First & Second Chapter

Accounting is the art of measuring, summarizing and communicating the results of business
operations.

Types of Businesses

1. Services Business
2. Merchandising Business
3. Manufacturer Business

Users of Accounting Information.

1. External Users e.g. Owners, Creditors, Labor unions, Governmental agencies, Suppliers,
Customers, Trade associations, General public have financial interest in the business and are not
involved in day to day operations of the business entity.
2. Internal Users e.g. Managers, Production supervisors, Finance directors, and Company officers,
who plan, organize and run business.

Types of Accounting Information

1. Financial Accounting has 4 major parts i.e. Balance Sheet, Income Statements, Statement of
Changes of equity and statement of cash accounts. It is basically about recording and
classifying the transactions of the business.
2. Cost Accounting is the process of tracking, recording and analyzing costs associated with the
activity of an organization, where cost is defined as 'required time or resources'. Costs are
measured in units of currency.
3. Managerial Accounting is the accounting information that aids in decision making. It mostly
is a mixture of accounting financial information and other factors such as politics and
fashions etc.

Transactions: Any event or dealing which causes a change in the firms financial position and can
be measured in monetary terms is called Transaction.

Transactions are the inputs.

Transactions Accounting Process Financial Statements

Assets: All economic resources which are owned by the business and can benefit the future operations
of the business are called Assets. There are two types of assets.
 1. Current Assets are the assets that are converted into cash or used up within one year. E.g.
Cash, marketable securities (investments), notes receivable, bill receivable, inventory (stock),
prepaid expenses etc.

2. Fixed Assets are the assets which are used up or give benefit to the business for more than one
year. Fixed assets are also known as plant assets, long lived assets and non current assets.

Capital: Capital is the residual claim or the right of the owner on business assets.
It is obtained by the equation called Balance Sheet equation or Accounting equation.

It states that:
Assets - Liabilities = Capital (Owners Equity)
OR
Assets = Liabilities + Owners Equity (Capital)

It increases by 2 ways.

1. By additional investment of the owner.

2. By earning revenue or income.

It decreases by 2 ways.

1. By withdrawal by owner.
2. By expenses or losses.

Expenses: The cost price of the goods and services consumed in the process of earning revenue e.g.
rent, salaries, supplies etc. The amount or resources paid or consumed by the business.

Revenue: Sale price of goods and the services sold to customer during a specific period is called
revenue. The amount (all the) consumers paid during an accounting period.

There are two conditions for the realization of revenues.

1. Good or services should have been delivered to the customer (Transaction should be completed).
2. Liability for the goods has been accepted by the customer.

In a case of services business, revenues name is services revenue or a name relevant to the types of
services being offered (e.g. medical fees, legal free, and/or commission revenue). In a case of
merchandising/manufacturer business, the revenues name is the same i.e. Sales revenue.
Balance Sheet: A statement which shows the financial position of the business on a particular day
(at a particular time).

Account Format of Balance Sheet

ABC (Company)
Balance Sheet
As on 31st Dec, 2004
ASSETS LIABILITIES & OWNERS EQUITY

Liabilities
Cash Rs. 10,000 Note Payables Rs. 5,000
Marketable Securities Rs. 15,000 Account Payables Rs. 10,000
Notes Receivable Rs. 20,000 Salaries Payable Rs. 5,000
Supplies Rs. 5,000 Long term Bank Loan Rs. 15,000
Prepaid Expenses Rs. 2,000
Land Rs. 20,000 Subtotal Rs. 30,000
Building Rs. 30,000
Equipment Rs .5,000 Owners Equity
Mr. As Capital Rs. 82,000

Total Rs. 112,000 Total Rs. 112,000

NOTE: There are 3 orders in which account-titles are listed in the balance sheet.
1. Liquidity means nearness to cash. While making balance sheet, liquidity
order is observed.
2. Permanence order is the opposite of liquidity order. Some officials use
permanence order.
3. Mixed order is used by banks. Assets are listed in liquidity order and
liabilities are listed in permanence order.

Income Statements: A statement which represents the results of business operations for a specific
period in the form of net income or net loss.

The income statements equation is

All Revenues All Expenses = Net Income/Loss

 ABC (A Law Firm)
Income Statement
For the year ended on Dec 31st, 2004

Revenues

Legal Fees (Revenue) Rs. 50,000

Expenses

Rent Expenses Rs. 10,000

Salaries Expenses Rs. 5,000
Supplies Expenses Rs. 2,000
Utility Expenses Rs. 5,000
Misc. Expenses Rs. 3,000

Total Expenses Rs. 25,000

Net Income Rs. 25,000

Statement of Cash Flows: A statement which summarizes the cash collections and cash
payments made during the same period as covered by the income statement (for the same accounting
period).

These cash flows can be categorized into 3 forms.

1. Operating Cash Flows are the cash flows associated with the revenues or expenses
and increase or decrease takes places in current assets and current liabilities except
for Bank loans.

2. Investing Cash Flows are the cash flows associated with the sale and purchase of
fixed assets.

3. Financing Cash Flows are the cash flows associated with the financing of the
business. These include acquiring or retiring bank loans (short of long term) and
additional investment or drawing by the owner.
 Business Name
Statement of Cash Flows
For the period April 1 6, 2004

Cash Flows from Operation Activities

Cash revenue 5,500

Cash Expense (4,000)

Cash from Operation Activities 1,500

Cash Flows from Investing Activities

Bought Land (66,000)

Cash from Investing Activities (66,000)

Cash Flows from Financing Activities

Additional Investment by owner 80,000

Cash from Financing Activities 80,000

Net increase 15,500

Beginning Cash Balance 300,000

Ending Cash Balance 315,500

Statement of Owners Equity: A statement which summarizes owners net worth.

ABC (Company)
Statement of Owners Equity
For the year ended Dec 31, 2003

Beginning Capital (as on Jan 1, 2003) 100,000

Add: Net Income 20,000
Additional Investment 10,000
30,000

Subtotal 130,000
Less: Drawings 15,000

Ending Capital (as on Dec 31, 2003) 115,000

 GAAP (Generally Accepted Accounting Principles)

Cost Principle (Historic Cost Principle)

All assets (especially fixed assets) are recorded in the accounting records and financial statements at
their original cost less (if any) accumulative depreciation.

Business Entity Principle

It states that from accountings point of view, business is a separate entity from its owner(s). That means
business's assets; liabilities and operations are kept separate from owners personal assets, liabilities and
operations.

Going Concern Principle

A business will continue its operations indefinitely. Thus, the assets it uses to run the business are not for
sale, and their market values are irrelevant to decision making.

Stable Currency Principle

The value of the currency used to measure accounting transactions does not fluctuate much from period
to period. If it does fluctuate, the fluctuation is ignored.

Realization Principle
A business records revenues when it ships goods or completes a service; in short, when it has done
everything needed to complete its part of the transaction.

Matching Principle
Expenses incurred in generating revenues must be recorded in the same time period that the revenues are
recorded.

Consistency Principle
An organization must persistently use the same accounting procedures period after period or inform the
user that a procedure has changed.

Adequate Disclosures
This GAAP states that all the information that is required for proper interpretation of financial
statements should accompany them while keep in view the costs for producing that information.

Concept of Materiality
It means that significance of an item should be considered when it is reported in the financial statements.

Principle of Consistency
It states that a business must use the same method of accounting throughout and should notify of any
changes.

Order of Making of Financial Statements

 Income statement Statement of owners equity
Balance sheet Statement of cash flows

Third Chapter

Ledger: A book which contains all the accounts of the business at one place.

Ledger Account: An account is a record which is used to summarize the changes taking places in a
particular financial statement item. I.e. any assets, liability, capital, revenue or expense item
E.g. Cash, Accounts Receivables etc

Account Title
Dr. Cr.

Debit Side Credit Side

T Account Version
(Simplified)

Account Title
Account No. Page No.
Dr. Cr.
Date Particulars J. F Amount Date Particulars J. F Amount

T Account Version
(Detailed)

Page No.
Account Title
Date Particulars J.F. Debit Credit Balance

Running Balance Account

Types of Accounts: There are 5 types of accounts.

1. Assets Accounts
2. Liability Accounts
3. Capital Accounts
4. Revenue Accounts
 5. Expense Accounts

Debit & Credit Rules

1. For Assets Accounts

Increase in assets are recorded as Debit
Decrease in assets is recorded as Credit.

2. For Liabilities Accounts

Increase in liabilities are recorded as Credit
Decrease in liabilities is recorded as Debit.

3. For Capital Accounts

Increase in capital is recorded as Credit
Decrease in capital is recorded as Debit

4. For Revenue Accounts

Increase in revenue is recorded as Credit
Decrease in revenue is recorded as Debit

5. For Expense Accounts

Increase in expense is recorded as Debit
Decrease in expense is recorded as Credit

Debit Credit

Increase in Assets Increase in Liabilities

Increase in Expense Increase in Capital
Increase in Revenue

Journal: A book of original entry in which transactions are recorded in chronological order.
Transactions are first recorded in the journal, showing which accounts have been debited and which
have been credited. The journal is then used to update the respective ledger accounts.

Journal Format

Date Account Title and Explanation Ledger Debit Credit

Folio
Accounting Cycle: The sequence of recording, classifying and summarizing the business
transactions is named as accounting cycle.
It starts from recording the transaction in the Journal and its end product is the preparation of Financial
Statements.

There are 8 steps in the Accounting cycle.

1. Journalizing the transaction

2. Posting the transaction into ledger accounts
3. Preparation of a trial balance
4. Making adjusting entries
5. Preparation of adjusted trail balances
6. Preparing financial statements (Income statement, Statement of owners equity, balance sheet,
statement of cash flows)
7. Making Closing entries
8. Preparation of after-closing (post-closing) trial balances.

Trial Balance: A trail balance is a two column schedule prepared at the end of the period with
account titles and account balances in order to check the equality of debits and credits before preparing
the financial statements.

For explanation of Accounting Cycle, problem 3.5 was solved. (On page number 134)
1st Step: Journalizing the Transaction.
Date Account Titles L.F Debit Credit
June 1 Cash 60,000
Pat Campbell, Capital 60,000
June 2 Aircraft 220,000
Cash 40,000
Notes Payable 180,000
June 4 Rent Expense 2500
Cash 2500
June 15 A/c Receivable 8320
Crop-Dusting Revenue 8320
June 15 Salaries Expense 5880
Cash 5880
June 18 Maintenance Expense 1890
Cash 1890
June 25 Cash 4910
A/c Receivable 4910
June 30 A/c Receivable 16450
Services Revenue 16450
June 30 Salaries Expense 6000
Cash 6000
June 30 Fuel Expense 2510
A/c Payable 2510
June 30 Pat Campbell, Drawing 2000
 Cash 2000

2nd Step: Posting Into Ledger Accounts.

CASH
Dr. Cr.
June 1 6,000 June 2 40,000
June 25 4910 June 4 2500
June15 5880
June 18 1890
June30 6000
June 30 2000
64910 58270
6640

3rd Step: Preparation of a Trial Balance.

Campbell Crop Dusting

Trail Balance
As on Dec 30, 2001
Account Titles Dr. Balance Cr. Balance
Cash 6,640
A/c Receivable 19,860
Aircraft 220,000
Notes Payable 180,000
A/c Payable 2510
Capital 60,000
Drawing 2000
Revenue 24770
Salaries Expense 11880
Fuel Expense 2510
Rent Expense 2500
Repair Expense 1890
TOTAL 267280 267280
Note: Liquidity Order is observed in making trail balances. Balance Sheet accounts come before Income statement accounts.

4th Step: Making Adjusting Entries.

Entries made at the end of the period in order to update certain ledger accounts are named
as Adjusting Entries.
Adjusting Entries are firstly recorded in the Journal and then posted to the Ledger.
The purpose of making adjusting entries is to allocate, to each period, the appropriate
amount of revenue and expenses.
5th Step: Adjusted Trial Balance.

A trial balance which is prepared after recording and posting of the adjusting entries is called
Adjusted Trial Balance. Income statement, statement of owners equity and balance sheet are
prepared directly from the adjusted trial balance

6th Step: Preparing Financial Statements.

7th Step: Closing Entries.

Entries made at the end of the accounting period to close the temporary accounts are called
Closing Entries.

By temporary accounts we mean accounts for revenue, expenses and drawing (or dividends in
case of Corporation.) Assets, liabilities and capital accounts are permanent.

There are 4 closing entries. General formats of each have been given.

1. Entries to close the revenue account(s).

Date Account Title Dr. Cr.

st
31 Dec Revenue Account xxx
Income Summary Account6 xxx
(Profile & Loss Account)

2. Entries to close the expense accounts

Date Account Title Dr. Cr.

31st Dec Income Summary Account xxx
(Profile & Loss Account)
Expense Account xxx

3. Entry to close the Income Summary Account(s) 6.

(i) In Case of Profit

Date Account Title Dr. Cr.
31st Dec Income Summary Account xxx
Capital Account xxx

(ii) In Case of Loss

Date Account Title Dr. Cr.
31st Dec Capital Account xxx
 Income Summary Account xxx

4. Entry to close the Drawing or Dividends Account(s).

Date Account Title Dr. Cr.

31st Dec Capital Account xxx
Drawing Account xxx

8th Step: Post-Closing Trial Balance

A trial balance prepared after the closing entries are recorded in Journal and posted to their
respective ledger accounts, is called Post-Closing Trial Balance.

This trial balance contains only assets, liabilities and capital accounts.

Depreciation [Cost of Asset Residual Value1 (Salvage Value)]

= -------------------------------------------------------------
Expenses Useful Life of Asset2

ADEQUATE DISCLOSURES FOR CHAPTER 3:

1. If residual value is not given, then it is assumed zero.
2. If life is given in months, then depreciation expense is also taken in per month.
3. The double entry system of accounting is the system in which 2 entries are made for each business transaction. One for debiting
certain account(s) and the other for crediting the corresponding account(s). The amount by which account(s) are debited is equal
to the amount by each corresponding accounts are credited.
This system makes possible the measurement of net income and also the use of error-detecting devices. (E.g. trial balance)
4. Accumulated Depreciation is a contra-asset account shown below the related asset account as a deduction from that asset account.
The depreciation through-out the life of an asset is called Accumulated Depreciation.
5. Income Summary A/c is the account in the ledger into which revenue and expense accounts are closed. Credit balance of this
account means net income or profit, Debit balance means net loss. This account is later closed into the Capital account.
6. Adequate disclosures establish that information necessary for proper interpretation of the financial statements should accompany
them. E.g. accounting system used, due dates of liabilities, depreciation policy, Lawsuits pending on the business etc.
Adequate disclosures are based on facts and reasonable estimates and not optimistic assumptions.
 Fourth Chapter
Adjusting Entries

Adjusting entries are made for internal adjustments. The basis of adjusting entries are two GAAP i.e.
Matching principle and Realization principle. These are fundamentally based on the accrual basis of
accounting. By accrual, we mean revenues or expenses that have grown or accumulated over time.
Accrued revenues need to be collected whereas accrued expenses need to be paid off.

Cash isnt mostly involved in adjusting entries because adjustment is made in our accounting records
only.

There are four types of Adjusting Entries.

1. Entries to apportion the recorded cost.

2. Entries to apportion the unearned revenues.
3. Entries to apportion the unrecorded expenses.
4. Entries to apportion the unrecorded revenues.

1. Entries to apportion the recorded cost

There are some costs which are firstly recorded as an asset as their benefit extends beyond one
accounting period. At the end of the period, it is necessary to allocate some portion of the
recorded cost (which has expired) to expense.
E.g. deprecation expense, supplies expense, prepaid expenses, unexpired insurance etc.

For this adjustment, expense account is debited and asset or contra-asset account is credited.

Date Account Title Dr. Cr.

Jan 1 Depreciation Expense: Furniture xxx
Accumulated Depreciation1: Furniture xxx
Apr 6 Rent Expense xxx
(2nd exp) Prepaid Rent Expense xxx

2. Entries to record the unrecorded expenses (Accrued expenses)

There are some expenses which are still unrecorded at the end of the accounting period but the
business has consumed those expenses. E.g. salaries are given at the 15th of each month but the
accounting period ends on the 30th or 31st.
E.g. Depreciation expense, salaries expense, Interest expense.

For this adjustment, Expense account is debited and a liability account is credited.

Date Account Title Dr. Cr.

Jan 1 Salaries Expense xxx
Salaries Payable xxx
Apr 6 Interest Expense xxx
(2nd exp) Interest Payable xxx

3. Entries to apportion the unearned revenue

Sometimes the business may collect, in advance, cash from its customers, against which goods or
services are to be delivered in the future. This advance is the liability of the business named as
Unearned Revenue or deferred revenue (a liability account).
E.g. advance payments of airline tickets.

For adjustment purposes, the unearned revenue account is debited and the revenue account is
credited.

Date Account Title Dr. Cr.

Apr 6 Unearned Revenue xxx
Revenue xxx

4. Entries to record the Accrued Revenue (Unrecorded Revenue)

There are some revenues which the business has earned during the period but still has not billed
the customers or still has not recorded it into its accounting records.
E.g. interest revenue.

For adjustment of this type, Account receivables are debited and the appropriate revenue account
is credited
.
Date Account Title Dr. Cr.
Apr 6 Accounts Receivables xxx
Revenue xxx

Workshit: A spreadsheet which displays the balances on the unadjusted trial balance, proposed
adjusting entries and the effects which adjusting entries will make on financial statements.
OR
A multicolumn schedule showing the relationships among items in trial balance, proposed adjusting
entries and the financial statements that would result if those adjustments are made.

It is prepared at the end of the period before adjusting entries are recorded into accounting records.
It is useful for accountants as they can see the effects of adjusting entries on financial statements items.
Thus, errors could be corrected or estimated amounts could be altered accordingly. It also enables the
internal users to preview the financial statements before they are made. A worksheet also enables the
preparation of interim financial statements4.

The preparation of Worksheet involves 5 steps.

1. Enter the ledger account balance in the Trial Balance columns.

2. Enter the adjustments in the Adjustments Column.
3. Prepare an Adjusted Trial Balance
 4. Enter balances from the Adjusted Trial balance column to their respective financial
statement columns.
5. Total the financial statement columns

ABC(Business Name)
Worksheet
For the year ended Dec 31, 2005

Trial Balance Adjustments Adjusted Income Balance

Trial Balance Statement Sheet
Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Balance Sheet
Accounts:
Cash 29,250 29,250 29,250
A/c Receivables 6500 6500 6500
Supplies 6600 6600 6600
Prepaid expenses 2300 2300 2300
Land 123000 123000 123000
Building 420000 420000 420000
Acc. Dep.: 6600 6600 6600
Building
Tools 57000 57000 57000
Acc. Dep.: Tools 7000 7000 7000
Notes Payable 24000 24000 24000
Interest Payable 5200 5200 5200
Wages Payable 16000 16000 16000
Unearned 600 6000 6000
Revenue
Capital 86000 86000 86000
Drawing 23000 23000 23000

Income Statement
Accounts:
Revenue 162960 162960 162960
Advertising 3460 3460 3460
Expense
Wages Expense 44269 44269 44269
Supplies Expense 3590 3590 3590
Dep. Exp.: 450 450 450
Building
Dep. Exp: Tools 890 890 890
Interest Expense 200 200 200 ..
XXX XXX YYY YYY ZZZ ZZZ XXY XXY
Net Income XYY XYY
XYZ XYZ XYX XYX

Layout of a Worksheet
Sample Only
ADEQUATE DISCLOSURES FOR CHAPTER 4:
 1. Accumulative depreciation is only for assets whose volume doesnt change. They are mostly fixed assets.
2. Prepaid expenses are our assets and Unearned Revenue is our liability.
3. Principle x Rate of Interest x Time Period ( P x R x T) is the interest equation
4. Interim financial statements are the financial statements an organization makes at various points during a fiscal year.

Fifth Chapter
Merchandising Business

Merchandising Business: A business that is selling goods, which are purchased by the business in
ready-to-sell condition, to generate revenue. The revenue in merchandising business is called Sales
Revenue. Goods or inventory, bought for sale, is relatively a liquid asset that is usually sold within days
or weeks. For this reason, inventory appears near the top of the balance sheet immediately below
Accounts Receivables. For services and merchandising business, the supplies are the same as
inventories or stock. For manufacturers business, raw material, semi-finished goods and finished goods
are the stock/inventory.

MERCHANDISING BUSINESS WHOLE SELLERS RETAILERS CONSUMERS

Whole sellers purchase goods in bulk from the manufacturer and sell to secondary whole sellers or
distributors. Retailers purchase goods from whole sellers or distributors and sell to the final consumers.

Operating Cycle of Merchandising Business: The sequence of activities through which

revenues and cash receipts are generated is called the operating cycle of merchandising business.

There are 3 steps in the operating cycle of merchandising business.

1. Purchase of Inventory/Stock.
2. Selling of merchandise or inventory on account.
3. Collection of accounts receivable.

The time (in days) used to collect money is called average collection period. The length of
operating cycle is specified in days. Length of operating cycle is inversely proportional to the
strength of the business. The time taken to sell goods is called inventory transit time. The cost of
goods sold is the largest cost in merchandising business.
 NOTE:
Gross profit = Sale price of goods direct expenses such as labor salaries, transportation expenses etc.
Net profit = Sale price of goods all expense (direct or indirect) such as stationary, phone bills etc.
Inventory = Stock = Goods = Merchandise; they all mean the same.

Income statement for Merchandising Business

ABC (Company)
Income Statement
For the period ended Dec 31, 2004

Sales Rs. 100,000

Less: Cost of goods sold Rs. 60,000
Gross Profit Rs. 40,000
Less: Other expenses: Rs. 15,000
Net Income Rs. 25,000

Note: The Cost of Goods Sold A/c is an expense account. It is the largest cost or expense or item appearing in the income statement of a
merchandising business.
Gross profit is also called Gross Margin.

Subsidiary Ledger: A book or a register which contains a separate account for each item in the
general ledger. For example, Inventory ledger, Customer book, Supplier register etc.

Control Account: The account in the general ledger for which a subsidiary ledger is kept is called a
Control Account. Also called Controlling Account, it summarizes the total of all of its relevant
subsidiary accounts. The balances of all subsidiary accounts add up to give the balance of their control
account..

Subsidiary Account: A subsidiary ledger account is a separate and detailed account for each item in
its control account.

Inventory Subsidiary Ledger (Inventory Ledger): An inventory ledger is a subsidiary ledger

that keeps a separate account for each item or product in the inventory. It maintains the records for
inventory bought, sold and the result of that change in inventory in the balance column.

Customer book: A book having the names, addresses and summaries of transactions or dealings of all
the customers in one place

Supplier book: A register having the names, addresses and summaries of transactions of all the
suppliers in one place.

Inventory Systems: There are two approaches for recording the merchandising transaction

Periodic Inventory System

 Perpetual Inventory System

Periodic Inventory System: Under this system, the inventory records are only updated at the end of
the accounting period by taking a complete physical inventory. No effort is made to keep the CGS or
Inventory account up-to-date. An inventory subsidiary ledger is optional under periodic inventory
system. If maintained, it is kept in units only.

Purchases of merchandise are recorded by debiting the Purchases account and

crediting the cash or accounts payable account.

Date Account Titles & Descriptions Debit Credit

Purchases xxx
Cash/Acc. Payable xxx

Sale of inventory requires only one entry, the entry to recognize the sales revenue.

Date Account Titles & Descriptions Debit Credit

Cash/Acc. Receivables xxx
Sales Revenue xxx

A physical inventory determines the amount of inventory appearing in the balance sheet. The cost of
goods sold for the whole year is determined at the end of the period by the following schedule.

Costs of goods sold

Beginning Inventory (Year 2005) 100
Add Purchases (During Year 2005) 500
Cost of goods available for sale 600
Less Ending Inventory (End of Year 2005)200
Cost of good sold (For Year 2005) 400

Note: The beginning inventory of Year 2005 is the ending inventory of last year (i.e. 2004. Cost of goods available
for sale is the amount that was available for sale during 2000.

Closing Process: For closing process in periodic inventory system, a CGS account is created. After
the creation of a CGS account, the closing is done in the same method as in Perpetual inventory system.

A Cost of Goods Sold account is created by two entries. The first entry is to create the CGS account by
bringing together the costs which contribute towards the CGS. The costs contributing towards the CGS
are Beginning inventory and purchases which are both closed into the CGS account. The second entry
adjusts its balance by debiting the Ending Inventory account and crediting the CGS account.

Date Account Titles & Descriptions Debit Credit

Sep 28 Cost of Goods Sold xxx
Inventory (Beginning) xxx
 Purchases xxx
Sep 28 Inventory (Ending) xxx
Cost of Goods Sold xxx

Perpetual Inventory System: Under perpetual inventory system, the stock books/ledger accounts
and/or inventory records are updated perpetually or continuously as the transaction occur. Under this
system, inventory subsidiary ledger is also maintained.

Purchase of merchandise is recorded by debiting an asset account, called inventory

(stock), and crediting Cash or A/c Payable account(s).

Date Account Titles & Descriptions Debit Credit

Inventory xxx
Cash/Acc. Payable xxx

The sale of merchandise requires two entries.

One entry to recognize the revenue earned and the other to recognize the related cost
of goods sold. This second entry also reduces the balance of inventory account to
reflect the sale of some of the companys stock.

Date Account Titles & Descriptions Debit Credit

Cash/Acc. Receivables xxx
Sales Revenue xxx
Cost of goods sold xxx
Inventory xxx

The entry for collection of accounts receivables is as follows. Cash is debited whereas
accounts receivables is credited.

Date Account Titles & Descriptions Debit Credit

Cash xxx
Accounts Receivable xxx

Layout of Inventory Subsidiary Ledger

Item: 21 TVs Supplier: Farooq Electronics

Description: LG Flatron Max Level: 500
Location: Store room #5 (A.K.A Order Point) Min Level: 20

Date Purchased Sold Balance

Unit Unit Total Unit Unit Total Unit Unit Total
Cost Cost Cost Cost Cost Cost
 Jan 1 50 100 5000 50 100 5000
Jan 2 10 100 1000 40 100 4000

Control Account for Inventory

Dr. Inventory Cr.
5000 1000

Journal Entry

Date Account Titles & Descriptions Debit Credit

Jan 1 Inventory 5000
Purchase Cash (A/c Payable) 5000
Jan 12 Cash 1500
Sale entry 1 Sales Revenue 1500
(This new price includes our profit)
Jan 12 Cost of goods sold 1000
Sale entry 2 Inventory 1000
(This is the price on which we bought the stock)

Taking Physical Inventory: When physical inventory is taken, management uses the inventory
ledger to determine on a product-by-product basis whether inventory on hand corresponds to the amount
indicated in inventory ledger.

The lessening of inventory on hand is called Inventory Shrinkage. It refers to unrecorded decreases in
inventory resulting from factors such as breakage, spoilage, theft or shoplifting. The process of taking
physical inventory is done usually once a year near the year-end. After taking physical count, the per
unit costs in inventory ledger determine the balance of Inventory Account.

The Inventory account is then adjusted in accordance with Inventory Shrinkage. The adjusting entry to
record shrinkage of inventory is as follows:

Date Account Titles & Descriptions Debit Credit

Apr 6 Cost of Goods Sold xxx
Inventory xxx
(To adjust perpetual inventory records to reflect inventory
shrinkage)

If a large amount of inventory shrinkage occurs through events such as fire or earthquake or theft, the
cost of missing or damaged goods can be debited to a Special Loss A/c. In the income statement, a loss
is deducted from the revenue in the same manner as an expense.

Special Journal: An accounting record designed to keep record of specified types of routine
transactions quickly and efficiently.
Sales Return & Allowances: The journal entry for returned goods is the opposite of the entry for
selling merchandise. The first entry if goods are returned or an allowance is given is as follows.

Date Account Titles & Descriptions Debit Credit

Apr 6 Sales Return & Allowances* xxx*
Acc. Receivables/Cash xxx
*Sales Return & Allowances is a contra-revenue account. It is deducted from gross sales when determining net sales.

The second entry, only if goods are returned, is as follows.

Date Account Titles & Descriptions Debit Credit

Apr 6 Inventory xxx
Cost of Goods sold xxx

Sales Discounts: If goods are sold on credit, an incentive given by the manufacturers for the
customer to encourage an early payment is called a Discount. The term n/30 means that full(net)
payment is due in 30 days. 10eom means within 10 days after the end of this month. 2/10 n/30 means a
2% discount is available if payment is made within 10 days but full payment is due in 30 days. It is read
as 2, 10 net 30.

The period for which a discount is available is called the Discount period. For buyers, the cash discount
is called Purchase discount and sellers refer it as Sales Discount.

Initially, the seller records the sale and the related account receivables at the invoiced price. If payment
is made after the discount period, no extra entries are required.
However, if the payment is made within the discount period, the following entry is made.

Date Account Titles & Descriptions Debit Credit

Apr 6 Cash xxx
Sales Discount* xxx
Accounts Receivables xxx
*Sales Discount is a Contra-Revenue Account. Contra asset accounts are deducted from Revenue for computing net sales and have debit
balances.

Sales Taxes: Sales tax is only applicable on the price offered to the final consumer. It is not applicable
on the transactions between manufacturer and whole-seller or distributor.

Sales tax is collected from the consumer himself and given to the government by the selling
organization.

The entry for sales tax may be recorded at the sale of merchandise for which the entry is as specified.

Date Account Titles & Descriptions Debit Credit

Apr 6 Cash/Acc. Receivables xxx
Sales xxx
Sales Tax Payable xxx

ADEQUATE DISCLOSURES FOR CHAPTER 5:

 1. Cost of an asset includes all expenses to bring it into use. E.g. transportation expenses, licensing fee.
2. Contra-Revenue A/c are closed into P&L account in the same manner as expense accounts.
3. If the seller pays for Delivery expenses, the cost is debited to a Delivery Expenses account.
4. Gross profit margin or gross profit ratio or gross profit rate is ratio of gross profit to net sales.

Seventh Chapter
Financial Assets

Financial Assets: Financial assets mean cash or highly liquid assets that can be converted into a
know amount of cash.

There are three types of financial assets.

1. Cash
2. Short Term Investments or Marketable Securities
3. Receivables

The value of cash is its face amount. The value of Marketable Securities may change daily based upon
different factors such as interest rates, stock prices etc. That is the reason why Short Term Investments
appear in the balance sheet at their current market value.
Accounts Receivables are stated at the amount which is expected to be received. Thus, Accounts
Receivables are recorded at their Net Realizable Value.

Cash: It is defined as the money on deposit in the bank and any items that banks will accept for deposit
including coin, paper money, cheques, money orders and travelers cheques.

Cash is listed on the top of all assets because it is the most liquid. The Cash account is usually combined
with cash equivalents and listed as Cash & Cash Equivalents.

Cash Equivalents include some short-term investments e.g. money market funds, treasury bills. To
qualify for a Cash Equivalent, an investment must be very safe, have a stable market value and mature
within 90 days from the date of acquisition.

Restricted Cash is the cash that is not available for paying current liabilities thus is not a current asset. It
is written directly after current assets as Investments & Funds.

Line of Credit is an agreement of the organization with its bank that the bank will let the business lend
any amount of money up to a specified limit. Money can be drawn using cheques . Liability arises as
soon as a portion of credit line is used. The unused Line of Credit is not an Asset. It just increases a
businesss solvency and is revealed in Adequate Disclosures.

Bank Reconciliation is a schedule explaining differences between the balance shown on bank statement
and the balance shown in customers accounting records. The need for reconciliation arises usually when
both the accounting records are not updated evenly or because of outstanding cheques or due to deposits
in transit. Conflicts may also arise when the customer has not yet recorded the services charges that the
bank has deducted from the account.

Petty Cash is the small amount of cash a business keeps at hand for miscellaneous expenses.
Marketable Securities/Short-Term Investments: A company having extra cash can invest its
reserves temporarily so that it generates revenue in the form of interest or dividend.
Marketable Securities mostly consist of investments in bonds and in stocks of publicly owned
corporations. Stocks are traded on daily basis in Stock Exchanges. Short-Term Investments are highly
liquid i.e. they can be sold immediately for cash at their quoted price.

Short term investments in marketable securities appear in the balance sheet at their current market value
as on the date of the balance sheet.

There are three types of marketable securities. Available for sale securities, trading securities and held to
maturity securities. This classification is based upon managers intent.

The value of marketable securities are adjusted to their market value on the balance-sheet-date. This
principle is called Mark to Market. The profit or loss due to adjustment of Mark to Market principle is
settled in an account called Unrealized Holding Gain or Unrealized Holding Loss. This account
appears as a special equity account in the balance sheet.

Accounts Receivable: Accounts Receivable are relatively liquid assets that are converted into cash
within a period of 30 60 days depending on the companys policies. Therefore, accounts receivable
appear in the balance sheet directly after cash and marketable securities. Accounts receivable that
require more than one year to be fully collected are also listed as current assets.6

Accounts receivables are listed in the balance sheet at their Net Realizable Value i.e. the receivables that
are expected to be recovered. A part of accounts receivable that has become doubtful is no longer an
asset. The amount of accounts receivables termed uncollectible are debited to an expense account called
Uncollectible Accounts Expense.

The entry when a portion of accounts receivable becomes doubtful is as follows:

Date Account Titles & Descriptions Debit Credit

Apr 6 Uncollectible Accounts Exp. xxx
Allowance for doubtful accounts xxx

The Allowance for Doubtful Accounts appears in the balance sheet as a deduction from the face amount
of Accounts Receivables. It reduces the Accounts Receivables to their net realizable value. The
Allowance for Doubtful Accounts is a contra asset account. It has a credit balance which is offset against
the Accounts Receivables in the balance sheet.

The estimate of uncollectible accounts is made before preparation of financial statements. It depends
upon professional judgment and circumstances like political, social, economic conditions.

Writing Off of Uncollectible Accounts is done when we are sure that the amount will not be received. It
is done by the following journal entry.

Date Account Titles & Descriptions Debit Credit

Apr 6 Allowance for doubtful accounts xxx
Accounts Receivables xxx

In this second entry, the balance reduced from Accounts Receivables is the same as balance reduced
from Allowance for Doubtful Accounts account.
Writing off of debit consists of two different entries. The first is done when the debit becomes doubtful
and the second is done when we are sure that receivables wouldnt be recovered.

Accounts Receivables that were previously written off could be recovered. The journal entry for
recoveries of bad debt is as follows.

Date Account Titles & Descriptions Debit Credit

Apr 6 Accounts Receivables xxx
Allowance for doubtful accounts xxx

A separate entry is required to debit cash and credit A/c receivables.

Different methods are used for estimating credit loses.

1. Balance Sheet Approach: Estimates of bad debts are predictable based on aging the account
receivables. An aging schedule is prepared in this method. It is useful for the management in
reviewing credit-worthiness.
Based on professional judgment, management estimate the percentage of credit losses likely to
occur in each age group. This percentage when applied gives the estimated amount of
uncollectible accounts.
2. Income Statement Approach: Based on experience, a certain percentage of credit sales for an
accounting period is considered to be uncollectible.

Direct Write Off is a fast and simple method of writing off uncollectible accounts. No estimates are
made whatsoever. When an account is sure to be uncollectible. It is written off by debiting Uncollectible
Accounts Expense and crediting Accounts Receivables.

Accounts Receivables Turnover Rate tells us how many times the companys average investment in
receivables was converted into cash during the year. The ratio is computed by dividing annual net sales
by average accounts receivables. The higher the turnover rate, the more liquid the companys
receivables.

Another method of judging a companys solvency is to convert the accounts receivable turn over rate to
the number of days required to collect account receivables. It is found by 365 days divided by turnover
rate.

ADEQUATE DISCLOSURES FOR CHAPTER 7:

1. Cash is recorded at its face amount, marketable securities at their market value and A/c Receivables at Net Realizable value.
2. Cash is usually a control account. Cash Ledger may contain accounts for different bank accounts.
3. Transactions involving bank cards are not credit sales but cash sales.
4. Transfer of money between bank accounts does not appear in Statement of Cash Flows as the amount of money remains
constant.
5. The valuation of Marketable Securities are exempt from Cost Principle.
6. The period used to define current assets is one year or the companys operating cycle, whichever is longer.
7. The normal period of time required to convert cash into inventory, inventory to a/c receivables and a/c receivables back into
cash is called the Operating Cycle.
Depreciation is recorded in Income Statement and Accumulated Depreciation is recorded in Balance Sheet.