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 ACCOUNTING PRINCIPLES AND PRACTICES

 The Nature of Accounting
Accounting: is the process of recording, summarizing, analyzing, and interpreting financial activities to
permit individuals and organization to make informed judgments and decisions.
• Recording: making written records of events
• Summarizing: The process of combining these written records
• Analyzing: examining these reports by breaking them down in order to determine financial
success or failure.
• Interpreting: involves the use of financial data to make sound decision.
By law all businesses must keep accounting records. Decisions are based on accounting information for
profit and non-profit companies alike. There are different forms of business organizations:
• Private business—object is to earn a profit
• Sole Proprietorship—owned by one person
• Partnership—co-owned by two or more persons
• Corporation—owned by investors called stockholders (The business—not the owners—are
responsible for the company‘s obligations.)
There are different types of business organizations:
• Service business: render/provide services to customers like doctors, lawyers, barber shop, etc.
• Merchandising business—purchases goods for resale
• Manufacturing business—produces a product to sell
1.2. Accounting as an Information System
Accounting is often called the ―language of business . This language can be viewed as an information
system that provides essential information about the financial activities of an entity to various individuals
or groups for their use in making informed judgments and decisions.
Why an Accounting system is an important?
An effective accounting system captures large amounts of data and organizes it into understandable,
useful information. This information is used within the organization for a variety of purposes, such as:
• Development of Business Strategy
• Identification of Areas of Risk
• Budgeting
• Trend Analysis
And also by those outside of the organization, accounting system used for purposes such as:
• Prospective Investing
• Creditworthiness
• Tax Liability Determination  Regulatory Compliance
Users of accounting information
Interested parties are also called accounting information users. There are two broad categories of
accounting information users:
• internal users
• external users Internal users:
 Internal users are parties inside the reporting entity (company) who are interested in the
accounting information.
 Internal users are those individuals directly involved in managing and operating an organization.
Example: managers-for controlling, monitoring and planning, officers, internal auditors, sales managers,
budget officer, other internal decision maker.
External users

1
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 External users are parties outside the reporting entity (company) who are interested in the
accounting information.
 They are not directly involved in running the organization.
Examples:
• lenders(banks and financial companies)-whether an organization is likely to repay its loan with
interest and to grant loan
• shareholders(investors)-what is income for current and past periods-to assess the return and risk in
acquiring shares
• External auditors-to examine and provide an opinion on whether financial statements are prepared
according to GAAP.
• Employees-to judge the fairness of their wages, to assess future jobs prospective. 
Regulators(internal revenue service, tax authorities)-to compute taxes
• Others such as:
 Voters, Legislators, elected officials to monitor and evaluate a government receipts and
expenses.
 Contributors to not for profit organization-to evaluate the use and impact of their
donations.
 Suppliers – to judge the soundness of the business before making sales on credit.
 Customers –to assess the staying power of suppliers.
1.3. The Elements of Accounting
1. Assets
 are items with money value that are owned by a business.
 An item has a dollar (birr) value to be recorded in accounting records. Example:
cash, accounts receivable, supplies, inventories, equipment, land buildings etc Business
Entity Concept: this concept states that a business entity should be kept separate and distinct from its
owners, and any other economic activities.
2. Liabilities:
 debts owed by the business-obligation of a business.
 A liability that results from purchasing goods and services on credit is called accounts
payable. Other liabilities include notes payable, interest payable, wages payable etc
3. Owner’s Equity:
 the difference between what is owned and what is owed is owner‘s equity.
 It is the excess of assets over liabilities.
 Also called capital, proprietorship, net worth, and net asset.
4. Revenues:
 Revenues are increases in capital due to inflow of resources from business operations such
as, provision of services or sales of goods.
5. Expenses:
 Expenses are decrease in capital due to outflow of resources for the purpose of business
operations.
6. Drawings: An owner may withdraw cash or other assets during the accounting period for personal
use. These withdrawals could be recorded as a direct decrease of owner‘s equity and recorded in
drawings account.
 Drawings decrease total owner‘s equity.

 Basic Accounting Equation

The relationship among the accounting elements can be expressed in a single mathematical form known
as the accounting equation or the basic accounting equation (balance sheet equation) Equities: are
claims against the asset of a business.
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Assets = Equities
Claims are divided into two categories:
• Creditors' claims that are called liabilities

• Owners' claims that are called equity

Assets = Liabilities + Owner’s Equity

A= L + OE
If a company goes bankrupt, liabilities are paid off first to creditors, while owner‘s equity is the last to be
distributed. Therefore, owners' equity is also called residual equity.
1.4. Business Transactions and Accounting Equation
 Any activity that changes the value of assets, liabilities, owner‘s equity, revenue or expenses is
called transaction.
 Business transaction is an exchange of economic consideration between two parties/event of
occurrence or condition that must be recorded.
E.g. hiring an employee does not change the value of any assets, liabilities and owner‘s equity, so it is not
a transaction.
 Transaction can be created internally or external.
Internal transaction: internally created
E.g. Salary payment, Depreciation, Supplies, Allowance for uncollectible
External transaction: transaction related to outsiders
Example: purchase of asset on account, cash payment to a creditor, receipt of cash for service rendered,
payment of rent and collection of accounts receivable
 Financial Statements
• Financial statements are summaries of financial activities of an enterprise.  Financial
statements are prepared at the end of an accounting period  Financial statements are
prepared from business transitions.
• Financial statements are output of accounting system
Time Period (Periodicity) concept: the economic life of a business should be divided in to artificial
period of time. Analysis of Financial condition and preparation of financial statements is done at regular
intervals.
• The length of time for which an analysis of business operations is done is called a Fiscal
Period or Accounting period.
• Fiscal period/accounting period may consist either of: a month usually minimum, a quarter,
semiannual, a year –usually maximum length.
• The accounting time period of one year in length is usually known as a fiscal year.
The four major financial statements are:
1. Income statement:
• Describes a company‘s revenues and expenses along with the resulting net income or net loss
over a period of time.
• An income statement is also called Statement of Operations, Earnings Statement, or
Profit and Loss Statement (P/L).
• When revenue exceeds expenses, there is a net income.
• When expenses exceed revenue, there is a net loss.
2. Statement of Owner’s equity:
• Explains changes in equity due to items such as net income, net loss, owner‘s investment, and
owner‘s withdrawal over a period of time.
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AWASH VALLEY COLLEGE ARIF M

• Expenses & owner‘s withdrawal decreases the Owners equity of a business.

• Revenues & owner‘s investment increases the Owners equity of a business.
• Preparation of owners‘ equity statement is optional.
3. Balance sheet:  A listing of a firm‘s assets, liabilities and owner‘s equity at a specific date.
• A balance sheet is also called Statement of Financial Position.
There are two forms of balance sheet:
• An account form balance sheet.
• a report form balance sheet

The body of account form balance sheet has two sides: a left-hand side and a right-hand side. The assets
of a business are listed on the left-hand side of the balance sheet. The liabilities and capital are listed on
the right-hand side of the balance sheet.
4. Statement of cash flows: identifies cash inflows and outflows over a period of time. There are 3
types of cash flows (CF):
 Cash flow from operating activities – cash flow generated by normal business operations
 Cash flow from investing activities – cash flow from buying and selling assets: buildings, real
estate, investment portfolios, equipment.
 Cash flow from financing activities – cash flow from investors or long-term creditors
 Financial statements have these elements:
• A proper heading, consisting of
o Company Name
o Title of Statement
o Time Period or Date of Statement
• The body of the statement presenting financial information, in correct format.
• Totals and subtotals, specific to each financial statement.
• Articulation of balances and totals between statements.
• Notes disclosing additional information according to GAAP

See the following financial statements prepared for Alex Barber, service business from the above
transactions.
 THE ACCOUNTING CYCLE FOR A SERVICE BUSINES
 Classification of Accounts
Accounting Cycle - sequence of procedures used to record, classify and summarize accounting
information in financial reports, on a regular basis.
Account:
• Account is an individual record or form used to record or to summarize information related to
each asset, each liability, and each aspect of owner‘s equity, each expense and revenue.
• used to record the changes caused by business transactions
• Account is a storage bin.
There are 5 types of Accounts (Classification of Accounts):
1) Assets
2) Liabilities
3) Owners' Equity (Stockholders' Equity for a corporation)
4) Revenues
5) Expenses
1. Assets: any physical thing (tangible) or right (intangible) that has a value is an asset.
Current asset: asset that may reasonably be expected to be realized in cash or sold or used up
usually within one year or less.
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Example: cash, account receivable, supplies, inventory, short term notes receivable.
Plant assets (fixed assets) tangible asset used in the business that are of a permanent or relatively
fixed nature. Fixed assets include: equipment, machinery, buildings, and land.

2. Liabilities: debts owed to outsiders (creditors)

Current liabilities: liabilities due within a short time (usually one year or less) and that are to be
paid out of current assets.
Example: account payable, short note payable, salaries payable, interest payable, tax payable,
unearned revenue.

Long term liability: liability that will not be due for a comparatively long time (usually more than one
year) or company‘s obligations not expected to be paid within one year (or a longer operating cycle).
Example: long term notes payable, bonds payable, lease liabilities.
3. Owner’s equity: residual claim against the business asset after the total liabilities are deducted.
4. Revenues: gross increase in owner‘s equity as a result of the sale of merchandize, performance
of service to customer, rental of property, lending of money, and other business and
professional activities.
5. Expenses: costs that have been consumed in the process of producing revenue are expired costs
or expenses.
Drawings: drawings represent the amount of withdrawals made by the owner of business. Standard
form of account has three major parts:
1. The account title and number
2. The left side, which is called the debit side 3.
The right side, which is called the credit side.
There are two forms of accounts: two amount columns account and four amount column account.
Two amount column account:
Account Title: Account No.:

Date Item Post Debit Date Item Post Credit

Ref. Ref.

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amount column account:
Account Title: Account No.:

Date Item Post. Ref. Debit Credit Balance

Debit Credit

The following advantages of the four-column account as compared with the two-column are: The four-
column account:

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1) provides an easy means of analyzing and examining the accounts,

2) presents transactions in their chronological order of occurrence as the journal does, facilitating easy
location,
3) uses only one date column, saving space and time required for analysis, and
4) Makes balance of an account always available after each transaction is transferred to the account.
Accounts are often grouped together in a book form; such a grouping of accounts is called a
ledger. Thus, accounts are frequently referred to as ledger accounts. A skeleton version of a
standard form of account, used for ease analysis of account balance is called T account.
The T account has three parts:
1. The account title
2. Space for recording increases in the amount of the item, and
3. Space for recording decreases in the amount of the item
Title of account
Left Side Right side
(Debit side) (Credit side)
 The left side of any account is the debit side and the right side is called the credit side.
Chart of Accounts
 A list of accounts in the ledger.
 outline the order of accounts in the ledger
 directory of accounts available in the ledger

Sample Chart of accounts

Assets
11 Cash
12 Accounts receivable
13 Supplies
16 Office equipment
17 Office furniture
Liabilities
21 Accounts payable
22 Salaries payable
Owner’s equity
31 Capitals
32 Drawing
Revenue
41 Service revenue
Expenses
51 Rent expense
52 Supplies expense
53 Repairs
54 Expense

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digit of account number indicates major division of the ledger in which account is placed.
• A second digit of account number indicates position of account with in its division.
 Rules of Debit and Credit

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Depending on the nature of account affected debit or credit may be either decrease or increase.
• Debit can signify either increase or decrease
• Credit can signify either increase or decrease Debit and Credit rules of accounts:
Account Increase side Decrease side Normal Balance
Any Asset Debit Credit Debit
Any Liability Credit Debit Credit
Owner‘s equity (Capital) Credit Debit Credit
Any Revenue Credit Debit Credit
Any Expense Debit Credit Debit
Owner‘s drawing Debit Credit Debit
Balance of an account: account balance is the difference between the increase and decrease
recorded in an account. The normal balance of all accounts are positive rather than negative
because 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.
Journal:
• Is the book in which the records of business are written.
• It is a chronological record of events.
General journal:
• Is the original book of entry
• Information recorded on this book is usually extracted from the source documents such as
invoices, receipts, contracts agreements and many other relevant documents.
• It would usually show the account to be debited and credited and short description on the
transaction.
• Information on this book will be posted to the ledger.
• General journal is used to record all kinds of entries Forms of Two Column Journal
Date Description P/R Debit Credit

Special Journals:
 A journal in which only one kind of business transaction is recorded is a special journal used to
record only one type of entries.
 Special journals differ from the general journal or the combination journal in that they are
meant only for specified types of transactions—only one type.

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Sales journal: Sales journal is a special journal used to record only sales of merchandized on
account.
Purchase journal: used to record purchase on account
Cash receipt journal: use to record cash receipt (cash collection) Cash
payment journal: used to record payment of cash.
Combination Journal: is a multi-column journal that combines all journals into one book of
original entry.
Companies may use various kinds of journals, but every company has the most basic form of
journal, a general journal. Typically, a general journal has; spaces for dates, account titles and
explanations, references, and two money (amount) columns.
The journal makes several significant contributions to the recording process:
1. It discloses in one place the complete effect of a transaction.
2. It provides a chronological record of transactions.
3. It helps to prevent or locate errors because the debit and credit amounts for each entry
can be readily compared.
 Posting: The procedure of transferring journal entries to the ledger accounts is called posting.
Advantages of Posting:
• Posting summarizes entries in the journal into accounts in the ledger,  It can also be viewed
as sorting journal entries into accounts.
• Posting is an activity that summarizes the records in the journal so as to make them convenient
for analysis and reporting.
• It brings all data of one kind together.

 General ledger is the main book of accounts. This is the book where all the accounts are kept.
Each account maintained in this book will contain specifically information that relates to that
particular item alone. Information will generally be from the journal.
• Ledger is a collection of accounts together in one book
• Ledger is a group of accounts in a book. Because the information recorded in the ledger
originates from the journal, a ledger is also known as a book of secondary entry.
• A ledger that contains all the accounts needed to prepare the income statement and the balance
sheet is called a general ledger.
• An account in the general ledger that summarizes all the accounts in the subsidiary ledger is
called a controlling account.
• A ledger that is summarized into and controlled by a single account in the general ledger is
called a subsidiary ledger.
• A single account in the subsidiary ledger is known as a subsidiary account.
The Trial Balance: A trial balance is a list of accounts and their balances at a given time.
Customarily, a trial balance is prepared at the end of an accounting period.
Trial Balance is:
• A list of accounts and their balances at a point in time.
• Used to prove the equality of debit and credit amount in the ledger.
• Does not provide complete proof of the accuracy of ledger.
• The primary purpose of a trial balance is to prove the mathematical equality of debits and
credits after posting.

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• A trial balance also uncovers errors in journalizing and posting. In addition, it is useful in the
preparation of financial statements.
The procedures for preparing a trial balance consist of:
1. Listing the account titles and their balances.
2. Totaling the debit and credit columns.
3. Proving the equality of the two columns
 Common Errors that Cause a Trial Balance not to Balance
1. Errors in the addition of the trial balance columns. If there are arithmetic errors in computing
trial balance debit and/or credit totals, the trial will obviously be out of balance. That is, debit total
will not be equal to credit total.
2. Listing an account balance in the wrong column of a trial balance. If a correctly determined
account balance is put in the wrong column of the trial balance, it will result in twice overstatement
of the side in which the balance is wrongly put.
3. Mistakes in arithmetic when figuring account balances. Assuming that all entries posted to
ledger accounts do not have problems, an arithmetic error in determining an account balance will
later cause inequality of the trial balance totals.
4. Copying an amount incorrectly when journalizing, posting or preparing the trial balance. An
amount may be copied wrongly either from source document to a journal, from a journal to
accounts in the ledger, or from ledger to the trial balance. And, any of these errors will make the
trial balance totals not to balance.
5. Posting only one part of a journal entry. In double entry accounting, debit entries are always
accompanied by equal amount of credit entries. So, if only one part of these two components is
posted and the other component is not, you should not expect the trial balance totals to be equal.
Steps in Locating Errors when the Trial Balance does not equal
After the trial balance has indicated that there is an accounting error, the next procedure would
be to locate the error. The steps in locating errors include:
1. Re-add the trial balance columns to prove the accuracy of the addition of these columns.
2. Find the difference between the totals of the trial balance columns. And then look in the ledger to see
if the difference is because of an omission from the trial balance.
3. Divide the amount of the difference between the two totals of the Trial Balance by 2 to check if the
difference is evenly divisible by 2—without remainder. If the difference is evenly divisible by 2:
• Look through the accounts to see if this amount has been recorded on the wrong side of an
account. or
• Check if this amount has been written in the wrong column of the Trial Balance.
4. Divide the amount of the difference of the two totals of the Trial Balance by 9. If this difference is
evenly divisible by 9, look for an amount in the trial balance in which the digits have been transposed
in copying the balance from the ledger. Also, the digits might have been transposed in posting from
the journal.
• Transposition error – a reversal of digits e.g. 69.236 as 96.236
• Slide error- moving decimal points incorrectly. E.g.: 46.98 as 469.5 or 4.698
5. Compare the balances on the trial balance with the balances in the ledger accounts if there are
balances omitted from the trial balance, if balances are taken to wrong trial balance columns, or both.
6. Verify the pencil footings and the account balances in the ledger if the error is due to wrong account
balance determination.

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7. Verify the posting of each item in the journal by comparing what was recorded in the journal against
items posted to accounts in the ledger.
 COMPLETION OF THE ACCOUNTING CYCLE
 Adjusting Entries
Accrual- Versus Cash-Basis Accounting
Accrual-Basis: Under this method, revenues and expenses are recognized as earned or incurred
Cash-Basis Accounting:
The cash basis is much simpler, but its financial statement results can be very misleading in the
short run.
Revenue is recorded when cash is received (no matter when it is "earned"), and expenses are
recognized when paid (no matter when "incurred").
The cash basis is not compliant with GAAP.
 Modified cash Basis Approaches:
The cash and accrual techniques may be merged together to form a modified cash basis system.
The modified cash basis results in revenue and expense recognition as cash is received and
disbursed, with the exception of large cash outflows for long-lived assets (which are recorded as
assets and depreciated over time).
The revenue recognition and matching principles are used under the accrual basis of accounting.
Generally, accepted accounting principles require accrual basis accounting rather than cash basis
accounting.
Matching principle:
The matching principle dictates that efforts (expenses) be matched with accomplishments
(revenues) in the accounting period.
The need for proper matching of revenues and expenses arises because of the existence of
accounting periods and of payments and receipts that apply for different accounting periods.
Meaning Adjusting Entries
Adjusting entries are entries made at the end of the period to bring the balances of accounts that
do not show their true balance to the true balance to be reported on the financial reports
Adjusting entries are required every time financial statements are prepared. Adjusting entries can
be classified: The Need of Adjusting Entries

To report all revenues earned during the accounting period.

To report all expenses incurred to produce the revenues earned in the same accounting period.
To accurately report the assets on the balance sheet date. Some assets may have been used up
during the accounting period.
To accurately report the liabilities on the balance sheet date. (Expenses may have been incurred,
but not yet paid.)

Types of Adjusting Entries

The number of adjustments needed at the end of each accounting period depends entirely upon
the nature of the company‘s business activities. However, most adjusting entries fall in to one of
the four general categories:
1. Converting assets to expenses
2. Converting liabilities to revenue
3. Accruing unpaid expenses, and
4. Accruing uncollected revenue

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Deferrals:
 Deferrals are previously recorded assets, liabilities, revenues, or expenses that need to be
adjusted at the end of the period to reflect revenues earned or expenses incurred in the
current accounting period.
 Some of the deferred items for which adjusting entry would be made include: prepaid
insurance, prepaid rent, office supplies, depreciation, and unearned revenue.
Deferral adjustments are of two types:
1. Prepaid expense (Assets/expense) adjustments
• Transfer amounts from asset accounts to expense accounts 2. Unearned revenue
(deferred Revenue) Liability/revenue adjustments
• Transferring amounts from liability to revenue accounts.
 Converting assets to Expenses /Prepaid Expense Adjustments:
Prepaid expenses are expenses paid in cash and recorded as assets before they are used or
consumed. Prepaid expenses expire with the passage of time or through use and consumption.
• An asset-expense account relationship exists with prepaid expenses.  Prior to
adjustment, assets are overstated and expenses are understated.  The adjusting entry
results in a debit to an expense account and a credit to an asset account.
 Converting liabilities to Revenue (Unearned Revenue) Adjustments:
These are cash received before providing products or services. The cash received is debited
against the liability account when it is received. Revenues are recorded when the work is done.
So, we owe the work - it‘s a liability. At the end of the period, we reduce the liability to reflect
the portion of the work that has been done (this increases a revenue account).
 Unearned revenues are revenues received and recorded as liabilities before they are earned.
 Unearned revenues are subsequently earned by rendering service to a customer.
 A liability-revenue account relationship exists with unearned revenues.
 Prior to adjustment, liabilities are overstated and revenues are understated.
 The adjusting entry results in a debit to a liability account and a credit to a revenue account.
Example: Assume that on December 1, the dental office accepted a Br 2,400 payment from local
businesses to provide dental care to their employees over the next three months. The initial entry
on December 1 would be as follows:
 ACCRUAL ADJUSTMENTS
 Accruals are revenues that have been earned and expenses that have been incurred by the end of
the current accounting period, but that will be collected or paid in a future accounting period.
 Accruals occur when no cash has been received or paid, but the company has undertaken
activities that result in earning revenues or incurring expenses.
 Unlike deferrals, no original entry has been recorded.
Examples:-
a. Interest earned but not yet collected on a loan: Accrued Interest Receivable (Asset) (or
simply Interest Receivable) – accrued revenue.
b. Wages earned by employees but not yet paid: Accrued Wages and Salaries Payable
(Liability) (or simply Wages and Salaries Payable) – an accrued expense.
Accrual adjustments are of two types:
• accrued revenue and
• accrued expenses

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Accruing uncollected Revenue (Accrued Revenue):

 Accrued revenues are revenues earned, but not yet received in cash.
 Accrued revenues may accumulate with the passing of time as in the case of interest and rent, or
through services performed, but not billed or collected.
• Accrued revenue requires an asset/revenue adjustment
• An asset-revenue account relationship exists with accrued revenues.
• Prior to adjustment, both assets and revenues are understated.
• The adjusting entry results in a debit to an asset account and a credit to a revenue
account
 Accruing unpaid Expenses (Accrued Expense):
 Accrued expenses are expenses incurred, but not yet paid or recorded.
 Accrued expenses result from the same causes as accrued revenues and include interest, rent,
taxes, and salaries.
A liability-expense account relationship exists with accrued expenses.
• Prior to adjustment, both liabilities and expenses are understated.
• The adjusting entry results in a debit to an expense account and a credit to a
liability account.
Depreciation:  A portion of their cost is simply allocated to each

accounting period.

• This process is called depreciation.

• Depreciation is an example of a deferred expense. In this case the cost is deferred over a
number of years, rather than a number of months. Principles of accounting II will cover
depreciation methods in great detail. However, one simple approach is called the straight-line
method.
• Under this method, an equal amount of asset cost is assigned to each year of service life. In
other words, the cost of the asset is divided by the years of useful life, resulting in annual
depreciation expense.
 Book Value & Salvage Value
Book value is the difference between the cost of an asset, and the related accumulated
depreciation for that asset
Book Value = Cost - Accumulated Depreciation
Book Value = (Br12, 000 - Br10, 000) = Br2, 000
The company will stop depreciating the truck after the end of the fifth year. The truck cost
Br12,000, but only Br10,000 in depreciation expense was taken. The remaining book value is
equivalent to the salvage value established when the vehicle was purchased. Book value will be
used to calculate any gain or loss when the truck is sold or traded
Summery of Adjustment and Their Effects on the Financial Statements
Types of Before Adjustment
Adjustment Balance Sheet Income Statement Adjusting Entries
Prepaid Expense • Asset overstated • Expense Understated Debit Expense ---- Dr
(Deferred • Owner‘s Equity overstated • Net Income Overstated Credit Asset --------Cr
Expense)
Unearned • Liability overstated • Revenue Understated Debit Liability ---- Dr
Revenue • Owner‘s Equity Understated • Net Income Understated Credit Revenue -------

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(Deferred Cr
Revenue)
Accrued Expense • Liability Understated • Expense Understated Debit Expense ---- Dr
• Owner‘s Equity overstated • Net Income Overstated Credit Liability -----
Cr
Accrued • Asset Understated • Revenue Understated Debit Asset ---- Dr
Revenue • Owner‘s Equity Understated • Net Income Understated Credit Revenue ------
Cr
Fixed Assets • Asset overstated • Expense Understated Debit Expense ---- Dr
• Owner‘s Equity overstated • Net Income Overstated Credit Contra Asset ---
-Cr

 Alternative Treatment of Deferrals

As an example, recall the illustration of accounting for prepaid insurance -- Prepaid Insurance
was debited and Cash was credited at the time of purchase. This is referred to as a "balance
sheet approach" because the expenditure was initially recorded into a prepaid account on the
balance sheet. However, an alternative approach is the "income statement approach." With
this approach, the Expense account is debited at the time of purchase. The appropriate end-
ofperiod adjusting entry "establishes" the Prepaid Expense account with a debit for the amount
relating to future periods. The offsetting credit reduces the expense account to an amount equal
to the amount consumed during the period.

 The balance sheet and income statement methods result in identical financial statements.
Notice that the income statement approach does have an advantage if the entire prepaid item or
unearned revenue is fully consumed or earned by the end of an accounting period. No
adjusting entry is needed because the expense or revenue was fully recorded at the date of the
original transaction.
 Meaning and Importance of Reversing Entries

• A reversing entry is simply an entry that reverses the debits and the credits of the previous
adjusting entry.
• Reversing entries are optional.
• They are used in order to make the accounting process more consistent or to make later
recording of related transaction simpler.
• If the company has the accounting policy of preparing reversing entries, the adjusting entries for
all accruals and for the deferrals that are first recorded as expense and revenue (income
statement) accounts are reversed.
Preparing a Work Sheet
The work sheet is an informal working paper that the accountant uses in preparing financial
statements and completing the work of accounting cycle. The work sheet has been described as
the accountant‘s scratch pad, and it is used to:
1. Organize data
2. Lessen the possibility of overlooking an adjustment
3. Provide an arithmetical check on the accuracy of work, and

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4. Arrange data in logical form for the preparation of financial statements. A work sheet is
not a permanent accounting record; it is neither a journal nor a part of the general ledger.
The use of work sheet is optional.

(2) Preparing Adjusting Entries from a Work Sheet

 The adjusting entries are prepared from the adjustment columns of the work sheet.
 The reference letters in the adjustment columns and the explanation of the adjustments
that appear at the bottom of the work sheet help identify entries.
 The journalizing and posting of adjusting entries follows the preparation of financial
statements when a work sheet is used.
The adjusting entries on July 31 for Hope Laundry are shown below:
 Nature of the Closing Process
At the end of the accounting period, the temporary account balances are transferred to the
permanent of owner‘s equity account, owner‘s capital.
• The process of transferring the balances of the temporary accounts to the owner‘s account is
called the Closing process.
• Entries necessary to accomplish the closing process are called Closing entries.
• All temporary accounts are closed and include all income statement accounts and owner‘s
drawing.
• Permanent or real accounts relate to one or more future accounting periods. They consist of all
balance sheet accounts including owner‘s capital.
• Permanent accounts are not closed. Instead, their balances are carried forward into the next
accounting period.
• Temporary (nominal) accounts are closed and include: Revenue account, all expense accounts
and, owner‘s drawing. Permanent (real) accounts are not closed and include: all asset accounts,
all liability accounts and owner‘s capital account. The closing process has two objectives:
1) To reduce the balances of temporary owner‘s equity accounts to zero and thus make the
accounts ready for entries in the next accounting period
2) To update the balance of the owner‘s capital account.
Preparing Closing Entries
• Journalizing and posting closing entries is a required step in the accounting cycle. This step is
performed after financial statements have been prepared.
Income Summary Account
• The account to which the balances of nominal accounts are transferred at the end of the fiscal
period is named Income summary account or Income and Expenses summary account.
• Income summary account is a temporary account used to summarize the balances of the
temporary revenue and expense accounts.  It is also called a clearing account.
• There is no ―normal balance for this account.
• Income summary account never appears on financial statements. This account is placed in the
capital division of the ledger.
Steps in the closing Process:
1) Close the balance of each revenue account in to income summary
2) Close the balance of each expense account in to income summary
3) Close the balance of income summary account to the owner‘s capital account
4) Close the balance of the owner‘s drawing account directly to the owner‘s capital
account

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 Post-Closing Trial Balance

Checking the accuracy of posting is once again needed after the closing entries are posted to their
respective accounts in the ledger. A Trial Balance used for testing the equality of Debit and
Credit in the ledger after the closing entries have been posted is called a post closing Trial
Balance.
After the closing entries have been posted and the accounts have been balanced and ruled, Debit
must still equal Credit.
Example:
 Remember that only Permanent accounts are seen with their balances on the post closing trial
balance. No nominal account is seen in this trial balance, as it is prepared after closing all the
nominal ones.
SUMMARY OF THE ACCOUNTING CYCLE
Step 1.Analyze transactions from source documents During the
Step 2.Record transactions in a journal accounting Step 3. Post
from the journal to the ledger

period Step 4. Prepare a trial balance of the ledger

Step 5. Determine needed adjustments

At the end of Step 6. Prepare a work sheet accounting

Step 7. Prepare financial statements from the completed work sheet

period Step 8. Journalize and post adjusting entries

Step 9. Journalize and post closing entries

Step 10. Prepare a post closing trial balance

 ACCOUNTING FOR MERCHANDIZING ENTERPRISE

 Merchandizing Activities  Merchandizing businesses are businesses engaged in the
purchase and sale of commodities with a motive of profit.
• A merchandiser earns net income by buying and selling merchandise. Merchandise consists of
products, also called goods that a company acquires for the purpose of reselling them to
customers. A merchandising company‘s operating cycle begins with the purchase of merchandise
and ends with the collection of cash from the sale of merchandise.
• A person or a firm to whom a business sells merchandize is called a customer.
• The goods that a merchandizing business purchases for sale to customers are called merchandize.
 Cost of Merchandize: This represents the total sum of costs incurred to make the
commodities (merchandize) ready for sale.

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• cost is a deduction against revenues to arrive at gross profit  It has got debit as its increase and
credit as its decrease.
• Merchandising inventory is items or commodities held for sale to customers in the ordinary
course of the business.
• Merchandising inventory have two common characteristics:
(1) They are owned by the company and
(2) They are in a form ready for sale to customers in the ordinary course of business.
 Inventory Systems
In merchandising inventory there are two inventory accounting systems used to collect
information about cost of good sold and cost of inventory on hand. The two systems are called
periodic and perpetual.
1. Periodic Inventory system
• The merchandise inventory account is updated only once at the end of the accounting period.
• When merchandise is sold, revenue is recorded.
• Cost of good sold is not recorded as each sale occurs.
• It does not require continual updating of the inventory account.
• The company records the cost of new merchandise in a temporary purchase account.
• When financial statements are prepared, the company takes a physical count of inventory by
counting quantities of merchandise on hand.
2. Perpetual Inventory system
 A perpetual inventory system keeps a continual record of the amount of inventory on hand.
 The merchandise inventory account is updated after each purchase and each sale.
 Cost of goods sold account also is updated after each sale
 When an item is sold, its cost is recorded in a cost of good sold inventory.
Adjusting the Inventory Account
The adjustment of merchandize inventory has got the following features:
1. It is needed under the periodic inventory system only.
2. It eliminates the beginning merchandize inventory balance.
3. It brings into being the ending merchandize inventory balance determined by the
physical count.
4. The Income Summary account is debited in the adjustment of beginning merchandize
inventory and credited for adjustment of ending merchandize inventory balance.
5. Merchandize Inventory account is credited in the adjustment of beginning merchandize
inventory and debited for adjustment of ending merchandize inventory balance. The
Inventory account usually does not agree with the physical count. If the Periodic
method is being used, the Inventory account has the balance as adjusted at the end of
the prior year. If the Perpetual method is being used, the Inventory account should be
close to the physical value calculated from the physical inventory count. There will
always be a difference, and the accounts must be adjusted so the Inventory account
agrees with the physical count and valuation.

 Purchases and Sale of Merchandise for Cash and on Account

The two sides of merchandizing are:

a) Purchasing and
b) Selling. Purchase and sale of merchandize are the dominant activities of any
merchandizing businesses.

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Accounting for Purchase

The account that shows the cost of merchandize bought only for resale is titled purchases or
merchandize purchases. Both purchase and sale of merchandize take two forms: for cash and on
account.
When purchases are made for cash, the transactions could be recorded as: Purchase
………….. xx
Cash …………….xx
Example: On December 1, 2009, Freedom Merchandizing purchased merchandize for cash Birr
60,000; (Ck. 001).
Purchase……………………….60,000
Cash………………………………60,000
A transaction in which merchandize is purchased with an agreement to pay at a later date is
called purchase of merchandize on account. The business firm from which merchandize is
purchased on account is called a creditor.
Most purchases of merchandize are made on account and could be recorded as:
Purchase …………….xx
Account payable ……….xx
Example: On December 2, 2009 Freedom purchase merchandise for Br1,200 on credit with terms
of 2/10, n/30. Freedom‘s entry to record this credit purchase is:
Purchase……………..1,200
Account payable………1,200
Trade Discount is a reduction in the list price granted to customers owing to oral bargain. No
accounting treatment is required for trade discount.

Cash discount: a reduction granted by the seller for the buyer in the invoice price for prompt
payment when credit period is long and buyers pays with in a certain period ( within a discount
period).
• A buyer views a cash discount as a purchase discount
• A seller views a cash discount as a sales discount

The arrangement agreed up on by the buyer and sellers as to when payments for merchandize are
to be made are the credit terms.
Common payment terms are explained as under;
Net Cash: No credit is allowed by seller. Payment must be made by the buyer at the time of
purchase n/30: The amount of an invoice must be paid within 30 days of the date of the invoice.
2/10, n/30: A discount of 2% is allowed if an invoice is paid within 10 days of the date of the
invoice. If payment is not made within 10 days, the total must be paid within 30 days of the date
of the invoice.
n/EOM: Payment of goods must be made by the end of the month in which the goods were
purchased.
C.O.D: Cash on delivery. Under these terms, payment for goods must be made when goods are
delivered to the buyer.
Special Purchase Accounts:

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Purchase accounts deal with suppliers and purchase transactions:

• Purchase Returns and Refunds
• Purchase Allowances
• Purchase Discounts

Purchase return and allowances: merchandise may be returned by the buyer because of either
defects in the product or wrong specifications.
• Purchase retunes are merchandize received by a purchaser but returned to the supplier
• Purchase allowances are a reduction in the cost of defective merchandise received by a
purchaser from the supplier. A form prepared by the buyer containing a record of the amount
of the debit taken by the buyer for returns and similar items is called a debit memorandum.
Transportation Costs
A. Transportation Costs—responsibility is assigned by terms:
1. FOB shipping point—buyer pays shipping costs. .
2. Increases cost of merchandise when the purchaser is required to
pay for transport
3. Debit Inventory, Credit Cash or Accounts Payable (if to be paid
for with merchandise later)
4. FOB destination—seller pays shipping costs.
5. Operating expense for seller
6. Debit Delivery Expense (or Transportation-Out or Freight-Out),
Credit Cash. B. Transfer of Ownership—also defined by terms:
1. FOB shipping point—title transfers at shipping point
2. FOB destination—title transfers at destination.
Summary: Identifying transfer of ownership
Shipping Terms Ownership transfer Transportation
when goods passed to cost paid by
FOB Shipping point Carrier Buyer
FOB Destination Buyer Seller
Example1: December 15, 2009 Freedom Company purchased merchandise for Br. 5,000.00terms
2/10,n/30 FDB shipping point transportation cost amount Br. 200.
2009,
December 15,
Purchase ………………..Br. 5,000
Transportation in ……….. 200
(Freight-in)
Cash ……………………. 200
Account payable ……….. 5,000
If no discount: Purchase ………… Br. 5,200
Cash ………………… 200
Account payable ……. 5,000

Accounting for sales

Sales just like you saw above for purchase can be made in two ways:

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1. Cash sales of Merchandize, and

2. Sale of Merchandize on Account.
 A sale in which cash is received for full amount at the time of the transaction is called a
cash sale.
 A sales transaction with an agreement that merchandize will be paid for at a later date is
called a sale of merchandize on account/ charge sale/ credit sale.
 A person or business to which a sale on account is made is called a charge customer.
 Sale of merchandize on account is a sales arrangement that allows the buyer to pay for
merchandize at a later date.
 When merchandize is sold on account, the seller debits an account called Accounts
Receivable and credit a revenue account called Sales.
Special Sales Accounts
Merchandisers use a few special accounts. When a sale is made, sometimes the customer returns
merchandise for a refund. We do not reduce the sales revenue account. We enter the refund in a
different account. This is done to help track the number and dollar (birr) amount of these types of
transactions.
Sales accounts deal with customers and sale transactions:
• Sales Returns and Refunds
• Sales Allowances
• Sales Discounts

 Sales Discount:
Sales discounts are granted to encourage prompt payments. When a sales discount is granted, the
seller receives less than the sales price recorded at the time of the sale. A sales discount reduces
the revenue from sales. Therefore, it is a contra sales account.
 Sales Returns and Allowances
Most businesses that sell goods may expect to have some of the goods returned because of their
wrong style, their wrong size, or damage. The return of goods for which the customer is allowed
credit on account or given cash refund is called "a sales return."
Credit given to a customer for part of the sales price of goods when the goods are not returned,
is called a "sales allowance".
When a sales return or a sales allowance is granted, the seller usually informs the buyer in
writing. A form showing the amount of credit granted by the seller for returns, allowances, and
similar items is called a "credit memorandum".
 FINANCIAL STATEMENTS FOR MERCHANDIZING ENTERPRISES
 Income Statement: A summary of an entity's results of operation for a specified period of time is
revealed in the income statement, as it provides information about revenues generated and
expenses incurred. The difference between the revenues and expenses is identified as the net
income or net loss. There are two widely used forms for the income statement:
1. Single step and
2. Multiple step
1. Single Step Form
In a single step income statement, the total of all expenses is deducted in one step from the total
of all revenues. The single step form emphasizes total revenues and total expenses as the factors

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that determine net income. In this form amount such as gross profit and income from operations
are not readily available for analyses.
Skelton of single step form:
2. Multiple Step Form: Multiple step form income statement is divided in to the following sections:
1. Revenues
2. Cost of goods sold
3. Operating expense
4. Income from operations
5. Other income and expenses
1. Revenue section: provides a figure for net sales, which is the balance of sales account, less the
balance of contra sales accounts (sales return & allowances & sales discounts).
2. Cost of Good sold section:- The cost of merchandize sold to customers during a period is
subtracted from the net sales figure for the same period to the get the amount of gross profit.

The formula to calculate CGS is:

Beginning mdse inventory
+ Net purchase of merchandise
Cost goods available for sale
- Ending merchandise inventory
Cost of goods sold
Total purchases
- Purchase return and allowances
- Purchase discount
+ Freight in
Net purchases
 Gross profit: The excess of the net revenue from sales over the cost of merchandise sold is called
gross profit or gross margin.
3. Operating expenses: are the regular expenses of operating the business. It is usually
satisfactory to subdivide operating expenses in to two categories: selling and administrative.
• Selling expenses:- are all expenses directly related to the sale of merchandize such as:
 sales salaries expenses,
 advertising expense,
 store supplies expense,
 depreciation expense-store equipment ,
 Miscellaneous selling expense.
• Administrative /general/ expenses: are expenses related to the business‘s office, the
over all administration of the business or any other operating expense that can not be tied
directly to sales activity, such as:-  office salaries expense,
 rent expense,
 depreciation expense-office equipment,
 depreciation expense – delivery equipment,
 utilities expense,
 office supplies expense,
 insurance expense,
 miscellaneous general expense

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4. Income from operation section: Gross profit, minus total operating expenses, equals income
from operations (also called operating income) is a measure of a firm‘s on going operations, or
its regular operations.
5. Other income and expense section: Revenue from sources other than the primary operating
activity of a business is classified as other income. In merchandizing other income includes
interest, rent, and dividends.
• Expenses that can not be traced directly to operations are identified as other expense.
Example: interest expense and loss incurred in the disposal of plant asset.
• Net income: - The final figure on the income statement is called net income or net loss.
It is the net increase (or net decrease) in the owner‘s equity as a result of the periods
profit making activity.
 ACCOUNTING FOR CASH

 Cash, Cash Equivalent, and Liquidity

Cash Defined
Cash is anything that a bank would accept for deposit at face value. Cash include coins, currency
(Paper money), Checks, money orders made payable to the business, bank drafts, and receipts
from credit card sales. Items such as postage stamps and post-dated checks (checks payable in
the future) are not cash. Stamps are a prepaid expense, the post-dated checks are accounts
receivable.
Characteristics of cash:-
 It is the most liquid asset
 Bears no identifying mark
 Easily transferable
 Easily portable( transported )
 Cash Equivalent Defined
To increase their return on investment, many companies invest idle cash in assets called cash
equivalent. Cash equivalents are short-term, highly liquid investment assets meeting two
criteria: (1) readily convertible to a known cash amount and (2) sufficiently close to their
maturity date so that market value is not sensitive to interest rate changes
Liquidity: All assets can be judged on their liquidity. Cash and similar assets are called liquid
assets. Cash and similar assets are converted easily in to other assets or used to pay for services
or liabilities. Because of these characteristics, cash is the asset most susceptible to improper
diversion and use. To safeguard cash and to assure the accuracy of the accounting records of
cash, effective internal control over cash is imperative.
 Perform Internal Control over Cash
Special controls are needed to protect cash because almost everyone wants it, and it is easily
taken if not protected. Further, it is often easy to conceal that cash has been taken by altering
accounting records. The protection and control of cash are part of the overall system of internal
control.
Some common steps that are used to control and protect cash are:
 Those who physically handle cash (cashiers, clerk, etc.) and should not be the same as those
who account for cash (bookkeepers, accountants).
 All cash received should be deposited in a bank daily
 Only a small amount of cash (called petty cash) should be kept on hand
 All cash payments, except for petty cash, should be made by check

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 Cheeks should be pre numbered so that it is easy to see what cheeks have been written and
when.
 Only a few properly designated persons should be involved in the receipt, payment, and
recording of cash.
 Receipt and payment of cash should be recorded efficiently and accurately
 Accounting and Administrative controls
Administrative control includes, but is not limited to, the plan of organization and the
procedures and records that are concerned with the decision processes leading to management‘s
authorization of transactions.
Accounting control comprises the plan of organization and procedures and records that are
concerned with the safeguarding of assets and the reliability of financial records and
consequently are designed to provide reasonable assurance that:
a) Transactions are executed in accordance with management‘s general or specific
authorization.
b) Transactions are recorded as necessary
 To permit preparation of financial statements in conformity with GAAP and 
To maintain accountability for assets.
c) Access to asset is permitted only in accordance with management‘s authorization
d) The recorded accountability for assets is compared with the existing assets at reasonable
intervals and appropriate action is taken with respect to any differences

To control cash, most businesses use bank checking accounts when making cash expenditures.
However, it is not practical to write checks for very small amounts. The time and effort involved
in writing a check for small amounts can not be justified.
 Internal Control of Cash Receipts
Department stores and other retail business ordinarily receive cash from two main sources:-
1) Over the counter from cash customers 2) By mail from charge customers.
Cash Short And Over
The amount of cash actually received during a day often does not agree with the record of cash
receipts. When ever there is deference between the record and the actual cash and no error can be
found in the record.
The cash shortage and overage is recorded in an account entitled cash short and over. A common
method for handling such mistakes is to include in the cash receipts journal a cash short and over
debit column in to which all cash shortages are entered, and cash short and over credit column in
to which all cash overages are entered.
Example: - If the actual cash received from cash sales is less than the amount indicated by the
cash register, the entry in the cash receipts journal would include a debit to cash short and over.
Cash in bank---------------------------5677.60
Cash short and over-----------------------3.16
Sales-----------------------------------------5680.76
If there is a debit balance in the cash short and over account at the end of the fiscal period; it is
an expense and may be included in the ―miscellaneous administrative expense on the income
statement. If there is a credit balance; it is revenue and may be listed in the other income section.
Cash Change Fund
The fund may be established by drawing a check for the required amount; debiting the
account cash on hand and crediting cash in bank.

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Internal Control of Cash Payments

It is common practice for business enterprises to require that a very payment of cash be
evidenced by a check signed by designated officials. As an additional control, some firms
required two signatures on all check or only one checks which are larger than a certain
amount.
Basic features of the voucher system
A voucher system is made up of records, methods and procedures used in providing and
recording liabilities and making and recording cash payments.
A voucher system uses:
1. Vouchers
2. A voucher register
3. A file for unpaid vouchers
4. A check register and
5. A file for paid vouchers
1. Vouchers: - The term voucher is widely used in accounting. In a general sense; it means any
document that serves as proof of authority to pay cash. The term has a narrower meaning when
applied to the vouchers system: a voucher is s special form on which is recorded relevant data
about a liability and the details of its payment. Vouchers may be paid immediately after they are
prepared or at a later date; depending up on the circumstances and the credit terms.
2. Voucher register:-After approval by the designated officials each voucher is recorded in a
journal known as voucher register. It is similar to and replaces the purchases journal.
3. Unpaid voucher file:- after a voucher has been recorded in the voucher register; it is filed in
an unpaid voucher file, where it remains until it is paid.
4. Check register:-the payment of the voucher is recorded in a check register. The check register
is a modified form of the cash payments journal.
5. Paid voucher file:- after payment vouchers are usually filed in numerical order in a paid
voucher file. They are then readily available for examination by employees or independent
auditors needing information about certain expenditures.
Petty Cash
 A common way of handling small payments is to use a petty cash fund.
 A petty cash fund is an amount of money (cash fund) kept in the office for making
relatively small expenditures.
 The amount of petty cash fund depends on the needs of the individual business.
The Operation of a petty cash fund, often called an imprest system, involves:
a) Establishing the petty cash fund
b) Making payments from the petty cash fund and
c) Replenishing the petty cash fund
In establishing a petty cash fund;
 The amount of cash needed for disbursements of relatively small amounts during a
certain period is estimated.
 Custodian assigned
 The check drawn
If the voucher system is used; a voucher is then prepared for this amount and it is recorded in the
voucher register as a debit to petty cash and a credit to accounts payable. The check drawn to pay
the voucher is recorded in the check register as a debit to accounts payable and a credit to cash in
bank.

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 When a petty cash payment is made the petty cash custodian prepares a petty cash
voucher.
 The petty cash voucher shows the details of the payment and serves as proof that a
payment was made from the fund.
 No accounting entry is made to record a payment at the time it is made from the petty
cash.
To replenish the petty cash fund means to put back in to the fund the amount that has been paid
out of the fund. Petty cash fund is replenished:
a) When the money in the petty cash fund reaches a minimum level, and
b) At the end of the month regardless of the cash in the fund.

If the petty cash fund is not reimbursed at the end of accounting period:  petty
cash asset is overstated and  Expenses are understated.
 The journal entry to record replenishing the petty cash fund involves a debit to each item
listed in the petty cash payments record and a credit to cash.
 The Bank Account as a Tool of Controlling Cash
To get benefits from a bank account all cash received must be deposited in the bank and all cash
payments must be made by checks drawn on the bank.
The forms used by a business in connection with a bank account are; a signature card; deposit
tickets; checks and records of checks.
1. Signature card:-it must be signed by each person authorized to sign checks drawn on the
account at the account is opened.
2. Deposit ticket: - Is a source document given by the bank for the money deposited by the
depositor. Deposit ticket may be prepared in duplicate and the copy is signed by the
banks taller and given to the depositor as a receipt
3. Checks: - is a written instrument signed by the depositor ordering the bank to pay a
certain sum of money to the order of designated person.
There are three parties to a check
i. Drawer(maker):- the one who signs the check ii.
Drawee(payer):- the bank on which the check is drawn iii.
The payee:- the one to whose order the check is drawn

4. Records of checks drawn: - a memorandum record of the basic details of a check should
be prepared at the time the check is written.

Bank Statement: bank statement is a monthly report showing the bank‘s record of the checking
account. The bank statement provides the following information about customers‘ cash accounts:
1. The balance at the beginning of the month
2. Additions in the form of deposits and credit memos
3. Deductions in the form of checks and debit memos and
4. The final balance at the end of the month
Canceled checks are checks the bank has paid and deducted from the customer‘s account during
the month. Other deductions also often appear on a bank statement include:
• Service charge and fees assessed by the bank  Customer‘s cheeks deposited that
are uncollectible

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• Corrections of previous errors

• Withdrawals through automatic teller machines (ATM) and
• Periodic payments arranged in advance by the depositor.
Except for service charges the bank notifies the depositor for each deduction with a debit
memorandum when the bank reduces the balance. There are also other transactions that increases
the depositors account such as amounts the bank collects on behalf of the depositor and
corrections of previous errors. Credit memoranda notify the depositor of all increases when they
are recorded.
• CM (credit memo) increases or credits to the account, such as notes or accounts
left with the bank for collection
• DM (debit memo) Decrease or debits to the account, such NSF checks,
automated teller withdrawals, and service charges.
Bank Reconciliation
The bank statement and the cheek book are both records of a depositor‘s checking account
transactions. The balance of checking account reported on the bank statement is rarely equal to
the balance in the depositor‘s accounting records. This is usually due to:
1. Time lags – a delay by either party in recording transactions and
2. Errors- by either party in recording transaction.
The process of bringing the difference between the balance of a checking account according to
the depositor‘s records and the balance reported on the bank statement in to agreement is called
Bank reconciliation. It is a listing of the items and amounts that causes the cash balance
reported in the bank statement to differ from the balance of the cash account in the ledger.
Among the factors causing the bank statement balance to differ from the depositor‘s book
balance are:
1. Outstanding cheeks: check written by the depositor, deducted/appear in the checkbook
but not in the statement.
2. Deposit in transit (also called outstanding deposits): these are deposits made and
recorded by the depositor but not recorded on the bank statement. E.g. Night deposits,
deposits by mail etc
3. Service charges and other bank fees: banks charge a fee for providing checking
accounts. This fee, called a service charge. Other charges that a bank may make include
fees for imprinting checks, fees for collecting money for the depositor and fees for the
use of ATMs.
4. Errors –it is not uncommon for depositors to make (1) arithmetic errors when making
entries in a cheek book and (2) errors due to transpositions and slides by depositors. The
bank will also make errors.
5. Bank collections – some banks collect notes or securities for the depositor and enter the
amounts directly in the depositor‘s account. Such collections appear on the bank
statement but not in the checkbook.
6. NSF (Not sufficient funds) checks – when a check is deposited, it is counted as cash. If
the balance in the customer‘s account is not large enough to cover the check, the check is
called NSF. The bank initially credits the depositor‘s account for the amount of deposited
check. When the bank learns the check is uncollectible, it debits (reduces) the depositor‘s
account for the amount of that check.
The bank statement is reconciled by the following steps
a) Deposit in transit – added to the bank statement balance
b) Outstanding checks – subtracted from the bank statement balance

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c) Any interest earned and any collection made by the bank for the depositor- added to the
check book balance.
d) Any charge appearing on the bank statement – subtracted from the checkbook balance
e) NSF – subtracted from the checkbook balance.
Format for bank reconciliation
Bank balance according to bank statements----------------------------------------xxx
Add: additions by depositor not on bank statement--------------------xx
Bank errors-----------------------------------------------------------xx xx
xxx
Deduct: Deductions by depositor not on bank statements--------------xx
Bank errors---------------------------------------------------------xx xx
Adjusted balance--------------------------------------------------------------xxx
Bank Balance according to depositors records--------------------------------------xxx
Add: additions by bank not recorded by depositor-------------------- xx
Depositor errors-----------------------------------------------------xx xx
Xxx
Deduct: deductions by bank not recorded by depositor------------- xx
Depositor errors------------------------------------------------xx xx
Adjusted balance ---------------------------------------------------------------------xxx
 ACCOUNTING FOR RECEIVABLES
 Receivables Defined
Accounts receivable are amounts that customers owe the company for normal credit purchases.
Since accounts receivable are generally collected within two months of the sale, they are
considered a current asset and usually appear on balance sheets below short-term investments
and above inventory.

Notes receivable are amounts owed to the company by customers or others who have signed
formal promissory notes in acknowledgment of their debts. Promissory notes strengthen a
company's legal claim against those who fail to pay as promised. The maturity date of a note
determines whether it is placed with current assets or long-term assets on the balance sheet.
Notes that are due in one year or less are considered current assets and notes that are due in more
than one year are considered long-term assets.

Accounts receivable and notes receivable that result from company sales are called trade
receivables, but there are other types of receivables as well. For example, interest revenue from
notes or other interest-bearing assets is accrued at the end of each accounting period and placed
in an account named interest receivable. Wage advances, formal loans to employees, or loans to
other companies create other types of receivables. If significant, these nontrade receivables are
usually listed in separate categories on the balance sheet because each type of nontrade
receivable has distinct risk factors and liquidity characteristics.

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Receivables of all types are normally reported on the balance sheet at their net realizable value,
which is the amount the company expects to receive in cash.

Sales of Merchandise on account (sales on credit)

Most transactions involving individuals, businesses, and governments are not paid for
immediately, but are paid over a period of time on a credit basis. Credit can be defined as
providing cash, goods or services in the present, with payment expected in the future. Credit
sales are recorded by debiting an Accounts Receivable account for a specific customer and
crediting the sales account.

To illustrate, assume that on March 23, 2009, Roba Company sold Br 500 worth of merchandize
on account to Hawi Company. On March 26, Hawi returned Br 200 worth of the merchandize
because of damage. The sale and the return are recorded in general journal form on the books of
Roba as follows:
2008
March 23. Accounts receivable -Hawi Co ……. 500
Sales ………………….. 500
(Recorded sales on account)
26. Sales return and Allowances …………. 200
Accounts receivable- Hawi Co……. 200
(To record merchandize returned from a customer)
 Evaluating Accounts Receivable
Business owners know that some customers who receive credit will never pay their account
balances. These uncollectible accounts are also called bad debts.

Companies use two methods to account for bad debts:

 the direct write-off method and 

the allowance method.

Direct write-off method:

• Bad debts charged directly to expense when debt is considered un-collectable  It is

only acceptable in those cases where bad debts are immaterial in amount.
• direct write-off method is simple
• also called direct charge off method
If a customer named Tola fails to pay a Br225 balance, for example, the company records the
write-off by debiting bad debts expense and crediting accounts receivable from Tola. The
appropriate entry for the direct write-off approach is as follows:

2-10-210 Uncollectible Accounts Expense 225

Accounts Receivable 225

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To record the write off of an

uncollectible account from Jones
Notice that the preceding entry reduces the receivables balance for the item that is deemed
uncollectible. The offsetting debit is to an expense account: Uncollectible Accounts Expense.

Allowance Method:

Allowance Method
• Estimate of doubtful debts made at the end of the period
• An adjusting entry is made at the end of each accounting period.
• This method is consistent with the principles of accrual accounting, recognizing the
expense in the same period as the related revenue
• Records an estimate of the expense in same period as the income to which it relates
• Creates an allowance that will be deducted from accounts receivable on the balance sheet
• Allowance also known as ‗provision‘
• Since the specific customer accounts that will become uncollectible are not yet known
when the adjusting entry is made, a contra-asset account named allowance for bad debts,
which is sometimes called allowance for doubtful accounts, is subtracted from
accounts receivable to show the net realizable value of accounts receivable on the
balance sheet.
1.3. Estimating Bad Debts expense
The allowance method of accounting for bad debts requires an estimate of bad debts expense to
prepare the adjusting entry at the end of each accounting period. There are two approaches to
estimate bad debts expense using the allowance method:
1. Percentage of Total Receivables method and
2. Percentage of sales method

1. Percentage of Total Receivable methods /Balance sheet Approach/

The accounts receivable methods use balance sheet relations to estimate bad debts primarily the
relation between accounts receivable and the allowance amount. It is based on the idea that some
portion of the end-of- period accounts receivable balance is not collectible. Estimating
uncollectible account using accounts receivable methods done in one of two ways:
a) Simple estimate of percent uncollectible from the total outstanding accounts
receivable/Percent of accounts receivable approach) and
b) Aging accounts receivable

a) Percent of accounts Receivable Method

The percent of accounts receivable approach assumes a given percent of a company‘s
outstanding receivable are uncollectible. This estimated percent is based on past experience and
the experience of similar companies.
Estimated amount of Uncollectible = Total Amount X all outstanding
of Receivables Estimated Percent
If a company has Br100,000 in accounts receivable at the end of an accounting period and
company records indicate that, on average, 5% of total accounts receivable become uncollectible,

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the allowance for bad debts account must be adjusted to have a credit balance of Br5,000 (5% of
Br100,000).
12-31- Uncollectible Accounts Expense 5,000
2010
Allow. for Uncollectible 5,000
Accounts
Estimate of bad debt
Unless actual write-offs during the just-completed accounting period perfectly matched the
balance assigned to the allowance for bad debts account at the close of the previous accounting
period, the account will have an existing balance.

 If write-offs were less than expected, the account will have a credit balance, and if write-
offs were greater than expected, the account will have a debit balance.

Assuming that the allowance for bad debts account has a Br200 debit balance when the adjusting
entry is made, a Br5,200 adjusting entry is necessary to give the account a credit balance of
Br5,000.

Dec. 31. Bad debts expense …………. 5,200

Allowance for Doubtful accounts ……… 5,200
(To record estimated bad debts)

If the allowance for bad debts account had a Br300 credit balance instead of a Br200 debit
balance, a Br4,700 adjusting entry would be needed to give the account a credit balance of
Br5,000.

* Allowance for doubtful account is:

- A contra receivable account.
- It is also called Allowance for Bad debt and allowance for uncollectible account
- On the balance sheet its balance is subtracted from the balance of Accounts
receivable
- Allowance for doubtful accounts is not closed at the end of the fiscal year. It is
deducted from accounts receivable in the current asset section of the balance sheet
Accounts Receivable
- Allowance for doubtful accounts
Net Realizable value
The difference between Accounts receivable balance and Allowance for Bad Debts is called net
receivable or net realizable value – the actual amount of receivables that is expected to be
collected
b) Aging Accounts Receivable

In general, the longer an account balance is overdue, the less likely the debt is to be paid.
Therefore, many companies maintain an accounts receivable aging schedule, which categorizes
each customer's credit purchases by the length of time they have been outstanding. Each
category's overall balance is multiplied by an estimated percentage of uncollectibility for that
category, and the total of all such calculations serves as the estimate of bad debts. The accounts
receivable aging schedule shown below includes five categories for classifying the age of unpaid

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credit purchases. The process of analyzing the receivable accounts in terms of the length of time
past due is called aging the receivables.

To illustrate assume the following age classification as of December 31, 2008 for Hacalu
Company.
Age Amount Provision (%) Estimated uncollectible
0-30 days ----Br 60,000 1% Br 600
31-60 days ------15,000 2% 300
61-90-------------10,000 10% 1,000
91-120--------------8000 20% 2,000
Above 120 --------7000 50% 3,500
Br.100, 000 Br7, 400

Dec 31, 2008 Bad debts expense --------------Br 7400

Allowance for uncollectible ------------------------7400
(To record estimated bad debts under aging method)
When using the balance sheet approach of estimating bad debts, you always consider any prior
balance in the allowance account. In determining the amounts of the adjustment apply these
rules:
1. A prior credit balance is subtracted from the current estimate – It exists because actual
write offs during the period were less than the amount estimated to be uncollectible.
2. A prior debit balance is added to the current estimate a debit balance results when the
actual written off during the period exceed the amount estimated.
Assume that Hacalu‘s ledger revealed an Allowance for Uncollectible Accounts credit balance of
Br1, 000 (prior to performing the above analysis). As a result of the analysis, it can be seen that
a target balance of Br7,400 is needed; necessitating the following adjusting entry:
12-31-X8 Uncollectible Accounts Expense 6,400
Allow. for Uncollectible 6,400
Accounts
To adjust the allowance account from
a
Br1,000 balance to the target balance
of Br7,400 (Br7,400 – Br1,000)

You should carefully note two important points:

(1) With balance sheet approaches, the amount of the entry is based upon the needed
change in the account (i.e., to go from an existing balance to the balance sheet target amount),
and
(2) The debit is to an expense account, reflecting the added cost associated with the
additional amount of anticipated bad debts.
2. Percentage of sales method (Income statement approach)

Under this method the amount of credit sales for the period is multiplied by an estimated rate of
bad debts. The estimated rate is usually based on the past experience of the business.
Estimated Bad Debts = Credit sales x Estimated rate for the
period of bad debts

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If a company has Br500,000 in credit sales during an accounting period and company records
indicate that, on average, 1% of credit sales become uncollectible, the adjusting entry at the end
of the accounting period debits bad debts expense for Br5,000 and credits allowance for bad
debts for Br5,000.

12-31-2009 Uncollectible Accounts Expense 5,000

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Allow. for Uncollectible 5,000
Accounts
Estimate of bad debt (Br,500,000 X
1% = Br5,000)
Companies that use the percentage of credit sales method base the adjusting entry solely on total
credit sales and ignore any existing balance in the allowance for bad debts account. If estimates
fail to match actual bad debts, the percentage rate used to estimate bad debts is adjusted on future
estimates.
Writing off Uncollectible Accounts under Allowance Method: Now, we have seen how to
record uncollectible accounts expense, and establish the related allowance. But, how do we
write off an individual account that is determined to be uncollectible? This part is easy. When a
specific customer's account is identified as uncollectible, it is written off against the balance in
the allowance for bad debts account.
The following entry would be needed to write off a specific account that is finally deemed
uncollectible:
For example, if uncollectible balance of Br5,000 is removed from the books by debiting
allowance for bad debts and crediting accounts receivable.
-15-2010 Allow. for Uncollectible Accounts 5,000
Accounts Receivable 5,000
To record the write-off of an
uncollectible account
Under the allowance method, a write-off does not change the net realizable value of accounts
receivable. It simply reduces accounts receivable and allowance for bad debts by equivalent
amounts.

Before writing off After writing off account

account
Accounts Receivable Br100,000 Br99,775

Less: Allowance for Bad Debts (5.000) (4.775)

Net Realizable Value Br95,000 Br95,000

Collection of an Account Previously Written Off

Customers whose accounts have already been written off as uncollectible will sometimes pay
their debts. When this happens, two entries are needed to correct the company's accounting
records and show that the customer paid the outstanding balance. The entry to record the
recovery involves two steps:

(1) A reversal of the entry that was made to write off the account, (reinstates the customer's
accounts receivable balance by debiting accounts receivable and crediting allowance for bad
debts) and (2) Recording the cash collection on the account records by debiting cash and
crediting accounts receivable.

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6-16- Accounts Receivable 1,000

2010
Allow. for Uncollectible Accounts 1,000
To reestablish an account previously written off via
the reversal of the entry recorded at the time of write
off
6-16- Cash 1,000
2010
Accounts Receivable 1,000
To record collection of account receivable

 ACCOUNTING FOR NOTES RECEIVABLES

Definition of Notes Receivable
A promissory note (note receivable) is a written promise to pay specified amount money either
on demand or at a definite future date. Promissory notes are used in many transactions, including
paying for products and services
in the ending and borrowing of money and
To pay for account receivables Note contains the following parts:
Date – the date of the note
Time – the length of time between the date the note is issued and the (period) date it is due for
payment (note’s life span)
Payee – the party to whom payment will be made
Principal (Face value) - the stated amount of the note
Maker – the party promising to make payment,
Interest – the charge imposed on the borrower of funds for the use of money
Due date – the day the note will be due

Determining the Due date of a Note

The maturity date (due date) of a note is the day the note (principal & interest) must be paid.
When the time of the note is expressed in days, the maturity date is the specified number of days
after the note‘s date. Example: - The Maturity date of a 90 – day note dated July 10 is computed
as follows:
Term of notes ………….. ……… 90
July (days) ……………… 31
Date of note July …. ………10 21
Number of days remaining ……... 69
August (days) …………………….. 31
Number of days remaining ………..38
September (days) ……………….. . 30
Maturity date, October ……… 8
The period of a note is sometimes expressed in months or years. When months are used, the note
matures and is payable in the month of its maturity on the same day of the month as its original
date.
A 3 – month note dated July 10, for instance, is payable on October 10, the same analysis applies
when years are used.

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Interest Computation
Interest is the cost of borrowing money for the borrower or the profit from lending money for
the lender. To calculate interest, three factors are needed:
Principal of the note – the amount borrowed
Rate of interest percent charged on the principal
Time of the note – Number of years, months, or days from the date of issue to the date of
maturity.
A note that provides for payment for interest for the period between the issuance date and the
maturity date is called an interest bearing note. If a note makes no provision for interest, it is
said to be non-interesting bearing note.
The following formula is used to calculate interest on an interest bearing note:
Interest = Principal X Rate X time
I= P X R X T
To illustrate, assume a note with a principal of Br 1, 400, a rate of 10% and a time of two years.
Interest is computed as follows:
I = P X RX T
= Br1, 400x10%X 2 years
= Br 280
The interest on a Br 1,200, 9% note for three months is calculated as: I =
PXRXT
= Br1, 200 X 9%X3/12
= Br27
When a time of a note is expressed in days, the time factor is stated as a fraction of 360 days. To
illustrate the note that has a principal of Br 700, a rate of 9%, and a time of 30 days is computed
as follows:
I=PXRXT
= Br 700 X 9% X 30/360 = Br 5.25

Accounting For Notes Receivable: To illustrate the accounting for a note receivable, assume
that Hope initially sold Br10,000 of merchandise on account to Wisdom. Wisdom later
requested more time to pay, and agreed to give a formal three-month note bearing interest at
12% per year. The entry to record the conversion of the account receivable to a formal note is as
follows:

1/6/2010 Notes Receivable 10,000

Accounts Receivable 10,000
To record conversion of an account
receivable to a note receivable
The principal and interest of a note are due on its maturity date. The maker of the note usually
honors the note and pays it in full.

The note that is paid in full at its maturity date is called honored note.
When the note matures, Hope's entry to record collection of the maturity value would appear
as follows:

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31/8/2010 Cash 10,300

Interest Income 300
Notes Receivable 10,000
To record collection of note receivable plus accrued
interest of Br300 (Br10,000 X 12% X 90/360)

A Dishonored Note: When a note‘s maker is unable or refuses to pay at maturity, the note is
dishonored. When a note is dishonored, we remove the amount of this note from the note
receivable account and charge it back to an account receivable from its maker.
If Wisdom dishonored the note at maturity (i.e., refused to pay), then Hope would prepare the
following entry:
31/8/2010 Accounts Receivable 10,300

Interest Income 300

Notes Receivable 10,000

To record dishonor of note receivable plus accrued

interest of Br300 (Br10,000 X 12% X 90/360)

The debit to Accounts Receivable in the above entry reflects the hope of eventually collecting all
amounts due, including the interest, from the dishonoring party. If Hope anticipated some
difficulty in collecting the receivable, appropriate allowances would be established in a fashion
similar to those illustrated earlier in the chapter.

Notes and Adjusting Entries: In the above illustrations for Hope, all of the activity occurred
within the same accounting year. However, if Hope had a June 30 accounting year end, then an
adjustment would be needed to reflect accrued interest at year-end. The appropriate entries
illustrate this important accrual concept:

Entry to set up note receivable:

1/6/2010 Notes Receivable 10,000

Accounts Receivable 10,000
To record conversion of an account
receivable to a note receivable
Entry to accrue interest at June 30 year end:

30/6/2010 Interest Receivable 100

Interest Income 100
To record accrued interest at June 30
(Br10,000 X 12% X 30/360 = Br100)
Entry to record collection of note (including amounts previously accrued at June 30):

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31/8/2010 Cash 10,300

Interest Income 200

Interest Receivable 100

Notes Receivable 10,000

To record collection of note receivable plus interest of

Br300 (Br10,000 X 12% X 90/360); Br100 of the total
interest had been previously accrued

Converting Receivables to cash before Maturity

Some times companies convert receivables to cash before they are due. Reasons for this include
the need for cash or a desire to not be involved in collection activities.
Converting receivables is usually done either:
By selling(factoring) or
By using them as security for loan(pledging)
Factoring (Selling) Receivables

Companies sometimes need cash before customers pay their account balances. In such
situations, the company may choose to sell accounts receivable to another company that
specializes in collections. This process is called factoring.
The company that purchases accounts receivable is often called a factor.
The factor usually charges between one and fifteen percent of the account balances. The reason
for such a wide range in fees is that the receivables may be factored with or without
recourse. Recourse means the company factoring the receivables agrees to reimburse the
factor for uncollectible accounts. Low percentage rates are usually offered only when
recourse is provided.

Suppose a company factors Br500,000 in accounts receivable at a rate of 3%. The company
records this sale of accounts receivable by debiting cash for Br485,000, debiting factoring
expense (or service charge expense) for Br15,000, and crediting accounts receivable for
Br500,000.

Cash……………………….485,000
Factoring fees expense……. 15,000
Accounts receivable……………..500,000 (Factor
accounts worth Br500,000)

In practice, the credit to accounts receivable would need to identity the specific subsidiary ledger
accounts that were factored, although to simplify the example this is not done here.

Pledging Accounts Receivable

A company can also raise cash by borrowing money and then pledging its accounts receivable as
security for the loan. Pledging receivables does not transfer the risk of bad debts to the lender.
The borrower remains ownership of the receivables. But if the borrower defaults on the loan, the
lender has the right to be paid from cash receipts when the accounts receivable are collected.

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When Forest Company borrowed Br35,000 and pledged its receivables as a security, it recorded
this transaction as:
Cash………………………..35,000
Notes receivable………………..35,000
(Borrowed money with a note secured by pledging accounts receivable)

Discounting a Note Receivable

Discounting a note receivable is a selling of note receivable at a discount that is less than the
maturity value. The process of discounting a customer‘s note involves several steps. To
illustrate, assume that Freedom Company received a Br 600, 60- day, 10% note on account from
a customer on July 14, 2008. Because the company needed cash immediately, Freedom
discounted the note at Oromia International Bank on August 3, 2008. Oromia International Bank
charges a discount rate of 12% on all discount notes. The steps involved:
Calculate Interest
Interest = Principal x Rate x time
= br600 x 10% x 60/360
= Br10
Calculate the maturity value of the note
Maturity value = principal + interest
= Br 600 + 600x10%x60/360
= Br600 + Br10= Br610

Calculate the due date of the note

Term of note ………………………………… 60
Number of days remaining in July (31-14)…. 17
Number of days remaining ……………… 43
Days in August …………… 31
Due date, September ……………. 12
Calculate the discount period. we can find the discount period as follows:
Issue date July ………. 14
Days in July…………...31……...17
Discount date August ………… 3
20days
Term of note ………………….. 60
Discount period ……………….. 40days
Calculate the amount of the bank discount.
Discount amount = maturity Value X Discount rate X Discount period
=Br 610 X 12% X 40/360 = Br 8.13
Calculate the proceeds (cash received)
Proceeds = Maturity value – Discount amount
= 610 – Br 8.13 = Br 601.87
Journalize the transaction
Aug. 3 Cash …………………… 601.87
Notes Receivable……………….600
Interest income………………….1.87
(Discounted customer‘s note at 12%)

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The cash account will be debited for the amount received Br601.87 and notes Receivable
account is credited for the face value of the note, Br600. The difference between the amount
debited (the proceeds) and the face value of the note is either interest income or interest expense.
If the proceeds are greater than the face value, you have interest income. Credit the interest
income account for the difference. If the proceeds are less than the face value, you have interest
expense, Debit the interest expense account for the difference.

Comparison of Accounts Receivable Vs Notes Receivable

A notes receivable has the following advantages over an accounts receivable:
A note is a formal written promise, serving as proof of a transaction.
A note can bear interest , which is additional revenue
A note is negotiable; it can be transferred by endorsement to obtain cash or other assets
A note can be pledged(used) as security for a loan

6.3. Accounting for Temporary Investments

A business may have a large amount of cash on hand that is not need immediately, but this cash
may be needed later in operating the business, possibly within the coming year. Rather than
allow this excess cash to lie idle until it is actually needed, the business may put all or a part of it
into income-yielding investments, such as certificates of deposit and money market funds. In
many cases, the idle cash is invested in securities that can be quickly sold when cash is needed.
Such securities are known as temporary investments or marketable securities.
Short term investments can include both:
debt and
Equity securities.
Debt securities reflect a creditor relationship and include investment in notes, bonds, and
certificate of deposits. Debit securities are issued by governments, companies, and individuals.
Equity securities reflect an ownership relationship and include shares of stock issued by
companies.
Debt securities
Short term investments in both debt and equity securities are recorded at cost when purchased.
Hope company, for instance, purchased short-term notes payable of Intel for Br4,000 on January
10. Hope‘s entry to record this purchase is:
Jan. Short-term investments……………4,000
Cash……………………………………4,000
Bought Br4,000 of Intel notes due May 10.
These notes mature on May 10 and the cash proceeds are Br4,000 plus Br120 interest. When the
proceeds are received, Hope records this as:
May Cash………………….4,10
Short-term investment………4,000
Interest earned……………… 120
Received cash proceeds from matured notes

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Equity Securities
The cost of an investment includes all necessary costs to acquire it, including commissions paid.
Hope Company purchased 100 shares of OIB common stock as a short term investment. It paid
Br50 per share plus Br100 in commissions. The entry to record this purchase on June 2 is:
June 2: Short-term investments………….5,100
Cash ……………………………..5,100
Bought 100 shares of OIB at 50 plus Br100 commission

Temporary Investments and Receivables in the Balance Sheet

Stocks and bonds held as temporary investments are classified on the balance sheet as current
assets. They may be listed after "Cash," or they may be combined with cash and described
as "Cash and marketable securities."
Temporary investments and all receivables that are expected to be realized in cash within a year
are presented in the Current Assets section of the balance sheet. It is customary to list the
assets in the order of their liquidity, that is, in the order in which they can be converted to
cash in normal operations.

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