Accounting principles
Accounting principles are a number of basic rules, which are developed gradually from fundamental logical set
of assumptions, concepts, and conventions. These rules are referred to as Generally Accepted Accounting
Principles (GAAP) and are to be applied to all accounting and financial activities. Following are the fundamental
accounting concepts:-
Business Entity Concept:-a business’ financial information is recorded and reported separately from the
owner’s personal financial information.
Cost concept: - the actual amount paid or received is the amount recorded in accounting records.
Going concern concept: - financial statements are prepared with the expectation that a business will remain in
operation indefinitely.
Objective evidence concept: -each transaction is described by a business document that proves the transaction
did occur.
Units of measurement concept: - all business transactions are recorded in a common unit of measurement-birr
Accounting period concept: - financial charges are reported for a specific period of time in the form of financial
statements.
Matching expense with the revenue concept: revenue from business activities and expenses associated with
earnings that revenue are recorded in the same accounting period.
Adequate disclosure concept: - financial statements should contain all information necessary for a reader to
understand a business’ financial information.
Consistency concept: - in the preparation of financial statements, the same accounting principles are applied in
the same way in each accounting period.
Materiality concept: - business activities creating birr amounts large enough to affect business decisions should
be recorded and reported as a separate items in accounting records and financial statements.
Conservatism concept: - when more than one accounting period is acceptable, the one used should result in the
least amount of reported earnings or value of assets
Realization of revenue: -revenue from business transactions is recorded when goods or services are sold.
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Accounting Methods
There are two basis of accounting methods– accrual and cash basis. Some companies use the hybrid of both
called modified cash basis.
Accrual Basis Accounting: accrual accounting records income and/or expenses at the time of transactions
regardless of when cash is received and/or paid. Reports in accrual accounting are calculated according to the
transaction date.
Cash Basis Accounting: Cash basis accounting records income and expenses at the time of cash receipt and
payment. Reports in cash basis accounting are calculated according to the cash transaction date.
Under the Ethiopian government Income tax proclamation No. 286/2002 article 58/2, tax payers shall account
for tax purposes on a cash or accrual basis.
The accounting cycle
The accounting cycle is a series of steps performed during the accounting period (some throughout the
period and some at the end) to analyze, record, classify, summarize, and report useful financial
information for the purpose of preparing financial statements. Before you can visualize the eight steps
in the accounting cycle, you must be able to recognize a business transaction. Business transactions
are measurable events that affect the financial condition of a business.
1. Analyze transactions by examining source documents
2. Journalize transactions in the journal
3. Post journal entries to the accounts in the ledger
4. Prepare unadjusted trial balance of the accounts
5. Prepare adjusting entries
6. Prepare adjusted trial balance of the accounts
7. Prepare financial statements
8. Prepare closing entries
9. Prepare a post-closing trial balance
10. Prepare reversing entries (Optional)
The journal
A journal is a chronological (arranged in order of time) record of business transactions. A journal
entry is the recording of a business transaction in the journal. A journal entry shows all the effects of a
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business transaction as expressed in debit(s) and credit(s) and may include an explanation of the
transaction. A transaction is entered in a journal before it is entered in ledger accounts.
The ledger
A ledger (general ledger) is the complete collection of all the accounts of a company. The ledger may
be in loose-leaf form, in a bound volume, or in computer memory.
Accounts fall into two general groups: (1) balance sheet accounts (assets, liabilities, and stockholders'
equity) and (2) income statement accounts (revenues and expenses). The terms real accounts and
permanent accounts also refer to balance sheet accounts. Balance sheet accounts are real accounts
because they are not sub classifications or subdivisions of any other account. They are permanent
accounts because their balances are not transferred (or closed) to any other account at the end of the
accounting period. Income statement accounts and the Dividends account are nominal accounts
because they are merely sub classifications of the stockholders' equity accounts. Nominal literally
means "in name only". Nominal accounts are also called temporary accounts because they
temporarily contain revenue, expense, and dividend information that is transferred (or closed) to the
Retained Earnings account at the end of the accounting period.
A trial balance is a listing of the ledger accounts and their debit or credit balances to determine that
debits equal credits in the recording process. The accounts appear in this order: assets, liabilities,
stockholders' equity, dividends, revenues, and expenses. Within the assets category, the most liquid
(closest to becoming cash) asset appears first and the least liquid appears last. Within the liabilities,
those liabilities with the shortest maturities appear first.
Adjustments
Types of Adjusting Entries:
1. Deferred expense (prepaid expense)
2. Deferred revenue (unearned revenue)
3. Accrued expense (accrued liability)
4. Accrued revenue (accrued asset)
5. Depreciation expense
The journal entries that bring the accounts up to date at the end of the accounting period are called
adjusting entries. All adjusting entries affect at least one income statement account and one balance
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sheet account. Thus, an adjusting entry will always involve revenue or an expense account and an asset
or a liability account.
The first two items are deferrals. Deferrals are created by recording a transaction in a way that delays
or defers the recognition of an expense or revenue, as described below.
• Deferred expenses, or prepaid expenses, are items that have been initially recorded as assets but are
expected to become expenses over time or through the normal operations of the business. Supplies and
prepaid insurance are two examples of prepaid expenses that may require adjustment at the end of an
accounting period. Other examples include prepaid advertising and prepaid interest.
• Deferred revenues, or unearned revenues, are items that have been initially recorded as liabilities
but are expected to become revenues over time or through the normal operations of the business. An
example of deferred revenue is unearned rent. Other examples include tuition received in advance by a
school, an annual retainer fee received by an attorney, premiums received in advance by an insurance
company, and magazine subscriptions received in advance by a publisher.
The second two items that require adjusting entries are accruals. Accruals are created by an unrecorded
expense that has been incurred or unrecorded revenue that has been earned, as described below.
• Accrued expenses, or accrued liabilities, are expenses that have been incurred but have not been
recorded in the accounts. An example of an accrued expense is accrued wages owed to employees at
the end of a period. Other examples include accrued interest on notes payable and accrued taxes.
Accrued revenues, or accrued assets, are revenues that have been earned but have not been recorded
in the accounts. An example of accrued revenue is fees for services that an attorney has provided but
hasn’t billed to the client at the end of the period. Other examples include unbilled commissions by a
travel agent, accrued interest on notes receivable, and accrued rent on property rented to others.
Depreciation
Depreciation is diminished in value of fixed assets through use or due to elapse of time.
It is the allocation of the cost of plant asset to the periods that benefit from the service of the asset. The
term depreciation is used to describe the gradual conversion of the cost of the asset in to an expense.
There are four methods often used to calculate depreciation, these are:
1. Straight Line Method
2. Units of Production Method
3. Declining Balance Method
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4. Sum of the years Digits method
1. Straight Line Method- this method provides for the same amount of depreciation expense for
each year of the asset’s useful life.
Annual Depreciation = Cost – Estimated residual value
Estimated Life
Financial statements
They are the means of conveying to management and to interested outsiders an organized picture of the
profitability and financial position of the business.
They are prepared on a regular basis at the end of accounting period.
All financial statements are inter-connected, therefore, the order of preparation is important
Income statement
Statement of Owner’s Equity
Balance sheet
Statement of cash flow
Income statement
Is a summary of the revenues and expenses of a business entity for a specific period of time
Net revenue is realized when revenues exceeds expenses
Net loss is realized when expenses exceeds revenues
Statement of Owner’s Equity
Shows the changes that occurred in the components of owner’s equity during a specific period of time
Provide a link between income statement and balance sheet
Prepared after the income statement
Balance sheet
Is a list of assets, liabilities and owner’s equity of a business entity as of a specific date
It is a detailed description of the basics of accounting equation and proves that the accounting equation is
in balance
Shows the financial position of the business on specific date
Statement of cash flow
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Shows the sources of cash (cash inflows) and the uses of cash (outflows) of a business entity for a
specific period of time
Prepared based on the following classifications
Operating activities
Investing activities
Financing activities
Preparing financial statements
All financial statements have headings that include:
Name of the organization
Title of the statement
Date or period covered by the statement
Exercise 1
Illustration
To illustrate the complete accounting cycle, we will consider the following list of selected transactions. The
transactions were completed by Bati Transport in the month of January 2003.
January 1. Ato yimer took Birr 450,000 from his personal savings and deposited it in the name of Bati transport.
January 2. Bati Transport purchased two used trucks for Birr 150,000 each, on cash.
January 4. Bati Transport received a check for Birr 650 for services given to Alem Trading.
January 4. Received an invoice for truck expenses Birr 90.
January 11. Paid Birr 600 for Awash Insurance Company to buy an insurance policy for its trucks.
January 16. Ato Yimer issued a check for Birr 9,400 to the workers as a salary for two weeks.
January 20. Bati trading Billed Muradu Supermarket for goods transported from Djibouti to Gondar Birr 2,650
January 21. Ato Yimer wrote a check for birr 450 to have one of the trucks repainted
January 21. Bati trading purchased stationary materials and other supplies of Birr 740 on account
January 22. Office equipment of Birr 11,600 is bought on account.
January 23. Purchased an additional truck for Birr 250,000 paying birr 100,000 in cash and issuing a note for the
difference.
January 23. Recorded services billed to customers on account birr 14,600.
January 25. Received cash from customers on account Birr 15,000.
January 27. The owner withdrew Birr 500 in cash for his personal use.
January 28. Paid Birr 9,400 to workers as a salary for the last two weeks of the month.
January 30. Paid telephone expense of Birr 95 and electric expenses of Birr 125 for the month.
January 30. Paid other miscellaneous expenses Birr 50.
January 31. Paid Birr 4,000 as a rent for a building used for office space.
These transactions are journalized as follows:
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Date Description Debit Credit
2003 Cash 450,000
Jan.1 Yimer Capital 450,000
To record investment by owner
2 Truck 300,000
Cash 300,000
Purchase of trucks
4 Cash 650
Service Income 650
Cash received from customers
4 Truck Expenses 90
Accounts Payable 90
Service received in advance
11 Prepaid Insurance 600
Cash 600
Purchase of insurance policy
16 Salary Expense 9,400
Cash 9,400
Payment of salary
20 Accounts Receivable 2,650
Service Income 2,650
Provision of service
21 Truck Expense 450
Cash 450
Cash paid to repaint truck
21 Supplies 740
Accounts Payable 740
Purchase of supplies of account
22 Office Equipment 11,600
Accounts Payable 11,600
Purchase of equipment
23 Truck 250,000
Cash 100,000
Notes Payable 150,000
Purchase of truck
23 Accounts Receivable 14,600
Service Income 14,600
Provision of service on account
25 Cash 15,000
Accounts Receivable 15,000
Collection of cash
27 Drawings 500
Cash 500
Owner withdrawals
28 Salary Expense 9,400
Cash 9,400
Payment of salary
30 Utilities Expense 220
Cash 220
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Payment for telephone, electricity
30 Miscellaneous Expenses 50
Cash 50
Payment for various expenses
31 Rent Expense 4,000
Cash 4,000
Payment of Rent
Exercise2
1. Three years ago, T. Roderick organized Harbor Realty. At July 31, 2006, the end of the current
fiscal year, the trial balance of Harbor Realty is as follows:
Harbor Realty
Trial Balance
July 31, 2006
Cash 3425
Accounts Receivable 7000
Supplies 1270
Prepaid Insurance 620
Office Equipment 51650
Accumulated
Depreciation 9700
Accounts Payable 925
Unearned Fees 1250
T. Roderick, Capital 29000
T. Roderick, Drawing 5200
Fees Earned 59125
Wages Expense 22415
Rent Expense 4200
Utilities Expense 2715
Miscellaneous Expense 1505
100,000 100,000
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The data needed to determine year-end adjustments are as follows:
a. Supplies on hand at July 31, 2006, are $380.
b. Insurance premiums expired during the year are $315.
c. Depreciation of equipment during the year is $4,950.
d. Wages accrued but not paid at July 31, 2006, are $440.
e. Accrued fees earned but not recorded at July 31, 2006, are $1,000.
f. Unearned fees on July 31, 2006, are $750.
Instructions
1. Prepare the necessary adjusting entries
2. Enter the trial balance on a ten-column work sheet and complete the work sheet.
3. Prepare an income statement, a statement of owner’s equity (no additional investments were made
during the year), and a balance sheet.
4. On the basis of the data in the work sheet, journalize the closing entries.
Harbor Realty
Work Sheet
For the Year Ended July 31, 2006
Adjusted Trial Income
Trial Balance Adjustments Balance Statement Balance Sheet
Account Title Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 3425 3425 3425
Accounts Receivable 7000 (e)100
0
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8000 8000
Supplies 1270 890 380 380
(b) 3 1 5 305 305
Prepaid Insurance 620
51 6 5 51650
0
Office Equipment 51650
Accumulated 14 6 5 0 14650
Depreciation 9700 c)4950
Accounts Payable 925 925 925
Unearned Fees 1250 (f) 5 0 0 750 750
29 0 0 0 29000
T. Roderick, Capital 29000
T. Roderick, Drawing 5200 5200 5200
Fees Earned 59125 (e)1000 60625 60625
(f) 500
Wages Expense 22415 22415 22415
Rent Expense 4200 4200 4200
Utilities Expense 2715 2715 2715
Miscellaneous
Expense 1505 1505 1505
Supplies Expense (a) 8 9 0 890 890
Insurance Expense (b) 315 315 315
Depreciation Expense (c)4950
4950 4950
Wages Payable 440 440
(d) 440
106 3 9 37 4 3 45765
8095 8095 0 106 3 9 0 0 60625 68960
23 1 9 23195
Net Income 5
60625 68960
60625 68960
Harbor Realty Inc.
Income Statement
For the Year Ended July 31, 2006
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Fees earned 60625
Operating expenses:
Wages expense 22855
Depreciation expense 4950
Rent expense 4200
Utilities expense 2715
Supplies expense 890
Insurance expense 315
Miscellaneous expense 1505
Total operating 37430
expenses
Net income 23195
Harbor Realty
Statement of Owner’s Equity
For the Year Ended July 31, 2006
T. Roderick, capital, August 1, 2005 29000
Net income for the year 23195
Less withdrawals 5200
Increase in owner’s equity 17995
T. Roderick, capital, July 31, 2006 46995
Harbor Realty
Balance Sheet
July 31, 2006
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Assets Liabilities
Current assets: Current liabilities:
Cash Accounts payable
342 5 925
Accounts receivable 8000 Unearned fees 750
Supplies Wages payable 440
380
Prepaid insurance 305 Total liabilities 211 5
Total current assets 12110
Property, plant, and Owner’s Equity
equipment:
Office equipment 51650 T. Roderick, capital
46 9 9 5
Less accumulated depr. (14650)
Total assets Total liabilities and
49110 owner’s equity 4911 0
Closing Entries
Date Description Post.Ref. Debit Credit
31-Jul Fees Earned 6062
5
Income Summary 60625
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31-Jul Income Summary 3743
0
Wages Expense 228 5 5
Rent Expense 4950
Utilities Expense 4200
Miscellaneous 2715
Expense
Supplies Expense 890
Insurance Expense 315
Depreciation 1505
Expense
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