DEPARTMENT OF ACCOUNTING AND

FINANCE
DISTANCE STUDIES

TECHNO STAR COLLEGE

DEPARTMENT OF ACCOUNTING
AND FINANCE

Distance Module for Degree

Program

Course Title: - Fundamentals of

Accounting I
Course Code: - AcFn2011

Distance Education Program

January, 2021

DISTANCE EDUCATION MODULE

FOR
PRINCIPLES OF ACCOUNTING PART I
(AcFn1031)
 UNIT ONE: BASIC STRUCTURE OF ACCOUNTING

List of Contents:
 Unit Objective
 Introduction
1.1 Accounting As an Information System
1.2 Profession of Accountancy
1.3 Specialized Accounting Fields
1.4 Accounting Principles and Practice
1.5 Business Transactions and the Accounting Equation
1.6 Financial Statements
1.7 Model Examination Questions
 List of Reference Materials

Unit Objective

The unit aims at discussing some of the fundamental concepts of accounting. Detail
discussions and explanations will be made on such issues like: accounting as information
system, profession of accountancy, accounting principles and practices, business transaction
and the accounting equation, etc. Thus, after the completion of this unit you will be able to:
 Explain accounting as an information system
 Describe the profession of accounting and its specialized fields
 Discuss the development of accounting principles and their relation to practice
 Describe business transaction

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  Identify the accounting equation and its basic elements
 Analyze the effect of business transactions on the basic accounting equation.
 Illustrate the effect of business transactions
 Describe the financial statements of a sole proprietorship and a corporation.

Introduction

Have you ever known the term “financial information system”? What are the processes
involved in the system?

As a financial information system, accounting is a process of three activities: identifying,

recording, and communicating the economic events of an organization (business or non-
business) to interested users of the information.

In this unit the various aspects of accounting principles and practices such as accounting is
used as part of information system; the profession of accountancy, the type and nature of
business transactions, how those transactions affect assets, liabilities and owner’s equity, and
various information that can be obtained from those basic financial statements of sole
proprietorship and a corporation will be covered.

1.1. Accounting as an Information System

Why accounting has been called “the language of business”?

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Accounting has been called the “language of business” because it is a means of
communicating business information.
As an information system it provides appropriate information about the financial activities of
an entity to various individuals or groups to make sound decision. Basically, accounting
information is composed of financial data about business transaction expressed in terms of
money. The financial data must be recorded. The mere record of a transaction does not
provide sufficient information to make informed decision. The recorded data must be sorted
and summarized to make reports. The reports are basis for decision making.

1.1.1. Users of Accounting Information

Dear students, would you identify the two broad groups of users of accounting in formation?
Cite few examples from each group before you go to the following discussion.
The users of accounting information may be divided into two broad groups: internal users
and external users.

1.1.1.1. Internal Users

Management personnel are the internal users of accounting information. This users group is
responsible for (i) planning and controlling current operation and (ii) for making informed
business decisions.

In broader terms there are three types of internal users: - Management, labor unions and
employees.
1.1.1.2 External Users
External users of accounting information are those parties which are having certain interest
with concerned entity. This users group is sometimes called outsiders because they are not
taking a part in the management and operation of the entity under consideration.

Check Your Progress: Exercise 1.1.

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1. Why often accounting is known as a “Language of business”?
___________________________________________________________________________
___________________________________________________________________________
__________________________________________________________________
2. What is the objective of accounting?
___________________________________________________________________________
___________________________________________________________________________
__________________________________________________________________

1.2. Profession of Accountancy

What is the purpose of public accounting? Have you heard about CPAs?
The accounting profession typically has two major fields: Private Accounting, and Public
Accounting.

1.2.1 Private Accounting

An accountant may be an employee of a business enterprise or for not profit organization i.e.
as a chief accountant, controller, or financial vice president is said to be engaged in Private
Accounting.

The scope of activities and responsibilities of private accountants varies widely. They are
frequently referred to as managerial accountants or cost accountants if they are employed by
a manufacturing concern, accountants engaged in different governmental units and not-for-
profit organization and also referred as private accountants.
Private accountants can be
i) Managerial accountants
ii) Internal auditors, etc.
1.2.2. Public Accounting

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In a public accounting, accountants offer expert services to the general public on a fee basis.
Public accountant who have met standard education, experience and examination
requirements may become certified public accountants, commonly called CPAs.

CPAs have a duty not only to their clients but to their colleagues and the public to perform
services competently and with integrity. Called code of professional conduct or codes of
professional ethics have been established by AICPA (American Institute of Certified Public
Accounting) to guide CPAs in the conduct of their practices.

The purpose of codes of professional ethics is to create confidence in the quality of services
rendered by CPA, in a manner to meet honorable behavior, even at the sacrifice of personal
advantage and interest.

1.3 Specialized Accounting Fields.

Can you identify some specialized accounting fields?

Several specialized field in accounting have evolved as a result of ever increasing rapid
technological advances and accelerated economic growth. Among the most important
accounting fields are described briefly in the following paragraphs.

Financial Accounting: - Concerned with the recording of transactions for a business

enterprise or other economic unit and the periodic preparation of various reports from such
records. The report is a general-purpose one that can equal is important in meeting the users’
interest. Financial Accounting reports are prepared based on Generally Accepted Accounting
Principles (GAAP)

Auditing: - as a specialized accounting field involving an independent review of the

accounting records. During audit work, public accountants examine the records supporting

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the financial reports of an enterprise and give an opinion regarding their fairness and
reliability. Auditors' responsibility (job) may take to forms.

i) Internal auditors: - those who are responsible about the operations of the
business (organization) to determine compliance with management policies and
evaluating the efficiency of operations.
ii) External auditors: - those examine the records supporting the financial
statements of a firm and give an opinion.

Cost Accounting: - particularly concerned with determination and control of the cost of
producing specific products. It is primarily concerned with the cost of manufacturing
processes and of manufactures products ultimately management uses these date in controlling
current operations and in planning for the future.

Managerial Accounting: - Uses both historical and estimated data in assisting management
in daily operations and planning future operations it deals with specific problems that
confront enterprise managers at various organizational levels. It is frequently concerned with
identifying alternative courses of action and then helping to select the best one.

Tax Accounting: - deals with the preparation of tax returns and the consideration of the tax
consequences of proposed business transactions or alternative courses of action. One
specialized in this field should be well informed about tax statues, administrative regulations
and court decisions on tax cases.

Accounting system: - is the specialized field concerned with the design and implementation
of procedures for the accountant must device appropriate “checks and balance” to safe guard
business properties and provide for information flow that will be efficient and helpful to
management.

Budgetary Accounting: - presents the plan of financial operation for a period and through
records and summaries, provided comparisons of actual operation in the predetermined plan.

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A combination of planning and controlling future operations, it is sometimes considered to be
a part of managerial accounting.

International Accounting: - is concerned with the special problems associated with

international trade of multinational business organizations, Accountants specializing in this
area must be familiar with the influences that custom, law and taxation of various countries
bring to bear on international operations and accounting principles.

Not-for-profit Accounting: - specializes in recording, reporting, and planning the operations

of various governmental units and other not-for-profit organizations such as churches,
charities, and educational institutions.

Social Accounting: - is a kind of specialization which emphasizes the measurement of social

costs and benefits.

Check Your Progress: Exercise 1.2

1. Differentiate between private accounting and public accounting

________________________________________________________________________
________________________________________________________________________
_______________________________________________________________

2. Identify some of the specialized fields of accounting activity.

________________________________________________________________________
________________________________________________________________________
_______________________________________________________________

1.4 Accounting Principles and Practice

Dear students, here after we are trying to have discussion with accounting principles that
can serve as a corner stone for accounting practices.

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To keep in pace the ever increasing changes and developments in science and technology,
accounting principles and practices develop constantly. Experienced professional accountants
contribute their best thinking to the solution of problems continually confronting their clients
or employers. Financial Accounting Standard Board (FASB) and Accounting Principles
Board (APB) are among the very important professional associations that issues
pronouncements on accounting principles periodically.

1.4.1 Business Entity Concept

The essence of this concept is business affairs of the business enterprise (organization) must
be kept separate from those of its owners and other entities.
The business entity concept is based on the applicability of accounting to individual
economic units in society. Among the individual economic units business enterprise
organized for profit and other not-for-profit are included. The basic assumption under this
concept is that personal transactions of owners should be kept separate from those of the
business enterprise. Commonly, business enterprises are organized in ownership as sole
proprietorships, partnerships or corporations.

 A sole proprietorship is a business owned by a single person. Most often

they are small business that are operated and managed by their owners.
 A partnership- a form of business entity in which two or more persons
owned the business based on their contractual arrangement.
 A corporation- A corporation organized in accordance with state or federal
status and is a separate legal entity in which ownership is divided in to shares
of stock.

1.4.2 The Cost Principle

The records of properties and services by a business are maintained in accordance with the
cost principle, which requires that the monetary record be in terms of cost. The time of
exchanges the amount paid by the buyer is used in the buyer’s accounting records.

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1.5 Business Transactions and the Accounting Equation

What do you understand when ever you heard about the term business transactions? Have
you encountered with such a transaction?

1.5.1 Business Transactions

Business transactions cause changes in the assets, liabilities, or owner’s equity of a business
enterprise /organization transactions may be classified in to two broad groups
i) External transaction : transactions occurred between the organization and
outsiders such as payment of debts, sales on account, etc.,
ii) Internal transactions: Expiration or transfer of costs within the firm. Such as
depreciation of plant assets, estimation of doubtful accounts expense.

A business transaction is the occurrence of an event or a condition that must be recorded. For
example the payment of monthly rent of Birr 3,000.00, the purchases of merchandise for Birr
5,000.00 on credit, and acquisition of land and building for Birr 450,000.00.

A certain business transaction may lead to an event or a condition that result in another
transaction. For example, the purchase of merchandise on credit will be followed by payment
to the creditor which is another transaction that must be recorded.

1.5.2 Assets, Liabilities and Owner’s Equity

The properties (resources) owned by a business enterprise are referred to as assets and the
rights or claims to the properties (or assets) are referred to as equities. If the assets owned by

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a business amount to Br. 500,000.00, the equities in the assets must also amount to Birr
500,000.00. The relationship between the two may be stated in the form of an equation as
follows.

ASSETS = EQUITIES

The equities may be subdivided in to two principal types the rights of creditors and the
rights of owners. The rights of creditors represent debts of the business and are called
liabilities. The rights of the owner or owners are called owner’s equity. Expansion of the
equation to give recognition to the two basic types of equities which is known as accounting
equation.

This equation is referred to as the basic accounting equation. Assets must equal to sum of
liabilities and owner’s equity. The extended form of algebraic form expression will be as
follows.

ASSETS = LIABILITIES + OWNER’S EQUITY

In terms of priority, placing “Liabilities” before “owner’s equity” is appropriate in the

accounting equation to show that creditors have preferential rights to the assets.

Check Your Progress: Exercise 1.3

1. What is meant matching principle?

______________________________________________________________________
______________________________________________________________________
_____________________________________________________________

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2. How are revenues reported under the accrual basis of accounting?

______________________________________________________________________
______________________________________________________________________
_____________________________________________________________

1.5.3 Transactions and the Accounting Equation

What is accounting equation? What are its elements?

In general, business transactions be it simple or complex, can be stated in terms of the

resulting change in the three basic elements of the accounting equation. The following
transactions are used to demonstrate the effect on the elements of the accounting equation.
The transactions are about a new transport business during the first month of operations.

Transaction (1)
In the first month of business operation Ato Melkamu made a deposit of Birr 80,000 in a
bank account in the name of Melkamu Transport Agency. The effect of this transaction is to
increase the asset (cash) on the left side of the equation by Birr 80,000 and to increase
owner’s equity on the other side of the equation by the same amount. Owner’s equity is
usually referred by the name of the owner and “capital” i.e. Melkamu, capital.”

Assets Owner’s Equity

Cash = Melkamu Capital
(1) 80,000.00 80,000.00 Investment

Note that Melkamu’s personal assets such as his home and his personal bank account and his
personal liabilities are excluded from consideration.

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Transaction (2)
For further expansion Melkamu decided to purchase land as a future building site for which
Birr 45,000.00 cash is paid. This transaction brings certain changes up on the composition of
the assets but does not change the total amount. The effects of the transaction and the new
balances are as follows:

Assets = Owner’s equity

Cash + Land Melkamu, capital
Bal. 80,000 80,000
(2) -45,000 + 45,000 ________
35,000 45,000 80,000

Transaction (3)
During the month, Melkamu purchases Birr.9000 of gasoline oil and other supplies from
various suppliers agreeing to pay in the near future. This types of transaction is called a
purchase on account and the liability create is termed an account payable. Consumable
goods such as supplies are considered to be prepared expenses or assets. The effect of the
above transaction is to increase asset and liabilities by birr 9,000 as follows.

Assets = Liabilities + owner’s Equity

Cash + supplies + Land Accounts payable + Melkamu’s Capital
Bal. 35000 45,000 80,000
(3)
_______ +9,000 _______ +9,000 ______
35,000 9,000 45,000 +9,000 80,000

Transaction (4)
During the month, Birr 6,000 is paid to creditors on account, thereby reducing both assets
and liabilities. The effect on the equation is as follows.

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 Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land Accounts payable + Melkamu’s capital
Bal. 35000 9000 45000 9000 80,000
(4) – 6000 _____ _______ -6000 ______
29000 9000 45000 3000 80,000
Transaction (5)
In general the amount charged to customers for goods or services sold to them is called
revenue. Other terms may be used for certain kinds of revenue, such as sales for the sale of
merchandise or business services, fees earned for charges by a physician to patients, rent
earned for use of real estate or other property and fares earned for services as transport
business.

During the first month of operation, Melkamu Transport Agency earned of Birr 18,000
receiving the amount in cash, the effect of this transaction is to increase cash by Birr 18,000
and to increase owner’s equity by the same amount as follows.

Assets = Liabilities + Owner’s Equity

Cash + supplies + land Account payable + Melkamu, capital
Bal. 29,000 9000 45,000 3,000 80,000
(5) 18,000 ______ _______ ______ 18,000 fares earned
47,000 9,000 45,000 3,000 98,000

In the ordinary course of business, the owner may not always require cash at the time goods
or services are sold, a business may make sales on account allowing the customer to pay
later. In such situation the firm acquires an account receivable, which is a claim against the
customer. An account receivable is as much an asset as cash and the revenue is realized in
exactly the same manner as if cash had been immediately received. At a later date, up on the
money collection, cash increased and accounts receivable decreased.
Transaction (6)

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The amount of assets consumed or services used in the process of earning revenue is called
expense. Expenses would include supplies used, wages of employees, and other assets and
services used in operating the business. For Melkamu Transport Agency, various business
expenses incurred and paid during the month were as follows: wages, Birr 3,500, rent, Birr
2000, utilities, Birr 950, miscellaneous, Birr 750. The effect of this group of transaction is to
reduce cash and to reduce owner’s equity as follows.

Assets = Liabilities + Owner’s Equity

Cash + supplies + land Accounts payable + Melkamu’s capital
Bal. 47000 9000 45000 3000 98,000
(6) -7200 - 3500 Wages Exp
- 2000 Rent Exp
- 950 Utilities Exp
- 750 Misc. Exp
______ _____ _____ ______ ________
39800 9000 45000 3000 90,800

Transaction (7)
At the end of the month it is determined that cost of supplies on hand is Birr 3000, the
remainder (9000 - 3000) have been used in the operations of the business. This reduction of
Birr 6000 of supplies from owner’s equity may be shown as follows:

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Land Account Payable + Melkamu, Capital
Bal. 39800 9000 45000 3000 90,800
(7) -6000 _____ -6000 Supp. Exp.
39800 3000 45000 3000 84800

Transaction (8)

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At the end of the month Melkamu withdraws from the business Birr 2000 in cash for his own
personal use. The effect of this transaction which reduces cash and reduces owner’s equity is
the exact opposite of an investment in the business by the owner. It is not a business expense,
but a withdrawal of a portion of the owner’s equity. The effect of such a withdrawal is shown
as follows:

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Land Accounts Payable + Melkamu, capital
Bal. 39,800 3,000 45,000 3,000 84,800
(8) -2,000 ____ ______ _____ -2,000Withdrawal
37,800 3,000 45,000 3,000 82,800

The business transactions of Melkamu Transport Agency are summarized in a tabular form
as follows. The transactions are identified by number, and the balance of each item is shown
after each transaction.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land Account Payable + Melkamu, Capital
1) + 80,000 +80,000 Investment
2) – 45,000 +45,000 _______
35,000 45,000 80,000
3) _________ + 9,000 ________ + 9,000 ________
35,000 9,000 45,000 9,000 80,000
4) - 6,000 _______ ______ - 6,000 ________
29,000 9,000 45,000 3,000 80,000
5) + 18,000 _______ ______ ______ +18,000Fares earned
47,000 9,000 45,000 3,000 98,000
6) – 7,200 - 3,500 Wages exp.
- 2,000 Rent exp
- 950 Utilities ex
- 750 Misc. exp
______ ______ ______ ______ _________
39,800 9,000 45,000 3,000 90,800
7) ______ - 6000 ______ _____ - 6,000Supplies exp

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 39,800 3,000 45,000 3,000 84,800
8) -2,000 _____ _______ _____ -2,000 Withdrawals
37,800 3,000 45,000 3,000 82800

The summary of the effect of the transaction shown above apply to all types of businesses.
The following observation should be noted.

i) The effect of every transaction can be stated in terms of increases

and/or decreases in one or more of the accounting equation elements.
ii) The equality of the two sides of the accounting equation is always maintained.
iii) The owner’s equity is increased by amounts invested by the owner and is decreased by
withdrawals by the owner. In addition, owner’s equity is increased by revenues and is
decreased by expenses.

Check Your Progress: Exercise 1.4

1. Identify the three elements of the accounting equation.
______________________________________________________________________
______________________________________________________________________
_____________________________________________________________
2. Suppose an enterprise has liabilities of Birr 50,000 and owner’s equity of Birr 250,000.
What is the total the amount of its total assets?
______________________________________________________________________
______________________________________________________________________
_____________________________________________________________

1.6. Financial Statements

Why business enterprises prepare periodic financial statements?

Would you identify the basic financial statements? Provide your answer in writing
before you go to the following discussions

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Periodic financial statements communicate users of accounting information those pertinent
data which enable them to know about the financial operation and position of a firm (an
entity). Moreover, the financial statements ultimately help users to make sound decision.

Thus, after completion of the analysis of business transactions, the essential information is
communicated to users through financial statements. The accounting statements that
communicate such information are known as financial statements.

The basic (principal) financial statements are the income statement, the statement of owner’s
equity, the balance sheet and the statement of cash flows.

1.6.1 Financial Statements for a Sole Proprietorship (and Partnership Business)

a) Income Statement

An income statement shows the operating results of a firm over a period time. It is a
summary of the revenue and expenses of a business entity for a specified period of time such
as a month or a year. The excess of revenue over expenses incurred in earning revenue is
called net income or net profit. If the expenses exceed the revenue, the result is net loss.

b) Statement of Owner’s Equity

It is all about a summary of changes in the owner’s equity of a business entity that have
occurred over a specified period of time such as a month or a year.

In our previous examples for Melkamu Transport Agency there are three types of
transactions affected owner’s equity account. (1) The original investment of Birr 80,000, (2)
the revenues and expenses which resulted net income of birr 4,800 for the month, and (3) a

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withdrawal of Birr 2,000 by the owner. All these information is summarized by the statement
of owner’s equity.
c) Balance Sheet
A balance sheet presents the financial condition of a business entity on a specific date. It is a
list of assets, liabilities and owner’s equity as of a specific date, usually at the end of a month
or a year.

d) Statement of Cash Flows

A statement of cash flows focuses on transactions that directly affect cash. It is a summary of
the cash receipts and cash payments of a business entity on a particular date, usually at the
last day of a month or a year. Hence statement of cash flows presents information about the
inflows and outflows of cash due to financing, operating and investing activities of a business
entity during an accounting period.

Based on our previous examples, each of these statements will be illustrated as follows:

Melkamu Transport Agency

Income Statement
For month ended Meskerem 30, 2000

Fares Earned.......................................................................................... Birr

18,000
Operating expenses
Wages Expanse.......................................................... Birr 3,500
Rent Expense ............................................................. 2,000
Supplies Expense........................................................ 6,000
Utilities Expense........................................................ 950
Miscellanies Expense.................................................. 750
Total Operating Expenses....................................................... 13, 2000

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Net Income.............................................................................. Birr 4,800

Statement of owner’s equity is affected by three types of transactions:

i) The original investment of Birr 80,000

ii) The revenues and expenses that have occurred and resulted in net income of Birr
4,800 for the month and.
iii) A withdrawal of Birr 2,000 made by the owner. All this information is
summarized in the statement of owner’s equity as follows:

Melkamu Transport Agency

Statement of Owner’s Equity
For the Month Ended Meskerem 30, 2000

Investment during the month............................................. Birr 80,000

Net Income for the month................................................. Birr 4,800
Less: Withdrawals............................................................ (2,000)
Increase in Owner’s Equity.............................................. 2, 800
Melkamu, Capital, Meskerem 30, 2000............................ Birr 82,800

As far as balance sheet preparation is concerned, the assets, liabilities and owner’s equity
amounts are arranged in two forms: one of the forms presents the liability and owner’s equity
sections just below the asset section, such a from is called report form. The other
arrangement which is the common one list the assets on the left side and the liabilities and
owner’s equity on the right side is referred to as the account form of balance sheet.

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Customarily, the listing begins with the asset section with cash. The following item is
receivables and then supplies and other prepaid expenses which depend up on their
convertibility in to cash or used up (consumed) in the near future.

Melkamu Transport Agency

Balance Sheet
Meskerem 30, 2000

Assets
Cash........................................................................................... Birr 37,800
Supplies..................................................................................... 3,000
Land........................................................................................... 45,000
Total Assets.............................................................................. Birr 85,800
Liabilities
Accounts payable....................................................................... Birr 3,000

Owner’s Equity
Melkamu, Capital...................................................................... 82,800
Total liabilities and Owner’s Equity...................................... Birr 85,800

In reporting cash flows (cash receipts and cash payments) statement of cash flows presents
those essential data from three perspectives. Three sections of business entity’s activities are
shown below.

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 1. Operating activities
2. Investing activities
3. Financing activities
Based on our previous data the statement of cash flows summaries the cash flows from
operating activities includes cash transactions that determine the net income. For Melkamu
Transport Agency, the cash received from customers was Birr 18,000 for fares earned. Cash
payments totaled Birr 13,200 which comprises of Birr 6000 paid to creditors for supplies
purchased and Birr 7,200 paid for wages, rent, utilities, and miscellaneous expense. The net
cash flow from operating activities is Birr 4,800 (Birr 18,000 – Birr 13,200)
Melkamu Transport Agency’s cash flow related to investing activities was the acquisition of
land for Birr 45,000.

The cash flows from financing activities section reports the cash transactions related to cash
investments by the owner and borrowings and cash withdrawals of the owner. For Melkamu
Transport Agency, the cash flows from financing activities were Birr 80,000 from the
investment by the owner, less Birr 2000 of cash withdrawals by the owner. The net cash flow
from financing activities, Birr 78,000 is determined by subtracting the cash withdrawals of
Birr 2,000 from Birr 80,000 cash received from the owner as an initial investment.

Since Meskerem was Melkamu Transport Agency’s first month of operations, the increase in
cash flows for Meskerem is the Meskerem 30, 2000 balance. In future statements, the cash
balance at the beginning of the period is added to the increase (or decrease) in cash for the
period to indicate the cash balance at the end of the period. To illustrate assume Melkamu
Transport Agency’s net cash flows for Meskerem increased by Birr 2,800. The increase
resulted from the following cash transactions:

Cash received from customers.................................. Birr 18,000

Cash payments from expenses and
Payments to creditors .................................... 13,200
Cash withdrawal by owner ........................................ 2,000

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The statement of cash flows for Melkamu Transport Agency for Meskerem would be as
follows:

Melkamu Transport Agency

Statement of Cash Flows
For Month Ended Meskerem 30, 2000

Cash flows from operating activities:

Cash received from customers...................................................... Birr 18,000
Deduct cash payments for expenses and
Payments to creditors........................................................ 13,200
Net cash flow from operating activities...................................... Birr 4,800
Cash flows from investing activities:
Cash payments for acquisition of land......................................... (45,000)
Cash flows from financing activities: ............................ Birr 80,000
Deduct: cash withdrawal by owner............................... (2,000)
Net cash flow from financing activities................................. 78,000
Net cash flow Meskerem 30, 2000 and cash balance........... Birr 37,800

Check Your Progress: Exercise 1-5

1. What are the basic financial statements of a service giving enterprise?

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 ________________________________________________________________________
________________________________________________________________________
_______________________________________________________________

2. Name the three types of activities reported in the statements of cash flows.

________________________________________________________________________
________________________________________________________________________
_______________________________________________________________

1.6.2 Financial Statement for Corporation

Is there any difference between the financial statements of a corporate type of business and
the financial statement of sole proprietorship? Give your own reasons before you go through
the following paragraphs.

The previous financial statements, illustrated, assume that the business enterprise was owned
by a single individual, a sole proprietorship.

Most of the time business enterprise having large amounts of assets are usually organized as
corporate businesses (corporations) and have many owners, called stockholders

a) Income Statement

If Melkamu Transport Agency had been organized as a corporation ownership represented by

shares of stock, its income statement would be similar to the one previously shown. The
remaining financial statements would be different in some respects from the corresponding
statements for a sole proprietorship (and partnership).

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b) Retained Earnings Statement

A statement of retained earnings or a statement of stockholders’ equity is included with a

every set of financial statements of a corporate type of business enterprises.

In a corporate enterprise the emphasis in reporting changes in stock holders (owners’) equity
is on the changes in retained earnings, or net income retained in the business. The changes in
retained earnings that have occurred during a period are reported in a retained earnings
statement.

In a corporate (corporation) business, changes in the amount of earnings retained in the

business would have resulted from:
1. Net income, and
2. Distribution of earnings, called dividends, to owners.
The retained earnings statement for Melkamu Transport Corporation for Meskerem would
appear as follows.

Melkamu Transport Agency

Retained Earnings Statement
For Month Ended Meskerem 30, 2000

Net Income for the Month................................................................... Birr 4,800

Less: Dividends.................................................................................... 2,000
Retained Earnings, Meskerem 30, 2000.............................................. Birr 2,800

c) Balance Sheet

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If Melkamu Transport Agency had been organized as a corporation its balance sheet at the
end of Meskerem, the first month of operations, would appear as follows

Melkamu Transport Agency

Balance sheet
Meskerem 30,000

Assets
Cash......................................................................................... Birr 37,800
Supplies .................................................................................. 3,000
Land ........................................................................................ 45,000
Total assets.............................................................................. Birr 85,800

Liabilities
Account payable...................................................................... Birr 3, 000

Stockholders Equity
Capital stock........................................................................... Birr 80,000
Retained Earnings................................................................... 2,800
Total Stockholders’ Equity ................................................... 82, 800
Total Liabilities and Stock holders’ Equity............................ Birr 85,800

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d) Statement of Cash Flows

If Melkamu Transport Agency had been organized as a corporation the statement of cash
flows would appear as follows at the end of Meskerem

Melkamu Transport Agency

Statement of Cash Flows
For Month Ended Meskerem 30, 2000

Cash flows from operating activities:

Cash received from customers........................................ Birr 18,000
Deduct cash payments for expenses and
Payments to creditors ................................................... 13,200
Net cash flow from operating activities.................................... Birr 4,800
Cash flows from investing activities:
Cash payments for acquisition of land................................... (45,000)
Cash flows from financing activities:
Cash received from sale of capital stock...................... Birr 80,000
Deduct: cash payments for dividends.......................... (2,000)
Net cash flow from financing activities....................... 78,000
Net cash flows and Meskerem 30, 2000 cash balance.............. Birr 37,800

Review Exercises

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Exercise 1.1
1. Ato Alemu is planning to start a business and has finalized preparations. The firm is
to be named Alemu Gent's Salon. The owner has invested Birr 18,000 to the firm and
has borrowed Birr 32,000 from Commercial Bank of Ethiopia. Assuming the owner
planned to invest Birr 50,000 and to borrow Birr 100,000 from commercial bank.
Answer questions (a) to (c) below..
(a) assets of the firm
(b) Liabilities of the firm
(c) Owner's Equity in the firm

Exercise 1.2
2. Nebiyu Company has total assets of Birr 30,000 and total capital balance of Birr
14,000 at the beginning of the year. During the year, assets were increased by Birr
25,000 and liabilities were decreased by Birr 10,000. By how much and in what
direction will capital of the firm affected?

Model Examination Questions

Part – I: True or False Questions

Write ‘True’ if the statement is correct and write ‘False’ is the statement is wrong.

1. A business transaction is an occurrence of an event or of a condition that must be

recorded.
2. The arrangement of a balance sheet, the liability and owner’s equity sections
presented below the asset section is said to be account form.
3. In private accounting, you would offer expert service to the general public on a fee
basis.
4. Taxation is another major area of public accounting.

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 5. Partnership is a form of business enterprise in which ownership is divided into shares
of stock.

Part- II: Multiple Choice Questions.

Chose the based among the given alternatives
1. The financial statement that reports, assets, liabilities, and owner’s equity is the:
A. Statement of cash flow C. Balance sheet
B. Income statement D. Owner’s equity statement
2. Which of the following is not a step in the accounting process?
A. Verification C. Recording
B. Income statement D Owner’s equity statement

3. Net loss will result during the time period:

A. when assets exceed revenues
B. When expenses exceed revenues
C. When revenues exceed expenses
D. When assets exceed liabilities.
4. The properties owned by a business enterprise are known as:
A. Owner’s equity C. Assts
B. Stockholders equity D. Liabilities
5. The business entity concept states that?
A. Assets should be initially recorded at cost and adjusted when the market
values changes.
B. Assets should be recorded at their cost
C. Activities of an entity should be kept separate from its owner.
D. None of the above.
6. Which of the following statements is incorrect about users of accounting information?
A. Management is considered as an internal user.
B. Government agencies are considered internal users.
C. Taxing authorizes are considered external users
D. None of the above

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 7. Debit signifies:
A. Decrease to liability C. Left-hand side amount column
B. Increase to an asset D. all of the above
8. The trial balance:
A. Proves the complete accuracy of accounting records :
B. Tests the equality of debits and credits in the ledger
C. Recording the same transaction more than once does not cause an inequality
in the trial balance.
D. B and C are correct.

9. Providing services on credit will have the following effects on the elements
(components) of the basic accounting equation.
A. Increase assets and increase owner’s equity.
B. Increase assets and decrease owner’s equity.
C. Increase assets and increase liabilities.
D. Increase liabilities and increase owner’s equity.
10. Services provided by a public accountant includes:
A. Internal auditing, budgeting, and management consulting
B. Auditing, taxation, and management consulting
C. Auditing, budgeting, and cost accounting
D. Auditing, budgeting, and management consulting
Part-III: Workout Questions
Attempt the following questions: Show the relevant steps in your computations.
1. Given the accounting equation, answer each of the following questions:
i) The total assets of Z-company are Birr 280,000 and its owner’s equity is
Birr 90,000. What is the amount of its total liabilities?
ii) The total assets of Y-company are Birr 500,000 and its liabilities are equal
to one half of its total assets. What is the amount of Y-company’s owner’s
equity?

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 2. Four different sole proprietorships, A, B, C and D, show the same balance sheet data
at the beginning and end of a year. These data, except the amount of owner’s equity,
are summarized as follows:
Total Total
Assets Liabilities
Beginning of the year................... Birr 650,000 Birr 250,000
End of the year............................. 730,000 320,000

On the basis of the above data and the following additional information for the year,
determine the net income (or net loss) for each of the company for the year.

Company A: The owner had made no additional investments in the business

and had made no withdrawals from the business
Company B: the owner had made an additional investments of Birr 65,000 and
had withdrawn Birr 60,000
Company C: the owner had made additional investments of Birr 65,000 but had
made no withdrawal.
Company D: the owner had made no additional investment in the business but
had withdrawn Birr 60,000

List of Reference Materials

1. Introduction to Accounting, 21st century
2. Fess and warren, Accounting principles, 16 th edition, south-western publishing
company.
3. Fess and warren, Accounting principles, 18 th edition, south-western publishing
company.
4. Weygandt, kieso, Kimmel, Accounting principles, 5 th edition, John wilily and sons,
Inc.
5. Mosich, Intermediate Accounting, 6th edition, MacGraw-itill Book Company.

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 UNIT TWO: THE ACCOUNTING CYCLE

List of Contents
 Unit Objective
 Introduction
Classification of Accounts
Chart of Accounts
Nature of an Account
Journal and Accounts
Illustration of Journalizing and Posting
The Trial Balance
Model Examination Questions
 List of Reference Materials

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Unit Objective
After the completion of this unit you will be able to:
 Explain what an account is and the common classification of accounts for a
small service enterprise.
 Describe the nature of chart of accounts
 Illustrate a chart of accounts for a small service enterprise
 Illustrate debits and credits and normal balances of accounts
 Describe the use of a two-column journal, a two-column account and a four-
column account, and the posting of transactions to the ledger.
 Prepare a trail balance
 Understand the use of a trial balance in the discovery of errors.
Introduction

Dear students, in the previous unit, you have been taught about the basic structure of
accounting. Mainly, business transactions were analyzed and their effects up on the
accounting equation were discussed.

In this unit, the terms debit and credit will be discussed and illustrated along with the formats
(two column or four-column) of accounts and the use of two-column journal. As a last
procedure, the equality of debits and credits will be tested by the preparation of trial balance.

2.1. Classification of Accounts

What is the basis for the classification of accounts in a ledger?

Customarily accounts in a ledger are classified according to common characteristics. Balance

sheet accounts are classified as assets, liabilities, or owner’s equity. Income statement
accounts are classified as revenue or expenses.

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Assets
Any physical thing (tangible) or right (intangible) that has a monetary value is an asset.
Assets are customarily divided in to groups for presentation on the balance sheet. The two
groups used most often are:
1. Current assets, and
2. Plant assets

Current Assets are cash and other related assets that may reasonably e expected to be realized
in cash or used up usually within one year or less, through the normal course of business are
known as current assets other than cash, current assets owned by a service business are notes
receivable and accounts receivable and supplies and other prepaid expenses.

Cash: is any medium of exchange that a bank will accept at face value. Among those
items bank deposits, currency, checks, bank drafts, and money orders. Notes
receivable are claims against debtors evidenced (backed) by a written promise
to pay a sum of money at a definite time to the order of specified person or
bearer.
Accounts Receivable: are also claims against debtors, but less formal than notes.
Accounts receivables arise from sales of services or merchandise on account.
Prepaid expenses include supplies on hand and advance payments of expenses
such as insurance and property taxes.
Plant Assets: Tangible assets used in the businesses that are of a permanent or
relatively fixed nature are called plant assets or fixed assets. Plant assets
include equipment, machinery, buildings, and land such assets, except land
gradually wear out or other wise lose their usefulness with the passage of
time. They are said to depreciate.

Liabilities
Liabilities are debts owed to outsiders (creditors) and are frequently described on the balance
sheet by titles that include the word “payable”. The two main categories most often used are.

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 1. current liabilities and
2. Long term liabilities

Current liabilities :- Liabilities that will be due within a short time (usually one year or less)
and that are to be paid out of current assets. The most common liabilities under this group are
notes payable and accounts payable, these liabilities are exactly similar with receivable
counter parts except that the debtor-creditor relation ship is reversed. Other current liability
accounts commonly found in the ledger are salaries payable, interest payable, and taxes
payable.

Long-Term liabilities – Liabilities that will not be due for a comparatively long term (usually
more than one year) are called long-term liabilities or fixed liabilities. Such liabilities become
current liabilities as they due within one-year range.

Owner’s Equity
Owner’s equity is the residual claim against the assets of the business after total liabilities are
deducted. For a corporate type of business owner’s equity is frequently called stockholders’
equity, shareholders equity, or stockholders investment.

Capital, Capita Stock, and Retained Earnings – Capital is the owner’s equity in a sole
proprietorship (and partnership). The owner’s equity may also be described as net worth. For
a corporation, capital stock represents the investment of the stockholders’ and retained
earnings represent the net income retained in the business.

Drawings and Dividends - Drawings represent the amount of withdrawals made by the
owner of a sole proprietorship (and partnership). For corporation, dividends represent the
distribution of earnings to stockholders.

Revenues
Revenues are the gross increases in owner’s equity as a result of the sale of merchandise, the
performance of services for a customer or a client, the rental of property, the lending of

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money, and other business and professional activities entered into for the purpose of earning
income. Revenue from sales of merchandise is known as sales, other than sales revenues are
termed as professional fee, commissions' revenue, fares earned, and interest income.

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

2.2. Chart of Accounts

What is a chart of accounts? Give your answer before you read the following paragraphs?

The number of accounts maintained by a specific enterprise is affected by the nature of its
operations, its volume of business, and the extent to which details are needed for taxing
authorities, managerial decisions, credit purposes, etc.

A listing of the accounts in a ledger is called a chart of accounts. As far as possible, the order
of the accounts in the chart of accounts should agree with the order of the items in the
balance sheet and the income statement. The accounts are numbered to permit indexing and
also for use as references.

Though accounts in the ledger may be numbered consecutively as a page of a book, a flexible
system of indexing is preferable. The following chart of accounts is for a small service

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business, Alem Dry cleaner, each account number has two digits. The first digit indicates the
major division of the ledger in which the account is placed. Accounts beginning with 1
represent assets; 2, liabilities; 3 owner’s equity (owner’s capital and drawing); 4, revenue;
and 5 expenses. The second digit indicates the position of the account within its division. In
such numbering system there is an advantage of later insertion of new accounts in their
proper sequence without disturbing the other account numbers. For a large enterprise with a
number of departments or branches, it is usual for each account number to have four or more
digits.

Balance Sheet Accounts Income Statement Accounts

1. Assets 4. Revenue
11 Cash 41 Sales
12 Accounts Receivable 5. Expense
14. Supplies 51 Supplies expense
14 Prepaid Rent 52 Salary expense
15 Dry Cleaning Equipment 53 Rent expense
18 Accumulated Depreciation 54 Depreciation expense
2. Liabilities 59 Miscellaneous expense
21 Accounts payable
22 Salaries payable
3. Owner’s Equity
31 Alem, capital
32 Alem, Drawing
33 Income Summary

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The initial preparation of the ledger based on the chart of accounts is often referred to as
opening the ledger.

Check your progress: Exercise 2-1

1. On what basis accounts in a ledger classified?
________________________________________________________________________
________________________________________________________________________
_______________________________________________________________
2. What is meant by chart of account?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
Nature of an Account

Do you think that using a T account is a formal accounting procedure? Provide your own
opinion.

The simples form of an account has three parts (1) a title which is the name of the item
recorded in the account, (2) a space for recording increases in the amount of the item, in
terms of money; and (3) a space for recording decreases in the amount form of the item, also
in monetary terms. This from of an account, illustrated below, is known as a T account
because of its similarity to the letter T.

The T account is a standard shorthand in accounting that helps make clear the effects of
transactions on individual accounts.

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 Title
Left side Right Side
Debit Credit

The terms debit and credit mean left and right sides respectively. The left side of an account
is called the debit side and the right side of an account is called the credit side. The word
charge is sometimes is used in similar fashion for the term debit. Amounts entered on the left
side of an account, regardless of the account title, are called debits or charges to the account,
and the account is said to be debited or charged. Amounts entered on the right side of an
account are called credits and the account is said to be credited.

The illustration that follows, receipts of cash during a period of time has been listed vertically
on the debit side of the cash account. The cash payments for the same period have been listed
in similar fashion on the credit side of the account. A memorandum total of the cash receipts
for the period to date, Birr 20,500 may be inserted below the last debit at any time when ever
the information is desired. The figures should be small and written in pencil in order to avoid
any mistakes while additional amount is debited. Such a procedure refereed to as Pencil
footing. The total of the cash payments, birr 16,800 may be inserted on the credit side in a
similar fashion. Deduction of the smaller sum from the larger, Birr 20,500- Birr 16,400,
produces cash on had amount, which is called the balance of the account. The cash account,
as per this illustration is Birr 3, 700. This amount may be inserted in pencil figures next to the
larger pencil footing, which identifies it as a debit balance. The debit balance of Birr 3,700
would have been taken if balance sheet were prepared.
Cash
7,200 2,000
8,800 6,450
4,500 1,900
3,700 3,500
20,500 2, 950
16,800

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Balance Sheet Accounts

The following two illustrations are presented the manner of recording data in the accounts
and their relationships to the balance sheet. Assume that Biftu A/Mecha establishes a
business venture, to be known as Biftu Equipment Repair, by making an initial deposit of
Birr 30,800 Cash in a bank accounted for the use of the business enterprise. Soon after the
deposit, the balance sheet for the business, in account form would consist of the following
data.

Balance Sheet Accounts

Assets Owner’s Equity
Cash................ Br 30,800 Biftu A/Mecha, Capital....... Birr 30,800

Each business transactions affects a minimum of two accounts in a balance sheet. The effect
of such a transaction on accounts in the ledger can be illustrated as a Birr 30,800 debit to
cash and a Birr 30,800 credit to Biftu A/Mecha, Capital. This information, at the beginning,
is entered in record called a Journal. Journal is the first book of original entry. In a journal,
the information is stated in formalized manner by listing the titre of the account and the
amount to be debited and followed by the amount to be credited. In doing this, the process of
recording transactions in a Journal is said to be journalizing. The form of presentation is
called a journal entry. This can be illustrated as follows:

Cash...................................................... 30, 800

Biftu A/Mecha, Capital........................................ 30,800

Once the data first is recorded in a journal, then the information is transferred to the
appropriate accounts by a process known as pasting. The followings are accounts after the
completion of the pasting process.

Cash Biftu A/Mecha, capital

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 30,800 30,800

Consider that the amount of the asset, which is reported on the left side of the account form
of the balance sheet, is posted to the left (debit) side of cash. The owner’s equity in the
business, which is reported on the right side of the balance sheet is posted to the right (credit)
side of Biftu, A/Mecha, capital.

Following the first illustration, assume that Biftu purchased a cost of Birr 28,000. Biftu paid
Birr 8,000 in cash by writing a check on the bank account, and agreed to pay the remaining
Birr 20,000within 30 days after the date of the invoice. Up on the completion of this
transaction, the data reported in the balance sheet would be as follows:

Balance Sheet Accounts

Assets Liabilities
Cash....................... Birr 22,800 Accounts payable............Birr 20,000
Equipment 28,000 Biftu A/Mecha, capital 30,800
Total Assets .............Birr 50,800 Total liab. Owners equity Birr 50,800

The effect of the transaction is described as a birr 28,000 (increase) to Equipment, an amount
of Birr 8,000 credit (decrease) to cash, and a Birr 20,000 credit (increase) to Accounts
payable. (An entry composed of two or more debits or of two or more credits is called a
compound journal entry.)

Equipment............................................ 28,000
Cash......................................... 8,000
Accounts payable.................... 20,000

After the completion of the posting of second transaction, the accounts of Biftu Equipment
Repair appear as follows:

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 Cash Accounts payable

30,800 8,000 20,000

Equipment Biftu A/Mecha, Capital

28,000 30,800

Consider that the effect of the transaction was to increase one asset account, decrease another
account, and increase a liability account. Consider also that although the amounts, Birr
28,000 Birr 8,000, and Birr 20,000 are different, the equality of debits and credits are kept.
For every business transaction, the sum of the debits is always equal to the sum of the credits.
In a basic accounting equation, A = L + OE the equality of debit and credit for each
transaction are always maintained. Because of its duality such a system is known as double-
entry account.

As per the general rules of debit and credit, the debit is a left hand side, whereas, a credit is
the right side of all accounts whether asset, liability, or owners equity, Hence, a debit may be
either an increase or a decrease, depending on the nature of accounts affected. Similarly, a
credit may be either an increase or a decrease, depending on the nature of the account. The
general uses of debit and credit may, thus, be stated as follows.

Debit may signify Credit may signify

Increase in asset accounts Decrease in asset accounts
Decrease in liability accounts Increase in liability accounts
Decrease in owner’s equity accounts Increase in owner's equity accounts

It is a common practice that, in sole proprietorship business enterprise, the owner may
withdraw cash from the business for personal use. Such withdrawals have the effect of

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decreasing owner’s equity as debits and increasing the withdrawals by the same amount as
debits. Withdrawals are debited to an account in the name of the owner followed by term
drawing. The balance of this account is periodically transferred to the owner’s capital
account. Hence, debits to the drawing account may be thought of as either decreasing
owner’s equity or increasing drawings.
In a corporate form of business enterprise, the dividends account is comparable to the
drawing account of a sole proprietorship. Distributions of earnings to the stockholders are
debited to Dividends, which is periodically transferred to the retained earnings account
Debits to the dividends account have the effect of decreasing owner’s equity or increasing
dividends.

Income Statement Accounts

The principle of debit and credit in its application to revenue and expense accounts is based
on the relationship of these accounts to owner’s equity.

Revenue increases owner’s equity. The same to as increases in owner’s equity are recorded
as credits; increases in revenues during an accounting period are recorded as credits.

Expenses have the effect of decreasing owner’s equity, similarly, just as decreases in owner's
equity are recorded as debits; increases in expense accounts are recorded as debits.

The rules of debit and credit as applied to revenue and expense accounts are shown in the
following diagram.
Income Statements Accounts
Debit for decrease Credit for increase
In owner’s equity in owner’s equity

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 Expense Accounts Revenue Accounts
Debit Credit Debit Credit
For for for for
Increases Decreases Decrease increases

At the close of the accounting period, all revenue and expense account balances are
transferred to a summarizing account and the accounts are then said to be closed. The
balance, which is, either a net income or net loss for the period is then transferred to the
owner’s capital account (to the retained earnings account for a corporation) and the
summarizing accounts is also closed. Because revenue and expense accounts are periodically
closed, they are sometimes called temporary accounts or nominal accounts. All those
accounts balances which are reported in balance sheet are carried forward from year to year
sometimes referred as a real accounts.
Normal Balances of Accounts

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. Due to this reason, the normal balances of all accounts
are positive rather than negative.

The general rules of debit and credit and the normal balances of the different types of
accounts are summarized as follows.

Increase Decrease Normal Balance

Balance Sheet Accounts:
Assets Debit Credit Debit
Liabilities Credit Debit Credit
Owner’s Equity or Stockholders
Equity:

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 Capital Capital Stock Credit Debit Credit
Retained Earnings Credit Debit Credit
Drawing/Dividends Debit Credit Debit
Income Statement Accounts:
Revenue Credit Debit Credit
Expanse Debit Credit Debit

Check Your Progress: Exercise 2.2

1. The term debit and credit mean increase and decrease, respectively. Do you agree?
______________________________________________________________________
______________________________________________________________________
_____________________________________________________________

2. Differentiate between an account and a ledger.

______________________________________________________________________
______________________________________________________________________
______________________________________________________________________

2.4. Journal and Accounts

The flow of accounting data from the time a transactions occurs to its recording in the ledger
may be depicted as follows.

Business Business Entry recorded Entry posted

TRANSACTION DOCUMENT IN JOURNAL TO LEDGER
Occurs Prepared

The first records of each transaction, is evidenced by a business document, such as a sales
ticket, a bill, or a cash register tape Based on the evidence provided by respective business

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documents, every transaction is entered in chronological order (date-wise) in a journal. The
amounts of the debits and credits in the journal are then transferred or posted to the accounts
in a ledger.

Two-column Journal

What is a journal? How is business transactions recorded in a journal?

Depending on the types and volume of business transactions, a business may use a single all-
purpose two-column journal, or it may use a number of multicolumn journals, limiting each
to single types of transaction.

Before a transaction is entered in the two-column journal, it should be analyzed according to

the following sequence of steps:
1. Determine whether an asset, a liability, owner’s equity, revenue, or expense is
affected
2. Determine whether the affected asset, liability, owner’s equity, revenue or expense
increases or decreases.
3. Determine whether the effect of the transaction should be recorded as a debit or as a
credit in an asset, liability, owner’s equity, revenue or expense account.

The following is the illustration that explains the analysis and recording of a transaction in to
a two-column journal.

Assume that Birr 3,450.50 is received from cash sales for Hidar 1, the asset cash increases
and therefore should be debited for Birr 3,450.50. The revenue account sales also increases
and therefore be credited for Birr 3,450.50. The two-column journal in which the transaction
has been recorded would be presented as follows.

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 Journal Page 15
Post
Date Description Ref. Debit Credit
2000 Cash 3,450 50
Hidar 1 Sales 3,450 50

The process of recording a transaction in a two-column journal is summarized as follows:

1. Record the date: Insert the year, the month and the day
2. Record the debit based on the given illustration.
3. Record the credit based on the given illustration.
4. Write the appropriate expiation for each transaction which is the last step in the
process of journalizing.

Two - Column Accounts and Four-Column Accounts

The simple T form of accounts is used primarily for illustration purposes. Additional rulings
to the T form create the standard two-column form as follows:

Account Cash Account No 11

Item Post Post
Date Ref Debit Date Item Ref Credit
2000 2000
Hider 1 Balance  15490 00 Hider 1 15 900 00
1 15 3450 50 1 15 2091 00
5 15 2015 30 5 15 790 00
5 15 3400 50
13,774.80 20955 80 7181 50

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Account Cash Account No 11
Post Balance
Date Item Ref Debt Credit Debit Credit
2000 15490 00
Hidar 1 Balance 
1 15 3450 50
1 15 900 00
1 15 2091 00
5 15 2015 30
5 15 790 00
5 15 3400 50 13,774 80

Among the significant advantages of the four-column account form are the following:
 Only a single date column is required, with each debit and credit appearing in
its chronological order
 The debit or credit nature of an account balance is more easily determined and
noticeable in the account.
 Just being adjacent, the debit and credit columns, makes it easier to examine
the data in an account.

Posting

Why posting is required?

The procedure of transferring journal entries to the ledger accounts is called posting. When
posting is done manually, all the debits may be posted first, followed by the credits. The

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posting of a debit journal entry or a credit journal entry to an account in the ledger is done in
the following manner:

1. Record the date and the amount of the entry in the account.
2. Insert the number of the journal page in the posting reference column of the
account.
3. Insert the ledger account number in posting reference column of the journal.
The followings are the steps involved in the procedures of posting to the cash
account. The same sequence of procedures is involved in the positing of credit entry.
Journal Page 15
Post
Date Description Ref Debit Credit
2000
Hidar 1 Cash 11 3450 50
Sales 3450 50
Cash sales for the day
Account Cash Account No. 11
Post Balance
Date Item Ref Debit Credit Debit Credit
2000
Hidar 1 Balance  15490 00
1 15 3450 50 18940 50

2.5 Illustration of Journalizing and Posting

Hamle 1. Alem Taye operated a Dry cleaning business at home and now she decided to go
for rented quarters as of Tir 1 and to work full time to her own business which is known as “
Alem Dry Cleaner. “ the following assets were invested in the enterprise: Cash Birr 11,000

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accounts receivable, birr 17,100, supplies Birr 4,400 and Dry Cleaning in Equipment birr
47,000. There were no liabilities transferred in the business

Analysis. All the four assets are increased and debited respectively.
The owners equity in these assets is equal to the sum of the assets, or birr 79,500; hence
Alem Taye, Capital is credited for the amount.

Journal Page 1
Post
Date Description Ref Debit Credit
2000
Hamle 1 Cash 11 11000 00
Accounts Receivable 12 17100 00
Supplies 14 4400 00
Dry cleaning Equipment 18 47000 00
Alem Teye, Capital 31 79500 00

Hamile 1. Paid Birr 5,400 on a rent contract represent three months rent of the quarters for
the business

Analysis: - The asset acquired in exchange for the cash payment is the use of the property for
three months. Hence, the asset prepaid rent increases and is debited for Birr 5,400.
Customarily when a rent for a particular month is prepaid at the beginning of month it is
debited to the rent expense account at the time of payment so as to avoid the necessity of
transferring the amount from Prepaid Expense to Rent Expense at the end of the month.

2000
Hamle 1 Prepaid rent 15 5400 00
Cash 11 5400 00

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Hamle 3. Purchased additional Dry cleaning Equipment on account from National
Equipment Co. for Birr 9,000

3 Dray-cleaning
Equipment 18 9000 00
Accounts payable 21 9000 00

Hamle 4. Received Birr 7,100 from customers in payment of their accounts

Analysis: the asset cash increases and is debited for Birr 7,100; the asset accounts receivable
decrease and is credited for Birr 7,100.

4 Cash 11 7100 00
Accounts receivable 12 7100 00

Hamle 5. Paid Birr 1,500 for a television advertisement

Analysis Expense accounts are subdivisions of owner’s equity. Increases in expense and
decreases in owner’s equity; thus, an expense account is debited for Birr 1,500. The asset
cash was decreased by the transaction; therefore that account is credited for Birr 1,500. (In
such a situation, usually Miscellaneous Expense account is used because total expenditure
for advertisement are expected to be relatively minor).

5 Miscellaneous Expense 59 1500 00

Cash 11 1500 00

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Hamle 9. Paid birr 4,000 to National Dry Cleaning company to apply on the Birr 9000 debt
owed to them
Analysis: the payment of the liability decreases Accounts payable, there fore the account is
debited for Birr 4,000. It also decreases the asset cash, which is credited for Birr 4,000.

9 Accounts payable 21 4,000 00

Cash 11 4000 00

Hamle 16. Received Birr 5,845 from sales for the first half of Hamle.
Analysis: Cash increases and is debited for Birr 5845. The revenue account sales, which is a
subdivision of owner’s equity, increases and is credited for Birr 5,845.

16 Cash 11 5845 00
Sales 41 5845 00

Hamle 19. Paid Birr 2,900 for supplies

19 Salary expense 14 2900 00

Cash 11 2900 00

Hamle 26. Paid Birr 470 a two weeks salary for the receptionist.
Analysis: Similar to transaction of Hamle 13.

26 Salary expense 52 470 00

Cash 11 470 00

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Hamle 30. Paid Birr 367 for electric, telephone, and water bills for a month.
Analysis: similar to transaction of Hamle 5.

30 Miscellaneous Expense 59 367 00

Cash 11 367 00

Hamle 30. Received Birr 5,735 from sales for the second half of Hamle
Analysis: similar to transaction of Hamle 5.
Journal Page 2
Post
Date Description Ref Debit Credit
2000
Hamle 30 Cash 11 5735 00
Sales 41 5735 00

Hamle 30. Sales on account totaled Birr 3925.

Analysis: the asset Accounts Receivable increases and is debited for Birr 3,925. the revenue
account sales increases and is credited for Birr 3,925. (When customers pay their accounts,
Cash will be debited and accounts receivable will be credited)

30 Accounts receivable 12 3925 00

Sales 41 3925 00

Hamle 30. Alem withdrew Birr 2,500 for her personal use.
Analysis: - the withdrawals of cash resulted in a decrease in the owner’s invested capital and
are recorded by a birr 2,500 debit to Alem Taye, Drawing; the decrease in cash is recorded
by a Birr 2,500 credit to cash.

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 30 Alem Taye, Drawing 32 2500 00
Cash 11 2500 00

After the completion of the postings of all the entries for the month, the ledger will appear as
shown below. The accounts are numbered according to the chart of accounts.

Review Exercises
Exercise 2.1
(a) What is the book that is used to record transactions?
(b) What are used as evidence when recording business transactions?
(c) What is an account?
(d) What is the meaning of debit and credit in recording and posting transactions?

Exercise 2.2
The following transactions occur during November 2008 for Lulit Trading Company.
November 15. The owner W/ro Lulit invested Birr 30,000 in a bank checking account
in the name of the business.
17. Paid Birr 8,500 for the acquisition of office equipments
18. purchased office supplies amounting to Birr 1,000 on account.
20. Sold service of Birr 15,000 to customers collecting 50% of it and the
remainder on account
23. Paid Birr 900 for utilities
27. Paid cash Birr 3,500 as salary of employees
28. Sold services to customers Birr 5,500 for cash.
28. Paid cash birr 500 for office repairs.
30. Paid cash Birr 400 as part payment of the amount owed.

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 Required:
(a) Record the above transactions on page 10 of a two-column general journal
(b) Post the entries to the accounts in the ledger
(c) Prepare trial balance as of November 30, 2008

Account Cash Account No. 11

POST BALANCE
DATE ITEM REF DEBIT CREDIT DEBIT CREDIT
2000 1 1 11000 00 11000 00
Hamle

1 1 5400 00 5600
4 1 7100 00 12700 00
5 1 1500 00 11200 00
9 1 4000 00 7200 00
13 1 470 00 6730 00
16 1 5845 00 12575 00
19 1 2900 00 9675 00
26 1 470 00 9205 00

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 30 1 367 00 8838 00
30 2 5735 00 14573 00
30 2 2500 00 12073 00

Account Accounts Receivable Account No. 12

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 1 1 17100 00 17,100 00
Hamle

4 1 7100 00 10,000 00
30 2 3925 00 13,925 00

Account Supplies Account No. 14

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 1 1 4400 00 4400 00
Hamle

19 1 2900 00 7300 00

Account Prepaid Rent Account No 15

Post Balance
Date Item Ref Debit Credit Debit Credit
2000
Hamle
1 1 5400 00 5400 00

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Account Dry Cleaning Equipment Account No.18
Post Balance
Date Item Ref Debit Credit Debit Credit
2000 1 1 47000 00 47000 00
Hamle

3 1 9000 00 56000 00

Account Accounts payable Account No 21

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 3 1 9000 00 9000 00
Hamle

9 1 4000 00 4000 00 5000 00

Account Alem Taye Capital Account No. 31

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 1 1 79500 00 79500 00
Hamle

Account Alem Taye, drawing Account No 32

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 30 2 2500 00 2500 00
Hamle

Account Sales Account No 41

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 Post Balance
Date Item Ref Debit Credit Debit Credit
2000 16 1 5845 00 5845 00
Hamle

30 2 5735 00 11580 00
30 2 3925 00 15505 00

Account Salary Expense Account No 52

Post Balance
Date Item Ref Debit Credit Debit Credit
2000
Hamle
13 1 470 00 470 00
26 1 470 00 940 00

Account Miscellaneous Expense Account No. 59

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 5 1 1500 00 1500 00
Hamle

30 1 367 00 1867 00

Check Your Progress: Exercise 2.3

1. What is the name of the record in a transaction is initially recorded?
________________________________________________________________________
________________________________________________________________________
_______________________________________________________________
2. What are the steps involved while we are analyzing a business transaction?

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 ________________________________________________________________________
________________________________________________________________________
_______________________________________________________________

2.6. The Trail Balance

What is a trial balance? What is the usual time for its preparation?

The equality of debits and credits in the ledger is known as trail balance. In such verification,
the summary listing of both the balances and the titles of the accounts is also useful in
preparing the financial statements. The illustrations for Alem Dry cleaners are as follows:

Alem Dry Cleaners

Trial Balance
Hamle 30, 2000
Cash 12073 00
Accounts receivable 13925 00
Supplies 7300 00
Prepaid rent 5400 00
Dry-cleaning equipment 56000 00
Accounts payable 5000 00
Alem Taye, capital 79500 00
Alem Taye, Drawing 2500 00
Sales 15505 00

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Salary expense 940 00
Miscellaneous expense 1867 00
100,005 00 100,005 00

The trial balance does not assure a complete proof of the accuracy of the ledger. It is simply a
test of the equality of debits and credits in a ledger. The following types of errors may cause
a trial balances not to balance

1. Error in the preparation of the trail balance:

 One of the columns of the trial balance was erroneously computed
 The amount of an account balance was wrongly recorded on the trial balance
 A debit balance was recorded on the trial balance as a credit, or vice versa, or
a balance was omitted entirely.
2. Error in determining the account balances, such as:
 Incorrect computation of a balance
 A balance was entered in the wrong balance column
3. Error in recording a transaction in the ledger, such as:
 An incorrect amount was posted to the account

 A debit entry was posted as a credit, or vise versa

 An omission of a debit or a credit posting

Numerous errors may exist even though the trial balance columns are in-balance. Such as, the
trial balance may balance even when:
1) a transaction is not journalized (complete omission)
2) a correct journal entry is not posted
3) a journal entry is posted twice
4) Incorrect accounts are used in journalizing or posting, or
5) Posting a part of a transaction correctly as debit or credit but to the wrong account.

Check Your Progress: Exercise 2.4

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1. What is a trial balance?
________________________________________________________________________
________________________________________________________________________
_______________________________________________________________

2. Identify some errors which are not detected by the trial balance.
________________________________________________________________________
________________________________________________________________________
_______________________________________________________________

2.7. Model Examination Questions

Part I. Short Answer Questions

1. What is the trial balance and how will it help to discover errors in recording and posting
transactions?
2. List the errors that will not be discovered by using a trial balance?
3. How are accounts identified in the ledger?

Part II. The following trial balance of Shekur Trading taken on November 26, 2008
doesn't balance because of several errors and irregularities

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 Account title Debit Credit
Cash 37,300
Accounts Receivable 3,000
Office supplies 20,800
Office Equipment 7,000
Office Furniture -
Accounts Payable 18,500
Shekur Capital 56,000
Shekur drawing 8,500
Fees Earned 40,000
Rent Expense 3,800
Salary expense 10,000
Utilities Expense 25,000
Review of the various documents indicated the following errors that need corrections:
(a) Office furniture of Birr 5,800 was not included in the trial balance
(b) Accounts payable of Birr 15, 800 was listed as Birr 18,500
(c) Fees income of Birr 9,400 was omitted when posting entries to the ledger
(d) The balance of Accounts Receivable should be Birr 3000
(e) All accounts should have normal balances
Required: Prepare the correct trial balance for Shekur Company
List of Reference Materials

1. Introduction to Accounting, 21st century

2. Fess and warren, Accounting principles, 16 th edition, south-western publishing
company.
3. Fess and warren, Accounting principles, 18 th edition, south-western publishing
company.
4. Weygandt, kieso, Kimmel, Accounting principles, 5 th edition, John wilily and sons,
Inc.
5. Mosich, Intermediate Accounting, 6th edition, MacGraw-itill Book Company.

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 UNIT THREE: COMPLETION OF THE ACCOUNTING CYCLE

List of Contents
 Unit Objective
 Introduction
Matching Principle

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Illustration of Adjusting Entries
Work Sheet
Financial Statements
Journalizing and Posting Adjusting Entries
Journalizing and Posting Closing Entries
Post-Closing Trial Balance
Fiscal Year and the Accounting Cycle
Model Examination Questions
 List of Reference Materials

Unit Objective

After the completion of the unit you will be able to:

 Discuss the matching principle as it pertains to the cash basis and the accrual basis of
accounting.
 Explain the nature of the adjusting process
 Describe the basic procedures for adjusting before the preparation of financial
statements.
 Illustrate the work sheet for summarizing the accounting data for the preparation of
financial statements.
 Prepare the principal financial statements.
 Journalize and post adjusting and closing entries
 Describe the basic procedures for the preparation of accounting records for
subsequent accounting period.

Introduction

In the preceding unit (unit two) you discussed how business transactions are journalized and
posted to the ledger. Moreover, you were acquainted with the preparation of a trial balance.

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Now, in this unit you will be acquainted with such accounting concepts as adjustments,
matching principle, revenue recognition principle, closing entries, recording and posting
adjusting and closing entries and a post-closing trial balance.

3.1 Matching Principle

Dear students what is the main emphasis of matching principle? What do you understand by
the term ‘accrual basis of accounting? Try to give your own answer before you start reading
the following paragraphs.

Matching principle emphasize the proper matching of revenues against expenses of the
period. Expenses are incurred to produce (generate) revenue of the period. The practice of
expense incurrence is referred to as the matching principle because it stress that efforts
(expenses) be matched with accomplishments (revenues).

Revenues and expenses may be reported on the income statement by (1) the cash basis or (2)
the accrual-basis of accounting. Cash basis-when cash basis is put into use, revenues are
reported in the period in which cash is received, and expenses are reported in the period in
which cash is paid. For instance, sales would be recorded only when cash is received from
customers, and salaries expense would recorded only when cash is paid to employees.
Net income (or net less) would be the difference between the cash receipts (revenues) and the
cash disbursements (expenses). Small service enterprises which are having few receivables
and payables may use the cash basis. Besides, small businesses which are rendering
professional services (such as services related to accountants, physicians, attorneys) may also
use cash basis.

However, for most businesses the cash basis is not considered an acceptable method.

Accrual basis of accounting is used by most business enterprises. Under the accrual method,
revenues are reported in the period in which they are earned, and expenses are reported in the

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period in which they are incurred in an attempt to generate revenues. For instance, revenue
would be recognized the moment services are rendered to customers and not when the cash is
collected from customers. Similarly, supplies are consumed and not when the cash is paid for
supplies purchased.

To match revenues and expenses properly, the accrual basis of accounting requires the use of
an adjusting process at the end of the accounting period.

Check Your Progress: Exercise 3-1

1. What is meant matching principle?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

2. How do revenues are reported under the accrual basis of accounting?

________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

3.2 Illustration of Adjusting Entries

In the preceding unit (unit two), the illustrations were ended up with the preparation of the
trial balance. As a starting point many of the account balances which have been shown in the
trial balance at the end of the accounting period, can be taken without any change for the
preparation of financial statements. For example balance of cash account is normally the
amount of that asset owned by the enterprise on the last day of the accounting period.
Likewise, the balance of accounts payable is the amount owed up on the last day of the
accounting period.

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Nevertheless, it does mean that all trial balance amounts are necessarily correct. For instance,
the amounts listed for prepaid expenses are normally overstated. The reason for such
overstatement is that the failure to record the day-to-day consumption or expiration of these
assets.

Moreover, the balance of the supplies account shows the sum total of the cost of supplies at
the beginning of the period added with that of supplies cost purchased during the period.
Practically, some of the supplies would have been used during the period; the balance listed
on the trial balance is overstated. In the similar manner, the balance of prepaid Insurance
shows the beginning balance plus the cost of insurance policies purchased during the period
and no journal entries were made for the premiums as they expired. Handling journal entries
on a daily basis would be costly and unnecessary. There are two possible effects on the
ledger when the daily reduction in the balance of prepaid expenses is not recorded: (1) asset
accounts are overstated and (2) expense accounts are understated.

Some other data may not be included in the trial balance and yet they are needed for the
financial statements preparation. The reason for this is revenue or expense related to the
period has not been recorded. For instance, salary expense incurred between the last pay day
and the end of the accounting period would not normally be recorded in the books of account
because salaries are usually recorded only when they are paid. As per principle of matching
(accrual-basis of accounting) expenses are recognized when they are incurred not when cash
is paid. Hence, accrued salaries are an expense of the period because services were rendered
during the period. On the other hand, they also represent a liability on the last day of the
period because they are owed to the employees.

At the end of an accounting period, entries that are required to bring the accounts up to date
and to assure the proper matching of revenues and expenses are called adjusting entries. For
an in-depth understanding it is illustrated as follows.

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The illustrations of adjusting entries that follow are based on the ledger of Alem Dry
Cleaners, as reported in the Hamle 30 trial balance. Presented below for illustration purpose,
T accounts are used.

Alem Dry Cleaners

Trial Balance
Hamle 30, 2000
Cash 12073 00
Accounts Receivable 13925 00
Supplies 7300 00
Prepaid Rent 5400 00
Dry-Cleaning Equipment 56000 00
Accounts Payable 5000 00
Alem Taye, Capital 79500 00
Alem Taye, Drawing 2500 00
Sales 15505 00
Salary expense 940 00
Miscellaneous expense 1867 00
100,005 00 100,005 00

Prepaid Expense

As per Alem’s trial balance, the balance in the supplies account on Hamle 30 is Birr 7,300.
During the past month, some portion of supplies has been consumed and some are still in
stock. Assuming that the inventory of supplies on Hamle 30 is determined to be Birr 5000 the
amount of supplies used (transferred to expense account) is computed as follows:

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 Supplies available (balance of account)............... Birr 7,300
Supplies on hand (inventory) ............................... 5,000
Supplies used (amount of adjustment)................. Birr 2,300

As a result, supplies expense should be debited for Birr 2,300 and the supplies account is
credited for Birr 2,300 to show the supplies consumed during Hamle. The adjusting entry is
illustrated in the following T accounts.

Supplies Supplies expense

Ham 1. 4400 Ham 30. 2300 Ham 30. 2300
19. 2900
7300

5000
After the adjustment, the asset account has a debit balance birr 5,000 and the expense
account has a debit balance of Birr 2, 300.

Alem’s prepayments for rent covering for three months have a debit balance of Birr 5,400 on
Hamle 1. At the end of Hamle, the potion belongs to Hamle is one-third (1/3) of the total
balance of prepaid Rent. Thus the rent expense account should be increased (debited) and the
prepaid rent account should be decreased (credited by Birr 1800.

Prepaid rent Rent expense

Ham 1. 5400 Ham 30, 1800 Ham 30. 1800

If adjustments are not made for the previous illustration supplies (Birr 2,300) and rent (Birr
1800), the effect on the financial statements prepared on Hamle 30 will be incorrect to the
extent indicated below:

i) Income Statement
- Expenses will be understated............................... Birr 4,100
- Net income will be overstated ............................ 4,100

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 ii) Statement of Owner’s Equity
- Net income will be overstated.............................. Birr 4,100
- Ending owner’s equity will be overstated. ........... 4,100
iii) Balance Sheet:
- Assets will be overstated............................................. Birr 4,100
- Owner’s equity will be overstated............................... 4,100

Plant Assets: - Like other assets plant assets are properties acquired for use in the ordinary
course of business. However with the passage of time the plant assets lose their capacity to
provide useful services. This decrease in usefulness is a business expense, which is called
depreciation. The treatment for adjusting entry to record depreciation will remain the same
to the entry illustrated in the previous section which means an expense account is debited and
an asset account is credited. The account debited is a depreciation expense account, where as
the account credited is not directly the plant asset account. It is a common practice to
maintain a separate account which is related to the given plant asset but it has a contra
(minus) relationship to the plant asset. The account credited is an accumulated depreciation
account. It helps to record depreciation since the acquisition of the plant assets. An
accumulated depreciation account is a contra account because it is “offset against” another
account

Typical titles for plant asset accounts and their related contra asset accounts are as follows.

Plant Assets Contra Asset

Land ................................................. -
Buildings............................................ Accumulated Depreciation – Buildings
Equipment......................................... Accumulated Depreciation – Equipment

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The adjusting entry to record depreciation for Hamle for Alem Dry Cleaners is illustrated in
the following T accounts. The estimated amount of depreciation for the month is assumed to
be Birr.

Dry cleaning Equipment Accumulated Depreciation

Ham 1. 4700 Ham 30. 4500
9000
56,000
Depreciation Expense
Ham. 30. 4500

The Birr 4,500 increase in the accumulated depreciation account represents a subtraction
from the Birr 56,000 cost recorded in the related plant asset account. The difference between
the two balances is the unexpired or is called the book value of the asset. The book value
sometimes referred to as residual value. Presentation of book value on the balance sheet may
be shown in the following manner.

Plant Assets:
Dry Cleaning Equipment............................................ Birr 56,000
Less: Accumulated depreciation................................. (4,500) Birr 51,500

If the depreciation of Birr 4,500 is not recorded, the financial statement of Hamle 30 will be
incorrectly affected to the extent shown below.
i) Income Statement:
- Expenses will be understated............. Birr 4,500
- Net income will be overstated ............ 4,500
ii) Statement of Owner’s Equity:
- Net income will be overstated............ Birr 4,500
- Ending owner’s equity will be overstated 4,500

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 iii) Balance Sheet:
- Assets will be overstated.................... Birr 4,500
- Owner’s equity will be overstated ...... 4,500

Accrued Expenses (Liabilities)

The incurrence of some expenses is related to the passage of time such expenses generally
are not recorded till payment is made, unless the end of an accounting period comes before
the required date of payment.

Typically, an expense related to such types of services is services performed by employees

are an example of this type of situation. Customarily, the wages or salaries are paid on the
pay day. Usually the end of the accounting period may to fall between the last payday and the
coming payday. The wages or salaries accumulated until the end of the accounting period is
not paid and unrecorded are referred to as an accrued expense.

The data in the following T accounts were taken from the ledger of Alem dry Cleaners. The
debits of Birr 470 on Hamle 13 and 26 in the salary expense account were biweekly
payments on alternate Fridays for the payroll periods ended on those days. The salaries
earned on Monday and Tuesday, Hamle 29 and 30, total Birr 94. This amount is an additional
expense of Hamle and is debited to the salary expense account. In the mean time it is also a
liability as of Hamle 30 and hence credited to salaries payable.

Salaries payable Salary expense

Hamle 30 94 Hamle 13. 470
470
940

94
1,034

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As it is shown in the T account for salary expense, the debit balance of the salary expense
account is Birr 1,034, which is the adjusted amount and also the actual expense for the
month. On the other hand, the credit balance of Birr 94 is salaries payable is the amount of
liability for salaries owed as of Hamle 30. If adjustment for salaries Birr 94 is not recorded,
the effect on the financial statements as of Hamle 30 will be incorrect to the extent indicated
as follows:

Income Statement:
Expenses will be understated......................................... Birr 94
Net income will be overstated ........................................ 94
Statement of Owner’s Equity:
Net income will be overstated........................................ Birr 94
Ending owner’s equity will be overstated ...................... 94

Balance Sheet:
Liabilities will understate............................................. Birr 94
Owner’s equity will be overstated................................ 94

Check Your Progress: Exercise 3-2

1. What are adjusting entries?

______________________________________________________________________
______________________________________________________________________
______________________________________________________________________

2. Why are adjusting entries needed at the end of an accounting period?

______________________________________________________________________
______________________________________________________________________
______________________________________________________________________

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3.3 Work Sheet

What is a work sheet? Do you think that work sheet is a permanent record? Show your own
position.

It is a common practice that before journalizing and posting adjustments, is necessary to

determine and assemble the relevant data. A preliminary draft of financial statements, and
other useful analyses prepared by accountants are generally called working papers.

A typical working paper frequently used by accountants prior to preparation of financial

statements is called a work sheet. Even though a work sheet is not a permanent record like
that of a journal and a part of a ledger, it has great importance with respect to reducing the
possibility of overlooking the need for adjustment, allows a convenient means of verifying
arithmetical accuracy, provided for the arrangement of data in a logical form, and helps as a
plan for the preparation of financial statements.

The work sheet is having three lines as a heading. That can be identified by: (1) the name of
the enterprise, (2) the nature of the form (work sheet), and (3) the period of time involved.

A work sheet has also a form usually used as an account title column and ten money columns
arranged in five pairs of debit and credit columns. The following are main headings of the
five sets of money columns of a worksheet presented on page 72.
o Trial Balance
o Adjustments
o Adjusted Trail Balance
o Income Statement
o Balance Sheet

Trial Balance Columns

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Alternatively, the trial balance data can be assembled directly on the work sheet form or they
may be prepared on a separate sheet first and then copied on the work sheet form. The work
sheet for Alem Drycleaners, with the trial balance data recorded is shown on the following
page.

Adjustments Columns

Both the debit and credit parts of an adjustment should be inserted on the appropriate lines
before extending to another adjustment. Cross-referring the related debit and credit of each
adjustment by letters is useful for the purpose of reviewing the worksheet. Moreover, it is
helpful later when the adjusting entries are recorded in a journal.

If the titles of some of the accounts to be adjusted do not appear in the trial balance because
of having zero balance before adjustment, they should be inserted in the account title column,
below the trial balance totals.

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 Account Title Trial balance Adjustments Adjusted total balance Income statement Balance sheet
Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Cash 12073 00 12073 00 12073 00
Accounts receivable 13925 00 13925 00 13925 00
Supplies 7300 00 (a)2300 00 5000 00 5000 00
Prepaid rent 5400 00 (b)1800 00 3600 00 3600 00
Dry cleaning equipment 56000 00 56000 00 56000 00
Accounts payable 5000 00 5000 00 5000 00
Alem Taye, Capital 79500 00 79500 00 79500 00
Alem taye, drawing 2500 00 2500 00 2500 00
Sales 15505 00 15505 00 15505 00
Salary expense 940 00 (d) 94 00 1034 00 1034 00
Miscellaneous expense 1867 00 1867 00 1867 00
100005 00 100005 00
Supplies expense (a)2300 00 2300 00 2300 00
Rent expense (b)1800 00 1800 00 1800 00
Depreiation expense (c)4500 00 4500 4500 00
Accumulated ©4500 00 4500 00 4500 00
Depreciation
Salaries payable (d) 94 00 94 00 94 00
8694 00 8694 00 104599 00 104599 00 11501 00 15505 00 89094 00
Net Income 4004 00 4004 00
15505 00 15505 00 93098 00 93098 00
Alem Dry Cleaners
Work Sheet
For Month Ended Hamle 30, 2000

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 a) Supplies. The supplies account has a debit balance of Birr 7,300, the cost of
the supplies on had at the end of the period is Birr 5,000, thus, the supplies
expense for Hamle is the difference between the two amounts or Birr 2,300.
the adjustment is entered by writing (1) supplies expense in the account title
column, (2) Birr 2,300 in the adjustments debit column on the some line,
and (3) Birr 2,300 in the adjustments credit column on the line with
supplies.
b) Rent. The prepaid rent account has a debit balance of Birr 5,400 which
represents a payment of three months beginning with Hamle therefore; the
rent expense for Hamle is Birr 1,800. The adjustment is entered by writing
(1) rent expense in the account title column (2) Birr 1,800 in the adjustments
debit column on the same line, and (3) Birr 1,800 in the adjustments credit
column on the line with prepaid rent.
c) Depreciation. Depreciation of the Dry cleaning Equipment is estimated at
Birr 4,500 for a month. This expired portion of the cost of the equipment is
both an expense and a reduction in the asset. The adjustment is entered by
writing (1) depreciation expense in the account title column, (2) Birr 4,500
in the adjustments debit column on the same line, (3) accumulated
depreciation in the account title column, and (4) Birr 4,500 in the
adjustments credit column on the same line.
d) Salaries: Salaries accrued but not paid at the end of Hamle amount to Birr
94. This is an increase in the expense and an increase in liabilities. The
adjustment is entered by writing (1) Birr 94 in the adjustments debit column
on the same line with salary expense, (2) salaries payable in the Account
title column, and (3) Birr 94 in the adjustments credit column on the same
line.

The last step in completing the adjustment columns is to prove the equality of debits
and credits by totaling and ruling the two columns.

75
Adjusted Trial Balance Columns

The data in the Trial Balance columns are combined with the adjustments data and extended
to the adjusted trial balance columns as indicated on the work sheet for Alem Dry Cleaners
below. For example, the cash and accounts receivable accounts are extended at their original
amounts of Birr 12,073 and Birr 13,925, since no adjustments affected either account.
Supplies has an initial balance of Birr 7,300 and a credit adjustment (decrease) of Birr 2,300
the amount to be extended is the debit balance of birr 5000. The same procedure is continued
until all account balances have been extended to the adjusted trial balance columns. The debit
and credit columns are then totaled to prove that no arithmetical errors have been made up to
this point.

Income Statement and Balance Sheet Columns

The data in the adjusted trial balance columns are extended to one of the remaining four
columns as indicated on the work sheet for Alem Dry Cleaners. The amounts of assets,
liabilities, owner’s equity, and drawing (or dividends) are extended to the balance sheet
columns, and the revenues and expenses are extended to the Income Statement Columns.

In the illustrative work sheet, first account listed is cash and the balance appearing in the
Adjusted Trial Balance debit column is Birr 12,073 this amount should be extended to the
appropriate column. Cash is an asset, it is listed on the balance sheet, and it has a debit
balance. Accordingly, the Birr 12,073 amount is extended to the debit column of the Balance
Sheet section. The balance of Accounts Receivable is extended in similar manner. The Birr
5000 adjusted balance of supplies is extended to the Balance Sheet debit column. The same
procedure is continued until all account balances have been extended to the appropriate
columns. The balances of the capital have been extended to the appropriate columns. The
balances of the capital and drawing accounts are extended to the balance sheet columns,
because this work sheet does not provide for separate statement of owner’s equity columns.

76
After all balances have been extended, each of the four columns is totaled. The net income or
the net loss for the period is the amount of the difference between the totals of the two
income statement columns. If the credit column total is greater than the debit column total,
the excess is the net income. For the work sheet presented on page 69, the Computation of
net income is as follows:

Total of credit column (revenue)............................... Birr 15,505

Total of Debit column (expenses)............................. 11,501
Net income (excess of revenue over expenses)......... Birr 4,004

Revenue and expense accounts, which are subdivisions of owner’s equity, are temporary in
nature. They are used during the accounting period to aid in the accumulation of detailed
operating data. After they have served their purpose, the net balance will be transferred to the
capital account (or the retained earnings account) in the ledger. This transfer is accomplished
on the worksheet by entries in the income statement debit column and the balance sheet
credit column, with the description of the amount, “Net Income,” inserted in the account title
column. If there had been a net loss instead of a net income, the amount would have been
entered in the income statement credit column and the balance sheet debit column, and
described as “Net Loss” in the account title column.

After the last entry is made on the work sheet, each of the four statement columns is totaled
to verify the arithmetic accuracy of the amount of net income or net loss transferred from the
income statement to the balance sheet. The totals of the two income statement columns must
be equal, as must the totals of the two balance sheet columns. The work sheet may be
expanded by the addition of a pair of columns solely for the statement of owner’s equity (or
retained earnings) data.

77
Check Your Progress: Exercise 3-3.
1. Why businesses prepare a worksheet before the preparation of financial statements?
________________________________________________________________________
________________________________________________________________________
_______________________________________________________________

2. If the balance sheet credit column of a worksheet exceeds its debit column, then there
should be: (a) Net Income (b) Net Loss, or (c) Neither net income nor net loss
________________________________________________________________________
________________________________________________________________________
_______________________________________________________________
3. Assume that the income statement debit and credit columns of a worksheet show a total of
Birr 125,000 and Birr 140,000, respectively. If the balance sheet credit column of the same
worksheet shows a total of Birr 210,000, what is the debit column total of the same
worksheet?
___________________________________________________________________________
___________________________________________________________________________
_______________________________________________________________________

3.4. Financial Statements

What are some of the purposes of financial statements?

The work sheet is the main and only source of all relevant data for the preparation of
financial statements. The income statement, statement of owner’s equity, and balance sheet
prepared from the work sheet of Alem Dry cleaners appear as follows.

78
 Alem Dry Cleaners
Income Statement
For Month Ended Hamle 30, 2000

Sales........................................................................................ Birr 15,505

Operating Expenses
Salary Expense....................................... Birr 1,034
Supplies Expenses.................................. 2,300
Pent Expense......................................... 1,800
Depreciation Expense ............................ 4,500
Miscellaneous Expense.......................... 1,867
Total Operating Expenses ..................... 11,501
Net income............................................................... Birr 4,004

Alem Dry Cleaners

Statement of Owner’s Equity
For Month Ended Hamle 30, 2000

Alem Taye, Capital Hamle 1, 2000............................................ Birr 79,500

Net income for the month............................................................ Birr 4,004
Less: Withdrawals...................................................................... (2,500)
Increase in owner’s equity .......................................................... 1,504
Alem Taye, Capital, Hamle 30, 2000.......................................... Birr 81,004

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 Alem Dry Cleaners
Balance Sheet
Hamle 30, 2000

Assets:
Current Assets:
Cash................................................................. Birr 12,073
Accounts Receivable ....................................... 13,925
Supplies........................................................... 5,000
Prepaid Rent..................................................... 3,600
Total Current Assets........................................ Birr 34,598

Plant Assts:
Dry Cleaning Equipment................................. Birr 56,000
Less: Accumulated Depreciation........... (4,500) 51,500
Total Assets.................................................... Birr 86,098
Liabilities
Current Liabilities:
Accounts Payable Birr 5000
Salaries Payable 94
Total liabilities Birr 5094
Owners Equity
Alem Taye, Capital................................................................ 81,004
Total Liabilities and Owner’s Equity................................. Birr 86,098

3.5. Journalizing and Posting Adjusting Entries

What is the purpose of adjusting entry? From where shall we get the data for recording
adjusting entries?

80
At every end of an accounting period, the adjusting entries appearing in the work sheet are
recorded in the journal and post to the ledger. Such a procedure brings the ledger accounts in
the agreement with the data reported on the financial statements.

The adjusting entries in the journal of Alem Dry Cleaners are presented as follows:
Journal Page No. 1
Post
Date Description Ref Debit Credit
Adjusting entries
Hamle 30 Supplies expense 51 2300 00
Supplies 14 2300 00

30 Rent Expense 53 1800 00

Prepaid rent 15 1800 00

30 Depreciation expense 54 4500 00

Accumulated depreciation 19 4500 00

30 Salary expense 52 94 00
Salaries payable 22 94 00

Check Your Progress: Exercise 3-4

1. What are the typical financial statements of a business enterprise?
________________________________________________________________________
________________________________________________________________________
_______________________________________________________________
2. What kinds of information do an income statement reports? [Answer this question from
your previous knowledge of an income statement]
________________________________________________________________________
________________________________________________________________________
_______________________________________________________________

81
3.6 Journalizing and Posting Closing Entries

What are closing entries? Why closing entries are required? What types of accounts
need to be closed? Give your answer in writing before you the following discussion.

The revenue, expense, and drawing (or dividends) accounts are subdivisions of the owner’s
equity account. Hence, they are temporary accounts and the net effect of their balances must
be recorded in a permanent capital (or retained earnings) account. The balances must also be
removed from the temporary accounts so that they will be ready for use in accumulating data
for the following accounting period. Both of these goals are accomplished by a series of
entries called closing entries.

An account titled income summary is used for summarizing the data in the revenue and
expense accounts. It is used only at the end of the accounting period and is both opened and
closed during the closing process.

Four entries are required in order to close the temporary accounts of a sole proprietorship at
the end of the period. They are as follows.
1. Each revenue account is debited for the amount of its balance, and Income Summary is
credited for the total revenue.
2. Each expense account is credited for the amount of its balance, and Income Summary
is debited for the total expense.
3. Income Summary is debited for the amount of its balance (net income), and the capital
account is credited for the same amount. (Debit and credit are reversed if there is a
net less).
4. The drawing account is credited for the amount of its balance, and the capital account
is debited for the same amount.
The account titles and amounts needed in journalizing the closing entries may be obtained
from any one of three sources (1) work sheet, (2) income statement and statement of owner’s
equity and (3) ledger.

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After the closing entries have been journalized, illustrated as follows, and posted to the
ledger, the balance in the capital account will correspond to the amounts reported on the
statement of owner’s equity and balance sheet, in addition, the revenue, expense, and
drawing accounts will have zero balances.

Journal Page 2
Date Description Post Ref Debit Credit
Closing Entries
Hamle 30 Sales 41 15505 00
Income summery 33 15505 00

30 Income summary 33 15001 00

Salary expense 52 1034 00
Miscellaneous expense 59 1867 00
Supplies expense 51 2300 00
Rent expense 53 1800 00
Depreciation expense 54 4500 00

30 Income summary 33 4004 00

Alem Taye, Capital 31 4004 00

30 Alem Taye, Capital 31 2500 00

Alem Taye, Drawing 32 2500 00

The ledger of Alem Dry cleaners after the adjusting and closing entries have been pasted is
shown as follows.

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Account: Cash Account No: 11
Post Balance
Date Item Ref Debit Credit Debit Credit
2000 1 1 11000 00 11000 00
Ham
1 1 5400 00 5600 00
4 1 7100 00 12700 00
5 1 1500 00 11200 00
9 1 4000 00 7200 00
13 1 470 00 6730
16 1 5845 00 12575 00
19 1 2900 00 9675 00
26 1 470 00 9205 00
30 1 367 00 8838 00
30 2 5735 00 14573 00
30 2 2500 00 12073 00

Account: Accounts Receivable Account No: 12

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 1 1 17100 00 17100 00
Ham
4 1 7100 00 10,000 00
30 2 3925 00 13925 00

Account: Supplies Account No.: 14

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 1 1 4400 00 4400 00
Ham
19 1 2900 00 7300 00
30 AJUSTING 2 2300 00 5000 00
Account: Prepaid Rent Account No.: 15

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 Post Balance
Date Item Ref Debit Credit Debit Credit
2000 1 1 5400 00 5400 00
Ham
30 Adjusting 2 1800 00 3600 00

Account: Dry Clearing Equipment Account No.: 18

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 1 1 4700 00 47,000 00
Ham
3 1 9000 56,000 00

Account: Accumulated Depreciation Account No: 19

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 30 Adjusting 2 4500 00 4500 00
Ham

Account: Accounts Payable Account No: 21

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 30 1 9000 9000 00
Ham
9 1 4000 00 5000 00
Account: Salaries Payable Account No.22
Post Balance
Date Item Ref Debit Credit Debit Credit
2000 1 Adjusting 2 94 00 94 00
Ham

Account: Alem Taye, Capital Account No. 31

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 Post Balance
Date Item Ref Debit Credit Debit Credit
2000 1 1 79500 00 79500 00
Ham
30 Closing 2 4004 00 83504 00
30 Closing 2 2500 00 81004 00

Account: Alem Taye, Drawing Account No. 32

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 30 2 2500 00 2500 00
Ham
30 Closing 2 2500 00 2500 00

Account: Income Summery Account No:.33

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 30 Closing 2 15505 00 15505 00
Ham
30 Closing 2 11501 00 4004 00
30 Closing 2 4004 00 4004 00 -

Account: Sales Account No. 41

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 16 1 5845 00 5845 00
Ham
30 2 5735 00 11580 00
30 2 3925 00 15505 00
30 Closing 2 15505 00

Account: Supplies Expense Account No.51

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 Post Balance
Date Item Ref Debit Credit Debit Credit
2000 30 Adjusting 2 2300 00 2300 00
Ham
30 Closing 2 2300 00 2300 00

Account: Salary Expense Account No.52

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 13 1 470 00 470 00
Ham
26 1 470 00 940 00
30 Closing 2 940 00

Account: Rent Expense Account No: 53

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 30 Adjusting 2 2300 00
Ham
30 Closing 2 2300 00

Account: Depreciation Expense Account No. 54

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 30 Adjusting 2 4500 00 4500 00
Ham
30 Closing 2 4500 00 4500 00

Account: Miscellaneous Expense Account No. 59

Post Balance
Date Item Ref Debit Credit Debit Credit
2000 5 1 1500 00 1500 00
Ham
30 1 367 00 1867 00
30 Closing 2 1867 00 1867 00

87
As the entry to close an account is posted, a line should be inserted in both balance columns
opposite the final entry, as illustrated by Alem Taye, Drawing and the remaining temporary
accounts. Transactions affecting the accounts in the following period will be posted in the
spaces immediately below the closing entry.

3.7 Post-Closing Trial Balance

The final procedure of the accounting cycle is the preparation of a trial balance after all of the
temporary accounts have been closed. The purpose of the post-closing trial balance, is to
make sure that the ledger is in balance at the beginning of the new accounting period. The
accounts and amounts should agree exactly with the accounts and amounts listed on the
balance sheet at the end of the period.

Alem Dry Cleancrs

Post-Closing Trial Balance
Hamele 30, 2000
Cash 12073 00
Accounts Receivable 13925 00
Supplies 5000 00
Prepaid Rent 3600 00
Dry Cleaning Equipment 56,000
Accentuated Depreciation 4500 00
Accounts Payable 5000 00
Salaries Payable 94 00
Mem Taye, Capital 81004 00
90598 00 90598 00

88
Review Exercise 3.1

At the end of a fiscal period, the income statement debit and Credit column subtotals of a
worksheet show Birr 65,000 and Birr 95,000, respectively. Total assets at the beginning of
the same period were Birr 130,000 and total liabilities at the end of the period were Birr
50,000. Liabilities increased by Birr 20,000 during the fiscal period. There was an additional
investment of Birr 5,000 but no withdrawals during the period.
What is the capital balance at the beginning of the period?
What is the amount of net income or net loss during the period?
Determine the capital balance at the end of the period
What is the amount of 6he total assets at the end of the period?

3.8 Fiscal Year and the Accounting Cycle

3.8.1 Fiscal Year
In the ordinary course of business, the duration of an accounting period is one year,
beginning on a specific day and ending 12 months later

The annual accounting period adopted by an enterprise is known as its fiscal year. Fiscal
years ordinarily begin with the first day of a particular month selected and end on the last day
of the twelfth month.

3.8.2 Accounting Cycle

The principal accounting procedures of a fiscal period have already been presented. The
sequence of procedures is frequently called the accounting cycle. It begins with analysis and
the journalizing of transactions and ends with the post-closing trial balance. The most
significant out put of the accounting cycle is the financial statements. The following are the
basic phases of the cycle.
Transactions are analyzed and recorded in a journal
Transactions are posted to the ledger.
Trial balance is prepared, data needed to adjust accounts are assembled, and the work
sheet is completed.

89
 Financial statements are prepared.
Adjusting and closing entries are journalized
Adjusting and closing entries are posted to the ledger.
Post-closing trial balance is prepared.

Check Your Progress: Exercise 3-5

1. Why are closing entries required at the end of an accounting period?
________________________________________________________________________
________________________________________________________________________
_______________________________________________________________
2. What is the purpose of income summary account?
________________________________________________________________________
________________________________________________________________________
_______________________________________________________________

3.9. Model Examination Questions

Part I: True or False Questions
Write ‘True’ if the statement is correct and write ‘False’ if the statement is wrong.
1. Under accrual basis of accounting, revenues are reported in the period in which they
are earned, and expenses are reported in the period in which they are incurred.
2. Closing entries are required at the end of accounting period to bring accounts up to
date.
3. Matching principles emphasizes the proper matching of revenues of a period with
expenses incurred in generating these revenues.
4. Cash received and recorded as liabilities before revenue is earned is called accrued
revenues.
5. Under cash basis of accounting, net income (or net loss) would the difference between
cash receipts and cash payments.

90
Part II: Multiple Choice Questions
Choose the best answer among the given alternatives.

1. Each of the following is a major type of adjusting entries except:

A. Prepaid expenses C. accrued revenues
B. Earned revenues D. Accrued expenses
2. Identify the incorrect statement about the accrual basis of accounting
A. Revenue is recognized in the period in which it is earned.
B. Revenue is recorded only when cash is received, and expense is recorded only
when cash is paid.
C. This basis (method) is in accord with generally accepted accounting principles
D. None of the above.
3. Which of the following accounts would be closed to the income summary account at
the end of a period?
A. salary expense C. both sales and salary expense
B. Sales D. Neither sales nor salary expense.
4. Adjusting entries are made to ensure that:
A. Revenues are recorded in the period in which they are earned.
B. Balance sheet and income statement accounts have correct balances at the end
of an accounting period.
C. Expense are recognized in the period in which they are incurred
D. All of the above

5. If the building account has a balance of Birr 85,000 and its accumulated depreciation
account has a balance of Birr 34,000 the book value of the equipment is:
A. Birr 85,000 C. Birr 51.000
B. Birr 119,000 D. birr 34,000
6. Senait earned a salary of Birr 850 for the last week of Sene. She will be paid on
Hamle 1. The adjusting entry for Senait’s employer at Sene 30 is:
A. Salaries Expense ....................................... 850
Cash ...................................................... 850

91
 B. Salaries Payable......................................... 850
Cash ...................................................... 850
C. Salaries Expense...................................... 850
Salaries payable .................................... 850
D. No entry is required
7. Adjustments for accrued expenses:
A. Increase expenses and decrease liabilities.
B. Decrease assets and increase liabilities.
C. Decrease expenses and increase assets.
D. Increase expenses and increase liabilities
8. Adjustments for unearned revenues:
A. Decrease revenues and decrease assets.
B. Decrease liabilities and increase revenues.
C. Increase assets and increase revenues
D. None of the above.
9. The following accounts would be included in the post-closing trial balance except.
A. Prepaid insurance C. Sales
B. Cash D. Accounts payable
10. The trial balance shows Supplies Birr 4,250 and Supplies Expense having zero
balance. If birr 3,250 of supplies are on hand at the end of the period, the adjusting
entry is:
A. Supplies Expense 3,250
Supplies 3,250
B. Supplies 3,250
Supplies Expense 3,250
C. Supplies 1,000
Supplies Expense 1,000
D. Supplies Expense 1,000
Supplies 1,000

92
Part III: Workout Questions
Attempt the following questions: Show the relevant steps in your computations.
1. The bookkeeper for Tabor Company asks you to prepare the following accrued adjusting
entries at December 31.
(a) Interest on notes payable of Birr 5,000 is accrued.
(b) Services provided but unbilled total Birr 7,500
(c) Salaries earned by employees of Birr 4,900 have not been recorded.

2. Use the following account titles: Service Revenue, Accounts Receivable, Accounts
payable, Interest Expense, Interest payable, salaries expense, and salaries payable.
At the Rainbow Company, prepayments are debited to expense when paid and unearned
revenues are credited to revenue when received. During January of the current year, the
following transactions occurred
Jan 3. Paid Birr 3,300 for fire insurance protection for the year.
9. Paid Birr 2,500 for supplies.
14. Received Birr 7,200 for services to be performed in the future.
On January 31, it is determined that birr 3,200 of the services fees have been earned and
that there are Birr 1,000 of supplies on hand.

Instructions:
1. Journalize and post the January transactions, (use T accounts).
2. Journalize and post the adjusting entries at January 31.
3. Determine the ending balance in each of the accounts
4. The trial balance of Eastern Laundromat at August 31, 1999, the and of the current
fiscal year, and the data needed to determine year end adjustments are as follows.

93
 Eastern Laundromat
Trial Balance
August 31, 1999
Cash 9,890
Laundry supplies 5,250
Prepaid insurance 3,125
Laundry equipment 87,000
Accumulated depreciation 56,200
Accounts payable 69,500
Nigist Abay, Capital 34,400
Nigit Abay, Drawing 19,000
Laundry revenue 79,800
Wages expense 26,500
Rent expense 16,575
Utilities expense 9,000
Miscellaneous expense 1,010
177,350 177,350

Adjustment Data:
e) Inventory of laundry supplies at august 31........................ Birr 2,100
f)Insurance premiums expired during the year ..................... 1,900
g) Depreciation on equipment during the year....................... 7,250
h) Wages accrued but not paid at august 31............................ 1,900

Instructions:
1. Record the trial balance on a ten-column work sheer and complete the work sheet.
2. Prepare an income statement, a statement of owner’s equity (no additional investments
were made during the year) and a balance sheet.
3. On the basis of the adjustment data in the work sheet, Journalize the adjusting entries.
4. On the basis of the data in the work sheet, journalize the closing entries.

94
List of Reference Materials

1. Introduction to Accounting, 21st century

2. Fess and warren, Accounting principles, 16 th edition, south-western publishing
Company.
3. Fess and warren, Accounting principles, 18 th edition, south-western publishing
Company.
4. Weygandt, kieso, Kimmel, Accounting principles, 5th edition, John wilily and sons,
Inc.
5. Mosich, Intermediate Accounting, 6th edition, MacGraw-itill Book Company.

95
 UNIT FOUR: ACCOUNTING FOR A MERCHANDISING
BUSINESS

List of Contents
 Unit Objective
 Introduction
4.1 Accounting for Purchases
4.2 Accounting for Sales
4.3 Merchandise Inventory Systems
4.4 Presentation of Cost of Merchandise Sold
4.5 Accounting for Deferrals and Accruals
4.6 Worksheet for Merchandise Enterprises
4.7 Financial Statements for Merchandising Business
4.8 Adjusting and Closing Entries
4.9 Reversing Entries
4.10 Interim Statements
4.11 Correction of Errors
4.12 Model Examination Questions
 List of Reference Materials

Unit Objective

So far, throughout your discussion of this course you were acquainted with the basic
concepts and practices of accounting for a service business. A service business is a business
that renders services to its clients. In this unit we will try to acquaint you with basic
accounting principles that are unique to merchandising enterprises. A merchandising

96
business is a business that buys and sells merchandise for a profit. Thus, after having
completed this unit, you will be able to:

 Understand the accounting for merchandising transactions including purchases of

merchandise, sales of merchandise, transportation costs, sales taxes, etc.
 Explain the difference between periodic and perpetual inventory systems
 Illustrate the cost of goods sold section of the income statement of a merchandising
concern
 Comprehend the difference between income statement for a service business and
income statement for a merchandising business.
 Illustrate adjusting entries for deferrals and accruals
 Describe the financial statements for a merchandising business
 Record closing, reversing, and correcting entries, etc.

Introduction

Hello Dear Students! In your previous discussion you have learned the fundamental
accounting concepts and practices as applied to small service enterprises. Service businesses
are business enterprises that generate (earn) revenue or income through rendering services to
their clients. As you discussed earlier in unit 3, the principal type of income or revenue for a
service business includes: fees income, (fees earned), commission income, fares income,
tuition fees, etc.

On the other hand, a merchandising business is a business enterprise that buys merchandise
(goods) for resale to customers. These types of businesses are primarily engaged in the
buying and selling of merchandise, instead of rendering service that makes the activities of
merchandising enterprises different from the activities of service enterprises. Hence, in this
unit you will discuss in detail the major accounting principles and practices applied for a
merchandising business.

97
4.1 Accounting for Purchases

Purchases of merchandise are usually identified in the ledger as purchases. A more exact
account title, such as “Purchases of Merchandise,” could be used, but the briefer title is
customarily used. Thus, a merchandising enterprise can accumulate in the purchases account
the cost of all merchandise purchased for resale during the accounting period. Purchases of
merchandise can be made (1) on a cash basis or (2) on account. These transactions are
illustrated below:

4.1.1 Recording Cash Purchases of Merchandise

When merchandise is purchased on a cash basis, the purchases account would be debited and
the cash account would be credited as shown below:

Oct. 1. Purchases ……………………………. 10,000

Cash …………………………. 10,000
Purchases from supplier, Gift Trading
4.1.2 Recording Purchases of Merchandise on Account

Most purchases of merchandise are made on a credit basis and are recorded as a debit to the
Purchases account and a credit to Accounts Payable account as illustrated below:
Oct. 2. Purchases ……………………………. 7,500
Account Payable …………….. 7,500
Purchases from Supplier ABC Co

Check Your Progress: Exercise 4.1

1. What distinguishes a merchandising business from a service enterprise?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
____________________________________________________________

98
2. What is the name of the account in which purchases of merchandise are recorded?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
_______________________________________________________________

4.1.3 Purchases Discounts

The arrangements agreed upon by the buyer and the seller as to when payments for
merchandise are to be made is called the credit terms. If payment is required immediately
upon delivery of goods, the terms are said to be “cash” or “net cash”. Otherwise, the buyer is
allowed a certain amount of time, known as the credit period, in which to pay.

It is usual for the credit period to begin with the date of the sale as shown by the date of the
invoice or bill. If payment is due within a stated number of days after the date of the invoice,
for example 30 days, the terms are said to be “net 30 days,” which may be written as “ n/30”.
On the other hand, if payment is due by the end of the month in which the sale was made, it
may be expressed as “n/eom”.

Why is the seller grants a cash discount to the purchaser? What do you think is the effect
of a purchases discount on the Purchases account? Give your answer in writing before you
read the discussion below.

For a credit sale, a buyer is expected to pay the seller within the credit period agreed upon.
To encourage a buyer to make payment before the end of this period, a seller may allow a
deduction from the amount of the invoice. A deduction that a seller allows on the amount of
invoice to encourage a buyer to make prompt payment is called a cash discount.

99
A cash discount is usually stated as a percentage that can be deducted from the amount of the
invoice. For example, the terms of sale on an invoice may be written as 2/10, n/30. These
terms are commonly read two ten, net thirty. The term two ten means that a buyer may deduct
2% of the invoice amount if payment is made within 10 days from the date of the invoice.
The term net thirty means that if an invoice is not paid within 10 days, the buyer is required
to pay the total amount within 30 days.

A business also may indicate the date for full payment of an invoice as EOM. This means
that full payment is expected not later than the end of the month. If, for example, the terms
are stated as 1/10, n/30 EOM, a 1% discount may be taken if the invoice is paid within 10
days after the end of the month in which the invoice is dated. The full amount of the invoice
must be paid on or before 30 days after the end of the month.

What is the advantage for the purchaser of taking a discount? Attempt the question by
your own in writing.

A cash discount on purchases taken by a buyer is called a purchases discount. From the
buyer’s view point, it is important to take advantage of all available discounts, because when
the buyer takes advantage of a purchases discount, he pays less than the purchase price
recorded on his books. Therefore, a purchase discount is a deduction from purchases.
Purchase discounts taken by the buyer for early payment of an invoice are recorded by a
buyer as a credit to the purchases discounts account to show a deduction from the purchases
account.

Check Your Progress: Exercise 4.2

100
 1. Why a cash discount is sometimes offered to a person who has purchased
merchandise on account?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
2. What is meant by terms of sale 1/10, n/30?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
3. What is the term applied to discounts for early payment by the buyer
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

Illustration of Purchases Discounts Transactions

Assuming that On October 5, Nobel Trading Purchased merchandise amounting to Birr

11,000 on account from Valley Supply Company with terms 2/10, n/30, FOB Shipping Point.
Novel’s entries for the purchase invoice presented above and its payment at the end of the
discount period could be recorded as follows:
Oct. 5. Purchases ……………………………………. 11,000
Accounts Payable ……………………. 11,000
To record purchases from Valley Supply Co.

Oct. 15. Accounts Payable …………………………… 11,000

Cash ………………………………….. 10,780
Purchases Discounts …………………. 220

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 To record the payment of the invoice to Valley Co. within the discount
period.

What if, payment is not made within the discount period? What would be the amount of
cash required for payment?

If payment of the invoice is made after the discount period had been elapsed, the amount of
cash required for payment is equal to the invoice amount and no discount will be recorded in
the buyer’s book. The entry to record the payment of the invoice, if payment is made after
the discount period would be:

Nov. 5. Accounts Payable ……………………………. 11,000

Cash …………………………………... 11,000
To record payment of the invoice to Valley Co. after the discount period.

4.1.4 Purchases Returns and Allowances

The buyer of merchandise may be allowed a reduction in an account for the return of part or
all of the merchandise purchased. Merchandise returned by a buyer for credit is called a
Purchases Return. A buyer may also be allowed a reduction in an account by the seller if the
merchandise received was inferior in quality or was damaged when received. In the second
situation, the merchandise is retained by the buyer and he will ask the seller a price
adjustment (reduction) for the defective or unsatisfactory merchandise. This is often called a
Purchases Allowance.

A purchases return or allowance should be confirmed in writing. The details may be stated in
a letter or on a form. A form prepared by the buyer containing a record of the amount of the
debit taken by the buyer for returns, allowances, and similar items is called a debit

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memorandum. It is called a debit memorandum because the amount is a deduction (debit)
from the liability account Accounts Payable.

The buyer may use a copy of the debit memorandum as the source document for recording a
purchases returns and allowances transaction. However, the buyer may wait for written
confirmation from the seller and use that as the source document.

Illustration of Purchases Returns and Allowances Transactions

To illustrate, assuming that Noble Trading identified defective merchandise with invoice
amount of Birr 1000 that were acquired from Gift Trading as of October 5. The entry for
Noble Trading to record the return of the merchandise identified in the debit memo above
would be as follows:

Oct. 12. Accounts Payable …………………………….. 1000

Purchase Returns and Allowances …….. 1000
To record a Debit Memo for Purchase returns and Allowances

NB. The purchases returns and allowances account can be viewed as a deduction from the
amount initially recorded in Purchases. In this sense, like Purchase Discounts, the Purchases
Returns and Allowances account is a contra (or offsetting) account to Purchases.

What if, the return and allowance for defective merchandise, is made by the buyer after
payment of the invoice is made? How do you record the entry? Attempt the question by
your own in writing.

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If the buyer identified defective merchandise after he has settled payment of the invoice, the
settlement may be a cash refund. That is, the buyer will ask the seller a cash refund for the
defective merchandise. To illustrate this, assuming that Noble Trading identified the Birr
1000 defective merchandise acquired from Valley Co., after settlement of the entire invoice.
Noble asked a cash refund equal to the value of defective merchandise and the entry to record
the receipt of the cash refund by noble Trading could be as follows:

Oct. 15. Cash (Accounts Receivable) ………………….. 1000

Purchases Returns and Allowances ……. 1000
To record the Purchase Returns and Allowances and the receipt of cash
refund from seller.

Check Your Progress: Exercise 4.3

1. Seka Trading purchased merchandise on account from a supplier for Birr 15,000, terms
2/10, n/30. Seka Trading returned Birr 3,000 of the merchandise and received full credit.
(a) If Seka pays the invoice within the discount period, what is the amount of cash
required for the payment? (Show the necessary computations).
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

(b) What accounts are credited by Seka Trading to record the returns and the cash
discount?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
_______________________________________________________________

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4.2 Accounting for Sales

In the previous section of this unit you have learned one of the major activities of a
merchandising business, the purchase of merchandise. Another major activity of a
merchandising business is the sale of merchandise. Merchandise sales are usually identified
in the ledger as Sales, or a more exact title, such as sales of merchandise, could be used.

A merchandising business may sell merchandise either (1) for cash or (2) on account or
credit basis.

4.2.1 Recording Sale of Merchandise for Cash

When a business sells merchandise on a cash basis, the asset account, Cash, would be debited
and the revenue account, Sales, would be credited as shown below:

Oct. 1. Cash ……………………………………….. 5,500

Sales ………………………………. 5,500
To record cash sales of merchandise

4.2.2 Recording Sales on Account

A merchandising business may also sell merchandise on account, that is, without receiving
cash immediately at the time of sale. Such sales result in a debit to the asset account,
Accounts Receivable, and a credit to the revenue account, Sales. To illustrate, assume that on
October 4, 2007, Noble Trading sold merchandise on account to Sunrise Co., amounting to
Birr 4,500, with terms 1/10, n/30, FoB Destination. The entry to record this transaction
would be as shown below:

Oct. 4. Accounts Receivable ………………………. 4,500

Sales ……………………………….. 4,500

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 Entry to record credit sales to a customer, Sunrise Co

4.2.3 Sales Discounts

A cash discount on sales granted to a customer by the seller is called a sales discount. Sales
discounts are granted by the seller to encourage the buyer to make prompt payment. When a
sales discount is granted, the seller receives less than the sale price recorded at the time of the
sale. Sales discounts reduce the revenue from sales and are viewed as a contra (or offsetting)
account to sales. To illustrate, assuming that Noble Trading received payment from Sunrise
Co. within the discount period. The entry to record the receipt of cash from Sunrise Co and
the accompanying sales discounts are shown below:

Oct. 14. Cash ………………………………………... 4,455

Sales Discounts …………………………….. 45
Accounts Receivable ………………… 4,500
To record collection of cash from the customer within the discount period

If Sunrise makes the payment after the discount period had been elapsed, say on November
3, the amount of cash received by Noble Trading would be equal to the invoice amount, i.e.,
Birr 4,500, and the entry would be recorded as below:

Nov. 3. Cash ………………………………........................ 4,500

Accounts Receivable ……………………. 4,500
To record collection of cash from the customer after the discount period

Check Your Progress: Exercise 4.4

1. What accounts are affected when cash is received on account and a cash discount is
taken? How are the accounts affected?
___________________________________________________________________________
___________________________________________________________________________

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___________________________________________________________________________
___________________________________________________________________________

4.2.4 Sales Returns and Allowances

Merchandise sold may be returned by the buyer (sales return) or, because of defects or for
other reasons, the buyer may be allowed a reduction from the original selling price at which
the goods were sold (sales allowance). If the return or allowance is for a sale on account; the
seller usually gives the buyer a credit memorandum. This memorandum shows the amount
for which the buyer is to be credited and the reason therefore.

Sales returns and allowances decrease the amount of sales and the amount of cash or
accounts receivable. Some businesses debit the sales account for the amount of a return or
allowance. However, most businesses debit these amounts to a separate account. A separate
account is used to show how large the amount of sales return and allowances has become.
Furthermore, the business can see if the returns and allowances are increasing or decreasing
from one accounting period to the next. If the amounts are very large, one account may be
maintained for sales return and another account for sales allowances. The sales returns and
allowances account is placed in the revenue division of the general ledger.

To illustrate the accounting for sales returns and allowances, assume that Noble Trading
received defective merchandise with invoice amount of Birr 500 from a customer, Ziquala
Trading. The entry would be recorded in the books of Noble Trading as follows:

Oct. 15. Sales Returns and Allowances ……………… 500

Accounts Receivable ………………… 500
To record credit memo for sales returns and allowances

NB. If a cash refund is made because of merchandise returned or for an allowance, Sales
returns and Allowances is debited and cash is credited.

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 4.2.5 Transportation Costs
The terms of the agreement between the buyer and seller include provisions regarding:
(1) when the ownership or title of the merchandise passes from the seller to the buyer,
and
(2) which party is to bear the cost of delivering the merchandise to the buyer.

There Are Two Terms Regarding the Ownership of the Goods:

a) FoB Shipping Point: if the term stated on the invoice is FoB Shipping Point, title or
ownership to the goods passes to the buyer at the shipping point or at the point of origin and
the buyer is responsible to cover the transportation costs. Transportation cost paid by the
buyer is added to the cost of goods to yield total cost of merchandise purchased. FoB
Shipping Point means that the seller places the merchandise “free on board” at the shipping
point and the buyer is responsible for the transportation costs beyond that point.

Sometimes, as a courtesy to a customer, a seller often pays the transportation charges on

merchandise at the time it is shipped. When this is done, the transportation charges are
included on the invoice and become part of the total of the invoice. If a seller pays the
transportation charges and includes them on the invoice, the buyer debits the entire amount
of the invoice, including the transportation charges, to the Purchases account. Transportation
charges on incoming shipments are part of the total cost of purchases. If transportation costs
are included on an invoice, the discount (if any) is not allowed on this portion of the invoice.
To illustrate, assume that on October 16, Noble Trading purchases merchandise from Bridge
Company on account, Birr 2,500, terms FoB Shipping Point, 3/10, n/45, with prepaid
transportation costs of Birr 200 added to the invoice. The entry by Noble Trading would be
recorded as follows:

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 Oct. 16. Purchases ……………………………………… 2,500
Freight – In …………………………………… 200
Accounts Payable ………………………. 2,700

On the contrary, the same transaction could be recorded by the seller as follows:
Oct. 16. Accounts Receivable …………………………. 2,700
Sales …………………………………… 2,500
Cash ……………………………………. 200
If the terms provide for a discount for early payment, the discount is based on the amount of
the sale rather than on the total amount of the invoice. To illustrate, if Bridge Co. pays the
amount due on the purchase of October 16 within the discount period, the amount of the
discount, the amount of the payment, and the entry to record the payment would be:

Oct. 26. Accounts Payable ……………………………… 2,700

Cash …………………………………….. 2,625
Purchases Discounts ……………………. 75

In some cases, the transportation charges on purchases are paid by a buyer directly to the
transportation Company. When a buyer pays the transportation charges, the buyer debits
Purchases for the amount of the charges. Some businesses prefer to record the transportation
charges in a separate account titled Transportation – In or Freight – In. When either of these
accounts is used, it is classified as a cost of merchandise account and is added to Purchases
on the income statement.

b) FoB Destination: On the other hand, if the term stated on the invoice is FoB Destination,
title or ownership to the goods passes to the buyer when the goods are received by the buyer.
In this case the seller is responsible to cover transportation costs. FoB Destination means that
the seller places the goods “free on board” to its destination by paying the delivery costs. In
this case, the transportation costs paid by the seller should be debited to Freight – Out,
Transportation – Out, Delivery Expense, or a similarly titled account. The total of such costs
incurred during a period is reported on the seller’s income statement as a selling expense.

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Check Your Progress: Exercise 4.6
1. Who bears the transportation costs when the terms of sale are (a) FoB Shipping point,
(b) FoB Destination?
___________________________________________________________________________
___________________________________________________________________________
__________________________________________________________________
2. Merchandise is sold on account to a customer for Birr 20,000, terms FoB shipping
point, 3/10, n/30, the seller paying the transportation costs of Birr 1,500. Determine
the following:
(a) the amount of the sale
(b) Amount debited to Accounts Receivable
(c) Amount of the discount for early payment
(d) Amount of the remittance due within the discount period
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
4.2.6 Sales Taxes
Hello Dear Students! Don’t you know a sales tax? We hope you know a little about it. It is a
tax imposed on the sale of goods. In Ethiopia, the government or other taxing units levy a tax
on retail sales of merchandise. The liability for the sales tax is ordinarily incurred at the time
the sale is made, regardless of whether the sale is made for cash or on credit basis.

At the time of cash sales, the seller collects the sales tax. When a sale is made on account, the
buyer is charged for the tax. The seller credits the sales account for only the amount of the
sale, and credits the tax to Sales Tax Payable Account. To illustrate, assume that Noble
Trading sold merchandise on account amounting to Birr 1000, subject to a 15% sales tax.
The entry to record the sale and the sales tax liability would be as shown below:
Oct. 19. Accounts Receivable ……………………… 1,150
Sales ………………………………… 1000
Sales Tax Payable …………………… 100

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NB. At the end of each period the actual amount of the sales tax liability is paid to the
appropriate taxing unit, and Sales Tax Payable is debited.

Check Your Progress: Exercise 4.7

1. A sale of merchandise on account for Birr 9000 is subject to a 4% sales tax.
(a) Should the sales tax be recorded at the time of sale or when payment is received?
(b) What is the amount of the sale?
(c) What is the amount debited to Accounts Receivable?
(d) What is the title of the account to which the Birr 360 is credited?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

4.3 Merchandise Inventory Systems

In a merchandising business, merchandise purchased during the period has been recorded in
the purchases account. Some of this merchandise may have been sold during the period, and
some may be unsold at the end of the period. The unsold merchandise at the end of the period
represents an ending inventory that should be reported on the balance sheet as an asset. This
same inventory becomes the beginning inventory in the next accounting period.

The physical quantities in inventory may be measured by use of either a periodic inventory
system or a perpetual inventory system. The essential difference between these two systems
from an accounting point of view is the frequency with which the physical flows are assigned
a value. In the periodic system, the inventory value is determined only at particular times,
such as at the end of the reporting period.

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In a perpetual system of inventory valuation, the ongoing physical flow is monitored, and the
cost of the items is maintained on a continual basis.

4.3.1 Periodic Inventory System

In a periodic inventory system, an actual physical count of the goods on hand is taken at the
end of each accounting period for which financial statements are prepared. The goods are
counted, weighted, or otherwise measured, and the quantities are then multiplied by unit cost
to value the inventory. In this system purchases are debited to a purchases account, and end-
of-period entries are made to close the purchases account, to close out beginning inventory as
an asset (i.e., the ending inventory replaces the beginning inventory in the accounts). When a
sale of merchandise is made only the revenue from sale is recorded and no attempt can be
made to record the cost of goods sold at the time each sale is made. Instead, the cost of goods
sold (cost of sales) is computed as a residual amount (beginning Inventory plus net purchases
less ending inventory).

4.3.2 Perpetual Inventory System

When a perpetual inventory system is used, detailed perpetual inventory records, in addition
to the usual ledger accounts, are maintained for each inventory item, and an inventory control
account is maintained in the general ledger on a current basis.

When purchase of merchandise is made, it is debited to the Merchandise Inventory account;

and when a sale of merchandise is made we record both the revenue from sale and the cost of
goods sold. Thus, in this method the accounting records continuously disclose the inventory
on hand.

4.4 Presentation of Cost of Merchandise Sold

For merchandising enterprises that use the periodic system, the cost of merchandise sold
during a period is reported in a separate section in the income statement. To illustrate assume
that Noble Trading began its business operations on January 10, 2007, and purchased Birr

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380,000 of merchandise during the year. If the inventory at December 31, 2007, the end of
the year, is Birr 90,500 the cost of merchandise sold during the year would be reported as
follows:

Cost of Merchandise Sold (For 2007 Fiscal period)

Purchases ……………………………………………………….. Birr 380,000
Less: Merchandise Inventory, December 31, 2007 ……………… 90,500
Cost of Merchandise Sold ………………………………. 289,500
Continuing the above illustration, assume that during 2008 Noble Trading acquired
merchandise amounting to Birr 471,800, receives credit for purchases returns and allowances
of Birr 11,800, takes purchases discounts of Birr 4,100, and pays transportation costs of Birr
21,000. The purchases returns and allowances and the purchase discounts are deducted from
the total purchases to yield the net purchases, and the transportation costs are added to the net
purchases to yield the total cost of merchandise purchased.

The merchandise inventory account as of January 1, shows a balance of Birr 90,500(i.e., the
ending inventory for one period becomes the beginning inventory for the next fiscal period),
and the physical count of the inventory as of December 31, 2008 reveals unsold inventory
amounting to Birr 102, 300. Therefore, the computation of the cost of goods sold section of
the income statement for Noble Trading based on the data given for 2008 fiscal period is
presented as follows:

Cost of Merchandise Sold (For 2008 Fiscal Period)

Merchandise Inventory, January 1, 2008 ……………………………………. Birr 90,500

Purchases during the period ……………………………….. Birr 471,800
Less: Purchase Returns and Allowances ………Birr 11,800
Purchase Discounts ……………………… 4,100 15,900
Net Purchases ……………………………………………….. Birr 455,900
Plus: Freight – In ……………………………………………. 21,000
Cost of merchandise purchased ……………………………… 476,900

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Merchandise Available for Sale ……………………………… 467, 400
Less: Merchandise Inventory, December 31, 2008 …………… 102, 300
Cost of Merchandise Sold …………………………………….. 365, 100

Check Your Progress: Exercise 4.8

1. In which type of system for accounting for merchandise held for sale is there no attempt
to record the cost of merchandise sold until the end of the period when a physical
inventory is taken?
___________________________________________________________________________
___________________________________________________________________________
__________________________________________________________________
2. Why is cost of goods sold sometimes characterized as a residual amount? In which
inventory system is this characterization appropriate?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
_____________________________________________________________
3. Explain the principal features of a periodic inventory system?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
_______________________________________________________________

4.5 Accounting for Deferrals and Accruals

In the previous unit (Unit 3), you have been learned the use of adjusting entries at the end of
the accounting period to match properly the revenues and expenses. Furthermore, prepaid
expenses (deferrals), such as supplies and rent, and accruals of expenses, such as wages, were
described and illustrated.

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In this unit you will learn in detail about the concepts of deferrals and accruals and the
corresponding adjusting entries.

4.5.1 Accounting for Deferrals

Dear students! In your opinion what are deferrals?

A deferral is a delay of the recognition of an expense already paid or of revenue already

received.

Deferred expenses expected to benefit a short period of time are listed on the balance sheet
among the current assets, where they are called Prepaid Expenses. Long-term prepayments
that can be charged to the operations of several years are presented on the balance sheet in a
section called Deferred Charges.

Deferred revenues may be listed on the balance sheet as a current liability, where they are
called Unearned Revenues or revenues received in advance. If a long period of time is
involved, they are presented on the balance sheet in a section called Deferred Credits.
4.5.1.1 Adjustments for Deferrals:
a) Adjusting Entries for Prepaid Expenses (Deferrals)

Prepaid expenses are the costs of goods and services that have been purchased but not used at
the end of the accounting period. The portion of the asset that has been used during the
period has become an expense; the remainder will not become an expense until some time in
the future. Prepaid expenses include such items as prepaid insurance, prepaid rent, prepaid
advertising, prepaid interest, and various hinds of supplies.

Insurance premiums or other services or supplies that are used may be debited to asset
accounts when purchased, even though all or a part of them are expected to be consumed

115
during the accounting period. The amount actually used is then determined at the end of the
period and the accounts adjusted accordingly.
Illustration of adjusting entries for deferrals:

Illustration 1

Assume that the office supplies account of Noble Trading Company has a balance of Birr
8,181 at December 31, 2008, the end of the year. This amount represents the cost of office
supplies on hand at the beginning of the year and the office supplies purchased during the
year. If the physical inventory at the end of the year indicated office supplies on hand totaling
Birr 2,550, the cost of the office supplies used during the year is Birr 5,635 (Birr 8,185-birr
2550). The adjusting entry to record the Birr 5,635 decrease of the asset and the
corresponding increase in expense is as follows.

Adjusting Entry
Dec. 31 Office supplies expense.......................... 5,635
Office supplies .......................................... 5,635

After the entry has been posted, the office supplies expense account will have a balance of
Birr 5,635 and that amount will be reported as an expense on the income statement. The
office supplies account will have balance of Birr 2,550 and that amount will be reported as an
asset on Noble Tracing's balance sheet.

Illustration 2
Assume that the prepaid insurance account for noble trading has a balance of Birr 16,750 at
December 31, 2008. This amount represents the unexpired insurance at the beginning of the
year plus the total of premiums on policies purchased during the year. Assume further that

116
Birr 10,435 of insurance premiums have expired during the year, leaving Birr 6,315 of
unexpired premiums (Birr 16,750-Birr 6,315). The adjusting entry to record the Birr 10,435
decrease of the asset and the corresponding increase in expense is as follows:
Adjusting Entry
Dec. 31 Insurance expense ......................... 10,435
Prepaid Insurance................................ 10,435

After this entry has been posted, the insurance account will have a balance of Birr 18,435 and
that amount will be reported as an expense on the income statement. The prepaid insurance
account balance will be Birr 6,315 and that amount will be reported as an asset on Noble
Trading’s balance sheet.

Check Your Progress: Exercise 4.9

Answer each of the following questions

1. From time to time during the fiscal year, an enterprise makes advance payment of
premiums on three-year and one-year property insurance policies:
a. At the close of such fiscal period will there be a deferral or an accrual? Give
reason in support of your decision.
b. Which of the following accounts will be affected by the related adjusting entry
at the end of the fiscal year; (1) asset, (2) liability, (3) revenue, (4) expense?
Why or why not?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

b) Adjusting Entries for Unearned Revenues (Deferrals)

Revenue received during a particular period may be only partly earned by the end of the
period. Items of revenue that are received in advance represent a liability that may be termed
unearned revenue. The portion of the liability that is charged during the period through

117
delivery of goods or services has been earned; the remainder will be earned in the future. For
example, magazine publishers usually receive in advance payment for subscriptions covering
periods ranging from a few months to a number of years. At the end of the accounting period,
that portion of the receipts which is related to future periods has not been earned and should,
therefore, appear in the balance sheet as a liability.

By accepting advance payment of a good or service, a business commits itself to furnish the
good or the service at some future time. At the end of the accounting period, if some portion
of the good or the service has been furnished, past of the revenue has been earned. The
earned portion appears in the income statement. The unearned portion represents a liability of
the business to furnish the good or the service in a future period and is reported in the balance
sheet as a liability

When revenue is received in advance, it may be credited to a liability account.

Illustration 1:
Assume that on October 1, 2008 Noble Trading Company rents a portion of a building that
has been leasing for a period of one year, receiving Birr 10,000 in payment for the entire
rental. Assume also that the transaction was originally recorded by a debit to cash and a
credit to the liability account Unearned Rent. On December 31, 2008, the end of the fiscal
period, one fourth of the amount has been earned and three fourths of the amount remains a
liability. The entry to record the revenue and reduce the liability appears as follows:
Adjusting entry
Dec. 31 Unearned Rent ........................ 2,500

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 Rent Income ........................... 2,500

After this entry has been posted, the unearned rent account will have a balance of Birr 1,600
(Birr 10,000 – Birr 2,500), which will be reported as a liability on Noble Trading balance
sheet. The rent income account will have a balance of Birr 2,500 and that amount will be
reported on the income statement.

Check Your Progress: Exercise 4.10

Samson Advertising received cash of Birr 24,000 as advertising income covering a period of
one year to release a single advertising per month. The Company's fiscal period ends on
December 31, 2007.
1. Assuming advance receipts are recorded as a liability, record the following:
(a) Receipt of cash on Dec. 1, 2007
(b) Adjustments to be made on Dec., 31, 2007
(c) Reversing entry on January 1, 2008

2. Assuming advance receipts are initially recorded as revenue, answer the above
questions.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
4.5.1.2 Adjustments for Accruals:
a) Adjusting Entries for Accrued Liabilities (Accrued
Expenses)
Some expenses accrue from day to day but are usually recorded only when they are paid.
Examples are salaries paid to employees and interest paid on notes payable. The amounts of
such accrued but unpaid items at the end of the fiscal period are both an expense and a

119
liability. It is for this reason that such accruals are called accrued liabilities or accrued
expenses.

Illustration 1:
Assume that on December 31, 2008, the end of the fiscal year, the sales salaries expense
account for Noble Trading Company has a debit balance of Birr 68, 250 and the office
salaries expense account has a debit balance of Birr 29,860. For this particular fiscal period,
the records of the business show that the accruals for sales salaries and office salaries are Birr
8,850 and Birr 4,450, respectively at the end of the year. The entry to record to additional
expense and liability is as follows:
Adjusting Entry
Dec.31 Sales salaries expense ......................... 8,850
Office salaries expense ......................... 4,450
Salaries payable ........................... 13,300

After the adjusting entry has been posted to the accounts, the sales salaries expense totals
Birr 77,100 (Birr 68,250 + Birr 8,850) and the office salaries expense totals Birr 34,310 (Birr
29,860 + Birr 4,450). These amounts will appear as expenses on the income statement. The
balance in salaries payable will be Birr 13,300 and that amount will be reported as a liability
on Noble Trading Company balance sheet.

Check Your Progress: Exercise 4.11

On December 31, the end of its fiscal year, an enterprise owes salaries of Birr 1,200 for an
incomplete payroll period. On the first payday in January, salaries of Birr 3,200 are paid.
(a) Is the Birr 1,200 a deferral or an accrual as of December 31?

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 (b) Which of the following types of accounts will be affected by the related
adjusting entry: (1) asset, (2) liability, (3) revenue, (4) expense?
(c) How much of the Birr 3,200 salary should be allocated to Janaury?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

b) Adjusting Entries for Accrued Assets (Accrued Revenues)

All assets belonging to the business at the end of an accounting period and all revenues
earned during the period should be recorded in the ledger. But during a fiscal period it is
common to record some types of revenue only as the cash is received; consequently, at the
end of the period there may be items of revenue that have not been recorded. In such cases,
the amount of the accrued revenue must be recorded by debiting an asset account and
crediting a revenue account. Because of the dual nature of such accruals, they are called
accrued assets or accrued revenues

Illustration 1:
To illustrate the adjusting entry for an accrued asset assume that on December 31,2008, the
end of the fiscal year Noble Trading Company has an interest-bearing note assume further
that the interest earned but not collected as of December 31, 2008 is Birr 4,980. The entry to
record this increase in the amount of interest due (receivable) on the note and the revenue
earned is a follows:
Adjusting entry
Dec. 31 Interest Receivable ................................. 4,990
Interest Income ............................ 4,990

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After the entry has been posted, the interest receivable account will have a balance of Birr
4,990 which would be reported as an asset in the balance sheet for Noble Trading Company
the interest income would be reported on the income statement.

Check Your Progress: Exercise 4.12

Classify the following items as:
(a) Prepaid Expenses
(b) Unearned Revenue
(c) Accrued Asset, or
(d) Accrued Liability
Print the letter identifying your response on the space provided:
________ 1. Interest earned but not collected
________ 2. Office supplies on hand
________ 3. Receipts from sale of meal tickets by a restaurant
________ 4. Interest owed but not yet due
________ 5. Insurance premium paid in advance
________ 6. Tuition fee collected in advance by a school
________ 7. Taxes owed but not yet due
________ 8. Salary owed but not payable
4.6 Work Sheet for Merchandising Enterprises

After year-end posting of the journals is completed, a work sheet is used to assist in
preparing the adjusting entries, closing entries, and financial statements.

Adjustments in the Work Sheet

The data needed for adjusting the accounts of Noble Trading Company are summarized as
follows:

122
 Interest accrued on notes receivable on
December 31, 2008............................................. Birr 4,990
Merchandise inventory as of December 31, 2008........ 102,300
Office supplies as of December 31, 2008 ................... 2,550
Insurance expired during 2008 ................................. 10,435
Depreciation during 2008 on:
Store equipment............................................... 5,650
Office equipment............................................... 8,998
Salaries accrued on December 31, 2008
Sales salaries...................................... Birr 8,850
Office salaries .................................... 4,450 13,300
Rent income earned during 2008 ............... 2,500

Although there is no specific order in which the accounts need to be analyzed, the adjustment
data assembled, and the adjusting entries made, time can be saved and greater accuracy
achieved by selecting the accounts in the order in which they appear on the trial balance

Completing the Work Sheet

As illustrated in the preceding chapter, the balances of the accounts in the Trial Balance
columns and the amounts of any adjustments are added or deducted as appropriate. The
adjusted balances are then extended into the adjusted trial balance columns, which are totaled
to prove the equality of debits and credits. Both the debit and credit amounts for income
summary are extended.

Income summary debit and credit amounts are directly extended to the income statement
columns of the work sheet. Since both the amount of the debit adjustment (beginning

123
inventory of Birr 90,500) and the amount of the credit adjustment (ending inventory of birr
102,300) may be reported on the income statement, there is no need to determine the
difference between the two amounts.

In the illustration, the difference between the credit and the debit columns of the income
statement section is Birr 50,818, the amount of net income. The difference between the debit
and the credit columns of the balance sheet section is also Birr 50,818, which is the increase
in the owner’s equity as a result of the net income.

The completed work sheet for Noble Trading Company is presented on page 124.

N.B. In this illustration, we assume that the Trial balance columns of the work sheet
consists of account balances which are directly taken from their respective ledger
accounts.

124
 Trial Balance Adjustments Adjusted trial balance Income statement Balance sheet
Noble Trading Company
Account title Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Cost 106500 Work sheet 106500 106500
Notes receivable 60000 60000 60000
Accounts receivable 102000 For year ended(a) December
4880 31, 2008 102000 102000
Interest receivable ©102300 4990 4990
Merchandise Inventory 90500 (b)90508 102300 102300
Onice supplies 8185 (d)5635 2550 2550
Prepaid insurance 16750 (e)10435 6315 6315
Store equipment 56500 56500 56500
Accumulated depreciation-store equipment 11300 (f)5650 16950 16950
Office equipment 44970 44970 44970
Accumulated depreciation office equipment 5996 (g)2998 3994 8994
Accounts payable 51448 51440 51440
Salaries payable (h)13300 13300 13300
Unearned rent 10000 (i)2500 7500 7500
Note payable (final payment 2010) 46750 46750 46750
Capital stock 801110 201110 201110
Retained earnings 116250 116250 116250
Dividends 26987 26987 26987
Income summary (b)90500 ©102300 90500 102300 90500 102300
Sales 695200 695200 695200
Sales returns and allowances 6942 6942 6942
Sales Discounts 6592 6592 6591
Purchases 471800 471800 471800
Purchases returns and allowances 11800 11800 11800
Purchases discounts 4100 4100 4100
Transportation In 21000 21000 21000
Sales salaries expense 68250 (h)8850 77100 77100
Advertising expense 12500 12500 12500
Deprecation expense-store equipment (f)5650 5650 5650
Miscellaneous sallies expenses 4860 4860 4860
Office supplies expense 29800 (b)4450 34250 34250
Rent expense 12450 12450 12450
Depreciation expense-office equipment (g)2998 2998 2998
Insurance expense (e)10435 10435 10435
Office suppose expense (d)5635 5635 5635
Miscellaneous administrative expense 4250 4250 4250
Rent income (i)2500 2500 2500
Interest Income 6130 (a)4990 11120 11120
Interest expenses 9240 9240 9240
1160076 1160076 235308 238308 1289314 1289314 776202 827020 513112 462294
50818 50818
827020 827020 513112 513112

126
Check Your Progress: Exercise 4.13

The following balances were taken from the records of Naod Company.
Balances Before Adjustment Balance After Adjustment
Interest Receivable....... Birr -0- Birr 12,400
Supplies expense ......... 4,500 1,500
Advertising Payable .... -0- 23,100
Rent Income................. 48,000 12,000
Required: Record the adjusting entries that should be recorded by the Company

4.7Financial Statements for Merchandising Businesses

Dear students you have already acquainted with those basic financial statements in the
previous unit.

Before you go to the subsequent discussions, what do you think about the similarity
and differences between the financial statements for service rendering enterprises
and merchandising enterprises? Give your own view in writing

Basically, in this unit, we are dealing with the same financial statements with the
exception of the income statement “cost of Merchandize sold” section. Since we are
dealing with a kind of enterprise whose major operation originated from buying and
selling of goods, “Cost of Merchandise Sold” section helps to determine the cost of goods
which are already sold (cost of sales).

127
Income Statement

It is known that income statement is prepared to summarize and report the operating
results of a business over a period of time.

As a starting point, would you list some income statement elements before you
proceed to the following discussions? Please attempt it.

Two Forms of Income Statement are in Common Usage

The two forms of income statement format used by merchandising enterprises are:
i) Single –step income statement
ii) Multiple – step income statement

a) Single -Step Income Statement

Single-step form is so named because only one step, subtracting total expenses from total
revenues, is required in determining net income (or net loss). To see in concrete terms let
us try to see the following illustration for Noble Trading Company.

128
 Noble Trading Company
Income Statement
For Year Ended December 31, 2008

Revenues:
Net sales Birr 681,666
Interest Income 11,120
Rent Income 2,500
Total revenues Birr 695,286
Expenses:
Cost of Merchandise sold Birr 465,100
Selling expenses 100,110
Administrative expenses 70,018
Interest expense 9,240
Total expenses 644,468
Net Income Birr 50,818

b) Multiple – Step Income Statement

This form is so named because it shows the numerous steps in determining net income
(net loss). It provides users with more information about an enterprise’s operating results.
The statement emphasizes intermediate components of income and shows sub- groupings
of expenses. The following are typical income statement elements.

Revenue from Sales: - principal source of revenue for a merchandising enterprise from
sale of merchandise, both for cash and on account. To determine net sales, sales returns
and allowances, and sales discounts are deducted from gross amount.
Cost of merchandise sold: - Cost of goods sold or cost of sales during the period.

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Gross Profit: The excess of the net revenue from sales over the cost of merchandise sold.
Similarly, it may be called as gross profit on sales or gross margin.

Operating Expenses: Expenses incurred in the process of earning (generating) sales

revenues that are deducted from gross profit in the income statement. For a retail
business, usually subdivided in the two groupings: i) selling expenses ii) Administrative
or general expense

Selling Expenses. Expenses that are incurred directly and entirely in connection with the
sale of merchandise, such as salaries of sales force, store supplies used, depreciation of
store equipment, and advertising, etc.

Administrative Expenses: Expenses relating to general operating activities such as

personnel management, accounting, and office supplies used depreciation of office
equipment, etc.

Other Income. Revenue from sources other than the principal activity of a business is
classified as other income, or non operating income.
Net Income. The final residual figure on the income statement is labeled net income or
net loss).

For better understanding let us go through the completed income statement for Noble
trading company.

130
 Multiple-Step Income Statement:
Noble Trading Company
Income statement
For year ended December 31, 2008
Revenue from sales
Sales Birr 695200
Less: Sales returns and allowances Birr 6942
Sales discounts 6592 13534
Net sales Br. 681666
Cost of merchandise sold:
Merchandise inventory
January 1, 2008 Birr 90500
Purchases Birr 471800
Less: purchases returns
And allowances Birr 11800
Purchases discounts 4100 (15900)
Net purchases Birr 455900
Add: transportation in 21000
Cost of merchandise purchased 476900
Merchandise available for sale Br 567400
Less: merchandise inventory
December 31, 2008 (1023000)
Cost merchandise sold (465100)
Gross profit Birr 216566
Operating expenses:
Selling Expenses
Sales salaries expense Birr 77100
Advertising expense 12500
Depreciation expense
Store equipment 5050
Miscellaneous selling expense 4860
Total selling expenses Birr 100110
Administrative Expenses:
Office salaries expense Birr 34250
Rent expense 12450
Depreciation expense
Office equipment 2998
Insurance expense 10435
Office supplies expense 5635
Miscellaneous administrative Expense 4250
Total administrative expenses 70018
Total operating expenses 170128
Income form operations Birr 46438
Other incomes
Interest income Birr 11120
Rent income 2500
Total other income Birr 13620
Other expenses:
Interest expense (9240) 4380
Net income Birr 50,818

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Statement of Retained Earnings

The retained earnings statement summarizes the changes which have occurred in the
retained earnings account during the fiscal period. It serves as a connecting link between
the income statement and the balance sheet. The retained earnings statement for Noble
trading company is illustrated as follows:

Noble Trading Company

Statement of Retained Earnings
For Year Ended December 31, 2008

Retained earnings, January 1, 2008.............................. Birr 116250

Net income for the year............... Birr 50,818
Less: dividends.......................... 26,987
Increase in retained earnings...... 23,831
Retained earnings, December 31, 2008......................... Birr 140081

Balance Sheet (Statement of Financial Position)

As it has been discussed earlier, balance sheet will take two forms one arrangement is an
account form-placing assets on the left-hand side of the balance sheet and the liabilities
with owner’s equity on the right hand side of the balance sheet.

The other arrangement is report form – it is a vertical listing of assets, liabilities and
owner’s equity practically, this format is widely used.

N.B. The total of the assets section equaling the combined totals of the other two
sections.

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 Noble Trading Company
Balance sheet
December 31, 2008

Assets
Current Assets
Cash Birr 106500
Notes payable 60000
Accounts payable 102000
Interest Receivable 4990
Merchandise Inventory 102300
Office supplies 2550
Prepaid insurance 6315
Total current assets Birr 384655
Plant assets:
Store equipment Birr 56500
Less: Accumulated depreciation 16950 Birr 39550
Office equipment 44970
Less: Accumulated depreciation 8994 35970
Total plant assets 75526
Total Assets Birr 460186

Liabilities
Current liabilities
Accounts payable Birr 51440
Note payable (Current portion) 6750
Salaries payable 13300
Unearned rent 7500
Total current liabilities Birr 78990
Long-term liabilities
Note payable (final payment 2010) 40,000
Total liabilities Birr 118,990
Stockholders Equity
Capital stock Birr 201110
Retained earnings 140001
Total Stockholders' Equity 341191
Total Liability and Stockholders' Equity Birr 436350

133
4.8Adjusting and Closing Entries
4.8.1 Adjusting Entries

In unit 3, you have recorded adjusting entries for a service type enterprise. The same
reason and purpose is also explained here

What was the prime importance of recording adjusting entries?

Generally, the whole analysis required to make the adjustments were completed during
the process of preparing the work sheet. After completion of the posting of these entries,
the balances of all assets, liability, revenue and expenses accounts correspond exactly to
the amounts reported in the financial statements. The adjusting entries for Noble Trading
Company are as follows.
General Journal Page __
Post
Date Description Ref Debit Credit
Adjusting Entries
2008 31 Interest receivable 4990 00
Dec.
Interest income 4990 00
31 Income summary 90500 00
Merchandise inventory 90500 00
31 Merchandise inventory 102300 00
Income summary 102300 00
Office supplies 5635 00
Office supplies 5625 00
31 Insurance expense 10435 00
Prepaid insurance 10435 00
31 Depreciation expense store equip 5650 00
Accumulated Depr. store 5650 00
equipment
31 Depreciation expense office equipment 2998 00
Accumulated Depr office 2998 00
equipment
31 Sales salaries expense 8850 00
Office salaries expense 4450 00
Salaries payable 13300 00
31 Unearned rent 2500 00
Rent income 2500 00

134
 4.8.2 Closing Entries

Why do we need to conduct closing entries?

Normally closing entries are recorded in the journal immediately following the adjusting
entries. The purpose is to clear the balances of all temporary owners' equity accounts,
reducing them to zero. The ultimate effect of these entries is net increase or a net
decrease in the retained earnings account. The closing eateries for Noble trading
company are as follows:

General Journal Page __

Post
Date Description Ref Debit Credit
Closing entries
2008 31 Sales 95200 00
Dec
Purchases returns and allowances 11800 00
Purchases discounts 4100 00
Interest Income 11120 00
Rent Income 2500 00
Income summary 724720 00
31 Income summary 685702 00
Sales returns and allowances 6942 00
Sales discounts 6592 00
Purchases 471800 00
Transportation In 21000 00
Sales salaries expense 77100 00
Advertising expense 12500 00
Depreciation exp-store equip 5650 00
Miscellaneous selling expense 4860 00
Office salaries expense 34250 00
Rent expense 12450 00
Depreciation exp-office equip 2998 00
Insurance expense 10435 00
Office supplies expense 5635 00
Miscellaneous administrative Expense 4250 00
Interest expense 9240 00
31 Income summary 50818 00
Retained earnings 50818 00
31 Retained earnings 26987 00
Dividends 26987 00

135
The effect of the aforementioned four entries may be described as follows:
i) The first entry closes all income statement accounts with credit balances by
transferring the total to the credit side of income summary
ii) The second entry closes all income statement accounts with debit balances by
transferring the total to the debit side of income summary.
iii) The third entry closes income summary by transferring its balance, the net
income for the year, to retained earnings.
iv) The fourth entry closes dividends by transferring its balance to retained
earnings.

At last, all temporary owners' equity accounts will be closed. The only accounts left are
the contra asset, liability, capital stock and retained earnings accounts. To verify the
equality of debit and credit in the balances of these accounts and to make them ready for
the subsequent accounting period, it is advisable to prepare a post-closing trial balance.

4.9 Reversing Entries

What kind of procedures should you follow in reversing entry? Please forward your
own opinion?

Customarily, following the adjusting and closing entry, reversing entry can be made. A
reversing entry is made at the beginning of the next accounting period and is the exact
opposite of the adjusting entry made in the previous period. The preparation of reversing
entries is an optional accounting procedure that may not be required necessarily.

4.9.1 Reversing entries for Accrued Liabilities

Naturally, some expenses accrue as time passes (from day to day) but are recorded only
when they are paid. For example, the wage or salary expense of an enterprise and the
related liability accumulates day by day during the fiscal period.

136
Dear students, if you were in a position of an accounting clerk, are you going to record
the expense and the related liability which are accruing on a daily basis? Why or why
not?

From practical point of view, it would not be advisable to carry out (handle) in such a
manner because it is not efficient (cost-effective).

Now let us exemplify, assume the following facts for an enterprise that pays salaries
weekly and ends its fiscal period on December 31.

i. Salaries are paid on Friday for five-day workweek ending on Friday.

ii. The balance in salary expense as of Friday, December 27 is Birr 105,600
iii. Salaries accrued for Monday and Tuesday, December 30 and 31 total Birr
800.
iv. Salaries paid on Friday, January 3, of the following year total Birr 2000

The adjusting entry to record the accrued salary expense and salaries payable for Monday
and Tuesday, December 30 and 31, is as follows.

Dec 31 Salary expense 800

Salaries payable 800

After completion of the posting of the foregoing entry, salary expense is in balance and
salary payable will have a credit balance of Birr 800 on the pay day Friday January 3 of
the following period. The journal entry will be a debit of Birr 2000 salary expense and a
credit of Birr 2000 cash.

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N.B. Mind you the amount of Birr 800 was recorded on December 31 for two days
salary (December 30 and 31). So, we must divide the weekly payment of Birr
2000 in a debit of birr 800 to salaries payable and a credit of birr 800 to salary
expense.

Dear students, to overcome such a complication recording of reversing entry on January

first (at beginning of new period) are recommended.

Continuing with the illustration, the reversing entry for the accrued salaries is as follows:

Jan 1 Salary Payable 800

Salary Expense 800

The effect of the reversing entry is to transfer the Birr 800 liability from salaries payable
to the credit side of salary expense. When a payroll is paid on January 3, salary expense
will be debited and cash will be credited for Birr 2000 the entire amount of weekly
salaries. After the entry is posted salary expense will have a debit balance birr 1200,
which is the amount of expense incurred for January 1-3.

4.9.2 Recording and Posting Reversing Entries

Now let us resort to our situation which is a case of Noble Trading Company. The year-
end procedure for Noble Trading Company is completed by journalizing and posting the
reversing entries for accrued salaries and accrued interest income. It will be illustrated as
follows:

138
 General Journal Page No.:
Post
Date Descriptions Ref Debit Credit
Reversing entries
2008 1 Salaries payable 13300 00
Jan.
Sales salaries expense 8850 00
Office salaries expense 4450 00
1 Interest Income 4990 00
Interest receivable 4990 00

4.10 Interim Statements

Statements issued for periods covering less than a fiscal year are called interim
statements

Both service and merchandising enterprises frequently prepare financial statements at

intervals within the fiscal year, i.e. as monthly quarterly, or semiannually.

When interim financial statements are to be prepared, the adjustment data are assembled
and a work sheet is completed as of the end of the interim period. Nevertheless, adjusting
and closing entries are not recorded in the accounts. These entries are recorded only at the
end of the fiscal period.

How revenues and expenses of interim period can be determined? Please forward your
own opinion.

139
4.11 Correction of Errors

Accounting records may not be hundred percent correct all the time unfortunately, errors
may occur in the recording process. Errors should be corrected as soon as they are
discovered by journalizing and posting correcting entries.

Procedures for correction of errors in the journal and ledger vary according to the nature
of the error. When an error in an account title or amount in the journal is discovered be
fore the entry is posted, the correction may be made by drawing a line through the error
and inserting the correct title or amount immediately above.

When an entry in the journal is prepared correctly, but the debit portion is incorrectly
posted to the account as a credit (or vice versa), the incorrect posting may be corrected by
drawing a line through the error and posting the item correctly.

Dear students, one thing that you should bear in mind is correcting entries is an
“avoidable step”.

To illustrate, assume on June 10, Birr 500 cash collection on account from a customer is
journalized and posted as a debit to cash “Birr 500 and a credit to rent income birr 500.
The error is discovered on May 20, when the customer pays the remaining balance in full.

Incorrect Entry (May 10) Correct Entry (May 10)

Cash 500 Cash 500

Rent income 500 Accounts receivable 500

A comparison of the incorrect entry with the correct entry reveals that the debit to cash
Birr 500 is correct. However, the Birr 500 credit to Rent Income and Accounts
Receivable are overstated in the ledger. The following correcting entry is required.

140
 Correcting Entry

May 20 Rent Income 500

Accounts Receivable 500
(to correct entry of may 10)

Procedures for correcting errors

Error Correction procedure
Journal entry incorrect, but not Draw line through the error and
Posted insert correct title or amount
Journal entry correct, but posted Draw line through the error and
incorrectly. post correctly.
Journal entry incorrect and posted Journalize and post a correcting
entry

4.12 Model Examination Questions

1. What are the major operations of merchandising business?

2. How are sales of merchandise recorded?
3. Discuss how each of the following are treated as related to the sale of merchandise.
(a) Sales returns and allowances
(b) Sales discounts
(c) Taxes related to the sales
(d) Freight costs
4. State the adjustment for beginning merchandise inventory
5. State the adjustment for ending merchandise inventory

141
List of Reference Materials
1. Introduction to Accounting, 21st Century
2. Dyckman, Dukes and Davis. (1995). Intermediate Accounting. Third Edition.
Volume I, Chapters 1 – 14. McGraw Hill Companies, Inc.,
3. Fees and Warren, Accounting Principles. 16th edition. South – Western
Publishing Company.
4. Fees and Warren, Accounting Principles. 18th edition. South – Western
Publishing Company.

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 UNIT FIVE: ACCOUNTING SYSTEMS DESIGN

List of Contents
 Unit Objective
 Introduction
5.1 Accounting Systems
5.2 Principles of Accounting Systems
5.3 Accounting System Installation and Revision
5.4 Internal Control Structure
5.5 Model Examination Questions
 List of Reference Materials

Unit Objectives

This unit is devoted to acquaint the students with the design of proper accounting system.
Thus, after carefully reading this unit the students will be able to:
 Explain the principles of properly designed accounting systems
 Apply the three phases of accounting system installation and revision
 Describe the principles of internal control
 Analyze the data processing methods that may be used in accounting systems.
 Understand the difference between administrative controls and accounting
controls.

143
Introduction

In the previous unit you have discussed periodic reporting for a merchandising business:
The preparation of single step and multiple step Income Statements, Retained Earnings
Statement, and Balance Sheet for a merchandising business have been discussed in detail.
Furthermore, you have learned the concepts, purposes and practical uses of adjusting,
closing, reversing, and correcting entries. Also, you have learned with illustrations about
the preparation of interim financial statements and their purposes.

One of the areas of specialization is the design and installation of accounting systems. An
accounting system should assure the availability of data required by management in
conducting the affairs of an enterprise and in reporting to owners, creditors, and other
interested parties.

In this unit you will be acquainted with the basic concept of accounting systems design,
the need for properly designed accounting systems, the phases of accounting system
installation and revision, the broad principles of internal control, etc.

In your opinion, what does it mean by the accounting system? Why firms design
and install accounting system? Attempt these questions in your own before you go
through the discussions below.

5.1. Accounting Systems

In unit 1, you have learned why accounting is viewed as the language of business or an
information system. It is an information system in the sense that, first data (business

144
transactions) are entered into the system, then analyzed, recorded, sorted, summarized,
and finally reported and communicated to users (decision makers) inside and outside the
business enterprise. Unless this information is communicated to the end users on time,
the whole process is considered as useless or futile.

The way in which management is given the information for use in conducting the affairs
of the business and in reporting to owner, creditors, and other interested parties is called
the accounting system.

In a general sense, an accounting system includes the entire network of communications

used by a business organization to provide needed information. Now a day many
organizations (especially large organizations) in Ethiopia are trying to design their own
accounting system by allocating huge budget.

Check Your Progress: Exercise 5.1

1. Why is the accounting system of an enterprise an information system?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

2. What is accounting system? What does it consists of? Explain in detail

________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

Do you believe that the accounting system designed and used by one firm is suitable
(or adaptable) to another firm (s)? If “Yes” why? If “No” why not? Try to justify
your reasoning before you go through the discussion presented below:

145
5.2 Principles of Accounting Systems

Since every organization designs its accounting system by carefully considering its own
operation and nature and type of activities, it is difficult that the accounting system
designed by one firm could be adaptable to another firm (s)

Because of differences in business operations, in the number of transactions to be

processed, and in the uses made of accounting data, accounting systems will vary from
business to business. However, there are a number of broad principles that apply to all
systems. Detailed discussions of these principles are presented hereunder:

a) Cost- Effectiveness Balance

An accounting system must be tailored to meet the specific needs of each business. Since
costs must be incurred in meeting these needs, one of the major considerations in
developing an accounting system is cost-effectiveness. For example, although the reports
produced by an accounting system are a valuable end product of the system; the value of
the reports produced should be at least equal to the cost of producing them. No matter
how detailed or informational a report may be, it should not be produced if it costs more
than the benefits received by those who use it.

b) Flexibility of Meet Future Needs

Now a day business organizations are operating in a turbulent changing environment.
Therefore, it is mandatory that each business must a dept to the constantly changing
environment in which it operates.

Whether the changes are the result of new government regulations, changes in accounting
principles, organizations changes necessary to meet practices of competing businesses,
changes in data processing technology, or other factors, the accounting system must be
flexible enough to meet the changing demands made of it. For example, regulatory

146
agencies such as the Ethiopian Auditors General, often requires a constantly changing
variety of reports that require changes in the accounting system.
c) Adequate Internal Controls

What do you understand by internal control?

Internal controls are detailed policies and procedures used to direct operations and
provide reasonable assurance that the firm’s objectives are achieved. Thus, in addition to
supplying the information needed by management in reporting to owners, creditors, and
other interested parties, the system should help management in directing operations.

d) Effective Reporting
Accounting information users are many and varied with different background,
knowledge, etc. These users rely on the accounting information provided by the
accounting system to make wise economic decisions. Therefore, when these reports are
prepared, the requirements and knowledge of the users should be taken into account. For
example, management may need detailed reports for directing operations on a weekly or
even daily basis and lending institutions like banks may need periodic reports to evaluate
the profitability of the business before they grant credit. Also, the taxing authorities (the
Inland Revenue Authority) may require uniform data and establish certain deadlines for
the submission of tax reports.

e) Adaptation to Organizational Structure

In order for the accounting system achieve its objective of providing information needs at
the lowest cost, we need to effectively adapt the system with the human resources of the
business. Since no two businesses are structured alike, the accounting system must be
tailored to the organizational structure of each business. The lines of authority and

147
responsibility will affect the information requirements of each business. Moreover, an
effective system needs the approval and support of all levels of management.
Check Your Progress: Exercise 5.2
1. In your discussion of the broad principles of accounting systems, what do you
understand by the principle of ‘cost – effectiveness balance’? Give your own
answer in writing in your own words.
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
2. What are internal controls?
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________

5.3 Accounting System Installation and Revision

In your opinion, who is going to assume the responsibilities of designing the firm’s
accounting system? What factors must be considered when designing the system?
Give your answer in writing before you read the text below and compare your
answer.

The responsibilities for designing and installing the firm’s accounting system should be
borne by people who have a complete knowledge of the business’ operations. However,
the designer should recognize that some areas of the system, such as the types and design
of the forms needed and the number and titles of the accounts required, may be affected

148
by factors that are not known when a business is first organized. As new information
about a business is obtained and as a business “outgrows” its accounting system when it
expands to new operational areas, the system will need to be revised.

Many large businesses continually review their accounting system and may constantly be
involved in changing some part of it.

The work of installing or changing an accounting system, either in its entirety or only in
part, is made up of three phases: (1) analysis, (2) design, and (3) implementation.

5.3.1 Systems Analysis

What do you think is the purpose of systems analysis? From where does the analyst
begin his activities?

The goal of systems analysis is to determine information needs, the sources of such
information, and the deficiencies in procedures and the data processing methods presently
used.

The analysis usually begins with a review of the organizational structure and the job
descriptions of the personnel affected. This review is followed by a study of the forms,
records, procedures, processing methods, and reports used by the enterprise. The source
of such information is usually the firm’s systems Manual.

149
Dear students, what else the analyst should consider while making his/her analysis of
the system?
In addition to looking at the limitations of the existing system, the analyst should
determine management’s plans for changes in operations.

5.3.2 Systems Design

After detailed analyses have been made; there comes the job of designing the accounting
system. The design of the new system may involve only minor changes for the existing
system, such as revision of a particular form and the related procedures and processing
methods, or it may be a complete revision of the entire system.

Systems designers must have a general knowledge of the qualities of different kinds of
data processing equipment, and the ability to evaluate alternatives. Successful system
design depends to a larger extent upon the creativity, imagination, and general
capabilities of the designer.

5.3.3 Systems Implementation

What is system implementation mean? What do you think are the major tasks that are
going to be undertaken in this phase? Dear students please takeout a piece of paper
and give your answer before you read the discussions below.

The final phase of the creation or revision of an accounting system is to carry out, or
implement, the proposals. In this phase new or revised forms, records, procedures, and
equipment must be installed, and any that are no longer useful must be discarded or
withdrawn. Training should be given for all personnel responsible for operating the
system and close supervision of these personnel should be made till satisfactory
efficiency is achieved.

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Check Your Progress: Exercise 5.3
1. What is the objective systems analysis?
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________

2. What skills and knowledge should be required from the systems designer?
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________

5.4 Internal Control Structure

An enterprise’s internal control structure consists of the policies and procedures

established to provide reasonable assurance that the enterprise’s goals and objectives will
be achieved. This internal control structure can be divided into three elements: (1) the
control environment, (2) the control procedures, and (3) the accounting system.

It should be noted that the policies and procedures of an internal control structure will
vary according to the size and type of business enterprise. In a small business where it is
possible for the owner-manager to supervise the employees personally and direct the
affairs of the business, few control policies and procedures are necessary. However, as
the number of employees and the complexities of an enterprise increase, it becomes more
difficult for management to maintain control over all phases of operations. As firm
grows, management needs to delegate authority and to place more reliance on the control
structure in order to achieve adherence to enterprise goals and objectives.

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 5.4.1 The Control Environment

What does it mean by a control environment? What are some of the factors
influencing the control environment of an enterprise?

The control environment of an enterprise represents an overall attitude toward and

awareness of the importance of controls by both management and other employees.

Factors influencing the control environment of an enterprise include management’s

philosophy and operating style, the organizational structure of the enterprise, and
personnel policies and practices.

Management’s philosophy and operating style includes management’s attitude

concerning control. For example, if top management routinely violates established
control policies and procedures, the control environment could be adversely affected
because lower management and employees may view controls as unimportant on the
other hand, a top management that emphasizes the importance of controls in dealing with
operating personnel and encourages adherence to control policies and procedures will
create a favorable control environment.

The organizational structure of an enterprise establishes the framework for planning and
controlling operations. For example, a merchandising enterprise might organize each of
its stores as relatively separate business units, with each store manager given full
authority over pricing and other operating activities.

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Finally, personnel policies and procedures include the training, evaluation, promotion,
and compensation of employees to accomplish an enterprise’s goals and objectives.
Common personnel policies that impact on the control environment include the
establishment of codes of ethics for employee conduct and conflict of interest policies.

5.4.2 The Control Procedures

Control procedures are those policies and enterprise, and management has established
within the control environment in order to provide reasonable assurance that enterprise
goals will be achieved.

The detailed procedures adopted by an enterprise to control its operations are collectively
termed its systems of internal control. The plan of organization and the accompanying
methods and procedures of such a system should be designed to:

 Safeguard assets,
 Yield accurate accounting data,
 Promote efficiency throughout the enterprise, and
 Assure adherence to management’s policies.

Internal controls are classified as: (1) internal administrative controls and, (2) internal
accounting controls. Internal administrative controls are procedures and records that aid
management in achieving business goals. On the other hand, internal accounting controls
consist of procedures and records that are mainly concerned with the reliability of
financial records and reports and with the safeguarding of assets.

Activities such as motion and time study, quality control, and statistical analysis are, in a
broad sense, elements of internal control. The cash register, sales invoices, credit
memorandums, receiving reports, vouchers, and other documentary evidences of
transactions are instruments forming an integral part of internal controls.

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Though the size and ownership of business determines the system of internal controls
employed, all businesses, large and small should consider the following broad principles
of internal controls.
(a) Competent Personnel and Rotation of Duties
The successful operation of an accounting system requires people who are sufficiently
competent to perform the duties to which they are assigned. All accounting employees
should be adequately trained and supervised in the performance of their respective tasks.
It is also advisable to rotate clerical personnel periodically from job to job. In addition to
broadening their understanding of the system, the knowledge that others may, in the
future, perform their tasks tends to discourage deviations from prescribed procedures.
Occasional rotation is also helpful in disclosing any irregularities that may be required to
take annual vacations, with their tasks assigned to others during their absence.

Check Your Progress: Exercise 5.4

Answer the following questions in writing and check your answer with the answers
attached at the back of the module.

1. How does a policy of rotating clerical employees from job to job aid in
strengthening internal control?
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
2. List the three elements of internal control structure
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________

(b) Assignment of Responsibility

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It is essential that their responsibilities be clearly defined so that employees can work
efficiently. There should be no overlapping or undefined areas of responsibility. For
example, if a particular cash register is to be used by two or more sales clerks, each one
should be assigned a separate cash drawer and register key. Thus, daily proof of the
handling of cash can be obtained for each clerk. Similarly, if several employees are
assigned to posting entries to customers’ accounts, each employee should be assigned to a
particular alphabetical sector so that errors can be traced to the person responsible for the
error.

(c) Separation of Responsibility for Related Operations

To minimize the possibility of inefficiency, errors, and fraud, responsibility for a
sequence of related operations should be divided among two or more persons. For
example, no single individual should be authorized to order merchandise, verify the
receipt of the goods, and pay the supplier. To do so would invite such abuses as placing
orders with a supplier on the basis of friendship rather than on price, quality, and other
objective factors; indifferent and routine verification of the quality and quantity of goods
received, conversion of goods to the personal use of the employee; carelessness in
verifying the validity and the accuracy of invoices; and payment of fictitious invoices.

When the responsibility for purchasing, receiving, and paying are divided among three
persons or departments, the possibilities of such abuses are minimized. The documentary
evidence of the work of each person or department, including purchase orders, receiving
reports, and invoices should be routed to the accounting department for comparison and
recording.

The “checks and balances” provided by the distributing responsibility among various
departments requires no duplication of effort. The work of each department, as evidenced
by the business documents that it prepares, must “fit” with those prepared by the other
departments.

(d) Separation of Operations and Accounting

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Responsibility for maintaining the accounting records should be separated from the
responsibility for engaging in business transactions and for the custody of the firm’s
assets. By doing so, the accounting records serve as an independent check on the business
operations. For example, the employees entrusted with remittances from credit customers
should not have access to the journals and ledgers. Separation of the two functions
reduces the possibilities of errors and defalcations.

(e) Proofs and Security Measures

Proofs and security measures should be employed to safeguard business assets and assure
reliable accounting data. This principle applies to a wide variety of techniques and
procedures, such as the use of controlling accounts and subsidiary ledgers; the use of a
bank account and other safekeeping measures for cash, investments, and other valuable
documents; and the use of various types of mechanical equipment.

Cash registers are widely used in making the initial record of cash sales. The practice of
facilitating for customers to observe the amount recorded as the sale or to accept a printed
receipt from the sales clerk increases the effectiveness of the machine as part of internal
control. Another similar device is the automatic counters in gas or oil stations.

(f) Independent Review

To determine whether the other internal control principles are being effectively applied,
the system should be periodically reviewed and evaluated by internal auditors who are
independent of the employees responsible for operations. The auditors should report any
weaknesses and recommend changes to correct them. For example, a review of cash
disbursements may disclose that invoices were not paid within the discount period, even
though sufficient cash was available.

5.4.3 The Accounting System

The accounting system is an integral part of the internal control structure of an enterprise.
Without the information generated by the accounting system, management would lack the
ability to plan and direct operations in achieving enterprise goals.

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Check Your Progress: Exercise 5.5
For the following questions give your answer in writing on a separate sheet of paper and
check your answers.
1. How does a periodic review by internal auditors strengthen the system of internal
control?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

2. Why should the responsibility for maintaining the accounting records be separated
from the responsibility for operations?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
3. The bookkeeper pays all obligations by prenumbered checks. What do you think
are the strengths and the weaknesses in the internal control?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

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5.5 Model Examination Questions

Instruction: Answer each of the following questions in writing.

1. What are the major components of accounting system?
2. Briefly describe the principles of properly designed accounting systems.
3. Describe and explain the three phases of accounting system installation and
revision.
4. Why should the essential features of internal control be incorporated in the design
of all accounting systems?
5. Why should the responsibility for a sequence of related operations be divided
among different persons?

List of Reference Materials

1. Fees and Warren, Accounting Principles. 16th edition. South – Western
Publishing Company.
2. Fees and Warren, Accounting Principles. 18th edition. South – Western Publishing
Company.

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 UNIT SIX: CASH AND CASH EQUIVALENTS

List of Contents

 Unit Objective
 Introduction
6.1 Internal Controls for Cash
6.2 Illustration of Bank Reconciliation and Journal Entries
6.3 Model Examination Questions
 List of Reference Materials

Unit Objective

After completing this unit, you will be able to:

 Define cash
 Understand the need for controlling cash
 Understand the need for maintaining petty cash
 Reconcile the bank statement with the book balance
 Summarize the procedures to be followed in the internal control of cash
receipts
 Summarize the procedures to be followed in the internal control of cash
payments

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Introduction

Dear students, welcome to the sixth unit of the course!

In the previous unit (unit five), you have covered the need for accounting systems
design for effective operations and reporting. Furthermore, you have discussed the
principles and need for effective internal controls. This unit deals with the
application of these internal control principles to the design of an effective system
for controlling cash and the accounting for cash transactions. Such concepts like
control of cash receipts and payments, the need for keeping imprest cash funds, the
bank account and reconciliation of bank statement and cash book balance, the need
for keeping cash change fund, etc will be discussed in detail.

What is cash? What are some of the items that are regarded as cash? What do you
think are some of the features of cash? Please give your own answers for the
above questions before you read the discussion below.

Cash is a medium of exchange that a bank will accept for deposit and immediate
credit to the depositors account. The cash account includes only those items
immediately available to pay obligations (liabilities). Specifically, the items that
are regarded as cash includes:

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 Balances on deposit with financial institutions,
 Coins and currency,
 Petty cash, and certain negotiable instruments accepted by financial
institutions for immediate deposit and withdrawal. These negotiable
documents include ordinary checks, cashiers checks, certified checks, and
money orders. Thus the balance of the cash control account reflects all items
included in cash.

What are Cash Equivalents?

Cash equivalents are items similar to cash but not classified as such. They include
treasury bills, commercial papers, and money market funds. Cash equivalents are
very near cash but are not in negotiable form, and hence they are not included in
the cash account. Other items that are excluded from cash are: Postage stamps,
travel advances to employees (prepaid expenses), receivables from company
employees and cash advances to either employees or outside parties (receivables).

Is an overdraft considered as cash? If not where shall you report it? How does
an over draft created?

An overdraft is not considered as cash rather it is a negative bank account balance

and is reported as a current liability.

Overdrafts occur when the amount of checks honored by the bank exceeds the
account balance. For example, if you ordered your bank to make payment of Br.

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10,000 to a creditor from your bank checking account whereas your account
shows only Br. 7000. Even though your account balance is insufficient to make
the payment you ordered, the bank may make the full payment on behalf of you to
the designated person. However, after the payment your checking account balance
shows negative Birr. 2000 (i.e. Br. 8000 - Br. 10,000).

The Br. 2000 is thus a bank overdraft created as a result of excess payment beyond
the balance in the bank account.

What is a compensating balance? Are compensating balances included in the

cash account? Why or why not?

A compensating balance is a minimum balance that must be maintained in a

depositors account as support for funds borrowed by the depositor. Compensating
balances are not included in the cash account because they are not currently
available for use. It is a restricted cash balance; that is, cash held for a specific
purpose and not intended for general payment use. For example, a firm may
borrows Br.15, 000 for one year at 10% but must maintain a Br. 1000
compensating balance in an account with the bank.

Dear students are you clear with the concept of restricted cash balance? What
other examples of restricted cash balance do you know? Please list as many
items as possible.
__________________________________________________________________
__________________________________________________________________

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__________________________________________________________________

6.1. Internal Controls for Cash

Dear students, in your opinion what are some of the reasons for maintaining
control over cash? And, what are some of the mechanisms used in safeguarding
cash?

The need to safeguard cash is crucial in most businesses. Cash is easy to conceal
and transport, carries no mark of ownership, and universally valued. The risk of
theft is directly related to the ability of individuals to access the accounting system
and obtain custody of cash.

Firms address the problem with cash through the internal control system. An
internal control system is a set of policies and procedures designed to:
 Protect assets
 Ensure compliance with laws and company policy
 Provide adequate accounting records
 Evaluate performance
A sound internal control system for cash increases the likelihood that the reported
values for cash and cash equivalents are accurate and may be relied up on by
financial statement users.

Internal controls for cash should

 Separate custody of and accounting for cash
 Account for all cash transactions
 Maintain only the minimum cash balance needed

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  Provide for periodic test counts of cash balances
 Permit reconciliation of ledger and bank cash account balances.
 Achieve an adequate return on idle cash balances
 Result in the physical control of cash

6.1.1 Control of Cash Receipts

How can companies control their cash receipts?

Cash inflows have many sources, and cash control procedures vary across companies the
following procedures apply in most situations.

1. Separate the responsibilities for handling cash, for recording cash transactions,
and for reconciling cash balances. This separation reduces the possibility of theft
and concealment through false recording.
2. Assign cash-handling and cash-recording responsibilities to different persons to
ensure an uninterrupted flow of cash from receipt to deposit. This control requires
immediate counting, intermediate recording, and timely deposit of all cash
received.
3. Another procedure used to control cash receipt is to maintain close supervision of
all cash - handling and cash - recording functions. This control includes both
routine and supervises cash counts, internal audits, and daily reports of cash
receipts, payments, and balances.

In general all of these are the procedures by which a company (or firm) used in order to
control and safeguard the cash receipts.

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 6.1.1.1 Cash Short and Over

The amount of cash actually received during a day often does not agree with the record of
cash receipts. Whenever there is a difference between the record and the actual cash and
no error can be found in the record, it must be assumed that the mistake occurred in
making change.

The cash shortage or overage is recorded in an account entitled cash short and over. A
common method of handling such mistakes is to include in the cash receipts journal cash
short and over debit column into which all cash shortages are entered. Let’s take
example.

Assume that the actual cash received from cash sales is Br. 7,577.60 and the amount
shown in the cash register tape is Br.7, 580.76. This means that the amount of cash
actually received during the day is less than the amount indicated by the cash register
tally by Br. 3.16. Thus, the Br.3.16 cash shortage is recorded in the cash receipts journal
as follows.
Cash in Bank……………………………….7, 577.60
Cash Short Over………………………………...3.16
Sales ………………………………………………….7, 580.76

If, at the end of the fiscal period, there is a debit balance in the cash short and over
account, it is an expense and may be included in “Miscellaneous administrative
expense” on the Income Statement. On the other hand, if there is a credit balance in the
cash short and over account, it is revenue and may be listed in the “Other Income”
section.

Check Your Progress: Exercise 6.1

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 1. The combined cash count of all cash registers at the close of a business is Birr
4.63 less than the cash sales indicated by the cash register tapes. (a) In what
account is the cash shortage recorded? (b) Are cash shortage debited or credited to
this account?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

2. In which section of the income statement would a credit balance in Cash Short
and Over be reported?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
6.1.1.2 Cash Change Funds

Dear students, what do you understand by a cash change funds? What do you think is
its purpose? Answer the questions in writing and read the discussions below for change
funds and compare your response with what is given in the module.

Retail stores and other businesses that receive cash directly from customers must
maintain a fund of currency and coins in order to make change. The fund may be
established by drawing a check for the required amount, debiting the account ‘Cash on
Hand’ and crediting ‘Cash in Bank’. No additional charges (debits) or credits to the cash
on hand account are necessary unless the amount of the fund is to be increased or
decreased. At the end of each business day, the total amount of cash received during the
day is deposited and the original amount of the change fund (with the proper
denominations) is retained for use in the next business day. And the desired composition

166
of the fund is maintained by exchanging bills or counts for those of other denominations
at the bank.
Check Your Progress: Exercise 6.2
1. Record in general journal form the following transactions:
(a) Check No. 012 is issued to establish a change fund of Birr 600.00.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

(b) Cash sales for the day, according to the cash register tapes, were Birr
10,327.75, and cash on hand is Birr 10,920. 35. A bank deposit ticket was
prepared for Birr 10,320.35.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

What are some of the mechanisms frequently used by firms to control cash
disbursements?

Although cash disbursement control systems are tailored to each firm’s specific needs,
certain fundamentals would apply to all firms.

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 6.1.2 Control of Cash Disbursements (Payments)

1. Separate the responsibilities for cash disbursement documentation check writing

check signing check mailing, and record keeping.
2. Except for internal cash fund (petty cash), make all cash disbursements by check.
3. If petty cash funds are employed, develop tight controls and authorization
procedures for their use
4. Prepare and sign checks only when supported by adequate documentation and
verification,
5. Supervise all cash disbursements and record keeping functions.

The Voucher System

One of the widely used methods of establishing control over cash payments is the
voucher system. The basic idea of this system is that every transaction which will result
in a cash payment must be verified, approved in writing, and recorded before a check is
issued. A written authorization called a voucher is prepared for every transaction that will
require cash payment, regardless of whether the transaction is for payment of an expense,
purchase of merchandise or a plant asset, for payment of liability.

Dear students! What is a voucher system?

A voucher system is the methods and procedures employed in verifying and recording
liabilities and paying and recording cash payments.

The use of a voucher system would enable that:

(a) the approval of invoices for payment be clearly separated from the issuance of
checks to make such payment:

168
 (b) Every transaction requiring a cash disbursement be verified and approved
before payment is made.
A voucher system uses:
(1) Vouchers
(2) Voucher register
(3) A file for unpaid vouchers
(4) A check register, and
(5) A file for paid vouchers

Vouchers

A voucher is a special form on which is recorded relevant data about a liability and the
particulars of its payment. A voucher may include information regarding: the name and
address of the creditors, the date and the number of the voucher, the basic details of the
invoice such as seller's invoice number and the amount and the terms of the invoice, and
the details of payment, etc.

Vouchers are customarily prepared by the accounting department on the basis of the
invoice or memorandum that serves as evidence of expenditure. Vouchers are prepared
after the following comparisons and verifications have been made:
(a) Comparison of the invoice with a copy of the purchase order to verify
quantities, prices, and terms.
(b) Comparison of the invoice with the receiving report to verify receipt of the
items billed.
(c) Verification of the arithmetical accuracy of the invoice.

169
Before a voucher for the purchase of merchandise is approved for payment, three
documents should be compared to verify the accuracy of the liability. Name these three
documents?

What are your answers? Compare your answers with the answers given below.

The three documents supporting the liabilities are: Seller's invoice, purchase order, and
receiving report. The invoice should be compared with the receiving report to determine
that the items billed have been received and with the purchases order to verify quantities,
prices and terms.

Voucher Register

After approval by the designated officials, each voucher is recorded in a journal known as
a voucher register. The voucher register is similar to and replaces the purchases journal. It
may be thought of as an expanded purchases journal with additional debit columns for
various types of expenses and asset accounts. Every entry in the voucher register will
consist of a credit to Accounts Payable, but the debits may affect various assets and
expenses accounts. Each voucher is entered in the voucher register in numerical order as
soon as it is prepared and approved. The total of the unpaid vouchers appearing in the
voucher register should agree with the total of the vouchers in the unpaid voucher file at
the same date.

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Unpaid Voucher File

After the voucher has been entered in the voucher register, it is filed in the unpaid
voucher file according to the date of required payment, where it remains until it is paid.
The amount due on each voucher represents the credit balance of an account payable, and
the voucher itself is comparable to an individual account in a subsidiary account payable
ledger; accordingly a separate subsidiary ledger is not necessary.

When a voucher is to be paid, it is removed from the unpaid voucher file and a check is
issued in payment. The date, the number, and the amount of the check are listed on the
back of the voucher for use in recording the payment in the check register. Paid vouchers
and the supporting documents are often run through a canceling machine to prevent
accidental or intentional reuse.

Cash Register

The payment of a voucher is recorded in a check register. The check register is a

modified form of the cash payments journal and it is so called because it is a complete
record of all checks. All checks including the voided have to be recorded in the check
register in sequential order.

Each check issued in payment of a voucher that has previously been recorded as an
account payable in the voucher register. The effect of each entry in the check register is a
debit to Accounts Payable and a Credit to Cash in Bank (and Purchases Discounts, when
appropriate).

Paid Voucher File

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After payment, vouchers are customarily filed in numerical sequence in a paid vouchers
file so that future examination of each voucher is made possible.

After payment, vouchers are customarily filed in numerical sequence in a paid vouchers
file so that future examination of each voucher is made possible.
So, what do you think are the uses of the voucher system?

The following are the uses of the voucher system:

(1) It provides effective accounting controls
(2) It provides assurance that all payments are in liquidation of valid liabilities.
(3) it assists in determining future cash requirements thereby enabling
management to make maximum use of cash resources by: (a) taking
advantage of cash discounts, (b) planning seasonal borrowing for working
capital

The following discussion highlights two of the most common elements of cash control
and management: Petty cash funds and bank accounts.
Check Your Progress: Exercise 6.3
1. Why is cash the asset that often warrants the most attention in the design of an
effective internal control structure?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

6.1.2.1 Petty Cash Funds

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What do you understand by a petty cash funds? Why firms maintain petty cash funds?
Dear students would you please try to answer the above questions in writing before you
are going through the discussion.
A petty cash fund is a type of imprest fund, providing ready currency for routine
disbursements. Sometimes it becomes very difficult to make small payments that arise
frequently during a day through checks.

Apart from its inconvenience it is considered very expensive to write a check for every
single payment. Therefore, it is advisable for firms to make small payments that are
frequently made by maintaining a petty cash fund.

The first step in establishing a petty cash fund is to estimate the size of the fund required
for disbursement of a specified period of time, say for a month. After determining the
size of the fund a check should be prepared and issued for the required amount there
comes recording the establishment of the petty cash fund by debiting petty cash account
and crediting the cash in bank account. The amounts of the fund may vary depending
upon the needs of the companies and the length of time involved. In addition a large
organization may have several petty cash funds in a variety of offices and production
facilities. Although the amount in any one location may be relatively minor, the total of
all petty cash can be significant. The balance of the petty cash account, which is part of
the total cash balance, changes only when the fund is established, changed in amount, or
discontinued.

Petty cash funds are intended to handle many types of small payments, including
employee transportation costs, postage, office supplies, and delivery charges. Generally,
control of cash in a petty cash system is informal. Increased economy and convenience
often justify the use of petty cash funds.

The following chronological steps illustrate a typical petty cash fund

operation:

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1. Assume that a Br. 3000 petty cash fund is established at a specific location. The
cash is placed in a secured location (usually a strong box or safe under custodial
control). The journal entry is as follows:
Petty cash …………………………. 3000.00
Cash ……………………….. ………….. 3000.00

2. The custodian reviews authorization on vouchers for cash requests and dispenses
the required cash. The vouchers are kept with the fund. The sum of cash and
vouchers should equal Br. 3000. Journal entries are not made for disbursements.

3. At the end of the first month, Br. 560 remains in the fund, indicating that Br 2,440
was disbursed during the month (Br. 3000 - Br. 560) and that the custodian should
have Br. 2,440 in supporting payout vouchers. The following individual vouchers
accompany the fund: postage, Br. 900, office supplies, Br. 700, and taxi fares, Br.
800 (Br. 2400 in total). There is a Br. 40 cash shortage (Br. 2,440 - Br. 2,400).
Presumably, a voucher was lost, or a voucher understates the amount disbursed.
The shortage is reflected in a replenishment entry:

Postage expense ……………………………….. 900.00

Office supplies expense ……………………….. 700.00
Transportation expense ……………………….. 800.00
Cash Short and Over ……………………………. 40.00
Cash ……………………………. 2,440.00

This entry is recorded by the accounting department, not the custodian.

Replenishment of the petty cash fund occurs whenever the fund runs low and at
the end of each fiscal period for proper reporting of expenses and cash balance.

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 Cash short and over is an expense (debit balance) or revenue account (credit
balance). A shortage or overage is caused by recording or disbursing errors. If a
shortage is larger than normal or if shortage occurs regularly with the same fund,
theft should be suspected. When fraud or theft is suspected, a loss is recorded
rather than cash short and over.

4. When a petty cash fund is increased, decreased, or closed, an entry is made

affecting both the petty cash and cash accounts. For example, if the fund is
increased to Br. 5000 because of increased office cash needs, the entry is as
follows:

Petty cash ……………………………. 2,000.00

Cash ……………………………………… 2000.00

What, if the firm in the above illustration, wants to decrease the size of the petty cash
fund to Br. 2, 500? Make the necessary journal entry.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

In Summary, petty cash systems foster internal control through the requirement that some
one other than the recipient of cash must authorize the disbursement. A record of each
disbursement is made, the fund is created and replenished by check and is reconciled, and
the replenishment check is written by someone other than the custodian of the fund.

Check Your Progress: Exercise 6.4

1. What account or accounts are debited when recording (a) the establishing a petty cash
fund and (b) replenishing a petty cash fund?

175
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
2. Record in general journal form the following related transactions
(a) A check is issued in the amount of Birr 750.00 to establish a petty cash fund
(b) The amount of cash in the petty cash fund is now Birr 47.30. Check No. 1213
is issued to replenish the fund, based on the following summary of petty cash
receipts: office supplies, Birr 282.15; miscellaneous selling expense, Birr
180.60; miscellaneous administrative expense, Birr 258.70; (Since the amount
of the check to replenish the fund plus the balance in the fund do not equal
Birr 750, record the difference in the cash short and over account.)
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
6.1.2.2 Control of Cash through Bank Accounts

What are some of the benefits of using a bank account? Try to give your answer from
your own perspectives.

Bank accounts are an important means of cash control and provide several advantages:
 Cash is physically protected by the bank
 A separate record of cash is maintained by bank
 Cash handling and theft risk are summarized
 Customers may remit payments directly to the bank
 Financial institutions provide cash management services such as checking
privileges, investment advice, and interest revenue on accounts.

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One of the major devices for maintaining control over cash is the bank account. To get
the most benefit from bank account, all cash received must be deposited in the bank and
all payments must be made by checks drawn on the bank or from special cash funds.
When such a system is strictly followed, there is a double record of cash, one maintained
by the depositor (business) and the other by the bank.

There are certain forms used by a business in connection with a bank account. These are:
signature card, deposit ticket, check, and record of checks drawn. A brief description
of each of these forms is presented below.

Signature card - when you open a bank account, an identifying number is assigned to
your account, and a signature card must be prepared and signed by you the account
holder or any other person(s) authorized to sign checks drawn on the account.

Dear students, do you have a savings account with any of the local banks in Ethiopia?
If your response is ‘yes’, haven’t you signed on the signature card up on opening this
account? What do you think is the purpose of signing on the signature card?

The bank later used the signature card to determine the authenticity of the signature on
checks presented to it for payment. If the signature presented on the check is not identical
with the signature on the signature card, the bank may refuse to make payment.

Deposit ticket - It is a printed form supplied by the bank to fill the detail of the deposit.
Deposit ticket is also known as a deposit slip or deposit voucher. It is prepared in two
copies, in which case the copy is stamped and initialed by the bank’s teller and given to
the depositor as a receipt or as a written proof of the date and the total amount of the
deposit.

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Check - A check is a written instrument signed by the depositor, ordering the bank to pay
a certain sum of money to the order of a specified person(s).

Three parties are involved in a check issuance: (1) the drawer, the one who signs the
check, (2) the drawee, the bank on which the check is drawn; and (3) the payee, the one
to whose order the check is drawn. In simple terms, the drawer is the person or firm who
owns the bank account (the account holder), the drawee refers to the bank (branch) in
which the account is deposited; and the payee refers to the person or firm to whose order
the payment is made.

When checks are issued to pay bills, they are recorded as credits to Cash on the day
issued, even though they are not presented to the drawer’s bank until some later time. On
the other hand, when checks are received from customers, they are recorded as debits to
Cash, on the assumption that the customer has enough money on deposit.

The check form contains information concerning the names and address of the depositor
(account holder) printed on each check. And, to facilitate internal control of cash
payments, checks are usually numbered sequentially.

Record of checks drawn - A memorandum record of the basic details of a check should
be prepared at the time the check is written. This record may be a stub from which the
check is detached or it may be a small booklet designed to be kept with the check forms.
Each type of record also provides spaces for recording deposits and the current bank
balance.

Business firms may prepare a copy of each check drawn and then use it as a basis for
recording the transaction in the cash payments journal.

Check Your Progress: Exercise 6.5

1. Distinguish between a drawer and a payee

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________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

Bank Statement

What do you understand by a bank statement? Who prepares a bank statement? And,
how often is a bank statement prepared? Would you please give your answer in writing
before you read the following discussion?

A bank statement is a statement that contains all checking account transactions made
by the depositor in a given period of time, usually a month. A bank statement is prepared
by the bank at the end of each month for all checking account depositors and includes:
 the beginning balance of the cash account,
 all deposits and other credits to the depositor’s account,(additions by the bank),
 all payments (checks) and other deductions by the bank, and
 the balance of the cash account at the end of the month.

Usually the bank sent the statement to each checking account depositor’s at the end of
each month. The statement may also include the depositor’s checks received by the bank
during the month arranged in the order of payment. The paid or canceled checks are
stamped “paid”, together with the date of payment.

In addition, debit or credit memorandums describing other entries in the depositor’s

account may also be enclosed with the statement. For example, the bank may have

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credited the depositor’s account for loans granted by the bank or for collections of
receivables from customers. Also, the bank may have debited the depositor’s account for
service charge or for deposited checks returned because of insufficient funds.

Bank Reconciliation

What does it mean by bank reconciliation? Who makes this reconciliation of the bank
statement balance with the balance in the depositor’s records?

When all cash receipts are deposited in the bank and all payments are made by check, the
account is often said to be “cash in bank”. This account in the depositor’s ledger is the
reciprocal of the account with the depositor in the bank’s ledger.

Cash in bank in the depositor’s ledger is an asset with a debit balance, and the account
with the depositor in the bank’s ledger is a liability with a credit balance. One can say
that the two balances should be equal, but they are not likely to be equal on any specific
date because of either or both of the following;

(1) Delay by either the bank or the depositor in recording transactions, and
(2) Errors by either the bank or the depositor in recording transactions.

With respect to delay, normally there is a time lag of one day or more between the date a
check is written and the date that it is presented to the bank for payment. Also, if the
depositor mails deposits to the bank or uses the night depository, a time lag between the
date of the deposit and the date that it is recorded by the bank may happen. To put this
differently, the bank may debit or credit the depositor’s account for transactions about
which the depositor will not be informed until later. Examples are service or collection

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fees charged by the bank and the proceeds of notes receivable sent to the bank for
collection.

Therefore, to determine the reasons for any difference and to correct any errors that may
have been made by the bank or the depositor, the depositor’s own records should be
reconciled with the bank statement.

Two Forms of Bank Reconciliation are in Common Usage

(a) Both the bank statement balance and the balance in the depositor’s records are
reconciled to a correct balance, and
(b) The bank statement balance is reconciled to the unadjusted balance in the
depositor’s records.

Based on the concepts discussed thus far, illustration of bank reconciliation will be made
in the following section using the two forms.

6.2 Illustration of Bank Reconciliation and Journal Entries

Assume that the bank statement as of April 30, 2008 sent to Abogida Trading Plc,
reported an ending balance of Birr 38,660, and the cash in bank account reflects an
ending Birr 34,880 cash balance. Data pertaining to the April bank reconciliation for
Abogida Trading Plc is summarized below:

(1) Deposit in transit - these are deposits made too late to be reflected in the bank
statement. You can determine this amount by comparing the firms record of deposits with
the deposits listed in the bank statement. Accordingly, the deposit in transit for the month
of April for Abogida Trading is Birr 3000. When making the reconciliation, the deposit in

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transit amount is added to the balance per bank statement.

(2) Outstanding checks - these are checks issued by the depositor but that have not been
paid by the bank. The amount of outstanding checks is determined by comparing checks
written with checks cleared and shown in the bank statement. The outstanding checks for
Abogida for the month of April is Birr 7000. While preparing the bank reconciliation, the
amount of outstanding checks should be deducted from the balance per the bank
statement.
(3) Bank Credit memo - this credit memo represents collection of receivables made by
the bank during the month on behalf of the depositor, or the bank may grant loans to the
depositor. These credit memorandums are traced to the cash receipts journal. Credit
memorandums not recorded in the cash receipts journal are added to the balance per the
depositor’s records. For Abogida Trading, the bank collected and credited the depositor’s
account for Birr 1,100 for a notes receivable with a face value of Birr 1000 plus Birr 100
interest. This amount was not recorded by Abogida Trading Plc.

(4) Error in recording - error discovered during the process of making comparisons are
listed separately on the reconciliation. For example, if the amount for which a deposit slip
was written had been recorded erroneously by the depositor, the amount of the error
should be added to or deducted from the balance according to the depositor’s records.
Similarly, errors by the bank should be added or deducted from the balance according to
the bank statement. For Abogida Trading Plc., the accountant of the firm recorded a Birr
240 check in the cash payments journal in the amount of Birr 420, causing the book
balance to be understated by Birr 180 (Birr 420 - Birr 240). Thus, when making the
reconciliation the Birr 180 depositor’s error should be added to the balance per
depositor’s records.

(5) Bank Debit Memorandums - these are transactions that decrease the depositor’s
cash balance with the bank. These are deductions made by the bank from the bank
balance with the depositor’s account. Debit memorandums include: bank service charge,

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non sufficient funds (NSF) checks, interest expense, cost of checks, and any other
transactions that decrease the depositor’s bank account balance.

(a) Non-sufficient funds (checks) - you may made collection from a customer
through checks and, it is common that you prefer to deposit the checks you
received from the client in your bank account, your bank initially credits your
bank account for the deposited amount with the assumption that the client has
sufficient funds. However, later on, the client who issued the check may not have
sufficient fund in his bank account. When this happens, the bank debits (deducts)
the depositor’s account for the amount and return the check with the statement to
the depositor.

For Abogida Trading Plc, a Birr 300 check from customer (Aleta Co.), which was not
supported by sufficient funds in Aleta’s checking account, was returned to Abogida
Trading by the bank. Abogida had deposited the check, increased cash, and decreased
accounts receivable, but the bank was unable to credit Abogida’s account. Thus, the Birr
300 NSF check is deducted from the balance per depositor’s records.

(b) Bank service charges - The bank service charge represents deductions by
bank from the depositors bank balance. These deductions are made each month
for the service rendered by the bank to the depositor.

Accordingly, the bank debited Abogida’s account for Birr 200 of bank charges in April
for check printing, checking account privileges, and processing customer checks and
notes.

Therefore, in making the reconciliation the Birr 200 service charge should be deducted
from the balance per depositor’s records.

Based on the above bank reconciliation information let's prepare a bank reconciliation
using both forms.

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Approach A. Bank statement balance and depositor’s balance reconciled to correct
(adjusted) balance.
This form of bank reconciliation has two sections: One section begins with the balance
per bank statement and ends with the adjusted (correct) balance and the other section
begins with the balance per depositor’s records and ends with the adjusted (correct)
balance. Bear in mind that the two adjusted balances should be equal.

Now let’s prepare the bank reconciliation for Abogida Trading Plc., for the month of
April 2008:

Abogida Trading Plc.,

Bank Reconciliation
April 28, 2008

Balance per bank statement, April 29, 2008 ……………………….. Birr 38,660
Additions: Deposit in transit not shown on the statement ………….. 4,000
Subtotal …………………………………………………………….. Birr 42,660
Deductions: Outstanding checks not shown on the statement ……... (7,000)
Adjusted balance, April 29, 2008 …………………………………… Birr 35,660*
Balance per depositor’s records, April 29, 2008 ……………………. Birr 34,880
Additions: Bank credit memo for:
 Notes receivable ……………………… Birr 1,000
 Interest Income ………………………. 100
o Error in recording check by the depositor... 180 1,280
Subtotal ……………………………………………………………… Birr 36,160
Deductions: Bank debit memorandums for:
 Insufficient fund ………………………. Birr 300
 Service charge …………………………. 200 (500)
Adjusted balance, April 29, 2008 …………………………………… Birr 35,660*

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 *As it has been indicated earlier the two adjustment balances should be equal i.e., for
Abogida Trading Plc., it is Birr 35,660.

Entries based on bank reconciliation. Bank debit and credit memorandums not
recorded by the depositor and depositor’s errors shown by the bank reconciliation require
that entries be made in the accounts. Therefore, the entries for Abogida Trading Plc.,
based on the April bank reconciliation above, are as follows:

April 28. Cash in Bank ………………………………. 1,100

Notes Receivable ……………………. 1,000
Interest Income ……………………… 100
To record notes collected by bank including interest

28. Cash in Bank ……………………………….... 180

Repairs Expense ………………………. 180
To record depositor’s error in recording checks

28. Administrative Miscellaneous Expense ……… 200

Accounts Receivable (Aleta Co.,) ……………. 300
Cash in Bank …………………………… 200
To record bank service charges and NSF checks

Check Your Progress: Exercise 6.6

1. Identify each of the following reconciling items as:
(a) an addition to the balance per bank statement
(b) a deduction from the balance per bank statement
(c) an addition to the balance per depositor's records, or
(d) a deduction from the balance per depositor's records
(Assuming that none of the transactions reported by bank debit or credit memorandums
have been recorded by the depositor.)

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 (i) Note collected by bank, Birr 700
(ii) Deposit in transit, Birr 4,500
(iii) Outstanding checks, Birr 5,300
(iv)Bank service charge, Birr 25.50
(v) Check drawn by the depositor for Birr 96 had been recorded in the check
register as Birr 69
(vi)Check of a customer returned by bank to depositor because of insufficient
funds, Birr 1,500
2. Which of the reconciling items listed in Question 1 above necessitates an entry in
the depositor's accounts?

Approach B. The bank statement balance is reconciled to the unadjusted balance in

the depositor’s records.

In this form of bank reconciliation the bank statement balance is reconciled to the un
adjusted balance in the depositor’s records, then the adjustment cash balance is added to
or deducted from this balance to yield the adjusted or corrected balance. Hereunder is the
illustration of this approach.

Abogida Trading Plc.,

Bank Reconciliation
April 28, 2008

Balance per bank statement, April 29, 2008 ……………………….. Birr 38,660
Additions:
 Deposit in transit not shown on the statement Br. 4,000
 Bank service charges………………………… 200
 NSF checks returned by bank………………... 300 4,500
Subtotal …………………………………………………………….. Birr 43,160
Deductions:
o Outstanding checks not shown on the statement ……… Br. 7,000

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 o Bank credit memo for notes collected including interest 1,100
o Depositor’s error in recording checks ………………… 180 8,280
Unadjusted balance per depositor’s records …………………… Birr 34,880
Additions: Adjustment to cash ledger account ……………….. 780**
Adjusted or corrected cash balance, April 28, 2008 …………… Birr 35,660

Journal entries as a result of the April 28 bank reconciliation follows:

April 28. Cash in Bank ………………………………. 780**

Miscellaneous Administrative Expense…… 200
Accounts Receivable………………………. 300
Notes Receivable …………………………… 1000
Interest Income …………………………….. 100
Repairs Expense ……………………………. 180

Therefore, whichever form of bank reconciliation is used the adjusted cash balance is the
same, Birr 35,660. But both forms have their own advantages.

NB. In general, the bank reconciliation is an important part of the system of internal
control because it is a means of comparing recorded cash, as shown by the accounting
records, with the amount of cash reported by the bank. It thus provides for finding and
correcting errors and irregularities. Greater internal control is achieved when the bank
reconciliation is prepared by an employee who does not take part in or record cash
transactions with the bank. Without a proper separation of these duties cash is more
likely to be embezzled.

Check Your Progress: Exercise 6.7

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 1. Do items reported on the bank statement as credits represent (a) additions made
by the bank to the depositor’s balance or (b) deductions made by the bank from
the depositor’s balance?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

2. Describe and explain the purpose of preparing a bank reconciliation

________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

3. When checks are received, they are recorded as debits to Cash, the assumption
being that the drawer has sufficient funds on deposit. What entry should be made
if a check received from a customer and deposited is returned by the bank for lack
of sufficient funds (NSF).
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

4. The cash in bank account for Ghibe Company at June 30 of the current year
indicated a balance of Birr 15,215.80 after both the cash receipts journal and the
check register for June had been posted. The bank statement indicated a balance
of Birr 20,513.90 on June 30. Comparison of the bank statement and the
accompanying canceled checks and memorandums with the records revealed the
following reconciling items:
(a) A deposit of Birr 4,207.85, representing receipts of June 30, had been
made too late to appear on the bank statement.
(b) Check outstanding totaled Birr 5,980.65.

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 (c) A check drawn for Birr 75 had been erroneously charged by the bank as
Birr 57.
(d) The bank had collected Birr 4,080 on an interest-bearing note left for
collection. The face amount of the note was Birr 4000.
(e) Bank service charges for June amounted to Birr 55.50
(f) Bank debit memo for check returned because of insufficient funds, Birr
517.20

Instructions: (a) Prepare a bank reconciliation for Ghibe Company for the month of June
(b) Record the necessary entries in General Journal form.

Review Exercise 6.1

Attempt the following questions:
1. The procedures employed by Bonga Trading mail receipts are as follows: mail
clerks send all remittances and remittance advises to the cashier. The cashier
deposits the cash in the bank and forwards the remittances advises and duplicate
deposit slips to the accounting department.
(a) Indicate the weak link in the internal control
(b) Howe van the weakness be corrected
2. The procedures employed by Variety Cafe for over the counter receipts are as
follows: At the close of each working day the sales clerks count the cash in their
respective cash drawer, after which they determine the amount recorded by the
register and prepare the memorandum cash form, noting any discrepancies. An
employee from the cashier office counts the cash, compares the total with the
memorandum, and takes the cash to the cashier's office.
(a) Indicate the weak link in the internal control
(b) How can the weakness be corrected
3. The cash in bank account for Surbo Company at January 31 of the current year
indicated a balance of Birr 17,450.80 after both the cash receipts journal and the
check register for January had been posted. The bank statement indicated a
balance of Birr 23, 713.90 on January 31. Comparison of the bank statement and

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 the accompanying cancelled checks and memorandums with the records revealed
the following reconciling items:
(a) A deposit of Birr 8720.50, representing receipts of January 31, had been
made to late to appear on the bank statement
(b) Outstanding checks, totaled Birr 4570.20
(c) The bank had collected Birr 5119.25 on an interest-bearing note left for
collection. The principal amount of the note was, Birr 5000.00
(d) Bank service charges for January amounted to Birr 50.00
(e) A check drawn for Birr 96 had been erroneously charges by the bank as
Birr 69.00
(f) A deposit slip for Birr 218.50 returned with the statement had been
recorded erroneously in the cash receipts journal as Birr 21.85
(g) A check amounting to Birr 400 received from Yebu Company had been
returned by bank because of insufficient t fund.
Instructions: (1) Prepare a bank reconciliation for Surbo Company
(2) Record the necessary journal entries

6.3 Model Examination Questions

Part I. 1. Define cash as it is used for accounting purposes
1. Why is a petty cash fund replenished at the end of a reporting
period?
2. Briefly explain the basic purpose of a bank reconciliation
3. Define the following terms related to accounting for cash:
(a) Deposit in transit
(b) Checks outstanding
(c) NSF check
(d) Correct cash balance
(e) Cash short and over
Part II. 1. Main Company decided to use a petty cash system for making small
payments. The following transactions were completed during December
2007:

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 (a) On December 1, 2007 the Company treasurer prepared an Birr 800
check payable to petty cash; the cash was given to the custodian.
(b) Expenditures by the custodian (and signed receipts received)
through December 20 were postage, birr 160; office supplies, Birr
140; newspapers, Birr 72; office equipment repairs, Birr 240;
coffee room supplies, Birr 60; and miscellaneous items, Birr 48.
(c) On December 20 the treasurer fully replenished the fund.
(d) Expenditures by the custodian through December 31 were postage,
Birr 52; office supplies, birr 72; newspapers, Birr 28; office
equipment repairs, Birr 84; Coffee room supplies, Birr 40; and
miscellaneous items, Birr 24. The fund was replenished on
December 31.
Required: 1. Give all journal entries that should be made relating to the petty cash fund
through December 31, 2007 (end of the annual accounting period),
assuming that the petty cash expenditures were for administrative
expenses.
2. Show how the petty cash fund should be reported on the balance sheet.

List of Reference Materials

1. Introduction to Accounting, 21st Century
2. Dyckman, Dukes and Davis. (1995). Intermediate Accounting. Third Edition.
Volume I, Chapters 1 – 14. McGraw Hill Companies, Inc.,
3. Fees and Warren, Accounting Principles. 16th edition. South – Western
Publishing Company.
4. Fees and Warren, Accounting Principles. 18th edition. South – Western
Publishing Company.

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 UNIT SEVEN: RECEIVABLES

List of Contents
 Unit Objective
 Introduction
7.1 Promissory Notes Receivables
7.2 Characteristics of Notes Receivable
7.3 Accounting for Notes Receivable
7.4 Uncollectible Receivables
7.5 Methods of Recognizing Receivables
7.6 Model Examination Questions
 List of Reference Materials

Unit Objective

In unit six you have discussed the concept of the most liquid asset, Cash and Cash
equivalents, which are much alike cash but would never be reported as cash on the
financial reports. In this unit, you will discuss in detail the concept of another current
asset category, Receivables. Thus, the purpose of this unit is to acquaint you dear learners

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with the basic concepts of receivables and temporary investments; the accounting for:
notes receivables, accounts receivables, uncollectible receivables and temporary
investments. Specifically, after discussing the concepts in this unit, you will be able to:
o Define and understand the term receivables
o Differentiate the different types of receivables used in business
o Determine the maturity date of a promissory notes
o Compute the maturity value and proceeds of a promissory notes
o Make the journal entries related to promissory notes
o Understand the concept of uncollectible receivables
o Comprehend the differences that exists between the allowance method and the
direct-write-off method of accounting for uncollectible

Introduction

As you discussed in the previous unit, you were acquainted with one of the most liquid
assets; that is, Cash and its equivalents. As it has been indicated earlier in the unit, cash is
the asset that is readily available for the payment of an obligation. Thus, to qualify as
cash an item must be readily available for the settlement of a liability and it must be free
from any contractual restrictions that may prohibit its use. In this unit you will be
familiarized with the concept of another current assets; that is, Receivables. Receivables,
like cash, are classified as ‘Current Assets’ on the balance sheet. But receivables are
considered less liquid than cash. Liquidity in this context means that the speed with
which the underlying asset is converted into cash, or consumed or expired. Since
receivables are expected to be converted into cash within a short period of time (usually
within one year or less), they are reported under the caption ‘current assets’ on the
balance sheet.

The term receivables include all money claims against people, organizations and other
debtors. Receivables represent expected future cash inflows for the creditor (to the
lending party). Receivables are acquired by a business enterprise in various kinds of

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transactions, the most common being the sale of merchandise (goods) or services on a
credit basis. For instance, if a shop near your home makes a sale of dry cell without being
receiving the money immediately (to be received at a later date), it means that a
receivable is created or acquired by the shop owner. The claim against the debtor (buyer
of dry cell on credit) represents a receivable to the shop owner (seller). The shop owner
expects this receivable to be collected in the near future.
Receivables can be classified into two groups, viz, (i) trade receivables and (ii) non-trade
receivables. The trade receivables are those receivables which result from the sale of
products or services to different groups of customers (individuals, firms, government
organizations, etc). On the other hand, the non-trade receivables originated from other
events and transactions (other than sale of products and services) and include among
others; advances to employees, accrued receivables, and deposits with utilities. To clarify
the concept further, suppose you apply for a loan from your employer to borrow your
annual salary in advance so that you agreed to repay back within 2 years time on
installments. This transaction between you and your employer creates a non-trade
receivable to your employer.

7.1 Promissory Notes Receivables

Credit may be granted on open account or on the basis of a formal instrument of credit,
such as a promissory note. A promissory note is a written promise to pay a sum of money
on demand or at a definite time. A Promissory note is frequently referred to as a note, a
written promise to pay a sum of money on demand or at a definite time.

A Promissory note is an unconditional promise to pay a definite sum of money on

demand or at a future date. Notes are usually used for credit periods of more than 60
days, as in the sale of equipment on the installment plan, and for transactions of relatively
large Birr amounts. For example, in Ethiopia most importers of electronics like Garad,
Equatorial Business Group, Glorious, etc and other enterprises like Omedad, Delux
Furniture, and 3F, and other firms used a promissory note while making credit sales on
the installment plan.

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Notes may also be used in settlement of an open account and as a means of borrowing or
lending money.

Check Your Progress: Exercise 7.1

1. Compared to other receivables, specially compared to Accounts Receivable, what do
you think are some of the benefits to a creditor of a claim in the form of a notes
receivable?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
______________________________________________________________________

Advantages of Notes Receivable to the Creditor

From the point of view of the creditor, a claim evidenced by a note has an advantage over
a claim in the form of an accounts receivable, in that:-
(1) By signing a note, the debtor acknowledges the debt and agrees to pay it
according to the terms given. Hence, the note represents a stronger legal claim
than accounts receivable for the creditor.
(2) It is also more liquid than accounts receivable because the holder can usually
transfer it more readily to a bank or other financial agency in exchange for cash.
Like a check, a note can be endorsed /transferred to a bank or to other financial
institutions or to other individuals.
(3) It also sometimes produces interest income. Some promissory notes may bear the
payment of a certain percentage of interest income for the period of time between
the issuance date and the due date.

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The enterprise owning a note refers to it as a note receivable. If notes and accounts
receivable originate from sales transactions, they are sometimes called trade receivables.
In the absence of any descriptive words or phrase, accounts and notes receivable may be
assumed to have originated from sales in the usual course of the business.

Although notes and accounts receivables are the common types of receivables, there are
also other less common receivables which include:
 Interest receivables
 Loans to officers or employees
 Loans to affiliated companies

All receivables that are expected to be realized in cash within a year are presented in the
current asset section of the balance sheet. Those that are not currently collectible, such as
long-term loans, should be listed under the caption “Investments” below the current
asset section.

7.2 Characteristics of Notes Receivable

(1) Like a check it must be payable to the order of a certain person or firm, or to the
bearer.
(2) It must also be signed by the person or firm that makes the promise.

Parties to a note:
1. Payee – The entity to whom payment is to be made. The one to whose
2. Maker – The entity who signs the note and there by promises to pay or, the one
making the promise.

Notes have several characteristics that have accounting implications. These are:

(1) Issuance Date: The data a note is issued by the maker.

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 (2) Due Date: The date a note is to be paid is called the due date or maturity data.
The period of time between the issuance date and the due date of a short – term
note may be stated in either days or months. When the term of a note is stated in
days, the due date is the specified number of days after its issuance.

Example: To illustrate the due date of a 90 – day note dated May 19 presented below
may be determined as follows:

Term of the rote …………………………………………………90

Days in May…………………………. 31
Date of Note ………………………….19………………………12
No of days remaining……………………………………........78
June (days)……………………………………………………….30
No of days remaining…………………………………………48
July (days) ……………………………………………………….31
Due date, August………………………………………………..17

When the term of note is stated as a certain number of months after the issuance date, the
due date is determined by counting the number of months from the issuance date.
For example: The due date of a 4- month note dated January 15 would be May 15. And a
2 – month note dated on December 31 would be due on February 28. In this case, the due
date becomes the last day of the month regardless of the number of days each month has.

Check Your Progress: Exercise 7.2

1. When is the due (maturity) date of a 75 – day note issued March 10?
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2. When will be the maturity date of a 3 – month note issued December 11?

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Interest Bearing and Non – Interest Bearing Notes

Promissory notes can be interest bearing or non-interest bearing. A note that provides for
the payment of interest for the period between the issuance date and the due date is called
interest bearing note. This type of notes in black and white states the interest rate that
they promise to pay on the face of the note. Up on maturity the holder of interest -
bearing note will receive not only the principal (face) amount of the note but s/he also
receive the interest accrued on the note.

On the other hand, a non – interest bearing note does not make interest payment for the
period of time between the issuance date and the due date. It should be clear that, it does
not mean that non-interest bearing note do not pay interest, but it means that the note
doesn’t specify in black and white the interest rate it promises to pay. In other words, the
interest is not stated explicitly. But there might be implicit interest as there is no free
lunch.
(3) Interest: Is an amount received (paid) for the use of the principal of a note for a
period of time between the issuance date and the due date. The interest
is the cost of borrowing money or the return for lending money,
depending on whether one is the borrower or the lender.

The amount of interest is based on three factors: These are:

 The amount of money borrowed (lent), [P]
 The loan’s length of time. [T]
 The rate of interest [R]

Interest rate for interest bearing notes usually stated in terms of a period of one year,
regardless of the actual period of time is involved. Notes covering a period of time longer

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than one year ordinarily provide that the interest be paid semiannually, quarterly, or some
other stated intervals. In computing interest for a period of less than one year, agencies of
the federal government uses the actual number of days in the year. For example, 90 days
is considered to be 90/365 of one year. However, the usual commercial practice is to use
360 as a denominator of the fraction.

The formula for computing interest is as follows;

PRINCIPAL * RATE * TIME = INTEREST

Example: What is the interest amount of a 60 - day, 12% note for Birr 10,000?
I = PRT/100
I = 10,000 * 12 * 60 = 200.00
100 * 360
One of the commonly used short cut methods of computing interest is called, the 60 day
6% method, (60/360 of 6%). Accordingly, the interest on any amount for 60 days at 6%
is determined by moving the decimal point in the principal amount two places to the left.

Example: The interest on Br.3000 at 6% for 60 days is Br. 30. The amount obtained by
moving the decimal point must be adjusted; (1) for interest rates greater or less than 6%
and, (2) for periods of time greater or less than 60 days. For example, the interest on Br.
3000 at 6% for 90 days is Br. 45 = (90/60x30).
When the term of a note is stated in months instead of in days, each month may be
considered as being 1/12 of a year, or alternatively the actual number of days in the term
may be counted.

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Example: The interest on a 3 – month note dated November 1 could be computed on the
basis of 3/12 of a year, or on the basis of 92/360 of a year.

Check Your Progress: Exercise 7.3

1. Using the short – cut method of computing interest, calculate the interest amount of a
120-day, 10% for Birr 5000?
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(4) Maturity Value: The amount that is due at the maturity or due date is called the
maturity value. The maturity value is the total proceeds of the note at the maturity date.
Maturity value for an interest bearing note is the face value of the note plus interest.
Whereas the maturity value of a non - interest bearing note is the face value or the
principal amount. In this case, the principal includes an implied interest cost.

For example, the maturity value of a 90 days 10% note for Birr 2500 would be
computed as follows:

Maturity Value = Principal + Interest on Principal Amount

MV = 2500 + (2500 x 0.1 x 90/360)

MV = Birr 2500 + Birr 62.50

MV = Birr 2562.50

Check Your Progress: Exercise 7.4

1. What is the maturity value of a 60 – day, 8% note for Birr 4,800?
2. What is the maturity value of a 60 – day, non – interest bearing note for Birr 4,800?
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7.3 Accounting for Notes Receivable

When a note is received from a customer to apply on account, the facts are recorded by
debiting Notes Receivable Account and Crediting the Accounts Receivable Controlling
Account and the related charge customers account in the subsidiary ledger.

In general, the accounting entries for promissory notes receivable fall in to five groups:
(1) Receipt of a note
(2) Record of adjusting entries,
(3) Collection of a note,
(4) Discounting Notes receivable, and
(5) Recording of a dishonored note.
Let's discuss each of these entries with the help of illustrations:

7.3.1 Receipt of a Note:

a) Receipt of Non – Interest Bearing Receivables

When a note is received from a customer to apply on account, the facts are recorded by
debiting Notes Receivable Account and Crediting the Accounts Receivable Controlling
Account and the related charge customers account in the subsidiary ledger.

Example: To illustrate, assume that the account of Abdulahi Co, which has a balance of
Birr 8400 is past due. A 90 - day, non interest bearing note for that amount, dated April
27, 2007 is accepted in settlement of the account. The notes receivable is recorded at its
face value, and the entry to record the transaction is as follows.
2007
April 27. Notes Receivable …………………..................8400.00

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 Accounts Receivable………………………………….. 8400.00
(Abdulahi Co,)
To record the acceptance of 90 day, Non interest bearing receivable

When the Birr 8400, is due on a note is collected, the following entry would be recorded
in the Cash Receipts Journal as follows:

2007
July 26. Notes Receivable ……………………………….8400.00
Notes Receivable ………………………………………..8400.00
To record the collection of notes from customer.

b) Receipt of Interest – Bearing Receivables

Assume that on June 15, 2007, WOW Fashion received a 60-day 12% note from a
custom, GYB Garment, in settlement of an existing Accounts Receivable of Birr 4000.00.
The entry for this transaction is as shown below:
2007
June 15. Notes Receivable …………………....................4000.00
Accounting receivable …………………………………4000.00
(GYB Garment)
To record the receipt of a 60 - day, 12% note

7.3.2 Record of Adjusting Entry

Continuing with the above illustration, assume that the accounting period for WOW
Fashion end on June 30 of the current year. The record of the accrued interest income and
the related accrued interest receivable for 15 days, (From June 15- June 30), is shown
below.
2001
June 30. Interest Receivable ………………….................. 20.00
Interest Income …………………………………...…… 20.00
To record accrued interest income for
the accounting period (400x12 x 15 = 20.00)
100 360

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After the above adjusting entry have been posted, the asset account Interest Receivable
shows a debit balance of Birr 20.00 that should be reported as current assets on the
balance sheet. On the other hand, the revenue account Interest Income should be
reported in the other income section of the income statement. Before the amount on the
note is collected in next fiscal period (i.e. on August 14, a reversing entry is made at the
beginning of the following year).
2001
July 1. Interest Income …………………....................... 20.00
Interest Receivable ………………….......................... 20.00

At the time the note matures and payment is received, the entire amount of the interest
received is credited to the interest income account.

Account Title: Interest Receivable Account No.:

Balance
Date Item P. R. Debit Credit Debit Credit
June 30 Adjusting J1 20 00 20 00
July 1 Reversing J1 20 00 -- -- -- --

Account Title: Interest Income Account No.:

Balance
Date Item P. R. Debit Credit Debit Credit
June 30 Adjusting J1 20 00 20 00
June 30 Closing J1 20 00 -- -- -- --
July 1 Reversing J1 20 00 20 00
Aug 14 J1 80 00 60 00

7.3.3 Collection of Notes Receivable

When the Notes receivable including the interest is collected, 60 days later, the entry is
recorded as follows:
2001

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 Aug.14. Cash. ………………….....................................4080.00
Notes Receivable. ………………….........................4000.00
Interest Income ………………………….....................80.00
To record the collection of a 60 day 12% note.
After the collection is made, the affected general ledger accounts are summarized as
follows:

Account Title: Notes Receivable Account No.:

Balance
Date Item P. R. Debit Credit Debit Credit
June 15 J1 4000 00 4000 00
Aug 14 J1 4000 00 -- -- -- --

Account Title: Cash Account No.:

Balance
Date Item P. R. Debit Credit Debit Credit
Aug 14 J1 4080 00 4080 00

Note that the Adjusting and reversing process divided the Br.80.00 of interest received on
August 14, 2007 in to two parts for the accounting purposes:

(i) Birr 20.00 representing the interest income for the current fiscal period ending
June 30, 2007 (recorded by the adjusting entry) and,
(ii) Birr 60.00 representing the interest income for the following year.

7.3.4 Discounting Notes Receivable

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Discounting a notes receivable involves selling a note receivable with recourse to a bank.
The bank deducts the interest from the maturity value of the note immediately and gives
the seller of the note only the proceeds. "With recourse" means that the bank will collect
the maturity value of the note from the seller if the original maker of the note fails to pay
to the bank at maturity. A contingent liability, therefore, arises when a note is discounted
on recourse.

The rate of interest the bank charges for discounting the note is called the discount rate.
The bank may charge a different rate of interest than is stated on the note. The cash
proceeds received by the seller is computed by deducting the bank discount from the
maturity value of the note.
The amount received by the endorser for a note after the bank has deducted the discount
is called proceeds. The amount of proceeds paid to the endorser is the excess of the
maturity value over the discount.

Example: To illustrate assume that a 120 day, 10% notes receivable for Birr 3000 dated
October 16, is discounted at the payees bank on December 25 at the rate of 12%. The
data used in determining the effect of the transaction is as follows.

Face value of a note, dated October 16 ………………...... Br. 3000.00

Interest on a note 120 days at 10% ………………………...…..100.00
Maturity value of the note, Feb.13 ………………………........3100.00
Discount period, (Dece.25 – Feb.13), 50 days
Discount on maturity value for 50 days at 12% (52.67)
Proceeds received by discounting the note……………… Br. 3048.33

The excess of the proceeds from discounting the note, Br. 3048.33, over its face value
Br. 3000 is recorded as interest income and the entry for the transaction is as follows in a
general journal form:
Dec. 25. Cash …………………..........................3048.33
Notes Receivable …………………….………… 3000.00

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 Interest Income ……………………………………. 48.33
It should be observed that the proceeds from discounting a note receivable may be less
than the face value. When this situation occurs, the excess of the face value over the
proceeds is recorded as a debit to Interest Expense.

Note: a contingent liability is a conditional liability that materializes only if an event

happens in the future. Contingent liabilities are not reported on the balance sheet but are
disclosed through a supplementary report or note to the financial statements.
Check Your Progress: Exercise 7.5

On a separate sheet of paper give your response for the following questions and
check your answer with the answers provided at the back of this module

1. The payee of a 100-day, 12% note for Birr 5000, dated September 2, endorses it to a
bank on November 1. The bank discounts the note at 14%.

Required: Identify or determine the following as they relate to the note: (a) face
value, (b) maturity value, (c) due date, (d) number of days in the discount period, (e)
proceed amount received by the endorser, (f) interest income or expense recorded by
the endorser, (g) amount payable to the bank if the maker should default, (h) pass the
entry to record the discounting of the note by the endorser.

2. The following questions refer to a 45-day, 10% note for Birr 20,000, dated
August 1: (a) what is the interest amount payable at maturity, (b) what is the maturity
value of the note? (c) When is the due date of the note? If on August 31, the holder of
the note discounted the note at the rate of 12%, (d) what is the amount of proceeds
received by the endorser of the note, (e) pass the entry to record the discounting of the
note.

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7.3.5 Dishonored Notes Receivable

Sometimes the maker (the one who makes the promise) may default (fails) to make the
payment due on the note upon maturity. When this happens, the note is said to be
dishonored. The holder, or payee, of a dishonored note should make an entry to transfer
the total amount due from notes receivable to an accounts receivable from the debtor. The
dishonored notes receivable is no longer negotiable.

Example: To illustrate, if the Br. 4000, 60-day, 12% notes receivable and recorded on
June 15, had been dishonored at maturity, the entry to change the note including the
interest back to the customers account would have been as follows:

2007
Aug. 14. Accounts Receivable …………………………. 4080.00
(GYB Garment)
Notes Receivable …………………….. 4000.00
Interest Income …………………….. ……. 80.00
To record a 12%, 60 - day note dishonored by GYB Garment.

On the other hand, when a discounted note receivable is dishonored, the holder usually
notifies the endorser of such fact and asks for payment. If the request for payment and
notification of dishonor are timely, the endorser is legally obligated to pay the amount
due on the note. The entire amount paid to the holder by the endorser, including the
interest, should be debited to the Accounts Receivable of the maker.

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Example: To illustrate, assume that the Birr 3000, 120-day, 10% note discounted on
December 25, is dishonored at maturity by the maker. The entry to record the payment by
the endorser, in General Journal form, would be as follows:

Feb 13. Accounts Receivable ………………. 3100.00

Cash ……………………………………… 3100.00

In some cases, the holder of a dishonored note gives the endorser a notarized statement of
the facts of the dishonor. The fee for this statement, known as a protest fee, is charged to
the endorser, who in turn charges it to the maker of the note. If there had been a protest
fee of Br.15.00 in connection with the dishonor and the payment previously recorded, the
Debit to Accounts Receivable (the makers) account and the Credit to Cash would have
been Birr 3115.00.

Check Your Progress: Exercise 7.6

1. The maker of a Birr 4000, 11%, 75 – day note receivable failed to pay the note on the
due date. What entry should be made in the accounts of the payee to record the
dishonored note receivable?

2. A discounted notes receivable is dishonored by the maker and the endorser pays the
bank the face of the note, Birr 15,000, the interest, Birr 900, and a protest fee of Birr 50.
What entry should be made in the accounts of the endorser to record the payment?
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7.4 Uncollectible Receivables

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 What do you understand by uncollectible receivables? How does it arise in the firm?
What is its effect on the firm’s profitability and operations? Dear students try to
answer these questions before you go through the discussion presented below.

When merchandise or services are sold without the immediate receipt of cash, a part of
the claim against customers usually proves to be uncollectible. Regardless of how
thorough and efficient its credit control system is, a company will always have some
customers who cannot or will not pay.

An accounts receivable that has been judged to be uncollectible is no longer an asset. The
operating expense incurred because of the failure to collect receivables is called an
expense, or a loss form uncollectible accounts, doubtful accounts, or Bad Debts.

There is no a single general rule for determining when an accounts receivable or notes
receivable become uncollectible. The fact that the debtor fails to pay the account
according to the sales contract or dishonor a note on the due date does not necessarily
mean that the account will be uncollectible.

Indication of Partial or Full Worthlessness of Receivables

How can a business know with certain that whether an amount with a specific customer
will be collected or not collected? As it has been indicated earlier, there is no hard and
fast rule for determining when a receivable becomes uncollectible. However, there are
some indications of partial or full worthlessness of receivables. Some of these indications
are described here under.

1. Bankruptcy of the debtor.

2. Closing of the debtor’s business
3. Disappearance of the debtor

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 4. Failure of repeated attempts to collect, and the barring of collection by the
stature of limitation

Dear students! We believe that now you are a bit aware of uncollectible receivables, and
as it has been said it represents receivables that will not or cannot be collected. These
receivables are frequently referred to as Doubtful Accounts, or Bad Debts, and are
expenses that result from the failure to collect receivables. Bad debt expense has the
effect of decreasing the firm’s profit and assets. But the question here is the timing and
amount of recognizing bad debts. In your opinion, when should these uncollectible
accounts be recognized in the accounting records? Give your answer in writing before
you read the following discussion.

7.5 Methods of Recognizing Uncollectible

There are two methods of accounting for receivables that are believed to be uncollectible:

7.5.1 The Allowance Method (Reserve Method)

This method provides in advance for uncollectible receivables. Most large business
enterprises used this method to provide currently for the amount of trade receivables
estimated to become uncollectible in the future. The advance provision for future
uncollectibility is made by an adjusting entry at the end of the fiscal period. As with all
periodic adjustments, the entry serves two purposes. In this instance, it provides for

(1) the reduction of the value of the receivables to the amount of cash expected to
be realized from them in the future and
(2) the allocation to the current period of the expected expense resulting from
such reduction.

These losses are expenses that occur at the time sales on credit are made and should be
matched to the revenues they help to generate at the time the sales are made.

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Management cannot identify which customer(s) will not pay their debts, nor can it predict
the exact amount of money that will be uncollectible. Therefore, to observe the matching
rule, losses from uncollectible accounts must be estimated, and this estimate becomes an
expense for the fiscal year in which the sales are made. The advance provisions for future
uncollectible is made by and adjusting entry at the end of the fiscal period.

Example: To illustrate, assume that Cottage Sales Company made most of its sales on
credit during its first year of operation. At the end of the year accounts receivable
amounted to Birr 97 500. On this date, management reviewed the collectible status of the
Accounts Receivable. Base on a careful study approximately Birr 5,500 of the Birr 97500
of Accounts Receivable were estimated to be uncollectible therefore, the uncollectible
accounts expense for the first year of operation was estimated to be Birr 5500. The
following adjusting entry would be made on December 31 of that year.

Dec 31. Uncollectible Accounts Expense …………................ 5,500.00

Allowance for Uncollectible Accounts…… 5,500.00
To record the estimated uncollectible accounts expense for the year.

Note that the Birr 5,500.00 reduction in Accounts Receivable cannot yet be identified
with specific customer accounts in the subsidiary ledger and should therefore, not be
credited to the controlling account in the general ledger. Therefore, the customary
practice is to use a contra asset account entitled Allowance for Doubtful Accounts.
(Reserve for Bad Debts)

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Uncollectible account expense is generally reported on the income statement as an
operating expense. And the allowance for doubtful account appears on the balance sheet
as a contra-asset account that is deducted from accounts receivable. It reduces the
Accounts Receivable to the amount that is expected to be realized or collected in cash as
follows:

Current Assets:
Cash................................................................................................ Br 45, 000.00
Short-Term Investments................................................................ 61, 500.00
Accounts Receivable …………………………........Br.97, 500.00
Less: Allowance for Uncollectible Accounts................. (5,500.00) 92,000.00
Merchandise Inventory………………………………………….. 17,000.00
Supplies ………………………………………………………..... 6,200.00
Total current Assets ……………………………........................Br. 217,700.00
The debit balance of Br. 97,500 in Accounts Receivable(the amount of the total claims
against customers on open account), and the credit balance of Br. 5,500 in the Allowance
for Uncollectible Accounts is the amount that will be deducted from the Accounts
Receivable Account to determine the net realizable value.

Note: Because some businesses are showing a tendency of overestimating the amount of
doubtful accounts in order to report less net income and to pay less profit tax, the
Allowance method of recognizing uncollectible accounts is not acceptable for the Federal
Income tax Purpose.

7.5.1.1 Write Offs To the Allowance Account

What would happen, if some of the customers of Cottage Sales Company is identified to
be bankrupted and are not able to pay their debt? What journal entry would be made to
record the fact? Make the journal entry by your own and understand the effect.

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When a specific customer account is believed to be uncollectible, it is written off against
the Allowance Account as in the following entry.

Jan 10. Allowance for Doubtful account ……................... 500.00

Accounts Receivable ………………………… 500.00
To write off the uncollectible account

Although the write-offs remove the uncollectible amount from Accounts Receivable, it
does not change the estimated net realizable value of Accounts Receivable. The write offs
simply reduces the customers account to zero and reduces the Allowance for Doubtful
Account by a similar amount.

Naturally enough, the total amount written off against the allowance account during the
period will rarely be equal to the amount in the account at the beginning of the period.
The allowance account will have a credit balance at the end of the period, if the write off
during the period amount less than the beginning balance. The allowance account will
have a debit balance at the end of the period, if the write offs during the period amount
greater than the beginning balance. However, after the year end adjusting entry is
recorded the allowance account has a credit balance.

7.5.1.2 Recovery of Accounts Receivable Written Off

What would happen, if a customer whose account was written – off earlier as
uncollectible is now collected? What would be the journal entry or entries to be made?
Make your answer before you start reading the following discussion.

An accounts receivable that has been written off against the allowance account may later
be collected. In such cases, the accounts should reinstated by an entry that is the exact

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reverse of the written off entry. When this happens, two journal entries must be made:
One to reverse the earlier write offs, and the other to show the collection of the account.

Example: Assume that on March 15 XY Co, after his bankruptcy on January 10, notified
the Cottage Sales Company, that he would be able to pay Br. 250 of his account and sent
a check for Br. 150. The entries to record this transaction are as follows.

March 15. Accounts Receivable (XY Co.) ……............... 250.00

Allowance for Doubtful Account ……………. 250.00
To reinstate account written off earlier in the year.
March 15. Cash………….................................................... 150.00
Accounts Receivable (XY Co,)…………… 150.00
Collection from XY Co.

7.5.1.3 Estimating Uncollectible

The estimate of uncollectible at the end of the fiscal period is based on past experience
and forecasts of future business activity.
There are two alternative ways to estimate uncollectible receivables:

a) Based on the amount of sales for the entire fiscal period, or

b) Based on the amount and age of receivables

a) Estimation Based on Sales

Accounts receivable are acquired as a result of sales on account. The amount of such
sales during the year may therefore be used to determine the probable amount of the
accounts that will be uncollectible. The amount of this estimate is added to whatever
balance exists in the Allowance for Doubtful Accounts.

Example: Assume that the Allowance account has a credit balance of Br. 500 before
adjustment. If it is known from past experience that about ½ of 1% of the charge sales

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will be uncollectible and the charge sales for a certain year is Br.400, 000.00, the
adjusting entry for uncollectible accounts at the end of the year would be as follows:

Dec. 31. Uncollectible Accounts Expense ………….. 2000.00

Allowance for Doubtful Accounts ……………… 2000.00
To record the adjusting entry for uncollectible accounts expense

After the adjusting entry is posted, the balance of the Allowance for Doubtful Account is
Birr 2500, (i.e., Br.500 credit balance + 2000 adjustment balance). If there had been a
debit balance of Br.500 in the Allowance for Doubtful Account before adjustment, the
amount of the adjustment would still have been Br.2000.00 but the balance in the
Allowance Account after adjusting entry is posted, would be Br.1500 (i.e. Br.2000 – Br
500).
Check Your Progress: Exercise 7.7

1. At the end of the current year, the accounts receivable account has a debit balance
of Birr 162, 500, and net sales for the year total Birr 1, 500,000. Determine the
amount of the adjusting entry to record the provision for doubtful accounts under
each of the following assumptions:
a) The Allowance Account before adjustment has a credit balance of Birr
1,050. Assuming uncollectible accounts expense is estimated at 2% of net
sales.
b) The Allowance account before adjustment has a debit balance of Birr 900.
Assuming uncollectible accounts expense is estimated at ½ of 3% of net
sales.
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 ________________________________________________________________________
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b) Estimation Based on Analysis of Receivable

The most widely used method of estimating the probable amount of uncollectible
accounts is based upon an aging of the accounts receivable. Under this method, the year-
end balance of Allowance for Doubtful Accounts is determined directly by an analysis of
accounts receivable. The difference between the amount determined to be uncollectible
and the actual balance of Allowance for Doubtful Accounts is the expense for the year.
“Aging” Accounts Receivable means classifying each receivable according to its age.

An aging schedule for the Accounts Receivable of East African Trading House is
illustrated below:
Analysis of Accounts Receivable by Age
Dec. 31.19x1
Days Past Due
Balance Not Yet
Customer Over
Due
1-30 31-60 61-90 91-181 181-365 365

ABC Trading Co., Br. 900 Br. 900

Abebe B., Supplies Co., 240 Br.240
Chaltu B. Supplies Co., 400 300 Br. 100
Debebe Z. Super mark 160 Br. 100
Br.60
XY Company 1300 700 600
Br. 400
Zoo Trading 7000 3200 2200 Br 240
960

Br.10. 000 Br. 5100 Br.2900 Br.1200 Br.240 Br. 400 Br.100 Br.60

There is a general assumption that the longer an account is past due, the greater the
likelihood that it will not be collected in full. Therefore, based on past experience, the
credit manager estimates the percentage of credit losses likely to occur in each age group
of accounts receivable.

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The following schedule lists the group totals from the aging schedule and shows how the
estimated total amount of uncollectible accounts is computed.

Estimated Uncollectible Accounts Receivable

December 31.
Age group Percentage considered Estimated Uncollectible
Total Uncollectible Accounts

Not yet due Br .5100 1% Br.51.00

1 – 30 days past due 2900 3% 87.00
31 – 60 days past due 1200 10% 120.00
61 – 90 days past due 240 20% 48.00
91 – 180 days past due 400 30% 120.00
181 – 365 days past due 100 50% 50.00
Over 365 days past due 60 80% 48.00
Birr 10,000 Birr 524.00

The estimated uncollectible accounts of Birr 524 in the example above, is the amount to be
deducted from Accounts Receivable to yield their expected net realizable value. It is thus, the
desired balance of the allowance for doubtful account after adjustment.

The excess of this figure over the balance of the allowance account before adjustment is the
amount of the current provisions to be made for uncollectible accounts expense.

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To continue with the illustration, assume that the allowance account has a credit balance of Birr
120 before adjustment. The amount to be added to this balance is therefore, Birr 404 (Birr 524 –
Birr 120), and the adjusting entry is as follows:

Dec. 31. Uncollectible accounts expense ……………………….. 404.00

Allowance for Doubtful ………………………….. 404.00
To record the adjusting entry for uncollectible accounts expense

After the adjusting entry is posted the credit balance in the allowance account will be Birr 524,
which is the desired amount. If there had been a debit balance of Birr 76 in the allowance account
before adjustment, the amount of adjustment would have been Birr 600 (Birr 524 desired balance
+ Birr 76 Debit balance).
Check Your Progress: Exercise 7.8

2. At the end of the current year, the accounts receivable account has a debit balance
of Birr 175,000, and net sales for the year total Birr 1, 500,000. Determine the
amount of the adjusting entry to record the provision for doubtful accounts under
each of the following assumptions:
a) The allowance account before adjustment has a credit balance of Birr
1,050. And analysis of the accounts in the customers ledger indicates
doubtful accounts of Birr 11,750
b) The Allowance account before adjustment has a debit balance of Birr 900.
Analysis of the accounts in the customers’ ledger indicated doubtful
accounts of Birr 10,100.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

7.5.1.4 Comparison of the Two Methods

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Both the percentage of net sales method and the accounts receivable aging method estimates the
uncollectible accounts expense in accordance with the matching rule, but they do so in different
ways.

The percentage of net sales method is an income statement approach. It assumes that a certain
proportion of each Birr of sales will not be collected, and this proportion is the amount of
Uncollectible Accounts Expense for the year.

The Accounts Receivable Aging method is a balance sheet approach. It assumes that a certain
proportion of each Birr of accounts receivable outstanding will not be collected. This proportion is
the desired balance of the Allowance for Uncollectible Accounts account. The expense for the year
is the difference between the targeted (desired balance and the current balance of the Allowance
account.
The two methods are further elaborated in the following diagram.

Income Statement Approach:

Percentage of Net Sales Method

Uncollectible Accounts
Net sales Apply a Expense
Percentage to
determine

Balance Sheet Approach:

Aging of Accounts Receivable Method

Targeted Balance of
Apply a Allowance for Doubt’s
Accounts Receivable Percentage to Accounts
determine

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Reveiw Exercise 7.1
Attempt the following questions.
1. Assume that on May 4, 2007, Dolce Company received from Meskel Company a Birr !
0,000, 60-day, 9 percent note dated May 4, 2007
(a) Determine the maturity date and value of the note
(b) On May 14, 2007 Dolce Company sold the note to Dashen Bank with a discount
rate of 10 percent. Determine the cash proceed received by Dolce Company.
(c) Pass the entry to record the collection of cash by Dolce Company
2. AT company uses the allowance method of recording uncollectibleaccounts expense. Sales
in the year 2007 were Birr 750,000 and the Accounts Receivable account had a Birr
350,000 balance on December 31, 1995. The Allowance for Dpoubtful Account had a
credit balance of Birr 3000 on the same date.
Required:
(a) What adjustment journal entry would be recorede on December 31, 2007 if (i) the
company estimates its uncollectible accounts to be 1% of the year's sales (ii) the
company estimates 55 of the receivables balance on December 31 will be
uncollectible.
(b) On January 15, 2008 it was decided that Almex Company's account in the amount
of Birr 500 is uncollectible.
(c) On February 12, 2008 Almex Company sent a check for Birr 300

7.5.2 Direct Write – off Method of Accounting for Uncollectible.

Some business enterprises do not use any contra account for accounts receivable. Instead
of making an end of year adjusting entries to record uncollectible accounts expenses on
the basis of estimates, these businesses recognize no uncollectible account expense until
specific charge customers are identified to be worthless.

One of the drawbacks of this method is that, it makes no attempt to match revenue and
related expenses, because uncollectible accounts expense is recorded in the period in

220
which individual accounts receivable are determined to be worthless rather than in the
period in which the sales were made.

When a particular customer’s account is determined to be uncollectible, it is written of

directly to uncollectible account expense as follows:

Uncollectible Accounts Expense…………… 150.00

Accounts Receivable (Abebe) ………… 150.00
To reinstate account written of earlier in the year.

 When the direct – write – off method is used the Accounts Receivable will be
listed on the balance sheet at their gross amount, and no valuation allowance
will be used. The receivables therefore are not stated at estimated realizable
value.
 If an account that has been written – off is collected later, the account should
be re- instated as follows:

Accounts receivable (Abebe)……………. 150.00

Uncollectible Accounts expense….. 150.00
To reinstate account written of earlier in the year.

The receipt of cash would also be recorded in the usual manner by:
Debiting: Cash… … ……….. 150.00
Crediting: Accounts Receivable (Abebe)……………….. 150.00
To record collection of cash

When an account that has been written off is collected in a later fiscal period, it may be
re- instated in the same way, or an alternative may be credit Recovery of Uncollectible
Accounts Written – off. The credit balance in such an account at the end of the year may
then be reported on the income statement as a deduction from Uncollectible Accounts
Expense.

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Check Your Progress: Exercise 7.9
1. The Birr 1000 balance of an account owed by a customer is considered to be
uncollectible and is to be written off. Give the entry to record the writ-off in the
general ledger
(a) assuming that the allowance method is used, and
(b) assuming that the direct-write off method is used
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

2. Which of the two methods of estimating uncollectible, when advance provision

for uncollectible receivables is made, provides for the most accurate estimate of
the current realizable value of the receivables?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________

7.6 Model Examination Questions

Part I. Answer the following short answer questions
1. What are trade receivables?
2. What are the advantages to the creditor, of a note receivable in comparison to
an accounts receivable?
3. Which of the two methods of accounting for uncollectible accounts provides
for the recognition of the expense at the earlier date?
4. What kind of an account (asset, liability, etc.) is Allowance for doubtful
accounts, and is its normal balance a debit or a credit?

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Part II. Work out the following questions
1. After the accounts are adjusted and closed at the end of the fiscal year
Accounts Receivable has a balance of Birr 317, 500 and Allowance for
Doubtful Accounts has a balance of Birr 9,750.

(a) What is the expected realizable value of the accounts receivable?

(b) If an account receivable of Birr 1,500 is written off against the
allowance account, what will be the expected realizable value of the
accounts receivable after the written-off, assuming that no other
changes in either account have occurred in the meantime?

2. Beza Company holds a 120 – day, 12% note for Birr 100,000, dated
September 19, that was received from a customer on account. On November
20, the note is discounted at Dashen Bank at the rate of 15%.
(a) Determine the maturity value of the note
(b) Determine the number of days in the discount period
(c) Determine the amount of the discount
(d) Determine the amount of the proceeds
(e) Present the entry in general journal form to record the discounting of
the note on November 20.

List of Reference Materials

1. Introduction to Accounting, 21st Century
2. Dyckman, Dukes and Davis. (1995). Intermediate Accounting. Third Edition. Volume
I, Chapters 1 – 14. McGraw Hill Companies, Inc.,
3. Fees and Warren, Accounting Principles. 16th edition. South – Western Publishing
Company.
4. Fees and Warren, Accounting Principles. 18th edition. South – Western Publishing
Company.

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ANSWERS TO CHECK YOUR PROGRESS QUESTIONS
UNIT ONE
Exercise 1.1
1. Accounting has been known as a “language of business” because of the fact that it can
be viewed as an information system. It provides relevant information about the
financial operations of an entity to various individuals or groups for their use in
making informed judgments and decisions.
2. Most importantly, the objective of accounting is mainly used to record, summarize,
report, and interpret economic data for use by many groups within the economic and
social system.

Exercise 1.2
1. The basic difference between the private (or managerial accounting) and a public
accounting is:
 Private (or managerial accounting) is an area of accounting within a firm
be it a company or governmental (not-for-profit organizations) that
involves such activities as cost accounting, budgeting, internal auditing,
and accounting information systems. A private accountant is an employee
of a firm who provides professional services on a salary basis.

224
  As against private accounting, public accounting is an area of accounting
in which the accountant offers expert (professional service to the general
public on a fee basis. The major portion of public accounting practice is
involved with auditing.
2. The following are some of the specialized fields of accounting activity: financial
accounting, cost accounting, managerial accounting, auditing, tax accounting,
budgetary accounting, accounting systems, accounting instructions, etc.

Exercise 1.3
1. Business entity concept emphasizes that economic events can be identified with a
particular unit of accountability. The particular unit (economic entity) can be a
business enterprise, governmental unit, not-for-profit organization, and an
individual or family unit. This concept requires that the activities of the entity be
kept separate from the activities of its owner and other economic entities.
2. Basically, equities are claims against assets of a firm. Equities may be subdivided
into two principal types.
 The rights of creditors represent debts (liabilities) of the business. Where
as, the rights of the owner or owners are owner’s equity (residual equity).

Exercise 1.4
1. The three elements of accounting equation are assets, liabilities, and owner’s
equity
2. An enterprise’s total assets: Total liabilities plus owner’s equity
Total assets = Birr 50,000 + Birr 250,000
= Birr 300, 000
Exercise 1.5
1. The following are the financial statements of a service giving enterprise:
i) Income Statement

225
 ii) Statement of Owner’s Equity
iii) Balance Sheet, and
iv) Statement of Cash Flows.

2. The following are three types of activities which are reported in the cash flows
statement
i) Operating activities,
ii) Investing activities and
iii) Financing activities.

UNIT TWO
Exercise 2.1
1. Accounts in a ledger are classified based on common characteristics usually;
accounts in the ledger are listed in the order in which they appear in the financial
statements. Balance sheet accounts are classified as assets liabilities, or owner’s
equity. Income statements accounts are classified as revenues or expenses.
2. Chart of accounts is a listing of accounts and the account numbers which identify
than location in the ledger.

Exercise 2.2
1. No. Because the terms debit and credit mean left and right respectively. These
terms do not mean increase or decrease. They can help to record as increase or
decrease depends on the nature of accounts. For example, assets would increase
through debit side and decrease though credit side.
2. The type of record traditionally used for the purpose of recording individual
transactions is an account. Whereas, the group of accounts maintained by a firm is
referred as the ledger.
Exercise 2.3
1. It is a business documents (paper) such as a sales ticket, a bill, or a cash register
tape.

226
 2. Steps involved in business transaction analysis are:
i. Identify the names of accounts affected
ii. Determine whether the accounts affected increases or decrease.
iii. Determine whether the effect of the transaction should be recorded as a
debit or a credit.
Exercise 2.4
2. A trial is a list of accounts and their balances at a given time. Besides, a trial
balance is a test for the equality of debits and credits in the ledger.
3. Errors which are not detected (discovered) by the trial balance are:
i. when a transaction is not journalized
ii. When a correct journal entry is not posted.
iii. When a journal entry is posted twice
iv. Recording the same incorrect amount for both the debit and the credit parts of
a transaction.
v. Posting a part of a transaction correctly as a debit or credit but to the wrong
account.

UNIT THREE
Exercise 3.1
1. Matching principle is one of the generally accepted accounting principles which
require the accrual basis of accounting, so that revenues recognized in the accounting
period are matched with the related expenses incurred in producing the revenues.
2. Under the accrual basis of accounting, revenues are reported in the period in which
they are earned, and expenses are reported in the period in which they are incurred in
an attempt to produce revenues.

Exercise 3.2
1. At the end of an accounting period, adjusting entries usually made to up date the
balance sheet and income statement accounts. This procedure brings the ledger into
agreement with the data reported on the financial statements.

227
2. The purpose of an adjusted trail balance is to prove the equality of the total debit
balances and the total credit balances in the ledger after all adjustments have been
made

Exercise 3.3
1. A Work sheet is a multiple column form that may be used in the adjustment process
and in preparing financial statements. A work sheet is a type of working paper
frequently used prior to preparation of financial statements. Basically, a work sheet is
not a permanent accounting record just like a journal or a ledger account.
2. No. Because work sheet is merely a plan (working paper) used to make it easier to
prepare financial statements.

Exercise 3.4
The following are the five steps involved in the preparation of a work sheet:
(1) Prepare a trial balance on the work sheet.
(2) Enter the adjustments in the adjustment columns
(3) Enter the adjusted balances in the adjusted trial balance columns
(4) Extend the adjusted trial balance amounts to appropriate financial statement
columns.
(5) Total the statement columns, compute the net income (or net loss), and complete
the work sheet
(6) The purpose of an income statement is to summarize the revenue and the expenses
of a business entity over a specified period of time, such as a month or a year.

Exercise 3.5:
1. At the end of an accounting period, closing entries are required to transfer the
temporary account balances to the permanent owner’s equity account. On top of
that, closing entries produce a zero balance in each temporary account, so that it
can be used to accumulate data in the subsequent accounting period.
2. Income summary account helps to close the account balances of revenues and
expenses. Since revenue and expenses accounts are directly transferred their

228
 balances to the income summary account, owner’s equity account would be saved
from being cluttered with excessive detail.

UNIT FOUR
Exercise 4.1
1. A merchandising business is different from a service business in that whereas a
service business renders services to its clients, a merchandising business buys
merchandise for resale to customers.
2. Purchases

Exercise 4.2
1. A cash discount is granted by the seller of merchandise for early payment of
invoice by the buyer. The seller grants a certain percentage of cash discounts to
encourage the buyer to make prompt payment.
2. The term 1/10, n/30 means that even though the credit period is 30 days, the buyer
will be allowed a 1% cash discount if payment is made within 10 days after the
invoice date.
Exercise 4.3
1. (a) Birr 15,000 – Birr 3000. Net invoice amount is Birr 12,000
If payment is made within the discount period, the amount of cash required for
payment is: Birr 12,000 – [Birr 12,000 *0.02]
= Birr 12,000 – Birr 240
= Birr 11,760
2. Purchases Returns and Allowances account is credited for the returns and
Purchases Discounts account is credited for the discounts.
Exercise 4.4
1. The accounts affected are:
 Cash – increased and debited
 Sales Discounts – increased and debited, and
 Accounts Receivable – decreased and credited

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Exercise 4.5
1. Sales Returns and Allowances and Accounts Receivable or Cash accounts are
affected
2. (a) The amount of the refund is Birr 4000 – (Birr 4000 * 0.02) = Birr 3,920

(b) Sales Returns and Allowances ………………… 4000

Cash ………………………………………. 3,920
Sales Discounts …………………………… 80

Exercise 4.6
1. (a) The buyer
(b) The seller

2. (a) Birr 20,000

(b) Birr 21,500
(c) Birr 600
(d) Birr 20,000 – Birr 600 + Birr 1,500 = Birr 20,900
Exercise 4.7
1. (a) The liability of sales tax is recorded at the time of sale not at the time of
collection
(b) Amount of sale is Birr 9000
(a) Amount debited to Accounts Receivable, Birr 9,360
(b) Sales Tax Payable
Exercise 4.8
1. In periodic inventory system
2. Because under periodic inventory system the cost of goods sold (or cost of sale) is
computed only after the cost of ending inventory is determined. From the total
cost of merchandise available for sale cost of ending inventory is subtracted to

230
 determine the cost of goods sold. Hence, it is a residual amount. This
characterization is appropriate under the periodic inventory system.

3. Under the periodic inventory system,

 the weighting, counting, and assigning values to the inventories are made
at the end of the fiscal period
 the revenues from sales are recorded when sales are made
 no attempt can be made on the sales date to record the cost of goods sold
 the cost of merchandise purchases are recorded in the Purchases account
 it is only at the end of the fiscal period that the determination of the cost of
ending inventory and goods sold are made.

Exercise 4.9
(a) a deferral (b) (1) asset, and (4) expense accounts will be affected
Exercise 4.10
1. (a) Cash ........................................................ 24,000
Unearned Advertising................. 24,000
(b) Unearned Advertising .............................. 2,000
Advertising Income .................. 2,000
(c) Not required!
2. (a) Cash .......................................................... 24,000
Advertising Revenue .................. 24,000
(b) Advertising Income .................................. 22,000
Unearned Advertising .................. 22,000
(c) Unearned Advertising................................ 22,000
Advertising Revenue .................. 22,000
Exercise 4.11
(a) the Birr 1,200 represents an accrual as of Dec., 31
(b) liability and expense are affected by the adjusting entry
(c) Birr 2,000 of the salary will be allocated to January

231
 Exercise 4.12
1. (c), 2. (a), 3. (b), 4. (d), 5. (a), 6. (b), 7. (d), 8. (d)
Exercise 4.13
Adjusting entries to be made in the books of Naod Company:
Interest Receivable .......................................... 12,400
Interest Earned .................................... 12,400
Office Supplies............................................... 3,000
Supplies Expense................................ 3,000
Advertising Expense....................................... 23,100
Advertising Payable ........................... 23,100
Rent Income ................................................... 36,000
Unearned Rent..................................... 36,000
Answers to Review Exercise – UNIT FOUR
Exercise 1. (a) Cash …………………………………… 5000
Sales ……………………………... 5000
(b) Accounts Receivable ………………….. 10,000
Sales ……………………………… 10,000
Exercise 2. Nov. 1. Accounts Receivable ………………… 8000
Sales ……………………………… 8000
Nov. 3. Accounts Receivable ………………… 200
Cash ………………………………. 200
Nov. 6. Sales Returns and Allowances ………. 500
Accounts Receivable ……………… 500
Nov. 10. Cash …………………………………. 7,550
Sales Discounts ……………………… 150
Accounts Receivable ……… 7,700
Exercise 3. (a) Purchases ………………………………….. 30,000
Accounts Payable …………………. 30,000

(b) Accounts Receivable ………………………. 21,000

Sales ………………………………… 20,000

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 Sales Tax Payable …………………… 1000
(c) Accounts Payable …………………………… 30,000
Cash …………………………………. 29,700
Purchases Discounts ………………… 300
(d) Sales Tax Payable …………………………… 4,560
Cash …………………………………. 4,560
Exercise 4. (a) Mason’s Ending Inventory = Cost of Merchandise Available for Sale –
Cost of Goods Sold
= Birr 223, 000 – Birr 191, 000
= Birr 32, 000

(b) Cost of Goods Sold:

Beginning inventory, January 1, 2007 ………………………… Birr 36,000
Purchases during the period …………………….. Birr 180,000
Less: Purchases Returns and Allowances … Birr 2,500
Purchases Discounts ………………… 500 (3,000)
Net Purchases during the period …………… Birr 177,000
Add: Freight – In ………………………….. 10,000
Total Cost of Merchandise Purchased …….. 187,000
Total cost of merchandise Available for sale Br 223,000
Less: Ending Merchandise Inventory ……… (32,000)
Cost of Goods Sold ………………………… Br. 191,000

UNIT FIVE
Exercise 5.1
1. The accounting system of an enterprise is often called an information system
because it provides useful information about the financial activities of an entity to
various individuals or groups for their use in making sound economic decisions.

233
 2. Accounting system refers to the way in which management is given the
information for use in conducting the affairs of the business and reporting to
owners, creditors and other interested parties. In general, an accounting system
includes the entire network of communications used by a business organization to
provide needed information.

Exercise 5.2
1. In the process of preparing and providing useful information costs are incurred.
The management of the enterprise should always be careful that the cost of the
reports produced should not exceed the benefits to be gained by those who use it.
Thus, cost is the major consideration in developing accounting information.

2. Internal control is defined as a process affected by an organization's structure,

work and authority flows, people and management information systems, designed
to help the organization accomplish specific goals or objectives. It is a means by
which an organization's resources are directed, monitored, and measured. It plays
an important role in preventing and detecting fraud and protecting the
organization's resources, both physical (e.g., machinery and property) and
intangible (e.g., reputation or intellectual property such as trademarks).

Exercise 5.3
1. The objective of systems analysis is to determine information needs, the sources
of such information, and the deficiencies in procedures and data processing
methods presently used.
2. Systems designers should have a sound knowledge of the qualities of different
kinds of data processing equipment, and the ability to evaluate alternatives.
Furthermore, s/he should be creative, imaginative, and capable in dealing with
things.

Exercise 5.4

234
 1. The knowledge that job rotation is practiced and one employee may perform
another's job at a later date tends to discourage deviations from prescribed
procedures. Also rotation helps to disclose any irregularities that may occur.
Moreover, it helps employees to broaden their knowledge of the system.
2. The three elements of internal control structure are:
(i) The control environment
(ii) The control procedures, and
(iii) The accounting system
Exercise 5.5
1. Internal auditors, who should be independent of the employees responsible for
operations, periodically review and evaluate the internal control system to determine
that the internal control principles are being effectively applied. They report
weaknesses and recommend changes to correct them.
2. The responsibility for maintaining the accounting records should be separated from the
responsibility for operations so that the accounting records can serve as an
independent check on operations.
3. The pre-numbering of checks and the paying of all obligations by check are desirable
elements of internal control, although the proper use of a petty cash fund for small
cash disbursements would be useful; and would not weaken the system. The basic
weakness in the internal control is the failure to separate the responsibility for the
maintenance of accounting records (bookkeeping) from the responsibility for operatio
ns (payment of obligations).

UNIT SIX
Exercise 6.1
1.
(a) The cash short is recorded in the cash short and over account
(b) The cash shortage is debited to the cash short and over account.
3. in the other income section of the income statement
Exercise 6.2
1. (a) Change fund ..................................... 600.00

235
 Cash in Bank.................... 600.00

(b) Cash in Bank .................................... 10,320.35

Cash short and over ......................... 7.40
Sales................................ 10,327.75
Exercise 6.3
1. Because cash is the most liquid asset that can be easily misappropriated and
embezzled by the employees in the organization. Furthermore, cash is subject to
theft.
Exercise 6.4
1. (a) Petty cash fund debited and cash in bank credited
(b) The various expenditures debited and cash in bank credited

2. (a) Petty cash .......................................... 750.00

Cash in Bank.......................... 750.00
(b) Office supplies .................................. 282.15
Miscellaneous selling expense ......... 180.60
Miscellaneous administrative expense 258.70
Cash in Bank ......................... 702.70
Cash short and over.............. 18.75
Exercise 6.5
(a) A drawer is the person or an organization who signs the check
(b) A payee is the person or an organization to whose order the check is payable
(drawn).
Exercise 6.6
1.
(1) Added to the balance as per the depositor's record
(2) Added to the balance as per the bank statement
(3) Deducted from the balance as per the bank statement
(4) Deducted from the balance as per the depositor's record
(5) Deducted from the balance as per the depositor's record

236
 (6) Deducted from the balance as per the depositor's record
2. Items that necessitates journal entry in the depositor's record are: (1), (4), (5), and (6)

Exercise 6.7
1. Items reported on the bank statement as credits represent additions made by the
bank statement to the depositor's account.
2. Bank reconciliation is prepared by the depositor to determine the reasons for any
discrepancy between the depositor's records and the bank statement balance and
to correct any errors that may have been made either by the depositor or by the
bank.
3. Accounts Receivable account is debited and Cash in Bank is credited

4. (a) Ghibe Company

Bank Reconciliation
June 30, 2008
Balance per bank statement........................................................... Birr 20,513.90
Additions: Deposit in transit ......................................................... 4,207.85
Subtotal............................................................................. 24,721.75
Deductions: Outstanding checks total................. Birr 5,980.15
Bank error ....................................... 18.00 (5,998.65)
Adjusted balance................................................. Birr 18,723.10
Balance per depositor's records........................... Birr 15,215.80
Additions: Notes collected by bank including interest 4,080.00
Subtotal..................................................... Birr 19,295.80
Deductions: Bank service charge.......................... Birr 55.50
NSF checks ....................................... 517.20 (572.70)
Adjusted balance, June 30, 2008........................... Birr 18,723.10

(b) Journal entries required as a result of the June Bank Reconciliation:

237
 June 30. Cash in Bank ................................................. 4080.00
Notes receivable .................................. 4000.00
Interest Income .................................... 80.00
To record Notes collected by bank
30. Administrative Miscellaneous expense ......... 55.50
Cash in Bank......................................... 55.50
To record Service charge

30. Accounts Receivable .................................. 517.20

Cash in Bank ........................................ 517.20
To record NSF Check returned by bank

Answer to Review Exercise – UNIT SIX

1. (a) The remittance advises should not be sent to the cashier
(b) The remittance advises should be sent directly to the accounting department by
mail clerks
2. (a) The sales clerks should not have access to the cash register tapes.
(b) The cash register tapes should be locked in the cash register and the key retained by
the cashier. An employee of the cashier's office should remove the cash register
tape, record the total on the memorandum form, and note discrepancies.

3. (a) Surbo Company

Bank Reconciliation
January 31, 2008
Balance per bank statement January 31, 08................................................ Birr 23,713.90
Additions: Deposit in transit....................................................................... 8,720.50
Subtotal.............................................................................................. Birr 32,434.40
Deductions: Outstanding checks totaled..................... Birr 4,570.20
Bank error ........................................... 27.00 (4,597.20)

238
Adjusted balance, January 31, 2008............................ Birr 27,837.20
Balance per depositor's records, January 31, 2008.... Birr 23,071.30
Additions: Bank credit memo for notes collected
including interest..................................... Birr 5,119.25
Depositor's error ..................................... 196.65 5,315.90
Subtotal........................................................... Birr 28,387.20
Deductions: Bank debit memorandum for:
 Service charge.................................................. Birr 50.00
 NSF check returned by bank............................ 500.00 (550.00)
Adjusted balance, January 31, 2008............................ Birr 27,837.20

(b) Journal entries required as of January 31, 2008:

January 31. Cash in Bank......................................... 5,119.25
Notes receivable.................... 5,000.00
Interest Income ................... 119.25
31. Cash in Bank......................................... 196.65
Sales .................................... 196.25
31. Administrative Miscellaneous expense. 50.00
Cash in Bank....................... 50.00
31. Accounts Receivable ............................ 500.00
Cash in Bank ...................... 500.00

UNIT SEVEN
Exercise 7.1
1. The note represents a strong legal claim than a claim in the form of accounts
receivable

239
 2. It is more liquid than a claim in the form of accounts receivable
3. Some notes also produce interest income.

Exercise 7.2
1. May 24 2. March 11
Exercise 7.3
1. Birr 166.67
Exercise 7.4
1. Birr 4,864 2. Birr 4,800

Exercise 7.5
1. (a) Birr 5000 (b) Birr 5,166.67 (c) December 11 (d) 40 days (e) Birr
5,086.30 (f) Interest Income of Birr 86.30 (g) Birr 5,166.67
(h) Cash ................................................ 5,086.30
Notes Receivable....................... 5000.00
Interest Income ......................... 86.30
2. (a) Birr 250.00 (b) Birr 20,250 (c) September 15 (d) Birr 20,148.75
(e) Cash ................................................ 20,148.75
Notes Receivable ............... 20,000.00
Interest Income ................... 148.75
Exercise 7.6
1. Accounts Receivable............................... 4,091.67
Notes Receivable ................... 4000.00
Interest Income ...................... 91.67
2. Accounts Receivable.................................. 15,950
Notes Receivable ................... 15,000.00
Interest Income ...................... 900.00
Protest Fee............................. 50.00

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Exercise 7.7
1. (a) Birr 30,000
(b) Birr 22,500
Exercise 7.8
(a) Birr 11,750 – Birr 1,050 = Birr 10, 700
(b) Birr 900 + Birr 10,100 = Birr 11,000

Answer to Review Exercise – UNIT SEVEN

1. (a) Maturity date July 3 and maturity value is Birr 10,150
(b) proceeds on the note is Birr 10.009.03
(c) Cash .................................... 10,009.03
Notes Receivable ......................... 10,000.00
Interest Income ............................ 9.03
2. (a) (i) Uncollectible Accounts Expense ........... 7,500.00
Allowance for Doubtful Accounts. 7,500.00
(ii) Uncollectible Accounts Expense........ 14,500.00
Allowance for Doubtful Accounts.... 14,500.00
(b) Allowance for Doubtful Accounts................ 500.00
Accounts receivable ...................... 500.00
(c) Accounts Receivable (Almex)...................... 300.00
Allowance for Doubtful Accounts 300.00
Cash ............................................................ 300.00
Accounts Receivable.................... 300.00

Exercise 7.9
1. (a) Allowance for Doubtful Accounts............... 1000.00
Accounts Receivable..................... 1000.00
(b) Uncollectible Accounts Expense................. 1000.00
Accounts Receivable ..................... 1000.00

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