Fundamental of Accounting-I Academic year2024

CHAPTER TWO
ACCOUNTING CYCLE: ACCOUNTINGFOR SERVICE GIVING BUSINESS
2.1. DEFINITION OF ACCOUNTING CYCLE
Definition - Accounting cycle refers to the procedures (steps) for gathering business
transactions, processing and converting them into useful accounting information that will be
communicated to users to serve as a basis for investment, credit and similar economic decisions.
Hence, the following refers the steps in Accounting cycle:
Step 1 Step 2 Step 3
. .
.
Analyzing transaction Journalize the transaction posting to ledger accounts
Step 4 Step 5

Preparing unadjusted trial balance Journalizing and posting adjusted entries (Deferrals/ Accruals)
Step 6 Step 7 Steps 8

Preparing adjusted trial balance Preparing financial statement Journalizing and pot closing entries

Step 9 Step 10

Preparing post closing trial balance reversing entries

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2.2. CLASSIFICATION OF ACCOUNTS

An accounts a detailed record of increases and decreases in a specific asset, liability, or equity
items, revenue and expense. Separate accounts are kept for each type of asset, liability, equity,
revenue, and expense items. All accounts are recorded on the Ledger.

A ledger is a book in which all accounts used by a business are written. Accounts in the ledger
are customarily listed in the order in which they appear in financial statements, and classified
according to common characteristics.
 Balance sheet accounts are classified as assets, liabilities and owner’s equity.
 Income statement accounts are classified as revenues or expenses.
2.2.1. Asset Accounts
Assets are resources owned or controlled by an organization that have current and future
benefits. They have value and are used in the operations of the business to create revenue. A
separate account is maintained for each asset.
Assets are, customarily divided into some groups for presentation on the balance sheet. The
two groups used most often are:-
1. Current Assets
2. Plant Assets
1. Current Assets:-
Cash and other 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.
*Examples include: - Cash, Receivable, Inventories, Prepaid Expenses, Supplies, etc.
2. Plant Assets:-
Tangible assets used in the business that are a permanent or relatively fixed in nature.
* Examples include: - Equipment, Machinery, buildings, Land, vehicles, etc. With the
Exception of land, such assets gradually wear out or otherwise lose their usefulness
With the passage of time is called depreciation.
3. Intangible Assets:-Nonphysical things controlled by the business:
* Examples include:- Good will, Patents, Copyrights, Trademarks, Franchises, etc.
2.2.2. Liabilities Accounts
Liabilities are debts owed to outsiders (creditors) and are frequently described on the balance
sheet by titles that include the word “payable”.
Liability accounts are classified in to:
Current Liabilities and Long-term Liabilities
1. Current Liabilities:-
Liabilities that will be due within a short time (usually one year or less) and that are to be paid
out of current assets are called current liabilities.
Examples: - Accounts payable, Notes payable, salaries payable, Taxes payable, etc.
2. Long-term Liabilities:-
Long-term Liabilities are a liability that will be due for a comparatively long time (usually more
than one year). If the obligation were to be renewed rather than paid, at maturity, however, it
would continue to be classified as long-term. When payment of a long-term debt is to be spread
over a number of years, the installment due within one year from a balance sheet date are
classified as current liabilities.
Examples include: - Notes payable (long-term) , mortgage payables, etc.

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2.2.3. Owner’s Equity Accounts:

Is the residual claim against the business after the total liabilities are deducted. For a
corporation, owner’s Equity is frequently called Stockholder’s equity or shareholder’s equity.
Example: Capital, Capital stock, Retained Earning
Capital - is the owner’s equity in a sole proprietorship or partnership form business.
Capital stock – represents the investment of stockholders.
Retained Earnings - represents the net income retained in business.
2.2.4. Revenues Accounts:
Are the gross increases in owner’s equity because of the sale of merchandise, the performance of
services for customer or a client, the rental of property, the lending of money, and other business
and professional activities. If an enterprise has various types of revenue, a separate account
should be maintained for each.
2.2.5. Expenses Accounts:
Costs that have consumed in the process of generating revenue. The number of expense
categories and individual expense accounts maintained in the ledger varies with the nature and
the size of the business.

2.3. CHART OF ACCOUNTS

A listing of the accounts in a ledger is called a chart of accounts. The order of items (accounts)
in the chart of accounts should agree with the order of the items in the balance sheet and the
income statement. The accounts are numbered to permit indexing and also for use as references.
For most simple (small) business organization has two digits: The first digit indicates the major
division of the ledger in which the account is placed. Accounts beginning with 1 represent asset,
2 liabilities, 3 owner’s equity and drawing, 4 Revenue and 5 expenses. The second digit
indicates the position of the account with in its division. A numbering system of this type has
the advantage of permitting the later insertion of new accounts in their proper sequence without
disturbing the other account numbers.
For a large enterprise with a number of departments, or branches, it is not usual for each account
number to have four or more digits.
Balance sheet Income statement
1. Assets 4. Revenue
11 Cash 41 Sales
12 Accounts Receivable 5.Expenses
14 Supplies
15 Prepaid Rent 51 Supplies Expense
18 Photographic Equipment 52 Salary Expense
19 Accumulated Depreciation 53 Rent Expense
2. Liabilities 54 Depreciation
21 Accounts Payable Expense
22 Salaries Payable 55 Miscellaneous Expense
3. Owner’s Equity
31 X- Capital

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32 X- Withdrawal
2.4. Characteristics of an Account
The simplest form of an account has three parts:
1. A title - Which is the name of item recorded in the account.
2. a space for recording increases in the amount of the item, in terms of money, and
3. a space for recording decreases in the amount of the item, in terms of monitory units.
* This form of an account is known as T- account because of its similarity with the letter T.

Title

Left (Debit) side Right (Credit) side

Debit: The left side of an account is called debit.

Credit: The right side of an account is called credit.
2.5. Rule of Debit and Credit
Every Business transaction affects a minimum of two accounts. For each transaction the debit
amount (or the sum of all debit amounts, if there are more than one) must equal the credit
amount (or the sum of all the credit amounts). This is known as double–entry system. It
follows that recording of a transaction in which debits do not equal credits is incorrect. For all
the accounts combined, the sum of the debit balances must equal the sum of credit balances;
otherwise something has been done incorrectly. Thus, the debit and credit arrangement used in
accounting provides a useful means of checking the accuracy with which the transactions have
been recorded.
 Double-entry system is based on accounting equation
Assets = Liabilities + Owner’s Equity
 For every dollar/birr entered as a debit to one account, a dollar /birr must be entered as a
credit to some other account.
Assets = Liabilities + Owner’s Equity

Debit side Credit side

(Positive asset balance) (Positive liabilities and owners’ Equity bal.)

 All Asset Accounts increase on the left hand side or debit side; and decrease on the right
hand side or credit side.
 All Liabilities and Owner’s Equity accounts increase, on the right hand side or credit side and
decrease, on the left hand side or debit side. This is known as General rule of debit and
credit.

Assets = Liabilities + Owner’s Equity

Debit Credit Debit Credit Debit Credit

+ - - + - +

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The rules for recording revenues and expenses are derived from the rules for owner’s Equity. By
definition revenue increases owner’s equity; and we have said that owner’s equity increase in the
right (credit) side. It necessarily follows that revenues increase in credit side and decrease on
debit side.
 Expenses are the opposite of revenues in that expenses decrease owners’ equity.
Therefore it follows that Expenses increase with debit side and decrease with credit side.
 Drawing or Dividends, similar with expense decrease owners’ Equity; therefore increase
with debit side and decrease with credit side.
Normal balance of an Account - Account balance refers to the difference between total increase
and total decrease recorded in an account. Total increase recorded in an account is usually
greater than the total decrease recorded in the same account. Thus, the usual (normal) balance of
an account is positive. This implies that the normal balance of an asset, an expense or a drawing
account is debit while that of a liability, capital or revenue account is credit.
The following summarized below shows the rules of debit and credit and the normal balances
of accounts.
Decrease
Account Type Increases Normal balance
s
Balance Sheet Accounts
Asset Debit Credit Debit
Liability Credit Debit Credit
Owner’s Equity
Capital Credit Debit Credit
Drawing Debit Credit Debit
Income Summary Credit Debit Credit (income) Debit
(loss)
Income Statement Accounts
Revenue Credit Debit Credit
Expense Debit Credit Debit
2.6. Analyzing and Recording of Transactions.
Assume that the following transaction take place during the month of November for the George
Duncan Lumber company:-
Nov1. The business is stated when George Duncan invests 100,000 in cash in a bank account in
the company’s name.
Nov.4 The Company purchases land for 28,000 in cash
Nov.7 The company purchases buildings for 42, 000paying 12,000 in cash and signing a
mortgage payable of 30,000.
Nov.10. The company purchases office equipment for 4,000 in cash
Nov.15 Duncan transfers to the company the title of a truck he owns that is worth of 5000 The
company will use the truck solely for making deliveries.
Nov.18 Duncan withdraws 1000 from the company for his personal use.
Nov.21 The company purchases offices supplies for 750 on credit.
Nov.23 The truck received from Duncan has been found to be too small. Thus, the company
acquires a larger truck by trading in Duncan’s truck and paying 3000 in cash.
Nov.28 The company pays 200 of the 750 owed for the office supplies purchased on Nov. 21.
Nov. 30 The Company pays 300 on the mortgage payable.

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Note: - Debits are listed vertically in chronological order on the debit (left) side of each account
and that credits are listed vertically in chronological order on the credit (right) side of each
account. In each case the date of the transaction is entered along the debit or credit.

Transaction Date
Nov.1 Effect of transaction (Analysis of transaction) Increase cash, and increase George
Duncan, Capital

Cash George Duncan Capital

Nov.1 100,000 Nov.1 100,000

Nov.4 Increase Land, Cash decrease

Cash

Nov.1 100,000 Nov.4 28,000

Land

Nov.4 28,000

Nov.7 Effect of Transaction Building increase, cash decreased and Mortgage payable increase

Cash Mortgage payable

Nov.1 100,000 Nov.4 28000 Nov.7 30,000

Nov.7 12,000

Building

Nov.7 420000

Nov.10 Office Equipment increase and Cash decrease

Cash Office Equipment

Nov.1 100,000 Nov.4 28000 Nov.10 4000
Nov.7 12000
Nov.10 4000

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Nov. 15 Truck /Vehicles increase, and capital increase

Delivery vehicle George Duncan, capital
Nov. 15 5000 Nov.1 100,000
Nov.15 5000

Nov.18 Cash and George Duncan capital decrease George Duncan, capital
Cash
Nov.1 100000 Nov.4 28000 Nov.1 100,000
Nov.7 12000Nov.15 5000
Nov.10 4000 Nov.18 1000
Nov.18 1000

Nov.21Effect of Transaction office supplies and Accounts payable account increase

Office Supplies Accounts payable
Nov.21 750 Nov.21 750

Nov.23 Delivery Vehicle both decreases and increases; cash decrease

Delivery Vehicle Cash

Nov. 15 5000 Nov.23 5000 Nov.1 100000 Nov.4 28000

Nov. 7 12000
Nov. 10 4000
Nov. 18 1000
Nov. 23 3000

Nov. 28 Accounts payable is decreased and cash also decrease

Cash Accounts payable

Nov.1 100,000 Nov.4 28000 Nov.30 200 Nov.21 750

Nov.7 12000
Nov.10 4000
Nov.18 1000
Nov.23 3000
Nov. 28 200

Nov. 30 Mortgage payable decrease and cash also decrease

Cash Mortgage payable

Nov.1 100,000 Nov.4 28,000 Nov.30 300 Nov7. 30,000

Nov.7 12,000
Nov.10 4000
Nov.18 1000
Nov.23 3000

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Nov.28 2000
Nov.30 300
2.6.1.1 Recording Transactions on the Journals and Ledger
The flow of accounting data from the time a transaction occurs to its recording in the ledger may
be diagramed as follow:

Business Business Entry Recorded Entry Posted

in JOURNAL to LEDGER
TRANSACTIONS
Occurs
⇒ DOCUMENT
Prepared
⇒ ⇒
2.6.1.2 Journals
Definition - Journal, also called the book of original entry, refers to a business document where
effects of business transactions on specific elements of the financial statements are recorded in or
copied from source documents. whereas, Journal entries is a record of the accounting
information for a business transaction, made at first in a journal and later transferred to a ledger.
In Chapter-1, we have seen how to record and summarize effects of business transactions on
asset, liability and owner’s equity items using the accounting equation format. Such system,
however, is not practicable or is not cost and time-effective when a business has thousands of
transactions to record and several asset, liability, capital, revenue and expense items. Directly
recording business transactions in the accounts is not also wise and may result in recording errors
which may be easily avoided by using journals. Thus, organizations design and use the journal to
initially record business transactions.

Transactions are recorded in the journal chronologically (i.e. in order of their occurrence) based
on the rules of debits and credits and the double-entry accounting system. Double-entry
accounting refers to the system of recording the dual, called debit and credit, effects of business
transactions. As a result, recording transactions initially in the journal helps, among other things,
to:
 Ensure that all effects of a business transaction are recorded
 Have in one place a complete information about a recorded transaction
 Easily identify recording errors, and
 Have an historical record of transactions.
1. Types - two types of journals: general and special.
o General journal - a two-column form used to record any kind of business transaction.
o Special journal - a journal designed to record frequently occurring identical transactions.
2.6.2. Two – Column Journal
There is great variety in both the design of journals and the number of different journals that can
be employed by an enterprise. A business may use a single all purpose two- column journal
(general journal) or it may use a number of multi column journals (special journals) , restricting
each for a single type of transaction .Before a transaction is entered in the two-column journal, it
should be analyzed according to the following sequence of steps:-
1. Determine whether an asset, a liability, owner’s equity, Revenue or Expense is affected
⇒ Determine; accounts(s) affected
2. Determine whether the affected, liability, owner’s equity revenue or expense increases or
decreases

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⇒ Determine, whether the affected account increases or decreases.

3. Determine whether the effect of the transaction should be recorded as a debit or as a credit in
an asset, liability, owner’s equity, revenue, or expense account.
⇒ Determine whether the effect (increase or decrease) should be recorded as debits or
credits.
The process of recording a transaction in a two-column journal is summarized as follow:
1.Record the date
a. Insert the year at the top only of the Date Column of each page, except when the year
date change.
b. Insert the month on the first line only of the date column of each page, except when
the month date changes.
c. Insert the day in the date column on the first line used for each transaction, regardless
of the number of transactions during the day.
2. Record the debit
Insert the title the account to be debited at the extreme, left of the description column
and enter the amount in the debit column.
3. Record the credit
Insert the title of the account to be credited below the title of the account debited
moderately indented, and enter the amount in the credit column.
4. Write an Explanation
Brief explanations may be written below each entry,
 It should be noted that all transactions are recorded only in terms of debits and credits to
specific accounts.
 The titles used in the entries should be the same as the titles of accounts in the ledger.
 The line following an entry is left blank in order to clearly separate each entry.
Look at the following General Journal and notice where each of the above information is found.
General Journal Page__________
Date Description P.R. Debit Credit
Year
Month Day Debited Account title xx xx
Credited Account title Xx xx
Explanation

Each one set of debits and credits for a transaction is called a journal entry.
The Four – Column account
Date Item P.R Debit Credit Balance
Debit Credit

The following are advantages of the four column account form:

1. Only a single date column is required, with each debit and credit appearing in its
chronological order.
2. The debit or credit nature of an account balance is more easily determined and more

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prominently displayed in the account.

3. Having immediately adjacent debit and credit columns makes it easier to examine the
data in an account.

2.6.3.Posting from the Journal to the Ledger

Definition - Ledger refers to a kind of folder/ring binder used to arrange and put in one place all
accounts used by a business. Accounts are placed in the ledger in sequence and each account
may take one or more pages of the ledger.
Types - two types of ledgers: general and subsidiary.
o General ledger - a ledger that contains all accounts that appear on the balance sheet and
income statement of a business. General ledger accounts are called controlling accounts
because they show the total balance of a certain element of the financial statements such
as Accounts Receivable and Accounts Payable regardless of the amount of money
expected to be collected from each credit customer and the amount of money payable to
each creditor, respectively. Controlling accounts are assigned with and identified by their
respective account numbers. According they are placed in the general ledger according to
their numerical orders.
o Subsidiary ledger - a ledger that contains accounts showing details of controlling
accounts. For example, Accounts Receivable Ledger, also called customers’ ledger,
contains accounts of individual credit customers showing the amount of money due from
each credit customer. Subsidiary ledger accounts are identified by the name of the credit
customer or creditor and are accordingly arranged alphabetically.

Note that a business may set up both general and subsidiary ledgers not only for Accounts
Receivable and Accounts Payable but also for any account for which the business wants to have
detailed information about.
The process of transfer journal entry information to ledger accounts is known as posting.
To ensure that the ledger is up to date, entries are posted as soon as possible. This might be daily,
weekly, or when time permits. All entries must be posted to the ledger by the end of a reporting
period. This is so that account balances are current when financial statements are prepared.
Because the ledger is the final destination for individual transactions, it is referred to as the book
of final entry.
 When posting entries to the ledger, the debits in journal entries are copied into ledger
accounts as debits, and credits are copied into the ledger as credits.
Steps in Posting:
When posting is done manually, the debits and credits in the journal may be posted in the order
they occur on if many items are to be posted at one time, all the debits may be posted first,
followed by the credits. The posting of a debit or credit journal entry to an account in the ledger
involves six steps.
1. Identify the ledger account that was debited in the journal entry.
2. Enter the date of the journal entry in this ledger account.
3. Enter the source of the debit in the PR column, both the journal and page.
4. Enter the amount debited from the journal entry into the Debit column of the ledger account.
5. Compute and enter the account’s new balance in the Balance column.

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6. Enter the ledger account number in the PR column of the journalentry.

Illustration of Journalizing and Posting
Hill Photographic Studio: Chart of Accounts:-
1 Asset:
11 Cash
12 Accounts Receivable
14 Supplies
15 Prepaid Rent
18 Photographic Equipment
19 Accumulated Depreciation – Photographic Equipment
2 Liabilities
21 Accounts Payable
22 Salaries Payable
3 Owner’s Equity
31 Ann Hill, Capital
32 Ann Hill, Drawing
33 Income Summary
4 Revenue
41 Sales
5 Expenses
51 Supplies Expense
52 Salary Expense
53 Rent Expense
54 Depreciation Expense
59 Miscellaneous Expense

Transactions
Mar 1, 1990. Ann Hill operated a photographic business her home on a part –time
basis. She decided to move to rented quarters as of March 1 and to devote
full time the business which was to be known as Hill photographic studio.
The following assets were invested in the enterprise; cash, 3500, accounts
Receivable 950 supplies 1200; and photographic equipment 15000.
There Were no liabilities transferred to the business.
March 1. Paid 2400 on a rental contract, the payment representing three months’ rent of
quarters for the studio.
March 4. Purchased additional photographic equipment on account for 2500.
March 5. Received 850 from customers in payment of their accounts.
March 6. Paid 125 for a newspaper advertisement – Advertising expense considered as
Miscellaneous expense by Ann Hill.
March 10. Paid 500 for the debt as a result of March 4 transaction.
March 13. Paid receptionist 575 for two weeks’ salary.
March 16. Received 1,980 from sale of service.
March 20. Paid 650 for supplies purchase.
March 27. Paid 575 receptionists for two weeks’ salary.
March 31. Paid 69 for telephone bill for the month.
March 31. Paid 175 for electric bill for the month.
March 31. Received 1870 from sales of service.

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March 31. Make sales on account for 1,675.

March 31. Hill withdrew 1500 for her personal use.
* Advertising expense, Electric expense, and telephone expense are classified as Miscellaneous
expense by Ann Hill.
Required : Journalize and Post the above transaction.

General Journal

Date Description P.R Debit Credit

1990 Cash- 3500
March 1 Accounts Receivable 950 00
Supplies 1200 00
Photographic Equipment 15000 00
Ann Hill, Capital 00 20650 00
1 Prepaid Rent 2400 00
Cash 2400 00
4 Photographic Equipment 2500 00
Accounts payable 2500 00
5 Cash 850 00
Accounts Receivable 850 00
6 Miscellaneous Expense 125 00
Cash 500 00
10 Accounts payable 500 00
Cash 500 00
13 Salary Expense 575 00
Cash 575 00
16 Cash 1980 00
Sale 1980 00
20 Supplies 650 00

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Cash 650 00
27 Salary Expense 575 00
Cash 575 00
31 Miscellaneous Expense 69 00
Cash 69 00
31 Miscellaneous Expense 175 00
Cash 175 00
31 Cash 1870 00
Sales 1870 00
31 Accounts Receivable 1675 00
Sales 1675 00
31 Ann Hill Drawing 1500 00
Cash 1500 00

These Journal Entries are posted to the accounts in the accounts in the ledger as follow:

1)Ledger
Balance
Date Item P.R Debit Credit Debit Credit
1990
March 1 1 3500 00 3500 00

1 1 2400 00 1100 00

5 1 850 00 1950 00

6 1 125 00 1825 00

10 1 500 00 1325 00

13 1 575 00 750 00

16 1 1980 00 2730 00

20 1 650 00 2080 00

27 1 557 00 1505 00

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31 1 69 00 1436 00

Balance
Date P.R Debit Credit Debit Credit
Item
1990
March 1 175 00 1261 00
31

31 1 1870 00 3131 00

31 1 1500 00 1631 00
1. Account Cash Account No.11
Balance
Date Item P.R Debit Credit Debit Credit
1990
March 1 1 950 00 950 00

5 1 850 00 100 00

31 1 1675 00 1775 00
2. Account Receivable Account No. 12
3. Account supplies Account No.14
Balance
Date Item P.R Debit Credit Debit Credit
1990
March 1 1 1200 00 1200 00

20 1 650 00 1850 00

4. Account Prepaid Rent Account No. 15

Balance
Date Item P.R Debit Credit Debit Credit
1990
March 1 1 2400 00 2400 00

5. Account Photographic Equipment Account No. 18

Balance
Date Item P.R Debit Credit Debit Credit
1990
Marc 1 1 15000 00 15000 0
h 0

4 1 2500 00 17500 0

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6. Account Payable Account No. 21

Balance
Date Item P.R Debit Credit Debit Credit
1990
March 4 1 2500 00 2500 00

10 1 500 00 2000 00

7. Account Ann Hill Capital Account No.31

Balance
Date Item P.R Debit Credit Debit Credit
1990
March 1 1 20650 00 20,650 00

8. Account Ann Hill, Drawing Account No.32

Balance
Date Item P.R Debit Credit Debit Credit
1990
Mar 31 1 15000 00 15000 00
ch

9. Account Sales Account No. 41

Balance
Date Item P.R Debit Credit Debit Credit
1990
Mar 16 1 1980 00 1980 00
ch

31 1 1870 00 3850 00

31 1 1675 00 5525 00

10. Account Salary Expense Account No.52

Balance
Date Item P.R Debit Credit Debit Credit
1990
March 13 1 575 00 575 00

27 1 575 00 1150 00

11. Account Miscellaneous Expense Account No. 59

Balance
Date Item P.R Debit Credit Debit Credit

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1990
Mar 6 1 125 00 125 00
ch

31 1 69 00 194 00

31 1 175 00 369 00

2.6.4. Trial Balance

1. Definition - Trial balance refers to list of all general ledger accounts and their respective
balances.
2. Types - Three types:
o Unadjusted Trial Balance - prepared before account balances are adjusted
o Adjusted Trial Balance - prepared after account balances are adjusted
o Post-closing Trial Balance - prepared after temporary accounts are closed.
3. Purpose - Regardless of its type, trial balance is prepared in order to check whether total
dollar amounts of debits and credits recorded in the general ledger accounts are equal. If the
total debit and total credit are equal, the ledger is said to be in balance. The agreement of the
debit and credit totals of the trial balance gives assurance that:
 Equal debits and credits have been recorded for each internal and external transaction.
 The debit or credit balance of each account has been correctly calculated.
 The determination of total debit and credit balances of the trial balance has been
correctly performed.

4. Limitation of trial balances

The trial balance does not provide complete proof of the accuracy of the ledger. It indicates only
that the debits and the credits are equal.
Errors and The Trial Balance - If the trial balance does not balance, it indicates that there is an
error or are errors somewhere in the accounting process which should be discovered and
corrected. Errors that may possibly result in disagreement between the two totals of a trial
balance include:
 Posting unequal debit and credit amounts for an entry;
 Posting a debit entry as a credit or vice versa;
 Arithmetic mistakes in balancing accounts;
 Clerical errors in copying account balances into the trial balance;
 Listing a debit balance in the credit column of the trial balance or vice versa; and
 Errors in determining the debit and credit totals of the trial balance.
Equality of the total debits and total credits on the trial balance, however, does not imply that
transactions are correctly analyzed and recorded. Below are examples of errors which cannot be
discovered/detected by preparing a trial balance:
 Failure to journalize and/or post a transaction
 Journalizing and/or posting the same transaction more than once
 Journalizing and/or posting a transaction correctly but in or to the wrong account
 Journalizing and/or posting erroneous but equal dollar amounts of debits and credits
Despite these limitations, the trial balance is a useful device. It not only provides assurance that
the ledger is in balance, but it also serves as a convenient springboard for the preparation of

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financial statements. The trial balance, however, is merely a working paper, useful to the
Hill Photographic Studio
Trial Balance
March 31, 1990

Debit Credit

Cash 1631 00
Accounts Receivable 1775 00
Supplies 1850 00
Prepaid Rent 2400 00
Photographic Equipment 1750 00
Accounts payable 0 2500 00
Ann Hill, Capital 20650 00
Ann Hill, Drawing 00
Sales 1500 5525 00
Salary Expense 00
Miscellaneous Expense 1150 00
369
Total 2817 00 28175 00
5
accountant but not intended for distribution to users of accounting information.

5. Procedures to locate errors - As a matter of fact, there is no one best way of locating errors.
However, the following procedures, done sequentially, may save considerable time and effort
in locating errors.

i. Recalculate the debit and credit totals of the trial balance.

ii. Compare amounts listed on the trial balance with the related account balances in the
ledger.
iii. Recalculate account balances in the ledger.

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iv. Check accuracy of posting from the journal to the ledger.

v. Check the equality of dollar amounts of debit and credit entries in the journal.

The difference between the total debit and total credit balances may indicate the nature and
location of the error, thus, avoid the need for sequentially performing all the aforementioned
procedures.
6. Correcting errors - Once an error is discovered, it has to be corrected. Ways of correcting
errors depend upon the nature of and the place in the accounting process the error is located.
 Drawing a single line over an erroneous amount/incorrect account name and writing
the correct amount/account title is a common way of correcting simple errors due to
incorrect journal entries not yet posted to the accounts in the ledger and posting
incorrect debit/credit part of an entry.
 Journalizing and posting correcting entries is another and perhaps the best way of
correcting errors commonly used to correct complex errors due to incorrect journal
entries posted to the accounts in the ledger.

2.7. Matching Principle

Matching principle focus on the proper matching of revenue against expenses of the period. The
expenses are incurred to generate revenue for the period.
Revenue and expenses may be reported on the income statement by
1) Cash base
2) Accrual basis of accounting
2.7.1. Cash 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.
2.7.2. Accrual basis of Accounting- Revenues are reported in the period they are earned, and
expenses are reported in the period incurred regardless of the time of cash receipt or payment.
* Revenues Earned- when a service or product is sold to customers.
i.e. when the seller’s side obligation is complete.
Expenses are incurred when the service of some asset is used, when some assets are consumed or
when the services of some Employees or party is used rather than when cash is paid.
 Accrual basis of Accounting is used by most business enterprises and it is in line with
GAAPs basically the matching principle.

2.8. Nature of the adjusting process

Adjusting Entries are journal entries that are made at the end of the accounting period, to adjust
expenses and revenues to the accounting period where they are actually occurred. Adjustments
based on reality, not on a source document
Note- 1. If all financial events are recognized on a day-to-day basis, there is no need of adjusting
entry.
Note-2. Every adjusting entry affects both a balance sheet account and an income statement
account.
 Adjusting entries are required only under accrual basis of accounting.

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 Preparing adjusting entries is a key step in the ongoing accounting cycle, coming right
after you’ve completed preparing a trial balance.

Generally, there are five basic types of adjusting entries:

 Accrued revenues (also called accrued assets) are revenues already earned but not yet
paid or recorded.
 Unearned revenues (or deferred revenues) are revenues received in cash and recorded as
liabilities prior to being earned.
 Accrued expenses (also called accrued liabilities) are expenses already incurred but not
yet paid or recorded.
 Prepaid expenses (or deferred expenses) are expenses paid in cash and recorded as
assets prior to being used.
 Other adjusting entries include depreciation of fixed assets, allowances for bad debts, and
inventory adjustments.
2.8.2. Purpose of adjusting Entries
1. To measure all assets and Liabilities correctly
2. To measure net income correctly by matching expired costs (Expenses) with
realized revenue.
By their nature, all adjusting entries will involve a pairing of either an asset or liability account
with a revenue or expense account. Here are some typical examples of adjusting entries of each
type mentioned above:
Example: 1. According to the Hill photographic studio trial balance, the balance in trial balance
For supplies account is 1850. Clearly some of these supplies have been used during the past
month (March) and some may be still in stock.
Therefore either of the two information is used to enter the required journal entry to update
supplies account and supplies expense account.
Assuming that the inventory supplies on March 31 is determined to be 890.
Supplies available on book. (Balance in the account)----------------- 1850.
Less supplies on hand (inventory)----------------------------------------- 890
Supplies used (amount of adjustment)-------------------------------- 960
Adjusting entry- decrease asset account and increase expense account for the amount of
Adjustment:
Therefore: Supplies Supplies Expense
Mar1, 1200
20, 650 960 960
31, 890 1850

Example: 2. The debit balance of 2400 in Hill’s prepaid rent account represents a pre
payment on March1 of rent for three months. (March, April and May)
At the end of March, the rent expense account should be increased (debited) and the prepaid
Rent account should be decreased (credited) by the amount of prepaid rent expired for march-
2400/3 = 800
Prepaid Rent Rent Expense

March1, 2400 800 800

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1600
If the preceding adjustments for supplies (960) and prepaid rent(800) are not recorded, the
financial statements prepared as of March31, will be incorrect (misleading) to the extent
indicated as follow:
On Income statement:
Expenses (supplies Expense for 960
Rent Expense for 800 will be understated ---------1760
Net income will be overstated----------------------- 1760
On statement of Owner’s Equity:
Net income will be overstated---------------------------1760
Ending Owner’s Equity will be over stated ------------1760
On balance sheet:
Assets (Supplies and prepaid Rent) overstated---------------------1760
Owner’s Equity will be overstated ----------------------------------1760

2. Pre-payments are initially recorded in an Expense account

Adjusting Entry- Reduce expense account and increase asset account for the amount of asset
not yet consumed or cost not expired. On the 1st day of the next period reversing entries are
required to facilitate consistency in recording.
Example1. If Hill recorded purchase of supplies in a supplies expense account at the time of
purchase; before adjustment supplies Expense Account has a debit balance of 1850. The
adjusting entry reduces the supplies expense account and increase the supplies account for the
unconsumed part of supply.
Supplies Expense Supplies
Mar1.1200
20 650 M31890
Mar31 890
960 1850

Example 2.
Similarly if Hill recorded payment of rent in advance as an expense (Rent Expense) before
adjustment Rent Expense account has a debit balance of 2400. Therefore, the adjusting entry
reduce Rent Expense account and increase the asset pre-paid rent for the amount of pre-payment
not yet expired.

Rent Expense Prepaid Rent

Mar1. 2400 1600
Mar31. Mar31.1600
800

Exercise: If the above adjusting entries are not made what is the effect on income
statement, statement of owner’s Equity and balance sheet prepared as of
March 31 under case 2 above?

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II. Plant Assets

Like supplies and other pre-payments plant asset was used in operation once acquired. Unlike
supplies there is no visible reduction in the quantity of plant asset. However, as time passes,
plant asset lose its capacity to provide useful services. This decrease in usefulness is a business
expense, which is called depreciation expense.

The adjusting entry to record depreciation is similar to the adjusting entry for prepayments when
initially recorded as assets. i.e. adjusting entry reduces the asset account and increases the
expense account.
Example: Assume that estimated amount of deprecation for Hill is 175 for March.
Photographic Equipment Accumulated Depreciation-Equipment

Mar1. 15000
4 2500 Mar.31 175
17500
Depreciation Expense
Mar.31.175
2.9. Worksheet
Accountants often use working papers for collecting and summarizing data they need for
preparing various analysis and reports. Such working papers are useful tools, but they are not
considered as part of formal financial statements.
Work sheet is a working paper that accountants can use to summarize adjusting entries and the
account balances for financial statements.
A work sheet is an important tool, but is not an essential part of the accounting system, like
accounts, journal, or ledger; for example for small companies with few accounts and
adjustments, a worksheet may not be necessary.
The work sheet is identified by:
1. The name of the enterprise
2. The nature of the form (work sheet)
3. The period involved.
A commonly used work sheet has an account title column and ten (10) columns divided in to five
pairs of debits and credit columns.
The main headings of the five pairs of money columns are:
1. Trial Balance
2. Adjustments
3. Adjusted Trial Balance

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4. Income Statement
5. Balance sheet

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Example-Work sheet
Hill photographic studio
Work sheet
For the month ended march31, 1990
S.N Account Title Trial Balance Adjustment Adjusted Trial Balance Income Statement Balance Sheet
Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
1 Cash 1631 00 1,631 00 1631 00

2 Accounts Recv. 1775 00 1775 00 1775 00

3 Supplies 1850 00 a.960 00 890 00 890 00
4 Prepaid rent 2400 00 b. 800 00 1600 00 1660 00
5 Photographic Equ. 17500 00 17500 00 17500 00

6 Accounts Payable 2000 00 2000 00 2000 00

7 Ann Hill Capital 20650 00 20650 00 20650 00
8 Ann Hill, drawing 1500 00 1500 00 1500 00
9 Sales 5525 00 5525 00 5525 00
10 Salary Expense 1150 00 d. 115 00 1265 00 1265 00
11 Miscellaneous 369 00
Exp.
12 28175 00 28175 00
13 Supplies Expense a.960 00 960 00 960 00
14 Rent Expense b. 800 00 800 00 800 00
15 Depreciation Exp. c. 175 00 175 00 175 00
16 Accumulated Dep. c.175 00 175 00 175 00
17 Salaries paya. d. 115 00 115 00 115 00
18 2050 00 2050 00 28465 00 28465 00 3569 00 5525 00 24896 00 22940 00
19 Net Income 1956 00 1956 00
20 5525 00 5525 00 24896 00 24896 00

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TRIAL BALANCE COLUMN

Lists account balances before adjustment.

2. ADJUSTMENT COLUMN

Both the debit and credit parts of an adjustment should inserted on the appropriate lines before
going on to another adjustment. Cross referring the related debit and credits of each adjustment
by letters (numbers) is important for reviewing the work sheet later, and also when recording the
adjusting entries in the journal.

The order in which the adjustments are entered on the work sheet is not important most
accountants enter the adjustments in the order in which the data are assembled.

If the titles of some of the accounts to be adjusted do not appear in the trial balance, they should
be inserted in the Account Title column, below the trial balance totals.

Explanation for Entries in adjustment columns of the Hill photographic studio work sheet:

a. Supplies: - The supplies account has a debit balance of 1,850 under the trial balance
column. This represents the acquisition cost of supplies; but as discussed earlier, the cost of
supplies; on hand at the end of the period is 890; therefore the adjustment is entered by writing 1.
Supplies Expense in the Account title column and 2. 960 in the adjustments debit column on the
same raw, 3. 960 in the Adjustment credit column on the line with supplies.
b. Rent: - The prepaid rent account has a debit balance of 2400; earlier we have determined the
rent expense for March amounts 800. Therefore, the adjustment is entered on the work sheet by
writing:
1. Rent Expense in Account title column
2. 800 in the adjustments Debit column on the same line.
3. 800 in the adjustments credit column on the line with prepaid rent
c. Depreciation: - Depreciation of photographic Equipment was estimated at 175 for the
Month. Therefore the adjustment is entered by writing:
1. Depreciation Expense on Account Title column
2. 175 in the adjustment Debit column of the Depreciation Expense account line.
3. Accumulated Depreciation in the Account title column and
4. 175 in the adjustments credit column on the line with Accumulated Depreciation.
d. Salaries: - Salaries accrued, but not paid at the end of March amounts to 115. The
adjustment is entered by writing
1. 115 on the adjustments debit column on the same line with salary Expense.
2. Salaries payable in the Account Title column
3. 115 on the adjustments credit column on the same line with salaries payable.
* The final step in completing the Adjustments columns is to prove the equality of debits and
credits.

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3. Adjusted Trial Balance Columns

The data in the trial balance columns are combined with the adjustments column data and
extended to the adjusted trial balance column.
4. and 5. Income statement and Balance sheet column
- The data in the adjusted trial balance column is extended to any one of the remaining four
columns under the Income statement and Balance sheet columns.

- All Balance sheet accounts:- Assets, liabilities and owner’s Equity (capital and Drawing) are
extended to the balance sheet column having their appropriate balances.

- All income statement accounts are i.e. Revenues and Expenses are extended to Income
statement column of the worksheet.

After all of the balances have been extended each of the four columns is totaled, the net income
or the net loss for the period is the amount of the difference between the totals of the two income
statement columns. If the credit column total is greater than the debit column total, the excess is
the net income, if the reverse is true, then the excess is the net loss.
- After this difference (Net Income /Loss) is computed this is inserted in the worksheet by
writing.
1. Net Income (Loss) under the Account Title column
2. The amount is entered in the debit column of the income statement column if it is Net income;
or entered in the credit column of the income statement column if it is Net loss.
3. The amount is entered in the credit column of the Balance sheet column if it is net income;
and it is entered in the Debit column of the balance sheet column if it is net loss.
After the final entry is made on the worksheet, each of the four columns is totaled to verify
arithmetic accuracy.
A. Financial Statements
The worksheet is an aid in preparing financial statements. The income statement, statement of
owner’s equity, and balance sheet are prepared from the work sheet.

2.10. Journalizing and posting Adjusting Entries.

At the end of the accounting period, the adjusting entries appearing in the worksheet are recorded
in the journal and posted to the ledger. This procedure brings the ledger into agreement with the
data reported on the financial statement.
The adjusting entries are dated as of the last date of the period.

Closing Entries
The revenue, Expense, drawing (dividend) accounts is temporary accounts used in classifying
and summarizing changes in the owner’s Equity during the accounting period.
To report amounts only for one period temporary account should have zero balances at the
beginning of a period.
Closing entries transfer the balances of temporary accounts to the owner’s capital account.
An account titled “Income summary” is used for summarizing the data in the revenue and
expense accounts.

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It is used only at the end of the accounting period and is both opened and closed in the closing
process.
⇒Others use for the same purpose account titles such as: Expense and Revenue Summary, Profit
and Loss Summary, or Income and Expense Summary.

Four entries are required in order to close temporary accounts of a sole proprietor ship at the end
of a period:
1. Each Revenue account is debited for the amount of its balance, and Income Summary
is credited for the total revenue
Revenue1---------xx
“ 2--------xx
“ 3-------xx
Income Summary-----------xx
2. Each expense account is credited for the amount of its balance, and Income Summary is
debited for the total expense.
Income Summary-----------xx
Expense 1--------------------xx
Expense 2--------------------xx
Expense 3--------------------xx
3. Income Summary is debited for the amount of its balance (net income) and the capital account
is credited for the same amount. (Debit and credit are reversed if there is net loss.)
4. The drawing account is credited for the amount of its balance, and the capital account is
debited for the same amount.
Example- For Hill photographic studio
1. To close Revenue:
Sales------------------------5525
Income Summary--------------------5525
2. To close Expenses:
Income summary------------3569
Salary Expense-----------------------1265
Miscellaneous Expense-------------369
Supplies Expense-------------------960
Rent Expense-------------------------800
Depreciation Expense---------------175
3. To close the Income Summary:
Income Summary------------1956
Ann Hill, Capital----------------1956

4. To close Drawing account

Ann Hill, Capital--------1500
Ann Hill, Drawing----------15000
Post closing Trial Balance
The last procedure of the accounting cycle is the preparation post closing trial balance after all of
the temporary accounts has been closed. The purpose is just to make sure that the ledger is in

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balance at the beginning the new accounting period. The account titles and amounts should
agree exactly with the accounts and amounts listed on the balance sheet at the end of the period.

Example:
Hill photographic studio
Post-closing Trial Balance
March 31, 1990

Cash ---------------------------------------------1631
Accounts Receivable--------------------------1775
Supplies-----------------------------------------890
Prepaid Rent-----------------------------------1600
Photographic Equipment--------------------17500
Accumulated Depreciation----------------------------------175
Accounts payable--------------------------------------------2000
Salaries payable-----------------------------------------------115
Ann Hill, Capital--------------------------------------------21,106
23,396 23,396

End of Chapter Two

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