ᤧ`ᕦᕥᕤᕣ ﷽

Name Muskan Chaudhary

Student Id 0001063414

Tutor Name Waqas

shahzad

Course Code 5418

Course Name Financial Accounting

Program BBA

Semester Autumn 2025

Assignment No 1
Question No 1

Describe the purpose of accounting and explain its role in business and
society. Also, Identify the primary users of accounting information.

Answer

Accounting is a systematic and scientific process of identifying, recording,

measuring, classifying, summarizing, interpreting, and communicating financial
information to relevant users. Its basic purpose is to provide an accurate and clear
picture of an organization’s financial performance and position. Accounting helps
businesses understand what they own, what they owe, how much profit they are
earning, and how effectively they are using their resources. Without accounting,
no business can track its financial activities, evaluate its success, or make rational
economic decisions. One of the fundamental purposes of accounting is to
maintain complete and reliable records of all financial transactions. These
transactions occur daily in every business, and if they are not recorded properly, it
becomes impossible to calculate true profit or loss. Accounting ensures that all
expenses, revenues, assets, liabilities, and equity items are recorded using
standardized rules, which remove confusion and maintain uniformity. Another
key purpose of accounting is to determine the profitability of the business. By
comparing revenues with expenses, accounting helps the business find out
whether it is earning profit or suffering a loss during a specific period. This
knowledge is crucial for owners and managers to assess performance and make
necessary adjustments. Similarly, accounting provides information about the
financial position of the business through statements like the balance sheet, which
shows
assets, liabilities, and capital. This helps stakeholders evaluate the financial
strength, liquidity, and long-term stability of the business. Accounting also plays a
critical role in compliance. Every business must follow laws, regulations, and tax
requirements. Through proper accounting, businesses calculate taxes accurately,
prepare financial statements as per legal standards, and safeguard themselves from
legal penalties. Lastly, another major purpose of accounting is to support
planning, controlling, and decision-making. Businesses cannot make future plans
without understanding past and present financial data. Accounting provides
budgets, forecasts, and performance evaluations which help management set
goals, control operations, and make informed strategic decisions. Hence,
accounting is not merely a record-keeping task, but a vital component of business
success, planning, and long-term survival.

Role of Accounting in Business

Accounting plays a foundational and indispensable role in the operation and

growth of any business, regardless of its size or nature. The first and most
important role of accounting is to provide financial information that helps
business owners and managers make informed decisions. These decisions may
relate to pricing, production, expansion, investment, cost control, and resource
allocation.
Without reliable accounting data, businesses would make decisions blindly,
increasing the risk of failure. Accounting also plays a crucial role in performance
measurement. By analyzing financial statements, management can evaluate the
efficiency and effectiveness of various departments, products, or services. It helps
businesses identify areas of improvement, unnecessary costs, and profitable
segments. For example, if a business finds that a particular product line is not
profitable, it can decide to improve, modify, or discontinue it. Another significant
role of accounting in business is ensuring internal control. Through processes like
internal audits, monitoring transactions, and establishing proper documentation,
accounting helps prevent fraud, errors, and misuse of assets. Companies rely on
accounting systems to safeguard their resources and maintain transparency. In
addition, accounting helps businesses manage cash effectively. Cash flow
statements prepared through accounting allow an organization to track inflows
and outflows of cash and ensure they have sufficient funds for daily operations.
Poor cash management is a major cause of business failure, and accounting serves
as the backbone for preventing such crises. Moreover, accounting supports
business communication. Financial reports prepared under accounting standards
enable businesses to communicate their performance to banks, investors,
regulatory bodies, employees, and the general public. This communication builds
trust and credibility, which are essential for attracting investment and securing
loans.
Accounting also facilitates budgeting and strategic planning. Businesses use past
financial data to forecast future trends, allocate resources, and prepare budgets.
These budgets guide management in controlling expenses, setting targets, and
monitoring progress. Additionally, accounting enables businesses to comply with
taxation laws, corporate regulations, and reporting standards. It ensures that all
financial activities are documented properly and submitted to authorities on time.
Therefore, accounting is crucial for transparency, governance, and long-term
sustainability of business organizations.

Role of Accounting in Society

Accounting plays a significant role not only within businesses but also in society
at large. One of its primary roles is to promote transparency and accountability in
economic activities. Governments, citizens, and organizations depend on
accounting information to understand how resources are being utilized.
Accounting promotes good governance by ensuring that public funds are used
efficiently and ethically. In the absence of proper accounting, corruption,
mismanagement, and misuse of funds would be difficult to detect. Accounting
contributes to economic development by enabling investors, banks, and financial
institutions to make rational decisions. When businesses publish their financial
statements, investors can assess their stability and risk, which encourages
investment. This investment leads to business expansion, job creation, and
economic growth. Similarly, banks rely on accounting information when granting
loans. If a business shows strong financial health, banks feel confident in
extending credit. This supports entrepreneurship and economic activity.
Accounting also helps society by creating trust in markets. Stock markets,
insurance companies, banks, and corporations function smoothly because
accounting ensures accuracy and reliability of financial information. If financial
information were unreliable, people would hesitate to invest or save money,
resulting in economic instability. Another societal role of accounting is taxation.
Governments depend on accounting records to calculate and collect taxes. Tax
revenues are used to build infrastructure, hospitals, schools, and other public
services. Without proper accounting, governments would struggle to generate
revenue and manage public finances. Accounting also contributes to social
responsibility reporting. Modern businesses publish sustainability reports,
environmental disclosures, and social responsibility statements along with
financial accounts. These reports help society understand how businesses impact
the environment, the community, and workers. Thus, accounting supports ethical
business practices and social accountability. Furthermore, accounting plays an
educational role in society. It equips individuals with financial literacy, helping
them manage personal finances, loans, savings, and investments. This improves
the overall financial health of society and reduces poverty by empowering people
to make informed financial decisions. Hence, accounting is a pillar of societal
stability, economic development, and transparency.

Primary Users of Accounting Information

Accounting information is used by a wide range of individuals and organizations,

each with different objectives. These users are generally classified into internal
and external users. Internal users are those who are part of the organization and
use accounting data for planning, controlling, and decision-making. The primary
internal users include owners, managers, and employees. Owners need
accounting information to evaluate the profitability and financial stability of their
business.
Managers use accounting records to analyze performance, prepare budgets,
control costs, and make strategic decisions. Employees may also use accounting
information to understand the financial health of their organization, as it affects
job security, bonuses, and compensation. External users are individuals or
organizations outside the business who rely on accounting information for various
purposes. Investors are among the most important external users. They use
financial statements to determine whether to invest, continue investment, or
withdraw investment. They assess profitability, liquidity, and growth potential
through accounting information. Creditors and banks also rely on accounting
information to assess the creditworthiness of the business. They examine financial
stability, cash flow capabilities, and debt levels before granting loans.
Government agencies are major external users. They use accounting information
for taxation, regulatory compliance, and national economic planning. Regulatory
bodies ensure that businesses adhere to reporting standards and financial laws.
Customers may also use accounting information to evaluate the long-term
stability of suppliers, ensuring continuous supply of goods and services. Suppliers
use accounting information to decide whether to extend credit to a business based
on its financial health. In addition, financial analysts, researchers, and the general
public use accounting information to understand market conditions and business
performance. Thus, accounting information serves a diverse group of users, each
using it for decision-making, evaluation, or regulatory purposes.

accounting is a fundamental pillar of business, governance, and society. Its

purpose extends far beyond recording transactions; it provides the foundation for
decision-making, transparency, planning, and financial control. Accounting
supports business performance by offering reliable financial information,
enabling budgeting, assessing profitability, ensuring compliance, and maintaining
internal control. In society, accounting promotes transparency, facilitates
taxation, encourages investment, and strengthens the economy. The primary users
of accounting information—both internal and external—depend on its accuracy
and reliability for making critical decisions. Therefore, accounting plays an
essential
role in the growth, survival, and success of businesses as well as the development
and stability of society as a whole.

Question No 2

(a) What do you understand by Generally Accepted Accounting Principles

(GAAPs)? Explain the need for GAAPs in financial reporting and discuss
at least five fundamental GAAPs with appropriate examples.

(b) The following transactions occurred in the books of Naeem

Traders during the year ended 31st December 2023. Identify the
accounting principle or concept applied in recording each
transaction under GAAP and briefly justify your answer:

1. The business paid Rs. 60,000 as rent for the office

premises. However, the owner included this in his personal
financial records.
2. The company purchased machinery worth Rs. 500,000 but
recorded it at the purchase price, not at its current market
value of Rs. 620,000.
 3. Goods costing Rs. 80,000 were sold to a customer on credit. The
company recorded the sale in the books even though payment
had not been received yet.
4. A sum of Rs. 200,000 was expected from a customer but was
not recorded as revenue due to uncertainty regarding recovery.
5. The company recorded the salary expense of Rs. 150,000
relating to December 2023 even though it was paid in January
2024.
Required:
(i) Identify the GAAP or accounting concept applied in each case.
(ii) Justify your identification with reasoning.

(a) Generally Accepted Accounting Principles (GAAPs): definition and

the need for GAAPs in financial reporting

Generally Accepted Accounting Principles (GAAPs) are the established framework of

accounting rules, conventions, standards and procedures that guide the
preparation and presentation of financial statements. GAAPs exist to ensure that
financial information is prepared in a consistent, comparable, reliable and
transparent manner so that users — managers, investors, creditors, regulators and
other stakeholders — can make informed economic decisions. The need for
GAAPs arises from the fundamental purpose of accounting: to convert business
events into meaningful financial information. Without a common set of
principles, each business might record and present transactions differently,
making comparisons across firms and periods impossible and undermining
confidence in published reports. GAAPs reduce information asymmetry between
managers and
outside parties, provide a basis for audit and verification, support legal and tax
compliance, and promote investor protection by preventing misleading
representations. They also allow management to plan and control operations
using standardized measures (for example, recognizing revenue or valuing assets
under commonly accepted rules), and they help courts and regulators settle
disputes by referring to accepted accounting doctrines. In short, GAAPs are the
backbone of trustworthy financial reporting: they create uniformity, improve
transparency, limit opportunistic reporting, and thereby foster efficient capital
allocation in the economy.

Five fundamental GAAPs (with explanations and examples)

Historical Cost Principle. The historical cost principle states that assets and
liabilities should initially be recorded at their original transaction price (cost), not
at subsequent market values. The rationale is objectivity and verifiability: the
purchase price is a factual number supported by invoices or contracts, whereas
market values may be subjective or volatile. For example, if a company buys
machinery for Rs. 500,000, it records that machinery at Rs. 500,000 on the
balance sheet even if its market value rises to Rs. 620,000 the next year. The
balance sheet thus reflects verifiable past transactions and avoids speculative
valuations. Subsequent revaluations are possible under specific accounting
frameworks but the basic GAAP preference is for historical cost unless
revaluation is permitted and properly disclosed.

Revenue Recognition Principle. This principle determines the timing of revenue

recording: revenue is recognized when it is earned and realizable, not necessarily
when cash is received. Under accrual accounting, delivery of goods or
performance of services that transfers risks and rewards to the buyer constitutes
earning the revenue. For example, goods costing Rs. 80,000 sold on credit are
recorded as revenue at the moment of sale because the company has fulfilled its
performance obligation even though cash will be received later. Applying
revenue recognition consistently ensures that income statements reflect the true
operating performance of the reporting period.

Matching (Accrual) Principle. The matching principle requires that expenses be

matched with the revenues they help generate in the same accounting period. It
underpins accrual accounting—expenses are recorded when incurred (or when
they relate to the period’s revenues), not only when paid. For instance, if salary
expense for December Rs. 150,000 was paid in January, GAAP requires
recognizing the expense in December so that December’s financial statements
show correct profit or loss. Matching gives a realistic measure of profitability for
a period by aligning revenues and the costs necessary to produce them.

Conservatism (Prudence) Principle. Conservatism advises accountants to

choose the accounting method that minimizes the overstatement of assets and
income when uncertainty exists. In practical terms, potential losses and liabilities
should be recognized as soon as they are foreseen, while gains should only be
recorded when they are realized. For example, if Rs. 200,000 is expected from a
doubtful customer and recovery is uncertain, conservatism suggests either not
recognizing it as revenue or creating an allowance for doubtful debts until
evidence supports recognition. This principle protects users from optimistic bias
and reduces the risk of reporting inflated profits or asset values.

Consistency and Comparability Principle. Consistency requires that a business

apply the same accounting methods and policies from period to period so that
financial statements are comparable over time. Where a change in policy is
necessary, GAAP requires disclosure of the nature and effect of the change so
users can understand and adjust comparisons. For example, if a company changes
its depreciation method from straight-line to reducing balance, it must disclose
the reason and quantify the impact. Consistency allows stakeholders to track
performance trends and detect real changes rather than accounting-driven
fluctuations.

(Other commonly cited GAAPs — such as full disclosure, materiality, going

concern, entity concept, and monetary unit assumption — are equally important;
the five above are among the fundamental pillars that govern recognition,
measurement and presentation.)

(b) Identification of the accounting concept applied in each Naeem

Traders transaction and justification

Transaction 1: The business paid Rs. 60,000 as rent for the office premises.
However, the owner included this in his personal financial records.
The accounting concept violated here is the Business Entity Concept (also
referred to as Separate Entity Concept). Under this principle the business is
treated
as an entity separate from its owners or other businesses; therefore all business
transactions must be recorded in the business books only. By including the rent
expense in the owner’s personal records rather than the business accounts, the
owner has mixed personal and business transactions — a breach of the business
entity principle. This mistake distorts the financial statements: the business will
understate its expenses (leading to overstated profit) and the owner’s personal
accounts will show expenses that do not belong to the owner personally. Correct
application would require the Rs. 60,000 to be recorded in Naeem Traders’ books
as rent expense, and if the owner paid from personal funds the business should
record either a capital contribution by the owner (if treated as owner funding) or a
payable/advance settlement depending on the agreed treatment.

Transaction 2: The company purchased machinery worth Rs. 500,000 but

recorded it at the purchase price, not at its current market value of Rs.
620,000.
This treatment applies the Historical Cost Principle. Recording the machinery at
its original purchase price of Rs. 500,000 is consistent with GAAP’s preference
for historical cost as the basis for initial recognition. Historical cost provides
objectivity and verifiability (purchase invoice supporting Rs. 500,000). Unless the
applicable accounting framework requires or permits revaluation to fair value (and
the entity elects that policy and discloses it), assets remain on the books at cost
less accumulated depreciation. The company’s action is therefore correct under
the historical cost principle; choosing not to record upward market movements
avoids introducing volatility and subjective valuations into the accounts.
Transaction 3: Goods costing Rs. 80,000 were sold to a customer on credit.
The company recorded the sale in the books even though payment had not
been received yet.
This is an application of the Revenue Recognition Principle together with the
Accrual Basis of Accounting. Under accrual accounting revenue is recognized
when it is earned — typically when goods are delivered or services performed —
regardless of cash receipt. By recording the sale when the goods were delivered
on credit, Naeem Traders properly recognizes revenue in the period when the
earning process was substantially complete. The corresponding receivable records
the company’s right to cash in the future. This treatment ensures correct matching
of revenue and cost of goods sold, and presents a realistic view of the company’s
performance and financial position.

Transaction 4: A sum of Rs. 200,000 was expected from a customer but was
not recorded as revenue due to uncertainty regarding recovery.
This action reflects the Conservatism (Prudence) Principle and caution in
applying the Revenue Recognition Principle. Where recovery is uncertain,
conservatism advises against recognizing revenue that may never be realized;
instead, an entity should either defer recognition or recognise a receivable with an
allowance for doubtful debts. By not recording the Rs. 200,000 as revenue, the
company has chosen a conservative stance to avoid overstating assets and
income. However, GAAP would require more nuance: if the sale has occurred
and revenue is objectively earned, the sale should generally be recorded with a
corresponding provision (allowance) for doubtful debts rather than completely
omitting the transaction. Total omission might understate both revenue and
receivables; the
preferred GAAP approach is to recognize the sale when earned and
simultaneously estimate an allowance for probable uncollectible amounts to
reflect uncertainty, thereby following both revenue recognition and conservatism
principles.

Transaction 5: The company recorded the salary expense of Rs. 150,000

relating to December 2023 even though it was paid in January 2024.
This is an application of the Matching Principle and the Accrual Basis of
Accounting. The matching principle requires expenses to be recognized in the
period in which related benefits (or revenues) are realized; thus salaries earned by
employees in December should be recognized as a December expense even if
paid later. Recording the expense in December aligns costs with the period’s
operations and yields a true measure of December’s profit or loss. Under accrual
accounting, the company should also record a corresponding accrual or liability
(salaries payable) at year-end, which will be settled when the payment occurs in
January.
This treatment ensures period-appropriate recognition and prevents distortion of
profit across accounting periods.

Conclusion and practical note

Identifying the correct GAAP or accounting concept for each transaction is
crucial because the selection determines whether an item is recognized, when it is
recognized, and how it is measured and presented. The business entity concept
preserves the separateness of owner and business, historical cost ensures
verifiability, revenue recognition and matching ensure period-accurate
performance measurement, and conservatism protects users from over-optimistic
reporting. In practice, where uncertainty exists (as with doubtful receivables)
GAAP often requires disclosure and the use of provisions rather than outright
omission; likewise any departure from standard principles (for example,
revaluation of assets) should be disclosed to maintain transparency and
comparability.

Question No 3

Shop Rite Services is ready to prepare its financial statements for the year
ended December 31, 2022. The following information can be determined by
analyzing the accounts:

1. On August 1, 2022, Shop Rite received a Rs. 4,800 payment in

advance for the rental of office space. The rental period is for one
year beginning on the date payment was received. Shop Rite
recorded the receipt as unearned rent.

2. On March 1, 2022, Shop Rite paid its insurance agent Rs. 3,000 for
the premium due on a 24-month corporate policy. Shop Rite
recorded the payment as prepaid insurance.

3. Shop Rite pays its employees wages in the middle of each month.
The monthly payroll (ignoring payroll taxes) is Rs. 22,000.
 4. Shop Rite received a note from a customer on June 1, 2012, as
payment for services. The amount of the note is Rs. 1,000 with
interest at 12%. The note and interest will be paid on June 1,
2024.

5. On December 20, 2022, Shop Rite received a Rs. 2,500 check for
services. The transaction was recorded as unearned revenue. By
year- end, Shop Rite had completed three-fourths of the contracted
services. The rest of the services won’t be completed until at least the
middle of January 2023.

6. On September 1, Shop Rite purchased Rs. 500 worth of supplies.

At December 31, 2022, one-fourth of the supplies had been used.
Shop Rite initially recorded the purchase of supplies as an asset.

Required: Where appropriate, prepare adjusting journal entries at

December 31, 2022, for each of these items.

Introduction to Adjusting Journal Entries

Adjusting journal entries are essential for preparing accurate financial statements at
the end of an accounting period. These entries ensure that revenues are recorded
when earned and expenses are recognized when incurred, regardless of cash
movements. This complies with the accrual basis of accounting, the matching
principle, and revenue recognition principles. For Shop Rite Services, several
transactions during 2022 require year-end adjustments on December 31, 2022.
These adjustments relate to prepaid expenses, unearned revenues, accrued wages,
interest revenue, and supplies usage. Each adjustment ensures that assets,
liabilities, revenues, and expenses are stated at their correct year-end balances,
thereby presenting a true and fair view of the company’s financial performance
and financial position.

Adjustment for Unearned Rent Revenue (Transaction 1)

On August 1, 2022, Shop Rite Services received Rs. 4,800 as advance rent for the
rental of office space for one full year. The firm initially recorded this receipt as
unearned rent, correctly identifying it as a liability because revenue had not yet
been earned at that time. By December 31, 2022, five months of the rental period
had passed (August to December). Since this portion of the service has already
been provided, a year-end adjustment must be made to recognize the earned part
of the rent. The total amount for the year equals Rs. 4,800, which means monthly
rent revenue amounts to Rs. 400 (4,800 ÷ 12). Over five months, Shop Rite has
earned Rs. 2,000 (400 × 5), and the remaining Rs. 2,800 is still unearned at year-
end. Therefore, the appropriate adjusting entry increases rent revenue and reduces
the liability unearned rent revenue. This adjustment ensures that revenue
recognition aligns with the passage of time and the earning of revenue.

Adjustment for Prepaid Insurance Expense (Transaction 2)

On March 1, 2022, Shop Rite paid Rs. 3,000 for a 24-month corporate insurance
policy and correctly recorded it as prepaid insurance. Prepaid insurance is an
asset representing the right to future economic benefit in the form of insurance
coverage. By December 31, 2022, ten months of the policy coverage have
expired (March to December). Monthly insurance expense is Rs. 125 (3,000 ÷
24). For ten months, the total insurance expense amounts to Rs. 1,250 (125 × 10).
This portion must be recognized as an expense for the year, and prepaid insurance
must be reduced accordingly. After adjustment, the remaining prepaid insurance
on the balance sheet equals Rs. 1,750 (3,000 – 1,250), representing coverage for
the next 14 months. This adjustment ensures that expenses are matched with the
accounting period in which the benefit is consumed.

Adjustment for Accrued Wages Expense (Transaction 3)

Shop Rite pays its employees in the middle of each month, with a monthly
payroll of Rs. 22,000. Since employees work throughout the month and payment
is made after the service has been rendered, at December 31, Shop Rite owes
wages for half a month. Therefore, an accrual for wages expense must be
recorded. Half of Rs. 22,000 equals Rs. 11,000. This represents the wages
incurred but not yet paid as of December 31, 2022. Recognizing this amount as
wages expense and wages payable satisfies the matching principle because the
expense relates to the current period, even though payment will occur in January.
Adjusting entries for accrued expenses are essential so that liabilities and
expenses are not understated.
Adjustment for Accrued Interest Revenue (Transaction 4)

On June 1, 2012, Shop Rite received a one-year Rs. 1,000 note from a customer,
bearing 12% annual interest. The note and interest will be paid in June 2024, but
interest is earned over time. As of December 31, 2022, seven months of interest
have been earned (June through December). Annual interest equals Rs. 120
(1,000
× 12%). The monthly interest is Rs. 10 (120 ÷ 12). For seven months, the interest
revenue earned equals Rs. 70. Shop Rite must recognize this accrued interest
revenue because it represents income earned but not yet received in cash. Thus,
the adjusting entry debits interest receivable and credits interest revenue.
Recording this adjustment ensures that revenues earned during the period are
correctly presented, even if payment will occur later.

Adjustment for Unearned Service Revenue (Transaction 5)

On December 20, 2022, Shop Rite received Rs. 2,500 from a customer for
services to be performed. The payment was initially recorded as unearned
revenue, which was correct because the service had not yet been performed. By
December 31, 2022, Shop Rite had completed three-fourths of the contracted
services. Therefore, three-fourths of the Rs. 2,500, or Rs. 1,875 (2,500 × 3/4),
must be recognized as revenue. The remaining one-fourth, Rs. 625, remains
unearned and will be recognized in 2023 when the services are completed. This
adjustment ensures the
accurate portion of earned revenue is reported during the current accounting
period.

Adjustment for Supplies Used (Transaction 6)

On September 1, Shop Rite purchased Rs. 500 worth of supplies and recorded the
amount as an asset, which was correct at the time because supplies had not yet
been consumed. By year-end, one-fourth of the supplies had been used, equal to
Rs. 125 (500 × 1/4). Since supplies expense represents the cost of supplies
consumed during the period, Shop Rite must transfer Rs. 125 from the supplies
asset account to the supplies expense account. The remaining Rs. 375 continues
to be shown as Supplies (asset). This adjusting entry ensures that the company’s
financial statements reflect the correct amounts of supplies expense and supplies
on hand.

Table: Adjusting Journal Entries for Shop Rite Services (December 31, 2022)

Transaction Adjusting Journal Entry (DATE: Dec Debit Credit

No. 31, 2022) (Rs.) (Rs.)
1 Unearned Rent Revenue Dr. 2,000 2,000
Rent Revenue Cr.
2 Insurance Expense Dr. 1,250 1,250
Prepaid Insurance Cr.
3 Wages Expense Dr. 11,000 11,000
Wages Payable Cr.
4 Interest Receivable Dr. 70 70
Interest Revenue Cr.
5 Unearned Revenue Dr. 1,875 1,875
Service Revenue Cr.
6 Supplies Expense Dr. 125 125
Supplies Cr.

The preparation of adjusting journal entries is vital for the preparation of

accurate year-end financial statements. Each adjustment recorded for Shop Rite
Services aligns with the basic principles of accrual accounting, the matching
principle, and revenue recognition rules. Through the adjustments discussed—
covering prepaid expenses, unearned revenues, accrued wages, interest
receivable, and supplies usage—the company ensures its financial statements
display the true economic activities of 2022. These adjustments protect the
integrity of financial reporting and ensure accurate measurement of revenues,
expenses, assets, and liabilities.

Question No 4

A company that records credit purchases in a purchases journal and records

purchase returns in a general journal made the following errors. Indicate
when each error should be discovered.
 1. Posted a purchase return to the Accounts Payable account and to the
creditor’s subsidiary account, but did not post the purchase return
to the Inventory account.

2. Posted a purchase return to the Inventory account and to

the Accounts Payable account, but did not post to the
creditor’s subsidiary account.

3. Correctly recorded a Rs. 4,000 purchase in the purchases journal but

posted it to the creditor’s subsidiary account as a Rs. 400 purchase.

4. Made an addition error in determining the balance of a creditor’s

subsidiary account.

5. Made an addition error in totaling the Office Supplies column of

the purchases journal.

Answer

Introduction to Error Identification in Accounting Journals and Ledgers

In accounting systems where specialized journals and subsidiary ledgers are used,
the accuracy of postings becomes essential for providing reliable and error-free
financial information. When a company records credit purchases in a purchases
journal and purchase returns in the general journal, each transaction must be
posted correctly to the general ledger as well as the subsidiary ledger. Errors in
posting can occur at various points—when recording transactions, posting them
to the general ledger, updating subsidiary ledgers, or computing balances. The
critical concern for accountants is not only identifying what error occurred but
also determining where and when such errors will be discovered. This is
important because not all errors immediately affect the trial balance, and some are
detected only during reconciliation procedures. Each type of posting error affects
different components of the accounting system, such as the Accounts Payable
control account, individual creditors’ subsidiary accounts, inventory or purchases
accounts, and column totals in specialized journals. Therefore, knowing when an
error will surface helps management maintain internal controls and detect
discrepancies before financial statements are prepared. In the following sections,
each error is analyzed in detail, and the stage at which it will be discovered is
explained according to accounting principles, use of subsidiary ledgers, and
reconciliation processes.

Error 1: Posted a Purchase Return to Accounts Payable and the Creditor’s

Subsidiary Account, but Not to the Inventory Account

In this case, the company properly recorded the purchase return in the general
journal and correctly posted the entry to the Accounts Payable (A/P) control
account as well as the creditor’s subsidiary ledger account. The only omission
occurred when the accountant failed to post the return to the Inventory account.
Since purchase returns are normally recorded as a reduction to Inventory (in a
perpetual inventory system) or to the Purchases Returns and Allowances account
(in a periodic system), failure to post the return affects only the inventory-related
account. The Accounts Payable control account and the subsidiary ledger remain
equal and therefore would not cause any imbalance during the reconciliation of
the A/P control account with the subsidiary ledger. Because everything matches in
the payable records, the error will not be detected through the accounts payable
reconciliation process. Instead, this error will be discovered when the company
performs either (a) an inventory reconciliation, (b) a cost of goods sold (COGS)
calculation, or (c) the preparation of the financial statements where the Inventory
balance appears overstated. When physical stocktaking or periodic inventory
adjustments are made, accountants will notice the inventory balance does not
reflect the purchase return. Thus, the error is detected at the time of inventory
analysis or preparation of the cost of goods sold schedule, not during the posting
of the A/P accounts.

Error 2: Posted a Purchase Return to the Inventory Account and to Accounts

Payable, but Not to the Creditor’s Subsidiary Account

In this scenario, the purchase return has been correctly posted to the Inventory
account and the Accounts Payable control account. The only posting that was
omitted is the entry to the creditor’s subsidiary ledger. This omission creates an
imbalance between the control account (Accounts Payable) and the subsidiary
accounts, because the A/P control account reflects a reduction in liability while
the individual creditor’s account does not show the return. During the
reconciliation process, which compares the total of subsidiary accounts with the
balance of the Accounts Payable control account, the accountant will detect a
mismatch. For example, if the A/P control account decreased by Rs. 1,000 due to
a posted return,
but the subsidiary ledger does not show that reduction, the total of subsidiary
accounts will exceed the control account balance. Such discrepancies are
identified when preparing schedules of accounts payable at month-end or year-
end, or any time the company performs ledger reconciliation. Therefore, this error
will be discovered when reconciling the Accounts Payable control account with
the total of creditor subsidiary accounts.

Error 3: Correctly Recorded a Rs. 4,000 Purchase in the Purchases Journal

but Posted It as Rs. 400 to the Creditor’s Subsidiary Account

Here, the purchase was recorded correctly in the purchases journal as Rs. 4,000,
and the Accounts Payable control account would be posted correctly with the Rs.
4,000 amount. However, the mistake occurs when posting to the creditor’s
subsidiary ledger, where only Rs. 400 was recorded instead of Rs. 4,000. This
creates an inconsistency between the Accounts Payable control account and the
total of subsidiary ledger accounts. When the company prepares a schedule of
accounts payable at the end of the month or year, the total of subsidiary ledger
accounts will be Rs. 3,600 less than the balance of the Accounts Payable control
account. This difference would immediately alert the accountant that a posting
error has occurred in one or more subsidiary ledger accounts. Therefore, this error
will be discovered at the time of reconciliation between the A/P control account
and the subsidiary ledger. It becomes apparent when the company attempts to
verify that the total of all supplier accounts equals the balance in the Accounts
Payable control account. Thus, the point of discovery is the reconciliation stage.
Error 4: Made an Addition Error in Determining the Balance of a Creditor’s
Subsidiary Account

An addition error within a subsidiary ledger typically involves incorrectly

computing the running balance of a specific supplier’s account. Because this error
occurs only at the subsidiary ledger level, it affects only the balance reported for
that creditor and does not affect the postings to the general ledger. The control
account in the general ledger will be correct because it is posted based on total
purchases and returns and is not influenced by the arithmetic errors within
individual subsidiary accounts. When the company performs reconciliation—
comparing the sum of all creditor balances in the subsidiary ledger to the
Accounts Payable control account—an imbalance will be revealed. The total of
subsidiary accounts will not equal the Accounts Payable control account,
prompting an investigation, which will reveal that the error lies in the addition
within the creditor's subsidiary account. Therefore, this type of error is typically
discovered during the monthly or year-end reconciliation of the creditor
subsidiary ledger with the Accounts Payable control account.

Error 5: Made an Addition Error in Totaling the Office Supplies Column of

the Purchases Journal

In this error, the addition mistake occurs within the specialized purchases journal
when summing the Office Supplies column. This column total is later posted to
the general ledger accounts for Office Supplies (or Purchases) and Accounts
Payable. Because the incorrect column total is transferred to the general ledger,
both the Office Supplies account and the A/P control account will be misstated.
Since subsidiary ledger accounts for creditors are posted from individual
purchases, not from column totals, the Accounts Payable control account will not
match the total of subsidiary ledger accounts. This discrepancy will be identified
at the time of reconciliation between the A/P control account and the total of
subsidiary ledger accounts. Additionally, the error may be identified earlier when
preparing the trial balance if the incorrect column total affects an account that is
included in the trial balance. Thus, this error can be discovered in two ways: (a)
during reconciliation of A/P control and subsidiary ledger accounts, or (b) when
preparing the trial balance if the misstatement affects the debit and credit totals.
Regardless, this error is detected because the wrong total was carried to the
general ledger, causing discrepancies in the accounting records.

Each type of accounting error has a specific stage at which it becomes detectable,
depending on which ledger or account the error affects. Errors that fail to post
amounts to Inventory or expense accounts usually surface during inventory
adjustments or financial statement preparation. Errors that impact the Accounts
Payable control account or the subsidiary ledger become evident during
reconciliation. Arithmetic mistakes in journals or subsidiary ledgers are
recognized when totals do not match or when the control account does not agree
with the sum of subsidiary accounts. Understanding when an error is discovered
is crucial not only for maintaining accurate financial statements but also for
improving internal control procedures. This systematic detection ensures that the
accounting records remain reliable, comparable, and free from misstatements,
thereby supporting effective decision-making and ensuring compliance with
accounting principles.

Question No 5

Prepare journal entries to record the following transactions involving both

the short-term and long-term investments of Sophia Corp., all of which
occurred during calendar year 2021. Use the account Short-Term
Investments for any transactions that you determine are short-term. (20)

a. On February 15, paid Rs. 150,000 cash to purchase American

General’s 120-day short-term notes at par, which are dated
February 15 and pay 10% interest (classified as held-to-maturity).

b. On March 22, bought 700 shares of Frain Industries common stock

at Rs. 25 cash per share plus a Rs. 250 brokerage fee (classified as
long- term available-for-sale securities).

c. On June 15, received a check from American General in payment

of the principal and 120 days’ interest on the notes purchased in
transaction a.
 d. On July 30, paid Rs. 50,000 cash to purchase MP3 Electronics’ 8%
notes at par, dated July 30, 2021, and maturing on January 30,
2012 (classified as trading securities).

e. On September 1, received a Rs. 0.50 per share cash dividend on

the Frain Industries common stock purchased in transaction b.

f. On October 8, sold 350 shares of Frain Industries common stock

for Rs. 32 cash per share, less a Rs. 175 brokerage fee.

g. On October 30, received a check from MP3 Electronics for three

months’ interest on the notes purchased in transaction d.

Answer

Below are the required journal entries for Sophia Corp.’s 2021 transactions involving
both short-term and long-term investments. Entries are prepared using the
accounts requested (use Short-Term Investments for any short-term
instruments). Calculations are shown implicitly in the amounts used (all interest
calculations use the usual day-count convention implied by the facts — i.e.,
interest = principal × annual rate × fraction of year). Each transaction’s date is
shown and the related debit/credit effects are provided so these can be posted
directly to the ledger.

Journal Entries (2021)

 Feb 15, 2021 — Purchase of American General 120-day short-term
note (held-to-maturity) at par, Rs. 150,000.
Dr Short-Term Investments (American General notes) Rs. 150,000
Cr Cash Rs. 150,000
 (Explanation/calculation used: 120 days interest on Rs.150,000 at 10% =
150,000 × 0.10 × (120/360) = Rs. 5,000 — this interest will be recognized
when cash is received at maturity; the note principal is recorded at cost as
a short-term investment.)
 Mar 22, 2021 — Purchase of 700 shares of Frain Industries common
stock, Rs.25 per share, plus Rs.250 brokerage (classified as long-
term available-for-sale).
Purchase cost: 700 × Rs.25 = Rs.17,500; plus brokerage = Rs.250; total cost
= Rs.17,750.
Dr Long-Term Investments — Available-for-Sale (Frain Industries) Rs.
17,750
Cr Cash Rs. 17,750
 June 15, 2021 — Receipt of principal and 120 days’ interest
from American General on the note bought Feb 15.
Amounts received: principal Rs.150,000 + interest Rs.5,000 (150,000 × 0.10
× 120/360) = Rs.155,000.
Dr Cash Rs. 155,000
Cr Short-Term Investments (American General notes) Rs. 150,000
Cr Interest Revenue Rs. 5,000
 July 30, 2021 — Purchase of MP3 Electronics 8% notes at
par, Rs.50,000 (classified as trading securities, short-term).
Dr Short-Term Investments (MP3 Electronics — trading) Rs. 50,000
Cr Cash Rs. 50,000
 Sept 1, 2021 — Receipt of cash dividend on Frain Industries
common stock purchased Mar 22: Rs.0.50 per share × 700 shares =
Rs.350.
Dr Cash Rs. 350
Cr Dividend Income Rs. 350
 Oct 8, 2021 — Sale of 350 shares of Frain Industries (half of the
700 shares) for Rs.32 per share less Rs.175 brokerage fee.
Proceeds: 350 × Rs.32 = Rs.11,200; less brokerage Rs.175 → Net cash
received Rs.11,025.
Cost allocated to shares sold: total cost Rs.17,750 for 700 shares → cost per
share Rs.17,750 ÷ 700 = Rs.25.357142857… ; cost of 350 shares = ½ of
total cost = Rs.8,875.
Journal entry to record sale:
Dr Cash Rs. 11,025
Cr Long-Term Investments — Available-for-Sale (Frain Industries) Rs.
8,875
Cr Gain on Sale of Investments Rs. 2,150

(Note: brokerage on sale has been netted against cash received; gain
computed as net proceeds less cost of shares sold = 11,025 − 8,875
= Rs.2,150.)
  Oct 30, 2021 — Receipt of three months’ interest from MP3
Electronics on notes purchased July 30 (8% annual).
Interest calculation: Rs.50,000 × 0.08 × (3/12) = Rs.1,000.
Dr Cash Rs. 1,000
Cr Interest Revenue Rs. 1,000

Conclusion and Presentation Notes

All entries above reflect (a) purchase of short-term notes and trading securities
recorded in Short-Term Investments, (b) the long-term available-for-sale equity
investment recorded in Long-Term Investments, (c) recognition of interest and
dividend income when received, and (d) proper removal of investment cost and
recognition of gain on sale when long-term AFS shares were sold. If Sophia
Corp. maintains separate subaccounts (for example Short-Term Investments —
American General; Short-Term Investments — MP3 Electronics; Long-Term
Investments — Frain Industries), post the debits and credits to those specific
subaccounts to preserve traceability. Also note: trading securities (MP3) may
require marking to market at reporting dates with unrealized gains/losses
recognized in earnings, and available-for-sale securities may have unrealized
gains/losses recorded in OCI under applicable GAAP; those year-end fair-value
adjustments are not included here because only the specified transactions were
given.