Fundamentals of Accounting I Awash Valley College

CHAPTER 1
Accounting Principles & Practices
An Overview
Definition:
Accounting is the process of identifying, measuring, recording, summarizing, reporting/communicating/ &
interpreting financial information of business enterprises to decision makers so as to make rational decision.
Accounting also defined as an information system whereby the providers and users of information communicate
each other.
As businesses & society have become complex over years, accounting has developed new concepts & techniques
to meet the ever increasing needs for financial information. Without such information, many complex economic
developments social programs might never been undertaken.
Account as Information System
Accounting provides information about financial activities of an entity to various individuals/groups for their use
in making decision.
It enables inter & intra businesses organization financial communication through financial statements.
Accounting is thus often called BUSINESS LANGUAGE.
Financial information is information that can be expressed in terms of financial or monetary value.
Users of Accounting Information:
1. External Users
Are those outside the business who have either a present of potential direct financial interest (investors &
creditors) or an indirect financial interest (taxing authorities, regulatory agencies, labor unions, customers and
economic planners).
 External users with direct financial interest
INVESTORS: need the accounting information to know the financial status of the organization to make a
decision whether to invest their capital in the entity.
BANKERS/LENDERS/ & SUPPLIERS: evaluate the risk of granting credit or lending money.
Some of the questions asked by investors & creditors about a company might be:
 Is the company earning satisfactory income?
 How does the company compare in size & profitability with competitors?
 Will the company be able to pay its debts as they come due?
Are interest payments and dividends protected by an adequate inflow of cash from operations?
 External users with indirect financial interest
Taxing authorities (such as the internal revenue service)-want to know if the company complies with the tax
laws.
Regulatory agencies (such as the Securities and Exchange Commission or the federal trade commission)-
want to know if the company is operating within prescribed rules.
Labor union: are interested if the company has the ability to pay the increased wages and benefits.
Customers: are also interested in whether a company will continue to honor product warranties & other wise
support its product lines.
Economic planners: use accounting information to analyze & forecast economic activity.

2.Internal Users
THE MANAGEMENT: these are the responsible people for directing the operation of enterprises, demand the
accounting information to accelerate favorable trends & to reduce those unfavorable, to evaluate the employees’

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 Fundamentals of Accounting I Awash Valley College

current performance & appraise them accordingly, to plan the future. For example, the managers of a company
might ask:
 Is cash sufficient to pay our debts?
 Are customers paying their billing promptly?
Can we afford to give employee pay rises this year?
 How much money must be borrowed to expand the factory?
etc.
To assist management in answering these questions, accounting provides internal reports. Examples include
statements on the financial position & results of operations of the entire business are prepared.

Accounting Principles & Practices

The accounting principles are the contributions of intellectual energies of experienced professional accounting
associations.
Several professional accounting associations periodically issue pronouncements on accounting principles.
Financial Accounting Standard Board/ FASB/ is the current Authorized body for the development of the
accounting principles. Those bodies established Generally Accepted Accounting Principles (GAAP) which
consists of principles, assumptions & standards that indicate how to report economic events. Below are some of
the basic Accounting Principles:
Business/Economic Entity Concept: Business/ economic entity can be any organization or units in a society. It
may be a business enterprise, a governmental unit, municipality, a school district or social organizations such as
church. This assumption states that economic events can be identified with a particular unit of accountability. It
requires that the activity of the entity be kept separate and distinct from: 1) The activity of its owner
2) All other economic entities
Profit making business entities are organized as sole proprietorship, partnership & corporation.
1. Sole proprietorship: is a business owned by one person. The owner is often the manager or operator of
the business. Usually only a limited amount of money/capital is necessary to start in business, and the
owner receives any profits, suffers any loses and is personally liable for all debts of the business. It is a
smallest in size and volume of the business. Small service-type businesses (barbershops, law offices,
plumbing companies, and auto repair shops), farms, and small retail stores (antique shops, clothing
stores, and book stores) are often sole proprietorships.
2. Partnership: A business owned by two or more persons associated as partners. When a partnership is
created, an agreement (written or oral) should set forth such terms as initial investment of each partner,
duties of each partner, division of net income (or net loss), and settlement to be made up on death or
withdrawal of each partner. Each partner generally has unlimited personal liability for the debts of the
partnership. Examples include retail and service-type businesses, including professional practices
(lawyers, doctors, architects, & certified public accountants).
3. Corporation: A business organized as a separate legal entity under state corporation law and having
ownership divided into transferable shares of stock. The holders of the shares (stockholders) enjoy
limited liability; they are not personally liable for the debts of corporate entity. Stockholders may transfer
all or part of their shares to other investors at any time(i.e., sell their shares in the securities market).
Because ownership can be transferred without dissolving the corporation, the corporation enjoys an
unlimited life.
Cost Principle: states that all assets (properties) of a business entity should be recognized at their respective
acquisition costs. Cost is the value exchange at the time something is required. Assume that Sherman building an

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assessed value of $125,000 for property tax purpose was offered $170,000. Finally, Mr. X acquired it at
$150,000. Mr. X should record the building at $150,000 disregarding the assessed values & the offers.
Matching Principles: refers to a close relationship between certain revenues & related expenses to generate
those revenues; & states that all related costs should be deducted after all revenues for the period have been
determined to measure the Net Income or Loss of the period.
Revenues Realization Principle: this principle states that all revenues & related expenses should be
recognized/recorded/ as soon as they are earned & incurred, respectively.
Business transactions and Accounting Equation
Business Transactions are the financial occurrences of an event that must be recorded in the accounting records
eg. Land & building acquisition of $100,000.
Payment of merchandise purchased on credit of $2,000
Payment of monthly rent of $500, and etc.
A particular business transaction may lead to an event or a condition that result in another transaction. For
example, the purchase of merchandise on credit will be followed by payment to the creditor, which is another
transaction. Transactions that are not directly related to outsiders are called internal tractions.
Eg, the wearing-out of the building is not an exchange of goods or services between the business and outsider,
but it is nevertheless a significant condition that must be recorded.
Assets, Liabilities and owners Equity
Assets: Are any properties that are owned by business enterprise.
Equity: the right/claims of the owner against the properties
Example: XYZ Company acquired an automobile of $100,000
Asset = Equity 100,000 = 100,000
Equity may be categorized to two broad principal subdivisions as:
1. The right of the creditors- Liabilities
2. The right of the owner-owner’s equity
Liabilities represent the debts of the business organization_ the amount that is borrowed, whereas owner`s
equity represents the amount that is contributed by the business concern itself. So we can say that:
Asset = Liabilities + Owner`s Equity
Further consider the above example that $45,000 of the total amount is borrowed from someone else to purchase
an automobile & remaining is contributed by the business itself. So we can indicate it in accounting equation as:

Asset = Liability + Owner`s Equity $45,000 + $55,000

All business transactions, whether simple or complex, are stated in terms of the resulting change in the three
basic elements of the accounting equation.
Key Terms
Accounts Payable: a liability that is created from purchase on account and/or raising funds through loan
Prepaid Expenses: purchase of consumable goods or advance payment for unused services
Revenues: income generated from sales of goods & services
Accounts Receivable: claim of the business organization against the customer that is created as a result of sales
on account or performing a certain services at not for cash.
Expenses: cost of goods or services used in the process of generating a certain revenues.
Analyzing Transactions
Assume that Mr. John established a Sole Proprietorship to be known as Long Taxi, and completed the
following transactions during the month of August, 2009:
August 1: Mr. John deposited $10,000 at bank in the name of his business

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5: Mr. John purchased land for future building site, $7,500for cash
8: Mr. John purchased gasoline, oil & other supplies agreeing to pay the amount on the near future,
$850
12: The business earned fares of $4,500 & received the amount for cash
18: Paid creditors on account for purchase of August 8, $400
27: Long taxi incurred & paid the following expenses for the month of August: wages expense = $1,125,
rent expense $850, utilities expense = $150 & miscellaneous expense = $75
30: Withdrew $1,000 for personal use
31: determined the cost of supplies on hand to be $250. Supplies of $600 have been used in the operation
The above business transactions are summarized in tabular form as follows:
Assets Liabilities Owner`s Equity Description
ust
Aug

Cash Land A/P John, Capital

1 + 10,000 + 10,000 Investment
5 (7,500) + 7,500
8 + 850 +850
12 + 4,500 + 4,500 Fares earned
18 (400) (400)
27 (2,200) (1,125) Wages expense
(850) Rent expense
(150) Utilities expense
(75) Misc. expense
30 (1000) (1000) Withdrawal
31 (600) (600) Supplies expense
$3,400 $25 0 $7,500 $450 $10,700

Note: The effect of every transaction stated in terms of increase and/or decrease in one or more accounting
equation elements. The equality of the two sides is always maintained; & the owner`s equity increases by
additional investment & revenues and decreases by expenses & withdrawals.
Financial Statements for Sole proprietorship
There are four principal financial statements namely Income Statement, Statement of Owner`s Equity, Balance
Sheet & Statement of Cash flows.
Income Statement: is the summary of all revenues & expenses of business entity for the specific period of time
such as a month, a quarter, a semiannual, or year. The excess of the revenue over the expenses incurred to earn
the revenues is called Net Income or profit, whereas the excess of expenses over revenues are said to be Net
Loss. Revenue is recognized after service has been rendered to the customers. The assets consumed in generating
revenue during a period recognized as expenses.
Long Taxi
Income Statement
For the month ended, August 31, 2009
Revenues:
Fares Earned $4,500
Expenses:
Wages expense $1,12
Rent expense 5
Supplies expense 850

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Utilities expense 600

Miscellaneous 150
expense 75
Total expense (2,800)
Net Income $1,700

Statement of Owner`s Equity: the summary of the changes in the owner`s equity that have occurred during the
specific period of time such as a month or year. Owner`s equity is affected by additional investment, net income
or net loss (the difference between revenues & expenses) & withdrawals.
Long Taxi
Statement of Owner`s Equity
For the month ended, August 31, 2009
Mr. John, Capital as of August 1, 2009 $
Beginning investment 0
Add: Net Income $10,000
Less: Withdrawal 1,700
Increase in owner`s equity (1000)
Mr. John, Capital as of August 31, 2009 10,700
$10,700

The sequential order of the Net Income & Withdrawal will be reversed if withdrawal exceeds the net income;
and said to be decrease in owner`s equity, the difference will then be deducted from the beginning capital.
Balance Sheet: is the list of assets, liabilities & owner`s equity of business entity as of a specific date, usually at
the close of the last date of month or the year. The preparation of the balance sheets takes either a report form or
account/equation form.
a. Report form: liabilities and owners equity sections are presented below the asset section.
b. Account form: lists the assets on the left side, and liabilities & owners equity on the right side.
Long Taxi
Balance Sheet
August 31, 2009
 Assets
Cash $3,400
Supplies 250
Land 7,500
Total assets $11,150
 Liabilities
Accounts Payable $450
 Owners Equity
John, Capital $10,700
Total Liabilities & Owner`s Equity $11,150

Statement of Cash flows: a summary of cash receipts & payments of a business entity for specific period of
time such as a month/year. It is customary to report cash flows in three sections:

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a. Cash Flows from operating activities: includes cash transactions that enter into the determination of
the net income.
NB: Net cash flow from operating activities will normally differ from the amount of net income for the
period.
b. Cash Flows from investing activities: the section reports the cash transaction for the acquisition & sale
of relatively long term or permanent type assets such as land, equipment, building and etc.
c. Cash Flows from financing activities: this section reports the cash transaction related to cash
investments by the owner & borrowed funds, and cash withdrawn by the owner for personal use.

Long Taxi
Statement of Cash Flows
For the month ended, August 31, 2009
 Cash Flows from operating activities:
Cash received from customers $4,500
Less: cash payments for expenses & to creditors (2,600)
Net cash flow from operating activities $1,900
 Cash flows from investing activities:
Less: cash payments for acquisition of land (7,500)
 Cash flows from financing activities:
Cash received from owner as investment $10,000
Less: Withdrawal (1,000)
Net cash flow from financing activities 9,000
 Net cash flow $3,400
Note: the preparation of all financial statements is identified by the name of the business, the title of the financial
statement & the date/period of preparation. The use of indentions, captions, dollar signs & rulings are much more
necessary because they aid the reader by emphasizing the various distinct sections of the statement.
Activity
Enmesh Business Center, which is owned Mr. Erik, at the beginning of Year 2009, has the following
beginning balance accounts:
Cash= $25,000, Accounts Receivable= $8,000, Supplies= $7,500, Building= $150,000 & Accounts= $32000
Enmesh Business Center completed the following transactions since January, 2009:
January 1. Mr. Erik invested additional cash of $10,000 in the business
2. Purchased equipments $5,000 on account
5. Performed service for cash $5,200
9. Billed customers for fees earned $2,000
13. paid suppliers on account $ 3,200
16. Received customers on account $5,200

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21. Purchased supplies $800 paying a half amount

24. Paid telephone, power & water expense $750
29. Determined supplies used in the operation process $2,300
30. Paid salary expense $800, trucks expense $650, & rent expense $980
30. Withdrew$1,750 for personal use
31. Paid miscellaneous expense of $320
Instruction:
 Analyze these transactions
 Prepare the four principal financial statements for the month of January, 2009

The analyses of transactions completed by Enmesh Business Center during the Month of January are
presented as follows:
Assets Liability Owner`s
y
Januar

Equity Description

Cash A/ R Supplie Equipment Building A/P Capital

s
$25,000 $8,000 $7,500 $150,000 $32,000 $158,500 Beginning
Balance
1 + + 10,000 Additional
10,000 Investment
2 + $5,000 + 5,000
5 + 5,200 + 5,200 service fees

9 + 2,000 + 2,000 fees earned

13 (3,200) (3,200)
16 + 5,200 (5,200)

21 (400) + 800 + 400

24 (750) (750) utilities expense

29 (2,300) (2,300) supplies expense

30 (2,430) (980) rent expense

(800) salary expense
(650) trucks expense
30 (1,750) (1,750) withdrawal
31 (320) (320) misc. expense
$36,550 $4,800 $6,000 $5,000 $150,000 $34,200 $168,150
The preparation of the four principal financial statements is presented below:
Enmesh Business Center
Income Statement
For the month ended, January 31, 2009

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 Revenues:
Service fees $5,200
Fees earned 2,000 $7,200
 Expenses:
Supplies expense $2,300
Rent expense 980
Salary expense 800
Utilities expense 750
Trucks expense 650
Miscellaneous expense 320
Total expenses (5,800)
 Net Income $1,400

Enmesh Business Center

Statement of Owner`s Equity
For the month ended, January 31, 2009
Erik, Capital as of January 1, 2009 $23,500
Add: Additional Investment $10,000
Net Income 1,400 $11,400
Less: withdrawal (1,750)
Increase in capital 9,650
Erik, Capital as of January 31, 2009 $33,150

Enmesh Business Center

Balance Sheet
January 31, 2009
Assets
Cash $36,550
Accounts Receivable 4,800
Supplies 5,800
Equipment 5,000
Building 150,000
Total Asset $202,350

Liabilities
Accounts Payable $34,200
Owner`s Equity
Erik, Capital 32,950
Total Liabilities & owner`s Equity $168,150

Enmesh Business Center

Statement of Cash Flows
For the month ended, January 31, 2009
 Cash flows from Operating Activities:
Cash received from customers $10,400
Less: Cash payments to creditors & suppliers (7,400)
Net cash flow from operating activities $3,300
 No Cash flows from Investing Activities
 Cash flows from Financing Activities:
Cash received from the owner $10,000
Less: Cash withdrawn by the owner (1,750)

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Net Cash from Financing Activities 8,250

Add beginning cash balance 25,000
 Net Cash flow $36,550

CHAPTER 2
The Accounting Cycle
Accounting Cycle: is a complete serious of accounting procedures carried out in one accounting period.
Account: refers to the form record used to record the increases and decreases in a single financial statement
element.
Ledger/general ledger/: is a collection/group of related accounts that compromise a complete unit, such as all of
the accounts of a specific business enterprise. It is a complete collection of all the accounts of a business unit.
Accounts fall into two general broad categories:
1. Balance Sheet Accounts
2. Income Statement Accounts
 The balance sheet accounts are called real or permanent accounts & classified as assets, liabilities
& owner`s equity.
ASSETS: are any physical/tangible and/or right/intangible properties that have monetary value. Assets are
customarily further classified as current assets & plant assets to ease the presentation of the balance sheet.
Current Assets: include cash & other assets that may reasonably expected to be realized/ converted to cash or
used up or sold usually within a year or less through the normal business operation. Example: notes receivable,
accounts receivable, supplies, prepaid expenses etc.
Cash: is any medium of exchange that a bank will accept at a face value, and includes bank deposits, currencies,
checks, etc.
Notes Receivable: are claims against the debtors evidenced by a written promise to pay the sum of money at
definite time to the order of the specific person or to the bearer.
Accounts Receivable: are also claims against the debtor, but less formal than notes receivable.
Prepaid Expenses: supplies on hand & advance cash payments for unused services.
Plant/Fixed Assets: tangible assets that are of permanent or relatively fixed nature such as land, building,
machinery, equipment, etc. With the exception of land, all plant assets gradually wear out/ lose their usefulness
with the passage of time.
LIABILITIES: are debts owed to the outsiders/ creditors, described on the balance sheet as payables, &
classified as current & long term liabilities.
Current Liabilities: are those liabilities which due/mature within a year or less, those are to be paid out of the
current assets. Example: accounts payable, salaries payable, interest payable, taxes payable, etc.
Long term Liabilities: liabilities those will not be due within a year or. If a part of the liability is paid within a
year, the portion paid becomes current liability. Examples include mortgage note payable which is a legal
agreement by which a bank or other financial institutions lends money to buy like a house and the amount paid
back over a particular number of years, bond payable that employed by corporations to borrow on a long term
basis & etc.
OWNER`S EQUITY: the residual claim/right against the assets of the business after the total liabilities are
deducted. Capital is the owner`s equity in a sole proprietorship & partnership, sometimes called Net Worth. For a
corporation, owner’s equity is frequently called stockholders’ equity, shareholders’ equity or stockholders
investment.
Withdrawal: represent the amount of money that is taken by the owner for personal use. For corporation,
dividends represent the distribution of earnings to stockholders.
 The income statement accounts are classified as revenues & expenses

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Revenues: the gross increase in owner`s equity as a result of the sales of goods, performance of services, rental
of properties, provision of loans, etc. Below are some types of revenues:
Fees: professional revenues
Fares: transportation revenues
Commission: revenues for brokers
Interest: revenues from provision of loans
Expenses: are costs that have been consumed in the process of producing revenue.
Charts of Accounts
The charts of accounts are the complete listing of the titles & numbers of the accounts in the ledger, and can be
compared to the table of contents. The order of accounts in the chart of accounts should agree with the order of
the items in balance sheet & the income statement. The accounts are numbered to permit indexing and also for
use as references. The group of accounts for sole proprietorship & partnership usually appear in the order of:
1. Assets
2. Liabilities
3. Owner`s equity
4. Revenues &
5. Expenses; and every account have two digits: the first digit indicates the major subdivision of the ledger
in which the account is placed and the second digit indicates the position of the account within its
subdivision. This numbering system permits the later insertion of new accounts in their proper sequence.

Balance sheet accounts Income statement accounts

1. Assets 4. Revenues
1.1. Cash 4.1. Sales
1.2. Accounts receivable 4.2. Fees earned
1.3. 4.3. Interest income
1.4. Supplies 5. Expenses
1.5. Prepaid rents 5.1. Supplies expense
1.6. 5.2. Salary expense
1.7. Equipments 5.3. Rent expense
1.8. 5.4. Depreciation expense
1.9. Land 5.9.Miscellaneous expense
2. Liabilities
2.1. Accounts payable
2.2. Salaries payable
3. Owner`s equity
3.1. Capital
3.2. Drawing
3.3. Income summary

Nature of an Account
The simplest form of an account is the T account, and the T account has three parts:
Title: the space reserved for the name of an account
Debit: the left side of the T account
Credit: the right side of the T account
Title

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Left Right
side side
(debit) (credit)

The debit side signifies:

 An increase of asset & expense accounts
 A decrease of liabilities, owner`s equity & revenues
The credit side signifies:
 A decrease of asset & expense accounts
 An increase of liability, owner`s equity & revenue accounts
The transactions before they are recorded in the T account initially will be recorded in Journal through the
process of Journalizing in the form of Journal entries.
Example:
1. Mr. John earned interest of $5,000 and collected the amount.
Cash----------------------------$5,000
Interest income----------------------------$5,000
2. Mr. John purchased supplies of $1,500 on account
Supplies-----------------------------------$1,500
Accounts payable---------------------------------------$1,500
An entry composed of two or more debits or of two or more credits is called a compound journal entry.
3. Mr. John purchased equipment of $2,800 paying $1,800 and agreeing to pay the remaining $1,000 within
a month
Equipment---------------------------------$2,800
Cash---------------------------------------------------$1,800
Accounts payable---------------------------------- 1,000
The data in journal entry are transferred to the appropriate accounts by a process known as posting.
Cash Interest Income Supplies Accounts Payable
$5,000 1800 $5,000 $1500 1,000

Equipment
$2,800

The duality system: is the procedure that keeps the equality of the debit & credit sides or the equality of the two
sides of the accounting equation.
NB: The amount which is reported on the left side of the account form is posted to the left (debit) side, where as
the amount which is reported on the right side of the account form is posted to the right (credit) side.
Normal Balances of the Accounts
All asset, expense & drawing accounts have a normal debit balance; to be credited whenever they decrease.
Their increase will have the reverse direction.
All liability, owner`s equity & revenue accounts have a normal credit balance; to be debited whenever they
decrease. Their increase will have the reverse direction.

Journals & Accounts

Business transaction occurs→Business documents→Journal Entry

→ posting
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 The initial records of transactions are evidenced by business documents such as sales tickets, bills,
cash register tape, etc.
 Based on these evidences, the transactions entered/recorded in their chronological order in the book of
journals.
 The debits & the credits are then transferred/ posted to the right ledger.
Two Columns Journal
A transaction, before it is entered into the two column journal,
- Determine the account affected
- Determine whether it is decreased or increased
- Determine whether to debit or credit the account
Further consider the illustration of Long Taxi:
Journal Page 22
Date Description P/R Debi Credit
t
2009

Januar 1 cash 11 $10,000

y Capital 31 $10,000
(to record
investment)

The process of recording transaction in the two column journal:

1. Record the date:
a. Insert the year at the top only of the date column of page, except when the year date changes
b. Insert the month on the first line only of the date column of each page, except when the month date
changes
c. Insert the day in the date column on the first line used for each transaction, regardless of the number
of transactions during the day
2. Record the debit:
Insert the title of the account to be debited at the extreme left of the description column & enter the
amount in the debit column
3. Record the credit:
Insert the title of the account to be credited below the account debited, moderately indented, & enter the
amount in the credit column.
4. Write explanation: a brief explanation moderately indented
5. Insert the ledger account number in posting reference column.

Transactions, after they are recorded in the two column journal, they will be transferred to a four column journal
by a process called POSTING, under an appropriate account.
Account Name: Cash Account Number: 11
Date Description P/R Debit Credit Balance
Debit Credit
2009

Januar 1 Balance  $25,000 $25,000

y 1 10,000 10,000
2

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2
The posting process takes the following process:
 record the date
 insert the number of the journal page in the post reference column, make a tick for the beginning
balance
 compute the final balance after each entry

Trial Balance
A trial balance is the listing of the ledger accounts & their debit & credit balances to determine the equality of
the two sides. The accounts appear on the trial balance in the following order:
 asset accounts
 liability accounts
 owner`s equity accounts/ capital
 revenue accounts
 expense accounts
Note that the most liquid assets are listed first & the least liquid assets are listed last, liabilities with short due
date appear first & expenses are to be listed in their ascending order.

Enmesh Business Center

Trial Balance
January 31, 2009
Cash $36,550
Accounts Receivable 4,800
Supplies 6,000
Equipment 5,000
Building 150,000
Accounts Payable $34,200
Erik, Capital 168,500
Erik, Drawing 1,750
Sales 5,200
Fees earned 2,000
Supplies expense 2,300
Rent expense 980
Salary expense
800
Utilities expense
750
Trucks expense
650
Miscellaneous expense
320
$209,900 $209,900

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Note that the trial balance doesn`t prove that all transactions have been recorded or not provide the accuracy of
the ledger; rather it merely indicates the equality of the debit & the credit sides.
The inequality of the two sides arises from:
1. error in preparing the trial balance
a. if either column incorrectly added
b. if the amount incorrectly entered
c. if the Debit is recorded as Credit or vice versa
2. error in determining the account balances, such as;
a. if a balance computed incorrectly
b. if a balance entered in a wrong column
3. error in recording a transaction in the ledger
a. if the erroneous amount is posted
b. if the Debit is posted as Credit or vice versa
c. if either column is omitted
Below are some types of errors that will not affect the equality of the debit & the credit sides:
i. failure to record the transaction or to post the transaction
ii. recording/posting the same erroneous amount to both sides
iii. to record the same transaction more than once
iv. to post a part of the transaction correctly, but to the wrong account

The common two types of errors are:

1. transposition error: erroneous rearrangement of the digits: e.g. $3,200 as $2,300
2. slide error: if the entire number is erroneously moved one or more spaces to the right or left: e.g. $ 45,200
as $45.20 or as $452.00
Ways of discovering errors:
a. By audit procedures
b. By chance discovery
c. Through the medium of trial balance
d. Backward ward process. Working back starting from trial balance to the journal until the error
discovered.
 If the total debit and credit of trial balance are not equal, the exact amount of the difference between the
totals should be determined before proceeding to search for the error. The amount of the difference
between the two totals of trial balance sometimes gives a clue to the nature of error or where it occurred.
 If the difference is 10, 100, 1000, etc, the error might be error of addition or omission.
 If the difference is divisible by two without a remainder; a debit may posted as a credit or vice
versa. For example, if the totals of trial balance’s debit and credit be $20,640 & &20,236
respectively, the difference will be &404. This may indicate that a credit of posting
$404omitted, or a credit of $202 was erroneously posted as a credit.
 If the difference is divisible by 9 (nine) without a remainder, the error might be transportation
or slide error.

ILLUSTRATION: Lake View has the following balances as of September 30, 2008
Lake View
Trial Balance
September 30.2008

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Cash $8,800
Accounts receivable 17,825
Supplies 1,800
Prepaid Insurance 400
Equipment 22,500
Notes Payable $25,000 The debit & the credit sides
Accounts Payable 5,000 are not equal as a result of
Joan Key, Capital 36,720 the following errors:
Joan Key, Drawing 8,000 1. the balance of cash
Sales 59,750 was understated by
Wages expense 31,500 $700
Rent expense 1,800 2. a cash receipt of
Advertising expense $470 was posted as
5,700
Utility expense a debit to cash $740
5,650
3. a credit of $325 to
$103,975 $126,470
accounts receivable
was not posted
4. a return of $245 of defective supplies was erroneously posted as $425 credit to supplies
5. an insurance premium acquired at cost of $400 was posted as a credit to prepaid insurance
6. the balance of notes payable was overstated by $5,000
7. a credit of $890 in accounts payable was over looked when to determine the balance of the account
8. a debit of $1,000 for withdrawal by the owner was posted as a debit to wages expense
9. the balance of $18,000 in rent expense was entered as $1,800 in the trial balance
10. miscellaneous expense with the balance of $1,100 was omitted from the trial balance
The corrected trial balance is presented below:
Lake View
Trial Balance
September 30.2008
Cash $8,800+700-270
Accounts receivable 17,825-325
Supplies 1,800+180
Prepaid Insurance 400+400+400
Equipment 22,500
Notes Payable $25,000-5,000
Accounts Payable 5,000+890
Joan Key, Capital 36,720
Joan Key, Drawing 8,000+1,000
Sales 59,750
Wages expense 31,500-1,000
Rent expense 1,800+16,200
5,700
Advertising expense
5,650
Utility expense
1,100
Misc. expense
$122,360 $122,360

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Completion of the Accounting Cycle

Nature the Adjusting process
 Definition: - adjustment is the process of updating the accounts & assuring the proper matching of
revenues & expenses at the end of an accounting period; adjusting entries are required entries to record
the adjustment process.
Deferrals & Accruals
Deferred items: - consist of adjusting entries involving data previously recorded in accounts. These entries
involve the transfer of data already recorded in the assets & liabilities account to expense & revenues account,
respectively. Deferred items consists two types of adjustments:
a. Assets/Expenses Adjustment: called deferred expenses or prepaid expenses. All prepayments remain
asset until they are used up or expired, & deferred to be recorded as expense.
E.g. supplies, prepaid insurance, prepaid rents, etc
There are two types of recording prepaid expenses: as asset & as expense
- If the original transaction is recorded as asset, the adjusting entry at the end of the accounting period is
needed to transfer the amount expired from asset account to expense account.
- If the original transaction is recorded as expense, the adjusting entry at the end of the accounting period
is needed to transfer the amount that is not expired from expense account to asset account.
Assume Mendacity ltd rented a building on September 1, 2003paying $48,000 for a period of one year.
Assume also that the accounting period of the business organization ends on December 31. The adjusting
entry will be recorded as follows:
 If recorded as asset:
September 1, 2003: Prepaid Rent---------------------------$48,000
Cash-----------------------------------------$48,000
(To record the original transaction)

December 31, 2003: Rent Expense---------------------------$16,000

Prepaid Rent---------------------------------$16,000
(To record adjustment)

 If recorded as expense:
September 1, 2003: Rent Expense--------------------------$48,000
Cash-------------------------------------------$48,000
(To record the original transaction)

December 31, 2003: Prepaid Rent---------------------------$32,000

Rent Expense-----------------------------------$32,000

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(To record adjustment)

Activity: Supplies provided for use during year 2 was $1,800, & at the end of the year only supplies of
$890 are available on hand. Pass a necessary journal entry!!

b. Liability/Revenue Adjustment: called deferred revenues, & arise from advance cash
receipts/collection. They remain liability till they are earned.
- If the original transaction is recorded as liability, the adjusting entry at the end of the accounting
period is needed to transfer the amount earned from liability account to revenue account.
- If the original transaction is recorded as revenue, the adjusting entry at the end of the fiscal
period is needed to transfer the unearned amount from revenue account to liability account.
E.g. Assume that on November 30, 2008, Cox ltd received cash in advance for rent of machinery, $36,000 for
three months, and its fiscal year ends on December 31. Pass a necessary adjusting entry!!
 the original transaction is recorded as liability:
November 30, 2008: Cash-------------------------------------$36,000
Unearned Revenue------------------------------------$36,000
(To record the original transaction)

December 31, 2008: Unearned Revenue-------------------------$12,000

Rent Revenue-----------------------------------------$12,000
(To record adjustment)

 the original transaction is recorded as revenue:

November 30, 2008: Cash---------------------------------------------$36,000
Rent Revenue------------------------------------$36,000
(To record the original transaction)

December 31, 2008: Rent Revenue---------------------------------------$24,000

Unearned Rent------------------------------------------------$24,000
(To record adjustment)
Note: Adjustment for all deferrals decrease either an item/side_ Debit or Credit

Accrued Items: - involves the initial record of assets & liabilities; and the related revenues & expenses.
They consist of two types of adjusting entries:
1. Assets/ Revenues Adjustments: called accrued revenues. A company performs services for customers &
bills them. This transaction then will be recorded as assets/receivables & as revenues because the
Company earned the revenues.

Example: PQR business loaned $20,000on November 1, 2009 at 12% interest rate. Pass a necessary
adjusting entry if the Business`s accounting period ends on December 31.
December 31, 2009: Interest Receivable-----------------------$400
Interest Revenue----------------------------------$400
(To record interest revenue earned)

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Activity: USP Business Concern, on October 1, 2009, agreed to perform an accounting Consultancy
service for $96,000 for a period of one yea r starting from that date. The full payment will be made after a
full discharge of all responsibilities, (i.e. after a year), the accounting period ends on December 31. Pass a
neccessry adjusting entry on the last date of the accounting period.
2. Liabilities/Expenses Adjustment: called accrued or post paid expenses. These are accumulated
expenses that are unpaid & unrecorded. They are already incurred, but not yet recorded & paid.
Example: DSAE Inc pays wages of $20,000 for five work days each Friday. The current year
accounting period ends on March 31, Wednesday. Pass ea necessary adjusting entry.
March 31: Wage Expense----------------------$12,000
Wages Payable---------------------------------$12,000
(To record wages expense incurred)
Activity: DDFC borrowed $200,000 from DDCB at 12% interest rate on July 1, 2002. Pass a necessary
adjusting entry on December 31, 2002 for DDFC.
Note: All accrual adjustments increase both sides_ the debit & the credit
Depreciation: is a decrease in usefulness of plant assets with a time passage. As time passes, all plant assets,
except land, loose their capacity to provide useful service, however, there is no visible reduction in quantity.
Depreciation is another type of prepaid/deferred expense.
Accumulated Depreciation is a contra/offset account for depreciable plant assets [deductible from the cost of
plant assets].
Example: Micro Train Co reported depreciation of $750 on December 31, 2009, on its tucks. The original cost
of the trucks was $10,000.
December 31, 2009: Depreciation Expense-trucks----------------------------$750
Accumulated Depreciation-trucks------------------------$750
(To record depreciation Expense)

Book Values: Are the recorded cost of plant assets less accumulated depreciation, [unexpired cost of plant
assets].
Book value= cost-accumulated depreciation
9,250=10,000-750

Worksheet – is a columnar sheet of paper or a computer spreadsheet on which accountants summarize

information needed to make the adjusting and closing entries, and to prepare the financial statements. It is only
an accounting tool & not the formal accounting record.
The major purpose of the worksheet is to organize data into a convenient form prior to the preparation of the
financial statements. The worksheet has five main money columns with their respective debit & credit sides,
each; in general there exist ten columns of worksheet for sole proprietorship & partnership businesses:
 The trial balance column
 Adjustment column
 The adjusted trial balance column
 The income statement column &
 The balance sheet column
The heading of worksheet should fulfill/satisfy the www requirements, & its date of preparation is similar with
that of the balance sheet. Below is the illustration of Joan Miller Advertising Agency

Joan Miller Advertising Agency

Worksheet
For the Month Ended, January 31, 2008
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Account Name Trial Balance Adjustment Adjusted Income Statement Balance Sheet
Trial Balance
Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Cash 1,720 1,720 1,720
Accounts Receivable 2,800 2,800 2,800
Art Supplies 1,800 c 500 1,300 1,300
Office Supplies 800 d 200 600 600
Prepaid Rent 800 a 400 400 400
Prepaid Insurance 480 b 40 440 440
Art Equipment 4,200 4,200 4,200
Office Equipment 3,000 3,000 3,000
Accumulated
Depreciation- e 70 70 70
 Art f 50 50 50
Equipment
 Office
Equipment
Accounts Payable 3,170 3,170 3,170
Unearned Art Fees 1,000 h 400 600 600
Joan Miller, Capital 10,000 10,000 10,000
Joan Miller, Drawing 1,400 1,400 1,400
Advertising Fees 4,200 i 200 4,400 4,400
Earned
Wages Expense 1,200 g 180 1,380 1,380
Utilities Expense 100 100 100
Telephone Expense 70 70 70
18,370 18,370
Rent Expense a 400 400 400
Insurance Expense b 40 40 40
Art Supplies Expense c 500 500 500
Office Supplies d 200 200 200
Expense
Depreciation Expense-
 Art e 70 70 70
Equipment f 50 50 50
 Office
Equipment
Wages Payable g 180 180 180
Art Fees Earned h 400 400 400
Fees Receivable i 200 200 2
00
2,040 2,040 18,870 18,870 2,810 4,800 16,060 14,070
1,990 1,990
Net Income 4,800 4,800 16,060 16,060

Journalizing the Adjusting Entries

a. Rent expense------------------400

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Prepaid rent---------------------------400

b. Insurance expense------------40
Prepaid insurance---------------------40

c. Art supplies expense-----500

Art supplies-------------------------500
d. Office supplies expense-------200
Office supplies-------------------200

e. Depreciation expense-Art equipment----70

Accumulated Depreciation-Art equipment----70

f. Depreciation expense-Office equipment----50

Accumulated Depreciation-Office equipment-----50

g. Wages expense---------------180
Wages payable-----------------180

h. Unearned Art fees --------------400

Art fees earned-----------------400

i. Fees receivable-------------------200
Advertising fees earned---------200
The Nature of the Closing process
 The net effect of all temporary/nominal accounts will be summarized to the capital account at the end
of the accounting period.
 These nominal accounts must have a zero balance at the end of the fiscal year, so that they will be ready
for use in the following accounting period. These two activities take place through the closing entries.
All expense & revenue accounts are first closed to Income Summary account, & then the Income Summary
account to the capital account; whereas the drawing account directly closed to the capital account.
Note that the Income summary account has NO NORMAL BALANCE, and it is only opened & closed during
the closing process. The accounts title & the amounts for journalizing the closing entries are obtained from:
- The worksheet
- Income Statement
- The Statement of Owner`s Equity &
- The ledger
All nominal accounts in the Adjusted Trial Balance column are closed to Income Summary as follows:

Advertising Fees earned-----------------4,400

Income Summary--------------------------4,400
(To close Advertising Fees earned)

Income Summary----------------1,380
Wages Expense-----------------1,380
(To close wages Expense)
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Income Summary----------------100
Utilities Expense-----------------100
(To close Utilities expense)

Income Summary --------------70

Telephone Expense---------------70
(To close telephone expense)

Income Summary------------------400
Rent expense--------------------400
(To close rent expense)

Income summary----------------40
Insurance expense----------------40
(To close Insurance expense)

Income Summary --------------------500

Art supplies expense----------------500
(To close Art supplies expense)

Income Summary----------------200
Office supplies expense---------200
(To close office supplies expense)

Income Summary --------------------70

Depreciation Expense-Art equipment ----70
(To close Depreciation Expense-Art equipment)

Income Summary-------------------50
Depreciation Expense-office equipment ----50
(To close Depreciation Expense-office equipment)

Art Fees Earned---------------400

Income Summary----------------400
(To close Art Fees Earned)

 Finally when to close the Income Summary Drawing Accounts to the Capital Account, it will
have the following format:
Joan Miller, Capital----------------------1,400
Joan Miller, Drawing--------------------------1,400
(To close the drawing account)

Income Summary--------------------4,800
Joan Miller, Capital----------------4,800
(To close Income Summaries with credit balance/Revenues)

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Joan Miller, Capital---------------------------2,810

Income Summary---------------------------2,810
(To close Income Summaries with debit balance/Expenses)
From the above entries, we can summarize that the Income Summary Account has the debit & credit balance of $
4,800 & $2,810, respectively. The debit side of the Income Summary signifies the summary of all Revenues
whereas the credit signifies the summary of all expenses. So we can say that the Company generated the Net
Income of $1,990(4,800-2,810).

Post Closing Trial Balance

The last procedure of the accounting cycle is the preparation of the post closing trial balance; after all nominal
accounts are closed, to make sure that the ledger is in balance at the beginning of the new accounting
period. The post closing trial balance incorporates only the balance sheet accounts & contra plant assets
accounts_ accumulated depreciation.

Joan Miller Advertising

Agency
Post Closing Trial Balance
January 31, 2008
Cash $ 1,720
Accounts Receivable 2,800
Fees Receivable 200
Art Supplies 1,300
Office Supplies 600
Prepaid Rent 400
Prepaid Insurance 440
Art Equipment 4,200
Chapter 4
Office Equipment 3,000
Accumulated Depreciation-
 Art Equipment $ 70
 Office Equipment 50
Accounts Payable 3,170
Unearned Art Fees 600
Wages Payable 180
Joan Miller, Capital _____ 10,590
$ 14,660 $ 14,660

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CHAPTER 3
Accounting for Merchandising Enterprises
Merchandising enterprises are those business concerns which are established in order to purchase/acquire
merchandise only for resale purpose rather than for further processing or consumption purpose.
Merchandises refers to items purchased for resale to customers, and merchandising is the process of purchasing
& reselling items.
Accounting for purchases & sales
Purchases of merchandise are usually identified in the ledger as ‘purchase’ whereas sales as ‘sales’.
Merchandising enterprises accumulate all the cost of merchandise in the purchase account.
Purchase------------------------------------------XXX
Cash/Accounts Payable-----------------------------XXX
(To record purchases)

Cash/Accounts Receivable---------------------------------XXX
Sales------------------------------------------------------------XXX
(To record sales)
Purchases/Sales Discount
The arrangements agreed upon by the buyer & the seller as to when payments for merchandise are to be made
are called Credit Terms. If the payment for merchandise is made immediately, the arrangement o the agreement
is said to be CASH/NET CASH. Otherwise the buyer is allowed a certain time of payment, known as the Credit
Period. The credit period begins with the date of the sales as shown by the date of the invoice/bill.
 If the payment is due within the stated number of days after the date of the invoice, say 30 days, the
terms are said to be Net 30 days_ ‘n/30’
 If the payment is due at the end of the month, in which the sales was made, it may be expressed as
‘n/eom’
As a means of encouraging payment before the end of the credit period, the sellers may offer a discount for early
payments of cash. For example, if the seller offers 2% discount for payment within 10 days, even if the credit
period is 30 days, can be expressed as ‘2/10, n/30’. This is known as a cash discount.
 2/10, n/30 Credit term
 2%Discount rate , 10 -Discount period, 30-Credit period
Example: Zimmer Company sold merchandise of $180,000 on account to Minco ltd_ term 2/10, n/30, Minco
paid the amount within the discount period.
Purchase Discount- Minco ltd Sales Discount- Zimmer Co
Purchase---------------------$180,000 Accounts Receivable----------------$180,000

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Accounts Payable------------$180,000 Sales-----------------------------$180,000

(To record Purchase) (To record Sales)

Accounts Payable------------$180,000 Cash--------------------------------$176,400

Cash------------------------------$176,400 Sales Discount-------------------- 3,600
Purchase Discount------------- 3,600 Accounts Receivable----------------$180,000
(To record cash payment) (To record cash collection)
Purchase/Sales Return & Allowance
In some special cases, part of merchandise purchased or sold might be returned & the price adjustment is
requested. The buyer asks for purchase return & allowance writing the Debit Memorandum. The Debit
Memorandum is the convenient medium to inform the seller/creditor/ the amount of the buyer/debtor/ & the
purposes to debit accounts payable or cash.
The seller gives a Credit Memorandum that shows the amount the amount for which it is going to Credit its
Accounts Receivable or cash. Purchase Return & Allowance is a deduction/a contra (offsetting account of)/ to
purchase account, whereas Sales Return & Allowance is a deduction/a contra (offsetting account of)/ to Sales
Account.
Illustration
On July 3, year 3, ABC ltd purchased supplies of $5,000 on account from XYZ Company; unfortunately supplies
of $450 were defective & ABC wrote a Debit Memorandum to XYZ on July 11, year 3. Record the original
transaction & the return on the behalf of the buyer & the seller.
ABC ltd XYZ Company
July 3, year: Purchase--------------$5,000 Accounts Receivable-----------$5,000
Accounts Payable--------$5,000 Sales -------------------------------------$5,000
(To record purchase) (To record sales)

July 11, year 3: Accounts Payable------$450 Sales Return & Allowance-----$450

Purchase Return & Allowance---$450 Accounts Receivable----$450
(To record Purchase Return & Allowance) (To record Sales Return & Allowance)
Activity
On July 4, 2000, Pinkie Company purchased items of $20,000, term 2/10, n/45 from Rainbow ltd & paid the
amount within the discount period. Three days after the last date of the discount period, items of $1,280 were
returned for some defects.
Instruction
1. Record the original transaction on the behalf of the seller & the buyer
2. Record the payment on the last date of the discount period for both the seller & the buyer
3. Record the return of the items for both the buyer & the seller specifying the date of the transaction.
Transportation Costs
The terms of agreement between the buyer & the seller include provisions concerning:
a. When the ownership title of the merchandise transfers to the buyer
b. Which party is to bear the cost of delivering the merchandising to the buyer (transportation cost).
There are two terms: FOB shipping point
FOB destination
FOB (Free On Board) Shipping point: - the ownership title transfers to the buyer at the shipping point, & the
transportation costs are to be covered by the buyer itself. The transportation costs paid by the buyer are then
debited to Transportation/Freight In & credited to cash.

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But in some special cases, the seller may repay the transportation costs & adds the amount to the invoice by
debiting to Accounts Receivable & crediting to cash; and the buyer will debit Transportation In & credit
Accounts Payable.
FOB (Free On Board) Destination: - the seller places merchandise free on board to its destination paying all
transportation/delivery costs, & the ownership title is transferred to the buyer at the destination of the
merchandise/at the address of the buyer/.
Illustration
On June 10, 2002, Durban Company purchased merchandise from Bell Corporation $900, term FOB shipping
point, 2/10, n/30, with the prepaid transportation cost of $50 that is added to the invoice. Pass necessary entries
for both the entities.
Durban Company Bell Corporation
June 10, 2002: Purchase--------$900 Accounts Receivable-------$950
Freight In --------- 50 Sales------------------------------$900
Accounts Payable-------------$950 Cash----------------------------------50
(To record Purchase) (To record Sales)

June 20, 2002: Accounts Payable-----$950 Cash-----------------------------$932

Cash--------------------------$932 Sales Discount-------------------18
Purchase Discount-------- 18 Accounts Receivable-----------$950
(To record the cash payment) (To record the cash collection)
Note that the discount rate is not applicable to the prepaid transportation cost.
When the agreement term is FOB destination, the transportation cost paid by the seller will be debited to
Transportation out/ Delivery Expense, & reported on the seller`s Income Statement as selling expense. And no
entry is needed by the buyer to record the transportation cost paid by the seller.
Example: GTY Company sold merchandise of $400, FOB destination paying $12 to RABS ltd.
GTY: Accounts Receivable---------$400 RABS: Purchase-------------$400
Sales------------------------------$400 Accounts Payable-------------$400
(To record sales) (To record Purchase)

Transportation out-------------$12 (No Entry)

Cash----------------------------$12
(To record transportation cost)

VAT
Taxing units (states) levy (impose) tax on retail sales of merchandise. The liability for VAT is ordinarily incurred
regardless of the terms of the sales. Sellers add the percent of the tax on the normal selling price of the
commodities.
Example: A sale on account of $100 is subject to VAT of 15%
Accounts Receivable ------------------115
Sales-----------------------------------$100
VAT payable--------------------- 15

Periodically, the appropriate amount of VATtax is paid to the taxing unit & the VAT payable is debited.
VATpayable-------------------$4
Cash--------------------------------$4

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Activity: Record the following transactions

a. Purchased merchandise on account $15,000, 2/10, n/30
b. Sold $3,000 of merchandise on account, subject to tax of 15%
c. Paid the amount owed in ‘a’ within the discount period
d. Paid $1,650 to the State Revenue Department for VAT collected
Merchandise Inventory Systems
There two main systems for accounting for merchandise held for sale:
Periodic inventory system perpetual inventory system
Records items purchased by temporary called record items purchased by permanent account
account called merchandise inventory.
Purchase…………..xxxx Merchandise…………..xxxx
A/P(Cash)………………..xxxx A/P(Cash)………………..xxxx
maintains purchase contra accounts (PD &  treats every increase/decrease in inventory to
PRA) merchandise inventory account.
Ending inventory or inventory on hand is continuously updates inventory level & cost of
determined from the inventory Period through merchandise inventory record sold
physical inventory/ taking/counting.
Records an entry up on sales: Records two entries up on sale.
A/R(Cash)………..xxxx A/R(Cash)………..xxxx
Sales…………..xxxx Sales…………..xxxx
CGS………….xxx
merch. Inventory…………….xxx

Cost of Merchandises Sold

Merchandising Enterprises determine cost of merchandise sold as follows:
Cost of merchandise sold:
Beginning Inventory xxx

Add: Purchases xxx

Less: Purchase discount (xx)

Purchase return & allowance (xx)

Net Purchase xx

Add: Transportation cost xx

Cost of merchandise purchased xxx
Cost of merchandise available for sale xxx
(xx)
Less: Ending Inventory
Cost of merchandise sold xxx
Activity: Based on the following data, prepare statement of cost of merchandise sold for the fiscal year ended on
June 30, 1991 for ABC Limited Company.
Merchandise Inventory:

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 June 30, 1991 $ 236,000

 June 30, 1990 127,000
Purchase 760,000
Purchase return and allowance 8,200
Purchase discount 4,800
Transportation cost 3,000

Chapter 4
Accounting for Cash
Definition- Cash is the most liquid of all assets. It consists coins, currency, checks, and money on hand or in
bank. Generally, anything that the bank accepts for deposit at its face value is said to be cash. Cash is an asset
that is readily convertible into any other type of assets; it is highly concealed and transported; and it is highly
desired. Because of these characteristics, cash is the asset most susceptible to improper diversion and use.
Moreover, because of the large volume of cash transactions, various errors may occur in executing and recording
cash transactions.
For proper safeguarding of cash and to assure the accuracy of the accounting records for cash, effective internal
control over cash is essential. Internal control is a system designed to safeguard the assets of a business and to
help in ensuring the accuracy and reliability of the accounting records.
Internal control over cash
Internal control is a system designed to safeguard the assets of a business and to ensure the accuracy and
reliability of the accounting records. The accounting system should be organized and operated in the manner that
the work of one person is checked by another, with minimum duplication of effort.
Cash is the most precious and most easily stolen asset of the business. It can easily be transferred, is most likely
to be diverted and used improperly. In addition, many transactions either directly or indirectly affect the receipts
or payments of cash. Therefore, it is necessary that all the money received from sale of goods or services must be
protected to make it available for payment of expenses, and other obligations. In addition, there must also be
control over payments so that none of the firm’s cash is spent without proper authorization or supervision.

Internal Control over Cash Receipts

Since cash can easily be lost or stolen, management must use special care in safeguarding its receipts.
Management and the accountant must set up a system for the internal control of cash receipts. One important
control procedure is promptly depositing the daily cash receipts in the bank. Another important control procedure
is to divide the duties of receiving, recording, and depositing cash among different persons.
The following preventive measures may be used to safeguard cash receipts.
1. One person should receive cash, whether it is delivered by mail or in person (over the counter). After
making a record of the receipts, this person should hand the cash over to another person for deposit in the
bank.
2. All daily cash receipts should be deposited in the bank promptly.
3. A person other than the one who receives the cash or the one who deposits it in the bank should make the
entries for cash receipts in the firm’s accounting records.
4. At the end of each month, a person other than the three mentioned above should obtain the bank
statement directly from the bank and should prepare bank reconciliation.

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Internal Control over Cash Payments

The control procedures for cash receipts are only one part of a well-designed system of internal control. There
must also be control over cash payments to ensure that none of the firm’s cash is spent without proper
authorization or supervision.
Internal control over cash payments may be achieved by adopting certain policies and by planning work
assignments.
The following are some of the means to enhance internal control over cash payments.
1. All payments should be made by check, except for minor payments for which petty cash fund should be
established.
2. No check should be issued before a proper approval and authorization of the payment.
3. Only experienced and responsible personnel should approve bills.
4. The one who does not authorizes, Signs and mails checks, should keep the records of payments.

Bank Account as a Tool for Controlling Cash

One of the major devices for maintaining control over cash is the use of a bank account. An efficient controlling
system requires the deposit of all cash receipts in the bank and all payments by checks drawn on the bank or
from special cash funds. When a business strictly follows the system of depositing all cash receipts in a bank and
paying all of its obligations by drawing a check on the bank, there will be double records for cash: one
maintained by the business (depositor) and the other by the bank.
The forms used by a business in connection with a bank account are the following:
Signature Card: - when a business opens an account in a bank, the person authorized to sign checks for the firm
to make payments will provide his signature to the bank. At the time an account is opened, the bank will assign
an identifying number to the firm’s account and the authorized person to sign checks drawn on the account will
sign on a signature card. The card is used by the bank to determine the validity of the signature on checks
presented to it for payment. The signature card serves as a contract between the depositor and the bank. It
authorizes the bank to make payments from funds in the depositor’s account on checks that have the authorized
signature.
Deposit Slip/Ticket: – A form, called a deposit slip, or a deposit ticket, must be prepared for each bank deposit.
These forms are provided to the depositor by the bank in which the account is maintained and are usually
preprinted with the assigned account number. The depositor on the deposit slip lists the details of each deposit
and it will be stamped or initialed by the bank’s teller and given to the depositor as a receipt. The stamped
deposit slip gives the depositor written proof of the date and the total amount of the deposit.
Check: - A check is a written order signed by the depositor or other authorized person (the drawer) instructing
the bank (the drawee) to pay a specific sum of money to the person designated (the payee). There are three
parties to a check. The “drawer,’’ the one who signs the check; the “drawee,’’ the bank on which the check is
drawn;’’ and the “payee,’’ the one to whom the payment is made.

Example
Suppose AB Boutique issued a Br. 400 check on June1, ordering the Commercial Bank of Ethiopia to pay the
stated amount to B.S. Company. Here, AB Boutique is the drawer, B. S. Company is the payee, & the
commercial bank of Ethiopia is the drawee.
When checks are issued for payments, they are recorded as credits to cash on the day issued, even if they are not
yet presented to the drawer's bank until some latter time. Likewise, when checks are received from customers,
they are recorded as debits to cash, on the assumption that the customer has enough money on deposit.

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In the above example, AB Boutique will credit its cash account on June1, even if B. S. Co. may not collect the
payment from the bank until July 30. On the other hand, B. S. Company will debit its cash account on June1,
with the assumption that AB Boutique have enough money on its CBE’S account.
Endorsements: - Sometimes a business may receive a check from its customers in payments for the goods and
services it provides. If such a check is to be deposited, it must be endorsed. Endorsement is a legal process by
which the payee (the firm to which the checks are payable), transfers ownership of the check to the bank. This
gives the bank the legal right to collect payments from the drawers or payers (the persons or firms that issued the
checks). In the event that a check cannot be collected, the endorser guarantees payments to all subsequent
holders.
Several forms of endorsement are common in use. Individuals often use a blank endorsement. This
endorsement consists of the signature of the payee written on the back of the check. The bearer can further
endorse a check that has a blank endorsement. A full endorsement is much safer. Here the payee is indicated as
part of endorsement, the name of the payee or firm or bank to whom the check is to be payable is indicated. Only
the person, firm, or bank named in the endorsement can transfer it to someone else.
The most appropriate form of endorsement for business purposes is the restrictive endorsement, which limits
further use of the check to a stated purpose. Usually, the purpose is deposit in the firm’s bank account.
The three types of endorsements are illustrated below:
Blank endorsement Full Endorsement Restrictive Endorsement
Belay Solomon Pay to the order of CBE Pay to the order of CBE
80 – 60 - 42269 B. S. Co for deposit only
80 – 60 - 42269 B. S. Co.

As it can be seen, the blank endorsed check can easily be transferred to another party. This type of endorsement
carries greater risk. The fact that it can easily be transferred makes it more susceptible to theft. The fully
endorsed check can be transferred to another party only by commercial bank of Ethiopia. There is no further
endorsement of the check that has a restrictive endorsement. Here, the check is endorsed for the only purpose of
deposit at commercial bank of Ethiopia.
Dishonored Checks: - Sometimes a check that has been sent for deposit may be rejected by bank. This occurs
when the bank on which the check was drawn has refused to honor it, usually because there are no sufficient
funds in the drawer’s account to cover it. The bank usually stamps the letters NSF for “Not Sufficient Funds’’ on
the check. Such a check is said to be “dishonored.” The depositor’s records must be adjusted (by means of
journal entry) to reflect the dishonored check.
If a firm is notified of a dishonored check by its bank, it must contact the drawer in order to arrange for
collection. For instance, assume that B.S. Co had endorsed the check it received from AB Boutique for deposit.
The bank returned the check back to B.S. Co. stamped NSF because AB Boutique does not have sufficient fund
in its bank account to cover the payment of Br. 400. In this case, B.S. Co. should adjust its cash records and
should contact AB Boutique to collect the amount it owed to, B.S. Co.
Record of Checks Drawn: - When a Check is issued to make payments, a memorandum record of the check
should be prepared. The record is made on either the check stub from which the check is detached or in a small
booklet designed to be kept with the check forms. Most individuals & many businesses use checkbooks provided
by a bank.
The bank’s standard checkbook contains checks with stubs attached to the check. Each type of record, however,
provides spaces for recording the details of the check. The record contains information that is important for
future reference. It used to record the opening balance, the amount of the check, the amount of deposits, the
current balance, the date the check is written, the name of the payee, & the purpose of the payment.

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Business firms may prepare a copy of each check drawn and then use it as a basis for recording the transaction in
the journal. Checks issued to creditors on account are usually accompanied by a notification of the specific
invoice that is being paid. The purpose of such notification, sometimes called a remittance advice, is to make
sure that the proper credit is recorded in the accounts of the creditor. The remittance advice is used for writing,
explanatory information, such as the amount, number, and date of the invoice being paid.

The Bank Statement

Once a month, the bank sends each depositor, a statement of the deposits received and the checks paid. The bank
statement shows the balance at the beginning of the period, checks withdrawn and other debits (deductions by
the bank) made by the bank on the depositor’s bank account, deposits and other credits (additions by the bank),
and the balance at the end of the period.

Bank Reconciliation
Since the bank and depositor maintain independent records of the depositor’s checking account, it may seem that
the balance as per the two will always agree, but they are not likely to be equal on any specific date, hence the
process of bringing the two balances to one is called bank reconciliation.
The lack of agreement between the two balances is due to:
 Time lag of one party in recording the transaction.
 Error by either party in recording the transaction.
Some checks may have been written and entered in the firm’s journal but they may not have been paid by the
bank and charged to the depositor's account before the end of the month .A deposit recorded in the firm’s journal
may have reached the bank too late to be included in the bank statement for the current month. The bank might
have deducted service charges or other items that have not yet been entered on the depositors’ record.

Bank reconciliation procedures

A company's general ledger account cash contains a record of transactions (checks written, receipts from
customers, etc.) that involve its checking account. The bank also creates a record of the company's checking
account when it processes the company's checks, deposits, service charges, and other items. Soon after the ends
of each month, the bank usually mails a bank statement to the company. The bank statement lists the activity in
the bank account during the recent month as well as the balance in the bank account. When the company receives
its bank statement, the company should verify that the amounts on the bank statement are consistent or
compatible with the amounts in the company's cash account in its general ledger and vice versa. This process of
confirming the amounts is referred to as reconciling the bank statement. The benefit of reconciling the bank
statement is to know the amount of cash reported by the company (company's books) is consistent with the
amount of cash shown in the bank's records.
As most companies write hundreds of checks each month and make many deposits, reconciling the amounts on
the company's books with the amounts on the bank statement can be time consuming. The process is complicated
because some items appear in the company's cash account in one month, but appear on the bank statement in a
different month.
For example, checks written near the end of August are deducted immediately on the company's books, but those
checks will likely clear the bank account in early September. On the other hand, sometimes the bank decreases
the company's bank account without informing the company of the amount. For example, a bank service charge
might be deducted on the bank statement on August 31, but the company will not know the amount until the

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company receives the debit memorandum for such deduction together with the bank statement in early
September.
From these two examples, you can understand why there is likely be a difference of cash balance of bank
statement vs. cash balance in the company's books. It is also possible (perhaps likely) that neither balance is the
true balance. Both balances may need adjustment in order to report the true amount of cash.
After you adjust the balance per bank statement and the balance per books to the true balance, it is said you have
reconciled the bank statement. Most accountants would simply say that you have done the bank reconciliation.
Steps in Reconciliation Process
Step 1. Adjusting the Balance per Bank
The bank reconciliation process is demonstrated by several steps. The first step is to adjust the balance on the
bank statement to the true, adjusted, or corrected balance. The items necessary for this step are listed in the
following schedule:
Step 1.  Balance per Bank Statement on Aug 31. 2006
 Adjustments:
     Add: Deposits in transit
     Deduct: Outstanding checks
     Add or Deduct: Bank errors
 Adjusted/Corrected Balance per Bank

Deposits in transit are deposits already sent to the bank and recorded by the company, but are not yet recorded
by the bank. For example, a retail store deposits its cash receipts of August 31 into the bank's night depository at
10:00 p.m. on August 31. The bank will process this deposit on the morning of September 1. This is a deposit in
transit as of August 31 (the bank statement date).
Since deposits in transit are already included in the company's cash account, there is no need to adjust the
company's records. However, deposits in transit are not yet appeared on bank statement. Therefore, they need to
be listed on the bank reconciliation as an increase to the balance per bank statement in order to report the true
amount of cash. A helpful rule of thumb is "put it where it isn't." A deposit in transit is on the company's book,
but it is not on the bank statement. Put it where it is not: as an adjustment to the balance on the bank statement.
Outstanding checks are checks that have been written and recorded in the company's cash account, but have not
yet cleared the bank. Checks written during the last few days of the month plus a few older checks is likely to be
among the outstanding checks.
As all checks that have been written are immediately recorded in the company's cash account, there is no need to
adjust the company's records for the outstanding checks. However, the outstanding checks have not yet reached
the bank and the bank statement. Therefore, outstanding checks are listed on the bank reconciliation as a
decrease in the balance per bank.
Recall the helpful tip "put it where it isn't." An outstanding check is on the company's book, but it is not on the
bank statement. Put it where it is not: as an adjustment to the balance on the bank statement.
Bank errors are mistakes made by the bank. Bank errors could include the bank recording an incorrect amount,
entering an amount that does not belong on a company's bank statement, or omitting an amount from a
company's bank statement. The company should notify the bank of its errors. Depending on the error, the
correction could increase or decrease the balance shown on the bank statement. (Since the company did not make
the error, the company's records are not affected).
Step 2. Adjusting the Balance per Books

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The second step of the bank reconciliation is to adjust the balance in the company's cash account so that it is the
true, adjusted, or corrected balance. Examples of the items involved are shown in the following schedule:
Step 2.  Balance per Books on Aug, 31 2006
 Adjustments:
     Add:Interest earned
     Add: Notes collected by the bank
     Deduct: Check printing charges
     Deduct: Bank service charges
     Deduct: NSF checks & fees
     Add or Deduct: Errors in company's cash account
 Adjusted/Corrected Balance per Books

Bank service charges are fees deducted from the bank statement for the bank's processing activities related to
the checking account (accepting deposits, posting checks, mailing the bank statement, etc.) Other types of bank
service charges include the fee charged when a company overdraws its checking account and the bank fee for
processing a stop payment order on a company's check. The bank might deduct these charges or fees on the bank
statement without notifying the company. When that occurs, the company usually learns of the amounts only
after receiving its bank statement.
An NSF check is a check that was not honored by the bank of the person or company writing the check because
that account did not have a sufficient balance. As a result, the check is returned without being honored or paid.
(NSF is the acronym for not sufficient funds and the bank describes the returned check as a return item. Others
refer to the NSF check as a "rubber check" because the check "bounced" back from the bank on which it was
written.) When the NSF check comes back to the bank in which it was deposited, the bank will decrease the
checking account of the company that had deposited the check. The amount charged will be the amount of the
check plus a bank fee. Since the NSF check and the related bank fee have already been deducted on the bank
statement, there is no need to adjust the balance per the bank. However, if the company has not yet decreased its
cash account balance for the returned check and the bank fee, the company must decrease the balance per books
in order to reconcile.
Check printing charges occur when a company arranges for its bank to handle the reordering of its checks. The
cost of the printed checks will automatically be deducted
from the company's checking account.
Since the check printing charges have already been deducted on the bank statement, there is no adjustment to the
balance per bank. However, the check printing charges need to be adjusted to the company book. They will be a
deduction to company's Cash account.
Interest earned will appear on the bank statement when a bank gives a company interest on its account
balances. The amount is added to the checking account balance and is automatically on the bank statement.
Hence, there is no need to adjust the balance per the bank statement. However, the amount of interest earned will
increase the balance in the company's cash account on its books. Recall "put it where it isn't." Interest earned on
the current account in the bank is on the bank statement, but it is not on the company's books. Put it where it is
not: as an adjustment to the cash account on the company's book.
Notes Receivables are assets of a company. When notes come due, the company might ask its bank to collect the
note receivable. For this service, the bank will charge a fee. The bank increases the company's checking account
for the amount it collected (principal plus interest) and will decrease the account by the collection fee it charges.
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Since these amounts are already on the bank statement, the company must be certain that the amounts appear on
the company's book in its cash account.
Recall the tip "put it where it isn't." The amounts collected by the bank and the bank's fees are on the bank
statement, but they are not on the company's book. Put them where they are not: as adjustments to the cash
account on the company's book.
Errors in the company's cash account result from the company entering an incorrect amount, entering a
transaction that does not belong in the account, or omitting a transaction that should be in the account. Since the
company made these errors, the correction of the error will be either an increase or a decrease to the balance in
the cash
account on the company's books.
Step 3. Comparing the Adjusted Balances
Dear learners, after adjusting the balance per bank (step 1) and the balance per book (step 2), the two adjusted
amounts should be equal. If they are not equal, you must repeat the process until the balances are identical. The
balances should be the true, correct amount of cash as of the date of the bank reconciliation.
Step 4. Preparing Journal Entries
Journal entries must be prepared for the adjustments to the balance per book (step 2). Adjustments to increase
the cash balance require a journal entry that debits cash account and credits another account. Adjustments to
decrease the cash balance require a credit to cash and a debit to another account.
Example:
a. On February 28, the V. Trading received a bank statement. The cash balance as per bank statement was
Br. 29,517.72. On the other hand, the firms’ cash ledger has got balance of Br. 28, 243.15 on the same
date.
b. A total debit memorandum was Br .39 of which Br. 25 is NSF check and Br. 14 is for bank service
charge.
c. In verifying the canceled checks, it was found that a Br. 100 check was charged by mistake to the
account of the V. Trading on February 28 and included in the canceled checks.
d. Outstanding checks were identified and listed as follows:
 Check No. 117, Br.127.56
 Check No. 118, Br.101.01
 Check No. 120, Br.375.00
e. Deposits in transit total Br. 220
f. Note and interest collected by bank Br 1,030.00
Bank reconciliation for V. trading will be prepared as follow:
V. Trading
Bank Reconciliation
February 28, 19X1
Balance on bank statement……………………………………………..Br. 29, 517.72
Add: Deposit in transit……………………………Br. 220
Bank error ……………………………… 100 320____
29,837.72
Deduct: Outstanding checks:
No 117, Feb. 27………………………Br. 127.56
No. 118, Feb.28 ……………………. 101.01
No. 120, Feb 28 ………………….. 375 603.57
Adjusted cash Balance…………………………………………………Br. 29,234.15

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Balance as per depositor……………………………………………… Br 28, 243.75

Add Note and interest collected by bank ……………………………… 1,030.00
Br. 29,273.15
Deduct: Bank service charge ………………….. Br…14
NSF check………………………………. 25 39.00
Adjusted cash Balance………………………………………………… Br. 29,234.15
Preparing the journal entries
The last step is passing the journal entries for all data adjusted on cash balance as per book. In other words, items
in the second section of the bank reconciliation require entries on the book of depositor to correct the cash
account balance. The data used for adjustment are those in the bank reconciliation section that begins with the
balance as per book. All information adjusted on the book balance in the reconciliation should be recorded in the
firm’s ledger.

The entries for V. Trading, based on the bank reconciliation above, are as follows:
Feb. 28 Cash in Bank…………………….1030
Notes Receivable………………………….1000
Interest income ………………………………30
(To record collection of receivable and interest by bank on behalf the V.Trading)
Feb. 28 Miscellaneous expense…………………..14
Cash in Ban……………………….14
(To record bank service charge)
Feb. 28 Account receivable……………….25
Cash in Bank………………………..25
(To record NSF check)

After these entries are posted, the cash account balance will be Br. 29,234.15, the same figure as the adjusted
balance on the bank reconciliation. This is the amount of cash available for use as of Feb.28 for preparation of
balance sheet on the same day.
Voucher System
It refers to a set of methods, procedures and records used in authorizing transactions, verifying and approving the
transactions and recording those transactions before effecting payment. States that the designated official should
approve every transaction before the check is issued for payment. Includes:
A. Voucher-is an authorized document consisting of relevant facts about the transaction.
B. Voucher Register-is a record used to journalize the transactions supported by voucher. Is similar
to the purchase journal.
Example: Equipment….xx
A/P(Voucher payable)……xx
C. File for unpaid voucher-used to keep vouchers until the checks issued for payment.
D. Check register-used to record the checks issued for payment of the approved vouchers.
Example: A/P(Voucher payable)…….xx
Cash in Bank…………….xx
E. File for paid vouchers-used to keep the vouchers paid by insurance of checks. The paid vouchers are
cancelled to prevent reuse.

The Petty Cash Funds

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Although payments should be made through check after proper authorization has been given for the payment,
sometimes it is not practical to make every payment through writing checks. There are times when small
expenditures must be made in cash. In most businesses, there is a frequent need for the payment of relatively
small amounts, such as for postage due, transportation charges, or purchase of urgently needed supplies at a
nearby retail store. Payment by check in such cases would result in delay, displeasure and higher cost. Therefore,
most businesses find it convenient to pay such small expenses in cash. The small amount of cash kept o hand for
such minor expenditures is called petty cash.
In establishing a petty cash fund, the first step is to estimate the amount of cash for such relatively small
disbursements.The initial fund would be created by issuing a check for the estimated amount. Usually Br.100
would be sufficient for most small business needs; however, larger businesses may have several thousand birr in
the funds available as petty cash. The entry for this initial fund would be to debit petty cash fund account and
credit cash in bank account.
The second step is making the payments from the petty cash fund. The payment to be made from the petty cash
fund is usually limited to a predetermined minimum such as Br. 100. This means those payments, which are
greater than Br. 100 will not be paid from the petty cash fund. As expenditures are made, the custodian of the
fund will reimburse employees and secure a petty cash voucher in return. At any given time the total of cash on
hand plus reimbursed vouchers must equal the original fund, if not, there is cash short or over.
Finally, When the amount of money in the petty cash fund is reduced, the fund is replenished (restored to its
established balance).
Example:
Assume that W Company has established petty cash fund of Br. 300 on May 1of the current year. At the end of
the month, the petty cash vouchers revealed the following expenditures:
 Office supplies………………….. ………… ..Br. 47.50
 Postage………….. ………. ………………… 22
 Store supplies…………………….. ………… 35
 Delivery, expense………………….. …………. 62
 Daily newspaper (miscellaneous expense)....... 87.70
Total……………………………………… Br. 254.20
To record the establishment and replenishment of the petty cash fund, the entries would be as follows:
May 1. Petty Cash…………………………………… 300
Cash in Bank……………………………………. 300
(To record establishment of petty cash fund)
May 30. Office Supplies………………… 47.50
Postage ……………………….. 22
Store Supplies………………….. 35
Delivery Expense……………… .62
Miscellanies Expense…………... 87.70
Cash in bank………………………….254.20
(To record the payment from the petty cash and replenishment of the petty cash fund).

It should be noted that the only entry in the petty cash fund account is the initial debit (the debit made when the
petty cash is established). Unless at some other time the standard amount of the fund (Br. 300 in this case) is
increased or decreased, no entry is made in the Petty Cash account. The expenditures from the petty cash fund
are recorded in the accounts only when the fund is replenished.

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Change Funds
Business firms that receive cash directly from customers must maintain a fund of currency and coins in order to
make change. For making change, firms usually establish a special fund called “Change fund’’. The amount is
drawn by check and given to the cashier (sales clerk). The cashier is in charge of and responsible for the change
fund. After the check is cashed, the cashier will have a variety of coins and bills to meet his needs for change. At
the end of each day, the total amount of cash received during the day is deposited and the original amount of the
change fund is maintained.

Cash Short and Over

The amount of cash actually received during day often does not agree with the record of cash receipts. Whenever
there is a difference between the records and the actual cash and no error is found in a record, it is assumed that
the mistake occurred in making change. If the amount of cash available for deposit is greater than the amount
shown on the record, the cash is said to be over. If there is less cash than the record, it is said to be cash short. In
practice, cash tends to be short often times than over, perhaps because customers are more likely to notice and
complain if they receive too little change than if they receive too much. The common method of handling such
mistakes is to open the Cash short and over account. Then, if there is cash short, the amount of the short is
entered in the debit side of the Cash short and over account. If cash is over, the amount is entered as a credit to
Cash Short & Over account.
Example: the amount counted on the hands of cashier is Br.10, 320, but the cash register indicates
Br.10, 350 for one day’s receipts (there is cash short of Br.30). The journal entry would be:
Cash in bank……………………….10,320
Cash short and over………………… 30
Sales……………………………………………….. 10,350

If there is a debit balance in the Cash Short and Over account at the end of the fiscal period, it is a reported as
“Miscellaneous expense’’ on the income statement. If there is a credit balance, it is reported as “Other income’’
on the income statement. Although errors in handling cash receipts can be expected, large shortages or overages
should be investigated. Similarly, if shortages or overages occur too often, it is wise to investigate the situation.

CHAPTER 5
RECIEVABLES AND TEMPORARY INVESTMENTS
Introduction

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The term receivable includes all money claims against people, organization or other debtors. Receivables are
acquired by a business enterprise in various kinds of transaction; the most common is from the sale of
merchandise or service on credit bases. They are mostly classified as account receivable and notes receivable.
Account Receivable is an amount owed by customers on account. It results from credit sale of goods and
services and it is generally expected to be collected within 30 to 60 days.
Notes Receivable represents claims that are evidenced by formal instrument of credit. The credit instrument
formally requires the debtor to pay interest extends from the period of 60 days to one year.
For many businesses, the revenue from sales on credit basis is the largest factor influencing the amount of net
income. As credit is granted, businesses must account for the resulting receivables, which may represent a
substantial portion of the total current assets. On the other hand, there is the probability that the businesses will
be unable to collect some of the amounts owed by credit customers. Whenever there are credit transactions, some
people fail to pay their obligations. Such losses will occur inevitably, and they must be considered as an expense
of doing business on credit. In addition, it is essential that managers keep informed about these losses from
uncollectible receivables. This enables them to determine the effectiveness of the credit policies (or procedures)
used by their firm, especially with regard to profitability.
Managers must also be alert to the possibility of investing idle funds for short periods in order to earn income
until the money is required in business operations. If the amount of cash on hand exceeds immediate cash
requirements, the excess cash has to be invested in securities until needed. Managers must keep a close watch
over investments in securities by appraising any changes in market conditions.

Accounting for Notes Receivables

A promissory note is an unconditional promise to pay a definite sum of money on demand or at a future date.
The one who signs the note is called the maker. The entity to which payment is to be made is called the payee.
The payee regards all promissory notes it holds and that are due in less
than one year as notes receivable in the current assets section of the balance sheet. The makers regard them as
notes payable in the current liability section of the balance sheet.
Many companies accept notes receivable in settlement of past-due accounts. Notes produce interest income and
represent a stronger legal claim than do accounts receivable. Selling or discounting notes is a common financing
method. Note Receivables are frequently accepted from customer who needs to extend the credit period of
outstanding account receivable .It is also accepted from high risky customer.
Note is a written promise to pay a sum of money on demand or at a definite time. A note receivable is usually
interest bearing (earns of interest for the period between the issuance date and the due date). However, if the
parties prefer it in that way, it can also be non-interest bearing. A note may serve as the basis for granting credit
in certain sales transactions. The buyer’s written promise gives the seller assurance of collection than a regular
account. The note applies moral pressure on the buyer and gives legal protection to the seller. The seller may
also earn interest in return for granting credit.
A firm may accept a note receivable from a customer at the time of a sale or while extending credit on a past-due
account receivable.
Several terms are important in accounting for promissory notes.
1. Maturity date.
• The date on which the note must be paid.
2. Duration of note.
• The length of time in days between a promissory note’s issue date and its maturity date.
3. Interest and interest rate.
• The cost of borrowing money or the return for lending money.
4. Maturity value.

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 The total proceeds at the maturity date

The procedures for handling notes receivable can be understood from the following example.
Non- Interest Bearing Notes Receivable
If the note is non- interest bearing the face value as well as the maturity value of the note are equal.
Example:
The account receivable from Dell enterprise, which has a balance of Br 10,000, is past due. A 90 days non
interest-bearing note for the amount was accepted in settlement of the account on May 16, 2000.
The entry to record the transaction is as follows:
May 16. Notes receivable…………. Br10,000
Account receivable……………10,000

On the maturity date the face value of the note, Br 10,000 is collected and recorded as follows:
Aug 14. Cash ………….10, 000
Notes receivable………..10,000
The maturity date (the date on which the note is collected), for the above note is computed as follows:
Total credit period…………………………………....90 days
Days in May after the notes is accepted 31-16…... 15
75
Days in June…………………………………………. 30
45
Days in July………………………………………….. 31
Maturity day (August)…………………………….......14
Interest bearing note receivables
If the note is the one that bears or earns interest, it is said to be interest-bearing note. Assume that WX Company
accepted a 60-day, 8% note of 6000 from JR Company in settlement of the past due account receivable on
October 21, 2000.
Oct 21. Notes receivable ……………..6000
Account receivable……………..6000
Dec20 cash………………6080
Interest income ………80
Notes receivable……6000
Interest = Principal x Interest Rate x Time in years
Interest = (6000 x8%X60/360) = Br80

Discounting Note Receivable

One of the advantages of a note receivable over an account receivable is that, the holder of the note can discount
it at a bank. Selling or discounting notes is a common financing method .That is, when a firm is in need of cash,
it may transfer its notes receivable to a bank by endorsement. The bank takes the note and charges interest at a
specified rate. The discount (interest) charged by the bank is computed on the maturity value of the note
applying discount rate for the period of time the bank holds the note, namely the number of days remaining until
maturity (the difference between the date of the transfer and the due date of the note). The bank deducts the
discount in advance and the endorser receives the “net proceeds” (the maturity value less the discount charge) or
the excess of the maturity value of the note over the discount.
Example:
Assume that the Kate Company accepted 60 days, 7% note of Br 600 dated April 17 from Warrior company in
settlement of the past due account. On May 2, Kate Company has discounted the note at Dashen bank at 8%. The

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maturity date of the note is June 16. On May 2, the Kate Company decided to discount Warrior Company’s note
at the bank at stated rate.
The discount and the proceeds on the note receivable are computed as follows:
Step 1, Maturity value.
Maturity value = principal (face value) + interest
60
The interest for 60 days at 7% ( 360 x 0.07 x Br 600) = Br. 7.
Thus, the maturity value of the note = 600 + 7 =607
Step 2. Determine the number of days in the discount period (the number of days from the discount date to
maturity date). This number can be computed by working back ward from the maturity date to the
discount date.
Maturity date……………………………. …............June 16
Discounting date …………………………………….May 2
Number of days from discount date to maturity date…..45 days.
Step 3. Determining the bank discount.
Bank discount is computed by Maturity value X Discount rate for the number of days between discount
day and maturity day (45 days)
Discount = Maturity Value X Discount Rate X Discount Period
Discount = Br 607 x 0.08 x 45/360
Discount = Br 6.07
Step 4 Determine the proceeds
The amount of proceed to be received from the bank is the difference between maturity value of the note and
bank discount, i.e.
Br 607 – Br 6.07 = Br 600.93
The discounting of the note receivable is recorded in the books of the Kate Company as follows:
April 17. Notes receivable…......600
Account receivable….....600
May 2. Cash …………..600.93
Notes receivable…………………600
Interest Income…………….…....0.93
Note that, if the proceed received is greater than the face value of the note, the difference is credited to interest
income .Likewise if the proceed received is less than the face value of the note the difference is debited to
interest expense.
Dishonored Notes Receivable
If the maker of the note fails to pay the debt on the maturity date, the note is said to be ‘’dishonored.’’ It
represents a note that is not collected on maturity date. A dishonored note receivable is no longer negotiable, and
the amount of the claim, including interest due against the customer (maker) is transferred to an Accounts
Receivable account.
If Warrior Company dishonors the note at maturity date, the Kate Company must pay the maturity value (the
face amount of the note plus the interest) to the bank. The firm charges the entire amount to the Accounts
Receivable account.
The entry to record the payment to the bank will be as follows:
June 16. Account Receivable ………607
Cash…………………… 607
Later when dishonored note is collected:
Cash………………………607
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Account receivable…........607

Accounting for Uncollectible Account Receivables

Once receivables are recorded in the accounts, the next question is, how should these receivables be reported on
the balance sheet. Because, some receivables may be uncollectible. To ensure that receivables are not overstated,
they have to be valued at net realizable value.
The income statement also is affected by the amount of uncollectible receivables. An expense for estimated
uncollectible is recorded to make certain that expenses are not understated and are matched with related revenue.
This expense is reported as bad debt expense on the income statement. Therefore, before receivables are
presented on the balance sheet and net income is computed, the accounts should be adjusted to reflect such
losses. There are two methods of accounting for uncollectible account receivable.
A. Direct write off
B. Allowance method
A) The Direct Write-Off
One procedure used by most small businesses is to wait until they make sure that the account of a specific
customer is definitely uncollectible to record the expense. The firm may carry the account on its books until the
account has definitely become uncollectible. Then, the direct charge-off method recognizes the loss at the time
the Account Receivable is determined to be uncollectible. It Reduces Account Receivable and increases
Uncollectible Accounts. The amount to be charged-off as a loss is debited to an expense account called Bad
Debts Expense, and credited to the asset account Accounts Receivable of the customer.
Suppose that Rosa Company, a customer of the Style Clothing, has bankrupted before paying its account balance
of Br. 750 and the Style Clothing decided to write-off the account as a bad debt as follows:
Sept. 16. Bad Debts Expense 750
Accounts Receivable 750
Sometimes, an account written-off as uncollectible may be collected later in total or in part. Under such cases,
two entries are made. The first is to reinstate the amount written off and the second is to record the collection.
Suppose that the account of Rosa Company has been collected in full after several months (on November 10).
Rosa Company’s account has already been written-off and the entry has to be reversed. The cash received up on
collection is recorded by debiting cash and crediting Account Receivable.
To reverse (reinstate) the account receivable that was written off is:
Nov. 10. Account recievable 750
Bad Debts Expense 750
Then, the collection of the money is recorded in the usual manner as a debit to cash and a credit to Accounts
Receivables.
Nov. 10. Cash 750
Account Recievable – Rosa co. 750

B) The Allowance Method

Bad debt expenses are matched against the sales they produced. At the time of sale, management cannot identify
which customers will not pay. To follow the matching rule, losses from uncollectible accounts must be
estimated. The estimate becomes an expense in the fiscal year in which the sales are made. Uncollectible
Accounts Expense appears on the income statement as an operating expense. Allowance for Uncollectible
Accounts appears on the balance sheet as a contra-asset account that is deducted from Accounts Receivable and
reduces the accounts receivable to the amount expected to be realized in cash.
Most large business enterprises put provisions for their receivables estimated to be uncollectible in the future.
This method permits the seller to match the estimated bad debt expenses against the sales revenue from which

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the accounts receivable has resulted. Even though it is not known which specific customers will not pay their
account, it allows the accountant to report accounts receivable on the balance sheet at the amount that is probably
collectible, rather than at the gross amount. In order to record bad debt expense and match it with the sales
revenue of the period, the losses likely to result from the estimated uncollectible receivable. The advance
provision for future uncollectible receivable is made by an adjusting entry at the end of the fiscal period.
Suppose that the Accounts Receivable account of Style Clothing has a balance of Br 200,000 at the end of the
period. After certain analysis, it is estimated that a total of Br. 4,500 will not be collectible. The amount expected
to be realized from the accounts receivable is, therefore, Br. 195,500 (Br. 200,000 – Br. 4,500), and the Br. 4,500
reduction is the uncollectible expense accounts for the period. The Br 4,500 reduction in accounts receivable
cannot yet be identified with specific customer accounts. Therefore, account receivable is not credited; instead, a
contra asset account called Allowance for doubtful account is used.
The entry to record this estimate in the journal is:
Dec 31. Bad Debts Expense 4,500
Allowance for Bad Debts 4,500

The effect of the debit part of the entry is to charge the estimated bad debt loss against the revenue of the period.
The credit part of the entry, the Allowance for Bad Debts accounts reflects the estimated shrinkage is the asset
accounts receivable. This account is called a valuation account, because it literally revalues or reappraises the
accounts receivable in the light of reasonable expectations. It is shown on the balance sheet as a deduction from
accounts receivable (as illustrated below).
Style Clothing
Balance Sheet
December 31,19X2
Assets
Current Assets:
Cash Br. 125,000
Accounts Receivable Br.200, 000
Less: Allowance for Bad Debts 4,500 195,500

Methods of Estimating Uncollectible Account

1. Percentage of Net Sales Method
This method asks the question, “How much of this year’s net sales will not be collected?” The answer is the
amount of uncollectible expense for the year. It is usually based on the company’s historical background interns
of default rate of accounts receivable collection. Allowance for Uncollectible Accounts contains the accumulated
amount from previous years.
For instance, the adjusting entry to record uncollectible accounts expense at 2% of Br600,000 net sales will be:
Uncollectible Accounts Expense 12,000
Allowance for Uncollectible Accounts 12,000
2. Accounts Receivable Aging Method
When this method is used, the accountant asks the question, “how much of the year-end balance of Account
Receivable will not be collected?” The difference between the amount determined to be uncollectible and the
prior balance of the Allowance for Uncollectible Accounts is the expense for the year. The aging of Account
Receivable is the process of listing each customer’s account according to the due date of the account. Assume
that the more the account receivable is past due, the less likely that it will be collected.
Example:

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Computed balance for uncollectible accounts……………………. Br2,459

Less: Credit balance in allowance for Uncollectible Accounts…….…..800
Uncollectible Accounts Expense for the period………………… Br1,659
The adjusting entry to record the uncollectible account receivable estimated using the aging of receivable method
is:
Uncollectible Accounts Expense 1,659
Allowance for Uncollectible Accounts 1,659

Write-Off of the Allowance Account

As we have just discussed, under the allowance method, Bad Debts Expense are debited and Allowance for Bad
Debt is credited for the estimated amount of uncollectible. Then, when a particular customer’s account has been
proved uncollectible, it is written- off. The amount owed is debited to Allowance for Bad Debt account and the
offsetting credit goes to the Accounts Receivable account of the specific customer in the ledger. Suppose that the
Style Clothing determines that the account of Roman shop with a balance of Br. 600 is uncollectible. The
accountant writes-off the account by making the following journal entry:
March 10. Allowance for Bad Debts 600
Accounts Receivable/Roman Abebe 600
Notice that when bad debt expenses are provided for in advance, the write-off of a particular uncollectible
account does not involve an entry in the Bad Debts Expense account. The expense has already been recorded by
means of the adjustment for estimated bad debt expenses made at the end of the period in which the sale took
place.
Collecting an Account that was Written-Off
Like the direct write-off method, when a firm uses the allowance method to provide for bad debts, the recovery
of an account previously charged-off as uncollectible also requires an entry to reverse the entry made at the time
of the write-off and to record collection. For example, the recovery of Br. 600 balance owed by Roman shop is
recorded in general journal form as shown below. Notice that Account Receivable account is debited and
Allowance for Bad Debt account is credited to reinstate the entry.
June 8. Account recievable – Roman shop 600
Allowance for Bad Debt 600
To record the collection of the account receivable:
June 8. Cash 600
Account Receivable- Roman shop 600

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