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UNIT .2 THE ACCOUNTING CYCLE
NATURE OF AN ACCOUNT
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.
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
Ti t l e
Debit Credit
Dr Cr
2.0 CLASSIFICATIONS OF ACCOUNTS
Accounts are classified into five: assets, liabilities, capital, revenue and, expenses. The first
three are called balance sheet accounts and the other two are called income Statement
accounts. Balance Sheet accounts are those reported on the 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
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1. Assets: Resources owned by a business or individual are called 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.
On the balance sheet assets are classified into two current assets and non – current assets.
Current Assets – are those assets, which can be used, sold, or converted into cash within one
accounting year. Example: cash, supplies, prepayments, receivables etc.
Non-current Asset: All assets other than current assets are called non-current assets.
Example: land, patent right, office equipment, vehicles.
2. Liabilities: Creditors‟ claims to the assets of a business; amounts owed to creditors are
called liabilities. Like assets, liabilities are classified in to two as current liabilities and non –
current liabilities
Current liabilities: The liabilities that are payable within the next (one) accounting year are
known as current liability. Example: Accounts Payable, Rent Payable, Salary Payable.
Non – Current Liabilities: Debts that are not required to be paid within the next accounting
period. Example long term notes payable.
3. 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.
4. Revenue: Are increases in owner‟s equity resulting from the main operations of the
business.
Examples of revenue accounts are sales, interest income, tuition fee, and sales commission.
5. Expenses: are decreases in owner‟s equity in the process of earning revenue. For example,
a hotel has to pay salary to its workers for the services rendered to clients in order to get the
income form customers (revenue) the Hotel has pay salary to the employees (expense).
Example of expenses: Salary, insurance, depreciation, supplies, utilities, rent etc.
CHART OF ACCOUNTS
The number and name of accounts used by an organization depends on the nature of its
operation. The list of accounts used by an organization and their codes is called the chart of
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accounts. Look at the following chart of accounts of Bati Transport.
Bati Transport
Chart of Accounts
Asset Account number
Cash-------------------------------------------------------------------------- 11
Accounts Receivable- 12
Supplies --------------------------------------------------------------------- 13
Prepaid Insurance ----------------------------------------------------------- 14
Equipment- 15
Accumulated Depreciation –Equipment -------------------------------- 16
Truck ------------------------------------------------------------------------- 17
Accumulated depreciation – Truck---------------------------------------- 18
Liabilities
Accounts Payable ------------------------------------------------------------- 21
Notes Payable ---------------------------------------------------------------- 22
Owners Equity
Yimer Adem, Capital ---------------------------------------------------------- 31
Yimer Adem Drawing ------------------------------------------------------- 32
Income Summary -------------------------------------------------------------33
Revenue
Service income ---------------------------------------------------------------- 41
Expense
Salaries Expense -------------------------------------------------------------- 51
Rent Expense ------------------------------------------------------------------ 52
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Utilities Expense --------------------------------------------------------------- 53
Supplies Expense ------------------------------------------------------------- 54
Insurance Expense ------------------------------------------------------------- 55
Maintenance Expense ---------------------------------------------------------5
56
Depreciation Expense ---------------------------------------------------------57
Truck Expense ---------------------------------------------------------------- 58
Miscellaneous expense -------------------------------------------------------- 59
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. Accounts other than cash will be listed in their frequency of use or in alphabetical
order.
The account number is a code to identify accounts. The number could be a two digit, three
digit or more digits. In the above example a three – digits code is used.
When the chart of accounts is prepared in an organization we say the ledger is opened.
RULES OF DEBITS AND CREDITS
As shown above every account has three parts. These parts are discussed below:
Title – The name of the account. This is written at the top of the account.
Debit – is the left hand side of an account –Debit is abbreviated as „Dr.‟. When an amount is
entered on the left side of an account we say the account is debited or charged.
Credit – is the right hand side of an account. Credit is abbreviated as Cr. An account is said
to be credited when an amount is entered on the right hand side of the account.
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
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Debit Credit
-Increase in assets -Decrease in assets
-Increase in expenses -Decrease in expenses
-Decrease in capital -Increase in Liabilities
-Decrease in liabilities -Increase in liabilities
-Decrease in revenue -Increase in revenue.
The normal balance of an Account
Normal balance refers to the side of an account (Dr. or Cr.), which will have greater entries
than the other. The increasing side will be the normal balance for accounts.
Example: The normal balance of all asset accounts is debit
JOURNALIZING BUSINESS TRANSACTIONS
When a business transaction takes place, source documents will be obtained and recorded.
The accounting record in which a transaction is initially recorded is known as a journal. The
journal is therefore referred to as “The book of original entry”.
The process of recording a business transaction in the accounting record is called
journalizing.
The Journal commonly used to record all types of transactions is the General Journal. This
Journal includes the following parts, entered step by step.
1. The date of the transaction
2. The title of the account debited
3. The title of the account credited
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4. The amount of debit and credit
5. Brief explanation of the entry or reference to the source document.
Look at the following General Journal and notice where each of the above information is
found.
Journal page
Date Description P.R Debit Credit
Year
Month day Debited account title XXX XX
Credited account title X XX XX
Explanation
There are also other types of Journals like, known as special journals that are used to record
specific types of transactions. The cash Journal, for instance, is used to record only
transactions affecting cash. The General Journal is used for illustrations in this chapter.
Special journals are discussed in unit 5.
Steps in Journalizing a Transaction
The following steps should be followed in recording a transaction in the journal.
1. Record the date - Insert the year, the month, and the date as shown above.
2. Record the Debit- Insert the account debited in the description column and the amount
of debit in the debit column.
3. Record the credit- Insert the account credited below the debited account and indented
to the right in the description column and the amount of credit in the credit column.
4. Explanation- Write a brief explanation or reference to source document in the
description column, when necessary.
Each one set of debits and credits for a transaction is called a journal entry.
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?
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d) Prepare the complete journal entry.
Example. On January 10,2003 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? Answer: 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.
2003 Description
Jan. 10 Salary expense 6000 00
Cash 6000 00
Payment of salary
Note: A journal entry is the complete presentation of the record in the journal.
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.
An account could be of tw
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Office equipment ....................................................... 11,600
Truck… .................................................................... 550,000
Accounts payable ................................................................................ Birr 12,430
Nots payable ............................................................................................. 150,000
Yimer capital ............................................................................................. 450,400
Total……………………………………Birr 612,830 Birr 612,830