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UNIT 1.
INTRODUCTION TO ACCOUNTING
1.1 INTRODUCTION
We live in the information age-a time of communication, and a time when information is a
vital resource. In this information era, how we live, whom we associate with, and the
opportunities we have all depend on our access to and understanding of information.
The same is true for businesses (businesses are one or more individuals selling products or
services for profit). Businesses that have better access to information and that process
information more quickly and accurately do the best.
Global computer networks and telecommunications equipment now allow us to get access to
all types of business information.
But to take advantage of these, we need knowledge of information systems.
An information system is the collecting, processing, and reporting of information to decision

makers. Understanding and processing information is the core of accounting.
The kind of information processed in accounting is financial i.e. of a monetary nature.

Providing information about what businesses own, what they owe, and how they perform is
the aim of accounting. Accounting is, an information and measurement system that identifies,
records, and communicates relevant, reliable, and comparable information about an
organization’s (a business’s) economic activities.
Therefore, a study of accounting helps people make better and informed decisions about
assessing opportunities, products, investments, and social and community responsibilities.
But the use of accounting information is not limited to accountants or people in business. You
can use accounting information in your daily life. You can use accounting information to get a
loan for a house or to start a new business.
The study of accounting, therefore, opens you new and exciting possibilities both in terms of
becoming a professional accountant and using accounting information in your daily life.
This course discusses the fundamental principles involved in processing accounting

information of business enterprises.
Understanding these fundamental principles is very important because forthcoming courses

that you are going to take in accounting will build on these principles.
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1.2. DEFINITION, IMPORTANCE, AND USERS OF ACCOUNTING
INFORMATION
1.2.1. Accounting Defined

As a financial information system, accounting is defined as a process of identifying
measuring, recording and communicating economic events of an organization (business or
non- business) to interested users of the information.
Let’s take a closer look at the activities involved in the process:
1. The first part of the process – identifying – involves selecting those events that are
considered evidence of economic activity relevant to a particular organization. The
sale of goods by Hadiya Super Market, the rendering of service by Ethiopian
Telecommunications Corporation, the payment of salary by the Commercial Bank of
Ethiopia, and the purchase of Building by Unity University College are examplesof
economic events.
2. Once identified and measured in Birr and cents, economic events are recorded to
provide a permanent history of the financial activities of the organization. Recording
consists of keeping a chronological diary of measured events in an orderly and
systematic manner. In recording, economic events are also classified and summarized.
(This will be discussed in detail in unit-2)
3. This identifying and recording activity is of little use unless the information is
communicated to interested users. The information is communicated through the
preparation and distribution of accounting reports, the most common of which are
called financial statements.
A Vital element in communicating economic events is the accountant’s ability and

responsibility to analyze and interpret the reported in formation. Analysis involves the use of
ratios, percentages, graphs and charts to show the importance of financial trends and
relationships. Interpretation involves explaining to the user the meaning, and limitation of
reported data. The analysis and interpretation part is left for advanced courses in accounting.
As accounting plays an important role in the decision making process of business entities, it is
often called the language of business. As a result, whether you are an economist a marketer,

investor, supplier or any other, to be successful, you should be able to “speak” and be
familiar with the basic terms used in the business environment.
1.2.2 Importance of Accounting and Users of Accounting Information
Importance of accounting
The main purpose of accounting is to provide financial information to be used for decision-
making. For instance, Business executives and managers need the financial information
provided by the accounting system to help them plan and control the activities of the business.
Outsiders such as bankers, potential investors, and labour unions and others also need
accounting in formation.
In short the goal of the accounting system is to provide useful information to decision makers.
Thus, accounting is the connecting link between decision makers and business operations.
1.3 BOOKKEEPING VERSUS ACCOUNTING
People often fail to understand the difference between accounting and bookkeeping.
Bookkeeping is the process of recording business activities, and keeping the records. It is the
record- making phase of accounting. The recording of transactions in Bookkeeping tends to
be mechanical and repetitive; it is only a small and probably the simplest but important part of
accounting.
Accounting, on the other hand, includes the design of an information system that meets users’
needs. The major goals of accounting are the analysis, interpretation, and use of information.
Accounting includes system design, budgeting, cost analysis, auditing and tax planning and
preparation.
A person might become a reasonably proficient bookkeeper in a few weeks or months;

however, to become a professional accountant requires several years of study and experience.
Check Your Progress Exercise -1
1. Answer the following questions and compare your answer with the answer key at the
end of the unit.
a. Define accounting
b. Write in few words the importance of accounting.
c. Describe the basic distinction between accounting and bookkeeping.

Users of Accounting Information
Today’s accountants focus on the ultimate needs of those who use accounting information,
whether the users are inside or out side the business. Accounting is not an end by itself. The
information that accounting provides allows users to make “reasonable choices among
alternative uses of scarce resources in the conduct of business”
The people who use accounting information basically fall in to two categories:
1. External Users, and
2. Internal Users
1) External Users: External Users of accounting information are

parties, which are not directly involved in running the business enterprise. These include
lenders, shareholders (stock holders), suppliers, employees and their Unions, government
(regulatory bodies) and others. External users rely (depend on) accounting information to
help them make better decisions in trying to achieve their goals.
- The area of accounting aimed at serving external users is called Financial

Accounting. Its main objective is to provide to external users information through
financial statements.
Each external user has its own specified information-need depending up on the decisions to be
made. That is to say, all external users do not have the same intentions (objectives) when they
use the information.
In the following paragraphs we well try to discuss how some external users use accounting
information.
a) Lenders / Creditors
Creditors lend money or other resources to an organization. Lenders include banks, mortgage
and finance companies. Lenders look for information to help them assess the ability of
borrowers to repay their debts.
b) Share- holders (Stockholders)
Shareholders have legal control over part or all of a corporation. When it comes to a
corporation, shareholders are not directly involved in the management of the corporation.

However, as owners, they have claims over the properties of the organization. Financial
reports help to answer shareholders’ questions such as:
- what is the income of the organization for the current and past periods?
- are the properties adequate to meet business plan?
- will the business continue to be profitable in the future?
c) Employees and labour Unions

Employees and labor unions are interested in judging the fairness of their wages and
assessing future job prospects. They also use accounting reports as evidence to ask for
bonuses, when the organization is successful.
d) Government
The Inland Revenue Authority requires organizations to prepare financial reports, in order to
compute taxes.
2) Internal Users: These are persons that are directly involved in

managing and operating an organization. They include managers and other important
decision makers. The internal role of accounting is to provide information to help
improve the efficiency and effectiveness of an organization.
The area of accounting aimed at serving the decision-making needs of internal users is called
Management Accounting. Internal users often have access to a lot of private and valuable
information. Internal reports aim to answer questions like:
 What are manufacturing costs per product?

 Which service activities are most profitable?
 What level of sales is necessary to break even?
1.4 THE ACCOUNTING PROFESSION
If you just joined the accounting profession, you may be wondering what job you will be
doing in the future. You probably would apply your expertise in one of three major fields:
 Public Accounting
 Private Accounting or
 Not – for – profit Accounting

i) 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 a 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 opinion as to the
fairness of presentation. When presentation is fair, users consider the statements to be
reliable.
Management consulting is another area of public accounting. In this case, the accountant
consults the management generally about the growth and development of the business
enterprise.
ii) Private Accounting

Instead of working in public accounting, an accountant may be an employee of a business
enterprise. In private accounting, you would be involved in one of the following activities:
1. Cost Accounting: Determining the cost of producing specific products.
2. Budgeting: Assisting management in quantifying goals concerning revenues,

costs of goods sold, and operating expenses.
3. General Accounting: recording daily transactions and preparing financial

statements and related information.
4. Accounting information systems: designing both manual and computerized

data processing systems.
5. Tax Accounting: preparing tax returns (-forms to be filled by a company and

returned to a taxing authority) and engaging in tax planning for the company.
6. Internal Auditing: reviewing a company’s operations to determine

compliance with management policies and evaluating efficiency of operations.
iii) Not for Profit Accounting
Like businesses that exist to make a profit, not - for-profit organizations also need sound
financial reporting and control. Donors to such organizations want information about how
well the organization has met its objectives and whether continued support is justified. In each
of these cases, accounting expertise is highly valued.

Check your Progress Exercise -2
1. What are the basic categories of the users of accounting information?
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2. _____________is the area of accounting aimed at serving external users of accounting

information.
3. _____________ is the area of accounting aimed at serving the decision-making needs

of internal users.
4. What are the three major fields of engagement for accountants?

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1.5. ACCOUNTING PRINCIPLES AND CONCEPTS
Accounting, as it is true for other disciplines, has got its own principles and practices. One
must be able to understand these principles and practices to understand and prepare financial
statements and reports. The principles and concepts used in accounting are called Generally
Accepted Accounting Principles (GAAP). These principles guide accountants how to record
and report business activities.
GAAP are developed over a long span of years by the accounting profession. That is, their
development is not revolutionary rather evolutionary. The main purpose of these basic rules
is to guide accountants in measuring and reporting financial events of business enterprises.
GAAP are not like the unchangeable laws of nature found in biology and chemistry. They
can be changed as better methods are developed or as circumstances change. Generally, it is
from research, practice, and pronouncements of professional bodies that GAAP evolve.
In this unit, we will discuss three of the generally accepted accounting principles: Business
Entity concept, Cost principle and Monetary Unit Assumption.
i) Business Entity Concept

Accountants frequently refer to a business organization as an accounting or business entity. A
business entity is any business organization, such as a “super market”, laundry, barberry, or a
hotel, which exist as an economic unit. For accounting purposes, each business enterprise has
a separate existence from its owners, creditors, employees, customers and other businesses.
This separate existence of the business enterprise is known as the business entity concept.
Thus, the business entity should have a completely separate set of records and its financial
records and reports should refer only about the business enterprises.
For example, W/o Muna Mamo has got her own two business enterprises one called Munaye
Super Market, and another hotel called Budena Hotel. Each Business would be considered as
an independent economic business unit. The activities of each business are kept separately
from each other and from the owner’s personal records. Let say W/O Muna bought a house to
live in. This house would not be recorded and reported in the records of either the
supermarket or the hotel. The personal saving account she has will not as well be included in
the financial reports of either one of the businesses. She must have to open separate bank
accounts for the two businesses. The super market should not record the payment of salary to
employees of the hotel.
ii) The cost principle

The cost principle states “properties and services acquired by business enterprises must be
recorded at actual amounts paid or assumed in acquiring the properties.”
For example, Modern Advertising Company is considering the purchase of a building. The
seller of the building offered a price of Birr 10,000 while the buyer first offered a price of Birr
8000. However, after certain bargaining, the seller agreed to sell the building for Birr 9000
and the buyer paid that amount. According to the “cost principle” the buyer has to record the
building in its records at birr 9000- the actual amount paid to get the building.
The buyer may receive an offer of Birr 12,000 for the building a month after if has been
acquired. This has no effect on the accounting records because it doesn’t originate from an
actual exchange. It is simply a mere offer.
If the buyer sells the building for Birr 20,000 after purchasing it, a gain of Birr. 11,000 would
be realized. The new owner would use Birr 20,000 as the cost of the building.
In an exchange between a buyer and a seller, both attempt to get the best price. Only amounts
agreed up on and paid are objective enough for accounting purposes.
Monetary Unit Assumption
All business activities (events) are recorded in terms of money (-Birr, Dollar, Pound or any
other currency). Of course, information of a non -financial nature can be recorded, but it is
only through the recording of dollar (Birr) amounts that the activities of a business can be
measured. Money is the only factor common to all business activities. Therefore, it is the
only practical unit of measurement that can produce financial data that can be compared.
The monetary unit used by a business depends on the country in which it exists. For example,
in Ethiopia the basic unit of measurement is the birr,as is the dollar in the U.S.A, and Pound
Sterling in the United Kingdom.
1. The abbreviation GAAP stands for ____________________________.
2. What do we mean by “GAAP are not like the unchangeable laws of nature”?
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3. Why do we need to record all business activities in terms of money?
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4. What is the principle that says properties acquired by business enterprises must be
recorded at actual amounts paid?
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1.6 FORMS OF BUSINESS ORGANIZATIONS
There are three basic forms of business organizations: sole proprietorships, partnerships, and
corporations. Accountants recognize each form as an economic unit separate form its owners
(Business Entity Concept).

In this course, we will begin by the accounting for sole proprietorships because it is the
simplest form of accounting.
1. Sole Proprietorships
A sole proprietorship is a business owned by one person and usually managed by the owner.
No special legal requirements must be met to start a sole proprietorship and usually only a
limited investment is required to begin operations.
A sole proprietorship is a separate entity for accounting purposes (Business entity Concept)
but it is not a separate legal entity from the owners. That is, from the legal point of view, the
owner and the business are treated as one and the same. The owner will be held personally
responsible for the debts and actions of the business.
For instance, assume Flower Laundry is a sole proprietorship owned by Ato Alemu.
Assume also that the business has borrowed Birr 10,000 from the Commercial Bank of
Ethiopia and failed to pay its debts. In this case, if the Commercial Bank of Ethiopia can’t
recover the amount it lent from the properties of the company it can go to the extent of selling
the owner’s personal properties.
2. Partnerships
A Partnership is like a sole proprietorship in most ways except that it has more than one
owner. A partnership is not a legal entity separate from the owners but an association that
brings together the talents and resources of two or more people. The owners of a partnership
are known as partners.
The partners share the profits and losses of the partnership according to an agreed –on
formula. The personal resources of each partner can be called on to pay the obligations of the
partnership. That is, each partner is personally responsible for the debts of the partnership.
From an accounting standpoint, however, a partnership is a business entity separate from the
personal activities of the partners.
3. Corporations
A business organized as a separate legal entity with ownership divided into transferable units
of capital is called a corporation. The owners of a corporation are called stockholders or
shareholders. The corporation issues capital stock certificates to each stockholder showing
the number of shares (orstock) he or she owns. The stockholders are free to sell all or part of
these shares to other investors at any time. This ease of transfer of ownership adds to the
attractiveness of investing in a corporation. Since a corporation is a separate legal entity, the
owners (stockholders) are not personally liable for the debts of the corporation. Their risk of
loss is limited to the amount they paid (invested). Because of this limited liability in a
corporation shareholders are willing to invest in riskier, but potentially more profitable,
activities.
Even though corporations are fewer in number than proprietorships and partnerships, they
contribute a lot to the economies of many countries in monetary terms.
1.7 BUSINESS TRANSACTIONS AND THE ACCOUNTING EQUATION
Business transactions are economic events that should be recorded because they affect the
financial position of the business enterprise. These businesses transactions are the raw
materials of accounting reports, as cotton is a raw material for a textile factory.
A transaction can be an exchange (such as the purchase or sale of property, payment or

collection of a loan etc.) between two or more parties. A transaction can also be an event that
has the same effect as an exchange transaction but doesn’t involve an exchange transaction.
Some examples of “non exchange” transactions are losses from fire, flood; physical wear and
tear on equipment; donation of property and so forth.
For a given transaction to qualify to be recorded it has:

1. to be related to the business enterprise
2. to be measurable in terms of money
3. to be completed / happened/ action.
(i.e. it should not be a mere promise or intention; it must be at least partially completed to be
recorded)
1.7.1 Assets, Liabilities and Owner’s Equity

If you have noticed, in any organization you will find properties such as a building, furniture,
land, vehicles and the like. Such properties owned by business enterprises are referred to as
Assets. To buy these assets, businesses get money from two sources: investments made by

owners or amounts borrowed from creditors. Therefore, both owners and creditors have a
claim over the assets of the business enterprise. The claims or rights of owners are referred to
as Equities. If the assets owned by a business amount to Birr 50,000 the equities in the assets
must also amount to Birr 50,000. The relationship between the two may be stated in the form
of an equation, as follows:
Economic Resources = claims over the resources

Assets =Equities.
Equity may be subdivided in to two principal types: the rights of creditors and the rights of
owners. The rights of creditors represent debts of the business and are called Liabilities. The
rights of owners are called Owners’ Equity (capital).
Assets=equities
Equities = Liability + Owner’s equity
This equation can be written as:
Assets= liability + Owner’s Equity
It is customary to place “liabilities“ before “Owners equity” in the accounting equation

because creditors have priority (preferential) rights to the assets. Because of this, the owners
have a residual claim over the assets. To help you understand this, assume X company has
total assets of Br. 5000, liabilities of Br 2000 and owner’s equity of Br 3000. If the business is
to be closed, the assets of the company will be sold and distributed to the claimants. In
accounting, the Owner’s are given their share after the creditors are given their entire share.
For example, assume the assets are sold for Br 4,500. The creditors will be given their share
of Br. 2,000 and what ever remained (Br.2,500)is given to the owners. If the assets were sold
for Br. 7,000, the creditors would have been given their share of Br. 2,000 and the remaining
balance Br 5,000 would have been given to the owners.
Liabilities
Assets &
Capital

As you can notice, the owners are given whatever is left (it could be greater or less than their
share). That is why we said owners have residual claim over the assets of the business
whereas creditors are said to have priority clam over the assets as they are paid first
1 Business organizations are classified in to three, based on what?

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2 What do we mean by the term ‘unlimited liability’?

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3 Which of the three forms of business originations is (are) separate legal entity
(entities) from their owners?
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4 ___________________ represents the claim of owner’s against assets of the business

enterprise.
5 Assume total asset of Br 60,000, and owner’s equity of Br 45,000. Determine the
amount of liability .
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6 L=A-C Is this an acceptable way of writing the basic accounting equation? Explain.
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7 What do we mean when we say “owners have a residual claim over the assets of the
business enterprise”?
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8 Define a business transaction, and give at least four examples.

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1.7.2 Transactions and the Accounting Equation

All business transactions from the simplest to the complex can be stated in terms of the
resulting effect on the three basic elements of the accounting equation. How ever, it is
important to remember that each transaction leaves the equation in balance. Assets always
equal the sum of liabilities and owner’s equity.
Let’s examine the effects of some of the most common business transactions on the
accounting equation. As a means of illustration, suppose Ato Dawit Gemechu establishes a
sole proprietorship to be known as Effective Garage, on September1,200x . During
September, the business engages in the following transactions:
Transection (1)- Owner’s investment

Ato Dawit starts business by depositing Br. 100,000in a bank account opened in the name of
Effective Garage. The transfer of cash from the owner to the business is on owner’s
investment. The effect of the transaction is to increase the assets (Cash) on the left side of
the accounting equation by Birr 100,000 and to increase owner’s equity by the same amount.
Assets = Liabilities + Owner’s Equity
Cash Dawit Gemechu, Capital

Tran.1 + Br. 100,000 +Br. 100,000
Balance Br. 100,000 Br. 100,000
At this point, the company has no liabilities; the only party having claim over the assets of the
company is the owner.

N.B. the equation relates only to the business enterprise. Ato Dawit’s personal assets, such as
his home and personal bank account and personal liability are excluded from consideration.
The business must be treated as a separate entity.
Transaction (2)- Purchase of land for cash

Effective Garage bought land for Birr 20,000 in cash, to be used as a future site for the
business. This transaction changes the composition of the assets but it doesn’t change the
total amount of assets. It has no effect on the liability and owner’s equity of the business.
Assets = Liabilities + Owner’s Equity

Cash + Land Dawit Gemechu, Capital.
Bal. Birr 100,000 Birr 100,000
Tran. 2 -20,000 +20,000 __-_____
Bal. Birr 80,000 + Br.20,000 = ________________ 100,000__
After the above transaction, the company will have less cash but a new asset (land ). The total
assets (cash + Land) amount to Birr 100,000, which is equal to the owner’s equity.
Transaction (3) -Purchase of Supplies On credit

Ato Dawit bought office supplies for birr 2,500 on credit, to be used by the business. Assets
can be purchased on credit (on account) basis, where the buyer promises to pay in the future.
This type of transaction is called a purchase on account and it results in a liability to the
buyer; the liability created when something is bought on credit is called Accounts Payable.
Assets______ = Liability + Owners Equity

Cash + Supplies + Land Accounts payable Dawit Gem, Captal
Bal. Birr 80,000 Br.20,000 Birr 100,000
Tran(3) -___ + 2,500 - + 2,500 ___-____
Bal. Br. 80,000 2,500 20,000 2,500 100,000
Birr 102,500 Birr 102,500
Goods that are physical consumed, such as a chalk to a school, gas oil for car, and stationery
materials for an office, are called supplies.
Transaction ( 4 ) – Payment of liability

Effective Garage paid Birr. 1,500 to creditors on account. As you might have noticed, the
business bought the supplies in transaction “C” by promising to pay in the future, and as per

the promise made it is now settling its liability. The effect of this transaction on the
accounting equation is as follows:

Bal Br 80,000 Br. 2,500 Br.20,000 Birr 2,000 Birr 100,000
Tran.4 -1,500 - - -1,500 -___
Bal. Br. 78,500 Br.2,500 Br.20,000 Birr 1,000 Birr 100,000
Birr 101,000 Birr 101,000
As a result of the transaction, the total cash decreases by birr 1,500 because cash is paid and
the liability of the company also decreases by the same amount. After the above transaction is
completed, the total amount the company has to pay in the future is only birr 1,000. Please
note that the transaction has no effect on the supplies that were bought on credit.
Transaction 5 – Selling of service

The amount charged to customers for goods or services sold to them is called revenue. For
instance, the amount of money that you pay to a shopkeeper after buying a pair of shoes or
something is revenue to the shopkeeper. Different titles may be used for revenue depending
up on the source of revenue. For example, a service fee for a garage, interest revenue for
interest earned by a bank, rent income for revenues that result from renting rooms, fares
earned for revenues from a taxi service and others.
During the first month of operation, Effective Garage earned service Fees of Birr 30,000
receiving the amount in cash for the garage services it rendered.
The effect of this transaction is to increase assets (because cash is collected) and to increase
owner’s equity by the same amount as revenue is earned.

Bal Br 78,500 Br. 2,500 Br.20,000 Birr 1,000 Birr 100,000
30,000 - - - 30,000
Bol. Br. 108,500 Br.2,500 Br.20,000 Birr 1,000 Birr 130,000
Birr 131,000 Birr 131,000

Service can be given for cash or on credit. In this example, the service is given for cash (i.e.,
the company collects the cash on the spot service was given). But instead of requiring
customers to pay at the time of sale, a business may let the customers to pay in the future.
Such expected collections in the future result in an Accounts Receivable to the company. An
accounts receivable is as much an asset as cash to the business enterprise. And the revenue
from the sale of the service or good on credit is realized and recorded on the date of sale with
out waiting for the collection of the cash.
Transaction (6 )- Recording Expenses

To generate revenue, Effective Garage has to hire employees and pay salary, it has to
consume electric power and water resource and pay the bill, and so forth. The amounts of
such cash payments and using up of supplies are expenses to the business. That is, an
expense is the amount of assets consumed or services used in the process of generating
revenue. Just as revenues are recorded when they are earned, expenses are recorded when
they are incurred (i.e. when the obligation to pay them arises).
During the month of September, Effective Garage paid Birr 15,000 for different types of
expenses (birr 10,000 to salary of employees, birr 3000 Telephone, birr 1,500 for rent, and
birr 500 for advertisement).
The effect of these transactions is to decrease assets (because cash is paid) and decrease
owner’s equity. This can be stated on the accounting equation as follows:

Bal Br108, 500 Br. 2,500 Br.20,000 Birr 1,000 Birr 130,000
-15,000 - - __-___ -15,000___
Birr 116,000 Birr 116,000
Transaction – 7 Owner’s Withdrawal

Ato Dawit Gemechu, the owner, withdrew Birr 3000 for his personal from the business. Such
assets taken out of the business for the owner’s personal use, by the owner are called
withdrawals. Owners can withdraw in cash or in kind. For example, an owner of a super
market can withdraw soap or something for his personal benefit instead of cash.

The effect of the transaction in our case is to decrease assets as cash is taken out, and decrease
owner’s Equity by the same amount. This can be stated on the accounting equation as
follows:
Bal Br 93, 500 Br. 2,500 Br.20,000 Birr 1,000 Birr 115,000
-3,000 - - __-___ -3,000___
Birr 113,000 Birr 113,000
Summary
The transactions of Effective Garage can be summarized in a tabular form as shown below.
Number identifies the transactions here and the balance of each item is shown after each
transaction.
Type of
Tra Accounts Dawit Gem. owner’s
. Cash + Supplies + Land Payable Capital Transaction
No
1 +100,000 - - - + 100,000 Owners
Investment
Bal Birr 100,000 - - - Birr 100,000
2 -20,000 - + 20,000 - -
Bal Birr 80,000 - Birr 20,000 - Birr 100,000
3 - +2500 +2500
Bal Birr 80,000 Birr 2,500 Birr 20,000 Birr2500 Birr 100,000
4 -1,500 - -1500
Bal Birr 78,500 Birr 2,500 Birr 20,000 Birr1,000 Birr 100,000
5 + 30,000 - - - + 30,000 Service fee
Bal Birr 108,500 Birr 2,500 Birr 20,000 Birr1,000 Birr 100,000
6 -15,000 - - - -10,000 Salary Exp.
-3000 Teleph. Exp
- - - - -1500 Rent Exp.
-500 Adv. Exp.
Bal Birr 93,500 Birr 2500 Birr 20,000 Birr 1000 Birr 115,000
7 -3,000 - - - -3000 Owner’s
withdrowal
Bal Birr 90,500 Birr 2500 Birr 20,000 Birr 1,000 Birr 112,000
Total Assets =Birr 113,000 Total Liabilities and Owner’s Equity = Birr

113,000
The following Observations, which apply to all types of Businesses, should be noted:
1. The effect of every transaction can be stated in terms of increases and /or decreases in
one or more of the elements of the accounting equation.
2. The equality of the two sides of the accounting equation is always maintained.
3. The owner’s investment and revenues increase the owner’s equity. Withdrawals and
expenses during the period decrease the owner’s equity. The effect of these four types of
transactions on owner’s equity can be illustrated as follows:
Owner’s Equity
Decreased by: Increased by:

Owner’s withdrawals Owner’s Investment
and Expenses and Revenues
The relationship of the above elements and their effect on the capital balance can be shown
as:
EC = BC + I – W + R - E
Where: EC – End Capital Balance
BC - Beginning Capital Balance.
I - Owner’s Investment
W - Owner’s Withdrawals
R - Revenue
E - Expense.
1.8 FINANCIAL STATEMENTS OF SOLE PROPRIETORSHIPS
After the effect of the individual transactions has been determined, the essential information is
communicated to users at certain intervals. The accounting reports, which communicate this
information, are called financial statements. Financial statements are said to be the central
features of accounting because they are the primary means of communicating important
accounting information to users.

Financial statements are the means of transferring the concise picture of the profitability and
financial position of the business to interested parties.
The major financial statements used to communicate accounting information about a business
are:
- income statement
- balance sheet
- statement of owner’s Equity
- statement of cash flows (will be discussed in senior courses)
Since these financial statements are in a sense the end products of the accounting process, a
student who acquires a clear under standing of the content and meaning of financial
statements will be in an excellent position to appreciate the purpose of the earlier steps of
recording and classifying business transactions.
1.8.1 The Income Statement

The income statement is a financial statement that summarizes the amount of revenues earned
and expenses incurred by a business over a period of time. It reports the profitability of the
business by comparing revenues and expenses for a stated period of time such as a month or a
year. In accounting profitability is measured for a period of time than on a daily basis.
Though measuring daily could be possible, it will not be practical and beneficial to the
business enterprise.
If the revenue of a period exceeds the expenses of that same period, net income results. If
expenses are greater than the revenues of a period, we say there is a net loss, that is, the
business has operated unprofitably.
N.B. The determination of periodic net income (net loss) is a matching process involving two
steps. First revenues earned are recognized during the period. Second, the expenses incurred
to generate revenues are matched (compared) against revenues to determine net income or net
loss.
All financial statements have a heading that you can find in any kind of a report. The heading
of these statements 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 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…”
The following is an income statement for Effective Garage for the month ended September
30, 200x.
Effective Garage
Income statement
For the Month Ended September 30,200x
Revenues:
Service Fee Birr 30,000.00
Expenses:
Salary Expense Birr 10,000.00
Telephone Expense 3,000.00
Rent Expense 1,500.00
Advertising Expense 500.00
Total Expenses 15,000.00
Net Income Birr 15,000.00
1.8.2 Owner’s Equity Statement

This is a statement that summarizes the changes in owner’s equity for a specific period of
time. Data for the preparation of owner’s equity statement are obtained from the owner’s
equity column of the tabular summary (Illustration 1- ) 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, 200x.” The beginning
owner’s equity amount is shown on 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. The Owner’s equity statement for effective Garage
for the month of September is shown below:
Effective Garage
Statement of Owner’s Equity

For the Month ended September 30,200x
Dawit G. Capital, September 1……………………………………Birr -0-

Add: Investments…………………………………Birr 100,000.00
Net income……………………………………15,000.00 115,000.00
115,000.00
Less: Drawings………………………………………………………………3,000.00
Dawit G. Capital, September 30………………………………… Birr 112,000.00
1.8.3 Balance Sheet
The balance sheet, sometimes called the statement of financial Position, lists the company’s
assets, liabilities and owner’s equity as of a specific date- usually at the end of a month or
year.
Shown below is the balance sheet for Effective Garage as of September 30, 200x. The
balance sheet heading contains the name of the company, the type of statement, and the
specific date on which assets; liabilities and owner’s equity are identified and measured.
The total assets must equal the total liabilities and owner’s equity. There are tow commonly
used formats of the balance sheet:
The account format

Which lists assets on the left side and equities (i.e. liability and owner’s equity) on the right
side. It resembles a basic accounting format called an ‘account’ to be introduced in unit 2.
_________
_________
_____
Assets Liability
Owner’s Equity
The Report Format

-Lists assets, Liability and Owner’s equity vertically
__________
_________

_____
Assets
Liability
Owner’s Equity
You can choose either of the two formats for your balance sheet preparation.
The following is a balance sheet prepared for effective Garage based on the sample
transactions illustrated in the chapter.
Effective Garage
Balance Sheet
September 30,200x
Assets Liability
Cash…………Birr 90,500.00 Accounts payable…… Birr 1,000.00
Supplies……………2,500.00
Land………………20,000.00 Owner’s Equity
Ato Dawit Gem., Capital Br12,000.00.
_________ Total Liabilities and
Total Assets……..113,000.00 Owner’s equity……...Birr 113,000.00
The double line is drawn only when the total assets on the left side are equal to total liabilities
and Owner’s equity. In the Effective Garage illustration, only one liability- accounts payable-
is reported on the balance sheet. In most cases, there will be more than one liability. When
two or more liabilities are involved, a customary way of listing is as follows:
Liabilities
Notes payable Birr 10,000.00
Accounts Payable 1,000.00
Salaries Payable 2,000.00
Total Liabilities Birr 13,000.00
Each statement provides management, owners, and other interested parties with relevant
financial data. The financial statements are interrelated: (1) Net income of Birr. 15,000
shown on the income statement is added to the beginning balance of owner’s capital in the
owner’s equity statement. (2) Owner’s capital of Birr 112,000 at the end of the reporting
period shown in the Owner’s equity statement is reported on the balance sheet as the Dawit
G/M. capital balance.
Be sure to carefully examine the format and content of each statement.
1. _____________ are assets used or consumed in the process of generating revenue.
2. Drawings are assets taken out of the business for the owner’s personal benefit. Do
you advise owners to withdraw cash or in kind (i.e. furniture, automobile..)? Why?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
3. List the four factors that change owner’s equity. What is their effect on owner’s
equity?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
4. What are the four financial statements?

…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
5. Every financial statement has three lines as a heading,
1st line____________________________
2nd line___________________________
3rd line __________________________

1.9 SUMMARY
Explain the meaning of accounting. Accounting is the process of identifying, measuring

recording and communicating the economic events of an organization (business or non
business) to interested users of the information. Accounting helps us in the allocation of
scarce resources in an efficient and effective manner.
Identify the users and uses of accounting. (a) Management uses accounting information in
planning controlling and evaluating business operations. (b) Investors (owners) judge the
wisdom of buying, holding, or selling their financial interests on the basis of accounting data,
i.e. to see how their investment is doing. (c) Creditors evaluate the risks of granting credit or
lending money. Other groups of users include taxing authorities, regulatory agencies,
customers, labor unions, and economic panniers. These users are grouped in to two: 1-
Internal users and ii- External users.
Explain the meaning of generally accepted accounting principles: Generally accepted

accounting principles are a common set of standards used by accountants.
Explain the meaning of business entity assumption, cost principle and the monetary unit
assumption. The business entity concept states the economic events of a particular business
should be identified separate from other entities and the owner’s personal records. The cost
principle requires properties acquired by business enterprises to be recorded at actual amounts
paid and /or assumed in acquiring the properties. The monetary unit assumption requires only
transactions capable of being expressed in terms of money be included in the accounting
records of the business enterprise.
State the basic accounting equation and explain the meaning of assets, liabilities, and owner’s
equity. The basic accounting equation is:
Assets = Liabilities + Owner’s Equity.
Assets are resources owned by a business, liabilities represent the claim of creditors on the
total assets, and owner’s equity is the ownership claim on the total assets. It is often referred
to as residual equity.
Analyze the effects of business transactions on the basic accounting equation. Each business
transaction must have a dual effect on the accounting equation. For example, if an asset is

decreased, there must be a corresponding (1) Increase in another asset, or (2) decrease in a
specific liability, or (3) decrease in owner’s equity. After each transaction, the equality of
assets to the sum of liabilities and Owner’s equity must be maintained.
Prepare an income statement, owner’s equity statement, and balance sheet. An income
statement presents the revenues and expenses of a company for a specific period of time. An
owner’s equity statement summarizes the changes in owner’s equity that have occurred for a
specific period of time. A balance sheet reports the assets, liabilities, and owner’s equity of a
business at a specific date.
1.10 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress Exercise - 1
1) Accounting is the process of identifying, measuring, recording and communicating

economic events to permit informed decisions and decisions by the users of the
information.
2) Accounting as an information system helps others to make informed decisions about
the use of scarce resources.
3) Bookkeeping is the recording part of accounting. Accounting includes analytical
interpretation phases in addition to the recording phase.
Check Your Progress Exercise –2

1) i )internal users ii) external users.
2) Financial Accounting
3) Management Accounting
4) i) Public accounting
ii) Private accounting
iii) Not –for- profit accounting

1. Generally Accepted Accounting Principles.
2. GAAP, are open for change whenever better methods are developed or as
circumstances change.
3. It is the only common unit of measurement to all business enterprises. That is, why
comparison of two unrelated business enterprises is possible.

4. The Cost Principle
Check Your Progress Exercise –4

1. Based on the number of people who own them and the style of ownership.
2. Unlimmitted Liability refers to the fact that the liability of the owners of a sole
proprietorship and a partnership is not limited to the extent of their investment, but it
extends to their personal properties.
3. Only corporations
4. Owner’s Equity
5. Liability=Asset –Owner’s Equity =>Liabilities=60,000-45,000=15,000
6. Though it is mathematically correct; it doesn’t reflect the practical fact that capital is
what is left after deducting liabilities from assets as creditor’s claims take precedence over
those of owners. Therefore, liability is not what is left after owners take their shares.
7. When the assets of a business are not sufficient to satisfy all the claims of both owners
and creditors, first creditors are paid in full and owners take whatever remains (i.e. the
residue) even if this means they will not be fully paid.
8. A transaction is an event that has to be recorded by accountants because it affects the
economic status of the business. The purchase of equipment, the consumption of supplies,
the collection of money from debtors, payment to creditors, and the provision of service to
customers are common examples of transactions that accountants have to record daily.

1. Supplies
2. It is not advisable for owners to withdraw in kind (such as a vehicle or furniture)
because this may interrupt the business's operation for sometime until the withdrawn
assets are replaced.
3. Factor Effect on owners equity

Revenues Increase
Expenses Decrease
Investment Increase
Drawings Decrease
4. The income statement, the balance sheet, statement of owner’s equity and statement of cash
flows.
- Name of company

- Name of report (statement)
- Period covered by financial statement
1.11 MODEL EXAMINATION QUESTIONS
1. Guji company had the following amounts of assets and liabilities at the beginning and
end of last year:
Assets Liabilities
Beginning of the year………………Br.75,000 Br. 30,000
End of the year….……………………120,000 46,000
Determine the net income or net loss of Guji for the year under each of the following
unrelated assumptions:
a) Owner made no additional investment and withdrew no amount during the year
b) Owner made no additional investment but withdrew Br.17,500 to pay for her
personal expenses
c) Owner withdrew no amount during the year but made additional investment of Br.
32,500 cash.
d) Owner withdrew Br.17,500 and invested Br.25,000 cash during the year.
2. For each of the following give an example of a transaction that creates the described
effects:
a) Decreases a liability and decreases an asset
b) Increases an asset and decreases another asset
c) Decreases an asset and decreases owners equity
d) Increases a liability and decreases owners equity
e) Increases an asset and increases a liability
f) Decreases an asset and decreases a liability
Mimi started a new business called Omo Company and completed the following transactions
during November:
Nov.1 Mimi transferred 56,000 out of a personal savings bank account to a checking
account she in the name of the business.
1. Rented office space and paid cash for the month’s rent of 800
3. Purchased electrical equipment for 14,000 by paying 3,200 and agreeing to pay the
remaining balance in six months
5. Purchased office supplies by paying 900 cash.
6. Completed electrical work and received 1,000 cash for doing the work.
3. Purchased 3,800 of office equipment on credit
15. Completed electrical work on credit in the amount of 4,000
20. Paid for the office equipment purchased on Nov.9
24. Billed a customer for electrical work completed 600
28. Received 4,000 for the work completed on Nov.15
30. Paid salary of employees 1,200
30. Paid the monthly utilities bill 440
30. Withdrew 700 from the business for personal use
Required:
1. Arrange the following asset, liability and owner’s equity titles in a table just like
illustrated in this unit: Cash, Accounts Receivable, Office Supplies, Office Equipment,
Electrical Equipment, Accounts Payable and Mimi Capital.
2. Use additions and subtractions to show the effect of each transaction on the items in
the equation. Show new totals after each transaction. Next to each change in owners
equity state whether the change was caused by an investment, revenue, expense or
withdrawal.
3. Prepare an income statement, a statement of owner’s equity, and a balance sheet
1.12 GLOSSARY OF TERMS
Accounting - the process of identifying measuring, recording, and communicating the

economic events of an organization to interested users of the information.
Assets – Resources owned by a business.
Auditing – the examination of financial statements by a certified public accountant in order to

express an opinion as to the fairness of presentation.
Balance Sheet – A financial statement that reports the assets, liabilities, and owner’s equity
on a specific date.
Basic Accounting Equation - Assets=Liabilities + owner’s equity
Bookkeeping – A part of accounting that involves only the recording of economic events.
Corporation – a business organized as a separate legal entity under state corporation law
having ownership divided into transferable shares of stock.
Cost Principle – an accounting principle that states the assets should be recorded at their
actual cost .
Drawings – Withdrawals of cash or other assets from the business for the owner’s personal
use.
Economic (Business) Entity Assumption – An assumption that states a business enterprise

must be given separate and distinct existence from the owners, creditors, customers and any
other party.
Expenses - the cost of assets consumed or services used in the process of earning revenue.
Income statement – A financial statement that presents the revenues and expenses and
resulting net income or net loss of a company for a specific period of time.
Investment by owner – the assets put in to the business by the owner.
Liabilities – Represents the claim of creditors on the assets of the business.
Monetary unit assumption– An assumption stating that only transactions that can be
expressed in terms of money be included in the accounting records of the business.
Net Income – the amount by which revenues exceed expenses.
Net loss – the amount by which expenses exceed revenues.
Owner’s Equity Statement – A financial statement that summarizes the changes in owner’s
equity for a specific period of time.
Partnership – An association of two or more persons to carry on a business as co-owners for

profit.
Private accounting – An area of accounting with in a company that involves such activities
as cost accounting, budgeting, and accounting information systems.
Public Accounting – An area of accounting in which the accountant offers expert service to
the general public on a fee bases.

Revenues – the gross increase in Owner’s equity, resulting form business activities entered in
for the purpose of earning income. It is the amount charged to customers for services sold or
goods delivered to them.
Tax Accounting - an area of public accounting involving tax advice, tax planning, and
preparing tax returns.
Transactions – The economic events of the business recorded by the accountant.

UNIT .2 THE ACCOUNTING CYCLE
2.1 INTRODUCTION
In unit 1, you have learned the relationship between the accounting equation and business
transactions. Every business transaction affects the elements of the accounting equation. This
accounting procedure will be discussed in detail. The different and interrelated stages of the
accounting cycle will be presented. The chapter is lengthy, but essential for the remaining
chapters in this course and other accounting courses. Therefore, you are advised to study the
chapter carefully.
2.2 NATURE OF AN ACCOUNT
In order to provide the necessary information to users, accountants maintain separate records
on each element of the financial statements. For example, to report the balance for cash at the
end of a year, a record regarding cash should be kept. The record includes beginning cash
balance, cash payments & cash collections during the period. This record is called an
account.
Definition: An account is a subdivision under the three elements of the accounting equation
used to record the changes over a single element in the financial statements. An account has
three parts, Title, Debit, and Credit. For illustration purposes an account can be represented
in the form of capital letter ‘T’.
Example
Title
Debit Credit
Dr Cr
2.3 CLASSIFICATIONS OF ACCOUNTS
Accounts are classified into five: assets, liabilities, capital, revenue and expenses. The first
three are called balance sheet accounts and the other two are called income Statement
accounts. Balance Sheet accounts are those reported on the balance sheet at the end of the
reporting period and Income Statement accounts are reported on the Income Statement.
The five groups of account are discussed below
1. Assets: Resources owned by a business or individual are called assets. Assets could be
tangible or intangible. Tangible assets are assets having physical existence, like cash, land,
computer, stationery materials. Intangible assets do not have physical existence. Example:
Goodwill, Copyright, patent right.
On the balance sheet assets are classified into two current assets and non-current assets.
Current Assets – are those assets, which can be used, sold, or converted into cash within one
accounting year. Example: cash, supplies, prepayments, receivables etc.

Non-current Asset: All assets other than current assets are called non-current assets.
Example: land, patent right, office equipment, vehicles.
2. Liabilities: Creditors’ claims to the assets of a business; amounts owed to creditors are
called liabilities. Like assets, liabilities are classified in to two as current liabilities and non-
current liabilities
Current liabilities: The liabilities that are payable within the next (one) accounting year are
known as current liability. Example: accounts payable, rent payable, salary payable.
Non – Current Liabilities: Debts that are not required to be paid within the next accounting
period. Example long term notes payable.
3. Capital: The excess of the assets of a business over its liabilities is referred to as capital. It
is the equity of the owner in the business.
4. Revenue: Are increases in owner’s equity resulting from the main operations of the
business.
Examples of revenue accounts are sales, interest income, tuition fee, and sales commission.
5. Expenses: are decreases in owner’s equity in the process of earning revenue.

For example, a hotel has to pay salary to its workers for the services rendered to clients in
order to get the income from customers (revenue) the Hotel has pay salary to the employees
(expense).
Example of expenses: Salary, insurance, depreciation, supplies, utilities, rent etc.
2.4 CHART OF ACCOUNTS
The number and name of accounts used by an organization depends on the nature of its
operation. The list of accounts used by an organization and their codes is called the chart of
accounts. Look at the following chart of accounts of Bati Transport.
Bati Transport
Chart of Accounts
Asset Account number

Cash---------------------------------------------------------------------------11
Accounts Receivable------------------------------------------------------ 12
Supplies-----------------------------------------------------------------------13
Prepaid Insurance------------------------------------------------------------14
Equipment------------------------------------------------------------------- 15
Accumulated Depreciation –Equipment----------------------------------16
Truck---------------------------------------------------------------------------17
Accumulated depreciation – Truck----------------------------------------18
Liabilities
Accounts Payable-------------------------------------------------------------21
Notes Payable-----------------------------------------------------------------22

Owners Equity
Yimer Adem, Capital-----------------------------------------------------------31
Yimer Adem Drawing----------------------------------------------------------32
Income Summary----------------------------------------------------------------33
Revenue
Service income------------------------------------------------------------------41
Expense
Salaries Expense ---------------------------------------------------------------51
Rent Expense -------------------------------------------------------------------52
Utilities Expense----------------------------------------------------------------53
Supplies Expense---------------------------------------------------------------54
Insurance Expense--------------------------------------------------------------55
Maintenance Expense----------------------------------------------------------56
Depreciation Expense----------------------------------------------------------57
Truck Expense------------------------------------------------------------------58
Miscellaneous expense--------------------------------------------------------59
In the chart of accounts, the asset accounts are listed according to their liquidity. Liquidity is
the ease with which an asset can be converted in to cash. Cash is the most liquid asset so it is
listed first. Accounts other than cash will be listed in their frequency of use or in alphabetical
order.
The account number is a code to identify accounts. The number could be a two digit, three
digit or more digits. In the above example a three – digits code is used.
When the chart of accounts is prepared in an organization we say the ledger is opened.
2.5 RULES OF DEBITS AND CREDITS
As shown above every account has three parts. These parts are discussed below:
Title – The name of the account. This is written at the top of the account.
Debit – is the left hand side of an account –Debit is abbreviated as ‘Dr.’ when an amount is
entered on the left side of an account we say the account is debited or charged.
Credit – is the right hand side of an account. Credit is abbreviated as Cr. An account is said
to be credited when an amount is entered on the right hand side of the account.
An account may increase or decrease on the debit side or on the credit side depending on the
nature of the account. In general, accounts appearing on the left hand side of the accounting
equation increase on their left side (Dr. side) and decrease on their right side (Cr. Side);
whereas accounts on the right side of the equation increase on their right side and decrease on
their left side.
The above general rule will be expanded as follows,

Debit Credit
-Increase in assets -Decrease in assets
-Increase in expenses -Decrease in expenses
-Decrease in capital -Increase in capital
-Decrease in liabilities -Increase in liabilities
-Decrease in revenue -Increase in revenue.
1. Unlike other accounts on the right hand side, expenses increase on the debit side and
decrease on the credit side. Explain the reason.
……………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
The normal balance of an Account
Normal balance refers to the side of an account (Dr. or Cr.), which will have greater entries
than the other. The increasing side will be the normal balance for accounts.
Example: The normal balance of all asset accounts is debit
2.6 JOURNALIZING BUSINESS TRANSACTIONS
When a business transaction takes place, source documents will be obtained and recorded.
The accounting record in which a transaction is initially recorded is known as a journal. The
journal is therefore referred to as “The book of original entry”.
The process of recording a business transaction in the accounting record is called

journalizing.
The Journal commonly used to record all types of transactions is the General Journal. This
Journal includes the following parts, entered step by step.
1. The date of the transaction
2. The title of the account debited
3. The title of the account credited
4. The amount of debit and credit
5. Brief explanation of the entry or reference to the source document.
Look at the following General Journal and notice where each of the above information is
found.
Journal page
Date Description P.R Debit Credit
Year
Month day Debited account title XXX X
X
Credited account title X XX XX
(Explanation)
There are also other types of Journals like, known as special journals that are used to record
specific types of transactions. The cash Journal, for instance, is used to record only
transactions affecting cash. The General Journal is used for illustrations in this chapter.
Special journals are discussed in unit 4.
Steps in Journalizing a Transaction

The following steps should be followed in recording a transaction in the journal.
1. Record the date - Insert the year, the month, and the date as shown above.
2. Record the Debit- Insert the account debited in the description column and the amount
of debit in the debit column.
3. Record the credit- Insert the account credited below the debited account and indented
to the right in the description column and the amount of credit in the credit column.
4. Explanation- Write a brief explanation or reference to source document in the
description column, when necessary.
Each one set of debits and credits for a transaction is called a journal entry.
In recording a business transaction answer the following questions based on the transaction to
be recorded may help you.
a) Which accounts are affected?

b) Is each account increased or decreased?
c) Which account is debited and which is credited?
d) Prepare the complete journal entry.
Example, On January 10, 2003 Tamget P.L.C paid Birr 6,000 to its employees as a salary for
the first week of the year.
This business transaction will be analyzed and recorded as follows.

a) Which accounts are affected? Answer: Cash and Salary Expense.
b) Is each account increased or decreased? Answer: cash is decreased and salary expense
is increased.
c) Which account is debited and which is credited? Answer: Salary Expense is debited
because increase in expenses is recorded on the debit side. And cash is credited because
decrease in assets is recorded on the debit side.
d) Prepare the complete Journal entry.
2003 Description
Jan. 10 Salary expense 6000 00
Cash 6000 00
(Payment of salary)
Note: A journal entry is the complete presentation of the record in the journal.
Journalize the following transaction by answering 4 questions suggested above.

 On January 11, 2003 Tamget bought a building for Birr 150,000 on credit.
ILLUSTRATION
To illustrate the complete accounting cycle, we will consider the following list of selected
transactions. The transactions were completed by Bati Transport in the month of January
2003.
January 1. Ato yimer took Birr 450,000 from his personal savings and deposited it in the
name of Bati transport.
January 2. Bati Transport purchased two used trucks for Birr 150,000 each, on cash.
January 4. Bati Transport received a check for Birr 650 for services given to Alem
Trading.
January 4. Received an invoice for truck expenses Birr 90.
January 11. Paid Birr 600 for Awash Insurance Company to buy an insurance policy for
its trucks.
January 16. Ato Yimer issued a check for Birr 9,400 to the workers as a salary for
two weeks.
January 20. Bati trading Billed Muradu Supermarket for goods transported from
Djibouti to Gondar Birr 2,650
January 21. Ato Yimer wrote a check for birr 450 to have one of the trucks repainted
January 21. Bati trading purchased stationary materials and other supplies of Birr 740 on
account
January 22. Office equipment of Birr 11,600 is bought on account.
January 23. Purchased an additional truck for Birr 250,000 paying birr 100,000 in cash
and issuing a note for the difference.
January 23. Recorded services billed to customers on account birr 14,600.
January 25. Received cash from customers on account Birr 15,000.
January 27. The owner withdrew Birr 500 in cash for his personal use.
January 28. Paid Birr 9,400 to workers as a salary for the last two weeks of the month.
January 30. Paid telephone expense of Birr 95 and electric expenses of Birr 125 for the month.
January 30. Paid other miscellaneous expenses Birr 50.
January 31. Paid Birr 4,000 as a rent for a building used for office space.
Solution, These transactions are journalized as follows:
Date Description Debit Credit

2003 Cash 450,000
Jan.1 Yimer Capital 450,000
To record investment by owner
2 Truck 300,000
Cash 300,000
Purchase of trucks
4 Cash 650
Service Income 650
Cash received from customers
4 Truck Expenses 90

Accounts Payable 90
Service received in advance
11 Prepaid Insurance 600
Cash 600
Purchase of insurance policy
16 Salary Expense 9,400
Cash 9,400
Payment of salary
20 Accounts Receivable 2,650
Service Income 2,650
Provision of service
21 Maintenance (truck) Expense 450
Cash 450
Cash paid to repaint truck
21 Supplies 740
Accounts Payable 740
Purchase of supplies of account
22 Office Equipment 11,600
Accounts Payable 11,600
Purchase of equipment
23 Truck 250,000
Cash 100,000
Notes Payable 150,000
Purchase of truck
23 Accounts Receivable 14,600
Service Income 14,600
Provision of service on account
25 Cash 15,000
Accounts Receivable 15,000
Collection of cash
27 Drawings 500
Cash 500
Owner withdrawals
28 Salary Expense 9,400
Cash 9,400
Payment of salary
30 Utilities Expense 220
Cash 220
Payment for telephone, electricity
30 Miscellaneous Expenses 50
Cash 50
Payment for various expenses
31 Rent Expense 4,000
Cash 4,000
Payment of Rent
2.7 POSTING FROM THE JOURNAL TO THE LEDGER

After the information about a business transaction has been journalized, that information is
transferred to the specific accounts affected by each transaction. This process of transferring
the information is called posting.
An account could be of two types; the two-column account and the four-column account.
We will use the four-column account for our illustration. The two forms of accounts are
given below.
The two-column account:
Account Account number
Date Item P. Debit Date Item P.R Credit
R
The four-column account:

Account Account number
Date Item P.R Debit Credit Balance
Debit Credit
The steps in posting are given below:

1. Record the date and amount of Dr. and Cr. Entry to the account
2. Insert the Journal page number in the P.R (Post Reference) column of the account.
3. Insert the account number in the P.R column of the journal.
Note. The P.R Column is used for reference purposes. The P.R column of the journal shows
whether the entry is posted and the account to which it is posted. In the account, the P.R
Column shows the Journal page number from which the entry was brought.
The group of accounts used by an organization is called ledger.
Illustration. As mentioned above, to illustrate the posting process the four column account is
used and the entries to the cash account are posted as follows.
Account Cash Account Number 11

Balance
Date Item P.R Debit Credit Debit Credit
2003, Jan 1 450,000 00 450,000 00
2 300,000 00 150,000 00
4 650 00 150,650 00
11 600 00 150,050 00
16 9,400 00 140,650 00
21 450 00 140,200 00
23 100,000 00 40,200 00
25 15,000 00 55,200 00
27 500 00 54,700 00
28 9,400 00 45,300 00
30 220 00 45,080 00
30 50 00 45,030 00
31 4,000 00 41,030 00
Account Accounts Receivable Account Number 12
Balance
2003, Jan 20 2,650 00 2,650 00
23 14,600 00 17,250 00
25 15,000 00 2,250 00
Account Supplies Account Number 13
Balance
2003, Jan 21 740 00 740 00
Account Prepaid Insurance Account Number 14
Balance
2003, Jan 11 600 00 600 00
Account Office Equipment Account Number 15

Balance
2003, Jan 22 11,600 00 11,600 00
Account Truck Account Number 16
Balance
2003, Jan 2 300,000 00 300,000 00
23 250,000 00 550,000 00
Account Accounts Payable Account Number 21
Balance
2003, Jan 4 90 00 90 00
21 740 00 830 00
22 11,600 00 12,430 00
Account Notes Payable Account Number 22
Balance
2003, Jan 23 150,000 00 150,000 00
Account Yimer Capital Account Number 31

Balance
2003, Jan 1 450,000 00 450,000 00

Account Yimer Withdrawal Account Number 32
Balance
2003, Jan 1 500 00 500 00
Account Service Income Account Number 41
Balance
2003, Jan 4 650 00 650 00
20 2,650 00 3,300 00
23 14,600 00 17,900 00
Account Salary Expense Account Number 51
Balance
2003, Jan 16 9,400 00 9,400 00
28 9,400 00 18,800 00
Account Rent Expense Account Number 52

Balance
2003, Jan 31 4,000 00 4,000 00
Account Utilities Expense Account Number 53

Balance
2003, Jan 30 220 00 220 00
Account Maintenance Expense Account Number 54
Balance
2003, Jan 21 450 00 450 00
Account Truck Expense Account Number 55
Balance
2003, Jan 21 90 00 90 00
Account Miscellaneous Expenses Account Number 56
Balance
2003, Jan 30 50 00 50 00

Rule the other accounts used by Bati Transport and post the respective Dr. & Cr. entries (Hint
17 accounts, including cash, are used by Bati Transport). Don’t continue without doing this
because the following discussion assumes you have done this exercise!

2.8 THE TRIAL BALANCE
After the posting phase is completed, we have to verify the equality of the debit and credit
balances. This is done through the use of the ‘Trial Balance’. A trial balance is a two column
listing of the accounts in the ledger and their balance to make sure that the total of debit
balances equals the total of credit balances.
The trial balance for our illustration, Bati Transport is presented bellow. The amounts are
taken from the balances of the accounts after all the transactions have been posted. Therefore,
after posting the above transactions, you should get the final balances shown on the trial
balance in the end.
Bati Transport
Trial Balance
January 31, 2003
Cash 41,030 00
Accounts Receivable 2,250 00
Supplies 740 00
Prepaid Insurance 600 00
Office equipment 11,600 00
Truck 550,000 00
Accounts payable 12,430 00
Notes payable 150,000 00
Yimer capital 450,000 00
Yimer drawing 500 00
Service income 17,900 00
Salary expense 18,800 00
Rent expense 4,000 00
Utilities expense 220 00
Maintenance expense 450 00
Truck expense 90 00
Miscellaneous expense 50 00
Total Br. 630,330 00 Br. 630,330 00
2.8.1 Proof Provided by the Trial Balance

The trial balance debit totals and credit totals are equal implies that the accounting work is
more likely to be free from any one or more of the following errors.
1. Error in preparing the trial balance including
-Addition error
-The amount of an account balance was in correctly listed on the trial balance
- A debit balance was recorded as a credit or vice versa
- A balance was entirely omitted.

2. Error in posting, including
- An erroneous amount was posted to the account.
- A debit amount was posted as a credit or vice versa
- A debit or credit posting was omitted
2.8.2 Limitations of the Trial Balance
The trial balance amounts are equal doesn’t mean that the accounting work is free from error.
That is, there are errors that may take place without affecting the trial balance totals. Some
examples are mentioned below:
- Failure to record a transaction or to post a transaction
- Recording the same erroneous amount for both the debit and the credit parts of a
transaction.
- Recording the same transaction more than once.
- Posting part of a transaction to the correct side but the wrong account.
Note: All these errors have the same affect (increasing or decreasing) on the debit totals and
credit totals
2.9 ADJUSTMENTS
All the transactions recorded above in the journalizing step are the result of daily transactions.
Other transactions result from the passage of time or from the internal operations of the
business. For example, insurance premiums are paid for a certain period of time and expire
during that time period. Another example is office supplies such as paper, pens & pencils.
At the end of the period the balances in accounts such as supplies and prepaid insurance must
be brought up to date. The supplies account balance, for example, must be credited by the
consumed part of the supplies, debiting supplies expense.
Example. Stationary materials totaling Birr 1,900.00 were purchased and recorded during the
year. At the end of the year, only Birr 150 of the supplies is left in hand.
The adjusting entry prepared at the end of the year to adjust the supplies account will be
1990 Supplies expense 1,750

Dec31 Supplies 1,750
Note: 1. Adjustments are dated as the last day of the year.

2. The accounting year here – we assume, runs from January 1- December 31.
Additional examples on adjustments will be given below under the topic ‘worksheet’
2.9.1 The Accrual Basis and the Cash Basis of Accounting
1. The cash basis of accounting – In this basis of accounting revenues are reported in
the period in which cash is received and expenses are reported in the period in which cash
is paid. Net in come will, therefore, be the difference between the cash receipts
(Revenues) and cash payments (expenses). This method will be used by organizations

that have very few receivables and payables. For most businesses, however, the cash
basis is not an acceptable method.
2. The accrual basis of accounting – Under this method revenues are reported in the
period in which they are earned, and expenses are reported in the period in which they are
incurred. For example, revenue will be recognized as services are provided to customers
or goods sold and not when cash is collected. Most organizations use this method of
accounting and we will apply this method in this course.
2.9.2 The Matching Principle

We have discussed three concepts and principles in accounting in unit one. Now we will see
one more principle, the matching principle. This principle states that the expense of a period
have to be matched with the revenue of that period regardless of when payment is made. In
order to do this, the accrual basis of accounting requires the use of an adjusting process at the
end of the period so that revenues and expenses of the period will be determined properly.
2.10 WORKSHEET
Most of the data required to prepare the accounting reports (financial statements) is now
gathered. The data will now be presented in a convenient form. The worksheet is a large
columnar sheet prepared to arrange in a convenient form all the accounting data required to
prepare financial statements. The worksheet has a heading and a body.
The heading has three parts:

i) Name of the Organization
ii) Name of the form (worksheet)
iii) Period of time covered.
The body contains five main parts each of them with two main columns. These parts are
1. The trial balance
2. The adjustment
3. The adjusted trial balance
4. The income statement
5. The balance sheet.
The worksheet for Bati Transport is given below. The five parts of the body are discussed as
follows. You are advised to read and understand the discussions before you look at the
respective columns of the worksheet.
Bati Transport
Work Sheet
For The Month Ended Jan.31, 2003
Account Title Trial Balance Adjustment Adjusted Trial Income Balance sheet
balance statement
1 Cash 41,030 41,030 41,030
©
2 Accounts receivable 2,250 7,400 9,650 9,650
(a)
3 Supplies 740 340 400 400
(b)
4 Prepaid Insurance 600 450 150 150
5 Office equipment 11,600 11,600 11,600
6 Truck 550,000 550,000 550,000
7 Accounts payable 12,430 12,430 12,430
8 Notes payable 150,000 150,000 150,000
9 Yimer Capital 450,000 450,000 450,000
10 Yimer drawing 500 500 500
©
11 Service income 17,900 7,400 25,300 25,300
12 Salary expense 18,800 18,800 18,800
13 Rent expense 4,000 4,000 4,000
14 Utilities expense 220 220 220
15 Maintenance expense 450 450 450
16 Truck expense 90 90 90
17 Miscellaneous 50 50 50
Expense
18 630,330 630,330
(a)
19 Supplies expense 340 340 340
(b)
20 Insurance expense 450 450 450
21 7,290 7,290 636,830 636,830
22 Net income
23 25,300 25,300 613,330 613,330
1. The trial balance column – this is the same trial balance we have prepared before. The
trial balance column of the work sheet can be brought direct from the ledger or from a
separate trial balance.
2. The Adjustment column – As mentioned previously, some account balances have to be
adjusted at the end of the year.
The accounts in the ledger of our illustration that require adjustment and the adjusting entry
for the accounts are presented below.
a) Supplies – The supplies account has a debit balance of Birr 740. The cost of supplies in
hand on July 31 is determined to be Birr 400. The following adjusting entry is required to
bring the balance of the account up to date:
Supplies expense………………………..340
Supplies……………………………………...340
b) Prepaid insurance – Analysis of the policy showed that three – fourth of the policy is
expired. That is only Birr 150 of the policy is applicable to future periods. The adjusting
entry to transfer the expired part of the insurance to expense will be.
Insurance expense……………………..450
Prepaid insurance…………………………...450
c) Service Income At the end of the month unbilled fees for services performed to clients
totaled Birr 7,400.
This amount refers to an income earned but to be collected in the future. The journal entry to
record it will be
Accounts receivable…………………..7, 400
Service income……………………………..7,400
All the above adjusting entries will be inserted in the adjustment column of the worksheet in
front of the accounts affected.
Note – The letters a, b & c are used to cross-reference the debits and credits to help future
review of the worksheet.

3. The Adjusted Trial Balance Column –The accounts that require adjustment are now
adjusted. Transferring the trial balance column amounts combined with the adjustment
column amounts will complete the adjusted trial balance column of the worksheet.
4. The income statement and the balance sheet columns – Transfer the income statement
account balances (revenue &expenses) to the income statement and balance sheet account
balances (Asset, Liability &owners equity) to the balance sheet columns. Note that what we
have to transfer is the adjusted trial balance column amounts, to the corresponding columns.
Look at the 22nd row. It shows the net income for the month and it is added to the two
columns (Income statement Dr. and balance sheet Cr.) as a balancing figure.
2.11 FINANCIAL STATEMENT PREPARATION
After the work sheet is completed financial statements could be prepared easily. In unit one
we have discussed four basic financial statements prepared by most organizations. Here, we
will prepare three of these statements for Bati Transport form the worksheet.
1. Income statement
All the data required to prepare the income statement is brought from the worksheet.
Bati Transport
Income Statement
For The Month Ended. Jan 31, 2003
Service Income ……………………………………………………… …Birr 25,300
Operating expenses
Salary expense…………………………..Birr 18,800
Rent “………………………………..…....4, 000
Maintenance expense …………..….………… 450
Insurance “……………………...………450
Supplies “…………………..………….340
Utilities “……………….……………..220
Truck “………………………………..90
Miscellaneous “…………………….…………50
Total operating expense…………………………...……Birr 24, 400
Net Income…………………………………………..… …Birr 900
2 Statement of owner’s equity

This statement shows the beginning balance of capital and the changes that affected it.
The balance of the owners equity account (Yimer capital) in the worksheet may not be the
beginning one. Therefore, the ledger has to be reviewed to see if there was an additional
investment during the priod or not. In our illustration there is no additional investment.
Bati Transport
Statement of Owner’s equity
For the month ended January 31, 2003
Yimer capital January 1, 2003………………………………Birr 450,000
Add: Net income for the month………………….Birr 900
Less: Withdrawal……………………………………...500 400
Yimer capital, January 31, 2003…….………….………….Birr 450,400
3. Balance sheet – The data to prepare this statement will be taken from the worksheet and
the other financial statements. Note that assets and liabilities are classified as current and non
– current.
Bati Transport
Balance sheet
January 31, 2003
Assets
Current Assets:
Cash…………………………………………Birr 41, 030
Accounts Receivable…………………………….. 9,650
Supplies…………………………………………… 400
Prepaid insurance…………………………………….150
Total current assets………………………………………………Birr 51,230
Plant Asset (None-Current Assets):
Office equipment……………………………..Birr 110,600
Truck………………………………………………550,000 561,600
Total asset…………………………………………………..…Birr 612,830
Liabilities
Current liabilities
Accounts payable……………………………..Birr 12,430
Non-current liabilities
Notes payable……………………………………..150,000 Equal (A= L + OE)
Total liabilities…………………………………………………Birr 162,430
Owner’s equity
Ato Yimer Capital……………………………………………………..….. 450,400
Total liability and owners equity…………………………….….….Birr 612,830
2.12 THE CLOSING PROCESS
Some of the accounts in the ledger are temporary accounts used to classify and summarize the
transactions affecting capital (owner’s equity). These accounts will be closed after financial
statements are prepared. That is, their balances will be transferred to the Capital account. The
temporary accounts that have to be closed are revenue, expense and withdrawal accounts.
Steps in closing:
1. Closing revenue accounts - Debit each revenue account by its balance and
credit the ‘Income Summary’ account by the total revenue for the period.
Note: Income summary is an account used to close revenue and expense accounts. This
account will immediately be closed to the capital account at the end of the closing process.

2. Closing expense accounts – Debit the income summary account by the
total of expenses for the period and credit each expense account by its balance.
3. Closing the income summary account – Income summary will be closed
to the capital account. The balance of his account depends on the nature of operation;
credit if result is profit and debit if result is loss.
4. Closing Withdrawal – Debit the owners equity account by the total of

drawings for the period and credit the drawing account.
The temporary accounts of Bati transport are closed as follows.
2003 Income summary………………….25, 300
January Service income…………………………………25,300
31 Closing Revenue
31 Salary expense…………………….…..18,800
Rent expense……………………...……4,000
Maintenance expense………………….. 450
Insurance expense………………………..450
Supplies expense…………………………340
Utilities expense………………………….220
Truck expense …………………………… 90
Miscellaneous expense…………………….50
Income expense…………………………………24,400
Closing Expenses
2003 Income summary………………900
January 31 Yemer Capital………………………..900
Closing income summary
31 Yimer capital…………………...500
Yimer drowing………………………..500
Closing withdrawal
The above closing entries have transferred the balance of the temporary accounts to the
permanent capital account.

Post all the above closing entries and recompute the balance of all the accounts affected.
2.13 POST CLOSING TRIAL BALANCE
After the closing entries have been journalized and posted, a trial balance is prepared to prove
the equality of the general ledger before recording the new year’s transactions. It should be
noted that this trial balance includes only balance sheet accounts. This is because the
temporary income statement accounts are closed during the closing process. This trial
balance is called the post – closing trial balance.

In practice the ledger balance after closing may be checked by a simple calculator print out
rather than a formal trial balance. The post closing trial balance for Bait Transport is
presented below.
Bati Transport
Post – Closing trial balance
Jan 31, 2003
Cash……………………………………………Birr 41,030
Accounts Receivable ………………………………...9,650
Supplies…………………………………………………400
Prepaid insurance……………………………………….150
Office equipment……………………………………11,600
Truck……………………………………………….550,000
Accounts payable…………………………………………………….Birr 12,430
Nots payable……………………………………………………………..150,000
Yimer capital……………………………………………………………..450,400
Total……………………………………Birr 612,830 Birr 612,830
2.14 SUMMARY
Accountants go through a number of step-by-step procedures to record transactions and to

summarize the records in to useful repotrs in a systematic manner. These procedures that
accountants go through from the time a transaction is identified until the time financial
statements are prepared are together called the accounting cycle. The accounting cycle is
summarized below:
Input Process Output
1. When a transaction 2. Transactions are recorded in the journal 7.Preparing financial statements
happens,source documents
3.Posting to individual accounts
are prepared.
4.Preparing a trial balance after
determining the balance of each ledger
account
5.preparing and completing the work
sheet with adjustments
6.Adjustments are journalized and posted
8.Closing entries are journalized and
posted
9. A post closing trial balance is prepared.
2.15 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

Expenses are found on the right hand side of the accounting equation; they are elements of
the owners equity account. When expenses increase capital will decrease and vice versa.
Because of this reverse effect of expenses on capital they increase on the Dr. sided and
decrease on the Cr. side, unlike other right hand side accounts.
a) Building and Accounts payable

b) Both accounts are increased.
c) Building is debited and accounts payable is credited
d) Journal entry:
2003, Building……………………………150,000
Jan 11 Accounts payable…………………………..150,000
Purchase of building on credit.
Prepare a four – column account for each account and post the respective entries to the
accounts. Compare the ending balance of each account in your answer with their balance in
the trial balance.
After all the closing entries are posted all temporary accounts will have zero balances. On the
other hand, permanent accounts will have non- zero balances. Example: Yimer Capital = Birr
450,400, supplies Birr 400.
A complete list of the permanent accounts and their balances is given on the post – closing
trial balance.
Account –a record showing separately the increases and decreases of a financial statement
item during a period.
T account - the simplest format of an account, which resembles the letter ‘T’
Chart of Accounts- a list of the account s used by an organization and their codes.
Debit - the left side of an account.
Credit - the right side of an account.
Source Documents- documents such as an invoice or a cash receipt voucher that evidence the
occurrence of a transaction.

Journal- a book or record where a transaction’s full debits and credits and other details are
first recorded.
Journal Entry-the debits and credits recorded in the journal for one transaction.
Ledger - a book, where increases and decreases in each account are separately recorded. It is
therefore the collection of the individual accounts of an organization.
Trial Balance – a form showing the final balance of each ledger account. It is used to
somehow check if any errors were made during the period.
Work Sheet –a working paper that accountants use to collect adjustment data and to easly
prepare the financial statements.
Adjustments – entries required to up-date some accounts before preparing financial

statements.
Post Closing Trial Balance- a trial balance prepared after all the accounts have been closed.
End of Chapter two!

2.17 MODEL EXAM QUESTIONS
1. Indicate whether each of the following items below is an asset, liability, revenue,
expense, gain or loss account and whether it appears in the balance sheet or income
statement.
a) Office furniture
b) Income from services
c) Salaries paid to workers
d) Supplies on hand
e) Salary payable to workers
f) Cash
g) Income form sale of a used truck
h) Goods damaged by fire in the store
2. Given below is a list of selected transactions performed by John Décor during the
month of September 2002, the first month of operation.
Sept. 10 Mr. John transferred cash form his personal account to be used in the business,
Birr 10,000.
“ 10 Paid rent for the month, Birr 500
“ 11 Purchased a truck for Birr 12,000 by paying Birr 3,000 Cash and giving a notes
payable for the difference.
“ 12 Purchased equipment on account Birr 1,460.
“ 13 Purchased supplies on account Birr 240.
“ 14 Paid insurance premiums of Birr 170 (Dr. prepaid insurance)
“ 15 Received cash for services completed Birr 360.
“ 16 Purchased Supplies on account Birr 240.
“ 18 Paid salaries of Birr 900.
“ 21 Paid its liabilities for the purchase of equipment
“ 24 Recorded sales on account Birr 2,080
“ 26 Received an invoice for truck expense Birr 115
“ 27 Paid utilities expense Birr 205.
“ 27 Paid miscellaneous expenses Birr 73.
“ 28 Received cash from customers on account birr 1,420
“ 30 Paid salaries to employees Birr 950
“ 30. The owner withdrew Birr 1, 750 for personal use.
Required:
a) Record the transactions in General Journal
b) Post each entry to the perspective account. Use the four – column account.
c) Prepare a trial balance
d) Prepare a worksheet. Assume the following adjustment for the accounts and
journalize them.
e) Prepare a Balance sheet, Income statement and statement of owner’s equity
f) Close the temporary accounts.
3. As of Sene 30 1994, the end of the current fiscal year, the accountant for Gada
General Trading company completed the worksheet before journalizing and posting the
adjustments.
Gada General Trading Company
Trial Balance
Sene 30, 1994
Un adjusted Adjusted Trial Balance

Cash 12,825.00 12,825.00
Supplies 8,950.00 3,635.00
Prepaid rent 19,500.00 1,500.00
Prepaid insurance 3,750.00 1,250.00
Equipment 92,150.00 92,150.00
Accumulated depreciation equipment 53,480.00 66,270.00
Automobile 56,500.00 56,500.00
Accumulated depreciation automobile 28,250.00 36,900.00
Accounts payable 8,310.00 8,730.00
Salary payable 3,400.00
Tax Payable 1,225.00
Gada capital 41,245.00 41,245.00
Gada drawing 18,600.00 18,600.00
Service income 261,200.00 261,200.00
Salary Expense 172,300 175,700.00
Rent Expense 18,000.00
Supplies Expense 5,315.00
Depreciation Expense Equipment 12,790.00
Depreciation Expense Automobile 8,650.00
Utilities Expense 4,700.00 5,120.00
Taxes Expense 1,500 2,725.00
Insurance Expense 2,500.00
Miscellaneous Expense 1,710.00 ____ 1,710.00 ____
Total 392,485.00 392,487.00 418,970.00 418,970.00
Required:
(a) Compare the adjusted and unadjusted trial balances and prepare worksheet that was
required to adjust the accounts.
(b) Prepare the journal entries that were required to close temporary accounts.

UNIT 3. ACCOUNTING FOR MERCHANDISING BUSINESSES
3.1 INTRODUCTION
In the previous chapters, you saw how to record transactions of a service business. The steps
that we go through to prepare the financial statements of other types of businesses (such as a
merchandising business) are basically the same. Transactions are first journalized, and then
posted to the ledger; a worksheet is prepared and complete. But, there are some transactions
in merchandising companies that you don’t find in a service giving business, like the purchase
of goods for sale and the sale of those goods. The first section of this chapter, therefore,
discusses the nature of a merchandising business and how to record merchandising
transactions. The next section discusses about the preparation of financial statements for
merchandising companies.
SECTION-ONE: RECORDING MERCHANDISING TRANSACTIONS
3.2 NATURE OF A MERCHANDISING BUSINESS

3.2.1What is a Merchandising Business?
A merchandising business buys goods in finished form for resale to customers.
A merchandising business sells tangible goods to its customers. When we say goods it can be
anything that has physical characteristics that you can see and touch (i.e. tangible). These can
be goods ranging from television sets, cars, office table and chair (furniture), to chewing
gums, toothbrushes and various stationery. These goods that a merchandising company sells
to its customers are called merchandise inventory. (A customer is an individual or a firm to
whom a business sells its products.)
One final thing that you should know about a merchandising business is that a merchandising
company does not produce the goods that it sells. Instead, it buys these goods from
manufacturers, which produce the goods using raw materials.
The following diagram can help you to better visualize the flow of goods from a manufacturer
to the final consumer:
sells Merchandising companies

Manufacturers wholesalers sell Retailer Final consumer
goods goods
A wholesaler is a trader, which buys goods from manufacturers and sells them to a retailer or
another wholesaler. It is the retailer who sells the goods to the final consumer by buying
them from wholesalers (or sometimes from a manufacturer).
When you want to buy a soap to wash your clothes, where do you buy it? Who is the
manufacturer of the soap? Are there any wholesalers of that soap in your area? Can the
wholesaler be taken as the customer of the manufacturer? And finally, can we say the shop
from which you buy the soap is a merchandising business?
3.2.2 Comparison of Financial Statements for Merchandising and Service

Businesses
1. Income Statement
A model income statement for a merchandising business and another one for a service
business are shown below. Compare them carefully.
ABC service company XYZ merchandising

Income statement Income statement
For the year ended Dec.31, 2004 For the year ended Dec.31, 2004
Revenue: Revenue:
Service fee…………………..Birr 23,200 Net Sales……………………Birr 360,000
Cost of goods sold…………….(256,000)
Gross Profit …………………….104,000
Expenses: Various Operating
Various Operating Expenses…. (7,120) Expenses…………………….….(79,400)

Net Income……………………...16,080 Net Income ………………….…..24,600
As you can see from the above Income Statements, merchandising companies have to pay to
buy the goods that they sell. Therefore, they have to deduct this cost of goods sold in addition
to other operating expenses from their sales revenue to determine their net income.
The difference between sales revenue and cost of goods sold is referred to as gross profit.
Why ‘gross’? Because other expenses have yet to be deducted to arrive at the net profit or net
income of the business.
2. Balance Sheet
The Balance Sheet of a service business and that of a merchandising business are similar in
every aspect except one thing. The current assets section of the Balance Sheet of a
merchandising business includes one asset that service companies do not have. That is
merchandise inventory. Merchandise inventory refers to goods bought by a merchandising
business for resale to customers. So, if a merchandising business has some unsold goods
(merchandise) on hand at the end of the year this would be reported as one asset on the
Balance Sheet.
3.3 THE PERIODIC AND THE PERPETUAL INVENTORY SYSTEMS
The value of goods (merchandise) on hand at the end of the year for resale would be reported
on the Balance Sheet as one asset as described above. This means that we need to open a
separate ledger account in which to record merchandise inventory information.
The two alternatives in dealing with this account are:

1. To up date this account every time goods are bought and sold (continuously =
perpetually) or
2. To up date this account only at the end of the period (periodically).
3. 3.1 The Periodic Inventory System
Under this system, as the name periodic suggests, the inventory account is updated only
periodically i.e., only at the end of a period.
When goods are bought, a temporary purchases account is debited instead of the inventory
account itself. Likewise, when goods are sold revenue is recorded, but the fact that there is a
reduction in merchandise inventory is not recognized. This is because the Merchandise
Inventory account is not credited every time goods are sold.
Therefore, if one wants to know the cost of goods on hand, it is a must that a physical
inventory be conducted first. The account doesn’t reflect the value of goods on hand because
it was not up dated when merchandise was bought and sold. Physical inventory means
counting the quantity of goods on hand. Once the quantity of goods on hand has been
determined, it is multiplied by the unit price of those goods to determine the cost of goods on
hand.
In conclusion, under the periodic system, since the merchandise inventory account is not
continually updated, the cost of merchandise on hand is determined only at the end of the
period after carrying out a physical inventory.

Companies such as department stores or ‘super markets’, which sell small items, use periodic
systems.
3.3.2 Perpetual Inventory Systems
A perpetual inventory system continuously records the amount of inventory on hand
(perpetual =continuous). Under this system, the merchandise inventory account is debited or
credited every time (goods) are bought or sold. When an item is sold, its cost is recorded in a
separate cost of goods sold account in addition to recording sales.
The cost of merchandise on hand can be looked up from the merchandise Inventory account
any time, without conducting a physical inventory.
Check Your Progress Exercise-1
If you have a supermarket business, would you use the perpetual or periodic system? What if
your system is computerized? Explain.
3.4 RECORDING PURCHASES AND SALES TRANSACTIONS
The following discussions in the remainder of this chapter all assume the use of a periodic
inventory system. The perpetual system will be discussed in part two of this course.
3.4.1 Recording Sales
When a merchandising company transfers goods to the buyer, in exchange for cash or a
promise top at a later date, revenue is produced to the company. This revenue is recorded in a
Sales account. However, the sales revenue, which is reported on the Income Statement is Net
Sales. That is,
Net Sales = Gross Sales – Sales Discounts - Sales Returns and Allowances
Recording Gross Sales
The gross sales amount is obtained from sales invoices. An invoice is a document, prepared
by the seller of merchandise to notify to the buyer the details of the sale. These details can
include number of items sold, unit price of items, total price, terms of sale and manner of
shipment. When goods are delivered to the customer, the Sales account is credited because
revenues are increased by credits.
A company can sell goods either for cash or on account.
Recording Cash Sales
When merchandise is sold on cash, the Cash account is debited and the revenue account Sales
is credited.
Example – Ika Company based in Bahir Dar, buys and sells used commodities. On January
14. 2001. Ika sold goods for Birr 20,000. Record the transaction.
Answer:
January 14, Dr. Cash………………………………..20,000.00
Cr. Sales……………………………………20,000.00
Recording Credit Sales
The Accounts Receivable account is debited when goods are sold on account (for credit).
Example -
Ika sold goods worth Birr 35,000 on account on January 15, 2001. Record the transaction.
Solution
January 15. Accounts Receivable…………………..35,000.00
Sales…………………………………………35,000.00

Determining Gross Sales when there are trade discounts
A trade discount is a percentage deduction from the specified list price or catalogue price of
merchandise.
Trade discounts allow us:
- To avoid publishing a new catalogues every time prices change.
- To grant quantity discounts
- Quotation of different prices to different types of customers.
Trade discounts are not recorded in the seller’s accounting records; they are only used to
calculate the gross selling price.
Example: IKA sold 500 T.V. sets, each with a list price of Birr 80, on January 17, 2001 for
cash. It gave the customer a 30% trade discount, as the customer was a very loyal one.
Record the sale.
Answer:
List price of goods (80 X 500) Birr 40,000
Less: Trade discount (30 % of 40,000) (12,000)
Invoice price 28,000
Journal entry:
Cash……………………..28,000
Sale………………………28,000
Recording Deductions from Gross Sales
Go back to illustration 1- and have a look at the model Income Statement of a merchandising
company. You will see that the sales reported on the income statement is net sales, i.e., after
deduction of sales discounts and sales returns and allowances.
Gross sales (from invoice)…………………...XXX

Less: Sales discounts…………………………….(XX)
Sales returns and allowances ………….…..(XX)
Net sales……………………………….XX
Sales Discounts
Sales Discounts are deductions from invoice price to customers who pay early when goods
are sold on credit.
As a seller, you would usually want to be paid as soon as possible. This is because, as
you can imagine, you can use the money for various purposes once you have been
paid. If you want your customers to pay you early the customary practice is to offer
them a (deduction) discount from the invoice price if they pay early.
How much discount is given usually depends on the credit terms. These terms (agreements)
are usually stated on the invoice. The most frequently used terms are stated below:
- “n/30” or “Net 30” – means there is no discount even if the customer pays before the
payment date.
- 2/10, n/30 –means the due date of the payment is after 30 days of the sale. But if the
customer pays with in 10 days she will get a 2% discount.
- 2/EOM, n/60- means the normal due date is with in 60 days of the sale but the
customer will get a 2% discount if she pays before the end of month of sale.

Sales discounts are purchase discounts from the side of the buyer. Sales discounts and
purchase discounts are the same thing seen from different sides. They are generally called
cash discounts together. A cash discount is, therefore, deduction from original invoice price
for early payment when goods are sold on credit (on account).
Example:
On January 21, 2001 IKA Company sold merchandise for birr 20,000 on account. The credit
terms are 2/30, n/30. The customer paid on January 31, (10 days after invoice date).
A. How much would IKA Company collect from this sale?
B. Record the necessary journal entries on January 21 and January 31.
Solution:
A- Since the customer paid with in the discount period, i.e., with in 10 days, she will get a
2% discount. Therefore,
Invoice price…………………….. 20,000
Less: Sales Discount (2% X 20,000)……… (400)
Cash collected …………. 19,600
B- Journal Entries:
January 21 A/R…………………..20,000
Sales……………....20,000
January 31, Cash………………… .19600
Sales Discounts ………...400
A/R………………..20,000
You might initially have thought of debiting the Sales account for Birr 400 on January 31,
since the actual cash collected from the sales of those goods is birr 400 less than what was
recorded as Sales on January 21. But it is better to record the reduction in sales in a separate
contra Sales account. A contra account reduces another account. In this case, the amount in
the Sales Discount account will be deducted from (Gross) Sales on the income statement. That
way, we can disclose how much sales discount was offered and taken during the year on the
income statement, separately.
IKA Company sold goods worth Birr 120,000 on account to Gizu company terms 1/10, n/60
on January 18, 2001. Gizu Company paid on January 28, 2001.
A- How much would IKA Company collect from this sale?
B- Record the necessary journal entries on January 18 and on January 28.
Sales Returns and Allowances
Customers can return merchandise they have bought if they find it to be defective or of the
wrong model, or unsatisfactory for a variety of reasons. A sales return is merchandise
returned by a buyer. The buyer would be paid back her money if she has already paid.
A sales allowance is a deduction from the original invoice price when the customer keeps the
merchandise but is dissatisfied. If, for example, a customer buys an item worth birr 100 and
finds it to be of the wrong color after receiving it, she may still want to retain the item even if
she is dissatisfied with its color. In that case the seller may let her pay only, say, Birr 95 by
giving her an allowance of Birr 5.
Example:

IKA Company sold merchandise worth Birr 15, 000 on February 3, 2001 on account terms
2/10, n/30. On February 5, the buyer returned a portion of the goods worth Birr 5,000 as they
were found to be of the wrong model. The buyer then paid on February 13, 2001.
Record the necessary journal entries on February 3,5 and 13.

Solution:
February 3 A/R…………………….15,000
Sales …………………….15,000
February 5 Sales Returns and Allowances ………5,000
A/R………………………………….5,000
February 13 Cash…………………………………..9800
Sales Discount ……………………….. 200
A/R…………………………10,000
Here, the buyer paid with in the discount period. Therefore, the amount that would be
collected is:
15,000 – 5,000 = 10,000
Deduct: 2% Cash discount (200)
Cash collected 9800
Go back to illustration (1) once again on page and you will see that we have so far been
dealing with what net sales is composed of. You should by now be able to figure out how the
net sales figure on the income statement is arrived at.
In the following section, we will see how to record purchase transactions. Keep in mind that a
merchandising company both buys and sells goods.
3.4.2 Recording Purchases
Under the periodic inventory system a merchandising company uses the Purchases account to
record the cost of goods bought for resale to customers.
Example:
IKA Company bought goods worth Birr 43,000 from Saba Co., which is based in Addis
Ababa, on account on January 4, 2001, terms 20/10, n/30. Record the transaction.
Solution:
January 4 – Purchases …………………..43,000
Accounts payable………………………..43,000
Deductions from Purchases
Purchase Discounts
A merchandising company can buy goods under credit terms that permit it to get a discount if
it pays with in a specified period of time. The deduction from the original purchase price is
recorded in a separate contra Purchase account called Purchase Discounts.
Example:
IKA Company bought goods worth Birr 50,000 from Gibir Company on account on January
14, 2001, terms 1/10,n/60. Ika Company paid on January 24, 2001. Record the transactions
on both dates.

Solution:
Jan. 14. Purchases………………..50,000
A/P………………………50,000
Jan. 24. A/P…………………… …50,000
Purchase Discounts …….......500
Cash…………………….. 49,500
Purchase Returns and allowances
A purchase return occurs when a buyer returns merchandise to a seller.A purchase allowance
is a reduction on the price of goods bought for dissatisfaction on the side of the buyer.
Both purchase returns and purchase allowances are recorded in a contra purchase account
called Purchase Returns and Allowances.
Example:
In the previous example for IKA Company, a portion of the goods worth birr 5,000 bought on
January 14 from Gibir Company were of the wrong size. Gibir Company acknowledged this
and gave IKa Company a 5% price allowance on January 17.
What should IKA Company record on January 17?
Solution:
January 17 A/P…………………………………250
Purchase Returnes and Allowance…………250
When both purchase discounts and purchase returns and allowances are deducted from
purchases what is obtained is called Net purchase.
That is,
Gross Purchase…………………………XX
Less: Purchase discounts…………………….(XX)
Purchase returns and allowances……..…(XX)
Net Purchases…………………….XX
Transportation costs
Once merchandise has been bought it has to be moved from the seller’s place to the buyer’s
place. A third party comes in to the scene here: the transportation company who moves the
goods between the two places.
That is:
Seller Goods goods goods Buyer

Freighter
So, the question is who is going to pay to the freighter (transportation) company. Who covers
the transportation costs depends, as you might have guessed, on the agreement between the
buyer and seller. The agreements are usually stated in the either of these two terms:
- FOB Destination – means “free on board at destination “. That is, since the
destination of the goods is the buyer’s place, it is free at destination means
transportation cost is paid when the goods are loaded. It simply means the seller pays

transportation cost. FOB Destination means goods are shipped to their destination (to
the buyer) with out transportation charge to the buyer.
- FOB shipping Point –means “free on board at shipping point”. That is, goods are
loaded (on a truck or train) or shipped free of charge. It is, therefore, the buyer, which
pays to the transportation company when the goods reach the buyer (their destination)
Briefly, when the terms are FOB Shipping Point the buyer pays transportation costs.
Transportation costs paid by a buyer of merchandise increase the cost of merchandise. They
are recorded in a separate Transportation-In account that is used to record freight costs
incurred in the acquisition of merchandise.
Example
IKA Company bought goods worth Birr 85,000 on account, terms 2/10,n/60 FOB shipping
point on March 2, 2001.Transportoin cost of Birr 1,500 was paid on March 2. Ika Company
paid on March 31, 2001. Record the necessary journal entries
Solution:
Here, since the terms are FOB Shipping Point, the buyer (Ika) pays transportation.
March 2 -Purchase…………………..85,000
A/P………………………..85,000
-Transportation in……….....1500
Cash………………………1500
March 31 A/P…………………………85,000
Cash……………………………85,000
Example:
IKA Company sold goods worth Birr 135,000 terms 1/15, n/EOM on February 1, 2001. FOB
Destination. It also paid transportation costs of Birr 800 on Feb. 1. The customer paid IKA on
February 16, 2001. Record the relevant Journal entries.
Answers:
Feb 1 A/R…………………………..135,000
Sales…………………………..…..135,000
Feb 16 Sales discount ………………….1, 350
Cash…………………………….133, 650
A/R………………………..………135,000
Delivery Expense…………………800
Cash…………………………..…….800
The Delivery Expense account shows how much was incurred to deliver goods sold to
customers. It is, therefore, shown on the income statement as a selling expense.
Sometimes, the seller prepays the freight as a convenience to the buyer and later collects it on
the due date of the invoice even though the terms are FOB shipping Point.
Example
RR Co. sold goods worth Birr 40,000 on April 1, 2001 to IKA company terms 2/10, n/30
FOB Shipping Point. It also paid Birr 2,500 to Ergib Movers for transporting the goods and
added the amount to the invoice. What would each of these companies record assuming IKA
paid on April 31, 2001

RR Co. (seller) IKa Co (Buyer)
April 1- A/R…………….40,000 April 1-Purchases …………40,000
Sales………………40,000 A/P………………….40,000
A/R…………….2,500 Transport-in ………2,500
Cash…………….2,500 A/P………………2,500
April 31-Cash……………42,500 April 31- A/P…………………42,500
A/R………………42,500 Cash…………………42,500
If the buyer pays the transportation costs for the seller (when the terms are FOB Destination)
the buyer simply deducts the freight paid from the amount to be paid to the seller.
Example:
X Company bought merchandise worth Birr 14,000 terms FOB destination from Y Co. on
account. It paid Birr 350 transportation costs. What would be recorded on the books of the
buyer and seller on the date of the sale?
Buyer (X Co) Seller Y Co.
-Purchase……….14, 000 -. A/R……………….14, 000
-A/P………………14,000 Sales………………….14, 000
-A/P……………350 -Delivery exp……….350
Cash…………..…...350 A/R…………….……350
Transfer of Title
Shipping terms determine not only determine who pays for transportation. They also
determine at what point ownership title of the goods sold transfers to the buyer. Put briefly,
whose property is it when merchandise is in transit?
1. When terms are FOB Destination we have seen that the seller covers transportation costs.
By implication the seller takes the responsibility of safely moving and delivering the goods to
the buyer. The buyer is not responsible for any damage that can happen to these goods in
transit. Therefore, the goods become the buyer’s property only when they are delivered to
him /her.
Conclusion: Ownership title of the goods transfers to the buyer at destination when the terms
are FOB destination.
2. When the terms are FOB shipping point the buyer pays freight costs. The buyer takes the
responsibility of safely moving these goods to his /her own place. The merchandise,
therefore, becomes his/her property as soon as they are loaded on a truck or a train.
Conclusion: Ownership title of goods transfers to the buyer at shipping point when terms are
FOB shipping point.
The following table summarizes it all.
Sipping terms Transportation paid by Title Transfers When goods are
Delivered to
FOB Destination Seller Buyer
FOB shipping point Buyer Freighter (transportation company)
Summary of Section One
Let’s once again present the model Income Statement that we saw at the beginning of this
chapter. This time around, however, it is a bit detailed. Please study the relationship between

each item on the Income Statement carefully. Also try to remember how each item was
recorded in journal entry form when the transactions affecting these accounts happened.
XYZ Merchandising Co.
Income statement
For the year ended Dec. 31, 2001
Gross Sales ………………………………………………… 400,000
Less: Sales Discounts (15,000)
Sales Ret &All (25,000)……… ……………………. (40,000)
Net sales………………………………………………………….360,000
Cost of goods sold:
Beginning merchandise inventory (January 1, 2001)…10,000
Add: Purchases………………….. 210,000
Less: Purchase Disc……….. (5,000)
Purchase Ret & All…(5,000)
Net purchase…………………………..200,000
Add: Transportation –In……………………….66,000
Total cost of goods Available for sale………………...276,000
Less: Ending M.I (Dec. 31, 2001)……………………(20.000)
Cost of goods sold……………………………………………… (256,000)
Gross profit……………………………………………………………… 104,000
Less: Various Selling and Administrative Expenses ……………………… (79,400)
Net Income………………………………………………… 24,600
Note:
Under a periodic inventory system, the cost of goods sold during a period is determined only
indirectly after comparing what was on hand at the beginning of the period, and the cost of
goods purchased during the period with what is left on hand at the end of the period. That is,
Beg inventory + Total cost of purchase –Ending inventory=Cost of Goods Sold.
Under periodic inventory procedures no attempt is made to determine the cost of goods sold at
the time of each sale. Instead, the cost of all the goods sold during the accounting period is
determined at the end of the period.
Summary of Important Relationships on the Income Statement
1. Net sales = Gross sales- (Sales Discounts + Sales Returns and allowances)
2. Net purchases = Purchases – (Purchase Disc. + Purchase Ret. & allowance)
3. Total cost of Purchase = Net purchase + Transportation –In
4. Cost of goods sold = Beg inventory + Total cost of purchase –Ending inventory
5. Gross profit = Net sales – Cost of goods sold
6. Net Income = Gross Profit – operating (i.e., selling & administrative) expenses.
SECTION TWO: REPORTING MERCHANDISING TRANSACTIONS
In the previous section, we saw how purchase and sales transactions are recorded.
In this section, we will see how those transactions are summarized and reported on the
financial statements.
3.5 COMPLETING THE WORKSHEET FOR A MERCHANDISING COMPANY

The use of a worksheet, as you remember, assists in preparing adjusting and closing entries.
In addition it contains all of the information needed for the preparation of the financial
statements. Except for the merchandise – related accounts, the work sheet for a merchandising
Co. is the same as for a service company. The following illustration, therefore, assumes that
all selling and administrative expenses have been adjusted. That accomplished, the only
account, which remains to be adjusted, is the Merchandise Inventory account.
Illustration
The following is the trial balance of Hard Works, a merchandising business owned by
Yibeltal. All accounts have been adjusted except the Merchandise Inventory account.
Hard Works
Trial Balance
December 31, 2002
Account title Dr CR
Cash 19,663
Account Receivable 1,880
Merchandise Inventory 7,000
Accounts Payable 700
Yibeltal, Capital 25,000
Yibeltal,Drawings 2,000
Sales 14,600
Sales Discounts 44
Sales Returns and Allowances 20
Purchases 6,000
Purchase discounts 82
Purchase Returns and allowances 100
Transportation –In 75
Selling expenses 2,650
Administrative expenses 1,150 ________
TOTAL 40,482 40,482
 A physical inventory of merchandise carried out on December 31, 2002 showed Birr
10,000 of goods on hand.
Required: A- Prepare a worksheet for Hard Works.
B- Prepare financial statements from the worksheet
C- Record the necessary adjustment journal entry in relation to merchandise
inventory
D- Record closing entries
Solution
Hard Works Co.
Worksheet
For the year ended December 31,2002
Trial Balance Adjustment Adjusted Trial balance
Income statement Balance sheet
Account title Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 19,663 19,663 19,663
Account Receivable 1,880 1,880 1,880
Merchandise Inventory 7,000 10,000 7,000 10,000 10,000
Accounts Payable 700 700 700

Yibeltal, Capital 25,000 25,000 2,5000
Yibeltal, Drawings 2,000 2,000 2,000
Income summery 7,000 10,000 7,000 10,000 7,000 10000
Sales 14,600 14,600 14600
Sales Discounts 44 44 44
Sales Returns and 20 20 20
Allowances
Purchases 6,000 6,000 6,000
Purchase discounts 82 82 82
Purchase Returns and 100 100 100
allowances
Transportation –In 75 75 75
Selling expenses 2,650 2,650 2,650
Administrative expenses 1,150 1,150 1,150
TOTAL 40,482 40,482 17,000 17,000 50,482 50,482 16,939 24782 33,543 25,700
7,843 7,843
24,782 24782 33,543 33,543
Note:
The merchandise inventory account before adjustment shows the inventory on hand at the
beginning of the period. This is because, since purchases and sales of merchandise have not
been debited or credited to the merchandise inventory account, this account would still show
the beginning inventory amount at the end of the period.
Therefore, an adjustment journal entry is needed to update this account. At the end of the
period, a physical inventory would be conducted to determine the amount of inventory on
hand

The adjustment journal entry removes beginning inventory amount from the merchandise
inventory account and replaces it with the (ending) actual value of merchandise inventory on
hand as determined by the physical inventory.
The adjustment is:
 Income summary (beginning inventory)…………..XXX
Merchandise amount inventory……………………XXX
 Merchandise Inventory…………………………….XXX
Income Summary…………………………………..XXX
An adjustment journal entry for Hard Works is presented latter in (c).
3.6 PREPARING FINANCIAL STATEMENTS FOR MERCHANDISING

BUSINESSES
We will discuss financial statements as we work on requirement (b) of our illustration.

Once the worksheet has been completed, the financial statements are prepared. Next, any
adjusting and closing entries are entered in the journal and posted to the ledger.
Income Statement
There are two widely used formats of the income statement. These are:
1. The single – Step Income Statement
This format is shown below for Hard Works Co. It shows cost of goods sold and operating
expense but has only one subtotal for total expenses.
Hard Works Co.
Income statement
For the year ended December 31, 2002
Net sales…………………………………………………..Br.14, 536

Expenses:
Cost of goods sold………………………2,893
Operating Expenses ……………………..3,800 (6,693)
Net Income……………………………………….7,843
67
2. The Multiple –Step Income Statement
Hard Works Co.
Income statement
Revenue:
Gross Sales……………………………………………… Br. 14,600
Less: Sales Discounts ………..44
Sales Returns &All……20……………… (64)
Net Sales 14,536
Less: Cost of goods sold:
Beg. Inventory (Jan 1)…………………..7,000
Add: Purchase………………………6,000
Less: Purchase.……………….(82)
Purchase Ret & all…….(100)
Net Purchases……………..5818
Add: Transportation –In ……………75
Total cost of purchase……..5893
Total cost of Goods Available for sale……………..12,893
Less: ending Inventory (Dec.31)…………………………(10,000)
Cost of Goods sold…………………………………………..(2893)
Gross Profit……………………………………………11,643
Operating Expenses:
Selling Expenses……………….2,650
Admin. Exp…………………….1,150
Total operating expenses……………….. (3800)
Net Income……………………………… 7,843
Hard Works Co.
Statement of Owner’s Equity
Yibeltal Capital Jan1,2002………………………Br..25,000

Add: Net Income for the year…………………………7843
Deduct: Owner’s withdrawal during the year………....2,000
Yibeltal Capital December 31, 2002…………………30843
Hard Works Co.
Balance sheet
For the year Ended December 31, 2002
Assets: Liabilities & capital
Liabilities:
68
Cash…………………..19,663 A/P……………………..700
A/R…………………… 1,880 Owner’s Equity:
Merch. Inventory…….10,000 Yibeltal Capital …..
30,843
Total Assets………….31,843 Total Liab. & O/E….…31,843
C. Adjustment Journal entry
-Income summary……………….……..7,000
Merchandise Inventory…………………………7,000
-Merchandise Inventory……………...10,000
Income Summary………………………….….10,000
D. Closing entries
-Sales………………………………..14,600
Income summary……………………………....14,600
-Income summary………………………66
Sales discount…………………………………..…44
Sales Returns and Allowances…………………. 20
-Income summary………………………………6,075
Purchases………………………………….…….6,000
Transportation-In…………………………………..75
- Purchase Discounts……………………..82
Purchase Ret. &All…………………...100
Income Summary………………………………….182
- Income summary………………..…….3,800
Selling Expenses…………………………………2650
Administrative expense…………………………..1150
- Income summary…………………..….7,843
Yibeltal Capital…………………………………7,843
- Yibeltal Captal………………………...2,000
Yibeltal Drawings………………………………2,000
3.7 SUMMARY
Even though the steps and procedures that we go through to prepare the financial statements
of merchandising companies are the same with that of service businesses, there are
transactions peculiar to merchandising companies. These include the purchase and sale of
merchandise. You should be able to record these transactions by now. Go back and study the
relationships between financial statement items summarized at the end of section one of this
unit.
69
1. You are provided with the following data from the records of three merchandising
companies: (a), (b) and (c). Determine each of the missing numbers for each company.
a b c
Invoice cost of merchandise purchase Br.90, 000 Br.40, 000 Br.30, 500
Purchase discounts 4000 ? 650
Purchase returns and allowances 3,000 1,500 1,100
Transportation-In ? 3,500 4,000
Merchandise inventory (beginning of period) 7,000 ? 9,000
Total cost of merchandise purchases 89,400 39,500 ?
Merchandise inventory (end of period) 4,400 7,500 ?
Cost of goods sold ? 41,600 34,130
2. Prepare journal entries to record the following merchandising transactions of Shiach

Company. The company uses the periodic inventory system.
July 1 Purchased merchandise form Gizhy Company for $6,000 under credit terms of
1/15, n/30, FOB shipping point.
2 Sold merchandise to Terra Co. for $800 under credit terms of 2/10, n/60, FOB
shipping point.
3 Paid $100 for freight (transportation) charges on the purchase of July 1.
8 Sold merchandise for $1,600 cash.
9 Purchased merchandise from Chilalo Co. for $2,300 under credit terms of 2/15,
n/60, FOB destination.
12 Received a $200 credit memorandum acknowledging the return of merchandise
purchased on July 9.
12 Received the balance due from Terra Co. for the credit sale dated July 2, net of the
discount.
16 Paid the balance due to Gizhy Company within the discount period.
19 Sold merchandise to Urban Co. for $1,250 under credit terms of 2/15, n/60, FOB
shipping point.
21 Issued a $150 credit memorandum to Urban Co. for an allowance on goods sold on
July 19.
22 Received a debit memorandum from Urban Co. for an error that overstated the
total sales invoice by $50.
70
24 Paid Chilalo Co. the balance due after deducting the discount.
30 Received the balance due from Urban Co. for the credit sale dated July 19, net of
the discount.
31 Sold merchandise to Terra Co. for $5,000 under credit terms of 2/10, n/60, FOB
shipping point.
3. The following unadjusted trial balance was prepared at the end of the fiscal year for
Gada Company:
GADA COMPANY
Unadjusted Trail Balance
July 31, 2000
Cash……………………………………………….. $
4,200
Merchandise Inventory…………………………… 11,500
Store supplies…………………………………….. 4,800
Prepaid Insurance………………………………… 2,300
Store equipment………………………………….. 41,900
Accumulated deprecation-Store Equipment… $ 15,000
Accounts payable…………………………………. 9,000
Gidey Gada, capital…………………………….. 35,200
Gidey Gada, withdrawals ………………………. 3,200
Sales……………………………………………….. 104,000
Sales discounts…………………………………… 1,000
Sales returns and allowances…………………… 2,000
Cost of goods sold………………………………... 37,400
Depreciation expense – Store equipment…….. -
Salaries expense………………………………… 31,000
Insurance expense………………………………. -
Rent expense…………………………………….. 14,000
Store supplies expense…………………………. -
Advertising expense…………………………….. 9,900
Totals……………………………………………... $163,200
$163,200
Rent and salaries expense are equally divided between the selling and the general and
administrative functions. Gada Company uses the periodic inventory system.
Required:
1. Prepare adjusting journal entries for the following:
a. Store supplies on hand at year-end amount to $1,650.
b. Expired insurance, an administrative expense, for the year is $1,500.
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c. Depreciation expense, a selling expense, for the year is $1,400.
d. A physical count of the ending merchandise inventory shows $11,100 of
goods on hand.
2. Prepare a multiple-step income statement.

3. Prepare a single-step income statement.
4. Prepare all the necessary closing entries.

A Merchandising Business- a business that buys and sells goods at a profit.
Merchandise- anything that a merchandising company buys in order to resale it to its
customers.
Periodic Inventory System- a system of recording inventories that updates inventory records
only once in an accounting period.
Perpetual Inventory System- a system of recording inventories that continuously shows the
balance of inventory on hand as the records about inventory are continuously updated.
Physical Inventory- the act of counting (measuring, weighing, etc) merchandise in order to
determine the quantity of goods on hand on a particular date.
Trade Discount- deduction from the normal selling price (list price) to determine the invoice
price of goods.
Cash Discount- deduction from the invoice price of goods for early payment when goods are
sold on credit. Cash discounts are called sales discounts for the seller whereas they are
referred to as purchase discounts by the buyer.
Purchase (or Sales) Returns- merchandise returned to the seller after it has already been sold
or bought.
Purchase (or Sales) Allowance- a deduction from the invoice price of goods when the goods
bought or sold are agreed to be of defective or unsatisfactory for any reason.
Contra Account- if an account is a contra account; its balance would be deducted from
another account when it is presented in the financial statements.
FOB Destination- an agreement that requires the seller of the goods to cover transportation
costs. It is read as free on board at destination.
FOB Shipping Point- an agreement that requires the buyer of merchandise to cover
transportation costs. It is read as free on board at shipping point.
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UNIT 4: ACCOUNTING SYSTEMS
4.1 INTRODUCTION
This unit introduces you to the components and principles of accounting systems.
A system is a way of doing something. There are various ways of doing things.
Let’s say you decided to go home when you go out of your office. There are many ways to do
that: You can either take a taxi or you can walk the whole distance home; you can take the
main road, or you may wish to use a short cut and so forth.
In accounting also, it is true that almost all business record, process and report business
transactions. However, the speed and efficiency of the processing depends on which
accounting system they use.
4.2 COMPONENTS OF AN ACCOUNTING SYSTEM
There are five basic elements of an accounting system. These are:
4.2.1 Source Documents

Source documents provide the basic information to be processed by the accounting system.
Invoices from suppliers, bills sent to customers, and payroll records are some examples of
source documents. You have already seen their meaning and importance in previous chapter.
4.2.2 Input Devices
Input devices capture information from source documents and enable its transfer to the
information-processing component of the system. Journal entries, both paper based and
electronic are a type of input devices.
4.2.3 Information Processors
An information processor is a system that interprets, transforms and summarizes information
for use in analysis and reporting. The information processing in an accounting system can be
manual or computerized.
Now days, computer are being increasingly used to process information. Many businesses in
Ethiopia, for example, use the Peachtree accounting software to process accounting
information.
4.2.4 Information Storage
After being input, processed data are usually saved for use in future analysis or report.
Information storage is the component of an accounting system that keeps data in a form
accessible to information processors.
4.2.5 Output Device
Output devices are the means to take information out of an accounting system and make it
available to users. Output devices include printers, and monitors, which provide such outputs
as financial statements, bills to customers and internal reports.
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4.3 FUNDAMENTAL PRINCIPLES OF ACCOUNTIG SYSTEMS
4.3.1 Control Principle

Any accounting information system should allow managers to control and monitor business
activities. To achieve this, accounting system must have internal control as an element.
Internal controls are methods and procedures that direct operations to one goal, ensure
reliability of financial reports and safeguard business assets. Internal controls are discussed
separately and at a greater detail in the next chapter.
4.3.2 Relevance Principle
The information that an accounting system provides should be relevant to decision makers.
This means, an information system should be designed to capture data that make difference in
decision. To ensure this, it is important that all decision makers, be considered when
identifying relevant information for disclosure.
4.3.3 Compatibility Principle
The compatibility principle requires that an accounting system conform to the company’s
activities, personnel and structure. The system must also be customized to the unique
characteristics of the company.
All in all, accounting systems must be consistent with the aims of the company, i.e., they
should work in harmony with company goals.
4.3.4 Flexibility Principle
Accounting information systems must be flexible to adjust to changes in the company, in the
business environment and needs of decision makers. These changes can be technological
developments, consumer tastes or company activities.
A system must be designed to adapt to these and other changes.
4.3.5 Cost-Benefit-Principle
You wouldn’t do anything in your daily life with out first weighing the costs and the benefits.
Likewise, the benefits of performing an activity in an accounting system should be greater
than its costs.
For example, when you decided whether or not to report certain information, you have to
compare the benefits (its usefulness to decision making) and the costs (of computing,
personnel and other indirect costs).
4.4 SPECIAL JOURNALS AND SUBSIDIARY LEDGERS
4.4.1 Subsidiary Ledgers

When a business has so many customers and suppliers, a control account for Accounts
Receivable and a control account for Accounts Payable are established in the general ledger.
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But in addition to these, subsidiary ledger for receivables and payables may be added to the
accounting system to show the balances for each individual customer and supplier separately.
A control account is an account in the general ledger that shows the total balances of all the
subsidiary accounts related to it.
Subsidiary ledger accounts show the details supporting the related general ledger control
account balance. For example, the subsidiary (supporting) accounts for accounts Receivable
may be used to send out to each customer statements showing the balance they owe the
company.
A subsidiary ledger is therefore, a group of related accounts showing the details of the
balance of general ledger accounts.
Subsidiary ledgers are used to relieve the general ledger of a mass of detail. Thereby, the
general ledger trial balance is shortened. What’s more, having separate ledgers promotes the
division of labor as one employee can handle the control account while its subsidiary can be
assigned to another employee.
The relationship between a control account in the general ledger and its subsidiary accounts
can be illustrated as follows in T- account form.
Control account in the Subsidiary accounts in the

General Ledger Accounts Receivable subsidiary
Ledger
Accounts Receivable Customer A Customer B
2001 2001 2001
Dec. 31 Dec. 31 Dec. 31
Bal. 10,000 Bal. 1,000 Bal. 4,000
Customer C Customer D
2001 2001
Dec. 31 Dec. 31
Bal. 2,000 Bal 3,000
As you can see the sum of all balances in the subsidiary accounts (1,000 + 2,000 + 4,000 +
3,000) on December 31, 2001 is equal to the balance in the control account (10,000).
When a transaction is recorded as a journal entry, it must indicate which of the subsidiary
ledger accounts is affected. Posting will be made to both the control account and the
subsidiary ledger account.
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Example
A Br. 450 sale was made on account to Gome Balcha on January 2, 20X2. The journal entry
would be:
Jan. 2 Accounts Receivable-Gome……………… 450
Sales……………………………………..450
The Br. 450 would be posted as a debit to both the Account Receivable control account in the
general ledger and G.Balcha’s account in the subsidiary ledger. The credit would, of course,
be to the Sales account in the general ledger.
The following can be a summary of what’s discussed above:
General ledger
Control Account Subsidiary ledger
Accounts Receivable Accounts Receivable subsidiary
Ledger (account for each customer)
Accounts Payable Accounts Payable subsidiary
Ledger (account for each supplier)
Office Equipment, Equipment subsidiary ledger
Delivery Equipment, (Account for each item of
Office Furniture equipment).
4.4.2 Special Journals

A general journal is an all-purpose journal where we can record any transaction. However, as
the transactions of a company increase, it is better to use special journals along with the
general journal to record transactions of similar type in one, such as sales on account or cash
payments. Special journals record transactions of a similar nature.
Special journals are designed to systematize the original recording of major transactions,
which occur very repeatedly.
The number and format of special journals used by a company depends on the nature and size
of the company’s business transactions.
The following are some of the typical examples of special journals used by most
merchandising businesses.
1. Sales Journals for 2. Cash Receipt journal

recording credit sales. for recording cash
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4. Cash payment journal
3. Purchase journal
for recording cash
for recording credit
4.4.2.1 ADVANTAGES OF USING SPECIAL JOURNALS
A- TIME IS SAVED IN JOURNALIZING. THE AMOUNT OF WRITING IS
REDUCED BECAUSE IT IS NOT NECESSARY TO REPEAT THE ACCOUNT
TITLES PRINTED ALREADY AT THE TOP OF THE SPECIAL COLUMNS FOR
EVERY DEBIT AND CREDIT.
B- TIME IS SAVED IN POSTING- MANY AMOUNTS ARE POSTED AS COLUMN
TOTALS RATHER THAN INDIVIDUALLY.
C- Detail is eliminated from the general ledger column. Totals are posted to the ledger
means that detail is left in the special journals.
D- DIVISION OF LABOR IS PROMOTED. SEVERAL PERSONS CAN WORK
SIMULTANEOUSLY ON THE ACCOUNTING RECORDS. THIS ALLOWS
MANAGEMENT TO FIX RESPONSIBILITY AND QUICKLY LOCATE ERRORS.
E- Management analysis is aided. The special journal can be useful to management in
analyzing classes of transactions, such as sales, because similar transactions are in one
place.
4.4.2.2 Sales Journal
The sales journal is used to record sales of merchandise on credit; sales on cash are
recorded in a cash receipts journal. Sales of assets other than merchandise on credit are
recorded in the general journal.
Each transaction recorded in the sales journal has a debit to Accounts Receivable and a credit
to Sales. Therefore, only one column is needed for these two accounts. The posting reference
(P/R) column is not used when transactions are recorded; instead this column is used when
posting.
Posting
Sales journal entries are posted as shown with the arrow line in the illustration. Individual
transactions in the sales journal are posted regularly (daily) to subsidiary customer accounts in
the accounts receivable subsidiary ledger. These postings keep customer accounts up to date.
THE SALES JOURNALS AMOUNT COLUMN IS TOTALED AT THE END OF THE
PERIOD. THE TOTAL IS DEBITED TO ACCOUNTS RECEIVABLE AND
CREDITED TO SALES.
THE OTHER SPECIAL JOURNALS ARE ILLUSTRATED BELOW. THEIR

OPERATION IS ALMOST SIMILAR TO THE SALES JOURNAL.
Albert Co.
4. 5 Computer technology and Accounting systems
Computer technology can be divided into two broad categories: hardware and software.
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Computer hardware-is the physical equipment in a computerized accounting information
system. The physical equipment includes processing units, hard drives, modems, monitors,
printers, etc.
Computer software- is the program that directs the operation of computer hardware.
Peachtree and Sun system are some example of accounting software that help to process
information.
Computer technology reduces the time and effort devoted to record keeping tasks.
Accountants can now concentrate on analysis and managerial type decisions and work with
less effort directed at record keeping tasks.
One added advantage of a computerized accounting system (as opposed to a paper-based

manual system) is that various computers in an organization can be networked. Networking
means linking or connecting computers with each other to give different users and different
computers access to a common database and programs.
4.6 SUMMARY
Although accounting systems vary from business to business the broad principles discussed in
this unit apply to all systems.
These principles are the control, relevance, compatibility, flexibility and cost -benefit
principle.
1. Assuming the use of a two-column general journal, a purchase journal and a cash
payments journal, indicate the journal in which each of the following transactions should
be recorded:
a) Payment of cash on account to creditor
b) Purchase of office supply on account
c) Purchase of merchandise for cash
d) Return of portion of merchandise bought in ‘c’
e) Purchase of store equipment on account
f) Withdrawal of cash by owner
4.8 GLOSSARY
General ledger -the principal ledger that contains all the balance sheet and income statement
accounts.
Controlling Account- a summarizing account in the general ledger, which represents a
summary of subsidiary accounts.
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Subsidiary ledger - a group of accounts, which contain detail regarding a controlling,
account.
Purchaser journal - a special journal for recording purchase of merchandise or other items
on account.
Cash payment journal- a special journal for recording payments of cash for any purpose.
Sales journal - a special journal for recording sale of merchandise on account.
Cash Receipts journal- a special journal for recording receipt of cash from any source.
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4. 9. INTERNAL CONTROL
A company’s internal control structure consists of the policies and procedures established to
insure that the company’s goals will be achieved.
As a company grows in size, it becomes difficult to maintain control over all phases of
operation. Therefore, management needs to delegate authority and rely on the control
structure in order to achieve adherence to enterprise goals.
4.10 THE PURPOSE OF INTERNAL CONTROL
Managers use an internal control system to monitor and control business operations. An
internal control system is all the policies and procedures managers use to:
 Protect business assets from theft and misuse. For example, what can be done to
protect cash from theft and misuse?
 Ensure reliability of accounting records. That is, how reliable and accurate are our
records and reports regarding Accounts Receivable, for instance.
 Promote efficiency of operation. Efficiency means achieving organizational goals by
using as minimum resources as possible.
 And make employees adhere to company policy.
4.11 COMPONENTS OF INTERNAL CONTROL

The internal control structure can be divided in to three elements?
4.11.1 The Control Environment
The control environment of an organization represents the overall attitude and awareness of
both management and employees about the importance of controls.
The control environment is influenced by such factors as management’s philosophy &
operating style, the organizational structure of the business and personnel policies.
4.11.2 The Accounting System
The accounting system consists of the methods and records established by management to
identify, record, process and report a company’s transactions, and to provide assurance that
the objectives of internal control are being met.
4.11.3 Control Procedures
Internal control procedures vary from company to company. They depend on the nature of the
business and of its size.
The following are common procedures that you find in the internal control of many
organizations.
4.11.3.1 Requiring Authorization
Management should properly authorize all transactions and activities before they take place.
For example, selling on credit requires management’s approval.
4.11.3.2 Establishing Responsibility
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Proper internal control requires responsibility for each task to be clearly established and
assigned to one person. Otherwise, if responsibility is not identified, it is difficult to say who
is at fault (responsible) when a problem occurs.
For example, if we allow two sales clerks to share access to (use) the same cash register, it
would be difficult to take which sales clerk accountable when and if there is a cash shortage.
4.11.3.3 Maintaining Adequate Records
Reliable records are a source of information that management uses to monitor company
operations. For example, when detailed records of office equipment are kept, items are
unlikely to be lost or stolen with out the discrepancy being noticed.
4.11.3.4 Insuring Assets and Bonding Key Employees
Good internal control dictates that assets be adequately insured against causality. In addition,
employees handling cash should be bonded. Bonding an employee means buying an insurance
policy against losses from theft by that employee.
4.11.3.5 Separating Record Keeping From Custody of Assets
A person who controls or has access to an asset must not keep that asset’s accounting records.
This prevents the loss of the asset from theft because the person who has control over the
asset knows that another person keeps records of the asset. The record keeper doesn’t have
access to the asset and therefore, has no reason to falsify records.
For a fraud to be committed in such a system, the two people must agree (-this is called
collusion). Collusion is usually less likely to occur.
4.11.3.6 Dividing Responsibility for Related Tasks (transactions)
In order to ensure that the work of one employee serves as a check on another, responsibility
for a series of related transactions should be divided between two or more individuals (or
employees) or departments.
This is usually referred to as segregation of duties.
For example, no one individual should be authorized to order merchandise, to receive
merchandise, and to pay the supplier. If one employee is allowed to do these all by herself
(alone), she can place orders with a supplier on the basis of friendship rather than price and
quality; convert goods to her personal use; pay false invoices; and so forth.
4.11.3.7 Rotating Duties
It is advisable to rotate clerical personnel periodically from job to job. This would help them
broaden their understanding of the system. In addition and more importantly, they know that
others would in the future perform their jobs (when rotated). This discourages them to deviate
from prescribed procedures because they fear that the employee who takes up their job will
discover it.
4.11.3.8 Applying Technical Controls

Cash register, check protectors, time clocks, mechanical counters, and personal identification
scanners are examples of control devices that can improve internal control.
A cash register has a locked in tape or electronic file, which makes record of each cash sale.
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A check protector perforates the amount written on a check in to its face and makes it difficult
to change the amount.
A time clock registers the exact time an employee arrives and leaves from the job.
Mechanical change and currency counters quickly and accurately count amounts.
Personal scanners limit access to some places only to authorized individuals.
4.11.3.9 Performing Regular and Independent Reviews
Regular reviews of internal control systems are needed to ensure that procedure are followed.
Internal auditors who are not directly involved in the operations of the business usually
perform these reviews. This encourages an evaluation on the efficiency and effectiveness of
the internal control system.
4.12 TECHNOLOGY AND INTERNAL CONTROL

Technology impacts an internal control system in many important ways. Some of these are:
 Technologically advanced systems allow saving time in processing information.
 They allow a regular review and more extensive testing of records as information can
be easily and rapidly accessed.
 Technologically advanced systems reduce the number of errors in processing
information provided the software and data entry are correct.
 They are so efficient these days that they require fewer employees. This makes
separation of crucial responsibilities difficult. The duties of these employees,
therefore, must be monitored to minimize the risk of error or fraud.
4.13 LIMITATIONS OF INTERNAL CONTROL

No internal control system is perfect. The most serious limiting factors are human error and
human fraud.
Human error can occur from negligence, fatigue or confusion. Human fraud involves a
deliberate act by employees to defeat internal controls for personal gains.
Another important limiting factor of an internal control system is the cost-benefit
consideration. This means that the cost of an internal control system must not exceed its
benefits.
We can’t employ an internal control system simply because it is good. We have to weigh its
costs against its benefits.
For instance, not all companies need to computerize their accounting system if the cost of
automating the system is greater than the benefits.
4.14 SUMMARY
Internal control consists of the control environment, the accounting system and control
procedures that work in line with the company’s policy to:
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 Protect assets from fraud and misuse
 Ensure completeness and reliability of financial statements
 Ensure efficiency of operations and
 Ascertain every employee adheres to the company’s policies
1. Write brief answers for the following questions.

a. What are the main objectives of internal controls and how are these objectives
achieved?
b. Why should record keeping for assets be separated from custody over the assets?
1. Musina is a government owned public enterprise that is growing rapidly. The
organization’s bookkeeper left town suddenly after the manager discovered that a large
sum of money has disappeared over the past 18 months. An audit showed that the
bookkeeper has written and signed several checks in the name of his fiancé and then
recorded the payments as salary expense. His fiancé, who cashed the checks but never
worked for Musina, also left town with the bookkeeper.
Evaluate Musina’s internal control system. Which principles (procedures) of internal

control seem to have been ignored?
Collusion - agreement between two or more employees to commit fraud.
Segregation of duties - assigning responsibility of related tasks to various employees.
Control procedures- the various ways through which an organization tries to protect fraud
and achieve other internal control objectives.
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unit 7. cash
CONTENTS
7.0 Aims & Objectives
7.1 Introduction
7.2 Meaning of Cash
7.3 Characteristics of Cash
7.4 Management of Cash
7.5 Internal Control of Cash
7.5.1 Control of Cash Through Bank Accounts
7.5.1.1 Reconciliation of Bank and Book cash Balances
7.5.1.2 Steps in Preparing Bank Reconciliation
7.5.1.3 Illustration of Bank Reconciliation
7.5.2 Petty Cash Fund
7.5.2.1 Establishment of Petty Cash
7.5.2.2 Replenishment of Petty Cash
7.5.3 Voucher System
7.5.4 Change Fund
7.5.5 Cash Short and Over
7.6 Summary
7.7 Answer to Check Your Progress Exercise
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7.8 Model Exam Questions
7.9 Glossary
7.0 AIMS & OBJECTIVES
In this unit, internal control of cash, the accounting for cash transactions and other aspects
will be discussed. After you have studied this unit, you should be able to:
- define cash
- identify the with composition of cash
- explain the objectives of cash management
- prepare a bank reconciliation
- understand the internal control of cash
7.1 INTRODUCTION
Since cash is the asset most likely to be used improperly by employees, exposed for
embezzlement and many business transactions either directly or indirectly affect it, it is
therefore necessary to have effective control of cash.
7.2 MEANING OF CASH
Cash includes money on deposit in banks and other items that a bank will accept for
immediate deposit. Money on deposit in banks includes checking and saving accounts. Other
items such as ordinary checks received from customers, money orders, coins and currency and
petty cash also are included as cash. Banks do not accept postage stamps, travel advances to
employees, notes receivable or post-dated checks as cash.
7.3 CHARACTERISTICS OF CASH
The following are some of the characteristics of cash:

a) Cash is used as medium of exchange
b) Cash is the most liquid asset
c) Cash is mostly affected by business transactions
d) Cash is used to measure the value of other assets
e) Cash is mostly exposed to embezzlements
7.4 MANAGEMENT OF CASH
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Cash management refers to planning, controlling and accounting for cash transactions and
cash balances. Efficient management of cash is essential to the survival and success of every
business organization. Managing cash requires planning wisely so that there will not be
excess cash held on hand at any point in time; or there is no shortage of cash at any point in
time to meet the business’s needs.

1. Define cash as it is used for accounting purpose.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
2. Which of the following items should not be included as cash?

a) Ordinary checks
b) Post-dated checks
c) Cash deposited in saving accounts
d) Postage stamps
e) Deposits in checking accounts
7.5 INTERNAL CONTROL OF CASH
The need to safeguard cash is crucial in most businesses because cash is mostly exposed to
embezzlement. Firms address this problem through the internal control system. An internal
control system is a set of policies and procedures designed to protect assets, provide accurate
accounting records and evaluate performances.
A sound internal control system for cash increases the likely hood that the reported values for
cash are accurate.
Internal control for cash should include the following procedures:

a) The individuals who receive cash should not also disburse (pay) cash
b) The individuals who handle cash should not access accounting records
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c) Cash receipts are immediately recorded and deposited and are not used directly to
make payments.
d) Disbursements are made by serially numbered checks, only upon proper authorization
by someone other than the person writing the check
e) Bank accounts are reconciled monthly.
The following are the most common elements of cash control and managements: bank
account system, petty cash fund, voucher system, change fund, and cash short and over.
7.5.1 Control of Cash Through Bank Accounts

Bank accounts are one of the most important means of controlling cash that provide several
advantages such as:
- Cash is physically protected by the bank,
- A separate record of cash is maintained by the bank,
- And customers may remit payments directly to the bank.
If a company uses a bank account, monthly statements are received from the bank showing
beginning and ending balances and transactions occurring during the month including checks
paid, deposits received, and service charges. These monthly statements (reports) received
from the bank are called bank statements. Bank statements generally are accompanied by
checks paid and charged to the accounts during the month, debit and credited memos, which
inform the company about changes in the cash accounts. For a bank, the depositor’s cash
balance is a liability, the amount the bank owes to the firm. Therefore, a debit memo describes
the amount and nature of decrease is the company’s cash accounts. A credits memo indicates
an increase in the cash balance of the depositor that it has with the bank.
7.5.1.1 Reconciliation of Bank and Book Cash Balances

Monthly reconciling of the bank balance with the depositor’s cash accounts balance is
essential cash control procedure. To reconcile a bank statement means to verify that the bank
balance and the accounting records of the depositor are consistent. The balance shown in a
monthly bank statement seldom equals the balance appearing in the depositor’s accounting
records. Certain transactions recorded by the depositor may not have been recorded by the
bank and vice versa.
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The most common examples that cause disparity between the two balances are:
a) Outstanding checks:
Checks issued and recorded by the company, but not yet presented to the bank for
payment.
b) Deposits in transit:
Cash receipts recorded by the depositor, but not reached the bank to be
included in the bank statement for the current month.
c) Service charges:
Banks often charge a fee for handling checking accounts. The amount of this charge is
deducted by the bank form bank balance and debit memo is issued for the depositor.
d) Charges for depositing NSF- checks:
NSF stands for “Not Sufficient Funds.” When checks are deposited in an account,
the bank generally gives the depositor immediate credit. On occasion, one of these
checks may prove to be uncollectible because the maker of the check does not
have sufficient funds in his or her account. In such a case, the bank will reduce the
depositor’s account by the amount of this uncollectible item and return the check
to the depositor marked “NSF”.
e) Notes collected by bank:
If the bank collects a note receivable on behalf of the depositor, it credits the
depositor’s account and issues a credit memorandum for the depositor.
When the depositor prepares bank reconciliation, the balances shown in the bank statement
and in the accounting records both are adjusted for any unrecorded transactions. Additional
adjustments may be required to correct any errors discovered in the bank statements or in the
accounting records.
7.5.1.2 Steps in Preparing Bank Reconciliation

A bank reconciliation is a schedule prepared by the depositor to bring the balance shown in
the bank statement and the balance shown in the depositor’s accounting into agreement.
The steps to prepare a bank reconciliation are:
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a) The deposits listed on the bank statement are compared with the deposits shown in the
accounting records. Any deposits not yet recorded by the bank are deposits in transit
and should be added to the balance shown in the bank statements.
b) The paid and received checks from the bank are compared with the check stubs. Any
checks issued but not yet paid by the bank are outstanding checks and should be
deducted from the balance reported in the bank statements.
c) Any credit memorandums issued by the bank that have not been recorded by the
depositor, are added to the balance per depositor’s record.
d) Any debit memorandums issued by the bank that have not been recorded by the
depositor are deducted from the balance per depositor’s record.
e) Any errors in the bank statement or depositor’s accounting records are adjusted.
f) The equality of adjusted balance of statement and adjusted balance of the depositor’s
record is compared.
g) Journal entries are prepared to record any items delayed by the depositor.
7.5.1.3 Illustration of Bank Reconciliation
The January bank statement sent by Awash Bank to RAM Company shows Br. 4,262.83.
Assume also that on January 31, 2000, the Cash account of RAM Co. shows a balance of Br.
5,000.17. The accountant of RAM Company has identified the following items:
1. A deposit of Br. 410.90 made after banking hours on Jan. 31 does not appear on the
bank statement.
2. Two checks issued in January have not yet been paid by the bank:
Check No. 301 Br. 110.25
Check No. 342 607.50
3. A credit memorandum was included in the bank statement, which was for proceeds
from collection of a non-interest bearing note receivable from MAN company Br.
524.74.
4. Three debit memorandums accompanied the bank statement: Fee charged by bank for
handling collection of notes receivable Br.5; a check of Br. 50.25 received from a
customer, RON company, and deposited by RAM company was charged back as NSF;
and service charge by bank for the month of January amounts to Br. 12.00.
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5. Check No. 305 was issued by RAM Company for payment of telephone expense in the
amount of Br. 85 but was erroneously recorded in the cash payments journal as Br. 58.
The January 31 bank reconciliation for RAM Company is shown below:
RAM Company
Bank Reconciliation
January 31, 2000
Balance per bank statement, Jan. 31,2000 Br. 5,000.17

Add: Deposit of Jan. 31 not recorded by bank 410.90
Subtotal Br. 5,411.07
Deduct: outstanding checks:
No. 301 Br. 110.25
No. 342 607.50 117.75
Adjusted cash balance Br. 4,693.32
Balance per depositor’s record, Jan. 31,2000 Br. 4,262.83

Add: Note Receivable collected by bank 524.74
Subtotal Br. 4,787.57
Deduct: collection fee Br. 5.00
NSF check of Ron Co. 50.25
Service charge 12.00
Error on check stub No. 305 27.00 94.25
Adjusted cash balance Br. 4,693.32
The following are journal entries related to the bank reconciliation.
2000
Jan. 31 cash 524.74
Notes Receivable 524.74
To record collection of Note Receivable
collected by bank
31 Miscellaneous Expense 17.00
Accounts Receivable-RON Co. 50.25
90
Utilities Exp. 27.00
Cash 94.25
To record bank service charges,
NSF check and error in recording
Check No. 305

1. Briefly explain the basic purpose of a bank reconciliation.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
2. Define the following terms related to the accounting for cash:

a) Outstanding checks
……………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
……
b) Deposit in transit
……………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
……
c) NSF- check
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
3. Which of the reconciling items necessitate an entry in the depositor’s accounts?

a) Deposit in transit
b) Outstanding checks
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c) Note collected by bank
d) Bank service charge
7.5.2 Petty Cash Fund

Petty cash fund, which is part of the total cash balance, is used to handle many types of small
payments such as employee transportation costs, purchase of office supplies, purchase of
postage stamps, and delivery charges. Many businesses find it convenient to make minor
expenditures instead of writing checks. The petty cash amount various from Br. 50 or less to
more than Br. 1,000, which will cover small expenditures for a period of two or three weeks.
7.5.2.1 Establishment of Petty Cash
To establish a petty cash fund a check is issued to a bank. This check is cashed and the money
is kept on hand in a petty cash box. One employee is designated as custodian of the fund. The
issuance of the check for establishment is recoded by debiting petty cash account and
crediting cash.
7.5.2.2 Replenishment of Petty Cash

During the period, the custodian makes small payments form the petty cash fund and obtains a
receipt or prepares a petty cash voucher. This petty cash voucher explains the nature and
amount of every expenditure and is kept with the fund. When the fund runs low or at the end
of the company’s fiscal period, a check is issued to reimburse the fund for the expenditures
made during the period. The issuance of this check is recorded by debiting the appropriate
expense accounts and crediting cash or vouchers payable.
7.5.3 Voucher System

One method to control cash disbursements is a voucher system. A voucher is a special form,
which contains relevant data about a liability and its payment.
In a voucher system, a voucher is prepared for each expenditure and approved by the
designated officials. Each approved voucher represents liability and recorded in a voucher
register, which is similar to purchases journal. Those registered vouchers are filed according
to their payment date in an unpaid vouchers file. The vouchers and supporting documents then
92
are sent to the treasure or other official is the finance department before issuing checks. When
the checks are signed, the paid vouchers are recorded in a check register which is similar to
cash payments journal. Those paid vouchers are filed in paid vouchers file according to their
serial number for future reference.
7.5.4 Change Fund

Some businesses that receive cash directly from customers should maintain a fund of currency
and coins in order to make change (Amharic=>”zirzir”). This fund, which is part of the total
cash balance, is called change fund. A change fund is established by issuing a check to the
bank and transferring the cash to the custodian. The issuance of a check to establish a change
fund is recorded by debiting cash on hand and crediting cash or voucher payable.
Once a change fund is established, there will be no change in its balance unless there is a
decision by management to increase or decrease the fund balance.
7.5.5 Cash Short and Over

In handling cash receipts from daily sales, a few errors in making changes will occur. These
errors may cause a cash shortage or overage at the end of the day. The account cash short and
over is debited if there is shortage and credited if there is overage. At the end of the period if
the account had a debit balance, it appears in the Income statement as miscellaneous expense;
if it has a credit balance, it is shown as miscellaneous revenue.
For example, assume that the total cash sales recorded during the day amounts to Br. 12,420.
However, the cash receipts in the cash register drawer (actual cash count) total Br. 12,415.
The following entry would be made to adjust the accounting records for the shortage in the
cash receipts:
Cash Short and Over 5.00

Cash 5.00
To record a Br. 5.00 (Br. 12,420 – 12,415)
Shortage in cash receipts for the day
Check Your Progress Exercise-3

1. The petty cash account has a debit balance of Br. 200. At the end of the accounting
period, there is Br. 160 in the petty cash fund along with petty cash receipts totaling Br.
40. Should the fund be replenished as of the last day of the period? Why?
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…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
2. In what order are vouchers ordinarily filed

A) In the unpaid voucher file
B) In the paid voucher file
3 In which section of the Income statement would a credit balance in cash short and over be
reported?
7.6 SUMMARY
1. Cash includes only those items immediately available to pay obligations.

2. The objectives of cash management are accurate accounting for cash transactions, the
prevention of losses through theft or fraud, and maintaining adequate cash balances.
3. The bank reconciliation adjusts the cash balance per book and the cash balance per
bank statement for any unrecorded items such as outstanding checks and bank service
charges.
4. Bank reconciliation produces the correct amount of cash to be included in the balance
sheet at the end of the month.
5. A company may use a petty cash fund to make small payments that occur frequently,
as payment by check would cause delay and excessive expense of maintaining records.
6. One of the best systems for establishing control of cash payments is the use of a
voucher system. A voucher system uses vouchers, a voucher register, a file for unpaid
vouchers, a check register and a file for paid vouchers.
7.7 ANSWER TO CHECK YOUR PROGRESS EXERCISES

1. Cash includes all the items that are accepted for deposit by a bank, notably paper
money and coins, money orders, and checks.
2. a) Post-dated checks
94
b) Postage stamps

1. The basic purpose of a bank reconciliation is to achieve the control inherent in the
maintenance of two independent records of cash transactions; one record maintained
by the depositor and the other by the bank. When these two records are reconciled
(brought into agreement), we gain assurance of a correct accounting for cash
transactions.
2. a) Checks issued that have not been paid by the bank.

b) Deposits not recorded by the bank.
c) A customer’s check which was deposited but returned because of a lack of funds in
the account on which the check was drawn (in the customer’s bank account).
d) Note collected by bank
e) Bank service charge

1. Yes. To record the unrecorded expenditures of Br. 40 at least by the end of the fiscal
period
2. a) According to the earliest date
b) In numerical order
3. In miscellaneous revenue section of Income statement
Part I. Short answer questions

1. In general terms, in which section does cash, appear on the balance sheet?
2. Explain some measures that strengthen internal control over cash receipts and payments.
3. What is the basic control feature in a voucher system?
4. List two items often encountered in reconciling a bank account that may cause cash per the
bank statement to be larger than the balance of cash shown in the depositor’s accounting
records.
Part II. Work Out Questions
95
1. Shown below is the information needed to prepare a bank reconciliation for MITE
company at December 31.
a) At December 31, cash per the bank statement was $ 15,981; cash per the
company’s records was $ 17,445.
b) Two-debit memorandum accompanied the bank statement: service charges for
December of $ 24, and a $ 600 check drawn by RAMI marked ‘NSF’.
c) Cash receipts of $ 4,353 on December 31 were not deposited until January.
d) The following checks had been issued in December but were not included
among the paid checks returned by the bank: no. 620 for $ 978, no. 630 for $
2,052, and no. 641 for $ 483.
Required:
i) Prepare a bank reconciliation at December 31
ii) Prepare the necessary journal entry or entries to update the accounting records
based on the reconciliation.
2. RAM Company maintains its checking account with the Commercz Bank. The
company is ready to prepare its December 31 bank reconciliation. The following data are
available:
a) The November 30 bank reconciliation showed the following:
1) Cash on hand (held by RAM company for day to day minor
expenses), Br. 400 (included in RAM’s cash account)
2) Deposit in transit, Br. 2,000, and
3) Checks outstanding: N0. 121 Br. 1,000
No. 130 2,000
No. 142 3,000
b) Bank Statement, December 31:
 Balance, December 31 Br. 67,600
 Deposits: 188,500
 Checks: No. 130, Br. 2,000; N0. 142, Br. 3,000;
N0. 143 – 176, Br. 191,000 (196,000)
 Note collected for RAM company (including
Br. 720 interest) 16,720
96
 NSF check, customer Binda (250)
 Bank service charges (20)
 Balance, December 31 Br. 76,550
Required:
i) Determine deposit in transit and checks outstanding
ii) Prepare the December 31 Bank reconciliation
iii) Based on your bank reconciliation, give all journal entries that should be made at
December 31.
Bank reconciliation: a schedule that explains the difference between the balance of cash
shown in the bank statement and the balance of cash shown in the depositor’s records.
Cash: money on deposit in banks and other items that a bank will accept for immediate
deposit.
Cash management: planning, controlling, and accounting for cash transactions and cash
balances.
Petty cash: small amount of cash, which is used to make small payments that occur
frequently.
Voucher: a written authorization used in approving a transaction for recording and payment.
Voucher system: an accounting system designed to provide strong internal control over cash
disbursements.
97
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UNIT 1.

But to take advantage of these, we need knowledge of information systems.

An information system is the collecting, processing, and reporting of information to decision

The kind of information processed in accounting is financial i.e. of a monetary nature.

This course discusses the fundamental principles involved in processing accounting

Understanding these fundamental principles is very important because forthcoming courses

Tilahun T. 2014/2015 Page 1

1.2.1. Accounting Defined

Let’s take a closer look at the activities involved in the process:

A Vital element in communicating economic events is the accountant’s ability and

Tilahun T. 2014/2015 Page 2

1.2.2 Importance of Accounting and Users of Accounting Information

1.3 BOOKKEEPING VERSUS ACCOUNTING

A person might become a reasonably proficient bookkeeper in a few weeks or months;

Check Your Progress Exercise -1

Tilahun T. 2014/2015 Page 3

1) External Users: External Users of accounting information are

- The area of accounting aimed at serving external users is called Financial

b) Share- holders (Stockholders)

Tilahun T. 2014/2015 Page 4

c) Employees and labour Unions

2) Internal Users: These are persons that are directly involved in

 What are manufacturing costs per product?

1.4 THE ACCOUNTING PROFESSION

Tilahun T. 2014/2015 Page 5

ii) Private Accounting

2. Budgeting: Assisting management in quantifying goals concerning revenues,

3. General Accounting: recording daily transactions and preparing financial

4. Accounting information systems: designing both manual and computerized

5. Tax Accounting: preparing tax returns (-forms to be filled by a company and

6. Internal Auditing: reviewing a company’s operations to determine

iii) Not for Profit Accounting

Tilahun T. 2014/2015 Page 6

2. _____________is the area of accounting aimed at serving external users of accounting

3. _____________ is the area of accounting aimed at serving the decision-making needs

4. What are the three major fields of engagement for accountants?

1.5. ACCOUNTING PRINCIPLES AND CONCEPTS

i) Business Entity Concept

Tilahun T. 2014/2015 Page 7

ii) The cost principle

Check Your Progress Exercise -3

1. The abbreviation GAAP stands for ____________________________.

1.6 FORMS OF BUSINESS ORGANIZATIONS

Tilahun T. 2014/2015 Page 9

1.7 BUSINESS TRANSACTIONS AND THE ACCOUNTING EQUATION

A transaction can be an exchange (such as the purchase or sale of property, payment or

For a given transaction to qualify to be recorded it has:

1.7.1 Assets, Liabilities and Owner’s Equity

Tilahun T. 2014/2015 Page 11

Economic Resources = claims over the resources

It is customary to place “liabilities“ before “Owners equity” in the accounting equation

Tilahun T. 2014/2015 Page 12

Check Your Progress Exercise -4

1 Business organizations are classified in to three, based on what?

2 What do we mean by the term ‘unlimited liability’?

4 ___________________ represents the claim of owner’s against assets of the business

Tilahun T. 2014/2015 Page 13

8 Define a business transaction, and give at least four examples.

1.7.2 Transactions and the Accounting Equation