CHAPTER TWO

ACCOUNTING CYCLE FOR SERVICE-GIVING BUSINESS

2.1 Introduction to accounting cycle
An accounting cycle is the sequence of the activities involved in the accounting process. The accounting cycle
starts with analyzing of business transactions and ends with the preparation of post-closing trial balance- that
making the accounts ready to record the transaction of the upcoming accounting period.
An accounting cycle is a step-by-step process. The sequence of the activities involves: (1) analyzing of business
transactions, or other economic vents, (2) recording the analyzed transactions in a journal known as
journalizing, (3) transferring the entries in a journal to respective ledger account known as posting (4)
determining the balance of each account and checking the equality of total debits and credits in the general
ledger by preparing a trial balance, (5) preparing a worksheet and making necessary adjusting entries, (6) based
on the adjusted worksheet/trial balance preparing the annual financial statements (7) preparing year end entries
closing and finally (8) preparing a post-closing trial balance-which is the proof of the equality debits and credits
of permanent accounts.
2.2 Characteristics’ of an account
In order to provide the necessary information to interested users of financial statements, accountants maintain
separate records on each element of the financial statements. The business form that maintains a detail record of
a specific item is known as an ACCOUNT. An account maintains an individual item’s accounting record of
increases or/and decreases and the account balance. In its simplest form, an account consists of three parts:
 a title,
 a left or debit side, and
 a right or credit side
Title
Debit Credit
Dr Cr

Because the format of an account resembles the letter T, we refer to it as a T-account.

For example, to report the balance for cash during a given accounting period, a record regarding cash should be
kept in a separate account. The record includes
 Beginning cash balance,
 Increases in cash during the accounting period
 Decreases in cash during the accounting period &
 Ending cash balance collections during the period.
2.3 Classification of an account
Accounts in the general ledger 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:
1) Assets: Economic resources owned and controlled by a business are called assets. Assets could be
tangible or intangible. Tangible assets are assets having physical existence, like cash, supplies, plant, property
and equipment. Intangible assets do not have physical existence. Example: Goodwill, Copyright, patent right.
On the balance sheet assets are classified as current and non-current assets
Current Assets: those assets, that are expected to be consumed or used, sold, or converted into cash within one
year or the operating cycle of the business whichever is longer. Example: cash, and cash equivalence, accounts
receivable, inventory and supplies, prepayments, and short-term investments etc.
1. Cash and Cash Equivalents: Cash on hand and balances in bank accounts, as well as highly liquid
investments that are easily convertible to known amounts of cash and have short-term maturities
(typically within three months or less).
2. Accounts Receivable: Amounts owed to a company by its customers or clients for goods or services
provided on credit. Accounts receivable represent a claim to future cash receipts.
3. Inventory: Goods held by a company for sale in the ordinary course of business. This includes raw
materials, work-in-progress, and finished goods. Inventory is typically expected to be sold or consumed
within one year.
4. Short-term Investments: Investments that are easily convertible to cash and have a maturity period of
less than one year. Examples include marketable securities, and treasury bills.
5. Prepaid Expenses: Payments made in advance for goods or services that will be received in the future.
Prepaid expenses are recorded as assets until the benefit is realized, at which point they are expensed.
These assets are considered current because they are expected to be converted into cash or used up
within a relatively short period, typically within one year or the operating cycle of the business.

Non-current Asset: None current assets are those that are expected to provide economic benefits to the entity
beyond one year or one operating cycle. All assets other than current assets are classified as non-current assets.
Example: land and building, property, plant and equipment. Intangibles like; patent right, copy rights,
trademarks and long term investments are included in this classification.
1. Property, Plant, and Equipment (PP&E): Tangible assets used in the operation of a business, such as
land, buildings, machinery, equipment, vehicles, and furniture. PP&E are expected to be used over
multiple accounting periods to generate revenue.
2. Intangible Assets: Non-physical assets that lack physical substance but have economic value.
Examples include patents, copyrights, trademarks, goodwill, brand recognition, and software. Intangible
assets are often valuable because they represent rights, privileges, or competitive advantages.
 3. Long-term Investments: Investments in other companies, bonds, or securities that a company plans to
hold for more than one year. Long-term investments may include investments in subsidiaries, associates,
or joint ventures, as well as bonds or stocks held for strategic purposes rather than short-term trading.
2) Liabilities: Liabilities are amounts owed to the creditors of the business. These represent claims against the
assets of the business. These are the obligations of the business whose settlement requires the commitment of
assets. Like assets liabilities are classified as Current and None current liabilities
Current liabilities: Refers to the liabilities that are payable within the next operating cycle or one year. The
settlement of these liabilities requires the use of current assets. Example: Accounts Payable, Rent Payable,
Salary Payable:
1. Accounts Payable: Amounts owed by a company to its suppliers or vendors for goods or services
purchased on credit. Accounts payable represent a short-term obligation to pay cash.
2. Short-term Loans and Borrowings: Debt obligations that is due for repayment within one year. These
may include short-term bank loans, or other forms of short-term financing.
3. Accrued Expenses: Expenses that have been incurred but not yet paid or recorded. Examples include
wages payable, interest payable, utilities payable, and taxes payable.
4. Income Taxes Payable: Taxes owed by a company to tax authorities based on its taxable income.
Income taxes payable represent the current portion of the company's total tax liability.
5. Dividends Payable: Obligations to pay dividends to shareholders that have been declared by the
company's board of directors but not yet distributed to shareholders.
Non-Current Liabilities: These are liabilities that are not required to be paid within the next operating cycle or
one year. Example long term notes payable, mortgage payables:
1. Long-term Debt: Debt obligations that is due for repayment beyond one year. Long-term debt may
include bank loans, bonds payable, mortgages, and other forms of long-term financing.
2. Deferred Tax Liabilities: Future tax obligations that arise from temporary differences between
accounting and tax rules. Deferred tax liabilities represent taxes that will become payable in future tax
periods as a result of differences in timing between when revenues and expenses are recognized for
accounting and tax purposes.
3. Lease Obligations: Long-term commitments arising from lease agreements for assets such as real
estate, equipment, or vehicles. Lease obligations represent future payments that the company is
obligated to make under the terms of the lease agreements.
3) Capital: Capital refers to the funds invested in a business by its owners or shareholders. It is excess of
assets of a business over its liabilities. It is the equity of the owner in the business. Capital can include cash
investments, equipment, buildings, and other assets contributed by owner.
4) Revenue: Revenue is the income earned by a business from its primary activities, such as sales of goods
or services. Revenue represents increases in owner’s equity resulting from the main operations of the business.
 It represents the inflow of economic benefits to the company resulting from its normal operating activities.
Businesses use different naming for their revenues’.
Asset Acct. No Revenue Acct. No Examples
of revenue
include
sales
revenue,
service revenue, interest revenue, and rental income
5) Expenses: Expenses are the costs incurred by a business in order to generate revenue and operate
effectively. They represent the outflow of economic resources from the company in the form of cash payments
or the use of assets. Expenses are typically incurred to purchase goods or services, pay employees, rent
facilities, and cover other operating costs necessary for running the business.
Examples of expenses include cost of goods sold, salaries and wages, rent expense, utilities expense, and
marketing expenses. Expenses are subtracted from revenue on the income statement to determine the
company's net income or net loss for a given period.
6) Drawing account, also known as a withdrawal account or owner's draw account, is a temporary equity
account used to record withdrawals of cash or other assets by the owner(s) of a sole proprietorship or
partnership. The drawing account is used to track the withdrawals made by the owner(s) for personal use or
other non-business purposes. It helps to distinguish between business expenses and personal withdrawals,
ensuring that personal transactions do not affect the accuracy of the business's financial records.
2.4 Chart of Accounts
The chart of accounts is a structured list of all the accounts used by an organization to record its financial
transactions. It serves as the foundation for the organization's accounting system and provides a systematic way
to classify and organize financial information.
The list of accounts used by an organization and their codes is called the chart of accounts. The chart of
accounts includes various categories of accounts, such as assets, liabilities, equity, revenue, and expenses. These
categories represent the major types of financial transactions and help to classify and organize accounts based
on their nature and purpose.
name given to an account is known as Account Title, and the number given to an account to locate its position is
called Account Number. The name and number of accounts used by an organization depends on the size and
nature of its operation.
The account number could be a two digit, three digit or more digits. In the account number:
 The first digit shows the group the account belongs
 The remaining digits show position of the account in the group
Example of a chart of accounts.
 Cash 11 Sales income 41
A/receivable 12 Expense
Supplies 13 Salary expense 51
Prepaid insurance 14 Rent expense 52
Equipment 15 Utility expense 53
Accumulated depn.-equipment 16 Advertising expense 54
Liabilities
N/payable 21
A/payable 22
Owner’s equity
Hewan’s capital 31
Hewan’s drawing 32
Income summary 33

2.5 The Rules of 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
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.
These rules serve as the foundation for double-entry bookkeeping, ensuring that every transaction maintains the
accounting equation's balance (Assets = Liabilities + Owner's Equity). They provide consistency and accuracy
in recording financial transactions, which is essential for preparing financial statements and making informed
business decisions. Understanding the rules of debits and credits helps accountants and business owners analyze
transactions, identify errors, and maintain accurate financial records.
The above general rule will be expanded as follows
Debit Credit
Increase in assets Decrease in assets
Increase in expense Decrease in expense
Decrease in capital Increase in capital
Decrease in liabilities Increase in liabilities
Decrease in revenue Increase in revenue

Normal balances of accounts

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. So the normal balance for:
  Asset account is debit
 Expense account is debit
 Capital account is credit
 Liability account is credit
 Revenue account is credit
2.6 Analyzing and recording of business transactions
When a business transaction takes place, source documents will be obtained and recorded. Common documents
describing transactions include invoices, receipts, purchase orders, contracts, etc. But before the transactions are
recorded in a journal they need to be analyzed. To analyze the transactions the following questions need to be answered:
a) Names of accounts affected?
b) Classification of accounts affected?
c) Which account is increased or decreased?
d) Which account is debited and which is credited?
Example 1: On January 7, 2024, ABC Company purchased equipment for cash of Br. 60,000.00 Check NO.
112? It is analyzed as follows
a) Names of accounts affected? Cash and Equipment
b) Classification of accounts affected? Cash is an asset and Equipment is an asset
c) Which account is increased or decreased? Cash decreases and Equipment increases
d) Which account is debited and which is credited? Cash is credited and Equipment is debited
Example 2: On January 13, 2024 ABC Company rendered services to customers’ for cash of Br. 15,000.00.
Receipt No. 305
a) Names of accounts affected? Cash and Service income
b) Classification of accounts affected? Cash is and asset and Service income is a Revenue
c) Which account is increased or decreased? Cash is increased and Service income is increased
d) Which account is debited and which is credited? Cash is debited and service income is credited
After the transactions are analyzed they will be recorded in an accounting book called Journal. Because
transactions are recorded for the first time in the journal, journal is referred to as “The book of original entry”.
Transactions are recorded in the journal in chronological order and for each transaction the journal shows the
debit and credit effects on specific accounts. The process of recording a business transaction in the accounting
record is called Journalizing.
There are two types of journals, general journal and special journal. Journal commonly used to record all types
of transactions is the General Journal. This Journal includes the following parts:
1) The date Column
2) The title or description Column
3) Posting Reference (P/R) Column
4) Debit and Credit amount columns
 5) Journal page number
Look at the following General Journal and notice where each of the above information is found.
GENERAL JOURNAL PAGE 001
Date Description P.R Debit Credit
Year day
Month Debited account title XXX XX
Credited account title X XX XX
( Explanation )
Steps in Journalizing a Transaction
The following steps should be followed in recording a transaction in the general journal.
Step-1 Record the date - Insert the year, the month, and the date as shown above.
Spep-2 Record the Debit- Insert the account debited in the description closer to the left margine column and the
amount of debit in the debit column.
Step-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.
Step-4 Explanation- Write a brief explanation or reference to source document in the description column,
indenting about an inch from the left margin
Examples: record the above analyzed transactions in a general journal page 001
GENERAL JOURNAL PAGE 001
Date Description P.R Debit Credit
2024 7 Equipment 18 60,000 00
January Cash 11 60,000 00
Check No. 112
13 Cash 11 15,000 00
Service Income 41 15,000.00 00
Receipt No. 305
2.7 Posting transactions into the ledger
After the information about a business transaction has been journalized, that information is transferred to the
specific accounts affected by that transaction. This process of transferring the information is called posting.
An account could be of two types; the two-column account and the four-column account. We will use the four-
column account for our illustration. The two forms of accounts are given below.
1. The two-column account (ledger):
Account Account number
Date Item P.R Debit Date Item P.R Credit

2. The four-column account (ledger):

Account Account number ______
 Date Item P.R Debit Credit Balance
Debit Credit

The steps in posting are given below:

1. Record the date and amount of Dr. and Cr. Entry to the account
2. Insert the Journal page number in the P.R (Post Reference) column of the account.
3. Insert the account number in the P.R column of the journal.
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 a ledger.
Lets post the above entries from the journal to respective ledger accounts:
CASH Account number 11__
Date Item P.R Debit Credit Balance
Debit Credit
2024
January 7 GJ1 60,000 00
13 GJ1 15,000 00

EQUIPMENT Account number___18__

Date Item P.R Debit Credit Balance
Debit Credit
2024
January 7 GJ1 60,000 00

SERVICE INCOME Account number 41_

Date Item P.R Debit Credit Balance
Debit Credit
2024 13 GJ1 15,000 00
January

2.8 Preparing a trial balance

After the posting phase is completed, we have to verify the equality of the debit and credit balances in the
general ledger. This is done through the use of the ‘Trial Balance’. A trial balance is a two column listing of the
accounts in the general ledger and their balance to make sure that the total of debit balances equals the total of
credit balances.
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.
2.8.1 Usefulness of a Trial Balance
The trial balance debit totals and credit totals are equal implies that the accounting work is more likely to be
free from any one or more of the following errors.
 Error in preparing the trial balance including
 Addition error
 The amount of an account balance was incorrectly listed on the trial balance
 A debit balance was recorded as a credit or vice versa
 A balance was entirely omitted.
 Error in posting, including
 An erroneous amount was posted to the account.
 A debit amount was posted as a credit or vice versa
 A debit or credit posting was omitted

2.8.2 Limitation 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. There are some errors that cannot be discovered by using the trial
balance. 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.
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.
Ilustratons:
Let us consider the illustration given in chapter one with some modifications:
Assume that Misses Hewan has decided to run her own business, naming it Hewan Beauty Salon. She has
opened a bank account by the mane of her business. The following are some selected transactions for the first
month of its operations. She started her operations on January-1 of the current year. Learn how each business
transactions affect the basic accounting equation.
January 2. Misses Helen deposited Br. 200,000.00 cash in the bank account opened by the name
of Hewan Beauty Salon, bank deposit slip NO. 1213
January 3. Hewan beauty salon rented office floor paying Br. 10,000.00 cash, check number 001
January 4. The beauty salon purchased beauty equipments paying Br. 150,000.00 cash, check number 002
January 7. The beauty salon purchased beauty supplies for Br. 25000.00 on credit. Credit invoice number 235
January 25. The beauty salon collected cash of Br. 45000.00 from beauty services, Cash receipt No. 001
January 26. The beauty salon paid cash of Br. 15000.00 to creditors on account, check number 003
January 28. The beauty salon provided beauty services to customers on account for Br. 12000.00, credit sales
invoice number 23
January 29. The beauty salon paid cash of Br. 3000.00 for utilities, check number 004
January 30. The beauty salon paid cash of Br. 12000.00 for salaries, check number 25
January 30. Misses Hewan the owner has withdrawn cash of Br 25,000 for personal assuage, check number 36
Instructions:
a) Journalize the January transactions, in general journal (Use J1 for the journal page number.)
b) Open a four columns ledger accounts and post the January transactions.
c) Prepare a trial balance as of January 30, 2024.

(A) Journalizing transactions

GENERAL JOURNAL PAGE 001
Date Description P /R Debit Credit
2024 2 Cash 11 200,000 00
January Hewan’s capital 31 200,000 00
Bank deposit slip No. 1213
3 Rent expense 51 10,000 00
Cash 11 10,000 00
Chech No.001
4 Equipment 14 150,000 00
Cash 11 150,000 00
check number 002
7 Supplies 13 25,000 00
Accounts payable 21 25,000 00
 Credit invoice number 235
25 Cash 11 45,000 00
Service revenue 41 45,000 00
Cash receipt No. 001
26 Accounts payable 21 15,000 00
Cash 11 15,000 00
Check number 003
28 Accounts receivables 12 12,000 00
Service revenue 41 12,000 00
Credit sales invoice number 23
29 Utilities expense 53 3,000 00
Cash 11 3,000 00
Check number 004
30 Salaries expenses 51 12,000 00
Cash 11 12,000 00
Check number 25
30 Hewan drawing 32 25,000 00
Cash 11 25,000 00
Check number 36

( B ) Opening a four columns ledger accounts and posting the entries from the journal
CASH ACCOUNT NUMBER 11
Date Item P.R Debit Credit Balance
Debit Credit
2024 2 GJ1 200,000 00 200,000 00
January 3 GJ1 10,000 00 190,000 00
4 GJ1 150,000 00 40,000 00
25 GJ1 45,000 00 85,000 00
26 GJ1 15,000 00 70,000 00
29 GJ1 3000 00 67,000 00
30 GJ1 12,000 00 55,000 00
 30 GJ1 25,000 00 30,000 00
ACCOUNTS RECEIVABLES ACCOUNT NUMBER 12
Date Item P.R Debit Credit Balance
Debit Credit
2024 28 GJ1 12,000 00 12,000 00
January
SUPPLIES ACCOUNT NUMBER 13
Date Item P.R Debit Credit Balance
Debit Credit
2024 7 GJ1 25,000 00 25,000 00
January
EQUIPMENT ACCOUNT NUMBER 14
Date Item P.R Debit Credit Balance
Debit Credit
2024 13 GJ1 150,000 00 150,000 00
January
ACCOUNTS PAYABLE ACCOUNT NUMBER 21
Date Item P.R Debit Credit Balance
Debit Credit
2024 7 GJ1 25,000 00 25,000 00
January 26 GJ1 15,000 00 10,000 00

HEWAN’S CAPITAL ACCOUNT NUMBER 31

Date Item P.R Debit Credit Balance
Debit Credit
2024 2 GJ1 200,000 00 200,000 00
January
HEWAN’S DRAWING ACCOUNT NUMBER 32
Date Item P.R Debit Credit Balance
Debit Credit
2024 30 GJ1 25,000 00 25,000 00
January
INCOME SUMMARY ACCOUNT NUMBER 33
 Date Item P.R Debit Credit Balance
Debit Credit
2024
January
SERVICE REVENUE ACCOUNT NUMBER 41
Date Item P.R Debit Credit Balance
Debit Credit
2024 25 GJ1 45,000 00 45,000 00
January 28 GJ1 12,000 00 57,000 00
RENT EXPENSES ACCOUNT NUMBER 51
Date Item P.R Debit Credit Balance
Debit Credit
2024 3 GJ1 10,000 00 10,000 00
January

SALARY EXPENSES ACCOUNT NUMBER 52

Date Item P.R Debit Credit Balance
Debit Credit
2024 30 GJ1 12,000 00 12,000 00
January

UTILITIES EXPENSES ACCOUNT NUMBER 53

Date Item P.R Debit Credit Balance
Debit Credit
2024 29 GJ1 3,000 00 3,000 00
January
( C ) Preparation of Trial balance as of January 30, 2024
HEWAN BEATY SALON
Trial balance
January 31, 2024
Cash 30,000 00
Accounts receivables 12,000 00
Supplies 25,000 00
Equipment 150,000 00
Accounts Payable 10,000 00
 Hewan’s Capital 200,000 00
Hewan’s Drawing 25,000 00
Service revenue 57,000 00
Rent expense 10,000 00
Salary expenses 12,000 00
Utilities expenses 3,000 00
Total 267,000 00 267,000 00

2.8 The adjusting process

All the transactions recorded above in the journalizing step are the result of daily transactions. Other
transactions result from the passage of time or from the internal operations of the business. For example,
insurance premiums are paid for a certain period of time and expire during that time period. Another example is
office supplies such as paper, pens & pencils.
At the end of the period the balances in accounts such as supplies and prepaid insurance must be brought up to
date. The supplies account balance, for example, must be credited by the consumed part of the supplies,
debiting supplies expense.
Example:Stationary materials totaling Birr 1,900.00 were purchased and recorded during the year. At
the end of the year, only Birr 150 of the supplies is left in the hand.

2.8.1 Accrual Vs. Cash Basis of Accounting

a. The cash basis of accounting
In this basis of accounting revenues are reported in the period in which cash is received and expenses are
reported in the period in which cash is paid. Net income will, therefore, be the difference between the cash
receipts (Revenues) and cash payments (expenses). This method will be used by organizations that have very
few receivables and payables. For most businesses, however, the cash basis is not an acceptable method.
b. The accrual basis of accounting
Under this method, revenues are reported in the period in which they are earned, and expenses are reported in
the period in which they are incurred. For example, revenue will be recognized as services are provided to
customers or goods sold and not when cash is collected. Most organizations use this method of accounting and
we will apply this method in this course.
2.9 Preparing a worksheet
Most of the data required to prepare the accounting reports (financial statements) are now gathered. The data
will now be presented in a convenient form. The worksheet is a large columnar sheet prepared to arrange in a
convenient form all the accounting data required to prepare financial statements. The worksheet has a heading
and a body.The heading has three parts:
i) Name of the Organization
ii) Name of the form (worksheet)
iii) Period of time covered.
The body contains five main parts, each of them with two main columns. These parts are
1. The trial balance
2. The adjustment
3. The adjusted trial balance
4. The income statement
5. The balance sheet.
Illustration
The trial balance of ABC Company at Hidar 30, 2005 is as follows:
ABC Company
Trial balance
Hidar 30, 2005
Account Debit Credit
Cash 4,000
Accounts receivable 3,200
Prepaid rent 1,900
Supplies 3,000
Equipment 34,800
Accumulated depreciation 1,600
Accounts payable 5,400
Salary payable
Abel’s capital 35,700
 Abel’s drawing 2,100
Service revenue 8,600
Depreciation expense
Salary expense 1,700
Rent expense
Utilities expense 600
Supplies expense
Total 51,300 51,300

Additional information at Hidar 30, 2005:

a. Accrued service revenue Birr 600
b. depreciation birr 300
c. accrued salary expense birr 800
d. prepaid rent expired birr 500
e. supplies used birr 100

Requirements
1. Complete ABC-company worksheet for the month ended Hidar 30, 2005.
2. Preparing financial statements from the completed worksheet
3. Journalize adjusting and closing entries
 Adjusted Trial
Account Title Trial Balance Adjustment balance Income Balance sheet
statement
Debit Credi Debit Credi Debit Credi Debi Credi Debit Credit
t t t t t
1 Cash 4,000 4,000 4,000
2 Accounts receivable 3,200 (a) 3,800 3,800
600
3 Prepaid rent 1,900 (d)500 1,400 1,400
4 Supplies 3,000 (e)100 2,900 2,900
5 Equipment 34,800 34,800 34,800
6 Accumulated depn. 1,600 (b)300 1,900 1,900
7 Accounts payable 5,400 5,400 5,400
8 Salary payable (c)800 800 800
9 Abel’s capital 35,700 35,700 35,700
10 Abel’s Drawing 2,100 2,100 2,100
11 Service revenue 8,600 (a)600 9,200 9,200
12 Depreciation expense (b)300 300 300
13 Salary expense 1,700 (c)800 2,500 2,500
14 Rent expense (d)500 500 500
15 Utilities expense 600 600 600
16 Supplies expense (e)100 100 100
17 Total 51,300 51,300 2,300 2,300 53,000 53,000 4,000 9,200 49,000 43,800
18 Net income 5,200 5,200
19 9,200 9,200 49,000 49,000

ABC COMPANY

WORK SHEET

FOR THE MONTH ENDED SENE 30, 2005

2.9.1 Preparing financial statements from a worksheet

After a company has completed a worksheet, it has at hand all the data required for preparation of financial
statements. The income statement is prepared from the income statement columns. The balance sheet and
owner’s equity statement are prepared from the balance sheet columns. At this point, the company has not
journalized or posted adjusting entries. Therefore, ledger balances for some accounts are not the same as the
financial statement amounts.
The amount shown inthe owner’s capital on the worksheet is the account balance before considering drawings
and net income (or loss).When the owner has made no additional investments of capital during the period, this
worksheet amount ofthe owner’s capital is the balance at the beginning of the period.
Using a worksheet, companies can prepare financial statements before they journalize and post adjusting
entries. However, the completed worksheet is not asubstitute for formal financial statements. The format
of the data in the financial statement columns of the worksheet is not the same as the format of the financial
statements. A worksheet is essentially a working tool of the accountant; companies do not distribute it to
management and other parties.
All the data required to prepare the income statement is brought from the worksheet
a. Income statement:A
income statement column.
ABC-company
Income statement
For the month ended Hidar 30, 2005
Revenue:
Service revenue 9,200
Operating expense:
Depreciation expense 300
Salary expense 2,500
Rent expense 500
Utilities expense 600
Supplies expense 100
Total operating expense (4,000)
Net income 5,200

b. Statement of owner’s equity – This statement shows the beginning balance of capital and the changes
that affected it.The balance of the owner's equity account in the worksheet may not be the beginning
one. Therefore, the ledger has to be reviewed to see if there was an additional investment during the
period or not. In our illustration there is no additional investment.

ABC-company
Income statement
For the month ended Hidar 30, 2005
Abel’s capital Hidar 1, 2006 35,700
Net income for the period 5,200
Less: Abel’s drawing (2,100) 3,100
Abel’s capital on Hidar 30, 2006 38,800

c. Balance sheet: The data to prepare this statement will be taken from the worksheet and the other
financial statements.
  Note that in balance sheet assets and liabilities are classified as current and non-current.

ABC-company
Balance sheet
Hidar 30, 2005

Asset Liability
Current assets:
Cash 4,000 Accounts payable 5,400
Accounts receivable 3,800 Salary payable 800
Prepaid rent 1,400 Total liability 6,200
Supplies 2,900 Owner’s equity
Total current asset 12,100 Abel’s capital 38,800
Plant asset (Non-currentasset)
Equipment 34,800
Less: Accumulated depn. (1,900)
32,900
Total asset 45,000 Total liabilities and owner’s equity 45,000

2.9.2 Adjusting and closing entries

2.9.2.1 Adjusting entries
Accounting systems are designed to record most recurring daily transactions, particularly those involving cash.
As cash is received or paid, it is recorded in the accounting system. In general, this focus on cash works well,
especially when cash receipts and payments occur in the same period as the activities that produce revenues and
expenses. However, cash is not always received in the period in which the company earns the related revenue;
likewise, cash is not always paid in the period in which the company incurs the related expense.
How do the accounting system record revenues and expenses when one transaction is needed to record a cash
receipt or payment and another transaction is needed to record revenue when it is earned or an expense when it
is incurred? The solution to the problem created by such differences in timing is to record adjusting entries at
the end of every accounting period so that:
 Revenues are recorded when they are earned (the revenue principle).
 Expenses are recorded when they are incurred to generate revenue (the matching principle).
 Assets are reported at amounts that represent the probable future benefits remaining at the end of the
period.
 Liabilities are reported at amounts that represent the probable future sacrifices of assets or services
owed at the end of the period.
Types of Adjusting Entries
There are four types of adjustments:
Revenues
  Unearned Revenues Previously recorded liabilities that were created when the cash was received in
advance and that must be adjusted for the amount of revenue actually earned during the period.
 Accrued Revenues Revenues that were earned but not yet recorded, with cash to be received in future
periods.
Expenses
 Prepaid Expenses Previously recorded assets, such as Prepaid Rent,Supplies, and Equipment that were
created when the cash was paid inadvance and that must be adjusted for the amount of expense
actuallyincurred during the period through the use of the asset.
 Accrued Expenses are expenses that were incurred but not yetrecorded, with cash to be paid in future
periods.
Each of these types of adjustments involves two entries:
 One for the cash receipt or payment.
 One for recording the revenue or expense in the proper period (throughthe adjusting entry).
We will illustrate the process involved in analyzing and adjusting theaccounts by reviewing all adjustments for
ABC - companies in the above example.
The information to make adjusting entries is obtained from the adjustment column of the worksheet. So let’s
make the adjusting entries based on the above information:

a) 2005A/receivable -------------------------------600
Hidar 30 service Revenue ------------------------------600
(To record delivery of service on account)
b) 2005Depn expense -----------------------------300
Hidar 30 accumulated Depn. --------------------------300
(To record Depn. Expense)
c) 2005 salary expense ---------------------------800
Hidar30 salaries payable --------------------------------800
(To record payment of accumulated salary)
d) 2005 Rent Expense ----------------------------500
Hidar 30 prepaid Rent -----------------------------------500
(To record expired rent)
e) 2005 supplies Expense -----------------------100
Hidar 30 supplies ----------------------------------------100
(To record usage of supplies)
2.9.2.2 Closing entries
After adjusting entries have been recorded and posted, companies need to prepare the ledger accounts for the
next period. This phase in the accounting cycle is called closing the books.
The ending balance in each of asset, liability, and owner’s equity accounts carries over as a beginning account
balance for the next period. So the balances in these permanent accountsare not reduced to zero (not closed) at
the end of the accounting period.
In contrast, revenue, expense, and owner’s drawing accounts accumulate data for the current accounting
period only. As such, these accounts must begin each period with a zero balance. Therefore, the balances in
these accounts, called temporary accounts, are closed (reduced to zero) at the end of each period.

Steps in closing
1. Closing revenue accounts - Debit each revenue account by its balance and credit the ‘Income Summary’
account by total revenue for the period.
Note: Income summary is an account used to close revenue and expense accounts. This
account will immediately be closed to the capital account at the end of the closing process.
2. Closing expense accounts – Debit the income summary account by the total of expenses for the period and
credit each expense account by its balance.

3. Closing the income summary account – Income summary will be closed to the capital account. The
balance of his account depends on the nature of operation; credit if result is profit and debit if the result is
loss.

4. Closing Withdrawal – Debit the owners equity account by the total of drawings for the period and credit the
drawing account.

a) To close revenue
2005 Service revenue ----------------------------------- 9,200
Hidar 30 Income summary --------------------------------------9,200
(To close service revenue)
b) To close expenses
2005Income summary --------------------------------- 4,000
Hidar 30 Depn. Expense --------------------------------------------300
Salary expense ----------------------------------------- 2,500
Rent expense -------------------------------------------- 500
Utility expense ------------------------------------------ 500
Supplies expense --------------------------------------- 100
(To close expenses)
c) To close income summary
2005 Income summary ------------------------------------ 5,200
Hidar 30 Abel’s capital --------------------------------------------5,200
(To close income summary)
 d) To clossdrawing account
2005 Abel’s capital -----------------------------------------2,100
Hidar 30 Abel’s Drawing ------------------------------------------2,100
(To close a drawing account)

2.10 Post-closing trial balance

After the closing entries have been journalized and posted, a trial balance is prepared to prove the equality of
the general ledger before recording the New Year’s transactions. It should be noted that this trial balance
includes only balance sheet accounts. This is because the temporary income statement accounts are closed
during the closing process. This trial balance is called the post – closing trial balance.
In practice the ledger balance after closing may be checked by a simple calculator print out rather than a formal
trial balance. The post closing trial balance for Bait Transport is presented below.

ABC-company
Post closing trial balance
Hidar 30, 2006

Account Debit Credit

Cash 4,000
Accounts receivable 3,800
Prepaid rent 1,400
Supplies 2,900
Equipment 32,900
Accounts payable 5,400
Salary payable 800
Abel’s capital 38,800
Total 45,000 45,000