Chapter Two

Accounting cycle For Service-Giving Business

In the first chapter, accounting is defined as the process of recording, classifying, summarizing,
analyzing and interpreting about business transaction of a given business unit and finally
communicated to the interested users in order to help them to make an informed judgment and
decisions. This definition by itself indicates different steps that must be undertaken in order to
prepare financial information and provided to the users as per their requirements. But, before the
financial statements are prepared, accountants need to gather information about
business transactions, record and summarize them to come up with the values to be presented in
the reports. Therefore, the term, accounting cycle, refers to the steps involved in accounting for
all of the business activities during an accounting period. In another term, it is a series of
procedures in the collection, processing, and communication of financial information. These
procedures are
1. Identification and Measurement of 6. Adjusted trial balance
Transactions and Other Events 7. Worksheet (optional)
2. Journalization 8. Financial Statement preparation
3. Posting 9. Closing (nominal accounts)
4. Trial balance Preparation 10. Post-closing trial balance (optional)
5. Adjustment 11. Reversing entries (optional)
Characteristics of Accounts
The basic summary device of accounting is the account. It is the detailed record of all the
changes that have occurred in a particular asset, liability, or owner’s equity during a period.
Account is systematic arrangement that shows the effect of transactions and other events on a
specific element (asset, liability, and so on). Companies keep a separate account for each asset,
liability, revenue, and expense, and for capital (owners’ equity).
In its simplest form, an account consists of three parts:
 a title
 a left side, and
 A right side.
Because the format of an account resembles the letter T, we refer to it as a T-account.
Title

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 Left side Right side
Classification of accounts
Basically accounts are classified as balance sheet accounts and income statement accounts.
Balance sheet statement is the list of assets, liabilities and owner’s equity accounts. Income
statement is also the combination of revenue and expense accounts.
Asset(s): is (are) any physical thing/s (tangible) or intangible controlled by the company that
has/(have) a monetary value and expected to provide future benefits to the organization.
Depending on their duration or useful economic life, assets are categorized as
current assets and
Plant assets.
Current assets are cash or other assets that companies reasonably expect to convert into cash,
sell, or consume in operations within a single operating cycle or within a year (if completing
more than one cycle each year), Example cash, account receivable, supplies, inventories and
prepaid expanse.
Plant asset ; Companies use assets of a durable nature. Such assets are called property, plant,
and equipment. Other terms commonly used are plant assets and fixed assets. We use these
terms interchangeably. Property, plant, and equipment is defined as tangible assets that are held
for use in production or supply of goods and services, for rentals to others, or for administrative
purposes; they are expected to be used during more than one period. Property, plant, and
equipment therefore includes land, building structures (offices, factories, warehouses), and
equipment (machinery, furniture, tools).
Liabilities are defined as a present obligation arising from past events, resulting in an outflow of
resources. Liability has three essential characteristics:
 It is a present obligation.
 It arises from past events.
 It results in an outflow of resources (cash, goods, services)
Because liabilities involve future disbursements of assets or services, one of their most important
features is the date on which they are payable. This feature gives rise to the basic division of
liabilities into (1) current liabilities and (2) non-current liabilities.
Current liabilities are liabilities
 Expected to be settled within its normal operating cycle; or

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  Expected to be settled within 12 months after the reporting date.
Current liability includes, accounts payable notes payable, unearned revenues, sales and value-
added taxes, income taxes payable and dividends payable
Non-current liabilities (sometimes referred to as long-term debt) consist of an expected outflow
of resources arising from present obligations that are not payable within a year or the operating
cycle of the company, whichever is longer. Bonds payable, long-term notes payable, mortgages
payable, pension liabilities, and lease liabilities are examples of non-current liabilities.
[Link] Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from shareholders.
The definition of income includes both revenues and gains. Revenues arise from the ordinary
activities of a company and take many forms, such as sales, fees, interest, dividends, and rents.
Gains represent other items that meet the definition of income and may or may not arise in the
ordinary activities of a company. Gains include, for example, gains on the sale of long-term
assets or unrealized gains on trading securities.
Expenses is decreases in economic benefits during the accounting period in the form of outflows
or depletions of assets or incurrences of liabilities that result in decreases in equity, other than
those relating to distributions to shareholders
The definition of expenses includes both expenses and losses. Expenses generally arise from the
ordinary activities of a company and take many forms, such as cost of goods sold, depreciation,
rent, salaries and wages, and taxes. Losses represent other items that meet the definition of
expenses and may or may not arise in the ordinary activities of a company. Losses include losses
on restructuring charges, losses related to sale of long-term assets, or unrealized losses on trading
securities.
When gains and losses are reported on an income statement, they are generally separately
disclosed because knowledge of them is useful for assessing future cash flows.
Chart of accounts
Most companies have a chart of accounts. This chart lists the accounts and the account numbers
that identify their location in the ledger. The numbering system that identify as the accounts
usually starts with the statement of fi manila Position a counts and follows with the income
statement accounts.

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 Debit and credit
The term debit indicates the left side of an account, and credit indicates the right side. They are
commonly abbreviated as Dr. for debit and Cr. for credit. They do not mean increase or decrease,
as is commonly thought. We use the terms debit and credit repeatedly in the recording process to
describe where entries are made in accounts. For example, the act of entering an amount on the
left side of an account is called debiting the account. Making an entry on the right side is
crediting the account. When comparing the totals of the two sides, an account shows a debit
balance if the total of the debit amounts exceeds the credits. An account shows a credit balance if
the credit amounts exceed the debits
In Chapter 1, you learned the effect of a transaction on the basic accounting equation. Remember
that each transaction must affect two or more accounts to keep the basic accounting equation in
balance. In other words, for each transaction, debits must equal credits. The equality of debits
and credits provides the basis for the double-entry system of recording transactions. Under the
double-entry system, the dual (two-sided) effect of each transaction is recorded in appropriate
accounts. This system provides a logical method for recording transactions.

Normal balances of accounts

The sum of the increases in an account is usually equal to or greater than the sum of the
decreases in the account. Thus, the normal balance of an account is either a debit or credit
depending on whether increases in the account are recorded as debits or credits. For example,
since asset accounts are increased with debits, asset accounts normally have debit balances.
Likewise, liability accounts normally have credit balances.
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The rules of debit and credit and the normal balances of the various types of accounts are
summarized as

NB. Owners drawing account has Debit entries only. The Drawing account decreases owner’s
equity. It is not an income statement account like revenues and expenses.
Analyzing and recording transactions
In practically every business, there are three basic steps in the recording process:
1. Analyze each transaction for its effects on the accounts.
2. Enter the transaction information in a journal.
3. Transfer the journal information to the appropriate accounts in the ledger
The first step in the accounting cycle is analysis of transactions and selected other events. The
first problem is to determine what to record. Although IFRS provides guidelines, no simple rules
exist that state which events a company should record. Although changes in a company’s
personnel or managerial policies may be important, the company should not record these items in
the accounts. On the other hand, a company should record all cash sales or purchases—no matter
how small.
An item should be recognized in the financial statements if it
 meets the definition of an element,
 Is probable that any future economic benefit associated with the item will flow to or from
the entity, and
 Has a cost or value that can be measured reliably.

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For example, should we value employees for statement of financial position and income
statement purposes? Certainly skilled employees are an important asset (highly relevant), but the
problems of determining their value and measuring it reliably have not yet been solved.
Consequently, human resources are not recorded. Perhaps when measurement techniques
become more sophisticated and accepted such information will be presented, if only in
supplemental form.
In short, a company records as many transactions as possible that affect its financial
position. As discussed earlier in the case of human resources, it omits some events because of
tradition and others because of complicated measurement problems.
The purpose of transaction analysis is
 to identify the type of account involved, and
 To determine whether a debit or a credit is required.
Journal
Companies initially record transactions in chronological order (the order in which they
occur).Thus, the journal is referred to as the book of original entry. For each transaction the
journal shows the debit and credit effects on specific accounts.
In its simplest form, a general journal chronologically lists transactions and other events,
expressed in terms of debits and credits to accounts.
In some cases, a company uses special journals in addition to the general journal. Special
journals summarize transactions possessing a common characteristic (e.g., cash receipts, sales,
purchases, cash payments).
Companies may use various kinds of journals, but every company has the most basic form of
journal, a general journal. Typically, a general journal has spaces for
Dates,
account titles and explanations,
references, and
two amount columns(debit and credit)
The journal makes several significant contributions to the recording process:
 It discloses in one place the complete effects of a transaction.
 It provides a chronological record of transactions.

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  It helps to prevent or locate errors because the debit and credit amounts for
each entry can be easily compared.
Entering transaction data in the journal is known as journalizing. Companies make separate
journal entries for each transaction.
Ledger.
Ledger is the book (or electronic records) containing the accounts. A general ledger is a
collection of all the asset, liability, equity, revenue, and expense accounts. A subsidiary ledger
contains the details related to a given general ledger account. The process of transferring the
essential facts and figures from the book of original entry to the ledger accounts is called posting.
Posting involves the following steps.
(1) In the ledger, enter in the appropriate columns of the debited account(s) the date, journal
page, and debit amount shown in the journal.
(2) In the reference column of the journal, write the account number to which the debit
amount was posted.
(3) In the ledger, enter in the appropriate columns of the credited account(s) the date, journal
page, and credit amount shown in the journal.
(4) In the reference column of the journal, write the account number to which the credit
amount was posted.
The posting of the general journal is completed when a company records all of the posting
reference numbers opposite the account titles in the journal. Thus, the number in the posting
reference column serves two purposes
It indicates the ledger account number of the account involved.
It indicates the completion of posting for the particular item. Each company selects its
own numbering system for its ledger accounts. Many begin numbering with asset
accounts
The reference J1 (General Journal, page 1) indicates the source of the data transferred to the
ledger account.
Trial balance
A trial balance is a list of accounts and their balances at a given time. Customarily, companies
prepare a trial balance at the end of an accounting period. They list accounts in the order in

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which they appear in the ledger. Debit balances appear in the left column and credit balances in
the right column.
The primary purpose of a trial balance is to prove (check) that the debits equal the credits after
posting. The sum of the debit balances in the trial balance should equal the sum of the credit
balances. If the debits and credits do not agree, the company can use the trial balance to uncover
errors in journalizing and posting. In addition, the trial balance is useful in preparing financial
statements.
The steps for preparing a trial balance are:
1. List the account titles and their balances in the appropriate debit or credit column.
2. Total the debit and credit columns.
3. Prove the equality of the two columns.
Limitations of a Trial Balance
A trial balance does not guarantee freedom from recording errors, however. Numerous errors
may exist even though the trial balance columns agree.
For example, the trial balance may balance even when:
A transaction is not journalized,
A correct journal entry is not posted,
A journal entry is posted twice,
Incorrect accounts are used in journalizing or posting, or
Offsetting errors are made in recording the amount of a transaction.
Locating Errors
Errors in a trial balance generally result from mathematical mistakes, incorrect postings, or
simply transcribing data incorrectly. What do you do if you are faced with a trial balance that
does not balance? First determine the amount of the difference between the two columns of the
trial balance. After this amount is known, the following steps are often helpful:
1. If the difference between the Debit and Credit column totals is 10, 100, or 1,000, an
error in addition may have occurred. In this case, re-add the trial balance column
totals. If the error still exists, recomputed the account balances.
2. If the difference between the Debit and Credit column totals can be evenly divisible
by 2, the error may be due to the entering of a debit balance as a credit balance, or
vice versa. In this case, review the trial balance for account balances of one-half the

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 difference that may have been entered in the wrong column. For example, if the
Debit column total is $20,640 and the Credit column total is $20,236, the difference
of $404 ($20,640 − $20,236) may be due to a credit account balance of $202 that was
entered as a debit account balance.
3. If the difference between the Debit and Credit column totals is evenly divisible by 9,
trace the account balances back to the ledger to see if an account balance was
incorrectly copied from the ledger. Two common types of copying errors are
transpositions and slides. A transposition occurs when the order of the digits is
copied incorrectly, such as writing $542 as $452 or $524. In a slide, the entire
number is copied incorrectly one or more spaces to the right or the left, such as
writing $542.00 as $54.20 or $5,420.00. In both cases, the resulting error will be
evenly divisible by 9.
4. If the difference between the Debit and Credit column totals is not evenly divisible
by 2 or 9, review the ledger to see if an account balance in the amount of the error
has been omitted from the trial balance. If the error is not discovered, review the
journal postings to see if a posting of a debit or credit may have been omitted.
As long as equal debits and credits are posted, even to the wrong account or in the wrong amount,
the total debits will equal the total credits. The trial balance does not prove that the company has
recorded all transactions or that the ledger is correct.
Illustration; During the month October 2020 Pioneer Advertising Agency owned by 1, C. R.
Byrd made the following business transactions.
a. On October 1, C. R. Byrd invests $10,000 cash in an advertising company called Pioneer
Advertising Agency.
b. On October 1, Pioneer purchases office equipment costing $5,000 by signing a 3-month,
12%, $5,000 note payable
c. On October 2, Pioneer receives a $1,200 cash advance from R. Knox, a client, for
advertising services that are expected to be completed by December 31.
d. On October 3, Pioneer pays office rent for October in cash, $900 for 3 days only..
e. On October 4, Pioneer pays $600 for a one-year insurance policy that will expire next
year on September 30.

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f. On October 5, Pioneer purchases an estimated 3-month supply of advertising materials
on account from Aero Supply for $2,500.
g. On October 9, Pioneer hires four employees to begin work on October 15. Each
employee is to receive a weekly salary of $500 for a 5-day work week, payable every 2
weeks—first payment made on October 26.
h. On October 26, Pioneer owes employee salaries of $4,000 and pays them in cash. (See
October 9 transaction.)
i. On October 31, Pioneer receives $10,000 in cash from Copa Company for advertising
services provided in October.
Additional information
1. An inventory count at the close of business on October 31 reveals that $1,000 of
supplies is still on hand.
2. Pioneer Advertising estimates depreciation on the office equipment to be $480 a year,
or $40 per month.
3. In October Pioneer Advertising Agency earned $200 for advertising services that
have not been recorded
Required
a. Prepare general journal for Pioneer Advertising Agency for the month October 2020.
b. Prepare general ledger for Pioneer Advertising Agency for the month October 2020.
c. Prepare un adjusted trial balance for Pioneer Advertising Agency the month
October 31, 2020
d. Prepare adjusting entries and adjusted trial balance

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 The adjusting process-accrual vs. cash basis of accounting
Accrual-basis accounting. Under the accrual basis, companies record transactions that change a
company’s financial statements in the periods in which the events occur. For example, using the
accrual basis to determine net income means companies recognize revenues when earned (rather
than when they receive cash). It also means recognizing expenses when incurred (rather than
when paid).
An alternative to the accrual basis is the cash basis. Under cash-basis accounting, companies
record revenue when they receive cash. They record an expense when they pay out [Link]
cash basis seems appealing due to its simplicity, but it often produces misleading financial
[Link] fails to record revenue that a company has earned but for which it has not received
the cash. Also, it does not match expenses with earned revenues. Cash-basis accounting is not in
accordance with IFRS
Individuals and some small companies do use cash-basis accounting. The cash basis is justified
for small businesses because they often have few receivables and payables. Medium and large
companies use accrual-basis accounting.
Adjusting Entries
In order for revenues to be recorded in the period in which services are performed and for
expenses to be recognized in the period in which they are incurred, companies make adjusting
entries. In short, adjustments ensure that companies follow the revenue recognition and expense
recognition principles.
The use of adjusting entries makes it possible to report on the statement of financial position the
appropriate assets, liabilities, and equity at the statement date. Adjusting entries also make it
possible to report on the income statement the proper revenues and expenses for the period.
However, the trial balance—the first pulling together of the transaction data—may not contain
up-to-date and complete data. This occurs for the following reasons.

1. Some events are not journalized daily because it is not expedient. Examples are the
consumption of supplies and the earning of salaries and wages by employees.

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2. Some costs are not journalized during the accounting period because these costs expire
with the passage of time rather than as a result of recurring daily transactions. Examples
of such costs are building and equipment depreciation and rent and insurance.
3. Some items may be unrecorded. An example is a utility service bill that will not be
received until the next accounting period.

Types of Adjusting Entries

Adjusting entries are classified as either deferrals or accruals. Each of these classes has two
subcategories,

Adjusting Entries for Deferrals

To defer means to postpone or delay. Deferrals are expenses or revenues that are
recognized at a date later than the point when cash was originally exchanged. The two types
of deferrals are prepaid expenses and unearned revenues. If a company does not make an
adjustment for these deferrals, the asset and liability are overstated, and the related
expense and revenue are understated. The adjusting entry for deferrals will decrease a
statement of financial position account and increase an income statement account.

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 Prepaid Expenses. Assets paid for and recorded before a company uses them are called
prepaid expenses. When expenses are prepaid, a company debits an asset account to show the
service or benefit it will receive in the future. Examples of common prepayments are
insurance, supplies, advertising, and rent. In addition, companies make prepayments when
they purchase buildings and equipment.

Prepaid expenses are costs that expire either with the passage of time (e.g., rent and
insurance) or through use and consumption (e.g., supplies). The expiration of these costs
does not require daily entries, an unnecessary and impractical task.

As shown above, prior to adjustment, assets are overstated and expenses are understated.
Thus, an adjusting entry for prepaid expenses results in a debit to an expense account and a
credit to an asset account.
Expanse accounts (rent, supplies, depreciation and insurance expanse) xxxx
Asset accounts (prepaid rent, prepaid insurance, supplies) xxxx
Supplies. A business enterprise may use several different types of supplies. For example, a
public accounting firm will use office supplies such as stationery, envelopes, and accounting
paper. An advertising firm will stock advertising supplies such as graph paper, video film, and
poster paper. Supplies are generally debited to an asset account when they are acquired.
Recognition of supplies used is generally deferred until the adjustment process. At that time, a
physical inventory (count) of supplies is taken. The difference between the balance in the
Supplies (asset) account) account and the cost of supplies on hand represent the supplies used
(expense) for the period.
Insurance. Most companies maintain fire and theft insurance on merchandise and equipment,
personal liability insurance for accidents suffered by customers, and automobile insurance on
company cars and trucks. The extent of protection against loss determines the cost of the
insurance (the amount of the premium to be paid). The insurance policy specifies the term and
coverage. The minimum term usually covers one year. A company usually debits insurance
premiums to the asset account Prepaid Insurance when paid. At the financial statement date, it
then debits Insurance Expense and credits Prepaid Insurance for the cost that expired during
the period.
Depreciation. Companies typically own various productive facilities, such as buildings,
equipment, and motor vehicles. These assets provide a service for a number of years. The term of
service is commonly referred to as the useful life of the asset. Depreciation is the process of
allocating the cost of an asset to expense over its useful life in a rational and systematic manner.
Need for depreciation adjustment.
Under IFRS, the acquisition of productive facilities is viewed as a long-term prepayment for
services. The need for making periodic adjusting entries for depreciation is therefore the same as
we described for other prepaid expenses. That is, a company recognizes the expired cost
(expense) during the period and reports the unexpired cost (asset) at the end of the period. The
primary causes of depreciation of a productive facility are actual use, deterioration due to the
elements, and obsolescence. For example, at the time the company acquires an asset, the effects
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of these factors cannot be known with certainty. Therefore, the company must estimate them.
Thus, depreciation is an estimate rather than a factual measurement of the expired cost.
To estimate depreciation expense, companies often divides the cost of the asset by its useful life.
The reason: Depreciation is an allocation concept, not a valuation concept. That is, depreciation
allocates an asset’s cost to the periods in which it is used. Depreciation does not attempt to report
the actual change in the value of the asset.
Accumulated Depreciation—Equipment is a contra asset account. A contra asset account
offsets an asset account on the statement of financial position. This means that the Accumulated
Depreciation—Equipment account offsets the Equipment account on the statement of financial
position. Its normal balance is a credit.
Unearned Revenues. When companies receive cash before services are performed, they record a
liability by increasing (crediting) a liability account called unearned revenues. In other words, a
company now has a performance obligation (liability) to provide service to one of its customers.
Unearned revenues are the opposite of prepaid expenses. The adjusting entry for unearned
revenues results in a debit (decrease) to a liability account and a credit (increase) to a revenue
account.
Unearned revenue xxx
Revenue (service fees or sales revenue xxx
Adjusting Entries for Accruals
The second category of adjusting entries is accruals. Companies make adjusting entries for
accruals to record revenues for services performed and expenses incurred in the current
accounting period. Without an accrual adjustment, the revenue account (and the related asset
account) or the expense account (and the related liability account) are understated. Thus, the
adjusting entry for accruals will increase both a statement of financial position and an income
statement account

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Accrued Revenues. Revenues for services performed but not yet recorded at the statement date
are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in
the case of interest revenue. These are unrecorded because the earning of interest does not
involve daily transactions. Companies do not record interest revenue on a daily basis because it
is often impractical to do so. Accrued revenues also may result from services that have been
performed but not yet billed nor collected, as in the case of commissions and fees. These may be
unrecorded because only a portion of the total service has been performed and the clients will not
be billed until the service has been completed.
An adjusting entry records the receivable that exists at the statement of financial position date
and the revenue for the services performed during the period. Prior to adjustment, both assets and
revenues are understated. Accordingly, an adjusting entry for accrued revenues results in a debit
(increase) to an asset account and a credit (increase) to a revenue account.
Accrued Expenses. Expenses incurred but not yet paid or recorded at the statement date are
called accrued expenses, such as interest, rent, taxes, and salaries. Accrued expenses result from
the same causes as accrued revenues. In fact, an accrued expense on the books of one company is
an accrued revenue to another company.
Adjustments for accrued expenses record the obligations that exist at the statement of financial
position date and recognize the expenses that apply to the current accounting period. Prior to
adjustment, both liabilities and expenses are understated. Therefore, the adjusting entry for
accrued expenses results in a debit (increase) to an expense account and a credit (increase) to a
liability account. Accrued expanse includes interest expense, salary expanse and bad debt
expanses.
Adjusting entries for Pioneer Advertising Agency
At the end of the month Pioneer Advertising Agency made the following adjusting entries.
 (To record supplies used)
Advertising Supplies Expense 1,500
Advertising Supplies 1,500
An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still
on hand. Thus, the cost of supplies used is $1,500 ($2,500 - $1,000).
 (To record insurance expired)
Insurance Expense 50
Prepaid Insurance 50
On October 4, Pioneer Advertising Agency paid $600 for a one-year fire insurance policy.
Coverage began on October 1. Pioneer recorded the payment by increasing (debiting) Prepaid
Insurance. This account shows a balance of $600 in the October 31 trial balance. Insurance of
$50 ($600 / 12) expires each month.
 (To record monthly depreciation)
Depreciation Expense 40

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 Accumulated Depreciation—Office Equipment 40
Pioneer Advertising estimates depreciation on the office equipment to be $480 a year, or $40
per month.
 (To record revenue for services provided)
Unearned Revenue 400
Service Revenue 400
Pioneer Advertising Agency received $1,200 on October 2 from R. Knox for advertising services
expected to be completed by December 31. Pioneer credited the payment to Unearned Service
Revenue; this account shows a balance of $1,200 in the October 31 trial balance. Analysis
reveals that the company earned $400 of those fees in October ($1200/3).
 (To record revenue for services provided).
Accounts Receivable 200
Service Revenue 200
In October Pioneer Advertising Agency earned $200 for advertising services that have not been
recorded.
 (To record interest on notes payable)
Interest Expense 50
Interest Payable 50
Pioneer Advertising Agency signed a $5, 000,3-month note payable on October [Link] note
requires Pioneer to pay interest at an annual rate

 (To record accrued salaries)

Salaries Expense 1,200
Salaries Payable 1,200
At October 31, the salaries for the last three days of the month represent an accrued expense and
a related liability. The employees receive total salaries of $2,000 for a five-day work week, or
$400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 /3).

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19
 Adjusted trial balance
After journalizing and posting all adjusting entries, companies prepare another trial balance from
its ledger accounts. This trial balance is called an adjusted trial balance. The purpose of an
adjusted trial balance is to prove the equality of the total debit balances and the total credit
balances in the ledger after all adjustments. Because the accounts contain all data needed for
financial statements, the adjusted trial balance is the primary basis for the preparation of
financial statements.

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 Work sheet
A type of working paper frequently used by accountants prior to preparation of financial
statements is called 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: adjustments, adjusted trial balance, income
statement and balance sheet.
The company now must total each of the financial statement columns. The net income or loss for
the period is the difference between the totals of the two income statement columns. If total
credits exceed total debits, the result is net income. In such a case, the company inserts the words
“Net Income” in the account titles space. It then enters the amount in the income statement debit
column and the balance sheet credit column. The debit amount balances the income statement
columns; the credit amount balances the balance sheet columns. In addition the credit in the
balance sheet column indicates the increase in owner’s equity resulting from net income. What if
total debits in the income statement columns exceed total credits? In that case, the company has a
net loss. It enters the amount of the net loss in the income statement credit column and the
balance sheet debit column. After entering the net income or net loss, the company determines
new column totals. The totals shown in the debit and credit income statement columns will
match. So will the totals shown in the debit and credit balance sheet columns. If either the
income statement columns or the balance sheet columns are not equal after the net income or net
loss has been entered, there is an error in the worksheet.

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 Pioneer advertising agency
Work Sheet
For the month ended October 31,2010
Trial Balance Adjustments Adju. Trial Bal. Income Balance Sheet
Account Title Statem. statement
Debit Credit Debit Credi Debit Credit Debit Credit Debit Credit
t
Cash $15,200 $15,20 $15,200
0
Accounts 200 200 200
Receivable
Advertising 2,500 1500 1000 1000
Supplies
Prepaid insurance 600 50 550 550
Office Equip. 5,000 5000 5000
Accumulated 40 40 40
Depr.
Notes Payable $ 5,000 $ 5,000 $ 5,000
Accounts Payable 2,500 2500 2500
Unearned 1,200 400 800 800
Revenue
Salaries Payable 1,200 1200 1200
Interest payable 50 500 50
C. R. Byrd, 10,000 10000 10000
Capital
C. R. Byrd, 500 500 500
Drawing
Service Revenue 10,000 600 10600 10600
Salaries Expense 4,000 1200 4000 5200
Supplies expanse 1500 1500 1500
Rent Expense 900 900 900
Insurance expans 50 50 50
Interest Expense 50 50 50
Depreciation 40 40 40
Exp.
total 28,700 28,700 3,440 3,440 30,190 30,190 7740 10600 22450 19590
Net income 2860 2860
10600 10600 22450 22450
The amount shown for owner’s capital on the worksheet is the account balance
before considering drawings and net income (or loss)

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 Preparing Financial Statements
Companies can prepare financial statements directly from the adjusted trial balance.
Companies
 first prepare the income statement from the revenue and expense accounts.
 Next, they use the owner’s capital and drawing accounts and the net income (or net loss)
from the income statement to prepare the owner’s equity statement.
 then prepare the balance sheet from the asset and liability accounts and the ending
owner’s capital balance as reported in the owner’s equity statement.
Pioneer advertising agency
Income Statement
For the Month Ended October 31, 2010
Revenues
Service Revenue 10600
Less Expenses
Salaries expense 5200
Advertising supplies expense 1500
Rent expense 900
Insurance expense 50
Interest expense 50
Depreciation expense 40
Total expenses 7,740
Net income $ 2,860
Pioneer advertising agency
Owner’s Equity Statement
For the Month Ended October 31, 2010
C. R. Byrd; Capital, October 1 $ –0–
Add: Investments by owners 10,000
C. R. Byrd, Capital 10,000
Net income 2,860
Less: Drawings 500
C. R. Byrd, Capital, October 31 $12,360
Pioneer advertising agency
Balance Sheet
October 31, 2010

cash $15,200
Accounts receivable 200
Advertising supplies 1,000
Prepaid insurance 550
Office equipment $5,000
Less: Accumulated depreciation 40
Total assets $21,910

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Liabilities
Notes payable $ 5,000
Accounts payable 2,500
Unearned revenue 800
Salaries payable 1,200
Interest payable 50
Total liabilities 9,550
Owner’s equity
C. R. Byrd, Capital 12,360
Total liabilities and owner’s equity $21,910

Closing
The closing process reduces the balance of nominal (temporary) accounts to zero in order to
prepare the accounts for the next period’s transactions.
In closing the books, the company distinguishes between temporary and permanent accounts.
Temporary accounts relate only to a given accounting [Link] include all income
statement accounts and the owner’s drawing [Link] company closes all temporary accounts
at the end of the period.
In contrast, permanent accounts relate to one or more future accounting [Link] consist of
all balance sheet accounts, including the owner’s capital account. Permanent accounts are not
closed from period to period. Instead, the company carries forward the balances of permanent
accounts into the next accounting period.

Preparing Closing Entries

At the end of the accounting period,the company transfers temporary account balances to the
permanent owner’s equity account, Owner’s Capital, by means of closing entries.
Closing entries formally recognize in the ledger the transfer of net income (or net loss) and
owner’s drawing to owner’s capital. The owner’s equity statement shows the results of these
entries. Closing entries also produce a zero balance in each temporary account. The temporary
accounts are then ready to accumulate data in the next accounting period separate from the data
of prior periods. Permanent accounts are not closed.
Journalizing and posting closing entries is a required step in the accounting cycle. Companies
generally journalize and post closing entries only at the end of the annual accounting period.
Companies generally prepare closing entries directly from the adjusted balances in the ledger.

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They could prepare separate closing entries for each nominal account, but the following four
entries accomplish the desired result more efficiently:
1. Debit each revenue account for its balance, and credit Income Summary for total
revenues(to close revenue ).
2. Debit Income Summary for total expenses, and credit each expense account for its
balance( to close expanse).
3. Debit Income Summary and credit Owner’s Capital for the amount of net income(to
close net income).
4. Debit Owner’s Capital for the balance in the Owner’s Drawing account, and credit
Owner’s Drawing for the same amount(to close owners drawing).
5. Debit retaind earning and credit dividend for its balance(to close dividend for
corporation).
6. If there were a net loss (because expenses exceeded revenues), :there would be a credit to
Income Summary and a debit to Owner’s Capital.
we will assume that Pioneer Advertising Agency closes its books monthly. The following table
shows the closing entries at October 31.

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A couple of cautions in preparing closing entries:
 Avoid unintentionally doubling the revenue and expense balances rather than zeroing
them.
 Do not close Owner’s Drawing through the Income Summary account. Owner’s
Drawing is not an expense, and it is not a factor in determining net income.
Preparing a Post-Closing Trial Balance
After journalized and posted all closing entries, companies prepares another trial balance, called
a post-closing trial balance, from the ledger. The post-closing trial balance lists permanent
accounts and their balances after journalizing and posting of closing entries.
The purpose of the postclosing trial balance is
to prove the equality of the permanent account balances carried forward into the next
accounting period. Since all temporary accounts will have zero balances, the post-closing
trial balance will contain only permanent—balance sheet—accounts.
The following Illustration shows the post-closing trial balance for Pioneer Advertising
Agency.

A post-closing trial balance provides evidence that the company has properly journalized and
posted the closing entries. It also shows that the accounting equation is in balance at the end of
the accounting period. However, like the trial balance, it does not prove that company has
recorded all transactions or that the ledger is correct.
Reversing Entries—An Optional Step
Some accountants prefer to reverse certain adjusting entries by making a reversing entry at the
beginning of the next accounting period.A reversing entry is the exact opposite of the adjusting
entry made in the previous period. Use of reversing entries is an optional procedure; it is not a
required step in the accounting cycle.

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 Correcting Entries
Unfortunately, errors may occur in the recording process. Companies should correct errors, as
soon as they discover them, by journalizing and posting correcting entries. If the accounting
records are free of errors, no correcting entries are needed.
You should recognize several differences between correcting entries and adjusting entries. First,
adjusting entries are an integral part of the accounting cycle. Correcting entries, on the other
hand, are unnecessary if the records are error-free. Second, companies journalize and post
adjustments only at the end of an accounting period. In contrast, companies make correcting
entries whenever they discover an error. Finally, adjusting entries always affect at least one
balance sheet account and one income statement account. In contrast, correcting entries may
involve any combination of accounts in need of correction. Correcting entries must be posted
before closing entries.
To determine the correcting entry, it is useful to compare the incorrect entry with the correct
[Link] so helps identify the accounts and amounts that should—and should not—be
corrected. After comparison, the accountant makes an entry to correct the accounts.
The following two cases for Mercato Co. illustrate this approach.
CASE 1
On May 10, Mercato Co. journalized and posted a $50 cash collection on account from a
customer as a debit to Cash $50 and a credit to Service Revenue $50. The company discovered
the error on May 20, when the customer paid the remaining balance in full.

Comparison of the incorrect entry with the correct entry reveals that the debit to Cash $50 is
correct. However, the $50 credit to Service Revenue should have been credited to Accounts
Receivable. As a result, both Service Revenue and Accounts Receivable are overstated in the
ledger. Mercato makes the following correcting entry.

CASE 2
On May 18, Mercato purchased on account office equipment costing $450. The transaction was
journalized and posted as a debit to Delivery Equipment $45 and a credit to Accounts Payable
$45. The error was discovered on June 3, when Mercato received the monthly statement for May

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from the creditor.

Comparison of the two entries shows that three accounts are incorrect. Delivery Equipment is
overstated $45; Office Equipment is understated $450; and Accounts Payable is understated
$405. Mercato makes the following correcting entry

Instead of preparing a correcting entry, it is possible to reverse the incorrect entry and then
prepare the correct [Link] approach will result in more entries and postings than a correcting
entry, but it will accomplish the desired result.

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