principle of accounting

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Principles of Accounting I

Fess Warren 16 Ed Edited by: Andualem Tsegaye

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CHAPTER ONEAccounting is a process of interpreting, recording, summarizing and reporting financial information to decision makers. Thus, the purpose of accounting to help decision-makers to make informed judgments and decisionsIf accounting information is not capable of helping to make better decision. Then it is waste of time and money to produce.Accounting is often called the “language of business” 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. Users of Accounting information

For accounting information to be useful, an accountant must be clear about for whom the information is being prepared and for what purpose the information will be used.Generally Every one in a society make decisions from very minor simple and ones to very broad and complex; In one way or another most decisions, use accounting information. Thus, in short we can say every body in a society use accounting information. However, when we speak about particular business organization, we can categorize accounting information users in to two broad groups as:

1. The internal user group2. The external user group

1. The internal user group - these include management and employees of the business enterprise. Those who are in the day-to-day operation of the enterprise Those who are part and parcel of the value chain of the enterprise.

Purpose by internal users Planning current and long-term operations Controlling (Evaluating) current operations Means of accelerating favorable

trends and reducing those that are unfavorable Management Accounting is designed to satisfy information need of this group.

2. External user groups- those who are not in the day-to-day operation of the business enterprise, but those who have some interest in the reporting enterprise. These are collectively known as stakeholders. Indeed here are: customers, suppliers, government, owners, etc

Purpose by external usersThe purposes by external users are quite different; each group within the external user group has their own interest:-Look at the following table, why each of the user group needs accounting information relating to a business.User group UseCustomer To assess the ability the business to continue in

business and to supply the needs of the customers.Government To assess how much tax the business should pay,

whether it complies with agreed prices, policies or


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whether financial support is needed.Owners To assess how effectively the managers are running

the business and to make judgments about likely levels of risk and return in the future (profitability and going-concern)

Creditors To assess the ability of the business to meet its obligations and pay interest and to repay the amount borrowed.

Liquidity; ability of the business to repay short-term debt as they due

Solvency; ability of the business to repay all kinds of debt as they due

The above descriptions show some of the purposes by some of the accounting information users in the external user group. Note that there are many accounting information users in the external user group; and the purpose mentioned here is not a complete list. However it is clear that because there are different user groups having different interest (objectives) their accounting information need is also different.

You may raise a question like this; how is possible to satisfy different user groups having different interest?

It is by providing general purpose financial statements. General purpose statements is financial statements that are prepared by following generally accepted accounting principles (GAAPS) or international financial reporting standards (IFRS) and that will be used by different user groups for different purposes.A single balance sheet is used by creditor to evaluate liquidity /solvency and by investor to evaluate attractiveness of the business in terms of risks and return.

Financial Accounting is designed to satisfy the information need of the external user group.

Profession of Accountancy Accounting can be characterized as a profession that has experienced rapid development during the current century. As professionals, accountants are typically engaged in either:-

1. Private Accounting or2. Public Accounting

Private Accounting; Accountants employed by a particular business firm not-for-profit organization or by government entities as chief accountant, controller or any other accounting position are said to be engaged in private accounting.Public Accounting; Accountants who render accounting services on a fee basis and staff accountants employed by them are said to be engaged in public accounting.


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Business Transactions A business transaction is the occurrence of an event or a condition that must be recorded.Example: Payment of telephone bill of 100birr

Purchase of merchandise on credit for 1200birrAcquisition of Land and Building for 210,000birr

A particular business transaction may lead to an event or a condition that result in another transaction. For example, the purchase of merchandise on credit will be followed by payment to the creditor, which is another transaction. Each time a portion of a merchandise sold, another transaction occurs.

Business transaction could be internal transaction or External transaction. External transactions are an exchange of goods or services between the business and an outsider. Internal transactions are not an exchange of goods and services between the business and an outsider, but these are conditions that must be recorded. Examples: - the wearing-out of building, consumption of office supplies, etc.

ASSETS, LIABILITES AND OWNER’S EQUITY

Assets: - The properties owned by a business enterprise are referred to as assets. Economic resources-things of value-owned by a businessLiabilities : - - The right of creditors /debts of the business.Owner’s Equity : - The right of owner /owners

The properties owned by a business enterprise are referred to as assets and the rights or claims to the properties are referred to as Equities. Note that always assets of business enterprise are equal with Equities. As mentioned above equities are divided into two principal types: the right of creditors and the right of owners. The right of creditor is liability where as the right of the owner is owner’s equity.

Assets = Liabilities + Owners Equity

It is customary to place “liabilities” before” owner’s Equity” in accounting equation because creditors have preferential rights to assetsNote ; Any increase or decrease in assets results in corresponding in liabilities or owner’s Equity or both. The two sides of the equation must always be equal.Transaction and the Accounting EquationAll business transactions, from the simplest to the most complex, can be stated in terms the resulting change in the three basic elements of the accounting equation.

Illustration: - Assume that Mr. X establishes a sole proprietorship to be known as x- taxi.Transaction aMr. X’s first transaction is to deposit 10,000bir in a bank account in the name of x-taxi price. The effect of this transaction is to increase the asset (cash), on the left side of the


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equation by 10,000birr and to increase the owner’s equity, on the other side of the equation by the same amount.

Assets = Liabilities + owner’s equityCash Mr. X-capital

10,000 10,000

It should be noted the equation relates only to the business enterprise Mr. X’s personal assets, such as his home and his personal bank account, and his personal liabilities are excluded from consideration. The business is treated as a separate entity, with cash of 10,000 (asset) and owners’ Equity of 10,000. This is known as Business Entity concept.

Business Entity concept; States regardless of the form of the business organization, the business affairs of the business should be separate from that of owners.Generally there are three forms of business organization namely: Sole proprietorships, partnerships, or corporations.

- A sole proprietorship is owned by one individual- A partnership is owned by two or more individuals in accordance with a

contractual agreement- A corporation is a separate legal entity in which ownership is divided in to

shares of stock.

Transaction bMr. X next transaction is to purchase land as a future building site for which 7500 in cash is paid. This transaction changes the composition of the assets but does not change the total amount.

Assets Liabilities + Owner’s Eq. Cash + Land

Beg. Bal 10,000b -7,500 + 7500

10,000

End. Bal 2500 7500

10,000 = 10,000

Cost principle - On the date it occurs, a financial transaction is recorded at the value of the transaction.


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Transaction cDuring the month, Mr. X – purchases 85birr of gasoline, oil and other supplies from various suppliers, is agreeing to pay in the near future. This type of transaction is called a purchase on Account and the liability created is termed accounts payable.

The effect of this transaction is to increase assets and liabilities by 850birr a follow:Assets Liabilities + Owner’s Equity

Cash + Supplies + Land Accounts P. + X- Capital 2500 850 7500 850 10,000 10,850 10,850

Transaction dDuring the month, 400birr is paid to creditors on account, thereby reducing both assets and Liabilities. The effect of this equation is as follow:

Assets Liabilities + Owner’s Equity Cash + Supplies + land Beg. Bal 2500 Account payable + x- capital (d) - 400 850 7500 850 10,000 Bal. 2100 -400

Bal. 450 10,000

10,450 10,450

10,450Transaction eDuring the first month operation’s Mr. X- business earned 4500birr receiving the amount in cash. The total effect of these transaction is to increase cash by birr 4500 and to increase owners’ equity by the same amount. In terms of the accounting equation, the effect of the receipt of cash for the services performed is as follow: Assets Liabilities + Owner’s Equity Cash + Supplies + Land Accounts pay. X- capitalBal. 2100 850 7500 450 10,000 e + 4500 + 4500 Bal. 6,600 850 7500 450 14,500

14,950 14,950


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In general, the amount charged to customers for goods or services sold to them is called revenue. Other terms may be used for certain kinds of revenue, such as sales for the sale of merchandise or business services, fees earned for charges by physician to patients, rent earned for the use of real estate or other property, and fares earned by Taxi service providers.Instead of requiring the payment of each at the time goods or services are sold, a business may make sales on account, allowing the customer to pay later. In such cases, the firm acquires an account receivable, which is a claim against the customer. An account receivable is as much an asset as cash and the revenue is realized in exactly the same manner as if cash had been immediately received. At a later date, when money is collected, there is only an exchange of one asset for another, with cash increasing and accounts receivable decreasing.

Transaction (f)In broad sense, the amount of assets consumed or services used in the process of earning revenue is called expense. Expenses would include supplies used wages of employees and other assets and services used in operating the business.For x- taxi various business expenses incurred and paid during the month were as follows: Wages, 1, 125birr, Rent, 850birr; Utilities 150birr; miscellaneous 75birr. The effect of this group of transactions is to reduce cash and to reducer owner’s equity, as follow:

Assets Liabilities + Owner’s Equity Cash + Supplies + Land Acct. pay. + x-capital Bal. 6600 850 750 450(f) - 2,200 14,500

-1,125 Wages Exp.- 850 Rent Exp.- 150 Uti. Exp.

-75 Mis. Exp 4400 850 750 = 450 12, 300

12,750 12,750

Transaction (g)At the end of the month it is determined that the cost of the supplies on hand is 250, the remainder (850-250) having been used in the operations of the business. This reduction 600birr in supplies and owner’s equity is shown as follows:-

Assets

Cash + Supplies + Land Liabilities + Owner’s Equity Acct. Pay. X- Capital

Bal. 4400 850 7500 450 12,300

(g) -600 -600supp.exp. Bal. 4400 250 7500 450 117000


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12,150 === 12,150

Transaction hAt the end of the month, Mr. X- withdraws, from the business 1000birr in cash for his personal use. This transaction, which reduces cash and reduces owner’s equity, is the exact, opposite of an investment in the business by the owner. It is not a business expense, but a withdrawal of a portion of the owner’s equity. The effect of the 1000 withdrawal is as follow:-

Assets Cash + Supplies + Land liabilities + Owner’s Eq.

Acc. Pay.Bal. 4,400 250 7500 450 11,700 h -1000 -- -- -- -1,000 withdrawal Bal. 3400 250 7500 450 10,700

11,150 == 11,150

Summary:- The business transactions of x- taxi are summarized in tabular form, as follows. The transactions are identified by letter; the balance of each item is shown after each transaction.

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Land Accounts. Pay + x- Capitala + 10,000 + 10,000b -7500

2500+75007500

------10,000

c 25002500

+ 850 850

75007500

+850 850

10,00010,000

d -4002100

_____ 850

_____7500

-400450

______10,000

e + 45006600

_ _--___ 850

__--___ 7500

__--___ 450

14500 14500

f -2200

______4400

_________850

_______7500

_________450

-1125W.Exp-850 R.Exp.-150.U.Exp.- 75 Mis. Exp.12300

g _____4400

-600250

_____7500

______450

-60011700


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h -1000 3400

_____250

_____7500

______450

-100010,700

Note the following observation, which apply to all types of business.1. The effect of every transaction can be stated in terms of increases and /or

decreases in one or more of the accounting equation element.2. The equality of the two sides of the accounting equation is always maintained.3. The owner’s equity is increased by amounts invested by owner and decreased by

withdrawals by the owner. In addition, owner’s equity is increased by revenues and is decreased by expenses.

Effects of transactions owner’s EquityExercise

TransactionPortrait- painting business of Rahel

1. On January 1, 2014, Rahel began her business by investing br. 35,000 in cash in a checking account that she opened in the name of business.

2. On January 2 Rahel rented a small room in the basement of a house for a studio. She paid br. 900 for a year’s rent in advance.

3. On January 3, Rahel purchased art supplies for br.1,000 on credit.4. On January 4, Rahel purchased furniture and fixtures costing br. 2,000 for cash.5. On January 10, Rahel delivered her first painting to a customer, with the painting,

Rahel delivered a bill for services rendered of br.3,000 on credit.6. On January 11, the customer in transaction 5 paid half of his bill.7. On January 12, the account payable that result from transaction 3 was paid in full.8. On January 15, Rahel withdrew br.1,000 from the business for her personal use.9. On January 15, Rahel paid br.100 to sure-clean Inc-to clean the studio.10. On January 31, Rahel determined that she had br.900 of art supplies left on hand.11. On January 31, Rahel determined that unused prepaid rent was br.825.12. On January 31, Rahel estimated depreciation on Furniture and fixtures for the

month was br. 25.

Required show the effect of each of the above transactions on the accounting equation elements; show the balance after each transaction.


Owner’s Equity

Decreased by Increased by

Owner’s withdrawals Expenses

Owner’s Investments Revenues

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Financial Statements After the effect of individual transaction has been determined, the essential information is communicated to users. The accounting statements that communicate this information are called financial statements. Financial statements are the result of financial accounting process.There are four principal financial statements for proprietorships and partnerships:

1. Income statement; Presents the results of operations of an entity for a particular period of time. It is a summary of the revenue and the expenses of a business entity for a specific period of time, such as a year or month.

2. Balance sheet; Presents information about the financial position of an entity at a particular date. It is a list of assets, liabilities and owner’s equity of a business entity as of a specific date, usually at the close of the last day of a month or a year.

3. Statement of Cash flow; a summary of cash receipts and cash payments of a business entity for a specific period of time such as a month or a year.

4. Statement of Owner’s Equity; Presents information about how owner’s equity has changed over a particular period of time. It is the summary of the changes in the owner’s equity of a business entity that have occurred during a specific period time.

Income Statement

The excess of revenue over the expenses incurred in the earning the revenue is called net income. If the expenses of the enterprise exceed the revenue, the excess is a net loss.

It is ordinarily impossible to determine the exact amount of expense incurred in connection with each revenue transaction. Therefore, it is satisfactory to determine the net income or net loss for stated period of time.

The determination of periodic net income or net loss is a matching process involving two steps.

First, Revenues are recognized during the period. Second, the assets consumed in generating the revues must be matched against the revenues in order to determine the net come or the loss.

Example of Income Statement

Rahel PortraitsIncome Statement

For the month ended January 31, 2014 Revenue (sales)-----------------------------------------------------------3,000

Expenses:Cleaning expenses-------------------100 Supplies expense---------------------100Rent Expense ------------------------75

Depreciation----------------------------25 300


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Net income----------------------------------------------------------- 2700

Note that, income statement shows financial performance of the business during a period; it shows by how much the business was better off or worse off during the period.

Balance sheet - the purpose of balance sheet is to show financial position an entity on a particular date. Balance sheet format could vary from business to business. The most common and acceptable formats are: Report format, Account format and financial position format. The difference between these formats lies on the manner in which the information’s are arranged in the statement; therefore it is a matter of the appearance of the report not the content.

Report format – Under the report format liabilities and owner’s equity are listed below the asset section.

Account format – Under this formats assets are listed on the left and liabilities and owner’s equity are listed on the right. It resembles the accounting equation.

Financial position format- It is a vertical format in which current liabilities are deducted from current assets to derive working capital. Other assets then are added and other liabilities are deducted leaving a residual amount as a owner’s equity.

Example

Rahel Portraits Balance sheetJanuary 31, 2014

Assets LiabilitiesCash-------------------------31500 AlP---------------------------0Accounts Receivable------1500 Owner’s EquityArt Supplies---------------- 900 Rahel, Capital----------36700Prepaid Rent--------------- 825Furniture and Fixture------1975

Total Assets 36700

Statement of Owner’s EquityGenerally we have said that three types of transactions affect owner’s Equity during a period:-

1. Investment by owner2. Revenues and Expenses as a result of operation of a business: and 3. Withdrawal by owner.

The purpose of preparing statement of owners’ Equity is to summarize these transactions effect in summary form. It is considered as a link between the balance sheet and the income statement.Example

Rahel Portraits


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Statement of Owner’s Equity For the month ended, January 31, 2014

Balance Before January 1 ------------------------0Add: Investments in January-----------35000

Net income for January----------------- 2700Sub-total------------------------------------37700Less Withdrawals in January------------(1000)Balance , January 31----------------------36,700

Statement of Cash flows (SCF)In the statement of cash flow, it is customary to report cash flows (cash receipts and cash payments) in three sections

1. Operating activities2. Investing activities3. Financing activities

Operating activities - Cash flows that result from the day-to-day income producing activities of business.Cash flows in this section includes cash transactions that enter in to the determination of net income.Examples includeCash in flows:- Collection of Receivable, sale of merchandise on cash, collection of interest Revenue collection of dividend from investment in other co.Cash out flows:- Payments for creditors for purchase of inventory or supplies; and other payment for business operating costs, payment for interest on debt.Investing activities - Cash flows from investing activities section reports the cash transactions for the acquisition and sale of relatively long-term or permanent type assets. It includes purchase or sale of productive assets like: Building, Land, Machinery, furniture and Fixtures, etc and Purchase or sale of other companies debt or equity long term securities.Financing activities - the cash flows from financing activities section reports the cash transactions related to cash investments by the owner, borrowings and cash withdrawals of owner. For corporation form of business this include payment of dividend to stockholders; issuance of equity or debt securities; repayment of the loan principal.Example

Rahel Portraits Statement of Cash FlowsFor the month ended, January 31, 2014

Cash flows from operating activities:Cash Received from customers------------------------------------1500Cash payments for expenses and to creditors------------------ (2000) Net cash flow from operating activity (500)

Cash flow from investing activityCash payments for purchase of Furniture and Fixture-------(2000)


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Cash flow from Financing activityCash withdrawal by owner--------------------------------------(1000)

Net cash flow during the period ( 3500)Cash balance Jan1, 2014-------------------------------------------------------35000Cash balance Jan31, 2014-----------------------------------------------------31,500

Financial statement for corporation; lecture Read from the book - principles of Accounting 16 th ed. Fees warren

Assignment one1. Assume that a company has the following balances on December 31, 2013:

Total assets-------------------------------20,000Total liabilities---------------------------15,000

Required: A.What is the amount of owner’s equity?B.What is the amount of net asset?

2. Indicate the net effect each of the following transaction has on the amount of assets, liabilities, and owner’s equity. ( + for an increase, - for a decrease and – 0 – for no change).

Assets Liabilities Owner’s EquityA. Purchase of Supplies for cashB. Purchase of supplies on creditC. Payment of Monthly water billD. Payment of Employee salariesE. Payment of Rent for one month in advanceF. Payment of fee of independent accountantG. Payment of telephone billH. Payment of the next three years’ property insurance premiums in advance

3) The following are group of accounts as of January 31,2014

Cash----------------------------------15,000Acc. Rece.--------------------------- 6,000Inventory---------------------------- 7,000Furniture Fixture------------------- 10,000

Accounts payable----------------- ? J. Jones, capital------------------- ?

The J. Jones, capital account balance on January 1, 2014, was 4000, J. Jones invested 4,000 of his personal funds in the business during January. She withdrew no funds during the month, the net income for the month of January was 2,000.Required:


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A. Determine the balance of Accounts payable and J. Jones, capital as of January 31, 2014.

B. Prepare a balance sheet as of January 31, 2014.

4) The following are the year-end balance sheet amounts for company for three years

31 Dec. 31Dec. 3Dec. 31Assets 2011 2012 2013 Cash-------------------------------------- 10,000 15,000 16,000 Accounts Receivable------------------- 12,000 14,000 16,000Supplies------------------------------------ 1,000 1,000 2,000Equipment--------------------------------- 10,000 12,000 14,000Total Assets 33,000 42,000 48,000 Liabilities and Owner’s Equity

Accounts payable----------------1000 2000 3000Bank Loan payabl 10,000 15,000 17,00

X- Capital 22,00 25,000 28,000Total Liabilities and owner’s Equity 33,000 42 , 000 48,000

Additional information 2011 2012 2013 Personal withdrawals by-Mr. X 1000 2000 3000 Investments in business by Mr. X 9000 7000 9000 The balance in Mr. Xs’ Capital on January 1, 2011 was br. 8,000

Required:-

A. What was the net income or net loss for the business for 2011, 2012, and for 2013?

B. On the basis of business’s earning trend, do you think that a bank should lend the business more money? Explain.


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5. Mr.Abebe established Abebe services on July 1 of the current year. The effect of each transaction and the balances after each transaction for the month of July are as follows:


Cash + AccountsReceivable +

Supplies Accounts. Pay + Joan Bow an Capital

a + 3000 + 3000investm.bBal.

-2000 1000

-2000 1000

cBal.

--------1000

+ 550 550

+ 550 550

--------1000

dBal.

-45005500

_____550

________550

_+4500Fee 5500

eBal.

-2505250

____ 550

_-250_ 300

_____ 5500

fBal

-----5250

+ 12500 1250

-------550

--------300

+1250Fees Ea. 6750

g

Bal.-6554595

---------1250

---------550

----------300

-380-Auto.Ex.-275 Mis.Ex.6,095

hBal.

-10003595

________1250

________550

__________300

-1000saler. Ex.5095

iBal.

_______3595

________1250

-125425

________300

-125 supp.Ex.4970

jBal.

-12002,395

__________1,250

_______425

___________300

-1200withd.3770

Required:1. Prepare income statement for the month ended July 31.2. Prepare balance sheet as of July 31.


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3. Prepare a statement of owner’s Equity for the month ended July 31.4. Prepare a statement of cash flows for the month ended July31

6. following are the amounts of ABC Corporations assets and liabilities at October 31, the end of the current year, and its revenue and expenses for the year ended on that date, listed in alphabetic order.ABC Corporation had capital stock of br. 50,000 and retained earnings of birr 16,765 on November 1, the beginning of the current year. During the current year, the corporation paid cash dividends of birr 15,000 and received cash from sale of capital stock of birr 20,000. Cash received from customers was birr 189,500 and cash paid for expenses and to creditors was birr 185,500.

Accounts payable-------------------------------------------------------------- br.12,100Accounts receivable----------------------------------------------------------- 21,250Advertising expense----------------------------------------------------------- 5,500Cash------------------------------------------------------------------------------ 16,500Insurance expense-------------------------------------------------------------- 1,900Land------------------------------------------------------------------------------ 80,000Miscellaneous expense-------------------------------------------------------- 1,750Prepaid insurance -------------------------------------------------------------- 950Rent expense-------------------------------------------------------------------- 42,000Salaries payable---------------------------------------------------------------- 2,250Salaries expense---------------------------------------------------------------- 85,500Fees earned---------------------------------------------------------------------- 206,500Supplies-------------------------------------------------------------------------- 865Supplies expense--------------------------------------------------------------- 6,125Taxes expense------------------------------------------------------------------ 5,775Utilities expense---------------------------------------------------------------- 24,500

Required A. Prepare income statement for the current period ended , October 31B. Prepare a retained earning statement for the current period ended , October 31C. Prepare balance sheet as of October 31 of the current yearD. Prepare statement of cash flows for the current year ended October 31. The cash

balance on November 1, the beginning of the current year, was birr 7,500.


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Chapter twoThe Accounting Cycle

From lessons in chapter one, we have seen the transactions completed by an enterprise during a specific period may cause increases and decreases in many different assets, liability and owner’s equity item. To have the details of these transactions readily available and to prepare periodic financial statements the effects of transactions must be recorded in systematic manner. Although all transactions can be analyzed and recognized in terms of their effect on accounting equation, such a format is not practical a design for actual accounting system. Accountants must provide information on business transactions for use in directing operations and for the preparation of timely periodic financial statements. These goals are met by keeping a separate record for each item that appears on financial statements. The individual records are then summarized at periodic intervals and the data thus obtained are presented in the financial statements or other reports.

For example, a record would be used only for recoding increases and decreases in cash, another record would be used only for recording increases in Supplies, another for Land, Prepaid Rent, Sales, Salary expense, Rent expense, etc.

The type of record traditionally used for the purpose of recording individual transactions is called an account. A group of related accounts that comprise a complete unit, such as all of the accounts of a specific business enterprise, is called a ledger.

Classification of AccountsAccounts in the ledger are customarily listed in the order in which they appear in financial statements, and classified according to common characteristics. Balance sheet accounts are classified as assets, liabilities and owner’s equity. Income statement accounts are classified as revenues or expenses. In addition, there may be sub groupings within the major categories. Assets: Any physical thing (tangible) or right (intangible) that has a monetary value is an asset.Assets are , customarily divided into some groups for presentation on the balance sheet. The two groups used most often are:-

1. Current Assets


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2. Plant AssetsCurrent Assets:- Cash and other assets that may reasonably be expected to be realized in cash or sold or used up usually within one year or less, through the normal operations of the business, are called current assets.Examples include: - Cash, Accounts Receivable, Inventories, Prepaid Rents, Supplies, etc. Plant Assets: - Tangible assets used in the business that is a permanent or relatively fixed nature are called Plant assets or fixed assets. Examples include:- Equipment, Machinery, buildings, Land, vehicles, etc. With the exception of land, such assets gradually wear out or otherwise lose their usefulness with the passage of time is called depreciation.Intangible Assets:- Nonphysical things controlled by the business: Examples include:- Good will, Patents, Copyrights, Trade marks, Franchises, etc.Liabilities; Liabilities are debts owed to outsiders (creditors) and are frequently described on the balance sheet by titles that include the word “payable” The two categories occurring most frequently are :-

Current LiabilitiesLong-term Liabilities

Current Liabilities:- Liabilities that will be due with in a short time (usually one year or less ) and that are to be paid out of current assets are called current liabilities. Examples include: - Accounts payable, Notes payable salaries payable, Taxes payable, etc.Long-term Liabilities:- Liabilities that will not be due for a comparatively long time (usually more than one year) are called long-term liabilities or fixed liabilities. As they come with in the one-year range and are to be paid, such liabilities become current.If the obligation is to be renewed rather than paid, at maturity, however, it would continue to be classified as long-term. When payment of a long-term debt is to be spread over a number of years, the installment due with in one year from a balance sheet date are classed as current liabilities.Examples include:- Notes payable (long-term) , mortgage payables, etc.Owner’s Equity - is the residual claim against the business after the total liabilities are deducted. For a corporation, owner’s Equity is frequently called Stockholder’s equity or shareholder’s equity.Capital, Capital stock, Retained EarningCapital - is the owner’s equity in a sole proprietorship or partnership form business.Capital stock – represents the investment of stockholders.Retained Earning - represents the net income retained in business.Revenues – are the gross increases in owner’s Equity as a result of the sale of merchandise, the performance of services for customer or a client, the rental of property, the lending of money, and other business and professional activities. Revenue from sale of merchandise is often identified as sales. Other terms used to identify sources of revenue include professional fees, commission’s revenue; fares earned, and interest income. If an enterprise has various types of revenue, a separate account should be maintained for each.Expenses - Costs that have been consumed in the process of producing revenue are expired costs or expenses. The number of expense categories and individual expense accounts maintained in the ledger varies with the nature and the size of the business.


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CHART OF ACCOUNTSA listing of the accounts in a ledger is called a chart of accounts. The order of items (accounts) in the chart of accounts should agree with the order of the items in the balance sheet and the income statement. The accounts are numbered to permit indexing and also for use as references. For most simple (small) business organization has two digits: The first digit indicates the major division of the ledger in which the account is placed. Accounts beginning with 1 represent asset, 2 liabilities, 3 owner’s equity and drawing, 4 Revenue and 5 expenses. The second digit indicates the position of the account with in its division.

A numbering system of this type has the advantage of permitting the later insertion of new accounts in their proper sequence without disturbing the other account numbers. For a large enterprise with a number of departments, or branches, it is not unusual for each account number to have four or more digits.

Balance sheet Income statement 1. Assets 4 Revenue11 Cash 41 Sales12 Accounts Receivable 5 Expenses14 Supplies 15 Prepaid Rent 51 Supplies Expense18 Photographic Equipment 52 Salary Expense19 Accumulated Depreciation 53 Rent Expense 2 Liabilities 54 Depreciation21 Accounts Payable Expense 22 Salaries Payable 55 Miscellaneous

3 Owner’s Equity Expense

31 X- Capital32 X- Withdrawal

Nature of An AccountThe simplest form of an account has three parts:

1. A title - This is the name of item recorded in the account.2. A space for recording increases in the amount of the item, in terms of money, and3. A space for recording decreases in the amount of the item, in terms of monitory

units.This form of an account is known as T- account because of its similarity with the letter T.

Title

Left side Right side Debit Credit


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Debit: The left side of an account is called debit.Credit: The right side of an account is called credit.The word “charge” is sometimes used as synonym for debit. Amounts entered on the left side of an account regardless of an account title are called debits or charges to the accounts and the account is said to be debited or charged. Amounts entered on the right side of an account called credits and the account is said to be credited.Rule of Debit and CreditEvery Business transaction affects a minimum of two accounts. For each transaction the debit amount (or the sum of all debit amounts, if there are more than one) must equal the credit amount (or the sum of all the credit amounts). This is known as double–entry system. It follows that recording of a transaction in which debits do not equal credits is incorrect. For all the accounts combined, the sum of the debit balances must equal the sum of the sum of the debit balances must equal the sum of the credit balances; otherwise some thing has been done incorrectly. Thus, the debit and credit arrangement used in accounting provides a useful means of checking the accuracy with which the transactions have been recorded.

Double-entry system is based on accounting equation Assets = Liabilities + Owner’s Equity

For every dollar/birr entered as a debit to one account, a dollar /birr must be entered as a credit to some other account.


Debit side Credit side (Positive asset balance) (Positive liabilities and owners’ Equity

All Asset Accounts increase on the left hand side or debit side; and decrease on the right hand side or credit side. All Liabilities and Owner’s Equity accounts increase On the right hand side or credit side and decrease On the left hand side or debit side. This is known as General rule of debit and credit.


Debit Credit Debit Credit Debit Credit + - - + - +

The rules for recording revenues and expenses are derived from the rules for owner’s Equity. By definition revenue increases owner’s equity; and we have said that owner’s equity increase in the right (credit) side. It necessarily follows that revenues increase in credit side and decrease on debit side.Expenses are the opposite of revenues in that expenses decrease owners’ equity. Therefore it follows that Expenses increase with debit side and decrease with credit side.Drawing or Dividends, similar with expense decrease owners’ Equity; therefore increase with debit side and decrease with credit side.

Nominal or Temporary accounts Vs Real or Permanent Accounts


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Because Revenue and expense accounts are periodically closed, they are some times called temporary accounts or Nominal accounts. The balances of the accounts reported in the balance sheet are carried forward from year to year and because of their permanence are referred to as real accounts or permanent accounts. In short, all income statement accounts are nominal or temporary accounts that are going to be closed to the Balance sheet account ) owner’s Equity). Thus, the normal balance for an asset account is a debit balance and a normal balance for a liability or owner’s equity account is a credit balance.The normal balance for an expense account is a debit balance and a normal balance for a revenue account is a credit balance.

Summary:

Balance sheet Accounts Increase Decrease Norma Balance

Assets Debit Credit Debit Liabilities Credit Debit Credit

Owners Equity (Capital) Capital stock) Credit Debit Credit

Retained Earning Credit Debit Credit

Drawing /Dividend Debit Credit Debit Income statement Accounts

Revenue Credit Debit Credit Expense Debit Credit Debit

Note that when an account that normally has a debit balance actually has a credit balance, or vice versa, it is an indication of an accounting error or unusual situation. For example, a credit balances in asset account such as building, Land, Inventory, Equipment, etc. could result only from an accounting error. On the other hand, a debit balance in liability account could result from over payment.

Illustration of Recording transactions in T- Accounts.Assume that the following transaction take place during the month of November for the George Duncan Lumber company:- Nov1. The business is stated when George Duncan invests 100,000 in cash in a bank account in the company’s name. Nov.4 The Company purchases land for 28,000 in cashNov.7 The Company purchases buildings for 42, 000paying 12,000 in cash and signing a mortgage payable of 30,000.Nov.10. the Company purchases office equipment for 4,000 in cashNov.15 Duncan transfers to the company the title of a truck he owns that is worth

5000. The company will use the truck solely for making deliveries.Nov.18 Duncan withdraws 1000 from the company for his personal use.


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Nov.21 The Company purchases offices supplies for 750 on credit.Nov.23 the truck received from Duncan has been found to be too small. Thus, the Company acquires a larger truck by trading in Duncan’s truck and paying 3000 in cash.Nov.28 The Company pays 200 of the 750 owed for the office supplies purchased on Nov. 21.Nov. 30 The Company pays 300 on the mortgage payable.

Note: - Debits are listed vertically in chronological order on the debit (left) side of each account and that credits are listed vertically in chronological order on the credit (right) side of each account. In each case the date of the transaction is entered along the debit or credit.

Transaction Date Nov.1 Effect of transaction

(Analysis of transaction)Increase cash, and increase George Duncan, Capital

Cash George Duncan Capital

Nov.1 100,000 Nov.1 100,000

Nov.4 Cash Increase Land, Cash decrease

Nov.1 100,000 Nov.4 28,000

Land

Nov.4 28,000

Nov.7 Effect of Transaction Building increase, cash decreased and Mortgage payable increase

Cash Mortgage payable

Nov.1 100,000 Nov.4 28000 Nov.7 30,000 Nov.7 12,000

Transaction Date Building


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Nov.7 420000

Nov.10 Office Equipment increase and Cash decrease

Cash Office EquipmentNov.1 100,000 Nov.4 28000 Nov.10 4000

Nov.7 12000 Nov.10 4000

Nov. 15 Truck /Vehicles increase, and capital increase

Delivery vehicle George Duncan, capitalNov. 15 5000 Nov.1 100,000

Nov.15 5000

Nov.18 Cash and George Duncan capital decrease

Cash George Duncan, capitalNov.1 100000 Nov.4 28000 Nov.1 100,000

Nov.7 12000 Nov.15 5000 Nov.10 4000 Nov.18 1000 Nov.18 1000

Nov.21 Effect of Transaction office supplies and Accounts payable account increase

Office Supplies Accounts payable

Nov.21 750 Nov.21 750

Transaction DateNov.23 Delivery Vehicle both decrease and increase; cash decrease Delivery Vehicle Cash

Nov. 15 5000 Nov.23 5000 Nov.1 100000 Nov.4 28000Nov. 7 12000Nov. 10 4000

Nov. 18 1000 Nov. 23 3000


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Nov. 28 Accounts payable is decreased and cash also decrease

Cash Accounts payable

Nov.1 100,000 Nov.4 28000 Nov.30 200 Nov.21 750 Nov.7 12000 Nov.10 4000 Nov.18 1000 Nov.23 3000 Nov. 28 200

Nov. 30 Mortgage payable decrease and cash also decrease

Cash Mortgage payable

Nov.1 100,000 Nov.4 28,000 Nov.30 300 Nov7. 30,000 Nov.7 12,000 Nov.10 4000 Nov.18 1000 Nov.23 3000 Nov.28 2000 Nov.30 300

Journals and Accounts

The flow of accounting data from the time a transaction occurs to its recording in the ledger may be diagramed as follow:

⇒ ⇒ ⇒

The initial record of each transaction, or of a group of similar transactions, is evidenced by a business document; such as sales ticket, a bill, cash register tape. On the basis of the evidence provided by the business documents, the transactions are entered in chronological order in a journal .

The amounts of the debits and the credits in the journal are then transferred to the accounts in a ledger. This process of transferring the amounts of the debits and credits from the journal to the accounts in the ledger is known as Posting.

Two – Column Journal


Business TRANSACTIONS Occurs

Business DOCUMENT Prepared

Entry Recorded in JOURNAL

Entry Posted to LEDGER

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There is great variety in both the design of journals and the number of different journals that can be employed by an enterprise. A business may use a single all purpose two- column journal (general journal) or it may use a number of multi column journals (special journals) , restricting each for a single type of transaction.Before a transaction is entered in the two-column journal, it should be analyzed according to the following sequence of steps:-

1. Determine whether an asset, a liability, owner’s equity, Revenue or Expense is Affected Determine; accounts(s) affected

2. Determine whether the affected, liability, owner’s equity revenue or expense Increases or decreases Determine, whether the affected account increases or decreases.

3. Determine whether the effect of the transaction should be recorded as a debit or as a credit in an asset, liability, owner’s equity, revenue, or expense account. Determine whether the effect (increase or decrease) should be recorded as debits or credits.

The process of recording a transaction in a two-column journal is summarized as follow:

1. Record the date Insert the year at the top only of the Date Column of each page, except when the year date change. Insert the month on the first line only of the date column of each page, except when the month date changes. Insert the day in the date column on the first line used for each transaction, regardless of the number of transactions during the day.

2. Record the debit Insert the title the account to be debited at the extreme, left of the description column and enter the amount in the debit column. 3. Record the credit Insert the title of the account to be credited below the title of the account debited moderately indented, and enter the amount in the credit column. 4. Write an explanationBrief explanations may be written below each entry, It should be noted that all transactions are recorded only in terms of debits and credits to specific accounts.The titles used in the entries should be the same as the titles of accounts in the ledger. The line following an entry is left blank in order to clearly separate each entry.Look at the following General Journal and notice where each of the above information is found.

Journal Page__________Date Description P.R. Debit CreditYearMonth Day Debited Account title xx xx

Credited Account title xx xxExplanation

Each one set of debits and credits for a transaction is called a journal entry.


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Posting from the journal to the LedgerAfter the information about a business transaction has been journalized, that information is transferred to the specific accounts affected by each transaction. This process of transferring the information is known as posting.

Two – Column Accounts and Four – Column AccountsA simple form of an account is a T- account illustrated earlier; beside the T- account; The account could be a two- column account or a four – column account for each of them look at the following accounts format:-

The two- column account Account No._____________

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

The Four – Column account

Date Item P.R Debit Credit BalanceDebit Credit

The following are advantages of the four column account form:1. Only a single date column is required, with each debit and credit appearing in its chronological order.2. The debit or credit nature of an account balance is more easily determined and more Prominently displayed in the account3. Having immediately adjacent debit and credit columns makes it easier to examine the data in an account.

Steps in Posting:When posting is done manually, the debits and credits in the journal may be posted in the order they occur on if many items are to be posted at one time, all the debits may be posted first, followed by the credits. The posting of a debit or credit journal entry to an account in the ledger is performed as follow:

1. Record the date and amount of Dr. and Cr. Entry to the account.2. Insert journal page number in the P.R (Posting Reference ) column of the account.3. Insert the account number in the P.R of the journal.


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Illustration of Journalizing and Posting

Hill Photographic Studio Chart of Accounts:-1 Asset:

11 Cash12 Accounts Receivable14 Supplies15 Prepaid Rent18 Photographic Equipment19 Accumulated Depreciation – Photographic Equipment

2 Liabilities21 Accounts Payable22 Salaries Payable

3 Owner’s Equity31 Ann Hill, Capital 32 Ann Hill, Drawing33 Income Summary

4 Revenue41 Sales

5 Expenses51 Supplies Expense52 Salary Expense 53 Rent Expense54 Depreciation Expense 59 Miscellaneous Expense

Transactions

Mar 1, 1990. Ann Hill operated a photographic business her home on a part –time basis. She decided to move to rented quarters as of March 1 and to devote full time the business which was to be known as Hill photographic studio. The following assets were invested in the enterprise; cash, 3500, accounts Receivable 950 supplies 1200; and photographic equipment 15000. There Were no liabilities transferred to the business.March 1. Paid 2400 on a rental contract, the payment representing three months’ rent of quarters for the studioMarch 4. Purchased additional photographic equipment on account for 2500March 5. Received 850 from customers in payment of their accountsMarch 6. Paid 125 for a newspaper advertisement – Advertising expense considered as miscellaneous expense by Ann HillMarch 10. Paid 500 for the debt as a result of March 4 transactionsMarch 13. Paid receptionist 575 for two weeks’ salaryMarch 16. Received 1,980 from sale of serviceMarch 20. Paid 650 for supplies purchaseMarch 27. Paid 575 receptionists for two weeks’ salaryMarch 31. Paid 69 for telephone bill for the month


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March 31. Paid 175 for electric bill for the monthMarch 31. Received 1870 from sales of serviceMarch 31. Make sales on account for 1,675March 31. Hill withdrew 1500 for her personal use advertising expense, Electric expense, and telephone expense are classified as miscellaneous expense by Ann Hill.Required: Journalize and Post the above transaction.

General Journal Page 1

Date Description P.R Debit Credit1990March 1

Cash-Accounts ReceivableSuppliesPhotographic Equipment Ann Hill, Capital

3500 950 120015000

00000000 20650 00

1 Prepaid Rent Cash

2400 00 2400 00

4 Photographic Equipment Accounts payable

2500 002500 00

5 Cash Accounts Receivable

850 00850 00

6 Miscellaneous Expense Cash

125 00500 00

10 Accounts payable Cash

500 00500 00

Date Description P.R Debit Credit13 Salary Expense

Cash575 00

575 0016 Cash

Sale1980 00

1980 0020 Supplies

Cash 650 00

650 0027 Salary Expense

Cash575 00

575 0031 Miscellaneous Expense

Cash 69 00

69 0031 Miscellaneous Expense

Cash175 00

175 0031 Cash

Sales1870 00

1870 0031 Accounts Receivable 1675 00


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Sales 1675 0031 Ann Hill Drawing

Cash1500 00

1500 00

These Journal Entries are posted to the accounts in the accounts in the ledger as follow: Account Cash Account No11

Date Item P.R Debit CreditBalance Debit Credit

1990March 1 1 3500 00 3500 00

1 1 2400 00 1100 00

5 1 850 00 1950 00

6 1 125 00 1825 00

10 1 500 00 1325 00

13 1 575 00 750 00

16 1 1980 00 2730 00

20 1 650 00 2080 00

27 1 557 00 1505 00

31 1 69 00 1436 00

DateItem

P.R Debit CreditBalance Debit Credit

1990March 31 1 175 00 1261 00

31 1 1870 00 3131 00

31 1 1500 00 1631 00

2. Account Receivable Account No. 12


1990March 1 1 950 00 950 00

5 1 850 00 100 00


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31 1 1675 00 1775 00

3. Account supplies Account No.14


1990March 1 1 1200 00 1200 00

20 1 650 00 1850 00

4. Account Prepaid Rent Account No. 15


1990March 1 1 2400 00 2400 00

5. Account Photographic Equipment Account No. 18


1990March 1 1 15000 00 15000 00

4 1 2500 00 17500 00

6. Account accounts Payable Account No. 21


1990March 4 1 2500 00 2500 00

10 1 500 00 2000 00

7. Account Ann Hill Capital Account No.31


1990March 1 1 20650 00 20,650 00


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8. Account Ann Hill, Drawing Account No.32


1990March 31 1 15000 00 15000 00

9. Account Sales Account No. 41


1990March 16 1 1980 00 1980 00

31 1 1870 00 3850 00

31 1 1675 00 5525 00

10. Account Salary Expense Account No.52


1990March 13 1 575 00 575 00

27 1 575 00 1150 00

11. Account Miscellaneous Expense Account No. 59


1990March 6 1 125 00 125 00

31 1 69 00 194 00

31 1 175 00 369 00


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ASSIGNMENT TWO Journalize and post the following transactions completed by bati transport in the month of Meskerem 2007, and prepare trial balance as of Meskerem 31

Meskerem 1. Ato Yimer, the owner took birr 450,000 from his personal savings and deposited it in the name of Bati transport.Meskerem 2. Bati transport purchased two used trucks for birr 150,000 each on cash.Meskerem 4. Bati transport received a check for birr 650 for services given to Ato Alem trading.Meskerem 11. Paid birr 600 for Awash insurance company to buy an insurance policy

for its trucks.Meskerem 16. Ato Yimer issued (signed) a check for birr 9400 to the workers as a salary

for two weeks.Meskerem 20. Bati transport Billed Muradu Supermarket for goods transported from

Djibuti to Addis birr 2,650.Meskerem 21. Bati transport purchased stationary materials and other supplies for birr

740 on account.Meskerem 22. Office Equipment of birr 11,600 is bought on account. Meskerem 23. Purchased an additional truck for birr 250,000 paying birr 100,000 in cash

and issuing a note for the difference.Meskerem 23. Recorded services billed to customers on account birr 14,600.Meskerem 25. Received cash from customers on account birr 15,000.Meskerem 27. The owner withdrew birr 500 in cash for his personal use.Meskerem 28. Paid birr 9400 to workers as a salary for the last two weeks of the month. Meskerem 30. Paid telephone expense of birr 95 and electric expense of birr 125 for the

month.Meskerem 30. Paid other miscellaneous expenses birr 50.Meskerem 30. Paid birr 4000 as a rent for a building used for office.

Required A. Journalize and post the above transactionsB. Assumed chart of Accounts; Electric, Telephone and Water Expenses are

considered as one account known as Utilities Expense by Bati Transport. C. Prepare the trail balance /after the discussion


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TRIAL BALANCEThe equality of debits and credits in the ledger should be verified at end of each accounting period, such verification, which is called a trail balance, may be in the form of calculator tape or in the form below. A trial balance is a two column listing of the accounts in the ledger and their balance to make sure that the total debit balances equals the total credit balances. As the first step in preparing the trial balance, the balance of each account in the ledger should be determined.

Example- Debit Credit

CashAccounts Receivable Supplies Prepaid RentPhotographic EquipmentAccounts payableAnn Hill, CapitalAnn Hill, DrawingSalesSalary ExpenseMiscellaneous Expense

163117751850240017500

1500

1150369

0000000000

00

0000

250020650

5525

0000

00

Total 28175 00 28175 00

Proof provided by trial Balance

The trial balance does not provide complete proof of the accuracy of the ledger. It indicates only that the debits and the credits are equal. This proof is of value because most errors affect equality of debits and credits. If the two totals of a trial balance are not equal it is probably due to one or more of the following types of errors:

1. Error in preparing the trial balance , such as:a) One of the columns of the trial balance was incorrectly added.b) The amount of an account balance was incorrectly recorded on the

trial balance.c) A debit balance was recorded on a trial balance as a credit or vice-

versa, or a balance was omitted entirely.2. Error in determining the account balances, such as:

a) A balance was incorrectly computedb) A balance was entered in the wrong balance column.

3. Errors in recording a transaction in the ledger, such as:a) An erroneous amount was posted to the accountb) A debit entry was posted as a credit or vice versa


Hill Photographic StudioTrial Balance

March 31, 1990

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c) A debit or credit posting was omitted

Among the types of errors that will not cause an inequality in the trial balance totals are the following:

1. Failure to record a transaction or to post a transaction2. Recording the same erroneous amount for both debit and

credit part of a transaction3. Recording a single transaction more than once4. Posting a part of a transaction correctly as a debit or credit

but to the wrong account.

CHAPTER THREECOMPLETION OF THE ACCOUNTING CYCLEAccounting Cycle - is the sequence of accounting procedures of a fiscal period is known as Accounting cycle.Fiscal Year; Annual accounting period adopted by an enterprise is known as fiscal Year. Fiscal year ordinary begin with the first day of a particular month selected and end on the last day of the twelfth month hence.It could be coincide with calendar year but not mandatoryAmerica case most (64%) – fiscal year from January 1, to December 31.Ethiopia case most (Hamle 1-to –Sene 30)

The following are basic phases in Accounting cycle1. Transactions are analyzed and recorded in the journal2. Transactions are posted to the ledger3. Trial balance is prepared, data needed to adjust the accounts are assembled, and the work sheet is completed4. Financial statements are prepared5. Adjusting and closing entries are journalized6. Adjusting and closing entries are posted to the ledger7. Post-closing trial balance is prepared8. Reversing certain adjusting entries (optional)

Accrual basis of Accounting Vs cash basis of Accounting

1. Accrual basis of Accounting- Revenues are reported in the period they are earned, and expenses are reported in the period incurred regardless of the time of cash receipt or payment. Revenues Earned- when a service /product is sold to customers. i.e. when the seller’s side obligation is complete. Expenses are incurred when the service of some asset is used, when some assets are consumed or when the services of some Employees or party is used rather than when cash is paid. Accrual basis of Accounting is used by most business enterprises and it is inline with GAAPs basically the matching principle.


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2. Cash basis of Accounting- Revenues are reported in the period in which cash is received and expenses are reported in the period in which cash is paid.Net income (or net loss) is the difference between cash receipts and cash disbursements in operating activity. Small service enterprises, which have few receivables and payables such as accountants, physician, may use the cash basis of accounting. It is not in line with GAAPs; basically it violates the matching principle.

Matching PrincipleThe Expenses incurred in producing revenue should be matched with recognized revenue.Nature of the adjusting processFinancial reporting on annual, quarterly or monthly basis requires accountants to summarize the operations of business enterprises for specific time period. All the trial balance amounts are not necessarily correct at the end of a particular period because of adjustment requirements.The entries required at the end of an accounting period to bring the accounts up-to-date and to assure proper matching of revenues and expenses are called adjusting entries.Adjusting entries are required only under accrual basis of accounting.Adjusting entries are end of accounting period entries because some financial events are not recognized on a day-to-day basis.Note- 1. If all financial events are recognized on a day-to-day basis, there is no need of

adjusting entry.Note-2. Every adjusting entry affects both a balance sheet account and an income

statement account.Generally, there are two types of Adjusting entries: 1. To apportion prepayments of Expenses or pre collection of Revenue (Deferrals)

2. To record Accrued Expenses and Revenue (Accruals)

Purpose of adjusting Entries

1. To measure all assets and Liabilities correctly2. To measure net income correctly by matching expired costs (Expenses) with realized revenue.

1. To apportion prepayments of Expenses or pre-collection of Revenue (Deferrals)a) Apportionment of Recorded costs.

b) Apportionment of Recorded Revenues2. To record Accrued Expenses and Revenue (Accruals)

a) Accrual of unrecorded Expensesb) Accrual of unrecorded revenue

1. Deferralsa. Apportionment of rerecorded costs:I. Pre payments (prepaid Expenses): Eg. Supplies, prepaid Rent, prepaid insurance, etc. Two alternative ways of recording the pre payments initially:


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1. Pre-payments are initially recorded in asset account:Adjusting entry- Reduce asset account and increase expense account for the amount of asset consumed or for cost expired during a period.Example: 1. According to the Hill photographic studio trial balance, the balance in trial

balance for supplies account is 1850. Clearly some of these supplies have been used during the past month (March) and some may be still in stock.

Therefore either of the two information is used to enter the required journal entry to up date supplies account and supplies expense account. Assuming that the inventory supplies on March 31 is determined to be 890.

Supplies available on book. (Balance in the account)-----------------1850.Less supplies on hand (inventory)--------------------------------------- --890

Supplies used (amount of adjustment)-------------------------------- 960

Adjusting entry- decrease asset account and increase expense account for the amount of adjustment:

Therefore: Supplies Supplies Expense Mar1, 1200

20, 650 960 960 31, 890 1850

Example: 2. The debit balance of 2400 in Hill’s prepaid rent account represents a pre payment on March1 of rent for three months. (March, April and May)

At the end of March, the rent expense account should be increased (debited) and the prepaid Rent account should be decreased (credited) by the amount of prepaid rent expired for march- 2400/3 = 800

Prepaid Rent Rent Expense

March1, 2400 800 800 1600

If the preceding adjustments for supplies (960) and prepaid rent(800) are not recorded, the financial statements prepared as of March31, will be incorrect (misleading) to the extent indicated as follow:

On Income statement:Expenses (supplies Expense for 960Rent Expense for 800 will be understated ---------1760Net income will be overstated----------------------- 1760


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On statement of Owner’s Equity:Net income will be overstated---------------------------1760Ending Owner’s Equity will be over stated ------------1760

On balance sheet: Assets (Supplies and prepaid Rent) overstated---------------------1760 Owner’s Equity will be overstated ----------------------------------1760

2. Pre-payments are initially recorded in an Expense account Adjusting Entry- Reduce expense account and increase asset account for the amount of asset not yet consumed or cost not expired. On the 1st day of the next period reversing entries are required to facilitate consistency in recording.Example1. If Hill recorded purchase of supplies in a supplies expense account at the time of purchase; before adjustment supplies Expense Account has a debit balance of 1850. The adjusting entry reduces the supplies expense account and increase the supplies account for the unconsumed part of supply.

Supplies Expense Supplies Mar1.1200

20 650 M31890 Mar31 890 960 1850

Example 2.Similarly if Hill recorded payment of rent in advance as an expense (Rent Expense) before adjustment Rent Expense account has a debit balance of 2400. Therefore, the adjusting entry reduce Rent Expense account and increase the asset pre-paid rent for the amount of pre-payment not yet expired.

Rent Expense Prepaid RentMar1. 2400 1600

Mar31. Mar31.1600 800

Exercise: If the above adjusting entries are not made what is the effect on income Statement, statement of owner’s Equity and balance sheet prepared as of March 31 under case 2 above

II. Plant AssetsLike supplies and other pre-payments plant asset was used in operation once acquired. Unlike supplies there is no visible reduction in the quantity of plant asset. However, as time passes, plant asset lose its capacity to provide useful services. This decrease in usefulness is a business expense, which is called depreciation expense.


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The adjusting entry to record depreciation is similar to the adjusting entry for prepayments when initially recorded as assets. i.e. adjusting entry reduces the asset account and increases the expense account.

Example: Assume that estimated amount of deprecation for Hill is 175 for March.

Photographic Equipment Accumulated Depreciation-Equipment

Mar1. 150004 2500 Mar.31 175 17500

Depreciation Expense

Mar.31.175

Apportionment of Recorded RevenueWhen a business enterprise receives payment for goods and services before goods are delivered or the services are performed, a liability exist until performance takes place.When cash is received, the original transaction may be recorded by a credit to a liability (Unearned Revenue) account or to a revenue account.1. Advance (pre) collection is initially recorded in a liability account.Adjusting Entry: - Reduce the liability account and increase the Revenue account for the earned portion of revenue during the period.Example: Assume that customer paid 500,000 birr for magazine subscription at the beginning of the year. Assuming that only magazines having a price of 425,00birr have been delivered to customers during the year; and the collection of cash was initially recorded as a liability the following adjusting entry is required at end of this year: Unearned subscription Subscription Revenue

Bal.Dec.31 500,000425,000

Adj. Entr.425, 000

2. Advance (pre) collection is initially recorded in a revenue account.Adjusting Entry: - Reduce the revenue account and increase the liability account for the unearned portion of revenue during the period. On the 1st day of the next period, reversing entry is required to facilitate recording consistency.Example: Assume the above example, except the initial collection of cash was recorded in a revenue account.

Subscription Revenue Unearned subscription


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Bal.Dece.31 500,00075,000

Adjusting Entry 75000

2. To record Accrued Expenses and Revenue (Accruals)a. Accrual of unrecorded ExpensesAccrued Expenses or accrued liabilities, are expenses that have been incurred but have not been recorded in the accounts. The incurring of certain expenses is related to the passage of time. The expenses generally are not recorded until payment is made, unless the end of accounting period comes before the required date of payment.Examples: Interest, salaries, TaxesIn order to measure expenses accurately for a period, an adjusting entry is necessary to record the accrued expenses and the corresponding liability.Example1: Assume that interest of 18000 on a 400,000 note payable is paid on March1

and September 1 of each year. If expenses and liabilities are to be reported the following year end adjusting entry is required on December 31 of the year.

Interest Expense Interest payable

Adj. Entry 12000 12,000

6 month 6 month

J F M - A - M - J - J - A - S - ON - D_-__ (1)

(1)Annual Expense = 18000X2 = 36000Monthly Expense = 36000/12 = 3000From September 1-to – December 31 = 4 monthsInterest Expense = 4 x 3000 = 12000On March 1 (next year) payment comes:

Interest expense --------6000Interest payable--------12000

Cash---------------------------18000

Example 2. The debits of 575 on March 13 and 27 in a salary expense account for Hill photographic studio were biweekly payments on alternate Fridays for the payroll periods ended on those days. The salaries earned on Monday and Tuesday March 30 and 31, total 115. This amount is additional expense of March 31, therefore credited to Salaries payable:

Salaries payable Salaries Expense


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Mar.13 575 Mar. 31 115 27 575

115031 115

1265

b. Accrual of Unrecorded RevenueRevenue that has been realized but not recorded must be recognized at the end of an accounting period. Accrued revenues or accrued assets, are revenues that have been earned but have not been recorded in the accounts.Examples include: Fees for services that an attorney has provided but has not billed to the client at the end of the period, unbilled commissions by travel agent, accrued interest on notes receivable, and accrued rent on property rented to others.In order to measure accurately the results of operations, revenues are recognized in the period earned.Example: Assume that rent totaling 625 that has been realized but not collected for the month of adjusting entry on December 31, is required to measure assets and Revenue correctly.

Rent Receivable Rent Revenue 625

Dece31. Ad. Entry 625

Example: At the end of the current year, 7,260 of fees have been earned but have not been billed to clients. The required adjusting journal entry is:

Accounts Receivable Fees Earned

Dec31, 7,260 7,260

Example 2: refer to example 1 under accrued expense.

The interest expense accumulated for the borrower is the interest revenue accumulated for it is a liability for the borrower and is an asset (interest receivable) for the lender; hence on the book of the lender the required adjusting entry is

Interest Receivable Interest Revenue


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Adj. Entry—12,000 12,000

Summary of Basic Adjustments:Type of Adjustment Adjusting Entry Effect of omitting

Adjusting Entry on Deferred Expense---xx B/sheet and/statement I. Deferrals Expense (1) Asset--------xx - Expense understated and

NI overstated

- Assets and owners Equity overstated (2) Asset---xx - Expense overstated and Expense----xx NI understated

Deferred Revenue (1) Liability—xx - Revenues understated

and NI understated Revenue---xx - Liabilities overstated

And owner’s Equity Understated

(2) Revenue ----xx - Revenues overstated and NI overstated

Liability-----------xx - Liabilities understated And owners Equity

overstated Fixed Assets Expense ------xx - Expenses understated and NI overstated Contra Asset-------xx - Assets overstated and owner’s Equity

overstated II. Accruals Accrued Expense---xx - Expense understated Expense Liability----xx -Liabilities understated and owner’s Equity overstated

Accrued Asset-------xx - Asset understated and Revenue owner’s Equity understated

Revenue------xx - Revenues understated


0926 17 58 17


and Net income understated

WorksheetAccountants often use working papers for collecting and summarizing data they need for preparing various analysis and reports. Such working papers are useful tools, but they are not considered as part of formal financial statements.Work sheet is a working paper that accountants can use to summarize adjusting entries and the account balances for financial statements.A work sheet is an important tool, but is not an essential part of the accounting system, like accounts, journal, or ledger; for example for small companies with few accounts and adjustments, a worksheet may not be necessary.The work sheet is identified by:

1. the name of the enterprise2. the nature of the form (work sheet)3. the period of time involved.

A commonly used work sheet has an account title column and ten (10) money columns divided in to five pairs of debits and credit columns.

The main headings of the five pairs of money columns are:1. Trial Balance2. Adjustments3. Adjusted Trial Balance4. Income Statement5. Balance sheet


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Example-Work sheetHill photographic studio

Work sheetFor the month ended march31, 1990

S.N Account Title Trial Balance Adjustment Adjusted Trial Balance Income Statement Balance Sheet

Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit

1 Cash 1631 00 1,631 00 1631 00

2 Accounts Recv. 1775 00 1775 00 1775 00

3 Supplies 1850 00 a.960

00 890 00 890 00

4 Prepaid rent 2400 00 b.800

00 1600 00 1660 00

5 Photographic Equ. 17500 00 17500 00 17500 00

6 Accounts Payable 2000 00 2000 00 2000 00

7 Ann Hill Capital 20650 00 20650 00 20650 00

8 Ann Hill, drawing 1500 00 1500 00 1500 00

9 Sales 5525 00 5525 00 5525 00

10 Salary Expense 1150 00 d. 115

00 1265 00 1265 00

11 Miscellaneous Exp. 369 00

12 28175 00 28175 00

13 Supplies Expense a.960 00 960 00 960 00

14 Rent Expense b. 800

00 800 00 800 00

15 Depreciation Exp. c. 175

00 175 00 175 00

16 Accumulated Dep. c.175 00 175 00 175 0017 Salaries paya. d. 115 00 115 00 115 0018 2050 00 2050 00 28465 00 28465 00 3569 00 5525 00 24896 00 22940 0019 Net Income 1956 00 1956 0020 5525 00 5525 00 24896 00 24896 00



TRIAL BALANCE COLUMN

Lists account balances before adjustment.

2. ADJUSTMENT COLUMN

Both the debit and credit parts of an adjustment should e inserted on the appropriate lines before going on to another adjustment. Cross referring the related debit and credits of each adjustment by letters (numbers) is important for reviewing the work sheet later, and also when recording the adjusting entries in the journal. The order in which the adjustments are entered on the work sheet is not important most accountants enter the adjustments in the order in which the data are assembled.

If the titles of some of the accounts to be adjusted do not appear in the trial balance, they should be inserted in the Account Title column, below the trial balance totals.Explanation for Entries in adjustment columns of the Hill photographic studio work sheet:

a. Supplies: - The supplies account has a debit balance of 1,850 under the trial balance column. This represent the acquision cost of supplies; but as discussed Earlier, the cost of supplies; on hand at the end of the period is 890; there

fore the adjustment is entered by writing 1. Supplies Expense in the Account title column and 2. 960 in the adjustments Debit column on the same raw, 3. 960 in the Adjustment credit column on the line with supplies.

b. Rent: - The prepaid rent account has a debit balance of 2400; earlier we have determined the rent expense for March amounts 800. Therefore, the

adjustment is entered on the work sheet by writing: 1. Rent Expense in Account title column2. 800 in the adjustments Debit column on the same line.3. 800 in the adjustments credit column on the line with prepaid rent

c. Depreciation: - Depreciation of photographic Equipment was estimated at 175 for the month. Therefore the adjustment is entered by writing:

1. Depreciation Expense on Account Title column2. 175 in the adjustment Debit column of the Depreciation Expense account line.

3. Accumulated Depreciation in the Account title column and 4. 175 in the adjustments credit column on the line with Accumulated Depreciation.

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d. Salaries: - Salaries accrued, but not paid at the end of March amounts to 115. The adjustment is entered by writing1. 115 on the adjustments debit column on the same line with salary Expense.2. Salaries payable in the Account Title column

3. 115 on the adjustments credit column on the same line with salaries payable.

The final step in completing the Adjustments columns is to prove the equality of debits and credits.3. Adjusted Trial Balance ColumnsThe data in the trial balance columns are combined with the adjustments column data and extended to the Adjusted trial balance column.4. And 5. Income statement and Balance sheet columnThe data in the adjusted trial balance column is extended to any one of the remaining four columns under the Income statement and Balance sheet columns.All Balance sheet accounts:- Assets, liabilities and owner’s Equity (capital and Drawing) are extended to the balance sheet column having their appropriate balances.All income statement accounts are i.e Revenues and Expenses are extended to Income statement column of the worksheet.After all of the balances have been extended each of the four columns is totaled, the net income or the net loss for the period is the amount of the difference between the totals of the two income statement columns. If the credit column total is greater than the debit column total, the excess is the net income, if the reverse is true, then the excess is the net loss. After this difference (Net Income /Loss) is computed this is inserted in the worksheet by writing.1. Net Income (Loss) under the Account Title column 2. The amount is entered in the debit column of the income statement column if it is Net income; or entered in the credit column of the income statement column if it is Net loss.3. The amount is entered in the credit column of the Balance sheet column if it is net income; and it is entered in the Debit column of the balance sheet column if it is net loss.After the final entry is made on the worksheet, each of the four columns is totaled to verify arithmetic accuracy.

A. Financial Statements The worksheet is an aid in preparing financial statements. The income statement, statement of owner’s equity, and balance sheet are prepared from the work sheet.Journalizing and posting Adjusting Entries.

At the end of the accounting period, the adjusting entries appearing in the worksheet are recorded in the journal and posted to the ledger. This procedure brings the ledger into agreement with the data reported on the financial statement. The adjusting entries are dated as of the last date of the period.

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Closing Entries

The revenue, Expense, drawing (dividend) accounts are temporary accounts used in classifying and summarizing changes in the owner’s Equity during the accounting period.To report amounts only for one period temporary accounts should have zero balances at the beginning of a period. Closing entries transfer the balances of temporary accounts to the owner’s capital account. An account titled “ Income summary” is used for summarizing the data in the revenue and expense accounts.It is used only at the end of the accounting period and is both opened and closed in the closing process. Others use for the same purpose account titles such as: Expense and Revenue Summary, Profit and Loss Summary, or Income and Expense Summary.Four entries are required in order to close temporary accounts of a sole proprietor ship at the end of a period:1. Each Revenue account is debited for the amount of its balance, and Income Summary is credited for the total revenue

Revenue1---------xx “ 2--------xx

“ 3-------xx Income Summary-----------xx

2. Each expense account is credited for the amount of its balance, and Income Summary is debited for the total expense.

Income Summary-----------xxExpense 1--------------------xxExpense 2--------------------xxExpense 3--------------------xx

3. Income Summary is debited for the amount of its balance (net income) and the capital account is credited for the same amount. (Debit and credit are reversed if there is net loss.)4. The drawing account is credited for the amount of its balance, and the capital account is debited for the same amount.

Example- For Hill photographic studio

1. To close Revenue:Sales------------------------5525 Income Summary--------------------5525

2. To close Expenses:Income summary------------3569 Salary Expense-----------------------1265 Miscellaneous Expense-------------369 Supplies Expense-------------------960 Rent Expense-------------------------800 Depreciation Expense---------------175

3. To close the Income Summary:Income Summary------------1956

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Ann Hill, Capital----------------19564. To close Drawing account

Ann Hill, Capital--------1500Ann Hill, Drawing----------15000

Post closing Trial BalanceThe last procedure of the accounting cycle is the preparation trial balance after all of the temporary accounts have been closed. The purpose is just to make sure that the ledger is in balance at the beginning the new accounting period. The account titles and amounts should agree exactly with the accounts and amounts listed on the balance sheet at the end of the period.

Example:

Hill photographic studioPost-closing Trial Balance

March 31, 1990

Cash ---------------------------------------------1631Accounts Receivable--------------------------1775Supplies-----------------------------------------890Prepaid Rent-----------------------------------1600Photographic Equipment--------------------17500Accumulated Deprecation----------------------------------175Accounts payable--------------------------------------------2000Salaries payable-----------------------------------------------115Ann Hill, Capital--------------------------------------------21,106 23,396 23,396

Assignment three 1. The balance in the supplies account, before adjustment at the end of the year is 1,475. Journalize the adjusting entry required if the amount of supplies on hand at the end of the year is 241.

2. At December 31, the end of the first month of operations the usual adjusting entry the income statement transferring supplies used to an expense account is omitted. Which items will be incorrectly stated, because of the error on: -

a. income statement b. the balance sheet

c. Indicate whether the items in error will be overstated or understated3. The balance in pre-paid Insurance account before adjustment at the end of the year is 4,280. Journalize the adjusting entry required under each of the following alternatives for determining the amount of adjustment.

a) The amount of Insurance expired during the year is 1,020.b) The amount of un expired Insurance applicable to the future period is 3,260.

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4. The balance in the unearned fees account, before adjustment at the end of the year is 6,750. Journalize the adjusting required if the amount of unearned fees at the end of the year is 2,800.5. At the end of the current year, 7,260 of fees have been earned but have not been billed to customers. Journalize the adjusting entry to record the accrued fees.6. The accountant for maxim medical co. mistakenly omitted adjusting eateries for to customers. Journalize the adjusting entry to record the accrued fees.

A. Unearned Revenue 10,390 andB. Accrue wages for 2,440

Indicate the effect of each error, considering individually, on the income statement for current year ended December 31. Also indicate the effect of each error on December 31, balance sheet. Note that the unearned revenue account was initially recorded in a liability account.

7. From the following list, identify the accounts that should be closed to Income summary at the end of Fiscal year:

A. Accounts payableB. Accumulated Depreciation- BuildingC. Depreciation Expense- Building D. x, CapitalE. x, DrawingF. EquipmentG. Fees EarnedH. LandI. Salaries payableJ. SuppliesK. Supplies Expense

8. Which of the following accounts will appear in the post-closing trial balance?A. Accounts ReceivableB. Accumulated DepreciationC. CashD. Depreciation ExpenseE. EquipmentF. y, capitalG. y, DrawingH. Fees earnedI. SuppliesJ. Wages ExpenseK. Wages payable

9. The trial balance of Addis Company on July 31, 2014, the end of current fiscal year, is shown at the below

Addis CompanyTrial BalanceJuly 31, 2014

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Cash-----------------------------------------------3,290Supplies-------------------------------------------5,850Prepaid Insurance--------------------------------3,000Equipment---------------------------------------109,750Accumulated Depreciation-----------------------------------------52,700Accounts payable-----------------------------------------------------4,950Addis, Capital---------------------------------------------------------39,450Addis, Drawing-----------------------------------3,500Service Revenue------------------------------------------------------77,900Wages Expense----------------------------------23,400Rent Expense------------------------------------16,400Utilities Expense---------------------------------8,500Miscellaneous Expense-------------------------1,310

175,000 175,000

The data needed to determine year-end adjustments are as follow:

a. Supplies on hand at July 31, are 1,140.b. Insurance premiums expired during the year are 1,500.c. Depreciation of equipment during the year is 6,000.

d. Wages accrued but not paid at July31 are 1,100.

Instructions:

1. Enter the trial balance on a ten-column worksheet and complete the work sheet. Add accounts as needed.

2. Prepare an income statement, a statement of owner’s Equity (No additional investment were made during the year), and the balance sheet.

3. On the basis of adjustment data in the work sheet, journalize the adjusting entries.4. On the basis of the data in the worksheet, journalize the closing entries.

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CHAPTER FOUR ACCOUNTING FOR MERCHANDISING BUSINESSMerchandising enterprise acquires merchandise for resale to customers. Difference Between merchandising, manufacturing and service Enterprises:

Merchandising enterprise acquires an item for resale to customers having the original form. Eg. Retailers, whole sellers

Manufacturing companies acquire raw material and convert the raw material in to some product and sale the product.

Service companies render a service to customers; these companies do not have any inventory to be reported except supplies.

Accounting for InventoriesPurchase of merchandise are treated based on the inventory system employed by business Enterprise. There are two alternative inventory systems that can be employed by businesses. These are:

1. Periodic inventory system2. Perpetual inventory system

1. Periodic inventory system: Under this system the cost of all merchandise purchased is accumulated in a “Purchase” account; i.e when purchases are made for cash or on account the transactions are recorded as follow:

Purchase-------------------------------------------xxCash) Account payable)--------------------------xx

When sales are made, the revenues from sales are recorded when sales are made, but no attempt is made on the sales date to record the cost of merchandise sold. The cost of merchandise sold during the period and the cost of inventory on hand is determined through the physical cont of inventory and cost flow assumptions.

2. Perpetual merchandise Inventory system:Purchase of inventory is directly accumulated in the “Inventory” account. When merchandise is sold the amount is recorded in cost of goods sold, In this manner the accounting records continuously (perpetually) disclose the inventory on hand.

Purchase Discount The arrangements agreed upon by the buyer and the seller as to when payments for

merchandise are to be made are called credit terms. If payment is required immediately up on delivery, the terms are said to be “cash” or “net

cash” otherwise the buyer is allowed a certain amount of time, known as the credit period, in which to pay.

It is usual for the credit to begin with the date of sale as shown by the date of invoice or bill. If payment is to due within a stated number of days after the date of invoice, say 60days, the terms are said to be “net 60days” which may be written as “n160”

If payment is due by the end of the month in which sales was made, it may be expressed as “nleom.”

As a means of encouraging payments before the end of credit period, the seller may offer a discount for early payment of cash. Thus, the expression “4120, n160” means that, though the

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credit period is 60 days, the buyer may deduct 4% of the amount of invoice if payment is made with in 20 days after the invoice date. This deduction is known as cash discount.From the buyer’s stand point, it is important to take advantage of all available discounts, even it is necessary to borrow the money to make the payments, when the discount given is attractive as compared with the market interest rate.

When there is purchase discount, two methods of accounting for purchases of merchandise are used under the periodic method. These are the gross method and the net method.

i. The Gross method- under this method, the purchase is recorded at the invoice amount before deduction of any related cash discount.

ii. The Net method- under this method purchase is recorded at the invoice amount less any related cash discount.

Example: If Faros company purchases merchandise costing 1,000birr on July 15. On terms 2110, n130, the transaction is recorded under the two methods as follow:

Gross Purchase------------------------1, 000Method: Accounts payable--------------------1, 000

Net method Purchase -----------------------980Accounts payable-----------------980

If the payment is made with in the discount period (10 days for example above) , the buyer is entitled to pay the net amount(980). Under the Gross method a purchase discount account is used by the purchases to accumulate discounts actually taken. However, if the net method is employed, cash discounts taken are not recorded. Thus, if the discount is taken by the purchaser, the cash payment is taken by the purchaser, the cash payment is the same under both methods, further, both methods result in the same cost of purchases if discount is taken. This is because, under the gross method, purchase discounts are subtracted from purchases account on the income statement.

If payment is not made with in the discount period, the discount is lost and the total invoice amount (1000 here) going to be paid by the buyer. Under the gross method, since the invoice amount (1000) liability is recorded, the Discount lost is not recorded in the books. However, under the net method, the Discount lost is rerecorded.

For Example above

A. Payment with in the Discount periodi. Gross method:

Accounts payable--------xx1,000Purchase Discount----------------xx20 Cash------------------------------xx980

ii. Net method:Accounts payable ---------xx980

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Cash -------------------------------xx1, 000

B. Payment after Discount Period Expirei. Gross method:

Accounts Payable------------------xx1,000Cash-----------------------------------xx1,000

ii. Net methodAccounts payable --------------------xx980Discount lost---------------------------xx20

Cash----------------------------------------xx1000

Under the net method, discounts are recorded in the accounts only if they are lost. This procedure calls management’s attention to cares, which should be taken in payment bills. Under the gross method, purchase discount is subtracted from the purchase accounts to determine cost of goods sold. However, under the net method, purchase Discount lost is an expense that is classified under the other Revenue and Expense. Theoretically, the net method is preferable because purchases and resulting liabilities are recorded at their cash equivalents. In practice, however, more firms use the gross method of recording Purchases because it is simpler and because the birr (dollar) difference between the two methods is normally not significant.

Purchase Returns and Allowances Some times merchandise received from suppliers is defective or otherwise not acceptable. In such event, the buyer may return it (purchase return) or the buyer may negotiate on price adjustment (purchase Allowance). In either case part or all of the purchaser’s liability to the supplier is eliminated. To make this information more ready available to management, the purchase Returns and Allowance account is credited for the amount of liability (Account payable) eliminated.

The details of why the return or allowance is requested may be stated in a letter or by a debit memorandum form used by the buyer. The seller may confirm through credit memorandum. Purchase returns and Allowance is a contra purchase account, same with purchase discount account.

Example: If half of the 1,000 worth of merchandise acquired by Fraol Company on July 15 were returned, on July 20, the following entry would be required using gross method:

Accounts payable---------------------xx500PurchaseReturns and Allowance -----------------xx500

If the net method is used; Accounts payable is debited and purchase return and Allowance is credited for the percentage proportion of the return in the original invoice; computed as follow for the above example:

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= Cost of product Returned (Price Reduction)/Total invoice price X Net purchase price after discount

= 500/1000 X 980 = 490, hence: Accounts payable ----------------490

Purchase Return Allowance----------- 490

Accounting for saleRevenues from merchandise sales are usually identified in the ledger as sales. A business may sell merchandise for cash or on credit. Some times sales of merchandise may be done through different credit cards. Sales to customers who use bank credit cards (such as Master card and VISA-us case) are generally treated as cash sales. Sales made by the use of nonblank credit cards (such as American express) generally must be reported periodically to the card company before cash is received. Therefore, such sales create a receivable with the card company. Before the card company remits cash it normally deducts a service fee.

Thus, sale of merchandise is recorded as:1. Cash ----------xx

Sales-------------------xx

2. Account Receivable-------xx Sales-------------------------xx

Example: A sale of merchandise for 1000birr cash is recorded as:Cash-----------------1, 000

Sales----------------------1, 000

The same sale on Account is recorded as:Account Receivable -----------1,000

Sale----------------------------1, 000

At the time of collection, cash is debited and Accounts Receivable is credited; If the receivable is as a result of credit card sale credit card collection expense is debited for the expense amount, the receivable Account is credited for the total amount and the cash account is debited for the difference.Sales Discount

The seller refers to the discounts taken by the buyer for early payment of an invoice as sales discounts. They are recorded by debiting the sales Discount account and are considered to be reductions in the amount initially recorded in sales. That is, the balance of sales discounts account is viewed as a contra (or off setting) account to sales.

Trade DiscountsMany manufacturers and whole sellers periodically publish catalogs advertising

their merchandise at list prices. However, a reduction from list price may be granted based on the volume of merchandise purchased or on the nature of the

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purchaser (whole-seller, retailer, or ultimate consumer.) A trade discount is a convenient means of making price reductions without reprinting catalogs. Thus business may offer special discount from the list price for customers that order large quantities. Both buyers, and sellers do not normally record the list prices of merchandise and the related trade discounts in their accounts. i.e. Trade discounts are not recorded in the accounts of either the seller or the buyer but are deducted from the product list price in arriving at the selling price; both the purchaser and seller record the transaction at the determined selling price.

Example: Wholesaler sells merchandise with a list price of 1,000 birr at a trade discount of 20 percent, a sale of 800 will be recorded by the seller. Similarly purchase

a of 800 is recorded by the buyer. If an additional cash (sales) discount is involved, it is based on invoice price rather on the list (gross) price. Trade discounts are frequently stated in terms of a series of discounts, such as 25/20/10, i.e. 25% of list price, 20% of remainder and again 10% of reminder.

Example: If a wholesaler sells merchandise with a list price of 1,000, at a trade discount stated as 25/20/10, then the items selling price would be:

List price-----------------1, 000 Less 25% discount---- (250) Remainder--------------750 Less 20% discount ------(150)

Remainder----------600 Less 10% discount------- 60 Selling price---------------540

Sales Returns and Allowances To maintain good customer relationship, many businesses permit buyers to return merchandise (sales Return) so long as it is undamaged and is returned with in a reasonable period. In some situations the purchaser may prefer to retain the goods, rather than return them, provided a price adjustment (sales allowance) is made. The sales Returns and Allowance account is used to record both sales returns and sales allowances. If the return or allowance is for sale on Account, the seller usually gives the buyer a credit memorandum, which shows the amount in particular receivable account is to be credited and the reason therefore.

Example: If a merchandise costing 100 birr is returned: The journal entry to record the return:

A. If the sale was made on creditSales Return and allowance--------100

Account Receivable------------------100B. If the sale was made on cash:

Sales Returns and Allowance-------100Cash---------------------------------------100

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Sales TaxesAlmost all states (governments) levy a tax on sales of merchandise, except when merchandise is purchased for reselling purpose. i.e. Business that purchase merchandise for resale to others are normally exempt from paying sales taxes on their purchases. Only final buyers (ultimate users of the item) normally pay sales taxes. The liability for the sales tax is ordinarily incurred at the time the sale is made regardless of the terms of sale.

Cash (Account Receivable) --------xxSales-------------------------------xxSales tax payable-----------------xx

EXERCISES

The following transactions were completed by ABC company during October of the current year.

Oct.1. Purchased Merchandise from XYZ co. for birr 10,500, terms FOB destination, n130.

3. Purchased merchandise from QRS co. for birr 8,000, terms FOB shipping point 2110, n/eom. Transportation costs of 150 birr were paid by ABC Co.

4. Purchased merchandise from EDF Co. for birr 7500, terms FOB destination, 2110, n130.

6. Issued debit memorandum to EDF Co. for 1,000 birr of merchandise returned from purchase on October 4.

13. Paid QRS Co. for invoice of October 315. Paid EDF Co. for invoice of October 4.19. Purchased merchandise from KLM Co. for 5,000 birr, terms FOB shipping point

n/eom.

Paid transportation charges of 120 birr on October 19 purchase.Purchased merchandise from GHI Co. for 8000birr, terms FOB destination 1/10 n130.

30. Paid GHI Co. for invoice of October 20.31. Paid XYZ co. for invoice of October 1.31. Paid KLM co. for invoice of October 19.

Required:Journalize the entries to record the transactions of ABC Company for October.Example: a sale of merchandise for 1000birr on Account subject to a 4% sales tax is recorded:

Account Receivable ------------1,040Sale---------------------------------1000Sales Tax payable----------------- 40

Periodically, the appropriate amount of sales tax is paid to the taxing unit, and sales Tax payable is debited.

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Perpetual Inventory system As stated earlier, in perpetual inventory system, each purchase and sale of merchandise is recorded in an inventory account. As a result the amount of merchandise available for sale and the amount sold are continuously (perpetually) disclosed in inventory records.

Accounting for PurchaseUnder the perpetual inventory system merchandise purchases are recorded as follow:

Merchandise Inventory---------------------xxCash or Account payable----------------xx

Example: Purchase merchandise having a price of 15000 on Account is recorded as Merchandise Inventory-----------------------15, 000

Account payable----------------------------------15000Purchase DiscountUnder perpetual system also, there is possibility of using the gross method or the net, method for recording the purchases of merchandise. But the gross method is widely used and it is merchandise inventory, which is going to be credited when discount is taken.Example: Purchase inventory at a price of 1500 terms 2110,n130 on January 12 is recorded as follow:

Gross method:Merchandise inventory----------1500

Account payable----------------1500i. Payment within the discount period

Account payable-------------1500Cash-----------------------------1470

ii. Payment after discounts period Expires:Account payable-----------------1500

Cash-----------------------------------------1500

Net Method:Merchandise Inventory--------------------1470

Account Payable---------------------------1470i. Payment within the discount period:

Account payable-------------------1470Cash---------------------------------------1470

ii. Payment after discount period Expires:Account payable----------------------1470Discount lost-----------------------------30

Cash--------------------------------------1500

Purchase Returns and AllowancesPurchase Returns and allowances are recorded in perpetual system as:

Accounts payable (cash) ------------xx900Merchandise Inventory-------------------xx900

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Accounting for sales:The sale transaction is recorded in similar manner as sin the case of periodic inventory system; However, under the perpetual inventory system, the cost of merchandise sold and the reduction in merchandise inventory should also be recorded.

Sale: Cash /Account Receivable -----------xxSale----------------------------xx

To record sale

CGS: Cost of goods sold------------------xxMerchandise Inventory---------------xx

Sales DiscountSame with periodic inventory system; i.e. if the discount is taken by the buyer the record is as follow:

Cash------------xxSales Dis. -----xx Accounts Rec.--------xx

To record collection within discount period

Sales Returns and AllowancesSame with periodic inventory system; but under the perpetual system, to keep the cost of goods sold and merchandise inventory accounts up to date, a record debiting merchandise inventory and crediting cost of goods sold is also necessary. Thus, sales returns and Allowance is recorded as follow:

Sales Return and Allowance---------------xxAccount Receivable (cash)---------------xx

To record sales return or Allowance

Merchandise Inventory------------xxCost of merchandise sold-----------xx

To record cost of merchandise returned

Transportation Costs (Freight Cost)The terms of sale should indicate when the ownership (title) of the merchandise posses to the buyer. This point determines which party the buyer or the seller, must pay transportation cost.The ownership of merchandise may pass to the buyer when the seller delivers the merchandise to the transportation company or freight carrier. In this case, the terms are said to be FOB (Free on board) shipping point. Under this term the buyer bears the transportation costs.The shipping point is, the point where the shipment originates. The buyer then pays the transportation costs to the final destination, such costs are part of the buyers the buyer’s total cost of purchasing inventory and should be added to the cost of the inventory by debiting purchase (periodic inventory system) or merchandise inventory (perpetual inventory system).

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Example: Assume that on June 10,ABC Company purchases form XYZ Company on account for 1850, terms FOB shipping point, and pays transportation cost of 150 birr. ABC Company records this transaction as follow:

1. Perpetual system:i. Merchandise Inventory-------------1850

Account payable----------------------------1850To record purchase merchandise

ii. Merchandise Inventory----------------150Cash---------------------------------150

To record payment of shipping cost

2. Periodic systemi. Purchase--------------------1850

Accounts payable------------------1850 To record purchase of merchandise ii. Purchase--------------------1850

Cash-------------------------------1850To record payment of shipping cost.

Sometimes, ownership of the merchandise may pass to the buyer when the buyer receives the merchandise in its warehouse. In this case, the terms are said to be FOB destination, and the seller bears the transportation cost.

In this case, the seller debits Transportation out or Delivery Expense, which is reported on the seller’s income statement as an expense.

Seller’s Warehouse Buyer’s Warehouse 1. FOB shipping point- buyer pays transportation cost and.

debits merchandise inventory (purchase) account 2. FOB Destination- seller pays transportation costs and

debits transportation (Freight) out or Delivery Expense account.

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Shipping Point

FreightCost

Destination


EXERCISEEach merchandising transaction affects a buyer and a seller. This exercise shows how the same transactions would be recorded by both the seller and the buyer. Assume the seller is Fraol Company and the buyer is Roza Company. Record the following transactions on both the seller (Fraol) and buyer (Roza) Company. Use perpetual Inventory system.July1. Fraol Company sold merchandise on account to Roza Company for 7500birr, terms FOB shipping point, n145. The cost of merchandise sold was birr 4500.July 2. Roza Company paid transportation costs of birr 150 on July1. Purchase from Fraol Company.July 5. Fraol Company sold merchandise on account to Roza Company for 5000 birr, terms FOB destination, and n130. The cost of merchandise sold was 3500birr.July 7. Fraol Company paid transportation of 250birr for delivery of merchandise sold to Roza Company on July 5.July 13. Fraol Company issued Roza Company a credit memorandum for merchandise returned having a price of 1000 birr. The merchandise had been purchased by Roza Company on account on July5. The cost of merchandise returned was

7000birr.July 15. Fraol Company received payment from Roza Company for purchase of July5.July 18. Fraol Company sold merchandise on Account to Roza Company for birr 12,000, terms FOB shipping point 2110, nleom. Fraol Company prepaid transportation cost of 500birr, which were added to the invoice. The cost of the merchandise sold was 7200.July 23. Fraol Company received payment from Roza Company for purchase of July 18.

Periodic Reporting for Merchandising EnterpriseTrought the life of a business enterprise, the operating data for the fiscal year must be summarized and reported for the use of managers, owners, creditors, various governmental agencies, and other interested persons. Summaries of the various assets of the enterprise on the last day of the fiscal year, together with the status of the equities of creditors and owners, must also be reported. The ledger which contains the basic data for the reports, must then be brought sequence of accounting cycle remain the same for all kinds of business except the nature of the transaction and the accounts affected.

Cost of Merchandise Sold For merchandising enterprise that use periodic system, the cost of merchandise sold during the period is reported in separate section in the income statement. The general formula for computing cost of merchandise sold during a period is: Beginning merchandise Inventory--------------------xx Add: Net Purchases------------------------------xx : Transportation In--------------------------xx Merchandise available for sale ----------xx Less: Ending Merchandise inventory---------xx Cost of Merchandise sold--------------xx

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Example: Given the following data for ABC co. for 1991- Merchandise Inventory, July 31, 1991--------------125,000 Merchandise Inventory, August 31,1990----------115,000 Purchases ----------------------------------------------550.000 Purchase Returns and Allowances-------------------4, 250

Purchase Discounts------------------------------------3, 200Transportation In---------------------------------------3, 950

On the basis of the above data, prepare the cost of merchandise sold, for the fiscal year ended July31, 1991 for ABC Company.

Solution:Beginning inventory------------------------115, 000 Add: Net purchase

(550,000-4,250-3200)--------------545,750 : Transportation In---------------------3, 950

Cost of Merchandise available for sale-------546, 500Less: Ending Merchandise inventory--------125, 000

Cost of Merchandise sold-----------------21, 500

Adjusting Entries for Merchandising Business:Merchandise adjustmentsThe best method of making the data reading available, for reporting the cost of merchandise sold, is to maintain a separate account entitled merchandise Inventory. Thought an accounting period this account shows the inventory at the beginning of the year under periodic inventory system. At the end of the period it is necessary to remove from merchandise inventory at the beginning of the period and to replace it with the amount representing the inventory at the end of the period. This is accomplished by two adjusting entries. The first entry transfers the beginning inventory to Income summary. Since this beginning inventory is part of the cost of merchandise sold, it is debited to Income summary. It is also a subtraction from the asset account, Merchandise Inventory, hence is credited to merchandise inventory.

For the amount of beginning Income summary------------xx inventory

Merchandise Inventory--------xx

To transfer the beginning inventory to Income summary

The second adjusting entry debits the cost of the merchandise inventory at the end of the period to the asset account, merchandise Inventory. The credit portion of the entry effects a deduction of the unsold merchandise from the cost of merchandise available for sale during the period.

For the amount of ending Merchandise Inventory-----------xx inventory

Income Summary--------xx

Adjustments for Deferrals and Accruals

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Financial Statements The basic financial statements for merchandising enterprise include: Income statement, statement of owner’s Equity, and balance sheet. For corporate enterprise, the statement includes statement of Retained earning instead of statement of owner’s Equity. The basic difference between the financial statement of a merchandising enterprise and a service enterprise include the cost of merchandise sold section of the income statement, and the inclusion of merchandise inventory on the balance sheet as current asset.Income Statement There are two widely used formats for preparing an income statement for a merchandising business: Multiple step and single step.

1. Multiple-step FormThe multiple-step income statement contains several section, subsections and subtotals. In practice, there is considerable variation in the amount of detail presented in these sections. For example instead of reporting separately the gross sales and related returns, allowances and discounts, the statement may begin with net sales. Similarly, the supporting data for the determination of the cost of goods sold may be omitted from the statement.

A- Typical model of or a multiple-step income statement

ABC Company Income statement

For the year Ended December 31,2006Revenues From Sale:

Sales---------------------------------------------------------------xxLess: Sales Ret. All---------------------------------xx

Sales Discount-------------------------------xx xxNet sales-----------------------------------------------------------xx

Cost of merchandise sold: Beginning Merchandise Inventory------------------------xx

Purchases-----------------------------------------xxLess: Purch.Ret.Al------------------------------xx

Purch. Discount------------------------xx xx Cost of goods available for sale------------------------------xx Less: Merchandise, ending----------------------------------xx

Cost of merchandise sold-------------------------------------xxGross profit-----------------------------------------------------xxOperating Expenses:

Selling Expense: Sales salaries Expense-----------------xxAdvertising Expense-------------------xxDeper. Exp-store Equipment----------xxMiscellaneous selling Expense--------xxetcTotal selling Expense ----------------------------xx

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Administrative Expenses:Administrative salary expense------------------xxRent Expense--------------------------------------xxInsurance Expense--------------------------------xxetcTotal Administrative Expense-------------------------xx

Total operating Expense -----------------------------------------------------xx Operating Income--------------------------------------------------------------xx

Other income: Interest Income-------------xx Rent income-----------------xx Total other income------------------xx

etcOther Expenses--------------xxInterest Expense--------------xxTotal other Expense----------------xx xx

Net income-----------------------------------------------------------xx

The sections of the multiple-step-income statementRevenues From sale: The total of all charges to customers for merchandise sold, both for cash and on account, is reported in this section. Sales returns and allowances and sales Discounts are deducted from the gross amount to yield net sales.Cost of Merchandise sold: The cost of merchandise sold during the period may also be called the cost of goods sold or cost of sales.Gross profit: The excess of net sales over the cost of merchandise sold is called gross profit. It is sometimes called gross profit on sales or gross margin. Operating Expenses: Most merchandising business classify operating expenses as either selling expense or administrative expenses. Expenses that are incurred directly in the selling of merchandise are selling expenses. They include such expenses as a salesperson’s salary store supplies used, depreciation of store equipments, and advertising. Expenses incurred in the administration or general operations of the business are Administrative expenses or general expenses. Examples of these expenses include president salary, depreciation of office equipment, office supplies used. Credit card expenses are also classified as administrative expense. Expenses that are related to both selling and administration may be divided between the two classifications. In small business, however such expenses as Rent, Insurance, and taxes are commonly reported as administrative expenses. Transactions for small, infrequent expenses are often reported as miscellaneous selling expense or miscellaneous Administrative expense.

Income from Operation- The excess of gross profit over the total operating expenses is called income from operation or operating income. The relationship of income from operations to total assets and to net sales are important factors in judging the efficiency and profitability of operations. If operating expenses are greater than the gross profit, the excess is called loss from operation.

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Other income and other expensesRevenue from sources other than the principal or primary operating activity of a business is classified as other income. In merchandising business, these items include income from interest, Rent, gains from sale of fixed assets. Expenses that cannot be traced to directly to operations are identified as other expenses. Interest expenses that result from financing activity and losses incurred in the disposal of fixed assets are examples of these items.

Other income and other expenses are offset against each other on the income statement. If the total of other income exceeds the total of other expense, the difference is added to income from operation if the revers is true; the difference is subtracted from income from operations. Net income;The final figure on the income statement is net income (net loss). It is the net increase (or net decrease) in owner’s equity as a result of the period’s activities.

2. 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 that determine net income. A criticism of a single-step form is that such amounts, as gross profit and income from operations are not readily available for analysis. But its advantage is that it is simple.

A typical model for a single-step income statement

ABC Company Income StatementFor the year ended, December31, 2006

Revenues: Net sales---------------------xx Interest Income------------xx Rent Income----------------xxTotal Revenue-------------------------------xxExpenses: Cost of merchandise sold-------xx Selling Expenses----------------xx Administrative Expenses-------xx Interest Expenses---------------xx Total Expenses--------------------xx Net Income------------------------------xx

Retained Earnings statementThe retained earnings statement summarizes the changes, which have occurred in the retained earnings account during a fiscal year. It serves as a connecting link between the income statement and the balance sheet.

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A typical model for statement of Retained Earning:

ABC CompanyRetained Earnings statement

For the year ended, December31, 2006

Beginning Retained Earning--------------------------------------------------xxAdd: Net income for the year----------------------------------------xx

Subtotal xx

Less: Dividends during the year---------------------------------------xx Retained Earning End of year------------------------------------------xx

Sometimes, the analysis of retained earnings may be added at the bottom of the income statement to form a combined income and retained earnings statement.Note; the statement of Retained earnings is prepared only for corporate form of business.Statement of Owner’s EquityFor sole proprietorship and partnership form of business, statement of owner’s Equity is prepared. The statement of owner’s equity for merchandising business is prepared in the same manner for service business.A typical model for statement of Owner’s Equity:

ABC CompanyStatement of Owner’s Equity

For the year ended, December 31,2006

Beginning Capital------------------------------------------------------xx Add: Net income--------------------------------------xx : Additional investment--------------------------xx xx

Sub-total----------------------------------------------------------------xx Less: Withdrawal-----------------------------------------------------xx Ending, capital---------------------------------------------------------xx

Balance SheetThe balance sheet of a merchandising business could be prepared in any of the formats discussed in earlier chapters; i.e. Account form (Liabilities and owner’s equity on the right hand side and assets on the left hand side), Report form or Financial position format (down ward sequence of assets, liabilities and owner’s Equity). The balance sheet of a merchandising business is slightly different from that of service business because of the inclusion of merchandise inventory at the end of the period in the current asset section of the merchandising business.

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A typical model of Balance sheet:ABC CompanyBalance Sheet

As of December 31, 2006 Assets: Current Assets: Cash------------------------------------------xx

Accounts Receivable----------------------xx Interest Receivable-------------------------xx Merchandise inventory--------------------xx Office Supplies-----------------------------xx Prepaid Insurance--------------------------xx

Total current Asset---------------------------xx Plant Assets:

Land--------------------------------------------xxEquipment ------------------------xx

Less: Acc. Depn. ----------xxTotal Plant Asset------------------------------xxTotal Asset-------------------------------------xx

Liabilities:Current Liabilities:

Accounts payable-----------xxSalaries payable--------------xx

Total current Liabilities-------------------xx Ling term Liabilities:

Notes payable-----------------xxMortgage bond payable------xx

Total Long-term Liabilities-----------------xx Total Liabilities------------------------------xx Owner’s Equity

A, Capital -----------------------xxB, Capital------------------------xxC, Capital ------------------------xx

Total Capital----------------------------xxTotal Liabilities and Owner’s Equity--------------xx

If the form of business is corporate form, the owner’s equity section is different from this mode, it reports balances in ending retained earnings, and stock issued and outstanding on the statement date.

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Adjusting Entries Adjusting Entries for Merchandising Business:Merchandise adjustmentsThe best method of making the data reading available, for reporting the cost of merchandise sold, is to maintain a separate account entitled merchandise Inventory. Thought an accounting period this account shows the inventory at the beginning of the year under periodic inventory system. At the end of the period it is necessary to remove from merchandise inventory at the beginning of the period and to replace it with the amount representing the inventory at the end of the period. This is accomplished by two adjusting entries. The first entry transfers the beginning inventory to Income summary. Since this beginning inventory is part of the cost of merchandise sold, it is debited to Income summary. It is also a subtraction from the asset account, Merchandise Inventory, hence is credited to merchandise inventory.

For the amount of beginning Income summary------------xx inventory

Merchandise Inventory--------xx

To transfer the beginning inventory to Income summary.The second adjusting entry debits the cost of the merchandise inventory at the end of the period to the asset account, merchandise Inventory. The credit portion of the entry effects a deduction of the unsold merchandise from the cost of merchandise available for sale during the period.

For the amount of ending Merchandise Inventory-----------xx inventory

Income Summary--------xx

Adjustments for Deferrals and AccrualsSame with what was discussed in previous chapterWorksheet – same

Merchandise Inventory shrinkage Under the perpetual inventory system, a separate merchandise inventory account is maintained in the ledger to record increases and decreases in the account. During the accounting period, this account shows the amount of merchandise for sale, at any time. However, merchandising business may experience some loss of inventory due to shoplifting, employee theft, or errors in recording or counting inventory. As a result, the physical inventory taken at the end of the accounting period may be differ from the amount of inventory shown in the inventory records. The difference is known as inventory shrinkage or inventory shortage. The adjusting entry debits cost of goods sold and credits the merchandise inventory account for the amount of shrinkage.

Example: If the inventory records of a company shows that 63,950 of merchandise inventory balance, but the physical inventory taken on the same date indicates a balance of only 62,150- it means that a shrinkage for this year is 1800(63950-62150) and the following adjusting entry is required.

Cost of merchandise sold--------1800Merchandise Inventory----------1800

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Closing EntriesThe closing entries for a merchandising business are similar to those for service business. The first entry closes the temporary accounts with credit balances such as sales, purchase Returns and Allowance, purchase Discount, Interest Income, rent income, etc to Income summary.i.e,

Sales----------------------------------xxPurchase Return allowance--------xxPurchase Discount------------------xxInterest Income --------------------xx

Income summary------------------xxTo close all income statement Accounts with credit balance.

The second entry closes the temporary accounts with debit balances, such as, purchase, sales Returns and allowances, Sales Discounts, cost of merchandise sold, Transportation in operating Expenses, etc. to Income summary account. i.e, Income summary--------------------xx Sales Returns and allowance------------xx Sales Discounts----------------------------xx Purchases------------------------------------xx Transportation in --------------------------xx Different operating Expenses-------------xx

The third entry closes the balance of the income summary account to the owner’s capital account or Retained Earnings account. i.e; If there is net income (credit balance in Income summary account after the 1st and 2nd closing entry) Income summary--------------------xx Capital /retained Earnings--------------xx If there is net loss, the account debited and credited is reversed as follow: Capital, Retained Earnings-----------xx

Income Summary----------------xxTo Close the Income summary account

The fourth entry closes withdrawal (Drawing) or Dividend account to owner’s capital or Retained Earnings.

i.e, Owner’s, Capital /Retained Earnings------------xx Owner’s, drawing/Dividends---------------xxTo close Drawing or Dividend account.

The income summary account, as it will appear after the merchandise inventory adjustments and the closing entries have been posted has a balance, which is either a credit (net income) or a debit (net loss).

After all temporary accounts have been closed; the only accounts with a balance are assets, contra assets, liability and owner’s equity accounts. These accounts are listed in a post-closing

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trial balance to verify the debit –credit equality of the balances of these accounts, which should correspond exactly with the amounts appearing on the balance sheet.

Reversing EntriesSome of the adjusting entries recorded at the end of a fiscal year have an important effect on transactions that will occur in the following year. To simplify the analysis and recording of subsequent transactions related to such adjusting entries, an optional procedure-the use of a reversing entry-may be used. As the term implies, the reversing entry is the exact reverse of the adjusting entry to which it relates, i.e, the amounts and the accounts are the same, the accounts debited and credited are merely reversed.

Reversing Entries may be required (suggested) after the following adjusting eateries:I. Deferrals

1. Prepaid Expenses- When prepaid Expenses are initially recorded as expenses2. Pre (Advance) collection- when pre-collections are initially recorded as

Revenues.Reversing Entry helps here in order to keep consistency in recording in the following year.II. Accruals

1. Accrued Expenses /Liabilities2. Accrued Revenues /assets

Here, reversing entry helps to simplify the analysis and recording of subsequent transaction related to these adjusting eateries.Interim StatementsBusinesses frequently prepare financial statements at intervals with in the fiscal year, such as monthly, quarterly, or semi annually. Statements issued for periods covering less than a fiscal year are called interim statements. The analysis and recording of transactions is performed on a continuous basis through out the fiscal year, regardless of when financial statements are prepared. When interim financial statements are to be prepared, the adjustment data are assembled and the worksheet is completed as of the end of the interim period. However, adjusting and closing entries are not recorded in the accounts. These eateries are recorded only at the end of the fiscal year.

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CHAPTER-5ACCOUNTING FOR MANUFACTURING ENTERPRISESComparison of merchandising and manufacturing enterprises

o merchandisers buy and resell goodsonly one type of inventory – merchandise inventory

o manufacturers convert raw materials into finished goods using direct labor (DL) and factory or manufacturing overhead (MOH) costs

o three types of inventories A. raw material (RM) inventory – stocks of raw materials to be used in the production processB. work in progress (WIP) inventory – products some way in the production process i.e. products

not yet completely manufactured C. finished goods (FG) inventory – completely manufactured goods awaiting sale cost of goods manufactured = WIPB + RMused + DLcost incurred + MOHcost incurred –WIPE

Cost classificationo different costs classification bases behavior – variability with volume of activity

A.fixed cost – doesn’t change in total with changes in the volume of activity e.g. rent expense, depreciation expenseB.variable cost – changes in total in proportion to the changes in the volume of activity e.g. sales

commission, raw material used, etc traceability – relationship with cost object (anything for which a cost measurement is

necessary e.g. product, customer, department, process A.direct costs – costs incurred for the benefit of one specific cost object B.indirect costs – costs incurred for the benefit of more thane one cost object

controllability – level of control over incurrence of the cost A.controllable costs – costs which may be directly regulated at a given level of management

authority e.g. variable costs are generally controllable B.uncontrollable costs – costs which cannot be influenced by the action of a specified member of

the enterprise e.g. fixed costs are generally uncontrollable relevance – whether it can be affected by particular action or decision being made

A.relevant costs – are future costs which differ under different alternatives and influence or make a difference in a decision being made

B.irrelevant costs – are costs that will not be affected by a decision (cost that do not change regardless of the action being taken or decision being made

inventoriable – whether cost should be expensed or recorded as asset when incurred A.product (also called inventorable/manufacturing) – costs (including DM, DL and MOH) that

should be debited to inventory account and then to cost of goods sold when the inventory is sold

B.period costs – costs that should be expensed at the time of incurrence o note that a given cost type may be place in more than one classes of costs depending on

purpose for which cost is being determined e.g. o classifications are useful in understanding cost patterns, analyzing performance, and

planning future operations

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Manufacturing costs (Product Costs) o manufacturing cost (also called factory or product cost – refer to total costs of

manufacturing a product and include A.direct material cost – costs of materials that are

used only in manufacturing a product clearly and easily traceable to the product included in the final product and its cost include purchase price, transportation, storage and handling costs

B.direct labor costs – wages, salaries and other benefits paid to all employees actually working on materials to convert them into finished goods

C.manufacturing over head costs – manufacturing costs that cannot be traced directly to a specific unit of product and include: indirect material costs – costs of materials used in manufacturing a product but

cannot/will not, for practical reasons, be traced directly to the products e.g. factory supplies and cleaning materials, lubricants,

indirect labor – wages, salaries and other benefits paid to employees that cannot or will not, for practical reasons, be traced to a product being manufactured e.g. salary to factory maintenance and cleaning employees, storekeepers, etc

depreciation on factory capital assets, factory utilities, factory rent, etc

Manufacturing cost terminologieso prime costs –sum of DM and DL costs incurred to manufacture a producto conversion costs –sum of DL and MOH costs

+ +

o non-manufacturing costs (also called period costs) – refer to expenditures more related to a time period rather than to a final product and include selling and marketing costs – all costs necessary to secure customer orders and

deliver finished products to the customer e.g. sales commissions, advertising, delivery, sales supplies, depreciation on store and marketing/selling facilities

administrative costs – all costs incurred outside the manufacturing and marketing units of a company or incurred for the benefit of the company as a whole e.g. salaries, wages and benefits to officers and employees outsider manufacturing and marketing units, office supplies, rent, insurance, and depreciation on office facilities

non-manufacturing costs are expensed when incurred

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Direct material

cost

Direct labor cost

Manufacturing overhead costs

Product cost (manufacturing or

factory cost)+ =+

Prime Cost

Conversion costs


5.1 General and cost accounting systemso two types of accounting systems in manufacturing enterprise

1.general accounting system records all transactions and events outside the manufacturing unit provides information mainly useful to external users

2.cost accounting system records manufacturing activities provides information about manufacturing activities for :

A. Planning, organizing and controlling activities and evaluating performance.

B. other decision making including product costing and pricing C. preparation of reports for external purposes

Two basic cost accounting systems job order costing process costing

5.2 Flow of product costs through accounts (perpetual inventory system)o purchase of raw materials (direct and indirect) on account

raw materials xxaccounts payable xx

o transfer of raw materials (direct and indirect) to production (uses of raw materials) work in process xx

raw materials xx

o accrual of wages, salaries and other benefits (direct and indirect) work in process xx

wages, salaries and other payables xx

o recording of MOH costs other than indirect material and indirect labor work in process xx

accumulated depreciation – factor equipment xxfactory utility payable xxfactory prepaid insurance xx

o transfer of work completed finished goods xx

work in process xx

o sales of finished goods accounts receivable xxcost of goods sold xx

sales xxfinished goods xx

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5.3 Flow of product costs in the manufacturing process

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5.4 Financial statements and year-end entries for manufacturing enterpriseso statement of cost of goods manufactured – a schedule used to summarize

manufacturing costs and determine cost of goods manufactured

ABC Pharmaceuticals Share CompanyStatement of Cost of Goods Manufactured

For the year ended December 31, 2007Direct materials:

Raw materials, January 1, 2007 $70,000Add: Purchases of raw materials 390,000Raw materials available for use $460,000Deduct: Raw materials, December 31, 2007 (50,000)

Raw materials used in production $410,000Direct labor 60,000Manufacturing overhead:

Insurance, factory $6,000Indirect labor 100,000Machine rental 50,000Utilities, factory 75,000Supplies 21,000Depreciation, factory 90,000Property taxes, factory 8,000Total overhead costs 350,000

Total manufacturing costs $820,000Add: work in process, January 1, 2007 90,000 Total cost of goods in process $910,000Deduct: work in process, December 31, 2007 (60,000)Cost of goods manufactured $850,000

o income statement

ABC Pharmaceuticals Share CompanyIncome Statement

For the year ended December 31, 2007

Sales $1,500,000Cost of goods sold:

Finished goods, January 1, 2007 $125,000Add: cost of goods manufactured 850,000Goods available for sale $975,000Less: Finished goods, December 31, 2007 (175,000)

Cost of goods sold (800,000)Gross margin $700,000Less: operating expense: Selling expense $250,000Administrative expense 300,000 (550,000)Net income $150,000

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o comparative income statement for a merchandising business

ALEM Drugs Share CompanyIncome Statement

For the year ended December 31, 2007Sales $1,000,000Cost of goods sold:

Merchandise inventory, January 1, 2007 $100,000Add: purchases 650,000Goods available for sale $750,000Less: Merchandise inventory, December 31, 2007 (150,000)

Cost of goods sold (600,000)Gross margin $400,000Less: operating expenses:Selling expense $100,000Administrative expense 200,000 (300,000)Net income $100,000

o balance sheet (current assets section)

ABC Pharmaceuticals Share CompanyBalance Sheet

As of December 31, 2007Assets: Current assets: Cash $15,000 Accounts receivable 100,000 Inventories:

Raw materials $50,000Work in process 60,000Finished goods 175,000 285,000

Prepaid expenses 10,000 Total current assets $395,000

ALEM Drugs Share CompanyBalance Sheet

As of December 31, 2007Assets: Current assets: Cash $10,000 Accounts receivable 60,000 Merchandise Inventory 150,000 Prepaid expenses 5,000 Total current assets $225,000

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The inventories for a manufacturing entity consist of materials to be used in production, goods partially manufactured, and goods completely manufactured.


o adjusting entries raw materials and work in process accounts are adjusted using

manufacturing summary account while finished goods are adjusted using income summary account

i) adjustment for inventories (periodic inventory system) eliminate beginning inventory balances

manufacturing summary 160,000raw materials 70,000work in process 90,000

income summary 125,000finished goods 125,000

record ending inventory balances raw materials 50,000Work in process 60,000

manufacturing summary 110,000Finished goods 175,000

Income summary 175,000

ii) adjustment for deferrals and accrualsiii) adjustment for capital assets

o closing entries close all manufacturing accounts with debit balance to the manufacturing

summary account Manufacturing summary xx

Raw materials purchases xxFreight-in (raw materials) xxDirect labor xxFactory overhead costsxx

close all manufacturing accounts with credit balance to the manufacturing summary account

Raw materials purchase discount xx

Raw materials purchase return and allowances xxManufacturing summary xx

close manufacturing summary account to income summary account

Income summary xxManufacturing summary xx

close all temporary accounts with credit balances to income summary account

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close all temporary accounts with debit balances to income summary account

close income summary to capital (retained earnings) account close drawing account to capital account

5.5 Exercises1. Hiwot Pharmaceuticals Share Company manufactures a single product. The following

data present transactions and additional information for November 2007, the company’s first month of operation:

Direct materials purchased on account $58,000Direct materials issued to production 40,000Direct labor costs accrued 26,000Factory insurance expired 3,000Factory utility paid 2,500Factory depreciation 6,000Finished goods, November 30 3,100 unitsIndirect materials purchased on account 5,000Indirect materials issued to production 2,000Indirect labor costs paid 8,000Marketing depreciation 1,800

Miscellaneous office expenses 7,000 Miscellaneous marketing expenses 5,500Office depreciation 2,500 Office salaries and wages 8,000Sales on account 106,000 ($20 per unit)Sales salaries and wages 9,000Work in process, November 30 14,000 (4,000 units)

Required: Using perpetual inventory system, determine a) units sold in November b) unit manufactured in November c) total cost of goods manufactured in November d) unit cost of goods manufactured in November e) prepare entries to record the flow of costs for Novemberf) prepare income statement for November

2. Cost of goods sold for Fews Share Company for June 2007 was $350,000. Work in process inventory on June 30, 2007 was 95% of work in process inventory on June 1, 2007. Manufacturing overhead costs are determined to be 80% of direct labor costs. During June 2007, $110,000 of direct materials were purchased. Other information for June 2007 follows:

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June 1, 2007 June 30, 2007Direct materials $22,200 $19,000Work in process 40,000 ?Finished goods 108,500 105,000

Required: For June 2007a) prepare a schedule to compute prime costs incurredb) prepare a schedule to compute conversion costs incurred c) prepare a schedule of cost of goods manufactured d) prepare a schedule of cost of goods sold

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principle of accounting

Education

accounting information

purpose of accounting

language of business

runningthe business

external user groups

external user group1

internal users

internal user group2