Fundamentals of Accounting I (ACFn 2031)

UNIT 1: ACCOUNTING PRINCIPLES AND PRACTICES

1.1. The Nature of Accounting
Accounting: is the process of recording, summarizing, analyzing, and interpreting financial
activities to permit individuals and organization to make informed judgments and decisions.
 Recording: making written records of events
 Summarizing: The process of combining these written records
 Analyzing: examining these reports by breaking them down in order to determine
financial success or failure.
 Interpreting: involves the use of financial data to make sound decision.
By law all businesses must keep accounting records. Decisions are based on accounting
information for profit and non-profit companies alike. There are different forms of business
organizations:
 Private business—objective is to earn a profit
 Sole Proprietorship—owned by one person
 Partnership—co-owned by two or more persons
 Corporation—owned by investors called stockholders (The business—not the owners—are
responsible for the company’s obligations.)
There are different types of business organizations:
 Service business: render/provide services to customers like doctors, lawyers, barber shop, etc.
 Merchandising business—purchases goods for resale
 Manufacturing business—produces a product to sell
1.2. Accounting as an Information System
Accounting is often called the “language of business”. This language can be viewed as an
information system that provides essential information about the financial activities of an entity to
various individuals or groups for their use in making informed judgments and decisions.
Why an Accounting system is an important?
An effective accounting system captures large amounts of data and organizes it into
understandable, useful information. This information is used within the organization for a variety
of purposes, such as:
 Development of Business Strategy
 Identification of Areas of Risk
 Budgeting
 Trend Analysis
And also by those outside of the organization, accounting system used for purposes such as:
 Prospective Investing
 Creditworthiness
 Tax Liability Determination
 Regulatory Compliance
Users of accounting information
Interested parties are also called accounting information users. There are two broad categories of
accounting information users:
 internal users

 external users
Internal users:
 Internal users are parties inside the reporting entity (company) who are interested in the
accounting information.

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 Fundamentals of Accounting I (ACFn 2031)
 Internal users are those individuals directly involved in managing and operating an
organization.
Example: managers-for controlling, monitoring and planning, officers, internal auditors, sales
managers, budget officer, other internal decision maker.
External users
 External users are parties outside the reporting entity (company) who are interested in the
accounting information.
 They are not directly involved in running the organization.
Examples:
 lenders(banks and financial companies)-whether an organization is likely to repay its loan
with interest and to grant loan
 shareholders(investors)-what is income for current and past periods-to assess the return and
risk in acquiring shares
 External auditors-to examine and provide an opinion on whether financial statements are
prepared according to GAAP.
 Employees-to judge the fairness of their wages, to assess future jobs prospective.
 Regulators(internal revenue service, tax authorities)-to compute taxes
 Others such as:
 Voters, Legislators, elected officials to monitor and evaluate a government receipts
and expenses.
 Contributors to not for profit organization-to evaluate the use and impact of their
donations.
 Suppliers – to judge the soundness of the business before making sales on credit.
 Customers –to assess the staying power of suppliers.
1.3. The Elements of Accounting
1. Assets
 are items with money value that are owned by a business.
 An item has a dollar (birr) value to be recorded in accounting records. Example:
cash, accounts receivable, supplies, inventories, equipment, land buildings etc
Business Entity Concept: this concept states that a business entity should be kept separate and
distinct from its owners, and any other economic activities.
2. Liabilities:
 debts owed by the business-obligation of a business.
 A liability that results from purchasing goods and services on credit is called
accounts payable. Other liabilities include notes payable, interest payable, wages
payable etc
3. Owner’s Equity:
 the difference between what is owned and what is owed is owner’s equity.
 It is the excess of assets over liabilities.
 Also called capital, proprietorship, net worth, and net asset.
4. Revenues:
 Revenues are increases in capital due to inflow of resources from business
operations such as, provision of services or sales of goods.
5. Expenses:
 Expenses are decrease in capital due to outflow of resources for the purpose of
business operations.
6. Drawings: An owner may withdraw cash or other assets during the accounting period for
personal use. These withdrawals could be recorded as a direct decrease of owner’s equity
and recorded in drawings account.
 Drawings decrease total owner’s equity.

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 Fundamentals of Accounting I (ACFn 2031)

Basic Accounting Equation

The relationship among the accounting elements can be expressed in a single mathematical form
known as the accounting equation or the basic accounting equation (balance sheet equation)
Equities: are claims against the asset of a business.
Assets = Equities
Claims are divided into two categories:
 Creditors' claims that are called liabilities

 Owners' claims that are called equity

Assets = Liabilities + Owner’s Equity
A= L + OE
If a company goes bankrupt, liabilities are paid off first to creditors, while owner’s equity is the
last to be distributed. Therefore, owners' equity is also called residual equity.
1.4. Business Transactions and Accounting Equation
 Any activity that changes the value of assets, liabilities, owner’s equity, revenue or
expenses is called transaction.
 Business transaction is an exchange of economic consideration between two
parties/event of occurrence or condition that must be recorded.
E.g. hiring an employee does not change the value of any assets, liabilities and owner’s equity, so
it is not a transaction.
 Transaction can be created internally or external.
Internal transaction: internally created
E.g. Salary payment, Depreciation, Supplies, Allowance for uncollectible
External transaction: transaction related to outsiders
Example: purchase of asset on account, cash payment to a creditor, receipt of cash for service
rendered, payment of rent and collection of accounts receivable
ILLUSTRATION
Recording the effect of transactions on the accounting Equation for the Month ended
December 31,2010
a) Alex the owner of Alex Barber invested Br. 10,000 cash in the business
b) Invested supplies valued at Birr 2000 in the business.
c) Paid rent for the month Birr 600.
d) Performed service and received cash Br 800.
e) Purchased supplies on credit Br 200.
f) Preformed service on credit, Br 625
g) Withdrew cash for personal use Br 500.
Assets Liabilities + Owners’ Equity Description
Cash + A/R + Supplies = A/Payable + Alex, Capital
a. Br.10,000 Br10,000 Investment
b. 2,000 2,000 Investment
c. (600) (600) Rent expense
d. 800 800 Revenue
e. 200 200
f. 625 625 Revenue
g. (500) (500) Withdrawal
h. 250 (250)
Total 9,950 + 375 + 2,200 = 200 + 12,325
h) Received Br 250 cash as partial payment for service performed on account.

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 Fundamentals of Accounting I (ACFn 2031)

Dr. Br12,525 Cr. Br12,525

1.5. Financial Statements
 Financial statements are summaries of financial activities of an enterprise.
 Financial statements are prepared at the end of an accounting period
 Financial statements are prepared from business transitions.
 Financial statements are output of accounting system
Time Period (Periodicity) concept: the economic life of a business should be divided in to
artificial period of time. Analysis of Financial condition and preparation of financial statements is
done at regular intervals.
 The length of time for which an analysis of business operations is done is called a Fiscal
Period or Accounting period.
 Fiscal period/accounting period may consist either of: a month usually minimum, a quarter,
semiannual, a year –usually maximum length.
 The accounting time period of one year in length is usually known as a fiscal
year.
The four major financial statements are:
1. Income statement:
 Describes a company’s revenues and expenses along with the resulting net income
or net loss over a period of time.
 An income statement is also called Statement of Operations, Earnings Statement,
or Profit and Loss Statement (P/L).
 When revenue exceeds expenses, there is a net income.
 When expenses exceed revenue, there is a net loss.
2. Statement of Owner’s equity:
 Explains changes in equity due to items such as net income, net loss, owner’s
investment, and owner’s withdrawal over a period of time.
 Expenses & owner’s withdrawal decreases the Owners equity of a business.
 Revenues & owner’s investment increases the Owners equity of a business.
 Preparation of owners’ equity statement is optional.
3. Balance sheet:
 A listing of a firm’s assets, liabilities and owner’s equity at a specific date.
 A balance sheet is also called Statement of Financial Position.
There are two forms of balance sheet:
 An account form balance sheet.
 a report form balance sheet
The body of account form balance sheet has two sides: a left-hand side and a right-hand side.
The assets of a business are listed on the left-hand side of the balance sheet. The liabilities and
capital are listed on the right-hand side of the balance sheet.

Account form Balance Sheet (Two sides of balance sheet)

Left-hand side Right-hand-side

A) ASSETS B) LIABILITIES
(What is owned?) (What is owed?)
C) CAPITAL
(What the businesses worth)

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TOTAL ASSETS Total LIABILITIES + CAPITAL

In report form of balance sheet, all items—assets, liabilities, and capital—are listed down in the
order shown below:
Report form balance sheet

Account Titles
Amounts
Assets
xx
Total Assets
xx
Liabilities
xx
Capital
xx
Total Liabilities & Capital
xx
4. Statement of cash flows: identifies cash inflows and outflows over a period of time.
There are 3 types of cash flows (CF):
 Cash flow from operating activities – cash flow generated by normal business operations
 Cash flow from investing activities – cash flow from buying and selling assets: buildings,
real estate, investment portfolios, equipment.
 Cash flow from financing activities – cash flow from investors or long-term creditors

Financial statements have these elements:

 A proper heading, consisting of

o Company Name
o Title of Statement
o Time Period or Date of Statement
 The body of the statement presenting financial information, in correct format.
 Totals and subtotals, specific to each financial statement.
 Articulation of balances and totals between statements.
 Notes disclosing additional information according to GAAP

See the following financial statements prepared for Alex Barber, service business from the above
transactions.

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 Fundamentals of Accounting I (ACFn 2031)

Alax Barber
Income statement
For the month ended December 31,2010
Revenue (service fee) …………………… Br1,425
Operating expense:
Rent expense …………………. … Br. 600
Net income ………………………………. Br825
Alax Barber
A statement of Owner’s Equity
For the month ended December 31,2010

Alex Beginning capital……………………………0

Add: Investment during the year ………. Br12,000
Net income (net loss)………………………. 825
Less: Withdrawal ……………………………..(500)
Alex, Ending capital -------------------------Br12,325
Alax Barber
Balance sheet
December 31,2010
Assets
Cash.……………………………………….Br9,950
Accounts receivable…………………………… 375
Supplies……………………………………… 2,200
Total assets……………………………... Br12,525
Liabilities
Accounts payable……………………………….. 200
Owner’s equity
Alex, capital…………………………………..12,325
Total liabilities and owner’s equity…………Br12,525
Alax Barber
Cash Flow Statement
For the month ended December 31,2010
Cash inflows:
Collection from customers Br1,050
Investment by the owner 10,000
Total cash inflows Br11,050
Cash outflows:
Expenses 600
Withdrawal 500
Total cash outflows 1,100
Net cash flow Br9,950

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 Fundamentals of Accounting I (ACFn 2031)

1.6. Top 10 differences between IFRS and GAAP accounting

We live in an increasingly global economy, so it’s important for business owners and accounting
professionals to be aware of the differences between the two predominant accounting methods
used around the world. International Financial Reporting Standards (IFRS) – as the name implies –
is an international standard developed by the International Accounting Standards Board (IASB).
U.S. Generally Accepted Accounting Principles (GAAP) is only used in the United States. GAAP
is established by the Financial Accounting Standards Board (FASB).

Let’s look at the 10 biggest differences between IFRS and GAAP accounting.

1. Local vs. Global

IFRS is used in more than 110 countries around the world, including the EU and many Asian and
South American countries. GAAP, on the other hand, is only used in the United States. Companies
that operate in the U.S. and overseas may have more complexities in their accounting.

2. Rules vs. Principles

GAAP tends to be more rules-based, while IFRS tends to be more principles-based. Under GAAP,
companies may have industry-specific rules and guidelines to follow, while IFRS has principles
that require judgment and interpretation to determine how they are to be applied in a given
situation.

However, convergence projects between FASB and IASB have resulted in new GAAP and IFRS
standards that share more similarities than differences. For example, the recent GAAP standard for
revenue from contracts with customers, Auditing Standards Update (ASU) No. 2014-09 (Topic
606) and the corresponding IFRS standard, IFRS 15, share a common principles-based approach.

3. Inventory Methods

Both GAAP and IFRS allow First In, First Out (FIFO), weighted-average cost, and specific
identification methods for valuing inventories. However, GAAP also allows the Last In, First Out
(LIFO) method, which is not allowed under IFRS. Using the LIFO method may result in
artificially low net income and may not reflect the actual flow of inventory items through a
company.

4. Inventory Write-Down Reversals

Both methods allow inventories to be written down to market value. However, if the market value
later increases, only IFRS allows the earlier write-down to be reversed. Under GAAP, reversal of
earlier write-downs is prohibited. Inventory valuation may be more volatile under IFRS.

5. Fair Value Revaluations

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IFRS allows revaluation of the following assets to fair value if fair value can be measured reliably:
inventories, property, plant & equipment, intangible assets, and investments in marketable
securities. This revaluation may be either an increase or a decrease to the asset’s value. Under
GAAP, revaluation is prohibited except for marketable securities.

6. Impairment Losses

Both standards allow for the recognition of impairment losses on long-lived assets when the
market value of an asset declines. When conditions change, IFRS allows impairment losses to be
reversed for all types of assets except goodwill. GAAP takes a more conservative approach and
prohibits reversals of impairment losses for all types of assets.

7. Intangible Assets

Internal costs to create intangible assets, such as development costs, are capitalized under IFRS
when certain criteria are met. These criteria include consideration of the future economic benefits.

Under GAAP, development costs are expensed as incurred, with the exception of internally
developed software. For software that will be used externally, costs are capitalized once
technological feasibility has been demonstrated. If the software will only be used internally,
GAAP requires capitalization only during the development stage. IFRS has no specific guidance
for software.

8. Fixed Assets

GAAP requires that long-lived assets, such as buildings, furniture and equipment, be valued at
historic cost and depreciated appropriately. Under IFRS, these same assets are initially valued at
cost, but can later be revalued up or down to market value. Any separate components of an asset
with different useful lives are required to be depreciated separately under IFRS. GAAP allows for
component depreciation, but it is not required.

9. Investment Property

IFRS includes the distinct category of investment property, which is defined as property held for
rental income or capital appreciation. Investment property is initially measured at cost, and can be
subsequently revalued to market value. GAAP has no such separate category.

10. Lease Accounting

While the approaches under GAAP and IFRS share a common framework, there are a few notable
differences. IFRS has a de minimum exception, which allows lessees to exclude leases for low-
valued assets, while GAAP has no such exception. The IFRS standard includes leases for some
kinds of intangible assets, while GAAP categorically excludes leases of all intangible assets from
the scope of the lease accounting standard.

Understanding these differences between IFRS and GAAP accounting is essential for business
owners operating internationally. Investors and other stakeholders need to be aware of these
differences so they can correctly interpret financials under either standard.

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 Fundamentals of Accounting I (ACFn 2031)

UNIT TWO: THE ACCOUNTING CYCLE FOR A SERVICE BUSINES

2.1. Classification of Accounts
Accounting Cycle - sequence of procedures used to record, classify and summarize accounting
information in financial reports, on a regular basis.
Account:
 Account is an individual record or form used to record or to summarize information related
to each asset, each liability, and each aspect of owner’s equity, each expense and revenue.
 used to record the changes caused by business transactions
 Account is a storage bin.
There are 5 types of Accounts (Classification of Accounts):
1) Assets
2) Liabilities
3) Owners' Equity (Stockholders' Equity for a corporation)
4) Revenues
5) Expenses
1. Assets: any physical thing (tangible) or right (intangible) that has a value is an asset.
Current asset: asset that may reasonably be expected to be realized in cash or sold or used
up usually within one year or less.
Example: cash, account receivable, supplies, inventory, short term notes receivable.
Plant assets (fixed assets) tangible asset used in the business that are of a permanent or
relatively fixed nature. Fixed assets include: equipment, machinery, buildings, and land.
2. Liabilities: debts owed to outsiders (creditors)
Current liabilities: liabilities due within a short time (usually one year or less) and that are to be
paid out of current assets.
Example: account payable, short note payable, salaries payable, interest payable, tax
payable, unearned revenue.
Long term liability: liability that will not be due for a comparatively long time (usually more than
one year) or company’s obligations not expected to be paid within one year (or a longer operating
cycle). Example: long term notes payable, bonds payable, lease liabilities.
3. Owner’s equity: residual claim against the business asset after the total liabilities are deducted.
4. Revenues: gross increase in owner’s equity as a result of the sale of merchandize, performance
of service to customer, rental of property, lending of money, and other business and
professional activities.
5. Expenses: costs that have been consumed in the process of producing revenue are expired
costs or expenses.
Drawings: drawings represent the amount of withdrawals made by the owner of business.
Standard form of account has three major parts:
1. The account title and number
2. The left side, which is called the debit side
3. The right side, which is called the credit side.
There are two forms of accounts: two amount columns account and four amount column
account.
Two amount column account:
Account Title: Account No.:

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 Fundamentals of Accounting I (ACFn 2031)
Date Item Post Debit Date Item Post Credit
Ref. Ref.

Four-amount column account:

Account Title: Account No.:
Date Item Post. Ref. Debit Credit Balance
Debit Credit

The following advantages of the four-column account as compared with the two-column are: The
four-column account:
1) provides an easy means of analyzing and examining the accounts,
2) presents transactions in their chronological order of occurrence as the journal does,
facilitating easy location,
3) uses only one date column, saving space and time required for analysis, and
4) Makes balance of an account always available after each transaction is transferred to
the account.
Accounts are often grouped together in a book form; such a grouping of accounts is called a ledger.
Thus, accounts are frequently referred to as ledger accounts. A skeleton version of a standard form
of account, used for ease analysis of account balance is called T account.
The T account has three parts:
1. The account title
2. Space for recording increases in the amount of the item, and
3. Space for recording decreases in the amount of the item
Title of account
Left Side Right side
(Debit side) (Credit side)

 The left side of any account is the debit side and the right side is called the credit side.
Chart of Accounts
 A list of accounts in the ledger.
 outline the order of accounts in the ledger
 directory of accounts available in the ledger

Sample Chart of accounts

Assets
11 Cash
12 Accounts receivable
13 Supplies
16 Office equipment
17 Office furniture
Liabilities
21 Accounts payable
22 Salaries payable
Owner’s equity
31 Capitals
32 Drawing
Revenue
41 Service revenue
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Expenses
51 Rent expense
52 Supplies expense
53 Repairs
54 Expense

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 Fundamentals of Accounting I (ACFn2031)
 The first digit of account number indicates major division of the ledger in which account is
placed.
 A second digit of account number indicates position of account with in its division.
2.2. Rules of Debit and Credit
Depending on the nature of account affected debit or credit may be either decrease or increase.
 Debit can signify either increase or decrease
 Credit can signify either increase or decrease
Debit and Credit rules of accounts:
Account Increase side Decrease side Normal Balance
Any Asset Debit Credit Debit
Any Liability Credit Debit Credit
Owner’s equity (Capital) Credit Debit Credit
Any Revenue Credit Debit Credit
Any Expense Debit Credit Debit
Owner’s drawing Debit Credit Debit

Balance of an account: account balance is the difference between the increase and decrease
recorded in an account. The normal balance of all accounts are positive rather than negative
because the sum of the increases recorded in an account is usually equal to or greater than the
sum of the decreases recorded in the account.

Double entry Accounting- The Equality of Debits and Credits

The double entry system of accounting takes its name from the fact that every business
transaction is recorded by two types of entries:
1. Debit entries to one or more accounts and
2. Credit entries to one or more accounts. In recording any transaction, the total dollar (birr)
amount of the debit entries must equal the total dollar (birr) amount of the credit entries.

Journal:
 Is the book in which the records of business are written.
 It is a chronological record of events.
General journal:
 Is the original book of entry
 Information recorded on this book is usually extracted from the source documents such as
invoices, receipts, contracts agreements and many other relevant documents.
 It would usually show the account to be debited and credited and short description on the
transaction.
 Information on this book will be posted to the ledger.
 General journal is used to record all kinds of entries
Forms of Two Column Journal
Date Description P/R Debit Credit

Special Journals:
 A journal in which only one kind of business transaction is recorded is a special journal
used to record only one type of entries.
 Special journals differ from the general journal or the combination journal in that they are
meant only for specified types of transactions—only one type.

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Sales journal: Sales journal is a special journal used to record only sales of merchandized on
account.
Purchase journal: used to record purchase on account
Cash receipt journal: use to record cash receipt (cash collection)
Cash payment journal: used to record payment of cash.
Combination Journal: is a multi-column journal that combines all journals into one book of
original entry.
Companies may use various kinds of journals, but every company has the most basic form of
journal, a general journal. Typically, a general journal has; spaces for dates, account titles and
explanations, references, and two money (amount) columns.
The journal makes several significant contributions to the recording process:
1. It discloses in one place the complete effect of a transaction.
2. It provides a chronological record of transactions.
3. It helps to prevent or locate errors because the debit and credit amounts for each entry can
be readily compared.
2.3. Recording Business Transactions
Entering transaction data in the journal is known as journalizing. The process of recording a
transaction in a two column journal involves:
1. Record the date(year, month, and date)
2. Record the debit part(title of account and amount)
3. Record the credit part(title of account and amount)
4. Write an explanation in the description column.
Before recording each transaction, you should decide:
1. Which accounts are affected by the transaction
2. Whether there is an increase or decrease in the accounts
3. How to increase or decrease (debit or credit) the accounts involved.
To illustrate, assume that Wisdom Company incurred the following transactions during April
2011:
Transactions:
1. Mr. Wisdom invested Br.10, 000 cash in to his business to get it started.
2. Purchased office equipment for Br3,000 on account
3. Purchased office supplies for cash Br125
4. Paid Br500 on equipment purchased in transaction(2)
5. Paid first month rent Br400
6. Paid for repairs to equipment Br50
7. Received cash from customer for services Br1,800
8. Performed services on account Br400
9. Mr. Wisdom withdrew Br800 cash from the business for personal use.
10. Collected Br100 cash on account from credit customers in transaction(8)
Record the above transactions in a general journal.

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 Fundamentals of Accounting I (ACFn2031)
GENERAL JOURNAL
Date Account Titles and Explanation Ref. Debit Credit
2011
April. 1 Cash 10,000
Wisdom, Capital 10,000
(invested cash in business)
2 Office Equipment 7,000
Account payable 7,000
(purchased equipment on account)
3 Office supplies 125
Cash 125
(purchased equipment for cash)
4 Account payable 500
Cash 500
(payment of on account)
5 Rent expense 400
Cash 400
(paid cash for rent)
6 Repairs expense 50
Cash 50
(Paid cash for repair)
7 Cash 1,800
Service revenue 1,800
(collection of on account)
8 Account receivable 400
Service revenue 400
(service rendered on credit)
9 Wisdom, Drawing 800
Cash 800
( cash withdrawn by the owner)
10 Cash 100
Account receivable 100
(collection of credit)

Posting: The procedure of transferring journal entries to the ledger accounts is called posting.
Advantages of Posting:
 Posting summarizes entries in the journal into accounts in the ledger,
 It can also be viewed as sorting journal entries into accounts.
 Posting is an activity that summarizes the records in the journal so as to make them
convenient for analysis and reporting.
 It brings all data of one kind together.
General ledger is the main book of accounts. This is the book where all the accounts are kept.
Each account maintained in this book will contain specifically information that relates to that
particular item alone. Information will generally be from the journal.
Ledger:
 Ledger is a collection of accounts together in one book
 Ledger is a group of accounts in a book. Because the information recorded in the ledger
originates from the journal, a ledger is also known as a book of secondary entry.

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 Fundamentals of Accounting I (ACFn2031)
 A ledger that contains all the accounts needed to prepare the income statement and the
balance sheet is called a general ledger.
 An account in the general ledger that summarizes all the accounts in the subsidiary ledger
is called a controlling account.
 A ledger that is summarized into and controlled by a single account in the general ledger
is called a subsidiary ledger.
 A single account in the subsidiary ledger is known as a subsidiary account.
The Trial Balance: A trial balance is a list of accounts and their balances at a given time.
Customarily, a trial balance is prepared at the end of an accounting period.
Trial Balance is:
 A list of accounts and their balances at a point in time.
 Used to prove the equality of debit and credit amount in the ledger.
 Does not provide complete proof of the accuracy of ledger.
 The primary purpose of a trial balance is to prove the mathematical equality of debits
and credits after posting.
 A trial balance also uncovers errors in journalizing and posting. In addition, it is useful
in the preparation of financial statements.
The procedures for preparing a trial balance consist of:
1. Listing the account titles and their balances.
2. Totaling the debit and credit columns.
3. Proving the equality of the two columns
Wisdom Company
Trial Balance
April 30,2011
Account title Account Debit Credit
number
Cash 11 10,025
Account receivable 12 300
Supplies 13 125
Equipment 16 7,000
Account payable 21 6,500
Wisdom, Capital 31 10,000
Wisdom, Drawing 32 800
Service revenue 41 2,200
Rent expense 51 400
Repair expense 53 50
Total 18,700 18,700
Limitations of a Trial Balance
A trial balance does not prove the all transactions have been recorded or that the ledger is correct.
Numerous errors may exist even though the trial balance columns agree. Errors not detected by a
trial balance among other things include the following
1. If the journalizing of a transaction is omitted altogether, the error will not be indicated by
the trial balance.
2. If an amount is posted to the correct side of a wrong account, trial balance column totals
will still be equal.

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 Fundamentals of Accounting I (ACFn2031)
3. If an entry is posted twice, the trial balance columns will be equal, failing to detect the
error.If posting of both debit and credit of an entry is omitted, the trial balance totals will
remain equal.
Common Errors that Cause a Trial Balance not to Balance
1. Errors in the addition of the trial balance columns. If there are arithmetic errors in
computing trial balance debit and/or credit totals, the trial will obviously be out of
balance. That is, debit total will not be equal to credit total.
2. Listing an account balance in the wrong column of a trial balance. If a correctly
determined account balance is put in the wrong column of the trial balance, it will result
in twice overstatement of the side in which the balance is wrongly put.
3. Mistakes in arithmetic when figuring account balances. Assuming that all entries
posted to ledger accounts do not have problems, an arithmetic error in determining an
account balance will later cause inequality of the trial balance totals.
4. Copying an amount incorrectly when journalizing, posting or preparing the trial
balance. An amount may be copied wrongly either from source document to a journal,
from a journal to accounts in the ledger, or from ledger to the trial balance. And, any of
these errors will make the trial balance totals not to balance.
5. Posting only one part of a journal entry. In double entry accounting, debit entries are
always accompanied by equal amount of credit entries. So, if only one part of these two
components is posted and the other component is not, you should not expect the trial
balance totals to be equal.
Steps in Locating Errors when the Trial Balance does not equal
After the trial balance has indicated that there is an accounting error, the next procedure would
be to locate the error. The steps in locating errors include:
1. Re-add the trial balance columns to prove the accuracy of the addition of these columns.
2. Find the difference between the totals of the trial balance columns. And then look in the
ledger to see if the difference is because of an omission from the trial balance.
3. Divide the amount of the difference between the two totals of the Trial Balance by 2 to check
if the difference is evenly divisible by 2—without remainder. If the difference is evenly
divisible by 2:
 Look through the accounts to see if this amount has been recorded on the wrong side of
an account. or
 Check if this amount has been written in the wrong column of the Trial Balance.
4. Divide the amount of the difference of the two totals of the Trial Balance by 9. If this
difference is evenly divisible by 9, look for an amount in the trial balance in which the digits
have been transposed in copying the balance from the ledger. Also, the digits might have
been transposed in posting from the journal.
 Transposition error – a reversal of digits e.g. 69.236 as 96.236
 Slide error- moving decimal points incorrectly. E.g.: 46.98 as 469.5 or 4.698
5. Compare the balances on the trial balance with the balances in the ledger accounts if there are
balances omitted from the trial balance, if balances are taken to wrong trial balance columns,
or both.
6. Verify the pencil footings and the account balances in the ledger if the error is due to wrong
account balance determination.
7. Verify the posting of each item in the journal by comparing what was recorded in the journal
against items posted to accounts in the ledger.

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 Fundamentals of Accounting I (ACFn2031)
UNIT THREE: COMPLETION OF THE ACCOUNTING CYCLE
3.1. Adjusting Entries
Accrual- Versus Cash-Basis Accounting
Accrual-Basis: Under this method, revenues and expenses are recognized as earned or incurred
Cash-Basis Accounting:
 The cash basis is much simpler, but its financial statement results can be very misleading
in the short run.
 Revenue is recorded when cash is received (no matter when it is "earned"), and expenses
are recognized when paid (no matter when "incurred").
 The cash basis is not compliant with GAAP.
Modified cash Basis Approaches:
 The cash and accrual techniques may be merged together to form a modified cash basis
system. The modified cash basis results in revenue and expense recognition as cash is
received and disbursed, with the exception of large cash outflows for long-lived assets
(which are recorded as assets and depreciated over time).
 The revenue recognition and matching principles are used under the accrual
basis of accounting.
 Generally, accepted accounting principles require accrual basis accounting
rather than cash basis accounting.
Matching principle:
 The matching principle dictates that efforts (expenses) be matched with
accomplishments (revenues) in the accounting period.
 The need for proper matching of revenues and expenses arises because of the
existence of accounting periods and of payments and receipts that apply for
different accounting periods.
Meaning Adjusting Entries
 Adjusting entries are entries made at the end of the period to bring the balances of
accounts that do not show their true balance to the true balance to be reported on the
financial reports
 Adjusting entries are required every time financial statements are prepared.
Adjusting entries can be classified:
The Need of Adjusting Entries

 To report all revenues earned during the accounting period.

 To report all expenses incurred to produce the revenues earned in the
same accounting period.
 To accurately report the assets on the balance sheet date. Some assets may
have been used up during the accounting period.
 To accurately report the liabilities on the balance sheet date. (Expenses
may have been incurred, but not yet paid.)

3.2. Types of Adjusting Entries

The number of adjustments needed at the end of each accounting period depends
entirely upon the nature of the company’s business activities. However, most
adjusting entries fall in to one of the four general categories:
1. Converting assets to expenses
2. Converting liabilities to revenue
3. Accruing unpaid expenses, and
4. Accruing uncollected revenue

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Deferrals:
 Deferrals are previously recorded assets, liabilities, revenues, or expenses that
need to be adjusted at the end of the period to reflect revenues earned or
expenses incurred in the current accounting period.
 Some of the deferred items for which adjusting entry would be made include:
prepaid insurance, prepaid rent, office supplies, depreciation, and unearned
revenue.
Deferral adjustments are of two types:
1. Prepaid expense (Assets/expense) adjustments
 Transfer amounts from asset accounts to expense accounts
2. Unearned revenue (deferred Revenue) Liability/revenue adjustments
 Transferring amounts from liability to revenue accounts.

Converting assets to Expenses /Prepaid Expense Adjustments:

Prepaid expenses are expenses paid in cash and recorded as assets before they are
used or consumed. Prepaid expenses expire with the passage of time or through use
and consumption.
 An asset-expense account relationship exists with prepaid expenses.
 Prior to adjustment, assets are overstated and expenses are understated.
 The adjusting entry results in a debit to an expense account and a credit to an
asset account.
Example 1: Assume that on November 15, the dental office paid Br 1, 800 for six
months of insurance coverage (from November 15 to May 15 of next year). This
results in Br300 coverage each full month. By December 31 (the end of the fiscal
period), the dentist will have received one and one-half months of coverage (Br 450).
Therefore, the following entry would be necessary:
Therefore on November 15, the following entry is made:
Date Accounts Debit Credit
2008
Nov. 15 Prepaid insurance expense 1800.00
Cash 1800.00
On November 15, the amount paid represents future benefits (insurance coverage) to
the dental office. The adjusting entry is to debit Insurance Expense and credit
Prepaid Insurance. On December 31, the following adjusting entry is prepared:
Date Accounts Debit Credit
2008
Dec. 31 Insurance Expense 450.00
Prepaid Insurance 450.00
Example 2: Assume that Gonzalez Company purchased Br 1,000 of supplies and
debits Office Supplies during the year 2008. The beginning balance of the Office
Supplies account was Br 200. At Dec. 31 2008, Br 300 of supplies was on hand. The
adjusting entry would, therefore, be:

Date Accounts Debit Credit

2008
Dec. 31 Supplies expense 900.00
Supplies 900.00

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 Fundamentals of Accounting I (ACFn2031)

Converting liabilities to Revenue (Unearned Revenue) Adjustments:

These are cash received before providing products or services. The cash received is
debited against the liability account when it is received. Revenues are recorded
when the work is done. So, we owe the work - it’s a liability. At the end of the
period, we reduce the liability to reflect the portion of the work that has been done
(this increases a revenue account).
 Unearned revenues are revenues received and recorded as liabilities before
they are earned.
 Unearned revenues are subsequently earned by rendering service to a
customer.
 A liability-revenue account relationship exists with unearned revenues.
 Prior to adjustment, liabilities are overstated and revenues are understated.
 The adjusting entry results in a debit to a liability account and a credit to a
revenue account.
Example: Assume that on December 1, the dental office accepted a Br 2,400
payment from local businesses to provide dental care to their employees over the
next three months. The initial entry on December 1 would be as follows:
Date Accounts Debit Credit
2008
Dec. 1 Cash 2400.00
Unearned Dental Fees 2400.00
The amount of cash received on December 1 represents what the dental office owes
to clients in the future. This is a liability since either the cash received must be
returned or the services must be delivered.
From December 1 to December 31, one month of dental service has been provided;
Br 800 x 1 month = Br 800 dental fee revenue. The remainder of Br 1,600 (Br
2,400 – Br 800) represents future dental service owed to businesses (a liability).
December 31 adjusting entry would be:
Date Accounts Debit Credit
2008 800.00
Dec. 31 Unearned Dental Fees
Dental Fees Earned 800.00

3.2.1.ACCRUAL ADJUSTMENTS
 Accruals are revenues that have been earned and expenses that have been
incurred by the end of the current accounting period, but that will be collected
or paid in a future accounting period.
 Accruals occur when no cash has been received or paid, but the company has
undertaken activities that result in earning revenues or incurring expenses.
 Unlike deferrals, no original entry has been recorded.
Examples:-
a. Interest earned but not yet collected on a loan: Accrued Interest
Receivable (Asset) (or simply Interest Receivable) – accrued revenue.
b. Wages earned by employees but not yet paid: Accrued Wages and
Salaries Payable (Liability) (or simply Wages and Salaries Payable) – an
accrued expense.
Accrual adjustments are of two types:
 accrued revenue and

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 Fundamentals of Accounting I (ACFn2031)
 accrued expenses
Accruing uncollected Revenue (Accrued Revenue):
 Accrued revenues are revenues earned, but not yet received in cash.
 Accrued revenues may accumulate with the passing of time as in the case of
interest and rent, or through services performed, but not billed or collected.
 Accrued revenue requires an asset/revenue adjustment
 An asset-revenue account relationship exists with accrued revenues.
 Prior to adjustment, both assets and revenues are understated.
 The adjusting entry results in a debit to an asset account and a credit to a
revenue account
To illustrate, consider a 12% note payable (Br. 1500) due on March 30, 2009 was
received by your business. The note was received on October 1, 2008. The interest
revenue earned on this note until Dec. 31, 2008 is calculated using the following
formula:
Interest = principal * rate * time
Therefore, the interest in this specific case would be,
Interest = 1,500 * 12% per year. * 3/12 year
= Br. 45.
The adjusting entry to record the interest expense incurred in October is:

Date Accounts Debit Credit

2008
Dec. 31 Interest Receivable 45
Interest Income 45

Accruing unpaid Expenses (Accrued Expense):

 Accrued expenses are expenses incurred, but not yet paid or recorded.
 Accrued expenses result from the same causes as accrued revenues and
include interest, rent, taxes, and salaries.
 A liability-expense account relationship exists with accrued expenses.
 Prior to adjustment, both liabilities and expenses are understated.
 The adjusting entry results in a debit to an expense account and a credit
to a liability account.
Example: Accrued salaries: Some types of expenses, such as employee salaries and
commissions, are paid for after the services have been performed. Assume that at Wisdom
Service Company, salaries were last paid on October 26 (Friday); the next payment of salaries
will not occur until November 9 (Friday). Three working days remain in October (October 29-
31).
At October 31, the salaries for these days represent an accrued expense and related liability to
Wisdom Company. The employees receive total salaries of Br.2,000 for a five-day workweek, or
Br.400 per day. Thus, accrued salaries at October 31 are Br.1,200 ( Br. 400 x 3), and the
adjusting entry is:
Oct. 31 Salaries expense 1,200
Salaries payable 1,200
(To record accrued salaries )

Depreciation:

 A portion of their cost is simply allocated to each accounting period.

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 Fundamentals of Accounting I (ACFn2031)
 This process is called depreciation.
 Depreciation is an example of a deferred expense. In this case the cost is deferred over a
number of years, rather than a number of months. Principles of accounting II will cover
depreciation methods in great detail. However, one simple approach is called the
straight-line method.
 Under this method, an equal amount of asset cost is assigned to each year of service life.
In other words, the cost of the asset is divided by the years of useful life, resulting in
annual depreciation expense.
Example: In January 1, 2000 the company buys a delivery truck for 12,000. They expect the
truck to last 5 years. They decide to use the straight line method, with a salvage value (SV) of
Br2,000. The depreciable value is Br10,000 (Br12,000 cost - Br 2,000 SV). The annual
depreciation expense is Br2,000 (Br10,000/ 5 years).
At the end of 5 years, the company has expensed Br10,000 of the total cost. The Br2,000
salvage value remains on the books.
General Journal
Date Account Debit Credit
Jan. 1, 2000 Delivery Trucks Br12,000
Cash Br12,000
To record purchase of delivery truck

Dec-31 Depreciation Expense Br2,000

Accumulated Depreciation Br2,000
To record depreciation expense for
the year
Book Value & Salvage Value
Book value is the difference between the cost of an asset, and the related accumulated
depreciation for that asset
Book Value = Cost - Accumulated Depreciation
Book Value = (Br12, 000 - Br10, 000) = Br2, 000
The company will stop depreciating the truck after the end of the fifth year. The truck cost
Br12,000, but only Br10,000 in depreciation expense was taken. The remaining book value is
equivalent to the salvage value established when the vehicle was purchased. Book value will be
used to calculate any gain or loss when the truck is sold or traded
Summery of Adjustment and Their Effects on the Financial Statements
Types of Before Adjustment
Adjustment Balance Sheet Income Statement Adjusting Entries
Prepaid Expense  Asset overstated  Expense Understated Debit Expense ---- Dr
(Deferred Expense)  Owner’s Equity overstated Credit Asset --------Cr
 Net Income Overstated
Unearned Revenue  Liability overstated  Revenue Understated Debit Liability ---- Dr
(Deferred Revenue)  Owner’s Equity Understated  Net Income Understated Credit Revenue ------- Cr

Accrued Expense  Liability Understated  Expense Understated Debit Expense ---- Dr

Credit Liability ----- Cr
 Owner’s Equity overstated  Net Income Overstated
Accrued Revenue  Asset Understated  Revenue Understated Debit Asset ---- Dr
Credit Revenue ------ Cr
 Owner’s Equity Understated  Net Income Understated
Fixed Assets  Asset overstated  Expense Understated Debit Expense ---- Dr
Credit Contra Asset ----Cr
 Owner’s Equity overstated  Net Income Overstated

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 Fundamentals of Accounting I (ACFn2031)
3.3. Alternative Treatment of Deferrals

As an example, recall the illustration of accounting for prepaid insurance -- Prepaid Insurance
was debited and Cash was credited at the time of purchase. This is referred to as a "balance
sheet approach" because the expenditure was initially recorded into a prepaid account on the
balance sheet. However, an alternative approach is the "income statement approach." With
this approach, the Expense account is debited at the time of purchase. The appropriate end-of-
period adjusting entry "establishes" the Prepaid Expense account with a debit for the amount
relating to future periods. The offsetting credit reduces the expense account to an amount equal
to the amount consumed during the period.

The balance sheet and income statement methods result in identical financial statements. Notice
that the income statement approach does have an advantage if the entire prepaid item or
unearned revenue is fully consumed or earned by the end of an accounting period. No adjusting
entry is needed because the expense or revenue was fully recorded at the date of the original
transaction.

Example: Assume that supplies worth Br 386 are purchased on Nov. 1, the entry
would be recorded as follows:

Date Accounts Debit Credit

2008
Dec. 31 Supplies Expense 386
Cash 386
If supplies on hand at the end of the year were worth Br 133, the adjusting entry
would be as follows:
Date Accounts Debit Credit
2008
Dec. 31 Supplies 133
Supplies Expense 133
In both alternatives, the supplies expense would be Br 253 and the asset portion
would be Br 133.
Example: assume you have advance collection of rent income for Br 450. If the
option of recording deferrals initially as income statement items is used, the entry
would be as follows:

Date Accounts Debit Credit

2008
Nov. 1 Cash 450
Rent Income 450

If Br 150 has been earned at Dec. 31, 2003, the adjusting entry transfers this amount
from the revenue account to a liability account as follows:
Date Accounts Debit Credit
2008
Dec. 31 Rent Income 450
Unearned Rent 450

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 Fundamentals of Accounting I (ACFn2031)
Meaning and Importance of Reversing Entries
 A reversing entry is simply an entry that reverses the debits and the credits of
the previous adjusting entry.
 Reversing entries are optional.
 They are used in order to make the accounting process more consistent or to
make later recording of related transaction simpler.
 If the company has the accounting policy of preparing reversing entries, the
adjusting entries for all accruals and for the deferrals that are first recorded as
expense and revenue (income statement) accounts are reversed.
Preparing a Work Sheet
The work sheet is an informal working paper that the accountant uses in preparing financial
statements and completing the work of accounting cycle. The work sheet has been described as
the accountant’s scratch pad, and it is used to:
1. Organize data
2. Lessen the possibility of overlooking an adjustment
3. Provide an arithmetical check on the accuracy of work, and
4. Arrange data in logical form for the preparation of financial statements. A work sheet is
not a permanent accounting record; it is neither a journal nor a part of the general ledger.
The use of work sheet is optional.
Steps in preparing a Work Sheet
Step 1: Prepare a trial balance on the work sheet.
Step 2: Enter the adjustments in the adjustment columns.
Step 3: Enter adjusted balances in the adjusted trial balance columns.
Step4: Extend adjusted trial balance amounts to appropriate financial statements columns.
Step 5: Total the statement columns, compute the net income (or net loss), and complete the
work sheet.
Illustration: The following information pertains to Hope Laundry at July 31,2008, the end of the
current fiscal year, and the data needed to determine year end adjustments:
Cash Br7,790
Laundry supplies 4,750
Prepaid insurance 2,825
Laundry equipment 85,600
Accumulated depreciation Br55,700
Accounts payable 4,950
Hope, capital 30,900
Hope, Drawing 18,000
Laundry Revenue 76,900
Wages expense 24,500
Rent expense 15,575
Utilities expense 8,500
Miscellaneous expense 910
Adjustment Data:
a) Inventory of laundry supplies at July 31…………Br1,840
b) Insurance premium expired during the year……… 1,500
c) Depreciation on equipment during the year………. 5,720
d) Wages accrued but paid at July 31………………... 850
Instructions:
1) Record the trial balance on a ten column work sheet.
2) Prepare financial statement from the work sheet:
a) income statement,

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 Fundamentals of Accounting I (ACFn2031)
b) Owner’s equity and
c) Balance sheet
3) Journalize the adjusting entries
4) Journalize the closing entries
1. Ten column worksheet
Hope Laundry
Work Sheet
For the year Ended July 31, 2008
Trial Balance Adjustments Adjusted trial Income Balance Sheet
Balance Statement
Account Titles Dr Cr Dr Cr Dr Cr Dr Cr Dr Cr
Cash Br7,790 7,790 7,790
Laundry supplies 4,750 2,910(a) 1,840 1,840
Prepaid insurance 2,825 1,500(b) 1,325 1,325
Equipment 85,600 85,600 85,600
Accu. depreciation 55,700 5,720(c) 61,420 61,420
Accounts payable 4,950 4,950 4,950
Hope, capital 30,900 30,900 30,900
Hope, Drawing 18,000 18,000 18,000
Laundry Revenue 76,900 76,900 76,900
Wages expense 24,500 850(d) 25,350 25,350
Rent expense 15,575 15,575 15,575
Utilities expense 8,500 8,500 8,500
Miscella. expense 910 910 910
Totals 168,450 168,450
Supplies expense 2,910(a) 2,910 2,910
Insurance expense 1,500(b) 1,500 1,500
Deprec. expense 5,720(c) 5,720 5,720
Wages payable 850(d) 850 850
Totals
10,980 10,980 175,020 175,020 60,465 76,900 114,555 98,120
Net income(net loss) 16,435 16,435
76,900 76,900 114,555 114,555
Totals

The preparations of financial statements from the work sheet of Hope Laundry are presented below.

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 Fundamentals of Accounting I (ACFn2031)
Hope Laundry
Income Statement
For the year Ended July 31, 2008
Revenues
Laundry Revenue 76,900
Expenses:
Wages Expense Br.25, 350
Rent expense 15,575
Supplies expense 2,910
Insurance Expense 1,500
Utilities Expense 8,500
Depreciation Expense 5,720
Miscellaneous expense 910
Total Expense 60,465
Net Income 16,435

Hope Laundry
Owner’s Equity Statement
For the year Ended July 31,2008

Hope, Capital, June 1 Br. 30,900

Add: Investment -0-
Net Income 16,435
Less: Drawing (18,000)
Hope, capital, October 31 29,335

Hope Laundry
Balance Sheet
July 31,2008
Assets
Cash Br.7,790
Laundry Supplies 1,840
Prepaid Insurance 1,325
Laundry Equipment 85,600
Less: Accumulated Depreciation 61,420 24,180
Total Assets Br. 35,135
Liabilities and Owner’s Equity
Liabilities
Account Payable 4,950
Wages Payable 850
Total Liabilities 5,800
Owner’s Equity
Hope, Capital 29,335
Total Liabilities and Owner’s Equity Br. 35,135
(2) Preparing Adjusting Entries from a Work Sheet
 The adjusting entries are prepared from the adjustment columns of the work sheet.
 The reference letters in the adjustment columns and the explanation of the adjustments
that appear at the bottom of the work sheet help identify entries.
 The journalizing and posting of adjusting entries follows the preparation of financial
statements when a work sheet is used.
The adjusting entries on July 31 for Hope Laundry are shown below:
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 Fundamentals of Accounting I (ACFn2031)

GENERAL JOURNAL J1
Date Account Titles and Explanation Ref. Debit Credit
Adjusting Entries
2008
July 31 Laundry Supplies Expense 2,910
Laundry Supplies 2,910
(To record supplies used)
31 Insurance Expense 1,500
Prepaid Insurance 1,500
(To record insurance expired)
31 Depreciation Expense 5,720
Accumulated Depreciation- equip. 5,720
(To record yearly depreciation)
31 Wages Expense 850
Wages Payable 850
(To record accrued salaries) Natu
re of
the Closing Process
At the end of the accounting period, the temporary account balances are transferred to the
permanent of owner’s equity account, owner’s capital.
 The process of transferring the balances of the temporary accounts to the owner’s account
is called the Closing process.
 Entries necessary to accomplish the closing process are called Closing entries.
 All temporary accounts are closed and include all income statement accounts and
owner’s drawing.
 Permanent or real accounts relate to one or more future accounting periods. They consist
of all balance sheet accounts including owner’s capital.
 Permanent accounts are not closed. Instead, their balances are carried forward into the
next accounting period.
 Temporary (nominal) accounts are closed and include: Revenue account, all expense
accounts and, owner’s drawing. Permanent (real) accounts are not closed and include: all
asset accounts, all liability accounts and owner’s capital account.
The closing process has two objectives:
1) To reduce the balances of temporary owner’s equity accounts to zero and thus make the
accounts ready for entries in the next accounting period
2) To update the balance of the owner’s capital account.
Preparing Closing Entries
 Journalizing and posting closing entries is a required step in the accounting cycle. This
step is performed after financial statements have been prepared.
Income Summary Account
 The account to which the balances of nominal accounts are transferred at the end of the
fiscal period is named Income summary account or Income and Expenses summary
account.
 Income summary account is a temporary account used to summarize the balances of the
temporary revenue and expense accounts.
 It is also called a clearing account.
 There is no “normal” balance for this account.
 Income summary account never appears on financial statements. This account is placed in
the capital division of the ledger.
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 Fundamentals of Accounting I (ACFn2031)
Steps in the closing Process:
1) Close the balance of each revenue account in to income summary
2) Close the balance of each expense account in to income summary
3) Close the balance of income summary account to the owner’s capital account
4) Close the balance of the owner’s drawing account directly to the owner’s capital
account
The following steps close a ledger:
General Journal Page 20
Date Account title P/R Debit Credit

2008 Closing Entries

July 31 Laundry 76,900 00
Income summary 76,900 00

31 Income summary 60,465 00

Wages Expense 25,350 00

Rent expense 15,575 00
Utilities expense 8,500 00
Supplies expense 2,910 00
Insurance expense 1,500 00
Depreciation expense 5,720 00
Miscellaneous expense 910 00
00

31 Hope , Capital 18,000 00

Hope, Drawing 18,000 00

31 Income Summery 16,465 00

Hope, Capital 16,465 00

Post Closing Trial Balance

Checking the accuracy of posting is once again needed after the closing entries are posted to their
respective accounts in the ledger. A Trial Balance used for testing the equality of Debit and
Credit in the ledger after the closing entries have been posted is called a post closing Trial
Balance.
After the closing entries have been posted and the accounts have been balanced and ruled, Debit
must still equal Credit.
Example:

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 Fundamentals of Accounting I (ACFn2031)
HOPE LAUNDRY
Post Closing Trial Balance
July 31, 2008
Account title Account No Debit Credit

Cash 11 7,790 00
Laundry Supplies 13 1,840 00
Prepaid insurance 14 1,325 00
Laundry Equipment 15 85,600 00
Accumulated Depreciation 61,420
Accounts Payable 21 4,950 00
Wages Payable 22 850 00
Hope, capital 31 29,335 00
Totals 96,555 00 96,555 00

 Remember that only Permanent accounts are seen with their balances on the post closing
trial balance. No nominal account is seen in this trial balance, as it is prepared after
closing all the nominal ones.

SUMMARY OF THE ACCOUNTING CYCLE

Step 1.Analyze transactions from source documents
During the Step 2.Record transactions in a journal
accounting Step 3. Post from the journal to the ledger
period Step 4. Prepare a trial balance of the ledger
Step 5. Determine needed adjustments
At the end of Step 6. Prepare a work sheet
accounting Step 7. Prepare financial statements from the completed work sheet
period Step 8. Journalize and post adjusting entries
Step 9. Journalize and post closing entries
Step 10. Prepare a post closing trial balance

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 Fundamentals of Accounting I (ACFn2031)
CHAPTER FOUR: ACCOUNTING FOR MERCHANDIZING ENTERPRISE
4.1. Merchandizing Activities
 Merchandizing businesses are businesses engaged in the purchase and sale of
commodities with a motive of profit.
 A merchandiser earns net income by buying and selling merchandise. Merchandise
consists of products, also called goods that a company acquires for the purpose of
reselling them to customers. A merchandising company’s operating cycle begins with the
purchase of merchandise and ends with the collection of cash from the sale of
merchandise.
 A person or a firm to whom a business sells merchandize is called a customer.

 The goods that a merchandizing business purchases for sale to customers are called
merchandize.
Cost of Merchandize: This represents the total sum of costs incurred to make the commodities
(merchandize) ready for sale.
 cost is a deduction against revenues to arrive at gross profit
 It has got debit as its increase and credit as its decrease.
 Merchandising inventory is items or commodities held for sale to customers in the
ordinary course of the business.
 Merchandising inventory have two common characteristics:
(1) They are owned by the company and
(2) They are in a form ready for sale to customers in the ordinary course of business.

Inventory Systems
In merchandising inventory there are two inventory accounting systems used to collect
information about cost of good sold and cost of inventory on hand. The two systems are called
periodic and perpetual.
1. Periodic Inventory system
 The merchandise inventory account is updated only once at the end of the accounting
period.
 When merchandise is sold, revenue is recorded.
 Cost of good sold is not recorded as each sale occurs.
 It does not require continual updating of the inventory account.
 The company records the cost of new merchandise in a temporary purchase account.
 When financial statements are prepared, the company takes a physical count of
inventory by counting quantities of merchandise on hand.
2. Perpetual Inventory system
 A perpetual inventory system keeps a continual record of the amount of inventory on
hand.
 The merchandise inventory account is updated after each purchase and each sale.
 Cost of goods sold account also is updated after each sale
 When an item is sold, its cost is recorded in a cost of good sold inventory.
Adjusting the Inventory Account
The adjustment of merchandize inventory has got the following features:
1. It is needed under the periodic inventory system only.
2. It eliminates the beginning merchandize inventory balance.
3. It brings into being the ending merchandize inventory balance determined by the
physical count.

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 Fundamentals of Accounting I (ACFn2031)
4. The Income Summary account is debited in the adjustment of beginning merchandize
inventory and credited for adjustment of ending merchandize inventory balance.
5. Merchandize Inventory account is credited in the adjustment of beginning merchandize
inventory and debited for adjustment of ending merchandize inventory balance.
The Inventory account usually does not agree with the physical count. If the Periodic method is
being used, the Inventory account has the balance as adjusted at the end of the prior year. If the
Perpetual method is being used, the Inventory account should be close to the physical value
calculated from the physical inventory count. There will always be a difference, and the accounts
must be adjusted so the Inventory account agrees with the physical count and valuation.

Example: The Inventory account has a balance of Br12,500. You take a physical count and
calculate the correct inventory value is BR11,975. You will decrease inventory by Br525 to
adjust the Inventory account the equal the actual physical inventory value.

General Journal

Date Account Debit Credit

Dec-31 Cost of Goods Sold Br525
Inventory Br525
To adjust Inventory to year-end
physical count and valuation

General Ledger
Inventory
[a Balance Sheet account]

Date Description Debit Credit Balance

Jan-1 Beginning balance forward 12,500 12,500
Dec-31 Year-end adjustment 525 11,975

Cost of Goods Sold

[an Income Statement account]

Date Description Debit Credit Balance

Dec-31 Balance 100,000
Dec-31 Year-end Inventory adjustment 525 100,525

The adjusting entry correctly uses an Income Statement account and a Balance Sheet account.
The additional merchandise cost is transferred to the Income Statement in this case, but the
reverse adjustment could just as easily be made.

4.2. Purchases and Sale of Merchandise for Cash and on Account

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 Fundamentals of Accounting I (ACFn2031)
The two sides of merchandizing are:
a) Purchasing and
b) Selling. Purchase and sale of merchandize are the dominant activities of any
merchandizing businesses.
Accounting for Purchase
The account that shows the cost of merchandize bought only for resale is titled purchases or
merchandize purchases. Both purchase and sale of merchandize take two forms: for cash and on
account.
When purchases are made for cash, the transactions could be recorded as:
Purchase ………….. xx
Cash …………….xx
Example: On December 1, 2009, Freedom Merchandizing purchased merchandize for cash Birr
60,000; (Ck. 001).
Purchase……………………….60,000
Cash………………………………60,000
A transaction in which merchandize is purchased with an agreement to pay at a later date is
called purchase of merchandize on account. The business firm from which merchandize is
purchased on account is called a creditor.
Most purchases of merchandize are made on account and could be recorded as:
Purchase …………….xx
Account payable ……….xx
Example: On December 2, 2009 Freedom purchase merchandise for Br1,200 on credit with
terms of 2/10, n/30. Freedom’s entry to record this credit purchase is:
Purchase……………..1,200
Account payable………1,200
Trade Discount is a reduction in the list price granted to customers owing to oral bargain. No
accounting treatment is required for trade discount.

Cash discount: a reduction granted by the seller for the buyer in the invoice price for prompt
payment when credit period is long and buyers pays with in a certain period ( within a discount
period).
 A buyer views a cash discount as a purchase discount
 A seller views a cash discount as a sales discount
The arrangement agreed up on by the buyer and sellers as to when payments for merchandize are
to be made are the credit terms.
Common payment terms are explained as under;
Net Cash: No credit is allowed by seller. Payment must be made by the buyer at the time of
purchase
n/30: The amount of an invoice must be paid within 30 days of the date of the invoice.
2/10, n/30: A discount of 2% is allowed if an invoice is paid within 10 days of the date of the
invoice. If payment is not made within 10 days, the total must be paid within 30 days of the date
of the invoice.
n/EOM: Payment of goods must be made by the end of the month in which the goods were
purchased.
C.O.D: Cash on delivery. Under these terms, payment for goods must be made when goods are
delivered to the buyer.
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Special Purchase Accounts:
Purchase accounts deal with suppliers and purchase transactions:
 Purchase Returns and Refunds

 Purchase Allowances
 Purchase Discounts

Purchase return and allowances: merchandise may be returned by the buyer because of either
defects in the product or wrong specifications.
 Purchase retunes are merchandize received by a purchaser but returned to the supplier
 Purchase allowances are a reduction in the cost of defective merchandise received by a
purchaser from the supplier. A form prepared by the buyer containing a record of the
amount of the debit taken by the buyer for returns and similar items is called a debit
memorandum.
Transportation Costs
A. Transportation Costs—responsibility is assigned by terms:
1. FOB shipping point—buyer pays shipping costs. .
2. Increases cost of merchandise when the purchaser is required to pay for transport
3. Debit Inventory, Credit Cash or Accounts Payable (if to be paid for with merchandise later)
4. FOB destination—seller pays shipping costs.
5. Operating expense for seller
6. Debit Delivery Expense (or Transportation-Out or Freight-Out), Credit Cash.
B. Transfer of Ownership—also defined by terms:
1. FOB shipping point—title transfers at shipping point
2. FOB destination—title transfers at destination.

Summary: Identifying transfer of ownership

Shipping Terms Ownership transfer Transportation
when goods passed to cost paid by
FOB Shipping point Carrier Buyer
FOB Destination Buyer Seller
Example1: December 15, 2009 Freedom Company purchased merchandise for Br. 5,000.00terms
2/10,n/30 FDB shopping point transportation cost amount Br. 200.
2009,
December 15,
Purchase ………………..Br. 5,000
Transportation in ……….. 200
(Freight-in)
Cash ……………………. 200
Account payable ……….. 5,000
If no discount: Purchase ………… Br. 5,200
Cash ………………… 200
Account payable ……. 5,000

Accounting for sales

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 Fundamentals of Accounting I (ACFn2031)
Sales just like you saw above for purchase can be made in two ways:
1. Cash sales of Merchandize, and
2. Sale of Merchandize on Account.
 A sale in which cash is received for full amount at the time of the transaction is called a
cash sale.
 A sales transaction with an agreement that merchandize will be paid for at a later date is
called a sale of merchandize on account/ charge sale/ credit sale.
 A person or business to which a sale on account is made is called a charge customer.
 Sale of merchandize on account is a sales arrangement that allows the buyer to pay for
merchandize at a later date.
 When merchandize is sold on account, the seller debits an account called Accounts
Receivable and credit a revenue account called Sales.
Example1: Assume on December 4, 2009, Hope Merchandizing sold merchandize for cash at
Birr 40,000 to Wisdom Company; Cash register tape No. 001.
Cash…………………..40,000
Sales………………………40,000
(To record cash sales)
Example 2: On December 5, 2009, Hope Merchandizing sold merchandize on account to
Wisdom Company for Birr 300,000 terms 2/10, n/30; sales invoice No 31.
Account Receivable-Wisdom Co……….300,000
Sales………………………………………...300,000
(To record credit sales)
Special Sales Accounts
Merchandisers use a few special accounts. When a sale is made, sometimes the customer returns
merchandise for a refund. We do not reduce the sales revenue account. We enter the refund in a
different account. This is done to help track the number and dollar (birr) amount of these types of
transactions.
Sales accounts deal with customers and sale transactions:
 Sales Returns and Refunds

 Sales Allowances
 Sales Discounts

Sales Discount:
Sales discounts are granted to encourage prompt payments. When a sales discount is granted, the
seller receives less than the sales price recorded at the time of the sale. A sales discount reduces
the revenue from sales. Therefore, it is a contra sales account.

Sales Returns and Allowances

Most businesses that sell goods may expect to have some of the goods returned because of their
wrong style, their wrong size, or damage. The return of goods for which the customer is allowed
credit on account or given cash refund is called "a sales return."

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 Fundamentals of Accounting I (ACFn2031)
Credit given to a customer for part of the sales price of goods when the goods are not returned, is
called a "sales allowance".
When a sales return or a sales allowance is granted, the seller usually informs the buyer in
writing. A form showing the amount of credit granted by the seller for returns, allowances, and
similar items is called a "credit memorandum".

Each merchandizing transactions affect a buyer and a seller. In the following illustrations, we
show you how the same transactions would be recorded by both the seller and the buyer.
Example 1: December 10, 2009, Hope Merchandizing granted credit to Wisdom Co. for
merchandize returned, with a cost price of Birr 3,500; Credit memorandum No. 001.
Sales return & allowance……….3,500
Account receivable……………..3,500
December 15, 2009, Hope merchandising collected from November 5 credit sales.
Cash…………………290,570
Sales discount………. 5,930
Account Receivable…………296,500
Example 2: A Company purchased merchandise for Br. 5,000 terms 2/10, n/30 FOB destination
transportation cost Br. 200
Account receivable ………….5000
Delivery expense …………… 200
Sales …………………………5000
Cash …………………………. 200
Example 3: Freedom Company sold merchandise on account to XYZ Company Br. 1000 on
which there is the 5% sales tax
Seller Buyer
Account receivable 1,050 Purchase 1,050
Sales 1,000 Account payable 1,050
Sales tax 50
(1,000x 5%)
Each merchandising transactions affects a buyer and a seller. In the following illustration, we
show how the same transactions would be recorded by both the seller and the buyer.
1. September 1, 2009 ABC Company sold merchandise to XYZ Company on account for Br.
1,000 terms net 30.
Seller Buyer
Account receivable 1,000 Purchase 1,000
Sales 1,000 Account payable 1,000
Assuming that collection is made by ABC Company on September 10 the entry would be:
Seller Buyer
Cash 1,000 Account payable 1,000
Account receivable 1,000 Cash 1,000
2. September 15 ABC sold merchandise to XYZ company Br. 10,000 terms 2/10, n/30
Seller Buyer
Account receivable 10,000 Purchase 10,000
Sales 10,000 Account payable 10,000

Assuming that collection is made by ABC Company on September 20 the entry would be:

Seller Buyer
Cash 9,800 Account payable 10,000
Sales discount 200 Cash 9,800
Account receivable 10,000 Purchase discount 200

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 Fundamentals of Accounting I (ACFn2031)
3. October 1,2009 ABC company sold merchandise to XYZ company for Br. 2,000 terms 2/10,
n30. October 2 XYZ Company retuned defective item of merchandise that costs Br. 200.
Record journal entries for both seller and buyer
Seller Buyer
Oct. 1 Account receivable 2,000 Purchase 2,000
Sales 2,000 Account payable 2,000

Oct. 2 Sales return and allowance 200 Account payable 200

Account receivable 200 Purchase return & allowance 200

Assuming the collection was made on October 8,2009 the entry would be:
Seller Buyer
Cash 1,764 Account payable 1,800
Sales discount 36 Cash 1,764
Account receivable 1,800 Purchase discount 36

4.3. FINANCIAL STATEMENTS FOR MERCHANDIZING ENTERPRISES

Income Statement: A summary of an entity's results of operation for a specified period of time
is revealed in the income statement, as it provides information about revenues generated and
expenses incurred. The difference between the revenues and expenses is identified as the net
income or net loss. There are two widely used forms for the income statement:
1. Single step and
2. Multiple step
1. Single Step Form
In a single step income statement, the total of all expenses is deducted in one step from the total
of all revenues. The single step form emphasizes total revenues and total expenses as the factors
that determine net income. In this form amount such as gross profit and income from operations
are not readily available for analyses.
Skelton of single step form:
XYZ Company
Single step Income Statement
For the year ended December 31,2009
Revenues:
Net sales xxx
Interest revenue xx
Rent revenue xx
Total revenues xxx
Expenses:
Cost of merchandise sold xxx
Selling expenses xx
Administrative expenses xx
Interest expenses xx
Total expenses xxx
Net income (Net loss) xx

2. Multiple Step Form: Multiple step form income statement is divided in to the following
sections:
1. Revenues
2. Cost of goods sold
3. Operating expense
4. Income from operations
5. Other income and expenses

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 Fundamentals of Accounting I (ACFn2031)
A skeleton form of income statement
Net sales for the period
- Cost of Goods sold
Gross profit
- Operating expense
Income from operations
+ Other income
- Other expenses
Net income
1. Revenue section: provides a figure for net sales, which is the balance of sales account, less the
balance of contra sales accounts (sales return & allowances & sales discounts).
2. Cost of Good sold section:- The cost of merchandize sold to customers during a period is
subtracted from the net sales figure for the same period to the get the amount of gross profit.

The formula to calculate CGS is:

Beginning mdse inventory
+ Net purchase of merchandise
Cost goods available for sale
- Ending merchandise inventory
Cost of goods sold
Total purchases
- Purchase return and allowances
- Purchase discount
+ Freight in
Net purchases
Gross profit: The excess of the net revenue from sales over the cost of merchandise sold is
called gross profit or gross margin.
3. Operating expenses: are the regular expenses of operating the business. It is usually
satisfactory to subdivide operating expenses in to two categories: selling and administrative.
 Selling expenses:- are all expenses directly related to the sale of merchandize such as:
 sales salaries expenses,
 advertising expense,
 store supplies expense,
 depreciation expense-store equipment ,
 Miscellaneous selling expense.
 Administrative /general/ expenses: are expenses related to the business’s office, the
over all administration of the business or any other operating expense that can not be
tied directly to sales activity, such as:-
 office salaries expense,
 rent expense,
 depreciation expense-office equipment,
 depreciation expense – delivery equipment,
 utilities expense,
 office supplies expense,
 insurance expense,
 miscellaneous general expense
4. Income from operation section: Gross profit, minus total operating expenses, equals income
from operations (also called operating income) is a measure of a firm’s on going operations, or
its regular operations.

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 Fundamentals of Accounting I (ACFn2031)
5. Other income and expense section: Revenue from sources other than the primary operating
activity of a business is classified as other income. In merchandizing other income includes
interest, rent, and dividends.
 Expenses that can not be traced directly to operations are identified as other expense.
Example: interest expense and loss incurred in the disposal of plant asset.
 Net income: - The final figure on the income statement is called net income or net loss. It
is the net increase (or net decrease) in the owner’s equity as a result of the periods profit
making activity.

Illustration: Kenenisa Sport Company a whole seller sporting goods, had the
following adjusted trial balance at December 31,2010.
Kenenisa Sport Company
Adjusted Trial balance
December 31,2010
Accounts Dr Cr
Cash Br8,200
Accounts receivable 11,200
Merchandise Inventory 21,000
Office supplies 550
Store supplies 250
Prepaid insurance 300
Office equipment 4,200
Accumulated depreciation-office equipment 1,400
Store equipment 30,000
Accumulated depreciation-store equipment 6,000
Accounts payable 16,000
Salaries payable 800
Kenenisa,Capital 42,600
Kenenisa, withdrawal 4,000
Sales 321,000
Sales discounts 4,300
Sales return & allowances 2,000
Cost of goods sold 230,000
Depreciation expense-store equipment 3,000
Depreciation expense-office equipment 700
office salaries expense 25,300
Sales salaries expense 18,500
Insurance expense 600
Rent expense 9,000
Office supplies expense 1,800
Store supplies expense 1,200
Advertising expense 11,200
Totals Br387,800 Br387,800
Required:
a. Prepare a multiple income statement for the year
b. Prepare a single step income statement for the year.
c. Prepare a balance sheet at December 31,2010
d. Prepare a closing entry at the end of December 31,2010

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 Fundamentals of Accounting I (ACFn2031)
a. Multiple income statement
Kenenisa sport Company
Income statement
For the year ended December 31,2010
Net Sales………………………………… Br314,700
Cost of goods sold………………………. 230,4000
Gross Profit……………………………… Br84,300
Operating expenses:
Depreciation expense………………… Br3,700
Salaries expense……………………… 43,800
Rent expense…………………………. 9,000
Insurance expense……………………. 600
Supplies expense…………………….. 3,000
Advertising expense…………………. 11,300
Total operating expenses…………….. 71,400
Net income……………………………. Br12,900
b. Single step income statement
Kenenisa Sport Company
Income statement
For the year ended December 31,2010
Net Sales………………………………. Br314,700
Cost of goods sold…………………….. 230,4000
Selling expenses………………………. 42,100
General & administrative expenses….... 29,300
Total operating expenses…………….. 301,800
Net income……………………………. Br12,900
c. Balance sheet
Kenenisa Sport Company
Balance Sheet
As of December 31,2010
Assets
Cash Br8,200
Accounts receivable 11,200
Merchandise Inventory 21,000
Office supplies 550
Store supplies 250
Prepaid insurance 300
Office equipment 4,200
Accumulated depreciation-office equipment 1,400 2,800
Store equipment 30,000
Accumulated depreciation-store equipment 6,000 24,000
Total assets 68,300
Liabilities
Accounts payable 16,000
Salaries payable 800
Total liabilities Br16,800
Owner’s Equity
Kenenisa,Capital 51,500
Total liabilities and owner’ equity 68,300

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 Fundamentals of Accounting I (ACFn2031)
d. Closing entries
Step 1: Close credit balances in temporary accounts to income summary
Dec.31 Sales……………………….321,000
Income summary…………………321,000
Step 2: Close debit balances in temporary accounts to income summary
Dec. 31 Income summary…………..308,100
Sales discount……………………..……4,300
Sales return and allowances………….....2,000
Cost of goods sold…………………….230,400
Depreciation expense-store equipment… 3,000
Depreciation expense-office equipment… 700
Office salaries expense……………… ..25,300
Sales salaries expense………………… 18,500
Insurance expense……………………….. 600
Rent expense…………………………….. 9,000
Office supplies expense…………………. 1,800
Store supplies expense……………………1,200
Advertising expense…………………… 11,300

Step 3: Close income summary to owner’s capital

Dec. 31 Income summary……………..12,900
Kenenisa, Capital………………..12,900
Step 4: Close withdrawals accounts to owner’s capital.
Dec. 31 Kenenisa, Capital…………4,000
Kenenisa, withdrawals………4,000

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 Fundamentals of Accounting I (ACFn2031)
Chapter-5: Accounting for manufacturing businesses
5.1. Characteristics of manufacturing business
Manufacturing-sector companies purchase materials and components and convert them into
various finished goods. These companies typically have one or more of the following three types
of inventory:
1. Direct materials inventory. Direct materials in store and awaiting use in the manufacturing
process
2. Work-in-process inventory. Goods partially worked on but not yet completed
3. Finished goods inventory. Goods completed but not yet sold.
5.2. Classification of manufacturing costs
Three terms commonly used when describing manufacturing costs are direct material costs,
direct manufacturing labor costs, and indirect manufacturing costs
1. Direct material costs: are the acquisition costs of all materials that eventually become part of
the cost object (work in process and then finished goods) and can be traced to the cost object in
an economically feasible way. Acquisition costs of direct materials include freight-in (inward
delivery) charges, sales taxes, and custom duties. To be classified as a direct materials cost, the
cost must be both of the following:
1. An integral part of the finished product
2. A significant portion of the total cost of the product
2. Direct manufacturing labor costs: include the compensation of all manufacturing labor that
can be traced to the cost object (work in process and then finished goods) in an economically
feasible way. Examples include wages and fringe benefits paid to machine operators and
assembly-line workers who convert direct materials purchased to finished goods.
3. Indirect manufacturing costs: Costs other than direct materials cost and direct labor cost
that are incurred in the manufacturing process are combined and classified as factory overhead
cost. Factory overhead is sometimes called manufacturing overhead or factory burden.
All factory overhead costs are indirect costs of the product. Some factory overhead costs include
the following:
1. Heating and lighting the factory
2. Repairing and maintaining factory equipment
3. Property taxes on factory buildings and land
4. Insurance on factory buildings
5. Depreciation on factory plant and equipment

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Factory overhead cost also includes materials and labor costs that do not enter directly into the
finished product. Examples include the cost of oil used to lubricate machinery and the wages of
janitorial and supervisory employees. Also, if the costs of direct materials or direct labor are not
a significant portion of the total product cost, these costs may be classified as factory overhead
costs.
Prime Costs and Conversion Costs Direct materials, direct labor, and factory overhead costs
may be grouped together for analysis and reporting. Two such common groupings are as follows:
1. Prime costs, which consist of direct materials and direct labor costs
2. Conversion costs, which consist of direct labor and factory overhead costs
Conversion costs are the costs of converting the materials into a finished product.
For financial reporting purposes, costs are classified as product costs or period costs.
1. Product costs: consist of manufacturing costs; direct materials, direct labor, and factory
overhead.
2. Period costs: consist of selling and administrative expenses.
Selling expenses are incurred in marketing the product and delivering the product to customers.
Administrative expenses are incurred in managing the company and are not directly related to
the manufacturing or selling functions. To facilitate control, selling and administrative expenses
may be reported by level of responsibility. For example, selling expenses may be reported by
products, salespersons, departments, divisions, or territories. Likewise, administrative expenses
may be reported by areas such as human resources, computer services, legal, accounting, or
finance. As product costs are incurred, they are recorded and reported on the balance sheet as
inventory. When the inventory is sold, the cost of the manufactured product sold is reported as
cost of goods sold on the income statement. Period costs are reported as expenses on the income
statement in the period in which they are incurred.
5.3. Financial statements for a manufacturing business
The retained earnings and cash flow statements for a manufacturing business are similar to those
illustrated in earlier chapters for service and merchandising businesses. However, the balance
sheet and income statement for a manufacturing business are more complex. This is because a
manufacturer makes the products that it sells and, thus, must record and report product costs. The
reporting of product costs primarily affects the balance sheet and the income statement.
Balance Sheet for a Manufacturing Business
A manufacturing business reports three types of inventory on its balance sheet as follows:
1. Materials inventory (sometimes called raw materials inventory). This inventory consists of
the costs of the direct and indirect materials that have not entered the manufacturing process.

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Examples for Legend Guitars: Wood, guitar strings, glue, sandpaper
2. Work in process inventory. This inventory consists of the direct materials, direct labor, and
factory overhead costs for products that have entered the manufacturing process, but are not yet
completed (in process).
Example for Legend Guitars: Unfinished (partially assembled) guitars
3. Finished goods inventory. This inventory consists of completed (or finished) products that
have not been sold. Example for Legend Guitars: Unsold guitars
Balance Sheet Presentation of Inventory in Manufacturing and Merchandising Companies

Legend Guitars.
Balance sheet
December 31,2010
Current assests:
Cash ------------------------------------------------------------------------------------------- $25,000
Accounts receivable (net) -------------------------------------------------------------------- 85,000
Merchandising inventory --------------------------------------------------------------------142,000
Supply ----------------------------------------------------------------------------------------- 10,000
Total current assets ----------------------------------------------------------------------- $262,000
Legend Guitars.
Balance sheet
December 31,2010
Current assests:
Cash ------------------------------------------------------------------------------------------- $ 21,000
Accounts receivable (net) --------------------------------------------------------------------120,000
Inventories:
Finished goods----------------------------------------------------------------------$62,500
Work in process ------------------------------------------------------------------- -24,000
Materials ----------------------------------------------------------------------------- 35,000
Supplies ------------------------------------------------------------------------------ 2,000 121,500
Total current assets ----------------------------------------------------------------------------- $ 264,500
Income Statement for a Manufacturing Company
The income statements for merchandising and manufacturing businesses differ primarily in the
reporting of the cost of merchandise (goods) available for sale and sold during the period.
A manufacturer makes the products it sells, using direct materials, direct labor, and factory
overhead. The total cost of making products that are available for sale during the period is called
the cost of goods manufactured. The cost of finished goods available for sale is determined
by adding the beginning finished goods inventory to the cost of goods manufactured during the
period. The cost of goods sold is determined by subtracting the ending finished goods inventory
from the cost of finished goods available for sale.
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Cost of goods manufactured is required to determine the cost of goods sold, and thus to prepare
the income statement. The cost of goods manufactured is often determined by preparing a
statement of cost of goods manufactured. This statement summarizes the cost of goods
manufactured during the period as shown below.
Statement of Cost of Goods Manufactured
Beginning work in process inventory . . . . . ……….. ………………………………….$XXX
Direct materials:
Beginning materials inventory . . . . . . . . . …………..$XXX
Purchases . . . . . . . . . . . . . . . . . . . . . . . . . __ XXX_
Cost of materials available for use . . . . . ……………..$XXX
Less ending materials inventory . . . . . . …………… XXX
Cost of direct materials used . . . . . . . . ……………… ………… $ XXX
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . ………………………XXX
Factory overhead . . . . . . . . . . . . . . . . . . . . ……………………… XXX_
Total manufacturing costs incurred . . . . . . ………………………………………………. XXX
Total manufacturing costs . . . . . . . . . . . . . . …………………………………………….. $XXX
Less ending work in process inventory . . . ……………………………………………… XXX
Cost of goods manufactured . . . . . . . . . . . ………………..............................................$XXX
To illustrate, the following data for Legend Guitars are used:
Jan. 1, 2010 Dec. 31, 2010
Inventories:
Materials . . . . . . . . . . . . . . . . . . . . $ 65,000 ………………………$ 35,000
Work in process . . . . . . . . . . . . . . . . 30,000 ……………………….24,000
Finished goods . . . . . . . . . . . . . . . . 60,000 …………………………62,500
Total inventories . . . . . . . . . . ……$155,000 …………………… $121,500
Manufacturing costs incurred during 2010:
Materials purchased . . . . . . . . . . . . . . . . . . $100,000
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . 110,000
Factory overhead:
Indirect labor . . . . . . . . . . . . . . . . . . . . . . $ 24,000
Depreciation on factory equipment . . . . . . 10,000
Factory supplies and utility costs . . . . . . 10,000 ………………….44,000
Total …………………………………… $254,000
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$366,000

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Selling expenses . . . . . . . . . . . . . . . . . . . . . . 20,000
Administrative expenses . . . . . . . . . . . . . . . 15,000
The statement of cost of goods manufactured is prepared using the following three steps:
Step 1. Determine the cost of materials used.
Step 2. Determine the total manufacturing costs incurred
Step 3. Determine the cost of goods manufactured.
Using the preceding data for Legend Guitars, the preparation of the statement of cost of goods
manufactured is illustrated below.
Step 1. The cost of materials used in production is determined as follows:
Materials inventory, January 1, 2010…………………… $ 65,000
Add materials purchased ………………………………….100,000
Cost of materials available for use ………………………..$165,000
Less: materials inventory, December 31, 2010……………..35,000
Cost of direct materials used……………………………… $130,000
The January 1, 2010 (beginning), materials inventory of $65,000 is added to the cost of materials
purchased of $100,000 to yield the total cost of materials that are available for use during 2010
of $165,000. Deducting the December 31, 2010 (ending), materials inventory of $35,000 yields
the cost of direct materials used in production of $130,000.
Step 2. The total manufacturing costs incurred is determined as follows:
Direct materials used in production (Step 1)…………………… $130,000
Direct labor ……………………………………………………….110, 000
Factory overhead …………………………………………………..44,000
Total manufacturing costs incurred …………………………… $284,000
The total manufacturing costs incurred in 2010 of $284,000 are determined by adding the direct
materials used in production (Step 1), the direct labor cost, and the factory overhead costs.
Step 3. The cost of goods manufactured is determined as follows:
Work in process inventory, January 1, 2010 …………………….. $ 30,000
Total manufacturing costs incurred (Step 2)……………………… 284,000
Total manufacturing costs……………………………………….. $314,000
Less work in process inventory, December 31, 2010 …………….. 24,000
Cost of goods manufactured …………………………………….. $290,000
The cost of goods manufactured of $290,000 is determined by adding the total manufacturing
costs incurred (Step 2) to the January 1, 2010 (beginning), work in process inventory of $30,000.

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 Fundamentals of Accounting I (ACFn2031)
This yields total manufacturing costs of $314,000. The December 31, 2010 (ending), work in
process of $24,000 is then deducted to determine the cost of goods manufactured of $290,000.
The income statement and statement of cost of goods manufactured for Legend Guitars is shown
Legend Guitars.
Income statement
For the year ended December 31,2010
Sales ------------------------------------------------------------------------------------------- $ 366,000
Cost of goods sold:
Finished goods inventory, January 1, 2010 -----------------------------60,000
Cost of goods manufactured--------------------------------------------- 290,000
Cost of finished goods available for sale -------------------------------$ 350,000
Less: finished goods inventory, December 31, 2010 ----------------------62,500
Cost of goods sold ----------------------------------------------------------------------------------287,5000
Gross profit--------------------------------------------------------------------------------------------$78,500
Operating expenses:
Selling expenses --------------------------------------------------------------------- 20,000
Administrative expenses ------------------------------------------------------------ 15,000
Total operating expenses ------------------------------------------------------------------------------35,000
Net income ------------------------------------------------------------------------------------------ $43,500
Legend Guitars.
Income statement
For the year ended December 31,2010
Work in process inventory, January 1, 2010 -----------------------------------------------------$30,000
Direct materials:
Materials inventory, January 1, 2010 ---------------------------------------$65,000
Purchases ---------------------------------------------------------------------- 100,000
Cost of materials available for use ------------------------------------------ $ 165,000
Less materials inventory, December 31, 2010 -------------------------------35,000
Cost of direct materials used ----------------------------------------------------------------130,000
Direct labor ------------------------------------------------------------------------------------110,000
Factory overhead:
Indirect labor --------------------------------------------------------------------24,000
Depreciation on factory equipment ----------------------------------------$10,000
Factory supplies and utility costs -------------------------------------------$10,000
Total factory overhead ------------------------------------------------------------------$44,000
Total manufacturing costs incurred -------------------------------------------------------------- $284,000
Total manufacturing costs ------------------------------------------------------------------------- 314,000
Less work in process inventory, December 31, 2010 -------------------------------------------$24,000
Cost of goods manufactured ------------------------------------------------------------------------$290,00

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 Fundamentals of Accounting I (ACFn2031)
5.4. Flow of Manufacturing Costs
Manufacturing costs

Balance sheet income statement

Direct
Materials Material
inventory

Direct
Labor Unfinished Work-in
Manufacturi process
ng process inventory
Factory
Overhead
Finished goods Finished sold Cost of
goods goods sold
inventory

Income Statement

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 Fundamentals of Accounting I (ACFn2031)

CHAPTER SIX: ACCOUNTING FOR CASH

6.1. Cash, Cash Equivalent, and Liquidity
Cash Defined
Cash is anything that a bank would accept for deposit at face value. Cash include
coins, currency (Paper money), Checks, money orders made payable to the business,
bank drafts, and receipts from credit card sales. Items such as postage stamps and
post-dated checks (checks payable in the future) are not cash. Stamps are a prepaid
expense, the post-dated checks are accounts receivable.
Characteristics of cash:-
 It is the most liquid asset
 Bears no identifying mark
 Easily transferable
 Easily portable( transported )
Cash Equivalent Defined
To increase their return on investment, many companies invest idle cash in assets
called cash equivalent. Cash equivalents are short-term, highly liquid investment
assets meeting two criteria: (1) readily convertible to a known cash amount and (2)
sufficiently close to their maturity date so that market value is not sensitive to
interest rate changes
Liquidity: All assets can be judged on their liquidity. Cash and similar assets are
called liquid assets. Cash and similar assets are converted easily in to other assets or used to
pay for services or liabilities. Because of these characteristics, cash is the asset most susceptible
to improper diversion and use. To safeguard cash and to assure the accuracy of the accounting
records of cash, effective internal control over cash is imperative.
6.2. Perform Internal Control over Cash

Special controls are needed to protect cash because almost everyone wants it, and it
is easily taken if not protected. Further, it is often easy to conceal that cash has been
taken by altering accounting records. The protection and control of cash are part of
the overall system of internal control.

Some common steps that are used to control and protect cash are:
 Those who physically handle cash (cashiers, clerk, etc.) and should not be the
same as those who account for cash (bookkeepers, accountants).
 All cash received should be deposited in a bank daily
 Only a small amount of cash (called petty cash) should be kept on hand
 All cash payments, except for petty cash, should be made by check
 Cheeks should be pre numbered so that it is easy to see what cheeks have been
written and when.
 Only a few properly designated persons should be involved in the receipt,
payment, and recording of cash.
 Receipt and payment of cash should be recorded efficiently and accurately

Accounting and Administrative controls

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Administrative control includes, but is not limited to, the plan of organization and the
procedures and records that are concerned with the decision processes leading to management’s
authorization of transactions.
Accounting control comprises the plan of organization and procedures and records that are
concerned with the safeguarding of assets and the reliability of financial records and
consequently are designed to provide reasonable assurance that:
a) Transactions are executed in accordance with management’s general or specific
authorization.
b) Transactions are recorded as necessary
 To permit preparation of financial statements in conformity with GAAP and
 To maintain accountability for assets.
c) Access to asset is permitted only in accordance with management’s authorization
d) The recorded accountability for assets is compared with the existing assets at reasonable
intervals and appropriate action is taken with respect to any differences
To control cash, most businesses use bank checking accounts when making cash
expenditures. However, it is not practical to write checks for very small amounts.
The time and effort involved in writing a check for small amounts can not be
justified.

Internal Control of Cash Receipts

Department stores and other retail business ordinarily receive cash from two main sources:-
1) Over the counter from cash customers
2) By mail from charge customers.
Cash Short And Over
The amount of cash actually received during a day often does not agree with the record of cash
receipts. When ever there is deference between the record and the actual cash and no error can be
found in the record.
The cash shortage and overage is recorded in an account entitled cash short and over. A common
method for handling such mistakes is to include in the cash receipts journal a cash short and over
debit column in to which all cash shortages are entered, and cash short and over credit column in
to which all cash overages are entered.
Example: - If the actual cash received from cash sales is less than the amount indicated by the
cash register, the entry in the cash receipts journal would include a debit to cash short and over.

Cash in bank---------------------------5677.60
Cash short and over-----------------------3.16
Sales-----------------------------------------5680.76

If there is a debit balance in the cash short and over account at the end of the fiscal period; it is
an expense and may be included in the “miscellaneous administrative expense” on the income
statement. If there is a credit balance; it is revenue and may be listed in the other income section.
Cash Change Fund
The fund may be established by drawing a check for the required amount; debiting the
account cash on hand and crediting cash in bank.
Internal Control of Cash Payments
It is common practice for business enterprises to require that a very payment of cash be
evidenced by a check signed by designated officials. As an additional control, some firms
required two signatures on all check or only one checks which are larger than a certain
amount.

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Basic features of the voucher system
A voucher system is made up of records, methods and procedures used in providing and
recording liabilities and making and recording cash payments.

A voucher system uses:

1. Vouchers
2. A voucher register
3. A file for unpaid vouchers
4. A check register and
5. A file for paid vouchers
1. Vouchers: - The term voucher is widely used in accounting. In a general sense; it means any
document that serves as proof of authority to pay cash. The term has a narrower meaning when
applied to the vouchers system: a voucher is s special form on which is recorded relevant data
about a liability and the details of its payment. Vouchers may be paid immediately after they are
prepared or at a later date; depending up on the circumstances and the credit terms.
2. Voucher register:-After approval by the designated officials each voucher is recorded in a
journal known as voucher register. It is similar to and replaces the purchases journal.
3. Unpaid voucher file:- after a voucher has been recorded in the voucher register; it is filed in
an unpaid voucher file, where it remains until it is paid.
4. Check register:-the payment of the voucher is recorded in a check register. The check register
is a modified form of the cash payments journal.
5. Paid voucher file:- after payment vouchers are usually filed in numerical order in a paid
voucher file. They are then readily available for examination by employees or independent
auditors needing information about certain expenditures.
Petty Cash
 A common way of handling small payments is to use a petty cash fund.
 A petty cash fund is an amount of money (cash fund) kept in the office for
making relatively small expenditures.
 The amount of petty cash fund depends on the needs of the individual
business.
The Operation of a petty cash fund, often called an imprest system, involves:
a) Establishing the petty cash fund
b) Making payments from the petty cash fund and
c) Replenishing the petty cash fund
In establishing a petty cash fund;
 The amount of cash needed for disbursements of relatively small amounts during a certain
period is estimated.
 Custodian assigned
 The check drawn
If the voucher system is used; a voucher is then prepared for this amount and it is recorded in the
voucher register as a debit to petty cash and a credit to accounts payable. The check drawn to pay
the voucher is recorded in the check register as a debit to accounts payable and a credit to cash in
bank.
 When a petty cash payment is made the petty cash custodian prepares a petty
cash voucher.
 The petty cash voucher shows the details of the payment and serves as proof
that a payment was made from the fund.
 No accounting entry is made to record a payment at the time it is made from
the petty cash.
To replenish the petty cash fund means to put back in to the fund the amount that
has been paid out of the fund. Petty cash fund is replenished:
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a) When the money in the petty cash fund reaches a minimum level, and
b) At the end of the month regardless of the cash in the fund.

If the petty cash fund is not reimbursed at the end of accounting period:
 petty cash asset is overstated and
 Expenses are understated.
 The journal entry to record replenishing the petty cash fund involves a debit
to each item listed in the petty cash payments record and a credit to cash.
Example: - Assume that a voucher system is used and that a petty cash fund of Br 100 is
established on August 1. At the end of August, the petty cash receipts indicate expenditures for
the following items:
Office supplies……………..28
Postage (office supplies)…….22
Store supplies………………..35
Miscellaneous expense………..3.70
The entry in the general journal form is:

August 1. Petty cash……………………..100

Voucher payable……………………100
August 1. Voucher payable………………100
Cash in bank………………………100

August 31. Office supplies expense……………50

Store supplies expense-…………….35
Miscellaneous Expense………………3.70
Voucher payable………………………..88.70

August 31. Voucher payable……………………88.70

Cash in bank…………………………….88.70
6.3. The Bank Account as a Tool of Controlling Cash
To get benefits from a bank account all cash received must be deposited in the bank and all cash
payments must be made by checks drawn on the bank.
The forms used by a business in connection with a bank account are; a signature card; deposit
tickets; checks and records of checks.
1. Signature card:-it must be signed by each person authorized to sign checks drawn on the
account at the account is opened.
2. Deposit ticket: - Is a source document given by the bank for the money deposited by the
depositor. Deposit ticket may be prepared in duplicate and the copy is signed by the
banks taller and given to the depositor as a receipt
3. Checks: - is a written instrument signed by the depositor ordering the bank to pay a
certain sum of money to the order of designated person.
There are three parties to a check
i. Drawer(maker):- the one who signs the check
ii. Drawee(payer):- the bank on which the check is drawn
iii.The payee:- the one to whose order the check is drawn
4. Records of checks drawn: - a memorandum record of the basic details of a check should
be prepared at the time the check is written.

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Bank Statement: bank statement is a monthly report showing the bank’s record of
the checking account. The bank statement provides the following information about
customers’ cash accounts:
1. The balance at the beginning of the month
2. Additions in the form of deposits and credit memos
3. Deductions in the form of checks and debit memos and
4. The final balance at the end of the month
Canceled checks are checks the bank has paid and deducted from the customer’s
account during the month. Other deductions also often appear on a bank statement
include:
 Service charge and fees assessed by the bank
 Customer’s cheeks deposited that are uncollectible
 Corrections of previous errors
 Withdrawals through automatic teller machines (ATM) and
 Periodic payments arranged in advance by the depositor.
Except for service charges the bank notifies the depositor for each deduction with a
debit memorandum when the bank reduces the balance. There are also other
transactions that increases the depositors account such as amounts the bank collects
on behalf of the depositor and corrections of previous errors. Credit memoranda
notify the depositor of all increases when they are recorded.
 CM (credit memo) increases or credits to the account, such as notes or accounts
left with the bank for collection
 DM (debit memo) Decrease or debits to the account, such NSF checks,
automated teller withdrawals, and service charges.
Bank Reconciliation
The bank statement and the cheek book are both records of a depositor’s checking
account transactions. The balance of checking account reported on the bank
statement is rarely equal to the balance in the depositor’s accounting records. This is
usually due to:
1. Time lags – a delay by either party in recording transactions and
2. Errors- by either party in recording transaction.
The process of bringing the difference between the balance of a checking account
according to the depositor’s records and the balance reported on the bank statement
in to agreement is called Bank reconciliation. It is a listing of the items and
amounts that causes the cash balance reported in the bank statement to differ from
the balance of the cash account in the ledger.
Among the factors causing the bank statement balance to differ from the depositor’s
book balance are:
1. Outstanding cheeks: check written by the depositor, deducted/appear in the
checkbook but not in the statement.
2. Deposit in transit (also called outstanding deposits): these are deposits made
and recorded by the depositor but not recorded on the bank statement. E.g.
Night deposits, deposits by mail etc
3. Service charges and other bank fees: banks charge a fee for providing
checking accounts. This fee, called a service charge. Other charges that a
bank may make include fees for imprinting checks, fees for collecting money
for the depositor and fees for the use of ATMs.
4. Errors –it is not uncommon for depositors to make (1) arithmetic errors
when making entries in a cheek book and (2) errors due to transpositions and

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 Fundamentals of Accounting I (ACFn2031)
slides by depositors. The bank will also make errors.
5. Bank collections – some banks collect notes or securities for the depositor
and enter the amounts directly in the depositor’s account. Such collections
appear on the bank statement but not in the checkbook.
6. NSF (Not sufficient funds) checks – when a check is deposited, it is counted
as cash. If the balance in the customer’s account is not large enough to cover
the check, the check is called NSF. The bank initially credits the depositor’s
account for the amount of deposited check. When the bank learns the check is
uncollectible, it debits (reduces) the depositor’s account for the amount of
that check.
The bank statement is reconciled by the following steps
a) Deposit in transit – added to the bank statement balance
b) Outstanding checks – subtracted from the bank statement balance
c) Any interest earned and any collection made by the bank for the depositor-
added to the check book balance.
d) Any charge appearing on the bank statement – subtracted from the checkbook
balance
e) NSF – subtracted from the checkbook balance.
Format for bank reconciliation
Bank balance according to bank statements----------------------------------------xxx
Add: additions by depositor not on bank statement--------------------xx
Bank errors-----------------------------------------------------------xx xx
xxx
Deduct: Deductions by depositor not on bank statements--------------xx
Bank errors---------------------------------------------------------xx xx
Adjusted balance--------------------------------------------------------------xxx
Bank Balance according to depositors records--------------------------------------xxx
Add: additions by bank not recorded by depositor-------------------- xx
Depositor errors-----------------------------------------------------xx xx
Xxx
Deduct: deductions by bank not recorded by depositor------------- xx
Depositor errors------------------------------------------------xx xx
Adjusted balance ---------------------------------------------------------------------xxx

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 Fundamentals of Accounting I (ACFn2031)
Illustration of bank reconciliation
The bank statement for Hope Company, recorded, indicates a balance of Br3359.78 as on July 31.
The balance in cash in bank in Hope Company’s ledger as of the same date is Br2, 234.99. The
following are reconciling items:
1. Deposit of July 31 not recorded on bank statement Br816.20
2. Check out standing: No 812,Br1061.00;No 878,Br435.39;883,Br48.60
3. Note plus interest of Br8 collected by bank (credit memorandum), Not recorded on cash
receipts journal Br408.00
4. Bank service charges (debit memorandum)not recorded on Cash repayments journal Br3.00
5. Check No 879 for Br732.26 to Taylor Company on account, Recorded in cash payments
journal as Br723.26
The bank reconciliation based on the bank statements and the reconciling items is as follows
Hope Company
Bank reconciliation
July 31, 2010
Balance per bank statement----------------------------------------Br3,359.78
Add: deposit of July 31, not recorded by bank-----------------------816.20
4,175.98
Deduct out standing checks:
No 812-------------------------1,061.00
No 878---------------------------435.39
No 883----------------------------48.60 1,544.99
Adjusted Bank balance----------------------------------------- Br2,630.99

Balance per depositors records-------------------------------------Br2,234.99

Add: Note and interest collected by bank-------------------------- 408.00
2,642.99
Deduct: Bank service charges-----------------------3.00
Error in recording check no 879---------9.00 12.00
Adjusted cash book balance---------------------------------------Br2,630.99

The entries for Hope Company, based on the bank reconciliation above are as follows:
July 31 Cash in bank-----------------------------408.00
Notes receivable---------------------------400.00
Interest in come-------------------------------8.00

31 Miscellaneous Expense---------------3.00
Account payable-----------------------9.00
Cash in bank----------------------------12.00

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 Fundamentals of Accounting I (ACFn2031)
CHAPTER SEVEN: ACCOUNTING FOR RECEIVABLES

1.1. Receivables Defined

Accounts receivable are amounts that customers owe the company for normal credit purchases.
Since accounts receivable are generally collected within two months of the sale, they are
considered a current asset and usually appear on balance sheets below short-term investments
and above inventory.

Notes receivable are amounts owed to the company by customers or others who have signed
formal promissory notes in acknowledgment of their debts. Promissory notes strengthen a
company's legal claim against those who fail to pay as promised. The maturity date of a note
determines whether it is placed with current assets or long-term assets on the balance sheet.
Notes that are due in one year or less are considered current assets and notes that are due in more
than one year are considered long-term assets.

Accounts receivable and notes receivable that result from company sales are called trade
receivables, but there are other types of receivables as well. For example, interest revenue from
notes or other interest-bearing assets is accrued at the end of each accounting period and placed
in an account named interest receivable. Wage advances, formal loans to employees, or loans to
other companies create other types of receivables. If significant, these nontrade receivables are
usually listed in separate categories on the balance sheet because each type of nontrade
receivable has distinct risk factors and liquidity characteristics.

Receivables of all types are normally reported on the balance sheet at their net realizable value,
which is the amount the company expects to receive in cash.

Sales of Merchandise on account (sales on credit)

Most transactions involving individuals, businesses, and governments are not paid
for immediately, but are paid over a period of time on a credit basis. Credit can be
defined as providing cash, goods or services in the present, with payment expected
in the future. Credit sales are recorded by debiting an Accounts Receivable account
for a specific customer and crediting the sales account.

To illustrate, assume that on March 23, 2009, Roba Company sold Br 500 worth of
merchandize on account to Hawi Company. On March 26, Hawi returned Br 200
worth of the merchandize because of damage. The sale and the return are recorded
in general journal form on the books of Roba as follows:

2008
March 23. Accounts receivable -Hawi Co ……. 500
Sales ………………….. 500
(Recorded sales on account)
26. Sales return and Allowances …………. 200
Accounts receivable- Hawi Co……. 200
(To record merchandize returned from a customer)

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1.2. Evaluating Accounts Receivable

Business owners know that some customers who receive credit will never pay their account
balances. These uncollectible accounts are also called bad debts.

Companies use two methods to account for bad debts:

 the direct write-off method and

 the allowance method.

Direct write-off method:

 Bad debts charged directly to expense when debt is considered un-collectable

 It is only acceptable in those cases where bad debts are immaterial in amount.
 direct write-off method is simple
 also called direct charge off method

If a customer named Tola fails to pay a Br225 balance, for example, the company records the
write-off by debiting bad debts expense and crediting accounts receivable from Tola. The
appropriate entry for the direct write-off approach is as follows:

2-10-210 Uncollectible Accounts Expense 225

Accounts Receivable 225
To record the write off of an uncollectible
account from Jones

Notice that the preceding entry reduces the receivables balance for the item that is deemed
uncollectible. The offsetting debit is to an expense account: Uncollectible Accounts Expense.

Allowance Method:

Allowance Method
 Estimate of doubtful debts made at the end of the period
 An adjusting entry is made at the end of each accounting period.
 This method is consistent with the principles of accrual accounting, recognizing the
expense in the same period as the related revenue
 Records an estimate of the expense in same period as the income to which it relates
 Creates an allowance that will be deducted from accounts receivable on the balance sheet
 Allowance also known as ‘provision’
 Since the specific customer accounts that will become uncollectible are not yet known
when the adjusting entry is made, a contra-asset account named allowance for bad debts,
which is sometimes called allowance for doubtful accounts, is subtracted from accounts
receivable to show the net realizable value of accounts receivable on the balance sheet.

1.3. Estimating Bad Debts expense

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The allowance method of accounting for bad debts requires an estimate of bad debts
expense to prepare the adjusting entry at the end of each accounting period. There
are two approaches to estimate bad debts expense using the allowance method:
1. Percentage of Total Receivables method and
2. Percentage of sales method
1. Percentage of Total Receivable methods /Balance sheet Approach/

The accounts receivable methods use balance sheet relations to estimate bad debts
primarily the relation between accounts receivable and the allowance amount. It is
based on the idea that some portion of the end-of- period accounts receivable
balance is not collectible. Estimating uncollectible account using accounts
receivable methods done in one of two ways:
a) Simple estimate of percent uncollectible from the total outstanding accounts
receivable/Percent of accounts receivable approach) and
b) Aging accounts receivable

a) Percent of accounts Receivable Method

The percent of accounts receivable approach assumes a given percent of a
company’s outstanding receivable are uncollectible. This estimated percent is based
on past experience and the experience of similar companies.
Estimated amount of Uncollectible = Total Amount X all outstanding
of Receivables Estimated Percent
If a company has Br100,000 in accounts receivable at the end of an accounting period and
company records indicate that, on average, 5% of total accounts receivable become uncollectible,
the allowance for bad debts account must be adjusted to have a credit balance of Br5,000 (5% of
Br100,000).
12-31-2010Uncollectible Accounts Expense 5,000
Allow. for Uncollectible Accounts 5,000
Estimate of bad debt

Unless actual write-offs during the just-completed accounting period perfectly matched the
balance assigned to the allowance for bad debts account at the close of the previous accounting
period, the account will have an existing balance.

 If write-offs were less than expected, the account will have a credit balance, and if
write-offs were greater than expected, the account will have a debit balance.

Assuming that the allowance for bad debts account has a Br200 debit balance when the adjusting
entry is made, a Br5,200 adjusting entry is necessary to give the account a credit balance of
Br5,000.

Dec. 31. Bad debts expense …………. 5,200

Allowance for Doubtful accounts ……… 5,200
(To record estimated bad debts)

If the allowance for bad debts account had a Br300 credit balance instead of a Br200 debit
balance, a Br4,700 adjusting entry would be needed to give the account a credit balance of
Br5,000.

* Allowance for doubtful account is:

- A contra receivable account.
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- It is also called Allowance for Bad debt and allowance for uncollectible
account
- On the balance sheet its balance is subtracted from the balance of Accounts
receivable
- Allowance for doubtful accounts is not closed at the end of the fiscal year.
It is deducted from accounts receivable in the current asset section of the
balance sheet
Accounts Receivable
- Allowance for doubtful accounts
Net Realizable value
The difference between Accounts receivable balance and Allowance for Bad Debts
is called net receivable or net realizable value – the actual amount of receivables
that is expected to be collected
b) Aging Accounts Receivable

In general, the longer an account balance is overdue, the less likely the debt is to be paid.
Therefore, many companies maintain an accounts receivable aging schedule, which categorizes
each customer's credit purchases by the length of time they have been outstanding. Each
category's overall balance is multiplied by an estimated percentage of uncollectibility for that
category, and the total of all such calculations serves as the estimate of bad debts. The accounts
receivable aging schedule shown below includes five categories for classifying the age of unpaid
credit purchases. The process of analyzing the receivable accounts in terms of the length of time
past due is called aging the receivables.

To illustrate assume the following age classification as of December 31, 2008 for Hacalu
Company.
Age Amount Provision (%) Estimated uncollectible
0-30 days ----Br 60,000 1% Br 600
31-60 days ------15,000 2% 300
61-90-------------10,000 10% 1,000
91-120--------------8000 20% 2,000
Above 120 --------7000 50% 3,500
Br.100, 000 Br7, 400

Dec 31, 2008 Bad debts expense --------------Br 7400

Allowance for uncollectible ------------------------7400
(To record estimated bad debts under aging method)
When using the balance sheet approach of estimating bad debts, you always
consider any prior balance in the allowance account. In determining the amounts of
the adjustment apply these rules:
1. A prior credit balance is subtracted from the current estimate – It exists
because actual write offs during the period were less than the amount
estimated to be uncollectible.
2. A prior debit balance is added to the current estimate a debit balance results
when the actual written off during the period exceed the amount estimated.
Assume that Hacalu’s ledger revealed an Allowance for Uncollectible Accounts credit balance of
Br1, 000 (prior to performing the above analysis). As a result of the analysis, it can be seen that
a target balance of Br7,400 is needed; necessitating the following adjusting entry:
12-31-X8 Uncollectible Accounts Expense 6,400
Allow. for Uncollectible Accounts 6,400

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To adjust the allowance account from a
Br1,000 balance to the target balance of
Br7,400 (Br7,400 – Br1,000)

You should carefully note two important points:

(1) With balance sheet approaches, the amount of the entry is based upon the needed change in
the account (i.e., to go from an existing balance to the balance sheet target amount), and
(2) The debit is to an expense account, reflecting the added cost associated with the additional
amount of anticipated bad debts.
2. Percentage of sales method (Income statement approach)
Under this method the amount of credit sales for the period is multiplied by an
estimated rate of bad debts. The estimated rate is usually based on the past
experience of the business.
Estimated Bad Debts = Credit sales x Estimated rate
for the period of bad debts

If a company has Br500,000 in credit sales during an accounting period and company records
indicate that, on average, 1% of credit sales become uncollectible, the adjusting entry at the end
of the accounting period debits bad debts expense for Br5,000 and credits allowance for bad
debts for Br5,000.

12-31-2009 Uncollectible Accounts Expense 5,000

Allow. for Uncollectible Accounts 5,000
Estimate of bad debt (Br,500,000 X 1%
= Br5,000)

Companies that use the percentage of credit sales method base the adjusting entry solely on total
credit sales and ignore any existing balance in the allowance for bad debts account. If estimates
fail to match actual bad debts, the percentage rate used to estimate bad debts is adjusted on future
estimates.

Writing off Uncollectible Accounts under Allowance Method: Now, we have seen how to
record uncollectible accounts expense, and establish the related allowance. But, how do we
write off an individual account that is determined to be uncollectible? This part is easy. When a
specific customer's account is identified as uncollectible, it is written off against the balance in
the allowance for bad debts account.

The following entry would be needed to write off a specific account that is finally deemed
uncollectible:

For example, if uncollectible balance of Br5,000 is removed from the books by debiting
allowance for bad debts and crediting accounts receivable.

-15-2010 Allow. for Uncollectible Accounts 5,000

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 Fundamentals of Accounting I (ACFn2031)
Accounts Receivable 5,000
To record the write-off of an uncollectible
account

Under the allowance method, a write-off does not change the net realizable value of accounts
receivable. It simply reduces accounts receivable and allowance for bad debts by equivalent
amounts.

Before writing off After writing off account

account
Accounts Receivable Br100,000 Br99,775

Less: Allowance for Bad Debts (5.000) (4.775)

Net Realizable Value Br95,000 Br95,000

Collection of an Account Previously Written Off

Customers whose accounts have already been written off as uncollectible will sometimes pay
their debts. When this happens, two entries are needed to correct the company's accounting
records and show that the customer paid the outstanding balance. The entry to record the recovery
involves two steps:

(1) A reversal of the entry that was made to write off the account, (reinstates the customer's accounts
receivable balance by debiting accounts receivable and crediting allowance for bad debts) and

(2) Recording the cash collection on the account records by debiting cash and crediting accounts
receivable.

6-16-2010 Accounts Receivable 1,000

Allow. for Uncollectible
1,000
Accounts
To reestablish an account previously
written off via the reversal of the
entry recorded at the time of write off

6-16-2010 Cash 1,000

Accounts Receivable 1,000
To record collection of account
receivable

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7.2. ACCOUNTING FOR NOTES RECEIVABLES

Definition of Notes Receivable
A promissory note (note receivable) is a written promise to pay specified amount
money either on demand or at a definite future date. Promissory notes are used in
many transactions, including
- paying for products and services
- in the ending and borrowing of money and
- To pay for account receivables
Note contains the following parts:
1. Date – the date of the note
2. Time – the length of time between the date the note is issued and the (period) date
it is due for payment (note’s life span)
3. Payee – the party to whom payment will be made
4. Principal (Face value) - the stated amount of the note
5. Maker – the party promising to make payment,
6. Interest – the charge imposed on the borrower of funds for the use of money
7. Due date – the day the note will be due

Determining the Due date of a Note

The maturity date (due date) of a note is the day the note (principal & interest) must
be paid. When the time of the note is expressed in days, the maturity date is the
specified number of days after the note’s date. Example: - The Maturity date of a
90 – day note dated July 10 is computed as follows:
Term of notes ………….. ……… 90
July (days) ……………… 31
Date of note July …. ………10 21
Number of days remaining ……... 69
August (days) …………………….. 31
Number of days remaining ………..38
September (days) ……………….. . 30
Maturity date, October ……… 8
The period of a note is sometimes expressed in months or years. When months are
used, the note matures and is payable in the month of its maturity on the same day
of the month as its original date.
A 3 – month note dated July 10, for instance, is payable on October 10, the same
analysis applies when years are used.
Interest Computation
Interest is the cost of borrowing money for the borrower or the profit from lending
money for the lender. To calculate interest, three factors are needed:
1. Principal of the note – the amount borrowed
2. Rate of interest percent charged on the principal
3. Time of the note – Number of years, months, or days from the date of issue to
the date of maturity.
A note that provides for payment for interest for the period between the issuance
date and the maturity date is called an interest bearing note. If a note makes no
provision for interest, it is said to be non-interesting bearing note.
The following formula is used to calculate interest on an interest bearing note:
Interest = Principal X Rate X time
I= P X R X T

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To illustrate, assume a note with a principal of Br 1, 400, a rate of 10% and a time
of two years. Interest is computed as follows:
I = P X RX T
= Br1, 400x10%X 2 years
= Br 280
The interest on a Br 1,200, 9% note for three months is calculated as:
I = PXRXT
= Br1, 200 X 9%X3/12
= Br27
When a time of a note is expressed in days, the time factor is stated as a fraction of
360 days. To illustrate the note that has a principal of Br 700, a rate of 9%, and a
time of 30 days is computed as follows:
I=PXRXT
= Br 700 X 9% X 30/360 = Br 5.25

Accounting For Notes Receivable: To illustrate the accounting for a note receivable,
assume that Hope initially sold Br10,000 of merchandise on account to Wisdom. Wisdom later
requested more time to pay, and agreed to give a formal three-month note bearing interest at 12%
per year. The entry to record the conversion of the account receivable to a formal note is as
follows:

1/6/2010 Notes Receivable 10,000

Accounts Receivable 10,000
To record conversion of an account
receivable to a note receivable

The principal and interest of a note are due on its maturity date. The maker of the
note usually honors the note and pays it in full.

 The note that is paid in full at its maturity date is called honored note.
 When the note matures, Hope's entry to record collection of the maturity value would
appear as follows:

31/8/2010 Cash 10,300

Interest Income 300
Notes Receivable 10,000
To record collection of note receivable
plus accrued interest of Br300
(Br10,000 X 12% X 90/360)

A Dishonored Note: When a note’s maker is unable or refuses to pay at maturity, the
note is dishonored. When a note is dishonored, we remove the amount of this note
from the note receivable account and charge it back to an account receivable from
its maker.
If Wisdom dishonored the note at maturity (i.e., refused to pay), then Hope would prepare the
following entry:
31/8/2010 Accounts Receivable 10,300
Interest Income 300

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Notes Receivable 10,000
To record dishonor of note receivable
plus accrued interest of Br300
(Br10,000 X 12% X 90/360)

The debit to Accounts Receivable in the above entry reflects the hope of eventually collecting all
amounts due, including the interest, from the dishonoring party. If Hope anticipated some
difficulty in collecting the receivable, appropriate allowances would be established in a fashion
similar to those illustrated earlier in the chapter.

Notes and Adjusting Entries: In the above illustrations for Hope, all of the activity occurred
within the same accounting year. However, if Hope had a June 30 accounting year end, then an
adjustment would be needed to reflect accrued interest at year-end. The appropriate entries
illustrate this important accrual concept:

Entry to set up note receivable:

1/6/2010 Notes Receivable 10,000

Accounts Receivable 10,000
To record conversion of an account
receivable to a note receivable

Entry to accrue interest at June 30 year end:

30/6/2010 Interest Receivable 100

Interest Income 100
To record accrued interest at June 30
(Br10,000 X 12% X 30/360 = Br100)

Entry to record collection of note (including amounts previously accrued at June 30):

31/8/2010 Cash 10,300

Interest Income 200
Interest Receivable 100
Notes Receivable 10,000
To record collection of note receivable
plus interest of Br300 (Br10,000 X
12% X 90/360); Br100 of the total
interest had been previously accrued

Converting Receivables to cash before Maturity

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Some times companies convert receivables to cash before they are due. Reasons for
this include the need for cash or a desire to not be involved in collection activities.
Converting receivables is usually done either:
1) By selling(factoring) or
2) By using them as security for loan(pledging)
1) Factoring (Selling) Receivables

 Companies sometimes need cash before customers pay their account balances. In such
situations, the company may choose to sell accounts receivable to another company that
specializes in collections. This process is called factoring.
 The company that purchases accounts receivable is often called a factor.
 The factor usually charges between one and fifteen percent of the account balances. The
reason for such a wide range in fees is that the receivables may be factored with or
without recourse. Recourse means the company factoring the receivables agrees to
reimburse the factor for uncollectible accounts. Low percentage rates are usually offered
only when recourse is provided.

Suppose a company factors Br500,000 in accounts receivable at a rate of 3%. The company
records this sale of accounts receivable by debiting cash for Br485,000, debiting factoring
expense (or service charge expense) for Br15,000, and crediting accounts receivable for
Br500,000.

Cash……………………….485,000
Factoring fees expense……. 15,000
Accounts receivable……………..500,000
(Factor accounts worth Br500,000)

In practice, the credit to accounts receivable would need to identity the specific subsidiary ledger
accounts that were factored, although to simplify the example this is not done here.

2) Pledging Accounts Receivable

A company can also raise cash by borrowing money and then pledging its accounts
receivable as security for the loan. Pledging receivables does not transfer the risk of
bad debts to the lender. The borrower remains ownership of the receivables. But if
the borrower defaults on the loan, the lender has the right to be paid from cash
receipts when the accounts receivable are collected. When Forest Company
borrowed Br35,000 and pledged its receivables as a security, it recorded this
transaction as:
Cash………………………..35,000
Notes receivable………………..35,000
(Borrowed money with a note secured by pledging accounts receivable)

Discounting a Note Receivable

Discounting a note receivable is a selling of note receivable at a discount that is less
than the maturity value. The process of discounting a customer’s note involves
several steps. To illustrate, assume that Freedom Company received a Br 600, 60-
day, 10% note on account from a customer on July 14, 2008. Because the company

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 Fundamentals of Accounting I (ACFn2031)
needed cash immediately, Freedom discounted the note at Oromia International
Bank on August 3, 2008. Oromia International Bank charges a discount rate of 12%
on all discount notes.
The steps involved:
1. Calculate Interest
Interest = Principal x Rate x time
= br600 x 10% x 60/360
= Br10
2. Calculate the maturity value of the note
Maturity value = principal + interest
= Br 600 + 600x10%x60/360
= Br600 + Br10= Br610

3. Calculate the due date of the note

Term of note ………………………………… 60
Number of days remaining in July (31-14)…. 17
Number of days remaining ……………… 43
Days in August …………… 31
Due date, September ……………. 12
4. Calculate the discount period. we can find the discount period as follows:
Issue date July ………. 14
Days in July…………...31……...17
Discount date August ………… 3
20days
Term of note ………………….. 60
Discount period ……………….. 40days
5. Calculate the amount of the bank discount.
Discount amount = maturity Value X Discount rate X Discount period
=Br 610 X 12% X 40/360 = Br 8.13
6. Calculate the proceeds (cash received)
Proceeds = Maturity value – Discount amount
= 610 – Br 8.13 = Br 601.87
7. Journalize the transaction
Aug. 3 Cash …………………… 601.87
Notes Receivable……………….600
Interest income………………….1.87
(Discounted customer’s note at 12%)
The cash account will be debited for the amount received Br601.87 and notes
Receivable account is credited for the face value of the note, Br600. The difference
between the amount debited (the proceeds) and the face value of the note is either
interest income or interest expense. If the proceeds are greater than the face value,
you have interest income. Credit the interest income account for the difference. If
the proceeds are less than the face value, you have interest expense, Debit the
interest expense account for the difference.
Comparison of Accounts Receivable Vs Notes Receivable
A notes receivable has the following advantages over an accounts receivable:
1) A note is a formal written promise, serving as proof of a transaction.
2) A note can bear interest , which is additional revenue
3) A note is negotiable; it can be transferred by endorsement to obtain cash or
other assets

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4) A note can be pledged(used) as security for a loan
7.3. Accounting for Temporary Investments
A business may have a large amount of cash on hand that is not need immediately, but this cash
may be needed later in operating the business, possibly within the coming year. Rather than
allow this excess cash to lie idle until it is actually needed, the business may put all or a part of it
into income-yielding investments, such as certificates of deposit and money market funds. In
many cases, the idle cash is invested in securities that can be quickly sold when cash is needed.
Such securities are known as temporary investments or marketable securities.
Short term investments can include both:
 debt and
 Equity securities.
Debt securities reflect a creditor relationship and include investment in notes, bonds, and
certificate of deposits. Debit securities are issued by governments, companies, and individuals.
Equity securities reflect an ownership relationship and include shares of stock issued by
companies.
Debt securities
Short term investments in both debt and equity securities are recorded at cost when purchased.
Hope company, for instance, purchased short-term notes payable of Intel for Br4,000 on January
10. Hope’s entry to record this purchase is:
Jan. Short-term investments……………4,000
Cash……………………………………4,000
Bought Br4,000 of Intel notes due May 10.
These notes mature on May 10 and the cash proceeds are Br4,000 plus Br120 interest. When the
proceeds are received, Hope records this as:
May Cash………………….4,10
Short-term investment………4,000
Interest earned……………… 120
Received cash proceeds from matured notes
Equity Securities
The cost of an investment includes all necessary costs to acquire it, including commissions paid.
Hope Company purchased 100 shares of OIB common stock as a short term investment. It paid
Br50 per share plus Br100 in commissions. The entry to record this purchase on June 2 is:
June 2: Short-term investments………….5,100
Cash ……………………………..5,100
Bought 100 shares of OIB at 50 plus Br100 commission

Temporary Investments and Receivables in the Balance Sheet

 Stocks and bonds held as temporary investments are classified on the balance sheet as
current assets. They may be listed after "Cash," or they may be combined with cash and
described as "Cash and marketable securities."
 Temporary investments and all receivables that are expected to be realized in cash within

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 Fundamentals of Accounting I (ACFn2031)
a year are presented in the Current Assets section of the balance sheet. It is customary to
list the assets in the order of their liquidity, that is, in the order in which they can be
converted to cash in normal operations.

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