FINANCIAL ACCOUNTING

This book is a compilation from different Accounting Books of home and

abroad. The copyright of the book belongs to Bangladesh Open
University. The compiler is not liable for any copyright issue with this
book.

Compiled by:
Professor Dr. Md. Serazul Islam
School of Business
Bangladesh Open University

School of Business
BANGLADESH OPEN UNIVERSITY

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 Need help?
For any kind of help concerned with the study book, consult with -
1. The tutor at your study center
Help
2. Dr. Qazi Mohammad Galib Ahsan
Professor (Accounting), School of Business
Bangladesh Open University
Gazipur-1705.
Phone: 880-2-9291106; 880-2-9291101-4/345 (Ext.)
E-mail: [email protected]

3. Dr. Md. Serazul Islam

Professor (Accounting), School of Business
Bangladesh Open University
Gazipur-1705
Phone: 880-2-9291106; 880-2-9291101-4/342 (Ext.)
E-mail: [email protected]

4. Ariful Islam
Lecturer (Accounting), School of Business
Bangladesh Open University
Gazipur-1705
Phone: 880-2-9291106; 880-2-9291101-4/135(Ext.)
E-mail: [email protected]

There are Assignments in this course; each contributing 10 per cent to the
total assessment of this course. Assignment questions and deadlines can
be found in the website of BOU.

Assignments

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 For BBA or PGDM Program
Two types of assessments will be followed in this course:
Assessments
Assignment # 1 10 percent
Assignment #2 10 percent
Final Examination 80 percent
Total 100 percent

For MBA or CEMBA/CEMPA Program

Three types of assessments will be followed in this course:

Assignment # 1 10 percent
Assignment #2 10 percent
Class Performance & Attendance 10 percent
Final Examination 70 percent
Total 100 percent

For Professional MBA Program

Five types of assessments will be followed in this course:

Class Participation 10 percent

Assignment /Presentation/Case Study 10 percent
Quiz/ Class Test 10 percent
Mid-term Examination-1 15 percent
Mid-term Examination-2 15 percent
Final Examination 40 percent
Total 100 percent

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Margin Icons
While going through this study book, you will notice the frequent uses of margin
icons. These serve to “signpost” a particular piece of the text; a new task or change
in question; they have been included to help you find your way around the course
units.
A complete icon set is shown below. We suggest that you familiarize yourself with
the icons and their meanings before starting your study.

Outcomes Time Terminology Study skills

Activity Assessment Assignment Case study

Group Summary Help Reading

discussion

Note it! Audio Video

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 Table of Contents

Unit Unit Title Lessons Page No.

Number
Lesson 1: Introduction to Accounting 8
Unit 1 Accounting: An Conceptual Framework of 17
Lesson 2:
Introduction Accounting
Lesson 3: Basic Accounting Equation 28

Lesson 1: The Recording Process 38

Unit 2 The Recording Lesson 2: Journalizing 41
Process Lesson 3: Posting 47
Lesson 4: Trial Balance 51

Lesson 1: Timing Issues 57

Adjusting and Lesson 2: Basics of Adjusting Entries- 62
Unit 3 Closing Accounts Prepayments
Lesson 3: Basics of Adjusting Entries-Accruals 65

Lesson 4: The Closing Journal Entries 72

Lesson 1: Merchandising Operations 79

Accounting for Lesson 2: Recording Purchases of Merchandise 84
Unit 4 Merchandising Lesson 3: Recording Sales of Merchandise 89
Operations Lesson 4: Forms of Financial Statement 97

Lesson 1: Inventory Basics 109

Lesson 2: Inventory Costing: Perpetual 111
Unit 5 Inventories Inventory System
Lesson 3: Inventory Costing: Periodic 120
Inventory System

Lesson 1: Concepts Underlying Long-term 129

Plant Assets, Assets
Unit 6 Natural Resources Lesson 2: Depreciation 137
and Intangibles Lesson 3: Methods of Computing Depreciation 140
Lesson 4: Plant Assets Disposal 150
Lesson 5: Natural Resources and Intangibles 157

Frauds, Internal Lesson 1: Frauds and Internal Control 163

Unit 7 Control and Cash Lesson 2: Cash Controls 166
Lesson 3: Bank Reconciliation Statement 172

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Unit Highlights
➢ Explanation of accounting.
➢ Users and uses of accounting.
➢ Importance of accounting.
➢ Generally accepted accounting principles (GAAP).
➢ Accounting equation and its components.
➢ Effects of business transactions on the accounting equation.
➢ Preparation of Financial statements.

Technologies Used for Content Delivery

❖ BOUTUBE
❖ BOU LMS
❖ WebTV
❖ Web Radio
❖ Mobile Technology with MicroSD Card
❖ LP+ Office 365
❖ BTV Program
❖ Bangladesh Betar Program

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Terminology

Accounting Recording and reporting of transactions of an organization.

Business Entity A specific identifiable business enterprise like Agora, Mina Bazar,
Swapna, Shyamoli Paribahan, etc.
Book-keeping Recording of financial transactions and part of the process of accounting
in business.
Creditors/ Organizations or persons who supply goods or services on credit or who
Suppliers lend money to the business. For example, bank, insurance company,
NGO, etc.
Equation Mathematical expression of the relationship beween two or more
variables.
Expenses Part of costs, the benefit of which has already been enjoyed. Expired
costs are normally expenses.
Financial Formal financial reports that reveal an organization’s periodical financial
Statements performance and the latest financial position. For example, Income
Statement and Balance Sheet
Liquidity Ability to pay short-term obligations.
Profitability Ability to make profit sufficient to attract and hold investment capital.
Recording Keeping systematic diary of economic events or transactions.
Reporting Communication of accounting information to internal and external users
through preparation and presentation of financial statements.
Solvency Ability to pay long term obligations.
Transactions Economic events that cause changes in assets, liabilities or owner’s
equity.

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Lesson 1: Introduction to Accounting

Lesson Objectives

After studying this lesson, you should be able to:

• explain what accounting is;

• identify the users and uses of accounting;
• understand why accounting is important;
• distinguish between book-keeping and accounting;
• identify the field of accounting profession;
• narrate the forms of business.

Meaning of Accounting
Accounting is an information system of identification, measurement, recording and reporting of
economic events or transactions of an organization to internal and external users.
Accounting is a process of the following 4 (four) activities:
1. Identification: Identification is the selection of those events or economic activities that are
measured in taka and that change the financial position of a particular organization. For
example, sale of goods, rendering of services, payment of wages, etc.
2. Measurement: Assignment of numbers or symbols to events. For example, depreciation, loss
due to fire, theft etc.
3. Recording: The events identified as economic events or transactions are recorded to provide a
history of financial activities of the organization. Recording consists of keeping a systematic
chronological diary (in order of date) of events, measured in taka. In this process, economic
events are also classified and summarized.
4. Reporting: To make the identified and recorded activities more meaningful the information
should be reported or communicated to the users of that information. To the end, formal
financial reports, also called financial statements (e.g income statement, owner’s equity
statement, balance sheet and cash flow statement) are prepared.
To make the communication more effective and to disclose fully an accountant should have the
ability to analyze and interpret the reported information. To highlight the significant financial trends
and relationship an analysis involves the use of ratio, percentage, graphs, charts etc. An
interpretation involves explaining the uses, meaning, and limitations of reported data.
Technical definitions of accounting have been published by different accounting bodies. American
Institute of Certified Public Accountants (AICPA) defines accounting as:
“the art of recording, classifying, and summarizing in a significant manner and in terms of money,
transactions and events which are, in part at least of financial character, and interpreting the results
thereof.”
This is a technical definition but if you study statements below, you will have a better understanding
of accounting.

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 Concepts of Accounting
The definition of accounting claims the following points and you will have a clear understanding of
accounting.
1. Accounting is Considered an Art and a Science
Accounting is considered an art because it requires the use of skills and creative judgment. One
has to be trained in this discipline to be able to perform accounting functions well.
Accounting is also considered a science because it is a body of knowledge. However, accounting
is not an exact science since the rules and principles are constantly changing (improved).
2. Accounting Involves Interconnected "Phases"
Recording pertains to writing down or keeping records of business transactions. Classifying
involves grouping similar items that have been recorded. Once they are classified, information is
summarized into reports which we call financial statements.
3. Concerned with Transactions and Events Having Financial Character
For example, hiring an additional employee is qualitative information with no financial character.
Hence, it is not recorded in accounts. However, the payment of salaries, acquisition of an office
building, sale of goods, etc. are recorded because they involve financial value.
4. Business Transactions are Expressed- in Terms of Money
Events that take place during the accounting period must be measured in terms of money to be
recorded. There are assigned amounts when processed in an accounting system. Using one of the
examples above, it is not enough to record that the company paid salaries for April. It must
include monetary figures – say for example, Tk. 20,000 salaries expense.
5. Determination of Results
The results of operations of an organization during an accounting period are determined through
preparation of an income statement, and the position of the same business is also disclosed at the
last of the accounting period by preparing a balance sheet.
6. Interpreting the Results
Interpreting results is part of the phases of accounting. Information is useless if they cannot be
interpreted and understood. The amounts, figures, and other data in the financial reports have
meanings that are useful to the users.
By studying the definition alone, we have learned some important concepts of accounting and also
an idea of what accountants do.
You may not notice but the simple things you do and encounter everyday can actually be related to
some level of accounting. You make budgets, count changes and check the receipts from the
supermarket. You may also have listed things you spent your money for.
We are surrounded by businesses – from managing our own money to seeing profit statements of big
corporations. And where there is business, sure there is accounting.
Accounting is, therefore, a system/process/method/ science/technique/an art that measures, records,
classifies, summarizes and processes events mainly of financial nature relating to an identifiable
economic entity and communicates in one understandable form to its interested users.

Accounting-An Integral Part of Business

Accounting as an integral part of business, helps business follow four areas:
• As an Integral System, accounting provides relevant financial information as inputs to external users
group (creditors, shareholders, customers and so on) for making the right decision in the right time.
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• As a Language of Business, accounting communicates operating performance (either net profit or
loss) and financial position (assets, and obligations) meaningfully to the interested users. The
essence of information depends greatly on how it is communicated to the users.
• As a Tool of Internal Control and of External Reporting, accounting ensures internal control over
operations inside business. Accounting helps management look back (control). External reporting
facilitates efficient use of scarce resources and their proper allocation among the involving parties.
• Finally, as a Means of Accountability, management (stewards of resources) of public limited
companies can discharge its accountability to the shareholders (owners of resources) providing an
annual report (including financial affairs) and by answering questions put at the annual general
meeting of shareholders.
Let's take a moment to illustrate that.
Meet Mr. Zaved
Mr. Zaved started a printing business. He invested Tk. 100,00,000 personal money to start entity’s operations.
After a month, he wants to know how much the business made. He also wants to know if the money he
invested is still there.
Without a way of recording the activities of the business, we will not be able to answer his questions. Surely,
we can tell him, "Mr. Zaved, we made a lot this month!", but we need proof! And he needs the figures!
We can easily answer Mr. Zaved's questions if we kept track of the company's transactions. If we used
Tk.30,00,000 of the Tk.100,00,000 we had at the beginning to buy printers and pay the bills, then we'd have
Tk.70,00,000 cash left. If we collected Tk.50,00,000 from our customers, then we would have Tk.120,00,000.
Easy, right?
Okay, that's just a tiny bit of what accounting can do. What if we have thousands of transactions? Also, there's
a lot more to accounting than just recording. How much income did we make? How much do we owe our
creditors? Is this a good investment? Ask away. The accountant would confidently say, "I'll have the reports
prepared." How cool is that?

Users and Uses of Accounting

Accounting is often called the language of businesses as it communicates financial information of a
business enterprise to divergent groups of users. We know language is a way of expressing our
feelings to others and this includes various words, terms & grammar. Like this, Accounting has its
terms [Debit, Credit], grammar [Double entry system]. So Accounting is, of course, a language. The
information that a user of financial information needs depends upon the kinds of decisions he or she
makes and on his or her ability.

On the basis of the differences in the decisions the users of financial information are divided into
two broad categories:

Users of Accounting Information

Internal Users External Users

Management Direct Interest Indirect Interest

- marketing manager Present & potential - tax authority

- decision makers - investors - regulatory agencies
- production supervisors - creditors - customers
- finance directors; and - employees
- company officers/secretary - economic planners, etc.
- academicians & researchers
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Internal Users: Individuals directly involved in managing and operating an organization.

Management: Management is a group of people responsible for achieving the entity’s goal,
Management at all levels uses accounting information in planning, controlling and evaluating
business operations. To perform these functions effectively and efficiently, managers need detailed,
timely and relevant information. So it is said that accounting information provides the ‘eyes and ears
of management’.
Management may need information of
➢ cash position to pay bills/debts;
➢ manufacturing cost of each unit of product;
➢ profitable product line; and
➢ profitable customers, etc.

External Users: Individuals or organizations, not directly involved in running the organization.
Present and Potential Investors/Shareholders: Present owners or investors or shareholders are
very much concerned with the position of their investments in the business. They want to know the
level of performance (profit, cash position, dividend, etc.) of the business in the past year. A present
investor can take the decision of dispose of (sale) or hold a particular security on the basis of
accounting information.
The future potential investors are also interested to know the past performance of the business and
their financial position with an objective to make investment (to buy stock or bond) in future.
Present and Potential Creditors or Suppliers: The creditors, such as trade creditors, banks,
insurance, leasing companies, etc. use accounting information to make sure whether the business
will be able to pay their claims, interest and principal in time and their earning capabilities. They
will expect to analyze the profitability (ability to make profit sufficient to attract and hold
investment capital), liquidity (ability to meet short-term obligation) and solvency (ability to meet
long-term obligation) position of the business before making a loan.
Tax Authorities: Tax authorities, such as National Board of Revenue (NBR) need financial reports
(statements) to ascertain the propriety and accuracy of taxes and other duties declared and paid by a
company and to know whether the company complies with the tax laws.
Regulatory Agencies: Regulatory agencies may include Bangladesh Securities and Exchange
Commission (BS&EC), Bangladesh Bank, Registrar of joint stock companies, stock exchanges
(DSE or CSE), tax authority, and so on. Public limited companies are required to report to these
regulators. Public utilities like Bangladesh Railway, Gas, PDB, WASA, etc. are to defend their
service charges with regular accounting reports to government.
Customers: Customers are interested in information indicating the fairness of pricing policies, such
as the relative proportion of unit price, which consist of costs, profits and taxes and in the
differential costs between a product and another produced by the same firm at a different price.
Periodical accounting reports give them such information.
Employees: Employees also need these reports (i) in making collective bargaining agreements
(CBA) with the management, and (ii) in the case of labor unions or for individuals in discussing
their compensation packages, fringe benefits (e.g., bonus), job security, promotion and other issues
related to their career.
Economic Planners: In measuring national income of the country which deals with total
production, inventories, income, dividends, taxes, etc., economic planners greatly depend on

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accounting information from different companies, institutions, business and production units etc., for
planning and forecasting.
Thus accounting information is used by different groups for many and varied purposes. It is difficult
to think of our present system of production, investments, credits and taxation without Accounting.
Practically the whole nation uses accounting information directly or indirectly.

Differences between Book-keeping and Accounting

Many people consider book-keeping and accounting as synonymous terms, but they are different
from each other. Broadly speaking, accounting includes book-keeping but in myopic sense, we
sometime make differences between these two in the following manner:

Basis of Book-keeping Accounting

Difference
Meaning It is concerned with identifying It is concerned with summarizing the
financial transactions; measuring recorded transactions, interpreting them and
them in monetary terms; recording communicating the results.
and classifying them.
Objective To keep permanent record of To communicate accounting information to
transactions. internal and external users.

Nature of Clerical It is the presentation of accounting

Work information through processing the recorded
data.
Scope It is to record business transactions. It is the recoding, classifying, summarizing,
So its scope is limited. Activities are interpreting business transactions and
journalizing, posting and communicating the results. Thus its scope is
summarization. quite wide. Preparation of income statement,
balance sheet, etc.
Basis Vouchers and other supporting Book-keeping works as the basis for
documents are necessary as evidence accounting information.
to record the business transactions.
Accounting It is enough to have elementary For accounting, advanced and in-depth
Knowledge knowledge of accounting to do knowledge and understanding is required.
bookkeeping.
Relation Book-keeping is the first step to Accounting begins where bookkeeping ends.
accounting.

Fields in the Accounting Profession

Accountants may be employed in five broad fields:
1. Public Accounting/Independent Professional Accounting
2. Private Accounting /Financial and Cost Accounting
3. Not-for-profit Accounting
4. Opportunities in Government
5. Forensic Accounting

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1. Public Accounting: An area of accounting in which the accountant offers expert services to the
public in much the same way that a doctor serves patients and a lawyer serves clients.
Auditing and Assurance: The principal service provided by a chartered accountant (CA) is
auditing. Banks normally require an audit of the financial statements of companies that apply for a
sizable loan. The CA examines the financial statements of companies and expresses an expert
opinion as to the fairness of presentation. When the presentation is fair, users consider the statements
to be reliable. The CAs are not employees of the audited concern but are independent professional
persons working for a fee.
Taxation (Tax service): Taxation is another area of public accounting. The work performed by tax
specialists includes:
• tax advice and planning as to how transactions may be completed so as to incur the
smallest tax;
• preparation and filling of tax returns;
• representing clients before governmental agencies, such as National Board of Revenue.
Management Consulting: In addition to the previous ones, public accountants commonly offer
management advisory services which include:
• design, installation, and improvement of a client’s general accounting system and any
related information systems it may have for managing the company.
This may involve:
• selecting appropriate computers (hardware);
• developing software; and
• installing the procedures necessary to bring an information system into effective
operating use.
Management consulting may also include:
▪ financial planning;
▪ budgeting;
▪ forecasting;
▪ inventory control;
▪ project management;
▪ cost-benefit analysis;
▪ total quality management (TQM); and
▪ performance management.
2. Private Accounting: An area of accounting within a company that involves such activities as:
General Accounting: Recording daily transactions, processing the recorded data and preparing
financial statements for the use of management, owners, creditors and governmental agencies.
Cost Accounting: Recording the cost of producing specific products and preparation of cost
statements.
Budgeting: Assisting management through preparation of all operating and financial budgets.
Accounting Information Systems: Designing both manual and computerized data processing
systems for recording transactions and preparation of financial statements.
Tax Accounting: Preparing tax returns and doing tax planning for the company.

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Internal Auditing: As a part of internal control system, internal audit reviews the company’s
operations to see if they comply with management policies and evaluates the efficiency of
operations.
3. Not-For-Profit Accounting: An area of accounting in which the organizations are operating their
activities with a view to providing services without any profit motive. Such organizations include:
• Hospitals
• Colleges/Universities
• WASA
• Bangladesh Railway
• Local & state governmental units (e.g., municipality, union council, city
corporation) etc.
Not-for–profit accountants record and account for ‘Receipts and Payment Statement’ and ‘Income
and Expenditure Statement’.

4. Opportunities in Government: Another option is to pursue one of the many accounting

opportunities in governmental agencies. For example, the National Board of Revenue (NBR), office
of the Comptroller and Auditor General of the Government of Bangladesh (CAG), the Bangladesh
Securities and Exchange Commission (BS&EC) employ accountants. There is also a very high
demand for accounting educators at public colleges and universities and in central and local
governments.

5. Forensic Accounting: Forensic accounting uses accounting, auditing, and investigative skills to
conduct investigations into theft and fraud. It is listed among the top 20 career paths of the future.
The job of forensic accountants is to catch the perpetrators of the estimated Tk.600 billion per year
of theft and fraud occurring at U.S. companies. This includes tracing money-laundering and identity-
theft activities as well as tax evasion. Insurance companies hire forensic accountants to detect
insurance frauds, such as arson, and law offices employ forensic accountants to identify marital
assets in divorces.

Forms or Types of Business Organization

In Bangladesh, a business organization may be any one of the following five types:
• Proprietorship (Sole-trader ship)
• Partnership
• Company
• Corporations
• Cooperative Societies
Proprietorship: A form of business that
• is owned by a person; and
• requires a relatively small amount of money (capital) to start.
In other words, it is a form of business enterprise where
• the owner (proprietor) enjoys or receives the profit and suffers any losses and is personally
liable for all debts of the business;
• there is no legal separation between the business as an economic unit and the owner.
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For example, grocery stores, beauty salons, clothing stores, book stores, etc.
Partnership: The relation between persons who have agreed to share the profits of a business
carried on by all or any of them acting for all. (Section 4 of the Partnership Act 1932).
The essentials or ingredients of partnership are the following:
• An association of two or more persons (maximum 10 for banking business and 20 for other
types of business).
• Partnership deed is the essence.
• To carry on a business (for example mere ownership of a business by some persons will be
treated as co-ownership, not a partnership).
• Sharing profits (including losses, if any) of the business.
• Partners are jointly and severally liable for the losses.
• Business to be managed by all or any one of them acting for all.
Each member individually is called partner, they are collectively called a firm, and the name under
which their business is carried out is called a firm name.
Firms of accountants and lawyers, and doctors’ practices are examples of partnership.
Company: A business organized as a separate legal entity under the Companies Act, 1994 and
having ownership divided into transferable shares of stock. In the USA, companies are known as
corporation. The holders of the shares (stockholders) enjoy limited liability; that is, they are not
personally liable for the debts of the corporate entity. Stockholders may transfer all or part of their
shares to other investors at any time (i.e., sell their shares).
For example, Square Pharmaceuticals Limited, Beximco Textiles Limited, etc.
Corporation: In Bangladesh, several corporations were created by the presidential order no. 1972 to
look after the management of all nationalized and abandoned industrial units. For example, BJMC,
BTMC, BCIC, BF&SIC, BSEC, etc.
Cooperative Societies: Forms of organizations which are owned and run jointly and voluntarily by
their members who share the profits or benefits as per Co-operative Society Act, 2001. For example,
Pathfinder Multipurpose Cooperative Society Ltd., Bangladesh Police Co-operative Society Ltd.,
National Fishery Society, etc.

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 Review Questions

1. Explain in your own language what accounting is.

2. How does accounting help a business? Explain.
3. “All transactions are events but all events are not transactions.” Explain.
4. How is accounting information communicated?
5. Who are internal users and why do they use accounting information?
6. “The objective of both book-keeping and accounting is same.” Do you agree? Explain.
7. What are the objectives of financial reporting?
8. Distinguish between book-keeping and accounting.
9. Who are creditors and why do they use accounting information?
10. Describe major fields of accounting profession.
11. Explain different forms of business organization.

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Lesson 2: Conceptual Framework of Accounting

Lesson Objectives

After studying this lesson, you should be able to:

• explain the levels of conceptual framework of accounting;

• state the qualitative characteristics of accounting information;
• explain the components of accounting equation;
• describe the assumptions, principles and constraints of accounting.
Conceptual Framework of Accounting
Conceptual Framework = Conceptual+Framework
• Conceptual = idea/plan
• Framework = basic structure/constitution/boundary
CF= The plan or ideas of basic structure of generating and presenting accounting information to
internal and external users.
A conceptual framework is “a coherent (intelligent or consistent) system of interrelated objectives
and fundamentals that
-can lead to consistent standard; and
-prescribes the nature, function, and limits of financial accounting and financial statements.”
To ease the definition of conceptual framework, we can state that conceptual framework is like a
boundary. The preparers and users of accounting information are permitted to work within this
boundary and they are not allowed to encroach these rules and regulations.
An overview of conceptual framework

Level 1 Objectives of Financial Reporting

Level 2 Qualitative Characteristics of Elements of Financial Statements

Accounting Information

Recognition and Measurement Concepts

Level 3

Assumptions Principles Constraints

❖ The first level explains the ‘why’-goals and purpose of accounting
❖ The second level links up the first level with third level
❖ The third level describes the ‘how’-implementation of accounting rationality
___________________________________________________________
IFRS: It is a practical tool that assists the board to develop IFRS standards that are based on consistent
concepts, assists preparers to develop accounting policies when no IFRS standard applies to a particular
transaction or event or when a standard allows a choice of accounting policy.

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 Objectives of Financial Reporting
To provide information that is useful to:
-present and potential investors,
-creditors, and
-other users in making rational investment, credit and similar decisions.

Qualitative Characteristics of Accounting Information

Qualitative characteristics of accounting information are those that help distinguish better (more
useful) information from inferior (less useful) information.
Qualitative Characteristics of Accounting Information

Primary
Relevance Reliability
Qualities

Predictive Value Verifiability

Predictive Verifiability
Feedback Value Representational
Value Feedback Value Faithfulness/
Timeliness
Value Accuracy
Timeliness

Secondary Neutrality
Qualities Comparability and/Consistency Neutrality

Materiality
Materiality
Primary Characteristics of Accounting Information
Relevance: Information becomes relevant when it is capable of making a difference in a decision.
To be relevant, information should contain: ‘Predictive value’, ‘Feedback value’ and ‘Timeliness’.
• Predictive value means information should be helpful in making predictions about ultimate
outcomes of past, present and future events.
• Feedback value means information helps users confirm or correct prior expectations.
• Timeliness means that information is available in time to influence a decision. That is the
financial statements of an organization are to be prepared and presented just after the end of the
accounting period, not after several months or years.
Reliability: Information can be relied if it is free from error and personal bias. To be reliable,
information should have ‘Verifiability’, ‘Representational faithfulness’ and ‘Neutrality’.
• ‘Verifiability’ is the ability to arrive at the same conclusion, given the same information &
method, by independent evaluators or users. For example, if there is a note of using straight-
line method for calculating depreciation of an organization’s tangible fixed asset, the amount
of depreciation will be same if any one uses this method. So this is verifiability.
• ‘Representational faithfulness’ is an important element of reliability in that it means the
information represents what really existed or happened. For example, if the gross sales of an
organization is Tk. 1,59,00,000 but if the organization discloses Tk. 1,60,00,000 in its income
statement then it will not be a faithful representation. So, the information should be free from
at least any intentional error.
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 • ‘Neutrality’ is the characteristic that the information presented is free from bias. The
information presented does not favor one party’s interests over another.
Example: The balance sheet should represent the assets, liabilities, and owner’s equity of a business
enterprise at a certain period of time as faithfully as possible (accuracy) without any bias (neutrality)
which can be verified by an auditor (verifiability).
Secondary Characteristics of Accounting Information
Information of an enterprise is more useful if it can be compared with similar information of another
enterprise (comparability) and with similar information of the same enterprise over time
(consistency).
Comparability states that information becomes more useful if it lends itself to intra- and inter-
comparison. Intra-comparison means comparing an organization’s one information of an accounting
period with its same information of another accounting period, for example, the comparison of sales
of organization of 2016 with that of 2017. Inter comparison; on the other hand, means comparing
one information of an organization with the same information of another organization.
Example: Dutch-Bangla Bank gave bonus six times in the year 2017 whereas the IFIC Bank gave
bonus four times in the same year. This information can be compared in a meaningful way.
Consistency states that the accounting terms, methods or principles mentioned in the financial
statements are to be used in a similar manner from one period to the next. Accounting methods may
be changed when it can be demonstrated that the result would be preferable. And this change must
be disclosed along with the justification for, nature, and effect of the change.
Example: In a business organization, the accountant changes its depreciation policy (from straight-
line to declining balance method) for its fixed assets as per the instruction of the management.
Management provides a note to the financial statements explaining that the new method is more
justifiable than the old method of depreciation because the use of fixed assets is usually higher in the
earlier years of their expected life.

Basic Elements of Financial Statements

Assets: Assets are economic resources owned by businesses that are expected to benefit future
operations. Example: Land, Building, Equipment, Accounts receivable, Goodwill, Patent, Copyright,
etc.
Liabilities: Liabilities are outsiders’ contribution to the business. These represent the amounts that
the firm owes to outsiders i,e., other than the owners. Liabilities are outsiders’ claims against total
assets- that is, existing debts and obligations. Example: Money borrowed from a bank, purchase on
account, etc.

Owner’s Equity: Owner’s Equity is the owner’s claim on total assets of the business. In other
words, it is the residual interest in the assets of an organization after deducting its liabilities.

Revenues: Revenues are inflows (receipts) or gross increase in equity or enhancements of assets or
reduction of liabilities of an entity resulting from such business activities as: delivering goods,
rendering services, rental of property or lending of money.
For example: cash received or receivable from a customer for selling goods or services to him/her by
an organization.
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Expenses: Expenses are outflows (payments) or decrease in equity. In other words, expenses are the
costs of assets consumed or services used in the process of earning revenues.
For examples: salaries paid to employees, sales commissions paid to salesmen, etc.
And the excess of revenues over expenses of normal courses of actions over a period of time is the
income or profit.

Gains: Increases in net equity from peripheral or incidental transactions of an entity which are
irregular and non-current in nature. For example, if a fast food shop sells an air conditioner for Tk.
75,000 whose book value (costs minus depreciation) is Tk. 72,000 then the gain will be=Tk.3,000
(75,000-72,000).
Losses: Decrease in equity from peripheral or incidental transactions of an entity and from all other
transactions and other events which are irregular and non-current in nature. For example, if an air
conditioner of Tk. 35,000 is sold by a fast food shop for Tk. 70,000, the loss will be= Tk.2,000
(72,000-70,000).
Learners, you may ask: is there any difference between income and gain?

Yes, there is a difference. Income is the excess of revenues earned over expenses incurred for
normal courses of operations. Income generates from the sales of goods or services and expenses
incurred for sales. But gain comes from the sales of fixed or non-current assets.

And to make you understand more clearly, I cite an example. Suppose a grocer has earned revenues
of Tk. 120,000 from sales of his grocery items like rice, salt, oil, etc. for which he incurred expenses
of Tk. 100,000. The additional Tk.20,000 is the income or profit of his business. But if he sells the
furniture or other non-current assets of his business at a price more than that of book value then the
business will enjoy a gain, otherwise loss.

Recognition and Measurement Concepts

Assumptions
Monetary Unit Assumption
You know, in our country, the monetary unit is taka. According to this assumption, only transaction
data that can be expressed in terms of money (in our country taka) be included in the accounting
records. This assumption enables accounting to quantify (measure) economic events. This
assumption is vital to applying the cost principle. There are some important events in the business
but those are not recorded in the books of accounts as their effects cannot be objectively translated
into money. These events inter alia are:
▪ Resignation of manager from the business.
▪ Quality of products/services.
▪ Health of owner.
▪ Strike, hartal, etc.
▪ Go slow policy of the workers.
▪ Morale of employees, etc.
Example: Suppose, the official executive of your business entity has switched to another business
and you have substantial loss. But it can’t be measured in terms of money. So it’s not recorded in
accounting books.
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Economic Entity Assumption
An economic entity can be any organization or unit in society. It may be:
• a business enterprise; or
• a municipality; or
• a governmental unit; or
• a mosque, temple, pagoda, etc.
According to this assumption, the business is treated as separate unit or entity from its owner(s). In
other words, transactions of an entity are to be kept separate and distinct from those of its owner and
of all other economic entities. The owner is treated as a creditor to the extent of his /her capital.
Example: If Mr. Rahim invests Tk. 500,000 into his business-M/S Rahim Enterprise then Tk.
500,000 will be the asset of his business as well as liability to the owner (Mr. Rahim). This is an
internal liability.
Mr. Rahim, the owner of Rahim Enterprise should keep his personal living expenses separate from
the expenses of his business-Rahim Enterprise.
Another Example: If Mr. Rahim has two business entities: a petrol pump- making a profit of Tk.
50,000 and a fast food shop- sustaining a loss of Tk. 10,000, both should be shown in the accounting
records separately.

Going Concern Assumption

This assumption is also known as the ‘Continuity assumption’. The main theme of this assumption is
that a business will continue in operation for an indefinite period of time, at least long enough to
carry out its existing plans and contracts. Simply to say, a business has a long life; it is not expected
to be liquidated. The going concern is not applicable in case of liquidation only, like a project.
Because you know the starting and ending time of a project is known whereas in business the
starting time is known but the ending time is unknown.

Starting time Ending time

Project Known Known
Business Known Unknown

In absence of this assumption, plant assets should be stated at their liquidation value, not at cost
price. Liquidation value means the excess of selling price over the cost of sale/disposal. In that case,
depreciation or amortization of these assets is not needed. Each period, these assets would simply be
reported at their liquidation value. Also, without this assumption, the current and non-current
classification of assets and liabilities would not matter i,e., classified balance sheet and income
statement preparation becomes difficult as all expenses including depreciation have to recognize at
once, not to defer until later periods.

Accounting Period Assumption

Learners, a few minutes back, you came to know that the life of a business organization is unlimited.
According to this assumption, this unlimited life of the business organization is divided into small
chunk of time. It may be one month, one three months, six months, or one year, usually one year for
the purpose of reporting to outsiders. If this cannot be done, it wouldn’t be possible to know about
21
the profit or loss and position of assets and liabilities of an organization until and unless the business
goes for liquidation. The stakeholders, like the owners, creditors, suppliers, and other parties,
particularly the NBR, want to know about the financial health of an organization at frequent duration
and for this purpose financial statements are prepared and provided by the company to the
stakeholders.

Generally Accepted Accounting Principles (GAAP)1

Before going to the discussion of GAAP, we have to know the meaning of principle.

Principles
Principle is a broad general law or rule adopted as a guide to action.
Consequently, GAAP may be defined as broad rules adopted by the accounting profession as guides
in identifying (measuring), recording and communicating (reporting) the economic events of an
organization.

In other words, GAAP are a common set of standards that indicate how to report the economic
events. For example,
• Cost principle
• Revenue recognition/ Realization principle
• Objectivity principle
• Matching principle
• Materiality principle
• Full disclosure principle
• Consistency principle
• Conservatism principle, etc.
❖ Establishment of GAAP [USA]
Two organizations are primarily responsible for establishing GAAP in the USA:
1. Financial Accounting Standard Board (FASB); and
2. Securities and Exchange Commission (SEC)
1. FASB (US): This private organization establishes broad reporting standards of
- general applicability
- specific accounting rules
2. SEC: The US SEC is a government agency that requires companies to file financial reports
following GAAP. In institutions where there is no principle, the SEC often mandates that certain
guidelines be used. To ensure the development of timely and useful accounting principles the FASB
and SEC generally work hand in hand.
In Bangladesh, BS&EC, ICAB, DSEL are responsible for developing GAAP.
________________________________________________________________________________
1. The phrase ‘generally accepted accounting principle’ is a technical accounting term that
encompasses the conventions, rules and procedures necessary to define accepted accounting
practice at a particular time. It includes not only broad guidelines of general application, but also
detailed practice and procedures. Those conventions, rules and procedures provide a standard by
which to measure financial presentation.

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Cost Principle
This principle states that tangible fixed (non-current) assets should be recorded at their costs
ignoring the market value. Cost is the exchange value or financial sacrifice for acquiring something.
Market value is the value determined by the market for homes at the time of sales.
Example: On January 1, you have purchased a land for your business for Tk. 10,00,000 and during
January the value of the land increased to Tk. 11,00,000. According to this principle, on January 31,
the land should be reported at Tk. 10,00,000 even if the value decreased to Tk. 9,00,000 At the time
of acquisition, cost and fair market value are the same. In subsequent periods, the fair market value
may vary, but the cost amount continuous to be used in the accounting records. Recently, the FASB
appears to support greater use of fair value measurements in the financial statements.
❖ Argument in Favor of Valuation at Cost
Learners, you can ask why tangible fixed (non-current) assets are recorded at cost. This is so because
cost has an important advantage over other valuations. Cost is reliable. The values exchanged at the
time of acquisition something can be objectively measured and can be verified. Objectively means
with supporting documents like invoice, voucher, deed, etc.

❖ Limitations of the Principle

Critics argue that cost is often not relevant and that market values provide more useful information.
This principle ignores the qualitative aspect of things; and the impact of inflationary changes is not
adjusted in financial statements. And due to these limitations, in developed countries like Japan and
USA, the inflation accounting system has been introduced.

Revenue Recognition Principle

Recognition means recording and reporting. So revenue recognition principle means the rules or
laws related to recording of revenue in the accounting records and reporting it in the income
statement. You know, revenues are gross increase in equity resulting from providing goods or other
services to customers. This principle is also called the realization principle. This principle
emphasizes on the ‘timing’ of recording revenue. As per this principle, revenue should be recorded
when it is earned and revenue is earned (realized or realizable) when goods are sold or services are
provided, it may be in cash or on credit. Suppose, you have sold 100 CDs to a customer at a price of
Tk.75 each and have received cash Tk. 5,000 only out of 7,500. So Tk.2,500 still remains as
receivable. According to this principle, both the received and receivable amounts are to be recorded
as revenues. Similarly, expenses are recognized when goods or services are purchased either in cash
or on account.
Illustration: If the firm gets an order in the month of March to supply goods in the month of May,
the revenue will be earned only in the month of May when the actual sales takes place.

Matching Principle
This principle reveals that revenues and expenses of a particular period should be properly matched.
The period in which the revenues are recognized, the expenses incurred to earn that revenue must be
charged to achieve the accurate income for the period concerned. Expenses are thus expired costs or
sacrifices made to earn revenue. The unexpired costs should not be shown as expenses rather they
are treated as assets.

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Example: Suppose, for your business you have paid Tk. 60,000 as store rent for 3 months (say
January to March) and your accounting period is only January. So at the end of January you have to
match or adjust or charge Tk. 20,000 (rent of January only) as expense against the revenues of
January to arrive at the actual profit of January. If this Tk. 20,000 is not matched with the revenues,
the expense will be understated and profit will be overstated. Prepaid rent for February and March
must be shown as assets.

Full Disclosure Principle

Full disclosure means the presentation of all relevant information (relevant for users’ decision). We
know an organization finances itself from the owners and from the creditors’ sources. Thus, the
stakeholders have the right to know about necessary data and information with supporting footnotes
and explanation. The organization should provide the data and information in such a way that it
becomes self-explanatory. In compliance to this principle additional data, explanation, schedules etc.
are attached as supplementary information for the users’ decision making.
Example: Suppose your organization has a fixed asset of Tk. 5 million. But an amount of Tk. 3
million is borrowed from a bank by the mortgage of the fixed asset. This information should be
disclosed in the financial statements or as a note to the statements.
Similarly, the accounting methods employed for example, for charging depreciation, change in
accounting method, an explanation regarding why it has been done, all these should be disclosed
properly.

Constraints in Accounting
Constraints mean that there are certain limitations or boundaries under which accounting functions
or policies are restricted.
Cost-Benefit Constraint
Cost-Benefit Relationship: It states that-
• The cost of information should not outweigh the benefit derived.
• Costs and benefits are not always derivable, obvious or quantifiable.
• Sound judgment must be used.
Example: If an organization purchases some waste-paper baskets for the use, it may be used for
couple of years to come, however the price of these baskets is so negligible that organizations,
though it will provide benefits or services for more than a year, charge it as an expense. Office
supplies like Pen, Pencil, Eraser, Pin, etc. are to be recorded as expenses, not assets. The cost of
recording these as assets (e.g. charging depreciation on eraser) is costlier than its benefit.
Materiality Constraint
The term ‘materiality’ refers to the relative importance and amount of an item or event in users’
decision. An item is material if its inclusion or omission would influence or change the judgment of
a reasonable person (investor). Thus, the determination of what is material and what is immaterial
depends on the judgment of a reasonable person, precise criteria cannot be applied.
Example:
Items Company A Company B
Sales revenue Tk. 1,00,000 Tk. 10,000
Net income 10,000 1,500

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Look at the figures above. Apparently, it seems that the Company A’s net income is more significant
than of Company B’s net income. But Company B makes 15% profit with regard to its sales whereas
Company A makes 10% profit with regard to its sales. So the net income figure of Company B is
more material than Company A.
Conservatism Constraint
This constraint is contrary to the principle of full disclosure. Because under this convention the
profit is understated than what actual profit is. It is often stated as follows:
“Anticipate no profit but provide for all possible losses.”
Example: Ending inventory/stock is valued at cost or market price whichever is lower. If market
price is higher than the cost, ending inventory will be valued at cost which is lower than the market
price. But if the market price is lower than the cost, the higher amount of cost will be ignored and
inventory will be valued at market price, which is lower than the cost.
The main theme of this constraint is “This is the policy of playing safe.”
The main limitation of conservatism is that a secret reserve is created due to the excessive
application of this convention. The company law does not recognize it.
[Illustration: Cost of ending inventory Tk. 10,000 but market price is Tk.12,000. It should not be
valued at Tk. 12,000. No doubt, there is a prospect of earning Tk.2,000 here, but that should not be
recognized in the accounts. In contrasts if its market price is Tk. 8,000, that is if there is a chance for
loss of Tk.2,000, ending inventory should be valued at Tk.8,000. It indicates, therefore, that the
accountants should recognize all possible losses however small that might be. But they should not
anticipate profit.]
Examples:
• Maintaining allowance for doubtful debts.
• Accelerated depreciation method for equipment and machinery.
• Inventory is valued at cost or market price, which one is lower.
• Probable gain from sale of share is not recognized.
• Unrealized gain: The cost of investment is Tk. 10,000 (current market price Tk. 12,000).
The gain of Tk. 2,000 is not recorded till it is realized.
Industry Practices
This constraint states that-
* Peculiar nature of some industries and business concerns sometimes requires departure from
basic accounting theory.
* The financial statements shall not mislead a reader. If following “pure” accounting theory
results in statements that are not comparable or consistent, not relevant or reliable then
theory should be adjusted.
Example: The costs of production or inventory valuation of agricultural products are difficult to
determine. So, these should be valued based on the market price.

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International Terminology
Your Fundamentals of Financial Accounting assessment will use international accounting terms and this text is
written in international accounting terms. It is a good idea to start now getting used to these terms. Following
the recent changes in terminology due to the revision of IAS 1, we give a list of UK terms with their
international equivalents.
UK term International term
Profit and loss account Income statement (statement of comprehensive income)
Profit and loss reserve (in balance sheet) Accumulated profits
Balance sheet Statement of financial position
Turnover Revenue
Debtor account Accounts receivable
Debtors (e.g. debtors have increased) Receivables
Debtor Customer
Creditor account Accounts payable
Creditors (eg creditors have increased) Payables
Creditor Supplier
Debtors control account Receivables control account
Creditors control account Payables control account
Stock Inventory
Fixed asset Non-current asset (generally). Tangible fixed assets are also
referred to as ‘property, plant and equipment’.
Long term liability Non-current liability
Provision (eg for depreciation) Allowance (you will sometimes see
‘provision’ used too).
Nominal ledger General ledger
VAT Consumption tax
Debentures Loan notes
Preference shares/dividends Preferred stock/dividends
Cash flow statement Statement of cash flows

Review Questions

1. What do you mean by conceptual framework of accounting?

2. State the qualitative characteristics of accounting information.
3. When does accounting information become relevant and reliable?
4. Graphically present the conceptual framework of accounting with the linkages of different
levels.
5. Explain the economic entity assumption.
6. What is the main theme of going concern assumption?
7. Explain the arguments for and against the recording of tangible fixed asset at cost.
8. Explain the matching principle.
9. What are the limitations of conservatism constraint? Explain.

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 10. Presented below are the assumptions, principles and constraints discussed in the
lesson 2 of Unit 1.
a. Economic entity assumption g. Periodicity assumption
b. Going concern assumption h. Historical cost principle
c. Monetary unit assumption i. Matching principle
d. Full disclosure principle j. Industry practices
e. Cost-benefit relationship k. Conservatism constraint
f. Materiality constraint l. Revenue recognition principle
Required:
Identify by letter the accounting assumptions, principle or constraint that describes each
situation below. Do not use a letter more than once.
(i) Allocates expense in the proper period.
(ii) Indicates that market value changes subsequent to purchase are not recorded in
the accounts. (Do not use revenue recognition principle)
(iii) Ensures that all relevant financial information is reported.
(iv) Rationale why plant assets are not reported at liquidation value. (Do not use
historical cost principle)
(v) Anticipates all losses, but reports no gains.
(vi) Indicates that personal and business record keeping should be separately
maintained.
(vii) Separates financial information into time periods for reporting purposes.
(viii) Permits the use of market value valuation in certain specific situations.
(ix) Requires that information significant enough to affect the decision of reasonably
informed users should be disclosed. (Do not use full disclosure principle)
(x) Assumes that the Taka is the ‘measuring stick’ used to report on financial
performance.
Answer: (i)i; (ii) h; (iii) d; (iv) b; (v) k; (vi) a; (vii)g; (viii) j; (ix)f; (x)c

27
Lesson 3: Basic Accounting Equation

Lesson Objectives

After studying this lesson, you should be able to:

• define basic accounting equation;

• explain the components of basic accounting equation;
• analyze the effects of business transactions with the help of accounting equation.

Basic Accounting Equation-Meaning and Components

Basic accounting equation is a mathematical expression of the relationship of assets, liabilities and
owner’s equity. This is stated as:
Assets = Liabilities + Owner’s Equity
Learners, you may ask a question, why liabilities precede owner’s equity in the basic accounting
equation. You know if a business is liquidated / wounded up /closed, liabilities are to be paid first.
So, liabilities precede owner’s equity.
Business transactions always affect at least two elements in the accounting equation. After a
transaction is recorded, the accounting equation must be in balance.
The accounting equation applies to all economic entities regardless of size, nature of business, or
form of business organization. It applies to a small proprietorship such as a corner grocery store as
well as to a giant corporation such as PepsiCo. The equation provides the underlying framework for
recording and summarizing economic events.
Let’s look in more detail at the elements of basic accounting equation.
Assets
Assets are resources which:
• are owned by a business;
• are used in carrying out production, consumption and exchange;
• provide future services or benefits (in the form of cash) to the enterprise;
• must be acquired at a cost;
• help to redemption of liability.
These are the features of assets.
Example: Suppose, Al-Amin Bread and Biscuits Ltd. owns a Delivery van that provides economic
benefits from its use in delivering Cosmos biscuits. So, Delivery van is an asset of the company.
Other assets of Al-Amin Bread and Biscuits Ltd. are tables, chairs, oven, etc. Now, we will discuss
the forms /nature of assets.
Assets include:
a) Physical resources like land, building, machinery, furniture, inventory, etc.
b) Non-physical resources like accounts receivable.
c) Intangible assets like goodwill, patent, copyright, trademark, etc.
d) Future benefits like insurance premium paid in advance for protection against future
misfortunes or any other expenses paid in advance.
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Liabilities
Liabilities are outsiders’ claims on total assets of the organization. In other words, liabilities are the
amount that the firm owes to outsiders i,e., other than the owners.
Businesses of all sizes usually borrow money and purchase merchandise on credit. These economic
activities result in various kinds of payables:
For example:
• Al-Amin Bread and Biscuits Ltd. purchases cheese, sausage, flour, sugar, etc. on credit from
suppliers. These obligations are called accounts payable.
• The company also has a note payable to BRAC Bank Ltd. for the money borrowed to
purchase the Delivery van.
• The company may also have wages payable to employees and sales and taxes payable to
the City Corporation.
All of these persons or entities to whom Al-Amin Bread and Biscuits Ltd. owes money are its
creditors. Creditors may legally force the liquidation of a business that does not pay its debts. In
that case, the law requires that creditor claims be paid before ownership claims.
Owner’s Equity
Owner’s Equity is the owner’s claim or interest in the business. In other words, it is the residual
interest in the assets of an organization after deducting its liabilities.
So, Owner’s Equity = Total Assets- Total Liabilities
Why? Because the assets of a business are claimed by either creditors and owners. To find out what
belongs to owners, we subtract the creditors’ claims (the liabilities) from assets. The remainder is the
owner’s claim on the assets, the owner’s equity. Since the claims of creditors must be paid before
ownership claims, owner’s equity is often referred to as residual equity.

Increase and Decrease in Owner’s Equity

❖ Increase in Owner’s Equity
In a proprietorship, owner’s equity is increased by:
• Owner’s investments; and
• Revenues.
Investments by Owner: Investments are the assets the owner puts into the business. These
investments increase owner’s equity. They are recorded in a category called owner’s capital.
Revenues: Revenues are the gross increase in owner’s equity resulting from such business activities
as
➢ sale of merchandise;
➢ performance of services;
➢ rental of property;
➢ lending of money, etc.

Common Sources of Revenue are as follows:

• Sales
• Fees
• Commissions
• Interests
29
 • Dividends
• Royalties
• Rent, etc.
Revenues usually result in an increase in an asset.
❖ Decrease in Owner’s Equity
In a proprietorship, owner’s equity is decreased by:
• Owner’s drawings; and
• Expenses.
Owner’s Drawings: An owner may withdraw cash or other assets for personal use. We use a
separate classification called drawings to determine the total withdrawals for each accounting
period.

Drawings decrease owner’s equity.

Expenses: Expenses are the costs of assets consumed or services used in the process of earning
revenue. Expenses represent actual or expected cash outflows (payments).
Forms/ Examples of Expenses are:
➢ Materials (cost of ingredients) expense;
➢ Wages expense;
➢ Utility expense (electricity, gas and water expense);
➢ Telephone expense;
➢ Delivery expense (gasoline, repairs, licenses etc.);
➢ Supplies expense;
➢ Rent expense;
➢ Interest expense;
➢ Property tax expense, etc.
Net Income= Revenues- Expenses

Summary:

Analysis of Business Transactions

Transactions are economic events that affect change the financial position of a business entity. A
transaction is the occurrence of an event or of a condition that brings changes in entity's assets,
liabilities or equity. This is the basic input of recording in accounting. Transactions may be external
or internal. External transactions involve economic events between the entity and some outside
parties or organizations, whereas internal transactions are events that occur entirely within the entity.
External events are only called transactions.

30
As per definition, a transaction must bring change in the financial position of an entity which refers
to the resources it owns and the claims on those resources in the form of liabilities and owner’s
equity. Accounting equation is nothing but the expression of financial position in an equation form.
So, a transaction must change or affect the elements of accounting equation. Analyses of
transactions refer to the identification of the changes brought about by a transaction on the elements
of the equation.
What changes may be made in the components of basic accounting equation if the transactions are
analyzed?

The analysis will show that:

❖ a transaction may increase in asset and an increase in liability or equity.
❖ it may increase in one asset with corresponding decrease in another asset without having any
change in another side of the equation.
❖ it may decrease in one asset with corresponding decrease in a liability or equity. Or
❖ it may decrease in a liability or equity with corresponding increase in another liability or
equity.
Now, we will discuss the effects of business transactions on the basic accounting equation with the
dialogue between a teacher and a student.
Student Sir, could you please explain the effect of transactions on the components of accounting
equation with examples?
Teacher Ok. I will discuss the effects of different transactions on assets, liabilities, and owner’s
equity.
Student Sir, what will be the changes in the assets, liabilities, and owner’s equity if the owner
invests his or her capital in the business?
Teacher Thank you. If an investor invests money in his or her business, both the asset and
owner’s equity of the business will increase equally. For example, Mr. Masum decides to
open a firm. On September 1, he invests Tk.150,000 cash in the business. This
transaction results in an equal increase in asset-Cash and Owner’s Equity-Masum’s
Capital.
Student Sir, if the owner of a business purchases an asset for Cash, what will happen in the
equation?
Teacher Important transaction. Suppose, the firm purchases an asset, for example, a computer
equipment for Tk. 70,000 cash. This transaction results in an increase of Tk. 70,000 in
one asset-Equipment with corresponding decrease in another asset-Cash without having
any change in other side of the equation.
Student Sir, then what will be effect on accounting equation if the firm purchases asset or
inventory on account or on credit?
Teacher If the firm purchases asset, for example, supplies for the firm for Tk. 16,000 on credit
from Acme Suppliers. This transaction results in an increase of supplies of Tk. 16,000 in
total assets, and an equal increase in liability-accounts payable.
Student Sir, the analysis shows that a transaction always preserves the equality of the accounting
equation. Therefore, each transaction must have a dual effect on the equation. Now, I ask
you to discuss the effect of rendering services for cash.

31
Teacher Thank you. If the firm receives Tk. 12,000 cash from customers for programming
services it has provided, both asset-Cash and owner’s equity-Masum Capital are
increased by Tk. 12,000.
Student Sir, I request you to discuss the effect of credit purchase or service receiving on
accounting equation.
Teacher OK. Suppose the firm receives a bill for Tk.2,500 from the Daily News for advertising
the opening of its business but postpones payment of the bill until a later date. This
transaction results in an increase in liabilities-Accounts Payable and a decrease in
Owner’s Equity.
Student Sir, if the firm renders services for Cash and Credit, what will be the impact?
Teacher Suppose, a firm provides programming services of Tk. 35,000 for customers. Cash
amounting to Tk. 15,000 is received from customers, and the balance of Tk. 20,000 is
billed to customers on account. This transaction results in an increase of Cash Tk. 15,000
and Accounts Receivable Tk. 20,000 in assets and Owner’s Equity of Tk.35,000.
Student Sir, kindly tell us what changes in components of accounting equation are made if the
firm pays different expenses during accounting period.
Teacher OK. Suppose, expenses paid in cash for July are store rent, Tk.6,000, salaries of
employees, Tk.9,000, and utilities, Tk.2,000. These payments result in a decrease in one
asset-Cash of total Tk. 17,000 with corresponding decrease in Owner’s Equity.
Student Fine. Sir, what will be the effect if liabilities are paid or redeemed?
Teacher Very common transaction in business. Suppose, the firm pays its Daily News advertising
bill of Tk.2,500 in cash. In analyzing the effect of this transaction, we must recall that the
bill was previously recorded in previous transaction as an increase in Accounts Payable
and a decrease in Owner’s Equity. So. with this transaction of payment of liabilities-
Accounts Payable and the Asset-Cash are decreased with Tk. 2,500.
Student Sir, discuss the effect of receipt of cash from customers for proving services on account.
Teacher OK. If the firm receives a sum of Tk.6,000 in cash from customers who have previously
been billed for services provided earlier, there will no change in total assets, but it
changes the composition of firm’s assets. That is, one asset-Cash of Tk. 6,000 will be
increased with corresponding decrease in another asset-Account Receivable.
Student Sir, we know, sometimes the owner withdraws Cash from his or her business for
personal use. Could you please tell me how this transaction affects the basic accounting
equation?
Teacher Thank you. If the owner Mr. Masum withdraws Tk. 13,000 in cash from the business for
his personal use, there will be an equal decrease in asset-Cash and Owner’s Equity of Tk.
13,000.
1. Mr. Masum decided to open a firm. On September 1, he invested Tk.150,000 cash in the business.
Assets = Liabilities + Owner’s Equity
Cash = Masum, Capital
T-1: + 150,000 = +150,000
2. The firm purchased computer equipment for Tk. 70,000 cash.
Assets = Liabilities + Owner’s Equity
Cash + Equipment = Masum, Capital
Old Bal: +150,000 = +150,000
T-2: -70,000 +70,000 = ______
New Bal: 80,000 +70,000 = 150,000

32
 3. The firm purchased supplies for the firm for Tk. 16,000 on credit from Acme Suppliers.

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Equipment = Accounts Payable + Masum, Capital
Old Bal: 80,000 +70,000 = + 150,000

T-3: ______ + 16,000 _____ = +16,000 _______

New Bal:80,000 + 16,000+ 70,000 = 16,000 + 150,000
4. The firm received Tk. 12,000 cash from customers for providing programming services.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Equipment = Accounts Payable + Masum, Capital
Old Bal: 80,000+ 16,000 +70,000 = +16,000 150,000
T-4: +12,000 ______ _______ = _______ +12,000
New Bal: 92,000 +16,000 + 70,000 = 16,000 + 162,000
5. The firm received a bill for Tk.2,500 from the Daily News for advertising the opening of its business but
postponed payment of the bill until a later date.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Equipment = Accounts Payable + Masum, Capital
Old Bal: 92,000 +1,6,000 +70,000 = +16,000 + 162,000
T-5: ______ ______ ______ = +2,500 -2,500
New Bal: 92,000 + 16,000 + 70,000 = 18,500 + 159,500

6. The firm provided programming services of Tk. 35,000 for customers. Cash amounting to Tk. 15,000 was
received from customers, and the balance of Tk. 20,000 was billed to customers on account.
Assets = Liabilities + Owner’s Equity
Cash + A/Cs Receivable + Supplies + Equipment = Accounts Payable + Masum, Capital
Old Bal: 92,000 + 16,000 +70,000 = +18,500 + 159,500
T-6: +15,000 + 20,000 _____ _____ = ______ + +35,000
New Bal:107,000 + 20,000 + 16,000 + 70,000 = 18,500 + 194,500
7. Expenses paid in cash for September were store rent, Tk.6,000, salaries of employees, Tk.9,000, and utilities,
Tk.2,000.
Assets = Liabilities + Owner’s Equity
Cash + A/Cs Receivable + Supplies + Equipment = Accounts Payable + Masum, Capital
Old Bal.:107,000+ 20,000 + 16,000 + 70,000 = +18,500 + 194,500
T-7: - 17,000 - 6,000
-9,000
_____ ______ ______ ______ ________ -2,000
New Bal.: 90,000 + 20,000 + 16,000 + 70,000 = 18,500 + 177,500
8. The firm paid its Daily News advertising bill of Tk.2,500 in cash .
Assets = Liabilities + Owner’s Equity
Cash + A/Cs Receivable + Supplies + Equipment = Accounts Payable + Masum, Capital
Old Bal.: 90,000 + 20,000 + 16,000 + 70,000 = +18,500 + 177,500
T-8: - 2,500_ _____ ______ _______ - 2,500 _______
New Bal.: 87,500+ 20,000 + 16,000 + 70,000 = 16,000 + 177,500
9. The sum of Tk.6,000 in cash was received from customers who had previously been billed for services in
Transaction (6).
Assets = Liabilities + Owner’s Equity
Cash + A/Cs Receivable + Supplies +Equipment = Accounts Payable + Masum, Capital
Old Bal.: 87,500 +20,000 + 16,000 + 70,000 = +16,000 + 177,500
T-9: + 6,000 - 6,000 _____ ______ _______ _______
New Bal.: 93,500 + 14,000 + 16,000 + 70,000 = +16,000 + 177,500

10. Mr. Masum withdrew Tk. 13,000 in cash from the business for his personal use.
Assets = Liabilities + Owner’s Equity
Cash + A/Cs Receivable + Supplies +Equipment = Accounts Payable + Masum, Capital
Old Bal.: 93,500+ 14,000 + 16,000 + 70,000 = +16,000 + 177,500
T-10: -13,000 _____ _____ _____ _______ - 13,000
New Bal.:8,0,500+ 14,000 + 16,000 + 70,000 = 16,000 + 16,4500

Financial Statements

33
Accounting information relates to the financial performance, financial position, and changes in cash
and owner’s equity. This information is communicated through preparation of financial statements.
The major financial statements prepared are (i) Balance Sheet; (ii) Income Statement; (iii) Statement
of Owner’s Equity; (iv) Statement of Cash Flows; and (v) The Value-Added Statement.
(i) Balance Sheet/Statement of Financial Position: A balance sheet reports the assets, liabilities,
and owner’s equity at a specific date. The company prepares the balance sheet from the column
headings of the tabular summary and the month-end data shown in its last line. The balance sheet
lists assets at the top, followed by liabilities and owner’s equity. Total assets must equal total of
liabilities and owner’s equity.
(ii) Income Statement (Profit or Loss Account): The income statement reports the revenues and
expenses for a specific period of time. The income statement lists revenues first, followed by
expenses. Finally, the statement shows net income (or net loss). Net income results when revenues
exceed expenses. A net loss occurs when expenses exceed revenues.
(iii) Statement of Owner's Equity: The owner’s equity statement reports the changes in owner’s
equity for a specific period of time. The time period is the same as that covered by the income
statement. Data for the preparation of the owner’s equity statement come from the owner’s equity
columns of the tabular summary and from the income statement.
(iv) Statement of Cash Flows: Financial statements, such as ‘Income statement’ and ‘Balance
sheet’ are prepared on accrual basis. One major deficiency of income statement and comparative
balance sheets is that they show the change in financial position, caused by operations of an
organization, but do not explain the effects of cash inflows and cash outflows, which is the life blood
of business entity. The present day investors are mainly interested in short-term benefits like cash
dividends or refund of loan money and interest payment. This is being served by cash flow statement
which summarizes information concerning the cash inflows (receipts) and outflows (payments) for a
specific period of time. As the statement shows changes in the financing pattern and investment
activities, it seems to be very useful to all user groups.
(v) Value-added Statement: This is a macro-level analysis of the effects of economic activities
performed by business organizations during a particular period of time. In other words, how the
business activities influence the total economy as a whole is being supplied by this statement. All
business organizations create values by transforming gift of nature to goods and services, capable of
satisfying human needs. The values are being created by the coordinated efforts of various factors of
production like land, labor, capital, organization and the government. These factors, in turn, receive
a particular part of the total value added in the process of production as their remuneration. And how
this value is created, what is the amount and how this total amount is being distributed among these
various factors are being shown by this statement. These distributions received by different factors
of production form the basis for calculation of national income of a country.

34
 Review Questions

1. What is accounting equation and what are its components?

2. Briefly explain the components of accounting equation.
3. If an asset increases, what are the possible three effects on accounting equation?
4. What are financial statements and why are different financial statements prepared?
5.On April 1, 2017 Sajal Hossain established Nowel Travel Agency. The following transactions
were completed during the month:
i. Invested Tk. 80,000 cash and Tk. 20,000 equipment to start the agency.
ii. Paid Tk. 4,000 cash for April office rent.
iii. Purchased office equipment for Tk.5,000 cash.
iv. Incurred Tk. 3,000 of advertising costs in the Daily Jugantar, on account.
v. Paid Tk. 6,000 cash for office supplies.
vi. Earned Tk. 75,000 for services rendered: Tk. 10,000 cash is received from customers and
the balance of Tk. 65,000 is billed to customers on account.
vii. Withdrew Tk. 2,000 cash for personal use.
viii. Paid Daily Jugantar amount due in transaction (iv).
ix. Paid employees’ salaries Tk. 22,000.
x. Received Tk. 50,000 in cash from customers who have previously been billed in
transaction (vi).
xi. Provided service on account Tk. 6,000.
Required:
Prepare a tabular analysis of the transactions, using the following column headings: Cash,
Accounts Receivable, Supplies, Office Equipment, Accounts Payable, and Sajal Hossain’s
Capital.

Answer: Balances: Cash (Tk.98,000), Accounts Receivable (Tk.21,000), Supplies (Tk.6,000),

Office Equipment (Tk.25,000), Accounts Payable (Tk.000), and Sajal Hossain’s Capital
(Tk.1,50,000).

35
Unit Highlights
➢ Basic steps in the recording process.
➢ Account and its contribution to recording process.
➢ Debits and credits and their use in recording business transactions.
➢ Journal and the recording process.
➢ Ledger and its use in the recording process.
➢ Trial balance and its purposes.

Technologies Used for Content Delivery

❖ BOUTUBE
❖ BOU LMS
❖ WebTV
❖ Web Radio
❖ Mobile Technology with MicroSD Card
❖ LP+ Office 365
❖ BTV Program
❖ Bangladesh Betar Program

36
Terminology
Account A record of increases and decreases in specific asset, liability, or owner’s equity
items kept in general ledger.
Chart of Accounts A list of accounts and the account numbers that identify their location in the
ledger.
Compound Entry A journal entry that involves three or more accounts.
Credit The right side of a T-account.
Debit The left side of a T-account.
Double-Entry A system that records in appropriate accounts the dual effect of each
System transaction.
General journal The most basic form of journal.
General ledger A ledger that contains all accounts relating to assets, liabilities, and owner’s
equity.
Journal An accounting record in which transactions are initially recorded.
Ledger A book which contains the entire group of accounts maintained by an
organization.
Normal balance An account balance on the side where an increase in the account is recorded.
All assets and expenses will have debit balances, whereas all liabilities,
revenues and equity will have credit balances.
Posting The procedure of transferring journal entries to the ledger accounts.
Simple Entry A journal entry that involves only two accounts.
T-account The basic form of an account having two sides-debit and credit.
Three-Column A form with columns for debit, credit, and balance amounts in an account kept
Form of Account under continuous balancing system.
Trial Balance A list of ledger accounts and their balances at a given date.

37
Lesson 1: The Recording Process

Lesson Objectives

After studying this lesson, you should be able to:

• identify the steps of recording process;

• explain the rules for debiting and crediting of accounts.

Steps in the Recording Process

The recording/accounting process constitutes the steps followed in recording, processing, and
communicating financial information. This process can be illustrated in the following way:
Step-1 Step-2 Step-3 Step-4 Step-5
Identification of Journalizing Posting to Summarizing Transactions Preparation
transactions & Ledger and Preparation of Trial of Financial
measurement of (Accounts) Balance Statements
effects
Step–1 : Identification and Measurement of Transaction
It is being done on the basis of basic assumptions of "Economic Entity" and "Money Measurement."
The documentary evidences of transactions might take the form of Memo, bills, vouchers, receipts,
etc. which give testimony to the fact that a transaction has taken place.
Step–2 : Analysis of Transactions into Debit and Credit
Formally a transaction is analyzed to find out its dual effect on the financial position as shown in the
previous lesson. Then transactions are recorded in the books of account under double entry system of
recording, i.e., one account is debited and another is credited. This system was discussed by Luca
Pacioli, an Italian monk in 1494 in a book on mathematics. So the amounts of debits and credits
should always equal each other.
The Account
An account (in book-keeping) refers to assets, liabilities, income, expenses, and equity, as
represented by individual ledger pages, to which changes in value are chronologically recorded with
debit and credit. These entries, referred to as postings, become part of a book of final entry or ledger.
An account usually has three parts: (1) the title of the account, (2) left hand side showing debits and
3) right hand side showing credits. It is illustrated below and it is known or T Account because of its
similarity to the letter ‘T’.
Title of Account
Left or debit side Tk. Right or credit side Tk.

Accounts may be of five types: Asset Account, Liability Account, Owner’s Equity Account, Revenue
Account, and Expense Account

38
Rules for Debiting and Crediting
Debit and Credits
The term debit indicates the left side of an account, and credit indicates the right side. They are
commonly abbreviated as Dr. for debit and Cr. for credit respectively. They do not mean increase
or decrease, as is commonly thought. We use the terms debit and credit repeatedly in the recording
process to describe where entries are made in accounts. For example, the act of entering an amount
on the left side of an account is called debiting the account. Making an entry on the right side is
crediting the account. When comparing the totals of the two sides, an account shows a debit
balance if the total of the debit amounts exceeds the credits. An account shows a credit balance if
the credit amounts exceed the debits. The normal balance of an account will be debit balance if it is
debited for increase and vice versa.

Rules for Debiting and Crediting

In Unit 1, you learned the effect of a transaction on the basic accounting equation. Remember that
each transaction must affect two or more accounts to keep the basic accounting equation in
balance. In other words, for each transaction, debits must equal credits. The equality of debits and
credits provides the basis for the double-entry system of recording transactions. Under the
double-entry system, the dual (two-sided) effect of each transaction is recorded in appropriate
accounts. This system provides a logical method for recording transactions.

Learners, now we discuss the rules for debiting and crediting with the help of accounting equation.
We know accounting equation is: Assets=Liabilities + Owner’s Equity
If we expand the equation, we have:
Assets=Liabilities + Owner’s Equity - Owner’s Drawings + Revenues – Expenses
Or, Assets(A)+ Owner’s Drawings (D)+ Expenses (E)=Liabilities(L)+ Owner’s Equity(OE)+
Revenues(R)

Figure: Rules for debiting and crediting of accounts

Summary of Debiting and Crediting of Accounts and Their Normal Balances:

Name of Accounts Debit Credit Effect Normal Balance

Assets Debit Increase
Debit Balance
Credit Decrease
Liabilities Debit Decrease
Credit Balance
Credit Increase
Owner’s Equity Debit Decrease
Credit Balance
Credit Increase
39
Drawings Debit Increase
Debit Balance
Credit Decrease
Revenues Debit Decrease Credit Balance
Credit Increase
Expenses Debit Increase Debit Balance
Credit Decrease

Steps in the Recording Process

Although it is possible to enter transaction information directly into the accounts without using a
journal, few businesses do so. Practically every business uses three basic steps in the recording
process:
(i) Analyze each transaction for its effects on the accounts.
(ii) Enter the transaction information in a journal.
(iii) Transfer the journal information to the appropriate accounts in the ledger.

Review Questions

1. Briefly explain the steps involved in the recording process.

2. Explain the rules for debiting and crediting of accounts.
3. State the rules of debit and credit as applied to (a) asset accounts, (b) liability accounts, and
(c) owner’s equity account.
4. What is the normal balance for each of the following accounts? (a) Accounts receivable, (b)
Cash, (c) Owner’s drawing, (d) Accounts payable, (e) Fees earned, (f) Salaries expense, (g)
Owner’s capital.
5. What are the basic steps in the recording process?

40
Lesson 2: Journalizing

Lesson Objectives

After studying this lesson, you should be able to:

• understand what journal is;

• understand the importance of journal as a book of original entry;
• explain the rules for debiting and crediting of major transactions.

Journal-Meaning and Importance

Journal is a book of accounts in which all day to day business transactions are recorded in a
chronological order i,e., in the order of date of their occurrence. Transactions when recorded in a
Journal are known as entries. It is the book in which transactions are recorded for the first time.
Journal is also known as ‘Book of Original Entry’ or ‘Book of Primary Entry’. Companies may use
various kinds of journals, but every company has the most basic form of journal, a general journal.
Typically, a general journal has spaces for dates, account titles and explanations, references, and
two amount columns.
The journal makes several significant contributions to the recording process:
1. It discloses in one place the complete effects of a transaction.
2. It provides a chronological record of transactions.
3. It helps prevent or locate errors, because the debit and credit amounts for each entry can be
easily compared.
Journalizing
Entering transaction data in the journal is known as journalizing. Companies make separate journal
entries for each transaction. A complete entry consists of (1) the date of the transaction, (2) the
accounts and amounts to be debited and credited, and (3) a brief explanation of the transaction.

Format of Journal
Every page of Journal has the following format. It is a columnar book. Each column is given a
name written on its top. Format of journal is given below:
General Journal
Date Account Titles & Explanation L.F Debit Credit
2017 Equipment Tk. 14,000
April 15 Cash Tk. 8,000
Accounts Payable 6,000
(Purchased truck for cash with
balance on account)

Column-wise details of journal are as:

Assume that on April 15, 2017, Rasel Company purchased a delivery truck costing Tk.14,000. It
paid Tk.8,000 cash and agreed to pay the remaining Tk.6,000 on account (to be paid later)

41
1. Date: In this column, we record the date of the transactions with its month and accounting year.
We write year only once at the top and need not repeat it with every date.
Example: 2017
April 15
2. Account Titles & Explanation: The accounts affected by a transaction i.e., the accounts which
have to be debited or credited are recorded in this column. It is recorded in the following way:
In the first line, the account which has to be debited is written. In the second line after leaving some
space from the left of the entry in the first line, the account which has to be credited is written. Then
in the third line, explanation for that entry which explains the transaction, the affected accounts of
which are entered, is written within bracket. A space is left between journal entries. The blank
space separates individual journal entries and makes the entire journal easier to read.
Example:
Equipment
Cash
Accounts Payable
(Purchased truck for cash with balance on account)

3. L.F: L.F stands for ledger-folio. The transaction entered in a Journal is posted to the various
related accounts in the ‘ledger’ (which is explained in another lesson). In ledger-folio column we
enter the page-number of the ledger where the account pertaining to the entry is opened and
posting from the journal is made.
4. Debit Column: In this column, the amount to be debited is written against the same line in
which the debited account is written.
5. Credit Column: In this column, the amount to be credited. is written against the same line in
which the credited account is written.

Simple and Compound Journal Entries

Some entries involve only two accounts, one debit and one credit. An entry like this is considered a
simple entry. Some transactions, however, require more than two accounts in journalizing. An
entry that requires three or more accounts is a compound entry (See, for example, the format given
above).

Rules for General Journal Entries of Major Transactons

DEBITING AND CREDITING OF MAJOR BUSINESS TRANSACTIONS

Transactions Account Titles L.F Debit Credit

Starting of Business Cash **
with/Investment of Cash Fixed Asset (If any) **
and Fixed Asset(s) in the Owner’s Capital ***
Business
Purchase ***
Purchase of Goods/Assets Cash (If for cash) **
(If for resale/stock) Accounts Payable (If on credit) **
Notes Payable (If on notes payable) **

42
Purchase of Assets (If for Asset ***
use in the business) Cash (If for cash) **
Accounts Payable (If on credit) **
Notes Payable (If on notes **
payable)
Return of Goods Purchased Cash (If cash received) **
Accounts Payable (If purchased on **
credit)
Purchase Return ***
Payment of Accounts Accounts Payable ***
Payable/to Creditor/for Cash (If in cash) **
credit Purchase or Service Bank (If by cheque) **
Receipts
Incurrence of Expenses Expense ***
(e.g. rent, salaries, Cash (If in cash) **
advertising, etc.) [If for Accounts Payable (If on **
current accounting period credit/account)
only]
Cash Payment for Prepaid Expense **
Expenses (e.g,. rent, Cash **
insurance, etc.) [If for more
than accounting period]
Sale of Goods/Providing of Cash (If for cash) **
Services Accounts Receivable (If on credit) **
Notes Receivable (If on notes) **
Sales/Service Revenue ***
Return of Goods Sold on Sales Return **
Credit Accounts Receivable **
Sale of Coupon (lottery) Cash **
Books for Cash/ Cash Unearned Revenue **
Receipts in Advance for
Future Services

Opening of Current Bank **

Account/Deposit Cash into Cash **
Bank
Cash Withdrawal from Cash **
Bank for Business Use Bank **
Interest Credited by Bank Bank **
Interest Revenue **
Payment of Expense (e.g,. Expense (e.g,. rent, interest, etc.) **
rent, interest, etc.) by Bank **
Cheque
Bad Debts Written off/ Bad Debts/Uncollectible Expense **
Uncollectible Debt Accounts Receivable/Allowance for **
Uncollectible
Discount Allowed Discount Expense **
Accounts Receivable **
Discount Received Accounts Payable **
Discount Revenue **

43
 Depreciation on Plant Depreciation Expense **
Asset Accumulated Depreciation **
Withdrawal of Cash/ Drawing **
Purchase of Asset for Cash **
Personal or Private Use
Withdrawal of Goods by Drawing **
Owners from Business Purchase/Inventory **
Borrowing from Bank on Cash **
Notes Payable Notes Payable **
Lost or Stolen Money of Miscellaneous Expense **
Business Cash **
Destroyed or Stolen of Accidental Loss **
Goods of Business Purchase/Inventory **
Issued Shares of Capital Cash **
Stock to Capital Stock **
Shareholders/Owners of
Company
Operating VAT Current VAT **
Account Cash **

Example: 2.2.1

Abdul Hamid opened the Muslima Dry Cleaners on September 1, 2017. During the first month of
operations, the following transactions occurred.

Sept. 1 Hamid invested Tk.20,00,000 cash in the business.

2 The company paid Tk.1,00,000 cash for store rent for September.
3 Purchased washers and dryers for Tk.25,00,000, paying Tk.10,00,000 in cash and
signing a Tk.15,00,000, 6-month, 12% note payable.
4 Paid Tk.1,20,000 for a one-year accident insurance policy.
10 Received a bill from the Daily News for advertising the opening of the Cleaners
Tk.20,000.
20 Withdrew Tk.70,000 cash for personal use.
30 Determined that cash receipts for laundry services for the month were Tk.6,20,000.
Required:

Journalize the September transactions.

Solution:
GENERAL JOURNAL

Date Account Titles & Explanation L.F Debit Credit

2017
Sept. 1 Cash Tk. 20,00,000
Hamid, Capital Tk.20,00,000
(Owner’s investment of cash in business)

44
 2 Rent Expense 100,000
Cash 100,000
(Paid September rent)
3 Equipment 25,00,000
Cash 10,00,000
Notes Payable 15,00,000
(Purchased laundry equipment for cash
and 6-month, 12% note payable)
4 Prepaid Insurance 120,000
Cash 120,000
(Paid one-year insurance policy)
10 Advertising Expense 20,000
Accounts Payable 20,000
(Received bill from Daily News for
advertising)
20 Hamid, Drawings 70,000
Cash
(Withdrew cash for personal use) 70,000
30 Cash 620,000
Service Revenue 620,000
(Received cash for services provided)

Review Questions

1. What is a journal and why is it important in the recording process?

2. Enter the following transactions in the books of Supriya, the owner of the business.
2018
January 8 Purchased goods worth Tk.5,000 from Sarita on credit.
January 12 Sold goods worth Tk.4,000 to Neha on credit.
January 18 Received a Cheque from Neha in full settlement of her account Tk.3,850.
Discount allowed to her Tk.150.
January 20 Paid to Sarita Tk.4,900. Discount allowed by him Tk.100.
January 22 Purchased goods for cash Tk.10,000.
January 24 Sold goods to Kavita for Tk.15,000. Trade discount @ 20% is allowed to
her.
January 29 Received payment from Kavita by Cheque.

3. Rakib started a business of Phone-fax on May 1, 2018. The following transactions were
completed during the month:
May1 Invested Tk. 95,000 cash to start the business.
3 Paid Tk.5, 000 cash for May office rent.
4 Purchased Tk.2, 000 of supplies on account.
45
 6 Provided Tk.2,500 of services to his friends on account.
19 Received a cash payment of Tk.1,000 for services provided on account.
24 Drew Tk.1,000 from the business for personal use.
Required:
Journalize the above transactions:

4. Shakil Ahmed is a Chartered Accountant. During March 2018, the following transactions
occurred:
March 1 Ahmed invested Tk.300,000 cash in his business.
3 Purchased Tk.15,000 of supplies on account from Nazmul Traders.
7 Paid office rent of Tk.9,000 cash for the month.
12 Received Tk.33,000 advance on a management consulting engagement.
25 Paid salary of secretary- receptionist Tk.10,000 for the month.
31 Paid 40% of balance due Nazmul Traders.
Required:
Journalize the March transactions.

46
Lesson 3: Posting

Lesson Objectives

After studying this lesson, you should be able to:

• explain what ledger is;

• know the importance and format of ledger;
• prepare ledger accounts.

Ledger-Meaning,Importance and Format

Meaning of Ledger
All the accounts identified on the basis of transactions recorded in different journals/books, such as
Cash Book, Purchase Book, Sales Book, etc. will be opened and maintained in a separate book
called Ledger. So a ledger is a book of accounts; in which all types of accounts relating to assets,
liabilities, capital, expenses and revenues are maintained. It is a complete set of accounts of a
business enterprise.
Importance of Ledger
Ledger is an important book of Accounts. It contains all the accounts in which all the business
transactions of a business enterprise are classified. At the end of the accounting period, each account
will contain the entire information of all the transactions relating to it. Following are the advantages
of ledger:
1. Knowledge of Business Results: Ledger provides detailed information about revenues and
expenses at one place. While finding out business results the revenue and expenses are
matched with each other.
2. Knowledge of Book Value of Assets: Ledger records every asset separately. Hence, you can
get the information about the Book value of any asset whenever you need.
3. Useful for Management: The information given in different ledger accounts will help the
management in preparing budgets. It also helps the management in keeping the check on the
performance of business it is managing.
4. Knowledge of Financial Position: Ledger provides information about assets and liabilities of
the business. From this we can judge the financial position and health of the business.
5. Instant Information: The business always needs to know what it owes to others and what the
others owe to it. The ledger accounts provide this information at a glance through the account
receivables and payables.
Standard Form of Account
The simple T-account form used in accounting textbooks is often very useful for illustration
purposes. However, in practice, the account forms used in ledgers are much more structured. This
format is called the three-column form of account. It has three money columns—debit, credit, and
balance. The balance in the account is determined after each transaction. Companies use the
explanation space and reference columns to provide special information about the transaction.

47
 ACCOUNT IN GENERAL LEDGER
Date Explanation J.F Debit Credit Balance

Posting
Transferring journal entries to the ledger accounts is called posting. This phase of the recording
process accumulates the effects of journalized transactions into the individual accounts. Posting
involves the following steps.
1. In the ledger, in the appropriate columns of the account(s) debited, enter the date, journal page,
and debit amount shown in the journal.
2. In the reference column of the journal, write the account number or code to which the debit
amount was posted.
3. In the ledger, in the appropriate columns of the account(s) credited, enter the date, journal page
(Journal Folio), and credit amount shown in the journal.
4. In the reference column of the journal, write the account number to which the credit amount was
posted.
Posting should be performed in chronological order. That is, the company should post all the debits
and credits of one journal entry before proceeding to the next journal entry. Postings should be made
on a timely basis to ensure that the ledger is up to date. The reference column of a ledger account
indicates the journal page from which the transaction was posted. The explanation space of the
ledger account is used infrequently because an explanation already appears in the journal. Most
companies have a chart of accounts. This chart lists the accounts and the account numbers that
identify their location in the ledger.
Considering the journal entries (example) made in the example of lesson two of this section, the
following general entries are posted to determine the ending balance of each account.
GENERAL LEDGER
Cash

Date Explanation J.F Debit Credit Balance

2017
Sept. 1 Tk. 20,00,000 Tk. 20,00,000
2 Tk. 100,000 19,00,000
3 10,00,000 9,00,000
4 120,000 7,80,000
20 70,000 7,10,000
30 6,20,000 Tk. 13,30,000
Prepaid Insurance
Date Explanation J.F Debit Credit Balance
2017
Sept. 4 Tk. 120,000 Tk. 120,000
Equipment
Date Explanation J.F Debit Credit Balance
2017
Sept. 3 Tk. 25,00,000 Tk. 25,00,000
48
 Notes Payable
Date Explanation J.F Debit Credit Balance
2017
Sept. 3 Tk. 15,00,000 Tk. 15,00,000
Accounts Payable
Date Explanation J.F Debit Credit Balance
2017
Sept. 10 Tk. 20,000 Tk. 20,000
Hamid, Capital
Date Explanation J.F Debit Credit Balance
2017
Sept. 1 Tk.20,00,000 Tk. 20,00,000
Hamid, Drawing
Date Explanation J.F Debit Credit Balance
2017
Sept. 20 Tk. 70,000 Tk. 70,000
Service Revenue
Date Explanation J.F Debit Credit Balance
2017
Sept. 30 Tk. 6,20,000 Tk. 6,20,000
Advertising Expense
Date Explanation J.F Debit Credit Balance
2017
Sept. 10 Tk. 20,000 Tk. 20,000
Rent Expense
Date Explanation J.F Debit Credit Balance
2017
Sept. 2 Tk. 1,00,000 Tk. 1,00,000

49
 Review Questions
1. What is a ledger? Why is it called the book of permanent entry?
2. The following transactions are obtained from the books of Mrs. Nurzahan for the month of
March, 2018:
March 1 Invested cash and building of Tk.10,00,000 and Tk.20,00,000, respectively.
7 Purchased machinery worth Tk.50, 000 on credit.
10 Rendered services for Tk.65, 000 but not collected.
15 Paid salaries for the current month Tk.20, 000.
20 Withdrew Tk.10, 000 for his personal use.
30 Received cash for the services rendered on 10th of this month.
31 Deposited Tk. 30,000 into BRAC Bank Ltd.
Required:
Open necessary Ledger Accounts.
3. Why is a ledger important? Explain.
4. How does ‘journal entry’ differ from ‘ledger posting’?
5. Some transactions of M/S Rageeb Enterprise during first month of its business are presented
below:
April 1 Invested Tk.15,00,000 cash in the business.
3 Purchased office equipment Tk.120,000 paying Tk. 70,000 in cash and the balance
on account.
7 Billed customers for services performed Tk. 100,000.
8 Paid Tk. 40,000 cash on balance owed for equipment.
15 Received cash Tk. 80,000 from customers for the services rendered on 7th of this
month.
20 Paid utilities expense Tk. 5,000.
22 Withdrew Tk.10,000 cash for his private use.
Required:
Post the above transactions using the standard accounts form.

50
Lesson 4: Trial Balance

Lesson Objectives

After studying this lesson, you should be able to:

• explain what a trial balance is;

• prepare a trial balance.

Trial Balance-Meaning and Preparation

Trial balance is a list or schedule or statement of all accounts and their balances (debit or credit)
which is customarily prepared at the last date of the accounting period. The accounts are listed in the
order in which they appear in the ledger. Debit balances appear in the left column and credit
balances in the right column. The schedule is prepared to test the arithmetic accuracy of the
recording process and also to facilitate the preparation of financial statements.
After the posting of transactions in particular accounts of a ledger, the debit and credit side of each
ledger account would be added up in order to find out balance, if any, of that account. A balance is
the difference between debit total and credit total of a ledger account. Of the totals higher one will
determine the nature of the balance of the account. The balance of the accounts would then be
entered in a Trial balance. Trial balance of totals could be taken by listing in parallel columns the
total of the debits and the total of the credits of each account. In general, a trial balance is prepared
in a loose sheet, rules almost similar as journal. It will have five columns viz., no. or the serial code
no. of accounts, particulars or account titles column, ledger folio column, and debit and credit
columns. All debit balances will be entered in debit column and credit balances in credit column. If
the books are arithmetically correct, then the total of debit column must agree with the total of credit
column.
The steps for preparing a trial balance are as:
1. List the account titles and their balances in the appropriate debit or credit column.
2. Total the debit and credit columns.
3. Prove the equality of the two columns.

Objectives or Advantages and Limitations of Trial Balance

Trial balance has several advantages/objectives. Some of them are as follows:
• To check the debits equal the credits.
• To find the uncover errors in journalizing.
• To find the uncover errors in posting.
• To locate the errors in ledger accounts.
• To make financial statements.
• To list the accounts at one place.
• To know the ending balance of each account at a glance.
• To make the adjustments for unrecorded transactions.
• To find the missing amount of an account in the special case.

51
 • To test the mathematical accuracy of recording process.
A trial balance does not guarantee freedom from recording errors; numerous errors may exist even
though the trial balance columns agree. For example, the trial balance may balance even the
following errors exist:
(1) Omission of an Entry in the Journal: Where a transaction has not been recorded in the books of
account either wholly or partially. For example, purchase or sales have entirely been omitted and
there is neither a debit entry nor credit entry. If a transaction has been totally omitted it will not
affect trial balance and hence it is more difficult to detect. On the other hand, if a transaction is
partially recorded, the trial balance will not agree and hence it can be easily detected.
(2) A Wrong Entry in the Original Book: Entering wrong original figure or amount in an account. If
a credit sale of Tk.12,120 is wrongly entered as Tk.11,210. Such an error will not be revealed by
the trial balance.
(3) Errors of Commission: Where we have entered the correct amounts but in wrong person’s
account. If Ratul's account has been debited instead of Rafin's account, the trial balance will not
detect such an error.
(4) Compensating Errors: When two/more mistakes are committed which counter balances each
other. Such an error is known as ‘Compensating Error’. For example, if the account is wrongly
debited by Tk.100 less and wrongly credited by Tk.100 less then such a mistake is known as
compensating error.
(5) Errors of Principle: These are the errors committed by not properly following the accounting
principles. These arise mainly due to the lack of knowledge of accounting. For example, revenue
expenditure may be treated as Capital Expenditure.
(6) Errors of Duplication: Such errors arise when an entry in a book of original entry has been made
twice and has also been posted twice in the ledger.
Detection of Errors
Errors in a trial balance generally result from mathematical mistakes, incorrect postings, or simply
transcribing data incorrectly. What do you do if you are faced with a trial balance that does not
balance? First determine the amount of the difference between the two columns of the trial balance.
After this amount is known, the following steps are often helpful:
1. If the error is Tk.1, Tk.10, Tk.100, or Tk.1,000, re-add the trial balance columns and re-compute
the account balances.
2. If the error is divisible by 2, scan the trial balance to see whether a balance equal to half the error
has been entered in the wrong column.
3. If the error is divisible by 9, retrace the account balances on the trial balance to see whether they
are incorrectly copied from the ledger. For example, if a balance was Tk.12 and it was listed as
Tk.21, a Tk.9 error has been made. Reversing the order of numbers is called a transposition error.
4. If the error is not divisible by 2 or 9, scan the ledger to see whether an account balance in the
amount of the error has been omitted from the trial balance, and scan the journal to see whether a
posting of that amount has been omitted.

Taking the ending balances of the ledger accounts of lesson 3, a trial balance is prepared below to
test the mathematical accuracy made.

52
 Muslima Dry Cleaners
Trial Balance
September 30, 2017
Sl No. Account Titles L.F Debit Credit
Cash Tk.13,30,000
Prepaid Insurance 1,20,000
Equipment 25,00,000
Notes Payable Tk.15,00,000
Accounts Pay able 20,000
Owner’s Capital 20,00,000
Owner’s Drawings 70,000
Service Revenue 6,20,000
Advertising Expense 20,000
Rent Expense 1,00,000
__________ ___________
Tk. 41,40,000 Tk. 41,40,000

Impact of Computerized Accounting Systems

In the area of accounting and finance, the use of hand in financial reporting has been replaced by the
use of computer software to enable quick reporting and easy processing and storage of financial
information, hence due to facilitation of accounting soft wares, preparation and access of financial
statements and use of accounting procedures has been made easy. The computerized accounting
system has proved to be effective in providing information regarding the financial position of an
entity in a timely and efficient manner. Accounting information system serves the purpose of
furnishing information about an entity’s economic resources, claims against those resources,
owner’s equity and changes in the resources and claims. Accounting software enables timely and
faster generation of financial reports. This helps managers to easily identify and solve problems
instantly and take evidence-based decisions within various departments/divisions/branches.
Computerized accounting system also enables data to be available instantly and be made available to
different users in different locations at the same time meaning that reporting can be done at any time.

Review Questions

1. What is a trial balance and how is it prepared?

2. What are the advantages of preparing a trial balance?
3. What are the limitations of a trial balance?
4. “A trial balance does not guarantee freedom from recording errors; numerous errors may exist
even though the trial balance columns agree.” Explain these errors with examples.
5. How can we detect the errors in trial balance?
6. Why is a trial balance prepared by a business organization?

53
 7. Following are the ledger balances of Nasima Enterprise as on April 30, 2018. Prepare a trial
balance as on that date.
Bank Tk. 20,000; Cash Tk.5,000; Accounts receivable Tk.4,600; Accounts payable
Tk.5,000; Advertising supplies Tk.5,000; Prepaid insurance Tk.3,000; Furniture Tk.20,000;
Office equipment Tk.2,500, Unearned fees Tk.2,200, Notes payable Tk.5,000, Common
stock Tk.36,000, Retained earnings and reserve Tk.10,400, Rent Tk.12,400; Salaries
Tk.12,100; Dividend Tk.2,000, Fees earned Tk.28,000.
Answer: Trial Balance Totals: Tk. 86,600
8. Prepare a Trial Balance as on December 31, 2017 with the given balances of M/S Mitu
Enterprise:
Supplies Tk. 88,000 Mitu, Capital Tk. 95,000
Mitu, Drawing 8,000 Notes payable 19,000
Accounts payable 22,000 Salaries payable 2,000
Supplies expense 2,000 Insurance expense 3,000
Accounts receivable 44,000 Prepaid insurance 6,000
Service revenue 95,000 Cash 7,000
Inventory (Jan.1, 2017) 75,000 Inventory (Dec.31, 2017) 35,000

9. Shajahan opened Shajahan’s Cleaning Service on January 1, 2018. During January the
following transactions were completed.
Jan. 1 Shajahan invested Tk.10,00,000 cash in the business.
1 Purchased used truck for Tk.200,000, paying Tk.150,000 cash and the balance on
account.
3 Purchased cleaning supplies for Tk.10,000 on account.
5 Paid Tk.144,000 cash on one-year insurance policy effective January 1.
12 Billed customers Tk.160,000 for cleaning services.
18 Paid Tk.20,000 cash on amount owed on truck and Tk.6,500 on amount owed on
cleaning supplies.
20 Paid Tk.50,000 cash for employee salaries.
21 Collected Tk. 120,000 cash from customers billed on January 12.
25 Billed customers Tk.50,000 for cleaning services.
31 Paid gas and oil for month on truck Tk.5,500.
31 Withdrew Tk.16,000 cash for personal use.
Required:
(a) Journalize the July transactions.
(b) Post to ledger accounts.
(c) Prepare a trial balance at January 31, 2018.

Answer: Trial Balance totals: Tk. 11,78,500

54
Unit Highlights
➢ Accounting assumptions and principles affecting income.
➢ Distinction between cash basis and accrual basis of accounting.
➢ Need for adjusting entries.
➢ Different types of adjusting entries.
➢ Adjusting entries for deferrals and accruals.
➢ Closing journal entries.
Technologies Used for Content Delivery
❖ BOUTUBE
❖ BOU LMS
❖ WebTV
❖ Web Radio
❖ Mobile Technology with MicroSD Card
❖ LP+ Office 365
❖ BTV Program
❖ Bangladesh Betar Program

55
Terminology
Accrual-basis The method of accounting whereby revenues and expenses are identified with
Accounting specific periods of time and are recorded as incurred without regard t o the
date of receipts or payment of cash.
Accruals The recognition of events and conditions as they occur, rather than in the
period of their incurrence, receipt or payment.
Accrued Expenses Expenses incurred but not yet paid in cash or recorded.
Accrued Revenues Revenues earned but not yet received in cash or recorded.
Adjusted Trial Balance A list of accounts and their balances after the company has made all
adjustments for all prepayments and accruals.
Adjusting Entries Entries made at the end of an accounting period to ensure that companies
follow the revenue recognition and matching principles.
Book Value The difference between the cost of a depreciable asset and its related
accumulated depreciation.
Calendar Year An accounting period that extends from January 1 to December 31.
Cash-basis Accounting Accounting basis in which companies record revenue when they receive cash
and an expense when they pay cash.
Contra Asset Account An account offset against an asset account on the balance sheet.
Deferrals Adjusting entries for either prepaid expenses or unearned revenues.
Depreciation The allocation of the cost of an asset to expense over its useful life in a
rational and systematic manner.
Fiscal Year An accounting period that is one year in length.
Interim Periods Monthly or quarterly accounting time periods.
Matching Principle The principle that companies match efforts (expenses) with accomplishments
(revenues).
Prepaid Expenses Expenses paid in cash that benefit more than one accounting period and that
are recorded as assets.
Revenue Recognition The principle that companies recognize revenue in the accounting period in
Principle which it is earned.
Time Period An assumption that accountants can divide the economic life of a business
Assumption into artificial time periods.
Unearned Revenues Cash received and recorded as liabilities before revenue is earned.
Useful Life The length of service of a long-lived asset.

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Lesson 1: Timing Issues

Lesson Objectives

After studying this lesson, you should be able to:

• explain accounting assumptions and principles affecting income;

• distinguish between cash basis and accrual basis of accounting.

Accounting Assumptions and Principles Affecting Income

We would need no adjustments if we could wait to prepare financial statements until a company
ended its operations. At that point, we could easily determine its final balance sheet and the amount
of lifetime income it earned. However, most companies need immediate feedback about how well
they are doing. For example, management usually wants monthly financial statements, and the
Internal Revenue Service requires all businesses to file annual tax returns. Therefore, accountants
divide the economic life of a business into artificial time periods. This convenient assumption is
referred to as the time/accounting period assumption. Many business transactions affect more than
one of these arbitrary time periods.

Fiscal Year, Calendar Year and Interim Periods

Both small and large companies prepare financial statements periodically in order to assess their
financial condition and results of operations. Accounting time periods are generally a month, a
quarter, or a year. Monthly and quarterly time periods are called interim periods. Most large
companies must prepare both quarterly and annual financial statements. An accounting time period
that is one year in length is a fiscal year. A fiscal year usually begins with the first day of a month
and ends twelve months later on the last day of a month. Most businesses use the calendar year
(January 1 to December 31) as their accounting period. Some do not.

Cash Vs Accrual Basis of Accounting

Cash Basis

The cash basis of accounting recognizes revenues in the period when cash is received and recognizes
expenses when cash is paid out. Cash-basis accounting is not in accordance with generally accepted
accounting principles (GAAP). Individuals and some small companies do use cash-basis accounting.
The cash basis is justified for small businesses because they often have few receivables and payables.

Examples:
(a) Purchase is made by paying cash Tk. 3,000.
(b) Cash received for sales made Tk. 2,000.

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Accrual Basis

Accrual basis of accounting recognizes revenues when sales are made or services are provided
regardless of when cash is received. Cash is realizable (receivable). The accrual basis also recognizes
expenses when they incur regardless of when cash is paid. Cash is payable at any future date. Medium
and large companies use accrual-basis accounting.

Examples:
(a) Purchase is made on account for Tk. 3,000 to be paid by next month.
(b) Goods are sold to a customer for Tk. 2,000 to be received by next month.

Revenue Recognition Principle

The revenue recognition principle states that revenue should be recognized in the accounting period
in which it is earned. Revenue is earned when goods are sold or services are provided. To illustrate,
assume that Muslima Dry Cleaners cleans clothing on June 30 but customers do not claim and pay
for their clothes until the first week of July. Under the revenue recognition principle, Muslima Dry
Cleaners earns revenue in June when it provided the service, rather than in July when it received the
cash. At June 30, Muslima Dry Cleaners would report a receivable on its balance sheet and revenue
in its income statement for the service provided.

Various criteria are acceptable for determining when revenue is realized. The most used criteria are
as follows:

(a) Point of Sale: When direct sale is involved the revenue is recognized at the point of sale. In
sale of goods when the title of the goods passes to the buyer i,e.,the buyer acquires the right
of ownership in the goods and the seller has a legal claim against the buyer. Revenue from
sale of services may be realized in similar manner.
(b) Receipt of Payment: In some cases, services are rendered but payment is delayed and
revenue is recognized at the time of payment. This procedure is adopted by physician, legal
advisers and others whose source of revenue is professional service. Such procedure has
practical advantage of avoidance of the problem of recognition of losses from un-collectible
accounts. It may be considered as a fair practice for professional persons for determining
their income for tax purposes.
(c) Percentage of Completion Method: When large contracts are undertaken and it takes
several years to complete, it becomes necessary to consider some revenues for years of
completion. In such a case, this method is used to recognize revenue. For example, if a
contract for Tk. 40,00,000 is accepted and it requires three years to complete with a cost of
Tk. 30,00,000 then for the first two years’ revenue may be estimated on the basis of progress
of work.

58
 (d) Installment Method: Under this method, the price of goods is paid over a period of time by
installments and each installment generally contains (i) some money paid for cost of goods
and paid for gross profit from sales.

N.B: To know in details of revenue recognition, you may study the IAS 18.

Matching Principle

Accountants follow a simple rule in recognizing expenses: “Let the expenses follow the revenues.”
Thus, expense recognition is tied to revenue recognition. In the dry cleaning example, this means
that Muslima dry Cleaners should report the salary expense incurred in performing the June 30
cleaning service in the same period in which it recognizes the service revenue. The critical issue in
expense recognition is when the expense makes its contribution to revenue. This may or may not be
the same period in which the expense is paid. If Muslima Dry Cleaners does not pay the salary
incurred on June 30 until July, it would report salaries payable on its June 30 balance sheet. This
practice of expense recognition is referred to as the expense recognition principle (often referred to
as the matching principle). It dictates that efforts (expenses) be matched with results (revenues).

Review Questions

1. Explain accounting assumptions and principles affecting income.

2. Distinguish between cash basis and accrual basis of accounting.
3. When is revenue of an organization recognized? Explain.
4. What is the main theme of matching principle and why is matching principle important?
5. The total contract price for construction of building was Tk. 100,00,000 and the estimated
construction cost was Tk. Tk. 80,00,000. During the current year the project was estimated to
be 40% completed and the cost would be Tk. 30,50,000. Under the percentage of contract
completion method of accounting, what amount of income would be recognized for the
current year?
Ans: Income Tk.950,000.

59
Lesson 2: Basics of Adjusting Entries-Prepayments

Lesson Objectives

After studying this lesson, you should be able to:

• define adjusting entries;
• explain the need for adjusting entries;
• describe different types of adjusting entries;
• pass adjusting entries for prepayments.

Adjusting Entries-Meaning , Importance and Types

Meaning of Adjusting Entries:
Adjusting entries are journal entries which are made at the end of an accounting period to ensure
that:
(a) revenues are recognized in the period in which they are earned,
(b) expenses are recorded in the period in which they are incurred so that
(c) balance sheet and income statement accounts have correct balances.
Need for Adjusting Entries
As per accrual basis, adjusting entries make it possible to report correct or up-to date amounts on the
balance sheet and on the income statement. The trial balance we prepare after journalizing and
posting may not contain up-to date and complete data. Because, you know there are
i) Some events which are not recorded daily even they can be recorded so. For example, the
daily use of supplies or stationeries like paper, pen, basket, envelope, rubber, etc. or the
earning of wages by employees. And there are
ii) Some costs which are not recorded during the accounting period because they expire
with the passage of time rather than as a result of daily transactions. Examples are rent,
insurance, deprecation etc. There are also
iii) Some items which may be unrecorded. An example is a utility like gas, electricity, or
water bill that the company will not receive until the next accounting period.
Adjusting entries must be made whenever financial statements are prepared. Thus, if monthly
financial statements are prepared, monthly adjusting entries are required, though by custom the
financial reports are made annually.
Types of Adjusting Entries
Adjusting entries are classified as either:
A. Prepayments 1. Prepaid Expenses
2. Unearned Revenues
B. Accruals/Deferrals 1. Accrued Revenues
2. Accrued Expenses
C. Estimates Depreciation, Bad debts, Income tax, etc.

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Adjusting Entries for Prepayments
Adjusting entries for prepayments are required to record the portion of the prepayment that
represents the expense incurred or the revenue earned in the current period. As mentioned earlier,
prepayments are either prepaid expenses or unearned revenues.
1. Prepaid Expenses
Prepaid Expenses are those expenses which are paid in advance and recorded as assets. Why are
they called prepaid? Because, the benefits of these payments will accrue for more than the current
accounting period.
Examples of common prepayments are insurance, supplies, advertising, and rent. Besides, purchase
of fixed assets such as buildings and equipment, furniture, machinery, etc. is also a sort of advance
payment.
Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or
through use and consumption (e.g., supplies). The expiration of these costs does not require daily
journal entries. Companies postpone recognizing these costs until they prepare financial statements.
At each statement date, organizations make adjusting entries:
• to record the expenses that apply to the current accounting period, and
• to show the unexpired costs in the asset accounts.
The adjusting entry for prepaid expense is:
Date Account Titles and Explanation Debit Credit
Oct. 31 Expense Account ***
Asset Account ***
(To record asset used/expired)
For adjustment, the expense (income statement account) is increased and the asset (balance sheet
account) is decreased. If the adjustment for prepaid expenses is not made, assets will be overstated
and expenses will be understated.
Let’s discuss in more detail at some specific types of prepaid expenses, beginning with supplies.
Supplies
Businesses use various types of supplies. For example, a CA Firm may use office supplies such as
stationery, envelopes, and accounting paper. An advertising firm may use advertising supplies, such
as graph paper, video film, poster paper, etc. Companies generally debit supplies to an asset account
when they acquire them. In the course of operations, supplies are used, but companies postpone
recognizing their use until the adjustment process. At the end of the accounting period, a company
counts the remaining supplies. The difference between the balance in the Supplies (shown in trial
balance) and the supplies on hand represents the supplies used (an expense) for the period.
Suppose, on October 5, 2017 Nahid Advertising Agency purchased advertising supplies at a cost of
Tk.25,000 and recorded that transaction by increasing (debiting) the asset Advertishing Supplies.
This account shows a balance of Tk.25,000 in the October 31 trial balance. An inventory count at the
colse of business account on October 31 reveals that Tk.10,000 of supplies are still on hand. Thus,
the remaining balance of Tk.15,000 (Tk.25,000 – Tk.10,000) is the cost of supplies used or expense.
For this change, Nahid makes the following adjusting entry as.
Date Account Titles and Explanation Debit Credit
2017 Advertising Supplies Expense 15,000
Oct. 31 Advertising Supplies 15,000
(To record supplies used)
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Due to the use of supplies, the expense-advertising supplies expense is increased and debited and the
asset-advertising supplies is decreased and credited. If Nahid does not make the adjusting entry,
October expenses will be understated and net income overstated by Tk.15,000. Also, both assets and
owner’s equity will be overstated by Tk.15,000 on the October 31 balance sheet.
Insurance
Companies pay insurance premium in advance to protect themselves from losses due to fire, theft,
and other unforeseen events. For this advance or pre-payment, prepaid insurance is normally debited
and at the end of the accounting period, it is credited for the amount expired and the insurance
expense is debited.
Suppose, On October 4, 2017 Nahid Advertising Agency paid Tk.6,000 for a one-year fire insurance
policy, coverage began on October 1. Nahid recorded the payment by increasing (debiting) Prepaid
Insurance. This account shows a balance of Tk.6,000 in the October 31 trial balance. But during
October Insurance of Tk.500 (Tk.6,000 ÷ 12) expires. Thus, Nahid makes the adjusting entry:
Date Account Titles and Explanation Debit Credit
2017 Insurance Expense 500
Oct. 31 Prepaid Insurance 500
(To record insurance expired)
Here, due to the expiration of prepaid insurance, the expense-insurance expense is debited and the
asset-prepaid insurance is credited as it is decreased. If Nahid does not make this adjustment,
October expenses will be understated and net income overstated by Tk.500. Also both assets and
owner’s equity will be overstated by Tk.500 on the October 31 balance sheet.
2. Unearned Revenues
Unearned revenues are those revenues which are not earned. You know, as per revenue recognition
principle, revenues are normally earned when goods are sold or service are provided. So in case of
unearned revenue cash received in advance and recorded as a liability because the revenue has not
been earned i,e., goods/services have not been sold. Unearned revenues often occur in regard to:
rent, magazine subscriptions, and customer deposits etc. for future service.
You know, US Bangla Airlines receives cash in advance from its passengers for the sale of tickets
and treats the receipts as unearned revenue until it provides the flight service. Unearned revenues are
the opposite of prepaid expenses.
Suppose, on October 2, 2017 Nahid Advertising Agency received Tk.12,000 from Shahin
Enterprise for Advertishing services expected to be completed by December 31. Unearned Service
Revenue shows a balance of Tk.12,000 in the October 31 trial balance. Analysis reveals that the
company earned Tk.4,000 of those fees in October. So the adjusting entry would be as:
Date Account Titles and Explanation Debit Credit
2017 Unearned Service Revenue 4,000
Oct. 31 Service Revenue 4,000
(To record revenue earned for services provided)
Because of providing services, the liability-unearned service revenue is decreased and debited and
the revenue-service revenue is increased and credited.
Without this adjustment, revenues and net income are understated by Tk. 4000 in the income
statement. Also, liabilities are overstated and owner’s equity understated by Tk. 4,000 on the
October 31 balance sheet.

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 Example: 3.2.1

The ledger of Radison Company, on March 31, 2017, includes these selected accounts before
adjusting entries are prepared.
Account Titles Debit Credit
Prepaid Insurance Tk. 3,60,000
Supplies 2,80,000
Equipment 25,00,000
Accumulated Depreciation—Equipment Tk.5,00,000
Unearned Service Revenue 9,20,000

An analysis of the accounts shows the following.

1. Insurance expires at the rate of Tk.10,000 per month.
2. Supplies on hand total Tk.80,000.
3. The equipment depreciates Tk.20,000 a month.
4. One-half of the unearned service revenue was earned in March.
Required:
Prepare the adjusting entries for the month of March.
Solution:
Date Account Titles and Explanation Debit Credit
2017 Insurance Expense 10,000
Mar. 31 Prepaid Insurance 10,000
(To record insurance expired)
31 Supplies Expense 200,000
Supplies 200,000
(To record supplies used)
31 Depreciation Expense 20,000
Accumulated Depreciation—Equipment 20,000
(To record monthly depreciation)
31 Unearned Service Revenue 460,000
Service Revenue 460,000
(To record revenue earned)

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 Review Questions
1. What are adjusting entries and why are they made?
2. The followings are some of the account balances extracted from Trial Balance of Riad Ltd. on
December 31, 2017 before adjusting entries are prepared:
Account Titles Debit Credit
Prepaid Insurance Tk. 48,000
Store Supplies 37,000
Office Equipment 250,000
Delivery Van 100,000
Accumulated Depreciation—Office Equipment Tk.75,000
Accumulated Depreciation—Delivery Van 30,000
Unearned Fees 1,05,000

An analysis of the accounts shows the following.

(i) Store supplies on hand total Tk.7,000.
(ii) Insurance expires at the rate of Tk.30,000 per annum.
(iii) The office equipment depreciates Tk.25,000 a year.
(iv) Delivery van depreciates Tk. 10,000 per year.
(v) One-half of the unearned fees were earned in December 2017.

Required:
Prepare the adjusting entries for the year ended December 2017.

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Lesson 3: Basics of Adjusting Entries-Accruals

Lesson Objectives

After studying this lesson, you should be able to:

• pass adjusting entries for accruals;
• prepare adjusting journal entries for estimates and others.

Adjusting Entries for Accruals

The second category of adjusting entries is accruals. Concerns make adjusting entries for accruals to
record revenues earned and expenses incurred in the current accounting period that have not been
recognized through daily entries.
1. Accrued Revenues: Accrued revenues are those revenues which are earned but not yet recorded at
the statement date. Accrued revenues may accumulate (accrue) with the passing of time, as in the
case of interest revenue and rent revenue. Or they may result from services that have been performed
but are neither billed nor collected. Interest and rent revenues are unrecorded because the earning
process does not involve daily transactions. Performed services may be unrecorded because the
concern has provided only a portion of the total service.
An adjusting entry for accrued revenues serves two purposes:
(a) It shows the receivable that exists at the balance sheet date, and
(b) It records the revenues earned during the period.
The adjusting entry for accrued revenue is as:
Date Account Titles and Explanation Debit Credit
Last day of Asset Account [Accounts Receivable] ***
accounting Revenue Account ***
period (To record revenue for services provided)

For adjustment, the asset (balance sheet account) is increased and the revenue (income statement
account) is increased. If the adjustment for accrued revenue is not made, both assets and revenues
will be understated.
Suppose in October 2017, Nahid Advertising Agency earned Tk.2,000 for advertising services that
have not been recorded. Nahid makes the following adjusting entry on October 31.

Date Account Titles and Explanation Debit Credit

2017
Oct. 31 Accounts Receivable 2,000
Service Revenue 2,000
(To record revenue for services provided)

If, On November 10, Nahid receives cash of Tk.2,000 for the services performed in October, the
general journal entry on November 10 will be:

65
 Date Account Titles and Explanation Debit Credit
2017
Nov.10 Cash 2,000
Accounts Receivable 2,000
(To record cash collected on account)

2. Accrued Expenses: Accrued expenses are those expenses which have been incurred but not yet
paid or recorded at the statement date. Interest, rent, taxes, and salaries are typical accrued expenses.
Accrued expenses result from the same causes as accrued revenues. In fact, an accrued expense on
the books of a concern is accrued revenue to another concern. For example, Nahid Advertising
Agency’s Tk.2,000 accrual of revenue is an accrued expense to the client that received the service.
An adjusting entry for accrued expenses serves two purposes:
(a) It records the obligations that exist at the balance sheet date, and
(b) It recognizes the expenses of the current accounting period.
The adjusting entry for accrued expense is:
Date Account Titles and Explanation Debit Credit
Last day of Expense Account ***
accounting Liability Account [Accounts Payable] ***
period (To record expense accrued for services received)
For adjustment, the expense (income statement account) is increased and the liability (balance sheet
account) is also increased. If the adjustment for accrued expense is not made, both liabilities and
expenses will be understated.
Nahid Advertising Agency signed a Tk.50,000, 3-month note payable on October 1.The note
requires Nahid to pay interest at an annual rate of 12%.
Date Account Titles and Explanation Debit Credit
2017 Interest Expense 500
Oct. 31 Interest Payable 500
(To record interest on notes payable)
Face Value of Note × Annual Interest Rate× Time in Terms of One Year = Interest
Tk.50,000 × 12% × 1/12 = Tk.500
Example: 3.3.1

Rajib and Raihan are the new owners of Micro Computer Services. At the end of August 2017, their
first month of operations, Rajib and Raihan attempted to prepare monthly financial statements. The
following information relates to August.
(i) At August 31, the concern owed its employees Tk.80,000 in salaries and wages that will be
paid on September 1.
(ii) On August 1, the concern borrowed Tk.30,00,000 from a local bank on a 15-year mortgage.
The annual interest rate is 10%.
(iii) Revenue earned but unrecorded for August totaled Tk.1,10,000.
Required:
Prepare the adjusting entries needed at August 31, 2017.

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Solution:
Date Account Titles and Explanation Debit Credit
2017 Salaries and Wages Expense Tk.80,000
Aug. 31 Salaries and Wages Payable Tk.80,000
(To record accrued salaries)
31 Interest Expense 25,000
Interest Payable 25,000
(To record accrued interest:
Tk.30,00,000 × 10% × 1/12= Tk.25,000)
31 Accounts Receivable 110,000
Service Revenue 110,000
(To record revenue earned)

Adjusting Entries for Estimates and Others

Accountants very often need to make estimates of future events to comply with accrual accounting
basis. They are as follows:
1. Depreciation
Business concerns typically own buildings, equipment, and vehicles, etc. and record them as long-
lived or non-current assets rather than expenses, in the year they are acquired. According to the
matching principle, concerns then report a portion of the cost of a long-lived asset as an expense
during each period of the asset’s useful life, which is called Depreciation. Depreciation is the
process of allocating the cost of an asset to expense over its useful life in a rational and systematic
manner.
The adjusting entry for recording depreciation is as:
Date Account Titles and Explanation Debit Credit
Last day of Depreciation Expense ***
accounting Accumulated Depreciation ***
period (To record depreciation expense for the accounting
period)
For example, if Nahid Advertising Agency purchased the office equipment on October 2, 2017 at a
cost of Tk.50,000 and its useful life is expected to be 10 years, and salvage value Tk.2,000, it
estimates depreciation on the office equipment to be Tk.4,800 a year, or Tk.400 per month. Thus,
Nahid makes the adjusting entry to record depreciation for October 2017 as:
Date Account Titles and Explanations Debit Credit
2017 Depreciation Expense 400*
Oct. 31 Accumulated Depreciation—Office Equipment 400
(To record monthly depreciation)
*[(Tk.50,000 – 2,000) ÷ 10] ÷ 12
The balance in the accumulated depreciation account will increase by Tk.400 each month. After
journalizing and posting the adjusting entry at November 30, the balance will be Tk.800; at
December 31, Tk.1,200; and so on.

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2. Other Adjusting Entries [All Independent Cases]
(a)To adjust allowance for bad debt/provision for bad debt:
Allowance for doubtful debt to be created 10% on accounts receivable of Tk. 11,000.
Date Account Titles and Explanation Debit Credit
Last day of Bad Debt Expense /Uncollectible Accounts 1,100
accounting Allowance for Bad Debt/Uncollectible Accounts 1,100
period (To record estimated uncollectible accounts)
(b)To write off of bad debt:
TK. 500 is to be written off as bad debt.
Date Account Titles and Explanation Debit Credit
Last day of Bad Debt Expense/Uncollectible Accounts 500
accounting Accounts Receivable 500
period (To write off uncollectible accounts)
(c)To adjust estimated income tax:
Estimated income taxes accrued Tk. 5,000.
Date Account Titles and Explanation Debit Credit
Last day of Income Tax Expense 5,000
accounting Income Tax Payable 5,000
period (To record income tax expenses)
(d) To adjust installation of machinery included in wages:
Date Account Titles and Explanation Debit Credit
Last day of Machinery ***
accounting Wages ***
period (To record installation of machinery included in
wages)

(e) To adjust repairs expense included in machinery:

Date Account Titles and Explanation Debit Credit
Last day of Repairs Expense ***
accounting Machinery ***
period (To record repairs expense)
(f) To adjust proposed dividend:
Date Account Titles and Explanation Debit Credit
Last day of Dividend Expense ***
accounting Dividend Payable ***
period (To record dividend declared)
(g) To adjust goods destroyed by fire and the insurance concern admitted the claim partially:
Date Account Titles and Explanation Debit Credit
Last day of Insurance Claim Receivable **
accounting Loss by Fire **
period Cost of Goods Sold ***
(To record the value of destroyed goods, loss and
claim)
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 (h) To adjust goods sold without profit:
Date Account Titles and Explanation Debit Credit
Last day of Sales **
accounting Purchase **
period (To record the value of goods sold without profit)

Example: 3.3.2
Selected accounts of City Real Estate Firm are shown below as of January 31, 2018 of the current
year before any adjusting entries have been made:

Account Titles Debit Credit

Prepaid Insurance Tk.27,000
Supplies 7,500
Office Equipment 84,000
Unearned rental fees Tk.30,000
Salaries expenses 21,000
Rental fees 120,000

Required:
Based on the following information, record in a general journal the necessary adjusting entries on
January 31, 2018:
(a) Prepaid insurance represents premiums for 3 years paid on January 1.
(b) Supplies of Tk. 4,500 were on hand January 31.
(c) Office equipment is expected to last 10 years.
(d) The firm collected 6- month rent in advance on January 1 from a tenant renting space for Tk.
5,000 per month.
(e) Accrued salaries not recorded as of January 31 are Tk. 3,600.

Solution: City Real Estate Firm

Adjusting Journal Entries
Date Account Titles & Explanation L.F. Dr Cr
2018
Jan. 31 (a) Insurance Expense Tk. 750
Prepaid Insurance Tk.750
(To record expired insurance premium)
[27,000*1/36=Tk 750]
31 (b) Supplies Expense 3,000
Supplies 3,000
(To record supplies expense)
[7,500-4,500=Tk 3,000]

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 31 (c) Depreciation Expense 700
Accumulated Depreciation –Equipment 700
(To record monthly depreciation)
[84,000/10×1/12= Tk. 700]
31 (d) Unearned Rental Fees 5,000
Rental Fees 5,000
(To record earned revenue)
31 (e) Salaries Expense 3,600
Salaries Payable 3,600
(To record accrued salaries)

Review Questions

1. What adjusting entries are passed for accruals?

2. Prepare adjusting journal entries for yearly depreciation.
3. Uzzal & Sajal are the owners of an advertising agency. At the end of March 31, 2018, the first
month of operations the company is going to prepare a monthly financial statement. The
following information relates to March:
(i) On March 1, Uzzal & Sajal borrowed Tk. 500,000 from a bank on a 10-year mortgage.
The annual interest rate is 15%.
(ii) At March 31, outstanding salaries of employees amounted to Tk. 12,000.
(iii) Fees earned but unrecorded for March totaled Tk. 23,000.
Required:
Prepare the adjusting entries needed at March 31, 2018.
4. A. Matin Company accumulates the following adjustment data at December 31,2017.
(i) Supplies of Tk.30,000 have been used.
(ii) Depreciation on the equipment for 2017 is Tk.1,000.
(iii) Rent collected in advance totaling Tk.65000 has been earned.
(iv) Prepaid insurance totaling Tk.35,000 has expired.
Required:
Prepare adjusting entries for the items described above.
5. Ahmed Raju started his own consulting firm, Ahmed Company, on June 1, 2017. The trial
balance at June 30 is shown below.
Ahmed Company
Trial Balance
June 30, 2017
Account Number Account Titles Debit Credit
101 Cash Tk. 7,15,000
112 Accounts Receivable 6,00,000
126 Supplies 2,00,000
130 Prepaid Insurance 3,00,000
157 Equipment 15,00,000
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 201 Accounts Payable Tk. 4,50,000
209 Unearned Service Revenue 4,00,000
301 Owner’s Capital 21,75,000
400 Service Revenue 7,90,000
726 Salaries and Wages Expense 4,00,000
729 Rent Expense 1,00,000 ________
Tk.38,15,000 Tk.38,15,000

In addition to those accounts listed on the trial balance, the chart of accounts for Ahmed
Company also contains the following accounts and account numbers: No. 158 Accumulated
Depreciation—Equipment, No. 212 Salaries and Wages Payable, No. 631 Supplies Expense, No.
711 Depreciation Expense, No. 722 Insurance Expense, and No. 732 Utilities Expense.
Other data:
i) Supplies on hand at June 30 are Tk.75,000.
ii) A utility bill for Tk.15,000 has not been recorded and will not be paid until next month.
iii) The insurance policy is for a year.
iv) Tk.2,80,000 of unearned service revenue has been earned at the end of the month.
v) Salaries of Tk.1,90,000 are accrued at June 30.
vi) The equipment has a 5-year life with no salvage value. It is being depreciated at
Tk.25,000 per month for 60 months.
vii) Invoices representing Tk.1,20,000 of services performed during the month have not
been recorded as of June 30.
Required:
Prepare the adjusting entries for the month of June. Use J3 as the page number for your
Journal.

71
Lesson 4: The Closing Journal Entries

Lesson Objectives

After studying this lesson, you should be able to:

• explain the concepts of closing entries;
• know the importance of closing journal entries;
• pass closing journal entries for the temporary accounts.

Closing Entries-Meaning and Importance

Closing entries are journal entries required to close all the nominal or temporary accounts at the end
of a certain accounting period or at the end of a financial or accounting year.
Revenue increases capital whereas expenses and drawing decrease it. Revenues, expenses and
drawings are called nominal or temporary accounts, because they accumulate the transactions of
only one accounting period. In this connection it is to be noted that the capital or retained earnings
and other Balance sheet accounts are called real or permanent account, because their balances
continue to exist beyond the current accounting period.
At the end of an accounting period, the change in retained earnings as accumulated through
temporary i,e., temporary accounts needs to be transferred to capital or Retained earnings statement.
This process of transfer is called closing the accounts and the journal entries made in this regard are
called closing journal entries.
At year end, for the purpose of preparing financial statements, revenues and expenses are transferred
to an account called Income Summary or Income Statement. When through such transfer the credit
balance of revenue account and debit balance of expenses account are transferred to the summary
account, the balance of that account will be net income or net loss. This is consistent with the rule
that the increase in owners' equity is recorded by credits and decrease is recorded by debits.
Closing Journal Entries-Illustration
The following journal entries are needed to close the major temporary accounts (RED):
R=Revenues
E=Expenses
D=Drawing
1. To Close the Revenues
Date Account Titles and Explanation Ref. Debit Credit
Last day of All Revenues ***
accounting Income Summary ***
period (To close revenue accounts)

2. To Close the Expenses

Date Account Titles and Explanation Ref. Debit Credit
Last day of Income Summary ***
accounting All Expenses ***
period (To close expense accounts)
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3. To Record the Profit
Date Account Titles and Explanation Ref. Debit Credit
Last day of Income Summary ***
accounting Capital or Retained earnings ***
period (To close/transfer net income to capital)
4. To Record the Loss
Date Account Titles and Explanation Ref. Debit Credit
Last day of Capital or Retained earnings ***
accounting Income Summary ***
period (To close/transfer net loss to capital)

5. To Transfer the Dividends Declared

Date Account Titles and Explanation Ref. Debit Credit
Last day of Retained earnings ***
accounting Dividends ***
period (To close dividend to retained earnings)
6. To Transfer the Drawings
Date Account Titles and Explanation Ref. Debit Credit
Last day of Owner’s Capital ***
accounting Owner’s Drawings ***
period (To close drawings to capital)

Example: 3.4.1

The trial balance of Raisa Clothing Company at December 31 shows Merchandise Inventory
Tk.25,000, Sales Tk.162,400, Sales returns and allowances, Tk.4,800, Sales discounts Tk.3,600,
Cost of goods sold Tk.110,000, Rental revenue Tk. 6,000, Freight-out Tk.1,800, Rent expense
Tk.8,800, salaries and wages expense Tk.22,000 and Drawing Tk.2,900.
Required:
Prepare the closing entries for the above accounts.

Solution:
Date Account Titles and Explanation Ref. Debit Credit
December 31 Sales Tk.162,400
Rental revenue 6,000
Income summary Tk.168,400
(To close accounts with credit balances)
_______________________________
Income summary
31 Cost of goods sold 151,000
Sales returns and allowance 110,000
Sales discounts 4,800
Freight-out 3,600

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 Rent expense 1,800
Salaries and wage expense 8,800
(To close accounts with debit balances) 22,000
_______________________________
Income summary
31 Capital
(To close net income to capital) 17,400
_______________________________ 17,400
Raisa’s Capital
31 Raisa’s Drawings
(To close drawings to capital) 2,900
2,900
Note: Merchandise is an asset and it is not closed as it is a permanent account. You may also close
the net sales by deducting the sales returns and sales discounts from sales.

After Closing Trial Balance

After the revenue and expenses accounts have been closed through closing entries, it is possible and
also considered necessary to prepare an After Closing Trial Balance" which thus, of course, will
consist solely of Balance Sheet items. This after closing or sometimes called post-closing trial
balance will be prepared based on ledger accounts and the transfer effects of closing entries. It gives
assurance that the accounts are in balance and also arithmetically accurate.

Reversing Entries
Some of the adjusting entries recorded at the end of an accounting period may have significant effect
on otherwise routine transactions that occur in the succeeding (i,e.,following) year. A typical
example is the adjusting entry for accrued salaries. In fact, the salary expenses of an enterprise and
the accompanying liability to employees accumulates day by day during any part of the year. Thus
when salaries are paid weekly, it will be recorded 52 or 53 times a year. In such a case, if there has
been an adjusting entry for accrued salaries at the end of the year, the payment of salary at year end
may include a part for current and a part for next year. As such, it will be necessary to debit salary
payable for the amount owned for the earlier year and salary expense for the portion of the payroll
that represent expense for the later year. Following example will make the point clear

Example: 3.4.2
a) Salaries are paid on Thursday for 5- day week.
b) The balance in salary expense as of Thursday day, December 27, is Tk.60,000
c) Salary accrued for Sunday & Monday, December 30 & 31 amounts to Tk.1,000
d) Salary paid on Thursday, January 3 amounts to Tk.4,000
The adjusting entry to record accrued salary payable for Sunday & Monday will be:
Date Account Titles and Explanation Ref. Debit Credit
Last day of Salaries Expense 1,000
accounting Salaries Payable 1,000
period (To close accrued salaries)
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After this adjusting entry has been passed the Salaries expense will have a debit balance of
Tk.61,000 (60,000+1,000) & Salaries payable will have credit balance of Tk.1,000. At this stage,
now it will be necessary to record Tk.4,000 payroll on January 3, as a debit of Tk.1,000 to salary
payable & a debit of Tk.3,000 to Salaries expense. This requires the employee who records payroll
to determine the amount of Tk.4,000 payment to distinguish and debit to each of the two accounts.
But the need to refer to earlier entries and to decide the debit between two accounts can be avoided
by an optional procedure of recording a reversing entry as of the first day as follows:
Salaries Expense
Date Explanations Ref. Debit Credit Balance
Debit Credit
2017
Dec.27 ............................................ .......
31 Adjusting 1,000 61,000
31 Closing 61,000 ⎯ ⎯
2018
Jan. 1 Reversing 1,000 1,000

3 3,000

Salaries Payable
Date Explanations Ref. Debit Credit Balance
Debit Credit
2017
Dec.31 Adjusting 1,000 1,000
2018
Jan. 1 Reversing 1,000
After reversing entry is posted, salary payable comes into balance. The entire amount of first payroll
in January will be debited to salary expenses & the balances of the accounts will thus automatically
represent the expenses of the new period.

75
 Review Questions

1. What are closing entries? What accounts are normally closed at the end of accounting period?
2. The trial balance of Khalid Fabrics at December 31, 2017 shows Merchandise inventory
Tk.50,000, Sales Tk.340,000, Sales discounts Tk.5,600, Cost of goods sold Tk.250,000,
Freight-out Tk.2,500, Prepaid expense Tk. 15,000, Rent expense Tk.12,800, Salaries and
wages expense Tk.42,000.
Required:
Prepare the closing entries for the above accounts.
3. On December 31, 2017, the adjusting trial balance of Dhaka Regency shows the following
selected data:
Accounts payable TK. 6,000
Interest expense 8,900
Commission revenue 98,000
Interest payable 3,000

Analysis shows that adjusting entries are made to

(i) accrue Tk. 6,000 of commission revenue, and
(ii) accrue Tk. 3,000 interest expense.
Required:
(a) Prepare the closing entries for the temporary accounts at December 31, 2017.
(b) Prepare the reversing entries on January 1, 2018.

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Unit Highlights
➢ Differences between service and merchandising companies.
➢ Recording of purchases under a perpetual inventory system.
➢ Recording of sales revenues under a perpetual inventory system.
➢ Steps in the accounting cycle for a merchandising company.
➢ Distinction between a multiple-step and a single-step income statement.
➢ Computation and importance of gross profit.

Technologies Used for Content Delivery

❖ BOUTUBE
❖ BOU LMS
❖ WebTV
❖ Web Radio
❖ Mobile Technology with MicroSD Card
❖ LP+ Office 365
❖ BTV Program
❖ Bangladesh Betar Program

77
 Terminology
Contra-Revenue An account that is offset against a revenue account on the income
Account statement.
Cost of Goods Sold The total cost of merchandise sold during the period.

FOB Destination Freight terms indicating that the seller places the goods free on board to
the buyer’s place of business, and the seller pays the freight.
FOB Shipping Point Freight terms indicating that the seller places goods free on board the
carrier, and the buyer pays the freight costs.
Gross Profit The excess of net sales over the cost of goods sold.
Income from Income from a company’s principal operating activity; determined by
Operations subtracting cost of goods sold and operating expenses from net sales.
Multiple-Step An income statement that shows several steps in determining net
Income Statement income.
Net Sales Sales less sales returns and allowances and less sales discounts.
Non-Operating Various revenues, expenses, gains, and losses that are unrelated to a
Activities company’s main line of operations.
Operating Expenses Expenses incurred in the process of earning sales revenues. Selling and
administrative expenses are operating expenses.
Periodic Inventory An inventory system under which a concern does not keep detailed
System inventory records throughout the accounting period but determines the
cost of goods sold only at the end of an accounting period.
Perpetual Inventory An inventory system under which a concern keeps detailed records of
System the cost of each inventory purchase and sale, and the records continuously
show the inventory that should be on hand.
Purchase Allowance A deduction made to the selling price of merchandise, granted by the
seller so that the buyer will keep the merchandise.
Purchase Discount A cash discount claimed by a buyer for prompt payment of a balance
due.
Purchase Invoice A document that supports each credit purchase.
Purchase Return A return of goods from the buyer to the seller for a cash or credit refund.
Sales Discount A reduction given by a seller for prompt payment of a credit sale.

78
Lesson 1: Merchandising Operations

Lesson Objectives

After studying this lesson, you should be able to:

• identify the differences between merchandising and service rendering concerns;

• depict the operating cycle of a merchandising and a service rendering concerns;
• explain the income measurement process for a merchandising concern;
• distinguish between a perpetual inventory and a periodic inventory system.

Merchandising Concern and Service Rendering Concern

Operations mean activities and merchandising operations mean purchase and sale of merchandise
or goods. So the concern that purchases merchandise at lower price and then resells them generally
for a higher price is called a merchandising concern. There are two types of merchandising
concerns - retail and wholesale. A retail concern is a concern that sells products directly to
customers such as grocery stores (eg. Agora), drug stores (e.g. Lazz Pharma), restaurants (Seven
Eleven), and so on. A wholesale concern is a concern that buys items in bulk from manufacturers
and resells them to retailers or other wholesalers.

Merchandising Concern

Manufacturer Wholesaler Retailer Final

Consumer

Merchandise (or merchandise inventory)—goods held for sale to customers in the ordinary
course of business. Note that this includes only goods held for resale. For example, if a grocery
store decided to sell an old display case, this would not be merchandise because grocery stores do
not normally sell display cases. But a display case would be merchandise for a furniture store.
Merchandise for one firm may be an asset for another. The merchandise (display cases) for the
furniture store is an asset (non-current) for the grocery store.
• Revenues of a merchandiser primarily result from sales of goods or merchandise and known
as sales revenue or sales.
• Expenses for a merchandising concern are divided into two categories:
a) Cost of goods sold (COGS): total cost of merchandise sold during the period.
b) Operating expenses (OE): expenses incurred in the process of earning sales revenue that
are deducted from gross profit in the income statement). Examples are sales salaries and
insurance expense.
• Gross profit (GP) is equal to Sales Revenue less Cost of Goods Sold.

A service rendering concern, on the other hand, is a concern that earns revenue by selling
(providing or rendering) its services to customers. Examples of service rendering concerns are

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 Premium bus service, Banking service, Consulting service, etc. The above figure shows that cost of
goods sold and gross profit are not used in a service rendering concern.

Operating Cycles of Merchandisig and Service Rendering Concerns

An operating cycle is the average length of time span between the purchase of merchandise
inventory and the realization of cash from customers. An operating cycle, is also known as cash
cycle or earning cycle.
Operating Cycles—Operating Cycles for a merchandising concern and a service concern:
• Merchandising Concern Operating Cycle (cash to cash) involves:
a) Buy Inventory,
b) Sell Inventory,
c) Obtain Accounts Receivable, and
d) Receive Cash.
Merchandising Concern

• Service Rendering Concern Operating Cycle (to go from cash to cash) involves performing
services which involves an outflow of cash and finally receiving the cash from customers
receiving the services.

Service Rendering Concern

The operating cycle of a merchandising concern is usually longer than that of a service concern.

Income Measurement Process for a Merchandising Concern

The net income or loss of a merchandising concern is measured as shown in the following figure.

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Perpetual and Periodic Inventory Systems
The flow of costs for a merchandising concern is as follows: Beginning inventory plus the cost of
goods purchased is the cost of goods available for sale. As goods are sold, they are assigned to cost
of goods sold. Those goods that are not sold by the end of the accounting period represent ending
inventory. Concerns use one of two systems to account for inventory:
• a perpetual inventory system, or
• a periodic inventory system.
Perpetual Inventory System
• Merchandise inventory and cost of goods sold are updated continuously on each sale
and purchase transaction.
• Some other transactions may also require an update to inventory account for example,
sale/purchase return, purchase discounts etc.
• Purchases are directly debited to inventory account whereas for each sale two journal
entries are made: one to record sale value of inventory and other to record cost of goods
sold.
• Purchases account is not used in perpetual inventory system.

Example: Volvo Car Overseas Corporation AB sells Volvo car in Bangladesh. It needs to maintain
inventory record each time a car is sold to a customer.

Periodic Inventory System

• Merchandise inventory and cost of goods sold are not updated continuously.
• Purchases are recorded in Purchases account and each sale transaction is recorded via a
single journal entry.
• Cost of goods sold account does not exist during the accounting period.
It is determined at the end of accounting period via a closing entry.

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Example: Hallmark may follow this inventory system. Because they sell low-value items at a large
quantity. They need not maintain record of inventory each time a purchase or sale is made.
Differences between Perpetual and Periodic Inventory Systems
Points of Difference Perpetual Inventory System Periodic Inventory System
Merchandise inventory are updated continuously on are not updated continuously,
and cost of goods sold each sale and purchase rather inventory is counted
transaction and also for physically and cost of goods
sale/purchase return, purchase sold is computed at the end of
discounts etc. accounting period.
Purchases are directly debited (increased) are recorded in Purchases
to Inventory account. account.
For each sale two journal entries are made: only sales value of inventory is
one to record sales value of recorded. Cost of goods sold
inventory and other to record account does not exist during the
cost of goods sold. accounting period.
Inventory position and can be known . can’t be known.
cost of goods sold at any
time
Organizations involved in merchandising of high priced merchandising of low priced
low volume items and using bar large volume items and using
code or optical scanning use it. no computer or electronic
For example, automobiles, scanning use it. For example,
furniture shop, computer shop, grocery, medicine store, fast
departmental store, etc. food shop, hardware shop, etc.
Better control over are possible . are not possible.
inventories and
identification of product
deficiency
Freight /Transportation is debited (increased) to is debited to Freight-in.
cost (FOB shipping point) Inventory account .
Purchase returns and is credited (decreased) to is credited by its name
allowances /Purchase Inventory account as it decreases (Purchase returns and
discount cost of purchasing inventory. allowances /Purchase
discount).
Closing journal entries are not required for inventory are only required to update
account. inventory and cost of goods
sold.

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 Find two organizations where a perpetual and a periodic inventory
system is followed to keep the records of inventory. Identify the
differences in inventory accounting systems of these organizations.
Activity

Review Questions

1. What are the major differences between a service rendering concern and a merchandising
concern?
2. Graphically show the operating cycle of a merchandising and a service rendering concern.
3. Explain how the income for a merchandising concern is measured.
4. Distinguish between a perpetual inventory system and a periodic inventory system.
5. Why is perpetual inventory system growing in popularity and use? Explain.

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Lesson 2: Recording Purchases of Merchandise

Lesson Objectives

After studying this lesson, you should be able to:

• record of purchases under a perpetual inventory system;

• record of sales revenues under a perpetual inventory system.
Purchase of Merchandise
• Merchandise is purchased for resale to customers
• Merchandise Inventory is debited for the cost of goods
purchase.
• Purchases may be made for cash or on account (credit).
• The purchase is normally recorded by the purchaser when
the goods are received from the seller.
• Each credit purchase should be supported by a purchase
invoice.

Recording Purchases of Merchandise Inventory Under Perpetual System

A. Purchase of Merchandise
• When merchandise is purchased for resale to customers, the account, Merchandise
Inventory, is debited for the cost of goods purchased.
(a) Each credit purchase should be supported by a purchase invoice.
(b) A purchase invoice is a document that indicates the total purchase price and other relevant
information. This invoice received (not prepared) by the buyer is actually a sales invoice
prepared by the seller. Note that only purchases of merchandise are debited to Merchandise
Inventory. Purchases if other assets: supplies, equipment, and similar items are debited to their
respective accounts.
Example: A4TECH Stereo makes the following journal entry to record its purchase from Fagun
Audio Visuals on credit. The entry increases (debits) Inventory and increases (credits) Accounts
Payable.
Date Account Titles and Explanation Debit Credit
May 4 Merchandise Inventory Tk. 380,000
Accounts Payable Tk. 380,000
(To record goods purchased on account
from Fagun Audio Visual)
*If the purchase is made for cash, cash is credited in place of accounts payable.

B. Purchase Returns and Allowances

• A purchaser may be dissatisfied with the goods or merchandise purchased because they may-
➢ be damaged or defective,
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 ➢ be of inferior quality, or
➢ not meet his or her specifications.
• The purchaser initiates the request for a reduction of the balance due through the issuance of a
debit memorandum.
• The debit memorandum is a document issued by a buyer to inform a seller that the seller’s
account has been debited because of unsatisfactory merchandise.
A purchase return or a purchase allowance (a deduction from the purchase price when
unsatisfactory goods are kept) is shown by the entry where Accounts Payable is debited and
Merchandise Inventory is credited to show that the cost of the merchandise inventory is reduced
with a return or an allowance. Assume that on May 8 A4TECH Stereo returned goods costing Tk.
30,000 to Fagun Audio Supply. The following entry by A4TECH Stereo for the returned
merchandise decreases (debits) Accounts Payable and decreases (credits) Merchandise Inventory.
Date Account Titles and Explanation Debit Credit
May 8 Accounts Payable Tk. 30,000
Merchandise Inventory Tk. 30,000
(To record return of goods purchased on
account From Fagun Audio Visual)
A4TECH Stereo increased Inventory when it received goods and decreased Inventory when it
returned the goods (or when it is granted an allowance). Suppose instead that A4TECH Stereo chose
to keep the goods after being granted a Tk.5,000 allowance (reduction in price). It would reduce
(debit) Accounts Payable and reduce (credit) Inventory for Tk.5,000.
C. Accounting for Freight (Transportation)Costs
Here a question arises: whether the costs of transporting the goods are to be borne by the seller or
the buyer. The question leads to two concepts:
a) FOB (free on board) Shipping Point
b) FOB (free on board) Destination

a) FOB Shipping Point

• Supplier/seller places the goods free on board at the point of origin.
• Buyer pays the freight costs.
• It is also called ‘FOB Factory’.
Example: A buyer of Dhaka purchased equipment from a dealer of Japanese Toshiba Corporation.
Toshiba delivered the shipment free on board to Chattogram. The buyer paid the transportation
cost from Chattogram to Dhaka.

85
 Freight Terms Place of Who Pays the Accounting Treatment in the
Delivery Freight Cost Buyer’s Book
FOB Shipping At origin Buyer Perpetual System:
Point Merchandise Inventory Dr.
Cash Cr.
Periodic System:
Freight-in Dr.
Cash Cr.
FOB At Seller/ No accounting entry
Destination destination Supplier

When Freight Costs are Borne or Incurred by the Buyer

When the buyer incurs the transportation costs, these costs are considered part of the cost of
purchasing inventory. Therefore, the buyer debits (increases) the account Inventory. For example, if
upon delivery of the goods on May 6, A4TECH Stereo (the buyer) pays Acme Freight Company Tk.
15,000 for freight charges, the entry on A4TECH Stereo’s books is:
Date Account Titles and Explanation Debit Credit
May 6 Merchandise Inventory Tk.15,000
Cash Tk.15,000
(To record payment of freight on goods purchased)
Thus, any freight costs incurred by the buyer are part of the cost of merchandise purchased. The
reason: Inventory cost should include any freight charges necessary to deliver the goods to the
buyer.
b) FOB Destination
• Supplier/seller places the goods at the place of delivery.
• Seller pays the freight costs.
Example: A buyer purchased equipment from Japanese Toshiba Corporation. They delivered the
shipment at Dhaka (Destination). The seller (Toshiba Corporation) paid the transportation cost
of the shipment (FOB destination).

When Freight Costs are Incurred by the Seller

In contrast, freight costs incurred by the seller on outgoing merchandise are an operating expense
to the seller. These costs increase an expense account titled Freight-out or Delivery Expense. If the
freight terms on the invoice had required Fagun Audio Supply (the seller) to pay the freight
charges, the entry by Fagun Audio Supply would be:
Date Account Titles and Explanation Debit Credit
May 4 Freight-out (or Delivery Expense) Tk.15,000
Cash Tk.15,000
(To record payment of freight on goods sold)

When the seller pays the freight charges, it will usually establish a higher invoice price for the goods
to cover the shipping expense.

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 D. Purchase Discounts/Cash Discounts
• Purchase discount is an offer from the supplier to the purchaser, to reduce the payment
amount if the payment is made within a certain period of time. For example, a purchaser
brought a Tk.10,000 item, with a credit term 3/10, net 30. If he pays within 10 days, he
will only need to pay Tk.9,700.
• Credit terms (specify the amount of cash discount and time period during which a
discount is offered) may permit the buyer to claim a cash discount for the prompt
payment of a balance due.
➢ 2/10, n/30 : a 2% discount is allowed if payment is made within 10 days (called the
discount period); otherwise the invoice amount is due in 30 days (credit period).
➢ 2/10, EOM (end of month): a 2% discount is available if the amount is paid within
the first 10 days of the next month.
➢ 2/EOM, n/60: a 2% discount is available if the payment is made by the end of
current month, otherwise the payment is due in 6o days.
• The buyer calls this discount a purchase discount or discount received or cash discount.
• Like a sales discount, a purchase discount is based on the invoice cost less returns and
allowances, if any.
• A buyer should usually take all available discounts, because trade credit is very costly.
When the buyer pays an invoice within the discount period, the amount of the discount decreases
Inventory. Why? Because companies record inventory at cost and, by paying within the discount
period, the merchandiser has reduced that cost. To illustrate, assume A4TECH Stereo pays the
balance due of Tk.3,50,000 (gross invoice price of Tk.3,80,000 less purchase returns and
allowances of Tk.30,000) on May 14, the last day of the discount period. The cash discount is
Tk.7,000 (Tk.3,50,000 × 2%), and A4TECH Stereo pays Tk.3,43,000 (Tk.3,50,000 - Tk.7,000).
The entry A4TECH Stereo makes to record its May 14 payment decreases (debits) Accounts
Payable by the amount of the gross invoice price, reduces (credits) Inventory by the Tk.7,000
discount, and reduces (credits) Cash by the net amount owed.
Date Account Titles and Explanation Debit Credit
May14 Accounts Payable Tk.350,000
Cash Tk.343,000
Merchandise Inventory 7,000
(To record payment within discount
period)
If A4TECH Stereo failed to take the discount, and instead made full payment of Tk.350,000 on
June 3, it would debit Accounts Payable and credit Cash for Tk.350,000 each.
Date Account Titles and Explanation Debit Credit
June 3 Accounts Payable Tk.350,000
Cash Tk.350,000
(To record payment with no discount
taken)

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 Example: 4.2.1
On September 5, 2017 Nowel Company buys merchandise on account from Rekha Company. The
selling price of the goods is Tk.150,000, and the cost to Rekha Company was Tk.80,000. On
September 8, Nowel returns defective goods with a selling price of Tk.20,000.
Required:
Record the transactions on the books of Nowel Company under the perpetual system.
Solution:
On the Books of Nowel Company
Journal Entries
Date Account Titles and Explanation Debit Credit
2017 Tk.150,000
Sept. 5 Merchandise Inventory
Accounts Payable Tk.150,000
(To record goods purchased on account)
8 Accounts Payable Tk.20,000
Merchandise Inventory Tk.20,000
(To record return of defective goods)

Review Questions

1. Explain the recording of purchases under a perpetual inventory system.

2. Furnished below are the selected transactions of Shaheen Company during July of the
current year:
July 2 Purchased merchandise on account from Zahir Company at a cost of Tk. 30,000.
FOB shipping point, terms 2/10, net 30.
5 Paid freight charges of Tk. 1,500 on merchandise purchased from Zahir
Company on July 2.
7 Returned damaged goods costing Tk. 3,000 to Zahir Company.
14 Paid Zahir Company the balance due related to July 2 purchase.
Required:
Journalize the July transactions on the books of Shaheen Company.

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Lesson 3: Recording Sales of Merchandise
Lesson Objectives

After studying this lesson, you should be able to:

• record of sales revenues under a perpetual inventory system.

Sales of Merchandise
➢ Like purchases, sales may be made either for cash or on account (credit).
➢ The sale is normally recorded when earned, usually when goods transfer from seller to
buyer.
➢ Sales invoice should support each credit sale.

B. Sales of Merchandise
• Revenues are reported when earned in accordance with the revenue recognition principle,
and in a merchandising company, revenues are earned when the goods are transferred from
seller to buyer.
• All sales should be supported by a document such as a cash register tape (provide evidence
of cash sales) or sales invoice.
• Two entries are made with each sale:
a) The first entry records the sale:
1) Debit—Accounts Receivable (if a credit sale) or Cash (if a cash sale) which increases
assets for the sales amount.
2) Credit—Sales which increases revenues
b) The second entry records the cost of the merchandise sold:
1) Debit—Cost of Goods Sold which increases expenses.
2) Credit—Merchandise Inventory which decreases assets.
• The sales account is credited only for sales of good held for resale. Sales of assets not held
for resale (such as equipment, buildings, land, etc.) are credited directly to the asset account.

Example: 4.3.1

The seller, Fagun Audio Supply, records the sale of Tk. 380,000 of merchandise to A4TECH Stereo
on May 4 as follows. Assume the merchandise cost Fagun Audio Supply Tk. 240,000.
Date Account Titles and Explanation Ref. Debit Credit
May 4 Accounts Receivable Tk. 380,000
Sales Revenue Tk. 380,000
(To record credit sales to A4TECH
Stereo)
4 Cost of Goods Sold Tk. 240,000
Merchandise Inventory Tk. 240,000
(To record cost of merchandise sold to
A4TECH Stereo)
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C. Sales Returns and Allowances
• Sales Returns result when customers are dissatisfied with merchandise and are allowed to
return the goods to the seller for credit or a refund.
• Sales Allowances result when customers are dissatisfied, and the seller allows a deduction from
the selling price.
• To grant the return or allowance, the seller prepares a credit memorandum to inform the
customer that a credit has been made to the customer’s account receivable.
• Sales Returns and Allowances is a contra revenue account to the Sales account.
a) A contra account is used, instead of debiting sales, to disclose in the accounts the amount of
sales returns and allowances.
b) This information is important to management as excessive returns and allowances suggest
inferior merchandise, inefficiencies in filling orders, errors in billing customers, and mistakes in
delivery or shipment of goods.
• The normal balance of Sales Returns and Allowances is a debit balance.
• Two entries are made with each sale return and allowance:
c) The first entry records the sales return or allowance:
1) Debit—Sales Return and Allowances which decreases revenues for the amount of the sale.
2) Credit—Accounts Receivable (if a credit sale) or Cash (if a cash sale and refund) which
decreases assets.
d) The second entry records the increase in Merchandise Inventory:
1) Debit—Merchandise Inventory which increases assets.
2) Credit—Cost of Goods Sold which decreases expenses.
Fagun Audio Supply’s entries to record credit for returned goods involve (1) an increase (debit) in
Sales Returns and Allowances (a contra account to Sales Revenue) and a decrease (credit) in
Accounts Receivable at the Tk.30,000 selling price, and (2) an increase (debit) in Inventory
(assume a Tk.14,000 cost) and a decrease (credit) in Cost of Goods Sold, as shown below
(assuming that the goods were not defective).

Date Account Titles and Explanation Debit Credit

May 8 Sales Returns and Allowances Tk. 30,000
Accounts Receivable Tk. 30,000
(To record credit granted to A4TECH Stereo for
returned goods)
8 Merchandise Inventory Tk. 14,000
Cost of Goods Sold Tk. 14,000
(To record cost of goods returned)
If A4TECH Stereo returns goods because they are damaged or defective, then Fagun Audio
Supply’s entry to Inventory and Cost of Goods Sold should be for the fair value of the returned
goods, rather than their cost. For example, if the returned goods were defective and had a fair value
of Tk. 5,000, Fagun Audio Supply would debit Inventory for Tk. 5,000, and would credit Cost of
Goods Sold for Tk. 5,000.

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 Example 4.3.2
On September 5, 2017 Nowel Company buys merchandise on account from Rekha Company. The
selling price of the goods is Tk.150,000, and the cost to Rekha Company was Tk.80,000. On
September 8, Nowel returns defective goods with a selling price of Tk.20,000 and a fair value of
Tk. 3,000.
Required:
Record the transactions on the books of Rekha Company.
Solution:
On the Books of Rekha Company
Journal Entries
Date Account Titles and Explanation Ref. Debit Credit
2017
Sept. 5 Accounts Receivable Tk.150,000
Sales Revenue Tk.150,000
(To record credit sale)
5 Cost of Goods Sold Tk. 80,000
Merchandise Inventory Tk. 80,000
(To record cost of goods sold on account)
8 Sales Returns and Allowances Tk.20,000
Accounts Receivable Tk.20,000
(To record credit granted for receipt of
returned goods)
8 Merchandise Inventory Tk. 3,000
Cost of Goods Sold Tk. 3,000
(To record fair value of goods returned)
Journalization of Merchandising Transactions under Perpetual & Periodic Systems
Purchase Related Perpetual Inventory System Periodic Inventory System
Transactions
Purchase of merchandise for Merchandise Inventory Dr. Purchase Dr.
cash Cash Cr. Cash Cr.
Purchase of merchandise on Merchandise Inventory Dr. Purchase Dr.
account Accounts Payable Cr. Accounts Payable Cr.
Purchase returns and Accounts Payable Dr. Accounts Payable Dr.
allowance Merchandise Inventory Cr. Purchase Returns & Cr.
Allowances
Purchase returns and Cash Dr. Cash Dr.
allowances out of cash Merchandise Inventory Cr. Purchase Returns & Cr.
purchase and cash refunded Allowances
Purchase discount Accounts Payable Dr. Accounts Payable Dr.
Merchandise Inventory Cr. Purchase Discount Cr.
Transportation (Freight) cost Merchandise Dr. Freight-in Dr.
on purchase [FOB Shipping Inventory Cr. Cash Cr.
Point] Cash
Payment on account without Accounts Payable Dr. Accounts Payable Dr.
a discount Cash Cr. Cash Cr.
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Payment on account with a Accounts Payable Dr. Accounts Payable Dr.
discount (payment within Cash Cr. Cash Cr.
discount period) Merchandise inventory Cr. Purchase Discounts Cr.

Sales Related Transactions Perpetual Inventory System Periodic Inventory System

Sale of merchandise for cash (i)For sales price (i) For sales price
Cash Dr. Cash Dr.
Sales Revenue Cr. Sales Revenue Cr.
(ii) For cost price (ii) For cost price
Cost of Goods Sold Dr.
Merchandise Inventory Cr. No entry
Sale of merchandise on (i)For sales price (i) For sales price
account Accounts Receivable Dr. Accounts Receivable Dr.
Sales Revenue Cr. Sales Revenue Cr.
(ii) For cost price (ii) For cost price
Cost of Goods Sold Dr.
Merchandise Inventory Cr. No entry
Return of merchandise sold (i) For sales price (i) For sales price
(Sales returns and Sales Returns and Dr. Sales Returns and Allowances Dr.
allowances) Allowances Cr. Accounts Receivable Cr.
Accounts Receivable (ii) For cost price
(i) For cost price Dr. No entry
Merchandise Inventory Cr.
Cost of Goods Sold
Sales discount Sales Discounts Dr. Sales Discounts Dr.
Accounts Receivable Cr. Accounts Receivable Cr.
Freight cost on sales Freight-out or Delivery Exp. Dr. Freight-out or Delivery Expense Dr.
Cash or Accounts Cr. Cash or Accounts Cr.
Receivable Receivable
Cash received on account Cash Dr. Cash Dr.
without a discount Accounts Receivable Cr. Accounts Receivable Cr.
Cash received on account Cash Dr. Cash Dr.
with a discount Sales Discounts Dr. Sales Discounts Dr.
Accounts Receivable Cr. Accounts Receivable Cr.

➢ Points to Remember

Merchandise Inventory under perpetual inventory system

is Debited for is Credited for
• purchase of merchandise (goods) • purchase returns & allowances, and purchase
• freight-in/Transportation-in (FOB Shipping discount
Point) • payment within discount period
• sales returns (at cost price) • sale of merchandise (for cost price)

92
 Comparison of Entries-Perpetual Vs Periodic Inventory Systems
On the Books of A4TECH
Journal Entries
Date Transaction Perpetual Inventory System Periodic Inventory System
May 4 Purchase of Inventory 380,000 Purchases 380,000
merchandise on Accounts Payable 380,000 Accounts Payable 380,000
credit.
6 Freight costs on Inventory 15,000 Freight-in 15,000
purchases. Cash 15,000 Cash 15,000
8 Purchase Accounts Payable 30,000 Accounts Payable 30,000
returns and Inventory 30,000 Purchase Returns 30,000
allowances. and Allowances
14 Payment on Accounts Payable 350,000 Accounts Payable 350,000
account Cash 343,000 Cash 343,000
with a discount. Inventory 7,000 Purchase Discounts 7,000

On the Books of A4TECH

Journal Entries
Date Transaction Perpetual Inventory System Periodic Inventory System
May 4 Sale of A/Cs Receivable 380,000 Accounts Receivable 380,000
merchandise Sales Revenue 380,000 Sales Revenue 380,000
on credit. Cost of Goods Sold 240,000
Inventory 240,000 No entry for cost of
goods sold
8 Return of Sales Returns and 30,000 Sales Returns and 30,000
merchandise Allowances Allowances
sold. A/Cs Receivable 30,000 A/Cs Receivable 30,000

Inventory 14,000 No entry

Cost of Goods Sold 14,000
14 Cash Cash 343,000 Cash 343,000
received on Sales Discounts 7,000 Sales Discounts 7,000
account with A/Cs Receivable 350,000 A/Cs Receivable 350,000
a discount.

Example 4.3.3

Purchase and sales transactions of the Pakiza Boutiques during May 2017 are listed below:
May 1 Purchased merchandise on account for Tk.3,000, terms 2/10, n/30.
7 Paid for merchandise purchased on May 1.
10 Purchased merchandise on account for Tk.5,000, terms 1/10, n/30.
11 Returned part of merchandise purchased on May 10, Tk. 200.
14 Sold merchandise on account for Tk.2,000, terms 2/10, n/30. The cost of
merchandise sold is Tk.1,800.
25 Paid amount owed on May 10 purchase.
27 Received payment in full for merchandise sold on May 14.
28 Sold merchandise on account for Tk.4,000, terms 2/10, n/30. The cost of
merchandise sold is Tk.3,500.
31 Received payment in full for merchandise sold on May 28.

93
 Required:
Make journal entries to record the transactions for the month of May 2017 for Pakiza Boutiques,
using perpetual and periodic inventory systems.

Solution:
On the Books of Pakiza Boutiques
Journal Entries

Date Perpetual Inventory System Periodic Inventory System

Account Titles and Debit Credit Account Titles and Debit Credit
Explanation Explanation
2017
May 1 Merchandise Inventory Tk.3,000 Purchase Tk.3,000
Accounts Payable Tk.3,000 Accounts Payable Tk.3,000
(To record purchase of (To record purchase of
merchandise on account) merchandise on
account)
7 Accounts Payable Tk.3,000 Accounts Payable Tk.3,000
Cash Tk. Cash Tk. 2940
Merchandise 2,940 Purchase Tk.60
Inventory Tk.60 Discounts
(Tk.3,000×2
(Tk.3,000×2%) %)
(To record payment on (To record payment on
account with a discount) account with a
discount)
10 Merchandise Inventory Tk.5,000 Purchase Tk.5,000
Accounts Payable Tk.5,000 Accounts Payable Tk.5,000
(To record goods (To record goods
purchased on account) purchased on account)
11 Accounts Payable Tk.200 Accounts Payable Tk.200
Merchandise Tk.200 Purchase Returns Tk.200
Inventory & Allowances
(To record return of ( To record return of
defective goods) defective goods)
14 Accounts Receivable Tk.2,000 Accounts Receivable Tk.2,000
Sales Revenue Tk.2,000 Sales Revenue Tk.2,000
(To record sale of (To record sale of
merchandise on account ) merchandise on
account )
14 Cost of Goods Sold Tk. 1,800
Merchandise Tk.
Inventory 1,800
(To record cost of goods
sold on account)

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25 Accounts Payable Tk.4,800 Accounts Payable Tk.4,800
Cash Tk. Cash Tk. 4,800
(To record payment on 4,800 (To record payment
account without a on account without a
discount) discount)
May 27: Received payment in full for merchandise s old on May 14.

27 Cash Tk.2,000 Cash Tk.2,000

Accounts Tk.2,000 Accounts Tk.2,000
Receivable Receivable
( To record collection of (To record collection
cash for goods sold of cash for goods sold
without discount) without discount)
28 (i)For sales price Accounts Receivable Tk.4,000
Accounts Receivable Tk.4,000 Sales Revenue Tk.4,000
Sales Revenue Tk.4,000 (To record credit
(ii) For cost price sales and cost of
Cost of Goods Sold merchandise sold on
Merchandise 3,500 account)
Inventory 3,500
(To record credit sales
and cost of merchandise
sold on account)
31 Cash Tk. 3,920 Cash Tk.3,920
Sales Tk. Sale Discounts Tk. 80
Discounts 80 (Tk.4,000×2%) Tk.4,000
(Tk.4,000 Tk.4,000 Accounts
×2%) Receivable
Accounts (To record collection
Receivable of cash within 2/10,
(To record collection of n/30 discount period)
cash within 2/10, n/30
discount period)

95
 Review Questions

1.
1. Write the journal entries required to record of sales revenues, sales returns and sales
discounts under a perpetual inventory system.
2. Following transactions occurred between Salam Store and Kalam Store during the month of
Janauary 2018:
Jan 5 Salam Store purchased merchandise on account from Kalam Store for Tk.
50,000, terms 2/10, net 30.
10 Salam Store received allowances of Tk. 2,000 from the gross invoice price
because of damaged goods.
13 Salam Store returned Tk. 4,000 from gross invoice price because they were not
the quality ordered.
14 Salam Store paid half of the amount due.
30 Kalam Store received payment in full from Salam Store.

Required:
Journalize the January transactions on the books of both Salam Store and Kalam Store.

96
Lesson 4: Forms of Financial Statement

Lesson Objectives

After studying this lesson, you should be able to:

• know the components of multiple-step income statement and balance sheet;
• identify the sections of a classified income statement and a balance sheet;
• prepare different statements.

Multiple-Step and Single-Step Income Statmentsss

A. Multiple-Step Income Statement
Gross Profit= Net sales – Cost of goods sold (COGS)
Net Sales= Sales- (Sales returns & allowances + Sales discounts)
COGS= Beginning inventory+ Net purchase – Ending inventory
Net Purchase = Purchase +Transportation in+ Import duty (if any) – (Purchase discounts+
Purchase returns and allowances)
Operating Income = Gross profit - Operating expenses
Operating Expenses = Selling expenses + Administrative expenses
Selling Expenses = Sales salaries expense+ Sales commission expense + Depreciation expense of
Delivery equipment+ Bad debts + Other selling expenses
Administrative Expenses= Office salaries expense + Depreciation expense of asset(s) used in
office + Property tax expense + Utilities expense+ Insurance
expense+ Other administrative expenses
Net Income before Tax= Operating income + Non-operating revenue – Non-operating expenses
Non-operating Revenue= Other revenues & gains (e.g. interest revenue (on investment), dividend,
rental revenue, gain on sale of fixed asset etc.)
Non-operating Expenses= Other expenses & losses (e.g. interest expenses, loss on sale of fixed
asset etc.)
Net Income after Tax= Net income before tax – Income tax expense
The following Figure exhibits the Multiple-Step Income Statement of Padma Limited with
imaginary figures:

Padma Limited
Income Statement
For the Year Ended December 31, 2017
Sales Revenue
Sales Tk.7,500,000
Less: Sales Return and Allowances Tk.5,000
Sales Discounts 45,000 50,000
Net Sales 7,450,000
Cost of Goods Sold
Inventory, January 1 2,225,000
Add: Purchases Tk.3,785,000
Less: Purchase Returns

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 & Allowances Tk. 5,500
Purchases Discounts 9,500 15,000
3,770,000
Add: Transportation in 85,000
Net purchases 3,855,000
Cost of Goods Available for Sales 6,080,000
Less: Inventory, December 31 270,000
Cost of Goods Sold 5,810,000
Gross Profit on Sales 1,640,000
Operating Expenses
Selling Expenses
Sales Salaries 135,000
Advertising 150,000
Delivery Expenses 25,000
Insurance, selling 70,000
Telephone 60,000
Depreciation 75,000
Total Selling Expenses 515,000
Administrative Expenses
Office Salaries 200,000
Rent 50,000
Insurance, General 65,000
Depreciation, Building 25,000
Depreciation, Equipment 35,000
Total Administrative Expenses 375,000
Total Operating Expenses 890,000
Net Income from Operations 750,000
Other Revenues and Gains
Dividend revenue 185,000
Rental revenue 135,000
Interest revenue 120,000 440,000
11,90,000
Other Expenses and Losses
Interest on debentures 115,000
Loss on sale of equipment 125,000 240,000
Income before Income Tax 950,000
Income tax 110,000
Net Income after Income Tax Tk.840,000

B. Single-Step Income Statement

• All data are classified under two categories:
(1) Revenues (operating revenues and other revenues and gains)
(2) Expenses (cost of goods sold, operating and other expenses and losses)
• Only one step is required in determining net income or net loss
Revenues – Expenses = Net Income.
• Two primary reasons for using a single step format:
98
(1) A company does not realize any type of profit or income until total revenues exceed total
expenses, so it makes sense to divide the statement into two categories.
(2) The format is simpler and easier to read than the multiple-step format.
The following Figure exhibits the Single-Step Income Statement of Jamuna Limited.
Jamuna Limited
Income Statement
For the Year Ended December 31, 2017
Revenues and Gains
Net Sales Tk.3,975,000
Interests 25,500
Dividends 127,500
Rent 72,000
Total Revenues & Gains Tk.4,200,000
Expenses and Losses
Cost of Goods Sold 2,500,000
Selling Expenses 250,000
Administrative Expenses 500,000
Interest 150,000
Income Taxes 95,000
Loss on Sale of Securities 55,000
Total Expenses and Losses 3,550,000
Net income Tk.650,000
C. Retained Earnings Statement
Retained earnings is the amount of an enterprise earnings which have not been returned to
shareholders as dividends. The statement summarizes the increases and decreases in retained
earnings resulting from the business operations for the period. This final section links the periods
income statement to the beginning of-the-period and end-of-the period balance sheets by
completing two balance sheets snapshots.
The following Figure exhibits the Retained Earnings Statement of Meghna Limited with imaginary
figures.
Meghna Limited
Statement of Retained Earnings
For the Year Ended December 31, 2017
Retained earnings, January 1 Tk.445,500
Add: Net income for the year 327,500
773,000
Deduct dividends declared on:
Preference stock, at Tk.6.00 per share Tk.120,000
Common stock at Tk.8.00 per share 160,000 280,000
Retained earnings, December 31 Tk.493,000

99
D. Classified Balance Sheet
• The balance sheet, also commonly known as the statement of financial position, is a summary
of assets, liabilities, and owners' equity accounts and their related account balances at a specific
date.
• When general purpose external financial statements are divided into useful categories, they are
called classified financial statements. The assets of a company are generally divided into four
categories: (i) current assets, (ii) investments, (iii) property, plant, and equipment, and (iv)
intangible assets. Some companies use a fifth category called other assets if there are
miscellaneous assets that do not fall into any other groups. Liabilities are divided into two
categories: (i) current liabilities, and (ii) long-term liabilities.
The following Figure exhibits the Classified Balance Sheet of Meghna Limited
Meghna Limited
Balance Sheet
As on December 31, 2017
Assets
Current Assets
Cash Tk.25,000
Notes Receivable 20,000
Accounts Receivable 75,000
Merchandise Inventory 225,000
Office Supplies 30,000
Prepaid Insurance 15,000
Prepaid Expenses 10,000
Total Current Assets Tk.400,000
Investments [Long Term]
Investments in Padma Co. 250,000
Land held for future 300,000
Total Investment 550,000
Property, Plant, and Equipment
Land 225,000
Building Tk.530,000
Less: Accumulated Depreciation 210,000 320,000

Delivery Equipment 215,000

Less: Accumulated Depreciation 85,000 130,000
Total Property, Plant & Equipment 675,000
Intangible Assets
Trade Mark 55,000
Goodwill 40,000
Total Intangible Assets 95,000
Total Assets Tk.1,720,000

100
 Liabilities and Stockholders' Equity
Current Liabilities
Note Payable 85,000
Accounts Payable 135,000
Accrued Salaries, Wages 40,000
Accrued Interest 30,000
Income Tax Payable 35,000
Total Current Liabilities 325,000
Long-Term Liabilities 200,000
Total Liabilities 525,000
Stockholders' Equity
Common Stock 1,000,000
Retained Earnings 195,000 1,195,000
Total Liabilities & Stockholders' Equity Tk.1,720,000

Example 4.4.1

From the following trial balance and additional information prepare: (a) multiple-step income
statement, (b) a retained earnings statement and (c) a classified balance sheet. The periodic
inventory system is in use.
Chand Sultana & Company
Trial Balance
December 31, 2017
Account Titles Debit Credit
Cash Tk. 10,000
Accounts Receivable 50,000
Notes Receivable 15,000
Merchandise Inventory, January 1, 2017 125,000
Purchase 750,000
Sales Tk. 1,500,000
Purchase Returns &Allowances 10,000
Purchase Discounts 25,000
Sales Returns & Allowances 45,000
Sales Discount 35,000
Land & Building 650,000
Fixtures 225,000
Accumulated Depreciation-Land & Building 150,000
Accumulated Depreciation-Fixtures 100,000
Office Supplies 15,000
Marketable Securities 45,000
Delivery Equipment 200,000
Notes Payable 40,000
Accounts Payable 75,000
Mortgage Payable 50,000
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Transportation-in 20,000
Officers' Salaries 110,000
Office Salaries 60,000
Sales Salaries 80,000
Advertising 60,000
Delivery Expenses 50,000
Utilities Expenses 15,000
Rent Expenses 30,000
Dividend Income 30,000
Investment in Uttara Company 100,000
Dividends 100,000
Common stock 600,000
Retained Earnings, January 1, 2017 215,000
Interest 5,000
Tk. 2,795,000 Tk. 2,795,000

Additional Information:
1. A physical inventory of merchandise on hand at December 31, 2017 showed goods worth
Tk.120,000.
2. Office supplies unused on December 31, estimated to Tk.5,000.
3. Interest accrued on investment Tk.7,000.
4. Land and Building is to be depreciated @ 5% p.a.
5. Interest on Mortgage due Tk.5,000.
6. Depreciate Fixtures @ 10% and Delivery Equipment @ 15%.
7. Accrued expenses: Officers' salaries Tk.10,000 Office salaries Tk.5,000 and Delivery
expenses Tk.15,000.

102
 Solution:
Chand Sultana & Company
Income Statement
For the Year Ended December 31, 2017
Sales Revenue
Sales Tk.1,500,000
Less: Sales Returns & Allowances Tk.45,000
Sales Discounts 35,000 80,000
Net Sales 1,420,000
Cost of Goods Sold :
Merchandise Inventory, January 1 125,000
Purchases Tk.750,000
Less: Purchases Returns
& Allowances Tk.10,000
Purchase Discounts 25,000 35,000
715,000
Add: Transportation-in 20,000
Net purchases 735,000
Cost of goods available for sale 860,000
Less: Merchandise Inventory, Dec. 31 120,000
Cost of Goods Sold 740,000
Gross profit on sales Tk.680,000
Operating Expenses
Selling Expenses
Sales Salaries Tk.80,000
Advertising 60,000
Delivery Expenses 50,000
Add: Accrued 15,000 65,000
Depreciation: Fixtures 22,500
Depreciation: Delivery Equipment 30,000
Total Selling Expenses 257,500
Administrative Expenses
Offices Salaries 110,000
Add: Due 10,000 120,000
Officers' Salaries 60,000
Add: Due 5,000 65,000
Office supplies 15,000
Less: Unused 5,000 10,000
Utilities Expenses 15,000
Rent 30,000
Depreciation: Land & Building 32,500
Total Administration Expenses 272,500

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Total Operating Expenses Tk.530,000
Income from operations Tk.150,000
Add: Non-operating Income
Dividend Income 30,000
Interest 7,000 37,000
Less: Non-operating Expenses Tk.187,000
Interest 5,000
Add due 5,000 10,000
Net Income Tk.177,000

Chand Sultana & Company

Statement of Retained Earnings
For the Year Ended December 31, 2017
Retained Earnings, January 1 Tk.215,00
Add: Net income for the year 177,000
392,000
Less: Dividends 100,000
Retained Earnings, December 31 Tk.292,000

Chand Sultana & Company

Balance Sheet
As on December 31, 2017
Assets
Current Assets
Cash Tk.10,000
Notes Receivable 15,000
Accounts Receivable 50,000
Marketable Securities 45,000
Merchandise Inventory 120,000
Office supplies 5,000
Interest Accrued 7,000
Total Current Assets Tk.252,000
Investments
Investment in Uttara Company 100,000
Property, Plant and Equipment
Land and Building Tk.650,000
Less: Accumulated Depreciation
(150,000+32,500) 182,500
467,500
Fixtures 225,000
Less: Accumulated Depreciation
(100,000+22,500) 122,500
102,500
Delivery Equipment 200,000
Less: Accumulated Depreciation 30,000 170,000
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 Total Property, Plant & Equipment 740,000
Total Assets Tk.1,092,000
Liabilities & Stockholders' Equity
Current Liabilities
Notes Payable Tk.40,000
Accounts Payable 75,000
Interest on Mortgage Due 5,000
Accrued Officers' Salaries 10,000
Accrued Office Salaries 5,000
Accrued Delivery Expenses 15,000
Total Current Liabilities Tk.150,000
Long-Term Liabilities
Mortgage Payable 50,000
Stockholders' Equity
Common Stock 600,000
Retained Earnings 292,000
Total Stockholders' Equity 892,000
Total Liability & Stockholders' Equity Tk.1,092,000

Review Questions

1. How is a single step income statement different from multiple-step income statement?
Explain.
2. Max Company distributes suitcases to retail stores and extends credit terms of 1/10, n/30 to
all of its customers. At the end of June, Max’s inventory consisted of suitcases costing
Tk.1,20,000. During the month of July, the following merchandising transactions occurred.
July 1 Purchased suitcases on account for Tk.1,80,000 from Padma Manufacturers, FOB
destination, terms 2/10, n/30. The appropriate party also made a cash payment of
Tk.10,000 for freight on this date.
3 Sold suitcases on account to Chattogram Leather for Tk.2,00,000. The cost of suitcases
sold is Tk.1,20,000.
9 Paid Padma Manufacturers in full.
12 Received payment in full from Chattogram Leather.
17 Sold suitcases on account to Apex Ltd. for Tk.1,80,000. The cost of the suitcases sold
was Tk.1,08,000.
18 Purchased suitcases on account for Tk.1,90,000 from Jamuna Manufacturers, FOB
shipping point, terms 1/10, n/30. The appropriate party also made a cash payment of
Tk.12,500 for freight on this date.
20 Received Tk.30,000 credit (including freight) for suitcases returned to Jamuna
Manufacturers.
21 Received payment in full from Apex Ltd.
22 Sold suitcases on account to Diamond’s for Tk.2,25,000. The cost of suitcases sold was
Tk.1,35,000.

105
 30 Paid Jamuna Manufacturers in full.
31 Granted Diamond’s Tk.20,000 credit for suitcases returned costing Tk.12,000.
Max’s chart of accounts includes the following: No. 101 Cash, No. 112 Accounts Receivable,
No. 120 Inventory, No. 201 Accounts Payable, No. 401 Sales Revenue, No. 412 Sales Returns
and Allowances, No. 414 Sales Discounts, and No. 505 Cost of Goods Sold.
Required:
Journalize the transactions for the month of July for Max Co. using a perpetual inventory system.

3. With the help of the following account information of Cresent Company, prepare a classified
/multiple-step income statement.
Sales Tk. 97,00,000
Sales returns and allowances 475,000
Sales Discount 250,000
Inventory, January 1 15,50,000
Purchases 45,00,000
Purchase discounts 375,000
Purchase returns and allowance 560,000
Freight-in 175,000
Inventory, December 31 750,000
Sales salaries expense 800,000
Sales commission expense 590,000
Depreciation expense - Delivery equipment 150,000
Utilities expense 75,000
Insurance expense 85,000
Office salaries expense 950,000
Depreciation expense – Building 185,000
Property tax expense 75,000
Utilities expense 65,000
Insurance expense 75,000
Interest revenue 36,000
Gain on sale of equipment 25,500
Interest expense 15,000
Loss on sale of equipment 35,000
Casualty loss from vandalism 7,500
Income tax expense 65,000
Answer:
Net sales Tk. 8,975,000
Cost of goods sold: 4,540,000
Gross profit on sales 4,435,000
Total operating expenses 3,050,000
Income before income taxes 1,389,000
Net income 1,324,000

106
Unit Highlights
➢ Concept of inventory.
➢ Importance of accurate inventory costing.
➢ Description of the steps involved in determining inventory quantities.
➢ Systems of accounting for inventory.
➢ Methods for inventory costing under perpetual and periodic inventory
systems.

Technologies Used for Content Delivery

❖ BOUTUBE
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❖ WebTV
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❖ Mobile Technology with MicroSD Card
❖ LP+ Office 365
❖ BTV Program
❖ Bangladesh Betar Program

107
 Terminology
Average-Cost Inventory costing method that uses the weighted-average unit cost to allocate to
Method ending inventory and cost of goods sold the cost of goods available for sale.
Finished Goods Manufactured items that are completed and ready for sale.
Inventory

First-in, First-out Inventory costing method that assumes that the costs of the earliest goods
(FIFO) Method purchased are the first to be recognized as cost of goods sold.
FOB (Free on board) Freight terms indicating that ownership of the goods remains with the seller
Destination until the goods reach the buyer. Freight costs will be borne by the seller.
FOB (Free on board) Freight terms indicating that ownership of the goods passes to the buyer when
Shipping point the public carrier accepts the goods from the seller. The buyer will bear the
freight costs.
Last-in, First-out Inventory costing method that assumes the costs of the latest units purchased
(LIFO) Method are the first to be allocated to cost of goods sold.
Lower-of-Cost-or- A basis whereby inventory is stated at the lower of either its cost or its market
Market (LCM) Basis value as determined by current replacement cost. This is the conservatism
concept.
Periodic Inventory A system of inventory in which updates are made on a periodic basis. In this
System system, no effort is made to keep up-to-date records of either the inventory or
the cost of goods sold. Ending inventory is value at the end an accounting
period.
Perpetual Inventory A system of inventory which updates inventory accounts after each purchase or
System sale. Inventory subsidiary ledger is updated after each transaction.
Raw Materials Basic goods that will be used in production but have not yet been placed into
Inventory production.
Specific An actual physical flow costing method in which items still in inventory are
Identification specifically valued to arrive at the total cost of the ending inventory.
Method
Weighted-Average Average cost that is weighted by the number of units purchased at each unit
Unit Cost cost.
Work in Process That portion of manufactured inventory that has been placed into the production
process but is not yet complete.

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Lesson 1: Inventory Basics

Lesson Objectives

After studying this lesson, you should be able to:

• know the concept of inventory;

• explain the importance of accurate inventory costing;
• describe the steps in determining inventory quantities.

Concept of Inventory
Inventories are assets which are owned by the business organization and are in a form ready for sale
to customers in the ordinary course of business. In a manufacturing organization, inventories are
usually classified into 3 categories:
(a) Finished Goods: are goods which are completed and ready for sale. For example: trading
merchandise, software, land or other properties held for re-sale.
(b) Work-in Process: are those portions of inventory which are partially completed and are on the
factory floor of a manufacturing organization.
(c) Raw Materials: are basic materials or substances which are on hand waiting to be used or
consumed in the production process or in the rendering of services. For example, cotton in a
spinning mill, fabrics for garments, etc.
In a merchandising or manufacturing organization, inventories, as a part of working capital, are
considered as its lifeblood. Conventionally, inventories are the most essential items for smooth
functioning of a business, and the sale of inventories provides the major source of revenue.
Importance of Accurate Inventory Costing
Now we will discuss why the accurate inventory costing is important in an organization. If we want
to determine actual income, we have to measure all assets properly. You know, inventories are
relatively large and their sizes fluctuate. So the correct inventory costing is important in measuring
the proper income. If there is any error in inventory costing, it can cause a material misstatement of
financial position and of net income. Let’s see how the correct and incorrect inventory costing
affects income measurement.
Relationship of Inventory Measurements to Reported Income
Assumed Data With Correct With Incorrect Ending
Ending Inventory Inventory
Sales Tk.415,000 Tk.415,000 Tk.415,000
Beginning Inventory 70,000 70,000 70,000
Net Cost of Purchases 310,000 310,000 310,000
Cost of Goods Available for Sale 380,000 380,000 380,000
Less: Ending Inventory 65,000 50,000 80,000
Cost of Goods Sold 315,000 330,000 300,000
Gross Profit on Sales 100,000 85,000 115,000
Operating Expenses 35,000 35,000 35,000
Reported Net Income Tk.65,000 Tk.50,000 Tk.80,000

109
You see in both the cases the sales, beginning inventory, net cost of purchase, and operating
expenses are identical. When the actual ending inventory is Tk. 65,000, the net income is Tk.
65,000. If the ending inventory is understated by Tk. 15,000 (at Tk. 50,000), the net income
will also be decreased by Tk. 15,000 (from Tk. 65,000 to Tk. 50,000). Again if the ending inventory
costing is incorrectly made at Tk. 80,000, the net income will be increased to Tk. 80,000 from Tk.
65,000. You know, the ending inventory of one year is also the beginning inventory of the following
year. Sometime it is argued that an error in reported income due to incorrect inventory costing of one
year is exactly offset by the error in the reported income for the next year. So, ultimately the error
has no serious consequences. But this is totally a wrong concept. Management may take many
actions on the basis of reported income. Moreover, the bankers, creditors, investors and other
interested groups may be influenced by the reported income and its trends. So, accurate ending
inventory costing in a period is essential to determine the actual income of an organization.

Determining Inventory Quantities

At the end of the accounting period each concern calculates the quantities of inventory whether it
uses a periodic or perpetual inventory system. If it uses the perpetual system, it takes a physical
inventory for two reasons:
(a) To check the accuracy of their perpetual inventory records.
(b) To determine the amount of inventory lost due to wasted raw materials, shoplifting, or
employee theft.
The concern, which uses the periodic inventory system, takes a physical inventory to determine the
inventory on hand at the balance sheet date, and to determine the cost of goods sold for the period.
The quantities of inventory are calculated by two steps:
(i) taking a physical inventory of goods which involves actually counting, weighing, or
measuring each kind of inventory on hand.; and
(ii) determining the ownership of goods ensuring that all of the goods included in the count belong
to the concern. Goods in transit should be included in the inventory of the concern that has
legal title to the goods.

Review Questions

1. Explain what inventory is.

2. Why is accurate valuation of inventory important? Explain with examples.
3. Describe the steps in determining inventory quantities.

110
Lesson 2: Inventory Costing/Pricing/Valuation: Perpetual Inventory System

Lesson Objectives

After studying this lesson, you should be able to:

• know the systems of accounting for inventory;

• discuss different methods for inventory costing under perpetual inventory system;
• make a comparison and find out the effects of alternative methods of inventory costing.
Systems of Accounting for Inventory

According to conservatism constraint, inventory costing is made at the lower of cost or net realizable
value. If all merchandises are purchased at the same unit cost, there will be no problem to determine
the cost of goods sold and that of ending inventory for a period. But merchandises may have to be
purchased at different prices at different dates. In this case, an accountant faces a problem in
determining which prices should be used as the costs of goods sold and that of ending inventory
(unsold). An accountant may follow any one of the systematic inventory cost flow assumptions. In
practice, the actual physical flow of goods and the cost flow assumptions are quite different, the
assumption is really an assumption about the flow of costs rather than flow of physical inventory.
Flow of goods describes the actual physical movement of goods in a concern's operations. Cost flow
is the real or assumed association of unit costs with goods either sold or in hand. The assumed cost
flow may not reflect the actual flow of materials.

Dear learners, there are two systems of accounting for inventories:

(i) Perpetual Inventory System: In perpetual inventory system, merchandise inventory and
cost of goods sold are updated continuously on each sale and purchase transaction.
(ii) Periodic Inventory System: In periodic inventory system, merchandise inventory and cost
of goods sold are not updated continuously. Instead purchases are recorded in Purchases
account and each sale transaction is recorded via a single journal entry.
Inventory Costing-Meaning and Methods

Inventory is accounted for at cost. Cost includes all expenditures necessary to acquire goods and
place them in a condition ready for sale. For example, freight costs incurred to acquire inventory are
added to the cost of inventory, but the cost of shipping goods to a customer is a selling expense.
After a concern has determined the quantity of units of inventory, it applies unit costs to the
quantities to compute the total cost of the inventory and the cost of goods sold. This process can be
complicated if a concern has purchased inventory items at different times and at different prices.
Inventory ledger is a document or computer record that tracks the inventory transactions. The total
of all transactions listed in this ledger should match the total for the corresponding account in the
general ledger. Depending upon the type of usage, an inventory ledger can be considered a
subsidiary ledger of the general ledger.

111
Example: 5.2.1

WALTON TV Company purchases three identical 50-inch TVs on different dates at costs of
Tk.70,000, Tk.75,000, and Tk.80,000. During the year, WALTON sold two sets at Tk.1,20,000
each. These facts are summarized in below.
Purchases Sales
February 3 1 TV at Tk.70,000 June 1 2 TVs for Tk.2,40,000 (Tk.1,20,000 × 2)
March 5 1 TV at Tk.75,000
May 22 1 TV at Tk.80,000
Cost of goods sold will differ depending on which two TVs the company sold. For example, it might
be Tk.1,45,000 (Tk.70,000 + Tk.75,000), or Tk.1,50,000 (Tk.70,000 + Tk.80,000), or Tk.1,55,000
(Tk.75,000 + Tk.80,000). In this section, we discuss alternative costing methods available to
WALTON.

There are two major generally accepted methods of inventory costing: These are as:

(i) Specific Identification.

(ii) Assumed Cost Flow
(a) First-in, first out (FIFO).
(b) Last-in, first out (LIFO).
(c) Average-cost.
Each of the two methods of inventory costing is acceptable for use in published financial statements.
The factors that should be considered in choosing an inventory costing method are the effects of
each method on the balance sheet, the income statement, income taxes, and management decisions.

(i) Specific Identification Method

If the units in ending inventory can be identified as coming from specific purchases, the specific
identification method may be used to price the inventories. This method is also called actual physical
flow costing method. Under this method,
a) the purchase price of each specific unit is recorded.
b) the specific units sold are known.
c) the actual prices of the specific units unsold are costs of ending inventory.
This method is suitable for valuation of high-priced but low volume items, such as automobiles,
heavy equipment, jewelry, estate homes, and other types of real estate. Conceptually, this method
appears to be logical and ideal as the actual costs are matched against actual revenue, and ending
inventory is reported at actual or original cost. Nowadays, in computerized accounting system, due
to the use of bar coding, electronic product codes, etc., this method has become popular for nearly
any type of product. However, the reality is that this method is not widely used because it is very
difficult and impractical in most cases to keep track of each item and make them separate if the
number of items is substantial and physically identical.

Example: 5.2.2
To illustrate the specific identification inventory costing method, we will consider the records of
WALTON Limited. for the month of July, 2017, which sells identical items.

July 1 Beginning inventory 200 units @ Tk. 400 each

5 Purchased 160 units @ Tk. 500 each
112
 8 Sold 240 units @ Tk. 800 each
17 Purchased 320 units @ Tk. 600 each
25 Purchased 200 units @ Tk. 640 each
30 Sold 400 units @ Tk. 800 each
Assume that of the 240 units sold on July 8, 160 units come from the beginning inventory and 80
units from the July 5 purchase, and that of the 400 units sold on July 30, 300 units come from July
17 purchase and 100 units from July 25 purchase.

Solution:
Under specific identification method, the cost of ending inventory is the total of the individual costs
of inventories still in hand at the end of the period.
Remaining 40 units from beginning inventory @ Tk.400 = Tk.16,000
Remaining 80 units purchased on July 05 @ Tk. 500= Tk.40,000
Remaining 20 units purchased on July 17 @ Tk. 600= Tk.12,000
Remaining 100 units purchased on July 25 @ Tk. 640= Tk.64,000
Total ending inventory (240 units) = Tk.132,000
Learners, you see here, the company’s beginning inventory is 200 units @ Tk. 400 and purchased
more 160 units on July 5 @ Tk. 500. On July 8, the company sold 240 units @Tk. 800. Assume that
out of 240 units sold, 160 units come from beginning inventory and the remaining 80 units from
purchase of July 5. So, on July 1, the remaining balances of inventory are 40 units @Tk. 400 or Tk.
16,000 and on July 5, 80 units remain @Tk. 500, i,e., Tk. 40,000. Further assume that on July 30 the
company sold 400 units of which 300 units come from July 17 purchase and 100 units from July 25
purchase. So the remaining balances of July 17 and July 25 are 20 units and 100 units or Tk. 12,000
and Tk. 64,000 respectively. Similarly, under specific identification method, the cost of goods sold
is the total cost of the specific units sold.
160 units from beginning inventory @ Tk. 400= Tk.64,000
80 units from purchase of July 05 @ Tk. 500= Tk.40,000
300 units from purchase of July 17 @ Tk. 600= Tk.180,000
100 units from purchase of July 25 @ Tk. 640= Tk.64,000
Total cost of goods sold Tk. 348,000

Here, as 160 units are sold @ Tk. 400 from beginning inventory of July 1, the cost of goods sold on
July will be Tk. 64,000. The similar treatments will be on July 5, 17, and 25. Thus, the total cost of
goods sold Tk. 348,000.

(ii) Assumed Cost Flow Methods

Because specific identification is often impractical, other cost flow methods are permitted. These
differ from specific identification in that they assume flows of costs that may be unrelated to the
actual physical flow of goods. There are three assumed cost flow methods: Now we will discuss
various assumed cost flow methods of inventory valuation. Under perpetual system issues of
merchandise are valued.

(a) First-in, First-out (FIFO) Method

The first-in, first-out method is based on the assumption that the oldest or earliest goods are sold first
and that the most recent or latest purchased goods remain in the ending inventory. This means that
113
cost of older inventory is charged to cost of goods sold first and the costs of ending inventory
consists of the costs of those goods which are purchased or produced later. This is the most widely
used method for inventory valuation. FIFO method is somewhat closer to actual physical flow of
goods because concerns normally sell goods in order in which these are purchased or produced.
IASB allows the use of this method. Now, we will see what will be the costs of ending inventory
and goods sold if the WALTON LIMITED uses the FIFO method.
WALTON LIMITED
Inventory/Store Ledger
Under FIFO Method
Date Ref. Purchases Cost of Goods Sold Balance of Inventory

No. of Unit Total No. of Unit Total No. of Unit Total

Units Cost Cost Units Cost Cost Units Cost Cost
Tk. Tk. Tk. Tk. Tk. Tk.
July 1 -- -- -- -- -- -- 200 400 80,000

5 160 500 80,000 -- -- -- 200

160
400
500  160,000

8 -- -- -- 200
40
400
500  100,000
120 500 60,000

17 320 600 192,000 -- -- -- 120

320
500
600  252,000

25 200 640 128,000 -- -- -- 120

320
200
500
600
640
 380,000

30 -- -- -- 120
280
500
600  228,000 40
200
600
640
152,000

Total 680 400,000 640 328,000 240 152,000

You see on July 1, the company had inventory 200 units of Tk. 400 per unit. So the balance of
beginning inventory is Tk. 80,000. On July 5, the company purchased 160 units @Tk. 500 per unit.
So the balance of inventory will be 200 units & 160 units or Tk. 160,000 (80,000+80,000). The
learning point is on July 8 when the company sold 240 units. As per FIFO method, the company sold
the older 200 units first then the remaining 40 units from 160 units at the respective rates. So the
balance of inventory remains 120 units of Tk. 500 each unit i.e., Tk. 60,000. Similarly, the purchases
of July 17 and 25 are added to costs of inventory and the sales of 400 units on July 30 are made from
earliest balances i,e., 120 units and the remaining 280 units from 320 units. So, the total cost of
goods sold is Tk. 328,000 and the cost of inventory remains Tk. 152,000.

The distinguishing characteristics of the FIFO method are that the oldest purchase costs are
transferred to the cost of goods sold, while most recent purchase costs remain in inventory.

(b) Last-in, First-out (LIFO) Method

This method of costing inventories is based on the assumption that the costs of the latest goods
purchased are to be included in costs of goods sold first and that the costs of the ending inventory
consist of the costs of merchandise purchased earliest. This assumption, of course, does not agree
with the actual physical movement of goods in most business. IASB does not allow the use of this
method. Let’s see how the costs of goods sold and ending inventory are computed under LIFO
method.

114
 WALTON LIMITED
Inventory/Store Ledger
Under LIFO Method
Date Ref. Purchases Cost of Goods Sold Balance (Cost) of Inventory
No. of Unit Total No. of Unit Total No. of Unit Total
Units Cost Cost Units Cost Cost Units Cost Cost
Tk. Tk. Tk. Tk. Tk. Tk.
July 1 -- -- -- -- -- -- 200 400 80,000

5 160 500 80,000 -- -- -- 200

160
400
500  160,000

8 -- -- -- 160
80
500
400  112,000 120 400 48,000

17 320 600 192,000 -- -- -- 120

320
400
600  240,000

25 200 640 128,000 -- -- -- 120

320
200
400
600
640
 368,000

30 -- -- -- 200
200
640
600  248,000 120
120
400
600  120,000

Total 680 400,000 640 360,000 240 120,000

Learners, you see, like FIFO method, the balances of inventory on July 5 remain 200 units and 160
units or Tk. 160,000. Under LIFO method, for sales of 240 units on July 8, the latest purchased
goods 160 units are to be sold first, then the remaining 80 units from the earlier balance of 200 units
are to be sold and the 120 units or Tk. 48,000 remain as inventory. Similarly, the balances of
inventory on July 25 are 120, 320 and 200 units of different unit costs. On July 30, as per LIFO
method, out of 400 units sold, at first, the latest 200 units @Tk. 640 per unit are to be sold, then the
remaining 200 units from the immediate past purchase of 320 units @Tk. 600 are to be sold. Thus,
the total cost of goods sold will be Tk. 3,60,000 and cost of inventory for 240 units will be Tk.
120,000.

(c) Moving Average- Cost Method

Another important assumed cost flow method of inventory valuation is moving average cost method.
This method is also known as moving weighted average unit cost method. Under this method, a new
unit cost is computed each time a purchase is made by dividing the total cost of goods in inventory
by total number of units in inventory. This average cost is then used as the unit cost of goods sold
and of ending inventory. This alternative is also allowed by IASB. Let’s see what will be the cost of
goods sold and cost of ending inventory if WALTON LIMITED uses average cost method.

Total Cost of Inventory

Average cost per unit after each purchase = = Total Units in Inventory

WALTON LIMITED
Inventory/Store Ledger
Under Average Cost Method
Date Ref. Purchase Cost of Goods Sold Balance (Cost) of inventory

No. of Unit Total No. of Unit Total No. of Unit Total

Units Cost Cost Units Cost Cost Units Cost Cost

115
 Tk. Tk. Tk. Tk. Tk. Tk.
July1 --- --- --- --- --- --- 200 400.00 80,000
5 160 500 80,000 360 444.44 160,000
8 --- --- --- 240 444.44 106,667 120 444.44 53,333
17 320 600 192,000 --- --- --- 440 557.58 245,333
20 200 640 128,000 --- --- --- 640 583.33 373,333
30 400 583.33 233,333 240 583.33 140,000

Total 680 400,000 640 340,000 240 583.33 140,000

Learners, notice here that after purchase on July 5, the weighted average unit cost Tk. 444.44 is
calculated by dividing the total cost of inventory of Tk. 160,000 by the total inventory of 360
units. Then only July 8, this average unit cost is multiplied by the number of units sold 240 units
to get cost of goods sold and with number of units in inventory 120 units to obtain cost of ending
inventory. Similarly, on the sale of July 30, the unit cost of inventory is multiplied with the
number of units sold and in hand to obtain the cost of goods sold and of ending inventory
respectively.

Example: 5.2.3
The inventory records of Apex Company show the following:
Jan 1 Beginning inventory consists of 12 units costing Tk. 48 per unit.
5 Purchased 15 units @Tk. 49 per unit.
10 Sold 9 units @Tk. 108 per unit.
12 Sold 7 units @Tk. 108 per unit.
20 Purchased 20 units @Tk. 50 per unit.
22 Purchased 5 units @Tk. 51 per unit.
30 Sold 20 units @Tk. 110 per unit.
Assume all purchase and sales are made on account.
Required:
(a) Using FIFO perpetual inventory procedure, compute cost of goods sold for January.
(b) Using FIFO perpetual inventory procedure, prepare the journal entries for January.

Solution:
(a) Computation of Cost of Goods Sold for January
Apex Company
Inventory Ledger
Under FIFO Method
Date Ref. Purchases Cost of Goods Sold Balance (Cost) of Inventory
No. of Unit Total No. of Unit Total No. of Unit Total
Units Cost Cost Units Cost Cost Units Cost Cost
Tk. Tk. Tk. Tk. Tk. Tk.
Jan 1 -- -- -- -- -- -- 12 48 576

5 15 49 735 -- -- -- 12
15
48
49  1,311

10 -- -- -- 9 48 432 3
15
48
49  879

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 12 -- -- -- 3
4
48
49  340 11 49 539

20 20 50 1,000 -- -- -- 11
20
49
50  1,539

22 5 51 255 -- -- -- 11
20
5
49
50
51
 1794

30 -- -- -- 11
9
49
50  989 11
5
50
51  805

Total 40 1,990 36 1,761 16 805

So, cost of goods sold for January Tk. 1,761.
(b) Preparation of Journal entries
Apex Company
Journal Entries
For January
(Under FIFO Perpetual Inventory System)
Date Account Titles and Explanation Ref. Debit Credit
Jan 5 Merchandise Inventory Tk. 735
Accounts Payable Tk. 735
(To record purchase of 15 units @Tk. 49 on account)
10 Accounts Receivable Tk. 972
Sales Tk. 972
(To record sales of 9 units @Tk. 108 on account)
10 Cost of Goods Sold Tk. 432
Merchandise Inventory Tk. 432
(To record cost of goods sold of 9 units @Tk. 48)

12 Accounts Receivable Tk. 756

Sales Tk. 756
(To record sales of 7 units @Tk. 108 on account)

12 Cost of Goods Sold Tk. 340

Merchandise Inventory Tk. 340
(To record cost of goods sold of 3 units @Tk. 48 and 4
units @Tk. 49)

20 Merchandise Inventory Tk. 1,000

Accounts Payable Tk. 1,000
(To record purchase of 20 units @Tk. 50 on account)
20 Inventory Tk. 255
Accounts Payable Tk. 255
(To record purchase of 5 units @Tk. 51 on account)
30 Accounts Receivable Tk. 2,200
Sales Tk. 2,200
(To record sales of 20 units @Tk. 110 on account)

30 Cost of Goods Sold Tk. 989

Merchandise Inventory Tk. 989
(To record cost of goods sold of 11 units @Tk. 49 and 9
units @Tk. 50)

117
Comparison and Effects of Alternative Methods of Inventory Costing

The specific identification, average cost, FIFO, and LIFO methods of pricing inventory have been
discussed so far. The specific identification method is based on actual costs, whereas the other
methods are based on assumptions regarding the flow of costs. Let us now compare the effects of
the four methods on net income, using same data as before:

Specific Average Cost First-in, Last-in,

Identification Method First-out First out
Method Method Method
Net sales Tk.512,000 Tk.512,000 Tk.512,000 Tk.512,000
Cost of Goods sold:
Beginning Inventory 80,000 80,000 80,000 80,000
Net Purchase 400,000 400,000 400,000 400,000
Cost of Goods
Available for Sale 480,000 480,000 480,000 480,000
Less: Ending Inventory 132,000 140,000 152,000 120,000
Cost of Goods sold 348,000 340,000 328,000 360,000
Gross Margin from Sales Tk.164,000 Tk.172,000 Tk.184,000 Tk.152,000

Effect of Inventory Costing Method on Net Income in Inflationary and Deflationary

Conditions
The effect of the methods of costing upon the net profit in inflationary and deflationary time is of
great significance. Use of FIFO method in a rising price matches rising sales prices with oldest low
cost inventory, thus expanding the gross margin on sales. In a period of falling prices, declining
sales prices are matched against oldest high-cost inventory, thus narrowing the margin on sales. On
the other hand, use of LIFO method leads to relate the current high cost of acquiring merchandise
with rising sales prices in a period of rising prices and low cost of acquiring merchandise with
decreasing sale, prices in a period of falling prices. The average method, however, recognizes both
past and present costs in the inventory. In this case, generally results will closely parallel to FIFO
costs since ordinarily purchases during the period are usually several times the inventory balance
carried into the period and the average cost forming the classing inventory valuation will thus
approach current costs.

118
 Review Questions

1. State the nature of business where the specification identification and assumed cost flow
methods are normally used for inventory costing.
2. Make a comparison and find out the effects of alternative methods of inventory costing.
Distinguish between perpetual and periodic inventory costing system.
3. During inflation, which method between FIFO and LIFO would show more income and why?
4. What is meant by goods flow and cost flow?
5. On June 10, Kogan Company purchased Tk.60,000 of merchandise from R. Rego Company
FOB shipping pint, terms 2/10, n/30. Kogan pays the freight costs of Tk. 3,000 on June 11.
Damaged goods totaling Tk.4,000 are returned to R. Rego for credit on June 12. The scrap
value of these goods is Tk.2,000. On June 19, Kogan pays R. Rego Company in full less the
purchase discount. Both companies use a perpetual inventory system.
Required:
(a) Prepare separate entries for each transaction on the books of Kogan Company.
(b) Prepare separate entries for each transaction for Rego Company. The merchandise
purchased by Kogan on June 10 had cost Rego Tk.30,000.
6. The beginning inventory, purchase and sales of product F 75 for April are presented below:
April 1 Beginning inventory 400 units @ Tk.50
5 Purchases 350 units @ Tk.55
8 Sales 500 units
12 Purchases 800 units @ Tk.66
15 Purchases 300 units @ Tk.58
20 Sales 1,000 units
25 Purchases 750 units @ Tk.62
30 Sales 800 units
Required:
Ascertain the quantity of ending inventory as on April 30, and state what will be its value (in
each case) if issues are made under the following methods:
(a) Specific Identification
(b) First-in, First-out (FIFO)
(c) Last-in, First-out (LIFO)
(d) Average cost

119
Lesson 3: Inventory Costing/Pricing/Valuation: Periodic Inventory System

Lesson Objectives

After studying this lesson, you should be able to:

• explain the periodic system of accounting for inventory which is different from perpetual
inventory;
• discuss different methods for inventory costing under periodic inventory system.

Periodic Inventory System

Although the perpetual inventory method provides excellent control over merchandise and allows
for a quick determination of the amount of inventory at all times, some businesses do not use the
perpetual system because it is too time consuming, complex and costly. A periodic inventory
system is an alternative to a perpetual inventory system. Under periodic inventory system, no effort
is made to keep up-to-date records of either the quantum of inventory or the cost of goods sold,
instead the quantity and cost of inventory is determined, as its name implies, only periodically -
usually at the end of each accounting year. It allows a firm to determine inventory and cost of
goods sold at the end of the period without recording the effect on inventory of every sale and
purchase transaction. Under this method, all the acquisitions of merchandise of the period is debited
to purchase account. The total of purchase account is added with the cost of beginning inventory at
the end of the period to determine the cost of goods available for sale. To compute the cost of goods
sold, ending inventory is deducted from the cost of goods available for sale.

Beginning Inventory of Merchandise Tk.***

Add Net Purchase ***
Cost of Goods Available for Sale ***
Less Cost of Ending Inventory ***
Cost of Goods Sold Tk.***
Note that under this system, the cost of goods sold is a residual amount that is dependent upon
physical count of inventory at the end of the period and its costs. Since inventory available for sale
has to be either included in the ending inventory or sold during the period, ending inventory and
cost of goods sold are complementary amounts, and their sum must always equal to the total cost of
goods available for sale. The physical count of inventory should be taken at the end of the
accounting year of the company so that correct inventory quantities both in physical and financial
measures are available, for use in preparing annual accounting reports and statements.

Periodic Inventory Cost Flow Assumptions

As discussed above, a concern which maintains periodic inventory system does not keep track of the
cost of goods sold during the period. The quantity of inventory is determined by taking a complete
physical count of the inventory on hand at the end of the financial year. The cost of ending inventory
is computed at the time of physical count and subtracted from cost of goods available for sale to

120
determine cost of goods sold. An accountant must choose one of several systematic inventory cost
flow assumptions - FIFO, LIFO or Weighted Average costing [LIFO is not allowed by IASB].

First-in, First-out (FIFO) Method

This method assumes that the earliest acquired items are first used or sold. The ending inventory,
therefore, represents the most recent purchases. Unlike the perpetual method, which makes
calculations throughout the period, the periodic inventory system makes all calculations at the end of
the period, normally after physical counting of ending inventory. To illustrate, under periodic FIFO
method, WALTON LIMITED (see previous example) would determine its ending inventory and
cost of goods sold as follows:
Units Costs
Beginning inventory 200 Tk.80,000
Add: Net Purchases 680 400,000
Goods available for sale 880 Tk.480,000
Less: Ending inventory * 240 152,000
Cost of goods sold 640 Tk.328,000
*200 units @ Tk. 640 (Purchased on July 25) Tk.128,000
40 units @ Tk. 600 (Purchased on July 17) 24,000
= Tk.152,000
Note that same results may be obtained under perpetual FIFO method also. Whatever the method is,
perpetual or periodic system, is used under FIFO, the amount of cost of goods sold, net income and
ending inventory will be same. Only the recording process is different.
Last- in, First-out (LIFO) Method
The LIFO method is opposite to FIFO i,e., under LIFO method the cost of the last items purchased is
first matched against revenue. With periodic LIFO system, the cost of goods sold and the ending
inventory of WALTON LIMITED (see previous example) is calculated as follows:
Units Costs
Beginning inventory 200 Tk.80,000
Add: Net Purchases 680 400,000
Goods available for sale 880 Tk.480,000
Less: Ending inventory * 240 100,000
Cost of goods sold 640 Tk.380,000
* 200 units beginning inventory @ Tk.400 = Tk.80,000
40 units (Purchased on July 17) @ Tk.500 = 20,000
Total Tk. 100,000
The cost of ending inventory under periodic LIFO method is Tk.100,000 and under perpetual LIFO
method is Tk.120,000. This difference of Tk.20,000 arises due to the fact that under periodic LIFO
method no calculation is made until the end of period.

Weighted Average- Cost Method

The weighted average cost approach is a cost flow alternative whereby the cost of goods sold and
the cost of ending inventory are determined by using a weighted average cost of all inventories
121
available for sale during the period. To illustrate, assuming that WALTON LIMITED (see previous
example) used the periodic inventory method, the ending inventory and cost of goods sold would be
computed as follows using a weighted average method:
Units Costs
Beginning inventory 200 Tk.80,000
Add: Net Purchases 680 400,000
Goods available for sale 880 Tk.480,000
Less: Ending inventory * 240 130,909
Cost of goods sold 640 Tk.349,091

* Under periodic weighted average method the average cost is computed by the cost of goods
available for sale by the number of units available for sale during that periodic, or;
Cost of goods available for sale Tk . 480,000
= = Tk . 548.454
Total no. of units available for sale 680
As discussed earlier, in periodic weighted average method, the rate is calculated only once at the end
of the period. By contrast, in perpetual moving average method, a new average rate is computed
after each purchase.

The Consistency in the Inventory Costing

The reliability of financial statement of a concern depends to a large extent whether the company
follows the principle of consistency. The principle of consistency means that once a concern has
adopted a particular method of accounting, the concern should follow the method consistently in the
following years without shifting to another method frequently. Therefore, before selecting a
particular method, the pros and cons of the method should be considered carefully. A concern can
increase or decrease its net income simply by changing its method of inventory costing. As
discussed earlier, the reported income of a concern differs due to adoption of different methods of
inventory valuation. Frequent methods switching would make income statements not reliable. In
order to ensure the reliability of financial statements, an organization should follow a particular
method for a reasonable period of time.
The principle of consistency does not mean that a concern can never change its inventory valuation
method. If circumstances demand, a concern can switch to another method. However, when a
concern changes its methods of inventory valuation, the effect of the change upon the reported
income should be disclosed fully in the footnotes accompanying financial statements. However, it
may be mentioned that when a concern follows a particular method consistently for adequate
disclosure of all information, even then inventory valuation method in use should be disclosed in
Balance sheet.

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 Example: 5.3.1

Elegant Company has the following inventory, purchases, and sales data for the month of March.
Inventory:
March 1 200 units @ Tk.4.00 Tk. 800
Purchases:
March 10 500 units @ Tk.4.50 2,250
March 20 400 units @ Tk.4.75 1,900
March 30 300 units @ Tk.5.00 1,500
Sales:
March 15 500 units
March 25 400 units
The physical inventory count on March 31 shows 500 units on hand.

Required:
Under perpetual and periodic inventory systems, determine the cost of inventory on hand at
March 31 and the cost of goods sold for March under (a) FIFO, (b) LIFO, and (c) Average-cost
methods.

Solution:
Under Perpetual Inventory System
Elegant Company
Inventory Ledger
Under FIFO Method
Date Ref. Purchases Cost of Goods Sold Balance (Cost) of Inventory

No. of Unit Total No. of Unit Total No. of Unit Total

Units Cost Cost Units Cost Cost Units Cost Cost
Tk. Tk. Tk. Tk. Tk. Tk.
Mar 1 -- -- -- -- -- -- 200 4.00 800


10 500 4.50 2,250 -- -- -- 200 4.00 3,050
500 4.50

15 -- -- -- 200
300  4.00
4.50
2,150 200 4.50 900

20 400 4.75 1,900 -- -- -- 200

400
4.50
4.75  2,800

25 -- -- -- 200
200
4.50
4.75  1,850 200 4.75 950

30 300 5.00 1,500 -- -- -- 200

300
4.75
5.00  2,500

Total 1,200 5,650 900 4,000 500 2,500

Cost of inventory on hand at March 31 Tk. 2,500 and the cost of goods sold Tk. 4,000.

123
 Elegant Company
Inventory Ledger
Under LIFO Method
Date Purchases Cost of Goods Sold Balance (Cost) of Inventory

No. of Unit Total No. of Unit Total No. of Unit Total

Units Cost Cost Units Cost Cost Units Cost Cost
Tk. Tk. Tk. Tk. Tk. Tk.
Mar 1 -- -- -- -- -- -- 200 4.00 800

10 500 4.50 2,250 -- -- -- 200

500
4.00
4.50  3,050

15 -- -- -- 500 4.50 2,250 200 4.00 800

20 400 4.75 1,900 -- -- -- 200

400
4.00
4.75  2,700

25 -- -- -- 400 4.75 1,900 200 4.00 800

30 300 5.00 1,500 -- -- -- 200

300
4.00
5.00  2,300

Total 1,200 5,650 900 4,150 500 2,300

Cost of inventory on hand at March 31 Tk. 2,300 and the cost of goods sold Tk. 4,150.

Elegant Company
Inventory Ledger
Under Average-Cost Method
Date Purchases Cost of Goods Sold Balance (Cost) of Inventory

No. of Unit Total No. of Unit Total No. of Unit Total

Units Cost Cost Units Cost Cost Units Cost Cost
Tk. Tk. Tk. Tk. Tk. Tk.
Mar 1 -- -- -- -- -- -- 200 4.00 800

10 500 4.50 2,250 -- -- -- 700 4.36 3,050

15 -- -- -- 500 4.36 2,180 200 4.36 872

20 400 4.75 1,900 -- -- -- 600 4.62 2,772

25 -- -- -- 400 4.62 1,848 200 4.62 924

30 300 5.00 1,500 -- -- -- 500 4.85 2,424

Total 1,200 5,650 900 4,028 500 2,424

Cost of inventory on hand at March 31 Tk. 2,420 and the cost of goods sold Tk. 4,030.

Under Periodic Inventory System

The cost of goods available for sale is Tk.6,450, as follows.

Inventory: 200 units @ Tk.4.00 Tk. 800

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Purchases:

March 10 500 units @ Tk.4.50 2,250

March 20 400 units @ Tk.4.75 1,900
March 30 300 units @ Tk.5.00 1,500
Total: 1,400 units Tk.6,450
Under a periodic inventory system, the cost of goods sold under each cost flow method is as follows.

FIFO Method
Ending inventory:
Unit Total
Date Units Cost Cost
March 30 300 Tk.5.00 Tk.1,500
March 20 200 4.75 950
Tk.2,450

Cost of goods sold: Tk.6,450 - Tk.2,450 = Tk.4,000

LIFO Method
Ending inventory:

Unit Total
Date Units Cost Cost
March 1 200 Tk.4.00 Tk. 800
March 10 300 4.50 1,350
Tk.2,150

Cost of goods sold: Tk.6,450 - Tk.2,150 = Tk.4,300

Average-Cost Method

Average unit cost: Tk.6,450 ÷ 1,400 = Tk.4,607

Ending inventory: 500 × Tk.4,607 = Tk.2,303.50
Cost of goods sold: Tk.6,450 - Tk.2,303.50 = Tk.4,146.50

125
 Review Questions

1. You are provided with the following information for Atlas Inc. for the month ended October 31,
2017. Atlas uses a periodic method for inventory.
Date Description Units Unit Cost or
Selling Price
October 1 Beginning inventory 60 Tk.25
October 9 Purchase 120 26
October 11 Sale 100 35
October 17 Purchase 70 27
October 22 Sale 60 40
October 25 Purchase 80 28
October 29 Sale 110 40
Required:
(a) Calculate ending inventory, cost of goods sold, gross profit, and gross profit rate
under each of the following methods:
(i) LIFO.
(ii) FIFO.
(iii) Average-cost.
(b) Compare results for the three cost flow assumptions.
2. Yamin Ltd. is a retailer operating in Pabna. Yamin uses the perpetual inventory methods. All
sales returns from customers result in the goods being returned to inventory; the inventory is
not damaged. Assume that there are no credit transactions; all amounts are settled in cash.

Date Description Units Unit Cost or

Selling Price
January 1 Beginning inventory 60 Tk.25
January 9 Purchase 120 26
January 11 Sale 100 35
January 17 Purchase 70 27
January 22 Sales 60 40
January 25 Purchase 80 28
January 29 Sale 110 40

Required:
(a) Calculate ending inventory, cost of goods sold, gross profit, and gross profit rate under
each of the following methods.
(i) LIFO.
(ii) FIFO.
(iii) Average-cost.
(b) Compare results for the three cost flow assumptions.

126
Unit Highlights
➢ Concepts underlying long-term assets.
➢ Concept of depreciation.
➢ Computation of depreciation under different methods.
➢ Issues related to accounting for natural resources, and intangible Assets.

Technologies Used for Content Delivery

❖ BOUTUBE
❖ BOU LMS
❖ WebTV
❖ Web Radio
❖ Mobile Technology with MicroSD Card
❖ LP+ Office 365
❖ BTV Program
❖ Bangladesh Betar Program

127
Terminology

Additions and Costs incurred to increase the operating efficiency, productive capacity, or useful life of
Improvements a plant asset.
Amortization The allocation of the cost of an intangible asset to expense over its useful life in a
systematic and rational manner.
Capital Expenditures Expenditures that increase the concern’s investment in productive facilities.
Copyright Exclusive grant from the government of a country that allows the owner to reproduce
and sell an artistic or published work.
Depletion The allocation of the cost of a natural resource to expense in a rational and systematic
manner over the resource’s useful life.
Depreciation The process of allocating to expense the cost of a plant asset over its useful (service)
life in a rational and systematic manner.
Depreciable cost The cost of a plant asset less its salvage value.
Franchise (license) A contractual arrangement under which the franchisor grants the franchisee the right to
sell certain products, provide specific services, or use certain trademarks or trade
names, usually within a designated geographical area.
Goodwill The value of all favorable attributes that relate to a business enterprise.
Intangible assets Rights, privileges, and competitive advantages that result from the ownership of long-
lived assets that do not possess physical substance.
Licenses Operating rights to use public property, granted to a business enterprise by a
governmental agency.
Natural resources Assets that consist of standing timber and underground deposits of oil, gas, or minerals
and resources in the sea.
Patent A government authority or license conferring a right or title for a set period, especially
the sole right to exclude others from making or selling an invention.
Plant assets Tangible resources that are used in the operations of the business and are not intended
for sale to customers.
Research and Expenditures that may lead to patents, copyrights, new processes, or new products or
development (R&D) product development.
costs
Revenue expenditures Expenditures that are immediately charged against revenues as an expense.
Salvage value An estimate of an asset’s value at the end of its useful life. It is also known as scrap
value or residual value or resale value.
Trademark (trade A word, phrase, jingle, or symbol that identifies a particular enterprise or product.
name)
Useful life An estimate of the expected productive life, also called service life, of an asset.

128
 Lesson 1: Concepts Underlying Long-term Assets

Lesson Objectives

After studying this lesson, you should be able to:

• explain the concept of long-term assets and their characteristics;

• identify the three major categories of long-term assets;
• understand the accounting issues related to acquisition of plant assets;
• distinguish between capital expenditure and revenue expenditure.

Concept of Long-term(Non-current) Assets

'Long-term’ assets are held and used by a business for a number of years, but they wear out or lose
their usefulness over time. Every tangible non-current asset has a limited life. The only exception is
land held freehold or on very long leasehold. In the Balance Sheet it is termed as non-current assets
or fixed assets or property, plant and equipment.

Characteristics of Long-term (Non-current) Assets

Long-term assets (or fixed assets or non-current assets) have the following characteristics:
■ They have a useful life of more than one year. This distinguishes them from current assets,
which a concern expects to use up or convert to cash within 1 year or during its operating cycle,
whichever is longer. The most common criterion for the useful life of a long-term asset is that it
be capable of repeated use for more than a year.
■ They are used in the operation of a business. For an asset to be classified as property, plant, and
equipment, it must be “put in use,” which means it is available for its intended purpose. An
emergency generator is “put in use” when it is available for emergencies, even if it is never used.
Assets not used in the normal course of business, such as land held for speculative reasons or
buildings no longer used in ordinary operations, should be classified as investments.
■ They are not intended for resale to customers. An asset that a concern intends to resell to
customers should be classified as inventory, no matter how durable it is. For example, a computer
that a concern uses in an office is a long-term plant asset. An identical computer hat a concern
sells to customers is inventory.

Classification, Accrual Accounting and Disclosure of Long-term Assets

Long-terms assets are classified into three categories:
• Plant Assets /Property, plant, and equipment;
• Natural Resources; and
• Intangible Assets.
Plant Assets are long-lived assets that have physical substance. This category includes land,
building, machinery, equipment, furniture, etc.

Natural Resources such as petroleum and natural gas under the ground, mineral deposit, gravel
deposits, and timber tracts are assets that are physically consumed or are used up.
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Intangible Assets are long-lived assets that do not have physical substance and in most cases, they
provide their owners with competitive advantages over other firms. Typical intangible assets are
patents, copyrights, trademarks, franchises, and goodwill.

Under accrual accounting, the cost of these assets, with the exception of land and some intangible
assets, is allocated to the periods they benefit, as follows:
■ The periodic allocation of the costs of plant and equipment over their estimated useful lives is
called depreciation. Although land is property, it is not depreciated because it has an unlimited
life.
■ The allocation of the costs of natural resources is called depletion.
■ The allocation of the costs of most long-term intangible assets, which represent a legal right or
advantage, is called amortization. Some intangible assets are not subject to amortization.

The methods used to determine depreciation, depletion, and amortization are disclosed in the notes
to the financial statements. The following table shows how long-term assets are classified and
defines the accrual accounting methods of allocating their cost of their use to the income statement.
Balance Sheet Income Statement
Long-term Assets Expenses
Plant Assets or Property, Plant, and Land is not expensed
Equipment: long-term assets with because it has an unlimited
physical substance used in business life.
operations
• Land Depreciation: periodic
• Plant Assets allocation of the cost of a
− Plant tangible long-lived asset
− Buildings (other than land and natural
− Equipment resources) over its estimated
useful life
Natural Resources: long-term assets Depletion: exhaustion of a
purchased for the economic value that can natural resource through
be taken from the land and used up, as mining, cutting, pumping, or
with ore, lumber, crude oil, and gas or other extraction and the way
other resources contained in the land in which the cost is allocated
• Mines
• Timberland
• Oil and Gas Fields
Intangible Assets: long-term assets that Amortization: periodic
have no physical substance but have a allocation of the cost of an
value based on rights or advantages intangible asset to the
accruing to the owner periods it benefits

Subject to Subject Only to Impairment: occurs when

Amortization and Annual Impairment the fair value of the asset
Impairment Test Test falls below the carrying
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 • Copyrights • Brand names value; all long-term assets
• Customer lists • Goodwill are subject to an annual test
• Franchises • Trademarks for impairment
• Licenses
• Leaseholds
• Non-compete covenants
• Patents
• Software

Acquisition Cost of Plant Assets

The acquisition cost of plant assets or property, plant, and equipment includes all expenditures
reasonable and necessary to:
• get an asset in place, and
• make it ready for intended use.
For example, the cost of installing and testing a machine is a legitimate cost of acquiring the
machine. However, if the machine is damaged during installation, the cost of repairs is an operating
expense. The cost of an asset is equal to its purchase price plus other costs:
Cost of Asset = Purchase Price + Additional Expenditures (freight, installation, etc.)
Thus, expenditures for freight, insurance while in transit, and installation are included in the cost of
the asset because they are necessary for the asset to function. In accordance with accrual
accounting, these expenditures are allocated over the asset’s useful life. Any interest charges
incurred in purchasing an asset are not a cost of the asset. They are a cost of borrowing the money to
buy the asset and are, therefore, an operating expense. An exception to this rule is that interest costs
incurred during the construction of an asset are properly included as a cost of the asset.
Many concerns establish policies that define when expenditure should be recorded as an expense or
as an asset. For example, small expenditures for items that qualify as long-term assets may be treated
as expenses because the amounts involved are not material. Thus, although a wastebasket may last
for years, it would be recorded as an expense rather than as a depreciable asset.

Specific Applications of Determining the Acquisition Cost of Plant Assets

Item What Assets are What Costs are Included in Acquiring and Depreciable?
Included? Using?
Land Raw land, (1) the cash purchase price,
building site, (2) closing costs such as title
vacant lot, etc. and attorney’s fees,
(3) real estate brokers’ commissions, and
(4) accrued property NO
taxes and other liens assumed by the
purchaser.
Land Paving, fencing, The costs associated with the improvement,
Improvement lighting, flag- i,e., paving costs, fencing, and lighting costs,
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 poles, include all costs to make ready for intended YES
sidewalks, etc. use.
built on a piece
of land.
Buildings Factory, store, Purchase price, closing costs, title insurance
office etc. costs, broker’s commissions, remodeling
costs, repair or replacement of roof, furnace,
etc. Include architect’s fees, permits, cost of YES
excavation, if self-constructed building. Also:
include interest costs during construction
period.
Equipment Manufacturing Purchase price, sales taxes, freight, insurance
devices, office in transit; also costs for machine assembly,
equipment, installation, and test runs. YES
vehicles, etc.

Illustrations

Land

The purchase price of land should be debited to the Land account. Other expenditures that should be
debited to Land include:
• Commissions to real estate agents
• Lawyers’ fees
• Accrued taxes paid by the purchaser
• Costs of preparing the land to build on, such as the costs of tearing down old buildings and
grading the land
• Assessments for local improvements, such as putting in streets and sewage systems
• Landscaping

Example: 6.1.1

A company pays Tk.340,000 for land, Tk.16,000 in brokerage and legal fees, Tk.20,000 to have an
old building on the site torn down, and Tk.2,000 to have the site graded. It receives Tk.8,000 in
salvage from the old building. The cost of the land is Tk.370,000, calculated as follows.
Net purchase price Tk.340,000
Brokerage and legal fees 16,000
Tearing down old building Tk.20,000
Less salvage 8,000 12,000
Grading 2,000
Total cost Tk.370,000

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Land Improvements
Some improvements to real estate, such as driveways, parking lots, and fences, have a limited
life and, thus, are subject to depreciation. They should be recorded in an account called ‘Land
Improvements’.

Buildings
Buildings are facilities used in operations, such as stores, offices, factories, warehouses, and airplane
hangars. Companies debit to the Buildings account all necessary expenditures related to the purchase
or construction of a building. When a company buys a building, the cost includes the purchase price
and all expenditures required to put the building in usable condition.
When a building is purchased, such costs include the
• Purchase price
• Brokerage commissions
• Sales and other taxes
• Repairing or renovating building for its intended purpose
Costs to make the building ready for its intended use include:
• expenditures for remodeling and replacing or repairing the roof, floors, electrical wiring, and
plumbing.
When a new building is constructed, cost consists of the:
• Architectural fees
• Building permits
• Contractor’s charges
• Materials
• Labor
• Overhead
• Cost of interest
In addition, companies charge certain interest costs to the Buildings account: Interest costs incurred
to finance the project are included in the cost of the building when a significant period of time is
required to get the building ready for use. In these circumstances, interest costs are considered as
necessary as materials and labor. However, the inclusion of interest costs in the cost of a constructed
building is limited to the construction period. When construction has been completed, the company
records subsequent interest payments on funds borrowed to finance the construction as debits
(increases) to Interest Expense.

Equipment
Equipment includes assets used in operations, such as store check-out counters, office furniture,
factory machinery, delivery trucks, and airplanes. The cost of equipment includes all expenditures
connected with purchasing the equipment and preparing it for use. These expenditures include:
• Invoice price less cash discounts
• Freight, including insurance
• Excise taxes and tariffs
• Buying expenses
• Installation costs
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 • Test runs to ready the equipment for operation

Equipment is subject to depreciation.

Example: 6.1.2

Maxpro Company purchases factory machinery at a cash price of Tk.50,00,000. Related

expenditures are for sales taxes Tk.3,00,000, insurance during shipping Tk.50,000, and installation
and testing Tk.1,00,000. The cost of the factory machinery is Tk.54,50,000, computed as below.
Factory Machinery
Cash price Tk. 50,00,000
Sales taxes 3,00,000
Insurance during shipping 50,000
Installation and testing 1,00,000
Cost of factory machinery Tk. 54,50,000
Maxpro makes the following summary entry to record the purchase and related expenditures.
Date Account Titles and Explanation Debit Credit

Equipment Tk. 54,50,000

Cash Tk. 54,50,000
(To record purchase of factory machine)

Example: 6.1.3

Landmark Company purchases a delivery truck at a cash price of Tk. 22,00,000. Related
expenditures consist of sales taxes Tk. 1,32,000, painting and lettering Tk. 50,000, motor vehicle
license Tk. 8,000, and a three-year accident insurance policy Tk.1,60,000. The cost of the delivery
truck is Tk. 23,82,000, computed as follows.
Delivery Truck
Cash price Tk. 22,00,000
Sales taxes 1,32,000
Painting and lettering 50,000
Cost of delivery truck Tk. 23,82,000
Landmark treats the cost of the motor vehicle license as an expense, and the cost of the insurance
policy as a prepaid asset. Thus, Landmark makes the following entry to record the purchase of the
truck and related expenditures:

Date Account Titles and Explanation Debit Credit

Equipment Tk. 23,82,000
License Expense 8,000
Prepaid Insurance 1,60,000
Cash Tk.25,50,000
(To record purchase of delivery truck and
related expenditures)

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 Example: 6.1.4
Assume that Diamond Heating and Cooling Co. purchases a delivery truck for Tk.15,00,000 cash,
plus sales taxes of Tk.90,000 and delivery costs of Tk.50,000. The buyer also pays Tk.20,000 for
painting and lettering, Tk.60,000 for an annual insurance policy, and Tk.8,000 for a motor vehicle
license. Explain how each of these costs would be accounted for.
Solution:
The first four payments (Tk.15,00,000, Tk.90,000, Tk.50,000, and Tk.20,000) are expenditures
necessary to make the truck ready for its intended use. Thus, the cost of the truck is Tk.16,60,000.
The payments for insurance and the license are operating costs and, therefore, are expensed.

Capital Expenditure and Revenue Expenditure

An expenditure is a payment or an obligation to make a future payment for an asset or a service.

Expenditures are classified as capital expenditures or revenue expenditures.
❖ A capital expenditure is for the purchase or expansion of a long-term/non-current asset.
Capital expenditures are recorded in asset accounts because they benefit more than the
current period.
❖ A revenue expenditure is for the ordinary repairs and maintenance needed to keep a long-
/non-current asset in good operating condition. For example, trucks, machines, and other
equipment require periodic tune-ups and routine repairs. Expenditures of this type are
recorded in expense accounts because their benefits are realized in the current period.
Capital expenditures include outlays for plant assets, natural resources, and intangible assets. They
also include the following:
• Additions are enlargements to the physical layout of a plant asset. For example, if a new
wing is added to a building, the benefits from the expenditure will be received over several
years, and the amount paid should be debited to an asset account.
• Betterments are improvements to a plant asset but not an addition to the plant’s physical
layout. Installation of an air-conditioning system is an example. Because betterments
provide benefits over a period of years, their costs should be debited to an asset account.
• Extraordinary repairs are repairs that significantly enhance a plant asset’s estimated useful
life or residual value. For example, the overhaul of a building’s heating and cooling system
may extend the system’s useful life by five years. Extraordinary repairs are typically
recorded by reducing the Accumulated Depreciation account. The effect is to increase the
asset’s carrying value by the cost of the extraordinary repair. The new carrying value should
be depreciated over the asset’s new estimated useful life.

Capital Expenditure Revenue Expenditure

Any material expenditure that will Expenditure for ordinary repairs and
benefit several accounting periods. maintenance.

To capitalize an expenditure means to To expense an expenditure means to

charge it to an asset account. 135 charge it to an expense account.
The distinction between capital and revenue expenditures is important in applying accrual
accounting, as illustrated in the examples that follow.

Asset Incorrectly Recorded as Revenue Revenue Expenditure

Expenditure Incorrectly Recorded as Asset

Example The purchase of a machine that will A revenue expenditure, such as the
benefit a concern for several years is routine overhaul of a piece of
mistakenly recorded as a revenue machinery, is charged to an asset
expenditure. account.

Result The total cost of the machine becomes ▼ The expense of the current
an expense on the income statement in period will be understated.
the current period. ▲ Current net income will be
▼Current net income will be reported at overstated by the same amount.
a lower amount (understated). ▼ The net income of future periods
▲In future periods, net income will be will be understated.
reported at a higher amount
(overstated).

Review Questions

1. What are meant by long-term assets? When are assets said to be long-term? Explain.
2. What costs are included in the costs of acquisition of land?
3. Distinguish between capital expenditure and revenue expenditure.
4. Distinguish among depreciation, depletion, and amortization.
5. Nova Ltd. bought land with a vacant building for Tk.17,00,000. Nova will use the building
in its operations. Must Nova allocate the purchase price between the land and building?
Why or why not? Would your answer be different if Nova intends to raze the building and
build a new one? Why or why not?
6. Sys Computers acquired twelve Linux Computers from an outside supplier for cash Tk.
45,000 each. Set up cost for each computer is Tk. 500 and installation cost for all the
computers is Tk. 3,000. License fee is Tk. 1,000 for each computer. Compute the acquisition
cost of twelve computers.
7. ABC Manufacturing Company acquires a land for Tk. 500,000. The land contains an old
godown that is removed at a cost of Tk. 20,000 (Tk. 50,000 in cost less Tk. 30,000 proceeds
from salvage materials). Other expenditures are deed registration fees Tk. 7,000, attorney’s
fees Tk. 3,000, clearing and grading Tk. 2,000 and real estate broker’s commission Tk.
3,000. What cost should be assigned to land?

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Lesson 2: Depreciation

Lesson Objectives

After studying this lesson, you should be able to:

• explain the meaning of depreciation;

• recognize the major causes of depreciation;
• describe the objectives of providing depreciation;
• identify the factors affecting depreciation.

Depreciation: Meaning

In accounting, economics, and finance, we often talk about the term ‘Depreciation’ but we all are
not well conversant with it. The concept of depreciation is really pretty simple. For example, let’s
say you purchase a truck for your business. The value of the truck will start to decline just after
acquiring it. The truck is considered an operational asset in running your business. Each year that
you own the truck, it loses some value, until the truck finally stops running and has no value to the
business. Measuring the loss in value of an asset is known as depreciation.

You know an asset will never have the same value throughout its lifetime. As time passes, every
plant asset except land asset loses value, which is known as ‘DEPRECIATION’. This total loss in
value is systematically divided into the total economic life of the assets. Therefore, depreciation is
the amount of plant asset cost allocated over its useful life. Depreciation is considered an expense
and is listed in an income statement under expenses.

Plant assets or depreciable assets are those assets which:

(i) are tangible;

(ii) have a useful life of more than one year; and
(iii) are held for use in the business rather than resale to a customer.

Major Causes of Depreciation

There are various causes of depreciation. The major causes are:

1. Physical deterioration;
2. Inadequacy for future needs; and
3. Obsolescence.
Physical Deterioration results from the use of the assets – (that means wear and tear of the assets) -
and the action of the elements. For example, an automobile may have to be replaced after a time
because its body rusted out.

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The Inadequacy of a plant asset is its inability to produce enough products or provide enough
services to meet current demands. For example, an air plane with a seating capacity of 90 passengers
cannot provide air service for 125 passengers on a flight.

The Obsolescence of an asset is its decline in usefulness due to new inventions and technological
improvements. For example, with the introduction sophisticated model of the computer like
Pentium-4, the old models of computers like 386 become obsolete.

Objectives of Providing Depreciation

The following are objectives of providing depreciation:

• Allocation of Asset Cost

Assets are consumed over the potential life of the assets. This consumption represents the expired
cost of the assets which must be distributed over the estimated life of the asset based on relevant
principles and method. This allocation of cost is the main objective of providing for depreciation.
• Determination of True Profits
The purchase of an asset is nothing more than a payment in advance for an expense. For example, an
asset is purchased for Tk.500,000, used for several years, and then sold for Tk.50,000. The
Tk.450,000 decline in value is, in every sums of the word, an expense of generating the revenue
realized during the periods that the asset was used. Therefore, if the income figure is to be
meaningful, Tk.450,000 of expense must be allocated to these periods and matched against the
respective revenue. Failure to do so would overstate income for the periods.

• Presentation of True Financial Position

An important objective of providing depreciation is that unless shrinkage in the value of the assets is
provided for, the value of assets will be overstated in the balance sheet. In order to present a true
state of affairs of the business, the assets should be shown in the balance sheet at their proper values.
• Replacement of Assets
The object of replacement of assets is also important in question of providing for depreciation. If
profits are fully distributed without providing for depreciation, a time will come when the concern
will find themselves in great difficulties to replace assets for want of necessary funds. This
objective, if to be achieved need creation of such fund and investment of the same to be realized at
required time. So, a depreciation provision is necessary to guard against impairment of capital and
for the replacement of fixed assets when the need for such replacement may arise.

Factors Affecting Depreciation

Now we discuss the factors that we should consider in computing depreciation. In computing
depreciation of a plant asset, we should consider the:
1. Cost of the assets;
2. Estimated Salvage Value/ Scrap Value of the asset;
3. Estimated Useful Life of the asset; and
4. Depreciation Method to be used in depreciating the asset.
Cost: The amount of cash and /or cash equivalent given up to acquire a plant asset and place it in
operating condition at its proper location.
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Salvage Value/Scrap Vale/ Residual Value: The amount of money a concern expects to recover,
less disposal costs, on the date a plant asset is scrapped, sold or traded in.

Useful Life: The useful life of a plant asset is either:

a. The period over which a plant asset is expected to be used; or
b. The number of output expected to be obtained.

Review Questions

1. Explain the term “depreciation”.

2. Discuss the major causes of depreciation.
3. Describe the objectives of providing depreciation.
4. What factors should be considered during computing depreciation.

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Lesson 3: Methods of Computing Depreciation

Lesson Objectives

After studying this lesson, you should be able to:

• compute the full-year depreciation under different methods;

• compute the partial-year depreciation under different methods;
• describe the procedure for revising periodic depreciation.

Depreciation Methods
There are various methods for calculating depreciation on assets. The most common methods
are:
1. Straight- Line Method;
2. Units-of – Production/Activity Method; and
3. Accelerated Depreciation Methods:
a. Sum-of-the-Years’-Digits Method
b. Double-Declining Balance Method
Computation of Full- Year Depreciation

Straight-Line Method
Straight-line method is the simplest and most widely used method for calculating depreciation. In
this method, an equal amount of plant asset cost is charged to each accounting period. It is measured
solely by the passage of time. This method is generally suitable for buildings or furniture, because
depreciation for these assets is more a function of time than of use. Under this method, the
depreciation per period is calculated by dividing the depreciable cost (Asset Cost-Estimated salvage
value) by the Estimated useful life.
Asset Cost−Estimated Salvage Value
Depreciation Per Period=
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒
Suppose on January 1, 2015, you purchased a machine for Tk.270,000 with an estimated useful life
of 10 years, and the estimated salvage value of is Tk.20,000. S0, the depreciation for 2015 would be:
Tk. 270,000−Tk.20,000
= 10
= Tk.25,000.
And each year, this Tk.25,000 should be charged on the machine up to its useful life of 10 years.
And if the machine produced 1,000 units in 2015, depreciation expense for 2015 would be
(Tk.5×1,000)=Tk.5,000.

Units-of –Production/Activity Method

Under this method, useful life is expressed in terms of the total units of production or output
expected from the asset, rather than as a time period. This method is ideally suitable for factory
machinery. Production can be measured in units of output or in machine hours. This method can also
be used for such assets like:
-delivery equipment (Kilometers driven) and
-airplanes (hours in use)
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Under this method, at first the depreciation per unit is calculated by dividing the depreciable cost
(Asset Cost-Estimated salvage value) by the total units of production or level of activity and then the
depreciation per period is calculated by multiplying this per unit depreciation with the number of
units produced during the depreciation period.
Asset Cost−Estimated Salvage Value
Depreciation Per Unit= 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑇𝑜𝑡𝑎𝑙 𝑈𝑛𝑖𝑡𝑠 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
Depreciation Per Period=Depreciation Per Unit × No. of Units Produced During Accounting Period
For example, if the machine you purchased in 2015 could produce total 50,000 units, the
Tk. 270,000−Tk.20,000
depreciation per unit would be = 50,000
= Tk. 5
And if the machine produced 1,000 units in 2015, depreciation expense for 2015 would be
(Tk.5×1,000)=Tk.5,000.
Accelerated Depreciation Methods
So far we have discussed straight line and units-of-output methods. With straight line depreciation,
each time period during the asset's useful life is assigned an equal amount of depreciation. With
units-of-output depreciation, each kilometer driven, hours used, or other measurement of useful life
is assigned an equal amount of depreciation. A second concept recognizes that the stream of benefits
provided by a fixed asset may not be level. Rather, benefits provided may be greatest in the first year
of the asset's service life and least in the last year. The accelerated method recognizes this fact.
Accelerated depreciation methods record higher amounts of depreciation during the early years of an
asset’s life and lower amounts in the later years of the asset’s life. This is consistent with the basic
accounting concept of matching costs with related revenue.
The two most common accelerated methods of depreciation are:
a. Sum-of –the-Years’ –Digits (SOYD) Method
b. Double-Declining –Balance(DDB) Method
Sum-of –the-Years’ –Digits Method: This method is so called because the consecutive digits for
each year of an asset’s estimated life are added together and used as the denominator of a fraction.
The numerator is the number of years of useful life remaining at the beginning of the accounting
period. This fraction is then multiplied by the acquisition cost of the asset less the estimated salvage
value to compute the periodic depreciation expense. So, the formula for calculating periodic
depreciation in this method is:
Asset Cost−Estimated Salvage Value
Periodic Depreciation Expense= ×
SOYD
Remaining Useful Life at the Beginning of Accounting Period
Here SOYD is calculated by adding the consecutive digits of the useful life or it can also be found
out by the formula:
n(n+1)
SOYD= 2
where, n = No. of Periods in the Asset’s Useful Life.
10(10+1)
Referring to previous example, SOYD for an asset with a 10-year useful life is: = 2
=55
Tk. 270,000−Tk.20,000
Using the formula, the depreciation for first year= 55
× 10 =Tk.45,455

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Double-Declining –Balance Method: This method is so named because the periodic depreciation is
based on a declining book value (cost minus accumulated depreciation) of the asset. The formula for
calculating periodic depreciation under this method is:

Depreciation Expense= (Asset Cost - Accumulated Depreciation) × (2×Straight Line Rate)

The straight-line rate is computed by dividing 100% by the number of years of useful life of the
asset.
100%
Referring to the original data and this formula, straight line rate = 10
=10 %

Again referring to the original data, depreciation for first year (2015) = (Tk.270,000 - Tk.0) × 2 ×
10% = Tk.54,000

Here, in the first year of the asset’s useful life, the accumulated depreciation is zero. But for
computing depreciation in 2016 it would be Tk.54, 000, and so on.

Computation of Partial- Year Depreciation

So far we have discussed the depreciation for the 12 months or full year where the assets were
acquired at the beginning of the year. Now we discuss how the depreciation for partial year is
calculated under four depreciation methods.

First of all, straight-Line Method: Under this method, at first the depreciation for 12 months is
normally calculated as explained earlier. Then this amount is multiplied by the fraction of the year
for which depreciation should be recorded. Let’s explain the calculations.

Suppose, on September 1, 2015, you purchased a machine for Tk.76,000 with an estimated salvage
value of Tk.4,000 and an estimated useful life of 5 years. As the machine was used for four months
(i.e., from September to December) of the year 2015, the depreciation for 4 months (one third of the
year) would be

Tk. 76,000−Tk.4,000 4
2015: × = Tk. 4,800
5 12

Units-of-Production Method: In this method, the depreciation is calculated as we explained earlier.

Here the per unit depreciation charge is multiplied by the no. of units produced during the partial
year (here 4 months). The depreciation for a particular year will probably be less than for a full year
because fewer units of goods or services are produced.

Sum-of-the-Years-Digits Method: Under this method, the computation of partial year depreciation
is more complex. Here the problems occur because the 12 months for which depreciation is
computed using the SOYD fraction do not correspond with the 12 months for which the financial
statements are being prepared. Let’s know the details.

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Suppose, in 2015, the depreciation is computed on machine of Tk. 76,000 for the last 4 months or
one third of the first year of the machine’s life. So the depreciation for the four months of 2015 will
be Tk. 8,000. At this moment the machine has useful life of 4 years and 8 months.
Tk. 76,000−Tk.4,000 4
Depreciation for 2015=. ×5× = Tk.8,000
15 12

The depreciation for 2016 is computed as follows:

Tk. 76,000−Tk.4,000 8
For the first 8 months (two thirds) of 2016 = 15
× 5 × 12 = Tk. 16,000
Tk. 76,000−Tk.4,000 4
For the last 4 months (one third) of 2016 = 15
× 4 × 12 = Tk. 6,400
Total depreciation expense for 2016 = Tk.22,400

Double-Declining-Balance Method: Under this method, it is relatively easy to determine

depreciation for a partial year and then for subsequent full years. For partial year, simply multiply
the straight-line rate times the asset’s cost times the fraction of the year.
100% 4
2015: (76,000-0) × 2 × 5
× 12 = = Tk. 10,133

Here, you see for the last 4 months or one third of the first year of the asset’s useful life, the
accumulated depreciation is zero. But for computing depreciation in 2016 the it would be Tk.10,133.

Example: 6.3.1

On January 1, 2012, Jamuna Ltd. purchased a truck at a cost of Tk.450,000. The following facts
apply:
Estimated salvage value Tk.50,000
Estimated life:
In years 4 years
In kilometers driven 160,000 kilometers
Year wise kilometers driven:
2012 60,000 kilometers
2013 40,000 kilometers
2014 35,000 kilometers
2015 25,000 kilometers
Required:
Prepare depreciation schedules for the following methods and compare them: (a) straight-line, (b)
units of- activity, (c) sum-of-the- years’ digits, and (d) declining-balance using double straight-line
rate.
Solution:

Straight-line Method
The annual depreciation expense for the truck will be calculated as:

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 Tk.450,000 − Tk.50,000
= Tk.100,000
4 years
This depreciation computation is shown below in tabular form.
Cost of the depreciable asset Tk.450,000
Less: Estimated salvage or residual value 50,000
Total amount to be depreciated (depreciable cost) Tk.400,000
Estimated useful life 4 years
Depreciation expense each year (Tk.400,000  4) Tk.100,000

The depreciation expense for four years would be as follows:

Depreciation Schedule: Straight-line Method:
Year Annual Accumulated Book /Carrying
Depreciation Depreciation Value
January 1, 2012 --- --- Tk.450,000
December 31, 2012 Tk.100,000 Tk.100,000 350,000
December 31, 2013 100,000 200,000 250,000
December 31, 2014 100,000 300,000 150,000
December 31, 2015 100,000 400,000 50,000
Tk.400,000

Units-of-Activity Method
450,000 − 50,000
2012:  60,000 kilometers = Tk . 150,000
160,000 kilometers
The entry to record units-of-output depreciation at the end of first year of the truck's life is:
Date Account Titles and Explanation Ref. Debit Credit
2012 Depreciation Expense Tk.150,000
Dec.31 Accumulated Depreciation-Truck Tk.150,000
(To record depreciation for the first year of the
truck)
The depreciation expense for four years would be as follows:
Depreciation Schedule: Units-of –Activity Method
Year Kilo-metros Depreciation Accumulated Book/Carrying
Driven Expense Depreciation Value
January 1, 2012 --- --- --- Tk.450.000
December 31, 2012 60,000 Tk.150,000 Tk.150,000 300,000
December 31, 2013 40,000 100,000 250,000 200,000
December 31, 2014 35,000 87,500 337,500 112,500
December 31, 2015 25,000 62,500 400,000 50,000
160,000 Tk.400,000

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Accelerated Depreciation Methods
Sum-of -the -Years'-Digits Method
In our example, the SOYD for a four-year asset life is
1 + 2 + 3 + 4 = 10
Determining the SOYD factor by simple addition may require tedious calculations for long-lived
assets. For these assets, the formula is n (n+1)/2. Where n = the number of years in the asset's useful
life, can be applied to find out SOYD. In our example,
n(n + 1) 4 ( 4 + 1) 20
SOYD = =
2 = = 10
2 2

The formula for yearly depreciation is:

Re maining useful life (Years )
 (Cost − Salvage value) = Depreciati on exp ense
SOYD
In our example, for the first year the depreciation on the truck will be:
4
2012:  (Tk .450,000 − 50,000) = Tk .160,000.
10
The depreciation schedule for the 4 years will be as follows:
Depreciation Schedule, Sum-of-the-Years' Digits Method
Year Computation Depreciation Accumulated Book/Carrying
Expense Depreciation Value
January 1, 2012 -- -- -- Tk.450.000
December 31, 2012 4 Tk.160,000 Tk.160,000 290,000
(  400,000 )
10
December 31, 2013 3 120,000 280,000 170,000
(  400,000 )
10
December 31, 2014 2 80,000 360,000 90,000
(  400,000 )
10
December 31, 2015 1 40,000 400,000 50,000
(  400,000 )
10
The schedule portrays that the depreciation is the highest in the first year and declines each year
after that. The book value of the asset decreases each year by the amount of depreciation until it
reaches the salvage value.

Declining-Balance Method
The formula for computing yearly depreciation
=(Asset cost-Accumulated depreciation) 2Straight-line rate
Where, straight-line rate=1÷Useful life
In our example, straight-line rate=1 4 = 25 per cent
Double the straight-line rate= 25 per cent  2=50 per cent
Depreciation for the first year when there is no accumulated depreciation will be:
2012: (450,000-0) 225%=225,000
Annual depreciation= 50 per cent  Book value (Un-depreciated cost).
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The following table shows the computation of each year's depreciation expense by declining-balance
method:
Depreciation Schedule: Double-Declining-Balance Method:
Year Computation Depreciation Accumulated Book/Carrying
Expense Depreciation Value
January 1, 2012 --- --- --- Tk.450.000
December 31, 2012 (50%  Tk.225,000 Tk.225,000 225,000
450,000)
December 31, 2013 (50%  112,500 337,500 112,500
225,000)
December 31, 2014 (50%  56,250 393,750 56,250
112,500)
December 31, 2015 * 6,250 400,000 50,000
* At the end of fourth year, depreciation expense cannot exceed Tk.6,250 since the book value
cannot be reduced below salvage value (Tk.50,000). It is to be noted here that although salvage
value is ignored in the initial computations, the assets is not depreciated below its salvage value.

Example: 6.3.2
Rafin Company purchases a factory machine at a cost of Tk. 18,00,000 on January 1, 2014. Rafin
expects the machine to have a salvage value of Tk. 2,00,000 at the end of its 4-year useful life.
During its useful life, the machine is expected to be used 160,000 hours. Actual annual hourly use
was: 2014, 40,000; 2015, 60,000; 2016, 35,000; and 2017, 25,000.
Required:
Prepare depreciation schedules for the following methods and compare them: (a) straight-line, (b)
units of- activity, and (c) declining-balance using double straight-line rate.

Solution:
(a)
Straight-Line Method
Year Computation Annual End of Year
Depreciable × Depreciation = Depreciation Accumulated Carrying/Book
Costs* Rate Expense Depreciation Value
2014 Tk. 16,00,000 25% Tk.4,00,000 Tk.4,00,000 Tk.14,00,000**
2015 16,00,000 25% 4,00,000 8,00,000 10,00,000
2016 16,00,000 25% 4,00,000 12,00,000 6,00,000
2017 16,00,000 25% 4,00,000 16,00,000 2,00,000
*Tk.18,00,000 - Tk.2,00,000
**Tk.18,00,000 -Tk.4,00,000

(b)
Units-of-Activity Method
Year Computation Annual End of Year
Units of × Depreciation = Depreciation Accumulated Carrying/Book
Activity Cost/Unit Expense Depreciation Value
2014 40,000 Tk.0.10* Tk.4,00,000 Tk.4,00,000 Tk.14,00,000**
2015 60,000 0.10 6,00,000 10,00,000 8,00,000
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2016 35,000 0.10 3,50,000 13,50,000 4,50,000
2017 25,000 0.10 2,50,000 16,00,000 2,00,000
*(Tk. 18,00,000 – Tk. 2,00,000) ÷160,000.

(c)
Declining-Balance Method
Year Computation Annual End of Year
Book Value × Depreciation = Depreciation Accumulated Carrying/Book
Beginning of Rate* Expense Depreciation Value
Year
2014 Tk. 18,00,000 50% Tk.9,00,000 Tk.9,00,000 Tk.9,00,000
2015 9,00,000 50% 4,50,000 13,50,000 4,50,000
2016 4,50,000 50% 2,25,000 15,75,000 2,25,000
2017 2,25,000 50% 25,000** 16,00,000 2,00,000
*¼ × 2.
**Adjusted to Tk. 25,000 because ending book value should not be less than expected salvage value.

Comparison of Methods
Year Straight-Line Method Units- of- Activity Declining- Balance
Method Method
2014 Tk.4,00,000 Tk.4,00,000 Tk.9,00,000
2015 4,00,000 6,00,000 4,50,000
2016 4,00,000 3,50,000 2,25,000
2017 4,00,000 2,50,000 25,000**
Total Tk. 16,00,000 Tk. 16,00,000 Tk. 16,00,000

Annual depreciation varies considerably among the methods, but total depreciation is the same for
the five-year period under all three methods. Each method is acceptable in accounting because each
recognizes in a rational and systematic manner the decline in service potential of the asset.

Revising Periodic Depreciation

Depreciation is one example of the use of estimation in the accounting process. Management should
periodically review annual depreciation expense. If wear and tear or obsolescence indicate that
annual depreciation estimates are inadequate or excessive, a concern should change the amount of
depreciation expense.
When a change in an estimate is required, the concern makes the change in current and future years.
It does not change depreciation in prior periods. The rationale is that continual restatement of prior
periods would adversely affect confidence in financial statements.
To determine the new annual depreciation expense, the concern first computes the asset’s
depreciable cost at the time of the revision. It then allocates the revised depreciable cost to the
remaining useful life.
Example: 6.3.3

Nibras Company decides on January 1, 2017, to extend the useful life of the machine one year (a
total life of five years) and increase its salvage value to Tk.2,20,000. The company has used the
straight-line method to depreciate the asset to date. Depreciation per year was Tk.4,00,000
((Tk.18,00,000 - Tk.2,00,000) ÷ 4). Accumulated depreciation after three years (2014–2016) is

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Tk.12,00,000 (Tk. 4,00,000 × 3), and book value is Tk.6,00,000 (Tk.18,00,000 - Tk.12,00,000). The
new annual depreciation is Tk.1,20,000, computed as follows.
Book value, 1/1/17 Tk. 6,00,000
Less: Salvage value 2,20,000
Depreciable cost Tk. 3,80,000
Remaining useful life 2 years (2017–2018)
Revised annual depreciation (Tk.3,80,000 ÷ 2) Tk. 1,90,000
Nibras Company makes no entry for the change in estimate. On December 31, 2017, during the
preparation of adjusting entries, it records depreciation expense of Tk. 1,90,000. Companies must
describe in the financial statements significant changes in estimates.
Example:6. 3.4

Metro Corporation purchased a piece of equipment for Tk.36,00,000. It estimated a 6-year life and
Tk.6,00,000 salvage value. Thus, straight-line depreciation was Tk.5,00,000 per year {(Tk.36,00,000
- Tk.6,00,000) ÷ 6}. At the end of year three (before the depreciation adjustment), it estimated the
new total life to be 10 years and the new salvage value to be Tk.2,00,000. Compute the revised
depreciation.

Solution:
Original depreciation expense {(Tk.36,00,000 - Tk.6,00,000) ÷ 6} = Tk.5,00,000
Accumulated depreciation after 2 years = 2 × Tk.5,00,000 = Tk.10,00,000
Book value = Tk.36,00,000 - Tk.10,00,000 = Tk.26,00,000

Book value after 2 years of depreciation Tk.26,00,000

Less: New salvage value 2,00,000
Depreciable cost 24,00,000
Remaining useful life 8 years
Revised annual depreciation(Tk.24,00,000 ÷ 8) Tk. 3,00,000

Review Questions

1. Which depreciation method would best reflect the risk of obsolescence from rapid technological
changes?
2. Describe the procedure for revising periodic depreciation.
3. Nova Ltd. bought land with a vacant building for Tk.17,00,000. Nova will use the building in
its operations. Must Nova allocate the purchase price between the land and building? Why or
why not? Would your answer be different if Nova intends to raze the building and build a new
one? Why or why not?

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 4. A business enterprise acquired a delivery truck for Tk. 200,000 cash. Its estimated salvage
value at the end of its useful life 10 years is Tk. 20,000. Find out the depreciable cost of the
truck.
5. On January 1, 2014, Fujian Electronics Company, an electronics tool manufacturer, acquired
for Tk. 120,000 a piece of new industrial equipment. The equipment had a useful life of 8 years
and salvage value was estimated to be Tk. 20,000 and its total production is estimated 48,000
units. Fujian Company estimated that the new equipment can produce 10,000 electronic tools in
its first year. It estimates that production will decline by 1,000 units per year over the remaining
life of the equipment.
The following depreciation methods may be used: (a) straight-line, (b) units of output, (c)
double declining balance, and (d) sum-of-the- years’ digits.

Required:
(a) Which depreciation method would minimize net income for income tax reporting for the
three-year period ending December 31, 2017?
(b) Which depreciation method would maximize net income for financial statement
reporting for the three-year period ending December 31, 2017?

6. On January 13, 2016, Padma Oil Company purchased a drilling truck for Tk.90,00000. Precision
expects the truck to last five years or 200,000 miles, with an estimated residual value of
Tk.15,00000 at the end of that time. During 2017, the truck is driven 48,000 miles. Precision’s
year end is December 31. Compute the depreciation for 2017 under each of the following
methods: (a) straight-line, (b) units of production, and (c) double-declining-balance. Using the
amount computed in (c), prepare the journal entry to record depreciation expense for the second
year, and show how the Drilling Truck account would appear on the balance sheet.

7. Aptech Company purchased a new machine on October 1, 2016, at a cost of Tk.120,00,000. The
company estimated that the machine will have a salvage value of Tk.12,00,000. The machine is
expected to be used for 10,000 working hours during its 5-year life.
Required:
Compute the depreciation expense under the following methods for the year indicated
(a) straight-line, (b) units of output, and (c) double straight-line rate for 2016 and 2017.

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Lesson 4: Plant Asset Disposals

Lesson Objectives

After studying this lesson, you should be able to:

• explain how to account for the retirement of plant assets;

• compute and record the gain or loss on disposal of sale of plant assets;
• explain the accounting treatment for the exchanges of plant assets.

Plant Assets Disposals

When plant assets except land, like buildings and equipment, are no longer useful because they have
physically deteriorated or become obsolete, a concern can:
• Discard them (retirement)
• Sell them
• Trade them in on the purchase of a new asset (exchange)
Regardless of how a concern disposes of a plant asset, it must record depreciation expense for the
partial year up to the date of disposal. This step is required because the concern used the asset until
that date and, under accrual accounting, the accounting period should receive the proper allocation
of depreciation expense.

Steps for Disposal of Plant Assets

• First, record depreciation to the date of disposal.
• Remove the asset and related accumulated depreciation from the books.
• Record the asset received in exchange (may be cash or other assets).
• Record the gain or loss on the disposal, if any.

Retirement of Plant Assets

Plant assets are retired from services when they are no longer useful to the concern and they have no
market value. It is an internal transaction.
What happens if a fully depreciated plant asset is still useful to the concern?
In this case, the asset and its accumulated depreciation continue to be reported on the balance sheet,
without further depreciation adjustment, until the concern retires the asset. Reporting the asset and
related accumulated depreciation on the balance sheet informs the financial statement reader that the
asset is still in use. Once fully depreciated, no additional depreciation should be taken, even if an
asset is still being used. In no situation can the accumulated depreciation on a plant asset exceed its
cost.

If Cash> Book Value, Record a gain (Credit) When a company disposes of an asset, it must bring the
If Cash< Book Value, Record a loss (Debit) depreciation up to date and remove all evidence of ownership of
If Cash= Book Value, Record no gain or loss the asset, including the contra account Accumulated Depreciation.

Discarding Assets with no Carrying/Book Value (No gain or loss on Retirement)

To illustrate the retirement of plant assets, assume that Canon Enterprise retires its computer
printers, which cost Tk.32,00,000. The accumulated depreciation on these printers is Tk.32,00,000.
The equipment, therefore, is fully depreciated (zero book value). The entry to record this retirement
is as follows:

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Date Account Titles and Explanation Ref. Debit Credit
Disposal Accumulated Depreciation—Equipment Tk.32,00,000
day
Equipment Tk.32,00,000
(To record retirement of fully depreciated
equipment)

Discarding Assets with a Carrying/Book Value (Loss on Retirement)

If a concern retires a plant asset before it is fully depreciated, and no cash is received for scrap or
salvage value, a loss on disposal occurs.
Transaction: Sunrise Concern discards its machinery that cost Tk.13,00,000 and has accumulated
depreciation of Tk.9,30,000. The discarded machinery has a carrying/book value of Tk.3,70,000 at
the time of its disposal (Tk.13,00,000 less accumulated depreciation of Tk.9,30,000).
Analysis: A loss equal to the carrying/book value should be recorded. This journal entry:
▼ decreases the asset Machinery with a credit.
▼ decreases Machinery’s related Accumulated Depreciation with a debit.
▲ increases the Loss on Disposal of Machinery account with a debit.
Journal Entry
Date Account Titles and Explanation Ref. Debit Credit
Disposal Accumulated Depreciation—Machinery Tk. 9,30,000
day
Loss on Disposal of Machinery 3,70,000
Machinery Tk. 13,00,000
(To record retirement of machinery at a loss)
Comment: Companies report a loss on disposal of plant assets in the “Other expenses and losses
(Non-operating income)” section of the income statement.

Sale of Plant Assets for Cash

The entry to record a plant asset sold for cash is similar to the one just illustrated, except that the
receipt of cash should also be recorded. The following entries show how to record the sale of a
machine at three different selling prices.
Cash Received Equal to Carrying/Book Value (No Gain or Loss on Sale)
Transaction: Tk.3,70,000 cash is received and is exactly equal to the Tk.3,70,000 carrying value of
the machine.
Analysis: The journal entry to record the sale of an asset at carrying value.
▼ decreases the Machinery account and the Accumulated Depreciation account.
▲ increases the Cash account.

Journal Entry
Date Account Titles and Explanation Ref. Debit Credit
Disposal Cash Tk. 3,70,000
day
Accumulated Depreciation—Machinery 9,30,000
Machinery Tk. 13,00,000
(To record sale of machinery at a no gain or
loss)
Comment: No gain or loss is recognized because the amount of cash is exactly equal to the carrying
value of the machinery being sold.

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Cash Received Less than Carrying/Book Value (Loss on Sale)
Transaction: Tk.2,00,000 cash is received, which is less than the carrying value of Tk.3,70,000,
resulting in a loss of Tk.1,70,000.
Computation of Loss:
Cost of machinery Tk. 13,00,000
Less: Accumulated depreciation 9,30,000
Book value at date of disposal 3,70,000
Proceeds from sale 2,00,000
Loss on disposal of plant asset Tk.1,70,000

Analysis: The journal entry to record the sale of an asset at less than carrying amount.
▼ decreases the Machinery account and the Accumulated Depreciation account.
▲ increases the Cash account.
▲ increases the Loss on Sale of Machinery account for the difference.
Journal Entry
Date Account Titles and Explanation Ref. Debit Credit
Disposal Cash Tk.2,00,000
day
Accumulated Depreciation—Machinery 9,30,000
Loss on Disposal of Machinery 1,70,000
Machinery Tk. 13,00,000
(To record sale of machinery at a loss)
Comment: A loss is recognized because the amount of cash is less than the carrying value of the
machinery being sold.

Cash Received More than Carrying/Book Value (Gain on Sale)

Transaction: Tk.4,00,000 cash is received, which exceeds the carrying/book value of Tk.3,70,000,
resulting in a gain of Tk.30,000.
Computation of Gain:
Cost of machinery Tk. 13,00,000
Less: Accumulated depreciation 9,30,000
Book value at date of disposal 3,70,000
Proceeds from sale 4,00,000
Loss on disposal of plant asset Tk.30,000

Analysis: The journal entry to record the sale of an asset at less than carrying amount.
▼ decreases the Machinery account and the Accumulated Depreciation account.
▲ increases the Cash account.
▲ increases the Gain on Sale of Machinery account for the difference.
Journal Entry
Date Account Titles and Explanation Ref. Debit Credit
Disposal Cash Tk.4,00,000

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 day Accumulated Depreciation—Machinery 9,30,000
Machinery Tk. 13,00,000
Gain on Disposal of Machinery 30,000
(To record sale of machinery at a gain)
Comment: A gain is recognized because the amount of cash is more than the carrying value of the
machinery being sold.

Example: 6.4.1

Ashokleyland Trucking has an old truck that cost Tk.30,00,000, and it has accumulated depreciation
of Tk.16,00,000 on this truck. Ashokleyland has decided to sell the truck.
Required:
(a) What entry would Ashokleyland Trucking make to record the sale of the truck for
Tk.17,00,000 cash?
(b) What entry would Ashokleyland trucking make to record the sale of the truck for
Tk.10,00,000 cash?
Solution:
(a) Sale of truck for cash at a gain:
Date Account Titles and Explanation Ref. Debit Credit
Disposal Cash Tk.17,00,000
day
Accumulated Depreciation—Equipment 16,00,000
Equipment Tk. 30,00,000
Gain on Disposal of Equipment 3,00,000
(To record sale of equipment at a gain)

(b) Sale of truck for cash at a loss:

Date Account Titles and Explanation Ref. Debit Credit
Disposal Cash Tk.10,00,000
day
Accumulated Depreciation—Equipment 16,00,000
Loss on Disposal of Equipment 4,00,000
Equipment Tk. 30,00,000
(To record sale of equipment at a loss)

Exchanges of Plant Assets

Some items of plant assets are disposed of by trading them in or exchanging them for new assets.
Exchange may involve similar assets or dissimilar assets. In either case, the purchase price is
reduced by the amount of the trade-in allowance given for the asset traded in. The amount used in
this calculation depends on whether or not the asset traded in is similar to the new asset. If the trade -
in is similar - of the same type or performing the same function-its value is assumed to be its net
book value. If the asset traded in is dissimilar, its value is its estimated fair market value.
• Exchange of Similar Plant Assets
When a plant asset is traded in to a similar new asset, the accounting analysis depends whether a loss
or gain is implicit in transaction. If the trade-in allowance received is greater than the book value of

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the asset surrendered, there has been a gain. If the allowance is less, there has been a loss. A loss
will be reflected in the accounting entry, but a gain will not.
To illustrate the recognition of loss, let us assume that the computer (in our earlier example) is
traded in after four years (accumulated depreciation Tk.60,000) for a newer, modern computer on
the following terms:
Price of the new computer Tk.90,000
Trade in allowance for old computer 10,000
Cash payment required Tk.80,000
In this case the trade-in allowance (Tk.10,000) is less than the book value (Tk.15,000) of the old
computer. There is a loss of Tk.5,000 (Tk.15,000 – Tk.10,000). The entry to record the exchange
would be:
Date Account Titles and Explanation Ref. Debit Credit
Exchange
Computer (new) Tk.90,000
day
Accumulated Depreciation – Computer 60,000
Loss on exchange of Computer 5,000
Computer (old) Tk.75,000
Cash 80,000
(To record trade of computer)

According to financial accounting principles the loss on exchange transaction should be recognized
in the financial statement. However, if a trade-in transaction involved only a small loss, most
companies do not recognize the loss. But the generally accepted accounting principles require that
no gain would be recognized when a depreciable asset is traded in on another similar asset. If in the
proceeding exchange the trade-in allowance was Tk.18,000 (rather than 10,000), there the concern
would require to pay cash Tk.72,000. There is a gain of Tk.3,000. But this gain would not be
recognized. The cost of the new asset would be the sum of the book value of the old asset traded in
plus the additional amount paid or to be paid in acquiring the new asset.
The journal entry for this exchange transaction is as follows:
Date Account Titles and Explanation Ref. Debit Credit
Exchange
Computer (new) Tk.87,000
day
Accumulated Depreciation – Computer 60,000
Computer (old) Tk.75,000
Cash 72,000
(To record trade of computer)
Note that in both cases the cost and accumulated depreciation of old assets are removed from the
accounts. In case of gain, the new asset is recorded at an amount equal to the sum of the book value
the assets traded in plus cash paid.

• Exchange of Dissimilar Plant Asset

Both gains and losses are recognized when a concern exchanges dissimilar assets. Assets are
dissimilar when they perform different functions. When dissimilar assets are exchanged, the new
assets should be recorded at the fair value of the asset. The used asset's book value, of course, is
removed from the accounts. Loss or gain on the exchange transaction is determined by comparing

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the fair value assigned to the new asset with the total of the used asset's book value plus cash
payment. If the used asset's book value plus cash paid exceeds the new asset's fair value, there is a
loss. On the other hand, if the new asset's fair value is larger, a gain is recorded. To illustrate the
recognition of a gain, we will continue the just earlier example, assuming that the computer is
exchanged for a machine. Here the trade-in allowance (Tk.18,000) exceeds the book value
(Tk.15,000) of the computer by Tk.3,000. Thus, there is a gain, if it is assumed that the price of the
new machine is not a figure that has been inflated for the purpose of allowing an excessive trade-in
value. Assuming this condition is true, the entry to record this transaction is as follows:
Date Account Titles and Explanation Ref. Debit Credit
Exchange
Machinery (new) Tk.90,000
day
Accumulated Depreciation – Computer 60,000
Gain on exchange of computer Tk.3,000
Computer (old)
Cash 75,000
(To record the exchange transaction) 72,000
In some exchanges, the suggested selling price may be higher than the asset's cash selling price,
therefore, the trade-in allowance is inflated and does not indicate the used asset's fair value. Situation
like this, the gain should not be recognized.
Nature of Assets Loss Recognized Gain Recognized In Compliance with
Exchanged Standards
Dissimilar YES YES
Similar NO NO IAS
YES NO GAAP(US)

Example: 6.4.2

On January 2, the first day of business of the current year, Ferrari Company sold a sports car that
cost Tk.47,50,000 and on which Tk.30,40,000 of accumulated depreciation had been recorded.
Required:
For each of the following assumptions, prepare the journal entry (without explanation) for the
disposal:
(a) The car was sold for Tk.17,10,000 cash.
(b) The car was sold for Tk.15,00,000 cash.
(c) The car was sold for Tk.20,00,000 cash.
Solution:
Date Account Titles and Explanation Ref. Debit Credit
Disposal Cash Tk.17,10,000
day
Accumulated Depreciation—Automobile 30,40,000
Automobile Tk. 47,50,000
Cash Tk.15,00,000
Accumulated Depreciation—Automobile 30,40,000
Loss on Disposal of Automobile 2,10,000
Automobile Tk. 47,50,000

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 Cash Tk.20,00,000
Accumulated Depreciation—Automobile 30,40,000
Automobile Tk. 47,50,000
Gain on Disposal of Automobile 2,90,000

Review Questions

1. How can you dispose of a plant asset? Write a short note on exchange of plant assets.
2. When would the disposal of a long-term asset result in no gain or loss?
3. Why is the accounting treatment different in between exchange of similar and that of dissimilar
assets?
4. Isamoti Printing owned a piece of equipment that cost Tk.32,40,000 and on which it had
recorded Tk.18,00,000 of accumulated depreciation. The company disposed of the equipment
on January 2, the first day of business of the current year.
Required:
(a) Calculate the carrying value of the equipment.
(b) Calculate the gain or loss on the disposal under each of the following assumptions:
(i) The equipment was discarded as having no value.
(ii) The equipment was sold for Tk.6,00,000 cash.
(iii) The equipment was sold for Tk.16,00,000 cash.

5. Star Company purchased a computer on January 2, 2014, at a cost of Tk.2,50,000. The

computer is expected to have a useful life of five years and a residual value of Tk.25,000.
Assume that the computer is disposed of on July 1, 2017. Using the straight line method, record
the depreciation expense for half a year and the disposal under each of the following
assumptions:
(a) The computer is discarded.
(b) The computer is sold for Tk.40,000.
(c) The computer is sold for Tk.1,10,000.
6. A piece of equipment that cost Tk. 64,80,000 and on which Tk. 36,00,000 of accumulated
depreciation had been recorded was disposed of on January 2, the first day of business of the
current year. For each of the following assumptions, compute the gain or loss on the disposal:
(a) The equipment was discarded as having no value.
(b) The equipment was sold for Tk. 12,00,000 cash.
(c) The equipment was sold for Tk. 36,00,000 cash.

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Lesson 5: Natural Resources and Intangible Assets

Lesson Objectives

After studying this lesson, you should be able to:

• compute periodic depletion of natural resources;

• explain the basic issues related to accounting for intangible assets.
Natural Resources

Natural resources are long-term assets that appear on a balance sheet with descriptive titles like
“Timberlands,” “Oil and gas reserves,” and “Mineral deposits.” These assets are converted to
inventory by cutting, pumping, mining, or other extraction methods.
Natural resources are recorded at acquisition cost, which may include some costs of development.
As these resources are converted to inventory, their asset accounts must be proportionally reduced.
For example, the carrying value of oil reserves on the balance sheet is reduced by the proportional
cost of the barrels pumped during the period. The original cost of the oil reserves is thus gradually
reduced, and depletion is recognized.
Depletion
Depletion refers not only to the exhaustion of a natural resource but also to the proportional
allocation of the cost of a natural resource to the units extracted. The way in which the cost of a
natural resource is allocated closely resembles the production method of calculating depreciation.
When a natural resource is purchased or developed, the total units that will be available, such as tons
of coal, must be estimated. The depletion cost per unit is computed as follows.
𝐶𝑜𝑠𝑡−𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒
Depletion Cost per Unit=
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑈𝑛𝑖𝑡𝑠

Depletion of a Natural Resource

Transaction: A mine was purchased for Tk.3,600,000. It has an estimated residual value of
Tk.600,000, and it contains an estimated 3,000,000 tons of coal. The depletion charge per ton of coal
is Tk.1, calculated as follows.
𝐶𝑜𝑠𝑡−𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒 Tk. 3,600,000−𝑇𝑘. 600,000
Depletion Cost per Unit= 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑈𝑛𝑖𝑡𝑠= 3000,000 𝑇𝑜𝑛𝑠
= Tk.1 per ton

The amount of the depletion cost for each accounting period is then computed by multiplying the
depletion cost per unit by the number of units extracted and sold. Thus, if 230,000 tons of coal are
mined and sold by Lane Coal Company during the first year, the depletion charge for the year is
Tk.230,000.
Analysis: The journal entry to record the depletion of a natural resource.
▲ increases the Depletion Expense account.
▲ increases the Accumulated Depletion account.
Journal Entry
Date Account Titles and Explanation Ref. Debit Credit
Dec. 31 Depletion Expense—Coal Deposits Tk. 230,000
Accumulated Depletion—Coal Deposits Tk.230,000
(To record depletion of coal mine:
Tk.1 per ton for 230,000 tons mined and sold)

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On the balance sheet, data for the mine would be presented as follows.
Lane Coal Company
Balance Sheet
Coal deposits Tk.3,600,000
Less accumulated depletion 230,000 Tk.3,370,000

Comment: If a natural resource is not sold in the year it is extracted, it is reported as inventory. It
would be recorded as a depletion expense in the year it is sold.

Many companies do not use an Accumulated Depletion account. In such cases, the company credits
the amount of depletion directly to the natural resources account. Sometimes, a company will extract
natural resources in one accounting period but not sell them until a later period. In this case, the
company does not expense the depletion until it sells the resource. It reports the amount not sold as
inventory in the current assets section.

Example: 6.5.1
Sharp Mining Company paid Tk.8,800,000 for land containing an estimated 40 million tons of ore.
The land without the ore is estimated to be worth Tk.2,000,000. The company spent Tk.1,380,000 to
erect buildings on the site and Tk.2,400,000 on equipment installed on site. The buildings have an
estimated useful life of 30 years, and the equipment has an estimated useful life of 10 years. Neither
the buildings nor the equipment has a residual value. The company expects to mine all the usable ore
in 10 years. During its first year of operation, it mined and sold 2,800,000 tons of ore.
Required:
(i) Compute the depletion charge per ton.
(ii) Compute the depletion expense that Sharp Mining should record for its first year of operation.
(iii) Determine the depreciation expense for the year for the buildings, making it proportional to
the depletion.
(iv) Determine the depreciation expense for the year for the equipment, using two alternatives:
(a) making the expense proportional to the depletion, and
(b) using the straight-line method.
Solution:
Tk. 88,00,000−𝑇𝑘. 20,00,000
(i) Depletion charge per ton= 40,000,000 𝑇𝑜𝑛𝑠
=Tk.0.17 per ton

(ii) Depletion expense =28,00,000 tons × 𝑇𝑘. 0.17 𝑝𝑒𝑟 𝑡𝑜𝑛 = Tk.476,000

28,00,000 tons
(iii) Depreciation expense= 40,000,000 𝑇𝑜𝑛𝑠 × Tk. 1,380,000 = Tk.96,600
28,00,000 tons
(iv) (a) Depreciation expense= 40,000,000 𝑇𝑜𝑛𝑠 × Tk. 2,400,000 = Tk.1,68,000

Tk.2,400,000
(b) Depreciation expense= 10 𝑦𝑒𝑎𝑟𝑠
× 1 year = Tk.240,000

Intangible Assets
As the word intangible implies, assets in this classification have no physical substance. Intangible
assets are exclusive rights and privileges that are long-term, are not held for resale, and usually
provide their owner with comparative advantages over other firms. Familiar examples are patents,
copyrights, leaseholds, trademarks and brand names, franchises, licenses, formula, and goodwill. An
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account receivable, for example or certain prepaid expenses have no physical existence, but they are
not called intangible assets because they are short-term. Intangible assets are both long-term and
nonphysical. In short, intangible assets are assets which are used in the operation of the business but
which have no physical substance and are long-term.
The basis of valuation for intangible assets is cost. A firm should record intangible assets acquired
from outside entities at acquisition cost, that is, the amount paid for them. Certain intangible assets
such as goodwill or trademarks may have great value and are needed for profitable operations but
may have been acquired at a little or no cost. An intangible asset should not appear on the balance
sheet of the company unless a cost of acquisition or development has been incurred.
The accounting process connected with intangible assets is essentially the same process as the
depreciation of tangible asset. The systematic allocation of the costs of intangible asset over the term
of its expected useful life is called amortization. Because salvage values are ordinarily not involved,
amortization typically entails (i) determining the asset's cost, (ii) estimating the period over which it
provides benefits the firm, and (iii) allocating the cost in equal amount to each accounting period
involved. Although it is difficult to estimate the useful life of an intangible asset, yet some intangible
assets have a determinable life, such as patents, copyrights and leasehold should be written off
through periodic amortization over their useful lives. Even though some intangible assets, such as
goodwill and trademarks, have no measurable limit on their useful lives, they should also be
amortized over a reasonable length of time (but no more than 40 years), because few things last
forever. The straight-line method of amortization is generally used for intangible assets.
The usual accounting entry for amortization consists of debit the appropriate amortization expense
account and a credit to the intangible asset account. There is no theoretical objection to credit an
accumulated amortization account rather than intangible asset account, but generally, there is no
particular benefit to financial statement users from accumulating amortization in a separate contra
asset account. To illustrate the accounting for patents, assume that Mehedi Ltd. purchased a patent
for Tk. 125,000. The entry to record the patent would be:

Date Account Titles and Explanation Ref. Debit Credit

Patent Tk. 125,000
Cash Tk.125,000
(To record legal costs of acquiring patent)

It is expected that the patent would provide benefits for 10 years. The following entry records the
first year's straight-line amortization:

Date Account Titles and Explanation Ref. Debit Credit

Amortization Expense: Patent Tk.12,500
Patent Tk.12,500
(To record annual amortization of patent)
Because an accumulated amortization account is not used, the asset account balance reflects the
asset's book value. The balance sheet presentation at year-end would be:
Patent (cost less amortization to date) Tk.112,500

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 Review Questions

1. What are intangible assets and what are their characteristics?

2. Ideal Company purchased land containing an estimated 5 million tons of ore for a cost of
Tk.8,800,000. The land without the ore is estimated to be worth Tk.500,000. During its first
year of operation, the company mined and sold 750,000 tons of ore. Compute the depletion
charge per ton (Round to two decimal places.). Compute the depletion expense that Ideal
should record for the year.
3. Aptech Company has created a new software application for PCs. Its costs during research
and development were Tk. 500,00,000. Its costs after the working program was developed
were Tk. 350,00,000. Although the company’s copyright may be amortized over 40 years,
management believes that the product will be viable for only 5 years. How should the costs
be accounted for? At what value will the software appear on the balance sheet after 1 year?
4. Sun Company purchased land containing an estimated 10 million tons of ore for a cost of
Tk.33,00,000. The land without the ore is estimated to be worth Tk.6,00,000. The company
expects that all the usable ore can be mined in 10 years. Buildings costing Tk.300,000 with
an estimated useful life of 20 years were erected on the site. Equipment costing Tk.3,60,000
with an estimated useful life of 10 years was installed. Because of the remote location,
neither the buildings nor the equipment has an estimated residual value. During its first year
of operation, the company mined and sold 4,50,000 tons of ore.
Required:
(a) Compute the depletion charge per ton.
(b) Compute the depletion expense that Sun Company should record for the year.
(c) Determine the depreciation expense for the year for the buildings, making it
proportional to the depletion.
(d) Determine the depreciation expense for the year for the equipment under two
alternatives: (i) making the expense proportional to the depletion, and (ii) using the
straight-line method.

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Unit Highlights
➢ Definition of fraud and internal control.
➢ Principles of internal control activities.
➢ Applications of internal control principles to cash receipts.
➢ Applications of internal control principles to cash disbursements.
➢ Description of the operation of a petty cash fund.
➢ Preparation of bank reconciliation.

Technologies Used for Content Delivery

❖ BOUTUBE
❖ BOU LMS
❖ WebTV
❖ Web Radio
❖ Mobile Technology with MicroSD Card
❖ LP+ Office 365
❖ BTV Program
❖ Bangladesh Betar Program

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Terminology

Bank Reconciliation A statement displaying the items of difference between the balance of an
Statement account, reported by a bank and the accounting appearing on statement (sent
monthly, weekly or even daily by the bank) with the cash the boards of the
bankers’ customers. The object of preparing this statement is to find out the
correct balances.
Bank Service Charge A fee charged by a bank for the use of its services.
Bank Statement A monthly statement from the bank that shows the depositor’s bank
transactions and balances.
Cash Resources that consist of coins, currency, cheques, money orders, and money
on hand or on deposit in a bank or similar depository.
Cash Book A type of subsidiary book where all cash receipts and payments (including
bank deposits and withdrawals) are recorded
during a period in a chronological order.
Cash Equivalents Short-term, highly liquid investments that can be converted to a specific
amount of cash.
Cheque A written order signed by a bank depositor, directing the bank to pay a
specified sum of money to a designated recipient.
Credit Memorandum Addition on a bank statement for such items as interest paid on the account and
notes collected by the bank for the customer.
Debit Memorandum Deductions on a bank statement for items such as NSF cheques and various
service charges.
Deposits in Transit Deposits recorded by the depositor but not yet been recorded by the bank.
Electronic Funds A disbursement system that uses wire, telephone, or computers to transfer
Transfer (EFT) funds from one location to another.
Fraud A dishonest act by an employee that results in personal benefit to the employee
at a cost to the employer.
Internal Auditors Company employees who continuously evaluate the effectiveness of the
company’s internal control system.
Internal Control All of the related methods and activities adopted within an organization to
safeguard its assets and enhance the accuracy and reliability of its accounting
records.
NSF Cheque A cheque that is not paid by a bank because of insufficient funds in a
customer’s bank account.
Outstanding Cheques Cheques issued and recorded by a company but not yet paid by the bank.
Petty Cash Fund A cash fund used to pay relatively small amounts.

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Lesson 1: Frauds and Internal Control

Lesson Objectives

After studying this lesson, you should be able to:

• define fraud and internal control;
• explain the principles and limitations of internal control.

Fraud
A fraud is a dishonest act by an employee that results in personal benefit to the employee at a cost to
the employer. Examples of fraud may include:
• A bookkeeper in a small company diverted Tk.7,50,00,000 of bill payments to a personal bank
account over a three-year period.
• A shipping clerk with 28 years of service shipped Tk.125,00,000 of merchandise to himself.
• A computer operator embezzled Tk.210,00,000 from a bank over a two-year period.
• A church treasurer “borrowed” Tk.150,000 of church funds to finance a friend’s business dealings.
Elements of Fraud Triangle/ Why Fraud Occurs
The three main factors that contribute to fraudulent activity are:
• Opportunity
• Financial pressure
• Rationalization
Opportunity: If the workplace does not have enough control over its employees’ activities, the
employees get an opportunity to involve in fraudulent activities like theft. In such a situation, they
think that they will not be caught for any fraud.
Financial Pressure: Sometimes, employees with too much debt or having personal financial
problems commit fraud. These problems may be for their lifestyle beyond their financial
affordability. Or they might commit fraud because they want to lead a lifestyle that they cannot
afford on their current salary.
Rationalization: Employees of a highly profitable organization often try to rationalize that they
commit frauds or involved in dishonest activities because they are paid lower compensation
package. They feel justified in stealing because they believe they deserve to be paid more.

Internal Control
Internal control consists of all the related methods and measures adopted within an organization to
safeguard its assets, enhance the reliability of its accounting records, increase efficiency of
operations, and ensure compliance with laws and regulations.
Internal control systems have five primary components as listed below.
• A Control Environment: It is the responsibility of top management to make it clear that the
organization values integrity and that unethical activity will not be tolerated. This component is
often referred to as the “tone at the top.”
• Risk Assessment: Companies must identify and analyze the various factors that create risk for
the business and must determine how to manage these risks.
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• Control Activities: To reduce the occurrence of fraud, management must design policies and
procedures to address the specific risks faced by the company.
• Information and Communication: The internal control system must capture and communicate
all pertinent information both down and up the organization, as well as communicate information
to appropriate external parties.
• Monitoring: Internal control systems must be monitored periodically for their adequacy.
Significant deficiencies need to be reported to top management and/or the board of directors.

Principles of Internal Control Activities

• Principle of Separation: Financial and accounting operations must be separated, i,e., the
handling of cash and the recording of the movement thereof should be done by separate person’s
information system relevant to financial reporting objectives, which, otherwise there may be the
scope of cash embezzlement.
• Principle of Responsibility: Responsibilities of the workers must be clearly stated so that there
may be no room for doubt or confusion in future.
• Principle of Skepticism: Too much confidence should not be pinned in one individual. Nearly
all frauds have been committed by ‘trusted’ officials or employees.
• Principle of Rotation: Job rotation is an important tool for both motivation and control of
chances of fraud. One individual is not interested to work in the same table for long time. On the
other hand, it creates opportunities for collusion. So, it is recognized as an important canon of
sound organization.
• Principle of Review/Internal Check: To prevent errors and frauds, the works or duties should
be arranged in such a way that the work of one employee should be automatically checked by
another independent employee.
• Principle of Clarification: Clear and well defined rules should be laid down and practically
followed, relating to dealing of cash, ordering, receiving, and issuing goods, etc.
• Principle of Documentation: Use of prescribed format for documents relating to receipts,
payments, orders and invoices reduces the chances of creating false documents.

Limitations of Internal Control

Concerns generally design their systems of internal control to provide reasonable assurance of
proper safeguarding of assets and reliability of the accounting records.
The concept of reasonable assurance rests on the premise that the costs of establishing control
procedures should not exceed their expected benefit.
To illustrate, consider shoplifting losses in retail stores. Stores could eliminate such losses by having
a security guard stop and search customers as they leave the store. But store managers have
concluded that the negative effects of such a procedure cannot be justified. Instead, stores have
attempted to control shoplifting losses by less costly procedures: They post signs saying, “We
reserve the right to inspect all packages” and “All shoplifters will be prosecuted.” They use hidden
TV cameras and store detectives to monitor customer activity, and they install sensor equipment at
exits.
The human element is an important factor in every system of internal control. A good system can
become ineffective as a result of employee fatigue, carelessness, or indifference. For example, a
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receiving clerk may not bother to count goods received and may just “fudge” the counts.
Occasionally, two or more individuals may work together to get around prescribed controls. Such
collusion can significantly reduce the effectiveness of a system, eliminating the protection offered by
segregation of duties. No system of internal control is perfect.
The size of the business also may impose limitations on internal control. A small company, for
example, may find it difficult to segregate duties or to provide for independent internal verification.

Review Questions

1. Identify and describe the five components of a good internal control system.
2. “Internal control is concerned only with enhancing the accuracy of the accounting records.” Do
you agree? Explain.
3. At the corner grocery store, all sales clerks make change out of one cash register drawer. Is this
a violation of internal control? Why?
4. What principles of internal control apply to most organizations?
5. State the limitations of internal control.

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Lesson 2: Cash Controls

Lesson Objectives

After studying this lesson, you should be able to:

• explain the applications of internal control principles to cash receipts;
• explain the applications of internal control principles to cash disbursements;
• describe the operation of a petty cash fund.
Cash Controls
Cash is the most liquid asset of an organization and all the business activities of an organization are
completed either by receipt or payment of cash. It can easily be concealed and taken out of business
and has higher acceptability than any other assets of a business. As such there is always a possibility
that cash may be improperly used or misappropriated through falsification or manipulation of cash
records. On the other hand, because of large volume of cash transactions many errors may occur in
its execution and records. Therefore, it is necessary to safeguard cash and to ensure the accuracy of
is recording. This can be accomplished by establishing effective internal control over cash.
Cash Receipts Controls
There may be variations in the application of the principles of internal control over cash receipts and
payments by different organizations. For your better understanding of internal control over cash
receipts, we will examine control activities for a retail store with both over-the-counter and mail
receipts.
(a) Over-the-Counter Receipts: In retail businesses like Arong, Agora, etc., the cash register
provides control over the cash receipts. A receipt is issued to ensure that each sale is recorded, with
the amount clearly visible to the customer. That is why the cashier cannot ring up a lower amount
and pocket the difference. The customer receives an itemized cash register receipt slip and is
expected to count the change received. The cash register’s tape is locked in the register until a
supervisor removes it. This tape accumulates the daily transactions and totals.
At the end of the clerk’s shift, the clerk counts the cash and sends the cash and the count to the
cashier. The cashier counts the cash, prepares a deposit slip, and deposits the cash at the bank. The
cashier also sends a duplicate of the deposit slip to the accounting department to indicate cash
received. The supervisor removes the cash register tape and sends it to the accounting department as
the basis for a journal entry to record the cash received.
This system for handling cash receipts uses an important internal control principle—segregation of
record-keeping from physical custody. The supervisor has access to the cash register tape, but not to
the cash. The clerk and the cashier have access to the cash, but not to the register tape. In addition,

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the cash register tape provides documentation and enables independent internal verification. Use of
these three principles of internal control (segregation of record-keeping from physical custody,
documentation, and independent internal verification) provides an effective system of internal
control. Any attempt at fraudulent activity should be detected unless there is collusion among the
employees.
In some instances, the amount deposited at the bank will not agree with the cash recorded in the
accounting records based on the cash register tape. These differences often result because the clerk
hands incorrect change back to the retail customer. In this case, the difference between the actual
cash and the amount reported on the cash register tape is reported in a Cash Over and Short account.
For example, suppose that the cash register tape indicated sales of Tk.6,95,600.20 but the amount of
cash was only Tk.6,94,600.10. A cash shortfall of Tk.1,000.10 exists. To account for this cash
shortfall and related cash, the company makes the following entry.
Date Account Titles & Explanations Ref. Debit Credit
Cash 6,94,600.10
Cash Over and Short 1,000.10
Sales Revenue 6,95,600.20
(To record cash shortfall)

Cash Over and Short is an income statement item. It is reported as miscellaneous expense when
there is a cash shortfall and as miscellaneous revenue when there is an overage. Clearly, the amount
should be small. Any material amounts in this account should be investigated.
(b) Mail Receipts: All incoming mail (receipts) should be opened in the presence of at least two
mail clerks. These receipts are generally in the form of cheques. A mail clerk should endorse each
cheque “For Deposit Only.” This restrictive endorsement reduces the likelihood that someone could
divert the cheque to personal use. Banks will not give an individual cash when presented with a
cheque that has this type of endorsement.
The mail-receipt clerks prepare, in triplicate, a list of the cheques received each day. This list shows
the name of the cheque issuer, the purpose of the payment, and the amount of the cheque. Each mail
clerk signs the list to establish responsibility for the data. The original copy of the list, along with the
cheques, is then sent to the cashier’s department. A copy of the list is sent to the accounting
department for recording in the accounting records. The clerks also keep a copy.
This process provides excellent internal control for the company. By employing two clerks, the
chance of fraud is reduced; each clerk knows he or she is being observed by the other clerk(s). To
engage in fraud, they would have to collude. The customers who submit payments also provide
control, because they will contact the company with a complaint if they are not properly credited for
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payment. Because the cashier has access to cash but not the records, and the accounting department
has access to records but not cash, neither can engage in undetected fraud.
Cash Disbursements Controls
Concern disburse cash for a variety of reasons, such as to pay expenses and liabilities or to purchase
assets. Generally, internal control over cash disbursements is more effective when companies pay by
cheque, rather than by cash. One exception is for incidental amounts that are paid out of petty cash.
Companies generally issue cheques only after following specified control procedures.
(a) Voucher System Controls: Most medium and large companies use vouchers as part of their
internal control over cash disbursements. A voucher is an authorization form prepared for each
expenditure. So, proper voucher should always be prepared when a payment is made. All payments
as far as possible, except petty cash should be made by cheque. The person issuing cheques should
verify vouchers authorized by responsible person in an organization. Vouchers are entered in a
voucher register by the book keeper. Receiving and paying functions of a business are maintained as
two separate systems and in each instance custodial and recording activities are performed by
different persons. Along with vouchers the receiver’s file should be consulted before any cheque is
issued or payment is made. Internal control over the preparation of wags sheet to prevent fraud and
manipulation should be exercised.
The use of a voucher system improves internal control over cash disbursements. First, the
authorization process inherent in a voucher system establishes responsibility. Each individual has
responsibility to review the underlying documentation to ensure that it is correct. In addition, the
voucher system keeps track of the documents that back up each transaction. By keeping these
documents in one place, a supervisor can independently verify the authenticity of each transaction.
(b) Petty Cash Controls: Learners, you have learned earlier in the unit that an organization can
make better internal control over cash disbursement if it is made by cheque. However, it is not
always possible to make small and frequent payment using cheque. For example, an organization
may not want to write cheques frequently to pay for postage due, morning breakfast, or rickshaw
fares. A common way of handling such payments, while maintaining satisfactory control, is to use a
petty cash fund to pay relatively small amounts. The operation of a petty cash fund, often called an
imprest system, involves (i) establishing the fund, (ii) making payments from the fund, and (iii)
replenishing the fund.
(i) Establishing the Petty Cash Fund: An can establish its petty cash fund by: (a) appointing a
petty cashier who will be responsible for the fund, and (b) determining the size of the fund.
Ordinarily, an organization expects the amount in the fund to cover anticipated disbursements for a
three- to four-week period.

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Issuing a cheque payable to the petty cashier for a fixed amount, a company establishes the fund. For
example, if a Company intends to establish a Tk.10,000 fund on May 1, the general journal entry
will be:
Date Account Titles & Explanation Ref. Debit Credit
May 1 Petty Cash Tk.10,000
Cash Tk.10,000
(To establish a petty cash fund)

(ii) Making Payments from the Petty Cash Fund: The petty cash fund cashier has the authority to
make payments from the fund that conforms to prescribed management policies. Usually,
management limits the size of expenditures that come from petty cash. Likewise, it may not permit
use of the fund for certain types of transactions (such as making short-term loans to employees).
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. If other supporting documents such as a freight bill or invoice are available,
they should be attached to the petty cash receipt.
The fund cashier keeps the receipts in the petty cash box until the fund is replenished. The sum of
the petty cash receipts and the money in the fund should equal the established total at all times.
Management can (and should) make surprise counts at any time to determine whether the fund is
being maintained correctly.

No accounting entry is made to record a payment when it is made from petty cash. It is considered
both inexpedient and unnecessary to do so. Instead, a subsidiary record may be kept in a petty cash
journal.
(iii) Replenishing the Petty Cash Fund: An organization replenishes the petty cash fund at the end
of the accounting period, or sooner it its money reaches a minimum level. The petty cashier initiates
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the request for reimbursement. S/he prepares a schedule (or summary) of the payments that have
been made and sends the schedule, supported by petty cash receipts and other documentation, to the
treasurer’s office.
The treasurer’s office upon verifying the receipts and supporting documents against proper payments
approves the request and issues a cheque to restore the fund to its established amount.
Simultaneously all supporting documentation is stamped “paid” so that it cannot be submitted again
for payment.
To illustrate, assume that on May 15 the Company’s petty cashier requests a cheque for Tk.8,700.
The fund contains Tk.1,300 cash and petty cash receipts for postage Tk.4,400, freight-out Tk.3,800,
and miscellaneous expenses Tk.500. The general journal entry to record the issue of cheque is as
follows:
Date Account Titles & Explanation Ref. Debit Credit
May 15 Postage Expense Tk. 4,400
Freight-out 3,800
Miscellaneous Expense 500
Cash Tk.8,700
(To replenish petty cash fund)

Note that the reimbursement entry does not affect the Petty Cash account. Replenishment changes
the composition of the fund by replacing the petty cash receipts with cash. It does not change the
balance in the fund.
Occasionally, in replenishing a petty cash fund, the company may need to recognize a cash shortage
or overage. This results when the total of the cash plus receipts in the petty cash box does not equal
the established amount of the petty cash fund. To illustrate, assume that the Company’s petty cashier
has only Tk.1,200 in cash in the fund plus the receipts as listed. The request for reimbursement
would therefore be for Tk.8,800, and the company would make the following journal entry.
Date Account Titles & Explanation Ref. Debit Credit
May 15 Postage Expense Tk. 4,400
Freight-out 3,800
Miscellaneous Expense 500
Cash Over and Short 100
Cash Tk. 8,800
(To replenish petty cash fund)

Conversely, if the cashier has Tk.14 in cash, the reimbursement request would be for Tk.86, and the
company would credit Cash Over and Short for Tk.1 (over age). A company reports a debit balance

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in Cash Over and Short in the income statement as miscellaneous expense. It reports a credit balance
in the account as miscellaneous revenue. The company closes Cash Over and Short to Income
Summary at the end of the year.
Companies should replenish a petty cash fund at the end of the accounting period, regardless of the
cash in the fund. Replenishment at this time is necessary in order to recognize the effects of the petty
cash payments on the financial statements.

Example: 7.2.1

Rageeb Company established a Tk.5,000 petty cash fund on July 1. On July 30, the fund had
Tk.1,200 cash remaining and petty cash receipts for postage Tk.1,400, office supplies Tk.1,000, and
delivery expense Tk.1,500. Prepare journal entries to establish the fund on July 1 and to replenish
the fund on July 30.

Solution:
Date Account Titles & Explanation Ref. Debit Credit
July 1 Petty Cash Tk.5,000
Cash Tk.5,000
(To establish a petty cash fund)
July 30 Postage Expense Tk.1,400
Office Supplies 1,000
Delivery Expense 1,500
Cash Over and Short Tk.100
Cash 3,800
(To replenish petty cash fund)

Review Questions

1. Explain how internal control principles are applied to cash receipts.

2. Narrate the applications of internal control principles to cash disbursements.
3. Describe the operation of a petty cash fund.
4. On March 20, Tomy’s petty cash fund of Tk. 10,000 is replenished when the fund contains
Tk.700 in cash and receipts for postage Tk.5,200, freight-out Tk.2,600, and travel expense
Tk.1,000. Prepare the journal entry to record the replenishment of the petty cash fund.

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Lesson 3: Bank Reconciliation Statement

Lesson Objectives

After studying this lesson, you should be able to:

• state the meaning and need of bank reconciliation statement;
• explain the reasons for difference between the balances of cash book and bank statement;
• prepare the bank reconciliation statement.
Bank Reconciliation Statement-Meaning
Business concern maintains the cash book for recording cash and bank transactions. The cash book
serves the purpose of both the cash account and the bank account. It shows the balance of both at the
end of a period. Bank also maintains an account for each customer in its book. All deposits by the
customer are recorded on the credit side of his/her account and all withdrawals are recorded on the
debit side of his/her account. A copy of this account is regularly sent to the customer by the bank.
This is called ‘Bank statement’. It is usual to tally the firm’s bank transactions as recorded by the
bank with the cash book. But sometimes the bank balances as shown by the cash book and that
shown by the bank statement do not match. If the balance shown by the bank statement is different
from the balance shown by bank column of cash book, the business firm will identify the causes for
such difference. It becomes necessary to reconcile them. To reconcile the balances of Cash Book
and Bank Statement, a statement is prepared. This statement is called the ‘Bank Reconciliation
Statement’. It can be said that:

Bank Reconciliation Statement is a statement prepared to reconcile the difference between

the balances as per the bank column of the cash book and bank statement on any given date.

Need of Preparing Bank Reconciliation Statement

It is neither compulsory to prepare Bank Reconciliation Statement nor a date is fixed on which it is
to be prepared. It is prepared from time to time to check that all transactions relating to bank are
properly recorded by the businessman in the bank column of the cash book and by the bank in its
ledger account. Thus, it is prepared to reconcile the bank balances shown by the cash book and by
the bank statement. It helps in detecting, if there is any error in recording the transactions and
ascertaining the correct bank balance on a particular date.

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Reasons for Difference
When a businessman compares the bank balance of its cash book with the balance shown by the
bank statement, there is often a difference. As the time period of posting the transactions in the bank
column of cash book does not correspond with the time period of posting in the bank statement of
the firm, the difference arises.
The reasons for difference in balance of the cash book and bank statement are as follows:
1. Cheques issued by the firm but not yet presented for payment (Cheques outstanding)
When cheques are issued by the firm, these are immediately entered on the credit side of the bank
column of the cash book. Sometimes, receiving person may present these cheques to the bank for
payment on some later date. The bank will debit the firm’s account when these cheques are
presented for payment. There is a time period between the issue of cheque and being presented in the
bank for payment. This may cause difference to the balance of cash book and bank statement.
2. Cheques deposited into bank but not yet collected (Deposit in transit/outstanding)
When cheques are deposited into bank, the firm immediately enters it on the debit side of the bank
column of cash book. It increases the bank balance as per the cash book. But, the bank credits the
firm’s account after these cheques are actually realized. A few days are taken in clearing of local
cheques and in case of outstation cheques few more days are taken. This may cause the difference
between cash book and Bank Statement balance.
3. Amount directly deposited in the bank account
Sometimes, the debtors or the customers deposit the money directly into firm’ s bank account, but
the firm gets the information only when it receives the bank statement. In this case, the bank credits
the firm’s account with the amount received but the same amount is not recorded in the cash book.
As a result, the balance in the cash book will be less than the balance shown in the bank statement.
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 4. Bank charges (Service charge)
The bank charge in the form of fees or commission is charged from time to time for various services
provided from the customers’ account without the intimation to the firm. The firm records these
charges after receiving the bank intimation or statement. Examples of such deductions are: interest
on overdraft balance, credit cards’ fees, outstation cheques, collection charges, etc. As a result, the
balance of the cash book will be more than the balance of the cheque.
5. Interest and dividend received by the bank
Sometimes, the interest on debentures or dividends on shares held by the account holder is directly
deposited by the company through Electronic Fund Transfer (EFT). But the firm does not get the
information till it receives the bank statement. As a consequence, the firm enters it in its cash book
on a date later than the date it is recorded by the bank. As a result, the balance as per cash book and
cheque will differ.
6. Direct payments made by the bank on behalf of the customers
Sometimes, bank makes certain payments on behalf of the customer as per standing instructions.
Telephone bills, rent, insurance premium, taxes, etc. are some of the expenses. These expenses are
directly paid by the bank and debited to the firm’s account immediately after their payment. but the
firm will record the same on receiving information from the bank in the form of Cheque or bank
statement. As a result, the balance of the cheque is less than that of the balance shown in the bank
column of the cash book.
7. Dishonor of Cheques/Bill discounted (NSF cheques)
If a cheque deposited by the firm or bill receivable discounted with the bank is dishonored, the same
is debited to firm’s account by the bank. But the firm records the same when it receives the
information from the bank. As a result, the balance as per cash book and that of bank statement will
differ.
8. Errors committed in recording transactions by the firm
There may be certain errors from firm’s side, e.g., omission or wrong recording of transactions
relating to cheques deposited, cheques issued and wrong balancing, etc. In this case, there would be
a difference between the balances as per cash book and as per bank statement.
Example: The firm received a cheque of Tk. 12,500 from its customer but recorded in the book as
Tk. 12,000 (i,e.,the firm understates its cash balance by Tk. 500). So, this should be added.
9. Errors committed in recording transactions by the Bank
Sometimes, bank may also commit errors, e.g., omission or wrong recording of transactions relating
to cheques deposited, etc. As a result, the balance of the bank statement and cash book will not
agree.

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Example: The bank paid a cheque of Tk. 12,000 but shown as Tk. 21,000 on the bank statement (i,e.,
the bank understates the bank statement by Tk. 9,000). So, this should be added.
Preparation of Bank Reconciliation Statement
To reconcile the bank balance as shown in the bank statement with the balance shown by the cash
book, Bank Reconciliation Statement is prepared. After identifying the reasons of difference, the
Bank Reconciliation Statement is prepared without making change in the cash book balance.
We may have the following different situations with regard to balances while preparing the Bank
Reconciliation Statement. These are as follows:
1. Favorable balances
(a) Debit balance as per cash book is given and the balance as per bank statement is to be
ascertained.
(b) Credit balance as per bank statement is given and the balance as per cash book is to be
ascertained.
2. Unfavorable balance/overdraft balance
(a) Credit balance as per cash book (i,e., overdraft) is given and the balance as per bank
statement is to be ascertained.
(b) Debit balance as per bank statement (i,e., overdraft) is given and the balance as per cash
book is to be ascertained. The following steps are taken to prepare the bank reconciliation
statement:
(i) Favorable balances:
When debit balance as per cash book or credit balance as per bank statement is given:
(a) Take balance as a starting point say balance as per cash book.
(b) Add all transactions that have resulted in increasing the balance of the bank statement.
(c) Deduct all transactions that have resulted in decreasing the balance of bank statement.
(d) Extract the net balance shown by the statement which should be the same as shown in
the bank statement.
In case balance as per bank statement is taken as starting point, all transactions that have resulted in
increasing the balance of the cash book will be added and all transactions that have resulted in
decreasing the balance of cash book will be deducted. Now extract the net balance shown by the
statement which should be the same as per the cash book. The following illustration helps to
understand dealing with the favorable balance as per cash book or bank statement.
Example: 7.3.1
Nasim Ltd. owns Linen Nova Fabrics. Nasim asks you to explain how he should treat the following
reconciling items when reconciling the company’s bank account:
(1) a debit memorandum for an NSF cheque,
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 (2) a credit memorandum for a note collected by the bank,
(3) outstanding cheques, and
(4) a deposit in transit.
Solution:
Nasim should treat the reconciling items as follows:
(1) NSF cheque: Deduct from balance per books.
(2) Collection of note: Add to balance per books.
(3) Outstanding cheques: Deduct from balance per bank.
(4) Deposit in transit: Add to balance per bank.

Format for Preparation of Bank Reconciliation Statement

(a) Both Balance Correction/Modern Method
Name ……………………
Bank Reconciliation Statement
Date
Balance as per bank statement **
Add:
1. Deposits in transit ***
2. Bank errors that understate the bank balance ***
***
Less: ***
1. Outstanding cheques ***
2. Bank errors that overstate the bank statement balance ***
***
Adjusted Balance as per bank statement ***

Balance as per depositor’s books ***

Add:
1. Cash collected by bank ***
2. Bank Interest ***
3. Book errors that understate the book balance ***
Less: ***
***
1. Dishonored cheque (NSF Cheques) ***
2. Bank charges not yet recorded in the books ***
3. Book errors that overstate the book balance *** ***
Adjusted balance as per books ***

(b) Single Balance/Traditional Method

Name ……………………
Bank Reconciliation Statement
Date ………………………..
Bank Balance as per cash book or Overdraft as per bank statement **
Add:

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 1. Cheques issued but not presented for collection **
2. Direct payment into Bank by customers **
3. Bills collected, Dividend received by the Bank, etc. **
4. Interest credited by Bank **
5. Interest on investment received by the Bank ** **
***
Less:
1. Cheques & Bills deposited, but not collected **
2. Cheques and Bills deposited for collection but dishonored **
3. Bank charges not yet credited in cash book **
4. Bank commission not yet credit in cash book **
5. Interest on overdraft not yet credited in cash money paid **
6. Bills payable, Insurance premium, share call money paid ** **
Balance as per bank statement/Overdraft as per cash book ***

Example: 7.3.2 (Both Balance Correction Method)

The cash in bank account in the ledger of Jamuna Traders Ltd. at 31st December, 2017 indicated a
balance of Tk.4,86,006. The bank statement indicated a balance of Tk.6,40,748 on the same date. A
comparison of the bank statement and the case book disclosed the following reconciling items:
a) Cheques issued but not presented Tk.2,02,687.
b) A deposit of Tk.89,017 on 31st December did not appear on the bank statement of
December.
c) A cheque for Tk.20,000 drawn by Dhaka warehouses Ltd. had been wrongly charged by the
bank account of Jamuna Traders Ltd.
d) The bank had collected for Jamuna Traders Ltd. Tk.51,000 on account of notes receivable
sent for collection. The face value of the note was Tk.50,000.
e) Bank service charge for December, 2017 amounted to Tk.675 debited on the statement.
f) Interest credited by the bank Tk.10,000.
g) A customer’s cheque for Tk.900 had been entered in the cash book as Tk.90 by the
depositor.
h) A cheque issued for Tk.392 had been entered in the cash book as Tk.329.
Required:
(a) A bank reconciliation statement using the form where both cash book and bank statement
balance are brought to a corrected balance;
(b) Journal entries to require the cash book balance.
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Solution: (a)
Jamuna Traders Ltd.
Bank Reconciliation Statement
As on 31 December 2017
Balance per bank statement Tk.6,40,748
Add: (i) Deposit in transit (b) Tk.89,017
(ii)Wrong charge by bank (c) 20,000 1,09,017
7,49,765
Less: (i) Outstanding cheque (a) 2,02,687
Corrected balance as per bank Tk. 5,47,078

Balance per books Tk. 4,86,006

Add: (i) Collection/Proceeds of note (d)
Principal Tk. 50,000
Interest 1,000 51,000
(ii) Interest credited (f) 10,000
(iii)Error in recording customer cheque (900-90) (g) 810 61,810
5,47,816
Less: (i) Bank service charge (e) 675
(ii) Under charge in cheque (392-329) (h) 63 738
Corrected balance as per books Tk. 5,47,078
Solution: (b)
Jamuna Traders Ltd.
Journal Entries
Date Account Titles and Explanation Ref. Debit Credit
2017 Cash Tk. 51,000
Dec. 31 Note receivable Tk. 50,000
Interest revenue 1,000
(To record note proceeds with interest
receivable)
31 Cash Tk. 10,000
Interest revenue Tk. 10,000
(To record the bank interest credited)
31 Cash Tk. 810
Accounts receivable Tk. 810
(To rectify the understatement of receipts
from accounts receivable)
31 Bank charges Tk. 675
Cash Tk. 675
(To record the bank charges)
31 Account payable Tk. 63
Cash Tk. 63
(To rectify the understatement of paid
cheque No.742)

Example: 7.3.3

The cash in bank account for Rakib Enterprise on December 31, 2017 indicated a balance of
Tk.3,600 after both the cash receipts and the cheque register for December had been posted. The
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bank statement indicated a balance of Tk.40,000 on December 31, 2017. Comparison of the bank
statement and the accompanying cancelled cheques and memorandums with the records revealed the
following reconciling items:
a) Total cheques outstanding Tk.25,000.
b) A deposit of Tk.10,000 representing receipts of December 31 had been made too late to
appear on the bank statement.
c) A cheque for Tk.20,000 drawn by Ratul Enterprise had been erroneously charged by the
bank to Rakib Enterprise’s account.
d) A cheque for Tk.21,000 had been recorded in the cheque register of Rakib Enterprise as
Tk.12,000.
e) The bank had collected for Rakib Enterprise Tk.50,500 on a note left for collection. The face
of the note was Tk.50,000.
f) Bank service charges for December amounted to Tk.100.
Required:
(a) Prepare a bank reconciliation statement.
(b) Journalize the necessary entries.
Solution: (a)
Rakib Enterprise
Bank Reconciliation Statement
As on 31 December 2017
Balance per bank statement, December 31 Tk.40,000
Add: (i) Deposit in transit (b) Tk.10,000
(ii) Error of understatement (c) 20,000 30,000
70,000
Less: (i) Outstanding cheque (a) 25,000
Corrected balance as per bank Tk. 45,000

Balance per books, December 31 Tk. 3,600

Add: (i) Cash collected by bank (e)
Principal Tk. 50,000
Interest 500 50,500
5,4,100
Less: (i) Error of overstatement (21,000-12,000) (d) 9,000
(ii) Bank service charge (f) 100 9,100
Corrected balance as per books Tk. 45,000

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Solution: (b)
Rakib Enterprise
Journal Entries
Date Account Titles and Explanation Ref. Debit Credit
2017 Accounts payable Tk. 9,000
Dec.31 Cash Tk. 9,000
(To record adjustment of payment to accounts
payable)
31 Cash Tk. 50,500
Note receivable Tk. 50,000
Interest revenue 500
(To record note proceeds with interest receivable)
31 Bank service charges Tk. 100
Cash Tk. 100
(To record the bank charges)

Review Questions

1. What do you understand by bank reconciliation statement?

2. “The bank balance and the bank statement may not agree with each other.” Why?
3. Explain how a bank reconciliation statement is prepared.
4. Diamond Company established a petty cash fund on May 1, cashing a cheque for Tk.10,000.
The company reimbursed the fund on June 1 and July 1 with the following results.
June 1: Cash in fund Tk.200.75. Receipts: delivery expense Tk.3,100.25; postage expense
Tk.3,900.00; and miscellaneous expense Tk.2,500.00.
July 1: Cash in fund Tk.300.25. Receipts: delivery expense Tk.2,100.00; entertainment
expense Tk.5,100.00; and miscellaneous expense Tk.2400.75.
July 10: Diamond increased the fund from Tk.10,000 to Tk.15,000.
Required:
Prepare journal entries for Diamond Company for May 1, June 1, July 1, and July
5. From the following information prepare a bank reconciliation statement for Dhanmondi Ltd. at
December, 2017:
Bank balance as per bank statement (31/12/2017) Tk.90,179
Deposit in transit 46,700
Outstanding cheques 1,31,478
Bank error (deposit understated) 10,450
NSF cheque from customer debited to account by bank 4,300
Bank service charge for December 75
Error on depositor’s books (cheque written to pay creditor
recorded at Tk.800 but written for only Tk.80) 720
Bank balance as per depositor’s record (31/12/2017) 19,506

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 Required:
(a) Prepare a bank reconciliation statement.
(b) Journalize the necessary entries.
6. From the following information, prepare a bank reconciliation statement showing correct cash
balance in the bank account for Naz Ltd. at December 2017.
Bank balance as per bank statement (31/12/2017) Tk. 81,790
Deposit in transit 44,700
Outstanding cheques 129,478
Bank error (deposit understated) 10,000
NSF cheque from customer debited to account by bank 2,300
(Separate notification no received from bank)
Bank service charge for December 75
Error on depositor’s books (cheque written to pay creditor recorded at Tk. 270
300 but written for only Tk. 30)
Bank balance as per 13,506
7. Nova Company’s bank statement for May 2017 shows the following data:
Balance 5/1 Tk.12,650 Balance 5/31 Tk.14,280
Debit memorandum: Credit memorandum:
NSF cheque Tk. 175 Collection of note receivable Tk. 505
The cash balance per books at May 31, is Tk.13,319. Your review of the data reveals the
following:
(i) The NSF cheque was from Eva Company, a customer.
(ii) The note collected by the bank was a Tk.500, 3-month, 12% note. The bank charged a
Tk.10 collection fee. No interest has been accrued.
(iii) Outstanding cheques at May 31, total Tk.2,410.
(iv) Deposits in transit at May 31, total Tk.1,752.
(v) A Nova company cheque for Tk.352 dated May 10 cleared the bank on May 25. This
cheque which was a payment on account was journalized for Tk.325.
Required:
(a) Prepare a bank reconciliation statement at May 31.
(b) Journalize the entries required by the reconciliation.

Further Readings
• Weygandt, J.J., Kimmel, P.D., and Kieso, D.E. (2015). Accounting Principles. Wiley &
Sons Inc. 12th Edition.
• Saha, S.K., Mahmud, M. M., and Hossain, A.T.M. (2008). Financial Accounting.
Readings
Bangladesh Open University.

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