UNIT 1.

INTRODUCTION TO ACCOUNTING

1.0 AIMS & OBJECTIVES

After studying this unit, you should be able to:

- explain the meaning of Accounting
- identify the users and uses of accounting
- explain the various branches in the profession of accounting
- explain the meaning of “generally accepted accounting principles”,
- explain the meaning of business entity assumption, cost principle and monetary unit
assumption
- state the basic accounting equation and explain the meaning of assets, liabilities, and
owner’s equity
- analyze the effects of business transactions on the basic accounting equation, and
- prepare an income statement, owner’s equity statement, and balance sheet.
1.1 INTRODUCTION

We live in the information age-a

age-a time of communication, and a time when information is a
vital resource. In this information era, how we live, with whom we associated, depend on
access to and understanding of information.
The same is true for businesses (businesses are one or more individuals selling products or
services for profit). Businesses that have better access to information and that process
information more quickly and accurately do the best.
Business is an artificial person or legal body which is engages in to 3 activities, such as giving
service (service business), purchased goods for the purpose of reselling (merchandising
business) and produced or manufactured goods and services for the purpose of selling
(manufacturing business).
Global computer networks and telecommunications equipment now allow us to get access to
all types of business information. But to take advantage of these, we need knowledge of
information systems.
An information system is the collecting, processing, and reporting to decision makers.
Understanding and processing information is the core of accounting.
accounting.
The kind of information processed in accounting is financial i.e. of a monetary nature.
Providing information about what businesses own, what they owe, and how they perform is
the aim of accounting. Accounting is, an information and measurement system that identifies,
records, and communicates relevant, reliable, and comparable information about an
organization’s (a business’s) economic activities.
Therefore, a study of accounting helps people make better and informed decisions about
assessing opportunities, products, investments, and social and community responsibilities.

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But the use of accounting information is not limited to accountants or people in business. You
can use accounting information in your daily life. You can use accounting information to get a
loan for a house or to start a new business.
The study of accounting, therefore, opens you new and exciting possibilities both in terms of
becoming a professional accountant and using accounting information in your daily life.
This course discusses the fundamental principles involved in processing accounting
information of business enterprises.
enterprises.
Understanding these fundamental principles is very important because forthcoming courses
that you are going to take in accounting will build on these principles.
1.2. DEFINITION, IMPORTANCE, AND USERS OF ACCOUNTING
INFORMATION

1.2.1. Accounting Defined

Definition of Accounting
Accounting is the process of identifying, measuring, recording, classifying, summarizing and
communicating (preparing, analyzing and interpreting accounting reports for users).
In short, it is an information system that measures business activities, processes that
information into reports, and communicates the results to decision makers.
Let’s take a closer look at the activities involved in the process:
1. The first part of the process – identifying – involves selecting those events that are
considered evidence of economic activity relevant to a particular organization. The
sale of goods by Tesfay Super Market, the rendering of service by Ethiopian
Telecommunications Corporation, the payment of salary by the Commercial Bank of
Ethiopia, and the purchase of Building by Axume University are examplesof economic
events.
2. Once identified, accountant measured in Birr and cents, economic events are recorded
to provide a permanent history of the financial activities of the organization.
Recording
Recording consists of keeping a chronological diary of measured events in an orderly
and systematic manner. In recording, economic events are also classified and
summarized. (This will be discussed in detail in unit-2)
3. This identifying and recording activity is of little use unless the information is
communicated to interested users. The information is communicated through the
preparation and distribution of accounting reports, the most common of which are
called financial statements.
A Vital element in communicating economic events is the accountant’s ability and
responsibility to analyze and interpret the reported in formation. Analysis involves the use
of ratios, percentages, graphs and charts to show the importance of financial trends and
relationships. Interpretation involves explaining to the user the meaning, and limitation of
reported data. The analysis and interpretation part is left for advanced courses in accounting.
As accounting plays an important role in the decision making process of business entities, it is
often called the language of business.
business. As a result, whether you are an economist, a marketer,

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investor, supplier or any other, to be successful, you should be able to “ speak”
speak” and be
familiar with the basic terms used in the business environment.
1.2.2 Roles/Importance/ of Accounting and Users of Accounting Information
Roles/Importance of accounting/
The main purpose of accounting is to provide financial information to be used for decision-
making. For instance, Business executives and managers need the financial information
provided by the accounting system to help them plan and control the activities of the business.
Outsiders such as bankers, potential investors, and labour unions and others also need
accounting in formation.
In short the goal of the accounting system is to provide useful information to decision
makers.
makers. Thus, accounting is the connecting link between decision makers and business
operations.
To sum up importance of accounting
Determines the operation results of the organization.
Facilitates rational decision making, for decision makers.
Keeps systematic record of business transaction.
It plays important role in all economic social system.
1.3 BOOKKEEPING VERSUS ACCOUNTING
People often fail to understand the difference between accounting and bookkeeping.
Bookkeeping is the process of recording business activities, and keeping the records. It is the
record- making phase of accounting. The recording of transactions in Bookkeeping tends to
be mechanical and repetitive; it is only a small and probably the simplest but important part of
accounting.
Accounting, on the other hand, includes the design of an information system that meets users’
needs. The major goals of accounting are the analysis, interpretation, and use of information.
Accounting includes system design, budgeting, cost analysis, auditing and tax planning and
preparation.
A person might become a reasonably proficient bookkeeper in a few weeks or months;
however, to become a professional accountant requires several years of study and experience.
Check Your Progress Exercise -1
1. Answer the following questions and compare your answer with the answer key at the end
of the unit.
a. Define accounting
b. Write in few words the importance of accounting.
c. Describe the basic distinction between accounting and bookkeeping.
Users of Accounting Information
Today’s accountants focus on the ultimate needs of those who use accounting information,
whether the users are inside or out side the business. Accounting is not an end by itself. The
information that accounting provides allows users to make “reasonable choices among
alternative uses of scarce resources in the conduct of business”

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The people who use accounting information basically fall in to two categories:
1. External Users, and
2. Internal Users
1) External Users: External Users of accounting information are parties, which are not
directly involved in running the business enterprise. These include lenders, shareholders
(stock holders), suppliers, employees Unions, government (regulatory bodies) and others.
External users rely (depend on) accounting information to help them make better
decisions in trying to achieve their goals.
The area of accounting aimed at serving external users is called Financial Accounting. Its
main objective is to provide to external users information through financial statements.
Each external user has its own specified information-need depending up on the decisions to be
made. That is to say, all external users do not have the same intentions (objectives) when they
use the information.
In the following paragraphs we well try to discuss how some external users use accounting
information.
a) Lenders / Creditors
Creditors lend money or other resources to an organization. Lenders include banks, mortgage
and finance companies. Lenders look for information to help them assess the ability of
borrowers to repay their debts.
b) Share- holders (Stockholders)
Shareholders have legal control over part or all of a corporation. When it comes to a
corporation, shareholders are not directly involved in the management of the corporation.
However, as owners, they have claims over the properties of the organization. Financial
reports help to answer shareholders’ questions such as:
- What is the income of the organization for the current and past periods?
- are the properties adequate to meet business plan?
- will the business continue to be profitable in the future?
c) Employees` labour Unions
Employees` labor unions are interested in judging the fairness of their wages and assessing
future job prospects. They also use accounting reports as evidence to ask for bonuses, when
the organization is successful.
d) Government
The Inland Revenue Authority requires organizations to prepare financial reports, in order to
compute taxes.
2) Internal Users: These are persons that are directly involved in managing and operating an
organization. They include managers and other important decision makers. The internal
role of accounting is to provide information to help improve the efficiency and
effectiveness of an organization.
The area of accounting aimed at serving the decision-making needs of internal users is called
Management Accounting. Internal users often have access to a lot of private and valuable
information. Internal reports aim to answer questions like:
 What are manufacturing costs per product?
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  Which service activities are most profitable?
 What level of sales is necessary to break even?
1.4 THE ACCOUNTING PROFESSION
If you just joined the accounting profession, you may be wondering what job you will be
doing in the future. You probably would apply your expertise in one of three major fields:
 Public Accounting
 Private Accounting or
 Not – for – profit Accounting
i) Public accounting
In Public Accounting you would offer expert service to the general public in much the same
way that a doctor serves patients and a lawyer serves clients. A major portion of public
accounting practice is involved with Auditing. In this area, a certified Public Accountant
(CPA) examines, the financial statements of companies and expresses opinion as to the
fairness of presentation. When presentation is fair, users consider the statements to be
reliable.
Management consulting is another area of public accounting. In this case, the accountant
consults the management generally about the growth and development of the business
enterprise.
ii) Private Accounting
Instead of working in public accounting, an accountant may be an employee of a business
enterprise. In private accounting, you would be involved in one of the following activities:
1. Cost Accounting:
Accounting: Determining the cost of producing specific products.
2. Budgeting: Assisting management in quantifying goals concerning revenues, costs of
goods sold, and operating expenses.
3. General Accounting:
Accounting: recording daily transactions and preparing financial statements
and related information.
4. Accounting information systems:
systems: designing both manual and computerized data
processing systems.
5. Tax Accounting:
Accounting: preparing tax returns (-forms to be filled by a company and returned
to a taxing authority) and engaging in tax planning for the company.
6. Internal Auditing:
Auditing: reviewing a company’s operations to determine compliance with
management policies and evaluating efficiency of operations.
iii) Not for Profit Accounting
Like businesses that exist to make a profit, not - for-profit organizations also need sound
financial reporting and control. Donors to such organizations want information about how
well the organization has met its objectives and whether continued support is justified. In each
of these cases, accounting expertise is highly valued.
Check your Progress Exercise -2
1. What are the basic categories of the users of accounting information?
…………………………………………………………………………………………………
…………………………………………………………………………………………………

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2. _____is the area of accounting aimed at serving external users of accounting information.

3. ___ is the area of accounting aimed at serving the decision-making needs of internal users.

4. What are the three major fields of engagement for accountants?

…………………………………………………………………………………………………
…………………………………………………………………………………………………

1.5. ACCOUNTING PRINCIPLES AND CONCEPTS

Accounting, as it is true for other disciplines, has got its own principles and practices. One
must be able to understand these principles and practices to understand and prepare financial
statements and reports. The principles and concepts used in accounting are called Generally
Accepted Accounting Principles (GAAP
(GAAP). ). These principles guide accountants how to record
and report business activities.
GAAP are developed over a long span of years by the accounting profession. That is, their
development is not revolutionary rather evolutionary. The main purpose of these basic rules
is to guide accountants in measuring and reporting financial events of business enterprises.
GAAP are not like the unchangeable laws of nature found in biology and chemistry. They
can be changed as better methods are developed or as circumstances change. Generally, it is
from research, practice, and pronouncements of professional bodies that GAAP evolve.
In this unit, we will discuss three of the generally accepted accounting principles: Business
Entity concept, Cost principle and Monetary Unit Assumption.
i) Business Entity Concept
Accountants frequently refer to a business organization as an accounting or business entity. A
business entity is any business organization, such as a “super market”, laundry, barberry, or a
hotel, which exist as an economic unit. For accounting purposes, each business enterprise has
a separate existence from its owners, creditors, employees, customers and other businesses.
This separate existence of the business enterprise is known as the business entity concept.
Thus, the business entity should have a completely separate set of records and its financial
records and reports should refer only about the business enterprises.
For example, W/ro Mana has got her own two business enterprises one called Asadu Mana
Super Market, and another hotel called Bahri Hatsey Hotel. Each Business would be
considered as an independent economic business unit. The activities of each business are kept
separately from each other and from the owner’s personal records. Let say W/O Mana bought
a house to live in Wajirat 20 Adi near Gragerbo. This house would not be recorded and
reported in the records of either the supermarket or the hotel. The personal saving account
she has will not as well be included in the financial reports of either one of the businesses.
She must have to open separate bank accounts for the two businesses. The super market
should not record the payment of salary to employees of the hotel.
ii) The cost principle

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The cost principle states “properties and services acquired by business enterprises must be
recorded at actual amounts paid or assumed in acquiring the properties.”
For example, Modern Advertising Company is considering the purchase of a building. The
seller of the building offered a price of Birr 10,000 while the buyer first offered a price of Birr
8000. However, after certain bargaining, the seller agreed to sell the building for Birr 9000
and the buyer paid that amount. According to the “cost principle” the buyer has to record the
building in its records at birr 9000- the actual amount paid to get the building.
The buyer may receive an offer of Birr 12,000 for the building a month after if has been
acquired. This has no effect on the accounting records because it doesn’t originate from an
actual exchange. It is simply a mere offer.
If the buyer sells the building for Birr 20,000 after purchasing it, a gain of Birr. 11,000 would
be realized. The new owner would use Birr 20,000 as the cost of the building.
In an exchange between a buyer and a seller, both attempt to get the best price. Only amounts
agreed up on and paid are objective enough for accounting purposes.
Monetary Unit Assumption
All business activities (events) are recorded in terms of money (-Birr, Dollar, Pound or any
other currency). Of course, information of a non -financial nature can be recorded, but it is
only through the recording of dollar (Birr) amounts that the activities of a business can be
measured. Money is the only factor common to all business activities. Therefore, it is the
only practical unit of measurement that can produce financial data that can be compared.
The monetary unit used by a business depends on the country in which it exists. For example,
in Ethiopia the basic unit of measurement is the birr,as is the dollar in the U.S.A, and Pound
Sterling in the United Kingdom.
Check Your Progress Exercise -3
1. The abbreviation GAAP stands for ____________________________.
2. What do we mean by “GAAP are not like the unchangeable laws of nature”?
…………………………………………………………………………………………………
3. Why do we need to record all business activities in terms of money?
…………………………………………………………………………………………………
What is the principle that says properties acquired by business enterprises must be
recorded at actual amounts paid?
…………………………………………………………………………………………………
FORMS OF BUSINESS ORGANIZATIONS
There are three basic forms of business organizations: sole proprietorships, partnerships, and
corporations. Accountants recognize each form as an economic unit separate form its owners
(Business Entity Concept).
In this course, we will begin by the accounting for sole proprietorships because it is the
simplest form of accounting.
1. Sole Proprietorships
A sole proprietorship is a business owned by one person and usually managed by the owner.
No special legal requirements must be met to start a sole proprietorship and usually only a
limited investment is required to begin operations.
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A sole proprietorship is a separate entity for accounting purposes (Business entity Concept)
but it is not a separate legal entity from the owners. That is, from the legal point of view, the
owner and the business are treated as one and the same. The owner will be held personally
responsible for the debts and actions of the business.
For instance, assume Flower Laundry is a sole proprietorship owned by Ato Alemu.
Assume also that the business has borrowed Birr 10,000 from the Commercial Bank of
Ethiopia and failed to pay its debts. In this case, if the Commercial Bank of Ethiopia can’t
recover the amount it lent from the properties of the company it can go to the extent of selling
the owner’s personal properties.
2. Partnerships
A Partnership is like a sole proprietorship in most ways except that it has more than one
owner. A partnership is not a legal entity separate from the owners but an association that
brings together the talents and resources of two or more people. The owners of a partnership
are known as partners.
The partners share the profits and losses of the partnership according to an agreed –on
formula. The personal resources of each partner can be called on to pay the obligations of the
partnership. That is, each partner is personally responsible for the debts of the partnership.
From an accounting standpoint, however, a partnership is a business entity separate from the
personal activities of the partners.
3. Corporations
A business organized as a separate legal entity with ownership divided into transferable units
of capital is called a corporation. The owners of a corporation are called stockholders or
shareholders. The corporation issues capital stock certificates to each stockholder showing
the number of shares (orstock) he or she owns. The stockholders are free to sell all or part of
these shares to other investors at any time. This ease of transfer of ownership adds to the
attractiveness of investing in a corporation. Since a corporation is a separate legal entity,
entity, the
owners (stockholders) are not personally liable for the debts of the corporation. Their risk of
loss is limited to the amount they paid (invested). Because of this limited liability in a
corporation shareholders are willing to invest in riskier, but potentially more profitable,
activities.
Even though corporations are fewer in number than proprietorships and partnerships, they
contribute a lot to the economies of many countries in monetary terms
1.7 BUSINESS TRANSACTIONS AND THE ACCOUNTING EQUATION
Business Transaction and the Accounting Equation
A Business Transaction
A business transaction is an occurrence of an event or a condition that must be recorded. A
particular business transaction may lead to an event or condition that result in another
transaction. Transactions may be divided in to internal and external.
A. External transactions: Exchanges or economic events take place between the business
enterprise and another entity. E.g. purchase of goods from a supplier, sales of goods to
customers, borrowing money from a bank.

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B. Internal transactions: such as the expiration or transfer of cost within the enterprise. E.g.
Depreciation of plant assets, transfer of production costs from work in process inventory to
the finished goods inventory.. A transaction can be an exchange (such as the purchase or sale
of property, payment or collection of a loan etc.) between two or more parties. A transaction
can also be an event that has the same effect as an exchange transaction but doesn’t involve an
exchange transaction. Some examples of “non exchange” transactions are losses from fire,
flood; physical wear and tear on equipment; donation of property and so forth.
. For a given transaction to qualify to be recorded it has:
1. to be related to the business enterprise
2. to be measurable in terms of money
3. to be completed / happened/ action.
(i.e. it should not be a mere promise or intention; it must be at least partially completed to be
recorded)
1.7.1 Assets, Liabilities and Owner’s Equity
An asset is a resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity.
The following three characteristics must be present for an item to qualify as an asset:
1. The asset must provide probable future economic benefit that enables it to provide future
net cash inflows.
2. The entity is able to receive the benefit and restrict other entities’ access to that benefit.
3. The event that provides the entity with the right to the benefit has occurred
If you have noticed, in any organization you will find properties such as a building, furniture,
land, vehicles and the like. Such properties owned by business enterprises are referred to as
Assets.
Assets. Examples of assets
1. Property, plant and equipment;
2. Investment property;
3. Intangible assets;
4. Financial assets (excluding amounts shown under items 5, 8, and 9);
5. Investments accounted for using the equity method;
6. Biological assets;
7. Inventories;
8. Trade and other receivables;
9. Cash and cash equivalents;
10. The total of assets classified as held for sale and assets included in disposal
Groups classified as held for sale in accordance with IFRS 5, Noncurrent Assets
Held for Sale and Discontinued Operations
To buy these assets, businesses get money from two sources: investments made by owners or
amounts borrowed from creditors. A liability is a present obligation of the entity arising from
past events, the settlement of which is expected to result in an outflow from the entity of
resources embodying future benefits.
The following three characteristics must be present for an item to qualify as a liability:
1. A liability requires that the entity settle a present obligation by the probable future transfer
of an asset on demand when a specified event occurs or at a particular date.
2. The obligation cannot be avoided.
3. The event that obligates the entity has occurred..

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Therefore, both owners and creditors have a claim over the assets of the business enterprise.
The claims or rights of owners are referred to as Equities.
Equities. If the assets owned by a business
amount to Birr 50,000 the equities in the assets must also amount to Birr 50,000. The
relationship between the two may be stated in the form of an equation, as follows:

Economic Resources = claims over the resources

Assets =Equities.

Equity 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.
Liabilities. The
rights of owners are called Owners’ Equity (capital).
Assets=equities
Equities = Liability + Owner’s equity
This equation can be written as:
Assets= liability + Owner’s Equity
NB: Liabilities should always be placed before owner’s equity in the accounting equation
since creditors have preferential rights or claims against the assets. To help you understand
this, assume X company has total assets of Br. 5000, liabilities of Br 2000 and owner’s equity
of Br 3000. If the business is to be closed, the assets of the company will be sold and
distributed to the claimants. In accounting, the Owner’s are given their share after the
creditors are given their entire share. For example, assume the assets are sold for Br 4,500.
The creditors will be given their share of Br. 2,000 and what ever remained (Br.2,500)is given
to the owners. If the assets were sold for Br. 7,000, the creditors would have been given their
share of Br. 2,000 and the remaining balance Br 5,000 would have been given to the owners.

Liabilities
Assets &
Capital

As you can notice, the owners are given whatever is left (it could be greater or less than their
share). That is why we said owners have residual claim over the assets of the business
whereas creditors are said to have priority clam over the assets as they are paid first

Check Your Progress Exercise -4

1 Business organizations are classified in to three, based on what?
…………………………………………………………………………………………………
2 What do we mean by the term ‘unlimited liability’?

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…………………………………………………………………………………………………
Which of the three forms of business originations is (are) separate legal entity (entities) from
their owners?
…………………………………………………………………………………………………
3 ___________________ represents the claim of owner’s against assets of the business
enterprise.

4 Assume total asset of Br 60,000, and owner’s equity of Br 45,000. Determine the amount
of liability .
…………………………………………………………………………………………………
5 L=A-C Is this an acceptable way of writing the basic accounting equation? Explain.
…………………………………………………………………………………………………
6 What do we mean when we say “owners have a residual claim over the assets of the
business enterprise”?
…………………………………………………………………………………………………
7 Define a business transaction,
transaction, and give at least four examples.
…………………………………………………………………………………………………
1.7.2 Transactions and the Accounting Equation
All business transactions from the simplest to the complex can be stated in terms of the
resulting effect on the three basic elements of the accounting equation. How ever, it is
important to remember that each transaction leaves the equation in balance. Assets always
equal the sum of liabilities and owner’s equity.

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14
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 Owner’s Equity

Decreased by: Increased by: Owner’s Investment and Revenues

Owner’s withdrawals and Expenses

The relationship of the above elements and their effect on the capital balance can be shown
as:
EC = BC + I – W + R - E
Where: EC – End Capital Balance
BC - Beginning Capital Balance.
I - Owner’s Investment
W - Owner’s Withdrawals
R - Revenue
E - Expense.

1.8 FINANCIAL STATEMENTS OF SOLE PROPRIETORSHIPS

After the effect of the individual transactions has been determined, the essential information is
communicated to users at certain intervals. The accounting reports, which communicate this
information, are called financial statements. Financial statements are said to be the central
features of accounting because they are the primary means of communicating important
accounting information to users.
Financial statements are the means of transferring the concise picture of the profitability and
financial position of the business to interested parties.
The major financial statements used to communicate accounting information about a business
are:
- income statement
- balance sheet
- statement of owner’s Equity
- statement of cash flows (will be discussed in senior courses)
Since these financial statements are in a sense the end products of the accounting process, a
student who acquires a clear under standing of the content and meaning of financial
statements will be in an excellent position to appreciate the purpose of the earlier steps of
recording and classifying business transactions.
1.8.1 The Income Statement
The income statement is a financial statement that summarizes the amount of revenues earned
and expenses incurred by a business over a period of time. It reports the profitability of the
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business by comparing revenues and expenses for a stated period of time such as a month or a
year. In accounting profitability is measured for a period of time than on a daily basis.
Though measuring daily could be possible, it will not be practical and beneficial to the
business enterprise.
If the revenue of a period exceeds the expenses of that same period, net income results. If
expenses are greater than the revenues of a period, we say there is a net loss, that is, the
business has operated unprofitably.
N.B. The determination of periodic net income (net loss) is a matching process involving two
steps. First revenues earned are recognized during the period. Second, the expenses incurred
to generate revenues are matched (compared) against revenues to determine net income or net
loss.
All financial statements have a heading that you can find in any kind of a report. The heading
of these statements identifies the company, the type of statement, and the time period covered
by the statement. Note that the primary focus of the income statement is reporting the success
or profitability of the company’s operations over a specified period of time. To indicate that it
applies for a period of time, the income statement is dated “For the month ended…”
The following is an income statement for the month ended September 30, 200x.

1.8.2 Owner’s Equity Statement

This is a statement that summarizes the changes in owner’s equity for a specific period of
time. Data for the preparation of owner’s equity statement are obtained from the owner’s
equity column of the tabular summary (Illustration 1- ) and from the income statement. The
heading of this statement identifies the company, the type of statement, and the time period
covered by the statement. The time period is the same as that covered by the income
statement and therefore is dated “ For the Month Ended August 30, 2013.” The beginning

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owner’s equity amount is shown on the first line of the statement. Then, the owner’s
investments, net income and the owner’s drawings are identified in the statement.
The information provided by this statement indicates the reasons why owner’s equity has
increased or decreased during the period. The Owner’s equity statement for the month of
August is shown below:

1 3. Balance Sheet
It is a list of assets, liabilities and owner’s equity of a business entity as of a specific date. The
assets section of a balance sheet (left hand side) begins with cash followed by receivables,
supplies, prepaid insurance and other assets that can be converted in to cash or used up in the
near future. The assets of relatively permanent nature such as land, building and equipment
follow that order. In the liability and owner’s equity section of the balance sheet (right hand
side), the liabilities are presented first followed by owner’s equity.
Form of Balance sheet (statement format)
As there is no universal form, the form of the balance sheet presentation varies in practice.
The balance sheet is prepared in one of two basis forms: Account form and Report forms
I. The account form of balance sheet: In this form of balance sheet, assets are reported on the
left-side & liabilities & owners' equity on the right hand side.
_________
_________
_____
Assets Liability

Owner’s Equity

The report form of balance sheet: In this form of balance sheet, liabilities & equity sections
are listed in sequential order directly below the asset section
-Lists assets, Liability and Owner’s equity vertically

__________

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 _________
_____

Assets

Liability
Owner’s Equity

You can choose either of the two formats for your balance sheet preparation.

The following is a balance sheet prepared based on the sample transactions illustrated in the
chapter.
MR. X. Tax
Balance Sheet
September 30,200x

Assets Liability
Cash…………Birr _______.00 Accounts payable…… Birr _____.00
Supplies……………______.00
Land………………______.00 Owner’s Equity
Ato Dawit Gem., Capital Br_____.00
Br_____.00..
_________ Total Liabilities and
Total Assets…….._______.00
Assets…….._______.00 Owner’s equity……...Birr _____.00

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The double line is drawn only when the total assets on the left side are equal to total liabilities
and Owner’s equity.
Be sure to carefully examine the format and content of each statement.
4. Statement of Cash Flows
The statement of cash flows reports the cash coming in (cash receipts) and the amount of cash
going out (cash payments) during a period. Business activities result in a net cash inflow
(receipts greater than payments) or a net cash outflow (payments greater than receipts). This
statement is reported in three sections: operating activities, investing activities, and financing
activities.
I. Cash Flow from Operating Activities
This section includes cash transactions that enter in to the determination of net income or net
loss. The net cash flow from operating activities normally differs from the amount of net
income for the period.
II. Cash Flow from Investing Activities
This section includes the cash transaction for the acquisition and sale of relatively long term
or permanent type of assets.
III. Cash Flow from Financing Activities
This section includes the cash transaction related to cash investment by the owner’s and
borrowing and withdrawals by the owner.
NB: the cash balance at the beginning of the period is added to the increase (or decrease) in
cash for the period to obtain the cash balance at the end of the period.
The basic features of the four statements and their interrelationships are illustrated by taking
data from Mr. X taxi business as follow:

Check Your Progress Exercise -5

1. _____________ are assets used or consumed in the process of generating revenue.

20
2. Drawings are assets taken out of the business for the owner’s personal benefit. Do you
advise owners to withdraw cash or in kind (i.e. furniture, automobile..)? Why?
…………………………………………………………………………………………………
3. List the four factors that change owner’s equity. What is their effect on owner’s equity?
…………………………………………………………………………………………………
What are the four financial statements?
…………………………………………………………………………………………………
4. Every financial statement has three lines as a heading,

1st line____________________________
2nd line___________________________
3rd line __________________________
Financial Statement for Corporation
Business enterprises with large amount of assets are usually organized as corporations and
have many owners, called stockholders. The financial statements of corporations are similar
to those of sole proprietorship and partnership except that retained earnings statement is
prepared instead of statement of owner’s equity. The owner’s equity section of balance sheet
is referred to as stockholders' equity rather than owner’s equity. In addition, the cash flows
from financing activities for a corporation arise from the sale of capital stock and the payment
of dividends, rather than from owner’s investment and drawings.
1. Retained Earning
The emphasis in reporting the changes in the stockholders’ equity is on the changes in
retained earnings, or net income retained in the business. The changes in retained earning that
have occurred during a period are reported in retained earnings statement. Change 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.

2. Balance Sheet
The only difference between the balance sheet of sole proprietorship or/and partnership and
corporation is that the stockholders’ equity section is presented rather than owner’s equity.

21
3. Statement of Cash Flows

The only difference between cash flows statement of corporation and sole proprietorship
or/and partnership is on the cash flows from financing activities section, i.e., cash flows arise
from the sale of capital stock and the cash payments to stockholders in the form of dividends.

22
4. Income Statement

Similar with the income statement prepared for sole proprietorship or/and partnership

1.9 SUMMARY

Explain the meaning of accounting.

accounting. Accounting is the process of identifying, measuring
recording and communicating the economic events of an organization (business or non
business) to interested users of the information. Accounting helps us in the allocation of
scarce resources in an efficient and effective manner.

Identify the users and uses of accounting. (a) Management uses accounting information in
planning controlling and evaluating business operations. (b) Investors (owners) judge the
wisdom of buying, holding, or selling their financial interests on the basis of accounting data,
i.e. to see how their investment is doing. (c) Creditors evaluate the risks of granting credit or
lending money. Other groups of users include taxing authorities, regulatory agencies,
customers, labor unions, and economic panniers. These users are grouped in to two: 1-
Internal users and ii- External users.

Explain the meaning of generally accepted accounting principles: Generally accepted

accounting principles are a common set of standards used by accountants.

23
Explain the meaning of business entity assumption, cost principle and the monetary unit
assumption. The business entity concept states the economic events of a particular business
should be identified separate from other entities and the owner’s personal records. The cost
principle requires properties acquired by business enterprises to be recorded at actual amounts
paid and /or assumed in acquiring the properties. The monetary unit assumption requires only
transactions capable of being expressed in terms of money be included in the accounting
records of the business enterprise.

State the basic accounting equation and explain the meaning of assets, liabilities, and owner’s
equity. The basic accounting equation is:

Assets = Liabilities + Owner’s Equity.

Assets are resources owned by a business, liabilities represent the claim of creditors on the
total assets, and owner’s equity is the ownership claim on the total assets. It is often referred
to as residual equity.
Analyze the effects of business transactions on the basic accounting equation. Each business
transaction must have a dual effect on the accounting equation. For example, if an asset is
decreased, there must be a corresponding (1) Increase in another asset, or (2) decrease in a
specific liability, or (3) decrease in owner’s equity. After each transaction, the equality of
assets to the sum of liabilities and Owner’s equity must be maintained.

Prepare an income statement, owner’s equity statement, and balance sheet. An income
statement presents the revenues and expenses of a company for a specific period of time. An
owner’s equity statement summarizes the changes in owner’s equity that have occurred for a
specific period of time. A balance sheet reports the assets, liabilities, and owner’s equity of a
business at a specific date.

1.10 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress Exercise - 1

1) Accounting is the process of identifying, measuring, recording and communicating

economic events to permit informed decisions and decisions by the users of the
information.
2) Accounting as an information system helps others to make informed decisions about the
use of scarce resources.
3) Bookkeeping is the recording part of accounting. Accounting includes analytical
interpretation phases in addition to the recording phase.

Check Your Progress Exercise –2

24
1) i )internal users ii) external users.
2) Financial Accounting
3) Management Accounting
4) i) Public accounting
ii) Private accounting
iii) Not –for- profit accounting
Check Your Progress Exercise - 3
1. Generally Accepted Accounting Principles.
2. GAAP, are open for change whenever better methods are developed or as circumstances
change.
3. It is the only common unit of measurement to all business enterprises. That is, why
comparison of two unrelated business enterprises is possible.
4. The Cost Principle
Check Your Progress Exercise –4
1. Based on the number of people who own them and the style of ownership.
2. Unlimmitted Liability refers to the fact that the liability of the owners of a sole
proprietorship and a partnership is not limited to the extent of their investment, but it
extends to their personal properties.
3. Only corporations
4. Owner’s Equity
5. Liability=Asset –Owner’s Equity =>Liabilities=60,000-45,000=15,000
6. Though it is mathematically correct; it doesn’t reflect the practical fact that capital is what
is left after deducting liabilities from assets as creditor’s claims take precedence over
those of owners. Therefore, liability is not what is left after owners take their shares.
7. When the assets of a business are not sufficient to satisfy all the claims of both owners and
creditors, first creditors are paid in full and owners take whatever remains (i.e. the residue)
even if this means they will not be fully paid.
8. A transaction is an event that has to be recorded by accountants because it affects the
economic status of the business. The purchase of equipment, the consumption of supplies,
the collection of money from debtors, payment to creditors, and the provision of service to
customers are common examples of transactions that accountants have to record daily.
Check Your Progress Exercise - 5
1. Supplies
2. It is not advisable for owners to withdraw in kind (such as a vehicle or furniture)
because this may interrupt the business's operation for sometime until the withdrawn
assets are replaced.

3. Factor Effect on owners equity

Revenues Increase
Expenses Decrease
Investment Increase
Drawings Decrease
25
4. The income statement, the balance sheet, statement of owner’s equity and statement of cash
flows.
- Name of company
- Name of report (statement)
- Period covered by financial statement
1.11 MODEL EXAMINATION QUESTIONS
1. Guji company had the following amounts of assets and liabilities at the beginning and end
of last year:
Assets Liabilities
Beginning of the year………………Br.75,000 Br. 30,000
End of the year….……………………120,000 46,000
Determine the net income or net loss of Guji for the year under each of the following
unrelated assumptions:
a) Owner made no additional investment and withdrew no amount during the year
b) Owner made no additional investment but withdrew Br.17,500 to pay for her
personal expenses
c) Owner withdrew no amount during the year but made additional investment of Br.
32,500 cash.
d) Owner withdrew Br.17,500 and invested Br.25,000 cash during the year.
2. For each of the following give an example of a transaction that creates the described
effects:
a) Decreases a liability and decreases an asset
b) Increases an asset and decreases another asset
c) Decreases an asset and decreases owners equity
d) Increases a liability and decreases owners equity
e) Increases an asset and increases a liability
f) Decreases an asset and decreases a liability
Mimi started a new business called Omo Company and completed the following transactions
during November:
Nov.1 Mimi transferred 56,000 out of a personal savings bank account to a checking
account she in the name of the business.
1. Rented office space and paid cash for the month’s rent of 800
3. Purchased electrical equipment for 14,000 by paying 3,200 and agreeing to pay the
remaining balance in six months
5. Purchased office supplies by paying 900 cash.
6. Completed electrical work and received 1,000 cash for doing the work.
3. Purchased 3,800 of office equipment on credit
15. Completed electrical work on credit in the amount of 4,000
20. Paid for the office equipment purchased on Nov.9
24. Billed a customer for electrical work completed 600
28. Received 4,000 for the work completed on Nov.15
30. Paid salary of employees 1,200
26
 30. Paid the monthly utilities bill 440
30. Withdrew 700 from the business for personal use
Required:
1. Arrange the following asset, liability and owner’s equity titles in a table just like
illustrated in this unit: Cash, Accounts Receivable, Office Supplies, Office Equipment,
Electrical Equipment, Accounts Payable and Mimi Capital.
2. Use additions and subtractions to show the effect of each transaction on the items in the
equation. Show new totals after each transaction. Next to each change in owners equity
state whether the change was caused by an investment, revenue, expense or withdrawal.
3. Prepare an income statement, a statement of owner’s equity, and a balance sheet
1.12 GLOSSARY OF TERMS
Accounting - the process of identifying measuring, recording, and communicating the
economic events of an organization to interested users of the information.
Assets – Resources owned by a business.
Auditing – the examination of financial statements by a certified public accountant in order to
express an opinion as to the fairness of presentation.
Balance Sheet – A financial statement that reports the assets, liabilities, and owner’s equity
on a specific date.
Basic Accounting Equation - Assets=Liabilities + owner’s equity
Bookkeeping – A part of accounting that involves only the recording of economic events.
Corporation – a business organized as a separate legal entity under state corporation law
having ownership divided into transferable shares of stock.
Cost Principle – an accounting principle that states the assets should be recorded at their
actual cost .
Drawings – Withdrawals of cash or other assets from the business for the owner’s personal
use.
Economic (Business) Entity Assumption – An assumption that states a business enterprise
must be given separate and distinct existence from the owners, creditors, customers and any
other party.
Expenses - the cost of assets consumed or services used in the process of earning revenue.
Income statement – A financial statement that presents the revenues and expenses and
resulting net income or net loss of a company for a specific period of time.
Investment by owner – the assets put in to the business by the owner.
Liabilities – Represents the claim of creditors on the assets of the business.
Monetary unit assumption–
assumption– An assumption stating that only transactions that can be
expressed in terms of money be included in the accounting records of the business.
Net Income – the amount by which revenues exceed expenses.
Net loss – the amount by which expenses exceed revenues.
Owner’s Equity Statement – A financial statement that summarizes the changes in owner’s
equity for a specific period of time.
Partnership – An association of two or more persons to carry on a business as co-owners for
profit.
27
Private accounting – An area of accounting with in a company that involves such activities
as cost accounting, budgeting, and accounting information systems.
Public Accounting – An area of accounting in which the accountant offers expert service to
the general public on a fee bases.
Revenues – the gross increase in Owner’s equity, resulting form business activities entered in
for the purpose of earning income. It is the amount charged to customers for services sold or
goods delivered to them.
Tax Accounting - an area of public accounting involving tax advice, tax planning, and
preparing tax returns.
Transactions – The economic events of the business recorded by the accountant.

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CHAPTER TWO : 2.1 ACCOUNTING CYCLE FOR SERVICE BUSINESS

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.
2.2 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

2.3 CLASSIFICATIONS OF ACCOUNTS

Accounts are classified into five: assets, liabilities, capital, 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:
Soft ware, 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.

29
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.
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.
2.4 CHART OF ACCOUNTS
The number and name of accounts used by an organization depends on the nature of its
operation. The list of accounts and their codes used by an organization is called the chart of
accounts. Look at the following chart of accounts of Bati Transport.

Bati Transport
Chart of Accounts

Asset Account number

Cash--------------------------------------------------------------------------11
Accounts Receivable------------------------------------------------------ 12
Supplies----------------------------------------------------------------------13
Prepaid Insurance-----------------------------------------------------------14
Equipment------------------------------------------------------------------- 15
Accumulated Depreciation –Equipment---------------------------------16
Truck--------------------------------------------------------------------------17
Accumulated depreciation – Truck----------------------------------------18
Liabilities
Accounts Payable-------------------------------------------------------------21
Notes Payable-----------------------------------------------------------------22
Owners Equity
Yimer Adem, Capital----------------------------------------------------------31
Yimer Adem Drawing-------------------------------------------------------32
Income Summary-------------------------------------------------------------33
Revenue
Service income----------------------------------------------------------------41
30
 Expense
Salaries Expense --------------------------------------------------------------51
Rent Expense ------------------------------------------------------------------52
Utilities Expense---------------------------------------------------------------53
Supplies Expense--------------------------------------------------------------54
Insurance Expense-------------------------------------------------------------55
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.
2.5 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
Debit Credit
-Increase in assets -Decrease inassets
-Increase in expenses -Decrease in expenses
-Decrease in capital -Increase in capital
-Decrease in liabilities -Increase in liabilities
-Decrease in revenue -Increase in revenue.
Check Your Progress Exercise - 1
1. Unlike other accounts on the right hand side, expenses increase on the debit side and
decrease on the credit side. Explain the reason.
……………………………………………………………………………………………

31
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
2.6 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.
Journal page
Date Description P.R Debit Credit
Year
Month day Debited account title XXX XX
Credited account title X XX XX
Explanation
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?
32
 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 credit side.
d) Prepare the complete Journal entry.
2003 Description
Jan. 10 Salary expense 6000 00
Cash 6000 00
Payment of salary

Note: A journal entry is the complete presentation of the record in the journal.
Check Your Progress Exercise - 2
Journalize the following transaction by answering 4 questions suggested above.
 On January 11, 2003 Tamget bought a building for Birr 150,000 on credit.
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.
33
 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.
These transactions are journalized as follows:

Date Description 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

34
 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
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
2.7 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.R Debit Date Item P.R Credit

The four-column account:

Account Account number

35
Date Item P.R Debit Credit Balance
Debit Credit

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.
Account Cash Account Number
Balance
Date Item P.R Debit Credit Debit Credit
2003 450,000 00 450,000 00
Jan 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
23 100,000 00 40200 00
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.
Check Your Progress Exercise -3
Rule the other accounts used by Bati Transport and post the respective Dr. & Cr. entries (Hint
17 accounts, including cash, are used by Bati Transport). Don’t continue without doing this
because the following discussion assumes you have done this exercise!
2.8 THE TRIAL BALANCE

36
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

Cash 41,030 00
Accounts Receivable 2,250 00
Supplies 740 00
Prepaid Insurance 600 00
Office equipment 11,600 00
Truck 550,000 00
Accounts payable 12,430 00
Notes payable 150,000 00
Yimer capital 450,000 00
Yimer drawing 500 00
Service income 17,900 00
Salary expense 18,800 00
Rent expense 4,000 00
Utilities expense 220 00
Maintenance expense 450 00
Truuck expense 90 00
Miscellaneous expense 50 00
Total 630,330 00 630,330 00
2.8.1 Proof Provided By the Trial Balance
The trial balance does not provide complete proof of accuracy of the ledger. It indicates only
that the debits and credits are equal. If the two totals of trial balance are not equal, it is
probably due to one or more of the following types of errors:
1. Error in preparing trial balance:
a. One of the columns of the trial balance was incorrectly added.
b. The amount of an account balance was incorrectly recorded on the trial
balance.
c. A debit balance was recorded as credit, or vice versa, or a balance was
omitted entirely.

37
 2. Error in determining the account balance:
a. A balance was incorrectly computed.
b. A balance was entered in the wrong balance column.
3. Error in recording a transaction in the ledger
a. An erroneous amount was posted to the account.
b. A debit entry was posted as a credit, or vice versa.
c. A debit or credit posting was omitted.

Among the types of errors that will not cause an inequality in the trial balance totals are the
following:
1. Failure to record a transaction or to post a transaction.
2. Recording the same erroneous amount for both the debit and credit parts of a
transaction.
3. Recording the same transaction more than one.
4. Posting a part of a transaction correctly as a debit or credit but to the wrong account.

2.8.2. DISCOVERY OF ERRORS

The existence of an error can be determined in various ways:
1. By audit procedures
2. By chance discovery, or
3. Through the medium of the trial balance.
2.8.3. TYPES OF ERROR
a. Addition: For example, a difference of $10, $100, or $1,000 between totals is
frequently the result of error in addition.
b. Omission: A difference between totals can happen due to the omission of a debit
or a credit posting or, if it is divisible evenly by 2, to the posting of a debit or a
credit, or vice versa. For example, if the debit and credit totals of a trial balance
are $ 20,640 and $20,236 respectively, the difference of $404 may indicate that a
credit posting of that amount was omitted or that a credit of $202 was erroneously
posted as a debit.
c. Transpositions: It is the erroneous rearrangement of digit, such as writing $ 542
as $ 524 or $452.
Slide: It is the entire number is erroneously moved one or more spaces to the right or the left,
such as writing $542.00 as $54200 or $54.20
2.8.4. 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
- Recording the same erroneous amount for both the debit and the credit parts of a
transaction.

38
 - 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
2.9 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.
The adjusting entry prepared at the end of the year to adjust the supplies account will be
1990 Supplies expense 1,750
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’
2.9.1 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.
2.9.2 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.
2.10. Adjustment
2. 10.1. TYPES OF ADJUSTING ENTRIES

39
A business may need to make a dozen or more adjusting entries at the end of each accounting
period. The exact number of adjustments will depend up on the nature of the company’s
business activities. But, all adjusting entries fall in to two general categories:
1. Adjusting entries to apportion deferrals
2. Adjusting entries to record accruals
1. ACCOUNTING FOR DEFERRALS
Definition: - The word “defer” means to delay or post pone. In accounting, Deferrals are the
delay (or post ponment) in the recognition of an expense already paid or revenue already
received.
Deferred items consist of adjusting entries involving data previously recorded in accounts.
These entries involve the transfer of data already recorded in asset and liability accounts to
expense and revenues accounts.
Types of Deferrals
Deferred items could be grouped into two major types:
i. Deferrals to apportion prepayments
ii. Deferrals to apportion advance receipts
I. Accounting Treatment for Prepayments (Deferred Expenses)
Companies often make advance expenditures that benefit more than one period, before
receiving the service. Such expenditures that are made before receiving the service are called
Prepaid Expenses or Deferred Expenses. At the initial point of payment, the total advance
payment is an asset not an expense to the business enterprise paying in advance. This is
because, according to the accrual basis of accounting, the recognition of expense is not related
to the payment of cash. Rather it is related to the receiving of the service; that is, incurring of
the expense. As far as the company has not received the service the total advance payment
remains to be an asset to the business enterprise.
However, each time the company receives the service, the asset will be converted to an
expense. That is, the part of the advance expenditure that has benefited current operations is
treated as an expense of the period in which the service is received as you can see, each time
the service is received (expense incurred) no payment will be made, because the payment has
already been made in advance.
And the part of the advance payment that has not been consumed or has not been expired
(used) is treated as an asset applicable to future operations. It is through the use of adjusting
entries that we apportion (divide) the prepayment in to used and unused portion. The adjusting
entry for the adjustment of prepayments uses an asset and expense accounts.
There are two alternative methods of recoding prepayment at the initial point of payment.
1. The asset method
2. The expense method
We have tried to discuss the asset method of recording prepayments in the previous chapters.
In this chapter, we will see both methods to help you understand the alternative methods of
recording prepayments.

40
To illustrate the alternative methods of recording prepayments, assume on Jan. 1,2002
CHAMO ADVERTIZMENT COMPANY paid Br. 36,000 for rent for the coming three years
for office it has rented from SHALA COMPANY. Also, assume that the fiscal year of
CHAMO ADV. COMPANY ends on December 31.
II. Recording Prepayments (Deferred Expenses) Initially in an Asset Account
(The Asset Method)
The total advance payment is debited to an asset account, in CHAMO ADV. CO.S’ case to a
Prepaid Rent Account. Recording the total advance payment in an asset account does not
imply that it will remain to be an asset. As we mentioned earlier, at the initial point of
payment, the total amount paid in advance is an asset. However, as each day passes, part of
the asset expires and becomes an expense. In accounting, we don’t transfer the expired
portion each day from the asset to an expense account. Rather we delay it until the end of the
accounting period.
The adjusting entry used in this case, debits an expense account and credit an asset for the
amount that has expired i.e. the portion for which service has been received.
Lets see these for CHAMO ADV. CO., On Jan. 2, 2002 the following journal entry will be
made by CHAMO ADV. CO.
 Prepaid Rent ………………………… 36,000
Cash ………………………………… 36,000
To record advance payment of rent for 3 years.
As you can notice, the total advance payment was debited to an asset account, and obviously
as cash was paid the cash account is credited.
After one year on Dec. 31, 2002, the company has used the office for one year. We say from
the total advance payment, Br. 12,000 (= Br. 36,000/3 Br. 12000) has expired. But until
adjustment, the used portion Br. 12000 remains in the asset account; it is through adjustment
that we transfer the used portion to an expense account.
The adjusting entry that transfers the used portion to the expense account for CHAMO ADV.
CO. made on Dec. 31,2002 is:
Rent Expense ……………… Br. 12,000
Prepaid Rent ………… ………….. Br. 12,000
After the adjusting entry has been posted, the Rent Expense account will have a balance of Br.
12,000 and prepaid Rent now shows the correct balance of Br. 24,000 (The portion that has
not expired or used). This relationship can be shown using a “T” account as follows:
Prepaid Rent Rent Expense
Dr. Cr. Dr. Cr.
Jan. 1,2002 36,000 12,000 Dec. 31, 2002 Dec. 31,2002 12,000
(Payment) (Adjusting) (Adjusting)

Balance Br. 24000

The used portion Br. 36000 = Br. 12000

41
 3
is transferred from the asset to an expense account
If CHAMO ADV.CO. decides to leave the office it rented on Dec.31,2002, do you think that
it will be refunded the amount it paid of Jan. 1,2002? No, because it has already used the
office for one year. As a result, the amount it should be refunded is the unused portion of the
prepayment. But in our case, CHAMO ADV. CO. has not decided to leave the office.
2. Recording Prepayments Initially in an Expense Account (The Expense Method)
In our illustration for CHAMO ADV. CO., advance payments for rent that will benefit three
years operation were recorded by a debit to an asset account, Prepaid Rent. However, each
time the service is used (i.e. stay in the office) it is obvious that the asset will be converted to
an expense account. As a result some companies follow an alternative practice of recording
prepayments directly to an expense by the assumption that the prepayment will be finally
converted to an expense. Remember that, though the pre payment is recorded initially
(directly) in an expense account, it still remains to be an asset to the company as far as the
service is not received.
In CHAMO ADV.CO.’S case the following journal entry will be made on Jan. 1,2001, the
date of advance payment.
Rent Expense ………………….. 36,000
Cash …………………………36,000
To record advance payments made for rent for three years.
Recording the prepayment directly in an expense account doesn’t necessarily indicate that the
total advance payment will expire during the year. That is, part of the prepayment might
remain unexpired (unused) at the end of the year. When there is unused portion, an adjustment
is needed to transfer the unused portion from the expense account to the asset account. The
adjusting entry will debit an asset account and credit an expense account for the amount for
which no service is received (unexpired
(unexpired petition).
petition).
On Dec. 31,2002, the following adjusting entry is made by CHAMO ADV. Company.
Prepaid Rent…………………………. 24000
Rent Expense………………………..24000
To record the adjustment that transfer the unexpired portion from an expense to
asset account.
The unexpired amount is computed as:
36,000
Yearly expiration = = Br. 12,000 per year. There fore, after one year only
3Year

1/3 (12,000) expires, the remaining balance Br. 24,000 (=Br. 36,000 – 12,000) is unexpired
and reported as an asset.
This alternative method leads to the same results in the balance sheet and income statement,
as does the asset method of recording. Here also, the balance of prepaid rent that will appear
on the balance sheet is Br. 24,000 and the amount of rent expense for the year is Br. 12,000.
1.1. Effect of Overlooking Adjustments for Deferred Expenses
42
What is the effect of over looking the adjustment on the financial statements?
Income Statement:
 The expenses would be over stated by Br. 24,000. Because it is through the
adjusting entry that we apportioned the unexpired portion from the expense account
and transferred to the asset account.
 The overstatement of expense leads to an understatement of net income (or
overstatement of net loss if there is net loss).
Balance sheet:
 The understatement of net income will be reflected on the owners equity (capital)
that is capital will be understated. Because through the closing process the
understated income balance will be transferred to the capital account, hence the
understatement of capital.
 The assets (Prepaid Rent) would be affected and understated, if the adjustment was
over looked. Because it is through adjustment that we transfer the unexpired
portion to the asset account. But if no adjustment, the unexpired portion remains in
the expense account than being in the asset account.
Therefore, we say never, never over look an adjustment, for failing to do so will misstate all
financial statements. And misstated financial statements will lead to WRONG DECISIONS.
Check Your Progress Exercise -1
Anbessa Co. purchased supplies worth br.5000 on March 12,20x2.At the beginning of the
fiscal year the company had br.3500 worth of supplies on hand. A physical count at the end of
the year December31, 20x2 showed that there is br.1500 worth of supplies on hand. Record
the necessary adjustment journal entry on December31, 20x2 if
A. The company has a policy of recording supplies as an expense initially when they are
bought.
B. The company has a policy of recording supplies as an asset initially when they are
bought
II. Deferred Revenues (Unearned Revenues)
Just as expenses can be paid before they are used, revenues can be received before they are
earned, i.e., before the service has been given. Unity University College collected money
from you in advance of giving service. Such advance collections made before giving service
are called Unearned Revenues.
When cash is received in advance, the company enters in to an obligation to deliver goods or
perform services. Therefore, unearned revenues are shown in a liability account, and will
appear on the Balance Sheet.
Unearned Revenues differ from other liabilities because unlike Accounts payable, they are
usually settled by rendering services, than payment in cash. We can say it is a work off rather
than a paid off liability. Of course, if the company fails to deliver the services as promised it
must refund the customers their money for the portion it has not rendered the service.
Each time the company renders services it is earning the revenues. No cash collection will be
made at this point, why? Because the cash has already been collected in advance.
43
Concerning the recording of Deferred Revenues, we have two alternative methods:
1. Recording advance collections directly in a liability account
2. Recording advance collection directly in a revenues account
The financial statements prepared using these two methods are one and the same. It is like two
roads leading to the same place.
To help us understand the difference between the alternative methods, consider the following
illustration:
On January 1,2001, Oceanic Advertisement Company collected Br. 18,600 in advance from
ZOOM Company by promising to advertise the products of ZOOM Co. on Ethiopian
Television and on one of the local news papers for the coming 20 months. Assume
advertisement services given each month are equal.
1. The Liability Method: Recording Unearned Revenues Directly (initially) in a
Liability Account
Amounts that are collected in advance from customers are not revenues of the business
enterprise, as far as service is not provided. As a result, one approach to record the advance
collections is to record them directly in a liability account; even if part or all of it might be
earned during the period.
On Jan. 1, 2001, Oceanic Advertisement Company will record the advance collection as:
Cash ………………………………………18,600
Unearned Advertisement Revenues ………………………18,600
Remember that the unearned advertisement Revenues is a liability account, not a revenue
account. The Advertisement Revenues will be earned gradually as Ocean Co. gives the
services as promised. Because it will not be practical to record weekly or monthly earnings of
revenues, what we do is to delay weekly or monthly earning until the end of the fiscal period.
By which time we will transfer the amount of Advertisement Revenues earned for the year
from the liability account to the revenue account. The adjustment journal entry for this debits
the liability account and credits the revenues account for the earned portion (the portion for
which service has been rendered).
On Dec. 31,2001, the following adjusting entry will be made in the case of Oceanic
Advertisement Company:
Unearned Advertisement Revenues ………………….11,160
Advertisement Revenues ……………………..11,160
To record adjustment
The amount that is earned can be computed as:
Monthly = Br. 18,600/20months = Br. 930 per month earnings.
i.e. each month the company earns Br. 930.00. Therefore, for the period from Jan.1,2001, to
Dec.31,2001, Br. 11,160 (=12 x 930) is earned by Oceanic Advertisement Company.
After the adjusting entry has been posted, unearned Advertisement Revenue will have a Br.
7440 end balance and Advertisement Revenue will have a Br. 11,160 balance. The balance in
unearned Advertisement represents the obligation of the company to render advertisement
services in the future periods. This can be stated using a “T” account as follows:
Unearned Advertisement Revenue Advertisement Revenue
44
 Br. 18,600 Jan. 1, 2001
Br. 11, 160 Br.7, 440 Br. 11, 160

To transfer the earned portion Br. 11,160

from the liability to the revenue account
What would be the effect of over looking the adjustment?
On the income statement:
- Revenues would be understated. This is because; it is through adjustment
that we transfer the earned portion from the liability to the revenue account.
- Net income would be understated; or net loss would be overstated. Because
there would be an understatement of revenue.
On the balance sheet
- Capital would be understated, because the understated net income would be
closed finally to the capital account.
- The liability would be overstated in the Balance sheet because the
adjustment has transferred out from the liability account to the revenue
account the portion that is earned. But, if there was no adjustment this
earned portion remains in the liability account and overstates it.
2. The Revenue Method: Recording Advance Collections Initially in a Revenue
Account
We have stressed that amounts collected from customers in advance are liabilities not revenue
because according to the revenue realization principle, revenue is earned when service is
given to the customer.
However, we know that each time service is given we earn revenue. As a result, some
companies prefer to record advance collections initially in a revenue account though it is not
earned.
Here, the expectation is that, in the future all of the advance collections will be earned and be
converted into revenue. Notice that, even if we record the advance collection in revenue
accounts it doesn’t mean that it is revenue. It still remains to be a liability as far as service is
not given.
On Jan. 1, 2001, the date of advance collection, Oceanic Advertisement Company will record
the following journal entry:
Cash -----------------------------------------------18,600
Advertisement Revenue ---------------------------18,600
To record advance collections for advertisement for 20 months

45
Recording the advance collection in revenue account does not necessarily imply that it will be
earned totally in the period.
A portion of it might remain unearned. When there is unearned revenue at the end of the year
an adjustment is necessary to transfer this unearned portion from the revenue account to the
liability account.
In year 2001, Oceanic Advertisement Company rendered services only for 12 months from
the total 20-month services it promised to give. Since the 8 months service is not rendered it
should NOT be reported as revenue. As a result, using an adjusting entry, which debits the
revenue account and credits the liability account, we transfer the unearned portion to the
liability account.
On Dec. 31, 2001, the following adjusting entry is necessary for oceanic advertisement
company:
Advertisement Revenue -------------------------------- 7440
Unearned Advertisement Revenue------------------------------------7440
After the adjusting entry is posted, the Advertisement Revenue account will have a balance of
Br. 11,160 and unearned Advertisement Revenue will have a balance of Br. 7,440. Notice
that, it is one and the same to the balance that resulted in the previous alternative.
2.1. Effect of Overlooking Adjustments for Deferred Revenues
What would be the effect of overlooking the adjustment?
On the income statement
- Revenues would be overstated by the amount of the adjustment, because it is through
the adjustment that the unearned portion is apportioned from revenue account.
- Net income would be overstated
On the Balance Sheet:
- Liability (= unearned Advertisement Revenue) would have been under stated because
it is through the adjusting entry that we transfer the unearned portion to the liability
account. That is, if no adjustment, nothing would have been transferred to the liability
account.
- Overstatement of owner’s equity thus results from the over statement of revenue or net
income.
Check Your Progress Exercise - 2
Nebir Publishing Co. received br.5600 in advance from customers who subscribe to the
magazine that the company publishes. At the beginning of the fiscal year the company had
br.3200 of unearned revenues. And at the end of the current fiscal year December31, 20x2
there were still br.4300 unearned revenues from magazine subscriptions received in advance.
Record the necessary adjustment journal entry on December31, 20x2 assuming
A-The company records advance receipts as a liability when they are collected
B- The company records advance receipts as a revenue when they are collected
2.ACCOUNTING FOR ACCRUALS

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Definition: an accrual is the recognition of revenue or an expense that has arisen but has not
yet been recorded.
The word “accrue” means to accumulate or grow in size. In accounting, an accrual is the
recognition of revenue or an expense that has accumulated overtime but has not yet been
recorded. In order to report a company’s financial position and profitability accurately, the
accruals should be recognized (recorded) in the accounting period in which they occur.
As you can notice from the definition, we have basically two types of accruals in accounting.
These are:
I – Accrued Expense / Accrued Liability/
II– Accrued Revenue /Accrued Assets/
I. Accrued Expenses /Accrued Liability/
Accrued expenses refer to expenses that are incurred but are both unpaid and unrecorded.
When we say the expense is incurred; it means, “ the service has been received but the
payment for it has not yet been made.” Since the incurred expense is not paid there is a sense
of a liability, hence the name accrued liability.
Most expenses in accounting are paid whenever they are incurred. There are, however, some
business expenses that accrue (accumulate) daily but are usually recorded when they are paid.
Such expenses include, salary and wages paid to employees, and interest paid on borrowed
money. As you know, employees work on a day-to-day basis but they are not paid on a daily
basis. Rather there is an interval on which the payment is made. Therefore, we say these
expenses accrue, that is, grow or accumulate over time.
Accrual (both accrued expenses and accrued revenues) in general need an adjusting entry
when the end of the fiscal period comes before the date on which the expense is to be paid.
Illustration
Mamush Bakery pays the salaries of its employees every Friday, for a five working days from
Monday to Friday. (That is, the employees are paid on every Friday for the work they perform
from Monday to Friday. The salary for five working days amounts to Br. 2500.
For the year 1998, the end of the fiscal year, Dec. 31, falls on Wednesday. What adjustment is
needed on December 31 in relation to salary expense.
Answer:
By the end of Dec. 31, 1998, the employees have already worked for three days (Monday,
Tuesday, and Wednesday) but they will not be paid until the regular pay day on Friday, which
lies on Jan. 2, 1999 in another fiscal period.
The salaries for the three days are rightfully an expense for 1998. As a result, the expense
must be recorded and reported in 1998, in the year in which it is incurred (According to the
expense recognition principle).
Since it is not paid on Dec. 31, 1998, there is a liability that the company owes to pay. The
salary rate is Br. 2,500 for the workdays, then, the rate per day will be Br. 500 (= Br. 2500/5).
Therefore, the expense for the three days is Br. 500 x 3 = Br. 1,500.f and the following
adjusting entry should be made to recognize the accrued expense on Dec. 31, 1998:
Salary Expense -----------------1500
Salary Payable ------------------------------ 1500
47
The balance in salaries payable that will be reported as a liability on Mamush Baker’s balance
sheet is Br. 1,500. And the Salary Expense of the three days Br. 1500 will be reported
together with the salary expenses of the year on the income statement.
Effect of Overlooking Adjustment of Accrued Expenses
As we stated earlier, adjustment is a mandatory step in the accounting cycle because failing to
do so will affect the amounts reported on the financial statements. As a result, the adjustment
for recognizing accrued expenses must be made always by the end of the fiscal year.
In our case, if the adjustment on Dec. 31, 1998 was overlooked, the following will be
reflected on the financial statements:
On the Income Statement
- Expenses would have been understated, because in the adjustment an expense account
has been increased.
- Understatement of expense leads to an overstatement of net income (or an
understatement of net loss, if there is net loss)
On the Balance Sheet
- Capital would have been overstated because of the overstatement of net income.
- Liability (salaries payable) would have been understated, because in the adjusting
entry a labiality account has been increased.
II. Accrued Revenues (Accrued Assets)
Accrued revenues are revenues for which a service has been performed or goods delivered but
for which no entry has been recorded.
That is, the revenues have been earned but not both yet recorded and received.
Any revenues that have been earned but not recorded during the accounting period call for an
adjusting entry that debits an asset account (= specifically a receivable) and credits a revenue
account.
2.11. REVERSING ENTRIES: THE OPTIONAL FIRST STEP IN THE NEXT
ACCOUNTING PERIOD
At the end of each accounting period, adjusting entries are made to bring revenues and
expenses into conformity with the matching rule. That is, using adjusting entries at the end of
the accounting period, we try to update the accounts of the business enterprise.
A reversing entry is a general journal entry made on the first day of the new accounting period
that is the exact reverse of an adjusting entry made at the end of the previous period. Unlike
adjusting entries, reversing entries are optional, i.e., without the use of reversing entries we
can prepare correct financial statements.
A reversing entry, as the name implies, is the exact reverse of the adjusting entry made at the
end of the previous period. It contains the same account titles and dollar amounts as the
related adjusting entry, but the debits and credits are the reverse of those in the adjusting entry
and the date is the first day of the next accounting period.
Reversing entries simplify the recording of certain routine cash receipts and payments and
minimize the possibility of making errors.

48
Not all adjusting entries can be reversed. In accounting, when the policy of using reversing
entries is adopted the adjusting entries to record the following adjustments can be reversed:
- Adjustments to record both types of accruals can be reversed.
- Prepaid expenses initially recorded as an expense can be reversed
- Unearned revenues initially recorded as a revenue can be reversed
N.B Deferrals that are recorded initially as an asset and as revenue cannot be reversed.
To show how reversing entries can be helpful, consider the following example.
- SAMRA COMPANY pays the salary of its employees each Friday for a five-day
workweek. Assume salary per day is Br. 300.00, or Br. 1500 for a five-day week.
Through out the year, the company’s accountant makes a journal entry each Friday as
follows:
Salary Expense ---------------- 1500
Cash ------------------------------ 1500
To record payment of salary for the week.

Next, let us assume that December 31, end of the year 2002 falls on Wednesday. All expenses
of the year must be recorded before the accounts are closed and financial statements are
prepared on December 31. Therefore an adjusting entry must be made to record the salaries
expense and the related liability for the three days (Monday to Wednesday) they have worked.
The adjusting entry for $ 900.00 (computed as 3 x 300 daily salary expenses) is:
Dec. 31, 2002
Salary Expense 900
Salary Payable 900
To record accrued salary for the three days worked
in December
The reversing entry would be:
Jan.1, 2003 Salary Payable 900
Salary Expense 900
To reverse adjustment made at the end of previous year.
After the reversing entry salary payable will have zero balance and salary expense will have a
credit balance of 900 birr. Open T-accounts for both the salary expense and salary payable
accounts and record adjustment, closing and reversing entries in the T-accounts ;you would
get the fore mentioned balances.
The payment of salary on the following Friday would simply be recorded as follows:
January 2 Salary Expense…………..1500
Cash…………………………….1500
Check Your Progress Exercise -3
How would the payment have been recorded if the adjustment were not reversed?
The Choice of Method of Recording Deferrals
As you can recall, for both types of deferrals there are two methods of recording. That is, in
the case of prepaid expenses the asset and expense methods and in the case of unearned
revenues the liability and revenue methods of recording. Both alternative methods of
49
recording deferrals result in the same effects on the financial statements. Then, the next
logical question to ask is which method of recording to use.
The choice between the two methods of recording prepaid expenses and unearned revenues
depends up on which method would normally result in fewer entries and would be least likely
to create errors in the recording process.
It is better to record those prepaid expenses that will be used (consumed) during the
accounting period initially as an expense. This way, only one entry would be required, and no
adjusting entry is necessary. On the other hand, those prepaid expenses that will not be totally
used or consumed during the accounting period are usually recorded initially as assets and an
adjusting entry is made at the end of the period for the amount consumed.
Recording prepaid expenses that last for more than one period requires only an adjusting
entry, but recording it initially as an expense would normally require both an adjusting entry
and reversing entry.
Similarly, for unearned revenues that will be earned in the current accounting period, the
revenue method of recording is preferable. In contrast, for unearned revenues that will be
earned in more than one period the labiality method of recording is preferable.
2.12. ANSWERS TO CHECK YOUR PROGRESS QUESTIONS OF ADJUSTMENTS
Check Your Progress Exercise - 1
A- December 31,20x2 Supplies………….1,500
Supplies Expense………1,500
B- December 31,20x2 Supplies Expense………7,000
Supplies………….7,000
Check Your Progress Exercise - 2
A- December 31,20x2 Unearned Subscription Revenue………4,500

Subscription Revenue……………4,500
B- December 31,20x2 Subscription Revenue …………..4,300
UnearnedSubscriptionRevenue………4,300
Check Your Progress Exercise - 3
January2 Salary Expense……………….600
Salary Payable………………..900
Cash…………………………….1,500
2.13. MODEL EXAMINATION QUESTIONS
Part I. Multiple Choice
1. Revenues which are earned but not collected resulting:
A. Accrued Assets
B. Accrued Liabilities
C. Accrued Revenues
D. Differed Revenues
E. “A” and “C”
2. Reversing entries are
A. made at the beginning of the new accounting period
50
 B. direct reverse of the adjusting entries made at the end of the previous year.
C. are optional
D. All
E. None
3. The adjusting entry to record accrued expenses will:
A. debit an asset account and credit a liability account
B. debit a liability account and credit a revenue account
C. debit an expense account and credit a liability account
D. debit an expense account and credit an asset account.
E. None
3. Unearned revenues are classified as:
A. liability
B. an asset
C. a revenue
D. an expense
E. None
Part II. Exercise
MAMO GASHA Company pays the salary of its employees on every Saturday for a six
working days from Monday to Saturday. The total salary for the six days amount to Br.
4,200.
For the year 2002, the fiscal year ended on Thursday, Dec. 31, 2002.
Instruction: On the basis of the above data:
1- Record the adjustment needed on 1 Thursday Dec. 31, 2002.
2- Record the payment of salary on Saturday, Jan. 2, 2002. (Assume the company
follows the policy of using reversing entries)
3- Repeat instruction “2” assuming the company does not use reversing entries.
On July 1, 2000
SELAM CONPANY rented Office rooms from BUDENA plc for 4 years by paying Br.
72000. The SELAM COMPANY agreed to use the office rooms as a show room for its
products it manufactures at its factory around kality.
Both Companies use a fiscal year that ends on Dec. 31.
Instruction:
1. Pass the journal entry to record
a) The payment of cash by Selam company on July 1,2000, assuming the
company records pre payments as an asset.
b) The adjusting entries entry repaired on Dec. 31, 2000 and 2001 in the
records of
SELAM COMPANY.
2. Pass the journal entry in the records of BUDENA Company to record:
a) The cash collection made on July 1, 2000, assuming the company records
advance collections as a liability.

51
 b) The adjusting entry required on Dec. 31, 2000 and 2001 in the records of
Budena company
c) What is the effect of failing to pass the adjustment on Dec. 31, 2000
2.14. 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 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.
Bati Transport
Work Sheet
For th3e month ended jan.31,2003
Account Title Trial Balance Adjustment Adjusted Trial Income Balance sheeet
balance statement
1 Cash 41,030 41,030 41,030
©
2 Accounts receivable 2,250 7,400 9,650 9,650
(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 550,000 550,000 550,000
7 Accounts payable 12,430 12,430 12,430
8 Notes payable 150,000 150,000 150,000
9 Yimer Capital 450,000 450,000 450,000
10 Yimer drawing 500 500 500
©
11 Service income 17,900 7,400 25,300 25300
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 expense 450 450 450
16 Truck expense 90 90 90
17 Miscellaneous 50 50 50
Expense

52
18 630,330 630,330
(a)
19 Supplies expense 340 340 340
(b)
20 Insurance expense 450 450 450
21 7290 7290 636,830 636,830
22 Net income
23 25300 25300 613,330 613,330

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 – 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 – 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 – At the end of the month unbilled fees for services performed to clients
totaled Birr 7,400.
This amount refers to an income earned but to be collected in the future. The journal entry to
record it will be
Accounts receivable………………………….7,400
Service income………………………………7,400
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.
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.

53
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.
2.15. 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
expense………………………………………24,400
Net Income…………………………………………………Birr 900
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………………………………Birr 450,000

Net income for the month………………….birr 900
Less:
Less: Withdrawal…………………………………...500
Withdrawal…………………………………...500 400
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.

54
 Bati Transport
Balance sheet
January 31, 2003
Assets
Current Assets:
Cash…………………………………………Birr 41, 030
Accounts Receivable…………………………….. 9,650
Supplies…………………………………………… 400
Prepaid insurance…………………………………….150
insurance…………………………………….150
Total current assets……………………………………………Birr 51,230
Plant Asset (None-Current Assets):
Assets):
Office equipment……………………………..Birr 110,600
Truck………………………………………………550,000
Truck………………………………………………550,000 561,600
Total asset………………………………………………………Birr 612,830
Liabilities
Current liabilities
Accounts payable……………………………..Birr 12,430
Non-current liabilities
Notes payable……………………………………..150,000
payable……………………………………..150,000
Total liabilities……………………………………………………Birr 162,430
Owner’s equity
Ato Yimer Capital…………………………………………………………….. 450,400
Total liability and owners equity………………………………………….Birr 612,830
2.16. THE CLOSING PROCESS
Some of the accounts in the ledger are temporary accounts used to classify and summarize the
transactions affecting capital (owners 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.
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 Service income…………………………………25,300
55
 Income summary………………….25,300
January
31 Closing revenue
31 Income summary ……………24,400
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
Closing expenses
2003 Income summary………………900
January 31 Yemer Capital………………………..900
Closing income summary
31 Yimer capital…………………...500
Yimer drowing………………………..500
Closing with drowal
The above closing entries have transferred the balance of the temporary accounts to the
permanent capital account.
Check Your Progress Exercise - 4
Post all the above closing entries and recompute the balance of all the accounts affected.
2.17. 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
Cash……………………………………………Birr 41,030
Accounts Receivable ………………………………...9,650
Supplies…………………………………………………400
Prepaid insurance……………………………………….150
Office equipment……………………………………11,600
Truck……………………………………………….550,000
Accounts payable…………………………………………………….Birr 12,430
Nots payable……………………………………………………………..150,000
56
 Yimer capital……………………………………………………………..450,400
capital……………………………………………………………..450,400
Total……………………………………Birr 612,830 Birr 612,830
2.18. SUMMARY
Accountants go through a number of step-by-step procedures to record transactions and to
summarize the records in to useful repotrs in a systematic manner. These procedures that
accountants go through from the time a transaction is identified until the time financial
statements are prepared are together called the accounting cycle. The accounting cycle is
summarized below:
Input Process Output

1. When a transaction2.Transactions are recorded in the journal 7.Preparing financial statements

happens, source 3.Posting
documents
to individual accounts
are prepared. 4.Preparing a trial balance after determining the
balance of each ledger account
6.preparing and completing the work sheet with
adjustments
8.Adjustments are journalized and posted
9.Closing entries are journalized and posted
10.A post closing trial balance is prepared
2.19. ANSWERS TO CHECK YOUR PROGRESS QUESTIONS
Check Your Progress Exercise - 1
Expenses are found on the right hand side of the accounting equation; they are elements of
the owners equity account. When expenses increase capital will decrease and vice versa.
Because of this reverse effect of expenses on capital they increase on the Dr. sided and
decrease on the Cr. side, unlike other right hand side accounts.
Check Your Progress Exercise - 2
a) Building and Accounts payable
b) Both accounts are increased.
c) Building is debited and accounts payable is credited
d) Journal entry:
2003, Building……………………………150,000
Jan 11 Accounts payable…………………………..150,000
Purchase of building on credit.
Check Your Progress Exercise - 3
Prepare a four – column account for each account and post the respective entries to the
accounts. Compare the ending balance of each account in your answer with their balance in
the trial balance.
Check Your Progress Exercise - 4

57
After all the closing entries are posted all temporary accounts will have zero balances. On the
other hand, permanent accounts will have non- zero balances. Example: Yimer Capital = Birr
450,400, supplies Birr 400.
A complete list of the permanent accounts and their balances is given on the post – closing
trial balance.
2.20. MODEL EXAM QUESTIONS

1. Indicate whether each of the following items below is an asset, liability, revenue, expense,
gain or loss account and whether it appears in the balance sheet or income statement.
a) Office furniture
b) Income from services
c) Salaries paid to workers
d) Supplies on hand
e) Salary payable to workers
f) Cash
g) Income form sale of a used truck
h) Goods damaged by fire in the store
2. Given below is a list of selected transactions performed by John Décor during the month
of September 2002, the first month of operation.
a) Record the transactions in General Journal
b) Post each entry to the perspective account. Use the four – column account.
c) Prepare a trial balance
d) Prepare a worksheet. Assume the following adjustment for the accounts and
journalize them.
e) Prepare a Balance sheet, Income statement and statement of owner’s equity
f) close the temporary accounts.
Sept. 10 Mr. John transferred cash form his personal account to be used in the business,
Birr 10,000.
“ 10 Paid rent for the month, Birr 500
“ 11 Purchased a truck for Birr 12,000 by paying Birr 3,000 Cash and giving a notes
payable for the difference.
“ 12 Purchased equipment on account Birr 1,460.
“ 13 Purchased supplies on account Birr 240.
“ 14 Paid insurance premiums of Birr 170 (Dr. prepaid insurance)
“ 15 Received cash for services completed Birr 360.
“ 16 Purchased Supplies on account Birr 240.
“ 18 Paid salaries of Birr 900.
“ 21 Paid its liabilities for the purchase of equipment
“ 24 Recorded sales on account Birr 2,080
“ 26 Received an invoice for truck expense Birr 115
“ 27 Paid utilities expense Birr 205.
“ 27 Paid miscellaneous expenses Birr 73.
58
 “ 28 Received cash from customers on account birr 1,420
“ 30 Paid salaries to employees Birr 950
“ 30. The owner withdrew Birr 1, 750 for personal use.
3. The trial balance of Betty Beauty Saloon does not balance. The errors in the accounting
work are given below. Determine the correct balance of each account and prepare the
corrected trial balance.
Betty Beauty Saloon
Trial balance
April 30
Cach 5,902.00
Accounts Receivable 6,300.00
Supplies 1,600.00
Equipment 5,200.00
Accounts payable 4,300.00
Betty capital 10,000.00
Service income 4,700.00
Operating expenses 1,980.00
Total 20,982.00 19,200.00
The errors are the following:
 Cash received form a customer on account was recorded (both debit and credit) as birr
 1,400 instead of Birr 1,120
 The purchase on account of an equipment costing Birr 780 was recorded as a debit to
 operating expense and credit to accounts payable.
 Service was performed to clients Birr 1,780 for which accounts Receivable was
 debited birr 1,780 and service income was credit birr 178
 A payment of Birr 80 for telephone charges was debited to Operating Expense and it
was also debited to cash
 The ledger balance of the service income account is birr 4,700 rather than Birr 4,720.
4. As of Sene 30 1994, the end of the current fiscal year, the accountant for Abay General
Trading completed the worksheet before journalizing and posting the adjustments.
Required: (a) Compare the adjusted and unadjusted trial balances and prepare the eight
journal entries that were required to adjust the accounts.
(b) Prepare the journal entries that were required to close temporary accounts.
Abay General Trading
Trial Balance
Sene 30, 1994
Un adjusted Adjusted
Cash 12,825.00 12,825.00
Supplies 8,950.00 3,635.00
Prepaid rent 19,500.00 1,500.00
Prepaid insurance 3,750.00 1,250.00

59
Equipment 92,150.00 92,150.00
Accumulated depreciation equipment 53,480.00 66,270.00
Automobile 56,500.00 56,500.00
Accumulated depreciation automobile 28,250.00 36,900.00
Accounts payable 8,310.00 8,730.00
Salary payable 3,400.00
Tax Payable 1,225.00
Ato Abay capital 41,245.00 41,245.00
Ato Abay drawing 18,600.00 18,600.00
Service income 261,200.00 261,200.00
Salary Expense 172,300 175,700.00
Rent Expense 18,000.00
Supplies Expense 5,315.00
Depreciation Expense Equipment 12,790.00
Depreciation Expense Automobile 8,650.00
Utilities Expense 4,700.00 5,120.00
Taxes Expense 1,500 2,725.00
Insurance Expense 2,500.00
Miscellaneous Expense 1,710.00 ____ 1,710.00 ____
Total 392,485.00 392,487.00 418,970.00 418,970.00
2.20. GLOSSARY OF TERMS
Account –a record showing separately the increases and decreases of a financial statement
item during a period.
T account-
account- the simplest format of an account, which resembles the letter ‘T’.
Chart of Accounts- a list of the account s used by an organization and their codes.
Debit-
Debit- the left side of an account.
Credit-
Credit- the right side of an account.
Source Documents-
Documents- documents such as an invoice or a cash receipt voucher that evidence the
occurrence of a transaction.
Journal-
Journal- a book or record where a transaction’s full debits and credits and other details are
first recorded.
Journal Entry-the
Entry-the debits and credits recorded in the journal for one transaction.
Ledger-
Ledger a book, where increases and decreases in each account are separately recorded. It is
-
therefore the collection of the individual accounts of an organization.
Trial Balance – a form showing the final balance of each ledger account. It is used to
somehow check if any errors were made during the period.
Work Sheet –a working paper that accountants use to collect adjustment data and to easly
prepare the financial statements.
Adjustments – entries required to up-date some accounts before preparing financial
statements.
Post Closing Trial Balance-
Balance- a trial balance prepared after all the accounts have been closed.
60
 CHAPTER 3:
3.1 INTRODUCTION
In the previous chapters, you saw how to record transactions of a service business. The steps
that we go through to prepare the financial statements of other types of businesses (such as a
merchandising business) are basically the same. Transactions are first journalized, and then
posted to the ledger; a worksheet is prepared and completed…. But, there are some
transactions in merchandising companies that you don’t find in a service giving business, like
the purchase of goods for sale and the sale of those goods. The first section of this chapter,
therefore, discusses the nature of a merchandising business and how to record merchandising
transactions. The next section discusses about the preparation of financial statements for
merchandising companies.
SECTION-ONE: RECORDING MERCHANDISING TRANSACTIONS
3.2 NATURE OF A MERCHANDISING BUSINESS
3.2.1What
3.2.1What is a Merchandising Business?
Business?
A merchandising business buys goods in finished form for resale to customers.
A merchandising business sells tangible goods to its customers. When we say goods it can be
anything that has physical characteristics that you can see and touch (i.e., tangible). These
can be goods ranging from television sets, cars, office table and chair (furniture), to chewing
gums, toothbrushes and various stationery. These goods that a merchandising company sells
to its customers are called merchandise inventory.
inventory. (A customer is an individual or a firm to
whom a business sells its products.)
One final thing that you should know about a merchandising business is that a merchandising
company does not produce the goods that it sells. Instead, it buys these goods from
manufacturers,
manufacturers, which produce the goods using raw materials.
The following diagram can help you to better visualize the flow of goods from a manufacturer
to the final consumer:

sells Merchandising companies

Manufacturers wholesalers sell Retailer final consumer

goods goods
A wholesaler is a trader, which buys goods from manufacturers and sells them to a retailer or
another wholesaler. It is the retailer who sells the goods to the final consumer by buying
them from wholesalers (or sometimes from a manufacturer).
When you want to buy a soap to wash your clothes, where do you buy it? Who is the
manufacturer of the soap? Are there any wholesalers of that soap in your area? Can the
wholesaler be taken as the customer of the manufacturer? And finally, can we say the shop
from which you buy the soap is a merchandising business?
3.2.2 Comparison of Financial Statements for Merchandising and Service Businesses
Income Statement

61
A model income statement for a merchandising business and another one for a service
business are shown below. Compare them carefully.
ABC service company XYZ merchandising
Income statement Income statement
For the year ended Dec.31, 200x For the year ended Dec.31, 200x
Revenue: Revenue:
Service fee………………….Birr 23,200 Net Sales…………………Birr 360,000
Cost of goods sold…………….(256,000
sold…………….(256,000))
Gross Profit …………………….104,000
Expenses: Various Operating
Various Operating Expenses (7120 (7120)) Expenses……………………….(79,400
Expenses……………………….(79,400))
Net Income 16080 Net Income ……………………..24,600
……………………..24,600
As you can see from the above Income Statements, merchandising companies have to pay to
buy the goods that they sell. Therefore, they have to deduct this cost of goods sold in addition
to other operating expenses from their sales revenue to determine their net income.
The difference between sales revenue and cost of goods sold is referred to as gross profit.
Why ‘gross’? Because other expenses have yet to be deducted to arrive at the net profit or net
income of the business.
Balance Sheet
The Balance Sheet of a service business and that of a merchandising business are similar in
every aspect except one thing. The current assets section of the Balance Sheet of a
merchandising business includes one asset that service companies do not have. That is
merchandise inventory. Merchandise inventory refers to goods bought by a merchandising
business for resale to customers. So, if a merchandising business has some unsold goods
(merchandise) on hand at the end of the year this would be reported as one asset on the
Balance Sheet.
3.3 THE PERIODIC AND THE PERPETUAL INVENTORY SYSTEMS
The value of goods (merchandise) on hand at the end of the year for resale would be reported
on the Balance Sheet as one asset as described above. This means that we need to open a
separate ledger account in which to record merchandise inventory information.
The two alternatives in dealing with this account are:
1. To up date this account every time goods are bought and sold (continuously =
perpetually) or
2. To up date this account only at the end of the period (periodically).
3. 3.1 The Periodic Inventory System
Under this system, as the name periodic suggests, the inventory account is updated only
periodically i.e., only at the end of a period.
When goods are bought, a temporary purchases account is debited instead of the inventory
account itself. Likewise, when goods are sold revenue is recorded, but the fact that there is a
reduction in merchandise inventory is not recognized. This is because the Merchandise
Inventory account is not credited every time goods are sold.

62
Therefore, if one wants to know the cost of goods on hand, it is a must that a physical
inventory be conducted first. The account doesn’t reflect the value of goods on hand because
it was not up dated when merchandise was bought and sold. Physical inventory means
counting the quantity of goods on hand. Once the quantity of goods on hand has been
determined, it is multiplied by the unit price of those goods to determine the cost of goods on
hand.
In conclusion, under the periodic system, since the merchandise inventory account is not
continually updated, the cost of merchandise on hand is determined only at the end of the
period after carrying out a physical inventory.
Companies such as department stores or ‘super markets’, which sell small items, use periodic
systems.
3.3.2 Perpetual Inventory Systems
A perpetual inventory system continuously records the amount of inventory on hand
(perpetual =continuous). Under this system, the merchandise inventory account is debited or
credited every time (goods) are bought or sold. When an item is sold, its cost is recorded in a
separate cost of goods sold account in addition to recording sales.
The cost of merchandise on hand can be looked up from the merchandise Inventory account
any time, without conducting a physical inventory.
Check Your Progress Exercise-1
If you have a supermarket business, would you use the perpetual or periodic system? What if
your system is computerized? Explain.
3.4 RECORDING PURCHASES AND SALES TRANSACTIONS
The following discussions in the remainder of this chapter all assume the use of a periodic
inventory system. The perpetual system will be discussed in part two of this course.
3.4.1. ACCOUNTING FOR PURCHASE
Purchases of merchandise identified (recorded) in the ledger as purchases. Merchandising
enterprise can accumulate in the purchases account the cost of all merchandise purchased for
resale during the accounting period.When purchases are made for cash, the transaction could
be recorded as follows:
Purchases…………………………………..510
Cash…..…………………………………………….510
When purchases are made on account, the transaction could be recorded as follows:
Purchases…………………………………..510
AP…………………………….…………………….510
3.4.1.1. Purchase Discounts
The agreement by the buyer and seller as to when payments to be made for the merchandise
purchased and sold are called credit terms. If payment is required for the merchandise
sold,up on the delivery of merchandise to the buyer, the term are said to be cashornet cash.
Otherwise, the buyer is allowed an amount of time, known as the credit period, in which to
pay. For example, Habesha Company purchased merchandise on account from ABC
Company:

63
The credit period usually begins with the date of the sale as shown on the invoice (invoice is a
bill that the seller sends to the buyer when transact with on account) prepared by the seller. If
payment is due within a stated number of days after the date of the invoice, such as 30 days,
the terms are net 30 days. These terms may be written as n/30. If payment is due by the end
of the month in which the sale was made, the terms are written as n/eom.

Ifinvoiceispaidwithin Invoice for $1,500 If invoiceis NOTpaidwithin10

10 days of invoice date Terms: days of invoice date
2/10, n/30

2%ofinvoice amountisallowed $1,470 $1,500

Fullamountisdue
asacashdiscount Paid within30daysof in voicedate
Paid

As means of encouraging payment before the end of the credit period, the seller may offer a
discount for the early payment of cash. Thus, the expression “2/10, n/30” means, the credit
period is 30 days, the buyer may deduct 2% of the amount of purchase if payment is made
within 10 days of the purchased date. Refer this diagram:
Discount taken by the buyer for early payment of an invoice (liability) are called purchases
discount. It is recorded by crediting the purchases discounts account and viewed as a
deduction from the initial (original) recorded of purchases. Purchase discount is a contra (or
offsetting) account to purchases. Take this illustration:
Illustration 1: Habesha Company on October 11, 2012 purchased $1,500 of merchandise on
account, with a credit terms of 2/10, n/30 from ABC Company. The journal entry to record
the purchase of merchandise on account is the following.
October 11, 2012 Purchases 1,500
AP 1,500
Illustration 2: On October 21, 2012, Habesha Company made cash payment to the ABC
Company for the merchandise purchased on October 11, 2012. The journal entry to record the
payment of cash is as follow:
October 21, 2012 AP 1,500
Cash 1,470
Purchases Discount 30
3.4.1.2. Purchases Returns and Allowances
If the merchandise purchased has defects, out of the value or due to other reason, the buyer
company might return the merchandise to the seller company (purchases return) or price
adjustments are requested by the buyer (purchase allowances) for the merchandise that has
defect or other reasons. In these cases, the buyer and the seller communicate with a document
called debit memorandum. Purchases returns and allowances accounts are deduction from the
amount initially recorded in purchases and it is a contra (offsetting) accounts.
Illustration 3: Habesha Company sent a debit memorandum for ABC Company for the
purchases return of merchandise that amounted to $62. The journal entry to record this
transaction is as follow:
64
AP 62
Purchases Returns & Allowances 62
Bear in mind that, when buyer returns merchandise prior to the payment of the invoice
(liability), the amount of debit memorandum is deducted from the invoice amount before
purchase discount is computed.
The following T accounts summarize the three purchases-related transactions of Habesha
Company and show their combined effect on net sales.
Purchases Purchases DiscountPurchases Returns & Allowances
1,500 30 62

Net Purchases
1408
3.4.2. Recording Sales
When a merchandising company transfers goods to the buyer, in exchange for cash or a
promise top at a later date, revenue is produced to the company. This revenue is recorded in a
Sales account. However, the sales revenue, which is reported on the Income Statement is Net
Sales.
Sales. That is,
Net Sales = Gross Sales – Sales Discounts- Sales Returns and Allowances
Recording Gross Sales
The gross sales amount is obtained from sales invoices. An invoice is a document, prepared
by the seller of merchandise to notify to the buyer the details of the sale. These details can
include number of items sold, unit price of items, total price, terms of sale and manner of
shipment. When goods are delivered to the customer, the Sales account is credited because
revenues are increased by credits.
A company can sell goods either for cash or on account.
Recording Cash Sales
When merchandise is sold on cash, the Cash account is debited and the revenue account Sales
is credited.
Example – Ika Company based in Bahir Dar, buys and sells used commodities. On January
14. 2001. Ika sold goods for Birr 20,000. Record the transaction.
Answer:
January 14, Dr. Cash………………………………..20,000.00
Cr. Sales……………………………………20,000.00
34.2.1. Recording Credit Sales
The Accounts Receivable account is debited when goods are sold on account (for credit).
Example -
Ika sold goods worth Birr 35,000 on account on January 15, 2001. Record the transaction.
Solution
January 15. Accounts Receivable…………………..35,000.00
Sales…………………………………………35,000.00
Determining Gross Sales when there are trade discounts

65
A trade discount is a percentage deduction from the specified list price or catalogue price of
merchandise.
Trade discounts allow us:
- To avoid publishing a new catalogues every time prices change.
- To grant quantity discounts
- Quotation of different prices to different types of customers.
Trade discounts are not recorded in the seller’s accounting records; they are only used to
calculate the gross selling price.
Example:
Example: IKA sold 500 T.V. sets, each with a list price of Birr 80, on January 17, 2001 for
cash. It gave the customer a 30% trade discount, as the customer was a very loyal one.
Record the sale.
Answer:
List price of goods ( 80 X 500) Birr 40,000
Less: Trade discount (30 % of 40,000) (12,000)
(12,000)
Invoice price 28,000
Journal entry:
Cash……………………..28,000
Sale………………………28,000
Check Your Progress Exercise –2
1. Record the journal entry if IKa Company above sold goods with a list price of Birr 52,000
to a customer on account. Ika offered the customer a trade discount of 20% for purchases
above Birr 40,000 as it usually does.
Recording Deductions from Gross Sales
Go back to illustration 1- and have a look at the model Income Statement of a merchandising
company. You will see that the sales reported on the income statement is net sales,
sales, i.e., after
deduction of sales discounts and sales returns and allowances.
Gross sales (from invoice)…………………..XXX
Less: Sales discounts…………………………….(XX)
Sales returns and allowances ………….…..(XX)
………….…..(XX)
Net sales……………………………….XX
sales……………………………….XX
So far we have seen the accounting systems on the side of the buyer, thus the opposite of
buyer records will be used in recording on the side of the seller company.Merchandise sales
are identified in the seller company’s ledger as sales. Sales of merchandise in cash should be
recorded as follows:
Cash…………………………………………510
Sales……………………………………………510
When thebusiness sells merchandise on account, the sales recorded as follow.
AR…………………………………………510
Sales……………………………………………510
3.4.2.2. Sales Discounts

66
Discount taken by the buyer for early payment is called sales discounts. Sales discounts are
recorded as debit to sales discounts and it is a reduction in the amount initially recorded in
sales.
Illustration1: On December 1, 2012, Habesha Company has sold merchandise of $500 on
account to XYZ Company with credit terms of 2/10, n/30. The journal entry to record sale of
merchandise on account is as follow:
AR 500
Sales 500
Illustration2: On December 9, 2012, Habesha Company received cash from XYZ Company
for December 1, 2012 transaction. The journal entry to record the receipt of cash is as follow:
Cash 490
Sales Discounts 10
AR 500
3.4.3. Sales Returns and Allowance
Merchandise sold may be returned by the buyer (sales return) or, because of defects or other
reasons, the buyer may be allowed a reduction from the original price at which the goods were
sold (sales allowance). Sales returns and allowances is a reduction in sales revenue and a
reduction in cash or accounts receivable. Sales returns and allowances are a contra (or
offsetting) accounts to sales. The seller and the buyer communicate the return of merchandise
or reduction in the original price with a document called credit memorandum.
Illustration: Habesha Company received credit memorandum for sales returns and
allowances of $110.
Sales Returns & Allowances……………110
AR…………………………………………….110
Bear in mind that, when buyer returns merchandise prior to the payment of the invoice
(liability), the amount of credit memorandum is deducted from the invoice amount before
purchase discount is computed.
The following T accounts summarize the three sales-related transactions of Habesha
Company and show their combined effect on net sales.
Sales Sales Discount Sales Return and
Allwowance
500 10 110

Net Sales
380
3.5. Transportation Costs
The terms of a sale should indicate when the ownership (title) of the merchandise passes to
the buyer. This point determines which party, the buyer or the seller, must pay the
transportation costs. Thus, the term of the agreement between buyer and seller include
provisions concerning:
1. When the ownership (title) of the merchandise passes to the buyer; and

67
 2. Which party is to bear the cost of delivering (cost of transportation) the merchandise
to the buyer.

If ownership passes to the buyer when seller delivers the merchandise to the shipper, the
buyer absorbs transportation cost and the term is said to be FOB Shipping Point . FOB
Shipping Point means the seller place the merchandise “free on board” and the buyer
responsible for the transportation cost beyond that point.
If ownership passes to buyer when the merchandise is received by the buyer, the seller assume
cost of transportation and the term is said to be FOB Destination. The shipping point is
presented as follow:
FOB Shipping Point FOB Destination
Ownership (title) passes to the buyer when merchandise is Delivered to shipper Delivered to buyer

Transportation cost are borne (paid) by … Buyer Seller

When merchandise is purchased on terms of FOB shipping point, transportation cost paid by
the buyer should be debited to Transportation In or Freight In account and credited to
cash.The balance of transportation in account should be added to net purchases to determine
the total cost of merchandise purchased.If the seller prepay the transportation cost and add
them to the invoice, the buyer will debit transportation in for transportation cost.
Illustration: On June 10, Durban Co. purchased merchandise of $900 from Bell Corp. on
account, terms of FOB shipping point, 2/10, n/30, with prepaid transportation cost of $50
added to the invoice. The entry by Durban Co. could be as follows:
Purchases 900
Transportation In 50
AP 950
Bear in mind that, when the terms provide for a discount for early payment, the discount is
based on the amount of sale rather than on the invoice total.
When the agreement states that the seller is to bear the delivery costs (FOB destination), the
amounts paid by the seller for delivery are debited to transportation out (it is expense
account and presented as selling expense).
3.6. Sales Taxes
Almost all countries throughout the world levy a tax on sales of merchandise.Thus, unless the
merchandising company remits the collected taxes to the government, liability for the sales
tax is incurred at the time when sale is made, regardless of the terms of the sale.At the time of
a cash sale, the seller collects the sales tax. When a sale is made on account, the seller charges
the tax to the buyer by debiting Accounts Receivable. The seller credits the sales account for
the amount of the sale and credits the tax to Sales Tax Payable.
Illustration: Sale of $100 on account, subject to a tax rate of 4%.
AR………………………………………………104
Sales…………………………………………………100
Sales Tax Payable…………………………………4

68
Periodically, the appropriate amount of the sales tax is paid to the taxing unit, and sales tax
payment is debited.
3.7. Accounting treatment for inventory system
Inventory refers to products a company owns and expects to sell in its normal operations of
business (Merchandise inventory refers to products that a company owns and intends to sell).
There are two systems of accounting for merchandise: periodic and perpetual system.
Periodic System: Many merchandising enterprise use this system. Revenues from sales are
recorded when sales are made, but no attempt is made on the sales date to record the cost of
merchandise sold.
Perpetual System: In this system both sales amount and the cost of merchandise sold
amount are recorded when each items of inventory are sold.
Cost of Merchandise Sold
Cost of merchandise sold is the cost of merchandise sold to customers during a period. In
periodic inventory system, the cost of merchandise sold during a period is reported in a
separate section in the income statement.
Illustration: ABC Corporation begun its operation on January 3, 2011, and purchased
$340,000 of merchandise during the year. If inventory at December 31,2011 is $59,700; the
cost of merchandise sold determined (computed) as follows:
Cost of merchandise sold:
Purchases……………………………………………………………….…$340,000
Less: Merchandise inventory Dec.31, 2011.……………..59,700
Cost of merchandise sold……………………………………………………..280,300
Assume, during 2012 ABC Corporation purchased additional merchandise of $521,980,
received credit memorandum of purchased returns and allowances of $9,100, in addition ABC
take purchases discount of $2,525, and pays transportation costs of $17,400 for FOB Shipping
Point agreement.
The purchases returns and allowances and 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 cost of merchandise purchased.The following is cost of merchandise purchased for 2012.
Purchases………………………………………………………………$521,980
less: Purchases returns and allowances…………………… $9,100
Purchases discount…………………………………….2,52511,625
Net Purchases…………………………………………………...……..$510,355
Add: Transportation In……………………………………………………..17,400
Cost of Merchandise Purchased ………………………………………$527,755
The ending inventory of ABC Corporation on Dec. 31, 2011, $59,700, becomes the beginning
inventory for2012. In the cost of merchandise sold section of income statement for 2012, this
beginning inventory is added to the cost of merchandise purchased to yield the merchandise
available for sale. The ending inventory, which is assumed to be $62,150, is then subtracted
from the merchandise available for sale to yield the cost of merchandise sold.
Cost of merchandise sold:
Merchandise inventory Jan. 1, 2012……………………………………………….59,700
69
 Purchases………………………………………………………………521,980
Less: Purchases returns and allowances……..…..9,100
Purchases discount………………………..2,52511,400
Net Purchases………………………………………………………….510,355
Add: Transportation In…………………………………………….…...17,400
Cost of merchandise purchased……………………………………..…………
527,755
Merchandise available for sale……………………………………………....587,455
Less: Merchandise inventory Dec. 31,2012……………………………….....62,150
Cost of merchandise sold………………………………………………525,305
3.8. MERCHANDISE INVENTORY ADJUSTMENTS
The best methods to report the cost of merchandise sold is maintaining a separate account
entitled merchandise inventory. At the end of the period, the amount of inventory at the
beginning of the period should be replaced by the amount of inventory at the end of the
period. This is adjusted by two entries:
Entry 1: Transfer the beginning inventory to income summary. For ABC Corporation it is
illustrated as follows:
Income Summary………………………………………….59,700
Merchandise Inventory…………………………………………59,700
N.B. This inventory is part of cost of merchandise sold. It is also subtracted from assets
account.
Entry 2:Debit the cost of merchandise inventory at the end of the periodto the asset account,
i.e. merchandise inventory:
Merchandise Inventory……………………………………62,500
Income Summary……………………………………………….62,500
Bear in mind, the credit portion of the entry effects is a deduction of the unsold
merchandise from the total cost of merchandise available for sale during the period.
3.9.
ADJUSTMENT FOR DEFERRALS AND ACCRUALS
Adjusting Entries for Deferrals (prepaid expenses)
Prepaid expenses are the cost of goods or services that have been purchased but not used at
the end of the accounting period. The portion of the assets that has been used during the
period becomes an expense. Prepaid expense includes as prepaid insurance, prepaid rent,
prepaid interest, etc.
Illustration: assume that ABC Corporation office supplies account has balance of $1,090 on
Dec. 31, 2012. Office supplies on hand amounted to $480 on Dec. 31, 2012. Office supplies
expense is 610 i.e. (610=1090-480).
Office Supplies Expense……………………………………..610
Office Supplies…………………………………………………..610
ABC Corporation prepaid insurance balance was $4,560 at Dec. 31, 2012. $1,910 of
insurance premiums has expired during the year.
Insurance Expense……………………………………..……1,910
Prepaid Insurance………………………………………………1,910
70
Adjusting Entries for Unearned Revenue (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 are received in
advance represent a liability that may be termed unearned revenue.
Illustration: assume ABC Corporation on Oct. 1, 2012 rents a portion of building that it has
been leased for a period of one year, receiving $2,400 in payment for the entire year’s rental.
The transaction was originally recorded as debit to cash and credit to liability account of
unearned rent. On Dec. 31, 2012, one fourth of the amount has been earned and three fourth
of the amount remains a liability.
Unearned Rent…………………………………………..600
Rent Income………………………………………………...600
Adjusting Entries for Accrued Liabilities (Accrued Expense)
Some expenses accrue from day to day but are usually recorded only when they are paid such
as salaries paid for employees and interest paid on notes payable. The amount of such accrued
but unpaid items at the end of the fiscal period are both expense and liability.
Illustration: On Dec. 31, 2012, the end of the fiscal year, the sales salaries expense account
for ABC Corporation has a balance of $59,250 and the office salaries expense account has a
debit balance of $20,660. For this fiscal year, the records of the business show that the
accruals for sales salaries and office salaries are $780 and $ 360, respectively, at the end of
the year.
Sales Salary Exp…………………………………………780
Office Salary Exp……..…………………………………360
Salary Payable………………………………………...1,140
Adjusting Entries for Accrued Assets (accrued Revenue)
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 accrued revenue must be recorded by debiting an
asset account and crediting a revenue account.
Illustration: on Dec. 31, 2012, ABC Corporation has an interest bearing note receivable. All
interest income will be collected in 2013, when payment is due on the note. The interest
earned but not collected as of Dec. 31, 2012 is $ 200.
Interest Receivable……………………………………...200
Interest Income………………………………………..…….200
WORK SHEET FOR MERCHANDISING ENTERPRISE
After yearend posting of the journals is completed, worksheet is used to assist in preparing the
adjusting entries, closing entries, and financial statements. The primary difference between
the worksheet of merchandise enterprise and service enterprise is that of the beginning and
ending merchandise inventories, which are shown in the income summary account, appear in
both the debit and credit income statement columns of the worksheet.
Adjustments on the Work Sheet
The data needed for adjusting the accounts of ABC Corporation are summarized as follows:
- Interest accrued on note receivable $200
71
 - Merchandise inventory as of Dec. 31, 2012 62,150
- Office supplies as of Dec. 31, 2012 480
- Insurance expired during 2012 1910
- Depreciation during 2012 on:
 Store equipment 3100
 Office equipment 2490
- Salaries accrued on Dec. 31, 2012
 Sales salary…………………………780
 Office salary……………………… 360
 Salary payable 1,140
- Rent income earned during 2012 600

The balances of the accounts in the trial balance columns and the amount of any adjustments
are added or deducted as appropriate. The adjusted balances are then extended in to the
adjusted trial balance columns, which are totaled to prove the equality of debits and credits.
Both the debit and credit amounts for the income summary are extended.
After all of the items have been extended into the statement sections of the work sheet, the
four columns are totaled and the net income or net loss is determined. The following work
sheet is for ABC Corporation illustration:
(a) Interest earned but not received on notes receivable, 200
(b) Beginning merchandise inventory, 59,700
(c) Ending merchandise inventory, 62,150
(d) Office supplies used, 510 = 1090- 480
(e) Insurance expired, 1910
(f) Depreciation of store equipment, 3,100
(g) Depreciation of office equipment, 2,490
(h) Salaries accrued but not paid (sales salary, 780 and office salary 360 ) total 1,140
(i) Rent earned from amount received in advance, 600

ABC Corporation
Work Sheet
For Year Ended Dec. 31, 2012
Account Title Trial Balance Adjustments Adjusted Income Balance
Trial Balance Statement Sheet
Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 62,950 62,950 62,950
Notes receivable 40,000 40,000 40,000
AR 60,880 60,880 60,880
Interest Receivable (a)200 200 200
Merchandise Inv. 59,700 (c)62,150 (b)59,700 62,150 62,150
Office Supplies 1,090 (d)610 480 480
Prepaid Insurance 4,560 (e)1,910 2,650 2,650
Store Equipment 27,100 27,100 27,100

72
Accum.DepSt.Eq. 2,600 (f)3,100 5,700 5,700
Office Equipment 15,570 15,570 15,570
Accum.Depof.Eq 2,230 (g)2,490 4,720 4,720
AP 22,420 22,420 22,420
Salaries Payable (h)1,140 1,140 1,140
Unearned Rent 2,400 (i)600 1,800 1,800
Note Payable 25,000 25,000 25,000
Capital Stock 100,000 100,000 100,000
Retained Earning 53,800 53,800 53,800
Dividends 18,000 18,000 18,000
Income Summary (b)59,700 (c)62,150 59,700 62,150 59,700 62,150
Sales 720,185 720,185 720,185
Sales R&A 6,140 6,140 6,140
Sales Discount 5,790 5,790 5,790
Purchases 521,980 521,980 521,980
Purchases R&A 9,100 9,100 9,100
Purchas Discount 2,525 2,525 2,525
Transportation In 17,400 17,400 17,400
Sales Salary Exp. 59,250 (h)780 60,030 60,030
Advertising Exp. 10,860 10,860 10,860
Depn. Exp. St. Eq. (f)3,100 3,100 3,100
Misce Selling Exp 630 630 630
Office Salary Exp 20,660 (h)360 21,020 21,020
Rent Exp 8,100 8,100 8,100
Depn. Exp.Of. Eq. (g)2,490 2,490 2,490
Insurance Exp (e)1,910 1,910 1,910
Office Supply Exp (d)610 610 610
Misce Admin Exp 760 760 760
Rent Income (i)600 600 600
Interest Income 3,600 (a)200 3,800 3,800
Interest Expense 2,440 2,440 2,440
943,860 943,860 131,000 131,900 1,012,940 1,012,940 722,960 798,360 289,980 214,580
Net Income 75,400 75,400
798,360 798,360 289,980 289,980

3.10. PREPARATION OF FINANCIAL STATEMENT

The basic financial statement for merchandising enterprise includes income statement,
balance sheet, statement of owner’s equity, and statement of cash flow, are similar to those of
service enterprise. For corporation type of merchandise enterprise the financial statement
includes statement of retained earnings rather than statement of owner’s equity.
The basic difference between the financial statement of merchandise enterprise and service
enterprise is the income statement section of cost of merchandise sold and the balance
sheet section of merchandise inventory.
Income Statement
There are two widely used forms for the income statement: multiple – step and single – step.
Multiple – Step for of Income Statement

73
Themultiple – step income statement is so called because of its many sections, sub sections
and intermediate balances. Such as:
1. Revenue from sales: the total of all charges to customers for merchandise sold, both on
account and cash, is reported in this section. Sales return and allowances and sales
discounts are deducted from the gross amount to yield net sales.
2. Cost of Merchandise Sold: this section is for the determination of cost of merchandise
sold. The other name of cost of merchandise sold is cost of goods sold or cost of sales.
3. Gross Profit: the excess of the net revenue from sales over the cost of merchandise sold is
called gross profit or gross margin. It is called gross because operating expenses must be
deducted from it.
4. Operating Expenses: for retail business, operating expenses can be sub divide in to two
categories: selling and administrative expenses. Selling expenses are incurred directly
and entirely in connection with sale of merchandise. They include such expenses such as:
salaries for sales man, store supplies used, depreciation of the store equipment and
advertisement cost. Administrative expenses or general expenses incurred in the
administration of the business, such as: office salaries, depreciation of office equipment,
and office supplies used rent expenses, insurance expenses etc.
5. Income from Operations: the excess of gross profit over total operating expenses is called
income from operation. If operating expenses are greater than gross profit, the excess is
called loss from operations.
6. Other Income: revenue sources other than the principal activities of the business are
classified as other income, or non-operating income. Such as: income from rent, interest
income and gain from sales of plant assets.
7. Other expenses: expenses that are not associated with operations of the business, such as
interest expenses and loss from disposals (sales) of the business plant assets.
The two categories of non-operating items are offset against each other on the income
statement. If the total of other income exceeds the total of other expenses, the difference
is added to income from operations. If the total of other expenses exceeds the difference
is subtracted from income from operations.
8. Net Income or net loss: the final figure on the income statement is net income (or net
loss).

Single – Step form of Income Statement

In single – step income statement the total expenses deducted from the totals of revenues. An
objection (disadvantage) of the single – step form of income statement is the relationships as
of gross profit to sales and income from operations to sales are not as readily determinable as
they are when the multiple – step form of income statement
In the following pages the multiple – step income statement and single – step income
statement for ABC Corporation illustration is presented as follows respectively:
Multiple – step income statement for ABC Corporation

74
 ABC Corporation
Income Statement
For the Year Ended December 31, 2012
Revenues from Sales:
Sale………………………………………………………………………...….$720,185
Less: Sales returns and allowances……….………......$6,140
Sales discounts……………………………....…..5,79011,930
Net Sales……………………………………………………………….….$708,255
Cost of Merchandise Sold:
Merchandise Inventory, Jan. 1, 2012……………………………..………….…....59,700
Purchases………………………………………………………....521,980
Less: Purchases returns and allowances……………9,100
Purchases discount …………………….……2,52511,625
Net Purchases………………………………………………….….510,355
Add: Transportation in…………………………………………..…17,400
Cost of Merchandise Purchased…………………………………………………
527,755
Merchandise Available for Sale………………………………………………..
…....587,455
Less: Merchandise Inventory, Dec. 31, 2012………………………………… ..62,150
Cost of merchandise
Sold……………………………………………………………………525,305
Gross Profit……………………………………………………………………..182,950
Operating Expenses:
Selling Expenses:
Sales Salary Exp………………………………………………………60,030
Advertising Exp……………………………………………………….10,860
Depreciation Exp. Store Equipment………………………………..…..3,100
Miscellaneous Selling Exp……………………………………………630
Total SellingExp……………………………………………………………..…
74,620
Administrative expenses:
Office salary Exp……………………………………………………...21,020
Rent Exp……………………………………………………………..…8,100
Depreciation Exp. Office Equipment…………………………………..2,490
Insurance Exp…………………………………………………………..1,910
Miscellaneous Administrative Exp………………………………..…760
Total Administrative Exp…………………………………………………34,890
Total Operating Exp…………………………………………..……………,,109,510
Income from Operation………………………………………………………....73,440
Other Income:
Interest Income……………………………………………………………3,800
75
 Rent Income………………………………………………………………. 600
Total Other
Income……………………………………………………………..4,400
Other Expenses:
Interest Expense…………………………………………………………….2,4401,960
Net Income……………………………………….……………………………....75,400
Single – step income statement for ABC Corporation
ABC Corporation
Income Statement
For the Year Ended December 31, 2012
Revenues:
Net Sales…………………………………………………………………….708,255
Interest Income………………………………………………………………...3,800
Rent Income……………………………………………………………. 600
Total Revenue…………………………………………………………712,655
Expenses:
Cost of Merchandise Sold………………………………………………..525,305
Selling Expenses……………………………………………………..……74,620
Administrative Expenses………………………………………………….34,890
Interest Expenses……………………………………………………..…….2,440
Total Expenses………………………………………………………..637,255
Net Income…………………………………………………………….……75,400
Retained Earnings Statement
Retained earnings statement summarizes the changes which have occurred in the retained
earnings account during the fiscal period. It serves as a link between the income statement and
the balance sheet.
ABC Corporation
Retained Earnings Statement
For the Year Ended December 31, 2012
Retained Earnings, January 31, 2012………………………………………….53,800
Net Income for the Year……………………………………………………….75,400
Less: Dividends………………………………………………………………..…
18,000
Increase in Retained Earnings………………………………………………….57,400
Retained Earnings, December 31,2012………………………………………111,200
Balance Sheet
The arrangement of assets on the left hand side of the balance sheet and, liabilities and
owner’s equity on the right hand side of the balance sheet is called account form. The
arrangement of the three section of the balance sheet in the downward sequence called report
form.

76
 ABC Corporation
Balance Sheet
December 31, 2012
Assets
Current Assets:

Cash………………………………………………………………………..62,950
Notes Receivable………………………………………………………..40,000
Accounts Receivable………………………………………………..…..60,880
Interest Receivable…………………………………………………...…….200
Merchandise Inventory………………………………………………. . .62,150
Office Supplies………………………………………………………….….480
Prepaid Insurance……………………………………………………..…2,650
Total Current Assets…………………………………………...229,310
Plant Assets:
Store Equipment……………………………………….…27,100
Less: Accumulated Depreciation……………………..…5,700
21,400
Office Equipment…………………………………….…..15,570
Less: Accumulated Depreciation…………………….…4,720
10,850
Total Plant Assets………………………………………….…. ... 32,250
Total Assets……………………………………………………….…….261,560
Liabilities
Current Liabilities:
Account Payable………………………………………………………22,420
Note Payable(Current Portion)………………………………………..5,000
Salary Payable……………………………………………………….....1,140
Unearned Rent…………………………………………………………….1,800
Total Current Liabilities…………………… ………….…...…..30,360
Long – Term Liabilities:
Note Payable……………………………………………………..…….20,000
Total Liabilities………………………………… ……………..………50,360
Stockholders’ Equity
Capital Stock………………………………………………………..……100,000
Retained Earnings…………………………………………………….….111,200
Total Stockholders’ Equity………………………………………........211,200
Total Liability and Stockholders’ Equity……………………….…….261,560

3.11. ADJUSTING ENTRIES

The followings are adjusting entries which were previously discussed for ABC Corporation as
of December 31, 2012.
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 Interest Receivable……………………………………………….200
Interest Income……………………………………………………..200
Income Summary…………………………………………….. 59700
Merchandise Inventory……………………….…………….....59700
Merchandise Inventory…………………………………………62150
Income Summary………………………..…………………….…62150
Office Supplies Expense…………………………………….… ....610
Office Supplies…………………………………….……………...610
Insurance Expense…………………………………………….…1910
Prepaid Insurance……………………………………………..….1910
Depreciation Expense- Store Equipment………………………..3100
Accumulated Depreciation –Store Equipment……………….….3100
Depreciation Expense- Office Equipment………………..……2490
Accumulated Depreciation –Office Equipment………….……….2490
Sales Salary Expense………………………………………….…780
Office Salaries Expense………………………………...….…….360
Salary Payable…………………………………..……….……...1140
Unearned Rent……………………………………………….....600
Rent Income………………………………….………………..…600

3.12. CLOSING ENTRIES

The closing entries are recorded in the journal immediately following the adjusting entries.
Closing entries cleared all of the temporary owner’s equity accounts, reducing them to zero
balance. The final effect of closing entries is a net increase or a net decrease in the retained
earnings. The closing entries for ABC Corporation as of December 31, 2012 are the
followings:
Sales………………………………………………………...…...720,185
Purchases Returns And Allowances……………………………..…9100
Purchases Discounts…………………………………………....…..2525
Interest Income……………………………………………........…..3800
Rent Income…………………………………………………………600
Income Summary………………………………………………………736,210
Income Summary………………………………………………663,260
Sales Returns And Allowances……….………………………………….$6,140
Sales Discounts…………………………….…………………..……........ 5,790
Purchases……………………………………………………………….521,980
Transportation In…………………………………………………….......17,400
Sales Salary Exp……………………………………………………...….60,030
Advertising Exp………………………………………...…….……...…..10,860
Depreciation Exp. Store Equipment…………………………..…………..3,100
Miscellaneous Selling Exp………………………………………...…….….630

78
 Office Salary Exp………………………………………………………..21,020
Rent Exp………………………………………………………………......8,100
Depreciation Exp. Office Equipment…………………………………......2,490
Insurance Exp…………………………………………………………….1,910
Office Supplies Expense……………………………………………………610
Miscellaneous Administrative Exp………………………………………...760
Interest Expense…………………………………………………………..2,440

Income Summary…………………………………………………75400
Retained Earnings………………………………………………….………75400

Retained Earnings………………………………………………..18000
Dividends…………………………………………………………....……..18000

The effects of the four closing entries are:

1. The first entry closes all income statement account with credit balance by transferring
to the credit side of the income summary.
2. The second entry closes all income statement account with debit balance by to the debit
side of the income summary.
3. The third entry closes income summary by transferring its balance to the retained
earnings.
4. The fourth entry closes dividends by transferring its balance to the retained earnings.

After all temporary owner’s equity accounts have been closed, the only account with
balances are the assets, contra assets(e.g. accumulated depreciation), liability, capital stock
and retained earnings.

3.13. REVERSING ENTRIES

To simplify the analysis and recording of subsequent transactions related to such adjusting
entries, an optional procedure is the use of reversing entries may be used. Reversing entry is
the exact reverse of the adjusting entry to which it relates. The amounts and the accounts are
the same as the adjusting entry; the debits and credits merely reversed.
Illustration: the adjusting entry for ABC Corporation recorded on Dec. 31, 2012 for accrued
salary expense and salary payable was as follows:

Sales Salary Exp……………………………………………..……780

Office Salary Exp………………………………………………….360
Salary Payable…………………………………………………..1140

The reversing entry could be recorded on Jan. 1, 2013 is as follows:

79
Salary Payable……………………………………………………1140
Sales Salary Exp………………………………………………….….780
Office Salary Exp………………………………………...……….…360

Illustration: ABC Corporation recorded the adjusting entry for accrued interest receivables as
follows:

Interest Receivable………………………..…………………….200
Interest Income…………………………………………….…….......200

The reversing entry for accrued interest receivable is as follows:

Interest Income………………………….……………………..200
Interest Receivable……………………………….…………….……200

3.14. INTERIM STATEMENTS

Business enterprises frequently prepare financial statements at intervals within the fiscal year,
such as monthly, quarterly, or semiannually. Statements issued for periods covering less than
a fiscal year are called interim statements. The analysis and recording of transaction is
performed on a continuous basis throughout the fiscal year, regardless of when financial
statements are to be prepared. When interim financial statements are to be prepared, the
adjustment data are assembled and worksheet is completed as of the end of the interim period.
However, adjusting and closing entries are not recorded in the accounts. These entries
are recorded only at the end of the fiscal year.

3.15. CORRECTION OF ERRORS

Occasional errors in journalizing and posting transactions are an avoidable. Procedures used to correct
errors in the journal and ledger varies in accordance with the nature of the error and the phase of the
accounting cycle in which the error is discovered.

When an error in account title or amount in the journal is discovered before 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 credit (or vice versa), the incorrect posting may be corrected by drawing a line through the
error and posting the item correctly

When an erroneous account title appears in a journal entry and the error is not discovered until after
posting is completed, the preferable procedure is to journalize and post a correcting entry. For
example, purchase of office equipment which was paid in cash, was erroneously journalized and
posted as a $500 to office supplies of debit but correctly journalized and post as $500 to creditto cash.
The correcting entry should be as follows:

Office Equipment……………………………………..500
Office Supplies………………………………………………500

80
 CHAPTER 4
ACCOUNTING SYSTEMS DESIGN
6.1. Introduction
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 is called the
accounting system. It includes the entire networking of communication. An accounting
system is the methods and procedures for collecting, classifying, summarizing, and reporting
a business’s financial and operating information.
6.2. Principles of Systems Design
Accounting systems are different from business to business. Accounting systems for large
businesses must be able to collect, accumulate, and report many types of transactions. Even
though the differences in the business that related to the number of transactions to be
processed and the uses made of accounting data there are a number of broad principles which
can apply to all systems. Those are:
a) Cost effective balance
b) Flexibility to meet future needs
c) Adequate internal control
d) Effective reporting
e) Adaption to organizational structure

6.3. Accounting System Installation and Revision

Before designing the accounting system the designer must have a complete knowledge of the
business’s operations.
Accounting systems evolve through a three-step process as a business grows and changes.
The first step in this process is analysis, which consists of (1) identifying the needs of those
who use the business’s financial information and (2) determining how the system should
provide this information. In the second step, the system is designed so that it will meet the
users’ needs. Finally, the system is implementedand used. In general, many large businesses
continually review their accounting system and may constantly be involved in changing part
of it. The job of installing and changing is made up of three phases:
i. Analysis
ii. Design
iii. Implementation

6.4. Internal Control Structure

An enterprise internal control structure consists of policies and procedures established to
provide reasonable assurance that the enterpriser’s goals and objectives will be achieved. This
internal control structure can be divided in to three elements.
1. Control environment: is affected by management’s philosophy and operating style,
organizational structure of the enterprise, personnel policies and practices.
2. Control procedures: The following are general control procedures
a) Competent personnel and Rotation of duties
b) Assignment of responsibilities
c) Separation of responsibilities for related operations
d) Separation of operations and Accounting
e) Proof and security measures
81
 f) Independent review by internal auditor\
3. Accounting system: Is an integral part of the internal control structure of an
enterprise.

6.5. Data Processing Methods

The entire amount of data (information) needed by an enterprise is called database. As the
data base increases, manual processing becomes too costly and takes much time. In such a
case, the manual system can be changed, or replaced or supplemented by computerized
system.
6.6. Subsidiary Ledgers and Special Journals
Subsidiary Ledger: As the number of purchase and sales on accounts increase, the need for
maintaining a separate account for each creditor and debtor is clear. When there is large
number of individual accounts with common characteristics, it is common to place them in
separate ledger called subsidiary ledger. Each subsidiary ledger is controlled by
summarizing account called controlling account. The sum of the balances of the accounts in
a subsidiary ledger must agree with the balance of the related controlling account.
Subsidiary ledger includes:
 Account payable ledger: controlled by account payable
 Customers’ ledger (account receivable) : controlled by account receivable

Special Journals: Special journals would be needed only for the kind of transactions that
occur frequently. The following are typical transactions which occur most often in a medium-
size merchandising firm and the special journals employed.
Types of Transaction Recorded in
1. Purchase of merchandise or other items on Purchases Journal
account
2. Payment of cash for any purpose Cash payment Journal
3. Sales of merchandise on account Sales Journal
4. Receipt of cash from any source Cash receipts journal

Purchase Journal
The purchase journal used only to record purchased materials on account. Sales journal is also
used to record goods or materials sold on account bases. The materials purchased or sold on
cash bases are treated on special journal known as cash journal
Date Account credited Post Account Purch Store Office Sundry P.Re Amount
Ref. payable ases supply Supply accountsDr
Cr Dr Dr Dr
Jan.2 2 Bedru Co.  11448 11448
008
3 Masreshaand Sons Plc.  14812 14812

9 Paulos Supply Co.  514 262 252

11 Diribcho corporation  7186 7186 30250

11 Masreshaand Sons Plc.  6416 6416

17 Robe supply  3000 3000

82
 20 Walelign Co.  30250 Store Equipment 121

23 Paulos supply Co.  264 150 114

27 Diribicho Corporation  12750 12750 00 00 00

30 Total  86640(21 55612( 412(115 366(116  30250

1) 511) ) )

Example: to shows how to post an account from purchase journal to subsidiary ledgers.
Ayele
Ayele 200200
Beyene 800Beyene
Chalachew 600 800
Deribe400chalachew
2000 600
Deribe
General Ledger 400
Account payable
2000

83
 CHAPTER 5
Accounting for cash
Cash is any medium of exchange that a bank will accept at face value. In other terms Cash is
an asset which includes coin, bank deposit, currency (paper money), checks, bank drafts
(incoming money via bank) and money orders (incoming check or cash from customer by
mailer bank.)
Control of cash
The management of cash is of major importance in any business enterprise since cash is a
vital factor in the operation of a business and many business transactions involve cash. In
addition, controlling of cash is important since it is the most liquid of all assets that is
vulnerable to theft or misappropriation. To protect its cash companies should:
1. account for all cash transactions accurately so that correct information will be
available regarding cash flows and balances.
2. make certain that enough cash is available to pay bill as they come due.
3. avoid holding too much idle cash, because excess cash could be invested to generate
income such as interest.
4. prevent loss of cash due to theft or fraud
3.2.1 CONTROLLING CASH RECEIPTS
Businesses ordinarily receive cash from two main source (1) over the counter from cash
customers: and (2) form charge customers making payments on account. The cash that is
received immediately over the counter is usually recorded and placed in a cash register. At
the end of each day, the cash in each cash register is reconciled with the cash register tape or
computer printout for that register. The cash is then taken to the cashier's office and the tapes
are forwarded to the accounting department, where they become the basis for entries in the
cash receipts journal.
When cash is received later, usually in the form of checks, a record of the checks received
should be prepared as soon as they are received. Then the cash is combined with the receipts
from cash sales and should be deposited immediately.

84
In general, though each business varies in its specific procedures for controlling cash receipts,
the following basic principles are used:
1. A record of all cash receipts should be prepared as soon as cash is received most thefts
of cash occur before a record is made of the receipt.
2. All cash receipts should be deposited in a bank on the day they are received or on the
next business day. Undeposited cash is more susceptible to misappropriation.
3. The employee who handles cash receipts should not also be the employee who records
the receipts in the accounting records.
4. It possible, the employee who receives the cash should not also be the employee to
disburse the cash. This control measure is possible in all but the smallest companies.
Illustration 7-1-
7-1- cash receipts cycle for a typical merchandising commonly
Initial sources of cash are Excess cash is used for
owner investment and purposes other than replacing
borrowing inventory

Cash

Accounts Receivable Inventory

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.
Thus, if the actual cash received from sales is less than the recorded amount, cash short and
over account is debited, where as if the actual cash is greater than the recorded the cash short
and over account is credited for the difference.
For example, assume that a clerk accidentally short change a customer Birr 1 and that total
cash sales for the day are Birr 740.50. At the end of the day, actual cash will be Birr 1 over
the sum of the sales tickets or the total of the cash register tape. The Journal entry to record
the day’s cash sales is;
Cash…………………………741.50
Sales……………………………....740.50
85
 Cash short and over……………….... 1.00
At the end of the fiscal period if 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. Where as if it has a credit balance, it is revenue and maybe listed in the “other
income” section.
Cash Change Fund
Businesses that receive cash directly from customers must maintain a fund of currency and
coins in order to make change. The amount of the change fund is deducted from the total cash
on hand at the close of business each day to determine the daily cash collections. Change
fund may be established by drawing a check for the required amount, debiting the account
cash on hand and crediting cash in Bank.

Check Your Progress Exercise - 1

1. What are the four objectives sought in effective cash management?
………………………………………………………………………………………………
2. List four essential features of a system of internal control over cash receipts?
………………………………………………………………………………………………
3.3.2 CONTROLLING CASH DISBURSEMENTS

Controls are also needed over cash disbursements. Since most of a company’s cash is spent by
check, many of the internal controls for cash disbursements deal with checks and
authorizations for cash payments.
The following are some basic control procedures for cash disbursements.
1. All payments of cash should be evidenced by a check signed by a designated official if
they are not payments from petty cash.
2. All checks should be serially numbered, and access to checks should be limited to
employees authorized to write checks.
3. Preferably, two signatures should be required on each check so that one person alone
cannot withdraw funds from the bank account
4. The responsibility for issuing purchase orders, inspecting goods received, and
verifying contractual and arithmetical details of invoices should be divided among the
employees of several departments ( That is apply the basic principle of segregation of
duties)
5. Approved documents should be required to support all checks issued.
In general it is desirable to coordinate these related activities and to link them with the final
issuance of checks to creditors. One of the best systems used for this purpose is the voucher
system.
86
 3.3.3 The Voucher System
A voucher system is made up of records, methods and procedures used in proving and
recording liabilities and in making and recording cash payments. A voucher system uses (1)
vouchers (2) a voucher register (3) a file for unpaid vouchers (4) a check register and (5) a file
for paid vouchers.
A voucher is a form with spaces provided for data about liability that must be paid. The data
include items such as creditor’s name and address, description of goods or services received,
invoice number, terms of payment, due date, amount due and often shows the ledger accounts
and amounts to be debited. The voucher also has spaces for signatures of those approving the
liability for payment.
Illustration 7-2 A voucher

SKY supply company

Texas 666

VOUCHER Voucher NO 111

Our p.o.No 2002
Vendor’s invoice 516
Paid by chedk No 1000

Payable To : Moon Corporation Date Paid 11/1/2003

Down town
Mithigan 777
Date Acct. No Description Quantity Unit price Total
Jan 5 53 Sony television 10 Birr 2000.00 Birr 200,000.00
Total Birr 200,000.00
discount 2% 4,000.00
Net payable 196,000.00

Terms 2/10,N/ 30
Explanations: Due date is February 4, 2003
Audited To Approved for Entered in voucher Date entered
correctness payment Register
5/1/2003

87
Vouchers are customarily prepared by the accounting department on the basis of an invoice or
a memorandum that serves as proof of expenditure. This is usually done only after the
following comparisons and verifications have been completed and noted on the invoice;
1. Comparison of the invoice with a copy of the purchase order to verify quantities,
prices and terms.
2. Comparison of the invoice with the receiving report to verity receipt of the items
billed
3. Verification of the arithmetical accuracy of the invoice.
After all data except details of payment have been inserted, the invoice or other supporting
evidence is attached to the voucher. The voucher is then given to the designated official or
officials for final approval.
 Voucher Register - After approval by the designated official, each voucher is recorded
in a Journal known as voucher register. It is similar to and replaces the purchase
journal.
 Unpaid Voucher File - After a voucher has been recorded in the voucher register, it is
filed in an unpaid voucher file, where it remains until it is paid. The amount due on
each voucher represents the credit balance of an account payable and the voucher itself
is like an individual account in a subsidiary accounts payable ledger. Accordingly, a
separate subsidiary ledger is not needed.
 Check 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 is so called because it is a
complete record of all checks.
 Paid voucher file – After payment vouchers are usually filed in numerical order in a
paid voucher file. They are then readily available for examination by employees or
independent auditors needing inf. About a certain expenditure.
The two controlling over cash devices for cash are:
I) The bank account &
II) Petty cash
I) The bank account: It is one of the major devices for maintaining control over cash.
To get the most benefit from the 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 system is strictly followed, there is a double record of cash, one
maintained by the business and the other by the bank. In some cases a bank may require a
business to maintain a minimum cash balance called compensating balance.
Forms used in a bank account

88
A) Signature card: When an account is opened, each person who is authorized to write
checks on that account must sign a signature card. The bank keeps the signature card on file
and compares it when checks are submitted.
B) Deposit ticket (slip): Used by the business as a receipt to record the cash deposit.
C) Check: is a written document signed by the depositor, ordering the bank to pay a sum of
money to an individual or business entity.
Three parties involved in a check:
1) Maker (drawer): the firm that writes the check.
2) Payer (drawee): the bank on which the check is drawn.
3) Payee: the person or company to whom the check is paid.
Maker check payee check Bank

Money
D) Check register: A form which used to record all transactions paid by check.
 A document which is attached with checks that tells the payee the reason for the
payment is called remittance advice
Bank statement
 It is the monthly statement/schedule send by the bank to the depositor.
Bank reconciliation
The process of comparing the bank’s balance of an account with the company’s balance and
explaining any differences to make them agree is called bank reconciliation.
 Reasons why the bank & depositor balances are not equal are:
a) Items recorded by the company but not yet recorded by the bank.
1) Deposit in transit: is the deposit that the company has recorded but not recorded
by the bank.
2) Outstanding checks: These have been issued by the company and recorded on its
book but have not yet been paid by the bank.
b) Items recorded by the bank only.
1) Bank collection: notes receivable and interest accrued on notes receivable
may be collected by the bank. The bank will notify (remind) the amount of
collection when ever the bank is sending the bank statement to the depositor.
2) Service charge: the amount of banks fee for processing and printing check.
When the bank provides the bank statement to the depositor.
3) Interest revenue on checking account.
c) Not sufficient fund (NSF) received from customer.
d) Checks collected, deposited and returned to payee by the bank for reason other than
NSF
 The bank return checks to the payee if:
 The maker account has closed.
 The signature is not authorized.
 The check form is improper/ changed.
 Accounting for all returned check is the same for NSF.
e) Error by either the company or the bank or both.
E.g. 1) A check written for $225 is drawn by the bank as $252.
2) A check written for $225 is journalized by the depositors as $522.It will understate
the cash ledger balance of the depositor.
A/p-------------------522
Cash-----------------------------------522
89
To record the balance of cash
Cash------------------------------297
A/p----------------------------------297
 Bank credit memorandums: are additions by bank not recorded by depositor.
 Bank debit memorandums: are the deductions by bank not recorded by the
depositor.
Format for bank reconciliation
Xx Company
Bank Reconciliation
Sep.30, xx
Cash balance according to bank record --------------------------------------------------xxx
Add: Additions of depositor not on bank statement (deposit in transit) ----xx
Bank error that under state bank balance ---------------------------------xx xxx
Ded: deduction by the depositor not by bank (outstanding Checks) --------xx
Bank error that overstate bank balance ------------------------------------xx xxx
Adjusted cash balance -------------------------------------------------------------------- xxx
Cash balance according to depositor records---------------------------------------------xxx
Add: additions by bank not recorded by depositor (credit memorandum :
Notes &interest collection, interest revenue on checking accounts)--------xx
Depositor error that understate the depositor cash ledger balance-------xx xxx
Subtotal---------------------------------------------------------------------------------------xxx
Ded: Deduction by bank not recorded by the depositor
(debit memorandum: NSF checks, service charges) --------------------------xx
Depositor error that overstate cash ledger balance------------------------xx xxx
Adjusted cash balance----------------------------------------------------------------------xxx
Example: The bank statement for ABC Company indicates a balance of $3359.78 as of July
31. The balance
In cash in ABC Company ledger of same date is $2549.99.
Additional information:
-Deposit of July 31, not recorded on bank statement --------816.20
-Outstanding checks: #812-------------------1061.00
#878------------------435.39
#883-------------------48.60
-Note plus interest of $8 collected by bank (credit memorandum) not recorded in cash receipt
journal 408.00.
-Bank service charge (debit memorandum) not recorded in cash payment journal ------18.
-Check #879 for $732.26 to “X” company on account, recorded in cash payment journal as
$723.26.
-NSF checks-----------------------$300.
Instruction
a) Prepare bank reconciliation
b) Journalize the necessary journal entries.
ABC Company
A. Bank reconciliation: Bank reconciliation
July 31, 2000
Cash balance according to bank record -------------------------------------------------3359.78
Add: Additions of depositor not on bank statement (deposit in transit) ------816.20
Ded: Outstanding Checks------#812-------------------1061.00
90
#878------------------ 435.39
#883------------------- - 48.60
Total out standing ( 1,544.99)
Adjusted cash balance -------------------------------------------------------------------2630.99
Cash balance according to depositor records---------------------------------------------2549.99
Add: additions by bank not recorded by depositor (Note plus interest collection) ---408
Subtotal------------------------------------------------------------------------------------2957.99
Ded: NSF checks-----------------------------------------------300
Service charge---------------------------------------------18
Depositor error that overstate cash ledger balance----------9.00 327
Adjusted cash balance-----------------------------------------------------------------------2630.99
B) Journal entries
July 31/ Cash-----------------------408
Notes receivable-----------400
Interest revenue---------------8
Accounts receivable-------------300
Cash -----------------300
Miscellaneous administrative expense-----18
Cash-----------------18
Accounts payable ---------9
Cash-------------------9
II) Petty cash fund l amounts during certain period, such as week or a month and
appointing the petty cash custodian, the one who is responsible for the operation of
the petty cash fund and for making disbursements from the petty cash fund.
No entrée will be made to the petty cash account unless the petty cash fund is
changed (increased or decreased).
If the Company decides to increase the size of the fund from $100 (initially established)to
$250 (new decision), it would debit Petty Cash $150 and credit Cash $150 as shown in the
example below.
2) Making payment from the petty cash:
Petty cash receipt: The employee who request for payment and the petty cash custodian will
sign on it. The petty cash custodian will make payment for the specified employee who
request disbursement.

Each payment from the fund must be documented on a pre numbered petty cash receipt (or
petty cash voucher). The signatures of both the fund custodian and the person receiving
payment are required on the receipt.
NB: No journal entry will be made at the time of disbursement (payment) from the petty cash
fund. It is considered both inadvisable and unnecessary to do so. Instead, the company
recognizes the accounting effects of each payment when it replenishes the fund.
3) Replenishing (reimbursing) the petty cash: When the money in the petty cash fund
reaches a minimum level the fund is replenished (reimbursed). Replenishing the petty cash
fund restores to its original amount. The request for this is initiated by the petty cash
custodian. The custodian will provide the summery of the petty cash payment with the petty
cash receipt to the treasurer. Then the treasurer approves the request and check is prepared to
restore the fund to its established amount.
Journal entry will be made to restore the petty cash fund to previously established amount and
to record all expenditures.
91
Occasionally, in replenishing a petty cash fund, a company uses a Cash Over and Short
account when the petty cash fund fails to prove out. That is, an error occurs such as incorrect
change, overpayment of expense, or lost receipt. If cash proves out short (i.e., the sum of the
receipts and cash in the fund is less than the imprest amount), the company debits the shortage
to the Cash Over and Short account. If cash proves out over, it credits the overage to Cash
Over and Short.
NB: A company reports a debit balance of Cash Over and Short in the income statement as
other expense. It reports a credit balance of cash over and short in the account as other
revenue. The company closes Cash Over and Short to Income Summary at the end of the
year..
Example:
A. July 1. ABC established petty cash fund by writing a check for $100.
B. July 5. ABC Increased the amount of the petty cash fund to $150 by writing a check
for $50.
C. July 25. ABC Replenished the petty cash fund by writing a check for $137. On this
date, the fund consisted of $13 in cash and the following petty cash receipts: freight-in
$74, postage expense $43 and Miscellaneous expense$17.
D. July 28. ABC Replenished the petty cash fund by writing a check for $135. On this
date, the fund consisted of $15 in cash and the following petty cash receipts: freight-in
$76, postage expense $45 and Miscellaneous expense$20.
Required: Journalize the petty cash transactions.
Solution:
A. Petty cash-------------100
Cash in bank---------------100
B. Petty cash-------------50
Cash in bank---------------50
C. Freight in ………………74
Postage expense ……… 43
Miscellaneous expense...17
Cash over & short …… 3
Cash in bank …………….. 137
{Cash over & short shows that there is an over payment error/lost receipt and will taken
asother expense on income statement i.e. the available fund on hand is $13 instead of
$16 = (150 – 74-43-17)}
D. Freight in ………………76
Postage expense ……… 45
Miscellaneous expense...20
Cash in bank …………….. 135
Cash over & short ………… 6
{Cash over & short shows that there is an expense which is saved or not paid because of
errors and taken as other revenue on income statement i.e. the available fund on hand is
$15 instead of $9 =(150-76-45-20)}

92
 CHAPTER-6
ACCOUNTING FOR RECEIVABLE
Receivables are all claims against individuals, organization or other debtors in the sales of
merchandise or services on a credit basis.
Receivables that are based on oral agreements are known as open accounts (account
receivable). Receivables that are based on formal (written) instruments are called promissory
notes (notes receivable).
The sales of equipment on the installment plan involving a large amount of money also come
under note receivables. Promissory notes may also be used installment of an open account and
in borrowing and lending.
From the point view of the creditor, a claim evidenced by a note has same advantages over a
claim in the form of account receivables. By signing a note, the debtor acknowledges the
debts and agrees to pay in accordance with the terms specified. The note is therefore strong
legal claim in the account of court action. It is also more liquid than an open account because
the holder cans usually transfers it more readily to a bank or other financial agency in
exchange for cash.
Accounts and notes receivables originating from sales transactions are called Trade
Receivables. Receivables originating from such sources as interest on N/R, loans to the officer
or employees and loans to affiliated companies are referred to as other receivables.
All receivables that are collectible in cash within a year are classified under current assets on
the balance sheet. If the period of collection is longer than a year such long term loan are
listed under investments.
Control over Receivables
The management of a business enterprise should arrange the means of internal control over
their receivables. Thus controls include the separation of the business operations and the
accounting for receivables, so that the accounting records can serve as an independent check
on options. Thus the employee who handles the accounting for notes and account receivables
should not be involved with credit approvals or collection of receivables. Separation of these
functions reduces the possibility of errors and embezzlement. The controls would also include
the separation of responsibilities for related functions, so that the work of one employee can
serve as a check on the work of another employee.
For most businesses, the principal receivables are notes receivable and account receivable.
Generally, notes receivables are recorded in a single general ledger account. If there are
numerous notes, the general ledger account can be supported by a notes receivable register.
Adequate control over account receivable begins with the approval of the sale by a
responsible company official or the credit department, after the customer’s credit rating has
been reviewed. Likewise, adjustments of account receivable, such as for sales returns and
allowances and sales discounts should be authorized or reviewed by a responsible party.
Effective collection procedures should also be established to ensure timely collection of
account receivable and to minimize losses from uncollectible accounts.
Characteristics of Notes Receivables
A note is a written promise to pay a sum of money on a demand or at a definite time. A note
is payable to the order of a particular person, firm or bearer. A note must be signed by the
person who makes it. The one to whose order the note is payable is a payee and the one
making the promise is a maker
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Notes have several characteristics that have accounting implications. These characteristics are
described as follows
 Due date: the date a note is to be paid is called the due date or maturity date. 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.

NB: When the term of a note is stated in days, the due date is the specified number of days after its
issuance. In counting the days, omit the date the note is issued but include the due date.
Example: Zamra construction makes a note receivable from sunshine construction on
October 2, 2008 of 60 days $2500 payable at Dashen bank with interest at 7%. The due date
for the note is
Term of the note-----------------------------------60 days
October (days) ----------------31
Date of note------------------- 2 , 29
Number of days remaining----------------------31
November (days) ----------------------------------30
Due date (December) ----------------------------- 1
When the term of a note is stated as certain number of months after the issuance date, the due
date is determined by counting the number of months from the issuance date.
Example: a 3 month note dated June 5 would be due on September 5.
NB: if there is no date in the month of maturity that corresponds to the issuance date, the due
date becomes the last day of the month. For example 2 month note dated July 31 would be
due on September 30.
 Interest bearing notes and non-interest bearing notes: there are two types of notes.
 Interest bearing note: a note that provides for the payment of interest for the period
between the issuance date and the due date.
 Non-interest bearing note: a note that does not provide for the payment of interest.
 Maturity Value: the amount that is due on a note on date of maturity or due date is
maturity value. The maturity value of non-interest bearing note is the same with the face
amount or principal of the note. The maturity of an interest bearing note is the sum of the
principal and the interest due on the note.
Example: the maturity value of the note receivable for sunshine construction is
Maturity value= principal + interest= 2500 + (2500x 7% x 60/360) = $2529.17
Accounting for Notes Receivable
The typical retail enterprise makes most of its sales for cash or on account. If the account of a
customer becomes delinquent, the creditor may insist that the account be converted into a
note. In this way, the debtor is given more time, if the creditor needs more fund, the note may
be endorsed and transferred to a bank or other financial agency. Notes may also be received
by retail firms that sell merchandise on long term credit.
When a note is received from a customer to apply on account, the facts are recorded by
debiting the note receivable account of the customer from whom the note is received.
Example : Assume that the account of BM co. , which has a debit balance of $900 is past due
a 20 day, 8% note for that amount , dated April 23, is accepted in settlement of the account.
The entry for the acquisition of the note is as follows
April 23 Notes Receivable----------------900
Accounts Receivable-----------900
After 20 days may 13 the note matures. The necessary entries on this date is
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 May 13 Cash--------------------904
Notes Receivable---------------900
Interest Income-----------------4
If the above information is non interest bearing note the entry on maturity date is:
May 13 Cash--------------------900
Notes receivable---------------900
Example: A 30 day, 12% note dated Dec.21, 2008, is accepted in settlement of the account of
Ambassel Company which has a balance of $4000. The entry to record the transaction on
1. December 21 settlement of the account
2. Adjusting entry for accrued ones, Dec.31,2008
3. Reversing entry Jan. 1,2009
4. The necessary entry on the maturity date
Dec 21 Note receivable----------4000
Income----------4000
Dec 31 Interest receivable-------13.3
Interest Income (4000 x 10/360 x 12%) ----------------13.3
Jan. 1 Interest receivable------------13.3
Interest revenue---------------13.3
Jan 20 Cash---------------------------4040
Note Receivable---------------4000
Interest receivable-------------------40

Discounting Notes Receivable

A business may keep the note it has received until the due date or transfer it to a bank by
endorsement. If a note is transferred to a bank, it is said to be discounted and bank charges
interest for discounting the note. The discount (interest) charged is computed on the maturity
value of the note for the period of time the bank must hold the note. The amount paid to the
endorser is the excess of the maturity value over the discount or interest charged by the bank.
This amount is known as proceeds.
Example: Assume that a 90 day non-interest bearing note for $1,350, dated august 21 is
discounted at Lion Bank on September 20 at the rate of 7%.
What is the maturity value of the note?
What is the number of days in the discount period?
What is the amount of the discount?
What is the amount of the proceeds?
Prepare the entry on Sep. 20
Solution:
Face value of the note dated aug.21------------------------------$1350
Maturity value of the note due Nov.19---------------------------1350
Discount period (sep.20-Nov.19) ----------------60 days
Discount on maturity value (1350 x 7% x60/360) -------------15.75
Proceeds (1,350 – 15.75)-----------------------------------------$1334.25
The entry for the transaction is
Sep. 20 Cash-----------------------1334.25
Interest expense------------15.75
Notes Receivable----------------------1350
Example: Misrak enterprise which has a 90 day, 9% notes receivable for $2000, dated Nov.8 is
discounted at a bank on Dec.3 at the rate of 10%.
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 What is the maturity value of the note?
What is the number of days in the discount period?
What is the amount of the discount?
What is the amount of the proceeds?
Prepare the entry on Dec.
Face value of the note dated Nov.8------------------------------$2000
Interest on note (2000x90/360x9%) 45
Maturity value of the note due Feb 6 --------------------------- 2045
Discount period (Dec 3-Feb 6) --------------------------65days
Discount on maturity value (2045x65/360x10%) -------------36.92
Proceeds------------------------------------------------------------$2008.08
The entry for the transaction is:
Dec 3 Cash ---------------------2008.08
Notes receivable----------------2000
Interest income------------------8.08
When the proceeds from discounted note is less than the face value is recorded as interest
expense and to the reverse the face value is less than the proceed the difference is recorded as
interest income.
Dishonored notes receivable
If the maker of the note fails to pay the obligation on the due date, the note is said to be
dishonored. A dishonored note is not negotiable, and for this reason the holder usually
transfers the claim including any interest due to the accounts receivable account. This action is
necessary in order to make the subsidiary ledger disclose the dishonor of the note.
Example: If the $900, 20 day, 8% note received and recorded on April 23 had been
dishonored at maturity, the entry to charge the note, including the interest, back to the
customers account would have been as follows:
May 13 Account receivable B.M co-----------904
Notes receivable---------------------------900
Interest income -----------------------------4
When the discounted N/R is dishonored, the holder usually notifies the endorser of such fact
and asks for payment. If request payment and notification of dishonor are timely, the endorser
is legally obliged 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 account receivable of the maker.
In some cases, the holder of the 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 intern charges it to the maker of the note. If there had been a protest fee in
connection with the dishonor and the payment is recorded as debit to the maker’s A/R and
credit to cash.
Example: Assume that the $2000, 90 day, 9% note discounted on Dec 3 is dishonored at
maturity by the maker, the bank charges a protest fee of $5 the entry to record the payment by
the endorser, in general journal form, would be as follows:
Feb 6 A/R ------------------ 2,050
Cash----------------------2,057
(Paid dishonored, discounted note: maturity value of $2,045 plus protest fee of $5).
Uncollectible receivables
When merchandise or services are sold without the immediate receipt of cash, a portion of
claims against customers ordinarily proves to be uncollectible. This is usually the case
regardless of the care used in granting credit and the effectiveness of the collection procedures
employed.
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 The operating expense incurred because of the failure to collect receivables is variously
termed as expense or loss from uncollectible accounts or bad debts.
There is no general rule for when an account becomes uncollectible. Some indications that an
account may be uncollectible include the following:
1. The receivable is past due.
2. The customer does not respond to the company’s attempts to collect.
3. The customer files for bankruptcy.
4. The customer closes its business.
5. The company cannot locate the customer.
There are generally accepted methods of accounting for receivables that are deemed to be
uncollectible.
1) The allowance method or the reserve method, which makes advance provision for
uncollectible receivables by estimating uncollectible accounts at the end of the accounting
period.
2) The direct write off method or direct charge off method, which recognizes the expense only
when specific accounts are believed to be worthless.
Allowance method of Accounting for Uncollectible
The allowance method estimates the uncollectible accounts receivable at the end of the
accounting period. Based on this estimate, uncollectible accounts expense is recorded by an
adjusting entry.
Example: A business enterprise has a balance of receivables $45,000 at the end of the year.
$2,500 is estimated to be uncollectible. The adjusting entry at the end of the year is:
Uncollectible accounts expense----------------2500
Allowance for doubtful accounts-----------2500
 Net realizable value of A/R = 45,000 – 2,500 = 42,500
 Allowance for Doubtful Accounts is a contra account to Accounts Receivable.
The balance in account receivable is the amount of the total claims against customers on open
account, and the credit balance of $2500 in allowance for doubtful accounts is the amount to be
deducted from account receivable to determine the expected realizable value, frequently called the
net realizable value. $2500 reduction in the asset was transferred to uncollectible accounts
expense, which will in turn be closed to income summary.
Uncollectible account expense is generally reported on the income statement as an
administrative expense because the credit granting and collection duties are responsibilities of
department within the general administrative frame work.
Write –offs to the Allowance Account
When an account is believed to be uncollectible, it is written off against the allowance
account as in the following entry:
Example: On January 21, 2010, ABC’s account receivable of $6,000 from XYZ Company is
written off as follows:
Allowance for Doubtful Accounts ……… 6,000
Accounts Receivable ……………… 6,000
During the year, as more accounts or portions of accounts are determined to be uncollectible,
they are written off against allowance for doubtful accounts in the same manner. Instructions
for write-offs should originate with the credit manager or other designated official. The
authorizations, which should always be written, serve as objective evidence in support of the
accounting entry.

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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 to less than the beginning balance.

After the year –end adjusting entry is recorded the allowance account will have a credit
balance.
An account receivable that has been written off a giant the allowance account may later
collected. In such cases, the account should be reinstated that is the exact reverse of the write-
off entry.
Example: Assume that Nancy Smith’s account of $5,000 which was written off on April 2 is
collected later on June 10. Prepare the necessary entries.
June 10. Accounts Receivable …………. 5,000
Allowance for Doubtful Accounts… 5,000
June 10. Cash ……………………………5, 000
Accounts Receivable ………………5,000
The cash received in payment would be recorded in the cash receipts journal as a receipt on
account. Although it is possible to combine the reinstatement and the receipt of cash in to a
single debit and credit, the entries in the customer’s account is appropriate.
Estimating Uncollectable
The allowance method requires an estimate of uncollectible accounts at the end of the period.
The two methods used to estimate uncollectible accounts are as follows:
1. Estimate Based on percentage of Sales: Accounts receivable are acquired as a result of
sales on account. The volume of such sales during the year there for used as an indication of
the probable amount of the account that will be uncollectable.
Example: It is known from past experience that about 1% of charge sallies uncollectable and
the credit sale for particular year amount is $300,000. The adjusting entry for uncollectible
accounts at the end of the year would be as follow:
Dec 31. Uncollectable Account Expense---------------------------3,000
Allowance for Doubtful Accounts------------------------3,000
Instead of credit sales, total sales (including those made for cash) may be used in developing
the percentage. Total sales are obtainable from the ledger without the necessity the analysis
that may be required to determine charge sales. If the ratio of the sales on account to cash
sales does not change materially from year to year, the result obtained will be equally
satisfactory. If the above example that balance of the sales account at the end of the year is
assumed to be birr 400,000 the application of ¾ of that amount would be also yield an
estimate of birr 3,000.
The estimate based on sales method of determining uncollectible account expense widely
used. In addition to its simplicity, it provides the best basis uncollectible account expense to
the period in which the related sales were made.
Example 2: At the end of the current year, Accounts Receivable has a balance of $800,000;
Allowance for Doubtful Accounts has a credit balance of $7,500; and net sales for the year
total $3,500,000. Bad debt expense is estimated at 1⁄2 of 1% of net sales.
Required: Determine
(a) The amount of the adjusting entry for uncollectible accounts;
(b) The adjusted balances of Accounts Receivable, Allowance for Doubtful Accounts, and
Bad Debt Expense; and
(c) The net realizable value of accounts receivable.
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Solution
a. $17,500 ($3,500,000 x 0.005) Adjusted Balance
b. Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000
Allowance for Doubtful Accounts ($7,500 + $17,500) . . . . . . . . . . ……. . 25,000
Bad Debt Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500
c. $775,000 ($800,000 -- $25,000)
Estimate based on Analysis of Receivable (aging methods of receivable): Under this method,
management estimates what percentage of receivables will result in losses from uncollectible
accounts. The company prepares an aging schedule in which it classifies customer balances
by the length of time they have been unpaid as shown below:
Group 1: Not past due, Group 2: 1–30 days past due, Group 3: 31–60 days past due,
Group 4: 61–90 days past due, Group 5: 91–180 days past due, Group 6: 181–365 days past
due, Group 7: Over 365 days past due
 The totals for each aged class are determined.
 The total for each aged class is multiplied by an estimated percentage of uncollectible
accounts for that class.
 The estimated total of uncollectible accounts is determined as the sum of the
uncollectible accounts for each aged class& journalized as follows:
Uncollectable account expense ……………….. XX
Allowance for doubtful accounts ………. XX
Example 1: At the end of the current year, Accounts Receivable has a balance of $800,000;
Allowance for Doubtful Accounts has a credit balance of $7,500; and net sales for the year
total $3,500,000. Using the aging method, the balance of Allowance for Doubtful Accounts is
estimated as $30,000.
Required: Determine;
(a) The amount of the adjusting entry for uncollectible accounts and record the journal;
(b) The adjusted balances of Accounts Receivable, Allowance for Doubtful Accounts, and
Bad Debt Expense; and
(c) The net realizable value of accounts receivable.
Solution
a. $22,500 ($30,000 – 7,500)
Uncollectable account expense …….. 22,500
Allowance for doubtful account ………. 22,500
b. Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000
Allowance for Doubtful Accounts ($7,500 + $17,500) . . . . . . . . . . ……. . 30,000
Bad Debt Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500
C. $770,000 ($800,000 -- $30,000)
Occasionally, the allowance account will have a debit balance prior to adjustment. This occurs
when write-offs during the year have exceeded previous provisions for bad debts. In such a
case, the company adds the debit balance to the required balance when it makes the adjusting
entry.
Example 2: Allowance for doubtful accounts has a debit balance of $1,500 at the end of the
year, before adjustment. After adjustment analysis of receivable indicates allowance for
doubtful accounts of $17,000 at the end of the year, the amount of the appropriate adjusting
entry will be what?
Solution
The original entry to set up the allowance for doubtful accounts would have been:
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Bad debt expense ………………….. 1,500
Allowance for doubtful account …….. 1,500

The adjustment is 17,000 – 1,500 = 15,500

Bad debt expense ……………… 15,500
Allowance for doubtful account ………………………. 15,500
If more accounts are written off than the original credit balance in the allowance account, it
will end up with a debit balance. If this debit balance gets too high, it
Means you should adjust your estimate higher for uncollectable account.
Example 3: At the end of the current year, Accounts Receivable has a balance of $1,400,000;
Allowance for Doubtful Accounts has a debit balance of $2,250; and net sales for the year total
$9,500,000. Using the aging method, the balance of Allowance for Doubtful Accounts is estimated as
$24,000.
Required: Determine;
(a) The amount of the adjusting entry for uncollectible accounts and record the journal;
(b) The adjusted balances of Accounts Receivable, Allowance for Doubtful Accounts, and Bad Debt
Expense; and
(c) The net realizable value of accounts receivable.
Solution
a. $26,250 ($24,000 +2,250)
Uncollectable account expense …….. 26,250
Allowance for doubtful account ………. 26,250 Adjusted Balance
b. Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,400,000
Allowance for Doubtful Accounts ($26,250-2,250) . . . . . . . . . . ……. . …24,000
Bad Debt Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,250
c. $1,376,000 ($1,400,000 -- $24,000)
Direct Write-off Method of accounting for Uncollectible
Under the direct write-off method, uncollectable account expense is not recorded until the customer’s
account is determined to be worthless. At that time, the customer’s account receivable is written off.
Under this method, companies do not recognize uncollectible accounts expense on the basis of
estimates.
The direct write-off method or the direct charge-off method is reasonable if a company sells all or
most of its output to few companies which financially strong. Because,

In such situations and in many small business and professional enterprise, it is satisfactory to defer
recognition of uncollectible until the period in which specific accounts are deemed to be worthless and
are actually written off as an expense.
Accordingly, when the direct- write- off method is in use, the accounts receivable will be listed on the
balance sheet at their gross amount, and no evaluation allowance will be used, and there is no
necessity for an adjusting entry at the end of the period.
Example: Assume that ABC has $42 account receivable from DL. This receivable is determined to be
uncollectible. The entry to write off the account on May 10 is as follows: Uncollectible Accounts
Expense………………….42
A/Receivable-Horn Co………………………………….42
If an account that has been written off is collectible later, the account should be reinstated.
Example: Assume that the account receivable of $4,200 written off on May 10 is later collected on
November 21. The reinstatement and receipt of cash is recorded as follows:
Nov.21 Accounts Receivable-Horn Co………………………42
Uncollectible Account Expense…………………………42
Nov 21. Cash …………………………42
A/R ……………………………..42

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