Chapter Two: The Accounting Cycle

2.1 Accounting Cycle

In order to provide the necessary information to users, accountants maintain separate records
on each element of the financial statements.
Hence, the accounting process involves a serious of activities that are repeated in the right
order during the accounting period/fiscal period. The activities to be undertaken in the
accounting cycle include:
 Analyzing and recording business transactions in a journal
 Posting entries to the accounts in a ledger
 Taking trial balance
 Planning adjustments in a worksheet and completing the worksheet
 Preparing financial statements
 Recording and posting adjusting and closing entries
 Preparing post closing trial balance.
Economic events are happening of consequences to an entity. An event generally is the source
or cause of changes in assets, liabilities, and owner’s equality.

2.2 The Use of Accounts for Recording Transaction

Accounting systems are designed to show the increase and decrease in each financial statement
item in a separate record. This is called an Account.

Example – A separate record is kept for the increase & decrease in cash, supplies, land,
Accounts payable, Fees earned, salary expenses etc

Therefore, Accounts are means of accumulating in one place all the information about changes
in a specific asset, liability, owner's equity, expense, or revenue. A file or other record
containing all the separate accounts of a business is called a ledger [a group of accounts for a
business entity].

2.3 Classification of Accounts

Accounts in the ledger are customarily listed in the order in which they appear in the financial
statements and are classified according to common characteristics.

Balance sheet Accounts are classified as assets, liability and owner’s equity.

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 Assets - are any physical thing (tangible) or right (intangible) that has a monetary value.
Asset is resources that owned / controlled by business enterprise as a result of past
transactions or events from which future economic benefits may be obtained. Assets are
classified as current and fixed assets.
Current assets are those tangible assets that may reasonably be expected to be realized in cash
or sold or used up usually within one year or less, through the normal operations of the
business. N/R, A/R, & Supplies & other prepaid expenses are currents assets owned by service
business. The following are some of the current assets.

Cash - is any medium of exchange that a bank will accept at face value. It include - bank
deposits, currency, checks, bank drafts, and money order.
Notes Receivable (N/R) - is claims against debtors evidenced by written promise to pay a
sum of money at definite time.
Account Receivable (A/R) - are also claims against debtors, but are less formal than notes.
They arise from sales of services or merchandise on account.
Prepaid Expenses - includes supplies on hand & advance payments of expenses such as
insurance & property taxes.
Plant Assets (permanent or fixed assets) are those assets acquired to be used for relatively
long period of time (more than a year). Example - land, machinery, equipment etc. All plant
assets except land lose their usefulness with the passage of time. This decline in usefulness is
called Depreciation.

Intangible Assets are assets which are used in the operation of business but which have no
physical substance and are noncurrent. Example- Good will, Copyright, patient etc.

Liabilities are debts owed to outsiders (creditors) and are frequently described on the
balance sheet by titles that include the word '' payable ''. Liabilities are also classified as
current and long term liabilities described as follows.

Current liabilities – are liabilities that will be due within a short time (usually one year or
less) and that are to be paid out of current assets. Example - Note payable, Account payable,
salaried payable, interest payable, unearned Revenue. Unearned Revenue - cash received
before services are delivered creates a liability to perform the services. These future service
commitments are often called unearned Revenue. Example - magazine subscriptions received
by publisher & tuition received by a college etc

Long - term liabilities – are liabilities that will be due for a comparatively long time (usually
more than one year). Example - Mortgage payable - purchases of real estate and certain types
of equipment often are financed by the issuance of mortgage payable.

Owner’s equity - is the residual claim against the assets of the business after the total
liabilities are deducted. For corporation, owner's equity is described as stockholder equity
Except the drawing account, all balance sheet account balances are carried forward from year
to year and b/c of their permanence are referred to as real accounts (or permanent accounts).

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Income statement accounts include Revenue and Expense.

Revenues - are the gross increases in owner's equity as a result of the sale of merchandise,
the performance of services for a customer or a client, the rental of property and the lending
of money etc.
Expenses -are those costs that have been consumed in the process of producing revenue.
Income statement accounts are said to be temporary accounts or nominal accounts since
they are closed to a summary account, called income summary, and transferred to capital
(owner’s equity account) at the end of the accenting period.

2.4 Chart Of Accounts

Accounts are usually arranged/ listed in the ledger in financial statement order i.e. assets, first,
followed by liabilities, owner's equity, revenue and expenses. 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.

Chart of accounts is a listing of the account titles and account numbers being used by a given
business. In numbering accounts in the ledger it is preferable to use a flexible system of
indexing so that it permits a later insertion of new accounts in their proper sequence without
distributing the other account numbers. A list of account in the ledger is called chart of
account.

Example - the chart of Account of Nile computer center is as follows:

Balance Sheet Accounts

1. Asset 2. Liabilities
11 Cash 21 A/R

12 A/R 23 Unearned Rent

14 Supplies 3. Owner’s Equity

15 prepaid insurance 31 Nile, capital

17 Land 32 Nile, Drawing

18 offices Equipment

Income Statements Account

4. Revenue

41 Fees earned

5. Expenses

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 51 Rent Expenses

52 Wages Expenses

54 Utilities Expenses

55 Supplies Expenses

59 Miscellaneous Expenses

2.5 Nature of an Account

The simplest form of an account (which is called T- account) has three parts.

A title for recording the name of the item

A space for recording increase in the amount of the item, in terms of money
A space for recording decrease in the amount of the items, in terms of money
The left side of the account is called the debit side, and the right side is called the credit side.
The amounts entered on the left side are called debits or charges, and the account is said to be
debited or charged. The amount entered on the right side is called credit and the account is
said to be credited. The following is the simplest form of account named as T- Account
because of its similarity with the letter T.

Title Acct No

Left side Right side

Debit side Credit side

Thus, increase in asset is recorded in the debit side and decreases are recorded in the credit
side. Increase in liability and owner’s equity is recorded in the credit side and decreases in
these accounts are recorded on the debit side. Every business transaction affects a minimum
of two accounts. Regardless of the complexity of a transaction or the number of accounts
affected, the sum of the debits is always equal to the sum of the credits. This equality of debit
and credit for each transaction is inherent in the equation A = L + C. It is also because of this
equality the system is known as double entry accounting.

Normal Balance of Accounts

The following table summarizes the normal balance of all accounts.

Balance sheet accounts Increase Decrease Normal

Asset Debit Credit Debit

Liability Credit Debit Credit

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 Owner's equity/Share holder’s
equity capital
Capital/Capital stock Credit Debit Credit
Retained Earnings Credit Debit Credit
Drawing/Dividends Debit Credit Debit
Income statement Accounts

Revenue Credit Debit Credit

Expense Debit Credit Debit

2.6 Steps in Accounting Cycle

1. Journalizing
Journalizing is the process of recording business transactions in a journal. The following is the
flow of activities in the first two steps of accounting cycle.

Business Business Entry recorded Entry posted

Transaction document in to
Occurs prepared journal ledger
A transaction involves the transfer of something of value between the business and another
party and within the business itself. It is an event of occurrence which results a change in the
economic resources (assets), obligations (liabilities) or residual interest (owner's equity).
Transaction can be external (purchase of equipment) and/or internal (using equipment which
is according deprecation).

The business documents (or source documents) are used in the accounting system as initial
input information for the recording process. Example – sales invoices, checks, freight bills etc
The source documents normally contain information as to
 The monetary amount to be recorded
 The parties involved
 The terms of the transactions & other relevant information.
A journal is a permanent document used for initial (first) or original recording of the day to
day business transactions. It is often called book of original entry or document of original
entry. It is classified as general journal and special journal.
 General journal (two column journal) – is a general purpose journal listing transactions
expressed in terms of debits and credits to particular accounts. The simplest type of journal.
 Special journal - is a special purposes journal designed to accumulate a single type of
transaction. Example – cash payment journal, sales journal, purchase journal, and cash
receipt journal.
In general, a journal consists of

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 A date column
 A description column to record the accounts
 A column to list the accounts number
 A debit & credit column for listing the amounts to be recorded as a debit or credit to each
account.
The standard form of the two column journal is:
Journal page No.
Date Description Posting Debit Credit
reference
2004 sep 1 Debit account title XXXX
Credit account title XXXX
(Explanation)
Procedures in recording transactions in a two column journal

 Recording the date – year, month & day of the first transaction
 Recording the debit account & amount. The debit account is written in the left margin
 Recording the credit account & amount. The credit account is written in the right margin
 Writing explanation about the Nature of the transaction.
In recording a business transaction answer the following questions based on the transaction to
be recorded may help you.
a. Which accounts are affected?
b. Is each account increased or decreased?
c. Which account is debited and which is credited?
d. Prepare the complete journal entry.
Example. On January 10, 2005 Tamget P.L.C paid Birr 6,000 to its employees as a salary for
the first week of the year. This business transaction will be analyzed and recorded as follows.

a. Which accounts are affected? Answer: Cash and Salary Expense.

b. Is each account increased or decreased? Cash is decreased and salary expense is
increased.
c. Which account is debited and which is credited? Answer: Salary Expense is debited
because increase in expenses is recorded on the debit side. And cash is credited because
decrease in assets is recorded on the debit side.
d. Prepare the complete Journal entry.
General Journal Page no------
Date Description Posting Debit Credit
reference
2004 sep 1 Salary Expense 6,000
Cash 6,000
(Payment of salary expense)

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Illustration
Hannon Maze opened a law office on October 1, of the current year. During the first month of
operations, the business completed the following transactions:
October 1. Hannon deposited $17,950 cash in the business bank account Hannon Attorney.
3. Purchased supplies, $2,040 on account.
4. Paid $2,400 for three months insurance coverage.
6. Performed legal service for a client and received cash, $2,160.
8. Purchase equipment on cash, $12,000.
12. Prepared legal documents for a client on account, $2,640.
15. Paid secretary’s wage, $1,100.
19. Performed consulting service for a client on account, $2,800.
21. Paid for creditors on account, $1,670
25. Received cash from clients on account, $3,800.
31. Paid secretary’s wages, $1,100.
31. Paid rent expense, $850.
31. Paid telephone expense of $230 and electric expenses of $120 for the month.
31. Paid other miscellaneous expenses $630.
31. Withdrew $1,500 for personal use.
Instruction: Prepare the complete journal entry for Hannon Company for the month of
October.
Solution:

General Journal Page No……1……

Date Description P.R Debit Credit
2003 day
October 1 Cash 17,950
Hannon capital 17,950
Initial investment
3 Supplies 2,040
Accounts Payable 2,040
Purchase of Supplies on account
4 Prepaid Insurance 2,400
Cash 2,400
Purchase of insurance policy
6 Cash 2,160
Fees Earned 2,160
Performed service for cash
8 Equipment 12,000
Cash 12,000

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 Purchase of equipment on cash
12 Accounts Receivable 2,640
Fees Earned 2,640
Performed service on account
15 Wage Expense 1,100
Cash 1,100
Payment of Wages
19 Accounts Receivable 2,800
Fees Earned 2,800
Performed service on account
General Journal Page No……2……
21 Accounts Payable 1,670
Cash 1,670
Paid cash on account
25 Cash 3,800
Accounts Receivable 3,800
Received cash on account
31 Wage Expense 1,100
Cash 1,100
Payment of Wages
31 Rent Expense 850
Cash 850
Payment of Rent
31 Utilities Expense 350
Cash 350
Payment for telephone, electricity
31 Miscellaneous Expenses 630
Cash 630
Payment for various expenses
31 Drawings 1,500
Cash 1,500
Owner withdrawals

2. Posting from the Journal to the Ledger

After the information about a business transaction has been journalized, that information is
transferred to the specific accounts affected by each transaction. This process of transferring
the information is called posting.
Accounts may be put either in the two-column account or four-column account. We will use
the four-column account for our illustration.
The standard form of the four column account is:
Account Name___________ Account number__________
Date Item P.R Debit Credit Balance
Debit Credit

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Steps in posting

 Write the name of the account and its related identification number
 Enter year, month, and date of the transaction in the date column
 Enter the amount by which it is affected in the debit or credit column
 Insert the journal page no in the posting reference column of the account & the account
number in the posting reference column of the journal
 Determine the accounts balance & enter it in the appropriate sub-column of the balance
column.
Note. The P.R Column is used for reference purposes. The P.R column of the journal shows
whether the entry is posted and the account to which it is posted. In the account, the P.R
Column shows the Journal page number from which the entry was brought. The group of
accounts used by an organization is called ledger.

Illustration. As mentioned above, to illustrate the posting process the four column account is
used and the entries to each account are posted as follows.

Account: Cash Account number: 11

Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 1 1 17,950 17,950
4 1 2,400 15,550
6 1 2,160 17,710
8 1 12,000 5,710
15 1 1,100 4,610
21 2 1,670 2,940
25 2 3,800 6,710
31 2 1,100 5,640
31 2 850 4,790
31 2 350 4,440
31 2 630 3,810
31 2 1,500 2,310

Account: Accounts Receivable Account number: 12

Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 12 1 2,640 2,640
19 1 2,800 `5,440
25 2 3,800 1,640

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Account: Supplies Account number: 14
Date Item P.R Debit Credit
Debit Credit
2013, Oct. 3 1 2,040 2,040

Account: Prepaid Insurance Account number: 15

Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 4 1 2,400 2,400

Account: Equipment Account number: 18

Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 8 1 12,000 12,000

Account: Accounts Payable Account number: 21

Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 3 1 2,040 2,040
21 2 1,670 370

Account: Hannon, Capital Account number: 31

Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 1 1 17,950 17,950

Account: Hannon, Drawing Account number: 32

Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 31 2 1,500 1,500

Account: Fees Earned Account number: 41

Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 6 1 2,160 2,160
12 1 2,640 4,800
19 1 2,800 7,600

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 Account: Rent Expenses Account number: 51
Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 31 1 850 850

Account: Wage Expenses Account number: 52

Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 15 1 1,100 1,100
31 2 1,100 2,200
Account: Utilities Expenses Account number: 54
Item P.R Debit Credit Balance
Debit Credit
Date
2013, Oct. 31 1 350 350

Account: Miscellaneous Expenses Account number: 59

Date Item P.R Debit Credit Balance
Debit Credit
2013, Oct. 15 1 630 630

3. The trial balance

After the posting phase is completed, we have to verify the equality of the debit and credit
balances. This is done through the use of the ‘Trial Balance’. A trial balance is a two column
listing of the accounts in the ledger and their balance to make sure that the total of debit
balances equals the total of credit balances. If the two totals agree, the trial balance is called in
balance.

Procedures followed in preparing trial balance

 Determine the balance of each account in the ledger

 List accounts that have balance (Debit or Credit) in the order they appear in the ledger, the
left amount column is for debit balance & the right amount column is for Credit balances.
 The debit and Credit balances are totaled to determine their equality
 The trial balance for our illustration, Hannon Attorney is presented bellow. The amounts are
taken from the balances of the accounts after all the transactions have been posted.

Hannon Company

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 Trial Balance
Month Ended October 31, 2013

Account Name Dr Cr

Cash 2,310
Accounts receivable 1,640
Supplies 2,040
Prepaid Insurance 2,400
Equipment 12,000
Accumulated depreciation

Accounts payable 370

Hannon, Capital 17,950
Hannon, withdrawals 1,500

Fees earned 7,600

Rent expense 850
Wage expense 2,200
Utilities Expense 350
Miscellaneous expense 630
25,920 25,920

Uses of Trial balance

 To check the equality of total debits & total credits posted to the accounts in the general
ledger
 Some errors can be detected & corrected before financial statements are prepared
 Facilities preparation of financial statements. Because of all accounts are available in one
place.

Proof provided by the Trial balance

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The trial balance doesn’t provide complete proof of the accuracy of the ledger. It indicates only
that the debits and the credits are equal. If the two totals of the trial balance are not equal, it is
probably due to one or more of the following types of errors:

1. Errors in preparing the trial balance, such as:

 One of the column of the trial balance was incorrectly added
 The amount of an account balance was incorrectly recorded on the trial balance
 A debit balance was recorded on the balance as credit or vice versa or a balance was
omitted entirely
2. Error in determining the account balances, such as:
 A balance was incorrectly computed
 A balance was entered in the wrong balance column
3. Error in posting to the ledger from the journal, such as:
 An erroneous amount may be posted to the account
 A debit entry may be posted as a credit or vice versa
 A debit or credit posting may be omitted (over looked)
Limitation of trial balance

Among the types of errors that will not cause an inequality in the trial balance totals are the
following:

 Failure to record or post a transaction

 Journalizing and /or posting erroneous but equal debit & credit
 Journalizing and /or posting a transaction more than ones
 Journalizing and /or posting a transaction correctly but into the wrong account.
Procedures to locate an error

 Verify the accuracy of the trial balance by re-adding the column

 Compare amount in the trial balance with the account balance in the ledger, making
certain that no accounts have been omitted
 Re compute the balance of each account in the ledger
 Verify or check the posting from the journal to the ledger accounts
 Verify the equality of debit and credit entry in the journal

Common Types of Errors

 Transposition – the erroneous rearrangement of digits

Example- Writing 265 as 625 or 562 etc

 Sliding – it is the erroneous movement of one or more spaces to the right or the left
Example- writing 625 as 6.25 or 6,250

Correcting errors

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  When an error is discovered in either the journal or the ledger, it must be corrected.
 If the error is discovered in journal entry before posting or if an incorrect amount was
posted to an account – it may be corrected by ruling a single line through the incorrect
amount or account title and writing the correct amount or account title.
 If an amount was posted to the wrong account it is best to correct the error with a
correcting entry.

The trial balance of Harvey Company, at November 30, 2013, does not balance:

Trial Balance

Cash 8,820
Accounts receivable 17,825
Supplies 1,800
Prepaid Insurance 400
Equipment 22,500
Notes Payable 25,000
Accounts payable 5,000
Harvey, Capital 36,720
Harvey, withdrawals 8,000
Fees earned 59,750
Rent expense 1,800
Wage expense 31,500
Advertising Expense 5,700
Utilities Expense 5,650
135,595 94,870

Investigation of the accounting records reveals that:

a. The balance of cash was understated by $700

b. A cash receipt of $470 was posted as a debit to Cash of $740
c. A credit of $325 to Accounts Receivable was not posted
d. A return of $245 of defective supplies was erroneously posted as a $425 credited to
supplies
e. An insurance policy acquired at a cost of $400 was posted as a credit to prepaid insurance.
f. The balance of Notes payable was overstated by $5,000
g. A credit of $910 in Accounts Payable was overlooked when determining the balance of the
account.
h. A debit of $1,000 for a withdrawal by the owner was posted as a debit to wages expense
i. The balance of $18,000 in rent expense was entered as $1,800 in the trial balance
j. Miscellaneous expense with a balance of $1,100 was omitted from the trial balance
k. Each account has a normal balance.

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Required: Prepare a corrected trial balance as of November 30, 2013.

The corrected trial balance is as follows:

Trial Balance

Cash 9,250
Accounts receivable 17,500
Supplies 1,980
Prepaid Insurance 1,200
Equipment 22,500
Notes Payable 20,000
Accounts payable 5,910
Harvey, Capital 36,720
Harvey, withdrawals 9,000
Fees earned 59,750
Rent expense 18,000
Wage expense 30,500
Advertising Expense 5,700
Utilities Expense 5,650
Miscellaneous Expense 1,100
122,380 122,380

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