Table of Contents

Course Outline
Chapter One: General Introduction
1.1 Definition of Accounting
1.2 Evolution of Accounting
1.3 Profession of Accountancy
1.4. Accounting Principles and Practices
1.5. Accounting As Information Systems (Data Processing Methods)
1.6. Principles And Practices
1.7. Business Transaction And The Accounting Equation
1.8. Financial Statements
Chapter Two: Accounting Cycle for Service Rendering Businesses
2.1.Nature And Classification of Accounts
2.2.Chart of Accounts
2.3.Flow of Accounting Data
2.4.Trial Balance
2.5.Adjusting Process
2.6.Worksheets For Financial Statements
2.7.Financial Statements
2.8.Journalizing And Posting Adjusting
2.9.Journalizing and Posting Closing Entries
2.10. Post Closing Trial Balance
Chapter Three: Accounting For Merchandising Businesses
3.1.Accounting For Purchases and Sales
3.2.Credit Terms, Cash Discounts and Return & Allowances
3.3.Trade Discount, Transportation Costs And Sales Tax
3.4.Worksheets For Merchandising Businesses
3.5.Financial Statements For Merchandising Businesses
3.6.Adjusting, Closing And Reversing Entries
3.7.Corrections of Errors
Chapter Four: Accounting for Accruals and Deferrals
4.1.Accruals- Accrued Assets And Liabilities
4.2.Deferrals- Prepaid Expenses And Unearned Revenues
Chapter Five: Accounting Systems Design
5.1.Principles Of Accounting Systems
5.2.Accounting Systems Installation And Revision
5.3.Internal Control Principles And Structures
5.4.Special Journals And Subsidiary Ledgers
Chapter Six: Accounting For Cash and Temporary Investment
6.1.Control Over Cash
6.2.Bank Reconciliation
6.3.Internal Control of Cash Receipts and Payments
6.4.Short Term Investment
Chapter 7: Accounting for Receivables
7.1.Classification of Receivables
7.2.Determination of Interest, Due Date, and Maturity Value
7.3.Notes Receivables
7.4.Uncollectible Accounts

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FUNDAMENTALS OF ACCOUNTING I Chapter One: Introduction to Accounting

Chapter One
General Introduction to Accounting

1.1) Definition Of Accounting

Accounting is defined as the process of identifying, measuring, recording, classifying,
summarizing, analyzing and interpreting economic events (financial transactions) and
communicating the results thereof to the entities interested in such information to enable them
make informed judgments. The analysis the definition is as follows:
 Identifying- to distinguish an event or a transaction that must be recorded.
 Measuring- quantifying an event or a transaction i.e. accounting deals with only those
transactions and events that can be expressed in terms of money.
 Recording- this is the basic function of accounting. It is essentially concerned with not
only ensuring that all business transactions of financial character are in fact recorded but
also that they are recorded in an orderly manner.
 Classifying- it is concerned with the systematic analysis of the recorded data with a view
to group transactions or entries of one nature at one place.
 Summarizing-this involves presenting the classified data in a manner which is
understandable and useful to the internal as well as external end users of accounting
statements or other accounting information
 Analyzing-means methodical classification of the data given in the financial statements.
For example, all items relating to “current assets” are put at one place.
 Interpreting- explaining the meaning and significance of the data so simplified and
analyzed
 Communicating- the accounting information after being meaningfully analyzed and
interpreted has to be communicated in a proper form and manner to the proper person.
Accounting: The Language of Business
Accounting has rightly been termed as the language of the business. Accounting is used to
communicate financial information to various parties who have some stake (interest) in the
affairs of the business.

1.2) Evolution of Accounting

Similar to medicine, law, economics, and accounting has evolved in response to the social and
economic needs of society. As business and society have become more complex over the
years, many complex economic development and social programs can not be undertaken due
to shortage of financial information. There fore, accounting has evolved to develop new
concepts and techniques to meet the ever increasing needs for financial information.

 Primitive Accounting
In the civilization of human being, various types of records of business activities have been
maintained. Of these, the oldest known is Clay Tablet records of the payment of wages in
Babylonia around 3600 B.C. There are numerous evidences of record keeping and systems of
accounting control in Egypt and Greek City States. In English, under the direction of King
William the 12th records were compiled to ascertain the financial resources of the kingdom.

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FUNDAMENTALS OF ACCOUNTING I Chapter One: Introduction to Accounting
Drawbacks of the Primitive Accounting:
I. It dealt with limited aspects of the financial operations of private or government
enterprises.
II. There was no systematic accounting for all transaction of a particular unit i.e. only for
specific type or portion of transaction

 Double Entry System Accounting

Since the primitive accounting was incomplete, the evolution of the system of record keeping
which was said to be called “Double Entry System” was strongly influenced by Venetian
merchants. Double entry system is the recordings process of a transaction into two parts. The
first known description of the system was published in Italy in 1494 by a person called LUCA
PACIOLI

Double Entry System provides:

1. For all business transaction, recording in a systematic manner i.e. to establish in an
equilibrium. For example, if a business borrowed Br 500 from a bank, the amount of the
loan is recorded both as cash of Br 500 and an obligation to repay Br 500. Either of the Br
500 amount is balanced by the other Br 500 amount. In double entry system, every
transaction entered twice in the books of accounts as means of check and control.
2. For the set of integrated financial statements, reporting in money terms
In spite of the tremendous development of business operations since 1494, and the ever
increasing complexities of business and governmental organizations, the basic elements of
Double Entry System have continued virtually unchanged.

Reading Assignment: the contribution of industrial revolution to the development of

accounting

1.3) Profession of Accountancy

To say a field of study is a profession, there must be accumulated body of knowledge
(scientific knowledge) and an individual should engage in it to get earning unlike hobby.
Based on these two criteria accounting is definitely a profession. There are employment
opportunities in accounting and are expected to continue to grow and expand as businesses
are growing and expanding from time to time. There are two types of job opportunities in
accounting:
1. Private Accounting
2. Public Accounting

Private Accounting: accountants employed by a business firm or not for profit organization
are said to be engaged in private accounting. These accountants provide accounting services
to one organization a salary basis and do a variety of work including financial accounting,
management and cost accounting, budgeting, internal auditing, controller and others.
Public Accounting: accountants and their staff who provide services on a fee basis are said to
be engaged in public accounting. Public accountant are independent professional persons and
provide accounting service to many clients. They provide service such as:
1. Auditing-providing an opinion as to fairness and truth-ness financial reports

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FUNDAMENTALS OF ACCOUNTING I Chapter One: Introduction to Accounting
2. Management advisory services-to offer constructive suggestions for improving a
company’s method of operations
3. Accounting System Development- developing an AS a private or public enterprises
Reading Assignment: specialized accounting fields such as financial accounting, auditing,
cost accounting, managerial accounting, tax accounting, accounting systems, budgetary
accounting, international accounting, not-for-profit accounting, social accounting and
accounting instruction

1.4) Types and forms of business organization in Ethiopia

 Forms of business organizations

There are three different legal forms of business organization: those are
1. Sole proprietorship: -is a business owned and managed by single individual.
Advantages:
Easy to establish the business
It is least regulated by government
No profit sharing
Disadvantages:
Limited life
Limited capital to finance business operation
Unlimited liability the owner is responsible to pay the debt of the business
even from his personal asset in case the business unable to meet its liability)
2. Partnership: - is business organization established by two or more persons.
Advantages:
Easier and less expensive to establish than corporation
Are not highly regulated by government
More capital and managerial skill than a single proprietor ship
Disadvantages:
Limited life
Unlimited liability (the partners are responsible to pay the debt of the
business even from their personal assets in case the business unable to meet
its liability)
Conflict between partners throughout operating the business.
3. Corporation: - is a business organized as a separate legal entity under state
corporation law with ownership divided into transferable shares of stock.
Advantages:
Long life
Limited liability
Can raise huge amount of capital to finance business operation
Disadvantages:
Double taxation
Highly regulated by government
Difficulty of controlling management, because ownership and management
is divorced in corporation.

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FUNDAMENTALS OF ACCOUNTING I Chapter One: Introduction to Accounting

 Types of Business Organizations

According to their type of activities or nature of operations, business organizations
are also classified in to three main types:

1. Service rendering businesses: - are business organizations that are

predominantly engaged in rendering of services to customers for the purpose
of maximizing profit.
Examples: Hotels, restaurants, cafeterias, bars, transport and communication
services, professional firms like consultations by accountants, lawyers,
engineers etc.
2. Merchandising businesses: - is profit seeking businesses, which are engaged
in purchasing and reselling of merchandises.
Examples: Supermarkets, boutiques, garment and shoe shops, drug stores,
stationary shops, auto spare parts, importers, exporters etc.
3. Manufacturing businesses: - are business organizations that are primarily
involved in the conversion of raw materials and parts in to finished goods;
and sale their finished goods to merchandising enterprises and consumers.
Sometimes, they sale goods to other manufacturing firms, which utilize the
goods as raw materials for production activities.
Examples: Cement factories, sugar factories, soap factories, textile factories,
paper factories, etc.

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FUNDAMENTALS OF ACCOUNTING I Chapter One: Introduction to Accounting
Accounting Functions Performed by accountants

Observe events

Identify those events

that are economic events Observe, identify
and measure
events.
Measure economic events
in financial terms

Record measurements

Classify measurements Record, Classify

and summarize
measurements

Summarize measurements

Report economic events in

financial statements and
other reports Report economic
events and
interpret financial
Interpret the contents of statements
financial statements and
other reports.

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1.5) Accounting as Information Systems
In order to provide information an entity must establish its own accounting system. An
accounting system consists of methods and devices used by an entity to keep track its
financial activities and summarize in a manner useful to decision makers. The process of
forming an accounting system to provide information is performed as follows:
Identification of Users

Information need of users

Economic Data Accounting System Financial Decision by

Reports users

Step-1: Identification of Users of Accounting Information

Individuals or organizations who/which have stake (interest) in accounting information of a
business to make sound decisions are called users of accounting information. They will
receive different reports a business to make decision and are classified in to two: (1) Internal
users and (2) External users
1. Internal Users: are individuals within an organization or business entity that need
accounting information of the business for the affairs of the business. Internal users are
responsible for the administration of the business and include the following management,
BOD, department head, corporate officer like chief executive officers and chief operating
officers and chief financial officers. Management need an accounting information:
 To plan future operation
 To evaluate and control current operation
 To know the profitability of each department
 To know the company’s cash position
 To know the trend of earnings
 To assess whether spending kept within the budget limit or not(especially in NGO
and Governmental organization)
 To assure whether expenditure are authorized or not( governmental and not-for-
profit organization)
2. External Users: are those individual or institutions inside or outside an economic entity
who/which need accounting information about that entity for their own affair. They need
accounting information for their benefit. This group include: owners of the business,
potential investors, bankers, suppliers and other creditors, employees and labor union,
governmental agencies, etc.

Owners need accounting information:

 To know the operating results of the business
 To know its financial position
Potential investors need accounting information a business to:
 Assess the risk ness of the investment

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  Predict its future prosperities
Bankers need accounting information to
 Evaluate the financial soundness of a business organization
 Assess risks involved in giving loans
Suppliers need accounting information to:
 Decide whether to sell or not to sell goods and services on credit basis
Employees and labor union need accounting information before beginning negotiation of for
new labor contract to know:
 The financial position of a businesses
 The profitability of a business
 The stability of a business
Governmental Agencies need accounting information for purpose of determining income tax
payable and pension contribution of an employee

Step-2: Information Need of Users

This to determine the information needs of internal users i.e. the type of information needed
by internal or external stakeholders should be identified by information provider before
information is provided to users.

Step-3: Information Processing

The information need of users determine the economic data to be gathered and processed by
accounting system. Then the accounting system generate reports that communicate essential
information to users

1.6) Accounting Principles and Practices

Experienced professional accountants contribute their best thinking to the solution of problem
continually confronting their staff or employees. Professional association periodically issue
pronouncements on accounting principles and concepts. Accounting principles or standards
are conventional rules and regulations that govern actions in undertaking accounting
activities. Concepts are basic assumption up on which the science of accounting is based.
Practices are the application of accounting principles and concepts to specific accounting
situation. The most important concepts and principles are:
1.6.1. Overview of international financial reporting standards (IFRS)
International Financial Reporting Standards. Financial accounting standards issued by
the IASB are referred to as International Financial Reporting Standards (IFRS).
Financial reporting
» General purpose financial reporting
» aims to provide useful financial information about the reporting entity to
primary users who cannot require the reporting entity to provide information
directly to them.
» Special purpose financial reporting
» responds to the requirements of users that have the authority to require the
reporting entity to provide the information that they need for their purposes
directly to them. Examples include:
» prudential regulation reporting requirements

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 » tax reporting requirements
International Financial Reporting Standards (IFRS)*
» Designed for general purpose financial reporting by profit-oriented entities
» might be found to be appropriate for not-for-profit activities too
» Focused on information needs of (primary users) existing and potential investors,
lenders and other creditors who cannot require information from the entity
» information to enable primary users to make their own assessments of the
reporting entity’s prospects for future net cash inflows
» as a basis for their decisions to buy, hold, sell equity and debt instruments or to
provide a loan or to require settlement of a loan

1.6.2. Basic Assumptions and accounting principles

The five basic assumptions in turn: (1) economic entity,

(2) going concern, (3) monetary unit, (4) periodicity, and (5) accrual basis.

Economic Entity Assumption

The economic entity assumption means that economic activity can be identified with
a particular unit of accountability. In other words, a company keeps its activity separate
and distinct from its owners and any other business unit. Thus, the entity concept does not
necessarily refer to a legal entity. A parent and its subsidiaries are separate legal entities, but
merging their activities for accounting and reporting purposes does not violate the economic
entity assumption

Going Concern Assumption

Most accounting methods rely on the going concern assumption—that the company will
have a long life. Despite numerous business failures, most companies have a fairly high
continuance rate. As a rule, we expect companies to last long enough to fulfill their objectives
and commitments.

Monetary Unit Assumption

The monetary unit assumption means that money is the common denominator of economic
activity and provides an appropriate basis for accounting measurement and analysis. That is,
the monetary unit is the most effective means of expressing to interested parties changes in
capital and exchanges of goods and services

Periodicity Assumption
To measure the results of a company’s activity accurately, we would need to wait until it
liquidates. Decision-makers, however, cannot wait that long for such information. Users need
to know a company’s performance and economic status on a timely basis so that they can

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evaluate and compare companies, and take appropriate actions. Therefore, companies must
report information periodically. The periodicity (or time period) assumption implies that a
company can divide its economic activities into artificial time periods. These time periods
vary, but the most common are monthly, quarterly, and yearly

Accrual Basis of Accounting

Companies prepare financial statements using the accrual basis of accounting. Accrual basis
accounting means that transactions that change a company’s financial statements are
recorded in the periods in which the events occur

Basic Principles of Accounting

There are four basic principles of accounting to record and report transactions: (1)
measurement, (2) revenue recognition, (3) expense recognition, and (4) full disclosure.
We look at each in turn

Measurement Principles
The most commonly used measurements are based on historical cost and fair value. Selection
of which principle to follow generally reflects a trade-off between relevance and faithful
representation.

Historical Cost. IFRS requires that companies account for and report many assets and
liabilities on the basis of acquisition price. This is often referred to as the historical cost
principle. Cost has an important advantage over other valuations: It is generally thought to
be a faithful representation of the amount paid for a given item.

Fair Value. Fair value is defined as “the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market participants at the measurement
date.” Fair value is therefore a market-based measure (exit price). Recently, IFRS has
increasingly called for use of fair value measurements in the financial statements. The IASB
believes that fair value information is more relevant to users than historical cost.

Revenue Recognition Principle

Revenue refers to increases in economic benefits during the accounting period in the form of
enhancements of assets or decreases of liabilities that result in increases in equity, other
than those relating to contributions from equity participants. When the company satisfies the
performance obligation, it should recognize revenue.

Expense Recognition Principle

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Expenses refers to decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants. Expenses should be recognized
in the period in which they are incurred.

Full Disclosure Principle

In deciding what information to report, companies follow the general practice of providing
information that is of sufficient importance to influence the judgment and decisions of an
informed user. Often referred to as the full disclosure principle, it recognizes that the nature
and amount of information included in financial reports reflects a series of judgmental trade-
offs.
1.7) Business Transaction and the Accounting Equation
1.7.1 Business Transaction
Business transactions are events or conditions that must be recorded in terms of money in
accounting records.
 Events-payments or a promise to make payment or receipts or acceptance of a promise to
receive cash within a specified period of time in exchange for goods and services
 Conditions- the tearing and wearing out of long lived properties of a business i.e.
decrease in usefulness of long lived property.
Example:
 Monthly electricity bill of Br 100
 The acquisition of a land and a building for Br 250,000

Nature of Business Transaction

 Business transaction could be Simple or complex
 Business transaction could be Internal or external
 Business transaction affects the financial position of a business and its operating results or
at least it affects two items
 Business transaction must be supported by source documents (business papers). Source
documents include sales invoice, receipts, checks, check stub, fright bill, and etc. Business
documents normally contain information as to the monetary amount to be recorded, the
parties involved, the term of transaction and other relevant information such as nature and
date of transactions.

1.7.2 The Accounting Equation

The whole of financial accounting is based on a very simple idea. This is called the
accounting equation which sounds complicated but infact easy to understand. If a firm is to be
set up or established definitely it need resources. In the first place let us assume that it is the
owner of the business has supplied all of the resources. This can be shown:
Resources in the Business = Resources Supplied by the Owner
In accounting the term used to describe the resources supplied by the owner is called Owner’s
Equity. The term used to describe the actual resource in a business is called Asset. Thus, the
accounting equation is:
Assets = Owner’s Equity

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In the second place let us assume that people other than the owner have supplied some of the
resources (material or financial resources). Thus,
Resources in a Business = Resources Supplied + Resources Supplied
by the Owner by Others
Liabilities are the term given to the amounts of resource supplied people other than the
owners. This is amount of asset owed to others by the business. Thus the accounting equation
is now changed to
Assets = Owner’s Equity + Liabilities

However, liabilities are placed before Owner’s Equity, in the accounting equation, because
creditors have preferential right to the assets of the business. Thus, the accounting equation
can be stated as:
Assets = Liabilities + Owner’s Equity

1.7.3 Definition of Terms Used in Business Transactions and Accounting Equation

Definition of elements of financial statements
ASSET. A resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity.eg cash ,account receivable, supplies
equipment building etc

LIABILITY. A present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources embodying economic
benefits. Eg account payable, wage payable bond payable etc

EQUITY. The residual interest in the assets of the entity after deducting all its liabilities. The
elements of income and expenses are defined as follows.
INCOME/Revenue. Increases in economic benefits during the accounting period in the form
of inflows or enhancements of assets or decreases of liabilities that result in increases in
equity, other than those relating to contributions from equity participants.eg sales, service
income
EXPENSES. Decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants.eg salary expense, rent
expenses etc
Other related definition
 Accounts receivable-is money to be collected in the future. It is an asset that arises from
the sell of goods and services on credit basis or on account.
 Account payable-is money to be paid in the future. It is a liability that arises from
purchasing goods or services on account basis.
 Prepaid expenses- are assets which represent consumable goods purchased such as
supplies, prepaid rent, prepaid insurance, prepaid interest
 Revenue-is a general term that stands for the amount of charge against customer for
goods or services sold to them. Based on the source of revenue, it is classified into two:

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 Miscellaneous Revenue and Principal Revenue. Revenue can have different names such
as:
1. Royalties- revenue from sale of franchise
2. Fares revenue- a revenue generated by providing transportation service
3. Fees revenue- by providing professional service
4. Sales- revenue from sales of goods and services
5. Rent revenue- from renting real-estate and other equipment
6. Tuition fee- revenue from providing educational service
 Net income/ net profit-is the excess of revenue earned over the expenses in the process of
generating revenue.
 Net loss- is the excess of expenses over the revenue earned during the period
 Investment- represent the cash or other assets put into the business by the owner of a sole
proprietorship
 Withdrawal (drawing)-is the cash or any asset withdrawn (taken away) from the
business by the owner for personal use. Withdrawal is recorded in accounting record of
the business.

1.7.4 Accounting Equation and Business Transactions

The effect of business transaction on accounting equation can be demonstrated by taking
some typical transactions.
Illustration: Mr. Hara established a Sole Proprietorship Business known as Hara Taxi on
August 1, 1995 and decided the fiscal year of the business to be from September 1 to August
31. During the first month of operation the following transactions occurred:
August 1: Hara deposited Br 300,000 in a bank account in the name of the business.
August 2: The owner purchased two taxis at Br 100,000 each for the business
August 4: Purchased a land as a future building sites for Br 7,500 paid in cash
August 7: Purchased Br 850 of gasoline, oil, and other supplies on account promising to pay
in the future
August 10: Paid creditors on account Br 400
August 15: Hara Taxi earned fares revenue of Br 4,500 receiving the amount in cash.
August 21: The business paid the following expenses in cash:
 Wages expense......................................... Br 1,200
 Rent expense............................................ 850
 Utilities expense....................................... 150
 Miscellaneous expense............................. 200
August 23: The business charged customers for the transportation service provided on account
Br 2,000
August 28: Received cash from customers on account Br 1,500
August 30: Mr. Hara withdrawn Br 1,000 from the business in cash for personal use
August 31: At the end of the month the cost of supplies left on hand is Br 50
Instructions:
1) Indicate (show) the effect of each of the above transactions on accounting equation
2) Prepare the accounting statements

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 Assets = Liabilities + Capital
Accounts Accounts Owner's
Date Cash Receivables Supplies Taxi Land = Payables Equity
August 1, +300,000 300,000
Balance 300,000 = 300,000
August 2, -200,00 +200,000
Balance 100,000 200,000 = 300,000
+75,00
August 4, -75,000 0  
Balance 25,000 200,000 75,000 = 300,000
August 7, +850 +850  
Balance 25,000 850 200,000 75,000 = 850 300,000
August 10, -400 -400  
Balance 24,600 850 200,000 75,000 = 450 300,000
August 15, +4,500   +4,500 F.Revenue
Balance 29,100 850 200,000 75,000 = 450 304,500
August 21, -2,400 -1,200 W.Expense
-850 W.Expense
-200 W.Expense
          -150 W.Expense
Balance 26,700 850 200,000 75,000 = 450 302,100
August 23,   +2,000         +2,000 F.Revenue
Balance 26,700 2,000 850 200,000 75,000 = 450 304,100
August 28, +1,500 -1,500          
Balance 28,200 500 850 200,000 75,000 = 450 304,100
August 30, -1,000           -1,000 Withdrawal
Balance 27,200 500 850 200,000 75,000 = 450 303,100
August 31,  ______ _____ -800 _____ _____ ____ -800 S.Expense
Balance 27,200 500 50 200,000 75,000 = 450 302,300

1.8) Accounting (Financial) Statements

Accounting statements are different summaries that communicate accounting information of a
business to users. And include:
 Income statement
 Statement of owner’s equity
 Balance sheet
 Cash flow statement
Financial statements are identified by three headings:
 The name of the business
 The title of the statement
 The specific date or period

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1. Income Statement
This statement is a summary of revenues and expenses for the specific period of time. The
procedure is the total expenses are deducted from the total of revenues to determine net loss
or net income. For example, income statement for Hara Taxi

Hara Taxi
Income Statement
For the Year Ended August 31, 1995
Fares Revenue................................................ Br 6,500
Less: Expenses
Wages Expense...................................... 1,20
0
Rent Expense......................................... 850
Utilities Expense.................................... 200
Supplies Expense................................... 800
Miscellaneous Expense.......................... 150
Total Expense................................... (3,200)
Net Income..................................................... Br 3,300

2. Capital Statement (Statement Of Owner’s Equity)

This statement is a summary which shows change in owner’s equity or capital. For Hara Taxi
the capital statement is as follows:
Hara Taxi
Statement of Owner’s Equity
For the period ended August 31, 1995
Hara Capital, August 1, 1995......................... Br 200,000
Add: Additional Investment........................... Br 100,000
Add: Net Income............................................ 3,300
Less: Withdrawal........................................... (1,000)
Net Increase In Capital............................ 102,300
Hara Capital, August 31, 1995....................... Br 302,300
3. BALANCE SHEET
Balance Sheet is a statement that shows the financial position of a business on a specific date.
It lists Assets, Liabilities and Capital on any specific date, which is the last date of the
accounting period.
Hara Taxi
Balance Sheet
August 31, 1995
Assets: In Birr Liabilities and Capital In Birr
Cash............................................27,200 Liabilities:
A/Receivables............................. 500 A/Payables.................................. 450

Supplies...................................... 50

Land............................................75,000 Capital:
Taxi.............................................
200,000 Hara, Capital...............................
302,300

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 Total Assets................................
302,750 Total liabilities + OE.................
302,750

4. Cash Flows Statement

Cash flows statement is a summary of cash inflows (Cash receipts) and Cash outflows (Cash
payments) for a specific period of time. It is reported in three sections:
 Cash flows from operating activities
 Cash flows from investing activities
 Cash flows form financing activities

Hara Taxi
Statement of Cash Flows
For the Year ended August 31, 1995
Cash Flows From Operating Activities:
Cash inflow from revenue...................................................... 6,000
Cash outflow for expense ...................................................... (2,800)
Net cash flows from operating activities................... 3,200
Cash Flows From Investing Activities:
Cash inflow from investing.................................................... 0.00

Cash outflow for investing..................................................... (75,000)

Net cash flows from investing activities.................... (75,000)
Cash Flows From Financing Activities:
Cash inflow from financing................................................... 100,000
Cash outflow from financing................................................. (1,000)

Net cash flows from financing activities................... 99,000

Cash Balance on August 31, 1995......................................... Br 27,200

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 Chapter Three: Accounting for Service Rendering Businesses

Chapter Two
Accounting for Service Rendering Businesses
2.1Nature and Classification of Accounts
2.1.1. Nature of Accounts
The simplest way of providing accounting information or preparing financial statements is to
record and summarize transactions on the accounting equation format. However, this format
is awkward and cumbersome for recording and analyzing ten thousands of transactions to
provide information. Thus, accountants accumulate the effects of individual transaction on a
separate record for each item to meet the goal of providing information. These separate
records show increases in the item, decreases in item and balance in item. The type of
separate records used for the purpose of recording all transactions related to individual item is
called An Account. A group of accounts is called ledger. The simplest form of an account has
three parts:
 Title- the account name
 A space for recording the amount of increases in item in terms of money
 A space for recording the amount of decreases in item in terms of money
The left side of an account is called Debit Side and the word “Charge” sometimes used
as a synonym for debit. Amounts entered in the left side of an account regardless of the
account title are called debit and the account is said to be debited. The right side of an account
is called credit side and the amount entered in the right side of an account is also called credit
and the account is said to be credited.

2.1.1.2. General Rules of Debit and Credit for Accounts

 Assets-the increasing side of all assets account is the debit side and the decrease is the
credit side.
 Liabilities-the increase side of all liabilities is the credit side and the decreasing side is the
debit side.
 Capital -the increase side of capital account is the credit side and the decreasing side is
the debit side.
 Revenue- the increase side of all Revenue accounts is the credit side and the decreasing
side is the debit side.
 Expenses -the increasing side of all expenses account is the debit side and the decrease is
the credit side.
 Drawing- the increasing side drawing is the debit side and the decrease side is the credit
side.

2.1.1.2. Normal Balance of Accounts

The sum of increases recorded in an account is usually greater than or equal to the sum of
decreases recorded in an account. For this reason, the normal balance of all accounts is

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positive rather than negative. Thus, the normal balance of any account is the increasing side.
Summaries Rules of Debit and Credit with normal balances of accounts

Items Increasing Side Decreasing Side Normal Balance

Assets Debit Credit Debit
Liabilities Credit Debit Credit
Capital Credit Debit Credit
Drawing Debit Credit Debit
Revenues Debit Credit Debit
Expenses Debit Credit Debit

2.1.1.3Classification Of Accounts
Accounts in a ledger are classified based on common characteristics as a balance sheet
accounts or income statement accounts

Balance Sheet Accounts

Balance Sheet Accounts further classified into three and are listed in the ledger in the order of
Assets, Liability and Owners Equity
A) Assets-assets are classified in the two groups as current assets and plant assets
1. Current Assets-are any assets that may reasonably be realized in cash or sold or
consumed within year or less period. For example: Cash, Accounts Receivable, supplies,
commodities
2. Plant Assets-these are used in the business operations and are of permanent nature. For
example Equipments, machinery, building, furniture, land, etc
B) Liability- the two categories occurring most frequently are:
1. Current liabilities- are liabilities that will be due within short period of time usually a
year or less that have to be paid out current asset. For example: salary payable, interest
payable, tax payable, and accounts payable
2. Long term liabilities- are liabilities that will not be paid or due or matured comparatively
for long period of time usually more than one year. For example mortgage payable, notes
payable
C) Owner’s Equity-is a residual claim against the asset of the business after liability is fully
deducted. For a corporation owners’ equity is called stock holder’s equity. Drawing
represents the amount of cash or other assets taken out of the business for personal use
and it is one of the capital accounts.

Income Statement Accounts

Income Statement Accounts are classified into three and are listed in the order of revenue first
and expense second.
Revenue is increase in capital by gross amount as a result of:
 Sale of goods and service

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 Chapter Three: Accounting for Service Rendering Businesses

 Renting real-estate and other properties

 Providing professional service
 Sale of assets
Expenses – represent decreasing in capital by gross amount as a result of business operation.
That is as a result of consuming assets or using up of services.

3.1) Chart of Accounts

Accounts are sequentially arranged and given number for use as references. The list of
accounts along with their numbers showing the sequence of account in the ledger is called
Chart of Accounts. According to their order in the financial statements asset comes first and
then followed by liabilities, capital, revenues and expenses. The chart of account of Ethio
Mobile Maintenance which is owned by Ato Samuel and managed by his wife W/o Ethiopia
is follows:
1. Assets
Cash...................................................................................... 11
Accounts Receivables.......................................................... 12
Supplies................................................................................ 13
Prepaid Insurance................................................................. 14
Office Equipment................................................................. 17
Land..................................................................................... 19
2. Liabilities
Accounts Payable................................................................. 21
Unearned Revenue............................................................... 23
3. Capital
Samuel, Capital.................................................................... 31
Samuel, Drawing.................................................................. 32
Income Summary................................................................. 33
4. Revenues
Fees Revenue....................................................................... 41
Rent Income......................................................................... 42
5. Expenses
Salary Expenses................................................................... 51
Rent Expense........................................................................ 52
Supplies Expense................................................................. 53
Utilities Expense.................................................................. 54
Miscellaneous Expense........................................................ 59
Note: A flexible system of numbering is desired. Such system has the advantage of permitting
of the later insertion new accounts without disturbing other account number. In the above
chart of accounts certain numbers (15, 16, 18, and 22, 55-58) have not been assigned. These
numbers are held in reserve so that additional accounts can be inserted in the ledger in proper
sequence whenever such accounts become necessary. The number of digits given may vary
from 2 to 30 digits depending up on the size and nature of the business. In the above chart of
accounts, 2 digits are assigned. The first digit shows the division of the item in the ledger and
the second digit indicates the position of the item in the division.

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 Chapter Three: Accounting for Service Rendering Businesses

3.2) Flow of Accounting Data

The flow of accounting data from the time a transaction occurs to its recording in the ledger is
diagrammed as follows:
Transaction Document Transaction Transaction Transaction
Occurs Prepared Analyzed Recorded Posted

1. Transaction Occurs – there must be business transaction, be it internal or external, to

initiate the flow of Accounting Data.
2. Document Prepared – If it is external transaction it must be supported by the necessary
source documents.
3. Analyzing Transaction
Analysis of a transaction is a three steps procedure:
 Determining the accounts affected by the transaction
 Determining the effect of a transaction as increases and decreases
 Analyzing the increases and decreases as Debit and Credit
Example: The owner of JJ Arts Club invested Br 20,000 on January 1, 2005
 The accounts affected are Cash (Asset) and Capital (Owner’s Equity)
 Cash increases and Capital also increases by Br 20000
 Cash increases is Debit and Capital increases is Credit
JJ Arts Club purchased electric guitar for Br 8,200 in Cash on January 10, 2005
 The accounts affected are Cash and Equipment
 Cash decreases and Equipment increases by Br 8200
 Cash decreases is debit and Equipment increases is Credit
4. Recording Transaction in a Journal
After analyzing transactions, they are recorded in a book called journal in an orderly manner.
Journal provides for transactions:
 Permanency-it is permanent record of transactions for reference
 Orderliness or chronology-transactions are recorded sequentially
 Accuracy or Approval- before transactions are recorded in their account approval will be
made
There are two types of journals:
General Journal- is a journal on which any type of transaction is recorded upon.
Special journal- this is a journal on which one type of transaction with recurrent nature is
recorded upon.
The process of recording transaction in a journal is called journalizing and the steps in
journalizing are as follows:
Step-1: Recording the Date
 Inserting the year

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 Chapter Three: Accounting for Service Rendering Businesses

 Inserting the month

 Inserting the date
Step-2: Recording the account title to be debited at the extreme left of the description column
of the General Journal and enter the amount of debit
Step-3: Recording the account title to be credited just below the debit entry moderately
indented and enter the credit amount
Step-4: Writing an explanation
Write an explanation for each transaction or replace it with its source document number if it is
self explanatory transaction. The above two analyzed transactions are recorded in the General
Journal as follows:
General Journal Page 5
Date Description P/R Debit Credit
2005
January, 1 Cash 20000
Capital 20000
Investment by the owner

10 Equipment 8200
Cash 8200
Purchase of Equipment

5. Posting a Transaction
The processing of transferring a transaction to ledger accounts is called posting. There are
different types of accounts:
 T-accounts which resembles a capital letter “T”
 Two column account which consists of two date, post referencing, debit and credit
columns
 Four column account which consists of one date, one post referencing, one debit, one
credit and one debit and credit under balance column
 Three column account which consists of one date, one post referencing, one debit, one
credit and one balance column. The abnormal balance is shown in bracket.
The steps in posting are:
Step-1: Record the date and Post the debit or the credit
Step-2: Insert journal page numbers in the post reference column of ledger accounts
Step 3: Insert Account numbers in the post reference column of General Journal
Account Cash Account No 11
P/
Date Item R Debit Credit Balance
2005
Jan. 1 20000 20000
10 8200 11800

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 Chapter Three: Accounting for Service Rendering Businesses
Illustration on Journalizing and Posting
The following transactions are related to Ethio Mobile Maintenance (EMM) which is owned by Ato
Samuel, for the first month operation ended December 31, 2004
December 1: The following assets were invested to the business:
Cash.............................................................................. Br 5,900.00
Supplies......................................................................... 550.00
Land.............................................................................. 10,000.00
The liabilities transferred to the business was............... 400.00
December 1: EMM paid a premium of Br 2,400 for a comprehensive insurance policy which
will cover a 2 years period
December 1: EMM received Br 720 for renting the land for 3 months
December 2: EMM paid Br 800 for the rent of the month December.
December 5: EMM Purchased Office Equipment on account Br 7,000
December 7: EMM paid Br 180 for a daily news paper
December 11: EMM paid Br 400 to creditors
December 13: EMM paid receptionist and part-time assistant Br 1,250 for two weeks salary
December 16: EMM received Br 5,000 from revenues earned for the 1st half of the month
December 16: fees revenue on account totaled Br 1,750 for 1st half of the month
December 20: EMM paid Br 3,500 to creditors on the Br 7000 debt owed from the December
4 transaction
December 23: EMM Received Br 1,150 from customers in payment of their accounts
December 25: EMM purchased supplies for Br 1,450 in cash
December 27: EMM paid receptionist and part-time assistant Br 1,250 for two weeks salary
December 31: EMM paid Br 310 and Br 240 telephone and electric bill for the month,
respectively
December 31: EMM received Br 2,750 from revenue earned for the second half of the month
December 31: fees revenue earned on account totaled Br 1,200 for the second half of the
month
December 31: the owner withdrew Br 1,000 for his personal use

Instructions: Analyze and Journalize the transaction for the month December 2005 in two
column journal assuming that the policy of the company is to record money paid for
telephone, electric and water as utilities expense and for advertising, postage and stamp and
news paper as miscellaneous expense. Post entries from journal to ledger accounts using a
four or three column ledger account

Journalizing: Recording Transactions in General Journal (Assume transactions from

Dec.1 to 15 and Dec.16 to 31 are recorded on page 1 and 2, respectively)
General Journal Page 1
Date Description P/R Debit Credit
2005
Dec. 1 Cash..................................................................... 5,900
Supplies............................................................... 550
Land..................................................................... 10,000
Accounts Payable......................................... 400
Samuel, Capital............................................ 16,050
investment by the owner

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 Chapter Three: Accounting for Service Rendering Businesses
1 Prepaid Insurance................................................ 2,400
Cash............................................................. 2,400

1 Cash..................................................................... 720
Unearned Rent.............................................. 720

2 Rent Expense....................................................... 800

Cash............................................................. 800

5 Office Equipment................................................ 7,000

Accounts Payable......................................... 7,000

7 Miscellaneous Expense........................................ 180

Cash............................................................. 180

11 Accounts Payable................................................ 400

Cash............................................................. 400

13 Salary Expense.................................................... 1,250

Cash............................................................. 1,250
Transactions from December 16 to 31, 2005
General Journal Page 2
Date Description P/R Debit Credit
2005
Dec. 16 Cash..................................................................... 5,000
Service Revenue........................................... 5,000

16 Fees Receivables................................................. 1,750

Service Revenue........................................... 1,750

20 Accounts Payable................................................ 3,500

Cash............................................................. 3,500

23 Cash..................................................................... 1,150
Fees Receivables.......................................... 1,150

25 Supplies............................................................... 1,450
Cash............................................................. 1,450

27 Salary Expense.................................................... 1,250

Cash............................................................. 1,250

31 Utilities Expense.................................................. 550

Cash............................................................. 550

31 Cash..................................................................... 2,750
Service Revenue........................................... 2,750

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 Chapter Three: Accounting for Service Rendering Businesses
31 Fees Receivables................................................. 1,200
Service Revenue........................................... 1,200

31 Samuel, Drawing................................................. 1,000

Cash............................................................. 1,000

Posting: Transferring transactions from General Journal to ledger accounts

Account: Cash Account No. 11
Date Item P/R Debit Credit Balance
2004
Dec.1 5,900 5,900
2,400 3,500
720 4,220
800 3,420
180 3,240
400 2,840
1250 1,590
5000 6,590
3500 3,090
1150 4,240
1450 2,790
1250 1,540
550 990
2750 3,740
1000 2,740
Cash Account has a debit balance of Br 2,740.
Account: Accounts Receivables Account No. 12
Date Item P/R Debit Credit Balance
2004
Dec.1 1,750 1,750
1,150 600
1,200 1,800

Accounts Receivables General Ledger Account has a debit balance of Br 1,800

Account: Supplies Account No. 13
Date Item P/R Debit Credit Balance
2004
Dec. 1 550 550
1,450 2,000

Supplies General Ledger Account has a debit balance of Br 2,000

Account: Prepaid Insurance Account No. 14
Date Item P/R Debit Credit Balance
2004
Dec. 1 2,400 2,400

Prepaid Insurance General Ledger Account has a debit balance of Br 2,400

Account: Equipment Account No. 15

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 Chapter Three: Accounting for Service Rendering Businesses
Date Item P/R Debit Credit Balance
2004
Dec. 5 7,000 7,000

Equipment General Ledger Account has a debit balance of Br 7,000

Account: Accumulated Depreciation Account No. 16
Date Item P/R Debit Credit Balance
2004

No transaction is posted to Accumulated Depreciation General Ledger Account so far.

Account: Land Account No.
Date Item P/R Debit Credit Balance
2004
10,00
Dec. 1 0 10,000

Land General Ledger Account has a debit balance of Br 10,000

Account: Accounts Payable Account No. 21
Date Item P/R Debit Credit Balance
2004
Dec. 1 400 400
7,000 7,400
400 7,000
3,500 3,500

Accounts Payable General Ledger Account has a credit balance of Br 3,500

Account: Unearned Rent Account No. 23
Date Item P/R Debit Credit Balance
2004
Dec. 1 720 720

Unearned Rent General Ledger Account has a credit balance of Br 2,400

Account: Samuel Capital Account No. 31
Date Item P/R Debit Credit Balance
2004
Dec.

Samuel Capital General Ledger Account has a credit balance of Br

Account: Samuel Drawing Account No 32
Date Item P/R Debit Credit Balance

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 Chapter Three: Accounting for Service Rendering Businesses
2004
Dec.

Samuel Drawing General Ledger Account has a debit balance of Br

Account: Income Summary Account No 33
Date Item P/R Debit Credit Balance
2004
Dec.

No transaction is posted to Income Summary General Ledger Account

Account: Service Revenue Account No. 41

Date Item P/R Debit Credit Balance
2004
Dec.

Service Revenue General Ledger Account has a Credit balance of Br

Account: Rent Income Account No. 42
Date Item P/R Debit Credit Balance
2004
Dec.

No Transaction is posted to Rent Income General Ledger Account

Account: Salary Expense Account No 51
Date Item P/R Debit Credit Balance
2004
Dec.

Salary Expense General Ledger Account has a debit balance of Br

Account: Supplies Expense Account No. 53
Date Item P/R Debit Credit Balance
2004
Dec.

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 Chapter Three: Accounting for Service Rendering Businesses

Supplies Expense General Ledger Account has a debit balance of Br

Account: Rent Expense Account No.56
Date Item P/R Debit Credit Balance
2004
Dec.

Rent Expense General Ledger Account has a debit balance of Br

Account: Utilities Expense Account No 52
Date Item P/R Debit Credit Balance
2004
Dec.

Utilities Expense General Ledger Account has a debit balance of Br

Account: Miscellaneous Expense Account No. 59
Date Item P/R Debit Credit Balance
2004
Dec.

Miscellaneous Expense General Ledger Account has a debit balance of Br

Account: Depreciation Expense Account No.55
Date Item P/R Debit Credit Balance
2004
Dec.

No Transaction is posted to Depreciation Expense General Ledger Account

Account: Insurance Expense Account No. 54
Date Item P/R Debit Credit Balance
2004
Dec.

Insurance Expense General Ledger Account has a debit balance of Br

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 Chapter Three: Accounting for Service Rendering Businesses

3.3) Trial Balance

Before preparing financial statements, the ledger account balances must be proved as to the
equality of the total debit balances and the total credit balances. The working paper which
provides the proof of the equality of debit and credit balances is called a trial balance. The
trial balance is a two column schedule listing the names and balances of all accounts in the
ledger i.e. debit balances are listed in the left hand column and the credit balances in the right
hand column. It is a working paper which is useful only to the accountant. It is not a financial
statement and it is not intended for distribution to the users of accounting information.
Preparing a trial Balance requires five steps
 Determine the balance of each account
 List the accounts with a balance other than zero, the debits in the left column and the
credits in right column
 Add debit balances
 Add credit balances
 Compare the sum of the debit balances with the sum of the credit balances
Instruction: Prepare a Trial Balance for EMM
Ethio Mobile Maintenance
Trial Balance
December 31, 2004
Account Title Debit Credit
Cash...................................................................... 2,740
Account Receivables............................................ 1,800
Supplies................................................................ 2,000
Prepaid Insurance................................................. 2,400
Office Equipment................................................. 7,000
Land......................................................................10,000
Account Payables................................................. 3,500
Unearned Rent...................................................... 720
Samuel, Capital.................................................... 16,050
Samuel, Drawing.................................................. 1,000
Service Revenue................................................... 10,700
Salary Expense..................................................... 2,500
Rent Expense........................................................ 800
Utilities Expense.................................................. 550
Miscellaneous Expense........................................ 180 _____
Total ....................................................................30,970 30,970

Uses of a Trial Balance

A trial balance provides a proof that the ledger in a balance and it is also a cornerstone for
preparation of financial statements. The following types of errors will cause the two total of
the trial balance to unequal.
Error in preparing the trial balance such as:
 One of the columns of the TB was incorrectly added

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 Chapter Three: Accounting for Service Rendering Businesses

 The amount of an account balance is incorrectly recorded on the trial balance

 A debit balance was recorded on the trial balance as a credit or vice-versa or the
balance was entirely omitted
Error in determining the account balances such as:
 A balance was incorrectly computed
 A balance was entered in the wrong balance column
Error in recording transaction in the ledger such as
 An erroneous amount was posted to the account
 A debit entry was posted as a credit or vice-versa
 A debit and a credit posting was omitted
Limitations of a Trial Balance
The trial balance does not prove that transactions have been correctly analyzed and recorded
in the proper account because there are many errors that do not cause the two totals of the trial
balance to be out of balance. The following errors do not affect the equality of the two
columns of the trial balance:
 Failure to record a transaction or to post a transaction
 Recording the same erroneous amount for both debit and credit parts of a transaction
 Recording the same transaction more than once for both parts of a transaction
 Posting a part of a transaction correctly as a debit or a credit but to the wrong account
Discovery of Errors
If the two totals of the trial balance are not equal, the error can be discovered in the following
manner:
 By Audit procedures
 By Chance discovery
 Through the medium of the trial balance
Through the medium of the trial balance, first determine the difference between the debit total
and the credit total. This gives the clue
 A difference of Br10, 100, 1000 is frequently the result of an error in addition
 If a difference divisible evenly by 2, the error is either the omission of a debit or a
credit or the posting of debit as a credit or vice-versa
 If the discrepancy of the two totals is evenly divisible by 9, the error is either
transpositions or slide.
 Transpositions error is the erroneous rearrangement of digits
 Slide error is the entire number is erroneously moved one or more spaces to the
right or to the left

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3.4) The Adjusting Process
Revenues and expenses might be reported on the income statement by the cash basis or the
accrual basis. In the cash basis of accounting, revenues are reported in the period cash is
received and expenses are reported in the period when cash is paid. In cash basis of
accounting, the net income equals cash receipts minus cash payments. This basis of
accounting is used by various professional service businesses. For most businesses, how ever,
it is not considered an acceptable method. In the actual basis of accounting, revenues are
reported in the period in which they are earned and expenses are reported in the period in
which they are incurred. Thus, accrual basis of accounting requires adjusting processing.

At the end of the acct period many of the amounts listed on the trial balance can be transferred
with out change to the financial statements. For example, cash, notes payable. On the other
hand there are some accounts whose balance listed on the trial balance should not pass
directly to the financial statements. For example, the amounts listed for prepaid expenses are
normally overstated. The reason is part of the amount is consumed in the day to day operation
of the business in generating revenues. Also other data needed for the financial statement may
be entirely omitted from the trial balance because revenues or expenses related to the period
has not been recorded. For example, salary expenses incurred between the last pay day and
the end of the accounting period would not ordinarily be recorded in the accounts because
salaries are customarily recorded only when they are paid. The entries required at the end of
the accounting period to bring the amounts up to date and to ensure the proper matching of
revenues and expenses are called adjusting entries. Adjusting entries are internal transactions
made at the end of the accounting period.
Illustrations of Adjusting Entry
1. Adjusting Deferred Expenses (Prepaid Expenses)
A) Adjusting Supplies
In a trial balance, the supplies account has a balance of Br2000 on December 31, 2004.
Assuming that the inventory of supplies on December 31, is Br 500, determine the amount to
be transferred from asset account (supplies) to the expense account (supplies expense)
Supplies available during the year.................Br 2,000
Supplies on hand............................................ (500)
Supplies used (amount of adjustment)........... 1,500
B) Adjusting prepaid insurance
The balance of prepaid insurance account has a balance of Br 2400 which was paid for 24
months. As a result every month Br 100 is expired. Other examples of prepaid expense are
prepaid advertising, interest, rent, etc

2. Adjusting Deferred Revenue (Unearned Revenue)

On December 31, the balance in the unearned rent account is Br720. This balance represents
the receipt of three month’s rent. At the end of December, the unearned rent account should
be debited (decreased) by Br 240 and the rent income account should be credited (increased)
by Br 240.

3. Adjusting Accrued Expenses (Accrued Liabilities)

Some services are paid for after the services have been performed. For example, Wages
expense accumulated or accrues hour by hour and day by day, but payment may be made only

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 Chapter Three: Accounting for Service Rendering Businesses
weekly, biweekly, or monthly. The amount of such an accrued but unpaid item at the end of
the accounting period is both an expense and a liability. For example, at the end of December
accrued wages for Ethio Mobile Maintenance was Br 250. This amount is an additional
expense of December and is debited to the salary expense and salary payable. In this example,
December 1 is on Sunday and the first and the second salary payment on 13th and 27th of
December, respectively if salary is paid on biweekly basis. If payment for the next 10 working
days is Br 1250 the accrued salary will be Br 250

4. Adjusting Plant Assets

As time passes, the equipment loses its ability to provide useful services. This decrease in
usefulness is called depreciation. All plant, except land, loses their usefulness. It is difficult to
objectively measure the decrease in usefulness of a plant asset. For this reason, depreciation in
accounting is the systematic allocation of plant assets cost to the useful life as an expense.
This allocation occurs over the asset’s estimated life during which it is expected to generate
revenue. The adjusting entry is made by debiting a depreciation expense account and crediting
an accumulated depreciation account followed by the specific name of that plant asset. For
example, assuming that the estimated amount of depreciation for the month is Br 100, the
adjusting entry debits (increases) Depreciation Expense by 100 and credits (increases)
Accumulated Depreciation-Equipment by the same amount.
 Book Value (BV) an Asset = Cost – Accumulated Depreciation
 Book Value of the Equipment= Br 7,000 – 100= Br 6,900

3.5) Worksheet for Financial Statements

A working paper often used by accountants to summarize adjustment data and assist in
preparing the financial statements is called the worksheet. It is identified by three headings
and has five columns: Trial Balance Column, Adjustment Column, Adjusted Trial Balance
Column, Income Statement Column, and Balance Sheet Column.
Uses of Worksheet:
1. It Reduces The Possibility Of Overlooking The Need For An Adjustments
2. It provides A Convenient Means Of Verifying Arithmetical Accuracy
3. It Provides For The Arrangement Of Data Is A Logical Form
4. It Provides The Source Data For The Financial Statements
Preparing worksheet based on the above adjustment data for the service rendering business.

Ethiopia Mobile Maintenance

Work Sheet
For The Year Ended December 31, 2004
Income Balance
Trial Balance Adjustment Adjusted T B Statement Sheet
Title of Accounts Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Cash 2,740 2,740 2,740
Account Receivables 1,800 1,800 1,800

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 Chapter Three: Accounting for Service Rendering Businesses
Supplies 2,000 A)1,500 500 500
Prepaid Insurance 2,400 B) 100 2,300 2,300
Office Equipment 7,000 7,000 7,000
Land 10,000 10,000 10,000
Account Payables 3,500 3,500 3,500
Unearned Rent 720 C)240 480 480
Samuel, Capital 16,050 16,050 16,050
Samuel, Drawing 1,000 1,000 1,000
Service Revenue 10,700 10,700 10,700
Salary Expense 2,500 D)250 2,750 2,750
Rent Expense 800 800 800
Utilities Expense 550 550 550
Miscellaneous Exp. 180 _____ 180 180
30,970 30,970
Supplies Expense A)1,500 1,500 1,500
Insurance Expense B)100 100 100
Rent Income C)240 240 240
Salary Payable D)250 250 250
Depreciation Expense E) 100 100 100
Accum. Depreciation-Equip. ______ E) 100 ______ 100 100
2,190 2,190 31,320 31,320 5,980 10,940 25,340 20,380
Net Income 4,960 ______ ______ 4,960
10,940 10,940 25,340 25,340

3.6) Preparation of Financial Statements

The worksheet is an aid in preparing the financial statement namely the income Statement,
The Capital Statement and the Balance Sheet. For Ethio-Mobile Maintenance, the financial
statements are presented as follows:
1. The Income Statement
Ethio Mobile Maintenance
Income Statement
For The Year Ended December 31, 2004
Revenues: In Birr In Birr
Service Revenue............................................. 10,700
Rent Income................................................... 240
Total Revenue........................................ 10,940
Expenses:
Salary Expense 2,750
Rent Expense................................................. 800
Depreciation Expense.................................... 100
Utilities Expense............................................ 550
Supplies Expense........................................... 1,500
Insurance Expense 100
Miscellaneous Expense 180
Total Operating Expense........................ 5,980

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 Chapter Three: Accounting for Service Rendering Businesses
Net Income..................................................... 4,960
2. Statement of Owner’s Equity
Ethio Mobile Maintenance
Statement of Owner’s Equity
For the Year Ended December 31, 2004
Samuel, Capital December 1, 2004................ Br 16,050
Add: Net Income (Net Loss).......................... 4,960
Less: Withdrawal...........................................(1,000)
Net Increase In Capital............................ 3,960
Samuel, Capital December 31, 2004.............. Br 20,010
3. The Balance Sheet
Ethio Mobile Maintenance
Balance Sheet
December 31, 2004
Assets: In Birr Liabilities and Capital: In Birr
Cash................................................. 2,740 Liabilities:
A/Receivables.................................. 1,800 Accounts Payable....................... 3,500
Supplies........................................... 500 Salary Payable............................ 250
Prepaid Insurance............................ 2,300 Unearned Rent............................ 480
Total Current Assets................. 7,340 Total Current Liabilities............. 4,230
Office Equipment: Long Term Liabilities................. 0.00
.............................................
7,000
Less: Acc. Depreciation......(100) 6,900 Total Liabilities........................... 4,230
Land................................................. 10,000 Capital:
Total Plant Assets..................... 16,900 Samuel, Capital...........................20,010
Total Assets..................................... Br24,240 Total Liab. and Capital............... Br24,240
Note: Financial statements may annual or interim. Statements that are prepared for a period of less
than one year are called interim statements. A financial report that is prepared annually is said to be
fiscal year statement.

3.7) Journalizing and Posting Adjusting Entries

At the end of the accounting period, the adjustment data appearing in the work sheet are
recorded in the journal and posted to the ledger. This procedure brings the ledger into
agreement with the data reported on the financial statements. The adjusting entries are dared
as of the last day of the period, even though they are usually recorded at a later date. Each
entry may be supported by an explanation, but a suitable caption above the first adjusting
entry is sufficient. The Adjusting Entries for EMM is presented in a General Journal as
follows:
General Journal Page
Date Description P/R Debit Credit
Adjusting Entries
December 31 Supplies Expense 1,500.00
Supplies 1,500.00

31 Insurance Expense 100.00

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 Chapter Three: Accounting for Service Rendering Businesses
Prepaid Insurance 100.00

31 Unearned Rent 240.00

Rent Income 240.00

31 Salary Expense 250.00

Salary Payable 250.00

31 Depreciation Expense 100.00

Accumulated Depreciation - E 100.00

3.8) Journalizing and Posting Closing Entries

Revenues, expenses and drawing or dividend accounts are temporary accounts used in classifying and
summarizing changes in the owner’s equity during accounting period. Since these accounts are
reported for each period, the balances of these accounts should be zero at the beginning of the next
period. Because the balances of these accounts are not carried forward, they are sometimes called
temporary accounts or nominal accounts. The balances of temporary accounts and preparing these
accounts for use in accumulating data for the following period is accomplished by removing their
balances through closing entries. Closing entries are made with the help of another temporary account
called Income Summary. The four entries required to close the temporary accounts of a sole
proprietorship at the end of the accounting period are:
A.to close revenue accounts-each revenue account is debited for the amount of its
balance and the income summary is credited for total revenue
B. to close expense accounts-each expense account is credited for the amount of its
balance and income summary is debited
C.Income summary might have debit (net loss) or credit (net income) balance after
revenues and expenses are closed. If it is debit balance income summary is credited
and capital is debited and if it is credit balance income summary is debited and capital
is credited.
D.To close drawing account-the drawing account is credited for the amount of its
balance and the capital account is debited for the same amount.
General Journal Page
Date Description P/R Debit Credit
Closing Entries
December 31 Service Revenue 10,700.00
Rent Income 240.00
Income Summary 10,940.00

31 Income Summary 5,980.00

Salary Expense 2,750.00
Rent Expense 800.00
Insurance Expense 100.00
Supplies Expense 1,500.00
Utilities Expense 550.00

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 Chapter Three: Accounting for Service Rendering Businesses
Depreciation Expense 100.00
Miscellaneous Expense 180.00

31 Income Summary 4,960.00

Samuel, Capital 4,960.00

31 Samuel, Capital 1,000.00

Samuel, Drawing 1,000.00

3.9) Post Closing Trial Balance

The last and optional procedure of the accounting cycle is the preparation of a trial balance after all the
temporary accounts have been closed. The purpose of the post closing trial balance is to make sure that
the ledger is in balance at the beginning of the new accounting period.
Ethio Mobile Maintenance
Post Closing Trial Balance
December 31, 2004
Account Title Debit Credit
Cash
Account Receivables
Supplies
Prepaid Insurance
Office Equipment
Accumulated Depreciation- Equipment
Land
Account Payables
Unearned Rent
Salary Payable
Samuel, Capital
Total

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 Chapter Four: Accounting for Merchandising Businesses

Chapter Four
Accounting for Merchandising Businesses
In the preceding chapters we have illustrated the accounting cycle for organizations that
render services to their customers. Merchandising companies, in contrast, earn their revenue
by selling goods.
A business that buys and resells goods is called Merchandising Business. The goods that a
merchandising company sells to its customers are called inventory (or merchandise).
Merchandising companies include both retailers and wholesalers. These companies purchase
readymade or ready to sell goods and get all earning or revenue by selling them. Merchandise
may include anything, which a merchandising business can buy for resell purpose and may
vary from needle to automobiles. Merchandising enterprises commonly use the procedures
described below. However, these procedures may very from business to business. For
Example:
 Purchases and sells may be made for cash or on credit basis
 Different arrangement may be made for making payment on accounts
 Policies for the return of merchandising may differ and
 Policies for the payment of transportation costs may also vary

4.1) Accounting For Purchases and Sales

Purchases of merchandise are usually identified in the ledger as purchases. A merchandising
business can accumulate in the purchases account the cost of all merchandise purchased for
resale during the accounting period. The cost of merchandise purchased is recorded by
debiting an account called “PURCHASES”. Purchases can be made for cash or on account.
The sale of merchandise during an accounting period credited to an account called “SALES”.
Merchandises may be sold on cash or may also be sold on account.
Illustration 4.1: Mulu Super Market purchases 2000 cartons of Canned Fish from Century
Trading House at a cost of Br 50 per carton on cash. Record the transaction for both the buyer
and the seller.
The Buyer (Mulu Super Market):
Purchases....................................100,000
Cash................................... 100,000
The seller (Century Trading House):
Cash............................................100,000
Sales.................................. 100,000
Illustration 4.2: Lucy Cosmo Trading Company sold merchandises of Br 5,700 on credit to
Selam Cosmetics. Record the transaction for both parties
The Buyer:
Purchases....................................5,700
Accounts Payable.............. 5,700
The Seller:
Accounts Receivable..................5,700
Sales.................................. 5,700

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 Chapter Four: Accounting for Merchandising Businesses
Illustration 4.3: Assume Ambassel Trading House purchases 10,000 cartons of Exercises
book from Guna Trading Enterprise for Br 150,000 with dawn payment of 60%. Record the
transaction in the book’s of the buyer and the seller.
The Seller (Guna Trading Enterprises):
Cash............................................90,00
0
Accounts Receivable..................60,00
0
Sales.................................. 150,000
The Buyer (Ambassel Trading House):
Purchases....................................150,000
Cash................................... 60,000
Accounts Payable.............. 90,000
Note: The Purchases account is used only for merchandise for resale to customers. That is,
other assets purchased for use in the business are not debited to the purchases account. The
acquisition of the asset recorded by debiting the appropriate asset account

4.2) Credit Terms, Cash Discounts and Return & Allowances

1. Credit Terms
The arrangements agreed upon by the buyer and the seller as to when payments for
merchandise are to be made is called the credit terms. If the payment is required upon
delivery, the terms are said to be “Cash term” or “Net cash term”. If the payment is not
required upon delivery, the buyer is allowed a certain period of time for payment; the term is
known as the credit period. The credit period usually begins with the date of the sale as shown
by the date of the invoice or the bill. Examples of Credit Period terms:
 n/30 (i.e. net 30 days) – payment will be made or due within 30 days after the date of the
invoice.
 n/EOM (i.e. net end of the month) – the payment will due by the end of the month in
which the sales was made.
 20/EOM (i.e. 20 end of the month) – Payment is due 20 days after the end of the month
in which the sales was made
2. Cash Discounts
As a means of encouraging payment before the end of the credit period, the seller may offer a
discount for the early payment of cash. Such type of deduction or discount is known, as a cash
discount. It is a discount for prompt payment made from the invoice price.
Illustration 4.4: A seller may offer a buyer a 2% discount if payment is received
within 10 days of the invoice date. For this, the term “2/10, n/30” can be used
and it means that:
 The credit period is net 30 days
 The period during which a discount is available is called the Discount Period i.e. is the
first 10 days
 The buyer will get a deduction of 2% of the amount of the invoice if it is paid within the
10 days of the credit period.

Cash discounts can be Purchase discount and Sales discount.

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 Chapter Four: Accounting for Merchandising Businesses
Purchase discount: the cash discount taken by the buyer for early or prompt payment of an
invoice is called purchase discounts. The buyer records purchase discount by crediting the
“PURCHASES DISCOUNTS” account and they are usually viewed as a deduction from the
amount initially recorded as in purchases. Purchase discount account is a contra (offsetting)
account to Purchases account.
Sales discounts: the seller refers to the same cash discounts taken by the buyer as “SALES
DISCOUNT”. It is recorded by debiting sales discount account and considered as the amount
to be deducted from the amount sales. Sales discount is a contra sales account.

Illustration 4.5: On March 1, 2005 assume Hebesha Trading House purchased ready made
clothes from Kombolcha Textile Factory on account for Br 600,000; terms 2/10,n/30.
Instructions: record the transaction in the books of both the buyer and the seller assuming
that (A) the Buyer settled the payment within the discount period, and (B) the Buyer did not
settle the payment within the discount period
A) Within the Discount Period
The Buyer:
March 1, 2005: Purchases....................................600,000
Accounts Payable.............. 600,000

March 10, 2005: Purchase Discount = 600,000 * 2% = 12,000

Accounts Payable.......................600,000
Cash................................... 588,000
Purchase Discount............. 120,000
The Seller:
March 1, 2005: Accounts Receivable..................600,000
Sales.................................. 600,000

March 10, 2005: Sales Discount = 600,000 * 2% = 12,000

Cash............................................588,000
Sales Discount............................120,000
Accounts Receivable......... 600,000

B) After the Discount Period

The Buyer:
March 1, 2005: Purchases....................................600,000
Accounts Payable.............. 600,000

March 10, 2005: Accounts Payable.......................600,000

Cash................................... 600,000
The Seller:
March 1, 2005: Accounts Receivable..................600,000
Sales.................................. 600,000

March 10, 2005: Cash............................................600,000

Accounts Receivable......... 600,000

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 Chapter Four: Accounting for Merchandising Businesses
Note: From the buyer’s stand point, it is important to take advantage of all available
discounts even though it may be necessary to borrow money to make the payment.
Example 4.6: on January 1, 2005 Ethiopian Electric Company purchased 20 transformers
from Wallace Electronic Supplies at Br 200 per unit; terms 2/10,n/30. The invoice is to be
paid within the discount period from the bank at 10% for remaining 20 days. Determine the
amount of net saving for Ethiopian Electric Company
 Total invoice price........................................................Br 4,000
 Cash discount (Br 4000 * 2%= 80)............................... (80)
 The amount to be borrowed.......................................... Br 3,920
 Interest on money borrowed (3920*10%*20/360)....... 21.80
 Net saving (Br 80- 21.80= ).......................................... Br 58.20
Net saving is the difference between the discount received and the interest to be paid for the
20 days i.e. if the business borrowed money and settled the liability within the discount
period, the business can save an amount of Br 58.20
Exercise 4.1: On November 1, 2004 ABC Company purchased merchandise on a credit terms
3/10, n/30 and on November 10, 2004 the company paid Br 9700. Instruction: record the
transaction in a journal at the date of purchases and on the date of payment

3. Return and Allowances

Merchandise purchased from the supplier may be unsatisfactory, defective or wrong
specification. In this case the goods may be returned to the supplier (this is called Returns) or
the buyer may requests for a price reduction or adjustment (this is called Allowances). The
same return and allowance is referred by the buyer as purchases returns and allowances
and by the seller as sales returns and allowances.
Purchases Returns and Allowances (PRA): The buyer sends a debit memo to the supplier to
notify that it is debiting the seller’s account. It is recorded by crediting “Purchases Return and
Allowances” or “Purchases” account. But management needs specific information as to the
percentage of purchases return and allowances so that they prefer the credit goes to
“Purchases Returns and Allowances”.
Sales Returns and Allowances (SRA): The effect of sales return and allowances is a
deduction in sales revenue and a reduction in or account receivable. There fore, excessive
sales return and allowances show there is loss in revenue, an additional expense and customer
dissatisfaction. It is possible to debit the sales account instead of debiting the sales returns and
allowances account. How ever, debiting sales account will not disclose the amount of sales
returns and allowances.

Illustration 4.7: On July 8, 2005 Global Trading Enterprise sold merchandises on account
to GYB Company Br 40,000 terms 3/10, n/eom. On July 11, GYB Returned Br4000
defective merchandises to Global which is part of the sale of July 8. On July 17, Global
received cash from GYB. Instruction: record the transactions in the books of the buyer and the
seller.
The Buyer:
July 8: 40,00
Purchases........................................................
0

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 Chapter Four: Accounting for Merchandising Businesses
Accounts Payable.................................. 40,000
July 11: Accounts Payable.........................................
4,000
Purchase Return and Allowance........... 4,000
July 17: Accounts Payable...................................... 36,00
0
Cash.................................................. 34,920
Purchases Discount............................ 1,080

The Seller:
July 8: Accounts Receivable......................40,000
Sales..................................... 40,000
July 11: Sales Return and Allowances.....4,000
Accounts Receivable............. 4,000
July 17: Cash............................................34,920
Sales discounts...........................1,080
Accounts Receivables........... 36,000
Exercise 4.2: Assume Guna Trading Enterprises sold merchandise for cash for Br 80,000
to Gungo Trading Company on August 10, 2004. Guna Trading Enterprises received some
of the merchandises sold to Gungo because they are found to be defective. The company has
given the cash refund of Br 2500 for goods returned by the buyer on August 12. Instruction:
Record the transaction in the book’s of the buyer and the seller

4.3) Trade Discounts, Sales Taxes, and Transportation Costs

1. Trade Discounts
Many wholesalers of merchandise publish periodic catalogs that are used by buyers in
ordering merchandise. Rather than updating their catalogs frequently, wholesalers publish
price updates which may involve large discounts from the list prices or suggested price or
gross price in their catalogs. In addition, the sellers offer certain classes of buyers such as
government agencies or buyers who order large quantities, special discounts. The special
discounts or discounts for large quantities purchased are called Trade discounts. Sellers and
buyers usually don’t record the list prices and the related trade discounts in their accounting
records. For accounting purpose only the final price or agreed price is important.
Illustration 4.8: KOKET Company purchased 600 units of merchandises from BB Company
terms 3/10, n/30. The merchandise has a list price of Br 50 per unit with the trade discount of
20%, 10% and 5%. Assuming that KOKET Company is allowed all these discounts compute
the invoice price for the 600 units and make the necessary journal Entries in the record of both
Companies assuming that the buyer paid within the discount period.
 List price (600 units * Br 50)........................................ Br 30,000.00
 Trade discount (20%*30,000)....................................... (6000.00)
 Balance after the 20% TD............................................. Br 24,000.00
 Less: TD (10%*24,000)................................................ (2,400.00)
 Balance after the 10% TD............................................. Br 21,600.00
 Less: TD (5%*21,600).................................................. (1,080.00)
 Agreed Price or Invoice price....................................... Br 20,520.00
The Buyer:

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 Chapter Four: Accounting for Merchandising Businesses
Date of Purchases....................................20,520
Purchases: Accounts Payable.............. 20,520

Date of Payment: Purchase Discount = 20,520* 3% = 616

Accounts Payable.......................20,520
Cash................................... 19,904
Purchase Discount............. 616
The Seller:
Date of Sales: Accounts Receivable..................20,520
Sales.................................. 20,520

Date of Receipts: Sales Discount = 20,520* 3% = 616

Cash............................................ 19,904
Sales Discount............................ 616
Accounts Receivable......... 20,520
2. Sales Taxes
Government usually levies or imposes tax on retail sales of merchandises. Sales of
merchandise that will be resold are usually not taxed. A sales tax is imposed on the final
consumer but the seller must collect the tax, file tax returns at a time specified by law and
remit the collected tax on the reported sales to the government.
Value Added Tax (VAT) one of the sales tax which charged on the supply of most goods and
services for the value added on it. Some goods are not taxable. For example, postal services
are not taxable. In addition, some persons and firms are exempted from sales tax- Ambassador
and Embassy residents and Charities organizations (Zero Rated Firms). Nature of the business
also affects the sales tax. A bank for instance does not have to add VAT on its bank charges
and small firms, too. If small firms do register for VAT then they will have to keep full VAT
records in addition to charging out VAT.

Accounting For Sales Tax by the Seller

The seller records sales tax collected by crediting sales tax payable account at the time of
sales whether it is cash sales or credit sales.
Illustration 4.9: assume Building Materials Supply Enterprise sold 200 KGs of nails at Br 10
per kilo; 600 iron sheets at Br 40 per sheet and 700 cans of Tsedey Paint at Br60 per can on
January 5, 2004. The goods are subject to sales tax at the rate of 15%. Record the transaction.
Quantity Unit price Total price Sales Tax Sales Tax Amount
200 Br10 Br 2,000.00 15% Br 300.00
600 40 24,000.00 15% 3,600.00
700 60 42,000.00 15% 6,300.00
Total Invoice Price.............Br 68,000.00 Total Sales Tax.......Br 10,200.00
The journal entries are as follows:
Cash............................................ 78,200
Sales.................................. 68,000
Sales Tax Payable............. 10,200

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 Chapter Four: Accounting for Merchandising Businesses
Illustration 4.10: Assume Building Materials Supply Enterprise sold 500 cans of paint at Birr
60 per can to Lalibela Engineering on account, on January 10, 2004. The sale was subject to a
sales tax of 15%. Journalize the transaction and the remittance of tax payable amount on
January 5 and 10, respectively.

 Total Price (Br 60 * 500 cans)......................................Br 30,000.00

 Sales Tax (Br 30000 * 15%)......................................... 4,500.00
 Total Amount................................................................ Br 3,4500.00
January 5: Accounts Receivable..................34,500
Sales.................................. 30,000
Sales Tax Payable............. 4,500

January 10: Sales Tax Payable...................... 14,700

Cash................................... 14,700

An Alternative Approach to Sales Tax:

Instead of recording the sales tax liability at the time of sale, some businesses prefer to credit
the sales with the entire amount collected including the sales tax and to make an adjustment at
the end of each period to reflect sales tax payable.
Illustration 4.11: suppose that the total amount recorded to the sales account including the
sales tax for the period was Br 345000. If the sales tax rate is 15% make the necessary
adjustment to record the sales tax liability at the end of the period.
 Total Amount-----Br 345,000.00
 Sales Tax -------------- 15%
 Sales + Sales Tax = 345,000.00
 Sales + (Sales * Sales Tax Rate) = 345,000.00
 Sales + 15% Sales = 345,000.00
 Sales + 0.15 Sales = 345,000.00
 1.15 Sales = 345,000.00
 Sales = 345,000.00 / 1.15
 Sales= 300,000.00
 Sales + Sales Tax = 345,000.00
 300000 + Sales Tax = 345,000.00
 Sales Tax = 345000- 300000
 Sales Tax= 45,000.00
 Sales:
Cash............................................ 345,00
0
Sales.................................. 345,000
 Adjusting Entries:
Sales...........................................45,000
Sales Tax Payable............. 45,000
 Payment:
Sales Tax Payable......................45,000
Cash................................... 45,000
 The Buyer:
Purchases.................................... 345,00

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 Chapter Four: Accounting for Merchandising Businesses
0
Cash................................... 345,000
3. Transportation Costs
The terms of agreement between a buyer and seller include when the ownership of the
merchandise passes to the buyer and which party is to absorb the cost of delivering the
merchandise to the buyer. There are two most common terms with respect to this: FOB (Free
on Board) Shipping Point and Destination.

FOB Shipping Point: under this term the seller places merchandise “Free On Board” at the
shipping point. Thus,
 The buyer pays transportation costs
 Ownership is transferred at point of shipment
 The goods are the property of the buyer after the point of shipment
 Any risk is absorbed by the buyer while the goods is in transit

FOB Destination: under this term the seller places merchandise “Free On Board” at the
buyer’s final destination by paying the delivery costs. Thus,
 The seller pays the transportation costs
 Title or ownership to the goods is transferred at the buyer’s location
 The goods are the property of the seller while in transit
 Any risk while the goods in transit is absorbed by the seller

When merchandise is purchased on terms of FOB shipping point, the transportation costs paid
by the buyer is debited to Transportation In or Freight In or Purchases account. In some cases,
the seller may prepay the transportation costs and add them to the buyer, even though the
agreement is states that the buyer bear such costs (i.e. terms FOB shipping point). This is also
debited to the same accounts as above.
When the agreement states that the seller is to bear the delivery costs (FOB Destination), the
amount paid by the seller for delivery of merchandise is debited to Transportation Out or
Freight Out or delivery Expense or a similarly titled account. The total of such costs incurred
during a period is reported on the seller’s income statement as a selling expense and will not
be included in the cost of goods sold.
Illustration 4.12: on February 1, 2004 RR Trading Company purchased merchandise on
account from KK Company for Br 12,000, terms FOB shipping point 2/10, n/30 and the
buyer paid a transportation cost of Br 100 to XX Transportation Company. On February 12,
RR Company paid cash to KK Co.
February 1: Purchases....................................12,000
Transportation-in........................1,000
Accounts Payable.............. 12,000
Cash................................... 1,000
OR: Purchases....................................13,000
Accounts Payable.............. 12,000
Cash................................... 1,000
February Accounts Payable.......................12,000
12:
Cash................................... 12,000

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 Chapter Four: Accounting for Merchandising Businesses

Illustration 4.13: On March 5, MM Company Purchased merchandise from JJ Company

on account Br 8500 terms 1/10, n/30 FOB shipping point. JJ Company pays the
transportation charges of Br 5000. Instructions:
 At the date of purchase
 If MM Co. returned some merchandise which have a cost Br 500 on March 9
 If MM Co. paid cash to JJ Company on March 14
March 5: Purchases..........................................8,500
Transportation-in..............................500
Accounts Payable.................... 9,000
March 9: Accounts Payable.............................500
Purchase Return & Allow........ 500
March 14: Accounts Payable.............................8,500
Cash......................................... 8,420
Purchase Discount................... 80
Illustration 4.13: on May 1, 2004 Melat Private Limited Company sold merchandise to
Belule Private Limited Company on account for Br 90,000 terms FOB destination 2/10,
n/30. The seller paid Br 4,000 to TT Transport Share Co. and received the amount on May 10.
Instructions: journalize the above transactions:
May 1: Accounts Receivable..................90,000
Delivery Expense.......................4,000
Sales.................................. 90,000
Cash................................... 4,000
May Cash............................................88,200
10:
Sales Discount............................1,800
Accounts Receivable......... 90,000
Exercise 4.3: MEWIT (Merchandise Whole Sale and Import Trade Enterprise) sold to
BMSE on account, list price Br40000, trade discount 20%, sales tax 5%, term 3/10, n/30,
FOB Shipping Point. The seller pays transportation cost of Br 1000 and adds it to the invoice
and the seller issues the credit memorandum for Br 5000 merchandise returned and
subsequently receives the amount within the discount period. Record the transactions for both
parties

4.4) Periodic Reporting and Merchandise Inventory System

1. Periodic Reporting
The sequence of year end procedures may be changed slightly, but in general the following
outline is typical:
1. Prepare a trial balance of the ledger on a worksheet form
2. Review the accounts and gather the data required for the adjustment
3. Insert the adjustments and complete the work sheet
4. Prepare financial statements from the data in the worksheet
5. Journalize the adjusting entries and post to the ledger
6. Journalize the closing entries and post to the ledger
7. Prepare a post closing trial balance of the ledger

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 Chapter Four: Accounting for Merchandising Businesses

2. Merchandise Inventory Systems

The system through which you can determine CGS and Cost of Ending Inventory is called
inventory system. The two main systems for accounting for merchandise held for sale are the
periodic inventory system and the perpetual inventory system.
 The Periodic Inventory System and Determination of Cost of Merchandise Sold
In this system:
 The purchase of merchandise is debited to purchases account
 The revenue from sales is recorded when at sale was made but no attempt is made to
record the cost of merchandise sold
 The cost of Ending Inventory is determined by taking a physical inventory (counting the
merchandise at hand or unsold and multiplying by its unit price).
 The cost of merchandise sold (CMS) is determined as follows:
Merchandise Inventory (Beginning)............................................xxxxx
Add: Purchases..................................................... xxxxx
Less: Purchase Return & Allow...........................(xxxxx)
Less: PD............................................................... (xxxxx)
Net Purchases....................................................... xxxxx
Add: Freight in..................................................... xxxxx
Cost of merchandise purchased.....................................xxxxx
Cost of Merchandise Available for sales (CMAS)........xxxxx
Less: Ending Inventory.................................................(xxxxx)
Cost of Merchandise Sold............................................. xxxxx

Adjustments in Merchandising Business

1. Adjusting Merchandise Inventory
Merchandise inventory account showed the inventory balance at the beginning of the period
through out an accounting period if the business is using Periodic Inventory System.
Purchases and purchases related account are recorded separately during the year and thus at
the end of the period two adjusting entries are required to update merchandise inventory
account.
A) To adjust beginning inventory:
Income Summary...................................... xxxxx
Merchandise Inventory.................... xxxxx
B) To adjust ending inventory:
Merchandise Inventory............................. xxxxx
Income Summary............................. xxxxx
Illustration 4.14: Assume from January 1, 2004, the merchandise inventory has a balance of
Br 180,000 and the ending inventory on December 31 of the same year is Br 220,000.
Instruction: journalize the adjusting entry
Adjusting Beginning Inventory
Income Summary...................................... 180,000
Merchandise Inventory.................... 180,000
Adjusting Ending Inventory

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 Chapter Four: Accounting for Merchandising Businesses
Merchandise Inventory............................. 220,000
Income Summary............................. 220,000
2. Adjusting Deferrals and Accruals
In merchandising business in addition to merchandise inventory, deferrals and accruals are
adjusted. This will be discussed in next chapter.

4.5) Worksheets For Merchandising Businesses

After all transactions for the year 2004 were recorded and posted, the accounts in the ledger of
Far East Trading Corporation appeared with the following unadjusted balances. See the Trial
Balance on the next Page. The data needed for year end adjustments on December 31 are as follows:
 Merchandise Inventory on December 31, 2004..............................Br 150,500.00
 Insurance expired during the year................................................... 6,400.00
 Store supplies inventory on December 31, 2004............................ 2,150.00
 Depreciation for the current year.................................................... 19,200.00
 Accrued Sales Salaries on December 31, 2004.............................. 2,800.00
 Accrued Office Salaries on December 31, 2004............................. 1,300.00
Required:
1. Complete the worksheet
2. Prepare Income statement in Single- step and Multiple- step forms
3. Prepare a Retained earnings Statement
4. Prepare a classified Balance sheet, in a Report form
5. Record the necessary year end adjusting and closing entries on general journal Page 1
6. Prepare a Post- closing trial balance

Far East Trading Corporation

Trial Balance
December 31,2004
Account Title Dr. Cr.
Cash.................................................................................... 43,750.00  
Accounts Receivable.......................................................... 96,150.00  
Merchandise Inventory....................................................... 145,250.00  
Store Supplies..................................................................... 8,250.00  
Prepaid Insurance................................................................ 12,690.00  
Store Equipment................................................................. 89,500.00  
Accumulated Depreciation -Store Equipment.................... 25,300.00
Accounts payable................................................................ 44,740.00
Salary payable..................................................................... –
Capital Stock....................................................................... 180,000.00
Retained Earning................................................................ 81,445.00
Dividend ............................................................................ 60,000.00
Income Summary................................................................ – –
Sales.................................................................................... 953,500.00
Sales Discount.................................................................... 2,500.00
Sales returns and allowances.............................................. 3,000.00
Purchase.............................................................................. 610,050.00
Freight in............................................................................. 6,000.00

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 Chapter Four: Accounting for Merchandising Businesses
Purchase Discount.............................................................. 6,000.00
Sales Salaries expense........................................................ 77,400.00
Advertising expense............................................................ 24,800.00
Depreciation Exp.-Store Equipment...................................
Store Supplies expense.......................................................
Delivery Expense /Freight Out/.......................................... 2,000.00
Miscellaneous Selling – Expense....................................... 4,400.00
Office Salaries Expense...................................................... 39,845.00
Rent Expense...................................................................... 40,000.00
Heating and lighting Expense............................................. 16,100.00
Taxes expense..................................................................... 8,500.00
Insurance expense...............................................................
Miscellaneous General –expense........................................ 3,600.00
Interest Expense.................................................................. 1,000.00
Gain on disposal of equipment........................................... _ _ _ _ 3,800.00
Total.................................................................................... 1,294,785.00 1,294,785.00

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 Chapter Four: Accounting for Merchandising Businesses
FAR EAST TRADING CORPORATION
WORK SHEET
FOR THE YEAR ENDED DEC.31,2004
  Unadjusted T.B Adjustment Adjusted T.B Income Statement Balance Sheet
Account Title Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 43,750       43,750       43,750  
Accounts Receivable 96,150       96,150       96,150  
Merchandise Inventory 145,250   150,500 145,250 150,500       150,500  
Store Supplies 8,250     6,100 2,150       2,150  
Prepaid Insurance 12,690     6,400 6,290       6,290  
Store Equipment 89,500       89,500       89,500  
Accumulated Depreciation - SE 25,300   19,200   44,500       44,500
Accounts payable 44,740       44,740       44,740
Salary Payable   4,100   4,100       4,100
Capital Stock 180,000     180,000     180,000
Retained Earnings 81,445     81,445     81,445
Dividend 60,000     60,000     60,000
Income Summary 145,250 150,500 145,250 150,500 145,250 150,500
Sales 953,500     953,500 953,500    
Sales discount 2,500     2,500 2,500    
Sales returns and allowances 3,000     3,000 3,000    
Purchase 610,050     610,050 610,050    
Freight in 6,000     6,000 6,000    
Purchase Discount 6,000     6,000 6,000    
Sales Salaries expense 77,400 2,800   80,200 80,200    
Advertising expense 24,800     24,800 24,800    
Depreciation Exp.-Store Equip. 19,200   19,200 19,200    
Store Supplies expense 6,100   6,100 6,100    
Delivery Expense/Freight out/ 2,000     2,000 2,000    
Miscellaneous Selling - expense 4,400     4,400 4,400    
Office Salaries Expense 39,845 1,300   41,145 41,145    
Rent Expense 40,000     40,000 40,000    
Heating and lighting Expense 16,100     16,100 16,100    
Taxes expense 8,500     8,500 8,500    
Insurance expense 6,400   6,400 6,400    
Miscellaneous General- expense 3,600     3,600 3,600    
Interest Expense 1,000     1000 1000    
_______
Gain on disposal of equipment _______ 3,800 _______ _ _______ 3,800 3,800    
1,468,58
Total 1,294,785 1,294,785 331,550 331,550 1,468,585 5 1,020,245 1,113,800 448,340 354,785

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 Chapter Four: Accounting for Merchandising Businesses
 
Net Income 93,555 ________   ______ 93,555
1,113,800 1,113,800 448,340 448,340

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 Chapter Four: Accounting for Merchandising Businesses
4.6) Financial Statements For Merchandising Businesses
1. Prepare Income Statement In Single- Step And Multiple- Step Forms
A. Multiple-Step Income Statement
Far East Trading Corporation
Income Statement
For the year ended December 31, 2004
Revenues: In ETB In ETB
Sales........................................................................................................ 953,500 .00
Less: Sales Discount......................................................................... 2,500.00
Less: Sales Return & Allow............................................................. 3,000.00 (5,500.00)
Net Sales............................................................................... 948,000.00
Cost of Merchandise Sold:
Merchandise Inventory, January 1, 2004................................................ 145,250.00
Purchase......................................................................... 610,050.00
Less: Purchase Discount................................................. (6,000.00)
Net Purchase................................................................... 604,050.00
Add: Freight in............................................................... 6,000.00
Cost of Merchandise Purchased........................................................... 610,050.00
Cost of Merchandise Available For Sale.............................................. 755,300.00
Less: Merchandise Inventory December 31, 2004............................... (150,500.00)
Cost of Merchandise Sold................................................. (604,800.00)
Gross Profit: 343,200.00
Operating Expenses:
Selling Expenses:
Sales Salaries Expense......................................................80,200.00
Advertising Expense..........................................................24,800.00
Depreciation Exp.-Store Equip..........................................19,200.00
Store Supplies Expense..................................................... 6,100.00
Delivery Expense/Freight-Out/......................................... 2,000.00
Miscellaneous Selling Expense......................................... 4,400.00
Total Selling Expense....................................................................... 36,700.00
General Expenses:
Office Salaries Expense.....................................................41,145.00
Rent Expense.....................................................................40,000.00
Heating and Lighting Expense..........................................16,100.00
Taxes Expense................................................................... 8,500.00
Insurance Expense............................................................. 6,400.00
Miscellaneous General- Expense................................... 3,600.00
Total General Expense...................................................................... 115,715.00

Total Operating Expense...................................................... (252,445.00)

Income from Operation........................................................................ 90,755 .00
Other Income:
Gain on Disposal of Equipment.............................................................. 3,800.00
Other Expense:
Interest Expense...................................................................................... (1,000.00) 2,800.00

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 Chapter Four: Accounting for Merchandising Businesses
Net Income............................................................................................. 93,555.00

B. Single Step Income Statement

Far East Trading Corporation
Income Statement
For the year ended December 31,2004
Revenue:    
Net Sales.................................................... 948,000.0
0
Other Income.............................................. 3,800.00
951,800.0
Total Revenue.................................... 0
Costs and Expenses:  
604,800.0
Cost of Merchandise Sold.......................... 0  
136,700.0
Selling Expense.......................................... 0  
115,745.0
General Expense........................................ 0  
Other Expense............................................ 1,000.00  
858,245.0
Total Expense..................................... 0
Net Income.................................................  93,555.00
2. Prepare a Retained Earnings Statement
Far East Trading Corporation
Retained Earning Statement
For The Year Ended December 31, 2004
Retained earning, January 1, 2004................. Br 81,445.00
Net Income for the Year................................93,555.00
Less: Dividends..............................................(60,000.00
)
Increase in Retained Earnings................. 33,555.00
Retained earnings December 31, 2004.......... Br 115,000.00
3. Prepare a Classified Balance Sheet
Far East Trading Corporation
Balance Sheet
December 31, 2004
Assets: In ETB
Current Assets:
Cash................................................................................... 43,750.00
A/Receivables................................................................... 96,150.00
Merchandise Inventory.....................................................150,500.00
Supplies............................................................................. 2,150.00
Prepaid Insurance.............................................................. 6,290.00
Total Current Assets................................................... 298,840.00

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 Chapter Four: Accounting for Merchandising Businesses
Plant Assets:
Store Equipment:................. 89,500.00
Less: Accum. Depreciation – SE ..................................... 44,500.00
Total Plant Assets....................................................... 45,000.00
Total Assets...................................................................... 343,840.00
Liabilities and Stockholders’ Equity:
Liabilities:
Accounts Payable..............................................................44,740.00
Salary Payable...................................................................4,100.00
Total Liabilities................................................................. 48,840.00
Stock Holders Equity:
Capital Stock.....................................................................180,000.00
Retained Earnings.............................................................115,000.00
Total Stockholders Equity................................................. 295,000.00
Total Liabilities and Stockholders' Equity........................ 343,840.00

4.7) Adjusting and Closing Entries

1. Adjusting Entries
General Journal Page 1
Date Description P/R Debit Credit
1985   Adjusting Entries      
3
DEC. 1 Income summary   145,250    
    Merchandise Inventory       145,250  
               
3
  1 Merchandise Inventory   150,500      
    Income Summary       150,500  
               
3
  1 Insurance expense   6,400      
    Prepaid Insurance       6,400  
               
3
  1 Store-supplies expense   6,100      
    Store-Supplies       6,100  
               
3
  1 Depreciation expense   19,200      
    Accumulated Depreciation       19,200  
               
3
  1 Sales salaries expense   2,800      
    Office salaries expense   1,300      
    Salaries payable       4,100  
               
2. Closing Entries

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 Chapter Four: Accounting for Merchandising Businesses
General Journal Page 1
    Closing Entries P/R Debit Credit
 DEC. 31 Sales   953,500    
    Purchase Discount   6,000    
    Gain on disposal of equipment   3,800    
    Income Summary       963,300
             
  31 Income summary   874,995    
    Sales discount       2,500
    Sales Return & Allow.       3,000
    Purchase       610,050
    Freight in       6,000
    Sales Salaries expense       80,200
    Advertising expense       24,800
    Depreciation Exp.-Store Equip.       19,200
    Store Supplies expense       6,100
    Delivery Expense/Freight out/       2,000
    Miscellaneous Selling - expense       4,400
    Office Salaries Expense       41,145
    Rent Expense       40,000
    Heating and lighting Expense       16,100
    Taxes expense       8,500
    Insurance expense       6,400
Miscellaneous General-
    expense       3,600
    Interest Expense       1000

March 31 Income summary   93,555  

    Retained Earnings       93,555
             
  31 Retained earnings   60,000    
    Dividend       60,000
             
3. Post Closing Trial Balance
Far East Trading Corporation
Post Closing Trial Balance
December 31, 2005
Account Title Dr. Cr.
Cash.......................................................................... 43,750      
Accounts Receivable................................................ 96,150      
Merchandise Inventory.............................................150,500      
Store Supplies........................................................... 2,150      
Prepaid Insurance..................................................... 6,290      
Store Equipment....................................................... 89,500      
Accumulated Depreciation -Store Equip..................    44,500  

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 Chapter Four: Accounting for Merchandising Businesses
Accounts payable......................................................    44,740  
Salary Payable..........................................................    4,100  
Capital Stock............................................................    180,000  
Retained Earnings.....................................................    115,000  
Total..........................................................................388,340   388,340  

4.8) Corrections of Errors

If there is error in recording transactions or posting to ledger accounts, it will be corrected
through correcting entries. For example a debit purchases account may be debited to plant
asset account while the credit is correctly recorded. Thus, the correcting will debit purchases
account and credit the plant asset account so that the error will be corrected.

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 Chapter Five: Accounting for Deferrals and Accruals

Chapter Five
Deferrals and Accruals

5.1) Adjusting for Deferrals

Deferrals are an expense that has already been paid or revenue that has already been received.
Deferrals are created when we record a transaction in the way that it delays or defers
recognition of an expense already paid or revenue already received. Deferrals include deferred
expense (prepaid expense) and deferred revenue (unearned revenue).

A) Deferred Expense(Prepaid Expense)

Deferred Expense is an expense that has been paid but delayed for recognition. At the time an
expense is paid, it may be debited either to an asset account or to an expense. Examples:
supplies, prepaid insurance, prepaid rent, prepaid interest, etc. Deferred Expense may initially
be recorded as an asset or as an expense.

Prepaid Expense Initially Recorded As an Asset

Advance payments or prepayments for deferred expense is recorded as debits to the
appropriate asset account even though all or a part prepayment is expected to be used or
consumed during the accounting period. Thus,
 The adjusting entry transfers the amount used or expired during the period to the
expense account
 The amount unused remains in asset account
 Reversing entry is not required

Illustration 5.1: assume that the unexpired insurance for OLYMPIC Company on January 1,
2003 amounted to Br 7,000. On January 2, the Company purchased additional insurance
policy for a total of Br 12,000. Assume further that Br 14,000 of the premium or the insurance
policy is expired during the year and the Company follows the system of recording
prepayment for insurance as an asset. Record the Transactions:
Initial Recording: Prepaid Insurance.......................12,000
January 2, 2003 Cash................................... 12,000

Adjusting: Insurance Expense......................14,000

December 31, 2003 Prepaid Insurance.............. 14,000

Closing: Income Summary.......................14,000

December 31, 2003 Insurance Expense............. 14,000

Reversing: Reversing is not required

Prepaid Expense Initially Recorded As an Expense

In this method:
 Prepayments for deferred expense is debited to the expense accounts

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 Chapter Five: Accounting for Deferrals and Accruals
 The adjusting entry transfers the amount unused or unexpired from expense account to
the asset account
 The amount expired or used remains in the expense account and closed at the end.
 Reversing entry is required- an entry which is made at the beginning of the period to
comply with the initial recording system and the exact reverse of the adjusting entry

Illustration 5.2: Assume all the data in the above illustration except that the business follows
the system of recording prepaid insurance as an expense and that the insurance policy that
applies to the future period is found to be Br 5,000. Record all the necessary transactions:
Initial Recording: Insurance Expense......................12,000
January 2, 2003 Cash................................... 12,000

Adjusting: Prepaid Insurance.......................5,000

December 31, 2003 Insurance Expense............. 5,000

Closing: Income Summary.......................14,000

December 31, 2003 Insurance Expense............. 14,000

Reversing: Insurance Expense 5,000

January 1, 2004 Prepaid Insurance 5,000
NOTE: In this system the assets account will have a zero balance where as the expense will
have a balance. This balance is not an expense rather it is an asset. Reversing entry transfers
the amount unused back to an expense account i.e. the amount in prepaid insurance at the
beginning of the new period is transferred to the expense.
B) Deferred Revenue (Unearned Rent)
Deferred revenue is revenue that has been received but delayed for recognition. Deferred
revenue includes money received in advance such as magazine subscription, tuition fee
revised by school, universities or college, money received by advertising companies. Deferred
Revenue is initially recorded either as an asset or as an expense.
Deferred Revenue Initially Recorded As a Liability
If Deferred Revenue is initially recorded as a liability, then:
 The adjusting entry transfers the amount earned during the period from the liability to
the revenue account
 The amount unearned remains in the liability account
 Reversing entry is not required
Deferred Revenue Initially Recorded As an a Revenue
In this method:
 Cash received in advance is credited to the revenue accounts
 The adjusting entry transfers the amount unearned from the revenue account to the
liability account
 The amount earned remains in the Revenue account and closed at the end
 Reversing entry is required

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 Chapter Five: Accounting for Deferrals and Accruals
Illustration 5.3: On November 1, 2004 OLYMPIC COMPANY rented the portion of its
building by receiving Br 1200 in advance for three months time. The fiscal period ends on
December 31, 2004 Instruction: Make the necessary journal entries assuming that the system
of recording Unearned Rent initially as a revenue and as liability:
As a Liability As a Revenue
Nov.1, Cash..................................1,200 Cash.......................................
1,20
2004 0
Unearned Rent......... 1,200 Rent Income................. 1,200

Dec.31 Unearned Rent..................800 Rent Income...................... 400

, Rent Income............. 800 Unearned Rent.............. 400
2004

Dec.31 Rent Income......................800 Rent Income...................... 800

, Income Summary..... 800 Income Summary..... 800
2004

Jan. 1, Reversing is not required Unearned Rent.......................

400
2005 Rent Income................. 400

5.2) Adjusting for Accruals

An accrual is an expense that has been incurred but not paid or revenue that has been earned
but not received. Accruals include accrued expense (accrued liability) and accrued revenue
(Accrued Asset).

A) Accrued Expense or Accrued Liability

Illustration 5.4: assume that on December 31, 2003 the end of fiscal year sales salary
expense and office salary expense account for XYZ PLC have debit balances of Br 86,000
and 60,000, respectively. For the reason that payment date is different from the end of the
accounting period, the total salary accrued is Br 10,000 out of which 4,000 was office salary
expense. Assume that the business paid Br 20,000 on January 15, 2004 out which Br 8,000
was for Office salary Expense including the accrued salary. Instruction: Record all the
necessary entries assuming that the business:
A) Does not use the policy of reversing entry
B) Uses the policy of reversing entry

Without Reversing Entry:

December 31 Sales Salary Expense......................6,000
Office Salary Expense....................4,000
Salary Payable...................... 10,000

December 31 Income Summary...........................156,000

Sales Salary Expense............ 92,000
Office Salary Expense.......... 64,000

Jan. 1, 2004: No Reversing Entry

Jan. 15, 2004: Sales Salary Expense......................6,000

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 Chapter Five: Accounting for Deferrals and Accruals
Office Salary Expense....................4,000
Salary Payable................................10,000
Cash...................................... 20,000
With Reversing Entry:
December 31 Sales Salary Expense......................6,000
Office Salary Expense....................4,000
Salary Payable...................... 10,000

December 31 Income Summary...........................156,000

Sales Salary Expense............ 92,000
Office Salary Expense.......... 64,000

Jan. 1, 2004: Salary Payable................................10,000

Sales Salary Expense............ 6,000
Office Salary Expense.......... 4,000

Jan. 15, 2004: Sales Salary Expense......................12,000

Office Salary Expense....................8,000
Cash...................................... 20,000

Illustration 5.5: On November 1, 2003 AA Company borrowed Br 60000 from CBE issuing
a promissory note payable showing 12% interest where by the loan and interest will be paid
after four months (March 1, 2004). The company has a fiscal period that ends on December
31 and the interest expense account has a balance of Br 17000 at year end. Make the
necessary journal entries for the Company assuming that the company:
A) does not use the reversing entry
B) use the policy reversing entry
With Out Reversing Entry:
Nov. 1, 2003 Cash...............................................60,000
Notes Payable....................... 60,000

Dec. 31, 2003 Interest Expense...........................1,200

Interest Payable..................... 1,200

Dec. 31, 2003 Income Summary.......................18,200

Interest Expense................ 18,200

Jan. 1, 2004 No Reversing Entry

March 1, 2004 Notes Payables...............................60,000

Interest Payable..........................1,200
Interest Expense.........................1,200
Cash...................................... 62,400
With Out Reversing Entry:
Nov. 1, 2003 Cash...............................................60,000
Notes Payable....................... 60,000

Dec. 31, 2003 Interest Expense...........................1,200

Interest Payable..................... 1,200

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 Chapter Five: Accounting for Deferrals and Accruals

Dec. 31, 2003 Income Summary.......................18,200

Interest Expense................ 18,200

Jan. 1, 2004 Interest Payable..........................1,200

Interest Expense................ 1,200

March 1, 2004 Notes Payables...............................60,000

Interest Expense.........................2,400
Cash...................................... 62,400
B) Accrued Revenue or Accrued Assets
These are items of revenue that have been earned at the end of the accounting period but not
recorded because cash is not received. Since the business recognizing both revenue and assets
it is so called Accrued Revenue or Accrued Assets.
Illustration 5.6: On September 1, 2000 BB Auditing Firm entered into a contract with Dire-
Dawa Food Complex to provide auditing service for 6 months for a total of Br 36,000 Payable
when the service is completed. The fees income account of the firm has a credit balance of Br
126,000 and that the firm has a fiscal year ending on December 31. Make the necessary
journal entries for the firm assuming that
A) Reversing Entry is not Used
B) Reversing Entry Is Used

With No Reversing Entry:

Dec. 31, 2000 Fees Receivables............................24,000
Fees Revenue........................ 24,000

Dec. 31, 2000 Fees Revenues................................150,000

Income Summary.................. 150,000

Jan. 1, 2001 No Reversing

March 1, 2001 Cash................................................36,000

Fees Receivables................... 24,000
Fees Revenue........................ 12,000

With Reversing Entry:

Dec. 31, 2000 Fees Receivables............................24,000
Fees Revenue........................ 24,000

Dec. 31, 2000 Fees Revenues................................150,000

Income Summary.................. 150,000

Jan. 1, 2001 Fees Revenues 24,000

Fees Receivables 24,000
March 1, 2001 Cash................................................36,000
Fees Revenue........................ 36,000

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Chapter Five: Accounting for Deferrals and Accruals

59
 Chapter Six: Accounting Systems Design

Chapter Six
Accounting Systems Design
Accounting system is a system which provides the information for use in conducting the
affairs of the business and in reporting to owners, creditors and other interested parties. In a
general sense, an accounting system includes the entire network of communications used by a
business organization to provide needed information. It consists of business paper (source
document), records (journals and ledger) and reports (financial statements).

6.1) Principles of Accounting Systems

Because of differences in businesses, in number of transactions to be processed and in the
uses made of accounting data, accounting systems will vary from business to business. How
ever, there are a number of broad principles that are discussed as follows and apply to all
systems:
 Cost- Effectiveness Balance
The major considerations in developing or designing an accounting system are cost
effectiveness. That is to balance the benefits against the cost information. Cost of information
at least should be equal to the benefit of information
 Flexibility to Meet Future Needs
An accounting system must be flexible enough to meet changing demands of the businesses
world. The business must adapt to the constantly changing environment in which it operates.
For example, changes in accounting principles or data processing technology or other factors
should comply with the government regulations.
 Adequate Internal Controls
An accounting system must provide information which help management in planning and
controlling activities. The system should aid management in directing operations. The detailed
policies and procedures used to direct operations and provide reasonable assurance that
entity’s objectives are achieved are called internal controls. An accounting system should
show any deviation from the internal controls structure.
 Effective Reporting
When reports (financial Information) are prepared, the requirements and knowledge of the
user should be recognized. For example, management may need detailed basis, and regulatory
agencies often require uniform data.
 Adaptation to Organizational Structure
Different businesses may have different organizational structure and level of management.
There fore, an accounting system that goes with the organizational structure must be designed
to meet the information needs of all level of management at the lowest cost.

6.2) Accounting System Installation and Revision

Before designing and installing or reviewing an accounting system for an enterprise, the
designer must have a complete knowledge of the business operations. The designer should
recognize that some areas of the system, such as the types and design of the forms needed and
the number and titles of the accounts required, maybe affected by factors that are not known

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 Chapter Six: Accounting Systems Design
when a business is first organized. As new information about a business is obtained and as a
basins “out grows” or expands to new operational areas, the system will need to be revised.
Many large businesses continually review their accounting system and may constantly be
involved in changing some part of it. The job of installing or changing an accounting system,
either in its entirety or only in part, is made up of three phases:
 System Analysis
 System Design and
 Implementation
1. System Analysis
The goal of system analysis is to determine information needs and sources of such
information, and deficiencies in procedures and data processing methods presently used. The
system analyst should determine management’s plans for changes in operations such as
volume, products, territories, etc.
2. System Design
This deals with determining the requirement of the new system and changing it based on the
result of the system analysis. In this stage a proposal for the new system is prepared and
finalized.
3. System Implementation
The final stage of the creation or revision of an accounting system is to carry out, or
implement the proposals fro the new system. It includes:
 Installing new or revised forms, records, procedures and equipment
 Training and supervising all personnel responsible for operating the system until
satisfactory efficiency is achieved.
 The old system is changed over time by new system. This is done gradually over an
extended period rather than all at once. Weakness and conflicting or unnecessary elements
in the design may also become apparent during the implementation.

6.3) Internal Control Principles and Structure

Internal control structure consists of the policies and procedures established to provide reasonable
assurance that the entity’s objective will be achieved. This internal control structure can be divided
into three elements: (1) the control environment, (2) the control procedures, and (3) the accounting
system, each of which is discussed as follows:

1. The Control Environment

The control environment represents an overall attitude toward and awareness of the importance of
controls by management and other employees. Factors influencing the control environment of an
enterprise include management’s philosophy and operating style, the organizational structure of the
enterprise and personnel policies and practices.

2. The Control Procedures

The general control procedures (strong internal control guidelines) which apply to all organization
through an accounting system are:
 Competent Personnel and Rotation of Duties
All accounting system requires procedures to ensure that people are able to perform the duties to
which they are assigned. It is also advisable to rotate clerical personnel periodically from job to job.

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 Chapter Six: Accounting Systems Design
 Assignment of responsibility
If employees are to work efficiently, their responsibilities must be clearly defined
 Separation of responsibility
The responsibility for a sequence of related operations should be divided among two or more persons.
For example, no one individual should be authorized to order merchandise, verify the receipt of the
merchandise and pay the supplier. That is purchasing, receiving and payment should be separated. The
business documents prepared as a result of the work of each department must fit with those prepared
by the other departments
 Adequate Documentation
There is control without adequate documentation.
 Separation of accounting and operations
The responsibility for maintaining the accounting records should be separated from the responsibility
for engaging in the business transaction and for the custody of the firm’s asset. A cashier should be not
having access to the journal and ledger.
 Proofs and Security Measures
This control procedure includes the use of bank account and safekeeping measures for cash and other
valuable documents, cash registers machine to record daily cash sales and fidelity insurance .
 Independent Review
To determine whether internal control procedures are being effectively applied, the
control structure should be periodically reviewed and evaluated by internal auditors.
Internal auditors should report any weakness and recommend changes to correct them

3. The Accounting System

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

6.4) Data Processing Methods: Special Journals and Subsidiary Ledgers

Depending upon the variety and the amount of data included in the database, various
processing methods- manual and computerized may be used. These processing methods may
use special journals and subsidiary ledgers to process an accounting data.
Special Journals: are journals used to record only one type of transaction. It is especially
useful to accumulate a transaction with recurrent nature. This saves time and costs. For
example: most businesses use the following four special journals:
 Purchases journal
 Cash payment journal
 Sales journal
 Cash receipts journal
Subsidiary Ledgers: ledgers that are used to provide detail information about a
general ledger accounts. Subsidiary ledgers may include accounts receivables, account
payables, subscriber’s subsidiary ledgers, stock subsidiary ledgers, etc.

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Chapter Seven
Accounting For Cash and Temporary Investments

7.1) Controls over Cash

Definition of Cash: is a medium of exchange that a bank accepts for deposit and used
immediately. As per this definition, cash includes the following items: coins, currencies,
change fund, petty cash fund, balances in the unrestricted savings account and checking
account, bank debit cards, bank credit cards such as master and visa cards which are
acceptable by the commercial banks, money orders (postal or bank), travelers checks, CPO,
personal checks, bank drafts, undeposited cash receipt (cash on hand).
Non-Cash Items: Even if all items other than cash are non-cash ones some non cash items are
confusing with cash and they are worth discussing at this point in time. Included in this
category are: NSF check-receivable, Post dated check-receivable, postage stamps-supplies or
inventory, IOUs-receivable, treasury bills-receivables, certificate of deposits-short term
investments, compensating balances-some other asset, travel advances-receivable, bank
balance in the blocked account-some other asset, saving account balances-some other asset, if
it has got some sort of restrictions such as not be able to withdraw, say, Birr 5,000 unless prior
notice of 10 days are served. However, savings accounts are usually classified as cash
although the bank has the right to demand notice before withdrawal in that banks rarely
exercise the privilege of prior notice.
Objectives of Cash management and control: there must be strong control over cash
because:
 Cash enters many transactions in the form of paying and receiving and it is vulnerable
to misappropriation and embezzlement
 Cash lacks identification of ownership.

To maintain the optimal amount of cash i.e. the amount of cash should be carefully regulated
so that neither too much nor too little is available at any time. If there is excess it has to be
invested temporarily to secure dividends, interest or other form of revenue. If shortage is
predicted relevant sources of financing should be envisaged well in advance failure of which
disrupts the operation of the business organization, cases of ill-liquidity in the short term and
insolvency in the long term which might lead, at times, to liquidation.
Cash is the asset most likely to be used improperly by employees so it must be effectively
safeguarded by special control. Businesses use different techniques to control cash. Some
these controls are useful to control over cash receipts while some are useful to control over
cash payments.

Internal controls over cash receipts

 Use of cash register machine
 Use of pre-numbered and consecutive sales tickets
 Two or more persons should open and record the cash receipts through the mail
 Use of Electronic scanning equipment
 Use of Change fund

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 Use of Bank System
 Use of Cash Short and Over Account

Internal Controls over Cash Payments

 Use of Petty Cash Fund
 Use of Voucher System
 Use of Bank System
 The Net Method of recording Purchases as opposed to Gross method

A) Cash Register: Cash received over the counter should be rung up on a cash register so
that the customer would see the amount recorded. On the other hand the cashier records the
amount simultaneously on a cash register tape, which is not accessible. At the end of business
or at the end of the day, the controller in whose hand the key for the cash register tape is kept
unlocks the cash register and compares the actual cash count with the tape.
B) Pre-numbered Sales Tickets: At the time of control if number(s) is (is) missing, it might
be an indicator that some sort of misappropriation is made and the corrective measure should
be taken in the proper time. Any page be it defective, void etc. should be kept in the pad.
C) Two or more employees should open the mail together: this control technique reduces
the likelihood of a single dishonest employee stealing cash undetected. They prepare a
schedule showing the name of the customers sending money, the purpose for which the
money was sent and the amount received. One copy is sent to the cashier with cash and the
second copy is sent to the accounting department for recording purpose and the third copy is
filed. The cashier deposits the cash in the bank as soon as possible daily, if not possible the
next day morning. The accounting department credits customers account and make other
appropriate entries. Later another individual compares the amount deposited by the cashier
with the total amount credited to various accounts. Theft and errors will be revealed whenever
these two amounts are not the same.
D) Electronic Scanning Equipment: Many large super markets have achieved faster check
out lines and stronger internal control by this equipment to read and record the price of all
groceries passing the check out counters.
E) Change Fund: It is a fund set up to make changes so that the cashier receives neither
above nor below the sales. It is usually kept with the daily sales receipt. At the close of a
business day the amount of change fund is re-kept in different denominations of currency and
coins. The daily sales receipt along with any cash overage is banked in tact, daily
F) Bank System
 All cash received must be deposited in the bank and all payments must be made by checks
drawn on the bank unless the amount is small.
 In some cases, a bank may require a business to maintain in a bank account a minimum
cash balance, called a compensating balance.
 The requirement of compensating balance is imposed by the bank as apart of loan
agreement.
 In Banking System different forms are used by depositors. The forms used in connection
with a bank accounts are:-
1. Signature Card
When an account is opened, an identifying number is assigned to the account, and each person
authorized to sign checks drawn on the account must sign a signature card. The card is used

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by the bank to determine the authenticity of the signature on the checks presented for
payment.
2. Deposit Ticket/Slip
Deposit Slip/ Ticket is prepared in duplicate, in which case the copy is stamped or initialed by
the bank’s teller and given to the depositor as a receipt.
3. Check
A check is a written instrument signed by the depositor, ordering the bank to pay a certain
sum of money to the order of a designated person.
There are three parties regarding check:
1. Drawer: The one who signs the check
2. Drawee: the bank on which the check is drawn
3. Payee: - the one to whose order the check is drawn
 The name and the address of the depositor are printed on each check and the check is
usually numbered in sequence to facilitate the depositor’s internal control
 Business firms may prepare a copy of each check drawn and they use it as a basis for
recoding the transaction in the cash payment journals.
4. Records of Checks Drawn: this cash payment journal in which all cash payment in check
is recorded up on.
5. Remittance Advice: Checks issued to a creditor on account are accompanied by a
notification called a remittance advice. This form notifies the creditor to record the
appropriate credit and is sent along with checks.
6. Stop Payment Order: the form that forbids the bank not to make for checks presented
because of lost checks or cheated checks.

7.2) Bank System: Bank Account; Bank Statement and Bank

Reconciliation Statement
Bank Account
 Cash in bank account in the depositor’s ledger is the reciprocal of the account with the
depositor in the bank’s ledger.
 Cash in bank in the depositor’s ledger is an asset with a debit balance, and the account
with the depositor in the bank’s ledger is a liability with a credit balance.
Bank Statement
The bank statement shows the beginning balance, checks and other credits (addition by the
banks), checks and other debits (deduction by the bank from the depositor’s account) and the
balance at the end of the period. The bank credits the depositor’s account for:
 Deposits by customer
 Receipts from notes receivable left for collection
 Loans to the depositor
The bank debits the depositor’s account for:
 Paid or cancelled checks
 Service Charges
 Deposited Checks but returned because of insufficient funds (NSF)

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Bank Reconciliation Statement

Why Bank Reconciliation Statement? As we discussed, there are double records for the same
cash, one of which is maintained by the Bank and the other is maintained by the Depositor.
The two records should have equal balance, but they are not likely to be equal on any specific
date because of:
1. Delay by either party in recording transactions
2. Errors by either party in recording transactions
Thus, to determine the reasons for any difference and to correct any errors that may have been
made by the bank or the depositor, the depositor records should be reconciled with the bank
statement using bank reconciliation statement. Bank Reconciliation Statement is prepared
once each month.

Elements of Bank Reconciliation

1. Delay in Recording Transactions by the Bank
A) Outstanding Deposits:
A time lag between the date of the deposit and the date it is recorded by the bank. E.g. the
depositor may mail deposits to the bank or use the night depository.
B) Outstanding Checks:
A time lag of one day or more between the date a check is written and the date it is presented
to the bank for payment. E.g. on the business account, checks are recorded on the date on
which they are issued by crediting cash though the bank does not yet pay it.
Accounts Payable.................................................. xxx
Cash in Bank............................................ xxx
2. Delay in Recording Transactions by the Depositors
A) Bank Debit Memo
This decrease the cash in bank balance of the depositor and includes items such as:
 Not Sufficient Fund (NSF)
 Service Charge
 Check Printing

Not sufficient Fund (NSF)

It refers to an amount of money collected form a customer in the form of check and deposited
to the depositors bank checking account while the customer did not have adequate balance to
cover the amount written on the check. Example
Sales on Account:
Accounts Receivables – X Co............................... xxx
Sales......................................................... xxx
Money Collected Form X-Company in the Form of Check
Cash....................................................................... xxx
Accounts Receivables – X Co.................. xxx
Unfortunately, no adequate balance of cash in customers account
Accounts Receivables – X Co............................... xxx
Cash in Bank............................................ xxx

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B) Bank Credit Memo
It increases the cash in bank balance of the depositor since cash in bank has a credit balance in
banks ledger. Example: Proceeds of notes receivable and interest
3. Errors committed either by the Bank or the Depositor
Any error that has been made by the bank or by the depositor affects the two records. Thus, it
should be considered in the Bank Reconciliation Statement.
Format of Bank Reconciliation Statement
Name of The Company
Bank Reconciliation Statement
Date: Usually Month of Reconciliation
Balance as per Bank Statement....................................................... xxx
Add: Deposit in Transit.................................................................. xxx
Bank Errors............................................................................. xxx xxx
Sub-Total......................................................................................... xxx
Less: Outstanding Checks............................................................... xxx
Bank Errors............................................................................. xxx (xxx)
Adjusted Cash Balance.................................................................... xxx
Balance per Depositor Records....................................................... xxx
Add: Notes And Interest Collected By Bank.................................. xxx
Depositor Error....................................................................... xxx xxx
Sub Total......................................................................................... xxx
Less: NSF (Not Sufficient Fund).................................................... xxx
Bank Service Charge.............................................................. xxx
Depositor Errors..................................................................... xxx (xxx)
Adjusted Cash Balance.................................................................... xxx

Example 7.1: the reconciling items on February 28, Year 5, bank reconciliation of XYZ
Company were as follows:
1. Balance in the bank statement, Feb 28, year 5 is Br 16,600
2. Balance in cash ledger account, Feb 28, year 5 is Br 11,060
3. Bank service charges for February, year 5 is Br 50
4. Deposit-in-transit, Feb 28, year 5 in Br 1,200
5. Error in XYZ Co. recording of Check No. 654 to vendor, ABC company (Br 400
check recorded by XYZ as Br 40)
6. Interest on note receivable collected by bank for XYZ Co. on Feb 28, year 5 was Br
300
7. NSF checks for customer, Bell Company, charged back by bank on Feb 28, year 5 was
Br 250.
8. Outstanding checks (total) Feb 28, year 5 is Br 4,100
9. Principal of notes receivable collected by bank for XYZ Co. on Feb 28 year 5 was Br
3,000
Required: Prepare Bank Reconciliation Statement for XYZ Company and journalize the
necessary entries

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XYZ Company
Bank Reconciliation
February 28, Year 5
Balance as per Bank Statement....................................................... Br 16,600
Add: Deposit in Transit................................................................... 1,200
Sub-Total......................................................................................... 17,800
Less: Outstanding Checks............................................................... (4,100)
Adjusted Cash Balance.................................................................... 13,700
Balance per the Depositor Record................................................... 11,060
Add: Notes Collected By Bank....................................................... 3,000
Interest on Note Collected By Bank....................................... 300 3,300
Sub-Total......................................................................................... 14,360
Less: NSF (Not Sufficient Fund)..................................................... 250
Bank Service Charge.............................................................. 50
Error in Recording Ck. No. 654 (400 – 40)............................ 360 (660)
Adjusted Cash Balance.................................................................... 13,700
The Journal Entries Based on The Bank Reconciliation is as follows:
Feb. 28, Year 5: Cash-in-Bank........................................................ 3,300
Notes Receivable..................................... 3,000
Interest Income......................................... 300

Feb. 28, Year 5: Miscellaneous Administration Expense................ 50

Accounts Receivable - Bell Co.............................250
Accounts Payable – ABC Co. ..............................360
Cash-in-Bank........................................... 660
Note: The data needed for adjusting entries are provided under the depositor section of bank
Reconciliation Statement.

7.3) Internal Control over Cash Receipts and Payments

Internal Control Procedures
The following factors should be taken into consideration in internal control
 Is the pool of cash protected from theft?
 Is the pool of cash managed efficiently to avoid both shortage and idle cash?
 Is there close control over cash disbursements for the true payee and correct amount?
Internal Control over Cash Payments
1. Alldisbursement should be made by checks or from petty cash.
2. Allchecks should be serially numbered, and accesses for check should be limited to
employee authorized to write checks.
3. The employee who authorized payment of bill should not be allowed to sign cheeks.
4. Approved documents should be required to supports all cheek issues.
5. The employee authorizing cash disbursements should certify that payment is for legitimate
purpose and is made out for the exact amount and to the proper aim.
6. The bank reconciliation should be prepared monthly.
7. The employee who will signed checks should not have access to canceled checks and
should not prepare the bank reconciliation.
8. The voucher system should be used.

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9. The net price method of recording purchases should be used.
10. When liabilities are paid the documents supporting it should be stumped “paid” under
quotes and the date number of checks issued should be indicated.

Internal Control Procedures over Cash Receipts

1. Prompt recording of all sorts of cash receipts
2. Depositing all cash receipts in bank promptly
3. Separation of the responsibility for handling cash receipts and recording in the accounting
system.

Cash Short and Over

The amount of cash actually received during a day often does not agree with the record of
cash receipts. Example 7.2: Total amount of coins and paper money in the cash register
drawer is Br 4,997.60. Total amount of sales shown on the cash register tape is Br 5,000.
 Sales as per Cash Register Tapes.............5,000.00
 Cash in a Drawer......................................4,997.60
 Cash Shortage.......................................... 2.40
Journal Entry:
Cash-in-Bank........................................................
4,997.60
Cash Short & Over................................................ 2.40
Sales......................................................... 5,000.00
Note: If there is a debit balance in the cash short & over account at the end of the period, it is
treated as expense and included in “Miscellaneous Expenses”. If there is a credit balance, it
is revenue and listed in “Other Income Section”. If the balance becomes larger than the
expected minor errors, management should take corrective measures.
Cash Change Fund
Business that receives cash directly from customers must maintain a fund of currency and
coins in order to make change. Example 7.3: Suppose the change fund amount to be Br 500
at the time of establishment. Therefore, the record will be:
Cash on hand......................................................... 500
Cash in Bank............................................ 500
Assume at the end of business day the amount in the cashier drawer and on the cash register
tape is 7,680, so the amount of sales should be:
 Cash in a Drawer............................................... 7,680.00
 Change Fund..................................................... (500.00)
 Sales.................................................................. 7,180.00
Cash in Bank.........................................................7,180
Sales......................................................... 7,180
Assume at the end of business day the amount in the cashier drawer is 7,677.40 and the
amount on the cash register tape is 7,180. The amount of cash received from sales = 7,677.40
– 500.00 = Br 7,177.40
 Sales as Per the Register................................... 7,180.00
 Cash in a Drawer...............................................(7,177.40)
 Cash Shortage................................................... 2.60

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Cash in Bank.........................................................
7,177.40
Cash Short & Over 2.60
Sales......................................................... 7,180.00

The Voucher System

Voucher is a special form on which is recorded relevant data about a liability and the details
of its payment. It is prepared by accounting department on the basis of invoice or a
memorandum that serves as proof of expenditure. This is done after the following
comparisons:
1. Comparison of the invoice with a copy of the purchase order to verify quantities,
prices and terms.
2. Comparison of the invoice with the receiving report to verify receipt of the items
billed
3. Verification of the arithmetic accuracy of the invoice.
The Voucher System and Management
The voucher system not only provides effective accounting controls but also aids management
in discharging other responsibilities. It gives greater assurance that all the payments are made
on valid liabilities. In addition, current information is always available for use in determining
future cash requirements which results in:
 Effective cash management
 Maintaining a favorable credit standing by taking cash discount and other invoices can
be paid on the final day of credit period.
Purchase Discounts: Net Method of Recording Purchases
In previous chapters, purchase of merchandise were recorded at the invoice price (gross amount) and
cash discount is taken at the time of payment but this method does not measure the cost of failing to
take discounts (management efficiency). If purchase of merchandise is recorded at net amount, it
measures the cost of failure to cash discounts and gives management an opportunity to take remedial
actions. Example 7.4: On Nov 1, ABC Company purchases merchandise with an invoice price of birr
15000 subject to terms of 2/10, n/30 FOB shipping point. Required:-pass the journal entries to be
made by the purchaser at a time of purchase and payment under the gross and net price method of
recording purchase assuming:
1. Payment was made on Nov. 11( Within the Discount Period)
2. Payment was made on Nov. 30( Outside the Discount Period)
I) At the Invoice Price (Gross Method) II) At Net Amount
Nov.1 A) At the time of purchase A) At the time of purchase
Purchases.............................
15,000 Purchases.............................
14,700
A/Payable................... 15,000 A/Payable................... 14,700
Nov. B) At the Time of Payment B) At the Time of Payment
11 1) Within the Discount Period 1) Within the Discount Period
A/Payable.............................
15,000 A/Payable.............................
14,700
Cash............................ 14,700 Cash............................ 14,700
Pur. Discount.............. 300
2) Out side the Discount Period 2) Out side the Discount Period
Nov. A/Payable.............................
15,000 A/Payable.............................
15,000
30 Cash............................ 15,000 Discount Lost....................... 300

Cash............................ 15,000

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Note: Any discounts not taken are then recorded in an expense account called Discount lost.
Petty Cash
It is a fund of money that is set for the purpose of making payments for small expenditure occurring
very frequently and that do not justify the use of checks, since checks has printing costs and delay for
approval of checks. In establishing a petty cash fund, the first step is to estimate the amount of cash
needed for disbursements of relatively small amounts during a certain period such as a week or a
month.
Petty Cash.............................................................
xxxxx
Cash in Bank............................................ xxxxx
 If voucher system is used:
Petty Cash.............................................................
xxxxx
Accounts Payable..................................... xxxxx
Accounts Payable.................................................. xxxxx
Cash in Bank............................................ xxxxx
The fund is replenished when the amount of money in the petty cash fund is reduced to the
predetermined minimum amount and at the end of an accounting period. Example 7.5: On
December 1, 1993, ABC Co. established a petty cash fund of Br 450.
Petty Cash.............................................................
450.00
Cash in Bank............................................ 450.00
December 19, 1993, because the money in the fund is reduced to Br 93.60, the fund is
replenished. The disbursements are as follows.
 Delivery Expense.............................................. 112.50
 Office Supplies.................................................. 62.28
 Utility Expense.................................................. 180.00
 Total.................................................................. 354.78
Compute Cash Shortage and Over:
 Petty Cash Balance .......................................... 450.00
 Total Expenditure ............................................. 354.78
 Expected Cash to be on Hand........................... 95.22
 Less: Actual cash on hand................................. (93.60)
 Cash Shortage................................................... 1.62
Journal Entry:
Delivery Expense........................................................
112.50
Office Supplies............................................................62.00
Utility Expense............................................................
180.00
Cash Short & Over......................................................1.62
Cash in Bank................................................. 356.40
Dec 31, 1993, the cash in fund is Br 240.75. The fund is replenished to include petty cash payment of :
 Delivery Expense.............................................. 85.50
 Office Supplies.................................................. 123.75
 Total.................................................................. 209.25
Compute Cash Short and Over
 Petty Cash Fund................................................ 450.00
 Less: Total Expenditure.................................... 209.25
 Expected Cash................................................... 240.75
 Actual Cash on Hand........................................ 240.75

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 Cash Short and Over......................................... ___0__
Journal Entry is as follows:
Delivery Expense........................................................85.50
Office Supplies............................................................
123.75
Cash in Bank................................................. 209.25
January 1, management decides the petty cash fund must be increased to Br 675.00
 New Petty Cash ................................................ 675.00
 Already Established.......................................... 450.00
 Incremental Petty Cash..................................... 225.00
Then the journal entry is debiting Petty Cash and Crediting Cash in Bank by Br 225.00. If
petty cash is increased by Br 675, the journal entry will be debiting Petty Cash by Br 675.00
and Crediting Cash in Bank by the same amount

7.4) Temporary Investments

A business may have a large amount of cash on hand that is not needed immediately, in such a
cause; the business may put all or part of it into income yielding investment such as:
 Certificates of depositors
 Money markets
 Treasury bills
In many cases, the idle cash is invested in securities that can be quickly sold when cash is
needed. Such securities are known as Temporary investments or marketable securities.
Temporary investments in securities include stocks and bonds. Short term investment is
accounted for under lower of cost or market on aggregate basis.
Example 7.6:
Temporary Unrealized
Investment Cost Market Gain (Loss)
Security A 30,500.00 28,750.00 1,750.00
Security B 19,200.00 22,100.00 (2,900.00)
Security C 21,600.00 23,900.00 (2,300.00)
Security D 70,300.00 65,250.00 5,050.00
Total 141,600.00 140,000.00 1,600.00
Marketable equity securities would be reported in the current asset section of the balance
sheet at market value of 140,000. No recognition of gain.

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 Chapter Eight: Accounting for Receivables

Chapter Eight
Accounting for Receivables
Receivables are amounts that are expected to be collected from different entities such as
customers and organizations

8.1) Classification of Receivables

Based the source, receivables are classified as trade and non trade receivables:
1) Trade Receivables – receivables that originate from the major operation of the business
such as sale of goods or services on account
2) Non-trade Receivables- receivables that originate from miscellaneous source rather than
the major operation of the business and includes lending money to:
 Outsiders
 Employees as advance
 Officers
Based on the nature, receivables are classified in to two as Accounts Receivable and Notes
Receivables:
1) Accounts Receivable: are receivables based on non written or oral promises to pay for
goods and services on credit. Accounts receivable:
 Are open accounts
 Are normally collectible within 60 days
 Are non interest bearing
2) Notes Receivable: is receivables based written promises to pay certain sum of money on
a specified future date to the bearer of the note. Promissory Note (Notes Receivables):
 Note is a written promise to pay a sum of money on demand or at a definite time.
 Are usually used for credit periods of more than 60 days and for transaction of
relatively large amounts.
 May also be used in settlement of an open account (Account receivables) and in
borrowing or lending money, since note is legal and formal instrument.
This classification is not mutual exclusive rather it is an overlapping classification because a
receivable can be both trade and accounts receivable or trade and notes receivables. All
receivables that are expected to be realized in cash with in a year are presented in the current
assets section of the balance sheet. Those receivables that is not currently collectible such as
long-term loans should be presented under the caption “Investments” below the current asset
section.

Characteristics of Notes Receivables:

1. Notes receivable is more liquid than Accounts Receivables
2. Notes receivable can be made interest bearing or non interest bearing. A note that provides
for the payment of interest for the period between the issuance date and the due date is
called an interest bearing note. If the note makes no provision for interest, it is said to be
non-interest bearing note.
3. Promissory notes have a stronger legal status than open accounts.
4. There are two parties regarding notes: (1) Payee – the party to which the ordered note is
payable, and (2) The Maker – the party which is making the promise.

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Example 8.1: On May 1, 2005 GG Co purchased merchandise for Br 5,000 from XYZ Co
giving a written promise to pay after 90 days. Determine the Payee and the maker of the note
Payee: XYZ Company
Maker: GG Company

8.2) Determination of Interest, Due Date, and Maturity Value

1. Determination of Interest
Interest = Principal @ Rate @ Time
Example 8.2: Compute the interest on Br 10,000, 12%, 90 days promissory note.
 Interest = 10,000 @ 12% @ 90/ 360
 Interest = Birr 300
2. Determination of Due Date
Due Date (Maturity Date): is the date on which the note is to be paid. The term of the note
may be stated in terms of specified number of days or months. When the term of a note is
stated in days, the due date is the specified number of days after its issuance. When the term
of a note is stated as a certain number of months after the issuance date, the due date is
determined by counting the number of months from the issuance date.
Example 8.3: X Company issued 90 days, 12%, Br 10,000 note, dated October 14 to Y
Corporation in settlement of an open account. Determine the due date of the note.
Solution:
Terms of the note........................................... 90 Days
Days remaining in October (31-14)............... 17 Days
Days in November......................................... 30 Days
Days in December.......................................... 31 Days
Total............................................................... 78 Days
Due Date, January.......................................... 12
Example 8.4: W Company issued a 60-day, 12% Br1000, dated May 10, to L Corporation.
Determine the due date of the note?
Solution:
Terms of the note........................................... 60 Days
Days remaining in May (31-10)..................... 21 Days
Days in June................................................... 30 Days
Total............................................................... 51 Days
Due Date, July................................................ 9
Example 8.5: The Maturity Date of a 3 months note dated June 5 would be on September 5.
On those cases in which there is no date in the month of maturity that corresponds to the
issuance date, the due date will be the last day of that month.
3. Determination of Maturity Value
 The amount that is due at the maturity or due date is called the maturity value
 The maturity value of a non-interest bearing note is the face amount.
 The maturity value of interest-bearing note is the sum of the face amount and the
interest.
Example 8.6: W Co. issued a 60 day, Birr 10,000, 12% interest bearing note , dated may 19
to L Corporation on account. Determine the Maturity Value of the Note.
Solution:

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 Face Value........................................................ Br 10,000.00
 Add: Interest (10,000 @ 12% @ 60/360)......... 200.00
 Maturity Value.................................................. Br 10,200.00

8.3) Accounting For Notes Receivable

If the accounts of a customer become delinquent, the creditor may insist that the account be
converted into a note. If the debtor is given more time and the creditor needs more funds, the
note may be endorsed and transferred to a bank or other financial agency.

Example 8.7: ABC Co purchased merchandise for Br30, 000 on Nov 11, 1995 with terms
2/10, n/30 from XYZ Corporation. However, as ABC Company didn’t pay its account to its
creditors on the agreed date (Dec.11, 1995) and XYZ Corporation insisted the debtor to give a
note in the place of the open account (A/R). Consequently, ABC Company signs a Br 30,000,
12%, 90 days interest bearing note dated December11, 1995. Required: Record the
appropriate journal entry to be made by XYZ Corporation (seller):
1. On December11, 1995 when the note was received
2. On December 31, 1995, end of the fiscal year
3. At maturity date of the note
A. Assuming reversing entry was made on Jan 1, 1996
B. Assuming reversing entry was not made on Jan 1,1996
Solution:
1. To convert an open account to a note
Dec. 11, 1995: Notes Receivable................................................... 10,000.00
Accounts Receivable................................ 10,000.00
2. To record accrued interest for 20 days
 From Dec. 11 to Dec. 31 = 20 days
 Accrued Interest = 30,000 @ 12% @ (20 / 360) = Br 200
Dec. 31, 1995: Interest Receivable................................................ 200.00
Interest Income......................................... 200.00
3. On Maturity Date
A. Assuming Reversing Entry was made
Terms of the note........................................... 90 Days
Days Remaining December (31-11).............. 20 Days
Days in January.............................................. 31 Days
Days in February............................................ 29 Days
Total............................................................... 80 Days
Due Date: March............................................ 10
March 10, 1996:
Cash.......................................................................
30,900.0
0
Notes Receivable..................................... 30,000.00
Interest Income......................................... 900.00
B. Assuming Reversing Entry was not made
Cash.......................................................................
30,900.0
0
Notes Receivable..................................... 30,000.00

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Interest Receivable................................... 700.00
Interest Income......................................... 900.00

Discounting of Notes Receivable

Discounting of notes receivable refers to the act of selling a note receivable by a company to
financial institutions before the maturity date of the note and get net cash proceeds in return.
When a company is in need of cash, it may transfer its notes receivable to a bank by
endorsement.
 The discount charged by the bank is computed on the maturity value of the note for the
period of time the bank holds the note. I.e. the time that will pass between the date of the
transfer and the due date
 The amount of the proceeds paid to the endorser is the excess of the maturity value over
the discount
 There are three parties: (1) Maker: the one who makes a note, (2) Endorser: the one
who takes the proceeds and (3) Payee: the bank or other Financial Institution accepting
the Note.
Example 8.8: XYZ Corporation discounted the 90 days, 12%, Birr 30,000 notes receivable
dated December 11, 1995 on December 21 at the rate of 14% at its local bank. Required:
Determine the proceeds and record the journal entries at the time of discounting the note.
Net Cash Proceeds = Maturity Value – Bank Discount Amount
Where Maturity Value = Principal + Interest
Bank Discount = Maturity Value @ Bank Discount Rate @ Time
Solution: The Discount Period: (Dec. 21 – Feb. 9) = 50 days
Face Value of Note Dated Dec. 11.................................... 10,000.00
Interest 60,000 @ 12% @ 60/360..................................... 200.00
Maturity Value.................................................................. 10,200.00
Bank Discount = 10,200 @14% @ 50/360....................... 198.33
Net Cash Proceeds............................................................ 10,001.67
Journal Entry:
Dec. 21, 1991: Cash................................................... 10,001.67
Notes Receivable.................. 10,000.00
Interest Income..................... 1.67

Example 8.9: Assume the above note is discounted at 15% instead of 14%. Determine the net
cash proceeds and record the journal entry.
Solution:
Face Value of Note Dated Dec. 11.................................... 10,000.00
Interest 60,000 @ 12% @ 60/360..................................... 200.00
Maturity Value.................................................................. 10,200.00
Bank Discount=10,200 @14% @ 50/360.........................
212.50
Net Cash Proceeds............................................................ 9,987.50
Journal Entry:
Dec. 21, 1991: Cash................................................... 9,987.50

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Interest Expense................................. 12.50
Notes Receivable.................. 10,000.00
Note: If the Cash Proceeds > Face Value, Interest Income will be recognized. If Cash
Proceeds < Face Value, Interest Expense will be recognized.
Dishonored Notes Receivable
If the maker of a note fails to pay the debt on the due date, the note is said to be dishonored. A
dishonored note receivable is no longer negotiable, and for that reason the holder usually
transfers the claim, including any interest due .At this time the bank will get the whole
amount from endorser. Dishonored notes can be:
1. Before Discounting the Note
Example 8.10: If the XYZ Company received a 10,000, 60 days, 12% note and recorded on
December 11, 1995 had been dishonored at maturity, the entry to charge the note, including
the interest back to the customer’s (ABC company) account would have been as follows:
Feb. 9, 1995: Accounts Receivable – ABC Co....... 10,200.0
0
Notes Receivable.................. 10,000.00
Interest Income..................... 200.00
2. After Discounting The Note:
Example 8.11: Br 10,000, 60 days, 12% notes discounted on December 21, had been
dishonored by the maker on maturity .The necessary journal entry in the book of endorser
(XYZ Company) is:
Feb. 9, 1995: Accounts Receivable – ABC Co....... 10,200.0
0
Cash...................................... 10,200.00
Assume the bank charges endorser a protest fee of 10 birr and the endorser, who in turn
charges it to the maker of the note in example 2, the journal entry in the book of endorser
(XYZ Company) is:
Feb. 9, 1995: Accounts Receivable – ABC Co....... 10,210.0
0
Cash...................................... 10,210.00

8.4) Accounting for Uncollectible Accounts

When merchandise or services are sold with out the immediate receipt of cash, a part of the
claims against customers is proves to be uncollectible. The operating expense incurred
because of the failure to collect receivable is called an expense or a loss from uncollectible
accounts, doubtful accounts, or bad debts. There are two methods: (1) The Allowance
Methods/Reserve Method and (2) Direct Write off Methods/Direct Charge off Method

8.4.1) Allowance Method:

This method makes a provision for possible future uncollectible amount in advance. This
procedure requires you to make an estimate about possible uncollectible amounts and
recognize this in the record as an adjustment to account receivable account at the end of every
accounting period. The journal entry for the estimated amount is:
Uncollectible Account Expense.......................... xxxx
x
Allowance for Doubtful Accounts......... xxxxx

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Note: Uncollectible accounts expense is generally reported on the income statement as an
administrative expense. Allowance for doubtful accounts is the amount to be deducted from
A/R to determine net realizable value.
Partial Balance Sheet Presentation
Current Asset:
Cash.................................................................... xxxxx
Accounts Receivable..........................................xxxxx
Less: Allowance for Doubtful Accounts............xxxxx xxxxx

Write-off to the Allowance Account

During the year, as more accounts or portions of accounts are determined to be uncollectible,
it is written off against allowance for doubtful accounts. When an account is believed to be
uncollectible, it is written off against the allowances account as follows
Allowance for Doubtful Accounts...................... xxxx
x
Accounts Receivable.............................. xxxxx
 The total amount written off against the allowance account during the period will rarely be
equal to the amount in the account at the beginning of the period
 The allowance account will have a credit balance at the end of the period if the write offs
during the period amount to less than the beginning balance
 It will have a debit balance if the write the write offs exceed the beginning balance
 After the year-end adjusting entry is recorded the allowance account will have a credit
balance
Reinstatement of Write-off Entry
An account receivable that has been written off against the allowance account may later be
collected. In such cases, the account should be reinstated as:
Accounts Receivable........................................... xxxx
x
Allowance for Doubtful Accounts......... xxxxx
Example 8.12: ABC Company’s account receivable has a balance of Br 25,000 at the end of
the period. Based on study, it is estimated that a total of Br 2,000 will be uncollectible. The
Adjusting Entry on December 31
Uncollectible Account Expense.......................... 2,000.00
Allowance for Doubtful Accounts......... 2,000.00
Account Receivable......................................................... 25,000.00
Less: Allowance for doubtful account............................. 2000.00
Net Realizable Value of account receivable.................... 23,000.00
Assuming Br 500 of the receivables is believed to be uncollectible and is written off on
January 10, the entry would as follows:
Allowance for Doubtful Account........................ 500.00
Accounts Receivables............................ 500.00
Account receivable........................................................... 24,500.00
Less: Allowance for Doubtful Account........................... 1,500.00
Net Realizable Value of Account Receivable.................. 23,000.00
Note: there is no change in net realizable value of account receivable.

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Further assume that the Br 500 written-off in the preceding journal entry is later collected.
The entry to reinstate the account would be as follows:
Accounts Receivables......................................... 500.00
Allowance for Doubtful Account.......... 500.00

Estimating Uncollectible
The estimate of uncollectible at the end of the fiscal period is based on past experience and
forecasts of future business activity. The two methods to estimate uncollectible are:
1. Estimate Based on Credit Sales
2. Estimate Based on Analysis Age of Receivables

1. Estimate Based on Credit Sales

The probable amount of the accounts that will be uncollectible is estimated based on credit
sales. The amount of this estimate is added to whatever balance exists in allowance for
doubtful accounts.
Example 8.13: Assume that the allowance account has a credit balance of Br 1,500 before
adjustment. The credit sales for the year is Br 100,000 and it is known from past experience
1% of the credit sales will be uncollectible. Therefore, the adjusting amount will be = 1% @
100,000= Br 1,000
Uncollectible Account Expense.......................... 1,000.00
Allowance for Doubtful Accounts......... 1,000.00
After adjusting entry is posted, allowance for doubtful account has Br 2,500 credit balance.
If the balance of Allowance for Doubtful Account had been a debit balance of Br 300, the
amount of the adjustment would still have been Br 1,000 (that is 1% @ 100,000)
Uncollectible Account Expense.......................... 1,000.00
Allowance for Doubtful Accounts......... 1,000.00
After the adjusting entry is posted, allowance for doubtful account has Br 700 debit balance.
Note: a newly established business enterprise, having no record of credit experience, may
obtain data from trade association journals and other publications.

2. Estimate Based on Analysis of Age of Receivables (Aging of Receivables)

There are some steps in aging of receivables methods:
1. Classify account receivable by age(days that receivables past due)
2. Provide percentage provision for uncollectibility
3. Apply the percentage
Example 8.14:
Amount of Est. Percentage Amount of
Age Interval Receivable of uncollectible Uncollectible
Not due 60,000 1% 600
1 – 30 days 15,000 2% 300
31 – 60 days 10,000 10% 1,000
61 – 90 days 8,000 25 % 2,000
The Estimate of Uncollectible 3,900
The estimate of uncollectible account is 3,900. This amount is the desired balance of the
Allowance for Doubtful Account after adjustment. Therefore, the adjustment will be
determined taking into account the existing balance of the Allowance for Doubtful Account.

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Assume, the Allowance for Doubtful Account has a credit balance of Br 1,500 before
adjustment. The adjusting entry will be by Br 2,400 (3,900 – 1,500)
Uncollectible Account Expense.......................... 2,400
Allowance for Doubtful Accounts......... 2,400
After posting is made, the Allowance for Doubtful Account has a credit balance of Br 1,500 +
2,400 = Br 3,900. If there had been a debit balance of Br 300 in the Allowance for Doubtful
Account before the year end adjustment, the amount of the adjustment would have been 4,200
(3,900 + 3,00=4,200)
Uncollectible Account Expense.......................... 4,20
0
Allowance for Doubtful Accounts......... 4,200
After posting is made, the Allowance for Doubtful Account has a credit balance of Br 3,900.
8.4.2) Direct Write-off Methods
It is useful when:
1. A particular customer is known
2. Bankruptcy notice is available
3. There is a continuous correspondence with customers
4. There is disappearance of a customer through death
 The entry to write off an account when it is believed to be uncollectible is as follows:
Uncollectible Account Expense.......................... xxxxx
Accounts Receivables............................ xxxxx
 If an account that has been written off is collected later, the account should be reinstated.
 If the recovery is in the same fiscal year as the write off, the entry to reinstate is
Accounts Receivables......................................... xxxxx
Uncollectible Account Expense............. xxxxx
 If the recovery is made in the subsequent fiscal year, it may be reinstated by an entry
illustrated below:
Accounts Receivables................................................................ xxxxx
Recovery of Written-off Uncollectible Account........... xxxxx

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