Chapter Three

Accounting cycle
Contents

1. Capturing economic events

2. Basis of Accounting

3. Adjustments

4. Reporting Financial Statements

Capturing economic events

Accounting cycle is a series of steps performed

during the accounting period (some throughout
the period and some at the end)
▪ to analyze

▪ record,

▪ classify,

▪ summarize, and

▪ report useful financial information for the purpose of preparing financial

statement.
Steps involved in the accounting cycle

1. Obtain and analyze business transactions by

examining the source documents. (through the
accounting period)

2. Journalize transactions in the journal.

(through the accounting period).

3. Post journal entries to the accounts in the

ledger. (throughout the accounting period)
4. Prepare an unadjusted trial balance.
5. Record adjusting entries.
6. Post the adjusting entries.
7. Prepare an adjusted trial balance.
8. Prepare financial statements.
9. Close temporary accounts.
10. Post closing entries.
11. Prepare a post closing trial balance.
 Account is a part of the accounting system
used to classify/summarize the increase,
decrease, and balances of each asset, liability,
stockholders’ equity item, dividend, revenue, and
expense.

 Companies set-up accounts for each different

business element such as cash, A/R, and A/P.

 The number of accounts in a company’s

accounting system depends on the information
needs of those interested parties.

 The main requirement is that each account

provides information useful in making decisions.
 The Account

▪ Record of increases and decreases

Account in a specific asset, liability, equity,
revenue, or expense item.
▪ Debit = “left”
▪ Credit = “right”

An account can Account Name

be illustrated in Debit / Dr. Credit / Cr.
a T-account
form.
Debits and credits

Double-entry system
▪ Each transaction must affect two or more accounts
to keep the basic accounting equation in balance.

▪ Recording done by debiting at least one account

and crediting another.

▪ DEBITS must equal CREDITS.

 If debit figures are greater than credit figures, the
account will have a debit balance.

Account name
Debit / Dr. Credit / Cr.
Transaction #1 $10,000 $3,000 Transaction #2
Transaction #3 8,000

Balance $15,000
If debit amounts are less than credit amounts, the
account will have a credit balance.

Account Name

Debit / Dr. Credit / Cr.

Transaction #1 $10,000 $3,000 Transaction #2

8,000 Transaction #3

Balance $1,000
1,000
Debits and credits

Assets
Debit / Dr. Credit / Cr.

◆ Assets - Debits should exceed

credits.
Normal Balance

Chapter
3-23
◆ Liabilities – Credits should
exceed debits.
Liabilities
Debit / Dr. Credit / Cr. ◆ Normal balance is on the
increase side.

Normal Balance

Chapter
3-24
 Debits and credits

Owner’s Equity
Debit / Dr. Credit / Cr.
▪ Owner’s investments and revenues
increase owner’s equity (credit).

Normal Balance ▪ Owner’s drawings and expenses

Chapter
3-25
decrease owner’s equity (debit).

Owner’s Capital Owner’s Drawing

Credit / Cr.
Helpful Hint Because
Debit / Dr.
Debit / Dr. Credit / Cr. revenues increase owner’s
equity, a revenue account
has the same debit/credit
Normal Balance
rules as the Owner’s
Normal Balance
Capital account. Expenses
Chapter
3-23
have the opposite effect.
Chapter
3-25
Debits and credits

Revenue
Debit / Dr. Credit / Cr.

▪ The purpose of earning revenues

is to benefit the owner(s).
Normal Balance

▪ The effect of debits and credits on

Chapter

revenue accounts is the same as

3-26

their effect on Owner’s Capital.

Expense
Debit / Dr. Credit / Cr.
▪ Expenses have the opposite
effect: expenses decrease owner’s
Normal Balance
equity.

Chapter
3-27
 Debits/credits rules

Balance Sheet Income Statement

Asset = Liability + Equity Revenue - Expense

Debit

Credit
Summary of the Rules

Relationship among the assets, liabilities and owner’s

equity of a business:
Basic Assets = Liabilities + Owner’s Equity
Equation

Expanded
Basic
Equation

The equation must be in balance after every

transaction. For every debit there must be a credit.
Recording steps

Analyze Enter Transfer journal

each transaction in a information to ledger
transaction journal accounts

Business documents, such as a sales slip, a check, a

bill, or a cash register tape, provide evidences for
transactions.
The journal

▪ Book of original entry.

▪ Transactions recorded in chronological order.

▪ Contributions to the recording process:

1. Discloses the complete effects of a transaction.

2. Provides a chronological record of transactions.

3. Helps to prevent or locate errors because the

debit and credit amounts can be easily compared.
Journalizing

Illustration
On September 1, Ray Neal invested $15,000 cash in the
business; soft-byte, and Soft-byte purchased computer
equipment for $7,000 cash.

General Journal

Date Account Title Ref. Debit Credit

Sept. 1 Cash 15,000
Ray Neal, capital 15,000

Equipment 7,000
Cash 7,000
Posting closing entries
Simple and compound entries

Illustration
On July 1, Butler Company purchases a delivery truck
costing birr 14,000. It pays birr 8,000 cash now and
agrees to pay the remaining birr 6,000 on account.

General Journal

Date Account Title Ref. Debit Credit

1-Jul Truck 14,000
cash 8,000
Accounts payable 6,000
The ledger

General ledger contains the entire group of accounts

maintained by a company.
Standard form of account
Posting
process of
transferring
amounts from
the journal to
the ledger
accounts.
Chart of accounts
Accounts and account numbers arranged in sequence in
which they are presented in the financial statements.
The recording process

Follow these steps:

1. Determine what
type of accounts
are affected.
2. Determine what
items increased or
decreased and by
how much.
3. Translate the
increases and
decreases into
debits and credits.
Summary of journalizing and posting
Trial balance
Limitations of a trial balance

The trial balance may balance even when:

1. a transaction is not journalized,

2. a correct journal entry is not posted,

3. a journal entry is posted twice,

4. incorrect accounts are used in journalizing or

posting, or

5. offsetting errors are made in recording the

amount of a transaction.
Timing issues

Accountants divide the economic life of a business into

artificial time periods (Time Period Assumption).

Jan. Feb Mar. Apr. Dec

. .

Generally, an accounting
period can be a: Alternative terminology
The time period assumption
▪ month, is also called the
▪ quarter, or periodicity assumption.
▪ year.
Fiscal and calendar years

▪ Monthly and quarterly time periods are called interim

periods.

▪ Public companies must prepare financial statements

both quarterly and annually.

▪ Fiscal year = an accounting time period that is one

year in length.

▪ Calendar year = the reporting year that runs from

January 1 to December 31.
Basis of accounting
Accrual-versus cash-basis accounting

Accrual-basis accounting

▪ Transactions recorded in the periods the events

occur.

▪ Companies recognize revenues when they render

services (rather than when cash is received).

▪ Expenses are recognized when incurred (rather

than when paid).
Accrual- vs. cash-basis accounting

Cash-basis accounting

▪ Revenues recognized when cash is

received.

▪ Expenses recognized when cash is paid.

▪ Cash-basis accounting is not in accordance

with generally accepted accounting
principles (GAAP).
Recognizing revenues and expenses

Revenue recognition principle

Recognize revenue in
the accounting period in
which the performance
obligation is satisfied.
Recognizing revenues and expenses

Expense recognition principle

Match expenses with

revenues in the period when
the expense makes its
contribution to revenue.

“Let the expenses follow the

revenues.”
GAAP relationships in
revenue and expense
recognition
Adjustments

Adjusting entries

▪ Ensure that the revenue recognition and

expense recognition principles are followed.

▪ Necessary because the trial balance may

not contain up-to-date and complete data.

▪ Required every time a company prepares

financial statements.

▪ Will include one income statement account

and one balance sheet account.
Types of adjusting entries

Deferrals Accruals

1. Prepaid Expenses 1. Accrued Revenues

Expenses paid in cash Revenues for services
before they are used or performed but not yet
consumed. received in cash or
recorded.

2. Unearned Revenues 2. Accrued Expenses

Cash received before Expenses incurred but
services are performed. not yet paid in cash or
recorded.
Types of adjusting entries

Trial balance
Each account
is analyzed to
determine
whether it is
complete and
up - to - date.
Adjusting entries for deferrals

Deferrals are expenses or revenues that

are recognized at a date later than the
point when cash was originally
exchanged. There are two types:

▪ Prepaid expenses and

▪ Unearned revenues.
Prepaid expenses

Payment of cash, that is recorded as an asset because

service or benefit will be received in the future.

Cash payment BEFORE Expense recorded

Prepayments often occur with regard to:

▪ insurance ▪ rent
▪ supplies ▪ equipment
▪ advertising ▪ buildings
Prepaid expenses

▪ Expire either with the passage of time or through

use.

▪ Adjusting entry:
• Increase (debit) to an expense account and

• Decrease (credit) to an asset account.

Illustration
PAA firm purchased supplies costing birr
2,500 on October 5. PAA recorded the
payment debited the asset Supplies. This
account shows a balance of birr 2,500 in
the October 31 trial balance. An inventory
count at the close of business on October
31 reveals that birr 1,000 of supplies are
still on hand.

Oct. 31 Supplies expense 1,500

Supplies 1,500
Illustration
On October 4, PAA firm paid birr 600 for a
one-year fire insurance policy. Coverage
began on October 1. PAA firm recorded
the payment as a debit to Prepaid
Insurance. This account shows a balance
of birr 600 in the October 31 trial balance.
Insurance of birr 50 (birr 600 ÷ 12) expires
each month.

Oct. 31 Insurance expense 50

Prepaid insurance 50
Depreciation

▪ Buildings, equipment, and motor vehicles

(assets that provide service for many years)
are recorded as assets, rather than an
expense, in the year acquired.

▪ Depreciation is the process of allocating the

cost of an asset to expense over its useful
life.

▪ Depreciation does not attempt to report the

actual change in the value of the asset.
Illustration
For Pioneer Advertising, assume that
depreciation on the equipment is $480 a
year, or $40 per month.

Oct. 31

Depreciation expense 40
Accumulated depreciation 40

Accumulated Depreciation is called a

contra asset account.
Statement presentation
▪ Accumulated Depreciation is a contra asset account
(credit).
▪ Appears just after the account it offsets (Equipment)
on the balance sheet.
▪ Book value is the difference between the cost of any
depreciable asset and its accumulated depreciation.
Unearned revenues

Receipt of cash that is recorded as a liability because

the service has not been performed.

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

▪ Rent ▪ Magazine subscriptions
▪ Airline tickets ▪ Customer deposits
Unearned revenues

▪ Adjusting entry is made to record the revenue for

services performed during the period and to show the
liability that remains at the end of the period.

▪ Results in a decrease (debit) to a liability account and

an increase (credit) to a revenue account.
Illustration
PAA firm received $1,200 on October 2 from R. Knox for
advertising services expected to be completed by December 31.
Unearned Service Revenue shows a balance of $1,200 in the
October 31 trial balance. Analysis reveals that the company
performed $400 of services in October.

Oct. 31 Unearned service revenue 400

Service revenue 400
Adjusting entries for accruals

Accruals are made to record

▪ Revenues for services performed

OR

▪ Expenses incurred

in the current accounting period that have not been

recognized through daily entries.
Accrued revenues

Revenues for services performed but not yet

received in cash or recorded.

Revenue Recorded BEFORE Cash Receipt

Accrued revenues often occur in regard to:

◆ Rent ◆ Services performed
◆ Interest
Accrued revenues

▪ Adjusting entry shows the receivable that exists and

records the revenues for services performed.

▪ Adjusting entry:
• Increases (debits) an asset account and
• Increases (credits) a revenue account.
Illustration
In October Pioneer Advertising Agency
earned $200 for advertising services that
had not been recorded.

Oct. 31
Accounts receivable 200
Service revenue 200
Accrued expenses

Expenses incurred but not yet paid in cash or recorded.

Expense Recorded BEFORE Cash Payment

Accrued expenses often occur in regard to:

▪ Rent ▪ Taxes
▪ Interest ▪ Salaries
Accrued expenses

▪ Adjusting entry records the obligation and recognizes the

expense.

▪ Adjusting entry:
• Increase (debit) an expense account and
• Increase (credit) a liability account.
Illustration
Pioneer Advertising Agency signed a three-month note
payable in the amount of $5,000 on October 1. The note
requires Pioneer to pay interest at an annual rate of 12%.

Oct. 31 Interest expense 50

Interest payable 50
Illustration
PAA firm last paid salaries on October 26; the next payment
of salaries will not occur until November 9. The employees
receive total salaries of Birr 2,000 for a five-day work week,
or Birr 400 per day. Thus, accrued salaries at October 31
are $1,200 (400 x 3 days).
Summary of basic relationships
Reporting financial statements
The adjusted trial balance

▪ Prepared after all adjusting entries are

journalized and posted.

▪ Purpose is to prove the equality of debit

balances and credit balances in the ledger.

▪ Is the primary basis for the preparation

of financial statements.
The financial statements

Financial Statements are prepared directly from the

Adjusted Trial Balance.

Owner’s
Income Balance
Equity
Statement Sheet
Statement
Preparation of the income statement and
owner’s equity statement from the adjusted
trial balance
Preparation of the balance sheet from
the adjusted trial balance
Alternative treatments

Prepaid expenses

▪ When a company prepays an expense, it debits

that amount to an expense account.

▪ When it receives payment for future services, it

credits the amount to a revenue account.
Prepaid expenses

Company may choose to debit (increase) an expense account

rather than an asset account. This alternative treatment is
simply more convenient.
Unearned revenues

Company may credit (increase) a revenue account when they

receive cash for future services.
Summary of additional adjustment
relationships
Using a worksheet

Steps in preparing a worksheet

◆ Multiple-column form used in preparing

financial statements.

◆ Not a permanent accounting record.

◆ Five step process.

◆ Use of worksheet is optional.

Steps in preparing a worksheet
Preparing Statements from a
Worksheet

▪ Income statement is prepared from the

income statement columns.

▪ Balance sheet and owner’s equity statement

are prepared from the balance sheet
columns.

▪ Companies journalize and post adjusting

entries.
Preparing statements from a
worksheet
Preparing adjusting entries

▪ Adjusting entries are prepared from the adjustments

columns of the worksheet.

▪ Journalizing and posting of adjusting entries follows

the preparation of financial statements when a
worksheet is used.
Closing the books

At the end of the accounting period, the company

makes the accounts ready for the next period.
Preparing closing entries

Closing entries formally recognize, in the general

ledger, the transfer of
▪ net income (or net loss) and
▪ owner’s drawing to owner’s capital.

Closing entries are only made at the end of the annual

accounting period.
Closing the books

Note
Owner’s drawing acct is
closed directly to capital
acct and not to I/S acct b/c
Owner’s Capital is a
drawing acct is not an permanent account; all
other accounts are
expense. temporary accounts.
Preparing a post-closing trial balance
Purpose is to prove the equality of the permanent
account balances after journalizing and posting of
closing entries.
Summary of the accounting cycle

1. Analyze business
transactions

9. Prepare a post- 2. Journalize the

closing trial balance transactions

8. Journalize and post 3. Post to ledger

closing entries accounts

7. Prepare financial 4. Prepare a trial

statements balance

6. Prepare an adjusted 5. Journalize and post

trial balance adjusting entries
Summary of the accounting cycle

Correcting entries

▪ Unnecessary if the records are error-free.

▪ Made whenever an error is discovered.

▪ Must be posted before closing entries.

Instead of preparing a correcting entry, it is

possible to reverse the incorrect entry and then
prepare the correct entry.
Summary of the accounting cycle

Reversing entries

▪ Reversing entries are normally made on the

first day of the subsequent accounting period
to make the some accounts ready for
recording new transactions affecting these
accounts

▪ When prepaid assets are initial recorded as

an expense and advance cash collection are
initially recorded as revenues (both as
income statement items), reversing entries
are required