DAMAT HOTEL

and
BUSINESS COLLEGE
Intermediate Financial Accounting I
Module

“A Journey towards Excellence”

 UNIT ONE
ACCOUNTING PRINCIPLES AND PROFESSINAL PRACTICE

Objectives
After studying this chapter a student is expected to understand:
 The environment of accounting
 The Conceptual Framework for Financial Reporting

 Basic Objectives of Financial Reporting

 Fundamental Concepts

 Recognition, Measurement, and Disclosure Concepts

 Cash Flows and Income Measurement.

 Accrual Basis of Accounting
 Cash Basis of Accounting
Introduction
Dear students, you have been taught the basic accounting function in your previous
courses i.e. principles of accounting part one and part two. Here, in this unit, you
will have an in – depth discussions on accounting principles and professional
practices.
1.1. The Accounting Environment
Fair presentation of financial information is the most important quality of accounting
theory and practice. To achieve such a quality, the theoretical structure must be
realistic in terms of the economic environment and must be tailored, especially to
meet the needs of users of financial statements.
Dear students, as we have been taught in the earlier course, accounting is the
process of identifying, measuring, recording, and communicating economic
information so as to enable users to make informed judgments and decisions. And
it is also called the ‘language of business.” Especially in this course we are mainly
dealing with one of the specialized field of accounting i.e. financial accounting. It is
concerned with the way businesses communicate financial information to the public
at large. As a system its purpose is to identify, collect, measure and communicate
information to users.
Other specialized branches of accounting are primarily concerned with the internal
managers, employees, labor union, etc.
1.1.1. Users of Accounting Information
Dear students could you mention few examples of users of accounting information?
Do they have meaningful category? Please give your own answers before you go
through the following discussions.
Users of accounting information can be categorized into two broad categories, i.e
external users and internal users. These two user groups do not have the same
information needs because of their different relationships to the business providing
the accounting information.

FINANCIAL ACCOUNTING I Page 1

External users of accounting information include stockholders, bondholders,
potential inventory, bankers, financial analysts, economists, brokers, taxing and
regulatory authorities, labor unions, and the general public. The specialized field of
financial accounting is directly associated with external reporting because it
provides investors and other outsiders with the financial information they required
for decision making.
Internal users for internal operations may request any information that the
accounting system is capable of providing to help them make sound decisions.
Internal users include all the management personnel of a business enterprise who
plan and control its operations on a day – to – day and a long – term basis. The
reporting of financial information for internal users is known as management
accounting. It relates to internal measurements and reporting; it produces detailed
current information which is valuable to all levels of management in decision making
designed to attain the goals of the enterprise.

1.1 Definition, Objective, Importance

Accounting is a/an: Service activity, Descriptive/analytical discipline, and
Information system. As a service activity its function is to provide interested parties
with quantitative information, primarily financial in nature, about economic entities
that is intended to be useful in making economic decisions [decisions about the
deployment and use of resources in business and non-business entities and in the
economy]., in making reasoned choices among alternative courses of action. As a
descriptive/analytical discipline, it defines the great mass of events and transactions
that characterize economic activity and through measurement, classification, and
summarization, reduces those data to relatively small, highly significant, and
interrelated items that, when properly assembled and reported, describe the
financial condition, and results of operation of a specific economic activity. As an
information system, it collects and communicates economic information about a
business enterprise or other entity to a wide variety of persons whose decision and
actions are related to the activity.

FINANCIAL ACCOUNTING I Page 2

 • Role of Accounting in Capital Allocation- accounting assists in the efficient
use of scare resources.

1.2 Accounting profession

Types of Accounting

Accountants may specialize in different accounting fields some of which include the
following.
 Financial accounting - area of accounting aimed at serving information
needs of external users.
 Managerial accounting - field of accounting concerned with serving
information needs of internal users - managers.
 Cost accounting - a managerial accounting activity designed to help
managers in identifying, measuring and controlling operating costs.

FINANCIAL ACCOUNTING I Page 3

  Tax accounting - field of accounting that includes preparing tax returns and
planning future transactions to manage the amount profit tax payable.

 Governmental Accounting, also known as public accounting or federal

accounting, refers to the type of accounting information system used in the
public sector.

 Forensic Accounting is the use of accounting, auditing and investigative

techniques in cases of litigation or disputes.

 Social Accounting, also known as Corporate Social Responsibility Reporting

and Sustainability Accounting, refers to the process of reporting implications
of an organization's activities on its ecological and social environment.

 Auditing-assure the credibility of accounting information

1.3 Development of Accounting Standards

 Accounting Standards [GAAP], as a term, prevalent in recent years signifies

all the rules, from whatever source, which govern accounting. Concepts,
principles, and procedures were developed to meet the needs of external
users.

 There are two major sets of accounting standards:

1. IFRS (International GAAP)

2. U.S. GAAP

 Historical Perspective and Standards

International Standard Setting

1. Standards set by private-sector

2. Standards set by governmental body

Organizations that have a role in international standard-setting are the IASB and
International Organization of Securities Commissions (IOSCO).IASC/IASCF
[International Accounting Standards Committee Foundation] formed in 1973. An
independent body that oversees the IASB, It was formed as a not-for-profit
corporation in the USA. IASC reorganized itself in 2001 and created a new
standard-setting body called the International Accounting Standards Board [IASB].
International Accounting Standards Board (IASB)
Composed of four organizations—
► IFRS Foundation

► International Accounting Standards Board (IASB)

► IFRS Advisory Council

► IFRS Interpretations Committee

FINANCIAL ACCOUNTING I Page 4

International Standard-Setting Structure

IASB members include accounting profession, analysts, academics, regulators, and

government. IFRS Foundation selects members, oversees, and ensures adequate
funding. IFRS Advisory Council advises on agenda and work priorities. IFRS
Interpretations Committee seeks to resolve accounting issues and interpret existing
IFRS. International Organization of Securities Commissions (IOSCO) provides
regulatory oversight of IASB.
International Organization of Securities Commissions (IOSCO)
► Does not set accounting standards.

► Dedicated to ensuring that global markets can operate in an efficient and

effective basis.

► Supports the use of IFRS as the single set of international standards in

cross-border offerings and listings.

Due Process [Operating Procedures]

The IASB due process has the following elements:
1. Independent standard-setting board;

2. Thorough and systematic process for developing standards;

3. Engagement with investors, regulators, business leaders, and the

global accountancy profession at every stage of the process; and

4. Collaborative efforts with the worldwide standard-setting community.

FINANCIAL ACCOUNTING I Page 5

Hierarchy of IFRS
Companies first look to:
1. International Financial Reporting Standards; International Financial
Reporting Standards, International Accounting Standards (issued by the
predecessor to the IASB), and IFRS interpretations originated by the IFRS
Interpretations Committee (and its predecessor, the IAS Interpretations
Committee)-IFRICs (International Financial Reporting Interpretation
Committee) & SICs (Standard Interpretation Committee);
2. The Conceptual Framework for Financial Reporting; and
3. Pronouncements of other standard-setting bodies that use a similar
conceptual framework (e.g., U.S. GAAP).

1.4 Financial Reporting Challenges

The Expectations Gap: What the public thinks accountants should do vs. what
accountants think they can do.
Significant Financial Reporting Issues: lack of focus/failure to provide:
 Non-financial measurements

• customer satisfaction, backlog information, quality, etc

 Forward-looking information

 Opportunities and risks including those resulting from key trends

 Management’s plans, including Critical Success Factors (CSFs)

 Soft assets

FINANCIAL ACCOUNTING I Page 6

 • know how, market dominance, brand image, well trained
employees

 Timeliness

 Ethics in the Environment of Financial Accounting

Companies that concentrate on “maximizing the bottom line,” “facing the challenges
of competition,” and “stressing short-term results” place accountants in an
environment of conflict and pressure. IFRS do not always provide an answer.
Technical competence is not enough when encountering ethical decisions.
 Globalization: A move to global markets and global investors

 New economy: A move from the traditional ‘resource’ based to a

‘knowledge based’ economy

 Accountability: Driven by more sophisticated and varied investors

1. 2. The Conceptual Framework for Financial Reporting

 Definition of the Conceptual Framework

The Conceptual Framework is a coherent system of interrelated objectives and
fundamentals that is expected to lead to consistent standards and that
prescribes the nature, function and limits of financial accounting and reporting.
• Frame of reference/benchmark for financial reporting.
• A body of knowledge or constitution
• Theoretical in nature but has highly practical final aims.

 Importance of the Conceptual Framework

a) Assist or guide the rule-making body in the standard setting process by

providing a basis for developing new and revised accounting and reporting
standards;

b) Serve the public interest by providing structure and direction to financial

accounting statements;

c) Provides description of current practice;

d) Serve as frame of reference for resolving new & emerging practical issues
not covered by existing GAAP;

e) Determine the bounds for judgment in preparing financial statements by

providing definitions of basic objectives, key terms, and fundamental
concepts;

f) Assist accountants and others in selecting from alternative accounting and

reporting methods that best represents the economic reality of a given
situation;

g) Increase users’ understanding of and confidence in financial statements;

FINANCIAL ACCOUNTING I Page 7

 h) Enhance comparability through standardized accounting practice; and

i) Forms the theoretical basis for determining which events should be

accounted and how they should be measured and communicated to the
users.

Components of the Conceptual Framework

Three levels:
 First Level = Objectives of Financial Reporting

 Second Level = Qualitative Characteristics and Elements of

Financial Statements [Fundamental Concepts]

 Third Level = Recognition, Measurement, and Disclosure Concepts

[Operational Guidelines].

We examine these three levels of the conceptual framework next.

FIRST LEVEL: BASIC OBJECTIVE
The objective of financial reporting is the foundation of the conceptual framework.
Other aspects of the framework—qualitative characteristics, elements of financial
statements, recognition, measurement, and disclosure—flow logically from the

FINANCIAL ACCOUNTING I Page 8

objective. Those aspects of the framework help to ensure that financial reporting
achieves its objective.

The objective of general-purpose financial reporting is to provide financial

information about the reporting entity that is useful to present and potential equity
investors, lenders, and other creditors in making decisions about providing
resources to the entity.
As indicated earlier in the chapter, to provide information to decision-makers,
companies prepare general-purpose financial statements. General-purpose
financial reporting helps users who lack the ability to demand all the financial
information they need from an entity and therefore must rely, at least partly, on the
information provided in financial reports. However, an implicit assumption is that
users need reasonable knowledge of business and financial accounting matters to
understand the information contained in financial statements. It means that financial
statement preparers assume a level of competence on the part of users.
SECOND LEVEL: FUNDAMENTAL CONCEPTS
Companies must decide what type of information to disclose and how to disclose it.
These choices are determined by which method or alternative provides the most
decision-useful information. The second level provides conceptual building blocks
that explain the qualitative characteristics of accounting information and define the
elements of financial statements. That is, the second level forms a bridge between
the why of accounting, first level (the objective) and the how of accounting, third
level (recognition, measurement, and financial statement presentation).

Qualitative Characteristics of Accounting Information

The qualitative characteristics of accounting information distinguish better and more
useful information from inferior and less useful information. The FASB identified
these characteristics of accounting information and recognized a cost constraint as
part of the conceptual framework (discussed later in the chapter). As the illustration
on the next page, the characteristics may be viewed as a hierarchy.
As indicated by in the illustration, qualitative characteristics are either fundamental
or enhancing characteristics, depending on how they affect the decision-usefulness
of information. Regardless of classification, each qualitative characteristic
contributes to the decision-usefulness of financial reporting information. However,
providing useful financial information is limited by a pervasive constraint on financial
reporting—cost should not exceed the benefits of a reporting practice.
Fundamental Qualities
The two fundamental qualities that make accounting information useful for decision
are Relevance and Faithful representation.
a. Relevance:
To have relevance, accounting information must be capable of making a difference
in a decision. Information with no bearing on a decision is irrelevant. Relevance is
comprised of:
Predictive value: means that the information can help users form expectations
about the future. Confirmatory value: means that the information validates or
refutes expectations based on previous evaluations. Materiality: means that
information is material if omitting it or misstating it could influence decisions that

FINANCIAL ACCOUNTING I Page 9

users make on the basis of the reported financial information. Faithful
representation Faithful representation means that the numbers and descriptions
match what really existed or happened. Faithful representation is a necessity
because most users have neither the time nor the expertise to evaluate the factual
content of the information. To be a faithful representation, information must be:
Complete, means that all necessary information is provided. Neutral, means that
the information is unbiased. Free from error, means that the information is accurate.
Enhancing Qualities
Enhancing qualitative characteristics are complementary to the fundamental
qualitative characteristics. These characteristics distinguish more-useful information
from less useful information. Enhancing characteristics are comparability,
verifiability, timeliness, and understandability.
Comparability: Information that is measured and reported in a similar
manner for different companies is considered comparable. Comparability
enables users to identify the real similarities and differences in economic
events between companies.
Another type of comparability, consistency, is present when a company
applies the same accounting treatment to similar events, from period to
period. Through such application, the company shows consistent use of
accounting standards. The idea of consistency does not mean, however,
that companies cannot switch from one accounting method to another. A
company can change methods, but it must first demonstrate that the newly
adopted method is preferable to the old.
Verifiability: Verifiability occurs when independent measurers, using the
same methods, obtain similar results.
Timeliness: Timeliness means having information available to decision-
makers before it loses its capacity to influence decisions. Having relevant
information available sooner can enhance its capacity to influence decisions.
A lack of timeliness, on the other hand, can rob information of its usefulness.
Understandability: Understandability is the quality of information that lets
reasonably informed users see its significance. Understandability is
enhanced when information is classified, characterized, and presented
clearly and concisely. Reasonably informed users should be able to
comprehend the information that is clearly classified and presented.

Basic Elements
An important aspect of developing an accounting theoretical structure is the body of
basic elements or definitions. Ten basic elements that are most directly related to
measuring the performance and financial status of a business enterprise are
formally defined in SFAC No. 6. These elements, as defined below, are further
discussed and interpreted throughout the module.
Assets: Probable future economic benefits obtained or controlled by a particular
entity as a result of past transactions or events.
To qualify as assets, there are three characteristics to be fulfilled
 Have future economic benefits (be capable of producing profits).
 Be under managements control ( can be freely deployed or disposed of)

FINANCIAL ACCOUNTING I Page 10

  Result from past transaction ( the transaction or event giving rise to the
entity’s right to, or control of, the benefit has already occurred)

Liabilities: Probable future sacrifices of economic benefits arising from present

obligations of a particular entity to transfer assets or provide services to other
entities in the future as a result of past transactions or events.
To qualify as liabilities, obligations must:
 Require transfer of assets having future economic benefit.
 Specify to whom the asset must be transferred (the terms, parties, and
conditions under which asset transfers will take place must be specified).
 Result from past transactions.

Equity: Residual interest in the assets of an entity that remains after deducting its
liabilities. In a business enterprise, the equity is the ownership interest.
Investments by owners: Increases in net assets of a particular enterprise resulting
from transfers to it from other entities of something of value to obtain or increase
ownership interests (or equity) in it. Assets are most commonly received as
investments by owners, but that which is received may also include services or
satisfaction or conversion of liabilities of the enterprise.
Distributions to owners: Decreases in net assets of a particular enterprise
resulting from transferring assets, rendering services, or incurring liabilities by the
enterprise to owners. Distributions to owners decrease ownership interests (or
equity) in an enterprise. They are characterized as:
Cash dividend payments or declarations
Transfer of assets to owners
Liquidating distribution (asset sale proceeds)
Conversion of equity ownership to liabilities.

Comprehensive income: Change in equity (net assets) of an entity during a period

from transactions and other events and circumstances from non-owner sources. It
includes all changes in equity during a period except those resulting from
investments by owners and distributions to owners.
Revenues: Inflows or other enhancements of assets of an entity or settlement of its
liabilities (or a combination of both) during a period from delivering or producing
goods, rendering services, or other activities that constitute the entity’s ongoing
major or central operations. The two essential characteristics of a revenue
transaction are:
 It arises from the company's primary earning activity (main stream business
lines) and not from incidental or investment transactions (assuming that the
entity is a non-investment company).
 It is recurring

Expenses: Outflows or other using up of assets or incurrence of liabilities (or a

combination of both) during a period from delivering or producing goods, rendering
services, or carrying out other activities that constitute the entity’s ongoing major or
central operations. The essential characteristic of an expense is that it must be
incurred in conjunction with the company's revenue-generating process.
Expenditures that do not qualify as expenses must be treated as assets (future

FINANCIAL ACCOUNTING I Page 11

economic benefit to be derived), as losses (no economic benefit), or as distribution
to owners.
Gains: Increases in equity (net assets) from peripheral or incidental transactions of
an entity and from all other transactions and other events and circumstances
affecting the entity during a period except those that result from revenues or
investments by owners.
Losses: Decreases in equity (net assets) from peripheral or incidental transactions
of an entity and from all other transactions and other events and circumstances
affecting the entity during a period except those that result from expenses or
distributions to owners.

THIRD LEVEL: RECOGNITION AND MEASUREMENT CONCEPTS

The third level of the framework consists of concepts that implement the basic
objective of level one. These concepts explain how companies should recognize,
measure, and report financial elements and events. The FASB sets forth most of
these in its Statement of Financial Accounting Concepts No. 5,“Recognition and
Measurement in Financial Statements of Business Enterprises.” According to SFAC
No. 5, to be recognized, an item (event or transaction) must meet the definition of
an “element of financial statements” as defined in SFAC No. 6 and must be
measurable. Most aspects of current practice follow these recognition and
measurement concepts. Here, we identify the concepts as basic assumptions,
principles, and a cost constraint.

Basic Assumptions
In the practice of financial accounting, certain basic assumptions are important to an
understanding of the manner in which data are presented. Four basic assumptions
underlie the financial accounting structure: (1) economic entity, (2) going concern,
(3) monetary unit, and (4) periodicity. We’ll look at each in turn.
Economic Entity Assumption
The economic entity assumption means that economic activity can be identified with
a particular unit of accountability. In other words, a company keeps its activity
separate and distinct from its owners and any other business unit. At the most basic
level, the economic entity assumption dictates that a company records the
company’s financial activities separate from those of its owners and managers.
Equally important, financial statement users need to be able to distinguish the
activities and elements of different companies. If users could not distinguish the
activities of different companies, they wouldn’t know which company financially
outperformed the other. The entity concept does not necessarily refer to a legal
entity. A parent and its subsidiaries are separate legal entities, but merging their
activities for accounting and reporting purposes does not violate the economic entity
assumption.
Going Concern Assumption
In the absence of contrary information, a company is assumed to have a long life.
Most accounting methods rely on the going concern assumption. Despite numerous
business failures, most companies have a fairly high continuance rate. As a rule, we
expect companies to last long enough to fulfill their objectives and commitments.

FINANCIAL ACCOUNTING I Page 12

This assumption has significant implications. The historical cost principle would be
of limited usefulness if we assume eventual liquidation become obsolete more
quickly. Many believe that, given technology advances, companies need to provide
more online, real-time financial information to ensure the availability of relevant
information.
Basic Principles of Accounting
Certain basic principles are followed by accountants in recording and reporting the
transactions of a business entity. These principles relate to how assets, liabilities,
revenues, and expenses are to be identified, measured, and reported. We generally
use four basic principles of accounting to record and report transactions: (1)
measurement, (2) revenue recognition, (3) expense recognition, and (4) full
disclosure. We look at each in turn.
Measurement Principle
We presently have a “mixed-attribute” system that permits the use of various
measurement bases. The most commonly used measurements are based on
historical cost and fair value. Here, we discuss each.
Historical Cost: GAAP requires that companies account for and report many
assets and liabilities on the basis of acquisition price. This is often referred to as the
historical cost principle. Historical cost has an important advantage over other
valuations: It is generally thought to be verifiable. To illustrate this advantage,
consider the problems if companies select current selling price instead. Companies
might have difficulty establishing a value for unsold items. Every member of the
accounting department might value the assets differently. Thus, many users prefer
historical cost because it provides them with a verifiable benchmark for measuring
historical trends.
Fair Value: Fair value is defined as “the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date.” Fair value is therefore a market-based
measure. Recently, GAAP has increasingly called for use of fair value
measurements in the financial statements. This is often referred to as the fair value
principle. Fair value information may be more useful than historical cost for certain
types of assets and liabilities and in certain industries. For example, companies
report many financial instruments at fair value. Certain industries, such as
brokerage houses and mutual funds, prepare their basic financial statements on a
fair value basis.
Fair value measures or estimates often , it is argued, provides a more relevant
information as it gives a better insight into the value of a company’s assets and
liabilities (its financial position) and a better basis for assessing future cash flow
prospects. Recently the FASB has taken a step of giving companies the option to
use fair value (referred to as the fair value option) as the basis for measurement of
financial assets and financial liabilities. It provides companies the option to record
fair value in their accounts for most financial instruments, including such items as
receivables, investments, and debt securities. As a result, use of fair value in
financial reporting is increasing. However, measurement based on fair value
introduces increased subjectivity into accounting reports when fair value information
is not readily available. To increase consistency and comparability in fair value
measures, the FASB established a fair value hierarchy that provides insight into the

FINANCIAL ACCOUNTING I Page 13

priority of valuation techniques to use to determine fair value. The fair value
hierarchy is divided into the following three broad levels:
Level 1: Observable inputs that reflect quoted prices for identical assets or
liabilities in active markets.
Level 2: Inputs other than quoted prices included in Level 1 that are
observable for the asset or liability either directly or through
corroboration with observable data.
Level 3: Unobservable inputs (for example, a company’s own data or
assumptions)
Level 1 is the least subjective because it is based on quoted prices, like a closing
stock price in the Wall Street Journal. Level 2 is more subjective and would rely on
evaluating similar assets or liabilities in active markets. At the most subjective level,
Level 3, much judgment is needed, based on the best information available, to
arrive at a relevant and representationally faithful fair value measurement.
For major groups of assets and liabilities, companies must disclose the fair value
measurement and the fair value hierarchy level of the measurements as a whole,
classified by Level 1, 2, or 3. Given the judgment involved, it follows that the more a
company depends on Level 3 to determine fair values, the more information about
the valuation process the company will need to disclose. Thus, additional
disclosures are required for Level 3 measurements; we discuss these disclosures in
more detail in subsequent chapters.
Revenue Recognition Principle
When a company agrees to perform a service or sell a product to a customer, it has
a performance obligation. When the company satisfies this performance obligation,
it recognizes revenue. The revenue recognition principle therefore requires that
companies recognize revenue in the accounting period in which the performance
obligation is satisfied. To illustrate, assume that HAHU Cleaners cleans clothing on
June 30 but customers do not claim and pay for their clothes until the first week of
July. HAHU should record revenue in June when it performed the service (satisfied
the performance obligation) rather than in July when it received the cash. At June
30, HAHU would report a receivable on its balance sheet and revenue in its income
statement for the service performed.
Many revenue transactions pose few problems because the transaction is initiated
and completed at the same time. However, when to recognize revenue in other
certain situations is often more difficult. The risk of errors and misstatements is
significant. Chapter 4 discusses revenue recognition issues in more detail.
Expense Recognition Principle
As indicated in the discussion of financial statement elements, expenses are
defined as outflows or other “using up” of assets or incurring of liabilities (or a
combination of both) during a period as a result of delivering or producing goods
and/or performing services. It follows then that recognition of expenses is related to
net changes in assets and earning revenues. In practice, the approach for
recognizing expenses is, “Let the expense follow the revenues.” This approach is
the expense recognition principle. Thus, companies tie expense recognition to
revenue recognition. That is, by matching efforts (expenses) with accomplishment
(revenues), the expense recognition principle is implemented in accordance with the

FINANCIAL ACCOUNTING I Page 14

definition of expense (outflows or other using up of assets or incurring of liabilities).
This approach is commonly referred to as the matching principle.
Some costs, however, are difficult to associate with revenue. As a result, some
other approach must be developed. Often, companies use a “rational and
systematic” allocation policy that will approximate the expense recognition principle.
This type of expense recognition involves assumptions about the benefits that a
company receives as well as the cost associated with those benefits. For example,
a company allocates the cost of a long-lived asset over all of the accounting periods
during which it uses the asset because the asset contributes to the generation of
revenue throughout its useful life.
Companies charge some costs to the current period as expenses (or losses) simply
because they cannot determine a connection with revenue. Examples of these
types of costs are officers’ salaries and other administrative expenses.
Full Disclosure Principle
In the preparation of financial statements, companies should include information
that is of sufficient importance to influence the judgment and decision of an
informed user. Often referred to as the full disclosure principle, it recognizes that the
nature and amount of information included in financial reports reflects a series of
judgmental trade-offs. These trade-offs strive for sufficient detail to disclose matters
that make a difference to users, yet sufficient condensation to make the information
understandable, keeping in mind costs of preparing and using it.
Users find information about financial position, income, cash flows, and investments
in one of three places: (1) within the main body of financial statements, (2) in the
notes to those statements, or (3) as supplementary information.
To be recognized in the main body of financial statements, an item should meet the
definition of a basic element, be measurable with sufficient certainty, and be
relevant and reliable.
The notes to financial statements generally amplify or explain the items presented in
the main body of the statements. If the main body of the financial statements gives
an incomplete picture of the performance and position of the company, the notes
should provide the additional information needed. Information in the notes does not
have to be quantifiable, nor does it need to qualify as an element. Notes can be
partially or totally narrative. Examples of notes include descriptions of the
accounting policies and methods used in measuring the elements reported in the
statements, explanations of uncertainties and contingencies, and statistics and
details too voluminous for inclusion in the statements. The notes can be essential to
understanding the company’s performance and position.
Supplementary information may include details or amounts that present a different
perspective from that adopted in the financial statements. It may be quantifiable
information that is high in relevance but low in faithful representation. For example,
oil and gas companies typically provide information on proven reserves as well as
the related discounted cash flows.
Supplementary information may also include management’s explanation of the
financial information and its discussion of the significance of that information. For
example, many business combinations have produced financing arrangements that
demand new accounting and reporting practices and principles. In each of these
situations, the same problem must be faced: making sure the company presents

FINANCIAL ACCOUNTING I Page 15

enough information to ensure that the reasonably prudent investor will not be
misled. We discuss the content, arrangement, and display of financial statements,
along with other facets of full disclosure, in Chapters 4.
Cost Constraint
In providing information with the qualitative characteristics that make it useful,
companies must consider an overriding factor that limits (constrains) the reporting.
This is referred to as the cost constraint (the cost-benefit relationship). That is,
companies must weigh the costs of providing the information against the benefits
that can be derived from using it.
The difficulty in cost-benefit analysis is that the costs and especially the benefits are
not always evident or measurable. The costs are of several kinds: costs of collecting
and processing, of disseminating, of auditing, of potential litigation, of disclosure to
competitors, and of analysis and interpretation. Benefits to preparers may include
greater management control and access to capital at a lower cost. Users may
receive better information for allocation of resources, tax assessment, and rate
regulation. As noted earlier, benefits are generally more difficult to quantify than are
costs.

1.4. Cash flows and Income Measurement

Dear students as you well known, we have attempted to grasp the concept of
revenue realization in our previous discussions. Thus at this time we are
going to relate cash flows and income measurement. Do you think that
all cash inflows are revenues? Explain.

With assumption of a continuous existence of a business enterprise, accountants

record the prospect future cash inflows as an increase in assets and as revenue
whenever they have reliable evidence of the amount of the future cash receipt.
Even though cash inflows are closely related to revenue realization, the
assumptions underlying the timing of revenue realization do not always permit cash
inflows and revenue to be recorded in the same accounting period.

By the same token, cash outflows are closely related to expenses of a business
enterprises, however, cash outflows and expenses may not be recorded in the
same accounting period.

Cash flows (inflows and outflows) during an accounting period is not useful in
evaluating an enterprises operating performance. Because, cash receipts and
payments are not representative of the economic activities of the business
enterprise carried in specific periods.

1.4.1. Accrual Basis of Accounting

Accrual basis of accounting is closely linked to matching principle and revenue
recognition. Under accrual accounting, revenue is recognized when realized and
expenses are recognized when incurred, without regard to the time of cash receipts
and cash payments. The focus of the accrual accounting is to match the company’s
revenue for an accounting period, against the expenses involved in obtaining the

FINANCIAL ACCOUNTING I Page 16

revenues of the period and relates these total expenses to the total revenues so as
to determine the net income of the period. As a result, some expenses are
advanced (accrued) or delayed (deferred) in a manner similar to revenues.
Under the accrual basis, the accounting records are adjusted periodically to ensure
that all assets and liabilities (and thus revenue and expenses) are correctly stated.

1.4.2. Cash Basis of Accounting

Some seller companies may use cash basis of accounting for simplicity purpose. In
cash basis of accounting, a company computes its income for an accounting period
by subtracting the cash payments from the cash receipts from operations.
Under this method, the determination of income thus, rests on the collection of
revenue and the payment of expenses, rather than on the realization of revenue
and the incurring of expenses. While this method may be convenient to use, it
can lead to incorrect evaluations of a company’s operating results and financial
position, since, cash basis accounting does not attempt to match expenses against
revenues, it is not in conformity with generally accepted accounting principles.

Purely, a cash basis of accounting seldom is found in practice, but, a modified cash
basis (a mixed cash – accrual basis) may be used for income tax purposes. Under
this modified cash basis method, acquisition of assets having an economic life of
more than one year may not be deducted their entire cost in the year of acquisition.
Which means that costs should be allocated by depreciation plan over the economic
life of the assets. Further more, expenses such as rent or advertising paid in
advance also are treated as assets and are deductible only in the year or years to
which they apply. On the other hand, expenses paid after the year in which
incurred are deductible only in the year paid. For income tax purposes, revenues
we reported in the year received.

Illustrative Exercise 1.1

The following illustration is based on the accounting records of A/BiyaJemal, a
practicing lawyer, who maintains accounting records on a cash – basis. During the
accounting period 2000, he collected Br. 120,000 from his clients and paid Br.
45,000 for operating expenses, and a net income of Br. 75,000 was resulted
A/Biya’s fees receivable, accrued liabilities, and short – term prepayments on
Meskerem 1, Sene 30, 2000 were as follows:
Meskerem 1, 2000 Sene30, 2000
Fees receivable ………………….. Br. 16,500 Br. 33,600
Accrued liabilities ………………. 5,500 7,700
Short – term prepayments………. 3,000 2,000
Required: Based on the above information try to restate the net income based on
of the cash basis of accounting to accrual basis of accounting

Solution to Illustrative Exercise 1.1

To make the restatement, first identify items to be added and items to be deducted
on both the revenue and expenses side:
i) Fees receivable on Sene 30,2000 which were realized in the year 2000 were
not included under cash basis should be added to the cash collected in the

FINANCIAL ACCOUNTING I Page 17

 restatement of revenue to accrual basis. Because, fees receivable on
Meskerem 1 were realized in the year 1999 and collected in year 2000, this
amount is subtracted from cash collections in the restatement of revenue to
the accrual basis of accounting.
ii) The Sene 30, 2000, the amount of accrued liabilities represents expenses
incurred during the year 2000 that will be paid in year 2001, and the amount
of short – term prepayments on Meskerem 1,2000, represents services paid
in 1999 that were consumed in year 2000. Hence, both amounts should be
added to the amount of cash paid for year 2000 to restate to the accrual
basis of accounting.
iii) The amount of accrued liabilities on Meskerem 1,2000 represents expenses
of the year 1999 paid in year 2000, and the amount of short – term
prepayments on Sene 30, 2000 represents cash outlays in year 2000 for
services that will be consumed in year 2001. Therefore, both amounts are
deducted from the amount of cash paid to restate to the basis accounting.
The following working paper summarized the necessary adjustments to restate the
income statement from cash basis of accounting to accrual basis of accounting.

Working Paper to Restate Income Statement from Cash Basis to Accrual Basis of
Accounting For Year Ended Sene 30, 2000
Income statement Adjustments to restate to Income
Under cash basis of accrual basis of accounting statement
accounting Add Subtract under accrual
basis of
accounting
Revenue from fees received in
cash ……………………. Br. 120,000
Add: fees receivable, Sene 30,
2000………………. Br. 33,600
Less: fees receivable, Mesk. 1,
2000 ……………….. 16,500 Br. 137,100
Operating expenses paid in
cash ……………………. 45,000
Add: Accrued liabilities, Sene
30,2000 …………… 7,700
Short – term prepayments,
Mesk. 1, 2000………… 3,000
Less: Accrued liabilities,
Mesk. 1, 2000…….. 5,500
Short – term prepayment
Sene 30, 2000…………. 2,000 48,200
Net income under cash basis
Of accounting ……………. Br. 75,000
Net income under accrual
basis of accounting Br. 88,900
……………….

FINANCIAL ACCOUNTING I Page 18

Illustrative Exercise – 1.2
Tabor Enterprise debits all insurance premium payments to the unexpired insurance
ledger account and prepares adjusting entries at the end of each month to
recognize expired insurance premium as an expense. The affected ledger account
balances were as follows for year 3:
Unexpired Insurance:
Jan. 1, year 3 ……………………………………. Br. 82,000
Dec. 31, year 3 …………………………………. 105,000
Insurance Expense, Dec. 31, year 3 …………………… 246,000
Based on the given data, compute the total insurance premiums paid by Tabor
enterprise.

Solution to Illustrative Exercise 1.2

To determine the total premiums paid follow the following steps:
Insurance expense for year 3 …………………….. Br. 246,000
Add: unexpired insurance Dec. 31 year 3 ………… 105,000
Subtotal…………………………………… Br. 351,000
Less: unexpired insurance, Jan.1, year 3…………. 82,000
Total insurance premiums paid during year 3……. Br. 269,000

Activity 1.4:
1) Distinguish between the cash basis of accounting and the accrual basis
of accounting.
2) Cash paid by NURA Enterprise for operating expenses during the
month of January, year 5, totaled Br. 18,200. short – term prepayments
and accrued liabilities were as follows:
Jan. 1, Jan. 31,
Year 5 Year 5
Short – term prepayments ……………… Br. 2,500 Br. 3,100
Accrued liabilities ……………………… 3,600 3,300

Required: Compute NURA enterprise’s operating expenses for the month of

January, year 5, under the accrual basis of accounting.
Model Examination Questions
Part I: Short Answer Questions:
1. What two conditions are required before revenue can be recognized?
2. Explain the distinction between financial and management accounting?
3. What is meant by monetary principle? Explain
4. Identify the two primary qualities of accounting information. Briefly discuss
them along with their ingredients.
5. Explain the matching principle. What is meant by “ expense should follow
the revenue”?
Part II: Multiple – Choice Questions: Select the best answer among the given
alternatives of each
questions:

FINANCIAL ACCOUNTING I Page 19

 1. Which of the following is considered a pervasive constraint by statement of
financial accounting concepts No. 2, “Qualitative characteristics of
accounting information?
A. Verifiability B. Conservatism C.Timeliness D.
Benefits/costs
2. The valuation of a promise to receive cash in the future at present value in
the financial statements of a business enterprise is valid because of the
accounting principle or concept of:
A. Materiality B. Continuity (going – concern)
C. Neutrality D. Entity
3. According to the FASB’s conceptual framework, comprehensive income
includes which of the following?
Operating Income Investment by
owners
A. Yes No
B. Yes Yes
C. No Yes
D. No No

4. Under Statements of financial Accounting Concepts No. 2, “Qualitative

characteristics of Accounting Information,” which of the following is an
ingredient of the primary quality of reliability?
A. Materiality B. Predictive value
C. Understandability D. Verifiability
5. According to statements of financial concepts, neutrality is an ingredient of
which of the following?
Relevance Reliability
A. Yes Yes
B. Yes No
C. No No
D. No Yes
6. According to statement of financial accounting concepts No. 2,
representational faithfulness is an ingredient of which of the following?
Relevance Reliability
A. Yes Yes
B. Yes No
C. No No
D. No Yes
7. Under statement of financial accounting concepts No. 3, “Elements of
Financial Statement of Business Enterprises,” comprehensive income does
not include changes in owners’ equity resulting from:
Investments by Distributions to
Owners? Owners?
A. No No
B. No Yes
C. Yes No
D. Yes Yes

FINANCIAL ACCOUNTING I Page 20

 8. According to statement of financial accounting concepts, which of the
following relates to both relevance and reliability?
A. Consistency B. Feedback value
C. Neutrality D. Timeliness

9. According to the FASB conceptual frame work, earnings

A. Include certain losses that are excluded from comprehensive
income.
B. Are the same as comprehensive income
C. Exclude certain gains and losses that are included in comprehensive
income.
D. Include certain gains and losses that are excluded from
comprehensive income.
10. Which of the following accounting concepts states that an accounting
transaction should be supported sufficient evidence to allow two or more
qualified individuals to arrive at essentially similar measurers and
conclusions?
A. Stable monetary unit B. Matching
C. Verifiability D. Periodicity

Part – III: Workout Questions:

Problem 1: Gibe enterprise paid cash for operating expenses during the month of
September, year 5, totaled Br. 24,580. Short- term prepayments and accrued
liabilities were as follows.
Sept. 1, Sept. 30,
Year 5 Year 5
Short – term prepayments …….. Br. 10,580 Br. 10, 830
Accrued liabilities ……………. 11,910 11,000

Required: Compute Gibe Enterprise’s operating expenses for the month of

September year 5, under the accrual basis of accounting.

Answer Key:
Part II: Multiple Choice Questions
1. D 3. A 5. D 7. D 9. C
2. B 4. D 6. D 8. A 10. C

FINANCIAL ACCOUNTING I Page 21

 UNIT TWO
INFORMATION PROCESSING AND THE ACCOUNTING CYCLE
Contents:
 Unit Objectives
 Introduction
2.1. Recording business Transactions and events
2.2. Adjusting Entries
2.3. Closing Entries
2.4. Reversing Entries
2.5. Correcting entries
2.6. Work Sheet
2.6.1. Illustration of work sheet for a merchandising enterprise
2.6.2. Illustration of work sheet for a manufacturing Enterprise
 Model Examination Questions

Unit Objectives
This unit focuses on the framework for accounting information processing and its
components. Further more, it discusses about the preparation of working paper (work
sheet). After you have studied this unit, you will be able to:
 Understand the purpose of an accounting information system.
 Describe and discuss the relationships among accounting information
processing components: accounts, journals, ledgers, and financial statements.
 Have a renewed understanding of a double – entry recording system.
 Know the major steps in the accounting cycle.
 Prepare journal entries and complete the work sheet.

Introduction
Dear students, in this unit, you will have a renewed understanding of what you have
been taught in your previous courses.
As it is well know, accounting has been called the “language of business” because it is a
method (means) of communicating business information. To carry out such an activity,
we need to have an accounting system.

Accounting system: the prime purpose of a company’s accounting system is to provide

useful information to both external and internal users for making sound operating
decisions. Through this system a company records and stores the financial and
managerial information from its transactions to that when a need arise it can retrieve and
report the information in an accounting statement.

FINANCIAL ACCOUNTING I Page 22

In this unit, we also discuss the basis of a financial accounting system that a company
can use in either a manual or a computer accounting process. For sake of simplicity, our
discussions are focused on a manual system.

Very importantly, the accounting process consists of three major parts:

1) The recording of transactions during an accounting period.
2) The summarizing of information at the end of the period.
3) The preparation of financial statements.

2.1. Recording Business Transactions and Events

Pretest
Dear students, from what you have been taught earlier, would you tell us the similarity
and differences between business transaction and events? Before you go to the
subsequent discussions try to answer in writing.

For financial accounting purposes, a change in a company’s economic resources

(assets), obligations (liabilities), or residual interest (stockholders’ equity) may be caused
by a transaction or an event. Transactions and events may be classified into two broad
groups: (1) external transactions and events or those between the business enterprise
and other party, and (2) internal events, such as the expiration or transfer of costs within
the enterprise. For example, recording depreciation of a plant asset.

Supporting Documents
The company uses business documents or source documents, relating to these
transactions and events as initial information for recording process. Such documents
show the date, amount, and nature of the transaction, and the parties involved. Journal
entries are prepared from supporting documents; for example, check- stub support
entries in the cash payment journal.

Double – Entry System

In the accounting information system, economic events are recorded in such a way as to
affect at least two accounts. This practice, called the double – entry system based on
the basic accounting equation.
The double – entry system also ensures that the accounting equation remains in
balance. For example, when a company acquires Br. 25,000 worth of equipment on
credit, both assets and liabilities increase by br. 25,000. The accounting equation
remains in-balance.
All Journal entries are made within the framework of the basic accounting equation
(assets = liabilities + owner’s equity). The self-balancing nature of this system facilitates
the preparation of a complete set of financial statements.

Double – entry system originated from the fact that equal debit and credit entries should
be made for every transaction or event. The terms debit and credit may be related to the
basic accounting equation (A = L + OE) in the following way:

FINANCIAL ACCOUNTING I Page 23

 Asset accounts = Liability + owners’ equity accounts
Increase are recorded by debits Increase are recorded by credits
Decrease are recorded by credits Decrease are recorded by debits

The two independent variables in basic accounting equation are assets and liabilities;
where as the dependent variable is owner’s equity. It is a residual value from assets and
liabilities. There are two classes of accounts which can be taken as one source to bring
a change in the owners equity i.e. revenue and expenses. Revenue accounts measure
the inflow of assets resulting from the production and distribution of goods and services
to customers.

Expresses accounts measure the outflow of assets necessary to produce and distribute
these goods and services.
The application of the rules of debit and credit for revenue and expenses is summarized
below:
Expense accounts Revenue accounts

Increase are recorded by debit Increase are recorded by credits

Decrease are recorded by credits Decrease are recorded by debits

The terms debit and credit are used in accounting, they have no further meaning except
the debit side is always the left side, and the credit side is always the right side.

Accounting Cycle
The accounting cycle is a complete sequence of accounting procedures that are
repeated in the same order during each accounting period. In a typical manual system
includes the following steps:
1. Recording business transactions and events in the journals.
2. Classifying data by posting from the journals to the ledger.
3. Summarizing data from the ledger in an unadjusted trial balance.
4. Adjusting, correcting, and updating recorded data; completion of the work sheet.
5. Summarizing adjusted and corrected work sheet data in the form of financial
statements.
6. Closing the accounting records (nominal accounts) to summarize the operations
of the accounting period.
7. Preparation of a post – closing trial balance.
8. Reversing certain adjusting entries to facilitate the recording process in the
subsequent accounting period.

Journals
A company initially records its transactions (and events) in a journal. It is possible for a
company to record all its transactions in a single journal, called the general journal.
However, many companies have a number of different special journals, each designed

FINANCIAL ACCOUNTING I Page 24

to record a particular type of transaction. Special journals may be used as a more
efficient means of recording and summarizing recurring transactions.
The journalizing process requires the analysis of business transactions and events in
terms of debits and credits to the ledger accounts they affect: 1) assets, 2) liabilities, 3)
owner’s equity, 4) revenue, and 5) expenses.

Much greater number of business transactions are of four types, for that reason most of
the data may be recorded by the use of special multicolumn journals and a general
journal.

As a company increases in size and complexity, it needs to efficiently record and

summarize many daily transactions. For this purpose, special journals are used. A
special journal is a journal used by a company to record its transactions with a similar
characteristic.

The major journals and their uses are:

1. Sales journal. Used to record all (and only) sales of merchandise on credit.
2. Purchases journal. Used to record all (and only) purchases of merchandise on
credit.
3. Cash receipts Journal. Used to record all cash receipts.
4. Cash payments Journal. Used to record all cash payments.
5. General Journal: Used to record adjusting, closing and reversing entries and
other transactions not recorded in special journals.

Ledger
After Journalizing, the next step is transferring information to ledger accounts. This
transfer process is called posting, which means that each debit and credit amount in the
journals is entered in the appropriate ledger account.

A ledger consists of a number of accounts. Each ledger account represents stored

information about a particular asset, liability, owners’ equity, revenue or expense.
Ledger accounts are often classified as nominal (temporary) and real (permanent)
accounts. The nominal (revenue and expense) accounts are closed at the end of each
accounting period by transferring their balances to other accounts.

Trial Balance
A trial balance is a working paper that lists all the company’s general ledger accounts
and their account balances. The trial balances is used to verify that the total of the debit
balances is equal to the total of the credit balances. At the end of each accounting
period an unadjusted trial balance of the ledger is prepared to determine that the
mechanics of the recording and posting operations have been carried out accurately.
Activity 2.1
1. What is double – entry system? Explain its purpose in relation to the basic
accounting equation (A = L+OE)

FINANCIAL ACCOUNTING I Page 25

 2. Describe the accounting cycle and list the sequence of procedure involved in the
accounting cycle.
3. What is the purpose of an unadjusted trail balance? Does it provide a complete
proof that there have been no errors in the recording, classifying, and
summarizing of business transactions?

2.2. Adjusting Entries

Dear students, in your previous learning, you have exposed to such a journal
entries i.e. adjusting entries. Hence, what is adjusting entries? When shall we
record such journal entries?, and what is the purposes of recording these
entries? It is advisable to attempt these questions before you go through the
following discussions.

Some financial events not recognized on a day – to – day basis must be recorded
through adjusting entries at the end of the period so as to bring the accounting records
up to date.

An adjusting entry ordinarily affects both a permanent (balance sheet) and a temporary
(income statement) accounts. Adjusting entries may be classified in to three categories:
1. Apportionment of prepaid and deferred items
a. Prepaid expenses
b. Deferred revenues
2. Recording of accrued items
a. Accrued expenses
b. Accrued revenues
3 Recording estimated items

Prepaid Expenses
A prepaid expense (some times called a prepaid asset) is a good or service purchased
by a business enterprise for its operations but not fully used up by the end of the
accounting period. The prepayment (original transaction) may be debited to either asset
or expense account.

Illustrative Exercise 2.2.1

Assume that office supplies are acquired during the accounting period at the cost of Br.
6,000. Physical inventory reveals that supplies on hand cost Br. 1,950. At time of
supplies acquisition, the Br. 6,000 were debited to asset account or debited, to expense
account.
Hence, you are required to record end of period adjusting entry on both procedure.

FINANCIAL ACCOUNTING I Page 26

Solution to Illustrative – Exercise 2.2.1
When prepayment debited to asset account:
Inventory of Office Supplies
Office supplies Expense

Balance, Dec. 31 6,000

Adjusting entry 4,050 4,050

 When Prepayment debited to expense account:

Inventory of Office Supplies
Office Supplies Expense
Balance, Dec. 31 6,000
Adjusting entry 1,950 1,950

Deferred Revenues
Deferred (or unearned) revenue is a payment received by a company in advance for the
future sale of inventory or performance of services. If cash is received, the original
transaction may be recorded as a credit to a liability account or a revenue account.

Illustrative Exercise 2.2.2

Assume that on December 1, a company received Br. 9,000 for three months rent in
advance. On December 31 it must make an adjusting entry because it has now earned
one month rent. Record the adjusting entry when the original transaction amount Br.
9,000, either credited to the liability or revenue account.

Solution to Illustrative – Exercise 2.2.2

 When liability account credited on receipt of cash:
Unearned Rent Rent Revenue
Balance, Dec, 31 9,000
Adjusting entry 3,000 3,000

 When revenue account credited on receipt of cash:

Unearned Rent Rent Revenue
Balance , Dec, 31 9,000
Adjusting entry 6,000 6,000

Accrued Expenses

FINANCIAL ACCOUNTING I Page 27

Accrued expense is an expense that a company has incurred during the accounting
period but has neither paid nor recorded. Interest and salaries are typical of the
expenses that accrue with the passage of time and are recorded only when paid, except
when the end of a period accrues between the time the expense was incurred and the
payment is due.

Illustrative Exercise – 2.2.3

Assume that interest of Br. 12,000 on a br. 300,000 note payable at 8% is paid on June
1 and December 1 of each year. Record the required adjusting entry on December 31.

Solution to Illustrative – Exercise 2.2.3

Annual interest expense: 0.08  300,000 = Br. 24,000
Interest Expense ……………………………………. 2,000
Interest payable ……………………………… 2,000
To record the interest accrued on a 8%, Br. 300,000 note for one month to Dec.31

Accrued Revenues
An accrued revenue is a revenue that a company has earned during the accounting
period but has neither received nor recorded. In order to measure accurately the results
of operations under the matching principle, revenue is recognized in the period earned.

Illustrative Exercise – 2.2.4

Assume that rent totaling Br. 1,500 that has been realized but not collected for the month
of December has not been recorded. To measure assets and revenue accurately we
need to have adjusting entry. Record the required adjusting entry on December 31.
Solution to Illustrative Exercise – 2.2.4
Rent Receivable ………………………………….. 1,500
Rent Revenue ……………………………. 1,500
To record rent revenue earned during December.

Estimated Items
Some other adjusting entries are based on estimated amounts because they relate, at
leastin part, to expected future events. Adjustments involving (i) the depreciation in
assets such as buildings and equipment, and (2) the uncollectibility of some accounts
receivable are both based upon estimates.

Illustrative Exercise – 2.2.5

Assume that a company acquired a building, at a cost of Br. 900,000 on March 30, 2006.
The company estimates that the asset will have useful life of 35 years and the residual
value of the building will be Br. 25,000 at the end of its life. The company is following a
straight – line method of depreciation. Record the required adjusting entry on December
31,2006.

Solution to Illustrative – Exercise 2.2.5

FINANCIAL ACCOUNTING I Page 28

 Cost  Estimated Re sidual Value
Annual depreciation =
Estimated Service Life
Br.900,000  Br.25,000
=
35
= Br. 25,000
Depreciation expense from March 30 – December 31 (9 months) =
9
 Br.25,000 = Br. 18,750
12
Adjusting Depreciation Expense ……………………… 18,750
Entry Accumulated Depreciation of Building … 18,750
To record depreciation expense for nine months

Activity 2.2.
1. What are adjusting entries and why are they necessary?
2. Record adjusting entries on January 31, year 3, indicated by the
following information:
i) Accrued wages total Br. 5,000
ii) The estimate of doubtful accounts expense is Br. 3,500 and the
allowance for doubtful accounts had a zero balance.

2.3. Closing Procedures

Pretest
Dear students, as you have been taught, closing procedures are end- of- period
accounting activities. How do you define closing entries? What is the purpose of closing
entities? Does closing entry is an optional procedure/ Explain. Before you proceed to
the following paragraphs try to give your own answer in writing.

Closing entries are journal entries that a company makes at the end of the accounting
period (1) to reduce the balance in each temporary account to zero, and (2) to update
the retained earnings account.

Closing Revenue and Expense Accounts

If we assume that a rent revenue ledger account after adjustment has a credit balance of
Br. 1,500, the closing entry is:
Rent Revenue ……………………………… 1,500
Income Summary …………………. 1,500
To close the rent revenue ledger account.

FINANCIAL ACCOUNTING I Page 29

To close an expense ledger account, you must transfer its debit balance to the left side
of the income summary account. The following Journal entry is to close a supplies
expense account with a debit balance of Br. 4,050:
Income Summary …………………………… 4,050
Supplies Expense …………………… 4,050
To close the supplies expense ledger account,

Closing Inventories and Related Ledger Accounts

Illustration: Assume the following for year 8: January 1 inventory Br. 90,000,
purchases, Br. 285,000; Freight – in, Br. 50,000; purchases returns and allowances, Br.
3,500; December 31 inventory, including applicable freight – in, $60,000. The Journal
entry to close the accounts is as follows:

Inventory (Dec. 31, year 8 ) ……………………………… 60,000

Purchases Returns and Allowances ………………………. 3,500
Income Summary ………………………………………….361,500
Inventory (Jan. 1, Year 8)…………………………. 90,000
Purchases …………………………………………. 285,000
Freight – in ……………………………………….. 50,000
To close beginning inventory and net purchases for the period, and to record ending
inventory.

Closing the Income Summary Account

After the completion of the closing of all revenues and expenses (including cost of goods
sold) the balance of the income summary ledger account indicates the net income or net
loss for the year. The income summary account is closed by transferring its balance to
the retained earnings account.
Activity 2.3
1. What are closing entries? Why are they made? What ledger accounts are
closed?
2. A company uses the periodic inventory system and uses a closing entry to
record the ending inventory (December 31). If the ending inventory is Br.
42,500 and the beginning inventory (January 1) was Br. 39,100, the correct
closing entry is:

i) Income Summary ………………………… 42,500

Inventory (Dec. 31)………………….. 42,500
ii) Inventory (Jan. 1) ……………………….. 39,100
Inventory (Dec. 31) ……………….... 39,100
iii) Inventory (Dec. 1) ………………………. 42,500
Income Summary …………………… 42,500
iv) Inventory (Dec. 31)…………………….. 3,400
Inventory (Jan 1) ……………………. 3,400

FINANCIAL ACCOUNTING I Page 30

2.4. Reversing Entries
Pretest
Dear students, it is well known that reversing entries are Journal entries. But, are these
entries should always be recorded? When shall we record them? Does reversing entry is
an optional procedure? You are expected to provide your answer in brief.
After the completion of adjusting and closing of accounting records for the current
period, it begins a new accounting cycle for the next accounting period. Before
Journalizing the daily transactions of the new accounting period in the general journal,
most companies prepare reversing entries.
A reversing entry is the exact reverse (accounts and amounts) of an adjusting entry.
A reversing entry is optional and has one purpose: to simplify the recording of a later
transaction related to the adjusting entry.

As a general guideline, reversing entries should be made for any adjusting entry that
creates a new balance sheet account as follows:
1. Adjusting entries that create accrued revenues or expenses to be collected or
paid in the next accounting period.
2. Adjusting entries related to prepayments of costs initially recorded as expenses
or receipts- in-advance initially recorded as revenues.

Illustrative Exercise 2.4

Assume that on June 30, Year 1, Tabor Company borrowed Br. 300,000 at 12% on a
long term note with interest of 9,000 payable every four months. The first payment of
interest was made on October 31, year 1; the next interest payment is due on February
28, year 2.
 End – of – period adjustment:
November & December months, interest 9,000 4 = 2,250 × 2 = 4,500
Adjusting Entry: Dec. 31 Interest expense …………………. 4,500
Interest payable ………….. 4,500
Reversing Entry: Jan. 1 Interest payable ………………. 4,500
Interest Expense ……… 4,500

This reversing entry has eliminated the liability account interest payable and has caused
the interest expense account to have a Br. 4,500 credit balance. Consequently, the
cash payment of four months interest on February 28 will not need to be apportioned.
The February 28 entry will consist of a debit to interest Expense for Br. 9,000 and a
credit to cash for Br. 9,000. After the February 28 interest payment has been recorded,
the interest expense ledger account for year 2 still contain a debit of Br. 9,000 and a
credit of Br. 4,500 and as a result it produces net balance of Br. 4,500 which interest
expense of January and February.
Activity 2.4
1. What are reversing entries, and under what condition are they most commonly
used?

FINANCIAL ACCOUNTING I Page 31

 2. Which of the following adjusting entries would be reversed when a business
enterprise adopts a policy of preparing reversing entries? Indicate your reasons
for reversing and not reversing.
i) Unearned subscriptions revenue …………… 8,000
Subscription revenue …………………. 8,000
ii) Depreciation Expense ……………………… 7,000
Accumulated Depreciation ……………. 7,000
iii) Inventory of office supplies ……………… 6,000
Office supplies expense ………………. 6,000
iv) Interest Expense…………………………… 9,000
Interest Payable ……………………….. 9,000

2.5. Correcting Entries

Pretest
Dear students, it is not unusual to commit errors in accounting activities. Hence, to
correct the error(s) committed, we need to have correcting entries. Does correcting
entry is an adjusting entry?

Adjusting entries and correcting entries may seem similar but they are not. Correcting
entries are not considered adjusting entries because their function is to correct errors of
omission and commission. For instance, omission such as failure to record a transaction
would be rectified by journal entry. The improper recording of a transaction requires a
journal entry to ensure that ledger accounts are stated properly. In the event of an error
is made in one accounting period but discovered in a subsequent period, the possible
effect of the error on the net income of the earlier periods is closed to the Retained
Earnings ledger account. Moreover, an error is detected in the period in which the error
occurs, but prior to the closure of the accounting records are closed, revenue and
expense accounts may require correction and the retained earnings account generally is
not affect.

Example: Assume that the following two errors were madein Year 1 and were detected
at the end of the accounting period when the work sheet for the year ended December
31, year 1, was being prepared:
i) A purchase of furniture for Br. 3,500 cash was wrongly recorded by a debit of
Br. 350 to the supplies expense ledger account and a credit of Br. 350 to
cash.
ii) An acquisition of machinery for cash of Br. 8,000 on February 1, year 1, was
recorded as a purchase of merchandise. The machinery had an economic
life of 10 years with no residual value, and was depreciated by the straight –
line method for 6 months in year 1.

Illustrations of the two errors to determine the appropriate correcting entries follows:
Incorrect Journal entry as recorded Correct Journal entry that Required correcting entry

FINANCIAL ACCOUNTING I Page 32

 should have been made
i) Supplies Exp ………. 350 Furniture ……… 3,500 Furniture ……. 3,500
Cash ………………. 350 Cash ……… 3,500 Supplies exp… 350
Cash …………. 3,150
ii) Purchases …………… 8,000 Machinery……… 8,000 Machinery …… 8,000
Cash ……………... 8,000 Depre. Expense … 400 Dep. Expense…. 400
Cash ………... 8,000 Purchases …. 8,000
Accumulated Accumulated
Dep. Machinery… 400 Dep. Machinery… 400

Activity 2.5
1. Do correcting entries are considered as adjusting entries?
2. What are the functions of correcting entries?

2.6. Work Sheet

Pretest
Dear students, at this point in time, you are not new about the term ‘worksheet’. Hence,
try to answer the following questions before you go through the subsequent discussions:
(1) why do you prepare a worksheet? (2) Does a work sheet is a permanent accounting
record?

A work sheet is a multicolumn work space that provides an organized format for
performing several end – of – period accounting cycle steps and for preparing financial
statements. It also provides evidence, for audit trail purposes, of an organized and
structured accounting process that can be more easily reviewed than other methods of
analysis. The main purpose of preparing a worksheet is to minimize errors, simplify
recording of adjusting and closing entries in the general journal, and make it easier to
prepare the financial statements.

A Worksheet is not a substitute for any accounting records or financial statement; it is

merely a working paper designed for these purposes.

Illustration of Work Sheet for a Merchandising Enterprise

Work Sheet is a plan for the preparation of financial statements for different form of
business organizations. Be it sole proprietorship, partnership and corporation. On Top
of that the nature of business may be service organization, merchandising enterprise or
corporation. The point is work sheet as a plan equally important to all of businesses.

Dear students, in general, it is expected that you have developed rich experience
towards the preparation of work sheet. Particularly, in your previous course, you have
been taught about the procedures (steps) to plan (prepare) a worksheet for a
merchandising enterprise. If you want to have detailed discussion, you better refer
principles of accounting – I’.

FINANCIAL ACCOUNTING I Page 33

Illustration of work sheet for manufacturing Enterprise
Dear students, even though there is asimilarly between merchandising and
manufacturing enterprises with regard to the procedures for preparation of a work sheet,
there is a major difference. It is due to additional pair of columns for summarizing the
manufacturing operations. The following is an illustration of a work sheet for a
manufacturing enterprise.
The following data are the basis for the adjusting entries included in the work sheet for
Ethio Manufacturing Company for the year ended December 31, year 6:

a) Doubtful accounts expense for year 6 is estimated to be Br. 4,000

b) A three – year insurance policy was acquired on July 1, year 5 at the cost of Br.
8,100, the insurance expense is allocated to other factory costs and other
general expenses in a 3:1 ratio.
c) The wages accrued since the last pay period are direct labor, Br. 2,800 and
indirect labor, Br. 1,950. The officers, office staff, and sales staff are paid on the
last day of each month.
d) Interest of Br. 2,225 has accrued on notes payable.
e) Depreciation expense for the plant assets is computed by the straight line
method based on the following information:
Assets Estimated Estimated Cost allocation, %
economic residual value Factory General
life(years )
Building …………….. 50 Br. ‘0’ 90 10
Machinery and equipment ……. 15 -0- 100 -0-
Furniture and fixtures…………. 20 3,000 20 80

f) The power bills of December has not been received as of December 31, year 6.
From experience, the cost applicable to December is estimated to be Br. 2,150.
All heat, light and poor costs relate to the factory.
g) An inventory of factory supplies on December 31, year 6, indicates that supplies
costing Br. 2,750 are on hand.
h) The income taxes expense for year 6 is estimated at Br. 5,500.
i) Inventories on December 31, year 6, are as following:
Finished goods ………………………………… Br. 50,000
Goods in process ………………………………….. 26,000
Raw Material ………………………………….. 14,000

FINANCIAL ACCOUNTING I Page 34

 ETHIO MANUFACTURING COMPANY
Work Sheet
For Year Ended December 31, Year 6
Unadjusted trial Adjustments Manufacturing Income Retained Balance sheet
balance Statement earnings
statement
Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Cash 42,000 42,000
Accounts receivable 60,000 60,000
Allowance for double 2,200 (a)4000 6,200
accounts
Inventories (Jan. 1, Year 6)
Finished goods 58,000 58,000 50,500 50,500
Goods in Process 20,000 20,000 26,000 26,000
Raw material 18,000 18,000 14,000 14,000
Un expired insurance 6,750 (b)2,700 4,050
Land 80,000 80,000
Buildings 150,000 150,00
0
Accum. Depr of buildings 40,000 (e)3,000 43,00
0
Machinery and equipment 120,000 120,00
0
Accum. Depr. Of mach. 40,000 (e)8,000 48,00
And equip. 0
Furniture and Fixtures 20,000 20,000
Accum. Depr. of furn. And 5,000 (e)850 5,850
fixtures
Notes payable – current 70,000 70,00
0
Accounts Payable 35,300 (f)2,150 37,45
0

FINANCIAL ACCOUNTING I Page 35

Common stock, 110,00 110,0
0 00

Paid in capital in excess of 110,00 110,0

par 0 00
Retained earnings (Jan. 1, 90,875 90,87
year 6) 5
Dividends 8,000 8,000
Sales 639,60 639,60
0 0
Sales returns and 4,600 4,600
allowances
Raw material purchases 120,000 120,00
0
Purchases returns and 9,250 9,250
allowances
Freight – in 2,500 2,500
Direct labor costs 190,500 (c)2,8 193,30
00 0
Indirect labor costs 71,600 (c)1,9 73,550
50
Heat, light, and power 9,300 (f)2,15 11,450
0
Other factory costs 15,000 (b)2,0 (g)2,750 14,275
25
Advertising expense 30,000 30,000
Sales Salaries expense 40,000 40,000
Delivery expense 9,000 9,000
Administrative salaries 48,000 48,000
expense
Office salaries expense 18,000 18,000
Telephone and telegraph 2,800 2,800
expense

FINANCIAL ACCOUNTING I Page 36

Other general expenses 3,800 (b) 4,475
675
Interest expense 4,375 (d)2,2 6,600
25
Doubtful accounts expense (a)4,0 4,000
00
Wages payable (c)4,750 4,750
Interest Payable (d)2,225 2,225
Depreciation of bldg. (e) 2,700
(factory) 2,700
Depreciation of bldg. (e) 300
(general) 300
Depreciation of mach. And (e) 8,000
equip. (factory) 8,000
Depreciation of furn. And (e)170 170
fix. (factory)
Depreciation of furn. And (e) 680
fix. (general) 680
Inventory of factory (g)2,7 2,750
supplies 50
Income taxes expense (h)5,5 5,500
00
Income taxes payable (h)5,500 5,500
Cost of finished goods 414,695 414,69 5,500
manufactured 5
Net income 43,450 34,95
0
Retained earnings 126,32 126,3
(Dec.31, year 6) 5 25
Totals 1,152,225 1,152,2 35,925 35,925 463,94 463,945 690,10 690,10 134,32 134,3 569,30 569,3
25 5 0 0 5 25 0 00

FINANCIAL ACCOUNTING I Page 37

Work Sheet and Year –End Procedures
In a manufacturing enterprise, the journal entries for closing the manufacturing ledger accounts,
for adjusting the inventory balances, for closing the revenue and expense accounts, and for
closing the Dividends account are illustrated for Ethio manufacturing as follows:

Ethio Manufacturing Company

Closing Entries
December 31, Year 6
Raw material Inventory (Dec. 31, year 6)………………………………… 14,000
Goods in process inventory (Dec. 31, Year 6)……………………………. 26,000
Purchases returns and Allowances………………………………………. 9,250
Cost of Finished Goods Manufactured …………………………………. 414,695
Raw material inventory (Jan. 1, year 6)…………………………. 18,000
Goods in process inventory (Jan. 1, year 6)…………………….. 20,000
Raw material purchases………………………………………… 120,000
Freight – in ……………………………………………………… 2,500
Direct labor costs……………………………………………….. 193,300
Indirect labor costs…………………………………………….. 73,550
Heat, high, and power ……………………………………….. 11,450
Other factory costs …………………………………………….. 14,275
Depreciation of Buildings ……………………………………… 2,700
Depreciation of machinery and equipment ……………………. 8,000
Depreciation of furniture and fixtures………………………….. 170
To record cost of finished goods manufactured and ending inventories and Goods in process:

Finished Goods Inventory (Dec. 31, Year 6)…………………………. 50,500

Cost of Goods Sold…………………………………………………… 422,195
Cost of Finished Goods Manufactured………………………. 414,695
Finished Goods Inventory (Jan.1, Year 6)…………………… 58,000
To record ending finished goods inventory and cost of goods sold.

Sales…………………………………………………………………… 639,600
Cost of Goods Sold………………………………………….. 422,195
Sales Returns and Allowances ……………………………… 4,600
Advertising Expense ……………………………………….. 30,000
Sales Salaries Expense……………………………………… 40,000
Delivery Expense…………………………………………… 9,000
Administrative salaries expense……………………………. 48,000
Office salaries expense…………………………………….. 18,000
Telephone and Telegraph Expense………………………… 2,800
Other General Expenses…………………………………… 4,475
Interest Expense…………………………………………… 6,600
Doubtful Accounts Expense………………………………. 4,000

Financial Accounting l Page 38

 Depreciation of Buildings ………………………………… 300
Depreciation of furniture and fixtures ……………………. 680
Income Taxes Expense …………………………………… 5,500
Income Summary ………………………………………… 43,450
To Close revenue and expense accounts.

Income Summary ………………………………………………… 43,450

Retained Earnings ………………………………………… 43,450
To close income summary account

Retained Earnings …………………………………………………. 8,000

Dividends………………………………………………….. 8,000
To Close Dividends Account

Financial Accounting l Page 39

 Ethio Manufacturing Company
Statement of Cost of Finished Goods Manufactured
For Year Ended December 31, Year 6
Goods in Process Inventory (Jan. 1, Year 6)……………………… Br. 20,000
Raw Material Used:
Raw material inventory (Jan.1, year 6)…………………… Br. 18,000
Raw material purchases (net)…………………………….. 113,250
Cost of raw material available for use …………………… Br. 131,250
Less: Raw material inventory (Dec. 31, year 6)…………. 14,000
Cost of raw material used ……………………………… Br. 117,250
Direct labor costs ……………………………………….. 193,300
Factory overhead costs (see work sheet for details)…….. 110,145
Total manufacturing costs ………………………….. 420,695
Total cost of goods in process during, year 6 …………… Br. 440,695
Less: Goods in process inventory (Dec. 31, year 6)…….. 26,000
Cost of Finished Goods Manufactured …………………. Br.414,695
Activity 2.6
1. What is the purpose of work sheet, and what benefits we can possibly derive
from using it?
2. Differentiate between work sheet for merchandising enterprises and
manufacturing enterprise.

Model Examination Questions:

Part – I: Short Answer Questions
1. Describe the accounting cycle and list the sequence of procedure involved in the
accounting cycle.
2. Explain the benefits of the double – entry system.
3. Why is it advantageous to a business enterprise to initially record each of its
transactions in a Journal?
4. What are adjusting entries and why are they necessary?
5. What are accrued expenses and accrued revenues? Give an example of adjusting
entry to record each of these items.
Part – II: Work out Questions
Exercise 1: Seada Retail Store uses a perpetual inventory system and engaged in the
following transactions during the month of June.
Date Transactions
June 1 Made cash sales of Br. 8,500; the cost of the inventory was Br. 5,900.
5 Purchased Br. 4,200 of inventory on credit.
9 Made credit sales of Br. 5,500; the cost of the inventory sold was Br. 4,100.
13. Paid sales salaries of Br. 3,100 and office salaries of Br. 2,800.
14. Paid for June 5 purchases.
18 Purchased equipment costing Br. 10,200; made a down payment of Br. 4,200 and
agreed to pay the balance in 30 days.
21 Purchased Br. 2,800 inventory for cash.
27 Sold land that had originally cost Br. 4,100 for Br. 4,800.

Financial Accounting l Page 40

Required: Record the preceding transactions in a general journal.

Exercise 2. The following data are available under a periodic inventory system; Purchases, Br.
90,000; sales Br. 170,000; returned sales, Br. 25,000; returned purchases, Br. 24,000; freight –
in, Br. 27,000; beginning inventory, Br. 52,000, selling expenses, Br. 38,000, and ending
inventory, Br. 49,000.
Required: Compute the cost of goods sold.

Exercise 3: On December 31, 1992, Gojeb Corporation made the following adjusting
entries:
a. Wage expense …………………… 42,000
Wage payable …………………… 42,000
b. Depreciation expense ……………………. 100,000
Accumulated depreciation ……………. 100,000
c. Bad debt expense …………………………. 12,000
Allowance for doubtful accounts …….. 12,000
d. Income tax expense ………………………. 58,000
Income tax payable …………………… 58,000
Required:
i) Give reversing entries that you think would be preferable on January 1, 1993.
ii) For each adjusting entry, explain how you decided whether to reverse it.

Problem 1: At December 31, 2,000 (at the end of the accounting period), Seka
corporation reflected the following amounts on its work sheet.
Sales revenue ………………………………. Br. 400,000
Interest revenue ……………………………. 28,000
Beginning inventory (periodic inventory system)… 80,000
Ending inventory ………………………….. 88,000
Freight – in (on purchases)……………………… 32,000
Purchases………………………………………… 236,000
Sales returns ……………………………………. 36,000
Purchase returns ……………………………….. 24,000
Operating expenses (including income tax) …… 124,000
Required: i) Compute cost of goods sold
ii) Give the adjusting entry for purchases, inventory, and cost of goods sold. If none
is required, explain why.
iii) Give the closing entries for (a) revenues, (b) expenses, and (e) net income.
Problem 2: Super Power Company prepared the following trail balance for the year ended
December 31. 2001:
Trial Balance
Accounts Debit Credit
Cash ……………………………………… 15,000
Accounts receivable ……………………… 6,000
Allowance for doubtful accounts ………….. 900
Inventory …………………………………… 8,800

Financial Accounting l Page 41

Prepaid rent ………………………………… 4,600
Equipment ………………………………….. 35,000
Accumulated depreciation …………………… 14,000
Accounts payable ……………………………. 4,700
Notes payable (due 7/1/2002)……………….. 6,000
Capital stock (1,000 shares ) ……………….. 9,900
Retained earnings (1/1/2001)……………….. 15,200
Dividends distributed ………………………. 1,500
Sales revenues ……………………………… 60,000
Cost of goods sold …………………………. 22,000
Salaries expense …………………………… 8,100
Utilities expense…………………………… 4,300
Advertising expense ………………………. 5,400 .
Total ………………………………. 110,700 110,700
Additional information: i) The equipment is being depreciated on a straight – line basis over a
10 – year life, with no residual value; (ii) salaries accrued but not recorded total Br. 1,500; iii) on
January 1, 2001 the company had paid three years’ rent in advance at Br. 1,000 per month; (iv)
bad debts are expected to be 1% of total sales; (v) interest of Br. 480 has accrued on the note
payable; and (vi) the income tax rate is 40% on current income and will be paid in the first
quarter of 2002.
Required:
a. Complete the work sheet
b. Prepare financial statements for 2001.
c. Prepare closing entries in the general journal.

Financial Accounting l Page 42

 UNIT THREE
REVENUE AND EXPENSE RECOGNITION;
INCOME MEASUREMENT AND REPORTING
Contents
 Unit Objective
 Introduction
3.1. Recognition of Revenue
3.1.1. Revenue Recognized at Time of Sale and Delivery
3.1.2. Revenue Recognized Before Delivery
3.1.3. Revenue Recognized After Delivery
3.1.4. Other Revenue Recognition Situations
3.2. Recognition of Expenses
3.2.1. Flow of Costs
3.2.2. Principles of Expense Recognition
3.2.3. Expense Recognition for Service Transactions
3.2.4. Recognition of Losses
3.3. Income Measurement and Reporting
3.3.1. Meaning of Income
3.3.2. Special Problems in the Measurement and Reporting Of Income
3.3.2.1. Income Tax Allocation
3.3.2.2. Disposal of a Business Segment
3.3.2.3. Extraordinary Items
3.3.2.4. Accounting Changes
 Model Examination Questions

Unit Objective
In this unit we will discuss about revenue recognition, the matching of expenses against the
revenue and the related issue of the measurement of the net assets (assets minus liabilities).
After you have studied this unit, you will be able to:
 Understand the concepts of income.
 Define the elements of income statement.
 Explain the conceptual issues regarding revenue recognition.
 Describe the alternative revenue recognition methods.
 Describe the alternative expenses recognition methods.

Introduction
Dear students, you do remember that in your previous course (principles of accounting) you
have been taught about the principles of revenue realization and matching. Moreover, you have
also discussed about accrual basis of accounting in comparison with cash basis of accounting.
In this unit, we are going to discuss about revenue and expenses recognition alternatives and
conceptual foundations of revenue recognition. On top of that, there will be a discussions about
measurement of income by matching expired costs with realized revenue under a system of
accrual accounting that requires workable standards for the recognition of revenue, expenses,
gains, and losses applicable to each period. Recognition of revenues, expenses, gains and
losses and the related increases and decreases in assets and liabilities – including matching of

Financial Accounting l Page 43

costs and revenues, allocation, and amortization – the essence of using accrual accounting to
measure the operating results of business enterprises.

3.1. Recognition of Revenue

At this point in time, dear students, you are knowledgeable about the concept and definition of
revenue. Thus, define the term ‘revenue’. Would you differentiate between revenue
recognition and revenue realization? So, try to provide your own answer in writing.

According to FASB statement of concepts No. 3, Revenue is defined as:

Revenues are inflows of (increases in) assets of a company or settlement of its liabilities during
a period from delivering or producing goods, rendering services, or other activities that are the
company’s ongoing major or central operations.
Recognition is the process of formally recording and reporting an item in the company’s
accounting records. Before a revenue is recognized it must be realized (realizable) and
measurable with sufficient reliability.
Realizationin a common definition it means the process of converting non cash resources in to
cash or rights to cash. In the measurement of revenue, realization generally means that a
measurable transaction (such as sale) or an event (such as the rendering of services) has been
completed or is sufficiently finalized to warrant the recording of earned revenue in the
accounting records. Determination of critical event signaling that revenue has been realized
(earned) is the fundamental of revenue realization principle.

Earning process: It includes purchasing, producing, selling, delivering, administering, and

collecting and paying cash. Even though, revenues are defined in relation to this entire
earnings (operating) process, revenues generally are recognized when two criteria are met:
(1) realization has taken place, and
(2) they have been earned.
These criteria provide an acceptable level of assurance (i.e. reliability) of the existence and
amounts of revenues.

Generally, revenue is recognized in financial accounting at a specific stage of the earning

process, when the following three revenue realization conditions are met:
1. Sufficient reliable evidence exists to measure the market value of the output; the
economic substance of the transaction indicates that an exchange has occurred; mere
legal form of an exchange does not support revenue realization.
2. The earning process (in essence the creation of goods and services) is complete or
virtually complete, and all necessary cost have been incurred or may be estimated with
reasonable accuracy.
3. Collection of the claims from customers and clients who have purchased goods and
services is reasonably assured.
In the following paragraphs, we will discuss and illustrate the various stages of the earning
process at which revenue may be recognized.

3.1.1. Revenue Recognized at Time of Sale and Delivery

Financial Accounting l Page 44

In the normal course of business activities, the most widely accepted evidence of revenue
realization is the sale and delivery of a product or the performance of a service. Because an
arm’s-length transaction has taken place that transfers title and possession of a product in
return for cash or the expectation to receive cash. The transaction determines both the time at
which to recognize revenue and the amount at which to record it.
In a consignment, goods are transferred to another party (the consignee), who acts as an agent
for the owner of the goods (the consignor). Title to the goods remains with the owner until the
agent sells the goods to ultimate consumers, at which time a sales transaction takes place and
revenue is recognized by the consigner.

Example: Assume the company recognizes the revenue, expense, and increase in net assets
at the time of sale. In this case, it records the following events as follows:
i) The company manufactures the inventory:
Inventory ……………………………… 2,000
Cash …………………………… 2,000
ii) The company sells the inventory, recognizes revenue of Br. 2,500, the related
expense of Br. 2,000, and the increase in net assets of Br. 500 (Br. 2,500 – Br.
2000):
Accounts Receivable ………………….. 2,500
Revenue ……………………….. 2,500
Cost of goods sold …………………….. 2,000
Inventory………………………. 2,000
iii) The company collects cash of Br. 600:
Cash ……………………………………. 600
Accounts Receivable ……………. 600

3.1.2. Revenue Recognized Before Delivery

Generally, realization does not occur unless a sale has taken place. Nevertheless, in some
cases revenue is considered realized before the product is delivered to customers because a
sale and a significant portion of the earning process is completed. Under these situations, the
postponement of revenue recognition may result in a shifting of income among periods and
procedure misleading financial statements.
Revenue recognition before delivery, may take one of the following forms: (1) prior to
production, (2) during production (3) on completion of production, and (4) at some other stage,
for example, on production, accretion, discovery, receipt of orders from customers.

During Production
This method is used to reflect economic substance instead of legal form so that economic reality
is not distorted.
Example: Now assume the same facts of the previous example, during production a company
recognizes a gross profit of Br. 500 (revenue of Br. 2,500 minus the related expense of Br.
2000) and bills the customer for a partial billing of Br. 2,300. The company now records the
preceding events as follows:
i) The company manufactures the inventory:
Inventory ………………………………….. 2,000

Financial Accounting l Page 45

 Cash ………………………………… 2,000
ii) The company recognizes revenue of Br. 2,500, the related expense of Br. 2,000, and
the increase of Br. 500 in the value of the inventory during production:
Production Expense …………………….. 2,000
Inventory ……………………………….. 500
Revenue ……………………………… 2,500
iii) The company bills the customer for a partial billing of Br. 2,300:
Accounts Receivable ……………………. 2,300
Partial Billings ………………. 2,300
iv) The company collects cash of Br. 600:
Cash ……………………………………… 600
Accounts Receivable ……………………. 600

The percentage – of – completion method is used for most long – term construction contracts
such as construction of dam or a bridge, which requires several years to complete, production,
is the major element in the earning process.
Under the percentage – of – completion method, revenue is recognized based on the amount of
work (production) completed each year. Costs incurred each year are deducted from realized
contract revenue to measure the gross profit earned in that year. When a company uses the
percentage – of – completion method, it may determine the percentage by using either “input” or
“output” measures.

Illustrative Exercise – 3.1

To illustrate assume a Addis company contracted to construct a dam that takes three years to
complete. Below you have been given with contract price, costs incurred, estimated costs to
complete, partial billings, and collection. Moreover, the company estimates the percentage
completed by the cost – to – cost method.
DMA Construction Contract Amounts:
2006 2007 2008
Construction costs incurred during the year …..Br. 2,000,000Br. 2,800,000Br. 4,200,000
Estimated costs to complete the contract…….. 6,000,000 4,000,000 -
Partial billings to customer ………………….. 1,800,000 4,500,000 3,800,000
Collections from customers………………….. 1,600,000 4,300,000 4,200,000
Total Contract Price Br. 10,000,000
Determine the gross profit recognized each year.

Solution to Illustrative – Exercise 3.1

The gross profit to be recognized each year under the percentage of completion method.
2006 2007 2008
Construction costs incurred to date Br. 2,000,000 Br. 4,800,000 Br. 9,000,000
Estimated costs to complete 6,000,000 4,000,000 - .
Total estimated costs Br.8,000,000 Br. 8,800,000 Br. 9,000,000
Percentage complete (construction cost
Incurred to date  total estimated cost) 25% 54.55% 100%

Financial Accounting l Page 46

Revenue to data (% complete  Br.10,000,000
Contract price) …………………………… Br. 2,500,000 Br. 5,455,000 Br.
10,000,000
Revenue recognized for the year
(revenue to date – revenue
previously recognized)………………… Br. 2,500,000 Br. 2,955,000 Br. 4,545,000
Construction cost (expense) incurred
for the year …………………………….. (2,000,000) (2,800,000) (4,200,000)
Gross profit recognized ………………… Br. 500,000 Br.155,000 Br.345,000

On Completion of Production
In some cases, even though, a contract of sale had occurred earlier the recognition of revenue
is delayed until production is complete. Completed – contract method is just like a production
and sale any unit of inventory. The recording and reporting of inventory costs and partial billings
are handed in the same way as for the percentage – of – completion method. The principal
advantage of the completed – contract method is that the revenue recognized when the project
is essentially completed, under the completed – contract method. The principal drawback is
that it is less relevant because a company’s net income does not reflect its current performance.

3.1.3.Revenue Recognition after Delivery

In the case of product sales, revenue recognition may be delayed until some stage in the
earning process subsequent to sale and delivery.
The installment and cost recovery methods are the two principal ways of recognizing revenue
after the sale. We will discuss each method in the following paragraphs.
Installment Method
When accrual accounting is not considered appropriate installment method may be used.
Installment sales involve a financing agreement whereby the customer signs a contact, makes a
small down payment, and agrees to make periodic payments over extended period. Generally, a
company selects the installment method of revenue recognition because the collectibility of the
receivable from the sale is not reasonably assured.
Example: Installment Method
To illustrate the installment method, consider the following information for the Global company
in the first two years of its operations:
2006 2007
Total credit sales……………………………….. Br. 400,000 Br. 500,000
Total cost of goods sold ………………………. 290,000 330,000
Installment method sales ……………………… 100,000 150,000
Installment method cost of goods sold ……….. 75,000 105,000
Gross profit rateon installment method sales …. 25% 30%
Cash receipts on installment method sales
2006 sales ……………………………… 30,000 40,000
2007 sales……………………………… 50,000
Cash receipts on other credit sales …………… 200,000 380,000

Financial Accounting l Page 47

 Assume that the company uses the perpetual inventory method and that, for simplicity, interest
on the installment receivables is ignored. The global company records the preceding events as
follows:

During 2006
i. Accounts Receivable ………………………….. 400,000
Sales …………………………………… 400,000
ii. Cost of Goods Sold …………………………… 290,000
Inventory ……………………………… 290,000
iii. Cash …………………………………………. 230,000
Accounts Receivable ………………… 230,000

The company recognizes each collectionsin the normal manner of these collections, Br. 30,000
is for installment sales and Br. 200,000 for other credit sales.

December 31, 2006

i) Sales ……………………………………………… 100,000
Cost of Goods sold ………………. 75,000
Deferred Gross Profit, 2006 (Br. 100,000 25%)… 25,000
The company identifies the sales recognized under the installment method and the related cost
of goods sold from the accounting records and “reverses” them. It also recognized the deferred
gross profit. It computes a 25% gross profit rate for 2006 (deferred gross profit of Br. 25,000
divided by the sales of Br. 100,000).

ii) Deferred Gross profit, 2006 ………………………. 7,500

Gross profit realized on Installment
Method of sales …………………… 7,500
The company uses the gross profit rate of 25% recognized on the cash collected. Since the
company collected Br. 30,000 on these sales for 2006, it reduces the deferred gross profit and
recognized a gross profit of Br. 7,500 (Br. 30,000  25%).

In 2007 the Global Company records the following:

i) Accounts Receivable ………………….. 500,000
Sales …………………………… 500,000
ii) Cost of goods sold ……………………. 330,000
Inventory …………………….. 330,000
iii) Cash ………………………………….. 470,000
Accounts Receivable ………… 470,000

Of these Br. 470,000 collections, Br. 90,000 is for installment sales and Br. 380,000 for other
credit sales pay attention that the cash collection on the installment sales in 2007 include
amounts from sales made in 2006 (Br. 40,000) and 2007 (Br. 50,000).

Financial Accounting l Page 48

 December 31, 2007
Sales ………………………………………… 150,000
Cost of goods sold …………………. 105,000
Deferred Gross profit, 2007 (Br. 150,000  30%) ….. 45,000
The company “reverses” the sales recognized under the installment method and the related cost
of goods sold for 2007, and recognizes the deferred gross profit for 2007.
December 31, 2007
Deferred Gross profit, 2006…………………. 10,000
Deferred Gross profit, 2007…………………. 15,000
Gross profit realized on
Installment method sales ……………. 25,000
During 2007 the company collected Br. 40,000 on its 2006 installment method sales, for which
gross profit is 25%. The company also collected Br. 50,000 on its installment method sales, for
which its gross profit is 30%.

Cost Recovery Method

Whenever a company makes a sale in which there is a very high degree of uncertainty about
the collectiblities of the sales price, it defers recognition of any profit until the company has
recovered the cost of the entire sale.

In the period of sale, the cost of the products is deducted from sales (net of the deferred gross
profit) in the income statement. The deferred gross profit also is deducted from the related
receivables in the balance sheet. Collections of principal reduce the receivable, and any
collections of interest are credited to the deferred gross profit ledger account.

Under the cost recovery method, a company records sales, cost of goods sold, and collections
during the year in the usual manner (as with the installment method). In contrast to the
installment method, however, it does not recognize a gross profit under the cost recovery
method until it has recovered all the cost of the item sold.

Example: Consider the following information for the Asha P.L.C.

Sale of property under cost recovery method ………… Br. 80,000
Cost of property sold (net) …………………………… 72,000
Cash collections
2006 ………………………………………….. 35,000
2007 ………………………………………….. 40,000
2008………………………………………….. 5,000

The company records the preceding events using the cost recovery method as follows:
During 2006
i) Accounts Receivable …………………………………. 80,000
Deferred Gross profit…………………………. 8,000
Property (net)…………………………………. 72,000
ii) Cash …………………………………………………… 35,000
Accounts Receivable …………………………. 35,000

Financial Accounting l Page 49

The company records the transaction and defers the profit. It does not recognize a gross profit
when it collects the cash balance because it has not yet recovered the Br. 72,000 cost of the
property sold.
During 2007
Cash ………………………………………………….. 40,000
Accounts Receivable ………………………… 40,000

December 31, 2007

Deferred Gross Profit ……………………………….. 3,000
Gross profit Realized on cost Recovery
Transactions ……………………………….. 3,000
In 2006, the company recovered Br. 35,000 of the Br. 72,000 costof the property sold.
Therefore, of Br. 40,000 cash collected in 2007, the first Br. 37,000 collected completes the
recovery of the cost, and the remaining Br. 3,000 collected results in the recognition of a gross
profit of Br. 3000.
During 2008
Cash ……………………………………… 5,000
Accounts Receivable …………….. 5,000
December31, 2008
Deferred Gross profit …………………… 5,000
Gross profit realized on cost Recovery
Transactions …………………… 5,000

Since the company recovered the total costin 2007, the Br. 5,000 cash collected in 2008 results
in the recognition of an equal amount of gross profit.

Cash Collection Method

Revenue recognition may be delayed beyond the point of sale until additional evidence confirms
the sales transaction. Under cash collection method, revenue is recognized as cash is
collected.
Example: Assume that South – West P.L.C. defers the recognition of revenue to the period
when the cash is received. The company now records the following events, (it is based on the
preceding events) as follows:
i) The company manufactures the inventory
Inventory ……………………………… 2,000
Cash ……………………………. 2,000
ii) The company “sells” (i.e. delivers) the inventory and defers the recognition of
revenue:
Accounts Receivable …………………… 2,500
Inventory ………………………. 2,000
Deferred Gross profit ………….. 500
Since the company has transferred the item, it records the receivable of Br. 2,500, removes the
inventory of Br. 2,000, and records the difference as Deferred Gross profit, which is contra

Financial Accounting l Page 50

account to accounts receivable. Thus, the net value of its accounts receivable is the cost of the
item of Br. 2,000 (i.e., Br. 2,500 – Br. 500).
iii) The company collects cash of Br. 600:
Cash …………………………………… 600
Accounts Receivable …………. 600
iv) The company recognizes revenue based on the cash received:
Cost of Goods sold ……………………480
Deferred Gross profit …………………120
Revenue ……………………………… 600
Since the company collects Br. 600, it recognizes revenue of Br. 600. This collection is 24%
(Br. 600  Br. 2,500) of the total sale price of Br. 2,500. Therefore, it recognizes 24% of the cost
of the item as cost of goods sold of Br. 480 (24%  Br. 2000). It reduces the deferred gross
profit by Br. 120 (Br. 600 – Br. 480), there by increasing the value of net receivable.

3.1.4. Other Revenue Recognition Situations

Revenue from service Transactions
Enterprises operating in service industries sell services, perform acts, and agree to perform
certain acts on a later date, or permit their resources to be used by others. Collectively this
revenue – generating activities are called service transactions. To cite few examples,
advertising agencies, computer service organizations, entertainment enterprises, banks, public
accounting, law firms, hospitals stock and real estate brokerage firms, leasing and franchising
enterprises.
In general, revenue is recognized from a service transaction when the provider has performed.
Performance consists of the completion of a specific act or acts, or occurs with the passage of
time. The following are four methods of revenue recognition for service transactions:

1. Specific – performance method. As its name suggested, it is similar to the sales method
of revenue recognition for product sales and is appropriate when a service transaction
consists of a single act; revenue is recognized at the time the acts performed.
Examples: entertainment performances, placement of candidate on a job by an
employment agency, the sale of real property for a commission.
2. Completed – performance method. This method is similar to the completed contract
method of revenue recognition for construction – type contracts. It is used when the
amount of services to be performed in the last of a series of acts is so significant in relation
to the entire service transaction that performance is not deemed to have occurred until the
final act is completed.
3. Proportional – Performance Method. A Company recognizes revenue for service
transactions based on performance because performance determines the extent to which
its earning process is completed.
When proportional – performance method is used a service transaction costs of (a) a specified
number of similar acts, (b) a specified number of dissimilar acts, or (c) an unspecified number of
similar acts with a fixed period for performance. To mention few examples in which this method
may be used are:
A mortgage bank’s processing monthly mortgage (specific number of similar acts); grading of
completed lessons, administration of examinations and grading examinations (specified number

Financial Accounting l Page 51

of dissimilar acts), and health clubs sale of three – year memberships for unlimited use of its
facilities (unspecified number of similar acts with a fixed period of performance).
A company recognizes revenue depending on the type and number of service act as follows:
1. Specified number of similar acts. Recognize an equal amount of revenue for each act.
2. Specified number of defined but not similar acts. Recognize revenue for each act based
on the ratio of the direct cost incurred to perform each act to the total estimated direct
costs.
3. Unspecified number of similar acts. Recognize revenue on a straight line method over
the performance method.
4. Cash – collection Method. When a considerable doubt exists about the collectability of
the revenue, revenue should be recognized only as cash is collected. This method is
similar to the installment and cost recovery method.
Recognition of Gains
Gains are increases in the equity (net assts) of a company from peripheral or incidental
transactions and all other events and circumstances during a period, except those that result
from revenues or investments by owners.
Gains from the disposal of assets or the extinguishment of debt generally are recognized in the
accounting period in the related transaction is considered to have resulted in the completion of
the earning process. The recognition of gains must pass a more severe test than the
recognition of losses because of the influence of the concept of conservatism.
Activity 3.1
1. Briefly describe the revenue realization conditions?
2. List and briefly describe methods that may be used to recognize revenue for
service transactions.

3.2. Recognition of Expenses

Dear students, in this section we are going to discuss about expenses recognition criteria along
with matching concept. Moreover, classification of costs will be discussed. Before we are going
to deal with the discussions, would you differentiate between expenses and losses? Explain
their differences and similarity.

Expenses are outflows of (decreases in) assets of a company or incurrence of liabilities during a
period from delivering or producing goods, rendering services, or carrying out other activities
that are the company’s on going major or central operations.

+
3.2.1. Flow of Costs
Flow of costs may not necessarily traceable with the physical product or service produced.
Even in a single – product case it is apparent that some cost are more directly related to the
product than are others. For example, the costs of direct material, direct labor, and some
variable factory overhead may be traced to the product because the relationship between effort
and accomplishment is relatively clear. To the contrary, selling and administrative expenses are
productive, but the relationship between effort and accomplishment is far more vague.
Consequently, accountants must make reasonable assumptions for the allocation of costs to
products and periods.

Financial Accounting l Page 52

Period and Product Costs
Products costs are traced to physical output are accumulated in inventories until evidence of
revenue realization is available. For instance, the costs of direct material and labor used to
manufacture a product attach to, and may be identified directly with, a unit of inventory. For a
merchandising enterprise, product costs relate solely to the cost of goods acquired for resale.
Other costs, called period costs, are considered expenses of the accounting period in which
they occur. For example, advertising and sales salaries, generally are not related to production
and are expensed (deducted from revenue immediately), because the benefits are received in
the same period the costs are incurred.
Expired Costs some asset services, such as equipment and intangible assets, are acquiredin
advance of their use. For example, the moment a business enterprise acquires equipment, it
acquires productive services. With a passage of time some portion of the services will be used
during the current accounting period, and the remaining portions will not be used for several
periods. The expiration of the services of some productive assets is a function of time.
3.2.2. Principles of Expense recognition
The FASB identified three expense recognition principles to properly match expenses against
revenues:
1. Association of Cause and Effect. Some costs may be recognized as expenses on
presumed direct association with specific revenues. Some transactions result
simultaneously in both a revenue and an expense.
Examples include costs of products sold, or services provided, sales commissions,
transportation costs for delivery of goods to customers, and direct costs incurred in relation
to construction – type contracts.
2. Systematic and Rational Allocation: In the absence of direct means to associate cause
and effect, costs may be recognized as expenses based on a systematic and ration
allocation among the periods in which benefits are provided. Assumptions as to the pattern
of benefits and as to the relationships between costs and benefits are required, because
both of them can not be objectively measured.
Examples of costs that are recognized as expenses may be depreciation of plants assets,
allocated amount for prepaid costs, and amortization of intangible assets.
3. Immediate Recognition: Expenses are recognized in the current accounting period,
because (1) costs incurred in the current accounting period are not expected to provide any
future benefits, (2) costs deferred as assets in previous periods no longer provide benefits,
and (3) allocation of costs to revenues or among accounting periods is impractical or is
considered not useful. This principle is applicable to research and developments costs,
general and administrative costs, and costs paid to settle litigation are recognized as
expenses in the period they are incurred. For better understanding the relationships
among the terms cost, asset and expense are depicted as follows:

Financial Accounting l Page 53

Cost: Asset or Expense

Expense Recognition for Service Transactions

In general, costs are recognized in the fiscal period in which the related revenue is recognized,
and costs that are not expected to be recovered are not deferred. To apply this general
principle of service transactions, cost may be categorized in the following manner.

i) Initial Direct Costs: Those costs are directly associated with negotiating and signing a
service contract. Such costs include legal fees, commissions, costs of credit
investigations, document processing fees, etc. Initial direct costs do not include any
portion of indirect cost such as rent, or supervisory and administrative salaries.
ii) Direct Costs: those costs that have a clear casual relationship to the services performed
(e.g ; labor costs )
iii) Indirect Costs – those costs other than initial direct costs and direct costs (e.g;
advertising and depreciation). Indirect costs are recorded immediately as expenses,
regardless of the method of revenue recognition used.

3.2.4. Recognition of Losses

Losses are decreases in the equity (net assets) of a business enterprise from peripheral or
incidental transactions, and all other events and circumstances during a period, except those
that result from expenses or distributions to owners.
Under accrual basis of accounting, losses are recognized in the accounting periods in which
they occur as a result of transactions and other events and circumstances. Losses resulting
from the disposal of assets or the retirement of debt are readily recognizable and measurable.
Losses resulting from events and circumstances such as causalities, contingencies, declines in
the market value of inventories and short- term investments in marketable securities, and
impairments of the value of plant assets and long - term investments create more difficult
recognition problems.

Generally, the standards for the recognition of losses are less severe than the standards for the
recognition of gains. For instance, a loss from an exchange of a plant asset for similar asset is
recognized but a gain is not, because it is not considered realized. In practice, the current
standards governing the recognition of losses resulting from events and circumstances are not
highly developed and are not consistent with the standards for the recognition of gains. For
example, losses from holding short – term investments in marketable equity securities are
recognized, but holding gains are not.
Activity 3.2
1. Distinguish between product costs and period costs
2. Describe the three principles of expense recognition.
3.3. Income Measurement and Reporting
Dear students, as you have learnt in unit one, FASB finalize the conceptual framework project
by issuance of statement of financial accounting concepts number 5, “Recognition and
measurement in Financial statements of business enterprises.” In such a statement, FASB

Financial Accounting l Page 54

provided guidance as to what information to be included and its timing of inclusion. Moreover,
the FASB provides guidance about the quantification of the information to report.
Dear Students, the traditional income measurement and reporting by business enterprises are
not fully satisfy all users of accounting information keeping other factors constant, some of the
special problems may arise as a result of the requirements for the allocation of income taxes,
disposals of discontinued business segments, extraordinary items, changes in accounting
principles and estimates, and the reporting of earnings per share data in the income statement.
Dear students, before you go to the following discussion try to define and distinguish income in
earnings and comprehensive income.

3.3.1. The Meaning of Income

In a very general understanding, the ultimate goal in measuring income is to determine by how
much a business enterprise has become “better off” during some period of time as a result of its
operations. Controversies over the meaning and measurement of income center on the
problem of determining what the financial position of an enterprise is on particular date, whether
its position has improved or worsened during a specified period of time and by how much.

Lifetime Income of a Business Enterprise: Theoretically, to determine how ‘well off ‘an
enterprise is on a specific date is to compute the present value of its future net cash inflows.
This is known as direct valuation. Generally, the lifetime income of a business enterprise at
the time it is liquidated can be measured in the following manner:
Total proceeds received on liquidation of enterprise …………….. Br. 1,000,000
Add: Amounts withdrawn by owners during life of enterprise…… 500,000
Less: Amount of cash invested by owners ………………………. (900,000)
Lifetime income of enterprise…………………………………….. Br. 600,000

Periodic income of a business enterprise: In practice , to measure how “well off” an

enterprise is on a specific date in order to measure periodic net income, accountants record
only those changes in financial position that can possibly supported by reasonably reliable
evidence.

3.3.2. Special Problem in the Measurement and Reporting of Income

Dear students! In the previous section you have learnt accounting and reporting for revenues
and expense. What are the major problems a particular accountant face in their
measurement and reporting? Please enumerate and discuss those special items
requires special measurement and reporting before studying the following sections.

The predicative ability of an income statement is significantly enhanced if normal and recurrent
transactions are separated from unusual and non-recurrent items. The income statement is a
historical report, summarizing the most recent operating activities of a company. The
information in the statement is useful if it can help users predict the future. Toward this end,

Financial Accounting l Page 55

users should be made aware of events reported on the income statement that are not likely to
occur again in the foreseeable future. The measurement and reporting of income has become
complex as a result of requirements for these unusual items which include; allocation of taxes,
disposals of discontinued business segments, extraordinary items, changes in accounting
principles and estimates, and the reporting of earnings per share data in the income statement.
Among these topics earnings per share data will be discussed in chapter four and we will
discuss the others briefly in the following pages.

3.3.2.1. Income Tax Allocation

Income taxes frequently constitute the largest single expense for many profitable corporations.
Taxable income is a legal concept that is related to accounting income, but there are significant
differences that may cause a corporation’s taxable income for a specific year to differ materially
from the pre-tax income taxes expense (or credit) included in the income statement must be
1assigned to any non-operating sources of income or loss.
There are two methods of tax allocation; intra-period and inter-period.
Inter period Tax Allocation: this is a process of apportioning income taxes among two or more
accounting periods because of temporary differences in the recognition of revenue and
expenses. Temporary differences result when revenue or expense items appear in the income
statement either before or after they appear in the income tax return. By means of inter period
tax allocation, the income taxes expense in the income statement is related to the pre-tax
income or loss reported in the income tax return. Thus, income taxes are allocated among
accounting periods as are other expenses.
Intra period Tax Allocation: in this method we associates (allocates) income tax expense (or
income tax benefits if there is a loss) of a single accounting period among each component of
income that causes it and are presented separately in the income statement. These include;
income or loss from continuing operations, income or loss from discontinued operations,
extraordinary items, and cumulative effects of changes in accounting principles. Similarly, the
correction of a material error relating to earlier accounting periods is recorded as a prior period
adjustment in the Retained earnings ledger account, net of the related income tax effect.

Illustration 3.3.2.1: Assume that GUTANE Company has reported the following data for the
year ended December 31, Year 4 (a tax rate of 30% applies to all items).
Pre-tax Income
amount tax effect
Income from continuing operations 1,000,000 300,000
Loss from operations of discontinued business
segment(there were no gain or loss on the disposal) (750,000) (225,000)
Extra ordinary item (gain) 375,000 112,500
Additional depreciation claimed in income tax return (125,000) (37,500)
Taxable income and income tax payable for year 4 500,000 150,000

From the above table one can understand that, GUTANE Company elected to take the
additional depreciation of Br. 125,000 in its income tax return for Year 4 in order to postpone the
payment of Br. 37,500 of income taxes. This is an example of inter period allocation of income
taxes; the other income tax effects are examples of intra period allocation of income taxes. The

Financial Accounting l Page 56

various sources of income and loss are reported by GUTENE Company in the bottom portion of
its income statement as shown below.
Income from continuing operations before taxes 1,000,000
Less: income tax expenses (30%) 300,000
Income from continuing operations 700,000
Loss from discontinued business segment, net of taxes (525,000)
Income before extraordinary items 175,000
Extra ordinary item (gain), net of taxes 262,500
Net income 437,500

In general, you should have to note that; the income from continuing operations, the loss from
discontinued operation and the extraordinary item of GUTENE Company are reported in its
income statement net of the related income tax effect. Similarly, any cumulative effect of change
in accounting principle would be reported in the income statement net of related income tax
effect, and any prior period adjustment would be reported in the statement of retained earnings
(or statement of stock holders equity) net of related income tax effect.

3.3.2.2. Discontinued Operation (Disposal of a Business Segment)

Discontinued operations are items of income or loss that arise from the discontinued operations
of a segment of a business whose assets, results of operations, and activities are clearly
distinguishable, both physically and operationally, for financial reporting purposes from the other
assets, results of operations, and activities of the entity.
The effects of discontinued operations are to be disclosed, net of tax, as separate items in the
income statement following income from current operations but before extraordinary items and
divided into the following two components:
a) Results of Operations-the results of operation is the income or loss from the operations of
the discontinued segment of the business from the beginning of the period up to the
measurement date (the date at which time management formally commits itself to a formal plan
to dispose of the segment of the business)
b) Gain or Loss on Disposal-the gain or loss on disposal is equal to the sum of the income or
loss from the operations of the discontinued segment of the business from the measurement
date to the date of disposal and the gain or loss on the disposal of the net assets of the
discontinued segment of the business.
Note that if a loss on the disposal of the discontinued segment of the business is expected, the
loss on disposal should be reported in full at the measurement date. The measurement date is
the date the company adopts a formal plan to dispose of the business segment.

Illustration 3.3.2.2 (a): AYANTU Corporation decided to dispose of a segment of the business
on September 1 of year 1; the corporation expects to dispose of the segment on April 1 of year
2; the corporation reported a loss from operations of the segment from September 1 to
December 31 of year 1 of Br. 50,000; the corporation expects a loss from operations of the
segment of Br. 10,000 from January 1 to April 1 of year 2; the corporation expects a loss on
the sale of the net assets of the segment of Br. 15,000 on April 1 of year 2
Loss on Disposal = (50,000) - 10,000 - 15,000 = 75,000

Financial Accounting l Page 57

Gain on Disposal-if a gain on the disposal of the discontinued segment of the business is
expected, the gain on disposal should be reported when it is realized.
If an overall gain results, the reporting of the gain is more complex. An estimated gain can be
reported in the measurement year only to the extent of realized losses.
Let us look at three possible overall gain scenarios, designating realized income or loss from the
measurement date to the end of the fiscal year as R, the combined estimated component
(estimated operating income or loss from the end of the fiscal year to the disposal date plus the
estimated gain or loss on disposal) as E, and (+) to indicate gain (income) and (–) to indicate
loss.
Scenario 1: R (+) and E (-): in this case, realized operating income exceeds estimated losses.
The overall net gain is reported in the measurement year.
Scenario 2: R (+) and E (+): As both components are gains (income), only the realized
operating income is recognized in the measurement year. The estimated component is
recognized in the year of disposal, when it is realized.
Scenario 3: R (-) and E (+): Because there is a realized operating loss, the estimated gain
(income) can be recognized in the measurement year but only to the extent of the realized loss.
Therefore, no amount of gain or loss is reported in the measurement year. The net gain is
reported in the year of disposal when the excess (E minus R) is realized.
The example in Illustration 3.2.2 (b) to 3.2.2 (d) demonstrates the possibilities.
Illustration 3.2.1 (b) Assume that BEDANE Corporation decided to dispose of a segment of the
business on September 1 of year 1; the corporation expects to dispose of the segment on April
1 of year 2;
Scenario 1: Assume that the corporation reported an income from operations of the segment
from September 1 to December 31 of year 1 of Br. 45,000; the corporation expects a loss from
operations of the segment of Br. 10,000 from January 1 to April 1 of year 2; the corporation
expects a loss on the sale of the net assets of the segment of Br. 15,000 on April 1 of year 2.
The amount of gain on disposal should be:
Gain on Disposal = 45,000 - 10,000 - 15,000 = Br. 20,000
Scenario 2: Assume that the corporation reported an income from operations of the segment
from September 1 to December 31 of year 1 of Br. 40,000; the corporation expects a loss from
operations of the segment of Br. 10,000 from January 1 to April 1 of year 2; the corporation
expects a gain on the sale of the net assets of the segment of Br. 18,000 on April 1 of year 2.
The amount of gain on disposal should be:
Gain on Disposal = 40,000 - 10,000 + 18,000 = 48,000 or 40,000 = Br. 40,000
As discussed above though the amount of total gain on disposal is Br. 48,000 we can transfer
only Br. 40,000 (i.e., gain from operations of the segment).
Scenario 3: Assume that the corporation reported a loss from operations of the segment from
September 1 to December 31 of year 1 of Br. 4,000; the corporation expects a loss from
operations of the segment of Br. 10,000 from January 1 to April 1 of year 2; the corporation
expects a gain on the sale of the net assets of the segment of Br. 15,000 on April 1 of year 2.
The amount of gain on disposal should be:
Gain on Disposal = (4,000) - 10,000 + 15,000 = Br. 1,000 or 0 = Br. 0
Note here is that no gain (0) is realized in the year of disposal; because the company reported a
loss from its operation.

Financial Accounting l Page 58

 3.3.3. Extraordinary Items
Extraordinary items are events and transactions that are distinguished by their both unusual
nature and by the infrequency of their occurrence. These items are said to be unusual in nature
in that the underlying event or transaction should possess a high degree of abnormality and be
of a type clearly unrelated to, or only indirectly related to, the ordinary and typical activities of
the entity, taking into account the environment in which the entity operates. They are also
infrequency of occurrence, that is the underlying event or transaction should be of a type that
would not reasonably be expected to recur in the foreseeable future, taking into account the
environment in which the entity operates.
The extraordinary items are to be disclosed, net of taxes, as separate items in the income
statement, for the period in which they occur, following income from operations.

Illustration 3.3.3: EBISE Corporation reported revenues from operations of Br. 120,000,
expenses from operations of Br. 84,000, and an extraordinary gain of Br. 12,000; the tax rate
was 30%. The presentation of the extraordinary items shall be made as follows:

EBISE Corporation
Income Statement
For the Year Ended December 31, Year 7
Revenues from operations 120,000
Expenses from operations 84,000
Net income from operations before taxes 36,000
Income tax expense 10,800
Net income from operations 25,200
Extraordinary gain 12,000
Income tax expense 3,600
Net income 33,600

3.3.4. Changes in Accounting Principles

Changes in accounting principles are changes that arise when a generally accepted accounting
principle is adopted that is different from a previously used generally accepted accounting
principle.
Changes in accounting principles require the adjustment of financial statements of all periods
prior to the changes in accounting principles to reflect the application of the new accounting
principles to all prior periods as if the new principles had always been used.
In Statement of Retained Earnings - the cumulative effect of the changes in accounting
principles on items of revenue and expense for periods prior to the earliest period presented is
to be disclosed, net of tax, as an adjustment to the beginning balance of retained earnings for
the earliest period presented.

Financial Accounting l Page 59

For example if the change in accounting principle is a switch to the FIFO inventory method from
LIFO or average method, there is no restatement of prior years’ income because it is impractical
to do so. Generally, a change in accounting principles (such as change inventory valuation,
method of computing depreciation, etc) requires the inclusion of the cumulative effect of a
change to a new principle in net income of the accounting period in which the change is made.
Illustration 3.4.4 (a): On January 1 of year 4 JIFARE Corporation switched from LIFO to FIFO
for inventory valuation purposes; during year 4 the corporation reported sales of Br. 140,000,
cost of goods sold computed under the FIFO method of Br. 70,000, operating expenses of Br.
35,000, and beginning retained earnings of Br. 90,000; the tax rate was 30%; if the FIFO
method had been used in earlier years, net income would have been Br. 45,000 higher; the
corporation presented financial statements for the current year only.

JIFARE Corporation
Income Statement
For the Year Ended December 31, Year 4
Sales 140,000
Cost of goods sold (FIFO) 70,000
Gross profit 70,000
Operating expenses 35,000
Net income from operations before taxes 35,000
Income tax expense 10,500
Net income 24,500

JIFARE Corporation
Statement of Retained Earnings
For the Year Ended December 31, Year 4
Retained earnings January 1, Year 4 90,000
Cumulative effect of a change in accounting principles 45,000
Income tax expense 13,500 31,500
Corrected retained earnings January 1, Year 4 121,500
Net income 24,500
Retained earnings December 31, Year 4 146,000

Illustration 3.3.4 (b): In addition to the above data in Illustration 3.4.4 (a), assume further that
during year 3 the corporation reported sales of Br. 110,000, cost of goods sold under LIFO of
Br. 55,000, operating expenses of Br. 30,000, and beginning retained earnings of Br. 76,000; if
the FIFO method had been used in year 3, cost of goods sold would have been Br. 55,000; the
corporation presented comparative financial statements for year 3 and year 4 as follows:
JIFARE Corporation
A Comparative Income Statement
For the Year Ended December 31
Year 4 Year 3
Sales 140,000 110,000

Financial Accounting l Page 60

 Cost of goods sold 70,000 55,000
Gross margin 70,000 55,000
Operating expenses 35,000 30,000
Net income from operations before taxes 35,000 25,000
Income tax expense 10,500 _ 7,500
Net income 24,500 17,500

JIFARE Corporation
A Statement of Retained Earnings
For the Year Ended December 31
Year 4 Year 3
Retained earnings January 1 121,500 76,000
Cumulative effect of a change in 45,000
accounting principles
Income tax expense 13,500 31,500
Corrected retained earnings January 1 121,500 104,000
Net income 24,500 17,500
Retained earnings December 31 146,000 121,500

Activity 3.3
1. Explain the meaning of intra period tax allocation and inter- period tax
allocation, and explain how these procedures improve the usefulness of an
income statement.
2. What is a change in accounting principle and how is it reported on a
company’s statement of retained earnings?
Model Examination Questions
Part –I: short Answer Questions:
1. Explain the basic difference between revenues and gains.
2. Briefly describe the three revenue realization conditions.
3. What are three principles for recognizing the expenses to be matched against revenue?
Give example of expenses that would be recognized under each principle.
4. How is an extra ordinary item defined/ explain the two criteria that must be met to
classify an event as extra ordinary.
5. Define initial direct costs, direct costs, and indirect costs incurred by a service
enterprise.
Part – II: Multiple Choice Questions: Select the best answer among the given alternatives
of each question:
1. Realization of revenue refers to:
A. The knowledge that it has been earned
B. The timing of its recognition in the accounting records.
C. Its receipt in the form of cash
D. Its recognition in an adjusting entry at the end of an accounting period.
2. Which of the following is the most widely accepted evidence of revenue realization?
A. The receipt of cash from the sale of finished products.

Financial Accounting l Page 61

 B. The process of production of product.
C. The completion of production of products.
D. The sale and delivery of products to customers.
3. A loss from the sale of a component of a business enterprise is reported separately as a
component of income
A. Before income from continuing operations and extraordinary items.
B. After income from continuing operations and before extraordinary items.
C. Income from continuing operations.
D. After extraordinary items.

Part III: Work Out Questions

Problem 1: National construction Company began to work on a contract in 2005. The contract
price is Br. 6,000,000, and the company uses the percentage-of-completion method. Other
information relating to the contract for the year 2005 is as follows:
Costs incurred during the year Br. 1,200,000
Estimated costs to complete 4,000,000
Billings during the year 1,500,000
Collection during the year 900,000

Required: How much gross profit does National Construction Company recognize in
2005?

Problem 2: Nice Company sells machinery service contracts agreeing to service machinery for
a two year period. Cash receipts from contracts are credited to unearned service contract
revenue, and service contract cost are debited to service contract expense as incurred.
Revenue from service contracts are recognized as earned over the term of the year 5, as
follows:
Unearned service contract revenue, January, Year 5
700,000
Unearned service contract revenue, December 31, Year 5 820,000
Cash receipts from service contracts sold 1,100,000
Service contract expense 600,000
Required: Compute the service contract revenue that National Company should recognize
for the year ended December 31, Year 5.

Answer Key:
Part II: Multiple Choice Questions Part III:
1. B Problem 1: Br. 600,000
2. D problem 2: Br. 980,000
3. B

Financial Accounting l Page 62

 UINT FOUR
FINANCIAL STATEMENTS AND ADDITIONAL DISCLOSURES

Unit Outline
 Introduction
 Unit Objectives
4.1. Income Statement
4.2. Statement of Retained Earnings
4.3. Balance Sheet
4.4. Statement of Cash Flows
4.5. Additional Disclosures
 Model Exam Questions

Unit Objectives:
After successful completion of this unit, you should be able to:
 Identify the basic financial statements used to report financial information for users.
 Understand the classification and orders of presenting in financial statements.
 Explore the extent of details required depending on the needs of different users of
accounting information.
 Understand the nature, content and significance of additional disclosure to financial
statements.
 Identify the limitation of financial statements.
 Relate items reported in each financial statement.

Introduction
Dear students, in unit three we have discussed the measurement of revenues, expenses, gains
and losses; by emphasizing that the measurement of resources and obligations of a business
enterprise is fundamental to the accounting process. The ongoing recording of transactions and
events and the preparation of adjusting entries at the end of the period may be described as a
process of measuring assets and liabilities. If assets and liabilities are measured correctly, it
should be apparent that revenues, expenses and owners’ equity also are measured correctly.
The results of these measurements are summarized in general-purpose financial statements
that provide decision makers with useful information. In this unit, we will discuss the set-of
general purpose financial statements which are the foundation of financial reporting and
disclosure that include: an income statement, a balance sheet, a statement of cash flows, a
statement of retained earnings (or statement of stockholders’ equity when changes in paid-in
capital occur during an accounting period), and notes to the financial statements.
For many years, the form and content of financial statements have received considerable
attention from accountants. Each statement has three headings which incorporates the name of
the reporting business (who), the name (title) of the financial statement (what) and the date(s)
the statement covered (when). The title should sometimes include descriptive words such as
consolidated, condensed, comparative or audited and the like.
The contents of the enterprise’s financial statements including the supplementary disclosures
have significant economic consequences on the enterprise, its owners, its creditors and all other
users or stakeholders of its assets and profitability. Financial statements that are relevant,

Financial Accounting l Page 63

complete, objective, timely and understandable are perceived by users as credible. Creditability
in financial reporting is an essential prerequisite to a healthy and efficient economic system.
A considerable amount of additional disclosures, which are intended to supplement the basic
financial statements and may be included in notes to the financial statements or in other
sections of the annual report to shareholders, shall be required by authoritative bodies, notably
the Financial Accounting Standard Board (FASB) and Securities Exchange Commission (SEC).
4.1. Income Statement

Dear students! What are the basic financial statements? List and differentiate each based on
their use?

In the preceding unit, we emphasized that the task of measuring revenue, expenses, gains and
losses is difficult. Also, the presentation of these items in the income statement has been more
of a routine process for accountants. A formal income statement consists of more than an
itemized list of revenue, expenses, gains and losses. Attention must be given to such issues as
the system of classification, the amount of detail that is appropriate, the order of presentation,
the relationship among the various components of net income, and the title used to describe the
line items in the income statement.
A traditional income statement may not be as useful to management as statement showing
income by products, departments, or divisions. Mangers obviously need detailed accounting
and statistical data that shed light on the contribution of the various segments of a business
enterprise to its overall success. Such information also might be useful to outsiders though the
information appearing in income statement issued to the public usually is highly condensed.
More detailed income statement may be submitted to credit grantors and others having a
special interest in the enterprise.
Some income statements may be quite complex. For example, if an enterprise sells a business
segment, recognizes an extraordinary gain or loss, or implements a change in accounting
principle that requires recognition of cumulative effect and the like, the bottom portion of the
income statement is expanded considerably.

Alternate Forms of Income Statement

The form and content of the income statement have been greatly affected by professional
pronouncements relating to such issues as intra period income tax allocation, accounting
changes, discontinued operations, extraordinary items, and earnings per share. These issues
often are complex and require careful study before the implications of income statement
reporting can be fully understood.
The accounting profession has not adopted a uniform format for the entire income statement.
Instead, it permits some flexibility, which enables the practicing accountant to structure an
income statement that best fit the circumstances of the reporting entity. Accountants traditionally
have presented the income statement in either a multiple step or a single step form.

Multiple-Step Form
A multiple-step income statement presents subtotals for gross margin and operating income
before showing net income. Net income is therefore derived in intermediate steps. In multiple-
step form (illustrated on the following pages for KENAKO Corporation), many details shown

Financial Accounting l Page 64

may be condensed or may be reported in footnotes or parenthetically. For example, the income
statement may begin with net sales if the accountant thinks that the revenue contra account
balances (sales returns and allowance and sales discounts) are immaterial. Moreover, the
accountant may report only the totals for cost of goods sold, selling expense, and general and
administrative expenses. The details may be presented separately in the footnotes.

As illustration 4.1(a) suggests, a multiple-step format calls for deducting cost of goods sold
from net sales to measure gross margin on sales (often called gross profit on sales). Gross
margin is an intermediate measure of profitability that indicates the difference between the
selling prices and costs of products sold during the accounting period.
To the extent possible, the operating expenses usually are divided into two categories: selling
expenses related to the sale of the company’s products; general and administrative expenses
related to the general operations of the business.
Income from operations (also called operating income) is a measurement of the company’s
profitability as a result of its primary business activities. Other revenues and other expenses are
related to the secondary activities of the company; these two sections often are combined.
Income before taxes and extraordinary item is an intermediate measure of income that would
simply be called “income before taxes” if KENAKO Corporation did not have an extraordinary
item. Income tax is the final expense deducted. The amount is determined by multiplying the
income before taxes and extraordinary item by the income tax rate, which we assumed is 40%.
Note that, income tax expense should always be shown separately, not combined with any
other expenses.
Income before extraordinary item indicates how profitable the company was without considering
the effects of extraordinary item. Because, as discussed in the preceding unit, extraordinary
items are unusual and nonrecurring, many financial statement users rely heavily on the income
before extraordinary item when they make predictions and evaluate management’s
performance.
Net income includes the effects of all revenues, expenses, gains and losses. The beneficiaries
of net income are both the preferred and common stockholders.
Earnings per share of common stock is widely used financial measurement that appears below
net income. Its beneficiaries are common stockholders. In the simplest case, an accountant
calculates earnings per share by dividing net income by the weighted average number of
common stock outstanding during the period. If KENAKO Corporation had preferred stock
outstanding we subtract preferred dividends from net income when calculating earnings per
share of common stock. Note that because KENAKO Corporation had an extraordinary item, it
reported three per share numbers:
i) Income before extraordinary item,
ii) Extraordinary gain (net of tax), and
iii) Net income.
Companies usually report these numbers separately to help users of financial statements make
better predictions and more meaningful evaluations of management’s performance.
Illustration 4.1 (a): Multiple Step Income Statement

KENAKO Corporation
Income Statement

Financial Accounting l Page 65

 For the Year Ended December 31, Year 3
Sales Revenue
Gross Sales Br. 2,005,000
Less: Sales Returns and Allowances 30,000
Sales Discounts 20,000
Net Sales Revenue 1,955,000
Cost of Goods Sold
Merchandise Inventories, January 1, Year 3 312,500
Plus: Gross Purchases 1,415,000
Freight Costs 80,000
Less: Purchases Returns and Allowances (17,500)
Purchases Discounts (12,500)
Total Merchandise Available for Sale 1,777,500
Less: Merchandise Inventory December 31, Year 3 (740,000)
Cost of Goods Sold 1,037,500
Gross Profit 917,500
Operating Expenses
Selling Expenses:
Sales Salaries Expenses 207,000
Advertising Expenses 47,500
Miscellaneous Selling Expenses 20,000
Depreciation Expenses on Store Equipments 15,000 289,500
General Administrative Expenses:
Office Salaries 90,000
Insurance Expenses 56,250
Uncollectible Accounts Expense 21,500
Depreciation expenses 55,000
Miscellaneous General Expenses 23,000 245,750
Total Operating Expenses 535,250
Income From Operations 382,250
Other Income
Plus: Gain on Sale of Short Term Investment 92,500
Rent Income 37,625
Other Expenses:
Less: Interest Expenses (45,625)
Loss on Sale of Equipment (6,750) 77,750
Income before taxes and extraordinary item 460,000
Less: Income tax expenses (40%) 184,000
Income before extraordinary item 276,000
Extraordinary Item-gain from expropriation of land less applicable income

Financial Accounting l Page 66

tax expense of Br. 16,000 24,000
Net Income Br. 300,000
Per share of common stock:
Income before extraordinary item (Br. 276,000  100,000 shares*) Br.2.76
Extraordinary gain (net of tax) (Br. 24,000  100,000 shares*) 0.24
Net Income (Br. 300,000  100,000 shares) Br. 3.00
*KENAKO Corporation has 100,000 shares of common stocks outstanding in the Year 3.
Single-Step Form
In the single step income statement, the accountant deducts total expenses from total revenues
to measure net income. No separate disclosure is made of gross margin or operating income.
Most companies that prepare single-step income statements deduct income tax as a separate,
final item. In illustration 4.1 (b), we present a somewhat condensed, single step income
statement. As you can see by comparing illustration 4.1 (a) and illustration 4.1 (b), extraordinary
items are reported in a special income statement category, regardless of the format used.
Moreover, the multiple-step and single-step formats always contain the same information after
“income before taxes and extraordinary item.” This can be shown on page 89.

Uses and Limitation of Income statement

As we mentioned, the income statement of a company is useful for evaluating management’s
performance, predicting the future income, and assessing the company’s creditworthiness.
However, the income statement has several limitations, as follows:
 Many of the expenses that are matched against revenues are based on an allocation of
historical cost (e.g. Depreciation expense) instead of “current value.” As a result, it is
argued that the net income does not adequately distinguish between a return of capital
and a return on capital.
 Many of the expenses (e.g. bad debts, depreciation and others) are based on estimates
that are subject to change and are less reliable.
Illustration 4.1 (b): Single Step Income Statement

KENAKO CORPORATION
Income Statement
For the Year Ended December 31, Year 3
Revenues:
Net Sales Revenue 1,955,000
Other Income 130,125
Total Revenues 2,085,125
Expenses:
Cost of Goods Sold 1,037,500
Selling Expenses 289,500
General Administrative Expenses 245,750
Other Expenses 77,750
Total Expenses 1,625,125
Income before taxes and extraordinary item 460,000

Financial Accounting l Page 67

 Less: Income tax expenses (40%) 184,000
Income before extraordinary item 276,000
Extraordinary Item-gain from expropriation of land less applicable income tax
expense of Br. 16,000 24,000
Net Income Br. 300,000
Per share of common stock:
Income before extraordinary item (Br. 276,000  100,000 shares) Br. 2.76
Extraordinary gain (net of tax) (Br. 24,000  100,000 shares) 0.24
Net Income (Br. 300,000  100,000 shares) Br. 3.00

 In some cases, companies may have too much leeway in selecting an accounting
method (e.g. FIFO, LIFO, or weighted average method for cost of goods sold), which
leads to a lack of comparability across companies.
 Adherence to rigid accounting rules (e.g. recognizing revenue at the point of sale,
expensing research and development costs when incurred) may lead to a distorted
picture of a company’s earnings activities.
 The use of different formats (e.g. single step Vs multiple step) by companies in the same
industry may hide differences in operating activities,
 The use of “functional” classifications (e.g. selling and administrative) for operating
expenses instead of “activity” classification (fixed, variable) may not provide sufficient
information for predicting future cash outflows.
To make it more useful, companies are urged by the authoritative bodies of accounting, FASB,
to disclose additional information in the notes or supplemental schedules to their financial
statements to help users in their decision making. We will discuss the additional disclosure to
financial statements at the end of this unit.
Activity 4.1.
11. What are the purposes and limitations of income statement?
12. Identify and discuss the two forms of income statement.

4.2. Statement of Retained Earnings

The statement of retained earnings describes the changes in a company’s retained earnings
during a period and relate the income statement to the balance sheet. The retained earnings
statement usually is fairly simple and may consist of four items:
i) The beginning balance of retained earnings,
ii) Net income or net loss for the period,
iii) Cash and/or stock dividends declared for the year and
iv) The ending balance of retained earnings.
Users of financial statements can analyze the statement to determine whether any prior period
adjustments exist and what relationship exists between a company’s net income and its
dividends. A statement of retained earnings for KENAKO Corporation is shown in illustration
4.2. Disclosure of cash dividends per share also is made in the statement of retained earnings.
In addition, the beginning balance of retained earnings may be restated as a result of either a
prior period adjustment or the effect on prior years’ net income resulting from certain types of
changes in accounting principles.

Financial Accounting l Page 68

Prior Period Adjustments
Unlike the extraordinary items described in the preceding unit, prior period adjustments are
excluded from the determination of net income and are reported net of the income tax effect, in
the statement of retained earnings. As per FASB definition, all items of profit and loss related to
the following shall be accounted for and reported as Prior period adjustments and excluded for
the determination of net income for the current period:
a) Correction of an error in the financial statements of a prior period and
b) Adjustments that result from realization of income tax benefits of pre-acquisition
operating loss carry forwards of purchased subsidiaries.
Material errors in the financial statements might include arithmetical mistakes, misuse or
omissions of information, mistakes in the application of accounting principles, and failure to
interpret properly the accounting aspects of transactions. A change from an accounting principle
that is not generally accepted to one that is generally accepted is also considered to be the
correction of an error.
In the financial statements for current accounting period, a prior period adjustment is reported
as a correction to the beginning retained earnings. When a correction of an error is made as a
prior period adjustment, the issuance of comparative financial statements requires the
restatement of prior periods’ financial statements to reflect the correction.
Illustration 4.2 (a): Statements of Retained Earnings
KENAKO CORPORATION
Statement of Retained Earnings
For the Year Ended December 31, Year 3
Retained Earnings, January 1, Year 3 228,000
Less: Effect of Correction of Depreciation Error from Year 2 (120,000)
Corrected Beginning Retained Earnings 108,000
Plus: Net Income 300,000
Less: Dividends (60,000)
Retained Earnings, December 31, Year 3 348,000

Alternative Forms of Statement of Retained Earnings

The basic format of a statement of retained earnings that includes a prior period adjustment is
shown in illustration 4.2 (a) above for KENAKO Corporation. As with other financial statements,
the statement of retained earnings generally is presented in comparative form showing data for
two or more years. Some companies combine the income statements with the statement of
retained earnings.

Financial Accounting l Page 69

Such a presentation has the advantage of displaying in one statement any prior period
adjustments and extraordinary items, thus reducing the possibility that any of these items will be
overlooked. One minor objection to this form is that the net income or net loss appears in the
middle of the statement. An example of combined statements of income and retained earnings
in comparative form for two years is shown in illustration 4.2 (b).
Illustration 4.2 (b): Combined Statement of Retained Earnings and Income Statement
KENAKO Corporation
Combined statement of Income and Retained Earnings
For the Year Ended December 31, Year 3
Net Sales Revenue 1,955,000
Cost of Goods Sold 1,037,500
Gross Profit 917,500
Operating Expenses
Selling Expenses: 187,500
General Administrative Expenses: 245,750
Total Operating Expenses 433,250
Income From Operations 484,250
Other Income
Plus: Gain on Sale of Short Term Investment 92,500
Rent Income 41,875
Other Expenses:
Less: Interest Expenses (45,625)
Loss on Sale of Equipment (6,750) 82,000
Income before Extraordinary items net of tax
Extraordinary Items
Less: Loss on Operation of Discontinued Business Segment (37,500)
Loss on Disposal of Discontinued Business Segment (20,000)
Cumulative Effect of change in Methods of Inventory Valuation (8,750) (66,250)
Income Before Income Taxes 500,000
Income Tax Expense (40%) 200,000
Net Income 300,000
Add: Retained Earnings, January 1, Year 3 228,000
Less: Effect of correction of Depreciation Error from Year 2 (120,000)
Dividends (60,000) (180,000)
Retained Earnings, December 31, Year 3 Br. 348,000

Sometimes a company also has changes in other accounts that comprise stockholders’ equity.
These changes occur as the company sells additional stock, buys and sells treasury stock, or
engages in other kinds of capital stock transactions. Such changes must be disclosed in a
separate statement, in the basic statements, or in the notes to the financial statements.
Changes in the number of shares outstanding should also be disclosed. Many companies report

Financial Accounting l Page 70

all of these changes in a separate statement of stockholders’ equity. This statement
combines the retained earnings statement with one that shows changes in all the other
components of stockholders’ equity. As a result, a company that reports a statement of
stockholders’ equity need not report a separate retained earnings statement. A statement of
stockholders’ equity is given in illustration 4.2 (c) below.
Illustration 4.2 (c): Statements of Stockholders’ Equity
KENAKO Corporation
Statement of Stockholders’ Equity
For the Year Ended December 31, Year 3
Additional
Common Preferred Paid in Retained
Stock Stock Capital Earnings Total
Balance January 1, Year 3 500,000 200,000 320,000 108,000 1,128,000
Issuance of Common Stock 180,000 20,000 200,000
Issuance of Preferred Stock 150,000 30,000 180,000
Net Income for the Year 300,000 300,000
Dividends Declared (60,000) (60,000)
Balance December 31, Year
3 680,000 350,000 370,000 348,000 1,748,000

Activity 4.2.
1. What is stock holders’ equity?
2. What are the items to be included in the statements of stock holders’ equity?

4.3. Balance Sheet

Dear students, from your studies of principles of accounting part I and II; would you remember
the use and limitation of balance sheet? What are the forms of balance sheet?
The balance sheet (sometimes called the statement of financial position) shows the financial
position of an enterprise at a particular point in time. Investors, creditors, and other users of
financial statements analyze an enterprise’s balance sheet to evaluate such factors as liquidity
(how close the assets are to cash realization), capital structure (what amount of assets has
been financed by creditors and what amount by owners), and financial flexibility (the ability of a
company to use its financial resources to adapt to change). Generally, companies that lack
sufficient liquidity and financial flexibility, perhaps because virtually all of their assets are far
removed from cash and a very large proportion of their capital structure consists of debt, are
less able than other companies to take advantage of attractive investment opportunities or to
absorb adverse in operating conditions.

A Classified Balance Sheet

In a classified balance sheet companies often group similar assets and similar liabilities
together as they have similar economic characteristics. The groupings help users to determine
(1) whether the company has enough assets to pay its debts and
(2) the claims of short-and long-term creditors on the company's total assets.
In a classified balance sheet, assets usually are presented in four groups;

Financial Accounting l Page 71

 1) Current assets
2) Long term investments
3) Plant and equipment and
4) Intangible assets.
Liabilities are classified into two categories:
1) Current liabilities and
2) Long term or noncurrent liabilities.
Equity are classified in to three categories:
1) Capital stock (common and/or preferred stock)
2) Additional paid in capital in excess of par and
3) Retained earnings.
This classification reflects the three elements of the basic accounting equation. In practice,
however, it is not unusual to get forth category between liabilities and stockholders’ equity with
the caption reserve or deferred credits to include the items such as deferred income tax credits
or unamortized investment tax credits.
In the following section, brief explanation will be given on each of the aforementioned items.
a) Assets
1) Current Assets
Assets that are expected to be converted to cash or used in the business within a short period
of time, usually one year. Examples of current assets include: cash, marketable securities,
receivables, inventories and prepaid expenses. On the balance sheet, current assets are listed
in order of liquidity.

2) Long-Term Investments
Assets that can be converted into cash, but whose conversion is not expected within one year.
These are assets not intended for use within the business. Examples are investments in stocks
and bonds of other corporations.

3) Property, Plant, and Equipment

Assets with relatively long useful lives and that used in the business. Examples include land,
buildings, machinery, delivery equipment, and furniture and fixtures.

4) Intangible Assets
These are also noncurrent assets which have no physical substance. Examples are patents,
copyrights, and trademarks or trade names.

b) Liabilities
1) Current Liabilities
Current liabilities are obligations that are supposed to be paid within the coming year. Common
examples are accounts payable, wages payable, bank loans payable, interest payable, taxes
payable, and current maturities of long-term bank loans payable, interest payable, and current
maturities of long-term obligations. Such type of obligations are expected to be paid from
current assets.
2) Long-Term Liabilities

Financial Accounting l Page 72

These are Obligations expected to be paid after one year. Their maturity date goes more than
one accounting period. Liabilities in this category include bonds payable, mortgages payable,
long-term notes payable, lease liabilities, and obligations under employee pension plans.

c) Stockholders' Equity
The owners’ equity in business enterprise is the residual interest in its assets after covering all
of its liabilities. The amount of owners’ equity, thus, is directly depends on the valuation
assigned to assets and liabilities. The presentation of stockholders’ equity in the balance sheet
of a corporation is influenced strongly by legal considerations because, a corporation is an
artificial person created by law. As a result, there are different ways of classifications that have
no particular accounting significance. These may include:

1) Invested Capital
a) Capital Stock
These are investments in the business by the stockholders through acquisition of either
common stock or preferred stock. The amount assigned to these shares of stock outstanding as
par or stated value is known as stated capital or legal capital of a corporation. This amount
usually appears in the balance sheet under the headings of preferred stock and common stock.
For each class of stock, the amount of par or stated value per share, the number of shares
authorized, issued, outstanding and in the treasury, and any dividend or liquidating preference is
disclosed in the balance sheet or in a note to the financial statements.

b) Additional paid in capital

This category includes all source of invested capital in express of par or stated value of shares.
The term paid in capital in excess of par and paid in capital in excess of stated value may be
used to designate amounts invested by stockholders that exceed the par or stated value of each
class of capital stock issued.
Sometimes corporations may receive less than par or stated value for its common stock at such
time a contra stockholders’ equity ledger account “Discount on common stock” appears in this
section of balance sheet. The cost of treasury stock is also a contra stockholders’ equity
account item. Contrary to any amount of capital in excess of par or stated value arising from the
issuance of common shares, the reissuance of treasury stock above cost, donation of assets to
the company (donated capital) or transfer from retained earnings through distribution of stock
dividends are those items that create a positive value to stockholders’ equity account.

2) Increase in stockholders’ equity through the retention of earnings

a) Retained earnings
These are earnings retained for use in the business. They constitute all net income balance of
past accounting periods that has not been distributed to the stockholders as dividends. The term
retained earnings is used far more widely than any other to describe this part of stockholders’
equity. Alternative terms are income retained for use in business and earnings reinvested in the
business. The term earned surplus, although still used by a few corporations, is obsolete. Its
use is discouraged because it is misleading.

b) Appropriated retained earnings

Financial Accounting l Page 73

A corporate board of directors sometimes may wish to indicate that a portion of retained
earnings has been appropriated. A formal segregation of retained earnings is a means of
disclosing that future dividend payments are restricted, either because of legal or contractual
agreements or by management intent. The use of appropriations of retained earnings as a
means of disclosure has almost disappeared; other more effective means of indicating the
restriction of retained earnings are available, principally the use of a note to the financial
statements.
3) Unrealized appreciation in value of plant assets; and unrealized loss in value of
long term investments.
In unusual cases, a business enterprise may report unrealized appropriation or decline in the
value of its assets in the balance sheet to disclose a material discrepancy between carrying
amount and current fair value. This procedure is an exception to the accounting principle that
only realized increases in asset values are entered in the accounting records. The offsetting
increase or decrease in owners’ equity is shown separately and designated as “unrealized
appraisal capital” (as an increase) or as “unrealized loss in value of long-term investments in
marketable equity securities” (as a decrease).

Use of Term “Reserve”

In the past, the term “reserve” was used by accountants in a number of different and
somewhat misleading ways. A reserve, in non-accounting usage, usually is thought of as
something held for a specific purpose, often for emergencies. This connotation leads to
misinterpretation when the word “reserve” is included in the title of an asset valuation or
estimated liability account. Currently, the trend is to avoid the use of the word “reserve,”
although some business enterprises continue to use it in the assets and liabilities sections of the
balance sheet.
The term ‘reserve,” when used to describe an appropriation of retained earnings, is acceptable,
although its use continues to decline. A reserve for Plant Expansion is more likely to be
misunderstood than Retained Earnings Appropriated for Plant Expansion. If used at all, the term
“reserve” should appear only in the stockholders’ equity section of the balance sheet. Because
its purpose is to indicate a restriction of retained earnings, the nature of the restriction may be
set forth more clearly in a note to the financial statements than by an appropriation of retained
earnings.

Standards of Disclosure
Accountants apply the disclosure principle as a basis for resolving a number of questions that
arise in the preparation of balance sheets.

Account Titles: In providing titles for ledger accounts, considerable leeway is permissible, in
deference to convenience and economy of space. The persons involved in the accounting
function understand the nature of the item; thus, short account titles are a matter of
convenience. However, in the preparation of financial statements, users of the information must
be kept in mind, and a clearly worded description of each item is desirable.

Financial Accounting l Page 74

Basis of valuation: informed users of financial statements are presumed to be familiar with the
general principles applicable to the valuation of assets and liabilities. However, variations in
accounting procedures often produce balance sheet amounts whose significance is difficult to
interpret unless the procedure used is disclosed.

Notes to the Financial Statements: explanatory comments and supplementary disclosure are
made in “Notes to financial statements.” The notes may cover many pages of an annual report
and include a complete description of significant accounting policies. For such matters as stock
option plans, pension plans, leases, and business combinations, the only reasonable way to
provide an adequate explanation is by use of notes.

Forms of Balance Sheet

Fairly standard ways of presenting balance sheet information have been developed though
there is no universal form of the balance sheet. The objectives are clearly and adequate
disclosure of all pertinent and material information; there are various ways of meeting these
objectives and experimentation is encouraged.
The arrangement of the major sections of the balance sheet also may vary. The three common
forms of the balance sheet are: the account form, the report form and the financial position
forms. Within the framework of these three forms, variations are possible.
Account Form- in this form of balance sheet, all assets are listed on the left hand side and all
liabilities and stockholders’ equity items are listed on the right hand side. This form includes the
typical accounts in each classification and follows the current standards of disclosure and
terminology. The appropriate degree of condensation depends on the needs of users.
Report Form – the report form of balance sheet lists liabilities and stockholders’ equity sections
immediately below the assets section. Consider the following Classified Balance Sheet
prepared by DEGITU Corporation in the Year 9as an example given on pages 99 and 100.
Financial Position Form –Both the account form and the report form of the balance sheet
express the basic accounting equation: Asset = Liabilities + Owners’ Equity. The financial
position form is a format emphasizing working capital of the firm. This form usually carries the
title statement of financial position instead of balance sheet. This is a vertical format in which
current liabilities are deducted from current assets to derive working capital. Other assets are
then added and other liabilities deducted to arrive at owners’ equity. This statement for DEGITU
Corporation is shown in illustration 4.3 (b) on pages 100 and 101.
Illustration4.3 (a): Report Form Balance Sheet

DEGITU Corporation
Balance Sheet
December 31, Year 9
Assets
Current assets:
Cash 90,000
Accounts receivable 225,000
Less: Allowance for uncollectible accounts (22,500) 202,500
Note receivable 67,500

Financial Accounting l Page 75

 Inventories 337,500
Prepaid expenses 33,750
Total current assets 731,250
Investments 56,250
Properly, Plant, Equipment
Land 135,000
Buildings 618,750
Less: accumulated depreciation-Buildings (202,500) 416,250
Machinery 562,500
Less: accumulated depreciation-Machinery (303,750) 258,750
Net property, plant, and equipment 810,000
Intangibles
Patent 56,250
Goodwill 45,000 101,250
Total assets 1,698,750

Liabilities and shareholders’ equity

Current liabilities:
Accounts payable 191,250
Salaries payable 45,000
Interest payable 11,250
Current maturities of long – term debt 11,250
Total current liabilities 258,750
Long – term liabilities
Note payable 101,250
Bonds payable 562,500
Total long – term liabilities 663,750
Total Liabilities 922,500
Shareholders’ Equity
Capital stock 450,000
Additional Paid in Capital 45,000
Retained earnings 281,250
Total shareholders’ equity 776,250
Total liabilities and shareholders’ equity 1,698,750

Illustration4.3 (b): Statement of Financial Position

DEGITU Corporation
Statement of Financial Position

Financial Accounting l Page 76

 December 31, Year 9
Current Assets:
Cash 90,000
Accounts receivable 225,000
Less: Allowance for uncollectible accounts (22,500) 202,500
Note receivable 67,500
Inventories 337,500
Prepaid expenses 33,750
Total current assets 731,250
Less: Current liabilities:
Accounts payable 191,250
Salaries payable 45,000
Interest payable 11,250
Current maturities of long – term debt 11,250
Total current liabilities 258,750
Working Capital 472,500
Add: Noncurrent Assets:
Investments 56,250
Land 135,000
Buildings 618,750
Less: accumulated depreciation-Buildings (202,500) 416,250
Machinery 562,500
Less: accumulated depreciation-Machinery (303,750) 258,750
Patent 56,250
Goodwill 45,000

Sub Total 1,440,000

Less: Noncurrent Liabilities:
Note payable (101,250)
Bonds payable (562,500)
Capital stock 450,000
Additional Paid in Capital 45,000
Retained earnings 281,250
Total shareholders’ equity 776,250

Uses and Limitations of Balance Sheet

At one time in the history of financial statements, the balance sheet was considered to be the
primary end product of accounting process. But, later it was discovered by users that earning
power is the primary determinant of the value of a business enterprise and users gradually
placed more emphasis on the income statement.

Financial Accounting l Page 77

These days, the balance sheet is recapturing the position in one hand; because users of
financial statements have come to realize that the income statement neither includes the
economic resources and the debt of the company nor measures the enterprise’s ability to raise
sufficient capital for continued growth.

Therefore, investors and creditors are placing more emphasis on the enterprise’s current and
quick ratios, debt to equity ratios, and return on assets and owners’ equity. After recent
experiences with credit crunches, business recessions, high levels of interest rates, and
inflation, enterprises are giving more attention to their balance sheet.
The profession of accountancy has also taken significant actions these days to make the
balance sheet more relevant and more meaningful for decision makers. These actions include
for example, movements towards disclosure of inflation, immediate expensing of research and
development costs, mandatory requirement of goodwill amortization and reporting of certain
long term leases as acquisition of plant assets.
In its comparative form, balance sheet can provide valuable information to creditors,
stockholders, management, investors, prospective investors and the public. Individuals with the
ability to interpret comparative balance sheets may learn much as to the short term solvency of
the business enterprises, favorable or unfavorable trends in liquidity, commitments that must be
met in the future, and relative positions of creditors and stockholders.

The major limitation of the balance sheet lies in the inability of accountants to measure the
current fair value of the enterprise’s net assets. In other situations, indirect valuation must be
used to measure the value of certain assets and liabilities.
Furthermore, it is impossible sometimes to identify and provide a valuation for many factors that
have material impact on the financial position of an enterprise. These may include for example,
the morale and commitment of the management of the business enterprise, the market share
and diversity of its operations. All these are subjective and intangible factors of great importance
in the evaluation of the business enterprise. But, none of these factors is reported in the dollars
and cents framework of the accounting process that leads to the balance sheet.
Activity 4.3.
1. Identify, and define each of the elements of classified balance sheet.
2. What are the uses and limitations of balance sheet?

4.4. Statement of Cash Flows

Dear students, have got a chance to read or discuss about statements of cash flows? What are
the importance of preparing statements of cash flows?

In addition to the income statement and the balance sheet, a statement of cash flows (SCF) is
an essential component within the set of basic financial statements. Specifically, when a
balance sheet and an income statement are presented, a statement of cash flows is required for
each income statement period. The purpose of the SCF is to provide information about the cash
receipts and cash disbursements of an enterprise that occurred during a period. Similar to the
income statement, it is a change statement, summarizing the transactions that caused cash to

Financial Accounting l Page 78

change during a reporting period. The term cash refers to cash plus cash equivalents as
discussed in unit six.

Classifying Cash Flows

As list of cash flows is more meaningful to investors and creditors if they can determine the type
of transaction that give rise to each cash flow. Toward this end, the statement of cash flows
classifies all transactions affecting cash into one of three categories:
1) Operating activities
2) Investing activities
3) Financing activities
In the following section we consider each of these activities.
1) Operating Activities

The inflows and outflows of cash that result from activities reported on the income statement
are classified as cash flows from operating activities. In other words, this classification of cash
flows includes the elements of net income reported on a cash basis rather than an accrual
basis.
Cash inflows include cash received from:
 Customers from the sale of goods or services.
 Interest and dividends from investments
These amounts may differ from sales and investment income reported on the income
statement. For example, sales revenue measured on the accrual basis reflects revenue
earned during the period, not necessarily the cash actually collected. Revenue will not equal
cash collected from customers if receivables from customers changed during the period.
Cash outflows include cash paid for:
 The purchase of inventory.
 Salaries, wages, and other operating expenses.
 Interest on debt.
 Income taxes.
Likewise, these amounts may differ from the corresponding accrual expenses reported on the
income statement. Expenses are reported when incurred, not necessarily when cash is ac-
tually paid for those expenses. Also, some revenues and expenses, like depreciation expense,
don’t affect cash at all and aren't reported on the statement of cash flows.
The difference between the inflows and outflows is called net cash flows from operating
activities. This is equivalent to net income if the income statement had been prepared on a
cash basis rather than an accrual basis

Direct and Indirect Methods of Reporting:

Two generally accepted formats can be used to report operating activities, the direct method
and the indirect method. Under the direct method, the cash effect of each operating activity is
reported directly on statement. For example, cash received from customers is reported as the
cash effect of sales activities. Income statement transactions that have no cash flow effect,
such as deprecation, are sample not reported.

The indirect method, on the other hand, arrives at net cash flow from operating activities

Financial Accounting l Page 79

indirectly by stating with reported net income and working backwards to convert that amount to
a cash basis. For example, depreciation expense would be added back to net income because;
this expense reduces net income but does not entail a cash disbursement. Also, adjustments
are necessary for changes in certain current assets and liabilities. For instance, if accounts
receivable increased during the period, credit sales revenue exceeded cash collected from
Customers. This increase in accounts receivable must be deducted from net income to arrive at
cash flow from operating activities. Both methods produce the same net cash flows from
operating activities; they are merely alternative approaches to reporting the cash flows.
However, either method is acceptable and both are used in practice.

2) Investing Activities
Cash flows from investing activities include inflows and outflows of cash related to the ac-
quisition and disposition of long-term assets used in the operations of the business (such as
property, plant, and equipment) and investment assets (except those classified as cash equiv-
alents). The purchase and sale of inventories are not considered investing activities. Inventories
are purchased for the purpose of being sold as part of the company's operations, so their
purchase and sale are included with operating activities rather than investing activities.
Cash outflow from investing activities include cash paid for;
 The purchase of long-term assets used in the business.
 The purchase of investment securities, like stocks and bonds of other entities (other than
those classified as cash equivalents).
 Loans to other entities.
Later, when the assets are disposed of, cash inflow from the sale of the assets (or collection of
loans and notes) also is reported as cash flows from investing activities. As a result, cash
inflows from these transactions are considered investing activities:
 The sale of long-term assets used in the business.
 The sale of investment securities (other than cash equivalents).
 The collection of a non-trade receivable (excluding the collection of interest, which is an
operating activity).
Net cash flows from investing activities represents the difference between the inflows and
outflows.
3) Financing activities

Financing activities relate to the external financing of company. Cash inflows occur when cash
is borrowed from creditors or invested by owners. Cash outflows occur when cash is paid back
to creditors or distributed to owners. The payment of interest to a creditor, however, is
classified as an operating activity.
Cash inflows include cash received from:
 Owners when shares are sold to them.
 Creditors when cash is borrowed through notes, loans, mortgages, and bonds.
Cash outflows include cash paid to:
 Owners in the form of dividends or other distributions.
 Owners for the reacquisition of shares previously sold.

Financial Accounting l Page 80

  Creditors as repayment of the principal amounts of debt (excluding trade payables that
relate to operating activities).
Net cash flows from financing activities is the difference between the inflows and outflows.
At first glance, it may appear inconsistent to classify the payment of cash dividends to
shareholders as a financing activity when, as stated earlier, paying interest to creditors is
classified as an operating activity. But remember, cash flows from operating activities should
reflect the cash effects of items that enter into the determination of net income. Interest expense
is a determinant of net income. A dividend, on the other hand, is a distribution of net income and
not an expense. Accordingly, the Statements of Financial Accounting Standards (SFAS) No. 95
designates cash outflows for interest payments and cash inflows from interest and dividends
received as operating cash flows. However, the International Accounting Standards (IAS) No. 7
allows companies to report cash outflows from interest payments as either an operating or
financing cash flows and cash inflows from interest and dividends as either an operating or
investing cash flows. On the other hand, the SFAS classifies dividends paid to shareholders as
financing cash flows while the international standard allows companies to report dividends paid
as either financing or operating cash flows.

Noncash Investing and Financing Activities

As we have just discussed, the statement of cash flows provides useful information about the in-
vesting and financing activities in which a company is engaged. Even though these primarily
result in cash inflows and cash outflows, there may be significant investing and financing
activities occurring during the period that do not involve cash flows at all. In order to provide
complete information about these activities, the SCF shows any significant noncash investing
and financing activities (that is, non-cash exchanges). An example is the acquisition of
equipment (an investing activity) by issuing either a long term note payable or equity securities
(a financing activity). These noncash activities are reported either in a separate schedule or in
an attached note.

Illustration 4.4: The following are summary transactions that occurred during Year 3 for the
DEGITU Corporation:

Customers Received from

Customers 577,500
Interest on note receivable 10,500
Sale of investments 17,500
Proceeds from note payable 87,500
Sale of equipment 35,000
Issuance of common stock 175,000
Cash paid for:
Purchase of investments (not cash equivalents) 87,500
Interest on note payable 15,750
Purchase of equipment 105,000

Financial Accounting l Page 81

 Operating expenses 385,000
Principal on note payable 131,250
Payment of dividends to shareholders 26,250

The balance of cash and cash equivalents is Birr 113,750 at the beginning of Year 9 and Birr
266,000 at the end of Year 9.
A statement of cash flows prepared for Year 9 for DEGITU Corporation using the direct method
for reporting operating activities can be presented below.
Illustration 4.4: Statement of Cash Flows (Direct Method)
DEGITU Corporation
Statement of Cash Flows
For the Year Ended December 31. Year 9
Cash Flows from Operating Activities
Collections from customers 577,500
Interest on note receivable 10,500
Interest on note payable 15,750
Payment of operating expenses (385,000)
Net cash inflows from operating activities 187,250
Cash Flows from Investing Activities
Purchase of investments (87,500)
Sale of investments 17,500
Purchase of equipment (105,000)
Sale of equipment 35,000
Net cash outflows from investing activities (140,000)
Cash Flows from Financing Activities
Proceeds from note payable 87,500
Payment of note payable (131,250)
Issuance of common stock 175,000
Payment of dividends (26,250)
Net cash inflows from financing activities 105,000
Net increase in cash 152,250
Cash and cash equivalents, January 1 113,750
Cash and cash equivalents, December 31 266,000

Activity 4.3.
1. What are the three sections of statements of cash flows?
2. What is the difference between net operating cash flows and the net
income?

4.1. Additional Disclosures to Financial Statements

Dear students, from your study in chapter three, about GAAP, can you explain the full disclosure
principles? Why do you think is important to have additional disclosure to financial statements?

Financial Accounting l Page 82

The usefulness of the balance sheet, as well as the other financial statements, is significantly
enhanced by financial statement disclosures. We now turn our attention to these disclosures.
Financial statements are included in the annual report a company mails/sends to its
shareholders. They are, though, only part of the information provided. Critical to understanding
the financial statements and to evaluating the firm's performance and financial health are
disclosure, notes and other information included in the annual report.

In a corporation, owners are far removed from their business and the business is managed by
professional executives who are employed by the stockholders. Management's major means
for communicating information to the stockholders consist of the annual report, quarterly
reports of earnings, and news releases of significant events and transactions.

Notes to Financial Statements

The disclosure principle requires that financial statements include all significant information
needed by users of financial statements. If the omission of certain information would cause the
financial statements to be misleading, disclosure of such information is essential. The financial
statements included in the annual reports to stockholders are accompanied by detailed notes to
the statements. But disclosure in notes is used to supplement the information in the body of the
financial statements, not to correct or justify an improper presentation in the statements.

Some examples of information often disclosed in notes to financial statements included in

annual reports of publicly owned companies include the following:
 A summary of significant accounting policies-information about the accounting
policies adopted by a reporting entity is essential for users of financial statements.
Included in this category are: basis of preparing consolidated financial statements;
methods of depreciation, amortization, and depletion; methods of inventory pricing;
methods of revenue recognition; and any changes in accounting principles during the
most recent accounting periods.
 Subsequent Events
When an event that has a material effect on the company’s financial position occurs after the
fiscal year-end but before the financial statements actually are issued, the event is disclosed in
a subsequent event disclosure note. Examples are an issuance of debt or equity securities, a
business combination, discontinued operations, an event that sheds light on the outcome of a
loss contingency, and an event having a significant effect on operations. Included also are,
major losses in the form of fire loss of plant, write off of receivables, etc.
 Noteworthy events and transactions
Some transactions and events occur only occasionally, but when they do occur are potentially
important to evaluating a company’s financial statements. In this category are errors and
irregularities, illegal acts, and related party transactions.
Errors and irregularities are somewhat related, their difference is errors are unintentional while
irregularities are intentional distortions of financial statements. Closely related to irregularities
are illegal acts such as bribes, kickbacks, illegal contributions to political candidates, and other
violations of the law. Sometimes a company will engage in transactions with owners,
management, families of owners or management, affiliated companies, and other parties that
can significantly influence or be influenced by the company. Borrowing or lending money at an

Financial Accounting l Page 83

interest rate that differs significantly from the market interest rate is an example of a transaction
that could result from a related-party involvement. Financial statement users are particularly
interested in more details about these transactions to assess the effect of any differences
between economic substance and legal form. When related-party transactions occur, disclosure
is required of the nature of the relationship, a description of the transaction, and any dollar
amounts involved.
 Litigation in which the company is a party, loss and gain contingencies, and unusual
commitments.
 The amounts of depreciation expenses and research and development costs.
 An analysis of the composition of income tax expense, including the reconciliation of the
company's effective income tax rate.
 Detailed description or summary of receivables, inventories, investments, plant assets,
intangible assets, borrowing arrangements with banks, long term debt, and
stockholders' equity.
The information included in notes to financial statements may be both numerous and complex.
With the growing complexity of business and the pressure of fall and complete disclosure,
management and independent accountants face a continuing challenge to provide sufficient
information in concise form in notes to financial statements.

Supplementary Information in Annual Reports

There are three special types of supplementary disclosures that are required in financial
statements:

1) Interim reports of earnings- interim financial information is generally issued quarterly

by publicly owned companies. These reports may include current data on financial
position, results of operations, and changes in financial position. However, interim
reports issued to stockholders seldom include full set of financial statements.

2) Segment reporting- many large and highly diversified business enterprises sell
products and services to distinct groups of customers in various geographic areas.
Disclosure of information relating to product lines, major customers, export sales, and
operations in foreign subsidiaries is required. In reporting supplementary information
relating to industry segments or lines of business, a business enterprise identifies the
products and services from which it derives revenue, combines the products and
services into meaningful industry segments, and identifies the reportable industry
segments. Reportable industry segments are those segments that are significant with
respect to the enterprise as a whole. To be considered significant and be reportable, an
industry segment generally must have 10% or more of the enterprise's total revenue,
operating income, or identifiable assets.

3) Prospective financial statements and forecasts- one of the objectives of financial

statements is to provide information useful for the predictive process. Virtually, every
large business enterprise prepares forecasts of future operations as a means of defining
goals and measuring performance. The problem is how to make such information
available to the public and yet avoid the danger of misleading investors. Forecasts of

Financial Accounting l Page 84

 financial operations are encouraged but not required by rule setting bodies from
business enterprise.

Model Exam Questions:

Part I: Discussion Questions
1. Identify the four basic financial statements discussed in this unit and explain their
importance.
2. What are the two forms of income statement presentation? What are their differences?
3. Which alternative forms of statement of retained earnings do you prefer? Why?
4. Identify and briefly describe the three categories of cash flows reported on the statement
of cash flows.
5. Do you think that the amount of cash reported on the balance sheet of a particular
company is exactly equal to the amount of ending cash balance reported on its
statement of cash flows? Why/ why not?

Part II: Fill in the Blank

1. Listed below are several transactions that typically result in either an increase or a
decrease in cash. Indicated by letter whether the cash effect of each transaction is
reported on a statement of cash flows as an operating (O), investing (I), or financing (F).
Transactions:
______ 1) Sale of common stock
______ 2) Sale of land
______ 3) Purchase of treasury stock
______ 4) Merchandise sales
______ 5) Issuance of a long-term note payable
______ 6) Purchase of merchandise
______ 7) Repayment of notes payable
______ 8) Employee salaries
______ 9) Sales of equipment at gain
______ 10) Issuance of bonds
______ 11) Acquisition of bonds of another corporation
______ 12) Payment of semiannual interest on bonds payable
______ 13) Payment of cash dividend
______ 14) Purchase of a building
______ 15) Collection of nontrade note receivable (principal amount)
______ 16) Loan to another firm
______ 17) Retirement of common stock
______ 18) Income taxes
______ 19) Issuance of short term note payable
______ 20) Sale of a copyright

2. Balance Sheet Classification

The following are the typical classifications used in a balance sheet:
A. Current assets C. Property, plant and equipment
B. Investments D. Intangible assets

Financial Accounting l Page 85

 E. Current liabilities G. Paid-in-capital
F. Long-term liabilities H. Retained earnings
Required: For each of the following Year 7 balance sheet items use the letters above to indicate
the appropriate classification category. If the item is a contra account (valuation account), place
a minus sign before the chosen latter.
______ 1) Accrued interest payable ______ 11) Machinery
______ 2) Franchise ______ 12) Land, in use
______ 3) Accumulated depreciation ______ 13) Unearned revenue
______ 4) Prepaid insurance, for year 9. ______ 14) Copyrights
______ 5) Bonds payable, due in 10 years ______ 15) Preferred stock
______ 6) Current maturities of long-term debt ______ 16) Land, held for speculation
______ 7) Note payable, due in three months ______ 17) Cash equivalents
______ 8) Long term receivables ______ 18) Wages payable
______ 9) Bonds sinking fund, will be used to ______ 19) Allowance for bad debts
retire bonds in 10 years ______ 20) Marketable securities.
______ 10) Supplies

Part III: Exercises

1. Income statement format
The following is a partial trail balance for OLJIRA Star Corporation as of December 31, year 7.

Account Title Debit Credit

Sales revenue 858,000
Interest revenue 19,500
Gain on sale of equipment 32,500
Cost of goods sold 468,000
Salaries expense 71,500
Depreciation expense 32,500
Interest expense 26,000
Rent expense 16,250
Loss from flood damage (event is both unusual and infrequent) 78,000
Income tax expense 65,000
100,000 shares of common stock were outstanding throughout year 7.
Required:
a) Prepare a single step income statement for year 7, including EPS discloser.
b) Prepare a multiple step income statement for year 7, including EPS discloser.

Answer Key:
Part II: 1. Fill in the blank spaces
4. F 8. F 12. I 16. F 20. F
5. I 9. O 13. F 17. I 21. O
6. F 10. F 14. I 18. I 22. O
7. O 11. O 15. F 19. I 23. I

Financial Accounting l Page 86

2. Balance Sheet Items
1. A 5. F 9. B 13. A 17. I
2. A 6. E 10. A 14. D 18. E
3. C 7. E 11. C 15. G 19. A
4. A 8. B 12. C 16. C 20. A
UNIT FIVE
CASH AND SHORT TERM INVESTMENTS
Unit Outline:
 Introduction
 Unit Objectives
6.1. Nature and Importance of Cash
6.2. Components and Management of Cash
6.3. Control of Cash
6.4. Controlling Cash Receipts and Cash Payments
6.4.1. Reconciliation of Bank Balance
6.4.1.1. Bank Balance and Depositor’s Balance Reconciled
to Correct Balance
6.4.1.2. Bank Balance Reconciled to Balance in Depositor’s
Records
6.4.2. Reconciliation of Cash Receipts and Cash Payments (Proof of
Cash)
6.4.3. Petty Cash Fund
6.5. Short Term Investments
6.5.1. Accounting for Marketable Securities
6.5.2. Balance Sheet Presentation of Cash and Short Term Investments

Unit Objectives
After successful completion of this unit, you should be able to:
 explain the components and management of cash
 explain controlling of cash receipts and cash payments
 illustrate how petty cash fund is used to control cash
 illustrate the reconciliation of bank balance and depositor’s balance to correct
Balance
 illustrate reconciliation of bank balance reconciled to balance in depositor’s
records
 illustrate reconciliation of cash receipts and cash payments (proof of cash)
 describe accounting for short term investments
 illustrate accounting for commercial paper and treasury bills
 elaborate price fluctuations and valuation of short term investments
 illustrate balance sheet presentation of cash and short term investments

Introduction
Cash is a medium of exchange that a bank will accept for deposit and immediate credit
to the depositor’s account. Cashes the most liquid asset every business owns and uses.

87
Most firms devote considerable effort to the management and control of cash. Because
a firm’s creditors expect payment in cash, a sufficient amount of cash must always be
available to meet obligations as they become due. This necessitates careful scheduling
of cash inflows and outflows.
Although an adequate cash balance is essential, excessive holdings of cash should be
avoided. Cash deposited in checking accounts (or even savings accounts) usually does
not earn much interest, if any. Cash amounts over and above those needed to meet
obligations due in the near future should be invested in assets earning higher returns.
The liquidity of cash also makes it easily pilfered. Firms must institute internal control
procedures so that cash is properly accounted for and safeguarded. Failure to do so
may tempt employees to misappropriate the firm’s cash and may also result in various
accounting errors.

6.1. Nature and Importance of Cash

Definition:
Cash exists both in physical and book entry forms: physical in the form of coin and paper
currency as well as other negotiable instruments of various kinds, and book entry in
various forms such as checking account deposits and savings deposits. In addition to
coin and paper currency, other kinds of physical cash instruments that are commonly
reported as cash for financial accounting purposes include certificates of deposit, bank
checks, demand bills of exchange (in some cases), travelers’ checks, post office or
other money orders, bank drafts, cashiers’ checks, and letters of credit.
All these forms of cash involve credit and depend for their ready acceptance on the
integrity and liquidity of some person or institution other than those offering or accepting
them as cash.
This is true even for coin and paper currency which is, ultimately, dependent on the
credit of the government issuing it. Given this integrity and liquidity, the book entry forms
and other physical instruments are properly viewed as cash because of their immediate
convertibility into cash in its currency form at the will of the holder. Convertibility in the
case of savings accounts, certificates of deposit, and other time deposits may be
something less than immediate depending on stipulated conditions imposed by the
depository, but the assurance of such convertibility makes these items a generally
accepted form of cash.
Cash is both the beginning and the end of the operating cycle (cash–inventory–sales–
receivables–cash) in the typical business enterprise; and almost all transactions affect
cash either directly or indirectly. Cash transactions are probably the most frequently
recurring type entered into by a business because (except for barter transactions) every
sale leads to a cash receipt and every expense to a cash disbursement. It is recognized
as the most liquid of the assets, and thus has prominence for users who are focusing on
issues of liquidity.
Cash derives its primary importance from its dual role as a medium of exchange and a
unit of measure. As a medium of exchange, it has a part in the majority of transactions
entered into by an enterprise. Assets are acquired and realized, and liabilities are

88
incurred and liquidated, in terms of cash. Thus, cash is generally the most active asset
possessed by a company. As a unit of measure, it sets the terms on which all properties
and claims against the enterprise are stated in its financial statements.

6.2. Components and Management of Cash

Dear students! What are the components of cash in accounting? List them and give brief
definition of each before start studying this section.

Cash is composed of funds that are readily available. This includes cash on hand and
cash on deposit in bank accounts that do not restrict the withdrawal of cash. Deposits in
checking accounts would qualify because those balances can be withdrawn on demand.
Because banks rarely enforce restrictions on withdrawals from savings accounts, they
are usually classified as cash. Also classified as cash are money market funds
permitting withdrawal by check, checks from customers awaiting deposit, and foreign
currency (converted to dollars).Items not classified as cash include certificates of
deposit, stamps, and postdated checks.
Large corporations may have hundreds of checking accounts. Multiple accounts are
needed because firms have numerous physical locations and each location makes
expenditures. Firms also find it convenient to use separate accounts for specific
purposes. Many firms use one or more checking accounts solely for payroll purposes, for
example.
All checking accounts are condensed into one cash item on the balance sheet. Many
firms keep petty cash funds on hand to pay for small, incidental expenditures, such as
cab fare or delivery charges. These funds are included in the cash amount on the
balance sheet. Many retailers also keep change funds. These funds enable cashiers to
make change for their customers. Change funds are also included in the cash item on
the balance sheet.
As part of borrowing agreements with banks, firms sometimes agree to maintain
compensating balances. These are minimum amounts the firm agrees to keep on
deposit at the lending bank in accounts that pay little or no interest. As a result, the bank
is able to use these funds interest free. This provides the bank with additional
compensation for lending funds to the firm. Compensating balances are usually included
in the balance sheet cash amount and are disclosed in the notes to the financial
statements.

6.3. Control of Cash

Dear students! In the previous section we have said that it is easy to misuse cash from
its very nature. So what do you think are the possible means of controlling cash?
As previously mentioned, because cash is so liquid and easily diverted, special care
must be exercised to ensure that it is properly recorded and safeguarded. Most
corporations follow several sound management practices that enhance their control over

89
cash. Employees who are permitted access to cash, for example, should not also have
access to the accounting records for cash. Access to both cash and the accounting
records might enable an employee to misappropriate cash and to conceal the theft by
altering the records.
For example, retail clerks (who have ready access to cash) should not “read” the cash
register. That is, they should not have the responsibility of ascertaining the daily sales
total from the register’s internal record and recording this amount in the accounting
records.
Checking accounts with banks provide firms with several cash control advantages. First,
cash receipts can be deposited daily. Limiting the amount of time that cash is on the
firm’s premises reduces the possibility that it will be misappropriated. Second, checks
provide a written record of a firm’s disbursements. Such a record would not necessarily
exist if disbursements were made in currency. Moreover, most firms require that checks
be supported by underlying documentation such as purchase orders, invoices, and
receiving reports. This helps ensure that only valid expenditures are made and provides
the basis for an analysis of costs and expenses.
Third, by limiting the number of people authorized to sign checks, firms restrict access to
cash and reduce the possibility that cash will be used for unintended purposes.
Finally, bank statements provide a monthly listing of deposits and withdrawals. So, not
only the firm keeps track of its cash flows, but also the bank does. Thus, the bank
statement can be used to verify the firm’s cash records.
This verification process is accomplished via bank reconciliation, which is a detailed
comparison of the firm’s records and the bank statement. Because the bank
reconciliation may uncover errors related to cash, it should be prepared by an employee
who has no other cash-related responsibilities. The preparation of bank reconciliation is
illustrated in the following section of this unit.
6.4. Controlling Cash Receipts and Cash Payments

Cash control -- Systems and procedures should be adopted to safeguard an

organization's funds. Internal control for cash is based on the general control features
which include; access to cash should be limited to a few authorized personnel,
incompatible duties should be separated, and accountability features (like renumbered
checks, etc.) should be developed.
 The control of receipts from cash sales should begin at the point of sale and continue
through to deposit at the bank. Specifically, cash registers (or other point-of-sale
terminals) should be used, actual cash on hand at the end of the day should be
compared to register tapes, and daily bank deposits should be made. Any cash
shortages or excesses should be identified and recorded in a Cash Short & Over
account.
 Control of receipts from customers on account begins when payments are received
(in the mail or otherwise). The person opening the mail should prepare a listing of
checks received and forward the list to the accounting department. The checks are
forwarded to a cashier who prepares a daily bank deposit. The accounting
department enters the information from the listing of checks into the accounting

90
 records and compares the listing to a copy of the deposit slip prepared by the
cashier.
 The controls over cash disbursements include procedures that allow only authorized
payments for actual expenditures and maintenance of proper separation of duties.
Control features include requiring that significant disbursements be made by check,
performance of periodic bank reconciliations, proper utilization of petty cash systems,
and verification of supporting documentation before disbursing funds.

The bank reconciliation and petty cash systems referred to above have specific
accounting implications to consider, and are the subject of the following sections of this
unit.

6.4.1. Bank Reconciliation

Dear students! What is bank reconciliation? How and why companies reconcile their
cash account balance to balance as per bank statement? What are the methods of bank
reconciliation?
6.4.1.1. Bank Balance and Depositor’s Balance Reconciled to Correct
Balance

One of the most common cash control procedures, and one which you may already be
performing on your own checking account, is the bank reconciliation. In business, every
bank statement should be promptly reconciled by a person not otherwise involved in the
cash receipts and disbursements functions. The reconciliation is needed to identify
errors, irregularities, and adjustments for the Cash account. Having an independent
person prepare the reconciliation helps establish separation of duties and deters fraud
by requiring collusion for unauthorized actions.

There are many different formats for the reconciliation process, but they all accomplish
the same objective. The reconciliation compares the amount of cash shown on the
monthly bank statement (the document received from a bank which summarizes
deposits and other credits, and checks and other debits) with the amount of cash
reported in the general ledger. These two balances will frequently differ. Differences
are caused by items reflected on company records but not yet recorded by the bank;
examples include deposits in transit (a receipt entered on company records but not
processed by the bank) and outstanding checks (checks written which have not cleared
the bank). Other differences relate to items noted on the bank statement but not
recorded by the company; examples include nonsufficient funds (NSF) checks ("hot"
checks previously deposited but which have been returned for nonpayment), bank
service charges, notes receivable (will be discussed somewhat in detail in the next unit)
collected by the bank on behalf of a company, and interest earnings.

The following format is typical of one used in the reconciliation process. Note that the
balance per the bank statement is reconciled to the "correct" amount of cash; likewise,
the balance per company records is reconciled to the "correct" amount. These amounts

91
must agree. Once the correct adjusted cash balance is satisfactorily calculated, journal
entries must be prepared for all items identified in the reconciliation of the ending
balance per company records to the correct cash balance. These entries serve to
record the transactions and events which impact cash but have not been previously
journalized (e.g., NSF checks, bank service charges, interest income, and so on).
In this section, we will reconcile both the bank statement balance and the book balance
to the corrected cash balance.
Note That:
 Both sections end with the correct cash balance, which is the amount that should
be reported on the balance sheet.
 Every reconciling item that appears in the "balance per books" section requires
an adjusting entry to bring the books to the correct cash balance.
Balance per Bank Statement Br. XXX
Add: Deposits recorded by business but not by bank XXX
(Example: Deposits in transit)
Bank Errors, if any XXX
Deduct: Charges recorded by business but not by bank (XXX)
(Example: Outstanding checks)
Bank Errors, if any (XXX)
Corrected balance Br. XXX
Balance per Books (Cash account in the General Ledger) Br. XXX
Add: Deposits recorded by bank but not by business XXX
(Example: Note collection)
Book Errors, if any XXX
Deduct: Charges recorded by bank but not by business (XXX)
(Examples: Service charges, NSF checks)
Book Errors, if any (XXX)
Corrected balance Br. XXX

Deposit In transit (Outstanding Deposit) these are additions to cash in the bank the
depositor has recorded but that do not appear on the bank statement. For example, on
the last day of the month, the depositor may place the day’s cash receipts in the bank’s
night depository for the bank to record on the next business day. These receipts should
appear on the next month’s bank statement.
Outstanding checks: checks that the depositor has issued and recorded but have not
yet cleared the bank will be deducted on the bank statement.
Bank collections: Promissory notes are often made payable at the payee’s bank. The
bank may therefore collect a note for the depositor and credit the proceeds to the
depositor’s account. Such collections made near the end of a month and appear on the
bank statement but not on the depositor’s books because the depositor is not yet aware
of the collection.
Bank charges: The bank often makes various charges that are not yet recorded on the
depositor’s books, such as charges for bank services, checkbooks, NSF checks, and
repayment of depositor loans.

92
Bank Errors: Occasionally, a bank error might affect the depositor’s account. For
example, the bank might erroneously charge one company’s check to another
company’s account. The depositor should instruct the bank to correct such errors.
Depositor errors: Sometimes an error is made in the depositor’s accounting records
(commonly called a book error). For example, the depositor may have written a check for
one amount but recorded it at a different amount. The depositor should promptly correct
their accounting records.
Illustration 6.1: The December bank statement of DESSE COMPANY indicates a
balance on December 31 of Br. 15,907.45. On that date, the balance of cash per book is
Br. 11,589.45. From the foregoing steps, the following reconciling items are determined:
Facts:
1) Deposit in transit: November deposits (received by bank on December 31)
Br. 2,201.40
2) Outstanding checks: Check # 835, Br. 3,000.00;
Check # 843, Br. 1,401.30;
Check # 860, Br. 1,502.70
3) Errors: Check No. 828 was correctly written by DESSE Company for Br. 1,226.00
and was correctly paid by the bank to the creditor; but recorded for Br. 1,262.00 by
DESSE Company.
4) Bank memoranda:
- Debit-NSF check from IYETI for Br. 425.60
- Debit- Printing company checks charge, Br. 30
- Credit- Collection of notes receivable for Br. 1,000 interest earned Br. 50, less
bank collection fee Br. 15.
Required: Prepare the bank reconciliation for DESSE Company for the month of
December 31, Year 3.
The bank reconciliation for December is determined by reference to the above bank
statement and other data. You must carefully study all of the above data to identify
deposits in transit, outstanding checks, and so forth. Below is the reconciliation of the
balance per bank statement to the adjusted cash balance. You should try to identify
each item in this reconciliation within the previously presented data.
DESSE COMPANY
BANK RECONCILIATION
For the Month Ended December 31, Year 3
Cash balance per bank statement 15,907.45
Add: Deposits in Transit 2,201.40
Less: Outstanding Checks:
Check # 835 3,000.00
Check # 843 1,401.30
Check # 860 1,502.70 (5,904.00)
Adjusted Cash Balance per Bank 12,204.85
Cash Balance Per Books 11,589.45
Add: Collection of note receivable for Br.
1,000 plus interest earned Br. 50,

93
 less collection fee Br. 15 1,035.00
Error in recording check No. 828 36.00 1,071.00
Less: Bank service charge 30.00
NSF Check 425.60 455.60
Adjusted Cash Balance per Books 12,204.85

Entries from Bank Reconciliation:

Note that each reconciling item used in determining adjusted cash balance per book
should be recorded by the depositor. If these items are not journalized and posted, the
cash account will not show the correct balance. Depending on the above reconciling
items, we can pass the following four necessary journal entries:

1) To record collection of note receivable by bank

December Cash 1,035

31, Year 3 Miscellaneous 15
expense
Notes 1,000
receivables
Interest Revenue 50

2) To correct error in recording check No. 828

December 31, Cash 36

Year 3 Accounts Payable 36

3) To record NSF checks

December 31, Accounts Receivables-W/ro IYETI 425.60

Year 3 Cash 425.60

4) To record charge for printing company checks

December 31, Miscellaneous Expense 30

Year 3 Cash 30

Even this fairly simple bank reconciliation demonstrates the pressing need for monthly
reconciliations. Without reconciliation, company records would soon become unreliable
as the process draws attention to various needed adjustments.

Note that the amount of cash to be shown on the balance sheet at the end of each year
should be the adjusted figure after adding and deducting the aforementioned data as the
case may be.

94
 6.4.1.2. Bank Balance Reconciled to Balance in Depositor’s Records
The second type of bank reconciliation takes the balance per bank statement to the
balance per depositor’s records and is a format favored by practicing accountants. In this
format, it is assumed that the depositor’s actions are correct and the bank will act in
accordance with the depositor. If after treating all reconciling items according to the
depositor, the bank may arrive at the depositor’s balance, then the cash accounts are
said to be reconciled.
If the balance per bank statement cannot be taken to the depositor’s balance in the
above manner, that is an indication of some sort of misappropriation and it must be
discovered.

Illustration 6.2: prepare the bank reconciliation for DESSE COMPANY as of December
31, year 3 (using the above data).

DESSE COMPANY
BANK RECONCILIATION
For the Month Ended December 31, Year 3
Cash balance per bank statement 15,907.45
Add: Deposits in Transit 2,201.40
Less: Outstanding Checks:
Check # 835 3,000.00
Check # 843 1,401.30
Check # 860 1,502.70 (5,904.00)
Collection of note receivable for
Br. 1,000 plus interest earned Br.
50, less collection fee Br. 15 1,035.00
Error in recording check No. 443 36.00 (1,071.00)
Add: Bank service charge 30.00
NSF Check 425.60 455.60 (4,318.00)
Cash Balance per Books 11,589.45
6.4.2. Reconciliation of Cash Receipts and Cash Payments (Proof of Cash)

Many businesses prepare a reconciliation just like that above. But, you should note that
it leaves one gaping hole in the control process. What if you learned that the bank
statement included a Br.100,000 check to an employee near the beginning of the month,
and a Br. 100,000 deposit by that employee near the end of the month (and these
amounts were not recorded on the company records)? In other words, the employee
took out an unauthorized "loan" for a while. The reconciliation would not reveal this
unauthorized activity because the ending balances are correct and in agreement. To
overcome this deficiency, some companies will reconcile not only the beginning and
ending balances, but also the total checks per the bank statement to the total
disbursements per the company records, and the total deposits per the bank statement
to the total receipts on the company accounts. If a problem exists, the totals on the bank
statement will exceed the totals per the company records for both receipts and

95
disbursements. This added reconciliation technique is termed a proof of cash. It is
highly recommended where the volume of transactions and amount of money involved is
very large. Such unauthorized "borrowing" not only steals company interest income, but
it also presents a risk of loss if the company funds are not replaced. Make no mistake,
such schemes are highly illegal!

Auditors frequently prepare an expanded version of the bank reconciliation known as

proof of cash or four column bank reconciliation. A proof of cash is more comprehensive
because it includes the following four reconciliations on one statement:

1) A reconciliation of the bank statement and book balances of cash at the end of
the previous month.
2) A reconciliation of the cash receipts (deposits) shown on the bank statement with
those shown on the books for the current month.
3) A reconciliation of the cash payments shown on the bank statement with those
shown on the books for the current month.
4) A reconciliation of the bank statement and book balances of cash at the end of
the current month.

The proof of cash method is a more comprehensive bank reconciliation often used by
auditors as one test of the internal control system for cash. It is particularly appropriate
when internal control over cash is weak.
Note the following steps will help you to prepare proof of cash.
1. Show the previous periods balance or opening balance as per bank statement
in the first column and receipts as per bank statement in the second column,
payment as per bank statement in the third column and closing balance at the
end of the period as per bank statement in the fourth column and tally them (i.e.,
check whether beginning cash balance plus cash receipts minus cash payments
is equal to the closing cash balance).
2. Prepare the bank reconciliation statement for the beginning of the period to arrive
at correct balance in the first column.
3. Prepare the bank reconciliation statement for the end of the current period to
arrive at the correct balance in the fourth column.
4. Then each reconciling item in both the reconciliation statement are taken
individually and then adjusted to total receipts and payment column for the
current year.
5. See the correct balance column also tally.
Repeat the same procedure for reconciling the balance as per cash book.

Illustration 6.3: Proof of Cash

The following information pertains to the cash of SIFEN COMPANY at the end of March
and April of Year 4:

96
 March 31 April 30
1) Cash per bank statement Br. 2,738 Br. 2,696
Cash per depositor’s record 2,578 2,500
Outstanding checks 863 1,015
Deposit Intransit 685 1,245
2) During the month of April the following activities were made:
Deposit shown on the bank statement was Br. 5,588
Charges shown on bank statement was Br. 5,630
Cash receipts shown on company’s books were Br. 5,398
Cash payments shown on company’s books were Br. 5,476
3) The bank service charge was Br. 18 in March (recorded by the company during
April) and Br. 24 in April (not yet recorded by the company).
4) Included with the April bank statement was a check for Br. 500 that had been
received on April 27 from a customer on account. The returned check, marked NSF
by the bank, has not yet been recorded on the company’s books.
5) During April the bank collected Br. 750 of bond interest for SIFEN COMPANY and
credited the proceeds to the company’s account. The company earned the interest
during the current accounting period but has not yet recorded it.
6) During April the company issued a check for Br. 696 for equipment. The check,
which cleared the bank during April, was incorrectly recorded by the company for
Br. 896.
Required: Prepare a proof of cash for April.
Solution:
The proof of cash for SIFEN Company on April 30, Year 4, is explained below:
1) Reconciliation of cash receipts in bank statement and in depositor’s
records
The Br. 685 deposit in transit on March 31 is deducted from deposits recorded by the
bank in April because it was a receipt of cash in March. The Br. 1,245 deposit in transit
on April is a receipt of cash in April and should be included in total cash receipts for
April. The Br. 750 proceeds of the note and interest collected by the bank must be
deducted from the deposits recorded by the bank because the proceeds had not been
entered in the accounting records (before adjustment) on April 30, Year 4.

2) Reconciliation of cash payments in bank statement and in depositor’s

records
The outstanding checks of Br. 863 on March 31 are included in the bank debits for April.
These do not represent cash payments during April but rather were shown properly as
cash payments in March. The outstanding checks of Br. 1.015 on April 30 did not include
any checks that were outstanding on March 31; therefore, this total is properly classified
as a cash payment by SIFEN Company during April.

Solution: Proof of Cash

SIFEN COMPANY
Proof of Cash

97
 For April Year 4
March April April April 30

Balance Receipts Payments Balance

Balance per Bank Statement 2,738 5,588 5,630 2,696
Deposit In transit:
March 31 + 685 - 685
April 30 + 1,245 + 1,245
Outstanding Checks:
March 31 - 863 - 863
April 30 + 1,015 - 1,015
Other Reconciling Items:
Bank Service Charges:
March 31 +18 +18
April 30 -24 +24
NSF Checks -500 +500
Collection by Banks -750 -750
Error by Depositor +200 - 200
Unadjusted balance per Book 2,578 5,398 5,476 2,500
Add: Adjustment to cash Account 426
Adjusted Cash Balance 2,926

The bank service charges of Br. 18 for the month of March should be added to the
payment as per the bank to determine the cash payment as per book; because the
depositor did not aware of the service charges until the bank statement is mailed to them
but in the bank side it was treated as payment of March. The service charge of Br. 24
and the NSF check of Br. 500 were included in the bank’s debits for April but not in the
accounting records (unadjusted). The depositor recorded check for Br. 696 erroneously
as Br. 896 during the month of April (i.e., over stating the cash payment by Br. 200);
therefore, the overstating figure should be added to cash payment per bank to arrive at
cash payments per depositor’s record.

Reconciliation of cash per bank statement and depositor cash balances

The last column of the reconciliation is identical to the reconciliation of the bank and
depositor balances to the correct cash balance illustrated for DESSE Company
(illustration 6.2). The journal entry required to adjust the accounting records of SIFEN
Company on April 30, Year 4, is the same as that illustrated for DESSE Company. The
following is entries are recorded, assuming April 30 as the end of fiscal year for SIFEN
Company.
Cash 426*

Account Receivables 500

98
 Miscellaneous Expense 24

Notes 750
Receivables
Equipment 200

To record adjusting entries related to bank reconciliation

*= 750  200   500  24   Br.426= reconciling figure

6.4.3. Petty Cash Fund

Pretest
Dear students! Why organizations establish a petty cash fund? How does this
fund contribute towards the control of cash account? Do you think that having
a petty cash is important for a particular company? Why or why not? Please
take a rough paper and try these questions before proceeding to the following
discussion.

PETTY CASH: Petty cash, also known as impress cash, is a fund established for
making small payments that are impractical to pay by check. Examples include postage
due, reimbursement to employees for small purchases of office supplies, and numerous
similar items.

The operation of petty cash involves three steps:

1. Establishing the Fund

The establishment of a petty cash system involves two major steps which begins by
making out a check to cash, cashing it, and placing the cash in a petty cash box and a
petty cash custodian (also called petty cash cashier) should be designated to have
responsibility for safeguarding and making payments from this fund.
At the time the fund is established, the following journal entry is needed. This journal
entry, in essence, subdivides the petty cash portion of available funds into a separate
account.
Petty Cash XXX
Cash in bank XXX
To establish a petty cash fund

2. Making Payments from the Fund

Policies should be established regarding appropriate expenditures (type and amount)
that can be paid from petty cash. The custodian of the petty cash fund has the authority
to make payments from the fund that conforms to prescribed management policies.
When a disbursement is made from the fund by the custodian, a receipt should always
be placed in the petty cash box. The receipt should clearly set forth the amount and

99
nature of expenditure. The receipts are sometimes known as petty cash vouchers.
Therefore, at any point in time, the receipts plus the remaining cash should equal the
balance of the petty cash fund (i.e., the amount of cash originally placed in the fund and
recorded by the entry above). No accounting entry is made to record a payment at the
time it is taken from petty cash. Instead, the account effects of each payment are
recognized when the fund is replenished.

3. Replenishing the Fund

As expenditures occur, cash in the box will be depleted. Eventually the fund will require
replenishment back to its original level. To replenish the fund, a check for cash is
prepared in an amount to bring the fund back up to the desired balance. The individual
prepares a schedule (or summary) of the payments that have been made and sends the
schedule, supported by petty cash receipts and other documentation, to the treasurer’s
office who then approves the request and a check is prepared to restore the fund to its
established amount. The check is cashed and the proceeds are placed in the petty cash
box. At the same time, receipts are removed from the petty cash box are formally
recorded as expenses.

The journal entry for this action involves debits to appropriate expense accounts as
represented by the receipts, and a credit to Cash for the amount of the replenishment.
Notice that the Petty Cash account is not impacted -- it was originally established as a
base amount and its balance has not been changed by virtue of this activity.

Illustration 6.4: Assume that TITIKO COMPANY has established petty cash fund of Br.
500 on September 30, year 3, and place it in the custody of the main secretary.

Required: Pass the journal entry to establish the petty cash fund.

September 30, Petty Cash 500

Cash 500
Year 3 (To establish petty cash fund)

Assume that as of October 16, year 3, the balance of cash in the fund become below the
minimum threshold of Br. 50. And the followings are expense items paid form the fund:

Supplies expense 163

Fuel expense 136
Postage expense 85
Miscellaneous expenses 68
Required: Record entry to replenish the petty cash to its original balance.

Supplies Expense 163

100
 October 16, Fuel Expense 136
Year 3 Postage Expense 85
Miscellaneous Expense 68
Cash in Bank 452
To replenish petty cash; receipts on hand of Br. 452 -- office supplies (Br. 163),
gasoline (Br. 136), postage (Br. 85), coffee and drinks (Br.68). Remaining cash
in the fund was Br. 48, bringing the total to Br. 500 (Br.452 + Br. 48).

Cash Short and Over

Occasionally, errors will occur, and the petty cash fund will be out of balance. In other
words, the sum of the cash and receipts differs from the correct Petty Cash balance.
This might be the result of simple mistakes, such as mathematical errors in making
change, or perhaps someone failed to provide a receipt for an appropriate expenditure.
Whatever the cause, the available cash must be brought back to the appropriate level.
The journal entry to record full replenishment may require an additional debit (for
shortages) or credit (for overages) to Cash Short (Over). In the following entry, Br. 455
is placed back into the fund, even though receipts amount to only Br. 452. The
difference is debited to Cash Short and over:
Supplies Expense 163
October 16, Fuel Expense 136
Year 3
Postage Expense 85
Miscellaneous Expense 68
Cash Short and Over 3
Cash in Bank 455
To replenish petty cash; receipts on hand of Br. 452 -- office supplies (Br. 163),
gasoline (Br. 136), postage (Br. 85), coffee and drinks (Br.68). Remaining cash in
the fund was Br. 45, bringing the total to Br.497 (Br.452 + Br. 45; a Br. 3 shortage is
noted and replenished).

The Cash Short (Over) account is an income statement type account. It is also
applicable to situations other than petty cash. For example, a retailer will compare daily
cash sales to the actual cash found in the cash register drawers. If a surplus or shortage
is discovered, the difference will be recorded in Cash Short (Over); a debit balance
indicates a shortage (expense), while a credit represents an overage (revenue). As a
means of enforcing accountability, some companies may pressure employees to
reimburse cash shortages.

Increasing or Decreasing the Base Fund

As a company grows, it may find a need to increase the base size of its petty cash fund.
The entry to increase the fund would be identical to the first entry illustrated above; that
is, the amount added to the base amount of the fund would be debited to Petty Cash and

101
credited to Cash. The opposite is true if the fund base balance is decreased from the
original balance. Otherwise, take note that the only entry to the Petty Cash account
occurred when the fund was established -- subsequent reimbursements of the fund did
not change the Petty Cash account balance.

6.5. Short Term Investments

Pretest
Dear students, this section describes the motivation for investments, the
accounting for short term investments, the price fluctuations and valuation of
short term investments and balance sheet presentation of cash and short term
investments. But before reading the following section, why, do you think,
peoples are making an investment?

Motivation for Investments

Companies make investments for at least three reasons. First, companies transfer
excess cash into investments to produce higher income. Second, some entities, such as
mutual funds and pension funds, are set up to produce income from investments. Third,
companies make investments for strategic reasons; for examples, are investments in
competitors, suppliers and even customers company.

Short Term Investment

Short term investments are investments that are both readily converted to known
amounts of cash and mature, usually, within 3 to 12 months. Short-term investments are
also called temporary investments and marketable securities. Specifically, short-term
investments are securities that:
(1) Management intends to convert to cash within one year or the operating cycle,
whichever is longer;
(2) are readily convertible to cash.
Short term investments are reported under current assets and serve a purpose similar to
cash equivalents. Companies with large amounts of liquid resources often hold most of
these resources in the form of marketable securities rather than cash.

Marketable securities consist primarily of investments in bonds and in the capital stocks
of publicly owned corporations. These marketable securities are traded (bought and
sold) daily on organized securities exchanges. A basic characteristic of all marketable
securities is that they are readily marketable-meaning that they can be purchased or
sold quickly and easily at quoted market prices.
Investments in marketable securities earn a return for the investor in the form of interest,
dividends, and-if all goes well- an increase in market value. Meanwhile, these
investments are almost as liquid as cash itself. They can be sold immediately over the
telephone, simply by placing a “sell order” with a brokerage firm or on the internet, by
using an online brokerage firm.
Because of their liquidity, investments in marketable securities usually are listed
immediately after cash in the balance sheet.

102
 6.5.1. Accounting for Marketable Securities
There are four basic accountable events relating to investments in marketable securities:
1) Purchase of the investments
2) Receipt of dividend revenue and interest revenue;
3) Sale of securities owned, and;
4) Adjusting Marketable Securities to Market Value

1) Purchase of Marketable Securities

Investments in marketable securities originally are recorded at cost, which includes any
brokerage commissions.
Illustration 6.5 (a): Assume that DOKO PLC purchases as a short term investment
6,000 shares of the capital stock of MULIYE Company. The purchase price is Br. 65 per
share, plus a brokerage commission of Br. 900.
Required: Record the purchase of these shares and compute the cost per share.
Solution:
Marketable Securities (MULIYE capital stock) 390,900*

Cash 390,900

(*Br. 65*6000 shares + Br. 900)

Cost per share:

The cost per share can be computed by dividing the total cost debited to marketable
securities’ account (Br. 390,900) by total number of shares purchased (6,000).
Br.390,900
Thus, the cost per share =  Br.65.15 per share.
6,000shares
2) Recognition of Investment Revenue
Most of the time interest and dividend revenues are recognized as they are received.
Thus, the entries involve a debit to Cash and a credit to either Interest Revenue or
Dividend Revenue.
Illustration 6.5 (b): Assume that DOKO receives a Br. 0.98 per share dividend on its
6,000 shares of MULIYE Company. The entry to record this cash receipt is:

Cash 5,880*

Dividend Revenue 5,880

(*Br. 0.98  6000 shares = Br. 5,880)

Note that the policy of recognizing revenue as it is received eliminates the need for
adjusting entries to accrue any investment revenue receivable at year end.

3) Sales of Investments
When an investment is sold, a gain or a loss often results. A sales price in excess of cost
produces a gain, whereas a sales price below cost results in a loss.

103
Illustration 6.5 (c): Sale at a price resulting in a gain
Assume that DOKO Company sells 1,500 shares of its MULIYE Company stock for Br.
70 per share, less a brokerage commission of Br. 250. The entry would be:
Cash 104,750

Marketable Securities 97,725

Gain on Sale of Investments 7,025

Computation of Gain sold 1,500 shares of MULIYE capital stock at a gain:

Sales Price (Br. 70  1,500 shares – Br. 250) Br. 104,750
Less; Cost (Br. 65.15  1500 shares)
97,725
Gain on Sale Br.
7,025

This transaction results in a gain because DOKO Company sold the shares at a price
above cost. The gain-representing the profit on the sale-increases DOKO Company’s
net income for the period. At the end of the period, the credit balances in any gain
accounts are closed into the income summary account, along with the credit balances of
the revenues accounts.

Illustration 6.5 (d): Sale at a Price Resulting in a Loss

Assume that several months later; DOKO Company sold another 1,500 shares of its
MULIYE Company stock, this time at a price below cost. The sales price is Br. 62 per
share, again less a brokerage commission of Br. 280. The entry would be:
Cash 92,720

Loss on Sale of Investments 5,005

Marketable Securities 97,725

Computation of Gain sold 1,500 shares of MULIYE capital stock at a loss:

Sales Price (Br. 62  1,500 shares – Br. 280) Br. 92,720
Less; Cost (Br. 65.15  1500 shares) 97,725
Loss on Sale Br. (5,005)

The loss decreases DOKO Company’s net income for the period. At the end of the
period, the debit balances in any loss account are closed in the Income Summary
account, along with the debit balance of expense accounts.
4) Adjusting Marketable Securities to Market Value
At the end of each accounting period, the balance in the marketable securities account is
adjusted to its current market value. This is an interesting concept because it represents
a departure from the historical cost principle. At present, marketable securities are the
only assets likely to appear in the balance sheet at an amount above cost.

104
The entry to adjust marketable securities affects only two accounts; Marketable
Securities and a special owners’ equity account, entitled Unrealized Holding Gain (or
Loss) on Investments. When we change the valuation of an asset, there is a
corresponding change in either total liabilities or total owners’ equity. In the case of the
marketable securities’ adjustment, the corresponding change is recorded in the owners’
equity account, Unrealized Holding Gain (or Loss) on Investments.
The adjustment to the Marketable Securities account may be either a debit or a credit-
whichever is necessary to adjust the account’s balance to current market value.

Illustration 6.5 (e): Assume that prior to making any adjusting entry; DOKO Company’s
Marketable Securities account has a balance of Br. 195,450 at year end. If the current
market value of the securities owned is, say, Br. 200,550, DOKO Company will make the
following adjustment at year end:
Marketable Securities 5,100

Unrealized Holding Gain (or Loss) on Investments 5,100

To adjust the balance sheet value of marketable securities to their current market
value of Br. 200,550.

But if the market value of the securities were only Br. 195,000 i.e. Br. 450 less than the
balance in the Marketable Securities account- the adjusting entry would be:
Unrealized Holding Gain (or Loss) on Investments 450

Marketable Securities 450

To adjust the balance sheet value of marketable securities owned to their current
market value of Br. 195,000.

Notice that, the Unrealized Holding Gain (or Loss) on Investments account may have
either a debit or credit balance. A debit balance represents an unrealized holding loss,
meaning that the current market value of the securities owned is below the investor’s
cost. A credit balance represents an unrealized holding gain, indicating that market value
of the securities exceeds the investor’s cost.
In the second unit of this module we made the point that adjusting entries usually affect
both the balance sheet and the income statement. The adjustment of marketable
securities is an exception to this rule it affects only the balance sheet.
The gains and losses recorded, as described above, are unrealized that is, they have
not been finalized though sales of the securities. These unrealized gains and losses are
not included in the investor’s income statement. Rather, the unrealized Holding Gain (or
Loss) account appears in the stockholders’ equity section of the balance sheet.
Because the Unrealized Holding Gain (or Losses) account does not enter into the
determination of net income, it is not closed at the end of the accounting period. Instead,
its balance is adjusted from one period to the next. At any balance sheet date, the
Unrealized Holding Gain (or Loss) account represents the difference between the cost of
the marketable securities owned and their current market value.

105
 6.5.2. Reporting Cash and Short Term Investment Transactions in the
Financial Statements
Presentation of Cash and Marketable Securities in the Balance Sheet
Assets Liabilities and Owners’ Equity

Current Assets: Liabilities:

Cash 12,204.85 Detail not shown XXX

Marketable Securities (cost, Br. 200,550 Stock holders’ Equity:

195,450; market value Br. 200,550) XXX
Capital stock
Account Receivable XXX Retained earnings XXX

Total Current Assets XXX Unrealized Holding Gain 5,100

on Investments
Fixed Assets XXX Total stockholders’ equity XXX

Total Assets XXX Total Liab& Owners’ XXX

Equity

In a multiple-step income statement, interest revenue, dividend revenue, and gains and
losses from sales of investments usually appear as nonoperating items, after the
determination of income from operations.
In a statement of cash flows, receipts of dividends and interest are classified as
operating activities. Purchases and sales of marketable securities classified as available
for sale are presented as investing activities, regardless of whether sales transactions
result in a gain or a loss. In the statement of cash flows, the total sales proceeds are
listed as cash receipts from investing activities, regardless of whether the investment is
sold at a gain or at a loss.

MODEL EXAM QUESTIONS

Part I: Discussion Questions
1. What are the usual component of cash?
2. What are the functions of bank reconciliation?
3. What are two forms of bank reconciliation in common usage? Which form of the bank
reconciliation is preferred by many practicing accountants? Why?
4. Why organizations establish a petty cash? What is the implication of using petty cash
on the company’s internal control system?
5. What is a proof of cash? What purpose does it serve?

Exercise I: At December 31, Year 5, WESENE Manufacturing Company owned the following
investments in capital stock of publicly traded companies:
Issuing Number of shares Cost per share Price per

106
 company share
ABEBU Inc. 5,000 Br. 19 Br. 23
BEDADA PLC 4,000 Br. 18 Br. 16

In Year 6, WESENE Manufacturing Company engaged in the following two transactions:

April 15: Sold 1,000 shares of its investment in ABEBU Inc., at a price of Br. 21 share, less a
brokerage commission of Br. 50.
August 9: Sold 2,000 shares of its investment in BEDADA PLC at a price of Br. 14 per share,
less a brokerage commission of Br. 60.
At December 31, Year 6, the market values of these stocks were ABEBU Inc, Br. 18 per share
and BEDADA PLC, Br. 16 per share.
Instructions:
1) Illustrate the presentation of marketable securities and the unrealized holding gain or
loss in WESENE Company‘s balance sheet at December 31, Year 5. Include a caption
indicating the section of the balance sheet in which each of these accounts appears.
2) Prepare journal entries to record the transactions on April 15 and August 9.
3) Prepare adjusting entries to reinstate marketable securities to market value.
4) Illustrate the presentation of the marketable securities and unrealized holding gain (or
loss) in the balance sheet at December 31, Year 6.
5) Illustrate the presentation of the net realized gains (or losses) in the Year 6 income
statement. Assume a multiple-step income statement and show the caption identifying
the section in which this amount would appear.

107
 UNIT SIX
RECEIVABLES
 Unit Objectives
 Introduction

 Unit Outline:

7.1 Classification of Receivables

7.2 Accounting for Uncollectible
7.2.1 Allowance Method of Accounting for Uncollectible
7.2.1.1 Method of Estimating Uncollectible under Allowance Method
7.2.2 Direct Write-Off Method of Accounting for Uncollectible
7.3 Notes Receivables
7.3.1 Characteristic of Notes Receivable
7.3.2 Accounting for Notes Receivable
7.3.3 Discounting Notes Receivable
7.3.4 Dishonored Notes Receivable
7.4 Using Receivables to Raise Cash
7.4.1 Pledging of Receivables
7.4.2 Assigning Receivables
7.4.3 Selling Receivables
7.5 Presentation of Accounts Receivables on the Balance Sheet
 Model exam questions.

Unit Objectives:
After successful completion of this unit, you should be able to:
 Identify different types of receivables:
 Identify methods of accounting for uncollectible (allowance and direct write-off
methods);
 Discuss and illustrate methods determining the uncollectibles;
 Describe the characteristics of notes receivables;
 Describe accounting for notes receivables;
 Illustrate accounting for the discounting of notes receivables;
 Illustrate accounting for the dishonored notes receivables;
 Describe how receivables are used as source of cash;
 Describe accounting for short term investment;
 Show the balance sheet presentation of receivables.

7.1 Classification of Receivables

Pretest

108
Dear students, what are receivables? What are the major sources of receivables? Please
enumerate the possible classification of receivables as many as you can before
studying this section.
Receivables refer to amounts due from individuals and companies. They are generated by the
functions for which a company is in business to perform. Receivables are claims that are
expected to be collected in cash. They represent one of a company’s most liquid assets next to
cash and short term investments.
Receivables are frequently classified as:
1) Accounts Receivable
Account receivables are generated by the functions for which a company is in business to
perform. They represent amounts owed by customers on account which result from the sale of
goods and services (often called trade receivables). Account receivables are usually expected
to be collected within 30 to 60 days and are usually the most significant type of claim held by a
company.
2) Notes Receivable
Notes receivable is more formal debt than account receivable because it involves a formal
written promise to pay. It is recorded at net present value which involves interest being stated
or imputed on the amount owed. Notes receivables represent claims for which formal
instruments of credit are issued as evidence of debt. As a credit instrument, notes receivable,
normally requires payment of interest and extends for time periods of 60-90 days or longer. It
may also result from sale of goods and services (often called trade receivables).
3) Other Receivables
Other receivables involve nontrade receivables including interest receivable, loans to company
officers, advances to employees, and income taxes refundable. These items are generally
classified and reported as separate items in the balance sheet.
Activity 7.1
1) What is meant by receivables?
2) Discuss the three major classifications of receivables?
3) Differentiate accounts receivables and notes receivables.

7.2 Accounting for Uncollectible Accounts

Pretest

Dear students take rough paper and treat the following basic questions by your own
before studying this section. Why sellers are not able to collect all of their credit sales
when they become due? What are the major reasons for recording uncollectibles?
Can you list the methods of determining uncollectibels?
Not all sales on account result in cash being collected for the customer. The loss from
uncollectible accounts receivable may be recorded using either the direct write-off method or
the allowance method.

7.2.1 The Allowance Methods

Pretest

109
 Dear students, when do creditors use allowance method for determining
uncollectibles? What are the methods of determination of uncollectible accounts
amount?
To compensate for the matching problem with direct write-off method, accountants
have developed “allowance method” to account for uncollectible accounts. Recognition of bad
debt expense is about matching the probable bad debt to the period in which the credit sale
(that may result in a bad debt) is made. This involves estimating bad debts and charging bad
debts expense in the period of sale as opposed to the period in which the bad debt becomes
apparent due to failure of collection efforts. Importantly, an allowance method must be used
except in those cases where bad debts are not material (and for tax purposes where tax rules
often stipulate that a direct write-off approach is to be used). This process involves the use of a
“contra” (also known as valuation) account called Allowance for Bad Debts (also known as
Allowance for Uncollectibles) in conjunction with the traditional expense account, Bad Debts
Expense. Under this method, the estimated credit losses are debited to Bad Debt Expense (or
Uncollectible Accounts Expense) and credited to Allowance for Bad Debts in the period in
which the sale occurs. When a specific account is determined to be uncollectible, the
allowance for uncollectible account is debited and Account Receivable is credited. As you will
soon see, the actual write off in a subsequent period will generally not impact income.
Note the following entries under each alternative.

i. to record estimated bad debts

Bad Debt Expense XXX
Allowance for Uncollectible Accounts XXX
ii. to record write off of accounts deemed uncollectible
Allowance for Uncollectibles XXX
Account Receivable-Mr. Y XXX
iii. to reinstate the accounts written off
Accounts Receivable-Mr. Y XXX
Allowance for Uncollectibles XXX
iv. to record the collection from accounts written off
Cash XXX
Accounts Receivable-Mr. Y XXX

Illustration 7.1: Assume that GAROMA Company has total accounts receivable of Br. 350,000
at the end of the year, and is in process of preparing a balance sheet and estimates that
Br. 21,700 of this amount may ultimately prove to be uncollectible.
The journal entry used to record this fact is:
Bad Debt Expense 21,700
Allowance for Bad Debts 21,700
(to record estimate of uncollectible accounts)

110
 7.2.1.1 Methods of Estimating Uncollectibles under Allowance Method
In the preceding illustration, the Br. 21,700 was simply given as part of the fact situation. But,
how would such an amount actually be determined? If GAROMA Company's management
knew which accounts were likely not to be collectible, they would have avoided selling to those
customers in the first place. Instead, the Br. 21,700 simply relates to the balance as a whole. It
is likely based on past experience, but it is only an estimate. It could have been determined by
one of the following techniques: Balance sheet approach and income statement approach.
1. Balance Sheet Approach
Bad debts may be estimated based on the historical relationship between actual amounts not
collected and accounts receivable. This approach is balance sheet oriented because the
resulting accounts receivable is reported on the balance sheet at its estimated net realizable
value. There are two method of computing the uncollectible balance: percentage of outstanding
accounts receivable and aging of accounts receivables; which are discussed and illustrated on
the following pages.

1.1 . Percentage of Total Receivables

Some companies anticipate that a certain percentage of outstanding receivables will prove
uncollectible. In GAROMA Company’s case (Illustration 7.1 above), may be 6.2% (Br.
350,000 X 6.2% = Br. 21,700).

1.2 Aging Analysis

Other companies employ more sophisticated aging of accounts receivable analysis. They will
stratify the receivables according to how long they have been outstanding (i.e., perform an
aging), and apply alternative percentages to the different strata. Obviously, the older the
account, the more likely it is to represent a bad account. GAROMA Company's aging may have
appeared as follows:

Estimated % Estimated
of Amount of
AGE Balance Uncollectible Uncollectible
Current 180,000 1% 1,800
31 - 60 days 90,000 4.5% 4,050
61 - 90 days 60,000 11% 6,600
OVER 90 days 20,000 46.25% 9,250
350,000 21,700
Both the percentage of total receivables and the aging are termed "balance sheet approaches."
In both cases, the allowance account is determined by an analysis of the outstanding accounts

111
receivable on the balance sheet. Once the estimated amount for the allowance account is
determined, a journal entry will be needed to bring the ledger into agreement. Because the
amount computed represents the required balance in Allowance for Doubtful Accounts at the
balance sheet date. Accordingly, the amount of the bad debts adjusting entry is the difference
between the required balance and the existing balance in the allowance account. Occasionally,
the allowance account will have a debit balance prior to adjustment because write-offs during
the year have exceeded previous provisions for bad debts.
Generally, the adjustment figure should be increased/decreased by the debit/credit balance in
the allowance account prior to the adjustment.

Illustration 7.2: Allowance Method: Balance Sheet Approach

Assume that GAROMA Company’s ledger revealed an Allowance for Uncollectible Accounts,
prior to performing the above analysis,
Case A: credit balance of Br. 8,500.
Case B: debit balance of Br. 1,300.
Required: Pass the adjusting entry under each of the above independent cases.
Solution: As a result of the analysis, it can be seen that a target balance of Br. 21,700 is
needed; necessitating the following adjusting entry:
Case A: If the Allowance Account has Credit Balance of Br. 8,500

Bad Debt Expense 13,200

Allowance for Bad Debts 13,200

To adjust the allowance account from a Br. 8,500 balance to the target balance of
Br. 21,700 (i.e., Br. 21,700 - Br. 8,500).
Case B: If the Allowance Account has Debit Balance of Br. 1,300

Bad Debt Expense 23,000

Allowance for Bad Debts 23,000

To adjust the allowance account from a debit balance of Br. 1,300 to the target
balance of Br. 21,700 (i.e., Br. 21,700 + Br. 1,300).

In summary, you should carefully note two important points: (1) with balance sheet approaches,
the amount of the entry is based upon the needed change in the account (i.e., to go from an
existing balance to the balance sheet target amount), and (2) the debit is to an expense
account, reflecting the added cost associated with the additional amount of anticipated bad
debts.

2. Income Statement Approach

Rather than implementing a balance sheet approach as above, some companies may follow a
simpler income statement approach. With this equally acceptable allowance technique, an
estimated percentage of sales (or credit sales) is simply debited to Uncollectible Expense

112
Accounts and credited to the Allowance for Uncollectible Accounts each period. Importantly, this
technique merely adds the estimated amount to the Allowance account. The amount of the
estimated loss is equal to the credit sales for the period multiplied by the estimated percentage
of the credit sales that will prove to be uncollectible.

Illustration 7.3: Allowance Method: Percentage of Sales Method (Income Statement Approach)
During year 7 KEKO Company made credit sales of Br. 360,000 and made collections of Br.
270,000; during year 8 the business made credit sales of 400,000, made collections of Br.
89,000 from year 7 credit sales and Br. 303,000 from year 8 credit sales, and wrote-off credit
sales from year 7 in the amount of Br. 1,000; the percentage-of-sales method was used to
estimate bad debt expense; bad debt expense was estimated to be 1 1 2 % of credit sales each
year.
Required: Record all entries to be made in KEKO Company’s book for the year 7 and 8, using
the above information.

Year 7:
i. To record sales on credit
Accounts Receivable 360,000
Sales 360,000
ii. To record cash collection during the year
Cash 270,000
Accounts Receivables 270,000

iii. To record uncollectible accounts expenses

Bad Debt Expenses 5,400*
Allowance for Uncollectibles 5,400

1
1 %
(* 2 of Br. 360,000 = Br. 5,400)

Year 8:
i. To record sales on credit
Accounts Receivables 400,000
Sales 400,000
ii. To record cash collection during the year
Cash 392,000*
Accounts Receivables 392,000
(*Br. 89,000 + Br. 303,000)
iii. To record write off accounts kept in doubt full accounts
Allowance for Doubtful 1,000
Accounts Receivable 1,000

113
 iv. To record uncollectible accounts expenses
Bad Debt Expense 6,000
Allowance for Uncollectibles 6,000

1
1 %
(* 2 of Br. 400,000 = Br. 6,000)

Activity 7.2.1.
1) What are the two broad methods of estimating uncollectible amounts under
allowance methods?
2) What are the common journal entries used to record the uncollectible under
each of the aforementioned methods?

7.2.2 Direct Write off Method of Accounting for Uncollectibles

The direct write off method recognizes bad debt expense in the period in which the account
receivables prove to be uncollectible. Under this technique, a specific account receivable is
removed from the accounting records at the time it is finally determined to be uncollectible. The
loss is recorded by debiting bad debt expense (also called Uncollectible accounts expense)
and crediting accounts receivable as shown here under in the journal entry.
Bad Debt Expense XXX
Accounts Receivable-Mr. X XXX
(to record write-off of Mr. X’s Account)
Note that:
i. Bad debts are written off only when the determination is made that they are
uncollectible.
ii. There is no attempt to match the bad debt expense to the revenue that it created ( the
matching principle is violated).
iii. When a previously written off account receivable is collected, the entry to write off the
account is reversed and the collection is recorded as a normal collection.

Illustration 7.4: Direct Write-Off Method

During year 1 of its operation, HATAU Corporation made credit sales of Br. 800,000 and made
collections of Br. 720,000; during year 2 the corporation made credit sales of Br. 960,000,
made collections of Br. 78,000 from year 1 credit sales and Br. 900,000 from year 2 credit
sales, and written-off credit sales from year 1 in the amount of Br. 2,000 which was related to
W/ro FATE.
Required: Pass entries to record: i) sales and collection during year 1 and 2 respectively ii)
written-off of W/ro FATE’s account.
i. To record Sales and Collection during:

Year 1:
a) to record credit sales

114
 Accounts Receivable 800,000
Sales 800,000

b) to record cash collection

Cash 720,000
Accounts Receivable 720,000
Year 2:
a) to record credit sales
Accounts Receivable 960,000
Sales 960,000
b) to record cash collection (78,000 (year 1) + 900,000 (year 2) = Br.
978,000
Cash 978,00
0
Accounts Receivable 978,000
ii. To write off W/ro FATE’s Account
Bad Debt Expenses 2,000
Account Receivable-W/ro FATE 2,000
Recovery of Accounts Written off:
Assume that W/ro FATE has agreed to pay the full amount (Br. 2,000) after the above journal
entries had been recorded.
Required; pass the journal entries: i) to reinstate FATE’s account and ii) to record the full
collection made.
i. to reinstate FATE’s Account
Accounts Receivable-FATE 2,000
Bad Debt Expense 2,000
ii. to record cash collection
Cash 2,000
Accounts Receivable-FATE 2,000
Drawbacks of direct write-off method:
a) Bad debts expense is often recorded in a period different from that in which the revenue
was recorded (violation of matching principle).
b) No attempt is made to show accounts receivable in the balance sheet at the amount
actually expected to be received (violation of full disclosure).
c) Use of the direct write-off method can reduce the usefulness of both the income
statement and balance sheet.

Why is the Direct Write off method allowed at all?

a) Proponents argue that because receivables are immaterial, the Direct write off method
can cause no material differences in the values presented in the financial statements.
b) Ease of use

Activity 7.2.2.
1. What does direct write off for account receivable mean?

115
 2. What are the disadvantages of using direct write off of account receivables?
3. What are the arguments of using direct write off method for accounts receivable?

7.3 Notes Receivable

Pretest
Dear students, what are the major differences and similarities of account
receivables and the note receivables? Do you think that they are following the same
accounting procedures?
7.3.1 Characteristics of Notes Receivables

Notes Receivable is a written promise from a client or customer to pay a definite amount of
money on a specific future date. Such notes can arise from a variety of circumstances, not the
least of which is when credit is extended to a new customer with no formal prior credit history.
The lender uses the note to make the loan more formal and enforceable. Such notes typically
bear interest charges. The maker of the note is the party promising to make payment, the
payee is the party to whom payment will be made, the principal is the stated amount of the note,
and the maturity date is the date the note will be due.

Note that notes receivable often are used when the goods sold have a high unit or aggregate
value and the purchaser of the goods wants to extend payment beyond the normal 30 to 90 day
period of trade credit. In the banking and commercial credit fields, notes are the typical form of
credit instrument used to support lending transactions. Notes receivable also may result from
sale of plant assets, or from the variety of other business transactions.

Interest is the charge imposed on the borrower of funds for the use of money. The specific
amount of interest depends on the size, rate, and duration of the note.

In mathematical form: Interest = Principal  Rate  Time. ---------------- Formula 1

For example, a Br. 1,000, 180-day note, bearing interest at 12% per year, would result in
interest of Br. 60 (Br. 1,000  12%  180/360). In this calculation, notice that the "time" was
180 days out of a 360 day year. Obviously, a year normally has 365 days, so the fraction could
have been 180/365. But, for simplicity, it is not uncommon for the interest calculation to be
based on a presumed 360-day year or 30-day month.

7.3.2. Accounting for Notes Receivable

116
 a) Short-Term Notes
Short term note can be of either interest bearing or non-interest bearing. In the Interest-bearing
notes the borrower is required to pay at the date of maturity the face value of the note plus an
explicitly stated interest on the face value of the note.
Note the following journal entries to be recorded by the payee:
a) Date of Receipt - the amount of cash or the value of goods or services given is equal to
the face value of the note. The notes receivable account is debited for the face value of
the note.
b) Date of Payment
- The notes receivable account is credited for the face value of the note.
- Interest income is recorded for an amount equal to the face rate of interest times the
face amount of the note times the length of time (see formula 1) from date of receipt of
the note to the date of maturity of the note.

Illustration 7.3.2 (a): Assume that SIFEN Corporation sold inventory on March 1 and received
a Br. 10,000, 8%, 6-month note; the note was paid on September 1.
Required: Pass the necessary journal entries on March 1 and September 1 on the book of
SIFEN.
September Notes Receivable 10,000
1 Sales 10,000
(To record sale of inventory on account)

March 1 Cash 10,400*

Notes Receivable 10,000
Interest Income 400**
(To record receipt of cash on maturity date of the note)
*(10,000 + (8%  10,000  6 / 12))
**(8%  10,000  6 / 12)

Noninterest-bearing note: in this case the borrower is required to pay at the date of maturity
the face value of the note unlike the interest bearing notes.
Accounting for Noninterest Bearing Note
a) Date of Receipt
On the date of receipt the amount of cash or the value of the goods or services given is equal to
the face value of the note less the implied rate of interest on the face value of the note.
The notes receivable account is debited for the face value of the note. While the discount on
notes receivable account is credited for an amount equal to the face rate of interest times the
face amount of the note times the length of time from date of receipt of the note to the date of
maturity of the note.
b) Date of Payment
The notes receivable account is credited for the face value of the note and the discount on
notes receivable is amortized as interest income over the life of the note.

117
Illustration 7.3.2 (b): Assume that BEDATU Corporation sold merchandise on January 1 and
received a Birr 100,000, 6-month, noninterest-bearing note with an implied interest rate of 12%;
the note was paid on July 1.
Required: Pass the necessary journal entries on January 1 and July 1 on the book of BEDATU.
January 1 Notes Receivable 100,000
Sales 94,000*
Discount on Notes 6,000**
Receivable
To record sale of merchandise on account.
*(Br. 100,000 – (12%  Br. 100,000  6 / 12))
**(12%  Br. 100,000  6 / 12)

July 1 Cash 100,000

Notes Receivable 100,000

Discount on Notes Receivable 6,000

Interest Income 6,000
To record receipt of cash on maturity date of the note.

Illustration 7.3.2 (c): Assume that BACHU initially sold Birr 10,000 of merchandise on account
to HAWEN on November 1, year 2. HAWEN later, on December 1, Year 2, requested more
time to pay, and agreed to give a formal three-month note bearing interest at 12% per year.
The entry to record the conversion of the account receivable to a formal note is as follows:
Nov. 1 Notes Receivable 10,000
Year 2 Accounts Receivable 10,000
To record conversion of an account receivable to a note receivable

When the note matures, BACHU's entry to record collection of the maturity value would appear
as follows:
Cash 10,300
Feb. 28,
Interest Income 300
Year 3
Notes Receivable 10,000
To record collection of note receivable plus accrued interest of Br. 300 (Br. 10,000 X
12% X 90/360

7.3.3. Discounting Notes Receivables

Occasionally, a company may find that it needs additional cash on a short term basis, but the
company does not wish to borrow money or sell or assign its accounts receivable. In these
cases the company may discount a customer’s notes receivable at a bank in return for cash.
When a company discounts a customer’s note receivable at the bank, it transfers the note to the
bank. Negotiable notes receivable may be sold or discounted. The term sale is appropriate
when a note is indorsed to a bank or finance company on a without recourse basis that is, in the
event the maker of the note defaults, the bank or finance company has no recourse against the

118
seller of the note. The term discounted applies when an enterprise borrows against notes
receivable and indorses them on the with recourse basis which means that the borrower must
pay the note if the maker does not.
When a customer’s note receivable is discounted, the proceeds (cash received) are determined
by multiplying the discount rate times the maturity value of the note (face value of the note plus
total interest) for the discount period, and deducting the resulting discount from the maturity
value.
Note that the discount rate is the rate charged by the bank. It has no relationship to the interest
rate charged the customer on the note receivable. The discount period is the length of time from
the date of discount to the maturity date. Any gain or loss from the discounting is computed by
comparing the current book value of the note receivable (including accrued interest revenue) to
the proceeds received. The company discounting the note makes journal entries on the date of
the discount to record any accrued interest revenue, the proceeds received and any gain or loss
on the discounting of the note. It eliminated the discounted note on the maturity date.

Illustration 7.3.3: Discounting Notes Receivables

Assume that on November 30, Year 6, KERANIO Company discounts (with recourse) a
customer’s note at its bank at a 15% discount rate. The note was received from the customer on
November 1, is for 4 months, has a face value of Br. 6,000 and carries an interest rate of 13%.
The customer pays the notes on the February 1, year 7 maturity date.
Required: Compute:
1) the maturity value of the note
2) the discount
3) proceeds received by KERANIO from its bank
4) the loss/gain from discounting of the note.
5) Pass the necessary journal entries to record the discounted note on November
30.
Solution: The data used in determining the effect of the transactions are as follows:
Answer Face value of note Computation Br. 6,000
Interest to maturity (Br. 6,000*0.13*4/12) 260
Q1 Maturity Value of note 6,260
Q2 Discount (6,260*.15*3/12) (234.75)
Q3 Proceeds Received (6,260 – Br. 234.75) 6,025.25
Accrued Interest revenue; (6,000*.13*1/12)= Br. 65
Book value of note (6,000 + Br. 65) (6,065)
Q4 Loss from discounting of note Br. (39.75)
Q5: KERANIO Company makes the following journal entry to record the discounted note on
November 30:
Cash 6,025.25
Loss from Discounting of Note 39.75
Notes Receivable 6,000
Interest Revenue 65

119
When a note is discounted, the difference between the book value of the note and its proceeds
is recorded as a gain or loss (as we did in this example) if a company usually does not discount
its notes. Alternatively, if a company normally discounts its notes, the difference is reported as
interest revenue or interest expense.
When KARANIO Company prepares a balance sheet on December 31, end of its accounting
period, it discloses the contingent liability in the notes to its financial statements. This note might
read as follows: “The Company is contingently liable for a discounted note receivable of
Br. 6,000. The company does not anticipate that this note will be defaulted on its maturity date.”
In this illustration (7.3 (d)) the contingent liability was eliminated on the maturity date when the
customer paid the note. If the customer does not pay this note at maturity, the bank would
require KARANIO Company to pay the maturity value of the note plus a service charge on the
dishonored note. KERANIO Company’s only recourse is to attempt to collect these amounts
from the customer. Consequently, up on default KERANIO Company establishes a Notes
Receivable Dishonored account. For example assume instead that on March 3, year 7, the bank
notified KARANIO Company that the note had not been paid and also charged KERANIO
Company a Br. 15 fee. At that time KERANIO Company would record the following journal entry
in paying the total maturity value of the note to the bank:
March 3, Notes Receivable Dishonored 6,275
Year 7 Cash 6,275

Note: if KERANIO Company does not collect the dishonored note in the future, it recognizes a
loss on the default.

7.3.4. Dishonored Notes Receivable

Illustration 7.3.4 (a): If HAWEN dishonored the note, in illustration 7.3 (c) above, at maturity
(i.e., refused to pay), then BACHU would prepare the following entry:
Jan. 31, Accounts Receivable 10,300
Year 2 Interest Income 300
Notes Receivable 10,000
To record dishonor of note receivable plus accrued interest of Br. 300 (Br. 10,000 X
12% X 90/360)
The debit to Accounts Receivable in the above entry reflects the hope of eventually collecting all
amounts due, including the interest, from the dishonoring party. If BACHU anticipated some
difficulty in collecting the receivable, appropriate allowances would be established in a fashion
similar to those illustrated earlier in the unit.

Notes and Adjusting Entries

In the above illustrations, 7.3 (c) and 7.3 (e), for BACHU, all of the activity occurred within the
same accounting year. However, if BACHU had a December 31 accounting year end, then an
adjustment would be needed to reflect accrued interest at year-end. The appropriate entries
illustrate this important accrual concept are given under:
Entry to set up note receivable:

120
 Nov. 1, Notes Receivable 10,000
Year 2 Accounts Receivable 10,000
To record conversion of an account receivable to a note receivable
Entry to accrue interest at December 31, Year 2 end:
Dec. 31, Interest Receivable 200
Year 2 Interest Income 200
To record accrued interest at December 31 (Br. 10,000 X 12% X 60/360 =
Br. 200)
Entry to record collection of note (including amounts previously accrued at December 31):
Jan. 31, Cash 10,300
Year 3 Interest Income 100
Interest Receivable 200
Notes Receivable 10,000
To record collection of note receivable plus interest of Br. 300 (Br. 10,000 X
12% X 90/360); Br. 200 of the total interest had been previously accrued.

Activity 7.3:
1. What are the major characteristics of notes receivables?
2. What are the accounts to be affected to record journal entries on the date of
receipt and date of payments of short term notes?
3. Why and how notes are discounted?
4. What is meant by dishonored notes?

7.4 Using Receivables to Raise Cash

Pretest

Dear students, do you think that receivables are used to raise immediate cash? If yes,
how? Answer this question before you go to detail of this sub section.

Receivables, like any other asset, can be sold or used as collateral for debt. In fact,
retailers often avoid the difficulties of servicing (billing and collecting) receivables by transferring
them to financial institutions. This also shortens the operating cycle by providing cash to the
retailer immediately rather than making the company wait until the credit customer pays the
amount due. Of course, the financial institutions will require compensation for providing this
service, such as interest and/or a finance charge.
The methods to generate cash from receivables, ranging from using receivables as collateral for
a loan to selling receivables outright. In general, we do have three methods of receivables

121
transfer. The methods differ with respect to which rights and risks are retained by the transferor
(the original holder of the receivable) and those passed on to the transferee (the new holder,
usually financial institutions). Despite this variety, any of these methods can be described by
one of the following arrangements: (1) pledging receivables as collateral for loans, (2)
assigning receivables, or (3) selling receivables.

7.4.1 Pledging Receivables

The owner of the receivables borrows cash from a lender by issuing a promissory note
designating or pledging the receivables as collateral. In some firms it is a common process to be
involved in these types of transactions while in others, this is done only rarely when the
company is in financial difficulties. A pledge of accounts receivable as a collateral for a loan
involves no special accounting problems. Like building or inventories, the receivables serve as
collateral until the borrower pays all the debt. Claim arises from the side of the lender in case
the loan is not payable. Note that information concerning assigned receivables is disclosed
either in a parenthetical explanation or in a note to the financial statements.

7.4.2 Assigning Receivables

Instead of selling receivables, a business enterprise may borrow money using receivables as
collateral. This may involve a pledge of the receivables under a contract providing that the
proceeds from the collection of the receivables must used to retire the loan. Alternatively,
receivables may be assigned under a more formal arrangement whereby a borrower (assignor)
pledges the receivables to a lender (assignee) and signs a promissory note payable.
Assignment gives the assignee the same right to bring action to collect the receivables that the
assignor possesses. The assignor retains the credit risks and continues collection efforts, and
promises to make good any receivables that cannot be collected. In most cases customers are
not notified of the assignment. The assignor generally has some equity in the assigned
receivables because the financing company advances less than 100% of the face amount of the
receivables assigned. Note that on the assignment date the borrower and lender enter into an
agreement as to (1) who receives the collection, (2) the finance charges, (3) the specific
receivables that serve as collateral, and (4) notification or non-notification of account debtors.

1) Accounting for Assignment of Receivables

a) On the Date of Assignment
Borrower:
1) The issuance of the note is recorded the same as the issuance of any note.
2) An expense from the assignment of the receivables is recognized equal to the
finance charge.
3) The proceeds from the assignment of the receivables is equal to the recorded value
of the note less the finance charges.
Lender:
1) The receipt of the note is recorded the same as the receipt of any note.
2) A revenue from the assignment of the receivables is recognized equal to the finance
charge.

122
 3) The proceeds from the assignment of the receivables is equal to the recorded value
of the note less the finance charges.

b) Date of Collection
Borrower:
The collection of the assigned receivables is recorded the same as the collection of unassigned
receivables with the proceeds from the collection being used to repay the debt and interest.
Lender:
The receipt of the proceeds from the collection is allocated to the debt and interest.
Illustration-7.4 (a): Assume that OLYAD Corporation assigned Br. 10,000 of accounts
receivable as security for a note; the lender advanced 80% of the assigned accounts receivable
less a finance charge of 2% of the assigned accounts receivable; the lender charged interest of
1% per month on the unpaid balance of the note; during the first month Br. 2,130 of assigned
accounts receivable less a Br. 50 discount and Br. 100 return were collected; during the second
month the rest of the assigned accounts receivable less a Br. 300 bad debt were collected.
Required: Pass the necessary journal entries on the book of Borrower and Lender respectively.
Borrower:
i. Cash 7,800
Finance Charge (2%  10,000) 200
Notes Payable 8,000
ii. Cash 1,980
Sales Discounts 50
Sales Returns and Allowances 100
Accounts Receivable 2,130
iii. Interest Expense (1%  8,000) 80*
Notes Payable 1,900
Cash 1,980
iv. Cash 7,570
Allowance for Uncollectible Accounts 300
Accounts Receivable 7,870
v. Interest Expense (1%  (8,000 – 1900)) 61*
Notes Payable 6,100
Cash 6,161
Lender:
i. Notes Receivable 8,000
Finance Revenue 200
Cash 7,800
ii. Cash 1,980
Interest Income 80
Notes Receivable 1,900
iii. Cash 6,161
Interest Income 61
Notes Receivable 6,100

123
7.4.3 Sale of Receivables
Enterprises engaged in the buying of receivables are known as factors, and the process of
selling receivables is called factoring. Factors generally buy receivables outright, that is, without
recourse or with recourse.
At the time of sale of receivables the seller and the purchaser enter into an agreement as to:
a) The specific accounts that are being sold;
b) The finance charges;
c) The party responsible for bad debts; and
d) The amount of the proceeds from the sale to be retained to cover estimated discounts,
returns, allowances, and bad debts.

I. Sale of Receivables Without Recourse

The purpose of selling receivables without recourse is to shift to the purchaser of the
receivables the risk of credit losses, the effort of collection, and the waiting period that result
from the granting of credit. The purchaser of the accounts receivable assumes the risk of any
bad debts. The seller simply accounts for the transaction as a sale of an asset. The buyer
charges the fee for providing this service, usually a percentage of the book value of receivables.
Because the fee reduces the proceeds received for selling the asset, it is recorded by the seller
as a loss on sale of assets. We can discuss accounting for sale of receivables without recourse
on date of sale, date of payment and date of settlement.

1) Date of Sale:
 Accounting on the book of the Seller:

A loss on the sale of the receivables is recognized equal to the finance charge. A receivable is
recognized equal to the amount retained to cover estimated discounts, returns and allowances.
Proceeds from the sale of the receivables is equal to the recorded amount of the receivables
less the finance charges and the retainer.

 Records on the book of the Purchaser:

The finance revenue from the purchase of the receivables is recognized equal to the finance
charge. A liability is recognized equal to the amount retained to cover estimated discounts,
returns and allowances. The proceeds from the purchase of the receivables is equal to the
recorded amount of the receivables less the finance charges and the retainer.

2) Date of Payment

Seller--actual discounts, returns, and allowances are recorded offsetting the retainer.
Purchaser--the collection of the purchased receivables is recorded the same as the collection
of unpurchased receivables with the actual discounts, returns, and allowances offsetting the
retainer.
3) Date of Settlement

124
Seller--the difference between the retainer and the actual discounts, returns, and allowances is
transferred between the parties.
Purchaser--the difference between the retainer and the actual discounts, returns, and
allowances is transferred between the parties

Illustration-7.4.2 (a): BIRA Corporation sold Br. 10,000 of accounts receivable to a factor; the
factor assessed a finance charge of 2% of the purchased accounts receivable and retained 4%
of the purchased accounts receivable to cover sales discounts, returns, and allowances; during
the first month the factor collected Br. 6,000 of the purchased accounts receivable less a Br.
100 discount and a Br. 250 return; during the second month the factor collected the rest of the
purchased accounts receivable less a Br. 150 bad debt; at the end of the second month the
parties settled the balance of the retainer
Seller:
Cash (10,000 – 2%  10,000 – 4%  10,000) 9,400
Loss on Sale of Receivables 200
Due From Factor 400
Accounts Receivable 10,000
Sales Discounts 100
Sales Returns and Allowances 250
Due From Factor 350
50
Cash (400-350)
Due from Factor 50

Purchaser:
Accounts Receivable 10,000
Finance Revenue 200
Due to Seller 400
Cash 9,400
Cash 5,650
Due to Seller 350
Accounts Receivables 6,000
Cash 3,850
Allowance for Uncollectible accounts 150
Accounts Receivable 4,000
Due to Seller 50
Cash 50

II. Sale of Receivables With Recourse

When receivables are sold with recourse, the seller called transferor, in effect guarantees the
receivables and the purchaser or the transferee is reimbursed for failure of debtors to pay the
full amount anticipated at the time of sale. Generally, the sale of ordinary trade receivables with
recourse results in receipts of proceeds that are less than the face amount of the receivables

125
sold.Unlike sale of receivables without recourse under, with recourse, the seller of the
receivables assumes the risk of any bad debts. In this type of arrangement, it is not clear that an
outright sale has occurred because not all the risks of ownership have been transferred. These
transfer usually resemble a loan of cash, with receivables serving as collateral for the loan,
much like the assigning of accounts receivables.
Consider the following activities to be done by the seller and purchaser from the date of sale up
to the settlement date.
 On the Date of Sale
I. The Seller
a) A recourse liability is recognized which is equal to the estimated loss from bad debts.
b) A loss on the sale of the receivables is recognized with equal amount to the finance
charge plus the recourse liability.
c) A receivable is recognized equal to the amount retained to cover estimated discounts,
returns, allowances, and bad debts.
d) The proceeds from the sale of the receivables is equal to the recorded amount of the
receivables less the finance charges and the retainer.
II. The Purchaser
a) A finance revenue from the purchase of receivables is recognized equal to the finance
charge.
b) A liability is recognized equal to the amount retained to cover estimated discounts,
returns, allowances, and bad debts.
c) The proceeds from the purchase of the receivables is equal to the recorded amount of
the receivables less the finance charges and the retainer.

 On the Date of Payment

I) On the book ofthe Seller the actual amount of discounts, returns, allowances, and bad
debts are recorded offsetting the retainer.
II) On the book of the Purchaser, the collection of the purchased receivables is recorded
the same as the collection of unpurchased receivables with the actual discounts, returns,
allowances, and bad debts offsetting the retainer
 On the Date of Settlement
I) Seller--the difference between the retainer and the actual discounts, returns,
allowances, and bad debts is transferred between the parties.
II) Purchaser--the difference between the retainer and the actual discounts, returns,
allowances, and bad debts is transferred between the parties.

Illustration-7.4.2 (b): SUFE Corporation sold Br. 10,000 of accounts receivable to a factor; the
factor assessed a finance charge of 2% of the purchased accounts receivable and retained 4%
of the purchased accounts receivable to cover sales discounts, returns, allowances, and bad
debts; the estimated recourse liability from bad debts is Br. 175; during the first month the factor
collected Br. 6,000 of the purchased accounts receivable less a Br. 100 discount and a Br. 250
return; during the second month the factor collected the rest of the purchased accounts

126
receivable less a Br. 150 bad debt; at the end of the second month the parties settled the
balance of the retainer.
Required: pass the necessary journal entries to be recorded by the seller and the buyer.
Seller:
Cash (10,000 – 2% x 10,000 – 4% x 10,000) 9,400
Loss on Sale of Receivables (200 + 175) 375
Due From Factor 400
Accounts Receivable 10,000
Recourse Liability 175
Sales Discounts 100
Sales Returns and Allowances 250
Due From Factor 350

Recourse Liability 150

Due form factor 150
Due form factor 100
Cash 100

Recourse Liability 25
Loss on sale of receivables 25
Purchaser:
Accounts Receivable 10,000
Finance Revenue 200
Due to Seller 400
Cash 9,400
Cash 5,650
Due to Seller 350
Accounts Receivable 6,000
Cash 3,850
Due to Seller 150
Accounts Receivable 4,000
Cash 100
Due to Seller 100

7.5. Presentation of Accounts Receivables in the Balance Sheet

a) The different types of receivables should be segregated, if material.

b) Each type of receivable should be offset by the appropriate valuation account.
c) The receivables should be classified as either current or long term.
d) Any loss contingencies that exist on the receivables should be disclosed.
e) Any receivables pledged as collateral should be disclosed.
f) All significant concentrations of credit risk arising from receivables should be disclosed.
Note that the current asset section of the balance sheet, material amounts of the following
classes of receivables are reported separately.

127
 1) Notes and other receivables arising from written negotiable contracts
2) Ordinary trade receivables
3) Installment accounts receivable
4) Receivables from government
5) Other current claims
Any discount or premium (gain or loss) relating to notes receivable is reported in the balance
sheet as a deduction from or as an addition to the face amount of the notes. The description of
notes receivables should include the effective interest rate. Receivables that have been pledged
are identified and any receivables that will not be collected within one year or the operating
cycle are excluded from the current asset category.
A credit balance in an individual account receivable account if material shall be reported as a
current liability. Receivables from officers, employees, and stockholders generally are classified
as noncurrent unless current collection is assumed.

Model Exam Questions:

Part I: Multiple Choice Questions: Choose the Best Answer among the Given Alternatives
1. The Allowance For Doubtful Accounts is classified in
A. the current asset section of the balance sheet
B. the current liability section of the balance sheet
C. the income statement as an expense
D. the income statement as a revenue
2. A company used the percent of sales method to determine its bad debts expense. At the
end of the current year, the company's unadjusted trial balance reported the following
selected amounts:
Accounts Receivable Br. 245,000 Debit
Allowance for Uncollectible Accounts 300 credit
Net Sales 900,000 credits
All sales are made on credit. Based on past experience, the company estimates 0.5% of credit
sales to be uncollectible. What amount should be debited to Bad Debts Expense when the year
end adjusting entry is prepared?
A. Br. 925 D. Br. 4,200
B. Br. 4,500 E. None of the above
C. Br. 4,800
3. When using the allowance method of accounting for uncollectible accounts, the entry to
record the bad debts expense is a debit to Bad Debts Expense and a credit to Accounts
Receivable.
A. True B. False
4. The aging of accounts receivable involves classifying each account receivable by how long
it is past its due date.
A. True B. False

128
5. A company ages its accounts receivables to determine its end of period adjustment for bad
debts. At the end of the current year, management estimated that Br. 12,000 of the
accounts receivable balance of Br. 200,000 would be uncollectible. Prior to any year-end
adjustments, the Allowance for Doubtful Accounts had a debit balance of Br. 175. What
amount would appear in the Allowance for Doubtful accounts at the end of the year, after the
adjusting journal entry is posted?

A. Br. 200,000 D. Br. 11,825

B. Br. 12,000 E. None of the above.
C. Br. 12,175
6. On January 1, FIKIR COMPANY had a Br. 3,100 credit balance in the Allowance for
Doubtful Accounts. During the year, sales totaled Br. 780,000 and Br. 6,900 of accounts
receivable were written off as uncollectible. A December 31 aging of accounts receivable
indicated the amount probably uncollectible to be Br. 5,300.
FIKIR’s financial statements for the current year should include, which of the following,
assuming no recoveries of accounts previously written off were made during the year)
A. Uncollectible accounts expense of Br. 9,100
B. Uncollectible accounts expense of Br. 5,300.
C. Allowance for Uncollectible accounts with a credit balance of Br. 1,500.
D. Allowance for Uncollectible accounts with a credit balance of Br. 8,400.
E. None of the above.
7. On October 1, Year 3, EFESON financial loaned YORDANOS CORPORATION Br.
300,000, receiving in exchange a nine-month, 12 percent note receivable. EFESON ends its
fiscal year on December 31 and makes adjusting entries to accrue interest earned on all
notes receivable. The interest earned on the note receivable from YORDANOS
CORPORATION during 2009 will amount to:
A. Br. 18,000
B. Br. 27,000
C. Br. 36,000
D. Br. 9,000

129
Part II: Work out Questions
Exercise 1: BINO STAR, a local whole supplier, uses the balance sheet approach to estimate
uncollectible accounts expense. At year-end an aging of the accounts receivable produced the
following five groupings:
Age Categories Balance % of Uncollectible
Not Yet due Br. 500,000 1%
1 – 30 days past due 210,000 3%
31 – 60 days past due 80,000 10%
61-90 days past due 15,000 20%
Over 90 days past due 30,000 50%
Total Br. 835,000

The allowance for Doubtful Accounts before adjustment at December 31 showed a credit balance of Br.
11,800.
Required:
1) Compute the estimated amount of uncollectible accounts based on the above classification by
age groups.
2) Prepare the adjusting entry needed to bring the Allowance for Doubtful Accounts to the proper
amount.
3) Assume that on January 10 of the following year, BINO STAR learned that an account
receivable that had originated on September 1 in the amount of br. 8,250 was worthless
because of the bankruptcy of the client, KUMSA PLC. Prepare the journal entry required on
January 10 to write off this account.

Exercise II: On September 1, MESKELE COMPANY acquired a 12 percent, nine-month note

receivable from BEATA PLC, a credit customer, in settlement of a Br. 38,500 account receivable.
Required: Prepare journal entries to record the following:
1) The receipt of the note on September 1 in settlement of the account receivable.
2) The adjustment of record accrued interest revenue on December 31.
3) The collection of the principal and interest on May 31.

Answer Key:
Part II: Multiple Choices Questions
1. D 2. B 3. B 4. A 5. B
2. A (Br. 3,100 – Br. 6,900 + X = Br. 5,300)
3
3. D ( Br.300,000  0.12   Br.9,000)
12
Part II: Work Out Questions
Exercise I:
1). Br. 37,300

130
 2) Debit Bad debt Expense account and credit Allowance for doubtful account by Br.
25,500 (i.e., Br. 37,300 – Br. 11,800).
3) Debit Allowance for doubtful account and Credit Account Receivables – KUMSA PLC for Br.
8,250.
Exercise II:
1) Notes Receivables 38,500
Accounts Receivables 38,500
2) Interest Receivables 1,540*
Interest Revenue 1,540
9 4
(* Br.38,500  0.12    Br.3,465)
12 9
3) Cash 41,985
Notes Receivable 38,500
Interest Receivables 1,540
Interest Revenue 1,925*
9 5
(* Br.38,500  0.12    Br.1,925
12 9

131
REFERENCES
1. Donald E.Kieso,Weygandt,Warfield(2014),Intermediate Accounting IFRS
second edition ,Wiley and sons inc
Mosich and Larson, Intermediate Accounting, (6th Ed. McGraw-Hill co 1982)
2. Smith and Skausen, Intermediate Accounting: Comprehensive volume 5th ed. (South
Western pub.co.1984)

3. Ellia and Thacker, Intermediate Accounting,(McGraw Hill 1982)

4. Meigs and Others, Intermediate Accounting.4th Ed.
5. Simons, Arary, Intermediate Accounting (Standard Volume), 6th Ed. South
Western pub. co.
6. FASB, objective’s of Financial Reporting by Business Enterprise: statement of
Financial Accounting concepts No.1 (Stamford Nov.1978.)
7. FASB- Element of Financial Statements, Statement of Financial Accounting
concept No. 6 Stanford Dec 1995.
8. Ethiopian Financial Accounting and Reporting Proclmation 847/2014 and
Regulation no. 332/2014

132