BONGA UNIVERSITY COLLAGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

FUNDAMENTAL OF ACCOUNTING ONE
Course code (AcFn2011)
Year 2 Semester 1

Edited by Ins, Abeba Ashebir (MSc)

Contents
CHAPTER ONE ......................................................................................................................................... 2
INTRODUCTION TO ACCOUNTING AND BUSINESS ................................................................................. 3
1.1. NATURE OF A BUSINESS ................................................................................................................ 3
1.2. THE ROLE OF ACCOUNTING IN BUSINESS ..................................................................................... 3
THE MAJOR USERS AND USES OF ACCOUNTING ARE AS FOLLOWS ....................................................... 4
FUNCTIONS OF ACCOUNTING ................................................................................................................. 5
BRANCHES OF ACCOUNTING/AREA OF SPECIALIZATION ....................................................................... 5
1.3. THE PROFESSION OF ACCOUNTING .............................................................................................. 7
1.4. TYPES OF BUSINESS ORGANIZATIONS .......................................................................................... 7
1.5. FORMS OF BUSINESS ORGANIZATIONS ........................................................................................ 8
1.6. OVERVIEW OF INTERNATIONAL FINANCIAL REPORTING STANDARD (IFRS) ................................ 8
SOME PRINCIPLES OF ACCOUNTING AND CONCEPTS .......................................................................... 10
1.7. THE ACCOUNTING EQUATION AND ELEMENTS OF THE EQUATION........................................... 10
1.8. BUSINESS TRANSACTIONS AND FINANCIAL STATEMENTS ......................................................... 16
CHAPTER TWO ...................................................................................................................................... 22
2. ACCOUNTING CYCLE FOR SERVICE-GIVING BUSINESS ................................................................... 22
2.1. THE CHARACTERISTICS OF AN ACCOUNT.................................................................................... 22
2.2. THE RULES OF DEBIT AND CREDIT .............................................................................................. 22
2.3. NORMAL ACCOUNT BALANCES................................................................................................... 23
2.4. ANALYZING AND RECORDING TRANSACTIONS ........................................................................... 23
2.5. PREPARING TRIAL BALANCE........................................................................................................ 29
2.6. ACCRUAL- VERSUS CASH-BASIS ACCOUNTING ........................................................................... 30
2.7. PREPARE A WORKSHEET ............................................................................................................. 38
2.8. PREPARING FINANCIAL STATEMENT FROM WORKSHEET .......................................................... 39
2.9. PREPARE CLOSING ENTRIES ........................................................................................................ 40
2.10. PREPARING A POST-CLOSING TRIAL BALANCE ......................................................................... 42
CHAPTER THREE .................................................................................................................................... 48
3. ACCOUNTING CYCLE FOR MERCHANDISING BUSINESS ................................................................. 48
3.1. CHARACTERISTICS OF A MERCHANDISING BUSINESS................................................................. 48
3.2. ACCOUNTING FOR SALES TRANSACTIONS .................................................................................. 50
3.3. ACCOUNTING FOR RECORDING PURCHASES .............................................................................. 53
3.4. PERIODIC AND PERPETUAL INVENTORY SYSTEM ....................................................................... 58
3.5. CHART OF ACCOUNTS FOR A MERCHANDISING BUSINESS ........................................................ 59
3.6. THE FINANCIAL STATEMENTS OF A MERCHANDISING BUSINESS ............................................... 59
3.7. ADJUSTING AND CLOSING ENTRIES FOR A MERCHANDISING BUSINESS ................................... 59
CHAPTER FOUR ..................................................................................................................................... 62
ACCOUNTINGSYSTEMS ......................................................................................................................... 62
4. MANUAL AND COMPUTERIZED ACCOUNTING SYSTEM ................................................................ 62
4.1. MANUAL ACCOUNTING SYSTEMS............................................................................................... 62

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4.2. COMPUTERIZED ACCOUNTING SYSTEMS ................................................................................... 62
4.3. ENTERPRISE RESOURCE PLANNING SYSTEMS ............................................................................. 62
4.4. THE NATURE AND PURPOSE OF A SUBSIDIARY LEDGER ............................................................. 63
CHAPTER FIVE ....................................................................................................................................... 63
CASH AND RECEIVABLES ....................................................................................................................... 63
5.1. THE NATURE OF CASH.................................................................................................................... 63
5.2. INTERNAL CONTROL OVER CASH ................................................................................................... 64
CONTROL OF CASH THROUGH BANK ACCOUNTS ................................................................................. 64
5.3. BANK RECONCILIATION .................................................................................................................. 65
5.4. ESTABLISHING THE PETTY CASH FUND .......................................................................................... 68
5.4. RECEIVABLES .................................................................................................................................. 69
5.5. CLASSIFICATION OF RECEIVABLE ................................................................................................... 69
5.6. ACCOUNTING FOR UNCOLLECTIBLE ACCOUNT ............................................................................. 71
5.7. ACCOUNTING FOR NOTES RECEIVABLE ......................................................................................... 72
5.8. PRESENTATION OF CASH AND RECEIVABLES ................................................................................. 74
REFERENCE ............................................................................................................................................ 75

CHAPTER ONE

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 INTRODUCTION TO ACCOUNTING AND BUSINESS
1.1. Nature of a business
A business is an organization in which basic resources (inputs), such as materials and labor,
are assembled and processed to provide goods or services (outputs) to customers.

The objective of most businesses is to maximize profits. There are three different types of
businesses that are operated for profit:

 Manufacturing,
 Merchandising, and
 Service businesses.
A business is normally organized in one of the following forms:

 Proprietorship,
 partnership,
 Corporation or Limited Liability Corporation.
A business stakeholder is a person or entity (such as an owner, manager, employee, customer,
creditor, or the government) who has an interest in the economic performance of the business

1.2. The role of accounting in business

Why We Need Accounting?
 Asking that question of an accountant is like asking a farmer why we need rain.
 We need accounting because it’s the only way for business to grow and flourish.
 Accounting is the backbone of the business financial world
Accounting
Accounting as service activity
Its function is to provide quantitative information, primarily financial in nature, about
economic entities that is intended to be useful in making economic decisions.
Accounting as "Language of business‖ This is because accounting is the means by which
businesses’ financial information is communicated to users.
Accounting as science and art
Accounting is a social science with a body of knowledge which has been systematically
gathered, classified, and organized. It is influenced by, and interacts with, economic, social
and political environments.
Accounting is a practical art which requires the use of creative skill and judgment.
The basic purpose/role of accounting in business is:

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  To provide quantitative information about economic entities intended to be useful
in making economic decisions.
 To provide information for managers to use in operating the business
 To provides information to other users in assessing the economic performance
and condition of the business.
The process by which accounting provides information to users is as follows:
 Identify users.
 Assess users’ information needs.
 Design the accounting information system to meet users’ needs.
 Record economic data about business activates and events.
 Prepare accounting reports for users.
Types of Information Provided by Accounting
1. Quantitative information – expressed in numbers, quantities or units.
2. Qualitative information – expressed in words or descriptive form
3. Financial information – expressed in terms of money
Economic Entity Vs Business Entity
 Economic entity – is a separately identifiable combination of persons and property
that uses or controls economic or scarce resources to achieve certain goals or
objectives. Not-for-profit or non-profit entity is one that carries out some socially
desirable needs of the community or its members whose activities are not directed
towards making profit.
 Business entity- is an entity that produces and distributes goods or services primarily
for profit.
 Accounting is an information system that provides reports to stakeholders about the
economic activities and condition of a business. Accounting is the ―language of
business.‖
 Accounting is an information system that identifies, records, and communicates the
economic events of an organization to interested users.
The major users and uses of accounting are as follows.

1. Internal users
2. External users
i. Internal users of Accounting

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 Management: uses accounting information to plan, organize, and run the business.
ii. External users
 Investors (owners): decide whether to buy, hold, or sell their financial interests on the
basis of accounting data.
 Creditors (suppliers and bankers): evaluate the risks of granting credit or lending money
on the basis of accounting information. Other groups that use accounting information are
taxing authorities, regulatory agencies, customers and labor unions.

FUNCTIONS OF ACCOUNTING
The following are the function of accounting:
 Identification. The accounting process of recognition or non-recognition of business
activities as accountable events or whether has accounting relevance.
 Accounting events- is a one that is quantifiable and has an effect on assets, liabilities and
equity.
 This also known as economic activity, which is the subject matter of accounting.
 Criteria for accountable
 It must affect a financial element of accounting (increasing or decreasing asset,
liability or equity)
 It is a result of a past activity
 Its cost can be measured reliably.
Measurement: The accounting process of assigning of piece amounts or numbers to the
economic transactions and events. The unit of measure of accounting is money, expressed in
prices.
Communication: The accounting process of preparing and distributing accounting reports to
potential users of accounting information and interpreting the significance of this processed
information. Such as:
Recording: the process of systematically committing to writing business transactions and
events after they have been identified and measured, in books of account in a systematic and
chronological manner according to accounting rules.
Classifying: The grouping of similar and interrelated items into their respective classes
Summarizing: Putting together or expressing in condensed or brief form the recorded and
classified statements in financial statements.
Branches of Accounting/Area of Specialization
1. Financial Accounting.

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  The recording of transactions, preparation of financial statements and communication
of financial information to external user groups. Focuses on general purpose reports.
2. Auditing.
 The examination of financial statements by independent certified public accountant
for the purpose of expressing an opinion on the fairness of presentation of financial
statements.
3. Management Accounting.
 Incorporates cost accounting data and adapts them for specific decisions which
management may be called upon to make. A management accounting system
incorporates all types of financial and non-financial information from a wide range of
sources.
4. Financial Management.
 Relatively new branch of accounting that has been grown rapidly over the last 35
years. Financial managers are responsible for setting financial objectives, making
plans based on those objectives, obtaining the finance needed to achieve the plans,
and generally safeguarding all the financial resources of the entity.
5. Taxation / Tax accounting.
 Involves the preparation of tax returns and rendering of tax advice, such as
determination of tax consequences of certain proposed business endeavors.
6. Government Accounting.
 Accounting for the national government and its instrumentalities, focusing attention
on the custody of public funds and the purpose or purposes to which such funds are
committed.
7. Environmental Accounting.
 The area of accounting that focuses on programs, activities and projects that are
focused care for Mother Earth.
 One example of this is carbon accounting such as ―Cap and Scheme‖, which is a
process of encouraging reductions in greenhouse gas emissions.

Importance of business ethics and the basic principles of proper ethical conduct

Ethics are moral principles that guide the conduct of individuals. Proper ethical conduct
implies a behavior that considers the impact of one’s actions on society and others.

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 Ethics are the standards of conduct by which actions are judged as right or wrong.
Effective financial reporting depends on sound ethical behavior.
Generally accepted accounting principles are a common set of standards used by
accountants.
The primary accounting standard-setting body in the United States is the Financial
Accounting Standards Board.
The monetary unit assumption requires that companies include in the accounting records
only transaction data that can be expressed in terms of money.
The economic entity assumption requires that the activities of each economic entity be
kept separate from the activities of its owner(s) and other economic entities.

1.3. The profession of accounting

 Accountants are typically engaged in either private accounting or public accounting.
a. Private Accounting: accountants employed by a particular business firm, government
or non-for-profit organization, perhaps as chief accountant, controller, and financial
vice –president.
 Example accountants who employed in the business to provide audit services, called
internal auditors, verify the accuracy of financial records, accounts, and systems.
There are also other careers categorized under private accounting such as bookkeeper,
payroll clerk, general accountant, budget analyst, cost accountant, information
technology auditor, etc.
b. Public Accounting: accountants who render accounting service on a fee basis and staff
accountants employed by them.
 In public accounting, an accountant may practice as an individual or as a member of
a public accounting firm.
 Public accountants who have met a state’s education, experience, and examination
requirements may become Certified Public Accountants (CPAs).
 CPAs generally perform general accounting, audit, or tax services.

1.4. Types of Business organizations

 There are three different types of businesses that are operated for profit:
1. Service business
2. Merchandising business

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 3. Manufacturing businesses.
Service businesses- provide services rather than products to customers.
Nice entertainment services, Selam Bus transportation service
Merchandising businesses- sell products they purchase from other businesses to customers.
Wal-Mart (general merchandise) and amazon.com (internet books, music, video)

 Manufacturing businesses- change basic inputs into products that are sold to
customers.
 Ford Motor Co. (cars, trucks, vans) and Dell Inc. (personal computers)

1.5. Forms of Business Organizations

 The common forms of business organization are the sole proprietorship, partnership,
corporation and limited liability corporation
A. Sole proprietorship: is a business entity owned and managed by a single person.
B. Partnership: is small a business entity owned by two or more people in accordance
with contractual agreement-called article of partnership.
C. Corporation: is organized under state or federal statutes as a separate legal taxable
entity. The ownership of a corporation is divided into shares of stock. A corporation
issues the stock to individuals or other businesses, who then become owners or
stockholders of the corporation.
D. Limited Liability Corporation is a combines attributes of a partnership and a
corporation in that it is organized as a corporation, but it can elect to be taxed as a
partnership. Thus, its owners’ (or members’) liability is limited to their investment in
the business, and its income is taxed when the owners report it on their individual tax
returns
 Manufacturing, merchandising, and service businesses are commonly organized as
proprietorships, partnerships, corporations, or limited liability corporations.
 However, because of the large amount of resources required to operate a
manufacturing business, most manufacturing businesses are corporations.

1.6. Overview of international financial reporting standard

(IFRS)
 The accounting profession has developed standards that are generally accepted and
universally practiced. This common set of standards is called generally accepted
accounting principles (GAAP). These standards indicate how to report economic events.

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 The primary accounting standard-setting body in the United States is the Financial
Accounting Standards Board (FASB).
 The Securities and Exchange Commission (SEC) is the agency of the U.S. government
that oversees U.S. financial markets and accounting standard-setting bodies.
 The SEC relies on the FASB to develop accounting standards, which public companies
must follow.
 Many countries outside of the United States have adopted the accounting standards issued
by the International Accounting Standards Board (IASB).
 The IASB issues standards are called International Financial Reporting Standards (IFRS).
 Financial accountants follow generally accepted accounting principles (GAAP) in
preparing reports so that stakeholders can compare one company to another. Accounting
principles and concepts develop from research, accepted accounting practices, and
pronouncements of authoritative bodies.
 Currently, the Financial Accounting Standards Board (FASB) is the authoritative body
having the primary responsibility for developing accounting principles.
 The business entity concept: views the business as an entity separate from its owners,
creditors, or other stakeholders. The business entity limits the economic data in the
accounting system to that related directly to the activities of the business.
 The cost concept: requires that properties and services bought by a business be recorded
in terms of actual cost.
 The objectivity concept: requires that the accounting records and reports be based upon
objective evidence.
 The unit of measure concept: requires that economic data be recorded in dollars.
GAAP and IFRS
 Following are the key similarities and differences between GAAP and IFRS as related to
accounting fundamentals.
Similarities
 The basic techniques for recording business transactions are the same for U.S. and
international companies.
 Both international and U. S. accounting standards emphasize transparency in financial
reporting.
 Both sets of standards are primarily driven by meeting the needs of investors and
creditors.

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  The three most common forms of business organizations, proprietorships,
partnerships, and corporations, are also found in countries that use international
accounting standard
Differences
 International standards are referred to as International Financial Reporting Standards
(IFRS), developed by the International Accounting Standards Board.
 Accounting standards in the United States are referred to as generally accepted
accounting principles (GAAP) and are developed by the Financial Accounting
Standards Board.
 IFRS tends to be simpler in its accounting and disclosure requirements; some people
say it is more ―principles-based.‖
 GAAP is more detailed; some people say it is more ―rules-based.‖

Some principles of accounting and concepts

 The two concepts in accounting are;
1. Business Entity Concept
2. Cost concepts
Business entity concept
 Under the business entity concept, the activities of a business are recorded
separately from the activities of the stakeholders.
Cost concepts
 Under the cost concept, the records of properties and services purchased by a
business are maintained in accordance with the cost principle.
 Initially, this requires that the monetary record be in terms of cost or purchase
price.

1.7. The Accounting Equation and Elements of the Equation

 The resources owned by a business are its assets.
 Examples of assets include cash, land, buildings, and equipment.
 The rights or claims to the properties are normally divided into two principal types:
(1) the rights of creditors and (2) the rights of owners.
 The rights of creditors represent debts of the business and are called liabilities.
 The rights of the owners are called owner’s equity.
 The relationship between the two may be stated in the form of an equation, as follows

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 Assets= Liabilities + Owner’s Equity
Business Transactions and Financial Statements
 An economic event or condition that directly changes an entity’s financial condition
or directly affects its results of operations is a business transaction.
 All business transactions from the simplest to the most complex can be stated in terms
of the resulting change in the three basic elements of the accounting equation.
 In order to summarize the effects of every transaction, the following points were
applied for all types of business:
1. The effect of every transaction increased and / or decreased one or more of
accounting equations.
2. Equality of the two sides of accounting equation should be maintained.
3. Owner’s equity increased by amounts invested by owner and decreased by
amounts withdrawal by the owner. In addition owner’s equity increased by
revenues earned and decreased by expenses; diagrammatically as follows:
Owner’s equity is:

Decreased by; Increased by;

 Expenses and withdrawal  Revenue (sales or earnings) and
Withdrawal has different names based on the  Owner’s investment (deposits or
type of business enterprise; savings)
 Withdrawal- for sole
proprietorship
 Drawing- for partnership and
 Dividend- for corporation type

Illustration
The following illustration will demonstrate types of transaction and the accounting equation
as follow:
TRANSACTION (1) INVESTMENT BY OWNER

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Johan starts a Smartphone app development company which he names Soft byte. On
September 1, 2017, he invests $15,000 cash in the business.

TRANSACTION (2) PURCHASE OF EQUIPMENT FOR CASH

Soft byte purchases computer equipment for $7,000 cash. This transaction results in an equal
increase and decrease in total assets, though the composition of assets changes.

TRANSACTION (3) PURCHASE OF SUPPLIES ON CREDIT

Soft byte purchases for $1,600 from Mobile Solutions headsets and other computer
accessories expected to last several months. Mobile Solutions agrees to allow Soft byte to pay
this bill in October.

TRANSACTION (4) SERVICES PERFORMED FOR CASH

Soft byte receives $1,200 cash from customers for app development services it has
performed.

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TRANSACTION (5) PURCHASE OF ADVERTISING ON CREDIT
Soft byte receives a bill for $250 from the Daily News for advertising on its online website
but postpones payment until a later date. This transaction results in an increase in liabilities
and a decrease in owner’s equity

TRANSACTION (6) SERVICES PERFORMED FOR CASH AND CREDIT

Soft byte performs $3,500 of app development services for customers. The company receives
cash of $1,500 from customers, and it bills the balance of $2,000 on account. This transaction
results in an equal increase in assets and owner’s equity.

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TRANSACTION (7). PAYMENT OF EXPENSES
Softbyte pays the following expenses in cash for September: office rent $600, salaries and
wages of employees $900, and utilities $200. These payments result in an equal decrease in
assets and owner’s equity

TRANSACTION (8) PAYMENT OF ACCOUNTS PAYABLE

Soft byte pays its $250 Daily News bill in cash. The company previously [in Transaction (5)]
recorded the bill as an increase in Accounts Payable and a decrease in owner’s equity

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TRANSACTION (9) RECEIPT OF CASH ON ACCOUNT
Soft byte receives $600 in cash from customers who had been billed for services [in
Transaction (6)]. Transaction (9) does not change total assets, but it changes the composition
of those assets.

TRANSACTION (10) WITHDRAWAL OF CASH BY OWNER

Johan withdraws $1,300 in cash from the business for his personal use. This transaction
results in an equal decrease in assets and owner’s equity.

N.B: Observe that the effect of a cash withdrawal by the owner is the opposite of the
effect of an investment by the owner. Owner’s drawings are not expenses. Expenses are
incurred for the purpose of earning revenue. Drawings do not generate revenue.

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 Summary of Transactions
 Summarizes the September transactions of Soft byte to show their cumulative effect on
the basic accounting equation. It also indicates the transaction number and the specific
effects of each transaction

1.8. Business transactions and financial statements

Financial Statements for Sole Proprietorship
 After transactions have been recorded and summarized, reports are prepared for users.
The accounting reports that provide this information are called financial statements.
 The principal financial statements of a proprietorship are the income statement, the
statement of owner’s equity, the balance sheet, and the statement of cash flows
1) Income statement a summary of the revenue and expenses for a specific period of
time, such as a month or a year.
2) Statement of owner’s equity a summary of the changes in the owner’s equity that have
occurred during a specific period of time, such as a month or a year.
3) Balance sheet a list of the assets, liabilities, and owner’s equity as of a specific date,
usually at the close of the last day of a month or a year.
4) Statement of cash flow a summary of the cash receipts and cash payments for a
specific period of time, such as a month or a year.
Income Statement
 The income statement reports the revenues and expenses for a period of time,
based on the matching concept.

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  The income statement also reports the excess of the revenue over the expenses
incurred. This excess of the revenue over the expenses is called net income or net
profit.
 If the expenses exceed the revenue, the excess is a net loss.

Statement of Owner’s Equity

 The statement of owner’s equity reports the changes in the owner’s equity for a
period of time.
 It is prepared after the income statement because the net income or net loss for
the period must be reported in this statement.
 Similarly, it is prepared before the balance sheet, since the amount of owner’s
equity at the end of the period must be reported on the balance sheet. Because of
this, the statement of owner’s equity is often viewed as the connecting link
between the income statement and balance sheet.

Balance Sheet

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  The balance sheet reports the amounts of assets, liabilities, and owner’s equity at
the end of the month or years. These amounts are taken from the last line of the
summary of transactions presented earlier.

Statement of Cash Flows

The statement of cash flows consists of three sections,
1) Operating activities
2) Investing activities
3) Financing activities.
Cash Flows from Operating Activities
 This section reports a summary of cash receipts and cash payments from operations.
 The net cash flow from operating activities ($2,900) will normally differ from the
amount of net income for the period ($3,050).
 This difference occurs because revenues and expenses may not be recorded at the
same time that cash is received from customers or paid to creditors.
Cash Flows from Investing Activities
 This section reports the cash transactions for the acquisition and sale of relatively
permanent assets.
Cash Flows from Financing Activities
 This section reports the cash transactions related to cash investments by the owner,
borrowings, and cash withdrawals by the owner.

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The impact of international accounting standards

 Following are the key similarities and differences between GAAP and IFRS as related to
accounting fundamentals.
Similarities
 The basic techniques for recording business transactions are the same for IFRS and
GAAP
 Both GAAP and IFRS accounting standards emphasize transparency in financial
reporting. Both sets of standards are primarily driven by meeting the needs of investors
and creditors.
 The three most common forms of business organizations, proprietorships, partnerships,
and corporations, are also found in countries that use international accounting standards
Differences
 International standards are referred to as International Financial Reporting Standards
(IFRS), developed by the International Accounting Standards Board. Accounting
standards in the United States are referred to as generally accepted accounting principles
(GAAP) and are developed by the Financial Accounting Standards Board
 IFRS tends to be simpler in its accounting and disclosure requirements; some people say
it is more ―principles-based.‖ GAAP is more detailed; some people say it is more ―rules-
based.‖

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 The internal control standards applicable to Sarbanes-Oxley (SOX) apply only to large
public companies listed on U.S. exchanges. There is continuing debate as to whether non-
U.S. companies should have to comply with this extra layer of regulation
Self-exercise on chapter one
1. Which of the following is not a step in the accounting process?
a) Identification b) Recording c) Verification d) Communication
2) Which of the following statements about users of accounting information is incorrect?
a) Management is an internal user.
b) Taxing authorities are external users.
c) Present creditors are external users.
d) Regulatory authorities are internal users.
3) The cost principle states that:
a) Assets should be initially recorded at cost and adjusted when the market value changes.
b) Activities of an entity are to be kept separate and distinct from its owner.
c) Assets should be recorded at their cost.
d) Only transaction data capable of being expressed in terms of money is included in the
accounting records.
4) Which of the following statements about basic assumptions is correct?
a) Basic assumptions are the same as accounting principles.
b) The economic entity assumption states that there should be a particular unit of
accountability.
c) The monetary unit assumption enables accounting to measure employee morale.
d) Partnerships are not economic entities.
5) The three types of business entities are:
a) Proprietorships, small businesses and partnerships.
b) Proprietorships, partnerships and corporations.
c) Proprietorships, partnerships and large businesses.
d) Financial, manufacturing and service companies
6) Net income will result during a time period when:
a) Assets exceed liabilities.
b) Assets exceed revenues.
c) Expenses exceed revenues.
d) Revenues exceed expenses.

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7) Performing services on account will have the following effects on the components of the
basic accounting equation:
a) Increase assets and decrease owner’s equity.
b) Increase assets and increase owner’s equity.
c) Increase assets and increase liabilities.
d) Increase liabilities and increase owner’s equity.
8) As of December 31, 2010, Stone land Company has assets of $3,500 and owner’s equity
of $2,000. What are the liabilities for Stone land Company as of December 31, 2010?
a) $1,500. b) $1,000. c) $2,500. d) $2,000.
9) Which of the following events is not recorded in the accounting records?
a) Equipment is purchased on account.
b) An employee is terminated.
c) A cash investment is made into the business.
d) The owner withdraws cash for personal use.
10) During 2010, Gibson Company’s assets decreased $50,000 and its liabilities decreased
$90,000. Its owner’s equity therefore:
a) Increased $40,000.
b) Decreased $140,000.
c) Decreased $40,000.
d) Increased $140,000

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 CHAPTER TWO
2. ACCOUNTING CYCLE FOR SERVICE-GIVING BUSINESS
Accounts are used to record and summarize the effects of transactions

 An account is a record of increases and decreases in specific asset, liability, and owner’s
equity items.
 The record used for recording individual transactions is an account. A group of accounts
is called a ledger. The system of accounts that make up a ledger is called a chart of
accounts.
 The accounts are numbered and listed in the order in which they appear in the balance
sheet and the income statement.

2.1. The characteristics of an account

The simplest form of an account a T account has three parts:

 A title, which is the name of the item recorded in the account.

 A left side, called the debit side.
 A right side, called the credit side.
Amounts entered on the left side of an account, regardless of the account title, are called
debits to the account.

 Amounts entered on the right side of an account are called credits.

 Periodically, the debits in an account are added, the credits in the account are added,
and the balance of the account is determined.

2.2. The rules of debit and credit

 General rules of debit and credit have been established for recording increases or
decreases in asset, liability, owner’s equity, revenue, expenses and drawing accounts.
 Each transaction is recorded so that the sum of the debits is always equal to the sum of
the credits.
 Transactions are initially entered in a record called a journal.
 The sum of the increases recorded in an account is usually equal to or greater than the
sum of the decreases recorded in the account.
 For this reason, the normal balance of an account is indicated by the side of the
account (debit or credit) that receives the increases.

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 2.3. Normal account balances
Increase Decrease Normal Balance

Financial position Accounts

Assets Dr Cr Dr

Liability Cr Dr Cr

Owner’s Equity

Capital/Capital Stock Cr Dr Cr

Retained Earnings Cr Dr Cr

Drawing/Dividends Dr Cr Dr

Performance Accounts

Income Cr Dr Cr
Expense Dr Cr Dr

2.4. Analyzing and recording transactions

The basic steps in the recording process are

 Analyze each transaction for its effects on the accounts,

 Enter the transaction information in a journal, and
 Transfer the journal information to the appropriate accounts in the ledger.
The initial accounting record of a transaction is entered in a journal before the data are
entered in the accounts.

A journal

(a) Discloses in one place the complete effects of a transaction.

(b) Provides a chronological record of transactions.
(c) Prevents or locates errors because the debit and credit amounts for each entry can be
easily compared.
How a ledger and posting help in the recording process

 The ledger is the entire group of accounts maintained by a company. The ledger provides
the balance in each of the accounts as well as keeps track of changes in these balances.
 Posting is the transfer of journal entries to the ledger accounts.

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 This phase of the recording process accumulates the effects of journalized transactions in
the individual accounts.
The Recording Process Illustrated
Illustrations I
Show the basic steps in the recording process, using the October transactions of Pioneer
Advertising. Pioneer’s accounting period is a month.
In these illustrations, a basic analysis, an equation analysis, and a debit-credit analysis
precede the journal entry and posting of each transaction.
Transaction A. Investment of cash by owner
On October 1, C. R. Byrd invests $10,000 cash in an advertising company called Pioneer
Advertising. Journalize the transaction

Transaction B: Purchase of office equipment

On October 1, Pioneer purchases office equipment costing $5,000 by signing a 3-month,
12%, $5,000 note payable. Journalize and analyze the transaction

Transaction C: Receipt of cash for future service

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On October 2, Pioneer receives a $1,200 cash advance from R. Robert, a client, for
advertising services that are expected to be completed by December 31. Journalize and
analyze the transaction.
N.B: The asset Cash increases $1,200; the liability Unearned Service Revenue increases
$1,200 because the service has not been performed yet. That is, when Pioneer receives an
advance payment, it should record unearned revenue (a liability) in order to recognize the
obligation that exists. Note also that although most liabilities have the word ―payable‖ in their
title, unearned revenue is considered a liability because the liability is satisfied by providing a
product or performing a service.

Transaction D: Payment of monthly rent

On October 3, Pioneer pays office rent for October in cash, $900

Transaction E: Payment for insurance

On October 4, Pioneer pays $600 for a one-year insurance policy that will expire next year on
September 30.
N.B. The asset Prepaid Insurance increases $600 because the payment extends to more than
the current month; the asset Cash decreases $600. Payments of expenses that will benefit
more than one accounting period are prepaid expenses or prepayments. When a company
makes a payment, it debits an asset account in order to show the service or benefit that will be
received in the future.

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Transaction F: Purchase of supplies on credit
On October 5, Pioneer purchases an estimated 3-month supply of advertising materials on
account from Aero Supply for $2,500.
N.B. The asset; Supplies increases $2,500; the liability; Accounts Payable increases $2,500.

Transaction G: Hiring of employees

On October 9, Pioneer hires four employees to begin work on October 15. Each employee is
to receive a weekly salary of $500 for a 5-day work week, payable every 2 weeks—first
payment made on October 26.
N.B. A business transaction has not occurred. There is only an agreement between the
employer and the employees to enter into a business transaction beginning on October 15.
Thus, a debit–credit analysis is not needed because there is no accounting entry.
Transaction H: Withdrawal of cash by owner
On October 20, C. R. Byrd withdraws $500 cash for personal use.

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Transaction I: Payment of salaries
On October 26, Pioneer owes employee salaries of $4,000 and pays them in cash (see
October 9 event).

Transaction J: Receipt of cash for services performed

On October 31, Pioneer receives $10,000 in cash from Copa Company for advertising
services performed in October.

Summary Illustration of Journalizing and Posting

General journal entries or Pioneer Advertising for October

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Posting

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 2.5. Preparing Trial Balance
 A trial balance is a list of accounts and their balances at a given time.
 Companies prepare a trial balance at the end of an accounting period.
 They list accounts in the order in which they appear in the ledger. Debit balances appear
in the left column and credit balances in the right column.
 The trial balance proves the mathematical equality of debits and credits
after posting.
 Under the double-entry system, this equality occurs when the sum of the debit account
balances equals the sum of the credit account balances.
 A trial balance may also uncover errors in journalizing and posting.
 In addition, a trial balance is useful in the preparation of financial statements, as we will
explain in the next two chapters.
 The steps for preparing a trial balance are:
1. List the account titles and their balances in the appropriate debit or credit
column.
2. Total the debit and credit columns.
3. Prove the equality of the two columns.
Illustration shows the trial balance prepared from Pioneer Advertising’s ledger. Note that the
total debits equal the total credits.

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Adjusting the Accounts
Fiscal and Calendar Years
 Both small and large companies prepare financial statements periodically in order to
assess their financial condition and results of operations.
 Accounting time periods are generally a month, a quarter, or a year.
 Monthly and quarterly time periods are called interim periods.
 Most large companies must prepare both quarterly and annual financial statements

2.6. Accrual- versus Cash-Basis Accounting

 Under the accrual basis, companies record transactions that change a company’s
financial statements in the periods in which the events occur.
 For example, using the accrual basis to determine net income means companies
recognize revenues when they perform services (rather than when they receive cash).
It also means recognizing expenses when incurred (rather than when paid).
 Under cash-basis accounting, companies record revenue when they receive cash. They
record an expense when they pay out cash.
Recognizing Revenues and Expenses
Revenue Recognition Principle
 When a company agrees to perform a service or sell a product to a customer, it has a
performance obligation.
 When the company meets this performance obligation, it recognizes revenue.
 The revenue recognition principle therefore requires that companies recognize
revenue in the accounting period in which the performance obligation is satisfied.
Expense Recognition Principle

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  Match expenses with revenues in the period when the company makes efforts to
generate those revenues.
The Need for Adjusting Entries
 In order for revenues to be recorded in the period in which services are performed and
for expenses to be recognized in the period in which they are incurred, companies
make adjusting entries.
 Adjusting entries are necessary because the trial balance—may not contain up-to-
date and complete data.
 This is true for several reasons:
1. Some events are not recorded daily because it is not efficient to do so.
 Examples are the use of supplies and the earning of wages by employees.
2. Some costs are not recorded during the accounting period because these costs expire with
the passage of time.
 Examples are charges related to the use of buildings and equipment, rent, and
insurance.
3. Some items may be unrecorded.
 An example is a utility service bill that will not be received until the next accounting
period.
Types of Adjusting Entries
 Adjusting entries are classified as either deferrals or accruals.
 As Illustration shows, each of these classes has two subcategories.

A. Preparing Adjusting entry for Deferrals

 Defer means to postpone or delay.
 Deferrals are expenses or revenues that are recognized at a date later than the point
when cash was originally exchanged.
 The two types of deferrals are:

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 1. Prepaid expenses and
2. Unearned revenues.
a. Prepaid Expenses
 When companies record payments of expenses that will benefit more than one
accounting period, they record an asset called prepaid expenses or prepayments.
 When expenses are prepaid, an asset account is increased (debited) to show the
service or benefit that the company will receive in the future.
 Examples of common prepayments are insurance, supplies, advertising, and rent.
 Prepaid expenses are costs that expire either with the passage of time (e.g., rent
and insurance) or through use (e.g., supplies).
b. Unearned Revenues
 When companies receive cash before services are performed, they record a
liability by increasing (crediting) a liability account called unearned revenues.
 Items like rent, magazine subscriptions, and customer deposits for future service
may result in unearned revenues.
B. Preparing Adjusting entry for Accrual
 The adjusting entry for accruals will increase both a balance sheet and an income
statement account.
Accrued Revenues
 Revenues for services performed but not yet recorded at the statement date are
accrued revenues.
 Accrued revenues may accumulate (accrue) with the passing of time, as in the
case of interest revenue. These are unrecorded because the earning of interest
does not involve daily transactions.
 An adjusting entry for accrued revenues results in an increase (a debit) to an asset
account (A/R) and an increase (a credit) to a revenue account.
Accrued Expenses
 Expenses incurred but not yet paid or recorded at the statement date are called accrued
expenses.

 Interest, taxes, and salaries are common examples of accrued expenses.

 Companies make adjustments for accrued expenses to record the obligations that exist
at the balance sheet date and to recognize the expenses that apply to the current
accounting period.

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  Prior to adjustment, both liabilities and expenses are understated.

 An adjusting entry for accrued expenses results in an increase (a debit) to an expense

account and an increase (a credit) to a liability account.

Illustration for adjusting entry

Transaction a: Adjustment for supplies
Pioneer debits an additional account, Supplies Expense, $1,500 for the cost of supplies used,
and credits Supplies $1,500. An inventory count at the close of business on October 31
reveals that $1,000 of supplies are still on hand. Thus, the cost of supplies used is $1,500
($2,500 - $1,000).

Transaction b: Adjustment for Insurance

On October 4, Pioneer Advertising paid $600 for a one-year fire insurance policy. Coverage
began on October 1. Insurance of $50 ($600 / 12) expires each month.
The asset Prepaid Insurance shows a balance of $550, which represents the unexpired cost for
the remaining 11 months.

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Transaction c: Adjustment for depreciation
 Depreciation is the process of allocating the cost of an asset to expense
over its useful life.
For Pioneer Advertising, assume that depreciation on the equipment is $480 a year, or $40 per
month.

Transaction d: Adjusting entries for unearned revenues

Pioneer Advertising received $1,200 on October 2 from R. Knox for advertising services
expected to be completed by December 31. Pioneer credited the payment to Unearned
Service Revenue. This liability account shows a balance of $1,200 in the October 31 trial
balance. From an evaluation of the services Pioneer performed for Knox during October, the
company determines that it should recognize $400 of revenue in October.

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Transaction e: Adjustment for accrued revenue
In October, Pioneer Advertising performed services worth $200 that were not billed to clients
on or before October 31. Because these services are not billed, they are not recorded.

Transaction f: Adjusting entries for accrued interest expenses

Pioneer Advertising signed a three-month note payable in the amount of $5,000 on October 1.
The note requires Pioneer to pay interest at an annual rate of 12%.

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Transaction g: Adjustment for accrued salaries and wages
Pioneer Advertising paid salaries and wages on October 26 for its employees’ first two weeks
of work. The next payment of salaries will not occur until November 9. As Illustration
shows, three working days remain in October (October 29–31). The employees receive total
salaries and wages of $2,000 for a five-day work week, or $400 per day. Thus, accrued
salaries and wages at October 31 are $1,200 ($400 x 3).

General journal showing adjusting entries

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Courses: Fundamentals of Accounting I
 Preparing the Adjusted Trial Balance

Account Title Unadjusted Trial Balance Adjustment Adjusted Tri

1 Cash 15200 15200
2 Accounts receivable (e) 200 200
3 Supplies 2500 (a) 1,500 1000
4 Prepaid Insurance 600 (b) 50 550
5 Office equipment 5000 5000
6 Accumulated Depreciation (c) 40
7 Notes payable 5000
8 Accounts Payable 2500
9 Salary & wages payable (g) 1,200
10 Interest payable (f) 50
11 Unearned Revenue 1200 (d) 400
12 Owner’s Capital 10000
13 Owner’s drawing 500 500
14 Service Revenue 10000 (d)+(e) 600
15 Salary and wages expense 4000 (g) 1,200 5200
16 Rent expense 900 900
28700 28700
17 Supplies expense (a) 1,500 1500
18 Insurance expenses (b) 50 50
19 Depreciation expenses (c) 40 40
20 Interest expenses (f) 50 50
Total 3,440 3440 30,190
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 1. analyze business transactions, 6. prepare an adjusted trial balance,
2. journalize the transactions, 7. prepare financial statements,
3. post to ledger accounts 8. journalize and post-closing entries,
4. prepare a trial balance, and
5. journalize and post adjusting entries 9. prepare a post-closing trial balance

2.7. Prepare a worksheet

 A worksheet is a multiple-column form used in the adjustment process and in preparing
financial statements.
 As its name suggests, the worksheet is a working tool. It is not a permanent accounting
record. It is neither a journal nor a part of the general ledger.
 The worksheet is merely a device used in preparing adjusting entries and the financial
statements.
 Worksheets make it possible to provide the financial statements to management and other
interested parties at an earlier date.

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 2.8. Preparing Financial Statement from Worksheet
 After a company has completed a worksheet, it has at hand all the data required for
preparation of financial statements.
 The income statement is prepared from the income statement columns.
 The balance sheet and owner’s equity statement are prepared from the balance sheet
columns.

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 2.9. Prepare closing entries
 At the end of the accounting period, the company makes the accounts ready for the
next period. This is called closing the books.
 In closing the books, the company distinguishes between temporary and permanent
accounts.
 Temporary accounts: relate only to a given accounting period.
 They include all income statement accounts and the owner’s drawings
account.
 The company closes all temporary accounts at the end of the period.
In contrast, permanent accounts: relate to one or more future accounting periods.
 They consist of all balance sheet accounts, including the owner’s capital account.
 Permanent accounts are not closed from period to period.
 Instead, the company carries forward the balances of permanent accounts into the next
accounting period.
Temporary Vs Permanent

Preparing Closing Entries

 At the end of the accounting period, the company transfers temporary account balances to
the permanent owner’s equity account, Owner’s Capital, by means of closing entries.
 Closing entries formally recognize in the ledger the transfer of net income (or net loss)
and owner’s drawings to owner’s capital.
 The owner’s equity statement shows the results of these entries.
 Closing entries also produce a zero balance in each temporary account.

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  The temporary accounts are then ready to accumulate data in the next accounting period
separate from the data of prior periods.
 Permanent accounts are not closed.
 Companies generally journalize and post closing entries only at the end of the annual
accounting period.
 In preparing closing entries, companies could close each income statement account
directly to owner’s capital.
 Instead, companies close the revenue and expense accounts to another temporary
account, Income Summary, and they transfer the resulting net income or net loss from
this account to owner’s capital
 Companies generally prepare closing entries directly from the adjusted balances in the
ledger.

They could prepare separate closing entries for each nominal account, but the following four
entries accomplish the desired result more efficiently:
1. Debit each revenue account for its balance, and credit Income Summary for total
revenues.
2. Debit Income Summary for total expenses, and credit each expense account for its
balance.
3. Debit Income Summary and credit Owner’s Capital for the amount of net income.
4. Debit Owner’s Capital for the balance in the Owner’s Drawings account, and credit
Owner’s Drawings for the same amount.

Preparing closing entries

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 2.10. Preparing a Post-Closing Trial Balance
 After Pioneer Advertising has journalized and posted all closing entries, it prepares
another trial balance, called a post-closing trial balance, from the ledger.
 The post-closing trial balance lists permanent accounts and their balances after the
journalizing and posting of closing entries.
 The purpose of the post-closing trial balance is to prove the equality of the permanent
account balances carried forward into the next accounting period.
Since all temporary accounts will have zero balances, the post-closing trial balance will contain
only permanent—balance sheet—accounts.

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The sections of a classified balance sheet

 A classified balance sheet categorizes;

 Assets as current assets; long-term investments; property, plant, and equipment;
and intangibles.
 Liabilities are classified as either current or long-term.
 Owner’s (owners’) equity section, which varies with the form of business
organization.
Prepare reversing entries

 Reversing Entries—An Optional Step

 Some accountants prefer to reverse certain adjusting entries by making a reversing entry
at the beginning of the next accounting period.
 A reversing entry is the exact opposite of the adjusting entry made in the previous period.
 Use of reversing entries is an optional bookkeeping procedure; it is not a required step in
the accounting cycle.
 Correcting Entries—An Avoidable Step
 Unfortunately, errors may occur in the recording process.
 Companies should correct errors, as soon as they discover them, by journalizing and
posting correcting entries. If the accounting records are free of errors, no correcting
entries are needed.
 The following two cases for Mercado Co. illustrate this approach.
CASE 1

On May 10, Mercado Co. journalized and posted$50 cash collection on account from a customer
as a debit to Cash $50 and a credit to Service Revenue $50. The company discovered the error on
May 20, when the customer paid the remaining balance in full.

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Comparison of the incorrect entry with the correct entry reveals that the
debit to Cash $50 is correct. However, the $50 credit to Service Revenue should
have been credited to Accounts Receivable. As a result, both Service Revenue and Accounts
Receivable are overstated in the ledger. Mercado makes the following correcting entry.

CASE 2
On May 18, Mercato purchased on account equipment costing $450. The transaction was
journalized and posted as a debit to Equipment $45 and a credit to Accounts Payable $45. The
error was discovered on June 3, when Mercato received the monthly statement for May from the
creditor.

Comparison of the two entries shows that two accounts are incorrect. Equipment is understated
$405, and Accounts Payable is understated $405. Mercatomakes the correcting entry shown

 International companies use the same set of procedures and records to keep track of
transaction data.

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  Thus, the material in Chapter 2 dealing with the account, general rules of debit and
credit, and steps in the recording process—the journal, ledger, and chart of
accounts—is the same under both GAAP and IFRS.
 Following are the key similarities and differences between GAAP and IFRS as
related to the recording process.
Similarities
 Transaction analysis is the same under IFRS and GAAP.
 Both the IASB and the FASB go beyond the basic definitions provided in the
textbook for the key elements of financial statements that is assets, liabilities, equity,
revenue, and expenses.
 Dollar signs are typically used only in the trial balance and the financial statements.
The same practice is followed under IFRS, using the currency of the country where
the reporting company is headquartered.
 A trial balance under IFRS follows the same format.
Differences
 IFRS relies less on historical cost and more on fair value than do FASB standards.
 Internal controls are a system of checks and balances designed to prevent and detect
fraud and errors. While most public U.S. companies have these systems in place,
many non-U.S. companies have nevercompletely documented the controls nor had
an independent auditor attest to their effectiveness.
Self-exercise on chapter two
1) Which of the following statements about an account is true?
a) In its simplest form, an account consists of two parts.
b) An account is an individual accounting record of increases and decreases in specific
asset, liability and owner’s equity items.
c) There are separate accounts for specific assets and liabilities but only one account for
owner’s equity items.
d) The left side of an account is the credit or decrease side.
a) Debits:
a) Increase both assets and liabilities.
b) Decrease both assets and liabilities.

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 c) Increase assets and decrease liabilities.
d) Decrease assets and increase liabilities
3. A revenue account:
a) Is increased by debits.
b) Is decreased by credits.
c) Has a normal balance of a debit.
d) Is increased by credits.
4) Accounts that normally have debit balances are:
a) Assets, expenses and revenues.
b) Assets, expenses and owner’s capital.
c) Assets, liabilities and owner’s drawings.
d) assets, owner’s drawings and expenses
5) The expanded accounting equation is:
a) Assets + Liabilities =Owner’s Capital + Owner’s Drawing + Revenues + Expenses.
b) Assets =Liabilities + Owner’s Capital + Owner’s Drawing + Revenues – Expenses.
c) Assets = Liabilities - Owner’s Capital - Owner’s Drawing - Revenues – Expenses.
d) Assets =Liabilities + Owner’s Capital - Owner’s Drawing + Revenues – Expenses.
6) Posting:
a) Normally occurs before journalizing.
b) Transfers ledger transaction data to the journal.
c) It is an optional step in the recording process.
d) Transfers journal entries to ledger accounts.
7) Before posting a payment of $5,000, the Accounts Payable of Senator Company had a
normal balance of $16,000.The balance after posting this transaction was:
a) $21,000. b) $5,000. c) $11,000. d) Cannot be determined.
8) A trial balance:
a) It is a list of accounts with their balances at a given time.
b) Proves the mathematical accuracy of journalized transactions.
c) Will not balance if a correct journal entry is posted twice.
d) Proves that all transactions have been recorded.

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 9) The trial balance of Clooney Company had accounts with the following normal balances:
Cash $5,000, Revenue $85,000, Salaries Payable $4,000, Salaries Expense $40,000, Rent
Expense $10,000, Clooney, Capital $42,000; Clooney, Drawing $15,000; Equipment
$61,000. In preparing a trial balance, the total in the debit column is:
a) $131,000. b) $91,000. c) $216,000. d) $116,000
10) The time period assumption states that:
a) Revenue should be recognized in the accounting period in which it is earned.
b) Expenses should be matched with revenues.
c) The economic life of a business can be divided into artificial time periods.
d) The fiscal year should correspond with the calendar year.

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 CHAPTER THREE
3. ACCOUNTING CYCLE FOR MERCHANDISING BUSINESS
3.1. Characteristics of a merchandising business
 The primary differences between a service business and a merchandising business relate to
revenue activities.
 Merchandising businesses purchase merchandise for selling to customers. On a
merchandising business’s income statement, revenue from selling merchandise is reported as
sales.
 The cost of the merchandise sold is subtracted from sales to arrive at gross profit. The
operating expenses are subtracted from gross profit to arrive at net income.
 Merchandise inventory, which is merchandise not sold, is reported as a current asset on the
balance sheet.
Nature of Merchandising Business
 A merchandising business buys goods in finished form for resale to customers.
 A merchandising business sells tangible goods to its customers.
 When we say goods it can be anything that has physical characteristics that you can
see and touch (i.e., tangible).
 Merchandising company does not produce the goods that it sells. Instead, it buys
these goods from manufacturers, which produce the goods using raw materials.
 The revenue activities of a merchandising business involve the buying and selling
of merchandise.
 A merchandising business must first purchase merchandise to sell to its customers.
 When this merchandise is sold, the revenue is reported as sales, and its cost is
recognized as an expense called the cost of merchandise sold.
 The cost of merchandise sold is subtracted from sales to arrive at gross profit. This
amount is called gross profit because it is the profit before deducting operating
expenses.
 Merchandise on hand (not sold) at the end of an accounting period is called
merchandise inventory.
 Merchandise inventory is reported as a current asset on the balance sheet.

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  The primary source of revenues for merchandising companies is the sale of
merchandise, often referred to simply as sales revenue or sales.
 A merchandising company has two categories of expenses:
 cost of goods sold and
 Operating expenses.
 Cost of goods sold is the total cost of merchandise sold during the period.
This expense is directly related to the revenue recognized from the sale of goods

THE OPERATING CYCLE

 Purchasing activity
 The operations of a manufacturing business involve
the purchase of raw materials.
 Production activity
 The conversion of the raw materials into a product
through the use of labor and machinery.
 Sales activity
 The sale and distribution of the products to
customers.
 Collection activity
 The receipt of cash from customers.
This overall process is referred to as the operating cycle.
The below diagram shows the flow of goods from a manufacturer to the final consumer:

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 Merchandising companies

Manufacturers wholesaler Sell Retailer Final consumer

s
 Merchandising companies that purchase and sell directly to
consumers are called retailers.
 Merchandising companies that sell to retailers are known as wholesalers.

3.2. Accounting for Sales Transactions

Recording Sales
 When a merchandising company transfers goods to the buyer, in exchange for cash
or a promise to pay at a later date, revenue is produced to the company.
 This revenue is recorded in a Sales account.
 The sales revenue, which is reported on the Income Statement, is Net Sales.
 Net Sales = Gross Sales – Sales Discounts - Sales Returns and Allowances
I. Recording Gross Sales
 The gross sales amount is obtained from sales invoices.
 An invoice is a document, prepared by the seller of merchandise to notify to the
buyer the details of the sale.
 These details can include number of items sold, unit price of items, total price, terms
of sale and manner of shipment.
II. Recording Cash Sales
 Sales of merchandise for cash is 1,872 Br should be recorded as follows:
J.E; Cash…………… 1,872
Sales………………….1,872
III. Recording Credit Sales:
 If a business sells a given amount of merchandise on account.
 Sales of merchandise on account $500.
J.E; A/Receivable………….….500
Sales………….……………..………500

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Deductions from Sales
a) Trade discounts
 Trade discounts are not recorded in the seller’s accounting records; they are only
used to calculate the gross selling price
 Example: IKA sold 500 T.V. sets, each with a list price of Birr 80, on January 17,
2001 for cash. It gave the customer a 30% trade discount, as the customer was a
very loyal one. Record the sale.
Answer:
List price of goods (80 X 500)……………Birr 40,000
Less: Trade discount (30 % of 40,000)……… (12,000)
Invoice price …………………………….28,000
Journal entry:
Cash……………………..28,000
Sale………………………28,000
(Recording Deductions from Gross Sales)
b) Sales Discounts
 Sales Discounts are deductions from invoice price to customers who pay early when
goods are sold on credit.
 The seller refers to the discount taken by the buyer for early payment the invoice as
sales discounts
 Much discount is given usually depends on the credit terms. These terms
(agreements) are usually stated on the invoice. The most frequently used terms are
stated below:
1. ―n/30‖ or ―Net 30‖: means there is no discount even if the customer pays before the
payment date.
2. 2/10, n/30: means the due date of the payment is after 30 days of the sale. But if the
customer pays within 10 days she will get a 2% discount.
3. 2/EOM, n/60: means the normal due date is within 60 days of the sale but the
customer will get a 2% discount if she pays before the end of month of sale.

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Example:
On January 21, 2001 IKA Company sold merchandise for birr 20,000 on account. The credit
terms are 2/10, n/30. The customer paid on January 31, (10 days after invoice date).
A. How much would IKA Company collect from this sale?
B. Record the necessary journal entries on January 21 and January 31.
Solution:
A. Since the customer paid within the discount period, i.e., within 10 days, she will get
a 2% discount. Therefore,
Invoice price……………………20,000
Less: Sales Discount (2% X 20,000)………(400)
Cash collected ……………………….. 19,600
B. Journal Entries:

January 21 A/R………………………..20,000
Sales……..…………………..20,000
January 31, Cash……………………….19600
Sales Discounts……….........400
A/R………..……………….20,000
c) Sales Returns and Allowance
 Merchandise sold may be returned by the buyer or, because of defects or other
reasons is known as sales return
 The buyer may be allowed a reduction from the original price at which the goods
were sold is sales allowance.
 Sales returns and allowances is a reduction in sales revenue and a reduction in cash
or accounts receivable.
 Sales returns and allowances are a contra (or offsetting) accounts to sales.
Example:
IKA Company sold merchandise worth Birr 15,000 on February 3, 2001 on account terms 2/10,
n/30. On February 5, the buyer returned a portion of the goods worth Birr 5,000 as they were
found to be of the wrong model. The buyer then paid on February 13, 2001.
Record the necessary journal entries on February 3, 5 and 13.

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Solution:
February 3; A/R…………….15, 000
Sales …………………….15, 000
February 5 Sales Returns and Allowances ………5,000
A/R………………………………….5, 000
February 13 Cash…………………………..9800
Sales Discount ……………….. 200
A/R…………………………10,000
3.3. Accounting for Recording Purchases
 Under the periodic inventory system a merchandising company uses the purchases
account to record the cost of goods bought for resale to customers
 Merchandising enterprise can accumulate in the purchases account the cost of all
merchandise purchased for resale during the accounting period.
 Example:
 IKA Company bought goods worth Birr 43,000 from Saba Co., which is based in
Addis Ababa, on account on January 4, 2001, terms 2/10, n/30. Record the
transaction.
Solution:
J.E January 4 – Purchases ……………….43, 000
Accounts payable…………………..43,000
Deductions from Purchases
i. Purchase Discounts
 A merchandising company can buy goods under credit terms that permit it to get a
discount if it pays within a specified period of time.
 The deduction from the original purchase price is recorded in a separate contra
Purchase account called Purchase Discounts.
Example:
IKA Company bought goods worth Birr 50,000 from Gibir Company on account on January 14,
2001, terms 1/10, n/60. Ika Company paid on January 24, 2001. Record the transactions on both
dates.

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Solution:
Jan. 14. Purchases…………..50,000
A/P………………………50,000
Jan. 24. A/P……………………50,000
Purchase Discounts …….......500
Cash……….……………….. 49,500
ii. Purchases Returns and Allowances
 Merchandise is returned by the buyer (purchases return) and price adjustments are
requested by the buyer (purchase allowances).
Example:
In the previous example for IKA Company, a portion of the goods worth birr 5,000 bought on
January 14 from Gibir Company were of the wrong size. Gibir Company acknowledged this and
gave IKa Company a 5% price allowance on January 17.
What should IKA Company record on January 17?

Solution:

January 17 A/P……………………250

Purchase Returns and Allowance…………250

When both purchase discounts and purchase returns and allowances are deducted from purchases
what is obtained is called Net purchase. That is
Gross Purchase…………………………..…XX
Less: Purchase discounts……….…..…... (XX)
Purchase returns and allowances… (XX)
Net Purchases…………..……………….XX
Transportation costs
Once merchandise has been bought it has to be moved from the seller’s place to the buyer’s
place.
A third party comes in to the scene here: the transportation company who moves the goods
between the two places.

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The sales agreement should indicate who—the seller or the buyer—is to pay for transporting the
goods to the buyer’s place of business.
When a common carrier such as a railroad, trucking company, or airline transports the goods, the
carrier prepares a freight bill in accord with the sales agreement.
The agreements are usually stated in the either of these two terms:
i. FOB Destination – means ―free on board at destination ―.
 That is, since the destination of the goods is the buyer’s place, it is
free at destination means transportation cost is paid when the goods
are loaded.
 It simply means the seller pays transportation cost.
 FOB Destination means goods are shipped to their destination (to
the buyer) without transportation charge to the buyer.
ii. FOB shipping Point –means ― free on board at shipping point‖.
 That is, goods are loaded (on a truck or train) or shipped free of
charge.
 It is, therefore, the buyer, which pays to the transportation company
when the goods reach the buyer (their destination)
 when the terms are FOB Shipping Point the buyer pays
transportation costs.
Transfer of Title
 Shipping terms determine not only who pays for transportation.
 They also determine at what point ownership title of the goods sold transfers to the
buyer.
When terms are FOB Destination
 The seller covers transportation costs.
 The seller takes the responsibility of safely moving and delivering the goods to the buyer.
 The buyer is not responsible for any damage that can happen to these goods in transit.
Therefore, the goods become the buyer’s property only when they are delivered to him
/her.
 Conclusion: Ownership title of the goods transfers to the buyer at destination when the
terms are FOB destination.

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When the terms are FOB shipping point
 The buyer pays freight costs.
 The buyer takes the responsibility of safely moving these goods to his /her own place.
 The merchandise, therefore, becomes his/her property as soon as they are loaded on a truck
or a train.
 Conclusion: Ownership title of goods transfers to the buyer at shipping point when terms are
FOB shipping point.
 When merchandise is purchased on terms of FOB shipping point, transportation cost
paid by the buyer the J.E should be debited to Transportation In or Freight In account
and credited to cash.
 The balance of transportation in account should be added to net purchases to
determine the total cost of merchandise purchased.
Example
IKA Company bought goods worth Birr 85,000 on account, terms 2/10,n/60 FOB shipping point
on March 2, 2001.Transportoin cost of Birr 1,500 was paid on March 2. Ika Company paid on
March 31, 2001. Record the necessary journal entries
Solution:
Here, since the terms are FOB Shipping Point, the buyer (Ika) pays transportation.
J.E: March 2 Purchase…………………..85,000
A/P………………………..85,000
Transportation In……….....1500
Cash………………………1500
March 31 A/P…………………………85,000
Cash………………………..85,000
When the agreement states that the seller is to bear the delivery costs (FOB destination), the
amounts paid by the seller for delivery the J.E are debited to transportation out (Delivery
expense) it is expense account and presented on the income statement as selling expense).
Example:
IKA Company sold goods worth Birr 135,000 terms 1/15, n/EOM on February 1, 2001. FOB
Destination. It also paid transportation costs of Birr 800 on Feb. 1. The customer paid IKA on
February 16, 2001. Record the relevant Journal entries.

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Answers:
Feb 1 A/R…………………..135,000
Sales…………………………..135,000
Delivery Expense………800
Cash…………………………800
Feb 16 Sales discount …………...…….1,350
Cash………………………….133,650
A/R…………………..…………135,000
 Sometimes, the seller prepays the freight as a convenience to the buyer and later
collects it on the due date of the invoice even though the terms are FOB shipping
Point.
Example
Raey Co. sold goods worth Birr 40,000 on April 1, 2001 to IKA company terms 2/10, n/30 FOB
Shipping Point. It also paid Birr 2,500 to Ergib Movers for transporting the goods and added the
amount to the invoice. What would each of these companies record the transaction, assuming
IKA paid on April 31, 2001
Solution
Raey Co. (seller) IKa Co (Buyer)
April 1- A/R……….40,000 April 1- Purchases ……40,000
Sales……..…40,000 A/P…………….40,000
A/R……….2500 Transport-in …2500
Cash…………2500 A/P………………2500
April 31- Cash……42,500 April 31- A/P…………42,500
A/R………42,500 Cash…………42,500

If the buyer pays the transportation costs for the seller (when the terms are FOB Destination) the
buyer simply deducts the freight paid from the amount to be paid to the seller.

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 Example:
X Company bought merchandise worth Birr 14,000 terms, FOB destination from Y Co.
on account. It paid Birr 350 transportation costs. What would be recorded on the books
of the buyer and seller on the date of the sale?
Solution
Buyer (X Co) Seller Y Co
Purchase……….14,000 A/R……………….14,000
A/P………………14,000 Sales………………….14, 000
A/P……………350 Delivery exp……….350
Cash……………..350 A/R………………350
Sales Taxes
The liability for the sales tax is incurred at the time when sale is made, regardless of the terms of
the sale.
Example
X Co. Sale merchandise worth Birr 100 on account, subject to a tax rate of 4%.
AR…………………………………104
Sales………………………………………100
Sales Tax Payable………….……………..4
Periodically, the appropriate amount of the sales tax is paid to the taxing unit, and sales tax
payment is debited.
3.4. Periodic and Perpetual Inventory System
 Inventory refers to products a company owns and expects to sell in its normal operations
of business.
 Merchandise inventory refers to products that a company owns and intends to sell.
 There are two systems of accounting for merchandise: periodic and perpetual system.
A. The Periodic Inventory System
 The inventory account is updated only periodically i.e., only at the end of a period.
B. The Perpetual Inventory Systems
 Inventory is continuously records the amount of inventory on hand


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 3.5. Chart of accounts for a merchandising business
 The chart of accounts for a merchandising business is more complex than that for a service
business and normally includes accounts such as Sales, Sales Discounts, Sales Returns and
Allowances, Cost of Merchandise Sold, and Merchandise Inventory.

3.6. The financial statements of a merchandising business

 The multiple-step income statement of a merchandiser reports sales, sales returns and
allowances, sales discounts, and net sales.
 The cost of the merchandise sold is subtracted from net sales to determine the gross profit.
The cost of merchandise sold is determined by using either the periodic or perpetual method.
 Operating income is determined by subtracting operating expenses from gross profit.
Operating expenses are normally classified as selling or administrative expenses.
 Net income is determined by adding or subtracting the net of other income and expense. The
income statement may also be reported in a single-step form.
 The statement of owner’s equity is similar to that for a service business. The balance sheet
reports merchandise inventory at the end of the period as a current asset.

3.7. Adjusting and Closing entries for a merchandising business

 For a merchandising company, like a service company, all accounts that affect the
determination of net income are closed to Income Summary.
 Data for the preparation of closing entries may be obtained from the income statement
columns of the worksheet.
 In journalizing, all debit column amounts are credited, and all credit columns amounts are
debited.
 To close the merchandise inventory in a periodic inventory system:
1. The beginning inventory balance is debited to Income Summary and credited to
Inventory.
2. The ending inventory balance is debited to Inventory and credited to Income Summary.
Self-exercise questions on chapter three
1) Gross profit will result if:
a) Operating expenses are less than net income.
b) Sales revenues are greater than operating expenses.
c) Sales revenues are greater than cost of goods sold.

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 d) Operating expenses are greater than cost of goods sold.
2) Under a perpetual inventory system, when goods are purchased for resale by a company:
a) Purchases on account are debited to Merchandise Inventory.
b) Purchases on account are debited to Purchases.
c) Purchase returns are debited to Purchase Returns and Allowances.
d) Freight costs are debited to Freight-out.
3) The sales accounts that normally have a debit balance are:
a) Sales Discounts.
b) Sales Returns and Allowances.
c) Both (a) and (b).
d) Neither (a) nor (b).
4) A credit sale of $750 is made on June 13, terms 2/10, net/30.A return of $50 is granted on
June 16.The amount received as payment in full on June 23 is:
a) $700. b) $686. c) $685. d). $650.
5) Which of the following accounts will normally appear in the ledger of a merchandising
company that uses a perpetual inventory system?
a) Purchases. B) Freight-in c) Cost of Goods Sold d) Purchase Discounts
6) To record the sale of goods for cash in a perpetual inventory system:
a) Only one journal entry is necessary to record cost of goods sold and reduction of inventory.
b) Only one journal entry is necessary to record the receipt of cash and the sales revenue.
c) Two journal entries are necessary: one to record the receipt of cash and sales revenue, and
one to record the cost of goods sold and reduction of inventory.
d) Two journal entries are necessary: one to record the receipt of cash and reduction of
inventory and one to record the cost of goods sold and sales revenue.
7) If beginning inventory is $60,000, cost of goods purchased is $380,000, and ending inventory
is $50,000, cost of goods sold is:
a) $390,000. b) $370,000. c). $330,000. d) $420,000.
8) The multiple-step income statement for a merchandising company shows each of the
following features except:
a) Gross profit. b) Cost of goods sold. c) Sales revenue section. d) Investing activities
section

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9) In a worksheet, Merchandise Inventory is shown in the following columns:
a) Adjusted trial balance debit and balance sheet debit.
b) Income statement debit and balance sheet debit.
c) Income statement credit and balance sheet debit.
d) Income statement credit and adjusted trial balance debit.

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 CHAPTER FOUR
ACCOUNTINGSYSTEMS
4. Manual and computerized accounting system
4.1. Manual Accounting Systems
 In manual accounting systems, someone performs each of the steps in the accounting cycle
by hand. For example, someone manually enters each accounting transaction in the journal
and manually posts each to the ledger. Other manual computations must be made to obtain
ledger account balances and to prepare a trial balance and financial statements.
 The accounting information system collects and processes transaction data and
communicates financial information to decision-makers
 An accounting system may be either manual or computerized. Most businesses use some
sort of computerized accounting system, whether it is an off-the-shelf system for small
businesses, like QuickBooks
 Efficient and effective accounting information systems are based on certain basic
principles. These principles, are
(1) Cost effectiveness
(2) Usefulness
(3) Flexibility

4.2. Computerized Accounting Systems

 Many small businesses use a computerized general ledger accounting system. General ledger
accounting systems are software programs that integrate the various accounting functions
related to sales, purchases, receivables, payables, cash receipts and disbursements, and
payroll.

4.3. Enterprise Resource Planning Systems

 Enterprise resource planning (ERP) systems are typically used by manufacturing companies
with more than 500 employees and $500 million in sales. The best-known of these systems
are SAP AG’s SAP ERP (the most widely used) and Oracle’s ERP.
 ERP systems go far beyond the functions of an entry-level general ledger package.
 They integrate all aspects of the organization, including accounting, sales, human resource
management, and manufacturing. Because of the complexity of an ERP system,

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 implementation can take three years and cost five times as much as the purchase price of the
system.

4.4. The nature and purpose of a subsidiary ledger

 Instead, companies use subsidiary ledgers to keep track of individual balances. A subsidiary
ledger is a group of accounts with a common characteristic (for example, all accounts
receivable). It is an addition to and an expansion of the general ledger.
 The subsidiary ledger frees the general ledger from the details of individual balances. Two
common subsidiary ledgers are as follows.
1. The accounts receivable (or customers’) subsidiary ledger, which collects transaction data
of individual customers.
2. The accounts payable (or creditors’) subsidiary ledger, which collects transaction data of
individual creditors.
 A general ledger account summarizes the detailed data from a subsidiary ledger. For
example, the detailed data from the accounts receivable subsidiary ledger are summarized in
Accounts Receivable in the general ledger.
 The general ledger account that summarizes subsidiary ledger data is called a control
account.

CHAPTER FIVE
CASH AND RECEIVABLES
5.1. The nature of cash
Cash includes coins, currency (paper money), checks, money orders, and money on deposit that
is available for unrestricted withdrawal from banks and other financial institutions. Because of
the ease with which money can be transferred, businesses should design and use controls that
safeguard cash and authorize cash transactions.
The following are some of the characteristics of cash:
 Cash is used as medium of exchange
 Cash is the most liquid asset
 Cash is mostly affected by business transactions
 Cash is used to measure the value of other assets
 Cash is mostly exposed to embezzlements

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 The need to safeguard cash is crucial in most businesses because cash is mostly exposed to
embezzlement.

5.2. Internal control over cash

 An internal control system is a set of policies and procedures designed to protect assets,
provide accurate accounting records and evaluate performances.
 Internal control for cash should include the following procedures:
 The individuals who receive cash should not also disburse (pay) cash
 The individuals who handle cash should not access accounting records
 Cash receipts are immediately recorded and deposited and are not used directly to make
payments.
 Disbursements are made by serially numbered checks, only upon proper authorization by
someone other than the person writing the check
 Bank accounts are reconciled monthly.
 Internal control principles to cash receipts and disbursement are;
 Establishment of Responsibility  Physical Controls
 Segregation of Duties  Independent Internal Verification
 Documentation Procedures  Human Resource Controls

Control of Cash through Bank Accounts

 Bank accounts are one of the most important means of controlling cash that provide several
advantages such as:
 Cash is physically protected by the bank,
 A separate record of cash is maintained by the bank,
 Customers may remit payments directly to the bank.
 If a company uses a bank account, monthly statements are received from the bank showing
beginning and ending balances.
 Transactions occurring during the month including checks paid, deposits received, and
service charges. These monthly statements (reports) received from the bank are called bank
statements
The two controlling devices for controlling cash are:

1. Petty cash fund

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 2. The bank account
A. The bank account
 It is one of the major devices for maintaining control over cash.
 To get the most benefit from the bank account, all cash received must be deposited in the
bank and all payments must be made by checks drawn on the bank or from special cash
funds.
 Forms used in a bank account
A) Signature card: An identifying number is assigned to the account which is used for
verification. The depositor will sign on. It is a written check.
B) Deposit ticket (slip): Used by the business as a receipt to record the cash deposit.
C) Check: is a written document signed by the depositor, ordering the bank to pay a sum of
money to an individual or business entity.
 Three parties involved in a check:
1) Maker (drawer): One who signs on the check is called drawer.
2) Payer (drawee): the bank on which the check is drawn is known as drawee.
3) Payee: the party to whom payment is made. It is the party to whose order the check is
drawn.

5.3. Bank Reconciliation

 Bank reconciliation is the schedule that accounts for any of the difference between the bank
statement balance and the company (depositor) book balance
 The bank and the depositor maintain independent records of the depositor’s checking
account.
 People tend to assume that the respective balances will always agree.
 In fact, the two balances are seldom (rarely) the same at any given time, and both balances
differ from the ―correct‖ or ―true‖ balance.
 Therefore, it is necessary to make the balance per books and the balance per bank agree with
the correct or true amount this process called reconciling the bank account (Bank
Reconciliation).
 It might seem that the two balances should be equal but they are not likely to be
equal on any specific date because of the following:
1) Items recorded by the company but not yet recorded by the bank.

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a) Outstanding checks:
 Checks issued and recorded by the company, but not yet presented or paid by the bank
b) Deposits in transit:
 It Is the deposit that the company has recorded but not recorded by the bank.
2) Items recorded by the bank but not yet recorded by the company
a) Service charges:
 Banks often charge a fee for handling checking accounts. The amount of this charge is
deducted by the bank form bank balance and debit memo is issued for the depositor.
B) Bank collection:
 Notes receivable and interest accrued on notes receivable may be collected by the bank.
The bank will notify (remind) the amount of collection whenever the bank is sending the
bank statement to the depositor.
3) NSF- checks:
 NSF stands for ―Not Sufficient Funds.‖
 Not sufficient fund (NSF) received from customer.
The bank return checks to the payee because
 If the maker account has closed.
 If the signature is not authorized.
 If the check form is improper.
 If the check has been altered.
4) Interest revenue on checking account.
5) The cost of printing check.
6) Error by either the company or the bank or both.
Bank credit memorandums:

 They are additions by bank not recorded by depositor.

 They are traced to the cash receipt journal that can be added to the balance according to
depositor’s record.
Bank debit memorandums:

 They are the deductions by bank not recorded by the depositor.

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  They are traced to the cash payment journals that have to be deducted from the balance
according to depositor’s record.
Format for bank reconciliation

Xx - Company
Bank Reconciliation
Sep. 30, xx
Bank balance according to bank record -----------------------------------------------xxx
Add: Deposit in transit -------------------------------------xx
Bank error that under state bank balance ----------xx xxx
Deduct: Outstanding Checks -------------------------------xx
Bank error that overstate bank balance ---------xx (xxx)
Adjusted cash balance --------------------------------------------------------------------- xxx
Bank balance according to depositor records-----------------------------------------xxx
Add: Additions by bank not recorded by depositor
(Credit memorandum):
Notes & interest collection -------------------------------------- xx
Depositor error that understate cash ledger balance-------xx xxx
Sub - total----------------------------------------------------------------------------------xxx
Deduct: Deduction by bank not recorded by the depositor
(Debit memorandum):
NSF checks, service charges) -------------------------------------xx
Depositor error that overstate cash ledger balance----------xx ( xxx)
Adjusted cash balance----------------------------------------------------------------------xxx
Example
The bank statement for Laird Company (Illustration 8-10) shows a balance per bank of
$15,907.45 on April 30, 2017. On this date the balance of cash per books is $11,589.45. Using
the four reconciliation steps, Laird determines the following reconciling items.
a. Deposits in transit: April 30 deposit (received by bank on May 1) is $2,201.40

b. Outstanding checks: for check no. 453, $3,000.00; no. 457, $1,401.30; no. 460, $1,502.70.

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 c. Laird wrote check no. 443 for $1,226.00 and the bank correctly paid that amount. However,
Laird recorded the check as $1,262.00.

d. NSF check from J. R. Baron for $425.60.

e. Charge for printing company checks $30.00.

f. Collection of note receivable for $1,000 plus interest earned $50, less bank collection fee
$15.00.

Required
I. Prepare bank reconciliation

II. Prepare the necessary journal entry

B. Petty cash fund

 It is the small fund used to make payment for small expenditures. There are three steps
involved in the operation of the petty cash.
1) Establishing the petty cash
2) Making payment from the petty cash
3) Replenishing (reimbursing) the petty cash.

5.4. Establishing the Petty Cash Fund

 To establish the fund, a company issues a check payable to the petty cash custodian for the
stipulated amount.
 Two essential steps in establishing a petty cash fund are;
1) Appointing a petty cash custodian who will be responsible for the fund, and
2) Determining the size of the fund.
 Checks payable to the petty cash fund custodian will be issued.
Petty cash----------------------------xx
Cash in bank----------------------------xx
2) Making Payment from the Petty Cash
 Petty cash receipt: The employee who request for payment and the petty cash custodian
will sign on it.

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  The petty cash custodian will make payment for the specified employee who request
disbursement.
3) Replenishing the Petty Cash Fund
 When the money in the petty cash fund reaches a minimum level, the company replenishes
the fund.

 The petty cash custodian initiates a request for reimbursement. The individual prepares a
schedule (or summary) of the payments that have been made and sends the schedule,
supported by petty cash receipts and other documentation, to the treasurer’s office.

 The treasurer’s office examines the receipts and supporting documents to verify that proper
payments from the fund were made. The treasurer then approves the request and issues a
check to restore the fund to its established amount

Example
If Laird Company decides to establish a $100 fund on March 1, on March 15 Laird’s petty cash
custodian requests a check for $87. The fund contains $13 in cash and petty cash receipts for
postage $44, freight-out $38, and miscellaneous expenses $5. Assume that March 15 Laird’s
petty cash custodian has only $12 in cash in the fund plus the receipts.
Required

g. Prepare the journal entry during establishment of petty cash fund.

h. Prepare the journal entry during replenishment of petty cash fund

5.4. RECEIVABLES
 Receivables are Varity of claims from other parties that generally provide a future inflow of
cash.
 Receivables refer to amount due from individuals and other companies and they are claims
expected to be collected in cash.

5.5. Classification of Receivable

Receivables are classified as;
1) Account Receivable
2) Notes Receivable
3) Others

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1) Account Receivables
o Represent amount owed by customers on account.
o They result from sales of goods and services on credit.
o Are expected to be collected within 30 to 60 days
2) Note Receivable
 Represent claims that are evidenced by formal instrument of credit.
 They are expected to be collected within 60 to 90 days or longer.
 N/R and A/R that result from sales transaction are often called Trade Receivables.
3) Other Receivables
 Include those non-trade Receivables such as interest receivables, loan to company
offices, advance to employees and income tax refundable etc
RECOGNITION OF ACCOUNT RECEIVABLES
 It is straight forward to recognized account receivables.
 It is explained with the following illustration.
Example

Assume that Betel Company on July 1, 2001 Sales merchandise on account to Robel Company
for $1000 terms 2/10, n/30 on July 5 merchandize worth $100 is returned. On July 11 Payment is
received from Robel Company for the balance due.
Required: - record the above transaction
July1. A/R---------------1,000
Sales---------------------1,000
July 5. Sales return and allowance-----100
A/R------------------------------------------------100
July 11. Cash-------------------882
Sales Discount-------18
A/R------------------------900
Valuing Accounts Receivable

 This issue is important because some receivables will become uncollectible.

 To ensure that receivables are not overstated on the balance sheet, they are stated net cash
realizable value i.e. Net amount expected to be received in cash.

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 Receivables are therefore reduced by estimated uncollectible receivable on the balance sheet.

 Uncollectible receivables refer to the amount that will not collect due to failure of the
customers to make payment.

 The expense is reported as bad debt expense (uncollectible account expense) on the income
statement.

 In accounting credit losses (receivables not collected) from customers are debited to bad debt
expense (uncollectible account expense).Such losses are considered a normal and necessary
risk of doing business on a credit basis.

5.6. Accounting for uncollectible account

 There are two accounting methods for uncollectible;

1. Allowance method

2. Direct write off method

Allowance Method (Reserve Method)

 This method is required for financial reporting purpose when bad debts are significant in
size.

 To present accurate financial statements, accountants in company’s with large credit sales
use the allowance method of measuring bad debts.

 This method also records collection losses based on estimates before the business knows
which specific customers account will be uncollectible.

 Allowance methods has the following essential features:-

 Uncollectible Account receivables are estimated and matched against sales on the same
accounting period in which sales occurs.

 Estimated uncollectible are debited to bad debt expense and credited to allowance for
doubtful account through an adjusting entry at the end of each accounting period.

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 Actual uncollectible are debited to allowance for doubtful account and credited to account
receivables at the time the specific account is written-off.

 To record the adjusting entry for the estimated uncollectible

Uncollectible Account Expense (Bad Debt)----------xxxxx

Allowance for Doubtful Accounts----------------------xxxxxx
(Estimated uncollectible)
Direct written off method
 Recording written off uncollectible Account

 When all appropriate means of collecting a past due amount have been exhausted and
collection appears impossible the account should be written off.

 To prevent premature write-off each write off should be formally approved in writing by
authorized management personnel.

 The entry to record the write-off is as follows.

Allowance for Doubtful Accounts --------------xxxxx

Accounts Receivable ----------------------------xxxxx
(Write-off of account)
5.7. Accounting for notes receivable
 Companies may also grant credit in exchange for a formal credit instrument known as a
promissory note.

 A promissory note is a written promise to pay a specified amount of money on demand or at

a definite time.

 Promissory notes may be used (1) when individuals and companies lend or borrow money,
(2) when the amount of the transaction and the credit period exceed normal limits, or (3) in
settlement of accounts receivable.

 In a promissory note, the party making the promise to pay is called the maker.

 The party to whom payment is to be made is called the payee.

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Determining the Maturity Date
 When the life of a note is expressed in terms of months, you find the date when it matures by
counting the months from the date of issue.

 For example, the maturity date of a 60-day note dated July 17 is September 15, computed as
follows.

Term of a note------------------ 60 day

July (31-17) -----------14
August-----------------31----------45
Maturity date: September----- 15
Discounting Notes Receivable
 When a company is a need of cash it may transfer its note receivable to a bank by
endorsement.
 The discount(interest) charged by bank is computed on the maturity value of the note for the
period of time the bank must hold the note;
 The amount of proceed paid to the endorser is the excess of maturity value after the discount
amount.
 The bank transfers cash (the proceeds) to the company after deducting a discount (interest)
that is computed on the maturity value of the note for the discount period.
 The discount period is the time that the bank must hold the note before it becomes due
Example
Assume that a 90 day 12% note receivable for $1,800 dated April 8 discounted at the pays bank
on May 3 at the rate of 14%.
Required: compute
a. Maturity value e. Interest on the note
b. Discount period f. The proceed
c. Due date g. Prepare Journal entry
d. Discount amount
Solution
1. Maturity value of note due July 7 is $1,854.00
Interest =1800x12%x90/360=54
Maturity Value= Principal + Interest

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 = 1800+54=1854
2. Discounting period is 65 day
April (30-8=22 day) + May 3 day=25 day
90-25=65 day
3. Due Date is July 7
Term of a note------------------------90 day
Issue date (April 8) 30-8----22
May------------------------------30
June-------------------------------31----83
Maturity Date or Due Date---July 7
4. Discount amount=1854X.14X65/360=46.87
5. Interest on the note (90 day at 12%) ---1800x12%x90/360=54
6. Proceed =Maturity value (-) Discount amount= 1854-46.87=1807.13
7. Journal Entry
Cash---------------1807.13
Notes Receivable ----------1800
Interest Revenue-------------7.13

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 Fundamental of accounting one

5.8. Presentation of cash and receivables

Companies should identify in the balance sheet or in the notes to the financial statements each of the
major types of receivables. Short-term receivables appear in the current assets section of the balance sheet,
below short-term investments. Short-term investments appear before receivables because short-term
investments are more liquid (nearer to cash). Companies report both the gross amount of receivables and
the allowance for doubtful accounts. In a multiple-step income statement, companies report bad debts
expense and service charge expense as selling expenses in the operating expenses section. Interest revenue
appears under ―Other revenues and gains‖ in the non operating activities section of the income statement.

Self-exercise questions on chapter five

1. Which of the following is not an element of the fraud triangle?

a) Rationalization b Financial pressure c Segregation of duties d Opportunity.
2. An organization uses internal control to enhance the accuracy and reliability of its accounting records
and to:
a) Safeguard its assets. b) Prevent fraud c) Produce correct financial statements. d) Detect employee
dishonesty.
3. Which of the following was not a result of the Sarbanes Oxley Act?
a) Companies must file financial statements with the Internal Revenue Service.
b) All publicly traded companies must maintain adequate internal controls.
c) The Public Company Accounting Oversight Board was created to establish auditing standards and
regulate auditor activity.
d) Corporate executives and board of directors must ensure that controls are reliable and effective, and
they can be fined or imprisoned for failure to do so.
4. The principles of internal control do not include:
a) Establishment of responsibility.
b) Documentation procedures.
c) Management responsibility.
d) independent internal verification
5. Permitting only designated personnel to handle cash receipts is an application of the principle of:
a) Segregation of duties.
b) Establishment of responsibility.
c) Independent check.
d) Human resource controls.
6. Which of the following control activities is not relevant to when a company uses a computerized
(rather than manual) accounting system?
a) Establishment of responsibility.
b) Segregation of duties.
c) Independent internal verification.
d) All of these control activities are relevant to a computerized system.
7. A company writes a check to replenish a $100 petty cash fund when the fund contains receipts of $94
and $3 in cash. In recording the check, the company should:

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 Fundamental of accounting one

a) Debit Cash Over and Short for $3.

b) Debit Petty Cash for $94.
c) Credit Cash for $94.
d) Credit Petty Cash for $3.
8. In bank reconciliation, deposits in transit are:
a) Deducted from the book balance.
b) Added to the book balance.
c) Added to the bank balance.
d) Deducted from the bank balance.

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 Fundamental of accounting one

Reference
 Kieso, D. E., Weygand, J. J. & Warfield, T. W. (2016). Financial Accounting, IFRS Edition, New York:
John Willey & Sons.
 Commercial Code of Ethiopia.
 Jerry J. Weygand, Paul D. Kimmel, and Donald E. Kieso principles of accounting 19th editions.
 John, J,Wild, Ken, W. Shaw ,Barbra.Chieppta Fundamentals of accounting principle 20th edition Mc
Graw-Hill,Irwin
 Jerry J. Weygandt, Paul D. Kimmel & Donald E. Kieso 12th edition (2016).Financial Accounting,
IFRS Edition, New York: John Willey &Sons
 Carl S. Warren, James M. Reeve, Philip E. Fess Accounting 21th edition.

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