases in
interest rates. An interest coverage ratio below 1.0 indicates the
business is having difficulties generating the cash necessary to pay its
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interest obligations (i.e. interest payments exceed its earnings
(EBIT)).
A higher ratio indicates a better financial health as it means that
the company is more capable to meet its interest obligations from
operating earnings. On the other hand, a high ICR may suggest a
company is “too safe” and is neglecting opportunities to magnify
earnings through leverage.
•Cash Flow to Debt Ratio
This coverage ratio compares a company’s operating cash flow to its
total debt, which, for purposes of this ratio, is defined as the sum of
short-term borrowings, the current portion of long-term debt and
long-term debt. This ratio provides an indication of a company’s
ability to cover total debt with its yearly cash flow from operations.
The higher the percentage ratio, the better the company’s ability to
carry its total debt.
OPERATING PERFORMANCE RATIOS
Operating performance ratios measure how different aspects of a
company’s finances are performing. The fixed-asset turnover ratio,
operating cycle ratio and revenue per employee ratio each provide a
different look into how a company is bringing in revenue, if the
business is spending its money well and how efficiently it is using its
assets and resources.
Analyzing these ratios provides deeper insight into the
company’s finances than simply studying accounting or other
financial records.
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•Fixed-Asset Turnover
The fixed-asset turnover ratio is a measure of whether the money a
company spends on the equipment and buildings the company owns,
often referred to as property, plant and equipment. The fixed-asset
turnover ratio is obtained by dividing the company’s net revenue by
the current value of the fixed assets.
A high ratio generally indicates that the company is generating
adequate revenue with its assets and that the fixed assets are a wise
investment of the company’s resources.
However, companies that don’t require much investment in
PP&E, such as consulting firms or IT companies, often have lower
fixed-asset turnover ratios than companies that rely more on
equipment to make money, such as manufacturers.
This means that you must analyze the fixed-assets turnover ratio
within the norms of the industry. You also must compare the current
fixed-assets turnover ratio to historical fixed-asset turnover ratio
figures to determine if the ratio is increasing or decreasing. A
declining ratio may indicate that the company has too much money
tied up in its equipment or property. An increasing ratio often
indicates that the company is making better use of its property and
equipment or has upgraded effectively
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employee ratio, divide the annual revenue the company earns by the
number of employees it has. This ratio is expressed as a dollar
amount .
A high revenue per employee ratio means that employees are
generating adequate sales or revenue for the company, while a low
ratio is often a sign of low productivity. This is especially true for
labor-heavy industries, such as retail and manufacturing. However,
businesses that do not rely as much on employee productivity, such
as technology fields, may have lower revenue per employee ratios,
even if the company’s employees are producing adequate revenue.
For this reason, you must compare the revenue per employee ratio to
other companies in the same industry to get an accurate idea of what
is normal.
•Operating Cycle
The operating cycle ratio shows if a company is managing its
accounts payable, accounts receivable and inventory efficiently. The
operating cycle ratio involves three aspects of the company’s
finances; the days inventory outstanding, the days sales outstanding
and the days payable outstanding. These aspects all are calculated the
same way. Divide the cost of processing the accounts payable,
accounts receivable or inventory by 365, the number of days in a year,
to get the daily cost. Add the beginning and ending balances of the
accounts payable, accounts receivable or inventory account and
divide the answer by two to get the average amount for each account.
Divide the average amount by the cost per day to find the days
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inventory outstanding, days sales outstanding or days payable
outstanding. Calculate the operating cycle ratio by adding the days
inventory outstanding and the days sales outstanding, then subtracting
the days payable outstanding. The resulting figure is expressed as a
number of days.
A shorter operating cycle means that a company collects money
from customers efficiently, has good payment terms with businesses
and other entities to which it owes money and is moving inventory at
a pace that keeps up with average production ability and customer
demand. A longer operating cycle indicates that the business has too
much money tied up in unsold inventory, uncollected payments, and
unpaid operating expenses. To perform an accurate analysis, the
operating cycle ratio should be compared against industry standards,
competitor operating cycle data and the company’s own historical
operating cycle information .
CASH FLOW INDICATOR RATIOS
These ratios can give users another look at the financial health and
performance of a company.
•operating Cash Flow/Sales Ratio
This ratio, which is expressed as a percentage, compares a company’s
operating cash flow to its net sales or revenues, which gives investors
an idea of the company’s ability to turn sales into cash. It would be
worrisome to see a company’s sales grow without a parallel growth
in operating cash flow. Positive and negative changes in a company’s
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terms of sale and/or the collection experience of its accounts
receivable will show up in this indicator.
•Free Cash Flow/ Operating Cash Ratio
The free cash flow/operating cash flow ratio measures the
relationship between free cash flow and operating cash flow.
Free cash flow is most often defined as operating cash flow minus
capital expenditures, which, in analytical terms, are considered to be
an essential outflow of funds to maintain a company’s
competitiveness and efficiency.
The cash flow remaining after this deduction is considered
“free” cash flow, which becomes available to a company to use for
expansion, acquisitions, and/or financial stability to weather difficult
market conditions. The higher the percentage of free cash flow
embedded in a company’s operating cash flow, the greater the
financial strength of the company.
Formula = Free cash flow (Operating cash flow — Capital
expenditures) / Operating cash flow
• Cash Flow Coverage Ratio
This ratio measures the ability of the company’s operating cash flow
to meet its obligations - including its liabilities or ongoing concern
costs .
The operating cash flow is simply the amount of cash generated by
the company from its main operations, which are used to keep the
business funded.
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The larger the operating cash flow coverage for these items, the
greater the company’s ability to meet its obligations, along with
giving the company more cash flow to expand its business, withstand
hard times, and not be burdened by debt servicing and the restrictions
typically included in credit agreements.
•Dividend Payout Ratio
This ratio identifies the percentage of earnings (net income) per
common share allocated to paying cash dividends to shareholders.
The dividend payout ratio is an indicator of how well earnings support
the dividend payment.
Here’s how dividends “start” and “end.” During a fiscal year
quarter, a company’s board of directors declares a dividend. This
event triggers the posting of a current liability for “dividends
payable.” At the end of the quarter, net income is credited to a
company’s retained earnings, and assuming there’s sufficient cash on
hand and/or from current operating cash flow, the dividend is paid
out. This reduces cash, and the dividends payable liability is
eliminated.
The payment of a cash dividend is recorded in the statement of cash
flows under the “financing activities” section.
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INVESTMENT VALUATION RATIOS
• Price Earning Ratio
The price/earnings ratio (P/E) is the best known of the investment
valuation indicators. The P/E ratio has its imperfections, but it is
nev¬ertheless the most widely reported and used valuation by
investment professionals and the investing public. The financial
reporting of both companies and investment research services use a
basic earnings per share (EPS) figure divided into the current stock
price to calculate the P/E
multiple (i.e. how many times a stock is trading (its price) per each
dollar of EPS).
Historically, the average P/E ratio for the broad market has been
around 15, although it can fluctuate significantly depending on
economic and market conditions. The ratio will also vary widely
among different companies and industries.
•Price/Book value Ratio
A valuation ratio used by investors which compares a stock’s per-
share price (market value) to its book value (shareholders’ equity).
The price- to-book value ratio, expressed as a multiple (i.e. how many
times a company’s stock is trading per share compared to the
company’s book value per share), is an indication of how much
shareholders are paying for the net assets of a company.
The book value of a company is the value of a company’s assets
expressed on the balance sheet. It is the difference between the
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balance sheet assets and balance sheet liabilities and is an estimation
of the value if it were to be liquidated.
The price/book value ratio, often expressed simply as “price-to-
book”, provides investors a way to compare the market value, or what
they are paying for each share, to a conservative measure of the value
of the firm.
•Price/Earnings to Growth Ratio
The price/earnings to growth (PEG) ratio is used to determine a
stock’s value while taking the company’s earnings growth into
account, and is considered to provide a more complete picture than
the P/E ratio. While a high P/E ratio may make a stock look like a
good buy, factoring in the company’s growth rate to get the stock’s
PEG ratio can tell a different story. The lower the PEG ratio, the more
the stock may be undervalued given its earnings performance. The
calculation is as follows :
The ratio is based on projected earnings per share growth.
Projections are not always accurate.
•Price/Sales Ratio
The price-to-sales ratio is an indicator of the value placed on each
dollar of a company’s sales or revenues. It can be calculated either by
dividing the company’s market capitalization by its total sales over a
12-month period, or on a per-share basis by dividing the stock price
by sales per share for a 12-month period. Like all ratios, the price-to-
sales ratio is most relevant when used to compare companies in the
same sector. A low ratio may indicate possible undervaluation, while
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a ratio that is significantly above the average may suggest
overvaluation. Abbreviated as the P/S ratio or PSR, this ratio is also
known as a “sales multiple” or “revenue multiple”.
•Dividend Yield
Dividend yield is the ratio of dividend per share to current share price.
It is a measure of what percentage an investor is earning in the form
of dividends.
Dividend yield is a measure of investor return. While dividend payout
ratio judges the amount of dividend in relation to the company’s
earnings for the period, dividend yield ratio provides a comparison of
amount of dividend in relation to investment needed to purchase its
share.
•Enterprise Value Multiple
Enterprise value multiple is the comparison of enterprise value and
earnings before interest, taxes, depreciation, and amortization. This is
a very commonly used metric for estimating the business valuations.
It compares the value of a company, inclusive of debt and other
liabilities, to the actual cash earnings exclusive of the non-cash
expenses .
This ratio is also known as “EV/EBITDA ratio” and “EBITDA
multiple”. Enterprise multiple can be used to compare the value of
one company to the value of another company within the same
industry. A lower enterprise multiple can be indicative of
undervaluation of a company. Enterprise value multiple is calculated
by dividing the enterprise value (Ev) by the earnings before interest,
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taxes, depreciation, and amortization (EBITDA). This can be written
as Enterprise value multiple is a better measure than the P/E ratio
because it is not affected by the changes in the capital structure.
Consider a scenario in which a company raises equity finance and
uses these funds to repay the loans. This will usually result in lower
earnings per share (EPS) and therefore a higher P/E ratio.
But the Enterprise value multiple will not be affected by this
change in capital structure. This means that Enterprise value multiple
cannot be manipulated by the changes in capital structure. Another
benefit of Enterprise value multiple is that it makes possible fair
comparison of companies with different capital structures.
Another positive point about the Enterprise value multiple is
that it removes the effects of non-cash expenses such as depreciation
and amortization. These non-cash items are of less significance to the
investors because they are ultimately interested in the cash flows.
Enterprise value multiple is not usually appropriate for comparison of
companies in different industries. Capital requirements of other
industries are different. Therefore, Enterprise value multiple may not
give reliable conclusions when comparing different industries.
LIMITATIONS
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There is considerable subjectivity involved, as there is no correct
number for the various ratios. Further, it is hard to reach a definite
conclusion when some of the ratios are favorable and some are
unfavorable. Still. Auditors must use ratios while conducting
analytical procedures, keeping in mind that departures from industry
average would not provide conclusive evidence of risk or
fraudulent .
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Financial Statement Analysis
Horizontal and vertical
Introduction:
The periodic financial statements give owners, employees,
creditors, government agencies, and others a picture of
management‘s performance. Thus, the solvency of the enterprise
is presented in the balance sheet, and its profitability in the
income statement.
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section.
Amount and Percentage change (Horizontal analysis)
In most cases published annual reports to stockholders show
financial statements for prior years, some- times extending back
over a 10- year- period. The year –to-year changes in each item can
then be computed and intercom pared. In such a horizontal, the
changes may be specified as absolute amounts or as percentages.
EXAMPLE 1
Rye field Company
Comparative Balance Sheet
Years ended December 31, 2022, 2021.
year 2022 2021 2022-2021 Percent %
Assets
Current assets 130,000 120,000 10,000 8.3%
Liabilities
Current liabilities 50,000 60,000 (10,000) (16.67%)
STOCKHOLDER
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Preferred stock ,5%, 100 par 10,000 10,000 - -
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amount, 66.7% the cost of sales increased by even more, 95.9%
This would indicate a decrease in percentage of gross profit in
relation to sales a feature shown more clearly in the component
analysis (vertical analysis)
FINANCIAL STATEMENT ANALYSIS: HORIZONTAL AND VERTEICAL
EXAMPELE 3
For the balance sheet of Rye Field Company (see example 1).
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We have the following vertical analysis:
Rye Field Company
Comparative Balance Sheet
Years ended December 31, 2022, 2021.
Liabilities
Current liabilities 50,000 60,000 25.1% 33.3%
STOCKHOLDER
Preferred stock 10,000 10,000 5.0% 5.6%
EXAMPELE 4
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vertical analysis:
Rye Field Company
Comparative Income statement
Years Ended December 31, 2022, and 2021
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purchase prices that was not yet reflected in sales prices. If
manufacturing was involved, the increase may be due to increases in
labor rates or labor use, materials cost, etc.
The percentages developed for one company by vertical
analysis can be company to those of another company or to the
industry percentages that are published by trade associations and
financial services. The comparison displayed on a common – size
statement, so called because all dollar amounts are omitted.
Ratio Analysis
All businesses must operate as economically as possible if
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they are to survive and prosper. To maintain operating efficiency,
management must make use of each and every tool of analysis.
Financial ratio analysis is recognized as such a tool.
FINANCIAL ANALYSIS AND CONTROL
A successful business operation depends greatly on
managerial planning. However, since planning involves the
consideration of an uncertain future, even the best management
plans have been known to go astray. Therefore, the management
team requires a continuous reading of the firm’s progress, or lack
of it toward previously established goals. Furthermore, many
businesses have been known to fail simply because management
discovered too late that plans were going astray. Through
continual evaluation of financial records, management might
have recognized the problem as it was developing, allowing
sufficient time for corrective action.
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Financial ratio analysis is frequently used to measure the
performance of various sectors of a business. If properly used (its
limitations understood), it can be a very useful management aid.
Following are a few reasons why ratio analysis is being used so
extensively:
a) Ratios are easy to calculate - most ratios compare two statistics
which are normally provided in the income statement or the
balance sheet. Because these data are readily available at a more-
or- less fixed cost, not much time or expense is required to
compute a ratio.
b) Ratios allow easy comparison - they allow comparison of a
firm’s past with its present performance, as well as comparisons
between similar firms at one time.
c) Ratios are easily understood - not all members of the
management team are financial sophisticates and ratios provide
simple overview information to all types of management
personnel.
d) Ratios communicate a firm’s financial position to interested
parties outside of management - for example, financial authorities
may rely on ratios to determine a firm’s credit worthiness.
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Ratio analysis helps to reveal the overall financial condition
of a firm. It helps investors to spot whether the firm is doing well
compared to its competitors and to evaluate the company's
performance and growth.
Accordingly, poor financial ratios lead to higher financial
costs, while good ratios usually mean that investors will be
willing to make funds available to the company at more
reasonable costs.
Groups of Financial Ratios:
Financial ratios can be divided into four basic groups:
1- Liquidity ratios.
2- Activity ratios.
3- Debt ratios.
4- Profitability ratios.
1- Liquidity Ratios:
Measure the company's ability to pay-off its short-term
obligations and to meet unexpected needs for cash.
• Net Working Capital:
Is the amount needed for one operating cycle; it’s the
amount of current assets remained after deducting the current
liabilities.
Net Working Capital = Current assets - Current liabilities
• Current Ratio:
Indicate whether, the company has adequate assets that either
are cash or are readily convertible into cash over the next year (or
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period) to cover the liabilities that are due over that same time
period. A current ratio greater than one indicate positive working
capital (defined as current assets - current liabilities).
Current ratio = Current assets = …..
Current liabilities
The standard ratio is 1: 1
• Quick Ratio (Acid test):
Measure the company's immediate short-term liquidity to
pay-off its short term liabilities excluding inventory.
Quick ratio = Current assets – Inventory = …..
Current liabilities
The standard ratio is 2:1
2-Activity Ratios:
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Inventory Turnover = Cost of goods sold = …. Times
Average inventory
The higher turnover the better indicator it is .
• Day’s inventory:
The day’s inventory ratio indicates how many days inventory
was held before it was sold. This restatement of the turnover ratio
into days is useful when attempting to estimation the costs of
holding inventory.
The longer that inventory must be held and stored before use or
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Day’s inventory = =… days
Inventory turn over
sale, the greater the storage costs. And The shorter period is the
better indicator.
• Accounts receivables turn over:
The accounts receivable turnover ratio indicates how many
times over the; reporting period a credit sale is made to a
customer and subsequently collected.
The accounts receivables turn over rate indicates how quickly
a company converts its accounts receivables into cash.
Credit sales
Accounts receivable turn over =…
= times
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The day’s receivable ratio uses the calculated turnover to
illustrate how many days are required to collect the average
account. As the turnover ratio is higher, the number of day
between the charge sale and collection of the cash is lower,
reducing the cost of operating cash tied up in receivables from
customers.
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Day’s receivables = =…..days
Acc. Receivables turn over
• Fixed Assets Turnover:
Measures how efficiently a firm uses its fixed assets to
generate sales.
Fixed Assets Turnover = Net Sales = …. Times
Net Fixed Assets
• Total Assets Turnover:
This measure shows how efficient a company is at generating
revenues for a given level of total assets.
Total Assets Turnover = Net Sales = …. Times
Total Assets
3-Debt Ratios:
Measures the extent to which the firm's activities are
financed by borrowing and the firm's ability to pay the debt.
Important Measures of debt:
• Debt to Total Asset ratio (operation leverage):
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It measures the extent to which borrowed funds have been
used to finance the company's assets.
Debt to Total Assets = Total Debt = …..
Total Assets
This ratio describes the proportion of “other people’s
money” to the total claims against the assets of the business.
The higher the ratio the greater the risk for the lender.
4-Profitability Ratios:
Measures the income or operating success of an enterprise
for a given period of time.
Important measures of profitability:
• Gross Profit Margin:
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It measures the percentage of each sales dollar remaining
after a firm has paid for its goods.
Gross Profit Margin = Gross Profit x 100 = … %
Sale
• Net Profit Margin:
Measures the percentage of each sales dollar remaining
after all expenses have been deducted, including taxes.
Net Profit Margin = Net profit x 100 = … %
Sales
Return on Assets (ROA):
Measure the overall effectiveness of management's use of a
firm's assets to generate profit.
ROA = Net profit = ….
Total assets
• Return on Equity (ROE):
Measures the return earned on the owner's investment in the
firm.
ROE = Net profit = …..
Owner's equity
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• Price-Earning ratio (P/E):
Measure the ratio of the market price of each share of
common stock to the earnings per share.
P/E = Common Stock Market Price = ….. $
Earning per share
Example: The following is “x” company’s financial report:
Balance Sheet:
Assets Amount Liabilities Amount
Cash 200 A/P 400
A/R 100 N/P 500
Inventory 150
Total C/A 450 Total C/L 900
Land 400 Loan 200
Building 300 O.E 350
Machines 300
Total Fixed Assets 1000
Income statement:
Sales 600
Sales return (100)
Sales allowance (80)
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Net sales 420
C.G.S (100)
Gross profit 320
Administrative expenses (20)
Net profit before interest 300
Interest (20)
Net profit before tax 280
Tax 20% (56)
Net profit after tax 224
Required: prepare the ratio analysis if you know that the credit
sales = 60% of sales.
Solution:
1- Liquidity ratio:
Current ratio = current assets / current liabilities = 450/900= 0.5
Quick ratio = (current assets – inventory) / current liabilities =
= (450- 150) / 900 = 0.3
Net working capital = current assets – current liabilities = 450 –
900 = - 450
2 – Activity ratio:
Total assets turn over = net sales / total asset
= 420 / 1450 = 0.28 times.
Fixed assets turn over = net sales / fixed assets
= 420 / 1000 = 0.42 times.
Inventory turn over = C.G.S / inventory = 100 / 150 = 0.6 times.
Day’s inventory = 365 / inventory turn over = 365 / 0.6 = 608.3 days
Account receivables turn over = credit sales / accounts
receivables
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Credit sales = sales * 60/100 = 360
Accounts receivables turn over = 360 / 100 = 3.6 times
Day’s receivables = 365/ accounts receivables turn over
= 365 / 3.6 = 101.3 days
3- Debt ratios:
Debt to Total Assets = Total debt / total assets = 1100 / 1450 = 0.7
Debt Equity Ratio = Total debt / O.E = 1100 / 350 = 3.14
Times interest earned = Earnings before interest and tax =
Interest expense
= 300 / 20 = 15 times
4-Profitability ratios:
ROA = Net profit / total assets = 224 / 1450 = 0.15
ROE = Net profit / O.E = 224/ 350 = 0.64
Gross profit margin = gross profit / sales = 320 / 420 = 0.7
Net Profit Margin = Net profit / sales = 224 / 420= 0.5
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