AcFn 2011

Chapter One
Introduction to Accounting & Business

Fundamentals of Accounting I
Ch1: Introduction to Accounting and
Business
Outline
– The nature of a business
– Types of business organizations in Ethiopia
– The role of accounting in business
– The profession of Accounting
– Overview of International Financial Reporting Standards
(IFRS)
– Overview of Financial Reporting Requirements in
Ethiopia and AABE
– The accounting equation and elements of the equation
– Business transactions and financial statements
Fundamentals of Accounting I
..Ch1: Introduction to Accounting and
Business
Chapter Objectives
After studying this chapter, you should be able to:
1. Explain what accounting is.
2. Identify the users and uses of accounting.
3. Understand why ethics is a fundamental business concept.
4. Explain accounting standards and the measurement principles.
5. Explain the monetary unit assumption and the economic
entity assumption.
6. State the accounting equation, and define its components.
7. Analyze the effects of business transactions on the
accounting equation.
8 Understand the four financial statements and how they
are prepared.
Fundamentals of Accounting I
Ch1: Introduction to Accounting and
Business
The Nature of Business
 A business is an organization in which basic
resources (inputs), such as materials and labor,
are assembled and processed to provide goods
or services (outputs) to customers.
 Businesses come in several types and sizes,
(Small shops, Supermarkets, Laundry, Hotels,
Garage, educational institutions, banks,
insurance and so on)

Fundamentals of Accounting I
 …Ch1: Introduction to Accounting
and Business
…The Nature of Business
Organizations can be classified in various forms:
 Based on objective:
 Profit making/ Not for Profit organizations
 Based on Function:
 Service giving, Merchandising, Manufacturing, Farming ..
 Based on Ownership, there are three common forms of
businesses:
1.Sole Proprietorship,
2.Partnership
3.Corporation (Share Company)
Fundamentals of Accounting I
…Ch1: Introduction to Accounting and Business
Forms of Business Ownership
Proprietorship Partnership Corporation

 Generally owned
 Owned by two or  Ownership
by one person
more persons divided into
 Often small
 Often retail and shares
service-type
service-type  Separate legal
businesses
businesses entity organized
 Owner receives
 Generally under corporation
any profits, law
suffers any unlimited
personal liability  Limited liability
losses, and is
personally liable  Partnership
for all debts agreement
LO 5 Explain the monetary unit assumption
Fundamentals of Accounting I
and the economic entity assumption.
 …Ch1: Introduction to Accounting
and Business
…The Nature of Business
Regardless of the objective, size, function and
form of ownership, all organizations are
required to keep records showing their
financial activities. This implies the fact that
accounting is needed in all types of
organizations.
 So what is Accounting? Why it is needed in all
organizations?

Fundamentals of Accounting I
…Ch1: Introduction to Accounting and Business

What is Accounting?
Accounting is the process of identifying, measuring, recording,
classifying, communicating and interpreting the reports.

Accounting consists of three basic activities - it

 identifies,
 records, and
 communicates

the economic events of an organization to interested users.

Fundamentals of Accounting I LO 1 Explain what accounting is.

…Ch1: Introduction to Accounting and Business

What is Accounting? Illustration 1-1

Three Activities The activities of the

accounting process

The accounting process includes

the bookkeeping function.

Fundamentals of Accounting I LO 1 Explain what accounting is.

 …Ch1: Introduction to Accounting and Business
Difference between Bookkeeping & Accounting
Book Keeping Accounting
 It is the recording part of • It is wider than book-keeping.
accounting • It includes activities such as
 It is purely clerical in designing the system of book
nature keeping (recording), it includes
 It is performed by Book- preparation and interpretation of
financial reports.
keepers or account clerks
• It is performed by Accountants
• Accountants are more qualified
than book keepers, they review
the work of book keepers

Fundamentals of Accounting I
 …Ch1: Introduction to Accounting
and Business
……What is Accounting?
Accounting is the language of business – it
can be viewed as an information system that
identifies, measures, and communicates
financial information about economic entities
to interested persons.
Accounting mainly deals with information
that is quantitative in nature.

Fundamentals of Accounting I
 …Ch1: Introduction to Accounting
and Business
 The Nature of Accounting can be summarized as
follows:
 Accounting is
 a service activity
 a descriptive/analytical discipline
 an information system
Accounting as a service activity:
 As a service activity, it provides interested parties
(users) with quantitative financial information that
helps them to make various decisions

Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and Business

Accounting as a descriptive/analytical
discipline:
It identifies mass of events and transactions that
characterize economic activity (purchases, sales,
collections, payments etc).
Through measurement, classification, and
summarization, it reduces those data to relatively
few, highly significant, and interrelated financial
reports.

Fundamentals of Accounting I
 …Ch1: Introduction to Accounting
and Business
Accounting as an information system
It is a system with 3 parts Input-Processing-Output:
 It collects raw data as an input (invoices, receipts),
then
 It processes the input (recording, classifying,
summarizing)
 Finally provides output in the form of financial
statements and communicates economic information
about business enterprise or other entity to a wide
variety of users to assist them in making decisions .
•

Fundamentals of Accounting I
……Ch1: Introduction to Accounting
and Business

What is the Role of Accounting in

Business?

The Role of Accounting in business is to

provide financial information to
managers for use in operating the
business. In addition, accounting provides
information to other users in assessing the
economic performance and condition of
the business.

Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and
Business
Who are users of Accounting
Information?
Users of accounting information
are parties that are interested to
know about the financial activities
of the organization to make
various decisions

Fundamentals of Accounting I
 …Ch1: Introduction to Accounting
and Business
 Users of accounting information can be broadly
classified into two categories;

Users of Accounting
Information

Internal Users External Users

Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and Business
Who Uses Accounting Data
External
Users
Internal
Users Human Taxing
Resources Authorities
Labor
Unions
Finance
Management Customers

Creditors
Marketing Regulatory
Agencies
Investors

LOof2Accounting
Fundamentals IdentifyI the users and uses of accounting.
 …Ch1: Introduction to Accounting and Business

Who Uses Accounting Data

Common Questions Asked User
1. Can we afford to give our
employees a pay raise? Human Resources
2. Did the company earn a
satisfactory income? Investors
3. Should any product lines be
eliminated? Management
4. Is cash sufficient to pay dividends
to shareholders? Finance
5. What price for our product will
maximize net income? Marketing
6. Will the company be able to pay
its debts? Creditors
LOof2Accounting
Fundamentals IdentifyI the users and uses of accounting.
 …Ch1: Introduction to Accounting and
Business
…….Internal users:
- Include Top executives, management, and
administrators within organizations. ( Managers at
different levels)
– Purpose: They need financial information to plan and
control operations
– Type of report & frequency- They need detailed and
frequent information
– These group of users have access to company
information

Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and Business

2. External Users
• Include Shareholders, Banks, Creditors, Investors,
suppliers, government
• Purpose: They need financial information about
entire company’s financial performance
(Profit/loss), financial position (resources and
sources) and cash flow
• Type of report: periodic report showing
aggregate/company wide information in the form of
general purpose financial statements
• They do not have access to company information
Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and
Business
• Fundamental relationships in the decision-
making process:

Accountant’s
analysis & Financial
Event Users
recording Statements

Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and
Business
How Accounting Evolves to its Current Stage?
Evolution of Accounting
• Similar to other fields of study, Accounting has
evolved to meet the increasing needs of the society
• As organizations increase in type, size and
complexities, the demand for financial information
has also increased
• Accounting has developed new concepts and
principles to meet these demands
Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and
Business
….Evolution of Accounting
• Primitive Accounting
– The oldest accounting record was the one that was
found in Babylonia in around 3600 B.C.
– Primitive accounting deals with limited aspect of
transactions
– There was no systematic recording
• Modern Accounting
– Modern accounting for business was developed in
response to the needs of Italian commercial orgs.
Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and
Business
…Evolution of Accounting
• Modern accounting was started with
the invention of a system of recording
known as “Double Entry Accounting
System”, a complete recording system
• This system was invented in 1494 in
Italy by an Italian Monk and
mathematician named Pacioli.
Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and Business
• Double Entry system provides a set of integrated reports
showing
1. The profit or loss (operation result) of a given
business for a certain period (Income statement)
2. The resources/assets/properties of a given business and the
sources of the finance to acquire these resources. (Statement
of Financial Position/Balance sheet)
• The invention of double entry accounting system is
considered to be the most important stage in the development
of accounting. In spite of the tremendous development in the
profession since 1494, the basic elements of the double entry
remains unchanged and it continues to this date.
Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and
Business
Influential factors for the Development of
Accounting
• The Industrial Revolution;
• The formation of Corporate forms of
organizations;
• The development of Public Accounting;
• The Government influence through tax
regulation and others.
Fundamentals of Accounting I
The ACCOUNTING Profession/CAREER OPPORTUNITIES

Public Accounting Private Accounting

Careers in auditing, taxation, Careers in industry working in
and management consulting cost accounting, budgeting,
serving the general public. accounting information
systems, and taxation.

Government Forensic Accounting

Careers with the tax Uses accounting, auditing, and
authorities, law enforcement investigative skills to conduct
agencies, and corporate investigations into theft and
regulators. fraud.

LO 9 Explain
Fundamentals the career
of Accounting I opportunities in accounting.
…Ch1: Introduction to Accounting and Business
STUDY OBJECTIVES 3, 4 & 5

The Building Blocks of Accounting

The following are considered to be the building

blocks of accounting

1. Ethics
2. Accounting Standards (IFRS)
3. Measurement Principles & Assumptions

Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and Business
….The Building Blocks of Accounting
Accounting Standards setters
International Accounting Standards Board (IASB)
http://www.iasb.org/

International Financial Reporting Standards (IFRS)

Financial Accounting Standards Board (FASB)

http://www.fasb.org/

Generally Accepted Accounting Principles (GAAP)

FASB and IASB recognize that global markets will best be served if
only one set ofLOstandard is used, ofIFRS.
4 ExplainFundamentals
accounting Accounting
standards I and the measurement principles.
 …Ch1: Introduction to Accounting and Business
• ..The Building Blocks of Accounting

Measurement Principles:

• IFRS generally uses one of two measurement principles,

the historical cost principle and Fair Value principle
• Cost Principle – or historical cost principle, dictates
that companies record assets at their cost.

• Fair Value Principle – states that assets and

liabilities should be reported at fair value (the price
received to sell an asset or settle a liability).
Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and Business
..The Building Blocks of Accounting
Example on Measurement Principle
Assume ABC Co. Purchased a Machine.
 Date of Purchase: January 1,2019, at Br 150,000
 Price listed by seller ……………..… Br180,000
 Buyer’s initial offer to buy at……... Br 120,000
 Assessed value for property taxes…Br190,000
 Market Value on December 31, 2019… Br 250,000
1. At what amount should ABC Co. record this Equipment on its
accounting records on January 1,2019?
a) by Cost principle b) by Fair value principle
2. At what amount should ABC Co. report this Equipment on its
accounting records on December 31,2019?
a) by Cost principle b) by Fair value principle
Solution: Fundamentals of Accounting I
…Ch1: Introduction to Accounting and Business
….The Building Blocks of Accounting
Assumptions
Monetary Unit – include in the accounting records only
transaction data that can be expressed in money terms.

Economic Entity – requires that activities of the entity be

kept separate and distinct from the activities of its owner and
all other economic entities.
 Proprietorship.
 Partnership. Forms of Business
Ownership
 Corporation.

LO 5 Explain the monetary unit assumption

Fundamentals of Accounting I
and the economic entity assumption.
 ..Ch1: Introduction to Accounting and
Business
….The Building Blocks of Accounting
The Monetary Unit Assumption
• In accounting money is used as a measurement unit due to this, all
transactions are recorded in terms of money.
• Money is both the common factor of all business transactions and the
only feasible unit of measurement that can be used to achieve uniform
financial data. However, the use of money as a measurement unit has the
following limitations:
1. It limits financial statements to report only quantifiable events. Qualitative
events affecting the performance of a business are not reported because of
the problem of quantification. For example, effect on profit of the death
of an excellent business manager is not included in financial statement.
2. It ignores the effect of inflation since it assumes money as a stable unit of
measurement. Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and
Business
….The Building Blocks of Accounting
The Business Entity/Economic Entity Assumption
 An Economic entity /Business entity can be any organization or
unit in society. It is an economic unit which enters into business
transactions that must be recorded, summarized & reported. It can
be profit making/not for profit.
 As per this assumption, a business organization is considered to be
separate from owners and creditors who supplied asset and from
other businesses;
 Each business organization should keep a separate accounting
records showing the activities of the business; Financial events of
the business should not be mixed with either of these parties, and it
should be kept separately.
Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and
Business
….The Building Blocks of Accounting
• Application of business entity concept enables users to
have accurate information about how well the entity is
doing.
The following are not violations of this assumption:
1. Withdrawal of assets by owners for personal use
recorded as owners withdrawals, not as a business
expense
2. Combining the financial statements of different
businesses to have an overall view/aggregate figure
Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and Business

..The Building Blocks of Accounting

• Frequency of reporting
An entity is required to present a complete
set of financial statements at least
annually.
• Accrual method of accounting
It is a method of accounting in which
transactions are recorded in the periods in which
the events occur.

Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and Business
Accrual Vs Cash Basis of Accounting
Companies prepare financial statements based on Accrual Basis

Accrual Basis of Accounting Cash Basis of Accounting

Revenue is recorded in the Revenue is recorded in the

period it is earned period of cash collection.
regardless of collection  In December 2019 ABC Co.
In December 2019 ABC Co. rendered Service :
rendered Service :  on cash: Br 100,000
 on cash: Br 100,000  on account/on credit: Br
200,000 (it was collected in
 on account/on credit: Br
Feb. 2020)
200,000 (it was collected in
Only Revenue of Br 100,000 is
Feb. 2020)
reported in December 2019 and
Total Revenue of Br 300,000 is
Br 200,000 is reported in 2020
reported in December 2019
Fundamentals of Accounting I
…Ch1: Introduction to Accounting and Business
Accrual Vs Cash Basis of Accounting

Accrual Basis of Accounting Cash Basis of Accounting

Expense is recorded in the Expense is recorded in the

period it is incurred period of cash payment.
regardless of payment  In December2019 ABC Co.
 In December2019 ABC Co. incurred Expenses as follows:
incurred Expenses as  paid in cash: Br 50,000
follows:  incurred but not paid Br 80,000
 paid in cash: Br 50,000 (it was paid in Jan. 2020)
 incurred but not paid Br Only Expense of Br 50,000 is
80,000 (it was paid in Jan. reported in December 2019 and
2020) Br 80,000 is reported in 2020
Total expense of Br 130,000 is
Fundamentals of Accounting I
reported in December 2019
 ..Ch1: Introduction to Accounting and Business
Which one is realistic, Accrual or Cash Basis?
Which method do companies use?
Accrual method is considered to be realistic in
measuring the operation results of the business in
terms of net income and net loss since it matches
efforts with accomplishments (revenues are
reported in the period efforts to generate revenues
are exerted).
IFRS requires companies to prepare financial
statements based on Accrual Basis
 Fundamentals of Accounting I
 …Ch1: Introduction to Accounting and Business

The accounting equation and elements of the equation

The Accounting Equation: The foundation of accounting system.
The accounting (balance sheet) equation is an equation that expresses the
following relationships:

Assets = Liabilities + Owner’s Equity

=
Resources Sources of the resources

Equity = Creditors equity + Owners equity

Fundamentals of Accounting I
The Basic Accounting Equation

Assets
Assets = Liabilities
Liabilities + Equity
Equity

Provides the underlying framework for recording and summarizing

economic events.
Applies to all economic entities regardless of size.

Fundamentals
LO 6 State of Accounting
the accounting I
equation, and define its components.
The Basic Accounting Equation

Assets
Assets = Liabilities
Liabilities + Equity
Equity

Provides the underlying framework for recording and summarizing

economic events.

Assets
 Resources a business owns.
 Provide future services or benefits.
 Cash, Inventory, Equipment, etc.

Fundamentals
LO 6 State of Accounting
the accounting I
equation, and define its components.
The Basic Accounting Equation

Assets
Assets = Liabilities
Liabilities + Equity
Equity

Provides the underlying framework for recording and summarizing

economic events.

Liabilities
 Claims against assets (debts and obligations).
 Creditors - party to whom money is owed.
 Accounts payable, Notes payable, etc.

Fundamentals
LO 6 State of Accounting
the accounting I
equation, and define its components.
The Basic Accounting Equation

Assets
Assets = Liabilities
Liabilities + Equity
Equity

Provides the underlying framework for recording and summarizing

economic events.

Equity
Ownership claim on total assets.
Referred to as residual equity.
Share capital-ordinary and retained earnings.

Fundamentals
LO 6 State of Accounting
the accounting I
equation, and define its components.
The Basic Accounting Equation
Illustration 1-7

Revenues result from business activities entered into for the purpose
of earning income.
Generally results from selling merchandise, performing services,
renting property, and lending money.

Fundamentals
LO 6 State of Accounting
the accounting I
equation, and define its components.
The Basic Accounting Equation
Illustration 1-7

Expenses are the cost of assets consumed or services used in the

process of earning revenue.
Common expenses are salaries expense, rent expense, interest
expense, property tax expense, etc.

Fundamentals
LO 6 State of Accounting
the accounting I
equation, and define its components.
The Basic Accounting Equation
Illustration 1-7

Dividends are the distribution of cash or other assets to shareholders.

 Reduce retained earnings
 Not an expense

Fundamentals
LO 6 State of Accounting
the accounting I
equation, and define its components.
Classify the following items as issuance of shares, dividends,
revenues, or expenses. Then indicate whether each item
increases or decreases equity.

Classification Effect on Equity

1. Rent expense Expense Decrease

2. Service revenue Revenue Increase

3. Dividends Equity Decrease

4. Salaries expense Expense Decrease

LO 6 State the accounting equation, and define its components.

Using the Accounting Equation

Transactions are a business’s economic events

recorded by accountants.
 May be external or internal.
 Not all activities represent transactions.
 Each transaction has a dual effect on the
accounting equation.

LO 7 Analyze the effects of business

Fundamentals transactions
of Accounting I on the accounting equation.
Using the Accounting Equation

Illustration: Are the following events recorded in the

accounting records?
Illustration 1-8
Discuss
Purchase product
Event Pay rent.
computer. design with
customer.

Criterion Is the financial position (assets, liabilities, or equity)

of the company changed?

Record/ Don’t
Record

Fundamentals
LO 7 Analyze the effects of Accounting
of business I
transactions on the accounting equation.
 Using the Accounting Equation

Transaction Analysis
Illustration 1-9
Expanded accounting equation

Fundamentals
LO 7 Analyze the effects of Accounting
of business I
transactions on the accounting equation.
Transaction Analysis
Transaction (1). Investment by Shareholders. Ray and Barbara Neal
decides to open a computer programming service which he names
Softbyte. On September 1, 2014, they invest €15,000 cash in exchange for
€15,000 of ordinary shares. Illustration 1-10

Fundamentals of Accounting I
LO 7
Transaction Analysis
Transaction (2). Purchase of Equipment for Cash. Softbyte purchases
computer equipment for €7,000 cash.

Illustration 1-10

Fundamentals of Accounting I
LO 7
Transaction Analysis
Transaction (3). Purchase of Supplies on Credit. Softbyte purchases for
€1,600 from Acme Supply Company computer paper and other supplies
expected to last several months. The purchase is on account.
Illustration 1-10

Fundamentals of Accounting I
LO 7
Transaction Analysis
Transaction (4). Services Provided for Cash. Softbyte receives €1,200
cash from customers for programming services it has provided.

Illustration 1-10

Fundamentals of Accounting I
LO 7
Transaction Analysis
Transaction (5). Purchase of Advertising on Credit. Softbyte receives a
bill for €250 from the Daily News for advertising but postpones payment
until a later date.

Illustration 1-10

Fundamentals of Accounting I
LO 7
Transaction Analysis
Transaction (6). Services Provided for Cash and Credit. Softbyte
provides €3,500 of programming services for customers. The company
receives cash of €1,500 from customers, and it bills the balance of €2,000
on account.
Illustration 1-10

Fundamentals of Accounting I
LO 7
Transaction Analysis
Transaction (7). Payment of Expenses. Softbyte pays the following
expenses in cash for September: store rent €600, salaries and wages of
employees €900, and utilities €200.

Illustration 1-10

Fundamentals of Accounting I
LO 7
Transaction Analysis
Transaction (8). Payment of Accounts Payable. Softbyte pays its €250
Daily News bill in cash.

Illustration 1-10

Fundamentals of Accounting I
LO 7
Transaction Analysis
Transaction (9). Receipt of Cash on Account. Softbyte receives €600 in
cash from customers who had been billed for services [in Transaction (6)].

Illustration 1-10

Fundamentals of Accounting I
LO 7
Transaction Analysis
Transaction (10). Dividends. The corporation pays a dividend of €1,300 in
cash.

Illustration 1-10

Fundamentals of Accounting I
LO 7
Financial Statements

Companies prepare four financial statements :

Retained Statement of
Income Statement of
Earnings Financial
Statement Cash Flows
Statement Position

LO 8 Understand the four financial

Fundamentals statements
of Accounting I and how they are prepared.
Financial Statements

Question
Net income will result during a time period when:
a. assets exceed liabilities.
b. assets exceed revenues.
c. expenses exceed revenues.
d. revenues exceed expenses.

LO 8 Understand the four financial

Fundamentals statements
of Accounting I and how they are prepared.
 Net income is needed to determine the
Financial Statements ending balance in retained earnings.

Illustration 1-11
Financial statements and
their interrelationships

Fundamentals of Accounting I LO 8
 The ending balance in retained earnings is
Financial Statements needed in preparing the balance sheet

Illustration 1-11

Fundamentals of Accounting I LO 8
 The balance sheet and income statement are
Financial Statements needed to prepare statement of cash flows.

Illustration 1-11

Fundamentals of Accounting I LO 8
Financial Statements

Question
Which of the following financial statements is prepared as
of a specific date?
a. Statement of financial position.
b. Income statement.
c. Retained earnings statement.
d. Statement of cash flows.

LO 8 Understand the four financial

Fundamentals statements
of Accounting I and how they are prepared.
 Chapter 1

The End

Any

Fundamentals of Accounting I
 AcFn 2011
Chapter Two
Accounting cycle for service-giving
business
(Ch 2 Part I-The Recording Phase)
Acfn 2011
70
 2. Accounting cycle for service-giving business

Chapter Outline
 The Accounting Cycle
 Account: Classification and Nature of Accounts
 Chart of Accounts
 Rules of Debit and Credit
-The Recording phase of the Accounting Cycle
 Analyzing and recording (journalizing) transactions
 Posting transactions
 Trial Balance
The Summarizing Phase Of the Account Cycle
 Adjusting entries
 Preparation of financial statements
 Closing entries
 Post-closing trial balance preparation
• Reversing entries
Acfn 2011 71
 2.1 The Recording Phase of the Accounting Cycle

Objectives of the Recording Phase

 After studying this phase, you should be able to:
• Explain what an account is and how it helps in the recording process.
• Define debits and credits and explain their use in recording business
transactions.
• Identify the basic steps in the recording process.
• Explain what a journal is and how it helps in the recording process.
• Explain what a ledger is and how it helps in the recording process.
• Explain what posting is and how it helps in the recording process.
• Prepare a trial balance and explain its purposes.

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 ..2. The Accounting Cycle for service Business

The Accounting Cycle

 The accounting system employs certain routine procedures to convert raw data in to information
The Accounting Cycle: is sequence of accounting procedure for a fiscal period.
It starts with analyzing and journalizing business transactions and ends with
preparation of post closing trial balance.
Financial statements prepared for users are the end results of an accounting system.

The activities in the accounting cycle can be summarized in to two phases,

1. the recording phase and
2. the summarizing and reporting phase

•
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 The Recording Phase

The Recording phase

 This phase of the accounting cycle focuses on

accumulation of financial data in accounting
records.
 Transactions are recorded using double entry
system

•
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 …The Recording Phase
 Tabular analysis of transaction is used to
understand the basic concept of double entry
system
 However, it is not practical to use tabular system
to formally record and summarize transactions
 In practice, transactions are recorded in ledger
accounts.

What is an account?
What is a ledger?

Acfn 2011 75
 Account
• An account is an individual accounting record
of increases and decreases in a specific asset,
liability, or owner’s equity item.
• It is a form used to record increase or decrease
caused by transactions on each item of asset,
liability and capital
• There are separate accounts for the items we
used in transactions such as cash, salaries
expense, accounts payable, etc.
• Ledger is a group of accounts. (eg. Asset
accounts, Liability accounts…)
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 Classification of Accounts
• Accounts in ledger are listed in the order in
which they appear in the financial statements.
Balance sheet accounts are classified as Asset,
Liabilities, and Owner’s equity.
• Income statement accounts are classified as
Revenues and Expenses.
• The size of Accounts of an organization
depends on factors such as:
– the nature and size of its activities
– The extent of details needed
Acfn 2011
by the management 77
 Chart of Account
• To easily identify the location of each, all accounts in the
general ledger are numbered.
• Chart of Account shows the list of account titles and account
numbers assigned to each account.
• In assigning an account number a business may use
– two-digit, three- digit or four-digit numbering system;
– it depends on the volume of transaction and extent of detailed
information required by the organization.
– In any case, the first digit always stands for the major classification
of the general ledger.
– For two-digits numbering system the second digit is used to indicate
the position/location of the account with in the division; and for three
or four digit numbering system it indicates the sub classification 78
Acfn 2011
 Chart of Account
For Example, in service business, with two digit
numbering system,
• Account No. 11 refers to the 1st asset account
• Account No. 17 refers to the 7th asset account
• Account No. 23 refers to the 3 rd liability account
• Account No. 31 refers to the 1st capital account
• Account No. 42 refers to the 2nd revenue account
• Account No. 54 refers to the 4th expense account
Acfn 2011 79
 Chart of Account
• A two-digit Numbering system permits 9 accounts in each division of ledger.
Eg. Asset: 11-19,
Liability: 21-29, etc.
A Three-digit Numbering system permits 99 accounts in each division of ledger.
Eg. Asset: 101-199,
Liability: 201-299 etc.
Small businesses with limited number of transactions can use two-digit
numbering.
Large organizations with large volume of transaction can use three or more digit
numbering, since it permits the accumulation of detailed data about each type
of asset, liability, revenue and expense.

Acfn 2011 80
 Nature of an Account

Nature of an Account
• An account can be ruled in various ways;
– in two column form,
– In three column form, or
– In four-amount column form.
• In whatever form it is ruled, an account has three
basic parts.
– The heading: A place to write the title which describes the
nature of the items being recorded in the account (cash,
salary expense etc).
– The Debit part (Left hand side)
– The Credit part (Right handAcfn
side)
2011 81
 Nature of an Account

The ” T” Account
-The simplest form of an account

Account Name
Debit / Dr. Credit / Cr.

Acfn 2011 82
 …… Nature of an Account

• Why an account has two sides?

– One side is used to record all increases
– Another side is used to record all decreases
• Account balance
– It is the difference between two sides total
– It appears in the side showing larger amount
• Normal balance of an account is positive
since usually increases exceed decreases

Acfn 2011 83
 Nature of an Account
…Why an account has two sides?
Comparison tabular summary with account

An account clearly show increases in one side, decreases in another side

and the balance.
Acfn 2011 84
 DEBITS AND CREDITS

• Debit indicates left and Credit indicates right

• Recording amounts on the left side of an account is
debiting/charging the account
• Recording amounts on the right side is crediting the
account
• If the total of debit amounts is bigger than credits, the
account has a debit balance
• If the total of credit amounts is bigger than debits, the
account has a credit balance

Acfn 2011 85
 …The Recording Phase

Double-entry accounting system

A recording system showing two-sided effect.
Recording done by debiting at least one account and
crediting another. More than one account can be
debited/credited.
Equal amounts recorded in debit and credit side
Debit signify Left side
Credit signify Right Side

Acfn 2011 86
DEBITING AN ACCOUNT

Cash
Debits Credits
15,000

Example:
Example: The
Theowner
ownermakes
makesan aninitial
initial
investment
investmentofof$15,000
$15,000to tostart
startthe
the
business.
business. Cash
Cashisisdebited
debitedas asthe
the
owner’s
owner’sCapital
Capitalisiscredited.
credited.
Acfn 2011 87
CREDITING AN ACCOUNT

Cash
Debits Credits
7,000

Example:
Example: Monthly
Monthlyrentrentof
of$7,000
$7,000isispaid.
paid. Cash
Cash
isiscredited
creditedas
asRent
RentExpense
Expenseisis
debited.
debited.
Acfn 2011 88
 Debits and Credits

If Debit entries are greater than Credit

entries, the account will have a debit balance.
Account Name
Debit / Dr. Credit / Cr.

Transaction #1 $10,000 $3,00 Transaction #

0
Transaction #3 8,000

Balance $15,000

Acfn 2011 89
 Debits and Credits
If Credit entries are greater than Debit
entries, the account will have a credit balance.

Account Name
Debit / Dr. Credit / Cr.
Transaction # $10,000 $3,00 Transaction #
0
8,000 Transaction #

Balance $1,000

Acfn 2011 90
 Debit and Credit Rules

Debit and Credit Rules of Accounts

• Permanent/real/open accounts: refers to balance sheet
accounts, Asset, Liability, and Capital; the balances of these
accounts are carried forward from year to year.
• Temporary/nominal/Closed accounts: refers to temporary
capital accounts, Revenue, Expense, Dividend & Drawing.
At the end of each fiscal period, the balances in these
accounts are closed to the real capital accounts through a
process known as closing.

Acfn 2011 91
 Debit and Credit Rules …..
• The debit and credit rules for permanent accounts have
been developed on the basis of the accounting equation.
• In accounting equation, assets are on the left side of the
equation and liabilities and capital are on the right side of
the equation.
• Assets increased on the left-hand side or debit side and
liabilities and owner’s equity accounts increased on the
right hand side or credit side.
• Decreases are recorded opposite to the increase side.

Acfn 2011 92
 Debit and Credit Rules …..
• The debit and credit rules for revenue and expense accounts
have been developed by considering the relationship of revenue
and expense to the owners equity account.
• Revenue and expenses are income statement accounts;
• Revenue is a gross increase in capital and expense is a gross
decrease in capital.
• At the end of each fiscal period, the balances in income
statement accounts, revenue and expenses, are closed to income
summary account and the net effect, net income or net loss is
transferred to the real capital account.
• Since revenue and expenses accounts are the details of the
capital or owner’s equity account, they are also called
temporary capital accounts.
Acfn 2011 93
 Debit and Credit Rules …..
• Revenue Increases owners equity,
– increase side of owners equity account
and revenue account is the same, credit.
• Expense decreases capital, the decrease
side of owners equity account is debit, so
the increase side for an expense account
is debit. An increase in expense causes a
decrease in capital.
Acfn 2011 94
 Debit and Credit Rules …..
• The same logic is used for the increase and decrease side of drawing
and dividend accounts:
– Drawing decreases owner’s capital, the decrease side of owners
equity account is debit, so the increase side for drawing account is
debit. An increase in drawing causes a decrease in owner’s capital.
– Dividend decreases retained earning, one of the real owners
equity account of the corporation. The decrease side of retained
earning account is debit, so the increase side for dividend account
is debit. An increase in dividend causes a decrease in retained
earning account.

Acfn 2011 95
 Rules of Debits and Credits
Increase and decrease sides
. Expanded Accounting Equation
(Assets = Liabilities + Equity + Revenues - Expenses - Dividends)

Assets Liabilities Equity

= +
Debit Credit Debit Credit Debit Credit

+ - - + - +
Common Stock
Debit Credit
The side you increase
on is called the - +
Retained Earnings
normal balance Debit Credit

- +
Dividends Expenses Revenues
Debit Credit Debit Credit Debit Credit

+ - + - - +

Acfn 2011 96
 Rules of Debit and Credit
Increase Decrease Financial statement
Account Side Side Balance Nature of the
account
Asset Debit Credit Debit Balance sheet
Permanent/Real/Ope
n
Liability Credit Debit Credit Balance sheet
Permanent/Real/Ope
n
Capital/Stockholder’s
equity:
Capital, Capital Balance sheet
Stock, Credit Debit Credit Permanent/Real/Ope
and Retained n
Earning Capital accounts
Contra Capital Capital statement,
Drawing, Dividend Debit Credit Debit Accounts, Retained Earning
Temporary/ Statement
Nominal/Closed
Temporary Capital Income Statement
Revenue Credit Debit Credit accounts,
Temporary/
Nominal/Closed
Temporary Capital Income Statement
Expense Debit Credit Debit accounts,
Temporary/
Nominal/Closed

Acfn 2011 97
 Debit and Credit Rules …..
• 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 of an unusual situation.
• For example, a credit balance in office
equipment, an asset account could result only
from an accounting error; on the other hand, a
debit balance in accounts payable could result
from an overpayment.
Acfn 2011 98
 Flow of Accounting Data

• The flow of accounting data from the time the transaction

occurs to its recording in ledger may be diagrammed as
follows:

Business Business Entry

Documents Entry Posted to
Transaction recorded in ledger
occur prepared journal

Acfn 2011 99
 Flow of Accounting Data….

• Business Transaction: it is an economic event that must be

recorded in accounting records.
• Source Document : It is written evidence to support entries
recorded in journal. A source document may be cash receipt,
sales invoice, bills, cash register tapes etc. An entry should
not be recorded in journal without being supported by
approved source document.
• Journal: A Journal is the first book in which the records of
a business are written. Each record in a journal is known as
entry. There are different types of journals such as the
(general journal, combination journal and special journals).
Acfn 2011 100
 Flow of Accounting Data….

General Journal It is a two-amount column book used to record

all kinds of business transactions.
Each entry recorded in a general journal has four parts -
the date part;
-the debit part which contains the account/s
debited and the amount;
-the credit part which contains the account/s
credited and the amount; and
-the source document and explanation part.
Journalizing : is the task of recording transactions in a journal
Analyzing comes before transactions are recorded in journals.

Acfn 2011 101

 Sequence of activities in the Accounting
Cycle
Step 1: Analyzing and Journalizing Business transactions
• Business transactions occurring should be analyzed in three
steps,
– 1. Determining whether the item affected is asset, liability,
capital, revenue, or expense;
– 2. Determining the effect of the transaction on the account,
whether the account affected increases or decreases and the
amount
– 3. Determining whether the effect of the transaction should be
recorded as a debit or credit.
• After a transaction is analyzed, the entry is journalized and
posted to the accounts in the ledger.
Acfn 2011 102
Step 1: Analyzing and Journalizing business
transactions
Steps in Journalizing using General Journal:
– 1. Record the date
– 2. Record the debit part of the entry (the account
title and the amount debited)
– 3. Record the Credit part of the entry (the account
title and the amount credited)
– 4. Record the explanation and the source
document

Acfn 2011 103

 Step 2: Posting from General Journal to the Ledger

Step 2: Posting from General Journal to the Ledger

Each entry recorded in a journal needs to be transferred to the
respective ledger accounts.
• Posting: is the process of transferring the entries in a journal to
accounts in a ledger
Steps in posting
1. Record the date and the amounts of the entry in the account;
2. Insert the number of the journal page in the Posting Reference
column of the account; and
3. Insert ledger accounts number in the post reference column of
the journal.
Acfn 2011 104
Step 2: Posting from General Journal to the
Ledger
• Purpose of Post Reference
– The major purpose of the 'Posting Reference' is to cross
refer the journal and the ledger:
– In the ledger, it refers the page of the journal from
which the entry is made (the source); and
– in the journal, it refers the account to which the entry is
posted. In the journal, the post reference column also
serves to identify the entries posted from those not yet
posted. The entries for which account numbers are
filled in the post reference column indicate that posting
is completed.
Acfn 2011 105
 2.4 The Trial Balance

Preparing TB–The 3rd step in the Accounting Cycle

• Trial Balance
– It is a means of proving the equality of the debits and credits in the
ledger.
– It shows the list of accounts and their balances on specific date usually
end of the accounting period.
How to prepare a TB?
– To prepare a trial balance, account balances of the accounts in the ledger
should be determined.
Why it is needed?
• It is part of the checking process.
• If debit side total of a trial balance is not equal to the total of the credit side,
it is an indication for the existence of error
• Therefore, at the end of the accounting period, before preparing financial
statements, the equality of debits and credits in the ledger should be verified.
Acfn 2011 106
 Trial balance…..
• If the two sides total of a trial balance are equal, the trial
balance is said to be “in balance”
• If the two sides of a trial balance are not equal, the trial
balance is said to be “Out of balance” and it may be an
indication of one or more of the following errors;
1. Error in preparing the trial balance:
– Incorrect addition of one of the sides of the trial balance;
– Wrong figures recorded in the trial balance;
– A debit balance recorded as a credit, or vice versa;
– A balance omitted entirely.

Acfn 2011 107

 Trial balance……
2. Error in determining account balances:
– Balance computed incorrectly;
– Balance entered in the wrong column.
3. Error in recording a transaction in the
ledger.
– Wrong or erroneous amount posted to the account;
– A debit entry posted as a credit or vice versa;
– Omission of a debit or a credit posting.

Acfn 2011 108

 Trial balance……
Errors that cannot be detected by a Trial Balance
• A trial balance is not a complete proof of the accuracy of the ledger; this is a
limitation of a trial balance.
• There are some errors that wouldn't cause the trial balance to be out of balance,
and these types of errors couldn’t be detected by trial balance. This happens when
both the debit and the credit sides are affected equally. Errors that don't cause the
trial balance to be out of balance include:
– 1. Failure to record a transaction or post a transaction (omission of a
transaction)
– 2. Recording the same erroneous amount for both the debit and credit parts of
a transaction
– 3. Recording the same transaction more than once; and
– 4. Posting a part of a transaction correctly as debit or credit but to the wrong
account.
In order to prepare accurate financial statements, errors in ledger should be
Acfn 2011 109
identified and corrected.
 Trial balance……
• Discovery of Errors: The existence of errors
in the accounts may be determined in various
ways such as:-
– By preparing a trial balance
– By chance discovery; and
– By audit procedures;

Acfn 2011 110

 Discovering errors by Preparing Trial
balance
Discovering Errors by Preparing a Trial balance:
• When the debit side of the trial balance is not equal with the credit side, it
indicates the existence of errors in ledger.
Clues for Locating Errors
• The amount of the difference between the two sides of the trial balance
may clue as to the nature of the error committed.

– l. A difference of figures like 100; 1,000; 10,000; etc. between the two total of
the trial balance is mostly the result of an error in addition. Therefore, re-add the
trial balance and re-compute the account balances,
– 2. If the difference between the two sides of the trial balance is divisible by two,
it indicates one of the following errors:
• Posting of a debit as a credit or vice versa; or
• Omission of one of the debit or credit posting,
– 3 If the two sides of the trial balance read a difference divisible by nine, it
indicates either a transposition or a slide error.
Acfn 2011 111
 Trial Balance….
• A transposition error is the error in re-
arrangement of digits; for example, writing 452 as
542; or 945 as 495.
• A slide error is error caused by moving of the
entire number one or more spaces to the right or to
the left; for example writing 1,200 as 12,000; or
1,200 as 120.
• In general, to locate errors it is essential to check
the journalizing, posting, and the trial balance in
their reverse order.
Acfn 2011 112
 How to Correct Errors
Correction of Errors
• When an error is discovered in either the journal or the ledger,
it must be corrected.
• The method of correction depends on the nature of the error
and the stage at which it is discovered.
– If an error is discovered in a journal before it is posted to the ledger,
the correction can be made by drawing a line through the incorrect
item and writing the correct item immediately above. This kind of
correction can also be used when a posting error involves entering an
incorrect amount in the ledger.
– If an error is due to posting to a wrong account, it needs to be
corrected by recording another entry called correcting entry.

Acfn 2011 113

 AcFn 2011
Chapter Two
Accounting cycle for service-giving
business
(Ch 2 Part 2-The Summarizing & Reporting
Phase)
114
 The Summarizing and Reporting Phase
The summarizing and reporting phase of the accounting cycle includes activities
such as :
– Gathering of data needed to adjust the accounts
– Preparation of worksheet;
– Preparation of financial statements;
– Journalizing and posting adjusting and closing entries;
– Preparation of post-closing trial balance.

•
Acfn 2011 115
Chapter 2-2:The
Summarizing Phase
(Service Giving
Business) Summarizing & Reporting Phase of
the Accounting Cycle
Learning Objectives
After studying this chapter, you should be able to:
1. Explain the time period assumption.
2. Explain the accrual basis of accounting.
3. Explain the reasons for adjusting entries.
4. Identify the major types of adjusting entries.
5. Prepare adjusting entries for deferrals.
6. Prepare adjusting entries for accruals.
7. Describe the nature and purpose of an adjusted trial balance.
8. Prepare a worksheet.
9. Explain the process of closing the books.
10. Describe the content and purpose of a post-closing trial balance.
11. State the required steps in the accounting cycle.
12. Explain the approaches to preparing correcting entries.
13. Identify the sections of a classified statement of financial position
Preview of The
Summarizing Phase

Based on Financial Accounting

IFRS Edition, 2e
Weygandt Kimmel Kieso
Timing Issues
Accountants divide the economic life of a business into
artificial time periods (Time Period Assumption).

.....
Jan. Feb. Mar. Apr. Dec.

 Generally a month, a quarter, or a year.

 Also known as the “Periodicity Assumption”

LO 1 Explain the time period assumption.

Timing Issues
Fiscal and Calendar Years
 Monthly and quarterly time periods are called interim
periods.
 Most large companies must prepare both quarterly and
annual financial statements.
 Fiscal Year = Accounting time period that is one year in
length.
 Calendar Year = January 1 to December 31.

LO 1 Explain the time period assumption.

Timing Issues

Accrual- vs. Cash-Basis Accounting

Accrual-Basis Accounting
 Transactions recorded in the periods in which the
events occur.
 Revenues are recognized when the services are
performed, rather than when cash is received.
 Expenses are recognized when incurred, rather than
when paid.

LO 2 Explain the accrual basis of accounting.

Timing Issues

Accrual- vs. Cash-Basis Accounting

Cash-Basis Accounting
 Revenues recognized when cash is received.
 Expenses recognized when cash is paid.
 Cash-basis accounting is not in accordance with
International Financial Reporting Standards (IFRS).

LO 2 Explain the accrual basis of accounting.

Timing Issues

Recognizing Revenues and Expenses

Revenue Recognition Principle
Recognize revenue in the
accounting period in which the
performance obligation is
satisfied.

In a service enterprise,
revenue is considered to be
earned at the time the service
is performed.

LO 2 Explain the accrual basis of accounting.

Timing Issues

Recognizing Revenues and Expenses

Expense Recognition Principle
Match expenses with
revenues in the period when
the company makes efforts to
generate those revenues.
“Let the expenses follow
the revenues.”

LO 2 Explain the accrual basis of accounting.

Timing Issues
Illustration 3-1
IFRS relationships in revenue
and expense recognition

LO 2 Explain the accrual basis of accounting.

The Basics of Adjusting Entries

Purpose of Adjusting Entries

 Ensure that the revenue recognition and expense
recognition principles are followed.
 To Accurately measure Revenue & Expenses on Profit & loss
statement
 To Accurately measure assets and liabilities on
SOFP(Balance sheet)
 Necessary because the trial balance may not contain up-
to-date and complete data.
 Required every time a company prepares financial
statements.(it is a period end procedure)
 Will include one income statement account and one
statement of financial position account.

LO 3 Explain the reasons for adjusting entries.

The Basics of Adjusting Entries

Types of Adjusting Entries

Illustration 3-2
Categories of adjusting entries

Deferrals Accruals

1. Prepaid Expenses. 3. Accrued Revenues

Expenses paid in cash before (Unrecorded Revenues).
they are used or consumed. Revenues for services performed
but not yet received in cash or
recorded.
2. Unearned Revenues. 4. Accrued Expenses.
Cash received before services (Unrecorded Expenses).
are performed. Expenses incurred but not
yet paid in cash or recorded.

LO 4 Identify the major types of adjusting entries.

The Basics of Adjusting Entries

Adjusting Entries for Deferrals

Deferrals are either:

 Prepaid expenses (Advance Payments)

OR
 Unearned revenues.(advance Collections)

LO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Prepaid Expenses
Payment of cash, that is recorded as an asset because service or
benefit will be received in the future.

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

 insurance  rent
 supplies  equipment
 advertising  buildings

LO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Depreciation
 Buildings, equipment, and vehicles (assets with long
lives) are recorded as assets, rather than an expense,
in the year acquired.
 Depreciation allocates a portion of the asset’s cost as
an expense during each period of the asset’s useful life.
 Depreciation does not attempt to report the actual
change in the value of the asset.

LO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Statement Presentation
 Accumulated Depreciation is a contra asset account
(credit).
 Appears just after the account it offsets (Equipment) on
the statement of financial position.
 Book value is the difference between the cost of any
depreciable asset and its accumulated depreciation.
Illustration 3-8

LO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Prepaid Expenses
 Expire either with the passage of time or through use.
 Adjusting entry:
► Increase (debit) to an expense account and
► Decrease (credit) to an asset account.

Illustration 3-4

LO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Illustration 3-9

Summary of

LO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Unearned Revenues
Receipt of cash that is recorded as a liability because service has not
be performed.

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

 Rent  Magazine subscriptions
 Airline tickets  Customer deposits

LO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Unearned Revenues
 Adjusting entry is made to record the revenue for
services performed and to show the liability that remains.
 Results in a decrease (debit) to a liability account and
an increase (credit) to a revenue account.

Illustration 3-10

LO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Illustration 3-12

Summary of

LO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Adjusting Entries for Accruals

Accruals are made to record

 Revenues for services performed

OR
 Expenses incurred

in the current accounting period that have not been

recognized through daily entries.

LO 6 Prepare adjusting entries for accruals.

The Basics of Adjusting Entries

Accrued Revenues
Revenues for services performed but not yet received in cash or
recorded.

Revenue
Revenue Recorded
Recorded Cash
Cash Receipt
Receipt
BEFORE

Accrued revenues often occur in regard to:

 Interest  Rent
 Services performed

LO 6 Prepare adjusting entries for accruals.

The Basics of Adjusting Entries

Accrued Revenues
 Adjusting entry shows the receivable that exists and
records the revenues for services performed.
 Adjusting entry:
► Increases (debits) an asset account and
► Increases (credits) a revenue account.

Illustration 3-13

LO 6
The Basics of Adjusting Entries
Illustration 3-15

LO 6 Prepare adjusting entries for accruals.

The Basics of Adjusting Entries

Accrued Expenses
Expenses incurred but not yet paid in cash or recorded.

Expense Recorded BEFORE Cash Payment

Accrued expenses often occur in regard to:

 Rent  Taxes
 Interest  Salaries

LO 6 Prepare adjusting entries for accruals.

The Basics of Adjusting Entries

Accrued Expenses
 Adjusting entry records the obligation and recognizes
the expense.
 Adjusting entry:
► Increase (debit) an expense account and
► Increase (credit) a liability account.

Illustration 3-16

LO 6
The Basics of Adjusting Entries

Illustration 3-21

Summary of

LO 6 Prepare adjusting entries for accruals.

The Basics of Adjusting Entries

Summary of Basic Relationships

Illustration 3-22

LO 6 Prepare adjusting entries for accruals.

Summary of Types of Adjusting Entries
1) Adjustment for Deferrals
Deferrals- advance payments/advance collections
Purpose of adjustment for Deferrals:
To split the already recorded but unadjusted balances in to balance sheet
item and income statement item
Eg; Supplies balance, in to used/unused; Prepaid rent in to expired/unexpired,
Equipment balance in to used(depreciation) and unused (book value)
Unearned revenue in to earned(revenue) and unearned (liability)
2) Adjustment for Accruals
Accruals- Unrecorded expenses/Unrecorded revenues
OR -Incurred but not paid/Earned but not collected
Purpose of adjustment for Accruals:
To record the unrecorded Assets/Liabilities (balance sheet items)
To record the unrecorded expenses and revenues (income statement items)
Eg; incurred but not paid expenses (eg. salary expense, salary payable);
earned but not recorded revenue (eg. Service rendered but not billed;
interest revenue earned but not collected);
Note: If these adjustments are not recorded, financial statements will not be
accurate. So adjustment is needed to prepare accurate financial
statements.

LO 3 Explain the reasons for adjusting entries.

 Zemen Studio January 31,Adjustment data The purpose of Adjustment is to
Trial Balance (Unadjusted) 1. Supplies on hand…….Br 800 update account balances by

A/Title
The Basics of Adjusting Entries
January 31,2023
A/No. Debit Credit
2. Prepaid rent………….Br 2,000
3. Unearned Rent……….Br5000
splitting all unadjusted
balances in to Balance sheet
Cash
11
134,300
4. Accrued salaries……..Br 80 items and Income statement
12 5. Services rendered but not billed….Br1,200 items
..Types of Adjusting Entries
A/R 10200
13 6. Dep. Expense………...Br 200
Office Supplies 7700
14
Prepaid Rent 3000 Analysis:
Photog. Equip.
15
20000 1.Unadjusted Balance of supplies…7,700 (deferral)
Acc. Depreciation
15.1 -On hand/Unused/Asset/Balance sheet item…………….800
A/ Payable
21
6000
-Consumed/Expense/Income statement item 7700-800=6,900
22 Supplies expense (53)……6,900
Salaries Payable
23 Office Supplies (13)…………….6,900
Emp. I. Tax Payable 500
24
Unearned Rent 15000
31 -It is a deferral adjustment
Zemen's Capital 135000
32
Zemen's Drawing 1300
Income Summary
33 Activity
41 Assume when financial statements are prepared the above adjustment is
Sales 37000
42 omitted
Rent Income
51
Salary Expense 12000
What is the effect of this omission on the balances that will appear on
52
Rent expense financial statement? Which items will overstate/understate?
53
Supplies expense
Depreciation expense 54
Utility expense 55 Illustration
3000 3-3
Miscellaneous expense 56
2000
Total 193,500 193,500
 Zemen Studio January 31,Adjustment data The purpose of Adjustment is to
Trial Balance (Unadjusted) 1. Supplies on hand…….Br 800 update account balances by

A/Title
The Basics of Adjusting Entries
January 31,2023
A/No. Debit Credit
2. Prepaid rent………….Br 2,000
3. Unearned Rent……….Br500
splitting all unadjusted
balances in to Balance sheet
Cash
11
134,300
4. Accrued salaries……..Br 80 items and Income statement
12 5. Services rendered but not billed….Br1,200 items
..Types of Adjusting Entries
A/R 10200
13 6. Dep. Expense………...Br 200
Office Supplies 7700
14
Prepaid Rent 3000 Analysis:
Photog. Equip.
15
20000 2.Unadjusted Balance of Prepaid Rent…3,000 (deferral)
Acc. Depreciation
15.1 - On hand/Unexpired/Asset/Balance sheet item…………….2000
A/ Payable
21
6000
-Expired/Expense/Income statement item 3000-2000…….1,000
22
Salaries Payable
23 Rent expense (52)……1,000
Emp. I. Tax Payable 500
24
Prepaid Rent (14)……….1,000
Unearned Rent 15000
31
Zemen's Capital 135000 It is a deferral adjustment
32
Zemen's Drawing 1300
33
Income Summary Activity
41 Assume when financial statements are prepared the above adjustment is
Sales 37000
Rent Income
42 omitted
51
Salary Expense 12000
52 What is the effect of this omission on the balances that will appear on
Rent expense
53 financial statement? Which items will overstate/understate?
Supplies expense
Depreciation expense 54
Utility expense 55 Illustration
3000 3-3
Miscellaneous expense 56
2000
Total 193,500 193500
 Zemen Studio January 31,Adjustment data The purpose of Adjustment is to
Trial Balance (Unadjusted) 1. Supplies on hand…….Br 800 update account balances by

A/Title
The Basics of Adjusting Entries
January 31,2023
A/No. Debit Credit
2. Prepaid rent………….Br 2,000
3. Unearned Rent……….Br5000
splitting all unadjusted
balances in to Balance sheet
Cash
11
134300
4. Accrued salaries……..Br 80 items and Income statement
12 5. Services rendered but not billed….Br1,200 items
..Types of Adjusting Entries
A/R 10200
13 6. Dep. Expense………...Br 200
Office Supplies 7700
14
Prepaid Rent 3000 Analysis:
15
Photog. Equip. 20000 3.Unadjusted Balance of Unearned Rent…15000 (deferral)
15.1
Acc. Depreciation Earned/Revenue/Income statement item 20days x 500/day=10,000
21
A/ Payable 6000 Un earned/Liability/Balance sheet item 10days x 500/day=5,000
22
Salaries Payable
Emp. I. Tax Payable
23
500 Unearned Revenue-Liability(24) ..10,000
Unearned Rent
24
15000
Rent income (42)……….……….10,000
31
Zemen's Capital
32
135000
-It is a deferral adjustment
Zemen's Drawing 1300
33
Income Summary Activity
41 Assume when financial statements are prepared the above adjustment is
Sales 37000
Rent Income
42 omitted
51
Salary Expense 12000
52 What is the effect of this omission on the balances that will appear on
Rent expense
53 financial statement? Which items will overstate/understate?
Supplies expense
Depreciation expense 54
Utility expense 55 Illustration
3000 3-3
Miscellaneous expense 56
2000
Total 193,500 193,500
 Zemen Studio January 31,Adjustment data The purpose of Adjustment is to
Trial Balance (Unadjusted) 1. Supplies on hand…….Br 800 update account balances by

A/Title
The Basics of Adjusting Entries
January 31,2023
A/No. Debit Credit
2. Prepaid rent………….Br 2,000
3. Unearned Rent……….Br5000
splitting all unadjusted balances
in to Balance sheet items and
Cash
11
120800
4. Accrued salaries……..Br 80 Income statement items
12 5. Services rendered but not billed Br1,200
..Types of Adjusting Entries
A/R 10200
13 6. Dep. Expense………Br 200
Office Supplies 7700
14
Prepaid Rent 3000
Photog. Equip.
15
20000 Analysis:
Acc. Depreciation
15.1 5.Accrued Salaries (Unrecorded Salary expense) 80 -Accrual
A/ Payable
21
6000
Salary expense (51)……80
22 Salary Payable(22)…………….80
Salaries Payable
23
Emp. I. Tax Payable 500
24
Unearned Rent 15000 -It is an accrual adjustment
31
Zemen's Capital 135000
32
Zemen's Drawing 1300
33
Income Summary
Activity
41
Sales 37000 Assume when financial statements are prepared the above adjustment is
42
Rent Income omitted
51
Salary Expense 12000
52 What is the effect of this omission on the balances that will appear on
Rent expense
Supplies expense
53 financial statement? Which items will overstate/understate?
Depreciation expense 54
Utility expense 55 Illustration
3000 3-3
Miscellaneous expense 56
2000
Total 193500 193500
 Zemen Studio January 31,Adjustment data The purpose of Adjustment is to
Trial Balance (Unadjusted) 1. Supplies on hand…….Br 800 update account balances by

A/Title
The Basics of Adjusting Entries
January 31,2023
A/No. Debit Credit
2. Prepaid rent………….Br 2,000
3. Unearned Rent……….Br5000
splitting all unadjusted balances
in to Balance sheet items and
Cash
11
134,300
4. Accrued salaries……..Br 80 Income statement items
12 5. Services rendered but not billed Br1,200
..Types of Adjusting Entries
A/R 10200
13 6. Dep. Expense………Br 200
Office Supplies 7700
14
Prepaid Rent 3000
Photog. Equip.
15
20000 Analysis:
Acc. Depreciation
15.1 5.Accrued revenue (Unrecorded Revenue) 1200 -Accrual
A/ Payable
21
6000
A/Receivable(12)……1200
22 Rent Income (42)…………….1200
Salaries Payable
23
Emp. I. Tax Payable 500
24
Unearned Rent 15000 -It is an accrual adjustment
31
Zemen's Capital 135000
32
Zemen's Drawing 1300
33
Income Summary
Activity
41
Sales 37000 Assume when financial statements are prepared the above adjustment is
42
Rent Income omitted
51
Salary Expense 12000
52 What is the effect of this omission on the balances that will appear on
Rent expense
Supplies expense
53 financial statement? Which items will overstate/understate?
Depreciation expense 54
Utility expense 55 Illustration
3000 3-3
Miscellaneous expense 56
2000
Total 193500 193500
 Zemen Studio January 31,Adjustment data The purpose of Adjustment is to
Trial Balance 1. Supplies on hand…….Br 800 update account balances by

A/Title
The Basics of Adjusting Entries
January 31,2023
A/No. Debit Credit
2. Prepaid rent………….Br 2,000
3. Unearned Rent……….Br5000
splitting all unadjusted balances
in to Balance sheet items and
Cash
11
134300
4. Accrued salaries……..Br 80 Income statement items
12 5. Services rendered but not billed Br1,200
..Types of Adjusting Entries
A/R 10200
13 6. Dep. Expense………...Br 200
Office Supplies 7700
Prepaid Rent
14
3000
Analysis:
15 6. Depreciation Expense Br 200
Photog. Equip. 20000
15.1 Depreciation expense is related to the usage of long-lived tangible assets of
Acc. Depreciation
21
the business.
A/ Payable 6000
22
Salaries Payable
23 Note: Assets are further classified in to:
Emp. I. Tax Payable 500
24
(1) Current Assets: Expected to be used/converted in to cash in a year
Unearned Rent 15000
period.
31
Zemen's Capital 135000 (2) Non Current/Long lived Assets: Expected to provide service for more
32
Zemen's Drawing 1300 than a year period. Includes:
33
Income Summary (such as Land-with unlimited life-No depreciation)
41 (such as building, equipment- with limited life-
Sales 37000
Rent Income
42 subject to depreciation.)
Salary Expense
51
12000
Depreciation: a process of allocating non current asset cost over its
52 useful life (the gradual conversion of non current asset cost in to
Rent expense
53 expense)
Supplies expense
Depreciation expense 54
Utility expense 55 Illustration
3000 3-3
Miscellaneous expense 56
2000
Total 193500 193500
 Zemen Studio January 31,Adjustment data The purpose of Adjustment is to
Trial Balance (Unadjusted) 1. Supplies on hand…….Br 800 update account balances by

A/Title
The Basics of Adjusting Entries
January 31,2023
A/No. Debit Credit
2. Prepaid rent………….Br 2,000
3. Unearned Rent……….Br5000
splitting all unadjusted balances
in to Balance sheet items and
Cash
11
134300
4. Accrued salaries……..Br 80 Income statement items
12 5. Services rendered but not billed Br1,200
..Types of Adjusting Entries
A/R 10200
13 6. Dep. Expense………...Br 200
Office Supplies 7700
Prepaid Rent
14
3000
Analysis:
15 ….6. Depreciation Expense…….…200 -Deferral
Photog. Equip. 20000
15.1 Book Value/Unexpired/Asset/Balance sheet item: 20000-200=19800
Acc. Depreciation
21
Expired/Expense/Income statement item …………………….….200
A/ Payable 6000 Depreciation expense (54)……200
22
Salaries Payable Accumulated Depreciation (15.1)……200
23
Emp. I. Tax Payable 500
Unearned Rent
24
15000 -It is a deferral adjustment
31
Zemen's Capital 135000
Zemen's Drawing
32
1300 Two Accounts are used to record adjustment:
Income Summary
33 1. Depreciation Expense-Income statement account
41 2. Accumulated depreciation-contra asset account; increase
Sales 37000
42 side=credit; it reduce the asset balance.
Rent Income
51
Salary Expense 12000 Activity
52 Assume when financial statements are prepared the above adjustment is
Rent expense
Supplies expense
53 omitted
Depreciation expense 54
Utility expense 55 Illustration What is the effect of this omission on the balances that will appear on
3000 3-3
Miscellaneous expense 56 financial statement? Which items will overstate/understate?
2000
Total 193500 193500
The Adjusted Trial Balance

Adjusted Trial Balance

 Prepared after all adjusting entries are journalized and
posted.
 Purpose is to prove the equality of debit balances and
credit balances in the ledger after accounts are adjusted.
 Is the primary basis for the preparation of financial
statements.

LO 7 Describe the nature and purpose of an adjusted trial balance.

Preparing Financial Statements

Financial
FinancialStatements
Statementsare
areprepared
prepareddirectly
directlyfrom
fromthe
the
Adjusted
AdjustedTrial
TrialBalance.
Balance.

Retained Statement
Income
Earnings of Financial
Statement
Statement Position

LO 7 Describe the nature and purpose of an adjusted trial balance.

 Zemen Studio
Trial Balance(Adjusted)
Illustration 3-25
January 31,2023
A/Title A/No. Debit Credit

11
Cash 134,300 Zemen Studio
12
A/R 11400 Income Statement
13
Office Supplies 800 For the month ended January 31,2023
14
Prepaid Rent 2000 Revenue
15
Photog. Equip. 20000 Sales 38,200
15.1
Acc. Depreciation 200 Rent Income 10,000
21
A/ Payable 6000 Total Income 48,200
22
Salaries Payable 80 Expenses
23
Emp. I. Tax Payable 500 Salary Expense 12080
24
Unearned Rent 5,000 Rent expense 1000
31
Zemen's Capital 135000 Supplies expense 6900
32
Zemen's Drawing 1300 Depreciation expense 200
33
Income Summary Utility expense 3000
41
Sales 38200 Miscellaneous expense 2000
42
Rent Income 10,000 Total Expenses 25,180
51
Salary Expense 12080 Net Income 23,020
52
Rent expense 1000
 Zemen Studio Financial Statements are prepared
Adjusted Trial Balance
January 31,2023 from adjusted trial balance
Illustration 3-25

A/Title A/No. Debit Credit

11
Cash 134,300
12
A/R 11400 Zemen Studio
13
Office Supplies 800 Capital Statement
14
Prepaid Rent 2000 For the month ended January 31,2023
15
Beginning capital January
Photog. Equip. 20000 1,2023 105,000
15.1
Acc. Depreciation 200 Add:
21
A/ Payable 6000 Owner’s investment 30,000
22
Salaries Payable 80 Less: Drawing -1300
23
Emp. I. Tax Payable 500 Add Net income 23,020
24
Unearned Rent 5,000 Net Increase in capital 56,720
31
Zemen's Capital 135000 Ending Capital, January 31,2023 156,720
33
Income Summary
41
Sales 38200
42
Rent Income 10,000
51
Salary Expense 12080
52
Rent expense 1000
53
Supplies expense 6900
 Zemen Studio
Adjusted Trial Balance
Illustration 3-25
January 31,2023
A/Title A/No. Debit Credit

11
Cash 134,300
12
A/R 11400 Zemen Studio
13
Office Supplies 800 Statement of Financial Position
14
Prepaid Rent 2000 As of January 31,2023
15
Photog. Equip. 20000 Property Plant & Equip.
15.1
Acc. Depreciation 200 -Photographic Equip. 20,000
21
A/ Payable 6000 -Less: Acc. Dep. (200) 19,800
22
Salaries Payable 80 Current Assets
23
Emp. I. Tax Payable 500 -Prepaid Rent 2,000
24
Unearned Rent 5,000 -Office Supplies 800
31
Zemen's Capital 135000 -A/R 11,400
Zemen's Drawing
32
1300
-Cash 134,300 148,500
33 Total Assets 168,300
Income Summary
41 Equity & Liabilities
Sales 38200
42
Rent Income 10,000 Equity
51
Salary Expense 12080 Zemen’s Capital 156,720
52
Rent expense 1000 Liability
53
Supplies expense 6900 A/ Payable 6000
Depreciation expense 54
APPENDIX 3A

Alternative Treatment of Prepaid Expenses and

Unearned Revenues
 When a company prepays an expense, it debits that
amount to an expense account.
 When a company receives payment for future
services, it credits the amount to a revenue account.

LO 8 Prepare adjusting entries for the alternative treatment of deferrals.

APPENDIX 3A

Prepaid Expenses
Company may choose to debit (increase) an expense account
rather than an asset account. This alternative treatment is simply
more convenient.
Illustration 3A-2

LO 8 Prepare adjusting entries for the alternative treatment of deferrals.

APPENDIX 3A

Unearned Revenues
Company may credit (increase) a revenue account when they
receive cash for future services.
Illustration 3A-5

LO 8 Prepare adjusting entries for the alternative treatment of deferrals.

APPENDIX 3A

Summary of Additional Adjustment Relationships

Illustration 3A-7

LO 8 Prepare adjusting entries for the alternative treatment of deferrals.

APPENDIX 3B CONCEPTS IN ACTION

Enhancing Qualities
 Comparability
 Consistency
 Verifiability
 Timeliness
 Understandability

LO 9 Discuss financial reporting concepts.

APPENDIX 3B CONCEPTS IN ACTION

Principles of Financial Reporting

 Measurement Principles
► Historical Cost Principle
► Fair Value Principle
 Revenue Recognition Principle
 Expense Recognition Principle
 Full Disclosure Principle

LO 9 Discuss financial reporting concepts.

APPENDIX 3B CONCEPTS IN ACTION

Principles of Financial Reporting

 Constraints in Financial Reporting

Accounting standard-setters weigh the cost that companies

will incur to provide the information against the benefit that
financial statement users will gain from having the information
available.

LO 9
Completing the
accounting cycle

Financial Accounting
IFRS Second Edition
Weygandt Kimmel Kieso
Using a Worksheet
Preparing a Worksheet
 Work sheet is a multiple-column form used in preparing
financial statements.
 It is a working paper used to design adjustments and
financial statements
 It is not a replacement for basic financial statements
 It is not a permanent accounting record/ its preparation is
optional because financial statements can be prepared
without it (from adjusted trial balance).
 Preparation involves five step process.
 Use of worksheet is optional.

LO 1 Prepare a worksheet.
Steps in Preparing a Worksheet
Illustration 4-1

LO 1 Prepare a worksheet.
 Steps in Preparing a Worksheet
1. Prepare a Trial Balance on the Worksheet Illustration 4-2
Adjusted Income Statement of
Trial Balance Adjustments Trial Balance Statement Financial Position
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200
Supplies 2,500
Prepaid Insurance 600
Equipment 5,000
Notes Payable 5,000
Accounts Payable 2,500
Unearned Revenue 1,200
Share Capital-Ordinary 10,000
Dividends 500
Service Revenue 10,000

Salaries and Wages Exp. 4,000

Rent Expense 900
Totals 28,700 28,700

Trial balance amounts come

directly from ledger accounts.
Include all accounts
with balances.

LO 1 Prepare a worksheet.
 Steps in Preparing a Worksheet
Illustration 3-23
General journal
showing adjusting
entries

Adjusting
Journal Entries

LO 1 Prepare a worksheet.
 Steps in Preparing a Worksheet
2. Enter the Adjustments in the Adjustments Columns
Adjusted Income Statement of
Trial Balance Adjustments Trial Balance Statement Financial Position
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200
Supplies 2,500 (a) 1,500
Prepaid Insurance 600 (b) 50
Equipment 5,000 Adjustments Key:
Notes Payable 5,000
Accounts Payable 2,500
(a) Supplies Used.
Unearned Revenue 1,200 (d) 400 (b) Insurance Expired.
Share Capital-Ordinary 10,000
Dividends 500
(c) Depreciation Expensed.
Service Revenue 10,000 (d) 400 (d) Service Revenue Earned.
(e) 200
Salaries and Wages Exp. 4,000 (g) 1,200 (e) Service Revenue Accrued.
Rent Expense 900 (f) Interest Accrued.
Totals 28,700 28,700
Supplies Expense (a) 1,500 (g) Salaries Accrued.
Insurance Expense (b) 50
Accumulated Depreciation (c) 40
Depreciation Expense (c) 40
Accounts Receivable (e) 200
Interest Expense (f)
50
Enter adjustment amounts, total
Interest Payable (f) 50 adjustments columns,
(g) 1,200
Salaries and Wages Payable and check for equality.
Totals 3,440 3,440

Add additional accounts as needed.

LO 1 Prepare a worksheet.
 Steps in Preparing a Worksheet
3. Complete the Adjusted Trial Balance Columns
Adjusted Income Statement of
Trial Balance Adjustments Trial Balance Statement Financial Position
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200 15,200
Supplies 2,500 (a) 1,500 1,000
Prepaid Insurance 600 (b) 50 550
Equipment 5,000 5,000
Notes Payable 5,000 5,000
Accounts Payable 2,500 2,500
Unearned Revenue 1,200 (d) 400 800
Share Capital-Ordinary 10,000 10,000
Dividends 500 500
Service Revenue 10,000 (d) 400 10,600
(e) 200
Salaries and Wages Exp. 4,000 (g) 1,200 5,200
Rent Expense 900 900
Totals 28,700 28,700
Supplies Expense (a) 1,500 1,500
Insurance Expense (b) 50 50
Accumulated Depreciation (c) 40 40
Depreciation Expense (c) 40 40
Accounts Receivable (e) 200 200
(f)
Interest Expense 50 50
Interest Payable (f) 50 50
Salaries and Wages Payable (g) 1,200 1,200
Totals 3,440 3,440 30,190 30,190

Total the adjusted trial balance

columns and check for equality.
LO 1 Prepare a worksheet.
 Steps in Preparing a Worksheet
4. Extend Amounts to Financial Statement Columns
Adjusted Income Statement of
Trial Balance Adjustments Trial Balance Statement Financial Position
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200 15,200
Supplies 2,500 (a) 1,500 1,000
Prepaid Insurance 600 (b) 50 550
Equipment 5,000 5,000
Notes Payable 5,000 5,000
Accounts Payable 2,500 2,500
Unearned Revenue 1,200 (d) 400 800
Share Capital-Ordinary 10,000 10,000
Dividends 500 500
Service Revenue 10,000 (d) 400 10,600 10,600
(e) 200
Salaries and Wages Exp. 4,000 (g) 1,200 5,200 5,200
Rent Expense 900 900 900
Totals 28,700 28,700
Supplies Expense (a) 1,500 1,500 1,500
Insurance Expense (b) 50 50 50
Accumulated Depreciation (c) 40 40
Depreciation Expense (c) 40 40 40
Accounts Receivable (e) 200 200
(f)
Interest Expense 50 50 50
Interest Payable (f) 50 50
Salaries and Wages Payable (g) 1,200 1,200
Totals 3,440 3,440 30,190 30,190 7,740 10,600

Extend all revenue and expense account

balances to the income statement columns.
LO 1 Prepare a worksheet.
 Steps in Preparing a Worksheet
5. Total Columns, Compute Net Income (Loss)
Adjusted Income Statement of
Trial Balance Adjustments Trial Balance Statement Financial Position
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200 15,200 15,200
Supplies 2,500 (a) 1,500 1,000 1,000
Prepaid Insurance 600 (b) 50 550 550
Equipment 5,000 5,000 5,000
Notes Payable 5,000 5,000 5,000
Accounts Payable 2,500 2,500 2,500
Unearned Revenue 1,200 (d) 400 800 800
Share Capital-Ordinary 10,000 10,000 10,000
Dividends 500 500 500
Service Revenue 10,000 (d) 400 10,600 10,600
(e) 200
Salaries and Wages Exp. 4,000 (g) 1,200 5,200 5,200
Rent Expense 900 900 900
Totals 28,700 28,700
Supplies Expense (a) 1,500 1,500 1,500
Insurance Expense (b) 50 50 50
Accumulated Depreciation (c) 40 40 40
Depreciation Expense (c) 40 40 40
Accounts Receivable (e) 200 200 200
Interest Expense (f) 50 50 50
Interest Payable (f) 50 50 50
Salaries and Wages Payable (g) 1,200 1,200 1,200
Totals 3,440 3,440 30,190 30,190 7,740 10,600 22,450 19,590
Net Income 2,860 2,860
Totals 10,600 10,600 22,450 22,450
Compute Net Income or Net Loss.
LO 1 Prepare a worksheet.
Steps in Preparing a Worksheet

Review Question
Net income is shown on a worksheet in the:
a. income statement debit column only.
b. statement of financial position debit column only.
c. income statement credit column and statement of
financial position debit column.
d. income statement debit column and statement of
financial position credit column.

LO 1 Prepare a worksheet.
Using a Worksheet

Preparing Statements from a Worksheet

 Income statement is prepared from the income
statement columns.
 Statement of financial position and retained earnings
statement are prepared from the statement of financial
position columns.
 Companies journalize and post adjusting entries.

LO 1 Prepare a worksheet.
Preparing Statements from a Worksheet
Illustration 4-4

LO 1 Prepare a worksheet.
Preparing Statements from a Worksheet
Illustration 4-4

LO 1 Prepare a worksheet.
Preparing Statements from a Worksheet
Illustration
4-4

LO 1
Using a Worksheet

Preparing Adjusting Entries from a Worksheet

 Adjusting entries are prepared from the adjustments
columns of the worksheet.
 Journalizing and posting of adjusting entries follows the
preparation of financial statements when a worksheet is
used.

LO 1 Prepare a worksheet.
Susan Elbe is preparing a worksheet. Explain to Susan how she
should extend the following adjusted trial balance accounts to the
financial statement columns of the worksheet.

Cash Statement of financial position (debit)

Accumulated Depreciation Statement of financial position (credit)
Accounts Payable Statement of financial position (credit)
Dividends Statement of financial position (debit)
Service Revenue Income statement (credit)
Salaries and Wages Expense Income statement (debit)

LO 1
Closing the Books

At the end of the accounting period, the company makes

the accounts ready for the next period.
Illustration 4-5

LO 2 Explain the process of closing the books.

Closing the Books

Preparing Closing Entries

Closing entries formally recognize, in the general ledger, the
transfer of
 net income (or net loss) and
 dividends
to retained earnings.

Closing entries are only made at the end of the annual

accounting period.

LO 2 Explain the process of closing the books.

 Closing the Books

Note:
Dividends are closed directly Illustration 4-6

to retained earnings and not

to Income Summary because
Retained earnings is a
dividends are not an permanent account; all
other accounts are
expense. temporary accounts.

LO 2
 Closing the Books

Closing
Entries
Illustrated

Illustration 4-7
Closing entries
journalized
Closing the Books

Posting
Closing
Entries

Illustration 4-8

LO 2
The worksheet for Hancock Company shows the following in the
financial statement columns:
Dividends €15,000
Share Capital-ordinary €42,000
Net income €18,000
Prepare the closing entries at December 31 that affect equity.

Income summary 18,000

Retained earnings 18,000
Retained earnings 15,000
Dividends 15,000

LO 1
Preparing a Post-Closing Trial Balance

Purpose is to prove the equality of the permanent account

balances after journalizing and posting of closing entries.

Illustration 4-9

LO 3
Summary of the Accounting Cycle
Illustration 4-12

1.
1. Analyze
Analyze business
business transactions
transactions

9.
9. Prepare
Prepare aa post-closing
post-closing 2.
2. Journalize
Journalize the
the
trial
trial balance
balance transactions
transactions

8.
8. Journalize
Journalize and
and post
post 3.
3. Post
Post to
to ledger
ledger accounts
accounts
closing
closing entries
entries

7.
7. Prepare
Prepare financial
financial 4.
4. Prepare
Prepare aa trial
trial balance
balance
statements
statements

6.
6. Prepare
Prepare an
an adjusted
adjusted trial
trial 5.
5. Journalize
Journalize and
and post
post
balance
balance adjusting
adjusting entries
entries

LO 4 State the required steps in the accounting cycle.

Summary of the Accounting Cycle

Correcting Entries—An Avoidable Step

 Unnecessary if the records are error-free.
 Made whenever an error is discovered.
 Must be posted before closing entries.

Instead of preparing a correcting entry, it is possible to reverse

the incorrect entry and then prepare the correct entry.

LO 5 Explain the approaches to preparing correcting entries.

 Correcting Entries—An Avoidable Step

Illustration (Case 1): On May 10, Mercato Co. journalized and posted
a $50 cash collection on account from a customer as a debit to Cash
$50 and a credit to Service Revenue $50. The company discovered the
error on May 20, when the customer paid the remaining balance in full.

Incorrect Cash 50
entry
Service revenue
50
Correct Cash 50
entry
Accounts receivable
50
Correcting Service revenue 50
entry Accounts receivable
50
LO 5 Explain the approaches to preparing correcting entries.
 Correcting Entries—An Avoidable Step

Illustration (Case 2): On May 18, Mercato purchased on account

equipment costing $450. The transaction was journalized and posted
as a debit to Equipment $45 and a credit to Accounts Payable $45. The
error was discovered on June 3.

Incorrect Equipment 45
entry
Accounts payable
45
Correct Equipment 450
entry
Accounts payable
450
Correcting Equipment 405
entry Accounts payable
405
LO 5 Explain the approaches to preparing correcting entries.
The Classified Statement of Financial Position

 Presents a snapshot at a point in time.

 To improve understanding, companies group similar
assets and similar liabilities together.

Standard Classifications
Illustration 4-17

LO 6 Identify the sections of a classified statement of financial position.

The Classified Statement of Financial Position

Illustration
4-18

LO 6
The Classified Statement of Financial Position

Illustration
4-18

LO 6
The Classified Statement of Financial Position

Intangible Assets
 Assets that do not have physical substance.
Illustration 4-19

LO 6 Identify the sections of a classified statement of financial position.

The Classified Statement of Financial Position

Question
Patents and copyrights are
a. Current assets.
b. Intangible assets.
c. Long-term investments.
d. Property, plant, and equipment.

LO 6 Identify the sections of a classified statement of financial position.

The Classified Statement of Financial Position

Property, Plant, and Equipment

 Long useful lives.
 Currently used in operations.
 Depreciation - allocating the cost of assets to a number
of years.
 Accumulated depreciation - total amount of
depreciation expensed thus far in the asset’s life.

LO 6 Identify the sections of a classified statement of financial position.

The Classified Statement of Financial Position

Property, Plant, and Equipment

Illustration 4-20

LO 6 Identify the sections of a classified statement of financial position.

The Classified Statement of Financial Position

Long-Term Investments
 Investments in ordinary shares and bonds of other
companies.
 Investments in non-current assets such as land or buildings
that a company is not using in its operating activities.
Illustration 4-21

LO 6 Identify the sections of a classified statement of financial position.

The Classified Statement of Financial Position

Current Assets
 Assets that a company expects to convert to cash or
use up within one year or the operating cycle, whichever
is longer.
 Operating cycle is the average time it takes from the
purchase of inventory to the collection of cash from
customers.

LO 6 Identify the sections of a classified statement of financial position.

The Classified Statement of Financial Position

Current Assets Illustration 4-22

Usually listed in the reverse order they expect to convert them into cash.

LO 6 Identify the sections of a classified statement of financial position.

The Classified Statement of Financial Position

Question
Assets that a company expects to convert to cash or use up
within one year or its operating cycle, whichever is longer
are called:
a. Current assets.
b. Intangible assets.
c. Long-term investments.
d. Property, plant, and equipment.

LO 6 Identify the sections of a classified statement of financial position.

Baxter Hoffman recently received the following information related to Hoffman
Company’s December 31, 2014, statement of financial position.
Prepaid insurance $ 2,300 Inventory $3,400
Cash 800 Accumulated depreciation—
Equipment 2,700 Equipment 10,700
Accounts receivable 1,100
Prepare the asset section of Hoffman Company’s statement of financial position.

LO 6
The Classified Statement of Financial Position

Equity
 Proprietorship - one capital account.
 Partnership - capital account for each partner.
 Corporation – Share Capital and Retained Earnings.

Illustration 4-23

LO 6 Identify the sections of a classified statement of financial position.

The Classified Statement of Financial Position

Non-Current Liabilities
 Obligations a company expects to pay after one year.
Illustration 4-24

LO 6 Identify the sections of a classified statement of financial position.

The Classified Statement of Financial Position

Current Liabilities
 Obligations company is to pay within the coming year or
its operating cycle, whichever is longer.
 Usually list notes payable first, followed by accounts
payable. Other items follow in order of magnitude.
 Liquidity - ability to pay obligations expected to be due
within the next year.

LO 6 Identify the sections of a classified statement of financial position.

The Classified Statement of Financial Position

Current Liabilities
Illustration 4-25

LO 6 Identify the sections of a classified statement of financial position.

The following accounts were taken from the financial statements of Callahan
Company.

Match each of the following accounts to its proper statement of financial

position classification, shown below. If the item would not appear on a
statement of financial position, use “NA.”
Current assets (CA) Current liabilities (CL)
Long-term investments (LTI) Non-current liabilities (NCL)
Property, plant, and equipment (PPE) Equity (E)
Intangible assets (IA)

LO 6
 CHAPTER THREE
Accounting For Merchandising Operation
(AcFn 2011)

208
 The Accounting Cycle for a Merchandising
Business
Learning Objectives
 Describe how the activities and financial statements of a service
and a merchandising business differ.
 Describe and illustrate the financial statements of a merchandising
business.
 Describe and illustrate the accounting for merchandise transactions
including:
• purchase and sale of merchandise
• freight, sales taxes, trade and cash discounts
• dual nature of merchandising transactions
 Describe the adjusting and closing process for a merchandising
business. Acfn 2011 209
Preview of Chapter 3

Acfn 2011 210

 The Accounting Cycle for a Merchandising
Business
• Merchandising business is a business engaged in
buying and selling merchandise
• Merchandise is an item bought for resale
Nature of a Merchandising Business
Chart of Account
• The chart of accounts for a merchandising business
is more complex than that for a service business and
normally includes accounts such as Sales, Sales
Discounts, Sales Returns and Allowances, Cost of
Merchandise Sold, and Merchandise Inventory.
Acfn 2011 211
 Nature of a Merchandising Business
The Ledger of a Merchandising Business:
The Ledger of a Merchandising Business is divided in to more than 5 divisions:
Division 100: Asset
Division 200: Liability
Division 300: Capital(SHE)
Division 400: Revenue
410: Sales
411: Sales Returns & Allowance
412: Sales Discount
Division 500: Cost of merchandise sold
Division 6: Selling Expenses (eg. Sales salary, Advertizing, delivery expense)
Division 7: Administrative Expense (eg. Office salary, Rent, Insurance
Division 8: Other income
Division 9: other Expense
• Acfn 2011 212
 Nature of a Merchandising Business
The Financial Statements of a Merchandising
Business:
1. Income statement shows Cost of Goods
Merchandising Sold
Business
Sales
Income statement of a Service Business Vs Merchandising
Service Business $XXX
Fees earned Cost of Merchandise Sold

$XXX –XXX
Operating expenses Gross Profit

–XXX $XXX
Net income Operating Expenses

$XX –XXX
Acfn 2011 213
Net Income
 Nature of a Merchandising Business
…The Financial Statements of a Merchandising
Business:
2. The Current Asset section of the Balance sheet
shows Merchandise Inventory
Service Business
Current Asset section of the BalanceMerchandising
sheet of a Service Business Vs
Business
Current Assets:
Merchandising
Current Assets:
Cash
Cash
$XXX
$XXX
A/Receivable
A/Receivable
XXX
XXX
Prepayments
Prepayments XXX
XXX
Merchandise Inventory XXX
Office Supplies XXX
Office Supplies XXX
Acfn 2011 214
Merchandising Operations

Income Measurement

Cost of goods sold is the total cost

of merchandise sold during the
period.

Acfn 2011 215

Merchandising Operations

Flow of Costs

Companies use either a perpetual inventory system or a periodic inventory

system to account for inventory.

Acfn 2011 216

 Periodic Vs Perpetual System
Periodic System
• It is a method of determining the cost of merchandise
sold and the amount of merchandise on hand
• Under this method, the inventory records do not
show the amount available for sale or the amount
sold during the period
• Under this method, purchase of merchandise is
recorded in an account titled “Purchase’’
• “Purchase” account is located in Cost of Merchandise
Sold division (the 5th division of Ledger).
Acfn 2011 217
 Periodic Vs Perpetual System
Perpetual System
• Under this method, each purchase and sale
of merchandise is recorded in the inventory
and the cost of merchandise sold accounts.
• The amount of merchandise available for
sale and the amount sold are continuously
disclosed in the inventory records.

Acfn 2011 218

 Chart of Account: Periodic Vs Perpetual System
Perpetual System
Periodic System
Division 100: Asset
Division 100: Asset
Division 200: Liability
Division 200: Liability
Division 300: Capital(SHE)
Division 300: Capital(SHE)
Division 400: Revenue
Division 400: Revenue
410: Sales
410: Sales
411: Sales Returns & Allowance
411: Sales Returns & Allowance
412: Sales Discount
412: Sales Discount
Division 500: Cost of Merchandise
Division 500: Costs
Sold (CMS)
510 Purchase
Division 6: Selling Expenses
511 Purchase Returns & Allowances
Division 7: Administrative Expenses
512 Purchase Discount Division 8: Other income
513: Freight in Division 9: other Expense
Division 6: Selling Expenses
Division 7: Administrative Expenses
Division 8: Other income
Division 9: other Expense
Note: Difference between the
two lies in the 5th division
Acfn 2011 219
 Periodic Vs Perpetual System
Assume, On January 5, 2020, ABC Co. Bought Merchandise on Account, Br 10,000

Periodic System Perpetual System

Dr. Purchase….10,000 Dr. Merchandise Inventory ….10,000
Cr. A/Payable………….10,000 Cr. A/Payable………….10,000
(Recorded in Cost of Merchandise sold (Recorded in Asset division)
division)

Assume, On January 10, 2020, ABC Co. sold Merchandise on account at Br 12,000.
Merchandise was bought at Br 10,000 (Cost price)

Perpetual System
Periodic System 1. Dr. A/receivable ….12,000
Dr. A/receivable ….12,000 Cr. Sales………………….12,000
Cr. Sales………….12,000 2. Dr. Cost of Merchandise Sold ….10,000
(One entry) Cr. Merchandise Inventory…………….10,000
(Two entries)
Acfn 2011 220
 Accounting for Purchase
Credit Terms

• A credit term: is an arrangement agreed up on by the purchaser

and the seller as to when payments for merchandise are to be
made.
A Credit term can be in two form:
• "Cash or Net cash term": Under this term, the buyer is
required to pay cash immediately, up on delivery of goods.
• "On Credit or On account term": Under this term, the buyer
is allowed a credit period, a certain time after delivery of goods
to make payments. A credit period may be stated, as follows:

Acfn 2011 221

 …Accounting for Purchase
…Credit term
• "n/30 or net 30" days: means payment is due
within 30 days after the date of the invoice
• "n/eom": means payment is due by the end of
the month in which the purchase/sales is made
• " 10,eom" : means payment is due with in 10
days after the end of the month in which the
purchase/sales is made.

Acfn 2011 222

 Accounting for Purchase
Look at the following Purchases with different terms:
Date: Transactions
1. November 23: Purchased merchandise on account, on
n/30 terms
Due date: December 23
2.November 23: Purchased merchandise on account, on
n/eom terms
Due date: November 30
3.November 23: Purchased merchandise on account, on
10,eom terms (with in 10 days after the end of month)
Due date: December 10
Acfn 2011 223
 Accounting for Purchase
Discounts:
• There are two types of Discounts:
1. Cash Discount
2. Trade Discount
1. Cash Discount
• It is a discount from invoice price allowed by the seller
to the buyer to encourage early payments (for payments
before the end of the credit period).
• Cash discount benefits both the buyer and the seller; the
buyer saves money and the seller gets the cash quickly.
Acfn 2011 224
 Accounting for Purchase
When the agreement involves discount, it is
expressed as 2/10, n/30 etc, 3/15,n45 etc:

Eg. on Nov. 2: Purchased merchandise on

account, Br 10,000 on 2/10, n/30 terms
Meaning: The credit period is 30 days, a 2%
discount is available if payment is made
within 10 days (On or before November 12)- Payment
These10 days are known as Discount periods terms are
.
On Nov. 2: Purchased merchandise on 2/10, n/30
account, Br 10,000 on 3/15, n/45 terms
Meaning: The credit period is 45 days, a 3%
discount is available if payment is made
within 15 days (On or before November 17)
These 15 days are known as Discount
periods. Acfn 2011 225
 Accounting for Purchase
Purchase can be on cash or on account
Purchase on Cash
Periodic System Perpetual System
Dr. Purchase….xxx Dr. Merchandise Inventory ….xxx
Cr. Cash………….xxx Cr. Cash…………………..xxx
(Recorded in Cost of Merchandise sold (Recorded in Asset division)
division)

Purchase on Account

Periodic System Perpetual System

Dr. Purchase….xxx Dr. Merchandise inventory… xxx
Cr. A/Payable………….xxx Cr. A/Payable………….vvv

Acfn 2011 226

 Accounting for Purchase
Purchase Discount
• It is a cash discount allowed by the seller for
payments made within the discount period. Periodic system
• It is recorded by the buyer at the time of Purchase=100,000
Purchase Discount=2,000
payment
 In periodic system it is recorded in Net purchase=98,000
Purchase Discount account
 In perpetual system it is directly
Perpetual system
credited to Merchandise inventory Price of Merchandise=100,000
Purchase Discount Account Purchase Discount=2,000
• it is an account with credit balance.
Net cost of merchandise
• It is a Contra purchase account, which =98,000
reduces purchase account to net amount.
Acfn 2011 227
 Accounting for Purchase
Assume, On January 5, 2014, ABC Co. Bought Merchandise on Account, Br 10,000 on
2/10,n/30 terms

Periodic System Perpetual System

Dr. Purchase….10,000 Dr. Merchandise Inventory ….10,000
Cr. A/Payable………….10,000 Cr. A/Payable………….10,000
(Recorded in Cost of Merchandise sold (Recorded in Asset division)
division)

Payment with in the Discount Period: (Discount Period: Jan 5 + 10days=Up to Jan 15)
Assume, On January 13, 2014, ABC Co. issued check to pay for January 5’s purchase
(it is paid with in the discount period)
Discount= 2% of 10,000=200; Payment=10,000-200=9,800

Periodic System Perpetual System

Dr. A/Payable………….10,000 Dr. A/Payable………….10,000
Cr. Cash………………….….9,800 Cr. Cash………………….….9,800
Cr. Purchase discount….200 Cr. Merchandise Inventory….200
Discount is recorded in a Separate *Discount is directly credited to the asset
account titled “Purchase Discount” account “Merchandise inventory”
Acfn 2011 228
 Accounting for Purchase

Payment after the Discount Period: (discount period ends on January 15)
Assume, On January 16, 2014, ABC Co. issued check to pay for January 5’s
purchase
(it is paid after the discount period)
Discount= 0; Payment=10,000-0=10,000

Periodic System Perpetual System

Dr. A/Payable………….10,000 Dr. A/Payable………….10,000
Cr. Cash………………….….10,000 Cr. Cash………………….….10,000

Acfn 2011 229

 Accounting for Purchase
Trade Discounts
 Reductions from the list price 10 %
Discount for
 Not recognized in the accounting records
new Retail
 Transactions are recorded net of discounts Store
Customers

Eg. April 1, 2020: Purchased merchandise with a list price of Br 10,000 and trade
discount of 20% on account on terms 2/10,n/30. Agreed Price= 100% - 20%=80%
i.e. 80% of 10,000=8,000
Periodic System
Dr. Purchase….8,000 Perpetual System
Cr. A/Payable………….8,000 Dr. Merchandise Inventory ….8,000
(Recorded in Cost of Merchandise sold Cr. A/Payable………….8,000
division) (Recorded in Asset division)

Acfn 2011 230

 Accounting for Purchase
Payment with in the Discount Period: (Discount Period: April 1+ 10days=Up to April 11)
Assume, On April 10, 2014, ABC Co. issued check to pay for April 1’s purchase
(it is paid with in the discount period)
Discount= 2% of 8,000=160; Payment=8,000-160=7,840

Periodic System Perpetual System

Dr. A/Payable………….8,000 Dr. A/Payable…………8,000
Cr. Cash………………….….7,840 Cr. Cash………………….….7,840
Cr. Purchase discount….160 Cr. Merchandise Inventory….160

Payment after the Discount Period: (discount period ends on April 11)
Assume, On April 12, 2014, ABC Co. issued check to pay for April 1’s purchase
(it is paid after the discount period)
Discount= 0; Payment=8,000
Periodic System
Perpetual System
Dr. A/Payable………….8,000
Dr. A/Payable………….8,000
Cr. Cash………………….….8,000
Cr. Cash………………….….8,000
Acfn 2011 231
 Accounting for Purchase
Purchase Returns and Allowances:
• When merchandise bought is found to be defective or inferior in
quality/below standard:
1. it may be returned to the seller (Returns) or
2. a price reduction may be requested for, as a compensation
(Allowance).
• “Debit memo/memorandum” is a document prepared by the
buyer to inform the seller about the return/allowance,
• On the Debit memo, the quantity and the cost of the items
returned/for which a price reduction is allowed are stated.
• It is a source document to debit the supplier’s account (Accounts
payable) for the cost of the goods
Acfn 2011returned/price reductions made
232
 Accounting for Purchase
Recording Purchase Returns and Allowances
• It is recorded by the buyer at the time
Periodic system
of retuning merchandise Purchase=100,000
 In periodic system it is recorded in Purchase Discount=2,000
Purchase Returns & Allowance Purchase Ret & Allow=5,000
account Net purchase=93,000
 In perpetual system it is directly
credited to Merchandise inventory Perpetual system
Price of Merchandise=100,000
Purchase Returns & Allow. Account Purchase Discount=2,000
Purchase Ret & Allow.=5,000
• it is an account with credit balance.
• It is a Contra purchase account, which Net cost of merchandise
reduces purchase account to net amount. =93,000
Acfn 2011 233
 Accounting for Purchase
Assume, On May 5, 2020, ABC Co. Purchased merchandise with a list price of Br
10,000 and trade discount of 20% on account on terms 2/10,n/30.

Periodic System Perpetual System

Dr. Purchase….8,000 Dr. Merchandise Inventory ….8,000
Cr. A/Payable………….8,000 Cr. A/Payable………….8,000
(Recorded in Cost of Merchandise sold (Recorded in Asset division)
division)

Assume, On May 7, 2020, ABC Co. returned merchandise purchased on May 5, $500,
debit memo No. 22
(Return was made before payment)

Perpetual System
Periodic System Dr. A/Payable………….500
Dr. A/Payable………….500 Cr. Merchandise Inventory 500
Cr. Purchase Returns & Allowance 500 *Return is directly credited to the asset account
*Return is recorded in a Separate account “Merchandise inventory”
titled “Purchase Returns & Allowance

Acfn 2011 234

 Accounting for Purchase
Payment of the remaining balance (8000-500-7500) with in the Discount Period:
Assume, On May 15, 2020, ABC Co. issued check to pay for May 5’s purchase
(it is paid with in the discount period)
Discount= 2% of 7,500=150; Payment=7,500-150=7,350

Periodic System Perpetual System

Dr. A/Payable………….7,500 Dr. A/Payable…………7,500
Cr. Cash………………….…. 7,350 Cr. Cash………………….….7,350
Cr. Purchase discount….150 Cr. Merchandise Inventory….150

Return after Discount is taken

Assume, On May 17, 2020, ABC Co. Made an additional return of merchandise
purchased on May 5, $200, debit memo No. 23
Periodic System
Perpetual System
Dr. Cash………………..….196
Dr. Cash………………..….196
Dr. Purchase discount….4
Cr. Purchase Returns & Allow. 200
Cr. Merchandise Inventory 196
Acfn 2011 235
 Accounting for Sales
Sales Discount
• It is a cash discount allowed by the seller
for collections made within the discount
period.
• It is recorded by the seller at the time Sales=100,000
of collection Sales Discount=2,000
 It is recorded in Sales Discount Net sales=98,000
account
Sales Discount Account
• it is an account with debit balance.
• It is a Contra Sales account, which
reduces Sales account to netAcfnamount.
2011 236
 Accounting for Sales
Assume, On January 8, 2014, ABC Co. Sold Merchandise on Account, Br 12,000 on
2/10,n/30 terms. (The cost price of the merchandise sold was br 10,000)
Perpetual System
1. Dr. A/receivable ….12,000
Periodic System
Cr. Sales………………….12,000
Dr. A/Receivable….12,000
2. Dr. Cost of Merchandise Sold ….10,000
Cr. Sales………….12,000
Cr. Merchandise Inventory…………10,000
(Only one entry-for revenue)
(Two entries: 1. To record revenue2. to record
the decrease in merchandise because of sale)
Collection with in the Discount Period: (Discount Period: Jan 8 + 10days=Up to Jan 18)
Assume, On January 15, 2014, ABC Co. received check from customers for January 5’s sale
(it is collection with in the discount period)
Discount= 2% of 12,000=240; Collection=12,000-240=11,760

Periodic System
Perpetual System
Dr. Cash……………….11,760
Dr. Cash……………….11,760
Cr. Sales discount……...240
Cr. Sales discount……...240
Cr. A/Receivable………...12,000
Cr. A/Receivable………...12,000
Discount is recorded in an account
Discount is recorded in an account titled “ Sales
titled “ Sales Discount” AcfnDiscount”
2011 237
 Accounting for Sales
Sales Returns and Allowances:
• It occurs when the buyer returns defective items or ask a
reduction of price for it
• “Credit memo/memorandum” is a document prepared
by the seller to confirm about the return/allowance,
• It is a source document to credit the customer’s account
(Accounts Receivable) for the cost of the goods
returned/price reductions made

Acfn 2011 238

 Accounting for Sales
Recording Sales Returns and Allowances
• It is recorded by the seller at the time of
receiving the retuned merchandise
 In both Periodic & Perpetual system it is In both systems:
recorded in Sales Returns & Allowance Sales=100,000
account (at selling price) Sales Discount=2,000
 In perpetual system one more entry is Sales Ret & Allow=5,000
recorded at cost price: by debiting Net Sales=93,000
Merchandise inventory & Crediting Cost of
Goods sold
Sales Returns & Allow. Account
• it is an account with debit balance.
• It is a Contra sales account, which reduces
sales account to net amount. Acfn 2011 239
 Accounting for Sales
Assume on May 5 XYZ Co. Sold merchandise costing Br 7,000 at Br 8,000, 2/10,n 30 terms

Perpetual System
Periodic System May 5 Accounts Receivable .-- 8,000
May 5 Accounts Receivable .---- 8,000 Sales-- -- 8,000
Sales--……………………….-- 8,000 Dr. Cost of goods sold …7000
(Only one entry) Cr. Merchandise inventory.7000
(Two entries)
Assume on May 7 XYZ Co. received merchandise returned from sale of May 5, $500,
credit memo No. 30. (selling price of returned items=500; cost price of returned
items=400
Perpetual System
May 7 Sales Ret. & Allow.------- 500
Periodic System Accounts Receivable ---- 500
May 7 Sales Ret. & Allow.------ 500 Dr. Merchandise inventory …400
Accounts Receivable -- 500 Cr. Cost of goods sold …….….400
(Only one entry at selling price) (Two entries: at selling price & at cost)
*Return is directly debited to the asset account
“Merchandise inventory”
Acfn 2011 240
Remaining Balance of A/R=8,000-500=7,500
 Accounting for Sales
Assume on May 10 XYZ Co. received a check from customers from sales made on
May 5. (Collection of the remaining A/R of 7,500 was made with in the discount
period)

Periodic System Perpetual System

May 10 Cash.------- 7,350 May 10 Cash.------- 7,350
Sales discount 150 Sales discount 150
Accounts Receivable ---- 7500 Accounts Receivable --7500
(Only one entry) (Only one entry)

Net sales= Sales – Sales returns & allowance-Sales discount

=8,000 -500-150=7,350
Merchandise returned after discount is taken
Assume on May 19 XYZ Co. received additional return of merchandise sold on May, 5,
$200, credit memo No.35 (The cost of returned items was Br 160)
Periodic System Perpetual System
Dr. Sales Returns and Allow.…………200 Dr. Sales Returns and Allow.…………200
Cr. Cash 196 Cr. Cash 196
Cr. Sales Discount 4 Cr. Sales Discount 4
Dr. Merchandise Inventory…160
Acfn 2011 Cr. Cost of goods sold….160 241
 Transportation Costs
Transportation Costs
• Either the buyer or the seller may cover the cost of
transporting merchandise from the seller’s warehouse
to the buyer’s. It depends of the agreement
1. FOB Shipping Point
2. FOB Destination Point.
FOB means Free On Board, which means title of
ownership to goods will be freed or transferred
from the seller to the buyer at specific location, at
shipment point or at destination.
Acfn 2011 242
 Transportation Costs
1.FOB Shipping Point Term:
• Under this shipping agreement, the freight cost
will be covered by the buyer
• No cost to the buyer until shipping point.
• At shipping point, the ownership title passes from
the seller to the buyer,
• While on transit goods are considered to be the
property of the buyer.

Acfn 2011 243

 Transportation Costs
2. FOB Destination Point Term:
• Under this shipping agreement, freight cost will
be covered by the seller
• No cost to the buyer until the buyer’s place of
business.
• At destination point, the ownership title passes
from the seller to the buyer,
• While on transit goods are considered to be the
property of the seller.
Acfn 2011 244
 Transportation Costs
How the Buyer Records it?
Transportation cost covered by the buyer is How the seller Records it?
added to the cost of the merchandise Transportation cost covered by the
seller is part of the operating
In Periodic system: It is recorded in a expense of the seller
"freight In/Transportation In" Account and It is recorded in a "Freight
finally added to the cost of merchandise Out/Delivery Expense" Account.

Freight In/Transportation In account: Freight-out/Transportation

- It is an account with debit balance. Out/Delivery Expense account:
- The balance of this account is added to the It is an Expense account,
cost of merchandise It is an account with debit
balance.
- In perpetual system: It is directly debited io
merchandise inventory account

Acfn 2011 245

 Transportation Costs
Recording freight Cost on Buyer’s Book
June 10: Purchased merchandise from MD Company,
Br9,000, terms FOB shipping point.
June 10 :Paid freight of Br 500 on June 10 purchase
from MD Company
Periodic Perpetual
Dr. Purchase…9,000 Dr. Merc. inventory…9,000
Cr. A/payable…………….9,000 Cr. A/payable……………….9,000
Dr. Freight in…….500 Dr. Merc. inventory…500
Cr. Cash…………500 Cr. Cash………………500

Acfn 2011 246

 Transportation Costs
Recording freight Cost on Seller’s Book
June 15: Sold merchandise to HH Company, at Br 10,000,
terms FOB destination point. The cost of merchandise
was Br 8,500.
June 16 :Paid freight of $400 on June 15 sale to HH
Perpetual
Company Dr. A/Receivable…10,000
Periodic
Dr. A/Receivable …10,000 Cr. Sales……………….10,000
Cr. Sales…………….….10,000 Dr. Cost of goods sold 8,500
Dr. Delivery expense…….400 Cr. Merc. inventory…8,500
Cr. Cash…………………………400 Dr. Delivery expense…….400
Cr. Cash…………………………400

Acfn 2011 247

 Transportation Costs
• The seller may prepay the freight, even though the terms are FOB
shipping point.
• The seller will then add the freight to the invoice.
• The buyer debits Merchandise Inventory for the total amount of
the invoice, including the freight.
• Any discount terms would not apply to the prepaid freight.

To illustrate, assume that ABC sells merchandise as follows:

• June 20. ABC Sold merchandise to MM Company on account,
$8000, 2,/10/n30 terms FOB shipping point. ABC paid freight of
$300, which was added to the invoice. The cost of the
merchandise sold is $7,000
Acfn 2011 248
 Transportation Costs
Seller (ABC Co.) Buyer (MM Co.)
Shipping Term: FOB Shipping Point Shipping Term: FOB
Freight is prepaid by the seller on behalf
Shipping Point
of the buyer Freight is to be covered by
The seller expects: 8000 + 300 from
the buyer though the seller
buyer has paid
Periodic Periodic
Dr. A/Receivable …8,300 Dr. Purchase …8,000
Cr. Sales…………….….8,000 Dr. Freight in… 300
Cr. Cash……………………300 Cr. A/Payable………….….8,300
Perpetual
Dr. A/Receivable…8,300 Perpetual
Cr. Sales……………….8,000 Merc. inventory…8,300
Cr. Cash………………… 300 Cr. A/Payable………….….8,300
Dr. Cost of goods sold 7,000
Cr. Merc. inventory…7,000
If paid with in the discount period,
discount is 2% of 8,000=160 Acfn 2011 249
 Sales tax
• Sales tax
– It is a tax levied on sales (on both cash and credit
sales).
– Sales tax is computed based on the sales amount and
added to the invoice.
– It is collected by the seller from buyers and
periodically submitted to the government.
– The government collects tax from buyers through
sellers; the sellers act as mediators between the buyer
and the government.

Acfn 2011 250

 Sales tax
May 5: Sold merchandise on cash, Br 5000 subject to 10% sales tax
Dr. Cash …..5,500
Cr. Sales……………..5,000
• Cr. Sales tax payable 500

May 7: Sold merchandise on account, Br 5000 subject to 10% sales tax, 2/10 n/30
Dr. A/Receivable …..5,500
Cr. Sales……………..5,000
Cr. Sales tax payable 500

May 7: Received merchandise with a price of 1000 returned by the buyer (from May 7 sales.)
Dr. Sales returns… …..1,000
Dr. Sales tax payable 100
Cr. A/Receivable ……………..1,100
May 15: Received cash (from May 7 sales less returns)
5500-1100=4,400
Dr. Cash… …..4,320
Discount=4000x2%=80
Dr. Sales discount 80
Amount collected
Cr. A/Receivable ……………..4,400
4000-80+400=4,320
Acfn 2011 251
 Sales tax
• Recording payment of Sales tax by the seller
May 31: The company remitted sales tax collected to the
government , Br 400

Sales tax payable……………..400

Cash……………………………………400

Acfn 2011 252

Dual nature of a merchandising transaction

• Each merchandising transaction affects a

buyer and a seller.
• In the illustration below, we show how the
same transactions would be recorded by the
seller and the buyer.
• 3.2 dual nature of merch bus.doc

Acfn 2011 253

 The Adjusting and Closing process
• In merchandising business, merchandise
inventory data is needed for preparing financial
statements.
• Ending merchandise inventory (EI) figure is
needed for Balance sheet
• Cost of Merchandise Sold (CMS) figure is needed
for Income statement

Acfn 2011 254

 The Adjusting and Closing process
Determining Cost of merchandise Sold (CMS) & Ending
Inventory (EI)
Perpetual System
 In perpetual system these two figures (CMS & EI) are readily
available in the accounting records. This is because:
 Merchandise inventory is updated continuously for increases and
decreases due to purchase, sales, returns and so forth
 Therefore:
1. Merchandise Inventory account shows ending balance of
merchandise as per book (that should be on hand) for balance
sheet
2. Cost of Goods sold account shows the cost of merchandise sold
during the period
3. Gross profit can easily be computed for income statement
Net Sales – CMS= Gross profit
Acfn 2011 255
 The Adjusting and Closing process
…Determining Cost of merchandise Sold (CMS) & Ending Inventory (EI)
Periodic System
 In periodic system these two figures (CMS & EI) are not readily available in the
accounting records. This is because:
 Merchandise inventory is not updated continuously for increases and decreases due to
purchase, sales, returns and so forth
 Purchase of merchandise is recorded in a separate account “purchase”
 Cost of goods sold was not recorded after each sale
 Therefore:
1. Merchandise Inventory account shows un updated balance (beginning balance of
merchandise )
2. No Cost of Goods sold account that shows the cost of merchandise sold during the
period
3. Therefore, Ending inventory balance is known by counting
Cost of merchandise sold balance is known by computing figures using the
following formula:
CMS= Beginning inventory + Net purchase – Ending inventory
Then Gross profit can be computed for income statement as:
Net Sales – CMS= Gross profit
Acfn 2011 256
 The Adjusting and Closing process
..Determining Cost of merchandise Sold & Ending Inventory
Periodic System
Merc. Inventory…January 1, 2014 1. Net Purchase (NP)
(BI)..145,250 (debit) Purchase - contra purchases
 Purchase………… 612,050 (debit) 612050-1000-5000
Purchase returns and allow. 1,000 (credit) =606,050
Purchase Discount …… 5,000 (credit) 2. Cost of Merchandise
Freight in 4,000 (debit) Purchased
Assume Physical count shows Merchandise Net Purchase + Freight in
Inventory…December 31, 2014 (EI) 606 050 +4000
…...150,500 =610,050

3. Cost of Merchandise Available for Sale

(CMAS) 4. Cost of Goods Sold
Beginning inventory + Cost of merchandise CMAS- ending inventory
purchased =755,300 -150,500
=145,250 + 610,050 = 755,300 =604,800
Acfn 2011 = 257
 The Adjusting and Closing process
Determining Cost of merchandise Sold & Ending
Inventory under periodic inventory

• 9.3 ex.doc

Acfn 2011 258

 The Adjusting and Closing process

Activity on how to compute CMS and Gross profit

under periodic system
Merc. Inventory…January 1, 2020
(BI)..150,000 (debit)
 Purchase………… 400,000 (debit) Compute:
Purchase returns and allow. 5,000(credit) 1. Net Sales
Purchase Discount …… 3,000 (credit) 2. Net purchase
Freight in 7,000 (debit) 3. Cost of merchandise
Assume Physical count shows Merchandise purchased
Inventory…December 31, 2014 (EI) 4. CMAS
…...160,000 5. CMS
Sales… 600,000 (credit). 6. Gross profit
Sales Returns & Allowance 2000 (Debit)
Sales Discount (sales Discount) 1,000
Freight out (Delivery Expense), 4,000
Acfn 2011 259
 The Adjusting and Closing process
Inventory Adjustment
The type of Inventory adjustment differs
depending on the inventory system in use
Perpetual inventory System
• Merchandise inventory is adjusted if there is a
difference between Book balance of merchandise
and actual count (due to overage/shortage eg. for
shrinkage)
Merchandise balance per book =180,000 Merchandise balance per book =190,000
Merchandise balance per count =178,000 Merchandise balance per count =195,000
Shortage=2000 Overage=5000
Adjusting entry Adjusting entry
Cost of Goods Sold.,…,2,000 Merchandise inventory………5,000
Merchandise inventory………2,000 Cost of Goods Sold.,…..…,5,000

Acfn 2011 260

 The Adjusting and Closing process
…Inventory Adjustment
Periodic inventory System
 Merchandise inventory is adjusted to update the
merchandise inventory account by replacing ending in
place of beginning
 Two adjusting entries are needed
eg. In previous example: BI=145,250; EI=150,500
Adjusting entry No. (2)
Adjusting entry No. (1)
Adjustment for Ending Inventory
Adjustment for Beginning Inventory
Merchandise inventory.,…,150,500
Income Summary.,…,145.250
Income Summary.,…, ………150,500
Merchandise inventory………145,250

Acfn 2011 261

 The Adjusting and Closing process
…Inventory Adjustment
 Other adjustments for deferrals (advance payments
& collections), supplies consumption, prepaid rent,
depreciation and so forth and Accruals (unrecorded
expenses and revenues), are recorded in similar way
as discussed in service business.

 Illustration KK Co. Periodic Adj & Closing.xlsx
Illustration KK Co. Perpetual Closing.xlsx

Acfn 2011 262

 Financial Statements of a
merchandising Business
Income Statement
Two Forms of Income Statement Advantage
 Simple to
1.Single Step prepare
 Easy to
2. Multiple Step
understan
1. Single Step d
– It is a short form that focuses on summary figures
 Limitation
– It consists just two groupings: revenues and expenses.  No detail
– Expenses are deducted from revenues to arrive at net  Does not
income or loss, hence the expression “single-step.” show
gross
Illustration KK Co. Periodic Adj & Closing.xlsx profit
– Illustration KK Co. Perpetual Closing.xlsx

Acfn 2011 263

 Financial Statements of a
merchandising Business
Multiple step
 It is a long form with many sections and
subsections
 It shows operating and non operating activities of
Advantage
the company separately. eg. companies often  Provides
present income from operations followed by detailed
figures
sections entitled “Other revenues and gains” and needed for
“Other expenses and losses.” analysis
.

Acfn 2011 264

 Financial Statements of a merchandising
Business
• Components of Multiple income statement

Illustration KK Co. Periodic Adj & Closing.xlsx

Illustration KK Co. Perpetual Closing.xlsx

Acfn 2011 265

 Chapter 3

The End

Any

Acfn 2011 266

CHAPTER FOUR
Accounting Systems
(AcFn 2011)

267
Learning Objectives
After studying this chapter, you should be able to:
 Explain Accounting System
 Identify the differences between Manual and Computerized accounting
systems.
 Describe the nature and purpose of a subsidiary ledger.
 Explain how companies use special journals in journalizing.
 Indicate how companies post a multi-column journal.

Acfn 2011
The Accounting System

The Accounting
System

Acfn 2011
2021
Accounting System
After
It is studying
an information system
this chapter, with
you should be set
able of
to: rules and procedures
for
 recording, summarizing and reporting financial activities of
Explain Accounting System
an
 entity.
Identify the differences between Manual and Computerized accounting
It issystems.
a means by which internal and external users are given
the
 information
Explain the usefor use injournals.
of special decision making .

Two Explain
majortheAccounting
use of subsidiary ledgers
data processing methods:
1. Manual Accounting System
2. Computerized Accounting System

AAU School of Commerce Acfn 1031

2017
 …. Accounting Systems
Manual Accounting Systems
In manual system, transactions are
recorded in journals and posted in
ledgers by hand,

Computerized Accounting Systems

In computerized system, transactions are
recorded in journals and posted in
ledgers using accounting softwares, Eg
peachtree, quick book, acc pack and so
forth
 Advantages
Advantages of
of aa Computerized
ComputerizedAccounting
Accounting
System
System Over
Over aa Manual
ManualAccounting
Accounting System
System
1. Computerized systems simplify the
record-keeping process.
2. Computerized systems are generally
more accurate.
3. Computerized systems provide
management current account balance
information to support decision
making.
 Accounting
Accounting System
System Installation
Installation and
and Revision
Revision
The installation and revision of an accounting system
requires a complete knowledge of a business operation.
1. System analysis: This stage determines data needs, the sources of data and any
problem in processing current data.
2. System design: This stage involves designing new or revising current
accounting systems based upon the results of the systems analysis.
3. System implementation: This is the final stage that installs and evaluates the
new or revised accounting system.

Analysis
F
E
Design E
D
B
Implementation A
 Principles
Principles of
ofAccounting
Accounting System
System
Even though accounting systems vary from business to business
depending on the nature and complexity of operations, the
following principles apply to all properly designed accounting
systems.
1. Cost Effectiveness: The accounting system must be cost-
effective. Benefits of information must outweigh the cost of
providing it.
2. Useful Output: To be useful, information must be
understandable, relevant, reliable, timely, and accurate. Designers
of accounting systems must consider the needs and knowledge of
various users.
3. Flexibility: The accounting system should accommodate a
variety of users and changing information needs. The system
should be sufficiently flexible to meet the resulting changes in the
demands made upon it.
 General
General Ledger
Ledger
Principles and
ofand Subsidiary
Subsidiary
Accounting Ledgers
Ledgers
System
Principles of Accounting System
A subsidiary ledger is a group of accounts with a common characteristic (for example, all
accounts receivable, all accounts payable). Subsidiary ledgers show details

Control account is a general ledger account that summarizes the detailed data from a
subsidiary ledger. (A/R,A/P)
For example, the detailed data from the accounts receivable subsidiary ledger are
summarized in Accounts Receivable in the general ledger

At the end of an accounting period, each general ledger control account balance must equal
the composite balance of the individual accounts in the related subsidiary ledger.
A/R Balance=Customer A’s balance + Customer B’s balance + Customer C’s Balance
A/P Balance=Creditor X ’s balance + Creditor Y’s balance + Creditor Z’s Balance
General
General Ledger
Ledger and
and Subsidiary
Subsidiary Ledgers
Ledgers

General Ledger Subsidiary Ledgers-Shows Detail

Cash 11 Accounts Receivable

Subsidiary Ledger

Accts. Rec. 12 Customer Accounts

A B C D

Supplies 14 Accounts Payable

Subsidiary Ledger

Accts. Pay. 21 Creditor Accounts

A B C D
 General
General Ledger
Ledgerand
and Subsidiary
Subsidiary Ledgers
Ledgers
Presented below is information related to SS Company for its
first month of operations.
Determine the balances that appear in the accounts
receivable subsidiary ledger. ____________
What Accounts Receivable balance appears in the general
ledger at the end of January?___________
Credit Sales Collections
Jan 10:Aaron Co. $ 6,000 Jan. 19: Aaron Co. $4,000
12: Best Inc. 3,000 21: Best Inc. 3,000
20: Caron Co. 3,000 29: Caron Co. 1,000
$12,000
$8,000
 General
General Ledger
Ledgerand
and Subsidiary
Subsidiary Ledgers
Ledgers
Presented below is information related to SS Company for its
first month of operations.
Determine the balances that appear in the accounts payable
subsidiary ledger. ___________
What Accounts Payable balance appears in the general
ledger at the end of January? _____________
Credit Purchases Cash Paid
Jan 5:Dima Co. $ 11,000 Jan. 9 Dima Co. $7,000
11: Star Inc. 7,000 14 Star Inc. 2,000
22: Taylor Co. 14,000 27 Taylor Co. 9,000
$32,000
$18,000
 General
General Ledger
Ledger
Principles and
ofand Subsidiary
Subsidiary
Accounting Ledgers
Ledgers
System
Principles of Accounting System
Advantages of Subsidiary ledgers
Subsidiary ledgers have several advantages:
1. They show in a single account transactions affecting one customer or
one creditor, thus providing up-to-date information on specific account
balances.
2. They free the general ledger of excessive details. As a result, a trial balance of the
general ledger does not contain vast numbers of individual account balances.

3. They help locate errors in individual accounts by reducing the number of

accounts in one ledger and by using control accounts.

4. They make possible a division of labor in posting. One employee can post
to the general ledger while someone else posts to the subsidiary ledgers.
Expanding the Journal—Special Journals
 The use of general journal is satisfactory in only very small companies.
 To expedite journalizing and posting, most companies use special journals in addition to
the general journal.
 Companies use special journals to record similar types of transactions.
The four widely used special journals are:
 Sales Journal (SJ)- Used to record sales on account (AR, Sales..)
 Cash Receipt Journal (CRJ)-Used to record collections of cash
from all sources (Cash sales, collection of credit sales,
owners’ investment, loan…)
 Purchase Journal (PJ)- Used to record Purchases on account of Merch. inventory,
Supplies, office equipment, (Merch. Inventory,……A/payable)
 Cash Payment Journal (CPJ)-Used to record all payments (Payment of expense,
suppliers account, cash purchase of various items, withdrawal/dividend, loan
repayment….)
 Note: a company that uses special journal uses general journal for transactions that
can not be recorded in the above special journals. (eg adjusting entries, closing
entries, correcting entries…)
AAU School of Commerce Acfn 1031
 Expanding the Journal—Special Journals
Advantages of special journals
 Special journals permit greater division of labor because several people can record entries
in different journals at the same time. For example, one employee may journalize all
cash receipts, and another may journalize all credit sales.

 The use of special journals reduces the time needed to complete the posting process.
With special journals, companies may post some accounts monthly, instead of daily,

AAU School of Commerce Acfn 1031

 Expanding the Journal—Special Journals
Assume ABC Co. uses Four special Journals (SJ,CRJ,PJ & CPJ)

Example of Transactions that are recorded in Sales Journal (SJ)

Sept. 2 Sold merchandise on account to JJ Co. invoice no. 101, $7800,
terms n/30. The cost of the merchandise sold was $4200.
.
21 Sold merchandise on account to KK Co., invoice no. 102 for $8000,
terms 2/10, n/30. The cost of the merchandise sold was $4800.
27 Sold merchandise on account to MM Co. for $7000. The cost of the
merchandise sold was $4000.

AAU School of Commerce Acfn 1031

 Expanding the Journal—Special Journals
Example of Transactions that are recorded in Cash Receipt Journal (CRJ)
July 3 Sold merchandise to DH Co. for $7000 cash. The cost of the merchandise sold was
$4000.
5 Received a check for $6,370 from JJ Company in payment of
an invoice dated June 26 for $6,500, terms 2/10, n/30.
9 Shareholders made an additional investment of $5,000 in cash
in exchange for ordinary shares

AAU School of Commerce Acfn 1031

 Expanding the Journal—Special Journals

Example of Transactions that are recorded in Purchase Journal (PJ)

June 10 Purchased merchandise on account from HG Co. $6000, terms
2/10, n/30.
12 Purchased office equipment on account from GG Co. $6,500
25 Purchased merchandise on account from LL Co. $8,500, terms
n/30.

AAU School of Commerce Acfn 1031

 Expanding the Journal—Special Journals

Example of Transactions that are recorded in cash payment journal(CPJ)

May 1 Purchased merchandise for $7,200 from RR Co. using check no. 101.
14 Paid salary to employees $7000 by issuing check no. 102.
22 A check of $9,000 paid in full for invoice 701; no discount.
23 A check of $8,000 is Paid with in the discount period; discount is
$200

AAU School of Commerce Acfn 1031

 Expanding the Journal—Special Journals
SS Company had the following transactions during March.
Identify the journal in which each of the transactions above is recorded.
1. Collected cash on account from KK Company.__________
2. Purchased equipment by signing a note payable.___________
3. Sold merchandise on account._______________
4. Purchased merchandise on account.____________
5. Paid $2,400 for a 2-year insurance policy.___________

AAU School of Commerce Acfn 1031

 CHAPTER FIVE
Accounting for Cash
(AcFn 2011)

287
 Accounting for Cash
• Learning Objectives
• After studying this chapter, you should be able to:
Define Cash, and
1. Define fraud and internal control.
2. Identify the principles of internal control activities.
3. Explain the applications of internal control principles to cash receipts.
4. Explain the applications of internal control principles to cash
disbursements.
5. Describe the operation of a petty cash fund.
6. Indicate the control features of a bank account.
7. Prepare a bank reconciliation.
8. Explain the reporting of cash.

Acct 2011 Cash 288

 …Accounting for Cash

Cash is defined as a medium of exchange

that a bank will accept for deposit and can be
withdrawn (used) immediately

 Cash is
- Most liquid asset
- Standard medium of exchange
- Basis for measuring and accounting
for all items
-Current asset
Acct 2011 Cash 289
 …Accounting for Cash
Cash includes Cash excludes
• Coins, currencies,
– NSF check-(it is a receivable),
• Change fund, petty cash fund, – Post dated check-(it is a receivable),
• Balances in the unrestricted savings – Postage stamp-(it is prepaid expense treated as
account and checking account, that can supplies),
be withdrawn at any time for operation – IOUs-(it is a receivable),
purpose – Certificate of deposits-(it is a short term
• investment),
Bank credit cards such as master and
– Travel advances-(it is a receivable),
visa cards which are acceptable by the
– Bank balance in the blocked account (it is not
commercial banks,
available for current use)
• Money orders (postal or bank), – Saving account balances, if it has got some sort of
• Travelers checks, restrictions such as not be able to withdraw, say,
• Birr 5000 unless prior notice of 10 days are served.
CPO (Cash payment Order),
However, savings accounts are usually classified as
• Personal checks, bank drafts, cash although the bank has the right to demand
• un-deposited check/cash receipt. notice before withdrawal in that banks rarely
exercise the privilege of prior notice.
– Compensating balance: it is an amount a business is
Acct 2011 Cash
required to maintain in a bank account (a minimum
290
cash balance); It is imposed by the bank as a part of
 Nature of Cash
Cash is the most liquid asset with greater temptation for
misappropriation
• Generally classified as High risk account because of its
susceptibility to theft, and can also be significantly misstated.
• Control systems are designed and implemented to minimize
risk of loss of cash.
Fraud and Internal Control

Fraud
Dishonest act by an employee that results in personal benefit
to the employee at a cost to the employer.

Three factors that

contribute to
fraudulent activity.

Illustration 7-1

LO 1 Define fraud and internal control.

 …Accounting for Cash
1. Opportunities occur when the workplace lacks suffi cient
controls to deter and detect fraud. For example, inadequate
monitoring of employee actions can create opportunities for
theft and can embolden employees because they believe they
will not be caught.
2. Financial pressure. Employees sometimes commit fraud
because of personal financial problems caused by too much debt.
Or, they might commit fraud because they want to lead a lifestyle
that they cannot afford on their current salary.
3. Rationalization: In order to justify their fraud, employees
rationalize their dishonest actions. For example, employees
sometimes justify fraud because they believe they are underpaid
while the employer is making lots of money. Employees feel justifi
ed in stealing because they believe they deserve to be paid more.
Acct 2011 Cash
293
 …Accounting for Cash
INTERNAL CONTROL
Internal control consists of all the related methods and
measures adopted within an organization:
 to safeguard its assets,
enhance the reliability of its accounting records,
increase efficiency of operations, and
ensure compliance with laws and regulations.
Internal control systems have five primary components as listed
below.
1. Control Environment
2. Risk Assessment
3. Control Activities
4.Information & Communication
5.Monitoring Acct 2011 Cash
294
 …Accounting for Cash
Five Components of Internal Control System

Control Environment

Risk Control Information and

Monitoring
Assessment Activities Communication
 …Accounting for Cash
…Five Components of Internal Control System
1. Control environment.
The control environment consists of the actions, policies, and
procedures that reflect the overall attitudes of top management,
directors, and owners of an entity about internal control and its
importance to the entity.
-It is the responsibility of top management to make it clear that the
organization values integrity and that unethical activity will not be
tolerated.
-It is the foundation for all other components of internal control . It has
pervasive influence on all the decisions and activities of an
organization.
-This component is often referred to as the “tone at the top.”, it means
employees follow the action of top management.
-Effective organizations set a positive “tone at the top”. It means
organizations with effective top management will be successful.
Acct 2011 Cash
296
 …Accounting for Cash
…INTERNAL CONTROL
2. Risk assessment. Companies must identify and analyze the
various factors that create risk for the business and must
determine how to manage these risks.

3. Control activities. To reduce the occurrence of fraud,

management must design policies and procedures to address the
specific risks faced by the company.
Five components of control activities:
1. Adequate separation of duties
2. Proper authorization of transactions and activities
3. Adequate documents and records
4. Physical control over assets and records
5. Independent checks on performance

Acct 2011 Cash

297
 …Accounting for Cash
……Five Components of Internal Control System

4. Information and communication. The internal control system

must capture and communicate all pertinent information both
down and up the organization, as well as communicate
information to appropriate external parties. Information should
reach the appropriate officer to discharge responsibilities.

5. Monitoring. Internal control systems must be monitored

periodically for their adequacy. Significant deficiencies need to be
reported to top management and/or the board of directors.

Acct 2011 Cash

298
 …Accounting for Cash
….INTERNAL CONTROL
Principles of Internal Control
Establishment of Responsibility:
Control is most effective when only one person is responsible for a
given task.

Segregation of Duties
Related duties should be assigned to different individuals.
Documentation Procedures
Companies should use prenumbered documents and all documents
should be accounted for
Independent internal verification
Other controls
Acct 2011 Cash
299
 …….Principles of Internal Control
Illustration 7-2

Physical
Controls

LO 2 Identify the principles of internal control activities.

 …….Principles of Internal Control

Independent Internal Verification

Illustration 7-3

1. Records periodically
verified by an
employee who is
independent.

2. Discrepancies
reported to
management.

LO 2 Identify the principles of internal control activities.

Fraud and Internal Control

…….Principles of Internal Control

Human Resource Controls

1. Bond employees.

2. Rotate employees’
duties and require
vacations.

3. Conduct background
checks.

LO 2 Identify the principles of internal control activities.

Fraud and Internal Control

…….Principles of Internal Control

Human Resource Controls

1. Bond employees.

2. Rotate employees’
duties and require
vacations.

3. Conduct background
checks.

LO 2 Identify the principles of internal control activities.

 …Accounting for Cash
Benefits of Internal control Limitation of Internal control
• To safeguard assets from • Its effectiveness is affected by
waste, fraud and inefficient human factors such as:
use; – Abuse, carelessness, collusion, lack
• To promote efficiency, of understanding , error in design
and implementation
reduce risk of loss,
• Its effectiveness is affected by
• To improve accountability
cost factors/ resource limitations :
and maintain public trust
– since it involves cost, smaller
• To ensure accurate and organizations may not design and
reliable accounting records implement it.
– Benefit should exceed cost

Acct 2011 Cash 304

 …Accounting for Cash
Need for Internal Control of Cash
 Stronger internal control mechanisms are applied Stronger
for cash due to the following reasons: Internal
Many transactions affect cash (payment and
Control
collection), exposed to misappropriation and
embezzlement, for is
Cash is the most liquid and risky asset that can needed
easily be misused for cash
Cash lacks identification of ownership
Due to
Objectives of Cash Management and Control High
 To protect cash from misuse and embezzlement Risk of
To maintain the optimal amount of cash (i.e.
Loss
neither too much nor too little)
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Cash Controls

Cash Receipts Controls

Illustration 7-4

LO 3
Cash Controls

Cash Receipts Controls

Illustration 7-4

LO 3
 Cash Controls

Cash Receipts
Controls

Over-the-Counter Receipts

Important internal
control principle—
segregation of record-
keeping from physical
custody.

Illustration 7-5

LO 3
Cash Controls

Cash Receipts Controls

Mail Receipts
 Mail receipts should be opened by two people, a list
prepared, and each check endorsed.
 Each mail clerk signs the list to establish responsibility for the
data.
 Original copy of the list, along with the checks, is sent to the
cashier’s department.
 Copy of the list is sent to the accounting department for
recording. Clerks also keep a copy.

LO 3 Explain the applications of internal control principles to cash receipts.

Cash Controls

Review Question
Permitting only designated personnel to handle cash receipts
is an application of the principle of:
a. segregation of duties.
b. establishment of responsibility.
c. independent check.
d. other controls.

LO 3 Explain the applications of internal control principles to cash receipts.

Cash Controls

Cash Disbursements Controls

Generally, internal control over cash disbursements is more
effective when companies pay by check, rather than by
cash.

Applications:
 Voucher system
 Petty cash fund

LO 4 Explain the applications of internal control

principles to cash disbursements.
Cash Controls

Cash Disbursements
Controls

Illustration 7-6

LO 4
Cash Controls

Cash Disbursements
Controls

Illustration 7-6

LO 4
Cash Controls

Review Question
The use of prenumbered checks in disbursing cash is an
application of the principle of:
a. establishment of responsibility.
b. segregation of duties.
c. physical, mechanical, and electronic controls.
d. documentation procedures.

LO 4 Explain the applications of internal control

principles to cash disbursements.
Cash Controls

Cash Disbursements Controls

Voucher System
 Network of approvals, by authorized individuals, to
ensure all disbursements by check are proper.
 A voucher is an authorization form prepared for each
expenditure.

LO 4 Explain the applications of internal control

principles to cash disbursements.
 …Accounting for Cash
Internal Controls over Cash Receipts
Retail businesses use the following Mechanisms to
Control Cash Receipts
Use of cash register machine
Use of pre-numbered and consecutive cash Receipts,
sales tickets etc
Two or more persons should open and record the cash
receipts through the mail
Use of Electronic scanning equipment
Change fund
Bank account and bank reconciliation
Use of cash short and over account
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 …Accounting for Cash
Internal Controls over Cash Payments
The following Mechanisms are used to Control cash
Payments:
Bank Account and Bank reconciliation
Petty Cash Fund
Voucher System
The Net Method of recording Purchases as opposed
to Gross method

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 …Accounting for Cash
Bank Account and Bank reconciliation
 When a bank account is used, all cash received must
be deposited in the bank and all payments must be made
by checks except for petty cash transactions.
Forms used by a business in connection with a bank
Signature card
Deposit ticket/slip
Check, remittance advice
Bank statement, bank reconciliation statement
There are three parties on check:
Drawer: The one who signs the check
Drawee: the bank on which the check is drawn
Payee: - the one to whose order the check is drawn.
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 …Accounting for Cash
Bank Statement
It is a report sent by the bank to the depositor at the end of each month
It shows:
The beginning bank balance as per bank’s record,
Checks and other debits (deductions by the bank),
Deposits and other credits (additions by the bank), and
The balance per bank at the end of the period.
The bank debits the depositor’s account for:
Paid or cancelled checks (checks written by the depositor)
Service charges (the bank informs the depositor through debit memo)
Deposited checks but returned because of insufficient funds (NSF)
The bank credits the depositor’s account for:
Deposits made to the bank account
Receipts form notes receivable left for collection, cash transferred to the
depositor’s account by different parties
Loans to the depositor-when the depositor borrows cash from bank
Note: Cash deposited at bank Acctis a2011
liability
Cash to the bank; it is an asset to the
319
depositor
 …Accounting for Cash
Bank Reconciliation
Cash in bank account in the depositor’s ledger is the reciprocal of the account
with the depositor in the bank’s ledger.
Cash deposited at bank is an asset for the depositor but it is a liability for the
bank.
The two balances (balance per depositor’s record and balance per bank’s
record) should be equal, but they are not likely to be equal on any specific
date because of:
Delay by either party in recording transactions
Errors by either party in recording transactions
To determine the reasons for any difference and to correct any errors that may
have been made by the bank or the depositor, depositor’s record should be
reconciled with the bank statement using bank reconciliation.
Elements of a Bank Reconciliation

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 …Accounting for Cash
Reasons for Differences Between Depositor’s Records and the
Bank Statement
1. Outstanding Deposit/s/Deposit/s in Transit- occurs due to a
time lag between the date of the deposit and the date it is
recorded by the bank.
2. Outstanding check/s- occurs due to a time lag of one day or
more between the date a check is written and the date it is
presented to the bank for payment.
3. Errors-Bank and depositor’s error-Recording errors
4. Not-sufficient-funds (NSF) checks – checks received from
customers and deposited to bank (but the customer did not
have adequate balance to cover the amount written on the
check).

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 …Accounting for Cash
…Reasons for Differences Between Depositor’s Records and the
Bank Statement
Example on NSF ck
Entry to record sales on account to customer K:
A/R from K 2,000
Sales 2,000
Entry to record the receipt of check form customer K in settlement of the
invoice.
Cash 2,000
A/R from K 2,000
The depositor will deposit this check to the bank assuming that cash will be
transferred from K’s account. Assume, there is no adequate balance of cash in K’s
bank account. Hence, the bank will return the check to the depositor after
marking it as “NSF”.
Entry to record the NSF check as a receivable from K.
A/R from K 2,000
Cash in bank 2,000
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 …Accounting for Cash
…Reasons for Differences Between Depositor’s Records and
the Bank Statement

5. Bank debit Memo – eg. Service charges, cost of check book

6. Bank credit Memo – eg. Collections by bank

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 …Accounting for Cash
Format of Bank Reconcilation
Balance per
BANK
Balance per
Bank’s record Depositor’s record
• Balance per Bank Statement xxx • Balance per Depositor records xxx
Balance per bank’s record
Add: Add:
Deposit in transit xxx Credit memo’s/collections by bank xxx
Bank errors understating the balance xxx Dep. errors understating the balance xxx

Sub totals xxx Sub totals xxx

Deduct
Deduct NSF checks (xxx)
Outstanding checks (xxx) Debit memos (xxx)
Bank errors overstating the balance(xxx) Dep. errors overstating the balance(xxx)
Sub totals Sub totals xxx)
xxx) Adjusted Balance …… ………………………… xxx
Adjusted Balance …… ………………………… xxx

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…Accounting for Cash

Journal
Journal entries
entries must
must be be prepared
prepared
for
for those
those items
items that
that affected
affected the
the
depositor’s
depositor’s side
side of
of the
the
reconciliation.
reconciliation.

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 …Accounting for Cash
Example on Bank Reconciliation
1. Bank reconcilation petty cash and change fund.doc

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 …Accounting for Cash
Recording Cash Short and Over
 The amount of cash actually received during a day often does
not agree with the record of cash receipts.
The amount of cash that is actually counted (Regardless of the
overage or shortage) is debited to the Cash in bank account
The amount of sales that is shown on the cash register
(Regardless of the overage or shortage) is credited to the Sales
account
Cash shortage is debited to the “Cash Short or Over account”
Cash overage is credited to the “Cash Short or Over account”
At the end of the period, “Cash Short or Over account” may
show debit or credit balance.
Debit balance-as other expense on I/Statement
debit or credit balance-as other income on I/Statement
1. Bank reconcilation petty cash and change fund.doc
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 …Accounting for Cash
Cash Change Fund
 Business that receives cash directly from customers must
maintain a fund of currency and coins in order to make change
 Change fund is not deposited to the bank since it is needed for
making change
Change fund is part of cash on hand
Activities at the end of each business day include:
Counting the total cash on the drawer, deducting the change
fund from it, then comparing this amount with what is shown
on the cash register tape to see if there is shortage/overage, then
recording the amount to be deposited on the deposit slip and
preparing a journal entry. 1. Bank reconcilation
petty cash and change fund.doc
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 …Accounting for Cash
The Voucher System
AAvoucher
voucher system
system isis aa set
set of
of
procedures
procedures forfor authorizing
authorizing and and
recording
recording liabilities
liabilities and
and cash
cash
payments.
payments.
Voucher is a special form on which
relevant data about a liability and the
details of its payment is recorded.
It serves as a proof of authority to
pay cash.

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 …Accounting for Cash
Basic Features of a voucher system
 A voucher system normally uses vouchers.
 The system normally has a file for unpaid vouchers
and a file for paid vouchers.
 Usually prepared by the Accounting Department after
all necessary supporting documents are received
(purchase order, supplier’s invoice, and a receiving
report).
In preparing the voucher, the accounts payable clerk
verifies the quantity, price, and mathematical accuracy of
the supporting documents and files the paid voucher
Voucher system gives greater assurance that all payment
are made on valid liabilities/for valid reasons
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…Accounting for Cash

Petty Cash

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 …Accounting for Cash
Petty Cash fund
Petty Cash fund is a fund of money that is set for the purpose
of making payments for small expenditure
It is used to pay small and frequent payments that do not
justify the use of checks,

Three Major Activities

1. Establishing the fund
2. Making payments from the fund
3. Replenishing the fund

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 …Accounting for Cash

1. Establishing Petty Cash Fund

 In establishing a petty cash fund, the first step is

to estimate the amount of cash needed for
disbursements of relatively small amounts during
a certain period such as a week or a month.

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 …Accounting for Cash
2. Making Payments from a Petty Cash Fund
The petty cash fund is kept with the custodian/petty cashier in
a safe box
Payment from the petty cash fund is based on evidences and
for valid reason.
The petty cash custodian obtains signed receipts from each
individual to whom he or she pays cash, attaching evidence of
the disbursement to the petty cash receipt.
Petty cash transactions are not recorded until the fund is
reimbursed;
Someone other than the petty cash custodian records those
entries.

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 …Accounting for Cash
3. Replenishment of Petty Cash
Replenishment is the process of restoring the fund balance to its
original level
Payments from the petty cash fund will reduce the fund balance
When the available cash is low, the custodian presents to the
controller a request for reimbursement supported by the petty
cash receipts and other disbursement evidence.
The custodian receives a company check to replenish the fund.
At this point, the company records transactions based on petty
cash receipts.
Generally, the petty cash fund is replenished/restored to its
original level when the amount of money in the petty cash fund is
reduced to the predetermined minimum amount and at the end of
an accounting period so that expenses should be recorded in the
proper period. Acct 2011 Cash
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 …Accounting for Cash
Petty Cash fund account is affected
1. When the fund is established
2. When management decides to
increase the amount of the
Petty Cash fund balance
3. When management decides to
decrease the amount of the Petty
Cash fund balance
1. Bank reconcilation
petty cash and change fund.doc

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 …Accounting for Cash
Reporting Cash on balance sheet
Cash- If unrestricted, report as Cash
Petty Cash and change fund –report as Cash
Cash Equivalents- Usually reported as Cash
Cash Equivalents-are Short-term, highly liquid investments that are both
-readily convertible to cash, and
-so near their maturity that they present insignificant risk of changes in
interest rates.
Examples: Treasury bills
Restricted Cash
Companies segregate restricted cash from “regular” cash for reporting purposes.
Examples, restricted for:
-plant expansion, - retirement of long-term debt, and compensating balances.
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 …Accounting for Cash
Bank Overdrafts
When a company writes a check for more than the amount in its cash account.
Generally reported as a current liability.

Offset against cash account only when available cash is present in another
account in the same bank on which the overdraft occurred.
Compensating balance
 It is classified as current or non current on balance sheet
It is disclosed separately in notes showing tye details of the
arrangement

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 Chapter Five: Cash

The End

Questions or Comments
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