Chapter One

Accounting Principles and Practice

1.1. Definition of Accounting.
Accounting is the process of identifying, measuring, and communicating financial information
about an entity to permit informed judgments and decisions by users of the information. It is a
system of gathering financial information about a business and reporting this information to users.
There are six major steps in accounting process:
1. Analyzing - is looking at events that have taken place and thinking about how they affect the
business. Such an economic events or conditions that directly changes an entity’s financial
condition or results of operation are known as business transactions in accounting.
2. Recording - is entering financial information about events in to the accounting system. This
can be done manually or using computer, this days most business use computers to perform
routine record-keeping operations.
3. Classifying - is sorting and grouping similar items and /or events rather than merely keeping
numerous items and /or events all together.
4. Summarizing - is bringing the various items of information together to determine a result.
5. Reporting - is telling the results.
6. Interpreting -is deciding the meaning and importance of the information in various reports.
This may include percentage analysis and the use of ratios to help explain how pieces of
information relate to one another.
1.2. Users of accounting information.
An Accounting profession should consider the needs of the users of financial information. As a
consequence, you should know who these users are and something about their needs for
information. Basically users of accounting information’s are classified in to two: Internal and
External users.
 Internal users: Internal users are basically refers to users, those involve in the day to day
activity of the organization. It includes management at all levels uses accounting information
in planning, controlling, and evaluating business operations.
 External Users: Include all external users those did not involve in the day to day activities of
the organization, But those users will have direct or indirect interest from the operation of the
organization.
Eternal users with a direct interest are the company’s investors and creditors. Investors (Owners)
make their decision to buy, hold, or sell their financial interest on the basis of accounting

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information. Creditors (suppliers and banks) evaluate the risks of granting credit or lending money
on the basis of available accounting information.
External users with indirect interest, such as: Taxing authorities (For example, the internal revenue
authority) want to know whether the company complies with the tax laws. Regulatory agencies
(For example, Investment Agency) want to know whether the company is operating within
prescribed rules. Customers are interested in whether a company will continue to honor product
warranties and otherwise its support a product line. Labor unions want to know if the owners have
the ability to pay increased wages and benefits. Economic planners use accounting information to
analyze and forecast economic activity.
1.3. Profession of Accounting.
You probably would apply your expertise in one of three major fields- public accounting, private
accounting, or not-for-profit accounting.
 Public Accounting
In public accounting, you would offer expert service to the general public in much the same way
that a doctor serves patients and lawyer serves clients. A major portion of public accounting
practice is involved with auditing. In this area, a certified public accountant (CPA) examines the
financial statements of companies and expresses an opinion as to the fairness of presentation. When
the presentation is fair, users consider the statements to be reliable.
Taxation is another major area of public accounting. The work performed by tax specialists
included tax advice and planning, preparing tax returns, and representing clients before
governmental agencies such as the Internal Revenue Authority.
A third area in public accounting is management consulting. Management consulting range from
the installing of basic computerize accounting systems to helping companies determine whether
they should use the space shuttle for high-tech research and development projects.
 Private Accounting
Instead of working in public accounting an accountant may be an employee of a business
enterprise. In private (Or managerial) accounting, you would be involved in one of the following
activities.
A. Cost accounting – determining the cost of producing specific products.
B. Budgeting- assisting management in quantifying goals concerning revenues cost of
goods sold, and operating expenses.
C. General accounting- recording daily transactions and preparing financial statement and
related information.
D. Accounting information systems- designing both manual and computerized data

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 processing systems.
E. Tax accounting- preparing tax returns and engaging in tax planning for the company.
F. Internal auditing- reviewing the company’s operations to determine compliance with
management policies and evaluating the efficiency of operations.
From the above, you can see that within a specific company, private accountant’s performance as
wide a variety of duties as the public accountant.
 Not-for-profit Accounting
Even if the objective of Not-for-profit organizations is different from profit seeking organization
they also need sound financial reporting and control.
1.4. Accounting principles and concepts.
Generally accepted accounting Principles (GAAP)
Its efforts have resulted in a common set of standards called generally accepted accounting
principles (GAAP). These standards indicate how to report economic events.
☼Who sets generally accepted principles?
Two organizations are primarily responsible for establishing generally accepted accounting
principles. The first is the Financial Accounting Standards Board (FASB), a private organization
that establishes broad reporting standards of general applicability as well as specific accounting
rules. The second, the Securities and Exchange Commission (SEC), is a US governmental agency
that requires companies filing financial reports with it to follow generally accepted accounting
principles. In situations where no principles exist, the SEC often mandates that certain guidelines
be used. In general, the FASB and the SEC work hand in hand to assure that timely and useful
accounting principles are developed. The Generally accepted accounting principle and
Assumptions has been discussed as follows:
 Cost Principles
The cost principle, which states that, assets should be recorded at their cost. Cost is the value
exchanged at the time something is acquired.
Example: If you buy a house today, the cost is the amount you pay for it, say Br. 100,000. If you
sell the house in two years for Br. 120,000, the sales price is its market value- the value determined
by the market for homes at that time.
Forms of business enterprise
Which may be organized as Sole proprietorship, partnership, or corporation?
1) Sole Proprietorship: A business owned by one person is generally a sole proprietorship. The
owner is often the manager/ operator of the business. Small service-type businesses are often sole
proprietorships. Usually only a limited amount of money (capital) is necessary to start in business

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as a proprietorship, and the owner receives any profits, suffers any losses, and is personally liable
for all debts of the business. Although there is no legal distinction between the business as an
economic unit and the owner, the records of the business activities are kept separate from the
personal records and activities of the owner.
2) Partnership: A business owned by two or more persons associated as partners is a partnership.
In most respects a partnership is similar to a sole proprietorship except that more than one owner is
involved. When a partnership is created, an agreement (written or oral) should set forth such terms
as initial investment of each partner, duties of each partner, division of net income (or net loss), and
settlement to be made upon death or withdrawal of a partner. Each partner generally has unlimited
personal liability for the debts of the partnership. Like a proprietorship, for accounting purposes the
partnership affairs must be kept separate from the personal activities of the partners. Partnerships
are often using to organize retail and service-type businesses, including professional practices
(lawyers, doctor, architects, an certified public accountants).
3) Corporation: A business organization as a separate legal entity under state corporation law and
having ownership divide in to transferable shares of stock is called a corporation. The holders of
the shares (Stockholders) enjoy limited liability; they are not personally liable for the debts of the
corporation entity. Stockholders may transfer all or part of their shares to other investors at any
time (i.e., sell their shares in the securities market). The ease with which ownership can change
adds to the attractiveness of investing in a corporation. Because ownership can be transferred
without dissolving the corporation, the corporation enjoys an unlimited life.

1.5. The distinction between Book - keeping and Accounting

Bookkeeping usually involves only the recording of economic events and is therefore just one part
of the accounting process. In total, accounting involves the entire process of identification,
recording, and communication.
The bookkeeping function is often performed by individuals with limited skills in accounting. As a
result, it is not surprising that the increased use of computers by business enterprise has resulted in
much of the detailed work that is part of the bookkeeping process being performed by machines.
1.6. Accounting Equation
The two basic element of a business are what it owns and what it owes. Assets are the resources
owned by a business. For example, XYZ Company has total assets of approximately Br 15 million.
Equities are the rights or claims against these resources. Thus a company such as XYZ Company
that has Br 15 million of assets also has Birr15 million of claims against those assets. This
relationship can be shown in equation form as follows:

Asset =Equities
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 Equities may be further subdivided in to two categories: claims of creditors and claims of
owners. Claims of creditors are called liabilities. Claims of owners are called owner’s equity.
For example, ABC Company has liabilities of Birr11 million and owners’ equity of Birr4
million. The equation above can, then, be expanded as follows:

Asset= Liability +Owners equity

This equation is referred to as the basic accounting equation. Assets must equal the sum of
liabilities and owner’s equity. Because creditors’ claims are paid before ownership claims if a
business is liquidated, liabilities are shown before owner’s equity in the basic accounting equation.
The accounting equation applies to all economic entities regardless of size, nature of business, or
form of business organization.
Let’s look in more detail at the categories in the basic accounting equation.
 Assets →owned by a business
As indicated above, assets are resources owned by a business. Thus, they are the things of value
used in carrying out such activities as production, consumption, and exchange. The common
characteristic possessed by all assets is the capacity to provide future services or benefits to the
entities that use them. In a business enterprise, that service potential or future economic benefit
eventually results in cash inflows (receipts) to the enterprise.
For example, the enterprise Shoa Bakery owns a delivery truck that provides economic benefits
because it is use in delivering breads. Other assets of shoa Bakery are tables, chairs, jukebox, cash
register, oven, mugs, and of course, cash.
 Liabilities →owes
Liabilities are claims against assets. Put more simply, liabilities are existing debts and obligations.
For example, business of all sizes and degrees of success usually find it necessary to borrow money
and to purchase merchandise on credit. Shoa Bakery, for instance, purchases, flour, and yeast on
credit from suppliers; these obligations are called accounts payable. Additionally, Shoa Bakery has
a note payable to Awash bank for the money borrowed to purchase its delivery truck. Shoa Bakery
may also have wages payable to employees, and turnover and profit taxes payable to the local
government. Persons or entities to which Shoa Bakery owes money are called creditors.
Most claims of creditors attach to total enterprise assets rather than to the specific assets provide by
the creditor. In the event of nonpayment, creditors may legally force the liquidation of a business.
In that case, the law requires that creditor claims be paid before ownership claims.

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  Owner’s equity
The ownership claim on total assets is known as owner’s equity. It is equal to total assets minus
total liabilities. Here is why: The assets of a business are supplied or claim by either creditors or
owners. To determine what belongs to owner, we therefore subtract creditors’ claims – the
liabilities- from assets. The remainder- owner’s equity- is the owner’s claim on the assets of the
business. Since the claims of creditors take precedence over ownership claims, the latter are often
referred to as residual equity.
In a proprietorship, owner’s equity is increased by owner’s investments and revenues. It is
decreased by owner’s drawings and expenses.
o Investments by owner: Investments by owner are the assets put into the business by the
owner. These investments in the business increase owner’s equity.
o Drawings: An owner may withdraw cash or other assets during the accounting period for
personal use. These withdrawals could be recorded as a direct decrease of owner’s equity.
However, it is generally considered preferable to use a separate classification referred to as
drawings to determine the total withdrawals for the accounting period. Drawings decrease
total owner’s equity.
 Revenues. Revenues are the gross increase in owner’s equity resulting from business activities
entered into for the purpose of earning income. Generally, revenues result from the sale of
merchandise, the performance of services, the rental of property, and the lending of money.
Revenue usually results in an increase in an asset. They may arise from different sources and are
identified by various names depending on the nature of the business. Shoa bakery, for instance,
has two categories of sales revenues-bread sales and cake sales. Other titles for and sources of
revenue common to many businesses are: sales, fees, services, commissions, interest, dividends,
royalties, and rent.
 Expenses. Expenses are the decreases in owner’s equity that results from operating the
business. They are the cost of assets consumed or services used in the process of earning revenue.
Expenses represent actual or expected cash out flows (payments). Like revenues, expenses take
many forms and are identified by various names depending on the type of assets consumed or
service used. For example, Shoa Bakery may recognizes the following types of expenses: cost of
ingredients (flours, cheese, yeast, creams, etc); wages expense; utility expense (electric, gas, and
water expense); telephone expense; delivery expense (gasoline, repairs, licenses, etc.); supplies
expense (napkins, detergents, etc); rent expense; interest expense; and tax expense.

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1.7. Business Transactions and Financial Statements
Business transactions are an economic events or conditions about business enterprise that must be
recorded. Transactions may be identified as external or internal. External transactions involve
economic events between the company and some outside enterprise or party. For example, for Lead
star University College, purchase of different equipment from a supplier, the payment of monthly
rent to the house owner, and collection of fee from students are external transactions. Internal
transactions are economic events that occur entirely within one company. The use of office
supplies illustrates this type of transaction for the University College.
The equality of the basic equation must be preserved. Therefore, each transaction must have a dual
effect on the equation. For example, if an individual asset is increased, there must be a
corresponding:
1. Decrease in another asset, or
2. Increase in a specific liability, or
3. Increase in owner’s equity.
It follows that two or more items could be affected when an asset is increased. For example, as one
asset in increased Br. 20,000, another asset could decrease Br. 12,000, and a specific liability could
increases Br.8, 000. Note also that any change in an individual liability or ownership claim is
subject to similar analysis.
Transaction Analysis
Assume that Mr. Tadala establishes a sole proprietorship to be known as xyz clinic.
Transaction (1)- Investment by owner: Mr. Tadala decide to open a clinic. On September 1,
2012, he invests Br.15, 000. This transaction results in an equal increase in assets and owners
equity. In this case, there is an increase in the asset Cash, Br.15, 000, and an equal increase in the
owner’s equity, Mr.Tadala’s, capital, Br.15, 000.
The effect of this transaction on the basic equation is:
Assets = Liabilities + owner’s equity
Cash = Mr. Tadala’s Capital,
(1) + Br. 15,000 = +Br.15, 000 Investment

Observe that the equality of the basic equation has been maintained. Note also that the source of
the increase in owner‘s equity is indicated, To make clear that the increase is an investment rather
than revenue from operations.
Transaction (2)- purchase of equipment for cash: XYZ clinic purchases Laboratory equipment
for Br.7,000 cash. This transaction results in an equal increase and decrease in total assets, though
the composition of assets is changed: cash is decreased Br. 7,000, and the asset Equipment is

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 increased Br. 7,000. Both the specific effect of this transaction and the cumulative effect of the first
two transactions are:

Assets = Liabilities + Owner’s Equity

Mr. Tadala’s
Cash + Equipment = Capital
Old Bal. 15,000 15,000
(2) -7,000 + 7,000 ______
New Bal. 8,000 + 7,000 =
15,000 15,000

Observe that total assets are still Br. 15,000 and Tadala’s equity also remains at Br. 15,000, the
amount of his original investment.
Transaction (3)- Purchase of supplies on credit: XYZ clinic purchase different office supplies
from ABC supply company for Br.1,600. ABC Company agrees to allow XYZ clinic to pay this
bill in October, a month later. This transaction is often referred to as a purchase on account or a
credit purchase. Assets are increased by this transaction because of the expected future benefits of
using the supplies, and liabilities are increased by the amount due ABC Company. The asset
supplies is increased Br.1, 600, and the liability accounts payable is increased by the same amount.
The effect on the equation is:
Assets = Liabilities + Owner’s equity

Cash+ Supplies+ Equipment= Accounts Mr.Tadala’s

Payable + capital
Old Bal. Br.8,000 - Br.7,000 - Br.15,000

- +Br.1,600 - +Br.1,600 -
Tran-3
New Bal. Br.8,000 Br.1,600 Br.7,000 Br.1,600 Br.15,000

Br.16,600 Br.16,600

Total assets are now Br.16, 600. This total is matched by a Br.1, 600 creditor’s claim and a Br.15,
000 ownership claims.

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Transaction (4) - Services rendered for cash: XYZ clinic receives Br.1, 200 cash from patient for
medical services it has provided. This transaction represents the principal revenue-producing
activity of XYZ clinic. Recall that revenue increases owner’s equity. Both assets and owners equity
are, then, increased by this transaction: In this case, cash is increased Br. 1,200, and Mr.Tadala’s,
Capital, is increased Br. 1,200. The new balances in the equation are:
Assets = Liabilities + Owner’s equity

Cash+ Supplies+ Equipment= Accounts Mr. Tadala’s

Payable + capital
Old Bal. Br.8,000 Br.1,600 Br.7,000 Br.1,600 Br.15,000

Tran-4 + 1,200 - - +1,200 Service Revenue

NewBal. Br.9,200 Br.1,600 Br.7,000 Br.1,600 Br.16,200

Br.17,800 Br.17,800

The two sides of the equation balance at Br.17,800. Note that owner’s equity is increased when
revenues are earned. The source of the increase in owner’s equity is indicated as service revenue.
Service revenue is included in determining XYZ clinic net income.
Transaction (5) Purchase of Advertising on Credit: XYZ clinic receives a bill for Br.250 from
the Addis Admas News paper for advertising the opening of its business but postpones payment of
the bill until a later date. This transaction results in an increase in liability and a decrease in
owner’s equity. The specific items involved are Accounts payable and Mr. Tadala’s, Capital. The
effect on the equation is:
Assets = Liabilities + Owner’s equity
Cash+ Supplies+ Equipment= Accounts Mr. Tadala’s
Payable + capital
Old Bal. Br.9,200 Br.1,600 Br.7,000 Br.1,600 Br.16,200
- - - + 250 -250 Advertising Expense
Tran-5
NewBal. Br.9,200 Br.1,600 Br.7,000 Br.1,850 Br.15,950
Br.17,800 Br.17,800
The two sides of the equation still balance at Br. 17,800. Observe that owner’s equity is decreased
when the expense is incurred, and the specific cause of the decrease (advertising expense) is noted.
Expenses do not have to be paid in cash at the time they are incurred. The cost of advertising is
considered an expense is included in determining net income.

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Transaction (6)- Services Rendered for Cash and Credit: XYZ clinic provides Medical services
of Br.3, 500 for customers. Cash amounting to Br.1,500 is received from customers, and the
balance of Br.2,000 is billed to customers on account. This transaction results in an equal increase
in assets and owner’s equity. Three specific items are affected: Cash is increased Br. 1,500;
Accounts Receivable is increased Br.2,000; and Mr.Tadala’s, Capital is increased Br.3,500. The
new balances are as follows:

Assets Liabilities
Cash + Accounts +Supplies + Owner’s Equity
Equipment = Account Mr. Tadala’s,
Receivable Payable + Capital

Old Br.9,200 Br.7,000 Br.1,850 Br.15,950

Br.1,600
bal. ______ _________ +3,500
+1,500 +2,000 Service revenue
Br.7,000 Br.1,850
Tran.6 ______
Br.19,450
Br.10,700 + Br.2,000 + 21,3
New
Br.1,600 00
bal
21,300

Why increase owner’s equity by Br.3,500 when only Br.1,500 has been collected? Because, the
inflow of assets resulting from the earning of revenues does not have to be in the form of cash.
Remember that owner’s equity is increased when revenues are earned, and in XYZ clinic case that
is when the service is provided.
Transaction (7)- Payment of Expenses: Expenses paid in cash for September are store rent,
Br.600, salaries of employees, Br.900, and utilities, Br.200. these payments result in an equal
decrease in assets and owner’s equity. Cash is decreased Br.1,700 and Mr Tadala’s, Capital is
decreased by the same amount. The effect of these payments on the equation is:

Assets Liabilities + Owner’s Equity

Cash + Receivable +Supplies + Account Mr Tadala’s,

Equipment =
Payable + Capital

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 Old Br.10,700 Br.2,000 Br.7,000 Br.1,850 Br.19,450
bal Br.1,600
-600 Rent
Tran. -1,700 expense
7
-900 Salaries
________ ______ + expense
______ ______ ______
Br.7,000 Br.1,850 -200 Utilities
Br.9,000 + Br.2,000 + expense
New Br.1,600 +
bal Br.17,750

The two sides of the equation now balance Br.19,600. Three lines are required in the analysis to
indicate the different types of expenses that have been incurred.
Transaction (8)- Payment of Accounts Payable: XYZ pays its Addis Admas News paper
advertising bill of Br.250 in cash. In analyzing the effect of this transaction, we must recall that the
bill has previously been recorded in Transaction (5) as an increase in Accounts payable and a
decrease in owner’s equity. Thus, this payment “on account” decreases both assets and liabilities.
In this case, the asset Cash and the liability Accounts payable are decreased by Br.250. the effect of
this transaction on the equation is:

Assets Liabilities + Owner’s Equity

Cash + Receivable +Supplies + Account Mr.Tadala’s ,
Equipment = Payable + Capital

Old Br.9,000 Br.2,000 Br.7,000 Br.1,850 Br.17,750

bal Br.1,600
Tran. -250
8 -250 ________ ______ + ________
______ ______ ______
Br.7,000 Br.1,600 17,750
Br.8,750 + Br.2,000 +
New Br.1,600 +
bal Br.19,350

Observe that the payment of a liability related to an expense that has previously been recorded does
not affect owner’s equity.

Transaction (9)- Receipt of Cash on Account: The sum of Br.600 in cash is received from
customers who have previously been billed for services in Transaction (6). This transaction does

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not change total assets, but it changes the composition of XYZ clinic assets. Cash is increased
Br.600 and Accounts Receivable is decreased Br. 600. The new balances are:
Assets Liabilities + Owner’s Equity
Cash + Receivable +Supplies + Account Mr. Tadala’s,
Equipment = Payable + Capital

Old Br.8,750 Br.2,000 Br.7,000 Br.1,600 Br.17,750

bal Br.1,600
Tran.9 +600 -600 ________ ______ + ________
______ ______ ______ Br.7,000 Br.1,600 17,750
New Br.9,350 + Br.1,400 +
bal Br.1,600 + Br.19,350

Note that a collection on account for services previously billed and recorded does not affect
owner’s equity. Revenue was already recorded in Transaction (6) and should not be recorded again.
Transaction (10) - Withdrawal of cash by owner- Mr. Tadala withdraws Br.1, 300 in cash from
the business for his personal use. This transaction results in an equal decrease in assets and owner’s
equity. Thus, both cash and Mr. Tadala, capital is decreased by Br.1, 300, as shown below:
Assets Liabilities + Owner’s Equity
Cash + Receivable +Supplies + Account MrTadala’s,
Equipment = Payable + Capital

Old bal Br.9,350 Br.1,400 Br.7,000 Br.1,600 Br.17,750

Tran.1 Br.1,600 -1,300
0 -1,300 ________ ______ + ________
______ ______ ______ Br.7,000 Br.1,600 16,450
New Br.8,050 + Br.1,400 +
bal Br.1,600 + Br.18,050

Br. 18,050

Observe that the effect of a cash withdrawal by the owner is the opposite of the effect of an
investment by the owner. Owner’s drawings do not represent expense. Like owner’s investment,
they are not included in determining net income.
Summary of Transactions
The transactions of XYZ Clinic are summarized in the following table to show their cumulative
effect on the basic accounting equation.

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 Assets Liabilities Owner’s equity
Trans Cash + Account Supplies Equipmen Account Mr.Tadala’
action Receivable + t= payable s
+ +
1 Br. +Br.15,000 Investme
15,000 + nt
2 -_7,000 +Br.7,000 _______
8,000 7,000 _
3 ________ + = ______ +Br.1,6 _______
__ + Br.1,600 _ 00 _
4 +1,200 _______ ________ _______ +1,20 Service
9,200 + _ _ _ 0 revenue
5 ______ ______ _______ +250 -250 Advertis
_ + _ _ 1,850 15,95 ing
9,200 1,600 + 7,000 + 0 expense
6 +1,50 +2,00 ______ = ________ ________ +3,50 Service
0 0 _ _ _ 0 revenue
7 - -600 Rent
1,700 _____ ______ -900 Exp.
__ ______ _______ __ -200 Salaries
_______ 2,000 _ _ 1,850 17,750 exp
8 - _______ ______ _______ -250 ______
250 2,000 _ _ 1,600 17,750
9 +600 + -600 _______ ______ + _____ _____
9,35 1,400 _ _ _ _
10 -1,300 -1,300 Drawing
Br.8,050 Br.1,400 + Br.1,600 Br.7,000 Br.1,600 Br.16,450 s
+ = +
Br.18, 050 Br.18,050
1.7.2. Financial Statements
After transactions are identified, recorded, and summarized, four financial statements are prepared
from the summarized accounting data:
1. An income statement presents the revenues and expenses and resulting net income or net
loss of a company for a specific period of time.

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 2. An owner’s equity statement summarizes the changes in owner’s equity for a specific
period of time.
3. A balance sheet reports the assets, liabilities, and owner’s equity of a business’s enterprise
at a specific date.
4. A statement of cash flow summarizes information concerning the cash inflows (Receipts)
and outflow (payments) for a specific period of time.
The essential features of each statement are briefly described in the following section
 Income Statement
The income statement for XYZ Clinic is prepared from the data appearing in the owner’s equity
column of the table above. The heading of the statement identifies the company, the type of
statement, and the time period covered by the statement. Note that the primary focus of the income
statement is on reporting the success or profitability of the company’s operations over a specified
period of time. To indicate that it applies for a period of time, the income statement is dated “for
the Month Ended September 30, 2012.”
XYZ Clinic
Income statement
For the Month Ended September 30, 2012
Revenues:
Service revenue Br. 4,700
Expenses:
Salary expense Br.600
Rent expense 600
Advertising expenses 250
Utilities expense 200
Total expenses 1,950
Net income Br.2, 750

On the income statement, revenues are listed first, followed by expenses finally net income (or net
loss) is determined. Note that investment and withdrawal transactions between the owner and the
business are not included in the measurement of net income. For example, the withdrawal by Mr
Tadala of cash from XYZ Clinic was not regarded as a business expense, as explain earlier.

XYZ Clinic
Owner’s Equity Statement
For the Month Ended September 30, 2012

Mr.Tadala’s, Capital, September 1 Br.-0-

Add: Investments Br.15, 000
Net income 2,750 17,750

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Less: Drawings 1,300
Mr.Tadala’s, Capital, September 30 Br.16, 450

Data for the preparation of the owner’s equity statement are obtained from the owner’s equity
column of the tabular summary and from the income statement. The heading of this statement
identifies the company, the type of statement, and the time period covered by the statement. The
time period is the same as that covered by the income statement and therefore is dated “for the
month ended September 30, 2012.” The beginning owner’s equity amount is shown in the first line
of the statement, then, the owner’s investments, net income, and the owner’s drawings are
identified in the statement. The information provided by this statement indicates the reasons why
owner’s equity has increased or decreased during the period.

XYZ Clinic
Balance Sheet
September 30, 2012

Assets:
Cash Br. 8,050
Account receivable 1,400
Supplies 1,600
Equipment 7,000
Total assets Br.18, 050

Liabilities and Owner’s equity:

Liabilities
Account payable Br.1, 600
Owner’s equity
Mr.Tadala’s, capital 16,450

Total liabilities and owner’s equity Br.18,050

The balance sheet for XYZ Clinic is prepared from the column headings and the month-end data
shown in the last line of tabular summary. The heading of a balance sheet must identify the
company, the statement, and the date. To indicate that the balance sheet is at a specific date, it is
dated “September 30, 2012.” Observe that the assets are listed at the top, followed by liabilities and
owner’s equity. Total assets must equally total liabilities and owner’s equity.
XYZ Clinic
Statement of Cash Flows
For the Month Ended September 30, 2012
Cash flows from operating activities:
Cash receipts from revenues Br.3, 300
Cash payments for expenses (1,950)
Net cash provided by operating activities 1,350

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Cash flows from investing activities:
Purchase of equipments (7,000)

Cash flows from financing activities:

Investment by owner Br.15, 000
Drawings by owner (1,300) 13,700

Net increase in cash 8,050

Cash at the beginning of the period 0
Cash at the end of the period Br.8, 050

The primary purpose of a statement of cash flows is to provide financial information about the cash
receipts and cash payments of an enterprise for specific period of time. To achieve this purpose and
to aid investors, creditors, and others in their analysis of cash, 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.

Self Examination questions

Part One: Multiple Choice
Choose the correct answer from the given alternative.
1. A profit-making business operating as a separate legal entity and in which ownership is
Divided into shares of stock is known as a:
A. proprietorship C. partnership
B. service business D. corporation
2. The resources owned by a business are called:
A. assets C. the accounting equation
B. liabilities D. owner’s equity
3. A listing of a business entity’s assets, liabilities, and owner’s equity as of a specific date
is a(n): A. balance sheet C. statement of owner’s equity
B. income statement D. statement of cash flows
4. If total assets increased Br.20, 000 during a period and total liabilities increased
Br.12, 000 during the same period, the amount and direction (increase or decrease) of
the change in owner’s equity for that period is a (n):
A. Br 32,000 increase C. Br 8,000 increase
B. Br 32,000 decrease D. Br 8,000 decrease
5. The accounting profession can be divided into three major categories; specifically, the practice
of public accounting, private accounting, and Not for profit accounting. A somewhat unique and
important service of public accountants is:

16
 A. Financial accounting. C. Auditing.
B. Managerial accounting. D. Cost accounting.

6. Which of the following would not be included on a balance sheet?

A. Account Receivable B. Account payable C. Sales D. Cash

Part Two: Work out Questions

Bontu opens her own Beauty Salon on July 1, 2012. During the first month of operations, the
following transactions occurred:
1. Invest Br.10, 000 in cash in the Salons activity.
2. Paid Br. 800 for July rent on business space.
3. Purchased Beauty salon’s equipment on account Br. 3,000.
4. Rendered services to customers for cash Br. 150. (Use Fees Earned).
5. Borrowed Br.700 cash from a bank on a note payable.
6. Rendered services to her customers on account Br. 2, 00.
7. Paid monthly expense: salaries Br. 500; utilities Br. 300; and telephone, Br. 100.
Instruction:
a) Prepare a tabular summary of the transaction.
b) Prepare the income statement, owner’s equity statement, and balance sheet at July
31 for Bontu Beuty Salon.

Chapter Two
The Accounting Cycle.
2.1. Nature of Accounts.
2.1.1. Definition of accounts and the use of accounts for recording transactions.

17
  An account is an individual accounting record of increases and decreases in a specific
asset, liability, or owner’s equity item.
For example, XYZ Clinic (discussed in chapter 1) would have separate accounts for cash, accounts
receivable, accounts payable, service revenue, salaries expense, and so on. In its simplest form, an
account consists of three parts :(1) the title of the account, (2) a left or debit side, and (3) a right or
credit side. Because the alignment of these parts of an account resembles the letter, it is referred to
as a T account. The basic form of an account is illustrated as follows:
Title of account
Left or Right
debt side credit side

This form of account will be used often throughout this module to explain basic accounting
relationships.
2.1.2. Rules of Debits and Credits.
The terms debits and credits mean left and right, respectively, they are commonly abbreviated as
Dr. for debit and Cr. for credit. These terms do not mean increase or decrease. The terms debit and
credit are used repeatedly in the recording process. For example, the act of entering an amount on
the left side of an accounting is called debiting the account, and making an entry on the right side is
crediting the account. When the totals of the two sides are compared, an account will have a debit
balance if the total of the debit amount exceeds the credits. Conversely, an account will have a
credit balance if the credit amounts exceed the debits.
The procedure of having debits on the left and credit on the right is an accounting custom, or rule.
We could function just as well if debits and credits were reversed. However, the custom of having
debits on the left and credits on the right is and were reversed. However , the custom of having
debits on the left side of an account and credits on the right side (like the custom of driving
on the right- hand side of the road) has been adopted in Ethiopia. This rule applies to all
accounts.

2.1.3. Classifications of accounts.

Accounts in the ledger are customarily listed in the order in which they appear in
financial statements, and classified according to common characteristics.
o The Balance sheet accounts are classified as assets, liabilities and owner’s equity.
o Income statement accounts are classified as revenues or expenses.

18
 o In addition, there may be sub groupings within the major categories.
Assets
Any physical thing (tangible) or right (intangible) that has a monetary value is an asset.
Assets are, customarily divided into some groups for presentation on the balance sheet.
The two groups used most often are:-
1. Current Assets 2. Plant Assets
1. Current Assets: - Cash and other assets that may reasonably be expected to be realized
in cash or sold or used up usually within one year or less, through the normal Operations of
the business are called current assets.
* Examples include: - Cash, Accounts Receivable, Inventories, Prepaid Rents, and
Expenses Supplies, etc.
2. Plant Assets: - Tangible assets used in the businesses that are of a permanent or
relatively fixed nature are called Plant assets or fixed assets.
* Examples include: - Equipment, Machinery, buildings, Land, vehicles, etc. With the
Exception of land, such assets gradually wear out or otherwise lose their usefulness with
the passage of time is called depreciation.
3. Intangible Assets: - Nonphysical things controlled by the business:
* Examples include: - Good will, Patents, Copyrights, Trademarks, Franchises, etc.
Liabilities
Liabilities are debts owed to outsiders (creditors) and are frequently described on the
balance sheet by titles that include the word “payable”. The two categories occurring most
frequently are:-
1. Current Liabilities 2. Long-term Liabilities
1. Current Liabilities:- Liabilities that will be due within a short time (usually one year
or less ) and that are to be paid out of current assets are called current liabilities.
Examples include: - Accounts payable, Notes payable salaries payable, Taxes payable,
etc.
2. Long-term Liabilities: - Liabilities that will be due for a comparatively long time
(usually more than one year) are called long-term liabilities or fixed liabilities. As they
come within the one-year range and are to be paid, such liabilities become current.

19
If the obligation is to be renewed rather than paid, at maturity, however, it would continue
to be classified as long-term. When payment of a long-term debt is to be spread over a
number of years, the installment due within one year from a balance sheet date are classed
as current liabilities.
Examples include:- Notes payable (long-term) , mortgage payables, etc.

Owner’s Equity - is the residual claim against the business after the total liabilities are
deducted. For a corporation, owner’s Equity is frequently called Stockholder’s equity or
shareholder’s equity.

Capital, Capital stock, Retained Earning

Capital - is the owner’s equity in a sole proprietorship or partnership form business.

Capital stock – represents the investment of stockholders.

Retained Earnings - represents the net income retained in business.

Revenues – are the gross increases in owner’s Equity as a result of the sale of
merchandise, the performance of services for customer or a client, the rental of property,
the lending of money, and other business and professional activities. Revenue from sale of
merchandise is often identified as sales. Other terms used to identify sources of revenue
include professional fees, commission’s revenue; fares earned, and interest income. If an
enterprise has various types of revenue, a separate account should be maintained for each.

Expenses - Costs that have been consumed in the process of producing revenue are expired
costs or expenses. The number of expense categories and individual expense accounts
maintained in the ledger varies with the nature and the size of the business.

2.2. Debit and Credit Procedure

Dear learners, in the first chapter of this module 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 in the accounts. The equality of debits and credits

20
provides the basis for the double- entry system or recording transactions (some-time
referred to as double- entry bookkeeping).
Under the universally used 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. It also offers a means of proving the accuracy of the recorded
amounts. If every transaction is recorded with equal debits and credits, then 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 one. Therefore, it was
necessary after each transaction to compare total assets with total liabilities and owner’s
equity to determine the equality of the two sides of the accounting equation.

o Assets and Liabilities: We know that both sides of the basic equation
(assets=liabilities +owner’s equity) must be equal; it then 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. The
effects that debits and credits have on assets and liabilities are summarized as
follows:
Debit Credits
Increase assets Decrease assets
Decrease liabilities Increase liabilities
Thus, asset accounts normally show debit balances, and liability accounts normally show
credit balances. The normal balances of Assets and Liabilities are presented as follows:

Assets Liabilities
Increase Decrease Increase Decrease

Debit Credit Credit Debit

Normal balance Normal balance

I hope that, you will understand something from the above diagram that, the normal
balance of Asset account is Debit and the normal balance of Liability account is Credit.

21
Then we can conclude that the normal balance of all accounts can be determined by its
increasing side.

o Owner’s Equity: as indicated in Chapter one, owner’s investments and revenues

increase owner’s equity. It is decreased by owner’s drawings and expenses. In a
double- entry system, accounts are kept for each of these types of transactions, as
explained below.

The rules of debit and credit for the owner’s capital account and it s normal balance is
stated as follows:
Owner’s Capital
Debits Credits
Decrease owner’s capital Increase owner’s capital

Normal balance

Owner’s equity /capital decrease on debit side and increase on credit side; hence its normal
balance is credit side/its increasing side. Since owners drawing will have a decreasing
effect on owner’s equity, it will increase on debit side and decrease on credit side, then its
normal balance is Debit.
o Revenues and Expenses: When revenues are earned, owner’s equity is increased.
Accordingly, the effect of debits and credits on revenue accounts is identical to
their effect on owner’s capital. Revenue accounts are increased by credits and
decreased by debits. On the other hand, expenses decrease owner’s equity. As a
result, expenses are recorded by debits. Since expenses are the negative factor in
the computation of net income, and revenues are the positive factor, 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. The effect of debits and credits on revenues and expenses may be stated as
follows:

Revenue Expenses
Debits Credits Debits Credits

22
Decrease revenues Increase revenues Increase expenses Decrease
expenses
Normal balance Normal balance

It is possible to understand something from the above diagram that, revenue decrease on
debit side and increase on credit side, and hence its normal balance is credit side. whereas
Expenses decrease on credit side and increase on debit side, thus its normal balance is
Debit side.

2.3. The Recording Process

Although it is possible to enter transaction information directly in to the accounts, few
business do so. However, to perform each transaction this way would be impractical,
expensive, and unnecessary. Therefore, a set of procedures and records are used to make it
possible to keep track of and accumulate transaction data more easily. This section will
discuss about the accounting process.

2.3.1. Steps in the Recording Process

Although it is possible to enter transaction information directly in to the accounts, few
business do so. In every business, the basic steps in the recording process are:
1. Analyze each transaction in terms of its effect on the accounts.
2. Enter the transaction information in a journal (book of original entry).
3. Transfer the journal information to the appropriate accounts in the ledger (book of
accounts).
The actual sequence of events begins with the transaction. Evidence of the transaction
comes in the form of a business document, such as a sales slip, a check, a bill, or a cash
register tape. This evidence is analyzed to determine the effect of the transaction on
specific accounts. The transaction is then entered in the journal. Finally, the journal entry is
transferred to the designated accounts in the ledger.
The basic steps in the recording process occur repeatedly in every business enterprise. The
analysis of transactions has already been illustrated, and further examples of this step will
be given in this and later units. The other steps in the recording process are explained in the
next sections.

23
Transactions are initially recorded in chronological order in a journal before being
transferred to the accounts. Thus, the journal is referred to as the book of original entry.
For each transaction the journal shows the debit and credit effects on specific accounts.
Companies may use various kinds of journals, but every company has the most basic form
of journal, a general journal. Typically, a general journal has spaces for dates, account
titles and explanations, references, and two money columns. Whenever the term journal is
used in this module without a modifying adjective, it will mean the general journal.
The journal makes several significant contributions to the recording process:
1. It discloses in one place the complete effect of a transaction.
2. It provides a chronological record of transactions.
3. It helps to prevent or locate errors because the debit and credit amounts for each
entry can be readily compared.

Journalizing
 Entering transaction data in the journal is known as journalizing.
To illustrate the technique of journalizing, the first two transactions of XYZ Clinic are
journalized as follows using the first page (J1) of the general journal. These transactions
were: September 1, Mr. Tadala invested Br.15, 000 cash in the business, and office
equipment was purchased for Br.7, 000 cash.

GENERAL JOURNAL
Date Account Titles and Explanation Ref. Debit Credit
2012
Sept. 1 Cash 15,000

Mr.Tadala’s, Capital
15,000
(invested cash in business)
1
office Equipment

Cash 7,000

(purchased equipment for 7,000

24
 cash)

The standard form and content of journal entries are as follows:

1. The date of the transaction is entered in the Date column. The date recorded
should include the year, month, and day of the transaction.
2. The debit account title (that is, the account to be debited) is entered first at the
extreme left margin of the column headed Account Titles and Explanation. The
credit account title (that is, the account to be credited) is then entered on the next
line, indented under the line above. The indentation decreases the possibility of
switching the debit and credit amounts.
3. The amounts for the debits are recorded in the Debit (left) column and the amounts
for the credits are recorded in the credit (right) column.
4. A brief explanation of the transaction is given.
5. A space is left between journal entries. The blank space separates individual journal
entries and makes the entire journal easier to read.
6. The column entitled Ref. (which stands for reference) is left blank at the time the
journal entry is made. The Reference column is used later when the journal entries
are transferred to the ledger accounts. At that time, the ledger account number is
placed in the Reference column to indicate where the amount in the journal entry
was transferred.
If an entry involves only two accounts, one debit and one credit, it is considered a simple
entry. For some transactions, however, it may be necessary to use more than two accounts
in journalizing. When three or more accounts are required in one journal entry, the entry is
referred to as a compounds entry.
To illustrate, assume that on June 1, Dula Company purchases a delivery truck costing
Br.14,000 by paying Br.8,000 cash and the balance on account (to be paid at a later
date).the entry is as follows:

GENERAL JOURNAL
Date Account Titles and Explanation Ref. Debit Credit

25
 1996

June 1 Delivery Equipment 14,000

Cash 8,000

Accounts payable 6,000

(Purchased truck for cash with

balance on account)

In a compound entry, it is important to determine that total debit and credit amounts are
equal. Also, the standard format requires that all debits be listed before the credits are
listed.
The Ledger
The entire group of accounts maintained by a company is referred to
collectively as the ledger.
The ledger keeps in one place all the information about changes in specific account
balances. Companies may use various kinds of ledgers, but every company has a general
ledger. A general ledger contains all the assets, liabilities, and owner’s equity accounts, as
shown below. A business can use a loose-leaf binder or card file for the ledger with each
account kept on a separate sheet or card. Whenever the term ledger is used in this module
without a modifying adjective, it will mean the general ledger.

The ledger should be arranged in statement order beginning with the balance sheet
accounts. First in order are the asset accounts, followed by liability accounts, owner’s
capital, owner’s drawing, revenues, and expenses. Each account is numbered for easier
identification.
The information in the ledger provides management with the balances in various accounts.
For example, the Cash account enables management to determine the amount of cash that
is available to meet current obligations. Amounts due from customers and the amounts
owed to creditors can be determined by examining the Accounts Receivable and Accounts
payable accounts, respectively.

26
 Standard Form of Account
The simple T-account form of an account used in an accounting is often very useful for
illustration and analysis purposes. However, in practice, the account forms used in ledgers
are much more structured. A form widely used in a manual system is shown below, using
assumed data from a cash account.

CASH No.10
Date Explanation Ref. Debit Credit Balance
1996
June 1 25,000 25,000
2 8,000 17,000
3 4,200 21,200
9 7,500 28,700
17 11,700 17,000
20 250 16,750
30 7,300 9,450
This form has three money columns –debit, credit, debit, and credit balance. The
balance in the account is determined after each transaction. Thus, this form is often
called the three-column form of account. Note that the explanation space and
reference columns are used to provide special information about the transaction.

Posting
The procedure of transferring journal entries to the ledger accounts is called posting.
This phase of the recording process accumulates the effects of journalized transactions
in the individual accounts.
 Posting involves the following steps:
1. In the ledger, enter in the appropriate columns of the account(s) debited
the date, journal page, and debit amount shown in the journal
2. In the reference column of the journal, write the account number to which
the debit amount was posted.
3. In the ledger, enter in the appropriate columns of the account(s) credited
the date, journal page, and credit amount shown in the journal

27
 4. In the reference column of the journal, write the account number to which
the credit amount was posted.
These four steps are diagrammed in the following table using the first journal entry of
XYZ Clinic. The boxed numbers indicate the sequence of the steps

General journal J1
Date Account titles and explanation Re Debit Credit
2012 Cash f10 15,000

Sep.1 Mr.Tadala’s, capital 31 15,000

(Invested cash in business)

No.10
General ledger
Cash 10
Date Explanation Re Debit Credit Balance
2012 J1
f 15,000 15,000
Sep.1
No.25
Mr.Tadala’s, capital 31
Date Explanation Ref Debit Credit Balance

2012 J1 15,000
Sep.1 15,000

Posting should be performed in chronological order. That is, all the debits and credits of
one journal entry should be posted before proceeding to the next journal entry. Under the
journalizing procedures described in this unit, postings should be made on a timely basis to
ensure that the ledger is up to date.
The reference column in the journal serves several purposes. The numbers in this column
indicate the entries that have been posted. After the last entry has been posted, the journal
reference column should be scanned to see that all postings have been made.
The reference column of a ledger account indicates the journal page from which the
transaction has been posted. The explanation space of the ledger account is used

28
infrequently because an explanation already appears in the journal. It generally is used only
when detailed analysis of account activity is required.

2.4. Chart of Accounts

The number and type of accounts used differ for each enterprise, depending on the size,
complexity, and type of business involved. For example, the number of accounts depends
on the amount of detail desired by management. The management of one company may
want one account for all type of utility expense. Another may keep separate expense
accounts for each type of utility expenditure, such as gas, electricity, and water. Similarly,
a single proprietorship like XYZ Clinic will not have many accounts compared with a
corporate giant like DH Geda Company. XYZ Clinic may be able to manage and report its
activities in 20 to30 accounts, while DH Geda requires thousands of accounts to keep track
of its worldwide activities.
Most companies have a chart of accounts that lists the accounts and the account numbers,
which identify their location in the ledger. The numbering system used to identify the
accounts usually starts with the balance sheet accounts and follows with the income
statement accounts.
In this and the next chapter, we will be explaining accounting for the proprietorship, Ifa
advertising agency (a service enterprise). Accounts 11-19 indicate assets accounts; 21-29
indicates liabilities; 31-33 indicates owner’s equity accounts; 41-49, revenues; and 61-69,
expenses. The chart of accounts for Ifa advertising Agency (Ifa Dumeso, owner) is shown
below.
If a Advertising Agency
Charts of Accounts

Assets 15-Office equipment

11-Cash
16-Accumulated Depreciation-office
12-Account receivable Equipment

13-Advertising supplies Liabilities

21-Note payable
14-Prepaid Insurance
22-Account payable

29
 23-Interest payable

24-Unearned fees

25-Salaries payable

Owner’s equity
31-Ifa Dumeso, capital

32-If a Dumeso, drawing

33-Income summary

Revenues
41-Fees earned

Expenses
61-Salaries expense

62-Advertising supplies expense

63-Rent expense

64-Insurance expense

65-Interest expense

66-Depreciation expense

30
Illustration for the recording process
The following illustration shows the basic steps in the recording process, using the October
transaction of the Ifa Advertising Agency. Its accounting period is a month. A basic analysis
and a debit-credit analysis precede the journalizing and posting of each transaction. The
purpose of transaction analysis is first to identify the type of account involved, and then to
determine whether a debit or credit to the account is required. Keep in mind that every
journal entry affects one or more of the following items: assets, liabilities, owner’s capital,
owner’s drawing, revenues, or expenses. By becoming skilled at transaction analysis, you
will be able to recognize quickly the impact of any transaction on these six items.

Illustration: Ato Ifa Dumeso opened Ifa Advertising Agency on October 1, 2012. During the
first month of operations the following transactions are occurred:

October-1 Ato Ifa invests Br. 10,000; cash in advertising venture to be known as the Ifa
Advertising Agency.
October-1 Office Equipment costing Br. 5,000 is purchased by signing a 3-month,
12%, Br. 5,000 note payable.
October-2 A Br. 1,200 cash advance is received from XYZ Company, a client, for
advertising services that are expected to be completed by December 31.
October-3 Office rent for October is paid in cash Br. 900.
October-4 Br. 600 is paid for a one-year insurance policy that will expire next year
on September 30.
October-5 An estimated 3- months of supply of advertising materials is purchased on
account from XYZ Company for Br. 2,500
October-9 Hire four employees to begin work on October 15. Each employee is to
receive a weekly salary of Br. 500 for a five day work week, payable every
two weeks.
October-20 Ato Ifa withdraws Br. 500 for his personal use.
October-26 Employee salaries of Br. 4000 are owed and paid in cash. (See Oct.9 trxn)
October-31 Received Br. 10,000 in cash from Tato Company for advertising
services rendered in October.

31
The journal for Ifa advertising Agency for the month of October is summarized below.

General Journal Page J1

Date Account tiles and explanation Ref Debit Credit
.
2012
Oct Cash 11 10,000
1 Ifa Dumeso’s, Capital 31 10,000
(Invested cash in business)

Office equipment 15 5,000

1 Notes payable 21 5,000
(Issued 3-month, 12% note for office equipment)
Cash 11
Unearned fees 24 1,200
2 (Received advance from XYZ Co. for future 1,200
services)
63
11 900
3 Rent expense 900
Cash
(Paid October rent) 14
4 11 600
Prepaid insurance 600
Cash 13
(Paid one –year policy; effective date, October 1) 22 2,500
Advertising supplies 2,500
5 Account payable
(Purchased supplies on account from XYZ Co. 32
20 supply) 11 500
Ifa Dumeso’s, drawing 500

32
 Cash 61
26 (Withdrew cash for personal use) 11 4,000
Salaries expense 4,000
31 Cash
(Paid salaries to date) 11
Cash 41 10,000
Fees earned 10,000
(Receive cash for fees earned)
The ledger for Ifa advertising Agency for the month of October is summarized below.

General Ledger
Cash 11
Date Explanation Ref Debit Credit Balance
2012

Oct 1 J1 10,00 10,000

0
Advertising supplies 14
Date Explanation Ref Debit Credit Balance
2012
Oct 5 J1 2,500 2,500

Prepaid insurance 14
Date Explanation Ref Debit Credit Balance
2012
Oct 4 J1 600 600

Office equipment 15

Date Explanation Ref Debit Credit Balance

2012
Oct 1 J1 5,000 5,000

33
Notes payable 21

Date Explanation Ref Debit Credit Balance

2012
Oct 1 J1 5,000 5000

Account payable 22

Date Explanation Ref Debit Credit Balance

2012
Oct 5 J1 2,500 2,500

Unearned fee 24

Date Explanation Ref Debit Credit Balance

2012
Oct 2 J1 1,200 1,200

Ifa Dumeso, capital 31

Date Explanation Ref Debit Credit Balance

2012
Oct 1 J1 10,000 10,000

Ifa Dumeso’s, Drawing 32

Date Explanation Ref Debit Credit Balance

34
 2012
Oct 20 J1 500 500

Fees Earned 41
Date Explanation Ref Debit Credit Balance

2012
Oct 31 J1 10,000 10,000

Salaries Expense 61
Date Explanation Ref Debit Credit Balance

2012
Oct 26 J1 4,000 4,000

Rent expense 63
Date Explanation Ref Debit Credit Balance
2012

Oct 3 J1 900 900

2.5. The Trial Balance

A trial balance is a list of accounts and their balances at a given time. Customarily, a trial
balance is prepared at the end of an accounting period. The accounts are listed in the order in
which they appear in the ledger, with debit balances listed in the left column and credit balances
in the right column. The totals of the two columns must be in agreement.

 The primary purpose of a trial balance is to prove the mathematical equality of debits and
credits after posting. Under the double-entry system this equality will occur when the sum
of the debit account balances equals the sum of the credit account balances. A trial balance
also uncovers errors in journalizing and posting. In addition, it is useful in the preparation
of financial statements.

35
 The procedures for preparing a trial balance consist of:
1. Listing the account titles and their balances.
2. Totaling the debit and credit columns.
3. Proving the equality of the two columns

The trial balance prepared from the ledger of Ifa Advertising Agency is:

IFA ADVERTISING AGENCY

Trial Balance
October 31, 2012
Debit Credit
Cash Br. 15,200
Advertising supplies 2,500
Prepaid insurance 600
Office equipment 5,000
Notes payable Br.5,000
Accounts payable 2,500
Unearned fees 1,200
Ifa Dumeso, capital 10,000
Ifa Dumeso, drawing 500
Fees Earned 10,000
Salaries expense 4,000
Rent expense 900 ______
Br.28,700 Br.28,700

Note that the total debits Br.28, 700 equal the total credits Br.28, 700. Account numbers are
sometimes shown to the left of the account titles in the trial balance.

Limitations of a Trial Balance

A trial balance does not prove the all transactions have been recorded or that the ledger is
correct. Numerous errors may exist even though 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 not posted twice,(4) incorrect accounts are used in
journalizing or posting, or (5) offsetting errors are made in recording the amount of a transaction.

36
In other words, as long as equal debits and credits are posted, even of the wrong account or in the
wrong amount, the total debits will equal the total credits.

Self Examination questions Part one: Multiple choices

Choose the best answer from the given alternative

1. A debit may signify a (n):
A. Increase in an asset account. C. Increase in a liability account
B. Decrease in an asset account. D. Increase in the owner’s capital account
2. The type of account with a normal credit balance is:
A. An asset. B. Drawing. C. A revenue. D. An expense.
3. A debit balance in which of the following accounts would indicate a likely error?
A. Accounts Receivable B. Cash C. Fees Earned D. Miscellaneous Expense
4. The receipt of cash from customers in payment of their accounts would be recorded by:
A. A debit to Cash and a credit to Accounts Receivable.
B. A debit to Accounts Receivable and a credit to Cash.
C. A debit to Cash and a credit to Accounts Payable.
D. A debit to Accounts Payable and a credit to Cash.
5. The form listing the titles and balances of the accounts in the ledger on a given date is the:
A. Income statement. B. Balance sheet.
C. Statement of owner’s D. Trial balance.

Part Two: Work out

Teddy established business named ABC laundry on January1, 2012. During the first month of
operations the following transactions are occurred: January,
1. Invested Br. 30,000 cash in the business.
1 Paid Br.2, 000 cash for store rent for the month of January.
2 Purchased washers and dryers for Br. 50,000 paying Br.20, 000 in cash and signing a
Br. 30,000 6-month 10% note payable.
3 Paid Br.2, 400 for one-year accident insurance policy.
10. Received bill from the Daily News for advertising the opening of the laundry Br. 400.
20. Withdrew Br. 1400 cash for personal use.

37
 30. Determined that cash receipt for laundry fees for the month were Br.5, 100.
Required:

i) Journalize the January transactions in journal page #1.

___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
ii) Open the accounts and post the January transaction.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
a. Prepare a trial balance at January 31, 2012.
(NB. The chart of accounts for the company is the same as in Ifa Advertising Agency
except for the following: A/c NO. 17 Laundry Equipment and A/c No. 67
Advertising Expense)
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

38
 Chapter Three
Completion of Accounting Cycle
Overview
In the previous chapter, we examined the basic steps in the recording process through the
preparation of the trial balance. Before we will be ready to prepare financial statements from the
trial balance, additional steps need to be taken. Prior to financial statements can be prepared,
questions relating to the recognition of revenues and expense of the current period must be
answered. With the answers in hand, the relevant account balances can then be adjusted.
Moreover, in this part, we will explain the role of the work sheet in accounting and the
preparation of financial statements from the work sheet as well as the remaining steps in the
accounting cycle.
Objectives of the Chapter:
At the end of this chapter the students will be able to:
 Explain the concept of revenue recognition.
 Describe, the basic nature and types of adjusting entries
 Understand the basis of accounting: Accrual and cash basis
 Prepare work sheet and financial statements.
 Understand the process of journalizing, posting and closing entries.

3.1. Adjustments
If the information reported on trial balance as debit and credit is not balanced an adjustment
would be required. Therefore, this lesson will discuss about adjustment processes.
3.1.1. Recognizing Revenues and Expense

☼How does revenue recognized in a given accounting period?

______________________________________________________________________________
______________________________________________________________________________
_____________________________________________________________________________
 Determining the amount of revenues and expenses to be reported in a given accounting period
can be difficult. Therefore accountants have developed two principles as part of generally
accepted accounting principles (GAAP) that help in this determination: the revenue
recognition principle and the matching principle.

39
 The revenue recognition principle dictates that revenue be recognized in the accounting
period in which it is earned.
In a service enterprise, revenue is considered to be earned at the time the service is performed.
To illustrate, assume that a dry cleaning business cleans clothing on June 30 but customers do
not claim and pay for their clothes until the first week of July. Under the revenue recognition
principle, revenue is earned in June when the service is performed and not in July when the cash
is received. At June 30, the dry cleaner would report a receivable on its balance sheet and
revenue in its income statement for the service performed.
In recognizing expenses, accountants follow the approach of “let the expenses follow the
revenues.” Thus, expenses recognition is tied to revenue recognition. In the preceding example,
this principle means that the salary expense incurred in performing the cleaning service on June
30 should be reported in the income statement for the same period in which the service revenue
is recognized.
The practice of expense recognition is referred to as the matching principle because it dictates
that efforts (expenses) be matched with accomplishments (revenues).

Ø Activity 3.1:
1. Explain the concept of revenue and Expense recognition in terms of, Revenue recognition
principles and Matching principles.
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

3.1.2. The Basics of Adjusting Entries

To record revenue in the period 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.
The Reason for Adjustment

☼Why an adjusting entry does is required?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

40
  Adjusting entries are needed to ensure that the revenue recognition and matching
principles are followed.
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:
1. Some events are not journalized daily because it is inexpedient to do so. Examples are the
consumption of supplies and the earning of wages by employees.
2. Some costs are not journalized during the accounting period because these costs expire
with the passage of time rather than as a result 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 be
received 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 date, the company may need to make inventory counts of
supplies and repair parts. Also 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 are dated
as of the balance sheet date.

3.1.3. Types of Adjusting Entries

Adjusting entries can be classified as either prepayments or accruals. Each of these classes has
two subcategories as shown below:
1. Prepayments:
1. Prepaid expenses. Expenses paid in cash and recorded as assets before they are used or
consumed.

41
 2. Unearned Revenues. Revenues received in cash and recorded as liabilities before they are
earned.
2. Accruals

i. Accrued Revenues: Revenues earned but not yet received in cash or recorded.

ii. Accrued Expenses: expenses incurred but not yet paid in cash or recorded.

Examples and explanations of each type of adjustment are given in the following sections. Each
example is based on the October 31 trial balance of Ifa Advertising Agency, reproduced in
chapter two.

Ifa Advertising Agency

Trial balance
October 31,2012
Debit Credit
Cash Br.15,200
Advertising supplies 2,500
Prepaid insurance 600
Office Equipment 5,000
Notes Payable Br. 5,000
Accounts Payable 2,500
Unearned fees 1,200
Ifa, Capital 10,000
Ifa, drawing 500
Fees earned 10,000
Salaries expense 4,000
Rent expense 900 __________
Br.28,700 Br.28,700

Our assumption here is that Ifa Advertising uses an accounting period of one month. Thus,
monthly adjusting entries will be made. The entries will be dated October31, 2012.

42
 Adjusting Entries for Prepayments
Adjusting entries for prepayments are required at the statement date to record the portion of the
prepayment that represents the expense incurred or the revenue earned in the current
accounting period. Assuming an adjustment is needed for both types of prepayments, the asset
and liability are overstated and the related expense and revenue are understated. For example, in
the trial balance, the balance in the asset, supplies, shows only supplies purchased. This balance
is overstated; the related expense account, supplies expense, is understated because the cost of
supplies used has not been recognized. Thus the adjusting entry for prepayments will decrease a
balance sheet account and increase an income statement account.

 Prepaid expenses

☼What is prepaid expense and how does it should be expired?

_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
 Expense paid in cash and recorded as assets before they are used or consumed are
identified as prepaid expenses. When a cost is incurred, an asset account is debited to
show the service or benefit that will be received in the future. Prepayments often occur in
regard to insurance, supplies, advertising, and rent. In addition, prepayments are made
when buildings and equipment are purchased.
 Prepaid expenses expire either with the passage of time (E.G., rent and insurance) or
through use and consumption (e.g., supplies)
1) Supplies: Several different types of supplies are used in a business enterprise. For
example, Ifa advertising Agency purchased advertising supplies costing Br.2, 500 on
October 5. The debit was made to the asset advertising supplies, and this account shows a
balance of Br.2, 500 in October 31 trial balance. An inventory count at the close of
business on October 31 reveals that Br.1, 000 of supplies are still on hand. Thus, the cost
of supplies used is Br.1,500 (Br.2,500-Br.1,000), and the following adjusting entry is
made:

43
 Oct. 31 Advertising supplies Expense 1,500
Advertising supplies 1,500
(To recorded supplies used)

After the adjusting entry is posted, the two supplies accounts in T- account form show:

Advertising supplies Advertising supplies expense

10/5 2,500 10/31 Adj. 1,500 10/31 Bal. 1,500
10/31 Bal. 1,000

The asset account Advertising supplies now shows a balance of Br.1,000, which is equal to the
cost of supplies on hand at the statement date. In addition, advertising supplies expense shows a
balance of Br.1, 500, which equals the cost of supplies used in October. If the adjusting entry is
not made, October expenses will be understated and net income overstated by Br.1,500.
Moreover, both assets and owner’s equality will be overstated by Br.1,5000 on the October 31
balance sheet.
2) Insurance: Most companies have fire and theft insurance on merchandise and equipment,
personal liability insurance for accident suffered by customers, and automobile insurance on
company cars and trucks. The cost of insurance protection is determined by the payment of
insurance premiums. The term and coverage are specified in the insurance policy. The minimum
term is usually one year. Insurance premiums normally are charged to the asset account prepaid
insurance when paid. At the financial statement date it is necessary to debit insurance expense
and credit prepaid insurance for the cost that has expired during the period.
On October 4, Ifa advertising Agency paid Br.600 for a one-year fire insurance policy. The
effective date of coverage as October 1. The premium was charged to prepaid insurance when it
was paid, and this account shows a balance of Br.600 in the October 31 trial balance. An analysis
of the policy reveals that Br.50 (Br.600 12) of insurance expires each month. Thus, the
following adjusting entry is made

Oct. Insurance expense 50

31

44
 Prepaid insurance 50
(To recorded insurance expired)
After the adjusting entry is posted, the two supplies accounts in T- account form show:

Prepaid insurance Insurance expense

10/4 600 10/31 Adj. 50 10/31 Bal. 50
10/31 Bal. 550

The assets prepaid insurance shows a balance of Br.550, which represents the unexpired cost
applicable to the remaining 11 months of coverage. At the same time, the balance in insurance
expense is equal to the insurance cost that has expired in October. If this adjustment is note
made, October expenses will be understated by Br.50 and net income overstated by Br.50.
Moreover, both assets and owner’s equity also will be overstated by Br.50 on the October 31
balance sheet.
3) Depreciation: A business enterprise typically owns a variety of productive facilities such as
building, equipment, and motor vehicles. These assets provide a service for a number of years.
The term of service is commonly referred as the useful life of the asset. Depreciation is the
process of allocating the cost of an asset to expense over its useful life in a rational and
systematic manner.
For Ifa Advertising, Depreciation on the office equipment is estimated to be Br.480 a year, or
Br.40 per month, accordingly, depreciation for October is recognized by the following adjusting
entry:
Oct. 31 Deprecation expense 40
Accumulate Deprecation-office equipment 40
(To recorded monthly depreciation )

After the adjusting entry is posted, the accounts show:

Office equipment
10/4 AccumulateDepreciation
depreciation-
5,000 office Equipment
expense
10/31 10/31 Adj. 40
Adj. 40
45
The balance in the accumulated depreciation account will increase Br.40 each month. Therefore,
after journalizing and posting the adjusting entry at November 30, the balance will be Br.80.

 Statement presentation: Accumulated deprecation –office equipment is a contra assets

account. A contra assets account is an account that is offset against an asset account on the
balance sheet.

Example:

Office equipment Br.5, 000

Less: accumulated depreciation-office equipment 40
Br.4,960

 Unearned revenues

☼What is unearned revenue and how it should be recognized or earned?

_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________

 Unearned revenues are revenues received in cash and recorded as liabilities before they
are earned. Such items as rent, magazine subscriptions, and customer deposits for future
service may result in unearned revenues. For example, Airlines such as Ethiopian Air
Lines treat receipts from the sale of tickets as unearned revenue until the flight service is
provided.
 When the payment is received for services to be provided in a future accounting period,
an unearned revenue (a liability) account should be credited to recognize the obligation
that exist. Unearned revenues are subsequently earned through rendering service to a
customer.
Assume that, Ifa Advertising Agency received Br.1, 200 on October 2 from XYZ Company for
advertising services expected to be completed by December 31. The payment was credited to
unearned fees, and this account shows a balance of Br.1, 200 in the October 31 trial balance.
When analysis reveals that Br.400 of those fees has been earned in October, the following
adjusting entry is made:

46
 Oct. 31 Unearned fees 400
Fees earned 400
(To recorded Fees earned)

After the adjusting entry is posted- account show:

Unearned fees Fees earned

10/31 Adj. 10/2 1,200 10/31 Bal. 10,000
400 31 Adj 400
10/31 bal 800

The liability Unearned fees now shows a balance of Br.800, which represents the remaining
advertising services expected to be performed in the future. At the same time, fees earned shows
total revenues earned in October of Br.10, 400. If this adjustment is not made, revenues and net
income will be understated by Br.400 in the income statement. Moreover, liabilities will be
overstated and owner’s equity will be understated by Br.400 on the October 31 balance sheet.
Adjusting Entries for Accruals
The other category of adjusting entries is accruals. Adjusting entries for accruals are required to
record revenues earned and expenses incurred in the current accounting period that have not been
recognized through daily entries. If an accrual adjustment is needed, the revenues account (and
the related asset account) and /or the expense account (and the related liability account) is
understated. Thus, the adjusting entry for accruals will increase both a balance sheet and an
income statement account.
 Accrued revenues

☼What is Accrued revenue and how it should be adjusted?

_____________________________________________________________________________________
_____________________________________________________________________________________
________________________________________________________________ ____________________

 Accrued revenue refers to Revenues earned but not yet received in cash or recorded at the
statement date.
 An adjusting entry is required to show the receivable that exists at the balance sheet date
and to record the revenue that has been earned during the period. An asset- revenues

47
 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 (increase) to an asset account and a credit (increase) to a revenue account.
In October Ifa Advertising Agency earned Br.200 in fees for advertising service that were not
billed to clients before October 31. Because these services have not been billed, they have not
recorded. Thus, the following adjusting entry is made:
Oct. 31 Account receivable 200
Fees earned 200
(To Accrue fees earned but not billed or collected)

After the adjusting entry is posted- account show:

Account Receivable Fees Earned

10/31 Adj. 200 10/31 Bal. 10,000
31 Adj 400
31 Adj 200
10/31 bal 10,600

The asset accounts receivable shows that Br.200 is owned by client at the balance sheet date. The
balance of Br.10, 600 in fees earned represents the total fees earned during the month (Br.10, 000
+Br.400+Br.200). If the adjusting entry is not made, assets and owner’s equity on the balance
sheet, and revenues and net income on the income statement, will all be understated.
In the next accounting period, the clients will be billed. When this occurs the entry to record the
billing should recognize that Br.200 of fees earned in October have already been recorded in the
October 31 adjusting entry.
To illustrate, assume that bills totaling Br.3, 000 are mailed to clients on November 10. Of this
amount, Br.200 represents fees earned in October and recorded as fees earned in the October 31
adjusting entry. The remaining Br.2, 800 represents fees earned in November. Thus, the
following entry is made:
Oct. 31 Account receivable 2,800
Fees earned 2,800

48
 (To Accrue fees billed )

This entry records the amount of fees between November 1 and November 10. The subsequent
collection of fees from clients (Including the Br.200 earned in October) will be recorded with a
debit to cash and a credit to account receivable.
 Accrued expense
☼What is Accrued expenses and how adjustments required for Accrued expenses?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

 Accrued expenses are Expenses incurred but not yet paid or recorded at the statement
date.
Example: Interest, rent, tax, and salaries can be accrued expenses. Accrued expense result
from the same cause as accrued revenues to another company. For example, the Br.200
accrued of fees by Ifa advertising agency is an accrued expense to the client that received
the service.
 Adjustments for accrued expense are necessary to record the obligations that exist at the
balance sheet date and to recognize the expenses that apply to the current accounting
period. A liability-expense relationship exists with accrued expenses. Prior to adjustment
both liabilities and expenses are understated. Therefore, the adjusting entry for accrued
expenses results in a debit (Increase) to an expense account and a credit (increase) to a
liability account.
1) Accrued interest: Ifa Advertising Agency signed a 3-month not payable in the amount of
Br.5,000 on October 1. The note requires interest at an annual rate of 12%. The amount of the
interest accumulation is determined by three factors: (i) The face value of the note, (ii) the
interest rate, which is always expressed as an annual rate, and (iii) the length of time the note is
outstanding. In this instance, the total interest due on the Br.5,000 note at its due date 3 months
hence is Br.150 (Br.5,000 x 12% x 3/12), or Br.50 for one month. The formula for computing
interest and its application to Ifa advertising Agency for the month of October is shown below.

Interest =Face Value* Annual Interest Rate* Time in Terms of Year

==Br.5, 000* 12%*1/12= Br.50

49
Note that the time period is expressed as a fraction of a year. The accrued expense adjusting
entry at October 31 is as follows:
Oct. 31 Interest expense 50
Interest payable 50
(To accrue interest on notes payable )

After the adjusting entry is posted, the accounts show:

Interest expense Fees earned

10/31 50 10/31 Bal. 50

Interest expense shows the interest charge applicable to the month of October. The amount of
interest owed at the statement date is shown in interest payable. It will not be paid until the note
comes due at the end of three months. The interest payable accounts is used instead of crediting
Notes payable to disclose the two types of obligation (interest and principal) in the accounts and
statements. If this adjusting entry is not made, liabilities and interest expense will be understated,
and net income and owner’s equity will be overstated.

2) Accrued salaries: Some types of expenses, such as employee salaries and commissions, are
paid for after the services have been performed. In the case of Ifa Advertising, salaries were last
paid on October 26 (Friday); the next payment of salaries will not occur until November 9
(Friday). Three working days remain in October (October 29-31).
At October 31, the salaries for these days represent an accrued expense and related liability to Ifa
advertising. The employees receive total salaries of Br.2, 000 for a five-day workweek, or Br.400
per day. Thus, accrued salaries at October 31 are Br.1, 200 (Br. 400 x 3), and the adjusting entry
is for this event is as follows.

Oct. 31 Salaries expense 1,200

Salaries payable 1,200
(To record accrued salaries )

After the adjusting entry is posted, the accounts show:

50
 Salaries expense Salaries payable
10/26 4000 10/31 Bal. 1,200
31 Adj 1,200
10/31 bal
5,200

Following this adjustment, the balance in salaries expense of Br.5, 000 (13days x Br.400) is the
actual salary expense for October. The balance in salaries payable of Br.1, 200 is the amount of
the liability for salaries owed as of October 31. If the Br.1, 200 adjustment for salaries is not
recorded, Ifa’s expense will be understated Br.1, 200, and its liabilities will be understated Br.1,
200.

In Ifa advertising agency, salaries are payable every two weeks. Consequently, the next pay day
is November 9, when total salaries of Br.4, 000 will again be paid. The payment consists of
Br.1,200 of salaries payable at October 31 plus Br.2,800 of the payment consists of Br.1,200 of
salaries payable at October 31 plus Br.2,800 of salaries expense for November (7 working x
Br.400). Therefore, the following entry is made on November 9:
Nov 9 Salaries payable 1,200
Salaries expense 2,800
Cash 4,000
This entry eliminates the liability for salaries payable that was recorded in the October 31
adjusting entry and records the proper amount of salaries expense for the period between
November 1 and November 9.

3.1.4. Preparing the Adjusted Trial Balance

Adjusted trial balance shows the balances of all accounts, including those, that have been
adjusted,
☼What is the purpose of an adjusted trial balance?
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________

51
  The main purpose of an adjusted trial balance is to show the effects of all financial events
that have occurred during the accounting period.
 An adjusted trial balance proves the equality of the total debit balances and the total
credit balances in the ledger after all adjustments have been made. The proof provided by
an adjusted trial balance, like the proof contained in a trial balance provides the primary
basis for the preparation of financial statements.
An adjusted trial balance for Ifa Advertising Agency is presented as follows:

Ifa advertising Agency

Trial Balance
October 31,2012
Before After
Adjustment Adjustment
Dr Cr Dr Cr

52
 Cash Br.15,200 Br.15,000
Account receivable 2,500 200
Advertising supplies 600 1,000
prepaid insurance 5,000 550
Office equipment 5,000
Accumulated depreciation-Office
equipment Br.5,000
Notes payable 2,500
Account payable 1,200 Br. 40
Interest payable 10,000
Unearned fees 5,000
10,000
Salaries payable
2,500
Ifa, capital
Ifa , drawing 50
500
Fees earned 800
500
Salaries expense
4,000 1,200
Advertising supplies Expense
5,200
Rent expense 10,000
Insurance expense 900 1,500

Interest expense 900

Depreciation expense 10,600
50

50 ________
______

Br.28,700 40_ Br.30,190

3.2. Basis of Accounting: Accrual vs. Cash

☼What is the difference between Accrual and Cash basis accounting?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
3.2.1 Accrual Basis of Accounting

53
Accrual basis accounting means that transactions that change a company’s financial statements
are recorded in the periods in which the events occur, rather than in the periods in which the
company receives or pays cash.

3.2.2 Cash Basis Accounting

Cash basis accounting means that revenue is recorded only when the cash is received, and an
expense is recorded only when cash is paid.

3.3. Preparation of Work sheet.

☼What is work sheet and what are the steps followed in preparation of work sheet?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

 A work sheet is a multiple-column form that may be used in the adjustment process and
in preparing financial statements.

As its name suggests, the work sheet is a working tool or a supplementary device for the
accountant. A work sheet is not a permanent accounting record; it is neither a journal nor a part
of the general ledger. The work sheet is merely a device used to make it easier to prepare
adjusting entries and the financial statements. In small companies with relatively few accounts
and adjustments, a work sheet may not be needed. In large companies with numerous accounts
and many adjustments, it is almost indispensable.
The use of work sheet is optional. When a work sheet is used, financial statements are prepared
from the work sheet. The adjustments are entered in the worksheet columns and are then
journalized and posted after the financial statements have been prepared. Thus, management and
other interested parties a can receive the financial statements at an earlier date than without a
worksheet.

 Steps in preparing a Work Sheet

We will use the October 31 trial balance and adjustment data of Ifa advertising in this section to
illustrate the preparation of a work sheet. Each step of the process is described and demonstrated
below.

54
Step 1. Prepare a trial balance on the work sheet. The account title space and trial balance
columns are used to prepare a trial balance. The data for the trial balance come directly form the
ledger accounts.

Step 2. Enter the adjustments in the adjustment columns. When a work sheet is used, all
adjustments are entered in the adjustment columns. In entering the adjustments, applicable trial
balance accounts should be used. If additional accounts are needed, they should be inserted on
the lines immediately below the trial balance totals. Each adjustment is indexed and keyed to
facilitate the journalizing of the adjusting entry in the general journal. It is important to recognize
that the adjustments are not journalized until after the work sheet is completed and the financial
statements have been prepared.

They are keyed in the adjustments columns of the work sheet as follows:
a) An additional account, Advertising Supplies Expense, is debited Br.1, 500 for the cost of
supplies used, and Advertising Supplies is credited Br.1, 500.
b) An additional account, Insurance Expense, is debited Br.50 for the insurance that has
expired, and Prepaid Insurance is credited Br.50.
c) Two additional accounts are needed. Depreciation Expense is debited Br.40 for the
months depreciation, and Accumulated Depreciation –Office Equipment is credited Br.40
d) Unearned Fees is debited Br.400 for fees earned, and Fees Earned is credited Br.400
e) An additional account, Account Receivable, is debited Br.200 for fees earned but not
billed, and Fees Earned is credited Br.200.
f) Two additional accounts are needed. Interest Expense is debited Br.50 for accrued
interest, and Interest Payable is credited Br.50
g) Salaries Expense is debited Br.1, 200 for accrued salaries, and an additional account,
Salaries Payable, is credited Br.1, 200
Note that after all the adjustments have been entered, the adjustment columns are totaled and the
equality of the column totals is proved.

Step 3 Enter adjusted balances in the adjusted trial balance columns. The adjusted balance
of an account is obtained by combining the amount entered in the first four columns of the work
sheet for each account. For example, the Prepaid Insurance account in the trial balance columns
has a Br.600 debit balance. When this is combined with the Br.50 credit in the adjusted columns,

55
the result is a Br.550 debit balance recorded in the adjusted trial balance columns. For each
account on the work sheet, the amount in the adjusted trial balance columns is equal to the
account balance that will appear in the ledger after the adjusting entries have been journalized
and posted.

Step4 Extend adjusted trial balance amounts to appropriate financial statements columns.
This step involves the extension of adjusted trial balance amounts to the last four columns of the
work sheet. Balance sheet accounts such as cash and notes payable are entered in the balance
sheet debit and credit columns, respectively. The balance in accumulated depreciation is
extended to the balance sheet credit column. This results because accumulated depreciation is
contra-asset account with a credit balance.
Because the work sheet does not have columns for the owner’s equity statement, the balance in
owner’s capital is extended to the balance sheet credit column. In addition, the balance in
owner’s drawing is extended to the balance sheet debit column because it is an owner’s equity
account with a debit balance. The expenses and revenue account such as Salaries Expense and
Fees Earned are entered in the appropriate income statement columns.

Step 5 total the statement columns, compute the net income (or net loss), and complete the
work sheet. The net income or loss for the period is then found by computing the difference
between the totals of the two income statement columns. If total credits exceed total debits, net
income has resulted. In such a case, “net income” is inserted in the account title space. The
amount then is entered the income statement debit column and the balance sheet credit column.
The debit amount balances the income statements columns and the credit amount balances the
balance sheet columns. In addition, the credit in the balance sheet columns indicates the increase
in owner’s equity resulting from net income. Conversely, if total debits in the income statement
columns exceed total credits, a net loss has occurred. The amount of the net loss is entered in the
income statement credit column and the balance sheet debit column.

After the net income or net loss has been entered, new column totals are determined. The totals
shown in the debit and credit income statement columns will be identical. The totals shown in
the debit and credit balance sheet columns will also be identical. If either the net income
statement columns or the balance sheet columns are not equal after the net income or net loss has

56
been entered, an error has been made in completing the work sheet. The completed work sheet
for Ifa Advertising Agency is shown below:

57
 Ifa Advertising Agency
Work Sheet
For the Month Ended October 31, 2012

Trial Balance Adjustments Adjusted trial income Balance Sheet

Balance Statement
Account Titles
Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr
Cash 15,200 15,200 15.200

Advertising Supplies 2,500 (a)1,500 1,000 1,000

Prepaid Insurance 600 (b) 50 550 550

Office Equipment 5,000 5,000 5,000

Notes Payable 5,000 5,000 5,000

Accounts Payable 2,500 2,500 2,500

Unearned Fees 1,200 (d) 400 800 800

Ifa, capital 10,000 10,000 10,000

Ifa, Drawing 500 500 500

Fees Earned 10,000 (d) 400 10,600 10,600

(e) 200

Salaries Expense 4,000 (g) 1,200 5,200 5,200

Rent expense 900 ____ 900 900

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 Totals 28,700 28,700

Advertising Supplies (a) 1,500 1,500 1,500

Expense

Insurance Expense (b) 50 50 50

Accum. Depreciation –

Office Equipment (c) 40 40 40

Depreciation Expense (c) 40 40 40

Interest Expense (f ) 50 50 50

accounts Receivable (e) 200 200

Interest Payable (f) 50 50 50

Salaries Payable ____ (g)1,200 ____ 1,200 _____ _____ _____ 1,200

Totals 3,440 3,440 30,190 30,190 7,740 10,600 22,450 10,590

Net income 2,860 _____ _____ 2,860

Total 10,600 10,600 22,450 22,450

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3.4. Preparation of financial statements.

Once a preparation of work sheet has been accomplished, the statement columns contain all the
data that are required for the preparation of financial statements: The income statement is
prepared from the income statement columns, and the balance sheet and owner’s equity
statement are prepared from the balance sheet columns. At this point, adjusting entries have not
been journalized and posted. Therefore, the ledger does not support all financial statement
amounts.

The preparations of financial statements from the work sheet of Ifa Advertising Agency are presented
below.

Ifa Advertising Agency

Income Statement
For the Month Ended October 31, 2012
Revenues:
Fees earned 10,600
Expenses:
Salaries Expense Br.5, 200
Advertising Supplies Expense 1,500
Rent expense 900
Insurance Expense 50
Interest Expense 50
Depreciation Expense 40
Total Expense 7,740
Net Income 2,860

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 Ifa Advertising Agency
Owner’s Equity Statement
For the Month Ended October 31, 2012

Ifa’s, Capital, October 1 Br. –0-

Add: Investment 10,000
Net Income 2,860
12,860
Less: Drawing 500
Ifa’s, capital, October 31 12,360

Ifa Advertising Agency

Balance Sheet
October 31, 2012

Assets
Cash Br.15, 200
Account Receivable 200
Advertising Supplies 1,000
Prepaid Insurance 550
Office Equipment 5,000
Less: Accumulated Depreciation 40 4,960
Total Assets Br. 21,910
Liabilities and Owner’s Equity
Liabilities
Notes payable Br. 5000
Account Payable 2,500
Interest Payable 50
Unearned Fees 800

Salaries Payable 1,200

Total Liabilities 9,550

Owner’s Equity
Ifa’s, Capital 12,360
Total Liabilities and Owner’s Equity Br. 21,910

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3.5. Closing entry.
In closing the books, it is necessary to distinguish between temporary and permanent accounts.
Temporary or nominal accounts related only to a given accounting period. They include all
income statement accounts and owner’s drawing. Revenue and expenses are closed to income
summary at the of accounting period. All temporary accounts are closed. In contrast,
Permanent or real accounts relate to one or more future accounting periods. They consist of all
balance sheet accounts including owner’s capital. Permanent accounts are not closed. Instead,
their balances are carried forward into the next accounting period.

Summary
Adjusting entries are made at the end of an accounting period. They insure that revenues are
recorded in the period in which they are earned and that expenses are recognized in the period in
which they are incurred. The major types of adjusting entries are prepayments (prepaid expenses
and unearned revenues) and Accruals (accrued revenues and accrued expenses).
After the adjusted entries are journalized and posted to accounts adjusted trial balance may be
prepared. An adjusted trial balance is a trial balance that shows the balances of all accounts,
including those that have been adjusted, at the end of an accounting period. The purpose of an
adjusted trial balance is to show the effects of all financial events that have occurred during the
accounting period.
A work sheet is a working paper used in the adjustment process and in preparing financial
statements. The use of a work sheet is optional in the accounting cycle.

As a required procedure of accounting cycle, closing the books occurs at the end of an
accounting period. The process is to journalize and post closing entries and then rule and balance
all accounts. In closing the books, separate entries are made to close revenues and expenses to
income summary, income summary to owner’s capital, and owner’s drawings to owner’s capital.
Permanent accounts are not closed; only temporary accounts are closed.

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 Self Examination questions

Part One: Multiple choices

Choose the correct answer from the given alternatives.

1. Which of the following accounts in the Adjusted Trial Balance columns of the end-of-period
Spreadsheet (work sheet) would be extended to the Balance Sheet columns?
A. Utilities Expense C. M. E. Jones, Drawing
B. Rent Revenue D. Miscellaneous Expense
2. Which of the following accounts would be classified as a current asset on the balance sheet?
A. Office Equipment C. Accumulated Depreciation
B. Land D. Accounts Receivable
3. Which of the following entries closes the owner’s drawing account at the end of the period?
A. Debit the drawing account, credit the income summary account.
B. Debit the owner’s capital account, credit the drawing account.
C. Debit the income summary account, credit the drawing account.
D. Debit the drawing account, credit the owner’s capital account.
4. Which of the following accounts would not be closed to the income summary account at the
end of a period?
A. Fees Earned C. Rent Expense
B. Wages Expense D. Accumulated Depreciation
5. Which of the following accounts would not be included in a post-closing trial balance?
A. Cash C. Accumulated Depreciation
B. Fees Earned D. J. C. Smith, Capital

Part Two: Work out

1. The trial balance of ABC Company shows following balances on April 30.
Prepaid insurance Br. 3,600
Equipment 28,000
Notes Payable 20,000
Unearned Fees 4,200
Fees Earned 1,800

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Analysis reveals the following additional data pertaining to these accounts:
(a) Prepaid insurance is the cost of a two-year insurance policy, effective April 1.
(b) Depreciation on the equipment is Br. 500 per month.
(c) The note payable is dated April 1. It is a six-month, 12% note.
(d) Seven customers paid for the company’s six months’ law service package of Br.
600 beginning on April. These customers were serviced on April.
(e) Law services rendered other customers but not billed at April 30 totaled Br. 15,000.
Instructions: Prepare the adjusting entries for the month of April.

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

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 Chapter Four
Accounting for Merchandising Enterprise
Overview
There are three types of business enterprises: Merchandising, Manufacturing and Service
companies. Merchandising enterprise acquires an item for resale to customers without changing
its original form. Example: Retailers and whole sellers. Manufacturing companies acquire raw
material and convert it in to some product and sale the product. Service companies render a
service to customers; these companies do not have any inventory to be reported except supplies.
In this Chapter, We will look at the operations cycle of merchandising enterprises. The
operations of a merchandising business involve the purchase of merchandise for sale
(purchasing), the sale of the products to customers (sales), and the receipt of cash from
customers (collection). This overall process is referred to as the operating cycle. Thus, the
operating cycle begins with spending cash, and it ends with receiving cash from customers.

Objectives of the Chapter:

At the end of this chapter students will be able to:
 Understand the concept of periodic and perpetual inventory system.
 Understand the concept of purchase discount, Purchase return and allowance in the
purchase of inventory in merchandising companies.
 Understand the concept of Sales discount, sales return& allowance and sales taxes under
periodic as well as perpetual inventory system.
 Record transportation costs(Freight cost) when buyers bear costs(FOB)Shipping point or
sellers bears cost(FOB)Destination, Under periodic as well as perpetual inventory system

4.1. Accounting for the purchase and sale of Inventories in merchandising companies
Purchases and sale of merchandise are treated based on the inventory system employed by
business Enterprise. There are two alternative inventory systems that can be employed by
businesses. These are:

1. Periodic inventory system

2. Perpetual inventory system

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4.1.1. Periodic inventory system

☼What is the difference between periodic and perpetual inventory system?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

 Under the Periodic inventory system the cost of all merchandise purchased is
accumulated in a “Purchase” account; i.e when purchases are made for cash or on
account the transactions are recorded as follow:
Purchase-------------------------------------------xx
Cash (Account payable) --------------------------xx
When sales are made, the revenues from sales are recorded, but no attempt is made on the
sales date to record the cost of merchandise sold.

The cost of merchandise sold during the period and the cost of inventory on hand is
determined through the physical cost of inventory and cost flow assumptions.
 Under Perpetual Inventory system purchase of inventory is directly accumulated in the
“Inventory” account. i.e when purchases are made for cash or on account the transactions
are recorded as follow:
Merchandise inventory---------------------------xx
Cash (Account payable) ----------------------------------xx
When merchandise is sold the amount is recorded in cost of goods sold, in this manner the
accounting records continuously (perpetually) disclose the inventory on hand.

4.1.1.1. Accounting for purchases under periodic inventory system

Purchase Discount
The arrangements agreed upon by the buyer and the sellers as to, when payments for
merchandise are to be made are called credit terms. If payment is required immediately up on
delivery, the terms are said to be “cash” or “net cash” otherwise the buyer is allowed a certain
amount of time, known as the credit period, in which to pay. It is usual for the credit to begin
with the date of sale as shown by the date of invoice or bill. If payment is to due within a
stated number of days after the date of invoice, say 60days, the terms are said to be “net 60

66
days” which may be written as “n/60”. If payment is due by the end of the month in which
sales was made, it may be expressed as “n/eom.”
As a means of encouraging payments before the end of credit period, the seller may offer a
discount for early payment of cash. Thus, the expression “4/20, n/60” means that, though the
credit period is 60 days, the buyer may deduct 4% of the amount of invoice if payment is
made within 20 days after the invoice date. This deduction is known as cash discount.

From the buyer’s stand point, it is important to take advantage of all available discounts, even
it is necessary to borrow the money to make the payments, when the discount given is
attractive as compared with the market interest rate.

When there is purchase discount, two methods of accounting for purchases of merchandise are
used under the periodic method. These are the gross method and the net method.
i. The Gross method- under this method, the purchase is recorded at the
invoice amount before deduction of any related cash discount.
ii. The Net method- under this method purchase is recorded at the invoice
amount less any related cash discount.
Example: If Abdi company purchases merchandise costing 1,000 birr on July 15. On the
terms of 2/10, n/30, the transaction is recorded under the two methods as follow:

Gross Method: Net method:

Purchase------------------------1, 000 Purchases -----------------------980

Accounts payable--------------------1, 000 Accounts payable-----------------980

If the payment is made with in the discount period (10 days for example above), the buyer is
entitled to pay the net amount of birr.980. Under the Gross method a purchase discount
account is used by the purchases to accumulate discounts actually taken. However, if the net
method is employed, cash discounts taken are not recorded. Thus, if the discount is taken by
the purchaser, the cash payment is taken by the purchaser, the cash payment is the same under
both methods, further, and both methods result in the same cost of purchases if discount is
taken. This is because, under the gross method, purchase discounts are subtracted from
purchases account on the income statement.

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If payment is not made within the discount period, the discount is lost and the total invoice
amount (1000 here) going to be paid by the buyer. Under the gross method, since the invoice
amount (1000) liability is recorded, the Discount lost is not recorded in the books. However,
under the net method, the Discount lost is rerecorded.

Example: Assume that:

A. Payment is made within the Discount period.

Gross method: Net method:

Accounts payable---------1,000 Accounts payable ---------980

Purchase Discount------------20 Cash ----------------------------------980

Cash--------------------------980

B. Payment after Discount Period Expired.

Gross method: Net method:

Accounts Payable------------------1, 000 Accounts payable --------------------980

Cash-----------------------------------1, 000 Discount lost---------------------------20

Cash-------------------------------1000

Under the net method, discounts are recorded in the accounts only if they are lost. This
procedure calls management’s attention to cares, which should be taken in payment bills. Under
the gross method, purchase discount is subtracted from the purchase accounts to determine cost
of goods sold. However, under the net method, purchase Discount lost is an expense that is
classified under the other Revenue and Expense. Theoretically, the net method is preferable
because purchases and resulting liabilities are recorded at their cash equivalents. In practice,
however, more firms use the gross method of recording.

Purchase Returns and Allowances

Sometimes merchandise received from suppliers is defective or otherwise not acceptable. In
such event, the buyer may return it (purchase return) or the buyer may negotiate on price

68
 adjustment (purchase Allowance). In either case part or all of the purchaser’s liability to the
supplier is eliminated. To make this information more ready available to management, the
purchase Returns and Allowance account is credited for the amount of liability (Account
payable) eliminated.
The details of why the return or allowance is requested may be stated in a letter or by a debit
memorandum form used by the buyer. The seller may confirm through credit memorandum.

Purchase returns and Allowance, is a contra purchase account, same with purchase discount
account.
Example: Assume that half of the 1,000 worth of merchandise acquired by Abdi Company on
July 15 were returned, on July 20, the following entry would be required using gross method:
Accounts payable---------------------500
Purchase Returns and Allowance -----------------500

If the net method is used; Accounts payable is debited and purchase return and Allowance is
credited for the percentage proportion of the return in the original invoice; computed as follow
for the above example:

Cost of product Returned = Price Reduction/Total invoice price X Net

purchase price after

Discount
= 500/1000 X 980 = 490, hence:
Accounts payable ----------------490
Purchase Return Allowance----------- 490

Ø Activity 4.1:
1. Write the difference between periodic and perpetual inventory system.
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

69
 2. Write the definition of the terms: Purchase discount, credit period, cash discount,
purchase return and allowance.
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

3. Describe the difference between Gross method and Net method in the record of purchase
discount.
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

4.1.1.2. Accounting for sale under periodic inventory system

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

Cash ----------xx Account Receivable-------xx

Sales-------------------xx Sales-------------------------xx
Example: A sale of merchandise for 1000 birr cash is recorded as:
Cash-----------------1, 000
Sales----------------------1, 000
The same sale on Account is recorded as:
Account Receivable -----------1,000
Sale----------------------------1, 000
At the time of collection, cash is debited and Accounts Receivable is credited.

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Sales Discount
The seller refers to the discounts taken by the buyer for early payment of an invoice as sales
discounts. They are recorded by debiting the sales Discount account and are considered to be
reductions in the amount initially recorded in sales. That is, the balance of sales discounts
account is viewed as a contra (or off setting) account to sales.
Trade Discounts
Many manufacturers and whole sellers periodically publish catalogs advertising their
merchandise at list prices. However, a reduction from list price may be granted based on the
volume of merchandise purchased or on the nature of the purchaser (whole-seller, retailer, or
ultimate consumer.) A trade discount is a convenient means of making price reductions without
reprinting catalogs. Thus, business may offer special discount from the list price for customers
that order large quantities. Both buyers and sellers do not normally record the list prices of
Merchandise and the related trade discounts in their accounts. i.e. Trade discounts are not
recorded in the accounts of either the seller or the buyer but are deducted from the product list
price in arriving at the selling price; both the purchaser and seller record the transaction at the
determined selling price.
Example: Wholesaler sells merchandise with a list price of 1,000 birr at a trade discount
of 20 percent; a sale of 800 will be recorded by the seller. Similarly purchase of 800 is recorded
by the buyer.
If an additional cash (sales) discount is involved, it is based on invoice price rather on the list
(gross) price. Trade discounts are frequently stated in terms of a series of discounts, such as
25/20/10, i.e. 25% of list price, 20% of remainder and again 10% of reminder.
Example: If a wholesaler sells merchandise with a list price of 1,000, at a trade discount
stated as 25/20/10, then the items selling price would be:
List price-----------------1, 000
Less 25% discount---- (250)
Remainder-------------- 750
Less 20% discount ------ (150)
Remainder----------600
Less 10% discount------- 60
Selling price---------------540

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

Example: If a merchandise costing 100 birr is returned:

The journal entry to record the return:
i. If the sale was made on credit
Sales Return and allowance--------100
Account Receivable------------------100
ii. If the sale was made on cash:
Sales Returns and Allowance-------100
Cash---------------------------------------100

Sales Taxes
Almost all states (governments) levy a tax on sales of merchandise, except when merchandise is
purchased for reselling purpose. i.e. Business that purchase merchandise for resale to others are
normally exempt from paying sales taxes on their purchases. Only final buyers (ultimate users of
the item) normally pay sales taxes. The liability for the sales tax is ordinarily incurred at the
time the sale is made regardless of the terms of sale.
Cash (Account Receivable) --------xx
Sales-------------------------------xx
Sales tax payable-----------------xx

Ø Activity 4.2:
1. Write the record of sale, when inventory sold on cash as well as on credit.

72
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

2. Write the difference between the terms of: Sales discount, Trade discount, Sales return
&allowance and sales taxes.
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

4.1.2. Perpetual Inventory system

As stated earlier, in perpetual inventory system, each purchase and sale of merchandise is
recorded in an inventory account. As a result the amount of merchandise available for sale and
the amount sold are continuously (perpetually) disclosed in inventory records.
4.1.2.1. Accounting for Purchase
Under the perpetual inventory system merchandise purchases are recorded as follow:
Merchandise Inventory---------------------xx
Cash or Account payable----------------xx
Example: Purchase merchandise having a price of 20,000 Birr on Account is recorded as
Merchandise Inventory-----------------------20,000
Account payable----------------------------------20,000
Purchase Discount
Under perpetual system also, there is possibility of using the gross method or the net method for
recording the purchases of merchandise. But the gross method is widely used and it is
merchandise inventory is going to be credited when discount is taken.
Example: Purchase inventory at a price of 1500 terms 2/10, n/30 on January 12 is
recorded as follow:
Gross method:
Merchandise inventory----------1500
Account payable----------------1500

i. Payment within the discount period

Account payable-------------1500

73
 Purchase discount-----------------30

Cash-----------------------------1470
ii. Payment after discounts period Expires:
Account payable-----------------1500
Cash-----------------------------------------1500

Net Method:
Merchandise Inventory--------------------1470
Account Payable---------------------------1470
i. Payment within the discount period:
Account payable-------------------1470
Cash---------------------------------------1470
ii. Payment after discount period Expires:
Account payable----------------------1470
Discount lost-----------------------------30
Cash--------------------------------------1500

Purchase Returns and Allowances

Purchase Returns and allowances are recorded in perpetual system as:
Accounts payable (cash) ------------xx

Merchandise Inventory-------------------xx

4.1.2.2. Accounting for sales:

The sale transaction is recorded in similar manner as in the case of periodic inventory system;
however, under the perpetual inventory system, the cost of merchandise sold and the reduction in
merchandise inventory should also be recorded.
Sale: Cash /Account Receivable -----------xx
Sale----------------------------xx
To record sale
CGS: Cost of goods sold------------------xx
Merchandise Inventory---------------xx

74
Sales Discount
Same with periodic inventory system; i.e. if the discount is taken by the buyer the record is as
follow:
Cash------------xx
Sales Dis. ----- -----xx
Accounts Receivable. --------xx
To record collection within discount period

Sales Returns and Allowances

Same with periodic inventory system; but under the perpetual system, to keep the cost of goods
sold and merchandise inventory accounts up to date, a record debiting merchandise inventory
and crediting cost of goods sold is also necessary. Thus, sales returns and Allowance is recorded
as follow:
Sales Return and Allowance---------------xx
Account Receivable (cash) ---------------xx
To record sales return or Allowance
Merchandise Inventory------------xx
Cost of merchandise sold-----------xx
To record cost of merchandise returned

Transportation Costs (Freight Cost)

The terms of sale should indicate when the ownership (title) of the merchandise passes to the
buyer. This point determines which party, the buyer or the seller, must pay transportation cost.
The ownership of merchandise may pass to the buyer when the seller delivers the merchandise to
the transportation company or freight carrier. In this case, the terms are said to be FOB (Free on
board) shipping point. Under this term the buyer bears the transportation costs.
The shipping point is the point where the shipment originates. The buyer then pays the
transportation costs to the final destination, such costs are part of the buyers total cost of
purchasing inventory and should be added to the cost of the inventory by debiting purchase
(periodic inventory system) or merchandise inventory (perpetual inventory system).

75
Example: Assume that on June 10, ABC Company purchases from XYZ Company on account
for 1850, terms FOB shipping point, and pays transportation cost of 150 birr. ABC Company
records this transaction as follow:

1. Perpetual system:

i. Merchandise Inventory-------------1850
Account payable----------------------------1850

To record purchase merchandise

ii. Merchandise Inventory----------------150

Cash---------------------------------150
To record payment of shipping cost

2. Periodic system
i. Purchase--------------------1850
Accounts payable------------------1850
To record purchase of merchandise
ii. Purchase--------------------150
Cash-------------------------------150
To record payment of shipping cost
Sometimes, ownership of the merchandise may pass to the buyer when the buyer receives the
merchandise in its warehouse. In this case, the terms are said to be FOB destination, and the
seller bears the transportation cost.
In this case, the seller debits Transportation out or Delivery Expense, which is reported on the
seller’s income statement as an expense.
1. FOB shipping point- buyer pays transportation cost and debits merchandise inventory
(Purchase) account.
2. FOB Destination- seller pays transportation costs and debits transportation (Freight) out or
Delivery Expense account.

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Summary
Merchandising enterprises purchase goods and service and sell it to customers without changing
its basic form. In the purchase and sale of inventory they use two basic accounting systems:
Periodic and perpetual inventory system. In Periodic inventory system the cost of all
merchandise purchased is accumulated in a Purchase account; where as in Perpetual Inventory
system purchase of inventory is directly accumulated in the Inventory account. A deduction
made on the purchase of inventory is considered as purchase discount. There are two basic
methods to record purchase discount: gross method and the net method. Under gross method, the
purchase is recorded at the invoice amount before deduction of any related cash discount is
made. In the case of Net method purchase is recorded at the invoice amount less any related cash
discount.
If merchandise received from suppliers is defective or not accepted, buyer may return it
(purchase return) or the buyer may negotiate on price adjustment (purchase Allowance). This
process is known as purchase return and allowances. Purchase returns and Allowance, is a contra
purchase account, same with purchase discount account.
Revenues from merchandise sales are usually identified in the ledger as sales. Sell of
merchandise can be made on cash or on credit (Account).
In the delivery of goods purchased always, there is an agreement or terms of sale between buyers
and sellers .For example on the payment of transportation cost. These terms are: FOB
Destination and FOB shipping point. If agreements are made on FOB destination, seller pays
transportation costs and debits transportation (Freight) out or Delivery Expense account. On the
other hand if an agreement is made on FOB shipping point buyer pays transportation cost and
debits merchandise inventory (Purchase) account.

 Self Examination questions

Part one: Multiple Choices
Choose the best answer from the given alternative.
1.If merchandise purchased on account is returned, the buyer may inform the seller of the
details by issuing a(n):
A. Debit memo. C. Invoice.
B. Credit memo. D. Bill.

77
2. If merchandise is sold on account to a customer for birr 1,000, terms FOB shipping point,
1/10, n/30, and the seller prepays birr $50 in freight, the amount of the discount for early
payment would be:
A. birr $0 B. birr $5.00 C. birr 10.00 D. birr $10.50.
3. Merchandise is sold on account to a customers for birr 1,000, terms of FOB destination.1/10,
n/30. If seller pays birr 50 in transportation costs and the customer return birr 100 of the
merchandise inventory prior to payment, what is the amount of the discount for early payment?
A. birr 0.00 B. birr 9.00 C. birr 10.00 D. birr 10.50
4. For an enterprise using the periodic inventory system, which of the following is added to
merchandise inventory at the be3fginning of the period in computing the cost of merchandise
sold?
A. Purchases discounts C. Merchandise inventory at the end of the period
B. Purchases Returns and allowances D. None of the above
5. The balance in unearned rent at the end of a period represents.
A. An assets B. liability C. a revenue D. an expense.

Part Two: Work out

Each merchandising transaction affects a buyer and a seller. This exercise shows how the same
transactions would be recorded by both the seller and the buyer. Assume the seller is Fraol
Company and the buyer is Roza Company. Record the following transactions on both the seller
(Fraol) and buyer (Roza) Company. Use perpetual Inventory system.

July1. Fraol Company sold merchandise on account to Roza Company for 7500birr,

terms FOB shipping point, n145. The cost of merchandise sold was birr 4500.

July 2. Roza Company paid transportation costs of birr 150 on July1. Purchase from

Fraol Company.

July 5. Fraol Company sold merchandise on account to Roza Company for 5000 birr,

terms FOB destination, and n130. The cost of merchandise sold was 3500birr.

July 7. Fraol Company paid transportation of 250birr for delivery of merchandise sold to

Roza Company on July 5.

78
July 13. Fraol Company issued Roza Company a credit memorandum for merchandise

returned having a price of 1000 birr. The merchandise had been purchased by

Roza Company on account on July5. The cost of merchandise returned was

7000birr.

July 15. Fraol Company received payment from Roza Company for purchase of July5.

July 18. Fraol Company sold merchandise on Account to Roza Company for birr

12,000, terms FOB shipping point 2110, nleom. Fraol Company prepaid

transportation cost of 500birr, which were added to the invoice. The cost of the

merchandise sold was 7200.

July 23. Fraol Company received payment from Roza Company for purchase of July 18.

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 Chapter Five
Accounting for Cash
Overview
Cash is one of the most liquid assets reported on balance sheet as current asset. Most
companies include cash equivalents, which are similar to cash, as part of cash. Cash
can be easily hidden and moved. Therefore, it is important to apply principles of a
good internal control to cash and cash equivalent. Good system of internal control
provides adequate procedures for protecting both cash and cash equivalents.
Dear students, in this chapter we will learn about the definition of cash and cash
equivalents and the application of internal controls for cash receipt and cash
disbursement.

Objectives of the chapter:

At the end of this section students will be able to:
 Define the term cash, cash equivalents and liquidity.
 Explain the applications of internal control system to cash receipts.
 Describe the applications of internal control system to cash disbursement.
 Apply the voucher system to control cash disbursement.
 Explain the operation of a petty cash.
 Indicate the control features of a bank account.
 Prepare bank reconciliation.

5.1. Definition of Cash, Cash Equivalent, And Liquidity

☼ Define the term Cash, cash equivalent and Liquidity.

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
 Cash is one of the most important assets a business owns. Cash is the
primary asset used to acquire other assets as well as to pay for operating
expenses. It consists of coins, currency (paper money), cheeks, money order,
and money on hand or on deposit in a bank.

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 Items such as postage stamps and post-dated checks (checks payable in the
future) are not cash. Stamps are a prepaid expense, the post-dated checks are
accounts receivable.
 Cash equivalents are short-term, highly liquid investment assets meeting two
criteria:
A. Readily convertible to a known cash amount
B. Sufficiently close to their maturity date so that market value is not sensitive to
interest rate changes.
Only investment purchased within three months of their maturity dates usually
satisfy these criteria. They include money market funds, money market savings
certificates, bank certificates of deposit, treasury bills and notes.

 Liquidity is how easily an asset can be converted in to another asset or be used in paying
for services or obligations.
All assets can be judged on their liquidity. Cash and similar assets are called liquid
assets, because, they are converted easily to other assets or used to pay for services
or liabilities. A company must own some liquid assets, for example, so that bills are
paid on time and purchases are make for cash when necessary.

5.2. Internal Control over Cash Receipt

Dear students, since cash is ease with which money can be transferred, many transactions either
directly or indirectly affect the receipt of cash. It is therefore necessary that cash be effectively
safeguarded by special control. Cash receipts may result from a variety of sources; such
as cash sales, collection on account from customers, the receipt of interest, rents and
dividends; investment by owners, bank loans and proceeds from the sale of
noncurrent assets.

Internal control of cash receipts ensures that all cash received is properly recorded
and deposited. The principles of internal control apply to all types of cash receipts.
There are two basic internal control mechanisms for cash receipts:
1. Over –the- counter cash and
2. Cash Receipt by mail

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5.2.1 Over-the-counter Cash Receipts
Control of over-the- counter receipts in retail businesses is centered on cash
registers that are visible to customers. In supermarkets and variety stores cash
registers are placed in checkout lines near the exit(s). In some stores, each
department has its own cash register. When a cash sale occurs, the sales are “rung
up” on a cash register with the amount clearly visible to the customer. This measure
prevents the cashier from ringing up a lower amount and pocketing the difference.
The customer receives an itemized cash register receipt slip and is expected to count
the change received. A cash register tape, which is locked in to the register until
removed by a supervisor or manager, accumulates the daily transactions and totals.
When the tape is removed, the supervisor compares the total with the amount of
cash in the register. It should show all register receipts accounted for. The
supervisor’s findings are reported on a cash count sheet that is signed by both the
cashier and supervisor.
The count sheet, register tapes, and cash are then given to the head cashier. This
individual prepares a daily cash summary showing the total cash received and the
amount from each source such as cash sales and Collection on account. The head
cashier sends one copy of the summary to the accounting department for entry in to
the cash receipts journal. The other copy goes to the treasurer’s office for
subsequent comparison with daily bank deposit. Next, the head cashier prepares a
deposit slip and makes the bank deposit. The total amount deposited should be equal
to the total receipts on the daily cash summary. This will assure that all receipts
have been placed in the custody of the bank. In accepting the bank deposit, the bank
stamps the duplicate deposit slip and send it to the company treasurer, who makes
the comparison with the daily cash summary. The activities of the sales department
are shown separate from those of the cashier’s department to indicate the
segregation of duties in handling cash.

5.2.1.1 Cash Short and Over

The amount cash actually received during a day often does not agree with the record
of cash receipts. Whenever there is a difference between the record and the actual

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cash and no error can be found in the record, it must be assumed that the mistake
occurred in making change.
The cash shortage or overage is recorded in an account entitled cash short and over.
A common method for handling such mistakes is to include in the cash receipt
journal cash short and over debit column in to which all cash shortage is entered,
and cash short and over credit column into which all cash overages are entered.
Example:
(1) If the actual cash received from cash sale is Br. 5, 754 and the amount indicated
by the cash register total was Br. 5, 750. The entry to record cash sales and its
overage is:
Cash 5,754
Sales 5,750
Cash short and over 4
(2)If a cash register shows cash sales of Birr 984 but the count of cash in the register
is Br 979. The entry to record cash sales and its Shortage is:
Cash 979
Cash short and over 5
Sales 984
If there is a debit balance in the cash short and over account at the end of the fiscal
period, it is an expense and may be included in “miscellaneous administrative
expense” on the income statement. If there is a credit balance, it is revenue and may
be listed in the “other income” section. If the balance becomes larger than may be
accounted for by minor errors in making change, management should take
corrective measures.

5.2.1.2 Cash Change Funds

Retail stores and other businesses that receive cash directly from customers must
maintain a fund of currency and coins in order to make change. The fund may be
established by drawing a check. For example, ABC Company establishes a cash
change fund for Br 150. The entry to record cash charge fund is:
Cash on hand 150
Cash in bank 150

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No additional charges or credits to the cash on hand accounts are necessary unless
the amount of the fund is to be increased or decreased. At the end of each business
day, the total amount of cash received during the day is deposited and the original
amount of the change fund is retained. The desired composition of the fund is
maintained by exchanging bills or coins for those of other denominations at the
bank.

5.2.2 Cash Receipt by Mail

Control of cash receipts that arrive through the mail starts with the person who
opens the mail. Preferably, two people are assigned the task of and are present for
opening the mail. Because two people are involved, theft of cash receipts by mail
usually requires collusion between these two employees. The person opening the
mail makes a list (in triplicate) of money received. This list should contain a record
of each sender’s name, the amount, and an explanation of why the money is sent.
The first copy is sent with the money to the cashier. A second copy is sent to the
record keeper in the accounting area. A third copy is kept by the clerk who opened
the mail. The cashier deposits the money in a bank, and the record keeper records
the amounts received in the accounting records.
This process reflects excellent internal control. First, when the bank balance is
reconciled by another person (to be explained later in this unit), he/she reveal errors
or fraud by the clerk, the cashier, or the record keeper. They are revealed because
the bank’s record of cash deposited must agree with the records from each of the
three people. This arrangement virtually eliminates the possibility of errors and
fraud. If the clerk does not report all receipts correctly, for instance, customers will
question their account balances. If the cashier does not deposit all receipts, for
instance, the bank balance does not agree with the record keeper’s cash balance. The
record keeper and the person who reconciles the bank balance do not have access to
cash; therefore, have no opportunities to divert cash to themselves. This system
makes errors and fraud highly unlikely.

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Ø Activity 5.1:
1. Write the two basic ways of internal control for cash receipts.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
2. Define the term cash short and cash over.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

5.3. Control of Cash Disbursement

Cash may be incurred or disbursed for a variety of reasons, such as to pay expense
and liabilities, or to purchase assets. Generally, internal control over cash
disbursements is more effective when payments are made by check, rather than by
cash except for incidental amounts that are paid out of petty cash.
Payment by check generally occurs only after specified control procedures have
been followed. In addition, the “paid” check provides proof of payment. Effective
internal controls of cash disbursements are achieved through a voucher system,
through the operation of petty cash, and can be controlled through bank account.

5.3.1 The Use of Voucher System

☼ What is voucher system?

___________________________________________________________________
___________________________________________________________________
________________________________________________________________
 A voucher system is made up of records, methods, and procedures used in
proving and recording liabilities and in making and recording cash payments.
A voucher system uses
1. Vouchers: The term voucher is widely used in accounting. In general sense,
it means any document that serves as proof of authority to pay cash, such as

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 an invoice approved for payment or as evidence that cash has been paid, such
as a canceled check. The term has a narrower meaning when applied to the
voucher system: a voucher is a special form on which is recorded relevant
data about a liability and the details of its payment.
2. A voucher registers: After approval by the designated official each voucher
is recorded in a journal known as a voucher register.
3. A file for unpaid vouchers: After a voucher has been recorded in the
voucher register, it is filed in an unpaid voucher file, where it remains until it
is paid. The amount due on each voucher represents the credit balance of an
account payable and voucher itself is like an individual account in a
subsidiary accounts payable ledger. Accordingly, a separate subsidiary ledger
is not needed.
4. A check register: The check register is modified form of the cash payments
journal and is so called because it is a complete record of all checks. It is
common to record all checks in the check register in sequential order,
including occasional checks that are voided because of an error in their
preparation.
5. A file for paid vouchers: After payment, vouchers are usually filed in
numerical order in a paid voucher file. They are then readily available for
examination by employees or independent auditors needing information about
certain expenditure. Eventually, the paid vouchers are destroyed according to
the firm’s policies, concerning the retention of records.

The Voucher System and Management

The voucher system not only provides effective accounting controls but also aids
management in discharging other responsibilities. For example, the voucher system
gives greater assurance that all payments are in liquidation of valid liabilities. In
addition, current information is always available for use in determining future cash
requirements. This in turn enables management to make the best use of cash
resources. Invoices on which cash discounts are allowed can be paid within the
discount period and other invoices can be paid on the final day of the credit period,

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thus reducing costs and maintaining a favorable credit standing. Seasonal borrowing
can also be planned more accurately, with a consequent saving in interest costs.

5.3.2. The Use of Petty Cash Fund

☼Why a petty cash does is established?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
As we have said earlier, better internal control over cash disbursements is possible
when payments are made by check. However, using checks to pay such small
amounts as those for postage due employee launches, and taxi fares is impractical
and a nuisance (in convenient). A common way of handling such payments, while
maintaining satisfactory control, is to use a petty cash fund.
 A petty cash fund is a cash fund used to pay relatively small amounts.
The operation of a petty cash fund, involves three basic things.
1. Establishing the fund
2. Making payment from the fund and
3. Replenishing (reimburse) the fund
1. Establishing the Fund
Two essential steps in establishing a petty cash fund are
(i) Appointing a petty cash custodian who will be responsible for the fund and
(ii) Determining the size of the fund. Ordinarily, the amount is expected to cover
anticipated disbursements for a 3-to-4 week period.
When the fund is established, a check payable to the petty cash custodian is issued
for the stipulated amount. The check is then cashed and proceeds are placed in a
locked petty cash box or drawer. Most petty cash funds are established on a fixed
amount basis.
To illustrate, if the XYZ Company decides to establish a Br.100 fund on January 1,
the entry to record the establishment of a petty cash is:
January 1 Petty cash 100
Cash 100

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However, no additional entries will be made to the petty cash account unless the
stipulated amount of the fund is changed. For example, if XYZ Company decides on
March 1, to increase the size of the fund to Br. 250, the journal entry would be:
(250-100=150)
March 1, Petty cash 150
Cash 150
(To establish a petty cash fund)

2. Making Payment from the Fund

The custodian of the petty cash fund has the authority to make payments from the
fund that conforms to prescribed managements policies. Usually, management limits
the size of expenditures that may be made and does not permit use of the fund for
certain types of transactions (such as making short-term loans to employees). Each
payment from the fund must be documented on a pre-numbered petty cash receipt
(or petty cash voucher). The signature of both the custodian and the individual
receiving payment are required on the receipt. If other supporting documents such as
a freight bill or invoice are available, they should be attached to the petty cash
receipt.
The receipts are kept in the petty cash box until the fund is replenished. As a result,
the sum of the petty cash receipts and money in the fund should equal the
established total at all times. This means the surprise counts can be made at any time
by an independent person, such as an internal auditor, to determine whether the fund
is being maintained intact.
No accounting entry is made to record a payment at the time it is made from the
petty cash. It is considered to be both inexpedient and unnecessary to do so. Instead,
the accounting effects of each payment are recognized when the fund is replenished.

3. Replenishing (Reimbursing) the Fund

When the money in the petty cash fund reaches a minimum level, the fund is
replenished. The request for reimbursement is initiated by the petty cash custodian.
This individual prepares a schedule (summary of the payments that have been made)
and sends the schedule, supported by petty cash receipts and other documentation,

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to the treasurer’s (Accounting) department. The receipts and supporting documents
are examined in the treasurer’s office to verify that they were proper payments from
the fund. The treasurer then approves the request and a check is prepared to restore
the fund to its established amount. At the same time, all supporting documentation is
stamped “paid” so that it cannot be submitted again for payment.
To illustrate, assume that on March 15 the petty cash custodian requests a check for
Br 87. The fund contains Br.13 cash and petty cash receipts for postage Br. 44,
freight- in Br.38 and miscellaneous expenses Br.5. The entry to record the
reimbursement check is:
March 15 Postage expense 44
Freight – in 38
Miscellaneous expense 5
Cash 87
(To replenish petty cash fund)
A petty cash fund should be replenished at the end of the accounting period
regardless of the cash in the fund. Replenishment at this time is necessary in order to
recognize the effects of the petty cash payments on the financial statements.
5.4 The Bank Account as a Tool for Controlling Cash
The use of a bank contributes significantly to good internal control over cash. A
company can safe guards its cash by using a bank as a depository and clearinghouse
for checks received and checks written. Use of a bank minimizes the amount of
currency that must be kept on hand. In addition, the use of a bank facilities, the
control of cash, because a double record is maintained of all bank transaction one by
the business and other by bank. The asset account, cash, maintained by the depositor
is the reciprocal of the bank’s liability account for each depositor. It should be
possible to reconcile these accounts (make them agree) at any time. In the following
paragraphs we will discuss the services and documents provided by banking
activities.
1. Bank Account
Opening a bank account is relatively simple procedure. A bank account is a record
set up by a bank for a customer. It permits for customer to deposit money for

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safeguarding and check withdrawals. Typically, the bank makes a credit check on
the new customer and the depositor is required to sign signature card. The card
should contain the signatures of each person authorized to sign check on the
account. The signature card is used by bank employees to validate signatures on the
check.
Many companies have more than one bank account to serve different needs and
handle special transactions such as a payroll bank account. In addition, a company
may maintain several bank accounts in order to have more than one source for
obtaining short-term loans when needed.
As soon as possible after an account is opened, the bank will provide the depositor
with a book of serially numbered checks and deposit slips imprinted with the
depositor’s name and address. Each check and deposit slip is imprinted with both a
bank and a depositor identification number in magnetic ink to permit computer
processing of the transaction.
2. Bank Deposits
Bank deposit should be made by an authorized employee, such as the head cashier.
Each deposit must be documented by a deposit slip (ticket). A deposit slip (ticket)
lists the items such as currency, coins, and checks deposited and their corresponding
dollar amounts.
Deposit slips are prepared in duplicate. The original is retained by the bank, the
duplicate, in duplicate. The original is retained by the bank, the duplicate, stamped
by the bank to establish its authenticity, is retained by the depositor.
3. Bank Check
To withdraw money from an account a customer uses a check. A check is a written
order signed by the depositor directing the bank to pay a specified sum of money to
a designated recipient. Thus, there are three parties to a check. The maker (or
drawer) who issues (signs) the check, the bank (Or payer) on which the check is
drown own, and the payee to whom the check is payable. A check is a negotiable
instrument that can be transferred to another party by endorsement.
For both individuals and businesses, it is important to know the balance in the
checking account all times. To keep the balance current, each deposit and check

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should be entered on running balance memorandum forms provided by the bank or
on the check stubs contained in the checkbook.
4. Bank Statement
Each month, the depositor receives a bank statement from the bank. A bank
statement shows the depositor’s bank transactions and balances. The items that
included in a bank statement are described as follows:
(i) The beginning balance
(ii) Checks paid and other debits (deductions by the bank)
(iii) Deposits and other credits (additions by the bank) and
(iv) The balance at the end of the month
Most banks offer depositors the option of receiving “paid” checks with their bank
statement. Irrespective of the depositor’s choice, all “paid” checks are listed in
numerical sequence on the bank statement along with date the check was paid and
its amount. Up on paying a check, the bank stamps the check “paid”; a paid check is
sometimes referred to as a canceled check. In addition, the bank includes with the
bank statement memoranda explaining other debits and credits made by the bank to
the depositor’s account.
5. Debit Memorandum
Bank charge a monthly fee for the use of their services. The fee, called a bank
service charge, is often identified on the bank statement by a code symbol such as
SC. A debit memorandum explaining the charge is included with the bank
statement. Separate debit memoranda may also be issued for other bank services
such as the cost of printing checks, issuing traveler’s checks, and wiring funds to
other locations. The symbol DM is often used for such charges.
A debit memorandum is used by the bank when a previously deposited customer’s
check “bounces” because of insufficient funds. In such a case, the check is marked
NSF (not sufficient fund) by a customer’s bank and is returned to the depositor’s
bank. The bank then debits the depositor’s account and sends the NSF checks and
debit memorandum to the depositor as notification of the charge. The NSF check
creates an account receivable for the depositor and reduces cash in the bank account.

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6. Credit Memorandum
A depositor may ask the bank to collect its notes receivable. In such a case, the bank
will credit the depositor’s account for the cash proceeds of the note. It will issue a
credit memorandum, which is sent with the statement to explain the entry. Many
banks also offer interest on checking account. The interest earned may be indicated
on the bank statement by the symbol CM or INT.
5.5 Bank Reconciliation

☼What is bank reconciliation and why it is necessary to reconcile a bank

account?
_____________________________________________________________________________________
_____________________________________________________________________________________
_____________________________________________________________________________________
Because the bank and the depositor maintain independent records of the depositor’s
checking account, you might assume that the respective balances will always agree.
In fact, the two balances are seldom the same at any given time, and it is necessary
to make the balance per books agree with the balance per bank – a process called
reconciling the bank account.
The lack of agreement between the two balances is due to:
1. Time lags – that prevent one of the parties from recording the transaction in the
same period.
Time lags occur frequently. For example, several days may elapse between the time
a cheek is mailed to a payee and, the date the check is paid by the bank.
2. Errors by either party in recording transactions
The incidence of errors depends on the effectiveness of the internal controls
maintained by the depositor and the bank. Bank errors are infrequent. However,
either party could inadvertently record a Br.450 check as Br.45 or Br.405.
In addition, the bank might mistakenly charge a check drawn by Birhane to the
account of Birhanu.

Reconciliation Procedure
To obtain maximum benefit from bank reconciliation, the reconciliation should be
prepared by an employee who has no other responsibilities pertaining to cash. When

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the internal control principle of independent internal verification is not followed in
preparing the reconciliation, cash embezzlements may escape unnoticed. For
example, cash who prepares the reconciliation can embezzle cash and embezzlement
misstating the reconciliation. Thus, the bank accounts would reconcile and
embezzlement would not be deducted.
In reconciling the bank account, it is customary to reconcile the balance per books
and per bank to their adjusted (correct or true) cash balances. The reconciliation
schedule is divided in to two sections, One section begins with the balance as per
bank statement and ends with the adjusted balance; the other section begins with the
balance per depositor’s records and also ends with the adjusted balance. The two
amounts designated, as the adjusted balance must be equal.
Section one:
Bank balance per bank statement - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Br. x x x x
Add: Additions by depositor not on bank statement - - - - Br. x x x
(Deposit in transit)
Bank error - - - - - - - - - - - - - - - - - - - - - xx xxx

Br. x x x x
Deduct: Deductions by depositors not on bank statement Br. xxx
(Outstanding checks)
Bank errors - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - xx xxx
Adjusted Balance - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ---- Br. x x x
Section Two:
Bank balance per depositor’s records - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Br. x x x x
Add - Additions by bank not recorded by depositor - - - - -Br. x x
(Credit memorandum)
- Depositor errors - - - - - - - - - - - - - - - - - - - - - - - - - - xx-------------- - xx
Br. x x x
Deduct – deductions by bank not recorded by depositor Br. xx
(Debit memorandum)
- Depositor errors - - - - - - - - - - - - - - - - - - - - - - -- - - x x xx

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Adjusted balance - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Br. x x

The starting point in preparing the reconciliation is to enter the balance per bank
statement and balance per depositor’s record (per book) on the schedule.
The following steps should reveal all the reconciling items that cause the difference
between the two balances.
1. Compare the individual deposits on the bank statement with deposits in transit
from the preceding bank reconciliation and with the deposits per company
records or copies of duplicate deposit slips. Deposits recorded by the depositor
that have not been recorded by the bank represent deposit in transit and are
added to the balance per bank
2. Compare the paid cash shown on the bank statement or the paid checks returned
with the bank statement with (a) Checks outstanding from the preceding bank
reconciliation and (b) Checks issued by the company as recorded in the cash
payments journal. Issued checks recorded by the company that has not been paid
by the bank represent outstanding checks that are deducted from the balance
per the bank.
3. Note any errors discovered in the foregoing steps and list them in the
appropriate section of the reconciliation schedule. For example, if a paid check
correctly written by the company for Br. 195 was mistakenly recorded by the
company for Br. 159, the error of Br.36 is deducted from the balance per books.
All errors made by the depositor are reconciling items in determining the
adjusted cash balance per books. In contrast all errors made by the bank are
reconciling items in determining the adjusted cash balance per the bank.
4. Trace bank memorandum to the depositor’s records. Any unrecorded
memoranda should be listed in the appropriate section of the reconciliation
schedule. For example, a Br. 50 debit memorandum for bank service charge is
deducted from the balance per depositor books, and a Br. 32 credit
memorandum of interest earned is added to the balance per books.
Example:

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Prepare bank reconciliation for Tolera enterprises for the month ended December
31, 2012. The following information is available to reconcile Tolera enterprises
book balance of cash with its bank statement balance as of December 31, 2012.
a. After all posting is completed on December 31, the company’s book
balance of the cash account had a Br. 16,380 debit balance, but its bank
statement showed a Br, 38,520 balances.
b. Checks No. 2024 for Br. 4, 810 and No. 2036 for Br.5000 are, Outstanding.
c. In comparing the canceled checks returned by the bank with the entries in the
accounting records. We find that check No. 2025 in payment of rent is correctly
drawn for Br. 1000 but was erroneously entered in the accounting records as Br.
880
d. The December 31, deposit of Br.17, 150 was placed in the night depository after
banking hours on that date, and this amount did not appear on the bank statement.
e. In reviewing the bank statement, a check belonging to Tolashi enterprises in the
amount of Br.160 was erroneously drawn against Tolera’s account.
f. A credit memorandum enclosed with the bank statement indicated that the bank
collected a Br. 30,000 note and Br. 900 of related interest on Tolera’s behalf. This
transaction was not recorded by Tolera before receiving the statement.
g. A debit memorandum for Br. 1000 listed a Br. 1,100 NSF check. The check had
been received from a customer, Tadesse Daba; Tolera had not recorded the return
of this check before receiving the statement.
h. Bank service charge for December totaled Br. 40. These charges were not
recorded by Tolera before receiving the statement.

Based on the prevailing information the bank reconciliation will be as follows

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 Tolera Enterprises
Bank reconciliation
December 31,2012
Balance per bank statement Br. 38, 520 Balance per book Br. 16, 380
Add Add
Deposit of Nov.30 Br. 17,150 Collection of Note- 30,000
Bank error 160 Interest earned 900 30,
17,310 900
Br. 55,830 47,280
Deduct: Deduct
Outstanding checks; NSF check – Br.1, 100
No.2024 - 4810 Recording error- 120
No.2036 5000 Service charge – 40 1,260
9,810 Adjusted book balance 46,020
Adjusted bank balance 46,020

Journal Entries from Bank Reconciliation

Each reconciling item in determining the adjusted balance per book should be
recorded by the depositor. If these items are not journalized and posted, the cash
account will not show the correct balance
Then adjusting entries for Tolera enterprise on December 31 are as follows.
December 31, cash - - - - - 30, 900
Notes receivable - - 30,000
Interest earned - - - 900
(To record collection of note principal and interest)
December 31, Accounts Receivable – Tadesse Daba – 1,100
Cash - - - - - - - - - - - - - - - - 1,100
(To reinstate account due from an NSF check)
December 31, Rent expense - - 120
Cash - - - - - - - - - - - - - - - - - 120

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 (To correct recording error on check No. 2025)
December 31, Bank service charges – 40
Cash - - - - - - - - 40
(To record bank service charges)
What entries does the bank make? If any errors are discovered in preparing the
reconciliation, the bank should be notifies so it can make the necessary corrections
on its records. However, the bank does not make any entries for deposits in transit
or outstanding checks. Only when these items reach the bank will the bank record
these items.

Summary
Cash is one of the most liquid assets reported on balance sheet as current asset. It
consists of coins, currency, checks, money orders, and money on hand or on
deposits in a bank or similar depository. Most companies also include cash
equivalents, which are similar to cash, as part of cash. Cash is the one asset that is
readily convertible in to any other type of asset; it is easily concealed and
transported; and it is highly desire. Because of these characteristics, cash is the
assets most susceptible to improper diversion and use.

To control cash and to assure the accuracy of the accounting recorded for cash,
effective internal control cover cash is imperative. The internal control principles
apply to cash receipts and cash disbursements.
The internal control over receipts contains over the- counter and mail receipts.
Effective internal controls of cash disbursements are achieved through a voucher
system. General, internal control over cash disbursements is more effective when
payments are made by check, rather than by cash, except for incidental amounts that
are paid out of a petty cash.
A company can safeguard its cash using a bank as a depository and clearing house
for checks received and checks written. The use of a bank facilitates the control of
cash because double recorded is maintained of all bank transactions. It should be
possible to reconcile these accounts at any time.

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Self Examination questions
Part One: Multiple Choice
Choose the correct answer from the given alternative
1. In preparing bank reconciliation, the amount of checks outstanding would be:
A. added to the cash balance according to the bank statement.
B. deducted from the cash balance according to the bank statement.
C. added to the cash balance according to the company’s records.
D. deducted from the cash balance according to the company’s records.
2. Journal entries based on the bank reconciliation are required for:
A. additions to the cash balance according to the company’s records.
B. deductions from the cash balance according to the company’s records.
C. both A and B D. neither A nor B.
3. A petty cash fund is:
A. used to pay relatively small amounts.
B. established by estimating the amount of cash needed for disbursements of relatively small
amounts during a specified period
C. reimbursed when the amount of money in the fund is reduced to a predetermined
minimum amount.
D. all of the above.
4. The bank erroneously charged Tropical Services’ account for birr 450.50 for a check that was
correctly written and recorded by Tropical Services as birr.540.50. To reconcile the bank account
of Tropical Services at the end of the month, you would:
A. add birr.90 to the cash balance according to the bank statement.
B. add birr.90 to the cash balance according to Tropical Services’ records.
C. deduct birr.90 from the cash balance according to the bank statement.
D. deduct birr.90 from the cash balance according to Tropical Services’ records.
5. One of the following leads to unbalance of bank account and depositors (book
account).
A. Time lag B. Error C. Both a & b

Part Two: Work out

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The following information is available to you to reconcile Tadios Company’s’ book
balance with its bank statement balance as for November 30, 2012.
1. The bank service charge for November was br.25
2. The bank collected a note receivable of Br. 1,200 for Tadios Company on Nov.15
plus Br.48 of interest. The bank made a Br.10 charge for the collection.
3. The Nov. 30 receipts of Br. 1,819.60 were not included in the bank deposits for
November. These receipts were deposited by the company in a night deposit on
November 30.
4. Company check No. 2480 issued to DEK Company, a creditor, for Br. 492 that
cleared the bank in November was incorrectly entered in the cash payments
journals on November 10 for Br. 429.
5. Checks written prior to November 30 that had not cleared by bank on November
30 totaled Br. 1,480.10
6. On November 30, the bank statement showed an NSF charge of Br. 550 for a
check received by the company from Ato Yilma, a customer on account
7. The cash balance per books of the company was Br. 6,815.30
8. The cash balance per bank statement was Br. 7,075.80.

Required:
i. Prepare the bank reconciliation as of November 30.
ii. Prepare the necessary adjusting entries at November July 30.

Chapter Six

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 Accounting for Receivables
6.1. Accounting for Accounts Receivable
Accounts receivable: is part of current asset reported on balance sheet next to cash. It is the
amounts owed by customers on account. They result from the sale of goods (merchandise)
and services on account. These receivables generally are expected to be collected within 30
to 60 days. They are the most significant type of claim held by company.There are two
basic accounting problems associated with the accounts receivable. These are:
1. Recognition of accounts receivable
2. Valuation of accounts receivable
6.1.1 Recognizing Accounts Receivable
Recognizing accounts receivable is relatively simple.
To illustrate, assume that on June 1, 2012, XYZ Company sells merchandise on account to
ABC Company for Br. 1,000 terms 2/10, n/30. On June 5, merchandise worth Br. 100 is
returned to XYZ co. on June 11, payment is received from ABC Company for the balance
due. The journal entries to record these transactions on the books XYZ co. are as follows:
June 1 Accounts Receivable ABC .Co 1000
Sales 1000
(To record sales on account)
June 5 Sales Returns and allowances 100
Accounts Receivable ABC .Co 100
(To record merchandise returned)
June 11 Cash (900-18) 882
Sales Discount (900x2%) 18
Accounts Receivable ABC .Co 900
(To record collection of accounts receivable)
The opportunity to receive a cash discount usually occurs when a manufacturer sells to a
whole seller or a wholesaler sells to a retailer. A discount is given in these situations either
to encourage prompt payment or for competitive purpose.
6.1.2 Valuing Accounts Receivable
Determining the amount to report as an asset is important because some receivables will
become uncollectible. To ensure that receivables are not overstated on the balance sheet,
they are stated at their cash (net) realizable value. Cash (net) realizable value- is the net amount
expected to be received in cash.

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The cash realizable value excludes amounts that the company estimates it will not be able to
collect. Receivables are therefore reduced by estimated uncollectible receivables on the
balance sheet.
6.2. Accounting for Notes Receivable
Notes receivable is evidenced by a promissory note that makes it more legal and strong.
Companies sometimes allow customers to sign a note receivable for sales. Also, companies
sometimes ask for note to replace an account receivable, when a customer requests
additional time to pay its past-due account. If the credit period is long, the customer usually
charged interest.

Promissory Notes
A promissory note is a written promise to pay a specified amount of money on demand or
at a definite time. Credit may also be granted in exchange for a formal credit instrument
known as a promissory note.
Promissory notes may be used:

1. When individuals and companies lend or borrow money

2. When the amount of the transaction and credit period exceed normal limits, and

3. in settlement of accounts receivable

In a promissory note, the party making the promise to pay is called Maker; the party to
whom payment is to be made is called the payee. The payee may be specifically identified
by name or may be designated simply as the bearer of the note.

Notes receivable gives the holder a stronger legal claim to assets than accounts receivable.
Like accounts receivable, notes receivable can be readily sold to another party. Promissory
notes are negotiable instruments (as are checks), which means that, when sold they can be
transferred to another party by endorsement.
Notes receivable are frequently accepted from customers who need to extend the payment
of an outstanding account receivable and are often from high-risk customers. The majority
of notes, however, originate from lending transaction.
The basic issues in accounting for notes receivable are the same as those for accounts
receivable
1. Recognizing notes receivable
2. Valuing notes receivable

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 3. Disposing of notes receivable

On the following pages, we will look at each of these issues. Before we do, though,
we need to consider two issues that did not apply to accounts receivable.

Determining the Maturity Date (Due Date)

The date a note is to be paid is called the due date or maturity date. The period of time
between the issuance date and the due date of a short-term note may be stated in either days
or months.
When the life of a note is expressed in terms of months, the due date is found by counting
the months from the date of issue. For example, the maturity date of a 3-month note dated
may 1- Is August 1 a note drawn on the last day of a month matures on the last day of a
subsequent month, that is, a July 31 note due in 2 months matures on September 30.
When the due date is stated in terms of days, it is necessary to count the exact number of
days to determine the maturity date. In counting, the date the note is issued is omitted but
the due date is included. For example, the maturity date of a 90-day note dated March 16
is computed as follows:
Term of the note - - - - - - - - - - - - - - - - - - - - - - 90
March (days) _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 31
Date of note _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 16 15
Number of days remaining - - - - - - - - - - - - - - - - 75
April (days) - - - - - - - - - - - - -- - - - - - - - - - - - - - 30

45
May (days)- - - - - - - - - - - - - - - - - - - - - - - - - - - - 31
Maturity date, June - - - - - -- - - - - - - - - - - - - - - - 14
Computing Interest
A note that provides for payment of interest for the period between the issuance date and
the maturity date is called an interest-bearing note. If a note makes no provision for
interest, it is said to be non-interest bearing note.
The basic formula for computing interest on an interest-bearing note is:

Interest = Face value X Annual Interest Rate X Time in Terms of one year

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The interest rate specified on the note is an annual rate of interest. The time factor in the
computation above expresses the fraction of a year that the note is outstanding. When the
maturity dated is stated in days, the time factor is frequently the number of days divided by
360. When the due date is stated in months, the time factor is the number of months divided
by 12. The computation of interest is shown below:

Terms of note Interest computation (

Interest = Face x Rate x Time
Br. 730, 18%, 120 days 730 x18% x 120/360 = Br. 43.80
Br. 1,000, 15%, 6 months 1000 x 15% x 6/12 = 75.00
Br 2,000, 12%, 1 year’s 2000 x 12% x 1/ = 240.00
Activity 6.1:
1. Write the difference between Account receivable and Notes receivable
2. Explain the two basic accounting problems for account receivable.
6.2.1 Recognizing Notes Receivable
To illustrate the basic entry for notes receivable assuming that ABC Company accepted a
Br. 2000, 2-month, 12% promissory note dated May 1 from XYZ Company. Assuming that
the note was written to settle an open account, the entry for the receipt of the note is:
May 1. Note Receivable 2000
Accounts Receivable – XYZ co. 2000
(To record acceptance of XYZ company note)
Observe that the note receivable is recorded at its face value. No interest revenue is
reported when the note is accepted because the revenue recognition principle does not
recognize revenue until earned. Interest is earned (accrued) as time passes.
If a note is exchanged for cash, the entry is a debit to Notes Receivable and credit to cash in
the amount of the loan.
6.2.2 Valuing Notes Receivable
Similar to Accounts receivable, short term notes receivable are reported at their Cash (net)
realizable value. The notes receivable allowance account is Allowance for Doubtful
Accounts. Valuing short-term notes receivable is the same as valuing accounts receivable.
The computation and estimations involved in determine cash realizable value and in
recording the proper amount of bad debt expense and related allowance are similar.

Long-term notes receivable, however, pose additional estimation problems. As an example,

we need only look at the problems a number of large U.S. banks are having in collecting

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their receivables. Loans to less-developed countries are particularly worries some.
Developing countries (like Ethiopia) need loans for development but often find repayment
difficult. Determining the proper allowance is understandably difficult for these types of
long-term receivables.

6.2.3 Disposing of Notes Receivable

Note may be held to their maturity date, at which time the face value plus accrued interest is
due. In some situations the maker of the note defaults and appropriate adjustment must be
made. In other situations, similar to accounts receivable, the holder of the note speeds up
the conversion to cash by selling the receivables.

Activity 6.2:

1. Explain the process of determining due date or Maturity date for notes receivable.
2. Calculate an interest value for the notes, which have Br,5000 face value,
issued for 8 months at 10% interest rate.
6.3. Honor of Notes Receivable
A note is honored when it is paid in full at its maturity date.
For each interest-bearing note, the amount due at maturity is the face value of the note plus
interest for the length of time specified on the note.
Example: assume that ABC Company accepted a Br.10, 000 90 – day, 12% note dated
October 18 from XYZ Company on settlement of open account. Record the entry (assuming
the cash is collected in the maturity date)

Oct.18 Notes Receivable 10, 000

Account Receivable 10,000
(To record acceptance of XYZ co note)
If ABC Company prepares financial statements as of December 31, it would be necessary to
accrue interest (from Oct.18 up to Dec.31). In this case, the adjusting entry would be:
Interest accrued = 10,000x 12% x 74/360 = 246.67
Dec.31 Interest Receivable 246.67
Interest Revenue 246.67
(To accrue interest)

The entry to record the honoring of XYZ co. note Maturity is:
Jan. 16 Cash 10,300 .00

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 Notes Receivable 10,000.00
Interest Receivable 246.67
Interest Revenue 53.33
(To record collection of note at maturity)
Total interest earned on this note is Br. 300. This entry’s credit to interest receivable records
collection of the interest accrued in the Dec. 31 adjusting entry. The interest earned is Br.
53.33 and reflects the ABC’s revenue from holding the note from January 1 to January 16
of the current period.
6.4. Dishonor of Notes Receivable
A dishonored note is a note that is not paid in full at maturity date.
A dishonored note receivable is no longer negotiable. However, the payee still has a claim
against the maker of the note. Therefore the Notes Receivable account is usually transferred
to an Account Receivable. To illustrate, assume ABC Company a Br. 60,000, 60 days, 12%
note dated July 1 on settlement of A/R had been dishonored at maturity. To record the entry
would be:
July 1, Notes Receivable – 60,000 August 30 A/R……61,200
Accounts Receivable – 60,000 N/R - - - - - - 60,000
Interest Revenue - - - - 1,200
(To record the dishonor of the note) (To record acceptance of note)

Self Examination questions

Part one: Multiple choices
Choose the best answer from the given alternative
1. At the end of the fiscal year, before the accounts are adjusted, Accounts Receivable has a balance of
birr.200, 000 and Allowance for Doubtful Accounts has a credit balance of birr 2,500. If the estimate of
uncollectible accounts determined by aging the receivables is birr 8,500, the amount of bad debt expense
is:
A. birr 2,500 C. birr 8,500.
B. birr 6,000. D. birr 11,000.
2. At the end of the fiscal year, Accounts Receivable has a balance of birr 100,000 and Allowance for
Doubtful Accounts has a balance of birr 7,000. The expected net realizable value of the accounts
receivable is:
A. birr 7,000. C. birr 100,000.
B. birr $93,000. D. birr $107,000.
3. What is the maturity value of a 90-day, 12% note for birr 10,000?

105
 A. birr 8,800 C. birr 10,300
B. birr 10,000 D. birr 11,200
4. What is the due date of a $12,000, 90-day, 8% note receivable dated August 5?
A. October 31 C. November 3
B. November 2 D. November 4
5. When a note receivable is dishonored, Accounts Receivable is debited for what amount?
A. The face value of the note C. The maturity value of the note less accrued interest
B. The maturity value of the note D. The maturity value of the note plus accrued interest
Part Two: Work out

1. on January 1, 2012, Mr. Dan Company sells merchandise on account to Mr Niftalem

Company for Br. 2,000terms 2/10, n/30. On January 5, merchandise worth Br. 200 is
returned to Mr. Dan co. on January 11, payment is received from Niftalem Company
for the balance due. Record all important entries on the book of Mr. Dan.
2. Calculate an interest value for the following notes

Face value interest rate Time

A. birr 10,000 10% 6 months

B. birr 15,000 8% 5 months
C. birr 5000 12% 3 months
3. Calculate the due date of notes issued on January 1 for 60 days?
Answers for Self Examination questions

Chapter One (Multiple choice)

1. sD 2. A 3. A 4.C 5. C 6.C

Chapter Two (Multiple choice)

1. A 2. C 3. C 4. A 5. D.

Chapter Three (Multiple choice)

1. C 2. D 3. B 4.D 5. B

Chapter Four (Multiple choice)

1. A 2. C. 3. B. 4. D. 5. B

Chapter Five (Multiple choice)

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 1. B 2.C 3.D 4.C 5.C
Chapter Six (Multiple choice)

1. B 2. B 3.C 4.C 5.B

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