Seven Star Health Science and Business College

Business Department
Distance education coordination office

Fundamental of Accounting I
May /2022
Module introduction
Principle of Accounting has designed to further develop students’ knowledge on the

Accounting record, closing and adjusting those records and finally preparing financial
statement. An in depth analysis on the accounting concepts and principles will be made. The
characteristics and Accounting different forms of business organizations especially of
merchandising will be introduced.
Course objective

After studying and up on combination of these course students should be able to

• Demonstrate the understanding of accounting concepts

• Build strong foundation for subsequent courses in Accounting

 DISTINGUI
UISHING FEATURES OF PRESENTATIONS
NS

Dear student I have employed several features of organization and design in order to make the
presentation more interesting to you throughout the material and above all to make
m your learning
faster and easier to as follows:

This teells your there is an introduction of the unit and an

a overview of
a section
tion and what the unit or section is about .
This teells your there is point to discussed in the chapterr or it is the
overall
ll objection of the unit or lessons.
This teells your there is an important point you must consid
onsidered in .

This teells you there is a self –check exercise for you to do.

This teells you there is self test for you to check your understanding
und
after coompleting each chapter.

This teells you there is glossary for each chapter key wo

ords.

This is the key to self –check exercise

This teells you there is a recommended reading material.

l.
Unit Contents
UNIT ONE
INTRODUCTION TO ACCOUNTING

1.0 Aims & Objectives

1.1 Introduction

1.2 Definition, evolution and Importance of Accounting

1.2.1 Accounting Defined

1.2.2 Evolution of accounting

1.2.3 Importance of accounting

1.3 Profession of accounting

1.4 Business Transactions and the Accounting Equation

1 .4 .1 assets, Liabilities, and Owner’s Equit y

1 .4 .2 Transactions and the Accounting Equation.

1.5. Financial Statements of Sole Proprietorships

1 .5 .1 Income Statement

1 .5 .2 Owner’s Equit y Statement

1 .5 .3 Balance Sheet

1.6. Summary

1.7. Answers to self Check Exercises

1.8. Self test Examination Questions.

1.9. Glossar y of Terms

1.10. References
 1.0 Aims & Objectives

After stud ying this unit, you should be able

to:

- explain the meaninng

g of Accounting

- identify the users and uses of accounting

- explain the various branches in the profession of accounting

- explain the meaninng

g of “generall y accepted accounting principles”,

- explain the meaning of business entity assumption, cost principle and monetary unit
assumption
- state the basic accounting equation and explain the meaning of assets, liabilities, and
owner’s equity
- anal yze the effects of business transactions on the basic accounting equation, and

- Prepare an income statement, owner’s equit y statement, and balanccee sheet.

1 .1 Introduction

We live in the information age-a time of communication, and a time when

information is a vital resouurrce. In this information era, how we live, whom we associate with,
and the opportunities we have all depend on our access to and understanding of information.

The same is true for businesses (businesses are one or more individuals selling products or
services for profit). Businesses that have better access to information and that process
information more quickl y and accuratel y do the best.
Global computer networks and telecommunications equipment now allow us to get access to
all types of business information.
But to take advantage of these, we need knowledge of information
s ystems.
An information s ystem is the collecting, processing, and reporting of information to decision
makers. Understanding and processing information is the core of accounting.
The kind of information processed in accounting is financial i.e. of a monetar y
nature.
Providing information about what businesses own, what they owe, and how they perform is the
aim of accounting. Accounting is, an information and measurement s ystem that identifies,
 records, and communicates relevant, reliable, and comparable information about an
organization’s (a business’s) economic activities.

Therefore, a stud y of accounting helps people make better and informed decisions about
assessing opportunities, products, investments, and social and community responsibilities.

But the use of accounting information is not limited to accountants or people in business. You
can use accounting information in your dail y life. You can use accounting information to get a
loan for a house or to start a new business.
The stud y of accounting, therefore, opens you new and exciting possibilities both in terms of
becoming a professional accountant and using accounting information in your dail y life.

This course discusses the fundamental principles involved in processing accounting

information of business enterprises.

Understanding these fundamental principles is ver y important because forthcoming courses that
you are going to take in accounting will build on these principles.

1 .2 . Definition, Importance, And Users Of Accounting Information

1 . 2 . 1 . D e f i n it io n o f a c c o u n t i n g

The main purpose of accounting is to ascertain profit or loss during a specified period, to
show financial condition of the business on a particular date and to have control over
the firm's property. Such accounting records are required to be maintained to measure
the income of the business and communicate the information so that it may be used by
managers, owners and other interested parties.
Accounting is a discipline which records, classifies, summarizes and interprets
financial information about the activities of a concern so that intelligent decisions can be
made about the concern.
The American Institute of Certified Public Accountants has defined the Financial
Accounting as "the art of recording, classifying and summarizing in as significant manner
and in terms of money transactions and events which in part, at least of a financial
character, and interpreting the results thereof".
American Accounting Association defines accounting as "the process of identifying,
measuring, and communicating economic information to permit informed judgments
and decisions by users of the information.
From the above the following attributes of accounting emerge:
i. Recording: It is concerned with the recording of financial transactions in an
orderly manner, soon after their occurrence In the proper books of accounts.
ii. Classifying: It is concerned with the systematic analysis of the recorded data so
 as to accumulate the transactions of similar type at one place. This function is
performed by maintaining the ledger in which different accounts are opened to
which related transactions are posted.
iii. Summarizing: It is concerned with the preparation and presentation of the
classified data in a manner useful to the users. This function involves the
preparation of financial statements such as Income Statement, Balance Sheet,
and Statement of Changes in Financial Position, Statement of Cash Flow, and
Statement of Value Added.
iv. Interpreting: Nowadays, the aforesaid three functions are performed by
electronic data processing devices and the accountant has to concentrate mainly
on the interpretation aspects of accounting. The accountants should interpret the
statements in a manner useful to action. The accountant should explain not only
what has happened but also (a) why it happened, and (b) what is likely t o
happen under specified conditions.
1 . 2 . 2 E v o l u t io n o f a c c o u n t i n g
Accounting is as old as money itself. However, the act of accounting was not as
developed as it is today because in the early stages of civilization, the numbers of
transactions to be recorded were so small that each businessman was able to record and
check for himself all his transactions. Accounting was practiced in India twenty three
centuries ago as is clear from the book named "Arthashastra" written by Kautilya,
King Chandragupta's minister. This book not only relates to politics and economics, but
also explains the art of proper keeping of accounts.
However, the modern system of accounting based on the principles of double entry
system owes it origin to Luco Pacioli who first published the principles of Double
Entry System in 1494 at Venice in Italy. Thus, the art of accounting has been practiced
for centuries but it is only in the late thirties that the study of the subject
'Accounting' has been taken up seriously.

1.2.3 Importance of Accounting and Users of Accounting Information

Importance of accounting

The main purpose of accounting is to provide financial information to be used for decision-
making. For instance, Business executives and managers need the financial information
provided by the accounting s ystem to help them plan and control the activities of the business.
Outsiders such as bankers, potential investors, and labour unions and others also need
accounting in formation.

In short the goal of the accounting s ystem is to provide useful information to decision makers.
Thus, accounting is the connecting link between decision makers and business operations.
 Self check Exercise -1

1. Answer the following questions and compare your answer with the answer key at the end of
t he uni t .
a. Define accounting

b. Write in few words the importance of accounting.

2. Describe how the modern double entr y s ystem is grown

___________________________________________________________________________
_______________________________________________________________

___________________________________________________________________________

___________________________________________________________________________

Users of Accounting Information

Today’s accountants focus oon n the ultimate needs of those who use accounting information,
whether the users are inside or out side the business. Accounting is not an end by itself. The
information that accounting provides allows users to make “reasonable choices among
alternative uses of scarce resoou
urces in the conduct of business”

The people who use accounting

unting information basically fall in to two categories:
s:

1. External Users, and

2. Internal Users
1) External Users: External Users of accounting information are parties, which are not directl y
involved in running the business enterprise. These include lenders, shareholders (stock
holders), suppliers, employees and their Unions, government (regulatory bodies) and
others. External users reell y (depend on) accounting information to help them make
better decisions in trying to achieve their goals.
The area of accounting aimed at serving external users is called Financial
Accounting. Its main objective is to provide to external users inffo ormation through
financial statements.
Each external user has its own specified information-need depending up on the decisions to be
made. That is to say, all external users do not have the same intentions (objectives) when the y
use the information.
In the following paragraphs we well try to discuss how some external users use accounting
information.
a) Lenders / Creditors
Creditors lend money or other resources to an organization. Lenders include banks, mortgage
and finance companies. Lenders look for information to help them assess the abilit y of
borrowers to repay their debts.
b) Share- holders (Stockholders)
Shareholders have legal control over part or all of a corporation. When it comes to a
corporation, shareholders are not directly involved in the management of the corporation.
However, as owners, they have claims over the properties of the organization. Financial
reports help to answer shareholders’ questions such as:
- What is the income of the organization for the current and past periods?

- are the properties adequate to meet business plan?

- will the business continue to be profitable in the future?

c) Employees and labor Unions
Emplo yees and labor unions are interested in judging the fairness of their wages and
assessing future job prospects. They also use accounting reports as evidence to ask for
bonuses, when the organization is successful.
d) Government
The Inland Revenue Authority requires organizations to prepare financial reports, in order to
compute taxes.

2) Internal Users: These are persons that are directly involved in managing and operating an
organization. The y include managers and other important decision makers. The internal
role of accounting is to provide information to help improve the efficiency and
effectiveness of an organization.
The area of accounting aimed at serving the decision-making needs of internal users is called
Management Accounting. Internal users often have access to a lot of private and valuable
information. Internal reports aim to answer questions like:

What are manufacturing costs per product?

Which service activities are most profitable?

What level of sales is necessary to break even?

1 .3 . The Accounting Profession
If you just joined the accounting profession, you may be wondering what job you will be doing
in the future. You probably would appl y your expertise in one of three major fields:
Public Accounting
Private Accounting or
Not – for – profit Accounting
i) Public accounting
 In Public Accounting you would offer expert service to the general public in much the same wa y
that a doctor serves patients and a lawyer serves clients. A major portion of public accounting
practice is involved with Auditing. In this area, a certified Public Accountant (CPA) examines
the financial statements of companies and expresses opinion as to the fairness of
presentation. When presentation is fair, users consider the statements to be reliable.
Management consulting is another area of public accounting. In this case, the accountant
consults the management generall y about the growth and development of the business
enterprise.
ii) Private Accounting
Instead of working in public accounting, an accountant may be an employee of a business
enterprise. In private accounting, you would be involved in one of the following activities:
1. Cost Accounting: Determining the cost of producing specific products.
2. Budgeting: Assisting management in quantifying goals concerning revenues, costs of goods
sold, and operating expenses.

3. General Accounting: recording dail y transactions and preparing financial statements and
related information.
4. Accounting information systems: designing both manual and computerized data processing
s ystems.
5. Tax Accounting: preparing tax returns (-forms to be filled b y a compan y and returned to a
taxing authorit y) and engaging in tax planning for the compan y.
6. Internal Auditing: reviewing a compan y’s operations to determine compliance with
management policies and evaluating efficienc y of operations.
iii) Not for Profit Accounting
Like businesses that exist to make a profit, not - for-profit organizations also need sound financial
reporting and control. Donors to such organizations want information about how well the
organization has met its objectives and whether continued support is justified. In each of these
cases, accounting expertise is highl y valued.
 S e lf c h e c k E x e r c is e - 2

1. What are the basic categories of the users of accounting information?

___________________________________________________________________________

___________________________________________________________________________

___________________________________________________________________________

___________________________________________________________________________

2. _____________is the area of accounting aimed at serving external users of accounting

information.

3. _____________ is the area of accounting aimed at serving the decision-making needs of

internal users.

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

5. _______________________________________________________________________

____________________________________________________________
_____________

____________________________________________________________
_____________

____________________________________________________________
_____________

6. Mention the area of engagement of private accounting

____________________________________________________________
_____________

____________________________________________________________
_____________

____________________________________________________________
_____________

____________________________________________________________
_____________
 1 .4 . Business Transactions and The Accounting Equation

Business transactions are economic events that should be recorded because the y affect the
financial position of the business enterprise. These businesses transactions are the raw
materials of accounting reports, as cotton is a raw material for a textile factory.
A transaction can be an exchange (such as the purchase or sale of property, pa yment or
collection of a loan etc.) between two or more parties. A transaction can also be an event that
has the same effect as an exchange transaction but doesn’t involve an exchange transaction.
Some examples of “non exchange” transactions are losses from fire, flood; physical wear and
tear on equipment; donation of propert y and so forth.
For a given transaction to qualify to be recorded it has:

1. to be related to the business enterprise

2. to be measurable in terms of money

3. to be completed / happened/ action.

(i.e. it should not be a mere promise or intention; it must be at least partially completed to be
recorded)

1 . 4 . 1 . A s s e t s , L i a b ilit i e s a n d O w n e r ’ s E q u it y

If you have noticed, in any organization you will find properties such as a building, furniture,
land, vehicles and the like. Such properties owned by business enterprises are referred to as
Assets. To bu y these assets, businesses get money from two sources: investments made b y
owners or amounts borrowed from creditors. Therefore, both owners and creditors have a
claim over the assets of the business enterprise. The claims or rights of owners are referred to as
Equities. If the assets owned by a business amount to Birr 50,000 the equities in the assets must
also amount to Birr 50,000. The relationship between the two ma y be stated in the form
of an equation, as follows: Economic Resources = claims over the resources
Assets =Equities.

Equity ma y be subdivided in to two principal t ypes: the rights of creditors and the rights of
owners. The rights of creditors represent debts of the business and are called Liabilities. The
rights of owners are called Owners’ Equity (capital).

Assets=equities

Equities = Liabilit y + Owner’s equit y

This equation can be written as:

Assets= liabilit y + Owner’s Equity
It is customar y to place “liabilities“ before “Owners equit y” in the accounting equation
because creditors have priority (preferential) rights to the assets. Because of this, the owners have
a residual claim over the assets. To help you understand this, assume X compan y has total assets
of Br. 5000, liabilities of Br 2000 and owner’s equit y of Br 3000. If the business is to be closed,
the assets of the compan y will be sold and distributed to the claimants.
In accounting, the Owner’s are given their share after the creditors are given their entire share. For
example, assume the assets are sold for Br 4,500. The creditors will be given their share of Br.
2,000 and what ever remained (Br.2,500)is given to the owners. If the assets were sold for Br.
7,000, the creditors would have been given their share of Br. 2,000 and the remaining
balance Br 5,000 would have been given to the owners.

Liabilities
Assets &
Capital

As you can notice, the

owners are given whatever
is left (it could be greater or
less than their share). That is
why we said owners have
residual claim over the
assets of the business
whereas creditors are said to
have priorit y clam over the
assets as they are paid first.
 Self check Exercise --3
1 ___________________ represents the claim of owner’s against assets of the business
enterprise.

2 Assume total asset of Br 60,000, and owner’s equity of Br 45,000. Determine the amount of
liabilit y.
___________________________________________________________________________

___________________________________________________________________________

___________________________________________________________________________

__________________________________________________________________________

3 L=A-C Is this an acceptable wa y of writing the basic accounting equation? Explain.

___________________________________________________________________________

___________________________________________________________________________

___________________________________________________________________________

___________________________________________________________________________

4 What do we mean when we sa y “owners have a residual claim over the assets of the
business enterprise”?
___________________________________________________________________________

___________________________________________________________________________

___________________________________________________________________________

___________________________________________________________________________

5 Define a business transaction, and give at least four examples.

________________________________________________________________________

________________________________________________________________________

________________________________________________________________________

________________________________________________________________________
1 . 4 . 2 . T r a n s a c t i o n s a n d t h e A c c o u n t i n g E q u a t io n
All business transactions from the simplest to the complex can be stated in terms of the resulting
effect on the three basic elements of the accounting equation. How ever, it is important to
remember that each transaction leaves the equation in balance. Assets always equal the sum of
liabilities and owner’s equity.

Let’s examine the effects of some of the most common business transactions on the
accounting equation. As a means of illustration, suppose Ato Dawit Gemechu establishes a sole
proprietorship to be known as Effective Garage, on September1, 200 xs. During September, the
business engages in the following transactions:

Transaction (1) - Owner’s investment

Ato Dawit starts business b y depositing Br. 100,000in a bank account opened in the name of
Effective Garage. The transfer of cash from the owner to the business is on owner’s investment.
The effect of the transaction is to increase the assets (Cash) on the left side of the accounting
equation b y Birr 100,000 and to increase owner’s equit y b y the same amount.

Assets = Liabilities + Owner’s Equit y

Cash Dawit Gemechu, Capital

Tran.1 + Br. 100,000 +Br. 100,000

Balance Br. 100,000 Br. 100,000

At this point, the company has no liabilities; the only party having claim over the assets of the
compan y is the owner.

N.B. the equation relates only to the business enterprise. Ato Dawit’s personal assets, such as his
home and personal bank account and personal liabilit y are excluded from consideration. The
business must be treated as a separate entit y.
Transaction (2) - Purchase of land for cash

Effective Garage bought land for Birr 20,000 in cash, to be used as a future site for the business.
This transaction changes the composition of the assets but it doesn’t change the total amount of
assets. It has no effect on the liabilit y and owner’s equit y of the business.

Assets = Liabilities + Owner’s Equity

Cash + Land Dawit Gemechu, Capital. Bal.

Birr 100,000 Birr 100,000
Tran. 2 -20,000 + 2 0 ,0 0 0 __-_____

Bal. Birr 80,000 + Br.20,000 = _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 0 0 ,0 0 0 _ _

 After the above transaction, the compan y will have less cash but a new asset (land). The total
assets (cash + Land) amount to Birr 100,000, which is equal to the owner’s equity.

Transaction (3) -Purchase of Supplies On credit

Ato Dawit bought office supplies for birr 2,500 on credit, to be used by the business. Assets can be
purchased on credit (on account) basis, where the bu yer promises to pay in the future. This type of
transaction is called a purchase on account and it results in a liabilit y to the bu yer; the liabilit y
created when something is bought on credit is called Accounts Payable.

Assets______ = Liabilit y + Owners Equit y

Cash + Supplies + Land Accounts payable Dawit Gem, Captal

Bal. Birr 80,000 Br.20,000 Birr 100,000

Tran(3) -___ + 2,500 - + 2, 500 _ _ _ - _ __ _ B a l .

Br. 80,000 2,500 2 0 ,0 0 0 2 ,5 0 0 1 0 0 ,0 0 0
Birr 102,500 Birr 102,500
Goods that are ph ysical consumed, such as a chalk to a school, gas oil for car, and stationer y
materials for an office, are called supplies.

Transaction (4) – Payment of liability

Effective Garage paid Birr. 1,500 to creditors on account. As you might have noticed, the business
bought the supplies in transaction “C” b y promising to pa y in the future, and as per
the promise made it is now settling its liability. The effect of this transaction on the
accounting equation is as follows:
Assets______ = Liabilit y + Owners Equit y

Cash + Supplies + Land Accounts payable Dawit Gem, Captal

Bal Br 80,000 Br. 2,500 Br.20,000 Birr 2,000 Birr 100,000

Tran.4 -1,500 - - - 1 ,5 0 0 -___ Bal. Br.

78,500 Br.2,500 Br.20,000 Birr 1,000 Birr 100,000
Birr 101,000 Birr 101,000
As a result of the transaction, the total cash decreases b y birr 1,500 because cash is paid and the
liabilit y of the company also decreases b y the same amount. After the above transaction is
completed, the total amount the compan y has to pay in the future is onl y birr 1,000. Please note
that the transaction has no effect on the supplies that were bought on credit.

Transaction 5 – Selling of service

The amount charged to customers for goods or services sold to them is called revenue. For
instance, the amount of money that you pa y to a shopkeeper after bu ying a pair of shoes or
something is revenue to the shopkeeper. Different titles may be used for revenue depending up on
the source of revenue. For example, a service fee for a garage, interest revenue for interest earned
b y a bank, rent income for revenues that result from renting rooms, fares earned for revenues from
a taxi service and others.
During the first month of operation, Effective Garage earned service Fees of Birr 30,000 receiving
the amount in cash for the garage services it rendered.
The effect of this transaction is to increase assets (because cash is collected) and to increase
owner’s equity b y the same amount as revenue is earned.

Assets______ = Liabilit y + Owners Equit y

Cash + Supplies + Land Accounts payable Dawit Gem, Captal

Bal Br 78,500 Br. 2,500 Br.20,000 Birr 1,000 Birr 100,000

3 0 ,0 0 0 - - - 30 , 00 0

Bol. Br. 108,500 Br.2,500 Br.20,000 Birr 1,000 Birr 130,000

Birr 131,000 Birr 131,000

Service can be given for cash or on credit. In this example, the service is given for cash (i.e., the
company collects the cash on the spot service was given). But instead of requiring customers to
pay at the time of sale, a business may let the customers to pay in the future. Such expected
collections in the future result in an Accounts Receivable to the compan y. An accounts receivable
is as much an asset as cash to the business enterprise. And the revenue from the sale of the service
or good on credit is realized and recorded on the date of sale with out waiting for the collection of
the cash.
Transaction (6 )- Recording Expenses
To generate revenue, Effective Garage has to hire emplo yees and pay salar y, it has to
consume electric power and water resource and pay the bill, and so forth. The amounts of such
cash pa yments and using up of supplies are expenses to the business. That is, an ex pense is
the amount of assets consumed or services used in the process of generating revenue. Just as
revenues are recorded when they are earned, expenses are recorded when they are incurred (i.e.
when the obligation to pay them arises).

During the month of September, Effective Garage paid Birr 15,000 for different t ypes of expenses
(birr 10,000 to salary of emplo yees, birr 3000 Telephone, birr 1,500 for rent, and birr 500 for
advertisement).

The effect of these transactions is to decrease assets (because cash is paid) and decrease owner’s
equity. This can be stated on the accounting equation as follows:

Assets______ = Liabilit y + Owners Equit y

Cash + Supplies + Land Accounts payable Dawit Gem, Captal

Bal Br108, 500 Br. 2,500 Br.20,000 Birr 1,000 Birr 130,000

-15,000 - - __-___ -15,000___ Bol.

Br. 93,500 Br.2,500 Br.20,000 Birr 1,000 Birr 115,000
Birr 116,000 Birr 116,000
 Transaction – 7 Owner’s Withdrawal

Ato Dawit Gemechu, the owner, withdrew Birr 3000 for his personal from the business. Such assets
taken out of the business for the owner’s personal use, b y the owner are called withdrawals.
Owners can withdraw in cash or in kind. For example, an owner of a super market can withdraw soap
or something for his personal benefit instead of cash.
The effect of the transaction in our case is to decrease assets as cash is taken out, and decrease owner’s
Equit y b y the same amount. This can be stated on the accounting equation as
follows:
Assets______ = Liabilit y + Owners Equit y

Cash + Supplies + Land Accounts payable Dawit Gem, Captal

Bal Br 93, 500 Br. 2,500 Br.20,000 Birr 1,000 Birr 115,000

-3,000 - - __-___ -3,000___ Bol.

Br. 90,500 Br.2,500 Br.20,000 Birr 1,000 Birr 112,000
Birr 113,000 Birr 113,000
Summary
The transactions of Effective Garage can be summarized in a tabular form as shown below.
Number identifies the transactions here and the balance of each item is shown after each
transaction.
Assets______ = Liabilit y + Owners Equit y

Type of
Tra. Cash + Supplies + Land Accounts Dawit Gem.
No Capital owner’s
Payable
Transaction
1 +100,000 - - - + 1 0 0 ,0 0 0 Owners

Investment
Bal Birr 100,000 - - - Birr 100,000
2 -20,000 - + 2 0 ,0 0 0 - -
Bal Birr 80,000 - Birr 20,000 - Birr 100,000
3 - +2500 +2500
Bal Birr 80,000 Birr 2,500 Birr 20,000 Birr2500 Birr 100,000
4 -1,500 - -1500
Bal Birr 78,500 Birr 2,500 Birr 20,000 Birr1,000 Birr 100,000
5 + 3 0 ,0 0 0 - - - + 3 0 ,0 0 0 Service fee
Bal Birr 108,500 Birr 2,500 Birr 20,000 Birr1,000 Birr 100,000
6 -15,000 - - - -10,000 Salary Exp.

-3000 Teleph. Exp

- - - - -1500 Rent Exp.
 -500 Adv. Exp.
Bal Birr 93,500 Birr 2500 Birr 20,000 Birr 1000 Birr 115,000
7 -3,000 - - - -3000 Owner’s

withdrowal
Bal Birr 90,500 Birr 2500 Birr 20,000 Birr 1,000 Birr 112,000
Total Assets =Birr 113,000 Total Liabilities and Owner’s Equity = Birr

1 1 3 ,0 0 0
The following Observations, which appl y to all t ypes of Businesses, should be noted:

1. The effect of ever y transaction can be stated in terms of increases and /or decreases in one
or more of the elements of the accounting equation.
2. The equalit y of the two sides of the accounting equation is always maintained.

3. The owner’s investment and revenues increase the owner’s equit y. Withdrawals and
expenses during the period decrease the owner’s equity. The effect of these four types of
transactions on owner’s equity can be illustrated as follows:

Owner’s Equity

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

Owner’s withdrawals and Expenses

The relationship of the above elements and their effect on the capital balance can be shown as:

EC = BC + I – W + R - E

Where: EC – End Capital Balance

BC - Beginning Capital Balance

I - Owner’s Investment
W - Owner’s Withdrawals
R - Revenue
E - Expense.
 1.5. Financial Statements

After the effect of the individual transactions has been determined, the essential information is
communicated to users at certain intervals. The accounting reports, which communicate this
information, are called financial statements. Financial statements are said to be the central
features of accounting because they are the primary means of communicating important
accounting information to users.
Financial statements are the means of transferring the concise picture of the profitabilit y and
financial position of the business to interested parties.
The major financial statements used to communicate accounting information about a business
are:
income statement
balance sheet
statement of owner’s Equity

statement of cash flows (will be discussed in senior courses)

Since these financial statements are in a sense the end products of the accounting process, a
student who acquires a clear under standing of the content and meaning of financial
statements will be in an excellent position to appreciate the purpose of the earlier steps of
recording and classif ying business transactions.
1.5.1 The Income Statement
The income statement is a financial statement that summarizes the amount of revenues earned
and expenses incurred by a business over a period of time. It reports the profitabilit y of the
business by comparing revenues and expenses for a stated period of time such as a month or a
year. In accounting profitabilit y is measured for a period of time than on a daily basis. Though
measuring dail y could be possible, it will not be practical and beneficial to the business
enterprise.
If the revenue of a period exceeds the expenses of that same period, net income results. If
expenses are greater than the revenues of a period, we sa y there is a net loss, that is, the business
has operated unprofitably.

N.B. The determination of periodic net income (net loss) is a matching process involving two
steps. First revenues earned are recognized during the period. Second, the expenses incurred to
generate revenues are matched (compared) against revenues to determine net income or net loss.
All financial statements have a heading that you can find in an y kind of a report. The heading of
these statements identifies the compan y, the t ype of statement, and the time period covered by
the statement. Note that the primar y focus of the income statement is reporting the success or
profitabilit y of the company’s operations over a specified period of time. To indicate that it
applies for a period of time, the income statement is dated “For the month ended…”
The following is an income statement for Effective Garage for the month ended September

30, 200x .
 Effective Garage
Income statement
For the Month Ended September 30,200x
Revenues:
Service Fee Birr 30,000.00
Expenses:

Salary Expense Birr 10,000.00

Telephone Expense 3 ,0 0 0 .0 0
Rent Expense 1 ,5 0 0 .0 0
Advertising Expense 5 0 0 .0 0

Total Expenses 1 5 ,0 0 0 .0 0
Net Income Birr 15,000.00
1.5.2 Ow ner’s Equity Statement

This is a statement that summarizes the changes in owner’s equit y for a specific period of time.
Data for the preparation of owner’s equity statement are obtained from the owner’s equity
column of the tabular summary (Illustration 1- ) and from the income statement. The heading
of this statement identifies the compan y, the t ype of statement, and the time period covered b y
the statement. The time period is the same as that covered b y the income statement and
therefore is dated “ For the Month Ended September 30, 200x.” The beginning owner’s equit y
amount is shown on the first line of the statement. Then, the owner’s investments, net
income and the owner’s drawings are identified in the statement.

The information provided by this statement indicates the reasons wh y owner’s equit y has
increased or decreased during the period. The Owner’s equit y statement for effective Garage
for the month of September is shown below:
Effective Garage

Statement of Owner’s Equity

For the Month ended September 30,200x

Dawit G. Capital, September 1……………………………………Birr -0-
Add: Investments…………………………………Birr 100,000.00
Net income……………………………………15,000.00
1 1 5 ,0 0 0 .0 0
115 , 00 0. 00
Less: Drawings………………………………………………………………3,000.00
Dawit G. Capital, September 30………………………………… Birr 112,000.00
1 . 5 . 3 B a la n c e S h e e t
The balance sheet, sometimes called the statement of financial Position, lists the compan y’s
assets, liabilities and owner’s equity as of a specific date- usuall y at the end of a month or year.
 Shown below is the balance sheet for Effective Garage as of September 30, 200x. The
balance sheet heading contains the name of the compan y, the t ype of statement, and the specific
date on which assets; liabilities and owner’s equit y are identified and measured. The total assets
must equal the total liabilities and owner’s equity. There are tow commonl y used formats of the
balance sheet:
The account format
Which lists assets on the left side and equities (i.e. liabilit y and owner’s equity) on the right
side. It resembles a basic accounting format called an ‘account’ to be introduced in u

_____
Assets Liabilit y

Owner’s Equit y

The Report Format

-Lists assets, Liabilit y and Owner’s equity vertically

Assets

Liability

Owner’s Equit y
You can choose either of the two formats for your balance sheet preparation.
The following is a balance sheet prepared for effective Garage based on the sample
transactions illustrated in the chapter.

Effective Garage

Balance Sheet

September 30,200x

Assets
Cash…………Birr 90,500.00
Supplies……………2,500.00 Liabilit y
Land………………20,000.
_ _ _ _ _ _ _ To Accounts pa yable…… Birr 1,000.00
tal Assets……..113,000.00 Owner’s Equit y

Ato Dawit Gem., Capital Br12,000.00.

Total Liabilities and
Owner’s equity……...Birr 113,000.00
The double line is drawn only when the total assets on the left side are equal to total liabilities
and Owner’s equit y. In the Effective Garage illustration, only one liabilit y- accounts payable- is
reported on the balance sheet. In most cases, there will be more than one liabilit y. When two or
more liabilities are involved, a customary wa y of listing is as follows:
Liabilities

Notes pa yable Birr 10,000.00

Accounts Pa yable 1 ,0 0 0 .0 0

Salaries Payable 2 ,0 0 0 .0 0

Total Liabilities Birr 13,000.00

Each statement provides management, owners, and other interested parties with relevant
financial data. The financial statements are interrelated: (1) Net income of Biirrr. 15,000 shown
on the income statement is added to the beginning balance of owner’s capital in the owner’s
equit y statement. (2) Owner’s capital of Birr 112,000 at the end of the reporting period shown
in the Owner’s equity statement is reported on the balance sheet as the Dawit G/M. capital
balance.

Be sure to carefull y examine the format and content of each statement.

S e lf c h e c k E x e r c is e - 4

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

2. Drawings are assets taken out of the business for the owner’s personal benefit. Do you
advise owners to withdraw cash or in kind (i.e. furniture, automobile..)? Why?
3. ________________________________________________________________________

________________________________________________________________________

________________________________________________________________________

________________________________________________________________________

4. List the four factors that change owner’s equity. What is their effect on owner’s equity?

___________________________________________________________________________

___________________________________________________________________________

___________________________________________________________________________

___________________________________________________________________________
 5. What are the four financial statements?

___________________________________________________________________________

___________________________________________________________________________

___________________________________________________________________________

___________________________________________________________________________

6. Every financial statement has three lines as a heading,

1st line____________________________

2nd line___________________________

3rd line __________________________

7. Write th e two forms of preparing t he balance sheet
_________________________________________________________
______________________________________________________________
______________________________________________________________
_______________________________________________________________
1.6. Top Of The Document Summary

Explain the meaning of accounting. Accounting is the process of identifying, measuring

recording and communicating the economic events of an organization (business or non
business) to interested users of the information. Accounting helps us in the allocation of scarce
resources in an efficient and effective manner.
Identify the users and uses of accounting. (a) Management uses accounting information in
planning controlling and evaluating business operations. (b) Investors (owners) judge the
wisdom of buying, holding, or selling their financial interests on the basis of accounting data,
i.e. to see how their investment is doing. (c) Creditors evaluate the risks of granting credit or
lending mone y. Other groups of users include taxing authorities, regulator y agencies,
customers, labor unions, and economic panniers. These users are grouped in to two: 1- Internal
users and ii- External users.
Explain the meaning of generally accepted accounting principles: Generall y accepted
accounting principles are a common set of standards used b y accountants.
Explain the meaning of business entity assumption, cost principle and the monetar y unit
assumption. The business entity concept states the economic events of a particular business
should be identified separate from other entities and the owner’s personal records. The cost
principle requires properties acquired b y business enterprises to be recorded at actual amounts
paid and /or assumed in acquiring the properties. The monetar y unit assumption requires only
transactions capable of being expressed in terms of money be included in the accounting records
of the business enterprise.
State the basic accounting equation and explain the meaning of assets, liabilities, and owner’s
equity. The basic accounting equation is:
Assets = Liabilities + Owner’s Equit y.
 Assets are resources owned b y a business, liabilities represent the claim of creditors on the total
assets, and owner’s equity is the ownership claim on the total assets. It is often referred to as
residual equit y.

Analyze the effects of business transactions on the basic accounting equation. Each business
transaction must have a dual effect on the accounting equation. For exam mpple, if an asset is
decreased, there must be a corresponding (1) Increase in another asset, or (2) decrease in a

specific liabilit y, or (3) decrease in owner’s equity. After each transaction, the equality of
assets to the sum of liabilities and Owner’s equit y must be maintained.
Prepare an income statement, owner’s equit y statement, and balance sheet. An income
statement presents the revenues and expenses of a company for a specific period of time. An
owner’s equity statement summarizes the changes in owner’s equit y that have occurred for a
specific period of time. A balance sheet reports the assets, liabilities, and owner’s equit y of a
business at a specific date.
1.7. Answers Key To Self check Your Progress Exercises
Self check Exercise -1Exercise - 1
1.1 Accounting is the process of identifying, measuring, recording and communicating
economic events to permit informed decisions and decisions b y the users of the
information.
1.2 Accounting as an information system helps others to make informed decisions about the
use of scarce resources.
2. Luco Pacioli
Self check Exercise -2Self Check Exercise –2
1) i) internal users ii) external users
2) Financial Accounting
3) Management Accounting
4) i) Public accounting ii)
Private accounting
iii) Not –for- profit accounting
5).

• Cost Accounting • Accounting information systems

• Budgeting: • Tax Accounting:

• General Accounting • Internal Auditing

 Self check Exercise

1. Owner’s Equit y

2. Liabilit y=Asset –Owner’s Equit y =>Liabilities=60,000-45,000=15,000

3. Though it is mathematicall y correct; it doesn’t reflect the practical fact that capital is what is
left after deducting liabilities from assets as creditor’s claims take precedence over those
of owners. Therefore, liabbiilit y is not what is left after owners take their shares.
4. When the assets of a business are not sufficient to satisfy all the claims of both owners and
creditors, first creditors are paid in full and owners take whatever remains (i.e. the residue)
even if this means the y will not be full y paid.
5. A transaction is an event that has to be recorded by accountants because it affects the
economic status of the business. The purchase of equipment, the consumption of supplies,
the collection of money from debtors, payment to creditors, and the provision of service to
customers are common ex amples of transactions that accountants have to record dail y.
Self check Exercise -5

1. Supplies

2. It is not advisable for owners to withdraw in kind (such as a vehicle or furniture)

because this may interrupt the business's operation for sometime unnttil the withdrawn
assets are replaced.
3. Factor Effect on owners equity

Revenues Increase
Expenses Decrease Investment
Increase
Drawings Decrease
4. The income statement, the balance sheet, statement of owner’s equit y and statement of
cash flows.
- Name of compan y

- Name of report (statement)

- Period covered b y financial statement

5. Report form and statement form

1 .8 . Self Test Examination Questions

1. Guji compan y had the following amounts of assets and liabilities at the beginning and end
of last year:
Assets Liabilities
Beginning of the year………………Br.75, 000 Br. 30,000
End of the year….……………………120,000 4 6 ,0 0 0
Determine the net income or net loss of Guji for the year under each of the following
unrelated assumptions:
 a. Owner made no additional investment and withdrew no amount during the year b.
Owner made no additional investment but withdrew Br.17,500 to pa y for her
personal expenses

c. Owner withdrew no amount during the year but made additional investment of
Br. 32,500 cash.
d. Owner withdrew Br.17, 500 and invested Br.25,000 cash during the year.
3. For each of the following give an example of a transaction that creates the described effects:
a. Decreases a liabilit y and decreases an asset
b. Increases an asset and decreases another asset
c. Decreases an asset and decreases owners equit y d.
Increases a liabilit y and decreases owners equit y e.
Increases an asset and increases a liabilit y
f. Decreases an asset and decreases a liabilit y
Mimi started a new business called Omo Company and completed the following transactions
during November:
Nov.1 Mimi transferred 56,000 out of a personal savings bank account to a checking
accounts her in the name of the business.
1. Rented office space and paid cash for the month’s rent of 800
3. Purchased electrical equipment for 14,000 b y pa ying 3,200 and agreeing to pa y the
remaining balance in six months
5. Purchased office supplies by pa ying 900 cash.
6. Completed electrical work and received 1,000 cash for doing the work.
4. Purchased 3,800 of office equipment on credit
15. Completed electrical work on credit in the amount of 4,000
20. Paid for the office equipment purchased on Nov.9
24. Billed a customer for electrical work completed 600
28. Received 4,000 for the work completed on Nov.15
30. Paid salary of emplo yees 1,200
30. Paid the monthl y utilities bill 440
30. Withdrew 700 from the business for personal use
Required:
1. Arrange the following asset, liabilit y and owner’s equit y titles in a table just like
illustrated in this unit: Cash, Accounts Receivable, Office Supplies, Office Equipment,
Electrical Equipment, Accounts Payable and Mimi Capital.
2. Use additions and subtractions to show the effect of each transaction on the items in the
equation. Show new totals after each transaction. Next to each change in owners equit y state
whether the change was caused b y an investment, revenue, expense or withdrawal.
3. Prepare an income statement, a statement of owner’s equit y, and a balance sheet
 1 .9 . GLOSSARY OF TERMS

Accounting - the process of identifying measuring, recording, and communicating the

economic events of an organization to interested users of the information.
Assets – Resources owned b y a business.
Auditing – the examination of financial statements by a certified public accountant in order to
express an opinion as to the fairness of presentation.
Balance Sheet – A financial statement that reports the assets, liabilities, and owner’s equit y on
a specific date.
Basic Accounting Equation - Assets=Liabilities + owner’s equity

Bookkeeping – A part of accounting that involves only the recording of economic events.
Corporation – a business organized as a separate legal entit y under state corporation law having
ownership divided into transferable shares of stock.
Cost Principle – an accounting principle that states the assets should be recorded at their actual
cost.
Drawings – Withdrawals of cash or other assets from the business for the owner’s personal use.
Economic (Business) Entity Assumption – An assumption that states a business enterprise must
be given separate and distinct existence from the owners, creditors, customers and an y other part y.
Expenses - the cost of assets connssumed or services used in the process of earning revenue.
Income statement – A financiaall statement that presents the revenues and expenses and resulting
net income or net loss of a compan y for a specific period of time.
Investment by owner – the assets put in to the business by the owner.
Liabilities – Represents the claim of creditors on the assets of the business.
Monetary unit assumption– An assumption stating that only transactions that can be
expressed in terms of money be included in the accounting records of the business.
Net Income – the amount b y which revenues exceed expenses
Net loss – the amount b y which expenses exceed revenues.
Owner’s Equity Statement – A financial statement that summarizes the changes in owner’s equity
for a specific period of time.
Partnership – An association of two or more persons to carry on a business as co-owners for profit.
Private accounting – An area of accounting with in a compan y that involves such activities as cost
accounting, budgeting, and accounting information s ystems.
Public Accounting – An area of accounting in which the accountant offers expert service to the
general public on a fee bases.
Revenues – the gross increase in Owner’s equity, resulting form business activities entered in for the
purpose of earning income. It is the amount charged to customers for services sold or goods delivered
to them.
Tax Accounting - an area of public accounting involving tax advice, tax planning, and preparin g
tax returns.
Transactions – The economic events of the business recorded b y the accountant.
1.13. References
• Fees and Warren, Accoounting principles 18th edition. (Text book)
• Merges’ and Mergs, Int
Introduction to Accounting, 9th edition.
• Harman son, Edwards
ards & Maher Accounting principles, 5th Ed,1992, USA
• Any Accounting principle
iple book can be used as a reference
 UNIT TWO
THE ACCOUNTING CYCLE AND COMPLETION OF ACCOUN UNTING CYCLE
Contents
2.0 Aims & Objectives
2.1 Introduction
2.2 the nature of accounts
2.3 Classification of Accounts
2.4 Chart of Accounts
2.5 Rules of Debits and credits
2.6 Journalizing Business Transactions
2.7 Posting From the Journal to the Ledger
2.8 The Trial Balance
2.8.1 Proof provided b y the Trial Balance
2.8.2 Limitations of the Trial Balance
2.9 Adjustments
2.9.1 The Accrual Basis and Cash Basis of Accounting
2.9.2 The Matching Principle
2.10 Worksheet for Financial Statements
2.11 Financial Statement Preparation
2.12 The Closing Process
2.13 Post Closing Trial Balance
2.14 Summary
2.15 Answers to Check Your Progress Questions
2.16 Self test Exam Questions
2.17 Glossar y of Terms
2.18 References
2.0 Aims & Objectives

By the time you have finished this unit you should be able to:
Explain the meaning and nature of an account.
apply debits and credits to record business transactions
Define the terms journal, ledger, journalizing, posting, trial balance etc.
complete the accounting cycle
2.1 Introduction
Dear distance education learner in unit 1, you have learned the relationship between the
accounting equation and business transactions. Every business transaction affects the
elements of the accounting equation. This accounting procedure will be discussed in detail. The
different and interrelated stages of the accounting cycle will be presented. The chapter is
length y, but essential for the remaining chapters in this course and other accccounting courses.
Therefore, you are advised to stud y the chapter carefully.
 2.2 Nature of an Account
In order to provide the necessary information to users, accountants maintain separate records on
each element of the financial statements. For example, to report the balance for cash at the end
of a year, a record regarding cash should be kept. The record includes beginning cash balance,
cash payments & cash collections during the period. This record is called an account.
Definition: An account is a subdivision under the three elements of the accounting equation
used to record the changes over a single element in the financial statements. An account has
three parts, Title, Debit, and credit. For illustration purposes an account can be represented in
the form of capital letter ‘T’.
Example

Ti t l e

Debit Credit

Dr Cr

2.3 Classifications of Accounts

Accounts are classified into five: assets, liabilities, capital, and revenue and, expenses. The
first three are called balance sheet accounts and the other two are called income Statement
accounts. Balance Sheet accounts are those reported on the balance sheet at the end of the
reporting period and Income Statement accounts are reported on the Income Statement.
The five groups of account are discussed below
1. Assets: Resources owned b y a business or individual are called assets. Assets could be
tangible or intangible. Tangible assets are assets having ph ysical existence, like cash, land,
computer, stationer y materials. Intangible assets do not have ph ysical existence. Example:
Goodwill, Cop yright, patent right.

On the balance sheet assets are classified into two current assets and non – current assets.
Current Assets – are those assets, which can be used, sold, or converted into cash within one
accounting year. Example: cash, supplies, prepayments, receivables etc.
Non-current Asset: All assets other than current assets are called non-current assets.
Example: land, patent right, office equipment, vehicles.
2. Liabilities: Creditors’ claims to the assets of a business; amounts owed to creditors are called
liabilities. Like assets, liabilities are classified in to two as current liabilities and non – current
liabilities
Current liabilities: The liabilities that are payable within the next (one) accounting year are
known as current liability. Example: Accounts Payable, Rent Pa yable, Salary Pa yable.
Non – Current Liabilities: Debts that are not required to be paid within the next accounting
period. Example long term notes payable.
3. Capital: The excess of the assets of a business over its liabilities is referred to as capital. It is
the equit y of the owner in the business.
4. Revenue: Are increases in owner’s equit y resulting from the main operations of the
business.
Examples of revenue accounts are sales, interest income, tuition fee, and sales commission.
5. Expenses: are decreases in owner’s equit y in the process of earning revenue. For example, a
hotel has to pay salar y to its workers for the services rendered to clients in order to get the
 income from customers (revenue) the Hotel has pay salar y to the emplo yees (expense).
Example of expenses: Salary, insurance, depreciation, supplies, utilities, rent etc.
2.4 Chart of Accounts

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

Zumbara Transport

Chart of Accounts
Asset Account number
Cash--------------------------------------------------------------------------11
Accounts Receivable------------------------------------------------------ 12
Supplies----------------------------------------------------------------------13
Prepaid Insurance-----------------------------------------------------------14
Equipment------------------------------------------------------------------- 15
Accumulated Depreciation –Equipment---------------------------------16
Truck--------------------------------------------------------------------------17
Accumulated depreciation – Truck----------------------------------------18

Liabilities
Accounts Pa yable-------------------------------------------------------------21
Notes Payable-----------------------------------------------------------------22
Owners Equity
Husen Adem, Capital----------------------------------------------------------31
Husen Adem Drawing-------------------------------------------------------32
Income Summar y-------------------------------------------------------------33
Revenue
Service income----------------------------------------------------------------41
Expense
Salaries Expense --------------------------------------------------------------51
Rent Expense ------------------------------------------------------------------52
Utilities Expense---------------------------------------------------------------53
Supplies Expense--------------------------------------------------------------54
Insurance Expense-------------------------------------------------------------55
Maintenance Expense---------------------------------------------------------56
Depreciation Expense---------------------------------------------------------57
Truck Expense-----------------------------------------------------------------58
Miscellaneous expense--------------------------------------------------------59
In the chart of accounts, the asset accounts are listed according to their liquidit y. Liquidit y is the
ease with which an asset can be converted in to cash. Cash is the most liquid asset so it is listed
first. Accounts other than cash will be listed in their frequency of use or in alphabetical order.
The account number is a code to identif y accounts. The number could be a two digit, three digit
or more digits. In the above example a three – digits code is used.
When the chart of accounts is prepared in an organization we say the ledger is opened.
2.5 RULES of Debits and Credits

As shown above ever y accounntt has three parts. These parts are discussed below:
Title – The name of the account. This is written at the top of the account.
Debit – is the left hand side of an account –Debit is abbreviated as ‘Dr.’. When an amount is
entered on the left side of an account we sa y the account is debited or charged.
Credit – is the right hand side of an account. Credit is abbreviated as Cr. An account is said to
be credited when an amount is entered on the right hand side of the account.
An account ma y increase or decrease on the debit side or on the credit side depending on the
nature of the account. In general, accounts appearing on the left hand side of the accounting
equation increase on their left side (Dr. side) and decrease on their right side (Cr. Side); whereas
accounts on the right side of the equation increase on their right side and deccrrease on their left
side.
The above general rule will be expanded as follows
Debit Credit

-Increase in assets -Decrease in assets

-Increase in expenses -Decrease in expenses
-Decrease in capital -Increase in Liabilities
-Decrease in liabilities -Increase in liabilities
-Decrease in revenue -Increase in revenue.

S e lf c h e c k E x e r c is e - 1
1. Unlike other accounts on the right hand side, expenses increase on the debit side and
decrease on the credit side. Explain the reason.
________________________________________________________________________________________________________
____________________________________________________________________________________________________

The normal balance of an Acc

ccount

Normal balance refers to the side of an account (Dr. or Cr.), which will have greater entries than
the other. The increasing side will be the normal balance for accounts.
Example: The normal balance of all asset accounts is debit
2.6 Journalizing Business Transactions
When a business transaction takes place, source documents will be obtained and recorded. The
accounting record in which a transaction is initially recorded is known as a journal. The journal
is therefore referred to as “The book of original entry”.
The process of recording a business transaction in the accounting record is called
journalizing.
The Journal commonly used to record all t ypes of transactions is the General Journal. This
Journal includes the following parts, entered step by step.

1. The date of the transaction

2. The title of the account debited
3. The title of the account credited
 4. The amount of debit and credit
5. Brief explanation of the entry or reference to the source document.

Look at the following General Journal and notice where each of the above information is

found.

Journal page

Date Description P .R Debit Credit

Year
Month day Debited account title XXX XX
Credited account title X XX XX
Explanation
There are also other t ypes of Journals like, known as special journals that are used to record
specific t ypes of transactions. The cash Journal, for instance, is used to record onl y transactions
affecting cash. The General Journal is used for illustrations in this chapter. Special journals are
discussed in unit 5.
Steps in Journalizing a Transaction
The following steps should be followed in recording a transaction in the journal.
1. Record the date - Insert the year, the month, and the date as shown above.
2. Record the Debit- Insert the account debited in the description column and the amount of
debit in the debit column.
3. Record the credit- Insert the account credited below the debited account and indented to
the right in the description column and the amount of credit in the credit column.
4. Explanation- Write a brief explanation or reference to source document in the
description column, when necessary.
Each one set of debits and credits for a transaction is called a journal entry.
In recording a business transaction answer the following questions based on the transaction to
be recorded may help yo u.
a) Which accounts are affected?
b) Is each account increased or decreased?
c) Which account is debited and which is credited?
d) Prepare the complete journal entr y.
Example on January 10, 2003 Tamget P.L.C paid Birr 6,000 to its emplo yees as a salar y for the
first week of the year.
This business transaction will be anal yzed and recorded as follows.
a) Which accounts are affected? Answer: Cash and Salary Expense.
b) Is each account increased or decreased? Answer: cash is decreased and salary expense is
increased.
c) Which account is debited and which is credited? Answer: Salary Expense is debited
because increase in expenses is recorded on the debit side. And cash is credited because
decrease in assets is recorded on the debit side.
d) Prepare the complete Journal entry.

2003 Description
Jan. 10 Salary expense 6000 00
Cash 6000 00
 Payment of salar y
Note: A journal entry is the complete presentation of the record in the journal.

S e lf C h e c k E x e r c i s e - 2
Journalize the following transaction b y answering 4 questions suggested above.

1. On January 11, 2003 Tamggeet bought a building for Birr 150,000 on credit.

__________________________ __________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
Illustration
To illustrate the complete accounting cycle, we will consider the following list of selected
transactions. The transactions were completed b y Zumbara Transport in the month of January
2003.
January 1. Ato Husen took Birr 450,000 from his personal savings and deposited it in the name
of zumbara transport.
January 2. Zumbara Transport purchased two used trucks for Birr 150,000 each, on cash.
January 4. zumbara Transport received a check for Birr 650 for services given to Abenezer

Trading.
January 4 Received an invoice for truck expenses Birr 90.
January 11. Paid Birr 600 for Awash Insurance Compan y to bu y an insuraan nce polic y fo r its
trucks
January 16. Ato Husen issued a check for Birr 9,400 to the workers as a salary for
two weeks.
January 20. Abenezer trading Billed Muradu Supermarket for goods transported from
Djibouti to Gondar Birr 2,650
January 21. Ato Husen wrote a check for birr 450 to have one of the trucks repainted
January 21. Abeneze trading purchased stationary materials and other supplies of Birr 740 on
account
January 22. Office equipment of Birr 11,600 is bought on account.
January 23. Purchased an additional truck for Birr 250,000 paying birr 100,000 in cash
and issuing a note for the difference.
January 23. Recorded services billed to customers on account birr 14,600.
January 25. Received cash from customers on account Birr 15,000
January 27. The owner withdrew Birr 500 in cash for his personal use.
January 28. Paid Birr 9,400 to workers as a salary for the last two weeks of the month
January 30. Paid telephone ex pense of Birr 95 and electric expenses of Birr 125 for the
m ont h
January 30. Paid other miscellaneous expenses Birr 50
January 31. Paid Birr 4,000 as a rent for a building used for office space

These transactions are journalized as follows:

Date Description Debit Credit
2003 Cash 4 5 0 ,0 0 0
Jan.1 Husen Capital 4 5 0 ,0 0 0
To record investment b y owner
2 Truck 3 0 0 ,0 0 0
Cash 3 0 0 ,0 0 0
Purchase of trucks
4 Cash 650
Service Income 650
Cash received from customers
4 Truck Expenses 90
Accounts Pa yable 90
Service received in advance
11 Prepaid Insurance 600
Cash 600
Purchase of insurance policy
16 Salary Expense 9 ,4 0 0
Cash 9 ,4 0 0
Payment of salar y
20 Accounts Receivable 2 ,6 5 0
Service Income 2 ,6 5 0
Provision of service
21 Truck Expense 450
Cash 450
Cash paid to repaint truck
21 Supplies 740
Accounts Pa yable 740
Purchase of supplies of account
22 Office Equipment 1 1 ,6 0 0
Accounts Payable 1 1 ,6 0 0
Purchase of equipment
23 Truck 2 5 0 ,0 0 0
Cash 1 0 0 ,0 0 0
Notes Payable 1 5 0 ,0 0 0
Purchase of truck
23 Accounts Receivable 1 4 ,6 0 0
Service Income 1 4 ,6 0 0
Provision of service on account
25 Cash 1 5 ,0 0 0
Accounts Receivable 1 5 ,0 0 0
Collection of cash
27 Drawings 500
Cash 500
 Owner withdrawals
28 Salary Expense 9 ,4 0 0
Cash 9 ,4 0 0
Payment of salar y
30 Utilities Expense 220
Cash 220
Payment for telephone, electricity
30 Miscellaneous Expenses 50
Cash 50
Payment for various expenses
31 Rent Expense 4 ,0 0 0
Cash 4 ,0 0 0
Payment of Rent
2.7 Posting from the Journal to the Ledger
After the information about a business transaction has been journalized, that information is
transferred to the specific accounts affected b y each transaction. This process of transferring
the information is called posting.
An account could be of two t ypes; the two-column account and the four-column account. We
will use the four-column account for our illustration. The two forms of accounts are given
below.
The two-column account:
Account Account number

Date Item P.R Debit Date Item P.R Credit

The four-column account:

Account Account number

Date Item P.R Debit Credit Balance

Debit Credit

The steps in posting are given below:

1. Record the date and amount of Dr. and Cr. Entry to the account
2. Insert the Journal page number in the P.R (Post Reference) column of the account.
3. Insert the account number in the P.R column of the journal.
Note. The P.R Column is used for reference purposes. The P.R column of the journal shows
whether the entr y is posted and the account to which it is posted. In the account, the P.R
Column shows the Journal page number from which the entr y was brought.
The group of accounts used b y an organization is called ledger.
Illustration As mentioned above, to illustrate the posting process the four column account is
used and the entries to the cash account are posted as follows.
Account Cash Account Number

Balance
Date Item P .R Debit Credit Debit Credit
2003 4 5 0 ,0 0 0 00 4 5 0 ,0 0 0 00
Jan 1
2 3 0 0 ,0 0 0 00 1 5 0 ,0 0 0 00
4 650 00 1 5 0 ,6 5 0 00
11 600 00 150050 00
16 9 ,4 0 0 00 140650 00
21 450 00 140200 00
23 1 0 0 ,0 0 0 00 40200 00
25 1 5 ,0 0 0 00 55200 00
27 500 00 54200 00
28 9 ,4 0 0 00 45300 00
30 220 00 4 5 ,0 8 0 00
30 50 00 4 5 ,0 3 0 00
31 4 ,0 0 0 00 4 1 ,0 3 0 00

Note. The item column is usually left blank. In some cases the word balance is written
when the account is carried forward to a new page.

S e lf C h e c k E x e r c i s e - 3
Rule the other accounts used b y Zumbara Transport and post the respective Dr. & Cr. entries
(Hint 17 accounts, including cash, are used b y zumbara Transport). Don’t continue without
doing this because the following discussion assumes as you have done this exercise!
___________________________________________________________________________

___________________________________________________________________________

___________________________________________________________________________

___________________________________________________________________________

2.8 The Trial Balance

After the posting phase is completed, we have to verif y the equalit y of the debit and credit
balances. This is done through the use of the ‘Trial Balance’. A trial balance is a two column
listing of the accounts in the ledger and their balance to make sure that the total of debit balances
equals the total of credit balances.
The trial balance for our illustration, Bati Transport is presented bellow. The amounts are taken
from the balances of the accounts after all the transactions have been posted. Therefore, after
posting the above transactions, you should get the final balances shown on the trial balance in
the end.
 Zumbara Transport

Trial Balance

January 31, 2003

Cash 4 1 ,0 3 0 00
Accounts Receivable 2 ,2 5 0 00
Supplies 740 00
Prepaid Insurance 600 00
Office equipment 1 1 ,6 0 0 00
Truck 5 5 0 ,0 0 0 00
Accounts pa yable 1 2 ,4 3 0 00
Notes pa yable 1 5 0 ,0 0 0 00
Husen capital 4 5 0 ,0 0 0 00
Husen drawing 500 00
Service income 1 7 ,9 0 0 00
Salary expense 1 8 ,8 0 0 00
Rent expense 4 ,0 0 0 00
Utilities expense 220 00
Maintenance expense 450 00
Truuck expense 90 00
Miscellaneous expense 50 00
Total 6 3 0 ,3 3 0 00 6 3 0 ,3 3 0 00
2 . 8 . 1 P r o o f P r o v i d e d b y t h e T r ia l B a l a n c e
The trial balance debit totals and credit totals are equal implies that the accounting work is
more likel y to be free from any one or more of the following errors.
1. Error in preparing the trial balance including
-Addition error
-The amount of an account balance was in correctly listed on the trial balance
- A debit balance was recorded as a credit or vice versa
- A balance was entirel y omitted.
2. Error in posting, including

- An erroneous amount was posted to the account.

- A debit amount was posted as a credit or vice versa
- A debit or credit posting was omitted
 2.8.2 Limitations of the Trial Balance
The trial balance amounts are equal doesn’t mean that the accounting work is free from error.
That is, there are errors that may take place without affecting the trial balance totals. Some
examples are mentioned below:
- Failure to record a transaction or to post a transaction
- Recording the same erroneous amount for both the debit and the credit parts of a transaction.
- Recording the same transaction more than once.
- Posting part of a transaction to the correct side but the wrong account.
Note: All these errors have the same affect (increasing or decreasing) on the debit totals and
credit totals
2.9 Adjustments
All the transactions recorded above in the journalizing step are the result of dail y transactions.
Other transactions result from the passage of time or from the internal operations of the business.
For example, insurance premiums are paid for a certain period of time and expire during that time
period. Another example is office supplies such as paper, pens & pencils.
At the end of the period the balances in accounts such as supplies and prepaid insurance must be
brought up to date. The supplies account balance, for example, must be credited b y the
consumed part of the supplies, debiting supplies expense.
Example. Stationary materials totaling Birr 1,900.00 were purchased and recorded during the
year. At the end of the year, onl y Birr 150 of the supplies are left in hand.
The adjusting entr y prepared at the end of the year to adjust the supplies account will be

1990 Supplies
expense
Dec31 Supplies 1 ,7 5 0
Note: 1. Adjustments are dated as the last da y of the year.
2. The accounting year here – we assume, runs from January 1- December 31.
Additional examples on adjustments will be given below under the topic ‘worksheet’

2 . 9 . 1 T h e A c c r u a l B a s is a n d t h e C a s h B a s i s o f A c c o u n t in g
1. The cash basis of accounting – In this basis of accounting revenues are reported in the period
in which cash is received and expenses are reported in the period in which cash is paid. Net
income will, therefore, be the difference between the cash receipts (Revenues) and cash payments
(expenses). This method will be used b y organizations that have ver y few receivables and
payables. For most businesses, however, the cash basis is not an acceptable method.
2. The accrual basis of accounting – Under this method revenues are reported in the period in
which they are earned, and expenses are reported in the period in which they are incurred. For
example, revenue will be recognized as services are provided to customers or goods sold and not
when cash is collected. Most organizations use this method of accounting and we will appl y this
method in this course.
2 . 9 . 2 T h e M a t c h i n g P r in c i p le
We have discussed three concepts and principles in accounting in unit one. Now we will see one
more principle, the matching principle. This principle states that the expense of a period have to
be matched with the revenue of that period regardless of when payment is made. In order to do
this, the accrual basis of accounting requires the use of an adjusting process at the end of the
 period so that revenues and expenses of the period will be determined properl y.
2.10 Worksheet for Financial Statements
Most of the data required to prepare the accounting reports (financial statements) is now gathered. The data
will now be presented in a convenient form. The worksheet is a large columnar sheet prepared to arrange in
a convenient form all the accounting data required to prepare financial statements. The worksheet has a
heading and a bod y.
The heading has three parts:
i) Name of the Organization
ii) Name of the form (worksheet)
iii) Period of time covered.
The bod y contains five main parts each of them with two main columns. These parts are
1. The trial balance
2. The adjustment
3. The adjusted trial balance
4. The income statement
5. The balance sheet.
The worksheet for Bati Transport is given below. The five parts of the bod y are discussed as
follows. You are advised to read and understand the discussions before you look at the respective
columns of the worksheet.

Zumbara Transport
Work Sheet
For th3e month ended jan.31,2003
Account Title Trial Balance Adjust ment Adjusted Trial Inco me Balance sheeet
balance statement
1 Cash 4 1 ,0 3 0 4 1 ,0 3 0 4 1 ,0 3 0
©
2 Acco unts receivable 2 ,2 5 0 7 ,4 0 0 9 ,6 5 0 9 ,6 5 0
(a )
3 Supplies 740 340 400 400
(b)
4 Prepaid Insurance 600 450 150 150
5 Office equip ment 1 1 ,6 0 0 1 1 ,6 0 0 1 1 ,6 0 0
6 T ruck 5 5 0 ,0 0 0 5 5 0 ,0 0 0 5 5 0 ,0 0 0
7 Acco unts payable 1 2 ,4 3 0 1 2 ,4 3 0 1 2 ,4 3 0
8 Notes payable 1 5 0 ,0 0 0 1 5 0 ,0 0 0 1 5 0 ,0 0 0
9 Yimer Capital 4 5 0 ,0 0 0 4 5 0 ,0 0 0 4 5 0 ,0 0 0
10 Yimer dra wing 500 500 500
©
11 Service inco me 1 7 ,9 0 0 7 ,4 0 0 2 5 ,3 0 0 25300
12 Salary expense 1 8 ,8 0 0 1 8 ,8 0 0 1 8 ,8 0 0
13 Rent expense 4 ,0 0 0 4 ,0 0 0 4 ,0 0 0
14 Utilities expense 220 220 220
15 Maintenance expense 450 450 450
16 T ruck expense 90 90 90
17 Miscellaneous 50 50 50
Expense
18 6 3 0 ,3 3 0 6 3 0 ,3 3 0
(a )
19 Supplies expense 340 340 340
(b)
20 Insurance expense 450 450 450
21 7290 7290 6 3 6 ,8 3 0 6 3 6 ,8 3 0
22 Net inco me
23 25300 25300 6 1 3 ,3 3 0 6 1 3 ,3 3 0
 1. The trial balance column – this is the same trial balance we have prepared before. The trial
balance column of the work sheet can be brought direct from the ledger or from a separate
trial balance.
2. The Adjustment column – As mentioned previously, some account balances have to be
adjusted at the end of the year.
The accounts in the ledger of our illustration that require adjustment and the adjusting entr y for
the accounts are presented below.
a) Supplies – The supplies account has a debit balance of Birr 740. The cost of supplies in
hand on July 31 is determined to be Birr 400. The following adjusting entry is required to
bring the balance of the account up to date:
Supplies expense…………………………….340
Supplies……………………………………..340
b) Prepaid insurance – Analysis of the polic y showed that three – fourth of the polic y is
expired. That is only Birr 150 of the policy is applicable to future periods. The adjusting
entry to transfer the expired part of the insurance to expense will be.
Insurance expense ……………………….450
Prepaid insurance………………………..450
c) Service Income – At the end of the month unbilled fees for services performed to clients
totaled Birr 6,500.
This amount refers to an income earned but to be collected in the future. The journal entry to
record it will be
Accounts receivable………………………….6, 500
Service income………………………………6,500
All the above adjusting entries will be inserted in the adjustment column of the worksheet
in front of the accounts affected.
Note – The letters a, b & c are used to cross-reference the debits and credits to help future
review of the workshop.
3. The Adjusted Trial Balance Column – The accounts that require adjustment are now
adjusted. Transferring the trial balance column amounts combined with the
adjustment column amounts will complete the adjusted trial balance column of the
worksheet.
4. The income statement and the balance sheet columns – Transfer the income
statement account balances (revenue &expenses) to the income statement and balance sheet
account balances (Asset, Liability &owners equit y) to the balance sheet columns. Note that
what we have to transfer is the adjusted trial balance column amounts, to the corresponding
columns.
Look at the 22nd row. It shows the net income for the month and it is added to the two
columns (Income statement Dr. and balance sheet cr.) as a balancing figure.
2.11 Financial Statement Preparation
After the work sheet is completed financial statements could be prepared easily. In chapter one
we have discussed four basic financial statements prepared b y most organizations. Here, we
will prepare three of these statements for Bati Transport form the worksheet.
1. Income statement All the data required to prepare the income statement is brought
from the worksheet.
Zumbara Transport

Income statement

For t he month ended. Jan 31, 2003

Service Income …………………………………………………………Birr 25,300
Operating expenses
Salary expense………… ……………..Birr 18,800
Rent “…………………………………….4, 000
Maintenance expense ……………………… 450
Insurance “……………………………450
Supplies “…………………………….340
Utilities “……………………………..220
Truck “……………………………...90
Miscellaneous “………………………………50
Total operating expense………………………………………24,400
Net Income…………………………………………………Birr 900
2. Statement of owner’s equity – This statement shows the beginning balance of capital and
the changes that affected it.
The balance of the owners equity account (Hussein capital) in the worksheet may not be the
beginning one. Therefore, the ledger has to be reviewed to see if there was an additional
investment during the period or not. In our illustration there is no additional investment.
Zumbara Transport

Statement of Owner’s equity

For the month ended January 31, 2003
Hussein capital January 1, 2003………………………………Birr 450,000
Net income for the month………………….birr 900
Less: Withdrawal…………………………………...500 4 00
Husen capital, January 31, 2003……………….…………….Birr 450,400
3. Balance sheet – The data to prepare this statement will be taken from the worksheet and the
other financial statements. Note that assets and liabilities are classified as current and non
– current.
 Zumbara Transport
Balance sheet
January 31, 2003

Assets
Current Assets

Cash…………………………………………Birr 41, 030

Accounts Receivable…………………………….. 9,650
Supplies…………………………………………… 400
Prepaid insurance…………………………………….150
Total current assets……………………………………………Birr 51,230
Plant Asset (None-Current Assets):
Office equipment……………………………..Birr 110,600
Truck………………………………………………550,000 5 6 1 ,6 0 0
Total asset………………………………………………………Birr 612,830

Liabilities

Current liabilities
Accounts payable……… ……………………..Birr 12,430
Non-current liabilities
Notes pa yable……………………………………..150,000
Total liabilities……………………………………………………Birr 162,430
Owner’s equity
Ato Husen Capital…………………………………………………………….. 450,400
Total liabilit y and owners equity………………………………………….Birr 612,830
2.12 The Closing Process

Some of the accounts in the ledger are temporar y accounts used to classify and summarize the
transactions affecting capital (owners’ equit y). These accounts will be closed after financial
statements are prepared. That is, their balances will be transferred to the Capital account. The
temporary accounts that have to be closed are revenue, expense and withdrawal accounts.
Steps in closing
1. Closing revenue accounts - Debit each revenue account b y its balance and credit the

‘Income Summar y’ account b y the total revenue for the period.

Note: Income summar y is an account used to close revenue and expense accounts. This
account will immediatel y be closed to the capital account at the end of the closing process.
2. Closing expense accounts – Debit the income summary account b y the total of expenses for
the period and credit each expense account b y its balance.
3. Closing the income summary account – Income summary will be closed to the capital
account. The balance of his account depends on the nature of operation; credit if result is
profit and debit if result is loss.
4. Closing Withdrawal – Debit the owners equity account b y the total of drawings for the
period and credit the drawing account.
The temporar y accounts of zumbara transport are closed as follows.
2003 Income summary………………….25, 300
January Service income…………………………………25,300
31 Closing revenue
31 Salary expenssee………………………..18,800
rent expense……………………………4,000
Maintenance ex pense………………….. 450
Insurance expense………………………..450
Supplies expense…………………………340
Utilities expense………………………….220
Truck expense ………… ………………… 90
Miscellaneous expense…………………….50
Income expense…………………………………24,400
Closing exxp
penses
2003 Income summary………………900
January 31 Husen Capital………………………..900

Closing income summary

31 Husen capital…………………...500
Husen drawing………………………..500
Closing withdrawal
The above closing entries have transferred the balance of the temporary accounts to the
permanent capital account.

S e lf c h e c k E x e r c is e - 4
Post all the above closing entries and recomputed the balance of all the accounts affected.
___________________________________________________________________________
___________________________________________________________________________
_____________________________________________________________________
2.13 Post Closing Trial Balance

After the closing entries have been journalized and posted, a trial balance is prepared to prove
the equality of the general ledger before recording the New Y ear’s transactions. It should be
noted that this trial balance includes onl y balance sheet accounts. This is because the
temporary income statement accounts are closed during the closing process. This trial
balance is called the post – closing trial balance.
In practice the ledger balance after closing ma y be checked b y a simple calculator print out
rather than a formal trial balance. The post closing trial balance for Bait Transport is
presented below.
 Zumbara Transport
Post – Closing trial balance
Jan 31, 2003

Cash……………………………………………Birr 41,030
Accounts Receivable ………………………………...9,650
Supplies…………………………………………………400
Prepaid insurance……………………………………….150
Office equipment……………………………………11,600
Truck……………………………………………….550, 000
Accounts payable……… …………………………………………….Birr 12,430
Notes pa yable……………………………………………………………..150,000
Husen capital……………………………………………………………..450,400
Total……………………………………Birr 612,830 Birr 612,830
2.14 Summary
Accountants go through a number of step-b y-step procedures to record transactions and to summarize the
records in to useful reports in a s ystematic manner. These procedures that accountants go through from
the time a transaction is identified until the time financial statements are prepared are to gether called
the accounting c ycle. The accounting c ycle is summarized below:

In p u t Process Output

1. When a transaction happ 2. Transactions are recorded in the journal 7.Preparing financial statements
documents are pr 3.Posting to individual accounts
4.Preparing a trial balance after
determining the balance of each ledger
account
6.preparing and completing the work
sheet with adjustments
8.Adjustments are journalized and posted
9.Closing entries are journalized and
posted
10.A post closing trial balance is
prepared
 2.15 Answers Key to Self Check
Ex e r c i s e
Self Chec
eck
Exercise - 1
Expenses are found on the right hand side of the accounting equatiio on; they are
elements of
the owners equit y account. When expenses increase capital will decrease and vice
versa. Because of this reverse effect of expenses on capital they increase on the Dr.
sided and decrease on the Cr. side, unlike other right hand side accounts.
Self Check
Exercise - 2 a) Building
and Accounts payable b)
Both accounts are
increased.
c) Building is debited and accounts payable is
credited d) Journal entry:
2003, Building……………………………150,000

Jan 11 Accounts payable…………………………..150,000

Purchase of building on credit.

Self Check Exerciseise - 3

Prepare a four – column account for each account and post the respective entries to the accounts.
Compare the ending balance of each account in your answer with their balance in the trial
balance.
Self Check Exerciseise - 4
After all the closing entries are posted all temporary accounts will have zero balances. On the
other hand, permanent accounts will have non- zero balances. Example: Yimer Capital = Birr
450,400, supplies Birr 400.
A complete list of the permanent accounts and their balances is given on the post – closing trial
balance.

2 .1 .6 . Self Test Exam Questions

1. Indicate whether each of the following items below is an asset, liability, revenue, expense,
gain or loss account and whether it appears in the balance sheet or income statement.
a) Office furniture
b) Income from services
c) Salaries paid to workers
d) Supplies on hand
e) Salar y pa yable to workers
f) Cash
g) Income from sale of a used truck
h) Goods damaged b y fire in the store
2. Given below is a list of selected transactions performed b y John Décor during the month of
September 2002, the first month of operation.
a) Record the transactions in General Journal
b) Post each entr y to the perspective account. Use the four – column account. c)
Prepare a trial balance
d) Prepare a worksheet. Assume the following adjustment for the accounts and
journalize them.
e) Prepare a Balance sheet, Income statement and statement of owner’s equity
f) Close the temporar y accounts.
Sept. 10 Mr. John transferred cash from his personal account to be used in the business,
Birr 10,000.
“ 10 Paid rent for the month, Birr 500
“ 11 Purchased a truck for Birr 12,000 b y paying Birr 3,000 Cash and giving a notes
payable for the difference.
“12 Purchased equipment on account Birr 1,460
“13 purchased supplies on account Birr 240
“14 Paid insurance premiums of Birr 170 (Dr. prepaid insurance)
“15 Received cash for services completed Birr 360
“16 Purchased Supplies on account Birr 240
“18 Paid salaries of Birr 900
“21 aid its liabilities for the purchase of equipment
“24 Recorded sales on account Birr 2,080
“26 Received an invoice for truck expense Birr 115
“27 Paid utilities expense Birr 205.
“27 Paid miscellaneous expenses Birr 73.
“ 28 Received cash from customers on account birr 1,420 “
30 Paid salaries to employees Birr 950
“ 30 the owner withdrew Birr 1, 750 for personal use.
3. The trial balance of Seni Beaut y Saloon does not balance. The errors in the accounting work
are given below. Determine the correct balance of each account and prepare the
corrected trial balance.

Seni Beauty Saloon

Trial balance

April 30

Cach 5 ,9 0 2 .0 0
Accounts Receivable 6 ,3 0 0 .0 0
Supplies 1 ,6 0 0 .0 0
Equipment 5 ,2 0 0 .0 0
Accounts pa yable 4 ,3 0 0 .0 0
Bett y capital 1 0 ,0 0 0 .0 0
Service income 4 ,7 0 0 .0 0
 Operating expenses 1 ,9 8 0 .0 0
Total 2 0 ,9 8 2 .0 0 1 9 ,2 0 0 .0 0
The errors are the following:
• Cash received form a customer on account was recorded (both debit and credit) as birr
• 1,400 instead of Birr 1,120
• The purchase on account of an equipment costing Birr 780 was recorded as a debit to
• operating expense and credit to accounts payable.
• Service was performed to clients Birr 1,780 for which accounts Receivable was
• debited birr 1,780 and service income was credit birr 178
• A payment of Birr 80 for telephone charges was debited to Operating Expense and it
was also debited to cash
• The ledger balance of the service income account is birr 4,700 rather than Birr 4,720.
4. As of Sene 30 1994, the end of the current fiscal year, the accountant for DH Geda
General Trading completed the worksheet before journalizing and posting the
adjustments.
Required: (a) Compare the adjusted and unadjusted trial balances and prepare the eight
journal entries that were required to adjust the accounts.
(b) Prepare the journal entries that were required to close temporar y accounts.

DH Geda General
Trading
Trial
Balance
Sene 30,
1994
Un adjusted Adjusted
Cash 1 2 ,8 2 5 .0 0 1 2 ,8 2 5 .0 0
Supplies 8 ,9 5 0 .0 0 3 ,6 3 5 .0 0
Prepaid rent 1 9 ,5 0 0 .0 0 1 ,5 0 0 .0 0
Prepaid insurance 3 ,7 5 0 .0 0 1 ,2 5 0 .0 0
Equipment 9 2 ,1 5 0 .0 0 9 2 ,1 5 0 .0 0
Accumulated depreciation equipment 5 3 ,4 8 0 .0 0 6 6 ,2 7 0 .0 0
Automobile 5 6 ,5 0 0 .0 0 5 6 ,5 0 0 .0 0
Accumulated depreciation automobile 2 8 ,2 5 0 .0 0 3 6 ,9 0 0 .0 0
Accounts pa yable 8 ,3 1 0 .0 0 8 ,7 3 0 .0 0
Salary pa yable 3 ,4 0 0 .0 0
Tax Payable 1 ,2 2 5 .0 0
Ato Degaga capital 4 1 ,2 4 5 .0 0 4 1 ,2 4 5 .0 0
Ato Degaga drawing 1 8 ,6 0 0 .0 0 1 8 ,6 0 0 .0 0
Service income 2 6 1 ,2 0 0 .0 0 2 6 1 ,2 0 0 .0 0
Salary Expense 1 7 2 ,3 0 0 1 7 5 ,7 0 0 .0 0
Rent Expense 1 8 ,0 0 0 .0 0
Supplies Expense 5 ,3 1 5 .0 0
Depreciation Expense Equipment 1 2 ,7 9 0 .0 0
Depreciation Expense Automobile 8 ,6 5 0 .0 0
Utilities Expense 4 ,7 0 0 .0 0 5 ,1 2 0 .0 0
Taxes Expense 1 ,5 0 0 2 ,7 2 5 .0 0
 Insurance Expense 2,500.00
Miscellaneous Expense 1 ,7 1 0 .0 0 ____ 1,710.00 ____
Total 3 9 2 ,4 8 5 .0 0 3 9 2 ,4 8 7 .0 0 418,970.00 4 1 8 ,9 7 0 .0 0
2.17 Glossary of Terms
Account –a record showing separatel y the increases and decreases of a financial statement
item during a period.
T account- the simplest format of an account, which resembles the letter ‘T’.
Chart of Accounts- a list of the account s used b y an organization and their cco odes.
Debit- the left side of an account
Credit- the right side of an account
Source Documents- documents such as an invoice or a cash receipt voucher that evidence the
occurrence of a transaction.
Journal- a book or record where a transaction’s full debits and credits and other details are first
recorded.
Journal Entry-the debits and credits recorded in the journal for one transaction.
Ledger- a book, where increases and decreases in each account are separately recorded. It is
therefore the collection of the individual accounts of an organization.

Trial Balance – a form showing the final balance of each ledger account. It is used to
somehow check if an y errors were made during the period.
Work Sheet –a working paper that accountants use to collect adjustment data and to easl y
prepare the financial statements.
Adjustments – entries required to up-date some accounts before preparing financial
statements.
Post Closing Trial Balance- a trial balance prepared after all the accounts have been closed

References

• Fees and Warren, A

Accounting principles 18th edition. (Text book)
• Merges’ and Mergss, Introduction to Accounting, 9th edition
n.
• Harman son, Edwaards & Maher Accounting principles, 5th Ed,1992, USA
• Any Accounting priinciple book can be used as a reference
 UNIT THREE
ACCOUNTING FOR MERCHANDISING BUSINESSES
3.0 Aims & Objectives
3.1 Introduction
3.2 Nature of a Merchandising Business
3.2.1 What is a Merchandising Business
3.2.2 Comparison of Financial Statements for Merchandising and Service
Bu s i n e s s e s
3.3 The Periodic and the Perpetual Inventor y S ystems
3.3.1 The Periodic Inventory System
3.3.2 Perpetual Inventory S ystems
3.4 Recording Purchase and Sales Transactions
3.4.1 Recording Sales
3.4.2 Recording Purchases
3.5 Completing the Worksheet for a Merchandising Business
3.6 Preparing Financiiaal Statements for Merchandising Businesses
3.7 Summary
3.8 Answers to Check Your Progress Questions
3.9 Sample Examination Questions
3.10 Glossar y of Terms
3.11 References
3.0 Aims & Objectives

After stud ying this unit, you should be able to:

Describe what a merchandising business is and compare it to a service giving
business.
describe the difference between the two alternative s ystems of recording inventor y
(periodic and the perpetual inventory s ystems)
record journal entries for merchandising transactions such as the purchase and sale of
merchandise
complete the worksheet of a merchandising business and record adjustment journal entries
related to the Merchandise Inventor y account
prepare financial statements for a merchandising business
3.1 Introduction

In the previous chapters, you saw how to record transactions of a service business. The steps
that we go through to prepare the financial statements of other t ypes of businesses (such as a
merchandising business) are basicall y the same. Transactions are first journalized, and then
posted to the ledger; a worksheet is prepared and completed…. But, there are some transactions
in merchandising companies that you don’t find in a service giving business, like the purchase of
goods for sale and the sale of those goods. The first section of this chapter, therefore, discusses the
nature of a merchandising business and how to record merchandising transactions. The next
section discusses about the preparation of financial statements for merchandising companies.
 LESSON -ONE: RECORDING MERCHANDISING TRANSACTIONS
3.2 Nature of a Merchandising Business
3 . 2 . 1 W h a t i s a M e r c h a n d is in g B u s i n e s s ?
A merchandising business buys goods in finished form for resale to customers.
A merchandising business sells tangible goods to its customers. When we say goods it can be
anything that has ph ysical characteristics that you can see and touch (i.e., tangible). These can
be goods ranging from television sets, cars, office table and chair (furniture), to chewing
gums, toothbrushes and various stationery. These goods that a merchandising compan y sells to
its customers are called merchandise inventory. (A customer is an individual or a firm to
whom a business sells its products.)
One final thing that you should know about a merchandising business is that a merchandising
compan y does not produce the goods that it sells. Instead, it bu ys these goods from
manufacturers, which produce the goods using raw materials.
The following diagram can help you to better visualize the flow of goods from a manufacturer
to the final consumer.

Sells Merchandising companies

ManufactureW holesale Sell Retailer Final consumer

Goods goods
A wholesaler is a trader, which bu ys goods from manufacturers and sells them to a retailer or
another wholesaler. It is the retailer who sells the goods to the final consumer b y bu ying them
from wholesalers (or sometimes from a manufacturer).
When you want to bu y a soap to wash your clothes, where do you buy it? Who is the
manufacturer of the soap? Are there an y wholesalers of that soap in your area? Can the
wholesaler be taken as the customer of the manufacturer? And finally, can we say the shop from
which you bu y the soap is a merchandising business?
3.2.2 Comparison of Financial Statements for Merchandising and Service
B u s in e s s e s
Income Statement
A model income statement for a merchandising business and another one for a service
business are shown below. Compare them carefully.
 ABC service compan y XYZ merchandising
Income statement Income statement
For the year ended Dec.31, 200x For the year ended Dec.31, 200x
Revenue: Revenue:
Service fee………………….Birr 23,200 Net Sales…………………Birr 360,000
Cost of goods sold…………….(256,000)
Gross Profit …………………….104,000
Expenses: Various Operating
Various Operating Expenses (7120) Expenses……………………….(79,400)
Net Income 16080 Net Income ……………………..24,600

As you can see from the above Income Statements, merchandising companies have to pay to
buy the goods that they sell. Therefore, the y have to deduct this cost of goods sold in addition to
other operating expenses from their sales revenue to determine their net income.
The difference between sales revenue and cost of goods sold is referred to as gross profit. Wh y
‘gross’? Because other expenses have yet to be deducted to arrive at the net profit or net income
of the business.
Balance
Sheet
The Balance Sheet of a service business and that of a merchandising business are similar in
every aspect except one thing. The current assets section of the Balance Sheet of a
merchandising business includes one asset that service companies do not have. That is
merchandise inventor y. Merchandise inventor y refers to goods bought by a merchandisin g
business for resale to customers. So, if a merchandising business has some unsold goods
(merchandise) on hand at the end of the year this would be reported as one asset on the
Balance Sheet.
3.3 The Periodic and the Perpetual Inventory Systems
The value of goods (merchandise) on hand at the end of the year for resale would be reported on
the Balance Sheet as one asset as described above. This means that we need to open a separate
ledger account in which to record merchandise inventory information.
The two alternatives in dealing with this account are:
1. To update this account every time goods are bought and sold (continuously =
perpetuall y) or
2. To update this account onl y at the end of the period (periodicall y).
3 . 3 . 1 T h e P e r io d ic I n v e n t o r y S y s t e m
Under this s ystem, as the name periodic suggests, the inventory account is updated only
periodicall y i.e., onl y at the end of a period.
When goods are bought, a temporary purchases account is debited instead of the inventor y
account itself. Likewise, when goods are sold revenue is recorded, but the fact that there is a
reduction in merchandise inventory is not recognized. This is because the Merchandise
Inventor y account is not credited every time goods are sold.
Therefore, if one wants to know the cost of goods on hand, it is a must that a ph ysical inventory
be conducted first. The account doesn’t reflect the value of goods on hand because it was not up
dated when merchandise was bought and sold. Physical inventory means counting the quantit y
of goods on hand. Once the quantit y of goods on hand has been determined, it is multiplied b y
the unit price of those goods to determine the cost of goods on hand.
In conclusion, under the periodic s ystem, since the merchandise inventory account is not
continuall y updated, the cost of merchandise on hand is determined only at the end of the period
after carr ying out a ph ysical inventory.
Companies such as department stores or ‘super markets’, which sell small itteems, use periodic
systems.
3.3.2 Perpetual Inventory Systems
A perpetual inventory system continuousl y records the amount of inventory on hand
(perpetual =continuous). Under this s ystem, the merchandise inventor y account is debited or
credited every time (goods) aarre bought or sold. When an item is sold, its cost is recorded in a
separate cost of goods sold accccount in addition to recording sales.
The cost of merchandise on hand can be looked up from the merchandise Inventory account an y
time, without conducting a ph ysical inventory.

S e lf C h e c k e x e r c is e y o u ’ r e - 1
If you have a supermarket business, would you use the perpetual or periodic s ystem? What if
your s ystem is computerized? Explain.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
3.4 Recording Purchases and Sales Transactions

The following discussions in the remainder of this chapter all assume the use of a periodic
inventory s ystem. The perpetual s ystem will be discussed in part two of this course
3 . 4 . 1 R e c o r d in g S a le s
When a merchandising compan y transfers goods to the buyer, in exchange for cash or a promise
top at a later date, revenue is produced to the company. This revenue is reeccorded in a Sales
account. However, the sales revenue, which is reported on the Income Statement is Net Sales.
That is,
Net Sales = Gross Sales – Sales Discounts- Sales Returns and Allowances
Recording Gross Sales
The gross sales amount is obtained from sales invoices. An invoice is a document, prepared b y
the seller of merchandise to notify to the bu yer the details of the sale. These details can include
number of items sold, unit price of items, total price, terms of sale and manner of shipment.
When goods are delivered to the customer, the Sales account is credited because revenues are
increased b y credits.
A compan y can sell goods either for cash or on account.
Recording Cash Sales
When merchandise is sold on cash, the Cash account is debited and the revenue account Sales is
credited.
Example – NOKIA Compan y based in Bahir Dar, bu ys and sells used commodities.
On January 14. 2001. NOKIA sold goods for Birr 20,000. Record the transaction.
Answer:
January 14, Dr. Cash………………………………..20,000.00
Cr. Sales……………………………………20,000.00
Recording Credit Sales
The Accounts Receivable account is debited when goods are sold on account (for credit).
Example -
Ika sold goods worth Birr 35,000 on account on January 15, 2001. Record the transaction.
Solution
January 15. Accounts Receivable…………………..35,000.00
Sales…………………………………………35,000.00
Determining Gross Sales when there are trade discounts
A trade discount is a percentage deduction from the specified list price or catalogue price of
merchandise.
Trade discounts allow us:
- To avoid publishing a new catalogues ever y time prices change.
- To grant quantit y discounts
- Quotation of different prices to different t ypes of customers.
Trade discounts are not recorded in the seller’s accounting records; they are onl y used to
calculate the gross selling price.
Example: NOKIA sold 500 T.V. sets, each with a list price of Birr 80, on January 17, 2001 for
cash. It gave the customer a 30% trade discount, as the customer was a very lo yal one. Record
the sale.
Answer:
List price of goods (80 X 500) Birr 40,000
Less: Trade discount (30 % of 40,000) (12,000)
Invoice price 28,000
Journal entry:
Cash……………………..28,000

Sale………………………28,000

S e lf C h e c k E x e r c i s e – 2
1. Record the journal entry if NOKIA Compan y above sold goods with a list price of Birr
52,000 to a customer on account. NOKIA offered the customer a trade discount of 20%

for purchases above Birr 40,000 as it usually does.

Recording Deductions from Gross Sales
Go back to illustration 1- and have a look at the model Income Statement of a merchandising
compan y. You will see that the sales reported on the income statement is net sales, i.e., after
deduction of sales discounts aan
nd sales returns and allowances.

Gross sales (from invoice)…………………..XXX

Less: Sales discounts…………………………….(XX)
Sales returns and allowances ………….…..(XX)
Net sales……………………………….XX
 Sales Discounts

Sales Discounts are deductions from invoice price to customers who pay earlly y when goods are
sold on credit.
As a seller, you would usually want to be paid as soon as possible. T his is because, as
Th
you can imagine, you can use the money for various purposes once you have been paid.
If you want your customers to pay you early the customary practice is to offer them a
(deduction) discount ffrrom the invoice price if they pa y earl y.
How much discount is given usually depends on the credit terms. These terrm ms (agreements)
are usuall y stated on the invoice. The most frequently used terms are stated below:
- “n/30” or “Net 30” – means there is no discount even if the customer pa ys before the
payment date.
- 2/10, n/30 –means the due date of the pa yment is after 30 da ys of the sale. But if the
customer pa ys within 10 days she will get a 2% discount.
- 2/EOM, n/60- means the normal due date is within 60 days of the sale but the
customer will get a 2% discount if she pays before the end of month of sale.

S e lf C h e c k E x e r c i s e - 3
1. What do the credit terms 1//1
15, n/60; 2/10, n/EOM; and n/60 mean?
__________________________________________________________________________
_________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

Sales discounts are purchase discounts from the side of the bu yer. Sales discounts and purchase
discounts are the same thing seen from different sides. They are generall y called cash discounts
together. A cash discount is, therefore, deduction from original invoice price for early pa yment
when goods are sold on credit (on account).
Example:

On January 21, 2001 NOKIA Compan y sold merchandise for birr 20,000 on account. The
credit terms are 2/30, n/30. The customer paid on January 31, (10 da ys after invoice date).
A. How much would NOK IA Compan y collect from this sale?
B. Record the necessar y journal entries on January 21 and January 31.
Sol ut i on:
A- Since the customer paid with in the discount period, i.e., with in 10 daay
ys, she will get a
2% discount. Therefoorre,
Invoice price……………………..20,000
Less: Sales Discount (2% X 20,000)………(400)
Cash collected …………. 19,600
B- Journal Entries:
January 21 A/R…………………..20,000
Sales……………………..20,000
January 31, Cash………………….19600
Sales Discounts ………...400
A/R………………..20,000
 You might initiall y have thought of debiting the Sales account for Birr 400 on January 31, since
the actual cash collected from the sales of those goods is birr 400 less than what was recorded as
Sales on January 21. But it is better to record the reduction in sales in a separate contra Sales
account. A contra account reduces another account. In this case, the amount in the Sales
Discount account will be deducted from (Gross) Sales on the income statement. That way, we
can disclose how much sales discount was offered and taken during the year on the income
statement, separatel y.

S e lf C h e c k E x e r c i s e - 4

NOKIA Compan y sold goods worth Birr 120,000 on account to Bita company terms 1/10, n/60
on January 18, 2001. Bita Compan y paid on January 28, 2001.
A- How much woou uld NOKIA Compan y collect from this sale?
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________

B- Record the necessar y journal entries on January 18 and on January 28.

________ ______ ______ ______ _____ _ ___ ________ ______ ______ ______ ______ __
________ ______ ______ ______ _____ _ ___ ________ ______ ______ ______ ______ __
________ ______ ______ ______ _____ _ ___ ________ ______ ______ ______ ______ __
________ ______ ______ ______ _____ _ ___ ________ ______ ______ ______ ______ __

Sales Returns and Allowances

Customers can return merchandise they have bought if they find it to be defective or of the
wrong model, or unsatisfactor y for a variet y of reasons. A sales return is merchandise returned
b y a bu yer. The bu yer would be paid back her money if she has alread y paid.
A sales allowance is a deduction from the original invoice price when the customer keeps the
merchandise but is dissatisfied. If, for example, a customer bu ys an item worth birr 100 and
finds it to be of the wrong color after receiving it, she may still want to retain the item even if
she is dissatisfied with its color. In that case the seller ma y let her pa y only, say, Birr 95 b y
giving her an allowance of Birr 5.
Example:
NOKIA Compan y sold merchandise worth Birr 15, 000 on February 3, 2001 on account terms
2/10, n/30. On February 5, the bu yer returned a portion of the goods worth Birr 5,000 as they
were found to be of the wrong model. The bu yer then paid on Februar y 13, 2001.
Record the necessar y journal entries on February 3,5 and 13.
Solution:
February 3 A/R…………………….15,000
Sales …………………….15,000
February 5 Sales Returns and Allowances ………5,000
A/R………………………………….5,000
February 13 C a s h … … … … … … … … … … … … … ..9 8 0 0

Sales Discount ……………………….. 200

A/R…………………………10,000
 Here, the bu yer paid within the discount period. Therefore, the amount that would be
collected is:
1 5 ,0 0 0 – 5 ,0 0 0 = 1 0 , 0 0 0

Deduct: 2% Cash discount (200)

Cash collected 9800

S e lf C h e c k E x e r c is e - 5
Assume the customer in the above example returned the goods on February 15 instead of
February 5, after pa ying within the discount period on February 13. Reeccord the relevant
Journal entries on February 3, 13 and 15.
________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
Now Go back to illustration (1) once again on page and you will see that we have so far been
dealing with what net sales is composed of. You should by now be able to figure out how the
net sales figure on the income statement is arrived at.
In the following section, we will see how to record purchase transactions. Keep in mind that a
merchandising compan y both buys and sells goods.
3 . 4 . 2 R e c o r d in g P u r c h a s e s
Under the periodic inventory s ystem a merchandising compan y uses the Purrcchases account to
record the cost of goods bought for resale to customers.
Example:
NOKIA Compan y bought ggo oods worth Birr 43,000 from Marshet Co., which is based in
Addis Ababa, on account on J anuary 4, 2001, terms 20/10, n/30. Record the transaction.
Solution:
January 4 – Purchases …………………..43,000

Accounts payable……… ………………..43,000

S e lf C h e c k E x e r c is e - 6

Record the same transaction for NOKIA Company if the merchandise were bought for cash.
___________________________________________________________________________
________ ______ ______ ______ ______ ___ ______ __ ______ ______ ______ ______ ___ _____
________ ______ ______ ______ ______ ___ ______ __ ______ ______ ______ ______ ___ _____
________ ______ ______ ______ ______ ___ ______ __ ______ ______ ______ ______ ___ _____
________ ______ ______ ______ ______ ___ ______ __ ______ ______ ______ __

Deductions from Purchases

Purchase Discounts
A merchandising company can bu y goods under credit terms that permit it to get a discount if it
pays within a specified period of time. The deduction from the original purchase price is
recorded in a separate contra Purchase account called Purchase Discounts.
Example:
 NOKIA Compan y bought goods worth Birr 50,000 from Asanti Company on account on
January 14, 2001, terms 1/10,n/60. NOKIA Company paid on January 24, 2001. Record the
transactions on both dates.

Solution:
Jan. 14. Purchases………………..50,000
A/P………………………50,000
Jan. 24. A/P…………………… …50,000
Purchase Discounts …….......500
Cash…………………….. 49,500
S e lf C h e c k E x e r c is e - 7

1. What would Asanti Compan y record on January 14, and January 24?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
Purchase Returns and allowances

A purchase return occurs wheen

n a bu yer returns merchandise to a seller.
A purchase allowance is a reduction on the price of goods bought for dissatisfaction on the side
of the bu yer.
Both purchase returns and purchase allowances are recorded in a contra purchase account
called Purchase Returns and Allowances.
Exam ple:
In the previous example for NOKIA compan y, a portion of the goods worth birr 5,000 bought
on January 14 from Asanti Company were of the wrong size. Asanti Company acknowledged
this and gave NOKIA Compaan n y a 5% price allowance on January 17.
What should NOKIA Compan y record on January 17?
Solution:
January 17 A/P…………………………………250
Purchase Returns and Allowance…………250

S e lf c h e c k E x e r c is e - 8
1. What would Asanti Co. record on January 17?
__________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
When both purchase discounts and purchase returns and allowances are deducted from
purchases what is obtained is called Net purchase. That is,
Gross Purchase…………………………XX
Less: Purchase discounts…………………….(XX)
Purchase returns and allowances………(XX)
Net Purchases…………………….XX
Transportation costs
Once merchandise has been bought it has to be moved from the seller’s place to the bu yer’s
place. A third part y comes in to the scene here: the transportation company who moves the
goods between the two places.
That is:
Seller Goods goods goods Bu yer

Freighter

So, the question is, who is going to pa y to the freighter (transportation) company. Who covers
the transportation costs depends, as you might have guessed, on the agreement between the
buyer and seller. The agreements are usuall y stated in the either of these two terms:
- FOB Destination – means “free on board at destination “. That is, since the
destination of the goods is the bu yer’s place, it is free at destination means transportation
cost is paid when the goods are loaded. It simply means the seller pa ys transportation
cost. FOB Destination means goods are shipped to their destination (to the bu yer)
without transportation charge to the bu yer.
- FOB shipping Point –means “free on board at shipping point”. That is, goods are
loaded (on a truck or train) or shipped free of charge. It is, therefore, the buyer, which
pays to the transportation company when the goods reach the buyer (their destination)
briefl y, when the terms are FOB Shipping Point the buyer pa ys transportation costs.
Transportation costs paid by a bu yer of merchandise increase the cost of merchandise. They are
recorded in a separate Transportation-In account that is used to record freight costs incurred
in the acquisition of merchandise.
Example
NOKIA Compan y bought goods worth Birr 85,000 on account, terms 2/10,n/60 FOB shipping
point on March 2, 2001.Transportoin cost of Birr 1,500 was paid on March 2. Ika Compan y
paid on March 31, 2001. Record the necessar y journal entries
Solution:
Here, since the terms are FOB Shipping Point, the buyer (NOKIA) pays transportation.
March 2 -Purchase…………………..85,000
A/P………………………..85,000
-Transportation In……….....1500
Cash………………………1500
March 31 A/P…………………………85,000
Cash………………………..85,000
 S e lf C h e c k E x e r c is e - 9
1. What would have been recorded by NOKIA, if it paid on March 12, 2001? What if the
terms were FOB destination?
2. ___________________________________________________________________________
________ ______ ______ ______ ______ ___ ______ __ ______ ______ ______ ______ ___ _____
________ ______ ______ ______ ______ ___ ______ __ ______ ______ ______ ______ ___ _____
________ ______ ______ ______ ______ ___ ______ __ ______ ______ ______ ______ ___ _____
________ ______ ______ ______ ______ ___ ______ __ ______ ______ ______ ______ ___ _____
________ ______ ______ ______ ______ ___ ______ __ ______ ______ ______ ______ ___ _____
________ ______ ______ ______ ______ ___ ______ __ ______ ______ ______ ______ ___ _____
Example:
NOKIA Compan y sold goods worth Birr 135,000 terms 1/15, n/EOM on Februar y 1, 2001.
FOB Destination. It also paid transportation costs of Birr 800 on Feb. 1. The customer paid
NOKIA on Februar y 16, 2001. Record the relevant Journal entries.
Answers:
Feb 1 A/R…………………………..135,000
Sales…………………………..135,000
Feb 16 Sales discount ………………….1,350
Cash………………………….133,650
A/R…………………………135,000
Deliver y Expense…………………800
Cash……………………………800
The Delivery Expense account shows how much was incurred to deliver goods sold to
customers. It is, therefore, shown on the income statement as a selling expense.

S e lf C h e c k E x e r c i s e - 1 0
1. What would the customer (bu yer) record, in the above example, on February 1,and 13,

2001?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

Sometimes, the seller prepays the freight as a convenience to the bu yer and later collects it on
the due date of the invoice even though the terms are FOB shipping Point.
Exam ple
Nedi Compan y sold goods worth Birr 40,000 on April 1, 2001 to NOKIA compan y terms
2/10, n/30 FOB Shipping Point. It also paid Birr 2,500 to Helen Movers for transporting the
goods and added the amount to the invoice. What would each of these companies record
assuming NOKIA paid on April 31, 2001
 Nedi Co. (seller) April 1- A/R…………….40,000
Sales………………40,000
A/R…………….2500
Cash…………….2500
April 31-Cash……………42,500

A/R………………42500
NOKIA Co (Buyer) April 1-Purchases …………40,000
A/P………………….40,000

Transport-in ………2500
A/P………………2500
April 31- A/P…………………42,500

Cash…………………42,500
S e lf C h e c k E x e r c i s e – 1 1
1. What would have been recorded on the above dates if NOKIA Co. Paid on April 11, 2001?
_______________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
If the bu yer pays the transportation costs for the seller (when the terms are FOB Destination)
the bu yer simpl y deducts the freight paid from the amount to be paid to the seller.
Example:
X Compan y bought merchandise worth Birr 14,000 terms FOB destination from Y Co. on
account. It paid Birr 350 transportation costs. What would be recorded on the books of the
buyer and seller on the date of the sale?
Buyer (X Co) Seller Y Co
-Purchase……….14, 000 -. A/R……………….14, 000
-A/P………………14,000 Sales………………….14, 000
-A/P……………350 -Delivery exp……….350

Cash………..350 A/R………………350
Transfer of Title
Shipping terms determine not only determine who pays for transportation. The y also
determine at what point ownership title of the goods sold transfers to the buyer. Put briefl y,
whose propert y is it when merchandise is in transit?
1. When terms are FOB Destination we have seen that the seller covers transportation costs. By
implication the seller takes the responsibilit y of safel y moving and delivering the goods to the
buyer. The bu yer is not responsible for an y damage that can happen to these goods in transit.
Therefore, the goods become the bu yer’s property onl y when they are delivered to him /her.
Conclusion: Ownership title of the goods transfers to the bu yer at destination when the terms
are FOB destination.
2. When the terms are FOB shipping point the buyer pays freight costs. The buyer takes the
responsibilit y of safel y moving these goods to his /her own place. The merchandise,
therefore, becomes his/her property as soon as they are loaded on a truck or a train.
 Conclusion: Ownership title of goods transfers to the buyer at shipping point when terms are

FOB shipping point.The following table summarizes it all.

Sipping terms Transportation paid by Title Transfers

When goods are

Delivered to
FOB Destination Seller Buyer

FOB shipping point Buyer Freighter (transportation company)

Summary of Section One

Let’s once again present the model Income Statement that we saw at the beginning of this chapter. This
time around, however, it is a bit detailed. Please study the relationship between each item on the Income
Statement carefull y. Also try to remember how each item was recorded in journal entry form when the
transactions affecting these accounts happened.
XYZ Merchandising Co.
Income statement
For the year ended Dec. 31, 2001
Gross Sales ………………………………………………… 4 0 0 ,0 0 0
Less: Sales Discounts (15,000)

Sales Ret &All (25,000)……… ……………………. (40,000)

Net sales………………………………………………………….360, 000
Cost of goods sold:

Beginning merchandise inventory (January 1, 2001)…10,000

Add: Purchases…………………..210,000
Less: Purchase Disc………..(5,000)
Purchase Ret & All…(5,000)
Net purchase…………………………..200,000
Add: Transportation –In……………………….66,000
Total cost of goods Available for sale………………...276,000
Less: Ending M.I (Dec. 31, 2001)……………………… (20.000)
Cost of goods sold……………………………………………… (256,000) Gross
profit……………………………………………………………… 104,000
Less: Various Selling and Administrative Expenses ………………………(79,400)
Net Income………………………………………………… 24,600
Note:
Under a periodic inventory system, the cost of goods sold during a period is determined only indirectly
after comparing what was on hand at the beginning of the period, and the cost of goods purchased during
the period with what is left on hand at the end of the period. That is, Beg inventory + Total cost of
purchase –Ending inventory=Cost of Goods Sold.
Under periodic inventory procedures no attempt is made to determine the cost of goods sold at the time
of each sale. Instead, the cost of all the goods sold during the accounting period is determined at the end
of the period.
 Summary of Important Relationships on the Income Statement
1. Net sales = Gross sales- (Sales Discounts + Sales Returns and allowances)
2. Net purchases = Purchases – (Purchase Disc. + Purchase Ret. & allowance)
3. Total cost of Purchase = Net purchase + Transportation –In
4. Cost of goods sold = Beg inventory + Total cost of purchase –Ending inventory
5. Gross profit = Net sales – Cost of goods sold
6. Net Income = Gross Profit – operating (i.e., selling & administrative) expenses.
LESON TWO: REPORTING MERCHANDISING TRANSACTIONS
In the previous section, we saw how purchase and sales transactions are recorded
In this section, we will see how those transactions are summarized and reported on the financial
statements.
3.5 Completing the Worksheet for a Merchandising Company
The use of a worksheet, as you remember, assists in preparing adjusting and closing entries. In
addition it contains all of the information needed for the preparation of the financial statements.
Except for the merchandise – related accounts, the work sheet for a merchandising Co. is the
same as for a service compan y.
The following illustration, therefore, assumes that all selling and administrative expenses have
been adjusted. That accomplished, the onl y account, which remains to be adjusted, is the
Merchandise Inventor y account.
Illustration
The following is the trial balance of METAL Works, a merchandising business owned by
YGEZAHEGN. All accounts have been adjusted except the Merchandise Inventory account.
Metal works
Trial
Account title Dr CR
Cash 1 9 ,6 6 3
Account Receivable 1 ,8 8 0
Merchandise Inventory 7 ,0 0 0
Accounts Payable 700
Gezahegn capital 2 5 ,0 0 0
Gezahegn ,Drawings 2 ,0 0 0
Sales 1 4 ,6 0 0
Sales Discounts 44
Sales Returns and Allowances 20
Purchases 6 ,0 0 0
Purchase discounts 82
Purchase Returns and allowances 100
Transportation –In 75
Selling expenses 2 ,6 5 0
Administrative expenses 1 ,1 5 0 ________
4 0 ,4 8 2 4 0 ,4 8 2
Balance
December 31,2002
A physical inventory of merchandise carried out on December 31, 2002 showed Birr 10,000 of goods on hand.
Required: A- Prepare a worksheet for Metal works.
B- Prepare financial statements from the worksheet
C- Record the necessary adjustment journal entry in relation to merchandise
inventory
 D- Record closing entries
Metal works company
Worksheet for the year ended December 31,2002
T rial Balance Adjustment Adjusted T rial balance Inco me statement Balance sheet
Account title Dr . Cr. Dr . Cr. Dr . Cr. Dr . Cr. Dr . Cr.
Cash 1 9 ,6 6 3 1 9 ,6 6 3 1 9 ,6 6 3
Account 1 ,8 8 0 1 ,8 8 0 1 ,8 8 0
Receivable
Merchandise 7 ,0 0 0 1 0 ,0 7 ,0 0 0 1 0 ,0 0 0 1 0 ,0 0 0
Inventory 00
Accounts Payable 700 700 700
Gezahegn , Capital 2 5 ,0 0 0 2 5 ,0 0 0 2 ,5 0 0 0
Gezahegn Drawings 2 ,0 0 0 2 ,0 0 0 2 ,0 0 0
Income summery 7 ,0 0 1 0 ,0 0 0 7 ,0 0 0 1 0 ,0 0 0 7 ,0 0 0 10000
Sales 1 4 ,6 0 0 1 4 ,6 0 0 14600
Sales Discounts 44 44 44
Sales Returns and 20 20 20
Allowances
Purchases 6 ,0 0 0 6 ,0 0 0 6 ,0 0 0
Purchase discounts 82 82 82
Purchase Returns 100 100 100
and allowances
Transportation –In 75 75 75
Selling expenses 2 ,6 5 0 2 ,6 5 0 2 ,6 5 0
Administrative 1 ,1 5 0 1 ,1 5 0 1 ,1 5 0
expenses
4 0 ,4 8 2 4 0 ,4 8 2 17, 1 7 ,0 0 0 5 0 ,4 8 2 5 0 ,4 8 2 1 6 ,9 3 9 24782 3 3 ,5 4 3 2 5 ,7 0 0
7 ,8 4 3 7 8 ,4 3
2 4 ,7 8 2 24782 3 3 ,5 4 3 3 3 ,5 4 3

Note:
The merchandise inventory account before adjustment shows the inventory on hand at the
beginning of the period. This is because, since purchases and sales of merchandise have not
been debited or credited to the merchandise inventory account, this account would still show
the beginning inventor y amount at the end of the period.
Therefore, an adjustment journal entry is needed to update this account. At the end of the
period, a physical inventory would be conducted to determine the amount of inventory on
hand.
The adjustment journal entry removes beginning inventory amount from the merchandise
inventory account and replaces it with the (ending) actual value of merchandise inventory on
hand as determined b y the physical inventor y.
The adjustment is:
Income summary (beginning inventor y)…………..XXX Merchandise amount
inventory……………………XXX
Merchandise Inventory…………………………….XXX
Income Summary…………………………………..XXX An adjustment
journal entry for Hard Works is presented latter in (c).
3.6 Preparing Financial Statements for Merchandising Businesses
We will discuss financial statements as we work on requirement (b) of our illustration.
Once the worksheet has been completed, the financial statements are prepared. Next, any
 adjusting and closing entries are entered in the journal and posted to the ledger.
Income Statement
There are two widel y used formats of the income statement. These are:
The single – Step Income Statement
This format is shown below for Hard Works Co. It shows cost of goods sold and operating
expense but has only one subtotal for total expenses.
Metal Works Co.
Income statement
For the year ended December 31, 2002
Net sales…………………………………………………..Br.14536
Expenses:
Cost of goods sold………………………2893
Operating Expenses …………………….3800 (6693)
Net Income……………………………………….7843
The Multiple –Step Income Statement

Metal Works Co.

Income statement
For the year ended December 31, 2002
Revenue
Gross Sales……………………………………………… Br. 14600

Less: Sales Discounts ………..44

Sales Returns &All……20……………… (64)

Net Sales 14536
Less: Cost of goods sold:
Beg. Inventor y (Jan 1)…………………..7,000
Add: Purchase………………………6,000
Less: Purchase.……………….(82)
Purchase Ret & all…….(100)
Net Purchases……………..5818
Add: Transportation –In ……………75

Total cost of purchase……..5893

Total cost of Goods Available for sale……………..12,893

Less: ending Inventor y (Dec.31)………………………… (10,000)

Cost of Goods sold………………………………………….. (2893)

Gross Profit……………………………………………11,643
Operating Expenses:
Selling Expenses……………….2, 650

Admin. Exp…………………….1, 150

Total operating expenses……………….. (3800)

Net Income……………………………… 7 ,8 4 3
 Metal Works Co. Statement
of Owner’s Equity
For the year ended December 31, 2002
Gezahegn Capital Jan1, 2002………………………Br..25,000

Add: Net Income for the year…………………………7843

Deduct: Owner’s withdrawal during the year………....2,000

Gezahegn Capital December 31, 2002…………………30843

Metal Works Co.
Balance sheet
For the year ended December 31, 2002
Assets: Liabilities & capital
Liabilities:
Cash…………………..19663 A/P……………………700
A/R…………………… 1880 Owner’s Equit y:
Merch. Inventor y…….10,000 Gezahegn Capital … 30843
Total Assets………….31,843 Total Liab. & O/E……31,843
C. Adjustment Journal entry
-Income summar y…………………..7,000
Merchandise Inventor y………………7,000
-Merchandise Inventory…………….10, 000
Income Summary…………………….10, 000
D. Closing entries
-Sales………………………………..14,600
Income summar y……………………..14,600
-Income summar y………………………66
Sales discount………………………………44
Sales Returns and Allowances…………… 20
-Income summar y………………………………6,075
Purchases…………………………………………….6, 000

Transportation-In………………………………………..75

- Purchase Discounts………………………………..82
Purchase Ret. &All……………………………...100
Income Summar y……………………………………….182
- Income summary……………………………….3, 800
Selling Expenses…………………………………2650
Administrative expense…………………………..1150
- Income summary………………………………….7, 843
Gezahegn Capital……………………………………7,843
-Gezahegn Capital……………………………………..2,000
Gezaheng Drawings……………………………………2,000
 3.7 Summary
Even though the steps and procedures that we go through to prepare the financial statements of
merchandising companies are the same with that of service businesses, there are transactions
peculiar to merchandising commppanies. These include the purchase and sale of merchandise. You
should be able to record these transactions b y now. Go back and stud y the relationships between
financial statement items summarized at the end of section one of this unit.
3.8 Answers to Self Check Exercise

Self Check Exercise - 1

List price of goods…… ………………………….52, 000
Less: Trade discount (20% X [52,000-40,000]) ……… (2400)
Invoice Price……………………..49,600
Journal entry:
- A/R……………………49,600
Sales…………………………49,600
Self Check Exercise - 2
- 1/15, n/60 – 1% discount if customer pa ys within 15 days, otherwiisse amount is due
within 60 days without any discount.
- 2/10, n/EOM – 2% discount if paid within 10 days, otherwise the whole amount due at
the end of the month of sale
- n/60 – No discount – amount is due in 60 days
Self Check Exerciisse - 3
A – Since the customer paid within the discount period, i.e., within 10 days, amount collected
would be:
120,000 – 1% (120,000) = 118,800
B – Jan. 18 A/R………………………..120,000

Sales……………………… ….120, 000

Jan. 28 Cashh…
……………………….118800

Sales Discount……………….1200
A / R … … … … … … … … … … … . 12 0 , 0 00
Self Check Exercise - 4
Feb 3 - A/R …………………………….15, 000
Sales …………………………….15, 000
Feb 13- Cash……………………………..14,700
Sales Discount……………………...300
A / R … … … … … … … … … … … … . 1 5 , 000
Feb 15- Sales Returns &Allowances……5,000
Cash……………………………….4900
Sales Discount………………………100
Self Check Exercise - 5
January 4 Purchase ………………………….43, 000
Cash……………………………….43, 000
 Self Check Exerciisse - 6
Jan 14. A/R……………………………….50, 000

Sales………………………………50,000
Jan 24. Cash………………………………49,500

Sales Discounts……………………… 500

A/R………………………………..50,000
Self Check Exercise - 7
Jan 17. Sales Returns & Allowances………250

A/R…………………………………..250
Self Check Exercise - 8
FOB shipping point
March 12. A/P……………………………………85,300

Cash……………………………………..83,300
Purchase Discounts……………………. 1,700
FOB Destination

March 2 - Purchase……………………………….85, 000

A/P……………………………………..85,000
March 31- A / P … … … … … … … … … … … … … … . 8 5 , 000
Cash……………………………………85,000
Self Check Exercise - 9

Feb 1- Purchase………………………………..135,000
A / P … … … … … … … … … … … … … … … . 1 3 5 , 00 0
Feb 13- A/P……………………………………..135,000

Cash………………………………………133,650
Purchase Discounts………………………… 1,350
Self Check Exercise - 10

Seller Buyer

April 1-A/R……………40,000
00 Purchase……………40,000

Sales…………………40,000 A/P……………………40,000

A/R………………2,500 Transportation-In……..2,500

Cash…………………..2,500 A/P……………2,500
April 11- Cash (39200 + 2500)…41,700 April 11-A/P…………42,500
Sales Discount…………...800 Cash…………….41,700

A/R (40,000 +2500)…….42,500 Purchase Discounts...800

3 .9 SELF TEST XAMINATION QUESTIONS

1. You are provided with the following data from the records of three merchandising
companies :(a), (b) and (c). Determine each of the missing numbers for each compan y.
a b c

Invoice cost of merchandise purchase Br.90, 000 Br.40, 000 Br.30, 500
Purchase discounts
4000 ? 650
Purchase returns and allowances 3 ,0 0 0 1 ,5 0 0 1 ,1 0 0
Transportation-In ? 3 ,5 0 0 4 ,0 0 0
Merchandise inventor y (beginning of period) 7 ,0 0 0 ? 9 ,0 0 0
Total cost of merchandise purchases 8 9 ,4 0 0 3 9 ,5 0 0 ?
Merchandise inventor y (end of period) 4 ,4 0 0 7 ,5 0 0 ?
Cost of goods sold ? 4 1 ,6 0 0 3 4 ,1 3 0
2. Prepare journal entries to record the following merchandising transactions of Shiach

Company. The compan y uses the periodic inventory s ystem.

Ju l y 1 Purchased merchandise form Gizh y Compan y for $6,000 under credit terms of

1/15, n/30, FOB shipping point.

2 Sold merchandise to Terra Co. for $800 under credit terms of 2/10, n/60, FOB

s hi ppi ng poi n t .

3 Paid $100 for freight (transportation) charges on the purchase of July 1.

8 Sold merchandise for $1,600 cash.

9 Purchased merchandise from Chilalo Co. for $2,300 under credit terms of 2/15,
n/60, FOB destination.
 12 Received a $200 credit memorandum acknowledging the return of merchandise
purchased on July 9.
12 Received the balance due from Terra Co. for the credit sale dated Jul y 2, net of the
discount.
16 Paid the balance due to Gizhy Compan y within the discount period.

19 Sold merchandise to Urban Co. for $1,250 under credit terms of 2/15, n/60, FOB

s hi ppi ng poi n t .

21 Issued a $150 credit memorandum to Urban Co. for an allowance on goods sold on

J ul y 19.

22 Received a debit memorandum from Urban Co. for an error that overstated the total
sales invoice b y $50.
24 Paid Chilalo Co. the balance due after deducting the discount.

30 Received the balance due from Urban Co. for the credit sale dated July 19, net of the
discount.
31 Sold merchandise to Terra Co. for $5,000 under credit terms of 2/10, n/60, FOB
s hi ppi ng poi n t .
3. The following unadjusted trial balance was prepared at the end of the fiscal year for
Tenkir Compan y:
ABDI COMPANY
Unadjusted Trail Balance
July 31, 2000
Cash……………………………………………….. $ 4,200
Merchandise Inventor y…………………………… 11,500
Store supplies…………………………………….. 4 ,8 0 0
Prepaid Insurance………………………………… 2,300
Store equipment………………………………….. 41,900
Accumulated depreciation-Store Equipment…
$ 1 5 ,0 0 0
Accounts pa yable…………………………………. 9 ,0 0 0
 Abdi saba , capital……………………………..
3 5 ,2 0 0
Abdi saba, withdrawals ………………………. 3,200

Sales……………………………………………….. 1 0 4 ,0 0 0
Sales discounts…………………………………… 1,000

Sales returns and allowances…………………… 2,000

Cost of goods sold………………………………... 37,400

Depreciation expense – Store equipment…….. -
Salaries expense………………………………… 31,000
Insurance expense………………………………. -
Rent expense…………………………………….. 14,000
Store supplies expense…………………………. -
Advertising expense…………………………….. 9,90
Totals……………………………………………...$163,200 $163,200
Rent and salaries expense are equall y divided between the selling and the general and
administrative functions. Tenkir Compan y uses the periodic inventory s ystem.
Required:
1. Prepare adjusting journal entries for the following:
a. Store supplies on hand at year-end amount to $1,650.

b. Expired insurance, an administrative expense, for the year is $1,500. c.

Depreciation expense, a selling expense, for the year is $1,400.
d. A physical count of the ending merchandise inventory shows $11,100 of
goods on hand.
2. Prepare a multiple-step income statement.
3. Prepare a single-step income statement.
4. Prepare all the necessary closing entries.
3.10 Glossary of Terms
A Merchandising Business- a business that bu ys and sells goods at a profit
Merchandise- an ything that a merchandising compan y bu ys in order to resale it to its
customers
Periodic Inventory System- a s ystem of recording inventories that updates inventory records
only once in an accounting period
Perpetual Inventory System- a s ystem of recording inventories that continuously shows the
balance of inventor y on hand as the records about inventory are continuously updated
Physical Inventory- the act of counting (measuring, weighing, etc) merchandise in order to
determine the quantit y of goods on hand on a particular date
Trade Discount- deduction from the normal selling price (list price) to determine the invoice
price of goods
Cash Discount: deduction from the invoice price of goods for earl y pa yment when goods are
sold on credit. Cash discounts are called sales discounts for the seller whereas they are
referred to as purchase discounts b y the bu yer.
Purchase (or Sales) Returns- merchandise returned to the seller after it has alread y been sold
or bought
Purchase (or Sales) Allowance- a deduction from the invoice price of goods when the goods
bought or sold are agreed to be of defective or unsatisfactory for an y reason.

Contra Account- if an account is a contra account; its balance would be deduuccted from another
account when it is presented in the financial statements.
FOB Destination- an agreement that requires the seller of the goods to cover transportation
costs. It is read as free on board at destination.
FOB Shipping Point- an agreement that requires the bu yer of merchandise to cover
transportation costs. It is read as free on board at shipping point.

Refereen
nces
• Fees and Warren, Accoounting principles 18th edition. (Text book)
• Merges’ and Mergs, Int
Introduction to Accounting, 9th edition.
• Harman son, Edwards
ards & Maher Accounting principles, 5th Ed,1992, USA
• Any Accounting principle
iple book can be used as a reference
 U N IT F O UR
A C C O U N T IN G S Y S T E M S

CONTENTS
4.0 Aims & Objectives
4.1 Introduction
4.2 Components of Accounting S ystems

4.2.1 Source Documents

4.2.2 Input Devices

4.2.3 Information Processors

4.2.4 Information Storage

4.2.5 Output Device

4.3 Fundamental Principles of Accounting S ystems

4.3.1 Control Principle

4.3.2 Relevance Principle

4.3.3 Compatibilit y Principle

4.3.4 Flexibility Principle

4.3.5 Cost-Benefit-Principle

5.4 Special Journal and Subsidiary Ledgers

5.4.1 Subsidiary Ledgers

5.4.2 Special Journals

5.4.2.1 Advantages of Using Special Journals

5.4.2.2 Sales Journal

5.5 Computer Technology and Accounting S ystems

5.6 Summary

5.7 Answer to Check your Progress Questions

5.8 Model Examination Questions

5.9 Glossary of Terms

5.0 Aims & Objectives

After stud ying this unit, you should be able to:

understand principles of accounting information systems

list out the components of accounting information s ystems

explain the purpose and use of special journals and subsidiary ledgers

Explain the impacts technology on accounting information s ystems.

5.1 Introduction

This unit introduces you to the components and principles of accounting s ystems.
A system is a wa y of doing something. There are various ways of doing things.

Let’s sa y you decided to go home when you go out of your office. There are man y wa ys to do
that: You can either take a tax i or you can walk the whole distance home; you can take the main
road, or you ma y wish to use a short cut and so forth.
In accounting also, it is true that almost all business record, process and report business
transactions. However, the speed and efficiency of the processing depends on which accounting
s ystem the y use.
5.2 Components of an Accounting System

There are five basic elements of an accounting system. These are:

5.2.1 Source Documents

Source documents provide the basic information to be processed b y the accounting s ystem.
Invoices from suppliers, bills sent to customers, and payroll records are some examples of
source documents. You have alread y seen their meaning and importance in previous chapter.
5 .2 .2 I n p ut D e v i c e s

Input devices capture information from source documents and enable its transfer to the
information-processing component of the system. Journal entries, both paper based and
electronic are a t ype of input devices.
5.2.3 Information Processso
o rs
An information processor is a s ystem that interprets, transforms and summarizes information
for use in anal ysis and reporting. The information processing in an accounting system can be
manual or computerized.
Now a day, computers are being increasingl y used to process information.

Man y businesses in Ethiopia, for example, use the Peachtree accounting software to process
accounting information.
5.2.4 Information Storage
After being input, processed data are usuall y saved for use in future anal ysis or report.
Information storage is the ccoomponent of an accounting s ystem that keeppss data in a form
accessible to information processors.

5 .2 .5 O ut pu t D e v i c e

Output devices are the means to take information out of an accounting s ystem and make it
available to users. Output devices include printers, and monitors, which provide such outputs
as financial statements, bills to customers and internal reports.

Self Check Exercise --1

Give one example of an information storage device.

___________________________________________________________________________

___________________________________________________________________________

Mention at list five input device that are used in accounting process

___________________________________________________________________________
___________________________________________________________________________
5.3 Fundamental Principles f Accounting Systems
5 . 3 . 1 C o n t r o l P r i n c ip l e
Any accounting information s ystem should allow managers to control and monitor business
activities. To achieve this, accounting s ystem must have internal control as an element.
Internal controls are methods and procedures that direct operations to one goal, ensure
reliabilit y of financial reports and safeguard business assets. Internal controls are discussed
separately and at a greater dettaail in the next chapter.
5 . 3 . 2 R e le v a n c e P r in c i p le
The information that an accounting s ystem provides should be relevant to decision makers. This
means, an information system should be designed to capture data that make difference in
decision. To ensure this, it is iim
mportant that all decision makers, be considered when identifying
relevant information for disclosure.
5 . 3 . 3 C o m p a t ib il it y P r in c i p le
The compatibilit y principle requires that an accounting s ystem conform to the compan y’s
activities, personnel and structure. The s ystem must also be customized to the unique
characteristics of the company.
All in all, accounting s ystems must be consistent with the aims of the company, i.e., the y should
work in harmon y with compan y goals.
5 . 3 . 4 F l e x ib ilit y P r in c i p le
Accounting information systems must be flexible to adjust to changes in the compan y, in the
business environment and needs of decision makers. These changes can be technological
developments, consumer tastes or compan y activities.
A system must be designed to adapt to these and other changes.
 5 . 3 . 5 C o s t - B e n e f i t - P r i n c ip le
You wouldn’t do anything in your dail y life without first weighing the costs and the benefits.
Likewise, the benefits of performing an activit y in an accounting s ystem should be greater than
its costs.
For example, when you decided whether or not to report certain information, you have to compare
the benefits (its usefulness to decision making) and the costs (of computing, personnel and
other indirect costs).
5.4 Special Journals and Subsidiary Ledgers
5 . 4 . 1 S u b s id ia r y L e d g e r s
When a business has so many customers and suppliers, a control account for Accounts
Receivable and a control account for Accounts Payable are established in the general ledger.
But in addition to these, subsidiary ledger for receivables and payables may be added to the
accounting system to show the balances for each individual customer and supplier separately.
A control account is an account in the general ledger that shows the total balances of all the
subsidiary accounts related to it.
Subsidiary ledger accounts show the details supporting the related general ledger control
account balance. For example, the subsidiary (supporting) accounts for accounts Receivable
may be used to send out to each customer statements showing the balance they owe the
company.
A subsidiary ledger is therefore, a group of related accounts showing the details of the balance
of general ledger accounts.
Subsidiary ledgers are used to relieve the general ledger of a mass of detail. Thereby, the
general ledger trial balance is shortened. What’s more, having separate ledgers p romotes the
division of labor as one employee can handle the control account while its subsidiary can be
assigned to another employee.
The relationship between a control account in the general ledger and its subsidiary accounts

can be illustrated as follows in T- account form

Control account in the Subsidiary accounts in the

Accounts Receivable subsidiary
General Ledger
Ledger
Accounts Receivable Customer A Customer B

2001 2001 2001

Dec. 31 Dec. 31 Dec. 31

Bal. 10,000 Bal. 1,000 Bal. 4,000

Customer C Customer D

2001 2001

Dec. 31 Dec. 31

Bal. 2,000 Bal 3,000

As you can see the sum of all balances in the subsidiary accounts (1,000 + 2,000 + 4,000 +

3,000) on December 31, 2001 is equal to the balance in the control account (10,000).
When a transaction is recorded as a journal entry, it must indicate which of the subsidiary ledger
accounts is affected. Posting will be made to both the control account and the subsidiary
ledger account.
Example
A Br. 450 sale was made on account to Gome Balcha on January 2, 20X2. The journal entry
would be:
Jan. 2 Accounts Receivable-Gome 450

Sales 450
The Br. 450 would be posted as a debit to both the Account Receivable control account in the
general ledger and G. Balcha’s account in the subsidiary ledger. The credit would, of course, be
to the Sales account in the general ledger.
The following can be a summary of what’s discussed above

General ledger

Control Account Subsidiary ledger

Accounts Receivable Accounts Receivable subsidiary
Ledger (account for each customer)
Accounts Pa yable subsidiary
Accounts Pa yable Ledger (account for each supplier)
Equipment subsidiary ledger
(Account for each item of
equipment).
Office Equipment,
Deliver y Equipment,
Office Furniture
 S e lf C h e c k E x e r c is e - 2

1. What factors would affect a company’s decision to set up subsidiary ledger accounts for the general ledger
accounts?
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
__________________________________________________________________

2. Describe the deference between general ledger and subsidiary ledger

_____________________________________________________________________
____________________________________
5 . 4 . 2 S p e c ia l J o u r n a ls
A general journal is an all-purpose journal where we can record an y transaction. However, as the transactions of
a compan y increase, it is better to use special journals along with the general journal to record transactions of
similar type in one, such as sales on account or cash payments. Special journals record transactions of a similar
nature.
Special journals are designed to s ystematize the original recording of major transactions, which occur ver y
repeatedly.
The number and format of special journals used by a compan y depends on the nature and size of the compan y’s
business transactions.

5.4.2.1 Advantages of Using Special Journals

A- Time is saved in journalizing. The amount of writing is reduced because it is not
necessary to repeat the account titles printed already at the top of the special columns for every
debit and credit.
B- Time is saved in posting- many amounts are posted as column totals rather than
individually.
C- Detail is eliminated from the general ledger column. Totals are posted to the ledger means that
detail is left in the special journals.
D- Division of labor is promoted. Several persons can work simultaneously on the accounting
records. This allows management to fix responsibility and quickly locate errors.
E- Management anal ysis is aided. The special journal can be useful to management in anal yzing
classes of transactions, such as sales, because similar transactions are in one place.
5.4.2.2 Sales Journal
The sales journal is used to record sales of merchandise on credit; sales on cash are recorded in
a cash receipts journal. Sales of assets other than merchandise on credit are r ecorded in the
general journal. Each transaction recorded in the sales journal has a debit to Accounts
Receivable and a credit to Sales. Therefore, only one column is needed for these two
accounts. The posting reference (P/R) column is not used when transactions are recorded;
instead this column is used when posting.
 Posting
Sales journal entries are posted as shown with the arrow line in the illustration. Individual
transactions in the sales journal are posted regularly (dail y) to subsidiar y customer accounts in
the accounts receivable subsidiary ledger. These postings keep customer accounts up to date.
The sales journals amount column is totaled at the end of the period. The total is debited to
accounts receivable and credited to sales.
The other special journals are illustrated below. Their operation is almost similar to the sales
journal.
5. 5 Computer technology and Accounting systems
Computer technology can be divided into two broad categories: hardware and software.
Computer hardware-is the ph ysical equipment in a computerized accounting information
system. The ph ysical equipment includes processing units, hard drives, modems, monitors,
printers, etc.
Computer software- is the program that directs the operation of computer hardware.
Peachtree and Sun s ystem are some example of accounting software that help to process
information.
Computer technology reduces the time and effort devoted to record keeping tasks.
Accountants can now concentrate on anal ysis and managerial t ype decisions and work with less
effort directed at record keeping tasks.
One added advantage of a computerized accounting s ystem (as opposed to a paper-based
manual system) is that various computers in an organization can be networked. Networking
means linking or connecting computers with each other to give different users and different
computers access to a common database and programs.
 S e lf C h e c k E x e r c i s e
-3
1. “With the increase in the computerization of accounting s ystems of many organizations in
Ethiopia, the demand for accountants would fall (decrease). This is because accountants are
going to be replaced b y computers.” Do you agree with this statement? If not, Why?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________

2. List some of the accounting soft ware that are mostly used by accountants.
_____________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________
_______________________________________________________________________

3. Mention and describe special journals

_____________________________________________________________________
__________________________________________________________________
5.6 Summary
Although accounting s ystems vary from business to business the broad principles discussed
in this unit apply to all s ystems.
These principles are the control, relevance, compatibilit y, flexibilit y and cost -benefit
principle.
5.7 Answers to Self Ch e c k Ex e r c i s e
Ch
SELF CHECK EXE EXERCISE - 1
Ledgers, either manual or electronic, can be examples of information storage devices.

SELF CHECK EXE EXERCISE - 2

The nature and size of its transactions determine to what accounts subsidiary ledgers should
be set up. In addition the cost- benefit factor should be considered.

SELF CHECK EXE EXERCISE - 3

Computers are never going to replace accountants. Of course, they make the processing of
data efficient and help reduce errors. However, there needs to be accounting professionals
who design how the computers work and who anal yze and interpret the output of the
computers (financial statements).

5 .8 Self Test Examination

Questions
1. Assuming the use of a twoo--column general journal, a purchase journal and a cash payments
journal, indicate the journal in which each of the following transactions should be recorded:
a) Payment of cash on account to creditor
b) Purchase of office suppl y on account
c) Purchase of merchandise for cash
d) Return of portion of merchandise bought in ‘c’

e) Purchase of store equuiipment on account

f) Withdrawal of cash b y owner

5 .9 GLOSSARY
General ledger -the principal ledger that contains all the balance sheet and income statement
accounts.
Controlling Account- a suum mmarizing account in the general ledger, which represents a
summary of subsidiar y accounts
Subsidiary ledger - a group of accounts, which contain detail regarding a controlling,
account.
Purchaser journal - a special journal for recording purchase of merchandise or other items on
account.
Cash payment journal- a special journal for recording pa yments of cash for an y purpose
Sales journal - a special journal for recording sale of merchandise on account.
Cash Receipts journal- a special journal for recording receipt of cash from any source.

5 .1 0 . References
• Fees and Warren, Accoounting principles 18th edition. (Text book)
• Merges’ and Mergs, Int
Introduction to Accounting, 9th edition.
• Harman son, Edwards
ards & Maher Accounting principles, 5th Ed,1992, USA
• Any Accounting principle
iple book can be used as a reference
 UNIT FIVE
CASH

CONTENTS

5.1 Introduction

5.2 Meaning of Cash

5.3 Characteristics of Cash

5.4 Management of Cash

5.5 Internal Control of Cash

5 .5 .1 Control of Cash Through Bank Accounts

5 .5 .1 .1 Reconciliation of Bank and Book cash Balances

5 .5 .1 .2 Steps in Preparing Bank Reconciliation

5 .5 .1 .3 Illustration of Bank Reconciliation

5 .5 .2 Petty Cash Fund

5 .5 .2 .1 Establishment of Petty Cash

5 .5 .2 .2 Replenishment of Petty Cash

5 .5 .3 Voucher S ystem

5 .5 .4 Change Fund

5 .5 .5 Cash Short and Over

5 .6 . Summary

5 .7 . Answer to Check Your Progress Exercise

5 .8 . Self test questions

5 .9 . Glossar y

5 .1 0 . References
Aims & Objectives

In this unit, internal control of cash, the accounting for cash transactions and other
aspects will be discussed. After you have studied this unit, you should be able to:
define cash
identify the with composition of cash
explain the objeecctives of cash management
prepare a bank reconciliation
understand the internal control of cash
5.1 Introduction
Since cash is the asset most likely to be used improperl y b y employees, exposed for
embezzlement and many business transactions either directl y or indirectly affect it, it is
therefore necessar y to have effective control of cash.
5.2 Meaning Of Cash
Cash includes money on deposit in banks and other items that a bank will accept for
immediate deposit. Money on deposit in banks includes checking and saving accounts. Other
items such as ordinary checks received from customers, money orders, coins and currency and
petty cash also are included as cash. Banks do not accept postage stamps, ttrravel advances to
emplo yees, notes receivable or post-dated checks as cash.
5.3 Characteristics Of Cash
The following are some of the characteristics of cash:
a) Cash is used as medium of exchange
b) Cash is the most liquid asset
c) Cash is mostl y affected by business transactions
d) Cash is used to measure the value of other assets
e) Cash is mostl y exposeed d to embezzlements
5.4 Management Of Cash
Cash management refers to planning, controlling and accounting for cash transactions and cash
balances. Efficient management of cash is essential to the survival and success of every
business organization. Managing cash requires planning wisel y so that there will not be excess
cash held on hand at an y point in time; or there is no shortage of cash at any point in time to
meet the business’s needs.

Self Check Exercise

ercise -1
1. Define cash as it is used for accounting purpose.
________ ______ ______ ______ _____ _ ___ ________ ______ ______ ______ ______ __
________ ______ ______ ______ _____ _ ___ ________ ______ ______ ______ ______ __
________ ______ ______ ______ _____ _ ___ ________ ______ ______ ______ ______ __
________ ______ ______ ______ _____ _ ___ ________ ______ ______ ______ ______ __
2. Which of the following items should not be included as cash?

a) Ordinary checks b)
Post-dated checks
 c) Cash deposited in saving accounts
d) Postage stamps
e) Deposits in checking accounts
f) IOU’S
5.5 Internal Control Of Cash
The need to safeguard cash is crucial in most businesses because cash is mostly exposed to
embezzlement. Firms address this problem through the internal control system. An internal
control s ystem is a set of policies and procedures designed to protect assets, provide accurate
accounting records and evaluate performances.
A sound internal control system for cash increases the likel y hood that the reported values for
cash are accurate.
Internal control for cash should include the following procedures:
a) The individuals who receive cash should not also disburse (pay) cash b)
The individuals who handle cash should not access accounting records
c) Cash receipts are immediatel y recorded and deposited and are not used directl y to make
payments.
d) Disbursements are made by seriall y numbered checks, onl y upon proper authorization
by someone other than the person writing the check
e) Bank accounts are reconciled monthl y.
The following are the most common elements of cash control and managements: bank
account s ystem, pett y cash fund, voucher s ystem, change fund, and cash short and over.
5 .5 .1 C o n t r o l o f C a sh T hr o ug h B a n k A c c o unt s
Bank accounts are one of the most important means of controlling cash that provide several
advantages such as:
Cash is physicall y protected b y the bank,
A separate record of cash is maintained b y the bank,
And customers may remit payments directl y to the bank.
If a compan y uses a bank account, monthl y statements are received from the bank showing
beginning and ending balances and transactions occurring during the month including checks
paid, deposits received, and service charges. These monthl y statements (reports) received from
the bank are called bank statements. Bank statements generall y are accompanied b y checks
paid and charged to the accounts during the month, debit and credited memos, which inform the
compan y about changes in the cash accounts. For a bank, the depositor’s cash balance is a
liabilit y, the amount the bank owes to the firm. Therefore, a debit memo describes the amount
and nature of decrease is the compan y’s cash accounts. A credits memo indicates an increase in
the cash balance of the depositor that it has with the bank.
5 .5 .1 .1 Reconciliation of Bank and Book Cash Balances
Monthl y reconciling of the bank balance with the depositor’s cash accounts balance is
essential cash control procedure. To reconcile a bank statement means to verify that the bank
balance and the accounting records of the depositor are consistent. The balance shown in a
monthly bank statement seldom equals the balance appearing in the depositor’s accounting
records. Certain transactions recorded b y the depositor may not have been recorded b y the bank
and vice versa.
The most common examples that cause disparit y between the two balances are:
1. Outstanding checks: Checks issued and recorded by the compan y, but not yet
presented to the bank for Payment
2. Deposits in transit: Cash receipts recorded b y the depositor, but not reached the bank to
be included in the bank statement for the current month.
3. Service charges: Banks often charge a fee for handling checking accounts. The
amount of this charge is deducted b y the bank form bank balance and debit memo is
issued for the depositor.
4. Charges for depositing NSF- checks: NSF stands for “Not Sufficient Funds.” When
checks are deposited in an account, the bank generall y gives the depositor immediate
credit. On occasion, one of these checks ma y prove to be uncollectible because the
maker of the check does not have sufficient funds in his or her account. In such a case,
the bank will reduce the depositor’s account b y the amount of this uncollectible item
and return the check to the depositor marked “NSF”.
5. Notes collected by bank: If the bank collects a note receivable on behalf of the
depositor, it credits the depositor’s account and issues a credit memorandum for the
depositor.
When the depositor prepares bank reconciliation, the balances shown in the bank statement and
in the accounting records both are adjusted for an y unrecorded transactions. Additional
adjustments may be required to correct an y errors discovered in the bank statements or in the
accounting records.
5 .5 .1 .2 Steps in Preparing Bank Reconciliation
Bank reconciliation is a schedule prepared b y the depositor to bring the balance shown in the
bank statement and the balance shown in the depositor’s accounting into agreement.
The steps to prepare bank reconciliation are:
a) The deposits listed on the bank statement are compared with the deposits shown in the
accounting records. An y deposits not yet recorded by the bank are deposits in transit and
should be added to the balance shown in the bank statements.
b) The paid and received checks from the bank are compared with the check stubs. An y
checks issued but not yet paid b y the bank are outstanding checks and should be
deducted from the balance reported in the bank statements.
c) An y credit memorandums issued b y the bank that have not been recorded b y the
depositor, are added to the balance per depositor’s record.
d) An y debit memorandums issued by the bank that have not been recorded b y the
depositor are deducted from the balance per depositor’s record.
e) An y errors in the bank statement or depositor’s accounting records are adjusted.
f) The equalit y of adjusted balance of statement and adjusted balance of the depositor’s
record is compared.
g) Journal entries are prepared to record an y items delayed b y the depositor.
5 .5 .1 .3 Illustration of Bank Reconciliation
The January bank statement sent b y Awash Bank to Satcon Compan y shows Br. 4,262.83.
Assume also that on January 31, 2000, the Cash account of Satcon Company shows a balance of
Br. 5,000.17. The accountant of Satcon Company has identified the following items:
1. A deposit of Br. 410.90 made after banking hours on Jan. 31 does not appear on the
bank statement.
 2. Two checks issued in January have not yet been paid by the bank:
Check No. 301 Br. 110.25
Check No. 342 60 7. 50

3. A credit memorandum was included in the bank statement, which was for proceeds
from collection of a non-interest bearing note receivable from MAN Company Br.
5 2 4 .7 4 .
4. Three debit memorandums accompanied the bank statement: Fee charged b y bank for
handling collection of notes receivable Br.5; a check of Br. 50.25 received from a
customer, RON compan y, and deposited b y RAM compan y was charged back as NSF;
and service charge b y bank for the month of January amounts to Br. 12.00.
5. Check No. 305 was issued b y RAM Compan y for payment of telephone expense in the
amount of Br. 85 but was erroneousl y recorded in the cash payments journal as Br. 58.
The January 31 bank reconciliation for Satcon Company is shown below:
Satcon Company
Bank Reconciliation January 31, 2000
Balance per bank statement, Jan. 31, 2000 Br. 5,000.17
Add: Deposit of Jan. 31 not recorded b y bank 4 1 0 .9 0
Subtotal Br. 5,411.07
Deduct: outstanding checks:
No. 301 Br. 110.25
No. 342 6 0 7 .5 0 1 1 7 .7 5
Adjusted cash balance Br. 4,693.32Balance per
depositor’s record, Jan . 31, 2 Br.
4 ,2 6 2 .8 3
Add: Note Receivable collected b y bank 5 2 4 .7 4

Subtotal Br. 4,787.57

Deduct: collection fee Br. 5.00
NSF check of Ron Company 5 0 .2 5
Service charge 1 2 .0 0
Error on check stub No. 305 2 7 .0 0 9 4 .2 5
Adjusted cash balance Br. 4,693.32
The following are journal entries related to the bank reconciliation.
2000
Jan. 31 cash 5 2 4 .7 4
Notes Receivable 52 4. 74
To record collection of Note Receivable
collected b y bank
31 Miscellaneous Expense 1 7 .0 0
Accounts Receivable-RON Co.
5 0 .2 5
Utilities Expense 2 7 .0 0
Cash 9 4 .2 5
To record bank service charges,
NSF check and error in recording
Check No. 305
 Self Check Exercise
ercise -2

1. Briefl y explain the basic purpose of bank reconciliation.

_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
2. Define the following term
mss related to the accounting for cash:

a) Outstanding checks

b) Deposit in transit

c) NSF- check

----------------------------------------------------------------------------------------------------------------
3. Which of the reconciling items necessitate an entry in the depositor’s accounts?

a) Deposit in transit

b) Outstanding checks

c) Note collected b y bank

d) Bank service cch
harge
5 .5 .2 P e t t y C a sh F un
Petty cash fund, which is part of the total cash balance, is used to handle many t ypes of small
payments such as employee transportation costs, purchase of office supplies, purchase of
postage stamps, and delivery charges. Man y businesses find it convenient to make minor
expenditures instead of writing checks. The petty cash amount various from Br. 50 or less to
more than Br. 1,000, which w wiill cover small expenditures for a period of two or three weeks.
5 .5 .2 .1 Establishment of Petty Cash
To establish a pett y cash fund a check is issued to a bank. This check is cashed and the money is
kept on hand in a pett y cash box. One employee is designated as custodian of the fund. The
issuance of the check for establishment is recorded by debiting pett y cash account and
 crediting cash.

5 .5 .2 .2 Replenishment of Petty Cash

During the period, the custodian makes small pa yments from the pett y cash fund and obtains a
receipt or prepares a petty cash voucher. This petty cash voucher explains the nature and
amount of ever y expenditure and is kept with the fund. When the fund runs low or at the end of
the compan y’s fiscal period, a check is issued to reimburse the fund for the expenditures made
during the period. The issuance of this check is recorded b y debiting the appropriate expense
accounts and crediting cash or vouchers payable.
5 .5 .3 V o u c h e r Sy st e m
One method to control cash disbursements is a voucher s ystem. A voucher is a special form,
which contains relevant data about a liabilit y and its payment. In a voucher system, a voucher is
prepared for each expenditure and approved by the designated officials. Each approved voucher
represents liability and recorded in a voucher register, which is similar to purchases journal. Those
registered vouchers are filed according to their payment date in an unpaid vouchers file. The
vouchers and supporting documents then are sent to the treasure or other official is the finance
department before issuing checks. When the checks are signed, the paid vouchers are recorded in a
check register which is similar to cash payments journal. Those paid vouchers are filed in paid
vouchers file according to their serial number for future reference.

5 .5 .4 C ha ng e F und
Some businesses that receive cash directl y from customers should maintain a fund of currenc y
and coins in order to make change (Amharic=>”zirzir”). This fund, which is part of the total
cash balance, is called change fund. A change fund is established b y issuing a check to the bank
and transferring the cash to the custodian. The issuance of a check to establish a change fund is
recorded b y debiting cash on hand and crediting cash or voucher payable.
Once a change fund is established, there will be no change in its balance unless there is a
decision by management to increase or decrease the fund balance.
5 .5 .5 C a s h S h o r t a n d O v e r
In handling cash receipts from daily sales, a few errors in making changes will occur. These
errors may cause a cash shortage or overage at the end of the day. The account cash short and
over is debited if there is shortage and credited if there is overage. At the end of the period if the
account had a debit balance, it appears in the Income statement as miscellaneous expense; if it
has a credit balance, it is shown as miscellaneous revenue
For example, assume that the total cash sales recorded during the da y amounts to Br. 12,420.
However, the cash receipts in the cash register drawer (actual cash count) total Br. 12,415.
The following entr y would be made to adjust the accounting records for the shortage in the cash
receipts:
Cash Short and Over 5 .0 0
Cash 5 .0 0
To record a Br. 5.00 (Br. 12,420 – 12,415)
Shortage in cash receipts for the day
 Self Check Exercis
ercise-3
1. The pett y cash account has a debit balance of Br. 200. At the end of the accounting period,
there is Br. 160 in the pett y cash fund along with petty cash receipts totaling Br. 40. Should
the fund be replenished as of the last da y of the period? Why?

2. In what order are vouchers ordinaril y filed

A) In the unpaid voucher file
B) In the paid voucher file
3 In which section of the Income statement would a credit balance in cash short and over be
reported?
5.6. Summary
1. Cash includes only those items immediatel y available to pay obligations.
2. The objectives of cash management are accurate accounting for cash transactions, the
prevention of losses through theft or fraud, and maintaining adequate cash balances.
3. The bank reconciliation adjusts the cash balance per book and the cash balance per bank
statement for an y unrecorded items such as outstanding checks and bank service charges.
4. Bank reconciliation produces the correct amount of cash to be included in the balance sheet
at the end of the month.
5. A compan y ma y use a pett y cash fund to make small payments that occur frequentl y, as
payment b y check would cause delay and excessive expense of maintaining records.
6. One of the best s ystems for establishing control of cash payments is the use of a voucher
system. A voucher s ystem uses vouchers, a voucher register, a file for unpaid vouchers, a
check register and a file for paid vouchers.
5 .7 . Answer To Self Check Exercises

Self Check Exercise - 1

1. Cash includes all the itteems that are accepted for deposit by a bank, notably paper money
and coins, mone y orders, and checks.
2. a) Post-dated checks
b) Postage stamps

Self Check Exercise - 2

1. The basic purpose of a bank reconciliation is to achieve the control inherent in the
maintenance of two independent records of cash transactions; one record maintained b y
the depositor and the other by the bank. When these two records are reconciled (brought
into agreement), we gain assurance of a correct accounting for cash trraansactions.
2. a) Checks issued that have not been paid b y the bank.
b) Deposits not recorded by the bank.
c) A customer’s checkk which was deposited but returned because of a lack of funds in
the account on which the check was drawn (in the customer’s bank account).
acc
d) Note collected b y bank
e) Bank service charge

Self Check Exercise - 3

 1. Yes. To record the unrecorded expenditures of Br. 40 at least b y the end of the fiscal
period
2. a) According to the earliest date
b) In numerical order
3. In miscellaneous revenue section of Income statement

5 .8 . SELF TEST EXAMINATION QUESTIONS

Part I. Short answer questions
1. In general terms, in which section does cash, appear on the balance sheet?
2. Explain some measures that strengthen internal control over cash receipts and payments.
3. What is the basic control feature in a voucher s ystem?
4. List two items often encountered in reconciling a bank account that may cause cash per the
bank statement to be larger than the balance of cash shown in the depositor’s accounting
records.
Part II. Work Out Questions
1. Shown below is the information needed to prepare bank reconciliation for MITE
Compan y at December 31.
a) At December 31, cash per the bank statement was $ 15,981; cash per the
compan y’s records was $ 17,445.
b) Two-debit memorandum accompanied the bank statement: service charges for
December of $ 24, and a $ 600 check drawn b y R AMI marked ‘NSF’.
c) Cash receipts of $ 4,353 on December 31 were not deposited until January.
d) The following checks had been issued in December but were not included
among the paid checks returned by the bank: no. 620 for $ 978, no. 630 for $
2,052, and no. 641 for $ 483.

Required: i) Prepare bank reconciliation at December 31

ii) Prepare the necessary journal entry or entries to update the accounting
records based on the reconciliation.
2.
RAM Compan y maintains its checking account with the Commerce Bank. The compan y is
read y to prepare its December 31 bank reconciliation. The following data are available:
a) The November 30 bank reconciliation showed the following:

1) Cash on hand (held by RAM compan y for day to day minor

expenses), Br. 400 (included in RAM’s cash account)
2) Deposit in transit, Br. 2,000, and

3) Checks outstanding: N0. 121 Br. 1,000

No. 130 2 ,0 0 0
No. 142 3 ,0 0 0 b )
Bank Statement, December 31:
• Balance, December 31 Br. 67,600
 • Deposits: 1 8 8 ,5 0 0
• Checks: No. 130, Br. 2,000; N0. 142, Br. 3,000;
N0. 143 – 176, Br. 191,000 (196,000)

• Note collected for RAM compan y (including

Br. 720 interest) 1 6 ,7 2 0
• NSF check, customer Binda (250)
• Bank service charges (20)

• Balance, December 31 Br. 76,550

Required:
i) Determine deposit in transiitt and checks outstanding
ii) Prepare the December 31 Bank reconciliation
iii) Based on your bank reconciliation, give all journal entries that shoou
uld be made at
December 31.

5 .9 . GLOSSARY OF TERMS

Bank reconciliation: a schedule that explains the difference between the balance of cash
shown in the bank statement and the balance of cash shown in the depositor’s records.

Cash: money on deposit in banks and other items that a bank will acceep
pt for immediate
deposit.

Cash management: planning, controlling, and accounting for cash transactions and cash
balances.

Petty cash: small amount of cash, which is used to make small payments that occur
frequentl y.

Voucher: a written authorization used in approving a transaction for recording and pa yment.
Voucher system: an accounting system designed to provide strong internal control over cash
disbursements

5 .1 0 . References

• Fees and Warren, Acc

ccounting principles 18th edition. (Text book)
• Merges’ and Mergs, IIntroduction to Accounting, 9th edition.
• Harman son, Edwards
ards & Maher Accounting principles, 5th Ed,1992,
d,1992, USA
• Any Accounting princciple book can be used as a reference
 CONTENT

U N IT S I X
IN T E R N A L C O N T R O L
6.0 Aims & Objectives

6.1 Introduction

6.2 The Purpose of Internal Control

6.3 Components of Internal Control

6.3.1 The Control Environment

6.3.2 The Accounting S ystem

6.3.3 Control Procedures

6.3.3.1 Requiring Authorization

6.3.3.2 Establishing Responsibilit y

6.3.3.3 Maintaining Adequate Records

6.3.3.4 Insuring Assets and Bonding Ke y Emplo yees

6.3.3.5 Separating Record Keeping From Custod y of Assets

6.3.3.6 Dividing Responsibilit y for Related Tasks (transactions)

6.3.3.7 Rotating Duties

6.3.3.8 Applying Technical Controls

6.3.3.9 Performing Regular and Independent Reviews

6.4 Technology and Internal Control

6.5 Limitations of Internal Control

6.6 Summary

6.7 Answer to Check Your Progress Exercise

6.8 Model Examination Questions

6.9 Glossary
 6.0 Aims & Objectives

After you have read this unit, you should be able to:

explain the purpose of internal control

identify components of internal control
describe how technology impacts internal control and,
list out the limitations of internal control
6.1 Introduction
A compan y’s internal control structure consists of the policies and procedures
established to insure that the compan y’s goals will be achieved.
As a compan y grows in sizee,, it becomes difficult to maintain control over all phases of
operation. Therefore, management needs to delegate authority and rely on the control
structure in order to achieve adherence to enterprise goals
6.2. The Purpose of Internal Control
Managers use an internal control s ystem to monitor and control business operations. An
internal control s ystem is all the policies and procedures managers use to:
• Protect business assets from theft and misuse. For example, what can be done to
protect cash from theft and misuse?
• Ensure reliabilit y of accounting records. That is, how reliable and accurate are our
records and reports regarding Accounts Receivable, for instance.
• Promote efficienc y of o peration. Efficiency means achieving organizational goals b y
using as minimum resources as possible.
• And make emplo yees adhere to compan y policy.
6.3 Components of Internal Control
The internal control structure can be divided in to three elements?

6 . 3 . 1 T h e C o n t r o l E n v ir o n m e n t
The control environment of an organization represents the overall attitude and awareness of
both management and emplo yees about the importance of controls.

The control environment is influenced b y such factors as management’s philosoph y &

operating st yle, the organizatioon

nal structure of the business and personnel policciies.

6 .3 .2 T he A c c o u nt i ng Sy s t e m
The accounting s ystem consists of the methods and records established by management to
identify record, process and report a compan y’s transactions, and to provide assurance that the
objectives of internal control are being met.
6 .3 .3 C o n t r o l P r o c e du r e s
Internal control procedures vary from compan y to compan y. The y depend on the nature of the
business and of its size.
The following are common procedures that you find in the internal control of man y
organizations.
6.3.3.1 Requiring Authorization
Management should properly authorize all transactions and activities before they take place.
For example, selling on credit requires management’s approval.
6.3.3.2 Establishing Responsibility
Proper internal control requires responsibility for each task to be clearly established and
assigned to one person. Otherwise, if responsibility is not identified, it is difficult to say who is
at fault (responsible) when a problem occurs.
For example, if we allow two sales clerks to share access to (use) the same cash register, it
would be difficult to take which sales clerk accountable when and if there is a cash shortage.
6.3.3.3 Maintaining Adequate Records

Reliable records are a source of information that management uses to monitor compan y
operations. For example, when detailed records of office equipment are kept, items are
unlikely to be lost or stolen without the discrepancy being noticed.
6.3.3.4 Insuring Assets and Bonding Key Employees
Good internal control dictates that assets be adequately insured against causality. In addition,
emplo yees handling cash should be bonded. Bonding an employee means buying an insurance
policy against losses from theft by that emplo yee.
6.3.3.5 Separating Record Keeping From Custody of Assets
A person who controls or has access to an asset must not keep that asset’s accounting records.
This prevents the loss of the asset from theft because the person who has control over the asset
knows that another person keeps records of the asset. The record keeper doesn’t have access to
the asset and therefore, has no reason to falsify records.
For a fraud to be committed in such a s ystem the two people must agree (-this is called
collusion). Collusion is usually less likel y to occur.
6.3.3.6 Dividing Responsibility for Related Tasks (transactions)
In order to ensure that the work of one emplo yee serves as a check on another, responsibilit y for
a series of related transactions should be divided between two or more individuals (or
emplo yees) or departments.
This is usuall y referred to as segregation of duties.
For example, no one individual should be authorized to order merchandise, to receive
merchandise, and to pa y the supplier. If one employee is allowed to do these all by herself
(alone), she can place orders with a supplier on the basis of friendship rather than price and
quality; convert goods to her personal use; pay false invoices; and so forth.
6.3.3.7 Rotating Duties
It is advisable to rotate clerical personnel periodically from job to job. This would help them
broaden their understanding of the s ystem. In addition and more importantly, the y know that
others would in the future perform their jobs (when rotated). This discourages them to deviate
from prescribed procedures because the y fear that the emplo yee who takes up their job will
discover it.
6.3.3.8 Applying Technical Controls
Cash register, check protectors, time clocks, mechanical counters, and personal identification
scanners are examples of control devices that can improve internal control.
A cash register has a locked in tape or electronic file, which makes record of each cash sale.
A check protector perforates the amount written on a check in to its face and makes it difficult
to change the amount.
A time clock registers the exact time an emplo yee arrives and leaves from the job.
Mechanical change and currency counters quickly and accuratel y count amoou unt s .
Personal scanners limit access to some places only to authorized individuals.
6.3.3.9 Performing Regular and Independent Reviews
Regular reviews of internal control s ystems are needed to ensure that procedure are followed.
Internal auditors who are not directl y involved in the operations of the business usuall y
perform these reviews. This encourages an evaluation on the efficienc y and effectiveness of the
internal control s ystem.

S e lf C h e c k E x e r c is e - 1
1. Give one set of related tasks as an example, that you think is desirable to divide and to rotate
emplo yees.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
6. 4. Technology and Internal Control

Technology impacts an internal control s ystem in many important ways. Some of these are:

• Technologicall y advanced s ystems allow saving time in processing information.

• They allow a regular review and more extensive testing of records as information can be
easil y and rapidl y accessed.
• Technologicall y advanced s ystems reduce the number of errors in processing
information provided the software and data entr y are correct.
• They are so efficient these days that they require fewer emplo yeeees. This makes
separation of crucial responsibilities difficult. The duties of these employees,
therefore, must be monitored to minimize the risk of error or fraud.
6.5 Limitations of Internal Control
No internal control s ystem is perfect. The most serious limiting factors are human error and
human fraud.
Human error can occur from negligence, fatigue or confusion. Human fraud fra involves a
deliberate act by employees to ddefeat internal controls for personal gains.
Another important limiting factor of an internal control s ystem is the cost-benefit consideration.
This means that the cost of an internal control s ystem must not exceed its benefits.
We can’t employ an internal control s ystem simply because it is good. We have to weigh its
costs against its benefits.
For instance, not all companies need to computerize their accounting s ystem if the cost of
automating the s ystem is greater than the benefits

S e lf C h e c k E x e r c is e - 2

1. Can collusion be taken (seen) as a limitation of internal controls? Explain.

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

6.6 Summary
Internal control consists of the control environment, the accounting system and control
procedures that work in line with the compan y’s policy to:
Protect assets from fraud and misuse
Ensure completeness and reliabilit y of financial statements
Ensure efficiency of operations and
Ascertain every employee adheres to the compan y’s policies
6.7 Answer to Self Check Exercises

SELF CHECK EXE EXERCISE - 1

One emplo yee shouldn’t be allowed to issue goods, to collect cash and keep the records when
merchandise is sold in a merchandising compan y.

SELF CHECK EXE EXERCISE - 2

Yes, in ever y internal control the s ystem works only if two emplo yees do not agree (collude)
to break the s ystem. Therefore, every s ystem has the inherent limitations of collusion.

6 .8 ELF TEST EXAMINATION QUESTIONS

1. Write brief answers for the following questions.
a. What are the main objectives of internal controls and how are these objectives
achieved?
b. Why should record keeping for assets be separated from custod y over the assets?
2. Musina is a government owned public enterprise that is growing rapidl y. The
organization’s bookkeeper left town suddenl y after the manager discovered that a large sum
of money has disappeared over the past 18 months. An audit showed that the
bookkeeper has written and signed several checks in the name of his fiancé and then
recorded the pa yments as salary expense. His fiancé, who cashed the checks but never
worked for Musina, also left town with the bookkeeper.
Evaluate Musina’s internal control s ystem. Which principles (procedures) of internal
control seem to have been ignored?

6 .9 GLOSSARY OF TERMS
Collusion - agreement between two or more employees to commit fraud.
Segregation of duties - assigning responsibilit y of related tasks to various emplo yees.
Control procedures- the various wa ys through which an organization tries to protect fraud
and achieve other internal control objectives.

6 .1 0 . References

• Fees and Warren, Accouunting principles 18th edition. (Text book)

• Merges’ and Mergs, Int
Introduction to Accounting, 9th edition.
• Harman son, Edwards & Maher Accounting principles, 5th Ed,1992, USA
• Any Accounting principle
iple book can be used as a reference