Accounting 1

3
Accounting I
Editor
Prof.Dr. Saime ÖNCE
Authors
CHAPTER 1, 2 Asst.Prof.Dr. Soner GÖKTEN
CHAPTER 3 Dr. Pınar OKAN GÖKTEN
CHAPTER 4 Assoc.Prof.Dr. Arman Aziz KARAGÜL
CHAPTER 5 Assoc.Prof.Dr. Mustafa Gürol DURAK
CHAPTER 6 Prof.Dr. Nazlı KEPÇE
CHAPTER 7 Asst.Prof.Dr. Sezen ULUDAĞ
CHAPTER 8 Prof.Dr. Semra KARACAER

General Coordinator
Assoc.Prof.Dr. Murat Akyıldız
Graphic Design Coordinator

and Instructional Designer
Assoc.Prof.Dr. Halit Turgay Ünalan
Printing and Distribution Coordinator

T.C.
Asst.Prof.Dr. Murat Doğan Şahin
ANADOLU
UNIVERSITY
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PUBLICATION
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OPEN EDUCATION
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Accounting I
Hilal Özcan
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Eskişehir, Republic of Turkey, October 2018

3270-0-0-0-1909-V01
Contents
Accounting
CHAPTER 1 and Business CHAPTER 2 Recording Process
Environment
Introduction ................................................... 3 Introduction ................................................... 41
Accounting Information: Basic Activities and Accounts ......................................................... 41
Information Users ........................................ 3 Typical Asset Accounts ......................... 41
Basic Activities in Accounting Process .... 4 Typical Liability Accounts .................... 42
Information Users ................................. 5 Typical Owner’s Equity Accounts ........ 42
Ethical Behavior, Measurement Principles, Chart of Accounts ................................. 43
and Basic Assumptions ................................. 7 Ledger .................................................... 43
Standardization ..................................... 8 Debits, Credits and Double-Entry
Measurement Principles ....................... 9 Accounting System ........................................ 44
Basic Assumptions ................................ 10 The T-Account ....................................... 44
Basic Accounting Equation and Elements Debits and Credits ................................. 44
of Financial Statements ............................... 11 Double-Entry Accounting System ....... 45
Definition of Basic Accounting Increases and Decreases in the Accounts... 46
Equation ................................................ 11 Steps in the Recording Process ..................... 49
Elements of the Basic Accounting The Journal and Journalizing ............... 50
Equation ................................................ 13 Posting to Ledger .................................. 51
Effects of Financial Transactions on The Recording Process Illustrated:
the Accounting Equation ............................. 17 Case of TRApps ...................................... 53
Analyzing the Effects of Trial Balance .................................................. 62
Transactions: Case of Trapps ............... 18 Preparing a Trial Balance: Case
Financial Statements ..................................... 24 of TRApps .............................................. 63
Preparing the Financial Preparing Financial Statements from
Statements: Case of Trapps .................. 27 Trial Balance: Case of TRApps .............. 64
iii
Accrual
Completing the
CHAPTER 3 Accounting and CHAPTER 4
Accounting Cycle
Adjusting Process
Differences Between Cash Basis Preparing Financial Statements ................... 105
Accounting and Accrual Basis Accounting ...... 75 Classified Balance Sheet ....................... 107
Related Concepts and Principles Applied Closing Process and Closing the
to Accrual Basis Accounting ......................... 76 Accounts ......................................................... 109
Time Period Concept ............................. 76 Closing Entries for Revenue
The Revenue Recognition Principle .... 77 Accounts ................................................ 111
Matching Principle ................................ 78 Closing Entries for Expense
Adjusting Process and Adjusting Entries ..... 78 Accounts ................................................ 111
The Basics of Adjusting Entries ........... 78 Closing The Income Summary
Categories of Adjusting Entries ........... 79 Account .................................................. 112
Adjusting Entries for Deferred Post-Closing Trial Balance .................... 113
(Unearned) Revenues ........................... 83 Accounting Cycle ........................................... 114
Adjusting Entries for Accrued
Expenses ................................................ 84
Adjusting Entries for Accrued
Revenues ................................................ 85
Adjusted Trial Balance and Financial
Statements ..................................................... 87
Adjusted Trial Balance .......................... 87
Illustration for Adjusted Trial
Balance of TRApps Company ............... 88
Financial Statements ............................ 92
iv
Merchandising Merchandise
CHAPTER 5 CHAPTER 6
Operations Inventory

Merchandising Operations ........................... 123 Classifying Inventory .................................... 161
Operating Cycle for a Merchandising Inventory-Related Accounting Principles ... 162
Company ................................................ 123 Consistency Principle ............................ 162
Cost Flow for Merchandising Disclosure Principle ............................... 162
Companies ............................................. 124 Materiality Concept .............................. 162
What Accounting Information a Conservatism ......................................... 163
Merchandising Company Needs .......... 124 Inventory Costing Methods .......................... 163
Income Statement of a Inventory Accounting Systems ............ 163
Merchandising Company ...................... 125 Inventory Cost Flow Methods ............. 164
Inventory Systems ......................................... 126 Impact of Using Different Inventory
Accounting for Purchase Transactions in a Cost Flow Methods on Financial
Perpetual Inventory System ......................... 127 Statements ............................................. 170
Purchase Of Merchandising Inventory Valuation of Inventories ............................... 171
on Cash ................................................... 129 Impact of Inventory Errors on Financial
Fright in (Transportation Cost) ........... 130 Statements ..................................................... 173
Purchase of Merchandising Inventory Inventory Related Ratios Used in
on Account ........................................... 130 Decision Making ............................................ 174
Purchase Returns and Allowances ....... 131 Inventory Turnover Ratio .................... 174
Purchase Discount ................................ 132 Days’ Sales in Inventory ....................... 174
Accountıng for Sales Transactions in a
Perpetual Inventory System ......................... 134
Sale of Merchandise Inventory on
Cash ........................................................ 135
Sale of Merchandise Inventory on
Account .................................................. 136
Transportation for the Sold
Merchandise Inventory ........................ 137
Sales Returns and Allowances .............. 138
Sales Allowances ................................... 139
Sales Discounts ...................................... 139
Net Sales Revenue, and Gross Profit... 140
Closing Entries for Merchandising
Companies ...................................................... 141
Closing Entries for The Buyer .............. 141
Closing Entries for The Seller ............... 142
Appendix: Periodic Inventory System ......... 144
Accounting for Purchase Transactions ........ 144
Purchases on Discount ......................... 144
Transportation ...................................... 145
Purchase Returns .................................. 145
Purchase Allowances ............................ 146
Payment of Liability ............................. 146
Accounting for Sales Transactions ............... 147
Transportation ...................................... 147
Sales Returns ......................................... 148
Sales Allowances ................................... 148
Collection of Receivable ....................... 148
Closing Entries in the Periodic Inventory
System ............................................................ 149
v
Internal Control
CHAPTER 7 CHAPTER 8 Receivables
and Cash

Internal Control ............................................. 189 Receivables ..................................................... 221
Definition of Internal Control .............. 189 Accounts Receivable ...................................... 222
COSO Framework ................................. 191 Recognition of Accounts Receivable ... 222
Fraud ............................................................... 195 Sales Returns and Allowances .............. 223
Types of Fraud ....................................... 196 Trade Discounts .................................... 224
Fraud Triangle ....................................... 197 Cash Discounts ...................................... 224
Internal Control Over Cash Receipts Valuation of Accounts Receivables ..... 225
and Payments ................................................ 198 Uncollectıble Accounts Receivable
Internal Control Over Cash Receipts.... 199 (Bad Debts) .................................................... 226
Internal Control Over Cash Payments..... 199 Allowance Method ................................ 226
The Bank Account as a Control Device ........ 203 Direct Write-off Method ...................... 232
Bank Statement .................................... 204 Disposing of Accounts Receivable ............... 233
Bank Reconciliation .............................. 205 Selling Receivables ............................... 233
Reporting Cash and Using Cash Ratio ......... 207 Credit Card Sales ................................... 234
Reporting Cash ...................................... 207 Debit Card Sales ................................... 235
Cash Ratio .............................................. 208 Analyzıng the Accounts Receivable ............. 235
Notes Receivable ........................................... 237
Determining the Maturity Date .......... 238
Recognition of Notes Receivable ....... 238
Valuation of Notes Receivable ............ 239
Disposition of Notes Receivable .......... 239
vi
Preface
Dear reader,
With the growing complexity of business, accounting definitions of asset, liability,
it has become essential that everyone who owner’s capital, revenue, income, cost and
desires to a position of responsibility in the expense etc. You’ll also need to understand the
businesses should have a knowledge of the structure and appreciate the purpose of the
basic principles of accounting. To understand basic financial statements. Chapter 2 focuses
and to be effective in business, you have on record-keeping vocabulary and processes
to understand the financial matters of a and uses T-accounts and journal entries as
business. An accounting course will be helpful tools for recording transactions in accounting
you to understand the fundamental financial books. Chapters 3 and 4 discuss the accounting
matters of businesses. Accounting is called cycle with adjusting and closing entries, and
as the language of business. So, knowing the preparation of the related trial balances to
fundamentals of accounting will be helpful generate the financial statements.
you to understand what is happening in the Today, financial accounting students should
business whether it is a large international learn more than how to prepare financial
company or a single owner small company. statements; they also need to learn how to
You do not need to become an accountant, find meaningful information in them. This
but you should do “speak the language”. Financial Accounting book is intended to
In this textbook, therefore, we will cover the teach students to do just that. Chapter 5 and
fundamentals of financial accounting. This 6 deepens the merchandise inventory related
book is intended to be an introductory and matters. Chapter 7 discusses cash and cash
fundamental source for business students equivalents. Chapter 8 presents receivables
at all levels with a desire to learn about the related issues.
fundamentals of accounting. As you continue While maintaining a solid foundation in
your studies in accounting, you will realize double-entry accounting, we aimed to reduce
that why accounting is vital for any type of complexity by eliminating some details in
business. This book comprises 8 chapters and journal entries and all nonessential procedural.
all chapters are tiers, or steps, in the learning
process. The chapters and of course the A successful textbook is a collaborative effort,
contents are interrelated. When you move many people helped make this book possible.
from one chapter to another please keep this We are grateful to them. We hope that this
in your mind. you will make important holistic book will be satisfactory to the students as
and analytical connections about what well as all interested readers for educational
constitutes the best accounting practices by and training purposes.
using this chapter-by-chapter learning. Great success in this course! Read on and
First of all, we present a general overview of enjoy!
the principal financial statements and basic
transactions recording and financial statement
preparation. We use the business activities and The Book Team
the financial statements of TRApps Company Editor
to illustrate the important terms and concepts.
Many students feel overwhelmed with the Prof.Dr. Saime Önce
new terms and concepts after reading just
Chapter 1. The specialized vocabulary can
be confusing. You will need to learn the
vii
Accounting and Business
Chapter 1 Environment
After completing this chapter, you will be able to;
Learning Outcomes
1 Identify the activities and information users

associated with accounting 2 Explain the ethical behavior, measurement
principles and basic assumptions
3 4
Describe the accounting equation and
understand the elements of financial Analyze the effects of financial transactions on
statements the accounting equation
5 Describe and prepare the basic financial

statements
Key Terms
Accounting Process
Chapter Outline Assets
Introduction Balance Sheet
Accounting Information: Basic Activities and Bookkeeping
Information Users Communication
Ethical Behavior, Measurement Principles, and Expenses
Basic Assumptions Income Statement
Basic Accounting Equation and Elements of Information Users
Financial Statements Liabilities
Effects of Financial Transactions on the Accounting Owner’s Equity Statement
Equation Owner’s Equity
Financial Statements Recording
Revenues
Statement of Cash Flows
Financial Transactions
2
Accounting I
INTRODUCTION
You have heard the term “accounting” and probably you have heard that students generally do not like
accounting courses. They usually think that accounting is not related with their career plans. On the other
hand, learning accounting is not needed for only making an accounting career. According to real business
environment, all students of administrative sciences need to know accounting. Because, you have to read
financial statements and understand the meaning of accounting numbers in order to know your business
and make effective and efficient decisions. Accounting is a complex and sophisticated task. It is critical to
success and gaining competetive advantage for any type of organizations.
For example, let’s say that you want to work as a human resources expert. How can you be able to design
employee benefit packages without knowing the financial capacity of the firm? In short, it is impossible.
Individual decision makings also need accounting. Accounting is one of the most important aspects of
being financially literate which refers the knowledge, skills, and confidence to make responsible financial
decisions. Therefore, without knowing the meanings of accounting numbers, you cannot define yourself
as financially literate. For example, it is clear that you will make lots of decisions as an investor in your
life. How can you be able to make a decision on buying or selling a stock without knowing the financial
capacities of potential firms? In short, it is impossible again.
We can increase the numbers of examples to explain why you need to know accounting. In all cases
you will reach the same conclusion: Knowing accounting is must to make an effective and efficient decisions!
In this sense, it is fair to say that accounting which produces financial statements is the most important
system to inform information users. The knowledge of accounting is used every day to help people make
business decisions.1
This course -Financial Accounting– concentrates on the way of producing and reporting financial
information. Therefore, we will not focus on reporting nonfinancial information in this course. Please
note that reporting of nonfinancial information is subject of sustainability accounting. Accordingly, as a
first step, you will learn how to read and prepare financial statements by analyzing the effects of financial
transactions on the basic accounting equation in this chapter.
ACCOUNTING INFORMATION: BASIC ACTIVITIES AND INFORMATION

USERS
What is the role of accounting in business? The simplest answer to this question is that accounting
provides information for owners or managers to use in operating the business. Operating a business requires
many kinds of information and decisions such as inventory volume, pricing, number of employees, amount
of capital etc. These decisions produce financial results which are critical to understand the performance
and the financial situation of businesses. Therefore, keeping track of financial transactions is one of the
main essential issues for the organizations in order to make effective and efficient decisions.
On the other hand, owners are not the only users of financial information. For instance, think about
your career planning. What kind of company you want to work for? Free from any doubt, you desire to
work in a company with sustainable growth which means that you can effectively manage your career
and gain more benefits. Financial information of the companies again plays the sig role in such a decision
making. In short, understanding what is happening in organizations requires to know the meanings of the
accounting numbers. So, accounting is called as “the language of business”.
In a general sense, Accounting is an information system which provides financial information about
the entity for decision makers. This system includes three kinds of basic activities which are identifying,
recording and communicating of the financial transactions of an entity. In the following subsection, we
take a closer look on these activities.
3
Accounting and Business Environment
Accounting is an information system which

Accounting is an information system that: provides financial information about the
• Identify business activities, entity for decision makers. This system
• Record the business transactions and, includes three kinds of basic activities
• Communicates the results to decision which are identifying, recording and
makers communicating of the financial transactions
of an entity to interested users
Figure 1.1 Accounting is an Information System
Basic Activities in Accounting Process

The first step of the accounting process consists of identifying the financial transactions related
with the organization. The sale of a table by a furniture shop, the payment of wages or the provisions for
services are the examples of financial transactions. Once these kinds of financial transactions are realized
and identified in Turkish Liras or in another currency, these events are recorded to provide the history of
financial activities of the organization. Recording is a systematic way of keeping chronological diary of
events measured in monetary unit. At the last step, company communicates the summarized information
obtained from the records to decision makers (information users) by using standardized reports which are
called financial statements.
Standardization makes the reported financial information meaningful and comparable because they
enable organizations to accumulate information of similar transactions. For example, all sales transactions
over a certain period of time are reported as total amount in the financial statements of the company.
Aggregation of the recorded data of similar transactions simplifies the presentation of transactions and
makes the history of activities understandable. Also summarizing the recorded data by aggregation in
financial statements increases the efficiency for analyzing and interpreting of reported information. Analysis
of financial statements includes using of tools such as ratios, analytical procedures, graphs etc. in order to
stress the financial trends and relationships while interpretation involves the meaning and limitations of
reported data. In this sense, aggregation is a concentrate effort on presenting recorded data by classifying
similar transactions in the same group.
4
Accounting I
Identifying includes selecting financial transactions.

Recording includes recording, classifying, and summarizing.
Communicating includes preparing financial reports.
Figure 1.2 illustrates three basic activities of accounting process.
Economic transaction Bookeeping Financial statements
Identification Recording Communication
Figure 1.2 Activities of Accounting Process
As seen in the illustration, accounting process includes the bookkeeping function. Bookkeeping is
an accounting action that usually refers only keeping of the chronological diary of financial transactions
while the concept of recording includes classifying and measuring as well. Accordingly, recording plays a
connective role between identification and communication activities and so refers a set of actions includes
bookkeeping, classifying and measuring. In total, accounting process involves a process of identification,
recording and communication of financial transactions.
Bookkeeping is an activity or occupation of

The accounting process includes the
keeping records of the financial transactions.
bookkeeping.
Information Users
Who uses accounting numbers? To answer that question, the accountant must be clear for whom
the information is being prepared and for what purpose the information will be used. There are likely to
be various information users such as owners, managers, creditors, suppliers etc. You should understand
the needs of users because information users focus on different financial information according to their
relevant decision making issues. The best way of explaining the needs on financial information is to make
a classification of potential users. Two main groups of information users are internal users and external
users. We can also classify accounting as Managerial Accounting and Financial Accounting according to
this classification of information users.
Internal Users
Managers of a company who plan, organize, and run the business are the most important group of
internal users. Managers have different roles and these roles determine the main needs for using financial
information. For example, one of the most important decisions made by a marketing manager is pricing
of goods and services. To make such a decision, marketing managers should know the total production
5
cost. Therefore, accounting plays an important role to provide this financial information to marketing
manager. In addition, internal users can also need some detailed information which is not ready to use in
basic and standardized financial statements. In these cases, managerial accounting procedures are applied
to produce internal reports to help internal users in their decision making process. In Figure 1.3 you can
find some other examples on the needs of internal users
and understand the way of using financial information
according to questions raised. Managers are internal information users.
Which product line is the Can we afford to raise

most profitable? minumum wage?
What price should be

What is the capital cost
charged in order to
of the company?
maximize net income?
How many products we
Do we have enough cash
need to sell to catch
to pay dividends?
break even?
Figure 1.3 Financial Information Needs of Managers
External Users
There are several types of external users and they can be individuals or organizations outside a company
such as investors, creditors, taxing authorities, government, customers, suppliers etc. The primary external
users are investors and creditors, because they have a direct financial interest in a business.
Investors’ decisions represent the expectations derived from cumulative beliefs that include past
experiences and formation of recent reasonable differences in prior beliefs2. In this sense, announced
accounting numbers as quantized signals play an important role on changes in beliefs which shape
the investors’ actions in the market. In other words, investors buy or sell stocks based on changes in
financial health or performance of firms which become
clear by recently announced financial information. On the
other hand, creditors use financial information to analyze
The primary external users are investors and
the company’s ability to fulfill its obligations. Therefore,
creditors.
financial information is the main tool for creditors to
evaluate the risks of lending money. In addition to investors
and creditors, government is also an important external user of financial information. Financial information
is used in tax base calculation and also they provide information to understand whether the company
complies with tax laws. In conclusion, financial accounting is the main tool to answer the questions asked
by external users. In other words, financial accounting provides information about the business entity to
external information users. This book focuses on financial accounting.
6
Accounting I
Don’t forget that, financial accounting provides financial information to meet the
information needs of external information users. Managerial accounting provides financial
information to meet theinformation needs of managers.
1
Identify the basic activities of accounting and give examples for users of financial information.
ETHICAL BEHAVIOR, MEASUREMENT PRINCIPLES, AND BASIC

ASSUMPTIONS
Since the financial information plays a critical role in decision making, the financial information must
be sufficient, useful, and understandable. Like other professions accounting also has a theory consisting of
principles, assumptions and standards. Therefore, accountants follow certain rules, principles, assumptions,
and standards in financial accounting process. Beside the specific rules, the quality of financial information
primarily depends on ethical behavior of individuals. Therefore, ethical behavior has a primacy in
accounting process. In other words, without ethical behavior, standards become inadequate to provide
effective financial statements.
Ethics are the humanly devised rules, procedures, and
norms to judge one’s action as right or wrong, honest or Ethics are the humanly devised rules,
dishonest, and fair or not fair. In this sense, identifying procedures and norms to judge one’s action
one’s action as ethical, it must be right, honest and fair. as right or wrong, honest or dishonest and
Actions—whether ethical or unethical, right or wrong— fair or not fair.
are the product of individual decisions. 3
The rightness of an action generally depends on the skills and knowledge of the accountant. In
other words, the possibility of making a mistake, for instance in classifying or measurement of financial
transactions, will be low if the accountant of a company has sufficient skills and knowledge. Therefore,
accounting profession is one of the most important professional groups in society, and so accountants
are legally subject to a set of procedures in their career. For example, certified public accountant refers a
professional who has earned a designation through a combination of education, experience and licensing.
In this sense, it is fair to say that companies can decrease the level of mistake by employing a certified
public accountant instead of employing an uncertified accountant.
Honesty refers to a facet of moral character. It also represents the rightness of an action but this concept
differs due to the source of behavior. Dishonesty involves intention. Intention refers an action which is
planned to carry out. In this sense, intended actions lead to anticipated outcomes. Therefore, if the wrong
situation is derived by intended action, the behavior becomes dishonest.
Let’s say, the finding of an audit report for a company indicates that the balance amount of sale
transactions in a given period doesn’t reflect the real situation. In this sense, a correctable mistake in
calculation can be the reason of the wrong result and if it is, it is not possible to say that there is a dishonest
behavior. By contrast, if the company uses a fake invoice to increase the total sale amount which is an
anticipated outcome, the accounting action involves an intended behavior. In this case, the behavior is
7
evaluated as dishonest and also can be a subject for criminal law. Therefore, please note that, the wrong
situation cannot always reflect a dishonest behavior. Accordingly, the way of the punishment of wrongs
must be fair. In short, ethical behavior involves right, honest and fair action. Ethics is especially important
in preparing financial reports because users of these reports must depend on the good faith of the people
involved in their preparation. Fourtunately the vast majority of accountants do their jobs ethically and their
actions are both legal and responsible. Effective financial reporting depends on sound ethical behavior.
2
What is ethics? Why ethical behavior has a primacy in accounting process?
Standardization
Accounting standards are a set of principles and rules that companies follow when they prepare and
publish their financial statements, providing a standardized way of describing the company’s financial
performance4. Many countries except United States have adopted the accounting standards issued by
International Accounting Standards Board (IASB) which is a not-for-profit, public interest organization
established to develop a single set of high-quality, understandable, enforceable and globally accepted
accounting standards called International Financial Reporting Standards (IFRS). As of the end of
2017, 126 countries now require the use of International
Financial Reporting Standards for all or most publicly listed
companies, whilst a further 12 countries permit its use. On
the other hand, The Financial Accounting Standards Accounting standards are a set of principles
Board (FASB) is the primary accounting standard-setting companies follow when they prepare and
body in the United States and issues Financial Accounting publish their financial statements, providing
Standards that are called Generally Accepted Accounting a standardized way of describing the
Principles (GAAP) which is a common set of standards company’s financial performance.
used by accountants in United States.
From past to present, globalization has created a need to compare financial statements of companies
from different countries. In this sense, especially in recent years, these two standard setting bodies have
worked on reducing the differences between GAAP and IFRS in order to increase the comparability of
financial statements. As a result of convergence process, except some major differences (for example it is
fair to say that IFRS is more principle-based while GAAP is more rule-based in accounting and disclosure
requirements), today GAAP and IFRS become nearly similar. For example, the IFRS 15 Standard was
jointly prepared and published by FASB and IASB. Maybe, in the future, there will be single global
accounting standards that are used by the all countries in the World.
internet
Many countries except United States have Public Oversight Accounting and Auditing
adopted the International Financial Standards Authority (KGK) of Turkey http://
Reporting Standards (IFRS) issued by www.kgk.gov.tr
International Accounting Standards Board International Accounting Standards Board
(IASB). http://www.ifrs.org
8
Accounting I
Measurement Principles
Measurement refers the valuation (determination of
the monetary amount subject to recording) of assets and
Measurement refers to the valuation of assets
liabilities in accounting process. Standards generally use
and liabilities in accounting process.
one of two main principles in measurement: Historical
cost principle or fair value principle.
Assets are recorded at their cost when acquired by the company and this value stays same over the
time according to the historical cost principle. On the other hand, the fair value principle dictates that
assets and liabilities should be reported at their fair values. Simply, fair value refers 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. Therefore, contrary to historical cost principle, the recorded monetary amount
of the asset should be revalued at reporting date according to the fair value principle.
Let’s say, a company purchases a land for 500,000 TL. In initial accounting, the company records the
land at 500,000 TL. But, if the value of the land increases to 550,000 TL how will the company report
the value of that land in its financial statements at the end of the year? There are two options. In the first
option, under historical cost principle, company will continue to report the value of the land at 500,000
TL. In the second option, if company chooses to apply fair value principle, the reported value of the land
will be 550,000 TL.
The historical cost principle states that assets are recorded at their cost.
The fair value principle states that assets and liabilities are reported at their fair value.
The relevance of fair value and necessity of faithful representation are the main factors used in
determining which measurement principle to apply. Relevance refers the impact capacity of financial
information generated by an accounting system on the decisions of information users. Therefore, relevance
also contains materiality concept which is the universally accepted accounting principle that all material
matters are to be disclosed.
Faithful representation means the factuality
of financial statements. In other words,
Selection of which principle to follow generally accounting numbers and descriptions presented
relates to trade-offs between relevance and faithful in the financial statements should represent
representation. what really existed and happened during a given
period.
Effective financial reporting aims to provide faithful representation, and so the level of the relevance of
accounting information affects the factuality of financial statements. In this sense, fair value principle may
be more useful than historical cost. On the other hand, reporting of fair values could not be convenient for
certain types of assets and liabilities. Namely, if there is a lack of efficient market condition which prevents
to obtain a market price realized through an orderly transaction for underlying asset or liability; historical
cost principle can be more appropriate in order to provide faithful representation. In other words, most of
companies choose to apply historical cost principle except for the situations where assets are actively traded
in an efficient market such as investment securities.
9
Relevance refers the impact capacity of financial information on the decisions of

information users.
Faithful representation means that the numbers and disclosures match what really
existed or happened.
Basic Assumptions
Assumptions provide the main conceptual frame of accounting information system. In general, as a
basic step, we have to be aware of some basic assumptions to understand the nature of accounting activities.
The main assumptions that will be explained for the beginning are the monetary unit assumption, the
economic entity assumption, and the going concern assumption.
Monetary Unit Assumption

The monetary unit assumption requires that financial transactions can only be recorded if the
transaction data can be expressed in terms of money. In other words, monetary unit is an accounting
concept which assumes that business transactions or events can be measured and expressed in terms of
monetary units and the monetary units are stable and dependable. Therefore, the existence of monetary
unit assumption enables accounting to measure financial transactions and so the assumption creates a
common language which states that accounting numbers represent the monetary amounts of financial
transactions. At first glance, you can think that since
accounting numbers only represent the events that can be
measured in money, this assumption may prevent to report
some relevant information such as the education level of the The monetary unit assumption requires that
employees, prospected projects etc. However, these kinds of financial transactions can only be recorded
information are not the subjects of financial accounting. if the transaction data can be expressed in
Therefore, the monetary unit assumption does not cause money terms.
any decrease in the quality of financial information.
Economic Entity Assumption

Business transactions of the entity are separated from the owner’s personal transactions. So, the economic
entity assumption requires that the financial transactions of the entity be recorded separate from the
economic activities of its owner and all other economic entities. An economic entity is an organization
that stands apart as a separate economic unit. Basically,
any organization or unit in society can be an economic
entity. For accounting purposes, a business is a separate
The economic entity assumption requires
entity, distinct not only from its creditors and customers
that the financial transactions of the entity
but also from its owners.
should be recorded separately from the
In general, there are three basic forms of business economic activities of its owner and all other
enterprises: Sole roprietorship, partnership and economic entities.
corporation.
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Accounting I
A sole proprietorship is a business owned and run by one person. They are often small type businesses
(e.g. auto repair shops, used-books stores etc.). Usually a small amount of capital is needed and the owner
is entitled to all profits. The owner is also personally responsible for all debts and liabilities of business.
In short, there is no distinction between the business and its owner, but the accounting records of the
business activities are kept separate from the personal records of its owner.
A partnership is a form of business where two or more people share ownership. In other words,
partnership refers a business owned by two or more persons associated as partners. The difference of
partnership from the proprietorship occurs in distribution of the rights which depends on the partnership
agreement, such as division of net income. On the other hand, generally, each partner still has unlimited
responsibility for all business’s debt. Like a proprietorship, the accounting records of the business activities
are kept separate from the personal records of its partners.
A corporation is a large company or group of companies authorized to act as a single entity and
recognized as such in law. The ownership is divided into transferable shares of stock. In other words,
shareholders can sell part or all of their stocks to other investors at any time. Therefore, the business with
corporate structure is fully separate and distinct from its owners (shareholders or stockholders). In this
sense, shareholders enjoy limited liability which means that owners of corporation are not personally
liable for the debts of the entity. The accounting records of the entity are kept separately according to the
economic entity assumption.
The Going Concern Assumption

The going concern assumption assumes that the business entity will remain in operation forever. Under
the going-concern concept, unless there is evidence to the contrary, accountants assume that the business
will remain in operation long enough to use existing assets for their intended purpose. Of course, many
businesses do fail and go bankrupt, but in general, it is reasonable to assume that the business will continue
operating. Because going out of business is the exception rather than the rule. Only when liquidation of
the business appears likely the going concern assumption will become inappropriate.
BASIC ACCOUNTING EQUATION AND ELEMENTS OF FINANCIAL

STATEMENTS
The accounting equation is the basic accounting tool to measure the economic resources of the business
and the claims to those economic resources. The basic elements which reflect the financial situation of
businesses are the assets that the entity owns and the sources which are used to finance these assets.
Definition of Basic Accounting Equation

The basic accounting equation provides the underlying framework for recording and summarizing
the financial transactions of a business entity. It shows the relationship among assets, liabilities, and owner’s
equity. Assets are on the left side of the equality while liabilities and owner’s equity are on the right side
of the equality. But the left side of the equality will alvays be equal to the right side of the equality. For
example, think about a company has total assets of 100 million TL. There are two options to finance these
assets. First one is using owner’s equity which refers the claims of owners. The second one is liabilities
which refers the claims of creditors. In normal business life, the efficient way of financing total assets is to
use both owner’s equity and liabilities.
If it is assumed that the company has used liabilities and owner’s equity to finance 60% and 40% of its
total assets respectively, we must understand that the company has liabilities of 60 million TL and owner’s
equity of 40 million TL. This relationship can be expressed by using a simple equation which is called the
basic accounting equation as shown in Figure 1.4.
11
Assets = Liabilities + Owner’s Equity
Figure 1.4 The Basic Accounting Equation
In the basic accounting equation, assets must always equal the sum of liabilities and owner’s equity. The
order and position of the assets, liabilities, and owner’s equity in the equation does not reflect a random
situation. Assets are always showed on the left side of the equation while liabilities and owner’s equity are
always showed on the right side of the equation. The logic of this positioning creates the background of
using debits and credits in recording process which is explained in Chapter 2. Also the reason of writing
liabilities before owner’s equity in the basic accounting equation is to stress that claims of creditors have
priority of the claims of owners. In other words, liabilities are paid first if a business is liquidated. Also,
please note that, the accounting equation applies to all economic entities regardless of size, nature of
business, or form of business organization.
The basic accounting equation shows the

relationship of assets, liabilities, and owner’s Assets must equal the sum of liabilities and owner’s
equity. equity.
Figure 1.5 In the Basic Accounting Equation, Assets must Always Equal the Sum of Liabilities and Owner’s Equity.
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Accounting I
Elements of the Basic Accounting Equation

As shown in the basic accounting equation, there are three elements which reflect the financial situation
of an organization: Assets, liabilities, and owner’s equity.
Assets
Assets are economic resources controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity. In short, assets are economic resources a business owns
and assets will provide future services or benefits.5 Examples for assets are Cash, Supplies, Merchandise
Inventory, Furniture, Land, Buildings, Equipments etc. They are identified as economic resources because
business uses assets to carry out its related activities. For example, a company needs a factory building and
machines to produce goods and a store to sell them. Also raw materials and supplies which are needed to
start production become assets of the company when they
are acquired. Therefore, the level of the assets determines
the capacity of the business to provide future services or Assets are economic resources that are
benefits. Please note that, the results of future services and expected to benefit the business in the future.
benefits eventually occur as cash inflows.
Figure 1.6 Assets are Economic Resources
Liabilities
Liabilities are defined as a present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow of the entity’s resources6. In other words, liabilities are claims
against assets as existing debts and obligations. In this sense, for example, if a company borrows money
from a bank to purchase a machine or purchases merchandise, this borrowing will create a liability for the
company. Please note that, there are various sorts of liabilities as well as assets. For instance, purchasing raw
materials on credit without debt security from suppliers creates an obligation called “accounts payable”.
If a business does not fulfill its obligations, creditors have legal right to force the liquidation of a business.
Because, as stressed in the definition of basic accounting equation, the law requires that claims will be paid
before ownership claims.
13
Figure 1.7 Liabilities are Existing Debts of Company
Many liabilities have the word “payable” in their Liabilities are debts that are owed to creditors.
titles such as Accounts Payable, Notes Payable, Liabilities are claims of creditors against to
Salaries and Wages Payable, Rent Payable. assets of the company.
Owner’s Equity
The owner’s claims to the assets of the business are called
Owner’s equity. Owner’s equity is the total assets of an
entity, minus its total liabilities7. This represents the capital
theoretically available for distribution to shareholders. In Owner’s equity is the owner’s claims to the
other words, owner’s equity is the reminder claims on assets
assets of the business
after creditors’ claims. Therefore, as the owner’s equity
refers the ownership claims on total assets and the claims
of creditors have to be paid before ownership claims, the
owner’s equity is also called as residual equity.
Increases and Decreases in Owner’s Equity

There are four main factors which increase or decrease the level of owner’s equity: Contributions by
owner(s), distributions to owner(s), revenues and expenses.
The basic type of contributions by owner is invested capital by owner which refers the funds invested
in a business during its life by shareholders (owners). These funds are the assets that owners put into the
business. These kinds of financial transactions increase owner’s equity and are recorded as owner’s capital.
Owner’s drawings for personal use refer distributions to owner in general and the basic type of
distributions to owner is paying dividend (profit sharing). These kinds of financial transactions decrease
owner’s equity and are recorded in a category called owner’s drawings.
Contributions by owner are the assets put in Distributions to owner are withdrawals of cash or
the business by the owner. other assets by the owner for personal use.
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Accounting I
Revenue is the gross inflow of economic benefits

during the period arising from the course of the
ordinary activities of an entity when those inflows
result in increases in equity, other than increases
relating to contributions from equity participants8.
In other words, revenues are earnings that result
from delivering goods or services to customers. In
this sense, revenues are the gross increase in owner’s
equity resulting from business activities entered into
for the purpose of earning income. For examples,
selling goods (sales), performing services (fees),
lending money (interest), leasing machine (rent)
all create revenues for a given period. As shown in
brackets, the sources of the revenues can differ due
the nature of the related activity, and therefore they
can be recorded in different categories such as sales
revenues, service revenues, interest revenues, rent
revenues etc. In short, revenues reflect the financial Figure 1.8 Revenues are the gross increase in owner’s
performance of activities, and usually result in an equity resulting from business activities
increase in an asset.
Expenses are decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating
to distributions to equity participants9. In other words, expenses are the cost of assets consumed or services
rendered in the process of earning revenue. For example, to earn revenue by selling a good, company needs
to consume raw materials, supplies, labor, energy etc. which determine the production cost. Therefore,
expenses decrease owner’s equity. Like revenues, expenses are recorded in different categories according to
their nature. For instance, salaries of salespersons are recorded as marketing, sales and distribution expenses
while the energy expenses of administration building are recorded as general administrative expenses.
Revenues are the gross increase in owner’s Expenses are the cost of assets consumed or
equity resulting from business activities entered services rendered in the process of earning revenue.
into for the purpose of earning income.
Figure 1.9 Expenses Will Reduce the Owner’s Equity
15
The net effect of revenues and expenses on owner’s equity occurs by calculating the net income or loss.
Net income results when revenues exceed expenses and loss results when expenses exceed revenues. In this
sense, net income increases owner’s equity while loss decreases owner’s equity. Therefore, net income or loss
is the financial result of the performance of a business in a given period.
Net income
The net effect of revenues and expenses on owner’s Revenues > Expenses
equity occurs by calculating the net income or loss. Loss
Revenues < Expenses
In summary, owner’s equity is increased because of contributions by owner and revenues while is
decreased because of distributions to owner and expenses. Please note that instead of using revenues and
expenses separately to identify the effects of business operations on owner’s equity, we can directly use net
income or net loss. Figure 1.10 shows the effects of these factors on owner’s equity.
Owner’s Equity = + Contributions by Owner - Distributions to Owner +- Net Income/Loss
Net Income/Loss = + Revenues - Expenses
Owner’s Equity = + Cont. by Owner - Dist. to Owner + Revenues - Expenses

Figure 1.10 Increases and Decreases in Owner’s Equity
Expanded Version of Basic Accounting Equation

Identifying the factors increase or decrease the level of owner’s equity enables us to expand the basic
accounting equation. By expanding the equation, we can understand that the accounting equation involves
revenues and expenses as well in addition to assets, liabilities and, owner’s equity. Figure 1.11 presents the
expended version of the basic accounting equation.
Basic Accounting Equation Assets = Liabilities + Owner’s Equity
Expanded Version Assets = Liabilities + Contributions – Distributions + Revenues - Expenses
Figure 1.11 Expanded Version of Basic Accounting Equation
Expanded version of the basic accounting equation indicates that elements of financial statements are
assets, liabilities, owner’s equity, revenues and expenses. In other words, these are the main elements of
financial statements which show the financial situation (assets, liabilities and owner’s equity) of a business
in a given date and the financial performance of operational effectiveness (revenues and expenses) of a
business in a given period of time. Please note that, since the net income or loss represents the result of
financial performance of operational effectiveness in terms of revenues and expenses of a given period, net
income or loss is also called as the bottom line of accounting.
State the accounting equation, and define the elements of financial statements.
16
Accounting I
EFFECTS OF FINANCIAL TRANSACTIONS ON THE ACCOUNTING

EQUATION
Financial transactions are business’s economic events recorded in accounting books. A financial
transaction is any event that affects the financial position of the business and can be measured with
faithful representation. Transactions may be identified as either external or internal transactions.
External transactions are realized between the company and a third party (an outside enterprise). Sale
of goods to customers is an example of external transaction.
Internal transactions refer financial transactions which occur entirely within one company. The use or
consume of raw materials for the production is an example of internal transaction.
As noted before, according to the monetary unit assumption, financial transactions can only be
recorded if the transaction data can be expressed in money terms. Therefore, activities that do not represent
business transactions or cannot be expressed in money terms such as hiring qualified and skilled employees
or making a meeting with customers cannot be evaluated as transactions which are subject to recording.
Accordingly, only business transactions which can be expressed in money terms show effects on the items of
accounting equation. Therefore, accountants must analyze each economic event before recording whether
it suits the monetary unit assumption and affects the items of accounting equation. This process is called
as identification of transaction.
In identification of transaction, accountant must ask the following question: Can economic event be
expressed in money terms? If the answer is ‘no’, there is no need to record the event. If the answer is ‘yes’, that
means that the transaction based on the economic event affects some of items in accounting equation. After
that the accountant must identify the items affected and determine the amount of the change in each item.
Are the following events recorded in the accounting records?

Event Purchase an equipment Discuss product design Pay interest
with employee
Criteria Is the financial position (assets, liabilities, or owner’s equity) of the company
changed?
Yes No Yes
Record or
not
Figure 1.12 Identification of Transaction
Identification of transaction includes analyzing of

The financial transactions of the business are each transaction in terms of its effect on the items of the
recorded by accountants. accounting equation, identifying the specific items affected
and determining the amount of the change in each item.
Item refers the categories under the elements of accounting equation. For example, cash, accounts
receivable or equipment are the items of assets while assets is one the elements of accounting equation.
17
Each transaction has two aspects and both of them will affect
the statement of financial position. So, each transaction has a dual
effect on the accounting equation. Dual effect means that at least
two items must be affected by a transaction and accounting equation
has to remain in balance after making the changes in accounting
equation. Accordingly, if an asset item is increased, there must be a
corresponding decrease in another asset item, or increase in a liability
item, or increase in owner’s equity item in the same amount. For
example, a company makes collection of 100,000 TL receivables.
In this transaction the cash which is an asset item is increased
100,000 TL while the accounts receivable which is another asset
item is decreased 100,000 TL. In the end, the accounting equation
remains in balance. In the following subsection, we take a closer Figure 1.13 Each Transaction Has
look on transaction analysis to demonstrate how to analyze the a Dual Effect on the Accounting
effects of transactions on the accounting equation. Equation.
Analyzing the Effects of Transactions: Case of TRApps

In this part, the way of analyzing is demonstrated by using a set of business activities of a company titled
TRApps which is established by Kaan Can, an entrepreneur who wants to develop mobile applications.
There are ten transactions realized during January of 2018 and we will follow the effect of each transaction
is mentioned below step by step.
Transaction 1: Contributions by Owner.
On January 1, 2018, Kaan Can as an owner of company invests 10,000 TL into the business to
establish a company titled TRApps which is a mobile application development company.
This economic event involves initial investment by owner and it is clear that the transaction can be
expressed in money terms. In this sense, we have to determine at least two items related with the transaction
and the equality of the accounting equation must be provided according to dual effect criteria. Since the
activity involves investment of capital by owner, this transaction increases the owner’s equity. Please note
that, investment does not represent revenues. Accordingly, the right side of the equation increases 10,000
TL. Since the investment is made for cash, the cash item of the assets increases 10,000 TL as well.
In conclusion, after the transaction the equation becomes;
Transaction 2: Purchasing Equipment for Cash.

On January 2, 2018, TRApps purchases a computer to use in the company by paying 4,000 TL for cash.
The computer equipment will be used to carry out related activities in the company. Therefore, it is an
asset for the company. In this sense, the equipment item of the assets increases 4,000 TL and so there must
be a corresponding decrease in the left side or increase in the right side of the accounting equation. Please
note that, paying of 4,000 TL for cash does not represent expenses. Because there is no any consumption
18
Accounting I
yet, in other words this transaction only involves acquiring of the asset. Accordingly, the transaction results
in an equal decrease in cash item of the assets which means a change in the composition of assets.
After the transaction the equation becomes;
Transaction 3: Purchasing Supplies on Credit.

On January 8, 2018, TRApps purchases computer accessories from ABC Computer Store on credit,
agreeing to pay 1,000 TL in 30 days. The liability created by purchasing “on credit” is an Accounts Payable.
Assets increase 1,000 TL because TRApps expects to provide future benefits by using these accessories.
Therefore, there must be a corresponding decrease in the left side or increase in the right side of the
accounting equation. Liabilities are claims against assets as existing debts and obligations. Since purchasing
assets on credit without debt security creates an obligation, accounts payable item of liabilities increases
1,000 TL as well according to that transaction.
As you see, the total assets amounted 11,000 TL. This amount is matched by a 1,000 TL creditors’
claim and a 10,000 TL ownership claim.
Transaction 4: Earning Service Revenue for Cash.
On January 11, 2018, TRApps receives 3,000 TL cash from its client for mobile application development
service has performed.
Revenues results of business activities for the purpose of earning income and increase owner’s equity.
So, there must be a corresponding increase in the left side or decrease in the right side of the accounting
equation. Since there is an amount of cash received, cash item of the assets increases 3,000 TL as well.
19
As you see, the total amount of the left side of the accounting equation becomes 14,000 TL which is
equal to the sum of the liabilities and owner’s equity. In other words, two sides of the equation balance
at 14,000 TL. In this practice, as the main concentration is to understand the effects of transactions on
the accounting equation, we ignore the categorization of revenues. On the other hand, please note that
in bookkeeping or in preparing of financial statements keeping track of the category is important to
provide the quality of financial information. Therefore, the revenue should be recorded as service revenue
in accounting process.
Transaction 5: Advertising Expense on Credit.
On January 12, 2018, TRApps gives advertisement on internet and receives a bill for 500 TL from the
advertisement agency. The agency agrees to receive the amount of the bill in the following days of January.
Services rendered in the process of earning revenue are recognized as expenses. As giving advertisement
aims to increase demand on the services of TRApps, the transaction decreases owner’s equity. So, there
must be a corresponding decrease in the left side or increase in the right side of the accounting equation.
Since services rendered from third parties on credit without debt security creates an obligation, accounts
payable item of liabilities increases 500 TL as well.
As you see, the balance of the equation remains same after the transaction. Like revenues, the related
expense should be recorded as advertisement expense. Also if we combine the results of transactions 4
and 5, it is clear that to understand the net income occurs as 2,500 TL which is the difference between
revenue of 3,000 TL and expense of 500 TL. Accordingly, as the date of January 12, 2018 the net increase
in owner’s equity is realized as 2,500 TL through realized revenues and expenses comes from transactions
4 and 5.
20
Accounting I
Transaction 6: Earning Service Revenue for Cash and on Credit.

On January 17, 2018, TRApps performs 4,000 TL of mobile application development service for its
client. The client pays 2,000 TL immediately for cash and states that the rest of this amount will be paid
in following days of January.
It is clear that this transaction is recognized as revenue which means an increase in owner’s equity.
Therefore, there must be a corresponding increase in the left side or decrease in the right side of the
accounting equation. Like transaction 4, cash item of the assets increases 2,000 TL. On the other hand,
customer promises to pay the rest of the amount in the future. The promise is an asset, an Accounts
Receivable. This promise creates a right for TRApps which is recognized as asset in the accounting
equation of TRApps and creates an obligation for customer which is recognized as accounts payable in the
accounting equation of customer. Accounts receivable, as the contrast of accounts payable, is an item of
assets which refers to the outstanding invoices a company has or the money the company is owed from its
clients. In this sense, the account receivable item of assets increases 2,000 TL as well.
claim and a 16,500 TL ownership claim. Also if we combine the results of transactions 4, 5 and 6, it is
clear that to understand the net income is 6,500 TL which is the difference between revenue of 7,000 TL
and expense of 500 TL. Accordingly, as the date of January 17, 2018 the net increase in owner’s equity
is realized as 6,500 TL through realized revenues and expenses comes from transactions 4, 5 and 6. In
addition, the revenue should be recorded as service revenue.
Transaction 7: Payment of Various Expenses with cash.
On January 18, 2018, TRApps pays the salaries of employees 3,000 TL and office rent 1,000 TL
for cash.
There are expenses which decrease owner’s equity. So, there must be a corresponding increase in the
right side or decrease in the left side of the accounting equation. Since the payments are done for cash, the
cash item of assets decreases 4,000 TL which is the sum of expenses.
21
claim and a 12,500 TL owner’s claim. Also if we combine the results of transactions 4, 5, 6 and 7, it is
clear that to understand the net income is 2,500 TL which is the difference between revenue of 7,000 TL
and expense of 4,500 TL. Accordingly, as the date of January 18, 2018 the net increase in owner’s equity
is realized as 2,500 TL through realized revenues and expenses comes from transactions 4, 5, 6 and 7. In
addition, the expenses should be recorded as salary expense and rent expense.
Transaction 8: Payment of Accounts Payable.
On January 22, 2018, TRApps pays its 1,000 TL ABC Computer Store bill (Transaction 3) and 500 TL
advertisement agency bill (Transaction 5).
As noted, TRApps previously recorded these bills as accounts payable. The total amount of accounts
payable is now paid by TRApps. Therefore, this transaction decreases accounts payable and cash in the
same amount.
As you see, the balance of the equation becomes 12,500 TL because the obligation of 1,500 TL was
fulfilled by TRApps. In other words, there is no any creditors’ claim after paying the bills. Please note
that, the 1,000 TL of computer accessories amount was previously recorded as assets and 500 TL of
advertisement amount was previously recorded as expense in transaction 3 and 5 respectively. So, this
transaction does not involve acquiring asset or making expense. This transaction only involves fulfilling
of obligation.
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Accounting I
Transaction 9: Collection of Accounts Receivable.

On January 25, 2018, customer pays the 2,000 TL cash to TRApps. It is the unpaid amount of the
bill for mobile application development service performed by TRApps (Transaction 6). It is clear that
this transaction does not change the balance of the accounting equation because it only changes the
composition of the assets. In other words, since the customer fulfills its obligation, the accounts receivable
item of TRApps turns into cash item.
The balance of the equation stays same because the obligation of 2,000 TL was fulfilled by customer.
Please note that, the 2,000 TL was previously recorded as sale revenue in transaction 6. So, this transaction
does not involve earning revenue. This transaction only involves collecting of accounts receivable.
Transaction 10: Distributions to Owner.
On January 31, 2018, Kaan Can withdraws 1,000 TL in cash as profit share (dividend) from the
TRApps for his personal use.
Owner’s drawings for personal use which refer distributions to owner are the opposite of contributions
by owner which refer investment by owner. Therefore, distributions to owner decrease the level of owner’s
equity. In this sense, there must be a corresponding decrease in the left side or increase in the right side
of the accounting equation. It should be stressed that distributions to owner are not expenses. They are
payments of cash or assets from a partnership or sole proprietorship to one of its owners (In corporation
structures distributions to owner are stated as dividend). In other words, an owner’s withdrawal is when
an owner takes money out of the company for personal use. In short, distributions to owner can be
identified as disinvestment by owner. Hence, as the withdrawal is realized in cash in this transaction, the
cash item of TRApps must be decreased.
23
Transactions 1 to 10 illustrate the effects of the financial transactions on the accounting equation.
In our case, we use the January (on month period) transactions of TRApps and reach the cumulative
accounting equation.
In analyzing of transactions we investigated their effects on the elements of accounting equation by
using specific items of the elements. At the end of the period, the equality of the equation is provided in
the frame of dual effect criteria.
4
Ms. Moon established the Moon Company on January 1, 2018 and the company made some
transactions during January, 2018. Analyze the effects of transactions mentioned below on accounting
equation. The column headings should be as follows: Cash, Accounts Receivable, Equipment,
Accounts Payable, Owner’s Capital, Owner’s Drawings, Revenues, Expenses.
1. Ms. Moon started his business by investing 20.000 TL for cash.
2. Purchased office equipment for 4.000 TL for cash.
3. Received cash for business services, 1.500 TL.
4. Provided services for 2.500 TL on credit.
5. Paid salaries of 1.200 TL.
6. Incurred 600 TL of advertising costs on credit.
7. Collected receivables of 500 TL for transaction 4 above.
8. Withdrew 1.000 TL for personal use.
FINANCIAL STATEMENTS
Financial statements are the business documents that companies use to report the results of their own
activities to the decision makers. So financial statements are communication tool between companies and
various information users, such as managers, owners, investors, creditors, suppliers, governmental and
regulatory agencies etc.
24
Accounting I
The realized cumulative accounting equation

of TRApps gives beneficial information to
Financial statements are the business documents that
information users about the financial situation
are used to communicate financial information needed
of the company as of January 31, 2018, and
in decision making process.
performance of the company for the month of
January 2018. Some of them are mentioned below.
• TRApps owned assets of 11,500 TL which are the resources of the company to carry out its future
activities.
• 6,500 TL of its total assets are cash.
• TRApps has equipment of 4,000 TL.
• The invested capital by owner is 10,000 TL.
• The earned revenue in January is 7,000 TL while TRApps made expense of 4,500 TL to earn this
amount of revenue.
• The all amount of assets is matched by ownership claim.
• Owner withdrew 1,000 TL.
• There is no obligation needs to be fulfilled by TRApps.
On the other hand, such an unstandardized presentation of the results of transactions to inform
information users is not an effective or a sensible way. Because, this kind of communication depends on
the person(s) who prepares presentation and so it prevents the comparability of financial information.
Comparability is extremely important for information users because it makes them enable to compare
company’s performance over different accounting periods or with other companies. Therefore, accounting
produces financial statements to inform information users in standardized way. There are four main
financial statements prepared by using summarized accounting data: Income statement, owner’s equity
statement, balance sheet and statement of cash flows.
Income statement shows the financial performance of a company over a specific accounting period.
In other words, income statement presents the revenues and expenses and resulting net income or loss
of a company for a specific period of time. Revenues are listed first and expenses follow revenues in the
format of income statement. Please note that income statement does not include distributions to owner
or contributions by owner.
Income statement is also referred as statement of profit
or loss and other comprehensive income in International
Accounting Standards (IAS 1: Presentation of Financial Income statement reports the revenues and
Statements) which definitely define its format in the expenses and resulting net income or loss of a
frame of the concepts of profit or loss and comprehensive company for a specific period of time.
income10. But, at this stage, we only consider revenues,
expenses and net income or loss in preparation of income
statement. Other concepts and formats of income statement
will be considered in later chapters.
Owner’s equity statement details the change in owner’s equity over an accounting period. In other
words, this statement shows why owner’s equity has increased or decreased for a specific period of time.
The period of owner’s equity statement must be same with the period of income statement. The statement
includes four main parts: Opening balance (the amount of owner’s equity at the beginning of the accounting
period), net income or loss, transactions with owner(s) and closing balance (the amount of owner’s equity
at the end of the accounting period). In this sense reaching closing balance needs to add net income and
investments by owner to opening balance and/or subtract loss and distributions to owner from opening
balance. Accordingly, the way of changing in owner’s equity for a specific period of time can be presented
and the amount of owner’s equity at the end of the accounting period can be calculated.
25
Owner’s equity statement is also referred as statement

of changes in equity in International Accounting
Owner’s equity statement details the
Standards (IAS 1: Presentation of Financial Statements)
changes in owner’s equity over an accounting
which definitely define its format in the frame of total
period.
comprehensive income for the period, the effects of
any retrospective application of accounting policies
or restatements and, reconciliations between the carrying amounts at the beginning and the end of the
period11. But, at this stage, we only consider the basic factors that affect owner’s equity in preparation of
this statement. Other concepts and formats of owner’s equity statement will be considered in later chapters.
Balance sheet shows the financial position of an organization at a particular instant in time – normally
at the end of an accounting period. In this sense balance sheet reports the assets, liabilities, and owner’s
equity at a specific date. In balance sheet assets are listed at the top and after liabilities are listed and owner’s
equity follows liabilities. Moreover, items of assets and liabilities are listed sequentially according to their
liquidity. In other words, balance sheet lists most liquid item at the top, followed by less liquid ones. The
order of listing depends on liquidity term which refers the degree of converting capability of an item into
cash without affecting its fair value. As described above total assets must be equal to total liabilities and
owner’s equity.
Balance sheet is also referred as statement of financial
position in International Accounting Standards (IAS 1:
Presentation of Financial Statements) which definitely
Balance sheet reports the assets, liabilities, define its format in the frame of current and non-current
and owner’s equity of the business at a classification, line items, share capital and reserves12. But,
specific date. at this stage, we only consider the used items in the case of
TRApps in preparation of balance sheet. Formats of balance
sheet based on current and non-current classification will
be considered in later chapters.
Statement of cash flows is a financial statement that shows the change in cash position of the company
over an accounting period. In other words, statement of cash flows summarizes information concerning
the cash inflows (receipts) and outflows (payments) for a specific period of time. Since the cash is the
most liquid asset (resource) of the company, information users always want to know what is happening
to cash of the company. In this sense statement of cash flows answers to following simple but extremely
important questions: What were the sources of the cash inflows during the period? What was the used cash
amount during the period? And what was the change in the cash balance during the period? Therefore,
statement of cash flows includes six main parts: Opening balance (the amount of cash at the beginning of
the accounting period), cash flows from operating activities, cash flows from investing activities, cash flows
from financing activities, net increase or decrease in cash and closing balance (the amount of cash at the
end of the accounting period). Cash flows from operating activities involve cash receipts from revenues
and cash payments for expenses. Cash flows from investing activities reports the aggregate change in a
company’s cash position resulting from any gains (or losses) from investments in the financial markets
and operating subsidiaries and changes resulting from amounts spent on investments in capital assets such
as plant, equipment or supplies. Cash flows from financing activities accounts for inflows and outflows
of cash resulting from debt issuance, investment by owner and distribution to owner. Net increase or
26
Accounting I
decrease in cash shows the total increase or decrease in

the cash position of the company over an accounting
period by summing the realized cash inflows and outflows Statement of cash flows summarizes
from operating, investing and financing activities. In this information concerning the cash inflows
sense reaching closing balance needs to add net increase (receipts) and outflows (payments) for a
to opening balance or subtract net decrease from opening specific period of time.
balance. Please note that the closing balance must be
equal to the cash item reported in the balance sheet.
Statement of cash flows is definitely defined in
International Accounting Standards (IAS 7: Statement of
Cash Flows)13. At this stage, we only consider the used The primary types of financial statements
items in the case of TRApps in preparation of Statement required by GAAP and IFRS are the same.
of cash flows. Comprehensive format of this statement
will be considered in later chapters.
Accountants should follow the order shown in Figure 1.14 to prepare the four financial statements.
Because they need to calculate net income or loss to prepare owner’s equity statement, need to calculate
closing balance of owner’s equity to prepare balance sheet and need the balance amount of cash item
reported in balance sheet to check the accuracy of the closing balance of statement of cash flows.
Income Owner's
Statement of
Statement equity Balance sheet
cash flows
statement
Figure 1.14 Order of Preparing Financial Statements
Preparing the Financial Statements: Case of TRApps

In this subsection we prepare the financial statements of TRApss by using accounting data of realized
transactions during January, 2018. In this sense, it is clear that the accounting period is the month ended
January 31, 2018.
At first, we should start with income statement.
TRApps has earned total revenue of 7,000 TL by transactions 4 and 6 while has made total expense
of 4,500 TL by transactions 5 and 7. Therefore we firstly list the revenues at the top and then write the
expenses to calculate the net income or loss. In addition, the categories of revenues and expenses must be
stated in income statement. Both in transactions 4 and 6, realized events involve service revenues. On the
other hand, while TRApps made advertisement expense in transaction 5, the expenses in transaction 7
occurred as salary expense and rent expense.
Accordingly, during January, the net income is 2,500 TL through realized revenues and expenses comes
from transactions 4, 5, 6 and 7. The income statement of TRApps is shown in Figure 1.15.
27
Figure 1.15 Income Statement of TRApps
After calculating the net income, the owner’s equity statement of TRApps can be prepared.
The opening balance of the owner’s equity statement is zero. A net income of 2,500 TL has occurred
in January. On January 1, owner invested 10,000 TL (Transaction 1) and on January 31, owner withdrew
1,000 TL (Transaction 10). Accordingly, the closing balance occurs as 11,500 TL. The owner’s equity
statement of TRApps is shown in Figure 1.16.
Figure 1.16 Owner’s Equity Statement of TRApps
As seen from Figure 1.16, the owner’s

equity has increased to 11,500 TL during
Net income is needed to determine the ending balance in January of 2018. 2,500 TL of that amount
owner’s equity. comes from net income while 9,000 TL
comes from transactions with owner.
After preparing the owner’s equity statement, the next step is to prepare the balance sheet of TRApps.
As it is noted above, balance sheet shows the assets, liabilities, and owner’s equity at the end of an
accounting period. In this sense, a specific date must be written in the balance sheet and in our case the
date is January 31, 2018.
Accordingly, the balance sheet must report the balances of items listed at the end of the January. The total
amounts of items of assets and liabilities calculated after transaction 10 reflect the balances of items subject to
balance sheet. In this sense total assets of 11,500 TL involve 6,500 of cash, 1,000 TL of supplies and 4,000
TL of equipment while there are not any liabilities. The balance sheet of TRApps is shown in Figure 1.17.
28
Accounting I
Figure 1.17 Balance Sheet of TRApps
As you can see that total assets are equal to total liabilities
and owner’s equity. And, the amount of owner’s equity comes
from the closing balance of owner’s equity statement.
The ending balance in owner’s equity is
needed in preparing the balance sheet. In the last step, we are ready to prepare statement of
cash flows.
The opening balance of the statement of cash flows is zero.
TRApps receives all the billed amount of 3,000 TL for cash in transaction 4. TRApps receives 2,000
TL for cash while the billed amount of service is 4,000 TL in transaction 6. And, in transaction 9, TRApps
collects the unpaid amount of the bill. Therefore, cash receipts from revenues realized as 7,000 TL in total
according to transactions 4, 6 and 9. On the other hand, TRApps makes cash payment of 500 TL in
transaction 8 for the advertisement expense recognized in transaction 5 and also makes cash payment of
4,000 TL for the salary expense and rent expense recognized in transaction 7. Therefore, cash payments
for expenses realized as 4,500 TL in total according to transactions 5, 7 and 8. In conclusion, TRApps has
2,500 TL cash inflow from operating activities during January.
TRApps purchased equipment in transaction 2 by paying 4,000 TL cash, purchased supplies of 1,000
TL on credit in transaction 3 and made its payment in transaction 8. These are the only investing activities
of the company in January which changes company’s cash position resulting from amounts spent on
investments in capital assets such as plant, equipment or supplies. In conclusion, TRApps has 5,000 TL
cash outflow from investing activities during January.
Owner invested 10,000 TL for cash into the TRApps which creates a cash inflow from financing
activities and TRApps made cash distribution of 1,000 TL to owner which creates cash outflow from
financing activities during January. There is no other financing activity like using credit from bank or
issuing shares so in conclusion TRApps has 9,000 TL cash inflow from investing activities during January.
Accordingly, 6,500 TL net increases in cash occur during January which makes the balance amount of
cash item 6,500 TL at the date of January 31, 2018. The statement of cash flows of TRApps is shown in
Figure 1.18.
29
Figure 1.18 Statement of Cash Flows of TRApss
In the statement of cash flows negative amounts represent cash outflows and positive amounts represent
cash inflows. As seen from the statement of cash flows the closing balance is same as the amount of cash
item reported in the balance sheet.
5
Prepare the financial statements of the Moon Company by using accounting data based on the
transactions mentioned in your turn 3.
Further Reading
Professional ethical crises: A case study of accounting majors

In October 2001 came the first reports of significant accounting irregularities in financial statements
issued by Enron, which at the time was the seventh largest company on the Fortune 500. Enron had
engaged in a widespread and highly complex series of financial transactions that had given investors
and other stakeholders the impression that Enron’s financial picture was considerably rosier than it
truly was, including a substantial understatement of its liabilities. Enron’s stock price fell precipitously
from nearly $34 per share on October 16 to a few pennies per share on November 28, when lenders
downgraded Enron’s debt to junk‐bond status. Enron eventually initiated the largest bankruptcy filing
at the time, only surpassed by Worldcom’s filing in 2002.
30
Accounting I
The scandal soon focused attention on Arthur Andersen, Enron’s public accounting firm. Evidence
emerged that Andersen had considerable complicity in Enron’s financial activity, having helped Enron
to create an arcane web of partnerships, in an effort to remove huge amounts of debt from Enron’s
balance sheet, as well as signing off on Enron’s annual financial statements. According to an internal e‐
mail message, Andersen had considered dropping Enron as an audit client as early as February 6, 2001,
but had nevertheless retained a high‐profile and profitable client.
When news of Enron’s accounting improprieties surfaced, several Andersen employees began
shredding relevant documents and deleting associated e‐mail messages and other electronic files,
allegedly based on the firm’s document retention policies. Six months later, Andersen was convicted of
obstruction of justice (although in 2005 this was overturned on appeal, but too late to save Andersen),
becoming the first major accounting firm to be convicted of a felony. As a result, the firm was no longer
able to perform public company audits and the Big 5 thus became the Big 4.
Unfortunately, the Enron scandal was only the beginning. The list of corporations involved in
recent major investigations of financial irregularities includes WorldCom, Computer Associates, Global
Crossing, Tyco, Xerox, Halliburton, Bristol‐Myers Squibb, Qwest Communications, Adelphia, K‐Mart,
Lucent Technologies, HealthSouth, and Freddie Mac. Every Big 4 accounting firm has been involved
in these investigations to some extent and some have already been penalized for their roles. However,
Arthur Andersen was associated with a disproportionate number of these firms (WorldCom, Qwest,
Global Crossing, and Enron) and was the only firm to receive a criminal conviction.
Because of the scandals, investors lost billions of dollars while thousands of employees lost both
jobs and their pensions. The crisis destroyed the credibility of financial analysts, led to the collapse of
a Big 5 accounting firm, and severely tarnished the images of corporate managers and auditors. The
single most significant consequence of these scandals was Congress’ passage of the Sarbanes‐Oxley
Act of 2002. After decades of self‐regulation, this legislation created the Public Company Accounting
Oversight Board to oversee the accounting profession in the area of public company audits.
Particularly unsettling is the uncertainty surrounding the long‐term effects of these events on the
accounting profession and corporate leadership. Based upon their status as the future of the accounting
profession, we view current accounting majors as a barometer by which we can assess these long‐term
effects. The long‐term effects are exhibited in two ways. First, the opinions students currently have of
accountants, the profession, and corporate managers illustrates the long‐term effects of these events,
given that these events took place when several current accounting students were still in high school.
Additionally, students’ educational and career aspirations will help predict the future and makeup of the
profession. Given the current perceived shortage in accounting graduates, which is dependent upon a
supply of current accounting majors, any significant reaction warrants attention
Source: Comunale, Christie L., Thomas R. Sexton, and Stephen C. Gara. (2006). Professional ethical
crises: A case study of accounting majors. Managerial Auditing Journal, 21, 6, p.636-656
31
Inside Practice
Explain the career opportunities in accounting?

In many countries in recent years, the demand for accountants exceeded the supply. Not only are
there a lot of jobs, but there is a wide array of opportunities. As one accounting organization observed
“accounting is one degree with 360 degrees of opportunity.”
Accounting is also hot because it is obvious that accounting matters. Interest in accounting has
increased, ironically, because of the attention caused by the accounting failures of companies such as
Enron and WorldCom. These widely publicized scandals revealed the important role that accounting
plays in society. Most people want to make a difference, and an accounting career provides many
opportunities to contribute the society. Finally, the Sarbanes-Oxley Act (SOX) significantly increased
the accounting and internal control requirements for corporations. This dramatically increased demand
for professionals with accounting training14.
Discuss:
1. Why is accounting such a popular major and career choice?
2. What are the career opportunities in accounting? Investigate and discuss the differences
among public accounting, private accounting, governmental accounting and forensic
accounting.
32
Accounting I
Identify the activities and

LO 1 information users associated with
accounting
Accounting is a financial information system which provides financial information for decision makers.
This system includes three kinds of basic activities which are identifying, recording and communicating
of the financial transactions of an organization. The first step of the accounting process consists identifying
of the financial transactions related with the business. Company records these events which provide
the history of financial information. Recording is a systematic way of keeping including chronological
Summary
diary of events measured in monetary unit. At the last step, company communicates the summarized
information obtained from the records to decision makers (information users). Managers of a company
who run the business are the most important group of internal users. External stakeholders also need
financial information to make decisions. They can be individuals or organizations. The primary external
users are investors and creditors. In addition, government is also an important external user of financial
information.
Explain the ethical behavior,

LO 2 measurement principles and basic
assumptions
Ethics are the humanly devised rules, procedures and norms to judge one’s action as right or wrong,
honest or dishonest and fair or not fair. In this sense, identifying one’s action as ethical behavior, it must be
right, honest and fair. In short, ethical behavior involves right, honest and fair action. Measurement refers
the valuation (determination of the monetary amount subject to recording) of assets and liabilities in
accounting process. Standards generally use one of two main principles in measurement: Historical cost
principle or fair value principle. The historical cost principle states that assets are recorded at their cost.
The fair value principle states that assets and liabilities are reported at fair value. Assumptions provide the
main conceptual frame of accounting information system. In general, as a basic step, we have to aware of
two basic assumptions to understand the nature of accounting activities. These two main assumptions are
the monetary unit assumption and the economic entity assumption. The monetary unit assumption
dictates that financial transactions can only be recorded if the transaction data can be expressed in money
terms. The economic entity assumption requires that the financial transactions of the entity be recorded
separate from the economic activities of its owner.
Describe the accounting equation

LO 3 and understand the elements of
financial statements
The basic accounting equation shows the relationship of assets, liabilities, and owner’s equity. Assets
must equal the sum of liabilities and owner’s equity. Assets are resources a business owns. Liabilities are
claims against assets. Owner’s equity is the claims of owners. There are two main elements which shows
the performance of the company in a specific period: revenues and expenses. Revenue is the gross inflow
of economic benefits during the period arising from the course of the ordinary activities of an entity
when those inflows result in increases in equity, other than increases relating to contributions from equity
participants. Expenses are decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than
those relating to distributions to equity participants.
33
Analyze the effects of financial

LO 4 transactions on the accounting
equation
There are four main factors which increase or decrease the level of owner’s equity: Contributions by
owner(s), distributions to owner(s), revenues and expenses. The basic type of contributions by owner
is invested capital by owner which refers the funds invested in a business during its life by shareholders
(owners). These funds are the assets that owners put into the business. These kinds of financial transactions
increase owner’s equity and are recorded as owner’s capital. Owner’s drawings for personal use refer
Summary
distributions to owner in general and the basic type of distributions to owner is paying dividend (profit
sharing). These kinds of financial transactions decrease owner’s equity and are recorded in a category called
owner’s drawings. Accountants record financial transactions of business. These financial transactions
are realized based on transactions and transactions may be identified as either external or internal
transactions. External transactions are realized between the company and a third party (an outside
enterprise). Sale of goods to customers is an example of external transaction.
Internal transactions refer financial transactions which occur entirely within one company. Each
transaction has a dual effect on the accounting equation. Dual effect means that at least two items
must be affected or more items could be affected by transaction and accounting equation has to remain
in balance after making the changes in accounting equation. Accordingly, if an asset item is increased,
there must be a corresponding decrease in another asset item, or increase in a liability item, or increase
in owner’s equity item in the same amount. Identification of transaction includes analyzing of each
transaction in terms of its effect on the items of the accounting equation, identifying the specific items
affected and determining the amount of the change in each item.
Describe and prepare the basic

LO 5 financial statements
There are four basic financial statements prepared by using summarized accounting data: Income
statement, owner’s equity statement, balance sheet and statement of cash flows. Income statement
is a financial statement which shows the financial performance of a company over a specific accounting
period. Owner’s equity statement details the change in owner’s equity over an accounting period. Balance
sheet shows the financial status of an organization at a particular instant in time – normally at the end
of an accounting period. Statement of cash flows is a financial statement that shows the change in cash
position of the company over an accounting period.
Accountants should follow an order in preparing financial statements which starts with income statement
and continue with owner’s equity statement, balance sheet and statement of cash flows. Because they need
to calculate net income or loss to prepare owner’s equity statement, need to calculate closing balance of
owner’s equity to prepare balance sheet and need the balance amount of cash item reported in balance
sheet to check the accuracy of the closing balance of statement of cash flows.
34
Accounting I
1 All of the following are external users of 6 Which one is true for the rent payment?
accounting information except …
A. It is an expense and decreases owner’s equity.
A. Labor unions. B. It is a revenue and decreases owner’s equity.
B. Taxing authorities. C. It is a revenue and increases owner’s equity.
Test Yourself
C. Regulatory agencies. D. It is an expense and increases owner’s equity.
D. Company officers. E. İt is an asset and increase owner’s equity
E. Banks.
7 Which of the following financial statements
2 Recording consists of …. is prepared as of a specific date?
A. Identifying financial transactions. A. Balance sheet.
B. Measuring financial transactions B. Income statement.
C. Preparing and distributing accounting reports. C. Owner’s equity statement.
D. Keeping a systematic, chronological diary of D. Statement of cash flows.
events, measured in dollars and cents. E. Statement at profit
E. Identifying, measuring, receiving, and
communicating financial transactions to
information users. 8 IFRS is considered to be more:
A. Principles-based and less rules-based than GAAP.
3 The financial statement that summarizes B. Rules-based and less principles-based than GAAP.
information about the cash inflows and outflows C. Detailed than GAAP.
during a period is the…. D. Equal at GAAP
A. Income statement. E. Better than GAAP
B. Owner’s equity statement.
C. Balance sheet. 9 What are the main factors used in determining
D. Audit report. the measurement principle?
E. Statement of cash flows. A. Monetary unit assumption and faithful
representation.
4 Which of the following is not an acceptable B. Economic entity assumption and monetary
statement of the basic accounting equation? unit assumption.
C. Relevance and faithful representation.
A. Assets – Liabilities = Owner’s equity
D. Relevance and monetary unit assumption.
B. Assets = Liabilities – Owner’s equity
E. Relevance and economic entity assumption.
C. Assets = Liabilities + Owner’s equity
D. Assets – Owner’s equity = Liabilities
E. Assets = Owner’s euity + Revenue - Expenses 10 Which of the following is true?
A. In partnership business owned and run by one
5 Ethics are the standards of conduct by which person.
one’s actions are judged as: B. In corporation each partner has unlimited
responsibility for all business’s debt.
A. Right C. In proprietorship shareholders enjoy limited
B. Honest liability.
C. Fair D. In corporation owners are not personally liable
D. Not Fair for the debts of the entity.
E. Right or wrong, honest or dishonest, fair and E. In proprietorship the ownership is divided into
not fair transferable shares of stock.
35
If your answer is wrong, please review the If your answer is wrong, please review the
1. D 6. A
“Accounting Information: Basic Activities “Effects of Financial Transactions on the
Answer Key for “Test Yourself”
and Users” section. Accounting Equation” section.
If your answer is wrong, please review the

2. D 7. A If your answer is wrong, please review the
“Accounting Information: Basic Activities
“Financial Statements” section.
and Users” section.

3. E If your answer is wrong, please review the 8. A
“Ethical Behavior, Measurement Principles
“Financial Statements” section.
and Basic Assumptions” section.

4. B If your answer is wrong, please review the 9. C
“Basic Accounting Equation” section.
and Basic Assumptions” section.
5. E “Ethical Behavior, Measurement Principles
10. D
and Basic Assumptions” section. and Basic Assumptions” section.
Suggested answers for “Your turn”
Identify the basic activities of accounting and give

examples for users of financial information.
Accounting is a financial information system that identifies, records, and

communicates the financial transactions of an organization to information
users. The basic examples for users of financial information are as follows: (1)
your turn 1 Managers of a company who run the business use financial information to
plan, organize, and run the business. (2) Investors use financial information
to make decision on buy or sell stocks. (3) Creditors use financial information
to analyze the company’s ability to fulfill its obligations.
What is ethics? Why ethical behavior has a primacy in

accounting process?
Ethics are the humanly devised rules, procedures and norms to judge one’s
action as right or wrong, honest or dishonest and fair or not fair. Beside the
specific principles and assumptions which are applied based on the standards,
your turn 2 the quality of financial information primarily depends on ethical behavior.
Because without providing sufficient skills and knowledge of the accountant,
and preventing dishonesty derived by intended actions standards become
inadequate to provide effective financial statements.
36
Accounting I
State the accounting equation, and define the elements

of financial statements.

The basic accounting equation is: Assets = Liabilities + Owner’s Equity.
Assets are economic resources controlled by the entity as a result of past events
and from which future economic benefits are expected to flow to the entity.
In short, assets are economic resources a business owns. Liabilities are defined
as a present obligation of the entity arising from past events, the settlement
of which is expected to result in an outflow of the entity’s resources. Owner’s
your turn 3 equity is the total assets of an entity, minus its total liabilities. This represents
the capital theoretically available for distribution to shareholders. There are
four main factors which increase or decrease the level of owner’s equity:
Contributions by owner (s), distributions to owner(s), revenues and expenses.
When these factors are combined with the basic accounting equation, the
expended equation is provided as: Assets = Liabilities + contributions by
owner – distributions to owner + revenues – expenses.
Ms. Moon established the Moon Company on January 1, 2018 and the
company made some transactions during January, 2018. Analyze the
effects of transactions mentioned below on accounting equation. The
column headings should be as follows: Cash, Accounts Receivable,
Equipment, Accounts Payable, Owner’s Capital, Owner’s Drawings,
Revenues, Expenses.
1. Ms. Moon started his business by investing 20.000 TL for cash.
2. Purchased office equipment for 4.000 TL for cash.
3. Received cash for business services, 1.500 TL.
4. Provided services for 2.500 TL on credit.
5. Paid salaries of 1.200 TL.
8. Withdrew 1.000 TL for personal use.
your turn 4
37
Prepare the financial statements of the Moon Company

by using accounting data based on the transactions
mentioned in your turn 3.
your turn 5
38
Accounting I
Prepare the financial statements of the Moon Company

by using accounting data based on the transactions

your turn 5
Endnotes
1
Miller-Nobles, T., Mattison, B. And Matsumura, 9
Weygandt, J. J., Kimmel, P. D., & Kieso, D. (2010).
E.M. (2016). Horngren’s Accounting The Accounting Principles. Wiley, Twelfth Edition,
Financial Chapters, 11th Edition, Pearson, p.26. p.18.
2
Gokten, P. O., Baser, F., & Gokten, S. (2017). Using 10
IAS 1: Presentation of Financial Statements,
fuzzy c-means clustering algorithm in financial International Accounting Standards Board. Access
health scoring. The Audit Financiar Journal, 15 from: http://www.ifrs.org at the date of 2 April, 2018.
(147), p. 385. 11
Ibid.
3
Needles Jr., Belverd E., and Marian Powers, (2007). 12
Ibid.
Financial Accounting, Ninth edition, Houghton
Mifflin Company, p.8. 13
IAS 7: Statement of Cash Flows, International
Accounting Standards Board. Access from: http://
4
IASB, International Accounting Standards Board.
www.ifrs.org at the date of 2 April, 2018.
Access from: http://www.ifrs.org/groups/
international-accounting-standards-board/ at 14
Weygandt, J. J., Kimmel, P. D., & Kieso, D. p.18.
the date of 2 April, 2018.
5
Conceptual Framework, International Accounting Bu Ünitede Kullanılan Resimler Anadolu Üniversitesi
Standards Board. Access from: http://www.ifrs. Açıköğretim Fakültesi Görsel Arşivinden Alınan
org at the date of 2 April, 2018. Resimlerdir.
6
Ibid.
7
Ibid.
8
Ibid.
39
Chapter 2 Recording Process
After completing this chapter, you will be able to:
Learning Outcomes
1 2
Describe the characteristics of an account and Define debits, credits, and normal account
explain accounts as they relate to recording balances, and use double-entry accounting
process and T-accounts in recording process
3 4
Prepare the trial balance from the T-accounts
Record transactions in a journal and post and illustrate how it can be used to prepare
journal entries to the ledger financial statements
Key Terms
Credit
Credit Balance
Crediting
Chapter Outline Debit
Introduction Debit Balance
Accounts Debiting
Debits, Credits and Double-Entry Accounting System Double-Entry System
Steps in Recording Process Journal
Trial Balance Journal Entry
Journalizing
Ledger
Posting
T-Account
Trial Balance
40
Accounting I
INTRODUCTION
Businesses will have a lot of financial transactions with customers, suppliers, creditors, employees, tax
authorities, governmental agencies, and others. As you learned in Chapter 1, financial transactions are
economic events that affect a company’s financial position. Therefore, you need to understand both the
recording of transactions and combining of those transaction records to prepare financial statements.
This chapter focuses on bookkeeping and record-keeping procedures. So this chapter demonstrates
how to record financial transactions and then combine transaction records to prepare financial statements.
Like all the information systems have their own procedures based on defined rules for recording the
data and reporting the results, accounting as a financial information system also uses its own procedures:
debit and credit procedure in recording. Debit and credit procedure includes different rules for different
types of accounts in order to show increases or decreases in assets, liabilities and owner’s equity. In short,
debit and credit procedure represents the accounting language and is applied to set up a double-entry
system which is a logical basis of accounting systems worldwide.
You have already learned to analyze the effects of transactions on accounting equation by applying
plus and minus procedure in Chapter 1. In this chapter, you will learn how to record transactions based
on debit and credit procedure by using accounts instead of applying plus and minus procedure on the
ACCOUNTS
Remember that the accounting equation expresses the basic relationships of accounting and contains
three categories: assets, liabilities, and owner’s equity
For each category of equation (for each asset, each liability, and each element of owner’s equity) we
use a record called the account. An account is an individual accounting tool that shows the increases
and decreases in a specific asset, liability, or owner’s equity item during a specified period. Accounts are
the basic storage units for accounting data and are used to accumulate amounts from similar financial
transactions. So, an account is a summary device of accounting.
An account is an individual accounting tool that shows the increases and decreases in a specific asset,
liability, or owner’s equity item during a specified period.
Accounting relies on a system of accounts, with the name or title of each account intended to capture the
nature of the items in the account. An account represents an amount on a line of a balance sheet or income
statement.1 Before starting to transaction analysis, let’s review some of the most commonly used accounts.
Typical Asset Accounts

Assets are economic resources that provide a future benefit for a business –something the business
owns. Most firms use the following asset accounts:
• Cash. Cash means business’s money and any medium of exchange including paper currency, coins,
certificates of deposit, and checks.
• Accounts Receivable. Companies might sell their goods and services on account and receives a
promise for future collection of cash. The Accounts Receivable account holds a customer’s promise
to pay in the future for services or goods sold on account. Arises from a credit sale. The company
collects cash from the customer sometime after the sale.
41
Recording Process
• Notes Receivable. A note receivable is similar to an account receivable, but a note receivable is
more formal than Accounts Receivable because the customer signed a formal note. Notes receivable
usually includes interest.
• Prepaid Expenses. Companies might pay certain expenses in advance, such as insurance and rent.
A prepaid expense is considered as an asset because the prepayment provides a future benefit for the
business. Prepaid Rent, Prepaid Insurance, and Supplies are examples of prepaid expenses.
• Land. The Land account shows the cost of the land a business uses in its operations.
• Buildings. The costs of an office building, factory building, a warehouse, and other buildings
appear in the Buildings account.
• Equipment, Furniture, and Fixtures. The cost of equipment, furniture and fixtures. A business
has a separate asset account for each type of equipment, for example, Manufacturing Equipment
and Office Equipment. The Furniture and Fixtures account shows the cost of these assets such as
desks, tables, chairs, counters, etc.
Typical Liability Accounts

As you learned in Chapter 1, a liability is a debt of company –that is, something the business owes. A
payable is always a liability. The most typical liability accounts:
• Accounts Payable. The Accounts Payable account is the opposite of Accounts Receivable. A or The
company promises to pay a debt in the future. Arises from a credit purchase.
• Notes Payable. A note payable is the opposite of a Note Receivable. The Notes Payable account
includes the amounts the company must pay because the company signed a written promise to pay
a debt amount in the future. Notes payable, like notes receivable, usually involves interest.
• Unearned Revenue (Advances from customers). The obligation occurs when a company receives
cash from a customer in advance but has not provided the product or service. The company gives
promise to provide services or deliver goods in the future.
• Accrued Liabilities. An accrued liability is a liability for an expense you have not yet paid. In
another words, an amount owed but not paid yet. Interest Payable, Salary Payable, and Income Tax
Payable are typical accrued liability accounts for most companies.
Typical Owner’s Equity Accounts

This section describes typical owner’s equity accounts. The owner’s claims to the assets of the business
is called owners’ equity. A company has separate accounts for each element of owner’s equity. Remember
the extended version of accounting equation!
• Owner, Capital. Owner’s Capital account represents the net contribution of the owner in the business.
• Owner, Withdrawals. The amounts taken out of the business by the owner appear in a separate
account titled Withdrawals, or Drawing. Owner’s withdrawals are distribution of cash or other
assets of company to the owner. The Withdrawals account decreases owner’s equity.
• Revenues. The company will receive assets (for example, cash) in exchange for goods sold and
services rendered. Therefore, company’s assets and owner’s equity will increase. The increase in
owner’s equity created by delivering goods or services to customers is called revenue. The company
uses as many revenue accounts as needed. Examples include Sales Revenue account, Service
Revenue account, Interest Revenue account, or Rent Revenue account.
• Expenses. Expenses use up assets or create liabilities in the course of operating a business. The cost
of operating a business is called expense. Expenses have the opposite effect of revenues; expenses
decrease owner’s equity. A business needs a separate account for each type of expense, such as Salary
Expense, Rent Expense, Advertising Expense, Insurance Expense, Utilities Expense, and Income
Tax Expense. Businesses will try to minimize expenses and thereby maximize net income.
42
Accounting I
Chart of Accounts
A chart of accounts is a created list of the account names used by an organization to define each class
of items. A chart of accounts is used to organize a company’s accounts.2 Chart of accounts is simply a list
of account names that a company uses in its general ledger for recording various business transactions. It
provides guidance to accountants or other relevant persons in using specific account names while recording
transactions.
Companies use a chart of accounts to list all their accounts along with the account numbers. Account
numbers are just shorthand versions of the account names. One account number equals one account
name.
Accounts are usually listed in the same order in which they appear in company’s financial statements.
Usually, the balance sheet accounts are listed first and income statement accounts are listed later.3 Thus,
the chart of accounts begins with cash, proceeds through liabilities and owner’s equity, and then continues
with accounts for revenues and then expenses. Please note that, the references (code) of accounts may vary
from country to country or from company to company.
In Turkey, businesses are required by law to use a statutory framework for their chart of accounts, which is known
as the Uniform Chart of Accounts. The Uniform Chart of Accounts consists of nine account classes numbered 1
through 9 (for example, account class 1, current assets; account class 2, non-current assets; and account class 3,
current liabilities). Each class is subdivided into account subclasses: account class, for example, includes current
asset subclasses 10, cash and Cash Equivalents, and 12, Trade Receivables. The subclasses are then further divided
into what are termed synthetic accounts – account subclass 12, for example, breaks down into synthetic accounts
120 Accounts Receivable, 121 Notes Receivables, and so on.
internet
KAP (Public Disclosure Platform) https://www.kap.org.tr/
A chart of accounts is a listing of the accounts and the account numbers which identify their location
in the ledger. The numbering system usually starts with the balance sheet accounts and follows with the
income statement accounts.
1
What should be account codes for Accounts Payable according to the Turkish Uniform Chart of Accounts?
Ledger
Besides to Chart of Accounts, companies need to show all of the increases and decreases in each
account along with their balances. Companies use a ledger to fulfill this task. The ledger is a record of all
the accounts that the company uses the changes in those accounts, and their balances. A ledger is often
defined as a book of accounts.
43
Recording Process
DEBITS, CREDITS AND DOUBLE-ENTRY ACCOUNTING SYSTEM

Remember that, the effect of transactions on the accounting equation was discussed in Chapter 1
and you learned that each transaction shows a dual effect on the accounting equation. As you learned
each financial transaction must affect at least two different items and so transactions always involve at
least two different accounts. Remember the establishment of TRApps Company in Chapter 1, the owner
contributed 10,000 TL cash to establish the company as capital, two accounts involved are Cash and
Owner’s Capital. Accounting uses the double-entry accounting system to record the dual effects of each
transaction. As a result, every transaction affects at least two accounts.
2
What should be account codes for Accounts Payable according to the Turkish Uniform Chart of Accounts?
The T-Account
The is a good place to begin the study of the double-entry system. In Chapter 1, we recorded the
January transactions for TRApps Company using the accounting equation format. However, this format
is not efficient or practical for companies that have to record and summarize thousands or millions of
transactions daily. As a result, accounting systems are designed to show the increases and decreases in each
financial statement item as a separate record by using accounts.
An account, in its simplest form, has three parts. First, each account has a title, which is the name of
the item recorded in the account. Second, each account has a space for recording increases in the amount
of the item. Third, each account has a space for recording decreases in the amount of the item. The
Title of Account
account form presented below is called a T account because it looks like
the capital letter T.
Debit (Left) Credit (Right) As seen from Figure 2.1 which illustrates the basic form of an account,
Side Side the vertical line divides the account into its left and right sides, with the
title at the top. The left-hand side is called as debit side, and the right-
hand side is called as credit side. Please do not look for any logic behind
It looks like the letter T these concepts. Because having debits on the left and credits on the right
Figure 2.1 Basic Form of Account is an accounting custom, or rule. This rule applies to all accounts.
The basic form of account generally is called as T-account, because the shape of the account resembles
the letter T.
T-accounts have a title and include two sides: Debit (left) and credit (right). Debit represents the left
side of an account. Credit represents the right side of an account.
Debits and Credits

Any entry made on the left side of the account is a debit (abbreviated Dr.), and any entry made on the
right side is a credit (abbreviated Cr.). These terms are used to describe the place of entries in recording
process not for “increase” or “decrease”. For example, entering an amount on the left side of an account
is called debiting while crediting refers to the act of making an entry on the right side of an account.
Also, if the sum of the left side exceeds the sum of the right side of an account, a debit balance occurs. In
44
Accounting I
other words, debit balance shows the difference between total amounts of the left and the right side where
debit amount exceeds the credits. In reverse situation, when the credit amount exceeds the debits, credit
balance occurs. Credit balance shows the difference between total amounts of the right and the left side
where credit amount exceeds the debits.
Debiting refers to the act of making an entry on the left side of an account and when debit amount
exceeds credits, debit balance occurs.
Crediting refers to the act of making an entry on the right side of an account and when credit amount
exceeds debits, credit balance occurs.
The T-account form for cash account related with the transactions of the Moon Company (the case
given as ‘your turn 4’ in Chapter 1) is illustrated in Figure 2.2.
Tabular Summary Account Form

Cash Dr Cash Cr
+ 20,000 20,000 4,000
1,500 1,200
- 4,000 500 1,000
+ 1,500
22,000 6,200
- 1,200
+ 500 15,800
- 1,000
Debit Balance
Sum of left side

(debits)
> Sum of right side
(credits)
Figure 2.2 T-Account Form for The Moon Company’s Cash Account
The data taken from the cash column of tabular summary of Moon Company’s transactions during
January, 2018 are used and are transformed into account form in order to show how an account is used in
recording process. For the cash account, as it is seen from Figure 2.2, positive entries are recorded as debits
while negative ones are recorded as credits. Please note that in cash account debits show increases,
for instance receiving cash for business services and credits show decreases, for instance purchasing
office equipment in cash. But, debit and credit effects on cash account are not valid for all kinds of
accounts. In other words, debit and credit effects vary due to the types of accounts.
The cash account gives debit balance which is calculated by netting the two sides at the end of January,
2018 and we can understand that Moon Company has 15,800 TL cash at the end of the accounting period
which also indicates that there is 15,800 TL increase in Moon Company’s cash account in given period.
Debit and credit effects vary due to the types of accounts.
Double-Entry Accounting System

Remember that, the effect of transactions on the accounting equation was discussed in Chapter 1
and you learned that each transaction shows a dual effect on the accounting equation. The accounting
45
Recording Process
equation provides the analytical framework that we use throughout this book to understand the effects of
transactions and events on the financial statements. This equation requires that a company’s assets exactly
balance, or offset, an equal amount of financing provided by creditors and owners of the corporation. 4
Each transaction must affect two or more accounts to keep the basic accounting equation in balance. In
other words, for each transaction, one or more accounts must be debited, or entered on the left side of
the account, and one or more accounts must be credited, or entered on the right side of the account, and
the total monetary amount of the debits must equal the total dollar amount of the credits. The equality
of debits and credits provides the basis for the double-entry system of recording transactions. Under
double-entry system, debit and credit procedure is used to keep the accounting equation in balance by
using appropriate accounts instead of using plus and minus procedure.
In a double-entry system, equal debits and credits are made in the accounts for each transaction.
Equality between the sum of all the debits and the sum of all the credits maintains the balance of
Increases and Decreases in the Accounts

We know that the elements of basic accounting equation are assets, liabilities and owner’s equity. Look
again at the accounting equation:
You can see that if a debit increases assets, then a credit must be used to increase liabilities or owner’s
equity because they are on opposite sides of the equality. Likewise, if a credit decreases assets, then a debit
must be used to decrease liabilities or owner’s equity. In addition, you learned that contributions (Owner’s
capital) and revenues increase the owner’s equity while distributions (owner’s withdrawals) and expenses
decrease the owner’s equity. In this sense, to keep the accounting equation in balance by applying debit and
credit procedure, we should define the debit and credit rules for each element of accounting equation. In
this sense, debit and credit rules are classified into five groups mentioned in Figure 2.3.
Dr./Cr. Rules for

Assets
Dr./Cr. Rules for
Contributions
Debit and Credit Dr./Cr. Rules for
Procedure Liabilities Dr./Cr. Rules for
Distributions
Owner’s Equity Dr./Cr. Rules for

Revenues
Dr./Cr. Rules for

Expenses
Figure 2.3 Debit and Credit Rules Classification
46
Accounting I
Dr./Cr. Rules for Assets: Assets increase on left side by debiting while decrease on right side by
crediting and normally show debit balance.
Dr./Cr. Rules for Liabilities: Liabilities increase on right side by crediting while decrease on left side
by debiting and normally show credit balance.
Dr./Cr. Rules for Contributions (Owner’s capital): Contributions increase on right side by crediting
while decrease on left side by debiting and normally show credit balance.
Dr./Cr. Rules for Distributions (Owner’s withdrawals): Distributions increase on left side by
debiting while decrease on right side by crediting and normally show debit balance.
Dr./Cr. Rules for Revenues: Revenues increase on right side by crediting while decrease on left side by
debiting and normally show credit balance.
Dr./Cr. Rules for Expenses: Expenses increase on left side by debiting while decrease on right side by
crediting and normally show debit balance.
The overview of debit and credit effects on accounts and double-entry system based on debit and credit
procedure is shown in Figure 2.4.
Assets Liabilities
Debit / Dr. Credit / Cr. Debit / Dr. Credit / Cr.
Debit Balance Credit Balance
Distributions Contributions
Debit Balance Credit Balance
Expenses Revenues
Amount of assets Amount of liabilities
Amount of distributions Amount of contributions
Amount of revenues Debit Balance Credit Balance Amount of revenues

+ +
TOTAL AMOUNT TOTAL AMOUNT
DEBITS MUST BE EQUAL TO CREDITS
of DEBITS of DEBITS
Double-Entry System
Figure 2.4 Overview of Debit and Credit Procedure
As seen from Figure 2.4, there are two opposite groups in terms of debit and credit effects. In the first
group which includes assets, distributions and expenses; accounts increase by debiting (on left side) and
normally show debit balance. In the second group which includes liabilities, contributions and revenues;
accounts increase by crediting (on right side) and normally show credit balance. After each transaction,
sum of debits and sum of credits must be equal. In other words, the balance of accounting equation must
be provided.
47
Recording Process
Assets, distributions, and expenses increase by debiting (on left side) and normally show debit balance.
Liabilities, contributions, and revenues increase by crediting (on right side) and normally show credit balance.
The Logic of Debit and Credit Procedure

You can memorize debit and credit rules for each item to apply double-entry system. On the other
hand, as an alternative way, you can understand the logic of debit and credit procedure and you do not
need to memorize. First of all, we need to understand why some accounts increase from the left side, and
why others increase from the right side. Hence, we again benefit from the expended version of the basic
accounting equation in order to show the logic of debit and credit procedure.
Remember that the expended basic accounting equation is as follows,
Assets = Liabilities + Contributions – Distributions + Revenues – Expenses
At the first step, we need to adjust the equation to make all the signs positive. For this, distributions
and expenses can be moved to the left hand side of the equation. Thus, the expended basic accounting
equation becomes as follows,
Assets + Distributions + Expenses = Liabilities + Contributions + Revenues
Does the accounting equation look familiar to you? Certainly it should be! The left hand side of the
equation includes assets, distributions and expenses while the right hand side of the equation includes
liabilities, contributions and revenues. This grouping is exactly the same as the grouping specified in the
Figure 2.4. In this sense, the elements on left side of the adjusted equation increase by debiting while the
ones on the right side of the adjusted equation increase by crediting.
Let’s draw a T-account on adjusted accounting equation in order to visualize the logic. Integration of
accounting equation and T-account is presented in Figure 2.5.
T-Account Form
Debit / Dr. Credit / Cr.
Assets + Distributions + Expenses = Liabilities + Contributions + Revenues
Increase on left side Increase on lright side
Debit balance Credit balance
T-Account Form
Debit / Dr. Credit / Cr.
- Liabilities - Contributions - Revenues = - Assets - Distributions - Expenses
Decrease on left side Decrease on right side
Figure 2.5 The Logic of Debit and Credit Procedure
48
Accounting I
The sign and the place of elements in the accounting equation determine the side of increase and
decrease in T-account. For instance, if an element on the left hand side of the accounting equation has
negative sign, that means accounts of the element decrease on the left side while increase by crediting.
3
Describe the debit and credit rules for each element of accounting equation.
STEPS IN THE RECORDING PROCESS

Accountants use source documents to provide evidence and data for recording transactions. Business
documents, such as a sales slip, a check, or a bill, provide evidence of the transaction.
Picture 2.1 Business documents provide evidence

of the transaction.
There are three main steps which occur repeatedly in the recording process:
1. Analyze each transaction for its effects on the accounts.
2. Enter the transaction information in a journal.
3. Transfer the journal information to the appropriate accounts in the ledger.
Analyzing includes identification of economic events to understand how it affects accounting equation
and which accounts should be used in recording. Please do not forget that recording process for each
transaction needs support documents. In other words, there must be business document(s) like receipt,
bill, contract etc. which provides evidence for transaction. In the next step, the transaction information is
entered into the journal. Finally, the journal information is posted to the ledger.
Source documents are Transactions are Transactions are

Transactions Occur
prepared Analyzed Journalized and Posted
Figure 2.6 Flow of Accounting Data
49
Recording Process
There are three main steps which occur repeatedly in the recording process: Analyzing, journalizing
and posting.
The Journal and Journalizing

After reviewing source documents, accountants record the transactions. Transactions are first recorded
in a journal. Thus, the journal is referred to as the book of original entry. The journal is the main book
which includes the original entries of company’s transactions. Transactions are recorded in chronological
order (following the order in which they occurred) by applying debit and credit procedure. In other words,
journal entries include debit and credit effects of each transaction.
Typically, a journal includes dates of transactions, titles and references (codes) of accounts used to
record transactions, column for debit amount and column for credit amount. The format of the journal
is illustrated in Figure 2.7 which includes data of first two transactions of the Moon Company (the case
given as ‘your turn 4’ in Chapter 1) as an example.
The Moon Company

General Journal (page 1)
Date Account Titles and Explanation Ref. Debit Credit
Chronological order
Cash 2 101 20,000 6
Journal entries
January 1, 2018 1 Owner’s Capital 3 301 5 20,000 7
(Owner’s contribution in cash) 4
Equipment 157 4,000
January 2, 2018 Cash 101 4,000
(Purchase office equipment in cash)
Figure 2.7 The Journal and Technique of Journalizing
Date column includes the dates of transactions. Note that transactions are recorded in chronological
order. The titles of the accounts used in the recording and the explanations of each transaction are shown
in the next column. References of each account are mentioned. Debit and credit amounts for each account
are entered. This is called journalizing. The rounded numbers in Figure 2.7 correspond to the spaces of
the journal entry are listed below in order to explain the technique of journalizing.
1. The date of transaction.
2. The debit account title (it shows an increase in assets in this journal entry). Note that, debit accounts
are entered first at the left margin of the column.
3. The credit account title (it shows an increase in owner’s equity in this journal entry). Note that,
credit accounts are entered on the next line and right margin of the column.
4. Explanation of the transaction.
5. Numerical identifications of the accounts which are used later in posting.
6. Debit amount.
7. Credit amount.
50
Accounting I
Picture 2.2 Journal is referred to as a book of original entry.
Journal contributes to the recording process in terms of disclosing the details of transactions in one
place. In other words, it helps to prevent and correct errors because it shows the complete effects of a
transaction and provides chronological order.
Journal is referred to as a book of original entry.
Entering transaction data in the journal is known as journalizing.
In a journal entry, Debits are ALWAYS entered first, and Credits are INDENTED and listed second.
Simple entry includes two accounts. On the other hand, some transactions can require using more than
two accounts in journalizing. When three or more accounts are used, it is known as compound entry.
Posting to Ledger
Journal entries represent the details of a transaction. However, journal entries are not useful for tracking
and viewing the changes in account balances. For instance the second entry of the Moon Company given
in Figure 2.7 indicates that Moon Company purchased office equipment by paying 4,000 TL cash on
January 2, 2018 but it doesn’t show the balances of the accounts. In other words, we can only see the
4,000 TL decrease in cash account by just looking at this entry. However, if the first journal entry is also
taken into consideration, it will be understood that the balance of cash account becomes 16,000 TL after
the second transaction. Considering that companies have hundreds or even thousands of transactions, it
would be very difficult to calculate the balance of each account by looking at the journal entries one by
one. For this reason, journal information for each transaction is simultaneously transferred to individual
T-accounts in order to calculate the balances of each account used in the journal entry. This act is called
posting and the ledger refers to the entire group of individual T-accounts. In short, posting refers the to
transfer of the journal information to the appropriate individual T-accounts in the ledger.
Figure 2.8 shows the technique of posting. It is clear that information of each journal entry (JE1 and
JE2) is transferred to ledger accounts. The debit amount of the specific account is entered into the debit
51
Recording Process
side of its T-account or the credit amount of the specific account is entered into the credit side of its
T-account. Consequently, the balances of the accounts – cash, equipment and owner’s capital – can be
calculated.
The Moon Company

General Journal (page 1)
Cash 101 20,000
JE1 January 1, 2018 Owner’s Capital 301 20,000 JE1
(Owner’s contribution in cash)
Equipment 157 4,000
JE2 January 2, 2018 Cash 101 4,000 JE2
(Purchase office equipment in cash)
Cash 101 Owner’s Capital 301

JE1 20,000 JE2 4,000 JE1 20,000
The Ledger
16,000 20,000
Equipment 157
Debit / Dr. Credit / Cr. Entire group of
individual
JE2 4,000 T- Accounts
4,000
Figure 2.8 The Ledger and Technique of Posting
As it can be seen from the Figure 2.8, both the complete effects of transactions and the amount of
balances can be disclosed by using journal and ledger simultaneously.
The ledger is the entire group of accounts maintained by a company. It keeps in one place all the
information about changes in account balances and it is a source of useful data for management.
Posting is the procedure of transferring journal entries to the ledger accounts.
The journalizing and posting process has five steps:

Step 1: Identify the accounts and the account types (asset, liability, or equity).
Step 2: Decide whether each account increases or decreases and then apply the rules of debits and credits.
Step 3: Record the transaction in the journal.
Step 4: Post the journal entry to the ledger.
Step 5: Determine whether the accounting equation is in balance.
52
Accounting I
The Recording Process Illustrated: Case of TRApps

In this part, the recording process is illustrated by using the case of TRApps which is also analyzed
in Chapter 1 by using plus and minus procedure. But at that time, we use journal and ledger entries by
applying debit and credit procedure.
Remember that TRApps is established by Kaan Can who wants to develop mobile applications. There
are ten transactions realized in January of 2018 in this case and recording of each transaction is mentioned
below step by step.
Transaction 1 (T1): On January 1, 2018, Kaan Can invests 10,000 TL into the business to establish a
company titled TRApps which is a mobile application development company.
Analyzing T1
Identification The asset ‘Cash’ increases 10,000 TL; owner’s equity ‘Owner’s Capital’ increases 10,000 TL.
Effects on Equation Assets = Liabilities + Owner’s Equity

Cash Owner’s Capital
10,000 10,000
Debit and Credit Procedure Debit ‘Cash’ 10,000 TL; credit ‘Owner’s Capital’ 10,000 TL.
Journalizing T1
Journal
Cash 101 10,000
January 1, 2018 Owner’s Capital 301 10,000
(Owner’s investment of cash in business)
Posting T1
Ledger
Cash 101 Owner’s Capital 301

T1 10,000 10,000 T1
Debit 10,000 10,000 Credit

Balance Balance
Transaction 2 (T2): On January 2, 2018, TRApps purchases a computer by paying 4,000 TL cash.
Analyzing T2
Identification The asset ‘Cash’ decreases 4,000 TL; asset ‘Equipment’ increases 4,000 TL.

- Cash +Equipment
-4,000 + 4,000
Debit and Credit Procedure Debit ‘Equipment’ 4,000 TL, credit ‘Cash’ 4,000 TL
53
Recording Process
Journalizing T2
Journal
Equipment 157 4,000
January 2, 2018 Cash 101 4,000
(Purchasing office equipment in cash)
Posting T2
Ledger
Cash 101 Equipment 157

T1 10,000 4,000 T2 T2 4,000
Debit 6,000 Debit 4,000

Balance Balance
Transaction 3 (T3): On January 8, 2018, TRApps purchases computer accessories from ABC
Computer Store. The amount of accessories is 1,000 TL and ABC Computer Store agrees to receive the
amount of the bill in the following days of January.
Analyzing T3
Identification The asset ‘Supplies’ increases 1,000 TL; liability ‘Accounts Payable’ increases 1,000 TL.

Effects on Equation Accounts
Supplies Payable
1,000 1,000
Debit and Credit Procedure Debit ‘Supplies’ 1,000 TL, credit ‘Accounts Payable’ 1,000 TL.
Journalizing T3
Journal
Supplies 126 1,000
January 8, 2018 Accounts Payable 201 1,000
(Purchasing accessories on credit)
Posting T3
Ledger
Supplies 126 Accounts Payable 201

T3 1,000 1,000 T3

Balance Balance
54
Accounting I
Transaction 4 (T4): On January 11, 2018, TRApps receives 3,000 TL cash from its customer for
mobile application development service it has performed.
Analyzing T4
Identification The asset ‘Cash’ increases 3,000 TL; revenue account ‘Service Revenue’ increases 3,000 TL.

Cash Service Revenue
3,000 3,000
Debit and Credit Procedure Debit ‘Cash’ 3,000 TL, credit ‘Service Revenue’ 3,000 TL.
Journalizing T4
Journal
Cash 101 3,000
January 11, 2018 Service Revenue 600 3,000
(Received cash for services performed)
Posting T4
Ledger
Cash 101 Service Revenue 600

T1 10,000 4,000 T2 3,000 T4
T4 3,000

Balance Balance
Transaction 5 (T5): On January 12, 2018, TRApps gives an advertisement on the internet and receives
a bill for 500 TL from the advertisement agency. The agency agrees to receive the amount of the bill in the
following days of January.
Analyzing T5
Identification The liability ‘Accounts Payable’ increases 500 TL; owner’s equity decreases 500 TL
due to increase in expense account ‘Advertisement Expense’.

Accounts Payable (-) Advertisement
500 500
Debit and Credit Debit ‘Advertisement Expense’ 500 TL, credit ‘Accounts Payable’ 500 TL
Procedure
55
Recording Process
Journalizing T5
Journal
Advertisement Expense 730 500
January 12, 2018 Accounts Payable 201 500
(Received a bill for advertisement)
Posting T5
Ledger
Advertisement Expense 730 Accounts Payable 201

T5 500 1,000 T3
500 T5
Debit 500 1,500 Credit

Balance Balance
Transaction 6 (T6): On January 17, 2018, TRApps performs 4,000 TL of mobile application
development service for its client. The client pays 2,000 TL in cash and states that the rest of this amount
will be paid in following days of January.
Analyzing T6
Identification The asset ‘Cash’ increases 2,000 TL and asset ‘Accounts Receivable’ increases
2,000 TL revenue account ‘Service Revenue’ increases 4,000 TL.

Cash + Acc. Rec. Service Revenue
2,000 + 2,000 4,000
Debit and Credit Procedure Debit ‘Cash’ 2,000 TL, debit ‘Accounts Receivable’ 2,000 TL, credit
‘Service Revenue’ 4,000 TL.
Journalizing T6
Journal
Cash 101 2,000
January 17, 2018 Accounts Receivable 112 2,000
Service Revenue 600 4,000
(Service revenue in cash and on credit)
56
Accounting I
Posting T6
Ledger
Cash 101 Service Revenue 600

T1 10,000 4,000 T2 3,000 T4
T4 3,000 4,000 T6
T6 2,000

Balance Balance
Accounts Receivable 112
T6 2,000
Debit 2,000
Balance
Transaction 7 (T7): On January 18, 2018, TRApps pays the salaries of employees of 3,000 TL and
office rent of 1,000 TL in cash.
Analyzing T7
Identification The asset ‘Cash’ decreases 4,000 TL; owner’s equity decreases 4,000 TL
due to 3,000 TL increase in expense account ‘Salaries and Wages
Expense ‘and 1,000 TL increase in expense account ‘Rent Expense’.
Effects on Equation Assets = Liabilitie + Owner’s Equity

- Cash (-) SW.Ex. (-) Rent. Ex.
- 4,000 -3,000 - 1,000
Debit and Credit Debit ‘Salaries and Wages Expense’ 3,000 TL, debit ‘Rent Expense’
Procedure 1,000 TL, credit ‘Cash’ 3,000 TL.
Journalizing T7
Journal
Salaries and Wages Expense 726 3,000
January 18, 2018 Rent Expense 729 1,000
Cash 101 4,000
(Payment of expenses)
57
Recording Process
Posting T7
Ledger
Salaries and Wages Ex. 726 Cash 101

T7 3,000 T1 10,000 4,000 T2
T4 3,000 4,000 T7
T6 2,000
Debit
Debit 3,000
Balance 7,000
Balance
Rent Expense 729
T7 1,000
Debit 1,000
Balance
Transaction 8 (T8): On January 22, 2018, TRApps pays its 1,000 TL ABC Computer Store bill
(Transaction 3) and 500 TL advertisement agency bill (Transaction 5).
Analyzing T8
Identification The asset ‘Cash’ decreases 1,500 TL; liability ‘Accounts Payable’ decreases
1,500 TL.

- Cash - Accounts Payable
- 1,500 - 1,500
Debit and Credit Procedure Debit ‘Accounts Payable’ 1,500 TL, credit ‘Cash’ 1,500 TL.
Journalizing T8
Journal
Accounts Payable 201 1,500
January 22, 2018 Cash 101 1,500
(Payment of accounts payable)
Posting T8
Ledger
Cash 101 Accounts Payable 201

T1 10,000 4,000 T2 T8 1,500 1,000 T3
T4 3,000 4,000 T7 500 T5
T6 2,000 1,500 T8
Debit
Balance 5,500 0 Credit
Balance
58
Accounting I
Transaction 9 (T9): On January 25, 2018, customer pays the 2,000 TL cash to TRApps. It is the unpaid
amount of the bill for mobile application development service performed by TRApps (Transaction 6).
Analyzing T9
Identification The asset ‘Cash’ increases 2,000 TL; asset ‘Accounts Receivable’ decreases
2,000 TL.

Cash - Acc. Rec.
2,000 - 2,000
Debit and Credit Procedure Debit ‘Cash’ 2,000 TL, credit ‘Accounts Receivable’ 2,000 TL.
Journalizing T9
Journal
Cash 101 2,000
January 25, 2018 Accounts Receivable 111 2,000
(Collection of accounts receivable)
Posting T9
Ledger
Cash 101 Accounts Receivable 112

T1 10,000 4,000 T2 T6 2,000 2,000 T9
T4 3,000 4,000 T7
T6 2,000 1,500 T8
T9 2,000
Debit 7,500 Debit 0
Balance Balance
Transaction 10 (T10): On January 31, 2018, Kaan Can withdraws 1,000 TL in cash as profit share
(dividend) from the TRApps for his personal use.
Analyzing T10
Identification The asset ‘Cash’ decreases 1,000 TL; owner’s equity decreases 1,000 TL due
to the ‘Owner’s Drawings’.

- Cash (-) Owner’s Drawings
- 1,000 - 1,000
Debit and Credit Procedure Debit ‘Owner’s Drawings’ 1,000 TL, credit ‘Cash’ 1,000 TL.
Journalizing T10
Journal
Owner’s Drawings 306 1,000
January 31, 2018 Cash 101 1,000
(Distributions to owner)
59
Recording Process
Posting T10
Ledger
Cash 101 Owner’s Drawings 306

T1 10,000 4,000 T2 T10 1,000
T4 3,000 4,000 T7
T6 2,000 1,500 T8
T9 2,000 1,000 T10
Debit 6,500 Debit 1,000
Balance Balance
Summary Illustration of Journalizing and Posting: Case of TRApps

Figure 2.9 shows the journal for TRApps for January.
GENERAL JOURNAL
January 1, 2018 Cash 101
Owner’s Capital 301 10,000 10,000
January 2, 2018 Equipment 157

Cash 101 4,000 4,000
January 8, 2018 Supplies 126

Accounts Payable 201 1,000 1,000
(Purchasing accessories on credit)

Service Revenue 600 3,000 3,000
January 12, 2018 Advertisement Expense 730

Accounts Payable 201 500 500

Accounts Receivable 112 2,000
(Service revenue in cash and on credit)
January 18, 2018 Salaries and Wages Expense 726

Rent Expense 729 3,000
Cash 101 1,000 4,000
(Payment of expenses)
January 22, 2018 Accounts Payable 201

Cash 101 1,500 1,500
(Payment of accounts payable)

Accounts Receivable 112 2,000 2,000
January 31, 2018 Owner’s Drawings 306

Cash 101 1,000 1,000
Figure 2.9 Summary Illustration of Journalizing
60
Accounting I
Figure 2.10 shows the ledger, with all balances.
GENERAL LEDGER
Cash Ref. 101 Owner’s Capital Ref. 301
Transaction Debit Credit Balance Transaction Debit Credit Balance
T1 10,000 10,000 T1 10,000 10,000
T2 4,000 6,000
T4 3,000 9,000 Owner’s Drawings Ref. 306
T6 2,000 11,000 Transaction Debit Credit Balance
T7 4,000 7,000 T10 1,000 1,000
T8 1,500 5,500
T9 2,000 7,500
Service Revenue Ref. 600
T10 1,000 6,500
Transaction Debit Credit Balance
Accounts Receivable Ref. 112 T4 3,000 3,000
Transaction Debit Credit Balance T6 4,000 7,000
T6 2,000 2,000
T9 2,000 0 Salaries and Wages
Expense Ref. 726
Supplies Ref. 126
T7 3,000 3,000
T3 1,000 1,000 Rent Expense Ref. 729
Equipment Ref. 157 T7 1,000 1,000
Advertisement Expense Ref. 730
T2 4,000 4,000
T5 500 500
Accounts Payable Ref. 201
T3 1,000 1,000
T5 500 1,500
T8 1,500 0
Figure 2.10 Summary Illustration of Posting
4 5
Describe the journal and journalizing. Describe the ledger and posting.
61
Recording Process
6
Ms. Moon established the Moon Company on January 1, 2018 and the company made some transactions
during January, 2018. Use journal and ledger entries and record the transactions mentioned below by
applying debit and credit procedure.
1. Ms. Moon started her business by investing 20,000 TL in cash.
2. Purchased office equipment for 4,000 TL in cash.
3. Received cash for business services, 1,500 TL.
4. Provided services for 2,500 TL on credit.
5. Paid salaries of 1,200 TL.
8. Withdrew 1,000 TL for personal use.
TRIAL BALANCE
Since equal amounts of debits and credits are entered in the accounts for every transaction recorded,
the sum of all the debits in the ledger must be equal to the sum of all the credits. If the computation of
account balances has been accurate, it follows that the total of the accounts with debit balances must
be equal to the total of the accounts with credit balances. Before using the account balances to prepare
financial statements, it is necessary to prove that the total of accounts with debit balances is in fact equal to
the total of accounts with credit balances. To test this, the accountant periodically prepares trial balance at
the end of each accounting period. This proof of the equality of debit and credit balances is called a trial
balance.5 A trial balance is a list of all ledger accounts with their balances at a point in time. A trial balance
summarizes the accounts by listing all the accounts with their balances—assets first, followed by liabilities,
and then owner’s equity.
Do not confuse the trial balance with the balance sheet! A trial balance is an internal document used
only by company insiders. Outsiders see only the company’s financial statements, not the trial balance.
A trial balance has three columns listing the names and the balances of all the accounts used in
transactions. Balances are entered into appropriate debit or credit columns. The total amounts of debit
and credit columns show the mathematical equality of debits and credits after posting. In this sense, if
the sum of debits equal to the sum of credits, it means that the recordings are correct under double-entry
system. If not, we must understand that there are errors in journalizing and posting then the accountant
or bookkeeper must determine the reason.
A trial balance is a list of accounts and their balances at a given time. The trial balance proves the
mathematical equality of debits and credits after posting.
The primary purpose of a trial balance is to prove (check) that the debits equal the credits after posting.
62
Accounting I
Preparing a Trial Balance: Case of TRApps

Although a trial balance may be prepared at any time, it is usually prepared on the last day of the
accounting period. We should first list the account titles in order to prepare a trial balance. After that
appropriate balance amounts are entered into debit or credit column. Then sum of debits and sum of
credits are calculated. And at the final step, the equality of the sum of debits and the sum of credits is
proved.
Please note that, the trial balance proof that the ledger is in balance. The agreement of the debit and
credit totals of the trial balance gives assurance that: (1) Equal debits and credits have been recorded for
all transactions, (2) the addition of the account balances in the trial balance has been performed correctly.6
On the other hand, trial balance does not prove that the company has recorded all transactions correct.
There may be errors in classification or in measurement event the equality is provided.
The trial balance does not prove that the company has recorded all transactions correct. There may be
errors in classification or measurement even the equality is provided. It indicates only that the debits and
the credits are equal.
The trial balance of TRApps prepared from its ledger is shown in Figure 2.12. Note that the total debits
equal to the total credits.
TRApps
Trial Balance
January 31, 2018
BALANCE
Debit Credit
Cash 6,500
Supplies 1,000
Equipment 4,000
Accounts Payable 0
Owner's Capital 10,000
Owner's Drawings 1,000
Service Revenue 7,000
Salaries and Wages Expense 3,000
Rent Expense 1,500
Advertisement Expense 500
17,000 17,000
Figure 2.11 A Trial Balance
7
Prepare the trial balance of the Moon Company by using accounting data based on the transactions
63
Recording Process
Preparing Financial Statements from Trial Balance: Case of TRApps

In addition to proving the equality of debits and credits, the trial balance is also used to prepare the
financial statements. The trial balance is normally prepared at the end of every accounting period and is
the basis for preparation of financial statements.
The income statement is prepared using the revenue and expense accounts from the trial balance. The
net income relates to the increase (or in the case of a net loss, the decrease) in owner’s equity.
Figure 2.12 Income Statement of

TRApps
Figure 2.13 Owner’s Equity

Statement of TRApps
64
Accounting I
Picture 2.3 Financial statements are prepared by

using summarized accounting data.
Further Reading
Notes on the Origin of Double-Entry Bookkeeping

It seems as if, before double-entry appeared, accounting records of proprietor ships, whether single
or multiple, were confined to records of dealings involving the granting or receiving of credit. The
records assumed various forms and often the “books of account” were mere scraps of paper. Sometimes
there were entries in diaries or journals, where the settlement of debts was indicated by the effective
though untidy method of deletion. Sometimes the entries in the journal were reclassified into accounts,
the beginnings of the modern ledger.
Though there is evidence that other transactions were sporadically recorded, the scope of the early
bookkeeping efforts was very similar to that of what is now known as single-entry bookkeeping. But as
the records were in no way systematized, it is perhaps incorrect to describe them as single-entry, which
term today implies the presence of some system in records. Indeed, single-entry as a system is more
likely to have been a development from double-entry. Dr. Jager has stated that single-entry, as a system,
developed out of double entry through the gradual omission of all impersonal accounts. Schmalenbach
says that “there existed in Germany, particularly in the Hanseatic towns and in the South German trade
centers, before the adoption of the Italian bookkeeping, a system of commercial accounting with a fairly
well-developed technique and no menclature.” He continues that double-entry considerably influenced
this native brand, “so that the single-entry bookkeeping methods of today have the appearance of being
stunted versions of double-entry bookkeeping.”
Source: Basil S. Yemy. (1947). Notes on the Origin of Double-Entry Bookkeeping. The Accounting
Review, 22, 3, p.263-272
65
Recording Process
Describe the characteristics of an

LO 1 account and explain accounts as
they relate to recording process
An account is an individual accounting tool that shows the increases and decreases in a specific asset,
liability, or owner’s equity item. Accounting relies on a system of accounts, with the name or title of each
account intended to capture the nature of the items in the account. Chart of accounts is simply a list
of account names that a company uses in its general ledger for recording various business transactions.
It provides guidance to accountants or other relevant persons in using specific account names while
Summary
recording transactions. The ledger is a record of all the accounts that the company uses, the changes in
those accounts, and their balances. A ledger is often defined as a book of accounts.
Define debits, credits, and normal account

LO 2 balances, and use double-entry accounting
and T-accounts in recording process
Accounting systems are designed to show the increases and decreases in each financial statement item
as a separate record by using accounts. An account, in its simplest form, has three parts. First, each
account has a title, which is the name of the item recorded in the account. Second, each account has a
space for recording increases in the amount of the item. Third, each account has a space for recording
decreases in the amount of the item. Debit represents the left side of an account. Credit represents the
right side of an account. Debiting refers to the act of making an entry on the left side of an account and
when debit amount exceeds credits, debit balance occurs. Crediting refers to the act of making an entry
on the right side of an account and when credit amount exceeds debits, credit balance occurs. Under
double-entry system, the sum of all the debits must be equal to the sum of all the credits according to
double-entry system which is a logical basis of accounting systems worldwide. Assets, distributions and
expenses increase by debiting (on the left side) and normally show debit balance. Liabilities, contributions
and revenues increase by crediting (on the right side) and normally show credit balance. The sign and the
place of elements in the accounting equation determine the side of increase and decrease in T-account. For
instance, if an element on the left hand side of the accounting equation has a negative sign, that means
accounts of the element decrease on the left side while increase by crediting.
66
Accounting I
Record transactions in a journal

LO 3 and post journal entries to the
ledger
Transactions are first recorded in a journal. The journal is the main book which includes the original
entries of a company’s transactions. Transactions are recorded in chronological order (following the order
in which they occurred) by applying debit and credit procedure. In other words, journal entries include
debit and credit effects of each transaction. Typically, a journal includes dates of transactions, titles and
references (codes) of accounts used to record transactions, column for debit amount and column for credit
Summary
amount. Journal contributes to the recording process in terms of disclosing the details of transactions in
one place. In other words, it helps to prevent and correct errors because it shows the complete effects of
a transaction and provides chronological order. Debit and credit amounts for each account are entered.
This is called journalizing.
Journal entries represent the details of a transaction. However, journal entries are not useful for tracking
and viewing the changes in account balances. For this reason, journal information for each transaction
is simultaneously transferred to individual T-accounts in order to calculate the balances of each account
used in journal entry. This act is called posting and the ledger refers to the entire group of individual
T-accounts. In short, posting refers to the transfer of the journal information to the appropriate individual
T-accounts in the ledger.
Prepare the trial balance from the

LO 4 T-accounts and illustrate how it can be
used to prepare financial statements
A trial balance is a list of accounts and their balances at a given time. The trial balance proves the
mathematical equality of debits and credits after posting. A trial balance has three columns listing the names
and the balances of all the accounts used in transactions. Balances are entered into appropriate debit or
credit columns. The total amounts of debit and credit columns show the mathematical equality of debits
and credits after posting. In this sense, if the sum of debits equal to the sum of credits, it means that
the recordings are correct under double-entry system. If not, we must understand that there are errors in
journalizing and posting. We should first list the account titles in order to prepare a trial balance. After that
appropriate balance amounts are entered into debit or credit column. Then the sum of debits and sum of
credits are calculated. And at the final step, the equality of the sum of debits and the sum of credits is proved.
67
Recording Process
1 Financial transactions are initially recorded in the 6 If an element on the …. side of the accounting
A. Ledger equation has ….. sign, that means accounts of the
B. Journal element decrease on the left side while increase by
C. Trial balance crediting.
Test Yourself
D. Income statement A. Right / negative B. Both/ positive

E. Statement of Cash Flows C. Left / negative D. Both/ negative
E. Left / positive
2 The right side of an account is referred to as the
A. Foot side B. Chart side 7 When three or more accounts are used in
C. Debit side D. Credit side journalizing, it is known as
E. Ledger side A. Balance sheet
B. T-account
3 A purchase of equipment for cash requires a C. Posting
credit to D. Simple entry
A. Equipment B. Cash E. Compound entry
C. Accounts payable D. Owner’s capital 8
E. Expense …. is the procedure of transferring journal
entries to the ledger accounts.
A. Journalizing B. T-account
4
The equality of the accounting equation can
be proven by preparing a C. Posting D. Simple entry
E. Compound entry
A. Trial balance
B. Journal 9 …… refers to the act of making an entry
C. Ledger on the right side of an account and when credit
D. T-account amount exceeds debits
E. Owner’s equity statement
A. Crediting / debit balance
B. Crediting / credit balance
5 Which of the following accounts would be C. Debiting / credit balance
increased with a debit? D. Debiting / debit balance
A. Accounts payable E. Debiting / no balance
B. Owner’s capital
C. Service revenue 10 The agreement of the debit and credit totals
D. Owner’s drawings of the trial balance gives assurance that:
E. Notes Payable
I. Equal debits and credits have been recorded
for all transactions.
II. The addition of the account balances in the
trial balance has been performed correctly.
III. Prove that the company has recorded all
transactions correct.
Which one(s) of the them following is(are) true?
A. Only I B. Only II
C. Only III D. I and II
E. II and III
68
Accounting I

1. B If your answer is wrong, please review the 6. C
“Basic Form of Account: Using of Debits
“Steps in Recording Process” section.
and Credits” section.

2. D 7. E If your answer is wrong, please review the
“Steps in Recording Process” section.
3. B If your answer is wrong, please review the 8. C If your answer is wrong, please review the
“Steps in Recording Process” section. “Steps in Recording Process” section.

4. A If your answer is wrong, please review the 9. B
“Trial Balance” section.
5. D If your answer is wrong, please review the 10. D If your answer is wrong, please review the
“Steps in Recording Process” section. “Trial Balance” section.
What should be account codes for Accounts

Payable according to the Turkish Uniform Chart
of Accounts?
Account class 3, current liabilities, and 32 Trade Payables (opposite of 12

Trade Receivables). The subclasses are then further divided into what are
your turn 1 termed synthetic accounts – account subclass 32, breaks down into synthetic
accounts 320 Accounts Payable, 321 Notes Receivables, and so on.
Consider a credit purchase of equipment. What

are the dual effects?
A credit purchase of equipment:

• Increases the account Equipment (the business owns to use in its own
your turn 2 operations)
• Increases on account Accounts Payable (the business owes, cash will be paid
in the future)
69
Recording Process
Describe the debit and credit rules for each

element of accounting equation.
Dr./Cr. Rules for Assets: Assets increase on left side, by debiting while decrease
on right side by crediting and normally show debit balance.
Dr./Cr. Rules for Liabilities: Liabilities increase on right side, by crediting
Dr./Cr. Rules for Contributions: Contributions increase on right side, by
crediting while decrease on left side by debiting and normally show credit
your turn 3 balance.
Dr./Cr. Rules for Distributions: Distributions increase on left side, by debiting
while decrease on right side by crediting and normally show debit balance.
Dr./Cr. Rules for Revenues: Revenues increase on right side, by crediting
Dr./Cr. Rules for Expenses: Expenses increase on left side, by debiting while
decrease on right side by crediting and normally show debit balance.
Describe the journal and journalizing.
The journal is the main book which includes the original entries of a
company’s transactions. Journal contributes to the recording process in
terms of disclosing the details of transactions in one place. In other words, it
your turn 4 helps to prevent and correct errors because it shows the complete effects of a
transaction and provides chronological order. Entering transaction data in the
journal is known as journalizing.
Describe the ledger and posting.
The ledger is the entire group of accounts maintained by a company. It keeps

in one place all the information about changes in account balances and it is a
your turn 5 source of useful data for management. Posting is the procedure of transferring
journal entries to the ledger accounts.
70
Accounting I
Ms. Moon established the Moon Company on January 1, 2018

and the company made some transactions during January,
2018. Use journal and ledger entries and record the transactions
mentioned below by applying debit and credit procedure.

1. Ms. Moon started her business by investing 20,000 TL in cash.
2. Purchased office equipment for 4,000 TL in cash.
3. Received cash for business services, 1,500 TL.
4. Provided services for 2,500 TL on credit.
5. Paid salaries of 1,200 TL.
8. Withdrew 1,000 TL for personal use.
your turn 6
GENERAL JOURNAL PAGE 1

1 Cash 101
Owner’s Capital 301 20,000 20,000
2 Equipment 157
Cash 101 4,000 4,000
3 Cash 101
4 Accounts Receivable 112
(Receive revenue on credit)
5 Salaries and Wages Expense 726
Cash 101 1,200 1,200
(Payment of salaries)
6 Advertisement Expense 730
Accounts Payable 201 600 600
7 Cash 101
Accounts Receivable 112 500 500
8 Owner’s Drawings 306
Cash 101 1,000 1,000
GENERAL LEDGER
Cash Ref. 101 Owner’s Capital Ref. 301
T1 20,000 20,000 T1 20,000 20,000
T2 4,000 16,000
T4 1,500 17,500 Owner’s Drawings Ref. 306
T5 1,200 16,300 Transaction Debit Credit Balance
T7 500 16,800 T8 1,000 1,000
T8 1,000 15,800
Service Revenue Ref. 600
Accounts Receivable Ref. 112 Transaction Debit Credit Balance
T3 1,500 1,500
T4 2,500 2,500 T4 2,500 4,000
T7 500 2000
Salaries and Wages
Equipment Ref. 157 Expense Ref. 726
T2 4,000 4,000 T5 1,200 1,200
Accounts Payable Ref. 201 Advertisement Expense Ref. 730

T6 600 600 T6 600 600
71
Recording Process
Prepare the trial balance of the Moon Company

by using accounting data based on the
transactions mentioned in your turn 4.
Moon Company
Trial Balance
January 31, 2018
BALANCE
Debit Credit
Cash 15,800
Accounts Receivable 2,000
your turn 7 Equipment 4,000
Accounts Payable 600
Owner's Capital 20,000
Owner's Drawings 1,000
Salaries and Wages Expense 1,200
Advertisement Expense 600
24,600 24,600
Endnotes
1
Stickney Clyde P., Roman L. Weil, Katherine Stickney, Roman Schipper, Francis, p.49.
4
Schipper, Jennifer Francis, (2010) Financial

Williams, J.R., Haka, S.F., Bettner, M.S., & Carcello,
5
Accounting, An Introductıon to Concepts,
J.V. (2018). Financial Accounting. Mc Graw
Methods, and Uses, 13th Edition, South-Western
Hill, Seventeenth Edition, p.114.
Cengage Learning, p.44.
Williams, Haka, Bettner, & Carcello, p.115.
6
2
Miller-Nobles, T.,Mattison, B. And Matsumura,
E.M. (2016) Horngren’s Accounting, The
Financial Chapters, 11th Edition, Pearson, p.80.
3
Weygandt, J. J., Kimmel, P. D., & Kieso, D. (2010).
Accounting Principles. Wiley, Twelfth Edition,
p.45.
72
Accrual Accounting and
Chapter 3 Adjusting Process
Learning Outcomes
1 2
Define and apply the time period concept,
Differentiate the cash basis accounting and revenue recognition principle and matching
accrual basis accounting principle
3 4
Explain the purpose of and prepare adjusted
Explain the purpose of and record adjusting trial balance, and identify the impact of
entries adjusting entries on the financial statements
Key Terms
Accrual Basis
Accrued Expense
Accrued Revenue
Chapter Outline Adjusted Trial Balance
Introduction
Adjustments
Differences Between Cash Basis Accounting and
Cash Basis
Accrual Basis Accounting
Depreciation
Related Concepts and Principles Apply to Accrual
Matching (Expense Recognition) Principle
Basis Accounting
Financial Statements
Adjusting Process and Adjusting Entries
Fiscal Year
Adjusted Trial Balance and Financial Statements
Interim Period
Prepaid Expense
Revenue Recognition Principle
Time Period Concept
Unearned Revenue
74
Accounting I
INTRODUCTION
You learned the basic accounting equation and financial statements, in Chapter 1. In Chapter 2, you
learned about T-accounts, debits, credits and basic steps in the recording process through the preparation
of the trial balance. Before preparation of financial statements from the trial balance, we have some
additional steps. In this chapter, we’ll continue our study of the accounting cycle by learning how to
update the accounts at the end of the period. This process is called adjusting the books, and it requires
adjusting entries. The main situation here is the importance of adjusting entries. By adjusting entries
made at the end of the accounting period, companies show their financial status accurately because, the
adjusting entries are part of the measurement of net income for the period and financial position at the
end of the period.
DIFFERENCES BETWEEN CASH BASIS ACCOUNTING AND ACCRUAL

BASIS ACCOUNTING
Accounting is based on either the cash basis or the accrual basis. The main difference between these
two is in the dictation of how the companies’ transactions are recorded. Revenues and expenses may be
recorded when the cash related with them is received/paid or when they are earned/incurred.
In cash basis accounting, companies record revenues
when they receive the cash and they record expenses when
the cash is paid. Cash basis accounting records only cash
transactions—cash receipts and cash payments. Basically, it Accounting is based on either the cash basis
is a simple method. But it prevents businesses from being or the accrual basis.
cautious. Companies adopting cash basis accounting focus
only transactions involving cash. Those with no monetary
input are not taken into consideration. It is possible to say
that cash basis accounting is mostly used by small businesses. In cash basis accounting, companies record
On the other hand, accrual basis accounting records revenues when they receive the cash and they
the impact of a business transaction as it occurs. When record expenses when the cash is paid.
the business performs a service, makes a sale, or incurs
an expense, the transaction will be recorded even if
the business did not receive or did not pay any cash. In
accrual basis accounting, companies record revenues In accrual basis accounting, companies
when they are earned and record expenses when they are record revenues when they perform services
incurred. Recording regardless of monetary inflows and (rather than when they receive cash) and
outflows forms the basis of accrual basis accounting. So, record expenses when they are incurred
the profitability of the company applying accrual basis (rather than when paid).
accounting can be measured much better when compared
with applying the cash basis accounting.
To illustrate the difference between cash basis and accrual basis, let’s give an example. Suppose that on
February 1 2018, TRApps company paid 600 TL for office rent for the next 3 months (200 TL per month).
This prepayment represents rent amount for February, March, and April. Under the cash basis, TRApps
company would record Rent Expense of 600 TL on February 1. The expenses will be recorded when the
company paid cash as cash basis offers. But, under the accrual basis of accounting, expenses will be recorded
when they incurred. TRApps company will record a 200 TL Rent Expense every month for February, March,
and April.
Suppose that Cinar company received 1,200 TL for services to be performed for the next three months
(March, April, and Mon March 1, 2018). Under the cash basis, Cınar company will record 1,200 TL of
revenue when the cash is received on March 1. But accrual basis requires that the revenue will be recorded
only when it is earned. Cinar company will record 400 TL of revenue for each month.
75
Accrual Accounting and Adjusting Process
Probably you realized that the total amount of revenues and expenses recorded by December 31 was
the same. Under the accrual basis, some accounts in the ledger require updating.
The major difference between cash basis and accrual basis accounting is related to the timing of recording
the revenue and expenses. We now will explain the Time Period Concept, The Revenue Recognition
Principle, and Matching Principle (it is also called as Expense Recognition Principle).
1
Identify why mentioning the type of accounting basis used is important for financial statement users.
RELATED CONCEPTS AND PRINCIPLES APPLIED TO ACCRUAL BASIS

ACCOUNTING
As you learned, the timing and recognition of revenues and expenses are the basic differences between
cash basis and accrual basis accounting. To understand the accrual accounting, you have to learn some
other accounting concepts: the time period concept, revenue recognition principle and matching principle.
Time Period Concept

Each company is set up with the expectation that it will
have an unlimited lifetime (remember the going concern
assumption). But companies’ related parties (such as The time-period concept assumes that
government, creditors, investors, management, customers, unlimited economic life of a company will be
etc.) wish to have information about the activities and divided into regular intervals and that financial
financial position of the company over certain periods. statements will be prepared for specific periods
In order to meet these demands and give feedback, the such as a month, quarter, or year.
unlimited economic lifetimes are divided into artificial
time periods by accountants. The time-period concept (or
alternatively periodicity concept) assumes that unlimited
Accounting periods may be monthly,
economic life of a company will be divided into artificial
quarterly, semiannually or yearly.
time periods and that financial statements can be prepared
for specific periods such as a month, quarter, or year.
All small, medium, and large sized companies are required to prepare their financial reports at certain
time periods. Because related parties are examining these financial reports in order to give right decisions,
they want to reach the right information on time. Even though the basic accounting period is one year,
some of the companies might prepare their financial reports monthly, quarterly or semiannually.
The 12-month accounting period used for the annual
financial statements is called as fiscal year. Most of the
companies use calendar year as a fiscal year. If the accounting Fiscal Year = Accounting time period that is
period consists of one year and the starting and ending one year in length.
dates are January 1 and December 31, fiscal year will be Calendar Year = January 1 to December 31.
equal to the calendar year. But that does not mean that it is
absolutely necessary. It may vary among companies, and for
example, may be between February 1 and January 31. In that situation, beginning and ending dates of the
fiscal and calendar year will be different even both of them cover a 12-month period.
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Accounting I
Sometimes companies can prepare their financial statements for

shorter time periods for internal reporting purposes. If the accounting
period is shorter than one year, then it is called as an interim period.
Interim periods may be monthly or quarterly.
The basic accounting period

is one year, and virtually all Monthly and quarterly time
businesses prepare annual periods are called interim periods.
Figure 3.1 The Time Period financial statements.
Concept
The Revenue Recognition Principle

It is important to know when companies should
recognize revenue, in other words, when the companies Revenue is the gross increase in owner’s
earned the revenue. Revenue recognition principle will equity from delivering goods or services to
guide us. But first of all we will start with the definition of customers and clients.
revenue and expense terms. Revenue is the gross inflow of
economic benefits during the period arising from the course
of the ordinary activities of an entity when those inflows
result in increases in equity, other than increases relating to Expense is the cost of assets consumed or
contributions from equity participants1. Expense is outflows services used during the revenue earning
or other using up of assets or incurrences of liabilities during process.
a period from delivering or producing goods, rendering
services, or carrying out other activities that constitute the
entity’s ongoing major or central operations2.
Moving from the definition of revenue, we also dwell on Expense is the gross decrease in owner’s
the revenue recognition principle. We made the definition equity that results from operations.
of revenue, now let’s define the term recognition. The term
recognize means to record. In revenue recognition principle,
revenue is recorded when it is earned, not when the cash is
received just the same as the accrual basis accounting. Let’s Revenue recognition principle dictates that
give an example related with this situation. Assume that a revenue is recognized when it is earned not
person comes to your bakery on April 1 and orders a cake for the cash is received.
the next month and pays the fee. On May 1, the same person
comes and takes the cake. So, the question here is: When
should the revenue be recorded? In April or May? The answer
is that revenue should be recorded in the month of May In deferred revenue, revenue is recognized
when the cake is given to the customer, in other words, when after the cash is received.
the performance obligation is fulfilled.3 This type of revenue
is named as deferred revenue. If cash is received in advance
(before revenue is earned), a liability account (called as deferred revenue) will be used as a correspondence to
cash account, a liability account called deferred revenue is used as a correspondence to cash account.
Let’s give another example. Suppose that you are a cleaning worker and you clean the house of a
person on April 1. But you receive your money on May 1. The question here is: When should the revenue
be recorded? On April or May? In course, revenue should be recorded in the month of April when the
house is cleaned. This type of revenue is named as accrued
revenue. In accrued revenue, revenue is recognized before
the cash is received. It is important to note that accrued In accrued revenue, revenue is recognized
means outstanding or unpaid. before the cash is received.
77
Matching Principle
Matching Principle, also referred as Expense
Recognition Principle is used to explain the relationship Matching Principle (Expense recognition
between expense and revenues. It means that you record the principle) means that you will record the
expenses at the same time with the revenues related with expenses at the same time with the revenues
these expenses which are recorded regardless of the time cash related with these expenses are recorded.
is paid. Also, it is important to allocate the costs through
all the periods that are benefitted. The same as the deferred
and accrued revenues, there are also deferred and accrued
expenses. When an expense is recognized after the cash paid, In deferred expense (prepaid expense),
then it is called as deferred expense. Please note that expense expense is recognized after the cash is paid.
is recognized when there is a consumption. Deferred expense
does not mean that there is a usage or a consumption. It
can also be named as prepaid expense. When an expense
is recognized before the cash is paid, then it is called as
In accrued expense, expense is recognized
accrued expense. When expenses are incurred but not yet
before the cash is paid.
paid, a liability must be recorded. For example, on March
1, Company rented an office building and started to use it.
At the end of March, one month’s rent expense is incurred when office building is used during March. The
company can pay the rent expense immediately, or it may record a liability for the rent to be paid later. In
both situations, the company incurs rent expense. The critical event to record an expense is the usage of the
office building by the company, not payment of cash. If rent payments will be made at the end of the year,
the company will record the rent expense for March and Rent Payable at the end of the March.
2
Compare the differences between deferred and accrued items.
ADJUSTING PROCESS AND ADJUSTING ENTRIES

At the end of each accounting period, companies present their financial statements in order to
communicate with information users. To present the company’s true and fair situation all accounts must
be updated because recording some revenue and expense transactions are omitted during the period. That
means some accounts must be adjusted, and some adjusting entries must be made.
The Basics of Adjusting Entries

Information users need to know how well company is performing. Actually, companies will identify and
record the company’s financial events on daily basis. To summarize and give information about the company’s
ending position at the end of the period, they must prepare their financial statements by using the accounts
balances. This process will begin with the trial balance (you learned in Chapter 2). This trial balance is unadjusted
because the accounts are not yet ready to prepare the financial statements. The reasons that are as follows:4
1. Some financial events are not recorded on a day-to-day basis because it is unwise to do so such as
consumption of supplies or the earnings of salaries by employees.
2. Some costs are not recorded during the current accounting period because these costs expire with the
passage of time rather than as a result of recurring daily transactions such as rent expense or insurance
expense.
3. Some types of expenses may be unrecorded. For example, an electricity bill may not be received
until next accounting period.
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Accounting I
The process of analysing and updating of accounts at the end of the period before the financial statements
are prepared is called the adjusting process. The journal entries that bring the accounts up to date at the
end of the accounting period are called adjusting entries.
Adjusting entries are necessary to update all account
balances before preparation of financial statements But,
these adjustments are not the result of physical events or Adjusting Entries are necessary every time
transactions, these adjustments are caused by the passage of financial statements are prepared.
time or small changes in account balances.
At the end of the accounting period, an adjusting entry
is completed, and it records revenues to the period in which
they are earned and expenses to the period in which they At the end of the accounting period, an
occur. Adjusting entries also update the asset and liability adjusting entry is completed, and it records
accounts. Adjustments are necessary to properly measure revenues to the period in which they are
several items such as:5 earned and expenses to the period in which
1. Net income (loss) on the income statement they occur.
2. Assets and liabilities on the balance sheet
All adjusting entries affect at least one income statement account and one balance sheet account. Thus,
an adjusting entry will always involve a revenue or an expense account and an asset or a liability account.
Categories of Adjusting Entries

Adjusting entries are important in order to prepare
correct and up-to-date financial reports. There are two
basic categories of adjusting entries. These are deferrals and Basic categories of adjusting entries are
accruals. In a deferral adjustment, cash will be paid before deferrals and accruals.
an expense is incurred or the cash will be received before the
revenue is earned. Accruals adjustments are the opposite of deferrals. An accrual records an expense before
the cash is paid, or it records the revenue before the cash is received.
The two basic categories of adjustments can be divided into four different types as follows:
1. Deferred (Prepaid) Expenses
2. Deferred (Unearned) Revenues
3. Accrued Expenses
4. Accrued Revenues
Adjusting Entries
Deferrals Accruals
(Prepayments)
Deferred Deferred Accrued Accrued

(Prepaid) (Unearned) Expenses Revenues
Expenses Revenues
Figure 3.2 Categories and Types of Adjusting Entries
79
Adjusting Entries for Deferred Expenses (Prepaid Expenses)

As we mentioned before, in deferral adjustments the cash payment occurs before an expense is incurred.
Deferred expenses are advance payments of future expenses. Deferred expenses are also called as prepaid
expenses.
As mentioned before, deferred expenses are the ones
that are firstly paid and reported as an asset but will not be
recorded as an expense until a future accounting period. In
other words, cash is paid before the expense is recognized. Deferred expenses (prepaid expenses) are
Rent, interest, insurance, etc. are the examples of prepaid advance payments of future expenses.
expenses. The amounts of office supplies used up may also
be considered as prepaid expenses. As it is not necessary, such kinds of expenses are not required in daily
recordings. For that reason, companies do not recognize them until the preparation of their financial
reports.
At each financial statement date, companies make the necessary adjusting entries related with deferred
expenses. As deferred expense is considered as an asset before the adjustments, positions of assets are
overstated and positions of expenses are understated. What we want to do is to reduce assets. Therefore, in
the adjusting entry, expense will be created as a debit and asset as a credit. As seen in Figure 3.3, companies
have to reduce the assets and transfer consumption part to the related expense account by increasing the
related expense.
Let’s give an example related with the
WITH THE ADJUSTING ENTRIES deferred expenses. On January 18, Cinar
Company purchased 10,000 TL of supplies on
account. The January 31 unadjusted trial balance
ASSET EXPENSE
still lists Supply with a 10.000 TL debit balance
as an asset item. But Cinar Company’s Balance
Sheet should not report Supplies of 10.000 TL if
the company used some of them. During January,
Figure 3.3 Adjusting Entries of Deferred Expenses the company used supplies to conduct business. The
cost of supplies asset becomes Supplies Expense. In
order to measure Supplies Expense, the company first counts the supplies on hand at the end of the period, which
is January 31 for this example. This is the amount of the asset still owned by the company. Assumes that at the
end of the month 2,000 TL of supplies remain on hand.
Supplies Account Balance Before Adjustment – Used Amount of Supplies = Supplies on Hand
or
Supplies Account Balance Before Adjustment – Supplies on Hand = Used Amount of Supplies
Then the supply expense amount is:
10,000 – 2,000 = 8,000 TL
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Accounting I
At the end of the period (January 31), adjusting entry to reflect supplies used is in the following:
Adjusting Entries for Depreciation

Most of the companies own a variety of productive
facilities such as machinery, equipment, buildings in the Do not forget that the plant asset is not only
operation of business for a long term. They are called as used in the year of purchase. Its useful life is
plant assets or fixed assets that are long lived and tangible. longer than 1 year.
Examples include buildings, land, machinery, ship, office
equipment, furniture, motor vehicle, etc. As all these assets
have a life longer than 1 year, and they will be used through
their useful lives by the business, their costs must be allocated Depreciable amount is the cost of an asset,
to their useful lives. But land is exception. As Land has an or other amount substituted for cost, less
indefinite useful life so, it is not subject to depreciation. than its residual value.
Value and usefulness of plant assets will decline when

the business uses them in its operations. The decline in
usefulness of a plant asset is an expense which is called as Depreciation is the systematic allocation of
a depreciation expense. Here the concept of depreciation the depreciable amount of an asset over its
emerges. Depreciable amount is the cost of an asset minus its useful life.
residual value, and depreciation is the systematic allocation
of the depreciable amount of an asset over its useful life.6 In other words, depreciation is a cost allocation
process over the plant asset’s useful life.
Plant assets are expected to provide usefulness for many years, therefore they will be recorded as an asset, rather
than an expense, in the year they are acquired. For example, a business might purchase an office building and pay
cash when purchased, but the office building will provide usefulness for 40 years. Hence, the office building must be
recorded as an asset at the cost value, and each year’s depreciation expense must be calculated because of the matching
principle. Depreciation allocates the cost of the office building over the time the business uses the office building.
The business believes that the office building will remain useful for 40 years, and at the end of 40 years, it will be
worthless. Some of the plant assets will still have value at the end of their useful life, which is called residual value.
As you realized, you have to know about the cost value, useful life and residual value of the plant asset
to calculate the depreciation expense. Useful life is the estimated lifespan of a plant asset, and at the end of
this period, it is expected that the plant asset will have only a residual value. Residual value is the expected
value of the plant asset at the end of its useful life.
Residual value as land has an indefinite useful life,

Useful life is the estimated lifespan of a plant asset.
it is not subject to depreciation.
81
To calculate the depreciation expense, we will use straight-line depreciation method. The straight-
line method allocates an equal amount of depreciation for each period and is calculated as:
Straight-line depreciation = (Cost-Residual Value)

Useful Life
Let’ say that a Company purchased an Office Building on January 1, 2018, and the cost of the office building
is 842,500 TL, and the residual value is 42,500 TL. Each year’s depreciation expense will be 20,000 TL:
Straight-line depreciation = (842,500 – 42,500) / 40 = 20,000 TL per year
At each financial statement date, companies make the necessary adjustment entries related with
depreciation. Before the adjustments, assets are overstated and expenses are understated. So in adjusting
entry, we are going to debit to the depreciation expense and credit to the accumulated depreciation which
is a contra asset account as seen in Figure 3.4.
Office Building Accumulated Depreciation-O.Building
XXXX XXX
Normal DR Balance Normal CR Balance
Related Account Contra Account
Figure 3.4 Accumulated Depreciation Account
As you noticed, we credited to Accumulated Depreciation-Office Building account, and not to the asset
account Office Building. Because we have to continue to see the original cost of the Office Building separately
from the accumulated depreciation because of the cost
principle. The accumulated depreciation account is the
sum of all depreciation expenses recorded for the depreciable Accumulated Depreciation is a contra
asset to date. As you can imagine, Accumulated Depreciation asset account and it will accumulate the
will increase (accumulate) over time, and at the end of the depreciation expense during the useful life of
useful life of the equipment, its balance will be equal to the depreciable asset.
depreciable amount of office building.
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Accounting I
The balance sheet will report both Office Building and

Accumulated Depreciation-Office Building. Accumulated
Depreciation-Office Building will be subtracted from
Book Value of an asset is the depreciable
Office Building to see the book value of Office Building.
asset’s cost minus the asset’s accumulated
The book value represents the cost invested in the asset
depreciation.
that the business has not yet expensed or unexpired, in
other words, reminder usefulness of plant asset. Book value
of Office Building on December 31 is 822,500 TL.
Book Value of Office Building on December 31, 2018:
Office Building 842,500 TL
(Less) Accumulated Depreciation- Office Building (20,000)
Book Value of Office Building 822,500 TL
Note also that depreciation expense identifies the portion of the asset’s depreciable cost that has expired
during the year of 2018.
Adjusting Entries for Deferred (Unearned) Revenues

It is useful to define the term deferred (unearned) revenue before going to adjusting entries related
with it. Deferred (unearned) revenues occur when the company receives cash before it gives the service
or delivers a product to earn. In other words, firstly cash is received, and after a time, revenue occurs.
You receive the cash in advance for the work you will do in the future. The company owes a product or a
service to the customer, or it owes the customer his or her
money back. Only after completing the work or service or
delivering the product does the business earn the revenue.
In unearned revenue, revenue is recognized
Because of this delay, unearned revenue is a liability. Rent,
after the cash is received.
deposits for future service, variety of services, etc. are the
examples of unearned revenues.
Suppose that a company received 12,000 TL cash for one year’s rent on December 1, 2018. When the
company received 12,000 TL cash on December 1, 2018, it should not record the revenue as 12,000 TL because
we did not give or complete the service to our client. When the time passes, we will earn the rent revenue, so we
have a liability to give service over 12 months. So it is unearned revenue. The Company’s cash will increase at
12,000 TL, and a liability, which is Unearned Rent Revenue, will increase at 12,000 TL.
At each financial statement date, companies
make the necessary adjusting entries related WITH THE ADJUSTING ENTRIES
with deferred (unearned) revenues. As unearned
revenue is considered as a liability, liabilities
are overstated and revenues are understated LIABILITES REVENUE
before the adjustments. As seen in Figure 3.5,
companies have to reduce the liabilities and
transfer it to the related revenue account.
As the company receives the cash before
providing goods and services, unearned Figure 3.5 Adjusting Entries of Deferred (Unearned)
revenue is reported as a liability by reflecting Revenues
the obligation. After goods and services are
delivered, unearned revenue is reduced and the amount of it is transferred into the related revenue account.
When one month passed, at the end of December, the company will prepare financial statements.
Remember, On December 1, Company received 12,000 TL cash for 12 months of rent service.
83
As a result of this transaction, on December 1, the Company makes the following record:
As each month passes, 1,000 TL (12,000/12) is removed from the liability account of the balance sheet
to the revenue account of the income statement.
Adjusting Entry on December 31,2018:
If we did not make the adjusting entry, the Liability-Unearned Rent Revenue would be overstated and
Rent Revenue would be understated.
Adjusting Entries for Accrued Expenses

Some types of services, such as insurance, are normally paid for before they are used. As you learned
before, these prepayments are deferrals. Rent, interest, salaries, wages, utilities, etc. are the other examples
of accrued expenses over time. Expenses incurred but not yet paid or recorded at the end of the accounting
period are accrued expenses. Accrued expenses are the ones that are firstly incurred and not recorded as
an expense until a future accounting period. Because of the unnecessity, such kinds of expenses are not
required for daily recordings. For that reason, companies do not recognize them until the preparation of
financial reports. The amount of such an accrued but unpaid item at the end of the accounting period is
both an expense and a liability.
At each statement date, companies make the necessary adjustment entries related with accrued expenses.
Before the adjustments, liabilities and expenses are understated. So in adjusting entry, expense account will
be debited and a liability account will be credited. As seen in Figure 3.6, companies increase both liabilities
and expenses by making adjusting entries.
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Accounting I
WITH THE ADJUSTING ENTRIES

Let’s give an example related with the accrued
expenses: Assume that on December 1, Cinar
Company rented an office building. According to LIABILITY EXPENSE
the agreement, the rent of 1,000 TL will be paid
within 5 days after the end of each month.
As a result of this transaction, on December
31, Cinar Company makes the following adjusting
entry in order to record accrued rent expense: Figure 3.6 Adjusting Entries of Accrued Expenses
When the rent is paid on January 4, Cinar Company makes the following record for the payment of
accrued rent:
Adjusting Entries for Accrued Revenues

Revenues earned by performing a service or delivering goods but not yet recorded at the end of the
period are accrued revenues. According to the accrual basis accounting, earned revenues are recorded
when they are earned. Any revenues earned but not recorded during an accounting period require an
adjusting entry that debits an asset account and credits a revenue account.
At each financial statement date, companies make the necessary adjusting entries related with accrued
revenues. Before the adjustments, assets and revenues are understated. So in adjusting entry, asset will
be created as a debit and revenue as a credit. As seen in Figure 3.7, companies increase both assets and
revenues by making adjusting entries.
85
Let’s give an example related with the WITH THE ADJUSTING ENTRIES
accrued revenues: Assume that on December
15, an advertising company is hired to perform
advertising services. The business will earn 600 TL ASSETS REVENUE
monthly and receive payment on January 15. As of
December 31, 300 TL is earned.
As a result of this transaction, on December
31, the Company makes the following adjusting
entry: Figure 3.7 Adjusting Entries of Accrued Revenues
When the Company receives the cash on January 15, the following record will be made:
3
State the position (overstated or understated) of the accounts before adjustments for four types of adjusting entries.
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Accounting I
ADJUSTED TRIAL BALANCE AND FINANCIAL STATEMENTS

The trial balance lists the balances of all accounts but it is unadjusted. In another words, it is not
completely up-to-date. Accrual basis accounting requires the business to review the unadjusted trial
balance and determine whether any additional revenues and expenses are needed to be recorded.7 It means,
we cannot directly prepare the company’s financial statements by this unadjusted trial balance. Adjusted
trial balance is the last step before preparation of financial statements.
Adjusted Trial Balance

The company has journalized and posted all adjusting entries. Next, it prepares another trial balance
from the ledger accounts. This is called an adjusted trial balance. An adjusted trial balance is a list of
all the accounts with their adjusted balances. The purpose is to ensure that total debit balances are equal
to total credit balances in the ledger after all adjustments. Adjusted trial balance is the last step to prepare
financial statements. So, we can say that adjusted trial balance is the basis for the preparation of financial
statements. Financial statements are prepared from the adjusted trial balance.
Let’s continue with our TRApps
TRApps Mobile Application Development Company mobile application development
Trial Balance company example from Chapter 1 and
January 31, 2018 2. Trial Balance of TRApps Company
was prepared on January 31, 2018, but
BALANCE before the adjusting entries (Figure 3.8).
Debit Credit
Remember we prepared the
Cash………………………… TL 6,500
income statement and other financial
Account Receivables ……… 0 statements in the previous chapter, but
Supplies …………………… 1,000 we did not make any adjusting entry.
Equipment ……………….. 4,000 Net income or loss amount, therefore,
Accounts Payable …….…… 0 will not reflect the all revenues and
Owner's Capital …………… 10,000 expenses of the period because some
Owner's Drawings ………… 1,000 accounts are not up-to-date on January
Service Revenue ………….. 7,000 31, 2018, and some transactions have
Advertisement expense ……. 500 not yet been recorded. For example,
3,000 think about supplies. TRApps
Salary-Wages expense….
1,000
purchased computer accessories from
Rent Expense ……………..
ABC Computer Store on January 8,
TOTAL TL 17,000 TL 17,000
2018. Some of the supplies are used
Figure 3.8 Trial Balance of TRApps mobile application development to give services. But TRApps company
company did not make a journal entry for each
supply item used every time. That
would be inefficient, wasting time and money. Instead, TRApps waits until the end of the period and then
records the supplies used up during the entire month. The cost of supplies used up will become an expense.
An adjusting entry at the end of January updates both Supplies (an asset) and Supplies Expense. We have
to adjust all accounts whose balances are not yet up to date.
For interim reporting purposes, we might prepare the financial statements before adjusting entries. In
accounting cycle at the end of the period, we will prepare trial balance, and after recording the adjusting
entries, adjusted trial balance will be prepared, and finally, financial statements can be prepared.
87
Illustration for Adjusted Trial Balance of TRApps Company

In this section, we will continue TRApps Company example related with the types of adjustments
mentioned above. Each example will be based on the trial balance of TRApps Mobile Application
Development Company mentioned in Figure 3.8. It is assumed that TRApps Mobile Application
Development Company uses an accounting period of one month, and adjusting entries are made monthly.
At the end of the period, we have to get the adjustment data. Data needed for adjusting entries include
the following:
a. Office supplies on hand at the end of January, 200 TL
b. Company has an equipment of 4,000 TL which was purchased on January 2, 2018. Useful Life is
4 years and residual value is 0, and straight-line depreciation method is used.
c. Accrued salary expense is 500 TL
d. Accrued service revenue is 400 TL
a. Supplies such as pens and envelopes are used up on an ongoing basis. Unless an accounting system
is programmed to record tiny incremental changes, the financial effects are not captured as they occur.
Remember, on January 18, TRApps Company purchased 1,000 TL of supplies on account. But the company
used some of them to conduct business. The supplies on hand at the end of the period, which is January 31 for
this example, 200 TL.
Then the supply expense amount is:
Supplies Account Balance Before Adjustment – Supplies on Hand = Used Amount of Supplies
1,000 – 200 = 800 TL
At the end of the period (January 31), adjusting entry to reflect supplies used is as follows:
b. Let’s continue to the TRApps Company’s example related with the depreciation: As seen from TRApps
Company’s trial balance of 31 January 2018 mentioned in Figure 3.8, it has an equipment of 4,000 TL.
Assume that this equipment has 4 years life and the residual value is 0, which was purchased on January 2,
2018, and straight-line depreciation method (equal amount of cost allocation method) is used.
As each year passes, 1,000TL ((4,000 – 0) /4) is removed from the asset account of the balance sheet
to the expense account of the income statement. The record mentioned below will be made at the end
of each period. As a result, 4,000 TL cost will be allocated to useful life of the equipment. But you have
to be careful! Yearly depreciation expense amount is 1,000 TL. We will prepare one month’s financial
statements. In other words, TRApps Company used this equipment just for one month. So you have to
record one month’s depreciation expense on January 31, 2018. It is 83.33 TL (1,000/12).
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Accounting I
c. Let’s continue to the TRApps Company’s example related with accrued salary expense. You cannot
see the accrued salary expense amount from TRApps Company’s trial balance. You will need additional
information. Assume that TRApps Company hired a secretary on January 16, 2018, and monthly salary
will be 1,000 TL, but payments will be made on every 15th day of the month.
As you can imagine, on January 16, the company will not make any journal entry because this event
is not a financial transaction. Did you remember which events are subject to accounting? If not, please look at
the definition of financial transaction.
The secretary worked for the company for the half of January and the salary expense is incurred for the
half of the month. But the monthly salary will be paid on February 15, 2018. So, at the end of the January,
incurred salary expense must be recorded as accrued expense for the month January.
d. Let’s continue to the TRApps Company’s example related with accrued revenue. Assume that
TRApps Company is hired on January 20 to perform a service. Under this agreement, the business will
earn 1,200 TL monthly and receive payment on February 20. At the date of hiring, TRApps Company
cannot record this event in journal and ledger, so the trial balance will not include any data for this event.
During January it will earn 1/3 of month’s fee, 400 TL, for the work from January 20 to January 31.
On January 31, TRApps Company makes the following adjusting entry to record the accrued revenue:
89
Figure 3.9 Journalizing and Posting the Adjusting Entries of TRApps Company
The adjusting entries and account balances after posting TRApps Company on January 31, 2018 are
shown in Figure 3.9.
Panel A: Data needed for adjusting entries include the following:
a. Office supplies on hand at the end of January, 200 TL
b. Company has an equipment of 4,000 TL, which was purchased on January 2, 2018. Useful Life is
4 years and the residual value is 0, and the straight-line depreciation method is used.
c. Accrued salary expense is 500 TL
d. Accrued service revenue is 400 TL
Panel B: Adjusting Entries
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Accounting I
Panel C: Account Balances after Posting the adjusting entries:
Now, we have all the necessary data (unadjusted trial balance, adjusting entries, and the ledger accounts
after adjusting entries) for the preparation of the adjusted trial balance. By using them, it is possible to
prepare the adjusted trial balance of TRApps Company.
TRApps Mobile Application Development Company

January 31, 2018
BALANCE
Debit Credit
Cash………………………… TL 6,500
Accounts Receivables ……… 400
Supplies …………………… 200
Equipment ……………….. 4,000
Accounts Payable …….…… 0
Owner's Capital …………… 10,000
Owner's Drawings ………… 1,000
Service Revenue ………….. 7,400
Advertisement expense ……. 500
Salary-Wages expense………. 3,500
Rent Expense …………….. 1,000
Supply Expense …………. 800
Depreciation Expense …….. 83.33
Accumulated Depreciation-Eq. 83.33
Salary Payable …………….. 500
TOTAL TL 17,983.33 TL 17,983.33
Figure 3.10 Adjusted Trial Balance of TRApps Company
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Financial Statements
Now, we are ready to prepare the financial statements. Remember the adjusted trial balance is used to
prepare financial statements. As you can realize, if adjusting entries are not recorded, the ledger accounts
will not reflect the correct balances, and financial statements will be incorrect.
You can see the income statement of TRApps Company in Figure 3.11.
(TL) TRApps
Income Statement (TL) TRApps
For the Month Ended January 31, 2018
Owner’s Equity Statement
For the Month Ended January 31, 2018
Revenues 7,400.00
Service revenue 7,400 Opening balance 0
(-) Expenses 5,883.33 Net Income 1,516.67
Advertisement expense 500 Transactions with owner(s) 9,000
Salary-Wages expense 3,500 Investment by owner 10,000

Rent expense 1,000 (-) Distribution to owner -1,000
Supply Expense 800
Depreciation expense 83.33 ____ Closing balance 10,516.67

Net Income 1,516.67
Figure 3.12 Owner’s Equity Statement of TRApps
Figure 3.11 Income Statement of TRApps
(TL) TTRApps
Balance Sheet
January 31, 2018
Assets Liabilities 500.00
Cash 6,500 Salary Payable 500
Accounts Receivables 400
Supplies 200 Owner's Equity 10,516.67
Equipment 4,000
- -
(-) Acc.Deprec (83.33)
Book Value of Equipment 3,916.67 -
- Total Liabilities and Owner's -

Total Assets 11,016.67 Equity 11,016.67
The balance sheet will report both Equipment and Accumulated Depreciation-Equipment. Accumulated
Depreciation-Equipment will be subtracted from Equipment to see the book value of Equipment. The
book value represents the cost invested in the asset that the business has not yet expensed or unexpired, in
other words, reminder usefulness of plant asset. Book value of equipment on January 31 is 3,916.67 TL.
Book Value of Equipment on January 31, 2018:
Equipment 4,000 TL
(Less) Accumulated Depreciation-Equipment (83.33)
Book Value of Equipment 3,916.67
92
Accounting I
4
Prepare the adjusted trial balance of XYZ Company whose trial balance and adjusting data are mentioned below.
XYZ Company
Trial Balance
December 31, 2018
Debit Credit
Cash TL 30,000
Supplies 4,000
Prepaid Cleaning Service 500
Equipment 5,000
Notes Payable TL 1,000
Accounts Payable 3,000
Unearned Cleaning Revenue 1,000
Owner’s Capital 15,000
Owner’s Drawings 500
TL40,000 TL40,000
Adjusting Data:
• On December 1, XYZ Company prepays 200 TL for 2 months of cleaning service.
• XYZ Company has an equipment of 5,000 TL. Assume that this equipment has a 5 years life, and this
equipment was purchased on January 1, 2018, and the straight-line method is used.
• XYZ Company leases a building. According to the agreement, the rent of 20,000 TL will be paid within 10
days after the end of each month.
93
Further Reading
How Adjusting Entries Affect the Quality of Financial Reporting: The Case of Frosty Co.
“Recent accounting scandals have emphasized the need to think beyond debits and credits. Accounting
students must understand the effects of transactions on a company’s financial position, as well as the pressures
and incentives they will someday face to misrepresent that position. This case introduces students in intermediate
financial accounting courses to both of these important objectives. First, the case improves students’ critical
thinking skills in accounting by allowing them to determine if various correcting entries should be made, and
what the effects of those transactions will be on the company’s financial statements. Second, the case improves
students’ ability to evaluate ethical consequences by introducing them to conflicting incentives regarding those
corrections: the obligation to provide investors with high-quality financial statements that fairly present the
company’s financial position versus the pressure to maintain a high stock price for investors. The case may be
completed using either U.S. GAAP or IFRS.”
Source: Jason C. Porter, How Adjusting Entries Affect the Quality of Financial Reporting: The Case
of Frosty Co. Issues in Accounting Education, American Accounting Association, Vol. 27, No. 2, 2012,
pp. 493–524.
Inside Practice
Using Depreciation in Tax Planning

Companies desire to maximize their revenues and minimize costs. The main aim of this desire is
to maintain the life in a comfortable way. Tax is qualified as a factor reducing the profits of companies
because it has an important share in the total costs. For this reason, companies try to minimize the
amount of tax they have to pay. The reduction of the tax that should be paid to the government by
implementing illegal means is tax evasion and should not be applied. Tax evasion is the evasion of the
taxes by not paying any of the obligations or paying some of them in an illegal way. On the other side,
companies can also pay less tax by taking the advantage of the gaps in the law. Here, the concept of tax
avoidance emerges. This is also described as tax planning. Tax planning is the most appropriate solution
for companies in order to decrease their tax liabilities.
There are so many methods used during tax planning. One of them is the selection of depreciation method.
Depreciation occurs as a result of tangible fixed asset consumption. In other words, it allows expenses to occur.
Companies may differ their tax liabilities by changing the depreciation method they will use. For example, if they
choose straight-line depreciation method, the amount of the depreciation will always be the same throughout
the useful life. But, if the company chooses the declining depreciation method, the depreciation amount in early
years will be much more when compared with the following years. So as the amount of cost increases, the tax
amount will be less.
Discuss:
1. Do you think that the share of depreciation in the total costs of a company is high when compared
with others?
2. What other methods can be used in tax planning?
94
Accounting I
Differentiate the cash basis

LO 1 accounting and accrual basis
accounting
There are two types of accounting methods used in record-keeping: the cash basis and accrual basis. The
main difference between these two is in the dictation of how the companies’ transactions are recorded.
Revenues and expenses may be recorded when the cash related with them is received/paid or when they
are earned/incurred.
In cash basis accounting, companies record revenues when they receive the cash and they record expenses
Summary
when the cash is paid. Cash basis accounting records only cash transactions—cash receipts and cash
payments. Basically, it is a simple method. Companies adopting cash basis accounting focus only
transactions involving cash. Those with no monetary input are not taken into consideration. It is possible
to say that cash basis accounting is mostly used by small businesses.
On the other hand, accrual basis accounting records the impact of a business transaction as it occurs.
When the business performs a service, makes a sale, or incurs an expense, the transaction will be recorded
even if the business did not receive or did not pay any cash. In accrual basis accounting, companies
record revenues when they are earned and record expenses when they are incurred. Recording regardless
of monetary inflows and outflows forms the basis of accrual basis accounting. So, the profitability of the
company applying accrual basis accounting can be measured much better when compared with applying
the cash basis accounting.
Define and apply the time period

LO 2 concept, revenue recognition
principle and matching principle
Each company is set up with the expectation that it has an unlimited lifetime. But companies’ related
parties (such as government, creditors, investors, management, customers, etc.) wish to have information
about the activities and financial status of the entity over certain periods. In order to meet these demands
and give feedback, the economic lifetimes of companies are divided into time periods. Accounting time
periods may be monthly, quarterly, or yearly.
The time-period concept (or alternatively periodicity concept) assumes that unlimited economic life of
a company will be divided into artificial time periods and that financial statements can be prepared for
specific periods, such as a month, quarter, or year.
There are two main principles for the income determination. These are revenue recognition principle
and matching principle. In revenue recognition principle, revenue is recorded when it is earned, not
when the cash is received just the same as the accrual basis accounting. Matching (Expense recognition)
principle means that you will record the expenses at the same time with the revenues related with these
expenses are recorded regardless of when cash is paid.
95
Explain the purpose of and record

LO 3 adjusting entries
Information users need to know how well a company is performing. Actually, companies will identify
and record the company’s financial events on daily basis. To summarize and give information about the
company’s ending position at the end of the period, they must prepare their financial statements by using
the accounts balances. This process will begin with the trial balance. This trial balance is unadjusted
because the accounts are not yet ready to prepare the financial statements. Because recording some revenue
Summary
and expense transactions are omitted during the period. That means some accounts must be adjusted and
some adjusting entries must be made.
The process of analysis and updating of accounts at the end of the period before the financial statements
are prepared is called the adjusting process. The journal entries that bring the accounts up to date at the
end of the accounting period are called adjusting entries.
At the end of the accounting period, an adjusting entry is completed, and it records revenues to the
period in which they are earned and expenses to the period in which they occur. Adjusting entries also
update the asset and liability accounts.
All adjusting entries affect at least one income statement account and one balance sheet account. Thus,
an adjusting entry will always involve a revenue or an expense account and an asset or a liability account.
Adjusting entries are important in order to prepare correct and up-to-date financial reports. There are two
basic categories of adjusting entries. These are deferrals and accruals. In a deferral adjustment, cash will
be paid before an expense is incurred, or the cash will be received before the revenue is earned. Accruals
adjustments are the opposite of deferrals. An accrual records an expense before the cash is paid, or it
records the revenue before the cash is received.
The two basic categories of adjustments can be divided into four different types as follows:
Types of Adjustments Position of Accounts Before Adjusting Entries
Deferred (Prepaid) Expenses Assets overstated, expenses understated
Deferred (Unearned) Revenues Liabilities overstated, revenues understated
Accrued Expenses Expenses understated, liabilities understated
Accrued Revenues Assets understated, revenues understated
Explain the purpose of and prepare adjusted trial

LO 4 balance, and identify the impact of adjusting
entries on the financial statements
After the preparation of unadjusted trial balance, which is not sufficient for the preparation of financial
statements, we have to make the necessary adjusting entries. The company has journalized and posted
all adjusting entries. Next, it prepares another trial balance from the ledger accounts. This is called an
adjusted trial balance. An adjusted trial balance is a list of all the accounts with their adjusted balances.
The purpose is to ensure that total debit balances are equal to total credit balances in the ledger after all
adjustments. Adjusted trial balance is the last step to prepare financial statements. So, we can say that
adjusted trial balance is the basis for the preparation of financial statements. Financial statements are
prepared from the adjusted trial balance. Balance sheet, income statement, and owner’s equity statement
are prepared with the data found in adjusted trial balance.
96
Accounting I
1 According to the time period concept, ...... 4 Which of the following is the explanation of
revenue recognition principle?
A. revenues don’t have to be matched with costs of
the related period. A. The gross increase in owner’s equity
B. fiscal year should be the same with interim B. The cost of assets consumed or services used
Test Yourself
period. during the revenue earning
C. accounting time periods may be weekly, C. Revenue is recorded when it is earned not the
monthly, quarterly, or yearly. cash is received the same as the accrual basis
D. the economic lifetimes of companies, which are accounting.
considered to be unlimited, are divided into D. Revenue is recognized after the cash is received.
time periods. E. It means that you will record the expenses at
E. fiscal year’s starting and ending dates have to be the same time with the revenues related with
January 1 and December 31. these expenses are recorded regardless of when
cash is paid.
2 Which of the following explanations related
with cash basis accounting is wrong? 5 Which of the following is not one of the
major kinds of adjusting entries?
A. It is one of the two types of accounting methods
used in record-keeping. A. Prepaid expenses
B. Companies record revenues when they receive B. Unearned revenues
the cash, and they record expenses when the C. Accrued expense
cash is paid. D. Capital
C. It is a simpler method when compared with the E. Accrued revenues
accrued basis.
D. Companies adopting cash basis accounting 6 Adjustments for unearned revenues: ......
focus only on transactions involving cash.
A. decrease liabilities and increase revenues.
E. Recording regardless of monetary inflows and
outflows B. increase liabilities and decrease revenues.
C. decrease assets and increase expenses.
3 Which of the following explanations related D. increase assets and decrease expenses.
with accrual basis accounting is wrong? E. increase expense decrease liability
A. Companies record revenues when they are
earned and record expenses when they are
7 Adjustments for accrued expenses: ......
incurred. A. decrease liabilities and decrease expenses.
B. Companies record revenues when they receive B. increase liabilities and increase expenses.
the cash and they record expenses when the C. increase assets and increase revenues.
cash is paid. D. decrease assets and increase expenses.
C. It is one of the two types of accounting methods E. decrease expense and decrease liabilities.
used in record-keeping.
D. Recording regardless of monetary inflows and
outflows
E. The profitability of the company applying
accrual basis accounting can be measured much
better when compared with applying the cash
basis accounting.
97
8 Depreciation is: ......

10 Which of the following is not one of the
A. the systematic allocation of the depreciable financial statements?
amount of an asset over its useful life.
A. Balance sheet
B. the estimated lifespan of a fixed asset.
B. Owner’s equity statement
C. the value at which the useful life of the fixed
Test Yourself
C. Adjusted trial balance

asset ends.
D. Income statement
D. a owner’s equity account.
E. Cash flow statement
E. a expense account.
9 Which of the following explanations related

with the adjusted trial balance is wrong?
A. This is sufficient for the preparation of financial
statements.
B. This is the trial balance prepared before the
adjusting entries.
C. This is the trial balance prepared after the
adjusting entries.
D. This is prepared by using the ledger accounts
recorded during the adjustment process.
E. It gives us the chance of checking the equality
of debits and credits.
98
Accounting I
1. D 6. A
“Related Concepts and Principles Apply to “Adjusting Process and Adjusting Entries”
Accrual Basis Accounting” section. section.

2. E 7. B
“Differences Between Cash Basis Accounting “Adjusting Process and Adjusting Entries”
and Accrual Basis Accounting” section. section.
3. B 8. A
“Differences Between Cash Basis Accounting “Adjusting Process and Adjusting Entries”
and Accrual Basis Accounting” section. section.
If your answer is wrong, please review the If your answer is wrong, please review
4. C 9. B
“Related Concepts and Principles Apply to the “Adjusted Trial Balance and Financial
Accrual Basis Accounting” section. Statements” section.
If your answer is wrong, please review the If your answer is wrong, please review
5. D “Adjusting Process and Adjusting Entries”
10. C
the “Adjusted Trial Balance and Financial
section. Statements” section.
99
Identify why mentioning the type of accounting basis

used is important for financial statement users.
In order to make the right decisions, financial statement users review the
financial statements of the company they are related to. Companies shall
specify which accounting basis is used in the disclosures of their financial
statements. By this means, financial statement users will be able to see this
information in the disclosures when they examine the financial statements.
Which accounting basis the company applies is extremely important in
terms of presenting the actual financial status of the company. As recording
your turn 1 regardless of monetary inflows and outflows forms the basis of accrual
basis accounting, the profitability of the company applying accrual basis
accounting can be measured much better when compared with applying the
cash basis accounting. In this respect, as the relevant groups know which
accounting principle is used, they will also have information about whether
the accounting profitability of the company is calculated correctly or not. So,
this will help them to make the right financial decisions.
Compare the differences between deferred and accrued

items.
Accruals and deferrals in the accounting cycle involve the time at which
income and expense entries are noted in their respective accounts. Accruals
your turn 2 and deferrals occur only when a business uses accrual based accounting
methods. If accruals and deferrals are not used correctly in the accounting
cycle, certain accounts may seem undervalued or overvalued.
State the position (overstated or understated) of the

accounts before adjustments for four types of adjusting
entries.
Kinds of Adjustments Position of Accounts Before Adjusting Entries

Prepaid Expenses Assets overstated, expenses understated
your turn 3 Unearned Revenues Liabilities overstated, revenues understated
Accrued Expenses Expenses understated, liabilities understated
Accrues Revenues Assets understated, revenues understated
100
Accounting I
Prepare the adjusted trial balance of XYZ Company whose trial balance and
adjusting data are mentioned below.
XYZ Company

Trial Balance
December 31, 2018
Debit Credit
Cash TL 30,000
Supplies 4,000
Equipment 5,000
Notes Payable TL 1,000
Accounts Payable 3,000
Unearned Cleaning
1,000
Revenue
TL40,000 TL40,000
Adjusting Data:
• On December 1, XYZ Company prepays 200 TL for 2 months of cleaning service.
• XYZ Company has an equipment of 5,000 TL. Assume that this equipment has
a 5 years life, and this equipment was purchased on January 1, 2018, and the
straight-line method is used.
• XYZ Company leases a building. According to the agreement, the rent of 20,000
TL will be paid within 10 days after the end of each month.
your turn 4
101
XYZ Company

December 31, 2018
Debit Credit
Cash 30,000
Supplies 4,000
Equipment 5,000
Accumulated Depreciation- Equipment 1,000
Notes Payable 1,000
your turn 4 Accounts Payable 3,000
Unearned Cleaning Revenue 1,000
Rent Payable 20,000
Cleaning Service Expense 100
Depreciation Expense 1,000
Rent Expense 20,000
TL 61,000 TL 61,000
Endnotes
1
Conceptual Framework, International Accounting 5
Miller-Nobles T., Mattison B. and Matsumura E.M.
Standards Board. Access from: http://www.ifrs. (2016). Horngren’s Accounting, Financial
org at the date of 26 March, 2018. Chapters, 11th Edition, Global Edition, Pearson,
p. 145.
2
Schroeder, R.G., Clark, M.W., & Cathey, J.M.
(2005). Financial Accounting Theory and 6
International Accounting Standard 16 – Property,
Analysis. Wiley, Eight Edition, p.143. Plant and Equipment, International Accounting
Standards Board. Access from: http://www.ifrs.
International Financial Reporting Standard 15 – Revenue
3
org at the date of 2 April, 2018.
from Contracts with Customers. Access from: http://
www.ifrs.org at the date of 19 May, 2018. 7
Miller-Nobles T., Mattison B. and Matsumura E.M.
p. 145.
4
Weygandt Jerry J, Kieso Donald D. And Kimmel
Paul D. Accounting Principles (1999), 5th
Edition, John Wiley and Sons, Inc., p.95.
102
Completing the
Chapter 4 Accounting Cycle
Learning Outcomes
1 Explain and prepare financial statements

2 Explain the purpose of closing process and
record closing entries
3 Explain the steps of accounting cycle
Key Terms
Chapter Outline Income Statement
Introduction
Statement of Owner’s Equity
Preparing Financial Statements
Balance Sheet
Closing Process and Closing the Accounts
Income Summary Account
Accounting Cycle
Closing Entries
Post-Closing Trial Balance
Accounting Cycle
104
Accounting I
INTRODUCTION
When founded on the 1 of January 2018, owner Kaan Can expected TRApps Co. to be a successful
st
company. But is it really so? In order to figure out how the company performed throughout the period, the
performance of the company must be measured. But how? As you learned in Chapter 1, the business entity
will remain in operation forever according to the period. But it is not possible to measure the performance
of the company when it is on operation. Because there has to be a beginning and an ending period for
the measurement results to be meaningful. For example, the company has a profit of 150,000,000 liras
for 2018 financial year. In this example, the company discloses that between the dates 1st of January
2018 – 31st of December 2018 the company had a profit of 150,000,000 liras. Besides measuring the
performance of the company, assets, liabilities and the owner’s equity must be reported at the end of the
year. The owner/owners and the managers want to know the current financial situation of the company.
They will compare current year’s financial situation with the past years’ and will make projections for the
coming year and future.
In this chapter, we will complete the accounting cycle, prepare financial statements and prepare the
company for the coming period.
PREPARING FINANCIAL STATEMENTS

Financial statements have vital importance for the companies. By analyzing the financial statements,
information users drill out information about the company according to their information needs. Therefore,
information given in the financial statements must be relevant, faithfully representable, comparable,
verifiable, timely and understandable1.
At the end of the period, companies prepare financial statements for evaluating the financial
performance, in other words profit and loss of the company, and also for analyzing the financial situation,
in other words assets, liabilities and owner’s equity of the company. After the preparation of financial
statements, there comes the final step of accounting cycle which is closing the accounts. This step is for
preparing the accounts for the coming year.
For the preparation of financial statements, the starting
point is the adjusted trial balance. As you can remember
from the previous chapters, adjusted trial balance is one
form of trial balance that holds in-term transactions’ totals Adjusted trial balance is one form of trial
and balances as well as the end of the period transactions’ balance that holds in-term transactions’ totals
totals and balances for final checking of the accounts and and balances as well as the end of the period
preparation of financial statements. After the preparation transactions’ totals and balances for final
of adjusted trial balance and financial statements, closing checking of the accounts and preparation of
entries will be recorded in order to get accounts ready for financial statements.
the next year. We will focus on closing process further in this
chapter. Now, let’s have a look at the financial statements.
Financial statements are prepared in order;2
• Income statement
• Statement of owner’s equity
• Balance sheet
Let’s break adjusted trial balance of TRApps Co. into parts and see if we can figure out the elements of
financial statements.
105
Completing the Accounting Cycle

January 31, 2018
BALANCE
Debit Credit
Cash………………………… TL 6,500
Supplies …………………… 200
Equipment ……………….. 4,000
Accounts Payable …….…… 0
Owner's Capital …………… 10,000
Owner's Drawings ………… 1,000
Service Revenue ………….. 7,400
Advertisement expense ……. 500
Salary-Wages expense………. 3,500
Rent Expense …………….. 1,000
Supply Expense …………. 800
Depreciation Expense …….. 83.33
Salary Payable …………….. 500
TOTAL TL 17,983.33 TL 17,983.33
Figure 4.1 Adjusted Trial Balance of TRApps Company
Income statement is the initial financial statement

that is going to be prepared. Now, let’s remember the
definition of income statement. Here is a little clue for Income statement is the financial statement
you. The contents of financial statements will be guide that reports operation results of a business
for their definitions. Income Statement shows the profit for a specific period of time (month, quarter
or loss of the company. So, how does profit or loss occur? quarter, or year year).
The positive difference between revenues and expenses give
profit whereas the negative difference gives the loss. So, in
the income statement company reports revenues, expenses
and their differences. It is very crucial not to forget that the
revenues and expenses must belong to the same financial In the income statement company reports
period. Since you have examined revenues and expenses revenues, expenses and their differences.
in the chapter on adjusting process, we can now make a
definition of the income statement. Income statement is the financial statement that reports operation
results of a business for a specific period of time (month, quarter, or year). Operation results indicate the
results from of the main operations and sub-operations of the business. Revenue and expense accounts are
shown in red in the TRApps Co.’s adjusted trial balance.
Statement of owner’s equity reports the changes in the capital throughout the period caused by the
owner’s capital investments or withdrawals, net profit or loss. As you know, profit and loss are the rights
of the owners’; and therefore, they are reported in owner’s equity section in the balance sheet. Let’s explain
why they are reported under owner’s equity. Profit and loss are differences between revenues and expenses.
Revenues are earnings that result from delivering goods and services to customers3. When revenue is
occurred, it makes an increase in the assets. On the contrary, expenses are the cost of selling goods and
106
Accounting I
services, and they may also occur from other activities of the business4. When expense is incurred, it
makes a decrease in the assets. As the equity is the owner’s claims over the assets, profit can be seen as the
net increase in the assets. Thus, profit increases the equity.
By the same manner, loss can be seen as the net decrease
in the assets. So loss decreases the equity. Therefore, when Statement of owner’s equity reports the
company has a profit, it is reported as an increase in the changes in the capital throughout the period
equity. When the company has a loss, it is reported as a caused by the owner’s capital investments or
decrease in the equity. Green colored accounts in TRApps withdrawals, net profit or loss.
Co.’s adjusted trial balance are used for reporting in owner’s
equity statement.
Balance sheet reports the assets, liabilities and the owner’s equity in a specific date. In other words,
balance sheet provides information about the financial position of the company. In the trial balance you
can easily find out asset, liability and owner’s equity accounts which will form the balance sheet. In a
technical manner, balance sheet can be defined as a summary or a list of accounts that have balances after
actual and constructive closing of the accounts according to generally accepted accounting principles in a
double-entry accounting system5. Orange colored accounts in the TRApps Co.’s adjusted trial balance will
be reported in the balance sheet. In the following sections, we will learn how to prepare balance sheet out
of trial balance. Adjusted trial balance holds the elements of the balance sheet in unclassified form. But in
practice, balance sheets are prepared in a classified form.
Balance sheet reports the assets, liabilities Revenues and expenses are reported in the
and the owner’s equity in a specific date. income statement; assets, liabilities and owner’s
equity are reported in the balance sheet.
Classified Balance Sheet

Classified balance sheet reports each asset, liability and owner’s equity in specific sections. There are
five sections in the classified balance sheet. As you can follow from Figure 4.2, assets are divided into
two sections: current assets and non-current assets. Liabilities are also divided into two sections: current
liabilities and non-current (long-term) liabilities. There is one more section in the classified balance sheet
and, that is for the owner’s equity.
You know the definition of assets from previous
TRApps Co. chapters. But what about current assets and non-
31/01/2018 current assets? They both have the properties of
BALANCE SHEET
assets but have differences between them. Assets
are reported according to their liquidity in the
CURRENT
CURRENT ASSETS balance sheet. Liquidity is the measure of how
L LIABILITIES M
I A quickly and easily an account can be converted
T into cash . From current assets to non-current
6
Q
U NON-CURRENT U assets, liquidity of the assets decreases.
I LIABILIES R
D I
I NON-CURRENT T
T ASSETS Y Liquidity is the measure of how quickly and
OWNER’S
Y easily an account can be converted into cash
EQUITY
Current assets include the assets that will be

Figure 4.2 Classified Balance Sheet of TRApps Co. converted into cash, sold, consumed or received
107
within 12 months or within the business’s operating

cycle, and the cash, and cash equivalents. For example,
Current assets include the assets that will be
cash, receivables of which due dates are shorter than
converted into cash, sold, consumed or received
12 months in the date of balance sheet, raw materials
within 12 months or within the business’s
that will be consumed within 12 months, merchandise
operating cycle, and the cash and cash equivalents.
inventory that will be sold within 12 months and,
prepaid items will be reported under current assets.
1
Give examples for current assets.
Non-current assets include the assets acquired to be used in business ‘s operations for more than 12
months and receivables of which due dates are more than 12 months. From the perspective of liquidity,
non-current assets’ convertibility into cash must be over 12 months. For example, receivable that has a
due date of 15 months will be reported in non-current assets. In fact, the main purpose of a business’s
acquisition of non-current assets is not to convert them into cash but to use them in its operations for more
than 12 months. Non-current assets are generally classified into three categories: Long term investments,
property and equipment, and intangible assets7
Non-current assets include the assets acquired to be used

in business ‘s operations for more than 12 months and 2
receivables of which due dates are more than 12 months. Give examples for non-current assets.
Companies have two finance sources for their assets. They are liabilities and owner’s equity. Sources are
classified according to their maturity dates on the balance sheet: from short-term maturity dates to owner’s
equity which has an indefinite maturity date. Liabilities are the existing debts of the company. They are
classified as current liabilities and non-current liabilities. Current liabilities are the short term liabilities. It
means that the company has to pay the liability either with cash of by handling goods or services within
one year or in an operating cycle. Companies benefit from current liabilities for financing its current
assets. Remember, companies use their current assets within one year, and also the current liabilities have
maturity dates mostly for one year. For the coherence of current assets and current liabilities, companies
must use current liabilities only for financing the current assets. If the company uses its current liabilities
for financing non-current assets, maturity mismatch will occur, and this will lead to cash shortage and will
result in bankruptcy. Non-current liabilities are the liabilities that their maturity dates are over one year or
the operating cycle. Companies use their non-current liabilities for financing non-current assets as well as
current assets. Financing current assets with non-current liabilities creates an advantage for the company
rather than using current liabilities. Company can use the assets financed by non-current liabilities and
earn more profit till the maturity date rather than using current liability.
Current liabilities are the liabilities that the company has

to pay either with cash of by handling goods or services 3
within one year or in an operating cycle. Give examples for liabilities
108
Accounting I
Owner’s equity is the owners’ claims on the assets.

In the balance sheet, owner’s equity shows the owners’
Owner’s equity shows the owners’
investments, profit and loss of the period. Capital account
investments, profit and loss of the period.
shows the investments done to the company or drawings
from the company by the owners.
Let’s now prepare the classified balance sheet of TRApps Co. for the 31st January 2018.
TRApps Co.
31/01/2018
Balance Sheet
CURRENT ASSETS 7.100.- CURRENT LIABILITIES
Cash 6,500.- 500.-
Acc. Rec. 400.- Salary Payale 500.-
Supplies 200.-
NON-CURRENT OWNER’S EQUITY
ASSETS 3,916.67 10,516.67
Equipment 4,000.- Capital 9,000-
(-)Acc. Depr., Eq. (83.33) Profit 1,516.67
11,016.67 11,016.67
Figure 4.3 Classified Balance Sheet of TRApps Co.
Now, you can compare the beginning and ending balance sheets of TRApps Co. easily. At the
beginning, TRApps Co. has only one type of asset: 10.000 TL of cash capital. But at the end of the period,
the company has various kinds of assets and liability, whereas the capital decreased to 9,000 TL for the
drawback of the owner, and the company has a profit of 1,516.67 TL. Though yerine Despite the decrease
in the capital, owner’s equity increased by the affect, of the profit.
CLOSING PROCESS AND CLOSING THE ACCOUNTS

As previously mentioned, owner’s equity shows the investments done by the owner/owners and the result
of the operations of the company which is either profit or loss. Assume that a company has a profit of
100,000,000 liras. Is this amount of profit enough for the company? So, how can the interested parties evaluate
the profit? It may be considered that the size of the business is important in evaluating, but besides that, it is
more important to know the details of revenues and expenses that form the result. Here is an example:
Revenues Expenses Profit / Loss

1,000,000,000.- - 900,000,000.- = 100,000,000.-
500,000,000.- - 400,000,000.- = 100,000,000.-
200,000,000.- - 100,000,000.- = 100,000,000.-
All situations above give the same result of 100,000,000 liras of profit. But when interpreted, in the
first situation, the company beared 900,000,000 liras of expense in order to earn 1,000,000,000 liras.
That’s the 90% of the company’s revenue. For the second situation, 80% percent of revenue lost by the
expenses, and in the final situation, half of the revenue is lost. Eventhough the results are the same for
each situation, the interpretation makes difference. In the balance sheet, all these three the companies
will report the profit of 100,000,000 liras, but for the stakeholders it is important to know the details of
revenues and expenses.
109
Profit increases the owner’s equity whereas the loss decreases. If so, it is possible to record revenues into
the credit side of the Capital account because revenues increase the claims of the owners’ on assets and also
it is possible to record expenses into the debit side of the Capital account. But by doing so it, will become
impossible for the stakeholders and decision makers to analyze the changes that form the profit or loss
and also the changes in the capital account that owners made investments on. Hence, instead of recording
revenues and expenses into capital account, they are separately recorded into several revenue and expense
accounts; and therefore, the company can measure revenues and expenses.
At the end of the period, the company must calculate the results of its operations. In other words, the
company must ascertain the term’s profit or loss. For this aim, the balances of revenue accounts and expense
accounts have to be posted to Income Summary account. By accounting meaning, the revenue accounts and
expense accounts have to be closed and their balances have to be posted to Income Summary account. Because
the company has so many different revenue and expense accounts separately, they have to be accumulated under
one account in order to figure out the exact result. This account is the Income Summary account. After the
accumulation of revenues and expenses under Income Summary account, the final result is clear. The balance
of the Income Summary Account will be either profit or loss. Now that the result of the period is found out,
Income Summary account will be closed and its balance will be transferred to Capital account as mentioned.
Transferring the balances of the revenue and expense accounts to Income summary account, and
transferring Income Summary account’s balance to Capital account are called the “Closing Entries”. The
accounts which are closed at the end of the term are called “temporary accounts” because they hold only
one period’s transactions and they have
Expenses Revenues
to be zeroed for the next period. Figure
+ + 4.4 shows the closing process.
+ +
+ + As seen from Figure 4.4, if the
revenue exceeds expenses under
Income Summary account, then
profit occurs. If expenses exceed
Income Summary
revenues, then loss occurs. Whatever
the result is, the balance of the Income
Expenses Revenues Summary account is transferred to
Capital account. Figure 4.5 shows the
transferring the balance of Income
Figure 4.4 Closing Process-1: Closing Revenue and Expense accounts Summary account to Capital account.
Revenus > Expenses =Profit

Income Summary Capital
Expenses Revenues
75.000.- 100.000.- Profit
25.000.- 25.000.-
Expenses > Revenus =Loss

Income Summary Capital
Expenses Revenues
125.000.- 90.000.- Loss
35.000.- 35.000.-
Figure 4.5 Closing Process-2: Transferring The Balance of Income Summary Account to Capital
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Accounting I
If the company has a profit at the end of the period, the credit balance of the Income Summary account
is transferred to the credit side of Capital account, because profit increases the Capital. If there is a loss, the
debit balance of the Income Summary account is transferred to the debit side of Capital account, because
loss decreases the Capital.
Closing Entries for Revenue Accounts

Revenue accounts have credit balances or have no balances at the end of the term. In order to close
revenue accounts, the revenue account must be debited with the same amount equal to its credit balance.
Let’s have a look at TRApps Co. TRApps Co. has only one revenue account which is Service Revenue.
Service Revenue account has a credit balance of 7,400. - TL.
SERVICE REVENUE
.
.
.
.
7,400.-
The closing entry will be as follows;
Date Account Titles and Short Explanation Debit Credit
January 31 Service Revenue 7,400.-
Income Summary 7,400
Closing of revenue account
Ass seen from the journal entry, Service Revenue account is debited with the same amount of its credit
balance and Income Summary account is credited. By doing so, TRApps Co. closes its revenue account
and transfers the balance to Income Summary account. After the transaction, the account will show up
like this:
SERVICE REVENUE INCOME SUMMARY

.
. 7,400.-
.
.
7,400.- 7,400.-
Closing Entries for Expense Accounts

Expense accounts have debit balances or have no balances at the end of the period. In order to close the
expense accounts, the expense accounts must be credited with the same amount equal to its debit balance.
Let’s have a look at TRApps Co. TRApps Co. has several expense accounts.
111
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RENT EXPENSE EXPENSE SUPPLY EXPENSE
. . .
. . .
1,000.- 500.- 800.-
DEPRECIATION SALARIES-WAGES
EXPENSE EXPENSE
. .
. .
83.33 3,500.-
The closing entry will be as follows;
January 31 Income Summary 5,883.33
Rent Expense 1,000.-

Advertisement Expense 500.-
Supply Expense 800.-
Depreciation Expense 83.33
Salaries-Wages Expense 3,500.-
Closing of expense accounts
As seen from the journal entry; Rent Expense, Advertisement Expense, Supply Expense, Depreciation
Expense and Salaries-Wages Expense are credited with the same amount of their debit balances, and
Income Summary account is debited. By doing so, TRApps Co. closes its expense accounts and transfers
them to Income Summary Account. After the journal entry, the accounts will show up like this;
ADVERTISEMENT
RENT EXPENSE EXPENSE SUPPLY EXPENSE
. . .
. . .
1,000.- 1,000.- 500.- 500.- 800.- 800.-
DEPRECIATION SALARIES-WAGES
EXPENSE EXPENSE INCOME SUMMARY
. .
. . 5,883.33 7,400-
83.33 83.33 3,500.- 3,500.-
Closing The Income Summary Account

Now that the revenue accounts and expense accounts are closed and their balances were transferred
to Income Summary account, the company may easily calculate its profit or loss. If credit side of Income
Summary account which holds the totals for revenues is bigger than the debit side of the account that
holds the totals for expenses, then profit will occur. If it is vice versa, loss occurs. Whether profit or loss
occurs, the balance of the Income Summary account will be transferred to Capital account. Because both
profit and loss are the rights of the owner/owners.
112
Accounting I
In TRApps Co. example, Income Summary account has the credit balance of 1,516.67 TL (7,400-
5,883.33). In other words, transferred revenue totals are higher than transferred expense totals. TRApps
Co has the profit! Now, as the company calculated its profit, it is time to close Income Summary account.
In this case, because the company has profit, the Income Summary account must be debited for closing.
The balance will be transferred to Capital account. If there were loss for the company, then there would be
a debit balance. In this case Income Summary account would be credited for closing. Here is the journal
entry for TRApps Co. for closing Income Summary account.
January 31 Income Summary 1,516.67
Capital 1,516.67
Closing of Income Summary Account
INCOME SUMMARY CAPITAL

5,883.33 7,400.- 1,000.- 10,000.-
1,516.67 1,516.67

After closing of revenue accounts, expense accounts and Income Summary account, it is time to prepare
post-closing trial balance as the ending step in the accounting cycle. Post-closing trial balance shows the
accounts with only balances. As the revenue accounts, expense accounts and Income Summary accounts
were closed, it means that they have no balances. So, in the post-closing trial balance those type of accounts
will not take place. Assets, liabilities and Capital accounts are the only accounts that have balances left at
the end of the period. Let’s preparea post-closing trial balance for TRApps Co.

January 31, 2018
BALANCE
Debit Credit
Cash………………………… TL 6,500
Supplies …………………… 200
Equipment ……………….. 4,000
Salary Payable …….…… 500
Owner's Capital …………… 10,516,67
TOTAL TL 11,100.- TL 11,100.-
Figure 4.6 Post-Closing Trial Balance
113
ACCOUNTING CYCLE
Now that the post-closing balance for TRApps Co. is prepared, the company completed its accounting
cycle. Throughout this chapter and also in previous chapters, we mentioned about accounting cycle. So,
what is an accounting cycle?
Accounting cycle can be defined as the process by which companies produce their financial statements
for a specific period of time8.
As briefly mentioned, accounting cycle includes three main stages of activities;
• beginning of the period activities
• during the period activities
• end of the period activities
Beginning of the period activities deal with the opening transactions of the company. After the closing
entries done for the previous term, the accounts have to be opened for the new fiscal year. The opening
of the accounts is based on the opening balance sheet which is also the closing balance sheet of the ended
period. Journal entry is recorded according to the opening balance sheet and accounts are posted to the
ledger. Hereby, the accounts are now ready for daily transactions, in other words, the accounts are ready
for during the period transactions.
During the period, the company makes tens of thousands of financial transactions. The company
purchases raw materials, produces goods, sells them, pays for the vendors, collects receivables, and pays
for labor, taxes, etc. Each transaction has to be recorded into journals and posted to the ledger. At the end
of each month, monthly trial balance is prepared in order to ensure that the totals and the balances of the
accounts are equal. Here, it must be paid attention that the trial balance only ensures the mathematical
equality. If the transaction is recorded recorded into a wrong account, the trial balance cannot figure it
out. The trial balance is prepared as a cumulative table. This means that monthly totals are added onto
previous months’ totals. For example, while January trial balance prepared on 31st of January includes only
the January totals, the February trial balance prepared on 28th of February includes both February and
January totals. With the same manner, the trial balance prepared at the end of June includes six months’
total amounts.
As the end of the period comes, adjusting entries are made to ensure the assets, liabilities and owner’s
equity. After the adjustment transactions, adjusted trial balance is prepared, and financial statements are
prepared afterwards. After the preparation of financial statements, the company journalizes and posts the
closing entries. The final step of the accounting cycle is preparing the post-closing trial balance. Now, let’s
summarize the steps in accounting cycles briefly:
• Opening entries based on opening balance sheet
• Posting opening entries to ledger accounts
• Analyzing and journalizing daily transactions
• Posting daily transactions to accounts
• Preparing monthly trial balances
• Preparing unadjusted trial balance at the end of the period
• Adjusting entries
• Preparing adjusted trial balance
• Preparing financial statements
• Closing entries
• Preparing post-closing trial balance
114
Accounting I
Further Reading
115
Inside Practice
116
Accounting I
Discuss: What is the main reason for the company having negative Owner’s Equity amount?
117
Explain and prepare financial

LO 1 statements
Financial statements have vital importance for the companies. By analyzing the financial statements,
information users drill out information about the company according to their information needs. At the
end of the year, companies prepare financial statements for evaluating the financial performance, in other
words, profit and loss of the company, and also for analyzing the financial situation, in other words, assets,
liabilities and owner’s equity of the company. For the preparation of financial statements, the starting
Summary
point is the adjusted trial balance. After the preparation of adjusted trial balance and financial statements,
closing entries will be recorded in order to get accounts ready for the next year.
Explain the purpose of closing

LO 2 process and record closing entries
Owner’s equity shows the investments done by the owner/owners and the result of the operations of the
company which is either profit or loss. Profit increases the owner’s equity whereas the loss decreases. If so,
it is possible to record revenues into the credit side of the Capital account because revenues increase the
claims of the owners’ on assets, and it is also possible to record expenses into the debit side of the Capital
account because expenses decrease the claims of the owners’ on assets. But by doing so, it will become
impossible for the stakeholders and decision makers to analyze the changes that form the profit or loss and
also the changes in the capital account that owners made investments. So, instead of recording revenues
and expenses into capital account, they are separately recorded into several revenue and expense accounts;
and therefore, the company can measure revenues and expenses.
Explain the steps of accounting

LO 3 cycle
Accounting cycle can be defined as the process by which companies produce their financial statements for
a specific period of time9.
As briefly mentioned, accounting cycle includes three main stages of activities;
• beginning of the period activities
• during the period activities
• end of the period activities
These are the steps in accounting cycle:
• Opening entries based on opening balance sheet
• Posting opening entries to ledger accounts
• Analyzing and journalizing daily transactions
• Posting daily transactions to accounts
• Preparing monthly trial balances
• Preparing unadjusted trial balance at the end of the period
• Adjusting entries
• Preparing adjusted trial balance
• Preparing financial statements
• Closing entries
• Preparing post-closing trial balance
118
Accounting I
1 “Our financial situation is the best for all 7 Company (A) leased machinery and
times” said the manager of TAXO Co. From which equipment to use in the operations. How does the
report the manager come to this conclusion? company report these elements?
A. Balance sheet A. As non-current asset in balance sheet
Test Yourself
B. Income statement B. As rent expense in income statement
C. Cost of the goods sold C. As capital in owner’s equity
D. Cash flow statement
D. As current liability in balance sheet
E. Statement of Owner’s Equity
E. As non-current liability in balance sheet
2 Which of the following is not a property
of financial information given in the financial 8 Which of the following is true for closing
statements? process?
A. Relevancy B. Faithful representation A. Revenue accounts are credited when closing
C. Comparability D. Auditability B. Expense accounts are debited when closing
E. Verifiability C. Income Summary account holds revenues on
credit side
3 Which of the following can be reported in D. Expense accounts’ balance are posted to credit
balance sheet? side of Income Summary account
A. Sales revenue B. Rent expense E. Revenue accounts’ balance are posted to
C. Salary payable D. Salary expense Capital account directly
E. Depreciation expense
9 The company has 10,000 liras of revenues
4 Which of the following can be reported in and 7,500 liras of expenses. Which of the following
income statement? statement is true for closing transactions?
A. Account receivable B. Sales revenue A. 2,500 liras of revenue will be posted to Income
C. Accumulated Depreciation D. Capital Summary account
E. Raw materials B. 7,500 liras of expense will be posted to credit
side of Income Summary account
5 The company has a notes payable which has C. 10,000 liras of revenue will be posted to debit
a due date of 6 months. In which section of the side of Income Summary account
balance sheet company should report this?
D. The company has a loss of 2,500 liras
A. Non-current assets B. Owner’s equity E. 10,000 liras of revenue will be posted to credit
C. Current assets D. Non-current liabilities side on Income Summary account
E. Current liabilities
10 The last step in the accounting cycle is:
6 Which of the following is true for classified
balance sheet? A. Preparing balance sheet
A. Assets are reported according to their liquidity B. Preparing income statement
B. Current liabilities have maturity dates more C. Making closing entries
than 12 months D. Preparing post-closing trial balance
C. Non-current assets must be financed only by E. Making adjustment entries
current liabilities
D. Owner’s equity should only finance current
assets
E. Maturity dates of current liabilities are longer
than non-current liabilities
119
1. A If your answer is incorrect, review “Preparing 6. A If your answer is incorrect, review “Classified
Financial Statements”. Balance Sheet”.
2. D If your answer is incorrect, review “Preparing 7. B If your answer is incorrect, review “Preparing
Financial Statements”. Financial Statements”.
3. C If your answer is incorrect, review “Preparing 8. C If your answer is incorrect, review “Closing
Financial Statements”. Process and Closing The Accounts”.
4. B If your answer is incorrect, review “Preparing 9. E If your answer is incorrect, review “Closing
Financial Statements”. Process and Closing The Accounts”.
5. E If your answer is incorrect, review “Preparing 10. D If your answer is incorrect, review review
Financial Statements”. “Accounting Cycle”
Give examples for current assets.
Current assets include the assets that will be converted into cash, sold,
consumed or received within 12 months or within the business’s operating
your turn 1 cycle, and the cash and cash equivalents. Here are some examples for current
assets: cash and cash equivalents, accounts receivables, merchandise inventory,
prepaid expenses, supplies, marketable securities, etc.
Give examples for non-current assets.
Non-current assets include the assets acquired to be used in business’s

operations for more than 12 months and receivables of which due dates are
your turn 2 more than 12 months. Here are some examples for non-current assets: Land,
vehicles, buildings, machinery, equipment, goodwill, trade names, long-term
receivables, etc.
Give examples for liabilities
Liabilities are the debts of the company. They are classified as current liabilities
and non-current liabilities. Here are some examples for current and non-
your turn 3 current liabilities: accounts payable (short term-long term), notes payable
(short term-long term), wages payable (short-term), unearned revenues
(short-term, long-term), bonds payable (long-term), etc.
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Accounting I
Endnotes
1
Conceptual Framework, International Accounting 6
Miller-Nobles, Mattison and Matsuma p.209.
Standards Board, Public Oversight Accounting 7
Cunningham B. M., Nikolai L. A., and Bazley J. D.
and Auditing Standards Authority, (www.kgk.gov.
(2004), Accounting: Information for Business
tr) (2011).
Decisions, Thomson-SouthWestern Publ. p.203.
2
Miller-Nobles, T., Mattison B., and Matsuma E. M. 8
Horngren, C. T., Harrison W. T., and Bamber, L. S.
(2016), Horngren’s Accounting: The Financial
(2001), Accounting, Prentice Hall, New Jersey.
Chapters, Pearson Education, p.206.
p.127.
3
Miller-Nobles, Mattison and Matsuma p.34. 9
Horngren, Harrison and Bamber, p.127.
4
Miller-Nobles, Mattison and Matsuma p.34.
5
Cemalcılar, Ö. and Önce S. (1999), Muhasebenin
Kuramsal Yapısı, T.C. Anadolu Üniversitesi
Yayınları No:1093, Eskişehir, p.75.
121
Chapter 5 Merchandising Operations
Learning Outcomes
1 Describe merchandising operations and

operating cycle of a merchandising company 2 Describing inventory systems
3 Account for purchase related transactions

under the perpetual inventory system 4 Account for sales related transactions under
the perpetual inventory system
5
Account for the purchase and sale of
merchandise inventory using a periodic
inventory system (Appendix)
Chapter Outline Key Terms

Introduction
Freight–in / -out
Merchandising Operations
Gross Profit
Inventory Systems
Inventory Shrinkage
Accounting for Purchase Transactions in a Perpetual
Merchandise Inventory
Inventory System
Multiple-Step Income Statement
Accounting for Sales Transactions in a Perpetual
Operating Cycle
Inventory System
Periodic Inventory System
Closing Entries For Merchandising Companies
Perpetual Inventory System
Appendix: Periodic Inventory System
Sales Returns and Allowances
Accounting for Purchase Transactions
Sales Discount
Accounting for Sales Transactions
Closing Entries in the Periodic Inventory System
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Accounting I
INTRODUCTION
Based on their operations, companies are classified in three categories as “service companies”,
“manufacturing companies”, and “merchandising companies”. Service companies, such as hospitals, hotels,
law firms etc., provide services to demanding parties without incurring any manufacturing or trading
activities. The second type of businesses is manufacturing companies, in which raw materials are
converted to finished goods and then sold to customers. These companies have three types of inventories:
(i) raw materials inventory, which includes materials and parts purchased to be used in production, (ii)
work-in-process inventory, which are the products that are not completed as of the end of accounting period
and (iii) finished goods inventory, which are the completed products available to be sold. The last type of
business is the merchandising companies. These companies purchase the goods that are ready to be sold
and sell them to generate revenue. Considering the type of their customers, merchandising companies are
called either as retailer or whole seller. A retailer buys merchandise inventory either from a producer or a
wholesaler and then sells those goods to consumers. A whole seller buts merchandising inventory from a
producer and then sells them to retailers.
This chapter deals with operations of merchandising
companies. Definition and explanations on operating
cycle is presented at first and then financial information Merchandising companies do not make
requirements of merchandising companies are stated. As the production. They only purchase goods and
major transactions of merchandising companies, accounting resell to either consumers or retailers.
for purchase and sales transactions are explained both from
buyers’ and sellers’ perspectives.
MERCHANDISING OPERATIONS
Whether a merchandising company is a wholesaler or a retailer, it uses the same basic accounting
methods as a service company. However, the buying and selling of goods adds to the complexity of the
business and of the accounting process. As you will learn, merchandising companies have some new balance
sheet and income statement items. To understand the issues involved in accounting for a merchandising
business, you have to pay attention to the operating cycle.
Operating Cycle for A Merchandising Company

The entire process through which the revenue is generated and the relevant cash is collected is called an
operating cycle. Merchandising companies engage in a series of transactions in the operating cycle. The
operating cycle of a merchandising company starts with the purchase of inventories from a producer or
an individual, called a vendor. Then these inventories are sold to customers, either in cash or on account.
When the cash is collected from customers, the operating cycle ends the first round. By purchasing new
inventories the other round starts and the same processes recur continuously; that is why it is called a cycle.
Cash from customers Purchase

Inventory
Cash
Collect
Accounts
Merchandise
Receivable
Sell the Inventory Inventory
Figure 5.1 Operating Cycle for A Merchandising Company
123
When the company sells in cash, operating cycle becomes

shorter; because in the case of credit sales company records
Operating cycle begins with the purchase of
a receivable at first and cash is collected at a later time. As
merchandise inventory and ends when the
the cycle shortens, companies become more profitable and
cash from sales is collected from customers.
liquid. With this fact in mind, considering the demand
increasing aspect of credit sales policies, companies schedule
their payment and collection periods.
Cost Flow for Merchandising Companies

The revenue activities of a service company involve providing services to customers; when the
service is rendered the company will earn and record revenue. In contrast, the revenue activities of a
merchandising company involve the buying and selling of merchandise. A merchandising company must
first purchase merchandise inventory to sell to its customers. Merchandise on hand (not sold) is called
merchandise inventory asset. When this merchandise inventory is sold, the revenue is reported as sales
revenue, and its cost is recognized as an expense called
the cost of merchandise sold. The cost of merchandise
sold is subtracted from sales to arrive at gross profit. This
amount is called gross profit because it is the profit before If the merchandise inventory is sold, its cost
deducting operating expenses. is taken from inventory account in balance
When the companies purchase merchandise inventory sheet and recognized as an expense (cost of
to resell, it is an expenditure. All expenditures that the goods sold) in the income statement.
companies incur until the goods become ready to be sold
are included in the cost of merchandise inventory. That cost is kept in the balance sheet until the goods
are sold3. When they are sold, the cost in balance sheet is transferred to income statement as an expense
(COGS). In other words, expenditures compose costs, and cost are converted to expenses when they are
used to generate revenue. The figure below, explains the flow of costs for merchandise inventory.
Cost of Goods
d Sold (COGS)
Sol
Beginning + Purchases Inventory
Inventory Avaliable for Sale
Un
so
ld
Ending Inventory
Figure 5.2 Inventory Cost Flow In A Merchandising Company
What Accounting Information a Merchandising Company Needs

As all other companies, merchandising companies have internal and external users of accounting
information, too. In other words, these companies need accounting information for both financial
reporting purposes and for internal use by management.
In terms of financial reporting, the primarily important information are the amounts of “Sales
Revenue” and “Cost of Goods Sold” accounts, as the main activities of a merchandising company are
purchasing goods from suppliers and selling them back to customers. Sales revenue is the gross amount
that the company charges from its customers as sales price, and Cost of Goods Sold (COGS), on the other
hand, represents the cost that the company incurs for purchasing the goods they sold. In order to provide
outsiders a complete perspective to assess the performance of a company, other types of revenues (gains
on sale of machines, interest revenues, gains on sale of marketable securities, etc.) and expenses (operating
expenses, losses from other ordinary activities etc.) must also be recorded. Merchandising companies
124
Accounting I
must gather complete information on balance sheet items

(assets, liabilities and equity) to provide information on
their financial positions.4 Although its name is Cost of Goods Sold, it is
However, that information presented in financial an expense item recorded under sales account
statements is not enough for managers and other employees in income statement. Because according to
to use in their daily business operations. They need much the “matching principle” expenses should be
more detailed information than the items presented in recorded in the period in which they generate
financial statements. For example, instead of the total amount revenues.5
of accounts payable item, supplier-based information is
needed to schedule the payments to suppliers, to manage the inventories flow etc. Therefore, companies use
subsidiary ledgers to have more specific information, such as the amounts of receivables from each customer
or the amount of payables to each supplier, etc.
Income Statement of a Merchandising Company

During the operating cycle, companies generate revenues which is called the “Sales Revenue” and this
item is recorded on the top of income statement to be the basis for net income. On the way to calculate
net income number, the first item that is deducted from revenue is Cost of Goods Sold (COGS), which
represents the total cost that the company had incurred
to acquire the sold products. When cost of goods sold is
deducted from revenues, gross profit is calculated. Gross When COGS is deducted from sales
profit represents the profit that a company generates only revenue, gross profit is calculated. Gross
from sales activities. But it is not only purchasing and selling profit evaluates the company’s profitability
activities that a merchandising company has. They also have in terms of selling activities.
other operating activities such as marketing, research and
development, etc. and these activities incur expenditures too. These expenditures are recorded as operating
expenses in income statement and deducted from gross profit to reach net income at the end.
Merchandising companies may prepare their income statements using either single-step or multiple-
step formats. In a single-step income statement, independent from their sources and causes, all types of
revenues are summed at first to determine the total revenues. Then all expenses are collected together and
deducted from total revenues to calculate income before tax6. An example for single-step income statement
is shown in Exhibit 1.A below.
When multiple-step income statement is prepared, there
is more than one income number presented in the income
statement. At the first stage, the difference between the sales Companies may prepare either single-step or
revenue and cost of the goods sold gives the gross profit. multiple-step income statement, depending
Deducting the operating expenses from gross profit results on the level of details they need. If income
in another income number, operating profit. This amount numbers at different levels are required,
provides the companies to evaluate the performance of their multiple-step income statement is preferred.
operating activities. However, companies may also generate
gains and/or incur losses from other (non-operating)
activities. By considering these gains and losses from other
ordinary activities, companies calculate Earnings Before
Interest and Taxes (EBIT), from which interest and tax 1
expenses are deducted to reach a net income number. As Assume that you are the manager of a
can be seen, multiple-step income statements provide merchandising company. Which of these two
a better perspective to evaluate the performance, by statements would help you more if your aim is
providing relevant income numbers at each step. Multiple to assess a company’s performance?
step income statement is presented in Exhibit 5.1.B below.
125
Table 5.1 Single-Step And Multiple-Step Income Statements
A. SINGLE-STEP INCOME STATEMENT B. MULTIPLE-STEP INCOME STATEMENT

OpenEd Corp OpenEd Company
Income Statement (.000; TL) Income Statement (.000; TL)
For the Year Ended 31 December 2018 For the Year Ended 31 December 2018
Revenues Sales
Net Sales (-) Sales Discount
Interest Revenue (-) Sales Returns and Allowances
Gain on Sale of Marketable Securities Net Sales
Total Revenues Cost of Goods Sold
Expenses Gross Profit
Cost of Goods Sold Operating Expenses
Marketing Expenses: Marketing Expenses
Salaries Expense Research and Development Expenses
Advertising Expense General and Administrative Expenses
Delivery Expense Other Operating Revenues and Gains
Total Marketing Expense Operating Income
Administrative Expenses: Gains and Losses From Other Ordinary Act
Rent Expense Earnings Before Interest and Taxes
Depreciation Expense Interest Expense
Insurance Expense Income Before Tax
Total Administrative Expenses
Interest Expense
Total Expenses
Income Before Tax
INVENTORY SYSTEMS
Information on inventories is very important for merchandising companies, as most of their activities
base on inventories. In accounting for inventories, these companies have two options:
a. Periodic inventory system and
b. Perpetual inventory system.
Periodic inventory system is used by the
Periodic inventory system is used by the companies with companies with inexpensive inventories and
inexpensive inventories and manual accounting systems. manual accounting systems.
However, with the increased use of technology in all areas
of businesses, this system is preferred less day-by-day. In
periodic inventory system, companies use “Purchase”
account to record their purchases of inventories and there is In periodic inventory system, companies use
no record for Cost of Goods Sold (COGS) until the end of “Purchase” account to record their purchases
accounting period. At the end of a period, companies take of inventories and there is no record for Cost
a physical count of inventories to determine the amount of of Goods Sold (COGS) until the end of
ending inventories and considering the balances of beginning accounting period
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Accounting I
inventory, total purchases and ending inventory, companies calculate the cost of goods sold during the
period. The formula that is used to calculate COGS is:
COGS = Beginning Inventory + Purchases – Ending Inventory
On the other hand, perpetual inventory system has a widespread use, because it provides high level of
control over inventories. In this system, companies continuously update the inventory account whenever
a transaction occurs. The purchases of inventories are directly debited to inventory account, while the cost
of inventories are credited when they are sold. By this way, companies may have accurate information on
inventories they have anytime they need.
Under the periodic system, the fundamental assumption
is that if an inventory does not exist on hand, it must be Companies prefer perpetual inventory system
sold. However, this is not the case many times. Perpetual to have continuous control over inventories.
inventory system provides the companies opportunity to Under periodic inventory system, any broken,
compare the amounts of inventories in accounting records stolen or wasted goods are not detected, because
and in warehouses. In other words, companies may control a merchandise is assumed to be sold if it is not in
whether there is any theft, spoilage, waste, or even maybe the warehouse at the end of the period.
a forgotten recording, etc. If the inventory on hand is less
than what the accounting records state, there is “inventory shrinkage7” and in the opposite case where there
is excess inventory on hand compared to the records, there is “inventory surplus”.
Accounting for purchases and sales differs between
the periodic and perpetual inventory systems.
Considering the fact that periodic inventory system is 2
being used less in businesses, this chapter focuses on Compare the use of inventory systems and specify
perpetual inventory system in explaining the accounting the advantages or disadvantages of each system
treatments for purchase and sales transactions. over the other one.
ACCOUNTING FOR PURCHASE TRANSACTIONS IN A PERPETUAL

INVENTORY SYSTEM
The cycle of a merchandising company begins with the purchase of merchandise inventory. They
normally record purchases when they receive the goods from the seller. Business documents provide
written evidence of the transaction. An invoice is a seller’s request for payment from a purchaser. Invoices
are also called bills (Table 5.2).
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Table 5.2 Invoice
Source: https://www.disticaret.biz.tr/2015/06/commercial-invoice-nedir-nasil-doldurulur.html
A company must determine the cost of purchases.

So, measuring the cost of purchases is the first step in Taxes, such as Value Added Tax (VAT), are
recording the inventories. The cost includes the price deducted from the amount of tax that the
that a merchandising company pays to its supplier company should pay the government at the
for the goods, after taking into account all discounts end of an accounting period. These types of
received. Additionally, transportation costs, custom recoverable amounts are not included in the cost
duties and other relevant (irrecoverable) taxes should be of merchandise inventory, as companies benefit
included in the cost as they incur in order to make the from those payments in terms of decreases in tax
liability, not as sales revenue.
inventory ready for sale.
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Accounting I
Transportation costs can take place in accounting records

in two ways. If the sales agreement states that shipment will
If two parties agree on the shipment as FOB
be as FOB shipping point (free-on-board shipping point), it
means the responsibility of the seller ends when the goods shipping point, transportation is the buyer’s
are loaded for shipment. Risks belong to the buyer starting responsibility. It is also called “Freight-in”,
from the shipment point. In other words, transportation is because freight cost is included in the cost of
under the buyer’s responsibility and the buyer pays for it. purchased goods.
If the buyer is responsible from transportation it is called
Freight-in. The cost of transportation will be included in
the cost of inventories, because transportation is necessary
If the shipment type is FOB destination,
to use the inventories in their purported aims8.
transportation is under the seller’s
However, if the parties have agreed on FOB destination responsibility. Freight cost is not included
point (free-on-board destination point) type of shipment,
in the cost of goods; therefore, this type of
then the seller is responsible until the goods arrive at the final
shipment is called “freight out”. The freight
destination (mostly the buyer’s warehouse). Transportation
cost is recognized as delivery expense, in the
cost and, if any, recovery of any possible damage belongs to
accounting records of the seller.
the seller in this case.
3
What if the goods are insured against any risk,
who should pay for the premiums of insurance
under each shipping type?
4
Which shipment term is a better choice for
a company that sells dangerous substance to
companies operating in overseas countries?
Purchase of Merchandising Inventory on

Cash
On April 1, Anatolian Company purchased 500 units of
drinking glasses from Best Glass Company in Eskişehir to sell
in its showroom in Izmir. Price of a glass is 6.00 TL. Suppose The Merchandise Inventory account increases
Anatolian Company receives the goods on April 1, and makes when a purchase is made, so use the debit side
payment on that date. of Merchandise Inventory account.
Anatolian Company records this purchase as follows:
Under the perpetual inventory system, purchased merchandise inventory is recorded in the Merchandise
Inventory account at the time of purchase.
129
Fright in (Transportation Cost)

On April 2, Anatolian Company paid a 200 TL freight charge for an April 1st purchase with FOB shipping
point.
Additional entries for the transportation cost is presented below:
When the purchaser incurs the freight costs, it debits (increases) the account Merchandise Inventory
for those costs. Thus, any freight costs incurred by the buyer are part of the cost of merchandise purchased.
FOB Shipping Point: In this type of shipment, Anatolian Company (buyer) is responsible from the goods starting
at the shipment point and pays for transportation. Because transportation is a necessary part of bringing the
glasses to showroom and making them ready for sale, its cost is included in the cost of inventory.
FOB Destination: In this type of shipment, Anatolian Company’s responsibility starts in the showroom in Izmir.
Therefore, there is no transportation cost to record for Anatolian Company.
Purchase of Merchandising Inventory on Account

Assume that on April 3, instead of paying cash, Anatolian Company purchased 500 units of tea glasses from
First Glass Company in Antalya to sell in its showroom in Izmir on account. Price of a glass is 5.00 TL.
Suppose Anatolian Company receives the goods on April 3, 2018. Anatolian Company records this
credit purchase as follows:
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Accounting I
Purchased merchandise inventory is recorded in the Merchandise

Inventory account at the time of purchase whether on cash or on account.
Purchase Returns and Allowances

Usually, customers are allowed to return the goods to the sellers in any unsatisfactory situation, such
as defective, damaged or under-performing products, etc. Purchase returns exist when sellers allow
purchasers to return merchandise that is defective, damaged, or under-performing. When the purchaser
returned the goods to the seller for credit if the sale was made on credit, or for a cash refund if the purchase
was for cash. Alternatively, the purchaser may prefer keeping the unsatisfactory merchandise if the seller
is willing to grant an allowance (deduction) from the purchase price.9 This transaction is known as a
purchase allowance. In these cases, cost of the merchandise to the buyer decreases.
Purchase Returns
Suppose that according to First Glass’s sales policy, any unsatisfactory merchandise is accepted back if it
is returned within the first 10 days after the sales. On April 3, when Anatolian Company received the glasses,
the quality checks detected 50 glasses with scratches on them. Therefore, on April 7, Anatolian Company returned
these 50 glasses and demanded refunding.
The entry to record this transaction is:
When 50 glasses are returned, Anatolian Company will not have these glasses on hand anymore.
Therefore, “Merchandise Inventory” account should be credited by 250 TL. On the other hand, as a result
of this return, liability to First Glass will decrease by 250 TL.
If the cash discount is taken before any return, effect of the discount
should be reflected in the cost of remaining units. If the cash discount is
taken after the return, discount will be applied to the remaining liability.
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Purchase Allowances
For example, on April 7, Anatolian Company realized that there were 20 more glasses with a different design,
next to the scratched ones. However, these different designed glasses are kept in the warehouse, because First Glass
offered to reduce the price to 1.00 TL from 5.00 TL per glass. The cost of inventory and the liability to First Glass
have both declined by 80 TL [20 glasses x (5.00 – 1.00)].
The following entry is made:
Purchase Discount
A lot of companies offer purchasers a discount for early payments. A purchase discount is a discount
that businesses offer to purchasers as an incentive for early payment. The cash discount is related to
the timing of payment. If the buyer pays the invoice price within a certain number of days before the
maturity, a predetermined rate of discount is applied on invoice amount by mentioning credit terms. Such
a discount or credit terms is shown as %/d1. n/d210, where
%= discount rate
d1 = number of days discount can be applied
n = net payment
d2 = maturity
Most credit terms specify the discount rate, the discount time period, and the final due date. Credit
terms are the payment terms of purchase or sale as stated on the invoice. For example, “2/10, n/30” means
a 2% discount if paid within 10 day; otherwise, the full amount is due in 30 days.
There are two types of discounts that companies provide to their customers; cash discount and trade (bulk) discount.
Trade discount is applied at the time of purchases in high volumes and is deducted from the list price before
the purchase cost is determined11. Therefore, there is no need to make additional entries for the discount. For
example, a shoe-seller may apply 10% discount on the list price to promote purchases in high volumes. Although
the list price of a shoe is 200 TL, when a customer purchases 50 shoes, the cost of shoes to the customer will be
9,000 TL [10,000 – (0.10 x 10,000)]. In this case, 9,000 TL is recorded as sales revenue for shoe-seller and as
inventory for customer.
The cash discount, on the other hand, is related to the timing of payment. If the buyer pays the invoice price
within a certain number of days before the maturity, a predetermined rate of discount is applied on invoice
amount. For example, if seller and buyer agree on sales terms of 3/15, n/40, it means that buyer should pay within
40 days; however, in case payment is made within the first 15 days, 3% discount is applied. This presentation may
change depending on the terms of sales, such as “n/30” (30 days maturity with no discount on early payment) and
“2/10, n/eom” (should be paid at the end of month, 2 percent discount if paid in 10 days).
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Accounting I
Suppose that credit terms of Purchase of Inventory on April 3 from First Glass Company is 3/10; n/30. Let’s
assume that Anatolian Company made payment on April 13.
The first step is to determine the ending balance of “Accounts Payable” to use as the basis for cash
discount if the payment is made within the discount period. T-Accounts for Merchandise Inventory and
Accounts Payable on April 13 are represented below:
The debt amount of Anatolian Company to First Glass Company is 2,170 TL (2,500 – 250 – 80).
Accounts payable is credited by 2,500 TL for the purchase but purchase returns and purchase allowances
decrease the payable by debit entries of 250 TL and 80 TL, respectively. At the end, Accounts Payable has
2,170 TL credit balance.
Anatolian Company makes payment in discount period, therefore Anatolian Company will pay 3%
less. The cash discount amount is 65.10 TL (2,170 x 3%), and Anatolian Company pays 2,104.90 TL
(2,170 – 65.10)
When Anatolian Company pays on April 13, which is within the discount period, the cash payment
entry would be:
The purchase discount is credited to the Merchandise Inventory account because companies record
inventory at cost and, by paying within the discount period, early payment decreases the actual cost paid
for Merchandise Inventory. In this case, it will be enough to pay 2,104.90 TL to close the total debt, and
the cost of inventory to the company will decrease by 65.10 TL.
133
Alternative Situation: If Anatolian Company pays on due date, which is not within the discount period,
the cash payment entry would be:
Cost of Inventory Purchased

Knowing the net cost of inventory allows a business to determine the actual cost of the merchandise
purchased. Net cost of inventory is calculated as follows:
Net Cost of Inventory Purchased = Purchase cost inventory – Purchase returns and allowances –
Purchase discounts + Freight in
5 6
How does a buyer account for it, if the seller Explain the relationship between rate of return in
provides trade discount after some of the goods are the market and possibility of buyers to pay early
sold to third parties (not at the time of purchase)? and get the cash discount.
ACCOUNTING FOR SALES TRANSACTIONS IN A PERPETUAL

INVENTORY SYSTEM
The financial performance of a company is assessed by using either the revenue itself or an income
number derived from it. Therefore, measuring the revenue accurately is one of the most important
tasks of an accounting information system. Companies may have some other types of revenues such
as the interest revenue; however, they do not reflect the
operating performance of the companies. This chapter is
related to the sales of inventories only; all other revenues
Revenue in question is the amount generated
are excluded.
by the sales of inventories. Sales of other
In this part of the chapter, the sales-related subjects assets does not result in revenue.
that the merchandising companies face are taken into
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Accounting I
consideration and their effects on revenue measurement are reflected by the accounting entries. The
accounting entries are prepared assuming that the companies apply perpetual inventory system. In
summary, when an inventory is sold, the amount of cash (or receivable if it is a credit sales) is debited to
represent the increase in assets and sales revenue is credited to represent the increase in income, which in
turn increases owner’s equity. Merchandise Inventory account is credited simultaneously with the sales
transaction to exclude the sold units from inventories, as they are not in the warehouse anymore. On the
other hand, cost of goods sold account is debited, to compare the revenue with the cost of inventories sold
to generate that revenue.
Merchandising companies purchase merchandising inventories to resell the consumers in order to earn
income. Therefore, after a company purchase merchandise inventory, the next important step is to sell the
goods and earn profit. Merchandising companies record sales revenues, like service revenues, when earned,
because of the revenue recognition principle. Typically, merchandising companies earn sales revenues
when the goods transfer from the seller to the buyer. At this point the sales transaction is complete and the
sales price established.
The amount a business earns from selling merchandise inventory is called Sales Revenue.
Two entries are required to record sale transactions:
• The first entry is necessary to record the earned sales revenue: The seller increases (debits) Cash (or
Accounts Receivable, if a credit sale), and also increases (credits) Sales Revenue for the invoice price
of the goods.
• The second entry records the expense side of the sales event (the cost of the merchandise sold): The
seller increases (debits) Cost of Goods Sold, and also decreases (credits) Merchandise Inventory for
the cost of those goods.
Sales may be made on credit or for cash. A business document should support every sales transaction,
to provide written evidence of the sale. Cash register tapes provide evidence of cash sales. A sales invoice
provides support for a credit sale. The original copy of the invoice goes to the customer, and the seller keeps
a copy for use in recording the sale. The invoice shows the date of sale, customer name, total sales price,
and other relevant information.
We will now illustrate the selling side and follow Anatolian Company through a sequence of selling
transactions using perpetual inventory system.
Sale of Merchandise Inventory on Cash

Retailers often make cash sales. Suppose that Anatolian Company sold 100 units of drinking glasses to a
customer for cash On April 18. Sales price of a glass is 7.00 TL.
Anatolian Company records this cash sales of 700 TL by debiting Cash and crediting Sales Revenue
as follows:
135
Anatolian Company sold goods. Therefore, a second journal entry must also be made to decrease the
Merchandise Inventory balance. Suppose these goods cost Anatolian Company 600 TL.
Under the perpetual inventory system, the cost of merchandise sold and the reduction in merchandise
inventory should also be recorded. The second journal entry will transfer the 600 TL from the Merchandise
Inventory account to the Cost of goods sold account, as follows:
The Cost of Goods Sold account keeps a current balance throughout the period in a perpetual inventory
system. In this example, cost of goods sold is 600 TL (the cost to Anatolian Company) rather than 700
TL, the selling price (retail) of the goods. Cost of goods sold is always based on the company’s cost, not
the retail price. The Merchandise Inventory account will show at all times the amount of inventory that
should be on hand (not sold).
Sale of Merchandise Inventory on Account

A merchandising company may sell merchandise on account. The seller records such sales as a debit
to Accounts Receivable and a credit to Sales Revenue. The cost of merchandise sold and the reduction in
merchandise inventory should also be recorded same as cash sales.
Suppose that Anatolian Company sold another 100 units of drinking glasses to another customer on credit on
April 20. But sales price of a glass is 8.00 TL.
Anatolian Company records this credit sales of 800 TL by debiting Accounts Receivable and crediting
Sales Revenue as follows:
Under the perpetual inventory system, the cost of merchandise sold and the reduction in merchandise
inventory should also be recorded. Therefore, a second journal entry must also be made to decrease the
Merchandise Inventory balance same as cash sales. We know that these goods cost Anatolian Company 600 TL.
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Accounting I
The second journal entry will transfer the 600 TL from the Merchandise Inventory account to the Cost
of Goods Sold account, as follows:
Transportation for the Sold Merchandise Inventory

Another point to account for in sales transactions is the transportation. In FOB shipping point type of
transportations, the seller is responsible from the goods only up to the shipment point, and these agreements are
freight-in agreements from the buyer’s perspective. For the seller,
since the transportation cost (freight) is not under the seller’s
responsibility, these agreements are called freight-out. If the seller Transportation cost is treated as delivery
pays the transportation cost on behalf of the buyer, the amount expense (a kind of marketing expense) for
is debited to accounts receivable and credited to cash account. seller if the shipment is FOB destination,
In other words, it is kind of a lending activity from the seller’s in which the seller is responsible from the
perspective. On the other hand, if the shipment terms are FOB merchandise until the destination point.
destination, the seller is responsible from the inventories until
the final destination and transportation cost is paid by the seller.
This is a freight-in agreement for the seller. In these kinds of sales transactions, seller records the amount paid for
transportation as delivery expense, which is a kind of marketing expense.
Suppose that on April 21 Anatolian Company paid 50 TL to the transportation company for the sold items
for April 20 sales. FOB destination point. In these kinds of sales transactions, seller records the amount
paid for transportation as delivery expense. Delivery expense is debited across the cash account. Anatolian
Company as a seller will prepare the following entry:
137

We learned that purchase returns and allowances and purchase discounts decrease the cost of inventory
purchases. In the same way, sales returns and allowances decrease the net amount of revenue earned on
sales. When goods are returned from the buyer, this can be accepted as a partial cancellation of the sales.
Therefore, receivables should be decreased to the extent sales are cancelled. On the other hand, return of
sold goods is recorded under an account called “Sales Returns & Allowances”. This contra-sales revenue
account is reported below the “Sales Revenue” in income statement to calculate “Net Sales”. Under the
perpetual inventory system, another entry should also be prepared to present the increase in inventories
and decrease in/cancellation of COGS as a result of the return.
Sales Returns
Suppose that on April 25, half of the 100 units of drinking
glasses sold on credit on April 20 is returned. “Sales Returns & Allowances” account is
a contra-sales revenue account, and it is
As a result of this return, Anatolian Company should
deducted from the gross sales revenue
cancel both Sales Revenue and COGS accounts with an
to reach net sales revenue in the income
amount equal to the return in terms of sales price and cost,
statement.
respectively. Additionally, the return will cause an increase
in inventories and decrease in receivables.
Return of 50 glasses will cause decreases in both revenues and receivables by 400 TL (8.00 TL x 50
glasses). The accounting entries are prepared as follows:
On the other hand, COGS is reversed and inventories are increased by TL 300 (6.00 x 50 glasses).
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Accounting I
Sales Allowances
If customers are unsatisfied with the goods they purchased, because of defects or for other reasons,
seller may reduce the initial price at which the goods were sold to pursue the customers to keep the goods.
It is sales allowance. This type of reductions is recorded in “Sales Returns and Allowances” which is a
contra account to Sales Revenue.
Remember half of the drinking glasses sold on April 20 was returned on April 25. Additionally, on April 26,
Anatolian Company grants 50 TL sales allowance to the customer for goods damaged in transit.
A sales allowance is recorded as follows:
There is no second entry to adjust inventory for a sales allowance because the seller did not receive
goods from the customer.
Sales Discounts
As mentioned earlier, as a means of encouraging the buyer to pay before the end of the credit period,
the seller may offer the customer a cash discount—called by the seller a sales discount. For example, a
seller may offer a 3% discount if the buyer pays within 10 days of the invoice date. If the buyer does not
take the discount, the total amount is due within 45 days. These terms are expressed as 3/10, n/45 and
are read as 3% discount if paid within 10 days, net amount due within 45 days. The terms of a sale are
normally indicated on the invoice or bill that the seller sends to the buyer.
Suppose that Anatolian Company received payment from the customer on April 30. This collection is related
to April 20 sales. Suppose that credit terms are 2/10; n/30.
When the customer makes payment within the discount period, on April 30, Anatolian Company will
record the receipt of cash and decrease Accounts Receivable for 350 TL, as follows:
139
Sales discount is based on the invoice price less returns and allowances. Considering the returns and
other allowances provided by Anatolian Company, the balance of Accounts Receivable item should be
determined at first. The T-account for “Accounts Receivable” is presented below:
Notice that Anatolian Company credited Accounts Receivable for the whole amount, but customer
pays 343 TL. So, cash asset of Anatolian Company is increased just for 343 TL. If the customer does not
pay within the discount period, the customer must pay the
full amount of 350 TL and there would not be any discount.
Since managers may want to know the amount of the “Sales Discounts” account is a contra-sales
sales discounts for a period, the seller normally records the revenue account, and it is deducted from the
sales discounts in a separate account. The sales discounts gross sales revenue to reach net sales revenue
account is a contra account to Sales Revenue. in the income statement.
Net Sales Revenue, and Gross Profit

Net sales revenue, cost of goods sold, and gross profit are key elements of profitability. Net sales revenue
is calculated as Sales Revenue less Sales Returns and Allowances and Sales Discounts.
Net sales revenue of Anatolian Company = 1,500 – (450 + 7) = 1,043 TL
Net sales revenue = Sales Revenue – (Sales Returns and Allowances + Sales Discounts)
After determining net sales revenue, gross profit can be calculated. Net sales revenue less Cost of goods
sold is called Gross profit, or Gross margin.
Gross profit = Net sales revenue – Cost of goods sold
Gross profit of Anatolian Company = 1,043 – 900 = 143 TL
Profitability of company can also be better evaluated with the help of representing the total income in
different sub-parts, such as gross profit, operating profit and income before tax, etc. Because, operating
income is a good performance indicator as it stems from main operations of merchandising companies.
Income resulting from sales and operations are expected to recur every period with almost the same
amounts. Therefore, it provides the outsiders an opportunity to better predict the future profitability.
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Accounting I
In a single-step income statement, all expenses

are deducted from total revenues and gains in
one step and income before tax is calculated. It is
quite simple to prepare. The sources of revenues or
causes of expenses are not taken into consideration
in single-step income statement. However, in a
multiple-step income statement, there are numerous
parts based on the sources of revenues and causes
of expenses. In a multiple income statement, you
can see the company’s gross profit for the period.
Gross profit, along with net income, is a measure
of business success. Companies must earn sufficient
gross profit to cover the company’s operating expenses
for the company to survive. Therefore, gross profit
amount is vital to a merchandiser. Income statement will 7
give this type of information about the profitability of a Prepare the multiple step income statement of
company to the information users. Anatolian Company.
CLOSING ENTRIES FOR MERCHANDISING COMPANIES

After recording the revenue- and expense- related entries, to complete the accounting cycle and prepare
the financial statements, companies should prepare closing entries (as you learned in Chapter 4 for a
service company). The key item used in closing process is “income summary” account, as revenues and
expenses are all pooled in it. The final balance of this item, either debit or credit balance, is transferred
to another account; retained earnings. If companies declare to distribute dividends, dividends payable is
credited and retained earnings is debited with the amount declared.
This process is applied by every company in the closing phase of accounting cycle, however to keep it
simple the closing entries for buyer and seller will be considered separately, assuming that both companies
apply perpetual inventory system. The closing entries for periodic inventory system is represented in Appendix.
Closing Entries for the Buyer

In merchandising activities, the buyer recognizes no revenue or expense item. When the goods are
purchased, the amount to be paid is a cost and it is presented in balance sheet as inventories until the goods
are sold to a third party. Any discount, taken or lost, is reflected in inventories, as well as purchase returns.
For the scope of this chapter, only the inventory shrinkage is related to the closing process. If the
physical counts show that the inventory account balance in trial balance is more than the amount of
inventory in warehouse, then an account is established with the name “inventory shrinkage”. This account
represents an inventory loss. This account can be represented in income statement either under the Cost
of Goods Sold or as a separate operating expense.
Suppose that Anatolian Company’s trial balance represents a debit balance for inventories by 4,204.90 TL.
However, the physical count of inventory determined 4,109.90 TL worth of inventory. The related closing
entries for each representation, either in operating expenses or in COGS, are explained below:
Shrinkage Reported as Operating Expense:
The first entry is an adjusting entry to record the 100 TL (4,204.90 – 4,109.90) inventory shrinkage
and the decrease in balance of “Merchandise Inventory” account:
141
After this entry inventory shrinkage appears among operating expenses in adjusted trial balance, to be
closed in income summary (together with all other debit balanced income statement items).
Shrinkage Added to COGS:

If the shrinkage is decided to be shown under COGS, the first entry is made to transfer the excess
amount in “Inventory” to “COGS”. Shrinkage of 100 TL should be credited to Inventory and debited to
COGS.
With this entry, the balance of Inventory account is reduced up to the amount that Anatolian Company
has in the warehouse, and the reduced amount is recorded to COGS. The second entry is to close the
COGS account with income summary pool account, as represented below.
Closing Entries for the Seller

In merchandising activities, when the goods are sold, the merchandising companies recognize Sales
Revenue and Cost of Goods Sold accounts. Also, these accounts are adjusted for cases such as returns,
discounts and allowances, as presented in the earlier parts of this chapter. In order to prepare the financial
statements, merchandising companies should close all of these income statement accounts. The process is
almost the same for all industries, but differs for perpetual and periodic inventory systems. Closing process
is explained with the example used throughout this chapter, assuming that perpetual inventory system is
applied.
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Accounting I
Anatolian Company applies perpetual inventory system, the entries to close revenues and expenses
(temporary accounts) are as follows:
To close all income statement items with debit balance, income summary account is debited and these
items are credited including all expenses and such items as sales discounts, returns and allowances.
These closing entries result in the following T-account for Income Summary:
To transfer the balance in income summary to owner’s capital account the following entry is prepared:
143
As you realized, the company earned 143 TL Gross profit and 93 TL net income. Net income of the
company will increase the owner’s equity.
In the closing process at first all revenues and expenses are closed to a
pool account, called “income summary”. Then the net balance in income
summary account is transferred to owner’s capital account.
APPENDIX: PERIODIC INVENTORY SYSTEM

Opposite to the case in perpetual inventory system, in periodic inventory system inventory accounts
are not up-to-date and do not provide information on inventory whenever needed. By performing physical
counts, companies measure the amount of inventory on hand at the end of each accounting period. Any
goods that are not counted are assumed to be sold12.
Accounting for merchandising operations under perpetual inventory system is explained in the chapter.
In order to provide a wider perspective on inventory systems, in this part, accounting for merchandising
operations are explained under the periodic inventory system.
Example: On April 1, Smart Company purchased 500 units of tea glasses on account with the terms
4/15, n/60 from Crystal Glass to sell in its showroom in Bolu. List price of a glass in Crystal Glass is 5.00
TL. However, for this high volume of purchase, 10% trade discount is applied for Smart Company.
On April 5, Crystal Glass shipped the glasses and paid 200 TL for transportation and collected it from
Smart Company the following day.
On April 7, after performing the quality checks, Smart Company detected 50 glasses with scratches on
them and returned them back to Crystal Glass. In addition, 20 glasses had different designs than ordered,
but with the reduction of the sales price to 1.00 TL for these different designed glasses, Smart Company
decided to keep them on hand.
Accounting records are prepared for two cases related to the payment time:
Case 1: Smart Company pays in the first 15 days (Within the discount period), or
Case 2: Smart Company pays on June 30 (at the maturity).
ACCOUNTING FOR PURCHASE TRANSACTIONS

In periodic inventory system, inventory account is not updated every time the purchase occurs.
Purchases on Discount
When a merchandise inventory is purchased, it is recorded in an account called “Purchases” (not
inventory) with its net cost to company. Net cost is the amount that the buyer is suggested to pay
considering any trade discount received. The journal entry for the purchase is as follows:
144
Accounting I
The amount to record in entry is 2,250 TL for 500 glasses, because of 10% trade discount reduces the
price to 4.50 TL /glass from 5.00 TL /glass. Under periodic inventory system, 2,250 TL is not directly
recorded in “Merchandise Inventory” account, instead “Purchases” account is debited across the payable.
Transportation
Depending on the terms of shipment, transportation cost (i.e. freight) may be a component of
purchases. If FOB shipping point is the shipment term, freight cost is under buyer’s responsibility so it is
included in the purchase cost, with FOB destination buyer has no cost for transportation. The first case is
called freight-in, and the latter is freight-out.
Assume that, Smart and Crystal Companies agree on FOB shipping point. Then, 200 TL transportation
cost should be recorded by Smart Company with the following entry:
With this entry, transportation also became a part of the purchase cost, but as this is periodic inventory
system, inventory account is not used until the end of the period. 200 TL is added to the payable, because
Crystal has paid for transportation on behalf of Smart Company.
The following day Smart Company pays 200 TL to Crystal for the payable.
Purchase Returns
When the buyers are not satisfied with the goods they have purchased, they are usually allowed to
return the goods. If this happens, buyers use another contra-purchase account, called “Purchase Returns &
Allowances” to record the decrease in amount of purchases.
In the example, it is stated that Smart Company returns 50 glasses as they have scratches. Then the
following entry should be made:
The liability of Smart Company to Crystal decreases by 225 TL with the return of 50 glasses (each
purchased from 4.50 TL). Thus, “Accounts Payable” account is debited and “Purchase Returns &
Allowances” is credited by 225 TL.
145
Purchase Allowances
Unsatisfactory goods are not always returned back to sellers, in some cases buyers may keep them in
exchange for a reduction in price. This price reduction causes a decrease in the liability of buyer and is
deducted from the cost of purchases, with the help of “Purchase Returns & Allowances” account.
Reduction of price from 4.50 TL to 1.00 TL for the 20 different designed glasses will cause a decrease
in liabilities by 70 TL [(4.50 – 1.00) x 20]. Then the following entry should be made on April 7:
Payment of Liability
In calculating the purchase cost at the beginning, trade discount (%10) is considered. But the sales
agreement states that although the payment is due in 60 days, if Smart Company pays in the first 15 days,
4% cash discount will be applied additional to trade discount.
It is suggested that Smart Company uses gross method in recording its payables, meaning that the gross
value is recorded first, then it is closed for less if the discount is taken. Accounting entries for both cases
are presented below after the presentation of T-account for Accounts Payable.
Case 1 Payment on April 15 (within discount period)

If Smart Company pays in the first 15 days, 4% cash discount will be applied. Then, the amount to
close the payable is 1,877 TL, because Smart Company will receive a 78 TL (1,955 x 4%) cash discount.
The journal entry is as follows:
The discount taken from Crystal Company is credited to a contra-purchase account, entitled “Purchase
Discounts” to decrease the cost of purchases to Smart Company.
Case 2: Payment on June 30 (at maturity)
If Anatolian Company does not pay its debt until April 15, the cash discount is lost and there is no
special account to record in payment entry. The entry is as follows:
146
Accounting I
The calculation of purchase cost considering the above transactions is presented in the following table:
ACCOUNTING FOR SALES TRANSACTIONS

Most of the differences between the periodic and perpetual inventory systems are recognized by the
buyers. Accounting records almost totally differ between two systems for the buyer, but from the seller’s
perspective, the only difference is the absence of COGS entry after each sales record. Considering this fact,
accounting for sales transactions are represented using the example without any additional explanations.
In periodic inventory system, balance of inventory account is not decreased after each sale. The ending
balances of COGS and Inventory account are determined by closing process. Therefore, the first journal
entry representing the sale of merchandise is as follows:
Transportation
In FOB shipping point terms Crystal Company does not have any responsibility for transportation.
Therefore, it will be assumed that the chosen shipment term is FOB destination, in which the seller should
pay for the freight. The entry to be made by Crystal Company is:
147
Sales Returns
If some of the sold merchandise is returned back, the only effect will be on the sales revenue and
receivables. Crystal Company received a return of 50 glasses from Smart Company and the entry for
return is as follows:
Considering the trade discount, sales price is 4.50 TL per unit. Return of 50 glasses decrease both the
receivable and sales revenue by 225 TL with the help of contra-sales account, Sales Returns & Allowances.
Sales Allowances
The unsatisfactory goods of 20 glasses are kept by Smart Company in exchange for a reduction in price
by 3.50 TL (from 4.50 TL to 1.00 TL) per glass and it makes 70 TL in 20 glasses. This reduction is debited
to “Sales Returns Allowances” account and credited to Accounts Receivable.
Collection of Receivable
Suggesting that Smart Company pays within the discount period, 4% discount will be provided on
receivable. As of April 15, T-account for Accounts Receivable is represented below.
As the T-account represents the basis for discount is 1,955 TL. To close the liability, Smart Company
will pay 1,877 TL because of 78 TL (1,955 x 4%) cash discount. Crystal Company will make the following
entry to record the collection:
148
Accounting I
CLOSING ENTRIES IN THE PERIODIC INVENTORY SYSTEM

In this part of the chapter, additional information will be used in closing the entries. By doing this,
closing entries of a merchandising company will be explained from both perspectives concurrently. Only
Smart Company will be considered in explaining the closing entries, because additional information
includes sales information together with the beginning and ending balances of inventories; so that
Anatolian Company is both seller and buyer in the extended example, which is more realistic.
Suppose that on April 1, Smart Company had 30 glasses with 120 TL cost at its warehouse. During
April the company purchased and sold glasses and as of April 30, there are 150 glasses remaining with a
cost of 620 TL. During April the company sold 280 glasses for 8 TL each in its Bolu showroom but 10 of
those glasses are returned back by the customers.
The closing process is explained by using the extended example. To close the temporary accounts and
determine the balance of inventories, as well as income number Smart Company follows the steps below:
1. The beginning balance of “Merchandise Inventory” account is closed to Income Summary. Smart
Company had a beginning inventory of 120 TL and this amount is closed to Income Summary
with this entry:
2. The amount of inventories determined by the physical count is debited to Merchandise Inventory
account and credited to “Income Summary”. There are 620 TL worth of merchandise in the
warehouse.
With this entry, Merchandise Inventory account has an ending balance of 620 TL on the balance sheet.
3. Debit-balanced items such as Sales Returns & Allowances, Purchases and Freight-in are closed to
Income Summary with the following entry:
The sales price of each glass is 8 TL and received 10 glasses as return. Thus, Smart Company has an
open Sales Returns & Allowances account with an ending balance of 80 TL.
149
4. Credit-balanced items such as Sales Revenue, Purchase Returns & Allowances, and Purchase
Discounts are closed to Income Summary using the entry below:
280 glasses are sold from 8 TL each. Therefore, the amount recorded in Sales Revenue account is 2,240
TL (280 x 8). This amount is also closed to income summary to determine income number.
5. Balance of Income Summary account is closed to Owner’s Capital. T-account for Income Summary
and record to close it are subsequently represented below:
The credit balance of 583 TL is closed to Owner’s Capital with the following entry:
150
Accounting I
Further Reading
“We net out the cost of product returns allocations toward the customers making the
from the sales revenue for each customer and returns. However, recent research has suggested
then apply the gross margin percent to work that satisfactory product return experiences can
with the gross contribution margin...” actually benefit firms by lowering the customer’s
“When managers make decisions on perceived risk of current and future purchases.
customer selection and marketing resource To better understand the role of this perceived
allocation, the main objective is often profit risk in the firm–customer exchange process, the
maximization. These decisions are based on the authors conduct a large-scale customer selection
premise that the profit objective function that and optimal resource allocation field experiment
firms try to maximize accurately represents the with 26,000 customers from an online retailer
firm–customer exchange process. However, it is over six months. They find that the firm is able
often the case that the objective functions that to increase both its shortand long-term profits
firms use for customer selection and optimal when accounting for the perceived risk related to
resource allocation only consider the dynamics product returns in addition to managing product
between marketing efforts and customer purchase return costs. Furthermore, the authors find
behavior, frequently ignoring customer product that by including this risk, rather than simply
return behavior or treating it only as a cost that implementing traditional customer lifetime
must be managed… value–based models generically, the firm can
target more profitable customers”.
Relatively few retailers include metrics such
as product returns in their customer selection
and optimal resource allocation algorithms Source: Petersen, J. A. and Kumar, V. (2015).
when measuring and maximizing customer “Perceived Risk, Product Returns, and Optimal
value. Even when they do include this metric, Resource Allocation: Evidence from a Field
increases in product return behavior are usually Experiment”. Journal of Marketing Research, 52,
considered merely an economic cost that must be 268-285.
managed by decreasing the marketing resource
151
Describe merchandising
LO 1 operations and operating cycle of
a merchandising company
A merchandising operation is the purchase and resell operation, in which there is no manufacturing or
service activity. Merchandising companies sell the merchandise inventory, which they purchase from the
supplier, back to the customers. The rounding process from purchase of goods up to the collection of cash
from customers is called the operating cycle. Merchandising companies purchase goods, then those goods
are sold to customers either in cash or in credit. And the last step in an operating cycle is the collection of
Summary
cash from the customers. Then this circle goes on continuously.
LO 2 Describing inventory systems
There are two types of inventory systems: a) Perpetual Inventory System, and b) Periodic Inventory
System. In a perpetual inventory system, balance of inventory account is always updated as each
transaction occurs. When goods are sold, they are immediately deducted from the inventories and in each
purchase the cost is added to inventory account. On the other hand, in a periodic inventory system, the
accumulated effect of sales and purchases on inventory is calculated and recorded at the end of reporting
period depending on the physical count of inventories. When goods are purchased, they are recorded
in an account entitled “Purchases” rather than “Merchandise Inventory”. When goods are sold, only
one entry is recorded to represent the sales revenue, but there is no entry for decreasing the balance of
inventory account. All calculations on inventory (and COGS) are dependent on the physical count taken
at the end of accounting period. If an inventory is not found in the warehouse, it is assumed to be sold
and recorded as COGS.
Account for purchase related

LO 3 transactions under the perpetual
inventory system
In a perpetual inventory system, when a merchandise is purchased, the purchase cost is debited to
“Merchandise Inventory” and credited to “Cash” (or Accounts Payable in purchases on account) account.
If any trade discount is deserved, as a result of purchasing in high volume, it is deducted from the cost
before journalizing the purchase transaction.
On the other hand, depending on the shipment type, transportation cost may be included in cost of
merchandise. If the FOB shipping point type of shipment is preferred, the transportation cost belongs
to the buyer. Therefore, transportation cost is added to the cost of merchandise, because it is a part of
purchase cost.
If the sales agreement includes cash discount, which is offered to be provided on early payments, and the
company pays within the discount period, the amount of discount is deducted from the “Merchandise
Inventory” account. However, if the discount is not taken, there is no need for adjustment on the cost. If
the company returns the merchandise, as it is not found satisfactory, the amount of return is reflected as
decrease in “Merchandise Inventory” account as well as “Accounts Payable”.
152
Accounting I
Account for sales related

LO 4 transactions under the perpetual
inventory system
Sales transactions in the perpetual inventory system, has two entries at the beginning; the first representing
the amount of revenue and increase either in cash or in receivables, and the latter representing the amount
of COGS and decrease in inventory.
Transportation costs are recorded as “delivery expense” if the shipment is FOB destination, in which the
seller is responsible from the goods until the final destination. In FOB shipment point, the seller has no
Summary
responsibility related to transportation, then no entry is required for it.
If the customer deserves cash discount by paying within the discount period, the amount of discount
is debited in a contra-sales account entitled “Sales Discounts” and credited to “Accounts Receivable” in
exchange.
If the sold merchandise is returned by the customer, the cost of returned goods is debited to Merchandise
Inventories and credited to COGS. As it is also a return of sales, the sales revenue is decreased by debiting
another contra-sales account entitled “Sales Returns and Allowances” and crediting the “Accounts
Receivable”.
Accounting for the purchase and sale of

LO 5 merchandise inventory using a periodic
inventory system (Appendix)
Opposite to the case in perpetual inventory system, in periodic inventory system inventory accounts are
not up-to-date and do not provide information on inventory whenever needed. By performing physical
counts, companies measure the amount of inventory on hand at the end of each accounting period.
153
1 Which of the followings is a kind of 6 Which of the following items is common to

merchandising company? both single- and multiple-step income statements?
A. Hospital A. Net Income
B. Bakery B. Gross Profit
Test Yourself
C. Hotel C. Unearned Revenue

D. Bookstore D. Operating Income
E. Bank E. Earnings Before Interest and Taxes (EBIT)
2 If the terms of shipment is FOB destination, 7 If a company applies a perpetual inventory

the responsibility of seller ends … ; system, which of the following two accounts are
used by the seller when the customer returns the
A. When the goods reach the customer’s warehouse merchandise?
B. When the invoice is prepared
C. When the goods are ready on board to be A. Inventory – Sales Return
shipped B. Purchase Return- Accounts Receivable
D. When the payment is received from the C. COGS– Inventory
customer D. Sales Return and Allowances – Accounts
E. When the goods are sold by the customer Receivable
E. Inventory - Sales Discount
3 Operating cycle of a merchandising company
starts with …; 8 On July 1, Read Bookstore sold 120
accounting books to Schoolist Company on
A. Payment to supplier account with 2/10, n/30. Sales price is 20 TL/
B. Purchase of merchandise book. If Schoolist Company pays on July 8, which
C. Sale of merchandise accounting entry should be prepared by Read?
D. Collection of receivable
A. Debit Accounts Receivable by 48 TL; credit
E. Production of finished goods Sales by 48 TL
B. Debit Cash by 2,352 TL; credit Accounts
4 Which of the followings does not have a role Receivable by 2,352 TL
in inventory cost flow? C. Debit Cash by 2,400 TL; credit Accounts
A. Cost of Goods Sold Receivable by 2,352 TL and Sales Discount by
B. Beginning Inventory 48 TL
C. Work-in-Process Inventory D. Debit Cash by 2,352 TL and Sales Discount by
D. Purchases 48 TL; Credit Accounts Receivable by 2,400
TL
E. Ending Inventory
E. Debit Accounts Receivable by 2,400; Credit
Sales Discount by 48 TL and Cash by 2,352
5 Trade discount is provided to customers, in
order to …
A. Earn customer loyalty
B. Encourage early payment
C. Make more profit
D. Prevent returns
E. Reward high volume purchases
154
Accounting I
9 Company has 400 TL worth beginning 10 On November 1, Anadolu Company

inventory on November 1. Total cost of inventories purchased 200 TVs from TechEleck Company
purchased during November is 5,200 TL, but for 1,000 TL each, on account. Credit terms is
150 TL worth of goods are returned and 50 TL 4/10, n/90 and FOB shipping point is chosen.
Test Yourself
received as reduction in price for some defective On November 8, Anadolu returned 10 TVs back.
merchandise. The physical count shows that there Which entry will be made by Anadolu?
are 1,050 TL worth of goods in the warehouse.
What is the amount of COGS to record? A. Debit Cash by 10,000 TL; credit Sales Returns
by 10,000 TL
A. 5,800 B. Debit Accounts Receivable by 9,600 TL; credit
B. 5,650 Purchase Discounts by 9,600 TL
C. 4,350 C. Debit Cash by 9,600 TL; credit Sales Returns
D. 4,400 by 9,600 TL
E. 650 D. Debit Purchase Returns by 10,000; credit Cash
by 10,000 TL
E. Debit Accounts Payable by 10,000 TL; credit
Merchandise Inventory by 10,000 TL
155
1. D 6. A If your answer is wrong, please review

the “Closing Entries for Merchandising
“Merchandising Operations” section.
Companies” section.

2. A If your answer is wrong, please review the 7. D
“Account for sales related transactions under
the perpetual inventory system” section.

3. B If your answer is wrong, please review the 8. D

4. C If your answer is wrong, please review the 9. C

5. E If your answer is wrong, please review the 10. E “Account for purchase related transactions
“Merchandising Operations” section. under the perpetual inventory system”
section.
Assume that you are the manager of a merchandising

company. Which of these two statements would help you
more if your aim is to assess the company’s performance?
Single-step income statements provide the managers only one income number
to assess the performance. However, in a multiple-step income statement,
income is calculated for each activity level separately. Starting from the top
your turn 1 to the bottom, the first level of income is gross profit, which reflects the
performance related to sales activities. In the second level, operating income
represents the operational performance and the third level income is Earnings
Before Interest and Taxes (EBIT), which is the complete performance of a
company except the financing activities and tax. Therefore, multiple-step
income statements guide the management through different aspects of
business performance to correct.
156
Accounting I
Compare the use of inventory systems and specify the

advantages or disadvantages of each system over the
other one.

There are two types of inventory systems; perpetual and periodic. By using
a perpetual inventory, system managers may reach up-to-date information
on inventories whenever they need. Because all transactions are reflected
in the inventories concurrently with the transaction. However, it requires
a well-established information system to keep all of thousands (or maybe
millions) of transactions on inventories. Today’s technology helps companies
a lot at this point. For example, point-of-sale terminals and barcode systems
help companies that sell several thousands of items per hour, to keep their
your turn 2 inventory systems up-to-date. Therefore, many companies are using perpetual
inventory system, with the technology getting closer day-by-day.
On the other hand, periodic inventory systems are still used by a small
number of companies, which are mostly family owned companies selling
immaterial in monetary amount products. Management’s vision is the most
important factor effecting these small companies in choosing the periodic
system. If management has little interest in the quantities on hand, or has
an old-school perspective of keeping the accounts manually with too much
familiarity with the business that perpetual system records are not required,
then the companies prefer periodic inventory system.
What if the goods are insured against any risk, who

should pay for the premiums of insurance under each
shipping type?
In FOB shipping point the responsibility of transportation for the merchandise

belongs to the buyer, including the freight cost and insurance. The seller is
your turn 3 responsible for the merchandise only up to the point of shipment. However,
in FOB destination terms, the seller is the responsible party. The insurance
costs are paid by the seller in a FOB destination type of shipment.
Which shipment terms is a better choice for a company

that sells dangerous substance to companies operating
in overseas countries?
If a company is selling dangerous substance to overseas countries, FOB

shipping point is mostly more beneficial to choose. Because, dangerous
your turn 4 substance requires special methods of carriage with specialized containers and
it makes the transportation too costly, together with the expensive insurance
premiums covering the high risk in the merchandise itself. By not choosing
the FOB destination type of shipment, company gets rid of the transportation
related responsibilities.
157
How does a buyer account for it, if the seller provides

trade discount after some of the goods are sold to third
parties (not at the time of purchase)?
If the trade discount is taken after some of the goods are sold to customers,
amount of discount should be taken into consideration in measuring the cost
of all goods, including both sold and unsold ones. For example, suppose that
your turn 5 for rewarding the purchase of 5,000 units at once, the seller provides the buyer
2,000 TL discount 15 days after the sale. However, in that 15 days period, the
buyer has already sold 30% of these goods to the customers. Then how should
the buyer record this discount is to record 30% of it as a deduction from
“COGS” account and 70% from the balance of “Merchandise Inventory”,
also reducing the amount of payable at the same time. The required entry is
shown below:
Explain the relationship between rate of return in the

market and possibility of buyers to pay early and get the
cash discount.
If the expected rate of return in the market is higher than the discount offered
by the seller company;
Assume that terms of sale are 2/10, n/90 and the return available in the
market is 4% for this 90 days period. If the buyer pays within 10 days, 2%
your turn 6 will be earned as discount but the amount cannot be invested in investments
providing 4% return. In other words, by paying earlier, buyer gains 2% but
loses 4% (as opportunity cost). In summary, if the rate of return in the market
is higher than the rate of discount provided by seller, the buyer chooses to pay
at maturity and use that money in other investments to earn more from it.
158
Accounting I
Prepare the multiple step income statement of

Anatolian Company.

(TL) Anatolian Company
Income Statement
your turn 7 For the Month Ended April 30, 2018
Sales revenue 1,500

(-) Sales Discount (7)
(-) Sales Returns & Allowances (450)
Net Sales Revenue 1,043
(-)COGS (900)
Gross Profit 143
(-) Delivery Expense (50)
Net Income 93
Endnotes
1
Horngren, C.T., Datar, S. and Rajan, M. (2015) Williams et al., op cit, p.230.
7
Cost Accounting: A Managerial Emphasis (Fifteenth

Monger, R. (2010) Financial Accounting: A Global
8
Edition). Pearson Education Limited, p.60.
Approach (First Edition). Barcelona: John Wiley
2
Simga-Mugan, F. N.C. and Akman, N.H. Principles and Sons Ltd., p.351.
of Financial Accounting Based on IFRS (Fifth
Weygandt, J. J., Kimmel, P. D. and Kieso, D. E.
9
Edition). McGraw-Hill, p.121.
(2010) Accounting Principles, 9th Edition. John
3
Horngren et al, op cit, p.67. Wiley and Sons Ltd., p.207.
4
Williams, J.R., Haka, S.F., Bettner, M. S. and Meigs, 10
Simga-Mugan and Akman, op cit, p.123.
R.F. (2003) Financial Accounting (Eleventh 11
Monger, op cit. P.453.
Edition). New York: McGraw-Hill, p. 224.
12
Weygandt, J. J., Kimmel, P. D. and Kieso, D. E.
5
Demski, J.S. (1994) Managerial Uses of Accounting
(2010) Financial Accounting: IFRS Edition. John
Information, Kluwer Academic Publishers, p. 45.
Wiley and Sons Ltd., p.251.
6
Simga-Mugan and Akman, op cit, p.135.
159
Chapter 6 Merchandise Inventory
1 2
Learning Outcomes
Explain and apply accounting principles to

Determine and classify inventory merchandise inventory
3 Apply different inventory cost flow methods 4 Discuss financial effects of different inventory
cost flow methods on financial statements
5 Valuation of inventories 6 Analyze the effects of inventory errors on the

financial statements
7
Compute and evaluate inventory turnover and
days’ sales in inventories for management
decisions
Chapter Outline
Introduction Key Terms
Classifying Inventory- Cost Flow Methods
Inventory Related Accounting Principles Days’ Sales in İnventories
Inventory Costing Methods Inventory
Valuation of Inventories Inventory Errors
Impact of Inventory Errors on Financial Statements Inventory Management
Inventory Related Ratios in Decision Making Inventory Turnover
160
Accounting I
INTRODUCTION
The basic financial aim of a company is to maximize its value by controlling and effectively managing
several resources. Inventories are one of those important resources which can be observed in several
categories whose effective and efficient management plays a critical role in a company’s success.
Chapter 5 introduced operations of merchandising companies and you learned how these companies
account for merchandising inventory assets. In this chapter, we expand our discussion on merchandise
inventory by learning how to account for the cost of merchandise inventory. We will start this chapter
by defining inventories and types of inventories exist in companies and inventory-related accounting
principles. Then, we will continue with inventory systems; inventory cost flow systems and impacts of using
different cost flow systems on financial statements. We will later explain valuation of inventories typical
inventory errors and their typical impact on financial statements. The chapter ends with explanation and
impact of inventory related ratios on management decisions.
CLASSIFYING INVENTORY
Inventories are frequently accepted as the largest current asset of merchandising (retail) and
manufacturing companies, that’s why the definition, classification and measurement of inventory require
a careful attention.
Inventories can can simply be defined as asset items that
a company holds for sale in the ordinary course of business,
or items that will be used or consumed in the production of Inventories are assets;
goods to be sold (IAS 2- Inventories). 1 a. held for sale in the ordinary course of
business;
From this definition, we understand that inventories can
b. use in the process of production for such
come out as different categories in companies depending on
sale; or
their activities.
c. in the form of materials or supplies to be
A merchandising company usually purchases its consumed in the production process or in
merchandise in a form ready for sale and reports only the the rendering of the services.
cost assigned to unsold units left on hand as “Merchandise
Inventory” in its financial statements.
A manufacturing company produces goods and usually
sells them to merchandising firms. Although the products
they produce may differ, manufacturers normally have Inventories are usually made up of a
three inventory accounts in their financial statements: raw combination of goods, raw materials and
materials, work in process, and finished goods. finished products.
Raw Materials Inventory reports the cost of goods and
materials on hand which will be used in production.
Work in Process Inventory reports the cost of goods, materials and other components of manufacturing
process used for the inventory which are still in production process, in other words unfinished at the time
financial statements are prepared.
Finished Goods Inventory reports the cost of goods, materials and other components of manufacturing
process used for the inventory produced and available for sale.
In other words, inventories for manufacturing companies are raw materials, work-in-process products
and finished goods that are considered to be portions of a business’s assets that are ready or will be ready
for sale.
A service company usually reports goods which are used in their service providing facilities as inventories
or stocks.
161
INVENTORY-RELATED ACCOUNTING PRINCIPLES

The guidelines for accounting information are called
Generally Accepted Accounting Principles (GAAP). In
order to use and prepare financial statements, it’s important Generally Accepted Accounting Principles
that we understand GAAP. To understand accounting (GAAP) rests on a conceptual framework
and reporting inventories, first, we should understand the that identifies the objectives, characteristics,
principles which are related to them such as consistency, elements, and implementation of financial
disclosure, materiality, and accounting conservatism. statements and creates the accepted
accounting principles.
Consistency Principle
The consistency principle holds that companies should
use the same accounting methods and procedures in each
accounting period, so that the information provided The consistency principle states that
will help investors and creditors to compare a company’s businesses should use the same accounting
financial statements from one period to the next. For methods and procedures from period to
example, assume that you are analyzing a company’s net period.
income over a two-year period in which there was a decrease
in net income from the first year to the second. Analysis of
the income statement shows that Sales Revenue was almost the same for both years, but Cost of Goods
Sold increased significantly, which resulted in decreases in gross profit and operating income.
Without any other information, you might conclude that the company was able to purchase its
inventory at a higher cost in the second year and that profits will continue to decrease in future years.
However, changing inventory costing methods could also have caused this one-time change, in which case
future profits will not be affected. Therefore, companies must be consistent in the accounting methods to
enable investors and creditors make wise decisions about the company by using this information.
Disclosure Principle
Financial statements by themselves are just composed
of numbers, and without any additional information, it is
A business’s financial statements must report
almost impossible to understand what those numbers mean.
enough information for outsiders to make
That’s why disclosure principle requires all major accounting
knowledgeable decisions about the company
methods and procedures to be described in the footnotes of
because of the disclosure principle rules.
financial statements for reliable and faithful representation.
In other words, the disclosure principle holds that a
company should report enough information for financial statement users to understand methods and
procedures used for each component of the financial statements to make wise decisions about the company
by providing additional information. From the point of merchandising inventories, companies should
disclose all methods being used to account for merchandise inventories.
Materiality Concept
The materiality concept states that a company must
perform strictly proper accounting only for significant items.2
A company must perform strictly proper
Information is significant (material in accounting terms)
accounting only for items that are significant
when it would cause someone to change a decision. The
to the business’s financial situation according
most important point about this concept is to understand
to the materiality concept requirements.
what is significant or material.
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Accounting I
When you do not report some information in your financial statements, and if it affects the decision
of financial statement users, then this information is accepted to be material. From company to company,
this information might differ.
Conservatism
Conservatism in accounting means being careful in
reporting items in the financial statements. Conservatism
follows these ideas: 3 A business should report the least favorable
figures in the financial statements when
• Anticipate no gains, but provide for all probable
two or more possible options are presented
losses.
according to the conservatism concept
• If in doubt, record an asset the lowest reasonable requirements.
amount and reliability at the highest reasonable
amount.
• When there is a question, record an expense rather than an asset.
• When you are faced with a decision between two possible options, you must choose the option that
undervalues, rather than overvalues, your business
The purpose of conservatism is to report realistic figures and never exaggerate assets or net income.
INVENTORY COSTING METHODS

Inventory management is an important aspect of any successful business. Inventory is accounted for at
cost. Cost includes all expenditures necessary to acquire goods and make them ready for sale. Businesses
must have a way to determine the value of merchandise inventory on hand and also the value sold (cost of
goods sold). For this reason, first they have to choose an accounting system and then a cost flow system for
their inventories. In this section, first, inventory accounting systems, which have already been explained in
the previous chapter, will be revisited; and then, inventory cost flow methods will be explained.
Inventory Accounting Systems

Choosing an inventory accounting system is fundamental for calculating the value of inventory on
hand and the cost of goods sold. As you learned in Chapter 5, there are two basic inventory accounting
systems: “Perpetual Inventory System” and “Periodic Inventory System”.
Perpetual Inventory System

Perpetual Inventory System is a system of tracking and
recording inventory and costs of goods sold on a continual Perpetual Inventory System is an inventory
basis, so current inventory balance can be calculated on system of tracking and recording inventory
real time basis, and the accounting system can display the and cost of goods sold on a continual basis.
current inventory balance at any point in time.
The perpetual inventory system keeps a running
computerized record of merchandise inventory, that is,
the number of inventory units and the money amounts
associated with the inventory are perpetually (continuously) Perpetual Inventory System always provides
updated. real time balances of Inventory Account and
This system achieves better control over the inventory the Cost of Goods Sold Account.
by recording the following information:
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• Units purchased and cost amounts

• Units sold and sales and cost amounts
• The quantity of merchandise inventory on hand and its cost.
Periodic Inventory System

Periodic Inventory System is an inventory system
which relies upon physical count of the inventory to Periodic Inventory System is a system of
determine the ending inventory balance and cost of goods determining the quantity of inventory on
sold. In other words, no effort is made to keep up-to- hand only periodically.
date records of either the inventory or cost of goods sold,
physical count of inventory is made at specific intervals.
The periodic inventory system requires businesses
to obtain a physical count of inventory to determine
Periodic Inventory System calculates the Cost
quantities on hand. The system is normally used for
of Ending Inventory and Cost of Goods Sold
relatively inexpensive goods, such as in a small, local store
once at the end of an accounting period.
without optical-scanning cash registers that does not keep
a running record of every loaf of bread and every key chain
that it sells. Restaurants and small retail stores often use the periodic inventory system which is becoming
less and less popular because most accounting is done using computerized methods.
As we defined before, an inventory is the stock of items used in an organization. An inventory system
monitors the levels of inventory and determines the time line and quantity of orders. Companies maintain
inventories of raw materials, work in process and finished goods inventory or merchandise inventory for
various reasons, including unpredictable raw material delivery time, allowing for production scheduling
flexibility, or demand variations.
Inventory Cost Flow Methods

As you learned in Chapter 5;
Ending inventory = Unit cost x Number of units on hand

Inventory Cost Flow Method is a method
Cost of goods sold = Unit cost x Number of units sold of approximating the flow of inventory costs
in a business that is used to determine the
Companies determine the number of units from amount of cost of goods sold and ending
perpetual inventory records backed up by a physical count. merchandise inventory.
The cost of each unit of inventory is as follows:
Cost per unit = Purchase price – Purchase discounts – Purchase returns + Freight in
After a company has determined the quantity of units of inventory, it applies unit costs to the quantities
to compute the total cost of the inventory and the cost of goods sold. Measuring inventory cost is easy
when prices do not change. But unit cost does change often. This process, therefore, can be complicated if
a company has purchased inventory items at different times and at different prices. There will be a major
accounting issue when identical units of merchandise are acquired at different unit costs during a period
unless the company uses a specific identification costing method. If a company is not able to use a specific
identification costing method, when an item is sold, it is necessary to determine its unit cost according to
the cost flow assumptions so that the proper accounting entry can be recorded.
There are three common cost flow assumptions used in business. Each of thewse assumptions is
identified with an inventory costing method, as shown below:
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Accounting I
Figure 6.1 Inventory Cost Flow Assumptions and Inventory Costing Methods
Source: Carl S. Warren, James M. Reeve, Jonathan E. Duchac, (2007) Accounting, 22ed., Thomson South-Western,
p.309.
With the exception of the specific identification method, each inventory cost flow method used
to determine cost of goods sold and cost of ending merchandise inventory approximates the flow of
inventory costs in a business. In other words, real physical flow of inventory might not be in the same
way used in the method chosen.
To illustrate all inventory costing methods, assume that Auk-Mart Inc. had the following transactions in its first
month of operations. Assume that 14,000 identical units of Item X are purchased during May, as shown below.
Date Purchases Sales (units) Balance (units)

May 5 ……… 4,000 @ TL 5.00 4,000
May 10 …….. 6,000 @ TL 5.20 10,000
May 15 …….. 2,000 8,000
May 20 …….. 2,000 @ TL 5.40 10,000
May 25 …….. 4,000 6,000
May 29 …….. 2,000 @ TL 5.50 8,000
Since perpetual inventory system is generally adopted by most of the companies as an inventory
accounting system, all inventory cost flow methods which will be explained in this chapter will be explained
under the assumption that the company uses the perpetual inventory system.
Specific Identification Method

The specific identification method uses the specific cost of each inventory unit to determine ending
inventory and cost of goods sold. Specific identification requires that companies keep records of the original
cost of each individual inventory item. In the specific
identification method, the company knows exactly
which item was sold and exactly what the item cost.4 Specific Identification Method is an inventory
The specific identification method is impractical unless costing method based on the specific cost of
each unit can be identified accurately. This costing method particular units of inventory.
is best for businesses that sell unique, easily identified
165
inventory items, such as jeweler (a specific diamond earring), an

automobile dealer (each automobile has a unique serial number) and
real estate (identified by address). This method requires the business
maintains detailed records of inventory sales and purchases as well as
carefully identifying the inventory sold.
To illustrate, assume that Auk-Mart Inc. uses Specific Identification
Method for inventory costing under perpetual inventory system.
May 15th sale of 2,000 units are from the May 10th purchase; and
May 25th sale of 4,000 units from May 5th purchase.
Calculation of Auk-Mart Inc.’s “Cost of Goods Sold” and “Ending
Inventory” by using Specific-Identification Method is as follows:
Cost of Goods Sold: If the specific identification method is used, Figure 6.2
the company knows exactly which item is sold and exactly what the
item cost is. In our example, we know that on May 15, 2,000 units are sold from May 10 purchase, May
25, 4,000 units are sold from May 5 purchase. So, cost of the goods sold of May is calculated as below:
Date Sold Unit Cost Cost of Goods Sold

May 15 ……… 2,000 units @ TL 5.20 = TL 10,400
May 25 …….. 4,000 units @ TL 5.00 = TL 20,000
Cost of Goods Sold TL 30,400
Cost of Ending Inventory: Calculation of cost of ending inventory is shown below. We simply multiply
number of units on hand with their unit cost and add the totals up.
Date Purchases Sales Unit Cost Total Cost Total Cost

Balance
May 5 ……… 4,000 units TL 5.00 TL 20,000 TL20,000
May 10 …….. 6,000 units 5.20 31,200 51,200
May 15 …….. 2,000 5.20 (10,400) 40,800
May 20 …….. 2,000 units 5.40 10,800 51,600
May 25 …….. 4,000 5.00 (20,000) 31,600
May 29 …….. 2,000 units 5.50 11,000 TL 42,600
Ending Inventory TL 42,600
Average Cost Method

The average cost method allocates the cost of goods available
Average Cost Method is an inventory
for sale on the basis of the weighted average unit cost incurred.
costing method based on the weighted
The average cost method assumes that goods are similar in
average cost per unit of inventory that is
nature. When the average cost method is used in a perpetual
calculated after each purchase. Weighted
inventory system, the business computes a new weighted average
average cost per unit is determined by
cost per unit after each purchase. This unit cost is then used to
dividing the cost of goods available for
determine the cost of each sale until another purchase is made
sale by the number of units available.
and a new average is computed. Ending inventory and cost of
goods sold are then based on the same average cost per unit.
To illustrate, assume that Auk-Mart Inc. uses Average Cost Method of inventory costing under perpetual
inventory method, calculation of “Cost of Goods Sold” and “Cost of Ending Inventory” are as follows:
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Accounting I
Cost of Goods Sold: Since we assume that the company uses perpetual inventory system as an
accounting system the company has to calculate cost of goods sold each time it makes a sale. In our
example, during the month of May the company makes sales on May 15 and on May 25. In this situation,
we have to calculate cost of goods sold for each sales separately.
Cost of Goods Sold for May 15: If the company uses average cost method, firstly we have to calculate
the average unit cost at the date of sale. It is simply calculated by dividing total cost of inventories by
number of units available for sale.
Date Goods Available For Sale Unit Cost Total Cost
May 5 ….. 4,000 units @ TL 5.00 = TL 20,000

May 10 … 6,000 units @ TL 5.20 = TL 31,200
May 15 …. 10,000 units TL 51,200
As of May 15, the company has 10,000 units on hand with a cost of 51,200 TL.
Average Unit Cost = 51,200 TL / 10,000
= 5.12 TL
After finding out the average unit cost, we multiply it with number of units sold to calculate cost of
goods sold.
Cost of Goods Sold = 2,000 units @ 5.12 TL

= 10,240 TL
Cost of Goods Sold for May 25: In order to calculate cost, of goods sold for May 25 sale, we will follow
exactly the same steps. First, we calculate the average unit cost of inventories on hand and multiply this
amount with the number of units sold. However, we have to be careful while we are calculating the total
cost of inventory available for sale.
May 15 ….. 8,000 units @ TL 5.12* = TL 40,960

May 20 … 2,000 units @ TL 5.40 = TL 10,800
May 25 …. 10,000 units TL 51,760
As of May 25, we have 10,000 units available for sale, 8,000 units of this amount are inventory left
from the sale of May 15, and 2,000 of this amount are from the purchase of May 20.
*While we are calculating the total cost of 8,000 units which are left from the sale of May 15 we have to use
the average unit cost already calculated as of May 15 which is 5.12 TL.
Average Unit Cost = 51,760/10,000 TL units

= 5.176 TL
Cost of Goods Sold = 4,000 units @ 5.176 TL
= 20,704 TL
Total Cost of Goods Sold for May = 10,240 TL + 20,704 TL

= 30,944 TL
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To calculate cost of goods sold for May, we simply add cost of goods sold calculated for May 15 and
May 25.
Cost of Ending Inventory: In order to calculate the cost of ending inventory, we take into consideration
the cost of inventory left on hand from the sale of May 25 using the average unit cost for that date and the
other inventory purchased during the period.
May 25 ….. 6,000 units @ TL 5.176 = TL 31,056

May 29 … 2,000 units @ TL 5.50 = TL 11,000
May 30 …. 8,000 units TL 42,056
1
Assume MNC Pipe Store completed the following inventory transactions for a line of Pipes:
Date Purchases Unit Cost Sales Unit Selling Price
February 2 8 TL 65
February 8 5 TL 78
February 14 6 TL 100
February 20 7 TL 80
Calculate the “Cost of Goods Sold” and “Cost of Ending Inventory” for the month of February
assuming that Company is using Weighted-Average-Cost Method.
Calculate Cost of Goods Sold for the Month of May and Cost of Ending Inventory as of April 30.
First-In, First-Out (FIFO) Method

The First-In, First-Out (FIFO) method assumes that the
earliest goods purchased are the first to be sold. Under the first-in, First-In, First-Out (FIFO)
first-out (FIFO) method, the cost of goods sold is based on the Method an inventory costing method
oldest purchases – that is, the first units to come in are assumed in which the first costs into inventory
to be the first units to go out of the warehouse (sold). FIFO are the first costs out to cost of goods
costing is consistent with the physical movement of inventory sold. Ending inventory is based on the
(for most companies). That is, under the FIFO inventory costing costs of the most recent purchases.
method, companies sell their oldest inventory first.
To illustrate, assume that Auk-Mart Inc. uses First-in-First Out (FIFO) method of inventory costing under
perpetual inventory method, calculation of “Cost of Goods Sold” and “Cost of Ending Inventory” are as follows:
Cost of Goods Sold: In order to calculate cost of goods sold for the month of May, we have to calculate
the cost of goods sold each time when we make a sale, then add them up.
If Company uses FIFO Method for inventory costing purposes, it is assumed that inventories which
are purchased first are sold first.
In this example, 2,000 units are sold on May 15. While we are calculating cost of goods sold for this
date, we assume the company makes this sale from inventories purchased on May 5 since that is the very
first purchase made in May. So cost of goods sold for May 15 sale is calculated as 10,000 TL.
To calculate cost of goods sold on May 25, we have to first look at how many units are on hand left
from the earliest purchase, and then we will continue with next purchases. In this example, 4,000 units
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Accounting I
are purchased on May 5, and 2,000 units of this purchase are sold on May 15. That means while we are
calculating the cost of 4,000 units sold on May 25, we will assume 2,000 units are sold from the inventory
purchased on May 5, and 2,000 units are sold from the inventory purchased on May 10. As a result, we
find cost of goods sold for the month of May as 30,400 TL.
Date Sold Cost of Goods Sold

May 15 ……… 2,000 units 2,000 @ TL 5.00 = TL 10,000
May 25 …….. 4,000 units 2,000 @ TL 5.00 = TL 10,000
2,000 @ TL 5.20 = TL 10,400
May 30 …… TL 30,400
Cost of Ending Inventory: Calculation of cost of ending inventory under FIFO is shown below in
detail.

May 5 ….. 0 units @ TL 5.20 = TL 0
May 10 ….. 4,000 units @ TL 5.20 = TL 20,800
May 20 ….. 2,000 units @ TL 5.40 = TL 10,800
May 29 ….. 2,000 units @ TL 5.50 = TL 11,000
May 30 ….. 8,000 units TL 42,600
2
February 2 8 TL 65
February 8 5 TL 78
February 20 7 TL 80
assuming that company is using the First-in-First-Out (FIFO) Method.
Last-In, First-Out (LIFO) Method

Last-in, First-out (LIFO) is just the opposite of FIFO.
Under the last-in, first-out (LIFO) method, ending Last-In, First-Out (FIFO)
inventory comes from the oldest costs (beginning inventory Method is an inventory costing method in
and earliest purchases) of the period. which the last costs into inventory are the first
costs out to cost of goods sold. The method
The cost of goods sold is based on the most recent
leaves the oldest costs –those of beginning
purchases (new costs) –that is, the last units in are assumed
inventory and the earliest purchases of the
to be the first units out of the warehouse (sold). This
period- in ending inventory.
method is forbidden for being misleading especially in
hyperinflationary economies.
169
To illustrate, assume that Auk-Mart Inc. uses the Last-in-First Out (LIFO) method of inventory costing under
perpetual inventory method, calculation of “Cost of Goods Sold” and “Cost of Ending Inventory” are as follows:
Cost of Goods Sold: If Company uses LIFO Method for inventory costing purposes, it is assumed that
inventories which are most recently purchased are sold first.
In this example 2,000 units are sold on May 15, under LIFO we assume Company makes this sale
from inventories purchased on May 10 since that is the last purchase made before the sale. So the cost of
goods sold for May 15 is calculated as 10,400 TL. Company also sold 4,000 units on May 25, to calculate
cost of goods sold, again we assume that the company made this sale from the most recent purchase made
before the sale, and then we move backwards to other purchases. So the cost of goods sold for May 25 is
calculated as 21,200 TL.

May 15 ……… 2,000 units @ 2,000 @ TL 5.20 = TL 10,000
May 25 …….. @ 2,000 @ TL 5.40 = TL 10,000
2,000 @ TL 5.20 = TL 10,400
May 30 …… TL 31,600
Cost of Ending Inventory: Calculation of cost of ending inventory is shown below in detail:

May 5 ….. 4,000 units @ = TL 20,000
TL 5.00
May 10 ….. 2,000 units @ = TL 10,400
TL 5.20
May 20 ….. 0 units @ TL 5.20 = TL 0
May 29 ….. 2,000 units @ TL 5.50 = TL 11,000
May 30 ….. 8,000 units TL 41,400
3
February 2 8 TL 65
February 8 5 TL 78
February 20 7 TL 80
assuming that company is using the Last-in-First-Out (LIFO) Method.
Impact of Using Different Inventory Cost Flow Methods on Financial

Statements
In the preceding sections of this chapter, we worked on different inventory cost flow methods. To
illustrate, the impact of using different cost flow methods on Financial Statements assume that Crane-
Mart Inc. had the following transactions in its first month of operations:
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Accounting I
Date Purchases Sales*
June 2 ……….. 3,000 units @ TL 2.00

June 5 ……….. 7,000units @ TL 4.00
June 8 ………. 6,000 units
June 10 ………. 6,000 units @ TL 5.10
June 15 ………. 8,000 units
June 19 ………. 8,000 units @ TL 5.50
June 22 ………. 5,000 units
June 25 ………. 4,000 units @ TL 5.75
* Unit Selling Price is 20.00 TL.

* Operating Expenses are 147,820 TL.
The illustration below shows the comparative results on the net income use of Average Cost, FIFO
and LIFO.
Average Cost FIFO LIFO
Sales TL 380,000 TL 380,000 TL 380,000
Less: Cost of Goods Sold (82,180) (81,100) (88,100)
------------- -------------- -------------
Gross Profit TL 297,820 TL 298,900 TL 291,900
Less: Operating Expenses (147,820) (147,820) (147,820)
--------------- --------------- ---------------
Income Before Taxes TL 150,000 TL 151,080 TL 144,080
Less: Income Tax (20%) (30,000) (30,216) (28,816)
--------------- -------------- --------------
Net Income TL 120,000 TL 120,864 TL 115,264
The illustration below shows the final balances of selected items at the end of the period:
Inventory Gross Profit Taxes Net Income
Average Cost TL 49,420 TL 297,820 TL 30,000 TL 120,000
FIFO TL 50,500 TL 298,900 TL 30,216 TL 120,864
LIFO TL 43,500 TL 291,900 TL 28,816 TL 115,264
As it can be seen above, depending on the cost flow method used the cost of ending inventory and the
cost of goods sold reported are directly affected. It is in fact critical for companies to decide which cost
flow method to adopt, and there are several factors that affect their decision. The first factor that limits the
choice of companies is the requirements of regulatory bodies. LIFO is forbidden by most of the regulators
especially by the ones in hyperinflationary economies. The other factor which affects the decision made
is the purpose of the company. In other words, if the company is planning to sell its shares in the market,
then it wants to be evaluated as a profitable company and would prefer to choose the method which will
show its financials in a more profitable way. On the other hand, if a company wants to pay less tax, then
it would prefer to choose the method which will show the company less profitable.
VALUATION OF INVENTORIES
In order to prepare reliable financial statements, they should be prepared with up to date and relevant
information. That’s the reason why at the end of each accounting period valuation process takes place for
each item reported. As we mentioned earlier, cost is the primary basis for valuing inventories. But the
171
value of inventory for companies selling high-technology or fashion goods might drop very quickly due to
changes in technology or fashions. In such cases, inventory is valued at market value other than cost. Two
such cases arise when (1) the cost of replacing items in inventory is below the recorded cost and (2) the
inventory is not salable at normal sales prices.5
If the market value is lower than the cost, the lower-of-cost-or-market (LCM) method is used to value
the inventory. This method requires inventory to be reported in the financial statements at “historical cost”
or “market value” whichever is lower.
For inventories, market value is generally accepted as current replacement cost or net realizable value.
When the replacement cost of inventory falls below its historical cost, the Lower of Cost or Market Value
Method (LCM) rules require that the inventory should be written down to the lower value and that a loss
be recorded. This rule is an example of the application of the conservatism principle because the loss is
recognized before an actual transaction takes place. If the market value is greater than cost, then we don’t
adjust the inventory account because of the conservatism principle.
Lower of Cost or Market Value Method

(LCM) is a valuation method which
requires inventory to be reported in financial
statements at whichever is lower – its
historical cost or its market value.
Net Realizable Value is the estimated sales

value minus estimated cost of completion
and minus estimated cost of sale.
Estimated cost of completion is used for the

calculation of the market value of work-in-
process inventory in manufacturing companies.
Figure 6.3
To illustrate, assume that as of December 31, Hawk-Mart Inc. had inventories on hand and the cost is
10,000 TL. Estimated selling price for those inventories was 15,000 TL and estimated cost of sales was 1,500
TL. With which value inventories should be reported?
In order to find out the reporting value for inventories on
hand, we have to compare cost with market value. In this question,
we know the cost was 10,000 TL, but we have to calculate market
value or net realizable value. When we deduct estimated cost of 4
sales from estimated sales value, we find it as 13,500 TL. Since Assume that as of December 31
the cost is lower, we keep on reporting inventories with 10,000 “Robin Merchandising Company”
TL. had inventory with a cost of 12,000
What happens if you find market value lower than book value TL on hand. Estimated selling price
of inventories in the valuation process? That means our inventory was 17,000 TL and estimated cost of
is impaired. Since the rule says we have to report inventories with sales was 2,000 TL. With which value
the lower of cost or market value, we have to report them with inventories should be reported?
market value.
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Accounting I
To illustrate, assume that as of December 31, Hawk-Mart

Inc. had inventories on hand with a book value of 10,000 TL.
Estimated selling price for those inventories was 11,000 TL,
5
and estimated cost of sales was 1,500 TL. With which value
inventories should be reported? Assume that as of December 31 “Ava
Merchandising Company” had inventory
In this question, we know that the cost was 10,000 TL,
with a cost of 20,000 TL on hand.
but we have to calculate market value or net realizable value.
Estimated selling price was 22,000 TL and
When we deduct estimated cost of sales from estimated sales
estimated cost of sales was 3,000 TL. With
value of inventories (11,000 TL – 1,500 TL), we find it as
which value inventories should be reported?
9,500 TL, and it is lower than cost which means inventories
are impaired by 500 TL.
It should be journalized as follows:
Date Accounts and Explanation Debit Credit
Dec.31 Cost of Goods Sold 500

Merchandise Inventory 500
IMPACT OF INVENTORY ERRORS ON FINANCIAL STATEMENTS

Having the ability to measure inventory in a timely and accurate manner is critical for having
uninterrupted business operations since inventory is often one of the largest current assets on a company’s
balance sheet. An error in ending merchandise inventory creates a whole string of errors in other related
accounts. So, businesses have to perform a physical count of their merchandise inventory at the end of
each accounting period to report their inventories with correct values.
To illustrate, assume Birch Merchandising Company accidentally overstated its ending merchandise inventory
by 7,000 TL.
In that case, total assets of the company would be overstated by 7,000 TL in its balance sheet, this error affects
the cost of goods sold the gross profit, and the net income of the company as follows:
Ending Merchandise Inventory
Overstated TL 7,000
Sales Revenue Correct (Not Affected)

Cost of Goods Sold Error: Understated by TL 7,000
Gross Profit Overstated by TL 7,000
Operating Expenses Correct (Not Affected)
Net Income Overstated by TL 7,000
If Birch Merchandising Company understates its ending inventory by 2,500 TL in its balance sheet, this
error affects the cost of goods sold, the gross profit, and the net income of the company as follows:
Ending Merchandise Inventory

Understated by TL 2,500
Sales Revenue Correct (Not Affected)
Cost of Goods Sold Error: Overstated by TL 2,500

Gross Profit Understated by TL 2,500
Operating Expenses Correct (Not Affected)
Net Income Understated by TL 2,500
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We should also remember that in accounting, ending inventory balance of one period is the beginning
inventory balance of the next period. So, if there is an error in ending merchandise inventory, this error
directly affects the beginning balance of the next period’s inventory.
To illustrate, assume that all other items of income statement is unchanged for three years. Year 1’s ending
inventory is overstated by 3,000 TL. The error carries over to Period 2. Period 3 is correct.
INVENTORY RELATED RATIOS USED IN DECISION MAKING

Organizations pay more and more attention to their inventory management systems every single day
because effective inventory management is accepted as a fundamental measure of the overall health and
success of a business. There are two financial ratios which are used by managers to monitor their inventory
levels: Inventory Turnover Ratio and Days’ Sales in Inventory.
Inventory Turnover Ratio

Companies always try to manage their inventory levels in a way to meet their customer demand on a
timely basis without making large investments.
Inventory turnover ratio is used to determine how frequently merchandise inventory is sold and it is
calculated as follows:
Cost of Goods Sold

Inventory Turnover Ratio =
Average Merchandise Inventory
Average (Beginning Merchandise Inventory + Ending Merchandise Inventory)

=
Merchandise Inventory 2
The answer is measured in terms of “times”. A

high turnover ratio indicates that a company sells its Inventory Turnover Ratio measures number
inventory easily whereas a low turnover ratio indicates of times a company sells average level of
that there is a problem. merchandise inventory during a period.
Days’ Sales in Inventory

Days’ Sales in Inventory Ratio is the other key ratio used by the management of a company to measure
average number of days that merchandise inventory is held by the company. It is calculated as follows:
365 days Days’ Sales in Inventory ratio measures the

Days’ Sales in Inventory = number days that inventory is held by a company.
inventory turnover
Average number of days simply varies from company to company depending on the industry it operates.
However, generally lower days’ sales in inventory is more preferable by companies than higher days.
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Accounting I
To illustrate, partial financial information of Ava Merchandising Company is presented below. Calculate the
Inventory Turnover and Days’ Sales in Inventories.
Merchandise Inventory, Beginning Balance TL 500,000

Merchandise Inventory, Ending Balance TL 1,450,000
Cost of Goods Sold TL 3,600,000
Cost of Goods Sold

Inventory Turnover =
Average Merchandise Inventory
= 3,600,000 TL / [(500,000 TL + 1,450,000 TL) / 2]
= 3,600,000 TL / 975,000 TL
= 3.69 times
Days Sales in Inventory = 365 / Inventory Turnover
= 365 / 3.69
= 98.9 days
6
Partial financial information of Meridian Merchandising Company is presented below. Calculate
the Inventory Turnover and Days’ Sales in Inventories.
Merchandise Inventory, Beginning Balance 1,500,000 TL

Merchandise Inventory, Ending Balance 3,700,000 TL
Cost of Goods Sold 6,500,000 TL
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Further Reading
IAS 2: Inventories
IAS 2 provides guidance for determining the cost of inventories and the subsequent recognition of
the cost as an expense, including any write-down to net realizable value. It also provides guidance on
the cost formulas that are used to assign costs to inventories. Inventories are measured at the lower of
cost and net realizable value. Net realizable value is the estimated selling price in the ordinary course
of business less the estimated costs of completion and the estimated costs necessary to make the sale.
The cost of inventories includes all costs of purchase, costs of conversion (direct labour and production
overhead) and other costs incurred in bringing the inventories to their present location and condition.
The cost of inventories is assigned by:
• specific identification of cost for items of inventory that are not ordinarily interchangeable; and
• the first-in, first-out or weighted average cost formula for items that are ordinarily interchangeable
(generally large quantities of individually insignificant items).
When inventories are sold, the carrying amount of those inventories is recognized as an expense in the
period in which the related revenue is recognized. The amount of any write-down of inventories to net
realizable value and all losses of inventories are recognized as an expense in the period the write-down
or loss occurs.
Source: https://www.ifrs.org/issued-standards/list-of-standards/ias-2-inventories/
Inside Practice
Financial statements provide relevant, reliable and understandable information in order to have
economic development and an efficient business life. Inventories are one of the most important
assets for any type of company. Inventory management, therefore, is very vital for the companies’
sustainability. Amount and cost of the inventories will affect the companies’ profitability and financial
position. In other words, cost of inventories will affect both the balance sheet and the income statement
of a company.
Discuss:
1. How can we determine the cost of inventory?
2. Which generally accepted accounting principles and accounting standards will guide us to record
the inventories?
3. Compare the requirements of Turkish Accounting Standards and Turkish Tax Procedure Law.
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Accounting I
LO 1 And Classify Inventory
Inventories are assets which are held for sale in the ordinary course of business; in the process of production
for such sale; or in the form of materials or supplies to be consumed in the production process or in the
rendering of the services.
A merchandising company usually purchases its merchandise in a form ready for sale and reports only the
cost assigned to unsold units left on hand as “Merchandise Inventory” in its financial statements.
Summary
A manufacturing company produce goods and usually sell them to merchandising firms. Although
the products they produce may differ, manufacturers normally have three inventory accounts- “Raw
Materials”, “Work in Process”, and “Finished Goods” in their financial statements.
Explain and apply accounting

LO 2 principles to merchandise
inventory
Consistency Principle states that businesses should use the same accounting methods and procedures from
period to period. From the inventories point of view, companies have to use the same accounting system
(periodic or perpetual inventory system) and the same inventory cost flow system (specific identification,
weighted average cost, FIFO or LIFO) within the accounting periods to provide comparability of their
financial statements.
Disclosure Principle states that a business’s financial statements must report enough information for
outsiders to make knowledgeable decisions about the company, and it can only be provided by disclosing all
the methods and procedures used while the financial statements are prepared. From the inventories point
of view, companies have to explain which methods are used in the calculation of the inventories’ value.
Materiality Concept states that a company must strictly perform proper accounting only for items that
are significant to the business’s financial situation. From inventories point of view, only significant lost
values determined in the valuation process should be taken into consideration.
Conservatism states that a business should report the least favorable figures in the financial statements when
two or more possible options are presented. Possible losses should be reported, not the possible income. We
can also apply this principle to inventories while we are making valuation at the end of an accounting period.
Apply different inventory cost

LO 3 flow methods
Four inventory cost flow methods can be used for the calculation of the cost flow of inventories.
Specific Identification Method uses the specific cost of each unit of inventory to determine the ending
inventory and the cost of goods sold. It is an ideal method, but not possible to adopt in all industries.
Weighted-Average-Method: A business computes a new weighted average cost per unit after each
purchase. Ending inventory and cost of goods sold are then based on the same average cost per unit.
First-in-First-Out Method (FIFO) Method: The cost of goods sold is based on the oldest purchases –
that is, the first units to come in are assumed to be the first units to go out of the warehouse (sold).
Last-in-First-Out Method (LIFO) Method: The ending inventory comes from the oldest costs (beginning
inventory and earliest purchases) of the period, but it is forbidden for being misleading.
177
Discuss financial effects of

LO 4 different inventory cost flow
methods on financial statements
Using different cost flow methods can directly affect financials of even the same company. For this reason,
companies should be consistent with the accounting method and cost flow method for their inventories
and should always disclose which methods are used.
It is in fact critical for companies to decide which cost flow method to adopt, and there are several factors
that affect their decision. The first factor that limits the choice of companies is the requirements of
Summary
regulatory bodies. LIFO is forbidden by most of the regulators, especially by the ones in hyperinflationary
economies. The other factor which affects the decision made is the purpose of the company. In other
words, if the company is planning to sell its shares in the market, then it wants to be evaluated as a
profitable company and would prefer to choose the method which will show its financials in a more
profitable way. On the other hand, if a company wants to pay less tax, then it would prefer to choose the
method which will show the company less profitable.
LO 5 Valuation of inventories
Valuation of inventories are made at the end of each accounting period for reliable and relevant reporting.
In the valuation process, the rule is comparing the book value (cost value) and the market value of the
inventory and choosing the lower one. That’s why the name of the valuation method also called as Lower
of Cost or Market Value (LCM). Market value is also considered as Net Realizable Value and calculated
by deducting estimated cost of completion and estimated cost of sales form estimated sales value of
inventories.
If book value < net realizable value, continue reporting with book value
If book value > net realizable value, you should adjust the book value of inventory to net realizable value.
Analyze the effects of inventory

LO 6 errors on the financial statements
The effects of inventory errors on financial statements can be summarized as follows:
…… COMPANY
Income Statement
For the Years Ended Periods 1 and 2
Period 1 Period 2
Cost of Gross Profit Net Income Cost of Gross Profit Net Income
Period 1 ending Goods Sold Goods Sold
overstated Understated Overstated Overstated Overstated Understated Understated
Period 1 ending
Overstated Understated Understated Understated Overstated Overstated
understated
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Accounting I
Compute and evaluate inventory

LO 7 turnover and days’ sales in inventories
for management decisions
Inventory turnover ratio is used to determine how frequently merchandise inventory is sold, and it is
calculated as follows:
Inventory Turnover Ratio = Cost of Goods Sold / Average Merchandise Inventory
Summary
Average Merchandise Inventory = (Beginning Merchandise Inventory + Ending Merchandise Inventory)/2
Days’ Sales in Inventory Ratio is the other key ratio used by the management of a company to measure
the average number of days that merchandise inventory is held by the company. It is calculated as follows:
Days’ Sales in Inventory = 365 days / inventory turnover
179
1 A business should report the least favorable 4 Assume that Raven Merchandising Company
figures in the financial statements when two or began July with 28 units of inventory that cost a
more possible options are presented. This statement total of 784 TL. During July, the company had the
refers to the ........ following transactions:
Test Yourself
A. cost principle
July 4 Purchase 84 units @ TL 30
B. materiality concept July 10 Sale 70 units @ TL 60
C. conservatism principle July 20 Purchase 56 units @ TL 33
D. consistency principle July 29 Sale 84 units @ TL 60
E. disclosure principle
Under the FIFO costing method, what is the
2 A company must perform strictly proper Raven’s cost of goods sold for the Sale of July 10?
accounting only for items that are significant to the A. 2,044 TL
business’s financial situation. This statement refers
B. 2,100 TL
to the ........
C. 4,200 TL
A. cost principle D. 2,065 TL
B. materiality concept E. 413 TL
C. conservatism
D. consistency principle
E. disclosure principle
5 According to the data in Question 4, what is
Raven’s cost of ending inventory as of July 31?
3 An inventory costing method based on the A. 2,044 TL
specific cost of particular units of inventory refers B. 2,100 TL
to the ........ C. 413 TL
A. Average Cost Method D. 4,200 TL
B. Last-in-First-Out (LIFO) Method E. 462 TL
C. First-in-First-Out (FIFO) Method
D. Specific Identification Method 6 Which of the following is true about the
Lower-of-Cost-or-Market Value (LCM) Rule?
E. Perpetual Inventory Method
A. Market value is sum of estimates selling price
and book value of inventory.
B. Market value is the sum of estimated selling
price and cost of sales.
C. Merchandise Inventory should be reported at a
higher of Cost or Its Market Value.
D. Merchandise inventory should be reported at a
lower of Cost or its Market Value.
E. Net Realizable Value is also called as book
value.
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Accounting I
7 If ending inventory is understated, the 9 Under the weighted average costing method
following is true except the fact that ....... what is the Bregenz’s cost of goods sold for
A. the cost of goods sold is overstated September 20?
B. the gross profit is overstated September 2 Purchase 168 units @ TL 60
C. the net income is understated September 12 Sale 140 units @ TL 120
Test Yourself
D. the cost of goods sold for the following year is September 15 Purchase 112 units @ TL 66
understated September 20 Sale 170 units @ TL 120
E. the grosas profit for the following year is
overstated A. 10,200 TL
B. 7,280 TL
8 Which of the following measures the number C. 17,980 TL
of times a company sells its average level of D. 1,560 TL
inventory during a period? E. 10,872 TL
A. Cost of goods sold
B. Asset Turnover 10 According to the data in Question 9, what is
C. Days’ in Inventory Bregenz’s cost of ending inventory as of September
D. Inventory turnover 30?
E. Average inventory A. 10,200 TL
B. 10,872 TL
C. 7,280 TL
D. 19,720 TL
E. 1,560 TL
181

1. C 6. D If your answer is wrong, please review the
“Inventory Related Accounting Principles”
“Valuation of Inventories” section.
section.
2. B 7. B
“Inventory Related Accounting Principles” “Impact of Inventory Errors on Financial
section. Statements ” section.

3. D If your answer is wrong, please review the 8. D
“Inventory Related Ratios Used in Decision
“Inventory Costing Methods” section.
Making ” section.
4. A If your answer is wrong, please review the 9. A If your answer is wrong, please review the
“Inventory Costing Methods” section. “Inventory Costing Methods” section.
5. E If your answer is wrong, please review the 10. E If your answer is wrong, please review the
“Inventory Costing Methods” section. “Inventory Costing Methods” section.
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Accounting I
Assume MNC Pipe Store completed the following inventory transactions for a line of
Pipes:

February 2 8 TL 65
February 8 5 TL 78
February 20 7 TL 80
Calculate the “Cost of Goods Sold” and “Cost of Ending Inventory” for the month of
February assuming that Company is using Weighted-Average-Cost Method.
Calculate Cost of Goods Sold for the Month of May and Cost of Ending Inventory as
of April 30.
your turn 1
February 2 8 units @ TL 65 = TL 520

February 14 13 units TL 910
As of February 14, Company had 13 units on hand with a cost of 910 TL.
Average Unit Cost = 910/13 TL
= 70 TL
Cost of Goods Sold = 6 units @ 70 TL
= 420 TL

February 26 14 units TL1,050
As of February 26, Company had 14 units on hand with a cost of 1050 TL.
Average Unit Cost = 1050/14 TL
= 75 TL
Cost of Goods Sold = 8 units @ 75 TL
= 600 TL
Cost of Goods Sold for February = 420+600 TL = 1,020 TL
Cost of Ending Inventory = 6 @ 75 TL = 450 TL
183
Pipes:
February 2 8 TL 65
February 8 5 TL 78
February 20 7 TL 80
February assuming that company is using the First-in-First-Out (FIFO) Method.
your turn 2
Cost of Goods Sold:

February 8 6 units 6 @ TL 65 = TL 390
5 @ TL 78 = TL 390
1 @ TL 80 = TL 80
February 14 units TL 990
Cost of Ending Inventory:

Calculation of cost of ending inventory under FIFO is shown below in detail.
Date Cost of Goods Sold Unit Cost Total Cost

6 units TL 480
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Accounting I
Pipes:

February 2 8 TL 65
February 8 5 TL 78
February 20 7 TL 80
February assuming that company is using the Last-in-First-Out (LIFO) Method.
your turn 3
Cost of Goods Sold:


1 @ TL 65 = TL 65
1 @ TL 65 = TL 65
February 14 units 1,080 TL
Cost of Ending Inventory:

Calculation of cost of ending inventory under LIFO is shown below in detail.
February 26 6 units @ TL 65 = 390 TL

6 units 390 TL
Assume that as of December 31 “Robin

Merchandising Company” had inventory with
a cost of 12,000 TL on hand. Estimated selling
price was 17,000 TL and estimated cost of sales
was 2,000 TL. With which value inventories
should be reported?
Book Value of Inventory = 12,000 TL

Estimated Selling Price = 17,000 TL
your turn 4
Estimated Cost of Sales = 2,000 TL
Market Price (Net Realizable Value) = 17,000 TL - 2,000 TL = 15,000 TL
Inventories should be reported at its book value 12,000 TL.
185
Assume that as of December 31 “Ava

Merchandising Company” had inventory with
a cost of TL 20,000 on hand. Estimated selling
price was TL 22,000 and estimated cost of sales

was TL 3,000. With which value inventories
should be reported?
Book Value of Inventory = 20,000 TL

Estimated Selling Price = 22,000 TL
your turn 5
Estimated Cost of Sales = 3,000 TL
Market Price (Net Realizable Value) = 22,000 TL - 3,000 TL = 19,000 TL
There is a 1,000 TL impairments in the value of inventories, in other words,
inventories should be reported at 19,000 TL.
It should be journalized as follows:
Date Accounts and Explanation Debit Credit
Dec.31 Cost of Goods Sold 1,000

Merchandise Inventory 1,000
Partial financial information of Meridian Merchandising Company is presented below.

Calculate the Inventory Turnover and Days’ Sales in Inventories.
Merchandise Inventory, Beginning Balance TL 1,500,000

Merchandise Inventory, Ending Balance TL 3,700,000
Cost of Goods Sold TL 6,500,000
your turn 6
Inventory Turnover = Cost of Goods Sold /Average Merchandise Inventory

= TL 6,500,000 / [(TL 1,500,000 + TL 3,700,000)/2]
= TL 6,500,000 / TL 2,600,000
= 2.5 times
Days Sales in Inventory = 365 /Inventory Turnover

= 365 / 2.5
= 146 days
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Accounting I
Endnotes
IAS-2: Inventories, www.ifrs.org
1
Horngren - Walter – Oliver, p.315.
4
Horngren Charles T., Walter T. Harrison Jr., M.

2
Warren Carl S., James M. Reeve, Jonathan E.
5
Suzanne Oliver (2012) Accounting, 9th Edition, Duchac, (2007) Accounting, 22ed., Thomson
Prentice Hall, p. 313. South-Western, p.320.
Miller-Nobles, T., Mattison, B., and Matsumura,
3
E.M. (2016) Horngren’s Accounting, The

Financial Chapters, 11th Edition, Pearson
Education Limited, p.348.
187
Chapter 7 Internal Control and Cash
After completing this chapter, you will be able to:
1 2
Learning Outcomes
Define internal control, its components, and Describe the impact of fraud on financial
principles with related procedures, statements,
3 Apply internal control over cash receipts and

payments, 4 Describe the bank account as a control device,
5 Understand the way of reporting cash and

using cash ratio.
Key Terms
Chapter Outline Internal Control
Introduction COSO
Internal Control Control Procedures
Fraud Fraud
Internal Control Over Cash Receipts and Payments Cash Receipts
The Bank Account as a Control Device Cash Payment
Reporting Cash and Using Cash Ratio Petty Cash Fund
Bank Account
Cash Ratio
188
Accounting I
INTRODUCTION
Internal control is a managerial task and responsibility to ensure that all of the activities of a company
are under the management control. In this chapter, we will explain controls that can be included in
accounting systems. We will describe and illustrate internal control using the framework developed by
the Committee of Sponsoring Organizations (COSO). Based on COSO framework, five components of
internal control and basic principles will be introduced. Afterwards, we will explain some special control
procedures so that you can understand the importance of control activities in internal control model.
Secondly, “fraud” will be explained. In this part of the chapter, you will learn some details about fraud and
you will understand how important it is to design effective “control procedures” in a business.
Cash includes coins, currency (paper money), checks, money orders, and deposits in checking and savings
accounts. Cash is the most liquid asset of a business. As you learned in Chapter 4, it should be reported as a
current asset on the balance sheet which is a financial statement that shows the financial position (status) of a
business entity. Because of its vulnerability, cash is a risky asset and control procedures should be considered
especially for cash. In other words, cash is susceptible to the errors and fraud. Therefore, businesses should
constitute effective controls especially related to cash. Additionally, the management should ensure that
these controls are operating effectively. As time passes by, some controls may be ineffective or there may be a
requirement for new controls according to some
new conditions. In conclusion, controls related
to cash is critical for all type of businesses.
Then we will focus on some special controls
about cash. So, you will learn how to apply
control procedures for cash receipts and cash
payments. After that, “petty cash fund” and
“bank account” will be introduced as control
devices. You will understand how effectively a
petty cash fund and a bank account could be
used to control the cash asset of a company.
Finally, we will explain “cash ratio” which is
a very important ratio while analyzing the
Picture 7.1 liquidity of a company.
INTERNAL CONTROL
One of the key responsibilities of a business
manager is to control the operations of
companies. Management has the responsibility
to constitute and maintain effective controls
in a business entity. These controls should be
designed in a systematical manner. In other
words, the control procedures which should be
designed by the management must constitute
a control structure in a business entity. This
control structure should provide reasonable
assurance. Realizing of internal control requires
Picture 7.2
a holistic perspective of the management.
Definition of Internal Control

The objective of internal control is to provide reasonable assurance that (1) assets are safeguarded and
used for business purposes, (2) business information is accurate, and (3) employees comply with laws and
189
Internal Control and Cash
regulations.1 In this context, internal control can be defined as a plan and a system of control procedures
designed and implemented by the management and the board of directors. Management should constitute
a control structure to safeguard assets, ensure accurate and reliable accounting records and comply with
legal requirements.2 In the following part, we will discuss the most popular internal control model.
“Committee of Sponsoring Organization of the Treadway Commission (COSO) is a joint initiative of

some private sector organizations. COSO published Internal Control-Integrated Framework in 1992.”
Internal Control-Integrated Framework is revised and republished in 2013.
COSO established a control framework and this model is the most important and popular framework
around the world. This framework tries to help (to) achieve the main objectives of the business effectively
in the most general sense.
COSO defined the internal control. “Internal control is a process, affected by an entity’s board of
directors, management, and other personnel, designed to provide reasonable assurance regarding the
achievement of objectives related to operations, reporting and compliance.3” This definition determines
the fundamental concepts of internal control. At first, internal control is defined as a process in a business.
As a process, internal control has a systematical approach with a series of actions in order to realize some
objectives.
Internal control is a process, affected by an entity’s board of directors, management, and other personnel,
designed to provide reasonable assurance regarding the achievement of objectives relating to operations,
reporting, and compliance.
Management and board of directors use judgement to determine how much control is enough.4 This is
because the management is responsible for the design and implementation of an effective internal control.
However this process does not consist of just some formal procedures, rules, or manuals. This process should be
internalized by all of the personnel. So, it is affected by board of directors, management, and other personnel.
Management and board of directors use judgement to determine how much control is enough.
Internal control process should provide reasonable assurance to board of directors and management.
Absolute assurance is not expected from internal control process. Internal control is a dynamic process in a
changing environment in which information technologies are highly used. So, it is accepted that there may
be some deficiencies. However, the level of deficiencies which cannot be blocked by internal control should
be at a reasonably low level. Under these circumstances, assurance should be on a reasonable level for ensuring
reliability and achieving the objectives. In other words, what is expected is just reasonable assurance.
An internal control should design and implement to achieve some objectives. According to the definition
of internal control, another fundamental concept is about related objectives. These related objectives can
be categorized into three groups: Operations objectives, reporting objectives, and compliance objectives.
• Operations objectives: These objective state the efficiency and effectiveness of the business’ activities.
• Reporting objectives: These objectives are about the reliability of financial, non-financial and all
other types of reports.
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Accounting I
• Compliance objectives: These objectives related to complying with laws and regulations that the
business is subject to according to the its characteristics.
All types of business have some objectives about operations, reporting, and compliance regarding with
their operations. They want to have some effective and efficient operations and they should ensure that all
the processes operate effectively and efficiently. Likewise, businesses should provide useful information to
the decision makers. So, they have to prepare accurate, reliable, comparable, and timely reports. Therefore,
they should manage the reporting process very well. Besides, businesses are subject to many formal laws
and regulations which may be very complex at times. So, they should adhere to all of the laws, regulations,
even internal rules, policies, and procedures. For these aims, they need a systematic structure; and COSO
framework is designed to meet these requirements.
COSO Framework
The framework that suggested by COSO is useful for board of directors, management, all personnel,
and all other related parties. However, this internal control framework has a particular importance and
benefit for board of directors and management.
Below are explained some important points which are beneficial for board of directors and management.
COSO framework:5
• can be applied to all types of business.
• has a principle-based approach and this approach can provide flexibility to the internal control process.
• states how components and related principles are present and functioning and how components
operate together. So, they can understand the requirements for effective controls.
• facilitates risk assessment prepares an appropriate response within acceptable level and deals with
fraud.
• can be applied not only in financial reporting but also all other types of reporting, operating and
compliance objectives.
• can help to eliminate ineffective, redundant, or inefficient controls.
The COSO framework is represented as a cube:
e
ns
nc
tin
io
ia
at
pl
po
er
m
Re
Op
Co
Control Environment
Operating Unit
Function
Division
Risk Assessment
Entiy Level
Control Activities
Information & Communication
Monitoring Activites
Figure 7.1 The Coso Cube

Source: http://www.sox-online.com/coso-cobit-center/the-new-coso-cube/
191
This generally accepted internal control framework represents an understanding related to control and
tries to lead the way of having an effective and efficient control mechanism. As you can see from Figure
7.1, the objectives related to the internal control process are on the top surface of the COSO cube. The
departments, sections, etc., are on the side surface of the cube. On the front face, the components of
internal control can be seen, i.e., control environment, risk assessment, control activities, information and
communication, and monitoring activities.
Internal control has five components: control environment, risk assessment, control activities,
information and communication, and monitoring activities.
Below are explained briefly the components and related principles of internal control.
• Control Environment: It defines a set of standards, processes, and structures that provide a basis to
carry control consciousness across the businesses. So, it serves as a basis or an umbrella for all other
components of internal control. The board of directors and management establish the tone at the
top and control environment reflects their attitude, awareness and understanding about internal
control.6 Hence, control environment comprises and affects the other components of internal
control. The principles regarding control environment are as follows:
The Revised Internal Control-Integrated Framework states 17 principles that explain the basic concepts
related to each component in an effective internal control.
• “The organization demonstrates a commitment to integrity and ethical values.

• The board of directors demonstrates independence from management and exercises oversight
of the development and performance of internal control.
• Management establishes, with board oversight, structures, reporting lines, and appropriate
authorities and responsibilities in the pursuit of objectives.
• The organization demonstrates a commitment to attract, develop, and retain competent
individuals in alignment with objectives.
• The organization holds individuals accountable for their internal control responsibilities in the
pursuit of objectives.”7
• Risk Assessment: It is a process to identify and assess risks to the achievement of objectives. Accordingly,
this process forms a basis to determine the way of risk management. Because of the numbers and
diversity of the risk that the businesses are subject to, risk assessment must be a dynamic and iterative
process in this changing environment.8 The principles regarding risk assessment are as follows:
• “The organization specifies objectives with sufficient clarity to enable the identification and
assessment of risks relating to objectives.
• The organization identifies risks to the achievement of its objectives across the entity and
analyzes risks as a basis for determining how the risks should be managed.
• The organization considers the potential for fraud in assessing risks to the achievement of objectives.
• The organization identifies and assesses changes that could significantly impact the system of
internal control.”9
• Control Activities: Control activities are some actions based on policies and procedures. The policies
and procedures for the actions named control activities, are established to ensure that management
directives are carried out. They should be performed at the all levels of the business. With respect to
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Accounting I
requirements, control activities may be detective or preventive.10 There are some traditional and very
effective control activities which are performed commonly. However, management may decide on
performing some other alternative control activities according to their requirements in some cases.
Control activities are some policies and procedures which ensure that the actions taken for the
achievement of the objectives are performed effectively.
The principles regarding control activities are as follows:

• “The organization selects and develops control activities that contribute to the mitigation of risks
to the achievement of objectives to acceptable levels.
• The organization selects and develops general control activities over technology to support the
achievement of objectives.
• The organization deploys control activities through policies that establish what is expected and
procedures that put policies into action.”11
Below there are some explanations about important control procedures.
Hiring competent, reliable, and ethical personnel is a key factor of designing an effective internal control
in a business. This is because personnel is very important in this structure. Ethical values are viewed as the
most essential condition for an effective internal control. Based on these needs, to work with appropriate
personnel, businesses should pay good salaries and support their training.
Separation of duties means dividing responsibilities between different people to prevent fraud and errors.
Generally, smart management separates custody of assets, record keeping and authorization of transactions.
In this context, the accounting department should be separated from all other operating departments. For
example, a sales person who may have some premium from total sales shouldn’t approve or journalize the sales
transactions. Likewise, in some cases, if a person is responsible for protecting some assets, he/she shouldn’t have
any responsibility about the accounting process.12 Otherwise, failure to comply with the separation of duties
means there are very important control deficiencies which may cause commitments of fraud. So, separation of
duties is the most important control activity; and board of directors and management are responsible to design
and implement effective controls regarding the separation of duties if they want to avoid control deficiencies.
To fulfill the separation of duties, some policies should be established. In addition, management’s
approval should be an obligation to process the transactions. For example, the credit department should
approve the sales transaction on account.13
Custody of assets, record keeping and authorization of transactions should be separated from each other.
Picture 7.3
193
Assignment of responsibilities requires that different people should be determined for each different duty.
Their responsibilities should be assigned and explained clearly.
Monitoring and audits, operating budgets and cash budgets are effective tools for monitoring. These
tools state the expectations about operations. If there are some differences between expectations and
realized amounts, department managers should explain the reason and take some actions about them.
Exception reports are used for these explanations and related actions. Besides the monitoring process,
external auditors determine whether the financial statements of a business agree with generally accepted
accounting principles or not. So, this process provides a professional opinion on the accuracy and reliability
of the financial statement which is very critical for decision makers.14 Moreover, internal auditors who are
the employees of a business, provide assurance and consultancy for the management in order to improve
and add value to the operations of the business.
Picture 7.4
Documentation, which is related to the accounting process, provides the details about financial
transactions in a business. These include sales invoice, purchase orders, shipping records, reports, etc. For
each transaction, separate and adequate documents should be prepared as hard copy or in an electronic
format. Documents should be pre-numbered to assure the completeness of the transaction and to prevent
control deficiencies.15 Briefly, documentation is a very effective control procedure in a business.
Information Technology has a critical effect on business’ transactions. In our times, accounting process
and related control procedures are realized in an information technology environment. For example, many
importand retailers in Turkey such as Boyner, Sarar, and Mavi Jeans use some electronic devices named electronic
sensors to control their inventories. Attaching electronic sensors to merchandise is a very effective control
procedure to protect inventory against theft. Some businesses may use sophisticated technologies or have
some benefits about e-commerce and their internal control processes gather speed and effectiveness. In
this case, they have to establish special control procedures on information technologies such as passwords,
data encryption, etc. These businesses should hire experienced and competent employees in information
technologies department.16 This is because they should design a plan against to cybersecurity risk which is
a critical risk area in our times.
Other controls may be needed in a business such as fireproof case, burglar alarms, fire alarms, security
cameras, loss-prevention specialists, job rotation, etc.17 Businesses can find many different types of control
procedures but they have to compare the cost of the controls and the expected benefit; and they have to
find the optimum level of controls.
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Accounting I
• Information and Communication: To achieve the internal control objectives, relevant and timely
information is required. After gathering information, an effective communication will be needed
to utilize this information in the business. Hence, the information and communication system
should be designed to carry out an internal control structure. The principles regarding the control
environment are as follows:
• “The organization obtains or generates and uses relevant, quality information to support the
functioning of internal control.
• The organization internally communicates information, including objectives and responsibilities
for internal control, necessary to support the functioning of internal control.
• The organization communicates with external parties regarding matters affecting the functioning
of internal control.”18
• Monitoring Activities: Management should monitor the effectiveness and efficiency of internal
control continuously. As a result of this monitoring process, some new controls may be designed
or some controls may become unnecessary and they may be abolished because the conditions
and requirements may change over the time. Therefore, management has the responsibility to
follow the changes in the business environment and to ensure that the controls operate effectively.
With the collaboration of internal audit, this responsibility will constitute the reliability of internal
control. The principles regarding monitoring activities are as follows:
• “The organization selects, develops, and performs ongoing and/or separate evaluations to
ascertain whether the components of internal control are present and functioning.
• The organization evaluates and communicates internal control deficiencies in a timely manner
to those parties responsible for taking corrective action, including senior management and the
board of directors, as appropriate.”19
1
Which type of objective may a business have other than operations, reporting, and compliance?
FRAUD
Related to the accounting process, there may be two different reasons for possible misstatements on
financial statements: “Error” and “Fraud”. An error is an unintentional misrepresentation of some items. But,
a fraud is an intentional misrepresentation of something. It can be defined as “an intentional misrepresentation
of facts which is, made for purpose of persuading another party to act in a way that causes injury or damage
to that party.20” Therefore, the difference between the terms error and fraud is based on intention. Some
terrifying international corporate scandals such as Enron, WorldCom, and Parmalat indicate the importance of
preventing from fraud and, in this context, the importance of accounting, control, and auditing. After these
scandals of fraud, many important regulations are introduced. Besides avoiding such frauds, it is obvious that
management must ensure about the efficiency and effectiveness of the control procedures.
Fraud is an intentional misrepresentation of facts which is made made for purpose of persuading another
party to act in a way that causes injury or damage to that party.
To design an effective control structure which can prevent fraud, the reasons and the ways for committing
fraud should be understood clearly. Because of this reason, there are many studies and some organizations
related to fraud. Changing environment and conditions make fraud a very dynamic concept. Therefore,
the efficiency and effectiveness of control structure should be monitored continuously.
195
The Association of Certified Fraud Examiners (ACFE) is a very important anti-fraud organization.
It is also the largest around the world. They conduct very important studies about this subject. For
details, visit: www.acfe.com
Types of Fraud
Fraud can be classified into two common types according to their impacts on financial statements:21
1. Misappropriation of assets: Frauds which are committed by employees to steal money or other
assets. In this type of fraud usually employee tries to cover the fraud up with an inaccurate entry or
tries to steal the asset before recording process.
2. Fraudulent financial reporting: Frauds which are committed by managers to make false and
misleading entries in the books. In this case, the purpose of fraud may be making performance or
financial status of the business appear to be better than they actually are; or deceiving investors,
creditors, or any other parties into loaning money that they need; or evading tax.
Picture 7.5
There are two types of frauds: misappropriation of assets and fraudulent financial reporting.
In some cases, fraud results from the conflict of different parties’ interests. Because of the conflicts in
interests, sometimes collusions might occur and those collusions can cause very big problems in business.
As it is explained, purpose, impact ways, and sides of fraud are different from each other. Generally,
fraudulent financial reporting causes heavier damage and it is more difficult to detect it because it is
committed by management responsible for designing an effective internal control. However, the most
common one is misappropriation of asset which is usually about small amounts of money and which is
easier than fraudulent financial reporting. Because of the vulnerability of the cash, the most common fraud
in this type is about stealing money. So this is the reason why the controls for cash should be considered
carefully.
“ACFE developed a “Fraud Tree” with a broad perspective in 1996. Then they improved it. According
to the ACFE report in 2016, in this fraud tree the second type of fraud is asset misappropriation which has
important impacts on financial statements. Asset misappropriation is divided into two categories: the first one is
cash and second one is inventory and all other assets. Besides, cash is divided into three categories: theft of cash
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Accounting I
on hand, theft of cash receipts, fraudulent disbursements. In fraud tree a detailed classification of theft of cash
receipts and fraudulent disbursements are explained. Briefly, these classifications emphasize the importance of
cash in fraud risk analyses.”22
In a collusion, at least two or more people work together to commit a fraud. Collusion may be very
difficult to detect and may cause very heavy damages.
Pressure Fraud Triangle

Understanding the conditions and factors that
lead to fraud is important to detect them and to find
ways to prevent them. In other words, to determine
the best controls, the conditions and factors that may
cause fraud risk should be analyzed. The description
of the factors that may cause fraud risk are called
fraud triangle.
As it is seen in Figure 7.2., Fraud Triangle has
three components: pressure, opportunity, and
Opportunity Rationalization rationalization. These components refer to some
Figure 7.2 Fraud Triangle factors that allow committing both types of fraud.
The components of fraud triangle are pressure, opportunity, and rationalization.
Pressure is one of the components which is based on the effects of the stress factor on the management
and other employees. Because of competition, desire to have some incentives, or some personal debts, they
may feel under pressure and commit fraud.
Opportunity is another component arising from control deficiencies. An ineffective internal control
creates an environment which is convenient for some mistakes or fraud. Therefore, management has to
establish an effective internal control structure. For example, if there are some control deficiencies that
stem from failure to comply with separation of duties, this situation creates an opportunity to commit
fraud. So, management has a very critical responsibility to prevent the business from control deficiencies
that will create an opportunity to commit fraud.
Rationalization is the third component in the fraud triangle. Sometimes, employees or some managers
try to make excuses and convince themselves that fraud is not an extraordinary action; and they try to
rationalize their action. Some conditions and especially week ethical values of top management may cause
this tendency toward rationalization.
Generally, a fraud may a result of a complex conditions and human motivations. So it is very important
and useful to understand these factors which can be seen as drivers in fraud triangle. Briefly, analyzing and
understanding the factors can be a powerful method to prevent them.23
“PricewaterhouseCoopers- PwC, one of the four largest auditing and advisory firms, called the big four,
published the 2018 Global Economic Crime and Fraud Survey. To prepare this survey, data were gathered from
more than 7,200 respondents across 123 different territories. According to this interesting study, a significant
increase in the share of economic crime committed by internal actors-employees (from 46% in 2016 to 52%
in 2018) and a dramatic increase in the proportion of those crimes were attributed to senior management
(from 16% in 2016 to 24% in 2018). 49% of global organizations said that they had been a victim of fraud
197
and economic crime. Other than these interesting results, participants were asked to what extent each factor of
the fraud triangle contributed to the incident of fraud and/or economic crime committed by internal actors.
According to the answers, 21% of respondents ranked pressure, 11% of them ranked rationalization, 59% of
them ranked opportunity as the leading contributing factor of the most disruptive fraud committed by internal
actors. So, the opportunity seems to be a leading factor but it is decreasing according to the previous survey. So,
they have a comment on this point. Based on the data, the ranking of these factors is 10% lower than the figure
in 2016 (69%). According to the the conclusion, this is evidence that technology has a key role to play – and,
more to the point, that companies are generally employing it effectively.24”
2
What is the meaning of the term “cooking the books”?
INTERNAL CONTROL OVER CASH RECEIPTS AND PAYMENTS

Internal control should consider for all types of assets, undoubtedly. But as mentioned before, control
procedures are very critical for cash because of some characteristics of cash. So, it can be said that internal
control has a significant importance for cash.
Cash is the most liquid asset of the business which is reported as a current asset on the balance sheet.
Cash is the most liquid asset, relatively easy to steal; and also many transactions have an impact on
cash. Even if the amounts may be very small in some types of fraud, the importance of the action will not
change. So, the management should design special control mechanisms to protect the business from fraud
involved in cash directly. Frauds related to cash can be committed before or sometimes after the recording
process. Hence the management should consider all the possibilities and benefit from past experiences.
Besides, new information technologies and some improved technologies such as artificial intelligence can
offer a very big advantage to protect cash against fraud. Owing to these technologies, it can be possible to
predict some unusual situations before they are brought about.
In this part of the chapter, we will discuss internal control from two sides:
1. Internal control over cash receipt
2. Internal control over cash payments
Because of the vulnerability of cash and the considerable amount of possibility for committing fraud
related to cash, both of them are very important.
Regarding with artificial intelligence,

“machine learning” and “deep learning” can
provide effective techniques to find some
solutions to protect businesses’ cash and
other assets against fraud.
Picture 7.6
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Accounting I
Many businesses are using a cash budget as an internal control device. A cash budget is a document that
shows the expected amount of cash receipt and payments for a period in the future. So, the management
can compare the realized amount and the budget later. This procedure provides an effective way of financial
planning. According to the success or failure of the forecasting, new business activities may be determined.
A cash budget, therefore, can be defined as an effective cash management device.
A cash budget is a document that shows the expected amount of cash receipt and payments for a period
in the future.
Internal Control Over Cash Receipts

After selling some inventories or providing some services, businesses can receive cash. However, the
time and type of receiving can be different depending on the conditions and agreements. In some cases,
a technology involved situation can occur such as e-commerce. Most certainly, in these situations, there
should be some special control procedures against deficiencies of a technological characteristic. “As banks,
payment providers, and retailers extend services to mobile and other digital channels, they face new challenges and
vulnerabilities that could open their customers and their business up to increased fraud and new types of attacks.
Organizations need to evaluate their omnichannel strategies to provide effective protection and fraud detection
across multiple channels, without losing sight of customer expectations for speed and convenience. Organizations
should be prepared to ask their fraud prevention providers hard questions about how well suited their solutions
are for multi-channel environments and, in particular, how they address mobile users’ needs. Technology partners
should also be able to demonstrate a clear understanding of how new and emerging regulations and standards
impact an organization’s business strategy.”25
Risks about cash are always changing, so it is one of the most important subject for businesses to find
effective ways of protecting cash. However, in this part, we will focus on the general controls to protect cash, not
on the specific controls to reduce control deficiencies related to the technological characteristics of transactions.
A point-of-sale terminal can provide effective control in transactions with cash receipt over the counter.
For example, in a store when inventories are sold, a receipt would be issued as evidence of transaction. After
an employee records this transaction, the cash drawer opens and the machine transfers this transaction to
the main computer. At the end of the day, the cash amount and machine record of cash sales are compared
by a manager. They must be equal to the each other. After the comparison according to the separation of
duties, a separate employee in the accounting department journalize these transactions. All these steps can
prevent theft by the employees and provide an oversight by the management.26 Of course, it is impossible to
prevent all of the possible frauds. Cash is an asset which is the most difficult to safeguard definitely. Some
malicious actions may be planned to pass all of these controls. For this reason, businesses should consider
to design more complex and formal control procedures. There are some ways to improve the effectiveness
of controls over the counter, e.g., using an improved software, giving responsibilities to different competent
employees over time, using more technological devices or may be some artificial intelligence, perform timely
reconciliations in some cases, working with banks which provide some special cash management services,
limiting some signature authorities or access, etc. However, first, have to consider the cost and benefits of
controls for cash and try to decide on an optimum level.
Cash is an asset which is the most difficult to safeguard.
Internal Control Over Cash Payments

While making payments, the most important principle is the separation of duties. There must be a
separate authorized employee to make payments and there must be well designed approval process. An
effective separation of duties over cash payments can protect the cash cycle.
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To achieve effective controls on cash payment, it should be verified, approved and recorded. In this
process, companies usually use a “voucher system.” In this system, the accounting department is responsible
for approving and journalizing cash payments.27 For this purpose, they can write a voucher which is a
specific form that has information about the payment. A voucher is a formal document which authorizes
a cash payment. In our times, as a modern procedure, Electronic Data Interchange can accelerate this
approval process; and by virtue of the Electronic Funds Transfer (EFT), the payment could be made
automatically after the approval. Using EFT is a very widespread way of making payments. These modern
procedures are important for not only cash payments but also cash receipts.28
A voucher is a formal document which authorizes a cash payment.
Drawing a check is the most frequent way of making payments; and it is an effective control procedure
for payments. This is because it provides a reliable evidence of payment in the first place. Furthermore, it
must be signed by a separate authorized employee and he/she must review other related documents about
that transaction. A check is a written document that tells the bank to pay a specific amount of cash. There
are three parties while drawing a check: A maker, a payee, and a bank. The maker is one who issues and
signs the check to tell the bank to pay a specific amount to another one. The payee is the party to whom
the related amount is paid29. All these formal procedures represent the reliability of checks.
There are three parties while drawing a check: A maker, a payee, and a bank.
“Besides, a QR code check is a new version of standard bank checks which is legally mandatory since
01.01.2017 in Turkey. On these checks, there is a data matrix that allows the maker to display information
about the check payment history and the validity of the check sheet. So, this regulation is very important for the
reliability of a check.” 30
“The Following information can be seen on a check with a QR Code report:

• the trade name of the drawee bank,
• the serial number,
• the name, surname or trade name of the owner of the check,
• the name, surname or trade name of the authorities registered in the trade register in case the owner of
the check account is a merchant,
• the total number of the banks in which the owner of the check has check account,
• the number and amount of the checks which are registered to the reading QR code and information
sharing system by the payee regarding the checks that are not presented to the banks of the owner of the
check.
• the number and amount of the checks which are drawn and delivered to the banks,
• the number and amount of checks paid within the last five years,
• the date of presentation for the first presented check,
• the date of presentation for the last presented check,
• the date of presentation for the last check paid,
• the number of the checks dishonored within the last five years and not yet paid;
• the name and number of the checks dishonored in the last five years, but paid afterwards,
• the date of presentation of the last check dishonored in the last five years,
• whether the owner of the check account is prohibited from opening a check account; if any, the date of
the prohibition decision,
• whether or not there is a cautionary judgment for each check sheet,
• if the owner of the check is a merchant, whether or not bankruptcy is decided; if decided, the date of
the decision. This information is presented to the third parties without the consent of the owner of the
check or endorser.” (http://www.resmigazete.gov.tr/eskiler/2016/12/20161231M3-16.htm)
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Accounting I
As it is emphasized, according to the separation of duties, there

should be separate authorized employees for preparing purchase
orders, receiving inventory/other assets and approving and paying
for inventory/other assets. Otherwise, any control deficiency in
this process create an environment convenient for commiting
fraud fraud (opportunity factor). In this process, before drawing
a check to make a payment, the purchase order, invoice and
receiving report of the transaction which are prepared by separate
responsible employees should be reviewed.
Even if drawing a check is a pervasive way to make payments,
it is not reasonable to write separate checks for each small
amounts. Instead of writing checks for small payments such as
stationery, meals, etc., businesses can prefer using a petty cash
fund. It is a fund that contains small cash amounts to use for
Picture 7.7
small expenditures, which enables businesses not to keep large
amounts of cash on hand. So, petty cash fund is a good control but it also needs some control procedures
to be effective. This is because the liquidity of petty cash fund is very high. An employee should be
assigned as a custodian and should be responsible for the petty cash fund. In addition, a specific amount
of cash should be determined for the petty cash fund. Sequentially numbered tickets should be prepared
to support small cash payments. So, there is an opening balance for the petty cash fund. After some
transactions, the remaining petty cash fund and the total amount of tickets/petty cash voucher should
be equal to this opening balance. If it is not equal, there must be an irregularity because of a mistake or
a fraud.31
A petty cash fund is a fund that contains small cash amounts to use for small expenditures.
A petty cash account is used for the accounting process. It is an asset account which is opened to set up
a petty cash fund for small expenditures.
Assume that Company (A) is creating a petty cash fund for 1,000 TL on April 14, of 2018. While
designating a specific amount of cash to be kept in the petty cash account, one of the asset accounts
decreases and the other one increases. The journal entry, then, is as follows:
Date Accounts and Explanations Debit Credit
April 14, 2018 PETTY CASH 1,000

CASH 1,000
Setting up a petty cash fund
While setting up a petty cash fund, petty cash account is opened and used in the journal entry.
After each transaction, the custodian should prepare a petty cash voucher/ticket as the evidence of the
transaction as it is explained above. After some transactions, the remaining amount of petty cash fund will
decrease. So, it needs to be replenished.
Assume that based on Company (A)’s financial transactions by using a petty cash fund, on April 30th of
2018 petty cash fund holds 510 TL, a petty cash voucher/ticket for 250 TL for advertising expenses and
another petty cash voucher/ticket for 230 TL for utilities expenses.
201
In this case, 10 TL missing amount of cash occurs. It can be summarized as follow:

Remaining amount of cash……………………………………… 510 TL
Petty cash voucher/ticket for advertising expense………...……… 250 TL
Petty cash voucher/ticket for utilities expense……………..…..… 230 TL
Total accounted for…………………………………………...….. 990 TL
Petty cash fund balance……………………………………........ 1,000 TL
Amount of cash missing……………………………………….… 10 TL
According to this situation, to replenish the petty cash fund, the cash on hand in the petty cash fund
should increase to 1,000 TL. For this aim, the petty cash account is not used. The responsible employee in
the company will give the required amount to the custodian. As a result, the balance of the petty cash fund
will equal to the beginning amount. So, there is no point in preparing a journal entry for replenishing the
petty cash account.
If there is no change in the total amount of the petty cash fund, the petty cash account is not used in the
journal entry while replenishing the petty cash fund periodically.
In the journal entry to replenish the petty cash fund, the 490 TL (the used up amount) should be
added to it. So, the petty cash fund can have the beginning designated amount. At the same time, a journal
entry should be prepared to journalize the expenses which arise by using the petty cash fund. 1,000 TL is
as follows:
April 30, 2018 ADVERTISING EXPENSE 250

UTILITIES EXPENSE 230
CASH SHORT & OVER 10
CASH 490
Replenishing a petty cash fund
There is a new account in the journal entry named “Cash Short & Over”. This account is used if there
is some cash missing or cash overage. In this example, there is a cash missing and this situation should be
journalized as a decrease in Cash account. So, the Cash Short & Over account is debited for the missing
amount and also this missing amount is subtracted from the Cash account. In some cases, there may be
some cash overage. If there is a cash overage, the related amount should be credited to the “Cash Short &
Over” account.
Periodic controls should be kept to replenish the petty cash fund as shown in the example. These periodic
controls are effective control procedures for cash. Some possible mistakes and frauds can be detected in a
timely manner owing to these periodic controls. After these controls, the expenses are journalized and cash
is decreased because of them. In some other situations, different from some expenses, the second reason
for using a petty cash fund may be purchasing some assets such as supplies. In such a situation, expenses
and also the related asset accounts should be debited in a journal entry.
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Accounting I
3
What is the definition and the aims of “Statement of Cash Flows”?
THE BANK ACCOUNT AS A CONTROL DEVICE

By using a bank account, businesses can keep their important amount of cash in a bank instead of
keeping on hand. Use of bank accounts reduces the amount of cash on hand at any one time. This is an
important way of protecting cash from possible thefts. Besides, businesses can take some advantages of
banks such as using a check, or electronic funds transfers, etc. Some of these advantages are very beneficial
and important for businesses.
Other than these special characteristics, bank account can be defined as a very important control
device for businesses because it requires approval from both the business and the bank. A company’s
cash account corresponds to the bank’s liability (deposit) account for that company. In this process, the
differences between the cash on the businesses’ books and the cash on the banks’ record can be seen clearly
and required journal entries can be prepared. So, using a bank account is a very effective, practical and
pervasive way to control cash.
Online banking, which is a streamlined term in our times, provides some very important advantages.
With online banking applications, transactions such as cash payments can be made electronically via an
online system. Also the business can check its bank accounts at any time. This advantage can provide real
time assurance instead of periodic assurance through controls. In other words, businesses don’t need to
wait for the end of the accounting period to compare and control their status in the bank as well as the
accuracy of their books. They can check these whenever they want.
Owing to the online banking, transactions such as cash payments can be done electronically.
The advantages and the different types of services of online banking are improving day by day while
the information technologies are improving too. Online banking will support the “speed” of transactions,
so it can improve the time management in the business. Secondly, it can provide effective “controls”, so
it can improve the effectiveness of monitoring and assurance in the business. Despite many advantages,
online banking may pose new types of risks about cybersecurity. To protect the business against these
risks, the management should establish new control procedures such as anti-virus programs, firewalls,
filtering systems, periodic software updates, passwords, secure logins, limited access, etc.
203
5 ADVANTAGES OF ONLINE BANKING

“Pay Your Bills Online
One of the advantages of online banking is you can bank at home. You can use online banking to pay
your bills. This will eliminate the need for stamps and protect yourself from the check being lost in the mail.
Most banks will have a section in which you set up payees. You will need to fill out the information once,
and then you can simply choose that profile every time you pay a bill online….
View Your Transactions
Online banking allows you to access your account history and transactions from anywhere. This is the
quickest way to check and see if a transaction has cleared your account. This can help you to find out the
amount of a transaction after you have lost your receipt. It also allows you to find out about unauthorized
transactions more quickly.….
Transfer Money Between Accounts
Online banking also allows you to transfer money between accounts much more quickly. It is more
convenient than using the automated phone service, and can save you a trip to the bank. When you apply or
set up your online banking, be sure that all of the accounts you have at the bank are listed. This will make
it easier to transfer money and make loan payments online. You also have the option of transferring money
between different banks online…
Mobile Banking
Most banks will have a mobile app that allows you to take advantage of online banking on your phone.
This makes online banking even more convenient and allows you to quickly check up on your account when
you are out shopping. However, you need to be sure you are accessing this information on a secure network
and avoid using public WiFi while completing these transactions. Mobile banking makes online banking
even easier….
Syncing with Your Money Applications
Many money apps will automatically sync with your online banking information. This makes sticking to
your budget much easier. Many apps will work both on your home computer and your mobile device so you
can stay up-to-date while you are on the go. It is also easier to track your spending for your budget if you are
using one of these apps. Many people no longer receive paper statements, but it is still important to balance
your account to your bank each month to prevent you from overdrawing your account. …” https://www.
thebalance.com/three-advantages-of-online-banking-2385804
Creating a culture against to the cybersecurity attacks and fraud is very important to strengthen the
control environment of the business.
Bank Statement
A bank statement is a document which is prepared by a bank to show the transactions that occurred
in the account of a business within a month. There may be some insignificant differences in the form of a
bank statement, but similar information regarding the account’s cash receipts and cash payments as well
as beginning and ending balances can be seen monthly. An example of a bank statement can be seen in
Figure 7.3.
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Accounting I
BANK STATEMENT
DATE
NAME OF THE BANK
Address
NAME OF THE BUSINESS ACCOUNT NAME

Address ACCOUNT NUMBER
DATE TRANSACTION WITHDRAWAL DEPOSIT BALANCE

Beginning balance
………………..
………………..
………………..
………………..
Ending Balance
Figure 7.3 Bank Statement
Briefly, a bank statement can be defined as a statement that provides a list of cash transactions. It
should be compared with accounting books of the business.
A bank statement can be defined as a statement that provides a list of cash transactions.
Bank Reconciliation
The bank and the business have different records in their own processes. These two independent records
should be compared. If there are differences between the records of the business and bank, some adjusting
entries should be journalized and posted. Usually, the records of a business and a bank may be different.
These may result from timing differences or, in some cases, from mistakes or frauds.
A bank reconciliation is a statement that explains any differences between the balance shown on the
bank statement and the balance shown on the business’s accounting records.32 A bank reconciliation has
two sides: One of them is for the bank and other one is for the business. Required corrections can be seen
for both sides. Some differences require adjusting entries for the business’s book side. After taking a list of
differences from the bank reconciliation, accounts can be updated.
A bank reconciliation is a statement that explains any differences between the balance shown on the
bank statement and the balance shown on the business’s accounting records.
An example of a bank reconciliation can be seen in Figure 7.4.
205
BANK RECONCILIATION
DATE
BALANCE FOR BANK Amounts

Add:
Transactions …………….
………….. .……………
Less:
Transactions ………………
………….. ………………
Adjusted Balance ……………
BALANCE FOR BOOKS Amounts

Add:
Transactions …………….
………….. .……………
Less:
Transactions ………………
………….. ………………
Adjusted Balance ……………
Figure 7.4 Bank Reconciliation
Owing to the advantages of online banking, a bank statement can be seen whenever it is required. In
this way, a real time control will be possible. Therefore, while using online banking there is no point in
preparing a periodical bank reconciliation. At the same time, to continue periodical controls for cash,
preparing a bank reconciliation statement will be necessary. However, it is important to emphasize that, in
any case, adjusting entries must be recorded.
Assume that Company (A) realized some differences between the balance in the books and the balance
in the bank statement. According to the investigations, the reasons for differences were determined as
follows:
1. The interest revenue earned in April is 450TL.
2. A check for 2,000TL is marked as NSF (Not Sufficient Fund) in April.
3. A telephone bill of 125TL was paid by EFT in April.
At the end of April, Company (A) should update its accounts regarding this information. For the first
one, Company (A) is earning some revenue. Therefore, its cash will increase. For the second one, a check
is defined as uncollectible. Hence, this check should be seen as receivable and should be subtracted from
cash. For the last one, an expense should be recorded while cash is decreasing. After doing these journal
entries and posting them to the ledgers, adjusted balance can be seen on the Company’s books. The journal
entries should be as follows:
April 30, 2018 CASH 450

INTEREST REVENUE 450
Recording interest earned
April 30, 2018 ACCOUNT RECEIVABLE 1,000

CASH 1,000
NSF check
April 30, 2018 UTILITIES EXPENSE 125

CASH 125
Recording the payment of telephone bill
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Accounting I
4
Why is the importance of “real-time assurance” increasing in our times?
REPORTING CASH AND USING CASH RATIO

It is very important to follow the rules for reporting all of the accounts especially for financial statement
analysis. For many ways of analysis, the cash amount may be an important amount.
Reporting Cash
As it is known, on the left side of a balance sheet, all of the assets are listed according to their liquidity.
Therefore, A Balance Sheet is started with “Current Assets” and the first current asset item is “Cash” which
is the most liquid asset of a business.
For different proposes of financial statement presentation process, the balance of the Cash is combined
with cash equivalents that include highly liquid assets such as time deposits and certificates of deposits. Cash
equivalents can be defined as highly liquid investments that can be converted into cash in a short term.33
Cash equivalents can be defined as highly liquid investments that can be converted into cash in a short term.
On the balance sheet, the balance of the cash and cash equivalents can be seen, but the details of them
should be explained in the footnotes of the financial statements. In the Figure 7.5, you can examine the
Koç Holding’s cash and cash equivalents on a Balance Sheet.
Source: https://www.koc.com.tr/
Figure 7.5 Partial Balance Sheet of Koç Holding
Source: http://www.koc.com.tr/
207
What can be seen above is the first part of Koç Holding A.Ş.’s balance sheet on December 31, 2017.
The first item of the current assets is cash and cash equivalents. Its balance was 16,996,921TL in 2016
and now at the end of 2017, it is 20,850,437 TL. Namely, cash and cash equivalents increased in 2017 in
comparison with 2016.
The details about the types of the cash equivalents can be seen in the footnotes of the financial
statements. Note 5 which explains the details of cash and cash equivalents is given in Figure 7.6.
Figure 7.6 Notes to Cash and Cash Equivalents of Koç Holding

Source: http://www.koc.com.tr/
As seen above, cash and cash equivalents for Koç Holding A.Ş. at the end of the 2017 are comprised of
cash in hand, cheques received, demands deposits, and time deposits. The balances can be compared with
those in 2016. At the end of 2017, cash in hand and cheques received increased, while demand deposit
and time deposit decreased in comparison with those in 2016.
Briefly, it is important to see the details about the most liquid asset-Cash- on the balance sheet. Every
company should explain the Cash balances and also the details that create this balance.
Cash Ratio
As you know, accounting is an information
system and it provides useful information to
the different decision makers such as investors,
owners, government, etc. Without some
analysis, it is impossible to see the relevant
information, which will be used in decision
making, directly from the financial statements.
There are different methods to analyze and
interpret the financial statements.
Using financial ratios is a very practical,
Picture 7.8 beneficial, and pervasive way of analyzing
financial statements. By analyzing some ratios, the relationship between different items can be understood.
One of the most important ratio is Cash Ratio.
“Cash ratio is a measure of a company’s ability to pay current liabilities from cash and cash equivalents34.”
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Accounting I
It can be calculated with an equation as follows:
Cash Ratio = (Cash + Cash Equivalents) / Total Current Liabilities
Cash ratio is a measure of a company’s ability to pay current liabilities from cash and cash equivalents.
If a business’s cash ratio is equal to 1, it means that business has the same amount of current liabilities
as it does cash and cash equivalents to pay them.
5
What is the meaning of the term “Net Working Capital”?
Further Reading
Essential IT Controls for Preventing Cash Fraud

“Cyber-thieves know the exact location of your organization’s cash. What is not certain is whether
you are working harder than the thieves to protect your organization’s most vulnerable asset. This
article encourages organizations to assess the controls they have in place around their cash operations.
It describes in detail a variety of general controls over cash, including adequate segregation of duties,
explicit authorization approval requirements, and physical access controls. The article then describes
several information technology (IT) application controls (including lockboxes, positive pay, ACF Fraud
Blocker, and zero balance accounts) that can help you protect your organization’s cash against fraud and
cyber-attack.”
In the article, lockboxes, electronic funds transfers, online banking defense in-depth as a layered
security strategy, IT application controls for checking and achtransactions and closing thoughts are
discussed. Seven Best Practice General IT Controls for Online Banking are summarized as follows:
• “Ensure that users know what the bank’s website looks like and what questions are asked to verify
their identity.
• Erase the web browser cache, temporary Internet files, cookies, and browsing history so that if the
system is compromised, key information will not be available.
• Type the bank’s website address into the web browser’s address bar each time since e-mail and search
• engine links are not secure.
• Verify that the browsing session is secure before initiating online transactions.
• Log out of all bank websites, then close the web browser immediately.
• Either turn the computer off or disconnect the computer from the Internet by manually unplugging
the web connection when finished.
• Initiate written agreements for all electronic or wire transfers, requiring the financial institution to
call the organization back before processing.”
Source: Robert Marley and J. Lowell Mooney (2015). Essential IT Controls for Preventing Cash Fraud.
The Journal of Corporate Accounting & Finance, January/February 2015
Follow this and additional articles at: https://onlinelibrary.wiley.com/doi/full/10.1002/jcaf.22019
209
In Practice
LIQUID ASSETS ON UNIFORM CHART OF ACCOUNTS

The Uniform Chart of Accounts, which is a basic regulation for Turkish Accounting System, was
introduced on 1 January 1994. It tries to ensure a true and fair presentation of a business. In this
regulation, it is recommended to use different accounts to record all of the money on hand, money in
bank, checks, etc. Therefore, we have different account names for different types of cash in the Turkish
accounting system. Below, there is a list of liquid assets according to their liquidity with their special
codes as well as some explanations.
10 Liquid Assets
100. Cash in hand
101. Checks received
102. Banks
103. Checks given and payments order (-)
108. Other liquid assets
100. Cash in hand
This account contains currency held by a business.
101. Checks received
This account comprises the checks that received, but not endorsed or given to banks for collection.
102. Bank
This account is used to record cash, which is deposited in and drawn from banks and similar
financial institutions.
103. Checks given and payment orders (-)
Payment orders or payments by checks to third parties are followed in this account.
This account is credited when checks are issued or when payment orders are given and debited
when they are collected.
108. Other liquid assets
This account comprises stamps, mail orders, bank remittances, etc.
Consequently, it can be said that based on these important differences in the regulations of the
Turkish accounting system, system’s regulations, beyond the differences in the recording process, there
is a difference in perspectives regarding control procedures on cash. Briefly, these do not only represent
a formal difference.
Discuss:
1. Explain the reason for using different types of accounts for liquid assets in the Uniform Chart of
Accounts. Discuss whether using different liquid assets is beneficial for internal control or not?
2. According to the Uniform Chart of Accounts, how can you journalize while you are drawing a
check for your accounts payable?
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Accounting I
Define internal control, its

LO 1 components, and principles with
related procedures
Internal control is a process, affected by an entity’s board of directors, management, and other
personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to
operations, reporting and compliance. This important definition represents the related parties and the
objective regarding internal control. COSO Framework has five components: control environment, risk
assessment, control activities, information and communication, monitoring activities. These are the
Summary
components which establish an effective control mechanism in a business. Control environment defines
a set of standards, processes, and structures that provide a basis to carry control consciousness across the
businesses. Risk assessment is a process to identify and assess risks to the achievement of objectives.
Control activities are some actions based on policies and procedures. Information and communication
is one of the components to realize the internal control aims; accurate, relevant, and timely information
is required. Monitoring activities is the last component which emphasizes the need for monitoring the
effectiveness and efficiency of internal control continuously.
Describe the impact of fraud on

LO 2 financial statements
Fraud is an intentional misrepresentation of facts which is made made for purpose of persuading
another party to act in a way that causes injury or damage to that party. Fraud is a very important
subject especially for cash because cash is the most vulnerable asset. Fraud can be classified into two
groups: Misappropriation of assets and fraudulent financial reporting. To detect fraud, the reason
behind it should be analyzed. Therefore, a fraud triangle is developed. The components of fraud are:
pressure, opportunity, and rationalization. With its three components, fraud triangle explains the factors
in committing fraud.
Apply internal control over cash

LO 3 receipts and payments
Because of the difficulties in protecting cash, the management should design and establish effective
internal control procedures. While designing these controls according to this significant requirement,
it should divide the transactions into two groups: transactions related to cash receipts and those related
to cash payments. For both types of transactions, separation of duties is the most important control
procedure. Establishing a point-of-sale terminal, using an improved software, giving responsibilities to
different competent employees over time, using a voucher system, using checks, using a petty cash fund,
etc. can be some examples of effective controls on cash. In our changing environment, technological
developments related to cash management requires some special controls. Besides, these developments can
provide effective technological ways of control procedures on cash.
211
Describe the bank account as a

LO 4 control device
Using a bank account can provide an effective control on cash. By virtue of a bank account, businesses
can keep their cash in a bank instead of keeping it on hand. This can be an important control procedure
against theft. Besides, businesses can take some advantages of banks such as using a check or, electronic
funds transfers, etc. Some of these advantages are very beneficial and important for businesses. Businesses
receive bank statements which provide a list of cash transactions. They should compare this statement
Summary
with their records. After this comparison, the business can prepare a bank reconciliation which is a
statement that explains the differences between the balance shown on the bank statement and the one
shown on the business’s accounting records.
Understand the way of reporting

LO 5 cash and using cash ratio
According to their liquidity, all of the assets of a business are listed on the left side of the balance sheet.
Therefore, it is started with “Current Assets” and the first current asset is “Cash” which is the most liquid
asset of a business. For different proposes of financial statement presentation process, it can be written
as Cash equivalents which is a highly liquid investment that can be converted into cash in a short term.
Cash ratio is a measure of a company’s ability to pay current liabilities from cash and cash equivalent:
Cash Ratio = (Cash + Cash Equivalents) / Total Current Liabilities
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Accounting I
1 For the achievement of which objectives 5 What are the components of fraud triangle?
should internal control provide reasonable
assurance? A. Pressure, Risk, Opportunity
B. Pressure, Monitoring, Opportunity
A. Operational, reporting, compliance
C. Opportunity, Risk, Rationalization
Test Yourself
B. Operational, strategic, compliance
D. Pressure, Opportunity, Rationalization
C. Strategic, control, compliance
E. Rationalization, Risk, Monitoring
D. Operational, risk assessment, control
E. Reporting, compliance, risk assessment
6 Which control procedure is the most
important one for cash payments?
2 Which component of internal control defines
a set of standards, processes, and structures that A. Separation of duties
provide a basis to carry control consciousness B. Documentation
across the businesses? C. Monitoring
A. Monitoring activities D. Hiring competent, reliable, and ethical
personnel
B. Control environment
E. Assignment of responsibilities
C. Risk assessment
D. Information and communication
E. Control activities 7 Which account should be credited if there
is missing amount while replenishing a petty cash
fund?
3 Which component of internal control
establishes some actions based on policies and A. An expense account
procedures? B. Cash
C. Petty cash fund
A. Monitoring activities
D. Cash short & over
B. Control environment
E. A revenue account
C. Risk assessment
E. Control activities 8 What is the name of the statement that
explains the differences between the balance
shown on the bank records and the one shown on
4 Which internal control component’s the business’s accounting records?
implementation is special for management with
the collaboration of internal audit? A. Statement of cash flows
B. Cash budget
A. Control environment
C. Petty cash ticket
B. Control activities
D. Bank reconciliation
C. Monitoring activities
E. Bank statement
E. Risk assessment
213
9 On April 30 2018, according to the bank statement, there is an EFT receipt from a customer in the
amount of 7,000TL. Which journal entry correctly records the required entry from the bank statement?
A.
Test Yourself
April 30 2018 CASH 7,000

INTEREST REVENUE 7,000

B. Date Accounts and Explanations Debit Credit
April 30 2018 ACCOUNT RECEIVABLE 7,000

CASH 7,000

C. Date Accounts and Explanations Debit Credit
April 30 2018 BANK EXPENSE 7,000

CASH 7,000

D. Date Accounts and Explanations Debit Credit
April 30 2018 INTEREST REVENUE 7,000

CASH 7,000

E. Date Accounts and Explanations Debit Credit
April 30 2018 CASH 7,000

ACCOUNTS RECEIVABLE 7,000

10 What is the name of the highly liquid investments that can be converted into cash in a short term?
A. Cash
B. Petty cash fund
C. Cash equivalents
D. Cash short & over
E. Checks
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Accounting I

1. A If your answer is wrong, please review the 6. A
“Internal Control Over Cash Payments”
“Definition of Internal Control” section.
section.

2. B If your answer is wrong, please review the 7. B
“Internal Control Over Cash Payments”
“COSO Framework” section.
section.
3. E If your answer is wrong, please review the 8. D If your answer is wrong, please review the “A
“COSO Framework” section. Bank Reconciliation” section.
4. C If your answer is wrong, please review the 9. E If your answer is wrong, please review the “A
“COSO Framework” section. Bank Reconciliation” section.
5. D If your answer is wrong, please review the 10. C If your answer is wrong, please review the
“Fraud Triangle” section. “Reporting Cash” section.

Which type of objective may a business have other than
operations, reporting, and compliance?
Typically, all of the organizations have operations, reporting, and compliance

objectives. Internal control should provide reasonable assurance to achieve
these aims. However, generally other than these three types of objectives, all
of the businesses have strategic objectives also. These types of objectives are
your turn 1 special for the management. They are high-level goals that are aligned with
the organization’s mission. These types of objectives are critical for a strategic
plan of a business, e.g., expanding sales to different countries, increasing
revenue by a determined amount, etc.
What is the meaning of the term “cooking the books”?
Manipulating of accounting records may cause a misleading status of a

business’s financial status or financial result. Cooking the books is an illegal
practice, it is the falsification of the accounting process. After these illegal
your turn 2 transactions, fraudulent financial statements are produced. So, it can be defined
as illegal transactions that cause fraudulent financial statements. For example,
accelerating some type of expenses can be defined as a way of cooking the books.
215
What is the definition and the aims of “Statement of Cash

Flows”?
The statement of cash flows is a financial statement that reports cash receipts
and cash payments for a specific accounting period. The first purpose of
preparing a statement of cash flows can be predicting future cash flows. So,
your turn 3 it may be related to some strategic objectives of a business. Evaluating the
management and predicting the ability to pay debts or dividends can be
said to be some other purposes of the statement of cash flows. It is a critical
financial statement for cash management.
Why is the importance of “real-time assurance”

increasing in our times?
The importance of “real-time assurance” is increasing because of some

important factors such as globalization, increased competition, developing
technologies, etc. Businesses are faced with extensive data hard to analyze
your turn 4 and manage, new types of risks, and a continuously changing environment.
So, obtaining reliable and timely information is the most important issue
for the decision making processes in a company. Because of the speed factor,
the conditions are always changing. Therefore, ensuring real-time assurance
is a critical success factor. Otherwise, without real time assurance, reactive
approaches cannot provide reliable, beneficial, timely information.
What is the meaning of the term “net working capital”?
Net working capital refers to the the differences between a business’s current
assets and its current liabilities. The amount of net working capital is important
your turn 5 for evaluating the liquidity of a business. In an efficient and effective business,
the current assets should exceed the total liabilities. Net working capital
measures a business’s ability to pay for its current liabilities with current assets.
216
Accounting I
Endnotes
Warren Carl S., Reeve James M., Duchac Jonathan
1 11
https://www.coso.org/Documents/990025P-
E. (2007) Accounting, 22e, Thomson South- Executive-Summar y-final-may20.pdf
Western, p.350. (02.27.2018)
Harrison, W. T., Horngren, C. T., Thomas, W.,
2 12
Harrison, W. T., Horngren, C. T., Thomas, W., &
& Suwardy, T. (2014). Financial Accounting: Suwardy, T. p. 279
International Financial Reporting Standards (9th 13
ed.), Global Edition. London, Pearson Educated
Suwardy, T. p. 280-281
Limited, p. 275.
14
Harrison, W. T., Horngren, C. T., Thomas, W.,
3
& Suwardy, T. (2014). Financial Accounting:
Executive-Summar y-final-may20.pdf
International Financial Reporting Standards (9th
(02.20.2018)
ed.), Global Edition. London, Pearson Educated
4
https://www.coso.org/Documents/990025P- Limited, p. 281
Executive-Summar y-final-may20.pdf 15
(02.20.2018)
Suwardy, T. p. 280
5
https://www.coso.org/Documents/990025P- 16
Executive-Summary-final-may20.pdf (02.21.2018)
Suwardy, T. p. 280-381
6
https://www.coso.org/Documents/990025P- 17
Miller-Nobles T., Mattison, B., Matsumara, E.M.
Executive-Summar y-final-may20.pdf
(2016). Horngren’s Accounting The financial
(02.27.2018), Arens, A.A., Elder, R.J., Beasly,
chapters (11th ed.),Global Edition. London,
M.S., Hogan, C.H. (2017). Auditing and Assurance
Pearson Educated Limited, p.459.
Services (16th ed.), London, Pearson Educated
Limited, p. 380-381, Messier, W.F., Glover, M.S., 18
Prawitt, D. (2016). Auditing & Assurance Services Executive-Summar y-final-may20.pdf
A Systematic Approach (10th ed.), New York, Mc (03.06.2018)
Graw Hill Education, p. 182. 19
7
https://www.coso.org/Documents/990025P- Executive-Summar y-final-may20.pdf
Executive-Summar y-final-may20.pdf (03.06.2018)
(02.27.2018) 20
8
https://www.coso.org/Documents/990025P- Suwardy, T. p. 271
Executive-Summar y-final-may20.pdf 21
(02.27.2018), Arens, A.A., Elder, R.J., Beasly, Suwardy, T. p. 273
M.S., Hogan, C.H. (2017). Auditing and Assurance
Services (16th ed.), London, Pearson Educated 22
http://www.acfe.com/rttn2016/docs/2016-report-
Limited, p. 380-388, Messier, W.F., Glover, M.S., to-the-nations.pdf (03.13.2018)
Prawitt, D. (2016). Auditing & Assurance Services 23
https://www.pwc.com.tr/tr/Hizmetlerimiz/
A Systematic Approach (10th ed.), New York, Mc danismanlik/ticari-anlasmazlik-cozumleri-ve-
Graw Hill Education, p. 182-189. suistimal-incelemeleri/yayinlar/pwc-2018-
9
https://www.coso.org/Documents/990025P- kuresel-ekonomik-suclar-ve-suistimaller-
Executive-Summar y-final-may20.pdf arastirmasi.pdf (03.20.2018)
(02.27.2018) 24
https://www.pwc.com.tr/tr/Hizmetlerimiz/
10
https://www.coso.org/Documents/990025P- danismanlik/ticari-anlasmazlik-cozumleri-ve-
Executive-Summar y-final-may20.pdf suistimal-incelemeleri/yayinlar/pwc-2018-
(02.27.2018), Arens, A.A., Elder, R.J., Beasly, kuresel-ekonomik-suclar-ve-suistimaller-
M.S., Hogan, C.H. (2017). Auditing and Assurance arastirmasi.pdf (03.13.2018)
Services (16th ed.), London, Pearson Educated 25
https://securityboulevard.com/2018/03/
Limited, p. 380-388, Messier, W.F., Glover, M.S., omnichannel-fraud-prevention-managing-risk-
Prawitt, D. (2016). Auditing & Assurance Services in-a-digital-age/ (03.21.2018)
A Systematic Approach (10th ed.), New York, Mc
Graw Hill Education, p. 182-189.
217
26
Miller-Nobles T., Mattison, B., Matsumara, E.M. p. Williams, Haka, Bettner, Meigs, p.267
32
284
Williams, Haka, Bettner, Meigs, p.263.
33
27
Jan R. Williams, Susan F. Haka, Mark S. Bettner,
34
Robert F. Meigs, (2002). Financial & Managerial
p.475
Accounting The Basis for Business Decisions
(12th ed.)New Yok, McGraw-Hill Companies, http://www.sox-online.com/coso-cobit-center/the-
p.266 new-coso-cube/
Horngren C.T., Harrison W.T., Oliver S. (2009)
28 h t t p : / / w w w. re s m i g a z e t e . g ov. t r /
Accounting, Pearson Education Limited, p.426-427 eskiler/2016/12/20161231M3-16.htm
29
Miller-Nobles T., Mattison, B., Matsumara, E.M. https://www.thebalance.com/three-advantages-of-
p.462-468 online-banking-2385804
30
https://www.findeks.com/karekodlu-cek?utm_ https://www.koc.com.tr/en-us/investor-relations/
source=facebook&utm_medium=f-21mart- financial-statements-and-statistics/Financial%20
k a re k o d l u - c e k & u t m _ c o n t e n t = f - 2 1 m a r t - Statement%20Documents/KOC%20
karekodlu-cek&utm_campaign=mart17 HOLDING%20-%2031%2012%202017%20
(03.21.2018) -%20SPK%20-%20ENG.pdf
31
p.464; Harrison, W. T., Horngren, C. T., Thomas,
W., & Suwardy, T. p. 287
218
Chapter 8 Receivables
Learning Outcomes
1 Define the receivables and introduce different

types of receivables. 2 Discuss accounting issues of account
receivable.
3 Understand methods used to account for bad

debts. 4 Discuss disposing of account receivable.
5 Identify ratios to evaluate company’s

receivables. 6 Discuss accounting issues for note receivable
and compute interest.
Key Terms
Accounts Receivable Turnover Ratio
Aging of Accounts Receivable
Chapter Outline Average Collection Period
Introduction Cash (Net) Realizable Value
Receivables Dishonored Note
Accounts Receivable Factor
Uncollectible Accounts Receivable (Bad Debts) Factoring
Disposing of Accounts Receivable Maker
Analysing of Accounts Receivable Payee
Notes Receivable Percentage of Receivable Basis
Percentage of Sales Basis
Promissory Note
Trade Receivables
220
Accounting I
INTRODUCTION
It is obvious that a business would prefer cash when it delivers goods or services, while its customers may
not prefer cash. As a result, it provides making sales of goods and services either in cash or by extending
credit to its customers. By selling on credit, a company can increase both its customer base and sales while
it may take time to collect its receivables or may never collect them. Heavy dependence on credit sales can
lead to severe credit losses. In this regard, management of receivables is a crucial issue for companies. In
this chapter, we mainly provide general information regarding receivables, especially accounts receivables
and notes receivables. We also briefly discuss practical issues, which International Financial Reporting
Standards deal with. More precisely, we explain valuation and expense methods of uncollectible accounts
receivables. Further, we discover how to analyze receivables. Finally, we consider recognition of notes
receivables and calculation of interest.
RECEIVABLES
Receivable is an accounting term associated with the
amounts that are owed to the business by other parties,
mainly its customers. These are basically the claims that Receivables can be classified with respect to
are likely to be acquired in future. These claims stem from the nature of the transaction or with respect
selling goods or services on credit. Receivables can also arise to their maturity structures.
when someone lends money to another person. Let’s assume
that your friend needs 200 TL cash to buy something. He
borrows 200 TL on June 1st and promises to pay it back at Trade receivables are account and notes
the end of the month. You give up cash and, instead, agree receivables from sales transactions.
with a 200 TL receivable from your friend. The receivable
is an asset, but it is not as liquid as cash.
Generally, receivables are classified into three main Receivables are known as claims arising
categories: (1) accounts receivables, (2) notes receivables, from credit sales or loan transactions.
and (3) other receivables.
Accounts receivables and notes receivables arise from
main operating activities of companies and they are known
as trade receivables. On the other hand, other receivables
Receivables are one of the main categories
item stands for a various category that includes other type
within current assets of a company.
of receivables arising from other activities, such as loans to
Management of receivables is so important
employees or interest receivables.
that if managers do not pay sufficient
Receivables can be also classified as current (short-term) attention to handle it, the company may have
and non-current (long-term) receivables with respect to to bear the risk of default of customers.
their maturity structures. Receivables that are expected
to be collected in less than one or exactly in one year (or
operating period) are presented as current asset in the
balance sheet. Receivables that are expected to be collected
in more than one year (or longer than the operating period)
1
are presented as non-current asset in the balance sheet.
How can receivables be classified?
Other receivable is the claim arising from nontrade
activities such as interest receivable from loans extended to
company officials, income tax refundable and advances to
company employees. This category basically involves any
other type of cash that is receivable by a company in future. 2
These other receivables are normally unusual in nature, and
What is the difference between accounts
hence it is usual to report and classify them as separate items
receivables and other receivables?
on company’s financial statement, i.e. on balance sheet.
221
Receivables
ACCOUNTS RECEIVABLE
Accounts receivable is the amount owed to a company by customers as a result of delivering goods
or services. It occurs when a business makes sales on credit. This means that the business agrees to get
cash from its customers later for goods or services delivered today. In the world of business, there are
more credit sales than cash sales. The main advantage for a company to sell on credit is the expansion of
the customer base, which means increase in sales. Each credit transaction involves two parties. One is the
creditor, who lends credit to the other party or in other words who will earn the receivable (the asset). The
second party is the debtor, who takes the credit or payable (a liability).
Accounts receivable are comparably liquid form of asset, where usually it takes 30 to 90 days to be
converted into cash. Therefore, this asset appears on the current assets part of the balance sheet soon after
cash and short-term investments in marketable securities. Accounts receivable are the most significant
kind of claims that are held by a business.
As shown in Figure 8.1, there are three main accounting issues with respect to the accounting of
receivables. They are:
1. Recognition of accounts receivable
2. Valuation of accounts receivable Accounts receivable is recognized when a
3. Disposition of accounts receivable company delivers good or services on credit.
ACCOUNTING FOR
RECEIVABLES
Recognition of Valuation of accounts Disposition of

accounts receivable receivable accounts receivable
Figure 8.1 Accounting for Receivables
Recognition of Accounts Receivable

Recognizing accounts receivable is comparatively simple and straight. Accounts receivable arises when
a company sells goods or services to its customer on credit in its normal course of business. Normally a 30
to 60-day time period is entitled to the debtors for payment.
When the company sells its goods or services on cash basis, there would be no need to consider for
accounts receivables. In such a case, cash account is debited; the sales revenue account is credited. As we
have mentioned before, if the company sells its goods and services on credit, then it has to debit accounts
receivables.
To illustrate, suppose that ABC Co. on May 1st, 2018, sells goods in cash to XYZ Co. at 1,000 TL. The
revenue is recorded in the books of ABC Co. are as follows:

May 1 Cash 1,000
Sales Revenue 1,000
To record sales in a cash
Cash account is debited and sales revenue is credited. This basic sales transaction has cash and income
increasing effect. If this transaction were entered on credit, then it would be recorded as follows:
222
Accounting I

May 1 Accounts Receivable 1,000
Sales Revenue 1,000
To record sales in a cash
As can be seen, account receivables account is debited when a company sells goods or services on credit;
sales revenue account is credited.
Receivables are valued at the actual exchange price agreed
between a company and its customer, deducting adjustments
Cash (net) realizable value shows the
for sales returns, cash discounts, and allowances, in order to
credit sales price adjusted for returns,
get cash (net) realizable value, which is the actual amount
discounts, and allowances expected to be
expected to be received by a company. In other words, cash
collected from customers.
(net) realizable value is the net amount that a firm anticipates
to collect in cash from its receivables.
A company can have accounts receivable from various customers. Hence, it should keep track of total
amount of receivables in a separate account in the general ledger on a customer-by-customer basis in a
subsidiary account. In other words, accounts receivable serves as a control account since it allows for
summarizing the total amount of all receivables from customers. A company also keeps related subsidiary
ledger account of per receivable from each customer.
Let’s assume that a company’s general ledger account has 20,000 TL debit balance. 10,000 TL, 7,000
TL, and 3,000 TL of this balance are due from Customer A, Customer B, and Customer C, respectively.
Each receivable from different customers will be tracked in their own subsidiary books. For example,
receivable from Customer A, which is 10,000 TL, will be tracked in Customer A’s subsidiary ledger. In this
regard, total subsidiary ledger value will add up to 20,000 TL, which is equal to the sum of each customer’s
own general ledger account.
General ledger and subsidiary ledger are as follows:
General Ledger Accounts Receivable Subsidiary Ledger
Accounts Receivable Customer A
Bal. 20,000 Bal. 10,000
Customer B
Bal. 7,000
Customer C
Bal. 3,000
Total 20,000

Return facility is often part of a company’s marketing program
that enables it to maintain competitiveness. It is basically a Sales returns and allowances reduce
contra sales account that records (1) any goods returned by the the amount of accounts receivables
customers and (2) any allowance given to a customer because since the customer delivers back the
the company delivered defective or improper goods. As a result, goods or the company waives a portion
this will reduce the company’s account receivable. of its claim due to product defects.
223
Receivables
Trade Discounts
Trade discount is the reduction in the catalogue price or listed price of the goods. Trade discounts
reduce the final sales price and are not affected by the date of payment. Hence, it is important to note that
trade discounts are not recorded and therefore they are not reflected in the books of accounting for both
buyer and seller. Only the price is recorded after a net of the trade discounts.
Cash Discounts
Companies often offer a cash discount to its customers if they agree to pay within a designated
period. In other words, the opportunity to get a cash discount usually arises for a customer when a
company either wants to encourage prompt payment or because of competitive reasons and also to
increase the chances of collection. Normally, sales terms
are 2/10, n/30. This means that the customer is given
Cash discounts are intended to encourage
a 2 percent cash discount if he agrees to pay within 10
the customer to make their payment earlier.
days from sale; otherwise, the whole amount net of any
allowances and returns is to be paid in 30 days.
To illustrate, let’s suppose ABC Co. on June 1st, 2018, sells goods on account to XYZ Co. worth 2,000
TL, at terms 2/10, n/30. On June 5th, goods at a value of 200 TL are returned to ABC Co. On June 11th,
XYZ Co. pays its due balance. The regular general entries to record the receivables part of above activities
in the books of ABC Co. are as follows:

June 1 Accounts Receivable 2,000
Sales Revenue 2,000
To record sales on account

June 5 Sales Returns and Allowances 200
To record goods returned

June 11 Cash 1,764
(1,800 TL - 36 TL)
Sales Discounts 36
(1,800 TL x 0.02)
To record collection of accounts receivable in

a discount period
First entry above shows that ABC Co. sells its goods at 2,000 TL on credit. Hence, accounts receivables
account is debited and sales revenue account is credited at the same amount of 2,000 TL. In the second
entry, however, the accounting impact of customer returns, which is 200 TL worth, is reported. In this
case, as it returns the goods, the customer will pay less in the future. For this reason, accounts receivable
is credited by 200 TL to account for such a decrease. Sales returns and allowances account is debited to
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Accounting I
record for customer returns. Third entry presents the records pertaining to the collection of receivables
before the maturity predetermined as 30 days. Since the customer makes an early payment, ABC Co.
applies a discount of 2% on the remaining receivable balance of 1,800 TL. This 36 TL discount is debited
as sales discount. Cash is also debited to stand for the collection of receivables after discount. Ultimately,
accounts receivable is credited as a whole in order to close the open balance.
Valuation of Accounts Receivables

After recording the receivables in the accounts, now we will see how these accounts will be reflected in
the financial statements, i.e. income statement and balance sheet.
Accounts receivables are recognized at their fair value, which comprises of transaction costs associated
with the transaction. Subsequent valuation, however, is made upon amortized cost. Furthermore,
impairment in accounts receivables should be taken into account as well. If objective indications of
impairment exist, relevant loss amount is measured as the difference between the present value of expected
future cash flows discounted on the effective interest rate and the book value of the receivables. The
accounting treatment requires the book value of the receivables is credited either by writing off the account
directly or by using a specific allowance account. Loss amount is recognized in the profit or loss account.
To illustrate, let’s suppose DEF Co. on May 31st, 2018, sells goods on credit to NCL Co. at 1,000
TL for 9 months. The cash equivalent of this sales amount is 800 TL. The transaction is recorded in the
accounts of DEF Co. as follows:

May 31 Accounts Receivable 1,000
Deferred Delay Charges 200
Sales Revenue 800
To record credit sales
In this example, the sales price (1,000 TL) offered by DEF Co. is greater than the cash equivalent price
(800 TL) of the goods. The difference between the sales price and the cash equivalent price should be
treated as deferred income as a contra-asset account, which should be allocated to the profit/loss accounts
in each accounting period. On December 31, 2018, DEF Co. will measure the accounts receivables
at amortized cost, which is calculated by means of effective interest rate. The relevant calculations and
accounting records are shown below:
Present Value = Future Value / (1 + Interest Rate)m/12
800 = 1,000 / (1 +r )9/12

r = 0.347
As the remaining maturity of the accounts receivables as of December 31st, 2018 is 2 months only, the
receivables should be discounted to the present value by using the effective interest rate calculated above.
Present Value (31.12.2018) = Future Value (28.02.2018) / (1+Interest Rate)m/12
Present Value (31.12.2018) = 1,000 / (1+0.347)2/12 = 951.62 TL
Since the amortized cost of the accounts receivables is 951.62 TL, the associated delay charge should
be calculated as 151.62 TL (951.62 TL – 800 TL) and should be treated as follows:
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Receivables

Dec 31 Deferred Delay Charges 151.62
Interest Income 151.62
To record end-of-year valuation
This example suggests that deferred

delay charges should be debited
and the relevant amounts accrued Under International Financial Reporting Standards (IFRS),
should be allocated to the income accounts receivables are treated with respect to the provisions of
statement at the end of the year. As IFRS 9: Financial Instruments (IFRS 9)1. IFRS 9 requires accounts
a consequence, the net amount of receivables to be classified as financial instruments measured at
accounts receivables will be 951.62 amortized cost. These provisions apply for notes receivables as well.
TL (1,000 TL – 48.38 TL).

UNCOLLECTIBLE ACCOUNTS RECEIVABLE (BAD DEBTS)
It is also important to be aware of that the amount to be reflected as an asset on the balance sheet
because some receivables might become bad or will be uncollectible. Hence, in order to ensure that account
receivables are not overstated on the balance sheet, they are reported in their cash (net) realizable value.
As mentioned before, this value deducts the amounts that the business expects it might not be able to get
from its receivables. Therefore, out of receivables, the estimated uncollectible amounts are reduced and
then reported on the balance sheet.
Income statement of a firm is also affected by the
uncollectible receivable amounts. The amount of expected
Bad debt expense is an income
uncollectible receivables is reported in the income statement
statement account that shows the losses
as an expense so that profit should not be overstated. This
incurred due to uncollectible receivables.
expense is recorded in bad debts expense account and reported
as bad debts expense in the income statement.
Although it is important for a seller to make sure that its customer is capable enough of meeting its
credit requirements, inevitably some of its customers might not be able to repay. Hence, some accounts
receivable becomes uncollectible. When a business is dealing on credit basis, it is possible to confront with
such risks due to customers’ failure in repayment of their debts. Therefore, companies should consider
this risk by making relevant arrangements in their accounting records. Common accounting practice
requires this loss amount of accounts receivable to be recorded as a debit in Bad Debts Expense account
(or Uncollectible Accounts Expense).
The level of bad debts is often a good indicator of a company’s credit policy. For example, if the bad
debts of a company are abnormally low, this means that the company is following a too strict credit policy,
resulting in loss of profitable business. While on the other hand if the bad debts are abnormally high, this
means that the company is following a too lenient credit policy.
There are two general approaches that
are used in the accounting for uncollectible Uncollectible accounts receivables are treated under the
receivables: (1) the allowance method and (2) allowance method or the direct write-off method.
the direct write-off method.
Allowance Method
This method of recognizing bad debts is used for company’s financial reporting objectives when the
uncollectible debts are significant in nature. This means they are in material amount.
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Accounting I
Under this method, the company should make necessary adjustments at the end of its accounting year
for the amount of losses it predicts as a result of making sales on credit to its customers. This allowance
method has three basic yet important features:
1. The uncollectible amounts are anticipated and the expense for the uncollectible account is matched
against sales in the same period in which sales were made.
2. Through an adjusting entry at the last of accounting year, forecasted uncollectible receivables are
credited to Allowance for Doubtful Debts Account and debited to Bad Debts Expense account.
3. Recognized uncollectible receivables are debited to Allowance for Doubtful Debts Account and
credited to Account Receivable account at the time when specific amount is written2.
The following example shows how to record for allowances for doubtful debts when companies are
reasonably confident that their customers are not expected to repay their debts.
To illustrate this method, let’s assume that B&B Co. made credit sales worth 1,500,000 TL in 2018,
out of which 400,000 TL remained uncollected by the year-end. The company predicts that 15,000
TL of these sales will prove to be uncollectible. The general entry to record the forecasted uncollectible
receivables is:

Dec 31 Bad Debts Expense 15,000
Allowance for Doubtful Debts 15,000
To record estimate of uncollectible accounts
Bad Debts Expense is recorded in the company’s income statement as an operating expense. Allowance
for the doubtful debts is basically a contra asset account (an asset account where the balance will either be
credit balance or zero) to accounts receivable that shows the claims on customers that are likely to become
bad in the future. The reason for using a contra account contrary to a direct credit to Accounts Receivable
account is that the company does not know exactly which customers will not pay. Hence, this account
will record the specific write-offs as they will occur. This contra account is usually called allowance for
uncollectible accounts (or allowance for doubtful accounts, allowance for bad debts, or reserve for
doubtful accounts)3.
The account of Allowance for Doubtful Debts is not closed at the end of the accounting year. In the
balance sheet, the balance of this account is deducted from Accounts Receivable part under current assets as:
B&B Co.
Balance Sheet (partial)
Current Assets
Cash ………………………………………………………. 15,500
Accounts receivables …………………………………….. 400,000
Less: Allowance for doubtful debts …………………… (15,000)
Cash (Net) Realizable Value of the Accounts Receivables ... 385,000
Inventory …………………………………………………. 400,000
Prepaid expenses ………………………………………….. 31,000
Total Current Assets ……………………...………………… 831,500
This amount of 385,000 TL represents cash (net) realizable value of the accounts receivable at the
statement date.
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Receivables
There is other presentation like as follows:
B&B Co.
Balance Sheet (partial)
Current Assets
Cash ……………………………………………………….. 15,500
Accounts receivables, net allowance for doubtful debts 385,000
Inventory …………………………………………………. 400,000
Prepaid expenses ………………………………………….. 31,000
Total Current Assets ……………………………………….. 831,500
One important issue regarding allowances is how to record the written-off uncollectible account
receivables. Whenever a company becomes sure that a particular customer will not be able to repay and
hence that account receivable would be uncollectible, then that particular account receivable will no longer
be categorized as an asset, so it has to be written off from the books. This write-off means to deduct the
receivables balance of that specific customer’s account to nil. The company credit Account Receivable and
making an offsetting debit to Allowance for Doubtful Debts account.
To illustrate, let’s assume that on February 1st, Disney Toy Co. discovers that Toyzz Store has gone
bankrupt and that the 4,000 TL account receivable from this customer is worthless. Therefore, Disney Toy
Co. will have to write off this uncollectible account receivable. Following is the entry that the company
will make:

Feb 1 Allowance for Doubtful Debts 4,000
(Toyzz Store)
To write off the receivable from Toyzz Store

as uncollectible
It is important to note that in this general entry, the Allowance for Doubtful Debts account is debited
instead of the Uncollectible Accounts Expense account. This is because at the end of each accounting
period, the forecasted expense of credit losses is debited to the uncollectible accounts receivable (Bad
Debts) account. When a particular account receivable is considered to be insignificant, this process does
not show an added expense but just approves company’s earlier estimation of that expense.
This write-off entry affects both Account Receivable account and Allowance for Doubtful Debts
account; both of them are balance sheet amounts. Therefore, the cash (net) realizable value in the balance
sheet remains the same as shown in an illustration below:”
BALANCE SHEET (Partial)
Before the Write-off After the Write-off
Accounts receivable 250,000 Accounts receivable 246,000

Less: Allowance for Doubtful Debts (10,000) Less: Allowance for Doubtful Debts (6,000)
Cash (Net) Realizable Value 240,000 Cash (Net) Realizable Value 240,000
Another point to consider is recording recovery of an uncollectible account receivable. Occasionally

it is also possible that company is able to collect its bad debt partially or fully from the receivables that it
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Accounting I
has already written off as worthless. Such collections are sometimes referred to as recoveries of bad debts.
In order to record this recovery of bad debts, two general entries are made: (1) to reverse the previously
written off entry to restore the customer’s account. (2) To record the collection of the amount in the
regular manner.
To illustrate, let’s assume that on July 1st, Toyzz Store. pays 4.000 TL amount that had been written off
by Disney Toy Co. on February 1st. The entries are:
July1 Accounts Receivable 4,000
(Toyzz Store)
To reverse write off of Toyzz Store account

July1 Cash 4,000
(Toyzz Store)
To record collection from Toyzz Store
The accounting records above show the impact of recovery of a doubtful debt in financial records. In
the first entry, Disney Toy Co. recovers the once written-off accounts receivable of 4,000 TL that belongs
to its customer, i.e., Toyzz Store. Disney Toy Co., in the second entry, immediately accounts for the
collection of these receivables.
It is important for a company to estimate an expected amount of uncollectible receivables if they
use allowance method. Under this method, there are two basic ways that are used to forecast uncollectible
receivables:
1. Percentage of net credit sales approach (percent-of-sales approach)
2. Percentage of accounts receivable approach (aging approach)
Depending on the preference that company’s management plans to give to revenues and expenses on one
side and cash (net) realizable value on the other, choice between these two methods is completely management’s
decision. However, both of these methods are widely accepted in accounting. Basically the choice is simple.
The company has to choose either to emphasize balance sheet or income statement relationships.
Percent-of-Sales Approach
In a situation where a company has been in a business for a
long time, it might be able to use historical relationships between
Percentage of sales basis is the
bad debts and net credit sales to estimate bad debts amount. This
percentage relationship between the
approach is based on historical or past experience and forecasted
amount of credit sales and estimated
credit policies. This approach is also called an “income statement
losses from uncollectible accounts.
approach” because of its focus on the size and amount of expense.
Usually a percentage is applied to either total credit sales or credit
sales (net) of the current accounting year.
To understand, let’s suppose WXY Company chooses to apply percentage of sales approach and decides
that 1% of the net credit sales will be bad or uncollectible. If the net credit sales for a company for 2018 are
900,000 TL, then the expected bad debts expense would be 9,000 TL (1% x 900,000 TL). The adjusting
entry will be:
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Receivables

To record estimated bad debts for the year
Let’s assume that the company already had a credit balance of 1,700 TL in the allowance account.
Hence, after making the adjusting entry, the accounts of WXY Company will show:”
Bad Debts Expense
12/31 Adj. 9,000
Allowance for Doubtful Debtst
Balance (beginning) 1,700

12/31 Adj. 9,000
Balance end 10,700
Aging Approach
Firms often believe that they are able to forecast bad debts if they relate them to the balance in
the Account Receivable account at the end of the period instead of the sales of that period. Under the
percentage of Account receivable approach, companies
establish a percentage relationship between the amount
Percentage of receivable basis is a percentage
of account receivables and forecasted losses from bad
relationship between amount of account
debts accounts. Although this method is using account
receivables and estimated losses from
receivable rather than sales, the objective of both the
uncollectible accounts.
approaches remain the same, i.e. the company uses
past experience with bad debts to determine future
amounts.
Aging of accounts receivable is the analysis of
A schedule, which is often called as an aging
customer balances with respect to the length of
schedule, is prepared by the company in which it
time they have not been paid.
categorizes customer balances with respect to the
duration of time since they have not been paid.
In this approach, two steps are followed. At the first step, each receivable amount is grouped with respect
to payment due dates. In this procedure, the company should be able to allocate the relevant amounts
of receivables in association with their due periods, as known as ages. For each group of receivables, the
company should assign percentages of estimates regarding the probability of collection. These percentages
are then multiplied with the amounts of receivables in each aging group. In other words, once the accounts
are aged, certain percentages based on past experience are applied to the totals of each category. At the
second step, expected bad debts losses are calculated by summing up each group sub-totals to reach a final
amount of bad debts.
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Accounting I
An aging schedule of Zen Company is shown below:
Number of Days Past Due

Customer Total Not Yet Due
1-30 31-60 61-90 over 90
AA 600 300 200 100

BB 300 300
CC 450 200 250
DD 700 500 200
EE 600 300 300
Others 36,950 26,200 5,200 2,450 1,600 1,500
39,600 27,000 5,700 3,000 2,000 1,900
Estimated Percentage
Uncollectible 2% 4% 15% 20% 45%
Total Estimated Bad

Debts 2,473 540 228 450 400 855
As the example suggests, higher percentages are assigned to the older receivables because the lengthier a
receivable is past due, there are more chances that it will be uncollectible. The total estimated bad debts of
2,473 TL show the amount of present customer claims that firm expects to become uncollectible in future.
Hence, this amount reflects the balance Allowance for Doubtful Debts on the company’s balance sheet.
Henceforth, the difference between the needed balance and the current balance in the allowance
account is the amount of the bad debts adjusting entry. If the current credit balance in the allowance for
Doubtful account is supposed to be 630 TL, an adjusting entry will be for 1,843 TL (2,473 TL - 630 TL)
as shown below:
To adjust allowance amount to total expected

uncollectible
After making this adjustment entry, the accounts of the Zen Company will show:”
Bad Debts Expense Allowance for Doubtful Debtst
12/31 Adj. 1,843 Balance beg 630

12/31 Adj. 1,843
Balance end 2,473
Sometimes, the more provision could be recorded during the period. In this case, the excess portion
should be cancelled to bring targeted amount.
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Receivables
Occasionally the allowance account may have a debit balance before adjusting entry, because of previous
period estimation or amount of write offs in the current period. In this case, debit amount is added to
targeted balance when recording the adjusting entry. Let’s assume that the Zen Company has 600 TL of
debit balance of allowance for doubtful account before adjusting entry. The targeted amount is 2,473 TL.
The adjusting entry will be for 3,073 TL (2,473 TL +600 TL) as shown below:

To adjust allowance amount to total expected

uncollectible
After making this adjustment entry, the accounts of the Zen Company will show:”
Bad Debts Expense Allowance for Doubtful Debtst
12/31 Adj. 3,073 12/31 Unadj. Bal. 600 12/31 Adj. 3,073
Balance end 2,473
The following figure displays a simple comparison between percentage of sales and aging methods.
Allowance Method
Percent of Sales Method Aging of Accounts Receivable Method
Adjusts Allowance for Adjusts Allowance for

bad debts bad debts
BY TO
Amount of Amount of
UNCOLLECTIBLE UNCOLLECTIBLE
ACCOUNT EXPENSE ACCOUNTS RECEIVABLE
Figure 8.2 Comparing the Percentage of Sales and Aging Methods
Direct Write-off Method

The other way in which uncollectible receivables can be calculated is through Direct Write-off Method,
which is mainly used by relatively small and private companies. Under this method, a company does not
estimate bad debts losses and does not use allowance account for the expenses based on estimates. Instead,
when a specific receivable is considered to be uncollectible or worthless, the loss amount is charged directly
to the uncollectible account expense4.
To illustrate, let’s assume KRM Company writes off Louis’s 100 TL balance as uncollectible on
December 16th. The journal entry for this will be:
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Accounting I

Dec 16 Bad Debts Expense 100
(Louis)
To record write off of Louis account
One important thing here is that when this direct write-off method is used, bad debts expense will
reflect only actual losses from the uncollectible receivables. On the other side, account receivables will be
reported at its gross amount. Under this method, generally bad debts expenses are recorded in the period
that is different from the period in which revenue was recorded. Therefore, there is no matching of bad
debts to sales revenues in the income statement or to show cash (net) realizable value of the accounts
receivable on the balance sheet of the company using this method.
Only when uncollectible receivables are very low, the direct write off method is acceptable. Otherwise,
this method is inadequate due to:
1. As it does not allow set up of allowance for doubtful debts account, it always report account
receivables at their full amount and hence overstating their amount on balance sheet.
2. As the revenue period and bad debts expense period does not match under this system, company’s
net income is understated in one period while overstated in the other.
DISPOSING OF ACCOUNTS RECEIVABLE

Normally, companies collect account receivables in cash and remove it from the books simultaneously.
However, in recent years as credit sales and receivables have grown considerably, some companies have
started to sell their receivables to other companies in order to accelerate receipt of cash from receivables.
There are many reasons due to which companies sell their receivables.
1. For competitive reasons, sellers like manufactures, retailers, and wholesalers often must provide
financing to buyers of their goods.
2. Sometimes receivables are the only reasonable cash source for companies.
3. Billing and collection of receivable is costly and time consuming. Hence it is must easier for small
retailers to just sell their receivables to another party that has expertise in collection and billing matters.
Selling Receivables
The most practiced method to sell receivables is the sale
to a factor, also called as factoring. A factor is generally
a bank or a finance company that purchases receivables Factoring is the business of purchasing
from companies for a fee and then it collects payments receivables from companies upon a fee for
directly from these customer receivables at their prescribed the services performed to manage and collect
time. Traditionally, factoring was associated with home receivables.
furnishing, footwear, textile, and furniture industries.
Factoring arrangements vary extensively. However,
factors (the buyer of the receivables) charge a fee or Factor is generally a financial intermediary.
commission for their services. This fee can range from
1% to 3% of the amount of receivables bought. On the
other hand, factoring business relies on two different techniques, i.e. with recourse factoring and without
recourse factoring. In the former, the factor has the right to demand funds back from the company in
case it cannot collect the receivables from the customers. In the latter, however, the factor undertakes the
responsibility of non-payments that is it assumes losses arising from possible customer defaults.
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Receivables
To illustrate, let’s assume that on July 1st, HND Textile factors 700,000 TL of receivables to Elliot
Factors, Inc. Elliot Factors charges commission of 2% on the amount of receivables it is buying. The
general entry for HND Textile will be:

July1 Cash 686,000
Commission Charge Expense 14,000
To record the sale of account receivables
In the books of HND Textile, the commission charged by Elliot Factors is calculated as applying the
commission fee percentage of 2% on 700.000 TL of total receivables. If the company raises funds by
selling its receivables as an ordinary course of business, then the commission fee should be recorded as
selling expense in order to reflect this fact. However, if the receivables are not sold frequently, it may be
recorded in the Other Expenses and Losses section of the income statement.
Credit Card Sales

In today’s world, many businesses have reduced their investments in receivables by encouraging
customers to pay via credit cards such as Visa or Master. The credit card companies pay these businesses
and later bill the customers.
Credit card companies provide convenience to customers of buying without having to pay at the
moment. To retailers, these credit card companies provide benefit of not checking each customer’s credit
rating or credit history. Also, there is no need for the businesses to keep account receivables for longer
period of time or to carry out collection from their customers.
Credit card companies are not providing these benefits for free. They are charging a commission fee of
1% to 5% normally on a sale. This means the businesses are not getting 100% of the face value of their
sale5.
To illustrate, let’s assume Mr. John and his family had dinner at Best Burger Restaurant on 1st of July.
John paid the bill of 50 TL, with his XYZ Bank credit card. Following the general entry made by Best
Burger Restaurant to record the sale of 50 TL, subject to the credit card company’s 4% discount:

July1 Accounts Receivable 48
XYZ Bank
Commission expense 2
(50 TL x 0.04)
Sales Revenue 50
To record credit card sales
On collection of cash, Best Burger Restaurant makes the following entry:
Cash 48
XYZ Bank
To record credit card sales
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Accounting I
Debit Card Sales

The working of debit cards is slightly different than the working of credit cards. Using a debit card is
similar to paying with cash, except that the customers will not have to carry cash with them. When debit
card is swapped by retailer at the point of sale terminal (POS) or cash counter, the bank balance of the
customer is automatically reduced and the amount is transferred to retailer’s account. Hence there is no
third party involve in debit card transaction.
3
On December 31, 2017, XYZ Imports reported the following information on its balance sheet:
Accounts Receivable 2,000,000
Less: Allowance for Doubtful Debts 80,000
During 2017, the company made the following transactions with respect to receivables:
1. Sales on credit 3,600,000
2. Sales returns and allowances 50,000
3. Received from accounts receivables 2,300,000
4. Write-offs (bad debts) of accounts receivables 75,000
5. Recovery of debts that were previously written as bad 35,000
Requirements:
a. Prepare journal entries to record all of the above transactions.
b. Enter the January 1, 2017 balances in Accounts Receivable and Allowance for Doubtful Debts account and
make the required entries in the two T-accounts and determine the ending balances.
c. Prepare the general entry that records the bad debts expense for 2017. Assume the given ageing of accounts
receivable and that expected bad debts are 70,000.
ANALYZING THE ACCOUNTS RECEIVABLE

Managers, investors and financial analysts are keenly interested to know how well a company manages
and controls its account receivables. One simple measure or ratio to evaluate a company’s ability to analyze
its receivables is accounts receivable turnover ratio6 This ratio is calculated by simply dividing Net credit
sales by Average Accounts Receivable for the duration during which the sales were made by the company.
The formula is:
Credit Sales
Accounts Receivable Turnover =
Average Account Receivable
This ratio reflects how quickly company’s collections

occur. Let’s suppose if the ratio turns out to be 12, which
means that the company collects its receivables after a Accounts Receivable Turnover Ratio
month on average. Higher turnover ratio indicates that measures the liquidity of accounts receivable
receivables are collected rapidly. However, this is not and is calculated as net credit sales divided by
always good. Sometimes this higher ratio means that the net accounts receivable.
company’s credit policies are too strict and hence it might
be losing sales as a result.
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Receivables
On the other side, lower turnover ratio indicates slower collection cycle, reflecting that company’s
credit department is not functioning effectively and hence the company is losing out opportunities with
the cash that is not available.
To illustrate this, let’s assume credit sales for CCC Co in 2010 is 1 million TL. The company had
115,000 TL accounts receivable at the start of the year and at year-end it had 112,000 TL.
1,000,000
Accounts Receivable Turnover = = 8.81
0.5(115,000 +112,000)
This amount of 8.81 shows that CCC Co. collects its account receivables 8.81 times a year.
Not only the turnover but also receivable levels are also assessed based on how long it takes to collect
the receivable. This can be taken as an alternative to the accounts receivable turnover ratio with more direct
interpretation. The ratio called days to collect account receivable is calculated by dividing total or 365 days
by accounts receivable turnover. For the above example, the days to collect account receivable would be:
365 days
Days toCollect Accounts Receivable =
Accounts Receivables Turnover
365 days
Days toCollect Accounts Receivable = = 41.4 days
8.81
This figure of 41.4 days shows that CCC Co. takes 41.4 days to get their money after making sales.
Another type of accounts receivable analysis receivable is a

Average collection period is the average
trend line of the proportion of customer sales that are paid
amount of time that a receivable payment
at the time of sale, noting the payment type used. Changes
is outstanding and is calculated as 365 days
in a company’s sales policies may shift sales toward or away
divided by receivable turnover ratio.
from up-front payments, which therefore has an impact on
the amount and characteristics of accounts receivable.
4
RVY Company disclosed the following figures (in million TL) in their 2017 annual report. The company’s
accounting year ends on June 30. The account receivable balances are shown net of allowances doe doubtful
debts.
Net Sales 6.500 TL
Trade accounts receivable, June 30, 2017 430
Requirements:
a. Calculate RVY Company’s accounts receivable turnover ratio for year 2017. (Assume all sales are on credit).
b. What is the average collection period in days for RVY Company? Explain your answer.
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Accounting I
NOTES RECEIVABLE
Notes receivable is a type of claim of a company that holds a formal written promise from another party
to collect a specific amount of cash in near future. It is recorded as an asset in the books of a company
that is entitled to receive the amount. Normally this
promissory note lengthens for the time period of 60-
90 days or sometimes even longer and hence debtor is Promissory note is a written agreement or a
required to pay interest on it. These notes receivable, commitment to pay a particular amount of
along with account receivables, which results from promised money at a particular period of time.
credit sales transactions are sometimes known as trade
receivables or just receivables.
Unlike account receivable, notes receivable is more formal as the debtor signs a promissory note, which
is a documented agreement to pay a particular sum of money at a specific time. There are two parties
involved in this; one is the maker of the note and the other one is payee. The maker of the note is the
party that agrees to repay the amount while payee is the receiver of the amount. Promissory notes are used
for a variety of purposes. Banks normally require a company to sign a promissory note to borrow money.
Promissory notes are often used in the sale of consumer durables with relatively high purchase prices, such
as appliances and automobiles.
A company that receives a promissory note from
another party has an asset called “notes receivable” and Maker is the writer of a note, promises to pay.
the company that sends or makes the promissory note
has a liability called “notes payable”. Throughout the
life of this promissory note, the maker incurs interest Payee is the receiver of a note, to get the
expense on the notes payable while payee earns interest payment.
revenue on its notes receivable.
There are three main reasons due to which promissory notes are used:
1. When a company or an individual want to borrow money or lend it.
2. When the size of credit or a transaction exceeds the normal limit.
3. To settle an existing overdue account receivable.
Notes receivable gives a legal right to the holder to claim assets. Similar to the sale of accounts receivable,
notes receivable can also be disposed to the third party like bank. Similar to checks, notes receivable is
transferable or negotiable instrument, meaning that an endorsement can be used to transfer them.
An illustrative example of promissory notes is given in Figure 8.3.
Figure 8.3 Notes Receivable
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Receivables
In this illustration, Jim Radd is the maker and Surf Breaker West is the payee. Issuing date of note is
June 18, 20X1, maturity date is October 18, 20X1. Principal amount is $1,000 and interest rate of note
is 9%.
General issues occurring in notes receivable’s accounting are just like those with accounts receivable.
1. Recognition of notes receivable
2. Valuation of notes receivable
3. Disposition of notes receivable
The two main concepts related to notes receivable are:
1. Determining its maturity
2. Computing its interest
Determining the Maturity Date

If the life of a promissory note is in months, then the due date of that note is calculated by counting
the months from that date on which it is issued. For instance, the date of maturity of a three-month note
that was issued on June 1st is September 1st. However, if the note is issued on the last day of the month,
it matures on the last day of the consecutive month. For example, a note that is issued on July 31st with 2
months due matures on September 30th.
If the maturity of the note is stated in number of days, then the exact days will be counted to ensure
exact maturity date. This is simple to calculate. The date of issue of the note is not included however the
due date is included in the counting.
Computing Interest
The interest rate mention on the promissory note is an annual rate of interest. This is the rate that
must at least be equal to the rate incurred by debtor on similar financing alternatives. There are many
different ways in which this interest rate is calculated. For example, some financial companies use 360 days
for computation while some use 365 days. However, it is more profitable to use 360 days instead of 365
because the note holder receives more interest.
Amount of Interest = Principal × Interest Rate × Time
Recognition of Notes Receivable

Notes receivables are recorded at its face value, the value that is stated on the face of the note. When
the note is accepted, no interest revenue is reported because according to the revenue recognition concept
of accounting, revenue is not recognized until it is earned. In this case, interest is earned as time passes.
To show the basic entry for notes receivable, let’s assume that on May 1st, 1,000 TL, 2-month, 12%
promissory note was written to settle an open account. The following entry will be made by XYZ Co, who
accepts this note:
May 1 Notes Receivable 1,000
To record acceptance of Montero Co

promissory note
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Accounting I
In place of accounts receivable if a note were exchanged for cash, then the entry would be a debit to
notes receivable and a credit to cash (with the amount of loan).
Valuation of Notes Receivable

Valuation of notes receivables is very similar to the valuation of accounts receivables. First, just as in the
case of accounts receivables, the difference between the sales price and the cash equivalent price should be
treated as deferred income as a contra-asset account, which should be allocated to the profit/loss accounts
in each accounting period. As mentioned before, amortized cost principle in IFRS is also valid for notes
receivables.
Again, just like accounts receivable, short-term notes receivables are also recorded at their cash (net)
realizable value. Allowance for doubtful account for notes, however, is the notes receivable allowance
account. Moreover, valuation of notes receivable is also similar to that of accounts receivable including
estimations and calculations involve in getting cash (net) realizable value. Finally, in reporting of bad debt
expense amount and other related expenses and losses, the basic process remains the same.
Disposition of Notes Receivable

Notes receivable may be held until maturity date, when both the face value and the accrued interest
are due. However, in some cases the issuer or writer of the note defaults and appropriate adjustments have
to be made simultaneously. There can also be a situation where the holder of note wants to have cash and
thus he sells the notes receivable to the third party. Hence, the disposition of notes receivable is divided
into three alternatives:
1. Honor of Notes Receivable
2. Dishonor of Notes Receivable
3. Sale of Notes Receivable
Honored Notes Receivable

Note receivable is said to be honored only when it is paid in full at the time of maturity. For the notes
receivable, the full amount includes its face value and interest for the time period that was written on the
note.
To understand it better, let’s assume that XYZ Company lends ABC Inc. 9,000 TL on May 1 for
4-months with 9% interest on note. In this situation, the interest amount is 150 TL (9,000 TL x 5% x
4/12); the full amount due at maturity is 9,150 TL. To get the payment, XYZ Company (the payee) should
either present the bill to ABC Inc. or to note maker’s appointed bank. Supposing that XYZ Company
presented the note to ABC Inc. on maturity date September 1st, the entry by XYZ Company to record the
collection of amount would be:
Sept 1 Cash 9,150

Notes Receivable 9,000
Interest Revenue 150
To record collection of ABC Inc.
If XYZ Company prepares its financial statements as of August 31, it would have been important for
the company to accrue interest. Hence, the adjusting entry by XYZ Company would be for 4 months or
150 TL as follows:
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Receivables
Aug 31 Interest Receivable 150

To accrue 4-months interest
When a company accrues interest, it is important to credit Interest Receivable at maturity. The entry by
XYZ Company to record receiving of the full amount of ABC Inc. at maturity, September 1st is:
Sept 1 Cash 9,150

Interest Receivable 150
To record collection of note at maturity
In this case, Interest Receivable is credited because receivable was created in the adjusting entry.
Dishonored Notes Receivable

A note receivable is said to be dishonored when its
full amount is not paid at the maturity date and hence
such note is no longer negotiable. However, the holder Dishonored note is said to be dishonored if it
of the note still has a claim against the writer of the is not paid in full at its maturity date.
note. Hence, such Notes Receivable account is generally
transferred to an account receivable.
To illustrate, let’s assume ABC Inc. indicates on September 1st that it will not be able to repay at the
present time. The record entry for this dishonored notes receivable depends on the condition whether the
company is likely to receive the payment in future. If XYZ Company is expecting to receive the amount in
future; the amount due (interest accrued plus the face value) on the note is debited to accounts receivable.
The correct entry made by XYZ Company would be:
Sept 1 Accounts Receivable 9,150

To record the dishonor of the note
If there is no possibility of collection, the face value of the note receivable should be debited to
Allowance for Doubtful Debt account and as there will not be any collection for the amount, no interest
revenue will be recorded.
Sale of Notes Receivable

The accounting for notes receivable is also similar to the accounting practice for the sale of accounts receivable;
the practice for the sale of notes receivable is also the same. Notes receivable is negotiable. This means that it can
be endorsed and can be given further to someone else for collection. In other words, a company can sell it to a
bank and in return can receive cash before the note’s actual maturity date. As banks purchase these notes from the
companies at a “discount” from their maturity values, this process is also called discounting of notes receivable.”
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Accounting I
Both accounts receivables and notes receivables have different General Communiqué on Accounting
accounting treatments in the context of the tax system in System Application requires all receivables
Turkey. Turkish Tax Code deviates from IFRS provisions an to be recorded at their face amounts. On the
done should take care of such deviations in preparing financial other hand, notes receivables are rediscounted
statements. Tax Code requires to use General Communiqué in order to reduce their values to the actual
on Accounting System Application in accounting for accounts values at the end of the relevant accounting
and notes receivables. period.
5
Assume that RYZ Company, furniture manufacturer, completed following selected transactions:
Transactions in year 2016:
Dec 1 Sold 10,000 TL worth of furniture supply to ZET Company, Three months, %10 note.
Dec 31 Made an adjusting entry to accrue interest on the ZET company note.
Dec 31 Made an adjusting entry to record uncollectible- account expense based on an aging of accounts
receivable. According to aging analysis RYZ Company will not collect 12,800 of accounts receivable.
Before this adjustment, the credit balance of Allowance for doubtful debt account is 11,000.
Mar 1 Collected the maturity value of the ZET company note.
May 1 Sold merchandise to L&L Co., receiving a 90 –day, %8 note for 2,000.
July 31 L&L Co., dishonored its note at maturity (fail to pay), ZET Company accepted to convert the note to
an accounts receivable with maturity value (assuming a year includes 360 days).
Requirement: Make journal entries for these transactions
Further Reading
Accounts Receivables Management of all, to extend accounts receivables, the credit-

There are three main components to consider administration process must be set up in order
within working capital management: (a) cash to: (1) assess the credit risk of the debtor, (2)
management, (b) inventory management, and make the credit-granting decision, (3) finance
(c) accounts receivable management. Since they the receivables until the maturity, (4) collect
contribute to a significant fraction of current assets, the receivables, and (5) bear the default risk.
it is a requirement to employ a proper control and Each responsibility can be retained within the
management of receivables. Otherwise, the risks company or assigned to external parties. At one
associated with receivables, e.g. bad debts, would extreme, the company may manage all of the
harm the business operations. process activities internally, while at the other
extreme; it can subcontract them to a factor. In
In this respect, developing a corporate
between, a single credit-administration function
accounts receivable management policy is crucial
can be delegated to a credit insurance company
to the company in mitigating such risks. First
or a credit-collection firm.
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Receivables
Alternate accounts receivable management history of a debtor generally requires payment for
policies include accounts receivable secured debt, each inquiry. Credit-collection agencies provide
captive financial subsidiary, factoring, credit- collection services for past-due receivables. These
reporting firm, credit-collection agencies, and services include legal action to recover unpaid
credit insurance. With accounts receivable secured balances. Credit insurance compensates the
debt, the company use accounts receivables company against bad debt losses.
as collateral in a borrowing transaction where Which policy is better easy-to-answer
the counterparty is generally a bank. A captive question and may depend on various reasons.
financial subsidiary issues debt and the progress Empirical findings show that main ones are the
of this issue are used to purchase accounts size, creditworthiness of the company, and the
receivable from the parent company. Factoring concentration of receivables among the assets.
is the sale of accounts receivables to a financial
intermediary known as factor. The use of a credit- Source: Mian, Shehzad L., & Smith Jr, Clifford
W. (1992). “Accounts receivable management
reporting firm delegates the risk-assessment
policy: theory and evidence.” The Journal of
function. The contract specifying access to credit
Finance, 47(1), 169-200.
Inside Practice
Law on the Payment by the Ministry of Finance of Medical Device Companies’ accumulated
receivables
Historically, medical device companies could not receive payments for any products sold to state
university hospitals in Turkey. On 6 April 2018, an Omnibus Bill was published in the Official Gazette
numbered 30383 (Turkish language), introducing a new payment model for accumulated unpaid debts
arising from the purchase of drugs and medical devices by state university hospitals. However, medical
companies wishing to receive such payments must agree to apply discounts.
The scope of the payment model covers the debts that are still unpaid according to each university’s
accounting records as of 31 December 2017 and are still not paid as of the publication date of this
provision. Accordingly, the creditors may request such payment from universities until 6 May 2018.
However, the entire debt shall be recalculated without including interest and by applying discounts,
which are determined by the Council of Ministers. Within 15 days following this deadline, all applying
companies must notify the Ministry of Finance of the amount of debt requested to be paid. The
Ministry of Finance will thereupon calculate the debt amounts according to the discount rates and
transfer to the debtor university the relevant amount within one month. The university is expected to
pay the companies within five working days of this transfer.
A real life example experienced by a medical firm that requests for payments for its receivables is
as follows:
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Accounting I
Invoice Invoice # Date of Receivables Discount Amount Amount

Date Maturity Amount (TL) Rate Waived to be Paid
18/12/2017 A021733 28.12.17 3.677,23 27,00% 992,85 2.684,38
12/02/2014 012336 14.03.15 8.205,35 1,50% 123,08 8.082,27
30/01/2015 15892 10.02.15 3.693,29 1,00% 36,93 3.656,36
12/11/2015 5149 28.12.15 10.705,20 6,00% 642,31 10.062,89
31/03/2016 018795 2.06.16 15.950,75 10,50% 1.674,83 14.275,92
21/12/2016 016165 30.12.16 47.415,47 15,00% 7.112,32 40.303,15
23/12/2016 16171 30.12.16 22.989,42 15,00% 3.448,41 19.541,01
02/02/2017 016282 28.04.17 13.643,21 19,00% 2.592,21 11.051,00
09/02/2017 16300 17.03.17 10.705,20 18,00% 1.926,94 8.778,26
30/03/2017 015914 5.05.17 12.268,16 20,00% 2.453,63 9.814,53
20/04/2017 015992 24.05.17 24.166,99 20,00% 4.833,40 19.333,59
11/05/2017 016057 7.06.17 7.900,44 21,00% 1.659,09 6.241,35
24/05/2017 016104 23.06.17 10.319,81 21,00% 2.167,16 8.152,65
20/06/2017 4564 11.07.17 8.906,73 22,00% 1.959,48 6.947,25
23/06/2017 004587 6.09.17 27.660,10 24,00% 6.638,42 21.021,68
07/08/2017 004712 14.11.18 4.608,59 38,00% 1.751,26 2.857,33
21/08/2017 004761 14.11.18 54.204,17 38,00% 20.597,58 33.606,59
16/11/2017 021590 18.12.17 8.735,44 27,00% 2.358,57 6.376,87
14/12/2017 21715 28.12.17 21.372,93 27,00% 5.770,69 15.602,24
TOTAL 317.128,48 68.739,18 248.389,30
According to this table, the medical firm has 317,128.48 TL as an original amount of accounts
receivables from a university hospital. The regulation requires various discount rates for each invoice
amount and the final figure shows that the firm has to agree to receive only 248.389,30 TL. The
medical firm will have to waive the difference, i.e. 68.739,18 TL.
Source: Dicle Doğan and Fatma Sevde Tan, Gun + Partners http://gun.av.tr/wp-content/uploads/law-
on-the-payment-by-the-ministry-of-finance-of-medical-device-companies1.pdf compiled by the author’s
own research
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Receivables
Define the receivables and

LO 1 introduce different types of
receivables
Receivable is an accounting term associated with the amounts that are owed to the business by other
parties, mainly its customers. These are basically the claims that are likely to be acquired in future.
Generally, receivables are divided into three main categories: (1) account receivables, (2) notes receivable,
(3) other receivables. Account receivable is a claim against a customer resulting from the sales made by a
business on credit. Notes receivable is a type of claim of a company that holds a formal written promise
Summary
from another party to collect a specific amount of cash in near future.

Accounts receivables and notes receivables arise from main operating activities of companies and they
are known as trade receivables. On the other hand, other receivables item stands for a various category
that includes other type of receivables arising from other activities, such as loans to employees or interest
receivables.
Receivables can be also classified as current (short-term) and non-current (long-term) receivables with
respect to their maturity structures.
Discuss accounting issues of

LO 2 account receivables
Accounts receivable is the amount owed to a company by customers as a result of delivering goods or
services. It occurs when a business makes sales on credit. Each credit transaction involves two parties. One
is the creditor, who lends credit to the other party or in other words who will earn the receivable (the
asset). The second party is the debtor, who takes the credit or payable (a liability). Receivables are valued
at the actual exchange price between a company and its customer, deducting adjustments for sales returns,
cash discounts, and allowances, in order to get net realizable value. Cash (net) realizable value shows the
credit sales price adjusted for returns, discounts, and allowances expected to be collected from customers.
Understand methods used to

LO 3 account for bad debts
It is also important to be aware of that the amount to be reflected as an asset on the balance sheet because
some receivables might become bad or will be uncollectible. Hence, in order to ensure that account
receivables are not overstated on the balance sheet, they are reported in their cash (net) realizable value.
There are two methods used in accounting for uncollectible receivables: (1) the allowance method and (2)
the direct write-off method.
Under the allowance method, there are two basic approaches that are used to forecast bad debts receivables:
first one is percentage of net credit sales approach and the second is percentage of accounts receivable
approach. Percentage of net credit sales basis focuses on one of the most important accounting principle,
matching principle while percentage of accounts receivable emphasizes the cash (net) realizable value of
accounts receivable with the help of aging schedule.
Under direct write-off method, the loss amount is charged directly to the Bad Debts Expense account.
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Accounting I
Discuss disposing of account

LO 4 receivables
Normally, companies collect account receivables in cash and remove it from the books simultaneously.
However, in recent years as credit sales and receivables have grown considerably, some companies have
started to sell their receivables to other companies in order to accelerate receipt of cash from receivables.
The most practiced method to sell receivables is the sale to a factor, also called as factoring. Factoring
arrangements vary extensively. However, factors (the buyer of the receivables) charge a fee or commission
Summary
for their services. In today’s world, many businesses have reduced their investments in receivables by
encouraging customers to pay via credit cards such as Visa or Master. The credit card companies pay these
businesses and later bill the customers. The working of debit cards is slightly different than the working
of credit cards. Using a debit card is similar to paying with cash, except that the customers will not have
to carry cash with them. When debit card is swapped by retailer at the point of sale terminal (POS) or
cash counter, the bank balance of the customer is automatically reduced and the amount is transferred to
retailer’s account.
Identify ratios to evaluate

LO 5 company’s receivables
To evaluate a company’s ability to analyze its account receivables, accounts receivable turnover ratio
is used. This accounting ratio is calculated by simply dividing Net credit sales by Average Accounts
Receivable for the duration during which the sales were made by the company.
Not only the turnover but also receivable levels are also assessed based on how long it takes to collect the
receivable. This can be taken as an alternative to the accounts receivable turnover ratio with more direct
interpretation. The ratio called days to collect account receivable is calculated by dividing total or 365
days by accounts receivable turnover.
Discuss accounting issues for note

LO 6 receivables and compute interest
A company that receives a promissory note from another party has an asset called, note receivable and the
company that sends or makes the promissory note has a liability called note payable. Throughout the life
of this promissory note, the maker incurs interest expense on the note payable while payee earns interest
revenue on its note receivable.
There are three main reasons due to which promissory notes are used: (1) when a company or an individual
want either borrow or lend money. (2) When the size of credit or a transaction exceeds the casual limit. (3)
To settle an existing overdue account receivable.
The maturity date of a note must be calculated unless the due date is already specified or the note is
payable/receivable on demand. If the life of a promissory note is in months, then the due date of that note
is calculated by counting the months from that date on which it is issued. If the maturity of the note is
stated in number of days, then the exact days will be counted to ensure exact maturity date, omitting the
date of issue but counting the due date. The interest rate mention on the promissory note is an annual rate
of interest. The formula for calculating interest is face value times interest rate times time.
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Receivables
1 Two bases for estimating uncollectible 5 Which method of estimating uncollectible

accounts are receivables focuses on Bad debt expense for the
A. Percentage of asset and Percentage of sales balance sheet?
B. Percentage of receivables and Percentage of A. Percent of sales approach
total revenue B. Aging of accounts receivables approach
C. Percentage of current asset and Percentage of sales C. Net realizable value of approach
D. Percentage of receivables and Percentage of sales D. Cash Basis
E. Percentage of Receivable E. Accrual Basis
2 X company uses the allowance method to 6 On May 1st, 2017, X Co. sells goods on
account for uncollectible receivables. Allowance account to EVE Co. worth 1,000 TL, at terms
for doubtful account had 2,200 TL credit balance 4/10, n/30. On May 3th, goods at a value of 300
at the beginning of year. During the year bad debt TL are returned to X Co. On May 9th, EVE Co.
expense was recorded for 3,300 TL and wrote off pays its due balance. What is the amount of cash
bad receivables for 3,500. What is the balance of received?
allowance for doubtful account year-end?
A. 600 B. 630
A. 1,300 C. 672 D. 686
B. 2,000 E. 700
C. 2,200
D. 2,300
E. 3,300
7 XYZ company’s aging of receivables account
data at December 31 shows the following:
Accounts Receivable ............................... 700,000
3 X company’s balance of accounts receivables
is 15,000 TL. Using the data in question two, what Allowance for Doubtful Accounts before
is the net realizable value of accounts receivable adjustment ............................................... 40,000
value at the year-end? Amounts expected to become uncollectible ..... 55,000
A. 11,700 The cash (net) realizable value of the accounts
B. 12,800 receivable at December 31, after adjustment, is:
C. 13,000
A. 55,000 B. 195,000
D. 13,700
C. 645,000 D. 660,000
E. 15,000
E. 700,000
4 Which of the following is true to calculate 8

Present value? One of the following issues about promissory
notes is incorrect. The incorrect matter is:
A. Present Value = Future Value / (1 + Interest
Rate)m/12 A. The party promises to pay is called the maker
B. Present Value = Future Value + (1 + Interest B. A promissory note is not a negotiable tool
Rate)m/12 C. The party to whom payment is to be made is
C. Present Value = Future Value / (1 - Interest called the payee
Rate)m/12 D. A promissory note is a negotiable tool
D. Present Value = Future Value / (1 + Interest E. There will be two parties as maker and payee
Rate)12/m
E. All of them
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Accounting I

9 Which of the following about VISA credit 10 The average collection period for receivables
card sales is incorrect? is computed by dividing 365 days by?
A. The collection process doesn’t include the A. Net credit sales
retailer B. Ending account receivables
B. The credit investigation of the customer is C. Average accounts receivable
made by the credit card issuer
D. Account receivable turnover ratio
C. The time to collect accounts receivables takes
E. Beginning account receivables
longer than the time to collect proceedings
from the customer’s credit card
D. Two parties are involved
E. The collection period is shorte
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Receivables

1. D 6. C If your answer is wrong, please review the
“Estimating Uncollectible Accounts and
“Recognition of Accounts Receivable” section.
Valuation” section.
2. B 7. C
“Cash (Net) Realizable Value, Balance Sheet, “Estimating Uncollectible Accounts, Cash
Write Off and Valuation” section. (Net) Realizable Value” section.
3. C 8. B
“Cash (Net) Realizable Value and Valuation” “Definition and Recognition of Notes
section. Receivables” section.

4. A 9. D If your answer is wrong, please review the
“Recognition of Accounts Receivable and
“Selling Receivables and Credit Card)” section.

5. B “Recognition of Accounts Receivable and
10. D If your answer is wrong, please review the
“Evaluating of Receivables” section.
How can receivables be classified?
Receivables can be classified as accounts receivables, notes receivables and

your turn 1 other receivables. In addition, receivables can be classified as short-term and
long-term asset according to time length.
What is the difference between accounts receivable and

other receivables?
Accounts receivable are trade receivables but other receivables are non-trade
your turn 2 receivables.
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Accounting I
On December 31, 2017, XYZ Imports reported the following information on its
balance sheet:
Accounts Receivable 2,000,000 TL

During 2017, the company made the following transactions with respect to
receivables:
1. Sales on credit 3,600,000 TL
3. Collected from accounts receivables 2,300,000
Requirements:
b. Enter the January 1, 2017 balances in Accounts Receivable and Allowance for
Doubtful Debts account and make the required entries in the two T-accounts and
determine the ending balances.
c. Prepare the general entry that records the bad debts expense for 2017. Assume the
given aging of accounts receivable and that expected bad debts are 70,000 TL.
your turn 3
a.
1. Date Account Titles and Short Explanation Debit Credit

Sales 3,600,000
2.
Sales Returns and Allowances 50,000

3.
Cash 2,300,000
4.

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Receivables
balance sheet:

receivables:
Requirements:
your turn 3
5. Date Account Titles and Short Explanation Debit Credit

6.
Cash 35,000
b. Accounts Receivable
bal 2,000,000 (2) 40,000

(1) 3,600,000 (3) 2,300,000
(5) 35,000 (4) 65,000
(5) 25,000
balance 5.635.000
Allowance for Doubtful Debts
(4) 75,000 Balance 80,000

(5) 35,000
Balance 40,000

250
Accounting I
balance sheet:

receivables:
Requirements:
your turn 3
c. Balance before adjustment 40,000

Balance needed 70,000
Adjustment required 30,000
The journal entry would be:
Bad Debts Expense 30,000

251
Receivables
RVY Company disclosed the following figures (in million TL) in their 2017 annual report.
The company’s accounting year ends on June 30. The account receivable balances
are shown net of allowances doe doubtful debts.
Net Sales 6.500 TL

Requirements:
a. Calculate RVY Company’s accounts receivable turnover ratio for 2017. (Assume all
sales are on credit).
b. What is the average collection period in days for RVY Company? Explain your
answer.
your turn 4
a.
Credit Sales
Average Accounts Receivable

6,500
(370 + 4,309) / 2

Accounts Receivable Turnover = 16.25
b. 365 days
Days to Collect Accounts Receivable =
Accounts Receivable Turnover
365 days
Days to Collect Accounts Receivable =
16.25
22.46 days
RVY Company takes 22,46 days to collect its receivables
252
Accounting I
Assume that RYZ Company, furniture manufacturer, completed following selected

transactions:

Dec.1 Sold 10,000 TL worth of furniture supply to ZET Company, three month, %10
note.
Dec 31 Made an adjusting entry to record uncollectible- account expense based on an
aging of accounts receivable. According to aging analysis RYZ Company will
not collect 12,800 TL of accounts receivable. Before this adjustment, the credit
balance of allowance for doubtful debt account is 11,000 TL.
July 31 L&L Co., dishonoured its note at maturity (fail to pay), ZET Company accepted
to convert the note to an accounts receivable with maturity value (assuming a
year includes 360 days).
your turn 5
Dec 1 Notes Receivable 10,000
Sales Revenue 10,000
Dec 31 Interest Receivable 83.33
Interest Revenue 83.33
(10,000 x 0,10 x 1/12)
Dec 31 Bad Debt Expense 1,800
Allowance for Doubtful Debt 1,800
(12,800-11,000)
253
Receivables
Assume that RYZ Company, furniture manufacturer, completed following selected

transactions:
Dec.1 Sold 10,000 TL worth of furniture supply to ZET Company, three month, %10
note.
Dec 31 Made an adjusting entry to record uncollectible- account expense based on an
aging of accounts receivable. According to aging analysis RYZ Company will
not collect 12,800 TL of accounts receivable. Before this adjustment, the credit
balance of allowance for doubtful debt account is 11,000 TL.
July 31 L&L Co., dishonoured its note at maturity (fail to pay), ZET Company accepted
to convert the note to an accounts receivable with maturity value (assuming a
year includes 360 days).
your turn 5
Mar 1 Cash 10,250

Interest Receivable 83,33
Interest Revenue 166,67
(10,000 x 0,10 x 2/12)
May 1 Notes Receivable 2,000

Sales Revenue 2,000
July 31 Accounts Receivable 2,040

Interest Revenue 40
(2,000 x 0,08 x 90/360)
254
Accounting I
Endnotes
IFRS 9: Financial Instruments https://www.ifrs.org/
1
Meigs, R .F., Williams, J. R., Haka S. F. and Bettner
4
issued-standards/list-of-standards/ifrs-9-financial- M. S., (2009), Accounting, Mc Graw Hill,

instruments/ Eleventh Edition, p.294.
JWeygandt, J. J., Kimmel, P. D., & Kieso, D., (2015),
2
Horngren C. T., Harrison W. T. and Oliver S. M.,
5
Accounting Principles. Wiley, Twelfth Edition, (2009), Accounting, Pearson Prentice Hal, Eigth
p.410. Edition, p. 243.
Horngren C. T., Sumden G.L., Elliott C.A. and
3
Porter G. A. and Norton C. L. (2010), Financial
6
Philbrick D.R. (2006), Introduction to Financial Accounting The Impact on Decision Maker, South-
Accounting, Pearson Prentice Hal, Ninth Edition, Western Cengage Learning, Sixth Edition, p.343.
p 243.
255

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3

Prof.Dr. Saime ÖNCE

CHAPTER 1, 2 Asst.Prof.Dr. Soner GÖKTEN

CHAPTER 3 Dr. Pınar OKAN GÖKTEN

CHAPTER 4 Assoc.Prof.Dr. Arman Aziz KARAGÜL

CHAPTER 5 Assoc.Prof.Dr. Mustafa Gürol DURAK

CHAPTER 6 Prof.Dr. Nazlı KEPÇE

CHAPTER 7 Asst.Prof.Dr. Sezen ULUDAĞ

CHAPTER 8 Prof.Dr. Semra KARACAER

Graphic Design Coordinator

Printing and Distribution Coordinator

All rights reserved to Anadolu University.

Eskişehir, Republic of Turkey, October 2018

Introduction ................................................... 123 Introduction ................................................... 161

Introduction ................................................... 189 Introduction ................................................... 221

1 Identify the activities and information users

5 Describe and prepare the basic financial

ACCOUNTING INFORMATION: BASIC ACTIVITIES AND INFORMATION

Accounting is an information system which

Figure 1.1 Accounting is an Information System

Basic Activities in Accounting Process

Identifying includes selecting financial transactions.

Figure 1.2 illustrates three basic activities of accounting process.

Economic transaction Bookeeping Financial statements

Identification Recording Communication

Figure 1.2 Activities of Accounting Process

Bookkeeping is an activity or occupation of

Which product line is the Can we afford to raise

What price should be

Figure 1.3 Financial Information Needs of Managers

ETHICAL BEHAVIOR, MEASUREMENT PRINCIPLES, AND BASIC

Relevance refers the impact capacity of financial information on the decisions of

Monetary Unit Assumption

Economic Entity Assumption

The Going Concern Assumption

BASIC ACCOUNTING EQUATION AND ELEMENTS OF FINANCIAL

Definition of Basic Accounting Equation

Assets = Liabilities + Owner’s Equity

Figure 1.4 The Basic Accounting Equation

The basic accounting equation shows the

Elements of the Basic Accounting Equation

Figure 1.6 Assets are Economic Resources

Figure 1.7 Liabilities are Existing Debts of Company

Increases and Decreases in Owner’s Equity

Revenue is the gross inflow of economic benefits

Figure 1.9 Expenses Will Reduce the Owner’s Equity

Owner’s Equity = + Contributions by Owner - Distributions to Owner +- Net Income/Loss

Net Income/Loss = + Revenues - Expenses

Owner’s Equity = + Cont. by Owner - Dist. to Owner + Revenues - Expenses

Expanded Version of Basic Accounting Equation

Basic Accounting Equation Assets = Liabilities + Owner’s Equity

Expanded Version Assets = Liabilities + Contributions – Distributions + Revenues - Expenses

Figure 1.11 Expanded Version of Basic Accounting Equation

EFFECTS OF FINANCIAL TRANSACTIONS ON THE ACCOUNTING

Are the following events recorded in the accounting records?

Figure 1.12 Identification of Transaction

Identification of transaction includes analyzing of

Analyzing the Effects of Transactions: Case of TRApps

Transaction 2: Purchasing Equipment for Cash.

Transaction 3: Purchasing Supplies on Credit.

Transaction 6: Earning Service Revenue for Cash and on Credit.

Transaction 9: Collection of Accounts Receivable.

The realized cumulative accounting equation

Owner’s equity statement is also referred as statement