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Accounting 1
Accounting 1
Internal users:
Internal users are parties inside the reporting entity (company) who are interested in the
accounting information.
Example: managers-for controlling, monitoring and planning, officers, internal auditors, sales
managers, budget officer, other internal decision maker.
External users
External users are parties outside the reporting entity (company) who are interested in the
accounting information.
They are not directly involved in running the organization.
Examples:
lenders(banks and financial companies)-whether an organization is likely to repay its loan
with interest and to grant loan
shareholders(investors)-what is income for current and past periods-to assess the return
and risk in acquiring shares
External auditors-to examine and provide an opinion on whether financial statements are
prepared according to GAAP.
Employees-to judge the fairness of their wages, to assess future jobs prospective.
Regulators(internal revenue service, tax authorities)-to compute taxes
Others such as:
Voters, Legislators, elected officials to monitor and evaluate a government
receipts and expenses.
Contributors to not for profit organization-to evaluate the use and impact of their
donations.
Suppliers – to judge the soundness of the business before making sales on credit.
Customers –to assess the staying power of suppliers.
1.3. The Elements of Accounting
1. Assets
are items with money value that are owned by a business.
An item has a dollar (birr) value to be recorded in accounting records. Example:
cash, accounts receivable, supplies, inventories, equipment, land buildings etc
Business Entity Concept: this concept states that a business entity should be kept separate and
distinct from its owners, and any other economic activities.
2. Liabilities:
debts owed by the business-obligation of a business.
A liability that results from purchasing goods and services on credit is called
accounts payable. Other liabilities include notes payable, interest payable, wages
payable etc
3. Owner’s Equity:
the difference between what is owned and what is owed is owner’s equity.
It is the excess of assets over liabilities.
Also called capital, proprietorship, net worth, and net asset.
4. Revenues:
Revenues are increases in capital due to inflow of resources from business
operations such as, provision of services or sales of goods.
5. Expenses:
Expenses are decrease in capital due to outflow of resources for the purpose of
business operations.
In report form of balance sheet, all items—assets, liabilities, and capital—are listed down in the
order shown below:
Report form balance sheet
Account Titles
Amounts
Assets xx
Total Assets xx
Liabilities xx
Capital xx
Total Liabilities & Capital xx
4. Statement of cash flows: identifies cash inflows and outflows over a period of time.
There are 3 types of cash flows (CF):
Cash flow from operating activities – cash flow generated by normal business operations
Cash flow from investing activities – cash flow from buying and selling assets: buildings,
real estate, investment portfolios, equipment.
Cash flow from financing activities – cash flow from investors or long-term creditors
See the following financial statements prepared for Alex Barber, service business from the above
transactions.
Alax Barber
Income statement
For the month ended December 31,2010
Revenue (service fee) …………………… Br1,425
Operating expense:
Rent expense …………………. … Br. 600
Net income ………………………………. Br825
Alax Barber
A statement of Owner’s Equity
For the month ended December 31,2010
The following advantages of the four-column account as compared with the two-column are: The
four-column account:
1) provides an easy means of analyzing and examining the accounts,
2) presents transactions in their chronological order of occurrence as the journal does,
facilitating easy location,
3) uses only one date column, saving space and time required for analysis, and
4) Makes balance of an account always available after each transaction is transferred to
the account.
Accounts are often grouped together in a book form; such a grouping of accounts is called a
ledger. Thus, accounts are frequently referred to as ledger accounts. A skeleton version of a
standard form of account, used for ease analysis of account balance is called T account.
The T account has three parts:
1. The account title
2. Space for recording increases in the amount of the item, and
3. Space for recording decreases in the amount of the item
Title of account
Left Side Right side
(Debit side) (Credit side)
The left side of any account is the debit side and the right side is called the credit side.
Chart of Accounts
A list of accounts in the ledger.
outline the order of accounts in the ledger
directory of accounts available in the ledger
Balance of an account: account balance is the difference between the increase and decrease
recorded in an account. The normal balance of all accounts are positive rather than negative
because the sum of the increases recorded in an account is usually equal to or greater than the
sum of the decreases recorded in the account.
Journal:
Is the book in which the records of business are written.
It is a chronological record of events.
General journal:
Is the original book of entry
Information recorded on this book is usually extracted from the source documents such
as invoices, receipts, contracts agreements and many other relevant documents.
It would usually show the account to be debited and credited and short description on
the transaction.
Information on this book will be posted to the ledger.
General journal is used to record all kinds of entries
Forms of Two Column Journal
Date Description P/R Debit Credit
Special Journals:
A journal in which only one kind of business transaction is recorded is a special journal
used to record only one type of entries.
GENERAL JOURNAL
Date Account Titles and Explanation Ref. Debit Credit
2011
April. 1 Cash 10,000
Wisdom, Capital 10,000
(invested cash in business)
2 Office Equipment 7,000
Account payable 7,000
(purchased equipment on account)
3 Office supplies 125
Cash 125
(purchased equipment for cash)
4 Account payable 500
Cash 500
(payment of on account)
5 Rent expense 400
Cash 400
(paid cash for rent)
6 Repairs expense 50
Cash 50
(Paid cash for repair)
7 Cash 1,800
Service revenue 1,800
(collection of on account)
8 Account receivable 400
Service revenue 400
(service rendered on credit)
9 Wisdom, Drawing 800
Cash 800
( cash withdrawn by the owner)
10 Cash 100
Account receivable 100
(collection of credit)
Posting: The procedure of transferring journal entries to the ledger accounts is called posting.
Advantages of Posting:
Posting summarizes entries in the journal into accounts in the ledger,
It can also be viewed as sorting journal entries into accounts.
Posting is an activity that summarizes the records in the journal so as to make them
convenient for analysis and reporting.
It brings all data of one kind together.
General ledger is the main book of accounts. This is the book where all the accounts are kept.
Each account maintained in this book will contain specifically information that relates to that
particular item alone. Information will generally be from the journal.
Ledger:
Ledger is a collection of accounts together in one book
To accurately report the assets on the balance sheet date. Some assets
may have been used up during the accounting period.
Deferrals:
Deferrals are previously recorded assets, liabilities, revenues, or expenses that
need to be adjusted at the end of the period to reflect revenues earned or
expenses incurred in the current accounting period.
Some of the deferred items for which adjusting entry would be made include:
prepaid insurance, prepaid rent, office supplies, depreciation, and unearned
revenue.
Deferral adjustments are of two types:
1. Prepaid expense (Assets/expense) adjustments
Transfer amounts from asset accounts to expense accounts
2. Unearned revenue (deferred Revenue) Liability/revenue adjustments
Transferring amounts from liability to revenue accounts.
3.2.1.ACCRUAL ADJUSTMENTS
Accruals are revenues that have been earned and expenses that have been
incurred by the end of the current accounting period, but that will be collected
or paid in a future accounting period.
Accruals occur when no cash has been received or paid, but the company has
undertaken activities that result in earning revenues or incurring expenses.
Unlike deferrals, no original entry has been recorded.
Depreciation:
As an example, recall the illustration of accounting for prepaid insurance -- Prepaid Insurance
was debited and Cash was credited at the time of purchase. This is referred to as a "balance
sheet approach" because the expenditure was initially recorded into a prepaid account on the
balance sheet. However, an alternative approach is the "income statement approach." With
this approach, the Expense account is debited at the time of purchase. The appropriate end-of-
period adjusting entry "establishes" the Prepaid Expense account with a debit for the amount
relating to future periods. The offsetting credit reduces the expense account to an amount
equal to the amount consumed during the period.
The balance sheet and income statement methods result in identical financial statements.
Notice that the income statement approach does have an advantage if the entire prepaid item
or unearned revenue is fully consumed or earned by the end of an accounting period. No
adjusting entry is needed because the expense or revenue was fully recorded at the date of the
original transaction.
Example: Assume that supplies worth Br 386 are purchased on Nov. 1, the entry
would be recorded as follows:
If Br 150 has been earned at Dec. 31, 2003, the adjusting entry transfers this amount
from the revenue account to a liability account as follows:
Date Accounts Debit Credit
2008
Dec. 31 Rent Income 450
Unearned Rent 450
Meaning and Importance of Reversing Entries
A reversing entry is simply an entry that reverses the debits and the credits
of the previous adjusting entry.
Reversing entries are optional.
They are used in order to make the accounting process more consistent or to
make later recording of related transaction simpler.
If the company has the accounting policy of preparing reversing entries, the
adjusting entries for all accruals and for the deferrals that are first recorded
as expense and revenue (income statement) accounts are reversed.
Preparing a Work Sheet
The work sheet is an informal working paper that the accountant uses in preparing financial
statements and completing the work of accounting cycle. The work sheet has been described as
the accountant’s scratch pad, and it is used to:
1. Organize data
2. Lessen the possibility of overlooking an adjustment
3. Provide an arithmetical check on the accuracy of work, and
4. Arrange data in logical form for the preparation of financial statements. A work sheet is
not a permanent accounting record; it is neither a journal nor a part of the general ledger.
The use of work sheet is optional.
Steps in preparing a Work Sheet
Step 1: Prepare a trial balance on the work sheet.
Step 2: Enter the adjustments in the adjustment columns.
Step 3: Enter adjusted balances in the adjusted trial balance columns.
Step4: Extend adjusted trial balance amounts to appropriate financial statements columns.
Step 5: Total the statement columns, compute the net income (or net loss), and complete the
work sheet.
Illustration: The following information pertains to Hope Laundry at July 31,2008, the end of the
current fiscal year, and the data needed to determine year end adjustments:
Cash Br7,790
Laundry supplies 4,750
Prepaid insurance 2,825
Laundry equipment 85,600
Accumulated depreciation Br55,700
Accounts payable 4,950
Hope, capital 30,900
Hope, Drawing 18,000
Laundry Revenue 76,900
Wages expense 24,500
Rent expense 15,575
Utilities expense 8,500
16,435 16,435
Net income(net loss)
76,900 114,555
76,900 114,555
Totals
The preparations of financial statements from the work sheet of Hope Laundry are presented below.
Hope Laundry
Income Statement
For the year Ended July 31, 2008
Revenues
Laundry Revenue 76,900
Expenses:
Wages Expense Br.25, 350
Rent expense 15,575
Supplies expense 2,910
Insurance Expense 1,500
Utilities Expense 8,500
Depreciation Expense 5,720
Miscellaneous expense 910
Total Expense 60,465
Net Income 16,435
Hope Laundry
Owner’s Equity Statement
For the year Ended July 31,2008
Hope Laundry
Balance Sheet
July 31,2008
Assets
Cash Br.7,790
Laundry Supplies 1,840
Prepaid Insurance 1,325
Laundry Equipment 85,600
Less: Accumulated Depreciation 61,420 24,180
Total Assets Br. 35,135
Liabilities and Owner’s Equity
Liabilities
By: Berhanu Gemule(BGK) Public Service College of Oromia/ 2011 Page 23
Principles of Accounting Part I
Account Payable 4,950
GENERAL JOURNAL J1
Date Account Titles and Explanation Ref. Debit Credit
Adjusting Entries
2008
July 31 Laundry Supplies Expense 2,910
Laundry Supplies 2,910
(To record supplies used)
31 Insurance Expense 1,500
Prepaid Insurance 1,500
(To record insurance expired)
31 Depreciation Expense 5,720
Accumulated Depreciation- equip. 5,720
(To record yearly depreciation)
31 Wages Expense 850
Wages Payable 850
(To record accrued salaries)
Wages Payable 850
Total Liabilities 5,800
Owner’s Equity
Hope, Capital 29,335
Total Liabilities and Owner’s Equity Br. 35,135
(2) Preparing Adjusting Entries from a Work Sheet
The adjusting entries are prepared from the adjustment columns of the work sheet.
The reference letters in the adjustment columns and the explanation of the adjustments
that appear at the bottom of the work sheet help identify entries.
The journalizing and posting of adjusting entries follows the preparation of financial
statements when a work sheet is used.
The adjusting entries on July 31 for Hope Laundry are shown below:
HOPE LAUNDRY
Post Closing Trial Balance
July 31, 2008
Account title Account No Debit Credit
Cash 11 7,790 00
Laundry Supplies 13 1,840 00
Prepaid insurance 14 1,325 00
Laundry Equipment 15 85,600 00
Accumulated Depreciation 61,420
Accounts Payable 21 4,950 00
Wages Payable 22 850 00
Hope, capital 31 29,335 00
Totals 96,555 00 96,555 00
Remember that only Permanent accounts are seen with their balances on the post
closing trial balance. No nominal account is seen in this trial balance, as it is prepared
after closing all the nominal ones.
The goods that a merchandizing business purchases for sale to customers are called
merchandize.
Cost of Merchandize: This represents the total sum of costs incurred to make the commodities
(merchandize) ready for sale.
cost is a deduction against revenues to arrive at gross profit
It has got debit as its increase and credit as its decrease.
By: Berhanu Gemule(BGK) Public Service College of Oromia/ 2011 Page 27
Principles of Accounting Part I
Merchandising inventory is items or commodities held for sale to customers in the
ordinary course of the business.
Merchandising inventory have two common characteristics:
(1) They are owned by the company and
(2) They are in a form ready for sale to customers in the ordinary course of business.
Inventory Systems
In merchandising inventory there are two inventory accounting systems used to collect
information about cost of good sold and cost of inventory on hand. The two systems are called
periodic and perpetual.
1. Periodic Inventory system
The merchandise inventory account is updated only once at the end of the accounting
period.
When merchandise is sold, revenue is recorded.
Cost of good sold is not recorded as each sale occurs.
It does not require continual updating of the inventory account.
The company records the cost of new merchandise in a temporary purchase account.
When financial statements are prepared, the company takes a physical count of
inventory by counting quantities of merchandise on hand.
2. Perpetual Inventory system
A perpetual inventory system keeps a continual record of the amount of inventory on
hand.
The merchandise inventory account is updated after each purchase and each sale.
Cost of goods sold account also is updated after each sale
When an item is sold, its cost is recorded in a cost of good sold inventory.
Adjusting the Inventory Account
The adjustment of merchandize inventory has got the following features:
1. It is needed under the periodic inventory system only.
2. It eliminates the beginning merchandize inventory balance.
3. It brings into being the ending merchandize inventory balance determined by the
physical count.
4. The Income Summary account is debited in the adjustment of beginning merchandize
inventory and credited for adjustment of ending merchandize inventory balance.
5. Merchandize Inventory account is credited in the adjustment of beginning merchandize
inventory and debited for adjustment of ending merchandize inventory balance.
The Inventory account usually does not agree with the physical count. If the Periodic method is
being used, the Inventory account has the balance as adjusted at the end of the prior year. If the
Perpetual method is being used, the Inventory account should be close to the physical value
calculated from the physical inventory count. There will always be a difference, and the accounts
must be adjusted so the Inventory account agrees with the physical count and valuation.
Example: The Inventory account has a balance of Br12,500. You take a physical count and
calculate the correct inventory value is BR11,975. You will decrease inventory by Br525 to
adjust the Inventory account the equal the actual physical inventory value.
General Journal
General Ledger
Inventory
[a Balance Sheet account]
The adjusting entry correctly uses an Income Statement account and a Balance Sheet account.
The additional merchandise cost is transferred to the Income Statement in this case, but the
reverse adjustment could just as easily be made.
Cash discount: a reduction granted by the seller for the buyer in the invoice price for prompt
payment when credit period is long and buyers pays with in a certain period ( within a discount
period).
A buyer views a cash discount as a purchase discount
A seller views a cash discount as a sales discount
The arrangement agreed up on by the buyer and sellers as to when payments for merchandize are
to be made are the credit terms.
Common payment terms are explained as under;
Net Cash: No credit is allowed by seller. Payment must be made by the buyer at the time of
purchase
n/30: The amount of an invoice must be paid within 30 days of the date of the invoice.
2/10, n/30: A discount of 2% is allowed if an invoice is paid within 10 days of the date of the
invoice. If payment is not made within 10 days, the total must be paid within 30 days of the
date of the invoice.
n/EOM: Payment of goods must be made by the end of the month in which the goods were
purchased.
C.O.D: Cash on delivery. Under these terms, payment for goods must be made when goods are
delivered to the buyer.
Special Purchase Accounts:
Purchase accounts deal with suppliers and purchase transactions:
Purchase Returns and Refunds
Purchase Allowances
Purchase Discounts
Purchase return and allowances: merchandise may be returned by the buyer because of either
defects in the product or wrong specifications.
Purchase retunes are merchandize received by a purchaser but returned to the supplier
Purchase allowances are a reduction in the cost of defective merchandise received by a
purchaser from the supplier. A form prepared by the buyer containing a record of the
amount of the debit taken by the buyer for returns and similar items is called a debit
memorandum.
Transportation Costs
A. Transportation Costs—responsibility is assigned by terms:
By: Berhanu Gemule(BGK) Public Service College of Oromia/ 2011 Page 30
Principles of Accounting Part I
1. FOB shipping point—buyer pays shipping costs. .
2. Increases cost of merchandise when the purchaser is required to pay for transport
3. Debit Inventory, Credit Cash or Accounts Payable (if to be paid for with merchandise later)
4. FOB destination—seller pays shipping costs.
5. Operating expense for seller
6. Debit Delivery Expense (or Transportation-Out or Freight-Out), Credit Cash.
B. Transfer of Ownership—also defined by terms:
1. FOB shipping point—title transfers at shipping point
2. FOB destination—title transfers at destination.
Sales Discount:
Sales discounts are granted to encourage prompt payments. When a sales discount is granted, the
seller receives less than the sales price recorded at the time of the sale. A sales discount reduces
the revenue from sales. Therefore, it is a contra sales account.
Each merchandizing transactions affect a buyer and a seller. In the following illustrations, we
show you how the same transactions would be recorded by both the seller and the buyer.
Example 1: December 10, 2009, Hope Merchandizing granted credit to Wisdom Co. for
merchandize returned, with a cost price of Birr 3,500; Credit memorandum No. 001.
Sales return & allowance……….3,500
Account receivable……………..3,500
December 15, 2009, Hope merchandising collected from November 5 credit sales.
Cash…………………290,570
Assuming that collection is made by ABC Company on September 20 the entry would be:
Seller Buyer
Cash 9,800 Account payable 10,000
Sales discount 200 Cash 9,800
Account receivable 10,000 Purchase discount 200
3. October 1,2009 ABC company sold merchandise to XYZ company for Br. 2,000 terms 2/10,
n30. October 2 XYZ Company retuned defective item of merchandise that costs Br. 200.
Record journal entries for both seller and buyer
Seller Buyer
Oct. 1 Account receivable 2,000 Purchase 2,000
Sales 2,000 Account payable 2,000
Assuming the collection was made on October 8,2009 the entry would be:
Seller Buyer
Cash 1,764 Account payable 1,800
Sales discount 36 Cash 1,764
2. Multiple Step Form: Multiple step form income statement is divided in to the following
sections:
1. Revenues
2. Cost of goods sold
3. Operating expense
4. Income from operations
5. Other income and expenses
A skeleton form of income statement
Net sales for the period
- Cost of Goods sold
Gross profit
- Operating expense
Income from operations
+ Other income
- Other expenses
Net income
1. Revenue section: provides a figure for net sales, which is the balance of sales account, less the
balance of contra sales accounts (sales return & allowances & sales discounts).
2. Cost of Good sold section:- The cost of merchandize sold to customers during a period is
subtracted from the net sales figure for the same period to the get the amount of gross profit.
Illustration: Kenenisa Sport Company a whole seller sporting goods, had the
following adjusted trial balance at December 31,2010.
Kenenisa Sport Company
Adjusted Trial balance
Operating expenses:
d. Closing entries
Step 1: Close credit balances in temporary accounts to income summary
Dec.31 Sales……………………….321,000
Income summary…………………321,000
Step 2: Close debit balances in temporary accounts to income summary
Dec. 31 Income summary…………..308,100
Sales discount……………………..……4,300
Sales return and allowances………….....2,000
Assets
Cash Br8,200
CostAccounts
of goods receivable
sold…………………….230,400 11,200
Merchandise Inventory 21,000
Office supplies 550
Depreciation expense-store equipment… 3,000
Store supplies 250
Prepaid insurance 300
Office equipment 4,200
Depreciation expense-office equipment… 700
Accumulated depreciation-office equipment 1,400 2,800
Store equipment 30,000
Accumulated depreciation-store equipment 6,000 24,000
Office salaries expense……………… ..25,300
Total assets 68,300
Liabilities
Accounts
Sales salariespayable
expense………………… 18,500 16,000
Salaries payable 800
Total liabilities Br16,800
Owner’s Equity
Insurance expense……………………….. 600
Kenenisa,Capital 51,500
Total liabilities and owner’ equity 68,300
Special controls are needed to protect cash because almost everyone wants it, and it
is easily taken if not protected. Further, it is often easy to conceal that cash has been
taken by altering accounting records. The protection and control of cash are part of
the overall system of internal control.
Some common steps that are used to control and protect cash are:
Those who physically handle cash (cashiers, clerk, etc.) and should not be the
same as those who account for cash (bookkeepers, accountants).
All cash received should be deposited in a bank daily
Only a small amount of cash (called petty cash) should be kept on hand
All cash payments, except for petty cash, should be made by check
Cheeks should be pre numbered so that it is easy to see what cheeks have been
written and when.
Only a few properly designated persons should be involved in the receipt,
payment, and recording of cash.
Receipt and payment of cash should be recorded efficiently and accurately
Cash in bank---------------------------5677.60
Cash short and over-----------------------3.16
Sales-----------------------------------------5680.76
If there is a debit balance in the cash short and over account at the end of the fiscal period; it is
an expense and may be included in the “miscellaneous administrative expense” on the income
statement. If there is a credit balance; it is revenue and may be listed in the other income section.
Cash Change Fund
The fund may be established by drawing a check for the required amount; debiting the
account cash on hand and crediting cash in bank.
Internal Control of Cash Payments
It is common practice for business enterprises to require that a very payment of cash be
evidenced by a check signed by designated officials. As an additional control, some firms
required two signatures on all check or only one checks which are larger than a certain
amount.
If the petty cash fund is not reimbursed at the end of accounting period:
petty cash asset is overstated and
Expenses are understated.
The journal entry to record replenishing the petty cash fund involves a debit
to each item listed in the petty cash payments record and a credit to cash.
Example: - Assume that a voucher system is used and that a petty cash fund of Br 100 is
established on August 1. At the end of August, the petty cash receipts indicate expenditures for
the following items:
Office supplies……………..28
Postage (office supplies)…….22
Store supplies………………..35
Bank Statement: bank statement is a monthly report showing the bank’s record of
the checking account. The bank statement provides the following information about
customers’ cash accounts:
1. The balance at the beginning of the month
2. Additions in the form of deposits and credit memos
3. Deductions in the form of checks and debit memos and
4. The final balance at the end of the month
Canceled checks are checks the bank has paid and deducted from the customer’s
account during the month. Other deductions also often appear on a bank statement
include:
Service charge and fees assessed by the bank
Customer’s cheeks deposited that are uncollectible
The entries for Hope Company, based on the bank reconciliation above are as follows:
July 31 Cash in bank-----------------------------408.00
Notes receivable---------------------------400.00
Interest in come-------------------------------8.00
31 Miscellaneous Expense---------------3.00
Account payable-----------------------9.00
Cash in bank----------------------------12.00
Accounts receivable are amounts that customers owe the company for normal credit
purchases. Since accounts receivable are generally collected within two months of the sale,
they are considered a current asset and usually appear on balance sheets below short-term
investments and above inventory.
Notes receivable are amounts owed to the company by customers or others who have signed
formal promissory notes in acknowledgment of their debts. Promissory notes strengthen a
By: Berhanu Gemule(BGK) Public Service College of Oromia/ 2011 Page 46
Principles of Accounting Part I
company's legal claim against those who fail to pay as promised. The maturity date of a note
determines whether it is placed with current assets or long-term assets on the balance sheet.
Notes that are due in one year or less are considered current assets and notes that are due in more
than one year are considered long-term assets.
Accounts receivable and notes receivable that result from company sales are called trade
receivables, but there are other types of receivables as well. For example, interest revenue from
notes or other interest-bearing assets is accrued at the end of each accounting period and placed
in an account named interest receivable. Wage advances, formal loans to employees, or loans to
other companies create other types of receivables. If significant, these nontrade receivables are
usually listed in separate categories on the balance sheet because each type of nontrade
receivable has distinct risk factors and liquidity characteristics.
Receivables of all types are normally reported on the balance sheet at their net realizable value,
which is the amount the company expects to receive in cash.
To illustrate, assume that on March 23, 2009, Roba Company sold Br 500 worth of
merchandize on account to Hawi Company. On March 26, Hawi returned Br 200
worth of the merchandize because of damage. The sale and the return are recorded
in general journal form on the books of Roba as follows:
2008
March 23. Accounts receivable -Hawi Co ……. 500
Sales ………………….. 500
(Recorded sales on account)
26. Sales return and Allowances …………. 200
Accounts receivable- Hawi Co……. 200
(To record merchandize returned from a customer)
Business owners know that some customers who receive credit will never pay their account
balances. These uncollectible accounts are also called bad debts.
If a customer named Tola fails to pay a Br225 balance, for example, the company records the
write-off by debiting bad debts expense and crediting accounts receivable from Tola. The
appropriate entry for the direct write-off approach is as follows:
2-10-210
Uncollectible Accounts Expense 225
Accounts Receivable
225
To record the write off of an uncollectible
account from Jones
Notice that the preceding entry reduces the receivables balance for the item that is deemed
uncollectible. The offsetting debit is to an expense account: Uncollectible Accounts Expense.
Allowance Method:
Allowance Method
Estimate of doubtful debts made at the end of the period
An adjusting entry is made at the end of each accounting period.
This method is consistent with the principles of accrual accounting, recognizing the
expense in the same period as the related revenue
Records an estimate of the expense in same period as the income to which it relates
Creates an allowance that will be deducted from accounts receivable on the balance sheet
Allowance also known as ‘provision’
Since the specific customer accounts that will become uncollectible are not yet known
when the adjusting entry is made, a contra-asset account named allowance for bad debts,
which is sometimes called allowance for doubtful accounts, is subtracted from accounts
receivable to show the net realizable value of accounts receivable on the balance sheet.
1.3. Estimating Bad Debts expense
The allowance method of accounting for bad debts requires an estimate of bad debts
expense to prepare the adjusting entry at the end of each accounting period. There
are two approaches to estimate bad debts expense using the allowance method:
1. Percentage of Total Receivables method and
2. Percentage of sales method
1. Percentage of Total Receivable methods /Balance sheet Approach/
The accounts receivable methods use balance sheet relations to estimate bad debts
primarily the relation between accounts receivable and the allowance amount. It is
based on the idea that some portion of the end-of- period accounts receivable
balance is not collectible. Estimating uncollectible account using accounts
receivable methods done in one of two ways:
a) Simple estimate of percent uncollectible from the total outstanding accounts
receivable/Percent of accounts receivable approach) and
b) Aging accounts receivable
Unless actual write-offs during the just-completed accounting period perfectly matched the
balance assigned to the allowance for bad debts account at the close of the previous accounting
period, the account will have an existing balance.
If write-offs were less than expected, the account will have a credit balance, and if
write-offs were greater than expected, the account will have a debit balance.
Assuming that the allowance for bad debts account has a Br200 debit balance when the adjusting
entry is made, a Br5,200 adjusting entry is necessary to give the account a credit balance of
Br5,000.
If the allowance for bad debts account had a Br300 credit balance instead of a Br200 debit
balance, a Br4,700 adjusting entry would be needed to give the account a credit balance of
Br5,000.
In general, the longer an account balance is overdue, the less likely the debt is to be paid.
Therefore, many companies maintain an accounts receivable aging schedule, which categorizes
each customer's credit purchases by the length of time they have been outstanding. Each
category's overall balance is multiplied by an estimated percentage of uncollectibility for that
category, and the total of all such calculations serves as the estimate of bad debts. The accounts
receivable aging schedule shown below includes five categories for classifying the age of unpaid
credit purchases. The process of analyzing the receivable accounts in terms of the length of time
past due is called aging the receivables.
To illustrate assume the following age classification as of December 31, 2008 for Hacalu
Company.
Age Amount Provision (%) Estimated uncollectible
0-30 days ----Br 60,000 1% Br 600
31-60 days ------15,000 3% 300
61-90-------------10,000 10% 1,000
91-120--------------8000 20% 2,000
Above 120 --------7000 50% 3,500
Br.100, 000 Br7, 400
If a company has Br500,000 in credit sales during an accounting period and company records
indicate that, on average, 1% of credit sales become uncollectible, the adjusting entry at the end
of the accounting period debits bad debts expense for Br5,000 and credits allowance for bad
debts for Br5,000.
12-31-2009
Uncollectible Accounts Expense 5,000
Companies that use the percentage of credit sales method base the adjusting entry solely on total
credit sales and ignore any existing balance in the allowance for bad debts account. If estimates
fail to match actual bad debts, the percentage rate used to estimate bad debts is adjusted on future
estimates.
Writing off Uncollectible Accounts under Allowance Method: Now, we have seen how to
record uncollectible accounts expense, and establish the related allowance. But, how do we
write off an individual account that is determined to be uncollectible? This part is easy. When a
specific customer's account is identified as uncollectible, it is written off against the balance in
the allowance for bad debts account.
The following entry would be needed to write off a specific account that is finally deemed
uncollectible:
For example, if uncollectible balance of Br5,000 is removed from the books by debiting
allowance for bad debts and crediting accounts receivable.
-15-2010
Allow. for Uncollectible Accounts 5,000
Accounts Receivable
5,000
To record the write-off of an uncollectible
account
Customers whose accounts have already been written off as uncollectible will sometimes pay
their debts. When this happens, two entries are needed to correct the company's accounting
records and show that the customer paid the outstanding balance. The entry to record the recovery
involves two steps:
(1) A reversal of the entry that was made to write off the account, (reinstates the customer's accounts
receivable balance by debiting accounts receivable and crediting allowance for bad debts) and
(2) Recording the cash collection on the account records by debiting cash and crediting accounts
receivable.
6-16-2010
Accounts Receivable 1,000
Allow. for Uncollectible
Accounts 1,000
To reestablish an account previously
written off via the reversal of the
entry recorded at the time of write off
6-16-2010
Cash 1,000
Accounts Receivable
1,000
To record collection of account
receivable
Accounting For Notes Receivable: To illustrate the accounting for a note receivable,
assume that Hope initially sold Br10,000 of merchandise on account to Wisdom. Wisdom later
requested more time to pay, and agreed to give a formal three-month note bearing interest at
12% per year. The entry to record the conversion of the account receivable to a formal note is
as follows:
1/6/2010
Notes Receivable 10,000
Accounts Receivable
10,000
To record conversion of an account
receivable to a note receivable
The principal and interest of a note are due on its maturity date. The maker of the
note usually honors the note and pays it in full.
The note that is paid in full at its maturity date is called honored note.
When the note matures, Hope's entry to record collection of the maturity value would
appear as follows:
31/8/2010
Cash 10,300
Interest Income
300
Notes Receivable
10,000
To record collection of note receivable
plus accrued interest of Br300
(Br10,000 X 12% X 90/360)
A Dishonored Note: When a note’s maker is unable or refuses to pay at maturity, the
note is dishonored. When a note is dishonored, we remove the amount of this note
from the note receivable account and charge it back to an account receivable from
its maker.
If Wisdom dishonored the note at maturity (i.e., refused to pay), then Hope would prepare the
following entry:
31/8/2010
Accounts Receivable 10,300
Interest Income
300
Notes Receivable
10,000
To record dishonor of note receivable
plus accrued interest of Br300
(Br10,000 X 12% X 90/360)
The debit to Accounts Receivable in the above entry reflects the hope of eventually collecting
all amounts due, including the interest, from the dishonoring party. If Hope anticipated some
difficulty in collecting the receivable, appropriate allowances would be established in a fashion
similar to those illustrated earlier in the chapter.
Notes and Adjusting Entries: In the above illustrations for Hope, all of the activity occurred
within the same accounting year. However, if Hope had a June 30 accounting year end, then an
adjustment would be needed to reflect accrued interest at year-end. The appropriate entries
illustrate this important accrual concept:
1/6/2010
Notes Receivable 10,000
Accounts Receivable
10,000
To record conversion of an account
receivable to a note receivable
30/6/2010
Interest Receivable 100
Interest Income
100
To record accrued interest at June 30
(Br10,000 X 12% X 30/360 = Br100)
Entry to record collection of note (including amounts previously accrued at June 30):
31/8/2010
Cash 10,300
Interest Income
200
Interest Receivable
100
Notes Receivable
10,000
To record collection of note receivable
plus interest of Br300 (Br10,000 X
12% X 90/360); Br100 of the total
interest had been previously accrued
Companies sometimes need cash before customers pay their account balances. In such
situations, the company may choose to sell accounts receivable to another company
that specializes in collections. This process is called factoring.
The company that purchases accounts receivable is often called a factor.
The factor usually charges between one and fifteen percent of the account balances.
The reason for such a wide range in fees is that the receivables may be factored with or
without recourse. Recourse means the company factoring the receivables agrees to
reimburse the factor for uncollectible accounts. Low percentage rates are usually
offered only when recourse is provided.
Suppose a company factors Br500,000 in accounts receivable at a rate of 3%. The company
records this sale of accounts receivable by debiting cash for Br485,000, debiting factoring
expense (or service charge expense) for Br15,000, and crediting accounts receivable for
Br500,000.
Cash……………………….485,000
Factoring fees expense……. 15,000
Accounts receivable……………..500,000
(Factor accounts worth Br500,000)
In practice, the credit to accounts receivable would need to identity the specific subsidiary ledger
accounts that were factored, although to simplify the example this is not done here.
Stocks and bonds held as temporary investments are classified on the balance sheet as
current assets. They may be listed after "Cash," or they may be combined with cash and
described as "Cash and marketable securities."
Temporary investments and all receivables that are expected to be realized in cash within
a year are presented in the Current Assets section of the balance sheet. It is customary to
list the assets in the order of their liquidity, that is, in the order in which they can be
converted to cash in normal operations.