Gage Bussiness College

Account and Budget Service Level III

Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.

UNIT ONE THE ACCOUNTING CYCLE

1.1. Aims & Objectives

1.2. Introduction

1.3. Nature of an Account

1.4. Classification of Accounts

1.5. Chart of Accounts

1.6. Rules of Debits and credits

1.7. Journalizing Business Transactions

1.8. Posting From the Journal to the Ledger

1.9. The Trial Balance

1.9.1. Proof provided by the Trial Balance

1.9.2. Limitations of the Trial Balance

1.10. Adjustments

1.10.1. The Accrual Basis and Cash Basis of Accounting

1.10.2. The Matching Principle

1.11. Worksheet for Financial Statements

1.12. Financial Statement Preparation

1.13. The Closing Process

1.14. Post Closing Trial Balance

1.0 AIMS & OBJECTIVES

By the time you have finished this unit you should be able to:

Explain the meaning and nature of an account.

apply debits and credits to record business transactions

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
Define the terms journal, ledger, journalizing, posting, trial balance etc.

complete the accounting cycle

1.1 INTRODUCTION

In unit 1, you have learned the relationship between the accounting equation and
business transactions. Every business transaction affects the elements of the accounting
equation. This accounting procedure will be discussed in detail. The different and
interrelated stages of the accounting cycle will be presented. The chapter is lengthy, but
essential for the remaining chapters in this course and other accounting courses.
Therefore, you are advised to study the chapter carefully.
1.2 NATURE OF AN ACCOUNT

In order to provide the necessary information to users, accountants maintain separate

records on each element of the financial statements. For example, to report the balance
for cash at the end of a year, a record regarding cash should be kept. The record
includes beginning cash balance, cash payments & cash collections during the period.
This record is called an account.
account.

Definition: An account is a subdivision under the three elements of the accounting

equation used to record the changes over a single element in the financial statements.
An account has three parts, Title, Debit, and credit. For illustration purposes an account
can be represented in the form of capital letter ‘T’.

Example
Title
Debit Credit
Dr Cr

1.3 CLASSIFICATIONS OF ACCOUNTS

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
Accounts are classified into five: assets, liabilities, capital, and revenue and,
expenses.
expenses. The first three are called balance sheet accounts and the other two are
called income Statement accounts.
accounts. Balance Sheet accounts are those reported on
the balance sheet at the end of the reporting period and Income Statement accounts are
reported on the Income Statement.
The five groups of account are discussed below
1. Assets: Resources owned by a business or individual are called assets.
assets. Assets
could be tangible or intangible. Tangible assets are assets having physical
existence, like cash, land, computer, stationery materials. Intangible assets do not
have physical existence. Example: Goodwill, Copyright, patent right.

On the balance sheet assets are classified into two current assets and non – current
assets.
Current Assets – are those assets, which can be used, sold, or converted into
cash within one accounting year. Example: cash, supplies, prepayments,
receivables etc.
Non-current Asset: All assets other than current assets are called non-current
assets. Example: land, patent right, office equipment, vehicles.
2. Liabilities: Creditors’ claims to the assets of a business; amounts owed to
creditors are called liabilities. Like assets, liabilities are classified in to two as
current liabilities and non – current liabilities
Current liabilities: The liabilities that are payable within the next (one)
accounting year are known as current liability. Example: Accounts Payable, Rent
Payable, Salary Payable.
Non – Current Liabilities: Debts that are not required to be paid within the next
accounting period. Example long term notes payable.
3. Capital: The excess of the assets of a business over its liabilities is referred to as
capital. It is the equity of the owner in the business.
4. Revenue: Are increases in owner’s equity resulting from the main operations of
the business. Examples of revenue accounts are sales, interest income, tuition fee,
and sales commission.

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
5. Expenses: are decreases in owner’s equity in the process of earning revenue.
For example, a hotel has to pay salary to its workers for the services rendered to
clients in order to get the income form customers (revenue) the Hotel has pay
salary to the employees (expense). Example of expenses: Salary, insurance,
depreciation, supplies, utilities, rent etc.
1.4 CHART OF ACCOUNTS

The number and name of accounts used by an organization depends on the nature of its
operation. The list of accounts used by an organization and their codes is called the
chart of accounts. Look at the following chart of accounts of Bati Transport.
Bati Transport
Chart of Accounts
Asset
Cash---------------------------------------------------------------------------------------------------------------------
---------11
Accounts
Receivable----------------------------------------------------------------------------------------------------------
12
Supplies----------------------------------------------------------------------------------------------------------------
---------13
Prepaid
Insurance--------------------------------------------------------------------------------------------------------------
14
Equipment-------------------------------------------------------------------------------------------------------------
---------15
Accumulated Depreciation
–Equipment-----------------------------------------------------------------------------------16
Truck--------------------------------------------------------------------------------------------------------------------
--------17
Accumulated depreciation –
Truck-----------------------------------------------------------------------------------------18
Liabilities

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
Accounts
Payable--------------------------------------------------------------------------------------------------------------21
Notes
Payable-----------------------------------------------------------------------------------------------------------------
-22
Owners Equity
Yimer Adem,
Capital----------------------------------------------------------------------------------------------------------31
Yimer Adem
Drawing---------------------------------------------------------------------------------------------------------32
Income
Summary--------------------------------------------------------------------------------------------------------------
33
Revenue
Service
income-----------------------------------------------------------------------------------------------------------------
41
Expense
Salaries Expense
--------------------------------------------------------------------------------------------------------------51
Rent Expense
------------------------------------------------------------------------------------------------------------------52
Utilities
Expense---------------------------------------------------------------------------------------------------------------
53
Supplies
Expense--------------------------------------------------------------------------------------------------------------
54
Insurance
Expense-------------------------------------------------------------------------------------------------------------55

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
Maintenance
Expense---------------------------------------------------------------------------------------------------------56
Depreciation
Expense---------------------------------------------------------------------------------------------------------57
Truck
Expense----------------------------------------------------------------------------------------------------------------
--58
Miscellaneous
expense--------------------------------------------------------------------------------------------------------59
In the chart of accounts, the asset accounts are listed according to their liquidity.
Liquidity is the ease with which an asset can be converted in to cash. Cash is the most
liquid asset so it is listed first. Accounts other than cash will be listed in their frequency
of use or in alphabetical order.
The account number is a code to identify accounts. The number could be a two digit,
three digit or more digits. In the above example a three – digits code is used.
When the chart of accounts is prepared in an organization we say the ledger is opened.
1.5 RULES OF DEBITS AND CREDITS
As shown above every account has three parts. These parts are discussed below:
Title – The name of the account. This is written at the top of the account.
Debit – is the left hand side of an account –Debit is abbreviated as ‘Dr.’. When an
amount is entered on the left side of an account we say the account is debited or
charged.
charged.
Credit – is the right hand side of an account. Credit is abbreviated as Cr. An
account is said to be credited when an amount is entered on the right hand side
of the account.
An account may increase or decrease on the debit side or on the credit side
depending on the nature of the account. In general, accounts appearing on the left hand
side of the accounting equation increase on their left side (Dr. side) and decrease on
their right side (Cr. Side); whereas accounts on the right side of the equation increase on
their right side and decrease on their left side.
The above general rule will be expanded as follows

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
Debit Credit
Increase in assets Decrease in assets
Increase in expenses Decrease in expenses
Decrease in capital Increase in Liabilities
Decrease in liabilities Increase in liabilities
Decrease in revenue Increase in revenue.
The normal balance of an Account
Normal balance refers to the side of an account (Dr. or Cr.), which will have greater
entries than the other. The increasing side will be the normal balance for accounts.
Example: The normal balance of all asset accounts is debit
1.6 JOURNALIZING BUSINESS TRANSACTIONS
When a business transaction takes place, source documents will be obtained and
recorded. The accounting record in which a transaction is initially recorded is known
as a journal.
journal. The journal is therefore referred to as “The book of original entry”. The
process of recording a business transaction in the accounting record is called
journalizing.
journalizing.
The Journal commonly used to record all types of transactions is the General Journal.
This Journal includes the following parts, entered step by step.
1. The date of the transaction
2. The title of the account debited
3. The title of the account credited
4. The amount of debit and credit
5. Brief explanation of the entry or reference to the source document.
Look at the following General Journal and notice where each of the above information is
found.
General Journal
Page
Date Description P.R Debit Credit
Year da Debited account title XXX XX
Month y
Credited account title X XX XX
Explanation

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
There are also other types of Journals like, known as special journals that are used to
record specific types of transactions. The cash Journal, for instance, is used to record
only transactions affecting cash. The General Journal is used for illustrations in this
chapter. Special journals are discussed in unit 5.
Steps in Journalizing a Transaction
The following steps should be followed in recording a transaction in the journal.
1. Record the date - Insert the year, the month, and the date as shown above.
2. Record the Debit- Insert the account debited in the description column and the
amount of debit in the debit column.
3. Record the credit- Insert the account credited below the debited account and
indented to the right in the description column and the amount of credit in the
credit column.
4. Explanation- Write a brief explanation or reference to source document in the
description column, when necessary. Each one set of debits and credits for a
transaction is called a journal entry.
entry.
In recording a business transaction answer the following questions based on the
transaction to be recorded may help you.
a) Which accounts are affected?
b) Is each account increased or decreased?
c) Which account is debited and which is credited?
d) Prepare the complete journal entry.
Example. On January 10,2003 Tamget P.L.C paid Birr 6,000 to its employees as a salary
for the first week of the year.
This business transaction will be analyzed and recorded as follows.
A. Which accounts are affected? Answer: Cash and Salary Expense.
B. Is each account increased or decreased? Answer: cash is decreased and salary
expense is increased.
C. Which account is debited and which is credited? Answer: Salary Expense is
debited because increase in expenses is recorded on the debit side. And cash is
credited because decrease in assets is recorded on the debit side.
D. Prepare the complete Journal entry.
Date Description P/R Debit Credit
2003 1 Salary expense 600 00
0 0
Jan. Cash 600 0

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
0 0
Note: A journal entry is the complete presentation of the record in the journal.

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
Check Your Progress Exercise - 2

Journalize the following transaction by answering 4 questions suggested above.

Illustration

To illustrate the complete accounting cycle, we will consider the following list of selected

transactions. The transactions were completed by Bati Transport in the month of

January 2003.

January 1. Ato Yimer took Birr 450,000 from his personal savings and deposited it in the

name of Bati transport.

January 2. Bati Transport purchased two used trucks for Birr 150,000 each, on cash.

January 4. Bati Transport received a check for Birr 650 for services given to Alem

Trading.

January 4. Received an invoice for truck expenses Birr 90.

January 11. Paid Birr 600 for Awash Insurance Company to buy an insurance policy for

its trucks.

January 16. Ato Yimer issued a check for Birr 9,400 to the workers as a salary for two

weeks.

January 20. Bati trading Billed Muradu Supermarket for goods transported from Djibouti

to Gondar Birr 2,650

January 21. Ato Yimer wrote a check for birr 450 to have one of the trucks repainted

January 21. Bati trading purchased stationary materials and other supplies of Birr 740 on

account

January 22. Office equipment of Birr 11,600 is bought on account.

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
January 23. Purchased an additional truck for Birr 250,000 paying birr 100,000 in cash

and issuing a note for the difference.

January 23. Recorded services billed to customers on account birr 14,600.

January 25. Received cash from customers on account Birr 15,000.

January 27. The owner withdrew Birr 500 in cash for his personal use.

January 28. Paid Birr 9,400 to workers as a salary for the last two weeks of the month.

January 30. Paid telephone expense of Birr 95 and electric expenses of Birr 125 for the

month.

January 30. Paid other miscellaneous expenses Birr 50.

January 31. Paid Birr 4,000 as a rent for a building used for office space.

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.

These transactions are journalised as follows:

Date Description P/R Debit Credit

2003 Cash 450,000

Jan.1 Yimer Capital 450,000
To record investment by
owner
2 Truck 300,000
Cash 300,000
Purchase of trucks
4 Cash 650
Service Income 650
Cash received from
customers
4 Truck Expenses 90
Accounts Payable 90
Service received in advance
11 Prepaid Insurance 600
Cash 600
Purchase of insurance policy
16 Salary Expense 9,400
Cash 9,400
Payment of salary
20 Accounts Receivable 2,650
Service Income 2,650
Provision of service
21 Truck Expense 450
Cash 450
Cash paid to repaint truck
21 Supplies 740
Accounts Payable 740
Purchase of supplies of
account
22 Office Equipment 11,600
Accounts Payable 11,600
Purchase of equipment
23 Truck 250,000
Cash 100,000
Notes Payable 150,000
Purchase of truck
23 Accounts Receivable 14,600
Service Income 14,600
Provision of service on
account
25 Cash 15,000
Accounts Receivable 15,000
Collection of cash
27 Drawings 500
Cash 500
Owner withdrawals
28 Salary Expense 9,400
Cash 9,400
Payment of salary

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
30 Utilities Expense 220
Cash 220
Payment for telephone,
electricity
30 Miscellaneous Expenses 50
Cash 50
Payment for various expenses
31 Rent Expense 4,000
Cash 4,000
Payment of Rent

1.7 POSTING FROM THE JOURNAL TO THE LEDGER

After the information about a business transaction has been journalized, that information
is transferred to the specific accounts affected by each transaction. This process of
transferring the information is called posting.
posting.

An account could be of two types; the two-column account and the four-column account.
We will use the four-column account for our illustration. The two forms of accounts are
given below.
The two-column account:
Account Account number
Date Item P. Debit Date Item P. Credit
R R

The four-column account:

Account Account number
Date Item P. Debit Credit Balance
R Debit Credit

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
The steps in posting are given below:
1. Record the date and amount of Dr. and Cr. Entry to the account
2. Insert the Journal page number in the P.R (Post Reference) column of the account.
3. Insert the account number in the P.R column of the journal.
Note. The P.R Column is used for reference purposes. The P.R column of the journal
shows whether the entry is posted and the account to which it is posted. In the account,
the P.R Column shows the Journal page number from which the entry was brought. The
group of accounts used by an organization is called ledger.
ledger.
Illustration.
Illustration. As mentioned above, to illustrate the posting process the four column
account is used and the entries to the cash account are posted as follows.

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.

Account Cash Account Number

Balance
Date Item P.R Debit Credit Debit Credit
450,000 00 450,000 00
1
2 300,000 00 150,000 00
4 650 00 150,650 00
11 600 00 150050 00
16 9,400 00 140650 00
21 450 00 140200 00
2003
23 100,000 00 40200 00
Jan
25 15,000 00 55200 00
27 500 00 54200 00
28 9,400 00 45300 00
30 220 00 45,080 00
30 50 00 45,030 00
31 4,000 00 41,030 00

Note.
Note. The item column is usually left blank. In some cases the word balance is written
when the account is carried foreword to a new page.
1.8 THE TRIAL BALANCE

After the posting phase is completed, we have to verify the equality of the debit and
credit balances. This is done through the use of the ‘Trial Balance’. A trial balance is a
two column listing of the accounts in the ledger and their balance to make sure that the
total of debit balances equals the total of credit balances.
The trial balance for our illustration, Bati Transport is presented bellow. The amounts are
taken from the balances of the accounts after all the transactions have been posted.
Therefore, after posting the above transactions, you should get the final balances shown
on the trial balance in the end.
Bati Transport
Trial Balance
January 31, 2003
A/title Debit Credit
Cash 41,03 00
0
Accounts 2,250 00
Receivable
Supplies 740 00
Prepaid Insurance 600 00
Office equipment 11,60 00
0

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
Truck 550,0 00
00
Accounts payable 12,43 00
0
Notes payable 150,0 00
00
Yimer capital 450,0 00
00
Yimer drawing 500 00
Service income 17,90 00
0
Salary expense 18,80 00
0
Rent expense 4,000 00
Utilities expense 220 00
Maintenance 450 00
expense
Truck expense 90 00
Miscellaneous 50 00
expense
Total 630,3 00 630,3 00
30 30
1.8.1 Proof Provided by the Trial Balance

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

The trial balance amounts are equal doesn’t mean that the accounting work is free from
error. That is, there are errors that may take place without affecting the trial balance
totals. Some examples are mentioned below:
- Failure to record a transaction or to post a transaction

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
- Recording the same erroneous amount for both the debit and the credit parts of
a transaction.
- Recording the same transaction more than once.
- Posting part of a transaction to the correct side but the wrong account.
Note: All these errors have the same affect (increasing or decreasing) on the debit totals
and credit totals
1.9 ADJUSTMENTS

All the transactions recorded above in the journalizing step are the result of daily
transactions. Other transactions result from the passage of time or from the internal
operations of the business. For example, insurance premiums are paid for a certain
period of time and expire during that time period. Another example is office supplies
such as paper, pens & pencils.
At the end of the period the balances in accounts such as supplies and prepaid insurance
must be brought up to date. The supplies account balance, for example, must be
credited by the consumed part of the supplies, debiting supplies expense.
Example. Stationary materials totaling Birr 1,900.00 were purchased and recorded
during the year. At the end of the year, only Birr 150 of the supplies are left in hand.

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.

The adjusting entry prepared at the end of the year to adjust the supplies account will be
1990 Supplies expense 1,75
0
Dec31 Supplies 1,750
Note: 1. Adjustments are dated as the last day of the year.
2. The accounting year here – we assume, runs from January 1- December 31.
Additional examples on adjustments will be given below under the topic ‘worksheet’
1.9.1 The Accrual Basis and the Cash Basis of Accounting

1. The cash basis of accounting – In this basis of accounting revenues are reported in
the period in which cash is received and expenses are reported in the period in which
cash is paid. Net in come will, therefore, be the difference between the cash receipts
(Revenues) and cash payments (expenses). This method will be used by
organizations that have very few receivables and payables. For most businesses,
however, the cash basis is not an acceptable method.
2. The accrual basis of accounting – Under this method revenues are reported in the
period in which they are earned, and expenses are reported in the period in which
they are incurred. For example, revenue will be recognized as services are provided
to customers or goods sold and not when cash is collected. Most organizations use
this method of accounting and we will apply this method in this course.
1.9.2 The Matching Principle

We have discussed three concepts and principles in accounting in unit one. Now we will
see one more principle, the matching principle. This principle states that the expense of
a period have to be matched with the revenue of that period regardless of when
payment is made. In order to do this, the accrual basis of accounting requires the use of
an adjusting process at the end of the period so that revenues and expenses of the
period will be determined properly.
1.10 WORKSHEET FOR FINANCIAL STATEMENTS

Most of the data required to prepare the accounting reports (financial statements) is now
gathered. The data will now be presented in a convenient form. The worksheet is a

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 Gage Bussiness College
Account and Budget Service Level III
Prepare Financial Report
Chapter one: - Accounting for Service Rendering Company.
large columnar sheet prepared to arrange in a convenient form all the accounting data
required to prepare financial statements. The worksheet has a heading and a body.

The heading has three parts:

I. Name of the Organization
II. Name of the form (worksheet)
III. Period of time covered.
The body contains five main parts each of them with two main columns. These parts are
1. The trial balance
2. The adjustment
3. The adjusted trial balance
4. The income statement
5. The balance sheet.
The worksheet for Bati Transport is given below. The five parts of the body are
discussed as follows. You are advised to read and understand the discussions before you
look at the respective columns of the worksheet.

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 Bati Transport
Work Sheet
For th3e month ended Jan.31, 2003.
S.n Account Title Trial Balance Adjustment Adjusted Trial Income Balance
balance statement sheet
1 Cash 41,030 41,030 41,030
©
2 Accounts 2,250 7,40 9,650 9,650
receivable 0
(a)
3 Supplies 740 340 400 400
(b)
4 Prepaid Insurance 600 450 150 150
5 Office equipment 11,600 11,600 11,600
6 Truck 550,00 550,000 550,00
0 0
7 Accounts payable 12,430 12,430 12,430
8 Notes payable 150,00 150,00 150,00
0 0 0
9 Yimer Capital 450,00 450,00 450,00
0 0 0
10 Yimer drawing 500 500 500
©
11 Service income 17,900 7,40 25,300 2530
0 0
12 Salary expense 18,800 18,800 18,800
13 Rent expense 4,000 4,000 4,000
14 Utilities expense 220 220 220
15 Maintenance 450 450 450
expense
16 Truck expense 90 90 90
17 Miscellaneous 50 50 50
Expense
(a)
18 Supplies expense 340 340 340
(b)
19 Insurance expense 450 450 450
21 Total 630,3 630,3 7290 7290 636,83 636,8
30 30 0 30
22 Net income
23 Total 25300 2530 613,3 613,3
0 30 30
 1. The trial balance column – this is the same trial balance we have prepared
before. The trial balance column of the work sheet can be brought direct from the
ledger or from a separate trial balance.
2. The Adjustment column – As mentioned previously, some account balances
have to be adjusted at the end of the year. The accounts in the ledger of our
illustration that require adjustment and the adjusting entry for the accounts are
presented below.
A. Supplies:
Supplies: – The supplies account has a debit balance of Birr 740. The cost of
supplies in hand on July 31 is determined to be Birr 400. The following adjusting
entry is required to bring the balance of the account up to date:
Supplies expense .340
Supplies ..340
B. Prepaid insurance:
insurance: – Analysis of the policy showed that three – fourth of the
policy is expired. That is only Birr 150 of the policy is applicable to future periods.
The adjusting entry to transfer the expired part of the insurance to expense will be.
Insurance expense .450
Prepaid insurance ..450
C. Service Income:
Income: – At the end of the month unbilled fees for services performed to
clients totaled Birr 6,500.
This amount refers to an income earned but to be collected in the future. The journal
entry to record it will be
Accounts receivable .6,500
Service income 6,500
All the above adjusting entries will be inserted in the adjustment column of the
worksheet in front of the accounts affected.
Note – The letters a, b & c are used to cross-reference the debits and credits to
help future review of the worksheet.

3. The Adjusted Trial Balance Column – The accounts that require adjustment are
now adjusted. Transferring the trial balance column amounts combined with the
adjustment column amounts will complete the adjusted trial balance column of the
worksheet.

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 4. The income statement and the balance sheet columns – Transfer the income
statement account balances (revenue &expenses) to the income statement and
balance sheet account balances (Asset, Liability &owners equity) to the balance
sheet columns. Note that what we have to transfer is the adjusted trial balance
column amounts, to the corresponding columns.

Look at the 22nd row. It shows the net income for the month and it is added to the two
columns (Income statement Dr. and balance sheet cr.) as a balancing figure.

1.11 FINANCIAL STATEMENT PREPARATION

After the work sheet is completed financial statements could be prepared easily. In
chapter one we have discussed four basic financial statements prepared by most
organizations. Here, we will prepare three of these statements for Bati Transport form
the worksheet.
1. Income statement: - All the data required to prepare the income statement is
brought From the worksheet.
Bati Transport
Income statement
For the month ended. Jan 31, 2003
Service Income Birr 25,300
Operating expenses
Salary expense ..Birr 18,800
Rent “ .4,000
Maintenance expense 450
Insurance “ 450
Supplies “ .340
Utilities “ ..220
Truck “ .. .90
Miscellaneous “ 50
Total operating expense .. 24,400
Net Income .. .. Birr 900

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2. Statement of owner’s equity – This statement shows the beginning balance of
capital and the changes that affected it.
The balance of the owners equity account (Yimer capital) in the worksheet may not be
the beginning one. Therefore, the ledger has to be reviewed to see if there was an
additional investment during the priod or not. In our illustration there is no additional
investment.
Bati Transport
Statement of Owner’s equity
For the month ended January 31, 2003
Yimer capital January 1, 2003 .… .…0
Investment .450, 000
Net income for the month .birr 900
Less:
Less: Withdrawal ...500
...500 450, 400
Yimer capital, January 31, 2003 . . . .Birr 450,400

3. Balance sheet – The data to prepare this statement will be taken from the
worksheet and the other financial statements. Note that assets and liabilities are
classified as current and non – current.
Bati Transport
Balance sheet
January 31, 2003
Assets
Current Assets:
Cash Birr 41, 030
Accounts Receivable .. 9,650
Supplies 400
Prepaid insurance .150
.150
Total current assets Birr 51,230
Plant Asset (None-Current Assets):
Assets):
Office equipment ..Birr 110,600
Truck 550,000 561,600
Total asset Birr 612,830
Liabilities

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Current liabilities
Accounts payable ..Birr 12,430
Non-current liabilities
Notes payable ..150,000
..150,000
Total liabilities Birr 162,430
Owner’s equity
Ato Yimer Capital .. 450,400
Total liability and owners equity .Birr 612,830

1.12 THE CLOSING PROCESS

Some of the accounts in the ledger are temporary accounts used to classify and
summarize the transactions affecting capital (owner’s equity). These accounts will be
closed after financial statements are prepared. That is, their balances will be transferred
to the Capital account. The temporary accounts that have to be closed are revenue,
expense and withdrawal accounts.

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Steps in closing:
1. Closing revenue accounts - Debit each revenue account by its balance and credit
the ‘Income Summary’ account by the total revenue for the period. Note: Income
summary is an account used to close revenue and expense accounts. This account
will immediately be closed to the capital account at the end of the closing process.
2. Closing expense accounts – Debit the income summary account by the total of
expenses for the period and credit each expense account by its balance.
3. Closing the income summary account – Income summary will be closed to the
capital account. The balance of his account depends on the nature of operation;
credit if result is profit and debit if result is loss.
4. Closing Withdrawal – Debit the owners equity account by the total of drawings for
the period and credit the drawing account.
The temporary accounts of Bati transport are closed as follows.
2003 Income summary .25,300
January Service income 25,300
31 Closing revenue
31 Salary expense ..18,800
rent expense 4,000
Maintenance expense .. 450
Insurance expense ..450
Supplies expense 340
Utilities expense .220
Truck expense 90
Miscellaneous expense .50
Income expense 24,400
Closing expenses
2003 Income summary 900
January 31 Yemer Capital ..900
Closing income summary
31 Yimer capital ...500
Yimer drawing ..500

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 Closing withdrawal
The above closing entries have transferred the balance of the temporary accounts to the
permanent capital account.

1.13 POST CLOSING TRIAL BALANCE

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

In practice the ledger balance after closing may be checked by a simple calculator print
out rather than a formal trial balance. The post closing trial balance for Bait Transport is
presented below.
Bati Transport
Post – Closing trial balance
Jan 31, 2003
A/title Debit Credit
Cash 41,030 00
Accounts 2,250 00
Receivable
Supplies 400 00
Prepaid Insurance 150 00
Office equipment 11,600 00
Truck 550,00 00
0
Accounts payable 12,430 00
Notes payable 150,00 00
0
Yimer capital 450,40 00

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 0
Total 612,83 00 612,83 00
0 0
Accounting for uncollectible Accounts Receivable.
When credit is extended, some amount of uncollectible receivables is generally inevitable regardless of the care
taken in granting credit and the control procedures used. The operating expense incurred because of the failure
to collect receivables is called Uncollectible Accounts Expense or Bad Debts Expense or Doubtful Accounts
Expense.

When does an account as a note become uncollectible? There is no general rule for determining when an
account receivable becomes uncollectible. The fact that a debtor fails to pay an account receivable according to
a sales contract or fails to pay a note on the due date does not necessarily mean that the account receivable will
be uncollectible. The debtor’s bankruptcy is one of the most significant indications of partial or complete
uncollectibility. Other indications include the closing of the customer’s business and the failure of repeated
attempts to collect.

There are two methods of accounting for uncollectible receivables. The allowance method, which provides an
expense for uncollectible receivables in advance of their write-off (removal from the ledger) and the direct
write-off method, which recognizes the expense only when accounts receivable are judged to be worthless. We
will discuss each of these methods next.
ALLOWANCE METHOD

The allowance method of accounting for bad debts matches the expected loss from uncollectible A/R against the
sales they helped produce. We must use expected losses since management can’t exactly identify the
customers who won’t pay their bills at the time of sale. This means at the end of each period the allowance
method requires us to estimate the total bad debts expected to result from that period’s sales. An allowance is
then recorded for this expected loss. This method has two advantages over the direct write-off method:
Bad debt expense is charged to the period in which the related sales are recognized, and
A/R is reported on the Balance Sheet at the estimated amount of cash to be collected.
The allowance method estimates bad debt expense at the end of each accounting period and records it through
an adjusting entry. To illustrate this method, assume the A/R account has a balance of Br. 50,000 and based on
careful study of the experience of other companies, Nile Co. estimates that a total of Br. 2000 will be
uncollectible.
This estimated expense is recorded through the following adjusting entry.

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 Dec. 31 Uncollectible Accounts Expense 2000
Allowance for Doubtful Accounts 2000
To record estimated bad debts
The amount Br. 2000 is an estimated reduction in A/R but it cannot be credited to specific customer accounts or
to the A/R controlling account. Instead, a contra asset account entitled Allowance for Doubtful Accounts is
credited.
As with all periodic adjustments the above entry serves two purposes. First, it reduces the value of the
receivable to the amount of cash expected to be realized in the future. This amount, which is Br. 48,000 (Br.
50,000 – Br. 2,000), is called the Net Realizable value of the receivables.
receivables. Second, the adjusting entry matches
the Br. 2000 expense of uncollectible account with the related revenues of the period.

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WRITE-OFF TO THE ALLOWANCE ACCOUNT.

When specific accounts are identified as uncollectible, they are written-off against the Allowance for Doubtful
Accounts. Assume after spending some time trying to collect from Shalla Co., Nile Co. decides that Shalla’s
Br. 200 accounts receivable is uncollectible and makes the following entry to writ-it off.
Jan. 25 Allowance for Doubtful Accounts 200
A/R-Shalla Co. 200
To write-off uncollectible accounts.
Note two aspects of this entry and its related accounts
Before Write-off after Write-off
A/R 50,000 49,800
Less Allowance for D. A/cs 2,000 1,800
NRV 48,000 48,000
Neither total assets nor net income are affected by the Write-off of a specific account. But both total assets and
net income are affected by the recognized bad debts expense for the year in the adjusting entry.
Recovery of Uncollectible Accounts
When a customer fails to pay and the account is written-off as uncollectibles, his or her credit standing is
jeopardized. To help restore credit standing, a customer may later choose to voluntarily pay all or part of the
amount owed. A company makes two entries when collecting an account previously written-off. The first is to
reverse the original write-off and reinstate the customer’s account. For example, assume the amount written-of
in the preceding entry is later collected on February 15.
On Feb. 15- The entries to record this recovery are:
Feb. 15- A/R Shalla Co. 200
Allowance for Doubtful Accounts 200
To reinstate accounts previously written-off
Feb. 15- Cash 200
A/R-Shalla Co. 200
To record full payment of account
ESTIMATING UNCOLLECTIBLES
The allowance method of accounting for bad debts requires an estimate of bad debts expense to prepare the
adjusting entry at the end of each accounting period. How does a company estimate bad debts expense? There
are two common methods. One is based on the Income Statement relationship between bad debts expense and

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sales. The second is based on the Balance Sheet relationship between A/R and the Allowance for Doubtful
Accounts. Both methods require an analysis of past experience.
ESTIMATING BASED ON SALES
Accounts receivable are created by credit sales. The amount of credits sales during the period may therefore be
used to estimate the amount of uncollectible accounts expense. The amount of this estimate is added to
whatever balance exists in Allowance for Doubtful Accounts. To illustrate, assume Wonji Co. has credit sales
of Br. 500,000 in 20X2. Based on past experience and the experience of other Cos, Wonji Co. estimated 0.007%
of credit sales are uncollectible. Using this prediction, the adjusting entry for uncollectible accounts at the end
of the period, 20X2 is as follows.
Dec. 31 Uncollectible Accounts Exp. (500,000 X 0.007%) 3500
Allowance for Doubtful Accounts 3500
To record estimated Uncoll. Exp.
This entry doesn’t mean that the Dec. 31, 20X2, balance of Allowance for Doubtful Accounts will be Br.
3500. A Br. 3500 balance results only if the account had a zero balance prior to posting the adjusting entry. For
example, assume that Allowance for Doubtful Accounts has a credit balance of Br. 1000 before adjustment.
Now, what will be the balance of Allowance for Doubtful Accounts be at the end of 20X2 ? It will be Br. 4500.
If there had been a debit balance of Br. 500 in the Allowance for Doubtful Accounts before the year-end
adjustment, and the amount of adjustment. would still have been Br. 3500. What will have been the end balance
of Allowance for Doubtful Accounts at the end of 20X2? (Find by your own!)
ESTIMATE BASED ON ANALYSIS OF RECEIVABLES
The longer an A/R remains outstanding, the less likely that it will be collected. Thus, we can base the estimate
of uncollectibles accounts on how long the accounts have been outstanding. For this purpose, we can use a
process called Ageing receivables which examines each A/R to estimate the amount of uncollectibles.
Receivables are classified by how long they are past their due date. Then, estimates of uncollectibles are made
assuming the longer an amount is past due the more likely it is to be uncollectible. After the outstanding
amounts are classified and analyzed in the Aging schedule the expected balance for the Allowance for Doubtful
Accounts will be estimated. Let’s assume the amount estimated is Br. 5000. So, do you think this is the
adjustment amount required for the current period? NO!

Because, this estimated amount is the expected balance of the Allowance for Doubtful Accounts after
adjustment rather than the current year provision for Uncollectible Accounts Expense. Therefore, to determine
the current year provision we must take in to account the balance before adjustment in the Allowance for
Doubtful Accounts. To illustrate, assume there is as credit Balance of Br. 1300 in the allowance account before

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adjustment. The amount to be added to this balance is therefore Br. 3800 (B.r 5000 – Br. 1200) and the
adjustment entry is as follows:
Dec. 31 Uncollectible Accounts Expense 3800
Allowance for Doubtful Accounts 3800
To record Uncollectible expense.
Alternatively, if the Allowance for Doubtful Accounts had an unadjusted debit balance of Br. 700, then the
required adjustment is Br. 5700. (Br. 5000 + 700) and the adjustment entry is as follows:
Dec. 31 . Uncollectible Accounts Expense 5700
Allowance for Doubtful Accounts 5700
To record Uncollectible expense .
THE DIRECT- WRITE-OFF METHOD
The Direct Write-off method of accounting for bad debts records the loss from an uncollectible A/R at the time
it is determined to be uncollectible. No attempt is made to predict uncollectible accounts expense. Bad debt
expense is recorded when specific accounts are determined to be worthless. If Wonji Co. uses a direct write-off
method and determines on Feb. 20, it can’t collect from a customer- Home Co.- Br. 500. The entry to write-off
the customer’s account is as follows
Feb. 20 Uncollectible Accounts Expense 500
A/R- Home Co. 500
To write-off Uncollectible accounts
Sometimes an amount previously written off is later collected. This can be due to factors such as continual
collection efforts or the good fortune of a customer. If the account of Home Co. that was written-off directly to
Bad Debt Expense is later collected in full, the following two entries record this recovery.
Mar. 5 - A/R- Home Co. 500
Uncollectible Accounts Expense 500
To reinstate account
Mar. 5 - Cash 500
A/R- Home Co. 500
To record full payment of account
If the recovery is in the year following the writ- off, there is no balance in the Uncollectible Accounts Expense
account related to the previous year’s write-off and no other write-offs are expected. So the credit portion of
the entry recording the recovery can be made to a Bad Debts Recoveries revenue account. To conclude this part
companies must weigh at least two principles when considering use of the direct write-off method:

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