UNITYUNIVERSITY

College of Business, Economics & Social Sciences

Department of Accounting & Finance

Module for:
Fundamentals of Accounting I

Pre- Requisite: None

Course Title: Fundamentals of Accounting I

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Course Number: ACFN______________

Dear students well come to unity university. This is your first accounting course. The course
deals with the meaning of business, importance of accounting for business, the relevance and
types of standards used in the accounting profession, the accounting system and its application in
capturing business events for a merchandising and service giving enterprises, and accounting for
cash and receivable.

Let me tell you a secret, to be successful in accounting courses the short cut is to understand this
course well. If you are truly determined to do so be sure you are laying a strong base to easily
understand the subsequent advanced courses. To be successful in this course give special
attention and more effort for the first two chapters. Thechapter opens a door for you to clears
with the fundamental concept of accounting and its application.

Course Objectives

The course has the general objective of introducing students to the basics of accounting and
reporting of financial activities of business organizations as per International Financial
Reporting Standards. Upon the successful completion of this course, the students will be
expected to:
 Understand the role of Accounting in business and develop an awareness of the accounting
profession
 Understand the purpose of the financial accounting function and standard financial
accounting practices
 Summarize and apply basic financial accounting terms, concepts, and principles.
 Define and apply accounting terminology, concepts, and principles in analyzing, recording,
and reporting basic business transactions
 Take a series of transactions through the accounting cycle
 Analyze, record, and report transactions for service, merchandising, and manufacturing
businesses.
 Prepare financial statements
 Analyze accounting system design and control
Apply accounting principles and control of cash and receivables

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Grading

- Attendance ………………………………... 5%
- Assignment( Individual and Group)……….15%
- Test ……………………………………...…25%
- Final Exam ……………………..………… 50%
- Total………………………………………. 100%

Text Books

- J. Weygandt, D. Kemmel and D. Kieso,(2012), Accounting Principles: 10th Edition,

John Wiley and Sons, inc. (ISBN 13 978-0-470-53479-3.
- Kieso, D. E., Weygandt, J. J., & Warfield, T. W. (2016). Financial Accounting, IFRS Edition,
New York: John Willey & Sons.
Additional Materials for Reading

- S. Warren, M.Reeve and E. Duchac (2009), Accounting: 23th Edition, South-Western

Cengage Learning, ISBN 13: 978-0-324-66296-2.
- Principles of Accounting I for distance education
- Commercial code of Ethiopia
- Any Accounting books published as per IFRS

Individual assignments

Instructions: - Record business transactions for:

i. A service business
ii. A Merchandising business

Specific Activity

- Prepare charts of account for your business

- prepare a three column general ledger account and open each account by writing the
name and number of the account on the first line of the ledger card.(record opening
balances if you have any)

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 - Write your one month events (Transactions) on a paper and journalize them
chronologically.
- Post each journal entry to the appropriate account in your ledger
- Prepare trial balance at the end of the month

Team Assignment

- Instructions
Complete the accounting cycles for a services giving and a merchandising business.
Due date (12th week) and (6th week for summer)

Specific activity

- Complete the 10 column work sheet.

- Journalize and post the adjusting and closing entry.
- Prepare the basic four financial statements on the last day of your monthly fiscal
- Prepare a post closing trial balance on the first day of the following fiscal period

CHAPTER ONE
INTRODUCTION TO ACCOUNTING AND BUSINESS
Overview of Chapter 1
The future story highlights the importance of having good financial information and knowing
how to use it to make effective business decisions. Whatever your pursuits or occupation, the
need for financial information is inescapable. You cannot earn a living, spend money, buy on

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credit, make an investment, or pay taxes without receiving, using, or dispensing financial
information. Good decision-making depends on good information.
The purpose of this chapter is to show you that accounting is the system used to provide useful
financial information. The core objectives and content of Chapter 1 are as follows.
1.0. Learning Objectives:
After completing this chapter the students should be able to:
- Understand the meaning of accounting
- Explain the main difference between bookkeeping and accounting
- Explain the nature and classification of business
- Identify the users and uses of accounting.
- Identify fields of accounting
- Understand the accounting profession
- Explain accounting standards and the measurement principles.
- Explain the monetary unit assumption and the economic entity assumption
- Analyze the effects of business transactions on the accounting equation.
- Understand about the four financial statements and how they are prepared.

Session 1(Hr 1and2)

Topic:- Nature Accounting and of Businesses
Session learning objective:
After completing this lesson you should be able to:
- Understand the meaning of accounting
- explain the main difference between bookkeeping and accounting
- Explain the nature and classification of business
1.1. Definition of Accounting
Thus, accounting can be defined as an information system that provides reports to users about
the economic activities and condition of a business. Accounting is a “language of business,”
through it businessescommunicated with information users.

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1.1.1. Activities of Accounting
Accounting consists of three basic activities—it identifies, records, and communicates the
economic events of an organization to interested users. Let’s take a closer look at these three
activities.
The first activity in the accounting process is identification of the economic events relevant to a
particular business. Purchase of school bus by Unity University, the provision of telephone
services by Ethio Telecom and Sale of food and beverages by Sheraton Hotel are examples of
business events.
Once identified, the economic events are recorded. Recording consists of keeping
a systematic, chronological diary of events, measured in monetary units. In recording,
economic events are also classified and summarized. (That will be discussed in chapter 2 of
this module)
Finally, the identified and recorded data are prepared in a standardized way and communicated  
to the interested users by means of accounting reports called financial statements. The
statements accumulate and aggregates information resulting from similar transactions as one
amount.By so doing the accounting process simplifies a multitude of transactions and makes a
series of activities understandable and meaningful.
Communicating economic events to users also requires the accountant’s ability to analyze and
interpret the reported information. Analysis involves use of ratios, percentages, graphs, and
charts to highlight significant financial trends and relationships. Interpretation
involves explaining the uses, meaning, and limitations of reported data. 
Dear students, at this point, the explanations about financial statements seem confusing and
complex. But by the end of this course, you’ll be able to easily understand, analyze, and
interpret them.

1.2. Overview of Business Organization and Accounting

1.2.1. Meaning of business in the Accounting Context
A business is an organization which is engaged in converting basic resources (inputs), such as
raw materials, labor (Physical and Mental effort of employees) into goods (cloths, tables,
computers and Automobiles) and services (transportation, banking, Education and health care
services) for sale on profit to customers. Businesses come in all sizes, that ranges from a small

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local commodity shop like Kedir Shop to big multinational businesses like Pepsi cola which
sales its products throughout the world.
The objective of businesses is to earn profit. Profit is the difference between the amounts
received from customers for goods or services and the amounts paid for the in-puts used to
provide the goods or services. In this module, we focus on businesses operating to earn a profit.
However there are also not-for- profit organizations such as hospitals, churches, and government
agencies which, convert inputs into goods and service for free delivery or at cost recovery to the
society without profit intention. These organizations will be fully addressed in your advanced
course known “Accounting for Governments and NFP organization”.
For accounting purposes, each business organization or entity has an existence separate from its
owner(s), creditors, employees, customers, and other businesses. This separate existence of the
business organization is known as the business entity concept. Thus, in the accounting records
of the business entity, the activities of each business should be kept separate from the activities
of other businesses and from the personal financial activities of the owner(s).

1.2.2. Forms and Types of Business Organizations in Ethiopia

There are three forms of business organizations: single-proprietorships, partnerships, and
corporations as briefly explained below:

There are three different legal forms of business organization: those are

1. Sole Proprietorship: -is a business owned and managed by single individual.

Advantages:
 Easy to establish the business
 Requires relatively small starting capital
 It is least regulated by government
 relatively long life
 No profit sharing
Disadvantages:

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  Limited capital to finance business operation
 Unlimited liability the owner is responsible to pay the debt of the business even from
his personal asset in case the business unable to meet its liability)
2. Partnership: - is business organization established by two or more persons.
Advantages:
 Easier and less expensive to establish than corporation
 Are not highly regulated by government
 More capital and managerial skill than a single proprietor ship
 Mutual Agency, sharing of responsibility and representing the business
Disadvantages:
 Limited life
 Unlimited liability (the partners are responsible to pay the debt of the business even
from their personal assets in case the business unable to meet its liability)
 Conflict between partners throughout operating the business.
 Relatively short life, can be dissolved because of partners disagreement
3. Corporation: - is a business organized as a separate legal entity under state corporation
law with ownership divided into transferable shares of stock.
Advantages:
 Long life
 Limited liability
 Can raise huge amount of capital to finance business operation
Disadvantages:
 Double taxation
 Highly regulated by government
 Difficulty of controlling management, because ownership and management is
divorced in corporation.
According to their type of activities or nature of operations, business organizations are also
classified in to three main types:

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 1. Service Rendering/giving Businesses: - are business organizations that are
predominantly engaged in rendering of services to customers for the purpose of
maximizing profit.
Examples: Hotels, restaurants, cafeterias, bars, transport and communication services,
professional firms like consultations by accountants, lawyers, engineers etc.
2. Merchandising businesses: - is profit seeking businesses, which are engaged in
purchasing and reselling of merchandises.
Examples:Super-markets, boutiques, garment and shoe shops, drug stores, stationary
shops, auto spare parts, importers, exporters etc.
3. Manufacturing businesses: - are business organizations that are primarily involved in
the conversion of raw materials and parts in to finished goods; and sale their finished
goods to merchandising enterprises and consumers. Sometimes, they sale goods to other
manufacturing firms, which utilize the goods as raw materials for production activities.
Examples: Cement factories, sugar factories, soap factories, textile factories, paper
factories, etc.

1.3. The Role of Accounting for Business

Accounting is often called “the language of business.” Because it communicatesso much of the
information that owners, managers, and investors need to evaluate a company’s financial
performance. These people are all stakeholders in the business—they’re interested in its activities
because they are affected by the business. In fact, the purpose of accounting is to help
stakeholders make better business decisions by providing them with financial information.
Obviously, no one tries to run an organization or make investment decisions without having
accurate and timely financial information. It is the accountant who prepares this information.

More importantly, accountants make sure that stakeholders understand the meaningof financial
information, and they work with both individuals and organizations to help them use financial
information to deal with business problems.

Actually, collecting all the numbers is the easy part—today, all the accountant have to do is start
up your accounting software. The hard part is analyzing, interpreting, and communicating the

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information. Now a day’s, accountants are required, to present everything clearly and
effectively in a way that has a predictive role to potential investors and decision makers from
every business discipline.

In any case, accounting is defined as the process of measuring and summarizing business
activities, interpreting financial information, and communicating the results to management
and other decision makers.

1.4. Book Keeping Vs Accounting

Accounting and Book keeping is to closely related activities. Both involves in recording business
transactions. Record keeping is the only task to bookkeepers, but one of the tasks to
accountants.Unlike bookkeeping the accounting process involves in a more detailed and
advanced professional activities, of designing the information system, analyzing and interpreting
the information of accounting. More over few days recording experience is enough for being
book keeper but being an accountant requires several years in-depth study and working
experience.
In general, Bookkeeping refers to the art of recording, in a prescribed and systematic way, the
economic activities of an organization. It is routine and clerical in nature. Accounting, on the
other hand, goes beyond bookkeeping and is concerned with
- Designing accounting and reporting systems
- Recording economic activities
- Preparing reports and statements
- Interpreting reported information and
- Reviewing records and reports for their accuracy.

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Synopsis of Lecture
 Accounting are identifying, recording, and communicating economic activities.
 Bookkeeping refers to the art of recording.
 Accounting refers to the art of recording, reporting, and interpreting economic events.
 Accounting is a language of business.
 A business is an organization which is engaged in rendering service or producing a
product for profit motive.
 Businesses can be categorized on the bases of ownership and activity.
 Based on ownership business are categorized into sole proprietorship, partnership and
corporation.
 Based on activity Businesses are categorized into service giving, Merchandising and
manufacturing.
 A business is an organization which is engaged in rendering service or producing a
product for profit motive

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  Businesses can be categorized on the bases of ownership and activity.
 Based on types of ownership business are categorized in to sole proprietorship,
partnership and corporation.
 Accounting is a language of business.
 Accounting are identifying, recording, and communicating economic activities.
 Bookkeeping refers to the art of recording where as Accounting refers to the art of
recording, reporting, and interpreting economic events.

Wrap-up discussion questions

 Distinguish between service and merchandising business
 Distinguish between bookkeeping and accounting company
 Explain accounting and its basic activity.
 Distinguish between service and merchandising business
 Distinguish between bookkeeping and accounting company
 Explain accounting and its basic activity

Next day’s Assignment

Read about fields of accounting
Session 2 (Hr 3 and 4)

Topic:- Fields of Accounting

Secession learning objective

 Identify fields of accounting

 Identify the users and uses of accounting.
 Understand the accounting profession

Reading Text:

1.5. Fields of Accounting

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Accountants typically work in one of the two major fields, namelyManagement accountants
and financial accountants. These basic categories farther decomposed in to various fields
which are maintained under the title “the Accounting Profession” below.

Managerial Accounting

Managerial accounting plays a key role in helping managers carry out their responsibilities.
Because the information that it provides is intended for use by people who perform a wide
variety of jobs, the format for reporting information is flexible. Since the reports are intended to
internal users they are not obliged to follow a uniform set of accounting standards and are
tailored to the needs of individual managers. The purpose of such reports is to supply relevant,
accurate, timely information in a format that will aid managers in making decisions. In
preparing, analyzing, and communicating such information, accountants work with individuals
from all thefunctional areas of the organization—human resources, operations, marketing, and
finance.

Financial Accounting

Financial accounting is responsible for preparing the organization’s financial statements.

Namelyincome statement, the statement of owner’s equity, the statements of financial
position, and the statement of cash flow. The statements summarizes a company’s past
performance and evaluates its current financial condition. The purpose of the report is to give
reliable, relevant and up-to-date information which serves to all external users. In preparing
financial statements, adherence to uniform set of accounting standards is mandatory. The
statements are general purposein nature and are not address the specific requirements of
individual users. I.e one type of income statement is prepared to serve different users like
investors, banks, government etc.
1.6. The Profession of Accounting
Why is accounting such a popular major and career choice? First, there are a lot of jobs. In recent
years, in our country Ethiopia, the demand for accountants highly increased because of the
increase in number of various businesses, the introduction of different tax laws like VAT, the

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change in accounting standard- IFRS, the emergence of different multinational organization and
the related reporting requirements, etc.
Accounting is also hot because it is obvious that accounting matters. Interest in accounting has
increased, ironically, because of the attention caused by the turmoil over toxic (misstated) assets
at many financial institutions. These widely publicized scandals revealed the important role that
accounting plays in society. Most people want to make a difference, and an accounting career
provides many opportunities to contribute to society. Finally, recent internal control requirements
dramatically increased demand for professionals with accounting training.
Accountants are in such demand that it is not uncommon for accounting students to have
accepted a job offer a year before graduation. As the following discussion reveals, the job options
of people with accounting degrees are virtually unlimited.
Public Accounting
Individuals in public accounting offer expert service to the general public, in much the same
way that doctors serve patients and lawyers serve clients.
A major portion of public accounting involves auditing. In auditing, an independent
accountant, such as a chartered accountant (CA) or a certified public accountant (CPA),
examines company financial statements and provides an opinion as to how accurately the
financial statements present the company’s results and financial position. Analysts,
investors, and creditors rely heavily on these “audit opinions,” which CAs and CPAs have
the exclusive authority to issue.
 Taxation is another major area of public accounting. The work that tax specialists
perform includes tax advice and planning, preparing tax returns, and representing
clients before governmental agencies.
 A third area in public accounting is management consulting. It ranges from
installing basic accounting software or highly complex enterprise resource planning
systems, to providing support services for major marketing projects and merger and
acquisition activities.

Many accountants are entrepreneurs. They form small- or medium-sized practices that frequently
specialize in tax or consulting services.

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Private Accounting
Instead of working in public accounting, you might choose to be an employee of a for-profit
company such as Unity University or Commercial Bank of Ethiopia (CBE).
In private (or managerial) accounting, you would be involved in activities such as cost
accounting (finding the cost of producing specific products), budgeting, accounting information
system design and support, and tax planning and preparation. You might also be a member of
your company’s internal audit team. In response to corporate failures, the internal auditors’ job of
reviewing the company’s operations to ensure compliance with company policies and to increase
efficiency has taken on increased importance.
Alternatively, many accountants work for not-for-profit organizations, such as the Mekodoniaya
Merja, International Red Cross or performing arts organizations.
Governmental Accounting
Another option is to pursue one of the many accounting opportunities in governmental agencies.
For example, tax authorities, law enforcement agencies, and corporate regulators all employ
accountants. There is also a very high demand for accounting educators at colleges and
universities and in governments.
Forensic Accounting
Forensic accounting uses accounting, auditing, and investigative skills to conduct investigations
into theft and fraud. It is listed among the top 20 career paths of the future. The job of forensic
accountants is to catch the perpetrators of theft and fraud occurring at companies. This includes
tracing money-laundering and identity-theft activities as well as tax evasion. Insurance
companies hire forensic accountants to detect insurance frauds such as arson, and law offices
employ forensic accountants to identify marital assets in divorces.

1.7. Users of Accounting Information

Users of financial information are categorized in to two, i.e., internal users and external users.

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1.7.1. Internal Users
Internal users of accounting information are managers who plan, organize, and run the
business. These include marketing managers, production supervisors, finance directors, and
company officers. Financial information show, for example, whether the company did or didn’t
make a profit, whether cash is adequate to make pay dividend, whether the company affords pay
raise to employee, etc. They also furnish other information that managers and owners can use in
order to take corrective action.
1.7.2. External Users
External users are individuals and organizations outside a company who are not directly
involved in running and organizing the business want financial information about the company
for their own purpose. External users include investors, creditors, government agencies and
others
Investors and Creditor
Investors and creditor are the two most common types of external users. Investors (owners) use
accounting information to make decisions to buy, hold, or sell ownership shares of a
company. Creditors such as bankers and suppliers use accounting information to evaluate the
risks of granting credit or lending money. 
If you lend money to a friend to start a business, wouldn’t you want to know how the business
was doing? Investors and creditors furnish the money that a company needs to operate, and not
surprisingly, they feel the same way. Because they know that it’s impossible to make smart
investment and loan decisions without accurate reports on an organization’s financial health, they
study financial statements to assess a company’s performance and to make decisions about
continued investment.
Government Agencies
Businesses are required to furnish financial information to a number of government agencies like
taxing authorities and regulatory agencies. The authorities want to know whether the company
complies with tax laws. Regulatory agencies want to know whether the company is operating
within prescribed rules.
Other Users
A number of other external users have an interest in a company’s financial statements.
Customers are interested in whether a company will continue to honor product warranties and

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support its product lines. Labor unions want to know whether the companies have the ability to
pay increased wages and benefits to union members.

NB: In general the information needs of internal users are supplied by both Financial and
Managerial accounting. Whereas the information needs of external users are satisfied only
by financial accounting.

Synopsis of Lecture

 Accounting generates information that brings a difference on the decision making of both
internal and external users.
 Internal Users are individuals within an organization or business entity that need
accounting information of the business for the affairs of the business.
 External Users are those individual or institutions inside or outside an economic entity
who/which need accounting information about that entity for their own affair.
 In dealing with a business accounting plays an important role in displaying operating
results of businesses, in analyzing and rating financial conditions, and in predicting their
futurity.
 Managerial accounting generates information for internal users where as financial
accounting generates information mainly for external users.
 The four basic category of the accounting profession are, public accounting, private
accounting, governmental accounting and forensic accounting.

Wrap-up discussion question

 Why is the profession of accounting required?

 Explain the users of accounting information.
 Which of the above fields of the accounting profession of study attracts you? Why?
 What are the factors that increase the demand for accountants?

Next day’s assignment

Read about accounting standards

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Session 3 (Hr 5 and 6)
Topic: The Accounting principles, standards, and Assumptions
Secession Learning Objectives:
 Explain accounting principles and standards
 Explain various assumptions and concepts of accounting
1.8. Accounting Principles and an Overview of International Financial Reporting
Standard
Accounting is often called the language of business through which a business house
communicates with the outside world. In order to make this language intelligible and commonly
understood by all, it is necessary that it should be based on certain uniform scientifically laid
down standards. These standards are termed as accounting principles.

1.8.1. Accounting Principles

Accounting principles have been defined as “the body of doctrines commonly associated with
the theory and procedure of accounting, serving as an explanation of current practices and as a
guide for the selection of conventions or procedures where alternatives exist”.

In short, accounting principles are guidelines to establish standards for sound accounting
practices and procedures in reporting the financial status and periodic performance of a business.
These principles can be classified into two categories (i) Accounting conventions; and (ii)
Accounting concepts (assumptions).

Accounting Conventions: The term ‘convention’ denotes custom or tradition or practice based
on general agreement between the accounting bodies which guide the accountant while preparing
the financial statements. It is a guide to the selection or application of a procedure.

Accounting concepts are defined as basic assumptions on the basis of which financial statements
of a business entity are prepared. They are used as a foundation for formulating various methods
and procedures for recording and presenting the business transactions. In this unit, we will
discuss some of these universally accepted principles: Business Entity concept, Monetary Unit
Assumption, Periodicity assumption, and the going concern assumption are covered under the

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headings of basic assumptions and Measurement principles, Revenue recognition principle,
Expense recognition and full disclosures are discussed under the heading of basic principles.

Basic Assumptions/Concepts are the following:

a) Business Entity Concept (Separate Entity concept)

According to this concept, business is treated as an entity separate from its owners. It is treated to
have a distinct accounting entity which controls the resources of the concern and is accountable
thereof. Accounts are kept for a business entity as distinguished from the person(s) owning it. All
transactions of the business are recorded in the books of the business from the point of view of
the business.

Transactions are also recorded between the owner and the business, for instance, when capital is
provided by the owner, the accounting record will show the business as having received so much
money and as owing to the proprietor. This concept is based on the sense that proprietors entrust
resources to the management and the management is expected to use these resources to the best
advantage of the firm and to account for the resources placed at its disposal. Hence, in
accounting for every type of business organization, be it Sole-proprietorship or partnership or
Corporation, business is treated as a separate accounting entity.

The failure to recognize the business as a separate accounting entity would make it extremely
difficult to evaluate the performance of the business since the private transactions would get
mixed with business transaction. The overall effect of adopting this concept is:

 Only the business transactions are recorded and reported and not the personal transactions
of the owners.
 Income or profit is the property of the business unless distributed among the owners.
 The personal assets of the owners or shareholders are not considered while recording and
reporting the assets of the business entity.
b. Monetary Unit Assumption (Money Measurement concept)

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It states that all business activities (events) are recorded in terms of money (-Birr, Dollar, Pound
or any other currency). Money measurement concept holds that accounting is a measurement
and communication process of the activities of the firm that are measurable in monetary terms.
Thus, only such transactions and events which can be interpreted in terms of money are
recorded. Events which cannot be expressed in money terms do not find place in the books of
account though they may be very important for the business. Non-monetary events like, death,
dispute, sentiments, efficiency etc. are not recorded in the books, even though these may have a
great effect. Accounting therefore, does not give a complete account of the happenings in a
business or an accurate picture of the conditions of the business. Thus, accountinginformation is
essentially in monetary terms and quantified. The system of accounting treats all units of money
as the same irrespective of their time dimension. This has created doubts about the utility of the
accounting data, leading to the introduction of inflation accounting.

C. Going Concern Assumption

Most accounting methods rely on the going concern assumption—that the company will have
a long life. Despite numerous business failures, most companies have a fairlyhigh continuance
rate. As a rule, we expect companies to last long enough to fulfill theirobjectives and
commitments.

d. Periodicity Assumption

To measure the results of a company’s activity accurately, we would need to wait until it
liquidates. Decision-makers, however, cannot wait that long for such information. Users need to
know a company’s performance and economic status on a timely basis so that they can evaluate
and compare companies, and take appropriate actions. Therefore, companies must report
information periodically. The periodicity (or time period) assumptionimplies that a company
can divide its economic activities into artificial time periods. These time periods vary, but the
most common are monthly, quarterly, and yearly

Basic Principles: the following are also the basic principles

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There are four basic principles of accountingto record and report transactions: (1)
measurement, (2) revenue recognition, (3) expense recognition, and (4) full disclosure. We
look at each in turn.
1. Measurement Principles
The most commonly used measurements are based on historical cost and fair value. Selection of
which principle to follow generally reflects a trade-off between relevance and faithful
representation.

 Historical Cost. IFRS requires that companies account for and report many assets and
liabilities on the basis of acquisition price. This is often referred to as the historical cost
principle. Cost has an important advantage over other valuations: It is generallythought
to be a faithful representation of the amount paid for a given item.
For example, assume that Alem Business Center purchased land for Br. 500,000, on
January 2016 and initially reports it in its accounting records at 500,000. But what does
the company do if, by the end of the year, the fair value of the land has increased to
650,000? Under the historical cost principle, it continues to report the land at 500,000. It
is a reliable report since it is supported by business document, but it is not relevant for
decision making since it does not represent the fact on the land i.e Br. 650,000.
 Fair Value. Fair valueis defined as “the price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between market participants at the
measurement date.” Fair value is therefore a market-based measure (exit price).Recently,
IFRS has increasingly called for use of fair value measurements in the financial
statements. The IASB believes that fair value information is more relevant to users
than historical cost.
2. Revenue Recognition Principle
Revenue refers to increases in economic benefits during the accounting period in the form of
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants. When the company satisfies the
performance obligation, it should recognize revenue.
3. Expense Recognition Principle

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Expenses refers to decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrence of liabilities that result in decreases in equity, other
than those relating to distributions to equity participants. Expenses should be recognized in the
period in which they are incurred.
4. Full Disclosure Principle
In deciding what information to report, companies follow the general practice of providing
information that is of sufficient importance to influence the judgment and decisions of an
informed user. Often referred to as the full disclosure principle, it recognizes that the nature and
amount of information included in financial reports reflects a series of judgmental trade-offs.

1.8.2. Overview of International Financial Reporting Standard (IFRS)

Meaning of IFRS
The term 'IFRSs' has both a narrow and a broad meaning. Narrowly, IFRSs refers to the new
numbered series of pronouncements that the IASB is issuing, as distinct from the International
Accounting Standards (IASs) series issued by its predecessor. More broadly, IFRSs refers to the
entire body of IASB pronouncements, including standards and interpretations approved by the
IASB and IASs and Standards Interpretation Committee (SIC) interpretations approved by the
predecessor International Accounting Standards Committee

Definitions

 The International Financial Reporting Standards, usually called the IFRS, are
standards issued by the IFRS foundation and the International Accounting Standards
Board (IASB) to provide a common global language for business affairs so that company
accounts are understandable and comparable across international boundaries.

 IFRS are the rules to be followed by accountants to maintain books of accounts which are
comparable, understandable, reliable and relevant as per the users internal or external

 IFRS are standards designed as a common global language for business affairs so that
company accounts are understandable and comparable across international boundaries
IFRS are the consequences of growing international shareholding and trade and are
particularly important for companies that have dealings with in several countries

Fundamentals of Accounting IPage22

  Are the rules to be followed by accountants to maintain books of accounts which is

 Comparable,

 Understandable

 Reliable and relevant as per the users (internal and external)

 IFRS is a single set of high quality, understandable and enforceable global accounting
standards, which is a “Principle based” set of standards that are drafted logically and are
easy to understand and apply.

Financial reporting can generally classified into two:

 General purpose financial reportingis a type of reporting which, aims to

provide useful financial information about the reporting entity to primary users
who cannot enforce the reporting entity to provide information directly to them.
 Special purpose financial reportingis a type of reporting that responds to the
requirements of users that have the authority to require the reporting entity to
provide the information that they need for their purposes directly to them.
Examples include:
o prudential regulation reporting requirements
o tax reporting requirements

International Financial Reporting Standards (IFRS) are Designed for general purpose
financial reporting by profit-oriented entitiesthat might be found to be appropriate for not-for-
profit activities too
» Focused on information needs of (primary users) existing and potential investors,
lenders and other creditors who have no authority to require information from the
entity
» information to enable primary users to make their own assessments of the
reporting entity’s prospects for future net cash inflows
» as a basis for their decisions to buy, hold, sell equity and debt instruments or to
provide a loan or to require settlement of a loan

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 1.8.3. Overview of Financial Reporting Requirements in Ethiopia and AABE
Ethiopia announced official adoption of IFRS as established by IASB. Accordingly, the
Accounting and Auditing Board of Ethiopia has established as per the council of ministers
regulation no. 332/2014. AABE is an autonomous governing organ to promote high quality
reporting of financial and reporting entities and to regulate the accounting and auditing
profession of Ethiopia.
Accordingly AABE has required reporting entities in Ethiopia to fully comply with all the
requirements of IFRS applicable in their circumstances. For smoothing the process of
adoption, AABE has established the following three phase IFRS implementation road map
under its four year strategic plan running from the year 2016-2020.

Phase I: Significant Public Interest Entities (PIEs)-primarily financial institutions and federal
public enterprises –are required to adopt IFRS standards from calendar year 2017, with
reporting under IFRS starting in 2018.

Phase II: Other PIEs-including ECX members–and private companies that meet the PIE
thresholds criteria and IPSAS for Charities and Societies are required to report under IFRS
by the end of 2019.

If at least two of the following requirement is fulfilled the company satisfied PIE qualitative
thresholds and it falls into phase II category:

1. >50 million annual Turnover/ Sales

2. > 100 Employees
3. > 100 million Total Asset
4. > 100 million total liability

Phase III: Small and Medium-Sized Entities (SMEs) are required to follow IFRS for SMEs,
a simplified self-contained standard, by the end of 2020.

If at least two of the following requirement is fulfilled the company falls into phase III
category:

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 1. Between 1 million – 50 million annual turnover/ Sales
2. Between 10 – 100 employees
3. Between 2 million - 100 million Total Asset
4. Between 2 million – 100 million Total Liability
1.9. The Basic Accounting Equations
Assets are the resources a business owns. If you noticed, in any organization you will find
property such as a building, land, and furniture etc., such properties owned by the business are
referred to as Assets. To acquire these assets, businesses may get money from two sources,
investment made by owners or the amounts borrowed from creditors. Therefore both owners and
creditors have a claim over the resources of the business. The claim or the right of owners is
referred to as equities, where as the claim of creditors’ referred to as liabilities. As a result we can
express the relationship of asset liability and equity as an equation as follows.

Asset = Liability + Equity

Economic resources = Claims over the resources

Asset = Equities
This relationship is the basic accounting equation. Assets must equal the sum of liabilities and
equity.
The accounting equation applies to all economic entities regardless of size, nature of business,
or form of business organization. The equation provides the underlying framework for
recording and summarizing economic events.
NB; If the amounts of two of the three elements of the accounting equation are known, we can
solve amount of three third one using the equation. To illustrate, assume that a business has a
total asset of Br.50,000 and a total liability of Br. 20,000, the owners equity as follows
Asset= Liability + Owners Equity
Equity = Asset – Liability (Br. 50,000- 20000) = 30,000
Let’s look in more detail at the categories in the basic accounting equation.

Assets

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As noted above, assets are resources that a business controls and uses its assets in carrying out its
activities of production and sales. The common characteristic possessed by all assets is the
capacity to provide future services or benefits. Assets include cash, tables, chairs, cash
register, etc. the further classification of assets will be discussed in chapter two.
Liabilities
Liabilities are claims against assets, those resulted from borrow money and purchase
merchandise on credit. Liabilities result in payables of various sorts. For instance a company
may purchase supplies on credit results Accounts Payable, Borrowing money from bank results
notes payable, having unsettled salary of employees results Salary Payable etc. the supplier, the
bank and the employees who owes money are a company are its creditor and have the first
claim against the assets before owners.
Equity
The ownership claim on a company’s total assets is equity. It is equal to total assets minus total
liabilities. Since the assets of a business are claimed by either creditors or shareholders and the
creditors have prior claim over the owners, equity is “left over” after creditors’ claims are
satisfied. Thus owner’s equity is often referred to as residual equity.
Equity of a sole propitiator and a partners business comes primarily from the investment made
by owners. Then this equity subsequently increased whenever there are revenuesgenerated from
sales of merchandise, performing services, renting property, and lending money etc.Withdrawals
made owners and payments for business expenses like salary, rent, electricity etc decreases
equity owners.
Equity = Owners’ investment + Revenue – (Expense + withdrawals)
Equity of a corporation business generally consists of share capital—ordinary and retained
earnings. Share capital is funds obtained by selling ordinary shares to investors. Whereas
retained earnings is obtained from the composition of three items i.e revenue, expanse and
dividends.
Equity = Share capital ordinary + Retained Earnings
Retained Earning = Revenue-(Expense + Dividend)

Therefore the equity of corporate business presents the equity obtained from owners investment
separately from the equity obtained from operating activity.

Fundamentals of Accounting IPage26

Revenue is The gross inflow of economic benefits during a period arising in the course of
ordinary activities when those inflows result in increases in equity, other than increases relating
to contributions from equity participants.For instance Unity University generates revenues by
selling educational service where as Shewa Supermarket generates revenue by selling goods. In
general revenue is an income generated from sales of a product or a service.
Expenses are the cost of assets consumed or services used in the process of earning revenue. For
example Unity University incurred expenses while using office and classroom equipments and
paying salary to employees in the process render educational service. Expenses results a gross
decrease in equity that result from operating the business. 
Dividend is the distribution of cash or other assets to shareholders. It is similar to owners’
withdrawal in the case of a proprietor and a partnership business. Dividend reduces retained
earnings.
In summary, the principal sources (increases) of equity are investments by shareholders and
revenues from business operations. In contrast, reductions (decreases) in equity result from
expenses and withdrawals or dividend.

1.10. Business Transaction

Transactions (business transactions) are a business’s economic events recorded by
accountants. All transactions have an effect on the components of an accounting equation.
Transactions may be external or internal. External transactions involve economic events
between the company and some outside enterprise. For example, payment of monthly electric
Bill, purchase of Computers, and sale educational service to students are external
transactions. Internal transactions are economic events that occur entirely within one company
in between different working departments. The releases of teaching supplies like markers, from
the store to departments, to be used for teaching are internal transactions for Unity University.
Companies carry on many activities that do not represent business transactions. For examples
hiring employees, answering the telephone, talking with customers, and placing merchandise
orders. Although most of these activities lead to business transactions: like employees will earn
wages (payment transaction), and suppliers will deliver ordered merchandise (purchase
transaction), they are not transactions by themselves.

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As a result companies must analyze each activities and event to find out whether it affects the
accounting equation or not. If it does, the company will record the transaction.Each transaction
must have a dual effect on the accounting equation. i.e., if an asset is increased, there must be a
corresponding (1) decrease in another asset, (2) increase in a specific liability, or (3) increase in
equity.
Synopsis of lecture
 A single set of high quality, understandable and enforceable global accounting standards,
called IFRS.
 IFRS should be properly followed to enhance, comparability, understandability, reliability
and relevance of financial reports to users.
 The two main assumptions of accounting are monetary unit assumption and
the economic entity assumption.
 Fair Value principle dictates that an asset or liabilities should be reported at the current
price received to sell an asset or to settle a liability.
 The three elements of the accounting equation are Assets, Liabilities and Owners equity.
 Every business transaction as a dual effect on the elements of the accounting equation.
Wrap-up Discussion Question
 Explain the difference between cost and fair value measurement principles.
 Explain the term accounting equation.
 The interrelation between Accounting equation and double entry book keeping system
 Using the concept of accounting equation, compute the missed figure for the following
a. Asset =? , Liability = Br. 100,000, Equity = br.80,000
b. Asset = Br. 250,000, Liability = Br. 160,000, Equity=?
c. Asset = ? Liability + equity = Br. 450,000
d. at the end of the accounting period December 2016, Selam company has assets of
Br. 500,000 and liability of Br. 300,000. How much will be the amount of owners
equity on December 2017, assume that asset is increased by Br. 90,000 and
liability is decreased by Br. 50,000 during year 2010.
Next day’s Reading Assignment
Read about transaction analysis and financial statement of sole proprietor business.

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Secession 4 and 5 (Hr 7, 8, 9 and 10)
Topic: Business Transaction and Financial Statements
Session Learning Objective
 Analyze the effects of business transactions on the accounting equation.
 Understand the four financial statements and how they are prepared

Reading Assignment Discussions

Discussion Issue: effects of transaction on the accounting equation
Question from Reading: Formulate different kinds of events to change, asset, and liability and
owners equity.
1.11. Analysis of Business Transaction
The term transaction analysis refers to an activity of specifying the effects of a particular
transaction on the components of the accounting equation. All transactions regardless of their
type and nature require to be analyzed. To demonstrate the way to analyze business transaction,
we will review the business activities of Melkam Internet Café and expand the impact of
transactions on the basic accounting equation. To make it clear we will use the extended form of
the accounting equation. The detailed (long) form of a basic accounting equation is referred to as
extended an accounting equation.As you see from the following format the extension is made for
the owners Equity section only.
The expanded accounting equation
Asset= Liability + Owners’ investment + Revenue – (Expense + withdrawals)

Illustration I Analysis of business transactions of Melkam Internet Café,

TRANSACTION 1 - INVESTMENT BY OWNER:  Melkam decided to start a business that
gives a photocopy and internet service, named Melkam Internet Café around Unity University.
On August 1, 2016, she has invested Br. 45,000 cash in a bank account opened by the name of
the business. This transaction results in an equal increase in both assets and equity.
Basic Analysis:-

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  The asset “cash” is increases by Br. 45,000, and Equity identified as “owner’s
investment” increases by Br.45,000.
Equation Analysis:-
Assets = Liabilities + Owner’s Equity

Cash = Owners Capital

Tran1 +Br. 45,000 + Br. 45,000
Bal
Br. 45,000 45,000 Initial Investment

Observe that the equality of the basic equation has been maintained. Note also that the source of
the increase in equity (in this case, initial investment) is indicated, because investments made by
owner’s do not represent revenues ( we will see it later), and they are excluded in determining
net income.
NB:
 What if Wt. Melkam has personal assets like house, personal bank account etc., obviously
it is excluded from the analysis. This assumption goes in line with separate Entity concept
that will be discussed later.
TRANSACTION 2 - PURCHASE OF EQUIPMENT FOR CASH: on August 2, Melkam
purchases computer and photocopy machine for Br. 20,000 cash. This transaction is resulted an
equal increase and decrease in total assets. So there is no change on the balance of total asset,
except the composition of assets.
Basic Analysis:-
 The asset “Cash” is decreases by Br. 20,000, and asset “Equipment” increases by
Br.20,000.
Equation Analysis:-
Assets = Liabilities + Owner’s Equity

Cash + Equipment = Owners Capital

Bal. 45,000 45,000
Tran2 -20,000 +20,000 -
Bal
Br 25,000 20,000 45,000

Fundamentals of Accounting IPage30

As you see from the above analysis, after the second transaction, the company will has less cash
and more equipment. As a result purchase of the equipment changes the components of assets,
but it does not change the total asset.
Observe also that total assets are Br.45, 000 and total Owner’s equity, is a Br.45,000. This means
that each transaction always leaves the basic accounting equation in balance.
NB:,
 What if Melkam purchases washing machine for her personal use. It is not business
transaction and not to be included in the analysis.

TRANSACTION 3 - PURCHASE OF SUPPLIES ON CREDIT: August 10,Melkam

purchases different stationary materials and cleaning supplies for Br. 2,500 from Hibir Trading.
The supplies are to be used by the business. Melkam is agreed to pay the bill next week.
Basic Analysis:-
 The asset “Supplies” increases by Br. 2,500, and liability “Accounts Payable” increases
by Br. 2,500.
Equation Analysis:-
Assets = Liabilities + Owner’s Equity

 Account Owner
Supplie Equipmen s s
  Cash  + s  + t  = Payable +  Capital
Bal. 25,000   -   20,000   -   45,000
Tran3    +2,500        +2,500     ___ -
Bal Br. 33,500   2,500   20,000   2,500   45,000

Asset of the business increase as a result of the above transaction because more stationary and
cleaning supplies are available now for future consumption.
on the other hand the above purchase made on account (a credit purchase). All purchases made
on credit increase liabilities. As a result Melkam Internet Café’s liability increases by the amount
due from Hibir Trading.
Total assets are now Br. 47,500 i.e (33,500 + 2,500 + 20,000.) This total is matched by a Br.
2,500 creditor’s claim and a Br. 45,000 ownership claim.
NB:,

Fundamentals of Accounting IPage31

  What if Melkam also purchases cleaning supplies on account for her personal use? It is
not to be considered in the analysis as it constitutes personal liability.

TRANSACTION 4 - SERVICES PERFORMED FOR CASH: during the first month of

operation Melakm Internet Café received Br. 8,500 cash for internet and photocopy service
provided to customers. This transaction results in an equal increase in both assets and equity.
Basic Analysis:-
 The asset “Cash” increases by Br. 8,500, and Equity identified as “owner’s capital”
increases by Br.8,500. This increase is resulted from sales of a service.
Equation Analysis:-
Assets = Liabilities + Owner’s Equity

 Account Owne
Supplie Equipme s rs Reven
  Cash  + s  + nt  = Payable +  capital  + ue
Bal. 25,000   2,500   20,000   2,500   45,000    
Tran4 +8,500                   +8,500
Bal
Br. 33,500   2,500   20,000   2,500   45,000   8,500

As it is clearly shown in the above analysis, the receipts of cash increase the balance of asset as
the same time the balance of Owner’s Equity for the amount of revenue earned. But this
increase in equity is quite different from the one which was analyzed on transaction one above.
As a result, it is necessary to clearly specify the source of increase in equity as owner’s
investment or revenues generated from day to day operation.
NB : - Businesses might generate revenue from different operating activities they have engaged
in. Different titles are used for various sources of revenue. Revenue from providing services is
recorded as fees earned. Revenue from the sale of merchandise is recorded as sales. Other
examples of revenue include rent, which is recorded as rent revenue, and interest, which is
recorded as interest revenue

Fundamentals of Accounting IPage32

TRANSACTION 5 – PAYAMENT FOR ACCOUNTS PAYBLE:- August 15, Melkam pay
cash of Br. 1,200 for the partial settlement for purchase of supplies made on transaction 3. The
transaction results an equal decrease in asset and liability.
Basic Analysis:-
 The asset “Cash” decreases by Br. 1,200, and Liability, “accounts payable” decreases by
Br. 1,200.
Equation Analysis:-
Assets = Liabilities + Owner’s Equity

 Account Owner
Supplie Equipmen s s Revenu
  Cash  + s  + t  = Payable +  capital  + e
Bal Br. 33,500   2,500   20,000   2,500   45,000   8,500
Tran 5 -1,200 -1,200
Bal Br. 32,300 2,500 20,000 1,300 45,000 8,500

As you see from the above analysis, payment of liability reduces the cash balance of the
company. After the transaction the total amount that the company has to pay ( liability) is
reduced to Br. 1,300 i.e, (Br. 2500- 1,200)
After the above transaction the total asset on the left hand side of the accounting equation of Br.
54,800 is exactly equal with the sum of total liability and equity found on the right hand side of
the accounting equation.
NB:- Remember that the above transaction has no effect on supplies that were bought on
transaction 3.
TRANSACTION 6 - SERVICES PERFORMED FOR CASH AND CREDIT: on August 20,
Melkam performs Br. 6,000 photocopy service for customers. The company receives cash of Br.
2,000 from customers, and it bills the balance of Br. 4,000 on account. This transaction results in
an equal increase in assets and equity.
Basic Analysis:-
 The asset “Cash” and “Account receivable” increases by Br. 2,000, and Br. 4,000
respectively. Whereas Owner’s equity on the right side the equation by br. 6,000.
Equation Analysis:-
Assets = Liabilities + Owner’s Equity

  Cash  + +Supp.  + Equip.  =  Accounts +  Owners  + Reve.

Fundamentals of Accounting IPage33

 Account
Rec. Payable capital
Bal Br. 32,300 2,500 20,000 1,300 45,000 8,500
Tran 6 +2,000 +4,000 +6,000
34,300 2,500 20,000 1,300 45,000 14,500
Bal. 4,000

As you see from the above transaction, Melkam recognizes Br. 6,000 in revenue when it
performs the services. Out of it Br. 2,000 is received in Cash and the remaining br. 4,000 is to be
receive after few days i.e Account Receivables. This Accounts Receivable represents customers’
promise to pay Br. 4,000 to Melkam internet Café in the future. When it is received later,
Melkam will increase Cash and decrease Accounts Receivable (see Transaction 8).

TRANSACTION 7 - PAYMENT OF EXPENSES:  Melkam internet Café pays the following

expenses in cash during August: Salary of employees Br. 2,800, Monthly rent Br. 3,200, and
Utilities Br. 750. These payments result in an equal decrease in assets and equity.
Basic Analysis:-
 The asset “Cash” decreases by Br. 6,750, and “Owner’s equity” decreases by Br. 6,750
because of the following specific expenses. i.e. Salary Expense, Rent Expense and
Utilities Expense.
Equation Analysis:-
Assets = Liabilities + Owner’s Equity

Account Account Owners

  Cash +Recei. +Supp. +Equip. = Payable +Capital +Reve -Expense

Bal Br. 34,300 4,000 2,500 20,000 1,300 45,000 14,500

Tran 7 -6,750 -2,800 Salary
-3,200 Rent
-750 Utility

Bal Br. 27,550 4,000 2,500 20,000 1,300 45,000 14,500 6,750

After the analysis of the above transaction, the two sides of the equation is still balance at
Br.54,050. Three lines are required in the analysis to list each expenseseparately.
NB;

Fundamentals of Accounting IPage34

  Businesses by their side also consume service of other business and individuals in the
process of producing products and services to customers. For instance Melkam Internet
Café should hire employees, and consumes electric power to render internet service. This
consumption creates expenses. Unlike revenues, Expense decreases the balance of
owner’s equity.

TRANSACTION 8 - RECEIPT OF CASH ON ACCOUNT: Melkam receives Br. 2,200 in

cash from customers who had been billed for services (in Transaction 6).
Basic Analysis:-
 The asset “Cash” increases Br. 2,200, and the asset “Account Receivable” decreases Br.
2,200
Equation Analysis:-
Assets = Liabilities + Owner’s Equity

Account Account Owners

  Cash +Recei. +Supp. +Equip. = Payable +Capital +Reve -Expense
Bal Br. 27,550 4,000 2,500 20,000 1,300 45,000 14,500 6,750
Tran 8 +2,200 -2,200
Bal.Br. 29,750 1,800 2,500 20,000 1,300 45,000 14,500 6,750

NB:
 Note that the collection of an account receivable for services previously billed and
recorded does not affect both revenue and equity. Melkam already recorded this revenue
(in Transaction 6) and should not record it again. On the other hand the above transaction
does not change the total asset, but it changes the composition of the asset.

TRANSACTION 9 – OWNER’S DRAWINGS: The Melkam Withdraws Br. 2,500 from the

business for her personal use. This transaction results in an equal decrease in assets and equity.
Basic Analysis:-
 The asset Cash increases Br. 2,500, and owner’s equity decreases Br. 2,500
Equation Analysis:-
Assets = Liabilities + Owner’s Equity

 Tran. Cash +Supp. +Equip. = Account

Fundamentals of Accounting IPage35

 Account
+Recei. Owners +Reve - Owner’s
Payable +Capital Expense -Drawi
Bal.Br. 29,750 1,800 2,500 20,000 1,300 45,000 14,500 6,750
Tran 9 -2,500 -2,500
Bal.Br. 27,250 1,800 2,500 20,000 1,300 45,000 14,500 6,750 2,500

Look, the Owner’s drawing reduces equity but this reduction is totally different from the
reduction resulted because of expenses. The reason is expenses are the costs incurred or
resources consumed for the running of run the day to day business activity, where as drawing is
an amount of capital consumed for owner’s personal use or non business activity.
NB: don’t confuse drawings with those personal transactions excluded from the transaction
analysis of the business. The essence here is not including the Melkam’s personal transaction in
to the analysis of the business transaction, but rather it is inclusion of the change in asset (cash)
and equity which accompanies her cash withdrawal in to the accounting equation.

 Summary of Transactions analysis

From the above nine transaction analysis students are required to clearly understand the
following basic points.
i. Each business transaction should be analyzed in terms of its effect on:
a. the three component of the basic accounting equation
b. the specific item within each component
ii. After each transaction, the left hand side of the equation must always be equal with
the right hand side of the equation.
iii. The owner equity is increased by the amount invested by owners and is decreased by
withdrawals by owners. Moreover the owner’s equity is increased by revenues and
decreased by expenses.
NB: The above basic points are commonly applicable to all transaction analysis. Illustration
1summarizes the August transactions of Melkam Internet Café to show their cumulative effect on
the basic accounting equation. Then tabular summery of the analyzed transactions is required.
Transaction summery used to display the effects of all those transactions occurred during the
month on the two sides of the basic accounting equation using a tabular format.
Illustration 1.2 Transaction Summery of Melkam Internet Café

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 Tabular Summery of Transactions

Asset Liability Owner's Equity  

Accoun
ts =Accoun +Owne - -
Tran. Cash Receiv +Suppli +Equi t rs +Revenu Expens Drawin
No. + able es pment Payable Capital e e g

1 Br.45,000         45,000       Initial Inv.

2 -20,000     20,000            

3     2,500   2,500          

4 +8,500           8,500     Serv. Rev.

5 -1,200       -1,200          

6 +2,000 4,000         +6,000     Ser. rev.

Salary
7 -6,750             2,800   Exp.

                -3,200   Rent Exp.

Utilities
                -750   Exp.

8 +2,200 -2,200                

9 -2,500               -2,500 Drawing

+20,00
Bal. 27,250 +1,800 +2,500 0 =1,300 +45,000 +14,500 -6,750 -2,500  
Total
Assets Br. 51,550. Total Liability and Equity Br. 51,550.

Look, the information contained clearly shows you the applicability of those basic points of
transaction analysis presented above.
Dear students, the above analysis are the simplest way to understand the basics of accounting.
More over it is the critical step to deal smoothly with the essence of whole recording activity

Fundamentals of Accounting IPage37

which you will learn in the following chapters. So please take sufficient time to do and review it
until you are certain about and capable enough to:
 Analyze the effects of each transaction on the accounting equation
 Identify the name specific item affected within the component names
 Keep the accounting equation in balance

1.12.Financial Statement
After transactions have been recorded and summarized, reports are prepared for users. The
accounting reports providing this information are called financial statements. These statements
provide a company’s history quantified in money terms. The financial statements most frequently
provided are the following.

1. Statement of profit or Loss and Other comprehensive income presents the summery
of revenues and expenses to determine the resulting net income or net loss for a specific
period of time. Such as a month or a year.
2. A statement of owner’s equity summarizes the changes in owner’s equity for a specific
period of time. Such as a month or a year.
3. A statement of financial position (sometimes referred to as a balance sheet) reports the
assets, liabilities, and equity of a company at a specific date. Usually at the close of the
last day of a month or a year.
4. A statement of cash flows summarizes information about the cash inflows (receipts) and
outflows (payments) for a specific period of time. Such as a month or a year.
NB:
 The income statement, statements of Owner’s equity, statement of cash flows, and
comprehensive income statement holds financial information of a particular period,
whereas the statement of financial position is for a point in time.

1. Statement of Profit or Loss and Other Comprehensive Income

The income statement reports the success or profitability of the company’s operations over a
specific period of time. Investors and creditors use this statement to determine and predict the
profitability and future cash inflows of a particular business. It is prepared from the data

Fundamentals of Accounting IPage38

appearing in the revenue and expense columns ofIllustration 1.3.1. The statement has two parts
i.e the heading and the body part. The heading of the statement identifies the company, the type
of statement, and the time period covered by the statement. The main body reports those revenue
and expense items with their respective balances for the specific period.
The income statement lists revenues followed by expenses and then, shows net income (or net
loss). Net income results when revenues exceed expenses, whereas net loss results when
expenses exceed revenues. IFRS does allow an alternative statement format in which the
information in the income statement can be combined and presented as a single statement with
the comprehensive income statement referred to as a statement of comprehensive income.NB:-
As discussed earlier income statement do not include investment and drawings made by owners,
even though both investment and drawing affects owner’s equity.
Illustration 1.3. Financial Statements of a Sole Proprietor Business
Illustration 1.3.1.Statement of profit or Loss and Other comprehensive income

Melkam Internet Café

Statement of profit or Loss and Other comprehensive income
For the Month ended August 30,2016
Revenues    
Br.
  Service Revenue 14,500
Expenses    
  Salary Expense Br. 2,800  
  Rent expense 3,200  
  Utilities Expense 750  
  Total Expense   6,750
  Net Income   7,750
Illustration 1.3.2 Statements of Owner's Equity
Melkam Internet Café
Statements of Owner's Equity
For the Month ended August 30,2016
Owners capital August 1,   Br. 0
Add Investments Br. 45,000  

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 Add Net income 7,750 52,750
      52,750
Less Drawing   2,500
Owner's capital August 30,   50,250
Illustration 1.3.3. statements of Financial Position

Melkam Internet Café

Statements of Financial Position
For the Month ended August 30,2016
Asset
Equipment   20,000
Supplies   2,500
Accounts Receivable   1,800
Cash   27,250
  Total Asset   51,550
Equity and Liability
Owners Equity    
Melkam Capital 50,250
Libilities  
Accounts Payable   1,300
  Total Equity and liabilities  Br. 51,550

Illustration 1.3.2. Statements of Cash Flow

Melkam Internet Café
Statements of Cash Flow
For the Month ended August 30,2016
Cash Flows from operating activity    
Br.
  Cash receipts from revenue   12,700
  Cash payment for Expenses   -7,950
  Net cash provided by operating activity 4,750
Cash flows from investing activity  
  purchase of equipment   -20,000

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 Cash flows from Financing activity   -20,000
  Investment by owner Br. 45,000  
  Drawing by owner -2,500 42,500
  Net increase in Cash   27,250
  cash at the beginning of the month   0
cash at the end of the month   27,250

2. Owner’s Equity Statement

The owner’s equity statement reports the changes in owner’s equity for a specific period of time.
It is prepared after the income statement because the amount of net income or net loss of the
period is necessary for the preparation of the statement.
Owner’s equity statement is prepared before the balance sheet, since the amount of owner’s
equity at the end of the period is necessary for the preparing balance sheet. Because of this, the
statement of owner’s equity is often viewed as the connecting link between the income statement
and balance sheet.
Data for the preparation of the owner’s equity statement come from the owner’s equity columns
of the tabular summary of illustration 1.3.2
As you see from the illustration owner’s equity for Melkam Internet Café is affected by three
instances during the reporting month. (1) The original investment of Br. 45,000, (2) the revenue
and expenses that resulted in net income of Br. 7,750 for the month, and (3) owner’s withdrawal
of Br. 2,500 by the owner.
Like income statement Owners Equity statement has two parts, i.e the heading and the main
body. The heading is summers the name of the business, the type of statement and the reporting
period with in three lines. Whereas the main body starts with the beginning balance of owners
equity (which is zero at the start of the business), and ends up with the ending balance of owner’s
equity. Investment and net income are added to whereas, Drawing and Net loss if any are
deducted from the beginning Owners Equity to determine the balance for equity at the end of a
particular period.
NB: Net income and net Loss are mutually exclusive; they never appear together for any
particular reporting period.

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 3. Statement of Financial Position
Statement of financial position reports the assets, liabilities, and equity at a specific date. The
asset and liability amounts are taken from the last line of the tabular summary of
illustration1.12.1 of. Melkam’s Capital as of August 30, 2016, is taken from the statement of
owner’s equity on illustration 1.3.3

The statements of financial position have two parts, i.e the heading and the main body. The main
body lists assets at the top followed by equity and liability. Total assets must equal total equity
and liabilities. For the current case of Melkam Internet café there is only one liability, i.e
Accounts Payable, on its statement of financial position. But in most cases, there will be more
than one liability. When two or more liabilities are involved, the proper order of listing is as
follows.  
Liabilities
Br.
  Notes payable XXX
  Accounts Payable XX
  Salary and Wages payable XX
  Total Liabilities XXX

4. Statement of Cash Flows

The statement of cash flows provides information on the cash receipts and payments for a
specific period of time. The statement of cash flows reports (1) the cash effects of a company’s
operations during a period, (2) its investing activities, (3) its financing activities, (4) the net
increase or decrease in cash during the period, and (5) the cash amount at the end of the period.

As you see in Melkam Internet café’s statement of cash flows in Illustration 1.3.4 cash is
increased by Br, 27,250 during the period. This is resulted because of the net effect of a Br.4,750
increase in the Net cash provided by operating activity, a Br. 8,000 decrease from investing
activity and a Br. 42,500 increase of cash flow from financing activities.

NB: Investing activities pertain to investments made by the company, not investments made by
the owners. Any ways don’t worry about the statements of cash flow the course Financial
Accounting I gives you the full detail.

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 - Most students do not consider the heading of financial statements as a necessary section.
But it is important to distinguish one finical statement from the other. Without heading
financial reports cannot gives complete information.
- Similarly most students’ give less attention for the necessity of underlings while
preparing financial statement. Proper underlinings are the ultimate indicators for sub
totals and final or the grand total of a particular statement. As a result please don’t
hesitate to make single underline under subtotal and double underline under final totals.
1.12.1. Financial Statements and their Interrelationships
The preparation of the financial statements for Melkam Internet café has been finalized. Now it
is the time to show you the interrelationship between the statements.
 Net income determined by the income statement, Br, 7,750 is used in the statements of
owner’s equity to determinate ending balance of owner’s equity.
 The figure for ending equity Br. 50,250, in the statements of owner’s equity is used by
statements of financial position for the determination of the balance for total liability and
equity.
 The cash balance Br. 27, 250 shown in the statements of financial position to reconcile
the ending cash balance determined in the statements of cash flow.

Synopsis of Lecture
 Transaction analysis refers to an activity of specifying the effects of a particular
transaction on the components of the accounting equation.
 Statement of profit or Loss and Other comprehensive income presents the summery of
revenues and expenses of the entity for a specific period of time.
 The owner’s equity statement reports the changes in owner’s equity for a specific period
of time.
 The statement of cash flows provides information on the cash receipts and payments of
the entity for a specific period of time.
 Statement of financial position reports the assets, liabilities, and equity at a specific date.
Wrap-up Discussion Question
 Explain the necessity of analyzing business transaction.

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  Explain the interrelationship among financial statements
Exercise: - Use an accounting equation and show the effects of the following transaction on the
components of the equation.
-purchase of supplies for cash Br. 200
-Sales of service on credit Br. 3000
- Purchase of equipment on credit Br. 5,000
- Payment of cash as a full settlement Br. 5000

SELF-EXAMINATION QUESTION
1. A profit-making business that is a separate legal entity and in which ownership is divided
into shares of stock is known as a:
A. Sole proprietorship C. Partnership
B. Single proprietorship D. Corporation
2. The properties owned by a business is called:
A. Asset C. Stockholders’ equity
B. Liability D. Owner’s Equity
3. If the total asset increased by Br. 20,000 during the year and liability increased by Br.
12,000 during the same year, the amount and direction(increase or decrease) of the year’s
change in owner’s equity is:
A. Br. 32,000 increase C. Br. 8,000 increase
B. Br. 32,000 decrease D. Br. 8,000 decrease
4. A list of Asset liability and owners equity at the specific date is:
A. Statement of owners equity C. Statements of Cash flow
B. Statements of financial potion D. Income statement
5. If revenue was Br. 45,000, expenses were Br. 17,500 and owner’s withdrawal were Br.
10,000, the amount of net income or net loss was:
A. Br. 45,000 net income C. Br. 37,500 net loss
B. Br. 32,000 net income D. Br.2,500 net loss

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 ILLUSTRATIVE PROBLEM
The assets and liabilities of White dry cleaners on December 1, 2016 of the current year are as
follows: Cash Br.1,000, Accounts Receivable, Br.2,200, Supplies Br. 850, Equipment Br. 3,500,
Land Br. 11,450. Accounts Payable, Br 4,030. A white dry cleaner is a sole proprietor owned and
managed by W/o Mihret. Currently the building, and delivery truck, are being rented, pending
expansion to new facilities. Another company at wholesale rates of does the company work of
dry cleaning. Business transactions during December are summarized as follows.
1. Received cash from customers for dry cleaning service Br. 4,928.
2. Paid creditors on account Br. 1,755.
3. Received cash from W/o Mihret as additional investment Br. 3,700.
4. Paid rent for the month Br. 1,200.
5. Charged customers for dry cleaning service delivered on account Br.1,025.
6. Purchased supplies on account, Br. 245
7. Received cash from customers on account Br. 2,000
8. Received a monthly bill for electricity for the month December(To be paid on January 2,
Br. 1,635,
9. Paid the following: Wages expense, Br. 850, Truck Expense, Br. 250, Utilities Expense,
Br.325, miscellaneous expense.Br. 75
10. W/o Mihret the owner withdraws cash Br. 1,800 for her personal use.
11. Determined by taking an inventory count, the cost of supplies used during the month Br.
115.

Required:
a. Insert the beginning balances to the appropriate account using the following tabular
headings.
Asset Liability Owner's Equity

Accounts
Tran. Cash Receivabl =Account +Owners +Reven
No. + e +Supplies +Equipment Payable Capital ue -Expense -Drawing

b. Analyze the above transactions and Indicate the effect of each transaction and the
balances after each transaction, using the following tabular headings:

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 c. Prepare financial statements for the business for the month of December 31, 2016.

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 CHAPTER TWO

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 ACCOUNTING CYCLE FOR SERVICE-GIVING BUSINESS
Overview of Chapter 2
As you recall from Chapter 1, we have analyzed business transactions of Melkam Internet café,
in the way that displays their effects on the elements of the accounting equation. Then we have
prepared a tubular summery the transactions and also the financial statements. This is so in this
way because the business is small. But what if we are going to record transactions of large
business like Unity University, Teklehaimanot Hospital or Ethiopian Airlines? These firms
entertain 100 or 1000 folds of the monthly transactions of Melkam Internet Café within a single
day. Do you think it seems practical and wise to analyze each and every transactions in the way
we did before? No. Record transaction in this way would be impractical, expensive, and
unnecessary. Though tabulation is a simple way to show you how transaction and their respective
effects are captured in the basic accounting equation, it is not the formal system for recording
business transactions at all. Instead, companies use a set of systematic procedures and records to
keep track of transaction data more easily. This chapter introduces and illustrates the basic
procedures used in the recording process and completion of accounting cycle.
2.0 Chapter Learning Objectives
After completing this chapter you should be able to:
 Explain what an account is and how it helps in the recording process.
 Define the term debits and credits and explain their role in the recording process
 Identify the basic steps in the recording process.
 Explain what a journal is and how it helps in the recording process.
 Explain what a ledger is and how it helps in the recording process.
 Explain what posting is and how it helps in the recording process.
 Prepare a trial balance and explain its purposes.
Session 6 (Hr. 11 and 12)
Topic: - The Recording Process

Session Learning Objectives:

 Explain what an account is and how it helps in the recording process.

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  Define debits and credits and explain their role in the recording process
 Identify the basic steps in the recording process.
 Explain what a journal is and how it helps in the recording process.
Recording Assignment decision
 Discussion Issue:- self examination question and illustrative problems at the end of
chapter one
2.1.The Recording Process
The recording process holds detailed discussions on the terminologies of the elements used in
recording of business transactions. These are an account, the recording system and the proving
process.
2.1.1. The Account
An account is an individual accounting record of increases and decreases in a specific asset,
liability, or equity item. An account is a sub division of the three elements of the accounting
equation For example; Melkam internet Cafe (the company discussed in Chapter 1) would
have separate accounts for Cash, Accounts Receivable, Accounts Payable, Service Revenue,
Salaries and Wages Expense, and so on.
2.1.2 Characteristics of an Account
The simplest (basic) form of an account consists of three parts: (1) an account title, (2) a left or
debit side, and (3) a right or credit side. We use this form often throughout this course to explain
basic accounting relationships. Illustration 2.1 shows the basic form of an account.
Illustration 2.1 Basic form of account.

Accounts Title
Debit Credit
   

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 As you see from the figures the format looks like the letter “T”, as a result the simplest form of
an account is referred to as a T-account
1. Account Title
The account title represents the name of the particular account which is written on the top of the
account.
2. Debits and Credits
The term debit indicates the left side of an account, where as the term credit indicates the right
side of the account. They are commonly abbreviated as Dr. for debit and Cr. for credit.
The termsdebit and credit repeatedly used in the recording of the increases and decreases of a
particular account.
The act of entering an amount on the left side of an account is called debiting. Whereas making
an entry on the right side is crediting the account.
The act of debiting or crediting by itself doesn’t represent an increase or a decrease in a specific
account. Increase or decrease of an account is determined on the basis of account classification
only.
2.1.3. Balance Side of an Account
Increasing side of an account is called balance side. An account shows a debit balance side if
the total of the debit amounts exceeds the credits. An account shows a credit balance side if the
credit amounts exceed the debits. Dear students’ illustration 2.1 shows you the recordings and the
balance determination of an account. Beside the illustration also shows you how the account
format sparely records increases and decreases in a particular account compared with tabular
format dealt on Chapter 1). The data for the illustration is taken from Melkam Internet Café
tabular summery of illustration 1.2.
Illustration 2.2 Tabular summary and account form for Melkam Internet Café Cash account
Account Form
Cash
Debit 45,000 Credit 20,000
8,500 1,200
2,000 6,750
2,200 2,500
Bal. 27,250
Tabular Summery of
Cash

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 Br.45,000

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 -20,000
+8,500
-1,200
+2,000
_6,750
_2,200
_-2,500
27,250

Look, the above two formats for your comparison. Every positive figure in the tabular summary
represents an increase in cash and every negative figure represents a decrease in cash
balance. Notice also in the account form the increases and decreases in cash are recorded in
a separate side. I.e the increases in cash is recorded as debits, and the decreases as
credits. There is no need to uses + or – signs in the account format.

Having increases on one side and decreases on the other reduces recording errors and helps in
determining the totals of each side of the account as well as the account’s balance side. The
balance is determined by netting the two sides (subtracting one amount from the other). The
account balance, a debit of Br. 27,250, indicates that Melkam Internet Cafe had Br. 27,250 more
increases than decreases in cash. As a result cash has a debit balance side.

NB: For simplicity all accounts which, appear in the left hand side of the accounting equation
has a debit balance side. Whereas all those accounts which appeared on the right hand side of
the accounting equation has a credit Balance side.
2.1.4. The Rules of Debit and Credit in a double entry system
In Chapter 1, you have learned the effect of a transaction each transaction has a dual effect on the
basic accounting equation and that maintains the accounting equation always in balance.
Thisfactprovides the basis for the double-entry system in the formal records of transactions.

Under the double-entry system, the dual (two-sided) effect of each transaction is recorded in
appropriate accounts as debits and credits. This system provides a logical method for recording
transactions and helps to ensure the recording accuracy. If every transaction is recorded with

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equal debits and credits, the sum of all the debits to the accounts must equal the sum of all the
credits.
The double-entry system for determining the equality of the accounting equation is much more
efficient than the plus/minus procedure used in Chapter 1. On the following pages, we will
illustrate debit and credit procedures in the double-entry system.

Rules of Debits and Credits for Asset, Liabilities and Owners Equity
In Illustration 2.2 above   increases in Cash (an asset) were entered on the left side i.e debit, and
decreases in Cash were entered on the right side i.e credit. Since assets are found on the left side
of the basic accounting equation.
On the other hand increases in liabilities must be entered on the right or credit side, and
decreases in liabilities must be entered on the left or debit side. It is therefore follows that
increases and decreases in liabilities will have to be recorded oppositefrom increases and
decreases in assets.
balance side or normal balance of an account is the side where the increaseing in the account is
recorded. For instance Asset accounts normally show debit balances. That is, debits to a
specific asset account should exceed credits to that account. Likewise, liability accounts
normally show credit balances. That is, credits to a liability account should exceed debits to
that account.
As it is discussed in Chapter 1 indicated, owner’s equity has four subdivisions: Owner’s Capital,
drawing, revenues, and expenses. In a double-entry system, companies keep accounts for each of
these subdivisions, as explained below.
Owner’s capital has a credit balance side. Revenues increase equity, a revenue account use the
same debit/credit rules as owner’s capital account. As you know Drawing and Expenses
decreases equity account, they have the opposite Debit/credit rules as owner’s capital account. As
a result they have a debit normal balance.
Knowing the normal balance in an account may help you to trace errors. For example, a credit
balance in an asset account such as Equipment or a debit balance in a liability account such as
Accounts Payable usually indicates an error.

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Summary of Debit/Credit Rules
Illustration 2.3 shows a summary of the debit/credit rules and effects on each type of account.
Study this diagram carefully. It will help you understand the fundamentals of the double-entry
system.
Illustration 2.3 Summary of debit/credit rules

Accounting
Equation Asset =  Liabilities + Owners Equity
Account Owners
Classification Asset = Liability + Capital + Revenue  - Expense  - Drawing
Dr. Cr.   Dr. Cr.   Dr. Cr.   Dr. Cr.   Dr. Cr.   Dr. Cr.
Debit/Credit
Rule  + -     - +     -  +    -  +    +  -    +  -
                               
NB: in the above illustration, the plus sign represents an increase in an account where as minus
sign represents a decrease in an account.
The information in the above table is summarized as follows.
Debit Credit
- Increase in asset - Decrease in asset
- Decrease in Liability - Increase in Liability
- Decrease in equity - Increase in equity
- Decrease in revenue - Increase in revenue
- Increase in Expense - Decrease in Expense
Synopsis of Lecture
 Account is a subdivision of the elements in accounting equation
 The simplest form of an account is referred to as a T-account
 The left side of an account is debit side and the right hand side of an account is credit
 Accounts with debit balances appear in the left column, and those with credit balances in
the right column.
 The increasing side of an account is normal balance or balance side

Wrap-up discussion questions

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  Describe how debits and credits rules are related with the accounting equation.
 Define the terminologies of debits and credits.
 Write the normal balance for the elements of the accounting equation.

Next day’s assignment

Read about classification of accounts

Session 7 and 8 (Hr. 11, 12, 13 and 14)

Topic:- Classification of accounts

Session Learning Objective

 Understand classification of accounts
 Identify the basic steps in the recording process.
 Explain what a journal is and how it helps in the recording process.
Reading Assignment discussion
Discussion issues:
 Analyzing transaction
 Journalizing
2.1.2 Classification of Accounts
Accounts are classified in to five. Namly Assets, Liability, Equity, Revenue (referred to as
income) and Expense. The first three are reported the statements of financial position accounts.
So they are called financial Position accounts. Whereas the last two are called Income statement
accounts and are called income statement accounts.

The simplified versions of the official account definitions provided by the FASB, using the IASB
definitional structure, are as follows.
i. Assets :- A resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity.

The following three characteristics must be present for an item to qualify as an asset:

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 1. The asset must provide probable future economic benefit that enables it to provide future
net cash inflows.
2. The entity is able to receive the benefit and restrict other entities’ access to that benefit.
3. The event that provides the entity with the right to the benefit has occurred.

Assets have features that help identify them in that they are exchangeable, legally enforceable,
and have future economic benefit (service potential). It is that potential that eventually brings in
cash to the entity and that underlies the concept of an asset.

IFRS based Classification of assets :-International Financial Reporting Standard made asset
classification as follows:

Property Plant and Equipments:- are asses held to be used in the production and supply of
goods or services, for administrative purpose, or for rental to others. As per IAS 16 Property,
plant, and equipment includes land,building structures (offices, factories, warehouses), and
equipment (machinery, furniture, tools). PPEs also include Biological assets (Bearer Plants) and
mineral recourses. Biological assets are Bearer plants that are used to produce agricultural
products, like Rubber tree, Fruit tree, Sheep, Dairy cattle etc. Mineral Recourses and Mineral
reserves used to produce such as oil, natural gas and mineral water etc.

Intangible Asset:- are identifiable assets, without physical existence, held for use in production
and supply of goods or services, for administrative purpose or, for rental to others. (IAS 38).
Intangible assets includes Brand, Copyrights, Trademarks, Trade secrets, Permits, Corporate
intellectual property etc.

Noncurrent Asset Held for Sale:-is a PPE that are available for immediate sale in its present
condition and its sale must be highly probable. In addition, the asset must be currently being
marketed actively at a price that is reasonable in relation to its current fair value. For example a
building in use by a business but the entity is committed to sale it on the moment the company
gets buyers.(IFRS 5)
Inventories:- Are asset held for sale in the normal course of business or in the process of
production for such sale or in the form of materials or supplies to be used in the production

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process or in the rendering of services. Harvested and stored biological assets held for sale is
also categorized under inventories. (IAS2)
Biological Asset in Agricultural Activity and Agricultural Products:- assets point of
harvest:- assets that are agricultural products growing on bearer plant Example, Picked fruit,
harvested sugar cane or wool on the sheep at point of harvest. (IAS41).
Investment Property:- Are properties held to earn rentals or for capital application or both
rather than for use in production for use or for sale. For instance, holding a building or a land for
rental purpose is an investment property.
Financial Asset:- is cash, an equity investment of another company (e.g., ordinary or preference
shares), or a contractual right to receive cash from another party (e.g., loans, receivables, and
bonds).( IAS 32 and IFRS 7)
NB: the above are detailed classification for the assets; you are required to read more about the
classifications. However for the purpose of simplicity, assets generally are classified in to
noncurrent and current asset. Noncurrent assets are assets that cannot be easily and readily
converted into cash and cash equivalents. Non-current assets are also termed fixed assets, or
long-term assets which serve an entity for a period more than one year. Noncurrent asset is
reclassified in to three. These are PPEs, Mineral Recourses and Intangible Assets.
On the other hand Current assets are cash or other assets that companies reasonably expect to
convert into cash, sell, or consume in operations within a single operating cycle or within a year.
This includes Cash, account receivable, inventory etc. The general classification is within the
scope of the above asset category.
ii. Liabilities. A present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources embodying economic
benefits.
The following three characteristics must be present for an item to qualify as a liability:

1. A liability requires that the entity settle a present obligation by the probable future
transfer of an asset on demand when a specified event occurs or at a particular date.
2. The obligation cannot be avoided.
3. The event that obligates the entity has occurred.

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IFRS based Classification of Liabilities:-IFRS categorized liabilities as follows:

Financial liabilities:- a contractual obligation to deliver cash or another financial asset,

obligation to exchange financial liabilities under unfavorable condition. Financial liability
includes accounts payables, deposit liabilities, bond issued etc.(FRS 9 and IAS39)

Lease liability:- a present obligation arising from lease agreements. Lease an agreement
whereby the leaser conveys to the lessee the right to use an asset for an agreed period of time in
return for payment. (IAS 17).

Employee Benefit liability:- a present obligation incurred by an entity in exchange for service
rendered by employees for the termination of employment. Employee benefits liability included,
salary payable, Bonus payable, pension payable, severance pay.(IAS 19)

Income Tax liability:- A present statutory obligation to pay taxes to the government based on
taxable profits(IAS12).

Provisions:- A provisionis a liability of uncertain timing or amount and sometimes referred to

as an estimated liability. Common types of provisions are obligations related to litigation,
warrantees or environmental damage etc.(IAS37).
Depending on the date of expected payment Liabilities can be classified in to Current and
Noncurrent liabilities. This classification is within the framework of the above category,
Current liabilities are obligationswhich are expected to be settled within its normal operating
cycle; or within 12 months after the reporting date. Current liabilities include Accounts payables,
salary payable, notes payables etc.
Non-current liabilities (sometimes referred to as long-termdebt) consist of an expected outflow
of resources arising from present obligations that are not payable within a year or the operating
cycle of the company, whichever is longer. Bonds payable, long-term notes payable, mortgages
payable, pension liabilities, and lease liabilities are examples of non-current liabilities.
iii. Equity. A residual interest in the assets of the entity after deducting all its liabilities.
iv. Income. Increases in economic benefits that result in increases in equity (other than those
related to contributions from shareholders). Income includes both revenues (resulting from
ordinary activities) and gains.

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v. Expenses. Decreases in economic benefits that result in decreases in equity (other than those
related to distributions to shareholders). Expenses includes losses that are not the result of
ordinary activities
2.2. The Recording System
Recording system is an accounting system used to capture (Record) continues track of business
transaction.
Steps in the recording transactions
There are three basic steps in the recording process:
I. Analyze each transaction for its effects on the accounts.
II. Enter the transaction information in a journal.
III. Transfer the journal information to the appropriate accounts in the ledger.
I. Analyzing Business Transaction
Analyzing a business transaction is reviewing the information included in a particular business
document and identifies the transaction effect on a particular account. Business documents are
those source documents like Receipts, invoices, a check or a bill that provides evidence for the
occurrence of the transaction.
The analysis of business transaction answers the following three questions.
i. Which accounts are affected? helps to identify the specific account affected by a
particular transaction
ii. How are they affected? Helps to specify whether the identified accounts are
increased or decreased due to the transaction.
iii. Which account is to be debited and which account is to be credited by how much.
NB; dear students this activity is a pre-stage for the recording activity. It helps to enhance the
accuracy of the recording activity. The company then enters the transaction in the journal.
Finally, it transfers the journal entry to the designated accounts in the ledger. 
The steps in the recording process occur repeatedly. In Chapter 1, we have illustrated the first
step, i.e transaction analysis, and in this chapter and the later chapters you will have more
examples and advanced illustrations to practice the recording activity.
2.2.1. The Journal and Recording Transactions
The journal is a format used to record a transaction for the first time. The process of enteringa
transaction from the source document in to a journal is called Journalizing. Companies uses a

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journal to record transactions in chronological order (the order in which they occur). Thus,
the journal is referred to as the book of original entry. For each transaction, the journal shows
the debit and credit effects on specific accounts.

Types of Journal
There are two types of Journal: General journal and the Special journal. General journal is
the most basic form of Journal which is used to record all kinds of business transactions.
Whereas special journal is a journal used to record only as specific transaction type. For instance
cash journal records only a transaction which involves cash receipt or payments, purchase
journal records only purchase transaction only etc., for the matter of this course whenever we use
the term “journal” in this course, we mean the general journal, unless we specify otherwise.
Significances of recording transaction in a journal
The journal makes several significant contributions to the recording process:
1. It discloses the complete effects of a transaction in one place.
2. It provides a chronological record of transactions.
3. It helps to prevent or locate errors because the debit and credit amounts for each entry
can be easily compared.
Illustration 2.3 Format for a General Journal
As shown inillustration2.3.below a general journal has a space for date, account titles and
explanations, references, and two amount columns.
General Journal Page No.
Date Descriptions P/R Debit Credit
               
               
               

Parts of a General Journal

Companies make separate journal entries for each transaction. A complete entry consists of: (1)
the date of the transaction, (2) the accounts and amounts to be debited and credited, and (3) a
brief explanation of the transaction.
Illustration 2.4 shows the technique of journalizing, using the first two transactions of Melkam
Internet café. On August 1, Melkam invested Br. 45,000 cash to start the business and on August

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2, Melkam purchased equipment for Br. 20,000 for cash. The number page 1 indicates that the
company records these two entries on the first page of the general journal.
Illustration 2.4 Steps of journalizing

General Journal Page 1

Date Account Title and Descriptions P/R Debit Credit
2016
Aug 1 Cash   45,000      
    Owner's capital       45,000  
    (Initial Investment)          

  2 Equipment   20,000      
    Cash       20,000  
    (purchase of equipment)          

Steps in Journalizing Transaction

1. Enter the date of the transaction in the Date column in the way it is shown on the above
table
2. Enter the name of the account to be debited in the “Account Titles and Description,”
column and record its respective amount in the Debit column. As you see from the above
table the account Cash is written bend to the extreme left end of the column, this is to
indicate that the account is recorded on the left hand side or debited.
3. Enter the name of the account to be credited in the “Account Titles and Description,”
column of the Journal and record its respective amount in the Credit column. As you see
from the above illustrations the account Owners capital is written bend to the right end of
the column, this is to indicate that specific account is recorded on the right side or
credited.
4. Include brief description of the transaction on the line below the credit account title. A
space is left between journal entries. The blank space separates individual journal entries
and makes the entire journal easier to read.
5. The column titled P/R. (which stands for Post Reference) is left blank when the journal
entry is made. This column is used later when the journal entries are transferred to the
ledger accounts.

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NB:
 Dear student’s as a beginner you might face difficulties in understanding while you have
tried to journalize transactions. But don’t worry, take it normal, what you are advised to
do is continue with practicing until you develop the knowhow to identify accounts, and
there balance sides to journalize them. Once you are able to journalize correctly and
properly, the other recording activities are so simple for you. The base for financial
reporting is the ability to journalize transactions properly. Note also that journal is the
source document or the base for further activities on the recording process so please take
time and record it properly and correctly.

Simple and Compound Entry

An individual record for debit or credit of a particular transaction is called journal entry. Journal
entries for a transaction which involves only two accounts i.e one debit and one credit account is
called simple entry. The journal entry on illustration 2.4 above is simple entries. Journal entries
which involve more than two accounts for a transaction is called compound entry. To illustrate let
us take transition 6 of Melkam Internet Café’ of chapter 1. On August 20, Melkam performed a
Br. 6,000 photocopy service to customers and receives cash of br. 2,000. Melkam billed the
customer balance of Br. 4,000 on account. The compound entry is as follow
Illustration 2.5 Compound Journal Entry
Date Account Title and Descriptions P/R Debit Credit
2016
Aug 20 Cash   2,000      
    Accounts receivable   4,000      
    Service fee       6,000  
    (Sales of service for cash and on account)          
NB; service fee is a revenue account.

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Synopsis of Lecture
 Account is a place to record increases or decreases of in the element of a particular
accounting equation.
 Asset, liability, owner’s equity, revenue and expense are the five classification of an
account.
 Assets are resources owned by a business and are classified in to current and noncurrent
asset.

 The basic steps in the recording system are analyzing traction, recording transaction to a
journal and post the journal to a ledger.
 Journalizing is a process of entering a transaction in to a journal.
 A journal is a general journal if it records all business transaction, where as it is a special
journal if record is made specific transaction types only.
 a single record of the journal is called an entry
Warm-up Discussion
 What distinguishes PPE,s from current assets
 Discuss which activities need to be recorded and which do not. Any that have economic
effects should be recorded in a journal.
 Analyze the effects of transactions on asset, liability, and equity accounts.
 Explain the term source documents and its role in the recording process.
Next day’s assignment
 Read about posting business transactions
Session 9 and 10 (Hr.17, 18, 19 and 20)
Topic:- Posting Journal to a Ledger
Session Learning Objectives
At the end of these sessions, students are expected to:
 Explain what a ledger is and its role in the recording process.
 Explain what posting is and how it helps in the recording process.
 Prepare a trial balance and explain its purposes.

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Discussion issues:
 Posting
 Preparation of trial Balance

2.2.2. The Ledger

The entire group of accounts maintained by a company is the ledger. The ledger keeps in one
place all the information about changes in specific account balances. Companies may use various
kinds of ledgers for each account. But every accountmust have at least one ledger calleda general
ledger. A general ledger contains all the asset, liability, and equity accounts.

The ledger provides the balance in each of the accounts and keeps track of changes in these
balances. For example, the Cash account shows the amount of cash available to meet current
obligations. The Accounts Receivable account shows amounts due from customers. The
Accounts Payable account shows amounts owed to creditors. Each account is numbered for
easier identification.
Standard Form of Account
The simple T-account format of a ledger used in accounting course is often very useful for
illustration purposes. However, in practice, the account format (three-column format) is
appropriate and standardized for the formal posting process. The three-column form of an
accounthas three money columns—debit, credit, and balance. The balance in the account is
determined after posting each entry. Companies use the Postreference (P/R) columns to
specifying the source document for each posting and for cross checking purpose. Illustration
2.6 shows a typical form, using assumed data from a cash account.
Illustration 2.6 Three-column form of account

Date Explanation P/R Debit Credit Balance

         
                   

Posting

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The process of transferring information from a journal to a ledger is called posting. This phase of
the recording process accumulates the effects of those journalized transactions into the respective
ledger accounts. Posting involves the following steps.
1. In the ledger, enter, the date and amount shown in the journal in the appropriate column
of the account(s) debited,
2. Enter the journal page number in the post reference column of the account
3. Enter account number in the post reference column of the journal.
4. In the ledger, enter, the date and amount shown in the journal, in the appropriate column
of the account(s) credited,
5. repeat step 2 and 3
Illustration 2.7  the following illustration shows you how to recording and post transactions.
On April 1, 2016, Ato Enkopa Bfikir established a House Finishing and Decor business, during
the month of April Ato Enkopa completed the following business transactions.
April 1. Enkopa transferred cash of Br. 50,000 fromhis personal bank account to the account
opened by the name of the business. He has Br. 175,000 left in his personal bank account and
one residential house worth br. 980,000 around Gereji.
April 3. Paid office rent for the month, Br. 3,000.
April 8. Purchased a used truck for Br.60,000, paying Br. 20,000 cash and giving a note payable
for the remainder.
April12. Purchased various equipments on account, Br. 10,000.
April 14. Purchased supplies for cash, Br. 3,200.
April 14. Paid for a one year property insurance premium Br. 2, 400.
April 18. Received cash for job completed, Br. 14, 800.
April 21. Paid creditor a portion of the amount owed for equipment on April 13 April, 15, 000.
April 23. Sent invoices to customers, of Br. 9,600 service delivered on account.
April 25. Received an invoice for truck expenses, to be paid in May Br.1,000.
April 26. Paid Telephone and electric expense of the month, Br. 650
April 27. Paid miscellaneous expenses, Br. 420.
April 27. Received cash from customers on account, Br. 4,000.
April 29. Paid salary and wages of employees for the month, Br. 6,400.
April 30. Ato Enkopa the owner withdrew cash for personal use, Br. 1,800.

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Instructions:
i. Journalize the above transactions using the general journal
ii. Post the Journal in to a ledger
iii. prepare Trail Balance
Summary Illustration of Journalizing and Posting
i. Journalizing
Illustration 2.7.1 Journal entries of the above transactions
General Journal Page 1
Date Account Title and Descriptions P/R Debit Credit
2016
April 1 Cash   50,000      
    Enkopa Capital       50,000  
    (Initial Investment)          
  3 Rent Expense   3,000      
    Cash       3,000  
    (Payment For rent)          
  8 Truck   60,000      
    Cash       20,000  
    Notes payable       40,000  
    (Purchase of Truck)          
  12 Office Equipment   10,000      
    Cash       10,000  
    (Purchase of Equipment)          
  14 Supplies   3,200      
    Cash       3,200  
    (Purchase of Supplies)          
  14 Prepaid Insurance   2,400      
    Cash       2,400  
    (Purchase of insurance coverage)          
  18 Cash   14,800      
    service fee       14,800  
    (cash received from customers)          
  21 Notes payable   15,000      
    Cash       15,000  
    (Cash Paid on account)          
  23 Accounts Receivable   9,600      
    Service Fee       9,600  
    (Provision of service)          
  25 Truck Expense   1,000      

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    Accounts payable       1,000  
    (Payment for Truck Expense)          
  26 Utilities Expense   650      
    Cash       650  
    (payment for Light and telephone)          
  27 Miscellaneous Expense   420      
    Cash       420  
    (Payment for various Expenses)          
Page 2
  27 Cash   4,000      
    Accounts Receivable       4,000  
    (cash received on account)          
  29 Salary Expense   6,400      
    Cash       6,400  
    (Salary payment)          
  30 Enkopa's Drawing   1,800      
    Cash       1,800  
    (Withdrawal of cash)          
ii. Posting the Journal to a Ledger
Illustration 2.7.2. Posting the above journal to individual ledger accounts
Before posting a journal you need to prepare charts of account. This helps you to open a ledger
by the name of each account.
Charts of Account
The list of all accounts used by the business with their account numbers is called Charts of
account. The account number is the identification code given to each account. Depending on the
size of the businesses, companies might code their accounts using two or more digits. In a two
digit coding the first digit represents account classification and the second indicates the position
of the account with in the classification. For instance is 13 is given to an account Supplies: it is to
mean that supplies is an assets account listed third.
Here is the chart of account for Enkopa House Finishing and Décor.
Enkopa House Finishing and Décor
Charts of Account

Account Account
Account Title Number Account Title Number
Asset Owner’s Equity
Cash 11 Enkopa's capital 31
Accounts Receivable 12 Enkopa's Drawing 32

Supplies 13 Income Summery 33

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Prepaid Insurance 14 Revenue 41
Office Equipment 15 Service Fee
Accumulated Depreciation – Equipment 15-1 Expenses
Truck 16 Salary Expense 51
Accumulated Depreciation – Truck 16-1 Rent Expense 52
Liabilities Utilities Expense 53
Notes Payable 21 Truck Expense 54
Accounts Payable 22 Miscellaneous Expense 55

NB:- Posting should be performed in chronological order. That is, the company should post all
the debits and credits of a particular day journal before proceeding to the next day journal entry.
Postings should be made on a timely basis to ensure that the ledger is up to date.

The reference column of a ledger account appoints the journal page from which the transaction
was posted. The explanation column of the ledger account is used infrequently because an
explanation already appears in the journal.
Illustration 2.7.2 below displayed all the postings of the above journal.
iii. Posting the Journal to a ledger
Illustration 2.7.2 posting of the above journal to the respective general ledgers accounts
Cash Account No.11
Date Explanation P/R Debit Credit Balance
2016
April 1   Jp1 50,000       50,000  
  3   Jp1     3,000   47,000  
  8   Jp1     20,000   27,000  
  12   Jp1     10,000   17,000  
  14   Jp1     3,200   13,800  
  14   Jp1     2,400   11,400  
  18   Jp1 14,800       26,200  
  21   Jp1     15,000   11,200  
24 Jp1 2,000 13,200
  26   Jp1     650   12,550  
  27   Jp1     420   12,130  
  27   Jp2 4,000       16,130  
  29   Jp2     6, 400   9, 730  
  30   Jp2     1,800   7, 930  

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Accounts Receivables Account No. 12
Date Explanation P/R Debit Credit Balance
2016
23   Jp1 9,600       9,600  
April
  27   Jp1     4,000   5,600  

Supplies Account No. 13

Date Explanation P/R Debit Credit Balance
2016
April 14   Jp1 3,200       3,200  
                   

Prepaid Insurance Account No. 14

Date Explanation P/R Debit Credit Balance
2016
April 14   Jp1 2,400       2,400  
                   

Office Equipment Account No. 15

Date Explanation P/R Debit Credit Balance
2016
April 14   Jp1 10,000       10,000  
                   

Truck Account No. 16

Date Explanation P/R Debit Credit Balance
2016
April 8   Jp1 60,000       60,000  
                   

Notes Payable Account No. 21

Date Explanation P/R Debit Credit Balance
2016
April 8   Jp1     40,000   40,000  
  21     15,000       25,000  

Accounts Payable Account No. 22

Date Explanation P/R Debit Credit Balance
2016
April 25   Jp1     1,000   1,000  

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Unearned Service Revenue Account No. 23

Debi
Date Explanation P/R t Credit Balance

2016 25 Jp1     2,000   2,000  

                 

Enkopa's Capital Account No. 31

Date Explanation P/R Debit Credit Balance
2016
April 1   Jp1     50,000   50,000  
                   

Enkopa's Drawing Account No. 32

Date Explanation P/R Debit Credit Balance
2016 30   Jp2 1,800       1,800  
                   

Service Fee Account No. 41

Date Explanation P/R Debit Credit Balance
2016 18   Jp1     14,800   14,800  
  23   Jp1     9,600   24,400  

Salary Expense Account No. 51

Date Explanation P/R Debit Credit Balance
2016 29   Jp2 6,400     6,400  
                   

Rent Expense Account No. 52

Date Explanation P/R Debit Credit Balance
2016 3   Jp1 3,000       3,000  
                   

Utilities Expanse Account No. 53

Date Explanation P/R Debit Credit Balance
2016 26   Jp1 650       650  
                   

Truck Expense Account No. 54

Date Explanation P/R Debit Credit Balance

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 2016 25   Jp1 1,000       1,000  
                   

Miscellaneous Expense Account No. 55

Date Explanation P/R Debit Credit Balance
2016 27   Jp1 420       420  
                   

2.2.3. Trial Balance

A trial balance is a list of accounts and their balances at a given time. It list accounts in the
order in which they appear in the charts of account. Debit balances appear in the left column and
credit balances in the right column.

The trial balance proves the mathematical accuracy and equality of the total debits and the
total credits after posting. Under the double-entry system, this equality occurs when the sum of
the debit account balances equals the sum of the credit account balances.  In addition, a trial
balance is useful in the preparation of financial statements.
The steps for preparing a trial balance are:
1. List the account titles and their balances.
2. Total the debit and credit columns.
3. Prove the equality of the two columns.
iii.Trial Balance
Illustration 2.7.3. Trial balance
Enkopa House Finishing and Decor
Trial Balance
For the month ended April30, 1016

Account Title Debit Balance Credit Balance

Cash 7,930  
Accounts Receivable 5,600  
Supplies 3,200  
Prepaid Insurance 2,400  
Office Equipment 10,000  

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 Truck 60,000  
Notes Payable   25,000
Accounts Payable   1,000
Unearned Service Revenue 2,000
Enkopa's capital   50,000
Enkopa's Drawing 1,800  
Service fee   24,400
Salary Expense 6,400  
Rent Expense 3,000  
Utilities Expense 650  
Truck Expense 1,000  
Miscellaneous Expense 420  
Total 102,400 102,400

The trial balance for Enkopa House Finishing and Décor as of April30, 2016, is shown in
illustration 2.7.3.The balances of the accounts in the above trial balance is taken from the ledger
balance of the individual ledger illustration 2.7.2. Before the preparation of a trial balance the
individual account balance of each account of ledger must be determined. The trial balance
prepared immediately after completion of posting is called unadjusted trial balance. The above
trial balance is known as an unadjusted trial balance. This is to distinguish it from the adjusted
trial balances that we will prepare in the next chapters.
Limitations of a Trial Balance
A trial balance does not guarantee freedom from recording errors, however. Numerous errors
may exist even though the totals of the trial balance columns agree. For example, the trial
balance may balance even when (1) a transaction is not journalized, (2) a correct journal entry is
not posted, (3) a journal entry is posted twice, (4) incorrect accounts are used in journalizing or
posting, or (5) offsetting errors are made in recording the amount of a transaction. As long as
equal debits and credits are posted, even to the wrong account or in the wrong amount, the total
debits will equal the total credits. The trial balance does not prove that the company has
recorded all transactions or that the ledger is correct.

Locating Errors
In locating errors the first activity is to determine the amount of the difference between the two
columns of the trial balance. After this amount is known, the following steps are often helpful:

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 1. If the difference is Br. 10, Br.100, or Br.1,000, it may be addition error, re-add the trial
balance columns.
2. If the difference is divisible by 2, scan the trial balance to see whether a balance equal to
half the error has been entered in the wrong column.
3. If the difference is divisible by 9, it is a transposition and slide error while copying.
Retrace the account balances to see whether they are incorrectly copied from the ledger.
For example, if a balance was Br. 43 and it was listed as Br.34, a Br.9 error has been
made. Reversing the order of numbers is called a transposition error.
4. If the difference is not divisible by 2 or 9, scan the ledger to see whether an account
balance in the amount of the error has been omitted from the trial balance, and scan the
journal to see whether a posting of that amount has been omitted.
Correction of Error
Occasional error in journalizing and posting transactions are unavoidable. Procedures used to
correct error in the journal and ledger varies according to the nature of the error and the
duration which it is discovered.
If an error in the journal is discovered before the entry is posted, the correction will be made
by drawing a line through the error and insert the correct account or amount immediately
above.
If an entry in the journal is recorded correctly, but incorrectly posted to wrong side, i.e debit
as credit, it will be corrected by drawing a line through the error and posting the correct item
above it.
If an error in the journal is discovered after it is posted to the ledger, it will be corrected by
recording and posting correcting entries.
Procedures for Correcting Entries
Error Correction procedure

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 Error in recording but not yet posted Draw a single line through the error
 Correct recording but incorrect posting Draw a single line through the error
 Incorrect journal entry is posted Journalize and post correcting entry
Lecture Synopsis
 A group of account is called a ledger.
 The process of transferring a journal to a ledger is called posting.
 Determine the ending balance by netting the total debits and credits.
 List of all accounts with their account number is called charts of account
 List of all accounts with their account balance is called trial balance.
 A trial balance proves the mathematical accuracy of the recording process.
 Trial balance doesn’t give an absolute prove about the accuracy of the recording process.
 An entry made to correct recording error is called correcting entry.
Next day’s assignment
 Read about the procedures for completion of accounting cycle
Session 11 and (Hr. 21and 22)
Topic:- Posting Journal to a Ledger
Session Learning Objectives
At the end of these sessions, students are expected to:
 Explain and prepare work sheet.
 Record and post adjusting and closing entries
 Prepare post closing trial balance
2.3. Completing an Accounting Cycle for Service Giving Business

Dear students in the previous part of this section we have tried to learn how business transactions
are recorded posted and preparing of trial balance. Now in this part we will try to complete the
accounting cycle and to issue financial statement. Then some accounts are adjusted and we have
also seen why and how to adjust accounts. Completion of the accounting cycle involves the
following completion activities,

i. Preparation of work sheet(optional Step)

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 ii. Preparation of financial statements
a. Income Statement
b. Statements of Owners Equity
c. Statements of financial position
iii. Record and post adjusting entries
iv. Record and post closing entries
v. Preparation of post closing trial balance

The following trial balance is taken from Enkopa House Finishing prepared for April 30,
2016. This trial balance is prepared by taking the ending balance of each ledger. Such trial
balance is referred to as unadjusted trial balance. So, adjusting (updating) accounts are
required before preparation of financial statement. Although issues of Adjusting accounts
will be deeply discussed in chapter 3, the following are the reasons for adjustment

1. To record those events which are not journalized daily, for example daily consumption of
supplies like a piece of paper
2. To record those costs, which expire with time and are therefore not recorded, for example
prepaid insurance or rent
3. To record those items previously unrecorded, for example accrued salary
Using the following information perform the instructions ordered below.

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 Enkopa House Finishing and Décor

Unadjusted Trial Balance

For the month ended April30, 1016

Account Title Debit Balance Credit Balance

Cash 7,930  
Accounts Receivable 5,600  
Supplies 3,200  
Prepaid Insurance 2,400  
Office Equipment 10,000  
Truck 60,000  
Notes Payable   25,000
Accounts Payable   1,000
Unearned Service Revenue 2,000
Enkopa's Capital   50,000
Enkopa's Drawing 1,800  
Service fee   24,400
Salary Expense 6,400  
Rent Expense 3,000  
Utilities Expense 650  
Truck Expense 1,000  
Miscellaneous Expense 420  
Total 102,400 102,400

Information for adjustments

 Supplies on hand April 30,2016 Br.1,200

 Insurance expired during April 30,2016 Br. 200
 Deprecation of for Truck April 30,2016 Br. 100
 Deprecation of office equipment for April 30,2016 Br. 150
 Revenue earned for April 30, 2016, Br.1,300
 Salary accrued but not yet paid Br. 1,250
Instructions:- using the above information perform:

i. Prepare work sheet

ii. Prepare of financial statements
a. Income Statement
b. Statements of Owners Equity
c. Statements of financial position

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 iii. Record and post adjusting entries
iv. Recording and posting closing entries
v. Prepare Post Closing trial balance
vi. Preparation of post closing trial balance

i. Work Sheet

Worksheet is a working paper of an accountant. It showed the details of accounting works and

adjustment to check their arithmetical accuracy before preparing financial statements.

It is a multi-columnar sheet of paper used in the accounting cycle to facilitate the work of
making adjusting and closing entries and preparingfinancial statements. It is a working paper,
which helps the accountant to assemble all the ledger account balance and adjustment
information together on one schedule. 

The basic objective of a worksheet is to organize the information needed to prepare financial
statement without recording and posting adjusting entries.

Worksheet is a working tool or a supplementary device for the accountant and not a permanent
accounting record.

A worksheet generally contains eight to ten columns. A ten column work sheet contains the
following five column heading. Each item needs two amount column, one for debit the other for
credit.

 Unadjusted Trial Balance:-a trial balance shows the balance of all accounts after adjustment
at the end of the accounting period.
 Adjustments:- Shows accounts that are adjusted as per the adjustment information.
 Adjusted trial balance:-a trial balance shows the balance of all accounts after adjustment at
the end of the accounting period.
 Income statement:- shows all revenue and expense accounts extended from the adjusted trail
balance.
 Balance sheet. Shows all asset, liability, and equity accounts extended from the adjusted trail
balance.

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 Steps in preparing worksheet
Step 1 entering unadjusted trial balance
Step 2 enter adjustments in the adjustments column
Step 3 prepare adjusted balance using unadjusted trial balance and adjustments column
Step 4 Extend the adjusted trial balance to the appropriate financial statements
Step 5 Total the income statement column and compute net income or net loss
Step 6 Extend the amount of the net income to credit column or the net loss to the debit column
of the balance sheet and equate the columns
Enkopa House Finishing and Décor
Work Sheet
For April 30,1016
Unadjusted Trial Adjustment Adjusted trail Income Balance Sheet
Balance Balance Statement
Account Title
Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Cash 7,930       7,930       7,930  
Accounts 5,600       5600       5600  
Receivable
Supplies 3,200     a)2,000 1200       1200  
Prepaid 2,400     b)200 2,200       2,200  
Insurance
Office 10,000       10,000       10,000  
Equipment
Accumulated       d)100   100       100
Depreciationequi
p.
Truck 60,000       60,000       60,000  
Accumulated       c)150   150       150
Depreciation
Notes Payable   25,000       25,000       25,000
Accounts   1,000       1,000       1,000
PayablePayable
Salary       g) 1250   1250       1,250
Unearned   2,000 e)1,300     700       700
Service Revenue
Enkopa's Capital   50,000       50,000       50,000
Enkopa's 1,800       1800       1,800  
Drawing
Service fee   24,400   e)1,300   25,700   25,700    
Salary Expense 6,400   g)1,250   7,650   7,650      
Rent Expense 3,000       3,000   3,000      
Utilities Expense 650       650   650      
Truck Expense 1,000       1000   1,000      
Miscellaneous 420       420   420      
Expense Expense
Supplies     a)2,000   2000   2,000      
Insurance     b) 200   200   200      
Expense
Deprecation   c,d) 250   250   250      
Expense
Total 102,400 102,400 5,400 5,400 103,900 103700 15,170 25700 88,730 78200
Net income             10,530     10,530
Total             25,700 25,700 88,730 88,730

Illustration 3.7 shows you how to prepare worksheet

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a. Statements of profit or loss and other comprehensive income

Enkopa House Finishing and Décor

Statements of profit or loss and other Comprehensive Income
For April 30,1016

Revenues    
  Service Revenue   Br. 25,700
Expenses    
  Salary Expense Br. 7,650  
  Rent expense 3,000  
  Utilities Expense 650  
  truck expense 1,000  
  Miscellaneous expense 420  
  supplies expense 2,000  
  insurance expense 200  
  Depreciation Expense 250  
  Total Expense   15,170
  Net Income   10,530

b. Owners Equity Statement

Enkopa House Finishing and Décor

Statements of Owner's Equity
For April 30,1016

Owners Capital January 1,   50,000

Add Net income 10,530
  sub total   60,530
Less Drawing   1,800
Owner's capital August 30,   58,730

c. Statements of Financial Position

Enkopa House Finishing and Décor

Statements of Financial Position

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 For April 30,1016

Asset
Non Current Asset
Property, Plant
Truck
and Equipment   60,000  
Accumulated depreciation on truck 150  

    59,850
Equipment 10,000  
Accumulateddepreciation on equipment 100  

    9,900
Total PPE’s 69,750
Current Asset
Prepaid Insurance   2,200
Supplies   1,200
Accounts Receivable   5,600
Cash   7,930
Total Current 16,930
 asset Total Asset   86,680
Liability and Equity
Owners equity
Enkopa.’s Br. 58,730
Liabilities
Capital    
  Accounts Payable   1,000
  Salary Payable   1,250
  Unearned   700
  Notes Payable
Revenue   25,000
Total Liability 27,950
Total Equity and liabilities Br. 86,680

vii. Recording Adjusting Entry

Adjusting Entry

2016 3 Supplies Expense   2000      

   0 Supplies       2000  
    (Adjustment of supplies)          

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  3 Insurance Expense   200      
   0 Prepaid Insurance       200  
    (Adjustment of insurance)          
  3 Deprecation Expense   150      
   0 Accumulated Dep.Truck       150  
    (Recognition of Deprecation)          
  3 Deprecation Expense   100      
   0 Accumulated Dep.Equip       100  
  3 Unearned Revenue   1,300      
    Service revenue       1,300  
    (Adjustments of unearned rev)          
  3 Salary Expense   1,250      
    Salary Payable       1,250  
    (Recording Accrued Salary)          

vi. Recording Closing Entry

Closing Accounts

The revenue, expenses, and drawing accounts are temporary accounts used in classifying and
summarizing changes in the owner’s equity during the accounting period. At the end of the
period, the net effect of the balances in these accounts must be included in the permanent capital
(Retained Earnings) account through closing entry. The balances must also be removed from the
temporary accounts and transferred to permanent account so that will be ready for use in
accumulating data for the following account period. Both of these goals are accomplished by a
series of entries is called closing entries. Closing entries transfer the balances of temporary
accounts to the owner’s capital account.

The closing process involves the following four steps:

1. Revenue account balances are transferred to an account called Income Summaryby debiting
each service fee and crediting Income Summary for the total revenue.

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2. Expense account balances are transferred to an account called Income Summaryby crediting
each expense account for its balance and debiting Income Summary for the total expenses.

3. The balance of Income Summary (net income or net loss) is transferred to the owner’s
capital account by debiting Income Summary for its balance and crediting the owner’s capital
account

4. The balance of the Owner’s Drawing account is transferred to the Owner’s Capital account
debiting the owner’s capital account for the balance of the drawing account and crediting the
drawing account .

In the case of a net loss, Income Summary will have a debit balance after the firsttwo closing
entries. In this case, credit Income Summary for the amount of its balanceand debit the owner’s
capital account for the amount of the net loss.Closing entries are recorded in the journal and are
dated as of the last day of theaccounting period. In the journal, closing entries are recorded
immediately followingthe adjusting entries. The caption, Closing Entries, is often inserted
above the closing entriesto separate them from the adjusting entries

Closing Entries

Date Account Title and Descriptions P/R Debit Credit

2016 31 Service Fee   25,700      

    Income Summery       25,700  

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    (Closing revenue Accounts)          
               
  31 Income Summery   15,170      
    Salary Expense       7,650  
    Rent Expense       3,000  
    Utilities Expense       650  
    Truck Expense       1,000  
    Miscellaneous expense       420  
    Supplies Expense       2,000  
    Insurance Expense       200  
Depreciation Expense 250
    (Closing Expense Accounts)          
               
  31 Income Summery   10,,530      
    Owner's Capital       10,530  
    (Closing income summery)          
  31 Owner’s Capital   1,800      
    Owner’s Drawing       1,800  
    (Closing Drawing account)          

Post closing Trial Balance

A post-closing trial balance is prepared after the closing entries have been posted. Thepurpose of
the post-closing (after closing) trial balance is to verify that the ledger is inbalance at the
beginning of the next period. The accounts and amounts should agreeexactly with the accounts
and amounts listed on the statements of financial position at the end of the period.

Enkopa House Finishing and Decor

Post Closing Trial Balance

For the month ended April30,1016

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 Account Title Debit Balance Credit Balance

Cash 7,930  
Accounts Receivable 5,600  
Supplies 1,200  
Prepaid Insurance 2,200  
Office Equipment 10,000  
Accumulated deprecation 100
Truck 60,000  
Accumulated deprecation 150
Notes Payable   25,000
Accounts Payable   1,000
Salary Payable 1250
Unearned Service Revenue 700
Enkopa's Capital   58,730
Total 86,930 86,930

2.1 The adjusting process-accrual vs. cash basis of accounting

2.2 Preparing a worksheet
2.3 Preparing financial statements from a worksheet
2.4 Adjusting and closing entries
Post-closing trial balance

Wrap-up Discussion Questions

 Explain the difference between journalizing and posting
 Explain the function of post reference column in the recording process.
 Why is posting necessary?
 Explain the purpose of preparing trial balance and its limitation.
 Explain the difference between per closing and post closing trial balance.

SELF-EXAMINATION QUESTIONS

1. a debit signify

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 a. an increase in an asset account c. An increase in a liability account
b. a decrease in an asset account d. an increase in the owner’s capital
2. the type of account with the normal credit balance is:
a. Asset c. A revenue
b. Drawing d. An expense
4. the current asset category will include
a. cash c. Supplies on had
b. Accounts receivable d. all of the above
5. the receipt of cash from customers in payments of their accounts would be recorded by a
a. debit to cash, credit to accounts receivable
b. Debit to accounts receivable, credit to cash
c. Debit to accounts payable, credit to accounts payable
d. debit to accounts payable, credit to cash
6. the form listing the balances and the titles of accounts in the ledger on a given date is the:
a. Income statement c. retained earning statement
b. statements of Financial position d. trial balance

ILLUSTRATIVE PROBLEM

Simret Abera, MD. has been practicing as a pediatrician for three years. During June, she has
completed the following transaction.

June 1, Paid office rent for June Br. 6,000

2, Purchased equipment on account Br. 20,000

5, Received Cash on account from patients Br. 10,000

8, Purchased X-Ray film and other supplies on account Br. 450

9, One of the items of equipment purchased on june2 was defective. it was returned with the
permission of the supplier, who agreed to reduce the account fot the amount charged for the item,
br. 200

12, paid cash to creditors on account, 7,600

16, Sold X-Ray film to another doctor at coat, as an accommodation, receiving cash, Br. 500

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17, Paid cash for renewal of a 2-year property insurance policy, Br, 1,800

20, Discovered that the balance of cash, and accounts payable as of june1 were overstated by br
160. A payment of that amount to a creditor in May had not been recorded. Journalize the Br. 160
payments as of June 20.

23, Paid cash for laboratory analysis Br. 2,450

27, Paid cash from the business’s bank account for personal and family expenses br. 3,200

30, Recorded the cash received in payments of service to patients during June Br.13,700

30, Paid salaries of receptionists and nurses Br. 8,000

30, Paid water and electric expense Br,1,200

30, Recorded fees charged to patients on account for services performed Br, 3, 800

30, Paid telephone expense Br. 800

30, Paid miscellaneous expense br. 600

Samrwit’s Account titles, numbers, and balances as of June 1 are listed as follows: Cash, 11, Br,
3,123, Accounts receivables, 12, Br, 6,725, Supplies, 13 Br. 290, Prepaid Insurance, 14, Br. 365,
equipment, 15, Br. 19, 745, Accounts Payable, 21, BR. 765, Samrawit’s capital, 31,Br.29,483,
Samrawit’s drawing, 32,, Professional Fee, 41, Salary Expense, 51, rent expense, 53, Libratory
Expenses, 55 utility Expense, 56 Miscellaneous Expense, 59

Instructions

1. Open a ledger of four-column accounts for Dr. Samrawit as of june1 of the current year.
Enter the balances in the appropriate balance column and place a check mark (-) in the
post reference column.(Please check the equality of the debits and credits before
proceeding to the next instruction.
2. Record each transactions using general journal
3. Post the journal to the ledger, extending the month end balances to the appropriate
balance columns after all posting is completed.
4. Prepare a trial balance of june30.
CHAPTER THREE

ADJUSTING ACCOUNTS

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Chapter over View
In the previous two chapters chapter you have tried to understand the basic accounting equation,
how to capture business transactions using an accounting equation and how to complete the
accounting cycle for service. Dear students’ while we are completing the cycle we have
meinshined the necessity of adjusting accounts before preparing financial statements at the end
of the accounting period In this chapter you will have the detail discussion about why and how
accounts are adjusted.

Learning Objectives:

After completing this chapter the students should be able to:

 Explain the time period assumption.

 Explain the accrual basis of accounting.
 Explain the reasons for adjusting entries.
 Prepare adjusting entries for deferrals
 Understand the characteristics of accruals
 Prepare adjusting entries for accruals.
 Apply alternative treatments for deferrals
 Describe the nature and purpose of an adjusted trial balance.
Session 12(Hr. 23 and 24)

Topic:- Adjusting Accounts

Session Learning Objective

 Explain the time period assumption.

 Explain the accrual basis of accounting.
 Explain the reasons for adjusting entries.
 Prepare adjusting entries for deferrals

Reading Assignment discussion

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Discussion issues:

 Adjusting accounts
3.1. Adjusting Accounts

The issue of Adjusting Accounts deals with the timing issue, the basics of adjusting entry and the
preparation of adjusted trial balance and financial statement.

3.1.1 Timing Issues

As per periodicity assumption, the economic life of the business is divided into artificial time
periods, i.e, a month, a quarter, or a year. An accountingperiod which covers less than a year is
aninterim period and a financial report prepared for it is an interim report. An accounting time
period that covers one year or 12 months in length is called a fiscal year. A fiscal year usually
begins with the first day of a particular month and ends 12 months later on the last day of a
month. Many businesses use the calendar year (January 1 to December 31) as their accounting
period. Periodicity assumption requires revenues and expenses be reported in the proper period.

3.1.2. The Revenue Recognition Principle

As per IFRS revenue is recognized when the performance obligation is satisfied partially or
completely. The earning process goes in line with the satisfaction of a particular performance
obligation. In a service company revenue is usually considered to be earned at the time the
service is performed. Where as in a merchandising company revenue is considered to be earned
at the time the goods are delivered. Dear students you will learn the detailed concepts and
applications of revenue recognition principle in your IntermediateFinancial Accounting I
course.
To illustrate, assume that Dr. Leul Dental Clinic delivers brass dental service on December 25,
2016 but the customer going to pay for it on January 25, 2017. Here revenue should be
recognized on December 25 on the date service is performed rather than on January 25 cash is
collected. At December 31, the clinic would report a receivable on its statement of financial
position and revenue in its income statement for the service performed. This requires recording
of the respective adjusting entry.
3.1.3. Accrual versus Cash- Basis of Accounting

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Under the accrual basis, companies record transactions that change a company’s financial
statements in the periods in which the events occur. This means that revenues should be
recognized in the period when service is performed and expenses should be recognized in the
period when incurred. Whether or not cash is received or paid. Accrual bases of accounting
adhere to revenue recognition principle. As you recalled from chapter one it is one of the
assumption of IFRS.

The alternative for the accrual basis is the cash basis of accounting. Under cash-basis accounting,
revenue is recognized when cash is received, when as expenses are recognized when cash is
paid. The cash basis seems appealing due to its simplicity, but it often produces misleading
financial statements. It fails to record revenue for a company that has performed services and
expanse that has incurred until cash is transacted. As a result, the cash basis does not obey the
revenue recognition principle.

3.2. The Basics of Adjusting Entries

At the end of the accounting period, many of the account balances in the ledger can be reported
in the financial statements without change. For example, the balances of the cash and office
equipment accounts are normally the amount reported on the balance sheet. Under the accrual
basis, however, some accounts in the ledger require updating because of the following reasons:

4. To record those events which are not journalized daily, for example daily consumption of
supplies like a piece of paper
5. To record those costs, which expire with time and are therefore not recorded, for example
prepaid insurance or rent
6. To record those items previously unrecorded, for example accrued salary
The process of updating an account is called adjusting. The journal entries recorded to that
update an account called adjusting entries. The entries are required each time when financial
statement is prepared. Each adjusting entries affect at least one income statement account and
one balance sheet account. Thus, an adjusting entry will always involve revenue or an expense
account in one side and an asset or a liability account in the other side.

3.3. Classifications and types of Adjusting Entries

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3.3.1 Classification of Adjusting Entries

Adjusting entries can be categorized in to three. These are:

i. Prepayments or Deferrals (prepaid expense or unearned revenue),

ii. Accruals (Accrued revenue or Accrued expense), or
iii. Estimates ( Deprecation or amortization)
Types of Adjusting Entry

i. Prepayments (Deferrals)
To defer means to postpone or delay. Deferrals are expenses or revenues that are recognized at a
date later than the point when cash was originally paid or received. Companies make adjusting
entries for deferrals to record the portion of the deferred item that was incurred as an expense or
recognized as revenue during the current accounting period. The two types of deferrals are
prepaid expenses and unearned revenues.

Prepayments

1. Prepaid Expenses: Expenses paid in cash and recorded as assets before they are used or
consumed.

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

ii. Accruals

Accrual is the recognition of revenue or an expense that has arisen but has not yet been recorded.
The word “accrue” means to accumulate or grow in size. An accrual is the recognition of revenue
or an expense that has accumulated overtime but has not yet been recorded. In order to report the
company’s financial position and results of operation, the accruals requires adjustments. The
adjusting entries for accruals are used to record revenues earned and expenses incurred in the
current period. There are two types of accruals in accounting. These are:

Accruals

1. Accrued revenues: Revenues for services performed but not yet received in cash or
recorded.

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 2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.
iii. Estimates
Deprecation is an allocation of the cost of capital assets to expense over their useful lives.The
capital assets included office Equipments, Trucks or Building etc. These items give long years
service and their serving capacity will reduce as a passage of time through use. The cost of a
particular asset is allocated to expense by the amount of estimated reduction in periodic service
giving capacity. Here adjusting entries are required to recognise expenses resulted from usage of
capital assets.

3.4. Analyzing and Recording Adjusting Entries for Deferrals

Prepaid Expenses

When expenses are prepaid, an asset account called “prepaid expense” is increased (debited) to
show the service or benefit that the company will receive in the future. Examples of common
prepayments are insurance, supplies, advertising, and rent.
Prepaid expenses are costs that expire either with the passage of time (e.g., rent and
insurance) or through use (e.g., supplies). The expiration of these costs does not require daily
entries, which would be impractical and unnecessary. Accordingly, companies postpone the
recognition of such cost expirations until they prepare financial statements. At each statement
date, they make adjusting entries to record the expenses applicable to the current accounting
period and to show the remaining amounts in the asset accounts.
Prior to adjustment, assets are overstated and expenses are understated. Therefore, an adjusting
entry for prepaid expenses results in an increase (a debit) to an expense account and a
decrease (a credit) to an asset account.
Let’s look in more detail at some specific types of prepaid expenses, beginning with supplies.

Supplies 
The purchase of supplies, such as paper and envelopes cleaning supplies, results in an increase (a
debit) to an asset account. During the accounting period, the company keeps using of the
supplies purchased without making the respective record. At the end of the accounting period,

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the company counts the remaining supplies and deducts it from the unadjusted balance in the
Supplies (asset) account to determine the used portion. Thenrecord an adjusting entry by debiting
supplies expenses and crediting supplies account for the used portion.

Illustration:As you remember the transaction 3 Enkopa House finishing and Décor of chapter 2,
the company purchased supplies costing Br. 3,200 on April 14,2016. The purchase was record by
debiting the asset account supplies. This account shows a balance of Br.3, 200 in the April 30
trial balance. An inventory count at April 30 reveals that Br. 1,200 of supplies are remained on
hand. This means the company consumed supplies costing br. 2,000. This reduces supplies and
increase supplies expense by the amount consumed. As a result Enkopa needs to record this
adjustment using adjusting entries. Illustration 3.1 presents the adjustments.
2016
30 Supplies Expense   2,000      
Apri
 l   Supplies       2,000  
    (Adjustments for supplies Used)          
After recording the adjusting entry it is posted to the appropriate accounts as follows.
Supplies Account No. 13

Date Explanation P/R Debit Credit Balance

2016
14   Jp1 3,200       3,200  

  30  Adjusting Entry       2,000     1,200  

Supplies Expense Account No. 53

Date Explanation P/R Debit Credit Balance

30  Adjusting Entry Jp1 2,000       2,000  
2016

NB: After adjustment, the asset account Supplies shows a balance of Br. 1,200, which is equal to
the cost of supplies on hand at the statement date. In addition, Supplies Expense shows a balance
of br. 2,000, which equals the cost of supplies used in April. If Enkopa did not make the
adjusting entry, April expenses are understated and net income is overstated by Br.

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2,000. Moreover, both assets and equity will be overstated by Br.2,000 on the April 30
statement of financial position.

Insurance 
Companies purchase insurance to protect themselves from losses due to fire, theft, and
unforeseen events. Insurance must be paid in advance, often for more than one year. The cost of
insurance (premiums) paid in advance is recorded as an increase (debit) in the asset account
Prepaid Insurance. At the financial statement date, companies increase (debit) Insurance
Expense and decrease (credit) Prepaid Insurance for the cost of insurance that has expired during
the period.
Illustration:as you recall in previous chapter discussion Enkopa paid Br. 2,400 for a one year
insurance premium on April 14, 2016. The Company recorded the payment by increasing
(debiting) Prepaid Insurance and decreasing (Crediting) Cash. Prepaid insurance shows a debit
balance of Br.2,400 in the April 30, 2016 trial balance before adjustment. Insurance of Br.
200expires each month. The adjusting entry is recorded in illustration 3.2 as follows.
 2016
30 Insurance Expense   200      
April
    Prepaid Insurance       200  
    (Adjustments for insurances Expired)          
The above adjusting entry is posted to appropriate accounts as follows.
Prepaid Insurance Account No. 14

Date Explanation P/R Debit Credit Balance

2016
14   Jp1 2,400       2,400  
April
   30 Adjusting Entry        200    2,200  

Insurance Expense Account No. 54

Date Explanation P/R Debit Credit Balance
2016  Adjusting
30 Entry Jp1 200       200  
April
                   

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After posting the adjusting entry the asset Prepaid Insurance shows a balance of Br. 2,200, this
represents the unexpired cost for the remaining 11 months of coverage. On the other hand, the
balance in Insurance Expense equals the cost of insurance expired during April. If Enkopa does
not make this adjustment, April expenses are understated by Br. 200 and net income is
overstated by Br. 200. Moreover, both assets and equity will be overstated by 200 on the
April 30 statement of financial position.
3.5. Alternative Treatment of Prepaid Expenses and Unearned Revenues
In discussing adjusting entries for prepaid expenses and unearned revenues, we have illustrated
transactions for which companies made the initial entries to statement of financial position
accounts. In the case of prepaid expenses, the company debited the prepayment to an asset
account. In the case of unearned revenues, the company credited a liability account to record the
cash received in advance.
Some companies use an alternative treatment: i.e. (1) When a company prepays an expense, it
debits an expense account instead of asset. (2) When it receives advance payment for future
services, it credits the amount to a revenue account instead of liability. Companies prefer to use
this alternatives if they think that prepayments are fully consumed in the period payment is made
and delivery of service is completed in the same period advance collection is made. This
alternative treatment of prepaid expenses and unearned revenues has the same effect on the
financial statements as the procedures described in the chapter.
Prepayments initially recognized as expense
To illustrate, assume that on December 1, 2016 Fresh Corner acquired supplies of Br. 1,000 for
cash. The company records prepayments initially as expanse and passes the following Journal
entry
2016 1 Supplies Expense 1000
Dec
Cash 1000
(to record purchase of supplies as expense)

As you see from the above illustration an expense account (supplies expense) recognized in
advance. Here the company expects that it will use all the supplies purchased before December

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31. If the supplies are used fully as expected there is no need for adjusting entry at the end of the
accounting period.
But what if, a br. 200 inventory of supplies is left un-used at the end of the month December 31.
If so adjusting entry is required to reduce the expense account (Supplies expense) and increase
and asset account (Supplies) by the amount of the unused portion of supplies as follows.
2016 3 Supplies 200
Decemb 1
er Supplies expense 200
(to record supplies inventory )

After recording the adjusting entry posting is made to the appropriate accounts as
follows

supplies expense

Date Explanation P/R bit Credit Balance

2016 1   Jp1 1000     1,000  

   3  Adjusting entry  Jp2     200     800  

Supplies 1

Date Explanation P/R Debit Credit Balance

31  Adjusting Entry  Jp1  200        200  

2016
                   

After posting the asset account Supplies shows a balance of Br.200, which is equal to the cost of
supplies on hand at December 31. In addition, Supplies Expense shows a balance of Br. 800.
This is equal to the cost of supplies used between December 1 and December 31. Without the
adjusting entry, expenses are overstated and net income is understated by 200 in the October
income statement. Also, both assets and equity are understated by Br.200 on the December 31
statement of financial position.
Comparison of Adjustments of prepayments
Prepayments initially recorded as

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 Asset Expense
  1 Supplies 1000     Supplies expense 1000  
    Cash   1000   Cash   1000
To record purchase of supplies
  2 Supplies expense 800     Supplies 200  
    Supplies   800   Supplies expense   200
Adjustment at used portion  Adjust at unused portion

800 Dec 31
Supplies
Bal. Br. 200  
Debit
Dec 1, 1,000 Credit

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 supplies

Debit Credit Dec.31 800

Supplies Expense Bal. Br.800  
Dec 1 - -
Debit
Dec 1,
Dec 31 - 200 Credit
Bal. Br. 200  

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As you see from the above illustration the ending balance of supplies ledger under both
treatments the same Br. 200 and also supplies expanse account shows an equal balance of in
both cases. As a result the alternative treatment of prepaid expenses has the same effect on the
financial statements as the procedures described in the chapter.

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Unearned Revenue
When companies receive cash before performing service, they record a liability by increasing
(crediting) Unearned Revenue. Advance collections for rent, magazine subscriptions, airplane
tickets and tuition may result in unearned revenues. Unearned revenue represents the presence
of performance obligation (liability) to deliver a service to particular customers. The company
subsequently recognizes revenues when service is performed. But performance of service does
not involve daily transaction. As a result the recognition of revenue delays until the date of
adjustment. Then, the company makes an adjusting entry to record the revenue earned for
services performed and the liability settled at the end of the accounting period. Typically, prior to
adjustment, liabilities are overstated and revenues are understated. Therefore, as shown
in Illustration 3.3, the adjusting entry for unearned revenues results in a decrease (a debit)
to a liability account and an increase (a credit) to a revenue account.

Alternative Terminology: Unearned revenue is sometimes referred to as deferred revenue.

Illustration: As you remember from Illustration 3.3 of chapter 2 Enkopa received Br. 2,000
from clients in advance for the finishing service. Unearned Service Revenue shows a balance
of Br.2, 000 in the April trial balance. Analysis reveals that the company performed Br.1, 300
services in April.
The liability (Unearned Service Revenue) is therefore decreased, and equity (Service Revenue) is
increased by the amount.
30 Unearned service Revenue 1,300
Service Revenue 1,300
    (Adjustments for unearned revenue)          

Unearned Service revenue Account No. 23

Date Explanation P/R Debit Credit Balance

2016
25    Jp1   2,000   2,000  

   30  Adjusting Entry    1,300        700  

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 Service Revenue Account No. 41

Date Explanation P/R Debit Credit Balance

2016
18  14, 800 14,800
April
23   Jp1    9,600   24,400  
   30  Adjusting Entry        1,300    25,700  

After recording and posting adjusting entries the liability Unearned Service Revenue now
shows a balance of Br.700 I.e the amount represents the remaining finishing services expected to
be performed in the future. On the other hand Service Revenue shows total revenue recognized
in April 26,600. Without this adjustment, revenues and net income are understated by Br.
1,300. Moreover, liabilities are overstated and equity is understated by Br. 1,300 on the
April 30 statement of financial position.
Advance Collections Initially Recognized as Revenue
Unearned Revenue
Unearned revenues are recognized as revenue at the time services are performed. Similar to the
case for prepaid expenses, companies may credit (increase) revenue account when they receive
cash for future services.

To illustrate, assume that on December 1Birhana Selam Printing press received Br. 8,000 in
advance to subscribe publishing service and expects to perform the services before December 31.
As per this expectation the company records advance collection as revenues.

2016 1 Cash 8,000

Decemb
er Service fee 8,000
(to record advance collection )

If the publication service is fully performed as expected there is no need for adjusting entry at the
end of the accounting period.

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But what if, a br. 1,800 worth subscription service is not yet performed on December 31. If so
adjusting entry is required to reduce the revenue account (Service fee) and increase a liability
account (unearned service fee) by the amount of the unfulfilled portion of supplies as follows.

2016
Decemb 1 Service fee 1,800

er
Unearned service fee 1,800
(to adjust advance collection )

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After recording the adjusting entry posting is made to the appropriate accounts as
follows

Service fee

Date Explanation P/R Bit Credit Balance

2016
1   Jp1   8000   8, 000  

 3
  1  Adjusting entry  Jp2 1,800         6,200  

Unearned service fee

Date Explanation P/R Debit Credit Balance

31  Adjusting Entry  Jp1      1,800    1,800  

2016
                   

The liability account Unearned Service fee shows a balance of Br.1,800. This equals the services
that will be performed in the future. In addition, the balance in Service fee equals the services
performed in December. Without the adjusting entry, both revenues and net income are
overstated by Br. 1800 in the December income statement. Also, liabilities are understated by Br.
1,500, and equity is overstated by Br.1,500 on the December 31 statement of financial position.

Comparison of Adjustments of unearned revenue

Unearned Initially Recorded as:
Liability Revenue
  1 Cash 8,000     Cash 8,000  
    Unearned serv. fee   8,000   Service fee   8,000
To record purchase of supplies

  2 Unearned serv. fee 6,500     Service fee 1,500  

    Supplies   6,500   Unearned serv.fee   1,500
Adjustment at performed portion  Adjust at unperformed portion

Credit
Debit
Unearned service fee
- 8,000 Dec 1

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Dec 31 , 6,500 Bal. Br. 1,500 

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 Unearned service fee

Debit Credit
-
- Dec 31
1,500 Dec31
Bal. Br. 1,500  

Service fee
Credit

Debit - - Dec 1

Dec.31
Bal. Br.6,500 

Service fee

Credit

Debit - 8,000 Dec1

Dec 31 1,500
Bal. Br.6,500  

NB: Dear student, under both treatments service fee, has a balance of Br. 6,200 and unearned
service fee has a balance of Br. 1,800. As a result application of the treatments has the same
effect on income statement and financial position statement.

NB: this alternative treatment for unearned revenue is not recommended by IFRS

Synopsis of lecture:
 As per periodicity assumption an accounting time period that covers a year in length or
12 months is called a fiscal year.
 The revenue recognition principle stats that revenue should be recognized in the period in
which it is measured reliably.

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  The principle of expense recognition is referred to as the matching principle.
 The journal entries that bring the accounts up to date at the end of the accounting period
are called adjusting entries.
 Adjusting entries can be categorized in to three. i.e. Deferrals (prepaid expense or
unearned revenue),Accruals (Accrued revenue or Accrued expense), and Estimates
( Deprecation or amortization)
- Deferrals are expenses or revenues that are recognized at a date later than the
point when cash was originally paid or received
- Accrual is the recognition of revenue or an expense that has arisen but has not yet
been recorded.

Wrap-up discussion Question

 Discuss the basic issues behind adjusting accounts
 describe what is meant by a fiscal year and a natural business year
 Explain the reasons for adjusting accounts
 Compare and contrast cash basis of accounting with that of accrual basis of accounting
 Identify the major types of adjusting entries
Next day’s assignment
Read about adjustments for accruals

Session 13(Hr. 25 and 26)

Topic: - Adjusting Entries for Accruals
Session Learning Objectives
 Understand the characteristics of accruals
 Prepare adjusting entries for accruals.

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  Apply alternative treatments for deferrals
 Describe the nature and purpose of an adjusted trial balance.
Reading Note

3.6. Analyzing and Recording Adjusting Entries for Accruals

Accrued Revenue
Revenues for services performed but not yet collected and recorded at the statement date
are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in
the case of interest revenue. These are unrecorded because the earning of interest does not
involve daily transactions. Companies do not record interest revenue on a daily basis because it
is often impractical to do so. Accrued revenues also may resulted from services that have been
performed but not yet billed or collected, as in the case of commissions and fees. These may be
unrecorded because only a portion of the total service has been performed and the clients will not
be billed until the service has been completed.

An adjusting entry records the receivable that exists at the statement of financial position date
and the revenue for the services performed during the period. Prior to adjustment, both assets and
revenues are understated. As shown inillustration 3.3, an adjusting entry for accrued revenues
results in an increase (a debit) to an asset account and an increase (a credit) to a revenue
account.
NB: For accruals, there may have been no prior entry, and the accounts requiring adjustment may
both have zero balances prior to adjustment.

Illustration:during the month April Enkopa performed finishing services worth Br. 800 that
were not billed to clients on or before April 30.

Because these services are not billed, they are not recorded. The accrual of unrecorded service
revenue increases an asset account called Accounts Receivable. It also increases equity by
increasing a revenue account, Service Revenue, as shown in illustration 3.4.

30 Accounts Receivable 800

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 Service Revenue 800
    (Adjustments for unearned revenue)          

Accounts Receivables Account No. 12

Date Explanation P/R Debit Credit Balance

2016
23    Jp1 9,600     9,600  

 30  Adjusting Entry       4,000     5,600  

  30 Adjusting Entry 800 6,400

Service Revenue Account No. 41

Date Explanation P/R Debit Credit Balance

2016
18  14, 800 14,800

23   Jp1    9,600   24,400  

   30  Adjusting Entry        1,300    25,700  
30 Adjusting Entry 800 26,500

After posting the adjusting entry the asset Accounts Receivable shows a balance of Br.6,400
i.e (9,600-4,000+ 800) on the other hand the updated balance of service revenue is 26,500, i.e
(Br. 14,800 + 9,600 +1,300+ 800). Without the adjusting entry, assets and equity on the
statement of financial position and revenues and net income on the income statement are
understated.
Accrued Expenses
Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses.
Salarypayables, rent payable, Interest payable, are common examples of accrued expenses.

Companies make adjustments for accrued expenses to record the obligations that exist at the
statement of financial position date and to recognize the expenses that are applied to the current
accounting period. Prior to adjustment, both liabilities and expenses are understated. Therefore
an adjusting entry has to be made that result in an increase (a debit) to an expense account
and an increase (a credit) to a liability account.

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 Illustration:Enkopa paid salaries and wages on April 25 for its employees’ first two weeks of
work. The next payment of salaries will not occur until May 10. As illustration 3.5 Shows, five
working days salary of Br. 1,250 is remained unpaid and unrecorded in April (April 26–30).
Recording adjusting entries for accruals
 2016
30 Salary Expense   1,250      
April
    Salary payable       1,250  
    (Recognition of Accrued Expense)          
As you see from the above table, the company accrued 5 days salary and record adjusting entries
At April 30. The entry increases both an expense(salary expense) and a liability account (Salaries
Payable). It also decreases equity by increasing an expense account, Salaries and Wages
Expense.
Posting Adjusting entries
Salary payable Account No. 24

Date Explanation P/R Debit Credit Balance

2016
30  Adjusting Entry Jp2   1,250   1,250  
April
                   

Salary Expense Account No. 51

Date Explanation P/R Debit Credit Balance

2016
29   Jp1 6,400     6,400  
April
   30  Adjusting entry  Jp2  1,250        7,650  

After posting the adjusting entry, the balance in Salaries and Wages Expense of Br.7,650 is the
actual salary and wages expense for April. The balance in Salaries and Wages Payable of Br.
1,250 is the amount of the liability for salaries and wages Enkopa owes as of April 30. Without
the Br.1, 250adjustmentsfor salaries expense, the company understated expense by Br.
1,200 and its liabilities by Br.1, 250.
Deprecation 
A company typically owns a variety of assets that have long lives, such as buildings, equipment,
and motor vehicles. The period of service is referred to as the useful life of the asset. Because a

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 building is expected to be of service for many years, it is recorded as an asset, rather than an
expense, on the date it is acquired. As explained inChapter 1, companies record such assets at
cost, as required by the historical cost principle. To follow the expense recognition principle,
companies allocate a portion of this cost as an expense during each period of the asset’s useful
life.Depreciation is the process of allocating the cost of an asset to expense over its useful life.
The acquisition of long-lived assets is essentially a long-term prepayment for the use of an asset.
An adjusting entry for depreciation is needed to recognize the cost that has been used (an
expense) during the period and to report the unused cost (an asset) at the end of the period. An
important point to understand here is that: Depreciation is a concept of cost allocation, not a
valuation concept. That is, depreciation allocates an asset’s cost to the periods in which it is
used. Depreciation does not attempt to report the actual change in the value of the asset.

Illustration 3.6, As per illustration 2.8 of chapter 2 Enkopa acquired equipment and Truck worth
Br. 10,000 and Br. 60,000. Assume that depreciation on the equipment and truck is Br. 1,200 and
1,800 a year, or br. 100 and 150 per month respectively.

30 Depreciation Expense 250

Accumulated depreciation-equipment 100
Accumulated depreciation-Truck 150
    (Adjustments for unearned revenue)          

Accumulated depreciation-equipment Account No. 15-1

Date Explanation P/R Debit Credit Balance

2016
30 Adjusting Entry Jp1      100    100  

                   

Accumulated depreciation- Truck Account No. 16-1

Date Explanation P/R Debit Credit Balance

30  Adjusting Entry  Jp1      150    150  

2016

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Depreciation Expense Account No. 57

Date Explanation P/R Debit Credit Balance
30  Adjusting Entry Jp1 250       250  
2016

Here rather than decrease (credit) the asset account directly, Enkopa credits Accumulated
Depreciation—Equipment and accumulated depreciation on Truck account. Accumulated
Depreciation is called a contra asset account. Such an account is offset against an asset account
on the statement of financial position. This account keeps track of the total amount of
depreciation expense taken over the life of the asset. To keep the accounting equation in
balance, Enkopa increasing an expense account, Depreciation Expense.

The balance in the Accumulated Depreciation—Equipment and Accumulated Depreciation –

Truck account will increase Br. 100 and 150 each month, and the balance in Equipment and truck
remains Br, 10,000 and br. 60,000 respectively.
Statement Presentation
As indicated, Accumulated Depreciation—Equipment is a contra asset account. It is offset
against Equipment on the statement of financial position. The normal balance of a contra asset
account is a credit. A theoretical alternative to using a contra asset account would be to decrease
(credit) the asset account by the amount of depreciation each period. But using the contra
account is preferable for a simple reason: It discloses both the original cost of the
equipment and the total cost that has been expensed to date. Thus, in the statement of financial
position, Enkopa deducts Accumulated Depreciation—Equipment from the related asset account.
The same procedure is made while presenting truck on the statements of financial position.

NB: All contra accounts have increases, decreases, and normal balances opposite to the account
to which they relate.

 Statement of financial position presentation of accumulated depreciation

Equipment Br. 10,000

Less Accumulated Deprecations-Equipment 100

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 Br.9,000

The Adjusted Trial Balance and Financial Statements

After a company has journalized and posted all adjusting entries, adjusted trial balance is
prepared using updated balance of the ledger accounts. Adjusted trial balance shows the
balances of all adjusted accounts, at the end of the accounting period. The purpose of an adjusted
trial balance is to prove the equality of the total debit with the total credit after adjustment. The
adjusted trial balance is thebasis for the preparation of financial statements.

Synopsis of Lecture

 Adjusting entries should not involve debits or credits to cash.

 Adjusting entries for accruals will increase both a statement of financial position and an
income statement account.
 Each adjusting entry affects one statement of financial position account and one income
statement account.
 Adjusted trial balance is thebasis for the preparation of Financial Statements.

Warp-up Discussion Question

 Explain the why adjusted trial balance is necessary

 Identify the major difference between adjustments of deferrals with the alternative
treatment
 Explain the consequences of the failure recording adjusting entries for accruals and deferral

SELF EXAMINATION QUESTION

1. Which of the following is correct when a company uses accrual bases of accounting
a. Revenue is recognized only when cash is received
b. Expense should be recorded in the period when cash is paid

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 c. Revenue and expense relating for the period should be recognizes regardless of cash exchange
d. revenue should be recognized in accrual bases and expenses on cash payment basis

2. An accrued expense was overlooked to be recorded when preparing income statement, the effect of
this error is that
a. Net income is not affected but liability is overstated
b. Net income is overstated and liability is understated
c. Net income as well as liability are overstated
d. Net income as well as liability are understated
3. a staff salary remained unpaid as of the year end should be incurred by
a. debiting salary accrued and crediting staff salary expense
b. debiting staff salary expense and crediting salary accrued account
c. Debiting prepaid salary and credit staff salary account
d. debiting staff salary expense and crediting cash
4. Prepaid rent account has a balance of br. 9,800 at the beginning of the year, The company is agreed to
pay br. 1,200 per month. assume the company is unable to make any payment for rent during the year,
which of the following holds true at the end of the fiscal year?
a. Prepaid rent has a balance of br. 4,800
b. Accrued rent has a balance of Br. 9,800
c. Prepaid rent has a balance of br. 9,800
d. Accrued rent has a balance of Br. 4,800
5. Which of the following statements is incorrect concerning the worksheet?
a. The worksheet is essentially a working tool of the accountant.
b. The worksheet is distributed to management and other interested parties
c. The worksheet cannot be used as a basis for posting to ledger accounts.
d. Financial statements can be prepared directly from the worksheet before journalizing and
posting the adjusting entries.
6. In a worksheet, net income is entered in the following columns:
a. Income statement (Dr) and balance sheet (Dr).
b. Income statement (Cr) and balance sheet (Dr).
c. Income statement (Dr) and balance sheet (Cr).
7. When a net loss has occurred, Income Summary is:

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 a. Debited and Owner’s Capital is credited.
b. Credited and Owner’s Capital is debited.
c. Debited and Owner’s Drawings is credited.
d. Credited and Owner’s Drawings is debited.
8. The closing process involves separate entries to close (1) expenses, (2) drawings, (3)
revenues, and (4) income summary. The correct sequencing of the entries is:
a. (4), (3), (2), (1)
b. (3), (1), (4), (2)
c. (1), (2), (3), (4)
d. (3), (2), (1), (4)
9. The proper order of the following steps in the accounting cycle is:
a. Prepare unadjusted trial balance, journalize transactions, post to ledger accounts,
journalize and post adjusting entries.
b. Journalize transactions, prepare unadjusted trial balance, post to ledger accounts,
journalize and post adjusting entries.
c. Journalize transactions, post to ledger accounts, prepare unadjusted trial balance,
journalize and post adjusting entries.
d. Prepare unadjusted trial balance, journalize and post adjusting entries, journalize
transactions, post to ledger accounts.

ILLUSTRATIVE PROBLEM

The following unadjusted trial balance belongs to Liyou Consulting Firm for the fiscal year
ended December 31, 2016.

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 Liyou Consulting Firm

Trial Balance

December 31,2016

Account Titles Debit Credit

Cash 12,500

Accounts Receivable 4,380

Supplies 1,330

Prepaid Insurance 3,600

Equipment 50,000

Notes Payable 20,650

Accounts Payable 17,400

Owner’s Capital 26,460

Owner’s Drawings 1500

Service Revenue 19,620

Salaries and Wages Expense 6,120

Rent Expense 4,200

Miscellaneous Expense 500

Total 84,130 84,130

Additional Data for Adjustment

1. Supplies on hand total Br. 500.

2. Depreciation is br. 5000 per quarter.

3. Interest accrued on 6-month note payable, issued September Br. 120.

4. Insurance expired during the period Br. 2,000

5. Services provided but unbilled at December 31 total br.2, 500

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6. Salary Accrued but not yet paid br. 1,500.

Instructions

a. Enter the trial balance on a worksheet and complete the worksheet.

b. Prepare an income statement and owner’s equity statement for December 31 and
financial position statement as of December 31.
c. Journalize the adjusting entries from the adjustments columns of the worksheet.
d. Journalize the closing entries from the financial statement columns of the worksheet.
e. Prepare post closing Trial Balance

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 CHAPTER FOUR

ACCOUNTING FOR A MERCHANDISING BUSINESS

Chapter Overview
Dear students’ in the previous two chapter i.e chapter 2 and 3, you have learnt about the
accounting for a service giving business. In the completion of those chapters you are familiar
with each activity undertaken in the recording process, adjusting, closing and completion of an
accounting cycle as a whole. Having that in mined in this chapter you will learn about the
overall accounting activities applicable for merchandising business. The recording process,
completion of work sheet, the adjustment and closing activities will be discussed in detail. Dear
student accounting activities for merchandising business is more or less similar with that of the
service giving business except the presence of additional unique transactions, accounts and
adjustments. What are those unique items? Grasp it from the chapter.

Learning Objectives:

After completing this chapter the students should be able to:

 Identify the differences between service and merchandising companies.

 Explain the recording of purchases under perpetual inventory and periodic system.
 Explain the recording of sales revenues under periodic and perpetual inventory
system.
 Prepare charts of account for a merchandising business
 Complete the accounting cycle for a merchandising business

Session 14 (Hr. 27 and 28)

Topic:-Accounting for a Merchandising Business

Session Learning Objectives

 Identify the differences between service and merchandising companies.
 Explain the recording of purchases under perpetual inventory and periodic system.

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Reading Assignment
Read about a merchandising business and identify the treatments of its unique transaction

4.1. Definition of a Merchandising Business

A merchandizing Businesses is a business that buy and sale Merchandise. The principal source of
revenue for a merchandising business is sales of merchandise. The account used to record this
revenue is sales. A merchandising business that sale to retailers is a whole seller; where as a
merchandising business that sale to finale users or customers is called retells. Unlike service
giving company merchandising companies has two major expenses. i.e Cost of Goods sold and
Operating expense.

Comparisons of Merchandising and Service Company

Merchandising Service Giving

 Long operating cycle Short Operating cycle

 has two major expenses One major expense
Sales ……………..….…. X Sales …..………………….… X

-Cost of Goods sold ……..X- Operating Expenses……….X

Gross Profit ………..…,……..X Net income.....………….. X

Operating Expense..……...…. X

Net Income ……………..…..X

4.2. Operating Cycle of Merchandising Businesses

The operations of a merchandising business involve the purchase of merchandise for sale
(purchasing), the sale of the products to customers (sales), and the receipt of cash from
customers (collection). This overall process is referred to as the operating cycle.

Thus, the operating cycle begins with spending cash, and it ends with receiving cash from
customers. When we compare it with service giving business, service giving business involves
rendering of service to customers and receiving cash from customers. As a result the operating
cycle of merchandising businesses is longer than service giving business.

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Cost flow Assumption

Cost flow assumption is about the transfer of a particular cost from one cost object or item to
another. The flow of costs for a merchandising company is as follows. Beginning inventory plus
the cost of goods purchased is the cost of goods available for sale. As goods are sold, they are
assigned to cost of goods sold and those goods which are not sold by the end of the accounting
period represent, ending inventory.

4.3. Merchandising Inventory System

A system used in determining the cost of merchandise sold and the cost of merchandise on hand
is called inventory system. Basically there are two inventory systems in practice, i.e Periodic
inventory system and perpetual inventory system. Companies use one of the two systems to
account for inventory costs

i. Periodic Inventory System

There is no continuous record of inventory items. I.e Purchase and sales of each inventory is not
directly recorded to inventory account.

Company’s which use periodic inventory system debited Purchase of merchandise to a purchase
account instead of an inventory account

d. Transportation costs covered by the business is debited to Transportation -in

account
e. Purchase return and allowance is credited to Purchase Return and Allowance
account
f. Purchase discount is credited to Purchase Discount account
g. Sales revenue is credited to sales but no record is made on the reduction on
inventory on hand due to sales
h. have a constant balance (the ending balance of the previous period)
i. require a physical inventory at least once per year to determine inventory balance
j. require a calculation of the of cost of goods sold
k. Preferred by companies which hold small volume and less costly items, like shops.

ii. Perpetual inventory system

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 l. There is a continuous record of inventory items. i.e records cost of each inventory
purchase and sale directly to the inventory account

In a perpetual system the account Inventory will:

 be debited when there is a purchase of goods (there is no Purchases account)

 be debited when there is transportation cost(there is no transportation- in account)
 be credited when there is purchase returns (No purchase return and allowance account)
 be credited when there is purchase discount (No purchase Discount account)
 be credited for the cost of the items sold (and the account Cost of Goods Sold will be
debited)
 have its balance continuously or perpetually changing because of the above entries
 Require a physical inventory to reconcile the actual inventory balance with that of the
record.
 Prefers by merchandising businesses which holds high cost items like Gold jewelries,
companies

The following illustration shows you how to apply the above inventory systems in recording
purchase and purchase related transactions.

4.4. Recording Purchase and Purchase Related Transactions

Purchase related transactions include the recording of transportation cost, purchase return and
allowance and purchase discount. The following illustration explains each item and how to
record them using both periodic and perpetual inventory system.

Recording Purchase of Merchandise

Purchase is an account used to record purchase of goods for resale purpose. Purchase of
merchandise can be made using cash or credit (on account). Purchase is an income statement
account and has a debit normal balance. Companies record purchase when they receive the goods
from the seller. The business document used as an evidence to record purchase transaction is
Purchase invoice.

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 NB: A business documents gives full information about a particular transaction. The basic
information included is date, amount and description of the transaction. Each transaction should
be supported by a business document.

Illustration4.1 shows you how to record purchase and purchase related transaction using both
periodic and perpetual inventory system as a compression.

Transaction1. January 2 Shewa Supermarket purchase of merchandise on account br.

10,000 from AlleBjimlla Plc. with terms 2/10 n/30. FOB shipping

A. Periodic Inventory system

Date Account Title and Descriptions P/R Debit Credit

2 Purchase   10,000      
2016
    Accounts payable       10,000  
    (purchase of merchandise)          

B. Perpetual inventory system

Date Account Title and Descriptions P/R Debit Credit

2 Inventory   10,000      
2016
    Accounts payable       10,000  
    (purchase of merchandise)          

When you compare the above two journal entries the second entry uses the account inventory to
record purchase instead of the purchase account. It is the only difference between periodic and
perpetual systems while recording purchase.

NB: when purchases are made for cash, in that case cash is credited instead of account payable
and the other item remains the same.

Recording Cost of Transportation

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 The sales agreement should specify who the seller or the buyer will covers transportation costs.
The terms of agreement is expressed as either FOB shipping point or FOB destination. FOB
Shipping means that the seller places the goods free on board of the sellers place, and the buyer
pays the freight costs. Conversely, FOB destination means that the seller places the goods free on
board to the buyer’s place of business, and the seller pays the freight. When the buyer covers the
transportation costs, these costs are considered as part of the cost of purchasing inventory.

Transaction 2. January 2. Shewa pays br. 800 to transport the merchandises purchased on
January 2.

As you recall the term of agreement is FOB shipping, Shewa has to cover the fright cost and
records the transaction as follows.

A. Periodic Inventory System

Date Account Title and Descriptions P/R Debit Credit

1 Transportation-in   800      
2016
    Cash       800  
    (Payment for fright charges)          
Transportation-in is an account used to record transportation costs when the buyer covers
transportation cost. The other name of this account is freight- in. it has debit normal balance.

Perpetual inventory system

Date Account Title and Descriptions P/R Debit Credit

2 Inventory   800      
2016
    Cash       800  
    (Payment for fright charges)          

NB; what if the Agreement is FOB destination, if so the transportation cost is covered by the
seller as a result no record for transportation is maintained by Shewa Super Market.

Recording Purchase Return and Allowance

A purchases return involves actually returning merchandise that is damaged or does not meet the
specifications of the order. The seller makes a price adjustment for the items returned, this is a

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 purchases allowance. The sources document used to record purchase return allowance is debit
memorandum prepared by the buyer and approved by the seller.

Transaction 3 Assume that on January 5, Shewa Supermarket returned merchandises

costing Br. 2,000 to AlleBjimlla plc. The following record is to be kept by Shewa Super
Market.

A. Periodic Inventory System

Date Account Title and Descriptions P/R Debit Credit
2016
5 Accounts Payable   2,000      
Jan
    Purchase return and       2,000  
Allowance
    (Return of merchandise          
purchased)
Purchase return and allowance is a contra account to purchase. This account is used to record
purchase returns mad by the buyer and it has credit normal balance.

B. Perpetual inventory system

Date Account Title and Descriptions P/R Debit Credit
2016
5 Accounts Payable   2,000      
Jan
    Inventory       2,000  
    (Return of merchandise          
purchased)

NB: as you see from the above record, the amount of purchase on January 2, I.e 10,000 now is
decreased by Br. 2,000 because of the return. At the same time the amount owed to AlleBjimlla is
also reduced by the same amount.

Recording Purchase Discount

The presence of purchase discount is expressed on credit terms.The terms that describe when
payments for merchandise are to be made are called credit terms. In our case on transaction 1
above the credit term is expressed as 2/10, n/30. It is to mean that, 2% cash deduction is offered
by Alle if Shewa pays its bill within 10 days, if not Shewa can pay the net(the full bill) within 30
days. Therefore 2/10 represents the discount period, where as n/30 represents the credit period.
Alternatively a credit term can be expressed as 2/10, n/Eom, it is to mean that 2% discount is

Fundamentals of Accounting IPage122

 allowed if paid within 10 days If not pay the invoice price at the end of the month in which the
purchase made.

NB; if the term do not specify the discount period i.e n/30 0nly, this notifies the absence of
discount as a result Shewa has to pay the full invoice within the credit period.

Transaction 4. January 12. Shewa paid cash for the full settlement of the merchandise
purchased on January 2

Here the company is entitled to get 2% discount, since it paid within the discount period. As per
January 1, Shewa owed br. 10,000, but as a result of merchandise return on January 5, the
liability is reduced by Br. 2000. so the amount owed now is Br. 8, 000 out of which 2% is
deducted and the amount of cash required to settle the liability is Br. 7,840(8,000-(0.02*8,000).
the record is made as follows

A. Periodic Inventory System

Date Account Title and Descriptions P/R Debit Credit
2016 1
2 Accounts Payable   8,000      
Jan
    Purchase discount       160  
Cash 7,840
    (payment with discount)          

B. Perpetual inventory system

Date Account Title and Descriptions P/R Debit Credit
2016
12 Accounts Payable   8,000      
Jan
    Inventory       160  
Cash 7,840
    (payment with discount)          

What if Shewa makes payment on January 15, instead of January 12? Now no discount is given
to Shewa as a result Accounts payable is debited and cash is credited for br. 8000.

NB: Both Purchases discount and purchase return and allowance are a contra accounts to
purchases. As a result they have credit normal balance.

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 Summary of Purchase Transactions

Assume that Shewa Super market has an inventory balance of Br. 1,200 on December31, 2015,
at the end of the previous accounting period. The following summery is to show you how the
inventory system affects the company’s inventory balance even though the transactions result
similar effect on company’s inventory.

Periodic Inventory System Debit Jan1 Credit

1,500
Perpetual Inventory
Jan2 10,000
Jan 2 800 2,000 Jan 5
Debit Credit
160 Jan12
Jan1, 1,500
Bal. Br.10,140  

Bal. Br.1,500  

Inventory

As you see from the above summery, the inventory account shows a balance of br. 1,500 under
periodic system and Br. 10,140 under perpetual system. Br. 1,500 represents the beginning
balance of inventory forwarded from the previous year. This is because periodic system does not
capture any event that changes the inventory balance. Unlike periodic system perpetual inventory
system keeps a continuous record of all events that affects inventory account. As a result an up to
date balance of inventor is presented in perpetual inventory system

NB: Based on the discussion we made above, you are clear about the unique accounts of
merchandising business. These are purchase, purchase discount, purchase return and allowance,
transportation in and inventory. The first four accounts only belong to the periodic inventory
system the last belongs to both periodic and perpetual system

Synopsis of Lecture
 Sales of merchandise is the principal source of revenue for a merchandising business.
 Perpetual or periodic inventory system is used to record merchandizing inventory

Fundamentals of Accounting IPage124

  Perpetual means a continuous record of inventory and determine up-to-date balance of
inventory on hand and cost of goods sold.
 Accounts unique to a merchandising business are purchase, purchase discount, purchase
return and allowance and transportation in.
 purchase discount, and purchase return and allowance are contra accounts to purchase,
Warp-up discussion questions
 Explain the basic difference between periodic and perpetual inventory systems
 Discuss the concept of cost flow assumption
 Identify the normal balances of the unique accounts for a merchandising business
Next day’s assignment
 Read about sales related transactions
Session 15 (Hr. 29 and 30)

Topic:-Recording Sales and sales related transaction

Session Learning Objectives

 Explain the recording of sales revenues under periodic and perpetual inventory system.
4.5. Recording Sales and Sales Related Transaction

Sales related transactions include the recording of transportation cost, Sales Return and
Allowance and Sales Discount. The following illustration explains each item and how to record
them using both periodic and perpetual inventory system.

Recording Sales of Merchandise

Sales are an account used to record the total amount charged from customers for merchandise
sold. It is equivalent to the account Service Revenue we used in chapter 2 to record amount
charged for service delivered. Sales is a revenue account and has a credit normal balance.

Sales may be made on credit or for cash. A business document should support every sales
transaction, to provide written evidence of the sale. Cash register tapes provide evidence of cash
sales. A sales invoice, provides support for a credit sale.

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 Illustration 4.2, Sales of merchandise on account and related transactions using both periodic
and perpetual inventory systems.

Transaction 1 On January 4 Shewa Super Market sold merchandise on account to Melo

Café Br. 4,500, terms 1/15, n/45. FOB Destination. The cost of merchandise sold is Br. 3,000

Shewa record this transaction as follows using Periodic and perpetual inventory system

a. Periodic
Date Account Title and Descriptions P/R Debit Credit

4 Accounts Receivable   4,500    

2016
    Sales       4,500
    (Sales of Merchandise on account)        

As you see from the above record if Shewa uses a periodic inventory system, makes only one
journal entry is required each sales transaction by increasing both Accounts Receivable and sales
accounts. No record is made for cost of goods sold. As a result the inventory account does not
show the balance of inventory on hand.

b. Perpetual
Date Account Title and Descriptions P/R Debit Credit
2016 4 Accounts receivable   4,500    
    Sales       4,500
    (Sales of Merchandise on account)        

Date Account Title and Descriptions P/R Debit Credit

2016
4 Cost of Goods Sold   3,000    
Jan
    Inventory       3,000
    (to record cost of Merchandise        
Sold)

As you see from the above tables, in the case of perpetual system. Shewa makes two entries for
each sale. The first entry records the sale. The seller increases (debits) Cash (or Accounts
Receivable, if a credit sale), and also increases (credits) Sales Revenue. The second entry records

Fundamentals of Accounting IPage126

 the cost of the merchandise sold.The seller increases (debits) Cost of Goods Sold, and also
decreases (credits) Inventory for the cost of those goods. As a result, the Inventory account will
show at all times the amount of inventory that should be on hand.

NB: Cost of Merchandise Sold the cost of merchandise sold is the cost of the merchandise sold
to customers.

Recording Transportation Costs

As you recall from the previous discussion of illustration 1 above, the agreement now is FOB
destination so the transportation cost is covered by the seller i.eShawa Super market.When the
seller pays the freight charges, it is considered as selling expenses.

Transaction 2 January 4 Shawa paid Br. 400 to transport the items sold to Melo Cafe

a. Periodic

Date Account Title and Descriptions P/R Debit Credit

2016
4 Delivery Expense   3,000    
Jan
    Cash       3,000
    (to record payment of        
transportation)

b. perpetual

The same as periodic system

Look the record for transportation cost in the two inventory systems is similar. Because delivery
expense is an expanse account which do not affect inventory account.

The other name for delivery expense is transportation out or freight out. It has debit normal
balance and classified an expense incurred to sale more or it is selling expense.

Recording Sales Return and Allowance

Merchandise that is returned to the vendor due to defect in the product or the wrong item shipped
is referred to as asales return. A price reduction made by the seller for the goods returned called

Fundamentals of Accounting IPage127

 sales allowance. The seller makes a price adjustment for the items returned called sales
allowance. It has a debit normal balance. The business document used to support sales return
and allowance is a credit memorandum.

Transaction 3. January 6 Shewa Super Market received merchandise returned Br. 500. The cost
of merchandise returned is br. 300. Shewa record the transaction as follows.

a. Periodic

Date Account Title and Descriptions P/R Debit Credit

2016
6 Sales return and allowance   500    
Jan
    Accounts Receivable       500
    (receipt of Merchandise return)        

The periodic inventory system records only the reduction in sales revenue. No entry is required
to record the change on inventory balance due to the return.

b. Perpetual

Date Account Title and Descriptions P/R Debit Credit

2016
6 Sales return and allowance   500    
Jan
    Accounts Receivable       500
    (receipt of Merchandise return)        

Date Account Title and Descriptions P/R Debit Credit

2016 30
6 Inventory   0    
Jan
    Cost of Goods Sold       300
    (to record cost of Merchandise        
returned)

Like the record for sale recording sales return and allowance needs two entries the first to record
the reduction on sales revenue which is made by increasing (debiting) Sales Return and
Allowance and decreasing (crediting) Accounts Receivable. The second entry is to record

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 increase in inventory account which is made by (debiting) Inventory account and decreasing
(crediting) cost of goods sold

Recording Sales Discount:-A cash discount granted by the seller to customers for prompt
payment of amounts owed.

January 13 Shewa received cash from customer on account

Here Shewa is required to make a 1% discount on the invoice price, as the amount is collected
within the discount period. As per transaction 1, Shewa has a receivable balance of br. 4,500, but
as a result of merchandise return on January 6, the receivable is reduced by Br. 500. So the
amount expected to be collected is Br. now is Br. 4,000 out of which 1% is deducted and the
amount of cash left for collection is Br. 3,960(4,000-(0.01*4,000). the record is made as follows.

A. Periodic Inventory System

Date Account Title and Descriptions P/R Debit Credit
2016
13 Cash   3,960      
Jan
    Sales Discount   40     
Account Receivable 4,000
    (Collection of cash with discount)          

B. Perpetual inventory system

The same entry to the periodic system

What if the amount is collected on January 15 instead of January 13. No Sales discount is given
as a result Shewa debit cash for Br. 4000 and credit Accounts receivable for the same account.

NB: Both Sales Return and Allowance and sales discount are contra accounts to Sales. So they
have debit normal balance.

Comparison of Perpetual and Periodic Inventory System

Illustration 4.3 Summarizes records of unique transactions of a merchandising business as

follows

Perpetual Inventory System Periodic Inventory System

Ja 2 Inventory 10,000     Purchase 10,00  
n
    Cash   10,000   Cash 0  10,00
                0 
  2 Inventory 800     Transportation In 800  

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    Cash   800   cash   800
                 
  4 Account Receivable 4,500     Account Receivable 4,500  
    Sales   4,500   Sales   4,500
                 
  4 Cost of Goods sold 3,000    
NO ENTRY
    Inventory   3,000  
                 
  4 Delivery Expense 400     Delivery Expense 400  
    Cash   400   Cash   400
                 
  5 Accounts Payable 2,000     Accounts Payable 2,000  
    Inventory   2,00   Purchase ret. and   2,000
allow.
                 
Sales return and Sales ret. and
  6 500     500  
allowance allowance
Accounts
    Accounts Receivable   500     500
Receivable
                 
  6 Inventory 300    
NO ENTRY
    Cost o Goods sold   300  
                 
  1 Accounts payable 8,000     Accounts Payable 8,000  
   2 Purchase Discount   160   Inventory   160
    Cash   7,840   Cash   7,840
                 
  1 Cash 3,960     Cash 3,960  
    3 Sales Discount 40     Sales Discount 40  
    Accounts Receivable   4,000   Accounts   4,000
Receivable

Transaction Summery of Perpetual and Periodic Inventory System

Perpetual Inventory system

Inventory

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Debit Jan1 Credit
1,500
-
Jan2 10,000 3,000 Jan4

Jan 2 800 2,000 Jan 5

Jan 6 300 160 Jan12

Bal. Br.7,440  

Periodic Inventory System

Fundamentals of Accounting IPage131

 Inventory

Debit Credit
Jan1, 1,500

Bal. Br.1,500  

Previously on the summery of purchase transaction above the inventory account as per the
perpetual record is Br. 10,140 where as it has Br. 7,440 now after posting the sales transaction.
This balance represents the cost of inventory left on hand after recording the sales transaction.
On the other hand the balance of inventory as per periodic inventory is still br. 1,500 which is the
beginning inventory balance.

Synopsis of Lecture

Fundamentals of Accounting IPage132

  Sales of merchandise is a principal source of revenue for a merchandising business.
 Sales return and allowance and sales discount are a contra accounts to sales
 Freight out is an expense account
 while using perpetual inventory system, sales of merchandise requires two separate
entries to record the sales revenue and the cost of goods sold

Warp-up discussion questions

 Explain contra sales accounts

 explain terms of sales and memos prepared by buyers and sellers
 Explain the terminologies of FOB Shipping and FOB Destination agreements

Next day’s assignment

 Read about adjustments for inventory

Session 16 (Hr. 31 and 32)

Topic:-Adjustments Related to Inventory

Session Learning Objectives

 Explain the recording of sales revenues under periodic and perpetual inventory system.

4.6. Adjustment in Relation to Inventory Account

At the end of the accounting period Shewa is required to make physical count of inventories to
determine the cost of inventory that are actually found on hand. If the company uses perpetual
inventory system the count balance is compared with the inventory account balance of the
record. Whenever there is a deference between the two balance, Shewa needs to record adjusting
entry that make the record balance similar to the physical count. The following illustration shows
you how to adjust the balance of inventory account in the case of perpetual inventory system

Illustration 4.4. Assume that the physical count of inventory made by Shewa supermarket on
January 31 indicates the balance of inventory on hand is Br. 7,400.

Fundamentals of Accounting IPage133

 As you see the actual inventory balance i.e 7,400 is less than the record balance displayed on
the summery above i.e br. 7,440 by Br 40. This is because of two basic reasons. One the record
balance includes inventories lost due to damages, breakages and thefts whereas the physical
count excludes them. Second there may be errors while recording transactions that affects
inventory. Any ways, Shewa has to pass one of the following adjusting entries to make the
record agreed with the count.

Date Account Title and Descriptions P/R Debit Credit

2016
13 Cost of goods sold   40      
Jan
    Inventory     40  
    (Adjustments of inventory )          

As you see from the above tables the inventory account is reduced (credited) by Br. 40, this
makes the record inventory balance equal with the actual inventory balance i.e br.7, 400.

If Shewa uses periodic inventory system, the counted balance of inventory is the only
information that is available to update the inventory balance on the record. As a result Shewa
needs to record two adjusting journal entries. The first to remove the beginning inventory
balance and the second to insert (substitute) the ending inventory found through physical count.

Illustration 4.5 shows how to adjust the balance of inventory account in the case of periodic
inventory system. Consider the information on illustration 4.4 above, i.e the actual balance of
inventory on hand is br. 7,400. Shewa needs to record two adjusting entry as follows

Date Account Title and Descriptions P/R Debit Credit

31 Income summery   1,500      

2016
    Inventory       1500  
    (Adjustment to remove beginning          
inv.)
Date Account Title and Descriptions P/R Debit Credit
2016
31 Inventory   7,400      
Jan
    Income summery       7,400  

Fundamentals of Accounting IPage134

    (Adjustments to insert ending inv.)          

After recording and posting the two adjusting entries the balance on the inventory account is
updated and reflects the actual balance of inventory on hand at the end of the year.

Perpetual Inventory system

Inventory Periodic Inventory System

Credit Inventory
Debit Jan1
1,500 -
Debit Credit
Jan2 10,000 3,000 Jan4 Jan1, 1,500
Jan 2 800 2,000 Jan 5 Bal. Br.1,500
Jan 6 300 160 Jan12 Jan 31 7400
1500 Jan 31 
Bal. Br. 7,440 40 Jan 31 Bal. Br. 7,400
Bal. Br. 7,400  

NB: look both periodic and perpetual inventory systems reflect the same inventory balance after
adjustment.

NB:_ Illustration 4.4 and 4.5 above tries to show you how to record the unique transactions of
the merchandizing business. Here be wise to take a time to re-read the concepts and to practice
the illustration. Do not proceed to the next discussion until you fill confidence on your ability to
record the transactions well.

Fundamentals of Accounting IPage135

When the unique transaction are clear for you, the question immediately comes to your mind is
that, is the above events are the only business transactions for a merchandizing businesses?A
merchandising business also involves lots of transaction other than the above but not included in
the illustration. These transactions not included here are the transactions which are totally similar
with the transactions you have discussed in chapter 2. It might include purchase of supplies or
equipment, payment of salary or rent, owners investment or drawing etc, are also available for a
merchandizing businesses. All this transactions are treated in similar way like we did in chapter
2. Now we can proceeds to the next activity i.e completion of the accounting cycle.

4.6. Charts of account for a Merchandising Business

4.7. Financial Position and Statements of income and loss accountsProfitor Loss
Statement

100 Assets 400 Revenues

110 Cash 410 Sales

112 Accounts Receivable 411 Sales Returns and Allowances

115 Merchandise Inventory412 Sales Discounts

116 Supplies 500 Costs and Expenses

117 Prepaid Insurance 510 Cost of Merchandise Sold

120 Land 520 Salaries Expense

125 Office Equipment 521 Advertising Expense

126 Accumulated Depreciation equipment 523 Delivery Expense

200 Liabilities 529 Rent Expense

210 Accounts Payable 531 Supplies Expense

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211 Salaries Payable 532 Depreciation Expense—Equipment

212 Unearned Rent 533 insurance Expense

215 Notes Payable 534 Miscellaneous Expense

300 Owner’s Equity 600 Other Income

310 Owner’s, Capital 610 Rent Revenue

311 Owner’s, Drawing 700 Other Expense

312 Income Summary 710 Interest Expense

NB: A dear student the above charts of account is the one which is commonly used format. The
number of accounts may be varied business to business, but they are not out of the above
classification. Those accounts which are displayed bold are accounts unique to merchandising
business and are not found on the charts of account of a service giving businesses.

Synopsis of Lecture

 In a perpetual inventory system adjustment is required to reconcile the recorded inventory

balance of the ledger with the actual inventory at hand.
 In a periodic inventory system adjustment is necessary to determine the cost of inventory
at and cost of goods sold.
 Sales return and allowance and sales discount accounts are a contra account to sales.
 Unlike transportation-in, transportation- out account is an expense account.
Warp-up discussion questions

 Identify those accounts which belongs to a merchandising business

 explain the two methods of inventory adjustment used in perpetual inventory system
Next day’s assignment

Read about the accounting cycle of a merchandising business

Fundamentals of Accounting IPage137

Session 17 - 19 (Hr. 33, to 36)

Topic:-Accounting Cycle of a Merchandising Business

Session Learning Objectives

After completing this section you should able to:

 Explain the steps in the accounting cycle for a merchandising company.

 Prepare a work sheet for a merchandising business( optional step)
 Distinguish between a multiple-step and a single-step income statement.
 Explain the computation and importance of gross profit.
 Prepare adjusting and entries for a merchandising business
 Prepare post closing trial balance
 Prepare reversing entry(optional step)

4.7. Completion of the Accounting Cycle of a Merchandising Business

Completion of the cycle is a yearend operation, which is done for the preparation of financial
statement. The completion process is started afterall transactions are recorded, posted and
presented on the trial balance. Like a service giving company merchandising business involves
the following completion activities.

i. Preparation of work sheet

ii. Preparation of financial statements
- Income Statement
- Statements of Owners Equity
- Statements of financial position
iii. Record and post adjusting entries
iv. Record and post closing entries
v. preparation of post closing trial balance

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 vi. record reversing entry

The following illustration shows how to complete the accounting cycle for a particular a
merchandizing business

Illustration 4.7. The following unadjusted trial balance belongs to Shewa Super Market for year
ended December 31.

Shewa Supermarket

Trial Balance

December 31,2016

 Account Title  Debit   Credit

Cash 11,800  

Accounts receivable 17,400  

Inventory 22,500  

Supplies 1,200  

Prepaid Insurance 2,800  

Equipment 49,300  

Accumulated Dep.   5,800

Accounts payable   5,200

Notes Payable 7,000

Owner's Capital   61,500

Drawing 4,900  

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Sales   115,000

Sales Discount 6,000  

Sales return and allowance 13,500  

Cost of Goods Sold 47,700

Salary Expense 8,800  

Rent Expense 5,600  

Advertising expense 2,000  

Utilities Expense 1,000  

Total 194,500 194,500

Information for Adjustment

a. Insurance expired during the year Br. 1,800

b. supplies on hand Br. 500
c. Deprecation on office equipment Br. 1,200
d. salary accrued Br. 1,500
e. Interest accrued Br. 300

Instructions:-Using the above information of Shewa Supermarket prepare the following:

a. Work Sheet
b. Prepare financial statement
a. Income statement
b. Statements of owners equity
c. Statements of financial position
c. Record and post adjusting entries
d. Recording and posting closing entries
e. Prepare post closing trial balance
f. Reversing entry
ii. Work sheet

Fundamentals of Accounting IPage140

 Shewa Super market

Work Sheet

December 31,2016

Unadjusted Trial Adjusted trail Statements of Profit Statements of

Balance Adjustments balance or Loss and other Financial Position
Income
Account Title Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit

Cash 11,800       11,800       11,800  

Accounts 17,400       17,400       17,400  
Receivable
Inventory 22,500       22,500       22,500  
Supplies 1,200     (b) 700 500       500  
Prepaid 2,800     (a)1,800 1000       1000  
Insurance
Equipment 49,300       49,300       49,300  
Accumulated   5,800   (c)3,200   9,000       9,000
Dep.
Notes payable 7,000 7,000
Accounts   5,200     5,200       12,200
payable
Salary       (d)1,500   1,500       1,500
payable
Interest (e) 300 300 300
Payable
Owner's   61,500       61,500       61,500
Capital
Drawing 4,900       4,900       4,900  
Sales   115,000       115,000   115,000    

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Sales 6,000       6,000   6,000      
Discount
Sales ret and 13,500       13,500   13,500      
all. of Goods
Cost 47,700     47,700   47,700      
Sold
Salary 8,800   (d)   10,300   10,300      
Expense
Rent Expense 5,600   1,500
    5,600   5,600      
Advertising 2,000       2,000   2,000      
expense
Utilities 1,000       1,000   1,000      
Expense
Supplies     (b) 700   700   700      
Expense
Insurance     (a)   1,800   1,800      
expense
Depreciation     1,800
(c)3,200   3,200   3,200      
Expense
Interest
Expense (e) 300 300 300

Total 194,500 194500 7,500 7,500 199,500 199500 92,100 115,000 107,400 84,500

Net Income             22,900     22,900

              115,000 115000 107400 107,400

iii. Financial Statement

a. Statements of Profit or Loss and other Comprehensive Income for a
merchandising business might have the following two formats.

Multiple Step Profit or Loss Statement

The multiple-step statementis so named because it shows several steps in determining net
income. A multiple-step statement also distinguishes between operatingand non operating
activities. Finally, the statement also highlights intermediatecomponents of income and shows
sub groupings of expenses.

A multiple statement starts with presenting sales revenues. This section determines the amount of
Net Sales by deducting Sales from Sales Discount and Sales Return and Allowance. The next
section of the statement determines Gross Profit by deducting Costs of Goods Sold from Net
Sales. Then Operating Income is determined by deducting total Operating Expenses from Gross
Profit. Finally non operating income is added and non operating expenses are deducted from

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 Operating income to determine Net Income or net loss for the period. Illustration 4.8 presents a
multiple step income statement as follows:

Shewa Supermarket

Statements of profit or Loss and other Comprehensive Income

For the Year ended December 31,2016

Sales Revenues    

  Sales   Br. 115,000

Sales return and

Less Allowance Br.13,500

Sales Discount 6,000 19,500

Net Sales   95,500

Costs of Goods
Sold   47,700

Gross Profit   47,800

Operating
Expenses    

  Salary Expense 10,300  

  Rent expense 5,600  

Advertising
  expense 2,000  

  Utilities Expense 1,000  

  Supplies Expense 700  

Insurance
  expense 1,800  

Depreciation
  Expense 3,200  

Total operating
  Expense   24,600

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Income from Operations   23,200

Other revenue
and gains     0

Other expense
and losses    

  interest expense   -300

Net Income   22,900

Non Operating Activities

Nonoperating activitiesconsist of various revenues and expenses and gains and losses that are
unrelated to the company’s main line of operations.

The following items are categorized under other income and gains:

 Interest revenue from notes receivable and marketable securities.

 Dividend revenue from investments in common stock.
 Rent revenue from subleasing a portion of the store.
 Gain from the sale of property, plant, and equipment.

The following items are categorized under other expense and losses:
 Interest expense on notes and loans payable.
 Casualty losses from recurring causes, such as vandalism and accidents.
 Loss from the sale or abandonment of property, plant, and equipment.
 Loss from strikes by employees and suppliers.

Single Step Statement

The other format for income statement is the single-step income statement. The statement is
so named because only one step i.e. subtracting total expenses from totalrevenues and is
required in determining net income.In a single-step statement, all data are classified into two
categories: one is revenues,which include both operating revenues and other revenues and
gains; and the second is expenses,which include cost of goods sold, operating expenses, and

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other expensesand losses. Illustration 4.9 below presents single step income statement.
Shewa Supermarket

Statements of profit or Loss and other Comprehensive Income

For the Year ended December 31,2016

Revenues    

  Net Sales   Br. 95,500

  Other revenue   0

Total Revenue   95,500

Expenses    

  Costs of Goods Sold 47,700  

  Operating Expense 24,600  

  interest expense 300  

  Total Expense   72,600

  Net Income   22,900

b. Statement of Owners Equity

The definition and the way of preparing owners equity is totally similar with the owners equity
statement of a service giving business, one you have learned in chapter 1 and chapter 2. So
please turn back and revise it again. Illustration 4.9 presents statements of owner’s equity as
follows.

Shewa Supermarket

Statements of Owner's Equity

For the year ended December 31,2016

Owners Capital January 1,   61,500

Add Net income 22,900

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  sub total   84,600

Less Drawing   4,900

Owner's capital December 31,   79,500

c. Statements of Financial Position

The definition and the way of preparing statements of financial position is totally similar
with the service giving business, one you have learned in chapter 1 and chapter 2. So please
turn back and revise it again. Illustration 4.9 presents statements of owner’s equity as
follows. Illustration 4.10 presents the statements of financial position as follows.

Shewa Supermarket

Statements of Financial Position

For the Month ended August 30,2016

Asset

Non current Asset

Property Plant and Equipment

Equipment 49,300  

Accumulated deprecation on equipment 9,000  

Total PPE’s   40,300

Current Assets
Prepaid Insurance   1,000
Supplies   500
Inventory   22,500

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Accounts Receivable   17,400

Cash   11,800
Total Current Asset 53,200
  Total Asset   Br.93,500

Liability and Equity

Owners Equity    
Enkopa’s Capital 79,500
Liabilities
Notes Payable Br. 7,000
  Accounts Payable   5,200
  Salary Payable   1,500
Interest Payable 300
Total Liabilities 14,000
  Total Equity and liabilities   Br.93,500

iv. Recording Adjusting Entries

Adjusting Entries

Date Account Title and Descriptions P/R Debit Credit

2016 31 Insurance Expense   1,800      

    Prepaid Insurance       1,800  
    (Adjustment of insurance)          
  31 Supplies Expense   700      
    Supplies       700  
    (Adjustment of supplies)          
  31 Depreciation Expense   3,200      
    Accumulated Deprecation       3,200  
    (Recording deprecation)          
  31 Salary Expense   1,500      
    Salary Payable       1,500  
(Recording Accrued Salary)

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 31 Interest Expense 300
Interest Payable 300
    (Recording Accrued Interest)          

v. Recording Closing entry

Closing Entries

Date Account Title and Descriptions P/R Debit Credit

2016 31 Sales   115,000      

    Income Summery       115,000  
    (Closing revenue Accounts)          
               
  31 Income Summery   92,100      
    Sales return and allowance       13,500  
    Sales Discount       6,000  
    Cost of Goods Sold       47,700  
    Salary Expense       10,300  
    Rent Expense       5,600  
    Advertizing Expense       2,000  
    Utilities Expense       1,000  
    Supplies Expense       700  
    Insurance Expense       1,800  
    Depreciation Expense       3,200  
    Interest Expense       300  
    (Closing Expense Accounts)          
               
  31 Income Summery   22,900      
    Owner's Capital       22,900  
    (Closing income summery)          
  31 Owner’s Capital   4,900      
    Owner’s Drawing       4,900  
    (Closing Drawing account)          
v. pr v. Preparation Post Closing Trial Balance

Shewa Supermarket

Post closing Trial Balance

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 December 31,2016

 Account Title  Debit   Credit

Cash 11,800  
Accounts receivable 17,400  
Inventory 22,500  
Supplies 500  
Prepaid Insurance 1,000  
Equipment 49,300  
Accumulated Dep.   9,000
Notes Payable 7,000
Accounts payable   5,200
Salary payable 1,500
Interest payable 300
Owner's Capital   79,500
Total  102,500 102,500

Reversing Entry

Accrued salary and accrued interest results a liability on the financial Position Statement of
Shewa Super Market. The company might have two options to treat those liabilities resulted from
yearend adjustment. That is either to keep these liabilities until the actual payment date or avoid
the liabilities from the recording of the subsequent period. If the company prefers the second
option a reversing entry is required to be recorded on the first day of the new accounting period.
Reversing entries are the exact reverse of adjusting entries made. Reversing entries are made at
the first date of the new accounting period. as a result reversing accounts is an optional step in
completion of accounting cycle.

Reversing entries for Shewa Super Market

NB. Reversing entry is not a mandatory step of completing an accounting cycle.

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2017
1 Salary payable   1,500      
Jan 
    Salary Expense       1,500  

(Recording Accrued Salary)

1 Interest Payable 300
Interest Expense 300
    (Recording Accrued Interest)          

SELF- EXAMINATION QUESTIONS

1. If the supplies account, before adjustment on May 31, indicated a balance of Br. 2,250
and an inventory of supplies on hand at May 31, totaled Br.950, the adjusting entry would
be:
e. Debit Supplies Br.950, credit Supplies Expense Br. 950
f. Debit Supplies Br. 1,300, credit Supplies Expense Br. 1,300
g. Debit Supplies Expense Br. 950, credit supplies Br. 950
h. Debit supplies expense, Br. 1,300, credit Supplies Br, 1,300
3. If the estimated amount of deprecation on equipment for a period is Br. 2,000, the
adjusting entry to record deprecation would be:
a. Debit Depreciation Expense, Br. 2,000, credit Equipment Br. 2,000
b. Debit Equipment, Br. 2,000, credit Depreciation Expense, Br. 2,000
c. Debit Deprecation Expense, Br. 2,000, credit Accumulated Depreciation, Br.
2,000
d. Debit Accumulated Depreciation, Br. 2,000, credit Deprecation Expense Br. 2,000
4. If the equipment account has a balance of Br. 22,500 and its accumulated deprecation
account has a balance of Br. 14,000, the book value of equipment is:
a. Br. 36,500 c. Br. 14, 000
b. Br. 22,500 d. Br. 8,500

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 5. Which of the following account would be closed to the income summery account at the
end of a period?
a. Sales c. Both sales and salary expense
b. Salary Expense d. Neither sales nor salary Expense
6. The post closing trial balance would include which of the following account
a. Cash c. salary Expense
b. Sales d. All of the above
7. If merchandise purchased on account is returned, the buyer may inform the selle of the
details by issuing
a. debit memorandum c. an invoice
b. a credit memorandum d. a bill
8. If merchandise is sold on account to a customer for Br. 1,000, terms FOB shipping Point,
1/10, n/30, and the seller prepays Br. 50 in transaction costs, the amount of the discount
for early payments would be:
a. Br. 0 c. Br. 10
b. Br. 5 d. 10.50
9. For a business using a periodic inventory system, which of the following is added to
merchandising inventory at the beginning of the period in computing the cost of
mechanizing available for sale?
a. Purchase discount c. Ending Merchandising inventor
b. Purchase returns and allowance d. Fright out

ILLUSTRATIVE PROBLEM

Discount supermarket entered in to the following selected transactions during August of the
current year.

August 1 purchased merchandise on account, terms 2/10, n/30, FOB shipping point, Br. 28,500.

1, paid rent for August, Br. 4,500

2, Paid transportation charges on purchase of August 1,Br. 1,180.

5, Purchases office supplies for cash Br. 600

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 7, Sold merchandise on account, terms 1/10, n/30, FOB destination, Br. 12,400

8, Paid transportation charges on August 7, Br. 550

11, Paid for merchandise purchased on August 1, less discount

12, Received merchandise returned from sales of August 7, Br. 3,200.

14, Purchased merchandise n account, terms 4/14, n/30, FOB shipping point Br.18,300 with
prepaid transportation costs of Br.750 added to the invoice.

16, returned merchandise purchased on augest14, Br. 5,200.

17, Received cash on account from sale of August 7, less returns and discount.

18, Sold merchandise on account, terms, 1/10, n/20 FOB shipping point Br.8,800. prepaid
transportation costs as an accommodation for the customer Br. 250.

26, Sold merchandise on bank credit card, Br. 3,700

29, Paid for merchandise purchased on august 14, less returns and discount.

31, Received cash on account from sale of August 18, Br. 9,050.

Instructions

1. Record the above transactions using general journal

2. The merchandise inventory on hand at September 1, 2016, the beginning of the current
fiscal year, was Br. 250, 000, the physical count taken on august 1, 2016 , determined
that merchandise on hand was Br, 274,600. Prepare the adjusting entries for merchandise
inventory for the current fiscal year ended August 31, 2017.

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 CHAPTER FIVE

ACCOUNTING SYSTEMS

Learning Objectives:

After completing this chapter you will be able

 Identify the basic concepts of an accounting system.

 Describe the nature and purpose of a subsidiary ledger.
 Explain how companies use special journals in journalizing.
 Indicate how companies post a multi-column journal.

Session 19 and 20 (Hr. 37 to 40)

Topic:- Basics of Accounting System Design

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Session Learning Objective

 Identify the basic concepts of an accounting system.

 Describe the nature and purpose of a subsidiary ledger.

Reading Assignment Discussion

 Goals of designing an accounting system

5.1. Introduction

The accounting system collects and processes transaction data and communicates financial
information to decision makers. The system will vary from business to business, because of the
differences in the nature and size of business, the number of transactions to be processed, etc.
Regardless of these variations an accounting systemis normally supported by either manual or
computerized operations. This chapter deals about the basic principles of an accounting system
and the tools used to implement the system.

5.1 Basics of Accounting System Design

As a business exhibits expansion and growth, its accounting system is required to be redesigned
in a way that accommodates the information requirement of the business. There are three-step in
designing an accounting system. process these are:

Step 1. Analyzeuser information needs.

Step 2. Designthe system to meet the user needs.

Step 3. Implementthe system.

Analysis the information need enables to determine the information requirement of a particular
company and to identify the gap of the existing system. On the base of this requirement and the
gap identified the accounting system is designed. The design is made using a basic manual
system that included a chart of accounts, a two-column journal, and a general ledger. Finally, the

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designed system is implemented to record transactions and prepares financial statements. Once a
system has been implemented, feedback,or input, from users is used to analyze and improve the
system.

Efficient and effective accounting systems is designed and implemented in a way that fulfills the
basic principles of cost-effectiveness, usefulness, and flexibility of information produced.

Cost-Effectiveness:- The accounting system must be cost effective.Benefits of information

mustoutweigh the cost of providing it.

Usefulness: - To be useful, information must be understandable, relevant, reliable, timely, and

accurate. Designers of accounting systems must consider the needs and knowledge of various
users.

Flexibility: - The accounting system should accommodate a variety of users and changing
information needs. The system should be sufficiently flexible to meet the resulting changes in the
demands made upon it.

5.2. Internal Control and an Accounting System

Internal controls and information processing methods are essential in an accounting system. The
designed accounting system has to work smoothly with the internal control elements of a
particular company. The system is required to strengthen the internal control and catalyze the
smooth implementation of the control activity.

Internal control is a process designed to provide reasonable assurance regarding the

achievement of objectives related to operations, reporting, and compliance. In more detail, it
consists of all the related methods and measures adopted within an organization to safeguard
assets, enhance the reliability of accounting records, increase efficiency of operations, and ensure
compliance with laws and regulations. Internal control systems have five primary components as
listed below.

 A control environment. It is the responsibility of top management to make it clear that

the organization values integrity and that unethical activity will not be tolerated. This

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 component is often referred to as the “tone at the top.”
 Risk assessment. Companies must identify and analyze the various factors that create
risk for the business and must determine how to manage these risks.
 Control activities. To reduce the occurrence of fraud, management must design policies
and procedures to address the specific risks faced by the company. The six principal of
control activities are,
- Establishment of responsibility:- Assign a task to specific employees and give
the employee the appropriate authority and responsibility. So that employee is
liable for his actions.
- Segregation of duties:- Different individuals should be responsible for related
activities, and separating record keeping from physical custody. If an employee
who orders goods also handles the invoice and receipt of the goods, as well as
payment authorization, he or she might authorize payment for a fictitious invoice.
- Documentation procedure:- Companies should establish procedures for
documents. Companies should use pre-numbered documents, and all documents
should be accounted for and promptly forward source documents for accounting
department. 
- Physical controls:- relate to the safeguarding of assets and enhance the accuracy
of the accounting records, using safe volts, passwords, locks etc.
- Independent internal verification:- verify records periodically, reconcile it with the
existing assets by an independent employee. Eg, compare the cash balance of the
record with the actual cash available.
- Human resource controls:- involves making a good background check of
employees, rotating the employee from one task to another and obtaining
insurance protection to employees against theft,
 Information and communication. The internal control system must capture and
communicate all pertinent information both down and up the organization, as well as
communicate information to appropriate external parties.
 Monitoring. Internal control systems must be monitored periodically for their adequacy.
Significant deficiencies need to be reported to top management and/or the board of
directors.

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5.3. Manual and computerized accounting system and enterprise resource planning

5.3.1. Manual Accounting System

Accounting systems are manual or computerized. Understanding a manual accounting system is

useful in identifying relationships between accounting data and reports. Also,most computerized
systems use principles from manual systems.

In prior chapters, the transactions for Enkopa Company were manually recorded in an all-
purpose (two-column) general journal. The journal entries were then posted individually tothe
accounts in the ledger. Such a system is simple to use and easy to understand when there are a
small number of transactions. However, when a business has a large number of
similartransactions, using an all-purpose journal is inefficient and impractical.For example, in a
given day, a company might earn service fees on account from 100 customers.Recording each
fee earned by debiting Accounts Receivable and crediting Service feewould be inefficient. Also,
a record of the amount each customer owes must be kept. Insuch cases, subsidiary ledgers and
special journals are useful.

5.3.2. Computerized Accounting Systems

Computerized accounting systems are widely used by even the smallest of

companies.Computerized accounting systems have the following three main advantages
overmanual systems:

1. Computerized systems simplify the record-keeping process in that transactions are

recorded in electronic forms and, at the same time, posted electronically to general and
subsidiary ledger accounts.
2. Computerized systems are generally more accurate than manual systems.
3. Computerized systems provide management with current account balance informationto
support decision making, since account balances are posted as the transactionsoccur.
The popular QuickBooks, Peachtree accounting software etc. are used by small- to medium-sized
businesses.

NB: Dear Students you will discuss and practice the detail application of computerized recording
on your advanced accounting course named “Computerized Accounting”.

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5.4. Subsidiary Ledgers and Controlling Accounts

An accounting system should be designed to provide information on the amounts duefrom

various customers (accounts receivable) and amounts owed to various creditors(accounts
payable). A separate account for each customer and creditor could be addedto the ledger.
However, as the number of customers and creditors increases, the ledgerwould become awkward.

A large number of individual accounts with a common characteristic can be grouped together in a
separate ledger called a subsidiary ledger. The primary ledger, which contains all of the balance
sheet and income statement accounts, is then called the generalledger. Each subsidiary ledger is
represented in the general ledger by a summarizing account, called a controlling account. The
sum of the balances of the accounts in a subsidiary ledger must equal the balance of the related
controlling account. Thus, a subsidiary ledger is a secondary ledger that supports a controlling
account in the general ledger. Two of the most common subsidiary ledgers are as follows:

1. Accounts receivable subsidiary ledger:- collects transaction data for individual customer

2. Accounts payable subsidiary ledger;-collects transaction data for individual creditors

The accounts receivable subsidiary ledger, or customer’s ledger, lists the individual customer
accounts in alphabetical order. The controlling account in the general ledger that summarizes the
debits and credits to the individual customer accounts is Accounts Receivable. The accounts
payable subsidiary ledger, orcreditor’s ledger, lists individual creditor accounts in alphabetical
order. The related controlling account in the general ledger isAccounts Payable.

To illustrate assume that the account receivable general ledger of a ZZ Company shows a balance
of Br.20, 000 as of September 30, 2016. The company has four credit customers namely Mr. A
Mr. B and Mr. C each owed Br. 2,000, Br. 9,500, and Br. 8,500 respectively. The following are to
illustrate how the customer ledger captures the credit history of individual customers and how it
is controlled by the general ledger.

Illustration 5.1 General and subsidiary ledgers for Accounts Receivable

Accounts Receivable General Ledger

Date Item p/r Debit Credit Balance

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2016sept. 4   15,000       15,000  
12 7,000 8,000
20 18,000 26,000
30 6,000 20,000
                   
Accounts Receivable subsidiary ledgers

Mr. A
Date Item p/r Debit Credit Balance
2016sept. 14   5,000       5,000  
3,000 2, 000
                   

Mr. B

Date Item p/r Debit Credit Balance

2016sept. 4   10,000       10,000  
12 4,000 6,000
20 5,500 11,500
30 2,000 9,500
                   

Mr. C

Date Item p/r Debit Credit Balance

2016sept. 20   12,500       12,500  
30 4,000 8,500
                   

As you see there are three customer ledgers (subsidiary ledger) opened by the name of each
customers and one general ledger (controlling ledger) opened by the name of an account called
“Accounts Receivable”. The sum of the ending balance of the three subsidiary ledger (Br. 2,000
+ 9,500 + 8,500) exactly equal with the balance in general ledger of account receivable (Br.
20,000).

NB; the number of subsidiary ledgers is increased by an increase in number of credit customer.

Synopsis of Lecture

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  System analysis, system design and implementation are the tree steps in changing an
accounting system.
 Cost-effectiveness, usefulness, and flexibility is the basic principle for the accounting
system design.
 Ledgers opened by the name of individual customers or credits is a subsidy ledgers
 A ledger that controls the subsidiary ledgers is referred to as a general ledger.

Wrap –Up Discussion Question

 Discuses the deference between manual and computerized accounting.

 Explain the meaning of the principles of accounting system design.
 Discuss the interrelationship between an accounting system and internal control.
 Discusses the difference between general and subsidy ledger.
Next day’s reading assignment

Read about special journals and there necessity

Session 22 and 23 (Hr 43 to 46)

Topic :-Special Journals and Vouchers

Session learning objective

 Explain how companies use special journals in journalizing.

 Indicate how companies post a multi-column journal.
Reading Assignment Discussion

Discussion issues

Special journal and their role in recording

5.4. Special Journal and Vouchers

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 5.4.1. Special Journals

One method of processing data more efficiently in a manual accounting system is toexpand the
all-purpose two-column journal to a multicolumn journal. Each column in a multicolumn journal
is used only for recording transactions that affect a certain account.For example, a special
column could be used only for recording debits to the cashaccount. Likewise, another special
column could be used only for recording credits to thecash account. The addition of the two
special columns would eliminate the writing of Cashin the journal for every receipt and every
payment of cash. Also, there would be no needto post each individual debit and credit to the cash
account. Instead, the Cash Dr. and CashCr. columns could be totaled periodically and only the
totals posted. In a similar way, specialcolumns could be added for recording credits to Service
Fees, debits and credits toAccounts Receivable and Accounts Payable, and for other entries
thatare repeated.

An all-purpose multicolumn journal may be adequate for asmall business that has many
transactions of a similar nature.However, a journal that has many columns for recording many
differenttypes of transactions is impractical for larger businesses.The next logical extension of
the accounting system is to replace the single multicolumnjournal with several special journals.
Each special journal is designed to beused for recording a single kind of transaction that occurs
frequently. Most transactions of merchandise for example, fall in to four groups i.e sales on
account, purchase on account, cash receipt and cash disbursements etc. To record each
transaction types the following four special journals are used.

Sales Journal

Sales journal is used only for recording sales of merchandise on account; sales of merchandise
for cash are recorded in the cash receipt journal. Sales of non merchandise assets are recorded in
the cash receipt journal or the general journal depending on whether the sales is made on account
or for cash. Illustration 5.2, below sows the general format for sales journal.

Sales Journal

Dat Post. Acc. Rec. Debit

Accounts Debited
e Ref sales credit
       

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As you see from the above format, there is one amount column to record a debit to accounts
receivable and credit sales. This mean an amount inters on the column represents both increase in
an asset and revenue account resulted from sale. If the company uses general journal it requires
two amount columns to record accounts receivable and sales separately. In addition recording
each sale requires at least three rows to write (1) Account Receivable, (2) Sales (3) brief
description of the transaction in a general journal but only one raw in special journal.

Using sales journal saves the time and space of posting, because only the total amount of sales is
posted to the sales ledger in the case of sales journal. But in general journal sales is posted
individuals to the sales ledger.

NB: the 2nd column named “Accounts debited” used to insert the name of credit customer.

Purchase Journal

All purchases made on accountare recorded in purchase journal using a special column named
purchase debit.Cash purchases would be recorded in the cash payments journal.Purchase of
Supplies, equipment and other plant assets also recorded in purchase journal general columns
other than the special column. Illustration 5.3, shows the general format for Purchase Journal.

Purchase Journal

Dat Accounts Post Purchase Accounts Other Account

e Credited Ref. Debit PayableCredit Debited
           
           
As the above illustration shows you a typical purchase journal having two special columns and
one general column. The special columns represent Purchase debit and Accounts Payable credit
serves to record the most frequent transaction of purchase of merchandise. The general column
“other account debited” used to record purchase of supplies or equipments on account. All the
accounts in special journal are posted in total, where as all accounts in general column is posted
individually to their respective ledgers.

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 NB: Accounts credited column used to list the names of those businesses and individuals who
offered credit to the company.

Cash Receipt Journal

All transactions that increase the amount of cash are recorded in cash receipt journal. In a typical
merchandising business, the most frequent source of cash receipt is likely to be cash sales and
collection from customers on account. Illustration 5.4 below shows the general format for cash
receipt journal.

Cash Receipt Journal

Dat Post Other account Accounts Receivable

Accounts Credited Cash Debit
e Ref. credit Credit
           
           
As of the above illustration cash receipt journal has two special columns used to record Accounts
receivables and Cash. Only one column entitled other account credit used to record receipts other
than collection from credit customers. Accounts in the special column are posted tin total where
as accounts in general column is posted individually.

Cash Payments Journal

All transactions that involve the payment of cash are recorded in a cash payments journal. The
kinds oftransactions in which cash is paid and how often they occur determine the titles of the
other columns Thus; the cash payments journal has two special columns named Accounts
Payable debit and Cash credit. Illustration 5.5 shows you the general format for cash payments
journal.

Cash payments Journal

Dat Accounts Debited Post Other Accounts Accounts Payable Cash Credit
e Ref. Debited Debit
           
           
The above special journal has two special columns to record a reduction in both Accounts
Payable and Cash. So the special column used to record payment of cash for purchase of
merchandise on account. The general column other account debit is used to record cash payments

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for expenses or purchase of assets like inventories, equipment etc.

5.4.2. The Voucher System

A voucher system is any system that gives documentary proof and written authorization for
business transaction. It consists of procedures for systematically gathering, recording, and paying
a company’s expenditure. Goal of voucher system is to exercise tightest possible control over
expenditure. For maintaining effective control the system separate the responsibility of
Authorization for expenditure form receipts of goods, Validating liability and payment of
liability.

Under the voucher system, every liability must be recorded as soon as it is incurred. A written
authorization, called a voucher, is prepared for each future expenditure, and checks are written
only for approved vouchers. In large companies, the duties of authorizing expenditure, verifying
receipts, recording liability and issuing check are divided among different people. A voucher is a
written authorization for each expenditure. A separate voucher is attached to each bill as it
comes in and it is given an identification number.

Steps of Operation in a Voucher System

There are five steps to implement a voucher system. These are

Step 1, preparation of the voucher

Step 2, Recording the Voucher

Step 3, Paying the voucher

Step 4, Posting the voucher and check registers

Step 5 Summarizing unpaid voucher

Preparation of the voucher: - a voucher is prepared for each expenditure. All documents i.e.
Purchase invoices, invoices, and receiving reports should be attached to the voucher when it is
submitted for approval.

Recording the Voucher: - All approved vouchers should be recorded in the voucher register.
Vouchers that do not have appropriate approval or supporting documents should be investigated

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immediately. If the net method were used, the purchase would be recorded at the net purchase
price after deducting the anticipated discount.

Paying the Voucher:- After a voucher has been recorded, it is placed in an unpaid voucher file.
Many companies file the vouchers by due date and by vendor (Supplier) within due date, so that
checks can be drown each day to cover all vouchers due on that day. In this way, all discounts
forprompt payments can be taken. After payments vouchers are filled by voucher number.

On the date voucher is due, a check accompanied by the voucher and supporting documents, is
presented to the individual authorized to sign checks. Based on this information a schedule for
unpaid voucher is prepared.

Posting the Voucher and Check Registers:- Posting the voucher and check registers is very
similar to posting the purchase journal and cash payment journal. The only difference is that the
Voucher payable account is substituted for accounts payable.

Summarizing unpaid vouchers:- At any time, the sum of the vouchers in the unpaid vouchers
file should equal the credit balance of the vouchers payable account. At the end of each
accounting period, the unpaid vouchers file should be totaled to prove the balance of the
vouchers payable account.

The Voucher System and Management

The voucher system not only provides effective accounting controls but also aids management in
discharging other responsibilities, for example the voucher system gives grater assurance at all
payments is in settlement of valid liabilities. In addition current information is always available
for use in determining future cash requirement. This in turn enables management to make the
best use of the resources. Invoices on which cash discount are allowed can be paid within a
discount period and other vouchers can be paid on the final date of the credit period, thus reduce
costs and maintaining a favorable credit standing.

Synopsis of Lecture

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  Special journal is used for recording a single kind of transaction that occurs frequently.
Special journal includes, Sales journal, purchase Journal, Cash receipt and cash payment
Journals.
 A voucher system is any system that gives documentary proof and written authorization
for business transaction.
 The five steps to implement a voucher system are, preparation of the voucher, recording
the voucher, paying the voucher, posting the voucher and check registers, Summarizing
unpaid voucher.

Wrap –Up Discussion Question

 Discuses the deference between manual and computerized accounting.

 Explain the meaning of the principles of accounting system design.
 Discuss the interrelationship between an accounting system and internal control.
 Discusses the difference between general and subsidy ledger.

SELF – EXAMINATION QUESTION

1. The detailed procedure used by management to direct operations to the enterprise goals can be
archived are termed:
a. Internal controls c. System design
b. System analysis d. System implementation
2. a payments of cash for the purchase of merchandise would be recorded in the:
a. Purchase journal c. Sales journal
b. Cash payments journal d. Cash receipt journal
3. A voucher system is requires all vouchers for purchase to be recorded in a net amount, and a
purchases is made for Br. 500 on account terms 1/10, n/30
a. purchases would be debited for Br, 495 to record the purchases
b. Discount lose would be debited for Br. 5 if the voucher is not paid within discount period

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 c. If the voucher is not paid until the discount the discount period is expired, the discount lost
would be reported as an expense on income statement
d. All of the above
4. when there is a large number of individual accounts with a common characteristics, it is common
to place them in a separates ledger called a:
a. Subsidiary ledger c. accounts payable ledger
b. Creditors Ledger d. Accounts receivable ledger
5. the controlling account in the general ledger that summarizes the debit and the credits to
individual customers account in the subsidiary ledger is entitles:
a. Accounts Payable c. Sales
b. Accounts receivable d. Purchases
6. the voucher system is strengthen internal control requiring that a voucher be prepared to
authorize payment on liability at the time that the liability is
a. Paid c. Planned
b. incurred d. Audited

ILLUSTRATIVE PROBLEM

Selected transactions of Marry Co., for the month of May is as follows

a. may 1, issued a check no. 1001 for payment of rent for may
b. May 2, purchased merchandise on account from McMillan Co. terms 2/10, n/30. fob
shipping point Br, 3,600.
c. may 7, issued check number 1003 in payment of transaction charges on merchandising
purchased on may 2, Br.320
d. may 8, sold merchandise on account to waller Inc. Invoice no 51, terms 1/10, n/eom, fob
shipping point Br. 4500.
e. may 9 Issued check no 1005 for office supplies purchased Br, 450.
f. May 10, received cash from office supplies sold to employee at cost Br. 120
g. May 11, purchased office Equipment on account from Fender Office Product Br, 15,000
h. May, 12, Issued credit memorandum No. 801 for Br.400 to waller inc. for merchandise
returned

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 i. may 12, issued check no 1010 in payment of merchandise purchased from McMillan Co.
on may 2, less discount Br, 3,528.
j. May 16, sold merchandise on account to ripe co, invoice no.58. terms 1/10, n/30, fob
shipping point Br. 8,000
k. may 18, received Br.4,059 from waller Inc. in payment of may 8 purchase, less return on
may 12 and discount.
l. May 20, issued additional capital stock for Br. 100,000
m. may25, sold merchandise for cash br. 15,900
n. may 31, recorded adjusting entry for the work sheet prepared for the fiscal year ended
may 31.
Merry Co. maintains a purchase journal, a cash payments journal, a sales journal a cash
receipt journal and a general journal. in addition the account receivable and account payable
ledgers are used.

Instruction

1. Indicate the journal entry in which each of the preceding transaction (a) through (n)
would be recorded.
2. Indicate whether an account is the account receivable or the account payable subsidy
ledger would be affected for each of the preceding ding transactions
3. Record transaction b,c,d,h,I, and k in the appropriate journal.

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 CHAPTER SIX

ACCOUNTING FOR CASH

6.0. Chapter Overview

In small businesses the owner may be able to control the entire operations through personal
supervision and direct participation in its activity. However as a business grows higher and
higher it becomes difficult to actively participate in routine operations and maintain adequate
control. At this point it becomes necessary to delegate authorized persons and design a reliable
internal control system over the business resources. The nature and extent of control might vary
resources to recourse. For instance liquid assets like cash and receivables need strict internal
control system compared with assets which are less liquid. This is due to the highest venerability
of these assets for misuses and theft. In this chapter unitwe will discusses internal control over
cash.

Learning Objectives:

After completing this chapter the students should be able to:

 Define cash and its characteristics

 Identify the principles of internal control over cash
 Indicate the control features of a bank account
 Prepare bank reconciliation.

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  Preparation of bank reconciliation
 Identify other mechanisms of control over cash receipt

Session 24 (Hr. 47 and 48)

Topic :- Control over Cash

Session learning objective

 Define cash and its characteristics

 Identify the principles of internal control over cash
 Indicate the control features of a bank account
 Prepare bank reconciliation.
Reading Assignment discussions

Discussion issues

Exercise and problems of chapter five

Reading Text

6.2. Meaning and Characteristics of Cash

Cash is the most liquid asset that can easily convertible to any other type of asset. Cash consists
of coins, currency (paper money), checks, money orders, and money on hand or on deposit in a
bank or similar depository institutions.

Cash is a medium of exchange and is used to measure the value of other assets. Majority of the
business transactions involves cash; this makes cash the most repeatedly used account in the

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recording system. These in tail increase the probability of making recording error compare with
other accounts used in the recording system. In addition Money is light in weight and heavy in
value. Anybody can easily pick and use it unless there is a strong control preventive mechanism.

6.3. Control over Cash

Because of the ease with which money can be transferred, cash is the asset most likely to be
diverted and used improperly by employees. In addition, many transactions either directly or
indirectly affect the receipt or paymentof cash. It is therefore necessary that cash can be
effectively safeguarded by special controls.

In general speaking cash is an asset account which is highly exposed to embezzlements and
misuse. As a result it is crustal to establish and exercise a strong internal procedure control over
cash.

Internal control for cash should include the following procedures:

 The individual who receive cash should not disburse (pay) cash.
 The individual who handle cash should not make the accounting records.
 Cash receipts are immediately recorded and deposited and are not used directly to make
payments.
 All mail receipts should be opened by more than one mail clerk and endorsed with “only
for Deposit” stamp
 Cash disbursements should be made by serially numbered check, only up on proper
authorization by somebody other than the person writing the check.
 Bank accounts should be reconciled monthly with a employee who has no other
responsibility pertaining to cash
 Using a petty cash fund for small payments.
6.3.1 Control of Cash through Bank Account

Using bank account is one of the most important mechanisms to control cash. To get an effective
control over cash all receipts must be deposited in the bank account and all cash payments should
be made through check. Banks provide physical protection for cash and maintain separate
records of transactions which belong to cash.

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Once a company starts using bank accounts, the bank sends a monthly bank statement to the
depositor. Bank statement is a bank report or a copy of banks record sent to a customer. if you or
your family members have current account you can see the following information on it.

i. an opening or beginning cash balance, the balance of cash brought from the previous
month
ii. checks paid and other debits (such as debit card transactions or direct withdrawals for bill
payments) that reduce the balance in the depositor’s account,
iii. Deposits and other credits that increase the balance in the depositor’s account, and
iv. The account balance after each day’s transactions.

A bank statement is accompanied by checks paid, debit and credit memorandum. Debit memos
describe the amount and nature of decreases in the company’s cash with the bank. It includes
bank service charge, fund transfers etc. Credit memorandums inform the increase in the cash
balance of the depositor. It includes collection of notes receivables, fund transfers etc

This bank statement is used to check whether the cash balance on the bank account agrees with
the balance on the accounting record. If there is difference the company accountant finds out
the reason and reconciles the two balances.

NB: a bank credits customer’s account for every deposit. As a result deposits are considered as a
liability for the bank. Banks debits customers account for every payments, because payment
reduces the banks liability.

6.4. Reconciliation of Bank and Book Cash balance

Balance of cash as per the bank record seldom agrees with the balance of cash as per the
depositor because of two reasons i.e time lags and errors made by either party. Time lags prevent
one of the parties from recording the transaction in the same day as the other party and result
different cash balance. For example deposit in transit and outstanding check. In addition to the
difference, both balances are different from the “correct” or “true” balance. Therefore, it is
necessary to make the balance per books and the balance per bank agree with the correct or true
amount i.e. a process called reconciling the bank account.

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Synopsis of lecture

 Cash is an asset item highly exposed to embezzlements and misuse

 Control over cash means having an effective control over cash receipts and payments
 The bank account is used as a tool to control cash
 Bank reconciliation is a statement that brings the bank balance and the book balance in to
agreement

Wrap-up discussion questions

 Explain the reason why special control is required to cash

 Identify the elements of internal control over cash
 Explain how the control system is supported by a bank account

Next day’s assignment

Read about control over cash receipts

Session 25, (Hr. 49 and 50)

Topic:- Procedures and steps in a bank reconciliation

SessionLearning Objective

 Preparation of bank reconciliation

 Identify other mechanisms of control over cash receipt
Reading Assignment Discussion
Discussion issue;

Internal control over cash receipt

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Reading Text

Bank reconciliation should be a routine monthly activity that has to goes in line with the
company’s internal control procedures. The activity should be undertaken by a designated
employee who is free from other responsibilities related to cash.

The starting point in preparing the reconciliation is to enter the balance per bank statement and
the balance per books on the reconciliation schedule. The company then makes various
adjustments as per the following step.

1. Step 1. Deposit in transit:- Deposits recorded by the depositor that have not been
recorded by the bank are the deposits in transit. Add these deposits to the balance per
bank. This is made by comparing the deposit lists of the depositor with the deposit list
shown in the bank statement.
2. Step 2. Outstanding Check:-Issued checks recorded by the company but that have not
yet been paid by the bank are outstanding checks. Deduct outstanding checks from the
balance per bank. This is made by comparing the list of checks paid by the bank with the
same list in cash payment journal of the company.
3. Step 3. Bank Errors:- any error made by the bank and discovered in the foregoing steps
are included in the schedule. An error which overstates the cash balance is deducted
where as an error which understates the cash balance is added to the balance as per the
bank. For example if a bank paid a check for Br. 547 and incorrectly record it as Br.574.
Here the bank understates cash balance by Br. 27 (547-574) and this amount is added to
the cash balance as per the bank. What if it is incorrectly recorded as Br. 457 instead of
Br. 574? Now the error overeats the cash balance for br. 90 (547-457) the amount is
deducted from the bank balance.
4. Step 4.Bank credit memorandum:- collection of notes receivables and other fund
transfers made by the bank on behalf of the depositor. List all credit memos and add
them to the cash balance as per the book.
5. Step 5. Bank Debit memorandum: -Banks charge a monthly fee for their services called
service charge. The bank also sends with the statement a debit memorandum explaining

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 the charge noted on the statement. Other debit memoranda may also be issued for other
bank services such as the cost of printing checks, issuing traveler’s checks, and wiring
funds to other locations. List all the debit memos and deduct them from the cash balance
as per the Book.
6. Step 6.Charges for depositing NSF- Checks:- When checks are deposited in an
account, the banks generally gives the deposit immediate credit. On occasions, one of
these checks may prove to be uncollectable because the maker of the check does not have
sufficient funds in his or her account. in such cases the bank will reduce the depositor’s
balance by the amount of the uncollectable item and return that check to the depositor
marked NSF. Deduct the amount of the NSF check from the cash balance as per the book.
7. Step 7. Depositor Error:- Any error made by the depositor is added or deducted from
the cash balance as per the book, in the same we made for bank error of step 3.
8. Step 8.Prove the equality of the adjusted cash balances as per the bank and as per the
book.
9. Step 9.Prepare adjusting entries to record those items which are not yet recorded by
the depositor.
Illustration of Bank Reconciliation

Enkopa Company is a customer of Dashin Bank Sc. The company received bank statements for
the month November 31, 2016. The statement shows cash balance of Br. 23,932.50 at the end of
the month. The balance of cash as per the company record is Br. 27, 220.50. The comparison of
the statement with the cash account reviled the following reconciling items.

1. A debit memorandum for Br. 30 for bank service charge accompanied the statement.
2. The following checks issued in November are not yet paid by the bank.
Ck No. CD 232425 Br . 762
Ck No CD 231429 Br., 930
3. Cash payment made for Br. 250 is incorrectly recorded as Br. 205 on the cash payment
journal. The payment is for purchase of supplies made on account.
4. A deposit of Br. 5,800 made after banking hour is not appearing on the bank statement.
5. A credit memorandum for br. 2,200 is accompanied the statement for the collection of
notes receivable

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 6. On November 30, the bank statement showed an “NSF” chares of Br. 1,100 for a check
issued by a customer on account.

Enkopa Company

Statements of Bank Reconciliation

For the month November 30,2016

Cash Balance as per the bank statement 23,932.50

Add Deposit In transit 5,800

Sub total 29,732.50

Deduct Outstanding checks

No.232425 762

No.232429 930 1,692

Adjusted Bank Balance 28,040.50

Cash Balance as per the book Balance 27,220.50

Add Note receivable collected by the bank 2,000

sub total 29,220.50

Deduct Bank service charge Br. 35

NSF check 1100

Error of recording payment of Br.250 as 205 45 1,080

Adjusted Book balance 28,040.50

Date Account Title and P/R Debit Credit

Descriptions
2016 30 Cash   2,000      
    Notes Receivable       2,000  
    Recording Bank Collection          
   30 Administrative Expense   35      
    Cash       35  

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    Recording bank service          
charge
   30 Accounts Receivable   1,100      
    Cash       1,100  
    Recording NSF          
   30 Account Payable   45      
    Cash       45  
.Internal Control over Cash Receipts

Retile businesses normally receive cash from two main sources (1) Over the counter from the
customers (2) By mall from charge customers making payments on account. At the end of the
business day, each sales clerk counts the cash in the assigned cash drawer and records on a
memorandum form. An employee from the cashers department removes the cash register tape on
which total receipts were recorded for each cash drawer, count the cash and compare the total
with the memorandum and the tape and forwarded to the accounting department, where they
become the basis for entries in the cash receipt Journal.

The employees who open incoming mail compare the amount of cash received with the amount
shown on the accompanying remittance advice to be certain that the two amounts agree. If there
is no separate remittance advice, an employee prepares one of the form designed for such use.
All cash received usually in the form of check and money order sent to the cashers department,
where it is combined with receipts from cash sales and a deposit ticket is prepared. The
remittance advice is delivered to the accounting department, where they become the basis for
entries for cash receipt journal and for posting to the customer account subsidiary
ledger.Duplicate deposit ticket, or other bank receipt forms obtained by the casher are sent to the
controller or other financial officer, who compare the total amount with that reported by the
accounting department as a total debit to cash in bank for the period.

Cash Short and Over

The amount of cash actually received during a day often does not agree with the record of cash
receipt. Whenever there is the difference between the recorded and the actual cash and no error
can be forum on the record, it must be assumed that the mistake occur in making change. The
cash sort or over account is recorded in accounting title. a common method for handling such

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mistake to record it as a debit to cash sort and over account whenever there is shortage and credit
cash short and over account whenever there is cash excess.

If there is a debit balance in the cash short and over account at the end of the fiscal year, it is
expense and may be presented in the other expense and loss section of the income statement. If
there is a credit balance, it is revenue and may be listed in the other income and gain account
section of the income statement.

Cash Change funds

Retail stores and other business is that receive cash directly from customers must maintain a fund
if currency and coins in order to make change. The fund may be stabilized by drawing a check
for the required amount – Debiting Cash on hand and Crediting cash in bank. No additional
change or credit to cash on hand at the end of each business day, the total amount of cash
received during the day is deposited and the original amount of the cash change fund is
maintained. Exchanging bills or coins maintain the desired composition of the fund for those of
other denomination at the bank.

Synopsis of lecture

 Adjusting entry is necessary to recognize unrecorded cash receipt or payment

belonging to bank reconciliation
 Cash sort and over is an account used to handle mistakes in making cash change
 All cash received in the form of check should be endorsed to the company account
 The employees who open the incoming mail compare the amount of cash received to
the remittance advice.

Wrap-up discussion questions

 What does the term deposit in transit means?

 What is the need to have cash change fund?
 Which section of the reconciliation statement used to make adjusting entry?

Next day’s assignment

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Read about Internal control over cash payments

Section 26 (Hr. 51 and 52)

Topic:- Internal Control over Cash Payments

Session learning Objective

 Illustrate internal control over cash

 Describe the voucher system
 Describe the operation of a petty cash fund.
6.5 Internal Control over Cash Payments

Control over cash payments involves two mechanisms, i.e the voucher system and petty cash
handling system. The voucher system is one of the best systems that control disbursements. A
voucher system is made up of records, methods and procedures used in proving and recording
liabilities and in making and recording cash payment. A voucher system uses (1) Voucher, (2) A
voucher register, (3) a file for unpaid voucher, (4) a check register and a file for unpaid voucher.
dear students the full discussion for voucher system is included in the previous chapter ( Chapter
5) and refer that for your understanding.

6.5. Petty Cash Fund

As you recalled from the above discussion, controlling cash through bank account is effective
when “all payments” are made through check. However, using checks to pay small amounts is
both impractical and a costly to a company. For example, writing a check to pay a Br. 5 taxi
fare, or a br. 10 daily labor fee. A better way to handle such small payments is establishing a
petty cash fund.

A petty cash fund is a special cash fund proposed to cover many small payments for a period of
two or three weeks. The operation of a petty cash fund, often called an imprest system, involves
(1) establishing the fund, (2) making payments from the fund, and (3) replenishing the fund.

i. Establishing the petty cash fund

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Establishment of the fund has three steps (1) assigning a custodian who handle the fund. (2)
Determining the maximum amount of fund required to cover anticipated payments for two or
three weeks. (3) Determine the minimum amount left in the custody to replenish the fund (4)
Issue a check for the maximum amount and record the appropriate journal entry.

Illustration assume that on august 10, 2016, Loin Company decides to establish a petty cash fund
and writes a check of Br. 500. The following is the journal entry to record the establishment of a
petty cash fund.

Date Account Title and Descriptions P/R Debit Credit

2016
10 Petty Cash   500      
August
    Cash       500  
    recording establishment of petty cash          
The custodian cashed the check, put in on safe custody or a petty cash box and then makes
payment from the fund for authorized purpose only.

NB:The Company will make no additional entries to the Petty Cash account unless management
changes the maximum amount of the established fund. For example if Loin decides to increase
the fund to Br. 650, then the company debit Petty Cash fund Br. 150 and credit cash for Br. 150.

ii. Making payment from the Petty Cash Fund

The custodian has authority to make payments from the fund. For each payment the custodian
prepares and keeps supporting evidence. The evidence must show the date and amount of
payment, the name and signature of the payee and the reason for payment. No journal entry is
required to record the payments until replenishment or the end of the fiscal year. When the fund
gets smaller and smaller and reaches a minimum level, the custodian prepares a summary of
payment and requests the treasurer’ to replenish the fund.

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 iii. Replenishing the petty cash fund
To replenish a petty cash fund the treasurer examines the summery and the supporting documents
of paymentto verify that proper payments were made. Then the treasurer approves the request
and replenishes the fund.

To illustrate, assume that on August 25, Loin’s custodian made payments for the following items
and requests replenishment for Br. 437. The payments are for Delivery expense Br. 160 Postage
stamp Br. 72, purchase of supplies Br. 205. The following is the journal entry to record the
issuance of the check for replenishment.

Date Account Title and Descriptions P/R Debit Credit

2016
25 Delivery Expense   160      

    Postage Expense   72      
    Supplies   205      
Cash       437
    Recording replenishment
Look the above entry do not change the balance of the petty cash fund rather it simply substitutes
the amount of cash withdrawn from the petty cash box.

Treatment for cash Short and over

In handling cash receipts from daily sales or in making payments from petty cash fund, a few
errors will occur. These errors might cause a cash short or cash over at the end of the day. The
account cash sort and over is debited if there is shortage and credited if there is overage.

To illustrate consider the information of the above illustration and assume that amount of cash
left on the petty cash box is Br. 55 instead of Br. 63(Br. 500-437). The balance shows Br.8
shortage and recorded as follows while replenishing.

Date Account Title and Descriptions P/R Debit Credit

25 Delivery Expense   160      

2016
    Postage Expense   72      

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    Supplies   205      
Cash Short and over 8
Cash       445
    Recording cash short  
Illustration 2 Assume that the cash register tape shows total cash sales for the day amounts to Br.
23,980. However, the actual cash count shows total of Br. 23,992. Here there is cash over of Br.
12 and recorded as follows

Date Account Title and P/R Debit Credit

2016 30 Cash Descriptions   12      
    Cash Short and over       12  
    Recording cash over          

Electronic Funds Transfer (EFT) System

It is not surprising that companies and banks have developed approaches to transfer funds among
parties without the use of paper (deposit tickets, checks, etc.). Such procedures, called electronic
funds transfers (EFT), are disbursement systems that use wire, telephone, or computers to
transfer cash balances from one location to another. Use of EFT is quite common. For example,
many employees receive no formal payroll checks from their employers. Instead, employers send
electronic payroll data to the appropriate banks. Also, individuals now frequently make regular
payments such as those for house, car, and utilities by EFT.

EFT transfers normally result in better internal control since no cash or checks are handled by
company employees. This does not mean that opportunities for fraud are eliminated. In fact, the
same basic principles related to internal control apply to EFT transactions. For example, without
proper segregation of duties and authorizations, an employee might be able to redirect electronic
payments into a personal bank account and conceal the theft with fraudulent accounting entries.

6.6. Reporting Cash

Companies report cash in two different statements: the statement of financial position and the
statement of cash flows. When presented in a statement of financial position, cash on hand, cash

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in banks, and petty cash are often combined and reported simply as Cash. Cash is listed last in
the current assets section of the statement of financial position.

The statement of cash flows shows the sources and uses of cash during a period of time. In this
section, we discuss some important points regarding the presentation of cash in the statement of
financial position.

Cash Equivalents

Many companies use the designation “Cash and cash equivalents” in reporting cash. Cash
equivalents are short-term, highly liquid investments that are both readily convertible to known
amounts of cash, and insensitive to changes in interest rate. Examples of cash equivalents are
Treasury bills, commercial paper (short-term corporate notes), and money market funds. All
typically are purchased with cash that is in excess of immediate needs.

While cash equivalents are now frequently reported with cash, it appears likely that the IASB
will end this practice in the future. Instead, those items that are now referred to as cash
equivalents will be reported as short-term investments.

Restricted Cash

A company may have restricted cash, cash that is not available for general use but rather is
restricted for a special purpose. Cash restricted in use should be reported separately on the
statement of financial position as restricted cash. If the company expects to use the restricted
cash within the next year, it reports the amount as a current asset. When this is not the case, it
reports the restricted funds as a non-current asset.

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Synopsis of lecture

 Voucher system is designed to control payments of liability and expenses.

 Small payments are controlled by establishing petty cash fund.
 A means of transferring funds using telephone, or computer is referred to as electronic
fund transacted.
Wrap-up discussion questions

 Explain the term unpaid voucher

 discuss how cash is presented on financial statement
 Explain the elements of establishment and replenishment of petty cash fund

SELF EXAMINATION QUESTION

1. In preparing a bank reconciliation the amount of the check outstanding would be:
a. Added to the cash balance according to the bank statement
b. Deducted from the cash balance according to the bank statement
c. Added to the cash balance according to the depositor’s record
d. Deducted from cash balance according to the depositor’s record
2. Journal entries based on the bank reconciliation is required for:
a. Additions to the cash balance according to the depositor’s record
b. Deducted from the cash balance according to the depositor’s record
c. Both a and b d. Neither a nor b
3. The journal used to record liability when a voucher system is used is called
a. A Voucher c. A check register
b. An unpaid voucher d. A voucher register
4. The voucher system records all purchases at net amount, which is the correct record for a
Purchase is made for Br. 5000 , terms 1/10, n/30
a. Purchase should be debited for Br, 4,950
b. Discount lose would be debited for Br. 50 , if the voucher is not paid with in the
discount period.

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 c. If the voucher is not paid after the discount period has expired, the discount lost
would be reported as expense on income statement
d. All of the above
5. A petty cash fund is:
a. used to pay relatively small amounts
b. Established by estimating the amount of cash for disbursement to relatively small
amounts
c. Reimbursed when the amount of money in the fund is reduced to a predetermined
minimum amount.
d. All of the above

ILLUSTRATIVE PROBLEM

1. The bank statement of Dunlap company for April 30, indicated a balance of Br.10,443.11,
the company employees a voucher system in controlling expenditure. All cash receipts
are deposited each evening in the night depository, after the banking hour. The accounting
records indicate the following summary data for cash receipts and disbursements.
 Cash in bank as of April 1 , Br. 5,143.50
 Cash receipt journal’s total cash receipt Br. 28,971.60
 Total amount of check issued in April Br. 26,060.85

Comparison of the bank statement and the accompanying canceled check and memorandum with
the records revealed the following items

a. The bank had collected for Dunlop Co. Br. 912 on a note left for collection. the face value
of the note is Br. 900
b. A deposit of Br. 1,852.21 representing a receipt of April 30 had been made too late to
appear on the bank statement
c. Check outstanding totaled Br. 3,265.27
d. A check drown for Br, 79 had been erroneously charged by the bank as Br.97
e. a check of Br. 10 returned with the statement had been recorded in the check register as
br.100. the check was for the payment of an obligation to Davis co. for purchase of office
supplies.
f. Bank service charge for April amounted to Br. 8.20

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 Instructions
i. prepare statements of bank reconciliation fro April
ii. Journalize the necessary entries

CHAPTER SIX

ACCOUNTING FOR RECEIVABLES

Chapter Learning Objective

After completing this part of the study you should be able to:

 Identify the different types of receivables.

 Explain how companies recognize accounts receivable.
 Distinguish between the methods and bases companies use to value accounts receivable.
 Describe the entries to record the disposition of accounts receivable.
 Compute the maturity date of and interest on notes receivable.
 Describe how companies value notes receivable.
 Describe the entries to record the disposition of notes receivable.

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Section 27 (Hr. 53 and 54)

Topic:- Definition and Classification of Accounts Receivables

Session learning Objective

 Identify the different types of receivables.

 Explain how companies recognize accounts receivable.
 Explain how to control Accounts Receivables

6.1 Definition and Classification of Receivable

Receivable is a legally enforceable claim for payment held by a business for goods supplied
and/or services rendered that customers have ordered but not paid for.

Classification of Receivables

i. Accounts Receivable:- used for selling merchandise or services on credit, and normally
expected to be collected in a relatively short period. Such receivables are supported only
by sales invoice, no formal written promise for payment. It is also known as open
account.
ii. Notes Receivable:- used to grant credit on the basis of a formal instrument of credit,
called a promissory note. Compared with account receivable note receivables is more
formal and legally binding. Notes are normally used for periods longer than 6o days and
for the transaction of relatively large in amount. Note may be used in settlement of open
account and in borrowing and lendingmoney.
iii. Other Receivables:- include interest receivable, taxes receivable, and receivables from
officers and employees advance. This receivables are known as Non- trade receivable.
6.2. Internal Control over Receivables
Like cash strong internal control procedure is necessary for receivables also. The following are
among the control mechanisms:

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  Background and paying capacity of customers should be examined before allowing credit
sales.
 Credit sales should be approved by as designated employee only.
 Don’t allow that, related functions like selling, approving and recording is performed
by one individual.
 Sales return and allowance and sales discount should be authorized, and there
adjustments are reviewed by aconcerned party.
 Effective collection effort should be made to minimize uncollectable.
6.3. Issues Associated with Receivables
There are three primary accounting issues are associated with receivable: These are

 Recognizing receivables
 Valuing receivables
 Disposing of receivable
6.3.1. Recognition of Receivables
When goods or services are sold on account, a business can recognize receivables at that point of
sale at invoice price by debiting accounts receivable and crediting sales or service revenue. To
illustrate, assume on July 3 Alemu Garage gives a repair service on account Br. 2,000. Here the
appropriate record is as follows.

Date Account Title and P/R Debit Credit

Descriptions
3 Accounts Receivable   2,000      
2016
    Service fee       2,000  
    Record sales on account          

6.3.2. Valuation of Accounts Receivables

To ensure that receivables are not overstated on the balance sheet, they are stated at their cash
realizable value.Cash (net) realizable value is the net amount expected to be received in cash and
excludes amounts that the company estimates it will not be able to collect.There is no general
rule for when an account becomes uncollectible. The common indictorsthat an account becomes
uncollectable are:

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  The receivable is past due.
 The customer does not respond to the company’s attempts to collect.
 The customer files for bankruptcy.
 The customer closes its business.
 The company cannot locate the customer.
6.3.2.1. Accounting for Uncollectable

Each customer must satisfy the credit requirements of the seller before the credit sale is
approved. Inevitably, though, some accounts receivable become uncollectible. For example, a
customer may not be able to pay because of a decline in its sales revenue due to a downturn in
the economy. Similarly, individuals may be laid off from their jobs or faced with unexpected
hospital bills. Companies record credit losses as debits to Bad Debt Expense (or Uncollectible
Accounts Expense). Such losses are a normal and necessary risk of doing business on a credit
basis. Recently, when home prices in many parts of the world fell, home foreclosures rose and
lenders experienced huge increases in their bad debt expense.

Two methods are used in accounting for uncollectible accounts: these are:

i. The direct write-off method

ii. The allowance method
i. Direct Write-off Method

Under the direct write-off method, when a company determines a particular account to be

uncollectible, it charges the loss to Bad Debt Expense. Under the direct write-off method, Bad
Debt Expense is not recorded until the customer’s account is determined to be worthless. once
the accounts is worthless,that customer’s account receivable is written off by debiting bad debt
expense and crediting Account receivable. To illustrate assume that, on October 20, 2016 a Br.
2,000 account receivable from Wt. Elsa has been determined to be uncollectable. The entry to
write of this account is as follows

Date Account Title and Descriptions P/R Debit Credit

20 Bad debt Expense   2,000      

2016
    Account Receivable- Elsa       2,000  

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    To record write-off          

NB: Under this method, Bad Debt Expense will show only actual losses from uncollectable. No
attempt is made to match bad debts to sales revenues or to show cash realizable value of
accounts receivable on the Statements of financial position. This reduces the usefulness of the
financial statements. Consequently, unless bad debt losses are insignificant, this method is not
acceptable for financial reporting purposes.

Synopsis of Lecture

 The major categories of receivables are Accounts receivable and notes receivable. But
there are also other receivables which hold receivables like tax, interest etc.
 The three issues related to accounts receivable are, recognition, valuation and disposal of
accounts receivables.
 Inthe financial statement Accounts Receivables are valued at their cash realizable value.
 Two methods are: direct write-off and allowance are the two methods used in accounting
for uncollectible accounts.
 Direct write-off method, records Bad Debt Expense when it is known that a particular
customer’s account is worthless.
Wrap-up discussion questions

 Explain the three classifications of receivables.

 Discuss how and why receivables are valued.
 Explain the meaning of cash realizable value.
Next day’s assignment

 Read about Allowance method of uncollectable

Section 29 (Hr. 57 and 58)

Topic:- Allowance method of accounting for uncollectable

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 Session Learning Objective

 Explain how companies apply Allowance method.

 Understand the two methods of estimating uncollectable
 Understand how to reinstate account receivables

Reading Text

ii. Allowance Methods of Uncollectable

The allowance method estimates the amount of uncollectible for accounts receivable at the end
of theaccounting period and recognize Bad Debt Expense using adjusting entry. Compared to
Direct write of method, Allowance method has two advantages i. e (1) Bad debit expanse is
charged to the period in which the related sales is made and (2) Accounts receivable is reported
at the amount the company actual expects to received (i.e. Net realizable Value).

IFRS requires business to use the allowance method for financial reporting purposes. This
method has three essential features:

a. Estimating doubtful accounts

To illustrate assume that, after making the appropriate review, the company estimated its
uncollectable accounts will be amounted Br. 5000. The following is the adjusting entry to record
the estimate.

Date Account Title and Descriptions P/R Debit Credit

31 Bad debt Expense   5,000      

2016
    Allowance for doubtful       5,000  
accounts
    To record estimated Uncollectable          

NB:Allowance for doubtful account is a contra account to accounts receivable like accumulated
depreciation is a contra account to equipment. As a result it has a credit normal balance and
presented on the statements of financial position.

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 b. Write-off Uncollectable
In allowance method when a particular customers is known to be uncollected after
performing all necessary collection steps, the allowance account is reduced and the customer
is written off.
Account receivable of br. 1,500 hold by Mr. Aaron(one of the credit customer) is now known to
be uncollected the appropriate record is as follows

Date Account Title and Descriptions P/R Debit Credit

Allowance for doubtful
10   1,500      
accounts
2017
    Account Receivable -Aron       1,500  
    To record actual uncollectable          
NB: As you see from the above table actual uncollectible are debited to Allowance for Doubtful
Accounts and credited to Accounts Receivable at the time the specific account is written off.

c. Recovery of actual Uncollectable

When there is recovery of an account that had been written off: two entries are require, the first
to reinstate the account written off and the second to record the collection (recovery). To
illustrate assume that on February 16, the company received the br. 1,500 from Ato Aron, which
had been written off on January, 10. The following entries are required to be recorded.

Reinstatement of the Account Written off

Reinstating means simply reversing the journal we record to written off the actual uncollectable.

Date Account Title and Descriptions P/R Debit Credit

16 Account Receivable –Aron   1,500      

2017
    Allowance for doubtful       1,500  
accounts
    To record reinstatement          
NB: as you see from the above table the entry is the exact reverse of the record made on January
10 to write off the account. Now account receivable has a debit of Br. 1,500 this canceled the
previous written of and make the receivable outstanding.

Record cash Collection of the Recovery

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 Date Account Title and Descriptions P/R Debit Credit
16 Cash   1,500      
2017
    Account Receivable -Aron       1,500  
    To record the recovery          
NB: The three essential feathers for allowance method are summarized as follows;

 Companies estimate uncollectible accounts receivable and debit estimated uncollectible to

Bad Debt Expense and credit them to Allowance for Doubtful Accounts through an adjusting
entry at the end of each period.
 When companies write off a specific account, they debit the actualuncollectible to Allowance
for Doubtful Accounts and credit to Accounts Receivable of specific customer.
 Whenever there is a recovery of balance written off, the company reverses the entry recorded
during written off and record the collects as a debit to cash and a credit to accounts receivable
of a specific customer.

6.3.2.2. Estimating and Recording Uncollectible 

Allowance for Doubtful Accounts shows the estimated amount of claims on customers that the
company expects will become uncollectible in the future. There are two common methods used
to estimate uncollectable. The first method is the estimate made on the base of the relationship
between bad debt expenses and sales called an income statement approach. The second is
estimate made based on relationship between the age of account receivable and the allowance for
doubtful accounts called financial Position approach. After the estimate is made Companies use a
contra account instead of a direct credit to Accounts Receivable because they do not know the
specific customer will fail to pay its balance. As a result allowance account will is credited in
place of accounts receivable.

i. Estimating Based on Percentage of Sales

Since accounts receivable are created by credit sales, uncollectible accounts can be estimated as
a percent of credit sales. If the portion of credit sales to sales is relatively constant, the percent

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 may be applied to total sales or net sales. This method is better to match expenses with revenue
of a particular period and follows an income statement approach.

To illustrate assume BM Bajai has a credit sales of Br. 850,000 in the year ended December
31,2016. Based on past experience 1% of the credit sales are uncollectable. As per this estimate
the adjusting entry for uncollectable is as follows.

Bad Debt Expense= sales * Bad debit as a percentage of sales

Bad Debt Expense = 850,000 * 0.01= 8,500

Date Account Title and Descriptions P/R Debit Credit

2016
31 Bad debt Expense   8,500      

    Allowance for doubtful       8,500  

accounts
    To record write-off          

Allowance for doubtful account

Credit
Debit
Jan 1, Br. 6,000
Jan 1,
2016. Dec 31, 8,500

Bal. Br 14, 500

NB: As you see from the above illustration Allowance for doubtful account has a credit balance
of br. 8,500. This is so if the account has zero balance before adjustment. What it the account has
a credit balance of br. 6,000 before adjustment. The adjusted balance of Allowance account is Br.
14,500 now.

Allowance for doubtful account

Debit Credit

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 Jan 1, 2016. -0-

Jan 1, 2016. Dec 31, Br. 8500

Bal. Br 8500

i. Estimate based on Percentage of Account Receivables

ii. Estimating Based on Ages or Receivables

The analysis of receivables method is based on the assumption that the longer an account
receivable is outstanding, the less likely that it will be collected. Company’s prepares an aging
schedule, in which it classifies customer balances by the length of time they have been unpaid.
Then multiply each aged classes by an estimated percentage of uncollectable as shown in the
table below. The analysis of receivables method places more emphasis on the net realizable value
of the receivables and, thus, emphasizes the financial position. The following table illustrates it.

Account Total Amount of Account Receivables

Days past Due
Total Balance Not past due 1-30 days 31-60 61-90 91- 181-365 above 365
180
Br. 225,000 70,000 25,000 18,000 22,000 8,000 4, 000 5,000
Percentage 2% 5% 10% 20% 30% 50% 80%
uncollectable
Estimate of 1,400 1,250 2,800 4,400 2,400 2,000 4,000
Uncollectable(18,250)

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 As per the above analysis of account receivable the amount of estimated uncollectable receivable
on December 31, 2016 is Br. 18,250. To record the adjusting entry this method takes the
balance of allowance on unadjusted trialbalance in to consideration. Here the amount of the
adjusting entry is the difference between the estimated balance and the existing balance in the
allowance account.

To illustrate assume that the allowance for doubtful account has a balance of br. 12,150 before
adjustment. The appropriate adjusting entry will use Br. 8,150 i.e(18,250 - 12,150)

Date Account Title and Descriptions P/R Debit Credit

31 Bad debt Expense   6,100      

2016
    Allowance for doubtful       6,100  
accounts
    To record allowance account          
What it the allowance for doubtful account has no balance before adjustment. Now we take the
estimate directly as follows.

Date Account Title and Descriptions P/R Debit Credit

31 Bad debt Expense   18,250      

2016
    Allowance for doubtful       18,250  
accounts
    To record allowance account          
NB: as the above table shows you the amount for adjustment is exactly equal to the estimate.thi
is because the difference between the estimate and the unadjusted balance is the same with the
estimate. i.e (Br. 18,250- 0)

Comparison between Direct Write off Method and Allowance Method

Dear students previously we have discussed about the meaning and the application of the two
methods in recognizing uncollectable. Now to enhance your understanding about the difference
between the two methods it is better to add one more illustration as a comparison.

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 Illustration

The following selected transactions, taken from the records of Home Depo Plc. for the year
ending December 31, 2016, are used:

May 10. Wrote off account of Wt. Luna, Br. 4,500,

June . 18,. Received Br. 3,100 2,250 as partial payment on the Br. 6,000 account of Ato Markos
and Wrote off the remaining balance as uncollectible.

August 25. Received the Br. 4,500 from Wt, Luna, which had been written off on May 10.
Reinstated the account and recorded the cash receipt.

October 1. Wrote off, the various customer accounts as uncollectible Br. 8.250.

Dec. 31. Home Depo uses the percent of credit sales method of estimating uncollectible
expenses. Based on past history and industry averages, 2% of credit sales are expected to be
uncollectible. Home Depo recorded Br. 2,000,000 of credit sales during 2016

Direct write-off Method Allowance Method

  10 Bad Debt Expense 4,500     Allow. for doubtful 4,500  
    A/R Luna   4,500   A/R
accts– Luna   4,500
To Record  Write off Luna account
  18 Cash 3,100     Cash 3,100  
    Bad Debt Expense 2,900    Allow. for doubtful 2,900 
      A/R – Markos   6,000    A/R
accts– Markos   6,000 
To Record  partial collection and Write off Markos account
25 A/R Luna 4,500 A/R – Luna 4,500
Bad Debt Expense 4,500 All. for doubtful 4,500
Acc.
To reinstate the account Written off
25 Cash 4,500 Cash 4,500
A/R – Luna 4,500 A/R – Luna 4,500
To record recovery of cash
1 Bad debits expenses 8,250 Allw. for doubtful accts 8,250
A/R- various 8,250 A/R- various 8,250
To record write-off for various accounts
  31     Bad debt Expense 40,000  
      All.for Dobutf,acct   40,000
No Entry   

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 To record estimated uncollectable

NB: As you see from the above table no allowance account is used for direct write off method.

6.3.3. Disposing of Accounts Receivable

Companies frequently dispose of accounts receivable in one of two ways:

1. Sell to a factor such as a other company or a bank and

2. Make credit card sale

Sales of Receivables

Companies might sale there receivables when immediate borrowing is expensive and impossible
to finance their urgent cash need or, when the billing and collection procedures are costly and
time taking for them. The process of selling receivable is called factoring. A factor buys
receivables from businesses for a fee and collects the payments directly from customers.

To Illustrate assume that on Februarys 26, 2017 Loyal Supermarket factors its receivable
amounted Br. 100,000 Dashin Bank Sc. The bank charges 3% on the amount of receivable sold.
Thejournal entry to record the transaction is as follows.

Date Account Title and Descriptions P/R Debit Credit

26 Cash   97,000      
2016
Service Charge Expense 3,000
    Accounts receivable       100,000  
    To record sales of account          
receivable
NB: service Charge Expense= 100,000 * 3%= 3,000

If the company often sells its receivables, it records the service charge expense as a selling
expense. If the company infrequently sells receivables, it may report this amount in the “Other
income and expense” section of the income statement.

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 Credit Card Sales

Credit cards are frequently used by retailers who wish to avoid the paperwork of issuing credit.
Retailers can receive cash more quickly from the credit card issuer. A credit card sale occurs
when a company accepts national credit cards, such as Visa, MasterCard, Discover, and
American Express.

The three parties involved when credit cards are used in making retail sales are the company
issued the credit card, the retailer, and the customer.A retailer’s acceptance of a national credit
card is another form of selling (factoring) the receivable.The retailer pays the credit card issuer a
fee of 2-6% of the invoice price for its services. From an accounting standpoint, sales from Visa,
MasterCard, and Discover are treated differently than sales from American Express. Because
selling using American Express is considered as credit sales.

To illustrate assume that Shraton Addis gives catering service for br. 12,000 and received
MASTERCARD from the customer. The service fee that MASTERCARD charge is 4%. The
journal entry to record the transaction is

Date Account Title and Descriptions P/R Debit Credit

26 Cash   11,520      
2016
Service Charge Expense 480
    Sales       12,000  
    To record sales on credit card          
What is the sale was made using American Express cared instead of MASTER, or VISA cards. If
so Account receivable is debited instead of cash as follows.

Date Account Title and Descriptions P/R Debit Credit

26 Accounts receivable   11,520      

2016
Service Charge Expense 480
    Sales       12,000  
    To record sales on credit card          

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Synopsis of lecture

 Estimates for doubtful accounts can be made using an income statement or financial
position approach.
 Allowance for doubtful account is a contra account to Accounts receivable and is
reversed when a particular costumer account is known to be uncollectable.
 Receivable in one of the two ways to dispose account receivables are factoring and
making credit sales.
 The process of selling receivable to financial institutions is called factoring.
 A credit card sale occurs when a company accepts national credit cards, such as Visa,
MasterCard, Discover, and American Express.
Wrap-up discussion questions

 Explain the difference between income statement and financial position approach for
estimating uncollectable.
 Explain the meaning of Allowance for doubtful account.
 Explain the ways of disposing accounts receivables

Next day’s assignment

 Read about meaning and characteristics of notes receivable

Section 60 (Hr. 59 and 60)

Topic:- Notes Receivables and its Characteristics

Session learning Objective

 Compute the maturity date of and interest on notes receivable.

 Describe how companies’ value notes receivable.

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  Describe the entries to record the disposition of notes receivable.
Reading Text

6.4. Notes Receivable

A promissory note is a written promise to pay a specified amount of money on demand or at a
definite time. A note has some advantages over an account receivable. By signing a note, the
debtor recognizes the debt and agrees to pay it according to its terms. Thus, a note is a stronger
legal claim.

6.4.1. Characteristics of Notes receivables

A promissory note is a written promise to pay the face amount, usually with interest,on demand
or at a date in the future. Characteristics of a promissory note are as follows:

1. The maker is the party making the promise to pay.

2. The payee is the party to whom the note is payable.

3. The face amount is the amount the note is written for on its face.

4. The issuance date is the date a note is issued.

5. The due date or maturity date is the date the note is to be paid.

6. The term of a note is the amount of time between the issuance and due dates.

7. The interest rate is that rate of interest that must be paid on the face amount for the term of the
note.

6.5. Issues Related to Notes Receivables

Companies frequently accept notes receivable from customers who need to extend the payment
of an outstanding account receivable. They often require such notes from high-risk customers.

The basic issues in accounting for notes receivable are the same as those for accounts receivable:

1. Recognizing Notes Receivable.
2. Valuing Notes Receivable.
3. Disposing of Notes Receivable.

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 6.5.1. Recognition of Note Receivables
To illustrate, assume that a company accepts a 60-day, 12% note dated August21, 2016, in
settlement of the account of Bunna Co., which is past due and has abalance of 7,500. The
company records the receipt of the note as follows:

Date Account Title and Descriptions P/R Debit Credit

21 Notes receivable   7,500      

2016
    Accounts Receivable Bunna       7,500  
    To record acceptance of Note          
NB: notes receivable is recorded at face value and no interest revenue is recognized on the
date of acceptance

6.5.1.1. Determining Maturity Date of a Note Receivable

The life of a note can be expressed in terms of months or days. When the life of the note is
expressed in terms of months, the due date is found by counting the months from the date of
issue Example: The maturity date of a 3-month note dated May 31 is August 31.

When the life of the note is expressed in terms of days, you need to count the days.In counting,
the date of issue is omitted but the due date is included. To illustrate Assume MC. company
issued a 45 days note on March 25. The maturity date of this note is computed as follows.

Term of the Note 45 days

March 31 -25 6

April 30 36

Maturity Date, May 9

Computing Interest for Note Receivable

The basic formula for computing interest on an interest-bearing note is:

Interest= Face value * interest rate * time in terms of one year

The interest rate specified on the note is an annual rate of interest.

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To illustrates Merry Co. issued a br. 6,000, 10% , 90days note to Jattu Company. Compute the
value of interest.

Interest = 6,000 * 10% * 90days/360= 150

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 6.5.2. Valuing Notes Receivable
Valuing short-term notes receivable is the same as valuing accounts receivable. Like accounts
receivable, companies report short-term notes receivable at their cash (net) realizable value.
The notes receivable allowance account is Allowance for Doubtful Accounts. The estimations
involved in determining cash realizable value and in recording bad debt expense and the related
allowance are done similarly to accounts receivable.

6.5.3. Disposing of Notes Receivable

Honor of Notes Receivable

A note is honored when it is paid in full at its maturity date. For an interest-bearing note, the
amount due at maturity is the face value of the note plus interest for the length of time specified
on the note.

Illustration Assume that Miky Co. lends Simert Inc. Br. 25,000 on May 1, accepting a 6-month,
10% interest-bearing note.Miky collects the maturity value of the note from Simert on November

Account Title and

Date Descriptions P/R Debit Credit

Nov 1 Cash   26,250      

2016
    Notes Receivable       25,000  
Interest Revenue 1,250
    collection of a note          

End period Interest Adjustment

Consider the above illustration for Miky Co, and assume that the company prepares financial
statements as of June 30. Here two months interest is accrued but not yet received until maturity.
The maturity date falls on the next accounting period. As a result interest revenue is recognized
by the amount of interest accrued as follows.

Date Account Title and P/R Debit Credit

June 30 Interest Receivable
Descriptions   417      
2016

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 Interest Revenue 417
    Recognition of interest rev.          
Br. 417 = 25,000 * .1 * 2/12 months

At the note’s maturity on November 1, Miky receives Br. 26,250. This amount represents
repayment of the Br.25, 000 note as well as six months of interest, i.e Br. 1,250 as shown below.

Date Account Title and P/R Debit Credit

Nov 30 Cash Descriptions   26,250      
2016
Note receivable 25,000
Interest receivable 417
Interest Revenue 833
    Collection of note          

The Br. 1,250 is comprised of the Br. 417 Interest Receivable accrued on June 30 plus Br. 833
four months interest earned (July to October).

6.6. Discounting Note Receivable

A company in need of cash may transfer its notes receivable to a bank by endorsement. This
process is referred to as discounting note. Through discounting notes receivable can be converted
to cash before they mature. The discount interest charged by the bank is computed on the
maturity value of the note for the period of time the bank must hold the note. The amount of the
proceed paid to the endorser is the excess of the maturity value over the discount.

The proceeds from discounting the note receivable may be less or greater than the face value. If
it is less than the face value, the excess of face value over the proceed will be recorded as a debit
interest expense. Otherwise interest revenue is recognized.

To illustrate, assume that a 90-day, 12%, Br.40, 000 Note Receivable from Amrot Co. dated June
10, 2016 is discounted at Awash Bank on July 10, 2016 at a discount rate of 14%. The amount of
proceeds is computed using the following steps:

Step1 – determine the maturity date and maturity value

 Maturity date September 8

 i.e 20days in June + 31 days in July + 31 days of August + 8days of September = 90days
 Maturity Value = Face value + interest

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  Maturity Value = 40,000 + (40,000 * 12% * 90/360) = 41,200

Step 2 – Determine the bank discount

Bank discount = Maturity value * Discount rate * Discount period

 41,200 * 14% * 60 days = 961

NB: Bank discount is an interest that is charged by the bank and is computed based on the
maturity value of the note for discount periods. On the other hand discount period in the number
of days that the bank holds the note.

Step3 – determine bank proceed

 Bank proceed = Maturity Value – Bank Discount

 Bank Proceed = 41,200 – 961 = 40,239

Step 4 – Record the necessary entry at the date of discount

Date Account Title and P/R Debit Credit

July 10 Cash Descriptions   40,239      
2016
    Notes Receivable       40,000  
Interest Revenue 239
    Record of Discounting note          

The length of the discount period and the difference between the interest rate and discount rate
determine whether interest expense or interest revenue will result from the discounting.

To illustrate assume in the above case that the discount rate of Awash bank is 18 % instead of
14%, what will happen to the proceed of the note.

 Now the bank discount = 41,200 * 18*60/360 = 1,236

 Bank proceed = 41,200 – 1,236 = 39,964

the journal entry will be as follows

Date Account Title and P/R Debit Credit

July 10 Cash Descriptions   39,964      
2016
    Interest expense   34     
Notes Receivable 40,000

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    Record of Discounting note          
As you see from the above table the face value of the note Br.40,000 is greater than the bank
proceed Br. 39,964, as a result a Br. 36 expanse is incurred by the company.

Dishonor of Notes Receivable

If the maker of the note fails to pay the debt on the due date, the note is said tobe dishonored.A
dishonored notes receivable is no longer negotiable and for this reason the holder usually
transfers the claims, including an interest due, to account receivable account.

It should be observed that the proceeds from discounting a note receivable might be less than the
face value. When this situation occurs, the excess of the face value over the proceeds is recorded
as interest expense. Notes receivable are discounted with recourse or without recourse. When a
note is discounted without recourse, the bank assumes the risk of a bad debt loss and the
original payee doesn’t have a contingent liability. A contingent liability is an obligation to make a
future payment if, and only if an uncertain future event occurs. If a note is discounted with
recourse and the original maker of the note fails to pay the bank when it matures, the original
payee of the note must pay for it. This means a company discounting a note with recourse has a
contingent liability until the bank is paid. A company should disclose contingent liabilities in
notes to its financial statements.

To illustrate Assume that Dashin Co., holds a Br. 30,000, 12%, 30-day note of Ato Mesert . At maturity,
Meseret dishonored the note. Dashin Co. records this dishonoring of its N/R, on March 20, as follows:

Date Account Title and P/R Debit Credit

March 20 AccountsDescriptions
Receivable   30,300      
2016
    Notes Receivable 30,000  
Interest revenue 300
    Record of Dishonored note          
If instead on November 1 there is no hope of collection, the note holder would write off the face
value of the note by debiting Allowance for Doubtful Accounts. No interest revenue would be

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recorded because collection will not occur.

6.7. Presentation of Accounts Receivable

Companies should identify in the statement of financial position or in the notes to the financial
statements each of the major types of receivables. Short-term receivables appear in the current
assets section of the statement of financial position. Short-term investments appear after short-
term receivables because these investments are more liquid (nearer to cash). Companies report
both the gross amount of receivables and the allowance for doubtful accounts.

In an income statement, companies report bad debt expense and service charge expense as selling
expenses in the operating expenses section. Interest revenue appears under “Other income and
expense” in the non-operating activities section of the income statement.

Synopsis of Lecture

 Notes receivable is a written promise to pay a certain sum of money on specific future
date to a specific person or entry.
 A note is honored when it is paid in full at its maturity date.
 Discounting is mechanism used to convert notes receivable to cash before they mature.
 If the maker of the note fails to pay the debt on the due date, the note is said to be
dishonored.

SELF EXAMINATION QUESTIONS

6. How much is the maturity value of a 90Day’s, 12%, not for Br. 10,000:
a. Br. 8,800 c. Br. 10,300
b. 10,000 d. Br. 11,200
7. On June 16, the enterprise discounts a 60 day’s 10% notes receivable for Br. 15,000,
dated June 1 at the bank of 12%. The proceed is
a. Br. 15,000.00 c. 15,250
b. Br. 15,021.25 d. 15,478.75
8. At the end of the fiscal year, before the accounts are adjusted, the accounts receivable
ledger has a balance of Br. 200,000 and the allowance for doubtful account has a credit

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 balance of Br. 2,500. if the estimate of uncollectable amount as a credit balance of Br.
2,500, the current provision to be made for uncollectable accounts expanse would Br,
a. Br. 2,500 c. Br. 8,500
b. Br. 6,500 d. Br. 200,000

ILLUSTRATIVE PROBLEM

2. Selected transactions completed by Topaz co. are as follows. the company uses allowance
method of accounting for uncollectable accounts receivable

Jan 28. Sold merchandise on account Br. 10,000 to LacKland Co.

Mar 1, accepted a 60 –day, 12% notes from lackland co. on account

April 11. Wrote off a Br. 4,500 account from Exdel inc. as uncollectable

April 16, loaned Br. 7,500 cash to Tomas receiving a 90day’s , 14% note

April 30, received the interest due from Lakeland inc. and a new 90 day’s, 14% note as a
renewal of the loan( record both the debit and credit to the notes receivable)

May 1 Discounted the note from Tomas at first national bank at 10%

June 13, Reinstated the account of Exdel Inc. written on April 11 and received Br. 4,500 in
full payment

July 15, received a note from first national bank that Tomas dishonored this note. paid the
bank the maturity value of the note plus Br.20 protest fee.

July 29, received from Lakeland inc. , the amount due on its note on April 30.

Dec 31. it is estimated that 2% of the credit sales of br. 958,600 for the year ended December
31, will be uncollectable.

Instructions:

Record the transaction in general journal

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 3. The account receivable ledger of Morning Co.shows a balance of Br. 65,200 at the end of
current year. The analysis of the accounts in the customers’ ledger indicates uncollectible
accounts of Br.6,010. (the company uses the percentage of receivable method) Record the
adjusting entry under the following assumptions.

A. The allowance for doubtful account before adjustment has zero balance.

B. The allowance for doubtful account before adjustment has a debit balance of Br. 400
C. The allowance for doubtful account before adjustment has a credit balance of Br. 2,100

4. Assume on February 20 Beki Plc. determines it can’t collect Br. 1,020 owed to it by its
customer Lusi. Co. Record the adjusting entry using the direct write-off method.

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