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CH 2 3
CH 2 3
Ch 2 3
∫Chapter-Two
The Accounting Cycle for Service Giving Business
Introduction
Every business transaction affects the elements of the accounting equation. This accounting
procedure will be discussed in detail. The different and interrelated stages of the accounting
cycle will be presented.
In order to provide the necessary information to users, accountants maintain separate records on
each element of the financial statements. For example , to report the balance for cash at the
end of a year, a record regarding cash should be kept. The record includes beginning cash
balance, cash payments & cash collections during the period. This record is called an account.
account.
Definition: 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’.
Example: Title
Debit Credit
Dr Cr
2.2. Classification of Accounts
Accounts are classified into five: assets, liabilities, capital, revenue and expenses.
expenses. The first
three are called balance sheet accounts (real accounts) and the other two are called income
accounts). Balance Sheet accounts are those reported on the
Statement accounts (temporary accounts).
balance sheet at the end of the reporting period and Income Statement accounts are reported on
the Income Statement. The five groups of account are discussed below
2.2.1. Balance Sheet Accounts
1. Asset: - Resources owned by a business or individual are called assets. assets. Assets could be
tangible or intangible. Tangible assets are assets having physical existence, like cash, land,
computer, stationery materials. Intangible assets do not have physical existence. Example:
Goodwill, Copyright, patent right. An asset is customarily classified into two groups as
current asset and plant asset.
i. Current Assets: - are cash and other assets which are expected to realize in cash or sold
or used up within one accounting period. Examples of current asset:
Cash is any medium of exchange that a Bank accepts at face value.
Notes receivable is a claim against debtors evidenced by a written promise to pay a sum
of money at a definite time to the order of a specified person or to bearer.
Accounts Receivable is also claims against debtors but less formal than n/receivable.
They arise from sale of service or merchandise on account.
Supplies are consumable assets which are expired trough the operation of the business.
Prepaid expense, Advance payments such as Insurance and Property taxes which are
expire trough the passage of time.
ii. Plant Assets: - are tangible assets used in the business that have an economic life of
more than one year. Examples of plant assets; equipment, machinery, building, land,
etc. such assets are gradually wear out or lose their value/usefulness trough the passage
of time except land, which is said to be depreciation.
2. Liabilities: - Creditors’ claims to the assets of a business; amounts owed to creditors are
called liabilities;
liabilities as like as assets liabilities are classified into two groups as current liabilities
and long term liabilities.
i. Current liabilities: - these are the claims of creditors on the organization which are due
within a short time usually one year or less, and that are to be paid out of current assets.
Examples accounts payable, salaries payable, wage payable, tax payable, etc.
ii. Long term liabilities: - - these are the claims of creditors on the organization which are
not due within one year. Examples bonds payable, mortgage payable, etc.
3. Owner’s equity/Capital:-The
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.
For sole proprietorship and partnership
o Owner’s capital: - amount invested by owner.
o Owner’s drawing: - amount drawn by the owner from the business for personal use.
For corporation
o Capital stock: - owners/stockholders investment.
o Retained: - earnings amount of net income retained in the business.
o Dividend: - amount of earnings distributed to stockholders.
2.2.2. Income Statement Accounts
i. Revenues: - are the causes of the gross increase in owner’s equity account as a result
of the sale of merchandise, the performance/render of service for a customers or
client. Example sales earned, fares earned, rent revenue, interest income, tuition fee,
fees earned, etc. if an enterprise has various sources of revenue a separate account
should maintained for each account.
ii. Expenses: - they are costs which are incurred in the process of generating revenue.
They causes of decreases
ecreases in owner’s equity. Examples supplies expense, salaries
expense, rent expense, depreciation expense, interest expense, etc.
2.3. Chart of Accounts
The number of accounts maintained by a specific enterprise is affected by the nature of its
operations, its volume of business, and the extent to which details are needed for taxing
authorities, managerial decisions, credit purposes etc.
A list of the account in the ledger is called chart of accounts. The order of the accounts in the chart of
accounts should agree with the order of the items in the balance sheet and the income statement . The
accounts are identified with numbers for the purpose of indexing and also for use as reference.
The following chart of accounts for a typical organization can be considered. In the chart of
account stated below, each account has two digits. The first digit indicates the major
classification of the ledger in which the account is located. The second digit indicates the
position of the account with in its division. Accounts beginning with number:
1 Represents Assets, 4 Represents Revenue and
2 Represents Liabilities, 5 Represents Expense
3 Represents Owners Equity,
For example: The chart of accounts of one organization may look like below:
Balance Sheet Accounts
1 Asset 2 Liabilities 3 Owner’s equity
11 Cash 21 Accounts payable 31 owner’s capital
12 Accounts receivable 22 Salaries payable 32 Owner’s drawing
14 Supplies 23 Unearned rent
15 Prepaid rent
18 Equipment
19 Accumulated depreciation
Income statement accounts
4 Revenue 5 Expense
41 Fees Earned 51 supplies expense
52 Salary Expense
53 Rent Expense
54 Depreciation Expense
59 Miscellaneous Expense
In the chart of accounts, the asset accounts are listed according to their liquidity. Liquidity is the
ease with which an asset can be converted in to cash. Cash is the most liquid asset so it is listed
first. When the chart of accounts is prepared in an organization we say the ledger is opened.
2.4. 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.
Title–
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.
debited.
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.
An account may increase or decrease on the debit side or on the credit side depending on the
nature of the account. In general, accounts appearing on the left hand side of the accounting
equation increase on their left side (Dr. side) and decrease on their right side (Cr. Side); whereas
accounts on the right side of the equation increase on their right side and decrease on their left
side. The above general rule will be expanded as follows
Debit may signify for Credit may signify for
-Increase in assets -Decrease in assets
Normal balance refers to the side of an account (Dr. or Cr.), which will have greater entries than
the other. The sum of the increases recorded in an account is usually equal to or greater than the
sum of the decreases recorded in the account. Thus the normal balance of an account is positive
rather than negative. Therefore the increasing side will be the normal balance for accounts.
Example: The normal balance of all asset accounts is debit.
The normal balance of capital/capital stock is credit.
The normal balance of drawing/dividend is debit.
The normal balance of all liability accounts is credit.
The normal balance of all revenue accounts is credit.
The normal balance of all expense accounts is debit.
Accounting Process
Once the business transaction is identified and measured its effect on the one or more items of
accounting equation elements; the next task of accountants/bookkeepers is the recording of
transactions in the general journal/special journal of the organization. Before discussing the
process of recording transactions look on the supporting documents and accounting period is
necessary since they are helping to clarify the recording process.
2.6.1. Supporting Documents
A supporting document (sometimes called business paper or voucher) is the first record for
business transaction. Such documents show the date, amount, and nature of the transaction and
the parties involved. Entries in the various journals are prepared from supporting documents; for
example sales invoice supports entries in the sales journal. The original copy of the sales invoice
is sent to the customer who uses it as a basis for recording the purchase; and a duplicate copy is
retained by the seller as evidence of the sale. Some supporting documents may never leave the
business enterprise, for example, cash register tapes, receiving reports, time reports, journal
vouchers, and minutes of directors’ meetings.
The normal accounting period is one year, beginning a specific day and ending 12 months later.
For Gregorian calendar a calendar-year accounting period ends December 31; all other 12 month
periods are known as fiscal periods. In the case of Ethiopian calendar a calendar-year accounting
period ends Sene/June 30.
Accounting Cycle
It is the complete sequence of accounting procedures that are repeated in the same order during
each accounting period. The accounting cycle has the following steps:
1. Recording transactions into journals
2. Classifying recorded transactions by posting from journals to ledger
3. Summarizing transactions in the form of trial balance/unadjusted
4. Adjusting, correcting, and updating recorded transactions/ledger accounts (completion of
the work sheet)
5. Preparations of financial statements/reports from the work sheet data
6. Closing nominal accounts/temporary accounts to summarize the operation of the
accounting period.
7. Preparation of post closing trial balance (optional)
8. Reversing some of adjusting entries to facilitate the recording process of the next
accounting period.(optional)
2.6.3. Journalizing Business Transaction
The flow of accounting data from the time the transaction occurs to its recording to the ledger.
On the basis of the evidence provided by the business documents such as sales tickets, a bill or a
cash register tape the transactions are recorded in a chronological order in the journal. The
amounts of the debits and the credits in the journal are then transferred or post to the ledger
account.
a) Journals
A journal is the book of original entry where the transactions and selected other events are
initially recorded. When numerous transactions of the same nature; special journals may be used
as a more efficient means of recording and summarizing such recurring transaction. The general
journal is necessary regardless of the special journals involved to record usual and non repetitive
transactions and also to record adjusting and closing entries at the end of the accounting period.
Two-Column Journal
The recording of transactions is done in a two column general journal which includes the date,
account title and debit and credit sides; but the last two (i.e. debit and credit) are considered as
column. Before a transaction is entered in the two column journal, it should be analyzed
according to the following sequence of steps:
a) Determine whether an asset, liability, owner’s equity, revenue or expense is affected.
b) Determine whether the affected asset, liability, owner’s equity, revenue or expense
increases or decreases.
c) Determine whether the effect of the transaction should be recorded as a debit or credit in
d) an asset, liability, owner’s equity, revenue or expense account.
A complete journal consists of:
The date of the transaction;
The accounts and amounts to be debited and credited;
A brief explanation of the transaction.
Example: On September 1, 1996 Mandela invested Br 15,000 in his business (Mandela
Internet Cafe).
On September 10, 1996Mandela purchased computer equipment for Br 7,000
which is to operate the business.
Record the above transactions in a general journal (two-column journal)?
General journal page no 1
Date Description Post reference Debit Credit
1996 1 Cash 15,000
September Mandela capital 15,000
(to record the investment
by the owner)
After transactions are recorded their balance is transfer/post to the standardized ledger account.
Posting is the process of transferring essential facts from the books of original entry to the
ledger. A ledger is the book (printout) which contains the accounts. A ledger is a book having
one page for each account in the organization's financial structure. The page for each account
shows its debits on the left side and its credits on the right side, so that each account’s balance
that is, the net credit or net debit amount can be determined.
Standard Forms of Two-Column Account ledger
As an illustration a month’s transaction for Ann Hill Photographic Studio are use based on their
occurrence during March, 2012.
March, 1. Ann Hill invested the following from her par-time business to transfer a full-time
business; cash Br 3,500, account receivable Br 950, supplies Br 1,200 and
photographic equipment Br 15,000
March, 1. Hill paid Br 2,400 on a lease rental contracts the payment representing three
months rent of quarters for the studio.
March, 4. Purchased additional photographic equipment on account from Limenih
photographic equipment Inc. for Br 2,500.
March, 5. Received Br 850 from customers in payment of their accounts.
March, 6. Paid Br 125 for a news paper advertisement.
March, 10. Paid Br 500 to Limenih photographic equipment Inc. as a payment of her debt.
March, 13. Paid receptionists Br 575 for two weeks salary.
March, 16. Received Br 1,980 from sales for the first half of march.
March, 20. Paid Br 650 for supplies.
March, 27. Paid receptionist Br 575 for two weeks salary.
March, 31. Paid Br 69 for telephone bill for the month.
March, 31. Paid Br 175 for electric bill for the month.
March, 31. Received Br 1, 870 from sales for the second half of march.
March, 31 Sales on account totaled shows balance of Br 1,675 for the month.
March, 31 Ann Hill withdrew Br 1,500 for her personal use.
Prepare the journal entry for the above transaction and post to the ledger?
Solution
0
2 575 1505
7
3 69 1436
1
3 175 1261
1
3 1870 3131
1
3 1500 1631
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Students are advised to read the remaining accounts ledger and post their balance from the journal to
the ledger.
2.7. Trial Balance
It is a list of accounts and their balance at a given time. The accounts are listed in the order in which they
appear in the ledger. The totals of the two columns should be agreed (equal). The primary purpose of trial
balance is to prove the equality of debits and credits after posting. The equality of debits and credits in
the ledger should be verified at the end of each accounting period. Such verification is called a trial
balance. Example for Ann Hill photographic studio is as follows:
Hill Photographic Studio
Trial Balance
March 31, 1990
Cash 1,631
Accounts Receivable 1,775
Supplies 1,850
Prepaid Rent 2,400
Photographic Equipment 17,500
Accounts Payable 2,000
Ann Hill, Capital 20,650
Ann Hill Drawing 1500
Sales 5,525
Salary Expense 1,150
Miscellaneous Expense 369
28,175
28,175
2.7.1. Proof Provided By the Trial Balance
Limitations of Trial Balance
The trial balance does not provide complete proof of accuracy of the ledger. It indicates only that
the debits and credits are equal. If the two totals of trial balance are not equal, it is probably due
to one or more of the following types of errors:
1. Error in preparing trial balance:
a. One of the columns of the trial balance was incorrectly added.
b. The amount of an account balance was incorrectly recorded on the trial balance.
c. A debit balance was recorded as credit, or vice versa, or a balance was omitted
entirely.
2. Error in determining the account balance:
a. A balance was incorrectly computed.
b. A balance was entered in the wrong balance column.
3. Error in recording a transaction in the ledger
a. An erroneous amount was posted to the account.
b. A debit entry was posted as a credit, or vice versa.
c. A debit or credit posting was omitted.
Among the types of errors that will not cause an inequality in the trial balance totals are the
following:
1. Failure to record a transaction or to post a transaction.
2. Recording the same erroneous amount for both the debit and credit parts of a transaction.
3. Recording the same transaction more than one.
4. Posting a part of a transaction correctly as a debit or credit but not to the wrong account.
Discovery of Errors
The existence of an error can be determined in various ways:
1. By audit procedures
2. By chance discovery, or
3. Through the medium of the trial balance.
Types of Error
1. Addition
For example, a difference of $10, $100, or $1,000 between totals is frequently the result of error
in addition.
2. Omission
A difference between totals can happen due to the omission of a debit or a credit posting or, if the
difference is divisible evenly by 2, orto the posting of a debit as a credit, or vice versa. For
example, if the debit and credit totals of a trial balance are $ 20,640 and $20,236 respectively, the
difference of $404 may indicate that a credit posting of that amount was omitted or that a credit
of $202 was erroneously posted as a debit.
3. Transpositions
It is the erroneous rearrangement of digit, such as writing $ 542 as $ 524 or $452.
4. Slide
It is the entire number is erroneously moved one or more spaces to the right or the left, such as
writing $542.00 as $54200 or $54.20
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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.
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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The entries required to record at the end of an accounting period to bring the accounts up to date
and to assure the proper matching of revenues and expenses are called adjusting entries. These
types of entries are required only when the accrual basis of accounting is used by the business
enterprise.
Adjusting Entries
Adjusting entries are journal entries that are required at the end of an accounting period to bring
the ledger up to date. Adjusting entries can be classified as either deferrals or accruals.
Deferrals
1. Prepaid Expenses: -Expense that are paid in cash before they are used or consumed.
2. Unearned Revenues: -Revenues received in cash before delivering goods or services.
Accruals
1. Accrued Expenses: -Expenses incurred but not yet paid in cash or recorded.
2. Accrued revenues: -Revenues earned but not yet received in cash or recorded.
Prepaid expenses (deferred expenses)
It is already paid before using the service or property. Such as: prepaid rent, prepaid insurance etc.
Illustration:
a. The inventory of supplies on March 31 is determined that $890 is on hand, the amount to
be moved from asset account to expense account is $960 i.e. (1,850-890=960).
Supplies supplies expense
Mar 1, Br 1,200 Mar 31, 960 Mar 31, 960
20, 650
1,850
890
Supplies Exp………………………………………….960
Supplies…………………………………………………960
b. The debit balance of Br 2,400 in the prepaid rent represent the prepayment for three
months; thus at the end of March the rent expense for one month should be computed and
recognized as expense, as a result the asset prepaid rent should be decreased by the
amount. Prepaid rent was used for one month (March 1 up to March 31) is Br 800, i.e.
2,400/3 = 800.
Rent Exp………………………………………………..800
Prepaid Rent………………………………………….800
Plant Assets
As time passes, equipments do lose its capacity to provide useful service. This decrease in
usefulness is a business expense, which is called depreciation. This expired portion of the cost
of plant asset is both an expense and a reduction in the asset. The adjusting entry to record is
depreciation expense debited and accumulated depreciation credited.
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c. The estimated amount of depreciation of the photographic equipment for the month is
assumed to be $175:
Depreciation expense …………………………………………………175
Accumulated Depreciation - Photo. Equip…………………175
Accrued Expenses (Liabilities)
Accrued expense is an accumulated expense that is unpaid and unrecorded, such as: unpaid and
unrecorded amount of salary for employees. The accrued expense and the related liabilities must
be recorded in the account by the adjusting entry.
d. Ann Hill uses to pay a bi-weekly salary on alternate Fridays for five working days
(Monday-Friday).The debit of $ 575 on March 13 and 27 in the salary expense account
were biweekly payments on Fridays for the payroll periods ended on those days. The
salaries expense on Monday and Tuesday, March 30 and 31 total $ 115 were not paid
(accrued expense/salary payable).
Salary Expense………………………………………….115
Salary Payable………………………………………..115
2.9. Work Sheet
A type of working paper frequently used by accountants prior to preparation of financial
statements is called work sheet.
Benefits of Work Sheet
Work sheet is not a required report (it is not available to external decision makers), yet using of
work sheet has several benefits, such as:
- Aids the preparation of financial statements.
- Reduce the possibilities of errors.
- Links accounts and adjustments to their impacts in the financial statements.
Work sheet has an account title column and ten money columns, ranged in five parts of debit
and credit columns. The main headings are: trial balance, adjustments, adjusted trial balance,
income statement and balance sheet.
Trial Balance Column
The trial balance data can be assembled directly on the work sheet form or can be prepared on
another sheet and then copied on to the work sheet form.
Adjustments Column
Both the debit and credit parts of an adjustment should be inserted on the appropriate lines before
going on to another adjustment.
a. Supplies: Supplies account………………………………………………………….Br 1,850
Less: Supplies on hand………………………………………………………..890
Supplies Expense ……………………………………………………………960
b. Rent: Prepaid rent (for 3 month)……………………..……………………….…Br 2,400
Less: Remaining prepaid rent (2 month)…………………….………………...1,600
Rent Expense for March…………………………………………………………800
c. Depreciation: depreciation of photographic equipment is estimated to be $175 for the month:
Depreciation expense………………………………………………………..Br 175
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Income Summary…………………………………1956
Ann Hill, Capital…………………………………….1956
Entry four
Ann Hill, Capital………………………………….1500
Ann Hill drawing…………………………………….1500
After journalizing, the journal entries should be posted to the ledger. The sales, expenses, income
summary, and drawing accounts then get zero balance.
2.12. Post Closing Trial Balance
The last procedure of the accounting cycle is the preparation of post closing trial balance after all
of the temporary accounts has been closed. The purpose of the post closing trial balance is to
make sure that the ledger is balance at the beginning of the new accounting period. The
following is Hill Photographic Studio post closing trial balance as of March 31, 1990:
Hill Photographic Studio
Post Closing Trial Balance
March 31, 1990
Cash 1,631
Accounts receivable 1,775
Supplies 890
Prepaid Rent 1,600
Photographic Equipment 17,500
Accumulated Depreciation 175
Accounts Payable 2,000
Salary Payable 115
Ann Hill, Capital 21,106
23,396 23,396
Fiscal Year
The maximum length of an accounting period is usually one year (12 months). The annual
accounting period adopted by an enterprise is known as fiscal year.
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