Chapter-I

Introduction to Accounting

Financial &
Managerial Accounting

MBA Programme
Paramed College
1
 1.1. Meaning, Branches,
objectives of accounting

 Accounting is the process of:

– Identification: select economic events
– Measuring: state in financial terms
– Recording: put the information in books
– Reporting: preparation of statements
– Interpreting: analyzing and explain the
implications

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Branches of Accounting/
Specialized accounting fields

 Financial accounting: external reporting

 Cost accounting: cost accumulation and
assignment
 Management accounting: detailed info to mgmt
 Auditing : attestation and verification service
 Tax accounting: tax related transactions
 Accounting information system: system analysis
and design
 Fund accounting: NFP accounting
 Forensic accounting: investigation of fraud and corruptions
 Objectives of Accounting

 Provide information about the reporting entity

that is useful to present and potential equity
investors, lenders, and other creditors in
their capacity as capital providers.

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Users of accounting information

 Are individuals and organizations who are

interested to know about the financial
activities of the firm.
 Classified as
1) Internal users: individuals within the firm
and collectively called management.
- Users who have direct access to the business
records
– Managers use information in planning,
controlling and evaluating business
operations.
Users of acct Information…

2) External users: users who lacks direct access to

the business records
 External users include:
–Owners/investors
–Bankers or creditors/suppliers
–Government authorities
–Donors/granters
–Financial analysts and consultants
 1.2. Fundamental concepts and
principles and rules of accounting

Generally Accepted Accounting Principles

 Primarily established by the Canadian Institute
of Chartered Accountants
Assumptions Principles Constraint
1.Economic entity 1. Measurement 1. cost
2.Going concern 2. Revenue recognition
3.Monetary unit 3. Expense recognition
4.Periodicity 4. Full disclosure

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 Assumptions

Generally Accepted Accounting Principles

1. Economic entity: A business is separate from its
owners
2. Going concern: A company continues in business
indefinitely.
3. Monetary Unit: Money is the common denominator
of economic activity
4. Periodicity: A company can divide its economic
activities into artificial time periods.

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 Principles
Measurement Principle
Historical cost-requires that companies
account for and report many assets and
liabilities on the basis of acquisition price.
Fair Value- 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
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 Principles

Revenue Recognition Principle

Revenue is recognized when realized and when
earned.
Expense Recognition Principle
Expenses are recognized when they are
incurred-when assets are consumed in the
process of generating revenue.
Period costs Vs Product costs.

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 Principles

Full Disclosure Principle

Requires that firms supply information that is
of sufficient importance to influence the
judgment and decisions of an informed user.
Information is disclosed through

(1) main body of financial statements

(2) notes to FS ,and
(3)Supplementary information.
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 Constraints

Cost
Firms should weigh the costs of providing
information against the benefits that can be
derived from using it.

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 1.3. Double entry Book keeping

 Double entry bookkeeping system consists of

debits and credits of accounts.
– Asset… debit ( increases side)
– Liability…Credit( Increase side)
– Owner’s equity…Credit(Increase side)
– Revenue…..Credit (increase side)
– Expense…..Debit( Increase side)
 The opposite sides of all the above accounts
are decrease side.
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 Double entry Book keeping

 An account is a subdivision under the three

elements of the accounting equation used to
record the changes over a single element in
the financial statements. An account has
three parts, Title, Debit, and credit. For
illustration purposes an account can be
represented in the form of capital letter ‘T’.

14
 1.4. Classification of accounts and
completion of accounting cycle

 There are five basic classes of accounts:

1. Asset Account
2. Liability Account
3. Owner’s equity Account
4. Revenue Account
5. Expense Account

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1. Assets

A- An asset is something of value that has

certain characteristics:

1- Has a probable future benefit, i.e., a future

monetary value; This value can arise through
its use within the business, its hire or sale.

2- The business has an exclusive right to

control its benefit.
Example: A business offering holidays on barges. The
business will not be able to control the access of others to
the canal system, so the canal system cannot be
regarded as an asset.
3- The benefit must arise from some past transaction or
event, i.e., the transaction must have already occurred.
Example: Thus an agreement by a business to purchase a
machine at some future date would not mean the item is
currently an asset of the business.
B- Tangible Vs Intangible Assets

- An asset does not need to have a physical presence. An

asset without physical presence is referred to as
intangible asset.
Examples
Patent technology
Internet domain names
Trade Secrets

- Those that have a physical substance and can be

touched are referred to as tangible assets.

Assets are split into two further groups………….

1. Non-current (fixed) Assets
Assets acquired for the long term use in the
organisation.
Listed(on the SOFP) in accordance with the
expected working life of the asset – the longest first.

The listing order of non-current assets is usually:

1.Intangiblenon-current assets; then

2.Tangible non-current assets
2. Current Assets
 Assets that are not held on a continuous basis.
 They are, normally, part of the day to day trading activities of
the business.
 They include cash and other assets that are expected to be
converted to cash at some future point in time (within a year).
 Current assets are inter-related:

- Cash is used to buy Inventory which is sold on credit terms to

Trade receivables (debtors);
- Trade Receivables pay cash and the cash is then used again to
buy more inventory.
2. Liabilities (claims)

 An obligation on the part of the business to

provide cash, or some other form of benefit
to an outside party.

 A claim or liability will normally arise as a

result of the outside party providing funds in
the form of assets for use by the business.

 There are two types of liability against a

business.
 Liabilities

 Liabilities represent the claims of individuals and

businesses, apart from the owner(s), due to past
transactions or events, such as, supplying goods or
lending money to the business.

 Once a claim or liability has been incurred by a

business (buying a raw materials on credit), it will
remain as an obligation until it is settled (paid).

 Liabilities are further classified into two groups.

A. Current liabilities (creditors): amounts due
within 1 year

Current liabilities represent amounts due to outside

parties within 12 months of the SOFP date. they include:
- Trade payables (creditors) – those who have provided goods or
services on credit terms for future settlement;

-Bank overdraft when money is withdrawn from a bank account and

the available balance goes below zero.

- Payable Dividends the share of annual profits that will be

distributed to the owners in the next twelve months; and
- Taxation the amounts owed under the various taxation regimes
which must be paid in the next twelve months.
B. Non-current liabilities (Creditors):
amounts due after 1 year

 Represent those amounts not due for

repayment within the next twelve months.

 These would normally include long term loans,

such as mortgages, from banks and other
lenders, and bonds which the company may
have issued to purchase assets.
 3. Capital

Capital: The excess of the assets of a business over its

liabilities is referred to as capital. It is the equity of
the owner in the business.
Capital (equity) represents the claim of the owner(s)
against the business (as a separate equity).
 4.Revenue

 Revenue: Are increases in owner’s equity

resulting from the main operations of the
business.
 Examples of revenue accounts are sales,
interest income, tuition fee, and sales
commission.

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 5. Expenses

 Expenses: are decreases in owner’s equity in

the process of earning revenue. For example, a
hotel has to pay salary to its workers for the
services rendered to clients in order to get the
income form customers (revenue) the Hotel has
pay salary to the employees (expense).
 Example of expenses: Salary, insurance,
depreciation, supplies, utilities, rent etc.

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 Chart of Accounts

 The number and name of accounts used by

an organization depends on the nature of its
operation. The list of accounts used by an
organization and their codes is called the
chart of accounts. Look at the following
chart of accounts of Bati Transport.


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 Bati Transport
Chart of Accounts
Asset Account number
Cash-----------------------------------------------------------------------------11
Accounts Receivable-------------------------------------------------------- 12
Supplies--------------------------------------------------------------------------13
Prepaid Insurance-------------------------------------------------------------14
Equipment---------------------------------------------------------------------- 15
Accumulated Depreciation –Equipment---------------------------------16
Truck------------------------------------------------------------------------------17
Accumulated depreciation – Truck----------------------------------------18
Liabilities
Accounts Payable-------------------------------------------------------------21
Notes Payable-----------------------------------------------------------------22
Owners Equity
Yimer Adem, Capital----------------------------------------------------------31
Yimer Adem Drawing-------------------------------------------------------32
30 Income Summary-------------------------------------------------------------33
 Bati Transport
Chart of Accounts
Account number
Revenue
Service income----------------------------------------------------------------41
Expense
Salaries Expense --------------------------------------------------------------51
Rent Expense ------------------------------------------------------------------52
Utilities Expense----------------------------------------------------------------53
Supplies Expense--------------------------------------------------------------54
Insurance Expense-------------------------------------------------------------55
Maintenance Expense---------------------------------------------------------56
Depreciation Expense---------------------------------------------------------57
Truck Expense-------------------------------------------------------------------58
31 Miscellaneous expense--------------------------------------------------------59
 Rules of Debits and Credits

 As shown above every account has three parts. These parts are
discussed below:
 Title – The name of the account. This is written at the top of
the account.
 Debit – is the left hand side of an account –Debit is
abbreviated as ‘Dr.’. When an amount is entered on the left side
of an account we say the account is debited or charged.
 Credit – is the right hand side of an account. Credit is
abbreviated as Cr. An account is said to be credited when an
amount is entered on the right hand side of the account.

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 Rules of Debits and Credits

The above general rule will be expanded as follows

Debit Credit
-Increase in assets -Decrease in assets
-Increase in expenses -Decrease in expenses
-Decrease in capital -Increase in Capital
-Decrease in liabilities -Increase in liabilities
-Decrease in revenue -Increase in revenue.

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 Journalizing Business
Transactions

When a business transaction takes place, source documents will be obtained and
recorded. The accounting record in which a transaction is initially recorded is
known as a journal. The journal is therefore referred to as “The book of original
entry”.
The process of recording a business transaction in the accounting record is called
journalizing.
The Journal commonly used to record all types of transactions is the General Journal.
This Journal includes the following parts, entered step by step.
The date of the transaction
The title of the account debited
The title of the account credited
The amount of debit and credit
Brief explanation of the entry or reference to the source document.

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 Journalizing Business
Transactions

Journal page

Date Description P.R Debit Credit

Year

Month day Debited account title XXX XX

Credited account title X XX XX

Explanation

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Accounting Nature of the Key elements
of financial statements

 The nature of Assets account is Debit

 The nature of Liabilities account is Credit
 The nature of Expenses account is Debit
 The nature of Income account is Credit
 The nature of Capital account is Credit

However,
Business’ bank account, for instance, is an asset
(debit Acc) But when we pay for cash purchases, it
should be decreased (credited) by the amount paid.
T Account Summary
Debit Side Credit Side
– Increase in Assets
Decrease in Assets
– Increase in Expenses
Decrease in Expenses
– Decrease in Income
Increase in Income
– Decrease in Liabilities
Increase in Liabilities
– Decrease in Capital
Increase in Capital
For every DR there is a CR and vice versa,
therefore two entries are made for each financial
transaction.
 Illustration to complete the accounting
cycle

Illustration
To illustrate the complete accounting cycle, we will consider the following list
of selected transactions. The transactions were completed by Bati Transport
in the month of January 2003.
January 1. Ato yimer took Birr 450,000 from his personal savings and
deposited it in the name of Bati transport.
January 2. Bati Transport purchased two used trucks for Birr 150,000 each,
on cash.
January 4. Bati Transport received a check for Birr 650 for services given to
Alem Trading.
January 4. Received an invoice for truck expenses Birr 90.
January 11. Paid Birr 600 for Awash Insurance Company to buy an insurance
policy for its trucks.

39
 Illustration to complete the
accounting cycle

January 16. Ato Yimer issued a check for Birr 9,400 to the workers as a
salary for two weeks.
January 20. Bati trading Billed Muradu Supermarket for goods
transported from Djibouti to Gondar Birr 2,650
January 21. Ato Yimer wrote a check for birr 450 to have one of the
trucks repainted
January 21. Bati trading purchased stationary materials and other
supplies of Birr 740 on account
January 22. Office equipment of Birr 11,600 is bought on account.
January 23. Purchased an additional truck for Birr 250,000 paying birr
100,000 in cash and issuing a note for the difference.
January 23. Recorded services billed to customers on account birr 14,600.

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 Illustration to complete the
accounting cycle ...

January 25. Received cash from customers on account Birr 15,000.

January 27. The owner withdrew Birr 500 in cash for his personal
use.
January 28. Paid Birr 9,400 to workers as a salary for the last two
weeks of the month.
January 30. Paid telephone expense of Birr 95 and electric
expenses of Birr 125 for the month.
January 30. Paid other miscellaneous expenses Birr 50.
January 31. Paid Birr 4,000 as a rent for a building used for office
space.

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 These transactions are journalized
as follows:
Date Description Debit Credit
2003 Cash 450,000
Jan.1 Yimer Capital 450,000
To record investment by owner
2 Truck 300,000
Cash 300,000
Purchase of trucks
4 Cash 650
Service Income 650
Cash received from customers
4 Truck Expenses 90
Accounts Payable 90
Service received in advance
11 Prepaid Insurance 600
Cash 600
Purchase of insurance policy
16 Salary Expense 9,400
Cash 9,400
Payment of salary
20 Accounts Receivable 2,650
42 Service Income
Provision of service
2,650
 These transactions are journalized
as follows:

21 Truck Expense 450

Cash 450
Cash paid to repaint truck
21 Supplies 740
Accounts Payable 740
Purchase of supplies on account
22 Office Equipment 11,600
Accounts Payable 11,600
Purchase of on equipment
23 Truck 250,000
Cash 100,000
Notes Payable 150,000
Purchase of truck
23 Accounts Receivable 14,600
Service Income 14,600
Provision of service on account
25 Cash 15,000
Accounts Receivable 15,000
43 Collection of cash
 These transactions are journalized
as follows:

27 Drawings 500
Cash 500
Owner withdrawals
28 Salary Expense 9,400
Cash 9,400
Payment of salary
30 Utilities Expense 220
Cash 220
Payment for telephone, electricity
30 Miscellaneous Expenses 50
Cash 50
Payment for various expenses
31 Rent Expense 4,000
Cash 4,000
Payment of Rent
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 POSTING FROM THE JOURNAL
TO THE LEDGER

 After the information about a business transaction

has been journalized, that information is transferred
to the specific accounts affected by each transaction.
This process of transferring the information is called
posting.
 The group of accounts used by an organization is called
ledger.
 Illustration. As mentioned above, to illustrate the
posting process the four column account is used and
the entries to the cash account are posted as follows.

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 Account Cash Account Number

Balance
Date Item P.R Debit Credit Debit Credit

2003 450,000 00 450,000 00

Jan 1

2 300,000 00 150,000 00
4 650 00 150,650 00
11 600 00 150050 00
16 9,400 00 140650 00
21 450 00 140200 00
23 100,000 00 40200 00
25 15,000 00 55200 00
27 500 00 54200 00
28 9,400 00 45300 00
30 220 00 45,080 00
30 50 00 45,030 00

46 31 4,000 00 41,030 00
 THE TRIAL BALANCE

 After the posting phase is completed, we have to verify the equality

of the debit and credit balances. This is done through the use of
the ‘Trial Balance’. A trial balance is a two column listing of the
accounts in the ledger and their balance to make sure that the total
of debit balances equals the total of credit balances.
 The trial balance for our illustration, Bati Transport is presented
bellow. The amounts are taken from the balances of the accounts
after all the transactions have been posted. Therefore, after posting
the above transactions, you should get the final balances shown on
the trial balance in the end.

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 Bati Transport
Trial Balance
January 31, 2003
Cash 41,030 00
Accounts Receivable 2,250 00
Supplies 740 00
Prepaid Insurance 600 00
Office equipment 11,600 00
Truck 550,000 00
Accounts payable 12,430 00
Notes payable 150,000 00
Yimer capital 450,000 00
Yimer drawing 500 00
Service income 17,900 00
Salary expense 18,800 00
Rent expense 4,000 00
Utilities expense 220 00
Maintenance expense 450 00
Truuck expense 90 00
Miscellaneous expense 50 00
Total 630,330 00 630,330 00
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 Adjustments

 All the transactions recorded above in the journalizing step are

the result of daily transactions. Other transactions result from the
passage of time or from the internal operations of the business.
For example, insurance premiums are paid for a certain period of
time and expire during that time period. Another example is office
supplies such as paper, pens & pencils.
 At the end of the period the balances in accounts such as
supplies and prepaid insurance must be brought up to date. The
supplies account balance, for example, must be credited by the
consumed part of the supplies, debiting supplies expense.

49
 Adjustments

 Example. Stationary materials totaling Birr 1,900.00 were

purchased and recorded during the year. At the end of the year,
only Birr 150 of the supplies are left in hand.
 The adjusting entry prepared at the end of the year to adjust the
supplies account will be
1990 Supplies expense 1,750
Dec31 Supplies 1,750

Note: 1. Adjustments are dated as the last day of the year.

2. The accounting year here – we assume, runs from January 1- December 31.
Additional examples on adjustments will be given below under the topic ‘worksheet’

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 WORKSHEET FOR FINANCIAL
STATEMENTS
 Most of the data required to prepare the accounting reports (financial statements) is now
gathered. The data will now be presented in a convenient form. The worksheet is a large
columnar sheet prepared to arrange in a convenient form all the accounting data required to
prepare financial statements. The worksheet has a heading and a body.
The heading has three parts:
 Name of the Organization
 Name of the form (worksheet)
 Period of time covered.
The body contains five main parts each of them with two main columns. These parts are
 The trial balance
 The adjustment
 The adjusted trial balance
 The income statement
 The balance sheet.
The worksheet for Bati Transport is given below. The five parts of the body are discussed as
follows. You are advised to read and understand the discussions before you look at the
51 respective columns of the worksheet.
 Bati Transport
Work Sheet
For the month ended jan.31,2003
Account Title Trial Balance Adjustment Adjusted Trial Income statement Balance sheeet
balance
1 Cash 41,030 41,030 41,030
2 Accounts receivable 2,250 ©
7,400 9,650 9,650

3 Supplies 740 (a)

340 400 400
4 Prepaid Insurance 600 (b)
450 150 150
5 Office equipment 11,600 11,600 11,600
6 Truck 550,000 550,000 550,000

7 Accounts payable 12,430 12,430 12,430

8 Notes payable 150,000 150,000 150,000

9 Yimer Capital 450,000 450,000 450,000

10 Yimer drawing 500 500 500

11 Service income 17,900 ©
7,400 25,300 25300

12 Salary expense 18,800 18,800 18,800

13 Rent expense 4,000 4,000 4,000
14 Utilities expense 220 220 220
15 Maintenance expense 450 450 450

16 Truck expense 90 90 90
17 Miscellaneous 50 50 50
Expense
18 630,330 630,330

19 Supplies expense 340

(a)
340 340
20 Insurance expense 450
(b)
450 450
21 7290 7290 636,830 636,830

22 Net income
23 25300 25300 613,330 613,330
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 Work sheet…

1. The trial balance column – this is the same trial balance we have prepared before. The
trial balance column of the work sheet can be brought direct from the ledger or from a
separate trial balance.
2. The Adjustment column – As mentioned previously, some account balances have to be
adjusted at the end of the year. The accounts in the ledger of our illustration that require
adjustment and the adjusting entry for the accounts are presented below.
a) Supplies – The supplies account has a debit balance of Birr 740. The cost of supplies in
hand on July 31 is determined to be Birr 400. The following adjusting entry is required to
bring the balance of the account up to date:
Supplies expense…………………………….340
Supplies……………………………………..340
b) Prepaid insurance – Analysis of the policy showed that three – fourth of the policy is
expired. That is only Birr 150 of the policy is applicable to future periods. The adjusting
entry to transfer the expired part of the insurance to expense will be.
Insurance expense ……………………….450
Prepaid insurance………………………..450
53
 Work sheet…

c) Service Income – At the end of the month unbilled fees for services
performed to clients totaled Birr 7,400. This amount refers to an income earned
but to be collected in the future. The journal entry to record it will be
Accounts receivable………………………….7,400
Service income………………………………7,400

All the above adjusting entries will be inserted in the adjustment column of the
worksheet in front of the accounts affected.
Note – The letters a, b & c are used to cross-reference the debits and credits
to help future review of the worksheet.

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 Work sheet…

3. The Adjusted Trial Balance Column – The accounts that

require adjustment are now adjusted. Transferring the trial
balance column amounts combined with the adjustment column
amounts will complete the adjusted trial balance column of the
worksheet.
4. The income statement and the balance sheet columns –
Transfer the income statement account balances (revenue
&expenses) to the income statement and balance sheet account
balances (Asset, Liability &owners equity) to the balance sheet
columns. Note that what we have to transfer is the adjusted trial
balance column amounts, to the corresponding columns.
Look at the 22nd row. It shows the net income for the month and
it is added to the two columns (Income statement Dr. and balance
55 sheet cr.) as a balancing figure.
 FINANCIAL STATEMENT
PREPARATION

 After the work sheet is completed financial statements

could be prepared easily. In chapter one we have
discussed four basic financial statements prepared by
most organizations. Here, we will prepare three of these
statements for Bati Transport form the worksheet.

 1. Income statement All the data required to prepare

the income statement is brought from the worksheet.

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 Bati Transport
Income statement
For the month ended. Jan 31, 2003

Service Income …………………………………………………………Birr 25,300

Operating expenses
Salary expense………………………..Birr 18,800
Rent “…………………………………….4,000
Maintenance expense ……………………… 450
Insurance “ ……………………………450
Supplies “ …………………………….340
Utilities “……………………………..220
Truck “ …………………………….. .90
Miscellaneous “………………………………50
Total operating expense………………………………24,400
Net Income……………………………………………Birr 900

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 Statement of owner’s equity

2. Statement of owner’s equity – This statement shows

the beginning balance of capital and the changes that
affected it.

The balance of the owners equity account (Yimer capital)

in the worksheet may not be the beginning one.
Therefore, the ledger has to be reviewed to see if there
was an additional investment during the priod or not. In
our illustration there is no additional investment.

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 Statement of owner’s equity

Bati Transport
Statement of Owner’s equity
For the month ended January 31, 2003

Yimer capital January 1, 2003…………Birr 450,000

Net income for the month………………….birr 900
Less: Withdrawal………………………………….......500
Yimer capital, January 31, 2003………….Birr 450,400

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 Balance Sheet

3. Balance sheet – The data to prepare this

statement will be taken from the worksheet
and the other financial statements. Note that
assets and liabilities are classified as current
and non – current.

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 Bati Transport
Balance sheet
January 31, 2003
Assets
Current Assets:
Cash…………………………………………Birr 41, 030
Accounts Receivable…………………………….. 9,650
Supplies…………………………………………… 400
Prepaid insurance…………………………………….150
Total current assets……………………………………………Birr 51,230
Plant Asset (None-Current Assets):
Office equipment……………………………..Birr 11,600
Truck………………………………………………550,000 561,600
Total asset………………………………………………………Birr 612,830
Liabilities
Current liabilities
Accounts payable……………………………..Birr 12,430
Non-current liabilities
Notes payable……………………………………..150,000
Total liabilities……………………………………………………Birr 162,430
Owner’s equity
Ato Yimer Capital…………………………………………………………….. 450,400
61 Total liability and owners equity………………………………………….Birr 612,830
 THE CLOSING PROCESS
 Some of the accounts in the ledger are temporary accounts used to classify and
summarize the transactions affecting capital (owners equity). These accounts will
be closed after financial statements are prepared. That is, their balances will be
transferred to the Capital account. The temporary accounts that have to be closed
are revenue, expense and withdrawal accounts.
 Steps in closing:
1. Closing revenue accounts - Debit each revenue account by its balance and credit the
‘Income Summary’ account by the total revenue for the period.
 Note: Income summary is an account used to close revenue and expense accounts.
This account will immediately be closed to the capital account at the end of the
closing process.
2. Closing expense accounts – Debit the income summary account by the total of expenses
for the period and credit each expense account by its balance.
3. Closing the income summary account – Income summary will be closed to the capital
account. The balance of his account depends on the nature of operation; credit if result is
profit and debit if result is loss.
62 4. Closing Withdrawal – Debit the owners equity account by the total of drawings for the
period and credit the drawing account.
 Closing Process
The temporary accounts of Bati transport are closed as follows.

2003 Service income ………………….25,300

January Income summary …………………………………25,300
31 Closing revenue
Income Summary…………………………………24,400
31 Salary expense………………………..18,800
rent expense……………………………4,000
Maintenance expense………………….. 450
Insurance expense………………………..450
Supplies expense…………………………340
Utilities expense………………………….220
Truck expense …………………………… 90
Miscellaneous expense…………………….50
63
 Closing process…

2003 Income summary………………900

January 31 Yemer Capital………………………..900
Closing income summary
31 Yimer capital…………………...500
Yimer drawing………………………..500
Closing withdrawal

The above closing entries have transferred the balance of the

temporary accounts to the permanent capital account.

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 POST CLOSING TRIAL BALANCE

 After the closing entries have been journalized and

posted, a trial balance is prepared to prove the
equality of the general ledger before recording the
new year’s transactions.
 It should be noted that this trial balance includes
only balance sheet accounts. This is because the
temporary income statement accounts are closed
during the closing process.
 This trial balance is called the post – closing trial
balance.
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 POST CLOSING TRIAL BALANCE

Bati Transport
Post – Closing trial balance
Jan 31, 2003

Cash……………………………………………Birr 41,030
Accounts Receivable ………………………………...9,650
Supplies…………………………………………………400
Prepaid insurance……………………………………….150
Office equipment……………………………………11,600
Truck……………………………………………….550,000
Accounts payable…………………………………………………….Birr 12,430
Nots payable……………………………………………………………..150,000
Yimer capital…………………………………………………………….. 450,400
Total……………………………………Birr 612,830 Birr 612,830
66
 1.5. Basic concepts of cost
Cost
 a resource sacrificed or foregone to achieve a
specific objective
Cost Object
 Anything for which a separate measurement of
cost is made. example: product, machine,
service or process, project, and program
 cost objects can vary in size from an entire
company, to a division or program within the
company, or down to a single product or service.
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1.5. Basic concepts of cost

 Cost accumulation – a collection of cost data in

an organized manner.
 Cost assignment – a general term that includes
tracing and allocating the accumulated costs
to a cost object. This includes:
– Tracing: assigning direct costs (costs with
a direct relationship to the cost object)
– Allocating: assigning indirect costs (costs
with an indirect relationship to a cost
object
 Fixed cost and variable cost

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Cost Behavior

 Total Variable costs – changes in total in

proportion to changes in the related level
of activity or volume
 Total Fixed costs – remain unchanged in
total regardless of changes in the related
level of activity or volume
 Costs are fixed or variable only with
respect to a specific activity or a given
time period
Cost Behavior, continued

 Unit Variable costs – are constant on a per-

unit basis. If a product takes 5 pounds of
materials each, it stays the same per unit
regardless of one, ten or a thousand units are
produced.
 Unit Fixed costs – change inversely with the
level of production. As more units are
produced, the same fixed cost is spread over
more and more units, reducing the cost per
unit.
 Cost Behavior Patterns…

 Total Variable Costs: Variable costs will

vary in direct proportion to changes in the
level of an activity.
 For example, direct material, direct labor,
sales commissions, fuel cost for a trucking
company, and so on, may be expected to
increase with each additional unit of output.

72
 Variable costs

73
 Fixed Costs

 Total FIXED COSTS: The opposite of variable

costs are fixed costs. Fixed costs do not
fluctuate with changes in the level of activity.
 Examples include administrative salaries, rents,
property taxes, security, networking infrastructure
support, and so forth. Observe that the fixed cost per
unit will decline with increases in production. This
attribute of fixed costs is important to consider in
assessing the scalability of a business proposition.

74
 Types of Fixed costs

 Types of fixed costs: For planning purposes,

fixed costs can be viewed as either committed or
discretionary.
 Committed fixed costs- Relate the investment
in facilities, equipment & basic organizational
structure.
 They have two key characteristics:
– They are long term
– They can’t be significantly reduced even for short periods of
time without seriously impairing the profitability or long run
75 goals of the organization .
 Types of Fixed costs

 Discretionary fixed costs- Usually arise

from annual decisions by management to
spend in certain fixed cost areas.
 Examples are:
 Advertising, R & D, Public relations,
Management development programs,
Internships for students.

76
 Fixed costs in totals and units

77
 Graphically, FC

78
Cost Behavior Summarized

Total
Total Dollars
Dollars Cost
Costper Unit
Per Unit
Change in
Change in Unchanged in
Variable relation to
proportion with
proportion with
Costs
Variable output output
output
Costs More output = More cost
More output = More
cost
Change inversely with
Fixed Unchanged in Changeoutput
inversely
Costs Unchanged
relation toin with
More outputoutput
= lower cost
Fixed Costs relation
outputto
per unit
More output = lower cost
output per unit
Other Cost Concepts
 Cost Driver – a variable that causally affects
costs over a given time span. E.g., kilowatt
hours, machine hours, labor hours, labor
costs .
 Relevant Range – the band of normal activity
level (or volume) in which there is a specific
relationship between the level of activity (or
volume) and a given cost
– For example, fixed costs are considered fixed
only within the relevant range.
Relevant Range Visualized
Multiple Classification of Costs

 Costs may be classified as:

– Direct / Indirect, and
– Variable / Fixed
 These multiple classifications give rise to
important cost combinations:
– Direct & Variable
– Direct & Fixed
– Indirect & Variable
– Indirect & Fixed
Multiple Classification of Costs,
Visualized
Different Types of Firms

 Manufacturing-sector companies – purchase

raw materials, hire labor, and use overheads
& produce goods and sell finished goods.
 Merchandising-sector companies – purchase
goods for resellers purposes.
 Service-sector companies – provides various
types of services (intangible products).
Types of Manufacturing Inventories

 Direct Materials – resources in-stock and

available for use.
 Work-in-Process (or progress) – products
started but not yet completed. Often
abbreviated as WIP.
 Finished Goods – products completed and
ready for sale.
Accounting Distinction Between Costs

Period Costs
 have no future value and are expensed as incurred.
 are expensed on the income statement as they are incurred
 also called operating costs (excluding cost of goods sold)
 examples: selling, general and administrative costs
Product Costs
 Are capitalized as assets (inventory) until they are sold and
transferred to Cost of Goods Sold
 Expensed only when the product or service is sold
 Are product manufacturing costs (inventoriable costs)
 Examples: materials and labour (manufacturing)
 Direct and indirect cost

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 Direct & Indirect Costs

 Direct costs – can be conveniently and

economically traced (tracked) to a cost object
– Direct Costs examples: Parts and Assembly line
wages
 Indirect costs – cannot be conveniently or
economically traced (tracked) to a cost
object.
– Instead of being traced, these costs are allocated to a cost
object in a rational and systematic manner.
– Indirect Costs examples: Electricity, Rent and Property taxes
BMW: Assigning Costs to a Cost
Object
 End of the chapter
Thank You!

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